WPS3813
                PREFERENTIAL TRADING IN SOUTH ASIA*



Tercan Baysan                          Arvind Panagariya                            Nihal Pitigala
World Bank                             Columbia University                          Consultant



Abstract. This paper examines the economic case for the South Asia Free Trade Area (SAFTA)
Agreement signed on January 6 th, 2004 by India, Pakistan, Bangladesh, Sri Lanka, Nepal, Bhutan,
and the Maldives. It starts with a detailed analysis of the preferential trading arrangements in South
Asia to look at the region's experience to date and to draw lessons. Specifically, the study examines
the most effective free trade area in existence, i.e., the India-Sri Lanka Free Trade Area, and evaluates
the developments under the South Asian Preferential Trade Area (SAPTA). The paper concludes that,
considered in isolation, the economic case for SAFTA is quite weak. When compared with the rest of
the world, the region is tiny both in terms of economic size as measured by GDP (and per capita
incomes) and the share in the world trade. It is argued that prima facie, these facts make it likely that
trade diversion would be dominant as a result of SAFTA. This point is reinforced by the presence of
high levels of protection in the region and the tendency of the member countries to establish highly
restrictive `sectoral exceptions/sensitive lists' and stringent 'rules of origin'.

We argue that SAFTA makes sense only in the context of a much broader strategy of creating a larger
preferential trade area in the region that specifically would encompass China and the member nations
of the Association of South East Asian Nations. In turn, the case for the latter is strategic: the pursuit
of regionalism in the Americas and Europe has created increasing discrimination against Asian exports
to those regions, which must inevitably impact the region's terms of trade adversely. An Asian bloc
could be a potential instrument of changing incentives for the trade blocs in the Americas and Europe
and forcing multilateral freeing of trade.

Assuming that the SAFTA Agreement is here to stay, the paper also suggests steps to ensure that the
Agreement can be made more effective in promoting intra-regional trade, while minimizing the likely
trade-diversion costs and maximizing the potential benefits.



World Bank Policy Research Working Paper 3813, January 2006

The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the
exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if
the presentations are less than fully polished. The papers carry the names of the authors and should be cited
accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the
authors. They do not necessarily represent the view of the World Bank, its Executive Directors, or the countries
they represent. Policy Research Working Papers are available online at http://econ.worldbank.org.



-------------------------------------------------------
*This work was supported under the South Asia Region's `Regional Programs' as a background paper on the merits of the
SAFTA Agreement. We are grateful to Richard Newfarmer, Jeffrey Lewis, Sadiq Ahmed, Shanta Devarajan, Ejaz Ghani,
Garry Pursell, and Sandeep Mahajan for their useful comments and suggestions.

                                   Preferential Trading in South Asia

                                   Tercan Baysan, Arvind Panagariya, and Nihal Pitigala


Introduction: Background and Context

         In the first three years of their independence, intra-regional trade among India, Pakistan and
Sri Lanka as a percentage of their total trade was in the double digits. In part, this large proportion
reflected the relatively protectionist trade regime in developed countries that had come to exist in the
1930s and 1940s (Figure 2 in Annex). But it also reflected low barriers to trade within the
subcontinent. In the subsequent years, while the developed countries opened their markets, thus,
opening the door wider to trade between them and other countries including those in South Asia, the
latter themselves turned inward. Import-substituting industrialization, with massive public-sector
participation in the production activity and tight control of the private sector, became the cornerstone
of the development strategy pursued in the region.

         The import-substitution policies worked towards limiting not just total trade but in some ways
asymmetrically towards limiting intra-regional trade. Once boundaries had been drawn between India
and Pakistan, new industries were promoted and others expanded to deliberately replace imports from
across the new borders. For example, before independence, most of Bengal's jute had been grown in
what became East Pakistan, and processed in jute textile mills in Calcutta. After 1947, jute farming
was promoted in India and protected by restricting the imports that had traditionally come from the
East, while in East Pakistan jute textile mills were established to process jute and protected against
competition from processed jute made in India.1 Similarly, imports of raw rubber that had previously
come to India from Sri Lanka (as well as from Malaysia) were restricted in order to protect the
development of a rubber industry in Kerala.2

         Bangladesh emerged as an independent country in 1971 and chose to follow the same road.
Two land-locked countries in the region, Nepal and Bhutan, had more open trade relations with their
dominant neighbor, India, but followed similarly restrictive policies with respect to the rest of the
world. Consequently, while they began to trade more intensively with India, they too remained
relatively closed with respect to the outside world. The only exception to this general South Asian
pattern was the Maldives, a tiny island state in the Indian Ocean.

         With the exception of Sri Lanka, which had undertaken significant liberalization in the late
1970s, anti-trade policies remained dominant in the region for nearly four decades. The collapse of
the Soviet Union and the success of China under outward-oriented policies finally convinced the
policy makers in the region that rapid growth could not be achieved without significant opening of
their trade regimes. Unilateral trade liberalization policies, which had begun to be introduced in the
second half of the 1980s, were introduced on a more systematic basis in the 1990s. The change
contributed to a more rapid expansion of trade of India, Pakistan, Bangladesh, and Nepal not only with
the outside world but with one another as well.

         Quite apart from the general opening up, the countries in the region also began to see
increased cooperation and trade among themselves as a key objective. This was reflected partially in
the founding of the South Asian Association of Regional Cooperation (SAARC) in 1985 to promote
dialogue and cooperation. In 1993, the member nations of SAARC went on to sign an agreement to


1For details, see: World Bank (2004). Trade Policies in South Asia: An Overview, Chapter 5, Volume II.
2See: Pursell, G. and Pitigala, N. 2001. "Trade Agreements in the South Asia Region". World Bank (mimeo); and World
Bank (2004), ibid, Chapter 5, Volume II.
                                                            2

forge the South Asian Preferential Trade Area (SAPTA), which became operational in December
1995. Though the actual exchange of preferences remained extremely limited, the process of
negotiation kept the dialogue among the member countries alive.

         But the worldwide proliferation of preferential trade arrangements in the last decade has now
led to a change in thinking in the region, especially in India, which has begun to negotiate a series of
preferential trade agreements of its own. Within the region, this has recently led to the signing of the
South Asian Free Trade Area (SAFTA) Agreement with the ultimate objective of turning South Asia
into a full-fledged FTA with the internal liberalization beginning in 2006. This agreement has come in
the wake of a bilateral FTA agreement between India and Sri Lanka in 1998 that became operational
on March 1, 2000. In addition, India has also had prior trade agreements involving Bhutan and
Nepal.3

         In this paper, we propose to carry out a detailed analysis of the preferential trade arrangements
in the region. We begin in Section I with the examination of the most effective FTA in existence in
the region: the India-Sri Lanka Free Trade Area (ISLFTA).4 We show that the agreement excluded
outright many of the major sectors in which the countries had comparative advantage and imposed
tariff-rate quotas (meaning the preferential tariff is applied up to a pre-specified quota while the `Most
Favored Nation' (MFN) tariff is applied to the out-of-quota imports) on many others. The strict `rules
of origin' (ROO) further handicapped the potential expansion of intra-regional trade on a preferential
basis in products that would have led to trade creation. Nevertheless, the ISLFTA has led to a
substantial expansion of bilateral trade between the two countries in both directions. This has come
about principally through the expansion of trade in products that were not traded or traded very little
between the two countries previously and therefore presumably escaped the sectoral exclusions. We
cannot determine whether this expansion represents trade creation or trade diversion, however, since
such determination requires information that we are not readily able to collect. Future work that tracks
the products experiencing large trade expansion will be useful to determine whether the expansion
represented trade creation or trade diversion.

         In Section II, we turn to the South Asia region as a whole and go over what is now familiar
territory to the informed observers: the evolution of intra-regional trade and of the region's preferential
trade agreements, namely, SAPTA and SAFTA. We show that after stagnating for several decades,
following trade liberalization in the region in the 1990s, especially by India, intra-regional trade in
South Asia has accelerated. We then describe the SAPTA and SAFTA agreements as they stand
currently.

         In Section III, we turn to a critical examination of SAFTA. We show that when compared
with the rest of the world, the region is tiny both in terms of economic size as measured by GDP and
share in world trade. We argue that prima facie, this fact makes the likelihood of trade diversion being
dominant as a result of the SAFTA likely. This point is reinforced by the presence of the high level of
protection in the region and the sectoral exceptions as also the rules of origin that are likely to be
chosen. We also offer a selective review of the partial- and general-equilibrium simulation studies that
have been attempted to-date. These studies show at best small benefits from SAFTA and at worst
losses for some of the member countries.

         In the last part, Section IV, we argue that considered in isolation, the economic case for
SAFTA is quite weak. Even when political factors are taken into account, the case that SAFTA is the
first or even second-best instrument for alleviating the India-Pakistan conflict remains to be
articulated. Therefore, SAFTA makes sense only in the context of a much broader strategy of creating


3For details on these agreements, see: World Bank (2004), ibid, Chapter 5, Volume II.
4As just noted, India also has trade agreements with Bhutan and Nepal, but these largely involve trade preferences by India
to the two countries rather than FTA agreements.
                                                             3

a larger preferential trade area in the region that specifically would encompass China and the member
nations of the Association of South East Asian Nations (ASEAN). In turn, the case for the latter is
strategic: the pursuit of regionalism in the Americas and Europe has created increasing discrimination
against Asian exports to those regions, which must inevitably impact the region's terms of trade
adversely. An Asian bloc could be a potential instrument of changing incentives for the trade blocs in
the Americas and Europe and forcing multilateral freeing of trade.


          The final issue we tackle is how best to make SAFTA effective, assuming that it is here to
stay. We argue that if the deleterious trade diversion effects are to be minimized, it is important that
the member countries move even more rapidly on their external liberalization both on a unilateral basis
and within the multilateral context. Moreover, the temptation to create long lists of sectoral
exceptions should be resisted. Also, the rules of origin should be liberal and take the across-the-board
form rather than being different for different sectors and countries. We also argue that the member
countries should use the instrumentality of SAARC rather than SAFTA to promote economic
cooperation in a variety of areas. Using the SAFTA instrumentality for promoting trade as well as
other agendas runs the risk that each can be held hostage to the progress in the other.


                                       I.         THE INDIA-SRI LANKA FTA

          We can analyze the ISLFTA at two levels. First, we may ask how ex ante the choice of the
sectors excluded from preferences, the phase out of tariffs, tariff-rate quotas and the rules of origin
were influenced by what the countries saw as the comparative advantage of the partner. And second,
we may ask ex post what has been the impact of trade preferences on trade flows, again from the
perspective of trade creation and trade diversion? We begin by considering the first question.

          Table 1 details the provisions of the FTA. Of the total of 5,112 items,5 India placed 429 items
on the negative list, meaning that no tariff preference is granted on these items.6 It gave Sri Lanka
duty-free access on 1,351 items in the first year of the coming into force of the FTA. It also agreed to
extend Sri Lanka duty-free status on 2,799 additional items in three years, extending 90 percent
preference in the first year itself. Thus, by March 1, 2003, India granted Sri Lanka duty free status on
81 percent of the items. Of the remaining items, 238 items receive a 50 percent tariff preference and
528 items receive 25 percent preference starting the first year with no further expansion of the
preference in the subsequent years. Some key items are also subject to physical quotas beyond which
the MFN tariff must be paid.

          Sri Lanka took the negative-list exception for 1,180 or 23 percent of all items. It gave India
immediate duty-free access on 319 items. On another 889 items, it gave 50 percent preference in the
first year that will be expanded to 75 percent in the second and 100 percent in the third year. On the
remaining 2,724 items, the phase out period is eight years --35 percent preference at the end of the 3rd
year, 70 percent at the end of the 6th and 100 percent at the end of the 8th year. Thus, at the end of the
8th year, Sri Lanka would have given duty-free status to India on 77 percent of all items.

          On the surface, India's offers to Sri Lanka look generous. Yet, a closer examination of the
data reveals that the products that Sri Lanka is capable of exporting to India are either excluded
through the negative list or constrained by the quota. Being a small economy, the production structure



5 At the 6-digit level of Harmonized System.
6 However, India made an exception by extending partial preference on several apparel products that were otherwise on the
negative list. The motivation behind this provision is not clear to us though we speculate that the preference may be for a
limited period so that India retains the right not to extend the preference beyond the specified period.

                                                                 4

of Sri Lanka is highly specialized. As such, even a small number of exceptions may be sufficient to
constrain its potential exports.

          This is eminently clear from Table 2, which shows the top 20 exports of Sri Lanka (to the
world and not just India) at the 6-digit HS level along with the corresponding MFN and preferential
tariff facing Sri Lanka in India as of March 1, 2001 (then in 2004). These products account for 46
percent of Sri Lanka's total exports in 1999. India subjects 15 out of these 20 products to either a
tariff rate quota (meaning the tariff preference applies only up to a pre-specified quantity of imports)
or negative-list exception. The ROO and rules of destination requirements further restrict the exports.
For example, apparel exports are not only subject to the tariff rate quota of 8 million pieces but at least
6 million of these pieces should be manufactured from fabrics of Indian origin exported to Sri Lanka
from India. Likewise, exports of tea from Sri Lanka at the preferential tariff are not to exceed 12.5
million kilograms within a calendar year. Both products are also subject to a uniquely South Asian
restriction that may be called `the rule of destination': the preference applies only if the products enter
through specific Indian ports. Thus, the politics of exceptions is clearly stacked against the goods in
which Sri Lanka is supposed to have a comparative advantage.

          Purely from the static efficiency standpoint, the tariff-rate quota may be a useful device to
minimize trade diversion. As long as imports from Sri Lanka continue to come beyond the specified
quota, at the margin, products from Sri Lanka still face the MFN tariff so that no trade diversion takes
place. All the tariff-rate quota does is to transfer the tariff revenue that would have been collected by
India to the extent of the tariff preference on the quota is to Sri Lanka. But from the viewpoint of Sri
Lanka, the quota does limit the transfers since the preferential tariff does not apply to the out-of-quota
exports. These transfers could be substantial since the MFN rates applied by India to the out-of-quota
imports (based on the simple average of the tariff rates) are set at the higher of 20 percent or the
specific rates (see Table 2) for textiles and apparels, and 100 percent for tea in 2004. The tariff-rate
quota also rules out any expansion of the exports on account of the preference since the preference
does not apply at the margin. Of course, if the tariff-rate quota is non-binding, the traditional
preferential trade analysis involving trade creation and trade diversion applies7

          A similar story emerges with respect to the exports of India to Sri Lanka. Table 3 lists India's
top 20 exports (to the entire world, including Sri Lanka) that account for 42 percent of its total exports.
Seven of these twenty products are subject to the negative-list exception (including one with zero
MFN rate). Of the remaining thirteen products, four are subject to zero MFN tariff so that the
preference is meaningless. One more product is subject to 5 percent MFN tariff on which 35 percent
tariff preference results in a preference of 1.75 percentage points. The remaining seven products
attract an MFN tariff rate of 10 percent on which the Indian products receive 3.5 percentage points
preference that reduces the tariff rate to 6.5 percent.8

          Alternatively, Tables 4 and 5 show how various concession categories of India and Sri Lanka
relate to the volume of trade with the world as well as each other. According to Table 4, 36 percent of
India's exports to Sri Lanka in 1999 were covered by the latter's negative list. Another 54 percent of
the bilateral exports were in the category subject to the eight-year phase out. Thus, only 10 percent of
India's 1999 exports to Sri Lanka were granted any immediate tariff preference. Conversely, as shown
in Table 5, even though the number of items placed by India on the negative list was relatively small ­


7However, India has made an adjustment on the concessions for tea (Table 2, last column): the previous 50 percent fixed
concession rate on quota was made free, but is now subject to a 26 paise (cents) reduction per Kg.
8The updates for 2004 (last column in Table 3) show that there was an amendment to the original concession categories
sometime between 2002 and 2004. Four items which were under 8-year phased removal (35 percent by 2003) were made
duty free with the other items remaining on the original schedule. Another noteworthy feature that emerges from the new
data is that Sri Lanka's MFN tariff in 2004 shows an upward revision for most items compared to the 2001 rates. Twelve out
of the 20 items show an increase in the MFN rates, while two items are subject to reduction in the rates; moreover, ad
valorem duties on two have been converted to specific duties.
                                                              5

8.4 percent of the total tariff lines as opposed to 23 percent of all items placed on the negative list by
Sri Lanka-- those items accounted for as much as 51 percent of Sri Lanka's exports to the world. Tea
and textiles, both subject to tariff-rate quota, accounted for another 17 percent of the exports.9

          Put another way, as Weerakoon (2001) points out in her excellent paper, at the time the lists of
concessions were finalized, of the 319 items on which Sri Lanka offered zero duty to India, the latter
exported only three items to the former. Of the 2,907 products exported by India to Sri Lanka, only 21
percent received any tariff preference at all. Conversely, of the 1,351 items in the zero-tariff list of
India, Sri Lanka exported only 68 items to the former. Of the 380 items exported by Sri Lanka to
India, 50 were on the Indian negative list, 44 received a 25 percent tariff preference, 218 received a 90
percent preference (expanded to 100 percent from March 1, 2003) and 68 received a 100 percent
preference.

          This pessimistic ex ante political-economy analysis notwithstanding, how has the Sri Lanka-
India trade evolved in the wake of the signing of the ISLFTA. Here we find a surprise. Traditionally,
the India-Sri Lanka trade has been relatively small. As Figure 1 shows, imports from Sri Lanka as a
proportion of India's total imports (purple line) remained below 1 percent and showed a declining
trend from late 1980s to early 1990s. With the opening up by India in the early 1990s, the share began
to pick up, but sharply declined again after peaking in 1996. The recovery of the share was initially
slow but picked up almost dramatically after the ISLFTA came into effect. From 0.09 percent, the
share shot up to 0.15 percent in the first two years of the ISLFTA.

          Sri Lanka being small and India being large, the share of the latter in the total imports of the
former is, of course, much larger. As Figure 1 shows, this share had a slight upward trend during the
1990s, which accelerated first in 1998 with unilateral liberalization by Sri Lanka and then again in
2001 with the ISLFTA coming into effect. During 1998-2002, the share has gone up from less than 10
percent to more than 20 percent. Since the effectiveness of ISLFTA alone, the expansion was from 12
to 21 percent during 2000-2002.

          The critical question one must answer is how the trade shares rose dramatically despite the
apparent limited grant of preferences by the two sides. The answer lies in the fact that the political-
economy pressures against preferences generally operate against the existing import from the partner
country. Goods that the partner country does not supply at the time of the negotiations do not pose an
obvious threat and therefore manage to receive significant preferences. And it is in these products that
the scope for trade expansion can be quite large.

          Detailed evidence presented in Table 6 shows that once the ISLFTA came into effect, the
composition of traded goods at HS six-digit level of classification shifted dramatically. The table is
constructed as follows. Take the upper part relating to the imports of India from Sri Lanka first. We
take the products with zero imports by India from Sri Lanka in 1999 and place them in category 1.
Next, we stack the remaining products in the ascending order of the value of their imports by India
from Sri Lanka in 1999 and then divide them such that each category contains 10 percent of the
imports in 1999. Because the bottom five products account for 50 percent of the imports by
themselves and do not allow a neat division into categories with 10 percent imports each, we simply



9 However, these initial magnitudes and proportions might have changed with the phase-out of duties by the two countries
since the Agreement became effective. As shown in Table 1, 889 items on the three-year phase-out list extended to India by
Sri Lanka and 2799 items on the three-year phase out list extended by India to Sri Lanka are currently duty free. This might
have impacted the trade between the two countries. Overall, India enjoyed tariff preferences on 1208 tariff lines (or 23
percent of total tariff lines), while Sri Lanka enjoyed tariff concessions by India on 4150 (or 79 percent of total tariff lines) as
of 2003 March.


                                                                 6

lump them together into a single category. This gives us a total of seven categories with the first
category accounting for no imports, next five accounting for 10 percent imports each and the seventh
one accounting for 50 percent of the imports by India from Sri Lanka in 1999. By construction, the
second category of products individually contributed very little and therefore contains the largest
number of products (except the first one, which contains products with zero bilateral imports by India
in 1999). By the same token, the last category contains products that individually contributed the
largest volume of bilateral imports in 1999 and hence contains the fewest products. We then fix the
products in each category and compute the change in the share of the products in each category in the
subsequent years. The bottom half of Table 6 carries out the same exercise for India's exports to Sri
Lanka.

          The most striking feature of Table 6 is that the share of products in category 1 rises from zero
to 38 percent in 2002! Much of the expansion in trade comes from new products that were not
previously exported by Sri Lanka to India at all. Indeed, previously best-established exports (category
7) lose the share in total exports dramatically from 50 percent in 1999 to just 19 percent.

          The same pattern repeats itself, though in a slightly less pronounced form, in the exports of
India to Sri Lanka. The category with zero imports in 1999 rises to 10.5 percent in 2001 but falls back
to 7.4 percent in 2002. The next category, with least but positive imports initially (category 2) rises
from 10 percent in 1999 to 39.5 percent in 2002! The last category with just 3 products accounting for
10 percent of all exports by India to Sri Lanka drops to 1 percent!

          That ISLFTA has led to an expansion of bilateral trade between India and Sri Lanka is not in
a great deal of doubt unless we can think of an alterative explanation for the large expansion in the
post-ISLFTA period. But without knowing more, we cannot tell whether this expansion represents
trade diversion from third countries or new trade that would not otherwise exist and therefore trade
creation. It could also represent trade deflection, though this is less likely unless the governments are
failing to implement the ROO.10 The question whether the trade expansion represents trade creation or
trade diversion is difficult to answer. For example, consider a product whose imports into India from
Sri Lanka expanded rapidly. We must verify if India imported this product from outside prior to
ISLFTA. If not, the expansion clearly represents new trade and hence trade creation. But in the more
likely case that the product was previously also imported from outside countries, the determination is
more difficult since we must then determine whether absent ISLFTA, India would have imported more
of the product from outside countries.

          Alternatively, we may examine the price effects of ISLFTA. We may ask whether the
ISLFTA led to a reduction in the prices of the products whose imports from Sri Lanka expanded. If
yes, the expanded trade necessarily contains an element of trade creation since ceteris paribus, new
trade must expand the total supply of the product in the Indian market. But again, this is not as simple
as it may sound, since the price may change because the world price itself changed.


                                       II.       SAARC, SAPTA and SAFTA

          Following the September 2003 Cancun Ministerial, the ongoing efforts on the part of the
larger South Asian countries to hold discussions on bilateral FTA agreements with countries in the
region and those outside the region have intensified. Within the region, there are ongoing discussion


10The Rules of Origin under ISLFTA stipulate that, in order to qualify for the preferential treatment, products not wholly
produced in the exporting country must satisfy all of the following conditions: (i) foreign content must be no more that 65
percent of the FOB (i.e., 35 percent local content); (ii) the product must undergo transformation at HS 4-digit level; and (iii)
the final processing must take place in the exporting contracting party. In addition, notwithstanding the transformation at the
4-digit HS level, the following conditions are insufficient to qualify for preferences: simple processing, packaging, break-
bulk, assembly of consignments and simple mixing.
                                                                 7

between Pakistan and Sri Lanka, between India and Bangladesh, and between Bangladesh and Sri
Lanka. Outside the region, India recently signed a `Framework' Agreement with Thailand for
establishing an FTA, has been discussing another with Singapore, and carrying out discussion
discussions with China. Pakistan has recently signed a limited trade (`Early Harvest') pact with China
to take effect from January 2006, with a view to moving to a full FTA in three years. Another `Early
Harvest' agreement was signed with Malaysia. And a trade and investment framework agreement
(TIFA) has been signed with the United States, with the ultimate aim of an eventual FTA. Pakistan is
also holding FTA discussions with Indonesia, Laos, Singapore, and Thailand, and these FTAs are
expected to be negotiated in 2006. And in July 2002, Sri Lanka and the United States signed a TIFA
as a step towards forming a FTA.

          Quite apart from these bilateral initiatives, efforts have been ongoing for a region-wide
preferential trade area. In the remainder of this paper we propose to focus on the analysis of these
efforts. As noted in the introduction, the initial efforts to form a PTA had culminated in the SAPTA in
1993. The SAPTA agreement provided for the exchange of tariff preferences among the member
nations without commitment that such exchange would be carried out on a scale that would turn the
region into a free trade area by a specified date. As such that arrangement could not be termed as the
South Asian Free Trade Area. The SAPTA agreement made a distinction between the least developed
and other developing member countries with the former consisting of Bangladesh, Nepal, Bhutan and
the Maldives and the latter India, Pakistan and Sri Lanka. The agreement provided for Special and
Differential Treatment for the LDC members and also included a "regional" MFN provision. Thus,
any preference extended within the SAPTA framework by a member that is not least developed to
another that is also not least developed must be automatically extended to all SAPTA members. The
preferences granted by a non-LDC member to an LDC member must be automatically extended to all
LDC members. As a part of the SAPTA special and differential treatment provisions, non-LDC
member countries are encouraged to offer one-way trade preferences to LDCs.

          The SAPTA `rules of origin' stipulate that if the products are not wholly produced or
obtained11 within the member country, the total value of the materials, parts or other inputs originating
from non-member states or of undetermined origin and used in the production of the exported product
should not exceed 50 percent of the f.o.b. value and that the final processing of the product must be
performed within the territory of the exporting member state. The non-local inputs are valued at their
c.i.f. prices where obtainable or otherwise at "the earliest ascertainable price". The rule thus stipulates
a minimum 50 percent of the f.o.b. value addition in the exporting member country to be eligible for
SAPTA preference. In order to encourage regional value addition, however, the agreement also allows
for eligibility for an available tariff preference if within-union cumulative content is not less than 60
percent of the f.o.b. price. As a further exception to these rules, the agreement provides for a
preference to the LDC members above and beyond the general and cumulative ROO, allowing an
additional 10 percent to be applied to the f.o.b. value of imported inputs from both union and non-
union countries. These ROO provisions have been a contentious issue and were subjected to
continuous scrutiny by members who realized that the effective concessions under SAPTA was quite
limited not just because the product coverage is limited (see below) but also because most member
countries are unable to satisfy the stringent ROO. After much resistance, principally from India, in
1999, the local content requirement was reduced to 40 percent for non-LDC members and to 30
percent for the four LDC members and the "cumulative" origin requirement was reduced to 50
percent.

          Despite three rounds of preference negotiations, the product coverage of SAPTA remained
limited so that the arrangement remained ineffective. An analysis of the top 20 export commodities of
each member country demonstrates that the SAPTA resulted in significant preferences for only the
least developed member countries. Mukherji (2000) estimates that the annual value of all imports that

11These include domestic raw materials, agriculture products, fish, waste and scrap and products wholly obtained from these.
                                                             8

entered the SAARC member countries under the SAPTA preferences amounted to approximately $480
million at the end of the 1990s. According to his calculations, the proportion of intra-regional imports
covered by the SAPTA preferences was the highest for Pakistan (39.6 percent), followed by Nepal
(35.2 percent), India (30 percent), Bhutan (17 percent) and Sri Lanka (12 percent). The import value
coverage of Bangladesh and Maldives was marginal.

          Nevertheless, the failure of the WTO ministerial meeting in Cancun gave impetus to a more
serious consideration of the regional option in South Asia, especially by India, and speeded up the
move towards a South Asian Free Trade Agreement (SAFTA).12 The SAFTA accord, signed in
January 2004, now proposes not only to turn the SAPTA into an FTA but goes beyond it by including
in the core agreement provisions for trade facilitation, harmonization of customs classification,
removal of restrictions on intra-regional investment, macroeconomic consultations, and development
of communication systems and transportation infrastructure. The agreement is to come into force on
January 1, 2006.

          Under the trade liberalization component, the member countries agree to gradually harmonize
and eventually bring down their import tariffs on trade within SAFTA to 5 percent or less.
Accordingly, in the first phase, the LDC members in SAFTA will reduce their maximum tariff rates to
30 percent within two years from the date of coming into force of the Agreement (i.e., by January 1,
2008). The non-LDC members will reduce their maximum rates to 20 percent within the same time
frame. In the second phase, which will resume on January 1, 2008, the non-LDC members will reduce
their import tariffs to 5 percent or less in 5 years (i.e., by January 1, 2013), while the LDCs will do the
same in 8 years (i.e., by January 1, 2016). The agreement allows the exclusion of "sensitive" items
through member-specific negative lists, which are to be negotiated by the member countries.


                                          III.      EVALUATING SAFTA13

          The economic case for SAFTA is relatively weak. Neither the qualitative arguments nor the
quantitative assessments that are available give one reason to feel enthusiastic about the arrangement
from an economic standpoint. Nor does the experience with SAPTA and ISLFTA give one reason to
hold optimism that the member countries will resist resorting to sectoral exclusions, strict rules of
origin, and tariff-rate quotas to minimize trade diversion. In our assessment below, we begin with the
qualitative arguments and then summarize the available quantitative studies.


a.        Qualitative Arguments

          A commonly used indicator to assess the desirability of an FTA is intra-regional trade as a
proportion of the total regional trade. It is claimed that the larger this trade, the more "natural" the
union. Bhagwati and Panagariya (1996) have systematically shown, however, that the extent of intra-
regional trade has little bearing on whether the union is beneficial or harmful in welfare terms except
when all trade is already intra-regional in which case there is no extra-regional trade to divert and trade
creation is the only possibility. The reason is that the change in intra-regional trade due to a tariff
preference at the margin bears no obvious relationship to the existing volume of intra-regional trade.
Depending on the precise structure of the model, it is entirely possible that when intra-regional trade is
small, its further expansion does not lead to the diversion of trade from extra-regional partners.
Nevertheless, since intra-regional trade remains a key target of PTAs, without implying that its
existing level suggests the likelihood of either trade creation or trade diversion dominating when the
union is formed, we briefly describe its evolution in the present section.

12The objective of converting the SAPTA into SAFTA had existed since 1997. At the time, the date for making SAFTA a
reality was set as 2001 but no real progress happened.
13For a general survey of the theory of preferential trading, see Panagariya (2000).
                                                                9

          Figure 2 shows the evolution of the total intra-regional trade in South Asia since the end of the
British rule in the region. Until 1951, this trade as a percentage of the region's total trade was in the
double digits. As noted in the introduction, this pattern reflected two facts: the world markets were
relatively closed and South Asia was relatively open. In the years that followed, the two trade regimes
exchanged places: the world markets opened up while South Asian borders became progressively
closed. Moreover, in the case of India and Pakistan, political tensions virtually closed official
international trade between them. By 1967, intra-regional trade had already fallen to just 2 percent of
the region's total trade. It recovered briefly in the early 1970s but declined steadily thereafter until
1990 when it was fell back to the 1967 level of 2 percent of total trade. The share began to recover
again only when the region, especially India, began to open its trade regime in the 1990s, reaching 4.2
percent in 1999, and 4.4 percent in 2002.

          We show country-level data on the direction of exports and imports in Tables 7 and 8,
respectively. The pattern at the country level essentially mirrors that at the aggregate level. On the
exports side, the countries trade mainly with developed countries and relatively little with South Asian
partners. For India and Pakistan, this fact also holds true on the imports side. But Bangladesh and Sri
Lanka import as much as 20 and 15 percent of their respective total imports from South Asian sources,
almost entirely from India. These volumes remain relatively small proportion of the total Indian
exports, however. What remains true is that even Indian exports to the South Asian partners have
expanded significantly during the 1990s, rising from 3 percent in 1990 to 5 percent in 2002. The
change has come about mainly due to unilateral liberalization of the MFN tariffs in the region (see
below).

          Against this background, we see three important features of the South Asian economies that
make an FTA among them economically unattractive.14 First, the economies are relatively small in
relation to the world both in terms of the GDP and trade flows. Table 9 shows the population, GDP
and the volume of trade in the SAARC-5 (Bangladesh, India, Nepal, Pakistan and Sri Lanka) in the
year 2001. In terms of population, the region is substantial: one fifth of the world. This clearly
indicates the future potential of the market if per-capita incomes reach the levels prevailing currently
in the ASEAN economies. But the current per-capita incomes are tiny in relation to the latter so that
the economic size of the region remains small: less than one twentieth of the world in terms of the
GDP. And if we take India out of the picture, this proportion drops to 0.4 percent. The probability
that the most efficient suppliers of the member countries are within the region is slim. Therefore, the
probability that the FTA is likely to be largely trade diverting is quite high.

          Trade-related indicators reinforce this conclusion. Thus, the last column of Table 9 shows the
share of the SAARC countries in the world trade (exports plus imports as a proportion of the GDP).
Together, the countries in the region account for only 1.1 percent of the world trade. Again, if India is
excluded, the proportion drops to 0.4 percent. The scope for trade diversion due to tariff preferences is
indeed very large.

          The second reason for why prima facie the economic case for SAFTA is weak relates to the
relatively high levels of protection among the SAARC economies. If the country participating in a
regional arrangement were itself open, it would not suffer from trade diversion even if it were tiny.
For example, Singapore only stands to benefit from FTAs with other countries since its union partners
must compete with the outside union countries on equal footing: everyone faces near zero tariffs in
Singapore. In an India-Singapore FTA, it is India that must suffer all the negative consequences of
trade diversion.15 Against this background, it is useful to consider the existing trade barriers in the


14Some of these concerns are discussed in greater detail with the associated analytics in Panagariya (2004).
15If the protection levels in a potential importing country are prohibitive, the inclusion of these industries in SAFTA could
have substantial overall welfare benefits in the importing high protection country and generally for the region if the
preferential exports are competitive and lead to substantial price reductions. But even larger economic welfare benefits
                                                               10

SAARC countries. This is done in Table 10. It is evident that the level of protection within the
SAARC region remains high in all countries except, arguably, Sri Lanka. The simple average of the
applied duties in non-agricultural goods ranges from 10.7 percent in Sri Lanka to 25.4 percent in
Bangladesh. In India, this tariff is approximately 20 percent. In agriculture, the level of protection is
even higher and ranges from 19.6 percent in Pakistan to 40 percent in India. And Bangladesh, through
the use of several para-tariffs on top of the customs duties, has recently raised nominal protection
levels for many import substituting industries to very high levels. 16

           The third and final reason that makes the economic case for SAFTA weak concerns the
political economy of the selection of excluded sectors and ROO. When countries are allowed to
choose sectors that can be excluded from tariff preferences in an FTA, domestic lobbies make sure that
the sectors in which they may not withstand competition from the union partner are the ones that get
excluded. On the other hand, lobbies go along with free trade in the sectors in which they are
competitive and the preference will threaten the imports from outside countries. In the same vein,
lobbies tend to go for tight ROO or outright quantitative restrictions in precisely those in which they
fear the competition from the partner most. On the other hand, when the threat is mainly to the
imports from outside countries, they are willing to accept greater liberalization. This pattern was
observed in our analysis of the ISLFTA above. In addition, we may note that the ROO can also be
subject to abuse by the bureaucrat administering them. In cases where imports from the partner may
be threatening an inefficient domestic competitor, bureaucratic discretion may be employed to block
entry of the imports.

           A common argument advanced in favor of SAFTA is that there is a substantial informal trade
among the countries of the region (Table 11) and that this trade involves large real costs. For example,
the bulk of India-Pakistan trade is routed through Dubai, which is costly. An FTA may help eliminate
these costs. There are three issues relating to this argument that must be examined critically. First, in
so far as the illegal trade between India and Pakistan is concerned, it is important to find out what part
of it is due to the restrictions that preclude trade at the MFN terms and what part tries to evade even
the MFN tariff. Second, is it possible that informal trade is largely driven by considerations other than
the evasion of tariffs? A recent paper by Taneja, Sarvanathan and Pohit (2003) studies the transacting
environments in the formal and informal trading between India and Sri Lanka. They find that the
transaction cost in formal trading in India as well as in Sri Lanka is significantly higher than in
informal trading. Thus, the presence of informal trade may simply reflect excessive transactions cost
of passing the goods across the border through formal channels. An FTA will likely add to this cost,
especially for small and medium firms, by adding the costs of complying with the ROO. Therefore,
paradoxically, the FTA might divert trade from the low- to high-transactions cost channel. Finally,
even if the real costs associated with informal trade are higher (contrary to what the Taneja et al. study
shows), benefits from such cost savings through the FTA must be weighed against the costs of trade
diversion.17



would result in the importing country if it were to simply cut its general `most favored nation' (MFN) tariffs, and the same
reasons and pressures that explain the existence of the high MFN tariffs are likely to lead its negotiators to put these
industries on negative lists or delay the introduction of reduced preferential tariffs. As with protection policies generally,
South Asian regional trade negotiations take account of the interests of producers and governments concerned about revenue
losses, but very little weight is generally given to buyer interests unless the products are intermediate inputs of interest to
producer lobbies.

16For a detailed assessment and analysis of nominal protection levels in South Asian countries, see: The World Bank (2004),
Trade Polices in South Asia: An Overview , (in three volumes).
17 If informally traded products are included in bilateral FTAs or SAFTA, it is reasonable to expect that formal legal trade
will to some extent replace the informal trade since one major reason for the informal trade is avoidance of the protective
import duties. However, for a number of reasons some --and in some products substantial volumes-- of informal trade is
likely to continue. First, at Customs formal imports are still subject to the importing countries' domestic indirect taxes and
other taxes (e.g., India's "additional" duties, Pakistan's sales tax and income withholding tax, and Bangladesh's VAT and
                                                                 11

          Given this pessimistic economic assessment, one may ask why has the move towards SAFTA
gathered momentum. The answer to this question appears to be rooted in the politics. First, with most
countries in the world moving forward with more and more PTAs, there is a clear sense in the region
that it may be falling behind in this race. There is an element of following the trend around the world
and South Asia region can hardly remain immune to it. Second, the region has definitely suffered
from the trade diversion generated by the many FTAs in the Americas and EU and its neighbors. The
leaders in the region may therefore see a strategic advantage in forging ahead with as many of their
own FTAs as possible in response. Third, politicians do not seem to distinguish between
discriminatory and nondiscriminatory liberalization as sharply as economists do. As a result they see
bilateral agreements as one of the instruments of liberalizing trade. Sometimes they even see it as a
superior instrument because it leads to reciprocal liberalization in the partner countries. Finally,
SAFTA is also seen as a vehicle of promoting better political ties among neighbors, especially India
and Pakistan that have had a long history of rivalry. The common example the proponents of this
argument have in mind is that of the European Economic Community (EEC) which is claimed to have
joined France and Germany into a tight economic union and made future conflicts between them very
costly.18

          In the context of SAFTA, this last argument has its limitations. For example, one may argue
whether SAFTA is itself feasible in the absence of political harmony between India and Pakistan. The
case of France and Germany involved a victorious power and a vanquished one and the military
presence of an outside superpower that made compliance feasible. The circumstances facing India and
Pakistan are altogether different. With an ongoing conflict and closed borders, they effectively deny
the MFN status to each other.

          But even if feasibility can be persuasively defended, one must ask whether SAFTA is the first-
best instrument of promoting peace between India and Pakistan. For example, trade between them
would likely grow substantially if they were to just open the borders to each other on a genuine MFN
basis, which is a precondition for SAFTA in any case. Moreover, even if preferential trade is an
essential aspect of the promotion of peace, can this not be accomplished more directly by an India-
Pakistan bilateral FTA? Or will the promotion of cultural ties through the movement of people across
the border not be a more direct means of achieving the objective? These are the tough questions that
the proponents of the "peace argument" have not confronted to-date.

b.        Quantitative Studies of the SAFTA

          Quite apart from the qualitative arguments, what do the quantitative studies say about
preferential trade in the region? Quantitative assessments of PTAs in general and SAFTA in particular
fall into three categories. First, we have gravity models that try to predict the impact of the
arrangement on bilateral trade flows. Second, we have the studies based on computable general
equilibrium (CGE) models that predict the effects of the arrangement on all variables including
production, consumption, trade flows in all sectors of the economy as also on welfare. Finally, we



advance income tax) which are avoided by informal importers. Secondly, as noted above, formally traded goods may
continue to face excessive transaction costs at Customs both at the export and import stages, and these transport costs and
transaction costs including delays, "speed money" and bribes in negotiating these procedures may be considerably higher
than the transaction costs and side payments of informal trade, especially for small scale businesses. Thirdly, an important
reason for informal trade in border areas --especially the border areas between India and Bangladesh and potentially between
India and Pakistan-- are distances to the nearest regional Customs post, and rules which exclude many products from
Customs clearance at these posts and require that they be transported long distances to a few larger offices for clearance.
18This argument, while quite fashionable, is not without flaws. For one thing, it was the military presence of the United
States in both Germany and Japan that ensured peace in the respective regions. If the PTA was such a potent force, why is it
that the U.S. military presence continued in Germany? Indeed, no FTA or customs union was formed in the Far East and yet
a lasting peace could be established there because the U.S. military was present in Japan. Moreover, even without any
regional arrangement, the Far Eastern economies have come to be as integrated economically as those in Europe.
                                                              12

have partial-equilibrium studies that try to capture the effects of trade preferences in specific sectors.
All approaches have their strengths and weaknesses.

          By construction, the gravity model is capable of answering only positive questions regarding
the impact of the union on trade flows. Some analysts have tried to draw normative inferences from it
but such attempts are highly questionable. Typically, the exercise involves estimating a bilateral
trade-flow equation with bilateral trade (imports, exports or total trade at the aggregate or sector level)
as the dependent variable and country characteristics such as the gross domestic products, population,
land area, distance, the commonality of language or cultural ties and the existence of preferential trade
arrangements as independent variables. Once estimated, the equation can then be used to predict the
impact of a union between country pairs that did not have such a union during the sample period.

          The gravity equation, by construction, cannot predict the welfare effects of the FTA. These
depend not only on the extent of trade creation and trade diversion that the gravity equation does not
readily predict but also on the associated trade barriers. Even if trade creation is larger than trade
diversion, if the diversion happens in sectors with very high tariffs and creation in sectors with very
low tariffs, the welfare effects may be negative. Analysts who have made claims of showing the
welfare effects going one or the other way by comparing the extent of trade creation and trade
diversion (the claims of whose measurement themselves remain questionable) might have simply
missed this key point.19

          The studies that employ the gravity model include Srinivasan and Canonero (1995) and
Sengupta and Banik (1997). Both studies predict that the impact of a South Asian FTA on trade flows
will be small for India but much larger on the smaller countries. Sengupta and Banik predict a 30
percent increase in the official intra-SAARC trade and as much as 60 percent if illegal trade, which is
currently out of the official count, becomes a part of official trade. These results are intuitive: India
being large, the impact on its trade of the FTA with the small neighbors cannot be proportionately
large.

          The second set of studies employ the computable general equilibrium models and have the
virtue that they can predict the changes in consumption, production and trade at the sector level as also
welfare as a result of the formation of the SAFTA. But the reliability of these models is in serious
question. The model does not have predictive power in the way econometric models do since it uses
the actual data from only one specific year called the base year. It assumes a specific general-
equilibrium model structure and functional forms and, taking a subset of the parameter values as
given, calibrates the remaining parameter values to reproduce the equilibrium in the base year. The
model is then shocked for the policy change in question and the new values of endogenous variable
calculated.

          Panagariya and Duttagupta (2001) demonstrate how the model structure, functional forms and
parameter values can make even a qualitative difference to the results of the CGE models.
Additionally, these models almost never incorporate the ROO. Frequently, they also fail to
incorporate new products that are now known to account for the bulk of the expansion of trade
following the formation of FTAs. As a result, as Kehoe (2003) demonstrates, not one of the numerous
CGE models of NAFTA done prior to its signing came even close to predicting the actual outcome.
For all these reasons, one can take the results of the studies with some grain of salt.



19For welfare calculations, the theoretically relevant measures of trade creation and trade diversion are ex post with income
levels allowed to change endogenously. The commonly measured trade creation and trade diversion in the gravity equation
hold all other variables including the income levels constant. Nevertheless, investigators have employed the gravity equation
to measure trade creation and trade diversion. According to Hoekman (2004), the recent study by Dee and Gali (2003) finds
"that the majority of PTAs in a sample of sixteen caused net trade diversion, including major PTAs such as NAFTA, the
European Union and MERCOSUR."
                                                              13

         Two studies that apply the CGE model to SAFTA are Pigato et al. (1997) and Bandara and Yu
(2003). Both employ the Global Trade Analysis Project (GTAP) database and model, though they
differ in details due to the evolution of the GTAP itself. Pigato et al. find that SAFTA produces
benefits for member nations though unilateral trade liberalization yields larger gains. Bandara and Yu
(2003) find that SAFTA leads to a 0.21 percent gain in the real income of India and 0.03 percent gain
for Sri Lanka. Bangladesh loses 0.10 percent while the rest of South Asia gains 0.08 percent in terms
of the real income. Thus, the largest gain, which accrues to India, is a tiny 0.21 percent. The authors
compare these gains to other forms of liberalization and conclude as follows: "Our results support the
pessimistic view and indicate that South Asian countries may gain much more from unilateral trade
liberalization and multilateral liberalization than from the current SAPTA or proposed SAFTA.
However, hypothetical FTAs between South Asia and NAFTA and the EU would also be beneficial in
the region."

         Finally, a number of studies have employed partial-equilibrium models. These models apply
to specific sectors. Their strength is that they can be (though they are not always) grounded better in
the data and modified more readily to incorporate the details of policy and institutional factors specific
to the sector such as the ROO and existing tariff preferences. The weakness is that they ignore
general-equilibrium interaction that can be important sometimes.

         The studies applying the partial-equilibrium model include Govindan (1994), DeRosa and
Govindan (1995) and Pursell (2004). Govindan (1994) estimates the price elasticities of demand in
food sector and uses them to estimate the effect of preferential liberalization within the region on intra-
regional trade. He concludes that such liberalization would yield welfare gains through increased
trade in food within the region. DeRosa and Govindan (1995) extend the analysis to include unilateral
liberalization and demonstrate that the gains are much larger when liberalization is on a non-
discriminatory basis. Pursell (2004) carefully studies the preferential liberalization of cement industry
between India and Bangladesh, and finds substantial gains from increased competition within the
regional market.

         A key question is the direction the future work on SAFTA should take. In view of the points
made above, we suggest two types of studies: ex post evaluation of the arrangements such as the
ISLFTA that are already in operation and ex-ante partial-equilibrium studies of the major sectors
where trade creation and or trade diversion are likely. The study by Pursell in the latter category offers
a good model in terms of taking into account the important policy and transport-trade logistics details
that are usually left out of the CGE studies.


                                  IV.      Making the Most of SAFTA

         The analysis in this paper shows that a persuasive case for the SAFTA remains to be made by
its proponents. Our own analysis in the light of the experience of the ISLFTA and SAPTA and the
review of the available studies has failed to produce such a case. Economically, the region is small in
relation to the outside world and remains heavily protected. Prima facie, these features imply that
trade preferences to regional partners will likely be trade diverting rather than trade creating. Based on
the experience with the Sri Lanka-India FTA, the ROO and, tariff-rate quota and sectoral exceptions
are more likely to restrict the expansion of intra-regional trade in precisely those sectors in which the
countries have comparative advantage, that is, the sectors in which trade creation is more likely.

         A political case for the SAFTA is often asserted by appeal to the experience of France and
Germany but to-date its proponents have only asserted rather than articulated it. The circumstances of
France and Germany, after Germany had been decisively defeated and the Allied military forces
occupied Germany, were quite different from those of India and Pakistan between which border
hostility is ongoing and unresolved. This difference raises serious doubts about successful

                                                     14

implementation of the SAFTA. On the other hand, if the arrangement is implemented, it is not going
to result in the kind of integration that took place among the member states of the European Economic
Community for the simple reason that the EEC was a customs union that eventually aimed to even
introduce factor mobility, whereas the SAFTA is intended to be an FTA that does not propose to even
harmonize the custom tariff across nations. Finally, it remains to be argued persuasively that the
SAFTA is the best means to break the hostility between India and Pakistan.

         Nevertheless, assuming the SAFTA is here to stay, what shape should it have so as to
minimize its potential adverse effects and maximize its beneficial effects? For starters, it deserves
repeating that the countries implement the SAFTA in earnest, meaning that they should:

           · minimize the sectoral/product exceptions;

           · have `rules of origin' that are very liberal, simple, transparent, and remain the same for
              all products;

           · have clear rules against tariff-rate quotas; and

           · India and Pakistan move to MFN-based trade immediately.

The more play these instruments get, the more likely that they will be used to exclude intra-regional
trade that promotes competition among firms within the region and include intra-regional trade that
displaces the more efficient outside suppliers.

         In addition, we may consider several areas in which unilateral trade liberalization and actions
within the multilateral context remain critically important and where possibilities of cooperation may
exist. Of course, in many cases, detailed and careful studies may be required before a final decision is
made. Among the areas are:

              · Unilateral and Multilateral Liberalization

              · Trade Facilitation

              · Harmonization of Standards and Policies

              · Meeting the SPS Standards in the Third Markets

              · Trade in Services

              · Infrastructure Cooperation

In the following, we offer some preliminary remarks on each of these subjects.

         Unilateral and multilateral trade liberalization. It is critical that the member nations continue
to liberalize their external trade barriers both on a unilateral basis and within the multilateral context.
As long as the external trade barriers of the nations are high, the risk of trade diversion effects
dominating within the SAFTA remains serious. In this respect, the region must avoid repeating the
mistake committed by the countries in Latin America. These countries effectively abandoned their
unilateral trade liberalization programs once they began moving on the bilateral track. The external
trade barriers in South Asia being substantially higher than in Latin America, the countries in the
region can hardly afford to freeze their unilateral liberalization programs. In the same vein, the focus
on the regional market should not divert attention from the much larger extra-regional markets. This
means active promotion of the multilateral negotiations since they will help open further the larger
rich country markets.

         Trade facilitation. The region may also consider taking advantage of the instrumentality of
SAFTA/SAARC in the area of trade facilitation. The study by Taneja, Sarvanathan and Pohit (2003)
reaches the conclusion that the cost of doing business through formal channels in the region is higher
                                                      15

than through informal channels. While there are reasons to be skeptical of this very strong conclusion
(for example, if this is true why does anyone trade through legal channels at all), it certainly points to
very high costs of trading via the formal channels.20 Such costs are especially bothersome because
unlike tariffs they do not even generate any revenue. The countries in the region could cooperate on
bringing down the costs of trade. This will also generate positive externalities for trade costs with
extra-union partners. Trade facilitation has also been included in the Doha Round negotiations. To
the extent that the concerns of the SAFTA countries in this area may be similar, there may be benefits
to result from consultation and cooperation and, if necessary, development of joint positions. Given
that the region's outside trade is going to be expanding rapidly in the forthcoming years, the
importance of precisely what is negotiated on trade facilitation as a part of the Doha Round can hardly
be underestimated. Finally, there may also be room for the SAFTA/SARC instrumentality to be used
for cooperation with the Asia Pacific Economic cooperation (APEC) forum, which has a substantial
program of trade facilitation as well. The APEC work having progressed farther ahead in this area,
there may be lessons to learn from it.

          Harmonization of standards and policies. The third area in which suggestions have been
made for regional cooperation concerns harmonization of standards and policies. SAFTA itself lists
banking practices as a target area for harmonization. Of course, if the region were to turn itself into a
customs union, which is the first important step towards creating a single market, there would be a
strong case for such harmonization in areas such as competition policy, anti-dumping procedures and
product standards --and, preferably, towards practices that give due consideration to the interests of
consumers. The case for harmonization is much weaker, however, within the context of a free trade
area. As such, while only further study of this subject can resolve more conclusively whether
harmonization should be a major subject within the SAFTA framework, our preliminary view is
pessimistic. Unless we are dealing with a truly single market, it is not clear why Bangladesh and Sri
Lanka should harmonize their policies with those of India rather than more significant trading partners
even if they do not have free trade area arrangements with the latter. It may make more sense for the
countries to go for the international "best practices" based on their income levels such that they
facilitate both intra-regional and extra regional trade. Of course, to a large degree, the move to the
international best practices itself may result in a considerable harmonization.

          Product safety and quality standards. The fourth area in which cooperation is worth serious
consideration is how best to meet the product standards, especially in agriculture, in the rich country
markets. With the mounting pressure on the rich countries to eliminate agricultural protection and
subsidies, they are likely to increasingly adopt more rigorous sanitary and phytosanitary (SPS)
standards to protect domestic producers against foreign competition. If the countries in the region are
to take advantage of the eventual decline in the subsides and tariffs on agricultural imports in the rich
countries, they will need to develop expertise in how best to satisfy that SPS measures as also how
best to challenge them in the WTO if they happen to be imposed with protectionist intent and without
sufficient health and safety justification. Given the commonality of interests, there are possible
synergies among the SAARC members in this area.

          Trade in services. The fifth area of cooperation is trade in services. To-date, SAARC
initiatives in the service sector have been limited to consultations related to the tourism sector and
recommendations to regularize the informal labor movement on the basis of regional norms and
mechanisms and evolving rules and procedures for particularly health and education. Yet, given that
the restrictions on trade in services are more akin to quantitative barriers, the likelihood of trade
diversion in them is lower than in goods. Moreover, it may be easier to use the instrumentality of
regional opening to open the market widely to all trading partners in the area of services. As such, it
may be worthwhile to study carefully the implications of the inclusion of services into the SAFTA


20It should be noted that transaction costs associated with formal trade will likely go down with the reductions in protection
levels.
                                                               16

agenda more centrally. Opportunities for mutually beneficial trade may exist, for example, in the IT in
which India is emerging as a leading exporter. Likewise, there may be room for joint projects across
borders in areas such as education and health.

         Cooperation in infrastructure. The final area of cooperation is infrastructure. There can be
issues of road and railway construction, building of bridges and telecommunication development in
which the countries in the region have common interest. Of course, the SAFTA is neither necessary
nor sufficient for such cooperation but may play a facilitating role. It should be remembered,
however, that such cooperative projects should be subject to proper cost-benefit analysis since their
opportunity cost is the alternative project forgone. Preferential trade already tilts the balance in favor
of intra-regional trade and there is no reason to add to that bias by building intra-regional transport and
communications links at the cost of extra-regional links without a carefully analysis.

         We conclude with a warning and a remark. The warning is that the region should avoid
substituting intra-regional trade liberalization for extra-regional liberalization. The countries need to
stay the course on their unilateral and multilateral liberalization. Such a caution should be taken
seriously: in the countries in Latin America that have gone whole hog for preferential liberalization,
unilateral liberalization has come to a standstill. Mexico, Brazil and Argentina have essentially
suspended their unilateral trade liberalization programs in the past several years either because of
protectionist pressures or in the hope that this will allow them to forge more preferential trade
arrangements. South Asia by itself is too small a region for which to sacrifice external liberalization.

         Our concluding remark is that a persuasive case for SAFTA can only be made in two sets of
circumstances. First, if the countries in the region bring their tariffs down to 5 percent or below, the
problem of trade diversion will be considerably reduced. Such low tariffs will also minimize the
impact of the ROO and sectoral exceptions. Second, the SAFTA may be defensible as a part of a full-
fledged FTA in Asia. An Asia-wide FTA will contain many efficient and competitive countries
minimizing, once again, the possibility of trade diversion. Moreover, such an FTA will also give the
member countries a strategic advantage in stemming the tide of regionalism elsewhere in the world,
namely, the Americas and Europe, by securing faster conclusion of the multilateral talks under the
Doha Round.




                                                     17

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       Agriculture, and the Environment Discussion Paper 7, Washington, D.C.: International Food
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Economist. 1996. "Pakistan's Least Favoured Nation", January.

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       J. Ghani, M. Ahmed).

Govindan, K. 1994. "A South Asian Preferential Trading Arrangement: Implications for Agricultural
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       Minneapolis.

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       presented to the Second Conference of the South Asia Network of Economic Research
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       Arrangements". Washington, D.C.: World Bank (May; mimeo).

Panagariya, Arvind. 2000. "Preferential Trade Liberalization: The Traditional Theory and New
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       Blackwell Publishing, 25-37.

                                                18

Panagariya, Arvind, and Rupa Duttagupta. 2001. "The `Gains' from Preferential Trade Liberalization
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        Asia's Integration into the World Economy." Washington, D.C.: World Bank.

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                                                   19

Figure 1: Bilateral Trade as a Proportion of the Total Trade between India and Sri Lanka

 0.16 %                                                                                                                          %25


                            Sri Lanka's share in India's imports (left axis)
 0.14                       India's Share in Sri Lanka's imports (right axis)

                                                                                                                                 20
 0.12



   0.1
                                                                                                         ILFTA                   15

                                                          SAPTA
 0.08
                                                                                                                 ILFTA

                                                Trade Reforms                                                                    10
 0.06                                                                                         Unilateral reforms phase 3
                                                          SAPTA


 0.04
                                                                                                                                 5

 0.02
                  Unilateral reforms Phase 2



     0                                                                                                                           0


            1988   1989      1990   1991    1992      1993    1994  1995    1996    1997  1998      1999     2000     2001  2002
Source: Based on Comtrade data (WITS)




                Fig 2: South Asia's Intra-regional Trade as a Share of Total Trade,
                                                            1948-99
       20
       18
       16
       14
       12
       10
        8
        6
        4
        2
        0

       1948      1953     1958          1963      1968       1973       1978     1983    1988           1993       1998

  Source: Pursell, G. and Pitigala, N. 2001. "Trade Agreements in the South Asia Region". World Bank (mimeo).




                                                                   20

                 Table 1: India-Sri Lanka FTA: Phase Out of Tariffs

                                                        Number of Tariff Lines (6 -digit H.S.
Tariff Preference                                                    Code)


                                                         Sri Lanka's  India's Commitment
                                                        Commitment
100 percent starting 1st year                                319               1,351
90 percent 1st year (100 percent by the end of 3rd
year)                                                                          2,799
50 percent 1st year (75 percent by 2nd and 100 by the
end of 3rd year)                                             889

50 percent in perpetuity (with Garment Quota)                 --                233
50 percent in perpetuity (with Tea Quota)                     --                5*
25 percent in perpetuity (Textile Items)                      --                528
35 percent in 3rd, 70 percent in 6th and 100 percent
in 8th year                                                 2,724                --

None (Negative List)                                        1,180             429**
    Total                                                   5,112              5,112
* A recent revision has adjusted preferential rates to Zero.
** Inclusive of the 233 items of garments, which have been offered preferences.




                                               21

                                                 Table 2: Preferences by India to top 20 Exports of Sri Lanka
HS Category Product Description                Percent            Trade Regime in India (2001)                           Trade Regime in India (2004)

                                               Total           MFN                       ISLFTA                       MFN                           ISLFTA
090240      Other black tea (fermented)           0.09         100%                   (Quota) 50%                    100%                   (Quota) Free less 26 paise per kg.

090230      Black tea (fermented) and partly      0.05         100%                   (Quota) 50%                    100%                   (Quota) Free less 26 paise per kg

710239      Non-industrial--Other                 0.04          30%                      3%                          20%                                  Free

621210      Brassieres                            0.03   30% or Rs.30/ piece   (Quota) 15% or Rs15/ piece      20% or Rs.30/ piece             (Quota) 15% or Rs15/ piece

620342      Trousers, bib and brace overalls,     0.03   30% or Rs.135/ piece (Quota) 15% or Rs67.5/ piece    20% or Rs.135/ piece           (Quota) 15% or Rs 67.5/ piece

620520                  Of cotton                 0.02   30% or Rs.85/ piece  (Quota) 15% or Rs42.5/ piece     20% or Rs.85/ piece           (Quota) 15% or Rs 42.5/ piece

620333      Jackets and blazers-- Of synthetic    0.02   30% or Rs.320/ piece (Quota) 15% or Rs160/ piece     20% or Rs.320/ piece            (Quota) 15% or Rs 160/ piece

620462      Trousers, bib and brace overalls,     0.02   30% or Rs.135/ piece (Quota) 15% or Rs67.5/ piece    20% or Rs.135/ piece           (Quota) 15% or Rs 67.5/ piece

620469      Trousers, bib and brace overalls,     0.02   30% or Rs.135/ piece (Quota) 15% or Rs67.5/ piece    20% or Rs.135/ piece           (Quota) 15% or Rs 67.5/ piece

880330      Other parts of airplanes or helicop   0.02          3%                       Free                         3 %                                 Free

610510      Of cotton                             0.02   30% or Rs.83/ piece (Quota) 15% or Rs 41.5/ piece     20% or Rs.83/ piece           (Quota) 15% or Rs. 41.5/ piece

610910      Of cotton                             0.02   30% or Rs.45/ piece  (Quota) 15% or Rs22.5/ piece     20% or Rs.45/ piece           (Quota) 15% or Rs 22.5/ piece

710391      Worked--Rubies, sapphires             0.01          30%                      3%                          20 %                                 3 %

620630      Of cotton                             0.01   30% or Rs.95/ piece  (Quota) 15% or Rs47.5/ piece     20% or Rs.95/ piece           (Quota) 15% or Rs 47.5/ piece

620690      Of other textile materials            0.01          30%                      15%                         20%                                  15 %

611020      Of cotton                             0.01   30% or Rs.85/ piece  (Quota) 15% or Rs42.5/ piece     20% or Rs.85/ piece           (Quota) 15% or Rs 42.5/ piece

620433      Jackets and blazers--Of synthetic     0.01   30% or Rs.390/ piece (Quota) 15% or Rs195/ piece     20% or Rs.390/ piece            (Quota) 15% or Rs 195/ piece

401290      Tires: Other                          0.01          30%                    Negative                      20%                                Negative

620640      Of man-made fibers                    0.01   30% or Rs.120/ piece  (Quota) 15% or Rs60/ piece     20% or Rs.120/ piece             (Quota) 15% or Rs 60/ piece

401519      Gloves--Other                         0.01          30%                      3%                          20%                                  Free




Source: Tabulated from data obtained from Comtrade (WITS) and the Official Website of India's Director General of Trade (http://dgft.delhi.nic.in/).

                                                                                22

                                            Table 3: Preferences by Sri Lanka to top 20 Exports of India
HS No.                Description             % of Total     Trade Regime in Sri Lanka (2001)              Trade Regime in Sri Lanka (2004)
                                               Exports
                                               (1999)    MFN           ISLFTA (Preference margin)     MFN                     ISLFTA (Effective Duty)
710239   Non-industrial--Other                  0.14          0              35% by 2003                     0                        Free

271000   Petroleum oils and oils obtained fr    0.05       16.2%               Negative                   16.2%                     Negative

711319   Of precious metal whether or not pl    0.03        10%              35% by 2003                   28%                 18.2% (free in 2008)

100630   Semi-milled or wholly milled rice,     0.02        35%                Negative                 Rs. 9 PK                    Negative

030613   Frozen--Shrimps and prawns             0.02        10%                Negative                    15%                      Negative

260111   Iron ores and concentrates, other t    0.02         5%              35% by 2003                   2.5%                1.6% (free in 2008)

610910   Of cotton                              0.01        10%              35% by 2003                   15%                 9.7% (free in 2008)

620630   Of cotton blouses                      0.01        10%              35% by 2003                   15%                 9.7% (free in 2008)

300490   Other medicaments                      0.01          0              35% by 2003                   0%                         Free

620520   Of cotton men's                        0.01        10%              35% by 2003                   15%                 9.7% (free in 2008)

294200   Other organic compounds.               0.01          0              35% by 2003                   2.5%                       Free

630492   Other--ot knitted or crocheted,        0.01        10%              35% by 2003                   15%                 9.7% (free in 2008)

080132   Cashew nuts--Shelled                   0.01        25%                Negative                    28%                      Negative

610510   Of cotton                              0.01        10%              35% by 2003                   15%                 9.7% (free in 2008)

100190   Other wheat                            0.01          0                Negative                    2.5%                     Negative

630790   Other                                  0.01        10%              35% by 2003                   15%                 9.7% (free in 2008)

170199   Other sugar                            0.01        25%                Negative                Rs 4.5 PK                    Negative

520710   Containing 85 % or more wgt.           0.01          0              35% by 2003                     0                        Free

230400   Oil-cake and other solid residues,     0.01        10%              35% by 2003                   15%                 9.7% (free in 2008)

380810   Insecticides                           0.01       12.5%               Negative                    11%                      Negative

   Source: Tabulated from data obtained from Comtrade (WITS) and Sri Lanka Customs http://www.customs.gov.lk/guides/tariff/index.htm




                                                                           23

                           Table 4: India's Exports to Sri Lanka by Concession Categories
 Concession Type and         No. of % of Total Exports to        % of Exports to Sri Lanka         % Growth in            Sri Lanka's
          Level               Tariff            WLD                 from Bilateral Total          Exports to Sri        Average MFN
                              Lines                                                                   Lanka              Tariff Rates
                                         1999       2002            1999            2002            1999-2002                2001
   Nil (Negative List)         1180       20          25             36              48                 146                   18.8

   100% (Zero duty)            319        3.6         3.8            0.8             0.7                 64                   4.3

50% (Phased out to 100%        889        4.5         6.3            8.8             8.4                 75                   5.2
        in 3-years)
 Up to 100% in 8 -years        2724       71          65             54              43                 n.a.                  9.2

          Total                5112       100        100             100             100

Source: Tabulated from the data obtained from BOI Sri Lanka and Comtrade WITS




                                 Table 5: Sri Lanka's Exports by Concession categories
Concession Type and Level            No. of        % of Total Exports to         % of Exports to India        % Growth        India's
                                  Tariff Lines             WLD                    from Bilateral Total        in Exports     Average
                                                                                                               to India    MFN Tariff
                                                                                                                              Rates
                                                   1999           2002            1999            2002        1999-2002        2001
Negative List (Except                  196          1.9            2.0              2.6           0.6            -20            40
Apparel)
50% (fixed) -Apparel Quota             233         49.1            47.9             0.2           0.09            29            35

100% (Zero duty)                      1351          1.6            1.2             24.6           10.1            48           29.8

90% (Phased out to 100% in            2799         29.8            31.7            67.6           88.4           493           29.7
3-years)
50% (fixed) -Tea Quota                   5          14             14                5             1             -101          63.0

25% (fixed) -Textile Items             528          3.4            3.0             0.05           0.01           -27           29.2

Total                                 5112          100            100             100            100

Source: Tabulated from the data obtained from BOI Sri Lanka and Comtrade WITS.
         o Garments are retained under the negative list despite 50% concession under quota. Negative List consist of 429 items (Totals
         of rows 1 & 2).
         o The apparel exports are subjected to an annual quota of 8 million pieces (which is equivalent to approximately 1% of Sri
         Lanka's total apparel exports in 2004).




                                                                      24

Table 6: India: Distribution of Imports from and exports to Sri Lanka (1999-2002)
         Category Number of Products 1999 2000 2001 2002 2003
                                        Imports

             1                                 0    28.0 30.6 38.0

             2               267              10    9.4    7.3    9.8

             3                21              10    7.6    6.6    6.7

             4                9               10    6.0    5.9    4.2

             5                3               10    7.3    4.0    6.9

             6                3               10    7.0   31.7 15.7

             7                5               50    34.7 13.7 19.0

                                        Exports
             1                                 0    4.6   10.5    7.4

             2              1929              10    18.4 27.0 39.5

             3               258              10    9.6    8.0    6.3

             4               109              10    8.4    7.1    4.9

             5                58              10    9.3    8.6    6.0

             6                37              10    11.1   8.7    6.2

             7                24              10    8.5    6.8    6.3

             8                13              10    10.4   6.8    9.2

             9                8               10    7.2    6.5    5.2

            10                5               10    7.1    8.0    8.0

            11                3               10    5.4    2.0    1.0

          Source: Authors' calculations using the U.N. Comtrade Data




                                           25

            Table 7: Direction of Exports by Major Destinations (%)
               USA             EU          Japan         Asean      South Asia

            1990   2002    1990  2002   1990    2002  1990    2002 1990   2002

  India      15      21    21     22     9       4     3       5    3       5
Pakistan     12      25     36    27     8       1     3       2    4       2
Bangladesh   32      35     32    50     4       2     1       0    2       2
Sri Lanka    26      38     26    30     5       3     1       1    4       5



               Table 8: Direction of Imports by Major Origins (%)
                US             EU          Japan        ASEAN       South Asia

            1990   2002    1990  2002   1990    2002  1990    2002 1990   2002

  India      11       7    22     20     8       3     3       5    0       1
Pakistan     13       6     24    17     12      6     5       9    2       2
Bangladesh   6        4     16    11     9       7     7       7    9      20
Sri Lanka    8        4     16    15     12      6     9       8    7      15
  Source: Comtrade via WITS




                                       26

      Table 9: Population, GDP and Trade in SAARC-5 (2001)
Country          Population (million) GDP ($ billion) Trade ($ Billion)

Bangladesh              133.3             48.6             15.6

India                  1,032.40          477.4             93.1

Nepal                    23.6             5.8               2.3

Pakistan                141.5              60              20.3

Sri Lanka                18.7             16.4             11.1

SAARC-5                1349.5            608.3            142.3

World                  6,130.10         31,400           12560.0


                      As % of World


Country              Population          GDP              Trade

Bangladesh               2.2              0.2               0.1

India                    16.8             1.5               0.7

Nepal                    0.4               0                0.0

Pakistan                 2.3              0.2               0.2

Sri Lanka                0.3              0.1               0.1

SAARC-5                  22               1.9               1.1

World                   100.0            100.0            100.0
     Source: WDI (2003)




                                  27

                                  Table 10: Simple Average of the Tariff Rates

                                              India            Pakistan      Bangladesh     Sri Lanka          Nepal



                                     1998-    2002-   2004- 1998- 2004-     1998-  2004-  1998-   2004-   1998- 2002-

                                      99       03      05     99     05      99      05     99     Jan       99      03

  All tariff lines

  Customs duties (CD)                39.6     29.0     22.2  21.3    16.8    20.0   16.3   17.6    11.3    14.0      13.7

  Other general protective taxes               6.0      0             0              3.3           2.1               2.5

  Other selective protective taxes             0.0      0             0              6.4            0                 0

  Total                                       35.0     22.2         16.8            26.5           13.4              16.2

  General maximum CD                 45.0     30.0     30    35.0     25     40.0   25.0   35.0    27.5    80.0      25

  Other general protective taxes               6.0      0             0              4.0           3.5                3

  General maximum: CD+ other                  36.0     30            25             29.0          31.25              28

  Non-agricultural tariffs

  Customs duties                              27.4     19.7          16.6           15.6           8.8               13.8

  Other general protective taxes               5.9      0             0              3.9           1.9               2.8

  Other selective import taxes                  0       0             0              5.9            0                 0

  Total                                       33.3     19.7         16.6            25.4           10.7              16.6

  General maximum: CD+ other                  36.0     20             25            29.0           31.3              28

  Agricultural tariffs

  Customs duties                              40.6     40.1          18.1           19.7           24.6              13.5

  Other general protective taxes               6.5      0             0              3.7           3.5               2.8

  Other selective import taxes                  0       0             0              8.7            0                 0

  Total                                       47.1     40.1         18.1            32.1           28.1              16.3

  General maximum CD                          100      100            25            25.0           27.5              25

  Other general protective taxes               8.6      0             0              4.0           3.8                3

  General maximum: CD+ other                  108.6    100           25            29.00           31.3              28



Notes: The averages are of non-preferential MFN rates as given in official tariff schedules and do not allow for
SAPTA or other preferential rates. The 2004-05 tariffs in India are the rates which came into force on January 9, 2004
in advance of the budget. The 2002-03 tariffs for Pakistan, Sri Lanka and Nepal changed only slightly in 2003-04.
Bangladesh figures are updated as of end June, 2004. All the Customs duty and other rates are percent of assessable
value (cif in Pakistan, Sri Lanka and Nepal, cif +landing charges in India and Bangladesh). The protective taxes
other than Customs duties that have been (or were) allowed for are: in India, the Special Additional Duty (Sadd) ,
which was abolished in January 2004; in Bangladesh the IDSC, SD, RD and domestic VAT exemptions; in Nepal the
Security tax introduced in FY 2002, and in Sri Lanka the 20 percent Customs surcharge and the 1 percent Port and
Airport Development Levy (PAL). They do not allow for duty exemptions for inputs imported by exporters. They
also do not allow for exemptions and partial exemptions which are separate from the general tariff schedules and
which are often use and/or user-specific. The "general maximum" Customs duty rate is defined as a rate which
includes at least 5percent of total tariff lines, and above which there are no more than 10percent of total tariff lines.


Source: World Bank. 2004. Trade Policies in South Asia: An Overview, Washington, D.C. (three volumes); Central
           Board of Revenue (Pakistan).




                                                             28

               Table 11: Informal Trade between India and its SAAARC Partners
 Trading Partner (year of         Indian informal exports          Indian informal imports
 estimate)                             ($US million)                    ($US million)
 Pakistan (1996)                          100-500                             n.a.
 Bangladesh (1992-93)                        299                               14
 Sri Lanka (1991)                            142                              121
 Sri Lanka (2000-01)                         185                               21
Sources:

Pakistan: Government of Pakistan (1996; Nabi et. al.). Provides two estimates: the "low" estimate (based
on visits to various markets for smuggled goods) suggests Indian informal exports to Pakistan were
US$100 million and the "high" estimate (based on interviews with customs officials) estimates about US$
500 million. Taneja (1999) and Rao et al (1996, p.23) cite The Economist (1996) as reporting informal
exports worth $2 billion from India to Pakistan in 1996.
Bangladesh: V. L. Chaudhary (1995), based on a detailed survey of Bangladesh-India informal trade.
Sri Lanka: Sarvanathan (1994) gives the estimates for the year 1991 and N.Taneja (2002) gives the one for
2000-2001.




                                                    29