At the 11th Saarc Summit held in Kathmandu in 2002, leaders envisioned an economic union among South Asian countries through the phase-wise integration of their economies. When this idea was proposed, Saarc was in the midst of the preferential trading system—the lowest degree of economic integration. After about 12 years and six successive Summits later, Kathmandu is once again hosting the Saarc Summit, and it is time to take stock of the plan to transform Saarc into the highest degree of economic integration.

Following the process of an economic union, Saarc, indeed, moved ahead from the phase of preferential treatment to a free trade system under the South Asian Free Trade Agreement (Safta) about a decade ago. But the performance of intra-regional trade has not been satisfactory—it has remained low in comparison to other regional groupings. While intra-Saarc trade could not rise above 5 percent of the region’s total trade so far, it is 25 percent for the Association of South East Asian Nations (Asean), 40 percent for the North American Free Trade Agreement (Nafta), and over 60 percent for the European Union (EU). There are three well-known economic reasons for the poor outcome of intra-Saarc trade.

Why trade suffers

First, as experts have commonly argued, the identical pattern of comparative advantage among Saarc countries has constrained trade among themselves. A number of studies show that a majority of Saarc countries have comparative advantages in primary commodities and similar manufactured products, such as textiles and clothing. Except for India, all Saarc countries lack varied comparative advantage products to trade with their partners. It must be remembered that trade is generated by the differences between trading partners.

Second, Saarc countries do not have trade complementarity due to less divergent comparative advantages and similar factor endowments among the countries in the region. Third, intra-industry trade or trade of similar products with differentiation has not been popular between these countries. Unlike Saarc, intra-industry trade in the EU takes place in large volumes and contributes significantly to intra-regional trade. For example, there is huge intra-industry trade in the automobiles sector in the EU—Germany exports Mercedes to Italy but also imports Fiats from Italy. But in case of the Saarc countries, the popular Sri Lankan tea is still not widely available in the Nepali market whereas renowned Nepali organic tea has yet to create a market in Sri Lanka, despite both countries being exporters of tea to international markets.

Progressing through phases

Nevertheless, Saarc has to progress through next two phases of integration to attain the goal of an economic union, which is the ultimate form of regional integration. Normally, the free trade phase is followed by a customs union. At this stage, the countries in the prospective union agree to impose uniform customs duties on imports from countries outside the group, in addition to free trade among the member countries. Because of the adoption of a common external tariff, the problem of trade deflection or trans-shipment of cheap third-country imports from the group’s low-tariff country to the high-tariff country does not arise. However, an agreement on a common external tariff does not look easy for Saarc countries as there are widespread disparities in their tariff rates. The trade weighted average tariff rate for non-agriculture products ranges from 8 percent in India and Sri Lanka to as high as 21 percent in the Maldives.

After a customs union, a common market policy phase comes into operation. At this stage of economic integration, member countries allow the free movement of labour and capital, apart from the policies of free trade and common external tariffs. Although the agreement for the flow of investment within the Saarc region can be foreseen, because many countries in the region need investment, free movement of labour cannot be expected so soon and so easily. But it is only after passing through these two phases, can Saarc transform into an economic union. Complete economic integration is when member countries proceed to unify their fiscal and monetary policies, besides assuming the principles of free trade, a customs union, and a common market.

Reaping benefits

The moot question is whether the Saarc countries are in a position to proceed with these higher levels of economic integration. The success of an economic union will depend on whether it creates convergence or divergence for the countries in the group. Economic union in the EU has set an example of convergence. Weaker countries, such as Portugal and Ireland, have caught up with richer countries. The integration has helped equalise disparities in the economic status of member countries.

Similarly, free trade under the Nafta has encouraged American companies to make massive investments in Mexico and flourished maquiladoras, which are similar to special economic zones in Mexico, to particularly serve American imports from Mexico. This has contributed vastly to trade flows between these two Naftta countries. Hence, the Kathmandu Summit should restart the debate on transforming Saarc into an economic union to realise gains similar to the ones made by the regional groupings like the EU and Nafta.

Shakya specialises in the economic and trade interests of Nepal and Least Developed Countries