Free Trade Areas can be a bad Idea

Some enthusiasts like Muchhkund Dubey, former foreign secretary, are gung-ho about the Free Trade Areas (FTAs) India is negotiating with Sri Lanka and other neighbours in SAARC. Now, a well-designed FTA can be a boon, but a badly designed one is worse than none at all. Those being negotiated in SAARC are not promising.

How does trade liberalisation improve living standards? First, it encourages specialisation and so shifts labour and investment from less efficient to more efficient uses. Second, it enhances efficiency by stimulating competition with the best in the world. Third, it enables firms to reap economies of scale by providing access to markets beyond the limited home market. Fourth, being exposed to world trade is a powerful way of acquiring knowledge about the latest ideas, technologies, and market patterns.

These gains can be realised far better by creating a Customs union between countries than an FTA. Few people know the difference between the two, but it is crucial.

The European Union is a Customs union. Member-countries have a common import tariff, and this facilitates free internal movement of imported goods without Customs inspection.

The North American Free Trade Area (NAFTA), encompassing the US, Canada and Mexico, is not a Customs union. The three countries have different rates of import duty, and this creates problems. Suppose the US has zero duty on a metal, but Mexico levies 10 per cent duty. If free movement were allowed within, NAFTA, US businessmen would import the metal duty-free and sell it at an assured profit in Mexico, a sort of ‘legalised smuggling’.

To check this, all FTAs have rules of origin. Goods made in the US can move freely to Mexico, but not goods originating in any country outside NAFTA. Goods made in the US may have imported ingredients. In that case, the rules say a certain minimum value must be added by processing in the US before entry into Mexico. For example, if a US firm imports $ 100 worth of plastic from China and converts that into $ 150 worth of plastic bottles, the bottles may enter Mexico, but not the unprocessed plastic.

In sum, trade is not actually free in an FTA: Only goods satisfying rules of origin can move freely (Why on earth do politicians and diplomats use such misleading terminology?) But a Customs union is indeed an area with free movement. A Customs union garners most of the economic benefits of trade. But an FTA, in sub continental conditions, is more likely to induce variations of legalised smuggling, despite rules of origin.

Consider the FTA covering India and Nepal, which have very different import tariffs. India levies 40 per cent duty on copper, while Nepal levies only 5 per cent. So hundreds of small Nepalese units are coming up which import cheap copper and convert it to wires for sale to India. These units are woefully uncompetitive by international or even Indian standards, yet beat all others because of the huge duty differential. Such ‘manufacture’ is essentially a disguised form I of legalised smuggling.

Does India gain from such an FTA? No, it ends up importing high-cost, low-quality goods, penalising efficient Indian producers, and losing import revenue.

Does Nepal gain? No, though the Nepalese elite does. Free trade is supposed to shift labour and capital to sectors where a country is efficient. But in Nepal, labour and capital shift to sectors where the duty differential is highest, even if these are woefully inefficient. Such bogus liberalisation penalises efficient businessmen while rewarding those most skilled in manipulating duty differentials. These manipulators then become the supposed captains of Nepalese industry, and their personal interest becomes identified with that of Nepal. They pay off politicians to manipulate duty differentials.

Thus the FTA benefits crooked politicians and businessmen at the expense of others, and a poor country’s scarce resources are channelled into unproductive areas for the enrichment of the elite.

Indian politicians deal with these crooks, and so believe this charade will improve relations with Nepal. This is myopia. If Nepal’s prosperity is made dependent on legalised smuggling to India, Nepal will never become prosperous and its relations with India will never be on a sound footing. No, India should insist on moving within a few years to a Customs union with Nepal.

Bangladesh has been pleading for duty-free access to India. We must not agree. We must say Bangladesh’s interest will not be served by diverting its scarce resources to legalised smuggling parading as manufacturing.

India and Sri Lanka have agreed to an FTA, and are working out its modalities. We must insist that Customs harmonisation in phases be a condition of duty abolition. Only then will the countries reap the genuine gains of trade.

Now, harmonising duties could raise prickly issues of sovereignty. If a full Customs union proves difficult, it may be sufficient for the countries to limit duty differentials to say 5 percentage points, low enough to make bogus manufacturing unprofitable.

This, indeed, is why NAFTA is a success: Duties differ across the three countries, but only modestly in most cases. And Customs deforcement of rules of origin is far better there, not dogged by corruption as in South Asia.

Still, Europe is far better integrated than North America, thank to its Customs union. So, Prime Minister, at the next SAARC summit please stop talking about FTAs and talk about forming Custom unions instead.

What do you think?