Thursday, November 29, 2012

Regional Trade Agreements (Basics) - PART 4

Global Trade

Trade in 20th Century:
Globalisation led to production being dispersed internationally but clustered locally (into factories and industrial districts). Co-ordination of production stages between these local units became important. It involved a continuous, two-way flow among these local units, people, ideas, and investment in machines, training and technology. Production clustered locally because proximity lowered the cost of the two-way flows.
So, the 20th century trade is dominated by goods made in factories in one nation and sold to customers in another. There are complex two-way flows of goods, people, and ideas (the double-headed arrows shown in diagram below) but primarily within local factory units.
Trade in 21st Century:
The rise in ICT revolution led to cheaper communication costs, the spectacular fall in the price of computing power (Moore's Law) and the equally spectacular rise in fibre optic transmission rates (Gilder's Law). Long-distance information sharing was revolutionised as these developments in telecoms were complemented by the rise of the internet. 

Growth of global internet and phone users, 1975 – 2011
[Note: Above figure displays several ICT indicators and also shows that there was an inflection point in the growth of internet users in 1985 and in telephone users in 1995. Which means the real impact of ICT on production stages, began sometime between 1985 and 1995.]
These developments helped trade, which meant that some production stages that previously had to be within walking distance could now be dispersed internationally. Once ICT made dispersion of production stages feasible, scale economies and comparative advantage made it inescapable(i.e. companies had to go international in its production). This is globalisation's second effect on trade – the spatial unbundling of productions stages previously clustered in factories and offices(as was seen in 20th century trade). All of this radically changed the nature of international commerce giving rise to what might be called the trade-investment-service nexus, but it did not end the need to coordinate production stages(as was required in 20th century trade) – it just internationalised it. International commerce became more complex. The result might be called 21st century trade. 
The heart of 21st century trade is composed of the following: 
1) trade in goods
2) international investment in production facilities, training, technology and long-term business relationships(through FDIs etc)
3) the use of infrastructure services to coordinate the dispersed production, especially services such as telecoms, internet, express parcel delivery, air cargo, trade-related finance, customs clearance services, etc. 
This is what is called the trade-investment-services nexus.

Rise of Regionalism

"Simple commerce needs simple rules; complex commerce needs complex rules." 
When trade meant factories in one nation selling goods to customers in another(20th century trade), international rules could be simple – dealing primarily with border measures and a few "behind-the-border barriers" such as discriminatory national taxes and regulations. 
Then came the 21st century trade, which was more complex in nature. Multinationals from advanced-technology nations were eager to lower production costs by dispersing production and technology to the most cost-effective locations(for cost advantage). Meanwhile, developing-nation governments embraced 21st century trade as a fast lane to industrialisation and growth.[How else can we account for services forming ~50% of India's GDP?]
We saw that at the heart of 21st century trade is the trade-investment-service nexus which gave rise to its own set of trade barriers, which were not there in case of 20th century trade, namely:
Governments across the world wanted these trade barriers on 21st century trade to be removed, which ultimately meant a more complex international trade rules. WTO is a multilateral organization(involving more than one country) formed in 1995 to deal with the international rules of trade between nations.One of the founding principles of WTO is non-discriminationWTO's international trade rules are competent enough, when it comes to the 20th century type of trade barriers, which it was initially designed to govern. 

So, if WTO was competent, then why did member countries go in or regional agreements bypassing multilateral systems like WTO? 
The new trade barriers of 21st Century trade, is intimately tied to the unbundling of production and requires negotiations that go far beyond those in the WTO's rulebook and most countries find it easier to deal with these issues on bilateral or regional level.
  • Large number of participants in multilateral trade negotiations, with varying aspirations, reduces the cost of non-cooperation and creates rigidity in the system. WTO was severely criticized for its inability to conclude the multilateral trade negotiations known as the Doha Round, despite 10 years of talks.
  • Failure on part of WTO to implement the promises made during the Uruguay Round agreement to expand global trade has not materialized in practice. Particularly for developing countries, the promised expansion of trade in three key areas of agriculture, textiles and services has been minimal.
  • Protectionism and lack of willingness among developed countries to provide market access on a multilateral basis has prompted many developing countries to look for regional alternatives.
  • The North-South divide which is appearing in the WTO ministerial meets is strengthening the apprehension of developing countries about the prospect of trade expansion under the WTO regime. This has induced many countries to adopt regionalism as an alternate option for expanding their markets.

So we see that the failure of WTO is giving its members, a reason to advance the WTO's liberalisation goals unilaterally, bilaterally or regionally.

Regional Trade Agreements - RTA

Regional Trade Agreements(hereafter RTA) are defined as "groupings of countries which are formed with the objective of reducing barriers to trade between member countries". RTA is a direct consequence of the phenomenon called Regionalism. One of the most striking development in the world trading system since the mid 1990s is a surge in number of RTAs. From ~50 till 1990, the number of RTAs notified to the WTO has crossed 511(319 in force) in 2012. 

Tariff liberalisation since 1947: RTAs
[Note: Couple of stark observations from above figure. (i) Global Average Tariff cut (ii) Sudden increase in RTAs post mid 1990s (iii) Establishment of WTO and the Doha global trade negotiations did not have any effect on RTAs, which to some extent questioned the centrality of WTO in global trade rules.] 

Contrary to what the name suggests, these groupings or unions may be between countries not necessarily belonging to the same geographical region. e.g. Recently announced and much publicised India-EU FTA.

The basic principles of the GATT/WTO rules are:
  • Non-discrimination - Most Favoured Nation (MFN)
    • It means if a country opens up its market to another country(giving it MFN status), it must also open it to all other GATT/WTO member countries.
  • Reciprocity
  • Transparency
  • Enforcement
  • The impartial settlement of disputes
RTAs in the WTO have one thing in common, that is, they are reciprocal trade agreements between two or more partners. That is "I cut my tariffs if you cut yours". This principle is borrowed from GATT.

RTA represent an important violation to the WTO's principle of non-discrimination, in which countries entering into RTA can trade among themselves using preferential tariffs and easier market access conditions than what is applicable to other WTO member countries. As a result, WTO member countries that are not a part of the RTA lose out in these markets.

RTA tariff between A & B is discriminatory for C 

So, if RTAs violate the basic principle of WTO trade rules then how come so many RTAs are being notified by WTO member countries? 
That is because WTO allows for RTA between its member countries under specific conditions as follows:
1. Article XXIV of the GATT - If the RTA is for the formation and operation of customs unions and free-trade areas(we will see types of RTA below) covering trade in goods.
2. The Enabling Clause - If the RTA is trade in goods between member developing countries

3. Article V of the General Agreement on Trade in Services (GATS) - If the RTA is an agreement to reduce barriers to trade in services among a set of counties.

Why did WTO allow for RTAs, which could seriously dent its centrality in world trade?
That is because RTAs have allowed groups of countries to negotiate rules and commitments that was not possible, at that time, multilaterally(i.e. through WTO). In turn, some of these rules have paved the way for agreement in the WTO. For e.g. Services, intellectual property, environmental standards, investment and competition policies are all issues that were raised in regional negotiations and later developed into agreements or topics of discussion in the WTO.

Economic Effects of RTA

Trade Liberalization through RTAs leads to two different trade phenomenon:
1. Trade Creation occurs where due to the formation of the RTA, member countries switch from inefficient domestic producers and import more from efficient producers from other members of the RTA. This tends to improve the welfare of both the countries.
2. Trade Diversion takes place when member countries, because of the RTA, switch their imports from low-cost production in the rest of the world and import more from higher-cost producers in the partner countries. Trade diversion lowers welfare of not only the partner countries but the rest of the world also.
Hence we see that trade creation and trade diversion have opposite welfare implications and the net effect will depend upon which of these two effects dominate.

Types of RTA

Depending upon the level of integration, RTAs can be broadly divided into following categories:
1. Preferential Trade Agreements(PTA) is one in which member countries impose lower trade barriers on certain goods produced within the participating countries. e.g. PTA the EU and the 71 ACP (Africa, The Caribbean & the Pacific) countries. It enables the EU to guarantee regular supply of raw materials and the ACP countries gain tariff preferences and access to special funds.
Free Trade Agreements(FTA) is a special case of PTA where member countries completely abolish trade barriers (both tariff barriers and non-tariff barriers) for goods origination within the member countries. It should be clarified here that in most cases, countries do not abolish trade barriers completely even within Free Trade Areas. Most agreements tend to exclude sensitive sectors. e.g. NAFTA(USA/Canada/Mexico), SAFTA(India, Pakistan, Nepal, Sri Lanka, Bangladesh, Bhutan and the Maldives)
2. Customs Union is an agreement made between countries, where the countries agree to trade freely among themselves, and also they agree to adopt common external barriers against any country attempting  to import into the customs union. e.g. Mercosur(comprising Brazil, Argentina, Urugay and Paraguay)

3. Common Market is an extension of a customs union. In common market, member countries attempt to harmonize some institutional arrangements and commercial and financial laws and regulations among themselves. A common market also entails free movements of factors of production, i.e. removal of controls on free movement of labour and capital. e.g. European Union

4. Economic Union is a common market with a common currency.The best example of economic union is the Eurozone, which includes the member countries of the EU that have adopted the EU as their currency.
[Note: Some countries in the EU have not adopted the Euro (Eg: Britain) and therefore are not part of Eurozone statistics.] 

5. Political Union is the final stages of economic integration where member countries involved would have common government and would have no control of its economic policy. There would be full monetary union and complete harmonization of fiscal policy. Political union does not exists currently.[Note: EU has common monetary policy, but individual member countries still have their own distinct fiscal policies. How else can we explain that while Germany has stacks of cash with it, Greece is craving for it, inspite of both of them being part of EU? Common monetary and different fiscal policies is one of the major problems of EU and is said to have led to the current Eurozone sovereign debt crisis.]

Rules of Origin & FTA

Rules Of Origin(hereafter ROOs) are criteria used to determine the “nationality” of a product. A product’s raw materials or components might come from a number of countries, but customs officials must determine the product’s origin to decide how to treat it, including what tariff to charge, as the product enters their jurisdiction. Since the preferential treatment provided for in a FTA is normally granted only to products originating from members to that FTA, ROOs are therefore an important part of any FTA.

Every country has its own way of determining ROO in its negotiated FTA. India employs the twin criteria of “value-added content” and “change in tariff heading(CTH)” to determine the ROO of the goods. 

1. The value-added content rule requires that a certain specified minimum percentage of local content be added to a product in the country where the origin is being claimed. The required value-added content percentage varies across FTAs. 
2. The change of tariff heading(CTH) rule, on the other hand, is based on a tariff shift — meaning that the product must be classified under a different tariff heading and not the tariff heading of the components used in its production. 

Let us take a hypothetical case to explain ROO. Let's assume for simplicity that India only uses value adding criteria for ROO and ignores CTH. Tariff and ROO specifications are mentioned below. In this example I have shown that India has FTA with both Thailand and Singapore. Lets also assume that there is a product A whose production stages is dispersed geographically. So while some part of Product A is manufactured in Thailand, something else gets manufactured in Singapore and then sold.(remember 21st century trade) However majority of work on that product happens in Thailand(~70%) and the finished product A ships out from Singapore.

So will this product be treated by Indian customs department under India-SGP FTA or India-Thailand FTA?   

So, what do we have for Product A value addition at two of its manufacturing units in Thailand and Singapore? 
Thailand - 70% value addition and Singapore - remaining 30%.

For the Indian customs to consider this product for ROO of India-SGP FTA, the product must have value addition of atleast 35% from Singapore(See below in picture that India-SGP FTA has ROO as 35%). If that was the case, tariff on that product would have been only 5%(see below). Its ROO for product will then fall under India-Thaliand FTA and a tariff of 15% as negotiated in its FTA will be applied.  
Rules of Origin example

The rules of origin pertaining to each FTA are different. In addition, India may have agreed to grant different levels of duty concession to a particular imported good from the same country under multiple FTAs. e.g India offers duty concessions for imports from Malaysia under the India-Malaysia FTA as well as the India-ASEAN FTA. As a result, importers may have a choice between multiple FTAs for obtaining preferential benefits when trading with one country. The rules of origin under these FTAs however differ and, therefore, though a product may originate from the partner country under one FTA, it may not satisfy the rules of origin under another.

The number of overlapping FTAs and the distinct set of rules specific to them pose a problem for importers. Furthermore, calculating whether a product satisfies the value-added content requirement of an FTA can be cumbersome.

Disadvantages of RTA

1. RTAs are discriminatory in nature(I have explained above, why its so) and the drift towards RTAs are often viewed as a serious threat to the multilateral trading system like WTO.

2. By agreeing on an aggressive trade treaties on a bilateral basis(bilateral RTAs), developed countries are weakening the power of developing countries in multilateral trade negotiations. In a RTA between a developed and a developing country, the developed country often manages to include aggressive trade liberalization clauses, investment protection clauses and extraneous issues in the treaty. Having abandoned objections about these issues on a bilateral level, the developing country cannot resist these issues on a multilateral platform.

3. “Spaghetti-Bowl” ProblemMultiple overlapping RTAs with different ROOs are difficult to monitor; may be contradictory and may not be cost effective.

4. Trade diversion may be higher than trade creation(I have explained both the terms above).

The dejection of developing countries about the functioning of WTO and the domination of developed countries in a North-South RTAs(because most of the developed countries are in Northern hemisphere), developing countries are now looking for South-South  RTAs to expand their market access. These RTAs are likely to be beneficial for developing countries because lower dependence on developed country markets will not only help these countries to resist the pressures of hegemonic economic powers but also it will help them forge and foster stronger South-South alliances at the multilateral trade negotiations. Given the fact that a clear North-South division has appeared in WTO, this is likely to have a strong impact on the multilateral trading system. 
In this context we will study the India-ASEAN FTA in the next part - PART 5.

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