How Does Regionalism Undermine the Global Trading System?

by Khairul Rizal

The proliferation of regional trade agreements (RTAs) has ignited scholarly debate on how its impacts on multilateral trading system (the WTO). Bhagwati (1993) has put the ongoing debate into two categories: ‘static’ and ‘dynamic’ time path. The first category analyses the welfare impacts of the RTAs and mainly focuses on the issues of trade creation and diversion introduced by Viner in 1950. The second category looks at the impacts of the RTAs on the WTO. Some have labelled the former as economic issues and the later as political issues of international trade.

Although both lines of debate are related to each other, this paper will mainly contribute to the second category of debate, which is political issue of international trade. This is because analysing the impacts of the RTAs on the multilateralism from economic perspective would be less relevant for the following reason. In economics sense, multilateralism is always superior to regionalism in promoting the world’s welfare as whole because in multilateralism there is no possibility for trade diversion to occur that can lead to welfare reduction. On the other hand, regionalism will always contain some degree of trade diversion effects. Thus, assuming countries act rationally, most countries would prefer multilateralism than regionalism. The reality, however, is not smooth like that. Countries are concern about the distribution of welfare, both among them and among their citizens. In this respect, political analysis plays crucial roles particularly in analysing behaviour of domestic interest groups who are negatively affected by multilateral liberalization. These interests have big influence not only on countries’ trade policies but also on multilateral negotiations.

This paper argues that the RTAs undermine the WTO progress toward global free trade because the interest groups are likely to manipulate countries’ trade policy toward regionalism rather than multilateralism, where the regionalism itself would weaken political supports from median voters for further liberalization. Moreover, the competition between hegemonic powers is likely to trap the world in the regionalism. Prior to the discussion, the nature and characteristics of the RTAs as well as their relationships to the WTO will be firstly discussed.

The nature and characteristics of the RTAs

In contrast to the nature of multilateral trading system which is based on most favour nation (MFN) principle, the RTAs are developed on preferential basis. Member countries of the RTA will give preferences to each other by setting lower or no tariffs that are not applied to non-member countries. In general, the configuration of the RTAs, or some may call it preferential trade agreements, can take two forms: bilateral and plurilateral (Fiorentino et al. 2007, p. 8). Bilateral agreement refers to an agreement between two parties, such as between the US and Israel, while plurilateral refers to an RTA involving more than two parties, mostly in the form of free trade areas (FTAs) and custom union (CU). It can geographically be one-continent agreements like the EU and the NAFTA or it can be cross-continent agreements like between the US and Singapore. It is important to note that an agreement between two RTAs or between an RTA and a country is considered as bilateral agreement. Therefore, trade agreement between the EU and Egypt is counted as bilateral agreement.

Preferentialism of the RTAs is characterized by lower internal tariffs among members but higher external tariffs against non-members. Here, external tariffs can be set up individually as to the case of the FTAs or collectively as to the case of the CUs. This difference has different consequences. While it is politically easier to reach agreement to form an FTA, it is confusing to administer the rules of origin to ensure eligibility of goods to get preferential treatment. The case of the CUs is just the opposite. It is easier to administer common external tariffs in a CU than to agree about it (Krugman & Obstfeld 2009, p. 240). This might explain the rapid grow of the FTAs relative to the CUs in the last two decades. Moreover, growing and overlapping FTAs has resulted in difficulty to form a CU for reason explained in the following simple example. If ASEAN is planning to move into a CU, it is likely to face many difficulties since member countries have already involved in different FTAs and bilateral agreements which might have various arrangements of tariffs. In this case, the ASEAN not only has to reach agreement on its external tariff but also has to deal with those various preferential agreements that binding most, if not all, of its members to non-member countries.

In addition, some scholars have developed a classification of the RTAs based on their integration levels. Frankle (1997) considers that a CU has deeper integration level than an FTA. Hoekman and Schiff (2002) define other deeper integrations beyond a CU as common market, a CU that also liberalizes factors of production, and economic union which requires synchronization of national economic policies (p. 548). LeClair (1997) however, views this kind of movements as a unification rather than integration. Nevertheless, this paper will not examine the intra-bloc integrations but focus primarily on their relations to the WTO system.  

The relationship between the RTAs and the WTO

The relationship between the RTAs and the WTO can be explained from three relations, namely legal relation, membership and shared objectives.

In terms of legal relation, the relationship between the WTO and the RTAs is set out in the WTO rules article XXIV of the GATT (regarding trade in goods), Article V of GATS (regarding trade in services), and Enabling Clause for developing countries. In essence, those articles allow some degree of exception to the MFN principle under certain conditions, i.e. reducing duties and other restrictive regulations for ‘substantially all the trade’ among members while ensuring trade barriers placed on non-member countries should not be ‘on the whole higher or more restrictive’. Simply put, countries can form a RTA as long as there is substantial reduction of internal tariffs for whole sectors and there is no increase in external tariffs imposed on non-member countries. Likewise but with less stringent requirements, enabling clause exempts less-developed countries from their MFN requirements and allow them to form preferential trade arrangements.

Thus, drawing from the WTO rules on the RTAs, the link between the two can be explained as follow. The WTO rules are affecting the ability of countries to form a RTA that fit with their developmental challenges and interests. In this respect, The WTO rules should ensure the compatibility of rule-making in the RTAs to the global trading system, or at least not working against it. However, unclear interpretation over the WTO rules as to the exact meaning and measurement of key terms such ‘substantially all the trade’ for instance, and also lack of discipline in incorporating the WTO rules into the RTAs arrangement have raised prolonged debate whether the RTAs act as building or stumbling blocks for the WTO’s system.

It is also important to note that many of the WTO rules are in fact started from the RTAs framework rules. Woolcock (2007) provides some examples. He shows how international investment regime is established from a patchwork of bilateral, regional and plurilateral rules. Another example is the sanitary and phytosanitary requirements which started at European level.

In terms of membership, almost all of the RTAs’ member countries are also the WTO’s members, with few exemptions like the FTA between the WTO member Armenia and Russian Federation, which is not (yet) the WTO member. Though formally the WTO has 151 members per July 2008, the effect of growing numbers of the RTAs makes its membership as if three times larger. As collective action theory warns us (Olson, 1960), the larger the group the greater the obstacles is to reach agreement for collective action. This is partly because of the free riders problem and partly because of divergence in motivations and interests. Even though there is a strong link between the RTAs and the WTO in this respect, it does not necessarily guarantee that both have common economic objectives.

In terms of objective, it is commonly assumed that all RTAs and the WTO are having common objectives of freer trade. In fact, they are not. While the WTO can be said to have this only single economic objective of freer global trade, many RTAs are used as just vehicles for non-trade agendas such as security, environment, labour rights agendas. Shared free trade objective may show a link between the RTAs and the WTO, however non-trade agendas underlie the RTAs formation indicate that the link is not as strong as commonly perceived.

Do the regional free trade agreements support or undermine progress in the WTO toward removing barriers to trade and investment?

It seems that there is no shortage of arguments in the literatures arguing that the RTAs can undermine multilateral liberalization. Frankle (1997) summarizes the arguments into four headings: i) block’s market power results in incentive to protect; ii) interest groups capture national trade policies; iii) scarce negotiator resources are diverted from multilateral to regional negotiations; and iv) the RTAs result in political dead-end for multilateralism. The first argument simply says that a larger bloc trade, referring to the case of a CU, tends to have collective monopoly power, thus it has incentive to protect against outsiders. The second argument emphasizes the roles of interest groups who know they will lose from liberalization thus seeking for protections. Up to here, this argument splits up into two lines. The first line argues that regionalism would weaken these interest groups thus promoting further liberalization. The second line, however, argues the opposites. The third argument simply says that regionalism diverts the attention of trade negotiators and bureaucrats away from multilateral negotiations. The last argument warns us that inherently regionalism undermines multilateral liberalisation since in the end successful multilateral liberalization would automatically eliminate all advantages of the preferential trades. As a result, the world trapped in regionalism.

In addition, another interesting argument is that regionalism is crowding out the global trading system. The term of ‘Spaghetti Bowl’ is introduced by Bhagwati to illustrate his concern regarding the systemic impact of regionalism on the global trading system. The spaghetti-like networks of regionalism are exacerbated by complicated rules of origin which are often captured by special interests. Complex rules of origin could be use as protectionist devices that have similar effect on trade as higher tariffs. 

Interestingly, most of the arguments above are mainly based on political economy analysis. This view is also shared by Roessler (1993) who argues that behaviour of governments negotiating a RTA cannot be examined solely in the light of economic efficiency considerations as most of the RTAs are concluded for non-economic purposes. Following this view, the analysis in this paper will be divided into two levels: domestic and regional levels. In domestic level, the analysis will focus on the roles of interest groups and median voters in influencing countries’ trade policies toward regionalism rather than multilateralism. In regional level, the analysis will focus on non-trade motivation of the RTAs and the roles of hegemonic powers which compete to manage globalization through regionalism, not multilateralism.

How does domestic political economy hinder multilateral trade negotiations?

There are two arguments put forward in explaining why countries’ decision would hinder global trading system. First is interest groups argument where countries’ trade policies are captured by small but politically powerful interest groups who are so far enjoying protection from the governments but threatened by further liberalization. Grossman and Helpman (1995) point out that when trade diversion outweighs trade creation, a FTA is likely to be formed. This is because these groups are benefiting from higher price caused by the trade diversion in the expense of non-member countries. Therefore, this creates a strong incentive for them to lobby the governments to form a RTA in order to block cheaper imports from non-member countries while expanding their market access to partner countries in addition to the existing domestic market. They can do this simply by exploiting the rules of origin. Another way they operate is through manipulating the arrangement of the FTAs so that sensitive-sectors are exempted from the agreements. Grossman and Helpman (1995) support this proposition where their model suggests that negatively affected sectors by trade creation are excluded in most FTAs. Panagariya (1994) shows a good example from the ASEAN’s experiences where in the past it excluded almost all the important sectors from its preferential arrangement.

The question is that how these political forces are blocking multilateral effort toward freer trade? Obviously further liberalization will eliminate trade diversion effects, thus threatening not only their sources of profit but also sources to survive. In the other words, full liberalization is not an option for these groups. The furthest liberalization they could tolerate is regional integration. Unfortunately, tough they are small in number; they are often well-organized and have strong lobby capacity, which is more than enough to hijack the governments’ trade policies in favour to their interests, which is regionalism rather than multilateralism.

The second argument is median voters argument introduced by Levy (1993). In essence, he argues that if further liberalization negatively affects median voters (defined as at least half of the voters) it will never get political supports to proceed. According to Levy, this situation particularly occurs in countries whose trades are mainly based on factor endowment rather than imperfect substitute. This is because adjustment to liberalization is relatively easier in the imperfect substitute industries since workers still can be employed in the same industries. However, adjustment is politically difficult in the factor endowment industries where workers have to move to different industries. He then argues that the RTAs weaken political supports from pro-liberalization constituencies. The reason is that a RTA is established because the gain in the imperfect substitutes industries outweighs the loss in the labour-intensive (factor endowment) industries (if this is not the case, a country will never join a trade agreement in the first place). Thus, when countries move toward multilateral liberalization, there will be fewer political supports from imperfect substitutes industries to countervail the labour-intensive industries, which are fighting against liberalization. This is because the imperfect substitutes industries already have reaped the gains in the RTAs. Simply put, pro-liberalization constituencies are paralysed by the RTAs, which means a political dead-end for multilateral supports.

Some argues the opposite. As identified by de Melo et.al (1993), the RTAs would dilute the power of interest groups because they have to reorganize at regional level as well as increase the incentive for pro-liberalization constituencies to compromise in efficient outcomes. The argument might be true, however pro-liberalization constituencies are likely to be much harder to reorganize at regional level as well. Consumer interests are harder to defend than producers’ interests both at national and regional level for a classic reason: larger group always suffers more with free riding problems.

In sum, the two arguments are mutual in working against multilateralism. While interest groups have bias toward regionalism, the regionalism itself undermines political supports for multilateralism.

How does political economy in the regional and international levels hinder multilateral trade negotiations?

Regarding international politics, the argument of why regional integration hinders multilateral trade negotiation relate to the roles played by hegemonic powers. The exercise of hegemonic powers by imposing non-trade agendas onto preferential trade agreements is unlikely to support multilateralism. This is started by the reversal of the US position from the multilateralism road toward regionalism road as a response to European resistance at a GATT ministerial conference for new round of multilateral negotiation in 1982 (Frankel, 1997). The competition between the two hegemonic powers later on becomes a race toward regionalism. As the US started to outflank the EU by forming FTAs that favoured its own firms, the EU began to negotiate FTAs itself to counter the US movements.

Sbragia (2010) argues that the competition between the two hegemonic powers is mainly driven by their own interests to manage globalization. Bhagwati (2008) shares this concern, at least partly, by saying it is in the US’s interests to negotiate a lot of FTAs in order to impose their non-trade agendas on poor and weak developing countries by using its huge market power. As an example, Polaski (2006) demonstrates how the US uses its market power to impose labor’s rights condition on Cambodia. Cattaneo (2009) argues and provides a long list of examples showing that the RTAs are primarily driven by political considerations (p. 42-9). Indeed, most of these examples are also illustrating the race to win global domination between the US and the EU. As he quotes from the former European Commissioner’s (Pascal Lamy)[1] speech referring to the US’ plan to form FTAA:

With the Pan-American zone, the US has an opportunity to impose its regulatory system to the whole continent, which would cause a serious problem to the EU. (…) We are in competition with the US. (…) Ultimately, the countries of the Southern Cone will need to decide which type of ‘geo-economic-political’ equilibrium they desire between the US and the EU (p. 43).  

The question then how does the competition between the two hegemonic powers with their non-trade regionalism affect the WTO’s mission of global freer trade? The answer is that the RTAs are the source of power for the US and the EU. Consider in a world of free trade, there will be no such market powers. Consequently, there is little or no incentive for the hegemonic powers to surrender this kind of powers to multilateralism. In this line of argument, thus, benevolent hegemonic powers that can be expected to take leadership in coordinating the efforts toward global economic integration as envisaged by Kindleberger’s (1981) are very unlikely to happen.

Conclusion

The political economy analysis of how the RTAs undermine the WTO will be concluded by looking at the potential damaging effects of the RTAs to their relationships with the WTO.  In terms of legal relation, domestic interest groups to significant degree have succeeded to exempt many sectors from the regional agreements, undermining the WTO provision of ‘substantially all the trade’. Moreover, many rules of origin applied in the FTAs are captured by interest groups that are used as protectionist devices against non-members, thus harming the WTO provision of ‘should not be higher or more restrictive barriers’. In terms of objectives, the RTAs and the WTO suppose to share a common objective of freer trade. However, this relationship is not as strong as commonly presumed since most RTAs have different non-trade agendas. These non-trade agendas are mainly driven by the interest of world hegemonic powers which are in favour of regionalism rather than multilateralism, thus trapping the world in regionalism.

References

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[1] Former Director General of the WTO.

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