IGTC KOLKATA

An India China Free Trade Agreement

There is an overwhelming theoretical basis favouring free trade. Yet, attempts towards an IndiaChina FTA have not made much progress and talks have stumbled. In this paper we address the question which is of utmost interest to policy makers - What could be the likely impact of a Free Trade Agreement with China on the Indian economy? Should India enter into a FTA with China?

EXECUTIVE SUMMARY
According to Trade Theory, in a world which is increasingly flat, trade between any two countries should be a product function of their GDPs. It is highly likely that China and India will be, by 2050, the two largest economies of the world and bilateral trade between them would assume paramount importance globally. Also, there is an overwhelming theoretical basis favouring free trade. It is expected to increase production, improve specialization and lead to other welfare improvements in the long run for consumers and producers alike. Yet, attempts towards an India-PRC FTA have not made much progress and talks have stumbled, with both countries sparring over various issues of contention. Practical experience and lessons from the FTAs that have been in place in other regions of the world do not provide the necessary backing to the conclusions that emerge from the theory of free trade. Thus, in this paper we address the question which of utmost interest to policy makers - What could be the likely impact of an IndiaChina FTA on the Indian economy. Should India enter into a FTA with the PRC? The paper concludes that though India should sign a FTA with China for its strategic value, the present state being as it is, given the virtual policy paralysis, a polity either unwilling or incapable of rising above concerns of electoral vote bank politics, half-baked reforms, piecemeal liberalization and a private sector crippled not only by the above but also by lack of adequate infrastructure, entering a Free Trade Agreement with a manufacturing behemoth like China would be painful for India in the short to medium run and there are significant risks which need to be weighed by the policy makers as India just doesnt seem to be prepared. A FTA, which in all probability would be a narrow one based on goods, would be heavily unidirectional, with most of the benefits flowing to China and is unlikely to be supported by Indian Industry, specially the manufacturing sector which is far from maturity and yet to reach its true potential competitiveness given our human and resource capital. It would definitely exert greater pressure on the margins of Indian manufacturers, threatening the already imbalanced domestic architecture (which is tilted heavily towards services and away from manufacturing). It also has the potential to negatively affect efforts for poverty eradication and employment generation through loss of labour intensive industries.

However, there are benefits to India which cannot be brushed away, provided India decides to respond with vigour to the external competition, taking it up as a challenge and playing a proactive role in shaping its domestic and trade policies to level the playing field and enable India Inc. to exploit its comparative advantage and the opportunities arising out of such an agreement. China would become a market for goods manufactured in India, especially those consumer goods which cannot be manufactured domestically in China due to resource constraints. It would be a way to accelerate the process of Indian manufacturers becoming more efficient and the elimination of infrastructure roadblocks presently hindering the development of the manufacturing sector. Indias deficit on account of Infrastructure spending can be partially met by Chinese investors, which have been showing interest in Greenfield infrastructure projects in India. An FTA with China could be used to address structural issues which have historically constrained India's growth, not allowing it to move beyond the 8 8.5% mark. It could be the stimulus for India to come out of its virtual policy paralysis, muster the required political will, undertake all those critical reforms and hasten decisions which have thus far been kept on the back burner. The Indian polity will have to meaningfully engage with the industry and society on policy imperatives. Thus, in view of the comparative disadvantage of Indias manufacturing sector, and a much lower tariff structure in the PRC, a PRC-India FTA trade cooperation should start with a preferential trade agreement, reducing tariffs in a phased manner covering selected manufactured items and services. The ultimate aim should be a comprehensive, overarching FTA which has to include service trade, cross-border investments, especially by way of Chinese FDI in infrastructure sector, other forms of financial co-operation, skill- sharing, technology-sharing, and collaboration on research and development.

Moreover it has to be backed by China taking concrete actions towards removal of invisible, hidden, non-tariff barriers, and implementing a robust framework for addressing issues like antdumping, standards, and dispute settlement. Trade integration between the PRC and India would be strengthened a great deal more through private sector enthusiasm and participation. And finally, in view of the recent trend of FTAs, the importance of a PRC-India FTA should not be viewed only economically but also politically.

OBJECTIVE
This paper tries to ascertain whether India should enter into a FTA with China. It analyses the possibilities of a FTA between India and China, some of its possible implications for the Indian economy, and suggests strategic policy initiatives India can pursue to further its national interests in the face of stiff competition arising out of increasing economic ties with China.

REVIEW OF LITERATURE
This survey aims to highlight the complexities in the signing of the India-China FTA and establish certain significant conclusions regarding the same. There is a growing body of literature on the subject and a few significant works have been incorporated in the present study. They have been categorized and arranged according to their focus respectively on the themes of 1) Both the giants rise in world trade and the influence of commercial policies, 2) model based, simulation based or statistical studies attempting to quantify the possible effects of a India-China FTA on Indias economy.

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One line of research suggests that Chinas expansion since the late 1970s was largely unforeseen and certainly not anticipated. In the view of some of the leading analysts, the Chinese growth phenomenon already has been the largest growth surprise ever experienced by the world economy (Winters and Yusuf 2007, Dancing With Giants: China, India, and The Global Economy) and both India and China would be, at least in terms of trade, among the biggest

economies in the world within a span of twenty years. (Maddison 2007) Another, draws a distinction between the giants record of export and reforms. India is recognised as having made a marked break from its previous dismal export performance since the adoption of reforms in the 1990s but is considered to still not have reached a stage where parallels could be drawn between the two (Panagariya 2007). Moreover, it is largely held that though both India and China initiated the process of economic liberalization roughly at the same time during the late 1970s, the PRC was quicker to adopt an open door policy toward FDI in 1978, while India agreed to a major reform package only in 1991 which led to the difference in export performance (Lardy 2003, Panagariya 2006 and 2007, Kowalski 2010). A third, recognises that opening of markets and freer trade were essential to both the countries export success, but an equally important and complementary role in nurturing domestic capabilities was played by the active industrial policies in the PRC. This is held to be especially

true for consumer electronics and other advanced areas and it is argued that they may not have flourished in the absence of such industrial policies (Amsden 2001, Rodrick 2006). This line of argument can be logically extended to arrive at the very real probability, that the reason why India lags behind China in advanced manufactured exports is the absence of any new industrial policies since 1991. Some of the latter works suggest that India and specially China have been engaging in global as well as preferential trade liberalization to foster regional integration and voices reservations about the efficacy of that the giants recent pursuit of free trade agreements (FTAs) in meeting their export objectives. Some of them even argue that these may in fact be detrimental to exporting due to their shallow coverage of agreements and the phenomenon of an Asian noodle bowl of overlapping FTAs (Baldwin 2008). The most recent line of research literature focuses its attention to examining the effects of the latest policy choices and challenges facing both the giants in the aftermath of a global financial crisis and the ongoing times of unprecedented economic as well as political turbulence and uncertainty. They grapple with issues like risks of protectionism, exchange rate management, business use of FTAs and poverty reduction. (Asian Development Bank Institute Working Paper Series, Reserve Bank Of India Publication, Bardhan 2010, Feenstra and Wei 2010, Zhang 2010, Kawai and Wignaraja 2011). All of the above works set the context for an India-China FTA, providing us with important clues about the various factors which have historically played an important role in determining the extent of success or failure of reforms, and economic liberalization. They show, how well India and China have handled these processes compared to each other, especially in matters of timing, degree of maturity and strategic foresight. Some of the key findings and policy suggestions noted in latter section of this paper draw on these works. We now move on to the second focus area in the survey of literature which aims to highlight some of the major model based work done thus far in assessing the possible impact of an IndiaChina FTA. It includes scenario based statistical works as well. These serve the purpose of adding an element of measurability and added quantitative proof to bolster the arguments made later in the paper.

Several studies are available on estimating the effects of regional trading blocs on intra-regional trade. Raipuria and Mehta (1990), Naqvi and Samad (1992), Srinivasan (1994), and Srinivasan and Canonero (1993a and 1993b) made some noticeable attempts in this context. Raipuria and Mehta (1990) outlined the framework of an approach (Inter-country Link Model System) for analyzing the impact of trade cooperation in the region, along with a review of 21 models for analyzing bilateral trade.

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(Bhattacharya & Bhattacharya 2006) Asian Development Bank Working Paper Series, examine empirically the likely impact of preferential and free trade agreements using Gravity Model developed by Frankel, et al. (1993 and 1997) and extensively used by Safadi and Yeats (1993). They measure the proportionate change in exports and imports of the PRC and India in dollar terms under four hypothetical comparative-static scenarios namely: 25% , 50% , 75% and 100% across the board tariff cuts by the PRC and India. The analysis is based on elasticities estimated by Srinivasan and Canonero (S-C) using panel data. Frankels estimation procedure is adopted in this model. They conclude that An FTA between the PRC and India certainly goes in favor of the PRC and is disadvantageous to India at least in the short run. This is because of the high tariff regime in India and the low tariff regime in the PRC. If there is free trade between the PRC and India, the simulation results show that Indias export to the PRC will increase by only 45.67%, whereas Indias imports from the PRC will increase by 110.37%. A likely increase in Indias imports from the PRC will be highest in the following items/products categories: manufacture of metals; professional instruments and optical goods; metaliferrous ores and metal scrap; man-made filament and spun yarn; raw silk (highest increase i.e., 48% in case of an FTA); iron and steel; inorganic chemicals; A 2008 report titled Indias Policy Choices, jointly produced by the Carnegie Endowment for International Peace in partnership with IGIDR Mumbai, and Institute for Development Studies (University of Sussex) uses a global model called GLOBE, is a member of the class of multicountry, computable general equilibrium (CGE) models that are descendants of the approach described by Dervis, de Melo, and Robinson (1982). It uses data derived from the Global Trade

Analysis Project (GTAP) database.The national model of the Indian economy is the STAGE (Static Applied General Equilibrium). It is a member of single-country CGE models described by Dervis, de Melo, and Robinson (1982) and models reported by Robinson, Kilkenny, and Hanson (1990) and Kilkenny (1991). The model is a (SAM) social accounting matrixbased CGE model, inuenced by Pyatts. The impact of India-PRC FTA according to this is as below : Indias overall real income increases by about $110 million, a gain of 0.02 percent. Indian households would lose about $10 million, while investment would increase by about $130 million (0.12 percent). Total domestic production would increase by $1.2 billion (0.14 percent). Exports would increase by $710 million (1.1 percent), whereas imports would increase by $480 million (0.6 percent). Exports would increase in the categories of other manufacturing ($190 million), chemicals ($130 million), textiles ($110 million), and apparel ($100 million). Indias only signicant increase in imports would be in chemicals ($200 million), with additional increases of less than $100 million in imports of minerals and metals and other manufacturing. An India-China FTA would increase the demand for unskilled labor very modestly, by 0.2 percent, or approximately 900,000 jobs. Increases in demand would be seen in trade and transport and other services. (Agarwal and Ghosh 2011) analyze the implications of a possible IndiaChina FTA on trade flows, real output and investment both at the aggregate and industry levels in India, China, the rest of Asia, the North American and European economies using a multi-sector, multi-region dynamic computable general equilibrium (CGE) model. Their simulation results suggest that the overall economic gains to India and China would be modest. The distribution of the economic gains, however, depends on the speed of elimination of the bilateral tariffs. China gains more if the tariffs are eliminated immediately, whereas India gains more from gradual liberalization. Indias exports to China could expand by almost 57 per cent, while imports from China could increase by over 240 per cent implying an increased bilateral trade deficit. Output in each sector in India would increase. Sectors such as clothing, leather, textiles and motor vehicles and parts would gain the most in India. Rupa Chanda PhD Economics from Columbia University and BA Economics from Harvard University in her 2011 paper written for IIM-B Management Review, uses two measures of

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competitiveness (i) Balassas Revealed Comparative Advantage (RCA) and (ii) Trade Intensity to identify those product groups in which Indo-China bilateral trade is not in-line with Indias and Chinas overall trade in that product group. Such deviations could be due to tariff or nontariff barriers, which a FTA could address. This analysis was conducted at the 2-digit level of harmonised system (HS) codes.. RCA is the ratio of a countrys share of exports in world exports in a particular category to its share of exports in overall world exports. An RCA of greater than 1 indicates high competitiveness. Thus while RCA is a measure of a countrys export competitiveness in a particular commodity category in the international market for that commodity TI of a country in a particular commodity measures the countrys export competitiveness in a specific partners market. while Hence, one could, by tracking for a given commodity, Indias TI in the Chinese market and Indias RCA identify any loss in Indias export competitiveness in the Chinese market. TI to RCA ratio of India and China in each of the 2-digit HS code product groups for the period 2001-2008 were calculated. Import elasticities computed by Keey, Nicitaz and Marcelo Olarreag7 at the HS 6-digit code level were used. Their results indicate that even in a scenario where China completely opens up its markets, while India does not, India will continue to have a deficit. In fact, the deficit only reduces from $22.1 billion to $21.4 billion. Indias exports register an increase of 8.6%, which is not enough to make a dent in the deficit. When both China and India agree to open up their economies completely to each other, overall bilateral trade grows by 15% from about $40 billion to $46 billion. However, Indias trade deficit goes up by 18.18% to $26 billion.

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FINDINGS
In China, the private sector has shown enthusiasm in using trade agreements to advance their interests. A little less than half of the respondents in a survey on the business use of FTAs, agreed to have used at least one FTA and another 32% demonstrated an intent and had plans to use them in the future. Non-tariff barriers play a far greater role than tariff barriers in the PRC. Beginning from the use of the mandarin language itself which is difcult to understand , there is a whole host of nontariff barriers that exporters into China have to deal with. China is often on the top of the list of disputes brought to the WTO by other member nations. India has been the most vociferous complainer. Of the 1061 anti-dumping complaints lodged at the WTO since 2005, a quarter of them have been registered by India, being the most vocal nation against dumping activities. China, quite naturally has been at the receiving end of the charges. Being fed up by Chinese trade malpractices, India in the past 15 years has lodged a total of 137 cases with the WTO. A large part of China's scal decit arises out of contingent liabilities mostly to bail out Stateowned banks and local governments. Financial repression is an unfortunate reality in both China and Inida. China is known for its practice of using household and corporate savings to nance large-scale infrastructure and capacity-creation projects in the Public sector with State-owned banks providing the funding at ultra-low cost of capital that bears no relation to the economic cost of capital. Some of the non-tariff barriers used by the Chinese government to support export-oriented industries is provision of Income tax reductions and refunds, VAT exemptions, other tariff exemptions, exemptions from mandatory worker benefit contributions etc. to companies that satisfy certain export performance requirements. Import substitution subsidies:- Income tax refunds available to companies that purchase Chinese-made equipment and accessories rather than imports. VAT refunds, available to companies that purchase Chinese-made equipment and accessories rather than imports.

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Among the non-tariff barriers, the single largest complaint against China has been its exchange rate. The complaint against the Renminbi is that it is being held unfairly low by the central bank. An RBI study on the long run trade elasticity between India and China found Indias import elasticity to be higher than its export elasticity. Its import elasticity was calculated to be 2.86 while that of exports is 2.38, possibly explaining why the current trade decit is so heavily skewed against India. With an undervalued Renminbi exchange rate, Indian consumers and businesses are enjoying cheap Chinese imports and its exporters are nding it hard to overcome the handicap of lower prices of exports in China. An FTA between India and China will focus almost entirely on manufacturing. This is because Intra-country trade in services between India and China face three major hurdles. First, there is the barrier of language. Second, free trade in services involves free movement of labor. For two of the worlds most populous countries, movement of labor across borders is an important policy consideration. Third it is difcult for FTA to facilitate free trade in services for they are difcult to measure and not malleable for duty imposition to begin with. Thus in an India-China FTA, manufactured goods will be the critical trade. The chances of an Indian manufacturing revival - closer to levels that prevailed in East Asian economies in their boom years - in the very near future are slim. The main reason is India's infrastructural bottlenecks and the rising cost of land. A McKinsey report from 2010 illustrates the weaknesses of Indias infrastructure relative to its competitor. According to the report, USD 45 billion is lost every year due to inefciencies in Indias logistics network. For instance, rail and coastal shipping costs in India are approximately 70% higher than those in the US. Likewise, road costs in India are higher by about 30%. Stiing labor laws prevent the free upgrades to more capital-intensive methods of production. It is often said that ring a worker in certain states in India is nearly impossible. The presence of government led rms in the industries is a signicant contributor to this type of inefciency. Luce and Kynge (2003) succinctly point out, whether it is Chinas cheaper, more reliable power supply or the more rapid turnaround at its ports, China remains an incalculably better environment for most manufacturing than India, which is slowly waking up to this.

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Another structural factor that places a ceiling on economic growth is India's scal decit . India has been unable to divorce itself from its marriage to high scal decit because of successive governments practice of handing out feudal and paternalistic doles with an eye on elections. Fiscal decit becomes extremely important for a country as it effects its cost of capital because the cost at which the sovereign can borrow sets the oor on the cost of capital. One of China's big contemporary competitive advantages and a source of big but yet unquantiable risk is its ultra-low cost of capital.
The case for FTA with China is based principally on its strategic value. With the creation of NAFTA, expansion of EU, and FTAs in Latin America, Asia has had diversion of these regions trade away from it. One way to counter this is to form an Asian block, which is truly possible only if India and China form a FTA.

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CONCLUSION
An India-China FTA could be the stimulus for India to come out of its virtual policy paralysis, muster the required political will, undertake all those critical reforms and hasten decisions which have thus far been kept on the back burner. The Indian polity will have to meaningfully engage with the industry and society on policy imperatives. In view of the comparative disadvantage of Indias manufacturing sector, and a much lower tariff structure in the PRC, a PRC-India FTA trade cooperation should start with a preferential trade agreement, reducing tariffs in a phased manner covering selected manufactured items and services. The ultimate aim should be a comprehensive, overarching FTA which has to include service trade, cross-border investments, specially by way of Chinese FDI in infrastructure sector, other forms of financial co-operation, skill- sharing, technology-sharing, and collaboration on research and development. Moreover it has to be backed by China taking concrete actions towards removal of invisible, hidden, non-tariff barriers, and implementing a robust framework for addressing issues like antdumping, standards, and dispute settlement. Trade integration between the PRC and India would be strengthened a great deal more through private sector enthusiasm and participation. Also, in view of the recent trend of FTAs, the importance of a PRC-India FTA should not be viewed only economically but also politically.

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BIBLIOGRAPHY
India and China: Trade and Foreign Investment . Arvind Panagariya 2006. Indias Trade Policy Choices: Managing Diverse Challenges. 2008 Carnegie Endowment for Internatonal Peace. An IndiaChina FTA: Potential Economic Implications for the Asian and the North American Economies. Manmohan Agarwal, Madanmohan Ghosh 2011. ADB Working Paper Series on Regional Economic Integration No. 83 - The Peoples Republic of China and India: Commercial Policies in the Giants. Ganeshan Wignaraja 2011. Dancing With Giants: China, India, and the global economy. L. Alan Winters, Shahid Yusuf 2007. China and India: Economic Performance, Competition and Cooperation An Update. T. N. Srinivasan. India-ASEAN Free Trade Agreement: A Survey of Literature. Tuli Sinha 2009. IPCS Special Report. Economic Reforms, Regionalism and Exports : Comparing China and India. G. Wignaraja 2011. India-China Free Trade Agreement (FTA) Viability, Prospects and Challenges. Rupa Chanda 2011. Demistifying India-China Trade Policies. Nageswaran and Ghosh 2011. The Impact of Free Trade Agreements on Business Activity: A Survey of Firms in the People's Republic of China. Yunling Zhang 2010. China and India: A Tale of Two Trade Integration Approaches. ICRIER Working Paper No. 221. Przemyslaw Kowalski 2008. ADB Institute Discussion Paper No. 59. Free Trade Agreement between Peoples Republic of China and India: Likely Impact and Its Implications to Asian Economic Community. Swapan K. Bhattacharya and Biswa N. Bhattacharyay. ICRIER Working Paper No. 168 Revealed Comparative Advantage: An Analysis for India and China. Batra and Khan 2005. Trade Liberalization and Its Role in Chinese Economic Growth. Nicholas R. Lardy 2003. Industrial Development: Stylized Facts and Policies . Dani Rodrik 2006. Trade Agreemenets in a Globalised World. Kati Suominen 2009. Feenstra and Wei 2009. NBER Working Paper No. 14716. Introduction to Chinas Growing Role in World Trade.

The India-China Strategic Economic Dialogue. Suman Bery 2011.

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