How to enter into an FTA that delivers

In the past three decades, over 300 free trade agreements (FTAs) have been signed the world over. Many did not meet expectations. Countries continue to grapple with questions like: How to select an appropriate FTA partner country? Can the FTA impact be foretold? By how much will exports grow post FTA? Will the FTA allow participation in global value chains (GVCs)?

Based on the understanding of 50 global FTAs, we provide yardsticks to answers such questions. These are universal and not India-specific.

First, the definition. An FTA is an arrangement between two or more countries under which they agree to end tariffs and non-tariff barriers on a large value of imports from partner countries. The agreement may also cover, among others, services, investment, and economic cooperation.

Impact can be predicted

Selection of an appropriate FTA partner is more important than the later act of negotiations. FTA outcome depends more on the trade profile of the FTA partner and less on the skill of trade negotiators. Negotiations do not substantially alter the results. The impact of an FTA on the exports, imports, domestic industry, and consumers can be predicted with a fair degree of accuracy.

Here are a few home truths:

One: A country with a large bilateral trade deficit is designed to lose the FTA game. Consider two countries A and B. A exports goods worth $10 billion to B, while B exports goods worth $80 billion to A. If both agree to end duty through an FTA, A will provide eight times the market access at zero duty to B than B to A. Even if B opens 20 per cent more market, A will end up opening 6.4 times more market for B.

Two: Non-tariff barrier (NTB) issues are not resolved in most FTAs. As a result, many times a partner country refuses imports even though it agreed to provide zero duty access. Experience shows that it is easier to harmonise when partners are at a similar level of development. So countries with diverse levels of development can hardly hope to align NTBs. Negotiations can barely alter this reality.

Of course, a dominant FTA partner may dictate changes in the partner country’s regulation to match its own. The US got many FTA partners to restrict the flexibilities like the use of compulsory licensing allowed under the TRIPs.

Three: Countries with high import duties are at a disadvantage. FTAs favour products from partner countries by allowing them duty-free access, while products from other countries continue to pay import duties.

This leads to the replacement of goods from the more efficient non-FTA country supplier by less efficient FTA partner country supplier. The effect is termed trade diversion. Countries with high import duties suffer from high trade diversion.

High import duty equals the high wall protecting domestic industry from imports. When zero duty imports replace local products, the effect is called trade creation. Local industries suffer more when the high wall crumbles as a result of an FTA. If import duty is 2 per cent, elimination entails little or no suffering.

Export growth prospects

Export growth post-FTA can be predicted to a fair level using the following: normal market access (NMA); additional market access potential (AMAP); and real additional market access (RAMA).

Let us say Country A exports only three products to Country B: shoes ($10 billion), shirts ($20 billion) and cars ($30 billion).

Import duties in B on shoes, shirts, and cars are zero, 5 and 10 per cent, respectively. We say A’s current NMA in B is $60 billion.

Now if A and B enter into an FTA and B ends duty on all products, A will get an AMAP of $50 billion for exports of shirts and cars. FTA will not benefit shoes as they already enter B at zero duty. FTA has just created a possibility of more exports of shirts and cars from A to B. But this remains a potential.

In reality, more exports will take place only if these products become cheaper (on account of the Customs duty elimination) than the similar products supplied by competing countries. Let us say just cars become cheaper. Now, there is a real possibility of an increase in export of cars from A to B. So baseline RAMA for cars is $30 billion. It should increase over time.

A high RAMA level decides the effectiveness of an FTA. All market access except RAMA are frivolous and do not result in any more trade. Doing FTAs with low MFN (most favoured nation) duty countries does not result in RAMA. RAMA can be calculated before entering into an FTA.

Global value chains

For taking part in GVCs, members must agree to a zero tariff zone and relax the rules of origin. Most FTAs fail to deliver on these counts. RCEP would be an apt example.

Members do not agree to a zero tariff area or even to a common tariff concession list.

Most countries already have an FTA with each other, so incremental market access would be negligible. All current FTAs will continue.

RCEP will just be adding many new tariff concession lists. Most countries do FTAs on instinct. For many, FTAs are a political and not economic decision. Diplomats may want to achieve political ends at the cost of economic.

A simple analysis as suggested above can save countries signing FTAs from unpleasant surprises.

The writer is from the Indian Trade Service. The views are personal.

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