Economic Determinants of Regional Integration

1. Economic Determinants of Regional Integration Caroline Freund World Bank Geneva November 4, 2010

2. Evolution of Regional Trade Agreements

3. Average Number of Partners

4. Concerns about Regionalism • Unnatural Agreements—Political support centers around trade diverting agreements • Trade diversion • Future Liberalization is at risk

5. When do Countries form Regional Agreements? • Social Welfare—No serious concerns, governments sign trade creating agreements • Political Interests—Governments may sign agreements that cater to specific interests. May be trade diverting and may alter future path of liberalization.

6. Why Preferential? • Multilateral negotiations stalled • Free-rider problem • Competition to multilateral system • Political Interests

7. Trade Diverting Agreements • Grossman and Helpman (1995) Krishna (1998) • Trade diversion yields profit gains, firms want to protect their preferences. • Only diverting agreements formed and reduce incentives for future liberalization.

8. Natural Partners • Trade agreements are formed by countries that are near and trade a lot. • Krugman (1991) shows that when trade costs are low, regionalism is trade creating. • Frankel (1995) regional trade is more than explained by natural factors. • Krishna (2003) estimates welfare effects of 24 hypothetical agreements, neither volume nor geography are good indicators of gains from trade. –however 80 percent of agreements are welfare improving.

9. Natural Partners cont. • Baier and Bergstrand (2004) GE model to determine the country pairs that gain the most from an agreement. • Variables include distance, remoteness, income, similarity of income, comparative advantage. • Variables correctly predict 85% of actual agreements.

10. Outcome • If agreements are formed for political reasons, should observe significant trade diversion.

11. Evidence on Diversion • Little robust evidence of diversion • Magee (2008) • Panel data from 133 countries, 1980-1998 • Country-pair, exporter-year and importer-year fixed effects • Average impact on trade is small—about three percent • Trade creation dominates trade diversion by one order of magnitude.

12. Does Regionalism Alter Future Multilateral Liberalization? World Welfare · Free trade R path I Multilateralism R path II R path IV R path III time Adapted from Bhagwati 1993

13. Building Bloc Theories • Domino Theory (Baldwin 1993)—countries outside the agreement increasingly hurt by discrimination want in. • Juggernaut (Baldwin 2006)—countries learn from liberalization allowing more liberalization. • External Tariffs (Bagwell and Staiger 1999, Freund 2000)

14. Trade Diversion in Partial Equilibrium price StA SA Ptw Pw DB M1 M2 M* imports

15. Trade Diversion in Partial Equilibrium price StA SA Ptw Pw imports M1 M2 M*

16. Endogenous Tariffs • Incentive to reduce tariffs to minimize diversion. • Explains why minimal diversion is observed.

17. Stumbling Bloc Theories • Political economy • Political groups support bilateral negotiations. Once they have preferences they don’t want to lose them (Levy 1997 and Krishna1998). • Lobby switches to international protection (Findlay and Wellisz 1982). • Customs unions • Countries maximize joint welfare (Bagwell and Staiger 1997, Freund 2000)

18. Regionalism and External TariffsEmpirics: Some Analyses, No Concensus • Cross-country studies regionalismis good • Irwin (1993) • Foroutan (1998) • Baldwin and Seghezza (2007). • Preferences lower external tariffs in FTAs • Estevadeordal, Ornelas and Freund (2008) • Calvo Pardo, Ornelas and Freund (2008) • Preferential imports lower external tariffs • Bohara, Gawande and Sanguinetti (2004) • Preferences Less liberalization in Uruguay Round • Limao (2006) • Karacaovali and Limao (2005)

19. Why the Difference? • Limao examines EU and US where tariffs are already low. Diversionary costs less important. • Preferences are North-South and may be for nontrade reasons. • 90 percent of products have preferences.

20. Regionalism and Multilateralism • Mansfield and Reinhardt (2003) more RTAs formed during multilateral negotiations than at other times. • US used NAFTA to push Uruguay Round Bergsten and Schott (1997)

21. Potential Advantages of Regionalism • Negotiations are simpler. • Regionalism allows countries to go much deeper on integration—into behind-the-border barriers. • Because tariff revenue is not involved in some areas associated losses are absent or smaller. • Examples: services, trade facilitation, product standards harmonization, labor mobility, regulatory control, competition policy, investment. • In some cases, non-members may gain.

22. Deeper Integration • Migration and Services offer larger gains • Alesina and Spolaore (2003) economic benefits versus heterogeneity. • Size—public goods, home market effects, redistribution of income • Costs—national policies less satisfactory to more people. • These issues are clearly highlighted in EU • Schengen, Turkey, Euro • Lisbon Treaty. "We can still have elections, but we cannot use our vote to change legislation in the many areas where the Union is given power to decide.” Danish MEP.

23. Deeper Integration from Fragmentation of Production • Is there a connection between fragmentation of production and regionalism? • Baldwin (2010) points out how it can enhance forces for liberalization. • Yi (2003) highlights effects of tariff liberalization on vertical specialization. • Together there can be a virtuous circle.

24. Ongoing Work: Regionalism study ECA • Did the EU expand vertical specialization? Dos this enhance growth? Does this lead to more synchronized GDP movements?

25. What Should the WTO Do? • Impose restrictions on PTA formation to confirm commitment to free trade. • Bind tariff rates at applied rates, leaving no room for tariff increases following a trade agreement. • Agree to lower multilateral tariffs part of the way with preferential tariffs. • Minimize of Rules of Origin—forcing tariff compression among regions. Allow only one ROO per agreement, not sector-specific ROO. • Redefine North-South Agreements • Preferences from North in response to MFN liberalization from South.

26. Or • Can regions govern themselves? • No jump in tariffs, even where bindings aren’t binding. • If anything, discrimination by product (eg. agriculture) has done more to thwart multilateral negotiations than regionalism has. • Is WTO effort better spent on • Deeper multilateral integration • Expansion

27. Conclusions • Preferential trade agreements are distortionary • Governments choose well when forming agreements • Adjust trade policies to minimize costs • Regionalism may endanger multilateralism • Really, we don’t know, no counterfactual • Future studies can probe this question • A different discrimination may be the problem • Products as opposed to country of origin

28. Future Issues • Better Data--RTA database • Coverage • Preferential tariffs • Rules of Origin—Shame list • Implementation • Benefits from Deeper Integration • IRTS, especially in public goods / institutions • Factor mobility • Home market effects • Fragmentation of Production • Lock-in of Policies • Security

29. Extras…

30. Trade Creation Generally Prevails • Trade Creation • Leamer (1990) 14 countries—trade creation • Srinivasan, Whalley and Wooton (1993) survey. • Gravity literature (Frankel 1997, Lee and Shin (2006). • Clausing (2001) Canada-US trade creation. • Krishna (2003) • Trade Diversion • Yeats (1998) and Haveman Nair-Reichert and Thursby (2003) Carrere (2006)

31. What Should Countries Do? • In 1991 Summers proclaimed that countries should pursue the living “ism”. • Flaw is governments are entering into too many agreements, facilitating discrimination and increasing bureaucracy. • Best strategy is unilateral, multilateral then and only then regional liberalization.

32. Developing Country Concerns • Tariffs tend to be much higher in the South. • Exhaustion of scarce trade negotiating resources. • Dependence on tariffs for tax revenue

33. An Aside on the Models • Endogeneity of tariffs--Common that everything besides FTA is exogenous. • Are gains from FTA so big that ML becomes undesirable? • Do outsiders benefit or lose when an FTA is formed. • Aghion Antras and Helpman (2007) show as long as free trade maximizes governments joint payoff it will be reached. • Ornelas (2008) show RTAs help get closer to free trade. • Customs unions versus free trade areas.

34. Concerns: North-South Agreements • Asymmetric bargaining power, sectors important for south may be left out, eg. agriculture and textiles. • Divide and rule • Break up coalitions of developing countries and impose own agenda, labor, environment, IP, investment, competition policy etc. • Eg. US-Jordan labor, and US- Chile and Singapore Capital controls.