Free trade at a heavy cost for India

Asia Times | 11 December 2004

Free trade at a heavy cost for India

By Kunal Kumar Kundu

MUMBAI - The recently signed India-Thailand free trade agreement (FTA) has stirred a hornet’s nest in India. It is being argued that India has shown unnecessary haste in signing the agreement without fully comprehending its economic implications for Indian industry.

Regional or bilateral free trade agreements (RTA/FTA) are not a new phenomenon and have become important aspects of any country’s trade policy. The trend started with the formation of the single European market by the European Union in 1992 and the North American Free Trade Agreement (NAFTA) in 1994. Over 300 FTA/RTAs are currently in different stages of negotiation. More than half of world trade is now conducted on preferential basis within FTAs. Therefore, any country that ignores this route of regional integration can do so only at its own peril.

The Indian experience
India’s first brush with new-age preferential trade arrangements was in the form of a bilateral FTA signed with Sri Lanka in 1998. This was followed by various FTAs. On the positive side, the India-Sri Lanka FTA has led to India’s exports to Sri Lanka increasing from Rs21.63 billion (US$490.4 million) to Rs60.67 billion between 1999-2000 and 2003-04. Similarly, Sri Lanka’s exports to India moved up from Rs1.92 billion to Rs8.93 billion during the same period.

FTAs also have a positive impact on the members’ ability to attract higher volumes of foreign direct investment (FDI). The India-Sri Lanka FTA is a case in point as it stimulated new FDI into Sri Lanka for rubber-based products, ceramics, electrical and electronic items, wood-based products, agri-commodities and consumer durables. According to the United Nations Conference on Trade and Development, 37 projects are now in operation with a total investment of $145 million and India has emerged as the third largest investor in Sri Lanka because of the FTA.

However, India’s approach has mostly been to focus only on the import tariff aspect, whereas rules of origin have come to play a much greater role in today’s World Trade Organization-guided trade geography. Because of the hurried approach, India today finds itself in a mess in the case of the Indo-Sri Lanka FTA. Since the rules of origin were not given the due importance in the FTA, India has not only lost revenue but it has also been victim of rampant dumping, causing several domestic units to turn sick.

Using the European model of 35% value-addition and sometimes even less, all sorts of products have been imported into the country through the Sri Lankan route. Chinese and European goods are being camouflaged by either re-packing or making minor changes, and are then being pushed into the Indian market through the Sri Lankan route. Though the country has levied anti-dumping duties on many products, it’s clear that a number of traders have been importing such goods to a third country and, with a minor change in packing or stamping, importing them into India.

The directorate of Revenue Intelligence and Customs has filed quite a few cases where Chinese-origin goods have been taken to Singapore or Hong Kong, but declared as made in Indonesia and Malaysia to evade anti-dumping duties. Also, in many cases where India has signed a FTA agreement, it has found that most items are agricultural products that are highly subsidized by the exporting nation and sold in India at a much cheaper rate - a price with which Indian industry cannot compete. In the case of Thailand, most marine products are very cheap. In the case of Sri Lanka, export of cloves, cassia and cinnamon hurts Indian industry enormously.

India has now embarked on an aggressive strategy of preferential liberalization with its Asian neighbors. Agreements have been signed for the creation of FTAs within South Asia and with the members of the Association of South East Asian Nations (ASEAN). Unlike tariff reductions announced by the finance minister that apply to all trading partners, FTAs eliminate tariffs against FTA members altogether. In most case, the move toward FTAs has been necessitated by political considerations. Unfortunately, very little effort has been made to evaluate the economic impact of these deals.

FTAs no win-win solution
While not many formal studies have been undertaken to ascertain the true impact of FTAs on respective economics, from a purely economic standpoint, FTAs could spell potential trouble for India. Any move toward preferential trading without further liberalization is unlikely to work. India continues to have high trade barriers, which make the scope for trade diversion and the accompanying losses considerable. Being relatively powerful in most countries in the region, business lobbies are likely to exploit the rules of origin and sectoral exceptions in these arrangements in ways that will maximize trade diversion and minimize trade creation. The rules of origin give bureaucrats power and opportunities to share in the rents created by tariff preferences and they too become active parties to the diversionary tactics of business lobbies. Therefore, member countries are better advised to proceed along non-discriminatory lines in achieving further liberalization.

According to economist Arvind Panagariya, countries within the South Asian Association for Regional Cooperation region trade "too little" with one another compared to what one would expect on the basis of their proximity and income levels. There could be various reasons for this. First, the low level of trade has been essentially the result of autarkic policies in the region. The reason for the low level of intra-regional trade until recently was not the absence of trade preferences but the absence of liberal trade policies in general. Pitigala, Pursell and Baysen (2000) have documented this fact systematically. Among other things, they show that once the countries in the region began to liberalize, their intra-regional trade expanded rapidly. The effect of trade liberalization by India, which is by far the largest country in the region, is especially pronounced. Second, there has been a considerable amount of "informal" trade among member countries of the region. This was not only to evade the high tariffs that must be paid on official trade, but also to carry out some trade that would not have been permitted at all.

Given that South Asia accounts for less than 1% of the world production and that tariffs in the region are high, the risk of trade diversion from preferential trade liberalization is high. With 99% of the world production outside the region, the likelihood that the most efficient and competitive producers of the large majority of products are within the region is very low. This means the scope for trade diversion is substantial. Clearly, the country with higher tariffs loses while the country with lower tariff benefits from FTA.

India has now woken up to this possibility. Recently, it rejected a proposal from Mauritius for an FTA because of apprehensions that it could turn into a channel for goods from other countries to evade import duty in the Indian market. The Indian view is that stipulations related to rules of origin would not be good enough to prevent such trade diversion and unintended benefits to goods from other countries. According to government sources, the commerce department argued that an FTA with Mauritius would result in trade diversion and the island nation would become a center for re-export of goods from other countries.

Non-discriminatory liberalization
All trade diversion can be avoided if the countries in the region were to liberalize on a non-discriminatory basis. Since all countries within the region are small in relation to the rest of the world, the risk of deterioration of terms of trade from liberalization is virtually absent. As many of the countries in the region share borders, coordination of trade policy would help discourage costly trade deflection. At present, there is much incentive for goods to be imported into Sri Lanka at low duties and then smuggled into India. India could greatly benefit from bringing its tariff rates down rapidly to match those of Sri Lanka.

The Federation of Indian Chambers of Commerce and Industry (FICCI) has urged the government to accelerate the pace of internal reforms so that the country can be better positioned to maximize gains from free and preferential trade agreements. This includes not only reduced tariff levels but also reforms pertaining to labor laws, improved quality and availability of infrastructure, lower transaction costs, lower cost of finance, VAT applicable to all goods and services, and seamless movement of goods across the country.

Over to multilateralism
India also needs to study whether it can afford to neglect the multilateral route and concentrate only on FTAs. Hardly, if at all, given the numerous FTAs that already exist in the Americas and Europe. India faces considerable discrimination against its products in those markets. The only way to end this discrimination is to bring tariffs down to near-zero levels on a multilateral basis under WTO auspices.

After all, despite the talk of FTA, ASEAN members have undertaken virtually all liberalization on a non-discriminatory basis. There is even a formal provision in the ASEAN FTA (AFTA) Agreement, encouraging member countries to extend whatever liberalization they undertake as a part of their AFTA obligation to the rest of the world.

Kunal Kumar Kundu is a senior economist with a leading bilateral Chamber of Commerce in India. He has a Masters in Economics with specialization in econometrics from the University of Calcutta.

source: Asia Times