The Hindu Business Line : SAFTA: Much effort for little gains?

SAFTA seems set for take off, but it may not as it is modelled now, liberalising commodity trade first and then services. For, apart from India, other countries have little to gain from a trading bloc; their industries would lobby against SAFTA fearing dumping of Indian goods. Contrarily, service trade liberalisation would offer two-way gains. It would then be easy to push for free trade in goods, says Sanjib Pohit.

HOPES are running high of South Asia's cherished dream of a regional economic grouping — the South Asian Free Trade Area — becoming a reality, what with the South Asian Association Regional Cooperation approving the draft SAFTA framework treaty in Islamabad.

Buoyed by the success in the penultimate round of talks of SAARC officials in Kathmandu, Commerce Ministry officials expect this to pave the way for the agreement to be signed at the ongoing SAARC summit.

The failure of the fifth Ministerial of the World Trade Organisation at Cancun now puts pressure on SAARC members to ensure the early birth of SAFTA. Bilateralism and regionalism are gaining momentum around the globe, and if South Asia is lax, it may be left out of the `trade paradigm' that is taking shape now.

As of now, trade within the SAARC region is hardly worth mentioning.

For instance, intra-SAARC trade at 5 per cent compares poorly with intra-EU trade of 63.4 per cent, intra-Nafta 37.3 per cent and intra-East Asian trade (38.4 per cent) and gives the impression that the seven countries of South Asia are paying lip-service to the concept of regional co-operation.

So far, the SAFTA charter envisages removing barriers to trade (tariff) on commodities between nations. At the first stage, there is no plan to remove barriers to service trade. Once SAFTA is achieved, the idea is to remove barriers to service sector trade. In this respect, the models of the European Union/Nafta is being followed which remove barriers on commodities first followed by that on services.

Unfortunately, this may not be the right model in the South Asia context. This model would lead to little gains for the member nations. As a result, members would have little inclination to focus on the second stage of South Asian integration — free movement of services — where gains are large. Let me explain why. Countries engage in international trade for two basic reasons, each of which contributes to their gains from trade.

First, countries trade because they are different from each other. Nations, like individuals, can benefit from their differences by reaching an arrangement in which each does things it does relatively well. That is, trade between two countries can benefit only if each exports the goods in which it has a comparative advantage.

A country will tend to produce efficiently relatively more of goods that use its abundant resources intensively. This is the basic proposition of the Heckscher-Ohlin theory of trade, which states that countries tend to export goods that are intensive in the factors with which they are abundantly supplied.

In layman's language, it implies that labour surplus economies such as India would export labour intensive goods while a capital surplus economy such as the US capital-intensive goods. It can said that about three-fourths of the world trade is governed by the law of comparative advantage.

Second, countries trade to achieve economies of scale in production. That is, if each country produces only a limited range of goods, it can produce each of these goods on a larger scale and hence more efficiently than if it tried to produce everything.

Over time, industrialised countries have become increasingly similar in their level of technology, and in the availability of capital and skilled labour. However, their firms continue to produce differentiated products and the demand of consumers for products made abroad continues to generate intra-industry trade (two-way exchange of goods within standard industrial classifications).

It is economies of scale that keep each country from producing the full range of products for itself; thus economies of scale can be an independent source of international trade. About one-fourth of world trade consists of intra-industry trade. Intra-industry trade plays a large role in the trade in manufactured goods among advanced industrialised nations.

To what extent are these two premises applicable to the members of SAFTA. As it stands, SAFTA would be essentially a trading bloc of labour abundant economies. All these countries have shortage of capital.

For this reason, their natural trade partners are the developed economies. If countries need to gain from the formation of a trading bloc, individual members need to be different from one another on resource endowment. For this reason Nafta is a success, while innumerable trading blocs in the African continent have failed. Thus, the member nations cannot gain from SAFTA under the first premise.

Can the members of the SAFTA benefit from economic of scale in production? Economy of scale is a phenomenon of capital-intensive goods. As they have comparative advantage in producing labour intensive goods, this does not hold for the members of SAFTA.

For this reason, there is little evidence of two-way intra-industry trade resulting from economic of scale in production in the SAARC region.

In the European Union, where this has played a major role in harnessing the gain of free trade, a large part of it can be attributed to the intra-firm trade of the multinational enterprises. Alas, they have an insignificant presence in the member nations. Except India, the other countries of SAFTA have little capacity to produce manufactured products.

Thus, while India's industry can benefit from the large market of SAFTA, it is unlikely that the domestic industries of the other members will gain from the large Indian market. For this reason, they would not be too eager to have SAFTA implemented.

Is there, then, no way for SAARC nations to benefit by forming a free trading bloc? If the members are to realise the gains of a free trading zone, they should spend more energy on abolishing barriers to trade in services such a transportation, tourism, investment, insurance, freight, energy rather than on commodities.

It is often said that trade in services entails the international movement of factors of production because services typically require simultaneous presence of factors of production.

Since except in tourism, education and medical services the consumer seldom moves, the producer must move instead and that seems to imply factor movements. In fact, this has been happening in South Asia legally or illegally since the 1940s. It is better to make it legal so that illegal immigrants do not have to go to the hawala markets for remitting their earnings. This way all the member countries would gain.

The removal of barriers to transportation services must be a high priority for the SAARC nations. Take the case of India and Bangladesh.

A transit route through Bangladesh would make access to the north-eastern States easier from the mainland and reduce the transportation cost, which is a root cause of the under-development of the region. Also, Bangladesh can export gas/power to North-East and benefit from economic of scale.

Often, it is argued that the services sector can be opened up only after free trade in commodities is established as a more durable kind of relationship is needed for service trade realisation. In the context of SAARC, this logic does not stand for the following reason.

Apart from India, other countries have little or nothing to gain from a trading bloc. The domestic industries in the other countries would lobby hard against SAFTA as they would fear being swamped by Indian goods. On the other hand, service trade liberalisation would produce two-way gains. It would then be easy to push for free trade in goods.

(The author is Principal Economist, NCAER. The views are personal.)