Estimating the Impact of the Indo-ASEAN Free Trade Agreement on India’s Balance of Trade

Ranajoy Bhattacharyya* and Avijit Mandal**


India signed a Free Trade Agreement with ASEAN on 13th August, 2009. In this paper we analyze one aspect of the possible impacts of the FTA: that on India’s Balance of Trade. It is found that the impact of the agreement on India’s balance of trade is expected to be negative. India’s imports will rise significantly, however there will be no commensurate rise in India’s export to these countries except to Indonesia.

Keywords: Tariff Elasticity, Balance of Trade, Free Trade Agreements, India, ASEAN

Journal of Global Analysis | Vol. 1 | No. 1 | 2010

1. Introduction

India signed a framework agreement on comprehensive economic cooperation with the Association of South East Asian Nations (ASEAN)[1] in October 2003. The agreement proposed to progressively liberalize and promote trade (in goods and services) as well as investments between them. As a means to that end the agreement proposed to enter into negotiations for the creation of a Regional Trade and Investment Area (RTIA) which includes a Free Trade Area in goods. After negotiations lasting almost six years a Free Trade Agreement (FTA) was signed between them on 13 August 2009. The objective of the proposed RTIA a part of which was implemented by the signing of the FTA appears to be economic as well as political with the political part being as important as the economic, if not more[2]. On the economic front, several arguments have been put forward, either for ASEAN as a whole or for particular countries within ASEAN, in favor of the RTIA in all the three areas that are expected to be covered by it: a goods agreement (see for example, Mehta (2005)), a services agreement (Joseph and Parayil (2004) and Karmakar (2005)) and an investment agreement (Mukherjee et al (2003)).

There are however skeptics who are especially critical of the FTA part of the RTIA. Interestingly some of these arguments have been put forward by politicians rather than economists. For example one of the members of the Indian parliament from Kerela, Mr. A. K. Anthony is of the opinion that a FTA with ASEAN “will hurt the interests of states like Kerala as Customs tariff of produces such as pepper, coffee and palm oil would have to be brought down substantially in the next 10 years under the agreement”[3]. Indeed there are clear economic reasons for being skeptical. The average tariff for the ASEAN countries in 2006 was 6.53% (for all products) which was substantially lower than the average tariff of India to these countries (16.55%). Thus a FTA will clearly imply that India will have to bring tariffs down to a greater extent than the ASEAN. Also, among the ASEAN members India has preferential trade agreements with Thailand, Myanmar and Singapore[4]. This leads to lower impact of the Indo ASEAN FTA for these three ASEAN members. Finally due to a much stronger trade relationship between these countries and China, market access for India will lower in the ASEAN member countries (see, Pal and Dasgupta (2009)).

Pitted against these are strong economic reasons in favor of signing an FTA. Almost all of India’s major trading partners are developed countries. There is therefore a greater potential of trade expansion when a trade agreement is signed with countries that are stronger than India economically but with whom India does not yet have a strong trade relationship. The ASEAN 6 countries are classic examples in this regard. Also India has large trade surpluses with many of its developed trading partners (like, for instance, USA, UK and Italy, see table 1).  Thus the deleterious effects of opening up the country’s production sector to foreign competition are not something that is empirically obvious. Also as numerous studies have shown India’s price elasticity of import is substantially smaller than price elasticity of export[5]. So the expectation of “the flood gate opening up” may be misnomer. Fourthly, if one presumes that a major reason for signing the FTA is that trade between India and ASEAN is well below potential[6], the FTA is expected to have a substantial amount of trade creation effect[7]. Also, ASEAN already has FTAs with three major Asian countries: China, Japan and South Korea giving these countries a competitive edge in the ASEAN region vis-à-vis India. Signing an FTA is expected to bring India at par with these countries in the ASEAN market. Finally, Indian industry is likely to gain from Indo ASEAN FTA from the cheaper import of the intermediate goods from ASEAN[8].

Given the above perspective in this paper we attempt to analyze the effect of the Indo-ASEAN FTA on India’s balance of trade (BOT). The approach that we follow is: we first estimate the tariff elasticity of India’s bilateral exports and imports to and from ASEAN 6[9] from 1989 to 2006. Once the elasticities have been estimated, we calibrate the post FTA situation by interpolating the tariff values to zero and reporting the resulting values of trade. We do this exercise (a) for the entire panel of the ASEAN 6 countries in a gravity model framework and (b) for individual countries over time by estimating the country specific import demand functions. Note that the approach gives us an upper bound to the trade effect in the sense that tariffs are not instantaneously adjusted to zero immediately after the signing of a FTA. Secondly, the approach gives us the ex ante summation of the trade creation and the trade diversion effects of the FTA[10]. However one limitation of the approach is that it fails to distinguish between the two.

Though, to our knowledge, this method of looking at the possible effects of a FTA is fairly uncommon to the literature, there is a long history of research on FTAs that have already been implemented[11] and the paper falls in this tradition. The paper also contributes to the currently raging debate (both in academic circles and in media) about the pros and cons of the Indo-ASEAN FTA (Sen, Asher and Rajan (2004), Mehta (2005), Yong (2005), Joseph and Parayil (2004), Karmakar (2005), Mukherjee et al (2003)).

The rest of the paper is arranged as follows. Section 2 introduces the current status of Indo ASEAN trade. Section 3 briefly reviews the background of the FTA between India and ASEAN. The methodology of the current analysis is covered in section 4 while the data sources are given in section 5. Section 6 deals with the analysis of empirical results. Concluding remarks are discussed in section 7.

  1. Current Trade between India and ASEAN

India and the South East Asian countries have traded with each other since the ancient period. In the middle ages India’s trade with this region was mainly in spices and textiles. Now the product basket has changed significantly. In recent times India’s exports to ASEAN mainly consists of oil (33.3%[12]), chemicals (8.6%), machinery (6.6%), gems and jewellery (4%), cotton yarn and fabrics (2.3%), meat and meat preparations (1.6%) and pharmaceuticals (1.6%). ASEAN’s export to India includes mineral oil (29%), machinery (22.7%), edible vegetable and vegetable oil (10%), organic chemical (5.4%), wood and wood products (4%).

Tables 2 and 3 bring out the salient features of trade between the two economic entities. Though India and ASEAN (as a whole) are comparable, in terms of area[13], in terms of imports ASEAN is much more important to India than India is to ASEAN. India is also less open than ASEAN. However India’s total trade with ASEAN has increased about three fold between 2001 and 2006 (from US $ 7.8 billion to US $ 30.7 billion). This growth in trade is significantly higher than India’s growth rate of trade with other regions of the world[14]. India has also penetrated ASEAN markets to a greater extent than ASEAN has been able to do for Indian markets (15.7 % vs. 2.8 %). One reason for this might be the fact that India is more protectionist than ASEAN (see col. 4 and 5 in table 2). However, India’s degree of openness is growing more rapidly (15.4%) than that of the ASEAN (1.7%).

Considering that ASEAN and India have a combined population of 1.7 billion, a GDP of US$ 1.9 trillion in 2006 and have advantage of geographical propinquity Table 3 also brings out the fact that Indo ASEAN trade is far below potential. In fact trade between them is minuscule compared to world trade flows. However Indo ASEAN trade as a proportion of ASEAN’s trade with world is growing at a much higher rate than that of India’s total trade with world (18.2% vs. 3.8%).

The issue of non-achievement of trade potential is fully brought out in table 4[15] where we have determined the Indo-ASEAN trade potential with respect to three data sets: a) the world gravity data set for 2003 b) the gravity data set for India with all its trading partners between 1950 and 2000 and c) for the Indo-ASEAN data set from 1989 to 2006 with which we are working here. We estimate three different gravity models using these three different data sets. For each, we estimate the value of India’s trade with ASEAN 6 partners and then in column 4 of table 4 present this as a ratio of the actual trade with that partner. Where this ratio exceeds 1, it indicates the potential for more trade. India’s trade is below potential with all the ASEAN countries when we consider aggregate world trade as the benchmark. However the situation drastically changes when we use India as the benchmark. Compared to what India has traded on the aggregate with its own partners India’s trade is below potential only with Philippines. Put in another way, India’s trade with most countries of the world is so small that India’s trade with the ASEAN countries (barring Philippines) can be considered as adequate given this (abnormally low) benchmark. When the potential is evaluated only with Indo-ASEAN data, as expected half of the countries operate above and half below potential with Thailand, Philippines and Indonesia being below potential. Of the countries that are above potential Singapore and Brunei are so because of the smallness of their GDP. Malaysia is the only country with whom India appears to have adequate amount of trade among the ASEAN countries.

  1. Indo-ASEAN FTA: A brief Background

Indo-ASEAN trading relations received a momentum about a decade ago after the adoption of the “Look East Policy”[16] (LEP) by India in 1991 (see table 5 for a full chronology of the events leading up to the signing of the FTA). The first step in this direction was taken in 1992 when India became a “dialogue partner” of the ASEAN graduating to the level of a “full dialogue partner” during the fifth ASEAN summit in Bangkok in 1995. This relation was reinforced in 1996 when India was granted membership of the Asian Regional Forum[17] (ARF). In this forum India’s renewed interest for closer economic and political ties with her south-east Asian neighbours was reciprocated by many of them who seemed to be pursuing an unstated “Look West” policy of increasing their interaction with India. This intensification of the economic linkages with the ASEAN led India into a second phase of its LEP. Phase-I of the policy was characterized by the establishment of trade and investment linkages. Phase-II (starting from 2004) is marked by arrangements for free trade areas and establishing institutional economic linkages between the countries of the region and India. The Indo-ASEAN FTA is the latest development in Phase II of the LEP thus far.

The gestation for the agreement has however been a long and tortuous one. The framework agreement of 2003 was followed by more than 15 meetings of the trade negotiation committee before a consensus was reached. The primary reason for the stalemate in talks was the disagreement over the sensitive list, which includes items which are to be protected against tariff cuts.

Ultimately when the agreement was signed there were four groups of products enlisted for tariff reduction: normal track, sensitive track, special products and exclusion list.  In case of normal track the applied most favoured nation (MFN) rates will be reduced and subsequently eliminated. For sensitive track (see table 6) all the applied MFN tariff rates that are above 5% will be reduced to 5% in accordance with the country specific reduction schedules. In case of special products India has decided to reduce tariff rates at a much more gradual pace than either the normal track or the sensitive track. Finally the agreement also refers to the exclusion list of 489 products for which no reduction commitments have been made.

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