“The “Peace Dividend, ‘SAFTA’, and Pakistan-India Trade"

Historically, formal trade between Pakistan and India has been extraordinarily low—only about one percent of either country’s global trade. In large part, this reflects the fact that relations between the two countries have been tense for most of the last 50 years. This situation is rapidly changing, however. The signing of the South Asia Free Trade Area (SAFTA) agreement on January 6, 2004, represents an important turning-point in the relationship between Pakistan and India. This chapter provides a first approximation of changes in overall trade flows that might result from improved relations within the region. The chapter employs a gravity model, a standard analytical tool used by trade economists to estimate trade flows between countries based on factors such as countries’ income, proximity, shared institutions, trade agreements, and the like. Gravity models are widely used to assess whether subsets of countries trade more or less than what one would expect, based on the “normal” trade that takes place within a larger set of countries. In particular, the chapter focuses on two factors: the reduction of conflict between India and Pakistan, and the elimination of barriers to trade between South Asian countries. Pakistan–India conflict has had a significant negative impact on aggregate trade flows. Controlling for other variables, we estimate that trade between Pakistan and India would increase by 405 percent in the absence of conflict. We also estimate that Pakistan and India could further increase their bilateral trade by another 79 percent by entering into a preferential trade agreement (PTA) such as SAFTA. The paper recommends that policy makers from both sides “let geography work” and open the way to further dynamic gains by giving impetus to cooperation at a high political level, and by smoothing the tension in defense and security policies. It is our hope that the results of our analysis will add strength to this process and endow policy makers with yet another proof of the gains from peaceful proximity and trade.