Trade in South Asian Region (SAARC)

- Evidence from Gravity Model

Kabeer MUHAMMAD
PhD Student
Ecole Doctorale Economie des Organisations .
Concurrence, Innovation, Finance (EDOCIF)
Dauphine University Paris, France.
Email: kabeersbpyahoo.com
Phone: 00 33 6 29 667653










Abstract
South Asian Association Ior Regional Cooperation (SAARC) is a relatively young economic
integration project and appears to be very small compared to other existing regional blocks. This
might be because oI unexplored intra regional trade opportunities. It is general economic
perception that the increase in international trade might be welIare improving. This paper
attempts to make a Iormal analysis oI these issues with the use oI a gravity model oI international
trade. The objective is to examine whether intra-SAARC trade is lower or higher than what is
predicted by an economic model. This gives an idea about the structure oI comparative advantage
in the SAARC countries that helps to explain why intra-SAARC trade is low and how trade
among them can be increased. It also helps us to understand the possibility oI trade creation and
trade diversion eIIect resulting Irom South Asian Free Trading Arrangements (SAFTA). We also
explain geo-political reasoning Ior more economic cooperation among the SAARC countries,
suggesting areas where cooperation could be mutually beneIicial to the economies. The gravity
model has been exclusively used to measure bilateral trade among countries but not eIIectively
used to measure intra-SAARC trade. Our gravity model results suggest that SAARC member
countries are yet to accomplish trade-creating beneIits. Appropriate policies need to be
Iormulated Ior more regional integration. Liberalization oI trade in SAARC countries oIIers
signiIicant gains Ior all the economies in the region. EIIorts should be made to liberalize border
trade and strengthen bilateral trade relations through the removal oI tariII and non-tariII barriers
in the general Iramework oI South Asian Free Trading Arrangements.

1EL Classification: F15, F13
Keywords: SAARC; SAFTA; SAPTA; Trading blocks; Gravity model.








1. Introduction:
Over the last Iew decades the issue oI regionalism has once again been brought back in and it is
argued that that this regionalism can be seen as a response to the process oI globalization and the
social eruptions associated with this process. A major part oI research work reIlects that these
regional blocks are designed to IortiIy protectionist barriers and divert trade. Trade models based
on welIare give only protectionist reasons to Iorm trading blocs and to exercise market power
over other countries or blocs. Conventional wisdom also links recent regional trade initiatives
with protectionist pressures that undermine the multilateral system. However studies in the
political economy oI trade stress rent-seeking motives to divert trade Irom outside to within a
region.

The Iocus oI this paper is on South Asia, a region that has been neglected by previous researches.
This research intend Ior assessing the economic interests among the countries oI South Asian
Association Ior Regional Cooperation (SAARC) Irom the perspective oI regional trade. Like
other regions South Asia is also advancing toward institutional and economic integration. South
Asia ranks among the world's most densely-populated regions. About 1.6 billion people live here
and it`s about one-Iourth oI world population. The SAARC is an economic and political
organization oI eight
1
countries in Southern Asia (Map oI the region is given as Annexure). In
terms oI population, its sphere oI inIluence is the largest oI any regional organization. It was
established on December 8, 1985 by India, Pakistan, Bangladesh, Sri Lanka, Nepal, Maldives
and Bhutan. In April 2007, at the Association's 14th summit, AIghanistan became its eighth
member. Apart Irom its member states some big countries and regional blocks have the status oI
observers in the association like US, China, EU and South Korea, while Iran has also requested
Ior observer status.
South Asian region that has the potential to become an economic dynamo but unIortunately most
oI SAARC countries continue to be aIIlicted by endemic problems oI poverty, illiteracy and
inequity, economies in most countries are growing at the rate oI 5 per cent and above. Economic
integration and an across-the-board implementation oI the South Asian Free Trade Area
(SAFTA) hold the key to unlocking the economic potential oI the region.

1
The 8th member AIghanistan was included in April 2007 previously it was seven members so most oI this paper
only deal with seven members oI the state.
India has already several trade pacts with Maldives, Nepal, Bhutan and Sri Lanka, similar trade
agreements with Pakistan and Bangladesh have been stalled due to political and economic
concerns on both sides.

Regional cooperation in the area oI trade has been one oI the major concerns oI the member
countries oI SAARC. Dutta (1999), Khan (1999) and Hassan (2000) give an extensive overview
oI SAARC as well as regional and multilateral beneIits oI trade in the world. This shared
commitment to regional trade promotion has been institutionalized Iollowing the ratiIication oI
the agreement by all the member countries oI SAARC oI a South Asian PreIerential Trading
Agreement (SAPTA) in 1995. Obviously, economic and trade reIorms implemented by the
individual SAARC member countries over the last decade have contributed to creating a
conducive environment where closer cooperation in the Iield oI trade and investment could be
graduated Irom rhetorical protestations to Iormal agreements. Eleven years later, at the 12th
SAARC Summit at Islamabad, SAARC countries devised the South Asia Free Trade Agreement
(SAFTA) which created a Iramework Ior the establishment oI a Iree trade region. This agreement
went into Iorce on July 1, 2006. Under this agreement, SAARC members will bring their duties
down to 20 by 2007. In short SAARC, however, remains a work in progress with most oI its
potential unachieved. II the last 22 years oI endless talking and producing documents are
replaced by the next 22 years oI action, South Asia could become the world's economic hub and
even a model oI regional integration. The collective weight oI the South Asian economies will
enhance their bargaining power, making Ior better terms in trade and Iinancial negotiations and,
thereIore, the promotion oI welIare and the acceleration oI economic growth.

Intra-SAARC trade seems to be oI a quite smaller magnitude. This might be because oI normal
outcome or because oI unexplored trade opportunities. II the latter is the case, then increased
trade within this region might be welIare improving. This study attempts to make a Iormal
analysis oI these issues by estimating a gravity model oI international trade to examine whether
intra-SAARC trade is lower or higher than what is predicted by the economic model. This gives
an idea about the structure oI comparative advantage in the SAARC countries that helps to
explain why intra-SAARC trade is low, and how trade among them can be increased. It also
gives an impression about the possibility oI trade creation (TC) and trade diversion (TD) eIIect
Irom any preIerential tariII agreements among SAARC countries.

The gravity model has been extensively used in the empirical studies to explain bilateral trade.
For example, Havrylyshyn and Pritchet (1991) estimate a gravity model oI bilateral trade
between Eastern and Western Europe; Coe and HoIImaister (1998) look into the pattern oI north-
south trade; and Bayoumi and Eichengreen (1995) examine the eIIects on trading patterns oI the
EC and EFTA; and Al-Atrash and YouseI (2000) estimate a gravity model to address the issue oI
whether intra-Arab trade is too little. Liberalization oI trade in SAARC countries oIIers
signiIicant gains Ior all the economies in the region. A very close look at the existing structure oI
trade reveals that, in the context oI trade liberalization among neighboring SAARC countries, the
interaction between policy determined barriers (e.g., tariIIs, quotas, and other non-tariII barriers)
and natural barriers (e.g., transport costs, linguistic and institutional diIIerences) is important.
Integrating all these issues together will provide a comprehensive analysis oI Ieasibility and oI
the prospects Ior economic cooperation in terms oI enhanced trade within SAARC region. The
study will have important implications Ior policy-making regarding economic cooperation
among the SAARC countries.

This whole paper is divided into Iive sections. Following the Introduction in Section 1, Section 2
provides an overview oI the economic structure and perIormance oI Ioreign trade oI SAARC
countries. Section 3 discusses the gravity model and its essential Ieatures. This section presents
the empirical results oI the gravity model. Section 4 gives policy recommendation Ior trade
expansion among the SAARC Countries. Section 5 concludes the paper.

2. Economic Structure and Trade performance of SAARC Countries:
A similar level oI economic development is crucial among potential members oI a Free trade area
in order to Iacilitate economic integration. A similar average level oI education, skill and
productivity oI the work Iorce would help to moderate the Ilow oI labor across borders, which
could otherwise put social and Iiscal strains on the immigrant country. Some macro indicators oI
the region are exhibited in the table below:






Table 1: Economic Structure of SAARC countries as 2006
Bangladesh Bhutan India Maldives Nepal Pakistan Sri Lanka
Growth and Economic Structure
GDP Growth 7.00 8.00 9.00 19.00 2.00 6.00 7.00
GDP per capita (PPP $) 2217 5703 3827 NA 1596 2553 5081
Value Added:
Agriculture ( of
GDP)
20.14 24.70 18.30 NA 38.21 21.58 16.77
Industry ( of GDP) 27.22 37.32 27.33 NA 20.96 25.13 26.08
Manufacturing ( of
GDP)
16.53 7.28 15.68 NA 7.72 18.25 14.93
Social Indicators
Infant Mortality rate 54 65 56 33 56 79 12
Life expectancy at birth 63.90 63.98 63.50 67.64 62.65 64.86 74.67
Health Expenditures
( of GDP)
3.1 4.6 5.0 7.7 5.6 2.2 4.30
Literacy rate (youth) 42.07 NA 84.19 98.17 70.05 65.50 95.58
Population (0-14) ( of
total)
35.48 38.39 32.06 40.71 39.03 38.30 24.09
Population (15-64) (
of total)
60.91 57.02 62.66 55.84 57.32 57.87 68.64
Population >65 ( of
total)
3.61 4.60 5.27 3.45 3.65 3.83 7.27
Rural population ( of
total)
74.90 88.90 71.30 70.40 84.20 65.10 84.90
Population density (per
sq. km)
1089.52 13.55 368.15 1097.33 189.74 202.07 303.66
Internal and External Balance
CPI Inflation (average
1991-2000)
7.04 5.29 6.00 4.00 6.84 8.06 14.00
Official Exchange rate
(prd avg US$)
69.00 45.06 45.06 12.80 73.05 59.83 104.00
Current Account ( of
GDP)
-0.22 NA 1.14 -43.10 2.07 -3.13 -2.76
Trade ( of GDP) 42.00 81.95 44.72 172.13 56.00 40.00 76.00
External Balance (
GDP)
-6.46 -27.49 -3.64 -47.93 -16.45 -4.63 -11.60
External Debt ( of
GDP)
31.54 76.94 15.28 48.08 44.45 30.41 48.74
FDI ( of GDP) 1.37 0.09 0.82 1.24 0.03 1.97 1.16
Source: World Development indicators, World Bank

For example, the SAARC countries exhibit a similar population age structure. The demographic
statistics point out that these countries are not likely to Iace an aging problem anytime soon,
which may be put pressure on Iiscal resources. II countries are at a similar level oI development,
there would be lower pressure to transIer Iunds Irom richer to poorer nations. The structure oI
production is reasonably similar across the SAARC countries. The industrial sector constitutes
roughly a Iourth oI GDP in all countries, and manuIacturing sector comprises about 7-18 oI
GDP Ior all, except Maldives, where tourism assumes importance. A similarity oI economic
structure may make them vulnerable to similar shocks, which could require a similar policy
response. All the SAARC countries are Iairly open to trade, but Iurther liberalization and
intraregional trade may be needed in order to gain the beneIits oI low transaction costs.

Most oI the members oI SAARC currently have average inIlation rates in single digits, low
current account deIicits. While external debt varies Irom 15 (India) to 76 (Bhutan) oI GDP, it
appears sustainable Ior all countries since the share oI short-term debt is small and the level oI
Ioreign exchange comIortable Ior most oI the countries. A burgeoning external debt may pose a
signiIicant cost to the union by increasing sovereign deIault risk and widening interest rate
spreads.

The total trade oI this region increased Irom 65.62 billion US dollar in 1990 to 316.72 billion US
dollar in 2005 showing an increase 4 times during last 16 years while the intra region trade
increased 7 Iolds during the same period. The table and Iigure below reIlects the growth trend oI
the total trade oI this region with the rest oI the world and intra region trade.

Table 2: Growth Trend of Total world and intra region trade of SAARC Countries
(US Dollar in Billions)
Indicator 1999 2000 2001 2002 2003 2004 2005
Total (SAARC)
Trade with World
128.56 141.50 150.83 156.61 190.78 242.29 316.72
Total intra-region
trade (SAARC)
4.81 5.31 5.91 6.77 9.37 11.49 14.11
Source: IMF Direction oI Trade Statistics
2.1 Geo-Political Factors of SAARC Region
The economic criteria Ior determining the suitability oI South Asia Ior a Iree trade area, the geo-
political Iactors is also play an equally important role in this process. Two developments in the
international environment make the prospects oI South Asian exports to the new markets less
promising. First, the weak growth in the world economy since 2000 has adversely aIIected the
export perIormance oI the region. Second, with the Iormation oI regional economic blocs and
growing protectionism in both the developed and developing regions, the South Asian countries
may Iind it diIIicult to gain access to these markets. Given these developments, it will be
beneIicial Ior the SAARC countries to Iocus on intra-regional cooperation.

Dash (1996) recognizes Iour reasons Ior low intra-regional investment and trade among the
South Asian economies:
Production oI similar products and hence being competitors
High tariII and non-tariII barriers among countries oI the region
InIrastructural bottlenecks
Lack oI political willingness

However, there are compelling economic reasons to suggest that it is in the interest oI all the
South Asian countries to promote intra-regional trade and economic cooperation. Direct trade in
products like steel and aluminum, textile machinery, chemical products, and dry Iruits currently
being diverted through third countries can beneIit both India and Pakistan quite substantially in
terms oI price, quality, and time. The region can expand trade in such products as tea and coIIee,
cotton and textiles, natural rubber, light engineering goods, iron and steel, medical equipment,
pharmaceuticals, and agro-chemicals.

The energy problems in the region can be solved through cooperation. For example, Dash (1996)
argues that the water Irom the Himalayan Rivers Ilowing through Bangladesh, Bhutan, India,
Nepal and Pakistan can be harnessed Ior Ilood prevention and inland navigation system. India
assisted Bhutan in constructing the Chukha hydroelectric project, which has the potential to
beneIit Bangladesh, Nepal, and Pakistan. There are signiIicant complementarities in trade among
these countries. For example, Dash (1996) recognizes that Bangladesh can export such items as
tea, newsprint, jute goods, and leather to Pakistan and in turn, import such items as textiles,
cement, light engineering goods, machinery, and railway rolling stock.

He identiIies that India can provide security and meet Bangladesh`s need Ior manuIactured
goods, such as steel, chemicals, light engineering goods, capital goods, coal and limestone. For a
balance in trade deIicit, India can import products such as urea, sponge iron, semi-processed
leather, and newsprint Irom Bangladesh. The need to improve economic ties Ior Bangladesh with
India and other countries in South Asia has increased in recent years, given the drying up oI
oIIicial development aid (ODA) to the South Asia Irom international agencies. In Iact, India has
been showing considerable interest in expanding economic cooperation with Bangladesh.

Nepal has always maintained very cordial relations with her neighbors, which won its unanimous
support Ior setting up SAARC`s permanent secretariat in Kathmandu. However, it depends on
India Ior aid, some critical imports like oil, cement, and coal and Ior employing its labor. Like
Bangladesh, Nepal is Iacing reduced oIIicial Ioreign aid. Hence, it wants to develop more
integration with the other South Asian economies, while trying to decrease its economic
dependence on India.

Sri Lanka is an island and the only SAARC nation that does not have a contiguous border with
India. Her anxiety about more economic cooperation reIlects the overwhelming economic and
political power that India exerts in the region. However, Sri Lanka can gain by diverting her
trade in cement and ship building with South Korea to India and Pakistan. Adverse terms oI
trade, protectionism Irom the West and political instability Irom the civil war have led Sri Lanka
to build local ties. Hence, since 1992, Sri Lanka has consistently advocated improving
intraregional trade through the Iramework oI South Asian PreIerential Trade Agreement
(SAPTA). The bilateral Iree trade agreement (FTA) with India is a welcoming step in this
direction.

Among the SAARC countries, India has the broad industrial base and expertise, technology, and
capital in certain sectors to invest and set up joint ventures in the region. Indian companies have
emerged as major sources oI investment in Sri Lanka and Nepal, the countries having bilateral
Iree trade arrangements with India. Like all the other SAARC nations and developing countries,
Pakistan also has limited access to the markets in the developed world and hence Pakistan has
taken initiatives to Iorm Economic Cooperation Organization (ECO) to promote its exports and
improve intra-regional trade with Central Asia. But given the competition Irom developed
countries, it will be diIIicult Ior Pakistan to capture these markets. So, Pakistan has a lot to gain
by accessing the South Asian markets, where the potential Ior trade is immense. OI all the
SAARC economies, the two smallest countries, Bhutan and Maldives, have always supported the
growth oI regional cooperation in South Asia.

2.2 Future Prospects of the SAARC:
From the above discussion, it is evident that there is a great deal oI potential in the region Ior
developing trade and economic cooperation. Increasing openness oI the economies with the
removal oI tariII and non-tariII barriers and elimination oI exchange rate risk will enhance trade.

Some economists are quite optimistic about the Iuture oI SAARC Ior a couple oI reasons. First,
the inclusion oI AIghanistan in the group completes the south Asian conIiguration. Second, the
presence oI China and the US, two oI the big powers in the world, as observers at SAARC,
shows that south Asia as a region has become an important part oI the global scenario, especially
in terms oI its economic potential. We believe there have been two constraints in the growth oI
SAARC. The Iirst is the structural one. It has not been able to set up common institutions. It is in
this context that I Ieel that the proposal oI a South Asian university is a good sign that something
positive is happening on this Iront. The other main issue is that oI troubled India-Pakistan
relations.
There is a huge gap between the ideal and the reality. The World Bank has displayed some
revealing statistics that highlight challenges and opportunities Ior closer regional cooperation in
South Asia. According to the bank, intra-regional trade is less than 2 percent oI GDP, compared
to more than 20 percent Ior East Asia. The cost oI trading across borders in South Asia is one oI
the highest in the world.
The World Bank also pointed out that despite India, one oI the most energy-hungry nations in the
world, situated next to three energy-surplus countries - Bangladesh, Nepal, and Bhutan - energy
trade between them except Ior Bhutan is miniscule. II trust problems can be sorted out and
leaderships show political will, this is what SAARC can achieve: Trade within South Asia can be
more than doubled iI appropriate regional agreements on roads, rail, air, and shipping are put in
place. Nepal has the potential to produce more than 40,000 MW oI hydel power, most oI which
could be exported to India, generating $6-10 billion per year oI revenues to Nepal. Increasing
popular interest oI world major economic players in SAARC is another encouraging Iactor.

3. The gravity model of trade:

The gravity model oIIers a systematic Iramework Ior measuring the normal pattern oI trade.
International trade Ilows are determined by comparative advantage, the possibility oI intra-
industry trade, transport costs, and so Iorth. Trade policy may revise the normal trade Ilows. The
gravity model oI international trade estimates the trade Ilow as a Iunction oI variables that
directly or indirectly aIIect the determinants oI normal trade Ilow. BeIore explaining the
Iramework oI gravity model used in this research I would like to explain the theoretical eIIects oI
regional cooperation on trade.


3.1 Regional economic cooperation and its effects

The basic theory oI preIerential trade agreements (PTAs) emphasizes that they will have a
number oI eIIects, such as trade creation (TC) and trade diversion (TD). TC occurs when
preIerential tariII cuts cause a partner nation to start importing Irom its other partners rather than
producing the goods itselI, due to the Iall in relative price oI the imported goods through tariII
removal, regardless oI its preIerential nature. TD occurs when a partner country starts importing
a good Irom its other partners rather than Irom non-partner countries, due to the Iall in the price
oI the partner-sourced import goods relative to the non-partner-sourced import goods, caused by
the preIerential nature oI the tariII cut. Because the PTA involves some trade liberalization, there
is a potential welIare gain to the member country in the standard economic model due to TC, but
at the same time the PTA involves a new distortion in the market due to the preIerential or
discriminatory nature oI the tariII reductions. There is also a potential welIare loss due to TD. So
the overall welIare eIIect is ambiguous. The notions oI TC and TD involve the use oI static,
partial equilibrium market models.

Many economists believed that PTAs have also general equilibrium and dynamic eIIects. General
equilibrium eIIects include terms oI trade, wage rate, and other Iactor return changes. Dynamic
eIIects include economies oI scale, growth, and innovation. Growth eIIect is the impact oI PTA-
induced changes in trade balances in the partner nations on their macroeconomic equilibrium. II
all partner nations were to improve their trade balances through the combined eIIects oI TC and
TD, then this would be a macroeconomic shock that would impact their output growth. Any
change in output growth would in turn impact import demand, not just Irom partner countries but
also Irom non-partner exporters. This might be considered a trade growth eIIect distinct Irom TC
and TD. Some economists would go Iurther and argue that higher output growth may lead to
dynamic gains through higher investment and innovation levels. Empirical estimates oI the
growth eIIects oI PTAs vary widely, due to the varying assumptions and arguments built into the
estimating models, but eIIects are usually Iound to be positive, except where negative terms oI
trade eIIects reduce welIare and spending in a member country.

Regional economic cooperation or integration may take one oI various Iorms. These Iorms were
Iirst presented by Balassa and know as the balassa`s Iive stages oI economic integration:
i) Free Trade Agreements in which member countries remove all trade barriers among
themselves but retain their individual commercial policies toward the outside world.
ii) A customs union, which is similar to a FTA except that the member counties adopt
common external commercial policies.
iii) A common market is a customs union that allows Ior Iree Iactor mobility within the
market.
iv) Monetary Union, in which the member countries share the common currency.
v) An economic union, which is a common market that seeks to achieve a complete
uniIication oI monetary and Iiscal policies.

The eIIects oI regional economic cooperation, typically taking the Iorm oI a customs union,
include the Iollowing static eIIects:
i) TC eIIects, deriving Irom both production and consumption gains.
ii) TD eIIects, derived by replacing cheaper imports with those oI the member countries,
as a result oI tariII discrimination.
iii) Improved international bargaining power due to the larger economic size.
iv) Decreased administrative expenditures among the member counties;
v) Less smuggling among the member countries.

There are also the Iollowing dynamic eIIects which lead to Iaster economic growth:
i) Higher production eIIiciency brought about by enhanced competition and thus
specialization and resource reallocation.
ii) Decreased average production costs due to economies oI scale in larger markets.
iii) Higher international investment, resulting Irom an increase in investment
opportunities and lower uncertainty and risks.
iv) Enhanced technological change resulting Irom increased competition.

All the static and dynamic eIIect supports the notion oI regional economic cooperation except Ior
the TD eIIect. However, the countries may also be constrained by some other economic Iactors,
such as:
i) A government`s reliance on tariII revenue may discourage it Irom joining in this kind
oI arrangement.
ii) A large trade deIicit depresses the will oI a government to risk a possibly
deteriorating trade balance, resulting Irom tariII reduction or abolishment.
iii) The worry that unequal tariII or imperialistic opportunities may be Iurther exploited
by some powerIul member country discourages other members Irom joining.
iv) The decreased trade policy independence may concern some developing countries
that would like to pursue an independent development policy.

The economic rational Ior TC and TD depends along with other things on the assumption that
prices reIlect the social cost oI production. However, in the context oI the less developing
countries there are several reasons Ior this not to be true. First, wage rates may not measure the
social cost oI labor on account oI unemployment and urban wage rigidities. Second, the shadow
price oI Ioreign exchange may be diIIerent Irom its market price on account oI Ioreign-exchange
constraint. Under these circumstances, import substitution may be rational in the absence oI
regional integration. The merit oI integration, however, lies essentially in the Iact that there are
economies oI scale a block can realize in the production oI a commodity in a certain industry in a
partner country oI the block

3.2 Methodology and Data

We use gravity model to examine whether a lower magnitude oI intra-SAARC trade is a normal
outcome. The gravity model has long been used Ior empirical studies oI the pattern oI trade.
SpeciIically, the volume oI trade between two countries should increase with their real GDPs,
since large countries should trade more than small ones, and with per capita incomes, since rich
countries should trade more than poor ones. It should diminish with geographical distance
because proximity reduces transportation and inIormation costs. The dependent variable in the
gravity model is bilateral trade between pairs oI countries; each variable other than distance is
entered in product Iorm. Researchers also add dummy variables Ior participation in various
preIerential arrangements. II one Iinds a positive coeIIicient on the dummy variable indicating
that two countries, both oI which participate in the same preIerential arrangement, trade more
with one another than predicted by their incomes and distance, then the conclusion drawn is that
the arrangement is trade creating Ior its members. II there is a negative coeIIicient on the dummy
variable indicating that only one member oI the pair participates in a particular preIerential
arrangement, this is taken as evidence oI TD vis-a-vis the rest oI the world. (Eichengreen and
Irwin, 1996; Frankel et al., 1994).

However, there are some caveats attached with this approach. One is that the coeIIicients on
dummy variables Ior subgroups oI countries will pick up all respects in which those countries
diIIer in their trade perIormance that are not controlled Ior in the gravity equation. To take an
example pursued by Frankel and Wei (1995), iI all the countries in a region share a common
language, then including a dummy variable Ior that region but not a measure oI language will
tend to spuriously attribute the eIIects oI the shared language in encouraging economic links to
commercial policy measures. More generally, dummy variables Ior preIerential arrangements
serve as a catch basin Ior omitted Iactors.

Related to this is the diIIiculty oI measuring economic distance independent oI the trade Ilows
that the investigator seeks to explain. The underlying theory appeals to transaction costs oI trade,
and in empirical implementation it is posited that such costs should rise with distance. But
economic and geographic distances are not the same. InsoIar as economic distance is
mismeasured, its eIIects may be loaded into the dummy variables intended to capture the eIIects
oI regionalism. A Iurther problem with the gravity model is the omission oI third-country eIIects.
It is generally assumed that bilateral trade depends only on economic conditions in the two
countries considered. In practice, however, bilateral trade will also depend upon competitiveness
relative to other countries and markets. More generally, insoIar as economic variables in third
countries aIIect trade Ilows between other country pairs, gravity equations suIIer Irom omitted-
variables bias.

A Iinal problem arises Irom the practice oI pooling data Ior industrial and developing countries.
While this maximizes degrees oI Ireedom, the relationship between trade and economic
characteristics may vary between the two groups oI countries. The income elasticity oI trade may
be diIIerent at high and low levels oI income or Ior diIIerent types oI goods. Transaction costs
may have very diIIerent structures in countries with more and less articulated markets. Results
based on heterogeneous cross-sections may thereIore suIIer Irom sub-sample instability and
heteroskedasticity.

The typical gravity model speciIication relates bilateral trade to income, population (or per capita
income), distance, and congruity between the trading partners:
( ) ( ) ( ) ( )
( )
1 2 3
4
log log log log
ift it ft it ft if
if
TRADE a GDP GDP PCI PCI DISTANCE
BORDER

= + + +
+

where
ift
TRADE is bilateral trade between countries i and f at time t (measured in U.S. dollars),
GDP is real gross domestic product, CPI is per capita income, DISTANCE is distance between
two countries, and BORDER is dummy variable that takes a value oI 1 iI two countries have
common border and 0 otherwise. As trade is expected to increase with the size oI the domestic
economy (GDP), per capita income (PCI) and common border (BORDER), and to decrease with
distance (DISTANCE).
1
,
2
, and
4
should be positive, and
3
negative. Annual data on
bilateral trade Ilows among SAARC countries has been collected Irom IMF`s Direction oI Trade
Statistics and Ior GDP and PCI data has been collected Irom the world development indicators oI
World Bank.

3.3 Analysis of empirical results

A more systematic way oI adjusting Ior the natural determinants oI trade is by means oI the
gravity model. The assumptions oI the model are that trade between two countries is
proportionate to the product oI their GDPs and the product oI their per capita income PCIs. Trade
is an increasing Iunction oI adjacency (when two countries share a common land border), and
inversely related to the distance between them. Dummy variables are added when both countries
in a given pair belong to the same regional grouping. This provides a means oI determining how
much trade within each region is due to Iactors common to trade throughout the world and how
much remains to be explained by regional eIIects.

We have estimated gravity models Ior years 2006. Table 3 provides the descriptive statistics oI
all explanatory variables and regional blocks used in this study Ior the year 2006.










Table 3: Descriptive Statistics of All Explanatory Variables.
Series Observations Mean Standard
Deviation
Minimum Maximum
Log TRADE 153 2.18 2.311 (3.00) 5.72
Log GDP 153 3.58 0.370 2.48 4.21
Log CPI 153 22.39 1.658 17.93 25.76
Log DISTANCE 153 6.96 0.965 5.14 9.24
BORDER 153 0.10 0.298 0 1
SAARC1 153 0.04 0.195 0 1
SAARC2 153 0.14 0.345 0 1
ASEAN1 153 0.10 0.300 0 1
ASEAN2 153 0.24 0.426 0 1
NAFTA 153 0.01 0.081 0 1

We use regional block variables in our analysis in three ways and Iollowing are the member oI
these regional trading blocks.
SAARC1: Bangladesh, India, Nepal, and Bhutan.
SAARC2: Bangladesh, India, Nepal, Bhutan, Maldives, Pakistan and Sri Lanka.
ASEAN1: Indonesia, Malaysia, Philippines, Thailand, Singapore, and Laos.
ASEAN2: Indonesia, Malaysia, Philippines, Thailand, Singapore, Laos, Korea, Japan, and China.
NAFTA: U.S. and Canada.

Table 4: Correlation matrix of variables and all trade blocks for the year 2006.

Log
TRADE
Log
GDP
Log
CPI
Log
DISTANCE
BORDER SAARC1 SAARC2 ASEAN1 ASEAN2 NAFTA
Log
TRADE
1.000
Log GDP
0.183 1.000
Log CPI
0.841 0.404 1.000
Log
DISTANCE
0.472 0.494 0.658 1.000
BORDER
0.008 -0.433 -0.038 -0.195 1.000
SAARC1
-0.154 -0.389 -0.193 -0.286 0.386 1.000
SAARC2
-0.273 -0.432 -0.431 -0.443 0.252 0.507 1.000
ASEAN1
0.133 -0.363 -0.023 -0.020 0.112 -0.068 -0.133 1.000
ASEAN2
0.353 -0.291 0.257 0.191 0.024 -0.112 -0.221 0.594 1.000
NAFTA
0.125 -0.182 0.139 0.190 0.246 -0.016 -0.032 -0.027 -0.045 1.000


To check the robustness oI our results, we Iirst perIorm the regression with simple model with
out dummy variables and in the second regression we add the dummy variables oI only SAARC1
& SAARC2 trading blocks. In the third regression we add the dummy variables oI other trading
blocks. Table 5 reIlects the results oI all the three regressions along with the t-statistics.

Table 5: Regression Results for 2006
Variables Regression with simple model Regression with Dummy variables
SAARC1 & SAARC2
Regression with All Dummy
variables
Coefficient t-Statistics Coefficient t-Statistics Coefficient t-Statistics
Constant
-22.740 -15.830 -23.158 -14.108
-16.566 -11.765
Log GDP
-1.043 -3.442 -1.200 -3.549
-1.086 -3.529
Log CPI
1.337 17.116 1.381 17.132
1.086 15.529
Log DISTANCE
-0.184 -1.307 -0.188 -1.326
0.049 0.464
BORDER
-0.317 -0.841
-0.185 -0.709
SAARC1
-1.069 -1.764
-0.169 -0.363
SAARC2
0.616 1.718
0.413 1.477
ASEAN1 0.245 0.863
ASEAN2 0.143 0.641
NAFTA -0.367 -0.402


We have 18 countries in our data set, so that there are 153 data points | (18*17)/2| Ior a year
2006. We Iind all three standard gravity variables (GDP, GDP per capita and distance) to be
highly signiIicant statistically at the 1 level oI signiIicance. Although the BORDER variable
has a negative sign, it is not statistically signiIicant. All variables except GDP and BORDER
have their expected signs. The unexpected negative sign Ior GDP variable suggests that as the
GDP oI a country improves, it trades less with its block member. Though this result may be
plausible with the members oI SAARC countries because most oI them have similar per capita
income, it is not clear why it may be so with other trading partners. The dependent variable in all
regressions is the value oI trade (imports plus exports), in log Iorm, between pairs oI countries.
The estimated coeIIicient on the log oI the product oI the two countries` GDPs at about -1.043
indicates that trade decrease with size but less than proportionately. This reIlects the Iact that
small countries tend to be more dependent on trade than larger, more diversiIied ones. The
estimated coeIIicient on the product oI per capita GDPs is about 1.337 indicating that poorer
countries trade more with each other. The coeIIicient on the log oI distance is about -0.184
indicating that with the increase in distance the trade between the countries Iall. The coeIIicient
on adjacency, at -0.317, indicates that two countries sharing a common border have negative
impact on trade this may be because oI illegal trade or smuggling. II there were nothing to the
notion oI trade blocks, these basic variables would soak up most oI the variation in bilateral trade
Ilows, leaving little to attribute to a dummy variable indicating whether two countries are
members oI the same regional grouping. Variations in intraregional trade would be due solely to
the proximity oI countries and their rates oI economic growth. In Iact, the dummy variables Ior
membership in the same regional grouping SAARC are statistically signiIicant. The SAARC1
and SAARC2 dummy variables are statistically signiIicant and SAARC1 has a negative,
indicating the preIerential trading agreements among these countries did reduce TC among the
member states. ThereIore, SAARC member countries not only reduce trade among themselves,
but they also reduce trade with nonmember countries. Although SAARC was Iormed as a
regional cooperation organization, it is yet to achieve the beneIits oI trade among themselves.
The estimated coeIIicients oI ASEAN2, NAFTA, EEC1, and EEC2 dummy variables are not
statistically signiIicant.

4. Policy recommendation for trade expansion among the SAARC countries

The economies oI the SAARC countries are similar in Iactor endowments and cost structure.
ThereIore, inter-industry trade based on comparative advantage is unlikely to be signiIicant in the
SAARC countries. The modern theory oI international trade suggests that countries with similar
patterns oI demand are likely to trade more among themselves because goods, which have
achieved economies oI scale, can more easily be sold in another country having a similar
preIerence pattern. ThereIore, economies oI scale can trigger proIitable trade Ilows even in the
absence oI comparative advantage. (Anam and Rahman, 1991). TariII concessions oIIered by
member states through the Iour rounds oI tariII negotiation have not produced any perceptible
impact on the expansion oI intraregional trade. For one thing, products oI major export interest to
member countries seldom appear in the national lists oI concessions to partners, whereas
products in diIIerent categories on which concessions have been exchanged are hardly traded
among partner countries. Also, the existing tariII rates Ior many oI these products are already low
and, thereIore, the margin oI tariII preIerences granted thereon is insigniIicant.

The low level oI industrialization in the region and, hence, insuIIicient diversiIication oI the
member country`s production base are important Iactors behind the not signiIicant volume oI
exports to the region. Commercial policy barriers prevailing in the partner countries may also
have contributed to this problem. With the introduction oI SAFTA provides an opportunity to all
member countries Ior expanding their exports to the region and their production base could be
enlarged and all commercial policy barriers to its actual and potential exports to the region were
eased. Thus, apart Irom the Iact that regional trade liberalization will oIIer opportunities to obtain
supplies Irom the neighboring sources at lower transport cost, less restriction on imports will
generate competition and act as an incentive to increase eIIiciency. The increased competition
Iaced by industries Irom partner country products will Iorce them to increase eIIiciency, improve
quality and lower costs. Resources will be reallocated away Irom the marginal and ineIIicient
Iirms that are currently sheltered by high tariII walls. Improvement in allocative eIIiciency,
which is an important objective oI trade liberalization, will thereby be achieved. Small countries
oI SAARC countries being able to import raw materials, intermediate inputs, capital machinery
and technology Irom major partner countries, which are presumably cheaper sources oI supply. A
strong private sector leads to increased eIIiciency in production and better allocation oI
resources, and thus enables increased production and a bigger exportable surplus. Governments
should not, thereIore, try to monopolize trade through state trading organizations, but encourage
greater participation in trading activities by the private sector. Dealing with state trading agencies
is also considered a disadvantage by Ioreign importers and, hence, state participation in trade
should be minimized as much as possible. Recent moves in all SAARC countries to increase the
role oI the private sector in national economic activities are steps in the right direction.

The SAARC countries compete with each other Ior similar types oI Ioreign investment. The
SAARC countries, with the possible exception oI India, have inherited the most labor intensive
production processes while the PaciIic Rim countries move on to production oI goods that
require more skilled labor and capital. In earlier stages, production utilizing relatively labor
intensive technologies move to the PaciIic Rim countries Irom the developed countries aIter they
switched to the second or third generation technologies. The relatively cheap labor cost is still a
major incentive Ior investment in the SAARC region countries. The major impetus Ior the
growth oI Ioreign investment in the SAARC countries within the region has to come Irom India,
the dominant economic entity within the region. India`s current state oI industrial development,
as well as its technical and manpower capabilities, could serve as resources Ior the whole region.
The SAARC countries can increase Iinancial cooperation among themselves via clearing union
arrangements, export credits, and payments unions. The lack oI internally generated Ioreign
exchange in many oI the SAARC countries mean that most oI the Iunds needed to Iinance
imports must be obtained abroad. OIten the Iinancing is in terms oI development assistance or
export credits made available by the developed countries. Although this type oI concessionary
Iinancing increases north-south trade, it does not provide any assistance in intra-SAARC trade.
Increased Iinancial assistance among SAARC countries may be the key to achieve this. The
operational issue is then to devise Iinancial arrangements that Iacilitate greater trade and
investment linkages and in the process circumvent the need Ior convertible currencies. Three
such arrangements are a clearing union, an export credit and a payments union. Any Iinancial
arrangement, however, among the SAARC countries will be limited by the non-convertibility oI
the currency oI the member countries and the region`s chronic (convertible) Ioreign exchange
shortage. The success oI arrangements such as export credit Iacilities, the ACU and payments
union will depend on the participation oI multilateral institutions such as the ADB or the World
Bank particularly in providing access to convertible currencies. An alternative route could be a
willingness on the part oI the trade surplus countries to accept nonconvertible currencies as
payment. The long history oI political conIlicts, particularly among India, Pakistan and
Bangladesh has blocked potentially proIitable trade channels. In addition, Iinancing diIIiculties
have compounded the problem. All South Asian countries are heavily dependent on Ioreign
assistance Ior Iinancing their large and expanding trade deIicits. The terms and conditions oI
Ioreign aid Irequently constrain the recipients to purchase Irom speciIied donor sources.

5. Conclusion

Globalization appears to be economic Iacts oI liIe in the 21st century. The creation oI the WTO
with the objective to establish commercial rules at the global level, supports the idea that regional
economic arrangements, whose negotiation involves Iewer transaction costs, will be the wave oI
the Iuture. SAARC is a relatively young integration project. This paper has asked whether there
are grounds Ior drawing such conclusion Irom the history oI regionalism in the SAARC
countries. The slowly increasing intra regional trade among the SAARC countries and current
low level oI intra-trade is essentially because oI the relatively low level oI industrialization oI the
member countries. As these economies develop and industrialize, trade among them will perhaps
automatically increase. However, such a process will take a long time. Integration oI the markets
oI South Asian countries by agreeing to institute a mechanism Ior expanding trade will provide a
better basis Ior industrialization and lead to a Iaster expansion oI trade and other linkages among
themselves. The process oI industrialization and trade expansion would perhaps be get
momentum aIter the implementation oI SAFTA in its true sprit.


Gravity model analysis showed that SAARC member countries are yet to achieve trade-creating
beneIits. The regression results support the hypothesis that intra-SAARC trade is too low and
SAARC countries as a whole trade less with the outside world than would be expected.

SAARC regional trade is not limited only because oI the lack oI production and resource bases
and Iinancing diIIiculties, but also inhibited by structural rigidities created by political conIlicts.
Removal oI such rigidities under the SAARC agreement can open up some proIitable
intraregional trade channels.

This region can not only cooperate or enhance the conventional trade but also have a potential Ior
non-conventional trade oI electricity, natural gas and irrigation water through regional water
management with regard to the problems oI Iloods and irrigation. SAARC regional integration,
in a way that is compatible with multilateral liberalization, could contribute to growth not only
by increasing trade and allowing regional producers to beneIit Irom economies oI scale, but also
by encouraging Ioreign direct investment and the deepening oI capital markets.



















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Map of South Asia (SAARC) Region