A theoretical and empirical analysis of trade liberalisation in South Asia

Abstract

Interest in economic analysis of preferential trade liberalisation has increased with the rise of regionalism in recent years. Growing dissatisfaction with the progress of multilateral trade negotiations, fuelled by the successful regionalism on both sides of the Atlantic has generated further momentum in regional initiatives. South Asia is not an exception to this process. The seven-nation South Asian Association for Regional Cooperation (SAARC) signed a preferential trade agreement in 1993 with the expressed intention to form a free trade area (FTA) by the year 2000. In view of the present low level of intra-regional trade and the perceived competitiveness among the South Asian countries, a question has arisen as to whether regionalism would benefit countries of the region. This study assesses the welfare implications of a regional trading arrangement among the major South Asian countries, Bangladesh, India, Pakistan and Sri Lanka. Formation of a discriminatory trading area (DTA) among these four countries and unilateral free trade (UFT) by each country are assessed. The welfare effects of two forms of a DTA- a customs union (CU) and a free trade area (FTA) - are considered. While both forms of DT A provide for free trade among members, they differ in the setting of external tariffs with non-members. A CU requires its members to have a set of common external tariffs (CET) while an FTA member is free to choose its external tariffs. The welfare effects of these DT As are evaluated in relation to the initial condition of protected trade regimes as well as being compared with UFT regimes. An analytical model for the measurement of static welfare gains/losses is developed in an increasing costs framework. The changes in welfare defined as 'economic welfare' derived from consuming goods and services are measured in a partial equilibrium framework by using the 'area variation measure' represented by consumer and producer surpluses. The model suggests that the welfare effects of a country becoming a member of a DTA are ambiguous. On the import side, a DT A has trade creation effects which increase welfare and trade diversion effects which decrease welfare. On the export side, the welfare implication is unambiguously welfare-improving by the amount of increased producer surplus. The net effect for a member of a DT A thus depends on the relative strengths of both the negative and positive effects. The model further shows that a DT A with no change in external tariffs is always welfare-reducing for the region as a whole, though there may be individual gainers and losers. As against this, UFT is always welfare-improving, which supports the postulate of trade theory. The empirical findings are consistent with the prediction of the theoretical model. Based on the countries' 1993 trade regimes, by forming a DTA without any change in external tariffs, the region as a whole would suffer a welfare loss of US$336 million, accounting for 0.1 per cent of the region's combined GDP. On the other hand, if the CET of a South Asian customs union is set at the level of Sri Lanka - the lowest-tariff country of the region -the total welfare gains (net import gains plus gains from increased exports) for the region as a whole would be approximately US$2.3 billion, accounting for about 0.7 per cent of the combined GDP. The two smaller countries, Bangladesh and Sri Lanka, would lose while the larger countries, India and Pakistan, would gain from a CU. Similar results hold in the case a South Asian free trade area. Empirical results suggest that a CU would be superior to an FT A. As against this, UFT, i.e., each country moving to a free trade regime as compared to a Sri Lanka-based CET, is welfare improving for each country. The total gains from unilateral free trade for the region as whole would be in excess of US$2.3 billion, accounting for more than 0.7 per cent of the combined GDP of the region. Differences in welfare gains among members depend on the trade creation effects. Factors that influence trade creation are the elasticity of import demand, the pre-union level of protection and the pre-union level of imports from the rest of the world. Both India and Pakistan have relatively higher levels of trade with the rest of the world and their import demands are relatively elastic. These two countries gain more from trade creation than they lose from trade diversion. Bangladesh is the highest-tariff country in the region. Its imports from the rest of the world are relatively less. As a result, its losses from trade diversion are so high that they outweigh its gains. Sri Lanka, being the lowest-tariff country, does not have to reduce its tariffs under a CU, while it reduces its tariffs at lower rates than the other members under an FT A. As a result, it does not gain from trade creation under a CU. However, it gains from trade creation under an FTA, but this gain is lower than that for any other country in the region. On balance, Sri Lanka's losses are greater than its gains. The question of concerted trade liberalisation is discussed in the political economy context. The smaller countries which would lose by regionalism need to be compensated by way of assistance with restructuring industries so that the larger markets are considered by others as a window of opportunity. It is suggested that a regional cooperation arrangement based on political understanding would provide a substantial peace dividend for all countries due to the reduction of military spending.