The Political-Economy of the South Asian Economic Union -- By: Athar Osama

In a preceding article on the subject, I analyzed the merits and demerits of South Asian Free Trade Agreement (SAFTA) from an economics standpoint. I concluded that if economic theory and the experience of existing trading arrangements was any sign of things to come, SAFTA does not seem to make much economic sense, at least not in the short run, and without adequate the necessary safeguards and sharing or transfer of costs and benefits among participant countries--mechanisms that they have, thus far, largely hesitated to put in place or have ignored outright. The political-economic ambitions of the region's politicians, however, do not stop here. The 2002 Katmandu Declaration on Economic Integration, in addition to calling for creation of a South Asian Free Trading Area by 2006, calls for the creation of a South Asian Customs Union (SACU) by 2015, and a South Asian Economic Union (SAEU) by 2020.

In this article, I would go beyond the case for SAFTA and examine whether, in the longer-run, a South Asian Economic Union along the lines of European Union, for example, makes any more or less sense than the former. In doing so, I would look at the issue from two lenses. Firstly, what additional effort and political-economic capital would the SAARC countries have to spend to realize a full-blown economic union, under what circumstances does that make sense, and what bottlenecks might be expected along the way. Secondly, and more importantly, whether or not a political rationale for moving forward with an economic union change our decision calculus, and if so, what are the implications of that for how the countries must approach the current (and on-going) efforts to bring about SAFTA in the lead on to an SAEU.

To answer the first question, it is important to first understand what various types of trading and economic integration arrangements mean and what are their inter-relationships with each other. These agreements can be broadly characterized under two classes, namely, free trading arrangements-blocks and economic integration schemes. The former-type deal strictly with ever deepening level of trade cooperation between participant countries while the latter-type includes other aspects of national policy, in addition to the trade, as well.

The various classes of trading arrangements start from a natural trading block that is an informal and naturally occurring ( i.e. not achieved through conscious policy choice) arrangement between countries which trade disproportionately with each other; to a preferential trading agreement in which two countries choose to apply lower tariffs to each others' products than to the same goods coming from other countries; to a free trade area that comprises an association of trading nations whose members agree to remove all tariffs and non-tariff barriers among themselves; and finally the customs union that is an agreement between two or more political jurisdictions to abolish customs duties and other trade restrictions among themselves and to adopt a common policy regarding trade with political jurisdictions outside the union.

Among the second class of these arrangements, namely, the economic integration schemes, are the common market that requires, besides the establishment of a customs union, the free movement of all factors of production, namely, goods, capital and labor and a gradual coordination of economic policies to sustain the arrangement; the monetary union that requires national governments to give up two key instruments of economic policy, namely, exchange rates and monetary policy, followed by establishing of common foreign reserves and a common stand on international monetary negotiations ; and finally, the economic union that goes beyond the monetary union and requires harmonization of social, taxation and fiscal policies by a supranational governing institution through a partial or complete transfer of national sovereignty.

What is interesting about this taxonomy is the pre-requisites and conditionalities as well as the relationships between the various kinds of arrangements. Establishing a customs union, for example, requires a lot of give-and-take on the part of the participants as they have to come up with a mutually agreeable and uniform external tariff structure that all members could live in. While a free trade area, on the other hand, allows some degree of relaxation as members
can have their own external tariffs for non-members countries that allows them, to an extent, to protect their import competing sectors. In Paul Krugman's words, therefore, "the latter [free trade area] is politically straight forward but an administrative headache, while the former [customs union] is just the opposite". Setting up each successive layer of integration also requires expending increasing levels of additional economic and political capital on the initiative. While the conditions for free trade areas and customs unions are relatively technical, setting up a common market requires considerably more commitment through factor mobility that might in turn require certain social commonalities like language, ethnicity, race and non-discrimination in certain elements of public policy. Going a step further, for example, in setting up an economic union calls for an even greater commitment and coordination between its members as it requires, in its strictest form, the alignment of monetary, fiscal and even social policy – all of which are generally considered as sovereign rights of a nation state.

C. Westerate, in a 1948 paper titled "The Economic and Political Implications of a Customs Union", talks at length about how the establishment of a Customs Union requires not only the absence (between the union countries) of import duties, quotas and exchange controls, but also of other protective measures, such as export subsidies and preferential rates etc. In a very simple yet convincing way, Westrate goes on to elucidate how an Economic Union between countries is bound to imply that the countries must have identical policies on a whole range of economic and social issues such as price policy, internal monetary policy, credit policy, wages policy, labor legislation, taxation policy, international trade policy, employment policy, external monetary policy, trust and cartel policy, and policy vis-à-vis nationalization of industries etc.

Westerate's analysis highlights how imbalances between these policies of member countries would lead to capital and labor flight towards the country of favorable policy position and thus undermine the political feasibility of such a union. Simply speaking, if SAARC countries are to form a South Asian Economic Union one day, they must be prepared to relinquish sovereignty over a whole list of policy areas not only within the trade sphere but also within the broader socio-economic sphere as well. Under this scenario of open and free movement of goods, capital, and labor, therefore, if any one of the SAARC countries (lets say India or Pakistan) want to encourage a certain industry by providing some protection or subsidies to it, this action is likely to create imbalances in that country in the favor of that particular industry which would mean that that industry in other countries would begin to migrate to this favorable country. This is going to mean a loss of revenues for the country where the industry is migrating from and hence attract retaliatory treatment of some sor thus jeopradizing the political feasibility of the economic uniont. The same dynamic plays out in all of the above mentioned policy areas.

This, Westerate argues, means a loss of policy sovereignty for all of the member countries involved, irrespective of whether they like it or not. Failing to do would mean that either the economic union would collapse under political pressures or the full benefits of an economic union would not be realized by the participating countries. Westerate's analysis, taken on its face value, has considerable logic behind it. It also imposes a very strict set of conditions on any such proposed venture. Setting up a customs union, a common market, or an economic union is certainly no child's play. It is very serious business that raises a whole Pandora's Box of interesting issues and challenges for the participating countries. Are the countries involved committed enough to the idea of an economic union that they would make the hefty economic, social, and political sacrifices needed to realize such an arrangement? Are the imperatives of setting up an economic union strong enough that the participants are willing to give up their sovereignty of economic and social policy? Are the countries involved willing to share--through mechanisms of fiscal transfers--the burdens that might, time and again, accrue to them due to the loss of autonomous policy-making ability?

Until these and other tough questions are adequate addressed by the politicians and people of the respective countries, the claims of setting up common markets and economic unions are just that--merely claims. Since the political requirements of undertaking an economic union are much more difficult and stringent than a common market or a free trading area, there is sometimes a likelihood that the strictest of all the conditions could eventually end up driving the results of even the preliminary stages of integration. This has particularly been the case with SAFTA and its precursor SAPTA (South Asian Preferntial Trading Area) whereby political considerations and rivalries have often hampered the realization of welfare benefits from the relatively harmless free trading arrangement.

What is, then, the future of the South Asian Economic Union? The answer to that question comes from the political rather than economic realm. As alluded to in a recent article by Dr. Shahid Javed Burki, a ex-WB economist and longtime proponent of SAFTA, the overriding motivation for forcing these seven South Asian countries and their 1.4 billion people towards greater integration are clearly political. After the end of the second world war, for example, it was inconceivable that Germany and France would ever enter into an economic arrangement--much less a union--of the kind that they find themselves in today. Some have argued that the biggest benefit of the EFTA and EU is that it has diminished the prospect of another war between these traditional European rivals to a virtual impossibility. Similar factors were at play when ASEAN was founded in the 1960s as the smaller countries in South East Asia region vowed to cooperate amongst each other to guard against possible invasion by larger players in the region ( e.g. China, Korea, and Japan). That seemed to have worked thus far as well.

The proponents of SAEU--whether they belong to the SAARC region itself our outside of it--are clearly looking at the larger political gains that are to be achieved from this scheme. Whether SAFTA and SAEU would be able to tie these seven South Asian countries, often at odds with each other, in bonds of friendship and tolerance is an open question. If anything, the past record of SAARC seems to suggest the opposite. Through its history, SAARC has been seriously hampered by the regional rivalries of these countries, especially that of its two largest players, India and Pakistan. Would forging ahead with SAFTA/SAEU change the foreign policy dynamic between these two very important members of the group or would it become another classic case of throwing good money after bad?

If the past and current behavior is a credible sign of things to come, the chances of realizing its political objectives of the SAFTA/SAEU are somewhat questionable. This is primarily because of the demonstrated lack of magnanimity among its larger members, most notably India, towards the smaller ones. While Indians may have lesser to gain economically from such an arrangement, they certainly have much more to gain politically if SAFTA or SAEU is to become a success, for it would not only cement India's tricky relationship with its neighbors but would also give it the largest share of representation in the unified voice of a (sub-)continent. Besides, as has been the case with EU and NAFTA, successful and sustainable economic integration arrangements require a large country to act as an anchor for the arrangement. The question is: Can Indians make the kind of sacrifices (made by larger EU members e.g. Germany and France) needed to make this arrangement a reality? Can India really prove themselves worthy of leading a group of skeptical countries without actually making them feel that they are being led? Can India show the kind of magnanimity fitting of an emerging super-power that has no insecurities about its new-found status--and hence no need to assert it--that would be required of an anchor country to make SAFTA/SAEU a success? This is the same role, played by Germany and France for the EU and the United States for NAFTA, that have helped keep these arrangements on track.

If the unsuccessful SAARC is to transition into a successful SAFTA (and more), the countries of this region would have to have a clean break from the past and build a different kind of relationship in the future. The onus for doing so clearly lies with India. Without that, SAFTA is likely to be still-born or, at the very least, lead to suboptimal results. The other countries of the SAARC region are justified in looking towards India's current actions, policies, and postures for signs of things to come. If, for legitimate or not-so-legitimate reasons, such degree of commitment is not to be expected of the SAARC countries, especially India and Pakistan, going forward with SAFTA, SACU, and SAEU is going to be a costly experiment whose failure can be easily foretold.


The author is a public policy analyst and a Doctoral Fellow at Frederick S. Pardee RAND Graduate School for Public Policy, Santa Monica, CA. Email: Athar.Osama@gmail.com.

The "Forgotten" Economics in the SAFTA Debate -- by: Athar Osama

With the recently concluded meeting of the SAARC Leaders in Dhaka, the debate on the South Asian Free Trade Agreement (SAFTA) has once again come into the forefront of the foreign policy discussion in the region. Many Pakistani newspapers have carried news items and editorials on the subject. On November 11, 2005, for example, this newspaper carried a news clipping that suggested that the Foreign Ministers of the the seven South Asian countries were meeting to "push a free trade agreement". If this were to come true, the resultant South Asian Free Trading Area (SAFTA) would create the world's biggest free trade area comprising 1.4 billion people, including 60 per cent of the world's poor. The news item, however, did not stop here and went further to quote an "anonymous" source in the Foreign Ministry as stating that the council of Foreign Ministers of SAARC states would aim to push regional integration forward to include "trade in services, enhanced investment and harmonizing of customs union and, beyond that, a South Asian Economic Union." (SAEU)

While much of this, one would assume, is likely to be merely hype and symbolics, the discussion and its portrayal in the media, however, is striking in its lack of participation of the trade experts and theorists of the region. Like war, politics and economics too are too important to be left to politicians alone. It is not only the right of the people--the citizens of all seven of the South Asian countries--to know the various arguments in support for or against the establishment of SAFTA and SAEU but also to be fully engaged in the decision, if and when such a decision is required of them. It is not merely an act of coincidence that European Union, over the last decade or so, has seen several referendums to judge the opinion of the respective people of its member countries on whether and how to proceed forward with greater integration. Free trading areas, and especially economic unions, whenever they come about, require tremendous commitment and impose disproportionate costs on various segments of the populations of the countries involved, that must be taken into account and catered for before moving forward, or at the very least, must be made known to those who are most likely to bear these.

Yet, in their enthusiasm to become a part of a free trading zone or an economic union and not be left out in this new found euphoria, politicians and even trade experts, in the recent years, have talked rather casually about these very serious instruments of economic and trade policy. The political and economic costs of miscalculation or misadventure are substantial, not only in terms of the opportunity cost but also the distress and dislocation of affected segments of the population. This article is an attempt to critically evaluate the possible effects of SAFTA in the light of the economic theory and practice of trading blocks. In a future article, I would address the broader issues and challenges in putting together an economic union of SAARC countries. For paucity of space and time, this would clearly not be a conclusive discussion on the subject. What it attempts to do, however, is to highlight certain elements of our collective knowledge and experience that is clearly missing from the ongoing debate leading to these momentous events and decisions in our history. It is important that we ponder over these issues, debate their value, and exercise adequate judgment and caution moving ahead with these irreversible, and potentially costly, changes.

The trend towards greater regionalization in the international trade has been continuously evolving alongside more one of greater globalization. These developments are partly motivated by the realization, on the part of the western nations, of the political difficulties of trying to 'pull everybody together on the high-road to prosperity through trade liberalization' and partly due to the mere negotiating burden of establishing a worldwide free-trading regime as has been experienced during the Uruguay and Doha Rounds of trade talks. The approach of pursuing concurrent regionalization and globalization of trade, therefore, allows their proponents to materialize whatever gains from increased trade that they can without having to wait for the entire world to come on board. While this trend towards regionalization of trade has certainly helped in pushing the agenda of the multi-lateral trade talks, the benefits of these regional arrangements have been more suspect.

Before we attempt to theorize the potential benefits of SAFTA by looking at the benefits realized from other similar arrangements, like EFTA, ASEAN, MERCUSOR, GCC, and NAFTA etc., it is important to revisit some lessons from the trade theory. The theory of international trade has come a long way from its simplistic view of Ricardian comparative advantage that advocated the welfare enhancing effects of free trade "no matter what". Paul Krugman, an influential MIT economist, having pioneered the field of strategic trade theory, acknowledges the inevitable ground reality "that everybody could gain, however, doesn't mean that every actually does".

Several trade economists have highlighted the conditionalities that must precede the realization of substantial benefits from various kinds of free trading and economic integration agreements. Maskell, Lipsey, and Viner talk about these in the context of a customs union, for example. According to them, some of the economic characteristics of countries that are ideal to create welfare-enhancing customs unions (and by that extension trading blocks and economic unions) are: complementary yet competitive economic and industrial structures; greater proportion of trade among members relative to total trade; closely coordinated exchange rates; larger economic area; less complementarity vis-à-vis protected industries; greater differences in cost structures of production of similar products among members; and greater range of products etc.

In fact Mikesell, while specifically looking at the prospects of trading arrangements between developing countries, stresses that many of the characteristics of the developing countries contemplating such arrangements, namely, intra-regional trade comprising mostly commodities (either due to complementary natural endowments or agricultural escape clauses), non-existence of trade in manufactures or industrial goods, generally import substitution orientation, disparate levels of development, and lack of proper redistribution policies make them unfavorable candidates for such arrangements, especially if undertaken amongst themselves.

The prescription from this analysis being that developing countries with similar economic and social structures stand a much lesser chance of benefiting from free trading agreements and economic integration arrangements, and therefore, must be very cautious before attempting to implement these. Maskell, however, allows for the possibility that while, for developing countries, the opportunities of static ( i.e. one time) welfare-enhancing benefits from such arrangements are small, there might be some dynamic benefits to be gained over the longer run. These include possibilities of greater specialization by altering the consumption and investment patterns, increased competition within industries, and major re-organization of domestic markets.

The overwhelming evidence from three free trading arrangements between similar sets of developing countries, namely, Mercusor, GCC, and ASEAN, however, tells a different story. Mercusor ( i.e. Mercado Cummun del Sur or Common Market of the South) is an economic arrangement of Latin American countries with Brazil and Argentina being the leading players in the arrangement that includes smaller countries such as Peru, Uruguay, and Paraguay etc. Started with much fanfare in 1991, Mercusor has little to show in progress against its very ambitious goals and has almost gone into an oblivion.

GCC ( Gulf Cooperation Council) is another arrangement between relatively similar developing (or semi-developed) countries in the Arab world that comprises 6 nations of the Persian Gulf, namely, Bahrain , Qatar, UAE, Saudi Arabia and Oman. With an initial deadline to establish a Common Market well past its year 2000 mark, it too has little to show in terms of accomplishments. The intra-GCC trade remains below 10% of the member countries' total trade of around $100 billion a year. The intra-Arab investment that it was supposed to generate shows and even more abysmal picture. Arab countries, on average, invest 1 dollar in other Arab countries for every 8 dollars that they invest outside the Arab world.

Similarly, while ASEAN seems to have made some headway in its political and social goals of achieving regional stability in South East Asia, its economic record is patchy. The main thrust of the ASEAN's economic arrangement was on joint venture investment cooperation between members which, some believed, would help create something along the lines of Europe's 'national champion' industries that would be able to exploit ASEAN-wide markets through effective monopolies and become competitive in the rest of the world. Three notable programs, namely, ASEAN Industrial Investment Projects (AIP), ASEAN Industrial Complementation (AIC), and ASEAN Industrial Joint Venture Program (AJV) were launched to undertake such projects. From its inception in 1967 until 1987, 30 AIC projects proposals had been considered but only 2 had been approved, both in the automotive industry. No AJV projects were implemented in the first six years of that program. The generally accepted verdict on these ASEAN schemes for coordinating investment projects and increasing complimentarity of the economic structures of the member countries is that they have failed because of the "effective opposition of national interests concerned for the profitability of their local investments".

The relatively thin record of achievements of the three economic integration arrangements most relevant to our experience calls into question the economic logic behind SAFTA itself. Clearly, the lessons learnt from several of the arrangements cited above or even SAARC's prior record on promoting intra-regional trade have not made it into the deliberations that have led to policy-making and target setting on SAFTA. The inherent logic behind the proposed, very ambitious, deepening of economic integration in South Asia seems to be that since the lesser ambitious schemes of regional integration ( e.g. SAARC itself) don't seem to have resulted in increase in trade between these countries, forging ahead with more ambitious ventures (such as SAFTA, SAEU etc.) might actually push things beyond a point of no-return and literally force these countries to enhance trade with each other.

This logic clearly does not internalize the idea that despite the ambitious designs of SAFTA proponents, the reality of the quite similar and even competing economic structures of these seven South Asian countries remains the same, and is not likely to change in the near future and/or without considerable expense and suffering for selected segments of population in these societies. Yet, none of these countries seem to have either a plan in place ( e.g. a social safety net for those who will lose jobs by hundreds and thousands) or even the will to share the disproportionate burden of costs that would have to be incurred if SAFTA is to ever be successful in doing what it plans to do. What these countries' leaders seem to be forgetting is that soon after the initial hoopla around creating such an arrangement would be over, it would be everyone left to fend for oneself in a rapidly changing and very turbulent economic landscape and, given the track record of governments in these countries, much of the brunt would be born by the poor and displaced workers themselves.

What good then is SAFTA for? Clearly, the short-term effects of putting SAFTA into place are likely to be turbulent and costly for certain segments of the member countries' populations. These, in the absence of corrective and compensatory mechanisms, are likely to lead to considerable displacement and misery to the workers. If the SAARC member countries are to justify the immediate benefits that accrue to some sectors at the expense of others, it is logical that they also devise adequate mechanisms to share the costs and alleviate the suffering of those who are on the wrong side of the trade equation. Mechanisms to do this have been in place in the European Union where the more fortunate members transfer a part of their benefits to the less fortunate ones and in NAFTA where the US government has a plan to compensate and retrain displaced workers to take up other jobs. The best SAARC countries have been able to do to plan for that transition so far is to come up with long "negative lists" of items that cannot be freely traded within the proposed SAFTA which, if one thinks about it, actually kills their entire purpose anyway. At the very least, we require setting up of a revolving fund to share the cost of this transition. This fund must be funded by member country contributions in proportion to the benefits they would derive from SAFTA and would disburse these funds to countries in proportion with largest economic dislocations.

It is also important, for realizing the potential long-term dynamic benefits of SAFTA, that proper consensus building must happen before the SAARC countries embark on this venture. Without the right consensus--among people but also among various governments and populations--this could potentially be a tremendous waste of energy and effort. What is the point of merely going through the motions if the countries are ultimately going to drag their feet on true trade liberalization, as they seem to have already started to do? What benefit--and to whom--would such a superficial effort likely to bring? Unless the true costs and benefits of SAFTA are analyzed and presented, in a transparent and convincing manner, to the people of the SAARC countries, appropriate institutional and organizational arrangements are put in place to deal with short-term costs and realize the promised long-term benefits of the proposed arrangement, the expectations of various state and non-state actors are managed appropriately, and steps are taken to address the sensitivities of various countries and minimize political resistance to the plan, SAFTA would remain an unrealized dream, at best, and a costly blunder, at worst. There is a lot that we can learn from the experiences of other such arrangements as we embark upon this venture of our own.

The author (Athar.Osama@gmail.com ) is a public policy analyst and a Doctoral Fellow at Frederick S. Pardee RAND Graduate School for Public Policy, Santa Monica, CA.