The Case for Free Trade and the Role of RTAs

The Case for Free Trade and the Role of RTAs P. J. Lloyd and Donald MacLaren University of Melbourne Seminar on Regional Trade Agreements and the WTO Geneva, 14th November 2003

The Case for Free Trade and the Role of RTAs • Introduction • 1. Predictions of trade theory • 2. Evidence from CGE models • 3. Hub and spokes arrangements • 4. Effects of RTAs on multilateral trade negotiations • 5. Conclusions

Country 1 RTA Country 2 ROW

1. Predictions of Trade Theory • The theory of RTAs on which GATT Article XXIV could have been based • Viner’s contribution: • trade creation and trade diversion • “... where the trade-diverting effect is predominant, one at least of the member countries is bound to be injured, the two combined will suffer a net injury, and there will be injury to the outside world and to the world at large.” • During the 1950s and 1960s it was demonstrated that parts of Viner’s predictions may not hold, e.g., trade diversion did not necessarily imply a lowering of welfare

Modern analytics for a single, open economy with perfect competition and constant returns to scale (first-generation assumptions), can use a compensation function: • B = e ( p, u ) – g ( p, v ) – ( p – p* ) m (1) • where e is national expenditure,g is national product and ( p – p* ) mis trade tax revenue • Bmeasures the compensation needed to allow households in the economy to reach a given level of utility

Suppose this economy joins an RTA • Then p will change as tariff rates are adjusted from pre-RTA MFN levels to preferential RTA levels • Then •  B =  e   g   R • which can be expanded, after some algebra, to give  B = + trade volume + intra-union terms of trade + extra-union terms of trade (2) • The sign of Bis ambiguous • If B < 0,the country gains; and if > 0, it loses • However, there is a presumption that members gain from the RTA

This expression for B also shows clearly that measuring changes in trade volumes alone will not predict whether a country gains or loses • Other assumptions: • imperfect competition (love of variety and economies of scale): second generation models • investment, factor accumulation and growth: third generation models • Second and third generation models tend to strengthen the presumption that members gain • For second-generation models, equation (2) becomes •  B = + trade volume + intra-union terms of trade + extra-union terms of trade + output + average cost + varieties

What are the welfare effects for excluded countries which, pre-RTA, traded with the members? • In first generation models, theory predicts that excluded members, as a group, lose, although some individual countries may gain • In second generation models, theory predicts that these losses may be greater than in first-generation models • What does the evidence from computable general equilibrium (CGE) models suggest?

2. Evidence from CGE Models • Structure: • data base of bilateral trade flows • data base of transportation costs and tariff rates • tariff on good i from region r to region s • behavioural equations • accounting identities • Caveats: • design of the experiment • values of the elasticities • the Armington assumption and CES functions: biases • Summary of Results:

Formation of NAFTA (Brown et al. (1992)): • using a second generation model they found that • each member gained • 31 excluded countries lost • using a third generation model they found that • the gains to Mexico were three times greater • the excluded countries lost • EU Single market (Haaland and Norman (1992)): • using a second generation model and representing deeper integration by a 2.5% reduction in intra-EU trade costs, they found that • EU gained 0.64% of GDP (internal markets integrated) and 0.40% (internal market segregated) • EFTA lost 0.22% and 0.15% of GDP, respectively • conclusion: excluded members lose but the size depends on assumptions about market structure in the RTA • Asia-Pacific Region

Table 1: Welfare Changes as a percentage of base period GDP Source: Scollay and Gilbert (2001)

Conclusions about gainers and losers: • global, multilateral trade liberalisation generates the greatest gains to the world economy • the size of the gains is dependent upon the underlying theory, the base period and the design of the experiment • countries, in aggregate, lose from being excluded from an RTA • the larger the RTA, the larger are these losses • in principle, a Pareto improvement is possible but in the absence of inter-regional transfers, RTAs are undesirable for outside countries

3. Hubs and Spokes • The configuration of RTAs has changed: • from a given country being a member of one and only one RTA, if a member at all • to the same country being a member of more than one RTA • The configuration today has been described as hub and spokes • The hub may be: • a single country, e.g., the U.S. or Singapore • a group of countries (plurilateral hub), i.e., an RTA itself, e.g., ASEAN • The spoke may be: • a single country • an RTA (plurilateral spoke)

Country 1: Hub RTA2 Country 3: Spoke RTA1 Country 2: Spoke ROW

Japan • Russia • Korea NAFTA • USA • Hong Kong • China • Mexico ASEAN Cambodia Vietnam Myanmar Laos Malaysia Philippines Indonesia Brunei • Canada • Thailand • Peru • Chile Singapore • Papua New Guinea CER • Australia • New Zealand RTAs in Effect in the APEC region, 2003

Hubs and spokes create: • two layers of discrimination: • the hub enjoys access to each and every spoke on a preferential basis: as most hubs are developed countries, it is to them that the bulk of the gains have gone • each spoke enjoys preferential access only to the hub • each hub and each spoke discriminates against non-members • complex rules of origin • forces for RTAs to coalesce into regional blocs • increased discrimination against excluded countries, particularly developing and least-developed countries

4. Effects of RTAs on Multilateral Trade Liberalisation • The growth of RTAs may affect the rate of multilateral liberalisation by: • affecting the pace of liberalisation from MTNs: the ‘building block’ or ‘stumbling block’ debate • affecting the pace of unilateral liberalisations • Evidence on the first: • if based on theory, is ambiguous, depending on whether the objective is welfare maximising or political self-interest • if based on empirical evidence pre-Cancún, RTAs have not slowed the pace • post-Cancún, the EU and the U.S. have signalled a passive role in MTN but a pro-active role in RTAs

Evidence on the second is mixed: • countries in ASEAN, CER and Latin America have continued to liberalise unilaterally within their RTAs • within NAFTA, Mexico and Canada have done likewise • neither the EU nor the U.S. has engaged in significant unilateral liberalisation over two decades

5. Conclusions • the growth in RTAs has substantially increased discrimination in world trade • with the creation of plurilateral hubs and spokes, that discrimination has become multi-layered • rules of origin have become more complex • Article XXIV of GATT has failed to protect the interests of outside countries because: • it was based on inadequate trade theory • it is inconsistent with “the elimination of discriminatory treatment in international commerce” (preamble to GATT 1947, see WTO (1995))

“the elimination of discriminatory treatment in international trade relations” appears in the preamble to the Marrakesh Agreement establishing the WTO (WTO (1995)) and yet it, too, is being ignored by those Members who are forming RTAs

References • Brown, D. K., A. V. Deardorff and Stern, R. M. (1992), “A North American Free Trade Agreement: Analytical Issues and Computational Assessment”, The World Economy, 15, 11-29 • Haaland, J. and V. Norman (1992), “Global production effects of European integration”, in L. A. Winters (ed.) Trade Flows and Trade Policy after ‘1992’, Cambridge University Press, Cambridge • Scollay, R. and J. P. Gilbert (2001), New Regional Trading Arrangements in the Asia Pacific?, Institute for International Economics, Washington, D. C. • Viner, J. (1950), The Customs Union Issue, Carnegie Endowment, New York • WTO (1995), The Results of the Uruguay Round of Multilateral Trade Negotiations: The Legal Texts, Geneva

The Case for Free Trade and the Role of RTAs