India’s Minister of Commerce was in town last week. He had the usual few words to say about the benefits that are supposed to have accrued to pretty much everybody since the entry into force of the free trade agreement with Sri Lanka in 2000. Trade between the two countries has increased at least four-fold, and it is now worth well over $2 billion. India had cut its tariffs on Sri Lankan goods by 2003, and Sri Lanka is due to do away with all remaining taxes on Indian imports during 2008. Free trade has triumphed, apparently.

Unfortunately, the story isn’t so simple. Taking a closer look at what has happened in practice would prompt even the most ardent believer to question the undoubtedly beguiling theory of free trade.

Sri Lanka’s major export under the free trade agreement is hydrogenated vegetable oil. It has become big business here. About a dozen factories have been set up, and they employ some thousands of Sri Lankans. Production has increased several times since 2000. In 2002, 80,000 MT of hydrogenated vegetable oil was shipped to India, and this had more than doubled to some 165,000 MT by 2005.  Sri Lanka’s trade deficit with its rather more powerful neighbour was cut from a ratio of 1:10 to around 1:3 over the same period.

Free trade is supposed to be about each country focusing on the goods that it can produce most efficiently, and then selling them to others and using the proceeds to buy whatever else it needs on a level playing field. However, this is clearly not the reality. Sri Lanka has been importing crude palm oil from Malaysia, putting it through a rather simple chemical process, and then exporting the end result as hydrogenated vegetable oil to India.  Indian products have been undercut only because the Sri Lankan government has been imposing very little duty on crude palm oil, while India has been taxing such imports heavily.

The industry was bound to run into trouble. Indian manufacturers were understandably upset at what they considered to be unfair competition, because many of their established plants were operating well below capacity or were being forced to close up altogether, and they began pressing the Indian government to protect them. Sri Lanka exported more than 100,000 MT of hydrogenated vegetable oil to India in the first six months of 2006, and it proved to be the beginning of the end for Sri Lanka’s industry.  India decided to forget the free trade agreement and simply put a stop to Sri Lankan imports. Factories stood idle for months while negotiations were underway to find a compromise solution, and everybody was relieved when the Indian government agreed to restart the trade with a fixed ceiling on Sri Lankan products of 250,000 MT per year.

In fact, the dispute didn’t end there. The Indian government faced further demands from its industrialists, and it finally decided to reduce its import tariff on crude palm oil at the end of 2007. Sri Lankan products rather abruptly became no cheaper than those made in India.

Hydrogenated vegetable oil will end up as just another small enterprise in Sri Lanka. Exports can’t endure for long, and the industry won’t prosper unless people in this country can be convinced to eat an awful lot more fatty foods. Sri Lanka benefited from the situation for a while, but there was never any real reason to manufacture large amounts of hydrogenated vegetable oil here, so this is far from an advert for free trade. Sri Lankan workers are hardly going to celebrate having temporarily stolen a few jobs from their probably no better off Indian counterparts. Sri Lankan leaders will have to start worrying about the trade deficit again.

Meanwhile, it turns out that most of the local producers are actually Indians. They only came over here to exploit the loophole in the free trade agreement. Sri Lanka was essentially incidental to this tale.

Pepper is the other important product in the free trade agreement.  Again, Sri Lanka has been exporting increasingly large quantities, and this has resulted in India imposing a cap on Sri Lankan pepper of some 2,500 MT per year.

Sri Lankan producers do have an advantage in this case.  Indian yields are now amongst the lowest in the world, and wages are probably the highest, so the principles of free trade would suggest that they ought to give it up. However, this is easier said than done. Pepper farmers have to make major investments in their cultivation, because vines take several years to yield after planting, and it is a brave farmer who rips them up to make way for another crop.

Desperate farmers don’t have a choice. Kerala produced almost all of India’s pepper in 2000, and it is one of the longest living, healthiest and most literate states outside the West, yet it also has one of India’s highest rates of farmer suicide, and literally thousands of Kerala farmers had taken their own lives by 2006.  Drought didn’t help, but plummeting prices were the major cause of distress, because most farmers depended exclusively on cash crops for their survival. In 2000, pepper fetched well over INR 200 per kilo, but this had dropped to under INR 70 per kilo by 2003, and prices only recovered to around INR 80 per kilo in 2006. Kerala’s government judged that its pepper farmers could have no hope of even recouping their costs after 2000, because one hectare produced less than 300 kilos of pepper and required inputs of around INR 33,000. Farmers were in deep trouble.

The free trade agreement can’t be blamed for all of this. Prices in the global market were adversely affected during this period by the massively increasing supply from new entrants to the pepper business like Vietnam. However, it certainly made the situation worse. Indian imports went up by a multiple of five from only 3,000 MT in 2000, while Indian exports dropped by more than half to some 20,000 MT in 2003. In 2005, Sri Lanka shipped some 7,500 MT of pepper, while total imports to India amounted to around 15,000 MT. Sri Lankan producers often complain about Indian protectionism. Free trade would allow them to further increase their market share and earn more foreign exchange for the country, but this doesn’t seem like such a great idea when one farmer commits suicide every 30 minutes in India.  Sri Lankan industry representatives announced earlier this year that there would be no further pepper exports under the free trade agreement until India removed the 2,500 MT cap, but they are still sending some 4,000 MT under a separate duty-free scheme to feed the essential oil factories of India’s export processing zones.  Pepper is going to survive as an important industry in Sri Lanka.

Meanwhile, Sri Lankan farmers may not even be profiting from the problems of their Indian comrades.  It has been suggested that pepper from other countries is being diverted this way to take advantage of the free trade agreement.  Sri Lanka should be ashamed if this is so.

India’s Minister of Commerce looked forward to signing a Comprehensive Economic Partnership Agreement with Sri Lanka later in 2008.  It will go beyond the abolition of duty on trade in goods to consider other barriers to free trade, and it will encompass trade in services as well. Both countries are also expected to reduce the number of products excluded from the free trade agreement. Trade is bound to receive another impressive boost in value, and bilateral investment may well increase too. Sri Lanka might gain, but past experiences need to be reviewed in a rather more circumspect manner than has been the tendency to date, because the modest successes of the free trade agreement have at the same time been glaring failures.