Does Regionalism Affect Trade Liberalization

Towards Non-Members? Estevadeordal, Freund and Ornelas (2008)

Jaeyoun Roh

Introduction

“Building blocs” vs. “Stumbling blocs”

• The main question is whether the member countries lower tariffs on non-member countries or not.

• If the preference induces a faster decline in external tariffs in Free Trade Area, the regionalism is a “building block” to free trade and if not, the regionalism is a “stumbling block”.

The result is that regionalism is a building bloc to free trade in Latin America.

The result is both statistically and economically significant.

“Free Trade Area” vs. “Custom Unions”

• CU members have the common external tariff. • The common external tariff allows CU members to pursue of

their joint market power in world markets, which lead to higher external tariffs.

• Therefore, the incentive to reduce external tariffs to moderate trade diversion may be weaker in CUs.

Based on this idea, extending preferences in customs unions does not seem to lead any significant change in multilateral tariffs.

At best, it could induce a reduction in the MFN tariff that is considerably smaller than that in an FTA.

Regionalism in Developing countries

• There are several reasons why regionalism may be correlated with external trade liberalization in developing countries.

First, since the multilateral system has had only a limited impact on tariff reduction in developing countries, regional agreements may serve as an enforcement mechanism for a broader reform package.

Second, with high external tariffs, the possibility of costly trade diversion resulting from RTA could provide governments with an incentive to liberalize.

• Because of these reasons, Free Trade agreement issue is especially important in developing countries.

Latin America

• Why Latin America can be an excellent area for this study Among the developing countries?

First, 88% of trade in Latin America is potentially eligible for preferential treatment.

Second, while applied tariffs in Latin America are normally high relative to those in advanced countries.

This implies that those countries have ample room to either raise or lower their applied tariffs subsequent to the formation of a regional agreement.

It makes it easier to identify the influence of RTAs.

Three distinct strategies

• Three distinct strategies to determine whether regionalism and multilateralism are correlated each other.

First, our results depend critically on the type of agreement, whether FTAs or CUs.

Second, the effect of a trading bloc on external tariffs depends not only on the preferential rates, but also on the relative importance of preferential imports.

Lastly, this paper uses an instrumental variable approach.

Related literature

• A lager literature has addressed the related questions of

(1) Whether allowing countries to form RTAs help or hinder the viability of a multilateral free trade agreement

(Levy 1997, Krishna 1998, Antras and Helpman 2007) (

(2) How RTAs affect the efficiency properties of the multilateral trading system. (Bagwell and Staiger 1996 b)

(3) How the efficiency properties of free trade differ when it is preceded by RTAs. (Freund 2000 b)

(4) How political economy motivations alter the willingness of governments to engage in RTAS

(Grossman and Helpman 1995, Ornelas 2005 b)

The problem of Theoretical analyses

• Existing theoretical analyses often also disregard two central features of actual RTAs.

First, preferential tariffs are frequently not reduced to zero. - The conventional theoretical approach is to assume that countries

within an RTA fully eliminate trade barriers among themselves. - This is consistent with Article 24 of the GATT but, in reality the

complete elimination of internal tariffs is the exception.

Second, countries engage simultaneously in multiple RTAs. - Increasingly, tariff preferences are granted to multiple countries, with

the margin of preferences varying across recipients and across time. - This implies that we need to define a measure of preferential

liberalization to use.

Data Sources and Initial Analysis

Data Sources

• This paper constructs a comprehensive tariff dataset for ten Latin American Countries – Argentina, Brazil, Chile, Colombia, Ecuador, Mexico, Peru Paraguay, Uruguay and Venezuela - from 1990 to 2001.

• The dataset includes MFN applied tariffs and bilateral

applied preferential tariffs at the ISIC 4-digig level. (ISIC: International Standard Industrial Classification)

Initial analysis

MFN tariffs were just slightly lower. The average preferential tariff was much lower under CU

Initial analysis The density for goods with a meaningful margin of preference lies to the left of that for goods without, which indicates that the former have experienced greater tariff reduction on average.

Initial analysis The mode for high-share goods is to the left of the mode for the low-share goods. Higher preferential import shares lead to deeper MFN tariff reduction.

Initial analysis

The bulk of points fall in the third quadrant, indicating the correlation between ΔMFN and ΔPREF

Initial analysis

Econometrics Specification and the results

Econometrics specification

The preferential tariff of country j in industry i, year t, as PREFijt ≡ min { τijt

k }

- τijtk represents the preferential tariff set by country j on

sector i imports from RTA partner k in period t.

- A country is defined as “partner ” when it can export sector i goods to country j under tariffs strictly below country j’s correspondent MFN rate.

Econometrics specification

(1) MFNijt = β1(PREFijt-1) + εijt

Where MFNijt represents the multilateral tariff of country j in industry I, year t, and PREFijt-1 is the corresponding preferential tariff, but lagged on period.

- Using lagged preferences to estimate MFN tariffs reflects the idea that preferences are pre-determined relative to MFN tariffs and MFN tariffs may react with a lag.

- It also reduces simultaneity bias from an overall reduction in all tariffs in some industries.

① β1 > 0 – “building blocs” view of preferential liberalization

② β1 < 0 – “Stumbling blocs” view of preferential liberalization

Econometrics specification

(2) MFNijt = αjt + αij + αijt + β1(PREFijt-1) + νijt

αjt: a country-year fixed effect. capturing the impact of broad programs of trade liberalization

αij : a country-industry fixed effect capturing overall economic, political and historical factors that influence the level of protection across industries

αijt : capturing trends in those factors. It reflects how distinct countries absorb the impact of sectoral multilateral agreements and the difficulties in multilateral liberalization experienced in some industries. (such as agriculture)

Econometrics specification

• To eliminate the unobserved heterogeneity αij , we take first differences in equation (2)

(3) Δ MFNijt = νjt + αij + β1(ΔPREFijt-1) + υijt where νjt ≡ αij - αj, t-1 and υijt ≡ νijt - νij,t-1

• This paper distinguishes between the hypotheses (H1) countries lower tariffs on outsiders because they

are offering preferential treatment. (H2) unobserved sector-specific shocks induce

countries to liberalize or restrict trade generally.

(4) Δ MFNijt = γjt + αij + β1(ΔPREFijt-1) + β2(Δ PREFCUijt-1) + υijt

The effect of regional agreements on MFN tariffs in Latin America

• Table 3 is the results from estimating equation (4)

(4) Δ MFNijt = γjt + αij + β1(ΔPREFijt-1) + β2(Δ PREFCUijt-1) + υijt

• Dependent variable: percentage point change in the MFN tariff

• Independent variables of interest: lagged percentage point changes in the preferential tariff, and with and without interaction with the customs union dummy.

The effect of regional agreements on MFN tariffs in Latin America

• The first column reports the results from estimating equation (4) using OLS.

• The positive coefficient on lagged ΔPREF indicates that MFN tariffs fall in FTA members following a reduction in preferential tariffs.

• The negative coefficient on ΔPREFCU indicates that this is not true when the bloc takes the form of a CU.

The effect of regional agreements on MFN tariffs in Latin America

• To control for potential endogeneity, we use the lagged values of the preferential tariffs of RTA partners as instrumental variables

• The IV results show strong support for tariff complementarities in free trade areas in column (2).

• They also show that this effect is absent in customs unions.

• In this case, we accept the hypothesis that preferential liberalization has effect on MFN tariffs in CUs.

• In column (3), we use two-and three-times lagged levels of preferential tariffs to instruments for lagged changes. Again, we find strong evidence of tariff complementarities in FTAs but not in CUs.

The effect of regional agreements on MFN tariffs in Latin America

• We estimate equation (4) eliminating the observations where the preference margin is too small to have a practical effect, given the costs to comply with ROOs.

• Thus, column (4) reports the results when we consider only cases which the preference margin is above 2.5 percentage points.

• The results imply that preferential liberalization in FTAs induces a slightly deeper reduction in MFN tariffs when ROOs are less likely to bind.

• The effect of preferential liberalization in CUs is statistically insignificant when ROOs are taken into account.

The effect of regional agreements on MFN tariffs in Latin America

• In column (5), to control for the alignment of tariffs in the CUs, we add the following variable.

• Where denotes total imports in year t, industry I, by members of the CU in which country j participates. This variable is the weighted-average MFN tariff in the unions.

• A positive coefficient indicates that members of CUs are moving toward aligning their external tariff overtime.

• The results on tariff complementarities in FTAs and small tariff subsitutitutablity in CUs are very similar to those in column (1)

The effect of regional agreements on MFN tariffs in Latin America

• In the column (6), the effects are only present in the early period, when the bulk of tariff reduction took place.

• In the last column, we split the ΔPREF variable into a period-one effect(1990-1994) and a period-two effect(1995-2001).

• The positive effect in FTA is present in both periods, although it is smaller in period 2.

The effect of regional agreements on MFN tariffs in Latin America

• In table 4, in all specifications, the coefficient on preferential import shares interacted with MRG (which means the preference margin is greater than 2.5 percent point) is negative and statistically significant

• It indicates that higher referential import shares are associated with reductions of MFN tariffs when meaning preference margins are present.

• This effect is neutralized in CUs.

• In all cases, the complementarities between tariffs in FTAs obtained previously remains present, while changes in preferential tariffs in CUs have no significant effect on MFN tariffs.

Conclusion and Extension

Conclusion

• We find that free trade areas are likely to be “building blocs” to eternal trade liberalization in Latin America.

- So, there is a complementarities effect between preferential and MFN tariffs.

- Furthermore, external tariffs fall by more in sectors in which the FTA partners are more important suppliers.

• These findings fit particularly well the theoretical analysis of Bagwell and Staiger (1999 a).

In their paper, the formation of an FTA induces a reduction of applied MFN rates, but the formation of CUs does not.

Conclusion

• Our finding contrast sharply with those of Kimao (2006, 2007) and Karacaovali and Limao (2008), who find that the U.S. and the E.U. liberalized less during the Uruguay Round in sectors where preferences were granted.

- This is because the types of countries analyzed are different.

- Since the multilateral system has not enforced much tariff reduction on developing countries, tariffs are relatively high there, creating a large potential for trade diversion.

- Our suggest that this force is important in explaining changes in MFN tariffs of Latin America countries involved in free trade areas.

Extension

• Overall, these findings offer an optimistic view of the ongoing regionalism trend for efficiency of the world trading system.

• Future work is needed to explore the robustness of these results to other region, as well as the implications of the rise of regionalism for liberalization at a multilateral level.

“ ASEAN Free Trade Area (AFTA) ”

To be continued

Q & A Thank you!