PolicyResearchW WORKING PAPERS TradePolicy Public Disclosure Authorized CountryEconomics Department TheWorld Bank February1993 WPS1094 The New Regionalism Public Disclosure Authorized A Country Perspective Public Disclosure Authorized Jaime de Melo Arvind Panagariya and Dani Rodrik Public Disclosure Authorized Regional integrationis on the rise again - but from different startingpoints and with differerntobjectives than in the past. PolicyReaomdWodcing Pap dianatzthefndingsofwokinp awgresscncd .getheexchdngeofidesmongB staffaa ai oteheirmacdindevopncniLuespaps,&tibutewdbytc RusrchAdvis yStaff.cuaythenaresoftheauthorflact odytbavrvisndsuldbeLwddctaccordin0y.lefinduiginti, ndc<ecusionsarethcauthotown.lcyshould notbtc atlted tothe Wozd Bank.its Boardof Dimcmta,its management,otay of itsm membcrenties. PolicyResearch I TradePolicy WPS 1094 This paper- a product of the Tradc Policy Division, Country Economics Department - is part of a larger cffort in the department to improve our understanding of the economics of regional integration. The paper was revised to reflect comments reccived at the Confcrence on New Dimensions in Regional Integration, (funded by the Bank's Research Suppon Budget underRPO 677-12).Copies of this paperare available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Plcase contact Dawn Ballantyne, room N 10-029, extension 37947 (February 1993, 47 pages). Regional integration is on the risc again, despite arbitrage can Icad to improved economic its apparent failure among developing countrics outcomes by making decision-making less in the past. sensitive to economically harmful factional interests - especially when regional institutions De Melo, Panagariya, and Rodrik survey the are designed properly. ambig-ous economics of customs unions, emphasizing that the traditional dichotomy An empirical evaluation of existing schemes betwecn "trade creation" and "trade diversion" is produces no evidenec that membership in not particularly helpful for policy. In a world integration schemes has any effect on growth. with trade restrictions, regional integration presents certain advantages, including enhanced Finally, the authors note that recent attempts bargaining power and market access. at regional integration have differcnt starting points and objectives than past efforts - so The authors point out that integration history is a poor guide to the future of regional enforces arbitrage in institutions as well as in integration. markets for goods and factors. This kind of Thc PolicyRcsearch Working Paper Scricsdisscminates the findings of workunder way in thcBank. An objectiveof the scries is to get thcse findingsout quickly, even if prescntationsare less than fully polished.The findings,interprctations, and | I conclusionsin these p '' not necessarilyrepresent official Bank policy. Producedby thePolicy Research Disscmination Centc: The New Regionalism: A Country Perspective by Jaime de Melo World Bank, Universityof Geneva and CEPR Arvind Panagariya World Bank and Univarsityof Maryland Dani Rodrik Harvard University and CEPR The authors are grateful to SumanaDhar, Claudio Montenegro, Francis Ng for superb assistance, and to conferenceparticipants for helpful cormnents. The New Regionalism: A Country Perspective Table of Contents 1. Introduction ....................................... 1 2. Welfare Economics of Free Trade Areas .2 2.1 The Basic Economics of FrAS .3 2.2 Designing A Welfare-Improving FTA in the Presence of QRS .6 2.3 The Compensation Issue .7 2.4 FrA vs. UTL .8 2.4.1 Partner Country Tariffs .9 2.4.2 Third Country Tariffs.10 2.4.3 The Import Substitution Objective.11 2.4.4 The Tariff Revenue Constraint .12 24.5 Economics of Scale and Product Differentiation.13 2.5 FrA vs. PTA .15 2.6 FTA vs. CU.16 2.7 Strategic Advantage of an FrA .18 2.8 Inplications for Efficiency.19 3. Institutional Dimensions of RI.21 3.1 An Exploratory Model .. 23 3.2 Modeling Regional Intergration .25 3.3 Economic Consequences of RI.28 3.4 Political Consequences of RI.30 4. Growth Effects of RI Schemes.32 5. Conclusions.35 Endnotes . .38 References .. 41 1. Introduction Three decades ago, under the impetus of European arrangements, the developingworld launchedthe first wave of regional integration(RI). Free trade areas and customs unions mushroomedin Latin America and Africa. Unfortunately,expectations of economicdevelopment through regional integrationwere not realized and two decades later virtually all regional arrangementsamong developingcountries were judged as failures. By the early eighties, multilateraltariff cutting by developedcountries and unilateraltrade liberalizationby developingcountries had substantiallyweakened the case for regional arrangements. Yet, paradoxicallyit is then that a second round of regionalismgot under way. More arrangements (eight) have been signed during the eightiesthan during the sixties, and still more (half-a-dozenor so) are under consideration. The GATr process is running out of steam and many countries are turning back to the bilateral alternative. From the viewpoint of developingcountries, the current regionalismdiffer_ .,.om the regionalismof the sixties in two important respects. First, the regionalismof the sixties represented an extensionof the import-substitution-industrializationstrategy from the national to the regional level and was therefore inward-looking. The current regionalism is by contrast taking place in an environmentof outward-orientedpolicies. Second, in the sixties, developingcountries pursued regionalintegration exclusively with other developingcountries. Today these countries, especially those in Latin America, have their eyes on integrationwith large, developedcountries. In this paper, we review and extend the theory of regional integrationand evaluate empiricallyits contributionto growth. Our objective is to assess the benefits of regional integration from the viewpointof participatingcountries rather than the world as a whole. In particular, we do not focus on the systemic implicationsof regional integrationemphasized in the precedingpapers. A central issue we address is whether the regional approach can accomplishobjectives that cannot be 2 accomplishedvia unilateral trade liberalization. We also study the role of economic institutionsin the process of regional integration. In analyzingthese issues, we draw a sharp distinctionbetween the nature of regional integrationtoday and that in the sixties. In Section 2, we introducethe conventionalwelfare economicsof regional integration via freer trade among partner countries. We concludethe section by alluding to motivationsbehind current integration efforts which go far beyond trade integration. This theme is developed in greater detail in Section 3 where it is formally recognizedthat integrationenforces a certain degree of arbitrage among national institutions. In Section4, we provide an empirical evaluationof past integrationschemes. Finally, in Section 5, we turn to forward-lookinglessons for the 'new" approachesto regionalism. 2. Welfare Economics of FreeTrade Areas To avoid confusion, we begin by definingthe terms preferentialtrading arrangement (PTA), free trade area (PTA), customsunion (CU), and unilateraltrade liberalization(UTL) precisely. A PTA refers to an arrangement under which partner countries impose lower tariffs on imports from each other than on imports from the outside world. An FTA involves zero tariffs on trade among partner countries but positive tariff on imports from outside countries. Both PTA and FTA allow for different tariffs by partner countrieson importsoL similar goods from the outside world.' A CU is an FTA with a common external tariff by partner countries. Finally, UTL is defined as a non- discriminatoryreduction in trade barriers. The literature on regional integradonis full of 'anything may happen' type of results. What we present below is what we regard as helpful insights from the literature.2 Unless otherwise noted, we assume throughout that the partner countries are small relative to the rest of the world. 3 In Section 2.1, we present the basic Vinerian analysis and derive conditionsunder which an FTA is likely to be welfare improving. In Section 2.2, we consider the Kemp-Wanproblem of designinga welfare improvingFrA and apply it to the analysis of FTAs in the presence of qubotas. In Section 2.3, we address the problem of compensationamong union members. In Sections2.4-2.6, we compare FTAs successivelyto UTL, PTAs and CUs. In comparingFTAs to unilateral trade liberalization,we discuss, inter alia, the roles of the import-substitutionobjective, tariff-revenue constraintand economiesof scale. In comparingFTAs to PTAs, we show that when chosen correctly the latter are superior, and then proceed to explainwhy the GATT approach of forbidding PTAs is, nevertheless,sensible. In comparingFTAs to CUs, we pay attention to the rules-of-originissue and political-economyimplications of the two regimes. In Section 2.7, wierelax the "small-union" assumptionand analyze the strategic advantagesof an FTA. In Section 2.8, we assess explicitlythe relevance of regional integrationbetween developingand developedcountries. Finally, in Section 2.9, we summarizethe main conclusionswhich follow from the review. 2.1 The Basic Econonics of FTAs Can an FrA be welfare improving? Yes but not always. This is the central point made by Viner in chapter 4 of his (1950) classic work, The CustomsUnions Issue. Viner introducedthe key conceptsof trade creation and trade diversion and concludedthat a