Hoover Daily Report

A Passage to India-Pakistan Peace

via Wall Street Journal
Sunday, April 15, 2012

With their sizable nuclear arsenals and tensions over territory, water and terrorism, India and Pakistan pose staggering risks to South Asia. But they also offer outsize economic potential for their citizens, the region and the world. Leaders in both nations seeking peace, stability and a prosperous future should seize on free trade as the best way to further these goals. The time has come for an India-Pakistan free trade agreement.

Free trade would substantially increase trade and investment flows, incomes and employment, and it would give the citizens of both countries a far greater stake in the other's success. Economists of varying backgrounds agree that free trade is a positive-sum economic activity for all involved. In the seven years following Nafta, trade among the United States, Canada and Mexico tripled and real wages rose in each country.

The International Monetary Fund reports that direct trade between Pakistan and India was a pitifully small $2.7 billion in 2010, just two-thirds of India's trade with far smaller Sri Lanka. Remarkably, Pakistan's exports to Bangladesh are larger than those to India, though Bangladesh's economy is only 6% the size of India's. South Asia doesn't have enough trade.

The tool economists use to analyze bilateral trade, called the "gravity model," suggests trade should be proportional to the states' GDP and inversely proportional to the distance between them (a proxy for transportation costs). India's GDP of over $4 trillion is roughly nine times that of Pakistan's.

Estimates based on gravity models by Amitra Batra of Nehru University and Mohsin Khan of the Peterson Institute suggest that Pakistan-India trade could be at least 20 times larger with a bilateral free trade agreement than it is today. That's a staggering expansion of over $50 billion that would raise real wages in both countries.

By modern standards, tariffs governing trade between India and Pakistan are still relatively high, at 15%-20%. India's tariffs are higher still on natural Pakistani exports such as textiles and agriculture. Non-tariff barriers loom large, for example in transportation, visas, customs, payments and banking. There is little trade in services or foreign direct investment, as prior government approval is necessary.

Since 2006, a South Asian Free Trade Agreement has included India, Pakistan, Sri Lanka, Bangladesh, Nepal, Bhutan, the Maldives and, more recently, Afghanistan. But it has not done enough to benefit the region. The world-wide average of a country's gross domestic product exported is 28%, but India, Sri Lanka and Bangladesh export only 18%-19% of GDP, and Pakistan exports just 12.9%.

Tariff reduction has been modest and is proceeding too slowly. More important, India's exports to Pakistan are still governed by a narrow list of less than 1,000 acceptable items, because Pakistan's bilateral import policy for India supersedes the free trade agreement. (A typical Wal-Mart in the U.S. has more than 50,000 items). India's bilateral free trade agreements with Sri Lanka and other countries have left Pakistan behind.

India and Pakistan have strong incentives to further trade liberalization and are moving in that direction. They established joint working groups last year to make recommendations on visas, energy and non-tariff barriers. These are welcome first steps, but incrementalism is not likely to make a major difference. Trade bureaucracies move slowly unless pressured from above.

A better, bolder approach would be a bilateral free trade agreement that rapidly phases in real tariff elimination and shifts from the distressingly small positive list of acceptable imports to a small and shrinking negative list.

The obstacles to such an agreement range from cross-border security concerns to old-fashioned protectionism. The perceived economic vulnerability to free trade of some domestic firms, sectors and regions can be addressed with transition relief such as worker retraining and tariff phase-in periods.

Realistically, it will take several years to negotiate and implement a free trade agreement between India and Pakistan. Even with strong political leadership, negotiating Nafta took four years.

Still, Pakistan President Asif Ali Zardari and Indian Prime Minister Manmohan Singh spoke of the importance of trade in their brief meeting earlier this month in New Delhi. Both men appear to understand that trade liberalization is economically necessary and will diffuse tensions between these two nuclear nations. The next step is to initiate high-level discussions of a free trade agreement.

Mr. Boskin is a professor of economics at Stanford and a senior fellow at the Hoover Institution. As chairman of George H.W. Bush's President's Council of Economic Advisers, he and Secretary of State James A. Baker III were instrumental in initiating Nafta.