Explained: Regional Trading Agreements

Indian Express, 15 Sept 2006

Does a trade agreement between India, Brazil and South Africa make economic sense? The three countries are geographically apart, they are all labour abundant developing countries without clear gains from trade, and it is not clear that the agreement will result in trade creation and an increase in welfare. It may be a politically useful arrangement, as perhaps most agreements that are not multilateral are, and increase the power of these emerging economies in international forums. Here we look at the genesis, the history and the outcomes of trading agreements across the world.

What are trading agreements?

A trading agreement is an arrangement between countries to reduce tariff barriers. Custom duties on imports has been a big barrier to international trade, reducing trade and the gains that could be made from trade. Reducing these leads to an increase in trade and business.

What are the kinds of trading agreements?

There are multilateral, bilateral and regional trade agreements. There are customs unions and free trade areas.

What are GATT and WTO?

The General Agreement on Tariffs and Trade (GATT), set up after World War II, aimed at bringing down tariff levels for member countries. It made a lot of progress in reducing tariffs through various "rounds" of discussions. Between 1986 and 1994, the "Uruguay round" negotiated further trade talks and on January 1, 1995, the WTO was created. The goal of the WTO is to reduce trade barriers among its 149 member countries. It is an example of a multilateral trade agreement.

What is the fundamental principle of a multilateral trade agreement like WTO?

The "Most Favoured Nation" (MFN) clause of the GATT agreement is the fundamental principle of WTO. It states that all countries belonging to GATT should be treated equally. Therefore, if India, a member of WTO reduces tariffs on goods imported from Singapore, it should also do so for all other member countries. This founding principle of GATT/WTO and is described in Article I of its preamble.

Do bilateral and regional trading agreements not violate MFN, the fundamental principle of WTO?

There are more than 200 regional and bilateral trading agreements. There are agreements between countries of Europe, North America, Asia, Africa and Latin America. There are bilateral agreements between the US and many countries such as Chile, South Korea and Jordan.

Interestingly, the WTO permits such trading agreements. Article XXIV, which actually violates Article I on the MFN, says that regional agreements are permitted as long as tariffs for those outside the agreement are not raised as a consequence.

Regional trading agreements(RTA) can be of broadly two categories: customs unions and free trade areas. Countries in a customs unions have a zero tariffs internally and a unified tariff against the rest of the world. A free trade area(FTA) is one in which countries maintain their own tariffs against non-member countries while having zero tariffs with members of the FTA. In other words, they do not have a unified tariff against the rest of the world.

The European Economic Community (EEC) is an example of a customs union. A good can enter the EEC in any country and once tariff is paid at the port of entry, the good is free to move through the EEC.

Another example of a customs union is MERCOSUR, formed in 1995, which includes Argentina, Brazil, Paraguay and Uruguay.

In contrast NAFTA, the North American Free Trade Area, is a free trade area. It was formed in 1994. Member countries -- the US, Canada and Mexico maintain different tariff rates with the rest of the world. This means that when a good enters NAFTA through Mexico it pays a differnt import duty than when it enters through the US. Only goods which are produced in North America can move freely in the free trade area. The others are subjected to Rules of Origin. A shirt made in India with labels and buttons stitched on in Mexico does not pass as a Made in North America shirt and cannot move freely from Mexico to the US. This is done to prevent third country exporters from taking advantage of lower duties in Mexico to enter the US market.

What have trade agreements meant for trade and welfare?

While most evidence finds that multilateral agreements help in increasing trade and welfare, it is not clear that regional agreements lead to trade creation, ie. an increase in trade, rather than trade diversion, i.e an increase in trade among member countries without an increase in total trade when the increase comes at the cost of trade reduction with non-member countries.

Remember that the purpose of FTAs is to eliminate tariffs against FTA members, but to retain them on non-members. Economists have often criticised FTAs, which may promote better political ties with neighbours, but are not based on sound economic principals.

How do FTAs lead to trade diversion, rather than trade creation?

Under an India South Africa FTA, for example, instead of importing steel from Europe, a producer would import it from South Africa. This does not help the Indian economy. Morevoer, as long as South Africa does not satisfy the entire Indian demand for imported steel, the price of steel in India does not fall. "Rules of origin" on which FTAs are based mean that only steel produced in South Africa can be imported under preferential tariffs - there will be zero tariff only when there is a minimum percentage of value added in South Africa.

PART II: India and Regional trading agreements

The importance of increasing regional trade within Asia cannot be emphasised enough. At a time when regional trading agreements, such as the EU and NAFTA have led to higher trade and investment, Asia lags behind. Trade within Asia is a miniscule proportion of world trade, even though the Association of South East Asian Nations (ASEAN) countries(Singapore, Phillipines, Thailand, Indonesia, Malaysia, Cambodia, Laos, Vietnam, Myanmar and Brunei) , along with China, Japan,Korea and India are among the fastest growing exporters in the world today. China is expected to enter into an agreement with the ASEAN countries to promote trade by cutting tariffs on a large number of commodities with the region. This will lead to greater economic integration, in a region in which members have, until now, seen themselves largely as competitors, than as potential partners.

What is the SAFTA?

The South Asia Free Trade Agreement (SAFTA) is the free trade agreement between India, Pakistan, Srilanka, Bangladesh, Bhutan and the Maldives. SAFTA came into being on 1 January 2006 and will be operational following the ratification of the agreement by the seven governments. SAFTA requires the developing countries in South Asia, that is, India, Pakistan and Sri Lanka, to bring their duties down to 20 percent in the first phase of the two year period ending in 2007. In the final five year phase ending 2012, the 20 percent duty will be reduced to zero in a series of annual cuts. The least developing country group in South Asia consisting of Nepal, Bhutan, Bangladesh and Maldives, gets an additional three years to reach zero duty.

What has been India's involvement with FTAs?

Over the last few years a number of FTAs have been signed with Asian neighbours like Sri Lanka and Singapore. Steps are being taken for the creation of free trading areas within South Asia and among the members of the ASEAN.

The benefit to India from entering an FTA is limited when India is dealing with a free-trading country. Since India is a high tariff economy, an FTA gives the partner a clear benefit, but if the partner already has zero or near zero tariffs, (as is the case with Singapore) Indian exporters do not stand to gain much. The FTA does not give Indian exporters additional market access. While India has an average custom to total import ratio of around 20 percent, Singapore is a zero tariff zone, Srilanka's is much lower at 5 percent and Thailand, with whom the next FTA is proposed to be signed has custom collections at 3.8 percent of total imports. Indian exporters gain little by getting preferential tariffs in these countries. It is their exporters who stand to gain. India loses the custom duties that would have been collected on their exports.

What are the other implications of Rules of Origin for India?

There is a big cost in terms of creating a whole bureaucracy which sits at custom points and checks whether goods coming from FTA partners satify "Rules of origin". Documentation would be provided to them which would need to show the percentage of value addition in Thailand for a good being imported from Thailand. This creates scope for corruption.

Then why does India try to enter RTAs?

First, there are political gains of belonging to a group. Second, it is a way to reduce barriers to trade and reduce custom duties which may not be as easy to do in a unilateral manner. Yashwant Sinha, when he was Finance Minister, had announced that Indian tariffs would be brought down to ASEAN levels. If India is part of a deal to cut custom duties, it becomes easier to do so. While domestic producers may protest, consumers stand to gain when duties are cut. In addition, these agreements can lead to an increase in service exports an area in which there is slower progress in multilateral arrangements like WTO.

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