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Regional Trade Agreements: a Tool for Development?

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Regional Trade Agreements: a Tool for Development? An Evaluation of Trade Capacity Building Programs Regional Trade Agreements: A Tool for Development? Bureau for Policy and Program Coordination October 2004 PPC EVALUATION WORKING PAPER NO. PAPER WORKING 15 PPC EVALUATION PN-ACT-170 RELATED PUBLICATIONS The analysis in this paper is based on the following documents: An Evaluation of Trade Capacity Building: Overview (PN-ACT-167) USAID Support for WTO/FTA Accession and Implementation (PN-ACT-168) USAID Behind-the-Border Trade Capacity Building (PN-ACT-169) Other relevant documents include Building Trade Capacity in the Developing World (PD-ABX-241) U.S. Contributions to Trade Capacity Building: Improving Lives through Aid and Trade (PD-ABY-500) An Evaluation of Trade Capacity Building Programs Regional Trade Agreements: A Tool for Development? James W. Fox The Louis Berger Group, Inc. October 2004 Abstract Caribbean Community and Common Market (CARICOM) and the Organization of East n the past, regional trade arrangements (RTAs) Caribbean States (OECS). Several large African among developing countries have not lived up groupings emerged: the Common Market for East Ito the hopes of proponents as vehicles for pro- and Southern Africa (COMESA), the Southern moting efficient industrialization. Newer approach- Africa Development Community (SADC), and the es, notably including low tariffs for countries out- Economic Community of West African States side the RTA, have more promise. RTAs with devel- (ECOWAS). Most sought to achieve an “open oped countries also are more likely to produce regionalism,” with lower external tariffs than the favorable results. Therefore, USAID should earlier efforts.1 approach supporting RTAs among developing countries with care. There are at least four ways to evaluate the impact of RTAs. First, there are the traditional static eco- There are advantages to assisting small countries nomic concepts of trade diversion and trade cre- through regional service centers or hubs so that ation that economists use. Second are dynamic USAID assistance does not have to rely on the “infant industry” effects that may come from narrower technical capabilities of small bilateral RTAs providing an initially protected environment missions. Such regional hubs may be efficient for firms that may eventually achieve competitive- tools for providing bilateral assistance. However, ness in world markets. Third is to determine in the absence of clear benefits to regionalism, whether RTAs provide a reliable platform for firms a hub is not a reason to promote regional to make investment decisions that would bring integration or RTAs. infant industry as well as other dynamic effects into play. Fourth, is to examine the potential of RTAs to promote peace and stability. The evidence Introduction on each of these four factors is discussed below. A Free trade with the world has always been viewed final section considers the implications for USAID with suspicion by all but economists. The contrary of the analysis. tends to be true of free trade among neighboring countries. Economists have usually been skeptical, while others—including political leaders—have Trade Diversion and Trade often been enthusiastic supporters. Support for Creation regional free trade has waxed and waned. There was considerable enthusiasm in the 1960s. The Central The Concepts American Common Market (CACM), the Latin The traditional analysis of the impact of regional American Free Trade Area, the East African groupings by economists is based on the concepts Community (EAC), and the association of fran- of trade diversion and trade creation. Trade diver- cophone West African countries (UOEMA) were sion occurs when a country ceases to import a established in that period. After some disappoint- product from the low-cost source on the world ment with results, and political changes that dis- market in favor of buying a product from a coun- solved some efforts, RTAs generated little interest try within the free trade area at a price higher than in the 1980s. world market but lower than the world market price plus the external tariff imposed by the RTA. In recent years, there has been renewed interest in RTAs. The Southern Cone Common Market— Mercosur—was established in South America. 1 See the appended brief summary of the experience of the current Other efforts were reenergized through the regional groupings of developing countries. An Evaluation of Trade Capacity Building Programs 3 A simplified numerical example illustrates the modity and begins importing it from another. point. Suppose that country A has a 50 percent Welfare is increased by reduced production of some import duty on refrigerators, which are not pro- goods, with the attendant adjustments required duced locally. A small refrigerator costing $100 (such as bankruptcies and layoffs of workers). internationally will sell for $150, with the govern- Because the country may be able to export other ment collecting $50 for each refrigerator imported. products to partner countries total employment Prior to the RTA, neighboring country B produced may increase, but the benefit comes from move- refrigerators that sold for $130 in its protected ment of workers and capital from some industries domestic market. When RTA refrigerators cost to others. Second, the potential for trade creation $130 in country A, there is an apparent benefit to and trade diversion depends on the level of the consumers because refrigerator prices have gone RTA’s external tariff: the higher the external tariff, down. Nevertheless, the $20 savings for the con- the greater the trade diversion that is likely to sumer has cost country A’s government $50 in occur. Had the external tariff in the case described revenues. In effect, the government spent $50 to above been only 20 percent, no trade diversion provide $20 in benefits to its citizens. The other would have occurred. $30 has gone to subsidize inefficient refrigerator production in country B. Country A did not Consider the following hypothetical example of an pursue the most beneficial alternative for its RTA between Nigeria and Benin. Nigeria’s manu- consumers: eliminating the tariff on refrigerators facturing sector is far larger than Benin’s, but the imported from all countries. In this case, govern- sector exports almost nothing to world markets. ment revenues would have fallen by the same That suggests that it is inefficient by world stan- amount ($50) for each refrigerator imported, but dards. Benin has a far smaller industrial sector, country A’s consumers would have received exactly so the potential for trade creation is small. Again, that reduction in costs. trade creation for Benin will occur only when its production is replaced by lower-cost production in Trade creation, in contrast, occurs when production Nigeria.2 On the other hand, Benin exporting to shifts from the domestic economy to that of another Nigeria presents a larger opportunity for trade member of the RTA. Suppose now that country A’s creation. Entrepreneurs in Benin would have a domestic refrigerator industry produces refrigerators far larger potential market for their products. at $140 per unit. As before, a 50 percent tariff means that consumers will buy the domestically Unfortunately, in practice there has been a produced item. Now the formation of the FTA with marked tendency for the industrialization from country B will produce trade creation. Country A such a regional agreement to concentrate in the will begin to import refrigerators at $130 each from country (and city) that already has the most country B, and will stop producing the high-cost industry. This “agglomeration” effect results from domestic refrigerators. In this case, consumers are the lower costs that firms encounter in such loca- better off, because their refrigerators are now $10 tions because of better infrastructure and better cheaper. The shift in production thus results in access to inputs and human resources. Less greater efficiency. Since the government collected advanced countries—such as Tanzania and no import duties in either case, its situation is Uganda in the East African Community, unchanged. Nevertheless, eliminating the 50 Honduras in the CACM—have found they incur percent tariff on refrigerator imports from other countries would have produced even cheaper refrigerators at no cost in government revenues. 2 Even where there is potential for trade creation in this way, it is often resisted within RTAs. For example, Trinidad and Tobago feared that its apparel sector would be harmed by imports from other CARI- Two points should be made. First, trade creation COM countries, so it prohibited imports of such products from part- ner countries. RTAs among developing countries seldom have occurs when one country stops producing a com- enforcement mechanisms to penalize such unilateral action. 4 PPC Evaluation Working Paper No. 15 the costs of higher prices and lower tariff revenues tition is prevented by high tariffs, but they make but do not obtain the benefits of increased invest- exporting to world markets impossible. The tradi- ment and industrial employment. The most likely tional economist’s model, based on greed as the prospect for Benin, then, is a diversion of manu- incentive to efficiency and productivity, is surely factured imports from low-cost producers in the wrong. Rather, it is the fear that one’s position in rest of the world to Nigerian producers. Benin the marketplace will be displaced by a more efficient will then import higher cost (and probably lower competitor that has shown itself to spur efficiency. quality) products from Nigeria that are exempt from import duties. Thus, Benin’s duty-paying The net benefits of Mercosur in its initial years imports and tax collections fall. were subject to debate. Leipziger (1997) concludes that the benefits were “small but positive,” while The Empirical Evidence others suggest that it was probably negative For developing countries, the experience with RTAs (Sanguinetti, Pantano, and Posadas 2001; Yeats has been that little trade creation occurs. Instead, 1998). Yeats concluded that the expansion of trade imports that previously came from world markets was largest in products—notably capital goods— now come from other RTA members.
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