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South Asian Free Trade Agreement

Chapter one: Regional trade agreements

1. Introduction
A regional trade agreement (RTA) is an economic trade agreement to reduce tariffs
and restrictions on trade between two or more nations within a certain region. There
are currently 205 agreements in force as of July 2007. A total of 300 RTAs have been
reported to the World Trade Organization (WTO). There are a variety of RTAs; with
some being quite complex(European Union, while others are far less intensive (North
American Free Trade Agreement. For the most part, governments are supportive of
further RTAs; however, there has been some concerns expressed by the WTO.
According to Pascal Lamy, Director-General of the WTO, the proliferation of RTA
“ breeding concern — concern about incoherence, confusion, exponential increase
of costs for business, unpredictability and even unfairness in trade relations.”RTAs
are preferential trade agreements and therefore different from arrangements such as
APEC, which are open not preferential. RTAs come in different forms:

1.1 Forms of Free Trade Agreements:

1. An FTA is a group of two or more customs territories which has eliminated
tariffs and other trade restrictions on substantially all trade.

1. A Customs Unions is two or more customs territories which have an FTA and
which also apply a common external tariff on goods from non-members.
2. A regional economic integration agreement is the next step: it can include the
free movement of capital as well as goods and services, a common currency
and a common economic policy

1.2 Why more trade?

Success of an FTA is measured in terms of increased flow of goods and services. The
more the economies trade among themselves, the greater the tendencies for further
economic integration. Since trade affects growth, a greater flow of goods and services
is likely to see less opposition in the way of economic integration.

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1.3 How Trade affects Growth?

Trade affects growth in three primary ways.

1.3.1 Flow of Resources?

First, trade encourages the flow of resourcesfrom the low productive sectors to high
productive sectors, leading to an overall increase in output. Export growth may affect
total productivity growth through dynamic spillover effects on the rest of the economy
The possible sources of this positive dynamic spillover include more efficient
management styles, better forms of organization, labour training and knowledge about
technology and international markets.
1.3.2 Expansion in Production
Second, with unemployed resources, an increase in export sales leads to an overall
expansion in production and a fall in the unemployment rate. As production increases,
because of increases in the scale of operations (economies of scale), firms become
more efficient
1.3.3 Exposure to Technological advances
Third, international trade also enables for the purchase of capital goods from foreign
countries and exposes an economy to the technological advances of the developed
countries. Recent theoretical work suggests that capital goods imported from
technologically advanced countries may increase productivity and thereby growth,
since knowledge and technology are embodied in equipment and machinery and
therefore transferred through international trade.

1.4 Criteria for a successful FTA

Despite these positive aspects, free trade is opposed mainly because workers and
producers associated with the inefficient industries stand to loose out. Considerable
lobbying pressure is applied by the inefficient producers who demand more
protection. As tariffs are not allowed under an FTA framework, individual
Governments try to protect their respective economies by imposing non-tariff barriers

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(NTBs), such as antidumping measures, import licences and sanitary standards. The
answer to a successful FTA therefore lies in controlling
those factors which act against FTAs, and nurturing the factors which help in forming
and sustaining an FTA. Some of the factors that affect the formation of an FTA are
considered below:
1.4.1 Intra-industry trade:
An FTA is more likely to be formed when trade happens in
similar commodities, that is, intra-industry trade. The likelihood that industry
association will demand more protection is less in cases of intra-industry trade. In the
presence of intra-industry trade (for example, India exporting Tata Indica cars to the
United States and at the same time importing Ford cars from that country), adjustment
costs associated with removing trade barriers are lower. In this case, jobs lost due to
customers shifting to more efficient foreign suppliers may, to a large extent, be offset
by job-enhancing expansion in foreign demand for similar differentiated goods
produced domestically. The political opposition to liberalizing and expanding intra-
industry trade tends to be far less when compared with trade involving dissimilar
items, that is, inter-industry trade.
1.4.2 Economic characteristics:
Economies that are similar in terms of size are better
candidates for forming an FTA. Similarities are measured in terms of economic
development and geographical proximities. The more similar are the economies, the
greater is the likelihood of intra-industry trade. This is because geographically close
economies with similar levels of economic development have access to similar kinds
of technology. Consequently, they tend to produce more or less similar items and tend
to trade in similar commodities (closely differentiated products as in the monopolistic
competition type market structure). As the literature on the gravity model of trade
demonstrates, similarities in economic structure and geographical distance between
respective economies are powerful determinants of trade. Trade increases with
economic size and the proximity of the trading partners.
1.4.3 Prices:
Low technology intensive items, such as leather footwear, garments, gems and
jewellery and textile products, which are typical of any developing country’s export
profile, are very sensitive to movements in price, i.e., they are price-elastic. When it
comes to forming an FTA, countries analyse whether such an arrangement would

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enable them to realize a greater demand for their exports. From the demand-side
perspective, it can be argued that sustained demand growth cannot be maintained in a
small domestic market, since any economic impulse based on expansion of domestic
demand is bound to be exhausted. However, export markets do not exhaust quickly.
FTAs not only provide a platform for a greater market share but also enable countries
to produce efficiently. As the literature on monopolistic competition suggests, a way
to produce exports competitively is to take advantage of economies of scale in
production, which can be realized from a greater market share resulting from an FTA
1.4.4Government policies:
More liberal government policies are likely to be beneficial for an FTA. There is a
general consensus in the literature that trade volume, for both exports and imports,
increases following external sector liberalization Higher
trade volume, resulting from external sector liberalization, is expected to increase the
likelihood of FTA formation.

1.5 History of Regional Trade Agreements:

Regional trade agreements (RTAs) have emerged as an alternative to achieve trade

liberalization as multilateral efforts have faced political and economic obstacles. The
difficulties of reaching agreements on sensitive issues like agriculture and services
have been evident in the Doha Round. The previous rounds were also marked by
complex and slow negotiation processes. For one, as the number of participants
increases, it has been more difficult to address each country’s demands for special
considerations. RTAs convey advantages as well as limitations. By reducing the
number of participants in the negotiation they can help expand the discussion to
include more dimensions of economic integration. Compared with unilateral
liberalization, political support for RTAs also seems to be greater given the perception
of reciprocity from other member countries. However, since the early work of Viner
(1950), these benefits have been weighted against distortions that RTAs can create.
By de facto discriminating against nonmembers, RTAs distort resource allocation,
favoring regional producers to the potential detriment of local consumers. Recent
research also emphasizes the global consequences of multiple and overlapping RTAs
in terms of the transaction costs they impose.

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1.6 Eight Elements of Regional Trade Agreements:

Although RTAs have varied components, these agreements include some or all of the
following eight elements:
1.6.1 A tariff liberalization program—TLP
(transformation of nontariff barriers, e.g. quotas, to their tariff equivalent and the
sequential reduction of tariffs; special considerations to least developed countries4 are
not uncommon);
1.6.2 Sensitive lists
(goods or services to be exempt from the tariff reduction program);
1.6.3 Rules of origin—ROO
(prevention of the application of the preferential tariffs to non regional goods or
services as defined by the agreement);
1.6.4 Institutional arrangements
(establishment of a council or administrative committee responsible for the
administration and implementation of the agreement);
1.6.5 Trade facilitation policies
(collection of instruments to reduce transaction costs of importing and exporting,
including homogenization of customs practices and technical assistance specially
to the least-developed members);
1.6.6 Dispute settlement mechanism
(procedures to report and deal with violations to the agreement);
1.6.7 Safeguards measures
(suspension of preferential treatment on grounds that imports are causing or
threatening to cause serious injury to the domestic industrial base); and
1.6.8 Parallel reduction in foreign investment barriers and/or trade in services.
Ever since ADAM SMITH published The Wealth of Nations in 1776, the vast majority
of economists have accepted the proposition that FREE TRADE among nations improves
overall economic welfare. Free trade, usually defined as the absence of tariffs, quotas,
or other governmental impediments to INTERNATIONAL TRADE, allows each country to
specialize in the goods it can produce cheaply and efficiently relative to other
countries. Such specialization enables all countries to achieve higher real incomes.

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Although free trade provides overall benefits, removing a trade barrier on a particular
good hurts the shareholders and employees of the domestic industry that produces that
good. Some of the groups that are hurt by foreign COMPETITION wield enough political
power to obtain protection against imports. Consequently, barriers to trade continue to
exist despite their sizable economic costs. According to the U.S. International Trade
Commission, for example, the U.S. gain from removing trade restrictions on textiles
and apparel would have been almost twelve billion dollars in 2002 alone. This is a net
economic gain after deducting the losses to firms and workers in the domestic
industry. Yet, domestic textile producers have been able to persuade Congress to
maintain tight restrictions on imports.

1.7 Are RTA’s Desirable?

While virtually all economists think free trade is desirable, they differ on how best to
make the transition from tariffs and quotas to free trade. The three basic approaches to
trade reform are unilateral, multilateral, and bilateral.

Some countries, such as Britain in the nineteenth century and Chile and China in
recent decades, have undertaken unilateral tariff reductions—reductions made
independently and without reciprocal action by other countries. The advantage of
unilateral free trade is that a country can reap the benefits of free trade immediately.
Countries that lower trade barriers by themselves do not have to postpone reform
while they try to persuade other nations to follow suit. The gains from such trade
liberalization are substantial: several studies have shown that income grows more
rapidly in countries open to international trade than in those more closed to trade.
Dramatic illustrations of this phenomenon include China’s rapid growth after 1978
and India’s after 1991, those dates indicating when major trade reforms took place.

1.7.1 Welfare Effects of Regional Trading Arrangements (RTA)

Trade theory and evidences suggest that there are several forms of RTA:
• Preferential Trade Area (PTA): Tariffs are lowered among the members but
maintained against the outside world
• Free Trade Areas (FTA): Tariffs are removed among members but maintained
against the outside world

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• Customs Union: All tariffs amongst the members are eliminated, while external
tariffs are adjusted to a common level
• Common Market: Customs Union + free movement of factors of production
• Economic Union: Customs Union + Common economic laws

Box 1 presents the boundaries of the scopes of these various RTAs

1.8 Advantages of Free Trade Agreements:

For many countries, unilateral reforms are the only effective way to reduce domestic
trade barriers. However, multilateral and bilateral approaches—dismantling trade
barriers in concert with other countries—have two advantages over unilateral

1.8.1 Enhanced Economic Gains

First, the economic gains from international trade are reinforced and enhanced when
many countries or regions agree to a mutual reduction in trade barriers. By broadening

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markets, concerted liberalization of trade increases competition and specialization

among countries, thus giving a bigger boost to EFFICIENCY and consumer incomes.

1.8.2 Reduction in Trade Barriers

Second, multilateral reductions in trade barriers may reduce political opposition to

free trade in each of the countries involved. That is because groups that otherwise
would oppose or be indifferent to trade reform might join the campaign for free trade
if they see opportunities for exporting to the other countries in the trade agreement.
Consequently, free trade agreements between countries or regions are a useful
strategy for liberalizing world trade.

1.8.3 The Multilateral Agreement as outcome of Free Trade negotiations:

The best possible outcome of trade negotiations is a multilateral agreement that

includes all major trading countries. Then, free trade is widened to allow many
participants to achieve the greatest possible gains from trade. After World War II, the
United States helped found the General Agreement on Tariffs and Trade (GATT),
which quickly became the world’s most important multilateral trade arrangement.

1.9 Examples of Trade Agreements:

Examples of regional trade agreements

The European Union
European Free Trade Association
North American Free Trade Agreement
Southern Common Market
Common Market of Eastern and Southern Africa
ASEAN Free Trade Area

1.9.1 G.A.T.T.

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The major countries of the world set up the GATT in reaction to the waves of
PROTECTIONISM that crippled world trade during—and helped extend—the GREAT
DEPRESSION of the 1930s. In successive negotiating “rounds,” the GATT substantially
reduced the tariff barriers on manufactured goods in the industrial countries. Since the
GATT began in 1947, average tariffs set by industrial countries have fallen from
about 40 percent to about 5 percent today. These tariff reductions helped promote the
tremendous expansion of world trade after World War II and the concomitant rise in
real per capita incomes among developed and developing nations alike. The annual
gain from removal of tariff and nontariff barriers to trade as a result of the Uruguay
Round Agreement (negotiated under the auspices of the GATT between 1986 and
1993) has been put at about $96 billion, or 0.4 percent of world GDP.

1.9.2 World Trade Organization:

In 1995, the GATT became the World Trade Organization (WTO), which now has
more than 140 member countries. The WTO oversees four international trade
agreements: the GATT, the General Agreement on Trade in Services (GATS), and
agreements on trade-related INTELLECTUAL PROPERTY rights and trade-related
INVESTMENT (TRIPS and TRIMS, respectively). The WTO is now the forum for
members to negotiate reductions in trade barriers; the most recent forum is the Doha
Development Round, launched in 2001.

The WTO also mediates disputes between member countries over trade matters. If
one country’s government accuses another country’s government of violating world
trade rules, a WTO panel rules on the dispute. (The panel’s ruling can be appealed to
an appellate body.) If the WTO finds that a member country’s government has not
complied with the agreements it signed, the member is obligated to change its policy
and bring it into conformity with the rules. If the member finds it politically
impossible to change its policy, it can offer compensation to other countries in the
form of lower trade barriers on other goods. If it chooses not to do this, then other
countries can receive authorization from the WTO to impose higher duties (i.e., to
“retaliate”) on goods coming from the offending member country for its failure to

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As a multilateral trade agreement, the GATT requires its signatories to extend most-
favored-nation (MFN) status to other trading partners participating in the WTO. MFN
status means that each WTO member receives the same tariff treatment for its goods
in foreign markets as that extended to the “most-favored” country competing in the
same market, thereby ruling out preferences for, or discrimination against, any
member country.

Although the WTO embodies the principle of nondiscrimination in international trade,

article 24 of the GATT permits the formation of free-trade areas and “customs
unions” among WTO members. A free-trade area is a group of countries that
eliminate all tariffs on trade with each other but retain autonomy in determining their
tariffs with nonmembers. A customs union is a group of countries that eliminate all
tariffs on trade among themselves but maintain a common external tariff on trade with
countries outside the union (thus technically violating MFN).

1.9.3 European Union:

The customs union exception was designed, in part, to accommodate the formation of
the European Economic Community (EC) in 1958. The EC, originally formed by six
European countries, is now known as the EUROPEAN UNION (EU) and includes twenty-
seven European countries. The EU has gone beyond simply reducing barriers to trade
among member states and forming a customs union. It has moved toward even greater
economic integration by becoming a common market—an arrangement that
eliminates impediments to the mobility of factors of production, such as capital and
labor, between participating countries. As a common market, the EU also coordinates
and harmonizes each country’s tax, industrial, and agricultural policies. In addition,
many members of the EU have formed a single currency area by replacing their
domestic currencies with the euro.

The GATT also permits free-trade areas (FTAs), such as the European Free Trade
Area, which is composed primarily of Scandinavian countries. Members of FTAs
eliminate tariffs on trade with each other but retain autonomy in determining their
tariffs with nonmembers.

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One difficulty with the WTO system has been the problem of maintaining and
extending the liberal world trading system in recent years. Multilateral negotiations
over trade liberalization move very slowly, and the requirement for consensus among
the WTO’s many members limits how far agreements on trade reform can go. As
Mike Moore, a recent director-general of the WTO, put it, the organization is like a
car with one accelerator and 140 hand brakes. While multilateral efforts have
successfully reduced tariffs on industrial goods, it has had much less success in
liberalizing trade in agriculture, textiles, and apparel, and in other areas of
international commerce. Recent negotiations, such as the Doha Development Round,
have run into problems, and their ultimate success is uncertain.

1.9.4 N.A.F.T.A.

As a result, many countries have turned away from the multilateral process toward
bilateral or regional trade agreements. One such agreement is the North American
Free Trade Agreement (NAFTA), which went into effect in January 1994. Under the
terms of NAFTA, the United States, Canada, and Mexico agreed to phase out all
tariffs on merchandise trade and to reduce restrictions on trade in services and foreign
investment over a decade. The United States also has bilateral agreements with Israel,
Jordan, Singapore, and Australia and is negotiating bilateral or regional trade
agreements with countries in Latin America, Asia, and the Pacific. The European
Union also has free-trade agreements with other countries around the world.

1.10 Advantages of Trade Agreements:

The advantages of such bilateral or regional arrangements include:

• Greater Trade among member countries:

Free trade agreements promote greater trade among the parties to the agreement. It is
clear fact that the trade among the member countries tend to increase when the
member countries follow the trade agreements.

• Reduction in trade barriers:

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Countries which undertake a regional trade agreement has to reduce the trade barriers
for the other member countries which promotes trade of goods and services among
the members.

• Social and Economic Welfare:

By undertaking a free trade agreement, countries gain economic advantages which

enhance their economies and the people of those countries enjoy higher standard of

1.11 Issues in Regional Trade agreements:

They may also hasten global trade liberalization if multilateral negotiations run into
difficulties. Recalcitrant countries excluded from bilateral agreements, and hence not
sharing in the increased trade these bring, may then be induced to join and reduce
their own barriers to trade. Proponents of these agreements have called this process
“competitive liberalization,” wherein countries are challenged to reduce trade barriers
to keep up with other countries. For example, shortly after NAFTA was implemented,
the EU sought and eventually signed a free-trade agreement with Mexico to ensure
that European goods would not be at a competitive disadvantage in the Mexican
market as a result of NAFTA.

But these advantages must be offset against a disadvantage: by excluding certain

countries, these agreements may shift the composition of trade from low-cost
countries that are not party to the agreement to high-cost countries that are.

Suppose, for example, that JAPAN sells bicycles for fifty dollars, Mexico sells them for
sixty dollars, and both face a twenty-dollar U.S. tariff. If tariffs are eliminated on
Mexican goods, U.S. consumers will shift their purchases from Japanese to Mexican
bicycles. The result is that Americans will purchase from a higher-cost source, and the
U.S. government receives no tariff revenue. Consumers save ten dollars per bicycle,
but the government loses twenty dollars. Economists have shown that if a country
enters such a “trade-diverting” customs union, the cost of this trade diversion may
exceed the benefits of increased trade with the other members of the customs union.
The net result is that the customs union could make the country worse off.

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Critics of bilateral and regional approaches to trade liberalization have many

additional arguments. They suggest that these approaches may undermine and
supplant, instead of support and complement, the multilateral WTO approach, which
is to be preferred for operating globally on a nondiscriminatory basis. Hence, the
long-term result of bilateralism could be a deterioration of the world trading system
into competing, discriminatory regional trading blocs, resulting in added complexity
that complicates the smooth flow of goods between countries. Furthermore, the
reform of such issues as agricultural export subsidies cannot be dealt with effectively
at the bilateral or regional level.

Despite possible tensions between the two approaches, it appears that both
multilateral and bilateral/regional trade agreements will remain features of the world
economy. Both the WTO and agreements such as NAFTA, however, have become
controversial among groups such as antiglobalization protesters, who argue that such
agreements serve the interests of multinational CORPORATIONS and not workers, even
though freer trade has been a time-proven method of improving economic
performance and raising overall incomes. To accommodate this opposition, there has
been pressure to include labor and environmental standards in these trade agreements.
Labor standards include provisions for MINIMUM WAGES and working conditions, while
environmental standards would prevent trade if environmental damage was feared.

One motivation for such standards is the fear that unrestricted trade will lead to a
“race to the bottom” in labor and environmental standards as multinationals search the
globe for low wages and lax environmental regulations in order to cut costs. Yet there
is no empirical evidence of any such race. Indeed, trade usually involves the transfer
of technology to developing countries, which allows wage rates to rise, as Korea’s
economy—among many others—has demonstrated since the 1960s. In addition, rising
incomes allow cleaner production technologies to become affordable. The
replacement of pollution-belching domestically produced scooters in India with
imported scooters from Japan, for example, would improve air quality in India.

LABOR UNIONS and environmentalists in rich countries have most actively sought labor
and environmental standards. The danger is that enforcing such standards may simply
become an excuse for rich-country protectionism, which would harm workers in poor

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countries. Indeed, people in poor countries, whether capitalists or laborers, have been
extremely hostile to the imposition of such standards. For example, the 1999 WTO
meeting in Seattle collapsed in part because developing countries objected to the
Clinton administration’s attempt to include labor standards in multilateral agreements.

A safe prediction is that international trade agreements will continue to generate




Following arguments support the need for free trade agreement in South Asia:

2.1 South Asian exports have lagged other developing countries




All developing
2000000 EAP



1981 1984 1987 1990 1993 1996 1999 2002

The graph of exports above demonstrates the fact that the South Asian exports have
been much lower than East Asia and Pacific and that of the remaining all the
developing countries. Hence there was need to improve the exports of these countries

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to speed up the pace of their economic development through a platform in the form of

2.2 Growth of intra-regional trade in South Asia has lagged

behind other regions

Intra-regional trade as a share of total trade

0.12 EAP
0.1 LAC
0.08 SAS























South Asian Trade has very small portion in the overall world’s trade although this
area has very huge population but trade growth as compared to its population is
desperately low. So, in order to enhance the trade activity in this region a trade
agreement in the form of SAFTA was necessary.

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2.2 South Asia is among the least integrated of all regions.

Intra-regional trade as a share of GDP, 2002



5% 3.5%

EAST ASIA -----------------------------26.5%

Europe and Central Asia---------------15.3%

Latin America--------------------------6.4%

Middle East and N.Africa------------3.5%

South Asia-----------------------------0.8%

Sub-Saharan Africa---------------------5.3%

2.4 Tariffs, though lower now, remain high relative to other regions

Tariffs have been very high in this area from 1986 to date as compared to the rest of
the world as shown by the graph below. One possibility to remove these very high

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trade tariffs seems to undertake a regional trade agreement to promote trade activity
among the South Asian countries.

Unweighted average tariffs, 1986-2000

South Middle Sub- East Asia Europe & Latin
Asia East & Saharan Central America
Africa Africa Asia

2.5 South Asian Exporters faced high protection rates

The following graph shows protection rates faced by the exporters of different regions
and it is clear that this rate is the highest for the South Asian exporters. High
protection rate affects trade activity adversely that’s why South Asian exports have
been lower than other countries in the region.

10 Series1
rates faced by South Asian exporters of manufactures, 19.97%




ri c

















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2.6 Trade between India and Pakistan has been

abnormally low

Bilateral trade in $ Chi na

Malaysia $10 b $1,266 b.
$95 b.
2.4% GDP

Share of total trade

Argentina $7.2 b. Brazil

$102 b.
8.4% $460 b.

Pakistan $ 254 m. India

$59 b.

0.4% $515 b.

Values in USD millions, 2002. T otal bilateral trade is calculat ed as the sum of bilateral exports, shares are ratios of total b ilateral trade to the sum of each
country’s total exports. Source: COMTRADE and Global Trends.

Trade between India and Pakistan has been abnormally low as compared to the most
of the bilateral trade in the world. This has been due to political and other regional
disputes between these countries.

This issue seemed to be resolved if these countries engage in a regional trade

agreement which was accomplished in the form of SAFTA.

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The Agreement on the South Asian Free Trade Area is an agreement reached at the
12th South Asian Association for Regional Cooperation (SAARC) summit at
Islamabad, capital of Pakistan on 6 January 2004. It creates a framework for the
creation of a free trade zone covering 1.4 billion people in India, Pakistan, Nepal, Sri
Lanka, Bangladesh, Bhutan and the Maldives.The seven foreign ministers of the
region signed a framework agreement on SAFTA with zero customs duty on the trade
of practically all products in the region by end 2016. The SAARC Preferential
Trading Arrangement (SAPTA), with concessional duty on sub-continent trade, went
into force on 7 December 1995. The new agreement i.e. SAFTA, came into being on
1 January 2006 and will be operational following the ratification of the agreement by
the seven governments. SAFTA requires the developing countries in South Asia, that
is, India, Pakistan and Sri Lanka, to bring their duties down to 20 percent in the first
phase of the two year period ending in 2007. In the final five year phase ending 2012,
the 20 percent duty will be reduced to zero in a series of annual cuts. The least
developed nations in South Asia consisting of Nepal, Bhutan, Bangladesh and
Maldives have an additional three years to reduce tariffs to zero. Pakistan has signed
but not ratified the treaty, though there is hope in India that it will sometime in 2008.

3.1 How well SAFTA members fit FTA criteria?

Given the discussion about the aforementioned criteria necessary to form an FTA in
general, it is of interest to examine the future prospects of SAFTA.
3.1.1 Economic characteristics
When comparing in terms of economic structure, namely,
savings as a percentage of GDP, demographic profile and labour mobility, SAFTA
member countries have many similarities (see table 1). The industrial sector
constitutes roughly a fourth of GDP in all countries, while the share of agriculture
varies from 20.1 per cent in Sri Lanka to almost 40.8 per cent in Nepal. Although a
majority of the population still lives in rural areas, all of these countries are becoming
increasingly urbanized. Except for the Maldives, saving as a proportion of GDP is
also similar across these countries. These countries also share a similar demographic
profile. The more similar are the economies, the more similar is their export profile.

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Greater economic cooperation among SAFTA members holds important implications

in the form of larger market and economies of scale in production. These factors
might act as further incentives for the smooth functioning of SAFTA

3.1.2 Trade
Trade in the SAFTA region is currently low. There are reasons for lower intra-
SAFTA trade. Most of the SAFTA member countries have a lower trade-GDP ratio
and have initiated external sector liberalization (that is, bringing down tariff barriers),
starting only in the 1990s. A large number of NTBs currently exist in the region.
These NTBs include antidumping measures, procedural requirements, sanitary and
phytosanitary standards, certification and technical standards (Banik, 2001). The
encouraging point is that most of these economies have started to open up and have
also registered healthy GDP growth. During the period 2003-2004, all SAFTA
countries, except Nepal, witnessed strong economic growth in the range of 5-9 per
cent as well as 4-5 per cent per capita GDP growth. As McCombie and Thirlwall
(1997) and Paulino and Thirlwall (2004) pointed out, robust economic growth
encourages a more liberalized trade regime. With a similar export profile, trading
partners are better off with less restrictions. Because countries in the SAFTA region
share a similar export profile they also face the same types of NTBs; hence, they share
a similar negotiating stance for removing these barriers. Recent trade data suggest that

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intra-SAFTA trade is on the rise. Most of the Governments in SAFTA are

undertaking considerable external sector liberalization. Therefore, there are
indications that the currently low level of intra-SAFTA trade is likely to flourish in
the future.
3.1.3 Symmetry in economic activity
South Asian countries exhibit symmetric economic activity (Banik, Biswas and
Saunders, 2006). Symmetric economic activity implies that longrun movements in
real output are synchronized. Such co-movements of outputs may be due to the
dependence of common factors such as geographical proximity and similar industrial
profile. When countries share a similar industrial profile and are located closely, then
the demand shocks in one country may affect other countries in the region. This could
also arise if these economies all share a common trade linkage with major import
markets. For example, if all of these countries engage in trade with the European
Union, then changes in the European Union’s economic performance would have a
similar effect on all the countries concerned and cause them to behave synchronously.
In this case, economic trends would become more similar because all the sectors and
therefore all the countries would be affected in a similar way. Another reason for the
presence of common economic trends and hence co-movements of output could be
explained through intra-industry trade. As far as the trade structure is representative of
the output structure, the cycles should become more synchronized because they would
be affected by common shocks. This is the argument of Kenen (1969) who stated that
when countries trade in similar commodities, this increases the synchronicity of their
output. Countries in South Asia in general have a similar export profile. Symmetry in
economic activity also implies that there is a lesser contradiction in terms of
formulating internal and external macroeconomic policies. In fact, this
aforementioned economic characteristic of South Asian countries will enable them to
go beyond the FTA framework and work for deeper economic integration, such as
forming a common market and economic union.

3.2 Objectives and Principles

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South Asian Free Trade Agreement

3.2.1 Promotion of mutual trade

The Objective of this Agreement is to promote and enhance mutual trade and
economic cooperation among Contracting States. There was existing high trade tariffs
among the South Asian countries.
3.2.2 Elimination of Trade barriers
Another important objective of SATA is to eliminate barriers to trade in, and to
facilitate the cross-border movement of goods between the territories of the
Contracting States;

3.2.3 Promoting Conditions of Fair Competition

To promote conditions of fair competition in the free trade area, and ensuring
equitable benefits to all Contracting States, taking into account their respective levels
and pattern of economic development;

3.2.4 Formation of Common Currency for the region

This agreement was initially signed with the goal of formation of common currency
like Euro in the region which would help the economical and financial development
in the region

3.2.5 Creation of Effective Mechanism

Creating effective mechanism for the implementation and application of this
Agreement, for its joint administration and for the resolution of disputes; and

3.2.6 Further Regional Cooperation

Establishing a framework for further regional cooperation to expand and enhance the
mutual benefits of this Agreement.

3.3 Principles
SAFTA shall be governed in accordance with the following
SAFTA will be governed by the provisions of this Agreement and also by the rules,
regulations, decisions, understandings and protocols to be agreed upon within its
framework by the Contracting States;
• The Contracting States affirm their existing rights and obligations with respect
to each other

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South Asian Free Trade Agreement

• under Marrakesh Agreement Establishing the World Trade Organization and

other Treaties/Agreements to which such Contracting States are signatories;
• SAFTA shall be based and applied on the principles of overall reciprocity and
mutuality of advantages in such a way as to benefit equitably all Contracting
States, taking into account their respective levels of economic and industrial
development, the pattern of their external trade and tariff policies and systems;
• SAFTA shall involve the free movement of goods, between countries through,
inter alia, the elimination of tariffs, para tariffs and non-tariff restrictions on
the movement of goods, and any other equivalent measures;
• SAFTA shall entail adoption of trade facilitation and other measures, and the
progressive harmonization of legislations by the Contracting States in the
relevant areas; and
• The special needs of the Least Developed Contracting States shall be clearly
recognized by adopting concrete preferential measures in their favour on a
non-reciprocal basis.

3.4 Instruments
The SAFTA Agreement will be implemented through the following instruments:-
1. Trade Liberalisation Programme
2. Rules of Origin
3. Institutional Arrangements
4. Consultations and Dispute Settlement Procedures
5. Safeguard Measures
6. Any other instrument that may be agreed upon.

3.5 Components
SAFTA may, inter-alia, consist of arrangements relating to:
a) tariffs;
b) para-tariffs;
c) non-tariff measures;
d) direct trade measures.

3.6 Inter-Regional Trade in South Asia: Some Stylized Facts

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South Asian Free Trade Agreement

Table suggests that intra-regional imports among the South Asian countries as a share
of world imports is very low, only 4.45 percent. However, there are differences
among individual countries in South Asia. For example, India’s figure of total imports
from other South Asian countries is only 0.86 percent of her total imports from all
over the world. Nepal’s share in this regard is the highest in South Asia, as Nepal is
heavily dependent on India for her imports. Bangladesh’s share is 20.3 percent which
is primarily imports from India. Figure shows that Bangladesh is the largest importer
in South Asia as far as regional imports share is concerned

Country-wise Share (%) in Intra-SAARC Exports and



Pakistan Nepal Maldives

5.4% 0.3%
Sri Lanka 7.3%

I ndia

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India accounts for three-fourth of regional export.

Bangladesh accounts for less than 3 percent


Nepal 2.6% I ndia
14.5% 12.8%

Sri Lanka 36.4%

Bangladesh is the single largest importer in South Asia

Intra-Regional Imports of South Asian Countries (million US$) in 2003

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3.7 Salient features of the Agreement on SAFTA

The Agreement on SAFTA has seven core elements:
• Trade liberalization Programme
• Rules of Origin
• Institutional Arrangements
• Revenue Compensation Mechanism
• Technical Assistance for LDCs
• Safeguard Measures
• Consultations and Dispute Settlement Procedures

3.7.1. Trade Liberalization Programme

As per Article 7 of the Agreement tariffs on all products except the products under
sensitive lists would be reduced to 0-5% within time frames agreed for LDCs and
Non- LDCs. The Agreement stipulates that SAFTA Committee of Experts would
review non-tariff barriers in its regular meeting with a view to eliminating them or
making them non-restrictive. The Agreement provides different timeframe for tariff
reduction by LDCs and Non-LDCs. Moreover, Non-LDCs are required to reduce their
tariffs for the products of LDCs within shorter period. Non-LDCs are required to
reduce their tariffs applied on 1 January 2006 to 0-5% among themselves within
seven years (with one extra year for Sri Lanka) (Table 1).

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Table: Tariff Reduction Programme

Tariff Lines 1 July 31 December 31 December 31st

2006 2006 2006 December
to 31st
Lines >20% (t-20)/4 (t-20)/4 (t-20)/2 0-5% in 5
Lines<20% 5% MoP 10% MoP 10% MoP
* for Sri Lanka the period is 31st December 2008 to 31st December 2013 and number
of installment is 6.
t= tariff applicable on 1 January 2006
MoP= Margin of preference to be applied on tariff of 1 January 2006

Non-LDCs are required to reduce tariffs on the products other than products under
Lists for LDCs to 0-5% within 31 December 2008 as per following schedule.

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South Asian Free Trade Agreement

However, India is reducing its tariff for LDCs at an accelerated pace. Time table for
tariff reduction by India is as follows:

Date Pace of Reduction

1st July 2006 33.33% MoP
1st July 2006 33.33% MoP
1st July 2006 0-5% ( end duty)

LDCs are required to reduce tariffs on the products other than the products under
sensitive lists to 0-05% within 31 December 2015 as per following schedule:

Table: Schedule of Tariff Reduction for LDCs

Tariff Lines 1 July 31 December 31 December 31st Dec. 2008

2006 2006 2007 to 31st Dec.
Lines >30% (t-30)/4 (t-30)/4 (t-30)/2 0-5% in 8
Lines<30% 2 ½ % MoP 2 ½ % MoP 5% MoP

3.7.2. Sensitive Lists

The Agreement provides scope for maintaining of sensitive lists, which are not
subject to tariff reduction programme. Although the Agreement maintains that
sensitive list shall be different for LDCs and non-LDCs, only three countries namely
Bangladesh, India and Nepal maintain different sensitive lists for LDCs and Non
LDCs. Besides, the LDCs maintain longer sensitive lists than the Non-LDCs.

Table: Sensitive Lists Among the SAFTA Members

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Country For Non-LDCs Forof

Total number LDCs
Sensitive List For Non-LDCs For LDCs
Coverage of Sensitive List
Bangladesh 1,254 1,249 24.0 as % of Total HS23.9
Bhutan 157 157 3 3
India 865.6 744 16 14.2
Maldives 671 671 12.8 12.8
Nepal 1,335 1,299 25.6 24.9
Pakistan 1,191 1,191 22.8 22.8
Srilanka 1,079 1,079 20.7 20.7

3.7.3. Non-Tariff and Para-Tariff barriers

The Agreement requires that all quantitative restrictions, if not permitted under GATT
1994 shall be eliminated. With respect to other non-tariff measures and para-tariff
measures the Agreement requires that the countries notify the measures to SAARC
Secretariat on an annual basis and SAFTA Committee of Experts review the non-tariff
and para-tariff barriers in its regular meeting with a view to making recommendation
for their elimination or making them non-restrictive. The Agreement also requires
“The initial notification shall be made within three months from the date of coming
into force of the Agreement and the COE shall review the notifications in its first
meeting and take appropriate decisions”. In order to implement commitment of this
provisions a sub-group on non-tariff measures has already been established, which is
engaged in addressing the non-tariff barriers.

3.7.4. Rules of Origin

Rules of origin are one of most important aspects of any free trade area. The Rules of
Origin agreed under SAFTA are general in nature (i.e. one criterion for all products)
barring 1991 products for which product specific rules are applied. Thus, SAFTA
Rules of Origin requires that in order to enjoy the preference under SAFTA a product
must undergo sufficient processing for changing the tariff heading from the non-
originating inputs and for having value at least 40% value addition measures as
percentage of fob value. However, value addition requirement is lower for Sri Lanka
and LDCs, which is 35% and 30% respectively. In order to avoid fraudulentpractices
detailed operational certification procedures have been adopted.

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South Asian Free Trade Agreement

3.7.5. Institutional Arrangement

In order to monitor the implementation of SAFTA Agreement two bodies namely
SAFTA Ministerial Council and Committee of Experts have been established.
SAFTA Ministerial Council (SMC) Comprising Commerce/Trade Minister of
Member countries is the highest decision making body of SAFTA. The Council shall
meet once in a year or more often. SMC will be supported by the SAFTA Committee
of Experts comprising senior trade officials of member countries, which will meet
once in every six months.

3.7.6. Mechanism for Compensation of Revenue loss

A mechanism has been established to compensate the revenue loss to be incurred by
the LDCs due to reduction of tariffs. The Compensation will be in cash and partial:
maximum 5% of the Customs duty collected from SAARC import in 2005.
Compensation will be available for 4 years only (for Maldives compensation will be
available for six years).
3.7.7. Technical Assistance for LDCs
There are provisions for technical assistance for LDCs at their request. Areas of
Technical Assistance as agreed upon are as follows:
• Capacity building (Trade related)
• Development and improvement of tax policy and instruments
• Customs procedures related measures
• Legislative and policy related measures, assistance for improvement of national
• Studies on trade related physical infrastructure development, improvement of
banking sector, development of export financing

3.7.8. Safeguard Measures

In order to protect domestic industry from possible injury due to increased preferential
import, the Agreement provided scope for partial or full withdrawal of preference
granted under SAFTA for a period of maximum 3 years. Safeguard measures cannot

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be applied against the product of LDCs if share of import from an LDC of the product
concerned in total import of importing country is less than 5%.

3.7.9. Consultations and Dispute Settlement Procedures

There is specific article on dispute settlement mechanism with specific time table.
Bilateral consultation shall be held within 30 days upon a request made by any
member. If dispute cannot be settled through bilateral consultation, the matter will be
referred to the COE for its recommendation within 60 days. The COE may consult
witth a panel of experts for peer review. Any decision of the COE can be appealed to
SMC for its decision within 60 days. The decision of the SMC will be final.

3.8 How successful has SAFTA been so far?

The South Asian Free Trade Agreement (SAFTA) signed by the members of the
SAARC and implemented in July 2006, has since been a matter of concern for the
countries involved, regarding how effective it is in increasing the economic
wellbeing of the region in general. When it was initially signed, the goals included
forming a common currency for the region and forming a Customs Union (CU)
which would eventually lead to Total Economic Integration. The first stage of the
agreement has been successful for only certain countries, and Sri Lanka only to
some extent. Recently a survey was conducted on the quantification of the benefits
of the SAFTA to the region as a whole was undertaken by The ADB and the United
Nations Conference on Trade and Development (UNCTAD). The findings were
discussed at a forum hosted by the Institute for Policy Studies, with the hope that
some of the feedback could be included in the results, which in turn could be
presented to the member governments to better their trade policies.

3.8.1 Comparative Advantage and Complementarities

One of the chief queries posed at the implementation of the agreement was as to
how economically rational the agreement would be and whether the countries

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which were mainly agriculture-based economies sharing many similar

characteristics could produce competition. According to Rashmi Banga, Chief
Economist of the UNCTAD India, the Revealed Comparative Advantage (RCA)
Index has shown that the number of items for which countries are more
competitive than other countries has increased. This indicates that more trade
would be possible within the region. Also, the complementarity indices have
shown an increase which means essentially that the compatibility of the exports
of each country has increased, as those exports being imported are more likely

One of the factors that contributed to this may be the fact that most of the
countries have gravitated toward manufacture and industry-based economies.

For a trade agreement to be fully beneficial it should ideally afford some

additional access to the country’s existing trading partners, measured by the
Effective Additional Market Access or EMEA. So far estimates have shown that
EAMA Sri Lanka gains from the agreement in terms of bilateral imports is 0%
from India, but close to 66% from the other countries. The main reason for this
would be the Indo-Lanka Free Trade Agreement that already has tariffs at an
extremely low rate on trade between the two countries.

3.8.2 Possible increases in FDI

The influx of Foreign Direct Investment is set to increase with the agreement for
a number of projected reasons: increased regional cooperation would make South
Asia more attractive as a destination for investment. If an investor were to settle
in one country, the low tariff rates would act as a gateway to expansion of his
market. Increased intra-regional trade would reduce the security fears of
investors as well. To quote the report by the ADB-UNCTAD, “higher trade
openness attracts higher FDI”. The SAFTA benefits on importing intermediate
goods too have shown to be healthy for investment as high import of these goods
has recorded high inward FDI into the same country. Exports of goods to other
areas of the country however do not seem to have any effect on the FDI situation
in general.

3.8.3 Costs of the agreement

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South Asian Free Trade Agreement

The survey records the main disadvantage of the SAFTA to be revenue loss
caused by the tariffs being cut down to almost 0%-5%. Sri Lanka is budgeted to
lose Rs. 100 million worth of revenue as a result of this. Also, the latter phases of
the SAFTA (up to 2016) would produce a negative impact on the unskilled
employment of the country. While all this was recorded, some of the forum
members highlighted other pressing issues that affect the credibility and logic of
the agreement as well as the survey.

An economist from the Ceylon Chambers of Commerce, Subhashini Abeysinghe

pointed out that to understand fully the cash cost of the agreement, the loss of
revenue should be recorded as a percentage of the countries’ annual revenues.
She also argued that the FDI in the region had little to do with the SAFTA, and
that the main investor- India -invested in the region for obvious advantages like
regional dynamics and the presence of niche markets for itself.

SAFTA ignoring non tariff barriers (NTB) was brought to light by Janaka
Wijeysiri, Research Economist from the IPS. “Unfortunately, no commitments
have been made to remove NTBs from the SAFTA,” he said, adding that when
the sensitive lists too were added into the equation, the trade potential within the
region was minimized substantially. The lack of binding commitments to reduce
or remove the negative lists too is a major barrier, he said.

The credibility of the models used by the ADB and UNCTAD were criticized by
Upali Wickremasinghe, Professor of Economics, University of Sri
Jayewardenepura, who suggested that the use of models which use past data to a
great extent might not be fully beneficial. “The RCA basically analyses what has
happened in the past,” he said, adding that the Trade Complementarity Index and
the Gravity models used were also of the same type, “using these to project
future possibilities may be elusive,” he said. The SMART model that was used
from some of the data simulations depends on Infinite Supply Elasticity, which
he pointed out would be tough assumption to adopt, especially for countries with
supply constraints.

3.8.4 Political black box

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South Asian Free Trade Agreement

The clause “according to political will” is commonly used in the SAFTA,

meaning that whatever trade benefits from the tariff reductions are subject to the
volatile political atmospheres of the South Asian region. Wickremasinghe
referred to the clause as a “safety valve for the academics” and suggested going
further into the matter.

He pointed out the animosity between certain countries, particularly India and
Pakistan, was only present at tense official-level meetings and that it does not
reflect in the business to business dealings or inter-personal encounters. His
opinion was that this should be kept in mind, and that the SAFTA should focus
on removing barriers like supply constraints instead of concentrating on “the
political black box”.

Some of the other main problems faced by the SAFTA are the Trade Restriction
Quotas (TRQ) and the Rules of Origin.

The ROO guidelines have been a significant bone of contention in the Indo-
Lankan FTA, as many of the local companies have significant foreign ownership,
and the solution remains to lower the threshold for foreign ownership.

The Tea and Apparel industries, the largest of the export sector and highest
contributors to local GDP have been hampered on the other hand by TRQ’s.

3.8.5 Transport facilitation and Trade in Services

Increasing transport facilitation is seen as one of the main avenues of increasing

the trade potential within the region. To quote the ADB-UNCTAD report, “High
trade costs such as transportation charges, documentation requirements and
clearance delays at the borders have a discouraging impact on trade and
production similar to trade restrictions such as tariffs and quotas.”

Simplification of customs barriers and enhancing connectivity is the main

objective of the SAFTA transport facilitation programme. Four main projects are
underway in this initiative, one of them being the Colombo Port expansion

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Kavita Iyenger, Regional Cooperation Specialist from the ADB said that when
compared to the Jawaharlal Nehru port in Mumbai, India, the Colombo port was
ranked highly in 1998 but that the ranking has fallen in 2004. Much of the traffic
at the port is trans-shipment traffic and the most of it from the SA region.
Currently, the survey has identified that the port requires enhancement of
operational efficiency and improvement of infrastructure to reach its full
potential. If Sri Lanka can finance the expenditure, the development will result in
considerable economic growth in the country.

Including services in the SAFTA has always been a topic of debate and five
sectors have been identified to increase trade liberalization - Health Services,
Tourism and Travel, Higher Education, Construction and Telecommunications.
The SAFTA countries, except Bhutan, have made commitments to liberalize
trade under the GATS, and the SAFTA offers them an opportunity to widen their
liberalization regionally. Liberalizing trade under the SAFTA would have a more
benefits when compared to liberalizing under GATS. For instance, the results are
more likely to be seen early regionally because a fewer number of countries are
involved, whereas with the GATS, the whole of the WTO would be included.

Also, since trade in services is still a relatively new mechanism, the risk factor
would be minimized with a small number of countries that already have Regional

What the SAFTA is concentrating now is on Mutual Recognition Agreements. In

the context of higher education, this would mean that a group of qualifications
will be chosen in each country that is give cross-border recognition, so that
students may be able to apply for foreign employment with local qualifications.
This should be successful in improving employment and regional relations.

Chapter Four: Afghanistan in SAFTA

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4.1 History

In the 1990s, it was known as the country ruled by the Taliban, the hard-line Islamic
group that re-imposed the veil and other restrictions on women and destroyed the
Bamiyan Buddhas, two priceless pre-Islamic statues regarded as part of the world's
cultural heritage.

In the next decade, it became the land bombed by the US and allied forces in search of
Osama bin Laden, believed to be the mastermind of the September 2001 terrorist
attacks in New York City.

This year, Afghanistan, occupying a strategic position between South and Central
Asia, has acquired yet another identity as the newest member of the South Asian
Association for Regional Cooperation (SAARC).

Though Afghanistan had expressed its desire to join the grouping since 1985 - when
SAARC came into being with seven members - Bangladesh, Bhutan, India, Maldives,
Nepal, Pakistan and Sri Lanka - political instability and civil war kept it isolated.

4.2 Introduction:

Afghanistan has learned stark lessons from its political and economic isolation. More
than two decades of conflict resulting from occupation and foreign interference
inhibited economic and political development.
It has been decided in fourteenth SAARC Summit by all SAARC members that
Afghanistan’s political and economic isolation must never be repeated. Instead,
enhanced economic cooperation must be pursued for the sake of regional economic
and political stability.
Afghanistan enters the SAARC bloc as a much-needed bridge between South and
Central Asia in terms of trade and security and defense cooperation.

4.3 Advantages to Afghanistan:

 Afghanistan needs facilitative measures like regional integration for peace

building and long-term economic growth. Trade, for sure, ensures larger
welfare gains for a nation than aid.
 The IMF estimates that Afghanistan can grow at 10 -19 percent per annum
with a non-drug economy -a goal enshrined in the 2004 government strategy
document titled "Securing Afghanistan's Future". According to the ADB,
43.3 percent of Afghanistan's exports and 32.8 percent of Afghanistan's
imports in 2004 came from India and Pakistan. Since 2001, Afghanistan's
imports and exports have increased around 2.7 times. India and Pakistan, as
the two important pillars of SAFTA, can play a critical role in Afghanistan's
 Article 7(6) of SAFTA stipulates that imports from LDCs will be duty free by
2008; hence, Afghanistan's exports would benefit from this dispensation. The
Special and Differential (S & D) mechanism to enhance exports from LDCs,
Mechanism for the Compensation for Revenue Loss (MCRL) due to

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implementation of SAFTA concessions and the Technical Assistance clauses

in SAFTA can facilitate Afghanistan' economic reconstruction and promote
state capacity building.
 Afghanistan is rich in natural resources like natural gas, petroleum, coal,
copper, iron ore and precious stones, which can be exported using the SAFTA
concessions. Currently, Afghanistan has 1.6 trillion cubic feet of natural gas,
95 million barrels of oil and 400 MT of coal - critical inputs for a possible
resolution of the regional energy problem. South Asia, in turn, will be linked
by land with the Central Asian Republics to facilitate trade and energy
security initiatives.
 India has provided $80 million assistance for constructing a road for
improving Afghanistan's trade access to Iran
 Afghanistan's entry into SAFTA will promote its economic growth and induce
greater interdependence amongst South Asian countries. SAARC has already
started debating services sector liberalisation, poverty alleviation and
counter-terrorism measures from which Afghanistan can benefit in future.
 The trade pact will give Afghanistan access to a much wider market with
preferential trading arrangements. Currently, Kabul's largest export markets
are the US, India and Pakistan .The main commodities are fruits and nuts,
hand-woven carpets, wool, cotton, hides and pelts and precious and semi-
precious gems.

4.4 Challenges to Afghanistan:

 Challenges have been realized to the potential of greater regional economic

integration, especially:

 Barriers to the movement of people and goods

 Working towards transit and transport facilities under the Regional Multi-
Model Transportation System. This will link the region’s road, rail and ports

 Access to each other’s airlines and airports

 Land locking members’ transit rights; it must not allow narrowly defined
interests to trump the benefits of free-flowing trade in the region. Its collective
efforts are required for the successful implementation of the SAFTA

 Rapidly growing energy needs: in this connection, it should speeding up the

process of Turkmenistan-Afghanistan-Pakistan-India (TAPI) gas pipeline and
its expansion to other SAARC member states.

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 Discouraging the narcotics trade that is damaging to all and encouraging

lawlessness and criminality across borders, and collectively undermining its
rule of law.

4.5 Conclusion:

Afghanistan seeks peaceful and prudent solutions to regional and international issues.
And it respects national sovereignty. Its foreign policy relies on the multilateralism
that SAFTA represents.

We hope that that Afghanistan will maintain constructive relations with each of its
regional partners, and will work in cooperation to further strengthen SAARC into an
effective instrument for regional prosperity. But at the same time we also know that
all this is not going to fructify overnight.

CHAPTER Five: Predicting Future

5. Trade Creation and Trade Diversion Effects under
SAFTA: Estimates using the GTAP Model

Studies based on the partial equilibrium gravity model to estimate the welfare gains
from regional trading arrangements (RTAs) are methodologically flawed. The left
hand side of the Gravity equation is the bilateral trade not the welfare. Also, the
impact of the RTA is captured by introducing the dummy variables in the equation
which is a very weak methodology. Furthermore, Gravity models are partial
equilibrium analysis, not a general equilibrium analysis. Therefore, they fail to take
into consideration the inter-sectoral and inter-regional linkage effects. Therefore,
gravity models can not actually estimate the trade creation and trade diversion
impacts of RTAs. We, therefore, argue that a global general equilibrium model like
the GTAP model is the best method in explaining the welfare effects of any regional
trading arrangements. Box 3 presents the commodity and regional aggregation of the
GTAP model under consideration.

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5.1. GTAP Simulation Design for Different SAFTA Scenarios

With the aim of estimating the welfare effects of the SAFTA on different member
countries of the world two different scenarios in the GTAP model are simulated.
Following Table presents the simulation scenarios. In the scenario SAFTA1 all
member countries eliminate their intra-regional tariffs and keep their tariffs with the
rest of the world unaffected. In the scenario SAFTA2, in addition to SAFTA1,
Bangladesh eliminates her tariffs for the rest of the world by 50 percent.

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SAFTA Scenarios
Name Explanation Banglades India Pakistan Rest of
h South
SAFTA1 Full 100% 100% 100% 100%
n of
SAFTA. 100%
Tariff cut for
SAFTA2 Full 100% for 100% 100% 100%
Implementatio SAFTA+
n of 50% for
SAFTA. 100%
MFN Tariff
Tariff cut for
countries and
reduces her
tariffs by 50%

5.2 Decomposition of the Welfare Effects into Trade Creation

and Trade Diversion
It should, however, be noted that the original GTAP framework does not provide any
estimates of trade creation and trade diversion aspects of the total welfare effects. In
order to estimate these two effects we have made some adjustments in the GTAP
model. The GTAP model provides a net welfare estimate of the SAFTA simulation
which is a sum of trade creation and trade diversion. With a view to separate the trade
creation effect from the total welfare effect a separate simulation is run where we
make necessary adjustments in the GTAP closure so that the imports to all the South
Asian countries from all over the world (except from the South Asian countries) are
held fixed. The welfare effects from this scenario are nothing but the trade creation
effects for individual South Asian countries. This trade creation effect is then
deducted from the welfare effect in the original simulation to get the estimate of the
trade diversion effect. Figure provides the results of this exercise. It appears that
Bangladesh incurs a net welfare loss from the SAFTA1 scenario. Though, for
Bangladesh there is a positive trade creation effect the negative trade diversion effect

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is large enough to offset the positive gain. However, all other South Asian countries
stand to gain from SAFTA1. The gain for India is the largest as far as any individual
country is concerned.
Trade Creation and Trade Diversion Effects of SAFTA1 Scenario

The high negative trade diversion effect for Bangladesh under SAFTA1 can be
explained by the fact that imports from India (a relatively high cost import source)
increases substantially and imports from all over the world (relatively low cost import
source) also declines significantly

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5.3 Changes in Imports to Bangladesh from different Countries

under SAFTA1 (Million US$)

Table reports the estimates of the changes in exports from Bangladesh to other South
Asian countries. Comparing the figures of table 6.10 with those of 6.9 it appears that
Bangladesh trade balances with India will deteriorate under SAFTA1. According to
table below Bangladesh’s exports to India increases by only 134 million US$,
whereas India’s exports to Bangladesh increases by 1489 million US$ (above table).
In fact, Bangladesh’s exports to other South Asian countries increase less than the
increases in the exports of other South Asian countries to Bangladesh.
5.4 Rise in Exports from Bangladesh to other South Asian Countries
under SAFTA1 (Million US$)

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Trade Creation and Trade Diversion Effects of SAFTA2


Figure above presents the welfare effects of SAFTA2 scenario. In contrast to

SAFTA1 under SAFTA2 Bangladesh undertakes some unilateral trade liberalisation
measure. The results suggests that the negative trade diversion effect of SAFTA1 is
eliminated to large extent under SAFTA2 and the trade creation effect is large enough
to offset the trade diversion effect, which leads to a net welfare gain. The welfare
statuses of other South Asian countries are largely unaffected.

It appears that a full implementation of SAFTA will lead to welfare
gains for India, Sri Lanka and rest of South Asian countries, though Bangladesh
suffers from welfare loss. Bangladesh’s welfare loss is mainly driven by the negative
trade diversion effect. Simulation results also suggest that the negative trade diversion
effect can be undermined by some associated unilateral trade liberalisation measure. It
is also important to note that trade diversion for Bangladesh and possibly for other
LDCs under SAFTA is inevitable. Bangladesh and other LDCs in South Asia will
have to raise their export share into the Indian market substantially in order to

COMSATS Institute of Information Technology, Lahore. 43

South Asian Free Trade Agreement

increase welfare through positive terms of trade effect. Export diversification in this
regard is very important. Technical assistance to Bangladesh and other South Asian
LDCs to diversify their export basket can be a vital agenda. It should also be noted
that the Special and Different Treatments for the LDCs under SAFTA are not
sufficient, especially maintaining the sensitive list for some of the critical products by
India will not help the South Asian LDCs to increase their export share. Also, South
Asian LDCs should reduce tariff on the import of (at least) raw materials from India,
which will have positive impact on LDCs welfare.

COMSATS Institute of Information Technology, Lahore. 44