Report

28 QUANTIFICATION OF BENEFITS FROM ECONOMIC COOPERATION IN SOUTH ASIA
further estimates the impact of SAFTA on inward FDI
into the region. Cost-benefit analysis is undertaken for
four transport facilitation projects.
RATIONALE FOR SAFTA
The costs and benefits of a Free Trade Agreement are
strongly premised on whether they are trade creating
or trade-diverting. An FTA would be trade-creating if
liberalisation by a member country allows it to replace
the higher cost domestic supply by a lower cost partner
country supply. This creates enhanced efficiency and is
therefore beneficial to the member countries of the
Agreement. It would be trade-diverting if preferential
liberalisation by a member country leads to replacing
the lower cost supply from non-partner member
countries by higher cost supply from a partner country.
In the case of SAFTA both these phenomena would
simultaneously take place and whether on balance it is
net trade-creating or net trade-diverting would depend
on small and large country situations.
To determine the real benefits of SAFTA, however
there is a need to examine whether proximity and
preferential trade is an issue which would change the
economic geography and commercial policy of the
region. This cannot be easily explained by using
standard trade theory even when account is taken of
SAFTA imperfections due to limited enforceability.
Alternatively, simple models of horizontal multinational
enterprise combined with limited enforceability produce
a strong inverse relation between physical transportation
costs and trade policy cooperation, thereby introducing
a preference for regional agreements such as
SAFTA (Ludema 1998). The possible role of regionally
generated MNC’s makes such agreements viable even
if the Preferential Trade Agreement (PTA) generates
trade flows which are small. It would be even more
useful to extend similar analysis to other models of
trade that exhibit strong home market effects. These
have produced welfare enhancing effects even though
limited. Ludema argues that some progress has been
made in extending such analysis to the oligopolistic
and monopolistic models of Venables.
Theory argues that RTA’s with one high income
hub country could lead to convergence to high income
level among members in the region (Venables). This
could be true for SAFTA with India playing the role of
the high income growth pole. Theory also argues that
FTA’s will tend to raise trade for countries that are near
each other on account of two major reasons: First,
because transportation costs would be low and second
because economies of scale would accrue easily and
multinational production would take place (Ludema
1998). This explains the EU and North Atlantic Free
Trade Area (NAFTA) welfare effects but equally applies
to Mercosur and ASEAN. For it to apply to the SAFTA
region considerable openness in the policy framework
will be required particularly with respect to investment.
Understanding the geography of trade agreements
should include an analysis of transport costs, economies
of scale and imperfect competition, all of which would
point to increased commercial activity in the SAFTA
context. The study estimates the extent of potential
trade that exists intra-regionally as well as bilaterally.
Further, an estimate is made of increased trade in the
region due to removal of factors other than tariffs, e.g.
non-tariff barriers.
Studies on Mercosur and ASEAN have found that
they tend to be net trade creating though the range of
trade effects vary from low to high depending on the
initial level of liberalisation of the member countries.
The more important effects however have been in terms
of FDI because FTA’s alter the incentives facing firms
for both those located within and outside the FTA direct
investment flows are affected. Investments in some cases
anticipate the effects on trade. FDI is motivated by
foreign investors seeking to exploit input or output
markets located in activities where operating of foreign
affiliates seem the most efficient strategy. Some other
investment project might be undertaken to reap
economies of scale or because of increased competition.
In fact a study by the World Bank argues that a 10%
increase in market size associated with an RTA produces
a 5% increase in FDI (World Bank, 2004a). Earlier
empirical work on regional integration on FDI have
focused primarily on the effects of EU integration which
show that EU share of worldwide inward FDI increased
from 28 to 33% consequent to the single market
programme. FTA might also promote technological
spillover among members affecting efficiency of sectors
that produce accumable factors such as knowledge
creation. This issue needs further examination in the
context of SAFTA.
On evaluating the diverse implications on FDI of
FTA’s, Blomstrom and Koko in the case of Mercosur
suggest inclusion of provisions on FDI in RTA’s. Further
by providing certainty and credibility on future policies
and economic environment there is a possibility of an
increase in private domestic investment. Yet another
study on the positive welfare effects of FTA’s (Shiff’s
and Winters) points to the political dimensions and
argues that as a tool of commercial diplomacy FTAs