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4 Bilateral Free Trade Agreements in SAARC and Implications for SAFTA Deshal de Mel 1. INTRODUCTION Regional economic integration within South Asia had been mooted since the early 1990s. The emergence
4 Bilateral Free Trade Agreements in SAARC and Implications for SAFTA Deshal de Mel 1. INTRODUCTION Regional economic integration within South Asia had been mooted since the early 1990s. The emergence of the South Asian Preferential Trade Agreement (SAPTA) in 1995 followed by the decision to deepen it to a South Asian Free Trade Agreement (SAFTA) in 1996 suggested that there was limited rationale for bilateral trade agreements within the region to emerge. However, the SAPTA had covered limited product lines of trade interests and, when efforts at regional economic integration came to a deadlock in 1998 following competing nuclear tests by the two largest countries in South Asia, countries looked at bilateralism with greater interest. Sri Lanka is involved in both bilateral trade agreements that have emerged within the region. The first was with India, signed in 1998 and implemented in March 2000, and the second was with Pakistan, which came into effect in June Although both agreements provided Sri Lanka with important market access to its main trading partners in the region, the fact that the three most developed countries within South Asian Association for Regional Cooperation (SAARC) have entered into bilateral trade agreements threatens the significance of SAFTA. Given the 90 Deshal de Mel current deadlock in the World Trade Organization (WTO), other South Asian countries (Bangladesh in particular) may consider the bilateral route of trade liberalization more seriously. Eight years have passed since the commencement of the Indo Sri Lanka FTA (ILFTA), and it is now possible to have a better idea of the implications of the agreement. Aggregate values show strong benefits for Sri Lanka in terms of export growth, but a more disaggregated analysis shows that the actual picture is less encouraging. The Pakistan Sri Lanka FTA (PSFTA) has had limited impact on trade thus far, and the efficacy of the agreement and lessons for other countries can be considered in this light. This chapter will examine the structure of each agreement and evaluate their impact on trade between Sri Lanka, India, and Pakistan. The chapter also touches on the position of the two agreements within the context of SAFTA and highlights some lessons that emerge for SAFTA and for other countries looking to sign bilateral agreements within the region. Section 2 will deal with the India Sri Lanka FTA (ISFTA) with subsections touching on the structure of the agreement, economic impacts, and the moves toward the Comprehensive Economic Partnership Agreement (CEPA) between the two countries. Section 3 will deal with the PSFTA, and subsections will again touch on the structure, economic implications, and the way forward. Section 4 compares the two bilateral trade agreements with SAFTA and highlights lessons for other countries; Section 5 concludes. 2. INDO SRI LANKA FTA The ILFTA was the first bilateral trade agreement that was signed by both Sri Lanka and India. The agreement was signed in the backdrop of expanding economic ties between the two countries following liberalization of the Indian economy in the early 1990s. While India had become one of Sri Lanka s major import sources, exports to India remained low. With the deteriorating political relationship between India and Pakistan stalling progress on SAFTA, Sri Lanka and India were keen to forge ahead with a bilateral agreement to cement the improving economic integration between the two countries. 2.1 Structure of the Agreement Learning from the poor trade impact of the product-by-product approach of SAPTA, the ILFTA utilized a negative list approach to trade Bilateral Free Trade Agreements in SAARC 91 liberalization. Thereby, all items would be liberalized except those deemed sensitive by each country. At the foundation of the agreement is that, given the asymmetry between India and Sri Lanka, there would be less than full reciprocity between the two countries. Several special and differential treatment measures were implemented to allow for this asymmetry Negative Lists India s negative list, with 429 tariff lines, was substantially smaller than that of Sri Lanka, which maintained 1,220 items on the negative list. Sri Lanka protected much of the agricultural sector and many other sectors for which particularly small and medium industries were perceived to be vulnerable to Indian competition. These included such sectors as rubber, ceramics, paper, and products thereof. Furthermore, revenue compensation was excluded from the agreement and, in lieu of this, Sri Lanka was allowed to maintain key revenue-earning items in the negative list. Therefore, products such as motor vehicles and parts key imports from India were kept in the negative list. Such measures were required to placate Sri Lankan domestic interests with regard to the perceived threat of flooding of Indian products and revenue implications. As a result, of the 1,180 items on Sri Lanka s negative list, 712 were traded between the two countries at a value of US$912.3 million. Therefore, around 50 percent of India s exports to Sri Lanka, in terms of value, were subject to the negative list and did not receive preferences under the FTA. On the other hand, 70 of the 429 items on India s negative list were exported from Sri Lanka to India, accounting for 3.3 percent of Sri Lanka s exports to India in value terms in 2006 (Weerakoon and Thennakoon 2008) Tariff Liberalization Program While India s tariff liberalization program (TLP) would be completed over a period of three years, Sri Lanka was given eight years to complete its liberalization process, allowing domestic firms time to adjust to the shocks associated with trade liberalization. The TLP for both countries is summarized in Table 4.1. India s initial preferences to Sri Lanka were larger than Sri Lanka s preferences to India. India provided immediate zero duty for 1,351 tariff lines compared with Sri Lanka s 319 tariff lines and also provided 50 percent preference margins for the remaining 2,870 tariff lines (to be phased out over 3 years), while Sri Lanka did the same for 889 items. 92 Deshal de Mel TABLE 4.1 Tariff Reductions ILFTA Tariff reductions India Sri Lanka Negative List 1, Immediate Zero Duty (March 2000) 1, Zero Duty within 3 years (cuts of 50%, 75%, and 100% 2, by March 2003) Zero Duty within 8 years (cuts of 35%, 70%, and 100% by March 2008) a 2,802 Source India Sri Lanka Free Trade Agreement, available at indusrilanka_freetrade.php (accessed on 4 October 2008). Notes ILFTA = India Sri Lanka Free Trade Agreement; = not available. a Because of procedural delays, Sri Lanka was only able to fulfill the March percent tariff reduction in September Accordingly, the March 2008 tariff reduction has not taken place at the time of writing. The remaining tariff lines exported by India were given a preference margin of 35 percent in March 2003, which was increased to 70 percent in September 2006 and then tariffs would be phased out after a total of 8 years in Tariff Rate Quotas India s negative list included many products of export interest to Sri Lanka, including tea and garments. To provide Sri Lanka with some degree of market access, tariff rate quotas (TRQs) were allowed for these products, with product-specific rules of origin, even though these products remained in the negative list (Table 4.2). However, due to difficulties for Sri Lankan exporters in taking advantage of the TRQs (Section 2.3), negotiations took place to ease these restrictions. In June 2007, India relaxed the port restriction for tea imports and allowed the import of 3 million garment pieces per year, free of duty and with no sourcing requirement. For tea, the initial notification (26/2000) by India was that a 50 percent margin of preference would be provided; however, a subsequent notification in the same year revised that to a standard tariff of 7.5 percent Rules of Origin Rules of origin (ROO) are required to prevent products of a third country being re-exported to one of the parties to the bilateral agreement, through the other party to the agreement, without substantial value added or Bilateral Free Trade Agreements in SAARC 93 TABLE 4.2 ILFTA Tariff Rate Quotas Product Tariff preference Quota Other restrictions Tea Standard duty rate of 7.5% a 15 million kg annually Entry allowed only to the ports of Cochin and Kolkata Garments (Chapters 61 and 62) Textiles (Chapters and 63, except few items in Chapters 53 56) 50% 8 million pieces per year, 6 million of which need to have material sourced from India to receive preferences 25% Source Respective Agreements, available at freetrade.php (accessed on 4 October 2008). Notes ILFTA = Indo Sri Lanka Free Trade Agreement; = not available. a According to the World Trade Organization (2006), India s average applied Most Favored Nation (MFN) tariff on tea and coffee is 56.3 percent. transformation in the final exporting country. The ISFTA uses a combination of domestic value addition (DVA) and change of tariff heading (CTH) to adjudicate origin. For products including inputs from third parties, minimum DVA is 35 percent of the freight on board (F.O.B.) value of the product (Table 4.3). If the inputs originate in the importing party (for example, if Sri Lanka is exporting a product to India where some of the inputs to that product originate in India), DVA must be a minimum of 25 percent of the F.O.B. value of the product, provided that the combined value addition of the two parties is at least 35 percent of F.O.B. value of TABLE 4.3 ILFTA Rules of Origin Measure Domestic value addition Cumulative rules of origin Change of tariff heading Requirement Minimum of 35% F.O.B. value Exporting country minimum value addition of 25% F.O.B. if inputs from importing country are utilized; subject to the condition that aggregate value addition is 35% F.O.B. value CTH at four-digit HS classification Source ILFTA, available at (accessed on 4 October 2008). Note F.O.B. = freight on board; HS = Harmonized Commodity Description and Coding System. 94 Deshal de Mel the product. In addition to fulfilling the DVA criteria, the final product being exported must have a different classification, according to the Harmonized Commodity Description and Coding System (HS Code) at the four-digit level, from all of its constituent inputs. 2.2 Economic Impacts Even before the FTA was implemented, India had become a significant source of Sri Lankan imports. In 1999, India accounted for 8.6 percent of Sri Lanka s total import basket and was the second highest source of imports (with Japan being the highest). Sri Lankan exports to India were not substantial before the FTA, with total exports in 1999 being a mere US$47 million, around 1 percent of total exports, and India not even being among Sri Lanka s top 10 export destinations. Furthermore, in 1999 Sri Lanka s trade deficit with India was substantial (US$463 million) with an import export ratio of 10.5:1. In 1999, Sri Lanka s main exports to India were in primary products mainly agriculture and unprocessed metals. The major exports included pepper, which made up 20 percent, and areca nuts, which made up 11 percent, while such products as waste steel and waste paper made up 8 percent and 5.5 percent, respectively. It is clear from this passage that before the FTA, Sri Lanka s trade with India was limited in terms of both value and industrial depth. While the trade balance was weighted toward India, this was not compensated by investment flows. Foreign direct investment (FDI) from India to Sri Lanka was limited, with cumulative investment as of 1998 a mere Sri Lankan Rupees (SL Rs)165 million (US$2.5 million 1 or 1.3 percent of total FDI). The implementation of the FTA had a dramatic impact on trade relations between the two countries (see Figure 4.1). By 2007, Sri Lanka s exports to India had increased to US$515 million (6.6 percent of total exports). India is now Sri Lanka s third largest destination for exports and largest source of imports, making up 23 percent of total imports in The trade balance between the two countries narrowed until 2006 (when the import export ratio was 4:1 compared with14.3:1 in 1998), as the rate of growth of Sri Lanka s exports was greater than that of imports. Furthermore, FDI from India followed trade as cumulative FDI expanded to reach SL Rs 9.5 billion by 2005 (US$191.2 million or 8.3 percent of total FDI). India is now the fifth highest investor in Sri Lanka. The number of products exported from Sri Lanka to India doubled from 505 in 2000 to 1,062 by 2005 (Kelegama and Mukherjee 2007), and more important, there was a shift from primary products to processed goods. Vegetable fats and oils, refined copper, wires (copper, aluminum), margarine, rubber, and articles Bilateral Free Trade Agreements in SAARC 95 FIGURE 4.1 Domestic Value Addition of Indian Investment in Sri Lanka Source Wickremasinghe thereof all come ahead of traditional exports such as pepper and spices. New products such as furniture (exports of which increased from US$1.7 million in 2002 to US$6.4 million in 2006), antibiotics (no exports until 2004 and reaching US$22 million in 2005), and ceramic products (US$0.8 million in 2002 increased to US$22.7 million in 2006) successfully entered the Indian market. 2 The FTA was instrumental in this expansion of trade, as 75 percent of Sri Lankan exports to India received preferential treatment in 2006, compared with 22 percent in Thus, bilateral market access to India for the smaller South Asian economies is evolving at a much more rapid pace than under the SAFTA framework. The net result of these alternative bilateral and regional agreements in South Asia with India playing a pivotal role eventually may become something approximating free trade within the region. However, Pakistan is conspicuously absent in the evolving network of such alternative agreements. In contrast to the other South Asian countries, Pakistan is seeking its own trade arrangements with the East Asian region. It has signed FTAs with China (2006) and Malaysia (2007) to date. 3 The benefits of tariff arbitrage had begun to wane since Copper exports were the first to be hit as earnings fell from US$145 million in 2005 96 Deshal de Mel to US$27 million in A key cause of this reduction in earnings was the change in invoicing methods after India insisted that pricing be done according to London Metal Exchange prices. This addressed the issue of underinvoicing by copper exporters to meet ROO criteria, and eligible exports reduced as a result. Exports of vanaspati (vegetable oil) improved in 2007 following a fall in 2006 resulting from the imposition of quotas by India. This progress is likely to be all but completely eroded in 2008, however, with the decision by India to completely slash Most Favored Nation (MFN) tariffs on palm oil imports. As a result, exporters from Sri Lanka lose their preferential margin and will not be competitive in the Indian market. The outcome of these changes will be significant in terms of Sri Lanka s trade with India because export earnings were dominated by copper and vanaspati for the last 3 years. 2.3 Factors Inhibiting Growth of Sri Lankan Exports The dominance of vanaspati and copper in the early years of the FTA is partly due to the fact that Indian entrepreneurs invested substantially in these industries and also to the fact that other exports have failed to expand in the same manner. Several factors contribute to the lack of dynamism in the export of other tariff lines to India. The key factor is that India is not a traditional export market of Sri Lanka. Sri Lanka s export basket is dominated by garments, and these items traditionally have been exported to the United States and European Union. This structure has been cemented over several years of developing buyer relationships, establishing markets, and creating supply chains. There is naturally a degree of inertia with regard to producer preferences when these factors are taken into consideration. Nonetheless, even in the garment sector there have been some recent developments in terms of Sri Lankan producers looking to tap the Indian market. MAS, a leading apparel exporter in Sri Lanka, recently launched an intimate wear label Amante, targeting India s upper-middle class. The product is specially designed to cater to South Asian women. Another important factor is that Sri Lanka s traditional export products (garments and tea) until very recently have been hampered by prohibitive ROOs. Garment exports to India were under the negative list except for a 50 percent margin of preference for 8 million pieces, 6 million of which would need to use Indian fabrics to receive preferences. The sourcing requirement ensured that Sri Lankan garment exports to India were not competitive relative to domestic producers and, as a result, there was less than 1 percent quota utilization. In June 2007, however, Sri Lanka was allowed 3 million Bilateral Free Trade Agreements in SAARC 97 garment pieces to enter India free of duty with no sourcing requirement. In the most recent secretary-level meeting of the India Lanka CEPA in July 2008, it was agreed that Sri Lanka will be allowed to export 6 million garment pieces to India free of duty with no sourcing requirement and an additional 2 million pieces with a margin of preference of 70 percent. This is yet to be implemented as the requisite administrative processes have not been completed. Nonetheless, the most recent indications suggest that garment exports to India have expanded, taking advantage of the 3 million pieces quota. With regard to tea, given the fact that pure Ceylon tea is more expensive than tea in the Indian domestic market, Sri Lanka s primary scope of export to India was realized through the blended tea market. This is why Sri Lanka chose the ports of Kolkata and Cochin as ports of entry that is, these ports provide easy access to Indian teas to produce a blended tea variety for the Indian market. Unfortunately, with the present agreement, the ROOs are such that blended tea has effectively no chance of penetrating the Indian market. The requirement of a CTF at the four-digit level is not practically possible. As a result, just 2.7 percent of the 15 million kg quota has been utilized by Sri Lanka (Kelegama and Mukherjee 2007). In June 2007, the port restriction on Sri Lankan imports was eased, but there was no change in the ROOs, and therefore it is unlikely that there will be an expansion of Sri Lankan tea exports to India. In order for tea exports to India to take off, a product-specific ROO that allows a CTF at the six-digit level is required. There have also been concerns about paratariffs, particularly the statelevel tariffs imposed on any products entering particular Indian states (even from other states) over and above those faced by domestic state producers. For instance, in Tamil Nadu, local producers pay a state tax of 10.5 percent, while producers from foreign countries and other states pay a tax of 21 percent, thereby eroding the preferences obtained through the FTA (Kelegama and Mukherjee 2007). It is argued that, despite the state taxes, Sri Lanka is provided a preferential advantage with respect to other international trading partners. A state like Tamil Nadu (population 66 million) is substantially larger than a country like Sri Lanka (population 20 million), however, and given Tamil Nadu s geographic proximity to Sri Lanka, it is a major export market (compared to more distant states where Sri Lankan exports are less competitive because of transport costs). Therefore, state taxes in Tamil Nadu substantially undermine Sri Lanka s competitive export potential to the Indian market. Another problem faced by Sri Lankan exporters is that, despite the insignificance of Sri Lankan exports compared to the size of the overall Indian market, Sri Lankan 98 Deshal de Mel exports have created turbulence within p
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