The European countries took several decades to move into full integration since the European Coal & Steel Community was launched in the late 1950s.

Economic integration undoubtedly offers great potential advantages for a small economy of 20 million people to gain market access to a large country with over 1 billion people. A large market makes possible economies of scale for, as Adam Smith observed, the division of labor and specialization are limited by the size of the market. So our producers have hitherto produced largely for the small domestic market except for the large plantations in tea and rubber which the British se up to export tea and rubber to world markets.

A large market will offer scope for larger scale of operations bringing with it economies of scale. There is also the promotion of technology change. Innovation shows increasing returns to scale and the incentive to innovate also depends on the size of the market. Innovation also involves high one-off fixed costs and a bigger market supports them more readily. The Indian companies are much larger than our business enterprises and they command greater resources for such investment. The theory of convergence says that the gap between the rich and poor countries will be narrowed when direct foreign investment takes place and hence there are advantages in attracting capital inflows from India or anywhere else for that matter. But our assets are too cheap in foreign currency due to the continual depreciations of the rupee and offer bargain prices to foreigners.

 But all these are only potential advantages and whether we have the capacity to convert this potential to realty is another matter.  Will our business enterprises be able to make use of the opportunity? We notice that our inflation rate is 25% while that of India is around 10%. We have had high inflation for decades, well over 10%, while Indian inflation was for a long timeless than 5% at least after the reforms of 1990. So the general price level in Sri Lanka is way above that of India. Another result of our high inflation is that we have been forced to depreciate the rupee considerably so as to enable our export industries and export agriculture to maintain their competitiveness. So our rupee is very weak relative to the Indian rupee. In 1950 both currencies had the same parity in respect of the US dollar and the pound sterling. Today the US dollar is converted to the Sri Lankan Rupee at Rs 108 while the Indian rupee conversion to the dollar is only at 40. So 108 of our rupees equal 40 Indian rupees.

Even his rate does not reflect the relative purchasing power parities. The Indian rupee is strengthening despite the oil price hike while our rupee is artificially maintained at its present value due to the heavy inflows of foreign exchange not from our earnings but from borrowings which have to be repaid. We have pegged our rupee to the   US dollar and followed the movements of the dollar in its relative value vis-a-vis the euro the pound and the Japanese yen. So when the dollar depreciated in relation to these currencies our rupee has followed its movement. That means the rupee has not maintained its value in relation to these currencies. In short if a US dollar is converted to Indian rupees and to the Sri Lankan rupees the equivalent values will not reflect the purchasing of the Sri Lankan rupee in India as equivalent.

What this means is that the Sri Lankan goods produced at high cost cannot be sold in India. But Indian goods will be cheaper in Sri Lanka and they will be able to under-cut our domestic goods if imports take place freely So the potential advantages of economic integration will remain potential advantages only and not be realized until we bring down our rate of inflation to that of India and adjust the exchange rate between the two currencies to reflect the relative purchasing power parities.

Strangely, the government has proposed a common currency for the SAARC region. But the same effect can be achieved by first linking the Sri Lankan rupee to the Indian rupee at a fixed value and then allowing Indian rupees to come in freely. Of course the Sri Lankan rupee will disappear then as happens in Latin America where there is dollarization in countries with excessive inflation. But today Exchange Control prohibits the bringing in of Indian rupees at all and if you hold Indian rupees you cannot even convert them to Sri Lankan rupees as I found when I brought a few hundred Indian rupees during my recent trip there. The banks do not accept or convert Indian rupees.

The parity rate would have to be determined on a consideration of the relative purchasing power parities. But it will mean that the government will not be able to carry out its deficit finance policy and restore macro-economic balance, which is a good thing for us. But it would mean a recession here to correct the built up imbalances If macro-economic balance can be restored, then inflation will come down apart from that component which is due to oil and food price hikes in the world market which affect both countries equally.

High inflation countries like Greece, Spain and Portugal delayed entry into the EU until they sorted out macroeconomic factors that had caused inflation.  To maintain the relative purchasing power parity thereafter requires an independent Central Bank much like the European Central Bank. The Central Bank will have to give up monetizing the budget deficit. But this requires the removal of the Treasury Secretary and any other government official from the Monetary Board. Although governments in India also resorted to deficit finance prior to the 1990 crisis, Dr Man Mohan Singh signed the First and the Second Supplemental Agreements with the Reserve Bank of India in the period 1990-97 when he was the Minister of Finance. Since then the RBI has stopped monetizing the budget deficits.

SAARC has nothing much to show

SAPTA was signed in 2004 and was to come into effect from 2006 to provide for a Free Trade Area in SAARC. This too has been a flop and bilateral efforts were put in place between India and Sri Lanka. Trade undoubtedly increased considerably between the two countries. But business lobbies point out that the increase was largely accounted for by vanaspati and copper products where Indian firms set up here to take advantage of the tax free status. It was against the spirit of the FTA with its rules of origin. So the Indian authorities clamped down and this trade has dried up. In any case it was not an indigenous product and there was little value addition here.

The Sri Lankan businessmen are also complaining that the Indian authorities not necessarily the Union government but regional governments resort to various non-tariff barriers such as limiting our exports to a single port for example. So our businessmen find themselves shut out or have to incur extra costs which put them off. It is time that the Institute of Policy Studies publishes a report on the position regarding the implementation of the Free Trade Area Agreement if they want the country to consider seriously any further integration.

Another field for consideration is the trade in services. In principle the argument for freeing trade in services is the same as for trade in goods. In both cases all countries can make themselves richer by specializing in activities in which they enjoy a relative advantage. That applies just as much to accountancy which requires a relative abundance of numerate workers. It also applies to legal services as well as to computer services, transport, communications, telecommunications and so on. But in practice and contrary to common wisdom, freeing trade in services now matter more than freeing trade in goods. One reason for this is that trade in goods has already seen waves of tariff cuts and the gradual dismantling of some non-tariff barriers.

Services account for 60% of our GDP growth and they have in general been least open to competition at least as far as the professional services are concerned. A dose of competition as shown in telecommunications would work wonders. Workers in India write computer programs for customers in developed countries. Any activity from secretarial to accounting services that can be conducted through a screen and a telephone can be carried out anywhere in the world linked to a head office in London or New York by satellite and computer.

GATS (the General Agreement of trade in Services) define trade in services in four different modes. Modes 3 and 4 refer to service supplied in one country by a supplier in another through a commercial presence as in the case of Apollo hospital. Mode 3 refers to the movement of natural persons where the service is supplied in the territory of another country through the temporary presence of natural persons from outside. There are the legal services, computer related services, postal and courier services, logistics services, maritime transport, education services, Entertainment services, cultural and sports services etc.