Free Trade Agreement in South Asia: A Fad or Fortune

Abstract: 
Present study analyses the issue of free trade agreement (SAFTA) in SAARC, if it is merely a fad or is a fortune. Though there is a small volume of bilateral trade between SAARC countries, the study revealed that there exists huge potential for bilateral trade. The gravity result showed a positive relation between intra region trade and growth in GDP. Trade data analyses revealed intra SAARC trade growing at a higher rate than SAARC - world trade. SAARC’s trade with major trading partners showed trade concentration in recent years shifting towards neighbouring and economically faster growing economies. Hence, though there is the challenge of proper implementation of SAFTA agreement, SAARC has a greater potential for intra region trade after SAFTA comes into operation in 2006. Therefore, the free trade agreement is not a mere fad, but potentially a fortune for South Asia.
Main Article: 

1. Introduction

Regional economic enhancement through trade integration has become a global phenomenon. The South Asian Free Trade Agreement (SAFTA), agreed by the members of the South Asian Association for Regional Cooperation (SAARC), including Bangladesh, Bhutan, India, Maldives, Nepal, Pakistan and Sri Lanka, in 2004, is one of the latest examples of this phenomenon. Following the SAFTA agreement, the SAARC nations have agreed to promote trade and economic cooperation among member countries through eliminating trade barriers, and facilitating the cross border movement of goods between the contracting states. The objective is the commitment to strengthen intra region economic cooperation to maximize the realization of the region’s potential for trade and development (Dawn, 2004 p14).

The first initiative in trade cooperation in the region had been the SAARC Preferential Trading Arrangements (SAPTA) in 1995. The SAPTA set a special trade zone offering preferential tariff and non-tariff treatment to member states. However, it had limited scope because of its voluntary and product-by-product approach to liberalization (Jain, 1999 p403). Therefore, the SAARC nations moved towards a greater opening of bilateral trade through the free trade agreement, the SAFTA.

Yet, due to adverse economic and political circumstances, the prospective of trade integration in SAARC is questionable. South Asia is one of the poorest regions in the world, accounting for one-fourth of world population, out of which 40 per cent live below the poverty line (World Bank, 2003). SAARC accounts for only 1 per cent of the world’s total trade and the intra-region trade is less than 4 per cent (IMF, 2004). Compared with other trading blocs such as EU, and ASEAN which have 60 per cent and 20 per cent bilateral trade in the region respectively, intra SAARC trade is negligible.

The smaller volume of intra-region trade is primarily, attributed to the enmity between the two largest economies[i] in SAARC, India and Pakistan. Frankel and Wei (1995 p31) found trade between the two countries 70 per cent less than two otherwise identical countries. Therefore, they have assessed South Asia as an ‘anti-bloc’ region, having less potential for any regional trade integration. Hence, intra-region trade in SAARC appears dubious, and the question arises if the free trade agreement in the region is merely a fad.

However, the meagre intra-region trade that has made the intra-SAARC trade questionable, could be due to unexplored trade opportunities (Khan and Khan 2003 p2), or restrictive trade policies (Frankel and Wei, 1995), due to low income and low demand (Khan 1997 p168) or due to the dominance of unofficial trade (Banskota, 2002 p118, Hussain, 2004 p1). These obstacles will be removed once SAFTA comes into operation in 2006. SAFTA proposes for removing barriers and facilitating free movement of goods between member countries through elimination of tariffs, para-tariffs and non-tariff barriers, and promoting conditions for fair competition in the region (Appendix A). SAFTA, subsequently, provides a platform for mitigating political differences. The examples of EU and ASEAN[ii], demonstrate that economic forums could become instrumental in mitigating political differences.

Likewise, SAARC countries possess socio-economic similarities. Thus, they have similarities in preferences (Khan and Khan, 2003 p3). Countries with parallel preferences should trade more bilaterally because of demand similarities (Anam and Rahman, 1991 p3). Thus, once the free trade agreement comes into force, intra-region trade in SAARC should increase significantly. Hence, the free trade agreement in SAARC, appears as a fortune, that is viable as well as instrumental in bringing economic integrity to the region.

Thus, the issue in the current study is to establish whether the free trade agreement in SAARC region is merely a fad, brought out to drift with the global phenomenon of regionalism or is a fortune, which can sustain and become instrumental in accelerating SAARC’s quest for economic development through trade integration. As this is one of the least studied, and a current issue, the study is timely and significant also.

The gravity model of international trade is the empirical instrument of the study. Simultaneously, it employs bilateral and multi-lateral trade data to a greater extent for further analyses of the study. The study is divided into five parts: introduction, literature review, methodology, results presentation and discussion, and conclusion. The essay hypothesis is that free trade agreement in SAARC should be a fortune; not a mere fad. The findings match the hypothesis, and hence, the essay concludes that though at present intra-SAARC trade is small, SAARC has a greater potential for intra-region trade. Therefore, the free trade agreement is not a mere fad but potentially a fortune for South Asia.

2. Literature Review

Frankel, Wei and Stein (1994), suggested five possible reasons for trade integration along geographic lines. First, to resolve issues such as migration and environmental policy and the regional dimension in their spill-over effects; Second, for the protection of intellectual property rights or trade related investment measures in the regions; Third, to promote political stability, democratic evolution and peaceful relation.; Fourth, trade liberalization and, fifth, promotion of trade creation (TC) over trade diversion (TD), through reduction in tariffs and other trade barriers within a preferential trading arrangement. Hence, the explanations are useful in understanding the worldwide phenomenon of trade integration along with neighbouring countries.

Similarly, Al-Atras and Yousef (1999), applying the gravity model in intra-Arab trade, concluded that intra-Arab trade and, more broadly, Arab trade with the rest of the world was lower than what would be predicted by the gravity equation. Therefore, there is scope for increased bilateral trade if Arab states form a trading bloc. Hence, the Al-Atras and Yousef explanation suggests that the smaller intra country trade is not an impediment in instituting a regional trading bloc, rather an opportunity in enhancing bilateral trade through trade integration.

Likewise, Hassan (2001) claimed that liberalization of trade in SAARC countries would offer significant gains for all the economies in the region. However, Srinivasanand Canonero (1993, 1995) argued the free trade agreement in SAARC would be beneficial to smaller countries than to larger countries. Simultaneously, looking at the long standing enmity and the existing low volume of trade between India and Pakistan, Bhagwati (1992) argues that border can breed hostility and undermine bilateral trade. Frankel and Wei (1995), have found SAARC unlikely to work as an integrated trading bloc. .

However, Hossain and Duncan (1998) argue that in the current context of globalization and trade integration, trade adjustment would bring the countries of South Asia closer to settling conflicts. They further argue that the economic asymmetry[iii] in this region would not preclude economic cooperation, rather, a trading bloc involving geographically larger India and its small neighbours would lead to a significant increase in intra region trade.

Yet, some literature is critical on the issue of trade integration. Viner (1950) started the debate on FTAs introducing two effects ‘trade creation’ (TC) and ‘trade diversion’ (TD), which is better known as ‘Viner’s Paradigm’. Lu (2003), has presented the paradigm in a hypothetical case as presented in Table 2.1.

Table 2.1: A hypothetical case for TC and TD

  Tariff Rate ($)
Cost of T-shirt in US from: 0 6 10
USA 20 20 20
Mexico, Pre-NAFTA 16 22 26
Mexico, Post-NAFTA 16 16 16
China 12 18 22

Source: Lu 2003

Table 2.1 shows that NAFTA has created a TC for Mexico but a TD for China’s exports. TC is good for Mexican export growth, and at the same time it is good for the US too, since the barrier (tariff) related distortion has been reduced. But the TD is bad, not only from the Chinese point of view, that its exports have been reduced, but also the production of T-shirts have diverted from a low cost area (China) to a relatively high cost area (Mexico). Therefore, there is loss in efficiency.

Though trade diversion is bad, Lu (2003), argues that FTA may be desirable even if it is trade diverting. As seen in Table 2.1, the T-shirt price has fallen, which is a welfare gain to the US consumers. At the same time, due to lowered price, the demand for Mexican T-shirts will increase, which will ultimately increase the quantity of T-shirts produced. Hence, again efficiency is realized through economies of scale.

However, Bhagwati and Schott (2004) are of the view that trading blocs at the expense of multilateral trading agreement would stem inefficiency in international trade. Still, since getting multilateral agreement in trade is difficult because of varying preferences of the members of World Trade Organization (WTO), regional trade integration is the second best alternative (Yamazawa, 2002 p4). The WTO also endorses the institution of preferential trading blocs (Article XXIV), provided such an agreement will not impose further tariffs on non-members (WTO, 2004 p6).

To sum up, the literature suggests that though there are some trade-offs, still a free trade agreement is trade facilitating. It contributes to trade liberalization, creates more trade opportunities, increases economies of scale and subsequently endows benefits on contracting states. However, there is a gap in the literature regarding the prospective of the free trade agreement in SAARC. The present study attempts to bridge this gap.

3. Methodology

Theory and model specification

The determinants of bilateral trade are based on the theory of ‘resistance’ to trade flows. In bilateral trade, resistances are obstacles to free trade which appear in the form of trade policy, distance between trading countries, or tariff-quota barriers. Statistical analyses carried out to explain the nature of resistance to bilateral trade flows have identified two approaches: first, the gravity model approach and, second, the intensity approach (Drysdale and Garnaut, 1982 p62). As the gravity model approach seeks to explain each bilateral trade flow independently, by reference to the measure of trade potentiality of the two economies and to resistance to bilateral trade, the essay applies the gravity model in analyzing bilateral trade in the SAARC.

The gravity model estimates trade flows as a function of variables that directly or indirectly affect the determinants of normal trade flows. In international trade, bilateral gross aggregate trade flows are commonly explained using the Bergstrand (1984:1) specification:

PXij=b0(Yi)b1(Yj)b2(Dij)b3(Aij)b4uij (1)

Where,

PXij is the value of the trade flow in US dollars from country i to country j,

Yi (Yj) is the value of GDP in i (j), in US dollar,

Dij is the distance from the economic center of i to that of j,

Aij is any other factor(s) either aiding or resisting trade between i and j,

uij is a log normally distributed error term with E(lnuij) = 0.

In log linear form:

log PXij = logb0 + b1log(Yi)+ b2log(Yj)+)+b3log(Dij)+ b4log(Aij)+..+εij (2)

Where εij = (uij)

Different specifications such as Linnemann (1966), Frankel and Wei (1995), and Baltagi, Egger and Pfaffermayr (2003), are applied to estimate the gravity model.

Hence, this study applies the gravity model, using Frankel and Wei (1995) specification in the log linear equation form as presented in equation 3. The choice is based on the better relevancy of the specification on this study.

Log(TBijt) = α + β1log(GDPitGDPjt) + β2log (DTij) + β3log (Aij) + εij (3)

Where,

TBijt is bilateral trade between countries i and j at time t (measured in the US$ million 1995 price),

GDPit is the real GDP of reporting country at time t,

GDPjt is the real GDP of partner country at time t.

DTij is the distance between countries,

Aij represents the dummies. In the essay pairs of regional trading blocs (RTBs) have been created as dummies. The dummies take value of 1 if two countries are in same regional trading blocs, it is 0 if they differ.

εij is error term.

Data description

The major source of trade data used in the study is the International Monetary Fund (IMF)’s Direction of Trade Statistics, 2004. The other sources have been the World Bank Development Indicators database 2003, The World Bank annual report 1997, and 2003, and the Asian Development Bank, Key Indicators of Developing Asian and Pacific Countries, 2003. Similarly, the data on distances between the capital cities of the countries in consideration has been retrieved from the US Department of Agriculture (2004) ‘Distance between great cities’.

The study covers the trade data of seven SAARC countries, and their bilateral trade in the region between1990-2002. However, the data on SAARC’s bilateral trade with EU (15 countries), ASEAN (10 countries)[iv], Middle East (16 countries), China, USA, and Japan between 1993-2003, have also been the important part of the data analyses. For gravity model test, the panel data of bilateral trade between six South Asian countries (Bhutan’s data could not be found at the required level), in 1991, 1993, 1995,1997, 1999, and 2001 have been estimated applying the OLS method. The model test covers a total 216 observations.

4. Result and discussion

The empirical result is drawn applying the gravity model as explained in section 3. The model is based on Frankel and Wei specification (1995)[v]. The dependent variable in the estimation is the volume of total trade, exports plus imports (in logarithmic form). The test estimates the ‘essence’ of the gravity model that is the effect of economic size and geographical distance in bilateral trade (Frankel and Wei, 1995). Simultaneously, the Brusch-Pegan test is conducted to check heteroscedasticity. The result revealed that there is a presence of heteroscedasticity at 5 per cent confidence level. Therefore, to fix the problem, the white robust standard error is applied. The test is conducted on the hypothesis that bilateral trade should have positive relation with GDP, and trade should be inversely related with distance. Hence, the observed result is presented in Table 4.1.

Table 4.1 Empirical result

lntradeij Coef t p>ItI [ 95% Conf. Interval]
lngdpi 0.4683 (0.0697)** 6.72 0 0.3307 0.6059
lngdpj 0.5651 (0.0625)** 9.04 0 0.4416 0.6886
lndist -0.8199 (0.2251)** -3.64 0 -1.2642 -0.3755
Rtb 0.9485 (0.3271)** 2.9 0.004 0.3027 1.5943
cons -1.0147 (1.6454)** -0.62 0.538 -4.2626 2.2331

Note: Robust standard errors are in parentheses and ** denote 5 per cent significant level.

Source: author’s own calculations

The empirical result in Table 4.1 shows a positive relation between bilateral trade and GDP, and a negative relation of bilateral trade with distance. With the regional trading block (RTB) in pairs of South Asian countries (a dummy), the result is again positive.

The estimated coefficient of bilateral trade of a reporting country, with its other partner countries, is 0.468 with a t statistics of 6.72. The result is highly significant and suggests that a 1 per cent increase in GDP of a reporting country (country i), will increase bilateral trade by 0.46 per cent. Similarly, the estimated coefficient for partner countries (country j) is 0.565 for which t statistics is 9.04. Hence, the coefficient is highly significant and suggests that with 1 per cent growth in GDP of partner countries, bilateral trade increases by 0.56 per cent. The GDP growth in partner countries appears to be more sensitive for bilateral trade compared to the growth of GDP in the reporting country. The trend suggests that with an increase in the size of the economy, bilateral trade increases.

The positive association between bilateral trade and GDP can be further analysed looking at growth rate of GDP in SAARC countries. Table 4.2, shows that between 1992-2001, GDP of SAARC countries grew at an average annual rate of 5.5 per cent.

Table 4.2: GDP of SAARC (US$ million)

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
395288 412912 440684 471917 503083 523993 554512 585842 610578 640413
% Change 4.5% 6.7% 7.1% 6.6% 4.2% 5.8% 5.7% 4.2% 4.9%
Average annual growth 5.5%          

Source: World Bank, 2003

During the same period, bilateral trade in the SAARC grew by 12 per cent annually (Table 4.6). Such a positive association between growth in GDP and bilateral trade contributed to a rise in GDP per capita. Table 4.3 shows that between 1993-2002, GDP per capita income of SAARC countries increased by 2.83 per cent, annually.

Table 4.3 GDP per capita income of SAARC countries (US $)
1648 228 4431

  1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
Bangladesh 299 306 316 325 336 348 358 373 386 380
Bhutan 406 426 442 453 474 493 512 532 554 600
Maldives 1541 1590 1750 1898 1812 1901 1942 1938 2140
India 341 360 381 401 412 431 450 460 477 470
Nepal 202 214 216 222 229 234 242 248 230
Pakistan 479 484 496 507 500 501 507 516 517 420
Sri Lanka 694 722 754 773 813 840 863 902 876 850
Total 3962 4103 4252 4662 4654 4825 4968 4996 5090
% Change   3.6% 3.6% 4.2% 5.2% -0.2% 3.7% 3.0% 0.6% 1.9%
Average annual growth 2.83 %        

Source: World Bank 2003

Thus, the positive association between bilateral trade, GDP and GDP per capita income in SAARC region satisfies the essence of the gravity model: bilateral trade should positively associate with economic size (Frankel and Wei, 1995: 35), and subsequently with GDP per capita (Cernat, 2001 p8).

Similarly, while testing distance, the estimated coefficient was found to be -0.82, with a significant t ratio of 3.64. The result suggests a strong negative relation between trade and distance; as the distance between two countries increases by 1 per cent, trade between them falls by 0.82 per cent. The increase in distance increases transportation costs as well as other transaction costs including costs stemming from what Linneman (1966) called, the psychic distance[vi]. Thus, the negative coefficient satisfies the other essence of the gravity model that trade is negatively associated with the increase in distance.

Likewise, the coefficient for regional trading bloc dummy for pairs[vii] of SAARC countries which have comparatively small bilateral trade, is found to be .948 with a 2.9 t statistics. The significant and positive correlation between bilateral trade and the regional trading bloc suggests that forming a trading bloc, would increase bilateral trade in SAARC by nearly 100 per cent. Table 4.4 also shows that after preferential trading arrangement[viii] (1995), bilateral trade in SAARC increased by nearly 100 per cent in post-SAPTA five years, compared to pre-SAPTA five years. This also suggests that preferential trading arrangement in SAARC is trade creating.

Table 4.4 Intra-SAARC trade: Pre-SAPTA and Post-SAPTA (US$ million)

  1990 1991 1992 1993 1994 1995 5 years total
Pre-SAPTA 1618 1913 2487 2457 2935 4265 15677
  1996 1997 1998 1999 2000 2001  
Post-SAPTA 4929 4669 5558 4807 5371 5899 31232

Source: IMF Direction of Trade Statistics

Hence, the empirical results satisfy the hypothesis that trade should have a positive relation with GDP and negative association with distance. Thus, the empirical results suggest that regional trade integration in SAARC is not just a fashion; rather it is empirically supported too. Therefore, SAFTA is potentially a fortune.

Yet, looking at the volume of intra SAARC trade, Table 4.5 reveals that the total intra-region trade compared with SAARC’s total trade, has always been less than 5 per cent between 1993-2002. Compared with the EU and ASEAN which have 60 per cent and 20 per cent intra region trade (Banskota, 2002 p115) respectively, the bilateral trade in SAARC is negligible. The small amount of bilateral trade has been one of the major points of suspicion behind the prospective of SAFTA initiation.

Table 4.5: Intra SAARC trade (US$ million)

  1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
Intra-SAARC 2457 2935 4265 4929 4669 5558 4807 5371 5899 6251
SAARC-World 72744 81818 103877 110957 118617 118146 128547 142328 149786 163309
Intra SAARC (in %) 3.38 3.60 4.10 4.40 3.90 4.70 3.70 3.80 3.90 3.80

Source: IMF Direction of Trade Statistics 2004.

Three reasons have been found behind the low volume of intra-SAARC trade: stringent policy barriers, unexplored trade opportunities followed by relative low industrialization and low income of the countries, and long standing political enmity. In fact, the first two are based mostly on the last reason.

The policy barrier is operated through a high rate of tariffs and trade restrictions. The prevailing tariff rates in South Asia shows the region as a whole having high level of tariff rates led by Pakistan (41 per cent) and India (30 per cent), followed by Bangladesh 22%, Sri Lanka 20% and Nepal 16%.

Due to high rate of tariffs and trade restrictions, a substantial amount of illegal trade which is estimated between US$ 1 to US $4 billion, takes place annually between India and Pakistan (Banskota, 2002: 118, Hussain, 2004). The Economist Intelligent Unit (2002) estimated that about 50 per cent of merchandise such as tyres and tubes originating in India illegally enter into Pakistan via Afghanistan. Simultaneously, large volumes of Indian and Pakistani products enter into the respective countries through Singapore as production of the latter (Banskota, 2002 pp118-19). The similar trend in bilateral trade is experienced between Nepal and Pakistan. The illegal trade is not only confined between India and Pakistan, but it also exists between Bangladesh-India, Nepal-India, Sri Lanka-Maldives, and India-Sri Lanka. Bangladesh estimates that the cross border smuggling between Bangladesh and India accounts for approximately 25 per cent of its total merchandise trade (Hassan, 2001 p270).

Similarly, SAARC countries are geographically close, natural trading partners[ix], and share social and economic similarities. According to the modern theory of international trade, countries with similar patterns of demand are likely to trade more between themselves because of goods which have achieved economies of scale can more easily be traded in another country having a similar preference pattern (Anam and Rahman, 1991 p3). However, the smaller trade volume demonstrates that this opportunity is not being explored to its potential level. Examples of unexplored trade opportunities are many. Such as, Pakistan imports iron ore from Australia, and Brazil, instead from India which is world’s third largest exporter of iron ore (Jain, 1999 p404). India imports scrap metals from South Korea, of which Pakistan has a huge store. Both India and Pakistan have Suzuki car assembly plants. A division of labor between the two countries could increase production and offer economies of scale in manufacturing components. But, the restrictive policies obstruct the potentials of mutual industrial endeavors. Likewise, power demand in India has been growing in recent years. Nepal possessesthe world’s second largest hydroelectricity resources (after Brazil), but lacks investment, which India could provide. But, because of failures in trade and tariffs agreement, this potential is not being explored.

In addition to this, low industrialization and low income of SAARC countries has also been repressing the potential of bilateral trade. South Asia generates only 1 percent of world trade, and its exports per capita are six times lower than the average for developing countries (World Bank, 1997). Approximately 40 per cent of South Asian people live below poverty line, and depend on subsistence farming for their livelihood thus; they lack sufficient income to meet their demands (World Bank, 2003).

However, as industrialization of the economies is rapidly increasing, bilateral trade in SAARC should be increased (Hassan, 2001 p265). Table 4.7 shows intra-SAARC trade growing at 12.01 per cent annually, which is higher by 2.4 per cent compared to SAARC-world trade. Thus,
the higher trade growth suggests
greater potential for intra-SAARC
trade.

Table 4.6: SAARC’s trade growth: intra-SAARC and SAARC-World

  1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
 Intra-SAARC 20% 45% 16% -5% 19% -14% 12% 10% 6%
SAARC-World 13% 27% 7% 7% 0% 9% 11% 5% 9%
Average annual: Intra – SAARC: 12.01% ; SAARC – World: 9.61%

Source: IMF Direction of Trade Statistics 2004.

Nevertheless, the SAARC paradox of having opportunity but not having sufficient volume of trade implies that without a major policy breakthrough, intra-SAARC trade is not improving to a noticeable volume. To unravel such a paradox, the free trade deal in South Asia is the best visible instrument. Such a trade alignment apart from facilitating bilateral trade could become a platform in resolving political mistrusts. The experience of the EU, where prominent members such as France and Germany had years of enmity, or the ASEAN countries, which had associated with different political blocs, present good examples in this respect. Therefore, SAFTA is seen as a breaking point (Spachis, 2004 p2, Hussain, 2004 p1) in bringing about economic and political integration among the SAARC countries

Trade liberalization and bilateral trade

Except Sri Lanka[x], SAARC has pursued liberal trade policy since the early 1990s. The comparative trade figures in Table 4.8 show a highly significant positive relation between trade liberalization and bilateral trade in SAARC.

Table 4.7: Intra-SAARC trade, five major members, 1990 and 2002 (US$ million)

  Bangladesh India Nepal Pakistan Sri-Lanka
  1990 2002 1990 2002 1990 2002 1990 2002 1990 2002
Export 60 74 486 2145 16 266 223 229 70 256
Import 257 1221 97 594 79 196 122 228 184 933
Total trade 317 1295 584 2739 95 462 344 457 254 1189
% Change 407%   469% 487% 32%   468%  

Source: IMF Direction of Trade Statistics 2004.

Table 4.8 shows that with the exception of Pakistan, the bilateral trade of other countries in the SAARC increased by more than 400 per cent after they opted for liberal trade policy. The reason that Pakistan did not have significant trade in the region is that it does not have direct border with any of the SAARC countries except India. And, due to political reasons it cannot use the Indian route to trade with the rest of the SAARC countries.

Since India is the largest economy in the region, its trade trend within SAARC will have a significant impact on total intra-region trade. Figure 4.1 shows, except for 1996-98, when the trade was almost stable, trade liberalization in India produced a continuous growth in India - SAARC trade.

Figure 4.1 India’s bilateral trade with rest of the SAARC countries, 1990-2002

Source: IMF Direction of Trade Statistics 2004.

Yet, India-Pakistan who account for 88 per cent of the region’s GDP, still have a very insignificant (0.3 per cent of total trade in 2002) bilateral trade. Officially, they treat each other as last resort trading partners, failing to exploit the trade opportunities (Jain, 1999 p402). Therefore, if relations between India and Pakistan could be normalized, the liberal trade policy would produce a significant level of bilateral trade in South Asia. Hence, it is the SAFTA accord that can fabricate both of the conditions: liberalization of trade, and normalization of relations (Spachis, 2004 p1). Therefore, liberal trade policy stemming from SAFTA agreement would eventually result in considerable improvement in intra-SAARC trade.

SAARC’s multi-lateral trade

SAARC’s major trading partners outside the region have been the EU, US, Middle East, ASEAN, China and Japan. Together, they account for approximately 70 per cent of SAARC’s multi-lateral trade.

Table 4.8: SAARC’s trade with major trading partners (US$ million)

SAARC’s trade with: 1994 1998 2003
EU 33.5% 35.7% 35.2%
US 20.9% 21.3% 20.6%
Middle East 21.4% 19.2% 18.4%
ASEAN 10.8% 11.7% 14.4%
China 1.9% 4.1% 5.8%
Japan 11.5% 7.9% 5.5%

Source: IMF Direction of Trade Statistics 2004.

According to Table 4.9, in multi-lateral trade, with 35.2 per cent share in total trade, the EU has been the largest trading partner of SAARC followed by the US with 20.6 per cent. The other major trading partners have been the Middle East, ASEAN, China and Japan.

The data between 1994-2003 shows that though the SAARC-EU trade increased by 2.2 per cent in 1994-1998, yet, compared with 1998, the SAARC-EU trade fell by 0.05 per cent in 2003. Similarly, a parallel trend is found in SAARC-US trade. Though it rose by .04 per cent in the first five years (1994-1998), it fell by 0.07 per cent in the second five years (1998-2003). SAARC’s trade with the Middle East and Japan, have a more noticeable falling trend. In 1994-2003, SAARC-Middle East trade went down by 3 per cent, and the SAARC-Japan trade fell by 6 per cent. Conversely, SAARC’s trade with ASEAN and China is rising steadily.

Table 4.10, shows on average in1994-2003, SAARC’s trade with its neighbouring region, ASEAN increased by 13.22 per cent, annually.

Table 4.9: SAARC’s trade with ASEAN (US$ million)
2976

  1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
Export 2226 2891 2891 2215 2503 3273 3696 4042 4833
Import 3870 5239 5290 6179 7333 8066 7843 10107 10724 13124
Total 6096 8131 8181 9154 9548 10569 11115 13804 14766 17957
% growth   33% 1% 12% 4% 11% 5% 24% 7% 22%
Average annual growth 13.2%        

Source: IMF Direction of Trade Statistics 2004.

Yet, SAARC-China trade is leading in SAARC’s multi-lateral trade growth. Table 4.11 shows that bilateral trade between SAARC and China has been increasing steadily in recent years, except in 1998[xi].

Table 4.10: SAARC - China trade (US$ million)

  1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
Export 284 423 693 905 689 709 1017 1849 2332 4358
Import 1543 2139 2127 2461 2365 2614 3125 3737 4926 7554
Total 1828 2562 2820 3366 3055 3323 4142 5586 7259 11912
% Growth 40% 10% 19% -9% 9% 25% 35% 30% 64%
Average annual growth 25%            

Source: IMF Direction of Trade Statistics 2004.

SAARC-China trade has been growing at a very high rate: 25 per cent annually in 1994-2003. Compared with ASEAN-China trade, the growth in SAARC-China trade is higher by 4 per cent (Table 4.12).

Table 4.11: SAARC and ASEAN comparative trade growth with China
49%

  1994-95 1996 1997 1998 1999 2000 2001 2002 2003
% Growth: Export
SAARC - China 64% 31% -31% 3% 43% 82% 26% 87%
ASEAN - China 28% 15% 7% -1% 9% 42% 2% 31% 81%
% Growth: Import
SAARC - China 39% -1% 31% -4% 11% 20% 20% 32% 53%
ASEAN - China 38% 5% 20% -15% 19% 35% 7% 35% 30%
Average annual growth Export Import Total
SAARC - China 40% 21%  
ASEAN - China 24% 19% 21 %

Source: IMF Direction of Trade Statistics 2004.

Table 4.12 further reveals that with an annual growth of 40 per cent, export is leading in SAARC-China trade. The SAARC-China export growth outpaces the ASEAN-China export by 16 per cent during the same period.

Hence, trade analyses with its major trading partners suggest two major directions in SAARC’s multi-lateral trade: first, SAARC’s trade is concentrating on the neighbouring region (ASEAN) and neighbouring country (China)[xii] compared to its traditional trading partners, the EU, US or Japan. Second, trade is associating more with the fastest growing economies, led by export growth. Thus, these two signals clearly suggest that geography does matter in SAARC’s trade and the trade orientation is following the fastest growing path. Therefore, regional trade integration has a prospective in South Asia. Hence, SAFTA agreement is not a mere fashion, rather a timely and a promising effort.

Potential benefits and challenges of free trade agreement

SAFTA will facilitate countries obtaining production inputs from each other at a lower price and subsequently save on transportation costs coming from transactions within a shorter distance. Thus, Pakistan could import iron ore from India instead of Australia, Canada and Brazil. Similarly, India could meet its needs for scrap metals by importing from Pakistan instead of having it shipped from South Korea.

Free trade agreement will enhance trade liberalization[xiii]. Through opening up markets, productivity in the region would increase; industries would realize economies of scale and expand market not only within the region but also globally. Trade integration would decrease average production costs as well as enhance technological change resulting from increased competition (Hassan, 2001 pp27-84). In addition, the increased competition among companies would enable consumers to obtain quality products at competitive prices.

The regional trading bloc, apart from increasing competitiveness would enable SAARC countries to deal with other blocs for reciprocal arrangements with built-in strength. Simultaneously, it would strengthen SAARC’s international bargaining power through their larger economic size.

Likewise, the free trade agreement would open up a market with 1.40 billion consumers for potential investors. Thus, there is a huge potential that Foreign Direct Investment (FDI) increases substantially, which would lead to higher economic growth as in ASEAN and China. In the long term, trade integration can result in an economic union/currency union similar to the European Union.

Yet, the free trade deal is not problem-free. SAARC lacks infrastructure, both physical as well as institutional, to facilitate regional trade. Cross-border road connections and communication facilities have not sufficiently developed to sustain the free trade. No separate institution has yet been established to look after the SAFTA accord. At the same time, changing laws and regulations of member countries to accommodate the SAFTA commitments may also take longer. Building political trust among the old enemies is still a huge challenge.

Yet, as SAFTA is seen as the breakthrough for economic and political enhancement, the major challenge lies in the implementation of SAFTA commitments. The slow and passive implementation of SAPTA agreement, 1995 suggests that South Asian countries are not proactive in fulfilling their commitments. Therefore, an institutional arrangement, such as establishing a SAFTA secretariat to steer the implementation process is crucial.

5. Conclusion

Regional economic cooperation through free trade arrangements has been emerging as a popular policy instrument, worldwide. The South Asian Free Trade Agreement is the latest example of this global phenomenon. This paper attempts to analyse the potentiality of SAFTA, if it has emerged as a fad or is a fortune for South Asian economic development. The study is based on the gravity model of international trade.

The gravity results obtained are significant and support the hypothesis that bilateral trade should be positively related with the growth in GDP and inversely related with the increase in distance. Simultaneously, the regional trade bloc dummy shows a positive coefficient for regional trading arrangement in the region. The pre-SAPTA and post-SAPTA comparative trade statistic demonstrate a preferential trading arrangement in the region being trade creating.

Similarly, this study finds a positive relationship between trade liberalization and bilateral trade in SAARC. SAARC’s multi-lateral trade performance shows a clear direction that SAARC’s trade is associating more with the fast growing neighbouring economies of ASEAN and the China than the rest of the world.

The prevailing meagre trade volume is found to be the outcome of policy restrictions, unexplored trade opportunities, and political enmity between member countries. Once the SAFTA agreement comes into operation in 2006, policy barriers would be removed. The simultaneous opening up of markets would avail more trade opportunities in the region. The trade statistics show that intra-SAARC trade is growing at a higher rate than SAARC’s trade with therest of the world. Simultaneously, the experience of EU and ASEAN integration suggested that a common economic forum between rival countries could become instrumental in mitigating political differences and enhancing economic development.

In addition to this, the SAFTA agreement is opening the South Asian market for competition and economies of scale. Through SAFTA, SAARC countries can deal with other blocs for reciprocal arrangements with built-in strength. Moreover, the larger economic size and greater trade opportunity in SAARC could attract FDI in the region. SAARC countries, collectively, can have a greater bargaining power in international trade negotiations. Thus, SAFTA provides a credible outlet for economic development through trade integration. The only condition is that SAFTA needs to be implemented as envisioned.

Hence, the study concludes that the prospective of the free trade agreement, the SAFTA, is promising. Thus, SAFTA is not merely a fad, rather it is a fortune; a timely and attainable initiation by SAARC countries to realize the potential benefit of bilateral trade for regional economic development. Nevertheless, the possible welfare that SAFTA can produce for each individual member country could not be analysed due to a time lag. Hence, that would be a promising area for future research.

Appendix A

Highlights of SAFTA Agreement 2004.

Motivation

  • To strengthen intra-SAARC economic cooperation to maximize the realization of the region’s potential for trade and development for the benefit of their people.
  • The agreement is to enhance trade through free movements of goods
  • The agreement accords special and differential treatment commensurate with the needs of Least Developed member countries

The Objectives

  • To promote and enhance mutual trade and economic cooperation among SAARC nations through:
  • Eliminating barriers to trade
  • Promoting conditions of fair competition in the free trade area
  • Establishing a framework for further regional cooperation to expand and enhance the mutual benefits of the SAFTA agreement.

The operational framework

  • SAFTA involves the free movement of goods, between countries through the elimination of tariffs, para-tariffs and non-tariff restrictions on the movement of goods
  • SAFTA will adopt a concrete preferential measures in the favor of Least Developed Countries on a non-reciprocal basis

The instruments of SAFTA implementation

  • Trade Liberalization
  • Transit facilities for efficient intra-SAARC trade, especially for the land-locked members

Entry into force

  • SAFTA will enter into force on 1st January 2006

Source: Text of SAFTA agreement accord, www.dawn.com (20/10/2004)

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End Notes

[i] India and Pakistan together occupy 88 per cent of SAARC’s GDP (World Bank 2003).

[ii] In the EU Germany and France fought a 100 years of war. Likewise, during cold war, ASEAN members were associated in rival blocs (Lu 2003).

[iii] India dominates the region in geographic size, size of GDP, population as well as in GDP growth.

[iv] SAARC’s bilateral trade in the ASEAN is concentrated mostly with 6 countries: Indonesia, Malaysia, , Philippines, Singapore, Thailand, and Vietnam, which occupy 93 per cent of SAARC-ASEAN trade.

[v] For specification please refer to part 3, Methodology.

[vi] Distance occurring due to ignorance of foreign customs, languages, preferences, etc.

[vii] Nepal-Maldives-Sri Lanka, one pair and Bangladesh -Pakistan the other pair.

[viii] Though SAPTA’s voluntary and product by product tariff concession commitments could not become effective as expected.

[ix] Geographically closer countries have been defined as natural trading partners, and other things remaining constant, they are supposed to have higher intra country trade 9Krugman 1991).

[x] Sri Lanka started liberalized trade policy in 1977 (World Bank 2003).

[xi] The reason behind this was Indian nuclear test, Feb 1998, which caused a temporary halt in Indo-China trade.

[xii] China borders four of seven South Asian countries, including the two giants, India and Pakistan.

[xiii] If not globally, but at least regionally: this is the second best alternatives of liberalization (Yamazawa 2002)