Trade Creation and Trade Diversion

resulting from SACU trading agreements

by

Ron Sandrey

tralac Working Paper No 11/2006 August 2006

Copyright © 2006 by the Trade Law Centre for Southern Africa (tralac).

Readers are encouraged to quote and reproduce this material for educational, non-profit

purposes, provided the source is acknowledged. All views and opinions expressed remain

solely those of the authors and do not purport to reflect the views of tralac.

This publication should be cited as: Sandrey, R. 2006. Trade Creation and Trade Diversion

resulting from SACU trading agreements. tralac Working Paper No 11. Stellenbosch: US

Printers.

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Key points

Trade creation is new trade from a Free Trade Agreement (FTA) partner which would

not have existed otherwise, and that, generally, is good. But often much of this may

be just trade diversion away from other, non-preference partners, and that may be

bad – bad in the sense that it has resulted from an artificial advantage under the

FTA, meaning that one is not buying from the world’s lowest cost supplier. Recent

research shows this to be a particular and potentially costly problem for Africa.

Starting from 2005 imports and the 2006 Southern African Customs Union (SACU)

tariff schedule and using the standard formulas for this type of analysis we find that

the Trade, Development and Cooperation Agreement (TDCA) increases imports from

the European Union (EU) into South Africa by some R4.3 billion, but R2.7 billion of

this is trade diverted from other sources. Next, simulating the impacts of the

Mercosur/SACU agreement as it now stands we found that it has limited impacts

upon imports from Mercosur: trade creation of R93 million but diversion of R70

million for an overall gain of only R23 million.

We then sequentially applied the TDCA tariff preferences in turn to China, the US

and then India, using the calculated post-TDCA trade flows from all the different

import sources. Granting China these preferences increased Chinese imports by

R4.1 billion, with R2.4 billion diverted and therefore R1.7 billion in new trade. Then,

bringing a SACU/US FTA at TDCA preferences into operation increased the imports

from the United States (US) by R0.7 billion, with R0.5 billion of this being trade

diversion. Next, granting India the same preferences led to trade creation of R325

million but some R 260 million of this in trade diversion limited the overall increase to

only R65 million.

Finally, to ‘level the playing field’ somewhat and examine what a moderate outcome

from the Doha Development Agenda (DDA) of the World Trade Organization (WTO)

may do we reduced bound tariff rates by 30 percent in all cases except heavy motor

vehicles and applied these rates to the imports from all those import sources

excluded from preferences to date. The trade creation here was another modest

R453 million, but with only R58 million in trade diversion and therefore an overall

import increase of R395 million. Thus, a Doha outcome would make limited

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difference to South Africa’s import profile under these conditions where much

(64.75%) of the imports were already entering under preferences.

What is significant with respect to the SACU Customs revenue pool is that this

revenue reduces by an estimated 29.7 percent from a non-preference base, and,

given that Lesotho and Swaziland rely on this revenue for half or more of their total

government revenues, this will have serious consequences for them. Otherwise, at

the end of all this creating and diverting, the total imports into South Africa increase

by only around one percent. There will, of course, be general welfare effects that

ripple through the economy, and these are not considered. As always, several

assumptions have been made, and there are limitations to the study that are

acknowledged.

Part one: Introduction and background

In the arcane world of economic theory economists talk about trade creation and

trade diversion as they relate to trading agreements. Viner (1950) in his seminal work

about the formulation of the European Customs Union first promulgated the concepts

of trade creation and trade diversion and how they may or may not be a good thing

for a country. Although his application was originally applied to a Customs Union

such as the EU or SACU, it can equally be applied to a Free Trade Agreement. In

this context it is well to keep in mind that South Africa and the BLNS countries1 are

already part of a Customs Union (SACU), so there has been a degree of trade

creation and trade diversion that has taken place. Although not specifically shown,

the opening up of trade to the outside world will reduce any trade diversion that has

already occurred within SACU over a long period of time, so we have already passed

the first stage and, in this paper, will be looking at second and subsequent steps.

The trade creation/trade diversion concept runs as follows: when a preference

agreement is initiated it is expected to result in increased trade between the two (or

more) parties, and this increase is generally referred to as ‘trade creation’ or the

gross volume of new trade in response to the lower consumer price from the tariff

1 Where BLNS refers to Botswana, Lesotho, Namibia and Swaziland respectively as the fellow members of the Southern African Customs Union (SACU).

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reductions2. However, offsetting these gains is the danger that much of this

increased trade from the new partner will be displacing imports from sources that are

more cost-efficient but are unable to compete over the tariff wall that remains in place

for them but not for the new preferential partner. The actors involved here are 1)

consumers, 2) producers, and 3) the government.

Consumers benefit from the free trade area as they have a wider access to goods at

lower prices. Producers in the importing country suffer losses as a result of the free

trade area, as there is a price decrease that induces a decrease in output of existing

firms (and perhaps some closures), a decrease in employment, and a decrease in

profit. And the government loses tariff revenue that would had been collected on

imports, and this then reduces government revenue which may in turn reduce

government spending or transfers or raise government debt. The aggregate national

welfare effect is found by summing these gains and losses to consumers, producers

and the government. The relative size of these components dictates whether the

overall effect is positive or negative. In practice, the producer effect is likely to be

negative notwithstanding the extent to which competition exhorts more efficiency, the

consumer effect will be unambiguously positive; and the tax collection effect is likely

to be negative notwithstanding the (largely) theoretical argument that it can be

positive as the increase in imports is such that more tariff revenue can, in fact, be

generated.

There are of course two (or more) partners involved in these agreements, and, in

effect, the trade diversion cost to one partner represents, in theory, a gain to

producers in the other partner who are able to increase their exports. However, the

summation of one partner’s loss and another partner’s producer-only gain are almost

certain to be negative unless, almost by chance, the two partners are the world’s

lowest cost producers of their respective export products.

Crucial to the size of this final overall national effect are the so-called elasticities of

demand and substitution. The price elasticity of demand is simply the percentage

change in goods demanded following a one percent change in price, while the

substitution elasticity shows how much of the new demand is merely consumers 2 Note that outside of the economics classroom there is unlikely to be a one-for-one mapping of the, say, 10 percent tariff reduction and a commensurate reduction in the price to consumers. Other actors such as the original exporter, agents, the tax gatherer if a VAT tax is applied on the post-duty price, and retail and wholesale merchants are all part of on-the-stage entourage and will be seeking some of the windfall gains.

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substituting away from old suppliers in favour of the new partner. Ideally, we would

use a full computer general equilibrium (CGE) model of the economy to get the

detailed flow-through impacts of tariff changes as they effect production and

consumption which, in turn, feeds through into second and subsequent round effects.

Such a model would have a comprehensive set of production costs data for the two

partners and other global suppliers.3 We will, however, just look at a partial analysis

in this paper in that, while it does analyse the dynamics of an increase in trade from

partner countries and the consequential decline in imports from third parties in

response to tariff changes, we assume that the 2005 import base remains as is and

does not change in response to currency fluctuations or any other macro-economic

effect. Thus, our results may be interpreted as changes to tariff revenues, ‘everything

else held constant’, in a world where everything else is, of course, not constant.

Therefore, in the absence of detailed cost data for the different world sources of

imports across a multitude of products as incorporated in the Global Trade Analysis

Project (GTAP) model, this paper will look at the aspect of trade creation and

diversion as it relates to firstly trade flows and then the collection of customs revenue

for the SACU pool. These monies are crucial to both Lesotho and Swaziland within

the region, as they constitute over half of the total revenues available to the

respective governments. We do not claim to generate any general equilibrium

welfare effects, although the reader is referred to Sandrey et al. (2006) for an

analysis of the tariff revenue losses in the absence of any trade creation and

diversion effects (and therefore an underestimation) and the subsequent

macroeconomic impacts upon Lesotho using a model of the Kingdom’s economy.

The starting point for this paper is that trade diversion in favour of the EU from the

TDCA and SADC from their almost duty-free access into SACU as from January

2006 will result in fewer duties being collected overall. This will include an overall

tariff revenue loss for SACU as trade is sourced from suppliers who may not

generally be the lowest cost suppliers in the absence of duty preferences and who

would have otherwise contributed to the customs pool. We will attempt to measure

3 The most commonly used of these models is the Global Trade Analysis Project (GTAP). GTAP is a global network of researchers who conduct quantitative analyses of international economic policy issues, especially trade policy. They cooperate to produce a consistent global economic database, covering many sectors and all parts of the world. The database describes bilateral trade patterns, production, consumption and intermediate use of commodities and services. See the website at www.gtap.agecon.purdue.edu.

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these tariff effects from the TDCA and SADC preferences, and then extend the

analysis to sequentially examine the potential introduction of more preferential

trading partners that SACU may sign with.

A review of the recent literature on the outcome from the nascent Economic

Partnership Agreements (EPA) in particular shows that trade diversion (along with

customs revenue losses) will lead to significant welfare losses to many African

nations from this phenomenon. The reader is again referred to Sandrey et al. (2006)

for a more comprehensive discussion. Research that warns of the trade

creation/diversion costs of the EPA and potential tariff revenues loss is also

discussed in the review by Szepesi and Bilal (2003). They consider that potentially

trade creation does outweigh diversion, but that there is a considerable diversion

effect, and that revenue losses are crucial in some countries. The World Bank also

finds that EPAs offer considerable potential benefits to Sub-Saharan African (SSA)

countries, but they also pose a number of policy, administrative and institutional

challenges, including replacing forgone tariff revenues, avoiding serious trade

diversion, appropriately regulating liberalised service industries, and liberalising

internal trade.

Zgovu and Kweka (2006) examine the six-digit HS trade, tariff revenue and net

welfare effects of Malawi and Tanzania reciprocating EU’s preferential tariff treatment

under an EU-ACP EPA4. They apply a partial equilibrium model that covers all

import products using 2003 trade data. Their findings show that there will be welfare-

enhancing consumption and trade creation effects but these will be swamped by

strong welfare-lowering trade diversion and tariff revenue losses leading to non-

negligible net welfare losses. For Malawi, the tariff revenue loss is 16 percent as EU

imports increase by 36 percent against an overall increase of a much lesser

4 percent, while in Tanzania the comparable figures are a revenue loss of 36 percent

flowing an increase in EU imports of 48 percent and an overall increase of

11 percent. The ‘losers’ from third party suppliers are South Africa in the case of

Malawi and Kenya in the case of Tanzania. Furthermore, the overall increase in

imports from the EU will pose a real threat to domestic and regional import-

competing production, and thus undermine the importance of intra-regional trade.

4 Note that they use a zero tariff for imports from the EU, while this study uses the TDCA tariff preferences that still maintain high duties on motor vehicles and their parts at the end point.

6

Thus, there is a real question as to whether or not trade liberalisation in general and

FTA options are really welfare enhancing for many African countries given their

special circumstances. The concept of trade diversion costs and overall losses to

tariff revenues are just one part of this debate, and this paper aims to produce some

solid data to provide policy makers with the possible tariff revenue costs given that

these revenues are crucial to the BLNS countries and Lesotho and Swaziland in

particular.

The data

The paper uses a very detailed line-by line approach to examine firstly the trade

creation and trade diversion impacts of the recent TDCA and effectively duty-free

access for non-SACU SADC goods, and then sequentially other potential FTAs that

involve SACU such as China and the USA. We undertake this analysis by taking the

imports into South Africa during 2005 and assessing the potential duties against

these imports using the relevant line in the 2006 SACU Tariff Schedule. Note that

there are some caveats we would like to acknowledge here; the 2006 SACU rates for

imports from non-SACU SADC are falling vis-à-vis the 2005 rates, but as the

schedule is a ‘live’ document we were obliged to use these more recent rates; and

there is a slight overestimation of the collection rate if the impacts of Tariff Rate

Quota (TRQ) duties are ignored for agricultural products5.

There is also the vexing question of rebates, as ignoring these will overestimate the

tariff loss that we calculate here in monetary terms although we would expect that in

percentage reductions terms the final result should be comparable. Indications of the

value of the rebates suggest that these are around one-third of the potential tariffs

calculated here. One source justifying this is the press release from Trevor Manuel,

South African Minister of Finance, 3 April 2006, where he announced that Customs

duties to the value of R18.4 billion had been collected to the year ending March 2006

(a similar but not exact time period to our analysis). Another is a paper (Edwards

2005) examining the extent to which South Africa has liberalised its trade in recent

5 We assessed these TRQ rates to reduce the potential tariff collection by around R150 million in total, or around 0.5 percent of the potential. In addition, imports assessed for duty in the BLNS countries are also not considered. We believe (anecdotally) that these may be around three percent of the total dutiable imports. Thus, these two are somewhat offsetting.

7

years, where Edwards calculates an average MFN rate of 8.3 percent (very similar to

our 2005/06 rate), but sets this against an actual collection rate of 6.1 percent.

During 2005 South Africa imported goods to the value of R350.6 billion. Assessing

these imports against the SACU 2006 tariff schedule6 at the HS 6- and 8-digit level

we calculated that, in the absence of tariff rebates, these imports would have paid

some R29.7 billion at an average rate of 8.35 percent. This is shown in Table 1,

along with the source of these imports and the average tariff rate by these sources.

6 Available on http://www.sars.gov.za/tariffs/Loose_Leaf/lltbookmainsch1.pdf. Note that this is a live document, thus the 2006 rates were used rather than the 2005 values.

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Table 1: RSA Import profile, 2005, rand million and % share & average duty

Source Imports Rm % Impts Av Duty % main second

All 350,624 100 7.84

EU 133.6 38.2 8.36 machinery vehicles

USA 27.4 7.8 4.80 machinery aircraft

China 31.3 8.9 12.80 machinery electrical

SADC 12.2 3.5 0.06 diamonds*

India 7.0 2.0 10.81 vehicles fuel

Mercosur 11.2 3.2 13.82 ‘special’ meat

Middle east 42.9 12.3 1.18 fuel

Japan 23.7 6.8 16.68 ‘special’ vehicles

Rest world 60.4 17.3 6.86

Source: tralac calculations from World Trade Atlas data and the SACU Tariff Schedule. There are some minor adjustments to this data. Note that SADC data includes (for the first time) imports of diamonds from Botswana and Namibia into South Africa. Other SACU imports are not recorded.

The average duty rate assessed on these imports (in the absence of rebates) would

have been 7.84 percent for a tariff take of R27.417 billion. Had the TDCA and SADC

preferences not been operational and given the same trade flows this rate would

have been 8.39 percent as the duties would have been R1,922 million greater (or

R29,339 in total). In effect, we are about half way through the TDCA tariff adjustment

process using the 2006 schedule rates while the SADC preferences are complete

except for vehicles and their parts and a small residual on used clothing.

Part two: The trade creation/trade diversion approach and results

Using the time-honoured formula for trade creation and diversion as developed by

Laird and Yates (1990) and applied in the WITS/SMART model7 we calculated these

effects at the HS 4 levels from the 2005 imports and the initial MFN and TDCA end

point duties8. We applied the formula by using demand and substitution elasticities of

7 See, for example, the UNECA documentation at http://www.uneca.org/eca_programmes/trade_and_regional_integration/documents/Analytical%20Methodology%20for%20EPAs%20Study.pdf. 8 This may give an overestimation, as some of the effects are double-counted in that the TDCA has already been in operation for period, but, as shown above in Figure 1, the overall aggregate effects to date are not obvious.

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-1.5 percent, and note that any change to this can easily be calculated in a sensitivity

analysis. These formulas are a function of the initial trade values and market share

and the relative reductions in tariffs for the importer given preferences vis-à-vis the

general non-preferential rate for the respective HS 4 levels.

The average rate on SDAC imports assessed at the MFN rate (no preferences)

would have been 3.43 percent, and we conducted a run outside of the main analysis

to assess the upper level of benefits to SACU as measured by the tariff preferences

on import flows into South Africa by starting with the MFN rate and then applying the

2006 preferences. This is an upper limit as rates have been reducing over the last

few years9. Results suggest that imports from the non-SACU SADC would be R651

million or 5.39 percent above what they otherwise would have been (trade creation).

However, some R408 million of this is trade diversion away from other sources,

giving an overall net effect of an increase in imports of R243 million. Duties collected

(theoretically) on the new SADC imports would be only R35.6 million, but this is

outweighed by the diversion loss from substitution of R112 million for total duty

foregone into the Customs pool of R76.4 million. By HS Chapters, much of this

stems from tariff concessions on imports in HS 5201 (cotton fibre), and HS 0902

(green tea). There are some limited increases in imports in the sensitive TCF sectors

as a result of generous preferences, and a small increase in tobacco products.

9 This same experiment was not undertaken on the TDCA imports from the EU.

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Step One: the TDCA through to the end

Imports from the EU expressed as a percentage of South African imports have been

trending downwards over the last ten years. This is shown in Figure 1. Following the

introduction of the initial tariff changes in 2000 there was an increase for three years

but this has been reversed over the last two years. Reasons for this decline are not

assessed here, but the increased market share of China and oil importers had to be

at the expense of others.

Fig 1: EU imports as a share of RSA

30%35%40%45%50%

1996

1998

2000

2002

2005

EU

Source: World Trade Atlas data

At the end point of the TDCA imports from the EU under full TDCA preferences

(where the increase in imports is trade creation) will be R4,370 million or

3.27 percent above what they otherwise would have been. However, some R2,616

million of this is merely substitution away from other possibly more efficient sources

(and therefore trade diversion), giving an overall net effect of an increase in imports

of R1,754 million by summing the two as discussed earlier.

Overall duties collected decline by R1,808 million, giving a new duty rate for the EU

of 7.03 percent and overall of 7.29 percent. Duties collected (theoretically) on the

new EU imports would be R113 million, but this is outweighed by the diversion loss

from substitution of R397 million for total duty foregone into the Customs pool of

R284 million from just the changes in trade induced by the tariff changes. By HS

Chapters, much of this change in imports stems from imports in HS 85 (electrical

machinery), and HS 39 (plastics). Other than some increases in footwear, there are

few impacts on the sensitive TCF sectors despite generous preferences, and limited

impacts on the motor vehicles as preferences here are modest.

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Who loses from the TDCA and SADC trade diversion? (Steps One and Two)

To answer the question of who is affected by the TDCA and SADC trade creation we

examined three importers: China, USA and all others combined. After assessing the

trade creation effects of the TDCA, we found that creation is R4,370 million, while

trade diversion is R2,616 for an overall gain of net gain in imports of R1,754 million.

Some R427 million of the trade diversion is at the expense of US imports, R641

million is away from China and the remaining R1,548 million is away from the rest of

the world (‘others’)10 combined, where this represents import sources other than the

EU, US and China. As this analysis has been undertaken at the HS 4 level, the

diversion impacts will be a function of both the tariff preferences and relative market

shares at this level. Table 2 shows the main products by HS 4 where trade is

diverted away from the US, China and ‘others’.

Table 2: Trade Diversion from other Import Sources; Product and R million

HS and Description Total USA China Others

Total 2,489 416 640 1,433

8708 car parts 180 31 25 123

8517 telephone equipmt 113 28 23 62

9401 furniture and seats 125 11 62 52

4011 new tyres 64 4 13 46

8704 trucks 48 10 1 38

3920 plastic sheets 43 9 3 31

Source: tralac calculations

10 Note that this ‘others’ is not the same ‘rest of the world’ as used elsewhere in the paper, as the ‘others’ here include SADC, Mercosur and India for ease of presentation.

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Step Two – the SACU/Mercosur FTA

Following the end of the TDCA we implemented an instant FTA between SACU and

Mercosur using the tariff preferences as currently proposed. Given the minimal tariff

preferences offered to Mercosur results here are, unsurprisingly, also minimal.

Imports from Mercosur increase by R93 million or 0.84 percent only, while trade

diversion of R70 million leads to an overall increase of only R21 million. Duties on

imports from Mercosur are now 13.15 percent, down from 13.82 percent originally,

while the overall duty take declines by R64.2 million. The only significant trade

increases are in soybean meal imports.

Step Three – a SACU/China FTA

From the point reached above, that of the end of the TDCA and with the SADC and

Mercosur preferences fully operational, we assessed the effects of then undertaking

an FTA between SACU and China using the TDCA end point preferential tariff rates

as a benchmark for the preference rates. Note that China’s 2005 trade profile has

been adjusted to its equivalent at the end of the TDCA and Mercosur periods to take

account of the trade diversion away from the base imports, and that is our new

reference point rather than unadjusted 2005 imports. Another important point is that

some of the ‘swing’ effects that take place from now on are in part reflecting a move

back to Chinese imports that have been lost earlier as a result of trade diversion from

the TDCA preferences. This highlights the point that the best way of avoiding trade

diversion is to give the same tariff concessions to all sources; and therefore

multilateral liberalisation avoids the whole problem and enables imports to source

from the genuinely lowest-cost source11.

The results suggest that the increase in imports from China (trade creation) is R4,125

million, but R2,439 of this is substitution away from other sources (trade diversion)

and therefore a net gain of R1,686 million. The average duty on Chinese imports is

now 3.50 percent, down from 12.80 percent otherwise. This trade creation in favour

of China is at the expense of the post-TDCA EU imports to the amount of R746

11 This brings up the related concept of a ‘first mover’ advantage, whereby the EU as first mover into South Africa is able to set up structures such as marketing linkages that enable EU exporters to consolidate in the South African market, thus enabling them to cement the early advantages from lower tariffs into a long-term gain.

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million, US at R90 million, SADC at R131 million, India at R200 million and ROW at

R885 million. Note that the trade creation/diversion outcomes from granting the

TDCA preferences to China are almost as much as those from the TDCA despite the

Chinese import share being much lower; this is because the relative tariff preferences

are higher on Chinese imports as a result of the product mix from China.

Overall duties collected reduce by some R3.071 million, a dramatic decline reflecting

the decline in tariffs on the major trade lines of shoes (from 30% to zero) and clothing

(from 40% to 20%).

By product line, the clothing and footwear sectors from HS 61 to 64 inclusive account

for R1,954 million of the trade creation from China, with some R1,033 million of this

as new trade and the remainder diverted trade. On a percentage basis this suggests

an increase of 32.1 percent in Chinese imports, but an overall increase in Chinese

imports of a lesser 15 percent once the substitution effects are factored in (which

equates to a 10.7 percent increase in global imports). Note, however, that this is a

result of a average tariff reduction from 25.0 percent to 9.3 percent for these imports

from China and not a full FTA to zero. At the HS 2 Chapter level, most of the

remaining trade creation favouring China takes place in electrical goods (HS85),

leather products (HS42), furniture (HS94), ceramics (HS69) and plastics (HS39).

Step Four: the USA

The next step is to examine an FTA between SACU and the US, with this taking

place immediately after the instantaneous FTA with China at the end of the TDCA

implementation period. Again, the end point tariffs for the TDCA are offered to the

US, and the post-China FTA is the reference point for US imports.

The impacts this time are much lower, in part because, as shown in Table 1, the US

faces much lower duties into SACU/RSA than other sources, and this is down the list

of the FTAs analysed. It is also a result of the US import product mix, as these

imports do not face as high an overall tariff as China, for example, and therefore will

not benefit as much from duty preferences. The trade creation/trade diversion results

suggest that trade creation is a much lower R662 million, and of this, R515 million is

trade diversion, therefore showing a net gain of only R106 million. The average duty

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on US imports is now 3.05 percent, down from 4.80 percent pre-FTA. The trade

creation in favour of the US is at the expense of the adjusted post-China and TDCA

EU imports to the amount of R289 million, China at R71 million, SADC at R6 million

and ROW at R86 million. US imports increase by 2.31 percent, and as can be seen

by the results give justification to the desire to negotiate an FTA with South

Africa/SACU in order to compete more favourably with the EU in this market. Overall

duties collected reduces by another R435 million, giving similar justification to the

region for one of the reasons making it reluctant to enter those negotiations given the

current template of the US Free Trade Agreements, with the emphasis on the

parentheses. By product line the gains for the US are in HS 85, electrical machinery

(R96m), plastics (R77m), general machinery (R59m), motor vehicles and parts (52m)

and rubber products (R30m) as the ‘playing field is levelled’ for the US.

Step Five: India The final FTA move is to bring India ‘into the club’ with the same preferential duties

as outlined in the TDCA end point and offered to China and the US. This FTA, again

on TDCA end point preferences, leads to trade creation of R325 million but a

significant diversion of R260 leading to an overall increase of a minor R65 million. It

is noticeable that the increase in Indian imports with these generous access

conditions is only R10.63 million or 0.15 percent from the original starting base of

2005 before we started the exercise of sequentially working through the preference

results. Thus, India has really only clawed back import losses from competing

sources further up ‘the FTA food chain’. We must, however, add that although India

may not, under this analysis, gain much from an FTA in straight mercantilist terms,

given the vibrant Indian community within South Africa, enhanced links to India may

result in welfare gains beyond the merchandise trade ones.

Tariff on Indian imports reduce from the starting level of 10.8 percent to 6.38 percent,

while the overall tariff reduction to the revenue pool is R233.5 million, clearly showing

that the main impact is not so much in increased trade but rather straight tariff

reductions. By commodity, the big increases for Indian imports are in the clothing

and footwear sectors, followed by vehicles and parts and then rubber products.

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The final TDCA/Mercosur/China/US/India FTAs result (Steps One through Five)

Table 4 shows the end result of all the sequential trade creation and trade diversion

calculations. Overall trade has increased by a relatively minor R3,869 million or

1.11 percent. The largest gainers have been the EU and China, whose imports have

increased by R3,110 million and R3,311 (2.41 and a large 10.59 percent)

respectively from the 2005 starting point. SADC lost ground, as imports decreased by

R221 million or 1.82 percent from the 2005 figure as others gradually gained similar

(but not the same) advantages. China, the big gainer, increased its own trade by a

combination of clawing back some of the ground lost to the EU through the TDCA

and gaining from ‘new’ trade from its own preferences in the clothing and footwear

sectors in particular. The US is an interesting study: it only gained R84 million or

0.31 percent in new trade overall trade overall as a result of losses to both the EU

and then China prior to its own preference regime, a regime in which it struggled to

make up the lost ground. As discussed, Mercosur gained little from its FTA while

India made modest progress. During this exercise the rest of the world stood on the

sidelines and watched others gain preferences (note that the relatively minor EFTA

agreement has not been factored in), with a result that their trade has declined by

R1,849 million or 3.06 percent. Neither Japan nor the Middle East has really

featured throughout this entire analysis; the Middle east because its oil imports are

already effectively duty-free, and Japan because its import mix, on the face of it,

does not appear to be directly in competition from those sources granted preferences

(it is a likely hypothesis that a more in-depth analysis of East Asian imports may

confirm that its competitors are not themselves active players in the FTA scene with

South Africa/SACU)

Of more interest to the BLNS countries, the theoretical SACU Customs pool has

declined from R29,7 million (with no preferences at all) to R21,805 million, or

25.5 percent. While the actual figure may not be accurate as it excludes rebates, the

percentage change will be indicative. Thus, we have a final situation where, under

our indicative analysis, (a) imports into SACU have not really changed once all the

factoring of trade creation and trade diversion in each sequential step has been done

but (b) the implications for the BLNS revenues have certainly changed as tariff

revenues have declined by some 25.5 percent relative to what they otherwise would

have been. As stressed, this percentage change relative to what tariff revenues may

16

otherwise have been is more rigorous than the actual amount, although both of

course are indicative. In particular, these tariff pool revenues represent at least half of

the total government revenues to both Lesotho and Swaziland, so the effects will be

dramatic on their economies.

Table 3: Imports at 2005 and post-FTA creation/diversion. R m and % duty

Position at 2005 End position

Imp source R million % duty R million % duty

EU 133,636 8.36 136,860 7.07

USA 27,349 4.80 27,433 3.05

China 31,262 12.80 34,573 3.49

SADC 12,151 0.06 11,930 0.06

India 7,028 10.81 7,039 6.58

Mercosur 11,214 13.82 11,073 13.12

Middle east 42,857 1.18 42,659 1.11

Japan 23,748 16.68 23,444 16.73

Rest of World 60,378 6.86 58,528 6.44

Total 349,624 7.84 353,540 6.17

Step Six: Doha to the rescue?

Trade diversion takes place in the presence of trade preferences, and the beauty of

the multilateral approach is that it neutralises trade diversion by offering the new

preferential rate to all. In doing so it effectively reverses much of the gains that

previous preference holders enjoyed by, in effect, having what may be looked upon

as a negative diversion effect, as the previous gains from trade diversion to these

preference holders away from others sources of imports is wound back. In a related

issue there is often a ‘cost’ to many African nations in particular as the gains from

preferential access for their exports to rich and protected markets are lost

(preference erosion), but that, although a major issue in liberalisation for the

Continent, is a separate issue outside of the scope of this paper.

17

It is important to stress that trade negotiators operate off so-called bound rates that

are WTO phenomena12, rather than the applied rate that faces imports at the border,

and that while these may be identical in many cases the bounds are above the

applied rates and sometimes significantly above them. This is the so-called ‘water in

the tariff’, which means that a DDA settlement may, in many cases, make no

difference to the actual tariffs faced at the border. Therefore, one must first of all

take the bound rates on a line-by-line basis, reduce them by this 30 percent and then

check against the applied rates to ascertain if the reductions will, in fact, ‘bite’.

We have proxied the DDA outcome by reducing the South African bound rates by

30 percent and then examining the SACU schedule to see where these reduced

bound rates are actually below the applied rates13. We then apply this DDA outcome

to the imports from the Middle east, Japan and ROW. There are two categories

where this is not strictly accurate. The first is where the duties are not actually

bound, but this category seems to be restricted to imports from all sources valued at

R6,888 (1.90% of the total), and almost all of this total is on oil imports that face an

average duty of under 2 percent. This segment can consequently be disregarded.

The second category is where the TDCA end rates would actually be above the DDA

outcome, and we have left the TDCA final tariff rates as a ‘floor’ on these imports for

operational ease. This ‘floor’ is relevant for R34,505 million of 9.8 percent of the total

imports. However, the vast majority (R30,626 million) of these imports apply to HS

9801 (heavy vehicle) that are not granted any preferences under the TDCA. Here,

the applied rate for all imports is 26 percent, while the bounds are currently at

30 percent and therefore would reduce to 21 percent with the assumed DDA

outcome. Such is the importance of these vehicle imports that using the DDA

outcome would reduce the potential tariff take by R1,531 million, although in practice

a high percentage of these duties are refunded through the rebate system in any

case. There would be no trade diversion effects as the 21 percent duty would apply

to all imports.

12 These are rates that a country has pledged not to go above, whereas applied rates are what are actually (by definition) applied at the border to all non-preferential imports. 13 In most cases the South African WTO bound rates are more than 30 percent above the applied rates used in this study, so therefore reducing the bound rate by 30 percent has no impact at all on revenues at the border. This is an important concept to keep in mind when looking at any possible DDA outcome.

18

Note that we have used the South African bound rates, and that at least some of the

BLNS countries have different (usually higher) bounds. How this difference would

ever be operationalised within SACU is an open and interesting question.

In applying the lesser of the DDA 30 percent reductions in bound duties or the

current MFN applied rates to the post-FTA scenarios as used to date imports from

the excluded Middle east, Japan and ROW we find a muted outcome as (a) we have

excluded HS 9801 (heavy vehicles), and (b) the DDA outcome is still above current

applied rates in most cases. The overall effect from the post-FTA imports is for trade

creation of R453 million, with trade diversion of R58 million for a final increase of only

R395 million. More significantly, the potential duty take would reduce by R364 million

as global average duty declines from 6.17 percent to 6.06 percent. If the duty rate

on imports of heavy vehicles had been applied, trade would increase by R564 million

but the duty would decline by R901 million to an average percent of 5.90 percent.

Note there is no trade diversion effects as the reduction is neutral to all sources for

these heavy vehicles.

In summary, a DDA outcome as described at a 30 percent across-the-board

reduction in bound rates (excluding heavy vehicles) would have limited impacts upon

the SACU imports unless preference concessions were made for heavy motor

vehicles. At the end of this final adjustment in the full FTA chain, new trade would

only amount to R4,311 million, an increase of only 1.23 percent from the original

starting point of 2005 imports. Such is the influence of the tariffs on motor vehicles

and their associated parts that at this stage some 77.2 percent of the total (ignoring

rebate) duty is assessed upon HS 87 and HS 98, vehicles and parts and heavy

vehicles respectively.

Sensitivity analysis and sequencing

Both the own price and substitution elasticities used in the trade creation and trade

diversion formulas respectively are assumed to be -1.5, meaning that (a) a one

percent decline in price will increase demand by one point five percent and (b) a

similar response will take place as imports from the cheaper source replace the

relatively more expensive ones that have to come over the tariff wall. A sensitivity

analysis is straightforward given that the spreadsheets are all linked. Increasing the

19

own price effect increases the imports, while increasing the substitution effect (a)

decreases the imports by taking more away from others and (b) decreases the

overall tariff take depending upon whether those substituted imports also receive

preferences or not, but the overall effects are relatively minor. This is shown in

Table 4, where the lower portion of the table shows there is a limited impact by

altering the elasticities from the -1.5 values used in either direction. As expected, a

large own demand value (-2.5) coupled with a low substitution value (-1.0) leads to

the largest increase in imports, while a low substitution value reduces the revenue

loss as less trade is diverted from the other imports sources.

Table 4. Sensitivity around elasticity values at end of FTAs Elasticity est duty (ignore rebate) Change in

Demand Substitution $bill rate% Imports $m Duty rate Start, no preferences 29.339 8.39% 349,624 na Start, 2006 SADC/TDCA% 27.4 7.84% na -0.55%

Results at end of Indian FTA process (no Doha effect) 1.5 1.5 21.8 6.17% 3,917 -2.22%2.5 2.5 21.6 6.08% 6,225 -2.31%2.5 1.5 22.1 6.13% 10,266 -2.26%2.5 1.0 22.0 6.15% 12,296 -2.24%1.5 1.0 21.9 6.19% 5,877 -2.20%

Source: tralac calculations

Sequencing is an interesting issue. In theory, we should end at the same point given

the standard formulas that we have used. In practice, the ‘first mover’ advantage that

was discussed earlier in a footnote may have some effect in that it ‘locks in’ a

preferred supplier, but we are unable to model this without making an assumption

and forcing it to happen.

General findings and limitations of the study

Examining the trade creation and trade diversion sequentially shows, as expected,

that each time a new partner is in effect added to the TDAC tariff preference, there is

some new trade, but most of the effect is in trade diversion that is winding back the

advantage of those already in the preference arrangement. Starting from the 2005

imports and applying the 2006 tariff rates, we moved through:

(1) accepting the full SADC preferences;

20

(2) then using the tariff rates at the TDCA end point on imports from the EU;

(3) then applying the Mercosur FTA preferences;

(4) then granting these TDCA rates to Chinese imports;

(5) then granting the same rates to US imports;

(6) then granting these preferences to India; and then

(7) applying an across-the-board DDA 30 percent reduction in bound rates.

At this finish line, rather than on the value of imports, the big impact is on duty

collections, where a reduction of R8,820 million or 29.7 percent from the original no-

preference starting base occurs. For Lesotho and Swaziland, this represents a

decline of at least 15 percent in total government revenues. This is the cost to BLNS

countries of what has been up to now largely South Africa’s trade policy.

There are, of course, many assumptions made with reference to the study and there

are also limitations. The first limitation is that rebates are ignored, and these are

likely to have a major and somewhat complicated effect on the final outcome. These

seem to apply in particular to the TCF sectors and the motor vehicles and their

associated parts. Another is that the TDCA tariff reductions were already in place at

the 2005 starting point, so although the percentage of South African imports sourced

from the EU has declined over the most recent time since the TDCA was activated in

percentage shares, that decline may have been more acute in the absence of the

TDCA14. Similarly, SADC tariff preferences effectively went to duty-free on 1 January

2006, whereas we were applying that rate to 2005 imports. There are also some

imports that enter SACA via the BLNS countries, with anecdotal wisdom suggesting

this to be around three percent. These imports have not been factored in. With its

internationally renowned proclivity for trade remedies and the use of tariff rate quotas

in many agricultural products, the schedule rates may at times be misleading and the

actions of the trade remedies may be dampening imports. Analysis of the TRQs in

agriculture suggests that the potential (non-rebate) duties may be around R150

million less than figures used here, so the duty impact, if not the trade volumes, is not

a major factor.

14 While, in theory, the ‘half-way’ stage of the TDCA would provide an opportunity to test our relatively simple model against what has happened to date, such an analysis would be very time-intensive. This would also involve going back to the import profile as it was around 2000, and that profile had changed dramatically by 2005 (which of course means that it may change just as much over the next five years, but we similarly are assuming that away as well).

21

Two technical points need to be noted. The first is that the analysis has been built up

from a very detailed HS 6 or even HS 8 on a line-by-line basis and then aggregated

to the more useful HS 4 level for reasons of operational tractability. This has both

advantages and disadvantages. The former is that an exact tariff can be applied to

the detailed line, while the disadvantage is that in the subsequent aggregation some

of this advantage is lost. Similarly, differences in product mix and their exact tariff

rates from the different import sources may have been papered over, although this

would tend to even out.

We would be remiss without commenting upon two aspects of the tariff reductions or

lack thereof. The first is that we have given TDCA preferences to all the future FTAs

(except Mercosur). This would seem to be an excessive concession to China in

particular, but one must expect a negotiator to sit at the table demanding the same

concessions as have been given to others. Indeed, this is the foundation of US

negotiating policy in its FTAs with partner countries. Secondly, the tariffs applied to

motor vehicles and the associated protectionist measures into SACU will increasingly

come under scrutiny from FTA partners and others15 (including a possiblt WTO

challenge), and are likely to be a focal point during the TDCA review. Changes here

will make a large difference notwithstanding the complex rebate regime.

Finally, we have not considered the general equilibrium effects of these tariff changes

as they impact through the community. There will be gains to consumers as goods

become cheaper, but not by the full amount of the tariff reductions, as part of these is

captured by other actors such as retailers and wholesalers. Similarly, traders who are

in danger of losing ground through trade diversion forced by other preferential

sources are likely to alter their prices and trading margins wherever possible to

counter and negate these challenges. Also, as discussed in the paper with respect to

China in particular, the example of much of the new trade coming in the form of

clothing and footwear imports will possibly have substantial effects on these

production sectors with SACU. This is being addressed in a subsequent tralac

paper, although some elements of a dynamic partial equilibrium approach is

incorporated into this approach as shown by the progressive movements in trade and

customs duties as the increasingly large FTA implementation is operationalised.

15 These others now include the South African Commerce Commission

22

The blunt policy message

South African/SACU trade liberalisation will reduce tariff revenues. This revenue is

crucial for the governments of Swaziland and Lesotho in particular. And the concept

of trade creation and trade diversion means that the revenue loss is increased. At

the final or near-final finish line, the big impact is on duty collections, where a

reduction of R8,820 million or 29.7 percent occurs from a no-preference base. For

Lesotho and Swaziland, this represents a decline of at least 15 percent in total

government revenues. This is a potentially serious situation.

Just how serious for Lesotho can be gleaned by looking at Sandrey et al. (2006) who

found, in an analysis of potential tariff losses to this same SACU revenue pool based

upon similar assumptions (not including the income and substitution effects or the

DDA component) and data base, that the revenue potentially available to Lesotho

from the SACU Customs pool will decline by some 11 percent over the next few

years. In order to assess just how crucial this actually will be, they fed the projected

11 percent revenue loss into a macro-economic model of the Lesotho economy. The

results showed a reduction in government expenditures in the next and subsequent

periods, that the Government budget moved into deficit but subsequently showed a

smaller surplus than was projected; and that there was a reduction in gross domestic

expenditures that rose to one percent annually. In addition, there were implications

for projected capital expenditure, and should there be a downturn in the vulnerable

export of clothing under preferences to the US market, these impacts would be

greatly exacerbated.

Analysis in this paper suggests that the end result incorporating trade creation and

trade diversion effects into the mix gives a reduction in revenues that is roughly half

as much again as much as the results for Lesotho (Sandrey et al. 2006).

It will be hard for Lesotho to replace these revenues. We hope that this paper alerts

policy makers to the potential impacts of SACU trade preference agreements upon

the economies of the BLNS countries. And we remind them that (a) the D and C in

the TDCA stand for Development and Cooperation respectively, so this should be

emphasised during the TDCA review; and (b) under the proposed Economic

Partnership Agreements (EPA) between the EU and the African, Caribbean and

23

Pacific Island (ACP) countries, there have been promises of development funds.

Although perhaps the BLNS may not be negotiating under the EPA umbrella, the EU

must be reminded of these promises. We also remind South Africa of its moral

obligation to consider the reductions in income transfers (i.e., transfers above and

beyond what could be considered a reasonable estimate of the tariff revenues

collected on behalf of the BLNS countries16) that were negotiated into the new SACU

revenue sharing agreement.

Then, who is gaining? Consumers are gaining, but most of these SACU consumers

live in South Africa. Producers in the EU and SADC are gaining, while producers in

China and the US may potentially gain in the future. But that raises an equity

question as to why poor consumers in the BLNS are effectively making transfers to

these generally richer producers. There will be some efficiency gains in South

Africa’s industrial sector to compensate SACU overall, and without a CGE model we

cannot calculate this.

16 Sandrey et al. point out that perhaps as much as 80 percent of the SACU revenue distribution is, in effect, an income transfer from South Africa to SACU as the BLNS countries receive tariff revenues that are around four or five times what they would be if the goods came directly into these BLNS countries. They also, however, counter that South African industrial policies are in effect denying BLNS access to lower price imports and forcing them to consume South African goods. This is a complex situation.

24

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Sandrey, R Matlanyane, A. and Maleleka, D. 2006. Trade Liberalisation: What

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Szepesi, S. and Bilal, S. 2003. EPA Impact Studies: SADC and the regional

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Working Papers 2002 US safeguard measures on steel imports: specific implications by Niel Joubert & Rian Geldenhuys. WP 1/2002, April A few reflections on Annex VI to the SADC Trade Protocol by Jan Bohanes WP 2/2002, August Competition policy in a regional context: a SADC perspective on trade investment & competition issues by Trudi Hartzenberg WP 3/2002, November Rules of Origin and Agriculture: some observations by Hilton Zunckel WP 4/2002, November 2003 A new anti-dumping regime for South Africa and SACU by Stuart Clark & Gerhard Erasmus WP 1/2003, May Why build capacity in international trade law? by Gerhard Erasmus WP 2/2003, May The regional integration facilitation forum: a simple answer to a complicated issue? by Henry Mutai WP 3/2003, July The WTO GMO dispute by Maxine Kennett WP 4/2003, July WTO accession by Maxine Kennett WP 5/2003, July On the road to Cancun: a development perspective on EU trade policies by Faizel Ismail WP 6/2003, August GATS: an update on the negotiations and developments of trade in services in SADC by Adeline Tibakweitira WP 7/2003, August An evaluation of the capitals control debate: is there a case for controlling capital flows in the SACU-US free trade agreement? by Calvin Manduna WP 8/2003, August Non-smokers hooked on tobacco by Calvin Manduna WP 9/2003, August Assessing the impact of trade liberalisation: the importance of policy complementarities and policy processes in a SADC context by Trudi Hartzenberg WP 10/2003, October An examination of regional trade agreements: a case study of the EC and the East African community by Jeremy Everard John Streatfeild WP 11/2003, October

26

Reforming the EU sugar regime: will Southern Africa still feature? by Daniel Malzbender WP 12/2003, October 2004 Complexities and inadequacies relating to certain provision of the General Agreement on Trade in Services by Leon Steenkamp WP 1/2004, March Challenges posed by electronic commerce to the operation and implementation of the General Agreement on Trade in Services by Leon Steenkamp WP 2/2004, March Trade liberalisation and regional integration in SADC: policy synergies assessed in an industrial organisation framework by Martine Visser and Trudi Hartzenberg WP 3/2004, March Tanzania and AGOA: opportunities missed? by Eckart Naumann and Linda Mtango WP 4/2004, March Rationale behind agricultural reform negotiations by Hilton Zunkel WP 5/2004, July The impact of US-SACU FTA negotiations on Public Health in Southern Africa by Tenu Avafia WP 6/2004, November Export Performance of the South African Automotive Industry by Mareika Meyn WP 7/2004 December 2005 Textiles and clothing: Reflections on the sector’s integration into the post-quota environment by Eckart Naumann WP 1/2005, March Assessing the Causes of Sub-Saharan Africa's Declining Exports and Addressing Supply-Side Constraints by Calvin Manduna WP 2/2005, May A Few Reflections on Annex VI to the SADC Trade Protocol by Jan Bohanes WP 3/2005, June Tariff liberisation impacts of the EAC Customs Union in perspective by Heinz - Michael Stahl WP4/2005, August Trade facilitation and the WTO: A critical analysis of proposals on trade facilitation and their implications for African countries by Gainmore Zanamwe WP5/2005, September An evaluation of the alternatives and possibilities for countries in sub-Saharan Africa to meet the sanitary standards for entry into the international trade in animals and animal products by Gideon K. Brückner WP 6/2005, October Dispute Settlement under COMESA by Felix Maonera WP7/2005, October

27

The Challenges Facing Least Developed Countries in the GATS Negotiations: A Case Study of Lesotho by Calvin Manduna WP8/2005. November Rules of Origin under EPAs: Key Issues and New Directions by Eckart Naumann WP9/2005, December Lesotho: Potential Export Diversification Study: July 2005 by Ron Sandrey, Adelaide Matlanyane, David Maleleka and Dirk Ernst van Seventer WP10/2005, December African Member States and the Negotiations on Dispute Settlement Reform in the World Trade Organization by Clement Ng’ong’ola WP11/2005, December 2006 Agriculture and the World Trade Organization – 10 Years On by Ron Sandrey WP1/2006, January Trade Liberalisation: What exactly does it mean for South Africa? by Ron Sandrey WP2/2006, March South African merchandise trade with China by Ron Sandrey WP3/2006, March The Multifibre Agreement – WTO Agreement on Textiles and Clothing by Eckart Naumann WP4/2006, April The WTO – ten years on: trade and development by Catherine Grant WP5/2006, May A review of the results of the 6th WTO Hong Kong Ministerial Conference – Considerations for African, Caribbean and Pacific (ACP) Countries by Calvin Manduna WP6/2006, June Trade Liberalisation: What exactly does it mean for Lesotho? by Ron Sandrey , Adelaide Matlanyane and David Maleleka WP7/2006, June A possible SACU/China Free Trade Agreement (FTA): Implications for the South African manufacturing sector by Hans Grinsted Jensen and Ron Sandrey WP8/2006, July Ecolabels and fish trade: Marine Stewardship Council certification and the South African hake industry by Stefano Ponte WP9/2006, August South African Merchandise Trade with India by Ron Sandrey WP10/2006, August Trade Briefs 2002 Cost sharing in international dispute settlement: some reflections in the context of SADC by Jan Bohanes & Gerhard Erasmus. TB 1/2002, July

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Trade dispute between Zambia & Zimbabwe by Tapiwa C. Gandidze. TB 2/2002, August 2003 Non-tariff barriers: the reward of curtailed freedom by Hilton Zunckel TB 1/2003, February The effects of globalization on negotiating tactics by Gerhard Erasmus & Lee Padayachee TB 2/2003, May The US-SACU FTA : implications for wheat trade by Hilton Zunckel TB 3/2003, June Memberships in multiple regional trading arrangements : legal implications for the conduct of trade negotiations by Henry Mutai TB 4/2003, August 2004 Apparel Trade and Quotas: Developments since AGOA’s inception and challenges ahead by Eckart Naumann TB 1/2004, March Adequately boxing Africa in the debate on domestic support and export subsidies by Hilton E Zunckel TB 2/2004, July Recent changes to the AGOA legislation by Eckart Naumann TB 3/2004, August 2005 Trade after Preferences: a New Adjustment Partnership? by Ron Sandrey TB1/2005, June TRIPs and Public Health: The Unresolved Debate by Tenu Avafia TB2/2005, June Daring to Dispute: Are there shifting trends in African participation in WTO dispute settlement? by Calvin Manduna TB3/2005, June South Africa’s Countervailing Regulations by Gustav Brink TB4/2005, August Trade and competitiveness in African fish exports: Impacts of WTO and EU negotiations and regulation by Stefano Ponte, Jesper Raakjær Nielsen, & Liam Campling TB5/2005, September Geographical Indications: Implications for Africa by Catherine Grant TB6/November 2006 Southern Africa and the European Union: the TDCA and SADC EPA by Catherine Grant TB1/2006, May Safeguarding South Africa’s clothing, textile and footwear industries by Gustav Brink

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TB2/2006, May Agricultural Safeguards in South Africa by Gustav Brink TB3/2006, May The WTO Trade Policy Review Mechanism: application and benefit to SACU by Paul Kruger TB4/2006, June