Termites in the Trading System: How Preferential Trade Agreements Undermine Free Trade Author: Jagdish Bhagwati (Review by Parthapratim Pal)

Publisher: Oxford University Press

ISBN: 978-0-19-533165-3

Review by Parthapratim Pal

Jagdish Bhagwati’s new book investigates the phenomena of surging Preferential Trade Agreements (PTAs) among the countries and analyzes how these PTAs undermine the world trading system and what are the possible consequences of this proliferation of PTAs across the world. This book, ‘Termites in the Trading System: How Preferential Trade Agreements Undermine Free Trade’ is a fascinating tale of origin and growth of PTAs and their possible impact on the global trading system. Bhagwati’s unique position as an academic and policymaker allowed him to seamlessly integrate various aspects of PTAs focusing on economic history, political economy, international trade theory and policymaking.

The first two chapters of the book are historical accounts which analyze the genesis and evolvement of PTAs and contain some fascinating facts. For example, Bhagwati shows that the concept of a PTA is older than most of us think. Referring to a speech by WTO Director General Pascal Lamy, Bhagwati points out that the first preferential trade arrangements can be traced back to the commercial treaty between the Egyptian Pharaoh Amenophis IV and the king of Alasia during the fourteenth century BC. This treaty exempted Cypriot traders from customs duties in exchange for the importation of a certain quantity of copper and wood.

In more modern times, the growth of PTAs dates back to the days of the great depression. During the 1930s, most countries “intended to divert limited world demand to one’s goods to reinflate one’s economy” and adopted measures which Joan Robinson famously described as “beggar my neighbor” policies. Countries adopted broadly three sets of protectionist policies during this period. There were competitive devaluation of currencies aimed at promoting exports, increased trade barriers in terms of tariff and non-tariff measures^[1] and widespread adoption of preferential trading arrangements. This led to a massive implosion of world trade between 1929 and 1933.

In the Post World War II period, there was a conscious attempt to revive international trade by general lowering of trade barriers and promoting non-discriminatory trade under the MFN principle. US started off as a strong proponent of non-discrimination whereas the British were keener to hold on to their imperial preference schemes. However, the British economists, led by Keynes gradually reconciled to the fact that multilateral trade based on non-discrimination is better than “bilateral barter and every kind of discriminatory practice”. The move towards a world of freer trade, however, was not without its problems. The proposed third Bretton Woods organization – the International Trade Organization (ITO) – never materialized, as it failed to get ratified by the US senate. The alternate provisional arrangement, the General Agreement on Tariffs and Trade (GATT), was used to carry forward the multilateral trade negotiations (MTNs). Bhagwati highlights that over the years GATT has been successful in significantly reducing trade barriers in manufactures in rich countries. But ironically the seed of the meteoritic rise of today’s regionalism was sowed in a GATT rule. A major exception to MFN principle was allowed in GATT in the form of Article 24 which permitted countries to form Customs Unions^[2] under certain conditions. Bhagwati argues that GATT allowed Article 24 as it was initially anticipated that not many countries would be in a position to use this exception as forming CUs are cumbersome and requires high level of coordination among the member countries. However, as the book highlights, the requirements of Article 24 were gradually relaxed and USA played a major role in this.

USA, which started the post WWII period as a staunch supporter of multilateralism, changed its position to fulfill some of its strategic objectives. Bhagwati gives two such examples, the first one being a secret US-Canada free trade agreement which incidentally never took off. The second objective was to facilitate European integration which was to act as a potential counterweight to the Soviet Union. Article 24 was further diluted during the Tokyo Round of GATT when the ‘Enabling Clause’ was introduced. The ‘Enabling Clause’ was required to legitimize unilateral tariff concessions given to developing countries by the developed countries. However, it also allowed developing countries to form PTAs without having to fulfill any of the conditionalities of Article 24. These loopholes allowed countries to form PTAs without violating WTO rules.

Analyzing the factors which led to the spread of regionalism since the establishment of GATT, Bhagwati concludes that intellectual misunderstanding about the potential costs and benefits of PTAs, eagerness of politicians to sign such agreements and dilution of the requirements of Article 24 led to the wave of regionalism which was seen during the 1970s. The “rush to discrimination” by Western Europe in the 1960s and USA’s increased involvement in regional agreements like NAFTA also helped the growth of PTAs.

There are a number of new elements which further fuelled the proliferation of regionalism in the 1990s. A major role was played by the USA which started signing bilateral trade deals with a number of countries due to various political and economic reasons^[3]. During this period, EU also started seeking preferential trade partners with other countries. Developing countries joined this bandwagon and this led to the massive proliferation of PTAs in the 1990s. One interesting feature of the present wave of regionalism is that both North-South and South-South agreements are on the rise. Bhagwati highlights a number of factors which motivated developing countries to increase their participation in PTAs. According to him, intra-developing country PTAs happen because some developing countries are reluctant to fully liberalize trade vis-à-vis developed countries and prefer to ‘test the water’ only by liberalizing trade with other developing countries. Some developing countries prefer PTAs as it gives them more bargaining power in multilateral negotiations. He also feels that some developing countries may be signing PTAs as possible insurance against a possible failure of the Doha Round.

Bhagwati argues that the motivations are different for PTAs between a developing country and a hegemonic power. As hegemonic powers like US and EU are increasingly getting involved in PTAs with some developing countries, it has prompted other developing countries to seek participation in PTAs with these developed countries as a defensive necessity against a possible exclusion from these markets. Some developing countries also view PTAs with hegemonic powers as a strategic move to consolidate peace and increase regional security. From the point of view of the bigger economic power, or the hegemon, the motivation to favour such PTAs often come from the possibility of pushing many trade unrelated clauses through the PTAs than it is possible under the MTN. This may include labour and environmental laws, stricter patent regimes etc.

As trading within preferential trade blocks does not come under the purview of WTO, there is a strong apprehension that they are weakening the multilateral trading system. To use Bhagwati’s words, “Acting like termites, PTAs are eating away at the multilateral trading system relentlessly and progressively”. To illustrate how pervasive the exception to the MFN clause has become, Bhagwati points out that European Union has MFN tariff rates only for six countries- USA, Australia, New Zealand, Canada, Japan and Taiwan. So the MFN has, in effect, become the LFN or the least preferred nation.

The third chapter deals with the problems of preferential trade agreements. It starts with the issues of trade creation and trade diversion^[4]. Bhagwati suggests that in the context of modern day international trade, the negative effects of trade diversion is likely to dominate over the positive effects of trade creation in PTAs. This is likely to happen because countries operate on a thin margin nowadays and even a small preferential margin can tilt the balance of competitiveness. Secondly, countries can push up their applied tariff rates or introduce administered measures like anti-dumping policies to increase the preferential margins and thereby further exacerbate the problems of trade diversion^[5]. Bhagwati also does not agree with the views of Summers (1991) and Krugman (1991) that the possibility of trade diversion is low if the PTA members are natural trading partners. However, one question which could have also been addressed in this chapter is whether and how do the arguments regarding trade diversion change if one relaxes the assumptions of perfect competition and full employment in an economy. This is important for developing countries as most of them face high unemployment rates.

With a surge in the number of PTAs, there has been an increase in overlapping RTAs where certain rules, especially the Rules of Origin (ROO) are not mutually consistent. Bhagwati argues that such uncoordinated growth of PTAs may lead to a complex system of regulatory structures and preferences where market access for products in one particular country will vary widely depending on their alleged origin. This phenomenon, termed as the “spaghetti-bowl” problem by Bhagwati, will lead to increased complexity and lack of transparency in the global trading system.

This chapter also has a detailed discussion about the tendency of developed countries to push non-trade issues through PTAs. Bhagwati reveals how powerful lobbies from US and the European Union managed to push in the laws regarding intellectual property rights in the WTO framework. Bhagwati warns that similar lobbies, under the patronage of hegemonic powers, will try to force more extraneous or non-trade issues on the developing countries through PTAs. There are some examples given in the book where developed countries have managed to include non-trade issues like stricter patent laws, labour and environmental clauses through PTAs. For developing countries currently negotiating PTAs with developed countries it is also worth pointing out that US has used PTAs to influence completely non-trade issues like capital control. Bhagwati says that this is primarily done to protect the interests of the financial lobby in the USA. It is noteworthy here that John Williamson has also pointed out that after the Asian crisis, PTAs are used by the US treasury to impose non-trade related issues like free movement of capital on developing countries^[6]. Developing countries, in spite of knowing the fact that capital controls are indeed good for the stability of an economy, often has to accept such preconditions because of the pressure from the hegemonic power. Moreover, when a developing country accepts these issues on a bilateral level, it is likely to become difficult for that developing country to resist the same issues on a multilateral platform. This not only helps developed countries push these issues in WTO, but it also has the potential to break the alliance of developing countries in the multilateral negotiations.

This chapter concludes that PTAs, especially the North-South PTAs are not only problematic for developing countries due to the aforementioned reasons, PTAs also affect multilateral trade negotiations by diverting negotiating power and policy focus away from the multilateral trade negotiations. Therefore, PTAs generally tend to act as “stumbling blocks” for the multilateral world trading system.

In the last chapter, Bhagwati examined the possible ways to counter the problems arising out of increasing PTAs. After deliberating different policy options, Bhagwati suggests that increased tariff liberalization through multilateral mechanism will be the best solution to eliminate the menace of PTAs. The logic is quite straight forward. Preferences are difference between MFN rates and preferential rates. If MFN tariff rates are brought down to negligible levels, then it virtually eliminates the preference margin. Though Bhagwati reckons that there may be political opposition to lowering of MFN rates to such low levels, he believes that it is the best way to deal with the “termites”.

This book is a must read for anybody interested in international trade theory and policy. The best part of this book is that along with being very informative and thought provoking, it is also fun to read as Bhagwati has thrown generous amounts of insider tidbits and jokes from the world of academia and policy making. However, a few observations stand out after reading the book. First, the book shows that USA has not been a fair player in the international trade arena. It has changed its positions according to its economic, political or strategic convenience and has used and abused the existing trade laws. Bhagwati’s book indicates that in many cases USA, to help its different lobbies, has repeatedly bend the trade laws and pressurized smaller countries to accept policies which are harmful for them.

Second, the book, willy-nilly, has focused the discussion exclusively on trade in manufactured goods. Discussions on substantive issues arising out of international trade in agricultural commodities and services are almost absent in this book. One way to justify this can be to argue that nature of goods should not change the theoretical arguments in favour of against PTAs. While that is true, we must keep in mind that the choice policymakers are making here is between PTAs and the multilateral trade regime. While trade in manufactured goods has been under the GATT rules since its inception, agriculture and services have been effectively covered only from the Uruguay Round. As a result, agriculture and services segments suffer from much more trade distortions at the multilateral level. Consequently, the actual comparison is really between two second-best situations – a multilateral trading system, which still has major distortions and PTAs which theoretically may offer an inferior solution. It is notable here that it is not NAMA (non-agricultural market access) which is holding up the negotiation in the Doha Round but it is the disagreement regarding distortions in agriculture where the negotiations are stuck. Some more discussion in this book on some of these issues would have been useful from the perspective of developing countries.

Thirdly, the multilateral trade liberalization has not progressed well and there are major concerns among WTO Members regarding implementation related problems of WTO. In many cases developing countries feel that developed country Members of WTO have managed to evade WTO regulations by clever manipulation of WTO rules. As a result, their faith on multilateralism has waned. Because of this dissatisfaction with the WTO and given the problems of North-South PTAs which have been discussed elaborately by Bhagwati in this book, South-South PTAs have merged as particularly useful policy alternatives.

Fourth, some researchers like Akyuz (2005) and Chang (2002) have argued that WTO commitments restrict policy space available to the developing countries and prevent them from adopting domestic and industrial policies used by currently developed countries. Bhagwati clearly highlights that provisions of most North-South PTAs go well beyond the WTO rules and are likely to impose much more restrictions on the developing countries. Interestingly, Bhagwati indicates that these problems are generally absent for South-South PTAs^[7]. Given these advantages of South-South PTAs, these are increasingly preferred by developing countries. As Bhagwati is a strong proponent of multilateralism, he surely has some sound arguments against these apparent advantages of South-South PTAs. It will be interesting to see Bhagwati’s take on these topics.

Finally, Bhagwati uses a version of a skit on Lady Diana’s death found on the internet to describe globalization. It goes as follows:

“An English princess with an Egyptian boyfriend
Crashes in a French tunnel,
Driving a German car with a Dutch engine,
Driven by a Belgian who was drunk on Scottish whisky,
Followed closely by Italian Paparazzi,
On Japanese motorcycles;
Treated by an American doctor,
Using Brazilian medicines.

This is sent to us by a Canadian,
Using Bill Gates ‘s American technology,
And you’re probably reading this on a computer,
That uses Taiwanese chips,
And a Korean monitor,
Assembled by Bangladeshi workers
In a Singapore plant,
Transported by Indian lorry-drivers,
hijacked by Indonesians,
Unloaded by Sicilian longshoremen,
And trucked to you by Mexican illegal”

The form of globalization emphasized by this skit ironically brings out a clear asymmetry between countries. It also shows that globalization may not bring the most desirable outcome for all the countries concerned. Trade liberalization, solely based on comparative advantage, is likely to perpetuate the asymmetry that is quite evident from this ‘witticism’. Bhagwati’s prescribed solution of removing all sorts of trade barriers to tame the ‘termites’ may not address this serious problem.

References:

Akyüz, Yilmaz (2005): “The WTO negotiations on industrial tariffs: what is at stake for developing countries?” RIS Discussion Paper No. 98. Research and Information Service for Developing Countries, New Delhi.

Bhagwati, J. (1993): ‘Regionalism and Multilateralism: An Overview,’ in Melo and Panagariya eds. New Dimensions in Regional Integration, Cambridge University Press, Cambridge.

Chang Ha-Joon (2002): Kicking Away the Ladder. Anthem Press, London.

Krugman, P. (1991): ‘Is Bilateralism Bad?’ in E. Helpman and A. Razin (eds.), International Trade and Trade Policy, Cambridge, Mass.: MIT Press.

Summers, L.,( 1991): ‘Regionalism and the World Trading System’. -Policy Implications of Trade and Currency Zones. Wyoming: Federal Reserve Bank of Kansas City

Viner, Jacob (l950): The Customs Union Issue, Carnegie Endowment for International Peace, New York.

Williamson, John (2006): “Why Capital Account Convertibility in India Is Premature”, The Economic and Political Weekly, VOL 41 No. 19 May 13 – May 19, 2006.

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[1] One example of such policies was the infamous Smoot Hawley tariff act which pushed US tariff rates to historically high levels.

[2] A Customs Union (CU) provides deeper integration than a normal PTA because, unlike PTAs where member countries are free to maintain their individual level of tariff barriers for goods imported from non-member countries, in a CU, member countries also apply a Common External Tariff (CET) on a good imported from outside countries. The CET can vary across goods but not across union partners.

[3] Bhagwati, in another paper, says:, “the main driving force for regionalism today is the conversion of the United States, hitherto an abstaining party to Article XXIV.” Bhagwati (1993) Pp. 29.

[4] Viner (1950) introduced the concepts of ‘trade creation’ and ‘trade diversion’ and showed that the net effect of trade liberalization on a regional basis is not unambiguously positive. Viner pointed out that PTAs can lead to trade creation if, due to the formation of the regional agreement, PTA members switch from inefficient domestic producers and import more from efficient producers from other members of the PTA. In this case, efficiency gains arise from both production efficiency and consumption efficiency. On the other hand, trade diversion takes place if, because of the PTA, members switch imports from low-cost production in the rest of the world and import more from higher-cost producers in the partner countries. Trade diversion lowers welfare of not only the partner countries but the rest of the world also.

[5] Article 24 requires that external tariff cannot be raised when forming a PTA. This ensures that non-members are not harmed. However, all WTO rules are based on the ‘bound Tariff rates’. The actual tariff rates imposed by countries (which are called the applied tariff rates) are often lower than the bound rates. So the WTO Members cannot be prevented from raising their applied tariff rates as long as these rates are below the bound rates.

[6] Willianson (2006) says: “When countries wanted to negotiate bilateral free trade agreements with the US, they found the treasury insisted that US negotiators demand that the partner country should commit itself to never reimposing effective capital controls for any length of time”. Pp1848.

[7] Bhagwati, in this book, says “it is noteworthy that PTAs among poor countries are almost never characterized by the inclusion of such trade-unrelated issues. They concentrate exclusively on trade liberalization. It is only when hegemonic powers… are involved that one finds the inclusion of such extraneous matters.” Pp72.