Shaheen Rafi Khan
shaheen@sdpi.org
The guesstimates of illegal trade between India and Pakistan range widely between 0.5 to 3 billion dollars. It exceeds considerably the value of legal trade between the two countries. Total annual trade over the past seven years has never exceeded 250 million dollars and stands at less than one percent of their combined total trade with the rest of the world. Further, over this period, the balance of trade has remained consistently in India’s favor – in some years five times as high. So, even the lower guesstimate (0.5 billion dollars) illustrates the trade potential and the scope for generating foreign exchange and revenue for the government. Clearly, these aspects have important policy implications and highlight the need for getting an accurate fix on the value of illegal trade.
Contextualizing this need are recent trade liberalization initiatives at several levels — global, regional and bilateral. The global WTO mandate has steadily driven down quota restrictions and tariffs between the two countries. Bilaterally, the South Asian Preferential Trade Agreement (SAPTA), signed in April 1993, allows reciprocal, bilateral tariff reductions on mutually agreed tradable items. So far, four rounds of trade negotiations have been concluded under SAPTA covering over 5,000 commodities. Each round contributed to an incremental trend in the product coverage and the deepening of tariff concessions over previous rounds.
SAPTA was both a precursor and provided a spur to the South Asian Free Trade Agreement (SAFTA). SAFTA calls for multilateral tariff reductions, eventually leading to free trade. It is likely to open up significant opportunities for intra-SAARC trade and enhance the historically lackluster economic exchange between South Asian countries. Concurrently, SAARC members, particularly India, have entered into free trade agreements (FTAs) with neighbors, such as Nepal and Sri Lanka. Such bilateral initiatives are likely to boost movement on SAFTA, which is expected to come into force in January 2006.
The perception that illegal trade is of a considerable magnitude, and the multi-level initiatives to improve trade relations between Pakistan and India, suggest that it would be possible to direct this trade into formal channels. This could have potentially important foreign exchange, revenue and industry impacts. The World Bank commissioned the Sustainable Development Policy Institute to assess these impacts. The study, which is now complete, had a three-pronged purpose:
Barriers to trade: The scope for diverting illegal trade to formal channels is a function of the trade barriers both countries have erected against each other. The barriers are both formal and informal. Formal trade barriers comprise tariff and non-tariff barriers. The latter consist of quota restrictions, trade bans, such as the denial of MFN status and social, environmental and quality standards. Informal barriers are defined as transaction costs, and they fall into three categories: transport costs, procedural costs and rent seeking – a euphemism for bribes.
In terms of their global trade, India and Pakistan have abolished quota restrictions and reduced tariff rates steadily in conformance with the WTO mandate. Bilaterally, tariffs in India remain much higher, on average, than in Pakistan. Similarly, Pakistan has not given India reciprocal MFN status. It maintains a positive list of over 800 importable items from India.
One would expect the one-sided arrangement to lead to a positive trade balance for Pakistan. But relatively higher tariffs in India, and an array of hidden barriers, leave little wriggle room for Pakistani exports to India. By and large, moves to facilitate trade by India have remained cosmetic. The perception is that, despite the MFN concession, official tariff rates and transaction costs (especially hidden) remain higher in India.
The existence of high transaction costs has forced much of the trade, even in commodities legally tradable, to flow through illegal channels. These costs are a key swing factor. In other words, if formal sector transaction costs in importing exceed those in illegal trading, and this difference is greater than the tariff rate, a switch from illegal to legal trade is not likely to occur.
Entrenched practices and institutional factors have a bearing on informal transaction costs. Finally, normative considerations, such as livelihood and employment, should also temper trade policy aimed at reaping economic benefits. These aspects are addressed in some detail.
Data for the study was acquired through secondary and primary sources. Primary data was collected through surveys and personal interviews with stakeholders and public officials. The respondents consisted of formal and informal importers, members of the chambers of commerce and industry, customs officials, forwarding agents, rangers, security officials, wholesalers, and transporters. The transport modalities are diverse and include ships, aircraft, trucks, buses, cars, motorcycles, bicycles and pack animals. Human carriers are known variously as gandamars and laghris and include women carriers and paraplegics. The truck and bus drivers also act as agents for retailers and wholesalers in the Punjab. They both order and transport goods.
Illegal trade routes: The study identified six major and five minor informal trade routes. The major routes are:
Trade through the first three channels is containerized; the containers are shipped to Bandar Abbas, transported overland by truck to Jalalabad, and from Jalalabad to Wesh and Noshki. Here they are unloaded and carried across the border by pack animals and human carriers. On the Jalalabad route, mules and donkeys carry the goods across the border. These are re-loaded onto trucks and finally stored in large godowns in Bara. Occasionally, the routes get blocked because of tribal infighting over control of the smuggling routes.
The Dubai-Karachi is the main channel for quasi-legal trade. The term refers to trade in Indian goods stamped with a certificate of origin other than India. These goods are rerouted through Dubai, an act which validates the new origin. In effect, the trade shows up in official trade statistics as exports from the country (whose origin is stamped) to Pakistan. In a minority of cases, trade shipments are conducted through what is known as the “switch bill of lading.” In such an arrangement, ships containing items banned in Pakistan are supposed to travel to Karachi via a third port (e.g. Dubai). However, in reality the ships travel directly from an Indian port to Karachi. The ship’s bill of lading, which shows its origin, is switched in the documentation to Dubai. While the cost of obtaining a switch bill of lading is low – approximately 50 dollars – in effect, the shipment needs to consist primarily of banned Indian items. If the vessel carries consignments destined for many countries, it is not viable for it to dock in Karachi.
The five minor routes are:
Study findings: The study confirmed the lower end of the range of guesstimates, valuing illegal trade at about 500 million dollars. Six items (of a total of 17) constitute 84% of the total import value. These are, in order of priority, cloth, pharmaceutical machinery, cosmetics, tires, medicine and livestock. Exports from Pakistan, at 10.37 million dollars, are a fraction of imports. A notable aspect is the balance of informal trade overwhelmingly in India’s favor. It is probable that informal exports have been underestimated, as we did not have access to information from India. However, even if the correct figure were higher by a factor of five, it would not make much of a dent in the imbalance. This has important trade and industrial policy implications and we address these a little later.
Smuggled goods from China have replaced a large chunk of Indian items in the last three or so years. Some of the items that have been completely or partially replaced are bicycles, electronics, rubber tires for trucks, buses and cars, cosmetics, cloth, jewelry and razor blades. Our guesstimate of Chinese illegal trade, which is rapidly growing, is anywhere from two to three billion dollars. The popularity of cheap and reasonable quality products across a large choice spectrum became increasingly evident during the course of the study. This is likely to have important implications for government revenues and local industries. It also underscores the need for an independent study on the subject.
The scope for switching: As mentioned earlier, the configuration of bans, tariffs, and duties and transaction costs, both in the formal and informal sectors, determine the likelihood of informal trade being converted to formal trade. The following table consolidates information on both tariffs and transaction costs across the major and minor informal trade routes.
The information on tariffs and transaction costs is combined to arrive at a qualitative determination of the scope for diverting informal trade to formal channels. Basically, informal transaction costs adjusted for formal transaction costs are compared with tariff rates. It determines the extent of tariff reduction required to switch to formal trade.
The overall message is that it will require a significant reduction in tariffs to change the status quo for almost four-fifths of the trade. For example, on the Bara route, the total transaction costs are about 10% of the value of a container of winter suiting. The duty and sales tax come to about 40%. If the ban were removed, it would require a 30% tariff reduction to divert informal to formal trade channels.
Thus trade liberalization is necessary in giving India MFN status, but not a sufficient condition for substantive switch in the mode of trade. Existing tariffs and procedural restrictions would, in addition, need to be reduced substantially. This was also borne out in interviews with stakeholders. Particularly in Bara where transport costs are high, importers were not unduly concerned. They thought the combination of tariffs and procedural requirements would more than offset the high transport costs they needed to factor in to their prices.
The exception is the Dubai-Karachi route, which accounts for about one-fifth of the informal trade. Transiting to MFN status suggests that such trade would switch to formal channels.
Another unexpected aspect is secondary effect of trade liberalization. It relates to opening more proximate access routes, such as cross-border trade, between the two countries (Delhi to Lahore, Mumbai to Karachi), which can induce an increase in smuggling, thanks to a combination of existing tariffs and lower transport costs.
Ultimately, it leads us to the conclusion that providing MFN status to India may not be enough of a stimulus to divert informal to formal trade – in fact, it could actually increase the volume of illegal trade. For the trade modality to change from illegal to legal, we need to transit into a free trade regime, à la SAFTA.
Institutional Attributes: Illegal trade also has institutional attributes, which impart an inertial character to it and create resistance to change. In other words, they lower transaction costs of illegal trade. The first attribute is ethnicity, and it is a recurring theme in the other attributes as well.
The ethnic groups involved in illegal trade in Indian goods are predominantly Afridi Pathans, Hindus, Sikhs, Afghans and Pathans. The Sikhs and Hindus settled in the tribal areas almost a century ago have adapted Pathan culture and are fluent in Pushto. In Balochistan, three clans – Achakzais, Milzais and Ghilzais – live on both sides of the border and dominate illegal trade. Most of the tire business in Balochistan is conducted by “kuchis" (gypsies) whose fortunes have improved visibly over time. Three major tribes — the Mehar, Mangrio and Bhambro — dominate the Sindh cross-border trade. A small proportion of this trade is conducted by the Thori and Bhatoory castes. The ethnicity-language-information interface is strongly evident. The tribal/ethnic connections across the border in Sindh facilitate information flows on prices and demand for goods.
Ethnicity also has a bearing on the second attribute, which is the rate of entry/exit. Entry and exit from informal trade is low. The ethnic complexion of the trade makes entry difficult. Second, ethnic ties increase credibility in a business much of which is based on trust and credit.
The third attribute is risk. One would expect that circumventing restrictions would entail the risk of confiscation. In reality, such risks are low, thanks to collusion between the smugglers and officials. The khepias (carriers) bribe the customs officials in Karachi and Dubai and the Federal Investigation Agency (FIA) officials in Karachi to ensure unhindered travel.
They provide their tentative weekly flight schedules to officials at the airport. Additional bribes are paid to the airport security police at Karachi and to police on the road leading to the airport. Personal contacts and ethnic connections also act as risk mitigating factors across trade routes. They minimize default in the delivery, specifications and payment for goods. Bribery is a common practice on the Chaman border. It can range from 0.15 to 2,000 dollars depending on the volume and quality of goods.
Five different agencies — Frontier Constabulary, Pishin Scouts, regular police, FIA and the Customs — are stationed within half a kilometer, from Wesh to Chaman. The various authorities are paid on daily, weekly and monthly basis. Payments extracted by low-level functionaries are graduated up the hierarchy of command. However, the multiple recipients notwithstanding, bribes are low and affordable on a per unit basis. It is only when the incidence of interdiction and seizure of goods increases that smugglers switch to other routes, such as Noshki and Gulistan.
The fourth attribute is financing. Payments, both to importers and wholesalers, are deferred under arrangements known variously as ograi (in Bara) and across other routes as hundi/havala. The arrangements are based on trust and client credibility, a large part of which has to do with common ethnic and tribal ties.
Bank financing is difficult and involves interest. Instead business capital is raised from family members or own savings are utilized. Payments for consignments are also done through inter-bank transfers outside the country, in Dubai or India. In Balochistan, Pakistani and Afghan currencies are accepted for transactions on both sides of the border.
Socio-economic imperatives: The socio-economic driver for illegal trade is extreme deprivation, in the absence of social and physical infrastructure and economic opportunities. There are few schools, medical facilities, roads, utilities and jobs in the major smuggling areas, whether in the tribal agencies, or in Pakistan close to the borders. This is the stark reality on the western and eastern borders where illegal trade flourishes, whether it is Bara, Chaman, Gandasingh Wala or Tharparkar.
Smuggling becomes the only viable recourse, a source of enormous profit for the favored few, and meager livelihood for a multitude of dependant carriers and transporters working under brutally harsh conditions. Such trade provides huge illegal gratuities for government officials.
Not surprisingly, this income distribution pattern replicates the national macroeconomic situation. While it is difficult to ascribe exact numbers, impressionistically, anywhere between a half to one million people and their dependants are sustained by smuggling.
The clan and tribal connections provide an historical context to this trade. Such connections also ensure some economic stability in a highly volatile business environment.
The situation clearly demonstrates that broad-sweep policy-cum-ethical takes on smuggling not only buck self-interest and tribal prerogatives but are premised upon providing alternative economic opportunities in marginalized areas, which the government traditionally has not been prone to do.
Revenue generation: The revenue impacts are likely to be insignificant since most of the informal trade would continue despite giving MFN status to India. As indicated, the only switch that is likely to take place is on the Dubai-Karachi route where the assessed value of third country trade is in the region of 90 million dollars. Additional tariff realization would depend on whether Indian tariffs are higher than those in “substitute” countries. Invoicing of Indian goods entering Pakistan via third country trade can, potentially, lead to increased revenue realizations once such imports are legalized, provided Pakistan customs maintains a detailed price list of these imports.
Industry Impacts: Re-directing illegal trade into formal channels is not likely to have much of an impact on domestic industry per se, as it merely changes the importing modality rather than the magnitude of imports. However, a price comparison of smuggled items illustrates the potential for de-industrialization in terms of the formal trade flows it would induce.
Drugs and medicines coming into Pakistan via illegal channels are valued at approximately 36 million dollars and cosmetics at approximately 50 million dollars. The large price difference for drugs reflects the subsidy on ATT consignments to Afghanistan. The illegal trade in these is valued at 1.6 million dollars. However, non-subsidized drugs and medicines, making up the remaining 34.4 million dollars in illegal trade, are also priced much lower than in Pakistan, and of a better quality.
At present, there are internal checks on their sales which prevent a large influx of these drugs – an influx warranted by the price difference. Trade liberalization would remove these checks. And as long as tariffs remain, and informal transaction costs are not high, there will always be an incentive to smuggle goods triggered by the opening of the more proximate routes (Delhi-Lahore, Mumbai-Karachi).
So we come to the interesting result that liberalization can lead to de-industrialization not only through the larger quantum of formal trade, but through the induced increase in informal trade as well. In fact, this is an argument that applies across the board for all illegally traded goods.
Recap: A priori, trade liberalization between India and Pakistan offers prospects of directing informal trade into formal channels. At present, while tariff rates and quantitative restrictions are coming down under various bilateral, regional and global (WTO) initiatives, Pakistan has not granted India MFN status. Similarly, India continues to maintain a host of hidden restrictions against imports from Pakistan. Trade between the two countries continues to remain at historically low levels and is exceeded by the volume of informal trade.
However, a discernible momentum is building up to lower the remaining restrictions, which should not only increase cross-border trade but also lower the incidence of smuggling. As potential trade dynamics between the two countries change, it is necessary to finesse trade policies further to maximize fiscal benefits and to ensure that adverse impacts on local industry are kept to a minimum. The process of fine-tuning trade policies entails determining the extent and speed of trade liberalization, as well as its sector focus.
An investigation of Indo-Pak informal trade was part of this policy imperative. Its purpose was to quantify the value of informal trade and assess the prospects of channeling such trade legally, under partial (MFN) and complete (SAFTA) trade liberalization regimes.
Not surprisingly, the ex post findings deviate substantively from the ex ante expectations. Guesstimates of informal trade between the two countries ranged from 0.5 to 10 billion dollars. The study confirms the lower end of the range. In recent years, India has lost a share of its informal market to China. Six items (of a total of 17) constitute 84% of the total import value (492 million dollars). These are, in order of priority, cloth, pharmaceutical machinery, cosmetics, tires, medicine and livestock. Exports from Pakistan, at 10.37 million dollars, are a fraction of imports; however, they may be understated. Cloth exports constitute 88% of the total.
The likelihood of diverting informal trade to legal channels is low under an MFN regime, as existing tariffs would more than offset the net transaction costs on the circuitous but important informal trade routes. It would take a substantial tariff reduction and a lowering of formal transaction costs to re-direct informal trade to the more direct routes between India and Pakistan. In fact, if tariffs remain – even at lower levels – the more proximate and legal direct routes may trigger additional informal trade. Institutional considerations are another factor, working through transactions costs, which lower the prospects of changed trade modalities.
Revenue generation for the government in this scenario is also not likely to be significant. The policy 
implication is that free trade, à la SAFTA, is likely to yield higher trade and revenue gains. However, it would also constitute a threat to local industries, especially textiles, cosmetics, and drugs and medicines. The comparative prices in the last two categories are highly indicative, and suggest that tariff reductions may need to be staggered.
Finally, trade policies need to consider the socio-economic consequences of disrupting practices, which are both historically entrenched and generate employment. In fact, they cushion the effects of government neglect in marginalized and politically volatile areas. So complementary polices which provide alternative livelihood and establish social and physical infrastructure become key.
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