The ABC of PTAs and FTAs

Regional economic cooperation is the flavour of the month. An Indo-Thai free trade agreement has been signed. So has a framework agreement for a FTA with ASEAN.

A comprehensive economic cooperation agreement with Singapore is in train. The Bangkok Agreement has a new signatory (China). Various other acronyms of alphabet soup are stalking the corridors of commerce and external affairs ministries.

But what really are FTAs, or, more generally, preferential trading arrangements? How do they affect cross-border trade? Are they good or bad for us? Can they substitute for freer, non-discriminatory multilateral trade? These are important questions for which the answers are not always crystal clear. But let's try some any way.

Broadly speaking, there are two types of PTAs (sometimes also referred to as RTAs or regional trading arrangements): FTAs and customs unions.

The WTO defines FTAs as "agreements among two or more parties in which reciprocal preferences (whether or not reaching complete free trade) are exchanged to cover a large spectrum of the parties' trade in goods".

Customs unions on the other hand, are PTAs "with a common external tariff in addition to the exchange of trade preferences". Both forms of PTAs can be either bilateral (two parties) or plurilateral, that is, involving three or more countries.

PTAs can also involve agreements where one party is itself a PTA, such as in the case of various agreements signed between the EC and several other European and Mediterranean countries. There can even be PTAs in which all parties are PTAs, such as the EC-MERCOSUR agreement under discussion.

As of 2000, the WTO identified 240 PTAs in the world! Of these, some 170 were already in force and the remainder under discussion/negotiation. In sheer numbers, about 90 per cent of the PTAs took the form of FTAs and only 10 per cent were customs unions.

But that 10 per cent included heavy weight players like the ever expanding EC. Historically, the Euro-Mediterranean region boasted a high concentration of PTAs. In recent decades the Americas and Asia has seen a lot of PTA activity.

What is the impact of a PTA on trade and welfare? Until the early 1950s the presumption was that formation of a PTA was necessarily trade liberalising and therefore resulted in freer trade and greater economic efficiency.

This conventional wisdom was convincingly challenged by economists (subsequently Nobel laureates) Jacob Viner and James Meade. They pointed out that a PTA had two kinds of effects: 'trade creation' and 'trade diversion'.

Trade creation occurred when (as a result of a PTA) a country's domestic production was replaced by lower cost imports from a partner country. Trade diversion occurred when low cost imports from the rest of the world (outside the PTA) were replaced by higher cost imports from partner countries because of tariff preferences.

They argued that a PTA would be welfare-enhancing only when its trade creation effects outweighed its trade diversion effects. The conditions under which this would occur would depend on several factors.

For example, if the partners to a PTA had widely different factor endowments and economic structures, then there is a much higher likelihood of trade creation gains outweighing trade diversion losses.

There is a lot more to the theory of PTAs but the Meade-Viner insight is crucial.

Economists, especially trade economists, tend to be deeply suspicious of the alleged benefits of PTAs. The Meade-Viner analysis is one reason. Another is that the discriminatory preferences built into any PTA are deeply antithetical to the principle of non-discrimination, which underpins the vision of a liberal world trading order.

Then there is the whole range of problems to do with defining and policing rules of origin (ROOs) in any PTA. These have to be framed to ensure that the tariff preferences are accorded only to goods 'actually produced' in the partner countries and not to goods from the rest of the world seeking entry into the PTA through the country with the lowest external tariff.

Documentation and enforcement of these ROOs can be costly (remember NAFTA had nearly 200 pages of ROOs!). Bemoaning the proliferation of PTAs, Jagdish Bhagwati has warned that "the world trading system comes to look like a spaghetti bowl of ever-more complicated trade barriers, each depending on the supposed 'nationality' of products".

If the economic benefits of PTAs are so dubious, how come they have mushroomed in such large numbers over the last 50 years? There seem to be several reasons. First, PTAs are often driven by non-economic or extra-economic reasons.

For example, the formation of the EC was heavily conditioned by the post-war drive for greater political unity in Europe. An important motivation for NAFTA was to check the flood of illegal migrant labour from Mexico to USA.

Many developing country PTAs are also driven substantially by motivations of political cooperation and solidarity, such as SAPTA, MERCOSUR and ASEAN. (It may not be wholly coincidental that the primary support for many developing country PTAs comes from foreign ministries and offices of presidents and prime ministers rather than usual economic ministries).

Second, many of the economic downsides of PTAs (including trade diversion costs) have been contained by the general trend of lower tariffs and trade barriers brought about through multilateral and unilateral trade liberalisation in the past half century.

Third, the major trading powers (US and EC) have frequently pressed ahead on the 'dirt road' of regional trade agreements when the 'turnpike' of multilateral trade liberalisation has been temporarily blocked.

More bluntly, these major trading powers have often used the carrot of PTA access to their huge markets to pry open trade barriers in other countries. All this comes under the so-called doctrine of 'open regionalism'.

So what is the lesson of all this for India's recent burst of PTA enthusiasm? I would make four points. First, the economic costs and benefits of each of the new PTAs will depend crucially on the details of the product lists, phasing, rules of origin, etc. Any sweeping judgment would be premature.

Second, since Thailand and other ASEAN countries are closer to us in economic structure and resource endowments than industrialised countries, we should not expect huge trade creation gains. Those could be expected if we were to enter a FTA with US or EC.

Nevertheless, since ASEAN countries are much more open economies than India, there is merit in our joining such trade-friendly clubs. Third, as I argued last month (BS, September 23), our new found fondness for PTAs should not distract us from the more strenuous (but more rewarding) endeavour of multilateral trade liberalisation under WTO auspices.

Fourth, and most importantly, we don't have to wait for any agreements with anyone to reap enormous benefits of freer trade. All we have to do is to carry through the tariff reductions promised in successive budget speeches by successive finance ministers of recent years.

Of course, the gains from such unilateral trade liberalisation would be greater if we solved our infrastructure bottlenecks and other policy impediments to industrial competitiveness. These include the 'usual suspects' such as labour laws and small-scale reservations as well as the growing problem of an appreciating rupee.

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