Free Trade Agreements: The Cost of US Nonparticipation

I appreciate the opportunity to testify before the subcommittee on the implications for US trading interests of free trade agreements (FTAs) to which the United States is not a signatory. Many of these arrangements (or prospective agreements) involve our trading partners in the Western Hemisphere, East Asia, and Europe. The United States has important economic and political interests in all these regions and our ability to advance those interests is impaired when those pacts discriminate against US companies.

I commend the committee on the timeliness of this hearing. Next week, US Trade Representative Robert Zoellick will be in Buenos Aires to meet with other trade ministers from the hemisphere to discuss progress in the negotiation of a Free Trade Area of the Americas (FTAA). The successful conclusion of the FTAA by the target date of January 2005, or possibly one year sooner, would create a more level playing field for US firms in markets in Latin America and the Caribbean that today are worth about $1.5 trillion (excluding Mexico).¹

Four years ago, I alerted this subcommittee that "most countries in the hemisphere continue to pursue bilateral and regional free trade pacts without us", and that US trading interests could be adversely affected if this trend continues.² It has, and we have. My testimony today will review the FTAs that have been negotiated without US participation and the long list of similar pacts currently under negotiation. I will then describe how US firms are affected and how the pacts affect the ability of US trade officials to advance US interests in other trade negotiations.

Are Free Trade Pacts Proliferating?

Over the past decade, there has been a sharp increase in the number of FTAs concluded between developed countries, between developed and developing countries, and between developing countries.³ The Inter-American Development Bank has catalogued more than 20 preferential trade arrangements involving Latin American countries. These accords vary from simple tariff reduction pacts to comprehensive free trade agreements and customs unions. Both Mexico and Canada have concluded free trade pacts with Chile; Mexico also has agreements with Costa Rica, Colombia and Venezuela, and with other Central American countries. Canada is in the final stages of FTA negotiations with Costa Rica as well. In addition, the Mercosur countries (Argentina, Brazil, Paraguay, and Uruguay) are consolidating their customs union and have entered into or are negotiating free trade arrangements with Chile, Bolivia, the Andean Community, and the European Union. The prospective Free Trade Area of the Americas is, of course, the most extensive example of this trend.

It is important to differentiate, however, between FTAs (which are the focus of this hearing) and other types of trade agreements between developed and developing countries. Some accords deal mainly with the conduct of trade relations; others provide trade preferences. Indeed, many pacts evolve in incremental steps over time from the granting of one-way trade preferences to reciprocal free trade agreements. For example, the United States often has first extended unilateral trade preferences (e.g., the Caribbean Basin Initiative and the Andean Trade Preferences Act) to our partner countries, and then negotiated so-called "framework" agreements that establish forums for consultations on bilateral trade relations and the settlement of disputes. In turn, the CBI legislation enacted last year envisages the new trade preferences as a way station to the negotiation of reciprocal free trade pacts.

The United States currently participates in two FTAs, the US-Israel FTA and the North American Free Trade Agreement (NAFTA), and has concluded talks but not yet ratified the US-Jordan FTA. It is also negotiating bilateral FTAs with Singapore and Chile as well as the broader FTAA with 33 democratic countries in the hemisphere. Consideration is also being given to expanding the current bilateral talks to Australia and New Zealand to create a broader "P-5" pact. Senator Baucus has proposed initiating FTA negotiations with those countries and with Korea.⁴ Such proposals have been advanced as part of an effort to revive progress on the commitments taken in the Asia Pacific Economic Cooperation (APEC) forum to achieve free trade and investment in the region by 2010 for developed countries and 2020 for developing countries.

The European Union, by contrast, has concluded a large number of "association" agreements with countries in its neighborhood and in the Mediterranean Basin. More recently, it also has concluded a comprehensive FTA with Mexico, which entered into force on July 1, 2000, and is conducting free trade talks with the Mercosur countries and Chile. Those talks, however, are advancing quite slowly. In addition, the recently minted "Partnership Agreement" between the European Union and its developing-country partners in Africa, the Caribbean, and the Pacific seeks to establish a more reciprocal relationship than existed under the previous Lomé accords that eventually transforms into an FTA.⁵

In essence, the European Union has been pursuing new trade initiatives with its trading partners in Latin America and the Caribbean Basin that presage the development of a free trade zone over the next decade or two, much like the FTAA. Unlike the United States, it has not yet integrated those initiatives into a single negotiation that over time could create a super-regional free trade zone. Rather its free trade strategy is more diversified and is proceeding at different speeds in various regions of the Americas. Discussions on a reciprocal trade agreement with the Caribbean countries are expected to begin within a few years, while similar initiatives with the Andean Community and the Central American countries are only in the planning stage. In short, the European Union is in the process of assembling the building blocks for free trade with Latin America and the Caribbean but it is a long way from putting such an initiative into effect.

Over the past two years, there also has been a dramatic resurgence of bilateral trade initiatives in the Asia-Pacific region. Japan and Singapore began FTA talks in January 2001.⁶ Japan also has held extensive consultations with Korea on the possibility of entering free trade negotiations within the next few years. Japan and Mexico have explored the idea of bilateral talks and have received support from a bilateral business working group.⁷ Korea has entered into FTA negotiations with Chile and discussed possible FTAs with Japan, New Zealand, and Singapore. New Zealand and Singapore concluded negotiations on a bilateral FTA in August 2000 and signed the pact in November 2000 just prior to the APEC summit meeting in Brunei. At that meeting, Singapore agreed separately with Australia and with the United States to launch FTA talks; the latter initiative in turn spurred the start of the oft-postponed US-Chile negotiations in early December 2000. Soon after the APEC meeting, leaders of the ASEAN countries along with Japan, Korea, and China (the "ASEAN + 3") agreed to study the possibility over time of a broader free trade regime in East Asia.

The Costs of Nonparticipation

Overall, FTAs involving US trading partners but not the United States can affect US interests in several ways. On the positive side, such agreements can serve US trading interests if they promote broad-based economic and political reforms in the partner countries and contribute to stronger and more sustainable growth in the developing countries. At the same time, however, they can-and do-discriminate against US exporters and complicate the achievement of US trade negotiating objectives, in particular:

• US exporters face discriminatory treatment in foreign markets compared to that accorded to producers from the participating countries. Export contracts are either lost or sourced from overseas production plants; either way, it hurts US-based production and workers.
• Moreover, when the United States is not a party to a negotiation and agreement, we cannot influence the outcome. Trade rules developed in such pacts may both increase transactions costs and establish precedents that differ from US practices and proposals that the signatory countries may seek to extend to other regional and WTO accords.

First, FTAs by their nature discriminate against outsiders; tariff preferences are accorded only to member countries and thus disadvantage foreign suppliers. As a result, US firms often are handicapped in competing for sales in South American markets when they have to pay sizable tariffs and their regional competitors do not. Sometimes US firms can source from foreign plants in countries that receive tariff preferences, although this is costly both for the company and diverts work away from US employees. Sometimes, US firms lose contracts to suppliers resident in the FTA partner countries. Such trade diversion is an important reason why multilateral liberalization is superior to discriminatory bilateral or regional accords.

How much does such trade diversion cost US firms? In the aggregate, the lost sales represent a very small share of US GDP; but for the particular firms, and the workers and communities affected by production cutbacks, the aggregate numbers mask significant costs. In a new study that will be released shortly by the Institute for International Economics, Rob Scollay and John Gilbert have examined the potential US welfare losses from a variety of prospective FTAs in the East Asia region using a computable general equilibrium model. Their simulation results show that the negative welfare effects for the United States generally amount to much less than 0.1 percent of GDP and in many cases less than 0.01 percent of GDP. Again, these findings provide little solace to the particular companies and workers that lose out to competitors that benefit from FTA trade preferences.

Second, FTAs usually contain trade rules that set criteria for qualifying for trade preferences (e.g., rules of origin) as well as other customs provisions that can impose significant transaction costs for US companies. The more complex and cumbersome the content/origin requirements, the more likely the policy will have a chilling effect on trade (and the harder to administer as well). To be sure, the most effective safeguard against abusive origin rules is multilateral tariff liberalization. Low most-favored nation (MFN) tariffs reduce the value of regional preferences; they also reduce the need for regional origin rules to block the transshipment of imported goods that have entered the regional bloc through low-tariff FTA member countries. So, the lower the MFN tariff levels (and the greater the harmonization of tariff levels between countries in the regional pact), the fewer the problems posed by "tight" rules of origin.

In addition, FTAs can discriminate by providing special treatment under escape clause and dispute settlement procedures only for firms from the partner countries (as is done in the NAFTA). The proliferation of different tariff rates, customs procedures, and content requirements can create a paperwork nightmare for businessmen. Indeed, after the entry into force of the US-Canada FTA, some firms did not request the FTA tariff preferences because the transaction cost of applying for the preferences was greater than the low most-favored nation tariff.

However, in many cases it is not practical to apply different rules to the trade and investment of member versus nonmember countries. For example, countries often implement investment reforms in a nondiscriminatory fashion lest the new investment regime run counter to the broader objective of promoting capital inflows from industrial countries, which provide both advanced technologies and management skills.⁸ Usually the demands of the marketplace (not to mention the inordinate administrative costs of implementing different standards and requirements for different countries) require convergence toward the standards in the predominant market of the regional partners (which for most Western Hemisphere countries means the United States).

Third, recently concluded regional agreements create precedents involving practices significantly different from those inscribed in US law that member countries may want to extend to the broader FTAA. For example, the Chile-Canada FTA prohibits the use of antidumping laws with respect to bilateral trade as soon as tariffs are removed (i.e., within six years). The Canada-Chile FTA also includes a side agreement on labor with enforcement provisions similar to those applicable to US-Canada disputes in the NAFTA (i.e., noncompliance penalties may involve monetary fines but not trade sanctions). Some countries in the hemisphere consider these provisions to be possible models for what could be included in the FTAA.

Lost Opportunities

Of course, perhaps the highest price we pay for not participating in FTAs is the lost opportunity to expand economic ties with our trading partners and promote economic growth and development. A number of recent economic studies conclude that as countries reduce barriers to trade (both internal and border restrictions), per capita income increases significantly. For example, Frankel and Rose (2000) estimate that over a period of 20 years, a 10 percent rise in the ratio of trade to GDP boosts per capita income by 3.3 percent.⁹ Their results can shed some light on the potential trade expansion generated by an FTAA.

If one projects future trade growth under an FTAA comparable to growth already achieved under NAFTA, the potential expansion of trade relations is notable. A comparison between Brazil and Mexico illustrates the medium-term possibilities of an FTAA agreement. In 2000, two-way merchandise trade between the United States and Mexico was more than eight times larger than two-way trade between the United States and Brazil. How much of the difference can reasonably be attributed to NAFTA?

The gravity model developed by Frankel and Rose can be used to estimate the potential increase in US-Brazil trade if the two countries were joined in a free trade agreement. The estimated parameter suggests that US-Brazil trade would double or triple, from $29 billion in 2000 to $58 billion or even $87 billion, if an FTA had been in place.

This estimate can serve as a proxy for the overall short-to medium-term potential between South America and North America under an FTAA. Over time, however, the potential volume of regional trade creation is far larger than the volume predicted by standard gravity models. This is illustrated by the fact that the density of merchandise trade flows within a country (e.g., between New York and Chicago, between Quebec and Ontario, or between Frankfurt and Hamburg) is estimated to be at least ten times greater than trade flows that cross international borders, holding constant the economic size and distance between the source and destination.¹⁰

Conclusions

The best way to neutralize the adverse effects on US trading interests of FTAs in which the United States is not a signatory is to engage more effectively in bilateral, regional and multilateral trade negotiations. The FTAA is particularly important to level the playing field in our own hemisphere. Furthermore, by deepening the economic partnership with our neighbors in the hemisphere, we can also strengthen cooperative efforts on other important US political and foreign policy goals, including cooperation on drug interdiction, improving environmental and labor conditions, supporting educational reforms, and reinforcing democracy. Thus, an FTAA could have important spillover effects on overall US relations with the region. This point is well illustrated by the 2000 Mexican presidential election, which demonstrated the salutary effect of economic integration on political reform.

In addition, we need to work intensively with other WTO countries to develop an agenda for a new round of multilateral negotiations that encompasses the priority concerns of both developed and developing countries. Fortunately, consultations to that end have resumed without the rancor and inflammatory rhetoric that inhibited efforts immediately after the ill-fated Seattle WTO ministerial. I am cautiously optimistic that trade ministers will succeed in launching a new WTO Round when they reconvene in Doha, Qatar, for the 4th WTO ministerial in November 2001.

Of course, none of these trade initiatives are likely to be concluded unless the Congress and administration develop a bipartisan agreement on US trade policy objectives and trade negotiating authority. Our trade officials must have a strong domestic base of support, clear and consistent objectives, and sufficient flexibility to get the job done. Approving new "trade promotion" authority, hopefully later this year, is the best way Congress can respond to the problems facing US companies in world markets and the best way to reassert US leadership in the world trading system.

Notes

1. For an analysis of the progress to date in the FTAA and current challenges facing the negotiations, see Jeffrey J. Schott, Prospects for Free Trade in the Americas, Washington: Institute for International Economics, April 2001.

2. "The Free Trade Area of the Americas: US Interests and Objectives," statement by Jeffrey J. Schott before the Subcommittee on Trade, House Committee on Ways and Means, 22 July 1997.

3. Inter-American Development Bank, Integration and Trade in the Americas, Periodic Report, December 2000.

4. For the pros and cons of a US-Korea pact, see Inbom Choi and Jeffrey J. Schott, Free Trade between Korea and the United States? Policy Analyses in International Economics 62, Washington: Institute for International Economics, May 2001.

5. For an analysis of these initiatives, and the interests and objectives of the participating countries, see Jeffrey J. Schott and Barbara Oegg, "Europe and the Americas: Toward a TAFTA-South?" The World Economy, forthcoming summer 2001.

6. For background on these talks, see the September 2000 report of a joint governmental study group, "Japan-Singapore Economic Agreement for a New Age Partnership", Tokyo: Keidanren.

7. Mexico proposed new FTA talks with Japan in January 2001. Instead, both sides agreed to study further the implications of such an accord and possibly commission an intergovernmental study group as was done prior to the launch of the Singapore-Japan FTA talks.

8. For this reason, Mexico committed to investment reforms in the NAFTA but applied their policies on a most-favored nation basis to non-NAFTA countries as well.

9. See, Jeffrey Frankel and Andrew Rose, "Estimating the Effect of Currency Unions on Trade and Output," NBER Working Paper 7857, August 2000.

10. See, for example, John Helliwell, "Do National Borders Matter for Quebec's Trade?" NBER Working Paper 5215, August 1995.