The debate about whether regionalism is the “stepping stone or stumbling block” for multilateral trade liberalisation was first brought up by Jagdish Bhagwati in his writings which have been referred to numerous times in this paper. He has been a staunch supporter of free trade and refers to RTAs (used interchangeably as FTAs or PFAs) as a stumbling block for trade liberalisation. This paper is written as a critique of Regional Trade Agreements. It looks into the analysis of why RTAs form a hurdle in the path of free trade. It first traces the origins of regionalism focussing on the four main waves of regionalism. Then it looks into the political and economic reasons why countries prefer to enter into RTAs instead of indulging into free trade. The WTO which was formed by the Uruguay round had envisaged a free trade society, but recent trends of the past two decades show how a shift has taken place where countries have started entering into RTAs. Finally, the main part of the essay looks into three broad themes of “trade diversion” & “trade creation”, “spaghetti bowl effect” and “domino effect” to bring forth why RTAs act as a stumbling block to multilateral trade liberalisation. These three concepts singularly bring forth the negative effects of RTAs in the world economy.
1.1 : Tracing the origins of Regionalism:
Even after extensive study and interest shown by economists on the topic of regionalism a clear definition of it has not been established. For a layman, it is the grouping of countries of the same region on the basis of economic policies. Region means a group of countries belonging to the same specific geographical location. Regionalism ‘connotes those state-led projects of cooperation that emerge as a result of intergovernmental dialogues and treaties’ (Breslin and Higgott (2000: 344))1. However, countries which enter into RTAs need not necessarily belong to the same geographical region.2 For example, even though Russia and America are in proximity to each other they do not form a region. Similarly, France and North West Africa is considered a region as they share same history, cultural background and political ties.3 Thus, is not a surprise that economists and political scientists have not reached a consensus on the definition of regionalism. The growth and study of regionalism has been primarily focused on the period after World War II. Jagdish Bhagwati in his paper has distinguished between two waves of regionalism.4 The first began after the World War II in the 1950s and lasted till 1970s and the second began in the mid-1980s. (Refer to diagram (b))5 Regional organizations, as defined above, are a relatively new phenomenon. Mansfield and Milner’s (1999) argument that there have been four waves of regionalism in modern history is based on instances of regional trade agreements; regionalism resulting in state-led integration schemes, however, did not become prominent until the post-World War II era. 6 Since then, we can observe two waves of regional integration out of which a total of 56 regional organizations emerged.
1.2: WAVES OF REGIONALISM:
End of the XIX century: During the end of the 19th century there was an increase in the coordination among European nations through mainly bilateral trade agreements, and the configuration of MFN status to some. During this period, the concept of regionalism was mainly confined to Europe.7 By the beginning of the 21st century, Britain had entered into bilateral agreements with 46 countries, similarly Germany and France had entered into such agreements with 30 and 20 States respectively.8 The First World War disrupted the flow of trade agreements that were being formed.
Interwar Period: The interwar period refers to the period between the two World Wars. It saw the countries taking up highly preferential and protectionist measures for their economy. It let to the consolidation of empires and led to the emergence of Trade Blocs.
Post World War II: Even after the world wars the term “regionalism” had not emerged as a concept in International Relations. It was during the Cold War period that countries became aware of the power they held as regions and how they can advocate it for their own benefit.9
End of the Cold War: This period which started from the 1980s is known as “new regionalism” and continues till today. There has been a surge in RTAs being signed
between countries and USA has taken the most prominent role in RTAs (see NAFTA) (Refer to table (a))10
a) The first table shows the surge in RTAs being signed after World War II12
b) The graph shows number of PTAs signed between 1948-1994
2. DRIVING FACTOR OF REGIONALISM FOR STATES:
To understand why countries have started entering into RTAs, we need to analyse the driving factors of regionalism for states. There are many reasons why countries enter into RTAs in the first place. The reasons can be categorized into economic and political reasons.13 Decline of a hegemonic country is one of the main reason why there has been a surge in the escalation of RTAs being signed between countries. For example, the decline of USA’s hegemony in the 1980s stalled the talks on multilateralism.14 As it will be explained in the Domino Effect, USA entering into RTAs also lead to smaller economies following the same trend. Another reason why states prefer entering into RTAs is because they want to increase integration between political allies.15 As stated earlier, regionalism does not primarily depend on geographical proximity but also on political background, history and other factors. The third reason why states want to enter into RTAs is that larger economies want to increase the dependence of smaller economies on them; it increases their power over them- the power increasing effect. At the same time, smaller economies also benefit from this power structure as they are given political security and stability. Fourthly, from the perspective of liberal peace theory, RTAs increase stability in the region.
3. REGIONAL TRADE AGREEMENTS ARE STUMBLING BLOCK FOR MULTILATERAL TRADE LIBERALISATION?
Trade agreements between countries can either be bilateral i.e involving two countries, or multilateral, i.e involving more than one country. Some scholars believe that bilateral free trade agreements are the first step towards multilateral free trade whereas others have pointed out that bilateral trade agreements are discriminatory in nature and lead to fragmentation of the world trade system and in the long run lead to a decline of the multilateral free trade. The onus is on us to decide the ability of WTO’s aim to maintain steady momentum towards liberalization, while contemplating the affect of agreements like NAFTA, EU and APEC on the same.
Economists have written extensively about both sides of the coins, i.e RTAs are not beneficial for the economy and for it being beneficial for the economy. This paper focuses mainly on the former. The main argument which people rely on, while siding in Multilateral Trade Liberalisation is Jagdish Bhagwati’s argument of the “spaghetti bowl” effect. But before we analyse Bhagwati’s proposition, it is imperative to look into Jacob Viner’s seminal contribution to the field of Regionalism.
3.1 “TRADE CREATION” AND “TRADE DIVERSION”:
The aim of any agreement which the country enters into is to strengthen it politically or economically. Jacob Viner (1950) has talked about the consequences of countries entering into RTAs.16 He has based his argument on how removal of tariffs lead to trade diversion and not trade creation (surge in imports by removing less efficient domestic producers). Trade diversion refers to the phenomenon when trade is passed from a more efficient supplier outside the country to one who is not so efficient but to an inefficient producer inside the country. The following three examples will show how RTA affects three parties, the two parties of the signed agreement and the non-member. 17
1) CASE I: Considering a hypothetical situation in which Mexico exports shoes to USA for $10. USA charges a tariff of 10%, increasing the price of the shoe to $11. A RTA is signed between Canada and USA, which removes all tariffs on imports from Canada. Canada starts supplying shoes at $10.99. Even though the price difference isn’t much, people will buy the goods which Canada provides. This in turn will lead to Mexico, which happens to be a more efficient producer to lose out on its profits. Even America loses out on the tariff amount it was receiving from Mexico. This is a situation of trade diversion.18
2) CASE II: In a similar situation, if USA charges a tariff of 5%, then Mexico will be providing shoes for $10.50, which will still be lesser than the price of shoes imported from Canada ($10.99). In this situation, there is no effect of the RTA on any of the countries. The trade diversion in this case will be more likely, if the external tariff is high.19
3) CASE III: In the third and final situation, if Canada provides the shoes at $10, and the tariff increases the price to $11. Then the RTA will lead to consumer welfare, as the price will drop to $10. Trade diversion in this case is completely absent, in such a case preferential tariff elimination is akin to free trade itself20.
The welfare consequences of RTA depend mainly on the response of member countries tariff. There is a lack of empirical evidence on trade diversion and trade policy, as data is required from before RTA and after RTA. 21
Freund and Ornelas show that there is a tendency for external tariffs to fall after a RTA which is more pronounced in case of developing countries rather than developed like UK and the US. However, since their tariff rates are already quite low, there may not be room for much change. This is proved by a simple yet logical analysis that shows marginal cost (economic) of high tariff rises while the marginal benefit (political) falls.22 Hence, resulting in the afore-mentioned behaviour of tariff policy.
3.2 SPAGHETTI BOWL EFFECT:
Bhagwati has furthered Viner’s argument by focussing on the adverse effect of RTAs on investment and economic efficiency. When we analyse the development of the global trade regime, we can see that free trade was the core objective of GATT (which later developed into WTO in 1995). The concept of MFNs displayed how members had to pay the lowest tariffs. For example, Article 24 of the GATT agreement prevented countries from entering into RTAs. It has been argued that allowing FTAs in a multilateral system will lead to unilateralism, i.e steps taken by hegemonies against smaller economies to push them away from multilateralism. Unilateralism is usually done by bigger economies to safeguard their own domestic industry or to gain access to a wider market. Though, by the time WTO was conceptualised the concept of multilateralism had been majorly wiped out. Countries started entering into RTAs. RTAs diluted the importance of MFNs which had been conceptualised in the GATT protocol. MFN creates an obligation on part nation to stretch out any benefit given to one nation to all other nations, however the RTA/PTA order of WTO weakens MFN by confining such benefits to nations, which form part of the RTA. This leads to customization of items to fit the requirements of RTA and leads legal and economic complication, which has been referred to as the “spaghetti bowl effect.”
In other words, domestic policies of countries lead to complications in multilateral trade, for example when the same goods are subjected to different tariff reductions and
c) The figure about shows how RTAs form a “spaghetti bowl” effect
tariffs when it passes through different trade trajectories. 23 When a single member nation is a part of several RTAs, there are different, complex rules of origin and different standards. This leads to lobbying by various groups and hence, transaction costs. There is a possibility of trade diversion.24 To explain the concept further, if a product passes through various stages of production like an Apple iPhone, it becomes very problematic to determine the country of origin. The country of origin matters for RTAs as they are applying tariff reductions only on certain specific countries which export certain specific items. This problem leads to a downfall in economic efficiency. This downfall in economic efficiency due to a noodle like trade trajectory has been termed as the “Spaghetti Bowl Effect”25
Bhagwati also talks of the selfish hegemonic which tries to satisfy its demands through FTAs with the weaker trading nations rather than by multilateralism. The point being that, if US tried to bargain at the international level ,it might not have got as good a bargain as it could through one-on-one negotiations with smaller, especially, developing countries. RTAs give better and faster results.26 It is true that regional trade agreements are easier to negotiate because of the fewer number of members involved and common interests.
3.3: DOMINO EFFECT ON REGIONALISM:
“Domino effect” refers to a chain reaction triggered by a small change leading to multiples similar changes, i.e when a line of dominoes fall. In the context of regionalism, we can see how countries prefer to enter into RTAs rather than liberalising the economy. Two reasons can be cited for this phenomenon. Firstly that it is easier for a country to negotiate with another country and the results of a RTA are faster. Secondly, since the world’s biggest hegemony, America has started indulging in RTAs itself rather can backing multilateral trade liberalisation which in turn has lead to smaller economies doing the same.27
In 1985, USA and Canada entered into talks of a FTA before the Uruguay round. It was only in 1989 than the agreement between the two countries came into being. The subsequent year, America and Mexico initiated talks of entering into a FTA. Canada fearing that it’s preference margin will be eroded, persuaded USA to make a tri-lateral agreement, which lead to the formation of NAFTA. (North American Free Trade Agreement)28 After this agreement many smaller economies like Argentina, Brazil, Chile and Paraguay started coaxing America to enter into FTAs. As many as 26 countries signed President Bush’s Enterprise for Americas Initiative in 1991, which asked for unilateral concessions in return for closer ties with America. Similar phenomenon was seen in Europe as well, which had lead to the formation of EEC (European Economic Area)29
c) This figure shows share of International Trade occurring under RTAs. Source: WTO Secretariat
The most logical solution to the problem of countries forming so many RTAs is to stop/ban them. Can banning of RTAs lead to multilateral trade liberalisation?
Riezman argues using a general equilibrium model to show that welfare losses from banning bilateral agreements are quite large and can surprisingly, lead to more protectionist measures and so the potential welfare losses are high. Even bilateral agreements may lead to more protection if trading blocks are of approximately same size but the welfare losses associated with it are quite low. Banning such bilateral trade agreements are a very risky trade policy and will hurt the world economy. 30 Although, banning of such agreements is not what is being debated, it gives an idea about the importance of bilateral agreements.
Levy argues that bilateral agreements reduce political support for multilateral free trade. The more politically popular a bilateral agreement is, the more likely it is to undermine support for multilateralism.31And popularity would arise from economic benefits. If the economic gains from such regional agreements are high enough, there is not much incentive for member nations to propagate free trade on a global scale. The same point is highlighted by Ornelas who notes that the source of failure for multilateral trade may be the success of the bilateral agreement in itself. If the gains from trade through bilateral agreements are large enough, these countries would not be willing to support multilateral trade.32
d) The figure above depicts pyramidal design of WTO member states.33 The current situation is arguably different.
Another major bone of contention is the Article XXIV of the GATT,
“4.The contracting parties recognize the desirability of increasing freedom of trade by the development, through voluntary agreements, of closer integration between the economies of the countries parties to such agreements. They also recognize that the purpose of a customs union or of a free-trade area should be to facilitate trade between the constituent territories and not to raise barriers to the trade of other contracting parties with such territories.” 34
Though it has been clearly outlined in the clause, that the member countries of RTAs are not to raise trade barriers to other countries (non-member), it is argued that there is relative increase in trade barriers implicit in such a case.35 When member countries reduce tariffs for each other while keeping external tariffs unchanged, the relative tariff levels for non-member countries would increase simultaneously. Another reason why countries prefer RTAs is because they give better and faster results.36 It is true that regional trade agreements are easier to negotiate because of the fewer number of members involved and common interests.
Winters (1996), Jayasinghe & Sarker (2004) and Bhagwati (1996) have clearly said that regionalism acts as a hindrance towards multilateral growth. The reasons why countries are tilting more towards RTAs can be categorized into two reasons; economic and political. Under economic reasons, each country aims at increasing its profits and have a wider access to markets. Under political reasons, it can be seen that integration among countries is easier at a regional level than at a multilateral level. For example, Doha rounds saw the failure of talks on multilateralism, which leaves the world with no other option except to enter into RTAs.
The abovementioned economists have given many reasons supporting the claim that RTAs are a stumbling block for multilateral liberalisation by stating effects like the spaghetti bowl effect and the domino effect. They also state reasons why hegemonic countries will prefer entering into RTAs and not support multilateral trade. The impact and influence which RTAs have on multilateralism cannot be ignored.
RTAs help in increasing efficiency by bringing down tariff barriers, which leads to a positive impact on multilateral trade by helping countries achieve the economies of scale. On the other side of the coin, RTAs have lead to a loss of transparency (spaghetti bowl effect) and decreased incentive for countries to enter into multilateral trade agreements. It also leads to trade diversion instead of trade creation. RTA also forms a platform for bigger economies to enter into unilateral agreements with smaller economies. Also, many small economies are left out as they don’t have much to offer to bigger economies in terms of trade.
This essay shows how RTA is going against the principles of WTO, i.e multilateral free trade. It is evident through the Doha Rounds, that there is a lack of political will to take a step towards multilateral free trade. Unless and until, this political fatigue is overcome, observing the current trend, it can be easily concluded that countries will enter into RTAs.