However, Jacob Viner showed that the formation of customs union could increase or reduce the welfare of member nations and of the rest of the world, depending on the circumstances under which it takes place. Whether a customs union will improve welfare depends on whether it largely leads to trade creation or trade diversion. Trade creation occurs when some domestic production of a country is replaced by lower-cost imports from another member nation. Trade diversion occurs when lower cost imports from outside the customs union are replaced by higher cost imports from a union member.

The following numerical illustration should make the concepts clear.

With 100 percent tariff, a pen would be produced at 'home.' If 'home' were to form customs union (tariff on pen removed) with its neighbour or the third country, welfare increases. A pen could be imported at a price of 20 or 26 as opposed to 35 at 'home.

' Trade creation thus increases welfare. With 50 percent tariff, pens would be imported from the third country. Let's assume 'home' forms customs union with its neighbour. Domestic consumers will then observe a price of 26 in the neighboring country and 30 in the third country, and switch imports from the third country to the neighboring country. Trade diversion reduces welfare. This possibility that a country may actually lose because of lowering tariff barriers is another example of economic theory of the second best.

The issue then is whether customs union of neighbours leads to trade creation or trade diversion.

Before we answer the question let's step back to look at the basic trade theory. Standard results of trade theory rest on complete specialization and are usually formulated as two-country illustrations, i.e. free trade between two countries leads to complete specialization in production of one good in each country and trade between them results in welfare gains. However, if there is incomplete specialization, and multiple sources for an identical good, willing to sell at the same price, importers will be indifferent between them and trade is indeterminate. Some economists have tried to answer the issue by using gravity models. The model is based on the simple idea that trade between two countries, like the gravitational force between two objects, is a function of the countries' mass as well as the distance between them.

The gravity model solves the indeterminacy problem, mentioned earlier, by positing that importers of homogenous goods buy only from the closest and, therefore, the cheapest source of supply. If trade were to follow the above pattern suggested by the gravity model, then nations would trade more with neighboring countries. It follows that if such neighboring countries, already doing most of their trading among themselves, were to form customs union there would be little trade diversion, hence little welfare loss and, therefore, should be beneficial for member countries.

It is precisely for this reason that WTO allows for deviation from its most favored nation (MFN) principle in case of preferential or free trade arrangements among a group of WTO member countries.

Intra-regional trade within South Asia is in some sense gravity defying, in spite of existence of a preferential trading arrangement (SAPTA) and the proposal to create a free trade area (SAFTA). For example, intra-regional trade among SAARC countries as a percentage of their world trade is negligible at 3.4 per cent. Intra-regional trade as a percentage of world trade is 38.4 percent in East Asia, 37.3 percent in North America, and 63.4 percent in the European Union. The distribution of this little intra-regional trade among the SAARC countries is again highly skewed. For example in the year 2000, India alone had a 72 percent share of all intra-regional exports. The shares of Pakistan, Sri Lanka, Nepal, and Maldives were 10 percent, 7 percent, 7 percent, and 1 percent respectively. Bangladesh's share in the regional export was miniscule, only 3 percent, while her share in import was more substantial at 34 percent. All of the South Asian countries except India have trade deficit within the region. Bangladesh has the largest trade deficit among them all.

What are the factors that have inhibited the growth of intra-regional trade in South Asia? Various studies suggest different answers. Some studies conclude that multilateral trade liberalization on a global basis would yield higher return for the region compared to preferential trading arrangements within the region. This view would suggest that why even bother about boosting inter-regional trade. The other studies that see benefits from intra-regional trade attribute the low intra-regional trade in South Asia to: an almost identical pattern of comparative advantage; lack of strong complementarity in the bilateral trade structure of South Asian countries; limited capacity, especially of small South Asian countries, to generate exportable surplus; and anti-regional bias in the trade structure of India and Pakistan.

What then is the way out? Unfortunately, regional co-operation efforts in South Asia focus mostly on trade liberalization. But trade is the outcome of overall relationships between countries. As examples from East Asia, EU, and North America demonstrate, the more integrated the economies are, the higher is the volume of inter-regional trade. Growth in inter-regional trade has also been found to be linked with the growth of foreign investment. To promote inter-regional trade we have to enhance economic integration of the countries in the region through investments.

Fortunately, a French company in Bangladesh has initiated a project that is a good example of such integration. I am talking about Lafarge Surma Cement Plant. While other multinationals look at Bangladesh only as their market, this company has set up an integrated, dry process cement manufacturing facility in Bangladesh with supply links for raw materials from sources in India. Similar investments could also be made for development of energy resources, transport infrastructure, and harnessing water resources in the region. Without creating such complementarities between the economies within the region, mere forming preferential trading arrangements or free trade area, will not, I am afraid, take us very far.

Dr. M. Fouzul Kabir Khan is an economist and co-author of the book Financing Large Projects (Prentice Hall).