The importance of studying informal trade in South Asia can be best understood if it is placed in the context of formal trade. The South Asian countries have made several attempts at enhancing trade in the region. As early as 1985, the South Asian countries of Bhutan, Bangladesh, India, Maldives, Sri Lanka, Pakistan and Nepal formed the South Asian Association for Regional Co-operation (SAARC). In 1991, a South Asian Preferential Trading Arrangement (SAPTA) amongst the SAARC member countries was set up with the ultimate goal of achieving a South Asian Free Trade Area (SAFTA). The signing of the SAFTA at the 12th SAARC Summit held in Islamabad is now a reality. In addition, there have been several bilateral free trade agreements within the region. India has free trade agreements with Bhutan and Nepal and has recently signed one with Sri Lanka. Similarly, Free Trade Arrangements are being negotiated between Pakistan and Sri Lanka and between Bangladesh and Pakistan. Despite such efforts by the South Asian countries, trade within the countries continues to be abysmally low. Clearly there would be other mechanisms that would inject vitality into trade flows in the region. One way would be to focus on the large and vibrant informal trade in the region. It is in this context that the present focus is on informal trade flows in the South Asian region. Available evidence suggests that informal trade is rampant and if such trade is brought within the ambit of official trade, a significant increase could be witnessed. However, this will largely depend on the nature of informal trade, which is discussed later.

There are two key issues that are at the forefront of studying informal trade in the South Asian region- the magnitude of such trade and the factors underlying such trade flows. Quantitative estimates are important since they would reflect the extent of potential trade that exists in the region. If recorded trade statistics give a misleading picture of the actual amount of trade taking place, poor regional trade policies may be formulated. In the latter issue it is important to understand the institutional mechanism that drives informal trade, how it differs from formal trade and why such trade takes place. To the extent that high tariffs and non-tariff barriers in the South Asian region encourage the use of informal channels, bilateral/regional Free Trade Arrangements would induce a shift of informal trade flows to formal trade channel. However, if there are factors other than trade policy distortions that determine informal trade, then a deeper understanding is needed. Thus, as long as the transacting environment for informal trading is more efficient than that of formal trading, informal trade may continue to co-exist with formal trade. It is useful to classify factors determining informal trade flows into two broad categories: (i) those that are related to trade policy barriers and (ii) institutional and other factors.
Since India is the only country which shares its borders with almost all the South Asian countries and at the same time no country shares its border with countries other than India within South Asia, the central actor in informal trade has been India. India shares a long and porous border with Bangladesh, Nepal and Pakistan. Informal trade with these countries largely takes place across the land borders. Informal trade with Sri Lanka takes place largely through air passengers, with a small proportion being carried out by sea through country boats. A crucial aspect to be kept in mind while analysing issues related to informal trade is the definition of such trade flows. Informal or unrecorded trade is broadly defined to include all trading activities between any two countries which should be included in the national income according to national income conventions but are presently not captured by official national income statistics.

I. Magnitude of Informal Trade
The only method to estimate informal trade flows is through primary surveys. The Delphi technique is the most robust methodology used so far. It is essentially used for gathering and processing the opinions of informed individuals. The iterations are repeated till broadly converging responses are received. Reasonably good estimates are available for Bangladesh, Nepal and Sri Lanka that are based on the Delphi technique. Estimates for Bhutan are based on primary surveys, but the methodology is not clear. Information on estimates for Pakistan is quite scanty, though its informal trade is believed to be the largest in the South Asian region.

It is worth noting some interesting features. Total informal trade in the South Asian region exceeds US$ 3 billion which is almost double the formal trade in the region for corresponding years for which informal trade estimates are available. India's informal trade with Pakistan is almost ten times that of formal trade in the region, that with Nepal and Bangladesh is almost as large as formal trade, with Sri Lanka it is almost one-third of formal trade and that with Bhutan is three times as much as formal trade. (see Table1 and Table 2)

Another noticeable feature is the fact that India has a trade surplus with Bangladesh, Pakistan, Sri Lanka and Bhutan on the unofficial trade account, while with Nepal it has a trade deficit. Interestingly, a similar pattern can be observed on the official trade account. (See Table 1 and Table 2)

One also needs to examine the extent to which the composition of formal and informal trade differs. Of the US$ 2 billion informal trade with Pakistan, almost half is traded through third countries (technically official trade) such as Dubai, CIS countries and Afghanistan, while the remainder is cross-border informal trade. Unofficial exports through both routes comprise machinery, cement, tyres, tea, medicines, videotapes, alcoholic beverages, chemical products, steel utensils etc.- the range covering low cost mass scale produced goods to Indian branded items such as Tata's Tetley tea and products made by Dabur and Pioma Industries. Informal imports from Pakistan consist of food items, synthetic fibers and some chemical products.

India's official exports to Pakistan consist largely of food items- the main item being animal feed stuff; primary products mainly iron ore and crude vegetable materials, and manufactured goods- the chief item being building material. Official imports comprise of food items, mainly sugar and dry fruits.

Table 1 India's Informal Trade with South Asia

	Exports (X)	Imports (M)	Trade Balance (X-M)	Total Trade (X+M)
Bangladesh1	299.0	14.0	285.0	313.0
Sri Lanka2	185.5	21.8	163.7	207.3
Pakistan3	n.a.	n.a.	Positive	2000
Nepal4	180.0	228.0	-48.0	408.0
Bhutan5	31.3	1.2	30.1	32.6
Total South Asia	-	-	-	2960.9

Sources: Chaudhary (1995) for Bangladesh; Taneja et. al. (2002) for Sri Lanka and Nepal; Economist (1996) for Pakistan; Rao et. al. (1997) for Bhutan. Notes : X denotes exports while M denotes imports. 1. (1992-93), 2. (2000-01), 3. (1996), 4. (2000-01), 5. (1993-94)

Table 2 India's formal Trade with South Asia

	Exports (X)	Imports (M)	Trade Balance (X-M)	Total Trade (X+M)
Bangladesh1	349.1	7.8	341.2	356.9
Sri Lanka2	640.2	45.0	595.2	685.2
Pakistan3	157.2	36.1	121.1	193.3
Nepal4	141.0	255.0	-114.0	396.0
Bhutan5	7.0	3.0	4.0	10.0
Total South Asia	-	-	-	1641.4

Sources: Chaudhary (1995) for Bangladesh; Taneja et. al.(2002) for Sri Lanka and Nepal; Commodity Trade Statistics for Pakistan, Nepal and Bhutan. Notes: X denotes exports while M denotes imports. 1. (1992-93), 2. (2000-01), 3. (1994), 4. (2000-01), 5. (1994).

As Bangladesh is sandwiched between the north-eastern region of India and the West Bengal borders of India, informal trade between India and Bangladesh takes place both along the borders between West Bengal and Bangladesh and between the north-eastern regions and Bangladesh. Commodities exported informally from India to Bangladesh through West Bengal comprise of cattle, sugar, kerosene oil, sarees, bicycles, automobile components and parts and other consumer goods like plastic items, razor blades, medicines etc. Items imported from Bangladesh into India through West Bengal comprise of synthetic fabrics, spices and Hilsa fish. Informal exports from the North East Region to Bangladesh comprise fruits, fish, sugar, cattle, raw cotton, spices, medicines, sarees and coal. Imports on the other hand consist of polythene, palm oil, plastic shoes and a range of miscellaneous consumer items. The formal exports are dominated by industrial manufactures among which textile products is the largest item. India's formal imports from Bangladesh comprise largely of crude raw materials- chiefly jute, and Chemical related products- mainly fertilisers.

India exports informally sarees, electrical and mechanical items, textiles and utensils to Sri Lanka while informal imports consist of spices, electronic items, cosmetics and liquor and cigarettes. India's formal exports to Sri Lanka comprise a wide range of goods, the bulk of which are a variety of manufactured goods, dominated by textile fabric, machinery and transport equipment and a variety of food items. India's formal imports from Sri Lanka consist overwhelmingly of primary products and raw materials.

Indo-Nepal informal trade includes a very wide variety of items. India exports textiles, processed and unprocessed food, cement, hardware, automobiles and parts, electrical goods, utensils, plastic, live animals, fuel, sanitary items, medicines, fertilizer, machinery and parts, coconut oil, spices, dry fruits, electronics, tobacco etc. Informal imports from Nepal are electronics, bags/suitcases, spices, electrical goods, footwear, betel nut, medicinal powder, glass crockery items, cosmetics, beverages, processed food, toys, lighter, lock, fuel etc. While formally, India exports transport equipment and machinery- mainly motor vehicles, medicines and other manufactured goods, official imports consist largely of edible and other essential oils, man-made filaments and copper.

Commodities exported informally from India to Bhutan consist of rice, sugar, flour, yarn, garments and aluminium. Major commodities imported by India from Bhutan are liquor, and electronic items and footwear. Formal exports consisted of products including spirit and beverages, residual chemical products etc. Informal imports from Bhutan consisted mainly of wood products and inorganic chemicals

It can be surmised that commodity baskets being traded formally and informally are different. Also important is the fact that while a large part of informal imports into India comprise third country goods, informal exports to the South Asian countries consist of essential goods (both food and non-food) and mass scale consumer items.

II. Why Informal Trade Takes Place
By their very definition, SAFTA and the bilateral trade agreements imply removal of trade barriers. Considering the extent to which such barriers restrict official trade flows, a removal would lead to a shift in trade flows from informal to formal trade channels. By the same logic, if informal trade is driven by factors that do not fall under the purview of free trade agreements, then informal trade will persist in the region.

(a) Trade policy distortions
High tariffs within the SAARC region encourage informal trade across borders. High tariff rates create a strong incentive to avoid the formal channel in order to evade tariffs. It can be seen that tariffs in India, Bangladesh and Pakistan have been high through the 1990s. The informal channel is particularly attractive for exports of mass consumer goods that are being exported informally from India to the other South Asian countries. Such products are not being produced by very large firms. Tariffs form a significant proportion of final prices for such firms and evading them makes informal trade profitable. It needs to be mentioned that a movement from SAPTA to SAFTA would mean gradually moving to zero tariffs and informal trade occurring due to high tariffs will automatically shift to formal channels. At the same time tariffs are continuously falling under the free trade agreements that India has with Nepal, Bhutan and Sri Lanka. With these developments a large part of informal trade is likely to shift to formal channels.

The presence of non-tariff barriers, (NTBs) in the form of quantitative and other restrictions has, in the 1990s, encouraged informal trade in the region. In the early 1990s, India and Bangladesh had the highest non-tariff barrier coverage ratio for primary and manufactured goods. In fact, India had an NTB coverage ratio of 66 per cent and Bangladesh had an NTB coverage ratio of 52 per cent. In recent years, quantitative restrictions have come down considerably in the region and, to the extent that trade in the region is obstructed by NTBs, a shift to formal channels is likely to occur.

While Free Trade Arrangements require abandoning both tariff and non-tariff barriers, they also require rules of origin to ensure that goods from third countries do not enter a low tariff country through official channels to be traded informally into the country with higher tariffs. Thus goods from third countries passing through another member country of the FTA before arriving at the final market for consumption need to meet minimum processing requirements to benefit from duty free entry. Even though SAPTA lays out such rules clearly, as long as tariff rates differ across countries, there is a strong incentive for traders to flout the rules of origin principles and trade informally. In the early 1990s, the unweighted tariff average was highest for Bangladesh at 79 per cent followed by Pakistan 59 per cent and India 51 per cent. Tariffs were relatively lower for Sri Lanka 27 per cent and Nepal 14 per cent¹. In 2000, the average tariffs were highest in India at 39 per cent, followed by Pakistan (25 per cent), Bangladesh (20 per cent) and Sri Lanka (15 per cent)². In several years, through the decade of the 1990s, India had higher tariffs than its neighbouring countries. Clearly there is an incentive for countries to import goods at lower tariffs from third countries and export them to India through informal channels.

Rules of origin are also known to be complex and sometimes provide the excuse to block trade, operating in effect as a non-tariff barrier. For instance, products eligible for preferential concessions have to be certified by a certificate of origin, which is to be issued by an authority designated by the Government of the exporting member state and notified to the other state in accordance with certification procedures. However the importing member state can refute the certificate and the settlement could be very time consuming, thereby affecting trade adversely.

(b) Institutional and other factors
In order to go beyond the conventional role of trade policy barriers in influencing informal trade flows, it is useful to understand the functioning of informal trading and formal trading markets. Under formal trading arrangements, the recourse to law defines contracts between two contracting parties. This ensures that goods move across borders and payments are guaranteed. On the other hand, contracting parties in informal trade cannot resort to the law for violation of terms of contract. Consequently, it is reasonable to assume that individuals trading through the informal channel have developed parallel institutional mechanisms for contract enforcement and dispute settlement. Also, the smooth functioning of such markets shows that traders have developed efficient mechanisms for obtaining information on quantities and commodities to be traded and for mitigating risk that arise from the transacting environment. On the other hand, it is important to understand the institutional structure that supports formal trade where exchange is affected by factors which are not related to the physical process of production, such as administrative processes, government rules and regulations, infrastructure bottlenecks, etc. Thus, if the institutional arrangement under informal trading is more efficient than that supporting formal trade, traders may prefer to trade informally.

The inadequate transport and transit systems that have been in existence between India and her neighbouring countries have led to high transportation costs in the region. One major hurdle in road transport between India and Bhutan is the temporary blockages due to landslides. In the case of trade between India and Nepal, the terrain in Nepal makes building and maintaining roads not only difficult but expensive as well. Even with respect to transit modalities several bottlenecks have been identified: port congestion, excessive documentation, delays³, slow movement of goods, non availability of equipment and railway wagons, transhipment and other indirect costs. A large part of trade therefore takes place informally. Thus traders use the informal channel in order to save on transportation costs. Particularly in the case of perishable commodities it is more cost effective to trade informally. Thus, as long as transport costs are higher in the formal channel than in the informal channel, informal trade will continue to take place.

There are other transaction costs that emanate from the transacting environment of formal and informal trading. While informal trading markets function smoothly, there are costs that have to be incurred to mitigate the risk associated with such transactions. Risk in such trading has been found to be extremely low. For instance in Indo-Bangladesh informal trading, the probability of goods being seized was less than 0.1 while that in Indo-Nepal and Indo-Sri Lanka informal trading was still lower at 0.03⁴. In fact, studies have shown that even when goods are seized, they can be released on nominal payments⁵. On the other hand, formal trading procedures are extremely complex in the South Asian region. For instance the number of documents that need to be filled up for trading is 29 for India, 83 for Nepal and 15 for Pakistan⁶. Also clearances have to be obtained from multiple agencies at various stages of trading that include obtaining licences and getting clearances from banks. Such procedures not only involve incurring costs in terms of time taken but also lead to rent seeking activities. Traders are known to pay hefty bribes at various stages of trading before their goods can finally reach their destination.

Intrinsic to the activity of trading is the issue of payments. Formal banking facilities are not only inadequate in the region but also very time consuming. Traders have to wait for several days before their payments can be realised. The informal banking system, on the other hand, is very organised and payments are not only ensured but are also very quick. The uniqueness of the informal banking system is that there is no physical transfer of currency. This mechanism, referred to as Hawala in India, Hundi in Bangladesh and Undiyal in Sri Lanka, operates on the same principles. Partner country currencies are easily convertible in the informal money market making it possible for traders to trade in different currencies. In fact, the informal banking is so efficient that payments can be received within a day. Traders may therefore prefer to use the informal channel as it has a better payments mechanism than the formal channel.

Perhaps what lies at the core of informal trading markets is the close ethnic ties between trading markets. A common language, religion, culture etc., play a crucial role in facilitating trading across the border. This is particularly so where the same ethnic community is divided into two national boundaries; for example in the case of India, Bangladesh, Pakistan and Nepal. There are strong ethnic links between the Tamils in South India and those in Sri Lanka. Ethnic ties amongst trading partner countries in the informal channel not only ensure that payments are made but also go towards reducing risk and other transaction costs in carrying trade across borders. It has been observed that in Indo-Nepal, Indo-Bangladesh and Indo-Sri Lanka informal trading ethnic ties are stronger in the informal channel than in the formal channel⁷.

In some cases, traders trade informally not because they are unwilling to abide by laws and regulations but rather because they lack the necessary resources to do so. A large number of informal traders have low levels of education. The lack of education deters traders from using the formal channel. Also, lack of education would preclude traders from having information on trade policy. Most informal traders are not aware of the details of different trading arrangements. In fact informal traders in Sri Lanka have pointed out that the terms and conditions of trade agreements are available only in English and not in any local language spoken in the two countries⁸. Under such conditions, traders would prefer to use the informal channel. It has been found in various studies that in Indo-Nepal, Indo-Bangladesh and Indo-Sri Lanka trading, levels of education for formal traders are significantly higher than those of informal traders⁹.

III. Concluding Remarks
It is evident that informal trade in the region is quite large and cannot be ignored in any policy dialogue. The Framework Agreement for SAFTA signed at the 12th SAARC Summit does not address this issue. Informal trade between India and Pakistan, believed to be the largest is a subject area where not much information exists. As the two countries move closer to improved trade relations, it is important to understand the functioning of such markets and the inadequacies of the formal trading channel. The Indo-Sri Lanka Comprehensive Economic Partnership Agreement Framework signed recently includes trade services, corrects the anomalies of the currently operational Indo-Sri Lanka Free Trade Agreement but makes no attempt to look into the issues of informal trade. India and Nepal have a long history of bilateral FTAs signed since 1961, but these agreements have focused only on unauthorised trade in third country goods, with clear reference to flow of goods informally from Nepal to India. It is not widely known that informal trade from India to Nepal in locally produced goods is of equal magnitude and cannot be ignored in bilateral talks. The bilateral Free Trade Agreement between India and Nepal was renewed in 2002 but did not recognise the importance of the two-way informal trade flow.

There is no doubt that the implementation of SAFTA and other bilateral trading arrangements would lead to a reduction in informal trade flows. It may be stated here that the incidence of informal trade, particularly in goods from third countries into India has come down with lowering of tariffs in the region. For instance, in 1991, informal trade in third country goods from Sri Lanka to India was almost as large as informal trade from India to Sri Lanka. Further, in 1990, informal trade in third country goods from Nepal to India was almost 10 times of formal trade¹⁰. Recent estimates of informal trade in third country goods show that such trade has come down considerably and further reduction and harmonisation of tariffs would reduce the incidence of informal trade.

It is evident that the institutional mechanism in the informal trading market facilitates informal trade. The channels through which informal trade takes place are rooted in the strong ethnic ties among the traders and in the historical linkages in these societies. Ethnic trading networks that operate on trust and honesty mitigate risks associated with such trading. The involvement of law enforcement agencies to collect rents (thereby mitigating informal trading risks) makes the transacting and transporting processes smooth and acts as an added incentive to carry on informal trade. It is easily perceived that informal trade under these circumstances would be difficult to eliminate. While it can well be argued that if the transacting environment for informal trading is more efficient than for formal trading, why not let it continue- the danger is that the associated money laundering to finance such trade deals might prove to be a threat to the smooth functioning of formal capital markets. A focus on law enforcement agencies to detect and obstruct informal transit of goods across borders is not a viable solution as increase in enforcement mechanisms could only lead to increase in rent collections. What would be more effective would be to reduce the impediments to trade in the formal channels. Time delays due to unnecessarily long and complicated procedures need to be reduced by simplifying procedures. Clearly, the reform process in the South Asian countries should undertake institutional reforms so that transaction costs can be lowered. This would also have a much larger impact in the form of trade expansion from and within the South Asian region. Information is another important aspect, which has to be looked into. It is true that a major proportion of informal traders are locals who do not have high levels of education or are only conversant with local languages. Such gaps have to be filled by suitable dissemination of information and creation of awareness among traders of the various norms.

In sum, while informal trade is unlikely to be totally eliminated because ethnic trading networks between trading partners would continue to facilitate informal trade by reducing transaction costs through minimisation of risk costs, market information and search costs; further reduction of tariffs, improvements in the transacting environment of formal trade, improving awareness and education levels and improving information dissemination would lead to a decline in informal trade flows.

(Nisha Taneja is Fellow at the Indian Council for Research on International Economic Relations (ICRIER), New Delhi).

End Notes

1.	World Bank (1997)
2.	World Bank (2003)
3.	Trucks have to wait for 8-10 days before documents are endorsed and checked at the customs before crossing the border. The concerned transit authorities at Petrpole-Bongaon transit point are closed three days in a week resulting in no trade on these three days.
4.	Pohit and Taneja (2000) and Taneja et.al. (2002)
5.	Taneja et. al. (2002)
6.	ESCAP (2000)
7.	Pohit and Taneja(2000); Taneja et. al. (2002)
8.	Taneja et. al. (2002)
9.	Pohit and Taneja (2000); Taneja et. al. (2002)
10.	Taneja (1999)

Bibliography

S.K. Chaudhari, 'Cross Border Trade Between India and Bangladesh', NCAER, Working Paper 58, New Delhi, 1995.
ESCAP, 'Alignment of Trade Documents and Procedures of India, Nepal and Pakistan', Paper presented at the National Workshop on Facilitating Intra- and Intra-sub-regional Trade in the SAARC sub-region, 2000.
S. Pohit and Nisha Taneja, 'India's Informal Trade with Bangladesh and Nepal: A Qualitative Assessment', Working Paper No. 58, Indian Council for Research on International Economic Relations, Delhi, 2000.
V.L. Rao, S. Baruah and R.U. Das, India's Border Trade with select