Economic Law of Gravity

by Ajay Shah

Editor’s note: From Wikipedia, the Newtonian Law of Gravity says the force between two bodies is proportional to product of the two masses and inversely proportional to the distance between them. The equation is

F = G \frac{m_1 m_2}{r^2}\ ,
where G is a proportionality constant known as the gravitational constant.

A key intuition of modern thinking in international trade and international finance is that distance matters much more than we think.

We may like to believe that the world is becoming more flat. We may like to believe that for weightless things like services and financial flows, distance is irrelevant. But the research evidence is unambiguous: there is a `gravity model’ in the affairs of men. The interactions between two countries tend to go up in proportion to the product of their GDP, and vary inversely with the squared distance between them.

Traditional trade theory would encourage us to think that India and Sri Lanka (say) have similar factor endowments, so the gains from trade might not be so great. But this is not borne out by the evidence: some of the most intense trade relationships are found between countries in Europe and between the US and Canada: between countries with very similar endowments.

In this region, we need to be much more mindful of the importance of intra-regional finance and trade activities. For India, this means a strong emphasis upon East Africa, the Middle East, Pakistan, Central Asia (by plane today, but someday we should get to road connectivity from the Indian ocean), the land route to China through Tibet, Nepal, Bangladesh, Burma, Singapore and Sri Lanka. India stands out, in international comparisons, for having unusually low economic engagement with its neighbours. This implies that there are opportunities for very large gains. In recent years, some Indian firms have emphasised these countries in their internationalisation strategy (both trade & investment), reflecting a greater role for natural conditions dictated by geography.

Some of these places are hobbled by political problems and abysmally low GDP. The product of the two GDPs matters, and bad political systems like to interfere with globalisation. The wise thing for us to do is to have a consistent and welcoming engagement strategy, waiting for the time that the country finds its feet in terms of establishing a healthy political system, waiting for the country to engage. A good example of India doing something right is the positive approach towards MFN status for Pakistan. We have to wait for Pakistan to understand that this is in their self-interest – and I do believe that in time, they will – but there is no reason for us to get stuck on reciprocity.

Of particular interest in recent months is Burma. Hamish McDonald has a beautiful piece titled Tractors may have replaced horses, but country is still decades behind. If Burma comes out of its deep freeze, then the opportunities for trade and financial links with India are huge. We would go closer to the arrangements which were prevalent in the early 20th century, which reflect the natural opportunities.

With increased trade & financial linkages will come greater macroeconomic correlations a.k.a. shared interests. I saw a fascinating new IMF working paper by Ding Ding and Iyabo Masha titled India’s growth spillovers to South Asia. This finds that after 1995, Indian growth has a significant impact in the region. If this is a robust finding, it is new; the idea that Indian business cycle fluctuations reach out and influence the region is not part of our intuition, particularly given the onerous trade barriers in place. Perhaps there is a lot more trade going on than meets the eye.

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Analysis and Opinion articles by Ajay Shah

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