Singapore Economic Review Conference 2009 Free Trade and the WTO by Peter Lloyd

Theme I want to address a set of issues which is fundamental to the future of the world economy, namely, restrictions on cross-border access to world markets for goods and services. The global economic crisis has shifted attention away from these negotiations but arguably they will have as much effect on the world economy as the pace of recovery from the global economic crisis.

Singapore is a suitable location Singapore is a good place to review these issues. It has been a duty free port for almost all of the time since it was established as the Straits Settlement in Today Singapore production is more integrated into world production chains than that of any other economy. It has evolved from an entrepot economy to a Southeast Asian hub with goods passing through as part of a regional production chain, facilitated by services trade and organised by multinational corporations (see Hoon and Ho, 2001).

Free trade is best The unanimous view of trade economists today is that free trade is the best policy for a small price-taking economy. Departures from free trade reduce national welfare. We are all familiar with this story. I want to argue that we still substantially underestimate the gains from trade liberalisation. There are two major reasons for this.

Intra-industry trade Intra-industry trade has been steadily increasing and spreading to all parts of the world economy. Brülhart (2008) calculated that, in 2006, it accounted for 44 per cent of global goods trade. Current cge models and other methods of calculating gains underplay intra-industry effects by using the Armington Assumption. New trade theory shows a variety of other effects – increased product variety and quality, economies of scale and agglomeration. The New New trade theory of Melitz (2003) introduces further gains due to the exiting of low productivity firms and other firm level adjustments.

Trade liberalisation increases growth rates New Growth theory shows that trade liberalisation accelerates the rate of growth of liberalising economies in several ways: increased savings rates, lower costs of capital and intermediate inputs, more productive R& D, etc. Empirical evidence is remarkably consistent across countries. Holding other growth-inducing factors constant, a 1 percentage point increase in the growth of exports is associated with a 1/5 percentage point increase in real GDP per capita.

Trade is the engine of world growth Higher growth in single economies lifts the growth rate of other countries through increased demand for imports, improved technologies and other mechanisms. These growth effects of trade liberalisation have been the main explanation of the record rate of growth of aggregate world GDP over the last 25 years.

Progress towards free trade in the GATT/WTO era Cross-border trade in goods and services has become much freer in the GATT/WTO era, though it is difficult to get comparable series for many countries. Figure 1 shows a series of the (unweighted) average tariff rates of 35 countries over the long period 1870 to 1990s. Figure 2 shows times series of average tariffs rates in the US and Australia over the last 100 years. Figure 3 shows the nominal rate of assistance to farmers in high-income and Developing economies.

Figure 3. Nominal rates of assistance to farmers

Regionalism Regional free trade agreements (RTAs) offer an alternative route to trade liberalisation. In the limit, if all pairs of countries signed RTAs that completely freed trade, there would be global free trade. Everyone knows of the rapid spread of regional agreements since the early Medvedev (2006) estimates that on average in 2002 countries have signed five agreements each. The number must now be six each.

How important is regionalism? Some economists argue that regionalism is less important than indicated by the rapid increase in the number of agreements. The usual approach is to estimate the share of world trade which takes place between countries that have signed an RTA. (Medvedev, 2006) estimates this is 32 per cent. After allowing for tariff lines which have zero MFN rates, the share of world trade which is subject to preferences fall to 22 per cent. After allowing for non-satisfaction of strict Rules of Origin requirements, the share falls further to per cent.

Preferences are important! This calculation underestimates the importance of regional preferences. First, where a preferential rate exists, we should look at the share of trade which is distorted. This may be all trade in the item, not merely the trade entering at the preferential rate. Second, tariff lines with zero MFN rates are predominantly imports of intermediate inputs. This trade increases the effective rate of protection of the goods which are produced and subject to positive preferences. Preferences are important! What, therefore, should we do about regionalism?

The gainers To answer this question, we need to know who are the gainers and losers? Countries that participate in RTAs have gained from trade discrimination with few if any exceptions. The costs of trade diversion have been exaggerated. This is borne out by cge studies. We need also to add in all of the features of RTAS that go beyond goods and services trade - freeing trade in capital and business labour, greater security of investments and protection of IP, etc.

The losers The losers are countries outside the agreements. They lose because of negative terms of trade effects as demand for their exports generally falls. Developing countries participation in RTAs has, as a generalisation, pushed import costs towards world prices and has improved their access to world major markets less than that of Developed countries. A few such as Mexico and Chile and the East European countries have benefitted greatly. The Least Developed countries have benefitted least. This does not mean that that Developing Countries as a group have lost from regionalism. For most of them, it means that they have gained less than richer countries.

Changing WTO rules re RTAs How can the WTO rules be changed to increase the gains and reduce the loses from trade discrimination? There is one key change. The present rules, under Article XXIV, require for a free trade area that …the duties and other regulations of commerce…shall not be higher or more restrictive than the corresponding duties and other regulations existing in the same constituent territories prior to the formation of the free trade area. This needs to be amended to require a reduction in tariff rates and other trade restrictions applying to MFN trade. Unfortunately, no one has found a simple operational rule that would eliminate losses to outside countries.

Multilateralising regionalismMultilateralising regionalism Much of the recent discussion has taken place under the banner of multilateralising regionalism. This catchphrase covers a number of ideas, including the coalescence of existing RTAs into bigger RTAs (an Asia-Pacific Community?) and extending cumulation provisions in Rules of Origin. But it is a self-contradiction. The only true multilateralisation of preferences occurs if MFN rates are lowered to Preferential rates. The only precedent here is ASEAN after the extension of preferences in AFTA.

New rules for PTAs The WTO could, if it wished, change the rules relating to the establishment of RTAs. But it has shown no desire to do so. I suggest two simple changes that would increase the net benefits of RTAs: A waiver of ROOs in RTAs when partners MFN tariff rates are identical or differ by, say, 2-5 % A waiver of ROOs in RTAs when partners MFN tariff rates are identical or differ by, say, 2-5 % A requirement that all preferential rates be zero. This would reduce trade costs due to multiple tariff rates. A requirement that all preferential rates be zero. This would reduce trade costs due to multiple tariff rates. These changes could be done unilaterally by participating countries. The best step the WTO could take to reduce the costs of trade discrimination is to succeed in the Multilateral Trade Negotiations.

Advancing the MTNs at the WTO The current Doha Round negotiations have stalled. This has led to a lot of soul searching inside and outside the WTO. Some economists have suggested the WTO concentrate on safeguarding its rules and the world rely on unilateral liberalisation to lower trade barriers. But unilateral liberalisation has always been selective; the US, EU and Japan have rarely cut tariffs unilaterally, and it has been more focused on tariffs than ntms. Moreover, we need multilateral reductions in trade barriers to reduce the impact of preferences in RTAs, and to tighten rules in areas such as subsidies, government purchasing and anti-dumping action.

Causes of Negotiation Failure After the July 2008 failure, the Director-General outlined the negotiation problem in the following terms: Three principal constraints today represent a challenge to our work: the first is the bottom-up approach, under which members must themselves always take the lead in tabling negotiating proposals and compromise solutions; the second is the concept of a single undertaking, which implies that in a round of negotiations with 20 different topics, nothing is agreed until all is agreed; and the third is the decision-taking by consensus, which is reasonably close to unanimity. The first allows Member governments to pursue their own objectives which are generally mercantilistic, pushing for improved export access and resisting all attempts to lower their own import barriers. The last two give a veto to those members who do not agree with a result in any area. These three features operating together have made negotiations very difficult in many areas.

Some suggestions Abandoning the Single Undertaking in negotiations Abandoning the Single Undertaking in negotiations Reviving the critical mass modalities used in the ITA and services agreements after the Uruguay Round Reviving the critical mass modalities used in the ITA and services agreements after the Uruguay Round Using the modalities and formulae of the Uruguay Round Using the modalities and formulae of the Uruguay Round Confining negotiations to OECD and larger trading DCs, giving other DCs and all LDCs a free ride. Confining negotiations to OECD and larger trading DCs, giving other DCs and all LDCs a free ride.

A fundamental problem The WTO lacks a clear objective and, because of this, it lacks a vision of where it is heading. The Preamble to the Marrakesh Agreement has two objectives: reciprocal reductions of tariffs and other barriers to trade and eliminating trade discrimination. The WTO has failed abysmally to pursue the second of these. The first is vague and has led to directionless incrementalism. The lack of progress in MTNs means that trade liberalisation in the world economy at present depends on regional actions, which the WTO is supposed to eliminate, and unilateral actions, which are outside its control and diminishing.

A new objective The WTO desparately needs a new objective. It should, in my opinion, adopt the objective of free trade. This implies the removal of all border measures that restrict trade. As well, free trade is non-discriminatory trade.

Developing countries too This objective should apply to all members, Developing Countries and Developed Countries alike. One of the bad features of the Doha Declaration is the interpretation of Special and Differential Treatment for DCs as less than full reciprocity in reduction commitments, or LTFR as it known in WTO-speak. Simulations done by the World Bank, using cge models, show that proposed WTO scenarios would benefit DCs to a greater extent than the Developed Countries, and most of the gains come from cuts in their own border barriers rather than improved export market access.

Concluding remarks Adoption of a clear objective of free trade is not going to happen in the foreseeable future. Economists have won some of the battles in the cause of free trade in many countries but they have not yet won the war. Meanwhile trade discrimination is increasing and multilateralism has stalled. Agur (2008) explains both trends in terms of the increase in the US trade deficit from around 1 % in early Nineties to more than 6 % of GDP.

Thus, the present international trade environment is mixed. The WTO has succeeded in holding trade restrictions in the global economic crisis period at almost where they were (cf the Great Depression) and the DSP has contained trade disputes. But the failure to maintain multilateral trade liberalisation is switching off the engine of growth in the world economy. The job of trade economists is to persist with analyses of the obstacles to trade liberalisation and proposals to accelerate the movement to free trade.