An India-China Free Trade Area?

Arvind Panagariya

India-China trade is among the fastest growing bilateral trade relationships in the world currently.  According to the Indian Commerce Ministry data, India's exports to China rose from a paltry $18 million in 1990-91 to approximately $3 billion in 2003-04.  India's imports from China expanded equally rapidly, from $35 million to $4 billion over the same period.

So rapid has this expansion been that from an insignificant supplier until the beginning of the 1990s, China has now come to replace the United States as India's top source of imports.  During April-December 2004, the latest period for which the Commerce Ministry data are available, imports from China grew a phenomenal 70 percent over those during April-December 2003.That effectively overwhelmed the hefty 25 percent growth in imports from the United States during the same period.

Of course, this expansion is a healthy development since it represents a shift from costlier domestic or other foreign sources of supply. Nevertheless, the domestic import-competing firms (as opposed to the buyers of cheaper Chinese goods that include both consumers and firms) may be inclined to appeal to the import surge to demand increased barriers against Chinese goods.  But that will be absurd for many reasons including the fact that the competitive Indian firms have been equally successful in penetrating the Chinese market:  India's exports to China during April-December 2004 grew 61 percent over those during April-December 2003.True, the bilateral balance is in favor of China (though the reverse is true according to the Chinese data) but no economist worth his salt would suggest that bilateral trade flows must be balanced-after all, India too runs a huge trade surplus vis-à-vis the United States.

Indeed, rather than fear the Chinese imports, we must use the occasion to address a more provocative question that figured prominently during the recent visit by the Chinese Prime Minister Wen  Jinbao: is there a case for an India-China Free Trade Area?

I have generally been critical of the discriminatory trade blocs not just because such arrangements fragment the global trading system but also because they often hurt economic efficiency within the countries forging the arrangements.  This is particularly true of the arrangements such as the India-Sri-Lanka and South Asian Free Trade Areas that exclude and therefore discriminate against countries accounting for nearly 99 percent of the world trade.  The discrimination works particularly to the disadvantage of India since it has relatively high trade barriers.  For example, when India gives tariff free access to Sri Lanka, tariff revenue previously collected on the imports from Sri Lanka turns into export revenues for the exporting firms of Sri Lanka.  Since tariffs in Sri Lanka are low, Indian exporting firms have less to gain from tariff-free access there.

Of course, this argument would apply to the India-China FTA as well though with less potency since China is a large player in the world market and a super-efficient producer of many goods.  The latter fact means that the tariff-revenue loss on the imports from China might translate at least partially into a reduction in the consumer prices.  Nonetheless, as long as India continues to have substantially higher tariffs than China, the danger of potential losses from the transfer of tariff revenue to the Chinese firms in the form of higher profits remains.  As such, in thinking of such an FTA, one must assume that India would remain committed to its current non-discriminatory liberalization and bring the external tariffs down to the Chinese levels in two or three years' time.

The case for an India-China FTA is based principally on its strategic value. During the last decade, with the creation of the NAFTA, several expansions of the EU and a host of smaller FTAs in Latin America, Asia has suffered from a diversion of these regions' trade away from it.  One response to this trade diversion for Asia would be to move towards a bloc of its own.  Such a bloc may give Asia the necessary leverage to pry open the NAFTA and EU blocs to outsiders through multilateral liberalization.

If one accepts this argument, an India-China FTA is probably the best starting point for such an Asian bloc.  For example, as an alternative, even if India and China both make good on their respective framework agreements with the members of the Association of Southeast Asian Nations (ASEAN) to forge FTAs with them, an effective Asian bloc will not form without these two countries signing an FTA agreement with each other.  On the other hand, if India and China signed an agreement, chances are much higher that the remaining countries in Asia will rush to sign agreements with them. Presently, the ASEAN is driving the integration process in Asia but with the emergence of India and China as major economic powerhouses and the relative stagnation faced by the most populous ASEAN country, Indonesia, its ability to serve as the engine of the Asian integration has substantially diminished. 

An India-China FTA also has the advantage that it will help promote an alternative FTA template that focuses on trade integration rather than non-trade subjects including labor standards, intellectual property rights and even restrictions on the use of capital controls.  These subjects are integral parts of the US FTA template that the US may eventually want to turn into the WTO template.  An Asian bloc that relies on a "trade only template will be an effective instrument of countering the US template in the future WTO negotiations.

Internally, India can surely benefit from cooperation with China in shaping its labor-intensive industry.  In particular, direct competition with China may help push some of the key reforms necessary to stimulate the expansion of the labor-intensive industry.  With the wages in China now rising, the time for India could not be more opportune for moving in a big way into such labor-intensive sectors as apparel, footwear and toys.  Likewise, China could gain from increased interaction with India in the information technology sector.

Economic Times April 20 2006