February 2006
Economy & Policy

SAFTA:
Major provisions and challenges

By Shiv Raj Bhatt

In a major effort to promote regional trade, leaders of the SAARC member countries at the Islamabad SAARC Summit in 2004 finalised the agreement on free trade area (SAFTA). Its objectives as stated in the preamble of the agreement are, “to strengthen intra-SAARC economic cooperation to maximise the realisation of the region’s potential for trade and development for the benefit of their people, in a spirit of mutual accommodation, with full respect for the principles of sovereign equality, independence and territorial integrity of all states.”

The SAFTA Committee of Experts (COE), set up to resolve outstanding issues, has carried out strenuous negotiations and held 12 meetings to reach the final decision. The 12 th meeting of the COE that ended in Kathmandu on 2 December 2005 took the final decision and cleared the way for enactment of SAFTA accord by January 1, 2006. Now it is time for contracting parties to fulfil the obligations agreed upon in SAFTA and other decisions concerned.

Major provisions of SAFTA

The SAFTA covers, among others, tariff reductions, rules of origin, safeguards, institutional structures, and dispute settlement. It also calls for the adoption of various trade facilitation measures such as harmonisation of standards and mutual recognition of test results, harmonisation of customs procedures, and cooperation in improving transport infrastructure.

Tariff reduction – as agreed, the non-LDC members (India, Pakistan and Sri Lanka) will reduce their tariff to 20 per cent in the first two years. Their tariff will be brought down to 0-5 per cent in the next five years, i.e. by the end of 2012. However, the LDC members (Bangladesh, Bhutan, Maldives and Nepal) will reduce their tariff to 30 per cent by the end of 2007 and to 0-5 per cent by the end of 2015.

Under the Rules of Origin, products of non-LDC members with 40 per cent domestic value addition will qualify for tariff reduction. In case of products of LDC members, a special and differential treatment will be given so that products with 30 per cent domestic value addition will qualify for the SAFTA treatment. Further, under Rule 9 of the Rules of Origin, any product having 50 per cent regional cumulative value addition with 20 per cent value addition in the final manufacturing/exporting country will qualify for tariff reduction. This Rule is expected to boost intra-SAARC trade and investment. It will also provide particular advantage to LDCs in terms of market access for low domestic value addition products. In addition, a Product Specific Rule provides lower tariff advantages to 191 products of export interest to LDCs.

A Mechanism for Revenue Loss Compensation to LDCs has been established, under which non-LDC members will provide compensation to LDCs for loss of customs revenue due to implementation of SAFTA tariff reduction commitments. This compensation will be determined by the COE through an agreed formula. The non-LDCs will pay the entire amount of compensation in US dollars to the LDCs. But, this mechanism will remain in force for four years. In consideration of the size of the economy of the Maldives and its heavy dependence on customs duties, the country will get compensation for an extra one year.

In order to protect relevant domestic industries, as per SAFTA agreement, member countries may maintain Sensitive Lists, i.e. lists of products, which will not be covered by SAFTA. The number of products in the Sensitive Lists shall be subject to maximum ceiling to be mutually agreed among the Contracting States with flexibility to Least Developed Contracting States to seek derogation in respect of the products of their export interest. The Sensitive List shall be reviewed after every four years or earlier as may be decided by SAFTA Ministerial Council (SMC), established under Article 10, with a view of reducing the number of items in the list. At the final COE meeting, it has also been agreed that non-LDC members may have two lists - one for the non-LDCs and the other, a more permissive one for LDCs.

Under the Technical Assistance, it is agreed that non-LDC members will extend assistance to LDCs in the areas of capacity building in trade matters, tax policy and instruments, customs procedures, legislative and policy related issues, studies on ICD, CFS, insurance and export financing, research and development, export promotion, investment promotion, human resource development in trade related areas, product development and marketing, market promotion in export oriented sectors etc.

Major challenges and ways to overcome them

It is expected that the implementation of SAFTA will enhance trade within the region by progressive reduction of tariff rates, elimination of non-tariff and para-tariff barriers, and putting in place trade and investment facilitation measures. However, such expectations are doubtful, particularly in the context of unfavourable political and economic climate in the region. Many other reasons are also making its success doubtful.

Firstly, within SAARC, intra regional trade is very marginal (low) in comparison of other regional blocs of the world. For example, intra-European trade was over 60 per cent, intra-ASEAN 35 per cent, while trade within the SAARC countries was less than 5 per cent of their global total in year 2005 (see table 1 and 2). Table 1 and 2 also reflects the high concentration of a few countries’ trade (Bhutan, Nepal and to some extent Bangladesh) with India. The tables also clearly reflect the low level of trade and economic cooperation among the members. Many reasons may be responsible for such low trade, but economic similarities and commonalities in resource endowment is the main factor that limits the scope of intra regional trade.

Secondly, transport, communication and energy links that are vital to promote regional trade are very weak in South Asia. The need for transport integration is perhaps the most urgent since it is integral to the operation of a free trade area. But, very little has been done so far to address the issue of transport integration in the region. Strategic vision to guide the integration process is weak mainly because of political tensions and less faith on the benefits of regional cooperation.

Thirdly, all SAFTA contracting parties are struggling to increase their export in the same markets for almost similar products, with very few exceptions. North America and the European Union (EU) is the principal export destination of all South Asian countries. Therefore, it is argued that trade liberalisation with South Asia has, thus, largely served to stimulate Indian exports within the region but with low levels of reciprocal export growth to India (see Rehman Sobhan, Roadmap for South Asian Cooperation, South Asian Journal, issue 6, January 2005). This reflects, among others, India's relatively more restrictive import regime compared to its neighbours and the structural rigidities in the smaller economies that have relatively little to export to India (ibid). Hence, the success of regional cooperation through SAFTA depends, among others, on its efforts to open up India's import regime (from SAARC members) and its help to the smaller countries to enhance as well as diversify their production and export capacity to exploit emerging market opportunities in India.

Fourth, the intra-regional investment climate is yet not very favourable. The move towards SAFTA will be meaningless unless the issue of stimulating investment in the region, particularly in the less developed areas, is accelerated. The substantive point of a free trade area is for small economies with narrow markets, such as Bangladesh, Bhutan and Nepal, to be able to use the incentive of the larger South Asian and particularly Indian market to stimulate enhanced investment from within and without.

Other important things to be looked upon are harmonisation of standards and simplification of customs procedures, monetary cooperation through greater and better coordination among Central Banks, investment cooperation involving public and private sector cooperation through joint ventures to sustain the trade links. To promote investment cooperation, concrete actions are needed to realise the idea of establishing the South Asia Development Bank that was endorsed by SAARC at least a decade ago. Similarly, as agreed by the members (under technical cooperation to the LDCs), a special fund is needed to enhance the development capacity of weaker countries to enable them to enhance their competitiveness in an integrated market. Such fund will enable them to upgrade their infrastructure and enhance their competitive capacity. Some members have tremendous potential for energy generation (like Nepal and Bhutan in the hydropower sector and Bangladesh in the natural gas sector) while the demand for energy is very high in fast growing countries like India. In this context, energy cooperation with a special focus on regional connectivity will enhance the attractiveness of these economies to prospective investors.

At the last, the role of the private sector, civil society, media and academia is very important in achieving the goals of SAFTA. Above all, visionary leadership, committed policymakers and bureaucrats are the key to its success. Proactive and positive role of all is needed to make SAFTA successful.

Water Plan Sans Energy Plan

by Gyanendra Lal Pradhan

The government has recently announced the national water plan with 40 per cent of the budget allocated to hydropower. This shows that the government is eager to develop hydropower. But the plan is not clear on how it is going to be implemented.

The plan has aimed to increase the hydropower generation capacity from the present 600 MW to 2,100 MW by 2017, and to 4,000 MW by 2057. However, the plan is silent on the source of funds required to achieve this target and the projects in which the investment is needed. In order to achieve the goal of the plan, it is required to add 175 MW every year. The goal is not too big to achieve but there are no grounds for believing that we will be able to add 175 MW every year. It took 90 years for Nepal to build the present capacity of 600 MW. If we look at the mid-Marsyangdi Hydro Electricity Project with the capacity of 70 MW, we see that it will not be completed soon although it has already taken seven years. In fact, the plan and policy for hydropower needs to be a part of a broader energy sector plan. Hence, making a national energy plan and a policy is required in the first place. But the current water plan has been announced inversely. There are too many errors in the plan.

For instance, water and energy have been put together in this plan. Water and energy are totally different issues. So, the plan which intermingles water and energy can never be successful.

The demand for water has been there from ancient days. It is not a recently created demand. Our problem is the lack of clean drinking water, and not scarcity of water as faced in Africa and the Middle East. Our problem is the lack of energy which is a recently created problem. How to produce more energy is our main concern. And this problem can be solved by increasing investment and using better technology in hydropower projects.

If we take a look at Bhutan, for example, we see that they treat water and energy as separate issues. So, they are making progress rapidly in producing hydroelectricity. Their agreement with India is concerned only with energy, not with water. But we are in the habit of dealing with water and energy together. As a result, we have already lost control over the Sapta Koshi and the Sapta Gandaki, two major rivers of Nepal. The Mahakali River is also not in our control due to the Mahakali Treaty.

Now, in the absence of Parliament it is very difficult to conclude treaties on water because a majority of two-thirds of the Members of Parliament is required to approve of such treaties. However, there are no such legal constraints to conclude treaties on energy.

Domestic Demand for Energy:

It is not necessary that we should export all the electricity that we produce. The study being conducted by Butwal Power Company (BPC) has shown in its preliminary estimation that 24,000 MW of energy, which includes hydroelectricity, firewood and burning animal waste, was consumed in Nepal in 2003-04. It is estimated that 6,000 out of the 24,000 MW of energy can be supplied as electricity. Nepal will certainly not be able to afford generating the entire energy from imported fossil fuels. Given the current price of electricity in Nepal, people use firewood equivalent to Rs. 100 billion. This source of energy will not last long. So, we have to think of a way out. The current water plan has aimed to generate 4,000 MW of hydroelectricity. Will this amount of hydroelectricity be enough to replace the energy generated by firewood? This is not possible. 4,000 MW of electricity is not enough even for lighting purpose. In this condition how can we get energy to cook our food? The study has shown that we need 18,000 MW of energy just for cooking purposes.

The above facts suggest that we should look for reliable sources of energy to fulfil our needs during peak hours. Unfortunately, the current water plan has made no provisions for hydroelectricity projects which can produce hydroelectricity to fulfil this demand. Nepal Electricity Authority (NEA) is producing electricity from diesel plants. It costs Rs. 35 per unit but NEA is selling the electricity at Rs. 6 per unit. And it is said that NEA is incurring a heavy loss. But blaming NEA is not justified. Obviously, the blame goes to the government rather than to NEA..

According to a study being conducted by BPC, 1,800 MW of energy is produced by burning animal waste in Nepal. It is equivalent to Rs. 45 billion when we look at the fact that NEA earns Rs. 15 billion by selling 600 MW of electricity. What we need to think is that had we used cow dung as fertilizer instead of using it as fuel, it would have had a tremendous positive impact on the development of agriculture. This may be a reason why we are not able to make any significant progress in developing agricultural sector.

It is estimated that 2 million units of biogas plants can be set up in Nepal. However, the statistics shows that only 140,000 biogas plants have been installed. These plants have helped reduce carbon emission. As a result, Nepal is to get $500,000 every year for saving on carbon emission. We can imagine how much money we would have earned if we had installed 200,000 biogas plants. Moreover, it would reduce the use of firewood. It would reduce pollution and keep people safe from respiratory diseases and health expenses. Apart from reducing the use of kerosene, the farmers would have got better fertilizer at the same time.

Persisting Problems:

Although the domestic demand for electricity is high, we have not been able to generate electricity from our water resources. The lack of financial resources is one of the main reasons behind it. Due to the lack of financial resources, many of the hydroelectric projects have not been able to start construction although they have already signed power purchase agreement with the NEA. There are two ways to solve this problem: encouraging banks to increase their investment in this sector and attracting foreign investment.

In order to encourage the banks and financial institutions to increase their investment in this sector, the government must recognise such bank finance as made to the priority sectors. As per the existing provisions, investment in micro hydel projects alone gets such recognition. Micro hydel projects, which produce 200-300 KW of electricity, make only a nominal use of the total hydroelectricity potential of the country. Hence, this recognition should be given also to big projects.

Foreign investors were attracted to hydro projects a few years ago. Two of the hydel projects had received foreign investments. However, all the foreign investors have given up on the Bhote Koshi Project now. The investors in the other project are also not willing to make further investment in any of the projects, rather they too are willing to quit if the opportunity arises.

The lack of stability in the policy and commitment on the part of the government are the main reasons for this apathy of foreign investors. When we make our electricity market secure, no doubt, foreign investors will come in droves. In Laos, a 1,000 MW hydel project is being developed with the assistance of foreign investment. The project was able to attract foreign investment because the government of Laos created an environment congenial for power trading with Thailand.

Selection of Wrong Projects:

The selection of wrong projects is one of the problems persisting in hydroelectricity sector. Most of the existing projects have their power house in the central and the western development region. Now Kabeli Project has been selected so that there will be a power house in the eastern development region too. But this is a folly. Tamakoshi Project is cheaper than Kabeli Project. It is estimated that Kabeli Project will take over $3,000 to produce 1 KW of electricity whereas Tamakoshi Projects will take only $1,000. Despite this fact, Kabeli Project has been selected. This is one of the reasons why electricity price is high in Nepal. If we import electricity from Sikkim (India) or Bhutan for eastern Nepal, it will be cheaper. In eastern India, the supply of electricity exceeds demand. Likewise, we can sell electricity produced from Tamakoshi Project to the northern part of India at a high price. So, it is necessary to make arrangements to facilitate power trading.

Kulekhani III is another example of the wrong project selected. It is said that the construction work of Kulekhani III is going to start soon. Instead of implementing Kulekhani III, we can use an alternative way, which will be cheaper. The alternative way is that the water that flows out from the reservoir while generating electricity is to be collected in the other reservoir below the power house. We can sell the electricity during the mornings and evenings. During the day, which is non-peak hours, the electricity can be used to draw water from the lower reservoir to the upper reservoir. In this way, we can maintain the required level of water in the upper reservoir all the time. It will help us to reduce the ongoing load shedding. If we implement Kulekhani III, this alternate will be lost for ever.

It is not necessary that Nepal adopt an expensive method to produce peaking energy. It takes a lot of money to make the engineering design and construct a reservoir. There are so many natural lakes in Nepal. We can produce plenty of electricity from these lakes to be used as peaking energy.

BPC has prepared a proposal to produce peaking energy from natural lakes. Begnas Lake is situated at a higher altitude than Rupa Lake. The distance between them is not more than 500 metres. According to the plan, a tunnel will be made to let water flow to Rupa Lake from Begnas and 20-40 MW of electricity can be produced from the water in Begnas Lake in peak-hours. During non-peak hours, the electricity will be used to draw water back to Begnas Lake from Rupa Lake. This project will take only $1,000 to produce 1 KW of electricity and the project will take only two years to complete.

If we put emphasis on constructing expensive reservoir instead of using natural lakes, we will always be dependent on others for energy. Therefore, we must change our way of thinking as soon as possible.