WTO and FTA: Seek the Best of Both Worlds

Kenzo ABE (Professor, Osaka University)

Although Free Trade Agreements (FTAs) are being concluded among various groups of countries, the WHO Doha Round is experiencing hard sailing at its critical stage. The principle of nondiscrimination is essential in realizing efficient allocation of resources, so reaching an agreement in the WTO Doha Round is important.

The new round at a critical stage

The WTO's current undertaking in multilateral trade negotiations, the Doha Round, is at its final and critical stage in reaching an agreement. Whether the WTO, with membership close to 150 countries and regions, can succeed in concluding the round has significant relevance for the future world economy.

Having started the attempt in 2001, it was in July 2004 when the framework of negotiation for the Doha Round was first agreed upon. At the ministerial meeting in December 2005, it was decided to aim for an agreement on universal rules, including tariff reduction on both agricultural and non-agricultural products by the end of April, to make it possible for the conclusion of the negotiation by the end of 2006. But due to antipathy over agriculture and other issues, the end of April target was missed and intensive discussions are presently going on to save the Round.

While the multilateral talks at the WTO are being delayed, Japan in recent years has actively pursued FTA negotiations, mainly with East Asian countries. FTA with Singapore became effective in November 2002 and with Mexico in April 2004. An agreement was signed with Malaysia in December 2005, and basic understandings have been established with the Philippines and Thailand.

An advantage of FTA is often referred to as the trade creation effect. When tariffs between the member countries are eliminated, trade increases and economic efficiency grows. FTA would facilitate inefficient domestic production to be replaced with efficient foreign production, allowing consumers to purchase less expensive imported goods, which in turn enhances the economic welfare of the member countries. However, such outcome can be brought about by reduction of trade barriers in general, which could be realized not necessarily by FTA but also by trade liberalizations implemented through multilateral negotiations at the WTO.

The advantage of trade liberalization in this manner is often not fully appreciated. For example, if trade were liberalized, domestic industries with comparative disadvantages would face tough competition, which could weaken the country’s industries as a whole. Adversaries often claim that trade liberalization is undesirable because even though efficiency might increase, domestic industries would suffer and problems such as unemployment could materialize.

But the fact that substitution of locally produced goods for more efficiently produced imports benefits the country as a whole can be explained with a simple example. Suppose the price of merchandise is 900 yen internationally. If a 300-yen tariff were imposed, the price of the goods in Japan would be 1,200 yen. If the actual selling price were higher than 1,200 yen, foreign companies would increase supplies to Japan because it would be more profitable to do so, until the price drops to 1,200 yen.

FTA could increase burden in some respects

When the tariff on the merchandise is removed, the goods would be imported at 900 yen, and the domestic company producing the goods at the cost of, say, 1,100 yen, would be forced out of the market and lose the 100-yen profit formerly available. But consumers benefit by the price decline of 300 yen. This means that by substituting the domestically produced goods with the imports, the overall net benefit of 200 yen could be achieved, considering both the gain for the consumers and the loss to the producers.

This means there is a definite benefit in trade liberalization for a country as a whole. And the loss incurred by specific industry sectors can be compensated through appropriate income redistribution schemes so that the benefit could be shared by all. Temporary unemployment should be solved by policy measures to support shifting of labor forces to industries with comparative advantage.

What then, is the difference between trade liberalization by FTA and that of the WTO? While FTA treats producers of its member countries differently from those outside the agreement, the WTO requires MFN (most favorable nation) treatment, the principle of nondiscrimination, to be generally applied equally to all the countries.

This leads to the often-mentioned drawback of FTA - the trade diversion effect. When the WTO principle is applied, imports from any country would be levied the same tariff, which would enable importing from the lowest cost producer among all the countries. But once FTA is concluded the goods could be substituted by the products from an FTA member country, which is not necessarily the most efficiently produced in the world. As a result, FTA could decrease the economic welfare of the member countries.

For example, suppose a certain product were supplied at 900 yen by country A, and at 1,000 yen by country B, and that Japan at that point concludes an FTA with country B. When the tariff on the goods was 300 yen for everyone in accordance with the MFN principle of WTO before the FTA agreement, the goods would be imported at 1,200 yen from country A. But by concluding the FTA with country B and the tariff for the goods from country B is to be totally removed, the goods would then be imported from country B at the price of 1,000 yen.

It may seem, at a glance, favorable for Japan, as consumers would be able to purchase the goods at a lower price than before. But before the FTA there was 300-yen tariff revenue for the government, which would have been transferred to the people through various means. In effect the goods were able to be purchased at 900 yen before the FTA for Japan as a whole, but by concluding the FTA with country B Japanese consumers would be in effect paying 100 yen more.

WTO enables improved efficiency with less distortion

As such, there can be cases where allocation of resources would become less efficient in FTA compared to the WTO.

Although it is sometimes pointed out that FTA negotiations are easier to be carried out because of the smaller number of parties involved, there are possibilities of high tariffs on specific products to be left unadjusted while removing tariffs on most of other goods so as to facilitate faster conclusion of the agreement. This could cause other types of distortions to increase inefficiency in terms of resource allocation. Indeed, certain agricultural products are often levied high tariffs in some FTAs. In the case of Japan's FTA with Mexico, tariff quotas remain for such produce as meat and oranges, where imports over a pre-set volume would be subject to high tariffs.

Moreover, the practical cost of managing the FTA could become large. As FTA is to remove trade barriers among only the member countries, rules regarding the origin of the good must be thoroughly defined, and a system must be in place to determine the country of origin in accordance with the stipulations of each applicable FTA.

Determining the country of origin could become a complicated task, especially in cases where the goods are the result of processes in a number of countries. Normally, the last country where substantial modification was effected to the goods would be considered the country of origin. But the definition of the term substantial modification, and the method of application of the rules, differs by agreements and products. When a significant number of FTAs are concluded each with unique definitions, determination of origin becomes a daunting task, driving the practical cost of administration to prohibitive levels. This is what Professor Bhagwati of Columbia University pointed out as the "spaghetti bowl" phenomenon.

Measures must also be implemented to prevent deception of origin. There have been a number of cases of fraud detected, mainly in foodstuff such as meat and vegetables.

WTO negotiations are not easy because there are countries such as the U.S. which strongly demand liberalization of agricultural goods. But as resulting liberalization by the WTO could realize better allocation of resources in comparison with FTA, unique advantages of the WTO and FTA should be incorporated to facilitate a better world.

For example, the WTO could concentrate on trade liberalization of goods including agricultural produce, while bilateral and regional FTAs could place emphasis on such matters as investment, movement of persons, and harmonization of competition policies. The Doha Round negotiation, now at the critical stage, should focus on trade liberalization of goods and every effort should be exerted to achieve consensus on modalities, including the farming sector, without delay. This would encourage conclusion of the agreement by the end of the year.

(The original Japanese article appeared in the June 12, 2006 issue of Nihon Keizai Shimbun.)