Should Canada unilaterally adopt global free trade?

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1 Should Canada unilaterally adopt global free trade?

2 Table of Contents About the Authors...3 About the Paper...3 Executive Summary...4 Regional trade agreements are not the only option...4 The benefits of unilateral tariff elimination...5 Introduction...7 Background The Gains from Trade Revisited Trade Policy in a Made in the World Production Paradigm: The Rise of Unilateralism The Pros and Cons of FTAs The Cost of Rules of Origin and the Opportunity Cost of Unilateral Free Trade.. 22 Empirical Strategy The Level of Protection Taking into account non-utilization of preferences The Welfare Cost of ROOs Compliance Alternative Closures Results Conclusions Canada s gains from unilateral liberalization The opportunity costs of unilateral liberalization are limited Unilateral liberalization requires active political management The bottom line References

3 About the Authors Dan Ciuriak is Director and Principal, Ciuriak Consulting Inc. and Research Fellow at the C.D. Howe Institute. He specializes in international trade, finance and development. He has wide-ranging experience in the analysis and formulation of public policy, development of legislation, economic analysis in support of litigation (both private and state-to-state), and training and technical assistance in applied trade analysis and modeling. Previously, he was Deputy Chief Economist at the Department of Foreign Affairs and International Trade (DFAIT) with responsibility for economic analysis in support of trade negotiations and trade litigation. Prior to this, he served as Deputy to the Chair of the APEC Economic Committee and as Finance Counsellor at Canada's Embassy in Germany. Mr. Ciuriak holds a Masters in Economics from McMaster University. Jingliang Xiao is a Research Associate with Ciuriak Consulting Inc. He holds a Ph.D. in Economics from the Centre of Policy Studies, Monash University, Australia. His Doctoral Thesis: A Dynamic Financial CGE Model of the Chinese Economy was developed under the supervision of Peter Dixon, a leading expert in the field. He also holds the designation of Chartered Financial Analyst (CFA). His research interests include international trade and financial CGE modeling. About the Paper This paper was commissioned for the Canadian Council of Chief Executives (CCCE) as part of an effort to articulate a vision for the future of Canada s trade agenda. The Canadian Council of Chief Executives brings CEOs together to shape public policy in the interests of a stronger Canada and a better world. Member CEOs and entrepreneurs represent all sectors of the Canadian economy. The companies they lead collectively administer C$4.5 trillion in assets, have annual revenues in excess of C$850 billion, and are responsible for the vast majority of Canada s exports, investment, research and development, and training. The opinions in this paper are those of the authors and do not necessarily reflect the views of the CCCE or its members. To be added to our mailing list or for additional information please contact 3

4 Executive Summary In recent years, the action in trade negotiations has shifted to various forms of bilateral and regional free trade agreements (FTAs). Since 2006, Canada, for example, has concluded trade agreements with nine individual states as well as agreements in principle with the European Union and South Korea. By definition, these agreements create new market access opportunities, but they can be costly and cumbersome for businesses to use. To take advantage of preferential tariffs, firms must demonstrate compliance with the rules of origin set out in each agreement. To comply with restrictive rules of origin, they must also sometimes bear the cost of sourcing inputs from higher-cost preferential zone suppliers. As a consequence, the utilization rates of bilateral and regional FTAs are often low and the incremental volumes of trade generated by such agreements can be substantially below the levels anticipated based on full utilization of preferences. The administrative costs to firms of accessing preferential tariffs not to mention the costs to border agencies of administering those tariffs should be taken into account when evaluating the economic gains from trade agreements, yet such costs are generally ignored in impact assessments. Given these considerations but also recognizing that Canada cannot stand still while its competitors negotiate preferential deals of their own the question must be asked: Is there an alternative? Regional trade agreements are not the only option It has long been recognized that a tariff on imports is equivalent to a tax on exports (Lerner, 1936). To put it another way, tariffs distort domestic prices and raise the cost of production inputs, which in turn makes it more expensive for companies to produce goods for export. Conversely, the reduction or elimination of tariffs on production inputs as Canada did in Budget 2010 can make exports more competitive. Accordingly, a country can in 4

5 principle improve its competitiveness and export prospects by using a lever that is fully within its own control that of relaxing its own import restrictions. The Australian Productivity Commission, in a major review of Australia s bilateral and regional trade agreements, emphasized the comparatively greater scope for unilateral policy reforms. It also noted the potentially counterproductive effects of delaying such reforms to preserve negotiating coin the ability to trade off tariff reductions in the context of a specific set of trade negotiations. According to the World Economic Forum s Global Competitiveness Report , Canada ranks 14th overall among countries with low trade-weighted average tariff rates. States with more liberal tariff regimes include Singapore, Finland, Germany, the United States, Sweden, Hong Kong, the Netherlands and the United Kingdom. This hints at the positive competitive effects of tariff elimination. The concept of unilateral free trade unilaterally dismantling all barriers to trade without seeking reciprocal action on the part of foreign governments is not new. Hong Kong has long functioned as a free port. Singapore s tariff is effectively zero across the board. These two city-states are ranked best in the world by the World Bank at facilitating trade and both perform exceedingly well in global economic rankings. China s Premier Li Keqiang has endorsed Shanghai s ambition to become a tariff-free zone and hence strengthen its position as one of the world s pre-eminent supply chain hubs. The benefits of unilateral tariff elimination Using a general equilibrium model, this paper explores the potential benefits of unilateral free trade for Canada. On the one hand, eliminating all tariffs would cost the federal government roughly $4 billion a year in revenue. Offsetting that, there would be some savings for government on the $75 million currently budgeted for collection of border taxes and the management of free trade agreements. More importantly, this paper projects output gains on the order of one per cent of Gross Domestic Product (GDP) approximately $20 billion a year based on the level of GDP in 2013 in additional economic activity due to the cost savings to firms engaged in trade. 5

6 As shown in the table below, such benefits exceed those from mutual tariff elimination under any of the major preferential trade agreements that Canada has been pursuing. Accordingly, unilateral liberalization deserves serious consideration. In comparing estimated gains from unilateral liberalization and preferential liberalization through trade agreements, it is worth noting that not only do the gains from the unilateral route come without the distortions associated with FTAs, they are certain to be realized since the question of utilization of preferences would not enter into the equation. Estimated GDP Gains for Canada: Unilateral Liberalization and Selected FTAs, percent Agreement Study % of GDP Unilateral Liberalization Present study (preferred scenario) 1.05% Unilateral Liberalization Present study (smallest impact with ROOs effects) 0.26% Trans-Pacific Partnership (TPP12) Petri, Plummer and Zhai (2013) 0.40% CETA Canada EU Joint Study (goods) 0.27% CETA Canada-EU Joint Study (all measures) 0.77% Canada-Korea FTA Ciuriak and Chen (2008) goods (preferred scenario) 0.11% Canada-India FTA Canada-India Joint Study (Canadian estimate) 0.41% Canada-India FTA Canada-India Joint Study (Indian estimate) 1.02% Sources: as given in the table. As the simulations in the study serve to illustrate, the effects of tariff elimination in narrow but highly protected sectors cascade through the economy, driving structural adjustment not only in these sectors but also in sectors where industrial input tariffs have already been eliminated. The simulations suggest that Canada s selective approach to trade liberalization is holding Canada back and reducing our economy s long-term growth potential. Unilateral tariff elimination would propel us forward toward a more productive and technologically advanced industrial base, raising Canada s attractiveness as an investment destination and the overall standard of living. 6

7 Introduction In recent years, the action in trade negotiations has moved decisively to the bilateral/regional sphere. In part, this reflected the repeated failures to conclude the Doha Round of WTO negotiations, which until the December 2013 breakthrough on trade facilitation seemed hopelessly stalled. In part, it also reflected the fact that preferential free trade agreements (FTAs) have their own attraction they allow likeminded states to go further and faster in addressing trade issues than can be achieved multilaterally. However, while FTAs expand trade and generate associated efficiency and economic welfare gains, the FTA route is not without its compromises and complications. As former US Trade Representative Susan Schwab remarked: [bilateral/regional agreements] are of uneven quality. Some eliminate virtually all barriers between signatory countries, while others exclude whole swaths of commerce. Yet they all exclude, and therefore discriminate against, the vast majority of other trading nations, including most developing countries. And they skew commerce and global supply chains through complex rules that dictate how much of a product must be made in a given location to qualify for duty-free treatment. 1 The term spaghetti bowl was coined by Jagdish Bhagwati as early as 1995 to capture the distortions introduced by proliferating discriminatory trade arrangements. Because FTAs have not been integrated as they have proliferated, there is a lot more spaghetti in the bowl today. 2 FTAs are also costly to use for businesses. There are fixed costs of accessing trade preferences the administrative costs of demonstrating compliance with rules of 1 Schwab (2011). 2 Bhagwati (1995). The rapid growth in East Asia of FTAs in recent decades has prompted the coining of the corresponding term, noodle bowl, to describe the complex trade rules setting that has emerged in the Asia Pacific (see, e.g., Kawai and Wignaraja, 2010). Abreu (2013; 9) provides a detailed up-to-date review of the state of play and trends. She observes that preferential rules of origin are increasingly becoming an economic, political and trade instrument. Within that context, there seems to be a tendency to design stricter rules of origin that are complemented with various flexibilities, implemented differentially: either temporary or permanent; regime-wide, sector- or product-specific; and towards all or selected RTA partners e.g. for LDCs. In short, the maze is growing more, not less, complex. 7

8 origin (ROOs). There are also variable costs the penalty that firms pay by sourcing from higher-cost preferential zone suppliers to comply with restrictive ROOs. Because of these costs, utilization rates of preferences are often low and the extent of trade engendered by FTAs is often substantially below levels predicted on the assumption of full utilization. Moreover, the administrative cost of accessing the regime by firms and of administering the regime by border agencies should be recognized in evaluating the gains from trade generated by FTAs; however, these costs are generally ignored in impact assessments. 3 FTAs are also are hard to get especially for a middle-ranked economic power like Canada which tends not to be on other countries A list for negotiations. The recently announced agreement between Canada and the European Union took over half a decade to progress from joint study to reaching an agreement in principle; the Canada- Korea negotiation took nine years to complete. And of course, being a middle power, Canada has weaker bargaining power in a bilateral context. Yet, recognizing that a country cannot stand still while its competitors are seeking to undercut its global market position by carving out preferential deals of their own, the question must be asked: Is there an alternative? FTAs are not the only alternative to WTO agreements to improve a country s competitive position in the global economy. Unilateral liberalization is another option. It has long been recognized that a tariff on imports is equivalent to a tax on exports (Lerner, 1936). For example, the removal of a tax on imports boosts imports. This leads to production cost reductions that make exports more competitive. The competitive pressure of new import entry into the domestic market is another channel through which domestic competitiveness is increased. The expansion of two-way trade results in more domestically-oriented companies participating in international trade both as exporters and as importers of intermediate goods and services which boosts their productivity through knowledge gained from interaction with foreign clients and suppliers. In the longer run, exchange rate adjustments also work to restore trade 3 Note that conventional trade modelling of FTAs quantifies trade diversion and thus takes into account the variable costs of FTAs. 8

9 equilibrium. In short, liberalizing imports works through various channels to expand exports. According to the World Economic Forum s Global Competitiveness Report , Canada is a highly open economy but still ranks 14th overall behind a number of countries. For example, Singapore, Finland, Germany, the United States, Sweden, Hong Kong, the Netherlands, and the United Kingdom all have a lower trade-weighted average tariff rate than Canada and all are highly competitive. This hints at the positive competitive effects of lower trade protection. Further, while a major selling point of FTAs is that they enable forward movement on services and investment and other new issues, the reality is that old-fashioned trade in goods still accounts for an outsized share of Canada s international earnings and payments (Table 1). Table 1: Share of Canada s International Receipts and Payments by Source, 2012 Receipts Share of Share of Payments Share of Share Total Commercial Total Commercial Goods 462, % 82.2% 474, % 82.0% Commercial Services 51, % 9.2% 48, % 8.3% Earnings on FDI 45, % 8.1% 45, % 7.8% Royalties and Licenses 2, % 0.5% 10, % 1.8% Total Commercial 562, % 100.0% 578, % 100.0% Other Receipts/Payments 66, ,837 Total Receipts/Payments 629, % 691, % Source: Statistics Canada, Balance of Payments Statistics; note that the estimate for royalties and license receipts is for 2011 and sourced from the IMF, converted to Canadian dollars at the 2011 Bank of Canada annual average exchange rate. of As can be seen, commercial services, earnings on direct investment and intellectual property charges account for only about 15-16% of the overall total receipts or payments, or about 18% of total commercial trade (i.e., excluding international transportation payments and tourism). Moreover, liberalization of goods trade leverages trade in embedded business services and technology. 4 Liberalization of goods trade thus remains a key element of any trade policy. 4 On the share of business services embodied in goods exports, see, e.g., Koopman et al. (2011); Table 5. Note that receipts on international transactions include, in the case of goods and services 9

10 Accordingly, a country can in principle improve its competitiveness and export prospects by using a lever that is fully within its own control reducing its own import restrictions. The Australian Productivity Commission, in its major review of Australia s bilateral and regional trade agreements, emphasized the comparatively greater scope for unilateral policy reforms and the potentially counterproductive effects of delaying such reforms to preserve negotiating coin for negotiated agreements. The Productivity Commission concluded that such coin was of limited value for an economy in Australia s position 5 which is not unlike Canada s position. There are some examples of countries that have adopted unilateral free trade. Hong Kong has long functioned as a free port. Singapore s tariff is effectively zero across the board. These two city-states sit close to the top of the rankings in the World Bank s Doing Business survey in the Trading Across Borders comparisons and both perform exceedingly well in global economic rankings. Notably, China s Prime Minister Li Keqiang is championing an idea to establish an extensive free trade zone in Shanghai to make this mega city the world s leading supply chain hub. 6 Meanwhile, Gordon Crovitz, the Wall Street Journal s Information Age columnist, has observed that The global information and technology industries in particular have thrived in nearly Hong Kong-like conditions. 7 Of course, what is feasible for cities or city states or for particular industries may be more problematic for larger, diversified economies. Is unilateral free trade an option that can realistically be considered by a large continental economy such as Canada, either as an alternative or complement to engagement in FTAs to improve its global competitive position? exports, the value of imported inputs; subtracting the import content of exports would modify the shares of net earnings reported in Table 1. 5 Productivity Commission (2010); see in particular the discussion at The Commission also noted that unilateral liberalization did not involve binding the tariffs at the new lower levels; this retained negotiating leverage. On both accounts limited benefits in terms of leverage and limited costs from unilateral liberalization the issue of negotiating coin amounts to small potatoes. 6 The Economist Free-trade zone for Shanghai: Mr Li's big idea, 13 June The Shanghai free trade zone will initially be limited to a circumscribed area in Shanghai s Pudong New Area but may eventually be increased to cover the entire Pudong district. Other Chinese industrial hubs are lobbying for similar treatment. 7 See Gordon Crovitz, A Better Way to Free Trade, Wall Street Journal, 18 August

11 We explore this question in this paper, paying particular attention to the context in which the global economy operates today, in which products are made in the world in global value chains. Section 2 considers the role of trade policy in the current global economic context, summarizes the well-rehearsed arguments concerning the utility of FTAs in achieving trade policy aims, and considers the cost of rules of origin and the opportunity costs of unilateral liberalization. Section 3 sets out an empirical strategy to evaluate the gains for Canada from unilateral liberalization. Section 4 sets out the results. Section 5 provides a discussion and draws policy conclusions. Background This section summarizes research to provide evidentiary support for the following claims that underpin the cost-benefit analysis in this paper of unilateral liberalization: That the gains from trade for Canada are very significant and that, even at Canada s advanced stage of trade liberalization, the remaining unrealized gains are important. That unilateral trade liberalization is emerging as the trade policy paradigm for a made in the world production paradigm. That preferential trade agreements liberalize trade incompletely because of the costs of accessing preferences. That there are significant welfare costs associated with accessing preferences. That the scale of the fiscal costs for Canada of moving to unilateral free trade can easily be offset in a technical sense. That the opportunity costs to Canada of moving to unilateral free trade are moderate. 11

12 The Gains from Trade Revisited The economist s case for trade is essentially about imports. Short-run considerations and the firm-level dynamics to be discussed below aside, a country would only ship valuable goods and services abroad in exchange for something it considers more valuable this could be gold in a traditional mercantilist perspective, cheaper consumer goods in a modern static economic welfare analysis based on consumer surplus, or advanced technology and production inputs in a dynamic growth framework. Whichever perspective one adopts, the main objective of trade is what is imported; exports are the price a country pays in order to have access to imports. Economic theory points out the advantages to engaging in trade: deepening trade through mutual specialization in areas of comparative advantage allows trading partners to expand their combined production beyond what would be possible without trade. But the point of trade remains the imports, including both goods and services and, in a broader sense, the technology embedded in imports or acquired from abroad through licensing arrangements. Knowledge spillovers that firms obtain in international markets and the pro-competitive effects of imports on domestic markets simply add gravy. The following question then arises: given where Canada presently is in terms of remaining trade constraints and the resulting share of trade in the economy, how significant are the remaining gains from trade? Formally, across a widely used class of theoretical trade models, the gain from trade (that is, the change in real income from trade liberalization) can be evaluated based on the share of imports in total domestic expenditure and the degree of substitutability of imports for domestic production. 8 Arkolakis et al. (2012) show that the real income gains from moving from autarky to an observed level of import penetration under widely used applied trade models can be calculated by the following expression: 1 λ 1/ε, where λ is the share of domestic goods in domestic expenditure and ε is the substitution elasticity which measures the degree of substitutability of imports for domestic production. Based on this equation, the gains from trade are greater: (a) the 8 Note: the trade elasticity has different structural interpretations in the various models. This affects how we understand the gains to arise but not affect the size of the gains in these models. 12

13 higher the share of imports in domestic final expenditure; and (b) the less that domestic production is substitutable for imports. The intuition is straightforward: Canada, which accounts for less than 3% of global GDP, produces only a small share of all the varieties of goods produced in the world, including intermediate production inputs. That being said, if Canadian-produced goods are highly substitutable for foreign products, the gain from switching to the imported variety is small. If, however, Canadian-produced goods are not close substitutes (or if, in the case of intermediate inputs, there are no suitable Canadian products) then the gains from trade become large. Following Arkolakis et al. (2012), we evaluate the gains from trade for Canada. Canada s import share is about three times larger than that of the United States and accordingly its income gains from trade are also about three times larger. Measured using the assumptions in Arkolakis et al, we obtain a range of 2.3% to 4.6% as a share of GDP for Canada, compared to the 0.7% to 1.4% range for the United States reported in the latter study. 9 However, Ossa (2012), in his paper entitled Why Trade Matters After All, applies the same approach but disaggregates imports across sectors and takes into account that some goods and services are non-traded and that in some industries critical inputs must be imported (i.e., there is no domestic supply and as a result the trade elasticity falls to near zero). Using 2000 data, he estimates Canada s welfare gains from trade at about 50%, given the import share of final consumption in that year. As the title of his article states, trade is important after all. 10 Modern trade theory adds an additional wrinkle to the above results. The new consensus trade theory emphasizes firm-level heterogeneity even within the same industry and firm level dynamics in terms of exit and entry and innovation. The 9 Canada s import share is about 21% whereas that of the United States is about 7%; both figures are based on the methodology employed by the OECD. 10 Costinot and Rodriguez-Clare (2013) develop this point further; they provide estimates of the income gains from trade for Canada under various theoretical models; these estimates range from 3.8% in the simple Armington model to as high as 39.8% in a Melitz-type model with imperfect competition. Melitz and Redding (2014) show that, when productivity of firms is increased by trade, the gains from trade expand as the stages of production in a sequential production model increase. 13

14 theory takes into account the existence of fixed costs of engaging in international markets, either to export or to import intermediate goods and services, and demonstrates gains from trade through a number of different channels: the reallocation of market share from less to more productive firms; 11 the dynamic effect flowing from export market entry to product and production process innovation; 12 the productivity gains from access to imported intermediate goods and services; 13 and learning by exporting by firms that enter into international trade, including through the relaxation of firm-level credit constraints as global financial markets learn about new exporters (i.e., entry into exporting signals dynamism and profitability). 14 At the same time, the firm-level trade literature provides new insights into the complex global strategies of multinational firms; 15 the factors that motivate the formation of global value chains (GVCs) such as the servitization of manufacturing, 16 and the emergence of a growing trade in tasks. 17 This theory generates predictions that align well with many observed facts, including inter alia: not all firms export and only, larger, more productive firms tend to enter export markets; there is constant entry and exit from export markets; trade liberalization drives up average productivity in import-competing industries (exit of least productive firms); and countries start to export in new areas following the reduction of trade barriers (i.e., there is an extensive margin response to trade liberalization firms entering into exporting or existing exporters introducing new products into export markets). 11 Melitz (2003), Bernard, Eaton, Jensen and Kortum (2003). 12 Melitz and Trefler (2012). 13 Kasahara and Rodrigue (2008) 14 Silva, Afonso and Africano (2012) provide a good review of the historical background of scholarship on the learning by exporting concept. See Ciuriak (2013) for a recent survey of the now extensive literature on this topic. 15 Antràs and Helpman (2004, 2008), Helpman (2006). 16 Neely et al.(2011). 17 Grossman and Rossi-Hansberg (2008, 2012), Van Assche (2012). 14

15 Importantly, the gains from trade at the extensive margin of trade are additional to the gains evaluated under models that do not take into account firm-level heterogeneity. Felbermayr et al. (2013) find that the failure to account for these gains in an accounting exercise such as conducted by Arkolakis et al. (2012) results in a significant underestimation of the gains, although there is considerable variation in the degree of underestimation by country, and for Canada the underestimation is fairly small (between 0.3% to 0.5% of real income gain under alternative assumptions). 18 To summarize, the absolute size of the gains from trade for Canada are open to debate; however, they are clearly: increasing with the degree of openness of the economy measured in terms of the share of imports; inversely related to the substitutability of Canadian production for foreign production in particular, if foreign products and intermediate production inputs do not have close substitutes in Canada the gains rise steeply; and increasing at the extensive margin through the entry of new products and new firms into trade. For a relatively highly open economy such as Canada, the remaining gains from trade liberalization are likely to be moderate in size when evaluated in terms of additional income gains; however, the gains at the extensive margin remain highly important given the impetus to productivity and innovation at the firm level that is associated with firms entering international markets as exporters or as importers of intermediate inputs. Trade theory today has been grafted onto an underlying theory of industrial dynamics in which firms must continually make technology bets. Successful bets allow firms to continue in business; unsuccessful bets lead to the exit ramp. Firms and products come and go; there is a constant churn. The theory fits available evidence well. 18 While the Arkolakis et al. (2012) evaluation of the gains from trade included the workhorse Melitz model that incorporates firm-level heterogeneity, it did so under restrictive assumptions that eliminated the extensive margin impacts that firm-level models generate. See on this point Felbermayr et al. (2013). In the latter study, the absolute gains from trade for Canada vary from 2.5% to 8.7% depending on the specific assumptions applied in this study (see Felbermayr et al. (2013), tables 2 and 3). 15

16 It is the firms that make the jump from domestic orientation to global orientation that drive productivity growth in an economy and that ultimately generate the exports that pay for imports. The cohort of exporting firms must however be constantly replenished (that is the message of the extensive margin). Policies that constrain the emergence of these firms including those that raise the cost of leading-edge production inputs and those that generate general equilibrium effects that raise the cut-off point for new exporter entry undermine an economy s dynamism. Such policies in Canada s case a tariff legacy from an era that has come and gone are a liability today. Trade Policy in a Made in the World Production Paradigm: The Rise of Unilateralism O Rourke (2000; 841) in his review of British trade policy in its free trade era in the 19 th Century observes that One of the most important functions of economic history is to alert economists to the obvious fact that the correct model may vary over time, whether the issue is the relationship between tariffs and growth, or the determination of the level and structure of protection. Reviewing the evolution of trade policy in a long historical perspective does indeed generate insights into some recent trends in this area. As O Rourke recounts, Britain s free trade policy, which was virtually sacrosanct after 1846, came increasingly under question, particularly after the turn of the century. The British faced rising competition from industrializing Germany and the United States, both of which were using tariff protection to support industrialization. For much of the 20 th Century, trade policy globally was then marked by protectionism as countries sought to industrialize behind tariff walls. In the postwar era, trade liberalization was achieved only through reciprocal agreements, initially on a multilateral basis under the GATT and subsequently under regional agreements. A considerable body of economic literature was developed to explain the phenomenon, with a key idea being that reciprocal negotiations enabled countries to break out of a terms-of-trade-driven Prisoner s Dilemma. Insofar as tariffs force foreign exporters to lower their prices, a country improves its terms of trade through trade protection. However, when all countries engage in this, the result 16

17 is a sub-optimal global production system with all losing. Reciprocal negotiations represented a rational way out of this bind. 19 In the late 20 th Century, however, unilateral trade liberalization emerged again but with a very different dynamic driven not by the world s industrial leader as was the case in nineteenth century Britain, but by developed and developing countries alike. As documented by Martin and Ng (2004), between 1983 and 2003, globally, applied tariffs declined from 29.9% to 9.3%, with autonomous liberalization accounting for 2/3 of the liberalization (compared to about 25% by multilateral cuts and only 10% by FTAs). Poorer countries (such as China and India) made greater unilateral tariff cuts than the richer. 20 As Baldwin (2011) argues, this move was associated with the incipient change in the global production paradigm (in his terms the great unbundling ), evidence for which is that unilateral liberalization was (a) particularly pronounced in parts and components, and (b) associated with outsourcing of labour-intensive production from rich countries to the developing economies. As global integrative trade accelerated in the 1990s, so did unilateral liberalization. Supporting this thesis is the fact that advanced industries that have emerged in the context of the new global production paradigm operate globally under effectively free trade conditions. 21 Canadian trade policy has been generally well attuned to these realities. The move to abolish tariffs on 1,541 industrial inputs in Budget 2010 was undertaken with the express intent to reduce customs compliance costs, allow for simplification of the tariff structure and eliminate the administrative burden of complying with rules of origin and with drawback regulations related to imports under these tariffs. 22 The 19 See Bagwell and Staiger (2011) for a formal exposition of this argument. Another rationale that has been advanced to explain the need for reciprocity is that international treaties enable governments to make credible commitments to their own private sectors; see e.g., Maggi and Rodriguez-Clare (2007). 20 The basic source is a World Bank mimeo by Will Martin and Francis Ng, which has been widely cited in the literature; and Schiff, Hoekman and Goto (2006). See also Langhammer (2011). 21 See, Gordon Crovitz, A Better Way to Free Trade, Wall Street Journal, 18 August Red-Tape Reduction Commission, Making Canada a Tariff-Free Zone for Industrial Manufacturers, (archived); see links to Budget 2010, Annex 5: Tax Measures: Supplementary Information and Notices of Ways and Means Motions, Customs Tariff Measures; and Bill C-9, An Act to implement certain provisions of the budget tabled in Parliament on March 4, 2010 and other measures. 17

18 recognition of the administrative burdens associated with meeting duty drawback regulations is important: even without ROOs, tariffs put administrative hurdles in the way of global systems of production; with ROOs, the hurdles rise. The above discussion points to several conclusions. First, the major trade policy issue of the day is no longer the terms-of-trade prisoner s dilemma. This has been in part tamed by the WTO tariff bindings and perhaps even more forcefully by the emergence of the made in the world production paradigm that makes tariffs a decidedly suboptimal form of industrial policy. Self-interest now drives countries towards free trade. Second, some states and some global industries operate under essentially free trade conditions and prosper. The times have changed and so apparently has the optimal trade policy. Is there a residual case for reciprocity? Put another way, are there significant opportunity costs to unilateral liberalization? We turn to this question next. The Pros and Cons of FTAs The pros and cons of preferential trade agreements have been dealt with in considerable depth in the literature 23 and do not bear more than a quick summary. The positive case for FTAs can be summarized as follows: They allow faster and deeper trade and investment liberalization than is possible at the multilateral level. They allow experimentation in terms of developing WTO-plus trade rules that can then be rolled out at the multilateral level if successful. Some areas of international commerce are intensely bilateral in nature and can only be effectively negotiated on a bilateral basis, e.g., services sectors where mutual recognition of credentials of service providers is involved They serve as building blocks towards multilateral trade liberalization by consolidating a large number of countries into a handful of trading blocs facilitating negotiations towards a multilateral agreement. 23 See in particular the recent in-depth reviews of preferential trade in the WTO s 2011 World Trade Report (WTO, 2011), and Australia s Productivity Commission (2010). 18

19 They trigger a domino effect as non-participants have an incentive to join regional groups or form their own ( competitive trade liberalization ). Some of the measures negotiated in preferential agreements are non-discriminatory and thus generate benefits on a multilateral basis. The concerns that have been raised concerning FTAs can be summarized as follows: They introduce discrimination into the trading system which in turn generates trade diversion that reduces the welfare gains from the trade that is created by the agreement. They generate welfare costs to non-participants. The fixed costs of accessing preferences skew the playing field for private sector firms in favour of the large, weakening the dynamic renewal of the private sector through competition. They induce investment patterns that are globally suboptimal resulting in future adjustment costs when preference erosion eventually exposes the inefficient industries, whose growth was induced by preferences alone, to global competition. The asymmetric bargaining power can result in the parties with weaker bargaining power being locked into policies that are suboptimal for them. FTAs have been used for global standards competition; differing standards can create prohibitive non-tariff barriers to trade between blocs. They constitute an inefficient path to multilateral free trade and indeed can serve as a stumbling block by creating rents that generate lobby activity to protect existing preferences. They can generate political frictions among beneficiary and excluded countries as, for example, the WTO trade disputes over bananas illustrate. Anecdotal evidence can be adduced for all of these arguments as they typically were inspired by specific examples. However, with a few notable exceptions, systematic evidence is not available to allow a comprehensive evaluation. Regarding the question of whether FTA trade creation dominates trade diversion or vice versa, the conventional wisdom at this point is that trade creation is the norm and trade diversion the exception, and that where diversion is observed it is fairly minor (Freund and Ornelas, 2010). That being said, the outcome depends heavily on the height of tariffs facing third parties the higher these tariffs, the greater the scope for 19

20 welfare-reducing trade diversion. 24 From a Canadian perspective, the low general level of tariffs facing non-fta parties means that trade diversion is likely to modest. On the building block/stumbling block question, the discussion has moved beyond conjecture to theoretical exposition, where it has been shown that FTAs can be either (Aghion, Antràs and Helpman, 2006). Empirical analysis shows that, for the two largest trading economies, the United States and the EU, multilateral tariff reductions for preferentially traded goods are significantly lower than for non-preferentially traded goods. This suggests a stumbling block effect (Limão, 2006). Limão (2007) also provides evidence that the non-trade objectives of preferential agreements work to hinder multilateral trade liberalization. Regarding the domino effect of preferential agreements, the proliferation of FTAs certainly suggests the action of a building block effect. The push to conclude the US- Korea FTA hot on the heels of the EU-Korea FTA is a case in point. The same dynamic was cited by the Government of Canada as propelling the Canada-Korea FTA that was finally concluded in April Much of the evidence on the trade creating/trade diverting effect of RTAs comes from the gravity model literature. Estimates of the impact of FTAs vary widely; see, for example, Hoekman, Schiff and Goto (2006), who report very significant variation from one PTA to the next as regards the degree of overall increase in imports and exports and increase in intra-pta imports. To some extent, differences reflect methodological issues most importantly taking into account the endogeneity of FTAs and the question of direction of causality (does intensity of trade induce countries to form FTAs or does the decision to enter into a PTA generate the observed trade intensity?). Baier and Bergstrand (2007) provide a good discussion of the issues. From an a priori perspective, the one thing that is hard to square is a finding that FTAs only create trade and do not divert trade. This follows from two methodological considerations. First, there is a compression effect from the presence of sunk costs of entering foreign markets; as a result, firms enter fewer markets than they otherwise would. By the same token, at least some firms that have options across different foreign markets and choose the PTA partner must be diverted by the PTA. Second, from the perspective of standard Armington-type trade models, the substitution elasticities across competing sources of imports are generally understood to be higher than between domestic products and foreign products (reflecting a home bias in consumer preferences). Accordingly, insofar as preferences induce substitution away from domestic products they are likely to have even more powerful effects in inducing substitution away from competing imports from third parties. This effect would be much stronger with high tariffs against third parties, as indicated by the Hoekman, Schiff and Goto (2006) results. 20

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