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Going beyond Indo – Sri Lanka FTA: An opportunity not a threat

28 April 2015 02:55 am - 0     - {{hitsCtrl.values.hits}}


The Ceylon Chamber of Commerce has the concept of Nation 1st; Private Sector 2nd; and Companies 3rd at the heart of all its policies, advocacy and activities. 
Uplifting the quality of life of all the people of Sri Lanka is, therefore, an over-riding objective. This is based on the premise that what is good for the country is good for the private sector whilst the reverse may not always hold true. In practical terms, this means focusing upon ways and means of achieving sustained increases in the incomes of the people on the basis of balanced and inclusive growth of the economy.
In a country of 21 million people, this can only be achieved by supplementing the domestic market with a sharp focus on external demand i.e. exports. 
The transformative successes achieved by several Asian countries demonstrate this vividly. It is noteworthy that countries varying in size from China to Singapore have gone down this route. In a context, where multilateral trade negotiations (the Doha Round) have stalled and regional integration is constrained by tensions between India and Pakistan, there is a robust case for attaching high priority to bilateral agreements. In this connection, given the significant competitive advantages associated with proximity, Sri Lanka needs to deepen and extend the existing FTA with India. Priority should also be attached to completing the FTA with China and making greater use of the Agreement with Pakistan. FTAs with other countries should also be pursued in a systematic way to support diversification of export markets.
Sustained improvements of living standards cannot be achieved without increased investment to drive productivity-linked expansion of economic activity, particularly exports. 
The domestic pool of investment is inadequate to achieve the country’s growth target of 8 percent. There is a savings/investment gap of about 5 percent of GDP. FDI, which is non-debt creating, offers the best option for filling this gap, with its added benefits of technology, know-how and markets.  It needs to increase from the current disappointing level of US$1 billion (2014) to US$4 billion. The domestic market is not large enough to attract this magnitude of FDI. It would be possible only if the prospects of export growth are improved. 
Bilateral arrangements, which promote preferential access to larger markets and improve the investment climate, are, therefore, a crucial component of the landscape for attaining an improvement in the living standards of the people of Sri Lanka over a decade or more. Deepening the ISLFTA in goods and extending it to services and investment fits very much into this narrative.
This article focuses on: the case for bilateral agreements; the need for a new growth model; deepening and extending the ISLFTA; the need for refection and a self-critique; the need for urgency as opposed to procrastination.

Case for bilateral trade agreements
In an ideal world global trade should be boosted through multilateral trade liberalisation. The Doha Round should be completed. The development dividend, which was promised at the launch of the negotiations, should be delivered. 
One can argue that bilateral and regional trade agreements are sub-optimal as they lead to trade diversion. They also result in a spaghetti or noodle bowl of trade agreements which lead to information asymmetries (it becomes difficult to keep up with the terms and conditions of various agreements) and increased transaction costs. However, the political will to complete the Doha Round is unlikely to materialise in the foreseeable future as concerns regarding unemployment in Europe and general labour market weakness in the US are likely to prevail for some time. 
In the meantime, all around the world countries are pushing ahead signing bilateral and regional trade agreements. 
Furthermore, Sri Lanka is excluded from the major regional trade negotiations currently underway e.g. the Trans Pacific Partnership (TPP) and the US/EU trade and investment agreement. So there is a strong rationale for Sri Lanka pursuing its trade interests through bilateral and regional agreements – to deepen existing ones and sign new ones. In this context, there is a strong case for giving high priority to building upon the existing ISLFTA; completing the FTA with China; making greater use of the FTA with Pakistan; and negotiating with ASEAN and South Korea.

Need for new growth model
In recent years, growth in Sri Lanka has been driven by foreign commercial public borrowing led infrastructure development. 
Headroom for this model is now severely constrained. Sri Lanka’s debt to GDP ratio is 74 percent; the median for our peers with the same rating is 44 percent. The external debt service ratio is 25 percent. The rule of thumb is that one enters amber light territory when this number gets over 20 percent. 
The total debt service payments, domestic and foreign, are over 100 percent of government revenue.  Hence the borrowing financed infrastructure development growth model is no longer viable due to these adverse debt dynamics. 
Moreover, the infrastructure-led growth model has not translated into appreciable growth in household incomes which remain below par in most homes in the country. Sri Lanka needs to move very quickly to strengthen what we have known for a long time but have not achieved: export-led growth. If not, growth will slow down.
It is a truism that a country with a population of 21 million can only attain a growth target of 8 percent or more on a sustained basis through export expansion. We have known for several decades that an accelerated growth trajectory can only be achieved in this way. The slogan ‘export or perish’ was first uttered in the late 1970s. However, in the intervening four decades, our export record has been poor. Countries like Malaysia, Thailand and Vietnam record exports which amount to over 70 percent of their GDP. In Sri Lanka, we have gone backwards. Fifteen years ago, exports amounted to 32 percent of GDP. Now exports of goods amount to about 15 percent of GDP and services account for a further 5 percent. i.e a total of 20 percent compared to the 70 percent plus achieved by the successful SE Asian countries. This needs to be turned around very quickly because, as mentioned above, Sri Lanka currently lacks a growth model. 
The repeating cycle of stop-go policies, which have characterised the post-77 era, can only be broken by developing an export-led development model. This process can be greatly facilitated by signing bilateral agreements which promote trade and investment. Leveraging our proximity to and deep ties with India and our friendship with China should be a major part of this narrative.

Moving beyond Indo-Lanka FTA
It is important to understand the changing landscape within which these negotiations are taking place. India has reset its relations with the countries in South Asia. It has concluded that peace and prosperity in the region would not only benefit its own development but also create a more conducive environment for pursuing its ambitions as a rising global power. It does not want to be distracted by irritations in the neighbourhood. 
Significant advances are already underway in India’s relations with Bangladesh, Nepal and Bhutan, particularly in the areas of power generation and grid connectivity, as well as land and rail transit which would boost trade. Sri Lanka should not be left behind. 
Modi’s visit to Sri Lanka was the first in 28 years by an Indian PM. It reflects India’s changed stance towards this region. 
The debate on the merits of the Indo-Lanka Comprehensive Economic Partnership Agreement (CEPA), as a means of taking advantage of our proximity to a resurgent India, seems to divide the protagonists on the basis of whether India is seen as an “opportunity” or a “threat”. Some of the antipathy to the Indo – Lanka CEPA is based on primordial fears and insecurities which are not evidence-based or rational.  Sadly, one side of the debate is often characterised by misinterpretation and misinformation. Emotion rather than hard-headed calculation based on current realities seems to dominate thinking. 
In some instances, individual corporate interests appear to outweigh the national interest and those of the people of Sri Lanka. Some critics also fail to take into account recent improvements in the bilateral trading environment. Modi clearly signalled the willingness to do more. It would be a mistake not to take advantage of this. Failure to do so would not be in the interests of Sri Lanka or its people. Other countries in the region and much of the rest of the world see India as an increasing opportunity. It would be a great pity if we ignore what is available at our door-step. We need to transcend our narrow-minded fears. The failure to do so would deprive Sri Lanka from taking advantage of a potentially transformative opportunity to boost its development prospects.
However, there is also more considered opposition based on the following argumentation which requires careful examination. 
  •     The asymmetry between the two economies means that the CEPA would inevitably be detrimental to Sri Lanka’s interests resulting in a loss of output (growth) and employment. 
  •     The ISLFTA has been a failure with more costs than benefits for Sri Lanka. 

Asymmetry between the two economies
The argument that the asymmetry in the size of the two economies would preclude a mutually beneficial CEPA ignores some important facts. There are provisions in all trade agreements for negative lists and safeguards. 
There can also be differences in the time periods over which the parties liberalize trade in the items on the positive list. The Indian authorities have shown an increasing willingness to adopt the principle of non-reciprocity to take into account the asymmetry of the two economies i.e. Sri Lanka has room to maneuver when it comes to the negative list, safeguards and the speed of liberalization. 
The focus, therefore, should be on negotiating to maximize the benefits for Sri Lanka through, among other things, effective use of these mechanisms. 
There are examples from the Asian region where deeper economic links have yielded substantial benefits despite asymmetry in the size of the economies involved. Singapore has been able to use its integration with the ASEAN economies, including Indonesia, to generate positive development outcomes for itself. Similarly, Hong Kong has benefited enormously from its link to the massive Chinese economy. It is also noteworthy that Mexico has benefited more than the US or Canada from the North Atlantic Free Trade Area (NAFTA).

Indo – Sri Lanka Free 
Trade Agreement (ISLFTA)
Some have argued that the ISLFTA has failed. They cite negative experiences regarding Vanaspathi oil and copper, as well as a number of very persistent non- tariff barriers, to make their case. The ISLFTA has certainly had a number of problems associated with it. 
However, it has also provided a framework for addressing these issues. The trading environment in goods has improved and a number of sources of friction have already been addressed. There is more to be done. Indeed Prime Minister Modi alluded to this when he addressed the Sri Lankan business community during his recent visit.  
Sri Lankan exports to India increased from US$56 million in 2000 to $559 million in 2005. They declined to $418 million in 2008 and $325 million in 2009. The fall in exports to India during the period 2007 – 2009 may be attributed to reductions in vegetable oil, primary copper and pepper as India eliminated opportunities to arbitrage on tariff differentials. 
However, it is noteworthy that the limited basket of exports to India at the inception of the ISLFTA was diversified during the period 2007 – 09 with the emergence of new items such as animal feed, electrical appliances and accessories, vessels, paper products, glass and plastic products. 
This happened despite the significant appreciation in the real effective exchange rate during this period. Since then, Sri Lankan exports have increased to $625mnin 2014, despite the fact that the Indian economy lost growth momentum due to policy paralysis.
Imports from India increased from US$ 600 million in 2000 to US$ 3007 million in 2008, and subsequently declined to $ 1710 million in 2009. The decline in 2009 may be explained by the overall slowdown in the economy and the resulting import compression during that year.  They have subsequently increased to $3978mnin 2014. Major imports from India include petroleum products, iron and steel, cotton, motor cycles and motor vehicles. 

Sri Lanka’s trade deficit with India grew from US$ 544million in 2000 to $2589 in 2008. It subsequently declined to $1385 in 2009 and then increased to $ 3353mn in 2014. It is important to analyze this growth in Sri Lanka’s trade deficit with India.  
It is noteworthy that imports which are on our negative list, such as motor vehicles, petroleum products, agricultural products and paper products have grown as part of normal trade (i.e. without the benefit of preferential tariffs). 
This implies these imports were internationally competitive and served to provide Sri Lankans with cheaper goods and to reduce the overall trade deficit by reducing import costs. One cannot, therefore, conclude that the ISLFTA has caused a sharp increase in the trade deficit with India. Much of this deterioration in the trade balance would have happened even without the ISLFTA as much of the Indian goods have been imported on MFN terms without the benefit of preferential tariffs. In most years, over 80 percent of Indian imports have been outside of the ISLFTA (on MFN terms) while about 70 percent of Sri Lankan exports to India have been on a preferential basis.

* Trade from March - December
The ISLFTA has resulted in an increase in total Sri Lanka – India trade from US$ 656 million in 2000 to US$ 4.6 billion  in 2014. Though exports have grown far less than imports, Sri Lanka has benefited through both an expansion as well as diversification of the export base to India. 
In addition, the deterioration in the trade balance would have taken place with or without the ISLFTA because of the competitiveness of Indian imports which have provided the people of Sri Lanka with access to cheaper goods. 
There has also been an increase in Indian investment in Sri Lanka. It has now reached US$1 billion. There is a pipeline of a further US$1 billion. This may be attributed, at least in part, to the ISLFTA in that it has created the conditions for increased investment to take advantage of growing bilateral trade relations. 
India has been the largest investor in Sri Lanka in recent years.  Much of this investment has been in services, such as health, education, fuel distribution, hotels, tourism, IT training, computer software and professional services. 
Despite the increase in trade and investment since the signing of the ISLFTA, performance is unimpressive when one compares it with what other countries have achieved in their trade with India even without an FTA. 
The ISLFTA provides market access for a wide range of products. At present, at 6 digit HS level 36 of the 3000 product groupings account for 75 percent of the exports from Sri Lanka to India via the ISLFTA. This provides the Sri Lankan private sector with considerable scope to explore how to take better advantage of the opportunities which are currently available but are not being utilized.

Negotiations with India
The negotiations with India should focus on the following: 
  •     Addressing the impediments which are constraining the full benefits of the Indo – Sri Lanka FTA (ISLFTA). It is encouraging in this respect that the Indian Prime Minister indicated that priority would be attached to addressing these issues. It is important to follow-up on this.
  •     The existing FTA should be deepened by reducing, in particular, the Indian negative list.  India has demonstrated some flexibility on this.
  •     The agreement in the trade in goods should be extended to include services and investment. The nomenclature does not matter. One can label it CEPA, CECA or something else. A combination of misunderstanding, misinformation and falsehoods has given “CEPA” a bad name. If it is helpful, the name should be changed. 
  •     There is a strong case for including services and investment in the agreement.

    Now that Sri Lanka can no longer leverage low labour costs, there is a general consensus that it has a better competitive advantage in services (shipping, aviation, ICT/BPO/KPO, financial services etc). For instance, Sri Lanka has a competitive advantage in shipping and logistics. It is a clear strength because of its location and the relative efficiency of the Colombo port. If earnings from providing such services to India are not increased at a time when its trade volumes are likely to expand sharply, the prospects for realizing the full potential returns from the large investment made in our ports are likely to be diminished. Hence, it would be illogical not to include services, particularly as India has recognised the principle of non-reciprocity and Sri Lanka would be opening up far less than India. 
In fact, Sri Lanka will be opening up very little beyond what is already available under existing agreements, such as the BOI Act. The alarmist claims that the country will be flooded by professionals and barbers are not founded on facts. Sri Lanka will not accept a CEPA agreement which would permit that. Nor is India asking for this as its interests are not driven by narrow market access. There is a strong political dimension based on India re-setting its relations with countries in the region and the entry of the dragon (China) into the neighbourhood.
It is also very important to include investment as the trade – investment nexus is crucial for maximising benefits from trade agreements between asymmetrical economies. Increased Indian investment to create competitive supplies to export back to India is also important for addressing the trade deficit between the two countries. Increased Indian investment can also generate more exports to China and Pakistan using the FTAs with those two countries. Sri Lanka can act as a bridge using the three agreements to its advantage.

Need for reflection
Exporting to India is not easy. There are well known NTBs and bureaucratic hurdles which need to be overcome. However, we need to ask ourselves the question whether we can use this as the main excuse for the relatively disappointing outcomes of the ISLFTA. There are grounds for self-examination and self criticism. During the period that the FTA has been in existence (2001 to-date) China has increased its exports to India from US$ 1.5 billion to over US$ 50 billion. 
Countries in SE Asia have also been much more successful than Sri Lanka. They have achieved this without the benefit of an FTA (India-ASEAN CECA was signed very recently). 
This seems to indicate that the bigger problem is not the difficulty of exporting to India but rather the lack of competitive goods and services to be exported from Sri Lanka. The overall policy framework needs to be more export-friendly and the private sector needs to learn from countries/companies which have been more successful in penetrating the Indian market.

The case for urgency
The economic asymmetry between Sri Lanka and India is going to increase in the future as the latter emerges as a major global player in an increasingly multi-polar world. 
This increases the need for a rules-based regime to manage Sri Lanka’s bilateral trade and investment relations with India. This has become particularly important in the absence of progress on multilateral (Doha Round) and regional (SAFTA) frameworks.  As a result, there is a case for negotiating the CEPA sooner rather than later in a context where the power relations between the two countries are likely to become even more asymmetric and India would inevitably continue to be a major trading partner given the immutable realities of geography.
In addition, delay would also allow others to steal a march over us. India is pursuing a number of FTAs. The more that are signed before us, the greater will be the erosion of potential benefits. Others, including our competitors, are already pressing ahead. They are not going to wait for us to get over our irrational primordial fears. It is noteworthy that the ASEAN countries, which have ratified a Comprehensive Economic Cooperation Agreement  with India, comprise both economies that are somewhat more developed than Sri Lanka (e.g. Malaysia, Thailand and Vietnam) as well as those that are less advanced (e.g. Cambodia, Laos and Myanmar). 
Countries as diverse in their economic development as Singapore and Cambodia/Laos have ratified the CECA with India. They have concluded an agreement which they believe will be beneficial for their people. If such a range of countries consider it advantageous to have such an agreement with India, it raises the question why Sri Lanka should be fearful of the impact of a CEPA on investment, growth and employment in this country. 
In addition, India has now become the fastest growing large economy in the world. It is likely to maintain this position in the coming years. It has overtaken China from a much lower base. There is growing global interest in the Indian market. By procrastinating, we will fall further behind in terms of accessing the growing Indian market. Seven years have lapsed since a draft CEPA was ready. Further delays based on emotion rather than facts would not be in the interests of the country.
There are two further factors which make the current context more propitious than 2008. First, Modi’s “Make in India” strategy is likely to spur manufacturing growth. This can create opportunities for Sri Lankan companies to plug into new supply chains of Indian companies and MNCs operating in India i.e. an opportunity to replicate what happened in East and SE Asia where the rise of first Japan and then China pulled up the whole region through supply chains. Secondly, in the past, poor infrastructure in both India and Sri Lanka made it difficult to take advantage of geographical proximity by increasing transport/transaction costs. 
The improvement in infrastructure in both countries is addressing this problem and can reinforce the point regarding supply chains by making it easier to realise the benefits of proximity.
Another positive development related to trading with India is the anticipated introduction of a goods and services tax. It will result in doing away with a number of state level taxes and levies. This will create better enabling conditions for the creation of a common market in India which will reduce transaction costs and significantly improve the prospects of doing business with the country.

An ongoing World Bank study has pointed out that greater trade integration with India can generate large gains for the smaller countries in South Asia. A CEPA can offer benefits for both sides. Sri Lanka can benefit from a larger market that will allow the realization of economies of scale, the ability to integrate into large value chains as well as access to investment which can bring in technology, markets and know-how. India, for its part, can demonstrate the value of a productive partnership with a neighbor, which, if emulated, has the potential to stimulate growth and reduce political friction in the neighbourhood –a priority for India as it pursues its global ambitions. 
The proposed Indo – Lanka CEPA can refine the existing disciplinary framework for the trade in goods by addressing major issues that have hitherto constrained benefits from the ISLFTA. These include conformity assessment procedures and product standards. It can also introduce rules-based regimes for trade in services and investment as well as strengthen the dispute – resolution process at a time when the asymmetry between the two countries is going to increase as Indian growth accelerates.
The debate on the proposed Indo – Lanka CEPA should be focused on a hard-nosed assessment of potential benefits and costs rather than on emotion and primordial fears. This article also argues that it should not be based on the premise that economic asymmetry precludes mutually beneficial bilateral trading agreements. The asymmetry can be addressed through negative lists, safeguards and differential transitional arrangements, particularly as India has accepted the principle of non-reciprocity. Furthermore, it is in the interests of smaller countries to seek a rules-based regime to manage relations with much larger trading partners. In the absence of a disciplinary framework everything has to be negotiated on a case-by case basis with a much more powerful partner. The challenge is to negotiate effectively and strive for good faith on both sides. 
Concern is often expressed that a combination of political interference, vested private sector interests and lack of capacity constrain the ability of Sri Lankan negotiators to pursue the country’s objectives effectively in trade negotiations, particularly with a country as large as India. A more transparent process, which involves key stakeholders and mobilizes technical expertise, both within and outside the government, can increase Sri Lanka’s capability to achieve favourable outcomes which are beneficial to the country and its people through effective negotiations.
In conclusion, it must be re-iterated that it is in the national interest to advance an Indo – Lanka agreement which deepens the existing FTA on the trade in goods and extends it to services and investment. 

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