SESSION IV THE POLITICAL ECONOMY OF REGIONALISM AND IMPLEMENTATION ISSUES

SESSION IV THE POLITICAL ECONOMY OF REGIONALISM AND IMPLEMENTATION ISSUES JAIME DE MELO This version, March 2004

OUTLINE: SESSION IV  Elements of the political economy of protection  Are government commitments credible?  Is regionalism likely to increase or diminish protection towards the outside world?  Application: The CET in the MERCOSUR  Regionalism as politics  Implementation issues : Rules of Origin  Application: Rules of Origin in NAFTA

 Elements of the political economy of protection General framework Pressure groups: Lobbying to get policy (more or less protection); type of protection (e.g. QRs) Box B Individual or group preferences: factor income, cost of living, etc.. Box A “Demand” for/against protection and type of protection Choice of commercial policy Politicians ’ preferences: Level, type (QRs?) of protection Box C Institutional set up: (executive vs. legislative; international obligations --WTO, RTA, WB) Box D “Supply” for/against protection and type of protection

 Elements of the political economy of protection BASIC QUESTIONS ON THE FRAMEWORK Within the general framework: 1. Who are the lobbies and how do they work (box B)? 2. What is the institutional setting (box D)?  To make framework more operational in N-S RIA setting: 3. Are commitments more credible in an RIA? 4. Elements of demand and supply of protection

 Elements of the political economy of protection WHO ARE THE LOBBIES?  Industrialized countries: • Most powerful lobbies represent producers (eg. guns, steel, automobile, farmers,…) • Few powerful lobby groups representing consumer interests  Developing economies: • Producers and importers often represent powerful lobbies • Few lobbies representing rural areas, especially in low-income countries

 Elements of the political economy of protection HOW DO LOBBIES WORK?  Public good characteristic of lobbying activity: Public good: non rival (several consumers at a time) and non excludable (free riders cannot be excluded). Ex: A tariff on shirt imports obtained by producer i benefits all national shirt producers = protection (as free trade and many other policies) has a public good nature Lobbies face free-riding = incur monitoring costs Monitoring costs are usually higher the larger the number of participants in the group = most efficient lobbies tend to be the less numerous ones = “tyranny of the many by the few”.

 Elements of the political economy of protection THE INSTITUTIONAL SET-UP  Internal institutions: How are rules and laws decided and implemented? “Checks and balances” limits on discretionary action? = voting process, lobbies contributions, separation of power, law enforcement, etc...  External institutions: = membership in WTO or in RTAs? May benefit countries with weak institutions as an “external agency of restraint”, putting a lid on the amount of discretionary action in trade (and other) policies

 Are government commitments credible? Often policies that appear optimal ex-ante no longer are so ex-post = there is a problem of “time-consistency” Time-consistency problem: Particularly relevant when decisions, once taken are costly to undo and the economy has rents to be fought over= LDCs Ex.: excessive taxation of crops with high sunk costs: Growers of tree crops (eg coffee) consider the use of fertilizers as sunk costs.  government has incentive to cheat: announce that taxes will be low, to induce producers to use fertilizers, that increase their profits and thus the tax base, … and then keep taxes high. ../..

 Are government commitments credible (II)? But: growers know from previous experience that government will cheat  no fertilizers applied  tax base shrinks and everybody is worse off. • Data show that crops with high ratio of sunk costs (coffee, vanilla, cocoa) are taxed at a higher rate than other crops (cotton, tobacco, groundnuts). So are trade policies credible or do governments have incentives (and leeway) to renege its promises?

 Are government commitments credible? (III) Will N-S RIAs bring credibility to Southern countries? • Here role for RIAs (eg. the EA between transition countries and the EU, NAFTA, REPAs) that can serve as external agencies of restraint to limit discretionary power of government, or backsliding in policies • Probably important in some cases where that credibility role would not be played by the WTO (notably because the countries would not avail themselves with binding tariffs at actual levels) ….but is that sufficient if the Northern partner does not have that much interest in the Southern partner? …and is it a diversion of scarce human capital for more negotiations?

 Regionalism and protection towards the outside world Do RIAs change the balance of incentives and forces for external liberalism since the gains from an RIA depend on a genuine liberal external policy stance?  Compare first pressures under FTA and under CU •  Keep in mind: No simple answer, as there is no empirical regularity: The CAP is protectionist (but would individual countries have been on average more or less protectionist?) • Under NAFTA, Canada reduced tariffs on 1500 items imported from non-partners, while Mexico raised tariffs on 503 • EC: Average CET has fallen from 13% to 3% for manufactures • CET on Andean Pact at 12.8% percent just above the average tariff of members.

 Regionalism and protection towards the outside world : Protectionist pressures in FTAs • A race to the bottom for FTAs • Optimal tariff on non-members should be close to zero if tariffs on members are constrained to zero • If there is trade deflection, high tariff countries lose revenue, unless they reduce tariff just below that of the partner (à la Bertrand competition) • If duties on inputs cannot be rebated (often part of the agreements), then exporters of final goods are uncompetitive.

 Regionalism and protection towards the outside world : Protectionist pressures in FTAs (end) • …but counteracting forces to the race to the bottom for FTAs • RoO essentially export protection and there is plenty of lobbying for obtaining RoO that allow exporting protection to the partner. • Fierce competition with the FTA might lead firms to seek protection against outsiders • And resources for lobbying previously devoted to lobbying for protection against partners may now be freed to seek lobbying against non-partners.

 Regionalism and protection towards the outside world : Protectionist pressures in Customs Unions (I) • Most CUs have a CET but not a truly common external trade policy (e.g. the EU-Turkey CU allows for AD between members. • …took 30 years for the EU to get to common external trade policy as for a long time members could keep their own NTBs towards outside world (so RoO were indeed still needed). • If CET is more uniform than previous regime, less lobbying and extra gain at same average level of protection • By coordinating their policies CU members gain power and hence may be tempted to use it. • Large countries usually dominate (e.g. Brazil), and since large countries usually have higher protection, the CET may be higher as a result.

 Regionalism and protection towards the outside world : Protectionist pressures in Customs Unions (II) CUs require the creation of supranational institutions. Are these going to increase or decrease protectionist pressures? ● Suppose that tariffs are strategic substitutes in the strategic interactions among blocs (if one blocs increases its tariff, then it is optimal for the other bloc to lower its tariffs ---as quantities in a Cournot game). → Pays to delegate and let the more aggressive member negotiate (but the opposite if tariffs are strategic complements). ► Not clear whether delegation leads to higher or lower tariffs in a CU ► Moreover, since negotiation is a continuous process (repeated game), probably a more aggressive leader will be able to extract better terms because of more credible threats

 Regionalism and protection towards the outside world : Protectionist pressures in Customs Unions (III) Typically (like the EU), a disproportionate influence is given to countries in areas in which they have a vital interest (i.e. to producer interests). So if comparative advantage is at work, over time the powerful sectors should be those that are efficient, thereby reducing protectionist pressures. …But biases towards protectionism still there ► More layers of bureaucracy shift the influence away from voters towards producers. ► with costs of protection more thinly spread and benefits concentrated, bias towards producers and protection.

 Regionalism and protection towards the outside world : Protectionist pressures in Customs Unions (end) ---two institutional failures ► restaurant bill problem (bigger bill when split evenly). Suppose benefit of a policy is proportional to its share in CU output, while costs are proportional to its share in GDP (a tariff which benefits producers at the expense of consumers has this characteristic). Countries around the negotiating table will each press for protection for goods where their share is higher than their GDP share. →All measures are added even though individually each country would have preferred no change. ►Universalism: benefits go to one country (say there are three countries each producing a type of steel: spoils go to the country that gets it, while costs are borne by all. The worst outcome is if protection passes but not for the type of steel you produce…so you back the protectionist measure.

 Regionalism and protection towards the outside world : Lobbying activities in RIAs Examples: Citrus growers in US oppposed FTAA and got 15 years to adjust to NAFTA (among most heavily protected sectors…..) UEMOA CET in 1998: 5% on interm., 10% on capital goods, 20% on consumer goods. …debate led to cement being declared a consumer good!!! Problem for gv’ts : TC hurts the most powerful lobbyists usually in import-competing activities. Brazil wanted free trade in IT for MERCOSUR, but was a holdout on the nearly global IT Agreement of 1996.  see the following model (due to P. Krishna) where trade policy in a three-country world is entirely determined by profits

 Regionalism and protection towards the outside world : Lobbies bias RIAs towards Trade Diversion (TD) Take two countries where oligopolists (making a positive profit) play Cournot. Then producers in A and B might well support an FTA because the gain they would make in each other’s country (notably at the expense of producers in C) would exceed the losses they would make via reduction in market share to firms in partner country …firms likely to support a TD FTA!!!  What about incentives for firms to participate in a MTL after the FTA is formed? Most unlikely as the MTL will be essentially giving market share, and hence profits to firms in C  FTAs can well be a stumbling bloc in the road to reaching multilateral free trade!!!

 Regionalism and protection towards the outside world : RIAs: A new environment for lobbying? Preference dilution effect. One view (see MP chapter 6 is that an RIA has a preference dilution effect because there is more opposition to overcome, more of a free-rider problem, more representatives to influence) Assumption here is that fragmented lobbies face a unified CU government. But what about the opposite? See the discussion in SW pp. 92-3 and the discussion about the growth of lobbying 300 in 1970 to 3000 in 1990) activity in Brussels.  In conclusion much depends on what type of institutions are adopted.

 Application: The CET in the MERCOSUR S-W box 3.3 With its highly non-uniform Common External Tariff—with numerous exceptions—Mercosur is an ideal case study of the role of pressure groups in RIAs It took several years to negotiate Mercosur’s CET, culminating in the December 1994 Ouro Preto Protocol. Each member was allowed an exceptions list and the initial CET applied only to about 75% of the universe of 9,119 tariff lines (table). Left out were capital goods, computer and telecommunication equipment, and automobiles and sugar. Convergence to the CET should be achieved for most goods by 2006; there is no agreement on convergence dates for sugar and automobiles. The Ouro Preto Protocol also established a list of deviations from intra-Mercosur free trade. These were planned to disappear by 2000.

 Application: The CET in the MERCOSUR Olarreaga and Soloaga tried to explain variations and deviations from the CET across 27 industries, using measures of political and interest group activity such as wages, industrial concentration indices, labor/capital ratios, import penetration, intra-industry. Main conclusions:  Sectors where significant trade creation is likely tend to be exempted from internal free trade. Internal free trade is also resisted more successfully by sectors with high employment shares. This reflects government desires to avoid large-scale labor adjustments, and the voting strength and trade union presence of large sectors. High third-country import penetration, which puts competitive pressure on domestic firms, also leads to high protection.

 Application: The CET in the MERCOSUR (end) Political considerations explain 58% of the variation in the CET across industries. The negotiated CET in any sector correlates with the share of capital remuneration in value added in that sector and the share of sector-specific capital in total inputs. If labor is fairly mobile and new firm entry difficult, it is existing capital that receives most of the benefits of protection. They also found a positive correlation with industry concentration: more concentrated industries find it easier to organize lobbying efforts, making them more effective lobbyists. · The CET in a sector mainly reflects the preferences of the member country that has the greatest production in that sector. Thus, Brazil’s preferences are the main determinants of the structure of the CET, as it represents at least 70% of Mercosur production in each of the 27 sectors considered.

Regionalism as politics (See WB chp. 1 SW chp. 7)  An RIA can reduce frictions along several dimensions • Trade can promote peace with secure trade relations reducing likelihood of war and RIAs promote trade…. (see EC case; MERCOSUR emerging from military regimes) • Will Euro-Med help diminish spread of civil disturbance? • Rich countries want to stem migratory pressures from the South. But NAFTA accompanied by decrease in wages of unskilled Mexicans…

Regionalism as politics (c’td)  Regional integration can reduce frictions along several dimensions • Trade can promote peace with secure trade relations reducing likelihood of war and RIAs promote trade…. (see EC case; MERCOSUR emerging from military regimes) • Will Euro-Med help diminish spread of civil disturbance? • Rich countries want to stem migratory pressures from the South. But NAFTA accompanied by decrease in wages of unskilled Mexicans…

 Implementation issues : Rules of Origin (RoO) RoO are necessary to prevent trade deflection (i.e. importing from the low tariff partner in an FTA)  Do you need RoO in a CU? In principle no, but then ALL of trade policy should be common (e.g. in the EU it took 30 years to get there since Article 115 of Rome Treaty allowed contries to keep their NTBs at national level notably in connection with the MFA  RoO were necessary)  But RoO do not prevent indirect trade deflection (i.e. exporting protection as the low tariff partner imports all its consumption needs from ROW while it exports all its inefficient production to the high tariff partner)

 RoO and governance RoO occupy 81 pages in EU’s agreement with Poland and 200 pages in NAFTA • Real problem, especially for low income developing economies as it : • Uses resources (customs officials can spend 25% of their time or more on RoO) • gives opportunity for discretion and bribes  Also a political economy issue as in typical N-S FTA, because it is the Northern country partner that determines the rules (see NAFTA case study below)

 An example of protectionist RoO NAFTA’s RoO for catsup (S-W: Box 3.1) . To Chile’s dismay, the tomato catsup rules changed when CUSFTA evolved into NAFTA. Under CUSFTA, catsup processed out of imported tomato paste qualified for duty-free treatment in internal trade. Under NAFTA rules the tomato paste itself must be produced within a NAFTA member in order for the catsup to qualify for free entry. In 1992, Chile was the leading foreign supplier of tomato paste to the United States, and the US-produced catsup enjoyed free entry under CUSFTA. Mexico and Chile together accounted for over 80% of US tomato paste imports in roughly equal quantities. Under NAFTA, catsup made out of Chilean paste could no longer circulate duty-free, Chile’s share dropped to 5%, with Mexico taking the other 75% -

Figure : Regional Organizations in Southern and Eastern Africa CBICBICBI BIBI COMESA ccOMESA Burundi Rwanda COMESA Djibouti Egypt Eritrea Ethiopia Sudan SADC Malawi Zambia Zimbabwe EAC EAC Kenya Uganda SADC Angola Dem. Rep. Congo Tanzania IOC Comoros Madagascar SACU IOC Mauritius Seychelles Namibia Swaziland Lesotho South Africa Botswana Mozambique Viva la pasta!!!

Two criteria for determining origin: • “wholly-obtained or produced” for agricultural products • “substantial transformation” criterion for manufactures • Components of RoO at the product level: • Change of tariff classification (CTC) • exception attached to a particular CTC (called an ECTC) • Value Content (VC) • Technical requirement (TECH) See variety of criteria used by PANEURO and NAFTA in next slide!

ri index takes a value 1<ri<7 See definition below in NAFTA case study ri=1 (not restrictive) ri=7 (restrictive)

Fig.1 : Physical content RoO and costs K L/K=0 R RoO: 0 1 K= imported inputs from ROW L/K=1 R() = Restricted costs 1/0 L A B O  Economics of RoO (I)

 Economics of RoO (I) This slide explains following figure 2 (from Krishna paper) •  A & B form an FTA, both importing final good from ROW • P* =world price (taken as given). B produces the good at a constant cost CB and has no tariff: tB= 0 • tA = A’s tariff on the import and for simplicity does not produce the good • PA and PB= (=P*=CB) denote domestic prices en A and B; •  With RoO, B firm makes profit (R)=PA - RB() • Without RoO, B firm makes profit (t)=PA - (1+tA) CB (assuming that tariffs are levied on the price which equals domestic cost) • Firm in B will take FTA option if RB()< CB (1+tA)

 Economics of RoO (II) This slide explains following figure 2 (from Krishna paper) • For   0  R()= CB (RoO is not binding and has no additional effect on costs) •  welfare in A increases because area DEFC (CS gain) exceeds area EFGD (loss of tariff revenue) • For  > 0  R()> CB • And for 0 <  < 2 it is still worth it for B to use FTA. However, as   , marginal gains and marginal costs   =3 makes A indifferent, since FGI=KIGD. But beyond that value A loses. • Also note that if B cannot satisfy A, it will get rents which can explain why FTA generates FDI!!

Price A F RB() E CB(1+tA) K I J H C CB D G 3 2 B 0 Quantity Figure 2: Demand, Price and Cost in and FTA

Application: Nafta RoO Map and cost estimates Preferences & utilization rates under NAFTA. 3 main types of RoO in NAFTA (Estevadeordal, 2000). • A change in tariff classification at the chapter (CC), heading (CH), sub-heading (CS) or item (CI) level; • A domestic content rule or a regional value content (RVC); • A technical requirement on product and/or on process (TECH).

Preferences and Utilization Rates (c’td) • Data on US imports from Mexico for 2001 at the HS-6 level of aggregation, 20 sectors, 99 chapters, 3555 tariff lines ; • ui = utilization rate = ratio of US imports from Mexico under US-NAFTA preferential tariffs to total US imports from Mexico; • Tariff preference margin;

Preferences and Utilization Rates (c’td) Estevadeordal’s (2000) observation rule: y = 1 if y ≤ CI y = 2 if CI < y* ≤ CS y = 3 if CS < y* ≤ CS and RVC y = 4 if CS and RVC < y* ≤ CH y = 5 if CH < y* ≤ CH and RVC y = 6 if CH and RVC < y* ≤ CC y = 7 if CC < y* ≤ CC and TECH y* :latent level of restrictiveness of RoO (as opposed to observed level of restrictiveness);

Preferences and Utilization Rates (c’td) Table 1 : RoO map, Preferences and Utilization Rates. All data on RoO refers to percentage of tariff lines subject to the corresponding RoO.

Preferences and Utilization Rates (c’td) Figure 1: cumulative distribution on total sample. Utilization Rates Tariff Preference Rates

Non-parametric Estimates Method of revealed preference as in Anson et al.(2004) but for 2001 data. • For products with ui=100%, τi> ci; • For products with ui=0%, τi< ci; • For 0%<ui<100% . Assumption: firms are indifferent to export to US under NAFTA or MFN regimes. c=τ=6.16% for 2001 [vs. 6.11% for 2000] with τ computed on 0%<ui<100%.

Non-parametric Estimates (c’td) Compliance costs: administrative component, , and a distortionary component : Assumption: administrative costs negligible for firms on their participation constraint (0%<ui<100%) when ri≤2 (values corresponding to CH). Calculating the average preference margins for utilization rates close to 100% (say ui=95%) when ri≤2 gives an upper bound of the distortionary component, or 2000 [2001].

Non-parametric Estimates (End) Summary: averagesfor 2000 [2001]: • Total compliance costs: c =6.11% [ 6.16%]; • Distortionary costs: =4.30% [ 4.44%]; • Administrative costs: Administrative cost estimate for 2001 less than for 2000 (both in absolute terms and in relative terms), as it falls from 45% to 42% of the total compliance costs. Learning!

SESSION IV THE POLITICAL ECONOMY OF REGIONALISM AND IMPLEMENTATION ISSUES