Organized By Islamic Economics Research Bureau Effects of South Asian Free Trade Area (SAFTA) on Intra-Regional Trade and Investment By Ayubur Rahman Bhuyan Organized By Islamic Economics Research Bureau

Introduction The 15th SAARC Summit of Heads of State and Government of the eight member countries reiterated the pledges of the three preceding Summits to fully implement the SAFTA. This paper dwells on the actual and potential economic effects of SAFTA on member economies in terms of the expansion of intra-regional trade and investment. It discusses the weaknesses of SAFTA that may impede its operationalisation and suggests mechanisms to make it useful and effective.

Introduction Contd/ 1 SAFTA Agreement was signed at the 12th SAARC Summit in January 2004 at Islamabad. Originally scheduled to start on 1 January 2006, SAFTA actually came into force on 1 July 2006. Afghanistan was made the 8th member by a decision of the 13th SAARC Summit in Dhaka in November 2005. China , Japan, South Korea, Iran, Mauritius, the U.S. and the E.U. have been given observer status. Australia and Myanmar have expressed desire to be conferred observe status.

Introduction Contd/ 2 A major objective of SAFTA is to expand intra-regional trade. The 13th SAARC Summit pledged to convert the ‘free trade area’ into an ‘economic union’ by 2020. The pledge has been reiterated in the 15th Summit held on 2-3 August 2008 in Colombo. The experience of SAFTA in the two years of its coming into force is not very encouraging, however.

Trends in SAARC’s Global and Intra-regional Trade (2000-2006) SAARC’s share in world trade is small but has been increasing. In 2006, the region’s share was 1.35% in world exports and 2.07% in world imports. SAARC’s intra-regional trade as proportion of its total trade is small – 5.64% in the case of exports, and 3.58% in the case of imports (overall 4.41%). If Afghanistan’s trade is included, then SAARC’s intra-exports would be 6.65%, and intra-imports would be 4.26% of total SAARC trade (overall 5.18%).

Trends in SAARC’s Global and Intra-regional Trade (2000-2006) Contd/1 Intra-regional trade of SAARC compares very poorly with other regions – for example, 65% in EU, and 42% in NAFTA. For a region that has now the lowest level of intra-regional trade, the aspiration to create an economic union after the next decade is ambitious indeed. It is, however, satisfying to note that intra-regional trade annually has been increasing faster (@ 23%) than the region’s total trade (19%).

Asymmetric Pattern of Intra-regional Trade in SAARC A disparate trend in intra-regional export and import is noticeable. India’s exports to the region have increased very fast, whereas all other member countries are net importers from the region. South Asia has become a fast-growing destination for India’s exports but the region remains a marginal source of India’s imports. This asymmetry owes in some measure to India’s restrictive trade policy but it is more due to the structural rigidity of the smaller economies, which have little to export to India. A primary goal of trade cooperation in South Asia should therefore be to encourage India to open up its market for imports from regional partners.

Core Elements of SAFTA 1. Trade Liberalization Programme A Negative List approach is followed in SAFTA trade liberalization. Non-LDC members shall reduce their existing tariff to 20% in two years, and thereafter to 0-5% over five years. Sri Lanka gets one extra year (i.e., till 2014). LDC members shall reduce their existing tariffs to 30% in two years (by 2008) and thereafter to 0-5% in eight years (i.e., by 2016). Non-LDC members shall reduce their tariff on LDC members’ exports to 0-5% within 3 years.

Core Elements of SAFTA Contd/1 2. Non-tariff Barriers: QRs will be removed as soon as the tariff levels reach 0-5%. There is no provision for removing the non-QR NTBs. 3. Negative List (Sensitive List in the SAFTA terminology): Each country will have its negative list of products, which will not be subject to tariff reduction. 4. Rules of Origin: SAFTA rules of origin are CTH plus 40% domestic value addition (35% for Sri Lanka, and 30% for LDCs). Regional cumulation allows the reduction of the domestic value addition requirement to 20%.

Core Elements of SAFTA Contd/2 5. S&DT provisions for the four LDC member countries Smaller tariff reductions and longer compliance period for LDC member countries in the trade liberalization programme Non-LDC members are to reduce tariff on LDC products to 0-5% within three years of the Agreement coming into force Non-LDC members are expected to be flexible towards LDC members in regard to continuing QRs or other trade-restrictive measures Non-LDCs are required to facilitate LDC exports by taking various direct trade measures Non-LDCs are to extend technical assistance to LDCs on trade-related matters

Core Elements of SAFTA Contd/3 6. Mechanism for Compensation of Revenue Loss (MCRL) MCRL is the most important S&DT provision for LDC members. Maximum of 5% of the customs duty collected by the LDC members from SAARC import in 2005. Compensation will be available for 4 years (for Maldives 6 years). Sri Lanka will provide compensation for three years. The rationale for compensation is open to debate. Transfer of technology, greater investment flows, and better provision of trade facilitation would be more beneficial in the long run.

Core Elements of SAFTA Contd/4 7. Safeguard Measures: Members shall have the right to withdraw preferences to safeguard domestic industry against possible injury. Safeguards will not apply to an LDC product if the share of import from LDCs is less than 5% of the total import of the importing country in that product.

Likely Effects of SAFTA : Positive Views SAFTA will bring significant gains for the small economies of the region. It will attract foreign capital. It will be a step toward better political relations and peace. Part of the informal trade will be diverted to official channels and bring revenue and other benefits. Elimination of tariffs will increase intra-regional trade by 1.6 times the existing trade. Dynamic gains will be more significant than static gains.

Likely Effects of SAFTA : Negative Views SAFTA does not meet the standard economic criteria for successful integration (other than high pre-FTA tariff and geographical contiguity). Other requisite criteria are high levels of international trade before the formation of the FTA, high degree of trade complementarity, secure market access (no tariff, no NTBs). Long sensitive lists of members will lower the benefits of trade. SAFTA will benefit India the most. Some member countries may even lose

Likely Effects of SAFTA : Negative Views Contd/1 Because of similar production structures in member countries, the expansion of intra-regional trade will be limited. SAFTA will lead to trade diversion. SAFTA will contribute to the “Spaghetti bowl” phenomenon, where many applicable tariff rates and multiple sources of origin will create confusion and difficulty among customs officials and producers.

Potential for Intra-regional Trade : Fresh Empirical Evidence According to a recent ADB-UNCTAD study, complementarily indices of the four major countries (India, Pakistan, Bangladesh and Sri Lanka) have improved between 1991-1993 and 2003-2005. RCA indices of these four countries in major products have increased between 1991 and 2004. Intra-industry trade indices (Grubel-Lloyd index) have also increased significantly. While, as indicated by these indices, intra-regional trade may increase, the potential benefits of trade cooperation may be different for different countries.

Potential for Intra-regional Trade : Fresh Empirical Evidence Contd/1 High welfare gains are foreseen for Bangladesh, attributable to the complete liberalization of tariffs, which generates consumption benefits for household consumers as well as user industries. A full SAFTA will help both India and Pakistan to double their exports to South ASIA. Sri Lanka’s trade gains are not likely to improve because it has already close to free access to the Indian market. Trade gains of Afghanistan, Bhutan, Maldives and Nepal (ABMN) are likely to be small because the sensitive lists of non-LDCs block the market access for their agricultural products.

Potential for Intra-regional Trade : Fresh Empirical Evidence Contd/2 The ABMN may also suffer output and employment losses in manufacturing because their manufacturing sectors are uncompetitive compared to other partners. Gravity modeling shows that SAFTA will raise intra-regional trade by 120 percent. Tariff removal alone will raise trade by 80 percent. Additional 40 percent increase in intra-trade will occur if NTBs and political constraints that affect trade are removed. All countries will suffer revenue loss, but that loss will be compensated by trade creation, except Bangladesh and Nepal.

Effects on Foreign Direct Investment (FDI) SAFTA, by lowering intra-regional tariffs, enhances the possibility of increased FDI from outside the region. Opportunities for intra-regional investment increase, too, including joint ventures. Lower tariffs among members make FDI attractive. SAFTA may act as a spur to Indian investment in SAARC countries as the experience of Sri Lanka and Nepal indicates. SAFTA also brightens the prospect of Indian investment in Pakistan.

Implications of SAFTA for Bangladesh The growing trade imbalance with the region, in particular India, is Bangladesh’s main concern. Bangladesh’s trade gap with the region will widen if market access is not broadened enough. The industry sector feels that SAFTA will hurt some domestic industries but benefit a few others that obtain their inputs from SAARC sources. Economists are generally receptive of the idea of SAFTA but are in favour of obtaining sufficient safeguards for the protection and development of the country’s manufacturing sector. Indian and Pakistani investors have expressed keen interest in investing in Bangladesh.

Implications of SAFTA for Bangladesh Contd/1 Bangladesh’s sensitive list covers about 24% of its tariff lines, which account for 51% of its dutiable imports and 80% of total customs duty collected by Customs. Hence loss of revenue will be small. However, immediate gains from SAFTA are also small because most major items of Bangladesh exports are in the partner countries’ Sensitive Lists. As a small country, the chances of reaping gains from SAFTA are high, but the determining factors are true market access, shorter lists of sensitive products of partners, liberal rules of origin, increased intra-regional investment, and transfer of technology from the major partner countries.

Principal Constraints to SAFTA Most member countries have not yet notified the implementation of the tariff reduction deal. Some 80% of intra-regional imports will remain outside the SAFTA process because of long sensitive lists. Two separate sensitive lists by some members, one for LDC and the other for non-LDC members, may lead to the abuse of the sensitive lists. Tariff reduction measures adopted by various bilateral and multilateral treaties have not been reconciled with SAFTA measures.

Principal Constraints to SAFTA Contd/1 Long timeframe may make SAFTA irrelevant because other trading arrangements and bilateral FTAs within the region will be put into effect well before the SAFTA becomes operational. There is no clear mechanism in SAFTA to remove NTBs. There is no provision in the SAFTA treaty relating to the removal of non-QR NTBs. In the ASEAN, NTBs are removed as soon as tariff cuts begin. This has not happened in SAFTA, however.

Principal Constraints to SAFTA Contd/2 The double criterion of ROO is complicated, for which reason even the genuinely competitive LDC products may find it difficult to enter the regional market. Supply-side constraints are a serious impediment to the expansion of intra-regional trade. There is no provision for investment liberalization or for services trade, including the movement of labour within the region.

Principal Constraints to SAFTA Contd/3 Lack of political will. Pakistan’s refusal to give MFN treatment to India is a case in point. Unless these problems are duly addressed, the gains from SAFTA will be much less than expected.

Concluding Observations There have been some welcome developments in the recent days, which promise a better future for SAFTA. The 15th SAARC Summit underscored the need for implementing the SMC decision to revise the sensitive lists at the earliest, but agreed to give special consideration to LDC members. The Summit has also strongly urged upon Members to remove all non-tariff and para-tariff barriers and directed the SAARC Committee of Experts (COE) to expeditiously resolve the issues concerning these trade barriers.

Concluding Observations Contd/1 Elimination of trade barriers, although a necessary condition, is not sufficient for trade expansion. Trade facilitation measures like standardization and harmonization of documentation procedures and formalities will be needed for trade expansion. The 15th Summit established: the South Asian Regional Standards Organization (SARSO), which is an important step toward trade facilitation and greater economic integration in the region.

Concluding Observations Contd/2 There should be free flow of investment to the less developed member countries. To that end, the GEP recommendations for the establishment of a SAARC Investment Area, a South Asian Development Bank, and a South Asian Development Fund should be seriously considered. The 15th Summit adopted the SAARC Development Fund charter, which shall be an important instrument to implement regional projects that would yield concrete benefits to member states. SAFTA should include trade in services, including the movement of labour within the region.

Concluding Observations Contd/3 A draft SAFTA Framework Services Trade Agreement has very recently (June 2008) been prepared by the SAARC Secretariat with a mandate from the Third SAFTA Ministerial Council. Cooperation in other services, viz., education and health is also important.

Concluding Observations Contd/4 Coordination of macroeconomic policies – fiscal, exchange rate and interest rate policies – is a must Policy coordination is important not only in a customs union or an economic union but also in a free trade area. The South Asian business community has a great deal at stake in regional cooperation under SAFTA.

Concluding Observations Contd/5 The interest of trade and industry will be best served by a genuine market enlargement, which will increase the flow of trade, investment and services. The South Asian business community, therefore, have a vital interest in how the ROO can be improved, how the negative list can be shortened, and how safeguard measures are designed. They should, therefore, advocate and work for the implementation of the following recommendations:

Recommendations Complete the trade liberalization programme within, and, if possible, ahead of, the scheduled timeframe Remove NTBs within 3 years after the process of tariff reduction has begun Reduce the size of the Negative List and phase it out within a specified time period

Recommendations Contd/1 Create the GEP-recommended SAARC Investment Area, and the South Asian Development Bank Implement the decision of the 15th Summit to set up the South Asian Development Fund Liberalize services flow, including the movement of labour

Recommendations Contd/2 Persuade India, the largest and the most rapidly growing member country of SAFTA, to serve as a ‘growth-pole’ for the region Establish a Standing Committee of SAARC Finance Ministers for coordination of macroeconomic policies, keeping in mind the goal of creating a Customs Union, and then, an Economic Union within a time-bound framework.

Thank you