Copyright © 2010 Pearson Addison-Wesley. All rights reserved. Chapter 9 Preferential Trade Arrangements

Copyright © 2010 Pearson Addison-Wesley. All rights reserved.

Chapter 9

Preferential Trade Arrangements

Copyright © 2010 Pearson Addison-Wesley. All rights reserved.9-2

• Introduction• Degrees of Economic Integration• Rules of Origin in International Trade• Trade Effects of Economic Integration• The Static Effects of a Customs Union• The European Union• NAFTA and Other U.S. Trade Agreements• Multilateralism Versus Regional Trade

Agreements• Summary

CHAPTER ORGANIZATION


INTRODUCTION

• There are an increasing number of regional trade agreements between countries

• They are different from multilateral trade agreements because they only apply to only a few countries

• Regional trade agreements are discriminatory


• Even though RTAs are controversial, the WTO has accepted them as there are both benefits and costs.

• The benefits are that the reduction of trade barriers will increase world trade

• The costs are that the total benefit is not shared equally among all nations and there will be some losers.

• What are the different types of regional economic integration?

INTRODUCTION


• The different degrees of international economic integration can be placed on a continuum

• Consider an RTA where two or more countries reduce or abolish tariffs on a limited number of products

• This is a preferential trade agreement between two countries and this is generally illegal under WTO rules, WTO require trade barriers to be lifted completely between the two countries.

DEGREES OF ECONOMIC INTEGRATION


• WTO requires trade barriers to be lifted on “substantially all” trade between countries

• Waivers can be granted• 1962 U.S.-Canadian Agreement on

Trade in Automobiles and Parts was granted a waiver as this was essentially removing the tariffs on intra firm transactions



• In free-trade areas (FTAs), the countries agree to eliminate tariffs and other non-tariff barriers between each other

• To be legal it must cover “substantially all” trade• This usually means nonagricultural products• It must be completed within a reasonable period of

time• Typically they are phased in over 15 years• May cover services, portfolio investments, and FDI



• Each country maintains its own separate national tariff schedule

• Trade deflection may occur, the diversion of exports to a country within a FTA that has lower tariffs on a specific good

• Can lead to establishment of “screwdriver plants” designed to provide minor assembly work produced in a foreign country but within a FTA to avoid higher tariffs



• A customs union is an agreement between countries to maintain a free-trade area and to construct and maintain a common external tariff

• It has a common external tariff where each country replaces its national tariff schedule with common tariff schedule applicable to all member countries

• It takes time for national schedules to harmonize• Customs unions are broad but may not include

trade in agricultural products, services and financial flows



• A common market is a customs union with the addition of factor mobility between member countries

• This allows more efficient allocation of capital and labor

• However, large wage differentials may induce large amount of migration between countries

• Harmonizing regulations among the member countries can be challenging



• An economic union is an agreement between countries to maintain a FTA, a common external tariff, free mobility of capital and labor, and some degree of unification in government policies and monetary policies

• Requires common currency and the abolition of each country's central bank and the creation of a new common central bank

• Each national government must align its national policies on taxes, antitrust, labor and environmental regulations, and so forth with other member countries




Levels of Economic Integration

Common Economic Policies and Common Currency

Intragroup Capital and Labor Mobility

Common External Tariff

Removal of Intragroup Tariffs

Reduction of Some Intragroup Tariffs

Preferential Trade

Agreement

Free-Trade Area

Customs Union

Common Market

Economic Union


Prominent Regional Trade Blocs (cont.)


2-14

Prominent Regional Trade Blocs


• Determining what country actually produced a good is known as the rules of origin1. Required for statistical reports on trade flows2. Necessary to enforce health, sanitary, and technical

regulations and maintain public safety3. Higher tariffs can be imposed on countries not

members of the WTO4. Necessary to administer antidumping and

countervailing duties5. Needed to ensure quotas are respected6. Required to enforce trade sanctions7. Needed to restrict the amount of trade deflection

resulting from RTAs

RULES OF ORIGIN IN INTERNATIONAL TRADE


• The U.S. traditionally relies on the substantial transformation test to determine nationality

• Determining substantial transformation is a difficult and long-standing problem

• The U.S. Generalized System of Preferences (GSP) created rules concerning the percentage of value-added in a good must be added within a country to qualify for duty-free treatment

• Under NAFTA the rule became even more complicated as there are now five different rules for determining North American origin



• Trade deflection results when a good is moved through a country that receives reduced tariffs in order to qualify for duty-free treatment

• Rules of origin are costly for firms and when compliance costs exceed the value of the tariff, rules of origin become a nontariff barrier to trade

• The use of rules of origin as a disguised form of protectionism is increasing



Economic Analysis of Preferential Trade Arrangements

• Assume there are three countries (A, B, and C) in the world

• A is the world’s high-cost producer of Orange juice; A is a small country

• C is the world’s low-cost producer of orange juice


FIGURE 9.1 Regional Trade Liberalization


Free Trade Effects

• A imports Orange juice from C• Consumer surplus• Producer surplus


Tariff Effects

• A protects its producers with 100% ad valorem tariff

• A continues to import Orange juice only from C

• Price effect

• Import effect

• Government revenue effect

• Other effects


Effects of FTA between A and B

• Trade Diversion—a shift in the pattern of trade from low-cost world producers to higher-cost FTA members; welfare-reducing effect.

• Trade Creation—an expansion in world trade resulting from formation of an FTA; welfare-increasing effect.

• Trade creation increases world welfare and trade diversion decreases world welfare


Welfare Effects of FTA between Countries A and B

TABLE 9.1 The Welfare Effects on Country of an FTA between Countries A and B


FTA Welfare Effects on A

• Price falls• Consumer surplus rises• Producer surplus falls• Government revenue falls• Net welfare impact of $(b + d) – $e

– Trade creation gain (b + d)– Trade diversion loss (e)


FTA Effects on B and C

• Country B gains due to new export market in A

• Country C loses because its producers have lost its market in A


What Happens If A Forms FTA With C?

• Pure trade creation as A’s imports from C return to free trade levels

• Zero trade diversion since, both before and after FTA, country A trades only with C

• A’s welfare gains are $(b + f + g + d + h + i)

• C gains due to rise in exports

• B neither gains nor loses (trade unaffected)


Why Would A Form FTA With B Instead of With C?

• Dynamic gains resulting from economies of scale

• Political reasons


Regionalism vs. Multilateralism

• Regionalism—where countries lower trade barriers only for a small group of partner or neighboring countries and discriminate against the rest of the world (refer to Item 9.2 for RTA examples).

• Multilateralism—non-discriminatory basis of the World Trade Organization.


Arguments Against Regionalism

• Bhagwati views the formation of regional trade arrangements (RTAs) as undermining the WTO

• Regionalism is harmful because it encourages trade diversion


Arguments Favoring Regionalism

• Krugman argues that trade diversion from FTAs is low because trading blocs are “natural” trading areas

• Due to proximity and similarity of cultures and standards of living, regional trade agreements stimulate trade that would have occurred even in the absence of an agreement


• The European Union (EU) is the largest and most successful RTA

• Contains 27 countries, a population of 459 million, and a larger GDP than the U.S.

• Developed in 1951 when European Coal and Steel Community (ECSC) was formed

• Created to eliminate tariffs and quotas for coal and steel industries between six countries

• This was also a political agreement designed to reduce the probability of another European military conflict

THE EUROPEAN UNION


• In 1957 the ECSC signed the Treaty of Rome

• Provided for the elimination of tariffs and nontariff barriers to trade between member countries and the institution of a common external tariff

• Treaty established the European Economic Community (EEC) as a customs union

• Has continually enlarged itself to cover more and more of Europe

THE EUROPEAN UNION


• In 1960 countries not in the EEC formed European Free Trade Association (EFTA)

• Provided for free trade in non-agricultural production among members and free trade in these products between itself and EEC

• In 1967, EEC and ECSC merged into European Communities (EC)

• The growth of the EU has come mostly from countries leaving the EFTA

THE EUROPEAN UNION


THE EUROPEAN UNION

Table 10.1(a) Chronological Development of the European Union

European Coal and Steel Community ECSC 1951

Belgium, France, Lux, the Netherlands, Italy, Germany

European Atomic Energy Community EURATOM 1957

European Economic Community EEC 1957

Treaty of Rome provided elimination of tariffs and nontariff barriers and the institution of a common external tariffReceived GATT waiver under the Lome Convention

European Free Trade Area EFTA 1960

Most European countries not included in the EEC provided for free trade in nonagricultural products

Common Agriculture Policy CAP 1962

European Community EC 1967

Combined EEC, ECSC, and EURATOM

Added The UK, Ireland, and Denmark 1973


THE EUROPEAN UNION

Table 10.1(b) Chronological Development of the European Union

Added Greece 1981

Added Spain and Portugal 1986

Added East Germany 1990

European Union EU 1993

Added Finland, Austria and Sweden 1995

European Monetary Union EMU 1999

EU

Added Cyprus, Estonia, Czech Rep, Hungary, Latvia,Lithuania, Malta, Poland, Slovakia and Slovenia

2004

Added Bulgaria and Romania 2007


• A customs union only requires a common external tariff and eliminating most trade barriers between member countries

• From the beginning the EU has had a Common Agricultural Policy (CAP)

• Agreement between EU members to subsidize their agricultural sectors in a similar manner

• If subsidy schemes vary, free trade in agriculture becomes problematic

THE EUROPEAN UNION


• Under the CAP, each country provides revenue to the EU which in turn pays the subsidies to the farmers

• The CAP guarantees prices for all farm commodities within the EU

• The EU purchases what is not sold on the open market

• Farmers are protected from international competition by a variable levy (tariff)

THE EUROPEAN UNION


• Support prices are generous which has create a chronic oversupply problem

• Further, surplus agricultural commodities are sometimes dumped on world markets

• This has created constant trade friction between the EU, the U.S., and other more efficient agricultural producers

• Controversies over the CAP continue and delayed the Uruguay Round and have created problems for the Doha Round

THE EUROPEAN UNION


• In 1985 the EU started working to determine the steps necessary to create a barrier-free internal market

• In 1992 the Maastricht Treaty laid out plans for a new European currency (the Euro)

• Euro replaced 12 separate national currencies in January 2002

• Barriers to the movement of labor and capital were also removed

THE EUROPEAN UNION


• The future of the EU is uncertain• Common currency is only one of the

characteristics of an economic union• It still needs a common fiscal policy,

common levels of business taxation, common labor laws, and commonality in other regulations that distort economic activity

• There are still areas of major disagreement

THE EUROPEAN UNION


The EU Government

• Headquarters in Brussels, Belgium

• Four institutions:– European Commission– Council of the EU– European Court of Justice– European Parliament


European Commission

• One of two executive offices of the EU government

• Its primary task is to draft and enforce EU laws

• It represents the EU in international trade negotiations

• It consists of 27 members, one from each country, and is headed by a president and six vice-presidents


Council of the EU

• Second executive office of the EU government

• Each EU country has one representative, usually its foreign minister

• It has power to decide about European Commission proposals and to issue directives and regulations to member states


European Court of Justice

• Chief judiciary body of the EU

• Decides on the legality of European Commission or Council of the EU actions with respect to EU treaties


European Parliament

• Legislative branch of the EU government

• Chief representative of the people in the process of setting EU policies

• Consists of 785 members, each elected for 5-year terms

• Number of representatives is based on population and size of economy:– Germany (99)– France, Italy, and UK (78 each)– Spain and Poland (54 each)


European Parliament (cont.)

• Administrative seat is in Luxembourg and in Strasbourg, France

• Has limited powers:– Can scrutinize but not initiate legislation– Can make suggestions regarding European

Commission proposals– Can amend some EU budget expenditures– Can amend council actions regarding Single

European Act– Has veto power over applications of candidate

countries


The Single Market Initiative

• Single European Act (1986) – the goal was to achieve a single market by 1992 by removing border checkpoints for intra-EU trade, harmonizing technical standards, and deregulating various economic activities.


• Up through the early 1980s, the U.S. was focused on reducing trade barriers though MTNs

• The policy started to change in the 1970s with the GSP and the Caribbean Basin Initiative in 1981

• The U.S. was moving away from a pure multilateral approach to reducing trade barriers because of the slow pace and lack of progress in agricultural products

• The focus shifted to trade liberalization through RTAs

NAFTA AND OTHER U.S. TRADE AGREEMENTS


• The first agreement was the U.S.-Israel FTA• This served as the template for all subsequent

RTAs• Covered trade in all goods including agriculture• Covered virtually all trade in service• Liberalized capital flows including FDI• Phased in over 10 years to give each economy

time to adjust• Not all subsequent RTAs have been identical to this

but the main features have been retained



• NAFTA– NAFTA has created a great deal of debate

over the past several years– It is a very straightforward trade agreement– Its economic effects on the U.S. are

relatively small– Essentially it establishes a free trade area

between US, Canada, and Mexico



What Accounts for Mexico’s Low Productivity Levels?

• Largely untrained Mexican workers• Small scale of manufacturing operations• Poor infrastructure• Shortage of qualified managers• Limited capital goods• Unreliable legal system


• In 1989 the U.S. and Canada signed a free-trade agreement that phased in tariff reductions over 10 years

• Covered trade in goods and services, investment and eliminated national preference on most government contracts

• Freed U.S. and Canada from the few remaining restrictions on trade

• In 1992 this was broadened to include Mexico



• Tariff reductions were phased in over a 15 year period

• The agreement covers all merchandise trade, services, investment, and intellectual property rights

• Trade disputes are to be adjudicated by member panel

• Agreement calls for each country to enforce its own labor and environmental laws

• The actual economic effect of the agreement on each country is small



• The agreement gives Canada unrestricted access to larger market allowing their firms to grow larger

• Trade with Mexico has long run appeal to the U.S. and Canada

• Mexican economy is growing much faster than the U.S. or Canada

• Mexican tariffs were much higher before the trade agreement

• Mexico sees NAFTA as a way to advance export-led growth



• Other U.S Trade Agreements– Many of the U.S. trade agreements are with

other Western Hemisphere countries– This is largely because of the failure of the

Free Trade Area of the Americas (FTAA)– In late 1994, 34 governments agreed to

pursue and FTA for the entire hemisphere– Progress has been quite slow largely

because many South American governments are concerned about protectionism and agricultural subsidies in the U.S.




Table 10.2(a) U.S. Regional Trade Agreements

Country Status of Agreement Date of Implementation

Israel Implemented 1985

Canada Implemented 1989, 1994

Mexico Implemented 1994

Jordan Implemented 2001

Chile Implemented 2003

Singapore Implemented 2003

Australia Implemented 2004

Bahrain Implemented 2004

Morocco Implemented 2004

Central American FTA Implemented 2005



Table 10.2(b) U.S. Regional Trade Agreements

Country Status of Agreement Date of Implementation

Oman Pending Implementation

Peru Pending Congressional Approval

Panama Pending Congressional Approval

Korea Pending Congressional Approval

Colombia Pending Congressional Approval

Malaysia Under Negotiation

Thailand Under Negotiation

South Africa Under Negotiation

United Arab Emirates Under Negotiation


NAFTA Country Characteristics

TABLE 9.2 Economic Characteristics of NAFTA Countries

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Copyright © 2010 Pearson Addison-Wesley. All rights reserved. Chapter 9 Preferential Trade Arrangements