Trade will bring us together

It is worth remembering that even as free trade makes the headlines, agreements by themselves are not likely to work the magic. For South Asia to unleash its long-suppressed economic potential, there has to be the backing of a far bolder political leadership than it has historically enjoyed.

In recent years, economic cooperation in South Asia has been seen mostly as a matter of lowering the high trade barriers that exist between India and its neighbours. In other words, while efforts to create a South Asian Free Trade Area (SAFTA) have been stymied by the Indo-Pak stalemate, India has been pursuing its own bilateral deals.

It is worth remembering though that even as free trade makes the headlines, agreements by themselves are likely to have limited impact. But combined with other initiatives they could play a significant role in unleashing the region´s long-suppressed economic potential. This will, however, require far bolder political leadership than the region has historically enjoyed.

The desire to increase South Asia´s trading Capacity is not misplaced. Openness to trade correlates closely with economic growth in developing Asian countries, as Table 1 shows. Countries whose trade volumes were high relative to gross domestic product (GDP) by the mid-1980s enjoyed substantially higher rates of GDP growth over the next decade than did their trade-averse neighbours. As a group, the trade-to-GDP ratio of the five "tiger" economies of East and Southeast Asia was double that of South Asia in 1985-1987; over the next decade, the tiger economies´ GDP growth rate was 60 percent higher than South Asia´s. It is no coincidence that the Subcontinent´s richest country, Sri Lanka, has long been the most open to trade.

And after years of dithering, India also seems to have gotten the message. The current government in New Delhi is making serious efforts—fiercely opposed by domestic producer lobbies—to shore up India´s trading strength. By 1 April next year, it will have abolished quantitative restrictions on all imports (except, ironically, on tea and textiles covered by a "free trade" agreement with Sri Lanka). India´s Commerce Minister Murasoli Maran has also announced ambitious plans to turn the country´s moribund export-processing zones into Chinese-style "special economic zones", with more liberal rules for foreign investment and possibly more flexible labour laws.

Regional swadeshi
All this would appear to favour the creation of a more liberal trade regime the centrepiece strategy for economic cooperation among the SAARC member nations. All South Asian countries need to trade more. And what better place to start than at home, especially since there is scarcely any trade among the region´s countries at present (Table 2a). Till now, most of SAARC´s limited energies on the economic front have been devoted to bringing about the current South Asian Preferential Tariff Arrangement (SAPTA), which has lowered tariffs within the region on a range of goods. Work has now begun on a South Asian Free Trade Area (SAFTA), with a draft treaty being scrutinised by ministries in all seven capitals.

But liberalised trade rules are not enough. A free-trade agreement must be set in the context of a wider commitment to regional economic development—a commitment which so far has been difficult to forge because of continued political tensions among the SAARC member nations. More disturbingly, intra-SAARC free trade is often conceived as a substitute for the more crucial goal of liberalising trade generally. Arguments for SAFTA often cite the foreign exchange savings that member nations would realise by importing goods from within the region rather than from outside. This argument conceptualises regional free trade not as a way of creating wealth but as a method of diverting trade from outside the region to within it. This amounts to little more than old-fashioned swadeshi writ within regional boundaries rather than national ones.

Some argue that this does not matter, that trade liberalisation must start somewhere and that the South Asian countries, late to the globalisation game, should liberalise trade among themselves as a first step to lowering trade barriers generally. But the evidence from elsewhere in the world suggests that it would make more sense for each country in the region to liberalise its trade rules generally, and work out a special regional trade deal later.

Free-trade agreements tend to follow trade flows, not create them. The established and emerging export powerhouses of East Asia Japan, South Korea, Taiwan and China don´t belong to any free-trade club and have no prospects of doing so either. The ASEAN nations became big exporters long before they started talking about free trade—the ASEAN Free Trade Area will not take effect until 2010. South Asia´s problem is that it does not trade enough with the rest of the world (Table 2b), and not that there is insufficient intra-regional trade. If all the South Asian countries independently pursued trade-friendly policies with the rest of the world, increased trade within the region would follow as a natural result, without the need for any preferential policies.

No complements
Closer economic cooperation within a region, whether of the free-trade variety or of any other kind, arises in two sets of circumstances. First, in highly-developed regions where the individual economies have become so complex and intertwined that even modest trade and investment barriers pose a significant obstacle to continued growth, and where the necessity for greater economies of scale in turn creates a demand for a larger market. This is what happened in Europe with the creation first of the Common Market and later of the unified currency.

Second, closer economic ties can develop among neighbour countries that have complementary resources—usually, abundant capital in one country and a large pool of cheap labour in another. This was one of the driving forces behind the North American Free Trade Agreement (NAFTA) and it has also been a key factor in the integration of East Asia, where Taiwan and Hong Kong have provided three-quarters of China´s foreign direct investment over the past two decades, with their sophisticated manufacturers taking advantage of China´s cheap and abundant land and labour. It is worth noting that trade in finished goods within the greater China region is not the chief goal of this activity: Hong Kong and Taiwanese factories in China export most of their production to third countries. Indeed, trade between China and Taiwan continues to be artificially depressed by Taiwan´s draconian quantitative restrictions on Chinese products.

South Asia possesses neither of the above sets of characteristics. The seven countries are all more or less equally poor. All countries rely on an extremely narrow range of similar export goods—principally textiles and garments—for which the natural markets are not within the region but outside it (see Table 3). The only significant complementarity is one of size: giant India could offer its neighbours a large market if it chose to do so.

Patterns of informal cross-border trade among SAARC countries also suggest that there is little pent-up demand that could create sudden benefits following a free-trade treaty. This informal trade is an important part of the region´s border-region economies: a 1995 study estimated that annual informal trade between India and Bangladesh was about INR 11650 million (USD 370 million at the exchange rate of the time), nearly as much as formal trade. Indirect trade between India and Pakistan, mostly via Dubai, is estimated at around USD 1 billion a year—seven times the official bilateral trade—and smuggling is also rife across the unfenced Rajasthan/Sindh border, though the value of these transactions is probably less.

But every effort to examine these informal trade networks has shown that they are dominated by purely opportunistic efforts to reap quick profits from price differences in basic commodities or very low value-added goods: cattle (India/Bangladesh), sugar (India/Pakistan) and gold (India/Nepal). The profits are rarely, if ever, invested in new productive capacity—that is, in factories that could form the basis of sustainable industry and employment. It is hard to see how a regional free-trade agreement could change this.

At any rate, progress on SAFTA is impossible in the current environment of Indo-Pak hostility. In the absence of a regional agreement, India is pursuing bilateral trade pacts with its neighbours. A very liberal Indo-Nepal trade agreement took effect in December 1996. A far more restrictive Indo-Sri Lanka pact became operational on 1 March of this year. And a limited trade liberalisation deal between India and Bangladesh could well be signed after the elections in Bangladesh later this year.

As with SAFTA, these bilateral deals is better than having none at all. But their effectiveness is limited by protectionist producer lobbies, which force these agreements to be hemmed in by restrictions and exceptions, and by the failure to complement them with improvements in local investment climates.

The history of the Indo-Sri Lanka agreement shows up clearly the conflicting pressures that make it difficult for trade agreements in the region to achieve substantial benefits. A broad agreement, granting reduced or zero-tariff status for 1350 Sri Lankan goods entering India, and 300 Indian goods entering Sri Lanka, was initialled by Indian Prime Minister Atal Behari Vajpayee and Sri Lankan President Chandrika Kumaratunga in December 1998. But India´s protectionist lobbies quickly leapt into action and forced New Delhi to exclude tea, rubber, textiles and coconut products—virtually all of Sri Lanka´s top exports—from the deal. This surprise action made the pact unacceptable to Colombo.

After a year of haggling, Sri Lankan officials travelled to New Delhi in February and hammered out a compromise that put tea and textiles back into the treaty, but on a restricted basis: low-tariff imports of Sri Lankan tea are limited to 15 million kg a year, and garments to eight million pieces. The preferential duty on tea was initially set at 17.5 percent, or half the basic tariff rate for tea; two months later, as a sign of its determination to make the treaty more meaningful, New Delhi cut this preferential duty to 7.5 percent. The South Indian tea-growers´ association, whose members are already being hurt by low prices and declining margins, protested. At the moment the Indian government seems intent on resisting the growers´ pressure, but how long it can stand firm is an open question.

It is still too early to say how successful the Indo-Sri Lanka pact will be; the experience of the Indo-Nepal agreement suggests it may be limited. Under that agreement, any item manufactured in Nepal—except alcohol, tobacco and cosmetics—may be exported duty-free to India. (Indian products are still subject to tariffs when entering Nepal.) On the positive side, Nepali exports to India have nearly quadrupled since the treaty took effect in April 1997, from NPR 3.8 billion in 1996/97 to NPR 13.1 billion (US$ 190 million) in 1998/99. Most of the new exports have been in low-end consumer goods: toothpaste, soap, detergent, instant noodles, vanaspati ghee. As a result, Nepal, alone of South Asian countries, has substantially reduced its reliance on a narrow range of export products (Table 3).

But the impact of the export boom on the wider Nepali economy has been limited, since it has not led to substantial new investment. In particular, it has not sparked significant investment by Indian manufacturers, as had been hoped. In the year before the treaty took effect, foreign investment in Nepal was USD 22.3 million. In the year after, it rose only slightly to USD 23.1 million; in the second year, it plummetted to USD 8.6 million.

One reason why this investment hasn´t occurred is that, aside from the free-trade arrangement, Nepal offers no particular advantages over locations in North India. Labour is only marginally cheaper than in India and less productive; it is no easier or cheaper to acquire land for a factory site; local currency financing is hard to come by; and Nepal´s regulatory system remains underdeveloped, with red tape remaining the rule.

A better answer
In short, cutting tariff rates is fine, but what the region really needs is a far wider concept of economic cooperation, in which liberalised trade rules complement other efforts to spur economic development across national boundaries; that is, a joint programme for creating a "South Asian Growth Area". What forms might these efforts take? Any answer to that question must start with an identification of the region´s basic economic problems. With the occasional exception of Sri Lanka, the South Asian economies share these characteristics:

• Low investment and even lower saving.
• Low levels of government revenue
• Inefficient allocation of public-sector re sources (too much money wasted on bureaucratic salaries and loss-making public enterprises)
• Low reliance on trade
• Low literacy and primary education rates
• Poor infrastructure

It is easy to see that any intra-regional free trade regime, even if it were magically to appear tomorrow, would solve none of these problems. The issues of government revenue, public sector waste and education are essentially matters of domestic policy, but it would certainly be fruitful for SAARC to sponsor region-wide conferences at which the best policy minds from all the member countries could share ideas about how to solve them. Research on how these problems have been dealt with in other developing economies, especially in Southeast Asia, would also be helpful..

In more concrete terms, probably the area in which regional cooperation could make the most difference is in infrastructure, including energy sales, water-sharing and transportation. To take transportation as an example, it is hard to talk about "free trade" in a region where movement between countries is still so unfree. Air routes between many of the countries are of recent vintage and limited capacity. Road links are poor. More important, no two countries in the region are connected by rail, so it is impossible to move cargo from the Calcutta or Haldia ports to eastern Bangladesh, or from Chittagong to Assam, or from Karachi to northwest India.

A regional approach to developing transportation infrastructure makes eminent sense, especially in the east where Nepal, Bangladesh, and India´s eastern and northeast provinces form a natural economic region fragmented by arbitrary national frontiers. So far, efforts to improve transport in this region have focussed more on legal rights than on building the infrastructure which would make those rights meaningful: India´s 1997 decision to allow transit of Nepali goods from Bangladesh through West Bengal, and Bangladesh´s offer earlier this year to allow a similar facility to Indian goods between West Bengal and the northeast. But these facilities remain moot partly because they remain hedged around by so many restrictions and partly because the dreadful state of roads makes large-scale cargo movements impossible. What is really needed is construction of new international road, rail and inland waterway networks that would link ports in eastern India and Bangladesh to their natural hinterland.

This was one of the thoughts that lay behind the now moribund "Growth Quadrangle´ concept, but it has never been pursued with any vigour. The usual excuse is that none of the countries involved, including India, has the money to finance such spending. But donor agencies such as the World Bank, as well as private foreign investors, might well underwrite much of the cost if they felt there was a strong political will to create a regional growth zone.

And this is the heart of the matter. Meaningful economic cooperation is unlikely to occur in South Asia unless a strong political consensus emerges to put economic development at the top of the regional agenda, and national leaders jointly articulate a common vision of a "South Asian Growth Area", accompanied by specific goals in a wide range of areas: freer trade and investment, a regional transportation network, cross-border energy sales, and water-sharing agreements. This will require some imaginative leadership.

Up to now, India has tended to view its neighbours more as potential security threats than as economic partners. Electorates in neighbouring countries, cowed by India´s sheer size, have tended to reward reflexive anti-Indianism in their political leaders. But a significant minority in India´s bureaucracy now recognises that India´s security would be best served by neighbours that are economically vibrant and hence politically more stable. Constituencies in most of the neighbour countries also exist for more open economic relationships with India. All that is now needed is a joint resolution by political leaders to face down domestic opposition and take a firm stand in favour of regional growth.

(This article was prepared by Analysis Asia under the direction of senior economist Daniel Gay. Analysis Asia is a research service, providing economic forecasting and analysis on the Asia-Pacific region.)