1.2 South Asian Intraregional Goods Exports and Imports, 2018 (US$ millions

TABLE 1.2 South Asian Intraregional Goods Exports and Imports, 2018 (US$ millions)

Exporter (source) ↓ AFG

BGD

BTN

IND

MDV

NPL Destination (importer)

AFG BGD BTN IND MDV NPL PAK LKA SAR WLD South Asia Region as export market (%)↓

0.11 315 0.01 202 517 716 72

3

7 4 793

490 43 69 20 932 31,448 3 15 0.12 513 541 95

726 8,789 647 0.13 3 8 218 7,225 2,386 4,442 24,434 320,142 8 0 22 33 205 16

0.00 11 1 416 0 0.29 0.10 428 757 57

PAK 1,232 746 0 377 6 2 367 2,730 23,193 12

LKA 0 129 0.01 748 107 9 79 1,074 11,308 9

SAR

1,962 9,686 652 3,147 331 7,293 2,737 4,852 30,661 388,310 7.9 WLD 8,268 58,169 766 489,750 2,464 9,993 62,739 21,166 653,315 19,180,641 SAR as import source (%) → 23.7 16.7 85.2 0.6 13.4 73.0 4.4 22.9 4.7

Source: Direction of Trade Statistics, International Monetary Fund. Note: This table should be read as, for example, Afghanistan’s exports to India are valued at US$315 million, while the country’s total exports are US$716 million. Exports to South Asia are worth US$517 million, which constitutes 72 percent of its total exports. Afghanistan imports goods with a total value of US$8,268 million, of which US$1,962 comes from South Asia. This amounts to 23.7 percent of Afghanistan’s imports. Numbers in bold are trade relationships of more than US$1 billion. AFG = Afghanistan; BGD = Bangladesh; BTN = Bhutan; IND = India; LKA = Sri Lanka; MDV = Maldives; NPL = Nepal; PAK = Pakistan; WLD = world. THE STATE OF PLAY IN SOUTH ASIA

of estimated potential trade), the trade tensions in the global environment, and the relatively strong growth of South Asia render the regional market highly attractive (Kathuria 2018). Among the bilateral trade relationships, India-Pakistan trade shows the largest gap between current and potential trade. Bangladesh-India and Bangladesh-Pakistan trade are also substantially below potential. The suboptimal levels of trade engagement imply significant welfare losses for consumers, exporters, and producers.

The report considers the complex relationship between trade and investment across space and time. South Asia is lagging relative to the world in the contribution of goods exports to national income (World Bank 2019), and foreign investment could address this situation. IFDI may stimulate exports through productivity increases and access to export markets. Outward trade-supporting investments are expected to increase exports of goods by increasing learning about markets and building stronger relationships with clients. Similarly, outward distribution investments by manufacturers would increase goods exports. Over time, trade and investment are connected through a learning mechanism in which a firm may enter a market first using an entry strategy that has relatively low capital costs (exporting) and later adopt the most expensive investment option. Annex 1B briefly examines the trading landscape in South Asia and foreshadows the type of FDI and the likely direction of FDI in the region; for example, key traded goods and services trade flows can provide good indications of potential FDI.

Developing Regional Value Chains Regional engagement is enhanced through the trade-investment-connectivity-trust–regional value chains nexus. The low level of trade is reflected in the lack of a network of regional value chains, which could provide a dynamic impetus to trade, as in East Asia. South Asia exhibits only pockets of evidence of regional value chains, the most visible being in the apparel sector and the auto industry. The entire value chain for apparel is available in the region, yet apparel manufacturers source extensively from East Asia. Cotton and yarn come from India and Pakistan, and fabrics are made in India, Pakistan, and, to a lesser extent, Bangladesh and Sri Lanka. Design capability is growing in India, Pakistan, and Sri Lanka; trade logistics and network coordination are strong in Sri Lanka; and manufacturing takes place in Bangladesh, India, Nepal, Pakistan, and Sri Lanka. Bangladesh is the second-largest exporter of apparel in the world after China. Moreover, the region’s economies have specialized within the sector, with Nepal and Sri Lanka having niche markets in pashmina shawls and complex intimate apparel, respectively. Bangladesh focuses on casual wear, and Pakistan specializes in denim and has a strong related industry of home textiles. Protection of the manufacture of human-made fibers has resulted in low-quality materials in the region, leading to substantial imports from China in addition to other inputs. Much of the intraregional FDI in this sector is associated with the emergence of regional value chain activity.

In the context of low-trust environments and difficulty in the enforcement of contracts, ownership through FDI offers the best option for developing regional value chains, albeit through intrafirm activity across borders. Such FDI activity has been seen

in the apparel value chain, with Bangladesh being the largest recipient of FDI. Regional trade has been volatile, especially for some bilateral trade relationships, including drops in the absolute value of exports (not just in export shares), as seen in figure 1.3. FDI may go a long way toward reducing uncertainty and bringing more stability to trade transactions through regional value chain development.

Reducing the Trust Deficit The report analyzes links between FDI and trust, the latter being in short supply in South Asia. Trust in business relationships has become an increasingly important determinant of global business activity because complex transactions within value chains cannot be fully specified in standard transactional contracts. Higher bilateral trust is positively linked with FDI and trade flows (Da Rin, Di Giacomo, and Sembenelli 2019; Guiso, Sapienza, and Zingales 2009).10 Moreover, once FDI occurs, because FDI is a stable and long-term commitment to economic engagement, it in turn helps enhance trust between countries through deeper people-to-people interactions. The report generates a measure of bilateral trust in South Asia using the same question asked of Europeans in the European Commission’s Eurobarometer surveys. It identifies bilateral trust deficits and surpluses in South Asia and explores the link between trust and knowledge connectivity.

The Region as a Springboard Neighbors tend to provide grounds for experimentation for exporters and investors and then a springboard for global engagement. South Asia’s tariffs have come down since 1990 (though they are still the highest among developing regions), so the region could potentially play this role. Because entry costs into regional economies tend to be lower, many firms use their region as a learning platform and a springboard to global markets. This is evidenced in developing countries’ exporting more sophisticated products first to other developing nations before facing more challenging markets and demanding consumers. In addition, as the ratio of foreign trade costs to domestic trade costs falls, value chain activities first become more regional and thereafter move to more global settings (Antràs and de Gortari 2020). Although earlier work (Yatawara 2013) finds that the South Asia Region was the first market for only 28 percent of goods exports, the findings of this report suggest that almost two-thirds of (the number of) investments are first placed within the region. Thus, continued increases in connectivity, including knowledge connectivity, and policy reform would help South Asian countries expand both exports and investments regionally and globally.

BROADER CONTRIBUTIONS AND LIMITATIONS

The general contributions of the report relate to the understanding of emerging market multinational enterprises; the highlighting of overlooked outward investment programs, their distortions, and new potential gains from reform; and the importance of information

frictions and the compilation of indicators of knowledge connectivity and social capital. Some key findings about investment decision-making result from the application of insights from the international trade literature to the investment literature, such as knowledge connectivity and exporting (Dickstein and Morales 2018) and sequential exporting (Albornoz et al. 2012). The literature also confirms some relationships seen in the trade literature for investment, such as the greater importance of trade costs for services exports compared with goods exports. The report contributes to the nascent work on information frictions, establishing the importance of knowledge connectivity for investment participation and showing how it can be even more important than productivity for some investments. It also adds to recent work on the dynamic relationship between exports and investment (Conconi, Sapir, and Zanardi [2016], using Argentinean data).

The empirical results show that reduced trade costs are important for investment directly (a theoretically ambiguous relationship) as well as indirectly, through increased learning about investment potential by export experimentation. Further, the importance, based on regression analysis, of visible ethnic or social networks (based on founder background) for investment entry is an uncommon finding. When entrepreneurs are asked to rank important factors in decision-making, they tend to rank ethnic networks low. This low rating likely occurs because entrepreneurs highlight the business case for investments, but at the same time network links provide an inherent knowledge or subconscious confidence to proceed with the investment. In addition, these networks are more important for services investments.

Another important contribution is the inclusion of firm-level “frictions” that are important in the private sector landscape, such as the prevalence of business groups, conglomerates, and family firms. The results point to business groups as an organizational structure that can capture pioneer firms’ knowledge spillovers for other related firms or incubated new firms. It also contributes to recent work that recognizes the importance of including entrepreneur characteristics in firm-level analyses.

Although the report offers an innovative approach and findings, it also has limitations. For the aggregate FDI data, the analysis does not make adjustments for the role of investment hubs or calculate the ultimate destination of investments. However, it does draw attention to the extent of outward investment from South Asia that goes to investment hubs (44–72 percent). Further, ultimate investor estimates from UNCTAD (2019) for IFDI are used to show that intraregional investment is only marginally underestimated in the unadjusted data.

By choosing to include all South Asian countries and unlisted firms (such as family firms not required to provide information), typically available variables used in advanced-economy firm-level studies of multinational enterprises were not available for analysis. Thus, the report does not emphasize the precision of the specific magnitude of the coefficients estimated. Instead, it relies on the sign of the coefficients and the relative size of coefficients. It is hoped that this report will inspire further work that uses more detailed firm-level financial information to provide a greater degree of precision in estimates for individual countries.