E-book Think Piece N°8 – 30 September 2016
Mega-regional trade deals and their impact on developing countries: how to construct them to ensure benefits for all?
by Fritz Putzhammer, Project Manager, Bertelsmann Stiftung
The world is witnessing a revolution in global trading. Due to stalled multilateral trade talks, nations have faltered putting their trust into a single global trading order as envisioned by the WTO and started shifting their emphasis towards negotiations of bilateral and regional agreements. Mega-regional trade agreements in particular seem to offer an alternative for countries which still want to reap the benefits of having largely harmonized trading patterns.
While developed countries are getting more and more involved in megadeals such as the Transatlantic Trade and Investment Partnership (TTIP) and the Transpacific Partnership (TPP), Asia is developing its own ideas through the Regional Comprehensive Economic Partnership (RCEP) or the quantitatively more ambitious China-backed Free Trade Area of the Asia-Pacific (FTAAP).
Nowadays, however, it seems that such agreements might be far off the silver bullet they were once praised. Indeed, voices have grown in Europe and the US condemning mega-regionals and some negotiations seem to have reached an impasse. While much of the criticism focuses on issues of transparency or standards within the participating developed nations, the potential effects of mega-regionals on the developing world have been widely questioned as well.
This article therefore serves to explore potential impacts of mega-regional free trade agreements on the developing world. While some developing countries are also directly involved in such agreements, as is the case for several Asian countries, this article primarily focuses on nations who are reduced to mere third-party bystanders to this new world trading order, as can be observed in Africa for example. It will furthermore present tangible suggestions as how to make this new order more inclusive and elaborates on the role that WTO could have to play in this game.
How do mega-regionals affect third party countries?
If completed, TTIP alone would cover about 45% of world GDP, 11.5% of the world’s population (as of 2013) and approximately 30% of world exports (as of 2012). Even though a developing nation might not be directly involved in any of such upcoming mega-regionals, we can assume that due to their sheer size, agreements like the TTIP, the TPP or the FTAAP will have significant effects on such economies.
Let’s then take TTIP as an example. Generally, an agreement like TTIP can impact a third party country in different ways. There will be direct effects on prices as well as on income, but these direct effects would impact the welfare of third countries in opposite ways. The price effect, also called the trade diversion effect, arises when imports from a third country suddenly become relatively more expensive for Europeans or Americans compared to the imports from their TTIP partner countries. This loss of price competitiveness can result in a lower trade volume and therefore reduce the revenues of such third party exporters.
At the same time, however, a trade agreement like TTIP is expected to lead to higher income – and therefore to increased buying power – in the TTIP member states. Greater purchasing power stimulates increased demand – also for imports from third party countries. This enables those countries to increase their export volume at higher prices. Whether TTIP has a direct positive or negative impact on the welfare of any third party developing nation thus depends on which of the two effects has a greater influence on its balance of trade.
Indirectly, developing countries could also be affected through so-called spill-over effects, which primarily rely on the harmonisation of regulations that go with large free trade agreements. This harmonisation could incentivize other economies to adjust their own regulations accordingly, making future trade in both directions between the original FTA countries and the outsider countries cheaper.
In a recent model simulation, the German Ifo institute on behalf of the Bertelsmann Stiftung has calculated such expected direct and indirect welfare effects of mega-regionals for a total of 25 African countries. Focusing on TTIP and TPP, the data show that for most African countries, the positive income effect of planned mega-regionals exceeds the negative trade diversion effects. For both TTIP and TPP, only Mozambique, Zambia and the Ivory Coast have to expect negative welfare effects according to the model.
While the calculated effects of Western agreements on developing economies thus seem promising in this scenario, they are below the economic potential the Chinese-backed FTAAP agreement could have for many developing countries. Under the grand envisioned Free Trade Zone, developing countries like Belize and Venezuela in Latin America or African economies like South Africa and Togo could expect estimated yearly boosts in real income of between 6 and 9 % according to model calculations.
To better understand such Eastern promises one needs to understand the changes that created the current world of global trade. No longer are final products and raw materials just exchanged from one country to another. Today, trade happens along global production chains. Many different countries contribute towards the production of a final good by supplying components and parts, services and assembly (trade in tasks rather than trade in goods). Goods are no longer made in one country for export; goods are made in the world for the world.
For the “factory of the world” – China – this means that once the FTAAP promises more exports, its demand for raw materials from all over the world rises too. And for many developing nations who are naturally prone to rely on raw material exports, this means profit.
However, while this is certainly not exactly bad news – growth beats no growth – this isn’t exactly high quality economic expansion either. Developing and especially least developed countries (LDCs) might be further pushed in their dominant reliance on commodities and on China. The uncertain distribution of any such gains further undermines the potential inclusivity of economic growth gained through China’s positive demand effect.
Inclusiveness and collaboration with WTO limit negative impacts on less developed countries
To ensure the most positive outcome for developing countries, mega-regional trade partners should strive to create mega-deals in the most inclusive form possible. For developed countries which are engaged in the TTIP and the TPP, an additional motivation would be to also secure future competitiveness towards China in the developing markets. Potential trade diversion effects of mega-deals and the resulting effects of preference erosion should be cushioned while the impact on demand from positive income effects should be maximized. At the same time, future options should be promoted in order to help developing countries adapt their regulations, so as to achieve potential spill-over effects. In more detail, here are 5 tangible suggestions how this could be achieved:
STEP 1: Complex rules of origin should be reduced as much as possible or be eliminated
In a free-trade agreement, rules of origin define what proportion of a product must have been actually produced in one of the partner countries, in order to qualify for tariff reduction. The more complex and restrictive such rules are, the sooner a domestic exporter will cut back on supplies obtained from third countries and replace them with those from domestic suppliers. This can however be doubly harmful. Important export opportunities are lost for third countries, while the exporter from the mega-deal country must switch to a more expensive domestic supplier in order to comply with the origin rules. Even LDCs, which already benefit from specific preferential market access rules under WTO face preference erosion through this. More complex rules of origin can mean higher bureaucratic burdens and costs for firms in partner countries, so that firms may prefer not to utilize existing trade preferences. A reduction or elimination of such rules in favor of a free-trade principle would substantially moderate trade diversion effects on third countries.
STEP 2: The mutual recognition of standards should be extended to third countries
An essential aspect of TPP and especially TTIP is the mutual adjustment or recognition of different production standards. How far this recognition is extended to third countries will determine the effect the TTIP will have on the rest of the world. Having products mutually recognized only if the producer of the goods is located in one of the partner countries should be avoided. Instead, the source of the supplier should be irrelevant, as long as the standards of either the USA or the EU are respected. Ideally, to verify compliance with standards, there could be an independent international inspection body coordinated and supervised by the WTO. This could initially concentrate on products and services that require less inspection and supervision but later be extended to the inspection and advising inspection and certification agencies of third countries.
STEP 3: Traditional trading partners should be involved at an early stage
To mitigate any negative trade diversion effects of an agreement from the outset, the opening of the agreement should be announced at an early stage. Let’s take TTIP as an example. TTIP partners should first approach their traditional, neighbor trading partners, such as Canada and Mexico as part of NAFTA as well as Australia for the USA and Norway, Switzerland or Turkey on the European side. The potential opening of the agreement for the whole NAFTA space would seem particularly appropriate, since this trading area is already highly integrated. At a later stage TTIP could be opened up to the other Pacific Alliance countries (Chile, Colombia, Costa Rica and Peru).
An early opening of any mega-regional agreement to traditional trading partner countries (developing and developed) would not only reduce trade diversion effects but, because of their economic interactions with other world trading regions, these countries would serve as decisive multipliers of the regulatory spillover processes mentioned earlier. On the other hand, it would be important to take into account the interests and needs of a new member in a fair and balanced way so that poorer countries in particular would not become unwilling participants of deals they did not themselves negotiate.
In a next step, older, already existing bilateral agreements between mega-regional countries and developing countries could be updated and extended. The agreements should extend beyond pure trade in goods to trade in services, investments, etc. In addition to tariff elimination, regulatory components should also be included. Like the previous options, such a step would reduce the relative trade disadvantages of third countries and diminish future trade diversion effects.
STEP 4: Future regulatory cooperation should be opened to third countries
Agreements like the TTIP contemplate future regulatory cooperation and adjustment in the form of so-called “regulatory councils”. These should likewise be opened to third countries. The more third countries, especially developing countries, are integrated in these bodies, the weaker the trade diversion effects would turn out to be. Member countries of mega-regionals would also benefit from the creation of “global” standards. However, it is clear that an unlimited opening of the bodies would not be really effective or functional. Here too only the traditional and central trade partners of mega-deal countries should be involved initially, along with an institutional representation of emerging, middle and lower income and least developed countries. The WTO would also be worth considering in this context as a potential forum for establishing new, more inclusive international regulatory councils.
STEP 5: The role of the WTO as advisor and mediator should be strengthened
The role of the WTO as arbitrator, mediator and advisor on the international trading stage will become ever more relevant and necessary in the future. In view of worldwide regional trade initiatives or “mega-regionals“, the demand for the fair and open design of new and old trade agreements, along with international information exchange about them, will grow – as will dispute resolution both within and between large trade areas. The WTO must be strengthened to play this role.
Even if the importance of the WTO in multilateral negotiations and international contracts declines, the Doha Round should at least be successfully concluded in a more streamlined version. Considering the rhythm in the ratification process, the Trade Facilitation Agreement signed in in Bali in 2013 should be implemented, at least in the medium term, leading to a further worldwide reduction of multilateral tariff and non-tariff barriers.
While negotiations for mega-regional free trade agreements are on-going around the globe, Western nations are facing reluctance towards trade deals like the TTIP and TPP in particular and a growing tendency of preferred protectionism from the public in general. Recent statements by European politicians in Germany, France and Brussels have put a successful conclusion of TTIP negotiations into question. As far as TPP is concerned, the agreement has been signed in early 2016 but has yet to be ratified by the member states’ parliaments and especially in the US, and the deal seems to have lost a lot of its original support.
Yet this piece has shown that, at least as far as the effects of such agreements on developing countries are concerned, mega-regional trade agreements might not be as fatal as critics seem to view it. On the contrary, models show that in most cases third party developing countries stand to benefit from such agreements. If trade diversion effects can be minimized and positive income effects due to higher external demand can be maximized, overall income effects for most developing countries should be positive and can in some cases grow quite substantial. For developing countries relying on commodity exports a warning has to be made not to over-rely on those sectors but rather to use the increased GDP gains to diversify and broaden their economies to guarantee not just today’s growth, but that of tomorrow and the day after as well. A strengthened WTO would be needed, to act as advisor, facilitator and mediator between developed mega-regional countries and developing third party countries.
Finally it has to be said that while this piece examines the potential economic consequences of mega-regionals for developing countries, it does not address the question of GDP distribution and inclusivity within the developing countries. Thus, while incomes per capita might rise in a country, this does not mean that every individual in that country automatically will be better off. It is possible that some people might have to stem the costs of increased globalization while others reap the benefits and especially LDCs will need specific measures as well as additional support, technical assistance and Aid for Trade in order to be able to have a share in the benefits or, at least contain the negative effects of mega-regionals.
Megadeals will most probably be a fact of life in international trade. While they can be constructed so as to minimize any negative impact and to maximize positive impacts on non-participating developing countries, they will always remain a second best solution. There is no remedy to the following issues:
- The rules will be made by the bigger trading partners and poorer, small developing countries will be reduced to rule takers, not rule makers;
- The megadeals will address the trading issues of interest to the more powerful nations and the specific interests of poorer countries will be ignored.
Less developed countries, which are unwilling or unable to participate in megadeals need to strengthen the inclusive multilateral system i.e. the WTO by:
- Not opposing megadeals, but trying to influence their rules so that they can also benefit from those deals;
- Try to link those deals to progress in the inclusive trading system covering their specific interests within the WTO;
- Request that megadeals contain positive measures in favour of poorer developing countries to help them to integrate their economies into the global value chains – and not only at the bottom by providing the primary products.
 This article is a revised version of a previous article published in Bridges Africa, Vol. 5, Issue 3 – April 2016. F. Putzhammer and U. Schoof, “Evaluating the effects of mega-regionals on Africa”.
 Felbermayr et al. (2015), Potential impacts of the Transatlantic Trade and Investment Partnership (TTIP) on developing and emerging economies, Ifo institute, Munich.
 Putzhammer et al. (2016), The Forgotten Continent – The effects of mega-regional free trade agreements on Africa, Bertelsmann Stiftung
 Putzhammer et al. (2016) and Fleischhaker et al. (2016), Bertelsmann Stiftung
 For more suggestions see: Felbermayr, G., W. Kohler, R. Aichele, G. Klee, und E. Yalcin (2015), Mögliche Auswirkungen der Transatlantischen Handels- und Investitionspartnerschaft (TTIP) auf Entwicklungs- und Schwellenländer, Study for Federal Ministry for Economic Cooperation and Development (BMZ)