Hindi Chini FTA

Indian Express, 22 November 2006

Will an FTA (Free Trade Agreement) between India and China be signed? Does such an agreement make economic sense? Both countries are labour abundant developing countries without clear gains from trade, and it is not clear that the agreement will result in trade creation and an increase in welfare for India. It may be a politically useful agreement, as perhaps most bilateral agreements are, but the economic benefits may be limited.

What is a Free Trade Agreement?

A free trade agreement is an arrangement between countries to reduce tariff barriers. Custom duties on imports has been a big barrier to international trade, reducing trade and the gains that could be made from trade. Reducing these leads to an increase in trade and business. Trade agreements can be multilateral, bilateral or regional agreements. An FTA between India and China is an example of a bilateral agreement.

Do all trade agreements lead to an increase in trade?

While most evidence finds that multilateral agreements help in increasing trade and welfare, it is not clear that regional agreements lead to trade creation, ie. an increase in trade, rather than trade diversion, i.e an increase in trade among member countries without an increase in total trade when the increase comes at the cost of trade reduction with non-member countries. The purpose of FTAs is to eliminate tariffs against FTA members, but to retain them on non-members. Economists have often criticised FTAs, which may promote better political ties with neighbours, but are not based on sound economic principals.

What are the benefits of an FTA?

Under an India China FTA, for example, instead of importing steel from Europe, a producer would import it from China. This does not help the Indian economy. Morevoer, as long as China does not satisfy the entire Indian demand for imported steel, the price of steel in India does not fall. "Rules of origin" on which FTAs are based mean that only steel produced in China can be imported under preferential tariffs - there will be zero tariff only when there is a minimum percentage of value added in China.

What are the difficulties with an FTA?

There are many difficulties originating from the army of bureaucrats who will be created to ascertain the country of origin of a good, the amount of value added done in that country and to certify that it qualifies for lower tariffs than other comprable goods coming from other countries. These custom officers will then have a vested interest in the continuation of FTAs rather than a multilateral trading agreement under which India brings down tariffs on goods from all countries. This army of officials which stands to earn bribes and becomes powerful under an FTA regime can create political economies against the first best path -- a unilateral reduction in tariffs. It is difficult to remove the inspector raj created by an FTA.

How will India gain from an FTA with China?

As in the case of Singapore, the gain from signing an FTA with a country that has low tariffs is limited for India. The gains are higher for Chinese exporters who face high tariffs when exporting to India. These tariffs will come down in an FTA. They stand to gain more than Indian exporters do in a treaty in which both countries agree to lower tariffs.

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