Indo-Sri Lanka Free Trade Agreement: Assessing Potential and Impact on Bilateral Trade Expansion

I.N. MUKHERJI

SAMAN KELEGAMA

Contents

• Statement of the Problem.. 1
• Review of Literature. 2
• Scope and Objectives. 5
• Methodology/Analytical Framework. 6
• Data Sources. 7
• Rationale and Significance. 7
• Endnotes. 8

Statement of the Problem

In recent years, there has been an upsurge in Bilateral Free Trade Agreements (BFTA). As of now there are as many as 38 such Agreements outside South Asia. In addition, several regional groupings have developed bilateral trade linkages with non-members. To illustrate, the European Community (EC) has as many as 28 BTFA with individual member states. Similarly, the European Free Trade Area (EFTA) has 12 bilateral trade agreements with member states.

            In South Asia, also there has been a surge in BFTA. India and Bhutan have BFTA since fifties. A BFTA between India and Sri Lanka became operational in March 2000. Indiais currently contemplating similar BFTA with Bangladesh and Maldives. Recently there have been initiatives to establish BFTA between Sri Lanka and Pakistan, Sri Lanka and Bangladesh, Nepal and Sri Lanka, and Nepal and Bangladesh. The recent shift in signing of BFTA has partly been due to the slow and tardy progress under South Asian Preferential Trading Arrangement (SAPTA) being negotiated under SAARC.

            The Commerce Secretary of India and Finance Secretary of Sri Lanka exchanged letters that operationalise the Free trade Agreement (FTA) between India and Sri Lanka signed in New Delhi on 28 December 1998 by H.E. the President of Sri Lanka and the Honorable Prime Minister of India with effect from 1^st March 2000.

            The Agreement provides for duty free as well as duty preference access for the goods manufactured in the two countries. Both the countries have listed products for immediate duty free entry into each other's territories. India has agreed to phase out its tariffs on a large number of items within a period of three years. Sri Lanka will likewise do so in eight years. Both the countries have drawn up Negative Lists in respect of which no duty concessions will apply. These Lists include items on which protection to local industry has been considered essential. Both the countries intend to reduce the items in the Negative List through periodic consultations.

            The Agreement sets out the rules of origin criteria for eligibility for preferential access. Products having domestic value addition of 35% will qualify for preferential market access. Sri Lanka's exports with a domestic value addition content of 25% will also qualify for entry to the Indian market if they have a minimum 10% Indian content.

            In respect of a number of sensitive items preferential treatment is accorded with only partial lifting of quantitative restrictions. India will permit the import of Sri Lankan tea to the extent of 15 million kg. per annum at a fixed tariff preference of 50%. As regards garments, India will permit import of 8 million pieces per annum from Sri Lanka at a fixed tariff preference of 50%. Out of this, 6 million pieces fabric need to be sourced from India. A ceiling of 1.5 million pieces has been prescribed for individual categories.  In respect of textile items, India's offer is restricted to a maximum of 25%.

            The FTA between India and Sri Lanka is a landmark in the bilateral relations between the two countries. It is expected to bring about enhanced trade between the two countries as well as to expanded and diversified cooperation in a range of economic spheres, including investments. This is the first such Agreement in the South Asian region which could serve as a model for similar bilateral Agreements in the region. Its significance further lies in that it can be implemented more expeditiously and also more flexibly, unlike the protracted nature of negotiations generally associated with multilateral arrangements.

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Review of Literature

            BFTA has been advocated by the so-called “natural trading partners” hypothesis group put forth by Wonnacut and Lutz (1989) and popularised by Krugman (1991, 1993)[1] and Summers (1991). These authors argue that countries, which are geographically proximate, trade a lot with each other. As a result BFTA between them would not lead to costly trade diversion. On the other hand Bhagwati (1993), Panagarya (1997)[2] and Bhagwati and Panagarya (1996) [3] have offered a detailed critique of this view. In their view, large initial volume of trade says nothing as to how tariff preferences will affect trade flows at the margin, which is trade diversion about. Further ‘natural trading partners are neither symmetric nor transitive. This happens when the trading partners have large imbalances in bilateral trade, as is the case between India and most other South Asian countries. In such a situation the country having larger exports is likely to benefit from BFTA. On the other hand it may be argued that when the terms of the Agreement are deliberately tilted in favor of less developed trading partner, the gains at the margin could be higher for the latter (as for in case of Indo-Nepal BFTA). To some extent the Indo-Sri Lanka Free Trade Agreement (ISFTA) is also so designed that the smaller trading partner is permitted to move to a Free Trade Area (FTA) over a longer time frame.

            Unlike multilateral free trade agreements, BFTA are easier to negotiate in a manner that takes note of the special relationship as well as the needs of partner countries. Further it is also possible to integrate bilateral trade preferences in a multilateral framework such as South Asian Preferential Trading Arrangement       

There have been attempts to promote Indo-Sri Lanka trade through formal bilateral agreement since the early 1960s. In 1991, the World Institute of Development Economic Research (WIDER) initiated a study to explore an operational program for stimulating Indo-Lanka Economic Cooperation (Panchamukhi et al, 1992)[4]. The main recommendation of this study was to evolve an institutional mechanism involving preferential trade to facilitate trade expansion both ways between the two countries. Jayawerdena et. al. (1993)[5] expanded on this idea and suggested a bilateral preferential agreement that deviates from a traditional focus on a product-by-product approach , to focus on granting reciprocal preferential treatment across-the-board to all commodities, except for a small limited exclusion list of sensitive items (negative list)

Kelegama (1999)[6] has made a comprehensive survey of trends in Indo-Sri Lankan trade and the Bilateral Free trade Agreement from a Sri Lankan perspective. He contends that although Sri Lankan exports to Indiaremains small, they have been growing faster than Indian imports to Sri Lanka in recent years. The Agreement, in his view, has a trade stimulating effect. While trade brings in benefits to both the nations, there is an import competing sector in both the countries that is yet not in a position to face free trade. The Agreement provides for a "negative list" to accommodate this sector. The challenge, in his view, may be a "warm up" exercise to face future free trade under SAFTA.

Mukherji (2000)[7] makes a comprehensive survey of Indo-Sri Lankan trade and in this context tries to assess the extent of trade coverage under the three rounds of negotiations under SAPTA. He further tries to assess the possible impact of SAPTA on bilateral trade flows in respect of products negotiated in the first round. Next he tries to estimate the trade potential between India and Sri Lanka and to further ascertain as to whether these have been exchanged under any of the SAPTA negotiations.

Weerakoon, Dushni. (2001)[8] in her study on ISFTA points out that bilateral trade between India and Sri Lanka seem to have been boosted by the Agreement. The vast Indian consumer market could serve as an entry point for Sri Lankan exports as ‘first movers’ before other potential competitors. The perceived advantages of this will depend on the satisfactory implementation of the Agreement as also on the capacity of Sri Lanka to generate the required export surplus. The study makes a valuable contribution in analyzing the applicability of ISFTA in respect of products offered concessions under the various categories. 

The aforementioned studies relate mainly to bilateral trade between the two countries in general, or in the context of SAPTA. Since the bilateral FTA between the two countries have become operational only recently, the lists of products offered duty-free or duty preference have become available only with the operation of the Agreement.

The aforementioned studies have not made any rigorous study of the trade and investment potentials of India and Sri Lanka. Now that ISFTA has been in operation for a year, it is necessary to take stock of the impact on bilateral trade flows if any. Further, responses of business chambers as also of businessmen in the two countries have not been adequately tapped. A close scrutiny of the implementation of the Agreement is called for in the light of the various interest groups acting both as facilitators as well as stumbling blocks in the operationalisation of the Agreement. . For any agreement to succeed, the possible as well as the actual gains must not only exceed those of losses, but also must be seen to be so. An academic exercise of this type can not only truly project the implications of the Agreement, but also set a path to attain the goal set for the Agreement.

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Scope and Objectives

            The project attempts to work out the implications of the FTA in terms of the following objectives:

¨      What percentage of the bilateral imports of the two countries have been covered under the Agreement in respect of products offered duty free and preference free?

¨      What are the implications of variable rules of origin for ILFTA ?

¨      What is the potential trade in respect of products offered concessions?

¨      What is the revealed comparative advantage of concession receiving exporting country?

¨      What is the competitive advantage of imports for concession offering country (i) without tariff preferences, and (ii) with tariff preferences?

¨      What is the existing rate of tariffs as well as non-tariff barriers in respect of negotiated products?

¨      Which products exported by India to Sri Lanka can be produced more cheaply in Sri Lanka with Indian investment for Sri Lankan / Indian market?

¨      Which products imported from Sri Lanka may be produced more cheaply in Sri Lanka by Indian investors for export to India?

¨      What is the role of different interest groups in promoting or causing resistance to the implementation of the Agreement? A structured questionnaire may be issued to various stakeholders to the Agreement.

¨      Even though the Agreement has been in operation for only a short period, an attempt would be made to assess its impact on bilateral trade flows on negotiated products.

¨      The study would estimate the potential trade, revealed comparative and competitive advantages of the two countries alternatively both as suppliers as well as markets for each other’s products that are traded globally, whether or not exchanged bilaterally.

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Methodology/Analytical Framework

Potential trade will be estimated for all products entering bilateral trade between India and Sri Lanka. It is given by the relation (min SE, MI) - ET, where SE, ME and ET are supplier’s global exports, market’s global imports, and existing trade (bilateral exports of supplying country) respectively. This exercise will be attempted alternatively with Indiaas supplier and Sri Lanka as market and Sri Lanka as supplier and India as market.

Revealed Comparative Advantage (RCA) will be estimated as  (X_iw^k/ X_IW) / (X_w^k/ X_w) where X_IW^K is India's world export of product K, X_IW is India's world exports, and Xw is world exports, superscript ^k is product K, subscripts I and W stand for India and world respectively.   Similarly the RCA for Sri Lanka is given by: (X_SW^K / Xs_W) / ( X_W^K / X_W) where X_SW^k stands for Sri Lanka's world exports of product k, subscripts S and W stand for Sri Lanka  and World respectively

Potential trade may be estimated either for no existing trade or with positive trade. Potential trade of supplier country may be sorted either without reference to RCA, or the

same may be sorted in terms of only products with positive RCA. Further, the trade potential could be sorted only in terms of RCA in descending order of importance. Such possibilities of estimation are available in TRAINS (UNCTAD).

Competitive Advantage of any identified potential export product of the supplier exporting country is estimated from the point of view of partner importing country in terms of unit cost of imports from the partner country in relation to similar imports from the world or other competing countries. The respective importing countries' import data at the desired level of seven/eight digit aggregation can be obtained from their national publications. A matching of high potential trade with comparative and competitive advantages provides the most ideal condition for trade liberalization. This exercise could help us to ascertain to what extent the nature and content of trade coverage of different categories of products liberalized so far conform to the desired attributes and suggest a list having highest trade potential with or without comparative / competitive advantages so that the path to trade liberalisation could follow the path of trade creation or minimize trade diversion.

The concept of potential trade would also be used to identify trade-investment linkages.

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Data Sources

            The full text of the Indo-Sri Lanka Free Trade Agreement including all Annexes is available on web sites of the Commerce Ministry both in India and Sri Lanka. This will very much facilitate data analysis. In addition bilateral trade flows as also trade flows in negotiated products can be further analyzed using CD-ROM from UNCTAD/ITC such as PC-TAS and TRAINS. All other relevant data can easily be accessed from Commerce Ministry of both the countries.  

Rationale and Significance

India and Sri Lanka have been keen to move towards a free trade area. Yet ground realities have indicated the role of interest groups in constraining movement in this direction. The project could throw interesting insights on the role of interest groups in regional cooperation. It is only through academic studies that the real impact of bilateral trade liberalization could be assessed. The costs and the benefits of bilateral trade liberalization need to be examined from the overall perspective of Indo-Sri Lankan trade.

Insofar bilateral trade between India and Sri Lanka has been tilted overwhelmingly in favor of India, there is need to examine how this could be moderated if not eliminated through trade creation. In this context it is hoped to identify possible areas in which Sri Lanka could develop comparative advantage in its exports to India. Further the linkage between trade and investment needs to be established to address the problem of trade imbalance.

The project intends to examine trade complementarities at a highly disaggregated level of analysis, which will be attempted for the first time. It is only through such disaggregated analysis of trade flows that the complementarities can be established. The significance of this proposal is enhanced by the attempt being made not only to examine the trade potential / comparative advantage, as it exists today, but also to link this up with trade generating investment potential that alone could impart growth and sustenance to bilateral trade.

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