This is ARTNeT Policy Brief No. 50, " India-Sri Lanka Free Trade Agreement: Sri Lanka reaping the benefits from preferential trade ", by Saman Kelegama.
The objective of a free trade agreement (FTA) is not to bring about a balance in trade, but to work out a ‘win-win’ situation for both producers and consumers in FTA member countries. In doing so, there can be instances where the trade deficit increases for one partner. For instance, the inflow of necessary consumer goods, machinery and spare parts for industrial activity, and intermediate goods like textiles and oil, to one trading partner can be huge while the supply capacity of the same trading nation may be limited and cannot immediately increase to expand its exports to match the import flow.
If one looks at the composition of imports from India to Sri Lanka, the bulk of it comes mainly to fulfill consumer needs like vehicles, pharmaceuticals, sugar, etc. Some other imports are intermediate imports for the industry like textiles, vehicle parts, and oil. For example, Sri Lanka annually imports close to US$60 million worth of yarn and US$300 million of fabric from India for use as inputs in the apparel industry. All these items constitute, on average, nearly 80% of Sri Lankan imports from India and they are imported outside the provisions of the FTA. In other words, these items are subject to normal customs duties and do not benefit from any tariff concessions. Hence, they enter the Sri Lankan market because they are the most competitive input source and provide value for money for intermediate and/or final products for local producers and consumers. Importing these items at a higher cost from other countries would increase Sri Lanka’s overall trade deficit and producers and consumers would be confronted with higher prices.
Contrary to goods imports, nearly 70% of Sri Lanka’s exports go to India using FTA provisions. Thus, these exports benefit from the zero tariffs granted by India. Clearly, Sri Lanka has been using the FTA more than India (figure 1). Plotting the goods traded between the two countries by using the preferential tariffs offered by the FTA shows that there is hardly any deficit between the two countries (figure 2). In fact, Sri Lanka has enjoyed a surplus on trade conducted under the bilateral FTA with India in six of the sixteen years since the FTA came into force.