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Regional and bilateral free trade schemes should be pursued with caution

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
June 2004
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IMFSurvey: Are bilateral and regional trade agreements—rather than multilateral agreements—driving U.S. trade policy?

Hilaire: U.S. trade policy is running along three parallel tracks. The first entails lowering tariffs on imports from certain countries without requiring a commensurate reduction in these countries’ tariffs, as is the case with sub-Saharan African countries under the African Growth and Opportunity Act. The second, multilateral, track involves proposals under discussion at the World Trade Organization’s Doha Round. And the third track, which has gained increasing momentum, focuses on bilateral and regional free trade agreements (FTAs). What is driving U.S. trade policy is a set of three goals: increasing U.S. exports of goods and services, enhancing the investment climate abroad, and cementing geopolitical and security links. This last element is especially relevant with regard to the Middle East, where the United States is rigorously pursuing FTAs.

IMFSurvey: Does the energy the U.S. expends on bilateral or regional arrangements come at the expense of a more vigorous push on multilateral trade negotiations?

Yang: There is no simple answer to this question. On the one hand, arguments have been made that competition for bilateral and regional trade arrangements creates incentives for countries to liberalize in the context of these agreements, which, in turn, favors deeper liberalization in the context of multilateral negotiations. Proponents of this view argue that “competitive regionalism” can catalyze global trade liberalization. It is often said that the establishment of the North American Free Trade Agreement (NAFTA) helped to move the earlier Uruguay Round forward when it was at a crossroads.

On the other hand, some observers worry that regional approaches to trade liberalization could weaken incentives for multilateral liberalization, and there are few signs yet that the recent push for regional arrangements has helped the Doha Round. Indeed, with the current round at a critical juncture, many countries seem to be following the U.S. lead and are placing increasing emphasis on bilateral or regional FTAs, possibly reducing the urgency to work toward a breakthrough at the multilateral level.

IMF Survey: A standard argument against preferential trade arrangements is that trade may be diverted away from lower-cost suppliers that are not members of the arrangement. How great a concern is this?

Hilaire: This could be of major concern to nonmembers, because they may see a sharp dip in their exports to members, depending on the level of tariffs levied on their goods. But this is not the whole story—consumers in a member country may indeed be able to pay less for imports (since these goods no longer bear tariffs from partner countries)—but these goods replace the lower-cost ones on which the government used to collect revenue. So the country may end up worse off when the loss in revenue is considered. Furthermore, later on, when preferential treatment is eroded because of subsequent multilateral liberalization or other preferential arrangements, the country may face considerable adjustment costs in attempting to regain competitiveness.

IMF Survey: Is this your only concern?

Yang: Apart from the trade diversion issue, we have several other concerns. First, negotiating regional or bilateral arrangements can be quite time-consuming and difficult, and small nations may find it difficult to cope with these demands while, at the same time, participating fully in multilateral trade talks. Second, there is a danger of trade blocs forming that would raise barriers against each other and marginalize small countries; this runs the risk of fragmenting global trade. Third, countries may become vulnerable if they come to depend on preferential arrangements that could be withdrawn or become less important as other partners enter. Fourth, a plethora of sometimes overlapping trade agreements can carry considerable administrative costs and lead to confusion because of the need to negotiate and police separate agreements. Jagdish Bhagwati refers to this as the “spaghetti bowl” effect. Fifth, the inclusion of additional elements—such as labor standards, environmental issues, intellectual property rights, and capital movements—in trade treaties may work to restrict trade and hinder development, especially for poor countries in which institutions are weak.

IMF Survey: Can regional or bilateral arrangements be structured to maximize their benefits?

Hilaire: Regional and bilateral arrangements are no substitutes for multilateral liberalization. They are not going to go away, however, and may even proliferate further. Regional arrangements are likely to offer the greatest benefits and to entail the least trade diversion if they cover a wide range of products and include a diverse group of countries. Many free trade agreements already cover manufactured products; the inclusion of services and agricultural goods may bring even greater benefits. Also, if it is carefully managed, developing countries stand to gain from integration with developed countries—not only through trade but also through positive spillover effects on investment and the business climate. Similarly, FTAs may play an important role in helping lock in broader reforms, such as in the legal environment and customs administration.

IMF Survey: Do U.S. bilateral and regional trade arrangements meet these criteria?

Yang: Yes, they meet several of the criteria. For example, the Free Trade Agreement with Central American countries (CAFTA) provides broad market access for goods and services and includes strong rules on investment, government procurement, and competition policy. But there are long transition periods for several agricultural products; tariffs will persist on some sensitive imports; and the rules of origin for textile products are quite restrictive.

Going forward, two major challenges remain for the United States. One is to ensure that the pursuit of FTAs does not undermine the momentum for multilateral liberalization, which we consider to be the first-best policy. The other is to tailor FTA rules to suit the needs of developing countries. That will mean avoiding excessive labor and environmental standards and refraining from using trade remedies—safeguard, antidumping, and countervailing measures—as a protectionist instrument.

U.S. free trade agreements
ExistingYear of agreement
Israel1985
Canada1993
Mexico1993
Jordan2001
Singapore2003
Chile2003
Morocco12004
Central America12004
Australia12004
In the worksExpected date
Southern Africa2004
Bahrain2005
Egypt2005
The Americas2005

These have been signed but not yet ratified.

These have been signed but not yet ratified.

IMF Survey: In your study, you carry out simulations of U.S. FTAs with Chile, Central America, and Australia. Why did you choose these three, and what did you find?

Hilaire: The three arrangements cover an interesting range of countries from which we thought we could draw important lessons. Chile already had low tariffs and a number of bilateral FTAs; the group of Central American countries already had strong trade ties with the United States; and Australia was geographically remote but had a strong interest in agricultural exports and investment relations with the United States.

What our study highlights is that, for the United States, the gain from each agreement is small but positive. With its large size and diversified trade structure, the United States suffers little from trade diversion. U.S. trading partners’ exports rise in industries where they have comparative advantages, but they do also experience some welfare losses from trade diversion. In addition, nonmembers of the new agreements see their welfare decline—this includes countries such as Mexico and Canada that have prior FTAs with the United States.

We also found that FTAs could greatly lose their value or have negative effects if a sensitive sector, such as agriculture, is excluded. Finally, our simulations support one of our main concerns about FTAs—that is, they could reduce incentives to participate in multilateral liberalization. For instance, in the case of CAFTA, Central American countries may, in the short term at least, gain more from CAFTA than from a multilateral reduction in trade barriers.

IMF Survey: What lessons does your study hold for policymakers—both within the United States and abroad?

Yang: Let’s start with policymakers abroad. First, it is clearly important to develop closer trading links with major partners, especially if they increase investment or encourage policy reforms that improve productivity. Second, care must be taken not to rely on preferential arrangements as a panacea because, over time, other countries may join and whittle away that preferential access. Third, countries should adopt policies appropriate to their specific conditions and development needs. For example, Latin American countries that rely on textile and garment exports should aim to streamline and improve domestic production to deal with upcoming global competition. This is a more durable solution than a temporary gain from preferential access to the United States.

For the United States, the lessons are similar. Moreover, given its size and leadership role, the United States can set the tone in shaping regional arrangements that complement a more stable global system incorporating multilateral and nondiscriminatory lowering of trade barriers within a common set of rules. The global framework would allow for treatment of many issues, such as barriers to agricultural trade and antidumping, which have proved to be difficult to handle at the bilateral and regional levels.

Finally, policymakers should be aware that regionalism may not be in the interest of the world economy in the long run. The multilateral approach—with its key objective of eliminating discrimination in trade—has been a cornerstone of global prosperity since World War II. In a world of regionalism and bilateralism, we could end up in a prisoners’ dilemma in which countries seek advantages over each other through discrimination (“competitive” regionalism), whose outcome would be in no one’s interest.

Copies of IMF Working Paper No. 03/206, “The United States and the New Regionalism/Bilateralism,” by Alvin Hilaire and Yongzheng Yang, are available for $15.00 each. Please see below for ordering details. The full text is also available on the IMF’s website (www.imf.org).

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