There has been a proliferation of regional trade agreements around the world since the early 1990s. In a survey of the latest theoretical and empirical research on regionalism, Caroline Freund and Emanuel Ornelas ask whether we should celebrate or be concerned about this trend.regional trade, trade negotiations, regionalism

Caroline Freund

Emanuel Ornelas

English

Research Papers in Economics

I
n December 2009, a Ministerial
meeting was concluded at the
World Trade Organisation (WTO).
The headlines typically read
something like ‘Ministers reaffirm
the need and their desire to conclude the
Doha Round by the end of next year’. For
many observers, this was a case of déjà
vu: since the current round of multilateral
trade negotiations began in 2001, there
have been numerous promises that it
would be concluded in the ‘near term’
and time and again, those expectations
have been frustrated.
The main concern with the seemingly
endless delay in achieving a new
agreement is that such a failure could
lead to a protectionist backlash. Like
riding a bike, the argument goes, if you
don’t move forward, you fall over.
Fears of a retreat to protectionism
became particularly intense after the
onset of the financial crisis – if the road
gets bumpier, then you really have to
push forward to avoid falling. As it turns
out, there has been only a very limited
retreat towards protectionism, even
though the WTO bike has not been
moving forward.
CentrePiece Summer 2010
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There has been a proliferation of regional
trade agreements around the world since the
early 1990s. In a survey of the latest theoretical
and empirical research on regionalism,
Caroline Freund and Emanuel Ornelas ask
whether we should celebrate or be concerned
about this trend.
Regionalism has become
and will probably remain
the preferred form of
reciprocal liberalisation
for most countries
Regional trade 
agreements:
blessing or burden?Still, even if the lack of progress in
multilateral talks does not imply a retreat,
many observers remain worried. After all,
if there are gains to be shared with
further liberalisation, we should make
sure we don’t waste the opportunity.
While this view is correct, it must be
noted that lack of progress in the
multilateral arena does not imply that the
world is not becoming more integrated. In
fact, governments across the globe are as
active as ever in negotiating new trade
agreements. The difference is that the
agreements are not multilateral but
‘regional’.
In 2009, for example, 25 new regional
trade agreements (RTAs) were notified to
the WTO. The agreements include
developed as well as developing
countries, and involve countries from
most parts of the world. In fact, they are
not always regional, increasingly
encompassing members from different
continents.
The new agreements bring the total
number of RTAs in force to nearly 300. In
the same period, the WTO also received
notification of 14 other RTAs that are
currently being negotiated or about to
enter into force. The WTO estimates that
there are around 100 other agreements
currently at this stage (WTO, 2009).
Should we celebrate the expansion of
RTAs, or should we be concerned with
this trend, which seems to be only
accelerating since it took off in the early
1990s? In a survey of the theoretical and
empirical literature on regionalism, we
conclude that although countries should
approach regionalism with care, to date
RTAs have been more of a blessing than a
burden for the multilateral trading system.
Assessing the impact 
of RTAs
To understand the impact of RTAs, it is
important first to recognise that they are
intrinsically different from both
multilateral liberalisation (under the aegis
of the WTO) and unilateral liberalisation.
In both of those cases, countries lower
trade barriers on all sources of imports of
a good by exactly the same extent.
In contrast, under an RTA, tariffs fall
on imports from the other members of
the agreement, but they need not change
on imports from non-members. As a
result, RTAs imply both trade liberalisation
and trade discrimination. Whereas there is
a near-consensus among economists that
the former is desirable, that is not true for
the latter.
Trade liberalisation within a trading
bloc tends to be beneficial when it
promotes a shift of resources from
inefficient domestic suppliers to more
efficient producers within the region.
Economists call this phenomenon 
‘trade creation’.
Conversely, a trading bloc is likely to
be harmful if it generates a shift of
resources from efficient external
producers to inefficient producers within
the region. This is a consequence of trade
discrimination, which economists call
‘trade diversion’.
In principle, either trade creation or
trade diversion can prevail within an RTA.
There are theoretical arguments that
support the primacy of each effect under
similar circumstances. Thus, in the 
end, which effect dominates is an
empirical matter.
Unfortunately, estimating trade
creation and trade diversion is no easy
task. It requires knowledge of the
counterfactual: what would have
happened to trade if there were no trade
agreement? As this is unknown,
assumptions must be made.
A variety of approaches have been
employed. While results inevitably vary
depending on the methodology employed
(as well as the time period, the trading
bloc in question and the level of
aggregation in the data), at least two
general messages arise from the large set
of studies investigating trade creation and
trade diversion in RTAs around the world:
  First, trade creation tends to be the
norm in RTAs – and trade diversion is the
exception.
  Second, when trade diversion is
observed, its magnitudes are normally
relatively small.
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To date,
regionalism has
been more a
blessing than a
burden for the
multilateral
trading systemCentrePiece Summer 2010
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benefit (and support the agreement)
because of the better access to foreign
markets, whereas purely domestic firms
suffer from the tougher competition from
the RTA partners.
But this also weakens the domestic
firms’ stance on protection against non-
members. The reason is that the free
access to the domestic market enjoyed by
the partners’ exporters under the RTA
lowers the market share of the domestic
industry. As a result, the RTA makes any
price increase generated by a higher tariff
less valuable for the domestic industry:
now whenever the government attempts
to help domestic producers through higher
external tariffs, the partners’ producers
absorb part of that surplus.
In other words, the RTA creates
‘leakage’ in the trade policy redistributive
channel. External protection also becomes
more costly, because of the trade diversion
that accompanies the RTA. As a result,
external tariffs tend to fall after the
formation of an RTA both because the
economic marginal cost of external
protection rises and because the political-
economy marginal gain from external
protection falls.
For developing countries, empirical
research supports this rationale because
trade preferences tend to lead to lower
external tariffs. Results for the United
States and the European Union (EU),
however, indicate that they are less likely
to reduce external tariffs on goods where
preferences are offered (see Limao, 2006).
But since the tariffs of both the United
States and the EU are very low to start
with, and cannot be raised because of
their WTO commitments, there is not
much room for change anyway.
Are RTAs welcome?
The benign view that trade creation
dominates trade diversion does not imply
that RTAs are necessarily welcome. In fact,
some commentators argue that the
multilateral negotiations at the WTO are
stuck because RTAs are spreading. Their
basic argument suggests that
governments’ resources are scarce, so if
officials are busy negotiating bilateral
Trade creation versus 
trade diversion
Why is there such a dominance of trade
creation over trade diversion? The answer
is in two parts. First, governments seem to
be choosing their RTA partners well. For
example, variables that suggest greater
gains from a bilateral RTA (such as
proximity between the members, a
similarity in their GDPs and a large
difference in their factor endowments) are
also sharp predictors of whether the two
countries actually have a common RTA
(Baier and Bergstrand, 2004).
Second, when countries form an RTA,
their governments not only lower tariffs
vis-à-vis their RTA partners, as they are
supposed to do; they also bring down the
trade barriers on imports from countries
outside the bloc. This is not part of the
agreement, so governments liberalise
externally because they choose to do so –
and without any type of reciprocity from
the favoured non-members of the bloc.
There is increasing evidence of
external trade liberalisation following an
RTA, especially in developing countries.
(See, for example, Estevadeordal et al,
2008, for an analysis of how Latin
American countries changed their import
tariffs on non-members after forming or
expanding their trade ties during the
1990s.) The lower external tariffs 
provide a double blessing: they imply that
RTAs are responsible for more trade
liberalisation than they mandate
(amplifying trade creation) and for less
trade discrimination than might be
expected (limiting trade diversion).
At first, it may seem odd that
governments, pressured by special
interests as they are virtually everywhere,
would voluntarily lower their external
tariffs without any compensation 
from the favoured countries. But it does
make sense.
Suppose that domestic special interest
groups pressure the government and
induce it to set relatively high tariffs,
which allow the domestic industry to
maintain high prices and enjoy a large
market share. If subsequently the country
enters into a RTA, export-oriented firms
Regional trade
agreements
generally seem
to amplify trade
creation and
limit trade
diversionCentrePiece Summer 2010
19
agreements, they will be unable to focus
on more evolving multilateral negotiations.
Others put forward more elaborate
arguments. For example, it is possible that
RTAs may create rents to some groups.
Once well entrenched, these groups may
be able to block further liberalisation
initiatives that would destroy such rents.
On the other hand, there are
arguments indicating that the opposite
may be true. A simple one is that
negotiating RTAs helps officials to develop
the expertise and the frameworks to
implement international trade agreements,
and these could be useful at subsequent
WTO negotiations. Moreover, RTAs also
destroy rents in parts of
the economy. If the rent-
holders who lose with RTAs were the
ones slowing down multilateral talks,
then RTAs can actually provide a boost to
such negotiations.
These and related arguments
constitute an intellectually engaging
debate, but which of them dominate?
When faced with opposing theoretical
results, the solution is typically to scrutinise
the divergent predictions empirically. The
problem here is that the nature of the
question – whether regionalism helps or
hinders multilateralism – does not lend
itself easily to testing.
Simply put, at any point in time we
observe a single realisation of WTO
negotiations. Would they have been any
faster, or easier, had there been fewer (or
more) RTAs? This is a very difficult
question. Consequently, to date empirical
scrutiny has not been able to help us
distinguish good (that is, empirically
relevant) from bad (empirically
inconsequential) theories.
Hence, to the extent that we can
measure, the increasing wave of
regionalism has been largely beneficial to
the world trading system. Most empirical
analyses indicate that trade creation, not
trade diversion, is the norm, both because
governments choose well when forming
RTAs and because they adjust other 
trade policies to moderate the distortions
from discrimination.
Although it is possible that regionalism
could endanger multilateralism, 
at the moment we just do not know.
Since regionalism has become and will
probably remain the preferred form of
reciprocal liberalisation for most countries,
no matter what we economists say,
henceforth we should focus on ways to
integrate regionalism with multilateralism
more effectively.
This article summarises ‘Regional Trade
Agreements’ by Caroline Freund and
Emanuel Ornelas, CEP Discussion Paper 
No. 961 (http://cep.lse.ac.uk/pubs/download/
dp0961.pdf) and forthcoming in the 
Annual Review of Economics 2: 139-67
(September 2010).
Caroline Freund is at the World Bank.
Emanuel Ornelas is a reader in LSE’s
management department and a research
associate in CEP’s globalisation programme.
Further reading
Scott Baier and Jeffrey Bergstrand
(2004) ‘Economic Determinants of Free
Trade Agreements’, Journal of
International Economics 64: 29-63.
Antoni Estevadeordal, Caroline Freund and
Emanuel Ornelas (2008) ‘Does Regionalism
Affect Trade Liberalization towards 
Non-members?’, Quarterly Journal of
Economics 123: 1531-75.
Nuno Limao (2006) ‘Preferential Trade
Agreements as Stumbling Blocks for
Multilateral Trade Liberalization: Evidence
for the US’, American Economic Review 96:
896-914.
WTO,World Trade Organisation (2009)
‘Overview of Developments in the
International Trading Environment,’
document WT/TPR/OV/12
(http://www.wto.org/english/news_e/
news09_e/wt_tpr_ov_12_a_e.doc).
With regionalism here to
stay, economists should
focus on ways of
integrating it more
effectively with
multilateralism

Regional trade agreements: blessing or burden?

http://cep.lse.ac.uk/pubs/download/cp313.pdf

Regional trade agreements: blessing or burden?

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