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‘FREE’ TRADE AGREEMENTS - Making Them Better
Prepared by
John Humphreys and Andrew Stoeckel
 

December 2005

RIRDC Publication No 05/035

Executive Summary
• The World Bank estimates that one-third of global trade now takes place between countries that have some form of reciprocal regional or bilateral trade agreement. While international trade is a good thing, it does not necessarily follow that regional preferential trade benefits trading partners or the multilateral world trading system.
• Free trade agreements (FTAs) may not always be beneficial because they are by definition preferential — they discriminate against countries not included in the agreement. A more useful and comprehensive description is preferential trade agreements (PTAs).
• The preferential nature of PTAs is cause for concern.
• The discrimination is twofold. One is against countries not in the bilateral or regional trade agreement. The other is the discrimination against trade in agriculture, which is often left out of such agreements.
• The number of PTAs has been increasing in recent years. The number of agreements recognised by the World Trade Organisation (WTO) has gone from six in 1970 to 206 today. Yet more are on the way. There could be over 300 by the end of 2005. Many others remain unreported to the WTO.
• Reasons for the growth in PTAs include the slow pace of liberalisation through the WTO, the fear of being left behind by other countries entering FTAs and a reduced commitment to the principles of free trade.
• Like them or not, PTAs are a part of the modern trading environment that open up a new range of opportunities and challenges.
• While free trade creates win–win outcomes, PTAs are not free trade and can sometimes result in more costs than benefits. Costs and benefits need to be assessed for each PTA.
• Whether a PTA creates a net benefit depends on four factors — the trade impacts, competition impacts, nontrade effects and political economy consequences.
• PTAs can create more trade between member countries.


If this trade is new trade, it is called trade creation and it creates a benefit. If this trade is diverted from lower-cost supplying countries then it is called trade diversion and it creates a cost. Either outcome is theoretically possible and empirical evidence has shown that some PTAs are net trade creating and some are net trade diverting. To fully understand these trade effects it is necessary to consider PTAs in a global economy-wide framework.

Cheaper imports and more robust international competition from a PTA can lead to productivity improvements as firms are forced to innovate and imitate world’s best practice in order to stay competitive.

The competition benefits from trade are less certain than the trade benefits. However, growing econometric and anecdotal evidence suggests there is some competitive benefit from trade.

PTAs often include several non-trade issues that can cause negative or positive net impacts. Two issues of particular relevance are changes to investment rules and changes to trade risk and certainty. Investment liberalisation and increased certainty can provide significant benefits. But PTA negotiations increasingly consider more domestic issues such as intellectual property, competition rules and regulation of the labour market and the environment. The value of including these auxiliary areas is questionable.

 PTAs are constrained by several limitations. Important multilateral issues, such as the reform of domestic subsidies, are often excluded from PTA considerations.

Also, rules of origin and safeguard measures are common and costly elements of PTAs.

The political economy impact of PTAs is difficult to assess and impossible to quantify. Depending on its nature, a PTA can either complement or substitute for multilateral negotiations. The growth of PTAs around the world could result in several outcomes: free trade, the formation of several large trading blocs or a complex mesh of overlapping and inconsistent agreements.

Debates about the virtues and vices of PTAs have occupied the attention of economists for years. This book does not attempt to resolve the debate either for or against PTAs. That debate remains inconclusive today for good reason: there is no empirical test that could resolve that debate. Given the ‘stampede’ by countries to form as many PTAs as possible and the difficulty of changing that, a more fruitful approach is to adopt the suggested checklist of points to enhance the good things about PTAs and minimise the bad things.

 The costs of PTAs can be reduced in a number of ways:

The success of multilateral negotiations would make PTAs less relevant. PTAs are a second best avenue towards complete free trade and if multilateral trade liberalisation through the Doha round of trade talks could be accelerated then PTAs would become redundant:

Ten-point checklist for better PTAs

1. Is the price reduction maximised?
2. Are ‘problem’ industries included in the PTA?
3. Is the PTA comprehensive, including substantially all trade that would have occurred under free trade?
4. Are the rules of origin simple, consistent and flexible?
5. Does the PTA increase certainty for trade and investment?
6. Does the PTA also liberalise investment rules?
7. Is the PTA free of any ‘new protectionist’ measures, such as unnecessary environment, labour market or competition law requirements?
8. Are the details and consequences of the PTA well understood following a transparent process and independent analysis?
9. Have PTA partners reinforced their commitment to the WTO and is there a sunset clause to multilateralise the PTA?
10. Does the PTA allow for expansion to include new members and potential integration with other PTAs?


GATT Article XXIV that permits countries to form bilateral or regional trade agreements requires that PTAs cover ‘substantially all’ trade. This requirement should be clarified and enforced and should be taken to mean substantially all (taken to mean 95 per cent) of the trade that would occur under free trade; and

To help improve the quality and consistency of PTAs, the WTO could develop and promote a PTA template for member nations to use. Such a template could make use of the ten-point checklist.

Outside of the WTO, countries can maximise their benefits from PTAs in a couple of ways:
With or without a WTO template, countries should develop consistent rules for trade negotiations and consider each PTA in the context of the ten-point checklist.

Countries genuinely interested in pursuing free trade could establish a non-region specific, fully comprehensive evolutionary PTA. The rules of the PTA would specify the requirements for membership, but would not specify the members. Any country that complies with the membership requirements would be included.
 

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