30 Economic Integration: RTA & FTA

Vishal Kumar

1.  Learning Objective

After completing this module, you will be able to:

i.   Understand the meaning of RTA & FTA

ii.  Understand the factors behind the proliferation of RTA

iii. Know about various types of Economic Integration

iv.  Understand the advantages and disadvantages of FTA

2.  Introduction

During the past two decades, nearly every country that participated in GATT or the WTO has also joined with neighbouring countries in some form of regional trade arrangement. These regional trade arrangements differ in structure and in the issues that they negotiate, but they have a common objective: to increase trade and prosperity through the mutual reduction of barriers to the exports of neighboring countries. A key premise of these regional trade arrangements is that neighbouring countries, which sometimes share cultural and language ties, can expand trade more rapidly which is difficult otherwise.

Regional trade agreements have proliferated in recent years. Bilateral and regional “free-trade agreements” have also played a larger role in recent years, seeking not only to reduce but also to eliminate nearly all restrictions on trade among participating countries. Arrangements that partially or fully embrace free trade among countries within a given region have been established in North America, Europe, Southeast Asia, the southern part of South America and in several African sub-regions.

3.  Meaning of Regional Trade Agreements

A regional trade agreement refers to free trade among a number of nations in a specified area or region. It is an economic trade agreement to reduce tariffs and non-tariff barriers on trade between two or more nations to promote trade and investment. Bilateral and multilateral trade agreements could be mutually beneficial to both the countries. However Regional trade agreements (RTAs) could accelerate trade liberalization and set higher benchmarks for the multilateral system.

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Regional trade agreements regulate more than one half of  global trade, according to the  Inter-American Development bank. Member nations signing a regional trade agreement agree to eliminate trade tariffs on exports and imports. This promotes and increases trade among member nations of a free trade agreement bloc. A regional trade agreement requires the approval of the legislators of the countries which sign the trade agreement.

4.  Factors behind the Proliferation of RTAs

The need for regional trade agreements has arisen from a number of socio-economic, political and security considerations. Increasingly, RTAs are also viewed as a way to link developing and developed countries in a common project of economic development. RTAs encourage investment, facilitate productivity gains in participating developing countries and accelerate their economic growth. A classic example of deep economic integration among nations through an RTA is the European Union. In the EU all internal trade barriers have been eliminated and a common external tariff is exercised on all non-members. All EU members also share a common currency and a set of macroeconomic policies.

Countries have embraced regional trade agreements primarily due to the following reasons:

1. To derive benefits of increased preferential access to highly competitive larger markets
2. The slow progress in trade liberalization under the WTO
3. The failure of multilateralism based trade talks
4. A sharp increase in FTAs around the world, which has prompted other countries not involved in regional trade agreements to also consider engagement in such agreements – termed as ‘demonstration effect’
5. To promote liberalization and bring about policy reforms
6. To attract more foreign direct investment into the country
7. Political and security considerations

5.  Advantages of RTA

1) Lower Prices

Regional trade agreements reduce the tariffs between the countries which are part of the trade agreement. The World Trade Organization requires regional trade agreements to reduce tariffs between countries, but does not allow these countries to increase tariffs on countries which do not participate. Tariff reductions allow people to purchase goods from other countries at lower prices.

2) International Export Advantages

Regional trade agreements provide trade advantages for all countries in a region which improve their worldwide competitiveness, including in the markets of countries not included in the trade agreement. A car manufacturer that can purchase cheap steel from a country with which it has a regional trade agreement can sell cars elsewhere at a lower cost.

3) Dispute Resolution

Regional trade agreements include processes to settle trade disputes. Countries come into conflict with one another over agricultural subsidies, dumping products at low prices, and currency manipulation. The trade agreement includes standardized arbitration rules and ensures that trade disputes are resolved according to consistent rules. Trade agreements often specify the forum in which trade disputes are resolved, reducing disputes about which organization has jurisdiction over the trade dispute.

4) Rewarding Allies

Allies can receive  rewards through a regional trade agreement. The United States  delayed signing  trade agreements with the nations of Chile and New Zealand since these nations opposed the Iraq War. A country can also reward nations that establish similar economic and political systems with a free trade agreement, and refuse to sign a free trade agreement with nations which violate human rights.

6.  Types of Economic Integration

Most RTAs are meant not merely to slash tariffs but also to reduce impediments in international trade and to promote trade by reducing either tariff or non-tariff measures. They also essentially include rules and regulations that improve the overall investment climate. RTAs range across different levels of economic integration  and  differ significantly in their  scope  and coverage.

RTAs are commonly classified into the following categories:

a. Preferential Trade Agreements: Preferential trade agreement is a trading agreement giving preferential access to certain products from certain countries. This involves reducing tariffs but not their elimination. This is the weakest form of economic integration. The South Asian Preferential Trade Arrangement (SAPTA) between Bangladesh, Bhutan, India, Maldives, Nepal, Pakistan and Sri Lanka was one such agreement.

b. Free Trade Agreement (FTA): A free trade agreement is the most widespread form of RTAs. In an FTA, member countries eliminate or reduce internal tariff and nontariff trade barriers (to trade in goods, and also increasingly in services) among members, while each member is free to maintain different most-favored-nation (MFN) barriers on non-members. The best known free trade agreements are the European Free Trade Association (EFTA), the North American Free Trade Agreement (NAFTA), and the Association of Southeast Asian Nations (ASEAN).

c. Customs Union: The next level of integration is a Customs Union (CU). A CU moves beyond an FTA by establishing a common external tariff (CET) on imports from non-member countries. Typically, customs unions contain mechanisms to redistribute tariff revenues among member countries. Some examples of Customs Unions include South African Customs Union (SACU), East African Community Customs Union (EAC), Gulf Cooperation Council (GCC), and Central American Customs Union (CACU).

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d. Common Market: Common Markets are a form of ‘deep integration’, where member countries attempt to harmonize institutional arrangements and laws and regulations among themselves. While all the features of a customs union are present under a common market system, the latter also provides for free movement of factors of production (labour and capital) among the member countries, in addition to the free flow of products (output). The Southern Cone Common Market (MERCOSUR) and the Common Market of Eastern and Southern Africa (COMESA) are examples of well known common markets. Other prevailing Common Markets include Caribbean Community and Common Market (CARICOM), and the Central American Common Market (CACM).

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e. Economic and Monetary Union: The most comprehensive RTA is an Economic and Monetary Union, in which  members  remove all internal  trade  barriers,  permit  the free  movement  of capital and labour, erect common external trade barriers, and unify their fiscal and monetary policies. Here, member countries share a common currency and macroeconomic policies. The best known and most successful form of a Regional Trade Agreement in the world,  in the  form of an Economic and Monetary Union is the European Union. Other Economic and  Monetary  Unions include the West African Economic and Monetary Union (WAEMU), Economic and Monetary Community of Central Africa (CEMAC) and the Economic Cooperation Organization (ECO).

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7.  Impediments to the Integration

Despite strong economic and political arguments in support, integration has never been easy to achieve or sustain for two main reasons:

1. First, although economic integration aids the majority, it has its costs. While a nation as a whole may benefit significantly from RTA, certain groups may lose moving to a free trade regime involves painful adjustments. For example; as a result of 1994, establishment of NAFTA, some of the Canadian & US firms moved production to Mexico. Thus the workers in industries like textile which employ low skilled and low cost labour lost their jobs.
2. The second one arises from concerns over national sovereignty. This arises because close economic integration demands that countries give up some degree of control over key issues like monetary policy, fiscal policy etc. This has been a major stumbling block in EU. To achieve full economic union, the EU introduced the common currency, the Euro controlled by the central Euro bank.

Although the tide has been running strongly in favour of RTA in recent years, some economists have expressed concern that the benefits of Regional integration have been oversold, while the cost have often ignored. They argued that the benefits of regional integration are determined by the extent of trade creation as opposed to trade diversion. Trade creation occurs when high-cost domestic production is replaced by low-cost imports within the free trade area. And Trade diversion occurs when low cost external suppliers are replaced by high cost suppliers with the free trade area. A RTA will benefit the world only if the amount of trade it creates exceeds the amount it diverts.

8.  Free Trade Agreements (FTA)

Free trade agreements are pacts between nations which express the desire to commit to engaging in free trade. The pact usually includes a detailed list of points which each party must satisfy, ensuring that trade between the partners is truly free and open. Multiple countries can also band together to create a free trade area of two or more countries in which free trade is actively promoted and encouraged. Pacts are an important way to make a free trade system work effectively, showing that all member nations are bargaining in good faith.

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In free trade, two countries can trade with each other without any limits. Tariffs, quotas, taxes, and other burdens to trade are lifted, while government subsidies, tax reductions, and other perks which are designed to benefit domestic producers are also halted. This removes disincentives to trade, encouraging nations to exchange goods, services, and labour as needed, promoting the free flow of capital, ideas, and goods across international boundaries. Proponents of free trade believe that it helps to lower costs while promoting innovation in the member nations, especially if a free trade area includes a large number of countries.

Objectives of Free Trade Area:

1. To create favourable conditions for greater economic cooperation and promote fair competition;
2. Progressively liberalize and eliminate barriers to trade in, and facilitate the cross-border movement of goods and services between the territories of the Parties on a reciprocal basis as well as create a transparent, liberal and facilitative investment regime; and
3. Explore new areas and develop appropriate measures for closer economic cooperation between the Parties.

Measures for Comprehensive Free Trade Area (FTA)

The Parties agree to expeditiously negotiate for establishing FTA with a view to strengthening and enhancing liberalization of trade through the following:

• Progressive elimination of tariffs and non-tariff barriers in substantially all trade in goods between the Parties;
• Progressive liberalization of trade in services between the Parties with substantial sectoral coverage;
• Establishment of an open and competitive investment regime that facilitates and promotes investment within and between the Parties;
• Establishment  of  effective  trade  and  investment  facilitation  measures,  including,  but  not  limited  to, simplification of customs procedures and development of mutual recognition arrangements;
• Expansion of economic co-operation in areas as may be mutually agreed between the Parties that will complement the deepening of trade and investment links between the Parties and formulation of action plans and programmes in order to implement the agreed sectors/areas of cooperation; and
• Establishment of appropriate mechanisms for the purposes of effective implementation of this Agreement.

9.  Advantages of FTA

Free trade area is a trade block that allows traders to transact business without any sort of interference or intervention from the government. It is believed that free trade area leads to mutual benefits for both the trading partners. It differs from other forms of trade in that there is no creation of artificial prices, or a false demand and supply of products. In a protectionist trade economy, government intervenes in the form of subsidies, taxes, tariffs, etc to lower prices of goods or adjust supply of products. Free trade area overcomes all this and gives a true picture of the actual demand and supply. To understand how free trade area creates a better market and trade environment, let’s take a look at its benefits.

1. Comparative Advantage

In 1776 Adam Smith stated, “If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry, employed in a way in which we have some advantage.” Smith’s comment states the largest advantage of free trade: countries, by specializing in goods that have lower opportunity costs, lead to an increase in the economic welfare of all countries. The theory is self-explanatory. Each country does what it is best in and trades with other for its needs. In this manner the market represents true supply and demand, and trade benefits all the countries.

2. Economies of Scale

When countries specialize in certain goods that they can produce, they can take advantage of economy of scale and produce these goods at lower average costs. This is more useful to industries where the fixed cost of production is very high or where the investment required is very high. By specializing in such products, the industry can ultimately gain from economy of scale and lower production costs. This would transfer to the consumer as lower prices for the finished goods.

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3. Consumer Satisfaction

Because free trade area leads to a global market, consumers benefit from the competition and variety of goods brought to the market. When other countries produce some items cheaper, the consumer’s purchases products for less price. Another benefit to consumers is increased innovations. As free trade expands, competition also expands. To stay competitive, companies must seek ways to create the comparative advantage. This leads to increased innovation that improves products.

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4. Employment and Economic Growth

Although free trade may cause jobs in one particular industry to wind up overseas, jobs in the exporting and importing sides will increase. When productivity increases in importing and exporting, wages also tend to rise. As the U.S. has lowered its trade restrictions, the gross domestic product has risen. Since consumers can purchase quality products for cheaper, they have more expendable income.

5. Effective use of raw materials

Free trade not only brings about economic growth but also effectively uses raw materials, especially highly valuable and highly limited raw materials. For instance, the Middle East is a rich source of oil, but there isn’t much else in these countries. Trade is what ensures that this limited resource is distributed to different countries which lack this resource and the Middle East, in turn, gets the products necessary for their day-to-day living and business.

6. Foreign Exchange Gains and Decreased Poverty

When a country purchases a product from another country with money, they essentially send the exporting country non-interest IOUs in exchange for real goods. The exporting country, though, must use the money within the country that imported the products. For example, the United States purchases steel from China with U.S. money at the current market value. China will later use the U.S. money to purchase computer programs from the United States at the future market value. Countries that open their trade barriers to allow free trade have the chance to enter the global market, which will increase income for the country. In the 1990s, developing countries that lifted trade restrictions tended to grow three times faster than countries that restricted trade.

7.  Increased Export

Countries with stringent trade restrictions often cause animosity with other countries. Therefore, the country with the restrictions also limits its own ability to export. When a country removes their trade restrictions, other countries are more willing to accept the exports.

10. Disadvantages of FTA:

Free trade refers to the removal of any barriers, taxes, tariffs, quotas or any other governmental restrictions on international trade which would allow the involved countries to more easily exchange particular commodities. For the most part, free trade is considered a good thing because the lack of trade barriers makes exportation easy and relatively inexpensive. In this way, a country can focus its resources more efficiently and achieve a higher real income. Despite the overall benefit of free trade to a nation’s economy, there can be some significant disadvantages to the establishment of free trade agreements.

1. Expensive

Even though free trade is primarily meant to lower costs on items, it can actually end up being quite expensive. There are complicated rules and contract conditions that go into the making of free trade agreements to protect the interests of the countries involved. As such, there is usually the need to establish several committees and working groups to handle the free trade agreements. For example, the NAFTA agreement involved a contract that was more than 1,000 pages long and more than 25 committees. In essence, free trade can be resource intensive, requiring multiple agreements, ways of enforcing rules and compliance among the partner countries.

2. Competition

The removal of international trade barriers can open up some domestic industries to unsustainable competition. Some international markets are not on the same level as the domestic industry and are able to produce a certain commodity way below cost. As such, this surplus commodity gets flooded into the local market at much cheaper prices and essentially takes over that industry. Many local industries, even efficient ones, may be unable to compete under these conditions.

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3. Domestic Instability

Free trade can also increase domestic economic instability as the local markets become dependent on global imports. It basically decreases the self-sufficiency of a nation so that a crisis in a significant trade partner country can directly affect the economy of the home country. In addition, it can encourage pollution and other environmental problems as imports and exports are encouraged, and environmental concerns are not a priority in a lot of countries with cheap labour.

4. Destruction of Domestic Industries

Trade agreements boost competition. While some producers manage to conquer foreign markets, others prove unable to compete internationally, lose market share, and eventually disappear. As a result, the economy becomes dependent on a limited number of industries, while many important sectors of the economy are “outsourced” abroad.

5. Unemployment

Because many domestic industries are hammered by foreign competitors, unemployment rises. Even though some foreign firms move their operations into the country, the net effect is often negative, as foreign producers prefer to employ their own workers rather than provide employment to foreign ones. Generally, work moves to countries with lower labour costs, while countries with relatively high wages import unemployment.

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6. Loss of National Identity

As international trade increases, national identity decreases. The world’s diversity suffers as a result of trade agreements and subsequent rises in cross-border trade. Indigenous peoples adopt Western ways of life, watch Hollywood blockbusters and dine at McDonald’s. While the general standard of living rises, local culture and national identity withers away.

Summary:

The principal point of Free Trade Agreements is to secure trade liberalisation. While the traditional debate about FTAs is the danger that they can divert rather than create trade, the record to date suggests there has been little diversion and that FTAs and regional agreements have been effective in encouraging wider trade liberalization. A practical advantage of FTAs is that they are quicker and easier to negotiate than multilateral agreements because fewer parties are at the table. Parties can secure advantages that are harder to win in bigger forums. The disadvantages are twofold. If FTAs are not set up within the right framework of policies, they can diminish rather than enhance economic welfare. The second disadvantage is that they are not good vehicles for liberalizing trade in sectors on which parties outside the agreement have a major influence. RTA (Regional trade agreements) have proliferated in recent years. Bilateral and regional “free-trade agreements” have also played a larger role in recently, seeking not only to reduce but also to eliminate nearly all restrictions on trade among participating countries.

Suggested Readings

1. Paul Justin (2010). Business Environment-Text and Cases. Tata McGraw Hill, New Delhi.
2. Gupta, S.L. Financial Derivatives. Prentice Hall of India Private Limited. New Delhi.
3. Cherunilam Francis (2010). International Business. Prentice Hall of India Private Limited. New Delhi.
4. Cherunilam Francis (2013). Global Economy and Business Environment. Himalaya Publishing House, New Delhi.
5. Levi MauriceD. (2009). International Finance. Routledge.
6. Conklin David w. (2011). The Global Environment of Business. Sage Publications.
7. Mithani D M. (2009). Economics of Global Trade and Finance. Himalaya Publishing House New Delhi.
8. Cherunilam Francis (2011). International Business Environment. Himalaya Publishing House, New Delhi.
9. Saleem Shaikh (2010). Business Environment. Pearson Education, New DelhiSundharam K.P.M. and Datt Ruddar (2010). Indian Economy, S. Chand & Sons, New Delhi.
10. Sharan Vyptakesh (2003). International Business: Concept, Environment and Strategy. Pearson Education, New Delhi
11. Cullen. (2010). International Business. Routledge.
12. Bennett Roger (2011). International Business. Pearson Education, New Delhi.