India-Pakistan Trade: The Most Favored Nation Breakthrough
by Mohsin S. Khan, Peterson Institute for International Economics
Reprinted with permission of Foreign Policy
November 4, 2011
© Foreign Affairs
On November 2, 2011, the Pakistan government announced that it was ready to grant most favored nation (MFN) status to India. This means that Pakistan's tariffs on Indian imports will have to be the same as the tariffs it imposes on imports from its other trading partners. Why is MFN important? To answer this question one has to ask why India and Pakistan trade so little with each other despite the existence of common history, language, culture, and long borders. Economic theory predicts that trade between the two largest economies in South Asia would be at least five to ten times greater than its current level of around $2 billion. While both sides are fully aware of the advantages of trade, a variety of political, infrastructural, legal, and regulatory impediments have essentially paralyzed bilateral trade relations between the two neighbors.
One of the main constraints to trade has been that Pakistan did not reciprocate India's granting of MFN in 1996 to Pakistan. Thus, the approval to grant MFN to India by the Pakistan cabinet is clearly a major breakthrough in trade relations between the two countries, and finally fulfills Pakistan's obligations as a member of the World Trade Organization (WTO). It is interesting to note that Pakistan and India were among the original 23 signatories to the General Agreement on Trade and Tariffs (GATT) in 1947, which articulated the MFN principle. It has taken Pakistan some 64 years to finally start implementing what it signed on to do.
Not discounting the importance of the announcement, there is still an enormous amount of work to be done to implement the cabinet decision. Pakistan will have to abandon the positive list of some 2000 items that it maintains on goods that can be imported from India. To be consistent with the MFN principle this positive list is to be replaced by a negative or "sensitive" items list of goods that will still be restricted. The Pakistan Ministry of Commerce has prepared this negative list but needs to consult with stakeholders on the items to be covered. This will take time as the sectors of the economy that feel that they would be adversely impacted by imports from India will lobby hard to have their products put on the negative list. The military is also a stakeholder, not just from a defense standpoint but wearing its hat as a major industrialist, and will naturally weigh into the discussion of the composition of the negative list.
In some sense, the MFN itself is symbolic, but it is a very important symbol. First, it means that Pakistan has decided to separate trade issues from other major political issues (in particular Kashmir) that have strained relations between the two countries since their independence in 1947. And second, Pakistan has apparently moved away from its previous position of linking MFN with the removal on Indian non-tariff barriers on Pakistani exports. While Pakistani businessmen have been pushing for liberalization of trade with India for some time, they have come up against a formidable array of opponents, including nationalist politicians, bureaucrats, industries that could potentially lose out to Indian competition, and most importantly the Pakistan military. Clearly, the military has now withdrawn its opposition to trading with India, thereby allowing the cabinet to vote unanimously in favor of granting MFN to India.
By itself granting MFN will not lead to the levels of trade that India and Pakistan should have with each other. It is expected there will be a jump in trade as unofficial trade between the two countries going through Dubai, estimated to be around $2 billion to $3 billion a year, could then take place directly through official channels. So some sizable increase in trade is very much in the cards.
However, there are still a host of other obstacles to trade that will have to be tackled, even after MFN is in place, to significantly boost trade between the two countries. On the tariff side, even though India's average MFN applied tariff is 13 percent, its tariffs on goods of particular interest to Pakistan such as agriculture, textiles, and leather goods remain high. For example, on agricultural products the average applied tariff is about 40 percent. Other constraints on trade between the two countries include significant non-tariff barriers, inadequate infrastructure, bureaucratic inertia, and excessive red tape.
The complete liberalization of trade between India and Pakistan is going to be a long and arduous process—but the granting of MFN by Pakistan to India is an important start to this process. Higher levels of trade will benefit both countries, and Pakistan more so than India. Indeed, as India is the engine of growth in South Asia, Pakistan has to hitch its wagon to the locomotive or risk getting left behind on the platform. This reality is now recognized and accepted by the Pakistan government, and it seems finally also by the supposedly "India-centric" Pakistan military.
Trade will of course not solve all the problems between the two countries, but it could be an important catalyst in reducing tensions. It is clearly in the interest of both countries, and the world for that matter, to find a political resolution to India-Pakistan problems, and increased trade can well be the starting point for this objective.