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Unravelling the complex rationale of RTAs

Financial Express (Delhi) | 3 November 2004

Unravelling the complex rationale of RTAs

These can impact development and trade only if domestic policies are supportive


Proliferation of regional trade agreements (RTAs) has been a striking development in the world’s trading systems since the mid-1990s. According to the World Trade Organisation (WTO), some 250 RTAs are in force, and the number might well approach 300 by the end of 2005. Preferential/reciprocal trading agreements reportedly cover as much as two-fifths of world trade.

RTAs are defined as groupings of countries formed to enter into preferential trading arrangements with each other. These groupings may be of countries not necessarily belonging to the same geographical region. RTAs, depending level of integration, can be divided into five categories (see chart). A majority of RTAs fall into what is described as shallow integration i.e. PTAs (e.g., Sapta) or FTAs (e.g. Safta and Nafta). Deep integration agreements are only a handful i.e., custom unions (e.g. Mercosur), common markets (e.g., Comesa) and economic unions (the EU).

Proliferation of RTAs highlights differing but complex underlying rationales, rooted in foreign policy and in development policy. But in nearly all cases both politics and economics are important.

Economists analyse the welfare impact of RTAs in terms of ‘trade creation’ and ‘trade diversion’. Trade creation occurs when an RTA member switches from inefficient domestic producers to lower cost producers in other RTA member-countries.

But the problem is that these lower cost producers may not be the world’s lowest cost producers. This leads to trade diversion, which occurs when low cost imports from countries outside of the RTA are replaced by higher cost imports from partner countries because of tariff preferences. Needless to say, an RTA would be welfare-enhancing only when its trade creation effects outweigh its trade diversion effects.

The relative dominance of the two effects has been debated among economists for several decades now. A group of economists led by Lipsey (1957), Summers (1991) and Krugman (1991) argue that risk of trade diversion is minimal in the case of formation of RTAs among geographically proximate countries, with high trade dependence among each other. Another group of economists, led by Bhagwati (1995) and Panagariya (1996), however, argues that trade diversion is inevitable because trade is by nature multilateral i.e., countries import from and export to RTA member countries as well as countries outside of the RTA. They say trade creation is unlikely if members of the RTA are small in relation to the outside world. Consequently, trade diversion is likely to be the more dominant effect.

In practice, trade agreements that provide for comprehensive liberalisation of trade across all major sectors and non-restrictive rules of origin are more likely to be successful.

Proponents of RTAs argue that they help nations gradually work towards global free trade by allowing countries to increase the level of competition slowly and give domestic industries time to adjust.

Opponents of RTAs point at the whole range of problems to do with defining and policing rules of origin (ROOs) in any RTA to prevent goods produced outside of the RTA obtaining preferential duties through a member country. Proliferating RTAs can impose tremendous burden on customs administration and they do absorb scarce negotiating resources, especially in poorer countries, and crowd out policy-makers attention from multilateral trade negotiations.

Trade performances in several RTAs (Nafta, EU, Mercosur, and Sapta) show substantial increase in inter-regional trade. The share of intra-Nafta trade rose from less than 35% to nearly 50% between late 1980s and 1999. Trade between Mercosur members doubled to 20% over the same period. The evidence from Africa, however, is mixed - regional integration among Comesa has been static, whilst trade for Ecowas and SADC has increased substantially.

The share of inter-regional trade for Asean remained fairly flat over the 1990s. An interesting aspect, however, is that except for Mercosur, all RTAs that have experienced an increasing share of inter-regional trade have also witnessed a growing share of extra-regional trade in GDP - an indication, perhaps, that openness to trade and expansion of inter-regional trade go hand-in-hand.

The literature seems to suggest that if the member-countries are similar and produce simple final products, typically labour-intensive, free trade amongst them is unlikely to give a big boost to intra-regional trade. In the absence of substantial comparative advantage, they are better off trading with the rest of the world than amongst themselves. However, developing countries are likely to gain from the economies of scale resulting from regional integration. Schiff and Winters argue that the small size and closed structure of many developing countries means that there is scope for more fully exploiting economies of scale and for removing local monopoly power.

In short, theoretical literature and empirical studies provides mixed evidence about the impact of the proliferation of RTAs on development and multilateral trade liberalisation. The evidence does indicate a tactical behaviour in trade negotiations that may lead to additional incentives for greater liberalisation.

On balance, trade policy also requires a sound domestic policy framework for success. Entrepreneurs can take advantage of new market access opportunities - whether they flow from bilateral, regional or multilateral trading arrangements - only if the domestic investment climate is supportive.

* The writer is minister (development) and head, DFID India

 source: Financial Express