Evaluating Regional Trade Agreements: Deep and Shallow Integration

1. Evaluating Regional Trade Agreements: Deep and Shallow Integration David Evans Peter Holmes Michael Gasiorek Tomek Ivanow Leo Iacovone Karen Jackson Sherman Robinson Jim Rollo February 2006

2. Evolution of the World Economy since the 1960s and Implications for Policy Orientated Research

3. RTAs in Force by Year of Entry

4. An RTA that considers only border protection measures is described as involving only “shallow integration”. Such an RTA generates “trade diversion” as countries within the bloc trade more with one another and less with potentially lower-cost countries outside the bloc, which will potentially lower welfare within the bloc. The lower barriers also generate new trade, or “trade creation,” which should be welfare enhancing. Whether the RTA is net welfare increasing or decreasing depends on the relative strengths of these two effects, and requires empirical analysis to determine the outcome • Most of the new wave of RTAs have involved much more than removing border policies that limit the sale of commodities across international borders. The analysis of these new RTAs requires consideration of the elements of “deep integration” they incorporate, and what is their potential effect on trade and welfare.

5. What are the empirical characteristics of these new RTAs that distinguish them from earlier “shallow” RTAs? • To what extent do the elements of “deep integration” incorporated in new RTAs lead to economic impacts of the RTA that go beyond the “gains from trade” considered by standard trade theory? • Can we draw on insights from recent work on “new trade theory”, on “Smithian trade induced division of labour” and on “new regionalism” to analyse these new RTAs? • In particular, are there elements of “deep integration” that generate links between expanded trade and productivity growth? • What are the major knowledge gaps, both empirical and theoretical, that need to be addressed for better analysis of new regionalism?

6. TRENDS IN REGIONAL INTEGRATION: 1960-1990. • The analysis of historical trends in regional integration is based on e method used to find trading take a 3-year average of imports and exports from the UN COMTRADE data for each of 67 trading regions for the 1960s, 1970s, 1980s and 1990s. The data were aggregated into three-year averages of export and import shares centred on 1967, 1977, 1987, 1997. • A mathematical clustering technique was used to analyse the data to find regional groupings or trade blocs that maximise the trade flows within blocs and minimise the trade flows between blocs. • The bloc memberships for each period are given in tables below, and a summary visual representation of the changing patterns of regionalisation is shown in Figure 1, which also includes charts showing average trade shares between blocs.

7. 1. The 1960s: Europe and the US in a bipolar world

8. 2.The 1970s: Restructuring world trade

9. 3. The 1980s: Consolidation

10. 4. The 1990s: Consolidation and diversification

11. Figure 1. Emerging Patterns of Regionalisation Summarised

13. This historical analysis: RTAs in three categories: • Bloc formation agreements. Examples include the European Union (EU), NAFTA, and Mercosur. In the case of South Africa, the regional customs union SACU (consisting of South Africa, Botswana, Lesotho, Swaziland, and Namibia) was originally formed in 1911. With the opening of South Africa, and increased trade in the region, SACU has become potentially more important as a focus of trade expansion. • Bloc expansion agreements. The major example is expansion of the European Union to include new members in its periphery. The proliferation of regional agreements between the EU and countries in Eastern Europe were clearly part of the process of preparing these countries for integration into the EU, and should be viewed as part of the process of EU expansion. The NAFTA agreement has not been expanded to include new members, but the recent Central American Free Trade Agreement (CAFTA) can be seen as part of the process of consolidating the North American bloc. However, the North American bloc has not yet evolved into deeper integration—for example, there is little discussion of even forming a customs union in the region. • Market access agreements. Most of the recent trade agreements under discussion, many of them involving bilateral agreements between either the US or EU and particular developing countries, are not part of expansion of an existing bloc, but instead are designed to provide additional access to markets.

14. Typology of Trade Blocs

15. Level of development of RTA members:

16. The standard arguments for gains from RTAs: Shallow Integration • potential gains from RTAs, are from the Ricardian and Heckscher-Ohlin (H-O) theories of comparative advantage. Ricardian gains from trade arise because of between-country differences in technology, whilst H-O theory points to between-country differences in factor endowments.

17. Sources of Gain from New Regionalism and RTAs: Deep Integration • technology and knowledge transfers, and technology diffusion, especially from developed countries to developing countries, that increase productivity, • dynamic comparative advantage and “learning by doing” efficiency gains through increased demand from expanded trade, • elimination of wasteful rent seeking activities through trade liberalization, • pro-competitive gains from increasing import competition in an environment of imperfect competition, allowing exploitation of potential economies of scale in production, • increased geographical dispersion of production through trade that supports (1) exploitation of different factor proportions for parts of the production process (Ricardian efficiency gains) and/or (2) local economies of scale through finer specialization and division of labour in production (“Smithian” efficiency gains). • increased foreign direct investment that carries with it advanced technologies and hence increases in productivity, • “challenge-response” increases in efficiency through increased competition due to expanded involvement in world markets, • Schumpeterian innovation and “creative destruction” induced by increased competition arising from expanded trade, and • externalities and productivity

18. Estimating Gains • Multi-country CGE model studies of shallow integration in many RTAs found that trade creation dominates trade diversion, with static welfare gains of 1-2% of GDP. • Asymmetric hub-and-spokes eg CGE model of Egypt-EU FTA give different results: • Trade diversion in EU-Egypt RTA dominates. • Welfare loss for Egypt over 1% of GDP, except in the presence of... • significant trade-productivity links • concomitant unilateral MFN tariff reductions

19. Implications for Trade and Poverty • Not much in links of poorest to global economy unless producers have access to world markets ie do not produce nontraded goods • Where global economic links are via shallow integration gains likely to be small • Not much deep integration of poorest producers into global economy

20. Implications for empirical work on trade and poverty • More modelling of shallow integration has limited role except where initial trade barriers high and where issues of trade creation and diversion important • Micro work on trade and poverty links and deep integration is were the action is. Formal modelling only useful where good econometric estimates of trade-productivity links. • Negotiation of institutional change to facilitate deep integration more likely at RTA rather than WTO level