Edited by Sultan Hafeez Rahman, Sridhar Khatri and Hans-Peter Brunner
2. Vertical integration of industries in South Asia Deshal de Mel and Suwendrani Jayaratne1 INTRODUCTION Intra-regional trade in South Asia has in the post-colonial era remained very low. Today intra-regional trade is around 5 per cent of total trade by South Asian countries, despite many efforts at regional economic liberalization since the South Asian Preferential Trade Agreement (SAPTA) in 1995. Furthermore, trade imbalances continue to be a feature in the region with many South Asian countries facing trade deficits with respect to India. Given the predictions of traditional trade theory (encapsulated in the Ricardian and Hecksher–Ohlin models), South Asian economies have limited scope for improving intra-regional trade given the fact that they have comparative advantages in the production of similar products (garments, light manufacturing and agricultural products). New Trade Theory, however, suggests greater scope for enhancing intra-regional trade in South Asia. One way to address both problems – that is, low intra-regional trade and persistent trade imbalances – is to invigorate the trade–investment nexus in the region. New Trade Theory draws on the relationship between trade theory and industrial organization to suggest theoretical possibilities of the interaction between trade liberalization and foreign direct investment (FDI). The first possibility is that of trade and FDI becoming substitutes as trade liberalization leads to factor price equalization between countries; accordingly, liberalization of trade in goods can substitute for trade in factors of production, thereby negating the incentives for FDI. A second possibility is that through the increased incentive for vertical integration of production...
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