Regional Trade Blocs:
Trade Creating or Diverting?
CLINTON SHIELLSWILLTHErapidly{proliferating regional\arrangements turn out
I to be "building blocks"
or "stumbling blocks" forliberalizing trade on a nondiscriminatory, multilateralbasis? Much will hinge on how
agreements are designed andcarried out.

During the early 1990s, countries all over theworld—especially in Europe and the Western
Hemisphere—have been forming regional
trading arrangements (RTAs) and intensifying existing ones at a rapid pace (see box).
Some of the increased emphasis on these blocs
stemmed from frustration with the slow paceof the Uruguay Round negotiations. But there
have been other reasons as well that suggestthat the trend toward increased regionalism
is likely to continue.

Some have questioned whether this trend isdesirable, as the best way to liberalize trade ison a most-favored-nation (MFN) basis (i.e., nodiscrimination between trading partners)—
which can be done unilaterally ("autonomousliberalization") or in the context of multilateral
trade talks. Formation of RTAs should not
be allowed to divert attention from MFN liberalization and the ultimate goal of global
free trade.
Whether an RTA facilitates or impedes
eventual global free trade depends on how it isdesigned—including whether procedures forjoining the arrangement are liberal, whether itsatisfies World Trade Organization (WTO)
rules, and whether it is accompanied by somedegree of liberalization on
an MFN basis. So far, itappears that the rapid expansion of intraregional
trade within the world's
leading RTAs has notbeen at the expense of
nonmembers, although
it is possible that tradewith nonmembers might have grown evenfaster without the RTAs.
This article explores motivations underlying the trend toward regionalism, reviews
recent developments in two prominent RTAs
—the European Union (EU) and the North
American Free Trade Agreement (NAFTA)—and develops principles for designing an
RTA so that it is more likely to promote eventual global free trade.

Motivations for RTAs
The motivation for forming RTAs varies
from region to region, and even from country
to country within an RTA, but a few factors
seem to play a key role.
• Members may see economic benefits
from achieving a more efficient production
structure (including by exploiting economies
of scale through spreading fixed costs
over larger regional markets), and enhanced
economic growth fromforeign direct investment,
learning by doing, andresearch and development.
• Members may value
noneconmnic objectives,
such as strengthening
political ties and managing migration flows.

Clinton Shiells,
a US citizen, is an Economist
in the Trade Policy Division of
the IMF's Policy Development
and Review Department.

30

Finance & Development / March 1995]©International Monetary Fund. Not for Redistribution• Smaller countries may seek increased
security of market access—"safe havens"—
by forming RTAs with larger countries.
• Countries may want to lock in unilateraldomestic policy reforms.
' Members may want to improve theirbargaining power in multilateral trade negotiations or express frustration with the slow
pace of these negotiations (as happened
during the Uruguay Round).
• As countries form new RTAs, or deepen
existing ones, trade is diverted from thirdcountries. This may tip the political balance inthird countries in favor of joining the RTA, as
exporters' interests begin to prevail over theinterests of import-competing firms. As morecountries join the RTA, excluded countries
may suffer additional trade diversion and,eventually, incentives to join outweigh interestsof import-competing firms—the domino effect.
' Members may want to promote industries that are not viable without a protected
regional market—regional infant industries—
the idea being that they would be internationally competitive if given sufficient time
to develop (although RTAs most influenced bythis perspective have been the least successful in expanding trade and promoting regional growth).
Economic theory does not state definitively
whether an RTA is welfare improving—likeMFN liberalization—either for its members orfor the world as a whole. However, some
general principles have been developed. If two
countries lower tariffs between them while
maintaining tariffs with nonmembers, there
will be both "trade creation" and "trade diversion." Imports from the partner will become
cheaper to consumers, so they will substitutepartner imports for domestic products (i.e.,
trade creation). However, consumers will also
substitute partner for nonpartner imports (i.e.,
trade diversion), even though partner imports
cost more to produce than nonpartner imports. Trade creation is welfare-enhancing forthe region, while trade diversion is welfarereducing. The RTA is beneficial for its members if trade creation exceeds trade diversion,other things being equal.
Trade creation and trade diversion, however, focus exclusively on production costs.
The benefits to consumers from lower prices
are also an important factor in assessing thewelfare implications of an RTA for the region.
Lower prices of partner imports will induce
consumers to substitute partner imports forboth domestic substitutes and nonpartnerimports; gains to consumers from lower prices
tend to raise the welfare of the member countries. Further, welfare gains could result fromother factors. There may be rationalization ofexisting industry structures, with inefficientWorldwide activity inregional trading arrangements
During the early 1990s, some important new
regional trading arrangements (RTAs) emerged,
and many existing ones were reactivated.
Europe. Developments in Europe wereamong the most numerous and rapid.
Implementation of the Single Market program
within the EU progressed quickly; the European
Economic Area (EEA) was formed between
Austria, Finland, Iceland, Liechtenstein, Norway,Sweden, and the EU (Austria, Finland, andSweden have acceded to the EU); several Central
and East European countries formed associationagreements with the EU (Hungary and Poland
have applied for EU membership); and the EU
entered into free trade agreements with theBaltic states, a customs union with Turkey, andcooperation and partnership agreements withseveral states of the former USSR.
Western Hemisphere. The trend toward
regional blocs accelerated. NAFTA was accompanied by formation of the Southern Cone
Common Market (MERCOSUR), and of numerous, overlapping RTAs between several Latin
American countries, such as Colombia andVenezuela. Among existing RTAs, the Andean
Pact and the Central American Common Market(CACM) agreed on common external tariffs, andthe Caribbean Community (CARICOM) became
more active.
Africa. There were some moves toward
greater integration. With the recent devaluationof the CFA franc, the Economic and Customs
Union of Central African States (UDEAC) moved

forward on a number of fronts, including carrying out a common external tariff, replacing quantitative restrictions with tariffs, and phasing outintra-UDEAC duties. In eastern and southern
Africa, a Cross Border Initiative—
cosponsored by the African Development Bank,
the Commission of the European Communities,
the IMF, and the World Bank—was launched asa pragmatic step toward economically integrating 13 countries in the subregion.
East Asia. Economic integration mainlyreflected private market forces. The Associationof Southeast Asian Nations (ASEAN) signed apact (the ASEAN Free Trade Agreement, orAFTA); the South Asian Association for
Regional Cooperation (SAARC) agreed to draft apreferential trading arrangement; and the AsiaPacific Economic Cooperation forum (APEC), aspart of its stepped up activity, agreed to include
Chile, Mexico, and Papua New Guinea asmembers, and announced plans to lower tradeand investment barriers by the year 2020.
Middle East. The Gulf Cooperation Council(GCC) liberalized movements of capital and labor,
worked toward setting up a common externaltariff, and held talks with the EU about a possible economic cooperation agreement. The
Economic Cooperation Organization signed on
several former states of the USSR as members.
But there was little movement on ambitious
plans for integration within the Arab CommonMarket (ACM) and the Arab Maghreb Union(AMU), which were established in the 1960s.

plants closing down and remaining ones operating at a more efficient scale. Foreign direct
investment might be stimulated, leading tocapital accumulation and higher economic
growth. Dynamic gains could arise fromlearning by doing, improved product quality,and greater product variety.

To assess the impact of RTAs more definitively, it is necessary to examine carefully thefeatures of particular RTAs.
The EU has gone through three distinct
periods of integration dating back to theTreaty of Rome in 1957, which created theEuropean Community (EC). The first period(1958-69) involved the phased elimination ofinternal tariffs, the dismantling of quantitative
import restrictions among the six original
members, and the establishment of a common
external tariff and the Common Agricultural
Policy (CAP). In the second stage (1970sand early 1980s), there were two membership enlargements and some key institutionalchanges (the European Council assumed
greater prominence). During the third stage,
the EU cooperated more closely with neighboring nonmember countries and implemented
the Single Market program.
The Single Market program has deepened
economic integration within the EU andcontinues to serve as a powerful stimulus
to intra-EU trade and economic growth.

How RTAs are performing
While there are numerous empirical studiesof the effects of RTAs, these mainly evaluate
the effects on members. Some indication of
how nonmembers have done, however, can beobtained by examining trends of nonmember
imports into RTAs—if appropriately scaled
import volumes do not fall, gains to members
have most likely not come at the expense ofthird parties. Trends in extraregional imports
as a share of GDP do not show any marked
tendency for RTAs to reduce trade with nonmembers. But these trade shares are onlyindicative, since they do not show how tradewith nonmembers would have evolved in theabsence of RTAs.

Finance & Development / March 1995]©International Monetary Fund. Not for Redistribution

31

European integration includes the removal of single currency. Fourth, the time taken for will continue to form RTAs. The following
border controls on intra-EU goods shipments integration was lengthy.
considers how RTAs may be designed toNAFTA was signed by the Governments of promote eventual global free trade.
and the movement of people, harmonization ofindirect taxes, establishment of minimum Canada, Mexico, and the United States onWTO compatibility. The General Agreeproduct standards, removal of domestic regu- December 17, 1992, and entered into force on ment on Tariffs and Trade (GATT) specifies
latory barriers to cross-border provision of January 1, 1994. The agreement improves in Article XXIV that a free trade area orservices, elimination of public procurement market access (phased tariff reductions and customs union should eliminate barriers topractices favoring national producers, and an liberalization of nontariff barriers) in many most trade among members (although in pracEU-wide competition policy to help assure sectors (e.g., agriculture, automobiles, ener- tice most existing RTAs omit at least somefree movement of goods between EU member gy, financial services, telecommunications, trade from liberalization). Coverage of moststates. Import restrictions on industrial goods textiles and apparel, and transportation). It trade best supports the ultimate objective offrom third countries were removed (although also covers investment and intellectual prop- global free trade.
in some instances, e.g., voluntary export re- erty rights, supplemented by separate accords
Low MFN tariffs. If MFN tariffs are
straints on Japanese autos, these were re- on import surges, labor, and the environment. initially low, or lowered as trade between RTA
All three members should gain from members is freed, the risk of trade diversion
placed with EU-wide restrictions). The CAP
was reformed substantially in 1992 to make NAFTA, although relative to its size Mexico will be reduced.
Liberal accession clauses. Liberal rules
producers more responsive to demand condi- will undergo most of the structural transfortions. Substantial funds were committed to mation and stands to receive most of the bene- for accession to an RTA help facilitate the multiimprove living standards in poorer members. fits—largely reflecting relative magnitudes lateral trade liberalization process, since thisThe deadline for completion of the Single of the three economies. Studies show that permits liberalization to be spread to newMarket was end-1992; though largely NAFTA is likely to lead to real income gains members.
completed the process is continuing,
Liberal rules of origin. Awith much work remaining to berule of origin is needed to specify
done in some areas.
*". . . in the manufactured goods
whether a product qualifies forThe Single Market program ispreferential duty treatment, sosector, European integration has
widely credited with expandingthat third countries do not simply
trade and enhancing welfare of EU
deflect trade through the member
resulted in substantial net trade
members. Recent studies show realwith the lowest external tradecreation. But, in agriculture,income gains to the EU of between
barriers. But the rules should be
2.4 and 3.4 percent of GDP (somethe CAP has led to significant trade transparent, not differ acrosswhat lower than the European
sectors, and not be too stringent,
diversion and welfare losses . . . ." sinceCommission's initial estimate of 4.3
they protect regional input
to 6.5 percent). Despite initial estisuppliers, leading to diversion ofmates by the Commission that trade diversion for Mexico of around 5 percent of GDP, around investment into the RTA.
would be 2.5 percent of imports, fears that the 0.3 percent for the United States, and around
Deep integration. Deeper integration,
Single Market program would create a 0.07 percent for Canada. On a sector basis, involving liberalization of services trade, inMexico agreed to liberalize its corn sector, vestment, and some coordination of regula"Fortress Europe" have not materialized.
Does the EU provide a model that other while the United States agreed to reduce its tions (acknowledging that preferred levels ofcountries could emulate? The EU has stimu- barriers to trade in fresh fruits and vegetables. environmental and labor standards and tax
lated trade and economic growth among its In the automotive sector, Mexico will disman- policy will in general differ within regions)members through deep economic integration. tle its domestic content, trade balancing, and offers greater scope for economic gains fromEvidence to date suggests that, in the manu- other provisions under the auto decrees, and it efficient resource allocation within the RTA,
factured goods sector, European integration will gain increased access to the US market in although it will have both trade creating andhas resulted in substantial net trade creation. textiles and clothing.
trade diverting effects.
While the aggregate effect on nonmembers
But, in agriculture, the CAP has led to signifiLimiting antidumping actions. Regioncant trade diversion and welfare losses due to is expected to be minor (generally less than 1 al liberalization may increase pressures forprice effects, and in manufacturing, there percent of a country's exports to the North protection through other means, such ascontinue to be pockets of discrimination. It is American market), there may be disruption antidumping measures—which are designed
also important to bear in mind some of the at the level of individual countries in certain to deter "dumping" (i.e., exporting at prices
special circumstances surrounding the EU's product categories. Countries whose exports lower than the comparable price in the homecreation. First, there was always a strong are concentrated in horticultural products, or market). RTAs should prohibit use of thesepolitical motive—a desire for an area of politi- in labor-intensive manufacturing such as measures against members, and should minical stability in Europe. Second, adjustment textiles and clothing, are more likely to experi- mize resort to antidumping duties against
costs were relatively low, as much of the trade ence trade diversion as a result of NAFTA. nonmembers (see "Antidumping: Unfair Tradeoccurred within industrial groupings, so fewer There is the potential for exclusion or invest- or Unfair Remedy?" in this issue).lH
plants had to be shut down than would ment diversion due to restrictive, nontransparhave been required if trade had led to re- ent rules of origin in sectors such as autos,
source movements between industries. Third, textiles, and clothing.
European integration goes beyond theThis article is based on a longer paper, "Regional
creation of an internal market in goods and Principles for designing RTAs
Trading Arrangements," in International Trade
While trade liberalization on an MFN basis Policies: The Uruguay Round and Beyond, Worldservices; member states have agreed to set up
an economic and monetary union, including a is the best approach, it is likely that countries Economic and Financial Surveys, IMF, 1995.
32Finance & Development / March 1995

©International Monetary Fund. Not for Redistribution