1

PROLIFERATION OF PREFERENTIAL TRADE

AGREEMENTS AND ITS IMPACT ON

EXCLUDED COUNTRIES

By Aditya Satpute,1

1 Satpute, Aditya (aditya@iift.ac.in), International Trade Consultant, currently working as a Legal Research Fellow at the Centre for WTO Studies, New Delhi

2

List of abbreviation

ACP Africa, Caribbean and Pacific

BRIC BrazilRussia Indian China

CARICOM Caribbean Community and Common Market

EBA Everything but Arms

EC European Community

EU European Union

FTA Free Trade Agreement

FTAA Free Trade Area of the Americas

GATT General Agreement on Tariff and Trade

GSP Generalized System of Preference

GOI Government of India

OECD Organisation of Economic Cooperation andDevelopment

PTA Preferential Trade Agreement

ROW Rest of the World

RTA Regional Trade Agreement

SAARC South Asian Association for RegionalCooperation

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SACU South Africa Custom Union

SADC South Africa Development Community

SAFTA South Asia Free Trade Agreement

WTO World Trade Organisation

I. Introduction

In the period 1948-1994, the GATT received 123 notifications ofRTAs, and since the creation of the WTO in 1995, over 300additional arrangements covering trade in goods or services havebeen notified.2 The rise in range of PTAs once formation of WTOappears contradictory to purpose of WTO, as an establishment tooversee, extend and harmonise the multilateral system of trading.However, it’s typically argued that PTAs will really support theWTO and additional its purpose. The argument goes show that PTAs

2World Trade Organisation, ‘Evolution of Regional Trade Agreements in the world,1948-2011’Available athttp://www.wto.org/english/tratop_e/region_e/regfac_e.htm#rtas(accessed on June 12, 2011)

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has facilitated the groups of countries to negotiate rules andcommitments that transcend this multilateral framework. Theemergence of RTAs is seen a most popular route to push foraggressive liberalisation, given the slow progress onmultilateral trade negotiations.

Given the rapid proliferation of PTAs the aim of this text is toassess the impact of PTAs on excluded countries, with specialreference to potential EU-India FTA. Such an analysis helps toidentify the scope and impact of PTAs on excluded countries. Thearticle will attempt to determine and suggest some policymeasures that excluded countries can take in order minimiseeconomic impact, if any.

Section II of the article reviews the literature on existing PTAsand their impact on excluded countries. Section III provides thebackground of EU-India FTA3 and its impact on excluded countriesas well as those countries that are currently profiting frompreferences provided by EU and India under varied arrangementslike GSP and EBA. Section IV describes the approach ahead for theexcluded countries as a selection between unilateralism,regionalism and multilateralism. Section V analyses the role ofWTO in regionalism and recommends a proactive role for theorganisation to safeguard excluded countries and supply legal andeconomic support to countries with restricted resources, toaccess economic impacts of recent proliferation.

II. Review of Literature

3 For the purpose of analysis it is assumed that all tariffs on mutualEU-India trade are reduced immediately to zero and the trade only interms of goods is considered, effect of liberalisation of trade inservices is not analysed.

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The literature on PTAs, beginning with Viner’s4 analysis of CUand continuing nowadays, emphasises that the positive andnegative effects of PTAs arise from two factors ‘tradecreation’and ‘trade diversion.’ A PTA is considered beneficial ifthe terms of trade created outweigh the terms of trade diverted.As a matter of logic, the trade and welfare created throughpreferential treatment extends solely to the countries within thePTAs, the very fact is doubtless to be true for the countriesthat stay outside the PTAs. ‘For them trade creation is basicallyirrelevant, whereas trade diversion represents a loss5.’

The majority of study that analysed the prevailing andprospective PTAs shows a negative impact on countries excludedfrom such preference. The support for the hypothesis that PTAshave negative impact on excluded country is found in the work ofWinters and Chang6, that examined the price effect of Spanishaccession to the EC in 1986 on the exports of major excluded OECDcountries. As Spain offered preferential access to EC suppliers,US pre-tariff export prices to Spain fell relative to those ofthe EC member states. The part of falling US prices, recommendthat the PTAs have adverse effect on the excluded country. Anadditional comprehensive study was conducted by Chang andWinters7 to examine the ex-posteffect of MERCOSUR on excluded

4 Viner, J. (1950), ‘The Customs Union Issue’, New York: Carnegie Endowmentfor International Peace.

5 Deardorff, A. V. and R. M. Ster (2005), 'Globalization’s Bystanders: DoesTrade Liberalization Hurt Countries that Do Not Participate’, Research Seminar inInternational Economics, Working Paper 529, University of Michigan.

6 Winters, L. A. and W. Chang (2000), ‘Regional Integration and Import Prices: AnEmpirical Investigation’, Journal of International Economics51, 363–77.

7 Chang, W. and L. A. Winters (1999), ‘How Regional Blocs Affect ExcludedCountries: The Price Effects of MERCOSUR’, Centre for Economic Policy Research,Discussion Paper Series, no. 2179.

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countries. To analyse the effect the authors compared the USexport prices to Brazil relative to US export prices to othermarkets, as well as relative to those of Argentina exports toBrazil. The comparison made it clear that US firms had discountedsales to Brazil, incurring loss of $600 million annually in termsof trade.

The work of Kemp and Wan8, the so called Kemp-Wan theorem howeverpresent contradicting dictum.The study concluded that CU couldn’tbe designed to impact excluded country whereas at identical timeis welfare-improving for members. Extending the Kemp-Wan theoremto PTAs Panagariya, and Krishna9 noted that in contrast to CU, inFTAs domestic price differ as member specific tariff concessionare provided so in economic terms marginal rate of substitutionthat’s the rate at which a consumer is prepared to relinquish onegood in exchange for another good whereas maintaining theidentical level of utility isn’t equal amongst partner states. Aneconomist would argue prices rely on wages and profits and vice–versa but their study shows that if member countries with in FTAsimported the identical quantities from ROW in the post-FTA asbefore, then the FTAs may well be designed to be neutral for theROW, at identical time welfare improving for members. Theanalysis rests on the belief that as FTAs drives demand fromexcluded countries to included countries; the prices commandedformer is probably going to decline.

The work of Francois, McQueen and Wignaraja10 which analyses EU’sPTA with 5 of its trading partners (Chile, Mexico, South Africa,

8Kemp, M. and H.Y. Wan (1976), ‘An elementary proposition concerning the formationof customs unions’, Journal of International Economics 6, 95–97.

9Panagariya, A. and P. Krishna (2002), ’On Welfare-Enhancing Free Trade Areas’,Journal of International Economics 57(2), 353-367.

10 Francois, J., M. Mcqueen and G. Wingnaraja (2005), ‘EU-DevelopingCountry FTA’s: Overview and Analysis’,World Development, Vol.33, No.10.

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Egypt and MERCOSUR) considering varied economic indicators. Theanalyses show most FTA partners have the benefit of theagreement, the EU edges estimated to be within the range of $9.1billion annually. The study recorded welfare losses for ROW, aswell as countries like Botswana, North Africa and Middle East. Ina specific study conductedby McDonald and Walmsley11 to establishthe impact of EU-South Africa on Botswana and remainder ofSADCconfirmed the welfare losses for quantity to $71.5 millionand $14.2 million respectively. In another work by of Brown,Kiyota and Stern12predict the effect of perspective FTAA. Thestudy found the potential agreement to be trade diverting formost of ROW, with a welfare reduction of $9.3 billion annually.

Against this background, if EU-India agreement achieves importantliberalization between them, a strong likelihood that it willhurt excluded countries cannot be denied.

III.EU-India Broad-Based Bilateral Trade andInvestment Agreement

A. Background

Annual trade between India and the European Union was around €84billion in 2009-10. India ranks eighth on the EU’s list of major

11 McDonald, S. and T.L. Walmsley,(2003), ’Bilateral Free Trade Agreements andCustoms Unions: The Impact of the EU Republic of South African Free Trade Agreement onBotswana’, Centre for Global Trade Analysis, GTAP Working Paper No. 29.

12 Brown, D.K., K. Kiyota and R.M. Stern (2005), ’Computational Analysis ofthe Free Trade Area of the Americas’, North American Journal of Economics andFinance 16, 153-185.

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trading partners. The EU accounted for 20.2% of India’s exportsand 13.3% of imports13.

India has pursued a policy of bilateral and regional agreementwith neighbours in South and Southeast Asia since 1975, butremained largely inactive. Recently India perceives a policy toenter into trade agreements with wider cluster of Asian anddeveloped countries14. The 2005 agreement with the Singapore isseen as most comprehensive and a possible model for futureFTA’s15.

As a part of the ‘Global Europe’ initiative, the EU has initiatedtalks with massive and rapidly growing markets around the world.EU-India FTA is a part of the new market strategy aimed at risingtrade powers16.

The agreements can boost EU exports to India by 56.8% and Indianexports to EU by 18.7%. Biggest gain for EU would come fromindustrial and manufactured goods to India (a 50% increaseworth€5.1 billion), India would gain from textiles and clothing goodsto EU (an increase of 46% worth €3.6billion)17.

13 DG Trade (2011), ‘India EU Bilateral Trade and Trade with the World’, Eurostat:Comet Statistics Regime 4.Available athttp://trade.ec.europa.eu/doclib/docs/2006/september/tradoc_113390.pdf(accessed on June 12, 2011).

14 Ministry of Finance, Government of India (2008), ‘India’s Regional &Preferential TradingArrangement’, Economic Survey (2007-08). Available athttp://indiabudget.nic.in/es2007-08/chapt2008/chap616.pdf (accessed onJune 12, 2011).

15 Rollo, J. (2007), 'Spice Route to Europe? Prospects for an India-EU Free TradeArea', Chatham House Briefing Paper 07/02.

16 Evenett, S. J. (2006), ‘“Global Europe”: An Intial Assessment of the EuropeanCommission’s New Trade Policy’, Centre for Economic Policy Research.

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B. Current Standing

The EU-India negotiations for a trade agreement began in June200718. By January 2011, 9 rounds of negotiations had taken placebetween the EC and the GOI however with no substantialadvancement, in keeping with reports,India wants to concludetalks in July, when Indian commerce minister Anand Sharma willvisit Brusselsafter last round of negotiations between the bothsides in the second half of June are concluded19. Given the slowprogress of talks, concerns are expressed that it might not beattainable to conclude FTA negotiations by the target closuredate20. The ambition is to attain elimination of duties on 90% oftariff lines and trade volume within 7 years of the entry intoforce of the agreement21.

C. Impact on excluded countries

17 European Commission (2007), Research shows big potential gains from new EUFTAs. Available athttp://trade.ec.europa.eu/doclib/docs/2007/april/tradoc_134543.pdf(accessed June 12, 2011).

18 European Commission (2007), EU and India hold bilateral discussions on new tradeand investment agreement. Available athttp://trade.ec.europa.eu/doclib/docs/2007/june/tradoc_135124.pdf(accessed June 12, 2011).

19Livemint : The Wall Street Journal (2011) ‘India looks to complete talks ontrade pact with EU in July’, May 26 2011.Available athttp://www.livemint.com/2011/05/26005933/India-looks-to-complete-talks.html?h=B(accessed June 12, 2011).

20 Khorana, S., N. Perdikis and D.K. Das (2008), ‘Convergence between theEU and India: Trade Implications for the UK and India’. Available athttp://www.icrier.org/pdf/Background%20Note.pdf (accessed June 12,2011).

21High-Level Trade Group(2006), ‘Report of the EU-India High Level Trade Group’,Report of EU-India Summit. Available athttp://trade.ec.europa.eu/doclib/docs/2006/september/tradoc_130306.pdf(accessed June 12, 2011).

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The impact of PTAs on excluded countries will arise in twocircumstances; the primary impact is the trade diversion effectthat happens when non-preferential imports are replaced bypreferential imports. The second impact arises through trade re-orientation that happens when imports from preferential partneris re-oriented to a replacement preferential partner if it’s moreeconomical in manufacturing the given good. For example, if underEU-South Africa trade agreement preference is granted to SouthAfrica with regard to given goodsfor which Indiamay be a leastcost producer,the EU-India trade agreement would change thedirection of given goods in favour of India, albeit it isbeneficial to EU, it can still be harmful to South Africa.

D. Trade Similarities with excluded economies

For effective assessment of impact, it’s helpful to examine thetrade similarities of excluded countries with Indian in EU marketand EU in Indian market. TableI. based on Finger-Kreinin(FK)index, construed by Winter’s and others22investigate the degreeof similarity. The FX index ranges between zero (no similarity)and one (identical).

TableI. Similarity of composition in trading structures (2004)

Country/region EU market: Indianmarket:

Similarity with India Similarity withthe EU

1 2 3 1 2 3

Bangladesh 0.179 0.173 0.000 0.020 0.020 0.020

22 Winters, L. A., M. Gasiorek, J. L. Gonzalez, P. Holmes, M. M. Parraand A. Shingal (2009),‘ Innocent Bystanders: Implications of an EU-India Free TradeAgreement for Excluded Countries’, Commonwealth Secretariat, London.

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Bhutan 0.046 0.038 0.0000.003 0.003 0.003

Nepal 0.138 0.126 0.000 0.033 0.033 0.033

Pakistan 0.259 0.241 0.200 0.031 0.031 0.031

Sri Lanka 0.269 0.180 0.1520.072 0.072 0.072

Brazil 0.161 0.105 0.0460.085 0.085 0.085

China 0.247 0.205 0.1060.242 0.239 0.239

Russia 0.073 0.039 0.0080.095 0.094 0.094

South Africa 0.122 0.070 0.0120.074 0.073 0.073

CARICOM 0.101 0.074 0.001 0.029 0.029 0.029

Central Africa 0.037 0.018 0.000 0.043 0.043 0.043

Pacific-EPA 0.031 0.013 0.002 0.010 0.010 0.010

SADA (less South Africa) 0.044 0.023 0.001 0.025 0.025 0.025

West Africa 0.056 0.034 0.001 0.031 0.031 0.031

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Source: Winters and others, 200923 (Computed using Comtrade)

In the first column we discover a maximum FK of 0.269 for SriLanka followed by Pakistan (0.259) and China (0.247). In thesecond column India and EU faces a positive tariff in eachother’s market, trade can receive a competitive boost from FTA.In the third column India, EU and excluded countries currentlyface positive tariff. Exports to EU market from India andexcluded countries don’t seem to be similar as a result of inprinciple exports already enters EU duty-free area under EBA (asin case of Bangladesh) and alternative extended preferences. Incase of exports to India from EU and excluded countries all 3columns seen to be similar as a result of India has extended onlya few preferences to countries in 2004.

E. Effect of Potential EU-India FTA

1. The SAARC countries would be the foremost prone to negativeimpacts from the FTA either because of trade diversionand/or trade orientation. SAARC countries notablyBangladesh, Pakistan and Sri Lanka are most exposed to theEU market, their exports are similar to India and that theyare more dependent on Indian market. In the Indian marketBhutan and Nepal, which are granted some preferences underSAFTA, would be in direct competition with EU, if the formsof product are similar, as EU would receive huge advantageof tariff reduction of almost 20 per cent24 from FTA

2. The tariff preference for India under FTA is relativelysmall as EU tariff are already low. The BRICS, excludingIndia won’t be largely affected within the EU market but

23 Ibid.

24supra N 14.

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they might face increased competition from EU supplierswithin the Indian market, the country that might be worsthit from the Indian preference granted to the EU would beChina. The BRICS will generally experience trade diversion.

3. The ACP countries currently receives preference from EU,extending preferences to India through FTA would causepossible trade re-orientation because Indian is a developingcountry with effective supply chain. On the other hand EUobtaining enhanced access to Indian market could lead totrade diversion.

In a far-reaching study conducted by Winter’s and others25

predicts Pakistan to be most affected because it can faceincreased competition from India in EU market, nearly 20 per centout of 78 per cent of its exports to EU may well be prone to somesort of diversion. With regard to BRICS (excluding India) theaffected trade might range from 11 per cent to 28 per cent ofexports to EU. The exports from ACP countries would be leastaffected. In the low income developing country categoryBangladesh and Maldives may well be doubtless most severelyaffected as 97.5 per cent and 91.7 per cent respectively of theircurrent exports to EU could be subject to increased competitionfrom Indian suppliers.

The terms of trade effect is probably going to be larger onexcluded countries whereIndia is a market leader and receives anoutsized improvement in access within the EU market. Estimates ofthe terms of trade may be sparse however necessary for policyanalysis.

25supra N 21.

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IV. The approach ahead for excluded countries:Unilateralism, Regionalism and Multilateralism

Certain sectors where tariff is high and trade flow is sensitiveto price and competiveness in certain countries could alsoseriously suffer from the EU-India FTA. The comparative advantagegranted by EU-Indian FTA, cannot be reversed by itself. Theexcluded countries ought to accommodate to the new circumstances,the Growth Commission26 prompt some policy measures to adopt acomparatively liberal international trade policy. Sound policy toenhance long run growth prospects,creating a business climatethat’s conducive to investment and innovation, providingaccessible finance at reasonable rate of interest, reliableutility and security of return for effort of risk-taking iscrucial. Availability of skilled labour and versatile labourmarket is additionally necessary to avoid sector shock andsupport movement of labour from uncompetitive to competitivesectors.

The response of the individual excluded countries mightconjointly also involve a WTO dispute against the parties, butimposing GATT’s Article XXIV on the PTAs doesn’t itself guaranteethat the excluded countries won’t be hurt. It is better toidentify attainable issues ahead and endure changes. Countriescan offer unilateral liberalization in Doha round, but noobligation to play reciprocally for developing countries withinthe WTO and effect of Article XXIV it will opt to sell its marketaccess bilaterally. The excluded countries will attempt tonegotiate the PTAs which might cause additional proliferation

26The Commission on Growth and Development (2008).‘The Growth Report:Strategies for Sustained Growth and Inclusive Development’, The World Bank.Availableat http://cgd.s3.amazonaws.com/GrowthReportComplete.pdf (accessed onJune 12, 2011).

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within the multilateral system of international trade. In thisregard it is fascinating to noticeBaldwin’s27, ‘domino theory’.The idea suggests that ‘when one country joins a regional bloc ittriggers a multiplier effect and provides an impetus to the non-participating countries to hunt membership’. Soon gradualaccumulation of PTAs,nearly each country is excluded from nearlyeach PTA andtheir cumulative effect would eventually doubtless tobe in everyone’s disadvantage and the welfare effects - positiveand negative for each successive RTA would also seem to be less.

At the backdrop of the idea, the excluded countries might opposethe regionalism in international trade because it undermines themultilateral framework. Bhagwati28, one amongst the critics ofregionalism says that the PTAs are two faced; they guaranteepreference for members and protection against non-member. Hestress the importance of rule-based multilateral trading system,he argues if regionalism will cause welfare gains then the gainsare even larger from multilateral liberalisation. Another authorKrueger29 worries that institution of the PTAs may producebeneficiaries who would form a political lobby againstmultilateralism.

One could argue, when negotiations on additional multilateralliberalization are blocked, the PTAs allow member countries toliberalize beyond the extent of commitments it will occurmultilaterally. Demonstration of such benefits could in turninduce other countries tosoften their resistance to multilateralliberalization. On the other hand, when trade diversion takes

27 Baldwin, R. E. (1993), ‘A Domino Theory of Regionalism’, Centre forEconomic Policy Research, CEPR Discussion Paper 857.

28Bhagwati, J. (1996), ‘Preferential Trade Agreements: The Wrong Road’, Law andPolicy in International Business 27.

29Krueger, A. (1995), ‘Free Trade Agreements versus Customs Unions’, NBERWorking Paper 5084.

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place as results of the PTAs, those benefiting from diversion cantend to oppose additional multilateral liberalization, as theymight lose their newly-found markets to lower price producers.Excluded countries could play the PTAs game more durablethemselves outside the WTO, in ways that would reducediscrimination and support their own agenda. However,the tradeministries usually are faced with restricted resources and use ofthese resources to concentrate on formation of PTAs coulddistract attention from multilateral liberalization.

As so much the world trading system is bothered (?), regionalismis here to remain. Arguments over the merits of regionalismversus multilateralism are helpful and can continue, however tofoster multilateralism, regionalism should be taken mutuallyapproach forward.

V. Conclusion

Regionalism is here to remain and there’s no going back. Thesefacts are unlikely to alter and so implied that for internationaltrade liberalisation this tangle of trade is best approachforward. The question that arises now could be what role WTO willplay to remodel this ‘spaghetti into lasagne and then intopizza.30’ There’s a heavy threat of WTO’s erosion significantly,at the backdrop of stalemate atDoha trade negotiation round andrapid proliferation of the PTAs. In 1996, the WTO GeneralCouncil created the Committee on Regional Trade Agreements(CRTA). Its mandate is to examine regional groups and to assesswhether or not they are in keeping with the WTO rules. The

30 Bhagwati, J. (2008), ‘Termites in the Trading System : How Preferential AgreementsUndermine Free Trade’, A Council on Foreign Relation Book, OxfordUniversityPress.

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committee is additionally examining how regional arrangements mayhave an effect on the multilateral trading system, and also therelationship between regional and multilateral arrangements.However, the experience in testing reciprocal preferential tradeagreement (PTAs) against Article XXIV is extremely discouraging.So far only one working group could agree that a regionalagreement absolutely satisfied the requirements of Article XXIV(the Czech-Slovak Customs Union).

Since each PTA nearly excludes each member of the internationaltrading community, measuring the consequences of PTAs on excludedcountries is clearly necessary. GATT article XXIV and also theEnabling Clause (and also GATS V) have tried to deal with theconsiderations of the broader WTO membership excluded from thePTAs by stating explicitly that these arrangements ought toarrange to ‘facilitate trade between the constituent territoriesand not to raise barriers to the trade of other contracting parties with suchterritories’. Nevertheless, even though the WTO demand has been metby not raising barriers to goods originating from nonmembernations, it’s accepted that the PTAs can still hurt thesenations. Recent empirical analysis31 has shown that Rules ofOrigin (ROOs) do conjointly act as trade barriers and thus oughtto in principle be subject to the Article XXIV: 5 discipline. TheWorldBank32 report states that ROOs in North–South agreements areadditional(more?) restrictive than in South–South agreements33.

31Cadot, O., A. Estevadeordal, A. S. Eisenmann and T. Verdier (2006),‘The Origin of Goods: Rulesof Origin in Regional Trade Agreements’, OxfordUniversity Press.

32World Bank, (2005),‘Global Economic Prospects: Trade, Regionalism, andDevelopment’, Available athttp://siteresources.worldbank.org/INTGEP2005/Resources/gep2005.pdf(accessed on June 12, 2011).

33Francois, J. F., M. McQueen and G. Wignaraja (2005), ‘EU-DevelopingCountry FTA’s: Overview and Analysis’ -

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Furthermore, the restrictive ROOs, non-tariff measures andsupply-side constrain adopted and implemented by developedcountries limits the gains for developing countries. Analyses ofNorth–South FTAs recommend that an FTA between developing anddeveloped economies won’t extend monumental advantage todeveloping countries34. The restricted gains are of concern fordeveloping countries because PTAs ‘reduce or absolutely take awaypolicy choices and instruments accessible to a developing countryto pursue its development objectives’35. There’s a necessity toset up institution just like the Advisory Centre on WTO Lawspecifically dedicated to North-South and South-South FTAs thataims to permit small-nation officials to assess the economicimplications of specific RTAs. Moreover hub economies just likethe EU, US, who havethe massive legal and economic analyticresources, ought tolend hand to small countries with restrictedresources at the negotiating table.

Overall the literature presents mixed proof on the consequence ofintegration for partner countries. On the one hand, the WorldBank36 finds that a trade agreement between countries results inwelfare gains (from trade creation) for the country that’s at a

“It should also be noted that the combination of restrictive rulesof origin with bilateral cumulation reinforces the "hub and spokeeffect" of the agreements, reducing the overall gains from tradeand concentrating them in the EU.”

34Polaski, S.A., S. Ganesh Kumar, M.P. McDonald and S. Robinson(2008),‘India’s Trade Policy Choices’, Carnegie Endowment for InternationalPeace;Powell, S. (2008), ‘The EU-FTA: Initial Observations from a DevelopmentPerspective’,Traidcraft Exchange, 1–21.

35UNCTAD (2007), ‘Trade and Development Report: 2007,’87–118.

36World Bank (2000), ‘Trade Blocks’,World Bank Policy ResearchReport.Available athttp://www-wds.worldbank.org/external/default/WDSContentServer/IW3P/IB/2000/09/01/000094946_00081805551199/Rendered/PDF/multi_page.pdf

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lower level of development, whereas some consider it as the‘stumbling blocks’ in efforts to liberalise at multilaterallevel37.

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