Even though both countries are members of the South Asia Free Trade Area (SAFTA) established in January 2006, trade between the two countries is unnaturally small and the scope for gains from increased trade correspondingly large. Total trade (exports plus imports) between India and Pakistan in 2008 amounted to a little more than US$2 billion, up from a paltry US$500 million in 2000. But still Pakistan accounts for less than 0.5 per cent of India’s trade, and India accounts for a little over 1 per cent of Pakistan’s trade compared with the very large trade shares following the independence of the two countries in 1947. In 1948-49, 70 per cent of Pakistan’s trading transactions were with India, while 63 percent of Indian exports went to Pakistan. Informal trade, via third countries (such as Dubai), is estimated at some US$2-3 billion per year, and this trade could obviously be undertaken bilaterally at significantly lower cost.

There have been a number of studies using gravity models to assess the effects of SAFTA on interregional trade. Based on these studies, India-Pakistan trade could increase up to 50 times its current level. A more recent study, using the Peterson Institute for International Economics (PIIE) gravity model, shows the potential of formal trade between India and Pakistan is roughly 20 times greater than recorded trade. This means that at 2008 trade levels total trade (exports plus imports) between India and Pakistan could expand from its current level of US$2.1 billion to as much US$42 billion if the ‘normal’ relations estimated by the PIIE gravity model for trading partners were to hold for the two countries.

What then is holding trade back between the two countries? Constraints on economic integration include high tariff and nontariff barriers, inadequate infrastructure, bureaucratic inertia, excessive red tape, and direct political opposition.

Pakistan has not yet reciprocated most favoured nation (MFN) status for India and maintains a fairly narrow positive list (of about 1400 items) on goods that India may export to Pakistan. At the same time, India’s tariff rates remain high, especially for goods of particular interest to Pakistan, such as textiles, leather, and the mineral onyx, and nontariff barriers are substantial. Poor transportation linkages make trade costly, with railway and road connections inadequate and sea shipments constrained by both limited port facilities and bureaucratic regulations and restrictions. Moreover, constraints on visas and cumbersome payments and customs procedures further limit the scope for trade. Finally, although there are no specific restrictions, there is virtually no trade in services or foreign direct investment (FDI) flows between the two countries. In both the cases of services and FDI, prior government approval has to be obtained, and it is clear that such approvals have been granted very sparingly by either country.

Before undertaking more long-term and wide-ranging fundamental trade reforms, both countries need to build public support for trade liberalisation between them. Initial steps should focus on bilateral measures that can be accomplished relatively easily—by executive order rather than via legislation and with minimal resource implications—and that would meaningfully increase trade while gaining support for bigger and bolder steps down the line. Reducing these various and eventually achieving regional integration could involve two phases: short-term (say one year) and medium-term (say 1-3 years).

The specific short-term measures, mainly related to trade facilitation, could include: easing restrictions on visas; eliminating the requirement that ships between India and Pakistan touch a third country port before bringing in imports; removing the requirement that rail wagons carrying goods across the border return empty; opening additional road border crossings and bus routes; increasing air links between the two countries (particularly establishing flights between Islamabad and New Delhi); increasing the number of customs posts; and allowing branches of Indian and Pakistani banks to operate in the other country.

The specific medium-term measures towards greater economic integration between India and Pakistan could include: Pakistan granting MFN status to India, and in turn India  significantly lowering  tariff rates for goods of particular interest to Pakistan (such as textiles and agricultural products); Pakistan allowing transit trade from India, which is required by WTO rules; facilitating energy trade between the two countries through building gas pipelines and eventually joint energy grids; allowing trade in information technology; harmonising customs procedures; and eliminating obstacles to foreign direct investments by the other country.

With relatively new governments in both India and Pakistan, there is once again a window of opportunity to improve economic ties. As shown by numerous empirical studies, the potential for trade between the two countries is huge, perhaps twenty-fold or even higher than at present. There is no doubt that increasing trade would significantly raise GDP and household incomes in both countries, and would particularly benefit Pakistan. While the measures for reducing trade barriers proposed here generally have the support of businessmen on both sides of the border, broader constituencies in each country need to be built for greater bilateral trade liberalisation. Trade will of course not solve all the problems between the two countries, but it could be an important catalyst in the lowering of tensions, which certainly has to be in the interest of both India and Pakistan.

Mohsin S. Khan is Senior Fellow at the Peterson Institute for International Economics, Washington, D.C.