The "Gulliver Effect" and the "Optimal Divergence" Approach to Trade Policies
The Case of Nepal

The relevant “size” of an economy is affected by its environment. A country could be small in the world economy yet become big in relation to its smaller neighbors, imposing on them its relative price structure and the consequences of its trade policies. We examine here the consequences of such a “Gulliver” effect, looking at the case of Nepal whose economy is closely linked to the economy of India. Since India’s protective policies are not optimal for Nepal, we consider the various alternatives for Nepal. The “optimal divergence” is for Nepal to allow the free import of intermediate and capital goods, while, for import-competing industries, it cannot depart from India’s trade policy.

Abstract

The relevant “size” of an economy is affected by its environment. A country could be small in the world economy yet become big in relation to its smaller neighbors, imposing on them its relative price structure and the consequences of its trade policies. We examine here the consequences of such a “Gulliver” effect, looking at the case of Nepal whose economy is closely linked to the economy of India. Since India’s protective policies are not optimal for Nepal, we consider the various alternatives for Nepal. The “optimal divergence” is for Nepal to allow the free import of intermediate and capital goods, while, for import-competing industries, it cannot depart from India’s trade policy.

I. Introduction

The trade policies which lead to optimal resource allocation are well known. They are usually based on the paradigm of free trade. Following neo-classical arguments, free trade tends to increase welfare because it allows countries to specialize according to their comparative advantage, thus maximizing the efficiency of their resource use. Moreover, for a small country, free trade increases its exposure to and its integration into a competitive world environment—which is bound to raise its efficiency and productivity. This does not mean that free trade will always be the best outcome, or that there is no role to be played by trade policy, particularly if the Government has objectives other than the maximization of global income in its social welfare function.

Departures from free trade have been advocated on many grounds, although these do not always have solid economic validity. Classical economists recognized the merit of certain arguments for imposing tariffs (such as terms of trade improvements) and modern international trade theory has refined the justification for an optimal form of protection in situations where market distortions or externalities are present. 2/

The purpose of this paper is to elaborate on one specific argument in favor of the implementation of an active policy of interference with the freedom of trade flows. The argument is related to the constraints faced by a small country which, given its geographical location and its insertion into a historical and political milieu, is compelled to adopt a pattern of production, trade, and costs which arise from the protectionist policies of a very large neighboring country.

This argument is an extension to the trade area of what Robert A. Mundell has called the “Gulliver effect”. The Gulliver effect refers to the relationship between a small country and a larger neighbor. The large neighbor becomes a “Gulliver” because, although it may be a small economy in the world context (taking world prices and financial market conditions as given), it becomes big in relation to its smaller neighbor in the sense that it imposes upon it its own relative price structure and the consequences of its own trade policies. 3/ We illustrate this effect here with the example of India vis-a-vis Nepal, and elaborate on the best trade policies for Nepal. These considerations give rise to what we call the “optimal divergence” approach.

II. The Case of Nepal

Nepal is a small country compared with India. 4/ The two share a long and open border, across which people, goods, and capital can move essentially unimpeded. 5/ In itself, this openness to a neighboring economy would not make the case of Nepal special, since there are many countries in the world which are in a similar situation and which have adopted a free trade policy, conditioning their economic structure to that of their larger neighbors. What makes Nepal’s case interesting is that India’s own trade regime is highly protective, encouraging the development of a large import-substituting sector. In addition, the Indian currency (the rupee) is not convertible, but nevertheless circulates widely in Nepal. 6/ Given its small domestic market, Nepal’s interest would seem to lie in an export-oriented, outward-looking strategy. To achieve that objective, manufacturers should be able to import capital goods and intermediate inputs at world prices and quality from the most competitive source available. The problem is that once these goods are imported into Nepal, they become liable to illegal reexport over the open borders to India, where prices for these goods are typically higher than world prices because of India’s very protective trade regime. Deflection of third country goods to India is a serious concern to the authorities of both Nepal and India: for Nepal, because it entails a loss of convertible international reserves in exchange for nonconvertible Indian rupees; 7/ and for India, because smuggling of third country imports from Nepal circumvents its protective trade barriers. Hence Nepal faces a dilemma. It can either try to pursue its comparative advantage, but at the cost of reserve losses and, indeed, a worsening of Nepal’s relations with India; or it can prevent smuggling by aligning its tariffs on third-country imports with those of India, but at the cost of a loss in efficiency in the production structure.

1. Nepal’s trade structure and regime

India’s share in Nepal’s foreign trade has been declining in recent years and currently India accounts for about one third of Nepal’s exports and imports. While imports from India cover a wide range of raw materials and manufactured goods, exports to India consist essentially of agricultural products. Trade between Nepal and India is regulated by the Nepal-India Trade and Transit Treaties. Imports from India are essentially free from quantitative restrictions and are subject to duties that in principle have been set so as to maximize revenue to the Government by minimizing smuggling. This principle means that the tariffs and other charges on imports from India have an exogenously given upper bound since they should not exceed the cost of smuggling. Regarding Nepalese exports to India, the bilateral treaties provide for preferential access to the Indian market, provided that certain strict maximum limits on third country import content are met. 8/ These limits on the import content have been set in order to prevent Nepal from becoming a conduit for circumventing India’s protective trade barriers against third country imports.

Vis-a-vis third countries, the possibility of deflection of imported goods to India becomes, again, an exogenous factor that necessarily dominates almost all other considerations in determining Nepal’s import policy. Since Nepal faces the likelihood of large-scale deflection of third-country imports to India, such imports into Nepal have been regulated by quantitative restrictions 9/ which serve essentially three purposes: to control trade deflection to India; to provide protection to domestic industries; and to regulate the allocation of scarce foreign exchange. As far as inputs and capital goods are concerned, the licensing of imports is accompanied by the licensing of industries to prevent the installation of industries solely for the purpose of obtaining third country imports destined for re-export.

The level of nominal tariffs is, overall, relatively low, although tariffs have been supplemented by other tariff-like charges, such as license fees and auction premia. 10/ Overall, however, the burden of protection and preventing deflection has fallen heavily on the licensing authorities.

Most of the quantitative restrictions on final commodities are administered through an auction system. Several times a year, import licenses are auctioned. The premium yielded on the auctions, which is essentially a tax on the rent of importers, is an additional cost on top of import taxes and therefore moves inversely with the level of these taxes.

2. Principal shortcomings of Nepal’s trade regime

The principal shortcoming of Nepal’s import regime is its reliance on quantitative restrictions and its very high and widely dispersed effective protection rates (EPRs). 11/ The distortionary effects of high and dispersed EPRs are well known, but it might be useful to recall some of those that are particularly relevant when the use of quantitative restrictions is as widespread as in Nepal.

First, there is a high administrative cost. Indeed, when there is an elaborate system of licensing, scarce administrative and entrepreneurial talent is diverted into nonproductive channels. Second, protection often leads to the creation and preservation of less efficient industries at the expense of potential high-growth industries, both in the import-substituting and export sectors. Third, high and widely dispersed EPRs, even if they are not the result of made-to-measure protection but rather the outcome of other policies (e.g., revenue or anti-deflection policies), discriminate against exports (and agriculture) and also among import-substituting industries and therefore tend to impede the efficient allocation of resources. If protection forces local manufacturers to purchase high-priced and lower quality inputs, economic efficiency and export competitiveness are affected. A case in point is the imposition of quantitative restrictions in Nepal—essentially for anti-deflection purposes—on such raw materials as synthetic textiles and (until not long ago) wool, which have seriously hindered production of exports to third countries. Finally, to the extent that taxes on imports under quantitative restrictions do not capture the rent of importers, there is an impact on income distribution and a loss of revenue to the Government without necessarily providing adequate safeguards against re-exports. All in all, these factors lead to distortions and misallocation of resources and therefore to lower growth and economic welfare.

Regarding the question of the appropriate level of protection, it could be said that, as a general proposition, the level of effective protection in a country such as Nepal, which has a very small domestic market, should be fairly low. However, the existence of the open border with India complicates matters in that to a large extent it renders the level of protection an exogenously determined variable. Since smuggling across the border cannot be effectively controlled, the level of effective protection vis-a-vis Indian products is largely determined by smuggling and transport costs, while the level of protection against third country imports is dictated by the level of protection in India. Indeed, if Nepal’s trade policy provided for different protection to an industry, significant incentives for illegal trade would arise.

Despite this Limited latitude in determining commercial policy in Nepal, there is ample room to correct distortions and provide the incentives necessary to maximize the country’s potential. In order to serve as an analytical framework, a review of optimal trade policies in the general case, and of the constraints in the Nepalese case, are provided in the next section.

III. The Improbability of First-Best Solutions in the Case of Nepal

1. Arguments for departures from free trade policies

While free trade is frequently regarded as a first best solution, departures from free trade have been advocated on many grounds. First, there is the oft invoked argument of protecting infant industry. This argument is based on the idea that a country may want to alter, over time, the nature of its comparative advantage. This can be sought for several reasons, such as the fear of a long-term deterioration in the terms of trade (e.g., for certain primary commodities); economic, social, and technological benefits of developing new activities; distributional considerations (e.g., regional distribution); and so on. Such considerations can give rise to policies geared to granting special temporary protection to certain activities in order to provide them with the necessary time for training, learning by doing, etc. However, such temporary protection may also result in disincentives to other activities and could prove difficult to remove. In addition, infant industries could be more efficiently assisted by direct subsidies and by the removal of rigidities in domestic capital and labor markets. Second, tariffs and quantitative restrictions may also be imposed for fiscal and balance of payments purposes. Even if the objective of these policies is not to change the allocation of resources, they certainly may result in varying EPRs and inefficiencies. Finally, strategic considerations, predatory dumping, retaliation, or even health and moral reasons may all lead to the need to interfere with the free flow of goods.

Given these and other considerations, what complicates the optimization of policy choices is the fact that some policy objectives can be conflicting and it may be necessary to reach compromises and deviate from policies that would be optimal if each objective could be considered separately. If deviations are considered necessary, the best set of commercial policies is that which minimizes departures from free trade while attaining the additional desired objective. How can these first best deviations be characterized?

2. Criteria for departures from free trade

There are some clear criteria for ranking deviations when designing a trade regime. The most important criterion is the minimization of discrimination between economic sectors so as to maximize allocative efficiency. Other relevant criteria are administrative simplicity and the minimization of discretionary decisions pertaining to resource allocation through preferential treatment. Also, on purely theoretical grounds, there is little justification for treating imports from, or exports to, different countries in a nonuniform manner, except within a customs union or between fully integrated economies.

Given these criteria, it is clear that there is a strong argument in favor of uniformity of treatment. Of course, it is not the nominal but the effective protection level that is relevant for assessing uniformity. In general, to reduce the dispersion in EPRs, the import taxes applied to inputs should not differ significantly from those on final goods. But, even if the EPRs on import-competing production are relatively uniform, they may still discriminate against export activities if these activities do not receive support to offset the high, protected cost of domestic production.

There is also a clear case for choosing tariffs over quotas as a means of protection. The main advantages of tariffs over quotas are that they entail lower administrative costs and rely on price signals. Finally, taxes on trade imposed for fiscal purposes may have protective effects as by-products. Thus, if the purpose of trade taxes is purely fiscal, the use of generalized sales taxes is preferable since they do not discriminate between domestic and imported goods.

3. Constraints for Nepal

The close relationship between the economies of Nepal and India distinguishes Nepal’s case and may provide analytical justification for significant departures from the usual first best solution, i.e. free trade. Given the full convertibility between the Nepalese and Indian rupees and the impossibility of avoiding smuggling, prices in Nepal cannot differ from those in India by more than transport costs plus a smuggling risk premium. These costs may differ from one commodity to another, but by and large the law of one price holds firmly between India and Nepal. Prices in India are of course influenced by India’s own restrictive trade policies, which have resulted in prices of tradeables that are generally well above world prices. 12/

As argued above, this situation has imposed a degree of exogeneity on Nepal’s trade policy. Since the Nepalese price cannot differ from the Indian price by more than the transport and smuggling cost, the tax that Nepal can impose on third country imports cannot be lower than the Indian implicit tariff less transport and risk costs; otherwise, there would be an incentive to deflect third country imports to India. But the tax cannot be significantly higher either, lest there would be an incentive to smuggle third country imports from India to Nepal, with a consequent loss of convertible reserves and fiscal revenue to the Nepalese Government.

These considerations lead to the conclusion that the implicit tariff rates of Nepal are basically dictated by the implicit tariff rates of India, the only flexibility being within the limits of transport and risk costs. The corollary of this conclusion is that as long as the levels of effective protection granted by India to its industries are high and widely dispersed, a first-best policy for Nepal, such as low and uniform EPRs, will be difficult to achieve. 13/ But trade policies which may be desirable for India may not be, and in fact are not, desirable for Nepal, given its vastly different resource endowments and domestic market size. With the two economies so closely integrated but with such different objectives, what flexibility does Nepal have in its trade policy to pursue its own development goals? It is argued in what follows that the best solution for Nepal is to determine its “optimal divergence” from India and to set its policies accordingly.

IV. The “Optimal Divergence” Approach

Despite the constraints that Nepal faces in setting its own commercial policies, it should certainly attempt to maximize the benefits that may be obtained given these constraints. In principle, three alternative approaches may be envisaged.

1. The Customs Union approach

One possibility, close to the current situation, would be the common market approach, that is, a fuller, more formal integration of the Nepalese and Indian economies. This would imply the elimination of all trade barriers between the two countries and the adoption by Nepal of the Indian tariffs and quantitative restrictions vis-a-vis third countries. On purely economic terms, a benefit of this alternative appears at first glance to be the opening up of the large Indian market to Nepalese producers. However, this benefit would be largely, if not completely, negated by the fact that Nepal would have aligned itself completely with the high cost structure of the Indian economy, exacerbating the drawback of the present situation: with a similar cost structure but a much less developed industrial base, Nepal could probably not compete effectively with Indian products. Moreover, as long as the trade policies of India remain as restrictive as they are today, the common market approach could also push Nepal into a pattern of production contrary to its comparative advantage, given its very different resource endowment and degree of industrialization. Finally, it would leave Nepal highly dependent on and vulnerable to changes in Indian industrial and trade policies.

2. Free floating cum free trade area

An alternative in the opposite direction would be to disengage the Nepalese economy from the Indian economy more completely by breaking the fixed link between the two currencies through a full and clean float of the Nepalese rupee. At the same time, however, for Nepal to take advantage of its potential comparative advantage, it would have to continue to allow, and indeed to liberalize, the imports of inputs and capital goods from third countries at world prices. 14/ Given India’s restrictive import policy and the inconvertibility of the Indian rupee, demand for foreign exchange would then spill over from India to Nepal and lead to an appreciation of the Nepalese rupee against the Indian rupee, which would adversely affect Nepalese exports to India. Meanwhile, the Nepalese rupee would depreciate against convertible currencies which would, of course, benefit exports to third countries. Although there may be some advantage to this outcome, the disproportionate size of the Nepalese and Indian economies implies that even small pockets of excess demand for certain third country imports in India would result in huge fluctuations in the exchange rate of the Nepalese rupee, with possibly very negative macroeconomic effects.

3. The “optimal divergence:” an export-oriented approach

Since neither of the above extreme solutions appears to be practical, Nepal should gear its trade and exchange policies in a manner that, within the existing constraints, builds on its potential comparative advantage. Where does Nepal’s main comparative advantage lie in the longer run? A number of considerations point in definite directions. Clearly, there are limitations on efficient import substitution given the small size of the domestic market. In any case, with the law of one price holding, it is unlikely that Nepal could protect industries producing for the domestic market at substantially different rates from those in India: import substitutes produced domestically at a higher cost than in India are unlikely to survive the competition from India.

The main advantage of Nepal over India is that while Nepal also has low labor costs, it does not have that many domestic industries producing intermediate or capital goods which it has to protect (or which it wants to develop in the longer run). This implies that Nepal, without worrying about protecting such goods, can import many high-quality inputs and capital goods at world prices (which are usually much lower than Indian prices) and thus reduce its costs of production of final commodities well below those of India. This gives an edge to Nepalese producers that can be exploited in order to promote exports to third countries. Of course, this requires not only that Nepal be more competitive than India, but that it be competitive also with the rest of the world.

Since the import of inputs and capital goods at world prices from third countries could result in their illegal re-export or the smuggling of the final commodities to India, it would be imperative to ensure that these goods were actually used for production and also that the final product was not exported illegally. This could be achieved by the replacement of the quantitative restrictions on the import of raw materials, intermediate inputs, and capital goods from third countries with tariffs that would be high enough to prevent re-exports to India. These tariffs should then be exempted/rebated upon proof of actual use in the production of exports to third countries. 15/

V. Summary and Concluding Remarks

As with Jonathan Swift’s Gulliver, the relevant concept of the “size” of an economy is affected by its surrounding environment: a country could be small in the world economy yet become a “giant” in its own region, imposing on its smaller neighbors its relative price structure and the consequences of its trade policies. In this sense, it becomes the relevant “rest of the world” for its smaller neighbors.

This paper has examined the consequences of such a “Gulliver effect” on trade and reviewed the policy options available for a small country whose economy is closely integrated with that of a larger neighbor which adopts trade policies with distortionary allocative consequences for the small country. The case studied is that of Nepal which shares an open border with India accross which goods can move essentially freely, implying that, within the limits of transportation and smuggling costs, prices in Nepal and India are basically the same. In India, the prices of tradeables are influenced by its own protective trade policies and, as a result, the protective features of these prices are a “given” for Nepal.

Whatever the merits of India’s protective trade policies toward import-substituting industries, these policies are not necessarily the best solution for Nepal, which has a very different resource endowment and a much smaller domestic market than India. Nepal’s comparative advantage lies, inter alia, in its low labor costs and the fact that it lacks domestic industries producing intermediate goods in need of protection. However, Nepal’s is a case where free trade and “first best” approaches clearly would not lead to optimal solutions. Rather, the situation calls for what we call an approach of “optimal divergence” from the trade policies of Nepal’s large neighbor to the South. This approach requires that Nepal should adopt an export-oriented strategy and allow the import of intermediate goods at world prices so as to provide higher effective protection than India to the production of goods destined for export to third countries—and eventually also to India when the latter relaxes its own import policy. Meanwhile, Nepal will have to live with the high and dispersed effective protection rates of India for goods produced for the domestic market.

Nepal does not seem to be a unique case where significant departues from free trade are justified by the country’s geopolitical location. Uruguay, a small country located between Argentina and Brazil, appears to be in a similar situation (see Del Castillo, 1987), and there are surely other cases. The case of Nepal illustrates that large countries, even if they are price takers in a global context, could impose externalities on small countries regarding trade policies.

References

  • Corden, W. Max, Protection, Growth, and Trade: Essays in International economics, Oxford, Basil Blackwell, 1981.

  • Corden, W. Max, Protection and Liberalization; A Review of Analytical Issues, IMF Occasional Paper 59, August 1987.

  • Del Castillo, Graciana, “The MCRC Model: A Test of the ‘Gulliver Effect’”, in 7th Latin American Meeting of the Econometric Society: Abstracts and Papers, Vol. 1, pp. 425426 (Sao-Paulo, Brazil, 1987).

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  • Krugman, Paul, R. “Is Free Trade Passe?”, Journal of Economic Perspectives, Volume 1, No. 2, Fall 1987.

1/

This paper is based on a broader study of tariff reform in Nepal conducted by a mission composed of G. Szapary from the IMF’s Asian Department, M.I. Blejer and D. Robinson from the IMF’s Fiscal Affairs Department, and D.B. Keesing from the World Bank. The authors benefited from valuable comments from W. Max Corden and from other colleagues in the World Bank and in the Asian and Fiscal Affairs Departments of the IMF.

2/

See, for example, Corden (1985 and 1987) and Krugman (1987).

3/

On the “Gulliver effect” for the case of Uruguay, see Del Castillo (1987).

4/

Nepal’s population is 17.6 million and its GDP, at about US$3 billion, is equivalent to approximately 1 percent of India’s GDP.

5/

The common border between Nepal and India spans approximately 800 miles.

6/

The Nepalese rupee has been de facto pegged to the Indian rupee with only three changes in the Nepalese rupee/Indian rupee exchange rate over the past decade.

7/

Commodities sold to India (legally or smuggled) are paid with Indian rupees.

8/

Broadly, exports with not less than 80 percent Nepalese and/or Indian materials enjoy free access to Indian markets, while exports with more than 50 percent third country import content are subject to the same Indian tariffs and quantitative restrictions as imports to India from third countries. Exports falling between these two categories receive preferential treatment determined on a case-by-case basis. The import content ratios are measured in physical rather than value terms.

9/

Except a few items which have recently been placed under Open General License (OGL).

10/

There are several exceptions to the usual import charges. The most important exceptions relate to imports under the Industrial Enterprise Act which subjects imports of raw materials, intermediate inputs, and capital goods to a 5 percent import duty and exempts them from sales tax.

11/

The calculation of EPRs has to take into account the level of “implicit” tariff, that is, all nontariff import taxes and the impact of quantitative restrictions. It should also consider export taxes and subsidies. Effective protection is, of course, influenced significantly by other factors as well, most notably the exchange rate, transportation costs, tax concessions, etc.

12/

In principle, the price in India will be equal to the world price, augmented by the implicit Indian tariff, which is the nominal tariff plus indirect taxation and the rent representing the effects of Indian quantitative restrictions.

13/

On a more technical level, another corollary of this conclusion is that it is difficult for Nepal to implement uniformity in the nominal level of import taxation (including tariffs, license fees, and premia) on imports from India and on imports from third countries.

14/

This would be equivalent to the establishment of a free trade area with India: Nepal would have its own barriers against third-country imports, possibly at zero, but there would be practically unimpeded trade with India.

15/

Vis-a-vis India, the import taxes should be set so as to maximize revenue to the Government by minimizing smuggling.