India’s Unfortunate Conversion to Preferential Trade Liberalization

During the 1990s, as the rest of the world succumbed to the temptation of discriminatory and preferential trade, India and its Asian neighbours remained steadfastly committed to non-discrimination in trade policy.

But lately, like its newly converted neighbours throughout Asia, India too is signing PTA agreements at breakneck speed. Trade economists have been skeptical of PTAs for two key reasons. First, these arrangements remove trade barriers preferentially among member countries, leaving the barriers against non-members intact. Such liberalization leads to “trade diversion”: when India eliminates tariff on imports from Thailand but not China, Thailand can take markets away from China even though its costs of production are higher.

The reason the GATT/WTO system places non-discrimination in trade policy at the centre of the global trading system is that it allows the lowest-cost trading partner to supply a country’s imports of any given product.

Second, once a set of PTAs is in place, the tariff depends on whether the product originated in a PTA partner and if so at what stage implementation is the agreement and what is the rule of origin applicable. This is in contrast to a discrimination-free system in which product origin is irrelevant to the tariff.

During the 1990s, trade economists had repeatedly warned the PTAs would Balkanize the global trade system into a complex web of PTAs with overlapping members and diverse rules. But while winning the intellectual debate, however, they failed to counteract the tide of the PTAs.

In the case of India, preferential access to its protected market, which is large and growing rapidly, has become an additional attraction to the potential PTA partners.

If we want to maximize the benefits of trade liberalization, the ideal course is to stick to non-discriminatory liberalization, both unilaterally and multilaterally, under the auspices of the Doha Round. Whereas such liberalization is a part of virtually all growth miracles, PTAs are yet to produce a single major success story. Fifteen years ago, the devotees of PTAs had promised the miracle of Mexico rising out of the North American Free Trade Agreement (NAFTA) but that has not happened.

Unfortunately, given the political compulsions, a course change is unlikely. The important question therefore is what measures can we take to minimize the damage.

First, in the future WTO negotiations, India can propose amending GATT Article XXIV to include the requirement that the PTA preferences be automatically extended to non-members within a period of, say, five years.

Second, India should continue to liberalize externally by bringing all tariffs down to five per cent or less, thereby reducing the scope for trade diversion.

Third, even though we do not advise that India conclude more PTAs, if it does, it should ensure that the rules of origin in the agreements are liberal.

Finally, in choosing our PTA partners, we should look for the most efficient suppliers of our imports. This ensures that we continue to buy our imports from the most efficient suppliers. This criterion points to China as the most attractive PTA partner. Paradoxically, it is the one country we have ruled out in our PTA game plan in part on the specious argument that China is a non-market economy.

But the gains from trade accrue from trading with a non-market economy just as much as from trading with market economies. Our trade with China is one of the fastest growing bilateral trade relationships in the world today. India’s exports to China rose from a paltry $18 million in 1990-91 to approximately $5.3 billion in 2004-05. India’s imports from China expanded equally rapidly, from $35 million to $6.8 billion over the same period.

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 it eventually plans to turn into the WTO template. An India-China “trade only” template will be an effective instrument of countering the US template.

Our ultimate goal has to be to move from PTAs to global trade liberalization. While PTAs are almost sure to inflict injury on non-members even if they benefit the member countries, global liberalization is far less prone to this shortcoming.

And it is not enough to adhere to the current PTA rules within the WTO: those rules must themselves be improved to minimize the discrimination promoted by the PTAs.

(The authors are professors at Columbia University and Yale University, respectively.)