Understanding Free Trade Agreements, Customs Unions, and Trade Dynamics
Understanding Free Trade Agreements and Trade Dynamics
Free Trade Agreement (FTA) or Area: An agreement among several countries to eliminate internal barriers to trade but to maintain existing barriers against nonmember countries. Tariffs (taxes on imported goods) between members are eliminated. Each member country maintains its own tariffs with respect to nonmembers. Such agreements usually do not free all trade immediately; rather, there are typically a number of products for which tariffs are abolished over time, and there can be a small number of products for which tariffs are never abolished or are subject to other restrictions. The principal objective is to develop economies of scale and comparative advantages in order to promote economic efficiency. NAFTA, the China-Costa Rica FTA, and the Chile-Mexico FTA are examples of this level of economic integration.
Customs Union: An agreement among several countries to eliminate internal barriers to trade and to erect common barriers against nonmember countries. In addition to removing tariff barriers among members, members of a customs union adopt common external tariffs to be applied on nonmembers. The harmonization of external tariffs is to prevent trade deflection. MERCOSUR is an example of a customs union.
Regional Trade Agreements (RTAs)
Regional Trade Agreements are reciprocal trade agreements between two or more partner countries to liberalize trade and investment flows with each other. RTAs offer benefits that go beyond trade effects. Countries engage in RTAs for political and economic reasons. RTAs have become a hugely relevant part of the global trading system, especially since the mid-1990s. There are now more than 270 RTAs in effect, and almost all countries in the world belong to at least one. After all, RTAs are extremely complex and encompassing in disciplines.
Four Major Waves of RTAs:
- Sub-regional trade pacts and customs union: Andean Community, CARICOM, Central American Common Market, MERCOSUR
- Free trade agreements in the hemisphere: NAFTA
- Bilateral transcontinental agreements: Chile-Korea FTA, Colombia-Korea, Korea-Peru, Chile-U.S.
- Mega-regional trade agreements: TTP
Trade Creation and Diversion
Trade Creation: is a shift in the pattern of trade from low-cost world producers to higher-cost Custom Union or FTA members. It is also viewed as welfare reducing for the world. It takes place when the lowering of border barriers to a partner in an FTA allows the most efficient supplier to the domestic market, displacing domestic producers. This raises the economic welfare of consumers by more than it depresses the economic welfare of producers, assuming that resources can be redeployed relatively easily.
Trade Diversion: Refers to the expansion in the world price that results from the formation of a preferential trade agreement. It takes place when a partner in an FTA displaces a third-country supplier to the domestic market as a result of the competitive advantage due to preferential removal of trade barriers on the market. The importing country then pays a higher before-tariff price than before the RTA was formed, thus increasing import prices relative to export prices and turning the terms of trade against itself.
Rules of Origin
Rules of Origin: Define whether a good is eligible for duty-free treatment, based on whether it has sufficiently originated in the partner country. These are the requirements that domestic producers or exporters have to fulfill in order to make their products considered as originated and receive the benefits of tariff reductions. It is a measure created to avoid trade deflection. *Define whether a good is eligible for duty-free treatment, based on whether it has sufficiently originated in the partner country. FTA requires the rules of origin in order to eliminate trade deflection and to stop exporting countries outside the FTA. Rules of Origin should be liberal and transparent. Are used to preventing trade deflection.
Three general rules are applied: Change of tariff classification, value-added rule, special processing rule; the minimum transformation is described.