relations were to hold for the two countries (Figure A1 of Annex 2).<sup>12</sup> Our analysis using a gravity model indicates Pakistan is having large unrealized trade with India. The gravity model estimates reported in Table A1 of Annexu2 reveal that US$ 2.56 billion bilateral trade between India-Pakistan was realized in 2010 against a potential of US$ 7.03 billion. We estimate that the India-Pakistan trade (official) potential is likely to reach US$ 12.05 billion in 2015 from Pakistan’s perspective. Pakistan’s trade potential with India is roughly 2.5 times greater than actual trade today, which may expand to 4.36 times in 2015, _ceteris paribus_ (Table A1 of Annex 2). However, most of the studies argue that trade potential between the two countries would be much higher than the current level if the large informal and/or third country trade is counted. The bottom line is that with a staggering expansion potential of bilateral trade, deeper engagement through normal bilateral trade would lead to significant welfare gains between the two countries.

**We estimates that there are significant welfare gains for India and Pakistan out of MFN trade; however, the welfare gains increase dramatically with the improvement in bilateral trade facilitation.**<sup>13</sup> Welfare results from two simulations using the global general equilibrium model (namely the GTAP model<sup>14</sup> ), depicting the first scenario where Pakistan gives MFN status to India and the second scenario where Pakistan extends MFN status to India along with improvement in trade facilitation between the two countries, are presented in Table 4.<sup>15</sup> The simulations indicate that welfare effects of MFN will be very high - both for India and Pakistan, if the initiative is accompanied by improved trade facilitation measures (Table 4)<sup>16</sup> . Therefore, improvement of connectivity and trade facilitation between India and Pakistan should get the utmost priority in order to make the benefits of trade arising from new trading arrangement more inclusive. Benefits of trade facilitation to Pakistan will be more if indirect benefits are also counted. With improvement in connectivity and trade facilitation, Pakistan could narrow the welfare gap while giving MFN to India. The GTAP simulation suggests that there would be some positive welfare effects on other South Asian countries (Table 4) out of the ‘peace dividends’ generating from improved economic cooperation between India and Pakistan. There will however be some negative welfare effects for the countries outside of South Asia, since Pakistan, after giving MFN status to India, would divert the source of some of its imports from other countries to India.

> 12 Estimated by the Peterson Institute for International Economics (PIIE) based on a gravity model, as reported in Khan (2011)

> 13 Annex 3 provides an analysis on the construction of the MFN scenario. In brief, the MFN scenario incorporates the reduction in import prices for Pakistan because of increased potential of sourcing imports from India at cheaper prices. In addition, it is assumed that there would be some ‘peace dividends’ for all the South Asian countries because of this improved trade relation between India and Pakistan.

> 14 Annex 4 provides the underline assumptions and further details on the GTAP modeling exercise.

> 15 By improvement in trade facilitation, the study assumes a cut in transportation cost for bilateral trade in goods between India and Pakistan by 25 percent. In this regard, the “ams” - import-augmenting "technical change" in the Armington nest in the GTAP model (which can be used to lower the effective price of imported products) is shocked in the model.

> 16 The sensitivity analysis of these GTAP simulations and the subsequent ones are presented in Annex 5. This analysis suggests that the direction of the results remain unchanged under all the sensitivity tests, though the magnitude of the results changed depending on the values of the elasticities.

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