- Regional trade agreements (RTAs) like the RCEP and CPTPP have been, and will be, the preferred form of trade liberalisation in the long term
- Once the RCEP comes into effect, it is slated to become the largest trading bloc in the world, displacing multilateral platforms like the WTO
The economic benefits of free trade is the prime mover for the multilateral trade liberalisation process which nearly every state in the world is party to. Compare this with the level of regional trade – free trade in a regional bloc. Many regional states enter into numerous bilateral and plurilateral trade agreements ranging from just one to more than twenty.
The reasons for this asymmetry are the result of the pressures of domestic and international life. For instance, states have to balance domestic forces that come into play which regularly threaten the public interest for the benefit of special interests. Certain industries are immensely profitable when globally-oriented, and these industries will tend to pressure the state to embrace regionalism.
More importantly the stage of domestic economic development is a decisive factor in who to partner in a trade agreement. Many regional trade agreements (RTAs) are formed by members in similar economic positions or with complementary economic agendas.
Domestic pressures to form RTAs are confounded by international trends. The economist Richard Baldwin argues that a domino theory of regionalism explains a non-member state’s preference to join in a RTA whose members are buyers of its exports. A state’s export industry suffers a disadvantage if it does not join in such a RTA.
The domino theory explains the enlarging of large trading blocs like the Canada-US Free Trade Agreement, now the North American Free Trade Agreement (NAFTA) and the European Free Trade Association (EFTA), now part of the European Union (EU) and predicts a further expansion of other free trade agreements like the RCEP and CPTPP.
Problems with the WTO
The role of the WTO has also been criticised for allowing states to ‘get away’ with regional deals. Much of the criticism is directed at Article XXIV of the WTO constitution which amounts to a departure from the precept of non-discrimination and its associated Most Favoured Nation (MFN) principle.
The article, which grants exemptions for ‘customs unions and free-trade areas’ from the MFN rule is notably weak in enforcing the criteria spelled out for such exemptions. These problems are due to the fact that the requirements of Article XXIV that were intended to facilitate bona fide free trade have been largely ignored.
These include the inordinate decade-long duration of negotiations allowed under the auspices of any free trade deal and a vague requirement for the liberalisation on ‘substantially all’ trade between the FTA members.
Furthermore, FTAs entered into by developing countries are generally exempted from applying MFN tariffs through the enabling clause which has the effect of allowing developing countries to escape the MFN regime scot-free. States that wish to enter into an RTA need to report to the WTO for assessment of eligibility to Article XXIV, but evidence has shown that over the past two decades the special use of Article XXIV has instead transformed into the very common and abusive employment of its provisions.
The question then is whether or not the reasons for regionalism apply equally to the multilateral efforts of the WTO. The answers to this question are broadly divided into what are called the ‘stumbling block’ and ‘building block’ views on regional trade.
Are RTAs stumbling or building blocks of the WTO?
RTAs have been argued to contribute to a more rules-based system as codification, enforcement and compliance are generally more aggressive than in those found at the WTO.
The clearest example of rules-based governance is exhibited in Europe where regional integration has given way to a predominance over national trade policy. Even if such a system is not possible in every part of the world, RTAs tend to exert more pressure on member states to establish predictable trade behaviour since it is likely that a high degree of trust exists among member states in regional settings.
More extensive liberalisation of other barriers to trade, such as in non-tariff, regulatory and structural barriers have also generally been more common when we compare RTAs to multilateral agreements.
The reason for this can also be attributed to trust and also because it has been notoriously difficult to accommodate the needs of every member in a multilateral agreement. These policies of liberalisation have, according to the WTO, ‘lock in’ effects on the MTL process in that they cause trade rounds to proceed on a more liberalised footing than they would otherwise.
However, none of the reasons for the ‘building block’ case given address the central question on whether they positively affect the MTL process. Creation of a rules-based trading regime and intra-regional liberalisation can bring benefits to a regional bloc and still be coincident with the impediment of the MTL process especially if they act to substitute the larger process in the long run.
Recall that the United States began a reversion of their multilateral approach after the Tokyo Round. The US-Canada FTA marked the start of a significant shift in the US position towards regionalism which has not reverted.
The economist Jagdish Bhagwati argues that the US shift diverted political will away from the multilateral framework and lead to ‘trade fatigue’ across the globe as states began to focus their energies on regional and bilateral projects.
Progress during the Uruguay Round was sluggish in part because regional efforts to create NAFTA and the European market were elevated in precedence and in part because large regional blocs could be played as trump cards during trade rounds.
The US shift also created a void in the multilateral process, leaving the WTO (then-GATT) member states without hegemonic leadership to prevent free riding. The result was that the WTO’s agenda no longer had powerful support and states were not as keen to go along a path of liberalisation unhedged against the high likelihood of defaulting states.
But the US shift was not accidental even though Europe and Japan had by then become sizeable trading forces. The US pursuit for market access through bilateral and regional agreements was an attempt to stop its rising trade deficit with the rest of the world, a demonstration of how international aspirations are often supplanted by domestic concerns.
Now that two of the largest trading nations, China and the US, have given preference to regionalism and bilateralism respectively, the search for consensus in the multilateral framework is even more unlikely, given that both are also currently in the thick of a trade war.
Is regionalism better for all?
Discriminatory trade has had a long history of winners and losers. From as early as the 17th century, Portuguese traders stationed in Macau received handsome profits by acting as middlemen during a Chinese trade embargo on Japan following Hideyoshi’s invasions of Korea in the late 16th century. Trade distortion as a result of discriminatory trade is bound to benefit some and hurt others in all its multifarious forms.
The late Jacob Viner argued that a customs union (CU) is substantially better for the world economy if the combined effect of increased trade within the bloc (trade creation) exceeds the diversion of imports away from efficient non-members to less efficient members owing to a relative increase in tariffs outside the bloc after liberalisation (trade diversion).
Trade diversion transpires when members in a CU are not low-cost producers and if there is high import demand for those goods in member states. Likewise, the effect of trade diversion is muted if the share of trade among member states was large prior to the establishment of the CU.
This was the case in Western Europe before the European Free Trade Association, and as a consequence, exacted marginal costs on countries outside the CU.
Another instance of the asymmetric effects of trade creation and trade diversion concerns China’s trade engagement with ASEAN. China has not entered into a customs union with ASEAN, but its FTA with ASEAN (ACFTA) exhibits trade creation just like any other RTA. This effect of trade creation within the ACFTA is likely to benefit Chinese exporters to a much larger degree than regionalism with Taiwan and Hong Kong.
Trade creation effects of RTAs and other forms of discriminatory trade regularly assigns winners to states with high levels of pre-existing trade. However, where there is low pre-existing trade and if the agreement involved a large trading nation and a small trading nation (a hub-and-spoke arrangement), an FTA between the two is likely to damage the world economy because the large state pays a small economic price for political support while the small state – with little significance to the world economy – benefits disproportionately from free trade.
Hub-and-spoke arrangements do not have substantial diversionary effects but they throw light on another question – to what extent are states and blocs willing to levy costs on the world economy through trade diversion for the purposes of self-aggrandisement?
Terms of trade and beggar-my-neighbour effects
Discriminatory trade improves the terms of trade for the trade bloc because more exports can now exchange for tariffed imports, and carries with it an increase in the national total benefit from trade.
In addition, because larger trading blocs (like customs unions) have greater monopsony power, the optimum common external tariff (CET) is usually higher and in inverse relation to the price elasticity of import supply.
The tendency for trade blocs is hence two-fold: expand membership and raise tariffs on non-members in order to improve the welfare of its residents and its terms of trade with respect to the rest of the world.
Such a situation is, of course, undesirable if you so happen to find yourself part of the rest, and gives further support to Baldwin’s ‘domino theory’ and Krugman’s three trade blocs hypothesis.
The effects that perpetuate these costs on non-members are termed ‘beggar-my-neighbour’ effects, a reference to the all-or-nothing card game that young teenagers played for leisure. These effects have serious consequences for the MTL process since affected nations are expected to take retaliatory measures against new FTAs through protectionism or by expanding their own network of FTAs, possibly through regionalism.
Customs unions that are sensitive to the potential for trade wars caused by ‘beggar-my-neighbour’ effects should adjust CET levels so that trade with non-members remain at pre-bloc levels. This proposition is the grounds for some recommendations which have called for the awarding of concessions and ‘lump-sum transfers’ to sectors that lose out from the creation of the CU by sectors that win so as to increase welfare for both members and non-members of a CU.
Trade diversion after the formation of a trade bloc is not the only attendant outcome on the world economy. Nuno Limao has argued that MFN tariffs could have been much lower on US Preferential Trade Agreement (PTA) goods in the absence of those PTAs.
He suggests that US PTAs acted as stumbling blocks to its own MTL that the US was pursuing prior to the Uruguay Round. States like the US would have had better chances of even freer trade had they continued along the path of multilateralism. But in defence of US doctrine, it is possible, if not, probable that that path was already moot.
New economic issues surface when we consider the nature of a RTA, FTA or PTA. All of these agreements are never as liberal as they appear and occasionally accomplish less than a multilateral agreement. For example, not all economic sectors are liberalised in Japanese agreements with other states. Protectionism continues to be the rule of thumb for agriculture, a desperately uncompetitive sector in Japan.
Coupled with domestic pressures discussed in the first part of this paper, most governments will succumb to industrial lobbying and take conservative approaches to trade liberalisation. A reduction of tariffs on substantially all trade within a trade bloc is a reasonable hope only if we pretend that weak traditional sectors and structural unemployment are small problems with quick solutions.
It is for this reason that Bhagwati insists that regional agreements should only exist if they lead to common markets. Trade, investment, migration barriers and barriers to the movement of the factors of production are eliminated in a common market so that states do not regress to selective protectionism as a failsafe option whenever liberalisation is inconvenient for their purposes.
A common market might also prevent forms of trade distortion caused by transshipment as is the case when a PTA non-member exploits a member’s low tariff rate as a conduit for entering the trading area. PTAs try to avoid this situation by instituting rules of origin (RoO) to identify goods eligible under the PTA, but RoOs are extraordinarily difficult to implement because a single product might have parts and materials from a whole chain of manufacturers situated in different countries.
The fact is that no matter the degree of intra-regional liberalisation of trade, protectionism is a real tendency that is impossible to eliminate in full.
Regionalism’s impact on trade flows
The amount of trade diversion is small if RTAs are made by ‘natural trading blocs.’ According to Krugman, these natural blocs also happen to form the majority of trading agreements. Low transportation costs within natural trading blocs is a key advantage that encourages trade even before the formal establishment of the bloc.
Trade diversion is unlikely to surge since member countries will continue to capitalise on low transportation costs and a large volume of preexisting trade. Krugman concludes that for the most part, RTAs are benign for the world economy, but only if (a large ‘if’) they do not result in a ‘totally fragmented world’ of small, numerous agreements which reduces world welfare.
Though regional trade blocs also have a tendency to increase tariffs, the level of tariff increase may be mitigated beyond a certain threshold of trade bloc expansion. The reality is quite consistent with this hypothesis and the few trade blocs that can reasonably threaten the world economy – NAFTA, EU and the Asian bloc – will tend to have tariffs that even each other out.
The result is that states will become subject to essentially equal external tariffs once they have consolidated. Of course, despite a powerful mutual incentive for trade blocs to implement beggar-my-neighbour strategies, it will be in everyone’s best interest if all acted to reduce tariffs rates multilaterally.
Ever since US disengagement from the multilateral process, the proliferation of RTAs has not been commensurate with equal development in the multilateral process. The death knell of the WTO has come with the CPTPP in effect and the forthcoming signing of the RCEP. These agreements are a signal to the rest of the world that RTAs will most certainly be the preferred form of trade liberalisation in the long term.
While the real impact of these mega-RTAs on the world economy is still uncertain. Future trends, political exigences and present forms of regionalism that pursue strategic and foreign policy advantages over economic rewards will play a large role in the final analysis.
By Raymond Gallego
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