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What price free-trade agreements?
The finance minister has proposed to slash the highest custom duty by five percentage points and to eliminate the Special Additional Duty of up to four percentage points. With some exceptions such as automobiles, which attract a duty of 60%, this will bring the highest tariff on industrial goods down to 20%.
Alongside, India has embarked on an aggressive strategy of preferential liberalisation with its neighbours in Asia . Agreements have been signed for the creation of free trade areas (FTA) within South Asia and with the members of the Associations of South East Asian Nations (Asean). Unlike tariff reductions announced by the finance minister that apply to all trading partners, FTAs eliminate tariffs against FTA members but retain them on non-members.
No doubt, we have adopted this alternative approach to promote better political ties with our neighbours as well as in reaction to similar arrangements elsewhere. Nevertheless, from an economic standpoint, FTAs bring two potential risks: our external tariffs being still as high as 20%, FTAs are likely to give rise to harmful trade diversion effects and they threaten to undermine our national liberalisation programme as well as that under the Doha multilateral negotiations.
Consider first the losses from trade diversion in the context of the proposed India-Singapore FTA. After the tariff cuts just announced are implemented, the tariff on steel imports would be 20%. Assuming the world price of steel to be $500 per ton, the tariff-inclusive price in India would be $600 per ton. The FTA with Singapore would give that country’s steel exporters tariff-free access to the Indian market allowing them to displace some of the steel previously imported from outside countries such as South Korea and Russia . Economists call this displacement trade diversion.
A surprising point is that despite this “liberalisation”, as long as some steel continues to be imported from the outside countries, internal price of steel would remain unchanged at $600. Outside countries must continue to receive $500 per ton of steel and with the Indian customs authorities collecting $100 in duty buyers must pay $600. Since Singaporean steel is exempt from the duty, however, their exporters now receive extra $100 per ton in revenue. What used to be the tariff revenue collected by India now becomes extra revenue for Singaporean firms!
One might ask why the price of steel in India will not drop to $500 per ton as a result of the FTA. This could happen but only if Singapore produced enough steel to supply the entire quantity of steel imported by India at $500. But as long as even a small quantity of steel continues to be imported from non-members, it will have to be sold at $600 and no change in the price can take place.
One possibility around this outcome is that Singaporeans may buy steel from Koreans and Russians for $500 per ton and then resell it in India at the higher internal Indian price. If enough Singaporean exporters do this, however, the price of steel in India would drop to $500. The outcome would be as if India removed duty on not just Singapore but all trading partners! But this type of transshipment is prohibited under FTA arrangement through what are called the “Rules of Origin”. For example, to claim the duty-free status, Singaporean exporters will have to prove to the satisfaction of a commerce ministry official that a minimum pre-specified percentage of value-added in each ton of steel being brought into India originated in Singapore . This regulation would eliminate transshipments.
It is tempting to conjecture that even though India might lose on goods it imports from Singapore , the losses may be offset by tariff preferences received on exports in Singapore . The catch, however, is that Singapore is already a free-trading country. The FTA gives Indian exporters no tariff preference whatsoever in the Singaporean market. More generally, in an FTA, a high-tariff member is likely to lose since it gives larger preference to its partner than it receives from the latter. The lesson is that it is best to have low external tariffs, as is the case with Singapore , if a country wants to benefit from FTAs.
The second risk of FTAs is their likely adverse effect on non-discriminatory liberalisation as illustrated by the experience of the countries in Latin America . These countries had been liberalising their external trade barriers aggressively prior to the North American Free Trade Agreement (NAFTA). But following NAFTA, they all turned to FTAs with a vengeance and the move toward non-discriminatory liberalisation came to a standstill. The countries felt they had a better chance of forming FTAs if they kept external tariffs so as to be able to exchange them for preferential access to partner country markets.
The move towards FTAs can also undermine the Doha negotiations. Because FTAs give preferential access to partner country markets, export lobbies prefer them to multilateral liberalisation. But in so far as India is concerned, it can scarcely afford to let the multilateral route close. Because of the numerous FTAs that already exist in the Americas and Europe , India faces considerable discrimination against its products in those markets. The only way to end this discrimination is to bring tariffs down to near zero on a multilateral basis under the WTO auspices.
The good news is that the prospects for a Doha agreement that serves India ’s interests are better than ever. In a letter written recently by the United States Trade Representative to WTO members, the US has made the elimination of agricultural export subsidies a priority and agreed to drop all Singapore issues from the agenda except trade facilitation. It has further offered to focus the round principally on trade liberalisation. India can scarcely pass this opportunity.
Economic Times January 28, 2004