Forming a regional trade agreement advantages and disadvantages

Since World Trade Organization (WTO) was established in 1995, the number of its membership has increased to 153 countries by 2010. Recently, a phenomenon is observed. As countries pursue trade liberalization under the multilateral standard of WTO, more and more regional economic integration are conducted. Many members in WTO sign new regional trading Arrangements (RTAs) to deepen each regional trade reaction. Because positions and demand for different trade issue are often diverse to the regional member countries, the negotiations become more and more difficult. Consequently, the trend of bilateral and multilateral free trade agreement rises gradually. Besides, due to the bitter competition in the global market, countries also exert to obtain trade partners. Countries found thorough forming regional trade agreements could be an easy way to enhance trade reaction with their close trade partners. According to RTA database offered by WTO (2010), 371 RTAs related to WTO have been announced and 193 of them were in force by 31 July 2010Figure 1 shows the evolution of the average number of RTA partners for the current members of the World Trade Organization (WTO): the average WTO member now has agreements with more than 15 countries. Therefore, regional economic integration has become one of the main trends in the present global economic development. In recent years, the global economic system expands gradually by the reaction between the forces of regionalization and globalization. The following offer a general historical data of regional integrations.

First, the trend of Regional Integration can be traced back to the 1950s. The 1950s saw European Communities (EC), the most important and representative regional integration case, was established. Then in the 1960s, numerous regional integrations were conducted by Africa, Latin America and other developing countries. Continually, United State is considered to be the main thrust of regional economic cooperation during the mid 1980s and the1990s. During this period, except for lasting the free trade agreement with Canada and Israel, also United State promoted to arrange North American Free Trade Agreement (NAFTA) and Free Trade Area of the Americas (FTAA). Meanwhile, In Europe, the target of expansion and cross-regional cooperation are approached by European Union (EU). On the side of the expansion, Greece, Spain and Portugal were subsumed in the 1980s and the steps were followed by Sweden, Finland and Austria during the 1990s. Then, in the 2000s, Czech Republic and other eleven countries also attended European Union and four more countries, for instance, Turkey, are candidate to join. A growth in membership in European Union is expected. On the other hand, the aspect of cross-regional economic integration is also approached. To ensure the market share and position in America area, European Union urged to conduct free trade agreements with Mexico and MERCOSUR. As a result, the free trade agreement was announced with Mexico in 2000 and became the first free trade agreement conducted with Latin American Countries.

Compared with Europe and America area, it is entirely reasonable to make the analogy in East Asia. One of the representative regional integrations in East Asia is ASEAN. ASEAN, namely Association of South East Asian Nations, was established in 1967, including Indonesia, Malaysia, Philippines, Singapore and Thailand five countries. The original motivation of ASEAN is to prevent the spread of communism and to improve the regional trade reaction and cooperation. Since its establishment, there has been 40 year of its history. On 8 Jan 1984, the membership increased to six with the join of Brunei, and these six countries are called the founding members of ASEAN. Then they were followed by Vietnam, Laos, Myanmar and Cambodia in the 1990s so that current membership expands to 10 countries. The communism prevailed when the time ASEAN was formed. As a consequence, the political purpose was more than economic one in that period so there was no free trade agreement until 1992 the founding members signed ASEAN Free Trade Agreement (AFTA). A gradually tariff reduction in member countries, which is called Common Effective Preferential Tariff (CEPT), was planed to be achieved before 2008. As in 1999 the thirteenth meeting of the ASEAN Free Trade Area decided CEPT should be achieved earlier and decided non-tariff among members instead of the initial target. Then AFTA was in force with the founding countries of ASEAN in 2003 and non-tariff in all members was planed to be reached by 2015.

Above is the development of ASEAN free trade agreement. Next, a difficult position of Taiwan will be introduced. Asian financial Crisis happened in 1997 and conduced the willingness of East Asia countries to cooperate. Since 1999, those important trade partners of Taiwan in Asia have committed to access the forming of free trade agreement. For example, Japan and Singapore signed Japan-Singapore in 2002 and in force in the same year. Also after AFTA was conducted, China, South Korea and Japan, three large economy countries in East Asia, had pursued to sign FTAs with ASEAN. In December 1999, ASEAN announced to impose cooperation in their economic with China, Japan, and South Korea, which is called ASEAN+3. According to Picture I, it reveals the ASEAN+3 member countries on the world map: the dark ink represents the members and, comparatively, Taiwan is circled to be pointed out. An interesting discovery is found: although being a country located in East Asia, Taiwan is excluded from ASEAN+3. Due to some political problem, Taiwan has just signed 5 free trade agreements with other countries and none of them are Asia countries. Table 1 see the export trade amount of Taiwan with ASEAN+3 countries. The export amount occupied 66% of total Taiwan export so that if ASEAN+3 non-tariff target is achieved (in fact ASEAN and China free trade agreement has progressed on 1 Jan 2010), Taiwan would face a difficult trade position. Therefore, to avoid being isolated away by other trade partners and to deepen the cooperation with them, accessing advantages and disadvantages of forming a regional trade agreement become necessary.

To analyze those advantages and disadvantages of forming a RTA, an understanding in regional trade agreements is important. Also, to know whether any limit exist to forming a RTA, a good way is to review the international trade criteria given by GATT and WTO. Hence, in the discussion, a two-phase study was designed to explore the advantages and disadvantages of forming regional trade agreements. First of all, there are three branches in the former phase. In the first branch, to realize what regional trade agreement is, the paper examines the theories of regionalism and all types of regional economics integrations. It is worthy to understand regional trade agreement from its original intention and distinguish those differences. Second branch provides an overview of the organizations, which aim for improving international trade. For example, a comparison between World Trade Organization, Asia-Pacific Economic Cooperation (APEC), Europe Union and Association of Southeast Asian Nations (ASEAN) will be made to clarify their objectives of the establishment. We will see a conflict between the globalization and the regionalization. Last branch reveals two forces which against each others, namely trade creation and trade diversion. These two forces determine the gain or loss of a regional economic integration. In the second part of the study, an analysis of the advantages and disadvantages will be offered, based on the knowledge provided in the first part of the studies.

The remainder of this paper is divided into four sections. The next section of the article is a review of the literature; addressing both empirical and theoretical aspects of regionalism, worldwide trade organizations, trade creation and trade diversion. Section III describes the development of regionalism and provides empirical economic integration to support that. Using the background provided in the section III, section IV analyses the advantages and disadvantages of forming regional trade agreement. In the end of the paper, section V concludes.

Trade Creation and Trade Diversion

Trade economists have being going the effort on whether the formation of a regional trade agreement will lead member countries to be better off. A common concept to analyze gain or loss of a RTA was given by Viner. In his crucial work, The Customs Union Issue, two forces, which decide whether a RTA better off the member countries, were well indicated, namely trade creation and trade diversion. Viner noted that preferential agreement member countries would have lower tariff barrier than non-members due to the preferential tariff and therefore trade creation effect and trade diversion effect are produced. Trade creation effect is generated because the bloc members increased each others intra-bloc import and export when a preferential tariff reduction or removal is induced, and consequently bilateral trade amount increases. In addition, the low-efficiency production in domestic provider would be replaced by high-efficiency providers in other bloc countries so that home countries can consume this product with lower social cost. In contract, Trade diversion might be happened when a preferential treat is offered in member countries. Originally home country imports products form those high-production efficiency countries; however, due to the preferential tariff home town might import products from those low-production efficiency countries so that the social cost to consume this product rise and decrease domestic social welfare.

Trade creation is a positive effect to domestic social welfare and trade diversion is negative. If trade creation effect is greater than trade diversion effect, home social welfare increase. Conversely, it would be harmful if trade diversion is greater. In The Customs Union Issue, Viner made a crucial conclusion that the formation of customs union has no certain welfare effect to member’s welfare due to these two trade forces. Accordingly, economists doubt whether we can prevent trade diversion as forming an RTA.

Ohyama , Kemp and Wan proved customs union improve the welfare of members as given a fixed trade amount between members and non-members. On the contrast, if a change in nonmember trade amount would lead an uncertain welfare effect.

Even Kemp and Wan theoretically showed that members improve their welfare completely in the fixed trade amount with outsider, that sounds once given an unchanging treat to outsider, the world must be better off. It implies through a negotiated optimal tariff we can create economic benefit and prevent being hurt from trade diversion; however, many empirical observations reveal that countries usually choose the trade policies which results trade diversion when they forming a RTA, namely RTAs benefit members and worse off nonmembers. The implication is Kemp-Wan result might not be the trade equilibrium.

In fact, there exist other factors influencing the trade outcome of RTAs. The formation of an RTA related to political, economic and regional factors, the external tariff might be influenced not only economically but also politically. For example, lobbying might cause a distortion in government optimal external tariff adjustment. Thus, as we analyze the trade effect we better to account those factors in. In these few decades, economists focus on these two trade effects in RTAs and question whether RTAs generate more trade diversion or trade creation.

Is RTA more trade diverting?

Freund and Ornelas noted “in principle RTAs can generate either net trade creation or net trade diversion, we must remember that participation in any RTA is a political decision. Thus only some types of agreements will be formed, depending on the objectives of governments.” Except for the intension to maximize the social welfare, the decision whether to take RTAs might be influenced by specific-interest groups. Some literatures indicate domestic political factor might be a better way to explain FTA phenomenon. Grossman and Helpman reckoned domestic powerful specific-interest group usually lobby their government with huge money and resources to conduct RTAs which advantage them. Milner offered a similar viewpoint as well. He considered those export-oriented companies usually push government to enter a preferential trade agreement (PTA) to enlarge the bloc market which disadvantage outside companies. The powerful domestic companies have influences to the government election outcome so that the relationship between lobbying and election outcome is another factor to be taken to examine the influence on RTAs. Above sounds RTA generates more trade diversion due to non-trade effects, but it still needs evidences

Empirics of trade creation and trade diversion

Unfortunately, the estimation of trade diversion is not an easy work. As above mentioned, the estimation has to account into both trade and non-trade factors which influence RTA outcome, therefore, a gravity equation is used to help this issue. The equation provides a theoretical way to examine whether a RTA generates more trade creation or trade diversion.

The concept of “natural trading partners” were first proposed by Wonnacott and Lutz . They pointed that the agreements, which are conducted with those geographically close countries and similar culture countries, are likely to attain more trade creation. Tinbergen and Poyhonen successively used gravity model in international trade analysis and used it to research world trade flow and size. Tinbergen hence pointed bilateral trade flow and bilateral economic size have a positive relationship and have a oppose relationship with their geographical distance.

Frankel applied gravity model to examine the “natural trade partner” hypothesis. He analyses the trade flow effect in different regional integrations by using different dummy variables like culture, whether they have common border or same languages etc. He reckoned gravity model is the best instrument to judge trade creation effect and trade diversion effect. Frankel used the data between 1965 and 1992 to examine the regional effect. When two countries belong to the same regional integration, then regional dummy effect is 1; therefore 0. The estimated correlation coefficient represents how many trade flows can be attributed to specific regional trade effect. The empirical result revealed the correlation coefficient in each variable was all significant. He found two-country GNP coefficient is less than 1. That means trade amount will not rise proportionally when the economic size of both countries increase 1. Also the distance coefficient is negative, that represents the trade decrease with an increase in distance. The distance result is similar to the result of Tinbergen. Frankel also found the same language and the same border has a positive influence to trade flow. For each regional variable, the outcome shows the regional trade effect is significant in Europe Union, MERCOSUR, Australia-New Zealand Closer Economic Relationship, and Andean Group, yet not significant in NAFTA. Frankel provided evidence for natural trade partners hypothesis by using gravity equation.

Clausing used HS-10 digit import data of United State to access CUSFTA. She found due to the agreement signed in 1994 the import of the US from Canada had increased 26 percentage. the import from Canada increased half amount since 1989 to 1994 and Clausing attributed it to tariff reduction decision in CUSFTA. She found that trade creation are more general than trade diversion in most of cases. Furthermore, RTAs increase bilateral trade between members . Their research points there is no significant trade reduction between members and non-members be found. Other studies also examined the impact of regional integration to trade effect. For Europe Union, Kreinin pointed the establishment and east-expansion of EU would cause little trade diversion and huge trade creation.

A distinct evidence was provided by Chang and Winer . They found the formation of MERCOSUR do hurt non-members but as Calvo-Pardo et al. pointed, MERCOSUR is a customs union (CU), which is different from CUSTA, NAFTA those FTAs.

According to the literatures above, we found in most cases RTAs except MERCOSUR are likely to trade creating more than trade diverting. As well, if countries, which are natural partners, sign an RTA, it would benefit them. That is because the similar culture, for example, language, may reduce transaction cost. Consequently, the trade creation effect has more opportunity to be greater than trade diversion. That gives the incentive of government to negotiate an RTA with their close countries.

Adjustment in External Tariffs

Another issue trade economist cared is optimal external tariffs after forming a RTA. The original Vinerian assessments of trade creation and trade diversion are normally constraint to the policies fixed. However, there is at least a trade policy those RTA members would use: external tariff policy. Kennan and Riezman (1990) were the first to examine the optimal external tariffs after RTA was formed and they found the formations of RTAs are usually with external tariff reduction. Also, the same result was in several literatures. To avoid the welfare costs of trade diversion, optimal external tariffs seem to be lower in RTAs. Kennan and Riezman pointed there is coordination of common external tariff under CU. Unlike CU, FTA members have authority to set their external tariff unilaterally. Kennan and Riezman use this key different chrematistic between CU and FTA to see the external tariff adjustment outcome after the formation of RTAs.

Another issue we will discuss in this section is the influence of lobbying to the formation of a RTA. In section II we reviewed those structural characteristics, which lead to more trade creation or trade diversion, of RTA members. Intuitively, bloc countries are willing to attain more trade creation and to reduce more trade diversion so that they can achieve the objective of social welfare maximizing, yet as mentioned in Section II the formation of RTAs are not only economically, more important, also politically. There are some incentives bloc countries hold to adjust their specific product external tariff rate so that they can achieve their objectives (no matter what that is). Thus, this section will introduce those incentives that members are likely to alter their external tariff and the reaction to member’s external tariff under the formation of RTAs, which is what we concerned. That will help us to figure out whether the political force would lead distortion among the RTA formation.

Incentives to alter external tariffs in RTAs with empirics

The incentives to alter external tariffs in RTAs can be clarified generally in three main parts: the incentive due to CU, due to FTA and due to domestic producer influence. We will discuss them in the following content. The external tariff policy adjustment might be influenced by different types of RTAs. In CU their external tariff are coordinated by all members, on contrast, FTA members have more authorities on their own external tariff. Thus, the motivation in different types of RTAs might be different.

Firstly, we examine the incentive to alter external tariff rate of CU members. According to Kenan and Riezman , the equilibrium external tariffs are also observed being higher than FTAs. They concluded two points. One is a custom union allows its members to internalize their tariff externality when bloc members import the same product. Another, a customs union makes several countries into one larger one and enlarges their market power. Similarly, the analysis of Bond, et al. also clarified the external tariff in an FTA would be lower in a CU due to the lack of external tariff coordination.

Preferential margin is the differences between external tariff and preferential tariff rate. Higher external tariff leads to higher preferential margin. Also, the higher the preferential margin is, the larger the discrimination and trade diversion effect are. Therefore, inter-bloc countries benefit more from the CU agreement due to the discrimination effect.

As what Kennan and Riezman found, Richardson indicated there is an intention of external tariffs to be reduced under FTA. The phenomenon is called the “tariff complementary effect.” Relative to customs union, there is neither large market power nor external tariff coordination effect under FTAs. Even so, motivations to alter external policies still exist. A simple way to think is that: trade creation is created due to the preferential tariff among the FTA members and trade diversion is generated simultaneously. An effective trade policy against trade diversion that government holds is external tariff policies. Hence, if a preferential trade agreement comes with a reduction of external tariff, it would enhance both the total welfare in the world and reduce a hurting on non-members. However, an issue is whether the external tariff should be removed under a FTA. Bond, et al. reckoned the implication of the lack of external policy coordination is that the optimal external tariff for an FTA should be positive. Logically, a principle is that external tariff for outsider should no less than preferential tariff for insider so that the agreement would not be meaningless.

As what have mentioned in Chapter 2, there are some non-trade factors also affect the trade effects. The one which is broadly discussed is the effect of lobbying to external tariff in a RTA. When political motivations are concluded in, the net trade effect will become ambiguous.

Empirics of external tariff adjustment in RTAs

With protection, are RTAs more trade diverting?

The impact of regionalism on multilateralism

Kyle and Robert examined whether exceptions from MFN for the purpose of forming preferential agreements can lead to lower external tariffs, and thereby to a more efficient tariff structure unter the multilateral agreement.

imply that the formation of the FTA benefits ROW.

These findings differ from those that arise under a CU where typically there is a

smaller external tariff reduction (or even an increase). This occurs because CU

members jointly choose the external tariff to maximize union welfare, thus internalizing the positive tariff externality that exists whenever two countries import the same good from ROW. With the objective function that we consider, a CU will always be preferred to an FTA for symmetric member countries because of its more favorable market power effects25. Thus, while this model does not provide a positive theory of FTA formation, it does point out how international distributional effects differ between FTAs and CUs. It also suggests that, in the short run, FTAs are more appealing from a world welfare perspective because they imply relatively less aggressive tariff setting for their members.