Public Disclosure Authorized Sou t h A sia P olic y N ote s A d vanc ing R e gional In te|  Jan 2015  grati o n1 Issue 1 93915 Public Disclosure Authorized Opening up Markets to Neighbors: Gains for Smaller Countries in South Asia Sanjay Kathuria and Sohaib Shahid A at how all countries, especially the smaller ones, could large body of literature shows that all countries gain from mutual trade liberalization (one critical aspect of benefit from trade openness, irrespective of size; regional integration). Consumers and exporters in smaller other work shows that smaller countries benefit even countries benefit significantly from trade liberalization, as more from mutual trade liberalization, due to their greater goods become cheaper for consumers while exporters Public Disclosure Authorized dependence on trade.i Trade liberalization, however, can gain access to a much larger market and more competitive be a difficult political sell because economic gains are often inputs. Import-competing firms (producers) in the smaller dispersed over time and space, while losses can be immedi- country present a mixed picture, with the more productive ate. Vested interest groups lobby governments for protec- ones gaining (especially ones that use imported inputs) and tion from more competitive imports. Moreover, when one of the less efficient losing. the countries involved in the process is disproportionately large, lobbies in smaller countries find it easier to bargain for domestic protection, on the often misplaced grounds that the larger economy might swamp the smaller one. The Consumers and Exporters: Undisputable gains from closer association between a large and small Gains country are often missed. Larger countries have strong protectionist lobbies as well, but since trade is usually a smaller share of their economies, they may be somewhat Consider the three key players in this debate: consumers, less influential than their counterpart lobbies in smaller exporters and producers. Consumers, the silent majority in Public Disclosure Authorized countries. In all countries, whether large any country and often ignored in trade or small, strong leadership appears to be policy decision-making, gain in several critical in envisioning and implementing ways from increased regional coopera- the silent Consumers, trade reforms. tion: through lower prices (leading to an majority in any country, increase in real income), more product In South Asia, the South Asia Free Trade and often ignored in trade variety, and better quality goods.ii Think Area (SAFTA) came into effect in 2006. policy decision making, will of cheaper consumer goods from Ban- But free and unfettered trade is still a work gladesh flowing to poor families in India’s always gain from increased in progress. For example, all countries less accessible North East, thereby maintain long “sensitive lists”, where the regional cooperation reducing their monthly food expenditure. SAFTA tariff concessions do not apply. through lower prices, more Analysis by a consumer advocacy and Even India, which offers virtual free trade product variety and better research group shows that intra-regional to the least developed countries (LDCs), tariff reduction would lead to an approx- quality of goods. still has extensive protection on imports imate gain of $2 billion a year in welfare from other countries in the region. Drawing for South Asian consumers.iii Similarly, from theory and evidence, this note looks the cost of basic household goods in www.worldbank.org/southasia 2 S o ut h A s i a Pol ic y N ot es A d vanc ing R e gional In te gration Mexico has fallen significantly (by half according to one countries (including the larger country, Brazil), grew faster estimate) since the North American Free Trade Agreement’s than its exports to the rest of the world. (NAFTA) implementation.iv Exporters are also big winners. With access to much Producers: A Mixed Story, but larger markets and sourcing opportunities for key inputs, the quality and quantity of exports would go up and new Opportunities Aplenty export products would emerge. A recent study shows that if Bangladesh were to sign a bilateral Free Trade Agreement There are several major ways through which trade liber- (FTA) with the larger country India, its exports to India would alization can affect small country firms, all representing grow substantially more than if it receives one-sided con- sources of dynamic gains from trade associated with higher cessions from India. This is due to Bangladeshi exporters productivity. gaining access to more competitive imported inputs.v First, lowering import tariffs, quotas and other non-tariff Mexico’s experience after joining NAFTA is a good example barriers (NTBs) leaves domestic firms open to foreign of sustained gains in trade arising from an agreement competition and cheaper products. This creates pressure between a smaller country, Mexico, and a much larger on domestic firms to become more efficient and increase trading partner, USA. Figure 1 shows that from 1993, the productivity. Those unable to cope would, in time, be year before NAFTA’s inception, to 2012, US imports from pushed out of the market; however the net effect would be Mexico rose by about 500 percent, more than twice as a higher level of firm productivity. The negative impact on fast as imports from the rest of the world. US exports to employment arising from firms unable to compete will be Mexico also rose faster than exports to the rest of the world, counterbalanced by expansion of the more productive and export-oriented firms. Second, firms in the small country gain by increasing their size and scale via access to a Figure 1: US-Mexico trade far outstripped trade with bigger market, which in turn could enable cost reduction, the rest of the world and the ability to spread the costs of technology absorption. 600 Third, firms in the small country will be able to compete Percentage Change 500 more effectively, both at home and overseas, through (1993 to 2012) 400 availability of cheaper and higher quality inputs. Fourth, 300 there would be dynamic gains for the economy and its firms 200 through the continued impact of competition on productivity, 100 access to newer technologies and inputs, and the ability 0 of firms to grow beyond their own relatively small markets. Imports Imports Exports Exports from from to to Gains would be compounded over time – more firms would Mexico Rest of Mexico Rest of become increasingly efficient, absorbing new technology, World World learning lessons from foreign competition, and gradually Source: Authors’ calculations based on WITS (World Bank) data branching into non-traditional export areas. Finally, trade liberalization could also encourage more foreign direct investment (FDI): trade and FDI liberalization many of these being product inputs needed by Mexico’s tend to complement each other, i.e., opening up FDI leads manufacturing industries, including the exporting sector that to more trade, and vice versa. In turn, FDI can bring skills, has a large foreign-value added component. A 2006 study technology and foreign capital, as well as access to new finds that Mexico has become an export platform for US markets. Thus, it is an additional source of dynamic gains investors since 1994: a platform that has acted as a catalyst from increased international engagement.viii FDI can also for Mexican export growth to its NAFTA partners and the lead to increased exports from the host country – for exam- rest of the world.vi Without NAFTA, Mexican exports to USA ple, FDI by an Indian apparel producer in Bangladesh can would have been lower.vii Similarly, in Mercosur (Southern lead to increased apparel exports from Bangladesh to South Common Market) – the free trade agreement between Asia as well as the rest of the world. Investment-friendly Argentina, Brazil, Paraguay, Uruguay and Venezuela – measures as part of the regional cooperation agenda can exports from a small country such as Paraguay to Mercosur also help encourage more FDI. www.worldbank.org/southasia Sou t h A sia P olic y N ote s A d vanc ing R e gional In te grati o n 3 How can countries overcome their fears and the pressure of In the Mexican case, the sectors of its economy oriented strong domestic lobbies? towards NAFTA (mostly large firms employing 500 people or more) enjoyed productivity growth of 5.8 percent annu- Strong leadership is a critical ingredient in opening up ally between 1999 and 2009, substantially higher than markets. In the NAFTA case, Mexican policy makers were the national average.ix Since NAFTA, prepared to take a strategic and long- Mexico has also seen a surge in FDI term view of the impact of trade reforms, including the realization that there would from the US, a major expansion of its It would be important auto industry, improvement in labor be short-term losses even as the economy for policymakers to note as a whole would benefit. Also, to ensure skills, and an increase in manufacturing that not all gains from that the benefits of free trade were realized, output.x Also, since NAFTA, Mexican states bordering the US have received opening up borders would the leadership made strong commitments a higher share of US-based FDI com- be apparent right away; to deregulate the economy. To mitigate pared to other Mexican regions.xi the negative impact, and improve reform many of the dynamic acceptability, they instituted policies such as gains in new products and the PROCAMPO program, established in The US-Mexican technologies, lower prices, 1993–1994 to compensate crop producers bigger markets, etc., would who were expected to face declining prices Asymmetry: An Example after the initiation of NAFTA. In the case manifest themselves over for Smaller South Asian of India, Prime Minister Manmohan Singh time. decided in 2011 to provide a duty-free- Nations quota-free market to all LDCs in the region, Mexico is much smaller than the US, overriding objections by domestic textile but turns out to be the biggest winner from NAFTA despite and other lobbies. initial domestic skepticism. Prior to joining NAFTA in 1994, Another aspect of trade reform is some element of gradu- the arguments made by some in Mexico echo current ones alism.xiv For sectors where there are concerns about large in South Asia: nascent and important industries would job displacements, trade liberalization can be phased in suffer, firms would lose to US competitors, unemployment over a reasonable but credibly finite period, to allow time for would increase, etc. Twenty years after NAFTA, data paint adjustment - with sunset clauses that would end protection a more positive picture. Mexican exports are now $1 billion within a defined period. The phasing in period also provides a day, more than 10 times their 1994 baseline; per capita an opportunity to address horizontal competitiveness income has risen at an average of 1.2 percent annually; and issues, such as flexibility of land, labor, and capital markets. Mexico is now the world’s 13th largest economy (as large Finally, it would be important for policymakers to note that as another NAFTA partner, Canada). Critics of NAFTA often not all gains from opening up borders would be apparent point to the low Mexican growth rate since it joined NAFTA, right away. Many of the dynamic gains in new products compared to ASEAN-4 (Indonesia, Malaysia, Philippines, and technologies, lower prices, bigger markets etc., would and Thailand) or even Chile, but a recent study shows that manifest themselves over time. this did not arise from NAFTA.xii Importance of Leadership and Vision About the Authors Sanjay Kathuria (@Sanjay_1818) is Lead Economist in The above evidence suggests that smaller countries in the the World Bank’s South Asia Regional Cooperation and region could reap significant benefits from a more inte- Integration (SACRI) unit, based in Washington, DC. grated South Asia. Given that the region is in the process of making SAFTA effective, nations that hold out from the Sohaib Shahid works with the World Bank’s SACRI unit process could suffer by being “innocent bystanders”, which and is a Ph.D. Candidate in International Economics at is a welfare loss faced by a country that does not fully par- the Graduate Institute of International and Development ticipate in a regional agreement being created around it.xiii Studies, Geneva. www.worldbank.org/southasia 4 S o ut h A s i a Pol ic y N ot es A d vanc ing R e gional In te gration iii. Chatterjee, B & George, J. (2012). “Consumers and economic cooper- Acknowledgements ation: cost of economic non-cooperation to consumers in South Asia,” CUTS International. The authors would like to thank, without implicating: Mohini iv. Aly Sergie, M. (2014). NAFTA’s Economic Impact. Council on Datt, Michael Ferrantino, Alexander Ferguson, David Gould, Foreign Relations Backgrounder. http://www.cfr.org/trade/ Sindhuja Khajuria, Delilah Liu, Gladys Lopez-Acevedo, naftas-economic-impact/p15790 Martin Melecky, Sebastian Saez, and Salman Zaheer. v. De, P., Raihan, S., and Kathuria, S. (2012). “Unlocking Bangladesh-In- dia trade: emerging potential and the way forward,” World Bank Policy Endnotes Research Working Paper 6155. i. Studies (Falvey et al. 2004, 2006; Melitz and Ottaviano 2005; Baldwin vi. Tunea, C. (2006). “Patterns of FDI in Mexico after NAFTA – the role and Forslid 2010) demonstrate that countries benefit with greater trade of export markets and geographical determinants.” Proceedings, openness irrespective of the differences in country size. Other studies Canadian Economic Association Conference 2006. (Cabrales and Motta 1996; Kowalczyk 2006; Sara 2008) show that vii. Gould, D. (1998). “Has NAFTA changed North American trade?” Eco- small countries benefit more from free trade agreements with larger nomic and Financial Policy Review, Federal Reserve Bank of Dallas, countries. Wonnacott and Wonnacott (1981) demonstrated that a issue Q1, pages 12-23. small country is better off signing a free trade agreement with mutual viii. Wang, Y. (2012). “Openness and Productivity: the role of imports, reductions in trade barriers with a large country than from only getting FDI and international telecommunications,” Latin American Journal of one-sided trade concessions from the large country. Helpman (2004) Economics, Vol. 49 No. 1 (May, 2012), 125-145. also makes the case that smaller countries are more dependent on ix. McKinsey Global Institute (2014). “A tale of two Mexicos: growth and trade, both for exports and imports, and the effect of trade on the prosperity in a two-speed economy,” Mexico City: McKinsey & Com- growth of small economies is significantly larger. Hence, the efficiency pany. The study shows that firms less connected with NAFTA (those of trade patterns (and therefore trade reforms) becomes even more employing 10 or fewer persons) saw a decline in their productivity, important for smaller countries. since they were more influenced by domestic economic changes. See Baldwin, R. E. & Forslid, R. (2010). “Trade liberalization with heteroge- footnote xi for some of the domestic handicaps in Mexico. neous firms,” Review of Development Economics, Wiley Blackwell, vol. 14(2), pages 161-176, 05. x. Scotiabank (2014). “NAFTA: What’s Next,” Special Report, March 31, Cabrales, A. & Motta, M. (1996). “Country asymmetries, endogenous 2014. product choice and the speed of trade liberalization,” CEPR Discussion xi. Clement, N., Rey, S., Fuentas, N., and Brugues, A. (2002). “The Paper 1326. US-Mexican Border Economy in the NAFTA Era: Implications for the Falvey, R., Greenaway, D. and Yu, Z. (2004). “Intra-industry trade Environment” in The US-Mexican Border Environment: US-Mexico between asymmetric countries with heterogeneous firms,” GEP Border Communities in the NAFTA Era, ed. By Norris C. Clement, Research Paper 04/05. SCERP Monograph Series No.4. Falvey, R.,Greenaway, D. and Yu, Z. (2006). “Extending the Melitz xii. Hufbauer, G., Cimino, C., and Moran, T. (2014). “NAFTA at 20: model to asymmetric countries,” University of Nottingham Research Misleading charges and positive achievements,” Peterson Institute Paper No. 2006/07. for International Economics. The study shows that Mexican exports Kowalczyk, C. (2006). “Free trade between large and small: what’s in it between 1993 and 2013 expanded 640 percent, Chilean exports for the large country? what’s in it for the small country?,” The Fletcher expanded 730 percent and ASEAN-4 exports expanded only 420 School, April, mimeo. percent. Mexico suffered from three specific handicaps: first, drug Melitz, M. & Ottaviano, G. (2005). “Market size, trade and productivity,” wars, starting around the same time as NAFTA, brought down GDP by NBER Working Paper 11393. around 1 percent annually; second, the peso crisis, coincided with the Sara, N. (2008). “Bilateral trade liberalization between asymmetric onset of NAFTA; and third, persistent monopolization of key sectors, countries,” November 12, Southern Methodist University, Dallas. poor infrastructure and corruption (unlike Chile and ASEAN-4) dragged Wonnacott, P. &Wonnacott, R. (1981). “Is unilateral tariff reduction down the Mexican economy. preferable to a customs union? The curious case of the missing foreign xiii. Krugman, P. (1991). “The move toward free trade zones,” in Federal tariffs,” American Economic Review, American Economic Association, Reserve Bank of Kansas City, Policy Implications of Trade and vol. 71(4), pages 704-14, September. Currency Zones, 7-42. Kansas City: Federal Reserve Bank. Helpman, E. (2004). “The Mystery of Economic Growth.” Cambridge, xiv. Trebilcock, M.J. (2014). “Dealing with losers: The political economy of MA. policy transitions” Oxford University Press. ii. See, for example: Tovar, J. (2012). “Consumers’ Welfare and Trade Liberalization: Evidence from the Car Industry in Colombia,” World Development, Elsevier, vol. 40(4), pages 808-820. Advancing Regional Integration in South Asia World Bank Group 1818 H Street, NW The SARConnect series aims to provide pointed analysis and discussion Washington, DC 20433 of topical cross-border issues in South Asia, with a view to stimulating and deepening the dialogue on regional economic cooperation. The Tel: 522-08-7775 findings, interpretations, and conclusions expressed in this work do not Email: SARConnect@worldbankgroup.org necessarily reflect the views of The World Bank, its Board of Executive www.worldbank.org/southasia Directors, or the governments they represent. 1415233 www.worldbank.org/southasia