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GlobalEconomic
Prospects

Trade, Regionalism,
and Development

2005

Global
Economic
Prospects
Trade, Regionalism, and Development

2005© 2005 The International Bank for Reconstruction and Development / The World Bank
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Washington, DC 20433
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1 2 3 4 07 06 05 04
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0-8213-5747-6
Cover artist: John Yanson

Contents

Forewordvii

Acknowledgments
Overview

ix

xi

Abbreviations

xix

Frequently Cited Regional Trading Agreements and the Parties to Them

xxiii

Chapter 1 Global Outlook and the Developing Countries
1
The Global Economy: From Recovery to Expansion
3
Commodity Markets
6
World Trade
8
International Finance
10
Risks and Policy Ppriorities
12Long-Term Growth, Structural Change, and Poverty
14
Structural Changes over Two Decades
16
Structural Change in the Future
19
Poverty Forecast
21
Concluding Remarks
23
Notes
23
References
25
Chapter 2 Regional Trade and Preferential Trading Agreements:
A Global Perspective
27
The Proliferation of Regional Preference Systems
28
Trends in Trade and Growth by Region
42
Changing Export Composition and the Rise of Global Production Networks
Preferential Trade and Regional Outcomes49
Conclusion
53
Notes
53
References
54
Chapter 3 Regional Trade Agreements: Effects on Trade57
The Impact of RTAs on Merchandise Trade and Incomes
Ingredients of Success
66

46

57

iii

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2 0 0 5Conclusions: Preferential Trade Agreements and Economic Development
Notes
74
References
74
Chapter 4 Beyond Trade Policy Barriers: Lowering Trade Costs Together
The Costs of Trade78
Regional Agreements to Facilitate Trade and Transport
79Standards, Conformity Assessments, and RTAs
85
Trade-Related Regional Cooperation Agreements
91
Conclusions
92
Notes
93
References
94

72

77

Chapter 5 Beyond Merchandise Trade: Services, Investment, Intellectual Property,
and Labor Mobility
97
Services, Investment, and IPRs in Regional Agreements
98
Economic Consequences of Services, Investment, and IPR Provisions in RTAs
RTAs and Provisions for Movement of Labor
111
Conclusions: Beyond Merchandise Trade
117
Notes
119
References
121
Chapter 6 Making Regionalism Complementary to Multilateralism
Preferential Agreements within the Global Context
126
Building Blocks versus Stumbling Blocks
133
The Competitive Liberalization Game: The Case of Doha
Multilateral Disciplines on Regional Arrangements
140
Making Open Regionalism Work for Development
144
Notes
148
References
150

125

136

Figures
1.1
A record year for developing countries in 2004
4
1.2
Strong growth across most regions
5
1.3
Tradable price developments
6
1.4
Terms of trade impacts from higher commodity prices, 2001–04
7
1.5
The oil-important burden for selected countries7
1.6
Crude oil prices, 1960–2004
8
1.7
World trade rebounds
8
1.8
Export performance, percent change in market share since 2000
9
1.9
Trade balances in major regions10
1.10
Developing countries’ debt and interest payments easing downward since 1999
1.11
Rising U.S. dollar reserves
11
1.12
Impact of a 200 basis point increase in interest rates
12
1.13
First year impacts of a $10 increase in oil prices
14
1.14
A rise in services
17
1.15
Rising openness to trade
18

iv

104

10

C O N T E N T S

1.16
1.17
2.1
2.2
2.3
2.4
2.5
2.6
3.1
3.2
3.3
3.4
3.5
3.6
3.7
3.8

6.1
6.2
6.3

Increased urbanization
19
Growth rate of labor supply declining
19
Number of RTAs exploded in the 1990s
29
Spaghetti and rigatoni: Multiple, overlapping RTAs, 2004
39
Trade within RTAs
41
Trade performance has differed across regions
43
Composition of trade has changed
47
Evolving trading blocs
50
Evolution of the share of intra-regional imports in total imports, 1960–2000
58
The ratio of external and intra-regional trade to GDP
59
Intra-regional trade grows faster when world trade growth is positive
60
Simulated welfare impact of various FTAs involving Chile
62
RTAs that divert imports tend to export less to global markets
64
Not all regions are open
66
Preferential tariffs in tandem with all tariffs in Latin America
68
Rules of origin in North–South agreements are more restrictive than in South–Southagreements
70
More efficient customs are associated with more trade80
Share of EU nationals in total population, for selected EU countries and Norway,
1985–2000
112
Global outcomes dominate alternatives
131
Global reform dominates North–South agreements
133
Global reform dominates South–South agreements
133

Tables
1.1
1.2
1.3
1.4
1.5
2.1
2.2
3.1
5.1
5.2
5.3
6.1
6.2

The Global outlook in summary
2
Current account balances
11
Long-term prospects: Forecast growth of world GDP per capita
17
Labor market structure, 2005–15
20
Regional breakdown of poverty in developing countries
21
Most countries belong to more than one RTA
30
RTAs cover many topics besides merchandise trade35
Implementation of tariff commitments by type of agreement, 1960–1999
Services, investment, and intellectual property: A comparison
99
Additional services liberalization in U.S. FTAs
100
Summary of agreements by degree of labor mobility
111
Comparison of bilateral agreements to global trade reform
128
Comparison of bilateral agreements with global trade reform
129

4.1
5.1

Boxes
1.1
2.1
2.2
2.3
2.4

69

The aggregation paradox
16
RTAs and types of trade liberalization
28
Reporting RTAs to the WTO
29
EPAs become the EU’s trade and development instrument: An experiment in“North-South-South” integration
32
Labor in U.S. FTAs
33v

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2.5
2.6
2.7
3.1
3.2
3.3
3.4
3.5
4.1
4.2
4.3
4.4
4.5
5.1
5.2
5.3
5.4
6.1
6.2
6.3
6.4
6.5
6.6

vi

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2 0 0 5Trade agreements and the environment
36
Can RTAs prevent conflict?
38
Regional versus multilateral and unilateral liberalization:
What’s more important?
42
A primer on modeling of RTAs
61
Regional trade agreements in gravity models: A meta-analysis
63
Implementation matters
65
Restrictive rules of origin under NAFTA—the case of clothing
71
Monitoring implementation of preferential trade agreements:“Single Market Scoreboard” in the European Union
73
Trading can be costly79
Border delays tax trade80
Standardization and simplification can increase trade volumes: The case of theTrans-Kalahari Corridor
82
Logistics costs in Europe have fallen in the last two decades
83
The case of the Northern Corridor Stakeholders Consultative Forum84
Not all investment is good investment
106
Do more investor protections mean more investment? Lessons from bilateral
investment treaties
107
Illegal migration: A growing global phenomenon
113
U.S. temporary admission programs under NAFTA and unilateral policies
116
Impacts of the new GTAP database
127
Regional trade agreements, structural change, and congruence132
Choosing partners: Selection criteria for U.S. RTAs
137
Sequencing of RTAs: Is there a good practice?
139
RTAs and WTO disciplines
141
Tunisia’s Association Agreement with the European Union
146

ForewordT

HIS YEAR—2004—is shaping up to be the healthiest year for developing countries in the last

three decades. East Asia has come out of the crisis of 1997–98 stronger and more vibrantthan ever; the countries of Europe and Central Asia are now almost completely out of thelong shadow of transition from socialism and are growing more rapidly; and South Asian countries, on the strength of continuing reforms, are performing well. Moreover, countries in Latin
America, Sub-Saharan Africa, and the Middle East and North Africa had a much better year. To
be sure, some countries within each region have not enjoyed the fruits of this recovery, and thesecountries remain a source of concern. But in aggregate, economic growth in 2004 was impressive.
This performance reflects a fortuitous combination of (1) long-term secular trends built on a foundation of better macroeconomic management and (2) an improved domestic investment climate
converging with a cyclical recovery of the global economy.
This is no time for complacency. Lingering imbalances in the global economy associated withthe rising twin deficits in the United States, a delayed recovery in Europe, high and volatile oil
prices, and questions about the path of China’s economy constitute risks to the pace of growthin developing countries over the medium term. Sustaining this pace is essential for the fate of millions of the world’s poor.
World trade grew by 10.2 percent in 2004, and has played an important role in this year’s exemplary performance. On the policy side, the WTO discussions in August recouped the groundthat was lost in late 2003 (after the Cancun WTO ministerial), when governments concluded anagreement that provides a framework for pursuing the Doha Development Agenda. The framework, however, is only an outline—the actual agreement is still to come. Whether the final agreement contains provisions that will provide a meaningful impulse to development remains to beseen.
In the meantime, this year’s Global Economic Prospects examines the evidence on an important development that is reshaping the architecture of the world trading system: The dramatic proliferation of regional trade agreements (RTAs). These take various forms of preferential reciprocal
treaties—they can be bilateral or plurilateral free trade agreements or, less commonly, customs
unions. In according preferential access to members, regional arrangements necessarily discriminate against nonmembers. Even though arrangements in some instances can promote development, it is important to recognize that they also can lead to trade diversion in a way that hurts both
member countries and excluded countries. Hence this year’s report identifies ways to design andimplement preferential trading agreements to maximize their benefits for participants and minimize their costs to nonmember developing countries. The key to making regional agreements complementary to a nondiscriminatory multilateral system is to strive for “open regionalism”—thatvii

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2 0 0 5is, agreements with low external barriers to trade, nonrestrictive rules of origin, liberalized service
markets, and a strong focus on reducing transaction costs at borders.
The international community working together can leverage the August framework to achieve
an ambitious Doha deal. Multilateral liberalization has a greater positive impact on development
than do the myriad regional arrangements now being spawned seemingly in every corner of the
globe. Moreover, multilateral oversight of inherently discriminatory RTAs must be strengthened,
and the first step is to increase transparency by empowering the WTO to collect and regularly
make public full details of all arrangements. If Doha can succeed in bringing down border protection in agriculture and manufactures, it will reduce the discriminatory effects of regional agreements and lower the probability of costly trade diversion for participating countries. Said differently, a strong Doha arrangement can contribute to open regionalism.
Along with other bilateral and multilateral institutions, the World Bank continues to promote
the integration of developing countries into the world economy so that the benefits of globalization can extend to the poor. The Bank now has 91 trade-related projects approved or planned in
75 countries for the three-year fiscal period 2004–06. The actual and projected commitments for
new trade operations are at $2.9 billion—larger than the commitments of all ongoing operations
approved over the preceding eight-year period of fiscal 1996–2003 ($2.4 billion). For trade facilitation the growth is even larger. Projected commitments over fiscal 2004–06, at more than
$1.2 billion, triple the commitments of ongoing trade facilitation operations approved between
fiscal 1996–2003. To guide this lending and to provide policy advice, the World Bank research
program in trade works for client countries all over the world, and the program continues to beambitious.
There is still a lot to be done. Poverty remains high—with 2.7 billion people living on less than
$2 dollars per day—and the global trading system is still riddled with obstacles that prevent the
products of the world’s poor from reaching markets. Pursuing these challenges through multilateral, unilateral, and regional policies can contribute to poverty reduction around the world,which will pay high dividends for generations to come.
François Bourguignon
Chief Economist
World Bank
November 2004

viii

AcknowledgmentsT

HIS REPORT WAS produced by staff from the World Bank’s Prospects Group and from theWorld Bank Trade Department. Richard Newfarmer was the lead author and manager ofthe report, under the direction of Uri Dadush. The principal authors of chapter 1 wereAndrew Burns and Dominique van der Mensbrugghe. Chapter 2 was written by Paul Brenton,
Carolina Diaz Bonilla, Denis Medvedev, and Philip Schuler; chapters 3 and 4 were written by Paul
Brenton; chapter 5 was written by Richard Newfarmer; and chapter 6 was written by Bernard
Hoekman, Jeffrey Lewis, and Dominique van der Mensbrugghe. Carolina Diaz Bonilla and Denis
Medvedev provided research assistance that informed all chapters. The Global Outlook—the online twin publication of Global Economic Prospects—was led by Fernando Martel Garcia. Several
reviewers, including Michael Finger, Julio Nogues, Guillermo Perry, and Jeffrey Schott, as well as
Alan Winters and Jaime De Melo, offered extensive and enormously useful comments. The report
was produced under the general guidance of François Bourguignon.
Several people contributed substantively to the various chapters. In chapter 1, the Global
Trends Team, under Hans Timmer’s leadership, was responsible for the projections, with contributions from John Baffes, Maurizio Bussolo, Betty Dow, Himmat Kalsi, Robert Keyfitz, Annette
De Kleine, Fernando Martel Garcia, Donald Mitchell, Mick Riordan, and Shane Streifel, and forthe poverty numbers, Shaohua Chen and Martin Ravallion. For chapter 2, Vlad Manole, Will
Martin and Francis Ng, Sherman Robinson and Carolina Diaz Bonilla, Maurice Schiff andYanling Wang provided background papers and notes. For chapter 3, Souleymane Coulibaly provided statistical analysis for the gravity model work, and Takako Ikezuki contributed backgroundmaterial. In chapter 4, Enrique Aldaz-Carroll, Gael Raballand, and Luc de Wulf wrote background papers. In chapter 5, Ximena Clark and William Shaw, Carsten Fink and Patrick
Reichenmiller, Howard Mann and Aaron Cosbey, Aaditya Mattoo, and Beatriz Nofal provided
background papers. Maurice Schiff and Alan Winters wrote papers for chapter 6. The Global
Outlook benefited from the efforts of several specialists, among them Abhijeet Dwivedi, Sabeera
Kulkarni, Bulent Ozbilgin, and Carlos Rossel. Awatif H. Abuzeid was the senior staff assistant,who, together with Katherine Rollins, produced the several drafts of the report and managed thewriting stage. Dorota Nowak worked with the World Bank’s Office of the Publisher to manage
the publication and dissemination process.
Many people provided written contributions and/or comments: Frederick Abbott, Hakim Ben
Hamouda and staff at the Economic Commission for Africa, Carlos Braga, Harry Broadman,
Aaron Cosbey, Robert Devlin and the staff of the Inter-American Development Bank, Peter
Draper, Dorothy Dworskin and the staff at the U.S. Treasury and U.S. Trade Representative;ix

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2 0 0 5

Philip English, Antoni Estevadeordal, Alan Gelb, Caroline Freund, Mary Hallward-Driemeier,Lawrence Hinkle, Elena Ianchovichina, Roumeen Islam, Alejandro Jara, Sebastien Jean, Stephen
Karingi, Odin Knudsen, Hans Peter Lankes, Patrick Low, Nuno Limao, Muthukumara Mani,
Howard Mann, Daniel Muller-Jentsch, Mustafa Nabli, Caglar Ozden, John Panzer, Carmen
Pont-Vieira, Jean-Francois Rischard, Kamal Saggi, Maurice Schiff, Raj Soopramanien, Peter Van
Den Heuvel and staff of the EU Commission, Stephen Woolcock, and Gianni Zanini.

xOverviewTregional trade
agreements (RTAs) is fundamentally altering the world trade landscape. The
number of agreements in force now surpasses
200, and it has risen sixfold in just two
decades. Today more than one-third of global
trade takes place between countries that havesome form of reciprocal RTA.1 The European
Union (EU) and United States are playing aprominent role in this proliferation (figure 1).
This report addresses two questions:
HE PROLIFERATION OF• What are the characteristics of agreements that strongly promote—or
hinder—development for member countries?
• Does the proliferation of agreements
pose risks to the multilateral trading
system, and how can those risks be
managed?

Identifying What Works: OpenRegionalismR

TAs are often one component of a larger
political effort to deepen economic relations with neighboring countries.2 As such,they can create opportunities to expand tradethrough joint action to overcome institutional
as well as policy barriers to trade. At a basic
level, it is often easier to motivate reciprocal reductions in border barriers when the participants are fewer and the policymakers feel morein control of outcomes. Moreover, RTAs havethe flexibility to pursue trade-expanding
policies not addressed well in multilateral trading rules. Trade agreements therefore usually
go beyond slashing tariffs to include measures
to reduce trade impediments associated withstandards, customs and border crossings, andservices regulations—as well as broader rulesthat improve the overall investment climate.
Finally, these agreements often form cornerstones of larger economic and political efforts
to increase regional cooperation. RTAs canhelp motivate and reinforce broader reforms indomestic policy; they can be designed to contribute to a political environment that is more
conducive to stability, investment, and growth.
Not all agreements create new trade andinvestment. Those RTAs with high external border protection are particularly susceptible to theadverse effects of trade diversion (figure 2). In
fact, a statistical analysis based on findings fromseveral econometric studies suggests that many
agreements cost the economy more in lost traderevenues than they earn, because they discriminate against efficient, low-cost suppliers in nonmember countries. Of course, this finding does
not take into account the potential dynamic
gains, the positive effects associated with services liberalization, or any of the benefits fromadopting new regulations. But it does underscore the point that regional agreements carryrisks that merit close scrutiny by would-beparticipants.

xi

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2 0 0 5Figure 1 Regionalism spreads
a. The number of RTAs exploded in the 1990s
Annual numbers

b. EU and U.S. agreements were most important
Total numbers

40
Cumulative number of agreementsa(right axis)

30
25
20

Cumulative number of agreementsb(right axis)

15
Agreements
notifiedto the WTO(left axis)

5
0
1958

1969

1976

1984

1989

1994

35

300

30

250

25

200

20

150

15

100

10

50

5

0
2004

0

SouthSouthU.S.

Agreements not
notified to the WTO(left axis)

10

Percent of world trade covered

350

1999

EU

1990

1996

2002

a. EU-25 counted as single country.
b. EU-15 counted as single country.
Source: World Trade Organization.

Figure 2 External protection can differ among agreementsa. Only a few agreements have low external tariffs

b. And so intraregional trade in some cases grows at theexpense of extraregional trade
SACU
NAFTA
EU
CACM
ECOWAS Overall
GCC exports
AFTA
CAN
CEMAC
MERCOSUR
SADC
SAPTA
CIS
EAC
WAEMU
COMESA

NAFTA
AFTA
SADC
EAC
MERCOSUR
COMESAECOWAS
SAPTA
0

5

10
15
20
Average weighted tariffs

25⫺4

Overall imports
Intraregional trade

⫺2
0
2
4
6
8
Estimated exponential impact on trade10

Note: In chart a, tariffs are import-weighted at the country level to arrive at RTA averages. In chart b, the bars show the magnitude ofthe dummy variables, capturing respectively the extent to which intraregional trade, overall imports, and overall exports differ from the“normal” levels predicted by the gravity model on the basis of economic size, proximity, and relevant institutional and historicalvariables, such as a common language.
Source: World Bank staff using UN TRAINS, accessed through WITS.

As agreements proliferate, a single country
often becomes a member of several different
agreements. The average African country
belongs to four different agreements, and thexii

average Latin America country belongs toseven agreements. This creates a “spaghettibowl” of overlapping arrangements (figure 3).
Each agreement has different rules of origin,

O V E R V I E W

Figure 3 RTAs can complicate customs administrationa. African agreements are overlapping
AMU

b. More efficient customs are associated with more trade
Nile River
Basin

ECCAS
Algeria
Libya
Morocco
Mauritania
Tunisia

ECOWAS
Conseil de
L’Entente
Ghana
Nigeria

CEMAC

Cape Verde
Gambia

Chad

Egypt

Kenya
Uganda200

150

AngolaR2 ⫽ ⫺0.338

Mali
SenegalLiberia
Sierra Leone

COMESA

Djibouti
Ethiopia
Eritrea
Sudan

BurundiRwandaDR Congo

WAEMU

Ratio of trade to GDP (percent)250

Sao Tomé & Principe
Cameroon
Central African Rep.
Gabon
Equat. Guinea
Rep. Congo

Benin
Niger
Togo
Burkina Faso
Côte d’Ivoire
Guinea-Bissau

IGAD
Somalia100

EAC

GuineaTanzania
SACU

Mano River UnionCILSS

Malawi
ZambiaZimbabwe

South Africa
Botswana
Lesotho

Mauritius
Syechelles
Comoros
Madagascar

Namibia
Swaziland

Reunion50

0
0

Mozambique

CBI

IOC

5

10

15

20

25

Days through customs (imports)

SADC

Sources: Chart a, Schiff and Winters (2003). Chart b, Investment Climate Surveys data and Global Trends as cited in Subramanian andothers (2003).

different tariff schedules, and different periodsof implementation, and together they complicate customs administration. Customs agents
report that it takes longer to process goods
covered by preferential arrangements, andlonger processing times drive up the cost of
trade. In general, the longer the delays in customs, the smaller the role of trade in GDP.
So what characteristics lead to expanded
trade and development? A prerequisite forthe success of any trade policy is that it be
integrated into a sound domestic policy framework. It is virtually impossible for entrepreneurs to take advantage of new opportunities—
whether they originate in market accessthrough an RTA, through a multilateral agreement, or other sources—if the domestic investment climate is not supportive. Macroeconomic stability, basic property rights, andadequate infrastructure regulation are all key.
Indeed, trade agreements can reinforce positiveelements in the domestic reform program byanchoring policy to the agreement itself. But
an RTA cannot substitute for sound domestic
policies.

With prerequisites in place, the RTAs most
likely to increase national incomes over time
are those designed with:• Low external MFN tariffs,• Few sectoral and product exemptions,• Nonrestrictive rules-of-origin tests thatbuild toward a framework common to
many agreements,• Measures to facilitate trade,• Large ex-post markets,• Measures to promote new cross-bordercompetition, particularly in services, and• Rules governing investment and intellectual property that are appropriate to thedevelopment context.
Low external tariffs and wide coverageminimize the risks of trade diversion, while
nonrestrictive rules of origin allow for increased trade. The practice of excluding many
agricultural products is common, and it canlimit development payoffs. Trade facilitation
measures, though worthwhile in and of themselves, receive more policymaker attentionxiii

2 0 0 5

xiv

Figure 4 Rules of origin in North-Southagreements are more restrictive than inSouth-South agreements
Index of restrictiveness
6
5
4
3
2
1

A
ES

O
W
AS

EC

TA

M
O
C

M
AC

D

-C

SA

le
C

hi

AF

C

le
hi

ex
i

-C
EU

TA

co

0
-M

when they are embedded in an RTA, and theyoften have positive trade-creating effects for
all trade partners.
Well designed agreements are of limited
value if they are not implemented, and many
RTAs have more life on paper than in reality.
Weak implementation often afflicts SouthSouth agreements. Monitoring mechanisms
are often inadequate and do not receive thesustained high-level political attention necessary to drive institutional improvements in,for example, adherence to tariff reduction
schedules, customs, and border crossings.
Against these benchmarks of success, it isdifficult to give universally high marks to any
single category of agreement. In general,
North-South agreements score better on implementation than South-South agreements.
Because North-South agreements can integrate economies with distinct technologicalcapabilities and other different factor proportions, and because they usually result in larger
post-agreement markets, the potential gains
are usually greater. However, tighter rules oforigin, more restrictive exclusions for particular sectors (such as agriculture), and a preoccupation with rules not calibrated to development priorities can undercut these benefits(figure 4). North-South agreements, particularly those with the United States, have been
more effective in locking in new services liberalization; they have pressed intellectual property rights beyond World Trade Organization(WTO) rules; and expanded the sphere of investment protections; but they contain few
provisions to liberalize the temporary movement of labor.
Some South-South agreements are betterat focusing on merchandise trade, minimizing exclusions, adopting less restrictive
rules of origin, and lowering the border costs.
For example, the Caribbean Community(CARICOM) and the Common Market ofEastern and Southern Africa (COMESA) have
had some success in reducing border costs. But
in general, South-South agreements have notadhered to implementation schedules, andthey suffer from their small market size andAF

P R O S P E C T SNE C O N O M I CEUG L O B A L

Note: Higher values of the index equals to more restrictive
rules of origin derived from Estevadeordal and Suominen(2004).

economic similarity. And like the North-Southagreements, South-South agreements rarely
provide for the temporary movement of labor.

Consequences for the Multilateral
SystemT

he development consequences of RTAs are
not limited to their effects on members—
they also have cumulative effects on the multilateral system. In one sense, RTAs are a step toward greater openness in the whole system, bypromoting more trade and generating new domestic constituencies with an interest in openness. Moreover, some regional trade policies
are effectively nondiscriminatory, such as measures to improve customs, speed transactions at
ports or border crossings, or in some cases open
services markets. These measures can complement unilateral and multilateral policies.
However, this view overlooks the effects
that RTAs can have on excluded countries.
Preferences for some countries mean discrimination against others. Indeed, the General
Agreement on Tariffs and Trade (GATT),
borne out of the sad experience of discrimination in the prewar years, was founded on the

O V E R V I E W

principle of nondiscrimination. Today, theadverse consequences for the excluded countries are much less severe than at GATT’s
inception, because tariffs and other barriers
have come down sharply, mitigating the exclusionary effects of regional arrangements.
The exception—and it is not trivial—is agriculture. Another mitigating factor is thatmany countries excluded by trade agreements
between the United States and the EU enjoy
some degree of preferential access throughvoluntary preference schemes, such as theGeneralized System of Preferences (GSP),
America’s Growth and Opportunity Act(AGOA), and the EU’s Everything But Arms
(EBA) program. To be sure, these programs
lack the certainty of market access that MFN
agreements and RTAs provide, because preferences are voluntary and subject to politicalwhim, but they do mitigate the effects of exclusions for selected, very low-income countries. Finally, some developing countries—the
spokes in the hub-and-spoke analogy—are
signing bilateral agreements with each otherand with other hubs.
Inevitably some countries get left out oftrade agreements, either because they are notfavored politically, because they cannot afford
the costs of many separate negotiations, or because their neighborhood is less open. Countries as diverse as Bolivia, India, Mongolia,
Pakistan, and Sri Lanka do not enjoy the samelevel of access to the United States or the EU
as Chile, Jordan, or Mexico, and they see theirtrade diminished when bilateral agreements
are signed.
RTAs can also undercut the incentives ofgovernments to press for multilateral liberalization, which would improve global trade
rules. This study finds little evidence thatmajor players in the current WTO negotiations have changed their negotiating positions
or retreated from the multilateral process,even as they avail themselves of regional tradedeals. However, as the discussions become
politically difficult, the risk is ever present thateven they will abandon multilateralism infavor of “satisficing regionalism.” One

consequence of the spread of regional agreements is that many poorer developing countries have diverted scarce negotiating resources to regional negotiations at the expenseof more active participation in the Doha discussions. The average developing country belongs to five separate RTAs and is negotiating
more all the time. In the future, will countries
that now enjoy preferences fight multilateralliberalization, or even oppose further regional
liberalization, to keep their privileged market
access? A few small developing countries areindeed likely to lose advantages in preferential
markets, and they may scuttle a deal if their legitimate concerns are not addressed.

The Importance of Doha to OpenRegionalismThe policy solution to these twin concerns—the need to design regional agreements that create trade and regional agreements that have minimal exclusionary
effects—comes together in the form of low
MFN tariffs and other border barriers. An
agreement that lowers border protection
around the world promotes open regionalism
by mitigating trade diversion. At the sametime, it would diminish the exclusionary effects of discriminatory preferences built into
regional agreements. The first order of business for the international community is to accelerate progress on the Doha Agenda and to
fill in the blanks of the August 2004 framework agreement with reductions in protection, especially for products produced by theworld’s poor.

For Developing Countries,a Three-Part Strategy

Developing countries wishing to harness
trade to their development strategy
should see regional integration as one element
in a three-pronged strategy that includes unilateral liberalization, multilateral liberalization,and regional liberalization.

xv

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2 0 0 5

Historically, unilateral liberalization, which
is usually linked to a broader program of domestic reform, has accounted for most of the
reductions in border protection. Most comprehensive trade reforms among large countries (Argentina, Brazil, and China in the early
1990s, and more recently, India) were primarily unilateral reforms that were undertaken toincrease the productivity of the domestic economy. The same process took place in manysmall countries as well. In fact, of the 21 percentage point cuts in average weighted tariffs
of all developing countries between 1983 and2003, unilateral reforms account for roughly
two-thirds of the reduction. Tariff reductions
associated with the multilateral commitmentsin the Uruguay Round accounted for about
25 percent, and the proliferation of regional
agreements amounted to about 10 percent of
this reduction (see figure 5).
Autonomous liberalization promotes global
competitiveness by lowering costs of inputs, increasing competition from imports to drive productivity growth, and integrating the national
economy into the global economy. Autonomous
trade reform is, ironically, more important thanever in the presence of RTAs; low border barriers minimize the risks of trade and investment
diversion. Low external barriers promote tradein world markets, and this is highly correlated

Figure 5 Share of total tariff reduction, by
type of liberalization, 1983–2003
Regional
Agreements
10%

Multilateral
Agreements
25%

Autonomous
Liberalization
66%

Source: Martin and Ng 2004.

xvi

with increases in intraregional trade, irrespective of the presence of an RTA.
Multilateral liberalization leverages domestic reforms into increased market accessaround the world. Developing countries collectively stand to gain much more in the WTO
arena than in any smaller regional market.
Moreover, this multilateral forum is the only
place that developing countries, working together, can press for more open markets inagriculture and can seek disciplines on tradedistorting agricultural subsidies and on contingent protection.
Some have argued that RTAs can be an alternative to multilateral liberalization. They
are not. Gains for all developing countries
from these agreements, even under the mostgenerous of assumptions, are usually only afraction of those from full multilateral liberalization. Of course, if one of the partner countries is a high-income, large-market economy,
and if most other countries are excluded frompreferential access, the countries signing thefirst trade agreement may benefit individuallyand substantially—but those benefits wither
as new countries sign additional agreements.
In fact, the scenarios in this study show thatall developing countries would collectively
lose if they were all to sign preferential agreements with the Quad (Canada, the EU, Japan,
and the United States) (figure 6). Therefore,
developing countries have a powerful collective interest in an effective Doha Agenda—
even if they all are scrambling to gain preferential market access to the Quad.
Forging policies on open regionalism is thethird component of trade policy strategy. Desirable as multilateral liberalization is, theDoha Round is likely to realize only part of its
development potential. For some types of policy, collective regional actions may be the first,
best course, and may result in effective nondiscriminatory benefits.3 For example, RTAs can
reduce regional political tensions, take advantage of scale economies in infrastructure provision, and lead to joint programs to improve
border crossings or to motivate liberalizationin services. But countries should sign on with

O V E R V I E W

Figure 6 Multilateral liberalization is far
more beneficial than RTAs
Change in real income in 2015 compared to baseline

Middle-income

BILAT

JBIL
Global

Low-income

Developing

Quad⫹⫺1.5 ⫺1.0 ⫺0.5

0

0.5

1.0

1.5

2.0

Percent
Note: Global refers to the global merchandise trade reform
scenario; JBIL corresponds to the simulation where alldeveloping countries sign bilateral agreements with the
Quad-plus countries; and BILAT corresponds to thesimulation where the bilateral agreements are signed
individually. Results reflect unweighted regional averages.
Source: World Bank simulations with the Linkage model and
GTAP release 6.04.

their eyes wide open. The lessons of this study(and others before it 4) are that, much as withunilateral or multilateral policies, design andimplementation determine the ultimate effects.
It is important to use trade policy to leverage
domestic reforms that promote growth. For
South-South agreements, it is essential that thefocus be on some combination of full tradeliberalization behind low external borderprotection, greater services deregulation andcompetition, and proactive trade facilitation
measures that together positively affect both
intra- and extra-regional trade.

High-Income Countries andDevelopment

High-income countries, in order to realize
their broad development objectives, must
intensify their efforts to realize the development promise of the Doha Agenda. This has
the potential to open up trade, particularly inagriculture, in a way that would benefit lowincome groups around the world. Because
the high-income countries are the large

players in the system, they have a special interest in—and responsibility for—using effective
multilateral reforms to discipline the discretionary aspects of the regional agreements.
Allowing developing countries to concentrate scarce negotiating resources on the multilateral agenda may require that high-income
countries decelerate their efforts at expanding
RTAs. Irrespective of the pace of new agreements, high-income countries could consider
the following rules of thumb when designingagreements to promote development. First, reducing the extensive exclusions for agriculture
would transfer the income gains to rural areasin participating developing countries. Second,
adopting more common and nonrestrictive
rules of origin across agreements would
reduce the administrative barriers that often
undermine agreements and that increase theburden on customs administration. Third,
working with prospective partners to ensurethat new regulations regarding investment andintellectual property are appropriate to thelevel of development would reduce risks ofundue enforcement costs. Finally, providing
trade-related technical assistance, not only in
the implementation phase but also in the negotiating phase, would promote greater liberalization of services and lower MFN tariffs.

Acting Collectively to Mute theEffects of DiscriminationTo minimize the discriminatory effects of
RTAs at the multilateral level, all countries
must assume greater responsibility for maintaining the multilateral system. The international community, working through the WTO,
should revisit Article V of its charter. If thestated disciplines cannot be enforced in thenear term for collective political reasons, thenincreasing transparency and information
should become a priority. At present, the WTO
collects little if any information updating specific provisions, their implementation, and thetrade consequences. It even fails to take advantage of extant public monitoring efforts inxvii

G L O B A L

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P R O S P E C T S

2 0 0 5

specific regions, which could inform their datacollection effort. Collecting and publishingspecific information on RTAs would allow
members that find themselves excluded tochallenge these agreements in the court of public opinion. Even the more modest goal oftransparency will require building a new consensus and providing the staff of the WTO
with more resources than they have currently
available.
Nonetheless, WTO members should consider enhancing the existing rules to ensurethat regional agreements have positive development and systemic outcomes. This could include (based on a modest tightening of current
practice) setting quantitative indicators thatdefine “substantially all trade.” It could include efforts to simplify and harmonize therules of origin that are applied to both developed and developing countries. These items
are on the Doha Agenda and may be ready foraction.

Organization of This StudyAs is customary, chapter 1 of this study presents the World Bank’s view of the global
economy. The short-term section analyzes themain forces shaping the global outlook and theimplications for developing countries; the longterm analysis focuses on structural changes
in the global economy that will affect poverty
rates and the prospects for attaining the Millennium Development Goals. A novel feature ofthis year’s report is the introduction of a companion online feature (see www.worldbank.
org/prospects), where the reader can find additional information on regional trends and commodity prices, and tools to design scenarios to
his or her own specifications.
Chapter 2 introduces the issues associatedwith regional trade agreements and provides
an overview of regional trading trends.
Subsequent chapters focus on the content andxviii

consequences of regional agreements for tradecreation (chapter 3), trade facilitation(chapter 4), and services, investment, intellectual property rights, and labor mobility(chapter 5). Chapter 6 returns to the issue ofmaking regional agreements more compatible
with a nondiscriminatory multilateral system.

Notes
1. Negotiated as bilateral or multicountry treaties,
regional trade agreements grant members assured preferential market access, usually at zero tariffs for eligible products. Following WTO convention, the term
“regional trade agreement” includes both reciprocal
bilateral free trade or customs areas and multicountry(plurilateral) agreements. These are distinct from nonreciprocal voluntary agreements, such as the generalized system of preferences (GSP). Also, for statistical
purposes, unless otherwise noted, intra-EU trade is excluded from quantitative trade analysis. The EU is defined as including the 15 countries that belonged to theunion before its enlargement in 2004.
2. See Devlin and Estevadeordal (2004) and Schiff
and Winters (2003), among others.
3. See Robert Lawrence (1997), who develops theidea of subsidiarity as applied to regional agreements.
4. See Schiff and Winters (2003).

References
Devlin, Robert and Antoni Estevadeordal. 2004. Tradeand Cooperation: A Regional Public Goods Approach. In Regional Public Goods: From Theory toPractice, eds. A. Estevadeordal, Brian Frantz,
and Tam Robert Nguyen. Washington, DC: InterAmerican Development Bank.
Lawrence, Robert. 1997. Preferential Trading Arrangements: The Traditional and the New. In Regional
Partners in Global Markets: Limits and Possibilities of the Euro-Med Agreements, eds. A. Galal
and B. Hoekman. London: Center for Economic
Policy Research/Egyptian Center for Economic
Studies.
Martin, W., and F. Ng. 2004. Sources of Tariff Reductions. Background paper.
Schiff, Maurice, and L. Alan Winters. 2003. Regional
Integration and Development. Washington, DC:
World Bank.

Abbreviations

ACP

African Caribbean and Pacific states

ACPEU

African Caribbean and Pacific states European Union

AFTA

ASEAN Free Trade Area

AGOA

African Growth and Opportunity Act

ANZCERTA

Australia-New Zealand Closer Economic Relations Trade Agreement

APEC

Asia Pacific Economic Cooperation

ASEAN

Association of Southeast Asian Nations

BITS

Bilateral investment treaties

CAFTA

Central America Free Trade Agreement

CARICOM

Caribbean Community

CEC

Commission for Environmental Cooperation

CEMAC

Economic and Monetary Community of Central Africa

CEPR

Center for Economic and Policy Research

CGE

Computable general equilibrium

CIS

Commonwealth of Independent States

COMESA

Common Market for Eastern and Southern Africa

CRTA

Committee on Regional Trade Agreement

EAC

East African Community

EBA

Everything but arms

EC

European Community

ECO

Economic Cooperation Organization

ECOWAS

Economic Community of West African States

EEC

European Economic Community

EFTA

European Free Trade Association

EPAs

Economic Partnership Agreements

EU

European Union

FDI

Foreign direct investmentxix

G L O B A L

xx

E C O N O M I C

P R O S P E C T S

2 0 0 5FTAAFree Trade Area of the Americas

GAO

General Accounting Office

GATS

General Agreement on Trade in Services

GATT

General Agreement on Tariffs and Trade

GCC

Gulf Cooperation Council

GDP

Gross domestic product

GSP

Generalized System of Preferences

GTAP

Global Trade Analysis ProjectHS

Harmonized system

IDB

Inter-American Development Bank

IFC

International Finance Corporation

IISD

International Institute for Sustainable Development

IMF

International Monetary FundINS

Immigration and Naturalization Services

IOM

International Organization for Migration

IPRIntellectual Property Rights

IRCA

Immigration and Regularization Control Act

IRPA

Immigration and Refugee Protection Act

LAFTA

Latin America Free Trade Area

LDCs

Least developed countries

MDGs

Millennium Development Goals

MERCOSUR

Southern Lone Common Market

MFN

Most favored nation

MRA

Mutual recognition agreement

NAFTA

North America Free Trade Agreement

NBER

National Bureau of Economic ResearchOECD

Organisation for Economic Co-operation and Development

PRSP

Poverty Reduction Strategy Paper

PTAs

Preferential trade agreements

RTAs

Regional trade agreements

SAARC

South Asia Association for Regional Cooperation

SACU

South African Customs Union

SAD

Single administrative document

SADC

Southern African Development Community

SAPP

Southern African Power Pool

SAFTA

South Asian Free Trade Area

SAPTA

South Asia Preferential Trade Agreement

SPS

Sanitary and phyto-sanitary standards

A B B R E V I A T I O N S

TBTTechnical barriers to trade

TFP

Total factor productivity

TRIM

Trade-related investment measures

TRIPS

Trade-related aspects of intellectual property rights

TTF

Transport and trade facilitation

UEMOA/WAEMU

West African Economic and Monetary Union

UNCTAD

United Nations Conference for Trade and Development

UNESCAP

United Nations Economic and Social Commission for Asia and the Pacific

USAID

United States Agency for International Development

USTR

United States Trade Representative

WCO

World Customs Organization

WIPO

World Intellectual Property Organization

WTO

World Trade Organizationxxi

Frequently Cited Regional
Trading Agreements and theParties to Them
Agreement

Full nameMembers

AFTA

ASEAN Free
Trade Area

Brunei, Darussalam, Cambodia, Indonesia, Lao
People’s Democratic Republic, Malaysia, Myanmar,
Philippines, Singapore, Thailand, Vietnam

APEC

Asia Pacific Economic
Cooperation

Australia, Brunei, Canada, Chile, China,
Hong Kong (China), Indonesia, Japan, Korea,
Malaysia, Mexico, New Zealand, Papua New
Guinea, Peru, Philippines, Russia, Singapore, Taiwan(China), Thailand, United States, Vietnam

CACM

Central American
Common Market

Costa Rica, El Salvador, Guatemala, Honduras,
Nicaragua

CAFTA

Central America Free
Trade Area

United States, Costa Rica, El Salvador, Guatemala,Honduras, Nicaragua, Dominican Republic

CAN

Andean Community

Bolivia, Colombia, Ecuador, Peru, República
Bolivariana de Venezuela

CARICOM

Caribbean Community
and Common Market

Antigua and Barbuda, Bahamas, Barbados, Belize,
Dominica, Grenada, Guyana, Haiti, Jamaica,
Monserrat, Trinidad and Tobago, St. Kitts andNevis, St. Lucia, St. Vincent and the Grenadines,
Suriname

CEFTA

Central European
Free Trade Agreement

Bulgaria, Czech Republic, Hungary, Poland,
Romania, Slovak Republic, Slovenia

CEMAC

Economic and Monetary Cameroon, Central African Republic, Chad,
Community of
Republic of Congo, Equatorial Guinea, Gabon
Central Africa

CER
Closer Economic(ANZCERTA) Relations Trade
Agreement

Australia, New Zealandxxiii

G L O B A L

xxiv

E C O N O M I C

P R O S P E C T S

2 0 0 5

Agreement

Full nameMembers

CIS

Commonwealth of
Independent States

Azerbaijan, Armenia, Belarus, Georgia, Moldova,
Kazakhstan, Russian Federation, Ukraine,
Uzbekistan, Tajikistan, Kyrgyz Republic

COMESA

Common Market for
Eastern andSouthern Africa

Angola, Burundi, Comoros, Democratic Republic ofCongo, Djibouti, Arab Republic of Egypt, Eritrea,
Ethiopia, Kenya, Madagascar, Malawi, Mauritius,
Namibia, Rwanda, Seychelles, Sudan, Swaziland,
Uganda, Zambia, Zimbabwe

EAC

East African Community Kenya, Tanzania, Uganda

ECOWAS

Economic Communityof West African States

Benin, Burkina Faso, Cape Verde, Gambia, Ghana,
Guinea, Guinea-Bissau, Côte d’Ivoire, Liberia, Mali,
Niger, Nigeria, Senegal, Sierra Leone, Togo

EEA

EuropeanEconomic Area

EU, Iceland, Liechtenstein, Norway

EFTA

European Free
Trade Association

Iceland, Liechtenstein, Norway, Switzerland

EMFTA

Euro-MediterraneanFree Trade Area

EU, Algeria, Cyprus, Egypt, Israel, Jordan, Lebanon,
Malta, Morocco, Syrian Arab Republic, Tunisia,
Turkey, Palestinian Authority

FTAA

Free Trade Areaof the Americas

Antigua and Barbuda, Argentina, Bahamas,
Barbados, Belice, Bolivia, Brazil, Canada, Chile,
Colombia, Costa Rica, Dominica, Dominican
Republic, Ecuador, El Salvador, Grenada,
Guatemala, Guyana, Haiti, Honduras, Jamaica,
Mexico, Nicaragua, Panama, Paraguay, Peru,
St. Kitts and Nevis, St. Lucia, St. Vincent and the
Grenadines, Suriname, Trinidad and Tobago,
United States, Uruguay, Venezuela

GAFTA

Greater Arab Free
Trade Area

Bahrain, Egypt, Iraq, Jordan, Kuwait, Lebanon,
Libya, Morocco, Oman, Palestine, Qatar, Saudi
Arabia, Somalia, Sudan, Syria, Tunisia,
United Arab Emirates, Yemen

GCC

Gulf Cooperation
CouncilBahrain, Kuwait, Oman, Qatar, Saudi Arabia,
United Arab Emirates

MERCOSUR

Southern Common
MarketArgentina, Brazil, Paraguay, Uruguay

NAFTA

North American
Free Trade Agreement

Canada, Mexico, United States

SACU

Southern African
Customs Union

South Africa, Botswana, Lesotho, Swaziland,
NamibiaR E G I O N A L

T R A D I N G

A G R E E M E N T S

A N D

T H E

P A R T I E S

SADCSouthern African
Development
Community

SAFTA

South Asian Free Trade
Area

Angola, Botswana, Democratic Republic of Congo,
Lesotho, Malawi, Mauritius, Mozambique,
Namibia, South Africa, Swaziland, Seychelles,
Tanzania, Zambia, Zimbabwe
Bangladesh, Bhutan, India, Maldives, Nepal,
Pakistan, Sri Lanka

SAPTASouth Asian Preferential
Trade Arrangement

Bangladesh, Bhutan, India, Maldives, Nepal,
Pakistan, Sri Lanka

WAEMU

West African Economicand Monetary Union

Benin, Burkina Faso, Côte d’Ivoire, Guinea Bissau,
Mali, Niger, Senegal, TogoT O

T H E Mxxv

1
Global Outlook and theDeveloping Countries

World growth accelerated sharply in 2004,
with GDP advancing an estimated 4 percent(table 1.1). All developing regions are now
growing faster than their average growth ratesof the 1980s and 1990s. The ongoing economic boom in China was a major factor, as
were the surges in activity registered in Japanand the United States. The economic recovery
was slower to take hold among European
high-income countries, which contributed to
the less marked increase in growth rates there.
Meanwhile, very strong import demand—
because of the torrid expansion in China andthe continued tendency for domestic demandin the United States to substantially exceed
production—contributed to an exceptional
10.2 percent increase in world trade volumes.
Economic growth is expected to slow in2005 and 2006, expanding by 3.2 percent ineach year. Several factors are likely to contribute to this more moderate pace of activity.
First, the investment cycle in the United States
has likely peaked, implying a slowdown ingrowth there.1 Second, world demand has
outstripped supply, resulting in substantial increases in oil and other commodity prices thathave cut into incomes, moderating demand inmany countries. Third, higher interest rates
will slow investment growth as central banks
continue shifting monetary policy from aloose to a more neutral stance. Fourth, thelarge fiscal impulse that has helped propel the
U.S. economy in recent years will weaken in
2004—although the deficit will remain high;and in Europe, budgetary policy is expected totighten as countries seek to regain control
over deficits, which in many cases exceed
Maastricht limits. Finally, efforts in China tobring growth down to a more sustainable paceshould also contribute to weaker, but still
strong, demand over the medium term.
Given this external environment and especially the less rapid expansion of trade,growth in most low- and middle-income countries is also expected to moderate but remainstrong. The extent of the slowdown should be
mitigated because of the far-reaching structural reforms carried out in many countries,
which have contributed to recent gains in market share and economic growth. Recent efforts
to reduce general government and current account deficits and to pay down debt should
enable most developing countries to withstandthe higher interest rates expected over the next
few years without excessive adjustment
costs. However, there is little room for complacency—especially for the more highly
indebted countries.
These favorable prospects for the next two
years represent a solid starting point for
longer-term growth through 2015 and increase
the likelihood that developing countries meet
the Millennium Development Goals (MDGs).
Improvements in macroeconomic fundamentals, enhanced structural flexibility, a stronger
investment climate, and further progress toward reducing trade barriers should, if
sustained, support the ability of developing1

G L O B A L

E C O N O M I C

P R O S P E C T S

2 0 0 5

Table 1.1 The global outlook in summary
Percentage change from previous year, except interest rates and oil prices
Forecast
2002

2003

2004e

2005

2006

3.7

5.5

10.2

8.4

7.8

1.0
1.6

1.6
2.3

1.7
2.7

1.4
2.2

1.2
1.7

5.3
24.9
2.4
1.3

10.2
28.9
15.9
7.4

17.0
39.0
35.0
5.2

3.1
36.0
7.7
0.8

4.2
32.0
11.1
0.3

1.8
3.3

1.2
2.3

1.6
2.1

3.5
2.4

4.7
3.6

Real GDP growthe
World
Memo item: World (PPP weights)f
High incomeOECD Countriesg
Euro Area
Japan
United States
Non-OECD countries

1.7
2.9
1.3
1.3
0.9
0.3
1.9
2.2

2.7
3.9
2.1
2.0
0.5
2.5
3.0
3.1

4.0
4.9
3.5
3.5
1.8
4.3
4.3
5.9

3.2
4.2
2.7
2.6
2.1
1.8
3.2
4.6

3.2
4.1
2.7
2.6
2.3
1.6
3.3
4.4

Developing countries
East Asia and Pacific
Europe and Central Asia
Latin America and the Caribbean
Middle East and North Africa
South Asia
Sub-Saharan Africa

3.4
6.7
4.6
0.6
3.2
4.6
3.1

5.2
7.9
5.9
1.6
5.7
7.5
3.0

6.1
7.8
7.0
4.7
4.7
6.0
3.2

5.4
7.1
5.6
3.7
4.7
6.3
3.6

5.1
6.6
5.0
3.7
4.5
6.0
3.7

Memorandum items
Developing countries
excluding transition countries
excluding China and India

3.2
2.1

5.1
3.8

5.9
5.4

5.4
4.6

5.1
4.3

Global Conditions
World Trade Volume
Consumer Prices
G-7 Countriesa,bUnited States
Commodity Prices (USD terms)
Non-oil commodities
Oil Price (World Bank average)c
Oil price (percent change)
Manufactures unit export valued
Interest Rates$, 6-month (percent)€, 6-month (percent)Note: PPP  purchasing power parity; e  estimate.
a. Canada, France, Germany, Italy, Japan, the United Kingdom, and the United States.
b. In local currency, aggregated using 1995 GDP weights.
c. The World Bank average is the unweighted mean of one barrel of West Texas Intermediate, Brent, and Dubai oil.
d. Unit value index of manufactured exports from major economies, expressed in U.S. dollars.
e. GDP in constant dollars at 1995 prices and market exchange rates.
f. GDP measured at 1995 PPP weights.
g. Now excludes the Republic of Korea, which has been reclassified as high-income OECD.
Source: World Bank.

countries to achieve rapid and sustained per
capita growth at a level of 3.5 percent per
annum between 2006 and 2015—double thegrowth rate of the 1990s. Such growth would
enable many developing countries to halve theincidence of extreme poverty by 2015, which isa key development goal. However, even if thehigher growth of recent periods were sustained, some regions, notably Sub-Saharan2

Africa, will fail to reduce poverty to thisdegree. In Sub-Saharan Africa, per capita
growth has been slow, and progress to reducepoverty has been minimal. It would take implausibly high growth rates during the next
10 years to achieve the poverty target alongwith substantial enhancements to pro-poor
policies and significantly more assistance.
Finally, even if many regions are expected toG L O B A L

achieve the MDG to reduce poverty, many are
off track for reaching other important MDGs,
such as reducing child and maternal mortality.
In many cases economic growth is not enough.
A more targeted approach and a realignmentof spending priorities are also necessary.
Despite the relatively positive picture forboth medium- and long-term prospects,
downside risks are ever present and could
have negative impacts in the near future and in
the long term. An additional rise in oil prices,or a failure of them to moderate, could further
restrain global demand and reduce incomes inmost less developed countries. While oil prices
are expected to decline from present highs,
especially given substantial efforts to increase
supply by oil exporting countries, existing
demand conditions are such that a significant
increase cannot be ruled out. Such a rise
would have important negative effects on all
oil-importing economies, particularly thoseof low- and middle-income countries thatface current account constraints. For thesecountries, difficulties accessing international
finance mean that they cannot absorb the increased costs associated with higher oil prices
by increasing their current account deficit.
Instead, the additional costs must be accommodated by lower imports, consumption, andinvestment volumes—implying a significant
real-side adjustment. For the most vulnerableof such countries, an additional $10 a barrel
increase in oil prices could reduce domestic incomes by as much as 4 percent. On average,
incomes of oil-importing low-income countries
would fall by about 1 percent of GDP.
Financing requirements of the U.S. current
account and government deficits, and renewed
downward pressure on the dollar, may cause
long-term interest rates to rise more than forecasted. If interest rates rise, short- to mediumterm impacts might include a slowing in world
economic growth, sharply increased financing
costs, and economic hardship for heavily indebted countries. Increased financial-market
turbulence might also ensue—especially for
those developing countries most exposed to the
U.S. dollar. Over the medium- to long-term,

O U T L O O K

A N D

T H E

D E V E L O P I N GC O U N T R I E S

failure to rein in the U.S. budget deficit, which
would also tend to reduce its current accountdeficit, could result in an ever increasing stockof dollar-denominated debt and rising futurefinancing burdens. Moreover, higher interest
rates would depress investment levels, provoking a prolonged slowing in the rate of increaseof potential output. All of these factors
heighten the risk of a resurgence in protectionist sentiment, which would thwart the pace atwhich developing countries are able to achieve
their poverty reduction objectives.
Finally, if current efforts to slow the unsustainable pace of growth in China fail, major
disruptions could result. Currently, investment
levels may be unsustainably high, and there
are some signs that rapidly rising food-priceincreases are feeding into production costs,
which could ultimately choke off competitiveness, (although for the moment there are noclear indications that this is happening). Either
problem could provoke a much more abrupt
slowdown than described in the baseline.
Given China’s growing importance as a driverof world trade growth, such a sharp slowdown could have a significant damping effecton global economic activity, particularly
among China’s major trading partners.

The Global Economy: From
Recovery to ExpansionT

he world economy accelerated sharply in
2004, expanding by an estimated 4 percent (figure 1.1). The United States and Japan,
whose economies grew by more than 4 percent,continued to lead Europe in the recovery. Evenstronger growth was experienced by a numberof large developing countries, notably China(8.8 percent), Russia (8.0 percent), and India(6.0 percent). Their performance helped power
developing countries as a whole to an anticipated 6.1 percent growth rate in 2004—an
expansion without precedent over the past
30 years. Moreover, it marks a second year ofvery strong growth, and it may be the first timethat recovery in developing countries preceded,rather than followed, recovery in high-income3

G L O B A L

E C O N O M I C

P R O S P E C T S

2 0 0 5Figure 1.1 A record year for developing
countries in 2004
GDP growth, 1995 US$ (percent)6

Developing countries
World

5
4
3
2
1

04
20

01
20

98
19

95
19

92
19

89

86

19

19

83
19

19

80

0

Source: World Bank.

countries. In contrast to the United States,
where the surge was initially led by investment
and household consumption, exports were themain source of growth in Europe and Japan—
and much of the increase in external demandcame from developing countries.
Across the developing world virtually
every region enjoyed solid growth, andrapidly rising trade volumes played an important role. Even excluding China, India, andRussia, economic activity in developing countries is expected to have risen 5 percent in2004. While easy credit contributed toChina’s remarkable performance, the benefitsof WTO accession were also a major factor,
and the increase of over 30 percent in Chinese
import demand helped underpin growthamong neighboring East Asian countries.
Russia and the oil-producing countries in the
Middle East and North Africa Region benefited from very strong oil revenues, whichwere reflected in strong import demand andthe solid export performance of their trading
partners. Increasing market shares, following
substantial inward investment flows associated with the accession of many of the Europe
and Central Asian Region’s members to theEU, also contributed to these positive outcomes. Elsewhere, a strong cyclical recovery

4

is under way in Latin America, and there aresigns of a more modest recovery in SubSaharan Africa.
Growth should moderate in 2005 and2006, led by a slowing of the expansion amongdeveloped countries. In the United States, as
the output gap closes, productivity growth isprojected to slow and unit labor costs to rise;these factors, in addition to external inflationary pressures from commodity prices, likely reflect the Fed’s decision to tighten monetaryconditions. This, plus the maturation of the investment cycle, a tailing off of fiscal stimulus,
and the impact of higher oil costs, will contribute to slowing growth. Similar factors explain the anticipated slowdown in Japan,
where output is expected to increase at about
trend rates. In contrast, because of its later
start and the fact that investment is only
now beginning to recover, Europe’s growth isexpected to continue gaining momentum
through 2005 and into 2006, notwithstanding
fiscal tightening and a slowdown in the rate of
growth of world demand. Overall estimatessuggest that the hike in oil prices already observed can be expected to dampen output in2005 by about 0.5 percent of GDP.
Moderating growth in the OECD economies
and a soft landing in China should translate intoslower but still buoyant growth in developing
countries (figure 1.2).
• In East Asia, efforts to stem the flow ofcredits into selected sectors of the Chinese economy are already having observable effects (figure 1.2a). The growth ofimports of raw materials such as steel,copper, and various ores have moderated
significantly in recent months. Steel imports have collapsed, although iron ore
import volumes were growing by morethan 25 percent (year/year) in September.
However, there are indications that
consumption demand continues to growrapidly, and the Chinese authorities
report that GDP increased 9.1 percent in
the third quarter. The baseline forecast
predicts that a soft landing (growthslowing to 7.1 percent by 2006) will beG L O B A L

O U T L O O K

A N D

T H E

D E V E L O P I N GC O U N T R I E S

Figure 1.2 Strong growth across most regions
a. East Asia and Pacificb. South Asia

Growth of real GDP (percent)

Growth of real GDP (percent)
Forecast

9
8

8

7

7

6

6

5

5

4

4

3

3

2

2

1

1

0

Forecast

90
1980–2002

2003

2004*

2005

2006

c. Europe and Central Asia

1980–2002

2003

2004*

2005

2006

d. Middle East and North Africa
Growth of real GDP (percent)

Growth of real GDP (percent)
Forecast

8
7

7

6

6

5

5

4

4

3

3

2

2

1

1

0

Forecast

80
1980–2002

2003

2004*

2005

2006

e. Latin America and the Caribbean

1980–2002

2003

2004*

2005

2006

f. Sub-Saharan Africa

Growth of real GDP (percent)

Growth of real GDP (percent)
Forecast

5.0
4.5

4.5

4.0

4.0

3.5

3.5

3.0

3.0

2.5

2.5

2.0

2.0

1.5

1.5

1.0

1.0

0.5

0.5

0

Forecast

5.0

0
1980–2002

2003

2004*

2005

2006

1980–2002

2003

2004*

2005

2006

Note: *  estimate.
Source: World Bank estimates.

5

G L O B A L

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P R O S P E C T S

2 0 0 5

achieved and will contribute to slowing
throughout the region.
• In South Asia, despite the moderation of
the Chinese and OECD economies,
growth is expected to accelerate in 2005,
reflecting the enduring impacts of structural reforms, market opening, andstronger domestic demand as the dampening impact of last year’s poor crop
fades. As agricultural production and related incomes return to trend growth
rates in 2006, GDP growth is projected
to moderate somewhat.
• Output in Europe and Central Asia is forecast to remain strong, with still-high oil
prices supporting demand in Russia andthe exports of its trading partners. Central
and Eastern European countries will continue to benefit from rapid investment
growth following the EU accession ofsome of their members. However, policymakers need to prepare for the next downturn by pursuing fiscal consolidation to reduce worryingly high government and, insome cases, current account deficits.
• Growth in the Middle East and North
Africa region is expected to remain robust,
but well below the highs observed in 2003,
which were boosted by sharp increases inoil production. All countries, but especially those of the Maghreb, should benefit
from the strengthening export demand
emanating from Western Europe; but consumption demand, reflecting still high oil
incomes, will continue to be the main
source of growth for the region as a whole.
• The return to growth in Latin America andthe Caribbean is projected to continue,
with only Argentina experiencing a significant slowdown as the competitive advantage from its depreciation in 2002 wears
off. Elsewhere, growth should remainstrong, with Brazil expanding steadily at
between 3.7 and 3.9 percent. Because
Latin America and the Caribbean is aheavily indebted region, outturns will ultimately depend on the success with which
policymakers deal with rising interest rates

6

and higher payments on debt (see the risks
section in this chapter). Here, countryspecific conditions and the degree towhich fiscal consolidation programs aremaintained will play an important role.
• Sub-Saharan Africa will also benefit
from the revival in Europe, its main trading partner, but many oil-importing
countries in Africa remain vulnerable
due to high oil prices. Notwithstanding
substantially improved performance,
growth in the region will continue to lag
the rest of the world by a significant margin, implying a further widening of income gaps. Moreover, the terms of tradeappear to be turning against this region
as non-oil commodity prices are expected to ease. Although additional development aid and debt relief would
help, continued efforts to improve fundamentals and the efficiency of public
expenditure are also required to speed
the pace at which these countries achieve
their poverty-reduction objectives.

Commodity Markets

S

trong world demand and supply shortages
were responsible for commodity prices rebounding sharply during the global recovery(figure 1.3). In dollar terms, metals and minerals

Figure 1.3 Tradable price developments
Cumulative percent change, 2001–2004
60
50

Nominal40

Exchange-rate
adjusted a

30
20
10

EUN

0
10
Petroleum

Metals andminerals

Agricultural Manufactures
products

a. The adjusted data show the price change expressed as atrade-weighted average of domestic currency prices.
Source: World Bank.

G L O B A L

Figure 1.4 Terms of trade impacts fromhigher commodity prices, 2001–04
Percent of GDP
10

Oil exporters

8
6
4
2

Oil importers

0

m

id

dl Lo
e w
in a
co n
m d
e
Lo
w
in
co
H
m
ig
e
hl
y
in
de
bt
ed
m
id
dl Lo
e w
in a
co n
d
Lo me
w
in
co
(e
m
xc Lo
e
lu w
di in
ng c
In om
H
di e
ig
a)
hl
y
in
de
bt
ed

2

Source: World Bank.

prices have increased the most since 2001 (up almost 60 percent), but the 40 percent hike inpetroleum prices has had the largest economic
effect. In domestic currency terms, the impact ofthese price hikes was less important for many
countries because of the 15 percent depreciation2 of the dollar over the same period.
Higher commodity prices since 2001 haveboosted incomes of low- and middle-income
countries as a whole by an estimated 1.1 percent of GDP. However, virtually all of the gain
accrued to low- and middle-income oil exporters. Most developing country oil importers suffered net terms of trade losses (figure 1.4). The major beneficiaries were theMiddle East and North Africa, Europe andCentral Asia, and Latin America and the
Caribbean Regions—all of which include
major oil exporters. In contrast, the net gains
from non-oil commodity prices for lowincome countries were modest or even negative. This is partly because most of the non-oil
commodity price gains were concentrated
in metals and minerals prices, which restricted
the benefits to a few resource-rich countries.
Moreover, many industrializing low-income
countries, notably India and Pakistan, are
now net commodity importers. The terms-oftrade impact on incomes of oil exportingO U T L O O K

A N D

T H E

D E V E L O P I N GC O U N T R I E S

developing countries was 5.6 percent of GDP,
whereas for oil importers the impact was aloss of 0.3 percent.
For the poorest oil-importing countries,
high oil prices have dramatically exacerbatedalready serious poverty. Many of thesecountries remain particularly vulnerable tohigh oil prices. Even before the oil price hikes,
a number of these countries were spending
more than 5 percent of GDP to cover oil imports. The unweighted average of West-Texas
Intermediate, Brent, and Dubai crude oils is
estimated to have been $39 in 2004.3 At thislevel, it is estimated that as many as sevencountries will have oil-import bills in excess of
10 percent of GDP; these countries would beforced to make substantial cuts in spending
elsewhere in their economies to compensate
for the additional burden (figure 1.5). Indeed,
for the poorest countries the net additionalburden in 2004 is expected to consume 75
percent of the World Bank funding they receive for all development programs, andFigure 1.5 The oil-import burden for
selected countries
Ethiopia
Kyrgyzstan
Burkina Faso
MalawiPakistan
Mali
Nicaragua
Moldova
Tajikistan
Bosnia andHerzegovina
Swaziland
Mongolia

Pre-hike burden

Lesotho
Additional burden

Mauritania
Lao PDR
0

5

10

15

20

25

Percent of GDP
Source: World Bank.

7

G L O B A L

E C O N O M I C

P R O S P E C T S

2 0 0 5

localized disruptions in production (figure 1.6). Indeed, OPEC excess capacity is estimated to have fallen from 4.6 million barrels
per day in 2001 to only 1.4 million barrels per
day in 2004. Moreover, oil prices remain well
below past peaks. Corrected for inflation andexpressed in 2003 dollars, oil prices averaged
more than $72 in 1980, and actually reachedmore than $100 in November of the previous
year. Viewed from this perspective, further
hikes would not be unprecedented.

Figure 1.6 Crude oil prices, 1960–2004
Price per barrel ($)
80
Constant dollarsa

70
60
50
40
30
20
10

76

84
19
88
19
92
19
96
20
00
20
04

19

19

68

72

19

19

19

60

64
19

19

80

Nominal dollars

0World Tradea. Nominal petroleum prices deflated by the U.S. GDP
deflator, 2003  1.

W

Source: World Bank.

12 percent of all the bilateral aid they receive.
To keep development projects on track, highincome countries will need to increase commitments substantially—at least as long as
high oil prices continue.
Although a substantial rise in oil prices is
not the most likely scenario, given newsources of supply and reduced oil intensities in
the world economy, there remains considerable scope for higher oil prices, particularly
given the current sensitivity of oil markets toorld trade growth averaged 10.2 percent in 2004, reflecting rapid increases
in industrial production and investment activity (figure 1.7). The expansion in trade volumes in 2004 is reminiscent of the increase observed in 2000 and mirrors the rapid recovery
in industrial production that began to takeshape in the second half of 2003 and continued into 2004. More than 20 percent of theincrease in world merchandise trade volumes
was represented by China, whose imports increased by 32 percent—reflecting both thepositive impact of its accession to the WTO
and unsustainable rates of investment andconsumption demand.

Figure 1.7 World trade rebounds
World industrial production (percent change, year/year)

Merchandise export volumes (percent change, year/year)

7.5

15.0
World trade

Industrial production

12.5

5.0

10.0
7.5

2.5

5.0
2.5

0

0
2.5

2.5

5.0
7.5

5.0
Q1
1991
Source: World Bank.

8

Q1
1993

Q1
1995

Q1
1997

Q1
1999

Q1
2001

Q1
2003

G L O B A L

Trade in raw materials and investment goods
was particularly strong. As discussed above, robust demand for raw materials was an important factor underlying the trade expansion in a
number of developing countries. In particular,oil, steel, and minerals trade was strongly influenced by the rapid increase in Chinese manufacturing and construction sectors. Similarly,
fast-growing global investment expenditures
were particularly important in spurring export
demand in countries such as Germany andJapan that specialize in the fabrication of machinery and other physical capital.
As a whole, developing countries havegrown their share in world markets by about
19 percent (figure 1.8), up from 19 to 23 percent since 2000. Much of this rise is attributed
to China, which has seen its share in world
exports double from 2.9 to 5.8 percent between 2000 and 2004. Excluding China, theimprovement in the export share of low- andmiddle-income countries has been more modest (from 16 to 17 percent), although developing countries in the South Asia and Europe
and Central Asia regions have increased theirmarket shares considerably. Other regions
either maintained their market share (the restof the Eastern Asia and Pacific and the Middle

Figure 1.8 Export performance, percent
change in market share since 2000
Percent

China, percent
120

60

100

50
40
30

Developing
countries(excluding China)

East Asia(excluding China)

80
60

20

40

10

20

0

0

10

20

20
30

China

Developed
countries

19
8
19 9
9
19 0
9
19 1
9
19 2
9
19 3
9
19 4
9
19 5
9
19 6
97
19
9
19 8
9
20 9
0
20 0
0
20 1
0
20 2
0
20 3
04

40

Source: World Bank.

40
60
80

O U T L O O K

A N D

T H E

D E V E L O P I N GC O U N T R I E S

East and North Africa) or lost market share(Sub-Saharan Africa and Latin America andthe Caribbean).
Within regions the performance of specificcountries continues to be dictated, in part, bydomestic factors. So notwithstanding verystrong Chinese import demand, exports in therest of East Asia failed to increase as quickly,
partly because political instability held backindustrial and investment activity in thePhilippines and Indonesia. In Latin American
and the Caribbean, export volumes in Brazil
and Argentina grew briskly under the continued influence of currency devaluations 2 years
ago, while strong world demand for metals
and minerals gave special impetus to Chilean
exports.
Slower activity throughout the global economy should translate into less rapid trade expansion in 2005 and 2006. Trade in goods andnonfactor services is forecast to expand by
about 8.5 percent in 2005, down from an estimated 10 percent in 2004. Much of the deceleration is conditional on the success of efforts
to dampen the pace of activity in China, whichshould be reflected in slower import growth inChina and slower exports among its trading
partners. Looking to other regions, the easingof activity in the United States, coupled withbroadly stable growth in Europe, is expected toresult in a somewhat more pronounced deceleration of trade volumes in Latin America ascompared with Africa, the Middle East, andEastern European areas.
Major imbalances in the world trading environment persisted during 2004 and will
likely continue to play a large role in 2005–06(figure 1.9). Notwithstanding the sharp acceleration in world import volumes, the U.S. current account deficit reached 5.7 percent of
GDP in the second quarter of 2004, as American consumption and investment volumes exceeded domestic production by a wide margin(higher oil prices represented 0.6 percentage
points of the 1.4 percentage point deterioration in the current account since the firstquarter of 2002). The expansion in the trade
deficit since the mid-1990s has been the main

9P R O S P E C T S

2 0 0 5Figure 1.9 Trade balances in major
regions
Billions of U.S. dollars, 2004
300

260

200

170

134

100

52

9

0

60

100
200
300
400
500
600
700

667
an

hi
L
na
th ati
e n
C Am
ar
ib er
be ica
an
de
ve O
lo th
pi er
ng

C

an

d

pe
ro
Eu

Ja
p

on a
ni
U
an

er
th
O

U

ni

te

d

N

St

AF

at

TA

es

800

a. European Union refers to the 15 member countries, prior
to the latest expansion.
Source: National agencies.

factor behind the rise in the U.S. current account deficit—itself a major factor behind the
15 percent real effective depreciation of thecurrency since February 2002. Barring a substantial increase in domestic savings by, for example, a tightening of fiscal policy, downward
pressure on the U.S. dollar is likely to resume
as U.S. foreign borrowing requirements remain high, and the already large amounts ofexternal debt continue to accumulate (see, forexample, Bergsten and Williamson 2004).
The U.S. trade deficit is largely a homegrown problem. While bilateral trade deficits
with specific countries are large, notably withrespect to China, the fact that these countries
have only small overall surpluses supports theview that the deficit with the United States ismore a reflection of U.S. trade patterns than anindication of unfair trading practices. For example, China’s large bilateral surplus with theUnited States (but very small global surplus)
reflects its specialization in the production of
final consumption goods (sold to the UnitedStates) based on intermediate and primary10

imports from other developing countries withwhom China has a cumulatively large trade
deficit (Lau 2003).4
Failure to address the twin U.S. deficits could
have significant impacts on developing countries, especially if that failure leads to an increasein protectionist behavior. This is especially relevant because the substantial improvements inliving standards, wages, and incomes in many
upper-lower and middle-income countries havebeen the result of expanding their world market
share in manufactures. An increase in protectionism could halt these countries’ progress anddeny other poor countries the same avenue todevelopment. Moreover, a retreat from recent
efforts to reduce trade barriers or a failure to
make further progress—especially concerning
agricultural subsidies—could have substantial
negative consequences on many of the world’s
poorest countries.

International FinanceOver the past several years, favorable
global conditions, strong growth, rapidly
expanding trade, and domestic reforms (including lower fiscal deficits and inflation) haveallowed developing countries to substantially
improve their financial positions (figure 1.10).

Figure 1.10 Developing countries’ debt
and interest payments easing downward
since 1999
Percent of GNI
60
Interest payments(right axis)

50

Percent of GNI
Total debt, outstanding anddisbursed (left axis)

3.0
2.5

40

2.0

30

1.5

20

1.0

10

0.5

0

0
9
19 0
9
19 1
9
19 2
9
19 3
9
19 4
95
19
9
19 6
9
19 7
9
19 8
99
20
00
20
0
20 1
02
20
03

E C O N O M I C

19

G L O B A L

Source: World Bank.

G L O B A L

On average, their debt to GNI ratio has fallenfrom 44 to 37 percent since its peak in 1999.
This progress, plus low interest rates andstrong growth, has substantially lowered thedebt-servicing burden for most countries.
While the situation of the most heavily indebted countries remains serious, they havemade the greatest gains—debt to GDP ratios
for these countries are down from 161 to 86
percent since 1994—partly because of debtrelief programs instituted over this period.
These favorable conditions have also allowed many countries to strengthen their external position. Most countries have succeeded
in improving their structural positions so that,even in the face of higher oil prices or a more
moderate pace for growth, their current account positions should not deteriorate to thepoint where financing becomes problematic.
As a whole, the current account position of the
major groups of developing countries is close
to balance or in surplus (table 1.2).
Developing countries have become major
sources of international capital. Since 2000, thecentral banks of some of the largest developing
countries have increased their foreign reserves bymore than 80 percent. Taken as a group, the reserves of Brazil, China, India, Mexico, Thailand,
and Turkey now represent over 45 percent of developing country reserves. Indeed, following

O U T L O O K

A N D

T H E

D E V E L O P I N GC O U N T R I E STable 1.2 Current account balances
Percent of GDP in 2004

East Asia and PacificSouth Asia
Middle East and North Africa
Sub-Saharan Africa
Europe and Central Asia
Latin America and the Caribbean
High-income countries

1.5
0.5
14.4
1.3
0.1
0.7
0.8

Source: World Bank estimates.

private investors’ retreat from equity and bondinvestments in U.S. dollar-denominated assets,5the central banks of these countries have become
one of the most important sources of financing
for the large U.S. current account deficit, absorbing 51 percent of the overall increase in foreign
officially-held U.S. treasury bills between March
2000 and January 2003. While this has allowed
these countries to increase their reserves by a substantial margin, it has been achieved at the expense of increasing their exposure to the U.S. dollar (figure 1.11). Among these countries, theshare of U.S. treasury bills in their official reserves has increased by as much as 20 percentage
points and equals almost 70 percent in the case of
Mexico, and 58 percent in China. Should thesecountries decide to rebalance their reserve portfolio by slowing the pace at which they accumulate dollar-denominated reserves, either

Figure 1.11 Rising U.S. dollar reserves
Developing country reserves

Share in increase

Billions of dollars
500
China

450

Other
currencies
28%

400
350

Other developing countries

300
250
200
150
100

U.S. dollar
72%

50
0
2000

2003

Source: World Bank.

11

G L O B A L

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2 0 0 5

downward pressures on the dollar will accentuate, or interest rates will have to rise in order toattract sufficient private capital inflow.
Notwithstanding robust aggregate performance, many countries have been lesssuccessful in reaping the benefits of the last
few years of strong economic conditions, andtheir high current account deficits could imperil their stability—especially in the context
of slower growth in trade and world economic
activity. More than 50 developing countries
have current account deficits that exceed
5 percent of GDP. As a result, even the moderate hikes in interest rates, deterioration interms of trade, and the slower export demand
projected in the baseline will likely require
these countries to undergo significant cuts toimports and domestic consumption in order tomaintain external stability. If trade growth
were to slow more than currently predicted, or
if terms of trade were to deteriorate more because of an additional hike in oil prices, the required adjustment could be severe.

Risks and Policy Priorities

F

orceful steps are required to reduce thetwin deficits in the United States. As
the preceding discussion has indicated, overthe past few years, private sector equity and direct investment financing of the very large U.S.
current account deficit has dried up,6 having
been replaced to a large extent by increased
purchases of U.S. bonds by foreign central
banks, notably those of developing countries.
While these countries’ build up of reserves hashelped improve their external financial position, the stock of U.S. dollars that they now
hold is very high and represents a disproportionate share of their assets. It is not clear thatthey can or should increase these stocks further by continuing to absorb the lion’s share of
net new U.S. treasury bills (6 developing countries absorbed more than half of net new issues
since 2000).7 Assuming their appetite for treasuries wanes, downward pressure on the U.S.
dollar is likely to re-emerge, and yields will

12

Figure 1.12 Impact of a 200 basis point
increase in interest rates
Deviation from baseline (percent of GDP)
0.7

Developing
countries

0.6
0.5

Developed
countries

0.4
0.3
0.2
0.1
0
2005

2006

2007

2008

Source: World Bank.

probably have to rise in order to motivate
private investors to re-enter the market.8
Simulations suggest that a 200 basis point increase in long-term interest rates could reduceworld GDP over the short- to medium-term by
about 0.5 percent per annum;9 the impact
would be somewhat stronger for developing
countries, because higher rates will raise debt
servicing burdens, which require additional cuts
to spending and demand (figure 1.12). Over the
longer term, if the twin deficits in the UnitedStates are not addressed (a tightening of fiscal
policy would reduce both deficits by increasing
U.S. savings10), the problem is likely to intensify.
Permanently higher long-term interest rates
would render a wide range of investment projects uneconomic and slow the pace of potential
output for a considerable time11— leading, perhaps, to a period of stagflation similar to thatobserved during the 1970–80s.
While higher U.S. interest rates might
maintain investor interest in the dollar, theywould have serious disruptive impacts on
countries with large U.S. dollar debts. For
countries such as Brazil, Indonesia, the Philippines, Poland, and Turkey, a 200 basis point
increase in dollar interest rates would significantly increase debt-servicing charges. Increased outflows could provoke large depreciations in their currencies (as much as
9 percent), which would only increase theG L O B A L

domestic burden of their external debt andgenerate further downward pressure on theircurrencies. Maintaining stability would, in all
likelihood, require a substantial reduction in
imports, consumption, and investment, which
would result in slower growth and impede increases in poverty reduction.
The risk of such outcomes makes redressing imbalances all the more pressing. Amongdeveloped countries, steps need to be taken to
reduce the U.S. government deficit, which
would lower overall borrowing requirements
and investor’s concerns over the long-term
financing of the debt. In Europe and otherOECD countries, more resolute steps to redress government deficits and to create thefiscal room necessary to deal with the fiscal
consequences of aging will be necessary iflong-term interest rates are to remain low. For
developing countries, a gradual appreciationof some currencies relative to the dollar could
help by permitting a further depreciation of
the dollar. However, in the absence of fiscal
tightening in the United States, such measures
are unlikely to have a significant impact. Fiscal consolidation is also required in many developing countries. Recent steps to lower existing government deficits move in the right
direction and need to be pursued—as do efforts to reduce trade barriers so that export
opportunities can increase. While these actions may well imply hardship and impose realpolitical costs, the human and political consequences of entering into a period of higher interest rates without external and internal finances on a firm footing would be even more
dramatic. Finally, funding for initiatives to relieve the debt burden of the poorest countries
needs to be increased.
Should oil prices rise even further, theeconomies of low-income countries are likely
to be among the hardest hit. Oil prices are assumed to moderate in the base case, fallingfrom $39 per barrel (for the average of WestTexas Intermediate, Brent, and Dubai oils)12
in 2004 to $32 in 2006. However, given supply and geopolitical conditions, there is a realrisk that prices will either remain at current

O U T L O O K

A N D

T H E

D E V E L O P I N GC O U N T R I E S

levels ($46.8 in October 2004 for thisaverage—$49.5 for Brent) or rise evenfurther. Simulations suggest that were events
to temporarily disrupt supply by about 1 million barrels per day, oil prices could be expected to increase by about $10 a barrel. In
macroeconomic terms, such an increase
would slow economic growth by about 0.5
percentage points in the following year.13
However, the resulting terms of trade shock
would be larger in many poorer countries(2.4 percent of GDP for highly indebted
poor oil-importing countries versus 0.2 percent of GDP for high-income countries) because of the relatively high share that energy
represents in their imports. And sucheconomies tend to be more sensitive to agiven terms of trade shock because of theirlimited ability to attract capital flows thatwould offset any resulting increases in theirtrade deficits. In contrast to high-income
countries, which can increase their externalborrowing to offset the real-side impact ofhigher oil prices, low-income countries are
obliged to absorb most of the shock immediately. As a result, they undergo a depreciation and substantial reductions in consumption and investment spending—adjustment
mechanisms that ultimately reduce spendingon imports by almost the entire amount of
the increased oil bill (figure 1.13). Their inability to defer adjustment (like high-income
countries do) implies significant costs, bothto individuals who see their consumption
possibilities reduced and to the economy, as
lower levels of investment feed through toreduce the capital stock and diminish productive capacity.
Finally, a failure of current efforts to slow
the unsustainable pace of growth in China byengineering a soft landing could result inmajor disruptions. The Chinese authorities
have put into place a number of specific—
mainly command and control—measures,that restrict additional investment and lending
to the construction and heavy production
sectors. In the World Bank’s forecast, this is
projected to succeed in slowing overall growth13

G L O B A L

E C O N O M I C

P R O S P E C T S

2 0 0 5Figure 1.13 First year impacts of a $10 increase in oil prices
Low-income net oil importers

High-income countries

Percent of GDP

Percent of GDP

0

0

0.1

0.1

0.2

0.2

0.3

0.3

0.4

0.4

0.5

0.5

0.6

0.6

0.7

0.7

0.8

0.8
Domestic
demandCurrent accountbalance

Domestic
demandCurrent accountbalance

Source: World Bank.

to some 7.1 percent in 2006, down from anestimated 8.8 percent this year.
So far, these steps have slowed import demand in a number of sectors, notably metals
and ores,14 while credit restrictions have dramatically reduced the pace of money creation.
In contrast, private consumption growthshows no sign of easing, and inflation has
picked up rapidly. For the moment increased
costs have not found their way into wages,
but such a possibility cannot be ruled out.
Should overheating contribute to further increases in inflation, a stronger policy response
may be required. Moreover, investment levels
remain very high, leaving open the possibilityof a very rapid correction, especially if badloans in the banking sector reveal themselves
to be a serious problem. Either eventuality
could provoke a more abrupt slowdown thanforecast.

Long-Term Growth, Structural
Change, and PovertyThis part of the report, as in years past, presents a long-term growth scenario forthe global economy and its implications formeeting one of the MDGs: the halving of the

14

proportion of the population living on $1 orless a day by 2015 (compared to 1990 levels).
The strong economic growth in developing
countries over the last 2 to 3 years, which is
expected to continue through 2006, albeit at asomewhat slower pace, is based on solid fundamentals that are likely to carry forward andcontribute to long-term economic prospects.
In our base scenario this leads to an annual
growth of some 3.5 percent in per capita GDP
between 2006 and 2015, and contributes toachieving the MDGs. The poverty MDG will
be met on a global basis, but a large numberof countries will not meet the goal, particularly those in Sub-Saharan Africa. And though
growth is necessary to make progress towardachieving the MDGs, in most countries,
growth is insufficient without more targeted
policies.
At least four factors are responsible for the
recent and prospective improvement ingrowth prospects. As outlined in the first section of this chapter, among the solid fundamental changes in developing countries is an
improvement in macroeconomic conditions(e.g., inflation and indebtedness). The recent
World Development Report stresses theimportance of the investment climate, which

G L O B A L

has improved in many countries and has led toan acceleration in growth. A third factor,
explored in more detail below, includes
significant structural changes—that is, economic diversification and a move away fromreliance on agriculture, and integration withthe global economy; both of these structuralchanges involve increased urbanization. A
fourth factor, pursued in greater detail inchapter 6, is the reduction in trade barriers.
The special focus of the long-term scenario
in this report is on structural changes, particularly as they affect employment. Rapid
growth will, in and of itself, lead to structuralchanges; that is, a relative decline in agriculture and a rise in the demand for services.
Countries need to think ahead, allocate scarcepublic investment in a rational manner, andpromote education to better position theirwork force for a changing environment.
While structural changes are likely to be important, many developing countries face anequal challenge in the sheer growth of thelabor force. Labor force growth rates arelikely to decline over the next decade, but inmany regions they will average between 1.5 to
2.5 percent per annum. For the poor, both
growth and structural change are likely to bebeneficial. Growth, to the extent that it lifts
all incomes, will inevitably lead to a fall inpoverty. Structural change can accelerate theprocess of poverty reduction. A decline in therural population could ease wage pressures.
A rising urban population provides easier access to essential health and education services
and can lead to a rise in transfers to rural
areas.
The focus on structural change also links tothe broader theme of the report—the shapeand impacts of regional trade agreements(RTAs). The RTAs will undoubtedly lead to additional structural shifts, and with associatedtransitional costs. How do RTAs compare withgrowth-induced structural shifts? Do RTAs
produce structural shifts that are broadly consistent with those induced by a truly open
global economy (which would emerge from amultilateral agreement)? And, if not, would the

O U T L O O K

A N D

T H E

D E V E L O P I N GC O U N T R I E S

vested interests protected by an RTA impede
progress toward a globally more beneficial
agreement? These questions will be addressedin chapter 6. The conclusion from this chapter
is that the challenge for most developing countries will be the creation of jobs for a rising
work force, rather than how to deal with employment shifts across economic activities.

Long-term growth scenario
The global economy is currently rebounding
from the downturn suffered in 2001 and2002. Not all regions are benefiting equallyfrom the rebound—Japan and the UnitedStates are leading the way among industrial
economies—but there is fairly solid progressin all the main developing regions on an aggregate basis. This year, 2004, is likely to be
the peak in the current upward cycle, witheconomies drifting toward long-term trend
growth in 2005 and beyond. Table 1.3 reflects a plausible long-term scenario for thehigh-income countries and the World Bank’s
six aggregate developing regions (see box 1.1
for details concerning aggregation). The scenario reflects current views on potential trend
growth over the 2006–15 decade. Better
policies, an acceleration in investment, andother factors could improve the prospects,
particularly for the slower growing regions.
There is still a considerable gap in the productivity levels between developing and industrial economies, and a number of developing countries—particularly in Asia—have
demonstrated, over the last 20 to 30 years, asustained ability for rapid growth.
The focus of this forecast section this year ison anticipated structural changes. These have
many dimensions—demographic, rural versus
urban, sectoral, employment shifts, openness,and income distribution, among others. Whilemost of these shifts have long-term positive
impacts, they can also be associated withshort-term transitional costs. Public policies
can limit the costs of transition, but they canalso be significantly reduced—at least in termsof duration—in a fast growing economy where
job growth is robust.

15

G L O B A L

E C O N O M I C

P R O S P E C T S

2 0 0 5

Box 1.1 The
aggregation paradox
The per capita growth rate for the world reflects the so-called aggregation paradox. The
long-term per capita growth rates for highincome and developing countries are, respectively, 2.4 and 3.5 percent per annum, but
the global growth rate is only 2.1 percent
and is not the average of the growth rates(weighted or un-weighted). The following
table highlights the aggregation paradox.
The paradox is explained by the relatively
high weight of high-income countries GDP
in the world total, but their low weight inworld population.
High- Develop
income-ing
Population (million)
2006
2015
Growth ratea

World

970
990
0.3

5,340
5,900
1.1

6,320
6,900
1.0

31,20039,5002.7

8,200
12,300
4.6

39,40051,8003.1

GDP per capita ($)
2006
32,0902015
39,700Growth ratea
2.4

1,530
2,080
3.5

6,240
7,510
2.1

GDP ($billion)
2006
2015
Growth ratea

a. Growth rates are percent per annum.

Structural Changes over Two
DecadesLooking back on the last 20 years of development, many developing regions have already witnessed significant structural shifts.
Perhaps foremost is the decline of agriculture
as a source of income and employment. In
East Asia and the Pacific, agricultural value
added has declined from a 28 percent share in1982 to only 15 percent in 2002, and manufacturing, other industrial, and services have16

risen (see figure 1.14). Services, according tothese figures, still represented less than
40 percent of GDP in 2002, well below thenearly 65 percent share in the high-income
countries of East Asia. Thus there is still significant scope for further structural shifts.
The value added shares also belie the relative employment share in agriculture, whichtends to be much higher. Take, for example,
Thailand, where agriculture’s share of value
added is below 10 percent, but still employsaround 50 percent of the total labor force. In
the high-income countries, the relevant sharesare around 2 percent of value added and lessthan 4 percent of employment.15 Higher agricultural productivity and relative wage differentials will continue to drive an exodus fromagriculture into other sectors. And the change
can come rapidly. In the Republic of Korea,
the percent of employment in agriculture
dropped from 32 percent in 1982 to 10 percent in 2001. The agricultural transformation
is present in some of the other developing regions as well; for example, in South Asia thepercent of employment in agriculture dropped
from 40 percent in 1982 down to 27.2 percent
in 2002, and in Latin America and the
Caribbean, the percent of employment in agriculture dropped from 14.4 percent down to
10.6 percent over the same two-decade
period. There has been no significant shift ineither the Middle East and North Africa or
Sub-Saharan Africa regions. At the same time,neither of those two regions witnessed mucheconomic growth, with only 0.4 percent percapita growth per annum in the former, and aloss of 0.3 percent per annum in the latter.
In all regions, save East Asia, one can see aclimb in the share of services. This is not surprising because services are assumed to be income elastic and a relative rise in the consumption share of services is understood. Thiseffect is reinforced by the relatively high rate ofproductivity growth in manufacturing. All else
being equal, this reduces the price of manufactures relative to services and hence enhances
the value share of services. Perhaps what ismore surprising is the variation across regions.

G L O B A L

O U T L O O K

A N D

T H E

D E V E L O P I N GC O U N T R I E STable 1.3 Long-term prospects: Forecast growth of world GDP per capita
Real GDP per capita, annual average percentage change
1980s

1990s

2000–06

2006–15

World total

1.3

1.1

1.6

2.1

High-income countries
OECD
United States
Japan
European Union
Non-OECD countries

2.5
2.5
2.2
3.5
2.1
3.5

1.8
1.7
1.9
1.1
1.8
4.1

1.7
1.7
1.8
1.7
1.5
1.6

2.4
2.3
2.5
1.9
2.3
3.5

0.6
5.8
1.0
0.9
1.6
3.3
1.2

1.5
6.3
1.8
1.5
1.1
3.2
0.5

3.4
6.0
5.2
0.8
2.4
4.2
1.2

3.5
5.3
3.5
2.4
2.6
4.1
1.6

Developing countries
East Asia and the Pacific
Europe and Central Asia
Latin America & the Caribbean
Middle East North Africa
South Asia
Sub-Saharan Africa

Note: Aggregations are moving averages, reweighted annually after calculations of growth in constant prices.
Source: World Bank.

Figure 1.14 A rise in services
East Asia and PacificSouth Asia

Structure of value added (percent)

Structure of value added (percent)

Structure of value added (percent)

60

60

60

50

50

50

40

40

30

30

20

20

20

10

10

10

40
30

1982
1992

Middle East and North Africa

2002

0

0
Agriculture

Industry

Services

0Agriculture

Industry

Services

Agriculture

Industry

Services

Sub-Saharan Africa

Latin America and the Caribbean

Structure of value added (percent)

Structure of value added (percent)

Structure of value added (percent)

60

70

70

50

60

60

50

50

40

40

30

30

40

Europe and Central Asia

30
20

20

20

10

10

10

0

0
Agriculture

Industry

Services

0Agriculture

Industry

Services

Agriculture

Industry

Services

Source: World Bank.

17

G L O B A L

E C O N O M I C

P R O S P E C T S

2 0 0 5In the high growth regions—East Asia andSouth Asia—there are two contrasting
patterns. In South Asia the employment inagriculture shifted mostly to services, with asmall increase in industrial output. In East
Asia, employment in agriculture shifted more
evenly between industry and services. And
there appears to have been a structural breakin the 1990s with an acceleration of industrial
output. This is consistent with the sharp rise in
the trade to GDP ratio doubling from 36 percent in 1982 to 72 percent in 2002, and with
East Asia as a hub of assembly and manufacturing activities (see figure 1.15). There are, ofcourse, exceptions in each region. The Philippines, for example, has a sharp rise in services
and a decline in manufacturing—perhaps as aresult of its regional comparative advantage inback office operations, call centers, and otherservices requiring specialized language skills.
In South Asia, India’s services dominate, but
growth is much lower in Bangladesh and Pakistan, where textile and clothing exporters may
be taking advantage of their relatively generous quotas to the main importing markets.
Three of the other regions—Latin America
and the Caribbean, the Middle East and North
Africa, and Sub-Saharan Africa—show lessFigure 1.15 Rising openness to trade
Trade (exports and imports) to GDP ratio (percent)
90

1992

80

1982 2002

70
60
50
40
30
20
10
an Ea
d st
Pa As
ci ia
fi
So c
ut
h
As
M
ia
id
dl
e
N E
or a
th st
Af an
Su rica dbSahLa
Af ara
tin
ric n
a
th Am
e e
C ric
ar a
ib a
be nd
Eu an
C r
en op
tra e
l A ansi da0

Source: World Bank.

18

growth overall, but are also more dependent
on natural resource production, and thoserelative prices have been declining over most of
the period. Natural resources appear under industrial production, so even if volume growthhas been positive, with declining relative prices
the natural resources share in output could be
declining. And apart from Latin America andthe Caribbean, these regions have also not really benefited from global production sharing
in the more integrated global economy. The
Middle East and North Africa Region hasbarely seen any shift in its trade to GDP ratio.
For both Sub-Saharan Africa and Latin America and the Caribbean, however, the ratio has
increased markedly, particularly in the
1990s—from 50 percent to 69 percent for SubSaharan Africa, and from 27 to 47 percent for
Latin America and the Caribbean. The more
recent rise in Latin America can be partly explained by the implementation of a raft ofregional agreements, including NAFTA and
MERCOSUR. At the same time Latin America’s degree of openness is lower than that ofEast Asia, and in general it has been less coopted into global production networks.
The transformation in the economies ofEurope and Central Asia over the last 15 years
is a result of an abrupt structural shift. The
dominance of industry as part of an economic
strategy of planned economies was eliminated.
Services in the transition economies quickly
filled the gap, which led to significant dislocation for a period, but is now forming the basisof more rational and sustained growth.
Looking ahead it is clear that there is thepotential for significant change. While the rateof urbanization has been persistent over thelast two decades, there is a long way to go,particularly in Asia and Africa, before attaining the 80 percent level of the industrial countries (figure 1.16). The income gap is alsohuge, even if incomes are measured in purchasing power parity (PPP) terms. In East
Asia, per capita incomes averaged just over
$1,000 (1995 dollars) in 2002, compared withnearly $31,000 in the industrial countries—
roughly a 30 to 1 differential. Even assuming

G L O B A L

D E V E L O P I N GC O U N T R I E S

able 1.3 presents the long-term growth
rates. This section focuses on some of theconsequences of growth and other underlying
assumptions of the long-term scenario on
structural changes, particularly regarding
labor shifts—both in volume terms and acrosssectors.16
In the aggregate, and assuming no change inlabor force participation rates, labor supply
growth will slow down sharply in most regions
after 2010—with the exception of the Middle
East and North Africa and Sub-Saharan Africa
regions (figure 1.17).17 In Western and Eastern
Europe, Russia, and Japan, the labor supply
would most likely shrink (even before 2010),
putting additional pressure on underfinanced
pension schemes. Additionally, it is the regionswith the highest labor force growth rates that
also tend to have the lowest per capita growth
rates, so these regions are on a knife-edge interms of their capacity to absorb high rates of
new workers. These same regions typically haverelatively low labor force participation rates,
particularly of females; thus increases in

2002
1992
1982

60

T H E

T

Urban population as a share of total population (percent)
70

A N D

Structural Change in the Future

Figure 1.16 Increased urbanization
80

O U T L O O K

50
40
30
20
10
an Ea
d st
Pa As
ci ia
fi
So c
ut
h
As
M
ia
id
dl
e
N E
or a
th st
Af an
Su rica dbSahLa
Af ara
tin
ric n
a
th Am
e e
C ric
ar a
ib a
be nd
Eu an
C r
en op
tra e
l A ansi da0

Source: World Bank.

a PPP exchange rate of 5 would still lead to asignificant 6 to 1 ratio in per capita incomes.
In Latin America, the richest developing
region with a per capita average income of$3,700, would have a ratio similar to East
Asia using a PPP exchange rate of around 2.

Figure 1.17 Growth rate of labor supply declining
Population between the ages of 15 and 65 (percent)
3.0
2.5
2.0
2005

1.5

2010

1.0
0.5
0
0.5
1.0

2015
XA
La
S
tin
th Am
e er
C ic
ar a
ib an
be d
an
Su
bSa
h
Af ara
ric n
a
an
d Mid
N d
or le
th E
Af as
ric t
a

a
di
In

na
hi
C

IE
N

pa
n

s
C tW
en e
tra st al A nd
si
a

Ea

Ja

pe
ro
Eu

U

ni

te

d

St

at
e

s

1.5

Note: United States+ includes Australia, Canada, New Zealand, and the United States. NIEs are newly industrialized economies.
XAS represents other major countries in East and South Asia.
Source: World Bank.

19

G L O B A L

E C O N O M I C

P R O S P E C T S

2 0 0 5

Table 1.4 Labor market structure, 2005–15
Growth between 2005–15: percent per annum

Australia, Canada & New ZealandUnited States
Japan
Korea and Taiwan
Hong Kong (China) and Singapore
EU with EFTA
BrazilChina
India
Indonesia
MexicoRussiaSACU
VietnamRest of East Asia
Rest of South Asia
EU accession countries
Rest of ECA
Middle East
North Africa
Rest of Sub-Saharan Africa
Rest of LAC
Rest of the world

Growth decomposition

Agric

Manuf

Services

Total

Structure

Expansion

Total

0.7
1.1
3.0
1.9
0.0
2.6
0.8
0.5
0.1
1.1
0.2
1.0
0.7
1.7
0.7
1.8
0.8
0.3
2.3
0.8
2.0
2.1
0.8

0.8
0.6
2.2
0.6
0.5
1.5
0.5
0.4
1.6
1.8
1.6
1.1
0.2
1.9
1.2
1.3
1.1
0.3
1.6
2.0
2.2
0.9
1.2

0.7
0.8
0.6
1.0
1.0
0.2
1.4
1.3
2.4
1.6
2.5
0.0
0.9
2.0
2.1
2.7
0.2
1.1
2.5
2.5
3.0
2.2
2.1

0.4
0.5
1.0
0.5
0.7
0.2
1.2
0.8
1.7
1.5
2.0
0.4
0.6
2.0
1.7
2.4
0.2
0.8
2.3
2.0
2.6
1.8
1.7

3.45
2.95
3.62
4.18
4.80
4.92
3.52
5.12
9.27
8.32
7.00
4.97
3.82
5.69
4.72
4.60
6.51
6.15
5.26
7.27
4.50
5.36
4.15

3.90
5.62
9.35
5.65
7.28
2.28
13.09
8.44
19.89
17.18
22.78
4.35
6.87
22.23
19.36
27.22
2.41
8.88
26.43
23.74
30.19
20.74
19.45

6.88
8.34
8.70
9.17
11.65
3.12
16.28
12.02
28.02
22.73
28.84
2.43
10.36
26.20
23.09
31.38
4.67
14.43
30.79
29.83
34.08
25.41
23.12

Source: World Bank simulations.

participation rates will lead to additional labot
market weakness.
With high-income demand elasticity for services and relatively higher labor productivity in
manufacturing, labor demand growth will tend
to be higher in services than in manufacturing
and/or agriculture (see table in endnote 17).
This effect is quite pronounced in the industrial
countries, where labor demand growth between 2005 and 2015 will be negative, on average, in agriculture and manufacturing in all
high-income regions, with all of the net growthoccurring in services (with the exception ofJapan, where labor force growth could potentially decline by 1 percent per annum on average). The shift toward services also occurs in developing countries, but with continued highgrowth in manufacturing and less growth inagriculture.
Table 1.4 also shows a summary measureof the structural changes. It decomposes thetotal change in the structure of the labor force
into two components. The first is the20“structural” component, which measures thequantity of labor force movement across sectors, assuming no change in the volume oflabor. The second is an “expansion” component, measuring the overall growth in thelabor force. In the case of India, for example,
the numbers suggest that the labor force willgrow by about 20 percent between 2005 and2015, or about 1.8 percent per annum. Andin each year, about 0.9 percent of the initiallabor force will move across sectors. Thus thetotal annual movement of 2.5 percent per
annum is composed roughly of 2/3 expansion
and 1/3 by intersectoral movements. It should
be clear from the decomposition that for mostof the developing regions, there will be morelabor movement from the expansion of thelabor force than from structural change, with
the notable exceptions of Russia and theother countries in Europe and Central Asia—
and, perhaps somewhat more surprisingly,
China. For the industrial regions with low or
declining labor growth, clearly the structural

G L O B A L

O U T L O O K

shifts will be relatively the same order of magnitude as the expansion component. But theshifts are relatively small on an annual basis,
perhaps 0.3 to 0.5 percent of the labor force.
Chapter 6 of this report will re-address one
issue related to structural shifts in the context
of RTAs. Do RTAs lead to structural changes
that are inconsistent with the structuralchanges from a broad multilateral agreement?
For example, a country signing an RTA may
have a local comparative advantage in a given
sector, but not a global comparative advantage.
In this case, would the country need to undergo
two potentially costly adjustments, should amultilateral agreement be signed subsequent to
an RTA? And would the vested interests that
benefit from the RTA hamper the ability
to achieve a broader multilateral agreement,

A N D

T H E

D E V E L O P I N GC O U N T R I E Swith positive aggregate benefits, but hurt thesectors that thrived under the preferential
arrangement?

Poverty ForecastD

eveloping country economic performancehas been strong since 2002, and this is
projected to continue over the next two years
and beyond (tables 1.1 and 1.3). This patternof high growth would in all likelihood lead toa halving of the number of poor (i.e., the percentage of poor living on $1 or less a day) indeveloping countries between 1990 and 2015
(table 1.5)—one of the key MDGs. At the
global level, the target to be achieved in 2015is around 14 percent (one-half of 27.9), andthe forecast is for a headcount index of
10.2 percent. This translates into a forecast of

Table 1.5 Regional breakdown of poverty in developing countries
Number of people living on less than $1 per day (millions)
GEP2004

GEP2005

Region

1990

2000

2015

1990

2001

2015

East Asia and Pacific
China
Rest of East Asia and Pacific
Europe and Central Asia
Latin America and the Caribbean
Middle East and North Africa
South Asia
Sub-Saharan Africa

470
361
110
6
48
5
467
241

261
204
57
20
56
8
432
323

44
41
3
6
46
4
268
366

472
375
97
2
49
6
462
227

271
212
60
17
50
7
431
313

19
16
2
2
43
4
216
340

1,237
877

1,100
896

734
692

1,218
844

1,089
877

622
606

Total
Excluding China$1 per day head count index (percent)
GEP2004

GEP2005

Region

1990

2000

2015

1990

2001

2015

East Asia and Pacific
China
Rest of East Asia and Pacific
Europe and Central Asia
Latin America and the Caribbean
Middle East and North Africa
South Asia
Sub-Saharan Africa

29.4
31.5
24.1
1.4
11.0
2.1
41.5
47.4

14.5
16.1
10.6
4.2
10.8
2.8
31.9
49.0

2.3
3.0
0.5
1.3
7.6
1.2
16.4
42.3

29.6
33.0
21.1
0.5
11.3
2.3
41.3
44.6

14.9
16.6
10.8
3.6
9.5
2.4
31.3
46.4

0.9
1.2
0.4
0.4
6.9
0.9
12.8
38.4

Total
Excluding China

28.3
27.2

21.6
23.3

12.5
15.4

27.9
26.1

21.1
22.5

10.2
12.9

21

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Table 1.5 Regional breakdown of poverty in developing countries (continued)
Number of people living on less than $2 per day (millions)
GEP2004

GEP2005

Region

1990

2000

2015

1990

2001

2015

East Asia and Pacific
China
Rest of East Asia and Pacific
Europe and Central Asia
Latin America and the Caribbean
Middle East and North Africa
South Asia
Sub-Saharan Africa

1,094
800
295
31
121
50
971
386

873
600
273
101
136
72
1,052
504

354
256
98
48
124
38
968
612

1,116
825
292
23
125
51
958
382

864
594
271
93
128
70
1,064
516

230
134
95
25
122
46
912
612

Total
Excluding China

2,653
1,854

2,737
2,138

2,144
1,888

2,654
1,829

2,735
2,142

1,946
1,812

$2 per day head count index (percent)
GEP2004

GEP2005

Region

1990

2000

2015

1990

2001

2015

East Asia and Pacific
China
Rest of East Asia and Pacific
Europe and Central Asia
Latin America and the Caribbean
Middle East and North Africa
South Asia
Sub-Saharan Africa

68.5
69.9
64.9
6.8
27.6
21.0
86.3
76.0

48.3
47.3
50.8
21.3
26.3
24.4
77.7
76.5

18.2
18.4
17.6
10.3
20.5
10.2
59.2
70.7

69.9
72.6
63.2
4.9
28.4
21.4
85.5
75.0

47.4
46.7
49.2
19.7
24.5
23.2
77.2
76.6

11.3
9.7
14.7
5.2
19.6
11.9
54.2
69.2

Total
Excluding China

60.8
57.5

53.6
55.7

36.4
42.0

60.8
56.6

52.9
54.9

32.0
38.6

Source: World Bank.

622 million persons living $1 or less a day in2015, compared with 1.2 billion in 1990 andan estimated 1.1 billion in 2001.18 With respect to the somewhat higher poverty line of$2 a day, the headcount should improve to32 percent in 2015—not quite a halving of theestimated 61 percent headcount index in
1990—and corresponding to almost 2 billion
poor.
However, progress is highly uneven acrossand within countries. The global target will
largely be achieved because of the significant
progress on poverty reduction in China andIndia. Sub-Saharan Africa lags far behind, andthough poverty rates are much lower in some ofthe other regions, for example Latin America
and the Caribbean, progress over the last22

15 years has been insufficient to be on track toachieve the income poverty target in 2015 without more rapid growth or policies that are better targeted to the poor. Within regions,progress has also been uneven. Despite the hugeoverall reduction in East Asia, several countries,
for example, Cambodia, Lao PDR, and Papua
New Guinea, are off track to meet the goal. In
Sub-Saharan Africa, there are only eight
countries—representing 15 percent of the subcontinent’s population—that will potentiallymake significant progress toward achieving theincome poverty target. Within countries, suchas China, there are large pockets of poor
people, and reducing poverty in these pockets isdifficult because they are often concentrated inremote, hard-to-reach locations. Links to theG L O B A L

national and/or global economy are weak, andprovision of public services—education, health,water and sanitation—is difficult andexpensive.
This year’s poverty forecast, as in years
past, reflects changes in two key dimensions.
First, new country surveys lead to a reevaluation of the level of poverty in 1990 andin the most recent base year, 2001. At the
global level, the $1/day headcount index for1990 has been shaved slightly from 28.3 percent in last year’s report, to 27.9 percent inthis year’s report. There is also a very modest
decline in the estimated level of poverty for2001. The new surveys also force a re-evaluation of the link between income growth andpoverty reduction. Using the latest survey information and last year’s economic forecast,
the forecasted decline in poverty is somewhat
more rapid, with the headcount index declining to 10.4 percent (from 21.1 percent in2001), instead of 12.5 percent (from 21.6
percent in 2000).19 The second key dimension is the change in the long-term economic
forecast. The changes overall are relatively
modest. However, the somewhat improved
performance anticipated between 2003 and2006 generates better average growth for theforecast period 2001–15 and drops the headcount index for 2015 from 10.4 percent to10.2 percent.
While progress on income poverty in partsof the world, particularly East and South Asia,
has been spectacular if not historic, there is noroom for complacency. As mentioned earlier,there are significant pockets of poverty even
within the more successful countries. Moreover, there are other dimensions of poverty inwhich progress has been more limited, andalmost all developing countries are off track. In
East Asia, for example, the region scores relatively well for achieving 100 percent primaryschool completion rates, with China and Vietnam already having achieved the target and thePhilippines on track.20 But Thailand and Indonesia are off track, as are some of the poorer
countries in the region. For the child mortality
MDG, the situation is more worrying. FourO U T L O O K

A N D

T H E

D E V E L O P I N GC O U N T R I E S

countries are on track to achieve the target—
Indonesia, Lao PDR, Malaysia, and the Philippines. All other countries are off track, andtwo—Cambodia and Papua New Guinea—areseriously off track. The situation is also dire forbirths attended (linked to maternal mortality)
and access to safe water. These examples also
illustrate that the other MDG targets are lessdirectly correlated to income levels.21 For example, Lao PDR and Indonesia are on track forthe child mortality target, but Thailand is not.

Concluding RemarksT

he rapid growth of developing economies,
mostly concentrated in East and SouthAsia, has produced a spectacular, if not historic, fall in poverty that will enable theachievement of the poverty MDG on a global
basis, although many countries will be seriously off-target. The rapid growth has been associated with large structural shifts—greater
openness, more urbanized populations, and a
sharp fall in agricultural employment. These
trends will persist in the future as growth rates
remain high, and incomes and productivity levels in developing countries are still well below
industrial country averages—even taking into
account PPP adjustments. As an example ofpotential structural shifts, take China’s level ofurbanization. Its rural population may not approach the 20 percent level of industrial countries, but a 50 percent share in 2015 could leadto a cumulative migration in the range of 140
to 175 million persons between 2005 and2015. Such large shifts will require considerable public and private resources and their efficient allocation. Chapter 6 addresses a complementary issue—structural changes induced bychanges in trade policies, notably the impacts
of preferential trade agreements.

Notes
1. The investment to GDP ratio in the UnitedStates is currently 21 percent, close to its peak of
21.5 percent during the Internet bubble, and well
above historical peaks of less than 18 percent.

23

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2. The weighted average of the dollar’s fluctuations
relative to world currencies.
3. West-Texas Intermediate was much higher in
October 2004 ($56). The overall average wasdepressed by the price of other oil (notably from
Dubai), which was lower because producers increased
the supply of lower quality oil.
4. Lau (2003) estimates that because of the reexport nature of its trade, the domestic value-added
content of Chinese exports may be as little as 20 percent.
5. Net equity and foreign direct inflows of foreign
private investors declined by 73 percent between 2001
and 2003. At the same time, net outflows by American
private investors increased by 10 percent. As a result,
total flows have reversed, from a significant inflow of$35 billion in 2001 to a $195 billion outflow in 2003.
Since then, these trends have continued, with total outflows representing $267 billion in the second quarterof 2004.
6. See endnote 5.
7. Calculated as the change in U.S. t-bills held by
the central banks of these countries divided by the netincrease in t-bills held by official lenders (see http://
www.treas.gov/tic/mfhhis01.txt).
8. Mussa (2004) suggests that a further 20 percent
depreciation might be required to bring the U.S. economy into external balance.
9. These results are consistent with those publishedby the OECD for developing countries (see Dalsgaard
and others 2001).
10. Even after Ricardian equivalence-basedchanges to private saving. Nevertheless, Brooks andothers (2003) show that, taken alone, neither a 2 percentage point cut in fiscal spending, nor a 10 percent
effective depreciation would be sufficient to restore external balance in the United States. They argue that a
combination of depreciation, stronger world demand,and a larger fiscal contraction would be required.
11. Under higher interest rates, the desired stock of
capital declines, which requires a prolonged period ofslower growth before the economy adjusts to the newlower levels of output and capital.
12. In October 2004, this average price was $46.8
comprised of $53 for West-Texas Intermediate, $49.5
for Brent, and $37.7 for Dubai oil.
13. Dalsgaard and others (2001) estimate similar
impacts for OECD countries.
14. Growth in steel demand fell 36 percent during
the 3-month period ending in July, while copper imports were flat.
15. World Bank 2003b.
16. Unlike the previous section, which focused on
the structure of value added, this section focuses onlabor. The focus on labor provides a better perspective on the poverty dimension of structural shift. The

24

historical analysis focused on output because of thegreater availability and reliability of the data. Historical data on employment patterns has many gaps, andthe data that does exist is often not compatible acrosscountries.
17. The baseline scenario and the induced structural changes are predicated on a number of assumptions. First, growth in the labor supply is equated withgrowth of the working age population. For all regions,this implies a slowing of labor force growth, albeit withhigh growth in some developing regions. At the sametime, the labor force is assumed to be flexible and thus
will reinforce anticipated structural shifts. Second, savings are similarly influenced by demographics. In many
developing countries this will translate into a slightacceleration in savings as the ratio of youth to workers
declines, and a decline in industrial countries as theratio of elderly to workers rise (explored in more detailin World Bank 2003a). Investment growth will largely
be driven by domestic savings, as it has in the past;
however, with modest increases in net capital flows toward developing countries, with the exception of East
Asia, which has been a major source of international
capital over the last five years.
Third are the assumptions regarding productivity
growth; based on previously observed trends, these are
divided into three broad economic sectors. In agriculture, it is assumed that the past growth of roughly
2.5 percent per annum is maintained through 2015(see, for example, Martin and Devashish 1999).
Maintaining this high rate of agricultural productivity
will require continued and perhaps increasing investment in agricultural research and extension, combinedwith rising investment in agricultural infrastructure,
particularly for water resource management. This rateof productivity growth in agriculture is consistent witha modest secular decline in agricultural prices, relative
to the general price trend, as observed in the past. The
other two broad sectors are manufacturing and services.
Again, based on past trends, it is assumed that productivity growth in manufacturing will be higher than inservices. This has two impacts: (1) it reduces the price of
manufactures relative to services, all else being equal,
and thus enhances the share of services in value terms;and (2) for the same level of output, it reduces the

Income elasticities in the Linkage model

United States
Japan
EuropeRest of high-income
Low-income

Ag. andfood

EnergyIndustrial
goods

Services

0.01
0.04
0.08
0.16
0.52

0.58
0.64
0.72
0.86
1.40

0.78
0.68
0.71
0.80
1.08

1.14
1.24
1.29
1.26
1.41

G L O B A L

demand for employment in the manufacturing sectors,
and thus allows for a shift of labor toward services.
Fourth are the demand assumptions—the other sideof the coin regarding structural changes. High-income
countries have already witnessed a large decline in
the demand for agriculture and food relative to income.
Demand for services has increased relative to income andthe demand for other goods. And there is no reason forthese trends not to continue in the future. Thus the forward-looking scenarios assume that income elasticities
over the next 10 years will largely reflect their current
levels, though highly differentiated across commodities
and regions (see table).
18. The absolute number of poor won’t necessarilybe halved due to population growth.
19. A more subtle change in the methodology has
also been incorporated in this year’s poverty forecast.
The poverty forecast is based on the growth of thesurvey-based per capita consumption, assuming distribution neutrality (with some exceptions). However, it
has been observed in the past that survey-based consumption growth deviates from consumption growth
as measured in the national accounts. A conversion
factor has been used to adjust for this deviation, which
for most countries implied an elasticity of 0.9. In otherwords, if national income consumption grows at
10 percent, the assumed growth in survey-based consumption is 9 percent. More recent econometric evidence suggests that the long-run elasticity is 1, but that
there are short-term deviations from the long-run
elasticity. Because of the robustness of the long-run relationship, the new forecast assumes an elasticity of 1.
Thus, all else being equal, this year’s forecast will belower than in the past because of higher implied consumption growth.
20. See World Bank 2004.
21. The World Bank, in its effort to improve its ability to monitor and forecast the other dimensions of theMillennium Development Goals, is developing and testing a new tool to forecast some of the MDGs. The tool
will link economic growth with expenditures on health,education, and infrastructure. It will also capture someO U T L O O K

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T H E

D E V E L O P I N GC O U N T R I E S

of the complementarities across targets, for example thedegree to which improvements in access to safe water
can improve health outcomes. A pilot study is currently
being undertaken for Ethiopia and first results will be
described in the Global Monitoring Report 2005.

References
Bergsten, Fred C. and John Williamson, eds. 2004.
Dollar Adjustment: How far? Against What? In
Special Report, No. 17, Institute for International
Economics, Washington DC.
Brook, Anne-Marie, Franck Sédillot, and Patrice Ollivaud. 2004. Channels For Narrowing The US
Current Account Deficit And Implications For
Other Economies. OECD Economics Department
Working Papers, No. 390, OECD, Paris.
Dalsgaard, Thomas, Christophe André, and Pete
Richardson. 2001. Standard Shocks In The
OECD Interlink Model OECD Economics
Department Working Papers, No. 306, OECD,
Paris.
Lau, Larence. 2003. Is China Playing by the Rules?
Free Trade, Fair Trade, and WTO Compliance.
Testimony at a Hearing of the Congressional Executive Commission on China, Washington, DC.
Martin, Will, and Devashish Mitra. 1999. Productivity
Growth and Convergence in Agriculture andManufacturing. Working Papers, No. 2171,
World Bank, Washington, DC.
Mussa, Michael. 2004. Exchange Rate Adjustments
Needed to Reduce Global Payments Imbalances.
Special Report, No 17, Institute for International
Economics, Washington DC.
World Bank. 2003a. Global Economic Prospects: Investing to Unlock Global Opportunities.
Washington, DC: World Bank.
———. 2003b. World Development Indicators.
Washington, DC: World Bank.
———. 2004. Global Monitoring Report. Washington,
DC: World Bank.

25

2
Regional Trade and Preferential
Trading Agreements:
A Global Perspective
In the last four decades, developing countries
have burst onto the global marketplace. Theirshare of global trade increased from about
one-fifth in 1960 to about one-third in 2004—
at a time when global trade as whole wasincreasing to unprecedented levels. In every
region, exports have outpaced the growth of
output and increased as a share of GDP. Threerounds of multilateral trade negotiations combined with structural economic reforms undertaken throughout the world ushered in thesustained reduction in border protection thatmade this growth possible. The World Trade
Organization (WTO), formed in 1994, consolidated an evolving system of rules based on
nondiscrimination among trading partners—
a cornerstone of the multilateral system.
Today a second trend in the trading system
is rapidly gaining momentum and establishinga very different set of rules. This new trend is
the proliferation of regional and bilateral
trade agreements (RTAs)—agreements amonga group of countries that reduce barriers totrade on a reciprocal and preferential basis for
those in the group. The number of these agreements has more than quadrupled since 1990,
rising to around 230 by late 2004.1 Trade between RTA partners now makes up nearly 40
percent of total global trade, and new agreements increasingly address issues beyond
trade. The value of preferences has steadily
fallen, however, as most countries have been
reducing tariffs across the board to allpartners on a most favored nation, or nondiscriminatory (MFN) basis, at the same time as
they have been eliminating barriers preferentially through RTAs. In fact, roughly 66 percent of the decline in average tariffs in developing countries during the last two decades
has come from unilateral reductions, as distinct from 25 percent coming out of the
Uruguay Round and around 10 percent from
RTAs. Moreover, product exclusions and restrictive rules of origin further limit the tradeexpanding effects of preferences. Nonetheless,the result of this proliferation is an increasingly complex global trading system where
different countries’ access to a given market
are often governed by very different sets ofrules.
This chapter charts the rise of RTAs, examines the different motivations countries havefor pursuing RTAs, and draws attention to
the complexity they generate. It then describes
the evolution of regional trading patterns andshows how the major developing regions differed strikingly in their timing of integration,
their pace of export growth, their policies
toward import competition and foreign investment, and the impact of regional tradingarrangements. It concludes that those regionsthat aspired to trade most with the global
economy became the most regionally integrated as well. Further, regional trade tends toprecede preferential trade agreements rather
than the other way around.

27

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Box 2.1 RTAs and types of trade liberalizationF

ollowing WTO convention, the term regional
trade agreement encompasses both reciprocal
bilateral free trade or customs areas and multicountry(plurilateral) agreements. Regional and bilateral trade
agreements provide for one type of trade liberalization, and they must be seen in a broader context ofalternative methods of liberalization. Members of
RTAs liberalize trade on a reciprocal and preferential
basis. While programs such as the U.S. African
Growth and Opportunity Act (AGOA) and the EU’s
Everything But Arms (EBA) also liberalize tradepreferentially (i.e., different trade partners receive
different treatment), the United States and EU extend
these preferences unilaterally rather than reciprocally.
In contrast to both of these types of preferential liberalization, countries often lower trade barriers in a
nondiscriminatory fashion for all trade partners. They
might do so multilaterally—through GATT/WTO
negotiating rounds—or autonomously, as in the caseof Pakistan in the late 1990s. The matrix below
illustrates this taxonomy of liberalization methods.
RTAs are commonly divided into several basic
categories, according the degree of economic integration they provide. The canonical taxonomy of RTAs
contains the following four levels of integration:
1. In a Free Trade Area, members eliminate
barriers to trade in goods (and increasingly services)among members, but each member is free to maintaindifferent MFN barriers on nonmembers. This lattercharacteristic requires members to develop rules oforigin to prevent imports from third countries frombeing transshipped through the member country withthe lowest tariffs.
2. A Customs Union moves beyond a free tradearea by establishing a common external tariff on all
trade between members and nonmembers. Customs
unions typically contain mechanisms to redistributetariff revenue among members.
3. A Common Market deepens a customs union
by providing for the free flow of factors of production (labor and capital) in addition to the free flowof outputs.
4. In an Economic and Monetary Union, members
share a common currency and macroeconomic
policies.
The international experience with RTAs is muchricher than this simple taxonomy suggests. NAFTA
andother more recent agreements establishing free
trade areas contain provisions governing domestic
labor standards and other regulatory issues, which
one traditionally associated with agreements fordeeper integration. On the other hand, many free
trade agreements exclude important categories ofgoods (notably agriculture) from trade liberalization.
In some cases customs unions still levy tariffs on
trade between members.

Method of implementation
Scope of beneficiaries

Reciprocal

Unilateral

Preferential: selected countries

NAFTA, EU, COMESA,
EPAs, and other RTAs

GSP, AGOA,
EBA, Cotonou

Nondiscriminatory(MFN): all countries

GATT/WTO
multilateral agreements

Autonomous liberalization

Source: World Bank staff.

The Proliferation of Regional
Preference Systems

M

ore agreements are being signed. Since
1990, the number of RTAs in force rosefrom 50 to nearly 230 (figure 2.1). The WTO

28

estimates that another 60 agreements are invarious stages of negotiation. The boom in
RTAs reflects changes in certain countries’
trade policy objectives, the changing
perceptions of the multilateral liberalization

R E G I O N A L

T R A D E

A N D

P R E F E R E N T I A L

T R A D I N G

A G R E E M E N T S

Figure 2.1 Number of RTAs exploded in the 1990s
Cumulative number of agreements(EU-25 counted as single country)
30

300

25

250

20

Agreements not
notified to the WTO

15
10

200

Cumulative number of agreements(EU-15 counted as single country)

150

Agreements notified
to the WTO

100
50

5

0

0
1958

1969

1976

1984

1989

1994

1999

2004

Sources: WTO data and WTO staff.

process, and the reintegration into the global
economy of countries in transition from socialism. This last category accounts for many of the
new agreements signed in the early 1990s, whencountries in Eastern Europe and the former
Soviet Union negotiated RTAs with Western
Europe [both the EU and the European Free
Trade Association (EFTA)] and with each other.
Some of the RTAs included in figure 2.1
have never been reported to the WTO, for anyof several reasons. One reason is that the
WTO does not enforce notification (the sameis true of notification requirements in other
WTO agreements). Another is that several
countries that have yet to join the WTO havebeen quite active in forming RTAs. Russia, forexample, is in the process of joining the WTO
and has signed bilateral free trade agreements(FTAs) with other members of the Commonwealth of Independent States (CIS). It is also

pursuing two regional arrangements that aredesignated to become customs unions: theEuroasian Economic Community and theSingle Economic Space. Because a consistent
data source covering all RTAs is lacking, data
are based on the information contained in the
WTO database, supplemented by data fromthe major unreported agreements.

Most countries are participating
Nearly all countries belong to at least one
RTA,2 and some are party to numerous
agreements (table 2.1). On average, eachcountry belongs to six RTAs, though there isconsiderable variation across regions andlevels of development. East Asian countries
sign fewer agreements than countries inother regions. Northern countries have participated to the greatest extent, each signing,on average, 13 agreements. A substantial

Box 2.2 Reporting RTAs to the WTO

R

TAs represent a fundamental departure from thecore WTO principle of nondiscrimination.
Nonetheless, the WTO affords its members a large
degree of flexibility in entering new RTAs. Within
the WTO mandate, countries may join agreements
by meeting the requirements of the General Agreement on Tariffs and Trade (GATT) Article XXIV

covering the formation of customs unions and free
trade areas in merchandise trade; the General Agreement on Trade in Services (GATS) Article V on
agreements in services; or the Enabling Clause (the1979 Decision on Differential and More Favorable
Treatment, Reciprocity, and Fuller Participation of(Box continues on next page)29

G L O B A L

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Box 2.2

P R O S P E C T S

2 0 0 5

(continued)

Developing Countries) dealing with trade in goods
between developing countries.
Countries are required to notify the WTO
secretariat of any RTAs they enter into, and their provisions are subject to review by the WTO. However,
the review process in practice ends with the committee’s queries of the parties and has not led to a subsequent report to the membership or formal WTO
endorsement in any case. Furthermore, even the notification requirement, though a formal rule, has enjoyedonly inconsistent compliance. An examination of the
WTO RTA database reveals very large gaps between
the date agreements are signed and the date they arereported to the WTO. Several agreements with WTO

members have yet to be reported to the organization.
These include the Greater Arab Free Trade Area, theAghadir Agreement in the Middle East and North
Africa, the India-Nepal and India-Bhutan agreements
in South Asia, and several agreements in Africa. Someagreements, such as EU accessions, are reported morethan a year in advance, while other agreements arenotified six or more years after entry into force. The
average gap is 354 days. Excluding agreements notified before signature, the average gap rises to 446. The
median delays between entry into force and notification are 135 and 188 days, respectively.
Sources: World Bank and WTO staff.

Table 2.1 Most countries belong to more than one RTA
East Asia
andPacific

EuropeandCentralAsia

Latin
Americaand theCaribbean

MiddleEast
and North
AfricaSouth Asia

Sub-SaharanAfrica

North

Total

32

36

39

21

8

48

25

209

4
2
4

12
1
4

6
2
4

10
1
3

0
0

2
1
1

10
4
24

44
2
24

All others
Countries belonging to at least one RTA
Average number of RTAs per country
Maximum number of RTAs per country

24
2
3

22
6
12

33
8
17

20
5
12

8
4
9

47
4
9

10
8
15

164
5
17

Total
Countries belonging to at least one RTA
Average number of RTAs per country
Maximum number of RTAs per country

26
2
7

26
6
12

35
8
19

20
5
13

8
4
9

48
4
9

11
11
29

174
5
29

Number of countries
North-South bilateralCountries belonging to at least one RTA
Average number of RTAs per country
Maximum number of RTAs per country

Note: Bilateral agreements are defined as an RTA with two members. North is OECD 24 plus Lichtenstein, and South is all othercountries.
Source: Published WTO data, World Bank staff.

number of developing countries (45) havesigned bilateral preferential agreements witha Northern partner. However, this activity is
not spread evenly across regions. Most activity has been in Eastern Europe, Northern
Africa, and Latin America. There are nocountries in South Asia that have signed a30bilateral agreement with a Northern partner.
The enlargement of the EU in May 2004 led
to a fall in the number of North-South RTAs
in Europe.
Since 2000, several major new trends haveemerged in the pattern of regional trade
agreements. One unifying characteristic is

R E G I O N A L

T R A D E

that these take RTAs well beyond agreements
between adjacent countries. For example,• The EU’s move toward bilateral market
access FTAs and Economic Partnership
Agreements (EPAs) with the ACP
countries;• The shift in the U.S. position towardbilateral preferential agreements; and• The effort of a handful of developing
countries to open markets through RTAs.
We turn now to a more in-depth investigation of these trends.

EU Preferential Trade Arrangements
During the 1990s, the EU was an active sponsor of bilateral arrangements with individual
countries and groups of countries and was the
major player in the RTA game. Prior to therecent accession of 10 new members, the EU
had bilateral or regional agreements with 111
countries. Trade agreements became an integral instrument of European foreign policy,
particularly in the aftermath of the collapse of
the Soviet Union.3
Three types of agreements were intended tostabilize the region after 1989. Europe Agreements were intended to prepare bordering
Eastern European countries for eventual accession into the EU. They involved bilateral agreements between each other and with the EU to
reduce tariffs, develop uniform rules of origin,
EU-consistent regulatory approaches to services, and common treatment of standards aswell as transition rules in sectors such as agriculture. These efforts culminated with the fulladmission of 10 new countries into the EU in
2004—which is why the number of RTAs registered with the WTO fell for the first time ever.
Euro-Mediterranean Agreements were intended to build bilateral trade relations between neighbors, with the objective of forming a NAFTA-like free trade area by 2010.
Launched in 1995, the EU and 12 countries
have been involved in talks on “associationagreements” that would subsume some existing bilateral arrangements. To date, bilateralagreements have been signed with Tunisia

A N D

P R E F E R E N T I A L

T R A D I N G

A G R E E M E N T S(1995), Israel (1995), Morocco (1996),
Jordan (1997), the Palestinian Authority(1997), Algeria (2001), Egypt (2001), andLebanon (2002). In general, services liberalization provisions are limited to the restatement of WTO GATS commitments with nonew liberalization or with preferential accessreserved for suppliers based in member countries. Dispute settlement is state-to-state basedon ad hoc arbitration.
Partnership and Cooperation Agreements(PCAs) with the Western Balkans, Russia, andthe CIS were designed to help promote stability on the border of the EU, and in the case of
Russia, expand trade. The EU has been providing technical assistance to these governments to help implement the institutional reforms that are part of the PCAs.
Two new agreements have been added tothis list since 2000.
• Economic Partnership Agreements(EPAs) are designed to replace the preferential systems embodied in the Contonou Agreement (the successor to the
Lomé Convention), which had received awaiver under the enabling clause fromGATT Article XXIV, a waiver that
expires in 2007. EPAs are designed topromote trade and development in the
ACP 77 countries in a WTO-consistentfashion by establishing agreements between large groups of countries forming
customs unions (box 2.3).
• Free Trade Agreements with South
Africa (which entered into force in2000), Mexico (2000), and Chile (2003)
are designed to open markets and secure
trade. Agreements with the Gulf Cooperation Council (GCC) and the Common
Market for the South (MERCOSUR) are
under active negotiation. These embody
free trade provisions for a range of products as well as provisions to liberalize atleast some services (Ullrich 2004).
The EU agreements govern services trade in
addition to trade in goods. The agreements

31

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Box 2.3 EPAs become the EU’s trade anddevelopment instrument: An experiment in“North-South-South” integration

E

PAs are the most ambitious attempt to harness
trade, development resources, and technical-legal
assistance to the cause of integration-led development. The objective is to promote development,
strengthen regional integration, and ensure compatibility with WTO principles. By negotiating reciprocal
liberalization with existing South-South regionalgroupings and by providing common rules of origin
with cumulative provisions, participants hope to prevent the hub-and-spoke effects that plague manybilateral North-South agreements. The EPAs will also
encourage liberalization of services, provide for common product standards, and set up the negotiation of
investor protections, based on state-to-state ad hocarbitration of disputes.
After a one-year clarification phase by the African
Caribbean and Pacific states (ACP), the first negotiations were launched in October 2003. The EU initiated discussions with the Economic Community ofWest African States (ECOWAS) plus Mauritania, theEconomic and Monetary Community of Central
Africa (CEMAC) plus São Tomé, Eastern andSouthern Africa (16 countries), the Southern African
Development Community (SADC), the Caribbean
ACP countries, and the Pacific states (Kiener 2004).
The content for the agreements is currently open
for discussion. Reciprocal trade liberalization would
be the centerpiece under the terms of the EPA program . . . (Most of the EPA countries already enjoy
preferential market access that the EU grants unilaterally under this program.) In addition, the EU has
stated that it would like to have services liberalization, investment, competition, government procurement, and trade facilitation covered in the agreements (Falkenberg 2004).
Several issues will determine the ultimate effectiveness of the EPAs in promoting development: thedegree of additional MFN liberalization in goods
and services markets in both the RTAs and in theEU; the restrictiveness of the rules of origin forgoods; and the extent of trade diversion that could
occur in the event that there are no concomitant reductions in MFN border protections (see Hinkle andSchiff 2004).

with Mexico and Chile provide for specificliberalization commitments in the financial
sector over and above those included in
GATS, with the Chilean agreement adding
telecommunications and maritime services(see Ullrich 2004). The South African agreement alludes to possible services liberalization, but without commitment. The EU agreements differ in important respects from the
U.S. agreements in that they are generally lesscomprehensive, provide less market access inagriculture, and do not provide for investorstate dispute resolution (see chapter 5).

The U.S. embraces bilateralism
Prior to the present administration, the U.S. had
generally eschewed reciprocal preferential
trade agreements, whether regional or bilateral.

32

Exceptions included only Canada and Israel inthe 1980s and NAFTA in the early 1990s. Indeed, many U.S. trade observers contend that
opening NAFTA talks was designed primarily
to support multilateral trade negotiations—tospur the Europeans and others into acting on
the Uruguay Round. Two years later, the Clinton
administration announced its desire to form aFree Trade Area of the Americas (FTAA), and it
signed an FTA with Jordan in 2000.
Since the approval of trade promotion authority in 2002, however, the United States has
given much greater emphasis to securing bilateral FTAs in tandem with its efforts to achieve
multilateral liberalization through the WTO.
Since 2002 the United States has signed bilateral accords with Australia, Bahrain, Central
America plus the Dominican Republic, Chile,

R E G I O N A L

T R A D E

Morocco, and Singapore. The United States
appears to have intensified its pursuit of RTAs
since the Cancun WTO Ministerial (September
2003). Negotiations are officially4 under way
with Colombia, Ecuador, Panama, Peru,
SACU, and Thailand. Other economies deemed
to be in the queue are Bolivia, Egypt, New
Zealand, Pakistan, the Philippines, South
Korea, Sri Lanka, and Taiwan (China), andUruguay (Schott 2004). This intensified pace
may reflect the intention to prod both the multilateral negotiations and the FTAA, as well as
to respond to U.S. businesses that fear being
shut out of export markets by a growing number of RTAs in which the United States is not amember.
In the broadest of terms, developing countries seek to provide access to their services
markets and guarantees in many nontradeareas in exchange for assured access to U.S.
goods markets. Key facets of these agreements
include:5• Tariff rates on most nonagricultural
products are bound at zero; for example,
the U.S.-Chile FTA will bind duties atzero for 85 percent of trade.
• Exclusion or delayed liberalization ofsensitive products, commonly including
agricultural products such as dairy products, cotton, ethyl alcohol, peanuts and

A N D

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A G R E E M E N T S

peanut butter, sugar, and tobacco for theUnited States. Some exclusions are due
to be phased out according to lengthy
timetables; in the Chile-U.S. FTA, for example, all duties will be phased out in
12 years (USTR 2004).
• Intellectual property rights are conventionally accorded stronger protections
than under the WTO’s TRIPS agreement,with investor-state suits permitted in theevent of disputes.
• Investment protections, with provisions
for national treatment and nondiscrimination in pre-establishment provisions
for companies based in each others
markets (though liberal rules of origin
indicate foreign subsidiaries located inmember countries qualify for eligibility).
• Services trade are to be open except for
those excluded in a negative list; notably
excluded are labor service providers, except for the provisional visas held by professionals associated with investing firms.
• Labor and environment issues are included in recent agreements, with signatory countries undertaking commitments
to enforce their own environmental andlabor laws. Dispute settlement panels are
empowered to impose monetary fines
rather than using trade sanctions to force
compliance (box 2.4.)

Box 2.4 Labor in U.S. FTAs

U

ntil NAFTA, the United States did not attempt
to include provisions on labor in trade agreements that it negotiated. As a presidential candidate,Bill Clinton promised to negotiate new side agreements to NAFTA on labor in order to secure sufficient political support for NAFTA. Since then labor
issues have featured prominently in Congressional
debates on granting the president negotiating
authority and the resulting trade agreements.
All recent FTAs negotiated with the United States
contain provisions requiring parties to enforce theirown labor laws. These are premised on the assump-tion that each member’s existing laws are satisfactory
and therefore any trade distortions that might arise
are caused by a lack of enforcement. The agreements
enumerate five core standards: the right of association; the right to organize and bargain collectively;
prohibitions on forced labor; a minimum age for employment of children; and acceptable working conditions. The FTAs establish a procedure for making
complaints, encouraging resolution first through consultation and, if this fails, by establishing a panel ofexperts to hear the dispute.
(Box continues on next page)33

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(continued)

The labor provisions break new ground in how adispute settlement panel’s decisions are enforced.
Rather than using trade remedies (i.e., granting the
injured party the right to withhold trade concessions), a panel can impose a monetary fine of up to$15 million per year (adjusted for inflation). Payments of the fines would go into a fund to support
appropriate labor initiatives, which may include
efforts to improve enforcement of labor laws. Thismechanism appears in the agreements that theUnited States has signed with Australia, Bahrain,
Chile, Central America and Dominican Republic,
Morocco, and Singapore.

Using fines rather than trade sanctions has several
advantages: while trade sanctions penalize both polluting and clean exporters, fines target the polluters;
increased trade sanctions hurt all workers in exportindustries, but fines help restructure plants andmaintain employment; and fines build in targeted
solutions to the problem rather than present protracted trade disputes.

Sources: Destler and Balint 1999, texts of FTAs on the USTR
web site (www.ustr.gov), and Weintraub 2004.

The United States indicated it would not negotiate changes in its antidumping statutes or on
its agricultural subsidies, insisting on addressing both through the WTO’s multilateral negotiations. In chapter 5, we return to a deeper discussion of provision for services, investment,
and intellectual property rights (IPR).

Developing countries actively pursue
major markets
The launching of NAFTA spawned a new
flurry of interest among developing countries
eager to use RTAs to secure market access.
Mexico and Chile have been at the forefront ofthese developments. Mexico, having created aworld-class trade negotiating team for NAFTA,
turned its attention to Central America andother countries in Latin America. It establishedarrangements with Costa Rica (1995), Bolivia(1995), Nicaragua (1998), the EU (2000),EFTA (2001), and Japan (2004). After NAFTA
was signed, Chile immediately solicited entry
into the accord. Rebuffed initially, the country
embarked on a wider strategy. Chile established agreements with MERCOSUR (1996),
Canada (1997), Peru (1998), Mexico (1999),
Central America (2002), the United States andEU (2003), and EFTA (2004). By 2004, Chile
had signed free trade agreements that provided

34

over 60 percent of its exports with duty-freeaccess to markets around the world (see Devlin
and Estevadeordal 2004).
Many existing regional organizations in
Africa also moved aggressively to intensify
preferential trade liberalization during the
1990s. For example, the treaty establishing
the Common Market for Eastern and Southern Africa (COMESA), which was signed in
1993 to replace the Preferential Trade Area,
called for a free trade area by 2000 and acustoms union by 2004. The East African
Community was formed in the mid-1990s toaccelerate economic integration among three
COMESA members (Kenya, Tanzania, andUganda). The SADC Trade Cooperation Protocol was signed in 1996 as part of an effort toreintegrate South Africa into the regional economy after the end of apartheid.
Asian countries have launched similar negotiations since 2001. India has concluded or isnegotiating limited arrangements with MERCOSUR and Thailand; MERCOSUR is negotiating with the Andean countries; China haslaunched bilateral accords with members of the
Association of Southeast Asian Nations(ASEAN), to mention a few. In 2004, India,
Pakistan, and other South Asian countries announced the South Asian Free Trade Agreement

R E G I O N A L

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Table 2.2 RTAs cover many topics besides merchandise trade

U.S.
U.S.-Jordan
U.S.-Chile
U.S.-Singapore
U.S.-Australia
U.S.-CAFTA
U.S.-Morocco
NAFTA
EU†
EU-South Africa
EU-Mexico
EU-Chile
Euro-Med.
Agreements
South-SouthMERCOSUR
Andean Community
CARICOM
AFTA
SADC
COMESA
Other
Japan-Singapore
Canada-Chile
Chile-Mexico

Standards

Transport

Customs
Cooperation

ServicesIntellectual
Property

Investment

DisputeSettlement

Labor

Competition

No
Yes
Yes
Yes
Yes
Yes
Yes

No
No
No
No
No
No
No

Yes
Yes
Yes
Yes
Yes
Yes
Yes

Yes
Yes
Yes
Yes
Yes
Yes
Yes

Yes
Yes
Yes
Yes
Yes
Yes
Yes

Yes
Yes
Yes
Yes
Yes
Yes
Yes

Yes
Yes
Yes
Yes
Yes
Yes
Yes

Yes
Yes
Yes
Yes
Yes
Yes
Yes

Yes
Yes
Yes
Yes
No
No
Yes

No
Yes*
Yes*

No
Yes
Yes

No
Yes*
Yes

No
Yes
Yes

Yes
Yes
Yes

No
Yes
Yes

Yes
Yes
Yes

No
No
No

Yes
Yes
Yes

No

No

No

No

Yes

No

Yes

No

Yes*

Yes
Yes
Yes
Yes

Yes
Yes
Yes
Yes
Yes
Yes

Yes
Yes
Yes
Yes
Yes
Yes

Yes
Yes
Yes
Yes

Yes
Yes
Yes
Yes
No
Yes

Yes
Yes
Yes
No
Yes
Yes

Yes
Yes
No

Yes
Yes
Yes
No

Yes

No
No
No
No
Yes
No

Yes

Yes

No
No

Yes
Yes
Yes

Yes
Yes
Yes

Yes
No
Yes

Yes
Yes
Yes

Yes
Yes
Yes

Yes
Yes
Yes

Yes
Yes
Yes

Yes
Yes
No
Yes

Source: World Bank staff.
†While EU agreements mention cooperation in most of the subject areas, only those in which specific commitments are undertaken receive a “Yes” rating.
*Implementation steps are to be agreed on at a later date.

(SAFTA), which is intended to encompass all of
the countries of the region (see Baysan 2004;
Newfarmer 2004).

Many RTAs, diverse provisions
RTAs have increasingly been designed to covermuch more than liberalization of tariffs andquotas. New provisions on enforcement of domestic labor and environmental laws have already been mentioned. Table 2.2 gives a flavorof the range of services and intellectual property rights issues that are addressed in current
agreements. Many of these issues, which aredealt with in more detail in later chapters,
have implications for trade, although the precise mechanisms by which trade is affected are
not always well defined.

Many RTAs, many rationales
These recent trends highlight different rationales that drive the quest for preferential

agreements, but in nearly all cases politics is as
important as economics. The classic NorthNorth agreement, the European Union, had its
origin in politics (see Schiff and Winters
2003). The fathers of the European Community, Robert Schumann and Jean Monnet,
clearly believed that Franco-German integration through trade and investment would
produce a new constellation of common economic interests that would attenuate historic
military animosity. As a first step, they feltthat placing French and German coal and steel
industries under a single authority, theEuropean Coal and Steel Community, would
make it impossible for either of these historical enemies to use these resources for military
purposes against the other.
Today, for North-South agreements,
Northern partners often have a complex mix
of rationales—rooted in foreign policy, commercial diplomacy, and development policy.

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“Trade policy has always been the principal
instrument of foreign policy for the European
Union” (Sapir 1998). The United States now
appears to be using preferential agreements
for reasons that are similarly broad. Both the
EU and the United States seek trade agreements that go beyond simple tariff removal toinclude rules governing services, protection of
intellectual property, and adherence to health,labor, and environmental standards.
One goal of developing countries seeking
an RTA with a large market, such as the EU6or the United States, is simply to secure market
access. One should note, however, that mostdeveloping countries, especially the least developed countries (LDCs), already enjoy considerable access to these markets for mostmanufactured products (whether through unilateral preference programs or because MFN
tariffs are already quite low), and RTAs withthese countries often exclude agriculture andother politically sensitive products. Nevertheless, RTAs provide some insurance against
future protectionist policies, and by reachingan agreement “preemptively,” they seek toavoid being left out of a future agreement.
A second objective is to reinforce internal
regulatory reforms through external treaty
obligations and visible political commitments.
Locking in domestic reforms through a foreign trade agreement with the EU clearlymotivated countries making the transition
from socialism in the 1990s. Mexico under
NAFTA was motivated by a similar objective.
Guaranteed market access combined withcredible domestic reforms can attract foreign
direct investment (see chapter 5).
South-South agreements often reflect a political desire to form or join a broadly based
regional initiative, such as ASEAN, COMESA,
or MERCOSUR. The drive for economic
integration often begins with political objectives. Like France and Germany in the 1950s,
the newly established democracies of theSouthern Cone formed MERCOSUR in the
mid-1980s in the hopes of damping the traditional military hostility between major regional powers—Argentina and Brazil. SADC
originated in the 1980s as a coalition opposed
to apartheid in South Africa and has more
recently turned to creating a free trade area.
Some observers note that African customs
unions and free trade areas are as active inareas such as conflict resolution as in tradeliberalization. Finally, many see relaxed tensions between India and Pakistan as the real
payoff from the proposed SAFTA agreement,
regardless of what happens to trade barriersin the region. The tentative conclusion of existing studies is that RTAs that expand tradeflows appear to have a substantial dampening
impact on conflict (box 2.6).

Box 2.5 Trade agreements and the environmentIt is important to establish coherent relationships
between environmental policies and the tradeobligations set out in various RTAs. The following
examples illustrate the various ways that environmental issues are handled in these trade agreements.
WTO. Within the WTO, environmental provisions
are limited to the adoption of product-related measures as “necessary to protect human, animal or plantlife or health,” or “relating to the conservation of exhaustible natural resources.” Process-related requirements continue to remain outside the scope of the36

WTO. However, in the absence of agreed-on international standards (e.g., fisheries), the risk of disguised
protectionism has prevented further consensus on theway forward. Long-standing disputes between the
United States and other countries on tuna fishing anddolphin or turtle protection are cases in point.
NAFTA. The environmental agreement under
NAFTA created the Commission for Environmental
Cooperation to promote environmental cooperation
among the three members. The commission itself does
(Box continues on next page)R E G I O N A L

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T R A D E

A N D

P R E F E R E N T I A L

T R A D I N G

A G R E E M E N T S(continued)

not set standards in the various countries, though partof its mandate is to help harmonize them upward. If a
country persistently fails to enforce environmental
laws that have conferred a trade benefit, dispute settlement provisions can be invoked. The commission’srole in the disputes is to see that enforcement of existing laws takes place. In addition, it is charged with
monitoring the environmental effects of NAFTA. Articles of agreement also dictate that countries will not
try to attract investment by relaxing or ignoring domestic health, safety, or environmental regulations. International environmental agreements recognized by
the three parties take precedence over national rules.
MERCOSUR. Environmental concerns are currently being dealt with in MERCOSUR by a working
group. This group has discussed issues such as theenvironment, competitiveness, non-tariff barriers totrade, and common systems of environmental
information. A draft agreement from this working
group provides for upward harmonization of environmental management systems and increased cooperation on shared ecosystems, in addition to mechanisms for social participation. It also includes
provisions on instruments for environmental management, including quality standards, environmental
impact assessment methods, environmental monitoring and costing, environmental information systems
and certification processes, provisions for protecting
health and quality of life, and other general

Not all political objectives involve war andpeace issues; some South-South agreements
are designed to pool resources for trade negotiations and trade policymaking. Much as theEuropean Union established a common trade
policy with a common commissioner in chargeof trade (in part to negotiate more forcefully
with the United States in the GATT), so too adriving force for MERCOSUR was to establish a common trade policy relative to the multilateral and hemispheric system.
Entering into a regional agreement may also
reflect a desire to deal with region-specific issues—such as transit, water, energy, migration,mechanisms for implementing the protocol. The
regime is still evolving, and the challenge at hand isto ensure that the promise of the protocol leads toeffective regional cooperation and action.
Bilateral agreements. A number of recently concluded bilateral FTAs, including the U.S.–Singapore
FTA and the Japan–Singapore Economic Agreement
for a New Age Partnership, contain environmental
provisions. The U.S.–Singapore FTA establishes animportant precedent for dealing with environmental
issues by including a chapter specifically on the environment. As discussed in box 2.4 on labor laws, thisagreement ensures that countries effectively enforce
their environmental laws, and it provides for enforcement mechanisms, including fines.
Even in the absence of such special provisions,however, trade agreements can contribute to acleaner environment simply by making trade more
responsive to market forces. In general, countries
that are more open to trade adopt cleaner technologies more quickly, and increases in real income areoften associated with greater demand for environmental quality (WTO 1999). Opening up domestic
markets also encourages cleaner manufacturing,
because protectionist countries tend to shelter
pollution-intensive heavy industries. The incentives
to over-exploit or deplete resources are more directly
related to policies and institutions within the sector
than to trade openness per se (World Bank 1999).

movement of labor, customs, and standards—
that are difficult to broach at the global level.
RTAs among CIS countries are arguably an
attempt to reconstruct some of the economic
linkages that were severed with the disintegration of the Soviet Union and the disorganization caused by the collapse of central planning.
Although many of these regional externalities
can be handled without a trade agreement,
RTAs may provide institutions and a framework through which to make progress on theseissues (see chapter 4).
The wide variation in RTAs flows from thevery different motivations countries have for37

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Box 2.6 Can RTAs prevent conflict?

D

oes trade inhibit or increase hostilities between
states? Greater contact among traders and consumers across borders may stimulate mutual respectand more harmonious relations, and high levels of
trade can create economic interdependence, which, inturn, raises the cost of political disputes and military
conflict.
In 1889, Wilfred Pareto suggested that “customs
unions and other systems of closer commercial relations [could serve] as means to the improvement ofpolitical relations and the maintenance of peace.” In
1919, John Maynard Keynes wrote that “a Free
Trade Union, comprising the whole of Central,
Eastern and South-Eastern Europe, Siberia, Turkey,and (I should hope) the United Kingdom, Egypt
and India, might do as much for the peace and prosperity of the world as the League of Nations itself.”
RTAs also can provide institutions and a forum
for bargaining and negotiation—to address tensions
before they erupt in conflict. European integration,
ASEAN, and MERCOSUR are often cited as venues
for improving political-military relations. Regional
trade agreements do not ensure positive political outcomes, however. The U.S. civil war (1861–65) was
fought—at least in part—over high protection ofnorthern manufactures and trade restrictions on cotton. Similarly, the Central American soccer war of1969 emerged out of lingering hostility over tradearrangements that created advantages for El Salvador
at the expense of Honduras. And one reason
Bangladesh seceded from Pakistan was the common

external tariff structure that deprived it of access tocheaper inputs from the global market and diverted
trade to Pakistan (Schiff and Winters 2003).
Mansfield and Pevehouse (2000) attempt to identify empirically the role of RTAs in ameliorating
conflict. They find that, on average, the likelihoodthat a pair of states will see the outbreak of a militarized interstate dispute declines by around 50 percent if both belong to the same RTA. However,
only RTAs that expand trade flows appear to havea substantial impact on conflict. When evaluated at
the lowest level of trade between partners, it appears that membership in a RTA reduces the chanceof dispute by just 15 percent. Other studies havesuggested that RTAs that have little impact on trade
may actually exacerbate conflict (see Powers 2003).
If the gains from trade are not distributed evenly,for example, then the subsequent change in interstate power relations can be a source of increased
tension. Also, rising interdependence may be seen as
a source of increasing vulnerability, making expansion through military force appear more attractive.
These results, which suggest that RTAs could contribute to a reduced risk of military conflict, should betreated with a high degree of caution, due to problems
of causality and omitted factors, such as the broader
institutional framework governing relations between
particular pairs of countries. In Africa, for example,
RTAs that address the management of cross-borderresource issues (such as water) are more effective in
reducing military conflict than other RTAs.

entering into the arrangements. As we will see
in subsequent sections, these motivations
contribute to greater complexity in rules
governing world trade.

Many RTAs can complicate
administrative procedures
An important feature of the rise in the number of RTAs is the growing number of overlapping agreements and the so-called“spaghetti bowl” that has emerged from theproliferation of bilateral agreements (figure 2.2). The associated myriad of rules

38

strains institutions charged with administering trade agreements. A web of differing tradearrangements can tangle administrative procedures—customs procedures, technical standards, rules of origin, and so on—and thereby
raises the costs for both enterprises and governments. This complexity undermines work
toward greater trade facilitation in developing
countries.
Many agreements between country pairs
are duplicated by other agreements to which
the same two countries are parties. In SubSaharan Africa, for example, about one-half ofR E G I O N A L

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Figure 2.2 Spaghetti and rigatoni: Multiple, overlapping RTAs, 2004
a. African agreements are overlapping
AMU

CEMAC

Somalia

São Tomé & Principe
Egypt

Cameroon
Central African Rep.
Gabon
Equat. Guinea
Rep. Congo

ECOWAS
Conseil de
L’Entente

Ghana
Nigeria

Cape Verde
GambiaChad

Niger
Burkina Faso

Kenya*
Uganda*AngolaMali
Senegal

COMESA

Djibouti
Ethiopia
Eritrea
Sudan

Burundi*Rwanda*DR Congo
Benin
Togo
Côte d’Ivoire
Guinea-Bissau

IGAD

Nile River Basin

ECCASAlgeria
Libya
Morocco
Mauritania
Tunisia

EAC

WAEMU
Liberia
Sierra Leone

GuineaTanzania*
SACU

Mano River Union
CILSS

Mauritius*
Syechelles*

Malawi*
Zambia*Zimbabwe*

South Africa
Botswana

Comoros*
Madagascar*

Namibia*

AMU:
Arab Maghreb Union
Swaziland*
Lesotho
CBI:
Cross Border Initiative
CEMAC: Economic and Monetary Community of Central Africa
CILSS:
Permanent Interstate Committee on Drought Control in the Sahel*CBI
Mozambique
COMESA: Common Market for Eastern and Southern Africa
SADC
EAC:
East African Cooperation
ECOWAS: Economic Community of Western African Studies
SADC:
Southern African Development Community
IGAD:
Inter-Governmental Authority for Government
WAEMU: West African Economic and Monetary Union
IOC:
Indian Ocean Commission* Indicates membership in CBI regional grouping
SACU:
Southern African Customs Union

ReunionIOC

Source: Schiff and Winters 2003.
b. “Spaghetti Bowl” of RTAs in the Americas and Asia-Pacific (Agreements signed and in force in Latin America as of
May 2004)

Hong KongFTAA

PR China
TaiwanCanadaBrunei

Costa
Rica

Cambodia

CACM

PanamaEl Salvador

Korea

GuatemalaHondurasThailand

MERCOSUR

Nicaragua
MalaysiaJapan

Paraguay
Argentina
BrazilUSA

Uruguay

Philippines
MexicoMyanmarBolivia

ASEAN
Singapore

Colombia
Chile

New ZealandVenezuela

Laos

BahamasEcuadorIndonesia

Australia
Peru

Vietnam
APEC

Papua New Guinea

APEC

Intra-Americas in force

Dominican
Republic
CARICOM

Dominica Trinidad and Tobago
Suriname Grenada Barbados
Jamaica St. Vincent and Grenadines
Guyana Antigua and Barbuda
St. Kitts and Nevis Belize
Haiti St. Lucia

RussiaFTAA

AndeanCommunity

Intra-Asia-Pacific in force

Intra-Asia-Pacific signed

Trans-Pacific signed

Source: Devlin and Estevadeordal 2004.

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2 0 0 5Figure 2.2 (continued)c. In Eastern Europe and Central Asia, bilateral agreements burden customs officials*
CEFTA

Bulgaria

TurkeyCzech Republic

CIS
LatviaSlovak Republic

Lithuania

PolandEstonia

Romania

BAFTA

Belarus
Moldova

Hungary
Slovenia

Macedonia

Tajikistan
Kazakhstan

Uzbekistan

Kyrgyz Republic

Armenia

RussiaCroatia

BosniaBAFTA: Baltic FTA
CEFTA: Central European FTA
CIS:Commonwealth of Independent States* Prior to EU expansion.

UkraineGeorgia

Azerbaijan

Turkmenistan

Source: World Bank staff.

the pairwise trade relationships covered by an
RTA are also covered by another agreement.
In other regions, overlapping agreements also
comprise a substantial share of the total number of agreements. There would be significant
benefits, in terms of lower administrative costs
and more effective implementation, from arationalization of the current structure ofoverlapping agreements.

advantageous than in the hub, which enjoys
improved access to all of the spokes. In comparison with a broad preferential trade agreement, a hub-and-spoke approach in theory
generates lower gains, which accrue mainly tothe hub (Wonnacott 1996). Hubs and spokes
are already clearly discernible as the EU andUnited States extend restrictive rules of origin
from one bilateral agreement to another.7

Uneven terms—hub-and-spoke integration

Trade within RTAs is rising but
preferential trade is less important

The substantial number of bilateral agreements involving large northern countries, mostof which have been signed since 1990, suggeststhat a hub-and-spoke structure in world tradeis emerging. Of the 109 North-South bilateralagreements, 86 have been created since 1990.
In a hub-and-spoke trading system, the largest
markets sign individual agreements with awide range of peripheral countries among
which market access remains restricted. Suchagreements can marginalize the spokes, where
market access conditions are usually less40

Trade between RTA members is growing as
the number of agreements increases, and onethird of world trade now takes place between
RTA members (figure 2.3). (Here we cover
only reciprocal agreements and exclude tradeunder the Generalized System of Preferences,
Cotonou Agreement, and AGOA.) Disregarding intra-EU trade, bilateral flows between
RTA members have been growing at a rate
similar to the growth rate of agreements
themselves, as shown in figure 2.3. This figure

R E G I O N A L

T R A D E

Figure 2.3 Trade within RTAs
a. Number of RTAs signed
250
200

S-S

150
100
USA
50

EU

0
1990

1996

2002

b. Share of world trade covered
35

S-S

30
25

USA

20
15
EU

10
05
0
1990

1996

2002

c. RTAs may be less than they appear
Share of world trade covered (2002), %
35
30
25
20
15
10
5
0
Including
all trade

Excluding
0% MFN

Excluding3% MFN

Note : EUN is EU-15.
Source: World Bank staff.

also reveals that the rapid increase in the number of South-South RTAs signed in the past
decade has not been matched by much change
in trade flows among parties to these agreements. This discrepancy highlights a point
made earlier: many new South-South agreements overlap with existing agreements.

A N D

P R E F E R E N T I A L

T R A D I N G

A G R E E M E N T S

Examining total trade flows between RTA
partners overstates the amount of trade thattakes place on a preferential basis. However,tariff schedules of many RTA members
increasingly contain duty-free MFN rates
on which no preference can be given. We
estimate that the amount of preferential trade
among RTA members, after accounting for
MFN rates of zero, is much lower at 21 percent of world trade (figure 2.3). Furthermore,
it is often more profitable for enterprises to
pay a low MFN tariff when there are highcosts to satisfy rules of origin or otheradministrative procedures that a trader must
follow to qualify for preferential treatment
under an RTA. If we exclude trade coveredby facing tariffs of 3 percent or less, we conclude that, at present, the amount of global
trade taking place under an economicallymeaningful tariff preference is around 15
percent. An earlier estimate on a similar, but
not directly comparable, basis suggests thatin the mid-1990s, trade on a preferential
basis amounted to 27 percent of global
trade.8
While the number of RTAs has been increasing, the importance of preferential trade
has been falling, reflecting lower tariff barriers, especially in OECD countries. Since 1996
the number of zero duty lines in the EU tariffschedule has increased from 13 to 21 percentof the total number of tariff lines and from 18
to 32 percent for the United States. In 2002
about 45 percent of the tariff lines in the EU
and United States schedules had duties of
3 percent or less. This reflects the impact ofmultilateral liberalization under the Uruguay
and earlier trade rounds. Thus a large andgrowing proportion of EU and U.S. imports
from preferential trade partners is unlikely toactually receive preferential access relative toother countries.
For many developing country agreements,
the situation is different because the number of
low-duty tariff lines is small. In 2002, 6 percentof Brazilian tariff lines had MFN tariff rates ofzero, as did 1 percent of Indian tariff lines. We
estimate that 88 percent of trade between

41

G L O B A L

E C O N O M I C

P R O S P E C T S

2 0 0 5

Box 2.7 Regional versus multilateraland unilateral liberalization: What’s more important?

H

ow does liberalization in RTAs compare to autonomous and multilateral liberalization? The
rapid expansion of RTAs has occurred during a period when developing countries were undertaking
autonomous liberalization and also fulfilling commitments made during the Uruguay Round of the
GATT. An examination of tariff reductions by developing countries finds that neither RTAs nor multilateral negotiations represent the largest driver of liberalization. Autonomous liberalization accounts for thelion’s share of trade liberalization since the 1980s.
The trade-weighted average MFN tariff rate leviedby the 33 largest developing country importers(which collectively account for 90 percent of all developing country imports) was 29.9 percent in the
1980s. By 2003 the average MFN rate had dropped
to 11.3 percent. Based on tariff concessions granted
during the Uruguay Round, multilateral negotiations
account for 5.1 percentage points of the total decline
in MFN tariffs, and the remaining 13.5 percentage
points resulted from autonomous liberalization. If
the RTAs that these 33 countries have signed were
fully implemented, the trade-weighted average applied tariff would fall further to 9.3 percent. The

chart below shows how trade liberalization is allocated according to these different sources.

Share of total tariff reduction, by type ofliberalization, 1983–2003
Regional
Agreements
10%

Multilateral
Agreements
25%

Source: Martin and Ng 2004.

countries in Latin America is potentially eligible for preferential treatment under an RTA.9
For the Middle East and North African countries it is 83 percent of the total. The new
SAFTA will lead to three-quarters of the trade
between members taking place on a preferential basis (assuming all products are included).
East Asia is an exception, where, for example,
22 percent of Indonesian and 59 percent of
Malaysian tariffs are zero. Thus the amount oftrade between East Asian countries receiving
tariff preferences is very small. Like OECD
countries, however, developing countries havetaken great strides to reduce MFN tariffs during the past two decades. Most of this liberalization has come from autonomous reductions
and not through trade agreements—either
RTAs or multilateral trade negotiations (seebox 2.7).

42

Autonomous
Liberalization
66%

Trends in Trade and Growth
by RegionThese agreements were superimposed in acontext of deep changes in global trading
patterns.10 The postwar period has seen major
global shocks and changes in the economic
environment, including oil crises in the 1970s
and financial crises in the 1980s and 1990s. In
the past 20 years there have also been majorchanges in policy regimes. Socialist countries
across the world restructured their economic
systems and started the process of reorienting
their trade to the world economy. In the former
Soviet Union, this meant collapse and reconstruction; in East Asia it meant progressive,
sustained, and profound institutional change.
Latin America went through its own, if lessdramatic, transition from import-substitution

R E G I O N A L

T R A D E

industrialization to a strategy of outwardoriented growth. Apartheid in South Africa,
political strife in various parts of the continent, and the struggle against HIV/AIDS delayed the establishment of stable policies and

A N D

P R E F E R E N T I A L

T R A D I N G

A G R E E M E N T S

depressed growth throughout Africa. It has
been a period of major transitions.
The growth performance of developing
countries in the past 20 years reflects thisvaried experience (figure 2.4). Only the East

Figure 2.4 Trade performance has differed across regions
a. East Asia and South Asia grew rapidly in 1980–2000,
but other regions slowedb. Exports became the driving force of growth everywhere

GDP growth rates by region (percent)Non-oil export share of GDP (percent)40

8
1961–1970

735

1970–1980

6

30

5
4

25

3

20

2

15

2000

1990
1980

1

10

0
1

5

1990–2000

1980–1990

2

an Eas
d tA
Pa s
ci ia
Eu ficC ro
en p
tra e aln
La Asi d
an ti
a
d nA
C m
ar e
ib ric
be a
M
id
an
dl
N eE
or as
th t
Af an
ric d
a
So
ut
h
As
ia
Su
bSa
h
Af araric n
aan Eas
d tA
Pa s
c ia
Eu ific
C ro
en p
tra e
l a
La As nd
an ti
ia
d nA
C m
ar e
ib ri
M
b ca
id
dl ean
e
N E
or as
th t
Af an
ric d
a
So
ut
h
As
Su
ia
bSa
h
Af araric na0

Source: World Bank staff.

Source: World Bank staff using WITS for non-oil/total exports
ratio.

c. East Asian exports grew fastest, and all but South Asia
and Africa increased their share of the global market

d. Integration with the world proceeded hand in handwith regional integration

Regional exports as share of world exports (percent)(oil
excluded)Intra-regional trade as a share of GDP (percent), 2002
30

14

26.5
12

East Asia
and Pacific

25

10

20

8

Latin America
and Caribbean

Middle Eastand North Africa

Europe andCentral Asia

15.3
15

6
10

4

6.4
Sub-Saharan Africa

5

02
20

98

20

96

19

94

19

92

19

90

19

88

19

86

19

84

19

82

19

19

80
19

00

South Asia0

Note: Data obtained from GTAP release 5.4 up to 1998, thefollowing years are projected from 1998 using regional growth
rates calculated from COMTRADE.
Sources: GTAP 5.4 and COMTRADE.

5.3
3.5
0.8

0
an Eas
d tA
Pa s
ci ia
Eu ficC ro
en p
tra e al A ndLan ati sia
d nA
C m
ar e
M ibb rica
ea
id
dl
n
N eE
or as
th t
Af an
r ic d
a
So
ut
h
As
ia
Su
bSa
h
Af arar ic na2

Source: COMTRADE.

43

G L O B A L

E C O N O M I C

P R O S P E C T S

2 0 0 5Figure 2.4 (continued)
e. One reason: East Asia liberalized early in tradef. Strong FDI flows coincided with relocation of
production processes

Applied average unweighted tariffs

FDI, net inflows (percent GDP)

80

3.5

70
60

3.0
1989–1990

2.5

50
2.0
40
30

1996–1998
2003

20

1.5
1.0

0

0

2000s

an Eas
d tA
Pa s
ci ia
Eu ficC ro
en p
tra e aln
La Asi d
an ti
a
d nA
C m
ar e
ib ric
M
be a
id
an
dl
N eE
or as
th t
Af an
ric d
a
So
ut
h
As
ia
Su
bSa
h
Af ara
ric n
a

0.5

1990s

an Eas
d tA
Pa s
ci ia
fic
Eu
C ro
en p
tra e al A nd
si
La
a
an ti
d nA
C m
ar e
ib ric
M
be a
id
an
dl
N eE
or as
th t
Af an
ric d
a
So
ut
h
As
ia
Su
bSa
h
Af ara
ric n
a

10

1980s

Source: TRAINS.

Note: Period averages for 1980–1989, 1990–1999, and 2000–
2002 calculated from annual data. For all regions except LAC,
some observations are missing.
Sources: World Bank, WDI.

Asia and Pacific and South Asia regions experienced higher GDP growth rates in the
1980–2000 period than during 1960–1980.
The other four regions fared worse in the lasttwo decades, with GDP growth rates thatwere one-half to two-thirds smaller thanbetween 1960 and 1980.
Nonetheless, trade grew. The share of tradein GDP grew in all regions in the 1990s. East
Asian exports grew faster than the other regions, and the region increased its share of
total world exports throughout the 1980s and1990s. Latin American exports also grew consistently as a share of the world market during
the 1990s, but not as steeply as for East Asia.
In South Asia, however, although GDP growthincreased in the 1980–2000 period and the export share of GDP rose in the latter part ofthat period, the trade growth is from a muchsmaller base. South Asia still has the lowest
trade shares of any region. Sub-SaharanAfrica has also had disappointing growth

44

performance. These trends reflect different initial conditions and external shocks, changes indevelopment strategies, and policies toward
trade liberalization.
East Asia generally followed a strategy ofexport-led growth, through elimination ofanti-export bias and sustained nondiscriminatory (MFN) liberalization. This trend wasmost dramatic in China, where border barriers at the start of the decade were prohibitive
for most tariff lines, and by the end of thedecade averaged less than 12 percent, with aplan to go to less than 10 percent by 2004.
But virtually all countries were liberalizing.
Average tariffs for the region as a whole fell
from about 23 percent in 1989–90 to 8 percent in 2003.
In Europe and Central Asia the disintegration of the Soviet Union after 1990 caused thecollapse of growth and required profound restructuring of the region’s economies and aredirection of its trade. Roughly half of theR E G I O N A L

T R A D E

region was drawn to the magnet of the EU’s
large and stable market. The EU respondedwith technical assistance and a political willingness to admit its Eastern European neighbors as full members. The combination of apolitical framework, trade, investment, andtechnical assistance led to an unprecedented
pace of reforms and economic integration that
culminated with 10 states joining the EU on
May 1, 2004. With their eyes turned towardmarkets in the EU, the Central European andBaltic countries achieved more extensive integration and higher trade and FDI flows, whichis evident in the rapid export growth of theregion as a whole.
The CIS has moved much more slowly inits process of reform and reorientation, particularly in Central Asia and the Caucasus.
Under the CIS-7 initiative, trade regimes havebeen generally liberalized, but have been limited by regional trade and transit barriers.
Latin America reversed its trade policy
stance, and during the 1990s average tariffs in
the region declined from over 30 percent to12 percent. The region’s share of the world
markets increased and net inflows of foreign
direct investment (FDI) as a percent of GDP
steadily climbed, reaching 5 percent of GDP in
1999—higher than East Asia. Overall, FDI net
inflows in the latter half of the decade morethan doubled from an average of 1.4 percent
of GDP in the first half to an average of 3.6
percent in the second half.
In the Middle East, policy and economic
barriers, together with a reliance on oil forseveral countries, prevented rapid growth intrade. High tariff rates, restrictions on services
entry, and controls on agriculture interactedwith poor investment climates to impede tradeand keep transactions costs high. A large
state-led sector also shaped a noncompetitive
industrial policy that discouraged trade. Average tariff rates were almost 30 percent in thelate 1990s, mirroring the import substitution
policies early in Latin America and more
recently in India. Flows of foreign direct investment as a percent of GDP have recovered

A N D

P R E F E R E N T I A L

T R A D I N G

A G R E E M E N T S

in the last decade, but still remain quite low atless than one percent.
South Asian countries other than Sri Lanka
neither liberalized trade rules nor the rules governing inflows of foreign direct investment
until the 1990s. Removal of the most egregious
forms of anti-export bias and gradual domestic
reforms, together with textile preferences,produced a rapid expansion in garment/textile
exports, and led to high growth rates for exports in the 1990–2000 period and an increasing share of exports in GDP. Since growth wasfrom a low base, South Asian exports as ashare of world trade have remained low
throughout the 1980–2000 period. South Asia
maintained the highest levels of average applied tariffs, even compared to the import-substitution industrialization period of other regions. However, this is changing. Nepal
launched trade liberalization in the early
1990s. Sri Lanka and then Pakistan in 1997
began to reduce their border barriers and increase their trade with the world economy.
India began to reduce border protection fromvery high levels in the early 1990s and has continued doing so; in early 2004, India announced tariff cuts of roughly one-third,
reducing the average tariff rate to about 22 percent. Bangladeshi border protections are stillamong the highest in the world, but they too
announced reductions in 2004.11 The region
remains only minimally integrated in world
capital markets. Net inflows of FDI, althoughhigher than in the early 1980s, are less than 0.8
percent of GDP—the lowest of all the regions.
As with the Middle East and North Africa
and South Asia regions, Sub-Saharan Africa
remains weakly integrated into the global
market. Although exports as a share of GDP
in Sub-Saharan Africa increased in 2000, exports as a share of world exports have remained flat throughout the last decade and arelower than in the early 1980s. GDP growth
has also been worse than in the earlier
decades. Many countries in Sub-SaharanAfrica are dependent on only a handful ofcommodities with highly volatile prices; most45

G L O B A L

E C O N O M I C

P R O S P E C T S

2 0 0 5face very high transport costs and have weak
institutions to facilitate trade. These countries
have also experienced a number of armed
conflicts throughout the previous decades andare plagued by endemic diseases such as
malaria and HIV/AIDS, which have major
impacts on their economies and societies. All
these factors hobble trade performance.

Changing Export Composition
and the Rise of Global
Production Networks

T

he differential in trade and growth performance reflects the fact that certain regions have been better placed—in partthrough the policies they adopted—to takeadvantage of new technologies and changes
in the nature of world trade. Not only has thevolume of international trade expanded in the
postwar period, but also its structure haschanged in three fundamental ways. First, exports of manufactured products from developing countries, and trade in manufactures
among them, have become increasingly important for all regions. Second, trade integration has allowed developing countries to specialize (most evident in the emergence of
production chains), with trade in intermediates becoming more important. This trend isalso evident in the role that new products
play in production. Finally, foreign direct investment is playing an ever-increasing role in
the integration process. These developments
have facilitated the integration of countries
that have adopted relatively open trade policies, and have increased the disadvantages
facing countries that have segmented themselves from global markets.

Specialization in manufactures
Manufactured products as a share of exports
increased strongly between 1981 and 2001 for
all regions (figure 2.5). Countries in East Asia
and later, Latin America and Eastern and Central Europe, have followed open development

46

strategies that have led to increasing exports,
especially of manufactures. The share of manufacturing in exports from East Asia, for example, increased from about 52 percent in
1981 to 88 percent in 2001, while the share in
Latin America tripled from about 20 percent
to 60 percent.
Trade has allowed manufacturers to exploit economies of scale, specialization, andscope. This is reflected in the growing shareof parts and components in total exports. In
the three more open regions—East Asia andPacific, Europe and Central Asia, and Latin
America and the Caribbean—parts andcomponents trade has surged. This international segmentation of production—“production chains” in which intermediate inputs are traded and transformed into more
processed intermediate inputs, which arethen moved across borders to the next stage
in production—has been a major factor driving the surges in intra-regional trade in
those areas.
One indicator of specialization is the import content of exports. To measure the roleof imported intermediates in trade, we calculated an index of vertical specialization,
which measures the share of the value addedof an export accounted for by imported intermediate inputs, either directly as imported inputs in the exporting sector or indirectly
through the use of imported inputs in the domestic production of intermediate goods usedby the exporting sector.12 Vertical specialization is most important in East Asia, and least
important in South Asia and Sub-SaharanAfrica (figure 2.5c).
The evolution of production chains andfiner division of the production processes
across countries, including developing countries, allows producers to exploit potential
efficiency gains from: (1) local increasing
returns to scale in the production of intermediate inputs, (2) regional differences in factor
costs for different parts of the production
process, (3) increased competition from awider market, and (4) technology transfer

R E G I O N A L

T R A D E

A N D

P R E F E R E N T I A L

T R A D I N G

A G R E E M E N T S

Figure 2.5 Composition of trade has changed
a. Manufactures have become increasingly important
Manufactures: Share of exports by region, %1981

East Asia and Pacific2001

Europe and Central Africa
Latin America and Caribbean
Middle East and North Africa
South Asia
Sub-Saharan Africa
0

10

20

30

40

50

60

70

80

90

100

Source: UN COMTRADE.
b. Parts and components have increased for all regions
Exports of parts and components
as a share of total exports (percent)

Import content of exports (percent)

16
14
12
10
8
6

c. Vertical integration with the global economy has
increased

1980 2002

4
2

Indirectan Eas
d tA
Pa s
ci ia
Eu ficC ro
en p
tra e aln
La Asia d
an ti
d nA
C m
ar e
ib ric
be a
an
an
M
d
i
d
N
or dle
th E
Af as
ric t
So a
ut
h
As
ia
Su
bSa
h
Af araric naDirectan Eas
d tA
Pa s
ci ia
Eu ficC ro
en p
tra e aln
La Asia d
an ti
n
d
C Am
ar e
ib ric
be a
an
an
d Mi
N dd
or le
th E
Af as
ric t
So a
ut
h
As
ia
Su
bSa
h
Af ara
ric n
a

0

50
45
40
35
30
25
20
15
10
5
0

Source: UN COMTRADE.

Sources: Data from GTAP (ver. 6.03) and World Bank for 2001.

d. New products propelled export diversification
Share of 1980’s bottom 10% of
manufactured exports in total intra-regional exports
50

Middle East and North Africa

45

Europe and Central Asia

40

East Asia and Pacific35

Sub-Saharan Africa

30
25
20
South Asia

15

Latin America and Caribbean

10
5
0
1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

Source: UN COMTRADE.

47

G L O B A L

E C O N O M I C

P R O S P E C T S

2 0 0 5Figure 2.5 (continued)
e. FDI flowed mostly into East Asia and Latin America

f. A positive trend between FDI and parts exports for theregions

Share of region’s net FDI inflows
in the region’s total investment (percent)Parts and components, FDI, GDP: 2000
FDI, percent of GDP
4.5
4.0

14

3.5

12

3.0

10

2.5

8

2.0

6

1.5

4

1.0

2

0.5

0

0

an Eas
d tA
Pa s
ci ia
Eu ficC ro
en p
tra e aln
La Asia d
an ti
n
d
C Am
ar e
ib ric
be a
an
an
d Mi
N dd
or le
th E
Af as
ric t
So a
ut
h
As
ia
Su
bSa
h
Af ara
ric n
a

18
16

LAC
ECA
EAP
SSA

SAS
0

MNA

Y  0.2333x  0.3067
R2  0.6801

2
4
6
8
10
12
14
Parts and components, percent of exports

16

Note: Period averages for 1980–1989, 1990–1999, and
2000–2002 calculated from annual data. Both net FDI (BoP)
and gross fixed capital formation are in current US dollars. For
1980–1989 in ECA, GFCF was estimated using a three-year
average share of GFCF in GDP over the 1990–1992 time period
and back-calculating GFCF from GDP for the entire 1980–1989
period. GDP time series (for 1980–1989 ECA only) obtained
from UN national accounts.
Sources: World Bank, WDI.

from developed countries embodied in imported intermediate inputs and backward
linkages through exports. The magnitude ofthese links between increased trade in intermediates and productivity growth in developing countries has been studied in both crosscountry analysis and country case studies.13
While causation is difficult to establish, theevidence indicates that such links are important, and productivity growth associated withincreased trade in intermediates is a potentially important source of growth.

Trade in new products
A large part of the expansion in exports incountries undergoing liberalization and successful trade expansion comes from productsthat were not traded—or minimally traded—prior to liberalization (see Kehoe and Ruhl
2002).14 Growth in trade in new products

48

Sources: World Bank, WDI, and UN COMTRADE.

may have the important advantage of allowing countries to escape the deterioration in theterms of trade that would come from trying toincrease market share in existing products.15
To assess this phenomenon, we reviewed thetrade performance of the least traded decile ofproduct categories. In East Asia and Pacific,
those products that figured in the lowest 10
percent of all EAP manufactured exports to theworld in 1981 grew to almost 40 percent by
2001 (figure 2.5). For the other five regions,the performance of products among their lowest initial 10 percent was also noteworthy.
Countries are building dynamic new markets
for their existing exports and developing new
variations of old products to replenish the
product cycle. This trend is also associatedwith increased trade in intermediates; detailed
analysis indicates that many of the new export
goods are intermediate inputs. Increased tradeR E G I O N A L

T R A D E

A N D

P R E F E R E N T I A L

in new products is thus part of the virtuous circle linking trade and growth.

Preferential Trade andRegional Outcomes

Investment, handmaiden of trade

M

Foreign investment has been a driver ofintegration, increased trade in manufactures,and vertical specialization. As tariff barriers
have come down in manufactures, marketseeking, horizontal FDI that once led the way inthe import-substitution process has faded in importance relative to efficiency-seeking, vertical
FDI that looks to locate segments of productionin the lowest-cost site. This form of investment
is associated with the rise in production chains
and trade in components and parts.
FDI has increased as a share of GDP in all regions. This trend abated somewhat since theEast Asia crisis in 1997–98 and the global recession of 2001–02, but FDI growth is likely toresume with the recovery of the global economy in 2004. East Asia and Latin America—
the largest markets—have had and haveretained by far the largest shares of FDI
throughout the period (figure 2.5).
In East Asia and Pacific, the increase in FDI
supported the pattern of segmentation and relocation of production processes within the region. In the 1990s, a large part of the FDI into
Latin America was due to the privatization
process the region underwent during this period. There is broad correspondence between
FDI trends by region and the share of parts andcomponents intermediates in regional exports.
Technology transfer from developed to developing countries is linked to trade, especiallythrough trade in manufactures and intermediates, and also through foreign direct investment.16 The better economic performance ofEast Asia and Pacific can be seen as resulting
from the emergence of a “virtuous circle” orsynergy between increased specialization in
production, increased trade in intermediates,
increased foreign investment, increased factor
productivity, and increased growth. Thisregion started earlier and appears more successful than other regions in achieving and sustaining this virtuous circle.

T R A D I N G

A G R E E M E N T S

any historical factors, not just preferential trading arrangements, contributed
to these trends. In the next chapter we provide
a more detailed analysis of the impact of RTAs
on trade. Here we simply highlight that the nature of RTAs and the context in which they
have been applied have varied enormously
across regions and that regional agreements
often follow, rather than determine, changes inregional trade patterns. This suggests that preferential trade agreements are just one of manyfactors affecting trade outcomes and that when
implemented in a highly restrictive economic
environment, they are usually inconsequential.

History shapes trading patterns
Differing regional performances in trade andgrowth have roots that go deeper than justboundaries on a map. Trade patterns—who
trades with whom—have grown out of longpolitical and economic histories that preceded
the trends evident in the last two decades. The
clusters of trading partners often bear little relationship to arbitrary definitions of regions(see Anderson and Blackhurst 1993, for an earlier analysis). Major trading blocs—that is,
those countries that trade more with each otherthan with those outside their group—emerge
from a cluster analysis. These blocs are not defined as traditional geographic political regions, but rather by statistical patterns in tradeflows over decades.

The bipolar world of the 1960s
Coming out of the postwar period, the structure of world trade by the 1960s reflected abipolar world, in which Europe and theUnited States had effectively formed blocs
with some of their close neighbors, former
colonies, and/or cold war partners; and with
hub-and-spoke links to most of the developing
countries. The two leading world trade blocs
effectively accounted for 80 percent of global
trade (figure 2.6). The European bloc was49

Figure 2.6 Evolving trading blocs
In the 1960s, the European Union and United States dominate trade . . .
1960sPercent
60

Asia-U.S.

52.7

50

Asia-UK
U.S. 
Europe 

40

29.9

30
20

10.3

10

7.1

0
Europe 

U.S. 

Asia-UK

Asia-U.S.

. . . but by the 1970s, Japan and Korea begin to lead an East Asian bloc . . .
1970sPercent
50

44.9
Rest

South America
East Asia
North America 4030Europe 

24.1

19.7

20
10

2.7
0
Europe North
America 

East andSouth
East Asia

South
America. . . a decade later, the East Asian Tigers, ASEAN countries, and Australia consolidate the East Asia bloc . . .
1980sPercent
60
48.3

50

Rest

South America
East Asia
North America Europe 

40
30

18.8

20

23

10

2.8

0
Europe North
America 

East andSouth
East Asia

South
America. . . and in the 1990s, ECA emerges and East Asia trades more with itself than with the U.S. and EU.

1990s

Percent
50
40
30

45.8

Rest

AndeanSouth Africa 
MERCOSUR
East Asia
North America Europe 
27.2

19.9

20
10
1.6
0
Europe North
America 

East and MERCOSUR
South
East Asia

Source: Robinson and Diaz Bonilla 2004.

50

R E G I O N A L

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closely linked with countries in Africa and former colonies. The United States was closely
linked to Latin America.17 Britain still retained leadership in a small Asian cluster consisting of former colonies, China, and the restof the Middle East, much as the United States
led a cluster of countries closely linked to thepost-WWII political order in the Pacific—
Indonesia, Japan, Korea, and Taiwan. The dependent developing countries traded much
more with Europe or the United States, andnot as much among themselves.

The realignment and the emergenceof East Asia in the 1970s and 1980s
In the 1970s and the 1980s, a realignment ofworld trade began. The European and U.S.
blocs fragmented in the 1970s, and their dominance dissipated to 65 percent of global trade.
The East and Southeast Asian countries left theEuropean bloc and effectively formed a new
bloc (East Asia).18 This bloc consolidated in
the 1980s, increasing the share of within-bloctrade and expanded membership to include
Australia and New Zealand. Its export share
shifted toward the United States (36.2 percent
in the 1980s compared to 26.4 percent in the
1970s). It also represented a growing share of
total world trade—23 percent in the 1980s
compared to 16 percent in the 1970s.

Consolidation and diversificationin the 1990s
By the 1990s, earlier trends blossomed into a
tri-polar world. One new element was thebreakup of the Soviet Union and Moscow’s
central management of trade in Eastern
Europe. Trading patterns began gravitating
toward the EU. A second new element was
the emergence of a new grouping: Argentina,
Brazil, Paraguay, and Uruguay (i.e., MERCOSUR).19 Finally, detailed analysis indicates a
nascent bloc forming around South Africa,
including the SACU countries.
These global trading patterns are revealing:First, today’s tri-polar world of global commerce does not signify that the world is evolving into three disparate, autarchic trading

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blocs. To the contrary, trade among these blocs
is intensifying, becoming more diversified, andlinked with a web of business ties acrossoceans that bind the world market together.
Second, in the 1990s, the emergence of newpoles of commerce—MERCOSUR and South
Africa—indicates that the process of segmentation and new bloc formation in world trade isstill evolving. Third, it is clear that many of theemerging preferential arrangements have deeproots in historical trading patterns, but thatsome of the more recent bilateral FTAs aregoing beyond these historical patterns.

RTAs in different regions havedifferent impacts
Patterns of regional integration tend to confirm
the view that usually trade has preceded trade
agreements. For East Asia, integration with theglobal economy was a strong impetus for regional integration. Exports to the world produced demand for imports from neighboring
countries. As Korea matured and China
opened, internal regional growth assumed its
own dynamic. As a share of GDP, intra-regional
trade in 2002 was 26.5 percent, twice as high as
in the next highest region, yet regional tradepreferences were very modest at best.
In fact, regional preferential tradingarrangements followed rather than preceded
this regional integration. The ASEAN Free
Trade Area (AFTA), established in 1992, accelerated these tendencies and contributed toSoutheast Asia’s integration, but much of thetariff reduction has accompanied rather thanpreceded these patterns of regional integration. However, ASEAN leaders accepted in
the Bali Declaration the need to pursue deeper
integration and to create a single market toenhance the competitiveness of the region.
The importance of preferential trade in the region was dramatically increased by the signing of a FTA between ASEAN countries andChina.
Regional arrangements were critical for the
successful integration of Eastern Europe into
the world economy, but have not been as
successful in the CIS countries. With the51

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assistance of the EU in its Europe Agreements
and with the aspiration of WTO membership,
the Eastern European countries have moved
swiftly toward integration. The CIS has beenburdened with incomplete reforms, a poor investment climate, and a plethora of tradingarrangements that have been implemented
only partially. The combination has weighed
down the subregion’s performance.
In Latin America, the intra-regional shareof exports in GDP in 2002 remains only onefourth of East Asia’s share. Since the 1960s,
with the formation of the Latin America Free
Trade Area (LAFTA), the region has struggled
to expand trade. This proved futile as long asimport substitution policies were in place andstate enterprises were used as instruments ofindustrial policy. Early attempts in Central
America and the Andean countries failed because of the inherent difficulty in managing
potential trade diversion and location of industries within the regions behind high external protection barriers.20
This situation changed with the wave of
unilateral reforms in the 1985–95 period.
Mexico’s reforms paved the way for the latercreation of NAFTA in 1994, and reforms in
Brazil and Argentina led to the creation of
MERCOSUR in the same year. Similarly, theCentral American countries, with a second go,
managed to put in place a successful common
market in the 1990s. As a result, intraregional
regional trade has proceeded pari pasu withgrowth in the external markets.
In the Middle East, intra-regional trade has
failed to gain dynamism. Because countries
begin with broadly similar production andexport structures, the scope for using regional
trade to establish patterns of specializationand diversification in manufacturing production is limited. Intra-regional trade cannot be
a substitute for extra-regional trade.
Several countries signed bilateral trade
agreements with the EU as part of the EuroMediterranean agreements. Jordan and
Morocco also signed agreements with theUnited States. All countries in the region

52

entered into the Pan-Arab Free Trade Agreement and most participated in the sub-regional customs union, the Gulf Cooperation
Council. Even so, these agreements have notbeen sufficient to overcome the effects of highborder barriers and restrictions on services.
The Euro-Med agreements with the EU havefallen short in their aspirations because of restrictions on trade in agriculture, services, andlabor; lack of harmonization of standards;
and stringent rules of origin.21
Regional agreements in South Asia, as with
Latin America in the 1960s and 1970s, floundered on the shoals of high protection. The
1993 South Asia Preferential Trade Agreement(SAPTA) was stillborn, given continuing highlevels of protection, a lack of meaningful concessions, domestic political problems, hostility
between India and Pakistan, India’s ban on
imports of all consumer goods (from SAPTA
countries until 1998 and from the rest of theworld until 2001), and India’s control overmajor primary goods (Baysan 2004).
Recently, however, unilateral trade reforms
in India and Pakistan, political rapprochement,
as well as concerns about rising preferential
tariff arrangements in other parts of the world,
led to the formation of the SAFTA Agreementin January 2004 (Newfarmer 2004).
In Sub-Saharan Africa, regional trade
agreements are common and reflect an aspiration to overcome the limits that small sovereign states impose. These include SACU—
one of the oldest customs unions in theworld—CEMAC, COMESA, ECOWAS, andthe East African Community. Although average applied MFN tariffs were cut by half between the 1990s and 2003, non-border barriers restrict internal trade. The recent regional
trade agreements have had more impact on
outward-looking MFN trade liberalization,and thus on external trade, than on intraregional trade. The economic impact of these
agreements appears to have been small, especially compared to pre-independence arrangements that essentially validated existing economic links (SACU, the West African

R E G I O N A L

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Economic and Monetary Union, and
CEMAC). The EPAs under negotiation with
the EU may reinforce this outward-looking
pattern of trade integration, but the hope isthat they will also aid Africa’s own regional
integration if they succeed in fostering economic reform and performance.22
The situation is different for agriculture
and food products. Here margins of preference are more substantial in all regions except
South Asia. The average margin of preferencein the high-income region is similar to that in
East Asia, Eastern Europe, and Latin America.
Again, preferences are greatest in those regions showing the lowest degree of regional
integration—the Middle East, and SubSaharan Africa.
Trade preferences have had very little impact on the high levels of intra-regional tradein manufactures in East Asia and Eastern
Europe. Regions that offer substantial tradepreferences behind high external barriers havenot fared well in stimulating the growth of
intra-regional trade.

ConclusionDeveloping countries have increased theirshare of global trade as multilateral tradenegotiations have led to sustained reductions
in border protection for manufactured products. At the same time, and for a variety of reasons, the preferential trade agreements haveproliferated. While the number of preferential
agreements has increased rapidly, their trade
coverage is substantially less than their official
span of influence. Because many tariffs havecome down close to zero, rules of origin restrict preferential access, and many products
within agreements are excluded. Nonetheless,
RTAs are leading to a more complex trading
system and inefficiencies in customs administration; high tariffs in certain regions still risk
significant trade diversion.
Notable differences are emerging between
North-South bilateral agreements and SouthSouth arrangements. North-South agreements

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A G R E E M E N T S

are considerably more ambitious in content
and coverage than South-South arrangements
and reach deep behind the border to include
services, protection of investment rules, andintellectual property rights.
In general, the wave of preferential tradingarrangements followed—rather than preceded—an intensification of regional trade. Regionswith the lowest external (MFN) border barriers ironically have developed the deepest
intra-regional links and have been best positioned to diversify and exploit the emergenceof global production chains in the manufacturing sector. East Asia is the starkest example, but Eastern Europe, in the wake of the
dissolution of the Soviet Union, and Latin
America, with the end of import-substitution
industrialization, are not far behind.
What are the economic consequences ofthese arrangements? That is the subject of thenext three chapters.

Notes
1. The recent accession of 10 new members to theEuropean Union reduced the total number of RTAs inforce from 285 to 229.
2. In fact there are only 12 countries that are notrecorded as being party to a RTA, and many of theseare small islands and principalities. The 12 are American Samoa, Bermuda, Channel Islands, Guam, Isle ofMan, Monaco, Mongolia, N. Mariana Islands, Palau,
Puerto Rico, Timor-Leste, and the Virgin Islands.
3. We are indebted to Gaspar Fontini of the European Commission’s Directorate General for Trade forthis formulation.
4. The U.S. Trade Representative is required to officially notify the U.S. Congress of its intent to negotiate FTAs.
5. See Weintraub (2004) and Schott (2004) for amore detailed discussion.
6. In the course of this discussion, the EU is treatedas a single entity. For example, an EU-Mexico agreement is classified as bilateral.
7. The provision for regional cumulation in therules of origin, particularly full cumulation, will tend
to offset the hub-and-spoke system. See Brenton andImagawa (2004). The EU, following substantial criticism of the hub-and-spoke system that emerged inEurope in the late 1990s, moved to create panEuropean cumulation, although in terms of the more
limited partial cumulation.

53

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2 0 0 5

8. See Grether and Olarreaga (1999), who include
GSP preferences but a smaller sample of countries.
9. In other words, 88 percent of intra-regional
trade takes place among RTA partners.
10. This section benefited from the World Bank’s
regional chief economists at a workshop titled Regionalism, Trade and Development, May 5, 2004. Sadiq
Ahmed, Harry Broadman, Alan Gelb, Homi Kharas,
Mustafa Nabli, and Guillermo Perry made presentations that became the basis of this discussion.
11. The announced reforms were to reduce “supplementary duties” that were, in legal terms, additional
to ad valorem tariffs; the economic effect is to reduce
effective tariffs.
12. Hummels, Ishii, and Yi (2001) define an index
of vertical specialization (VS). For direct effects forcountry k:uAMX
VSk  Xk
where u is a 1 x n vector of 1’s, Am is the n x n imported coefficient matrix, X is an n x 1 vector of exports,
n is the number of sectors, and Xk is the sum of exports
across the n sectors. When indirect effects are added,uAM[IAD]1X
VSk 
Xk
the index becomes: , where I is the identity matrix and
AD is the n x n domestic coefficient matrix. Typically,
given data limitations, measures of vertical specialization are imperfect. For example, a sector which produces both for exports and domestic markets, which iscommon given the aggregation available for sectoral
data, is assumed to have the same production technology, particularly use of imported intermediates, forgoods sold in either market. Even with these limitations, the measures provide a good picture of thechanging role of trade in intermediates.
13. Winters (2004, 10–11) reviews the literatureon links between trade in intermediates and productivity growth.
14. See Kehoe and Ruhl (2002). They present limited empirical evidence and then suggest a theoreticalmodel that captures the phenomenon. Increased tradein new products is difficult to capture in standard models of world trade, so such models will tend to overstate terms-of-trade effects from changes in trade.
15. See Hummels and Klenow (2002).
16. Winters (2004) surveys work on the links between trade, productivity, and growth in developing
countries. See also Nishimizu and Robinson (1984),
and Esfahani (1991) who consider the links in semiindustrial countries. Schiff and Wang (2004) consider
the link between TFP growth and regional trade
links. Keller (2002) considers the mechanisms
involved.

54

17. The definition of “closely linked” is countries
that have such large trade shares with their bloc partners, particularly the United States and Europe, that
adding them to the bloc increases the average withinbloc trade share.
18. Plus one region, “rest of Middle East and North
Africa” (MENA), which is closely linked to Europe, but
has significant trade with East and Southeast Asia.
19. The within-bloc trade share for MERCOSUR
of 23 percent is lower than its trade share with Europe (27 percent), but given the increasing trend of its
within-cluster trade share and the legal formation of
MERCOSUR in 1995, it makes sense to designate it
as a bloc. Latin American countries fall into threegroups. One group is linked closely with North America, including RB de Venezuela, Colombia, and rest ofCentral America. The MERCOSUR countries define asecond group, a trade bloc with diversified exports(a slightly higher share to the EU than to the UnitedStates). Finally, the third group is a heterogeneous collection of countries (Peru, Chile, and Other AndeanPact) with exports largely to the EU, partly to Eastand Southeast Asia, and with little trade among
themselves.
20. IDB, Beyond Borders, 2002.
21. Chief Economist, MENA, 2004.
22. Chief Economist, Africa, 2004.

References
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Anderson, Kym, and Richard Blackhurst, eds. 1993.
Regional integration and the global trading system. New York: St. Martin’s Press.
Baldwin, R. 2003. Openness and Growth: What’s the
Empirical Relationship? National Bureau of Economic Research, Working Paper no. w9578.
Baldwin, R., and A. Venables. 1995. Regional Economic Integration. In Handbook of International
Economics, vol. 3, eds. Grossman and Rogoff,
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Baysan, T. 2004. South Asia: Lessons and the Way
Forward. Mimeo, World Bank, Washington, DC.
Bhagwati, J., and A. Panagariya, eds. 1996. The
Economics of Preferential Trade Agreements.
Washington, DC: American Enterprise InstitutePress.
Brenton, Paul, and Hiroshi Imagawa. 2004. Rules ofOrigin, Trade, and Customs. In Customs Modernization Handbook, Conference edition, eds.
Luc De Wulf and Jose Sokol. Washington, DC:
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Burfisher, Mary, Sherman Robinson, and Karen
Thierfelder. 2004. Forthcoming. Regionalism:
Old and New, Theory and Practice. In Agricultural Policy Reform and the WTO: Where Are
We Heading? Eds. G. Anania, M. E. Bohman,
C. A. Carter, and A. F. McCalla. Cheltenham,
UK & Northampton MA, US: Edward Elgar.
Destler, I. M., and Peter J. Balint. 1999. The New Politics of American Trade: Trade, Labor, and theEnvironment. Washington, DC: Institute for International Economics.
Esfahani, H. S. 1991. Exports, Imports, and Economic
Growth in Semi-Industrialized Countries. Journalof Development Economics 35.
Falkenberg, Karl F. 2004. EPAs and Doha Development Agenda—Parallelism or Crossroads
Trade Negotiations Insights 3, (July) (4).
www.ictsd.org.
Frankel, J. A., E. Stein, and S-J. Wei. 1996. Regional
Trading Arrangements: Natural or Supernatural?
American Economic Review 86, (2): 52–56.
Grether, Jean-Marie, and Marcelo Olarreaga. 1999.
Preferential and Nonpreferential Trade Flows inWorld Trade. In Trade rules in the making:
Challenges in regional and multilateral negotiations, 159–79. Washington, DC: Brookings
Institution Press and Organization of American
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Hinkle L., and M. Schiff. 2004. Economic Partnership
Agreements between Subsaharan Africa andthe EU: A Development Perspective on the Trade
Components, Africa Region Working Paper(draft). February, World Bank, Washington, DC.
Hummels, David, Jun Ishi, and Kei-Mu Yi. 2001.
The nature and growth of vertical specialization
in world trade. Journal of International
Economics (Netherlands) 54 (June) (1): 75–96.
Hummels, David, and Peter J. Klenow. 2002. The
variety and quality of a nation’s trade. National
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Kehoe, Timothy J., and Kim J. Ruhl. 2002. How
Important is the New Goods Margin in International Trade? University of Minnesota.
Keller, Wolfgang. 2002. Trade and the Transmission ofTechnology. Journal of Economic Growth 7, (1):
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Kiener, Christophe. 2004. Economic Partnership
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Mansfield, Edward D., and Jon C. Pevehouse. 2000.
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Newfarmer, R. 2004. SAFTA: Promise and Pitfalls ofPreferential Trade Arrangements. Background
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3
Regional Trade Agreements:
Effects on Trade

Regional trade agreements (RTAs) can havepositive or negative effects on trade dependingon their design and implementation. Analysis
in this chapter confirms that gains from a preferential trade agreement cannot be taken for
granted; moreover, even in agreements withpositive impacts on average incomes, not all
members are assured of increases. The interesting policy question then is not whether
RTAs are categorically good or bad, but what
determines their success?
The broader policy context in which an
RTA is designed and implemented is crucial.
Agreements that have been designed to complement a general program of economic reform have been most effective in raising trade.
When RTAs have tended to be fruitless, it isoften because of the lack of a coherent program of reform.
For an RTA itself, the most important
ingredient for success is low trade barriers
with all global partners. Most-favored-nation(MFN; i.e., nondiscriminatory) liberalization,
which creates more trade, is the fastest andmost efficient way to increase intraregional
trade. In addition, agreements that minimize
excluded products expand the scope for positive net benefits through competition andtrade creation.
Recent research has added nonrestrictive
rules of origin to the list of successful factors;
local firms must be able to effectively source
materials at the lowest cost. Such rules of origin are an essential element of agreements that

expand both regional exports and exports to
the rest of the world.1
RTAs can be a springboard to global markets, but here too, low MFN trade barriers arenecessary for success. RTAs can help countries
integrate with global markets, but no agreement provides guarantees, so design and implementation matter.

The Impact of RTAs on
Merchandise Trade and Incomes
RTAs cover much more than trade barriers
RTAs have increasingly been designed to covermuch more than formal trade policies (seechapter 2), and RTAs are signed for a varietyof reasons. The impact of these agreements on
trade determines the extent to which broader
political and social objectives are achieved. It
is difficult to identify an agreement that has
fostered wider political objectives withoutachieving economic integration. It is clear thatthe political context and broad economic environment in which integration takes place are
crucial for determining the trade impact. Success derives from a strong willingness to liberalize and to accept the subsequent economic
adjustments, accompanied by intense mutual
economic dialogue and communication andgenuine efforts toward mutual understanding.
Severe macroeconomic disturbances and a turbulent investment climate can easily disrupt
trade and derail an agreement.

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2 0 0 5The simplest measure of integration is thetrend in the share of imports from regional partners in the total imports of a region. Successful
regional agreements might be expected to increase trade between partners relative to thosecountries’ trade with the rest of the world. But
three important caveats need to be understood.
First, successful regional integration is typically accompanied by reductions in tariffs for
all partners. Hence, regional trade shares may
not rise even though the volume of regional
trade is increasing. Second, regional trade
agreements that provide for the removal or
reduction in trade costs other than those associated with formal trade policies (such as improved customs procedures), may stimulate
trade from all sources. Third, many agreements cover nontrade issues such as investment, services, and labor, and these can haveimportant consequences for growth andincomes. These are analyzed in subsequent
chapters, but it is important to bear in mind
here that an agreement may be successful even
if the propensity for members to trade among
themselves does not increase markedly.
Trade performance in several regional trade
agreements shows that the increase in intraregional trade shares of agreements signed in
the 1990s has been substantial (figure 3.1).
The share of intra-NAFTA (North America
Free Trade Agreement) trade rose from lessthan 35 percent in the late 1980s to almost

50 percent in 1999. Over the same period, theimportance of trade between MERCOSUR
members doubled from 10 to 20 percent.
For many of the agreements signed in the
1990s, intra-regional trade shares weregrowing strongly before the agreements weresigned (NAFTA, MERCOSUR, SAPTA,
SADC). There may have been some anticipation effect in the year or two before signing, but
this doesn’t explain trend increases in sharescommencing five or more years previous, as in
the case of MERCOSUR. In many cases this increase in regional trade reflects the impact of
unilateral, multilateral, as well as regional tradeliberalization and the fact that agreements
often follow growing trade relationships.
In Africa, the picture is mixed. The extent
of regional integration among the Common
Market for Eastern and Southern Africa(COMESA) members has been relatively static
over the past two decades. In contrast theshare of intra-area trade has increased substantially for Economic Community of West
African States (ECOWAS) since the early
1980s and for SADC since the late 1980s. In
East Asia, a region that has experienced substantial economic progress over the past 20
years, there has been little increase in intraregional trade shares.
Given these disparate results, it is necessary
to go beyond simple trade shares to identify
the economic impact of regional trade

Figure 3.1 Evolution of the share of intra-regional imports in total imports, 1960–2000
Percent

Percent

70

14

EC

SADC

60

12

50
40

8

30

4

10

2

00

96

20

92

19

88

19

84

19

80

19

76

19

72

19

68

19

64

19

60

19

19

00

96

SAPTA

0
20

92

19

19

84

19

80

19

76

19

72

19

68

19

64

19

60

19

Source: World Bank staff.

88

MERCOSUR

019

COMESA

6

ASEAN

CACM

20

58

ECOWAS10NAFTA

R E G I O N A L

agreements. Because a decline in the share of
extra-regional trade in total trade will be ofless significance if the total value of trade isincreasing, a logical (and commonly used)measure is the share of extra- and intraregional trade in regional GDP (figure 3.2).

T R A D E

A G R E E M E N T S: E F F E C T S

O N

T R A D E

With the exception of MERCOSUR, allregions that have experienced an increasing
share of intra-regional trade in total trade
have also seen the ratio of extra-regional
trade in GDP increase. The Association ofSoutheast Asian Nations (ASEAN) is an

Figure 3.2 The ratio of external and intra-regional trade to GDP
ASEAN

CACM

Percent

1992

1991

RevisedOriginal

30

CACM extra

25
ASEAN extra

20
Year of entry
into force

ASEAN intra

15
10

CACM intra

5

Percent
1994

COMESA extra

14

35
30

10

25

8

4

COMESA intra

2
0

00

96

20

92

19

88

19

84

19

Year of entry
into force

15
10

ECOWAS intra

5
20
00

19
96

19
92

19
88

19
84

19
80

19
76

19
72

19
68

19
64

19
60

20
00

19
96

19
92

19
88

19
84

19
80

19
76

19
72

19
68

19
64

0

NAFTA

MERCOSUR
Percent

Percent

1991

16

1994

7

14

NAFTA extra

6

12Year of
entry
into
force

MERCOSUR extra

10
8

5
4
3

00

96

Year of
entry
into
force

20

92

88

19

84

19

80

76

19

72

19

68

19

64

19

60
19

00

96

20

92

19

88

19

84

19

80

19

76

19

19

19

19

19

72

0
68

1

0
64

2

NAFTA intra

19

2

MERCOSUR intra

19

4

19

6

60

ECOWAS extra

20
Year of
entry
into
force

6

19
60

1975

40

12

19

80

ECOWAS

Percent
16

19

76

COMESA

19

72

19

68

19

64

19

60

19

19

00

96

20

92

19

88

19

84

19

80

19

76

19

72

19

68

19

19

64

0
19

60

50
45
40
35
30
25
20
15
10
5
0
19

Percent
1961
35

Source: World Bank staff.

59

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2 0 0 5Figure 3.3 Intra-regional trade grows faster when world trade growth is positive
Annual growth of intra-regional exports (percent)Annual growth of intra-regional exports (percent)

35

40

30

35

25

30

SADC

20
15

MERCOSUR

25
20

ECOWAS

10

ASEAN

15

COMESA

5

CACM

10
NAFTA

0

5

5

0

10

5
0

5

10

15

20

25

Annual growth of world exports (percent)

0

5

10

15

20

25

Annual growth of world exports (percent)

Source: World Bank staff.

interesting example. The share of intraregional trade remained fairly flat during the
1990s. However, the ratios of intra-ASEAN
trade to GDP and ASEAN imports from therest of the world to GDP have both increased
strongly. ASEAN appears to have been very
successful.
In general, this suggests that external openness and the expansion of intra-regional trade
go together. To take this analysis a little further,
we plot the estimated relationship between annual changes in intra-regional trade and annualchanges in the total volume of world trade, andwe find a positive association in all cases (figure 3.3). Although crude, this analysis suggeststhat the successful expansion of trade among
the members of a regional trade agreement
tends to be associated with increasing extraregional imports as a share of GDP and withthe growth of world trade.2

Do regional trade agreements
stimulate trade?
The analysis just discussed provides useful information, but it does not directly measure
the impact of regional trade agreements. To
isolate the role of policy—that is, RTAs—
from other factors influencing trade patterns
requires more sophisticated economic
modeling. Different, yet complimentary,

60

approaches are available that we can crudely
separate into ex ante general equilibrium simulation studies and ex post econometricanalyses by using the gravity model (box 3.1).
The broad results3 from general equilibrium exercises are that, first, excluded
countries almost always lose. Second, for developing countries the bottom line determinant of positive income effects is the increasein market access. Third, in Free Trade Areas(FTAs) each country can always lower its tariff to ensure gains. This may be more difficultin a customs union. Finally, regional trade
agreements are typically expected to create
more trade than they divert, although this is
not always the case.
These points are highlighted in figure 3.4,
which summarizes model estimates of the impact of Chile signing FTAs with different regional groupings. Excluded countries lose inevery case. Chile loses from an FTA with
MERCOSUR. FTAs with larger markets
bring bigger gains for Chile but also tend toentail larger losses for excluded countries.
Large northern countries gain little from
FTAs with substantially smaller southern
partners.
A number of analysts have concluded thatthe numerous estimates from the gravity
model generally support the contention thatR E G I O N A L

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Box 3.1 A primer on modeling of RTAs
A. Simulation studies: Looking forward to potential
gains
The ex ante studies are based on a specific generalequilibrium model structure that allows a rich analysis of the impact of RTAs at both the aggregate andsectoral levels. A key strength of this approach is its
ability to highlight which sectors may expand andwhich may contract in the face of given resource
constraints. The richness of the model structure,
however, requires that many key parameters be
selected, (often on the basis of an extensive literaturesearch), with others being derived by a process ofcalibration to a single base- year observation; that is,
the remaining parameters are derived such that themodel replicates the situation in the base year. To alarge extent the results of the impact of RTAs are
determined by the choice of value for key relevant
parameters (in this case the price elasticity ofdemand for exports). Also, given that parameters arechosen and not estimated, the statistical properties of
the results are unknown.
The characterization of RTAs is often simple,
with most studies focusing on the removal of tariffs
but ignoring issues such as the rules of origin, product exclusions, and services. These simulation exercises answer the question, “What would be the impact of the preferential removal of tariffs against alimited set of trade partners, given the assumed
model structure?” But they do not tell us whether
particular agreements have actually created ordiverted trade.
B. Econometric studies using the gravity model:
Looking back at actual performance
The gravity model provides a useful framework
for assessing the impact of policy variables on the
behavior of bilateral flows between countries. Its
name is derived from its passing similarity to
Newtonian physics, in that flows between two
countries increase in proportion to their economic
mass (as measured by GDP) and are constrained by

RTAs create trade.4 This merits further analysis. Differing studies have produced sharply
different results for the same agreement. For
example, Bayoumi and Eichengreen (1997)
find no evidence of trade diversion fromthe friction between them (due to trade and othercosts, which is proxied by distance). It is also common to use so-called dummy variables to capture geographical effects (such as whether the two countries
share a border, or if a country has access to the sea),cultural and historical similarities (such as if two
countries share a language or were linked by pastcolonial ties), and regional integration (such as belonging to a free trade agreement or sharing a common currency). A disadvantage of using dummy variables is that they may capture the impact of a rangeof other effects that occurred during the same time
period as the RTA. For example, most applications
do not distinguish the extent of multilateral trade liberalization. Ideally, specific trade policy variables
would be included in the estimating equations, suchthe level of multilateral and preferential tariffs. However, the complexity of preferential trade arrangements precludes such an approach. A notable exception is the study done by Estevadeordal andRobertson (2004), who included a measure of preferential tariffs in their analysis of the impacts of RTAs
on regional trade in Latin America.
Although widely used because of its empirical
success, the gravity model had lacked rigorous theoretical underpinnings and was long criticized forbeing an ad hoc model. Recent theoreticallygrounded gravity equations are derived from models
with strong constraints on preferences and technology, which undermines a straightforward interpretation of some of the estimated coefficients. Anderson
and van Wincoop (2004) provide a good overview ofthis debate. Another weakness of many applicationsof the gravity model is the proxying of trade costs by
distance, and the implicit assumption that cargoes
traveling 1,000 miles in Africa face exactly the same
trade costs as similar cargoes traveling 1000 miles in,
say, Europe.
Sources: Inter-American Development Bank 2002 and Bank staff.

enlargement of the European Union (to include Greece, Portugal, and Spain), whereas
Wei and Frankel (1995) find “massive trade
diversion.” One way to digest this contradictory literature is to combine and assess these61

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2 0 0 5Figure 3.4 Simulated welfare impact ofvarious FTAs involving Chile
Change in welfare ($)
2500
2000

Other
included

1500

Regional trade agreements and exports tothe world

Chile

1000
500
0
500

su Nafr  ta
EU 
M

er

co

M Na
er fta
co 
su
r

AF
N

M

er

co

su

r

TA

Sum for excluded

1000

Source: Harrison et al (2004).

results in a single statistical analysis, called
meta-analysis (box 3.2). This meta-analysis of
the literature on the impact of regional trade
agreements on intra- and extra-regional trade
indicates that although agreements typicallyhave a positive impact on intra-regional trade,their overall impact is uncertain. Actual
experience reinforces that there can be nopresumption that a preferential trade agreement will be trade creating.

Do regional trade agreements benefit
all members?
The attention in most of the econometric studies is on the impact of particular RTAs. Few
studies have sought to estimate the impact of
RTAs on individual members. This is despite
the fact that studies of agreements that failed
in the 1960s typically identify the lack ofmechanisms for redistribution in the presenceof asymmetric impacts as a crucial factor creating political tension and undermining commitment to the agreement (Greenaway andMilner 1990). We estimated gravity equations
that identify impacts for individual members
for each of 17 different regional trade agreements to determine whether the statistical evidence suggests that the agreement has createdtrade, diverted trade, or had no significant net
effect on trade for each country.

62

For none of the agreements do we find unambiguous evidence of a net trade-creating
effect extending to all members.5 Thus even if
an agreement as a whole creates trade, it isimportant that there are mechanisms to ensurethat all members benefit.

So far the analysis has concentrated onwhether increases in intra-regional trade following the signing of a RTA are associatedwith falling imports from the rest of the world
relative to a scenario in which the RTA wasnot signed. It is equally important to ask how
regional agreements can be used as part of abroad approach to openness and especiallywhether they can provide a springboard to
global markets for local exporters.
Applying the gravity model with an additional variable to capture overall exports of amember of a particular set of RTAs, we canassess whether these countries tend to export
proportionately more than would “normally”
be the case for a similar country that was notparty to the agreements.6
These results, based on a sample period of1948 to 2000, show that different agreements
are associated with different propensities
for higher-than-“normal” overall exports(figure 3.5). AFTA, EC, GCC, MERCOSUR,NAFTA, and SACU all appear to export significantly more than they would have done in theabsence of the agreement. The countries thatcomprise these regional groups appear to haveadopted policies that led them to be more
export-oriented than they otherwise would
have been. We cannot say, however, that it was
the RTA alone that led to these policies. The
variables that pick up changes in trade flows
may be capturing the effects of unilateral andmultilateral trade policies. Other agreements—
CEMAC, CIS, COMESA, EAC, ECOWAS,
and WAEMU—show a propensity to export
significantly less than “normal.” The Andean
Community and SADC appear to export lesswhen the whole sample period is considered,but not when the analysis is confined to themore recent sub-period, from 1980 to 2000. In

R E G I O N A L

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Box 3.2 Regional trade agreements in gravity models:A meta-analysisM

eta-analysis provides a means of assessing andcombining empirical results from different
studies. The approach takes as individual observations the point estimates of relevant parameters fromdifferent studies. This set of observations is then used
to test the hypothesis that the relevant coefficient isstatistically different from zero. Here we are concerned with two parameters. The first measures theimpact of the agreement on total imports (which welabel overall impact); a negative value for this parameter suggests that for the agreement concerned, thelevel of trade between a member and any other country is less than the normal level of trade that one
could expect. Thus a negative value is evidence oftrade diversion. The second parameter captures theimpact of a regional trade agreement on the level oftrade between partners (internal impact). In our
analysis we have included 254 estimates of overall
impact and 362 estimates of internal impact from17 research studies. The table below reports themean value of the overall and internal impacts, thestandard deviation, the number of statistically significant estimates, and the total number of estimates ofeach impact.
Of the estimates of the overall impact, 76 percent
are statistically significant, 42 percent are negativeand significant, and 34 percent are positive and significant. For the internal impact, 66 percent of theestimates are statistically significant, 54 percent are
positive and significant, and only 12 percent are negative and significant. The mean estimate of the overall impact is negative. The most robust estimates ofthe overall impact are negative. The mean value ofthe internal impact is positive. For both parameters
there is a high degree of variance about the meanvalues. Within this analysis the estimates of 19 regional agreements were assessed; 10 exhibited on
average net trade diversion.

Summary of the estimates by regional trade agreement
Overall impact

Total

Mean
Value
0.31

Standard
error
1.12

Significant
estimates
194

Internal Impact
Total
estimates
254

Mean
value
0.79

Standard
error
1.30

Significant
estimates
238

Total
estimates
362

Source: World Bank staff.

that period, the Andean Community also
appears to have been more export-oriented
than they otherwise would have been, perhaps
reflecting substantial trade policy revisions.
Most of the agreements in which export
propensities are lower also appear to generate
fewer imports than would “normal” countries
not participating in the agreements (CEMAC,
CIS, COMESA, EAC, WAEMU). At the sametime, those agreements that appear to be more
export-oriented tend to be more open to imports (AFTA, EC, GCC, MERCOSUR since1980, NAFTA, SACU). In many cases, there
has been a strong impact on intra-regional
trade. In general, members of regional agree-ments that have been relatively open to imports have shown higher propensities to export
to the global market than would otherwise be
expected. Elsewhere, intraregional trade has
been initiated, but imports have been diverted
and exports suppressed.

The potential gains from larger markets
and higher growth
Trade of RTA members will be affected
through the changes in trade policies that takeplace, but will also change if there is an improvement in technology, higher investment,
and a higher rate of growth. By crudely using
dummy variables, gravity models provide a

63

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2 0 0 5Figure 3.5 RTAs that divert imports tend to export less to global markets
SACU
NAFTA
EC
CACM
ECOWAS

Overall imports
Intra-regional trade

Overall exports

GCC
AFTA
ANDEAN
CEMAC
Mercosur
SADC
SAPTA
CIS
EAC
WAEMU
COMESA
4

2

0

2
4
Estimated exponential impact on trade

6

8

10

Note: The bars show the magnitude of the dummy variables capturing respectively the extent to which intraregional trade, overall
imports, and overall exports differ from the “normal” levels predicted by the gravity model on the basis of economic size, proximity,
and relevant institutional and historical variables, such as a common language.
Source: World Bank staff.

measure of RTAs, which catches all of thesefactors through their impact on trade but cannot distinguish the precise mechanisms. Complementary approaches look at the impact of
RTAs on these other factors.
Berthelon (2004), using cross-country regressions to estimate the effects of RTAs on growthduring 1960–99, found that RTAs that enlarged
the market substantially had substantial positive effects on growth. The results suggest, forexample, that the FTA signed between Chileand the EU might be expected to increase thegrowth rate in Chile by 0.6 percentage points
and in the EU by 0.005 percentage points. The
larger market permits wider competition, larger
scales, and greater specialization, all of which
increase productivity and growth. South-Southagreements face an uphill struggle in two respects: they generally entail much smaller markets, and they have less scope for realizing thegains from comparative advantage that different factor intensities would otherwise bring.

64

RTAs can also affect growth through technological transfer. Trade raises total factor
productivity by providing access to a wider
and more advanced range of technologies. The
productivity of an importing country can increase through the importation of intermediate goods, which as a result of R&D in theexporting country, are either new and/or of
better quality relative to existing products. In
this way a country that is open to trade canbenefit from R&D activities undertaken overseas. RTAs will have a positive effect if theystimulate imports from technological leaders.
On the other hand, if the trade agreement
leads to trade diversion away from more
technologically advanced sources of inputs,
then there could be a negative impact on
productivity growth.
Schiff and Wang (2003) found that, for Mexico, trade with NAFTA partners had a large andpositive impact on Mexico’s total factor productivity (TFP), while trade with the rest of theR E G I O N A L

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Box 3.3 Implementation matters
The European Union and agriculture
The founding treaty (the Treaty of Rome), and subsequent replacements, commit the European communities to “the harmonious development of world trade,the progressive abolition of restrictions on international trade, and the lowering of customs barriers.”
The European Union (EU) has failed to meet theseobjectives for agricultural products. There is little
doubt that EU agricultural policy has been the sourceof considerable disharmony among trading partners.
Movement of Moldovan wine through Ukraine
Moldova is a major producer of wine. Although it
has a free trade agreement with Russia, its mainmarket, it costs more to ship a case of wine from
Chisinau to Moscow than from Australia to Moscow(UNECE 2003). Why? Moldovan wine must passthrough Ukraine, usually by rail. Although the twocountries are party to the CIS free trade agreement,
which provides for fair treatment in transit, theUkrainian authorities, in addition to imposing delays
and requiring unofficial payments, recently introduced an additional requirement that bulk wines
must be transported in specially heated railway
wagons, although a clear rationale for this is difficult
to ascertain (World Bank 2004).
ASEAN and exclusions from preferences
ASEAN members initially were allowed to exclude
certain products from tariff reduction, a right thatthey exercised liberally. In many cases the tariff
reductions offered were of very limited value to othermembers. Thailand’s offers, for example, included
wood products that it did not import and that othermembers did not produce. Malaysia’s list of productsOECD did not. They suggest that this is because
Mexico not only benefited from the content oftrade with the NAFTA partners, the country
also experienced closer contact and more information exchanges, especially among subcontracting firms, which are more integrated into
the production networks of their Northern partners than was the rest of the OECD. They simulate the impact of NAFTA as a consequence andfor tariff cuts included a number of rubber productsof which it was a major exporter. Indonesia, whichlies on the equator, offered a 10 percent cut in the
duty on snow plows (Balasubramanyam 1989).
More recently, the trade elements of the agreement
have been intensified with the launching of the AFTA(ASEAN Free Trade Area), the aim being to create agenuine free trade area. In 1995 the deadline forfully implementing AFTA was reduced from 15 to
10 years, although there has been some backsliding
recently from agreed tariff-reduction schedules.
SADC and rules of origin
SADC initially agreed to simple, general, and consistent rules of origin similar to those of neighboringand overlapping COMESA. The initial rules required
either a change of tariff heading, a minimum of
35 percent of value-added within the region, or a
maximum import content of 60 percent of the valueof total inputs. Subsequently, however, the rules wererevised to include more restrictive sector- andproduct-specific rules. The requirement concerningchange of tariff heading has been supplanted by detailed technical-process requirements, a much higher
domestic value added requirement, and lower
permitted import contents. The rules became much
more similar to those of the EU and of NAFTA,
reflecting in part the influence of the recently negotiated EU-South Africa agreement and the rules oforigin governing EU preferences to ACP countries(Flatters and Kirk 2003). This example illustrates
how sectoral interests and misperceptions of the roleand impact of rules of origin can undermine RTAs.
Source: World Bank staff.

find that it has led to a permanent increase in
TFP in Mexican manufacturing of between
5.5 percent and 7.5 percent.
In a later study, Schiff and Wang (2004)
look at the dynamic impact of North-South
trade on technology diffusion to Korea,
Mexico, and Poland from the EU, Japan, andNorth America. Using industry level data,
they found that technology diffusion and65

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2 0 0 5productivity gains tend to be regional. A
possible reason for this being that knowledge
diffusion is also governed by close contacts
and the hands-on relationships that are more
likely with neighbors. Nevertheless, for all
countries the biggest impact of trade on
TFP can be guaranteed by removing tradebarriers on knowledge-intensive goods fromall countries.

Figure 3.6 Not all regions are open
NAFTA
AFTA
SADC
EAC
MERCOSUR
COMESAECOWAS
SAPTA

Ingredients of Success
Open regions do better
RTAs are only effective for developing countries if implemented in conjunction with morecomprehensive domestic reforms. At the sametime, a successful RTA will contribute to theoverall economic impact of that reform program. In Europe, the eight Central and Eastern European countries that recently joined
the EU experienced strong growth in tradeand investment inflows during the 1990s; yet
two countries in the region, Bulgaria andRomania, having almost identical trade agreements with the EU but much less extensive domestic reform programs, saw a much weaker
trade and investment response. Regional integration initiatives in Latin America in the
1990s have been much more effective thanearly efforts, reflecting broad and credible
structural reforms in many countries (Devlin
and French-Davis 1999). Given this context,
there are a number of key features of RTAs
that are likely to contribute to favorable tradeoutcomes.
The external trade regime is a crucial determinant of the success of RTAs for several
reasons. First, trade diversion tends to fallwith the level of the external tariffs maintained by member countries after they form apreferential trade agreement. The negative
effects of trade diversion are offset or overcome if the preferential removal of trade barriers against some countries is accompanied
by a degree of liberalization to all countries,
whether undertaken unilaterally or throughmultilateral negotiations. If a country that enters into a free trade agreement increases its
imports from all countries, not just its

66

0

5

10
15
Average tariff

20

25

Note: Tariffs are import-weighted at the country level toarrive at PTA averages.
Source: UN TRAINS, accessed through WITS.

partners in the agreement, then it will experience an improvement in economic welfare.
Therefore, countries forming preferential
trade areas should simultaneously reduce thelevel of external protection facing nonmember
trading partners. Risks of trade diversion are
particularly high in the newly proposed South
Asian Free Trade Area (SAFTA); (figure 3.6).
Second, where there are asymmetries in thelevel of external protection, it is importantthat the high-duty country reduce tariffs toavoid an adverse terms-of-trade shock. This isparticularly relevant for developing countries
seeking to sign agreements with the EU or theUnited States. In developed countries where
tariffs on manufactured products are rather
low (and high-duty agricultural products are
typically excluded from regional preferences),
trade diversion and trade creation are lesslikely to be significant. Thus with no trade
being created in the developed market, the decline in domestic sales by firms in the hightariff developing country may not be offset bya rise in exports to the developed country.
Overall, the demand for goods produced in
the high-tariff country may fall, and its termsof trade could worsen.
Third, low MFN tariffs (and nonrestrictive
rules of origin) ensure that producers within
the regional trade agreement will have accessto competitively priced inputs. In today’s

R E G I O N A L

globalized market, policies that significantly
raise the input costs of producers will constrain their exports to both regional andglobal markets. Regional integration is more
likely to be successful if it is achieved on thebasis of strong competition and ease of accessto low-cost inputs.
Trade liberalization is a crucial mechanism
for increasing competition in domestic markets. Where it is not politically feasible toopen up broadly to all external suppliers, a regional approach can provide a stepping stone
toward the benefits of comprehensive liberalization. However, it is important to take thesecond step: Even in a large region such as theEU, competition from within the region has
been found to be much weaker than that provided by external imports. Jacquemin and
Sapir (1991), for example, found that profit
margins in European countries were significantly dampened by external imports but not
by intra-regional imports. And collusive
agreements are more difficult to enforce forcompanies based in distant locations. Firms
that face little competition in local and regional markets will have low incentives toachieve the efficiency necessary to compete inworld markets.
Clearly RTAs may affect the setting of external tariffs. This is true by definition in thecase of a customs union and indirectly true inthe case of a free trade area. Recent researchfinds that World Trade Organization (WTO)
members do not appear to have more liberal
external trade policies than non-WTO members (Rose 2004), and that membership in a
RTA has, on average, no clear effect on a country’s trade policy (Nitsch and Sturm 2003).
Foroutan (1998), on the other hand, concludes
that countries in effective regional groupings,
distinguished by the growth of intra-area
trade, have undertaken more far-reachingtrade liberalization. However, there are casesof liberalizing countries that did not belong toan RTA and of countries in an effective RTA
that did not liberalize trade policy. The conclusion is that the acceptance of a liberal trade
policy may be a requirement for the survival

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and deepening of a meaningful RTA, whereas
belonging to a regional scheme constitutes neither a necessary nor a sufficient condition for
an open and liberal trade regime.
In the 1960s and 1970s, preferential agreements among developing countries were typically accompanied by high external tariff barriers as part of an import substitution strategy.
In contrast, agreements among more developed countries in the same period were more
often associated with declining external barriers. For example, the simple average externaltariff of the original six members of the European Union fell from 13 percent in 1958 to
6.6 percent after the Kennedy Round of General Agreement on Tariffs and Trade (GATT)
negotiations. Agricultural products were excluded from these reductions, reflecting their
exclusion from GATT negotiations until the
Uruguay Round. The failure to reduce agricultural tariffs in Europe led to substantial trade
diversion in agriculture with significant welfare losses for European consumers, especiallythe poorest, and a considerable hardship forpoor farmers in developing countries.
Many developing countries have since reduced external tariff barriers both unilaterally
and through multilateral negotiations. As aresult, recent preferential agreements among
many developing countries have been introduced or revamped with lower external barriers. This is particularly true in Asia and Latin
America, where preferential and MFN tariffs
declined in tandem after 1985, so that margins
of preference remained stable or were slightly
compressed (figure 3.7).

Paper agreements are not enough
Important aspects in the assessment of RTAs
are whether their members have implemented
their objectives under the agreement and theextent to which the objectives in the agreement have been met. Often the objectives in anagreement are defined by foreign ministers oreven prime ministers, while the way that thoseobjectives are to be carried out is determinedlater in negotiations between ministries. If tariff concessions are subsequently negotiated67G L O B A L

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2 0 0 5Figure 3.7 Preferential tariffs in tandemwith all tariffs in Latin America
MFN and preferential tariff liberalization
Latin America, 1985–1997
Average tariff rates (percent)50

40
MFN tariffs
30

20
Preferential
tariffs
10

0
1985

1987

1989

1991

1993

1995

1997

Note: MFN tariffs represents the simple average of themost-favored-nation tariffs applied by the following 11 Latin
American countries (based on country averages): Argentina,
Bolivia, Chile, Colombia, Ecuador, Mexico, Paraguay, Peru,
Uruguay, and Venezuela. Preferential tariffs represent the
average preferential tariff that each country applies to theother countries in this sample under different regional trade
agreements. Calculations include only ad valorem tariffs.
Source: Estevadeordal and Robertson 2004.

sector by sector or item by item, the process
becomes cumbersome and open to capture bydomestic interests. The distinction is often
made between agreements that reduce duties
only on products specified in a positive list
and other agreements, typically more liberal,
implemented on the basis of a negative list of
products excluded from tariff reduction.
Sectoral accords within RTAs can curb
market forces and limit the benefits fromcompetition. For example, Ozden and Parodi(2003) found that the auto agreement embedded in MERCOSUR between Argentina andBrazil compelled companies in both countries
to balance trade, ensuring that production
would not be reallocated to the lowest costproducer (Brazil); this move secured the
support of the companies for the agreement.
Because a new entrant would have to build
plants in both countries (not just one), theagreement acted as a barrier to competition
that favored insiders.

68

North-South agreements appear to have abetter track record than South-South agreements. The comprehensive tariff objectives ofmost North-North agreements signed before
the mid-1980s were implemented on or aheadof schedule (table 3.1). In contrast, SouthSouth agreements reached during thisperiod—most based on limited positive lists ofproducts for tariff liberalization—had a very
weak record of implementation. The delays in
implementing initial regional tariff commitments “generally reflected a basic incompatibility between the inward-oriented development strategies of most members and regional
liberalization”(De la Torre and Kelly 1992).
A larger number of South-South agreements signed or substantially revised in thelate 1980s and early 1990s have sought amuch broader degree of internal tariff liberalization, have been more effective in implementing agreed-on tariff reductions, and havetended to reduce external tariffs. For example, the GCC, launched in 1982, was originally intended to become a free trade area—agoal achieved by 1983. By the late 1980s,
however, the objective evolved into formationof a customs union, which was established in2003 (see World Bank 2003). However,table 3.1 also reports that substantial problems with implementation remain in many of
the regional agreements involving developing
countries.

Nonrestrictive rules of origin are integral
to successPreferential rules of origin are integral to preferential trade agreements. However, it has become increasingly clear that rules of origin
can be designed in a way that restricts trade
beyond what is necessary to prevent tradedeflection or the transshipment of products
from third countries through a member forthe purpose of obtaining preferential duties.
In addition, the proliferation of free trade
agreements with accompanying rules of origin
is increasing the burdens on customs services
in many countries, and these burdens haveconsequent implications for trade.

R E G I O N A L

T R A D E

A G R E E M E N T S: E F F E C T S

O N

T R A D E

Table 3.1 Implementation of tariff commitments by type of agreement, 1960–1999
Agreement

North-North agreements reachedfrom 1960–89
ANZERTA (signed 1983)
European Economic
Community (signed 1957)
U.S.-Canada FTA (1988)
EFTA (1960)

Objective on intra-bloc tariffs

Implementation record

Eliminate all tariffs by 1988
Eliminate all tariffs by 1968

On schedule
Ahead of schedule

Eliminate all tariffs by 1999
Eliminate all tariffs on manufactures by mid 1967

Ahead of schedule
On schedule

South-South agreements, 1960–89
Andean Pact (1969)
Eliminate tariffs on positive list
Central American Common
Elimination of tariffs
Market (1960)
EAC (1967–1977)
Latin American Integration
Association
ECOWASASEAN (1967)
GCC (1982)

Postponed several times
Initially on schedule, most duties
removed in the early 1970s, but
restrictions reintroduced in the 1980s
Establishment of a common market
The Community was dissolved
Liberalization of common lists of products by 1972 Common lists not liberalized onschedule
Tariff liberalization by 1990
Progress negligible
FTA based on positive lists
Repeatedly postponed
FTA
Virtual elimination of all tariffs in 1983

South-South agreements, 1990–99
AFTA (1992)
Gradual reduction of tariffs over 12–15 years
according to member-specific schedules
CACM—Revised (1991)
Customs union
GCC
COMESA

MERCOSUR
SAPTA
SADC

CEMAC (1999)
WAEMU (2000)

Liberalization took place ahead oforiginal schedule
Implementation postponed; progress
uneven among members
Customs union begins in 2003; completed by 2005 Customs union established on schedule
Progressive tariff elimination to be completed
Implementation varies by country, 9
by 2000
out of 20 members have moved toduty-free trade
Elimination of all tariffs by 1995
All lines, with the exception of sugar
and automobiles, have been liberalized
Limited tariff concessions from a country-specificNo formal schedules have been adopted
positive list
Tariff liberalization by 2008, with sensitive lists
Implementation delayed in some sectors
eliminated by 2012
due to lack of agreement on rules oforiginEconomic Union
Tariffs liberalized according to schedulein nearly all lines
Economic and monetary union
Tariff liberalization mostly on schedule

North-South agreements, 1990–99
Europe Agreements
Country-specific tariff removal schedules in(Bulgaria, Romania)
preparation for the EU membership
NAFTA
EU-Mexico
EU-South Africa
U.S.-Chile

Bulgaria mostly on schedule, Romania
continues to have some unresolved
issuesTariff elimination in stages to be complete by 2008 On schedule
Progressive tariff elimination by 2010
On schedule
FTA establishment by 2012
Partial implementation pending
official ratification
Progressive tariff elimination by 2015
N/A

Source: World Bank staff.

In general, the rules of origin in NorthSouth agreements are more restrictive thanthose adopted by South-South agreements(Figure 3.8). A feature of both EU and NAFTA
agreements is the high degree of variation inrules of origin across product categories. Different rules are specified for different products:

sometimes the rule may be a change of tariffheading, sometimes a change of tariff chapter;for other products there will be a value-added
requirement; and in others the rules of origin
may specify a particular technical process.
The amount of the required value added
can vary across products. The change of tariff

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2 0 0 5Figure 3.8 Rules of origin in North–Southagreements are more restrictive than inSouth–South agreements
Index of restrictiveness
6
5
4
3
2
1

A
ES

O
W
AS

EC

TA

M

AF

O
C

C

hi

le

-C

AC

D

M

C

le
SA

hi

ex
i

-C
EU

-M
EU

N

AF

TA

co

0

Note: Higher values of the index equal more restrictive
rules of origin [derived from Estevadeordal and Suominen(2004)].

classification can be used to provide a positive
test of origin by stating the tariff classificationof imported inputs that can be used in the
production of the exported good. Or it may
be defined to provide a (more restrictive) negative test by stating cases where a change oftariff classification will not confer origin. For
example, in the EU rules of origin, bread, biscuits, and pastry products (heading 1905 of
the Harmonized System) can be made fromimported products of any other tariff heading
except those of chapter 11, which includes
flour, the basic input to these products.
Specifying rules of origin on a product byproduct basis offers opportunities for sectoralinterests to influence the specification of therules in a protectionist way. The outcome ofhighly detailed product-specific rules of origin
is typically a complex set of rules, which canbe highly restrictive. Box 3.5 provides an example of the sort of complexity that can arise.
Many agreements involving developing countries, on the other hand, tend to specify general rules that apply to all products. The
AFTA, COMESA, and ECOWAS, for example, have a single value-added rule applicable
to all products.

70

Anson and others (2004) and Carrere andde Melo (2004) estimate that the administrative costs of providing the documentary evidence to support the certificate of origin under
NAFTA are in the region of 1.8 percent of thevalue of exports. The distorted impact of therules, resulting from the need to use local andhigher cost inputs to qualify, may be equivalent to an average duty of around 4.3 percent.
Thus, restrictive rules of origin can very easily
wipe out any margin of preference generated
by a trade agreement. Other things being
equal, compliance costs are lowest for rules involving a change of tariff heading, followed byvalue-added rules. Rules requiring a specifictechnical process have the highest compliancecosts.
Estevadeordal and Suominen (2004)
introduce a synthetic measure of therestrictiveness of rules of origin (the basis for
figure 3.8) into a standard gravity model of bilateral trade flows. Their econometric analysis
leads them to conclude that restrictive product-specific rules of origin undermine overall
trade between preferential partners and thatprovisions such as cumulation7 and de minimis
rules,8 which increase the flexibility of applying a given set of processing requirements,
boost intraregional trade. Applied at the sectoral level, this approach yields support for the
hypothesis that the restrictiveness of rules oforigin for final goods stimulates trade in intermediate products between preferential partners and diverts trade away from nonmembers. Cadot and others (2002) find that for
sectors where tariff cuts are larger than average, the rules of origin are more restrictive andthe rate of use of preferences by Mexican exporters lower than average. They conclude
that rules of origin are the “prime culprit” forthe very modest impact of NAFTA on Mexican
exports identified by other researchers.

Deeper agreements can lead to larger tradeand income effects
In principle, agreements that address a wider
range of barriers can have a greater impact on
trade flows and incomes.

R E G I O N A L

T R A D E

A G R E E M E N T S: E F F E C T S

O N

T R A D E

Box 3.4 Restrictive rules of origin under
NAFTA—the case of clothingH

ere is an example of what rules of origin look
like; the following pertains to men’s or boys’
overcoats made of wool (HS620111).
A change to subheading 620111 from any otherchapter, except from heading 5106 through 5113,
5204 through 5212, 5307 through 5308 or
5310 through 5311, Chapter 54 or heading 5508
through 5516, 5801 through 5802 or 6001
through 6006, provided that: The good is bothcut and sewn or otherwise assembled in the
territory of one or more of the Parties.
The basic rule of origin stipulates change of chapter but then provides a list of headings and chaptersfrom which inputs cannot be used. Thus in effect,
the overcoat must be manufactured from the stage ofwool fibers forward, because neither imported
woolen yarn (HS5106-5110) nor imported woolen
fabric (HS5111-5113) can be used. However, therule also states that imported cotton thread(HS5204) or imported thread of man-made fibers(HS54) cannot be used to sew the coat together. This
rule in itself is very restrictive; however, the rule isfurther complicated by requirements relating to thevisible lining:
Except for fabrics classified in 54082210,
54082311, 54082321, and 54082410, the fabrics
identified in the following subheadings and headings, when used as visible lining material in certain men’s and women’s suits, suit-type jackets,
skirts, overcoats, car coats, anoraks, windbreakers, and similar articles, must be formed fromyarn and finished in the territory of a party: 5111
through 5112, 520831 through 520859, 520931
through 520959, 521031 through 521059,
521131 through 521159, 521213 through521215, 521223 through 521225, 540742
through 540744, 540752 through 540754,
540761, 540772 through 540774, 540782

Subsequent chapters elaborate on the potential economic impacts of dealing withmany of the regional agreement issues introduced in chapter 2. Here we simply ask

through 540784, 540792 through 540794,
540822 through 540824 (excluding tariff item
540822aa, 540823aa or 540824aa), 540832
through 540834, 551219, 551229, 551299,
551321 through 551349, 551421 through551599, 551612 through 551614, 551622
through 551624, 551632 through 551634,
551642 through 551644, 551692 through551694, 600110, 600192, 600531 through600544 or 600610 through 600644.
This stipulates that the visible lining used must be
produced from yarn and finished in either party’s
location. This rule may well have been introduced toconstrain the impact of the tolerance rule, which
would normally allow 7 percent of the weight of thearticle to be of nonoriginating materials. In overcoats
and suits, the lining is probably less than 7 percentof the total weight. Finally, it is interesting to notethat the rules of origin also provide very specificexemptions for materials that are in short supply or
are not produced in the United States. In this regard,
the rule reflects firm-specific lobbying to overcome
the restrictions of these rules of origin when the original NAFTA rules were defined. The most extreme
example is the following, where the apparel will bedeemed eligible for tariff preferences if assembled
from imported inputs of:
Fabrics of subheading 511111 or 511119, if
hand-woven, with a loom width of less than
76 cm, woven in the United Kingdom in accordance with the rules and regulations of the Harris
Tweed Association, Ltd., and so certified by the
Association.
Clearly, the job of the relevant official to checkconsistency and compliance with such rules is not a
simple one.
Source: World Bank staff.

whether deeper agreements have a significantly greater impact on aggregate merchandise trade than more narrow trade agreements. Two studies9 assume a productivity

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2 0 0 5

response to trade liberalization when othermeasures are included and ascribe the results
to the deep integration measures. The calculations of these ex ante simulation studies illustrate the potential that deeper agreements
may hold when they produce a productivity
response, with changes in trade flows and incomes being a multiple of that under preferential tariff removal. However, because
this result is inevitable from the way thatdeeper integration is modeled (i.e., inducing
economy-wide increases in productivity),
these results from one or another deep integration measure should be seen as indicativeof potential rather than evidence of success.
Ex post exercises based on the gravity
model will tend to capture all of the policy related impacts of a regional trade agreementon trade, not just the removal of trade policy
variables. Several authors have tried tocapture in an index the differences of depth
between agreements; it is then used as thedummy variable in the gravity model to capture the impact of RTAs [Li (2000), Adams
and others (2003)]. However, this approachpresents the issue of how to weight different
policy measures—for instance, should services liberalization get more weight than customs cooperation? Thus the value of theindex would be dependent on the subjective
weights that are assigned. The weights chosen
by Adams and others lead to EFTA being
ranked as much more restrictive than the Andean Pact or NAFTA. Further, many agreements appear extensive on paper but haveaccomplished little in practice.

Extensive monitoring of agreements
is crucial to ensure effective
implementation
In order to assess the impact of RTAs, information is needed on the extent to which theagreement’s provisions are being implemented
and how they are affecting decisions by producers and consumers. Given the need formonitoring, an implementation scorecard
would be useful—such an approach has been
adopted by the EU Commission which, as

72part of its monitoring of the implementationof the single market, has introduced the“Single Market Scoreboard” (box 3.5). In
addition to providing vital information, thescorecard is useful as a disciplinary measure—
to shame governments with a record of poor
implementation into action and to empower
governments with good records of implementation to challenge those members who are
not meeting their commitments.
More extensive monitoring could make animportant contribution to the implementationof many trade agreements. Lack of effective
implementation has been a major factor limiting the impact of many trade agreements in
Africa, South America, South Asia, North
Africa, and the CIS.

Conclusions: Preferential Trade
Agreements and Economic
Development

This review of the experience of preferential trading agreements over the past 40
years offers the following conclusions:• There is no strong evidence to support
the claim that a preferential trade agreement will be net trade creating or that all
members will benefit. Positive outcomes
depend on design and implementation.
• When embedded in a consistent andcredible reform strategy, the key determinant of regional trade agreements’success is low levels of external tradebarriers. While many developing countries have reduced tariffs, they remainhigh in many countries and regions, andthe risk of trade diversion remains significant. Further reductions in applied
MFN tariffs will be required to ensurethat regional agreements are beneficial
for those participating in them and tominimize the impact on the countries
that are left out.
• Trade agreements that provide for comprehensive liberalization of trade acrossR E G I O N A L

all major sectors and nonrestrictive rulesof origin are more likely to be successful.
Agreements that devote considerable resources to negotiating limited positive
lists or large negative lists and detailed

T R A D E

A G R E E M E N T S: E F F E C T S

O N

T R A D E

product specific rules of origin limit thescope for gains.
• Effective implementation is crucial to positive outcomes, yet implementation iscompromised by proliferation. If different

Box 3.5 Monitoring implementation of preferential trade
agreements: “Single Market Scoreboard” in the European
Union

T

he Single Market Scoreboard measures (1) the
extent to which Single Market directives havebeen transposed into national law by each member
state, (2) the average time it takes each member totranspose directives, and (3) the extent to which
members are cooperating with enforcement andproblem solving. This analysis by the European
Commission is supported by regular surveys of businesses and individuals on perceptions of the Single
Market and where it is not working. The Commission also monitors differences in prices of identicalgoods for indications that integration is leading toconvergence.
The left figure below shows the implementation
deficit for each member; that is, the proportion of
directives that have not been notified as having beentransposed into national law. The figure shows asubstantial improvement in implementation since1997; it also shows that the original six members of
the EU and Greece are currently the worst offenders.
Effective monitoring of implementation also requiresthat clear targets be established. In 2001, the EU
Heads of State established an interim target of a
1.5 percent implementation deficit. As of July 2004,
only five members had achieved this target.
A further measure of implementation is the extent
to which agreed-on rules are being properly applied.
In Europe, the Commission is charged with monitoring when Single Market rules are not being appliedcorrectly; the Commission also takes infringementcases against member countries that are breaking EU
laws. In terms of the number of infringement cases
open in May 2004, Italy and France are the worst
offenders (lower right figure).

Single Market Scoreboard
a. Implementation of single market directives by EU members

b. EU law breakers

Percentage rate of nonimplementation

Open infringement case (May 2004)

12

160

10

140

1997

120
8

100

6

80

2004

60

4

40
2

20
U
N Ire K
et la
he nd
rla
nd
Au s
s
Po tria
Lu rt
xe ug
m al
bo
Sw urg
ed
Fi en
nl
D and
en
m
ar
k

G

Ita
Fr ly
an
ce
S
G pai
er n
m
a
G ny
re
e
Be ce
lg
iu
m

Fr
an

G

U
K
Sp
ai
D
en n
m
ar
k

0
ce
re
ec
Lu erm e
xe an
m y
bo
ur
g
N
et Ita
he ly
r la
n
Be ds
lg
Po iumrtu
Sw gal
ed
e
Au n
st
r
Fi ia
nl
an
Ire d
la
nd

0

Source: http://europa.eu.int/comm/internalmarket/score/index
en.htm#score.

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2 0 0 5agreements have different product coverage, different liberalization schedules,and different rules of origin, the ability ofagencies such as customs to apply theagreements is severely undermined. The
capacity to effectively implement is a
crucial issue that countries should consider before signing an RTA.
• Monitoring can play an important rolein providing for effective implementation, but often there is insufficient monitoring as well. Technical reviews are frequently not done, and when reports are
made, senior officials fail to act on theirrecommendations.

Notes
1. Flatters and Kirk (2003).
2. The conclusion is unchanged if intra-EU andintra-NAFTA trade are excluded from the total ofworld exports.
3. Drawn from Burfisher and others (2004) andHarrison and others (2004).
4. For example, Ghosh and Yamarik (2004) suggest that “a consensus has emerged among researchersthat RTAs are trade creating.”
5. In this exercise, where the counterfactual is basedon the historical pattern of trade flows, we assess how
the regional trade agreement affected trade flows after
its introduction. As a measure of robustness of the effects, we used three different estimation methods.
Effects are considered statistically robust only if all
three methods generate a significant impact of the samesign. The three methods are pooled OLS with robust
standard errors. The second estimation method includes
country-pair fixed effects using a specific OLS method.
The third approach is a pooled Tobit estimation.
6. Here we follow Soloaga and Winters (2001),
who include an additional dummy variable to assess
the impact on the exports of members of regional trade
agreements, although their focus is on the welfare
effects of RTAs. However, here we apply a panel
approach to a sample period of 1948 to 2000, covering bilateral trade between 178 countries with countrypair fixed-effects, which a number of authors, although
not all, suggest is the preferred method. We apply theabove equation. The regional dummies are time sensitive; that is, they are relevant only after the agreement
has been signed. Using a different estimation technique, such as Tobit and OLS, and a different sample
period can lead to different results for a particular
agreement but the overall conclusion remains firm.

74

7. The basic rules of origin define the processing thathas to be done in the individual beneficiary or partner toconfer origin. Cumulation is an instrument allowing producers to import materials from a specific country or regional group of countries without undermining the originof the final product. In effect the imported materials fromthe identified countries are treated as being of domestic
origin of the country requesting preferential access. There
are three types of cumulation, bilateral, diagonal (or partial), and full. The most basic form of cumulation is bilateral cumulation, which applies to materials provided
by either of two partners of a preferential trade agreement. In this case originating inputs, that is materials,
which have been produced in accordance with the relevant rules of origin, imported from the partner, qualify as
originating materials when used in a country’s exports tothat Partner. Second, there can be diagonal cumulation
on a regional basis so that qualifying materials from anywhere in the specified region can be used without undermining preferential access. Finally, there can be full cumulation whereby any processing activities carried out inany participating country in a regional group can becounted as qualifying content regardless of whether theprocessing is sufficient to confer originating status to thematerials themselves. Under full cumulation all of theprocessing carried out in participating countries is assessed in deciding whether there has been substantial
transformation. Hence, full cumulation provides fordeeper integration among participating countries.
8. De Minimis or tolerance rules allow a certain
percentage of nonoriginating materials to be usedwithout affecting the origin of the final product. Thus,
the tolerance rule can act to make it easier for productswith nonoriginating inputs to qualify for preferences
under the change of tariff heading and specific manufacturing process rules. This provision does not affectvalue added rules.
9. For example, Hoekman and Konan (1999) findthat a free trade agreement between the European
Union and Egypt limited to goods (but with substantial
progress on removing regulatory barriers) could raise
welfare by around 4 percent while an agreement that
reduced barriers to services in Egypt could raiseeconomic welfare by over 13 percent. Similarly,
Brenton, Tourdyeva, and Whalley (2002) find that an
EU-Russia FTA limited to tariff removal would increase welfare by around one-tenth of one percent
while a comprehensive agreement removing technicalbarriers to trade and barriers to trade in services would
raise welfare by more than 13 percent.

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4Beyond Trade Policy Barriers:
Lowering Trade Costs Together

The removal of tariffs and quotas is a key feature of regional trade agreements (RTAs), butmodern RTAs can, and are, being designed toachieve much more than that. Trade policies
are only one element—and often a relatively
minor one—of the overall costs of trade. Because logistical, institutional, and regulatory
barriers are often more costly than tariffs andgenerate no offsetting revenue, cooperative
governmental efforts to improve customs procedures, minimize the trade distorting impact
of standards, and reduce transport costs may
have a higher payoff than reciprocal reductions in overt trade policy barriers.
When RTA membership is part of a broad
program of economic liberalization in which
the objective is to attract international investment as much as to promote trade, a broad setof regulatory issues becomes paramount.
Which are the most appropriate institutions toaddress these regulatory barriers? In certain
cases, institutions at the regional level will
provide for the most effective solutions, relative to both the multilateral and national
levels.1 RTAs can effectively promote dialogue
and implement coordinated responses.
However, most RTAs have contributed little
to reducing the associated trade costs, especially RTAs among developing countries.
Many regional policy initiatives havefoundered because of the lack of effective implementation, and crossing borders between
most developing countries is still a major
impediment to trade.

This chapter focuses on three key issues related to trade facilitation: customs clearance,transport, and standards and their conformity
assessment. Coordinated action among developing countries is likely to be greatest with thefirst two issues, customs clearance and transport; examples of best practices in these areas
are available and can be followed in regional
trade agreements. Progress in reducing barriers is likely to facilitate trade to and from all
trading partners with little or no scope to bediscriminatory. And while cheaper, faster, andmore predictable customs clearance and improved transport services have a direct impact
on trade, they are also crucial elements of theinvestment climate.
Initiatives to deal with standards and conformity assessment on a regional basis are
scarce; the most successful agreements
have been between rich countries that areundertaking a deep integration process, as in
the case of the European Union (EU).
Nonetheless, systems of standards, quality
assurance, accreditation, and measurement
are crucial to competitiveness and sustained
growth. Regional interventions can be useful if developed in a transparent way andwith the participation of private groups (toensure that procedures are not manipulated
to serve a protectionist end). Initiatives
targeted at a small number of key sectors
and toward improving the quality of conformity assessment are likely to be the mostuseful.

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Agreements that involve large markets andhave differing levels of institutional capacity
generally appear to have had the greatest success in dealing with these trade facilitation
issues. This is because the more advanced
partner tends to drive institutional improvements among the less advanced partners.
(However, a real danger is that, in seeking
greater access to industrial country markets
through bilateral trade agreements, developing countries agree to apply a set of rules andregulations defined by the advanced country
that are inappropriate for their level of development.) For many developing countries,
agreements with industrial countries alone
will not be sufficient, because the main sourceof higher trade costs are the borders and theweak transport systems they share with theirdeveloping country neighbors.
Progress often requires coordinatedactions; for example, joint customs inspections must be allowed, common rules fortransport must be established (including vehicle weight restrictions), and test results frompartners’ laboratories must be accepted. RTAs
can provide a forum to enhance trust among
trade partners that genuinely wish to move
forward on these and other fronts.

The Costs of TradeD

espite globalization and the rapid increasein trade over the past 40 years, the costsof trading remain substantial—particularly fordeveloping countries (box 4.1). Because of
those costs, the actual volume of international
trade is far less than economic theory would
predict in the absence of significant barriers totrade [the case of the “missing trade” (Trefler
1995)]. And trade within countries is much
more intense than between countries. If trade
costs were insignificant, the propensities totrade nationally and internationally would beequal. In fact, crossing a national borderappears to dampen trade flows even in regions
such as the EU, where formal trade barriersand customs posts have been removed.2
Finally, the retail prices of particular goods

78

tend to diverge with distance, and this difference is much higher when the two locations
being compared lie on either side of a national
border. If trade costs are low, then arbitrage
should constrain such price variation (Engeland Rogers 1996).
The tax equivalent of trade costs can range
from 30 to 105 percent, depending on the sector, according to estimates for imports by theUnited States (Anderson and van Wincoop
2004; Evans 2001). High trade costs discourage investment and constrain the ability of local
firms to integrate into global production chains(Faini 2004). Given the magnitude of thesebarriers, ex ante simulation studies suggest thatthe benefits of lowering transaction costs, reducing insecurity, integrating services sectors,
and increasing competition are multiples of
reducing tariffs (Hoekman and Konan 1999).
However, there is very little convincing ex post
evidence of significant returns to regional initiatives that must deal with these issues, suggesting that substantial progress is difficult toachieve.
Ignoring institutional barriers during a tariff reform may undermine the objectives ofreform—and indeed produce perverse results.
For example, tariff liberalization in the face ofborder delays and customs corruption may
have no impact on imports and may even reduce welfare if tariff revenues are replaced bylonger waits to clear customs (Cudmore andWhalley 2003). In the absence of competitionin the domestic transport sector, trade liberalization may simply lead to a transfer of revenue from the government to monopolistictransport owners. On the other hand, progresson many issues is not possible while high tariffbarriers remain in place.
Cost raising barriers may be linked in circles of causation, with significant impacts due
to scale economies in transport. For example,
a reduction in tariffs or a decline in costs at theport may stimulate trade that can offer opportunities for transport companies to operate atmore efficient levels of scale. And if there is effective competition in the transport sector, this
could lead to lower transport prices and more

B E Y O N D

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B A R R I E R S

Box 4.1 Trading can be costlyVarious policies and factors isolate national
economies from world markets and thereby raise
the cost of international trade:• Tariffs, quantitative restrictions, and other border barriers—such as taxes on trade that raise
the prices of imported goods relative to those
produced domestically.
• Transport costs, both direct (freight andinsurance) or indirect (inventory costs).

trade, and so on.3 A reduction in corruption
and delays at the border may stimulate trade,
add to government revenues, and allow for a
reduction in tariffs to achieve a given revenue
target, which again stimulates trade.
Landlocked countries that face high barriersin moving their imports and exports throughneighboring countries have no choice but topursue bilateral or regional solutions.4 These
need not be embedded in a regional preferential
trade agreement (PTA), but to be effective forsmall countries, agreements must provide forthe settlement of disputes. Such provisions arelikely to be more effective if they are part of abroad and comprehensive agreement.
Finally, removing institutional obstacles tocrossing borders has a more certain benefit
than reducing intra-regional barriers, because
it saves real resources. Trucks that make moredeliveries to the port are more productive. Interventions that lead to higher productivity
have the greatest impact on trade andwelfare—and on further increases in productivity. In contrast, removing revenue-generating
tariff barriers on a preferential basis can leadto trade diversion and reductions in welfare.

Regional Agreements to Facilitate
Trade and TransportAs countries develop their trade beyond theexport of basic agricultural and extracted
commodities, logistics requirements become• Costs incurred when crossing a border due todocumentation, delays, and bribes to corrupt
officials.
• Compliance with national product standards
and technical regulations.
• Insurance against risk, especially credit risk,
and uncertainty associated with macroeconomic
instability, lack of effective institutions, andunpredictable politics.

more important—and more costly. To compete in international markets and function
within global production chains, firms need
not only low transport costs and efficient
ports, but also short transit times, reliable delivery schedules, appropriate storage facilities,
and security (Carruthers and others 2003).
High transport costs, inefficient or corrupt
customs, and long delays at borders reduce
the trading opportunities available to many
developing countries and can have significant
economic and social costs (box 4.2). Conversely, better conditions tend to be related tohigher levels of trade (Wilson and others2003). Increasing the efficiency of customs,
for example, can reduce costs and increase
trade (figure 4.1). High transport and bordercrossing costs thwart, in particular, the poor
landlocked developing countries.5

Regional integration can help promote
more efficient and effective customs
operations
Unlike many other factors that raise trade
costs, there is broad agreement on what constitutes good customs procedures. Since its
inception, the World Customs Organization(WCO) has developed best practices of customs policies and procedures. The Kyoto Convention commits its signatory members to implement these best practice principles andprovides them with guidance in their efforts toimprove national practices. While there is79

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Box 4.2 Border delays tax tradeE

ach day lost in transport delays is equivalent to a
tax of about 0.5 percent (Hummels 2000). The
situation in crossing borders between developing
countries can be much worse.

• Crossing a border in Africa can be equivalent• In Southern Africa, delays at the main border-

Border delays are associated with other trade
costs as well, especially corruption in customs—andhave been linked to the spread of HIV/AIDS. The
World Bank has recently initiated a project in Western Africa to reduce, by the end of 2006, the averagetime for commercial vehicles to clear border formalities along the Lagos–Abidjan corridor by at least
20 percent, and average delays at the Nigeria–Beninborder by at least 50 percent. These reductions are
critical for this project and its mandate to reduce theincidence of sexually transmitted infection amongcommercial vehicle drivers.

crossing between South Africa and Zimbabwe(Beit Bridge) amounted to six days in February
2003, leading to an estimated loss of earnings
per vehicle of $1,750, equivalent to the costs ofa shipment from Durban to the United States.
• In Central Asia, on average, it takes morethan 100 hours to cross the border between
Uzbekistan and Turkmenistan. A truck traveling from Tashkent to Berlin, passing throughTurkmenistan, Iran, and Turkey, will spend, on
average, a third of total transport time waiting
at border crossings (UNESCAP 2003).
• In the Andean Community, trucks spend morethan half of the total journey time at bordercrossings (Pardo 2001).

to the cost of more than 1,000 miles of inlandtransportation; in Western Europe theequivalent is 100 miles (Arvis 2004).

Source: World Bank staff.

Figure 4.1 More efficient customs areassociated with more trade
Ratio of trade to GDP (percent)
250
200
150
R2 ⫽ ⫺0.338

100
50
0
0

5

10

15

20

25

Days through customs, imports
Source: Investment Climate Surveys data and Global Trends
as cited in Subramanian and others 2003.

much that countries can do individually to improve customs procedures, there is also scopefor regional initiatives to modernize customs.
Contacts fostered by regional agreements
can generate a mutual understanding of each80

other’s problems and difficulties and can engender the sharing of best practices and positive experiences among members. This exchange is likely to be more relevant and better
accepted inside the regional group of developing countries than examples from countries
that are much more advanced and face very
different implementation issues.
On the other hand, when regional units are
made up of developed and developing countries, there is scope for financial support andtechnical assistance for less developed countries in their modernization efforts. The EU,
for instance, provides assistance to theAfrican, Caribbean, and Pacific (ACP) countries and incorporates customs technical assistance provisions in its Euro-Mediterranean
Initiative. Such assistance will also be available
under the Economic Partnership Agreements it
intends to establish with regional groupings in
Africa, such as ECOWAS. Similarly, Japan
provides funding for capacity-building initiatives in APEC member countries.

B E Y O N D

For a variety of reasons, tackling customs
issues autonomously may be too daunting atask, and cooperation with trading partners
may create the necessary momentum to overcome reluctance and opposition from domestic
policymakers, customs officials, and traders.
A review of a number of regional initiatives tomodernize customs suggest the following areasin which RTAs can lead to improvements:• Align customs codes with international
standards. A good customs code supports efficient customs operations. It establishes the competence of the relevant
authorities, promotes transparency andpredictability of operational procedures
and enforcement, encourages cooperation with the private sector, provides for
effective appeals procedures, and enhances integrity. It would be advantageous for all countries to align theircustoms codes with international
standards.
• Simplify and harmonize procedures. The
recommendation here is to introduce asingle customs document that limits thedata requirement to a single set andadopts e-commerce techniques.
• Bring all tariff structures in line with
the international harmonized tariff classification (HS). Many disputes can be
avoided if all members of the grouping
adhere strictly to an identical tariffclassification.
• Strive for transparency. Increase theavailability and accessibility of the legal
text and regulations that traders andcustoms officials require and include
other relevant information such as trade
statistics.
• Adopt and effectively implement the
WTO Valuation Agreement. Member
countries can assist each other througheffective mutual assistance agreements
and shared databases.
• Work together toward customs integrity.
• Establishment of joint border posts.
Joint border posts preclude multiple

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examinations and lengthy border crossing procedures. A simple first stage
would coordinate hours of operation andprovide compatible computer systems on
both sides of the border; these efforts
would increase efficiency significantly.
• Joint training centers. Countries can join
forces to operate regional training centers that can benefit from leveraged-up
resources and can build cohesion between the customs officers of different
customs services in the region.

Transport and trade facilitation
initiatives raise productivity
In recent years there has been a developmentof a web of transport and trade facilitation(TTF) agreements aimed at easing the movement of goods and services across borders.
Most of these agreements have been reachedas part of, or in parallel with, an RTA.6
Effectively implemented, TTFs can improveaccess to global markets for developing
countries with poor transport systems—
particularly landlocked countries.
TTFs often contain provisions to standardize customs procedures at borders and to harmonize customs documentation. TTFs canfurther facilitate trade by providing for theinteroperability of transport resources and by
fostering market access and competition in
the transport sector.
Divergent national regulations for truck size
and weight require vehicle checks on both sidesof the border and often lead to overload
charges and costly delays (box 4.3). In
Southern Africa, for example, axle-load regulations are different in Namibia, Botswana,and Zambia (Röschlau 2003). Truckers whoare in full compliance in one country can beprosecuted and fined across the border.
Regulations concerning insurance, driver’s
licenses, and other documentation provide
ample opportunities for cost savings. For example, the COMESA carrier’s license systemallows companies to operate regionally without having to pay for multiple licenses. And
COMESA’s vehicle insurance scheme enables

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Box 4.3 Standardization and simplification
can increase trade volumes: The case of theTrans-Kalahari CorridorT

he Trans-Kalahari Corridor (TKC), the roadroute between Gauteng province (South Africa)
and Walvis Bay (Namibia) via Botswana was opened
in 1998, replacing the traditional longer route
through western South Africa. Despite major roadrehabilitation in 1999, traffic reached only 15 percent of the expected capacity. The major obstacles
occurred at the border crossings. This led the TKCCorridor Management Group to seek a partnershipwith the customs administrations of Namibia,
Botswana, and South Africa. This partnership

Zimbabwe

Namibia

Walvis Bay
Windhoek
Trans-Kalahari
MamunoGaborone
Pioneers Gate
Skilpadshek
Ramatlabama
Ramatlabama
JohannesburgiqumbGaborone

Ra

ma

tla

Trans-Kalahari
corridor offices/
border posts:

ba

ma

za

MamunoMo

Trans-Kalahari

Windhoek

Pi
o
G nee
at rs
e

WalvisBaye

Botswana

MaputoSkilpadshek

Ramatlabama

Johannesburg Swaziland
LesothoSouth Africa

Durbanresulted in agreements (October 2000) to extend theoperating hours of customs at the Namibia/Botswana
border from 22 to 24 hours to enable loading andunloading in Windhoek and crossing the border inthe same day.
In August 2003, the TKC started a pilot phase to
replace all existing transport documents with a single
administrative document (SAD). To complement thiseffort, South African Customs developed a website
with details on the SAD process. Border processing
times were cut by more than half, from an averagetime of 45 minutes to 10–20 minutes. According to
the United States Agency for International Development (USAID) estimations, reduced border delays
created savings of $2.6 million per year along thecorridor. As a result, the route had become economical, and traffic flows increased. Operators were moving about 620,000 tons annually along the TKC,
about 65 percent of expected capacity, until the
Botswanan government increased road user charges
in February 2004. In some cases, road charges were
multiplied by a factor of 10. The customs problem
had been settled, but following this unilateral decision affecting the transport sector, traffic decreased
significantly.

Cape Town

Source: World Bank staff.

transport operators to comply with insurance
obligations throughout the region with a single
policy. Similarly, ECOWAS’s brown card system, introduced in 1982, has helped to reduce
settlement time significantly. The success ofsuch initiatives requires effective cooperation
between different ministries (transport, interior) in the member states.
The impact of harmonizing customs procedures and transport rules may be limited
unless there is competition in the domestictransport sector. In the extreme case of a82

domestic transport monopoly, the gains fromlower operating costs and more efficient customs procedures may accrue to the transportcompany in the form of greater monopoly
profits—with little impact on trade andpoverty. Equally important is competition between routes and between different modes oftransport. For example, Lao goods were
almost exclusively exported through Vietnam
until the Lao People’s Democratic Republic
developed alternative transit routes throughThailand. It now takes one day for an export

B E Y O N D

container loaded with garments from
Vientiane to reach a main international transport node at Bangkok, compared with three tofour days to reach Danang (Banomyong2000).
Although competition is often included inregional treaties (such as the 1982 ECOWAS
convention regulating interstate road transportation or the 1993 COMESA Kampala
Treaty),7 effective implementation is rare. Because national authorities often fear a loss ofsovereignty if they allow foreign operators in
the market, a regional legal framework and effective enforcement mechanisms are necessary
for successful implementation. In the case of
the EU, full implementation was not achieved
until 1985—28 years after the signing of theTreaty of Rome. Since then, the benefits havebeen substantial (box 4.4).
In several West African countries, transit
regimes are governed by national, bilateral, or

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customs frameworks, rather than regionalarrangements (UEMOA Commission 2000).8
Many transport companies oppose the adoption of regional frameworks for fear of
upsetting the “tour de role” system.9 Bilateraltransport treaties often predefine the transportshare of both countries (normally 50-50); theexporter therefore has no choice in selecting atransport operator. The effect of this system isto protect less efficient operators. Even the
more sophisticated North America Free Trade
Agreement (NAFTA) has experienced difficulties in implementing cross-border trucking
competition, following protectionist pressuresfrom U.S. unions, concerns about truck
safety, and Mexican driver qualifications andcompetence.
MERCOSUR countries implemented the“International Common Manifesto Cargo andCustoms Transit Dispatch” (IMC/CTD) in1991. This form harmonized and unified all

Box 4.4 Logistics costs in Europe have fallen
in the last two decades

S

ince the late 1980s the proportion of company
revenues spent on logistics in Europe has declined
from 14.3 percent to 6.8 percent, a reduction that
far exceeds the average level of EU external tariff on
manufactured goods (Mentzoni 2003).
This development reflects the following important
trends in the logistics industry:• Centralization of inventory through a smaller
number of warehouses;• Increased outsourcing of logistics services tospecialized companies; and• Just-in-time supply policy (Ruijgrok 2001).
These changes have followed key policy initiatives. The removal of borders within the EU reduced
uncertainty and the costs of international transport.
At the same time, the EU acted to increase competition in the industry through the adoption of
cabotage—a policy that enables carriers to operate

Logistics cost in Europe
Percentage of revenue
15
1.5

Administration and planning
Warehousing

10

5.8

1.4
Transport

4.1

5

1.2

2.6

3.1

3.1

1998

2003

7
4.6

1.1

3.4

0
1987

1993

Source: ELA/ATKearney.

domestically in all member countries, regardless of
their country of registry.
Source: World Bank staff.

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information required by different bordercontrol institutions (customs, migratory; see
Nofal 2004).

Regional cooperation reinforces transport
and trade facilitation programs
Trade liberalization—whether unilateral, multilateral, or regional—may have a very muted
economic impact in the presence of very hightransport costs, weak logistical services, andlong delays to clear customs. Conversely, inthe presence of high trade barriers there may
be little reason for traders to lobby for improvements in transport. And trade restrictions that limit quantities may undermine the
incentive to invest in improved transport andtrade facilitation services. Hence, actions toimprove transport and reduce trade barriers
are often complementary.
Trade facilitation can be effective even in
the absence of a formal RTA. However, a formal agreement may help to entrench and enhance facilitation initiatives beyond what is
possible through cooperation alone. In principle, unilateral and multilateral liberalization
by itself should lead to larger trade volumes—
and hence raise incentives to invest in tradefacilitation. By inducing a more thoroughdismantling of trade barriers among neighboring countries, regional cooperation can createa broader constituency for facilitating tradeflows. Integrating fragmented markets canmake infrastructure projects more viable, andthus promote a virtuous cycle of integrationand growth.
Realizing the inherent potential of transport and trade facilitation requires both asound institutional environment and a conducive economic one. RTAs can help address
institutional gaps and reinforce the corridor
approaches that are common in agreements
between developing countries. At the sametime, RTAs can provide a forum for the discussion and definition of norms and harmonized rules that are often necessary for effective implementation. Involvement of theprivate sector in these discussions is often aprerequisite for effective action (box 4.5).
Finally, negotiating transport issues in a regional forum can act to depoliticize issues(Schiff and Winters 2002).
Despite the enormous potential for gains
from regional initiatives to improve customs
and transport services, progress in many cases
has been slow. Trade costs remain very high formany developing countries. Many initiatives

Box 4.5 The case of the Northern Corridor
Stakeholders Consultative Forum

S

ince 1999, officials dealing with transport, transit,
and private operators along the Northern Corridor (including Ministry of Transport, Ministry ofTrade, customs agencies, exporters, and importers
associations, etc.) have been regularly meeting twicea year to discuss transit issues. This private-public
sector alliance has produced the following positive
developments:• Elimination of charges on imports routed
through the port of Mombasa (by Kenya
Bureau of Standards and the Kenya Plant
Health Inspectorate Service);• Development of a one-stop processing center;and• Reduction of the number of required stamps togo through Mombasa port (from 21 to 11).
As a result of this forum, national transit and tradefacilitation committees are being established in the region. Private sector participation has been extended toinclude insurance clearing agents, bank associations,shippers’ council, and the like. Public/private partnerships to tackle trade and transport facilitation are also
being established in West Africa.
Source: World Bank staff.

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to facilitate trade have suffered from a lack ofeffective implementation. In several agreements, disputes over implementation can only
be raised at the political level, which often
means that small landlocked countries havegreat difficulty in securing the necessary compliance from larger neighbors. In these cases
implementation is very much a function of political will.
The possibility of taking legal action
under regional treaties can help drive implementation of transport facilitation initiatives.
The European Court of Justice has played an
important role in the implementation of acommon transport policy in Europe (Funck1998). A regional court of justice has recently been established in the Eurasian Economic community of the CIS; another regional court exists in UMEOA in West Africa.
While a regional court of justice does notguarantee implementation, it does create potential for more efficient enforcement than isavailable through less formal dispute settlement channels.

Standards, Conformity
Assessments, and RTAs

T

he construction and implementation ofsystems of standards, quality assurance,
accreditation, and metrology are crucial tocompetitiveness and sustained growth—andhence to development. Standards have become
key elements for facilitating transactions andtrade both within countries and in international exchange between countries. Standards
support markets and provide for efficienttransactions. Standards and technical regulations stipulate what can or cannot be exchanged, and they define the procedures thatmust be followed for exchange to take place.10
The ability of would-be exporters to comply with mandatory health and safety standards, as well as market-driven voluntarystandards in overseas markets, is a major factor determining access to those markets.
Divergent product standards and duplicative
systems for assessing conformity with those

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standards can constitute substantial barriers
to trade, but these may only become clear
after other barriers have been addressed. Reducing tariffs and improving customs andtransport can be likened to reducing the waterlevel in a swamp only to find a range of previously covered “snags and stumps that need to
be cleared away” (Baldwin 1970).
When producers must alter their product tomeet divergent standards in foreign markets,
they lose some of the benefits of larger scalesof production. When the foreign government
does not recognize standards-compliance tests
performed in the exporter’s home market, orthe home country does not have the facilities
to test the product, the exporter must foot thebill for additional tests in the foreign market.
For example, in Moldova the certification oforganic nut production exported to Germany
has to be renewed every 6 months, and each
visit from an international certifying company
costs $5,000 plus $2,000 per production
test—once before processing and once after
processing. This can amount to $18,000 per
year, which is a heavy burden for firms in an
economy such as Moldova, an economy trying
to compete in international markets. Upgrading testing facilities and measuring equipment
is essential for reducing the costs of conformity assessments.11
To reduce the damping effect of divergent
standards on international trade, WTO members have agreed to discipline the use of
mandatory standards by governments. These
are relatively modest provisions—they deal
with transparency of standards regimes, equal
treatment, and the need to justify standards
that differ from internationally agreed-on
norms. Efforts to reduce barriers to tradecaused by standards and conformity assessment have been more extensive in a small
number of RTAs, although empirical evidence
identifying the benefits of these interventions
is scant at best. The issue for developing countries is whether regional initiatives can provide
for more efficient and effective standards andconformity assessment systems. These improved systems would allow governments to85

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2 0 0 5meet domestic objectives to raise health andsafety levels, and at the same time, facilitate
trade.

Different paths to better standards systems
Different approaches are available to raise
standards and to address technical barriers totrade. Countries can unilaterally upgrade
standards by adopting international standards. However, the technological content andthe health, security, and environment objectives of the international standard may not beappropriate for developing countries, because
the international standards are strongly influenced by the OECD countries. Further, someof the returns to adopting the international
standard—in terms of greater market access—only materialize if the country’s trading partners also accept products produced to thatstandard.
A second approach requires cooperation
between countries to upgrade standards.
Countries agree that products satisfying particular standards will be accepted in eachother’s markets. However, cooperation agreements do not discipline other market accessbarriers, so that returns from the upgrading ofstandards may be undermined if other barriers
are raised to protect a particular sector once
standards are harmonized. Typically, the dispute panels in cooperation agreements have amediation role, not an arbitration role. For
these reasons, and unless all parties are committed to the upgrading process, the process ofstandards upgrading could have importantobstacles.
The upgrading of standards within a RTA
is characterized by more formal institutions, ahigher degree of enforcement, and greater
trust originating from the frequent interactions between members and the comprehensive nature of the agreement. Members cannot
use tariffs to prevent the entry of a productsatisfying the regional standard; this increases
the certainty that a country’s upgrading efforts
will be translated into greater market access.
Within PTAs different approaches to standards have been followed, which reflect the86

different levels of development and institutional capacities.
We start by discussing the EU experience,
where integration has proceeded the furthest.
The basis for the free movement of goods inthe EU is the principle of mutual recognitionof the regulations of partners or the recognition of equivalence. Although standards varyfrom one country to another, it is presumed
that they are designed to meet the same regulatory objectives and to offer equivalent levelsof protection to the public. Thus products
produced in partner countries can be acceptedwith the assumption that those products will
not undermine basic regulatory objectives
concerning health, safety, and the environment.12 Mutual recognition of regulations is
the simplest approach to differences in standards: it is a powerful tool for removing barriers to trade in goods and services, and withthis approach the difficulties of detailed harmonization measures, which intrude on national policy making, can be avoided.13 However, mutual recognition of standards requires
a high degree of trust between regulatory authorities (essentially the responsibility for protection of domestic consumers is, in part,transferred to the overseas partner). As such,mutual recognition can only work in regions
comprising countries of similar levels of income that have comparable standards.
Effective institutions are also important. In
the EU, governments can defer from nondiscrimination and the free circulation of goods
for reasons of “public policy or public security”
and protection of health as long as such restrictions are not a disguised restriction on
trade. To ensure the latter, the EU has developed the following mechanisms for disciplining national regulations and interventions into
product markets:14• Infringement procedures, whereby theEuropean Commission acts to enforce
community law, although such procedures are very time consuming and costly,
have an impact only after the event andare ad hoc.

B E Y O N D• Notification procedures, whereby member states are required to notify all draft
technical regulations for scrutiny by an
EU Committee, whose objective is to prevent new regulatory barriers to trade. In
practice, all new national regulations ofEU member states have to pass an EU
test regarding their impact on the freemovement of goods.
• Notification of derogation procedures,
which require member states to notify
authorities of cases in which they wish toprevent the sale of goods lawfully produced or marketed in another member
state, on the grounds of nonconformity
and nonequivalence with domestic requirements. This ensures that any derogations from the principle of mutual
recognition are transparent and subject
to scrutiny.
While mutual recognition of regulations
underpins the EU Single Market, it has been
apparent for a long time that for certain products and for certain risks (when consumers are
directly exposed to hazards), equivalence between levels of regulatory protection embodied in national regulations cannot be assumed.
In these cases the EU seeks agreement among
members on a common set of legally binding
requirements. EU legislation harmonizing
technical regulations has involved two distinct
approaches, the “old” and the “new.”
The old approach mainly applied to products (chemicals, motor vehicles, pharmaceuticals, and foodstuffs), involved extensive
product-by-product or even component-bycomponent legislation, and was carried out by
detailed directives. Achieving this type of harmonization was slow for two reasons. First,
the process of harmonization became highly
technical, with attention given to very detailed
product categories. Consultations were often
drawn out. Second, the adoption of directives
required unanimity in the Council, whichmeant that they were slow to be adopted. The
limitations of the old approach as a broad tool
for tackling technical barriers to trade become

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apparent in the 1970s and early 1980s, when
new national regulations were proliferating at
a much faster rate than the production ofEuropean directives harmonizing regulations(Pelkmans 1987).
It became clear that the degree of intervention by the public authorities before a productwas placed on the market needed to be reduced, and that changing the decision-making
procedure to allow the adoption of harmonization directives by a qualified majority in
the Council was needed. The “new approach”
regulations indicate only “essential” healthand safety requirements, allowing greater freedom to manufacturers to satisfy the essential
requirements and to industries to flesh out
product specifications in the form of voluntary standards. The new approach makes
good use of established standardization
bodies—European Committee for Standardization (CEN), European Committee for Electrotechnical Standardization (CENELEC),
and the national standards bodies. Standardization work is achieved in a more efficientway, is easier to update, and involves greater
participation from industry. Products that
conform to the standards promulgated by theEuropean standards agencies are presumed tocomply with the essential requirements of theregulations. However, these standards are voluntary, and firms can produce to different
standards if they can prove compliance withthe requirements of the regulation.
MERCOSUR has followed the oldapproach of the EU and focused its limited
resources on harmonizing national standards at the regional level (see Nofal 2004).
MERCOSUR has formulated 366 common
technical regulations and some 300 voluntarystandards. The Andean Community has recently decided to focus regional harmonization on a targeted number of standards—thoseof the products most traded. Only 40 regional
standards were created, although they cover
60 percent of trade.
When harmonized regulations are pursued,
it is important to avoid overly bureaucratic
mechanisms. Harmonization through the use

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2 0 0 5of detailed regulations can lead to excessive intervention by public authorities before a product can be placed on the market and have achance to prove its viability. Regulators should
concentrate on defining essential health andsafety requirements while allowing firms theflexibility to meet those requirements and not
stifle technological change and competitiveness. The CIS, MERCOSUR, and Andean
Community countries still apply an approachbased on very detailed harmonized regulations. When a company wishes to introduce a
new product, it is often necessary to change
the existing regulations or wait for a new technical regulation to be promulgated, which cantake considerable time and be very costly. A recent Peruvian technical regulation for gas containers specifies the minimum width of thewalls, stating the exact thickness, which effectively prevents the use of new materials thatmight be lighter but thicker.
ASEAN is also following a policy of targeting key sectors, but it is harmonizing
around international standards rather thanpromulgating its own standards. For 20 key
product groups, members should adopt, as
national regulations, the agreed-on international norms. Members that do not adopt anyof the identified international standards as
their national standards still need to accept
products from partners that comply withthese international standards—unless they
can demonstrate an inability to adopt the international standard due to “climatic conditions or infrastructural reasons.”
Here the contribution of the RTA has been
to provide an enforcement mechanism
through dispute settlement procedures, suchthat members who do not accept from partners products that satisfy an ASEAN standard
are ultimately liable to fines for compensation
or removal of concessions. Therefore, ASEAN
countries can adopt the ASEAN standards
with confidence that incurring the associatedcosts will not be undermined by subsequentdenial of access to partners’ markets.
In agreements where regional institutions
are weak, especially free trade areas, barriers

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to trade can be removed when standards fromdifferent members are shown to be compatible. This is the approach of NAFTA and also
tends to be applied in bilateral trade agreements that have a standards component, suchas those between Chile and the EU and Chileand the United States.15 The compatibility approach is the converse of the mutual recognition of regulations. Under the compatibility
approach, the standards of a trading partner
are assumed to be insufficient in their ability
to satisfy the importer’s regulatory objectives,
unless proven otherwise.

Recognizing the results of conformity
assessment in partners
Mutual recognition of conformity assessment[usually negotiated in the form of a mutual
recognition agreement (MRA)] is necessary if
nontariff barriers are to be fully removed.
This ensures that the test results from laboratories in the exporter’s home market are accepted by the importer so that the costs ofduplicative testing can be avoided. This agreement does not require that both countries
have the same standards nor that both countries be members of a PTA. For example, theEU and the United States, for certain sectors,
accept the results of product tests (for compatibility with their own standards) that havebeen completed in the partner’s laboratories.
If conformity assessment institutions are
relatively weak, however, harmonization ofstandards may be a necessary step to facilitate
mutual recognition of conformity assessment.
This is the approach being followed in
ASEAN. The Andean Community establisheda regulation for compulsory mutual recognition in 2003 for sectors covered by regional
standards. MERCOSUR will proceed withmutual recognition of conformity assessment
procedures in the near future. However,
MERCOSUR is a perfect example of how theconformity assessment infrastructure is lacking: Policymakers prefer to harmonize standards before moving to mutual recognition ofconformity assessment, but firms do not showmuch interest in standards because, in theB E Y O N D

absence of mutual recognition of conformity
assessment, the returns to investment in standards are low. This suggests that improvements in the conformity assessment infrastructure are necessary.
Singapore has signed a bilateral trade
agreement whereby the United States recognizes certifications provided by Singapore tosome of its East Asian partners. This highlights that rules of origin can be an importantelement in an MRA. If Singapore has a comparative advantage in the region in testing
and laboratory facilities and is well endowedwith professional staff in this activity, then the
U.S. agreement with liberal rules of origin(whereby the United States accepts tests fromSingapore labs of products from other countries), may help to establish or enhance theposition of Singapore as a regional hub for
testing and conformity assessment. Rules oforigin that restrict the testing and conformity
activities to products produced only in
Singapore would tend to constrain such a development. EU MRAs tend to have theserestrictive rules of origin.16

Regional trade agreements can facilitate
mutual recognition of standards
Effective solutions to problems arising fromdifferent standards require a high degree of dialogue and trust among trading partners.
RTAs, while not the only path to trust, tend topromote dialogue and communication, which
in turn build trust. This has been the case formember countries of MERCOSUR and theAndean Community, in which trust has grownas integration has deepened (Nofal 2004).
Such trust needs to be nurtured through openness and transparency when new national
regulations are being considered.
RTAs also can provide a favorable negotiating environment and so reduce politicizationin standard disputes among members, making
it easier to find common solutions for the removal of non-tariff barriers. The interactions
that take place in an RTA often improve institutional relationships between the different
standards bodies of member countries—and

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sometimes even between the institutions ofindividual countries. These close relationships
allow obstacles to be overcome in informal
ways, circumventing cumbersome formal interventions. MERCOSUR has yet to adopt
mutual recognition of standards, but many
conflicts over standards have already beensolved by telephone between relevant officials
in member countries.
A degree of trust between public institutions and the private sector is also important
if more flexible approaches, such as mutual
recognition of conformity assessment and/orof regulations, are to succeed. Strong, centralized regulatory cultures tend to produce technical regulations that are too detailed and difficult to change. It is important to ensure theeffective participation of the private sector
and consumers so that the setting of standards and their enforcement reflect broadrather than narrow interests.

Successful cooperation in harmonizing
standards depends on simple principles
To date, RTAs in the developing world have
not realized their full potential for overcoming standards-related obstacles to regional or
global trade, although some slow progress isevident, such as in MERCOSUR. That is
likely to change as the WTO agreements on
Technical Barriers to Trade (TBT) and Sanitary and Phytosanitary Measures (SPS) comeinto full practical application, and as the importance of reforming standards systems indeveloping countries gains prominence. In themeantime, several principles can contribute tosuccessful cooperation in standards and conformity assessment procedures.
A first step for developing countries is to
identify priority sectors for reform to keep
costs low and gather momentum for further
reform. The sectors to prioritize are thosewhere trade costs resulting from differences instandards and conformity assessment procedures are higher and where trade between
members is large.
Second, if international standards exist forthese products and they are appropriate for89

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2 0 0 5all members given their level of development,
then the simplest approach is to harmonize
around these international standards. This
will only be relevant if all members have thecapacity to implement them. It is important toclearly define objectives before harmonizing
standards so as to avoid overregulation. For
example, requiring information on labels thatthe consumer is unlikely to understand will
increase costs and contribute little to theobjective of making information available toconsumers.17
An open and transparent system, withstandards published in an accessible official
bulletin before being implemented, is essential
if regional initiatives are to facilitate trade
between members and preclude the difficulties facing exporters from outside of the region. Ensuring flexibility is also important;thus, regulations that set minimum standards
rather than detailed requirements are less restrictive for firms. When countries face internal resistance to modernizing and adopting
new standards, the compliance with standards can be offered on a voluntary basis.
This allows those firms that are able and willing to satisfy the new standards to progress.
Daskalov and Hadjikolonov (2002) show
how such an approach made it possible formore advanced and competitive local producers in Bulgaria to quickly adopt European
standards before they were formally introduced as mandatory Bulgarian standards.
In the short run, the greatest gain for many
developing countries is likely to come from
improvements in the testing, certification, andaccreditation institutions to underpin greater
enforcement capacity. Initiatives that improvethese institutions are likely to have large payoffs by allowing governments to achieve more
effectively their existing objectives concerning
health and safety and facilitating greater exports on both a regional and a global basis.
For example, most MENA countries requirethat testing be done at their national laboratories, which are usually less sophisticatedthan European testing centers and saddledwith cumbersome procedures, pushing up

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product costs (World Bank 2003). This hurts
MENA exporters and prevents MENA countries from joining global production chainsdestined for EU markets.
Many developing countries are too small toefficiently offer a full range of these conformity assessment services. Often there are too
many laboratories offering poor quality
services.
RTAs can contribute to better conformity
assessment first, and most simply, by facilitating dialogue and the sharing of technicalknowledge. More ambitious initiatives canbuild regional accreditation bodies to increase
efficiency and enhance the reputation of local
certification bodies in the global market. An
open regional market for laboratory services
can lead to cheaper yet higher quality testingon the basis of specialization and economies ofscale. However, it must be stressed that while
the potential gains are large, there are very few
successful initiatives that can provide useful
guidelines. ASEAN provides an example where
members are pushing forward with a numberof initiatives, including cooperation on legal
metrology, and efforts to enhance conformity
assessment bodies to facilitate mutual recognition of test reports and certifications.
RTAs can also provide a framework forcollaboration that increases the effective participation of developing countries in international standards organizations and at the
WTO. This is important if international standards and conformity assessment measures
are to reflect the interests of developing
countries—and therefore make the TBT and
SPS agreements relevant for the majority of
WTO members. For this participation to be
successful, the structure of international standards institutions needs to be modified toreduce the costs of representation of developing countries. The International Standards
Organization (ISO) has moved one step in thisdirection by being the first standard institution to allow electronic voting. This could be
extended to other institutions. Another possibility would be to allow RTAs to represent
their members in standard-setting committees,B E Y O N D

which would reduce members’ costs ofrepresentation.
Attempts to remove barriers caused by differences in standards and conformity assessment requirements will be more effective in a
climate of trust and mutual understanding.
Such a climate requires a genuine willingness toliberalize and is unlikely to result in agreementswith many exceptions, frequent recourse tosafeguard measures, and high barriers at theborder that can be due to customs delays andinefficient port and transport services.
The lack of relevant examples of successfulintervention at the regional level to deal withstandards issues makes it difficult to derive
clear proposals based on best practices. In thislight the best recommendation is for developing countries to proceed with caution andconcentrate on targeted coordinated action
for which the institutional requirements are
not extensive and the gains are clear.

Trade-Related Regional
Cooperation AgreementsCountries can benefit from other forms ofcooperation that are linked to trade directly through RTA arrangements or indirectly
when they influence trade-related inputs or
outputs.18 Such trade-related cooperation candeal with shared resources, such as water, fishing areas, power, railroads, or the environment. Schiff and Winters (2002) make the casethat in the presence of economies of scale orinter-country externalities, market solutions toproblems are not necessarily the best, andregional cooperation can often pay large
dividends.
When regional cooperation arrangements
are embedded in RTAs, it may be easier toconclude and implement these arrangements.
Increasing trade raises the level of salience of
all aspects of regional cooperation and may
foster greater high level attention to the regional arrangement and allow for more effective and informal dispute resolution. Moreover, agreements that cover more policy
domains—for example, trade, transport,

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power, and the like—allow countries to trade
off gains in one area against losses in another,
reducing or even eliminating the explicit compensatory schemes that would otherwise beneeded (Schiff and Winters 2002).
Consider some examples. The Southern
African Development Community (SADC)
provided the coordination point for regional
integration in a regional power cooperationagreement. The Southern African Power Pool
(SAPP), launched in 1995, was designed totake advantage of power resources in the region and was the first formal international
power pool outside of North America. The
12-country region has abundant hydropower
resources, especially the Inga Reservoir, large
reserves of cheap coal in South Africa, and the
Karriba Dam on the Zambia/Zimbabwe border. The pool covers 6 million square miles
and serves 200 million people. Utilities in theregion had been trading electricity for decades
through bilateral contracts, but these were
cumbersome to administer. The objective forshifting to the pool was to create a more efficient regional market. The SAPP is modeledon the “loose” pools in Western Europe andthe United States, which emphasize constantexchange of information to maximize the costand reliability benefits from trading and system autonomy. Rather than relying on central
dispatch, loose pools rely on long-term bilateral contracts drawn up with common designs
and security standards plus some central services. Unlike in the developed world, SAPP
membership is limited to national utilities.
Each member must meet its Accredited
Capacity Obligation, a requirement that eachutility have capacity to cover its forecastmonthly peak. Each member is also obliged tocover emergency energy up to six hours, toprovide automatic generation control andother facilities in its control area, and to allow
wheeling through its system. SAPP includes
most Southern African Development Community (SADC) members and is predicated on
the latter’s institutions, including the SADC
Treaty, the SADC Dispute Resolution
Tribunal, the SADC energy ministers, and the91

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Technical and Administrative Unit. The energy ministers are responsible for resolving
major policy issues.
Though still in its early stages, the pool’s potential benefits include reducing or postponing
new requirements for generating capacity andreserves, lower fuel costs, and more efficientuse of hydroelectricity. A SADC electric powerstudy conducted in 1990–92 estimated a savings of 20 percent ($785 million) in costs over
1995–2010.
Three factors were critical to the development of the regional agreement: The availability of complementary power sources, an active
regional organization for economic cooperation, and the political will to support increased regional energy trade. SADC and its
predecessor, the Southern African Development Coordination Conference, served as
focal points for promoting regional integration and facilitating investments in the neededinterconnection projects.
NAFTA offers another example. NAFTA
has also fostered regional cooperation for theenvironment by tying essentially extraneousenvironmental issues to the trade and investment deal. This link helped to create the necessary political support for NAFTA in the
United States, and it encouraged Mexico toaccelerate their environment program in orderto close the deal. The North American
Agreement on Environmental Cooperation(NAAEC) was signed as one of the side agreements appended to NAFTA at the last moment. It created the Commission for Environmental Cooperation (CEC) in Montreal inearly 1994 to carry out the provisions of theagreement. The CEC has a young but growing
conservation portfolio, focused mainly on protecting habitats and species. A broad programof cooperation to protect North American
birds is in place, aimed at identifying important bird areas across the three member countries and tying them into a protected network.
A Biodiversity Information Network is undercreation, and strategies are being developed
for cooperation to protect marine and coastal
ecosystems. The CEC has also coordinated92

measures to protect the monarch butterfly.
Currently there is an active task force working
to stop the smuggling of endangered species.
Under this program, U.S. Fish and Wildlife
officers are training Mexican officers.
While the trade agreements underpinningthese regional cooperation initiatives were notessential to the actual activities, it is clear thatthey have provided useful political and institutional synergies.

ConclusionsOne advantage of regional preferential
trade arrangements is that they create
opportunities to lower trade costs in areas
other than tariffs and non-tariff barriers totrade. This review of trade facilitation, standards administration, and regional cooperation agreements points to several conclusions.
The potential to expand trade by lowering
trade costs other than policy border barriers isgreat—and it may have a higher payoff to cooperative governmental efforts than reciprocal
reductions in border barriers. This is because
the costs of institutional obstacles, informal
barriers, and sub-optimal regulatory scales areoften higher than the costs associated with
policy border barriers. Further, many of thesebarriers do not generate revenues but simply
waste economic resources and directly constrain productivity. These issues are also
important elements defining the investment
climate.
RTAs can precipitate cooperation to lowering trading costs in these areas because RTAs
raise the level of policy salience, spread information about members and about international markets, improve the institutional efficiency of countries (better coordination
between the different institutions within acountry and between countries), provide “institutional homes” for joint initiatives, andmay facilitate dispute resolution acrossmultiple areas.
Countries need not act in concert to reap
the benefits of unilateral reforms; the chancesof unilateral success are much improved,
however, when policymakers are well

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informed about international standards andthe trade-facilitation activities of other countries. In the absence of such information, andof the capacity to act on it, it is unlikely that acountry, acting alone, will be able to matchthe benefits from participating in an RTA.
Finally, it seems clear that many RTAs are
not realizing their potential as a forum forreducing trade costs. North-South agreements
appear to have had somewhat greater success,perhaps because of the institutional interestsand strength of the more advanced partner.

Notes
1. Lawrence (1997).
2. For example, McCallum (1995) reports results
suggesting that Canadian provinces are more than 20
times more likely to trade among themselves than they
are to trade with U.S. states after controlling for the maineconomic determinants of trade. Subsequently, Nitsch(2000) found evidence of substantial border effects in
Europe, with internal trade being, on average, larger bya factor of 10 than trade with EU partners, although themagnitude of this effect did decline during the 1980s.
3. See, for example, Hummels and Skiba (2002).
4. GATT Article V mandates freedom of transit andnational treatment of products in transit. However, thisprovision has never been invoked. The WTO framework provides little leverage for poor, landlocked countries to improve transit conditions.
5. Trade facilitation is of particular importanceto landlocked countries, whose products must passthrough numerous border crossings and checkpoints.
Of the 50 least developed countries, 16 are landlocked:
Afghanistan, Bhutan, Lao People’s Democratic Republic, Nepal, Burkina Faso, Burundi, Central African Republic, Chad, Ethiopia, Lesotho, Malawi, Mali, Niger,
Rwanda, Uganda, and Zambia. Even coastal developing countries may be effectively landlocked if they are
not on major shipping routes and are served by inefficient and high cost coastal feeder services to main
ports. Being landlocked has a significant and depressing effect on trade. For these countries, a regional approach may be the only way to improve access to
global markets, since there seems to be little scope atpresent for solving transit issues within the WTO. Corridor solutions are efficient responses to the transport
problems of landlocked economies with deficient infrastructure. By definition they require bilateral or regional intervention.
6. RTAs with TTF approaches include theEuropean Union, MERCOSUR, Andean Community,
SADC, COMESA, EAC, UMEOA, SAFTA, Eurasec,

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and ASEAN. Two RTAs have no associated TTF:NAFTA and GCC. Three examples of TTFs existing
independently of RTAs are ECO, ECOWAS, and theNorthern Corridor Transit and Transport Agreement.
7. In treaties, competition is literally ensured
through “equal treatment of carriers” or nondiscrimination regarding carrier’s nationality, known
as respect of the third party rule.
8. According to UMEOA Commission (2000),
73 percent of the legal rules and customs governingtransport and transit regimes were derived from bilateral treaties (34 percent), national legislation (24 percent), and customs (15 percent); 27 percent were derived from regional treaties.
9. Collusion between transport operators leads toagreement on price setting. National associations playa role in determining which goods a company willtransport.
10. Standards can be mandatory as defined by governments (through technical regulations) so as to meettheir objectives regarding health, safety, and environmental issues; as well as voluntary, reflecting the demands and tastes of consumers or the technological requirements of industrial purchasers. In addition to thewriting of standards, an essential element of the systemof standardization is conformity assessment, the technical procedures such as testing, verification, inspection, and certification, which confirm that products
fulfill the requirements laid down in regulations andstandards.
11. From The Republic of Moldova Trade Diagnostic Study, World Bank, 2004.
12. The principle of mutual recognition was developed on the basis of European Court of Justice caselaw, specifically, the Cassis de Dijon and Dassonvillejudgements. In the former case, cassis from France wasprevented from being sold in Germany because it did
not contain enough alcohol!
13. Mutual recognition of regulations has also
been used within federal countries to remove barriers
to inter-state trade. For example, Australia formally
adopted mutual recognition in 1993 to remove regulatory barriers to the free flow of goods and labor between Australian states and territories. As in the EU,
some harmonized regulations are promulgated at thefederal level.
14. See Pelkmans and others 2000.
15. Bilateral trade agreements with the EU tend
to contain support for developing capacity in thedeveloping country, whereas those with the UnitedStates provide little such support.
16. Chen and Mattoo (2004) show evidence that
MRAs promote trade, but that restrictive rules of origin lead to trade diversion, especially against developing countries.

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17. Large companies in Brazil used their influence
to their advantage in setting a voluntary labeling standard that requires water bottlers to include the resultsof numerous tests that are not understood by, or particularly relevant to, the consumer, but that constitutean effective barrier to entry to small companies thatcannot afford the battery of tests required to provide
the information. SEBRAI, a private institution thatprovides support services for small enterprises in
Brazil, is working to improve access to certificationand metrology for its client firms. Through “solidarity
certification,” for example, SEBRAI helps groups ofsmall enterprises become certified at subsidized grouprates. SEBRAI also provides bonds that subsidize small
enterprises’ expenditures for metrology services.
18. This section draws heavily from Schiff andWinters (2002).

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5Beyond Merchandise Trade:
Services, Investment, Intellectual
Property, and Labor Mobility
As barriers to merchandise trade have comedown and trade has expanded, policymakers
and trade negotiators have turned their attention to services and trade-related regulatory
issues. Of these, services, investment, intellectual property, and temporary movement oflabor arguably have the greatest potential for
affecting incomes and trade in developing
countries. Agreements on these four issues are
now becoming common in bilateral and some
preferential regional trade agreements (RTAs).
North-South agreements, notably thebilateral free trade agreements of the UnitedStates and of the European Union (EU), havebeen the important drivers for services, investment, and intellectual property rights(IPRs). In broad terms, the United States, forexample, offers access to its large market forgoods in exchange for access to services markets in developing countries and their acceptance of rules governing investment andintellectual property rights. The EU market
access agreements also cover many of these
topics, if less specifically. Labor services—that is, the temporary movement ofworkers—are largely confined to professional and skilled workers, often intracorporate transfers. South-South agreements
tend to feature services liberalization lessprominently, and their rules governinginvestment, intellectual property, and eventhe temporary movement of workers, arecommonly weak or absent altogether.

From a development perspective, the mostpotentially beneficial components of this set ofissues are provisions that open services markets to additional potential suppliers throughforeign subsidiaries (in GATS terminology,
Mode 3) and the temporary movement ofworkers (Mode 4).1 Services liberalization in
preferential arrangements can enlarge thenumber of competitors and carries fewer risks
of income losses than preferential merchandise trade because lifting most common restrictions does not cost the government revenue. Though multilateral liberalization isusually preferable even in services,2 RTAs inservices can be predicted, in general, to increase welfare. Similarly, preferential agreements that widen the scope for the temporary
movement of workers have the potential toraise incomes.
In both services and labor mobility, however, agreements have yet to fulfill their development potential. Many of the North-Southagreements are between countries with unusually open service sectors, so the additionality to
the various parties is limited to a handful of
relatively small sectors and to the credibility
effects of locking in openness via treaties and“seals of approval” that investors might take asa sign of lower risk. Meanwhile, in many of theSouth-South agreements, where the potential
scope for liberalizing measures is often far
greater, RTA-driven additional liberalization
has been sporadic. For labor services, both the97

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North-South and South-South agreements are
confined to intra-firm movement of professionals, and neither agreement has substantiallywidened market access for the temporary
movement of labor.
By contrast, North-South agreements regarding investment and IPRs have succeededin promulgating comprehensive new rules that
go beyond multilateral rules in the agreement
on Trade Related Intellectual Property Rights(TRIPs). The United States and EU bilateralagreements have enhanced market accessthrough negative-list and positive-list (respectively) pre-establishment rights, and theUnited States has implemented investor-state
dispute settlement mechanisms that empower
foreign investors to seek arbitration awards incases of uncompensated expropriation orother violations of treaties.
Ironically, of the four areas, investment and
IPRs are the two where the development potential is largely unproven. The investment
provisions that enhance investor’s rights havenot been shown to increase the flow of investment to developing countries. Nor havestronger IPRs embedded in the TRIPS-Plusagreements been shown to accelerate technological flows to low-income countries—
though it may do so for middle-income countries. On the other hand, because free tradeareas that result in larger markets do attract
additional investment flows, it may be that in
combination with large, preferential tradeareas, enhanced investor protections and IPRs
do have a positive impact—but agnosticism
seems warranted.
This chapter begins with a synoptic comparison of agreements and a focus on theregulation-intensive bilateral U.S. and EU
free trade agreements (FTAs). Understanding
the diversity and reach of these agreements
permits us, in a subsequent section, toreview the economic consequences of provisions that deal with services, investment,
and intellectual property. A final section
examines the treatment of movement of
temporary labor.

98

Services, Investment, and IPRs
in Regional AgreementsNorth-South agreements differ sharply intheir coverage of services, investment,
and intellectual property. At one end of thespectrum, U.S. FTAs usually involve the most
explicit negotiations for market access in services and U.S.-style rules for investment andintellectual property. The EU market accessagreements similarly contain market accessprovision in services, but tend to reinforce prevailing international rules for intellectual property; its Economic Partnership Agreements in
Africa use development assistance in combination with trade preferences to promote rules
beyond international agreements, including
EU-style concerns for competition policy andgeographical indications. At the other end of
the spectrum, most South-South agreements
are focused primarily on merchandise trade,and tend to treat services, investment, andIPRs unevenly, if at all. These distinctions
should become clearer when we consider the
U.S., EU, and South-South approaches in turn.

U.S. FTAs are rule intensive
Key features of the U.S. FTAs that cover services, investment, and intellectual property
rights include:• Opening services markets to competition
from foreign suppliers or locking inprior autonomous liberalization, except
in those sectors excluded (i.e., on a negative list). Because most of the countries
with which the United States has concluded bilateral FTAs are already open in
most sectors, the agreements generally
lock in prevailing openness and affectchanges in only a few still-restrictedactivities. Significant market openings
took place in the Costa Rican telecommunications and insurance sectors andless dramatic market openings occurredin the banking sector in Bahrain. Provisions range from inclusion of insurance,

99

Yes
Yes
Yes

Positive-list
Negative-list
Negative-list

Positive-list

Positive-list
Positive-list
Negative-list
Positive-list

No
Standstillc
Positive-list

Negative-list
Negative-list
Negative-list
Negative-list
Negative-list
Negative-list
Negative-list

No
Yes
Yes

No
No
No
No

No
No
No

No
Yes
Yes
Yes
Yes
Yes
Yes

No
Yes
Yes

No
No
No
No

No
No
No

No
Yes
Yes
Yes
Yes
Yes
Yes

Yes
–
No
Yes
No
Nog

No
No
Yes

Yes
Yes
Yes
Yes
Yes
Yes
Yes

No
No
No
Yes
No
No

No
No
No

Negative-list
Negative-list
Negative-list
Negative-list
Negative-list
Negative-list
Negative-list

Negative-list
Positive-list
Positive-list
Positive-list
None
Positive-list

No
No
Positive-list

Negative-list
Negative-list
Negative-list
Negative-list
Negative-list
Negative-list
Negative-list

TRIMS+TRIMS+
No
No
No
No

No
No
No

TRIMS+TRIMS+TRIMS+TRIMS+TRIMS+TRIMS+TRIMS+

Ban onPerformance
Requirements

Yes
Yes
No

Yes
No
Yes
No
No
No

Non
Non
Non

Yes
Yes
Yes
No
Yes
Yes
Yes

Investor-State
DisputeSettlement

Yes

Noj
Nok
No
No1
TRIPS
Nom

Yesi
Yesi
Yesi

Yesh
TRIPS+TRIPS+TRIPS+TRIPS+TRIPS+TRIPS+

Intellectual
PropertyIntellectual
Propertya. Includes fair and equitable treatment.
b. Denial benefits only to juridical person that do not conduct “substantial business” in one of the member countries.
c. Provides for future negotiation of commitments à la GATS.
d. Right of non-establishment, that is no establishment required to supply a service.
e. Autonomous liberalization is automatically incorporated into the agreement.
f. Limits on equity shareholdings for companies in sectors other than those excluded from pre-establishment limitations.
g. COMESA does grant fair and equitable treatment to members, but not to non-members.
h. The IP provisions are considered TRIPs Plus. However the chapter coverage is less specific and comprehensive than other subsequent U.S. free trade agreements.
i. Requires only adherence to international conventions.
j. The MERCOSUR agreement does not include IP, but provides for interparliamentary committees to begin work on harmonization of IP laws.
k. Andean community regulates all patents.
l. ASEAN has a framework agreement.
m. Act 128(e) calls for adoption of new patent laws.
n. EU bilateral investment treaties provide for investor-state dispute resolution.
Sources: Legal treaties; Mattoo and Sauve 2004; te Velde and Fahnbulleh 2003; Mann and Cosbey 2004; Szepesi 2004a, 2004b; Abbott 2004a and 2004b; OECD 2003; information
provided by governments.

No
Yes
Yes

Other
Japan-Singapore
Canada-Chile
Chile-Mexico

No
Yes
Yes

Yes
Yes
Yes
Yes
Yes
Yes
Yes

Yes
Yes
Yes
Yes
No
No

No
Yes
Yes

EU
EU-South Africa
EU-Mexico
EU-Chile

Ownership
Limitationsf

Preestablishment
Limitations

RatchetMechanisme

National
Treatment/MF
Postestablishment

Pre-establishment
Right to& Limitations
ProvideRule of Origin
Market Access
Services w/o(Nonrestrictive)b
Exceptions
establishmentd

South-SouthMERCOSUR
Yes
Andean Community
No
CARICOM
Not specified
ASEAN
Yes
SADC
No
COMESA
Yes

Yes
Yes
Yes
Yes
Yes
Yes
Yes

U.S.
U.S.-Jordan
U.S.-Chile
U.S.-Singapore
U.S.-Australia
U.S.-CAFTA
U.S.-Morocco
NAFTA

Agreements

National and
MFN/Treatment
Market Accessa

Investment

Services

Table 5.1 Services, investment, and intellectual property: A comparison

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2 0 0 5financial advisory services, and selected
telecommunications services to arguably
relatively minor changes to the alreadyopen regimes, such as the commitment ofSingapore to cease cross-subsidies in express mail delivery or the commitment ofChile to open selected insurance services(table 5.2).
• Ratchet provisions and negative-list exclusions. The ratchet clauses mean that
new autonomous liberalization will automatically be subsumed under the termsof the agreements. Negative lists ensurethat yet-to-be-invented new service areas
are guaranteed to be covered by thetreaty. Notable for their absence is the
exclusion of labor services, except provisional visas for professionals associatedwith investing firms (discussed in the
penultimate section of this chapter).
• Investment rights. Investment rights, with
provisions for national treatment,
nondiscrimination, pre-establishment
provisions for companies based in eachothers markets, bans on trade-related
investment measures (TRIM), andinvestor-state arbitration of dispute limited only by a negative list of exclusions.
• TRIPs-Plus provisions that provide
stronger protections for IPRs than under
the TRIPS agreement, with investor-state
arbitration dispute settlement permitted
in the event of disputes (subject tocertain limitations).

Other noteworthy provisions (not the subject of this chapter) include labor protections
and environment issues that figured prominently in the CAFTA, Chile, and Singapore
agreements, among others. Signatory countries committed to enforcing their own laborlaws in five areas: right of association, theright to organize and bargain collectively, prohibitions on forced labor, a minimum age for
employment of children, and acceptableworking conditions. Complaints can be filed,
and if the agreed-on procedures to mediate thedispute fail, a panel of experts would review
the case and, if warranted, impose a fine to be
used for the enforcement of labor rights; thatis to say, trade sanctions are not an agreed-on
remedy (Weintraub 2004).
The FTAs involve innovations in trade law
in two important areas: investment and IPRs:
Investment Access and Protections. The
FTAs have incorporated the provisions ofbilateral investment treaties (BITs), and insome cases, provided new measures covering investment (table 5.1). Agreements, especially post-NAFTA ones, include broad
definitions of investment, comprising not
only foreign direct investment (FDI), but also
portfolio flows, private debt, and even sovereign debt issues as well as intellectual property (Mann and Cosbey 2004; Vivas-Eugui
2003). The inclusion of short-term debt, together with pre-establishment rights, led the
U.S. Treasury to demand that Chile modify
its controls on capital inflows that wereTable 5.2 Additional services liberalization in U.S. FTAs
Chile

Banking
Insurance
Telecommunication
Broadcasting & Audiovisual
Financial Advisory Services and Data
Retail/Wholesale Distribution
Restrictions on Foreign Directors & Managers
Express Mail Delivery
Real Estate
Legal Services
Source: Legal treaties.

100

◆
◆
◆

Australia◆

Bahrain

CAFTA

MoroccoSingapore

◆
◆
◆

◆
◆

◆
◆
◆

◆

◆

◆
◆

◆

◆
◆
◆
◆

B E Y O N D

designed to curtail destabilizing hot money
inflows.3 Such broad definitions expose
countries to dispute settlements across a rangeof assets that go far beyond multilateralcommitments.
All agreements provide for treatment offoreign investors on the same basis as domestic investors (national treatment) and haveprovisos banning discrimination among investors from member countries (MFN, or
nondiscriminatory treatment). For many of
the initial FTA countries, these stipulations
had been included in national legislations
and/or had been incorporated into bilateral
investment treaties, mainly on a postestablishment basis.
What is new is the extension of the preestablishment right to invest in businesses andactivities in all sectors, except where expressly
prohibited via a negative list.4 These preestablishment rights lock in the right ofMexican and Canadian investors under
NAFTA to invest in all activities in the UnitedStates. Exceptions for the United States include foreign investment with NAFTA guarantees in selected areas of communication,
media, transportation, and social services.
Pre-establishment rights mark a broad expansion of market access by foreclosing future
government policies that would raise barriers
to foreign investment. The rationale for accepting such disciplines is that it provides certainty on the rules of the game, which
will in turn translate into increased investment
inflows.
Another discipline more expansive thanmultilateral accords is in trade-related investment measures (TRIMs). The WTO TRIMs
agreement of 1995 attempted to clarify disciplines on government policies that require
foreign companies to establish joint ventures,
export in a certain portion of its sales or balance trade, use local inputs to achieve valueadded objectives, or hire local staff. However,
the agreement failed to provide adequate definitions of disciplines, and it presented poorly
formulated implementation periods andinadequate notification and monitoring

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procedures; the operation of the agreement
was to be reviewed by January 1, 2000, but
so far the review has not occurred (Bora
2003). All of the bilateral FTAs ban, in someform, trade-related investment requirements,
such as by local content rules, value-added requirements, and restrictions on management.
The U.S. bilateral agreements have, in effect,
established a “TRIMs-Plus” set of obligations
that includes outright bans on certain performance requirements, including exports, minimum domestic content, domestic sourcing,trade balancing, and technology transfer.
In general, government procurement,
environmental standards, some health measures, and requirements for local research anddevelopment (R&D) are all exempt (Te Velde
and Fahnbulleh 2003).
Freedom to make transfers is a nontrivial
investment right granted under the investment
agreements. This assures investors thatthey will be able to transfer profits, makeinvestments, or lend without government
interference.
Finally, all U.S. agreements except theAustralian FTA create an investor-state
dispute resolution provision that permits investors to take foreign governments to dispute
resolution for violation of the treaty’s national
treatment, nondiscrimination, or expropriation provisions, among others. NAFTA’s
Chapter 11 and Chile’s Chapter 10 are themost widely known mechanisms, but thesemechanisms are contained in the other bilateral agreements as well.
Intellectual Property Rights. The IPR provisions embedded in all recent U.S. FTAs go
beyond the multilateral IPR standards established in the WTO’s TRIPS Agreement.
“TRIPS-Plus” elements found in many—but
not all—of the IPR chapters include:5• Extension of the patent term for delays
caused by regulatory approval processes;
extension of the term of copyright protection to life of author plus 70 years(compared to life of author plus 50 years
in TRIPS).

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• A requirement to provide patent protection for plants and animals.
• A limitation on the use of compulsory
licenses for national emergencies and as
antitrust remedies, and for public noncommercial use.
In the area of pharmaceuticals:• An obligation to prohibit the marketing
approval of generic drugs during theterm of the drug patent.
• A five-year period of marketing exclusivity following the submission of safety
and efficacy data to drug regulatory
authorities (so-called data exclusivity).
In addition, marketing exclusivity effectively applies across borders, so that marketing approval in one market—say, theUnited States—impedes registration ofcompeting products in another market.
• An additional three-year period of marketing exclusivity based on the submission of new clinical data with respect to
new uses of previously approved drugs.
Exclusivity would also apply to drugs forwhich the patents have expired (althoughgeneric competition for previously approved uses would remain unaffected).
• Imposition of restraints on parallel importation, impeding the possibility thatparties to the agreements open theirmarkets to the import of products thathave already been sold—possibly morecheaply—in foreign markets.
In the area of digital works:• An obligation against circumventing
so-called
technologicalprotection
measures—devices and software developed to prevent unauthorized copying ofdigital content. Rules on the liability ofInternet service providers (ISPs) when
copyright infringing content is distributed through their servers and networks.
These provisions are based on standards
found in the U.S. Digital Millennium
Copyright Act of 1998.

102

The inclusion of these services, investment,
and IPR issues was a contributing factor to thebreakdown in negotiations in the Free
Trade Area of the Americas (Nogues 2004).
We return to these issues below when considering the economic consequences of thesearrangements.

EU FTAs take a different approach
In addition to market access in merchandise,the EU has focused heavily on services in its
bilateral FTAs. The earliest (and least specific)
is the South African agreement (1999) that
contains only the promise of potential liberalization after discussions transpire in 2004 and2005. In the EU-Mexico FTA, several generalprovisions were included (many ratifying
GATS arrangements), as well as specific liberalization commitments in the financial sector.
The EU-Chile agreement went further than theother two and included liberalization of
telecommunications and maritime services(Ullrich 2004).
The EU agreements with Mexico and Chile
differ from the U.S. agreements in important
respects. First, the trade provisions arephrased on the basis of a positive list andimplicitly exclude new products. Second, thetreatment of intellectual property effectively
reaffirms a multilateral approach to IPRs,
because the agreements provide only the listof conventions that signatory countries havealready ratified, those it intends to ratify, andthose that it will consider ratifying in the
future.6 This approach differs from that taken
toward the EU-accession countries, in which
new entrants were required to apply the rigorous EU standards on data protection and marketing exclusivity; these have a major impact
on generic producers.
The treatment of investment and capital
flows in both agreements does not appear to
be extensive. For example, the EU-Mexico
agreement simply states that the existing restrictions on investment will be progressively
eliminated and no new restrictions adopted;
the agreement did not specify particular sectors or set a timeline for liberalization. The

B E Y O N D

language in the EU-Chile agreement calls forthe “free movement of capital relating to direct investments made in accordance with thelaws of the host country.” In both instances,
the agreements allow for the use of safeguards
in the event of monetary or exchange rate difficulties, and although the time limit is set
at 6 months for Mexico and 12 months for
Chile, it would allow for continuation of thesafeguard after the time limit through its formal reintroduction. That said, many of thesame investor protections found in U.S. FTAs
are also found in EU bilateral investment
treaties with developing countries.
The treatment of dispute settlement is similar in both agreements. In general, the EU has
no special provisions pertaining to investment,
but these are covered under the general dispute settlement provisions for all matters in
the agreements (Szepesi 2004a and b). Disputesettlement is covered on a state-to-state level
and is first attempted through consultations
with a Joint Committee (Association Committee in the case of Chile) within 30 days ofa party’s request. If this step of “dispute avoidance” proves unsuccessful, the concerned
party can forward its request to an arbitration
panel comprised of representatives of bothparties. The arbitration panel’s decisions arebinding, and the panel can also rule on theconformity of any measures undertaken as aresult of its decision with the original ruling.
Both agreements provide extensive detail on
the process of appointing members to thearbitration panel, timelines for the panel’s
ruling, and compliance with the panel’sdecisions.

South-South agreements focus
on expanding trade
Virtually all of the other major agreements
contain references to services liberalization.
Most agreements allow for national treatment, post-establishment nondiscriminatory
provisions (table 5.1). At the other extreme,
there are more limited agreements like Association of Southeast Asian Nations (ASEAN)
and Southern Common Market Agreement

M E R C H A N D I S E

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(MERCOSUR) that have delivered services
liberalization additional to levels negotiatedmultilaterally or determined unilaterally. Regional agreements in services have competed
to create complex structures of rules and commitments. But in many cases, the sound andfury of the negotiations has signified limited
liberalization. Many agreements do not provide new market access beyond what countries have already scheduled with the GATS.
In telecommunications and financial services,
the GATS has in fact achieved a higher level ofbound liberalization than that offered in most
RTAs.
All South-South agreements have a relatively nonrestrictive definition of preferential
access; by allowing firms from nonmember
countries that have “substantial business” inmember countries to invest through subsidiaries based in member countries, the number of potential competitions in the market isenlarged.
Agreements with negative lists have several
advantages in terms of market access: they
permit automatic liberalization of new service
industries; they establish a stronger floor for
liberalization by locking in the status quo;
they are more transparent; and they may leadto a more productive internal dialogue withsectoral private interests (Mattoo and Sauve
2004). Ratchet mechanisms that allow newautonomous liberalization to be incorporated
automatically into treaties are most likely toco-exist with negative list provisions.
However, most of the South-South agreements
have not liberalized many sectors, and some,like MERCOSUR, have not implemented
accords in the way that was anticipated atsigning (Nofal 2004).
Investment provisions have differed aswell. South-South RTAs generally have beenless ambitious with respect to investor protections. This is true for the right to provide services without establishing local affiliates. It isalso true for investor-state dispute settlement.
For the most part, only the United States andEU bilaterals have established sophisticatedmechanisms to deal with disputes on

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investment. Some agreements provide forinvestor-state dispute resolution, though these
protections are less strong than in the NorthSouth Agreements.
Intellectual property rights, while mentioned in South-South agreements, rarely go
beyond disciplines negotiated at the multilateral level, and they do not have the tightly formulated provisions that characterize theNorth-South agreements, notably those with
the United States. MERCOSUR, for example,
has agreed to establish a commission to examine areas of intellectual property harmonization, while ASEAN has a framework agreement. The Andean community has moredetailed restrictions, but these are written lesswith the view of protecting intellectual property than of eliminating territorial restrictions
on the use of patented technology; the restrictions were designed to end the restraints
multinational companies put in their technology contracts with their foreign affiliates,
which explicitly prevented them from using
the patents in export production.

Economic Consequences ofServices, Investment, and IPR
Provisions in RTAs
New market access in services could
promote growthServices liberalization with proper regulation
can be a powerful driver of economic growthand poverty reduction. At the sectoral level,
removing barriers to competition can lower
prices, improve quality, and add variety. Because of the linkage effects—the fact that producers require telephones, use finance, needadequate transportation services, and benefit
from business services—improving service sector performance can generate huge economic
gains. Mattoo, and others (2001) show thatcountries with fully liberalized financial andtelecommunications sectors grew annually on
average about 1.5 percentage points fasterthan other countries, controlling for other factors. These gains are not automatic—theyrequire adequate regulation and a supportive104

investment climate—but the potential gains
are large (World Bank 2001).
Realizing these gains requires allowing foreign investors greater market access, and thisis the most important provision in a preferential arrangement. Countries can open previously closed sectors to RTA partners as part ofan agreement. Since today most countries accept, indeed clamor for, foreign investment in
manufacturing and natural resources, RTAdriven reductions in entry barriers affectmainly services. Moreover, services now play alarger role in investment flows, and for somecountries, such as Mexico, they have dwarfed
investments in manufacturing. The great bulkof services investment are market-seeking,horizontal investments. These cover a vast
range of large multinationals: Deutsche Bank,
WalMart, Starbucks, Microsoft, and so on.
These “mode 3” services require the commercial presence of affiliates, branches, or franchises to deliver the service. To be sure, somecountries (such as India) have experienced
substantial flows associated with call centersand data processing, and this new investment
accompanies these cross-border supply(“mode 1”) activities, though these activities
remain small in comparison to trade throughcommercial presence.
Because preferential arrangements permit
more suppliers to compete in the market, acountry is almost certain to gain from preferential liberalization of the services trade, irrespective of the supplier. This is in sharp contrast to merchandise trade, where the income
loss associated with trade diversion can occur
with the loss in tariff revenue. In services, barriers to entry usually take nonmonetary forms
such as regulatory restrictions on entry, foreign equity limitations, quotas on outputs andforeign service workers, and requirements on
legal form of establishment. None of thesegenerate revenue for the government, so removing these restrictions is less likely to produce income losses (with merchandise trade,
income losses associated with trade diversion
occur because the government loses the tariff
revenue as trade is diverted to higher-cost

B E Y O N D

sources of imports). Moreover, the scope forincreased competition and exploitation ofscale economies, as well as the possibility of
inducing knowledge spillovers, strengthens thepresumption that a country would gain from apreferential agreement in services.
Multilateral, nonpreferential liberalization
is likely to produce even larger gains thanpreferential regional agreements. This is because multilateral liberalization opens themarket to the largest number of competitors
and permits consumers maximum choice; itallows imports from the most competitive
source. It also leads to a less complex policy
regime than a preferential arrangement, andtherefore implies lower administration costs
for government agencies and lower transaction costs for the private sector. Finally, it ispossible that preferences could lead to ahigher-cost firm gaining a competitive advantage relative to investors from outside the region. And first mover advantages and barriers
to entry can make it difficult for lower-costsuppliers from third countries to enter themarket. Inefficient suppliers from member
countries might establish positions behindmarket barriers sufficiently high that new andeven more efficient potential competitors
would not choose to pay the cost of entry.
Rules of origin for services, as with merchandise trade, can play a significant role in determining the degree to which regional tradingarrangements discriminate against nonmember
countries, and hence the degree of competition
in services associated with an RTA. For example, if one participant has a fully liberalized
market, the adoption of a nonrestrictive rule oforigin by the other participants can be likened
to MFN liberalization. Service suppliers canenter the liberal jurisdiction and from there
move to the other partner countries. Many governments take the liberal rules of origin one stepfurther and extend regional preferences on an
MFN basis under the GATS. This widens thenumber of competitors in the market and offers
greater opportunities for securing access to themost efficient suppliers—particularly of infrastructural services likely to exert significant

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T R A D E

effects on economy-wide performance. Becauseof the strong potential links to growth (WorldBank 2002), the additional market access provided through RTAs could be important. Unfortunately, the actual additional liberalization
has not yet matched this promise.
Nonetheless, restrictive rules of origin canlimit the potential benefit to liberalization.
Participants who seek to benefit from preferential access to a protected market and denybenefits to third country competitors are likely
to argue for the adoption of restrictive rules oforigin, based on criteria such as ownership orcontrol considerations. This could be the attitude of regionally dominant but globally noncompetitive service providers toward thirdcountry competition within a regionally integrating area.
Examples of restrictive rules of origin forservices and investment can be found in
MERCOSUR and the Andean Pact, both ofwhich limit benefits to juridical persons thatare owned and controlled by natural personsof a member country. The Hong Kong-China
Free Trade Agreement, for example, features adetailed annex spelling out the set of criteria
by which Hong Kong service suppliers may
benefit from the terms of the agreement.

Do RTAs attract more investment?
RTAs can, in theory, promote more investment through new trade rules that create alarger market, new investment rules that
permit market access by relaxing restrictions
on market entry (such as discussed above forservices), and new investor protections.
New trade rules that eliminate internal barriers create a larger internal market, which canraise the return to investment and create an
incentive to invest for members and for third
countries. Firms investing in the RTA countries can achieve economies of scale and scopein serving a larger market of potential buyers,
may experience reductions in transactions
costs, and if services are included, benefit from
more efficient financial, telecommunications,and other services (Schiff and Winters 2003).
Trade rules can induce greater efficiency in

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2 0 0 5transactions with the global economy.
Markusen (2004), for example, notes thatinward investment to reach the local market
may also include tapping into lower cost production sites within the new RTA to serve thewealthier parts. Japanese multinational companies might well locate in Mexico to reachthe U.S. market, though the net effects might
be diluted as U.S. firms also set up in Mexico.
Frischtak (2004) found that MNCs in autos,
textiles, and electronics reallocated their production to Mexico to serve the U.S. market.
The larger market can also increase productivity in other ways. Aside from economies
of scale, a larger market can increase competition among a potentially larger set of suppliers, and take advantage of differing regional
factor prices to drive productivity increases
and hence more rapid growth; and the more
rapid growth provides a dynamic attraction
to intra-bloc and extra-bloc investment. If the
RTA reduces border protection on investment
goods and allows domestic producers to source
cheaper and higher technology capital goods,
members may benefit.
However, efficient results are not automatic.
Even though investment may be destined for alarger market, border barriers may create incentives to invest in high-cost import-substituting

activities that are not internationallycompetitive. Latin America’s early experimentswith admitting FDI behind high border barriers produced inefficient investment and a protectionist political economy that took decades
to unwind (box 5.1). The formation of RTAs
may increase both internal and external investment, but the resulting market size may
not be sufficient to realize modern scales, andthe high external tariffs drive up the costsof imported inputs. Indeed, the first Andean
Pact in the early 1970s and the Central American Common Market in the 1960s failed
to generate investment-related productivity
gains.
RTAs may include new investment rules tofacilitate market access. As with services, thedecision to lift an administrative barrier impeding manufacturing investment or an investment in natural resources can create an
opportunity for investors and hence prompt
new investment. Most remaining restrictions
today—equity ownerships limitation and banson foreign investment in particular activities—
are not restrictions on manufacturing, butrather on services (e.g., broadcasting,telephony, and airlines in the United States,
among other countries) and natural resources(e.g., oil in Mexico). RTAs that reduce market

Box 5.1 Not all investment is good investment

Trade barriers in preferential arrangements candivert trade to higher-cost sources. No less important is the investment undertaken to produce the
new trade. If trade policies provide high protection,
they will limit competition, allow for shared monopoly pricing, and incur the inefficiencies of price distortions. This pattern of investment was common—and costly—in the period before high protection was
brought down. Lall and Streeten (1977) who studied
some 90 foreign investments using a cost-benefit
methodology, found that more than 33 percent
reduced national income; this was mainly from excessive tariff protection that allowed high cost firms
to produce for the local market at very high106

prices, even though they could have imported much
more cheaply. (It turns out domestic firms performed
even more poorly.) Encarnation and Wells (1986)
found that between 25–45 percent of 50 projects
studied (depending on analytical assumptions) reduced national income; again the main culprit washigh protection. As average tariff levels have comedown, these low-quality type of investments have
faded in importance. Trade and tax policy often interact in ways that magnify their competition-restricting effects.
Sources: Lall and Streeten 1997; Encarnation and Wells 1986;
Newfarmer 2001.

B E Y O N D

access barriers associated with restrictions on
foreign entry are likely to have greater impact through this channel than throughmanufacturing.
Granting new investment rights may also
attract additional investment, though here thecase is more contentious. In general, thestrongest investor protections entail nondiscrimination among all investors, provisions
against expropriation, dispute settlement witheligibility for investor-state suits, and independent arbitration. The legal power granted toinvestors to sue governments under terms of
the bilateral or regional agreements is arguably the strongest new protection in the
trade agreements. These provisions differ indetail, but they closely mirror the bilateral investment treaties, even though they are anchored to the trade agreement.
Despite the proliferation of new protections
to foreign businesses, the positive economic
consequences have yet to be demonstrated.
Theory would suggest that sound property
rights are a foundation of any country’s invest-

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T R A D E

ment climate, and, other things being equal,
stronger rights would lower risk and enticemore investment at the margin. Since investors
put money at risk against the promise of returns in subsequent periods, predictable regulation and protection of property rights are integral to the investment decision. However, theevidence for many of the same protections contained in the bilateral investment treaties is thatthese additional protections have no significant
effects on inflows of FDI (box 5.2). To be sure,signing an FTA with new investor protections
may enhance the credibility of a reform program, but evidence that these have observableconsequences is scarce.
While the benefits of these protections in
the form of new FDI inflow are open to question, the costs in the form of investor suits
are nontrivial and growing. In NAFTA, forexample, as of July 2004, there were 31
cases brought under Chapter 11 (including 14
against Mexico, 9 against Canada, and 8
against the United States). Six cases have been
decided in favor of the investor, but theBox 5.2 Do more investor protections mean moreinvestment? Lessons from bilateral investment treatiesD

oes increasing investor protections produce thebenefit of high investment? One test of this
proposition was Hallward-Dreimeier’s (2003) studyof the enhanced investor protections through bilateral investment treaties for flows of FDI among signatory countries.6 Analyzing bilateral flows ofOECD members to 31 developing countries over two
decades, she found that, controlling for a time trend
and other factors, BITs had virtually no independent
effect in increasing FDI to a signatory country froma home country. Said differently, countries signing a
BIT were no more likely to receive additional FDI
than countries without such a pact. Even comparing
flows in the 3 years after a BIT was signed to the
3 years prior, there was no significant increase in
FDI. This agrees with the findings of UNCTAD(1998) that the number of BITs signed by the hostwas uncorrelated with the amount of FDI it received.

BITS do not add much
Share of annual FDI flow
0.3

0.2

0.1

0

3

2

1

Years before signingYearsigned123Years after signing

Source: World Bank Global Economic Prospects 2003.

Sources: Hallward-Driemeier 2003; UNCTAD 1998.

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2 0 0 5amount awarded has been small compared toinitial—and inflated—claims. Tribunal awards
have totaled $35 million, compared to claims
of $1015 billion. Under the similar BITs, 48
alleged BIT violations are under review arbitration at the International Center for Dispute
Resolution. Cases have arisen out of theArgentine devaluation, the changes in tax policy perceived as adverse by investors, expropriations following conflict or coups, irregularities in bidding processes, and others(Peterson 2003a). In perhaps the most significant case to date, a tribunal in Stockholm ordered the government of the Czech Republic
to pay one company, Central European Media(CME), $350 million for violation of a bilateral investment treaty that deprived CMEfrom a stake in an English language TV
station in Prague.
This amount was 10 times higher than previously known awards under arbitration cases
and about equal to the entire public sector
deficit of the Czech Republic (Peterson
2003b).
The legal and macroeconomic consequences of investment rights in treaties arelargely unknown. They have not been thoroughly analyzed and tested in arbitration
cases, and are without precedent. One could
certainly speculate about adverse outcomes.
For example, new rules for Chile could complicate management of short-term capital
flows; in fact, the IMF expressed reservations
to the U.S. government that the limitations
that the U.S.-Chile bilateral FTA imposed on
the Chilean government regarding short-term
capital inflows reduced the government’s ability to manage a macroeconomic crisis. Similarly, the breadth of definition of investment
coverage opens the government to investorstate arbitration in event of default on debt orsuspension of payments in emergencies—
which may ultimately be unenforceable. For
instance, Argentina’s default has led investors
to file nearly 30 arbitration cases; none ofthese appear to have been associated with
nonpayment of debt. However, these debts arealso subject to ongoing discussions between

108

the government and creditors. By defining
intellectual property as an “investment,” aforeign investor who claims his intellectual
property rights have been abrogated has recourse beyond the national court system to international arbitration proceedings under theinvestment provisions of the bilateral agreements.7 These provisions have unquantifiable
development benefits—and bring risk, which
incurs uncertain costs.

The combination of changes in RTAs may
have an effect on investment
Even if protections by themselves contributelittle additional inflows, evidence is mountingthat RTAs—that is, the combination of appropriate trade rules, liberalized market access,and investor protections—can have positiveeffects on inflows of foreign investment, provided that the investment climate is supportive
and the size of the newly created market is
attractive.
Indeed, Lederman, and others (2004)
found that RTAs that formed large markets attracted FDI, (controlling for other factors that
influence location), but that small markets
had no effect. They also found positive effects
for NAFTA, although the flow of FDI, evencontrolling for privatizations, appears to have
surged in the first years but has not been sustained. Waldkirch’s (2001) study, with lesscomplete annual data, found that NAFTA increased FDI substantially, mostly from theUnited States and from Canada. Chudnovsky
and Lopez (2001) found that FDI increased in
the MERCOSUR, largely from outside
sources, but that it often entered via acquisition, displaced domestic investment, and wastariff-hopping to produce for the local
market—so it probably contributed to less togrowth less than it otherwise would have.
They also found that FDI inflows tended tolocate in the larger countries, underscoring theneed for stronger institutions and policies inthe smaller countries.
Levy Yayati, Stein, and Daude (2004) useda gravity model to analyze the effects of RTAs
on FDI inflows in 13 major agreements, andB E Y O N D

then applied their findings to a simulation for
the FTAA. They found that RTAs have astrong positive impact on inflows, and that if
these average magnitudes hold after the signing of an FTAA, the results would be substantial increases in flows to FTAA countries.
However, the distribution is uneven, andcountries with larger post-RTA market size,
low inflation rates, strong domestic institutions, and open economics are likely to be thebiggest beneficiaries.
To investigate further whether RTA formation can affect FDI flows in a consistent fashion, we examine the effects of RTA membership and other variables on FDI inflows for apanel of 152 countries over the 1980–2002
period. The sample takes into account 238
RTAs (both regional and bilateral), many ofwhich overlap, that encompass the vast majority of sample countries.8 In general, countries that are more open (measured as the sumof exports and imports over GDP), growing
more rapidly, and are more stable (captured
in less volatile inflation rates), attract greater
quantities of FDI, controlling for growth ratesof FDI to all countries and the world growthrate.9 RTAs that result in larger markets do attract greater FDI. The interaction of an RTA
signing and additional market size associatedwith the integrated markets is significant andpositively related to FDI. On average, a 10
percent increase in market size associated withan RTA produces an increase of 5 percent.10
This has important policy implementations: If
a country seeks to use an RTA to attract investment, it should seek to amalgamate withthe largest possible markets; RTAs amongsmall market countries have little effect.
Two important caveats to this conclusion
are worth underscoring: First, a preferential
trading arrangement cannot compensate for
an inadequate investment climate. Stein and
Daude (2001) have shown that institutionalvariables that make up the whole of a country’s investment climate—including politicalstability, government effectiveness, rule oflaw, and lower risks of expropriation—are all
significantly associated with increases in

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T R A D E

investment flows, controlling for other determinants of FDI. These wash out the otherwise
positive effects of RTAs. If the economy suffers from poor macroeconomic management,high levels of corruption, and poor infrastructure, an RTA by itself will not offset the disadvantages. To be sure, an RTA may help governments through their collective action to
improve the investment climate and bring in
more investment; but an RTA is no substitutefor an adequate investment climate (WorldBank 2004). Second, creation of an RTA will
not have much effect on investment inflows
from outside the region if restrictions on market access are severe and remain unchanged.

How do IPRs affect the priceof technology?
Creation and enforcement of IPRs have an important role to play in development, but neither theory nor available studies provide much
guidance on the likely outcomes of implementing in trade agreements the strongest of
the IPRs or none at all. On the one hand,stronger IPR enforcement in general is likely
to enhance the overall investment climate,especially for high technology firms. On theother, recognizing full patent protection forfirms may require poor countries to pay
higher prices, with little additional incentive
either to innovate or to make investments inthe local market.11 Full enforcement ofpatents12 could produce substantial financial
flows, estimated roughly at $19 billion to
the United States and $7 billion to Germany(World Bank 2001). Moreover, the administrative costs of upgrading IPR systems are nottrivial (Finger and Schuler 2004).
It was the prospect that developing countries would have to pay higher prices forpatented drugs that motivated the international community to agree to clarify flexibilities embedded in the TRIPS Agreement at the
WTO Ministerial Meeting in 2001. The
resulting Doha Declaration on TRIPS and
Public Health reaffirmed the right of WTO
members to use the flexibilities of TRIPS in
the areas of compulsory licensing and parallel109

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2 0 0 5

importation to “. . . promote access to medicines for all.”13 In August 2003, WTO members created a special mechanism under the
TRIPS Agreement that allows countries withinsufficient manufacturing capacity to effectively use compulsory licenses by importing
generic drugs.
At first blush, the TRIPS-Plus portions of the
U.S. FTAs seem to circumscribe the policy spaceprovided in the Doha Declaration. In particular, provisions on the link between patent status, marketing approval, and data exclusivity
appear to put limits on the spirit of the Doha
Declaration, because countries may be prevented from effectively employing compulsory
licenses to introduce competition from genericdrug producers.14 To address these concerns,
the U.S. bilateral agreements with Bahrain,
CAFTA-DR, and Morocco contain side lettersthat share the understanding that the intellectual property chapters do not affect the abilityof governments to “. . . take necessary measures to protect public health by promoting
medicines for all [. . .].”15 In other words,
government can be justified as protecting
public health, as permitted under the three
FTAs. The United States Trade Representative
office recently clarified: “. . . if . . . a drug is
produced under a compulsory license, and it isnecessary to approve that drug to protect public health . . . the data protection provision in
the FTA would not stand in the way.”16
Notwithstanding the potential flexibilities
provided by these side letters, they raise several questions. How widely will the parties tothe three agreements define the “protection of
public health”—or, what definitions would anarbitration panel use? Uncertainty in this respect may become itself a barrier to making
use of the flexibilities and may open the door
for restrictive interpretations by vested interests. Also, several of the other U.S. FTAs do
not contain comparable side letters, raisingquestions about conflicts between intellectual
property obligations and public health objectives in at least some of the affected countries.
The welfare effects of stronger and new
copyright protection standards are ambiguous.

110

On the one hand, most countries haveindustries that rely on copyright protection andthat may benefit from strengthened protection.
And new technologies that greatly facilitate thecopying of digital works pose challenges thatpolicymakers need to address. On the other
hand, copyright laws have historically sought
to strike a balance between the interests ofcopyright producers and the interests of thegeneral public. So-called fair use exemptions
allow the copying of protected works for educational or research purposes. There are questions that new rules on the technological protection measures and the liability of Internet
service providers could diminish the rights ofconsumers and the general public (CIPR 2002).
Ensuring fair use of copyrighted material isparticularly important for educational material. The opportunities and gains from the use ofdigital libraries, Internet-based distance learning programs, or online databases would be
limited if access to such tools became unaffordable or otherwise restricted by copyright law.
Evidence is inconclusive about the responsiveness of FDI to intellectual property
regimes. Although surveys of foreign investors
typically indicate concerns for IPRs, this isoften of secondary priority (Mansfield 1995).
Maskus (2000) concludes that countries (especially low-income countries) should focus on
their overall investment climate to attract
more and high technology investment, rather
than to fine-tune their IPRs. Nonetheless,some multinational companies (MNCs), whenselecting an investment location among
middle-income countries, clearly take into account the laws governing intellectual property.
Other studies have found that weak laws andweak enforcement deter investment in middleincome countries,17 but the results for lowincome countries are inconclusive. Finger andNogues (2002), in fact, argue that the introduction of patent protection for drugs in Chile
made several multinational pharmaceuticalcompanies stop production and investment
and source this market from other locations.
In summary, Fink and Maskus (2004) in their

B E Y O N D

review of the evidence conclude: “. . . countries that strengthen their IPR regimes are unlikely to experience a sudden boost in inflows
of foreign direct investment,” but that IPRs
can stimulate formal technology transfer
through FDI and licensing.
All in all, the general conclusion is that countries have to develop an IPR strategy appropriate to their level of development, and then analyze carefully which if any IPR provisions ought
to be contained in trade treaties or RTAs.

RTAs and Provisions for
Movement of Labor
Using RTAs to promote movementof unskilled workers
Walmsley and Winters (2003) estimated that if
a temporary visa system were introduced inthose developed countries that permitted the
movement of up to three percent of their labor
force, world incomes would rise some $160
billion. Some 70 percent of the global welfare
gains from increased migration would comefrom the movement of unskilled workers. To
date, progress under the GATS Mode 4 negotiations in easing restrictions on the temporary
entry of workers has been limited; the agreement has generally been used for skilledworkers, not unskilled.
Regional agreements might offer a more
promising venue for realizing the gains fromM E R C H A N D I S E

T R A D E

temporary movement of workers—that is, bygoing beyond the relatively limited scope of
the GATS Mode 4 provisions. Regional agreements are often between countries with historical ties, and former migrants (or their children and grandchildren) tend to support
increased opportunities for citizens of theirhome countries. Working on bilateral orregional levels may provide receiving countries with greater control over the numbers
and nationalities of temporary workers. Thatis, receiving countries that wish to ensure
maximum control in immigration decisions
may prefer to design their policies without
having to negotiate the terms with countries
outside the region. Given both labor market
and security concerns, this control may makeit easier for countries to implement temporary
programs for unskilled workers. Close neighbors tend to have a high proportion of immigrants in receiving countries. To what extent
have RTAs facilitated labor movement?
Regional agreements treat labor movement
in varying ways, ranging from full labor mobility to no provisions at all. As shown intable 5.3, RTAs treat labor in one of four different ways:18• free labor mobility, with limited exceptions;• temporary market access for certain(usually skilled) groups of workers;

Table 5.3 Summary of agreements by degree of labor mobility
Degree of labor mobility under agreement

Agreements

Full labor mobility

European Union, Agreement on the European Economic Area, European Free
Trade Association, Australia-New Zealand Closer Economic Relations

Market access for certain groups

Caribbean Community, North American Free Trade Agreement, Europe
Agreements, Group of Three, and Canada-Chile, U.S.-Singapore, U.S.-Chile,
Japan-Singapore Free Trade Agreements

Based on GATS Mode 4, withadditional provisions or limitations

ASEAN Free Trade Area, Euro-Med Association Agreements, New ZealandSingapore Closer Economic Partnership, Southern Common Market
Agreement, and EU-Mexico, EU-Chile, MERCOSUR, and US-Jordan
Free Trade Agreements

No effective provisions for labor mobility

Asia Pacific Economic Co-Operation Forum, South Asian Association for
Regional Cooperation, Central European Free Trade Agreement, andCommon Market for Eastern and Southern Africa

Source: World Bank staff; Nofal 2004.

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2 0 0 5• temporary movement based on the
GATS Mode 4 model, often with additional provisions or limitations;19 and• no provision in place for market access(beyond facilitating entry visas), or plansdesignated to be realized only in the
future.

three months. The European agreements include exceptions for public services, public security, and/or public health works.
ANZCERTA provides for both full market
access and national treatment for all service
suppliers, excluding a few sectors.
The migration provisions of these agreements facilitated regional integration by making it easier for firms from one country totransfer personnel to their operations in othercountries in the region. The potential for
workers to move to higher-paying jobs inother countries may have improved discipline
in some labor markets. However, the EU
agreements had almost no impact on stocks ofpermanent migration from other EU countries(figure 5.1), in part because several EU countries had already provided for free labor mobility. In addition, most of these countries areof similar income levels, so the incentive to
disrupt family and personal relationships bymoving for higher incomes was limited. The
entry of less wealthy countries into the EU in
the 1980s also did not result in greatly increased migration.
Several factors may explain this: among
these, the free movement of workers from theMost agreements do not override migration
legislation, and parties retain broad discretion
to grant, refuse, and administer residence permits and visas. It should be noted also that theright of labor mobility does not automaticallyentail the right to practice a certain profession;national regulations regarding licensing andrecognition of qualifications are still
applied.20

RTAs with full labor mobility
The EU, the European Economic Area andEuropean Free Trade Association, and theAustralia-New Zealand Closer Economic
Relations Trade Agreement (ANZCERTA)
allow for free labor mobility, with very limited
exceptions.21 The EU also allows the right toreside (with family), although residence permits are not required for stays of less thanFigure 5.1 Share of EU nationals in total population, for selected EU countries and Norway,
1985–2000
Percent

1990 1995

6
1985

5

2000

4
3
2
1

wa
y
N

or

al
tu
g
Po
r

ai
n
Sp

Ita
ly

m

Fr
an
ce

iu
lg
Be

an
y
m
er
G

nl
an
d

la
he
r
et
N

Fi

nd
s

a
tri
Au
s

om

U

ni

te

d

Ki

Ire

ng
d

la

nd

en
Sw
ed

D

en

m

ar

k

0

Highest income
Source: OECD.

112

Lowest income

B E Y O N D

new member states were subject to transitional periods; the EU’s regional funds aimed
at developing less prosperous regions combined with the prospect of a positive economic
development in the new countries are likely tohave thwarted a significant migration of labor.
Greece, Portugal, and Spain underwent
6 years of transition, which limited the freemovement of people after their entry to the
EU. Even the richest EU countries (Denmarkand Sweden) experienced only a slight rise in
EU nationals as a share of population after thetransition periods of the poorest EU countries(Spain and Portugal) expired.22
It remains to be seen whether the recent accession of Central and Eastern European countries to the EU will result in substantial migration. While this agreement will ultimately
provide for full labor mobility, most of theoriginal EU countries have taken advantage

M E R C H A N D I S E

T R A D E

of provisions that delay this migration for alimited period (renewable up to 7 years). Most
studies find that the accession agreements areunlikely to greatly boost migration to Western
Europe. Forecasts of the additional migration
due to expansion of the EU, which relies onboth econometric models and opinion polls,
generally find that migration will be limited toabout 3–4 percent of residents of the 10 firstround East European nations within a decadeof freedom of movement; this amounts toabout 4 million people or 1 percent of the current EU population. Additionally, about half ofthese laborers are likely to return home within
the 10-year period, meaning a net migration of
2 million persons (Martin 2003). However,some of the EU countries, particularly thosebordering the Eastern European countries like
Germany and Austria, could experience larger
flows relative to population.

Box 5.3 Illegal migration: A growing
global phenomenonThe number of migrant workers without proper
work permits, so-called undocumented or illegal
workers, is increasing. The International Organization of Migration estimates that each year, somewhere between 700,000 and 2 million people crossborders to take jobs without legal permission.*
Of this number, up to 500,000 seek entry into
Western Europe and 500,000 into the United States,
Canada, Australia, and New Zealand. In the UnitedStates, the stock of undocumented workers increased
from an estimated 3.5 million in 1990 to 7 million in
2000, of which 69 percent were Mexicans (USCIS
2003). In Europe, illegal migrants numbered as manyas 3 million by the end of the 1990s.* Countries in
Asia have also experienced an increased number of irregular foreign workers in their labor force. In Singapore, undocumented workers accounted for 4.5 percent of the total labor force in 2000, and in Hong
Kong (China), it was 2.3 percent. In Hong Kong
(China), Korea, and Taiwan, there is one undocumented foreign worker for every three legal foreign

workers. Thailand is one of the countries most affected by undocumented workers, with nearly 5.5
undocumented workers for each registered foreign
worker (IOM 2003). In 2000–01, some 73,000
Chinese irregular migrants were assumed to be living
in South Korea, and, in turn, China hosted some
50,000 irregular migrants.
Stricter enforcement of immigration rules may nothave been successful in cutting off illegal migration,
but it may have contributed to the very high costs
involved, particularly between countries that do nothave a common border. Today, irregular migrants
from China wanting to enter the United States pay
up to $35,000 to smugglers,† to Europe they pay inthe range of $10,000–$15,000, and those seeking
entry into Japan up to $10,000. The “fee” for moving from Lebanon to Germany varies between$5,000–$10,000; from India to the United States it isaround $25,000, and from North Africa to Spain it
is between $2,000–$3,500.
(Box continues on next page)113

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Box 5.3

P R O S P E C T S

2 0 0 5

(continued)

The vast majority of undocumented workers are
unskilled for several reasons. Policies in most receiving countries offer greater opportunities for skilledworkers to migrate legally than for unskilled. Manyskilled workers, coming from middle- or upperincome households, may be less willing to experience
the uncertainty inherent in breaking the immigrationlaw (including the prospect of being jailed temporarily), than persons from lower-income households.
Also, employers are more likely to offer unskilledjobs to undocumented workers, whose tenure is relatively uncertain, as skilled jobs may require a greater
investment to apply technical backgrounds to thedemands of specific jobs.
Efforts to control illegal entry have varied in
effectiveness.‡ Receiving countries have addressed undocumented workers by offering amnesties that generally involve the promise of regularization for undocumented workers who have been in the country
for a period of time. For example, the U.S. Immigration and Regularization Control Act (IRCA) of 1986
regularized the status of undocumented workers who
had been living in the country since before 1982, as
well as undocumented agricultural workers. This program, which took effect mostly in 1989–91, granted aregular status to more than 2.5 million people, mostly
from Mexico and Central America. However, thismassive regularization program did not prevent Mexicans or other undocumented immigrants from continuing to cross the U.S. border. Similarly, in Europe,
approximately 1.5 million undocumented migrants
saw their status regularized under amnesty programs
implemented by Belgium, France, Greece, Portugal,
and Spain during the 1990s.§
Source: International Organization for Migration (IOM) 2003.

Regularization programs for undocumented arealso present across developing countries. For
example, in the 1990s, Argentina regularized undocumented workers from Bolivia, Paraguay, and Peru
under bilateral agreements. Thailand had a similar
program. Other countries have opted for more drastic measures to address undocumented workers. For
example, Malaysia in 2002 deported hundreds ofthousands of irregular migrants back to Indonesia
and the Philippines, in reaction to rising levelsof criminality; however, there was a slowdown in
its economy given its dependency on foreign
workers.

*IOM (2003). Unless otherwise noted, the data in this box
are based on this document.
**The number may be even higher today. The United Kingdom may have up to one million irregular migrants (UK Immigration Service), France 500,000, Belgium 90,000 (Belgium Antiracist Centre), and Ireland 10,000 (Irish Police). In terms offlows, some 100,000 irregulars are smuggled into Germany eachyear (German Police Trade Union), and some 95,000 irregulars
from Albania, Romania, and Iraq alone enter Greece each year.
†Annually, some 25,000 to 50,000 Chinese irregular migrants enter the United States.
‡Hanson and Spilimbergo (1999) find that additional resources devoted to border enforcement in the United States haveyielded only limited results, and Boeri and others (2002) find thattighter controls at a given entry point can be effective, but divert
migrants to other points of entry. Worksite inspections can havea greater impact, but in the United States such efforts are very
limited.
§Italy regularized 716,000 irregular migrants in three waves;
Greece accepted 370,000 people (in 1997–98) mostly from theBalkans and Eastern Europe; Spain regularized 260,000 irregularimmigrants mostly from Africa and Latin America; and Portugal
regularized 61,000.

Some countries have recognized the need to
manage both regular and irregular migration
on a regional basis. Regional consultative
processes, such as the Manila Process (1996),
the Migration Dialogue for Southern Africa(MIDSA 2000), the Puebla Process (1996), andothers have emerged—and all of them include
consultations to deter human trafficking and114

the movement of undocumented workers.
However, most of these groups are informal
ones that mostly share information on
migration-related issues and generally do not
impose requirements on the immigration policies of the participating countries. It appears
that neither unilateral policies nor consultative
arrangements have had significant success inB E Y O N D

controlling the substantial pressures for
migration to industrial countries.

Agreements that permit temporary accessfor certain groups
Several agreements provide for market accessof certain groups of workers, usually thehighly skilled. The most recent agreements
have focused heavily on intra-corporate transferees, including managers and skilled technical staff.
The Central America and Caribbean Community (CARICOM) allows university graduates to move among member countries
without passport requirements and allows
university graduates, professionals, skilled
persons, and workers from some selected occupations to work without a permit.
NAFTA, along with the Canada-Chile,
U.S.-Chile, and the U.S.-Singapore Free Trade
Agreements, do not provide for permanent
migration, but allow for the temporary movement of business visitors, traders and investors, intra-corporate transferees, and professionals.23 Visas are still required for all four
categories, and work permits are required forall except business visitors.24 Numeric restrictions on temporary entry are not allowed forthe first three categories, but were imposed by
the United States on professionals from Chile,
Mexico, and Singapore, but not from Canada.
U.S. professionals seeking to enter either market are not subject to numerical limits. In the
Canada-Chile agreement there are no numerical limits to any of the four categories. Following the NAFTA agreement, the number ofprofessionals entering the United States from
Canada and Mexico increased substantially,
and although the gap in favor of Canadiansremained high, it narrowed considerably by
2002. Similarly, in the treaty traders and investors category, the ratio of Mexican overCanadian admittances into the United States
increased from 0.4 in 1996 to 1.1 in 2002.25
The EU agreements with Central and Eastern European countries (prior to their 2004
accession to the EU) allowed for temporary
entry of workers providing a service,

M E R C H A N D I S E

T R A D E

managers and/or highly qualified employees,
and company representatives negotiating forthe sale or supply of services. Transition periods as well as restrictions for public service
works and sectoral exclusions applied. They
are still in force for the nonaccession countries, Bulgaria and Romania. The JapanSingapore FTA provides for the temporary
movement of natural persons for business purposes, including investors, subject to conditions for entry (such as pre-employment for atleast one year for intracorporate transferees)
and time limits of stay. The Group of Three(Colombia, Mexico, and Republica Bolivariana de Venezuela) facilitates temporary entry
for business persons. As in other agreements,
GATS Mode 4 restrictions regarding accessto the employment market or permanent employment also apply. MERCOSUR also has
provisions to facilitate the temporary entry ofbusiness persons and the exercise of temporary
professional practices, and it is working on theissues relative to a “MERCOSUR National
Residency” and a more flexible migratory regulation for MERCOSUR citizens (Nofal
2004). Other agreements among Latin American countries (such as the Mexico-Nicaragua,
Mexico-Chile, Mexico-Bolivia, Mexico-Costa
Rica, and the agreement between Central
America and Dominican Republic) containsimilar provisions.

Agreements based on GATS Mode 4
Several bilateral agreements, along with theASEAN Free Trade Agreement (AFTA) and
MERCOSUR, base labor mobility provisions
on the principles of Mode 4 of the GATS. However, most of these agreements add provisions
that allow for labor mobility in categories notcovered by the GATS. For example, the U.S.Jordan agreement facilitates visa arrangements
for independent traders and persons linked toinvestment. The EU-Mexico agreement provides for a standstill and sets common regulations of work, labor conditions, and residency
permits for temporary workers in eachcountry. The AFTA since 1998 has covered allmodes of supply, including services sectors not

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2 0 0 5previously covered by the GATS. The Framework Agreement on the ASEAN Investment
Area (1998) commits members to support freer
flows of skilled labor, professionals, capitaland technology among ASEAN members. By
contrast, the Euro-Med agreements with
Morocco and Tunisia do not provide for preferential access beyond GATS (the case for other
Mediterranean agreements as well). The New
Zealand-Singapore agreement generally follows the GATS model regarding labor mobility
for service suppliers. MERCOSUR (and its
agreements with Bolivia and Chile) is limited to
the GATS provisions on the movement of

natural persons as services suppliers (Nofal
2004).

Agreements without effective provisions
for market access
The Asia Pacific Economic Cooperation
Forum (APEC), the South Asia Association for
Regional Cooperation (SAARC), and Common Market for Eastern and Southern Africa(COMESA) do not provide for labor mobility.
However, the first two have taken measures tofacilitate business travel. Most of the membersof APEC (except the United States andCanada) participate in the Business Travel

Box 5.4 U.S. temporary admission programs under
NAFTA and unilateral policies

T

he U.S. has several visa categories for the admission of temporary workers. NAFTA provided
for the temporary admission of professionals under
TN visas and made it easier for Mexicans to takeadvantage of already existing visa categories forskilled workers and professionals. However, NAFTA
made no provision for increasing admissions of unskilled workers to the United States. In contrast, theUnited States has unilateral programs that do allow
for the temporary admission of unskilled workers,
and these have grown from from about 14,000 in

1996 to about 66,000 in 2002. Moreover, the largest
temporary business visitor program (B1 visa) is limited to six months (renewable, but total time cannot
exceed one year), and generally is used for shortterm trips to the United States. The other visas canbe granted for one year or more, often with extensions. Thus more long-term unskilled Mexican workers have been admitted to the United States underunilateral programs than under programs initiatedunder, or supported by, NAFTA.

Temporary entry of Mexican workers to the United States(thousands of persons)
Program initiated under NAFTA
Professional (TN visa)
Programs supported by NAFTAa
Intracompany transferees (L1 visas)
Treaty traders and investors (E1, E2 visas)
Business visitors (B1 visas)
Unilateral programs
Professionals with specialty occupations (H1B visas)
Agricultural temporary workers (H2A visas)Non-agricultural temporary workers (H2B visas)

1996

2002

0.2

1.8

4.8
1.0
309.0

15.3
4.0
475.0

5.3
8.8
5.5

15.9
12.8
53.0

aThese visa categories existed before NAFTA and apply to many countries. However, provisions of NAFTA make it easier for

Mexicans to use them.
Source: USCIS 2002, INS 1997.

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B E Y O N D

Card Scheme, under which holders of the card
receive expedited entry at the airport, and are
not required to submit separate applications
for business visas. Members of the SAARC
adopted a Visa Waiver Scheme in 1992, which
exempts 21 categories of persons from visa requirements. Free labor movement is envisaged
as a long-term objective of COMESA, to beaccomplished by 2025. However, progress has
been limited to date.26

To date: Limited labor integration
Most regional agreements have had little impact on increasing migration. First, the agreements with full labor mobility have been between countries of similar income levels, so
there has been little incentive for migration.
Most agreements, and particularly thoseagreements that include both industrial anddeveloping country members, do not allow forpermanent migration.
Second, while these agreements often provide for some temporary labor mobility, particularly for the service sectors, the provisions
are generally restricted to higher-skilled workers. This is consistent with the trend in industrial countries of changing unilateral migration policies to attract higher-skilledworkers—in principle on a temporary basis,but in practice allowing for the possibility tosettle after some period of time. For example,
the Temporary Immigration Program of Australia allows for unlimited visa renewal forskilled workers. In the United Kingdom,
highly skilled temporary workers in certain
occupations can settle after 4 years of continuous work. In Norway, temporary workers
with special skills can be issued a permanent
work permit after 3 years of stay. In Canada,
the 2002 Immigration and Refugee Protection
Act (IRPA) placed more emphasis on education, job experience, and language ability inallowing entry. This trend toward favoringhigher-skilled workers limits the potential
global gains from migration.
To the extent that developed countries havepermitted entry for unskilled workers from
RTA countries, it has occurred throughM E R C H A N D I S E

T R A D E

parallel programs, many of which predated
the RTA, such as programs in the UnitedStates with Mexico and in the EU with nonmembers of Southern Europe. Where industrial countries have allowed for some admittance of unskilled workers, the rules differ
significantly from those governing admissionof skilled workers. Unskilled workers legallyentering host countries usually do so underseasonal work agreements, project (or guest)
worker agreements, or specific provisions
such as the working holiday maker programs(WHMP). Seasonal employment usually allows foreign workers to stay in the host country for periods between three months and one
year, with work permits provided to foreign
workers only in the event that no domestic
labor can do the job and only in some specificsectors (such as agriculture, forestry, andtourism). Project worker agreements allow
foreign workers entry for specific projects andusually include limits on the maximum stayand quotas (often determined on the basis oflabor market conditions). WHMP allows
young people (roughly 18–30 years old) toholiday and work for short periods, provided
there is a prior bilateral working holiday
agreement among the involved countries.
Developing countries’ regional agreements
also tend to discriminate in favor of skilledworkers when providing for labor mobility. As
mentioned above, CARICOM allows for thefree movement of university graduates, otherprofessionals, skilled persons, and workers
from selected occupations. Several Latin
American agreements (Group of Three, Central America-Dominican Republic, and agreements between Mexico on the one hand, andChile, Nicaragua, Bolivia, and Costa Rica on
the other) also provide for the movement ofsome skilled, not unskilled, workers.

Conclusions: Beyond Merchandise
Trade

A

greements differ markedly in their treatment—to say nothing of their implementation—of non-merchandise provisions for117

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2 0 0 5services, investment, intellectual property, andtemporary movement of workers. Differences
between the United States and EU bilateral FTAs
and other agreements are particularly vast.
In those areas where RTAs could seriously
promote development—services liberalizationand temporary movement of workers—results
have ranged from mixed to missed opportunities. In general, the U.S. FTAs have prompted
some additional services market openings in
Bahrain, CAFTA, and Morocco, some changes
in Singapore, but relatively few changes inAustralia and Chile. To be sure, even thoseagreements that required no additional market opening could benefit developing countries, because investors may attach credibility
to the lock-in effects of the treaty.
In the South, agreements that have substantially improved services access are relatively limited, and those with greater market
access often have the most restrictive rulesof origin for investor nationality. Morecommon is the lack of progress on services
liberalization.
More disappointing from a development
perspective is the minimal attention given to
creating opportunities for the temporary
movement of workers, particularly unskilledworkers. In neither North-South nor SouthSouth agreements is there evidence of much
activity. In the wake of the September 11,
2001, attacks on the United States, concerns
for security have made cross-border movement of all persons subject to greater controls
and scrutiny. This atmosphere does not bodewell for expanding programs for temporary
workers.
At the same time, in those regulatory areas
where development benefits are largely unproven, the North-South bilateral FTAs arestrengthening their rules. Strengthening therules governing investment and intellectual
property may contribute to better institutional
environment, but the greatest gain is to befound in services. Enhancing protections offered to investors has not been shown to increase the flow of investment, and preventing

118

the erosion of monopolistic returns to theowners of technology through enhanced IPRs
is of doubtful development benefit for the average developing country.
Moreover, the downside risks of misjudgments in terms of adverse legal and economic
ramifications are nontrivial, especially forunsophisticated governments. International
treaty law in these areas is evolving fast andis being set through case laws of arbitration
panels, whose judgments at times conflict(Ewing-Chow 2001). Governments may findthemselves hauled before arbitration panels
and compelled to pay large amounts of compensation for enacting regulations they had
considered in their sovereign domain.
Broadly defining investment to include allcapital flows and assets, including intellectual property, carries risks. For example, one
potential risk, is the set of provisions associated with the U.S.-Chile arrangement. These
provisions could limit a less sophisticatedgovernment’s ability to deal with a financial
crisis.

Realizing the promise of services,
investment, IPRs, and labor mobility
Using RTAs as a lever to liberalize services has
several advantages. The potential for improving economy-wide performance is often great.
Moreover, most services liberalization is inherently multilateral. This is because member
governments that open markets want to realize the immediate gain of full competition andso open markets to all comers, or because
members adopt lenient rules regarding domicile of investors, thereby permitting external
investors to invest in the region through subsidiaries located in member countries. Even if
restrictions impede full MFN access, regional
agreements can be cost-free stepping stones
to open markets insofar as they do not carry
the trade-diversion costs of lost revenues associated with tariff reductions for goods trade.
More could be done in RTAs, particularly
in South-South agreements, to realize thesebenefits.

B E Y O N DCountries have to design strategies toward
investment and intellectual property that areappropriate to their development priorities
and then analyze carefully which elements, ifany, ought to be contained in trade treaties.
For some countries, improving other property
rights—for example, land rights or small business assets—may have a higher priority thanestablishing market access rights for investors
or rights for patent holders; for other countries, especially middle-income countries,
these may indeed be a priority. Once a strategy
is in place, it is possible to ascertain which of
the new rules customarily associated with
regional trade agreements make sense fordevelopment.
Evaluating the development benefit of any
given RTA cannot rest solely on one component because often rules are accepted in one
area to achieve market openings in partnercountries in another. For example, the net development benefits of the investment and IPR
components hinge critically on their appropriateness for development and the market accessgranted in product markets of partnercountries.
A corollary lesson is that multilateral liberalization in goods markets is essential for
reaping any gains from RTAs that contain newrules. Governments wishing to maximize
gains from RTAs should ensure that new rules
are consistent with extant border protection,and if not, they should consider lowering that
protection. If a country has high tariff barriers
and forms an RTA with a partner requiring investor protections and TRIPS-Plus, it may end
up entrenching the businesses of that partner
behind new barriers. It may confer first moveradvantages in services and IPR restrictions in
drug or other high technology manufacture,with reinforced barriers to parallel imports or
new entry from third parties.
Finally, RTAs—and other regional cooperation agreements—do offer some important
opportunities for countries to collaborate, especially in South-South agreements. To stimulate investment, particularly in services, theyM E R C H A N D I S E

T R A D E

might adopt common standards that facilitatecross-border competition in services and investment. Adopting common technical standards for telecommunications, for example,
has helped integrate markets and opens theway for competition. To adopt international
norms regulating technology, new agreements
could adopt their own IPR standards, with theadvantage of foreclosing additional restrictions motivated by private interest groups in
the North. At the same time, some regions
may find opportunities to agree on common
administration of patent and copyright law.

Notes
1. Agreements can also increase the number ofcompetitors by allowing cross-border provision ofservices, Mode 1, such as supplying back-office services. Restrictions on these tend to be less common
than on supplying through commercial presence of aforeign subsidiary, Mode 3. One exception is supplying
various types of insurance and reinsurance, which canbe done cross-border, though a sales affiliate is normally required.
2. RTAs that restrict service providers to member
countries by definition limit the number of potential
competitors relative to multilateral liberalization. Even
if later followed with multilateral opening, RTAs may
confer on members first mover advantages, and, if
some market barriers to entry remain, they will not bereadily competed away; the result is higher prices to
consumers.
3. According to the agreement, if Chile chooses toimpose restrictive measures on capital flows it considers speculative, then special dispute settlement rules
will apply.
4. For some FTA countries, pre-existing BITs had
virtually the same rights; however, about half of thecountries had no BIT prior to the FTA, and where BITS
did exist, pre-establishments were often fewer and lessextensive.
5. See Fink and Reichenmiller (2004) for a moredetailed review.
6. These include, for example, TRIPS, the Paris
Convention for the Protection of Industrial Property,
the Berne Convention for the Protection of Literaryand Artistic Works, the Rome Convention for the Protection of Performers, Producers of Phonograms andBroadcasting Organizations, and others also contains alist of new conventions that parties are expected to ratify within a specified timeline, such as the Budapest

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2 0 0 5Treaty on the International Recognition of the Depositof Micro-organisms for Mexico and the World Intellectual Property Organization (WIPO) CopyrightTreaty for Chile. Finally, the list includes several conventions that the member states are expected to ratify“as soon as possible” without mentioning a specificdeadline, such as the WIPO Copyright Treaty for
Mexico or the Madrid Agreement concerning the International Registration of Marks for Chile.
7. BITs customarily provide a definition of investment coverage, provide investor protections such as
against expropriation, require national treatment for
post-entry establishments, stipulate compensation
for the expropriation of their investments, and provide
for a dispute resolution mechanism. The latter usuallypermit the investor to sue the state for breach of treaty
under binding arbitration. In some cases, treaties proscribe any government action that would reduce thevalue of the private investment, even if it were environmental, and establish grounds for compensation.
Such compensation could either entail extensive liabilities for the host government or compel them to refrainfrom making certain policy choices.
8. The United States initiated the practice of defining investment to broadly include intellectual property
in the late 1990s in negotiations of its bilateral investment treaties. See Vivas-Eugui (2003).
9. Some of the problems include the absence ofdata on implementation and the variable coverage of
FDI provisions across agreements, which makes it difficult to distinguish the effects of investment rules fromtrade rules. Moreover, the absence on FDI data thatwould enable us to distinguish the effects of RTAs on
differing type of investment—vertical or horizontal–
limits the analysis. Nonetheless, the regressions arerobust to variations in specifications.
10. The regression with fixed effects estimation of
net FDI inflows is:
lfdi | Coef. Std. Err. t P|t|lgdp | .9404982 .2065772 4.55 0.000
lgnppc | .1228465 .2008249 0.61 0.541
open | .0051226 .0011387 4.50 0.000
growth | .0198651 .0040816 4.87 0.000
cpi | .0196485 .0060906 3.23 0.001
lfdiwld | .4472645 .0719058 6.22 0.000
growld | .0611576 .0432152 1.42 0.157
lftagdp | .0518633 .0163279 3.18 0.002
R-sq: within  0.3973 corr(u_i, Xb) -0.0410
between  0.7469
F(28,2003)  47.16
overall  0.6690 Prob  F  0.0000
F test that all u_i  0: F(143, 2003)  12.79
Prob  F  0.0000
11. As mentioned earlier, this variable contains thesum of the host country’s RTA partners GDP, excluding120

the host country itself. Thus if we consider Brazil as thehost country and MERCOSUR as the relevant RTA,
the variable lftagdp would be the log of the sum of
GDP of Argentina, Paraguay, and Uruguay. This variable serves a twofold purpose in the estimation routine.
First, since it is equal to zero prior to signing an RTA
and carries a positive value afterwards, it measures
whether signing an agreement has an effect on FDI inflows (i.e., including a dummy variable for RTA membership would be counterproductive in the presence of
this variable, since it will capture the “threshold effect”
of signing an RTA). Furthermore, this variable also
captures the effects of participating in a larger market
following the signing of an agreement. This is particularly important if a country is party to more than one
agreement—the variable will then be a sum of all of its
partners’ GDP, reflecting the fact that the country has
now created a larger market. The fact that this variable
is positive and significant shows not only that signingan RTA will generally bring benefits in terms of greater
FDI inflows, but also that larger market size of thecountry’s partners tends to generate more incoming
FDI.
12. See Finger and Schuler (2004) for a richer discussion of the the asymmetry in TRIPS; they argue thatit protects the knowledge that businesses and individuals have in rich countries and that poor people buy, but
not the knowledge that poor people generate and sellto the world.
13. In this sense, full enforcement is equivalent to a
TRIPs standard (Maskus 2000, 183–85).
14. See paragraph 4 of the Doha Declaration on
TRIPS and Public Health, available at http://www.
wto.org.
15. Technically, the Doha Declaration does notaddress questions of marketing approval during thepatent term and test data exclusivity. However, the provisions of the bilateral FTAs in these areas can still beseen as being at odds with the spirit of the Doha Declaration, to the extent that they preclude the effective
use of compulsory licenses.
16. See the letter from USTR General Counsel
John K. Veroncau to Congressman Levin dated
July 19, 2004, available at Inside US Trade. Moreover,the side letters refer “in particular [to] cases such as
HIV/AIDS, tuberculosis, malaria, and other epidemics
as well as circumstances of extreme urgency on national emergency.” The language chosen mirrors wording in the Doha Declaration on TRIPS and Public
Health, except that the latter employs the term “especially” instead of “in particular” and does not mention“circumstances of extreme urgency or national emergency.” This difference in language may imply a narrower definition of public health and therefore flexibility to issue a compulsory license, but this is subject toB E Y O N D

legal interpretation that must await actual cases of dispute settlement.
17. See the letter from USTR General Counsel
John K. Veroneau to Congressman Levin dated
July 19, 2004.
18. See the excellent studies in Fink and Maskus(2004) including particularly Fink (2004) for the U.S.
and German MNCs; Smarzynska Javorcik (2004) for
Eastern Europe; and Maskus, Dougherty, and Mertha(2004) for China.
19. The description on agreements that follows isstrongly based on Nielson (2003) and a complement,in some cases, to the text of the agreements.
20. GATS (under “Mode 4”) covers the movementof some temporary foreign workers among WTO
members, specifically individual service suppliers. Although in theory GATS covers services suppliers at all
skill levels, in practice WTO members’ commitments
have been limited to the higher skilled.
21. Some agreements include provisions facilitating mutual recognition (e.g., EFTA), and others havecomplementary arrangements (e.g., the ANZCERTA
Services Protocol, the Trans-Tasman Travel Arrangement, and the Trans Tasman Mutual Recognition
Arrangement together provide that persons registeredto practice an occupation in one country can practicean equivalent profession in the other country).
22. ANZCERTA does not cover labor mobility
other than for services suppliers, but under the TransTasman Travel Arrangement (signed in 1973), nationals of each country have the right to visit, reside, andwork in each other’s country without time restrictions.
23. Between 1987–97, there was a total increase of
102,000 Greeks in the rest of the (11) European countries, which is an annual average of 10,000 only. In
the case of Portugal, the annual average increase of
Portuguese immigrants in the rest of the EU countries
during 1986–97 was only 7,700.
24. In NAFTA, definitions for business persons
and, in particular, a list of professionals are provided,
as well as the minimum academic conditions that thelatter must satisfy (in general, at least a baccalaureate
degree, and sometimes complemented with someyears of experience). The other agreements provide
for a more flexible requirement, in that instead oflisting the professions, they specify the academic
and/or experience requirements that professionals
must satisfy.
25. Business visitors need to demonstrate thoughthat the proposed activity is international in scope andthat they are not seeking to enter the local labor market. They need also to demonstrate that the primarysource of remuneration, their principal place of business, and actual place of accrual of profits are fromoutside the territory they are seeking to enter.

M E R C H A N D I S E

T R A D E

26. Mexicans entering through this category into
the United States increased to 4,000 business persons
in 2002, from 980 in 1996.
27. Nonetheless, migration flows within COMESA
have been substantial. The annual inflow of workers toSouth Africa from other African countries is estimatedto have increased from roughly 500,000 in 1990 tomore than 3.5 millions in 1995; most were temporary
workers in mining and farming.

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US Citizens and Immigration Services (USCIS, formerly
the INS). 2002. Yearbook of Immigration Statistics (formerly Statistical Yearbook of the Immigration and Naturalization Service, INS). Table 27.
http://uscis.gov/graphics/shared/aboutus/statistics/
TEMP02yrbk/Temp2002list.htm.
US Citizens and Immigration Services (USCIS, formerly
the INS). 2003. Estimates of the Unauthorized
Immigrant Population Residing in the UnitedStates: 1990 to 2000. Office of Policy and Planning. Table B. http://uscis.gov/graphics/shared/
aboutus/statistics/Illegals.htm.
USTR (United States Trade Representative). 2004.
USA—Chile Free Trade Agreement.
Vivas-Eugui, David 2003. Regional and bilateral agreements and a TRIPS-plus world: the Free Trade
Area of the Americas (FTAA). TRIPS Issue
Papers 1. Geneva: Quaker United Nations Office.
Waldkirch, A. 2001. The ‘New Regionalism’ andForeign Direct Investment: The Case of Mexico.
Oregon State University Working Paper.
Walmsley, Terri Louise, and L. Alan Winters. 2003. Relaxing the Restrictions on the Temporary Movement of Natural Persons: A Simulation Analysis.
Centre for Economic Policy Research Discussion
Paper Series No. 3719. January.
Weintraub, Sidney. 2004. Lessons from the Chile andSingapore Free Trade Agreements. In Free Trade
Agreements: US Strategies and Priorities, ed. J. J.
Schott. Washington, DC: Institute for International Economics.
World Bank. 2001. Global Economic Prospects andthe Developing Countries 2002: Making Trade
Work for the World’s Poor. Washington, DC:
World Bank.
. 2002. Global Economic Prospects and theDeveloping Countries 2003: Investing to Unlock
Global Opportunities. Washington, DC: WorldBank.
. 2004. World Development Report 2005:
A Better Investment Climate for Everyone.
Washington, DC: World Bank.

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6
Making Regionalism
Complementary to Multilateralism

The emergence of a more proactive stance inmultilateral negotiations by developing countries in parallel with an explosion of preferential
regional trade agreements (RTAs) around theworld raises an important question: Are thesetrends complementary, representing different
paths to the same desired outcome of faster
growth, development, and poverty reduction,or are they competing and incompatible? In
principle, the best outcome for all countries
would be a nondiscriminatory trading system;
developing countries, in particular, would benefit from a nondiscriminatory trading systembecause most poor people and many poor countries might find themselves excluded from preferential deals. If the explosion in RTAs implies
a higher probability that the majority ofdeveloping countries would face greater discrimination than under an MFN (or nondiscriminatory) regime, the world as a whole will
be worse off, and individual developing countries may lose substantially.1
RTAs can be a complement to multilateralreform, but they are not a substitute. Consider
a scenario, modeled in the first section of thischapter, in which each developing country
signed an agreement with the United States,
the European Union (EU), Canada, andJapan—the Quad. Each developing country
could raise its real incomes by individuallysigning bilateral agreements with the Quadcountries; and in some cases they would raise
their real incomes more than they would
through multilateral accords. But these gains

disappear if all developing countries were tosign such agreements. In fact, all developing
countries would lose relative to a multilateralagreement and even relative to the baseline.
This scenario underscores the fact that, whilestalled collective action through multilateralchannels creates a strong incentive for eachdeveloping country to sign a regional agreement, if every country does so, they all lose.
RTAs do alter the incentives for countries
to participate in multilateral liberalization.
RTAs can be a stumbling block to multilateralarrangements by creating incentives to resist
the preference erosion that can occur throughnew multilateral liberalization. However,
because the gains are often substantially larger
in multilateral agreements, concerns over preference erosion may be limited to a few small
countries that could conceivably block a multilateral agreement. Those recalcitrant countries resisting reforms are likely the beneficiaries of preferences associated with distorted
agreements encompassing agriculture or theclothing and textile trade, not RTAs. Large developed countries may gain more from signingindividual bilateral agreements than theywould from a multilateral accord, because
they can use the carrot of preferential access to
extract concessions in nontrade areas fromdeveloping country partners that would be resisted in the WTO negotiating framework. But
we see little evidence that the high-income
countries have reduced their effort to bring thecurrent multilateral negotiations to fruition.

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From a development perspective, the WTO
remains the best-available forum to discipline
the use of trade-distorting policies. RTAs cancomplement the WTO efforts by cooperating
on behind-the-border policies, especially on
regulation-intensive issues such as services,trade facilitation, and the investment climate.
Governments pursuing this agenda through
RTAs must adopt rules that are appropriate totheir own level of development. To be effective, the rules must target a priority concern,must be enforceable, and must avoid becoming a tax on scarce resources that would bebetter used elsewhere. Getting the rules“right” so that they promote development
has implications for negotiations and enforcement of the resulting disciplines. The potential
for inappropriate outcomes is higher inNorth–South RTAs because the asymmetry innegotiating power can overtake real development priorities.
Reinforcing the complementarity between
regionalism and multilateralism and minimizing the latent tensions must begin with thecompletion of the Doha Development Agenda.
If the Doha Development Agenda is completed
in a way that actually promotes development,
it would bring down tariffs, enhance the gains
from open regionalism, and discipline any exclusionary effects of regional accords.
All countries could take steps to promote
open regionalism—the developing countries,
high-income countries, and the international
community working together through the
WTO. Developing countries are likely to havethe greatest success in harnessing trade for
growth and poverty reduction if they adopt
a three-pronged strategy that involvesautonomous liberalization, active multilateralism, and open regionalism.
High-income countries could promote
open regionalism by including agriculture in
RTAs. They could adopt more common andnonrestrictive rules of origin across agreements; and, to the extent that these rules set
patterns common to most agreements, theburden on customs administration would be
reduced. They could work with prospective

126

partners to ensure that new regulations regarding investment and intellectual property
are appropriate to the level of development,
which would reduce risks of undue enforcement costs. Finally, they could provide traderelated technical assistance not only in the implementation phase but also in the negotiatingphase, which could promote greater liberalization and supply response to new market
opportunities in regional or global markets.
The international community, working
through the WTO, can reduce discrimination in
the system. The procedures associated with
RTA disciplines as currently configured are illsuited to limit either their proliferation or tocontrol their discriminatory provisions. WTO
members should establish stronger multilateralsurveillance mechanisms to document, analyze,
and monitor the effects of RTAs on nonmembers. Expanding the information on the impactof RTAs to stakeholders—firms, consumers,
taxpayers—would also help ensure that the potential benefits of liberalization are both realized and distributed more equitably. Mediumterm efforts should focus on implementing
WTO disciplines on regional agreements.

Preferential Agreements within
the Global ContextTo place preferential trade arrangements ina multilateral context, we evaluate how
different collections of trade agreements compare with multilateral alternatives. For thisevaluation, we utilize the World Bank’s global
trade model known as LINKAGE, which has
been used in previous Global Economic
Prospects. The model is built around the
GTAP database that is widely used to assess
the global, regional, and country implicationsof alternative trade liberalization scenarios.
However, the results described in this year’s
report reflect an update of the model’s database, which has two notable differences. First,
it has a new base year, 2001 (the old base year
was 1997). Second, it has a new protection
database that takes better account of preferential trade access. Box 6.1 provides a brief

M A K I N G

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C O M P L E M E N T A R Y

T O

M U LT I L A T E R A L I S M

Box 6.1 Impacts of the new GTAP databaseT

he simulation results from the World Bank’s
LINKAGE model were presented in the past threeissues of Global Economic Prospects (2002, 2003,
and 2004) and were based on the use of various
versions of Release 5 of the GTAP dataset.* An updated version of the data has become available; prerelease 6.04 was released in September 2004. The
main innovations of the new dataset include a more
recent base year (2001 instead of 1997), revised national input-output tables, and a new database for
estimating the levels of trade protection. This lastinnovation is likely to have a large impact on tradescenarios. First, a brief digression on a technicalissue regarding the new base year: The global database, to a large extent, is the outcome of merging
national data. The national input-output tables havedifferent base years and are virtually always innational currencies. Thus they must be updated to
the given base year—2001 in the case of the newrelease—and converted to the database’s common
currency (i.e., the U.S. dollar). This has a practical
implication because of movements in the value of thedollar. In 1997, the U.S. dollar was relatively strong(for example, $1.13 per euro), and it was much
weaker in 2001 ($0.90 per euro). This means thatthe relative weight of countries will change between
the two base years (holding growth constant). In
fact, the global U.S. economy as a share of global
output was around 32 percent in 1997 and only
27 percent in 2001. Thus the change in the value ofthe dollar will have some impact on the reported
gains from trade reform, both globally and by region.
The more important change in the database relates
to the change in protection. The new protection data
relies on the MAcMaps dataset—a collaborative effort of CEPII (Paris) and the International Trade Centre (ITC, Geneva). Among the prominent features ofthe MAcMaps dataset is the incorporation of preferential tariff regimes and the conversion of specifictariffs to ad valorem equivalents; it thus represents a
more realistic picture of the bilateral levels of protection. In summary, the new database will capture thesummary of these changes and the impacts ofusing the new database relative to the results
outlined in previous Global Economic
Prospects.

considerable reform between 1997 and 2001 (e.g.,continued implementation of the Uruguay Round andChina’s progress towards WTO accession), and an
improved treatment of preferential trade agreements.
The overall impact of these changes is that theWorld Bank’s estimate of the global gains fromglobal merchandise trade reform is now around$260 billion** (in 2015, relative to the baseline
scenario), compared with around $380 billion using
the 1997-based results from previous GEPs.*** The
lower number reflects, to a large extent, the impactsof trade reforms achieved between 1997 and 2001
and the incorporation of preferences.**** The
allocation of the gains across regions and sectors is
broadly consistent with the previous results. Thus
41 percent (instead of 45 percent) of the gains fromglobal reform accrue to developing countries, andagricultural reform generates some 47 percent(instead of 58 percent) of the global gains.

*The GTAP dataset is a product of the Global Trade Analysis Project (GTAP), based at Purdue University, with funding
from an international consortium of international and national
agencies (including the World Bank), universities, and research
centers. Since its initial development in the early 1990s, theGTAP dataset has become the premiere dataset for undertaking
global trade analysis. The current version includes a full social
accounting matrix for 87 regions (of which 69 are individual
countries), 57 economic sectors, and fully consistent bilateral
trade flows.
**These results should still be viewed as preliminary as the
GTAP consortium is preparing for the final release sometime before the end of 2004. The final release may result in somechanges at the micro level, but will probably only have a relatively minor impact at the aggregate level.
***These gains refer to the so-called “static” effects, i.e., nottaking into account dynamic effects such as improvements in
productivity.
****There are other technical differences, including among
others, the relative change of the value of the U.S. dollar as mentioned above. The LINKAGE model, apart from the change in the
database, is identical to that used in the last Global Economic
Prospects.

To assess the relative impacts of various
RTAs, it is useful to develop a benchmark
simulation (apart from the baseline). The
benchmark simulation is a global reform127

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Table 6.1 Comparison of bilateral agreements to global trade reform(change in real income in 2015 compared to baseline)
Global(1)

Bilateral with
Quad
(2)

Bilateral minus
large countries(3)

Global(4)$ billion

High-income countries
Low-income countries
Middle-income countries
All developing countries
World Total

154.4
16.6
92.2
108.8
263.2

133.6
19.0
2.6
21.5
112.0

Bilateral with
Quad
(5)

Bilateral minus
large countries(6)

Percent

46.9
1.9
4.7
6.6
40.3

0.6
0.9
1.2
1.2
0.8

0.5
1.0
0.0
0.2
0.3

0.2
0.1
0.1
0.1
0.1

Source: World Bank simulations.

scenario in which all merchandise trade distortions are eliminated (services reform is left
out for lack of sufficient data), domestic distortions in agriculture are removed (input andoutput subsidies, direct payments, and export
subsidies), and import quotas in the textile
and clothing sectors are removed. This scenario would be the ultimate long-run outcomeof successful multilateralism. Under this reform scenario, the global gains in 2015
amount to $263 billion, or an increase of 0.8
percent in baseline income (table 6.1).2

How much do regional trade agreements
benefit developing countries?
To examine how bilateral agreements affectdeveloping countries, we look at three simulations: One in which all developing countries
sign a bilateral agreement with Quad-plus
countries (United States, EU, Japan, Canada,plus Australia and New Zealand);3 a second
simulation—similar to the first simulation—in
which the large countries, such as Brazil,
China, and India are excluded, which is perhaps a more plausible scenario; and a third inwhich each developing country/region signs
an individual bilateral agreement with the
Quad-plus countries, assuming other developing countries do not sign agreements.4 Notethat these scenarios overstate bilateral andmultilateral effects because they assume thatno sectors are exempt, and rules of origin are
not restrictive. In reality, the United States andEU bilateral agreements usually exclude important sectors, such as sensitive agricultural
products, or attach extended phase-in periods

128

beyond even our 2015 time horizon, and rulesof origin tests often limit preferential market
access.
The first simulation, in which all developing countries sign a bilateral agreement with
the Quad-plus countries (columns 2 and 5 intable 6.1), shows that, as a group, developing
countries are substantially worse off than witha multilateral agreement. Instead of gaining$109 billion from global reform, they lose
$22 billion relative to a baseline scenario, withno change in protection. If one looks at individual countries (table 6.2), the effect is nearly
universal; only a handful of developing countries—for example, Brazil and China—would
gain from a full hub-and-spoke system of bilateral agreements, and all developing countries would lose compared to full multilateral
trade.
It is interesting that some of the Quadcountries would benefit from this strategy. Although the high-income countries would generally lose from this set of bilateral agreements
compared to global reform, the impact is not
uniform.5 Both the United States and the EU(the most aggressive advocates of bilateraldeals) would appear to benefit more from pursuing bilateral agreements with all developing countries than from global reform(table 6.2); the United States would gain an
additional $7 billion (0.1 percent of GDP),
while the EU would gain $27 billion (0.4 percent of GDP). Although they would have toopen up their agricultural markets to some extent (assuming exemptions are disallowed),
they would not have to dismantle domestic

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Source: World Bank simulations.

High-income countries
Low-income countries
Middle-income countries
All developing countries
World Total

Australia, Canada, and
New ZealandUnited States
European Union with EFTA
Japan
Republic of Korea andTaiwan (China)
Hong Kong (China) andSingapore
BrazilChina
India
Indonesia
MexicoRussiaSACU
VietnamRest of East Asia
Rest of South Asia
EU accession countries
Rest of ECA
Middle East
North Africa
Rest of Sub-Saharan Africa
Rest of LAC
Rest of the World
154.4
16.6
92.2
108.8
263.2

133.6
19.0
2.6
21.5
112.0

46.9
1.9
4.7
6.6
40.3

1.4
0.6
0.5
1.4
0.0
0.8
1.8
5.0
4.7
0.2
0.2
0.5
0.9
6.7
1.1
1.6
1.3

1.7
7.2
3.1
3.0
1.3
1.3
0.8
0.6
2.8
1.1
0.5
1.3
0.1
4.3
2.5
6.4
1.2

1.5
9.7
10.0
2.3
1.5
1.7
0.3
0.2
5.0
3.2
2.0
3.3
2.7
1.9
3.0
0.9
0.3

8.0
14.1
4.3
3.6
0.3
2.9
2.5
2.4
19.6
0.4
0.8
2.3
6.1
19.1
2.9
16.3
3.0

7.3
21.8
2.1
5.1
2.6
0.8
3.7
0.9
7.4
1.2
0.9
0.4
1.3
5.7
–0.2
9.6
4.0

2.8

0.3

2.4

9.8

0.6
0.9
1.2
1.2
0.8

0.2
0.7
0.9
2.6

10.7
33.6
4.8
2.3

32.3
82.4
25.0
9.8

0.7

Globalmerchandise
trade reform
(5)

24.9
55.0
29.7
26.4

0.5

Bilateral agreements
between Quad andeach developing
country(4)

6.0$ billion

Bilateral agreements
between Quad anddeveloping countries
excluding large
countries(3)

8.4

Global merchandise tradereform(1)

Bilateral agreements between
Quad and all
developing
countries(2)

Table 6.2 Comparison of bilateral agreements with global trade reform(change in real income in 2015 compared to baseline)

0.5
1.0
0.0
0.2
0.3

0.3
0.4
1.2
0.9
0.2
0.5
0.2
0.5
1.2
1.3
0.4
0.7
0.4
0.6
1.2
0.1
0.1

0.7

0.3
1.1
0.8
1.0

0.5

Bilateral agreements between
Quad and all
developing
countries(6)
Percent

0.2
0.1
0.1
0.1
0.1

0.3
0.3
0.4
1.2
0.2
0.3
0.5
1.3
0.7
0.4
0.1
0.3
0.0
1.5
1.0
0.6
0.6

0.1

0.1
0.4
0.1
0.2

0.0

Bilateral agreements
between Quad anddeveloping countries
excluding large
countries
(7)

1.3
1.0
0.2
2.1
0.3
0.2
2.6
1.9
1.8
0.5
0.2
0.1
0.2
2.0
0.1
0.9
1.8

Bilateral agreements between
Quad and eachdeveloping
country(8)

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2 0 0 5support programs. Hence the EU and theUnited States improve market access in highly
protected markets in developing countries, butthey do not face the full force of competition
between themselves, particularly in agriculture, nor the full brunt of competition in developing countries. For example, when India
opens up to Quad country imports, Quadcountry exporters do not simultaneously face
increased competition from developing country exporters as they would in a multilateralagreement. In agriculture, Quad producers
will face greater competition from relatively
efficient developing country exporters, butsome of the fiercest competition will be among
themselves. And the terms of trade losses thatthey would suffer from removing agriculturalprotection between Quad countries is muted
when signing the bilateral agreements. Notethat this is not the case with Japan, whose
agriculture is relatively more threatened bydeveloping country market access; it would
gain more from a multilateral agreement, although it nonetheless gains significantly frombilateralism. It is the Quad-plus agricultural
exporters—Australia, Canada, and New
Zealand—that would prefer multilateralism,
because the gains from access to European,
Japanese, and the American markets, and thedismantling of distortionary agricultural support programs would be highly beneficial for
their farmers.
Were the large developing countries6 to be
excluded from the hub-and-spoke bilateralarrangements (perhaps a more plausible scenario), the broad conclusions still hold, but
are muted (columns 3 and 6). First, many developing regions still lose in absolute terms
compared with the baseline scenario. Second,
all lose relative to the gains from a global reform scenario, though for some, the hub-andspoke gains approach those in the global
reform scenario (e.g., Indonesia, and to alesser extent, the rest of LAC and rest of theworld regions). The gains for the high-income
countries, on the other hand, are significantly
lower when the large developing countries are

130

excluded—not surprising given their weight inglobal trade with the Quad countries. Finally,
the impacts on the excluded countries are
mixed: Brazil and China, which would gain ina full hub-and-spoke system, lose when excluded. The other excluded regions—India,
Mexico, Russia, rest of East Asia, and rest ofSouth Asia—would see a dampening of theirlosses.
This adverse outcome from bilateral agreements with the Quad raises the question of
why developing countries are so anxious topursue them. There are a number of possible
reasons, not necessarily mutually exclusive.
First, countries may hope to maximize theirbenefits through first-mover advantages. Second, countries aim to guarantee market accesson a permanent basis. Third, there might bea desire to pre-empt other countries. Fourth, abilateral agreement may be used as leverage
to facilitate domestic reforms. And fifth, othercomponents of an agreement (for example,
services, trade facilitation, and so on) may
have significant benefits in addition to simply
improving market access for merchandise
goods. Focusing on the first of these possible
reasons, we use the model to simulate the impact of each developing country signing anagreement with the Quad countries, but withno other country doing so. The results(table 6.2 columns 4 and 8) provide some justification for developing countries’ pursuit of
RTAs with the Quad if they believe they can doso exclusively, or at least capture a “firstmover” advantage by getting there first. About
one-half of the developing regions would bebetter off with a bilateral agreement than witha global agreement; the winners (relative toglobal liberalization) include China, Indonesia,
Mexico, Southern African Customs Union(SACU), rest of South Asia, and EU accession
countries. Losers include Brazil (slightly),
India, Russia, Vietnam, rest of East Asia, rest of
ECA, Middle East, North Africa, rest of SubSaharan Africa, and rest of LAC.
A few cases deserve special mention. The
rest of the Sub-Saharan Africa region couldM A K I N G

R E G I O N A L I S M

suffer losses from a bilateral agreement with
the Quad. Because this region already has relatively free access to the Quad markets, opening up to permit greater imports from the
Quad worsens their terms of trade and negates
any gains from the bilateral agreement. Russia
and the Middle East are dependent on energy
exports and these face low tariffs in industrial
countries (even if energy is heavily taxed), so
these regions have little to gain from additional market access. These cases highlight
one of the key findings from recent Global
Economic Prospects, that developing countries have much to gain from greater market
access to other developing countries. First, because protection is, on average, higher in developing countries, and second, because of thehigh growth potential of developing countries
over the next decade compared with the industrial countries.
The idea that a single developing country
or region would be able to sign bilateral agreements with the Quad countries without otherdeveloping countries doing the same over the
next decade is unrealistic. Indeed, the increasein the number of agreements over the last
decade means that a portion of any firstmover advantage has been eroded already. But
as a conceptual exercise, it does help illustrate
what may have motivated some developing
countries to aggressively pursue deals with
one or more Quad members.
To summarize, developing countries could
gain an (unweighted) average of 1.7 percent inreal income from a global agreement (figure 6.1). But if all developing countries signbilateral agreements with the Quad, creating acomplex hub-and-spoke system, developing
countries actually suffer losses averaging
0.4 percent (1.0 percent for the low-income
countries alone). While some individual developing countries might have gained from entering exclusive agreements with Quad countries,
RTA proliferation has already eliminatedthat first-mover advantage. Moreover, RTAinduced structural changes could produce disincentives for achieving broad-based multilateralC O M P L E M E N T A R Y

T O

M U LT I L A T E R A L I S M

Figure 6.1 Global outcomes dominate
alternatives
Change in real income in 2015 compared to baseline

Middle-income

BILAT

JBIL
Global

Low-income

Developing

Quad
1.5 1.0 0.5

0

0.5

1.0

1.5

2.0

Percent
Note: Global refers to the global merchandise trade reform
scenario, JBIL corresponds to the simulation where alldeveloping countries sign bilateral agreements with the
Quad-plus, and BILAT corresponds to the simulation where
the bilateral agreements are signed individually. Results
reflect un-weighted regional averages.
Source: World Bank simulations.

reforms (box 6.2). The implications are clear:
The most development friendly outcome is associated with global reform, and a full set ofbilateral agreements would leave virtually all
developing countries worse off than atpresent.
Countries are also pursuing other RTAs,
both North-South and South-South. These
agreements are linked to the ongoing talks on
the Free Trade Areas of the Americas (FTAA),
the ASEAN3 negotiations, and the EU’s various agreements/negotiations with the EUaccession countries toward the east, partners
around the Mediterranean, and in SubSaharan Africa toward the south. Chapter 2 ofthis report documents the large number of existing or prospective agreements among developing countries. Figures 6.2 and 6.3 summarize the overall impacts from simulating
selected North-South and South-South agreements.7 Some of these proffer relatively significant gains (for example, a broad free trade region in East Asia), but are nonetheless clearly
inferior to the gains from global merchandise131

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Box 6.2 Regional trade agreements, structural change,
and congruence
Joint bilateral vs. bilaterals
Index (1 —> fully congruent)
6
5
4

BILAT
JBIL

3
2
1

lc
R

af
Xs
s

N

ec
Xe
c
M
de

C

a

a
Xs

Xe

d
Id
n
M
ex
R
us
Sa
c
Vn
m

Source: World Bank simulations.

likely lead to a 50 percent change in our structuraladjustment measure.
For most of the developing regions, the joint bilateral agreements are broadly consistent with the global
agreement, with the structural index varying fromaround 1 (or near perfect congruence) to a high ofaround 2—for example, for Middle East and North
Africa. On the other hand, the individual bilateralagreements are clearly not congruent with a global
agreement. The pattern of structural change inducedby the individual bilateral agreements is markedly different from what one would anticipate with a global
agreement. Developing countries therefore face a
tradeoff. They can get short-term benefits from signinga bilateral agreement with the Quad—assuming othercountries do not—but the longer-term gains from a
global agreement may be more difficult to attain because the patterns of capital and labor allocation
would be misaligned by the partial agreement.

trade reform. Two additional comments regarding the results of these regional simulations
are suggested by the figures.8 First, when
North-South agreements are implemented simultaneously, the gains are dampened relative
to when they are implemented in isolation—areflection of the impacts of trade diversion. In

132

In

hn

0
Br
a

hile impact assessment of RTAs and global
agreements often focus narrowly on the real
income impacts, from a political economy point ofview, the main drivers of these agreements typicallywill be at the micro or institutional level, where it iseasier to identify the potential winners and losers.
Moreover, the macro analysis typically ignores thetransitional costs. A final issue deals with the compatibility of partial reforms (as represented by preferential trade agreements) with multilateral reforms,
which is arguably where the world economy is heading. In other words, how compatible are the structural changes induced by a partial reform with thestructural changes one would anticipate from a multilateral reform? For example, what if a country suchas Vietnam has a regional comparative advantage in
agriculture, but a global comparative advantage inapparel? Would a regional agreement then make it
more difficult to achieve a multilateral accord?
The figure above provides a summary indicatorof the congruence or compatibility of the bilateralagreements—both the individual (BIL) and joint(JBIL). The indicator measures the average structuralchange of moving from the baseline to the partial
agreement, and then moving from the partial agreement to global free trade, relative to the structuralchange induced by the global agreement. If the partial agreement is compatible (or congruent) with theglobal agreement, this measure is 1; that is, the twostep structural change is identical to the one-step
structural change from implementing directly a
global free trade agreement. For example, a global
agreement of a 50 percent tariff cut is largely congruent with a 100 percent tariff cut and would mostCW

the case of the South-South agreements, theweak gains reflect, in part, the preferences already granted in many of these regions as well
as a lack of distinct comparative advantage.9
This again emphasizes that broad South-Southand North-South trade reform is needed to reap
significant gains.

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Change in real income in 2015 relative to the baseline
Percent
1.6
1.4
Global1.0
0.8
Separate
0.6

Block

0.4
0.2
0.0
East Asia

EuropeThe Americas

Note: Global refers to the global merchandise trade reform
scenario, separate is when the North/South regional blocks
are formed individually and block is when the North/Southregional blocks are implemented simultaneously.
Source: World Bank simulations.

Figure 6.3 Global reform dominates
South–South agreements
Change in real income in 2015 relative to the baseline
Percent
3.0
2.5
2.0

Global1.5
1.0
Separate
0.5
0.0
0.5
LAFTA

AFTA

CIS

SSA

MNA

SAFTA

Note: Global refers to the global merchandise trade reform
scenario, and separate is when the South/South regional
blocks are formed in isolation.
Source: World Bank simulations.

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Building Blocks versus Stumbling
BlocksFigure 6.2 Global reform dominates
North–South agreements

1.2

C O M P L E M E N T A R Y

Whether regional agreements are building
blocks or stumbling blocks to open
global markets—the terms Jagdish Bhagwati(1991) used—remains a central question.10
Proponents of the stumbling block theory emphasize that: (1) RTAs may promote costly
trade diversion rather than efficient trade creation, especially when sizable MFN tariffs
remain—these tariffs create vested interests tomaintain preferential margins in “their” markets; (2) proliferating regional agreements absorb scarce negotiating resources (especially inpoorer WTO members) and crowd out policymakers attention; (3) competing RTAs (especially different North-South combinations)
may lock in incompatible regulatory structuresand standards, and may result in inappropriate
norms for developing country partners; and(4) by creating alternative legal frameworks
and dispute settlement mechanisms, RTAs
may weaken the discipline and efficiency associated with a broadly recognized multilateralframework of rules.
Building block proponents stress that moving forward in smaller steps is often easier toaccomplish, and it creates a certain reform
momentum: (1) regional/bilateral agreements
can help sensitize domestic constituencies toliberalization and keep the stakes lower toallow for incremental progress on trade; (2)expanding the number and coverage of RTAs
can erode vested opposition to multilateralliberalization because each successive RTA reduces the value of the margin of preference,
thereby reducing the discriminatory impact;(3) RTAs are often more about building strategic and/or political alliances or locking in domestic reforms than about actual trade liberalization, and so are not necessarily competitive
with multilateral efforts; (4) regional arrangements can provide an incubator for developing country firms/producers to learn to tradewith RTA partners without facing full global
competition; and (5) for some issues, such as
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2 0 0 5and more manageable alternative to the
WTO, where “lowest common denominator”
outcomes tend to prevail.
One strand of analysis in the literature explores theoretical bargaining models to shedlight on these divergent perspectives. For example, Saggi (2004) considers how RTA formation affects incentives to participate in multilateral trade liberalization. Using a stylized
three-country oligopoly model of intraindustry trade, he reasons that while formation of RTAs can reduce tariffs in the shortrun, in the long run it hinders multilateral
trade liberalization because it lowers the incentives for nonmembers to pursue multilateral cooperation. In a three-country model,
where country size and costs differ, Saggi andYildiz (2004) look at tariff outcomes under
two different sets of rules: One where countries can form RTAs, and another where theycannot. They find that free trade is less likely
to occur as an outcome when countries canjoin RTAs as well. Moreover, the outcome depends on size and cost features: When countries are relatively similar, the RTA option
tends to lower world welfare; whereas withlarger differences among countries, welfare increases. In the latter case, gains are somewhat
larger for the small country getting access to
the larger country (because it gains more in
new export earnings and loses less in domestic
surplus) than for the country with lower costs(because gains from expanded market accessincrease when their own costs are lower andpartner costs are higher). Aghion and others(2004) construct a dynamic bargaining model
to assess the relative effects of simultaneous
multilateral liberalization or sequential bilateral liberalization, and they identify situations
in which the latter can lead to worldwide free
trade. Their model concludes that, as long aslarge coalition payoffs are higher than if all
countries were combined in alternative coalition structures, the outcome is likely to end up
in global free trade, regardless of sequencing.
The Saggi findings support the empiricalevidence that North-South RTAs with small
developing countries yield the biggest benefits

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for developing country participants. This intuition comes from the fact that most empiricalmodels derive their impact from the effect of
RTAs on prices and quantities of traded
goods. But when one partner is much smaller
than the other, its participation in an RTA has
virtually no impact on prices, and any incremental exports it sells are a tiny share of thelarge country trade flows—so the resulting
gains or losses for the larger partner are also
small. Support for this conclusion comes fromthe computable general equilibrium model(CGE) simulations on the impact of RTAs; inmost cases, the net impact on the Northern
partner has been exceedingly small, whether
measured in terms of trade flows, terms oftrade, or welfare changes.
This result in turn has implications for how
RTA proliferation affects incentives to pursue
multilateral liberalization. If the impact of additional North-South RTAs on the industrial
partner is indeed quite marginal, then it seems
likely that the economic consequences of these
agreements would not dampen their willingness to pursue multilateral deals. As we see
below, neither the EU nor the United States
seem to be less disposed toward multilateralnegotiations because of their RTAs or the
RTAs of each other.
Other studies show less sanguine results.
Limão (2003) notes that North-South RTAs
can involve more than just the mutual loweringof tariffs; industrial countries often lower theirtariffs and expand market access in exchange
for cooperation in a variety of nontrade areas,such as labor standards, intellectual property,
migration, security, and so forth. Limão models the interaction between such RTAs andmultilateral liberalization, and concludes that
pursuit of RTAs creates a strategic incentive forindustrial countries to maintain their multilateral tariffs at a higher level than they otherwise
would—to hold back tariff concessions in themultilateral arena in order to have bargaining
room for negotiating RTAs. In the case of theUnited States, multilateral trade liberalizationcommitments are less deep for products thatare produced by regional firms.11

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A more compelling argument is that developing countries with preferential access may
have a vested interest in perpetuating the tariff walls that screen out competing countries
from preferred markets. In fact, Barbados,
Jamaica, and Mauritius have all been outspoken opponents of the agricultural liberalization that would erode their preferences in EU
sugar markets, and Bangladesh has advocatedmeasures that would delay the phaseout of the
textile and apparel quotas required under the
WTO Agreement on Textiles and Clothing.
Nonetheless, this seems confined to a handfulof relatively small countries heavily dependent
on a narrow range of preference-benefiting
products.
An illuminating example of how preferences can be a stumbling block to multilateralliberalization is provided by rum. Low-valued
bottled and bulk rum is one of the largest exports from several Caribbean countries to theUnited States. It enters the United States dutyfree under the Caribbean Basin Initiative. In
1994 there was a single tariff line for rum in the
U.S. schedule (HS 22084000) with a tariff of37 cents/liter. As result of WTO discussions,the United States and EU in 1996 agreed tophase out all tariffs on rum and other “whitespirits” by 2000. Caribbean governments wereconcerned that this would be costly to
Caribbean exporters because they would haveto compete with the rest of the world in
the U.S. market. In response to this concern,the United States agreed to substantially liberalize the duties on expensive rum but to maintain duties on low-valued rum. As of 2003, theU.S. schedule now has four tariff lines for rum,two for high-valued rum with no MFN tariffcharged, and two for low-valued rum with an
MFN tariff of 23.7 cents/liter.12 Since then, theimports of rum from the affected Caribbean
countries have fallen sharply, apparently
replaced by imports from Mexico—another bilateral RTA partner. So efforts to prevent erosion of preferential access may have only limited the impact temporarily.
An increase in RTA activity may be associated with multilateral trade negotiations.

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Mansfield and Reinhardt (2003) argue thatmultilateral trade negotiations motivate countries to conclude RTAs; the motivation is forincreased negotiating power and the desire toobtain or maintain preferential access to markets. They also note that as WTO membership expands, larger membership reduces
individual countries’ ability to influence thecontent and pace of MFN liberalization andmakes it more difficult to formulate coordinated positions. Finally, they find that countries use RTAs to increase leverage against
third parties with which they are embroiled ina WTO dispute. In their empirical analysis
they conclude that countries are more likely
to form RTAs when: (1) GATT/WTO membership rises; (2) a multilateral round is taking place; and (3) parties have recently been
involved in a GATT/WTO dispute in which
they lost.
Others have argued that RTAs are a mechanism to enhance the pressure to move on themultilateral front, and they act as laboratories
for international cooperation on behind-theborder policy issues. This line of reasoning has
a long history. Winham (1986) and Lawrence(1991) have both argued that the creation andsubsequent expansion of the European Economic Community (EEC) motivated earlier
General Agreement on Tariffs and Trade(GATT) rounds—the objective being to reduce
European external protection. More recently,
Schott (2004) noted that the United States has
pursued bilateral trade agreements over thelast two decades in part to complement andcajole progress at the multilateral level. He
argues that tensions from the GATT meetingsin 1982 were the impetus to pursue bilateraldeals with Canada and Israel; he also claims
that the start of the NAFTA negotiations in1991 reflected some frustration over failure
to conclude the Uruguay Round negotiations
on time in late 1990. In the early 1990s, theUnited States also began to pursue broader
umbrella regional initiatives, including Asia
Pacific Economic Cooperation (APEC)—
whose members have never formally committed to a binding RTA—and the FTAA.

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2 0 0 5In short, there is only limited evidence
from the theoretical literature and a handfulof empirical studies that the proliferation of
RTAs affects multilateral liberalization either
way. On balance, the evidence does point totactical behavior in trade negotiations, which
seems to provide mild additional incentives
for greater liberalization. The exception isfor small countries that suffer from preference
erosion—a nontrivial obstacle to futureliberalization.

The Competitive Liberalization
Game: The Case of DohaThe rapid proliferation of RTAs may haveaffected the negotiating dynamics of the
Doha Round, and it is unclear whether the increase in bilateral deals is in response to slow
progress in the Doha talks. Concerns over RTA
proliferation played a role in the launch of theRound and came back full force after the failure of the Cancun ministerial. Consider theactions of the major players in the global andregional game.

The U.S. pursuit of like-minded partners
With the change in U.S. administration in2001 and the subsequent congressional approval of the Trade Promotion Authority in
2002, the pace of bilateral, regional, and multilateral efforts increased. Then, in the absenceof progress on the Doha agenda in Cancun in
September 2003, the U.S. Trade Representative (USTR) indicated that the United States
would pursue deals with “like-minded” partners, and the result has been an unprecedented
spurt of U.S. negotiating activity. The UnitedStates had negotiated RTAs with six
countries/groups by 2004 (Australia, Bahrain,
Central America and Dominican Republic,
Chile, Morocco, Singapore), and anotherdozen are under negotiation, including SACU
(Botswana, Lesotho, Namibia, South Africa,and Swaziland), Colombia, Ecuador, Panama,
Peru, and Thailand. As discussed in chapters 2
and 5, the United States is pursuing new rules
in key areas (investment, intellectual property,

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and services liberalization)—areas wheremultilateral efforts have gone slowly or halted
altogether—while developing countries seek
market access.
Eligibility is not guided by a single criterion
or ranking system (box 6.3). Political criteria
include national security-cum-foreign policy
concerns (a major factor in the recent agreements and ongoing discussions with Arabcountries), while others reflect a mixture ofclassic market access goals and a desire to export U.S. regulatory standards (for instance, in
the area of investment and IPRs—see
chapter 5). The U.S. decision to pursue bilateral arrangements in Latin America also has
the effect of putting pressure on Brazil andother countries, which are seen to be impeding
progress on the now-stalled negotiations on
the FTAA. Reaching these agreements does
not appear to have reduced the United States’
participation in the WTO negotiations, nor tohave had much effect on the content of its
negotiating position.

Recent EU regional initiatives
Having been a leading (and early) player in the
RTA game, the EU had established many
RTAs prior to the launch of the Doha Round(see chapter 2). Since then, it has pursued market access agreements with a few individual
partners (notably Chile and Mexico, with
South Africa predating 2001) as well as
MERCOSUR. The EU has preferred to negotiate with blocs of countries and has encouraged
the Mediterranean countries to sign agreements with one another; the EU made the RTA
with Gulf Cooperation Council (GCC) countries conditional on the adoption of a common
external tariff by the GCC and supported thedevelopment of a web of bilateral RTAs between Southeastern European economies. The
recent Economic Partnership Agreements(EPAs)13 were launched to replace the Cotonou
agreement with the African, Caribbean, andPacific (ACP) group in a WTO-compatible setof agreements, and the EPAs are seen by the EU
as a development-promoting vehicle rather
than as a way to gain additional market access.

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Box 6.3 Choosing partners: Selection criteriafor U.S. RTAs

T

he U.S. choices of developing country RTA partners reflect a range of different objectives, whichmakes categorization difficult. In a report prepared
for the U.S. Congress, U.S. General Accounting Office (GAO) (2004) reports that early RTA proposals
were (according to the USTR) based on evaluation of
13 different factors (without any formal weighting
scheme) that covered five themes: Congressional
guidance, business interests, political will of partners,
security and foreign policy concerns, and regional
parity. Following consultations with relevant agencies, there is now a shortened list of six factors to
guide the choice of future U.S. FTA partners: country
readiness (political, trade, and legal); economic/commercial benefit; benefits to broader trade liberalization strategy (including success in meeting WTO
obligations and support of key U.S. positions in
FTAA and WTO negotiations); compatibility with
U.S. interests (including foreign policy positions);

These agreements do not appear to have altered the EU’s approach to the Doha Round.
After the conclusion of the Mexican andChilean bilateral deals, the EU had declared it
would negotiate no new trade agreements,
save for the EPAs that were necessary to replace the Cotonou agreement set to expire in2008. However, this stance may be shortlived. In September 2004, the incoming EU
Trade Commissioner announced that hewould review this policy and consider launching new negotiations.

Japan is a latecomer but moving quickly
Until recently, Japan remained disengaged
from the RTA trend and instead pursued avoluntary approach that centered on APEC.
A distinguishing feature of APEC is that it
focuses primarily on exchanging informationand identifying good practices in the trade
policy (and other) areas. While it also sets specific targets for trade policy (e.g., free intraAPEC trade by 2020), implementation of thecongressional/private sector support; and U.S. government resource constraints. The report emphasizes
that the selections are not mechanical and argues
that trade strategy and foreign policy factors dominate the selection criteria.
Schott (2004) identifies the same broad criteria,
but also notes the role of partner choice in selectionof U.S. FTA partners. Current U.S. law requires that
potential partners must request negotiations with theUnited States, rather than the other way around. He
notes that most of these requests reflect concerns
over discriminatory treatment (from other agreements, especially NAFTA) and serve to demonstratecommitment to domestic audiences who may need tobe convinced of the benefits of reform trade anddomestic policies.

Source: Schott 2004.

good practices and targets are left to individual members. The primary enforcement devices are mutual surveillance and peer review.
More recently, it appears that competitive
pressures that emerged from the more intensive activity by the United States—also an
APEC member—and the concern that even in
the Asia region there was a risk of being left
out of the new generation of RTAs, haveprompted new Japanese activity. Japan completed the negotiation of its first RTA with
Singapore in 2002. Negotiations with Mexico
are advanced. The competitive disadvantage
in Mexican markets relative to the UnitedStates and the EU is a strong inducement, withJapanese products facing an average customs
duty of 16 percent (Tojo 2004). Negotiations
are beginning with Republic of Korea, which
are considered important because JapanKorea could form the basis of a future East
Asian economic zone. Talks have also begun
with three individual members of ASEAN(Thailand, Malaysia, and the Philippines), and137

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2 0 0 5

consultations have been initiated over how tomove forward with a proposed Comprehensive Economic Partnership between Japan andthe full ASEAN group. Finally, there are preliminary discussions and analysis of a possible
ASEAN3 RTA (including China, Republicof Korea, and Japan) in the context of efforts
to strengthen economic relations among thisgroup.

Developing country objectives andnegotiating strategies
Developing countries have three general approaches to RTAs. Some have adopted an aggressive approach and pursued a serial RTA
strategy; that is, they negotiate a string ofagreements and use the sequence to demonstrate their commitment to trade reforms bylocking these in and increasing the incentive
for excluded countries to negotiate. Harrison,
Rutherford, and Tarr (2002) have labeled thisnegotiating dynamic “additive regionalism.”
Its most prolific proponents include Chile,
Mexico, and Singapore, which have pursued
RTAs with most of their geographic neighbors, as well as with many of the other major
players (Schott 2004). The idea is that negotiating additional RTAs will progressively lower
the effective average tariff (reducing potential
trade diversion costs) and assure stability ofmarket access for partner countries. A second,much larger group of countries has pursued astrategy more explicitly regional in focus,
which seeks to deepen ties with neighboring
countries; examples include ASEAN, the
GCC, MERCOSUR, and SADC. A thirdgroup has focused on negotiating NorthSouth RTAs, often in parallel with their regional integration efforts with neighbors;
examples are the southern Mediterraneancountries with the EU and the US-CAFTA
agreement. The ACP-EU Economic Partnership Agreements are another example.
Additive regionalism could create adverse
global effects by reducing the incentives forcountries to participate in multilateral liberalization efforts. That has not been the case with
Chile, Mexico, or Singapore. The fact remains

138

that these countries still have incentives to see
lower barriers in the many countries withwhich they do not have RTAs and to harness
the multilateral process to achieve movementin areas outside of the RTAs, such as agriculture and anti-dumping. The WTO provides aforum to achieve these objectives at a lower
cost than negotiating a plethora of bilateral
RTAs. Countries pursuing such strategies arevery much a minority—most developing countries are not in this game (box 6.4). Chile,
Mexico, and Singapore are all economies thatmoved substantially toward free trade andthus have already captured most of the potential gains from unilateral trade reforms. Froma global point of view, therefore, these are notcountries that have a vested interest in maintaining high MFN barriers. These countries
are examples of open regionalism.
The determinants of the multilateral negotiating stance of the broader group of developing countries are more varied. For a handful of countries, existing preferences underunilateral accords as well as multilateral andregional agreements are openly driving theiropposition to multilateral liberalization. For
some other developing countries, it is possiblethat RTAs are undermining their interest in
multilateral negotiation, either because they
mistakenly see RTAs as an alternative, because
they feel subsumed in large coalitions withother countries, or because they do not havethe resources to negotiate with both the WTO
and with potential regional partners.
This discussion suggests a few impressionistic conclusions. It is hard to argue that competitive liberalization through RTAs has muchinfluence on the behavior of the major players
in the WTO, either in their fundamental negotiating positions or their willingness to compromise to achieve a result. As evident in theJuly WTO Framework Agreement, major
players are still working with commitment
toward an agreement in Doha. To be sure, forsmaller countries with scarce negotiating capacity, RTAs do absorb resources that could
be devoted to multilateral negotiations; butthese countries tend to participate in the WTO

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Box 6.4 Sequencing of RTAs:
Is there a good practice?

D

ebates over trade liberalization have often included extensive discussions of whether there isa preferred (or even optimal) sequence for reforms.
Theoretical guidance for policymakers in the designof RTAs speaks to two dimensions of the question—
the choice (and sequence) of partners over time
and the substantive coverage of an RTA (and thesequencing of inclusion of different elements)—that
have implications for the debate. On the former, thesequencing of partners may affect incentives of members to pursue MFN liberalization. Thus as discussed
elsewhere in this report, the formation of large blocs
creates incentives to join for smaller countries that
trade heavily with members—what has been termed“domino regionalism” (Baldwin 1993). The EU is thebest example of this phenomenon: EFTA countries
that were not in favor of the EU integration model ultimately concluded that the costs of staying out were
too high. Whether this process makes RTAs more orless receptive to MFN reforms depends in part on thepreferences and interests of those who join the bloc
over time—which in turn will affect the willingness of
incumbent countries to accept new members.
On the product/policy coverage issue, the conventional wisdom appears to be that agreements should
first focus on trade liberalization and then move on
to behind-the-border areas—that is, go from shallow
to deeper integration. There is no theoretical justification for this, however, and there is a welldocumented history that, in the case of the EEC,
many policymakers were of the view that the twoneeded to be pursued in tandem. The rhetoric ofpolicymakers and their advisors often suggests thatdeeper integration is necessary to attain free trade.
During the period leading to the creation of the EEC,

as members of coalitions, and it is not clearthat these constraints impede compromise. If
the effects on the multilateral round are negligible, it does seem that all players appear to bequickening their efforts to seek new preferential agreements. The outcome of the game of
RTA-based competitive liberalization is likely
more RTAs.

Jelle Zijlstra, the Dutch Minister of Economic Affairs
argued that credible tariff removal required common
policies on taxes, wages, prices, and employment
policy. Similarly, the Belgian government felt thatpolicy harmonization was required to equalize costs,
and that without it, a customs union would not be
feasible because countries would impose new forms
of protectionist policies. French officials persistently
demanded harmonization in social policies—equalpay for both sexes, a uniform work week—as a precondition for trade liberalization—French standards
in this area were higher than in other countries(Milward 1992).
Recent research on the effects of, and interplay
between, efforts to liberalize trade and investment inservices (and FDI more generally) suggests that countries may be better of pursuing both shallow anddeeper forms of liberalization in tandem. Hoekman
and Konan (2001) and Konan and Maskus (2003),
for example, note that not only can this generatemuch greater welfare gains, it can also reduce aggregate adjustment costs over time—through avoiding
outcomes in which factors of production must moverepeatedly across sectors (as will, by definition, occur
if goods are liberalized first and then services/investment, or vice versa). They also note that because
many services continue to be less tradable than
goods, there is greater scope for employment opportunities to be created as a result of allowing greater
competition in services markets, thus helping to absorb labor from other sectors as prices change due totrade reform.

Source: World Bank staff.

One negative incentive effect created by
preferences—reciprocal RTAs or voluntary
programs—is that members’ desire to safeguard their preferential access to the regional
market may result in less support for MFNbased trade reforms. This incentive effect haslong been recognized; it was one of the arguments made against the Generalized System of139

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2 0 0 5Preferences when they were initially proposedin the 1960s. Indeed, unilateral preference
programs, especially the more comprehensive
and meaningful schemes adopted in recent
years, such as the EU’s Everything But Arms
(EBA) program and the United States’ African
Growth and Opportunity Act (AGOA), potentially make matters worse, because theirvalue to recipients depends on the existenceof trade barriers against imports from othercountries—with the greatest rents generated
by programs that distort markets the most,such as in the sugar market. Maintaining preference margins—whether for RTA partners or
beneficiaries under unilateral preference
programs—is not the answer. What is needed
is a willingness on the part of developed countries to move away from preferential access as
an instrument to assist lower-income partnercountries and to move toward greater relianceon direct transfers of technical and financial
assistance (Stoeckel and Borrell 2001). Thishas the advantage of allowing high-income
countries to target their trade-related development assistance to those countries most in
need, something the system of preferences
cannot do.

Multilateral Disciplines on
Regional ArrangementsE

fforts to deal with the implications of
RTAs within the multilateral trading system are long standing. The primary disciplines
are laid out in Article XXIV of the GATT—
others are discussed in box 6.5. They permit
RTAs if: (1) external trade barriers do not rise
(Article XXIV:5); (2) all tariffs and other regulations of commerce are removed on substantially all exchanges of goods between thepartner countries within a reasonable length oftime (Article XXIV:8); and (3) notification ismade to the WTO Council.
The first criterion is intended to limit thenegative impact of an RTA on nonmembers.14
The second condition might at first seemcounterintuitive—after all, the more extensiveis the liberalization with an RTA, the more140

detrimental it is likely to be to nonmembers.
But the rationale here was in fact different; as
noted by Finger (1993), the objective was toensure that participants in RTAs are serious.
In other words, while more trade in an RTA
hurts nonmembers, pursuit of numerous partial RTAs can severely undermine the incentives for multilateral trade negotiations andcreate opportunities for special interests(farmers, specific industries) to carve out special arrangements. As a counterexample, if a
restrictive interpretation (say 99 percent of all
trade) of this criterion were agreed to and enforced, it is likely that the appetite for RTAs
would be substantially diminished.
Determining whether the GATT or General
Agreement on Trade in Services (GATS) tests
are met is left for the Committee on Regional
Trade Agreements (CRTA). Before the creation of the WTO, the GATT Council usuallycreated a working party to evaluate whether
its conditions were satisfied. Under the WTO,
the CRTA was established for this task. The
GATT experience in testing reciprocal preferential trade agreement (PTAs) against Article
XXIV was very discouraging. Starting withthe examination of the treaty establishing the
EEC in 1957, almost no examination of agreements that were notified under Article XXIV
led to clear conclusions or specific endorsements that the GATT requirements had been
met. Only one working party could agree thata regional agreement fully satisfied the requirements of Article XXIV (the Czech-Slovak
Customs Union).
There had been a conscious political decision made by GATT contracting parties in thelate 1950s not to scrutinize the formation of
the EEC because the EEC member states had
made it clear that if the EEC treaty was foundto be inconsistent with Article XXIV, theywould withdraw from GATT (Snape 1993).
Given that the EEC did not meet all the requirements of Article XXIV—agricultural
trade was not liberalized—it created a precedent. It is also true that the criteria and language of Article XXIV are ambiguous. Legitimate differences of opinion are possible

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Box 6.5 RTAs and WTO disciplinesT

he fundamental building block of the multilateral system is the principle of nondiscrimination. This is enshrined in Article I of the originaltext of the GATT signed in 1947. But from thestart, there have been exceptions. One such provision is Article XXIV of the GATT, which permits
WTO members to enter into preferential trade
agreements (RTA) that extend trade concessions to
RTA participants not offered to nonparticipants, aslong as certain criteria are satisfied—in particular,
regarding the scope of the RTA. Second, rules covering preferential agreements that deal with trade
in services are set out in Article V of the GATS.
Finally, developing countries may, if they wish, invoke
the provisions of the 1979 Decision on Differential
and More Favourable Treatment, Reciprocity andFuller Participation of Developing Countries (the socalled Enabling Clause) to exchange tariff and, to acertain extent, nontariff preferences among them.
Unlike Article XXIV, the Enabling Clause does not
require that internal barriers be removed on “substantially all” trade among participants in thosearrangements. MERCOSUR was notified to GATT
under this provision, not under Article XXIV. The

regarding issues such as the definition of“substantially all” trade; how to determine
whether the external trade policy of a customs
union has become more restrictive on average;
and what a reasonable time period is for thetransition toward full implementation of an
RTA (Hoekman and Kostecki 2001).
In the Uruguay Round some of these issues
were clarified: Specific criteria were adopted
to assess whether a customs union’s externaltariff satisfies Article XXIV; a 10-year maximum for the transition period for implementation of an agreement was imposed; and, as
mentioned, a standing committee was createdto oversee RTAs. None of these changes had
any effect on the ability of WTO members toagree on whether an RTA conformed to WTO
requirements. Most observers would agree
that existing WTO disciplines and enforcement mechanisms have no teeth, and are not

Enabling Clause also legitimizes non-reciprocal programs such as the Generalized System of Preferences(GSP).
The task of verifying the WTO compliance of
RTAs notified under GATT Article XXIV and GATS
Article V is entrusted to the CRTA. The CRTA wasestablished in 1996, in particular to (1) oversee,
under a single framework, all regional trade agreements, and (2) consider the implications of suchagreements and regional initiatives for the multilateral trading system and the relationship between
them. RTAs among developing countries, when notified under the Enabling Clause, are not, in principle,
subject to review by the CRTA. As was the caseunder the GATT, however, the CRTA has been unable to carry out effectively its functions of examining the consistency of RTAs with the rules, and overseeing their implementation. The reason for this isessentially a fear of setting a precedent and opening
up agreements to dispute settlement proceedings. The
CRTA has thus far been unable to conclude the examination of any of the 110 RTAs currently under
scrutiny and has a backlog of about 35 RTA reports
to prepare.

particularly effective at controlling, limiting,or shaping the growth and coverage of RTAs.
At the Fourth Ministerial Conference in Doha,ministers agreed to launch negotiations toclarify and improve the disciplines and procedures under the existing WTO provisions that
apply to RTAs, taking into account the developmental aspects of these agreements.
The Doha Agenda negotiations on rules forpreferential trade agreements have been conducted on two tracks, one focusing on transparency issues and the other addressing thesubstantive disciplines. Transparency is generally less contentious, and includes:• Administrative overload in reviewing
proposals. Review of long, detailed, andoften unclear RTA documents imposesa substantial workload on committee
members. One possible solution would141

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2 0 0 5be an expanded “first review” by WTO
staff based on clear and objective criteria;
this would require a significant expansionof resources allocated by the Secretariat.
• Notification of RTAs to the WTO. The
WTO has been notified of around 300
agreements (of which about 140 are currently in force), and another 60 or so arein advanced stages of negotiation (seechapter 2). Many of these are for RTAs
among developing countries. Moreover,few RTAs have been designated as“interim arrangements,” even thoughmost RTAs have been implemented instages.
• Data and information requirements.
There is no clarity on the type, quantity,
and level of detail to be provided when
the WTO is notified of an agreement.
Developing countries often lack thecapacity to undertake this task. Whilesome members want more detail, it is understood that unduly straining the capacity in developing countries should be
avoided. Some suggest that WTO assistance could be provided for the notification process if necessary.
• Review of South-South agreements. The
Enabling Clause does not provide forany consistency examination. Current
practice is for RTAs formed between developing countries (and notified under
the Enabling Clause) to be reported to
the Committee on Trade and Development (some developing countries havechosen to notify the WTO of agreements
under Article XXIV). Countries haveraised the issue of reporting Enabling
Clause Agreements to a single body, the
CRTA.
• Services. Some of the requirements of theprovisions of Article V of GATS are unclear (e.g., in terms of the departure from
MFN obligations in key areas such astransparency, emergency safeguards, andadministration of domestic regulations).
• Process. Some delegations want notification of RTAs to occur before they are142

implemented. Others support issuing a
final report that does not pass or fail a
RTA, but allows members to registerconcerns. Finally, some delegations want
greater diligence in encouraging RTA
participants to file biennial reports on
the implementation of RTAs.
Although no early harvest on transparency
issues was undertaken for the 2003 Cancun
Ministerial, negotiations for a (provisional)
application of strengthened surveillance mechanisms are considerably advanced. Suchmechanisms would require more detail in the
RTA notification procedures and might involve an enhanced role for the Secretariat in
preparing an assessment of each RTA thatwould be provided to WTO members.
Informal discussions on the substantive
rules began in June 2004, and there are many
issues under consideration. The fact that
WTO rules on RTAs relate to several otherregulatory areas (some of which are undernegotiation)—including rules of origin, tradefacilitation rules on trade remedies, theGATS—adds to the complexity. Issues underconsideration include:• Product coverage of RTAs. One central
issue is whether to make more specificthe requirement that “substantially all”
trade be covered in each RTA. Lack ofclarity regarding this criterion is viewed
by many as a source of the CRTA’s inability to reach clear-cut conclusions on
WTO compatibility for most RTAs.
Many RTAs exclude agriculture, which isa major problem. Some have proposedthat “substantially all” trade should be
defined as a percentage not only of actual trade but also of all the six-digit tariff lines listed in the Harmonized System.
This approach could ensure that thestandard is set high, but that there is alsosufficient flexibility to set aside productareas that remain sensitive for one reason or another. A related issue concerns
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they be subject to the same percentage,or grandfathered in under the existing
imprecise criterion? Although inherently
arbitrary, a more specific coverage criterion could help to move the review
process for RTAs along. Schiff and Winters (2003) suggest adopting a coverage
criterion of 95 percent of the value of
trade after 10 years of operation of theagreement, rising to 98 percent after 15
years. This would require that at least
some sensitive products be included (e.g.,
agriculture), but not all, and would
imply that over time the set of excluded
products would decrease.
• Policy coverage of RTAs. GATT Article
XXIV.5 requires that duties and otherregulations of commerce applied bymembers of a RTA are not more restrictive than those existing prior to its formation. In assessing the impact of a
RTA, there is no agreement on what thiscovers. In particular, it is unclear to what
extent it covers policies such as safeguards, anti-dumping measures, mutual
recognition agreements, or rules oforigin—and if they are covered, how
they should be evaluated. Many RTAs
continue to allow for the use of antidumping and safeguards on intramember trade—that is, conflict with thesupposedly free trade objective of RTAs.
Only a few RTAs have abolished thereach of antidumping (the EU,
ANZCERTA, Canada-Chile). Alternatively, some RTAs preclude the use ofsafeguards on goods originating in partner countries—for example, Canada and
Mexico were exempted from the recent
U.S. steel safeguard action. This increases the negative effect of the action
for nonmembers.
Whether rules of origin are a regulation ofcommerce has been a key source of disagreement for decades. The rules of origin are relevant not just for normal trade flows, but also

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play a role in the application of safeguards
and other contingent trade policies. Issues related to rules of origin were already being discussed in the early 1970s in working parties
that were considering RTAs. Thus in connection with the 1972 free trade agreement between the EEC and European Free Trade inEurope (EFTA) member states, the UnitedStates argued that the rules of origin would
harm nonmembers.15 Not surprisingly, preferential rules of origin are being discussed in thecurrent Doha talks, although expectations are
low that there will be agreement on common
disciplines. Discussions on harmonization of
nonpreferential rules of origin have been
under way for almost 10 years and have yet tobe concluded.16 In any event, these harmonized rules of origin will not apply to regional
agreements or to GSP schemes. Because rulesof origin facilitate the fine tuning of preferential liberalization at the product level, many
countries do not want to see constraints imposed on their policy freedoms in this arena.
Many proposals have been made in the
WTO for stronger rules for RTAs. One suggestion is that all RTA members be required toextend their preferential concessions to therest of the world within a specific time frame(Srinivasan, 1998).17 Another suggestion is tominimize the adverse discriminatory consequences of RTAs by requiring (or exhorting)members to allow any developing country to“opt in” on the same terms as existing members, perhaps after a certain time period. This
goes back to Viner (1950). As noted, virtually
every existing RTA has geographic restrictions
on membership and has features that requirenegotiation, so the practical promise of suchopen regionalism is limited. Other suggestions
do not make good economic sense (see Schiff
and Winters, 2003).
Many observers have concluded that thequest for stronger rules is unlikely to succeed
because many RTAs will not satisfy the rules,
which will, in turn, lead countries to prefer the
status quo. Schiff and Winters (2003) conclude their discussion of regionalism and the
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Answer.” From this perspective, the primaryfunction of the WTO is to act as a negotiating
forum to bring down the discrimination created by RTAs. The importance (and feasibility) of this depends, in part, on the motivationof governments to pursue RTAs.

Making Open Regionalism Workfor Development
Defining the role of the WTO
Numerous observers and analysts of RTAs,
who are interested in enhancing their compatibility with the global trading system, proposethat WTO disciplines be applied more stringently. Years of discussion in the GATT/WTO
on the interpretation of existing criteria, andthe many papers proposing more specific criteria have had no impact on the spread or content of RTAs. Improving the enforcement of
Article XXIV or strengthening/changing WTO
disciplines on regionalism is unlikely to fareany better.
Whether it is helpful to articulate more specific criteria delimiting what “substantiallyall” trade means, or tightening up disciplines
on “other regulations of commerce,” depends
in large part on the feasibility of attaining
a consensus on specific criteria. Given theplethora of RTAs that are in force, and theshare of global trade notionally covered
through such agreements, a strong case can bemade that the horse has already bolted fromthe barn—shutting the barn door will makelittle difference. The problem is a political one;any number of countries will oppose stronger
rules because they are already members of
RTAs that would violate them. Indeed, even ifgroups of developed countries—such as theEU—make a case that their agreement satisfies
whatever criteria might be proposed, or that
their model should become the benchmark,other countries could legitimately argue that if
it was acceptable for the EEC to pass musterin the 1960s and 1970s, it would be hypocritical to impose stronger rules on all WTO
members today.

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Nonetheless, WTO members should lookfor ways that existing disciplines on RTAs canbe reinforced and new disciplines introduced
to enhance their development impact. One
area where knowledge is much more extensive
now, compared to when the original GATT
rules were written, regards rules of origin. It isclear that complex and restrictive rules of origin limit the benefits of RTAs for developing
country participants and divert trade in intermediate products. Rules of origin that differ
across agreements complicate world trading
conditions and contribute to the emergence of
hub-and-spoke patterns. Thus there would besubstantial benefits from an agreement that
promoted common, simple, less restrictive,and easy-to-apply rules of origin. That being
said, the delays and problems in achieving theobjectives defined in the Uruguay Round forthe nonpreferential rules of origin are not propitious in this case.
From a development perspective, the mostuseful and immediate step for the WTO is toimprove transparency. Information and analysis are important inputs for a well-functioning
trading order. Greater monitoring and assessment of the impacts of RTA-related policies
would allow more informed and proactive engagement by civil society (think tanks, nongovernmental organizations, consumers, andtaxpayers) in the policy formation and negotiation process. It is true that to reduce protection and protectionist pressures, those thatlose (pay) need to be aware of the costs ofsuch policies. The suppliers of and the clientsfor such analysis and information are not necessarily governments, but the constituencies inindividual countries who are affected by policy. In order for trade agreements to promote
good policy-making in member countries,
stakeholders must be able to be active in thedomestic policy formation process.
This could be achieved by augmenting thecapacity of the WTO Secretariat andthe CRTA to review, document, and analyze
the effects of RTAs. That is, WTO attention inthis area should focus on gathering information and analysis. Efforts could concentrate on

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addressing such questions as: Are RTAs being
implemented? How? What is the effect onmember countries and on nonmembers? Howmuch trade is covered by the RTA (and is it“substantially all”)? Ideally, stronger surveillance would involve those responsible for
implementing each RTA and, in the process,empower them to engage policymakers andstakeholders. Such surveillance and analyticalmonitoring should extend to South-South
RTAs—which should all be notified to the
CRTA.
Strengthening information exchange andmutual (multilateral) dialogue, (including
through the establishment of formal monitoring mechanisms), would facilitate cooperation
on new regulatory issues. If existing or proposed policies could be evaluated using objective criteria on their ability to achieve thestated national objectives, countries andstakeholders could assess their efficacy and, if
needed, adjust the policies. Greater analysis of
the effects of trade discrimination—both unilateral preferences and RTAs—should be partof this agenda.
Information of this type would help RTA
stakeholders to hold governments accountablefor outcomes and to assist nonmembers byproviding data that could feed into demandsin the context of WTO negotiations.18 As
argued by Hoekman and Kostecki (2001)
among others, the primary means throughwhich the WTO can impose limits on RTAs isby providing a venue for negotiation to reduce
MFN barriers, which will automatically limit
the discrimination against outsiders that is inherent in RTAs.

Priorities for the industrial countries
The major industrial countries must strike adifficult balance in their pursuit of bilateraland regional deals with developing countries.
On the one hand, there are legitimate reasons
to pursue such initiatives, rather than relying
only on multilateral channels. The ongoingEU effort to deepen relations with a wider
Europe is an important example. Cooperation
among a smaller number of countries may

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also be the most effective solution to mitigating environmental externalities, addressing
nontrade issues such as labor migration (legal
or illegal), or attaining national security objectives. But it must be recognized that the aggressive pursuit of RTAs with developing
country partners in all corners of the globe
serves the cause of global liberalization poorly
if it delays or halts altogether the progress
toward multilateral liberalization.
Fostering development is increasingly identified as a key rationale for North-South
RTAs. In part this reflects economic
interests—growing markets abroad are expanding export markets—and in part it is dueto the recognition that there is a correlation between sustained economic growth in partnercountries and national security. From this vantage point, several recommendations emerge.
The highest priority should be to ensurethat the Doha Development Agenda is completed in a manner that provides new market
access to exporters in developing countries. In
addition to their interests in development, thelarge countries have an important historicaland systemic responsibility to ensure that theworld trading system remains as open as
possible.
Supporting open regionalism by encouraging partner countries to adopt low externalbarriers would create momentum toward
integration with the world, establish a more
efficient development path, and reduce theadverse negative implications of RTAs on nonmembers. Because these countries are lesslikely to be preferred RTA partners of theUnited States and the EU, they will continue tohave an incentive to engage at the WTO level.
Adopting the widest possible product coverage and greatest market access expansion
would increase the development impact. Thismeans that agricultural trade policies should be
included in RTAs. Excluding agriculture from
RTAs—the dominant practice at present—does
not promote development. Although inclusionof agricultural market access will increase the
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Box 6.6 Tunisia’s Association Agreement with theEuropean UnionIn July 1995, Tunisia signed the Association Agreement with the European Union (AAEU). The agreement, which came into effect in March 1998, would
liberalize trade for industrial goods over a 12-year
period and ultimately create a free-trade zone. Trade in
agricultural goods and services was left out for futurenegotiations. By the mid-1990s, Tunisia had alreadybecome a successful exporting country, thanks to theestablishment, in 1972, of a special offshore system forexporting enterprises that mitigated the anti-export
bias of the highly protective trade regime.* Exports ofmanufactured goods had increased from 4 percent of
GDP in 1975 to 20 percent by 1994. Free market access to EU markets under the AAEU further enhanced
Tunisia’s export performance, with manufactured exports increasing to 25 percent of GDP in 2002.
The AAEU gave momentum to trade liberalization in Tunisia. Average MFN tariffs were reduced
from 33 percent in 1994 to 26 percent in 2003.
However, Tunisia still posts the second highest average MFN tariffs in the broader EU neighborhood,including in the EU accession countries. For example, only Morocco, with a tariff rate of 30 percent,has a higher border barrier, but countries as diverse
as Turkey, Bulgaria, Ukraine, Lebanon, and Moldova
have tariffs of 10 percent or lower.
High MFN tariff differentials in the presence ofEU preferential access risks diverting trade awayfrom the lowest cost sources, denying Tunisian producers and consumers the benefit of less expensive
imports from outside the preferential trade zone with
the EU. As a result of high MFN tariffs and geographical proximity, about 75 percent of Tunisia’s

trade is dependent on the European market—
especially in EU neighborhood countries.
A trade strategy linked to the domestic reform
agenda would help Tunisia fully realize the development promise of deeper trade integration. First, ambitious reduction of MFN tariffs for industrial goods
would prevent trade diversion. Second, removing
beyond-the-border obstacles to trade—by reducing
the still-high trade logistics costs—would enhancefirms’ ability to exploit export opportunities and improve their competitiveness; liberalization of backbone services, especially in transport, ICT, and finance, are also essential. Third, once the free-tradezone with the EU is fully implemented in 2007, preferential tax treatment of exporting firms will becomemuch harder to justify, because both offshore and onshore firms will be equally exposed to foreign competition. The regulatory framework of investment incentives and trade facilitation will thus have to
become more even. The EU could also liberalize market access for Tunisian agricultural exports in products in which Tunisia is competitive. Unless market
access is improved, the scope for farmers to shift into
these products will remain limited, and sectoral adjustment in agriculture will continue to be impaired.

*This system covers companies located anywhere in the
country and it grants duty-free imports of capital and intermediate goods, exemptions from the VAT and excise taxes, and exemption from the corporate income tax for the first 10 years ofoperation.
Source: World Bank staff.

downside of RTAs for large agricultural producers in the developing world. The latter willthen have a greater incentive to push for WTOlevel MFN reforms; the marginal increases incompetition from preferred partners may help
overcome the domestic interests opposed to reforms through a process of gradual, piecemeal
expansion of access to agricultural markets.
Industrial countries negotiating NorthSouth RTAs should adopt liberal cumulation
provisions in their rules of origin. Because the146least-developed countries (LDCs) already havenearly free access to OECD markets, NorthSouth RTAs will erode such preferences. Cumulation will ensure that rules of origin do
not impose an additional burden on thesecountries. For member countries, liberal rulesof origin will enhance the benefits of NorthSouth RTAs. A demonstrated willingness ofindustrialized countries to put partner country
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would show that development objectives arebeing taken seriously in RTAs.
Industrial countries could also enhance thedevelopment credentials of their RTAs by taking action to abolish antidumping and similar
instruments of contingent protection. There isa plethora of evidence that antidumping isstraightforward protectionism and that insofar as there is a rationale for intervention,other policy instruments can be used (i.e.,competition policy). A number of RTAs—
ANCERTA, Canada-Chile, the EU itself—have proceeded down this path, which illustrates that it is feasible.19
Industrial countries should exercise caution
regarding their demands for new regulatory
policies in RTAs. Behind-the-border, regulatory policies are critical for a positive impact
on development outcomes, but getting the rules
right—ensuring that rules are calibrated to development capacities and do not detract fromother, more pressing priorities—is as essential
as it is difficult to orchestrate. Applying regulatory norms in RTAs on a nondiscriminatory
basis will avoid creating another complex setof discriminatory preferences. In other words,
RTAs will be supportive of development if thenegotiation and implementation process is designed to ensure that such priorities are set appropriately, and the preconditions for benefiting development are in place. Many RTAs arefar from satisfying this prescription.
Increasing the effectiveness of development
assistance for trade can help. Aid is an important part of the equation motivating RTA negotiations, especially for agreements with the
EU. Export growth in many LDCs and othersmall and low-income countries is limited by
the lack of supply capacity and the high-costbusiness environment. Firms in these countries
may also find it difficult to deal with the regulatory requirements that apply in export
markets. Health and safety standards, for example, are often regulatory barriers to entry;
the standards can be excessively strict and thecompliance costly, which weighs disproportionately on producers in low-income countries. Development assistance can help to build

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the institutional and trade capacity needed tobenefit from increased trade and better accessto markets. This assistance will be more effective when it is focused more broadly on supply
capacity, and when it addresses the adjustment
costs associated with reforms. Recently attention has been given to expanding programs
that provide aid for trade, but only when tradeissues are integrated into a nation’s overall development priorities. Although priorities will
differ, in many cases assistance will be neededto address trade-related policy and public investment priorities. More could be done to replace preferential access as the primary carrot
for RTAs with financial transfers. It has
been argued at length (e.g., Hoekman,
Michalopoulos, and Winters 2004), that tradepreferences should not be a permanent featureof the global trading system. Appropriately
designed aid would offer a similar result topreferences and at a lower overall cost.

Challenges for developing countries: A
three-pronged strategy
Developing countries would benefit fromadopting a coherent three-part strategy that
integrates unilateral, multilateral, and regional
initiatives. A number of middle-income countries have enunciated a clear set of priorities
and objectives regarding regional and multilateral efforts, and have the technical and negotiating capacity to pursue them; however,many developing countries show less evidenceof a coherent strategy on how to use RTAs to
maximum advantage.
At the multilateral level, the Doha Agenda
negotiations are the best instrument for mostdeveloping countries to reduce the discrimination they face from the prevailing web of
RTAs. Doha is also critical insofar as it provides the greatest potential new market accessfor the greatest number of the world’s poor. It
is also the only venue in which key policy
areas such as agricultural support policies orantidumping can be negotiated in a comprehensive and substantive manner. As with thehigh-income countries, completing the Dohadeal is the highest priority.

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Unilateral reforms can increase the benefitsof RTAs. Governments should generally lower
external (MFN) barriers to trade in conjunction with the reduction of trade barriers
against partners and build this commitment
into the agreements signed. This not only reduces the scope for detrimental trade diversion, it also helps to support multilateralism
and increase global welfare. Such commitments can be made in the context of the ongoing Doha Round, with the advantage of potentially generating additional quid pro quo
reductions by other WTO members. Thatsaid, strategies that deliberately delay tradeliberalization and domestic reforms in order
to conserve bargaining chips for either RTA or
Doha Agenda negotiations are misguided.
Most developing countries have only limited
leverage within any such negotiations, and thecosts of delayed reforms outweigh any transitory negotiating advantage. The rapid growth
rates realized by countries such as India following trade liberalization and related
reforms in the 1990s illustrate this point.
Pursuing bilateral or plurilateral NorthSouth RTA arrangements at the regional level
may yield short-term market access benefits toparticipating developing countries. But countries should be aware that preferential access islikely to be eroded as more countries sign suchdeals, reducing the value preferences, if not theaccess. Moreover, the impact of commitments
on nontrade regulatory policies must be taken
into account. As noted above, it is importantto get the rules right. For RTAs to be beneficial
in the longer term, there needs to be mechanisms through which governments and stakeholders are assisted in implementing a set ofreforms that will help sustain growth andreduce poverty. The establishment of these national mechanisms is an important precondition for benefiting from the RTA game.
South-South RTAs, especially regional
agreements among neighboring countries, cangenerate substantial benefits to participants in
non-trade policy areas such as border crossings, infrastructure, standards and regulatory
frameworks, and related enforcement institu-

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tions. Emphasis should be directed toward enhancing cooperation in areas where there is astrong public goods dimension—collaboration
here can yield large gains. Such cooperation
can have positive spillovers on the multilateralprocess by helping to identify what type ofmultilateral rules might be beneficial.
Only by adopting a three-part integrated
strategy built around unilateral, multilateral,and regional components can developing
countries ensure that their trade policy willcontribute the most to growth and poverty reduction. To be fully effective, each trade policy lever must be used to its best purpose, andcoherent trade policy and associated technicalassistance resources have to be integrated intoa national development strategy. In the case of
low-income countries, the Poverty Reduction
Strategy Paper (PRSP) is an example of such as
instrument. Governments and stakeholders
have an interest in building such a three-partstrategy into their development strategies. In
this way, open regionalism can help countries
improve their standards of living.

Notes
1. For a summary of earlier World Bank researchon the linkage and compatibility of regionalism andmultilateralism, see World Bank (2000) or Schiff andWinters (2003).
2. The results reported herein refer to so-called“static” gains, that is, it is assumed that trade reform
has no impact on productivity. Thus the gains aremainly associated with the efficiency gains from removing the trade (and perhaps other) distortions.
3. This grouping is referred to as the Quad-plus, orQuad, because of the inclusion of Australia and New
Zealand.
4. Note that under the bilateral agreements, domestic distortions are not removed because they are
not specific to any individual trading partner.
5. Note that some of the high-income Asian
countries—for example, the Republic of Korea andSingapore—are excluded from the bilateral agreements
and therefore tend to lose, in part, because of trade
diversion effects.
6. The excluded countries/regions are Brazil,
China, India, Mexico, Russia, rest of East Asia, andrest of South Asia.

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7. The three North-South agreements include a
broad East Asian region that encompasses both thehigh-income and developing countries, the FTAA in theWestern Hemisphere, and a broad free trade area centered on the EU, including the new accession countries,
extending to the Middle East and North Africa and SubSaharan Africa. The South-South agreements include a
Latin American-wide RTA (LAFTA), a developing East
Asia RTA (AFTA), a Europe and Central Asia RTA
excluding the EU-accession countries (CIS), a SubSaharan African RTA (SSA), the Middle East and North
Africa (MNA), and a South Asian RTA (SAFTA).
8. In a result not shown in these figures, South Asia
is not included in any of the three broad North-Southagreements, but is simulated to create its own RTA. In
isolation, the gains from SAFTA, the South Asian regional trade agreement, yields a positive gain of some
0.2 percent of baseline income, as shown in figure 6.3.
However, SAFTA’s exclusion from the 3-block NorthSouth agreements induces a loss of 0.3 percent of baseline income, largely due to trade diversion and a loss inthe terms of trade.
9. The simulated South/South agreements reflect
free trade among geographic neighbors where the differences in comparative advantage are slight. Reductions in South/South trade barriers across more distantcountries have significantly more potential for increasing trade and incomes.
10. Concerns about the impact of discrimination
on multilateralism in trade has a long history, e.g.,
Patterson (1965). There is voluminous literature on
this issue, much of it conceptual. Interested readers arereferred to Bhagwati (1991), De Melo, Panagariya andRodrik (1993), Winters (2000, 2001), and Schiff andWinters (2003).
11. Much of the early theoretical literature that analyzed the incentive effects of RTAs for multilateralism
assumed, for simplicity, that the latter implied free
trade—see Levy (1997), and Krishna (1998). [Winters(2000) provides a thorough review of the theory.] As aresult, the focus was on a binary choice between multilateral free trade and no MFN liberalization. However, in practice countries can choose to conclude amultilateral round with considerable liberalization orwith very little. Thus an empirical perspective that focuses on whether RTAs change the probability of concluding a trade round is too narrow. Moreover, it is virtually impossible to test this in a systematic way
because one never observes simultaneously a country
with and without RTAs. Therefore an empirical assessment of the stumbling block hypothesis must use
Bhagwati’s definition and investigate if RTAs lead toless multilateral liberalization.
12. Testimony before the House Committee onWays and Means, May 8, 2001; accessed June 2003 on

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http://waysandmeans.house.gov/legacy/trade/
107cong/5-8-01/5-8chri.htm; U.S. tariff schedule 1994
and 2003. See Limão (2003).
13. These are described in chapter 2.
14. A practical problem faced by the drafters of
Article XXIV was that in the case of a customs union,changes in the external tariffs of member countries
would occur as they adopt a common external tariff.
The rule that applies to customs unions is that duties
and other barriers to imports from outside the union
may not be, on the whole, higher or more restrictive
than those preceding the establishment of the customs
union (Article XXIV:5a). The interpretation of thisphrase became a source of much disagreement among
GATT contracting parties. However, except for customs unions, (in which a common tariff structure
would be adopted), the rule for RTAs was unambiguous. Duties applied by each individual member country
may not be raised (Hoekman and Kostecki 2001).
15. The RTA was argued to lead to “trade diversion by raising barriers to third countries’ exports ofintermediate manufactured products and raw materials. This resulted from unnecessarily high requirementsfor value originating within the area. In certain cases ...
the rules disqualify goods with value originating within
the area as high as 96 percent. The rules of origin limited non-originating components to just five percent of
the value of a finished product of the same tariff heading [for] nearly one-fifth of all industrial tariff headings” (GATT, 1974:152-53, cited in Hoekman andKostecki 2001).
16. The WTO Agreement on Rules of Origin aims
to foster the harmonization of the (nonpreferential) rules
used by members. The objective is that common rules beapplied equally to all nonpreferential trade policy instruments by WTO members—tariffs, import licensing, antidumping, and so forth. The agreement calls for a work
program to be undertaken by a Technical Committee, in
conjunction with the WCO, to develop a classification
system regarding the changes in tariff subheadings(CTH), based on the Harmonized System (HS); thiswould constitute a substantial transformation. In cases
where the HS nomenclature does not allow substantial
transformation to be determined by a CTH test, theTechnical Committee is to provide guidance regarding
the use of supplementary tests such as value-added criteria. Although the harmonization program was to becompleted by July 1998, deadlines have also been
missed, in part, reflecting lack of consensus among members over the formulations to be adopted for sensitive
products, especially agriculture, textiles, and clothing.
17. As the implied move to full global free trade isunlikely to be politically feasible, the implication
would be to impose a ban on most if not all RTAs—
also unlikely to be acceptable.

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18. Clearly there would be budgetary implications
associated with a stronger surveillance role, and aprecondition is that WTO members accept that the
Secretariat be given the independence to undertake theanalysis and form an explicit judgment of the effects ofspecific agreements. However, if the required resources
or willingness for the WTO to undertake the task cannot be found, this in itself would be a good indicationof the importance that is accorded by WTO members
to the spread of RTAs.
19. See Hoekman (1998) for a discussion.

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151

The World BankGLOBALECONOMIC PROSPECTS
Global Economic Prospects 2005
Trade, Regionalism, and Development
As an important annual publication from the World Bank, Global
Economic Prospects presents the Bank’s view of the global economy
and analyzes prospects for poverty reduction around the world.
This year’s 15th edition examines the proliferation of regional
trade agreements that has fundamentally altered the world
trade landscape.
While the multilateral WTO talks remain mired in contentious debate,
new bilateral and regional preferential trading arrangements are mushrooming all over the
globe. Will these agreements promote or stifle development? Global Economic Prospects 2005 addresses
this and other questions, such as:• What type of regional and bilateral arrangements are most beneficial?
• Do these agreements inspire deeper integration that multilateral trade agreements cannot?
• Do they contribute to—or detract from—incentives for countries to engage in the multilateral Doha
trade talks?

New! Global Outlook online
Your source for:• Macroeconomic indicators and forecast data, from 1980
to 2006• Insightful interactive calculators and simulation tools• One-page PDF briefs summarizing countries’ externalfinancial position and trade• 16 individual commodity reports and price forecasts• Timely analysis of worldwide economic prospects and risks
Please visit the new interactive Global Outlook website at www.worldbank.org/globaloutlook
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A wave of regional agreements
is sweeping the trade world.
Both North–South bilateralarrangements, such as theUnited States–Chile free trade
agreement, and South–Southplurilateral arrangements, such as
the just-proposed South Asia
Free Trade Area, pose challenges
and opportunities for developing
countries.These agreements
not only influence trading
opportunities for people inmember countries and elsewhere
but also violate the most basic
principle of the multilateral
trading system: nondiscrimination. Global Economic Prospects
2005 takes on two urgent
questions: can these agreements
be designed to promote
development in its broadest
sense, and can they do
so without hurting
countries left out?
—François Bourguignon
Senior Vice President andChief Economist

he proliferation of regional trade agreements is fundamentally
altering the world trade landscape.The number of agreements
in force surpasses 200 and has risen eight-fold in two decades.
Today as much as 40 percent of global trade takes place among countries
that have some form of reciprocal regional trade agreement.

T

Global Economic Prospects 2005:Trade, Regionalism, and Development addresses
two questions:• What are the characteristics of agreements that most promote—or hinder—development for member countries?
• Does the proliferation of agreements pose risks to the multilateral
trading system, and if so, how can these risks be managed?
The report argues that agreements leading to open regionalism—that is,deeper integration of trade as a result of low external tariffs, increased
services competition, and efforts to reduce cross-border and customs delays
costs—are effective as part of a larger trade strategy to promote growth.
Such regional agreements can complement a strategy that, on the one
hand, includes autonomous liberalization to promote productivity gains
and, on the other hand, leverages domestic reforms to enhance market
access.
Although regional agreements can prove beneficial to member countries, they can have adverse effects on excluded countries.The loweringof border barriers around the world is crucial to minimizing these effects.
The completion of the Doha Development Agenda by all countries in
the World Trade Organization will reduce the risk of trade diversion
associated with regional agreements and will decrease the trade lossesof countries excluded from agreements.
Chapter 1 of this study presents the World Bank’s view of the global
economy. It analyzes both short-term dynamics for the global economy
and long-term prospects for reductions in poverty around the world.
Chapter 2 introduces the issues associated with regional trade agreements
and provides an overview of regional trading trends. Subsequent chapters
examine the effects of regional agreements on trade creation (chapter 3);
trade facilitation (chapter 4); and services, investment, intellectual property
rights, and labor mobility (chapter 5). Chapter 6 analyzes ways that regional
agreements can be made more compatible with a nondiscriminatory
multilateral system.
For additional information and to access the Global Outlook online
publication, please visit www.worldbank.org/prospects.

ISBN 0-8213-5747-6