EFFECTS OF UNILATERAL TRADE LIBERALIZATION IN SOUTH ASIAN COUNTRIES: Applications of CGE Models of Bangladesh, India, Nepal, Pakistan and Sri Lanka

ESCAP SOUTH AND SOUTH-WEST ASIA OFFICE EFFECTS OF UNILATERAL TRADE LIBERALIZATION IN SOUTH ASIAN COUNTRIES: Applications of CGE Models of Bangladesh, India, Nepal, Pakistan and Sri Lanka Selim Raihan DEVELOPMENT PAPERS 1501

South and South-West Asia Development Papers 1501 Disclaimer: The views expressed in this Development Paper are those of the author(s) and should not necessarily be considered as reflecting the views or carrying the endorsement of the United Nations. Development Papers describe research in progress by the author(s) and are published to elicit comments and to further debate. This publication has been issued without formal editing. For any further details, please contact: Dr. Nagesh Kumar, Director South and South-West Asia Office (SSWA) Economic and Social Commission for Asia and the Pacific (ESCAP) C-2 Qutab Institutional Area, New Delhi-110016, India Email: sswa.escap@un.org 2

Effects of Unilateral Trade Liberalization in South Asian Countries Contents Foreword... 6 Abstract... 7 Executive Summary... 8 I. INTRODUCTION... 12 II. METHODOLOGY... 12 2.1. The CGE Model... 12 2.2. Brief Description of Social Account Matrix (SAM) for 2012... 14 2.3. Structure of the Economies of Bangladesh, India, Nepal, Pakistan and Sri Lanka as in 2012 SAM... 16 III. TARIFF LIBERALIZATION SIMULATION IN THE CGE MODELS AND CLOSURES... 19 IV. SIMULATION RESULTS... 19 4.1. Macroeconomic Effects... 19 4.2. Production Effects on Broad Sectors... 22 4.3. Effects on Exports by Broad Sectors... 23 4.4. Effects on Imports by Broad Sectors... 25 4.5. Effects on Output in All Sectors... 26 4.6. Effects on Exports in All Sectors... 28 4.7. Effects on Imports in All Sectors... 29 4.8. Effects on Factor Market... 31 4.9. Effects on Capital Returns... 35 4.10. Effects on household Income... 36 V. CONCLUSION... 39 REFERENCES... 41 3

South and South-West Asia Development Papers 1501 List of Tables Table 1: Description of Bangladesh SAM Accounts for 2012... 14 Table 2: Description of India SAM Accounts for 2012... 15 Table 3: Description of Nepal SAM Accounts for 2012... 15 Table 4: Description of Pakistan SAM Accounts for 2012... 16 Table 5: Description of Sri Lanka SAM Accounts for 2012... 16 Table 6: Structure of the Bangladesh economy in 2012 as reflected in the SAM 2012... 17 Table 7: Structure of the Indian economy in 2012 as reflected in the SAM 2012... 17 Table 8: Structure of the Nepal economy in 2012 as reflected in the SAM 2012... 18 Table 9: Structure of the Pakistan economy in 2012 as reflected in the SAM 2012... 18 Table 10: Structure of the Sri Lanka economy in 2012 as reflected in the SAM 2012... 19 Table 11: Macro-economic effects (% change from base)... 20 Table 12: Percent changes in value added, capital stocks and employment: Bangladesh... 31 Table 13: Percent changes in value added, capital stocks and employment: India... 32 Table 14: Percent changes in value added, capital stocks and employment: Nepal... 32 Table 15: Percent changes in value added, capital stocks and employment: Pakistan... 33 Table 16: Percent changes in value added, capital stocks and employment: Sri Lanka... 33 4

Effects of Unilateral Trade Liberalization in South Asian Countries List of Figures Figure 1: Effects on key macroeconomic variables (% change from base)... 20 Figure 2: Production-related effects (% change from base)... 21 Figure 3: Percent changes in the volume of output (by broad sector)... 22 Figure 4: Percent changes in the price of output (by broad sector)... 23 Figure 5: Percent changes in the volume of exports (by broad sector)... 23 Figure 6: Percent changes in the price of exports (by broad sector)... 24 Figure 7: Percent changes in the volume of imports (by broad sector)... 25 Figure 8: Percent changes in the price of imports (by broad sector)... 26 Figure 9: Percent changes in the volume of output (by sector)... 26 Figure 10: Percent changes in the price of output (by sector)... 27 Figure 11: Percent changes in the volume of exports (by sector)... 28 Figure 12: Percent changes in the price of exports (by sector)... 29 Figure 13: Percent changes in the volume of imports (by sector)... 30 Figure 14: Percent changes in the price of imports of (by sector)... 30 Figure 15: Percent changes in employment (by skill and broad sector)... 34 Figure 16: Percent changes in total sectoral employment... 35 Figure 17: Percent changes in capital returns (by broad sector)... 36 Figure 18: Percent changes in nominal household income (by household categories)... 37 Figure 19: Percent changes in household-specific CPI (by household categories)... 37 Figure 20: Percent changes in household real incomes (by household categories)... 38 5

South and South-West Asia Development Papers 1501 Foreword The Development Papers series of the UNESCAP South and South-West Asia Office (UNESCAP-SSWA) promotes and disseminates policy-relevant research on the development challenges facing South and South-West Asia. It features policy research conducted at UNESCAP-SSWA as well as by outside experts from within the region and beyond. The objective is to foster an informed debate on development policy challenges facing the subregion and sharing of development experiences and best practices. In this paper prepared by Selim Raihan for UNESCAP-SSWA, country specific Computable General Equilibrium (CGE) models are employed to assess the economy-wide effects of unilateral trade liberalization in five selected South Asian countries; Bangladesh, India, Nepal, Pakistan and Sri Lanka. Effects of elimination of all import tariffs on economic growth, trade, employment and household income are captured through exogenous shocks to the price operator. Though the degree of effects varies from country to country, all the five selected South Asian countries are observed to benefit out of improving economic conditions. A general fall in import prices is followed by increase in domestic demand, employment, wage rates, return to capital and return to land. Terms of trade improves for all five countries with depreciation in real exchange rates and rising export competitiveness. Higher exports in turn pull up gross production across sectors. The analysis finds growth in real GDP triggered by tariff elimination in South Asian countries ranging from 0.6 percent in Sri Lanka to 3.1 percent in Bangladesh. Certain sectors such as textiles and clothing are well placed to secure massive export growth, which may go up by more than 13 per cent in Bangladesh and by 10 per cent in India. One of the key observations of the paper is the positive impact of across-the-board import tariff cuts on both agricultural output and exports. This implies that some vital solutions for reviving South Asia s farm sector could be sought through a more comprehensive approach to trade liberalization. Permitting us to appreciate a larger picture without the limitations of partial trade models, this paper offers rich insights on potential effects of unilateral trade liberalization programmes. We hope that this paper s exposition of economy-wide effects will inspire trade practitioners from the subregion to fast-track trade reforms. Nagesh Kumar Head, ESCAP South and South-West Asia Office 6

Effects of Unilateral Trade Liberalization in South Asian Countries Effects of Unilateral Trade Liberalization in South Asian Countries: Applications of CGE Models of Bangladesh, India, Nepal, Pakistan and Sri Lanka Selim Raihan 1 Abstract This paper explores the economy-wide effects of trade liberalization in five South Asian countries (Bangladesh, India, Nepal, Pakistan and Sri Lanka) using updated Social Accounting Matrices (SAM) and static Computable General Equilibrium (CGE) models of these countries for the year 2012. The CGE framework captures the impact of unilateral trade liberalization on macro-economy, trade, employment and household welfare in the selected countries by tracing the price effects of exogenous shocks, where the variations in prices lead to re-allocation of resources among competing activities, which then may alter the factorial income and, hence, the distribution of household income. The results show that trade liberalization measures stimulates growth in employment, for skilled and unskilled labour, as well as real income for all the five South Asian countries. Tariff elimination increases real GDP at factor cost by 3.1 percent in Bangladesh, by 2.5 percent in India, by 2 percent in Nepal, by 0.9 percent in Pakistan, and by 0.6 percent in Sri Lanka. The relative price and wage changes in these five economies are also observed to culminate in a general depreciation of real exchange rates, making their exports more competitive in the world markets. JEL Codes(s): F14, F16 Key words: South Asia, Unilateral Trade Liberalization, Computable General Equilibrium Models, Trade and Employment, Household Income Distribution. 1 Professor, Department of Economics, University of Dhaka, Bangladesh and Executive Director, South Asian Network on Economic Modeling (SANEM), email: selim.raihan@econdu.ac.bd. This paper was written with support from UNESCAP Subregional Office for South and South-West Asia. 7

South and South-West Asia Development Papers 1501 Executive Summary This paper provides a report of developing CGE models for five South Asian countries (Bangladesh, India, Nepal, Pakistan and Sri Lanka) and their application in the analysis of impact of unilateral trade liberalization on macro-economy, trade, employment and household welfare in these countries. Trade liberalization has been among the major policy reforms in South Asia. This paper explores the economy-wide effects of trade liberalization in Bangladesh, India, Nepal, Pakistan and Sri Lanka using the most of updated Social Accounting Matrices (SAM) of these countries and CGE models of these countries. The advantage of a CGE framework is that it traces the price effects of the exogenous shock. In an increasingly market-oriented economy, the variations in prices may be the most important sources of re-allocation of resources among competing activities, which then may alter the factorial income and, hence, the distribution of personal income. This exercise employs a static CGE model for five South Asian countries and the Social Accounting Matrix (SAM) of these countries for the year 2012. This experiment undertakes a unilateral elimination of all commodity tariffs. The following closure assumptions are imposed on the CGE models of the South Asian countries. On the income-side: total stocks of land, tax rates and technical changes are fixed. Capital is sector specific. Rigidities in the labor market are reflected by allowing aggregate employment to change i.e., labor is in elastic supply with a pool of unemployed workers waiting to be hired at a wage (nominal and real) indexed to the economy-wide consumer price index (CPI). On the expenditure-side: Total real inventories, total real investment and total real government expenditures are held fixed, whereas both aggregate real household consumption and real trade balance (exports imports) are endogenous. The consumer price index (CPI) is the model s numéraire. The macroeconomic effects of the tariff liberalization simulation for the five South Asian countries suggest that the price of imports in local currency falls by larger margins in Bangladesh and Nepal. Bangladesh experiences the largest rise in total demand for imports followed by India. Total domestic demand increases most in Bangladesh, followed by Pakistan. The average cost of domestic production increases in all countries due to rise in primary factor costs. India has the highest rise in nominal return to capital followed by Bangladesh. The GDP price deflator increases in all countries; because, though tariff reduction lowers the price of investment goods, this is offset by the rise in primary factor costs, nominal wage, return to capital and return to land. The GDP price deflator has the highest rise in Bangladesh followed by India and Nepal. The real exchange rate depreciates in all countries with the largest depreciation in Bangladesh. The terms of trade improves in 8

Effects of Unilateral Trade Liberalization in South Asian Countries all countries with the largest improvement in Bangladesh. The real exchange rate depreciation makes exports more competitive in the world market. Hence, exports expand and the largest positive effect on exports is found for Bangladesh. Higher exports pull up economy-wide gross production for all five countries with the largest positive effect on Bangladesh. The largest positive effect on real GDP is seen on Bangladesh and least on Sri Lanka. Also, largest positive effect on employment is observed for Bangladesh. Production effects on broad sectors of the simulation shows that, due to tariff liberalization, larger effects on outputs are observed in Bangladesh and least effects are observed in Sri Lanka. Average output price of agriculture increases in all five countries with largest effect in Bangladesh. Average price of industrial goods falls in Bangladesh, Nepal and Pakistan and increases in India and Sri Lanka. Average price of services increases in all countries except Pakistan. The effects on exports by broad sector suggest that there will be positive effects on exports in all three broad sectors. In general, largest effects on exports would be observed for Bangladesh followed by India. Sri Lanka will have the least positive effect. The effects on imports by broad sector indicate that tariff elimination reduces the average local currency price of imports in all five countries, with largest effect in Bangladesh and least effect in Sri Lanka. Agricultural imports will rise by more than 100 percent in India due to the elimination of high agricultural tariff. Industrial imports become cheaper due to tariff elimination, while import prices of tariff-free services increase due to exchange rate depreciation. Agricultural sectors in all countries expand, except in India where the grains and crops sector contract. Textile and clothing sector in all five countries expands most, with largest expansion is in Bangladesh. In Bangladesh, Nepal and Pakistan, light and heavy manufacturing sectors contract, whereas they expand in India and Sri Lanka. Services sectors expand in all five countries. All the export-oriented sectors experience rise in export in all five countries. India experiences the largest rise in agricultural exports. Export of Bangladesh s major export product textile and clothing rises by more than 13 percent (highest in South Asia). Bangladesh, India and Nepal experience rise in exports of light and heavy manufacturing by more than Pakistan and Sri Lanka. In Bangladesh, imports in all sector increase. However, in all other four countries, there are mixed experience. In India, import of grains and crops rise by more than 100 percent. Import in all other sectors, except transport and communication services and other services, increase. 9

South and South-West Asia Development Papers 1501 In Nepal, imports in all sectors, except livestock and meat products, transport and communication services and other services, increase. In Pakistan, import in all sectors, except grains and crops, mining and extraction, transport and communication services and other services, increase. In Sri Lanka, imports in all sectors, except mining and extraction, transport and communication services and other services, increase. In Bangladesh, tariff elimination increases real GDP at factor cost by 3.1 percent. The average price of value added (1.8 percent) reflects the general increase in returns to capital (3.4 percent). Tariff elimination increases overall supply of labor by 6.2 percent. Labor moves from contracting sectors to expanding sectors. Within industry, workers move away from import substituting sectors (heavy and light manufacturing) to export-oriented sectors, especially to the textile and clothing sector. In India, tariff elimination increases real GDP at factor cost by 2.5 percent. The average price of value added (1.6 percent) reflects the general increase in returns to capital (3.7 percent). Tariff elimination increases overall supply of labor by 4.8 percent. Labor moves from contracting sectors (grains and crops) to expanding sectors. Larger rise in employment is observed in mining and extraction and textile and clothing sector. In Nepal, tariff elimination increases real GDP at factor cost by 2 percent. The average price of value added (1.7 percent) reflects the general increase in returns to capital (3.1 percent). Tariff elimination increases overall supply of labor by 4.8 percent. Labor moves from contracting sectors (light and heavy manufacturing) to expanding sectors (mainly the services sectors). Larger rise in employment is observed in textile and clothing sector, processed food and utilities and construction. In Pakistan, tariff elimination increases real GDP at factor cost by 0.9 percent. The average price of value added (0.9 percent) reflects the general increase in returns to capital (1.5 percent). Tariff elimination increases overall supply of labor by 2.2 percent. Labor moves from contracting sectors (light and heavy manufacturing) to expanding sectors (mainly textile and clothing). Larger rise in employment is observed in textile and clothing sector and processed food sector. In Sri Lanka, tariff elimination increases real GDP at factor cost by 0.6 percent. The average price of value added (0.7 percent) reflects the general increase in returns to capital (1.3 percent). Tariff elimination increases overall supply of labor by 1.5 percent. Employment increases in all sectors. However, largest rise in employment is observed in textile and clothing sector. In all five South Asian counties employment increases for both skilled and unskilled labor. In Bangladesh and Sri Lanka employment of unskilled labor increases more than skilled labor. In India, Nepal and Pakistan employment of skilled labor increase more than the unskilled labor. In all South Asian countries all agricultural sectors experience rise in employment, except grains and crop sector in India. In the manufacturing sectors, the effects on employment are mixed. In Bangladesh, Nepal and Pakistan, sectors like heavy and light manufacturing experience employment loss with rise in employment in other sectors. In India 10

Effects of Unilateral Trade Liberalization in South Asian Countries and Sri Lanka, the effects on employment are positive in all sectors (except grains and crop sector in India). For the effects on capital returns by broad sectors, South Asian countries have different experiences. In the case of agriculture, Bangladesh experiences the highest rise in returns to capital and least rise is for Sri Lanka. In the case of Industry, Bangladesh has the highest rise, whereas Sri Lanka has the lowest rise and Nepal has negative returns. In the case of services, Nepal has the highest rise and Sri Lanka has the lowest rise. In Bangladesh, the largest rise in nominal income is for urban low educated households. In India, the largest rise is for rural other labor households. In Nepal, the largest rise is for urban low educated households. In Pakistan, the largest rise is for urban poor and in Sri Lanka the largest rise is for Western region and Saba region households. In general, households in Bangladesh and India experience larger rises in nominal incomes than households in three other countries. CPIs of households either fall or rise marginally in the five South Asian countries. Real income (household nominal income deflated by household-specific CPI) of all household increases in all South Asian countries. 11

South and South-West Asia Development Papers 1501 I. INTRODUCTION The economy-wide impact of trade liberalization is a much debated and controversial issue. Theoretically, trade liberalization results in productivity gains through increased competition, efficiency, innovation and acquisition of new technology. Trade policy works by inducing substitution effects in the production and consumption of goods and services through changes in prices. These effects, in turn, change the level and composition of exports and imports. In particular, the changing relative prices induced by trade liberalization cause a re-allocation of resources from less efficient to more efficient uses. Trade liberalization is also thought to expand the set of economic opportunities by enlarging the market size and increasing the effects of knowledge spill over. These are the key theoretical components of the effects of trade liberalization, which together induce growth of output and consequent poverty alleviation. Trade liberalization has been among the major policy reforms in South Asia. This paper explores the economy-wide effects of trade liberalization in Bangladesh, India, Nepal, Pakistan and Sri Lanka using the most of updated Social Accounting Matrices (SAM) of these countries and Computable General Equilibrium (CGE) models of these countries. The advantage of a CGE framework is that it traces the price effects of the exogenous shock. In an increasingly marketoriented economy, the variations in prices may be the most important sources of re-allocation of resources among competing activities, which then may alter the factorial income and, hence, the distribution of personal income. The organization of the paper is as follows: Section II presents on the methodology of the paper; Section III discusses on the simulation design and model closures; Section IV presents the simulation results in terms on impact on macro-economy, sectoral output, sectoral exports, sectoral imports, factor market and household welfare. II. METHODOLOGY This exercise employs a static CGE model for five South Asian countries and the Social Accounting Matrix (SAM) of these countries for the year 2012. The modules of the CGE model and a description of the SAM are provided below. 2.1. The CGE Model The CGE model is built using the PEP standard static model (Decaluwe et al, 2009) and with further developments and modifications. In the CGE model, a representative firm in each industry maximizes profits subject to its production technology. The sectoral output follows a Leontief production function. Each industry s value added consists of composite labor and composite capital, following a CES specification. Different categories of labor are combined 12

Effects of Unilateral Trade Liberalization in South Asian Countries following a CES technology with imperfect substitutability between different types of labor. Composite capital is a CES combination of the different categories of capital. It is assumed that intermediate inputs are perfectly complementary. They are combined following a Leontief production function. Household incomes come from labor income, capital income, and transfers received from other agents. Subtracting direct taxes yields household s disposable income. Household savings are a linear function of disposable income, which allows the marginal propensity to save to differ from the average propensity. Corporate income consists of its share of capital income and of transfers received from other agents. Deducting business income taxes from total income yields the disposable income of each type of business. Likewise, business savings are the residual that remains after subtracting transfers to other agents from disposable income. The government draws its income from household and business income taxes, taxes on products and on imports, and other taxes on production. Income taxes for both households and businesses are described as a linear function of total income. The current government budget surplus or deficit (positive or negative savings) is the difference between its revenue and its expenditures. The latter consists of transfers to agents and current expenditures on goods and services. The rest of the world receives payments for the value of imports, part of the income of capital, and transfers from domestic agents. Foreign spending in the domestic economy consists of the value of exports and transfers to domestic agents. The difference between foreign receipts and spending is the amount of rest-of-the-world savings, which are equal in absolute value to the current account balance but are of opposite sign. The demand for goods and services, whether domestically produced or imported, consists of household consumption demand, investment demand, demand by government, and demand as transport or trade margins. It is assumed that households have Stone Geary utility functions (from which derives the Linear Expenditure System). Investment demand includes both gross fixed capital formation (GFCF) and changes in inventories. Producers supply behavior is represented by nested constant elasticity of transformation (CET) functions. On the upper level aggregate output is allocated to individual products; on the lower level the supply of each product is distributed between the domestic market and exports. The model departs from the pure form of the small-country hypothesis. A local producer can increase his share of the world market only by offering a price that is advantageous relative to the (exogenous) world price. The ease with which his share can be increased depends on the degree of substitutability of the proposed product for competing products; in other words, it depends on 13

South and South-West Asia Development Papers 1501 the price-elasticity of export demand. Commodities demanded on the domestic market are composite goods, combinations of locally produced goods and imports. The imperfect substitutability between the two is represented by a CES aggregator function. Naturally, for goods with no competition from imports, the demand for the composite commodity is the demand for the domestically produced good. The system requires equilibrium between the supply and demand of each commodity on the domestic market. The sum of supplies of every commodity made by local producers must equal domestic demand for that locally produced commodity. Finally, supply to the export market of each good must be matched by demand. Also, there is equilibrium between total demand for capital and its available supply. However, the model assumes flexible wage rates for labor, allowing for unemployment. 2.2. Brief Description of Social Account Matrix (SAM) for 2012 The CGE models of the five South Asian countries use the latest available Social Accounting Matrix (SAM) of these countries for the year 2012 (Raihan, 2014). The summaries of the SAM of these five countries are provided below. The 2012 SAM for Bangladesh has the following accounts: (1) total domestic supply of 10 commodities; (2) production accounts for 10 activities; (3) 4 factors of productions-two labor types and two capital categories; (4) current account transactions between 4 current institutional agents- households and unincorporated capital, corporate enterprises, government and the rest of the world; household account includes seven representative groups (5 rural and 2 urban); and (5) one consolidated capital account. The structure of the Bangladesh SAM is described in Table 1. Set Activity (10) Commodity (10) Factors of Production (4) Households (7) Other Institutions (4) Source: Raihan (2014) Table 1: Description of Bangladesh SAM Accounts for 2012 Description of Elements Agriculture and extraction:,,. Manufacturing:,,,. Services: Utilities and Construction,,. Agriculture and extraction:,,. Manufacturing:,,,. Services: Utilities and Construction,,. Unskilled labor, Skilled labor, Capital and Land : landless, Agricultural marginal, Agricultural small, Agricultural large, Non-farm : Households with low educated heads, and households with high educated heads Government; Corporation; Rest of the World and Capital The 2012 SAM for India identifies the economic relations through following accounts: (1) total domestic supply of 10 commodities; (2) production accounts for 10 activities; (3) 4 factors of productions-two labor types and two capital categories; (4) current account transactions between 4 current institutional agents- households and unincorporated capital, corporate enterprises, 14

Effects of Unilateral Trade Liberalization in South Asian Countries government and the rest of the world; household account includes 9 representative groups (5 rural and 4 urban); and (5) one consolidated capital account. The structure of the India SAM is described in Table 2. Set Activity (10) Commodity (10) Factors of Production (4) Households (9) Other Institutions (4) Source: Raihan (2014) Table 2: Description of India SAM Accounts for 2012 Description of Elements,,., Textiles and Clothing,,. Utilities and Construction, Transport and Communication,.,,., Textiles and Clothing,,. Utilities and Construction, Transport and Communication,. Unskilled labor, Skilled labor, Capital and Land non-agricultural self-employed, agricultural labor, other laboor, agricultural selfemployed and other households self-employed, salaried class, casual labour and other households Government; Corporation; Rest of the World and Capital The 2012 SAM for Nepal has the following accounts: (1) total domestic supply of 10 commodities; (2) production accounts for 10 activities; (3) 4 factors of productions-two labor types and two capital categories; (4) current account transactions between 4 current institutional agents- households and unincorporated capital, corporate enterprises, government and the rest of the world; household account includes 7 representative groups (4 rural and 3 urban); and (5) one consolidated capital account. The structure of the Nepal SAM is described in Table 3. Set Activity (10) Commodity (10) Factors of Production (4) Households (7) Other Institutions (4) Source: Raihan (2014) Table 3: Description of Nepal SAM Accounts for 2012 Description of Elements,,., Textiles and Clothing,,. Utilities and Construction, Transport and Communication,.,,., Textiles and Clothing,,. Utilities and Construction, Transport and Communication,. Unskilled labor, Skilled labor, Capital and Land : landless, Agricultural marginal farmer, Agricultural small farmer, Agricultural large farmer : Households with low educated heads, Households with medium educated heads and households with high educated heads Government; Corporation; Rest of the World and Capital The 2012 SAM for Pakistan has the following accounts: (1) total domestic supply of 10 commodities; (2) production accounts for 10 activities; (3) 4 factors of productions-two labor types and two capital categories; (4) current account transactions between 4 current institutional agents- households and unincorporated capital, corporate enterprises, government and the rest of the world; household account includes 9 representative groups (4 rural and 3 urban); and (5) one consolidated capital account. The structure of the Pakistan SAM is described in Table 4. 15

South and South-West Asia Development Papers 1501 Set Activity (10) Commodity (10) Factors of Production (4) Households (9) Other Institutions (4) Source: Raihan (2014) Table 4: Description of Pakistan SAM Accounts for 2012 Description of Elements,,., Textiles and Clothing,,. Utilities and Construction, Transport and Communication,.,,., Textiles and Clothing,,. Utilities and Construction, Transport and Communication,. Unskilled labor, Skilled labor, Capital and Land Large farm, Medium farm, Small farm, Landless farmer, Landless agricultural labor, non-farm non poor, non-farm poor non-poor, poor Government; Corporation; Rest of the World and Capital The 2012 SAM for Sri Lanka has the following accounts: (1) total domestic supply of 10 commodities; (2) production accounts for 10 activities; (3) 4 factors of productions-two labor types and two capital categories; (4) current account transactions between 4 current institutional agents- households and unincorporated capital, corporate enterprises, government and the rest of the world; household account includes 8 representative groups (4 rural and 3 urban); and (5) one consolidated capital account. The structure of the Sri Lanka SAM is described in Table 5. Set Activity (10) Commodity (10) Factors of Production (4) Households (8) Other Institutions (4) Source: Raihan (2014) Table 5: Description of Sri Lanka SAM Accounts for 2012 Description of Elements,,., Textiles and Clothing,,. Utilities and Construction, Transport and Communication,.,,., Textiles and Clothing,,. Utilities and Construction, Transport and Communication,. Unskilled labor, Skilled labor, Capital and Land Western, Central, Southern, North East, North West, North Central, Uva, Saba Government; Corporation; Rest of the World and Capital 2.3. Structure of the Economies of Bangladesh, India, Nepal, Pakistan and Sri Lanka as in 2012 SAM Table 6 presents the structure of the Bangladesh economy in 2012. In terms of value-addition, among the agricultural sectors, the leading sector is the grains and crops with 11.33 percent share. Among the manufacturing sectors, the leading sector is textile and clothing (7.55 percent). Among the services sectors, the leading sector is transport and communication (27.65 percent). The textile and clothing sector is highly export oriented. The export basket is highly concentrated as 88.12 percent exports come from textile and clothing. The heavy manufacturing sector is highly import dependent. In the case of tariff rate, agricultural sectors have lower tariff rates than the manufacturing sectors. 16

Effects of Unilateral Trade Liberalization in South Asian Countries Table 6: Structure of the Bangladesh economy in 2012 as reflected in the SAM 2012 1 2 3 4 5 6 Sectors Vi/TV Ei/Oi Ei/TE Mi/Oi Mi/TM TAR 11.33 0.42 0.56 9.09 8.05 4.52 1.25 7 1 2.25 0.25 8.22 6.60 0.16 8 2.20 0.75 7.61 1.34 1.53 1.59 15.96 10.87 13.38 7.55 51.68 88.12 17.57 19.70 25.33 1.74 2.41 1.44 20.83 8.22 19.59 0.99 1.17 1.26 60.96 43.16 11.77 Utilities and Construction 16.86 - - - - - 27.65 2.87 6.30 2.42 3.49-24.69 0.28 0.63 3.65 5.52 - Total 100 100 100 Note: Vi=sectoral value added, TV=total value added, Ei=sectoral export, Oi=sectoral output, TE=total export, Mi=sectoral import, TM=total import, TAR=tariff rate, All figures are expressed in percentages. Source: Raihan (2014) Table 7 presents the structure of the Indian economy in 2012. In terms of value-addition, among the agricultural sectors, the leading sector is the grains and crops with 9.36 percent share. Among the manufacturing sectors, the leading sector is heavy manufacturing (7 percent). Among the services sectors, the leading sector in other services (31.86 percent). The export basket is fairly diversified. The heavy manufacturing and mining and extraction sectors are highly import dependent. In the case of tariff rate, grain and crops sector has the highest tariff rate. Table 7: Structure of the Indian economy in 2012 as reflected in the SAM 2012 1 2 3 4 5 6 Sectors Vi/TV Ei/Oi Ei/TE Mi/Oi Mi/TM TAR 9.36 5.23 2.55 2.70 1.06 58.88 3.33 0 0.38 0.51 8 8.54 4.20 9 1.34 65.44 33.88 2.98 1.80 7.05 2.35 9.55 2.57 32.90 1.63 25.99 5.64 4.18 0.73 19.83 4.61 31.47 19.44 13.15 6.55 17.45 7.00 16.17 32.49 21.62 34 12.85 Utilities and Construction 10.63 - - - - - 25.57 15.97 23.90 6.20 7.49-31.86 7.66 11.92 14 12.60 - Total 100 100 100 Note: Vi=sectoral value added, TV=total value added, Ei=sectoral export, Oi=sectoral output, TE=total export, Mi=sectoral import, TM=total import, TAR=tariff rate, All figures are expressed in percentages. Source: Raihan (2014) Table 8 presents the structure of the Nepal economy in 2012. In terms of value-addition, among the agricultural sectors, the leading sector is the grains and crops with 25.19 percent share. Among the manufacturing sectors, the leading sector is light manufacturing (2.25 percent). Among the services sectors, the leading sector is other services (28.04 percent). The export basket is concentrated around textile and clothing, transport and communication and other services. The heavy manufacturing sector is highly import dependent. In the case of tariff rate, agricultural sectors have lower tariff rates than the manufacturing sectors. 17

South and South-West Asia Development Papers 1501 Table 8: Structure of the Nepal economy in 2012 as reflected in the SAM 2012 1 2 3 4 5 6 Sectors Vi/TV Ei/Oi Ei/TE Mi/Oi Mi/TM TAR 25.19 1.66 4.73 13.94 14.47 0 8.09 0.17 0.21 5.93 2.63 1.48 2.34 3.24 0.84 15.84 1.49 7.04 0.95 4.23 3.39 52.12 15.25 4.43 1.25 88.97 28.34 47.47 5.52 8.64 2.25 3.53 3.04 21.45 6.76 25.54 1.57 4.66 7.24 65.27 37.04 15.86 Utilities and Construction 8.47 - - - - - 21.85 12.74 30.64 5.85 5.14-28.04 8 21.57 0.12 11.70 - Total 100-100 - 100 - Note: Vi=sectoral value added, TV=total value added, Ei=sectoral export, Oi=sectoral output, TE=total export, Mi=sectoral import, TM=total import, TAR=tariff rate, All figures are expressed in percentages. Source: Raihan (2014) Table 9 presents the structure of the Pakistan economy in 2012. In terms of value-addition, among the agricultural sectors, the leading sector is the livestock and meat products with 11.52 percent share. Among the manufacturing sectors, the leading sector is textile and clothing (4.16 percent). Among the services sectors, the leading sector is transport and communication (33.51 percent). The export basket is concentrated as 50.73 percent exports come from textile and clothing. The heavy manufacturing sector is highly import dependent. In the case of tariff rate, agricultural sectors have lower tariff rates than the manufacturing sectors. Table 9: Structure of the Pakistan economy in 2012 as reflected in the SAM 2012 1 2 3 4 5 6 Sectors Vi/TV Ei/Oi Ei/TE Mi/Oi Mi/TM TAR 8.62 5.60 7.98 7.48 7.21 2.17 11.52 0.50 0.99 0.15 0.21 3.75 3.55 1.63 1.05 30.86 13.35 0.12 3.27 4.78 6.40 5.26 4.76 11.20 4.16 36.30 50.73 2.80 2.65 9.78 1.08 12.64 7.73 26 9.11 17.68 3.27 3.73 8.70 35.25 55.52 7.97 Utilities and Construction 5.12 - - - - - 33.51 1.34 5.52 1.15 3.21-25.89 2.72 10.91 1.48 1 - Total 100-100 - 100 - Note: Vi=sectoral value added, TV=total value added, Ei=sectoral export, Oi=sectoral output, TE=total export, Mi=sectoral import, TM=total import, TAR=tariff rate, All figures are expressed in percentages. Source: Raihan (2014) Table 6 presents the structure of the Sri Lanka economy in 2012. In terms of value-addition, among the agricultural sectors, the leading sector is the grains and crops with 16.37 percent share. Among the manufacturing sectors, the leading sector is processed food (7.24 percent). Among the services sectors, the leading sector is transport and communication (27.63 percent). Textile and clothing takes more than 35 percent share in the export basket. This sector is also 18

Effects of Unilateral Trade Liberalization in South Asian Countries heavily import dependent. The heavy manufacturing sector is highly import dependent and takes around 45 percent share in total import. In the case of tariff rate, agricultural sectors have higher tariff rates than the manufacturing sectors (except processed food). Table 10: Structure of the Sri Lanka economy in 2012 as reflected in the SAM 2012 1 2 3 4 5 6 Sectors Vi/TV Ei/Oi Ei/TE Mi/Oi Mi/TM TAR 16.37 15.47 11.18 8.10 3.98 6.60 1.86 0.64 5 2.19 0.13 6.13 4.75 4.99 1.39 41.19 8.75 5 7.24 13.86 7.95 16.03 6.37 8.45 6.44 68 35.54 62.48 11.87 0.56 2.56 21.61 9.54 48.73 13.57 5.25 5.13 13.39 14.69 58.83 44.99 2.64 Utilities and Construction 10.14 - - - - - 27.63 12.32 16.70 8.94 8.55-17.88 2.86 2.95 2.39 1.79 - Total 100 15.47 100-100 - Note: Vi=sectoral value added, TV=total value added, Ei=sectoral export, Oi=sectoral output, TE=total export, Mi=sectoral import, TM=total import, TAR=tariff rate, All figures are expressed in percentages. Source: Raihan (2014) III. TARIFF LIBERALIZATION SIMULATION IN THE CGE MODELS AND CLOSURES This experiment undertakes a unilateral elimination of all commodity tariffs. The following closure assumptions are imposed on the CGE models of the South Asian countries to capture the short-run effects. On the income-side: total stocks of land, tax rates and technical changes are fixed. Capital is sector specific. Rigidities in the labor market are reflected by allowing aggregate employment to change i.e., labor is in elastic supply with a pool of unemployed workers waiting to be hired at a wage (nominal and real) indexed to the economy-wide consumer price index (CPI). On the expenditure-side: Total real inventories, total real investment and total real government expenditures are held fixed, whereas both aggregate real household consumption and real trade balance (exports imports) are endogenous. The consumer price index (CPI) is the model s numéraire. IV. SIMULATION RESULTS 4.1. Macroeconomic Effects The macroeconomic effects of the tariff liberalization simulation for the five South Asian countries are presented in Table 11. The price of imports in local currency falls by larger margins in Bangladesh and Nepal. Bangladesh experiences the largest rise in total demand for imports followed by India. Total domestic demand increases most in Bangladesh, followed by Pakistan. The average cost of domestic production increases in all countries due to rise in primary factor 19

South and South-West Asia Development Papers 1501 costs. India has the highest rise in nominal return to capital followed by Bangladesh. The GDP price deflator increases in all countries; because, though tariff reduction lowers the price of investment goods, this is offset by the rise in primary factor costs, nominal wage, return to capital and return to land. The GDP price deflator has the highest rise in Bangladesh followed by India and Nepal. The real exchange rate depreciates in all countries with the largest depreciation in Bangladesh. The terms of trade improves in all countries with the largest improvement in Bangladesh. The real exchange rate depreciation makes exports more competitive in the world market. Hence, exports expand and the largest positive effect on exports is found for Bangladesh. Higher exports pull up economy-wide gross production for all five countries with the largest positive effect on Bangladesh. The largest positive effect on real GDP is seen on Bangladesh and least on Sri Lanka. Also, largest positive effect on employment is observed for Bangladesh. Table 11: Macro-economic effects (% change from base) Prices Bangladesh India Nepal Pakistan Sri Lanka Investment price index 0.32 0.49 1.52 0.22-0.31 Government price index 0.97 1.20 1.20 0.58 3 Export price index (in local currency) 5 6 1.52 1.77 1.16 GDP price deflator 1.80 1.64 1.64 0.91 0.70 Imports (in local currency) -4.43-9 -4.70-3.27-0.81 Exchange rate 8.51 8.29 4.21 3.51 1.94 Terms of trade 6.77 4.15 6.53 5.21 1.98 Domestic production 0.58 0.54 0.24 0.10 0.24 Intermediate input costs -0.53 0.37-1.27-0.55 1 Primary factor costs 1.80 1.64 1.65 0.91 0.70 Nominal return to capital 3.40 3.67 3.05 1.52 1.33 Nominal return to land 5.24 1.77 2.15 1.52 0.58 Volume Exports supply 13.07 8.38 5.46 3.58 1.65 Import demand 8.87 4.63 9 4.58 4 GDP 3.05 2.49 2 0.88 0.63 Domestic demand 2.43 1.53 1.59 0.62 0.36 Gross production 3.36 2.37 1.90 0.78 0.61 Aggregate employment 6.16 4.83 4.81 2.22 1.45 The graphical presentations of the effects on key macroeconomic variables are provided in Figure 1. Figure 1: Effects on key macroeconomic variables (% change from base) Bangladesh India 1 8.0 8.51 6.77 1 8.0 8.29 6.0 3.05 1.80 6.0 2.49 1.64 4.15 GDP GDP deflator Exchange rate (nominal) Terms of Trade (ToT) GDP GDP deflator Exchange rate (nominal) Terms of Trade (ToT) 20

Effects of Unilateral Trade Liberalization in South Asian Countries Nepal Pakistan 1 1 8.0 6.0 2 1.64 4.21 6.53 8.0 6.0 0.88 0.91 3.51 5.21 GDP GDP deflator Exchange rate (nominal) Terms of Trade (ToT) GDP GDP deflator Exchange rate (nominal) Terms of Trade (ToT) Sri Lanka 1 9.0 8.0 7.0 6.0 3.0 1.0 0.63 0.70 GDP GDP deflator Exchange rate (nominal) 1.94 1.98 Terms of Trade (ToT) The production related effects of the simulation are presented in Figure 2. Figure 2: Production-related effects (% change from base) Bangladesh India 1 1-0.58-0.53 Domestic Intermediate production input costs costs 1.80 Primary factor costs 3.36 Gross production (volume) 13.07 Exports (volume) 2.43 Domestic sales (volume) 1 1-0.54 0.37 Domestic Intermediate production input costs costs 1.64 2.37 Primary factor costs Gross production (volume) 8.38 Exports (volume) 1.53 Domestic sales (volume) Nepal Pakistan 1 1 1-0.24 Domestic production costs -1.27 Intermediate input costs 1.65 1.90 Primary factor costs Gross production (volume) 5.46 Exports (volume) 1.59 Domestic sales (volume) 1-0.10-0.55 Domestic Intermediate production input costs costs 0.91 0.78 Primary factor costs Gross production (volume) 3.58 Exports (volume) 0.62 Domestic sales (volume) Sri Lanka 1 1-0.24 1 0.70 0.61 1.65 Domestic Intermediate production input costs costs Primary factor costs Gross production (volume) Exports (volume) 0.36 Domestic sales (volume) 21

South and South-West Asia Development Papers 1501 4.2. Production Effects on Broad Sectors Production effects on broad sectors of the simulation are presented in Figure 3 and Figure 4. Figure 3 shows that, due to tariff liberalization, larger effects on outputs are observed in Bangladesh and least effects are observed in Sri Lanka. Figure 3: Percent changes in the volume of output (by broad sector) Bangladesh India 4.80 3.0 1.90 2.91 3.36 3.0 2.46 2.63 2.37 1.0 1.0 0.51 Nepal Pakistan 3.0 1.0 1.70 0.24 2.45 1.90 3.0 1.0 0.95 0.47 0.89 0.78 Sri Lanka 3.0 1.0 0.34 0.59 0.71 0.61 Figure 4 suggests that average output price of agriculture increases in all five countries with largest effect in Bangladesh. Average price of industrial goods falls in Bangladesh, Nepal and Pakistan and increases in India and Sri Lanka. Average price of services increases in all countries except Pakistan. 22

Effects of Unilateral Trade Liberalization in South Asian Countries Figure 4: Percent changes in the price of output (by broad sector) Bangladesh India 3.0 1.0-1.0 - -3.0 3.2 0.7 0.7-1.0 3.0 1.0-1.0 - -3.0 0.9 0.3 0.1 0.3 Nepal Pakistan 3.0 1.0 0.6 1.4 3.0 1.0 0.4-1.0 - -0.7-1.0 - -0.3-0.2-0.1-3.0-2.4-3.0 Sri Lanka 3.0 1.0 0.2 0.2 0.3 0.2-1.0 - -3.0 4.3. Effects on Exports by Broad Sectors The effects on exports by broad sector are presented in Figure 5 and Figure 6. There will be positive effects on exports in all three broad sectors. In general, largest effects on exports would be observed for Bangladesh followed by India. Sri Lanka will have the least positive effect. Figure 5: Percent changes in the volume of exports (by broad sector) Bangladesh India 1 13.39 13.07 1 1 7.15 9.46 1 10.19 8.61 7.84 8.38 23

South and South-West Asia Development Papers 1501 Nepal Pakistan 1 1 1 5.21 6.82 4.36 5.46 1 4.36 3.57 3.22 3.58 Sri Lanka 1 1 2.36 1.55 1.61 1.65 Figure 6: Percent changes in the price of exports (by broad sector) Bangladesh India 7.0 6.0 3.0 1.0 5.94 3.71 1.90 5 7.0 6.0 3.0 1.0 4.84 3.90 4.28 6 Nepal Pakistan 6.0 6.0 2.46 0.83 1 1.52 5 1.71 1.88 1.77 Sri Lanka 6.0 1.16 1.16 1.13 1.16 24

Effects of Unilateral Trade Liberalization in South Asian Countries 4.4. Effects on Imports by Broad Sectors The effects on imports by broad sector are presented in Figure 7 and Figure 8. Tariff elimination reduces the average local currency price of imports in all five countries, with largest effect in Bangladesh and least effect in Sri Lanka. Agricultural imports will rise by more than 100 percent in India due to the elimination of high agricultural tariff. Industrial imports become cheaper due to tariff elimination, while import prices of tariff-free services increase due to exchange rate depreciation. Figure 7: Percent changes in the volume of imports (by broad sector) Bangladesh India 104.98 9 9 7 7 5 5 3 1 1.94 11.49 8.87 3 1 6.47 4.63-1 AGRICULTURE INDUSTRY SERVICES -7.99 All SECTORS -1 AGRICULTURE INDUSTRY SERVICES -8.28 All SECTORS Nepal Pakistan 9 9 7 7 5 5 3 1 1.71 6.48 9 3 1 5.76 4.58-1 -2.88-1 -0.72 AGRICULTURE INDUSTRY SERVICES -2 All SECTORS Sri Lanka 9 7 5 3 1-1 9.13 2.11 4 AGRICULTURE INDUSTRY -1.33 SERVICES All SECTORS 25

South and South-West Asia Development Papers 1501 Figure 8: Percent changes in the price of imports (by broad sector) Bangladesh India 3.47 8.52 8.29 - -1-6.43-4.43 - -1-1.31-9 -2-2 -3-3 -30.49 Nepal Pakistan 0.58 4.21 1.27 3.51 - -1-7.93-4.70 - -1-4.18-3.27-2 -2-3 -3 Sri Lanka 1.92 - -1-4.35-0.95-0.81-2 -3 4.5. Effects on Output in All Sectors The effects on output in all sectors are presented in Figure 9 and Figure 10. Agricultural sectors in all countries expand, except in India where the grains and crops sector contract. Textile and clothing sector in all five countries expands most, with largest expansion is in Bangladesh. In Bangladesh, Nepal and Pakistan, light and heavy manufacturing sectors contract, whereas they expand in India and Sri Lanka. Services sectors expand in all five countries. Figure 9: Percent changes in the volume of output (by sector) Bangladesh India - - 6.0 8.0 Utilities and Construction - - 6.0 8.0 Utilities and Construction 26

Effects of Unilateral Trade Liberalization in South Asian Countries Nepal Pakistan - - 6.0 8.0 Utilities and Construction - - 6.0 8.0 Utilities and Construction Sri Lanka - - 6.0 8.0 Utilities and Construction Figure 10: Percent changes in the price of output (by sector) Bangladesh India -8.0-6.0 - - Nepal Utilities and Construction -8.0-6.0 - - Pakistan Utilities and Construction -8.0-6.0 - - Utilities and Construction -8.0-6.0 - - Utilities and Construction 27

South and South-West Asia Development Papers 1501 Sri Lanka -8.0-6.0 - - Utilities and Construction 4.6. Effects on Exports in All Sectors The effects on export by all sectors are presented in Figure 11 and Figure 12. All the exportoriented sectors experience rise in export in all five countries. India experiences the largest rise in agricultural exports. Export of Bangladesh s major export product textile and clothing rises by more than 13 percent (highest in South Asia). Bangladesh, India and Nepal experience rise in exports of light and heavy manufacturing by more than Pakistan and Sri Lanka. Figure 11: Percent changes in the volume of exports (by sector) Bangladesh India 6.0 8.0 1 1 1 Nepal 6.0 8.0 1 1 1 Pakistan 6.0 8.0 1 1 1 6.0 8.0 1 1 1 28