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Proliferation of Free Trade Agreements and Currency Conflicts

K.N.Harilal, May 23rd 2013, Moscow, 4th Euro-BRICS seminar
K.N.Harilal is Coordinator, Research Unit on Local Governments, Centre for Development Studies, Trivandrum, India

KN Harilal

I am extremely happy and feel highly privileged to have got this opportunity to ‘address’ the distinguished participants of the EURO-BRICS conference in spite of my inability to reach Moscow. I thank the chairperson Ms. Marie Calliol for giving me this opportunity. I also wish the Moscow conference a big success.

In a way my presentation here can be seen as a continuation of the paper I presented in the previous EURO-BRICS conference at Cannes. In the Cannes conference the focus of my presentation was on the growing contradiction between global accumulation of capital and the idea of democracy. Let me recapitulate main points so that the present paper is understood in the right background. Global governance is taking over hitherto unreached spaces of policy making including internal policies of nation-states and even those of local governments. It is undertaken with the overriding objective of facilitating global accumulation of capital. Globalisation of governance, however, cannot be a smooth process because of its obvious contradiction with the institutions of democracy. Democracy, if it is genuine, cannot undermine all other interests including those of labour, gender, environment, local capital, etc., to favour the interests of transnational monopoly capital. Yet, because of the competition to woo capital, the nation-states, and governments at various levels, are under pressure to favour monopoly capital even at the expense of other interests. But, the success of capital is fast eroding its social constituency. The spread of popular movements, including wall-street movement, are a sign of growing incongruence in the global system, which is only going to aggravate in the future. Nation-states, governments, political parties, and their leaders will be constrained by popular opinion to take positions that are not necessarily friendly to international monopoly capital. But, they cannot do that in isolation. They will need to build up global collective action in favour of an alternative and balanced global governance system, that allow democracy to recapture its meaning, that is sensitive to environmental issues as well as various rights of the people, and that help sustain national economic habitats and the economic diversity they conserve, against the forces of devastating economic homogenisation. It will be the movement of the new century. I concluded by noting that Europe and BRICS cannot but be in the forefront of this global movement of the future.

Obviously, policy space available for nation states or local governments is fast disappearing under the pressure of globalisation of governance, which is heightening in the context of global economic crisis.  In this paper my attempt will be to establish the connection between the ongoing process of globalisation of governance and the threat of currency conflicts. Currency conflicts over the past  decade, which at several points were about to break into full fledged currency wars among leading nations of the world, are nothing but a reflection of the loss national policy space on the one hand its pressure on institutions of democracy on the other. Currency conflicts in other words underline the need to have a more balanced approach to global governance that protect national and local policy space and the democratic right of self determination of different peoples of the world.

It should be mentioned at the outset that the overriding ideology that inform global economic governance is that of free trade and unfettered competition. Following the mainstream theories of trade, free trade is portrayed as a win-win game which augments world welfare and benefits all the participants. Therefore, global governance arrangements almost invariably sought to promote free trade and unhindered competition among countries. It endeavoured to facilitate free competition among foreign suppliers and between domestic and foreign sources of supply, first by forcing the most favoured nation (MFN) principle, second by scaling down border barriers through multilateral trade negotiations and third, by extending national treatment to foreign suppliers [1].

What about the impact of proliferation of Preferential Trading Arrangements (hereafter PTAs) on national policy space? Introduction of free trade among member countries would definitely limit the policy space available to the participating countries. But, there are no easy answers to the question whether PTAs among member countries would help strengthen the multilateral trading system or not. The PTAs are known to generate impulses that strengthen as well as weaken the multilateral arrangement. The question, however, assumes special importance in the context of the stalemate in the Doha round on the one hand and the recent mushrooming growth of PTAs on the other. The race among countries and regions to get into more and more PTAs is attributed to the failure of the multilateral system, especially the Doha Round impasse. The PTAs apparently offered a bypass to the flow of trade across countries when it was constrained by blocks in the main (multilateral) system of circulation of goods and services. The question is whether the bypass would make the main system redundant and obstruct its revival. In this paper our endeavour is to argue in favour of the opposite line of causation. We argue that the PTAs, especially the recently formed ones are likely to weaken the resistance against non-discriminatory, i.e., MFN liberalization of trade barriers. In other words they are likely to contribute in a big way to the contraction of autonomous policy space available to nation states.

free trade

A PTA Road to Multilateralism

Regionalism and multilateralism cannot normally go together for the former would tend to develop forces that strengthen it at the expense of the latter (Bhagwati 2008). This is true of PTAs as well. The PTAs are known to generate trade diverting as well as creating tendencies. Trade diversion occurs because preferential reduction in tariffs shifts trade from efficient external sources to relatively inefficient sources

within the PTA. The beneficiaries of the preference margin – between tariff rates applicable to PTA members and MFN rates – would not like to lose the advantage. They will be normally opposed to MFN reduction in tariffs proposed in multilateral negotiations or elsewhere. But, it is only logical to argue that such vested interests behind preferential tariff treatment would take time to emerge and consolidate so that they have the required clout to influence commercial policy making in individual PTA partners. We consider this argument important in the current juncture because a good proportion of present PTAs are of very recent origin. Further, customs unions are too rare to be seen among the new PTAs. They are mostly free trade areas (FTAs), wherein members are free to maintain their own external tariffs.  In order to protect the preference margin those who enjoy the benefits of such margin will have to ensure that the FTA members fulfil two important conditions. First, the FTA partners are not reducing their MFN tariffs. Second, they are not entering into preferential trading arrangements individually or collectively with other countries. If so the existing FTA partners will be forced to share preferential access with the newly accessed partners. But, these conditions are difficult to be satisfied because in an FTA there is no agreement on common external tariff (CET); members retain the freedom to decide their foreign trade policy. In the absence of common external tariff policy those who wish to protect regional preference margins will have to lobby for it at the level of individual countries and not at the FTA level. Each FTA member state will have to be convinced not to reduce the MFN tariffs that too with respect to each tariff line. It is likely to be a difficult proposition because the policy concerns as well as choices would differ significantly among FTA member countries.

 

An FTA member country that does not have much import competing production in the case of a given product need not prefer sourcing it from high cost FTA partners. Instead by lowering the MFN tariff it can source the product from least cost sources outside the FTA[2]. In the case of many products, there could be one or more members in the FTA who do not have much import competing production to protect. They could very well opt for reducing the MFN tariffs on such products. Unlike in customs unions this tendency among members to cut MFN tariffs can be a major trade policy problem in FTAs. Imports would tend to enter through the lowest tariff member and get re-exported to other members of the FTA (Krishna and Kruegar 1995).

A solution to the problem of such trade deflection in FTAs is to have stringent Rules of Origin (RoO), which would help prevent simple transhipment of goods by requiring products to originate in exporting member countries. But, the current tendency among PTAs is to go for more and more liberal RoO. If weak RoO norms were designed it would lead to trade deflection, making protection of domestic value added by way of MFN tariffs almost impossible. All members will be forced to scale down their tariffs to the level of the lowest tariff member of the FTA.

Another important threat to preference margin within an FTA perhaps is the PTA contagion by which preferential regional arrangements tend to multiply (Baldwin 1993). The contagion of preferential arrangements can take various shapes. The original FTA, for instance, can allow entry of new members. Similarly, members of the FTA in question can enter into other already existing or new PTAs.  The fear of isolation and trade diversion might induce even countries which were initially reluctant to join the bandwagon of preferential trading arrangements[3]. The expansion of the PTA network would introduce new claimants for the preference margin and make the markets more contested.

It is fairly clear from our discussion so far that the trade diversion impulses generated by the FTA would tend to subside over time. In the conflict between those who want to protect the preference margin and those who wish to reduce MFN tariffs the latter is more likely to gain an upper hand. In sharp contrast the trade creation impulse generated by the FTAs is likely to spread and get strengthened over time. Trade creation occurs because of the shift in trade from inefficient domestic sources to relatively more efficient member sources. Such trade creation is made possible by the commitment to remove trade barriers on intra-FTA trade. Notably, this commitment to liberalize trade among FTA members is nearly irreversible.

Even though, non-discrimination is the founding principle of the WTO regime it allows for discriminatory arrangements such as free trade areas and customs unions under Article XXIV of the GATT 1994. The Article XXIV provision for the FTAs, however, is subject to stringent conditions set to discourage misuse of the provision for perpetrating discriminatory trade policies (Snyder 2009). It insists on well laid out road maps and early completion of the process of formation of the FTA. Tariffs on intra-PTA trade will have to be completely removed as per the road maps and deadlines set for the purpose. Further, discrimination between members and non-members is allowed provided it is achieved by removing tariffs on intra-PTA trade and not by raising the MFN rates. Clearly, the spirit of the Article XXIV is against any upward revision of MFN tariffs. Admittedly, Article XXIV does not insist on any reduction in MFN tariffs. But, as we have already seen, there are forces within the new generation PTAs that favour MFN liberalization. We may conclude by noting that liberalization of trade among PTA members might provide further impetus for trade liberalization and facilitate reduction even in MFN tariffs. Liberalization of trade among members would expose domestic industry in each member country to competition from other PTA partners. In some cases the domestic industry might even fail to survive such competition. If so there may not be much domestic interests left to clamour for maintaining the level MFN protection granted to the industry. A similar situation will arise if the PTA partners were the leading players in the international market of the product in question. In such cases the very formation of the PTA would be exposing the domestic industry to the full heat of international competition. In such cases there would not be much point in maintaining high MFN tariffs. There may not be much competition to be warded off from the MFN sources.

It should be reiterated here that MFN tariff cuts in WTO negotiations as well as preferential cuts in PTAs are virtually irreversible. In WTO most tariffs are bound and it is not allowed, except in rare cases, to raise them beyond the bound rates. Further as we have already seen WTO discipline is not in favour of upward revision of MFN tariffs; preferential cuts are also rarely reversed.  Therefore, there is hardly any room for raising tariffs to protect domestic production, or to stabilise the external sector.

In the absence of control over the borders and trade, what mechanisms are left with the nation states in handling external sector imbalances?  Monetary and fiscal policy tools can be used to reduce the level of economic activity and perhaps also to deflate the economy. The environment of austerity that it entails may not be politically acceptable, especially when recessionary conditions prevail and unemployment levels reach unacceptable levels. Needless to say the environment of global economic crisis, which is worldwide in nature, tends to complicate and aggravate the policy crises. The global crisis is driving capital as well as nation-states to partake in a predatory hunt for market on the one hand investment opportunities on the other. It is this struggle for existence that drives nation states to engage in competitive devaluation. Devaluation of the national currency will make exports of the nation cheap and imports costly. If certain well known conditions are satisfied it can ease the policy stress by enhancing exports and restricting imports. But, as is well known such beggar thy neighbour policies are likely to encounter retaliatory action from competitor countries. It can even prove to be a disastrous contagion. The risk of it being contagious is high when major economic powers engage in currency manipulation. For instance, China being the leading trading power houses of the contemporary world, all its competitors will be concerned about its currency policy. The US complaint against alleged undervaluation of Yuan over the last one decade or so is important to be cited here.

The contagion of competitive devaluation to say the least will be disastrous to the world. The uncertainty that it is sure to produce is not good for economic activity. This certainly is what economic history of the world teaches us. Obviously, major economic powers should refrain from such beggar thy neighbour policies. But, it is important to ask why many nation-states are forced to resort such exchange rate policy to correct external imbalances. Clearly it is absence of alternative policy tools that necessitate currency interventions. The democratic pressure from below make it imperative to adopt expansionary policies. Since the nation state is deprived of other policy measures they take currency manipulation as the last resort.

There is no doubt that countries should have the freedom to fashion their exchange rate policy. But, it is advisable that they have sufficient policy space to support democracy.  Therefore, the currency conflicts can be avoided only when the nation-states are endowed and empowered with alternative economic policy measures. In the absence of such policy space exchange rates are likely to be in the centre stage of the global political drama for some time to come.

Thank You

K.N.Harilal,

Centre for Development Studies,

Trivandrum, Kerala, India

 

References

Baldwin, Richard and Jaimovich, Dany (2010), ‘Are Free Trade Agreements Contagious?’ Working Paper 16084, National Bureau of Economic Research, Cambridge.

Baldwin, Richard (1993), ‘A Domino Theory of Regionalism’, National Bureau of Economic Research, Working Paper 4465, Cambridge.

Bhagwati, Jagdish (2008), Termites in the Trading System: How Preferential Trading System Undermine Free Trade, Oxford University Press, Oxford.

Harilal, K.N. (2012), ‘Regional Route to Multilateralism: Proliferation of PTAs among Developing Countries and WTO Negotiations’, Millennial Asia, January-June, New Delhi

Harilal, K. N. and Sejuti, Jha (2006), ‘Rules of Origin Regimes and South Asia: A preliminary Survey of Issues’, South Asian Yearbook of Trade and Development, Centre for Trade and Development, New Delhi, 357-87.

Krishna, Kala and Anne, O. Krueger (1995), ‘Implementing Free Trade Areas: Rules of Origin and Hidden Protection’, National Bureau of Economic Research, Working Paper No 4983, Cambridge.

Snyder, Francis (2009), ‘China Regional Trade Agreements and WTO Law’, Journal of World Trade, 43, 1, 1-57.



[1] Here we do not overlook the exceptions to the general rule of unfettered competition and integration. The rule was followed quite assiduously when it suited big capital, but not so much when it was the need of lesser players. For instance, the restrictions on competition introduced by the WTO agreement on trade related intellectual property rights (TRIPS) in a way are barriers to international mobility of capital. Needless to say that mobility of labour is even more stringently regulated.

[2] In fact, there are real economic incentives that may prompt the FTA members to go for such tariff cuts. For instance, if the product in question were a critical input for other industries such tariff cuts would enhance the effective rate of protection given to the final goods producing industries. Liberalisation of imports of natural rubber, for example, will be advantageous, at least in the short-run, for the rubber manufacturing industries, including automobile tyres. If the final good producing industry is export oriented liberalisation of imports of inputs would add to its international competitiveness.

[3] For a recent empirical verification of the ‘domino effect’ see Baldwin and Jaimovich (2010), ‘Are Free Trade Agreements Contagious?’, Working Paper 16084, National Bureau of Economic Research, Cambridge.