The U.S.-Republic of Korea Free Trade Agreement and its Impact on Latin America

Transcription

1 The U.S.-Republic of Korea Free Trade Agreement and its Impact on Latin America Diploma Thesis Anja Breuer International Degree Course in Economics University of Applied Sciences Bremen 1. Examiner: Prof. Dr. Hans H. Bass, University of Applied Sciences Bremen 2. Examiner: Raquel Artecona, UN Economic Commission for Latin America and the Caribbean August 2008

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3 iii Contents List of Figures and Tables...iv List of Abbreviations and Acronyms...vi 1 Preferential Trade Arrangements: Forms, Development and Implications Forms of Preferential Trade Arrangements The Recent Proliferation of Preferential Trade Arrangements The Economic Impact of Free Trade Agreements in Theory The KorUS FTA and its Impact on Latin American Exports to the U.S. and Korea History and Basic Facts of the KorUS FTA The Impact of the KorUS FTA on the Member Countries Current U.S.-Korea Trade and Its Development Estimated Effects on Trade and Welfare for the U.S. and Korea The Impact of the KorUS FTA on Latin American Exports A Short Literature Review on Trade and Welfare Effects Current Latin American Trade with Korea and the U.S. and its Dynamics Composition of Latin American Exports Comparison of Export Structures Competitiveness of Latin American Exports Conclusions The Nature of International Trade Relations Under Construction Is There a Superior Construction Plan? PTAs: Building Blocks or Stumbling Blocks? Changing the Design? An Assessment of Policy Options...83 References...87

4 iv List of Figures and Tables Figure 1: Main forms of economic integration...4 Figure 2: Preferential Trade Arrangements Notified to the WTO...6 Figure 3: Static Partial Equilibrium Analysis of a Free Trade Area...10 Figure 4: U.S. Commodity Trade with South Korea...21 Figure 5: Shares of Total U.S. Commodity Trade...22 Figure 6: Shares of Total Korean Commodity Trade...22 Figure 7: Development of Exports to the Republic of Korea...38 Figure 8: Development of Exports to the United States...41 Figure 9: ESI and WESI Values for the Korean Market...51 Figure 10: ESI and WESI Values for the U.S. Market...55 Figure 11: Static Impact and Dynamic Time-Paths of Regionalism...79 Table 1: Summary of Modeled Sectoral Output Effects of the KorUS FTA...28 Table 2: Summary of Modeled Welfare Effects of the KorUS FTA...30 Table 3: Basic Information on Selected Latin American Countries...33 Table 4: Welfare Effects of the KorUS FTA on Latin America...34 Table 5: Changes in Latin American Exports due to the KorUS FTA...34

5 v Table 6: Trade with the Republic of Korea in Table 7: Trade with the United States in Table 8: Import Shares in the Korean Market in Table 9: Import Shares in the U.S. Market in Table 10: Product Penetration in the Korean Market in Table 11: Product Penetration in the U.S. Market in Table 12: Top 5 Exports to the Korean Market in Table 13: Top 5 Exports to the U.S. Market in Table 14: Decomposition of ESI Values for the Korean Market...52 Table 15: Decomposition of WESI Values for the Korean Market...53 Table 16: Decomposition of ESI Values for the U.S. Market...56 Table 17: Decomposition of WESI Values for the U.S. Market...57 Table 18: Highest Latin American RCAs in the Korean Market...62 Table 19: RCAs Shared by the U.S. and Latin American Countries in the Korean Market...63 Table 20: Highest Latin American RCAs in the U.S. Market...64 Table 21: RCAs Shared by Korea and Latin American Countries in the U.S. Market..65

6 vi List of Abbreviations and Acronyms APEC CGE CU ESI FDI FTA GATS GATT GDP GTAP KorUS FTA LA MFN NAFTA n.e.s. PTA RCA Asia-Pacific Economic Cooperation computable general equilibrium customs union export similarity index foreign direct investment free trade agreement General Agreement on Trade in Services General Agreement on Tariffs and Trade gross domestic product Global Trade Analysis Project United States - Republic of Korea free trade agreement Latin America most-favored-nation North American Free Trade Agreement not elsewhere specified preferential trade arrangement revealed comparative advantage SITC Rev.3 Standard International Trade Classification, Revision 3

7 vii UN Comtrade USITC WESI WTO United Nations Commodity Trade Statistics Database United States International Trade Commission weighted export similarity index World Trade Organization

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9 1 Preferential Trade Arrangements: Forms, Development and Implications The world economy has changed considerably over the last few decades. The world grew together in many ways experiencing an improvement of transportation networks, an expansion of information and communication networks, the liberalization of financial markets and an increase in world trade. The last decade, however, is particularly marked by a new development: The growth of regional trade blocs has been one of the major developments in international relations in recent years. Virtually all countries are members of a bloc, and many belong to more than one. Over a third of world trade takes place within such agreements. (Schiff and Winters 2003, p. 1) There is a long list of reasons given by different stakeholders on why countries seek economic integration. Jovanović (2006, p. 192) mentions e.g. the reduction in the cost of trade through the elimination of trade barriers, technological advances and downward pressure on prices through increased competition, the exploitation of economies of scale in larger markets, improved efficiencies and a strengthened bargaining position with external partners. This new aspect of the current economic reality also leaves the world with many questions. What are the characteristics and determinants of the recent proliferation of preferential trade arrangements 1 (PTAs)? How will this new trend influence the economic landscape? What impact of a preferential trade agreement can be expected by member countries and by the rest of the world not party to the agreement? Will there be winners and losers in the race towards trade blocs? How will 1 The term preferential trade arrangements is used as an umbrella term for all discriminatory forms of economic integration in the context of this thesis.

10 2 Preferential Trade Arrangements: Forms, Development and Implications the expansion of bilateral (or in a few cases plurilateral) trade negotiations as a trade policy instrument change the way countries negotiate multilaterally? In the light of the recent developments this paper tries to answer these complex questions making use of relevant literature and analyzing trade data. In the first chapter the paper explores the framework surrounding preferential trade arrangements giving an introduction to basic theoretic concepts and highlighting recent trends concerning PTAs. The second chapter analyzes the economic impact of a specific preferential trade agreement. For this purpose the proposed free trade agreement (FTA) between the U.S. and the Republic of Korea has been chosen, because it would be the United States most commercially significant FTA in over a decade (USTR 2007) and a FTA is the form of economic integration most often chosen by countries negotiating bilaterally (see section 1.2). A special emphasis of the second chapter lies on the impact that the FTA, upon entering into force, might have on Latin American exports to the FTA member countries and is performed with the help of case studies of Brazilian, Chilean, Costa Rican, Mexican and Peruvian exports. The competitiveness of Latin American countries in the U.S. and in the Korean market is of substantial interest as the U.S. is a traditional export market for Latin America and the South Korean market could provide Latin America with a valuable option for a diversification of export markets. Therefore the impact of the proposed FTA on this region of the world seems especially relevant, but has, so far, not been analyzed thoroughly in recent studies. Finally, the third chapter addresses the influence of the recent spread of PTAs on the multilateral trading system and its future as discussed in the respective literature. 1.1 Forms of Preferential Trade Arrangements Countries have many options for structuring their trade relations with other nations. They can pursue a multilateral approach seeking and granting market access via multilateral negotiations on the rules of trade within the framework of the World Trade Organization (WTO). One of the guiding principles of the WTO is the most-favored-nation (MFN) principle according to which in general all countries have to receive equal treatment (WTO 2007, p. 10). Alternatively, countries can pursue strategies that are based on preferential market access between two partner countries or among a group of several partner countries. Although the pursuit of strategies giving preferential access to some countries seems to be an apparent contradiction to the WTO s MFN principle, there are provisions within the

11 1 Preferential Trade Arrangements: Forms, Development and Implications 3 General Agreement on Tariffs and Trade (GATT) and the General Agreement on Trade in Services (GATS) that allow for certain exceptions (WTO 2007, p. 64). GATT article 24 and GATS article 5 give permission to set up preferential trade arrangements provided that certain criteria are met (WTO 2008b; WTO 2008d). They specify that barriers should be reduced or removed on substantially all sectors of trade in the group and that barriers for the outside world should not be raised. Under the so-called Enabling Clause (WTO 2008c) there are also exceptions provided for developing countries that wish to reduce or eliminate trade barriers among themselves. Since these possibilities for exceptions to the MFN principle have become widely used over the last decades in the following an overview of different forms of economic integration is given and the extent of commitments that these forms of preferential trade arrangements entail is explained. According to Balassa (1961, p. 4) economic integration can be defined as a process and as a state of affairs. With regard to the definition as a process, the analysis of economic integration is concerned with the measures leading to the suppression of discrimination between different national states. Understood as a state of affairs, economic integration results in forms of economic integration that can be characterized by the absence of discrimination in various areas (Balassa 1961, p. 5). Subsequently Balassa distinguishes five forms of economic integration each characterized by varying degrees of integration. The first of the five forms of economic integration mentioned by Balassa (1961, pp. 5-6) is the free trade area, which is characterized by the abolition of tariffs and quantitative restrictions in trade between the participating countries. The second form introduced is the customs union, which in addition to the provisions of a free trade area also requires the establishment of a common external tariff towards non-member countries. The next higher form of integration is represented by a common market, characterized by the elimination of not only trade restrictions but also restrictions concerning factor movements. An economic union as the fourth form of economic integration according to Balassa goes even further in its requirements and calls for the harmonization of economic, monetary, fiscal, social, and countercyclical policies. The highest form of integration is total economic integration. It is achieved by the unification of all policies and the setting up of a supranational authority whose decisions are binding for all member-countries. Figure 1 illustrates the first four forms (by other

12 4 Preferential Trade Arrangements: Forms, Development and Implications authors also called types, tiers or stages ) of economic integration of Balassa s concept matching each form with the corresponding areas that are characterized by the absence of discrimination. Form Characteristics free trade between members common external tariff full mobility of factors of production harmonization/ unification of economic policy Free Trade Area Customs Union Common Market Economic Union Figure 1: Main Forms of Economic Integration; Source: based on Blank et al. 1998, p. 35. When comparing economic integration initiatives in real life with Balassa s theoretic categorization, it is noticeable that the distinctions between the different forms of integration are not always as clear cut as Balassa s concept might suggest. Nevertheless, Balassa s categorization is generally accepted and adopted by the relevant literature. Some authors, however, do not include the last form (total economic integration) because it is not viewed as a form of strictly economic integration but rather as political integration (compare e.g. Blank et al. 1998, p. 34; Das 2004, p. 15). Others include this stage of integration and express their differing view by adjusting the form s name. It is, e.g., termed complete political integration by El-Agraa (1989, p. 2) and political union by Kaiser (2003, p. 28). Furthermore, some authors add additional stages to the scheme that are embedded at a degree of integration inferior to that of a free trade area. Jovanović (2006, p. 22), Das (2004, p. 15) and Kaiser (2003, p. 27) e.g. include preferential trade (or tariff) agreements, which eliminate tariffs on a specified number of commodities only or lower tariffs among member countries relative to third parties without eliminating tariffs completely. Jovanović also mentions the form of partial customs unions, which retain their initial tariffs for trade among the member countries, but establish a common external tariff on trade with the rest of the world. In his contribution Das (2004, p. 15) distinguishes between shallow and deep stages of integration grouping preferential trade (tariff) agreements, free trade areas and customs unions as forms of shallow integration and common markets and economic unions as

13 1 Preferential Trade Arrangements: Forms, Development and Implications 5 forms of deep integration. Regardless of where you chose to draw the line between shallow and deep integration, however, it is important to observe that economic integration is not necessarily a gradual process in which countries continuously advance from one stage of integration to the next higher form (Jovanović 2006, pp ). According to their wishes and needs countries can negotiate to start at the degree of integration that best fits their interests, they can remain at the same stage, advance slowly, skip stages or they can cancel existing integration agreements. Furthermore, in practice many agreements do not enter into force entailing immediate elimination or reduction of tariffs, but are phased in lowering tariffs in various steps over a specified period of time. 1.2 The Recent Proliferation of Preferential Trade Arrangements Much has been talked and written about the new regionalism since the 1990s and proliferation of RTAs [regional trade arrangements] has become a common term, in the press and relevant literature, to account for the increasing number of RTAs being recorded in recent years (Fiorentino et al. 2006, p. 2). But is regionalism (understood as the spread of preferential trade arrangements) really a new phenomenon? In short: yes and no. Regionalism is, in fact, not a new phenomenon in itself. In 1664 e.g. a customs union of the provinces of France was proposed and in 1834 the German Zollverein was established as one of the earlier examples of a customs union (compare Schiff and Winters 2003, p. 4; Jovanović 2006, p. 16; Blank et al. 1998, pp ). Furthermore, according to Kaiser (2003, p. 20) multilateralism and regionalism have co-existed since the multilateral trading system was established in form of the General Agreement on Tariffs and Trade (GATT) in As she notes, however, in the past for most countries multilateral negotiations were the dominant approach for arranging international economic relations, whereas the massive proliferation of regional arrangements within the last decade has definitely changed the current weighting of the two approaches. Looking back at the last century two waves of regionalism can be identified of which the first appears starting with the establishment of the European Economic Community in 1957 and the second wave of regionalism dates to the 1990s (Das 2004, p. 10; Kaiser 2003, p. 30).

14 6 Preferential Trade Arrangements: Forms, Development and Implications Preferential Trade Arrangements Notified to the WTO notifications (left-hand scale) notified (cumulative) notified and active (cumulative) Figure 2: Preferential Trade Arrangements Notified to the WTO according to GATT Art. 24, GATS Art. 5 and Enabling Clause; Source: based on WTO data (WTO 2008a) As figure 2 shows the number of PTAs notified to the GATT increased slowly over time and until into the mid-1970s there were still less than 50 notified agreements. Only in the 1990s the number of notifications increased substantially and by now almost 400 PTAs have been notified to the GATT and the WTO. Therefore, first of all, a significant quantitative change concerning PTAs can be observed. Nevertheless, it is important to note, that out of the almost 400 PTAs notified only slightly more than 200 are actually active. Additionally, it has to be mentioned that the WTO figures overstate the physical number of agreements as countries have to submit a notification in case of accession to an existing agreement and, since 1995, have to submit separate notifications for an agreement containing provisions on trade and services (Fiorentino et al. 2006, p. 2). In spite of methodological limitations, however, the increasing number of notifications received by the WTO is still a valuable indicator for the spread of PTAs. In addition, the percentage of world trade conducted under such agreements gives an impression of the importance of regionalism in the modern world: According to direct communication with the WTO s Economic Research and Statistics Division the share of exports among partners of PTAs (excluding the overlap of PTAs) in world exports was slightly over 40% in 2005 and 2006.

15 1 Preferential Trade Arrangements: Forms, Development and Implications 7 There is not only a quantitative change regarding the spread of PTAs, there is also a qualitative change. Whereas the old wave of PTAs consisted mostly of agreements among neighboring countries, the new wave of regionalism is first and foremost characterized by an ever increasing number of cross-regional alliances with a diverse range of partners (Das 2004, p. 17). While in 2006 only 12% of the PTAs notified and in force were cross-regional, among the agreements signed but not yet notified and those still under negotiation 43% were of a cross-regional nature (Fiorentino et al. 2007, p. 9). This steep increase in cross-regional alliances in combination with the trend to rely increasingly on bilateral 2, not plurilateral, negotiations is, according to Fiorentino et al. (2007, p. 8), evidence for the new focus on strategic market access that guides modern trade policy in most countries. Since most countries are members of various PTAs simultaneously, in fact, some members are party to more than 20 different PTAs (WTO 2008), an ever more complex net of preferential trade relationships is created (see also chapter 3). Yet another distinguishing characteristic of the recent development of PTAs is the increase in alliances between developing/emerging-market economies and industrialized countries (Das 2004, p. 64). As of December 2006 among the PTAs in goods notified to the WTO 27% are between a partner from a developed and a partner from a developing country. Among the agreements in services notified to the WTO 44% fall within this category (Fiorentino et al. 2007, p 11). The statistics also reveal that there is a strong tendency towards forming a free trade area (FTA) instead of a customs union (CU). As of December % of notified PTAs in force were intended to be FTAs, 8% CUs and 8% partial scope agreements. Among the PTAs signed, under negotiation and proposed as of December 2006 the share of FTAs rises to 92%, whereas the share of partial scope agreements remains almost unchanged at 7% and the share of customs unions drops to only 1% (Fiorentino et al. 2007, p. 6). Schiff and Winters (2003, pp ) believes the current tendency towards the creation of FTAs is due to the fact that CUs require common external tariffs, that can be hard to agree on, and after their establishment more ongoing 2 Bilateral in this context means that the negotiations take place between two parties. One or both of the parties can, however, be a trade bloc consisting of more than one country.

16 8 Preferential Trade Arrangements: Forms, Development and Implications coordination in all areas of trade policy thereby limiting the members sovereignty. He points out that in order to reap the benefits of absent customs inspections for all goods at intra-area borders in a CU trade policy has to be harmonized not only with regard to tariffs but also with regard to non-tariff barriers. Fiorentino et al. (2007, p. 5) attribute the increasing popularity of FTAs among the forms of economic integration to three characteristics of this form: Fist, FTAs usually allow for faster negotiations. Second, they offer more flexibility regarding the scope of the agreement and the choice of partners. And third, they provide higher selectivity by allowing member countries to agree to ambitious preferential concession while, at the same time, safeguarding each member s sovereignty over its trade policy. He concludes that the FTA is the form of economic integration that best fits the modern world s trade policy needs and objectives. Although the quantitative and qualitative changes regarding PTAs have been recorded and continue to be monitored closely, the underlying reasons for the proliferation of PTAs over the last decade are hard to single out. Kaiser (2003, pp ) e.g. identifies several determinants leading to a more intense second wave of PTAs such as a changed economic environment with better integration of world markets through the successive liberalizations of trade under the GATT, financial liberalization and better information, communication and transportation networks. She also points to a greater willingness of developing countries to open up their economies and the changed attitude of the U.S. towards bilateral trade agreements as likely causes for the recent proliferation of PTAs. 1.3 The Economic Impact of Free Trade Agreements in Theory The decision about entering into a customs union or any other type of integration has always been primarily political, but economic considerations usually play a very important role. (Jovanović 2006, p. 23) Not surprisingly, therefore the analysis of the economic impact of CUs, although with small variations in the focus of analysis, is a frequent subject in introductory books to economic integration and trade policy (compare e.g. Robson 1998, pp ; Zimmermann 1999, p. 10; Jovanović 2006, p. 40; Schiff and Winters 2003, p. 55). A partial equilibrium analysis of a FTA, however, is much harder to find in the relevant literature. This might reflect the view that FTAs and CUs are similar forms of preferential trade arrangements (for definitions see section 1.1) and thus the analysis of

17 1 Preferential Trade Arrangements: Forms, Development and Implications 9 one form is sufficient to shed light on the effects of both forms of economic integration (Kreinin and Plummer 2002, p. 5). However, there are also essential differences between customs unions and free trade areas regarding their operation and economic impact, which should attract the observer s attention (Robson 1998, p. 28). Taking into account the special role of FTAs in the proliferation of PTAs this section will focus particularly on the economic impact of FTAs. In the following a theoretical analysis of the economic impact of free trade areas in a comparative static partial equilibrium setting is presented and rounded off with further explanations. The main observation and the main concern of the so-called traditional customs union theory, starting with Viner s famous contribution (Viner 1950), is summed up by Schiff and Winters (2003, p. 31) with the following words: A trade bloc usually increases trade between its members. An important issue, however, is whether it creates trade [ ] or diverts it. To illustrate the concepts of trade creation and trade diversion and their economic and welfare impact on a free trade area this section uses an example given by Robson (1998, pp ). With the help of the model we can observe how trade in a certain good between two FTA member countries and the rest of the world is affected by the entering into force of the FTA. Being a comparative static partial equilibrium model Robson s example is subject to the typical but rather restrictive assumptions of homogeneous goods, perfect competition in goods and factor markets, increasing marginal costs, the absence of transportation costs and production factors that are mobile on a national level but immobile across national borders. Robson s example (figure 3) shows a country (country H) forming a free trade area with a partner country (P) and their respective domestic demand (Dh, Dp) and supply curves (Sh, Sp). Whereas demand conditions are similar in both countries for the good in question, the partner country is a more efficient producer with a relatively elastic supply curve (Sp). The world supply price is given by Pw for both countries with world supply assumed to be perfectly elastic. Before the free trade area is formed the home country applies a tariff to all imports represented by the difference between Pw (the world supply price) and Th (the tariff-inclusive price for imports in H). Before the entering into force of the FTA H s market is supplied by domestic production up to the quantity

18 10 Preferential Trade Arrangements: Forms, Development and Implications L and the quantity LN is imported at the tariff-inclusive price of Th from the rest of the world. The partner country (P) applies a prohibitive tariff to imports from the rest of the world meaning that at the tariff-inclusive price of Tp demand in P is satisfied by domestic production only. Figure 3: Static Partial Equilibrium Analysis of a Free Trade Area; Source: Robson 1998, p. 31. When a free trade area is formed between H and P the two countries eliminate all tariffs on imports from the member countries but continue to apply their respective tariffs to the imports from the rest of the world. In order to avoid that imports from the rest of the world enter the free trade area through the country with the lowest tariff and are subsequently distributed duty-free to the different FTA member countries (which would be termed trade deflection ) most FTAs establish rules of origin (Robson 1998, p. 28). Rules of origin that determine which products are sought to have originated within the free trade area and are therefore eligible for duty-free treatment have been created using different criteria. Frequently used rules of origin are e.g. that a commodity needs to have changed tariff classifications between import and export by a FTA member country, that a specified percentage of the commodity s sales price must consist of value added in a member country or that a specified percentage of a commodity s parts and components must be purchased from member countries (Krueger 1999, p. 263). Although rules of origin are essential for protecting the effectiveness of the external tariffs of the individual member countries (Zimmermann 1999, p. 16), they can also give rise to exported protectionism and distortions in trade flows as producers within

19 1 Preferential Trade Arrangements: Forms, Development and Implications 11 the free trade area might be forced to import more expensive within-area inputs to fulfill the requirements for duty-free exports to other member countries (Schiff and Winters 2003, p. 79; Carlowitz 2003, p. 116) After the entering into force of the FTA, imports from P can enter H duty-free. P s suppliers are willing to export to H at the minimum price of Tp (which is the price they could obtain in their domestic market) any quantity demanded that can be domestically produced in P at the respective price. Essentially, the demand in H determines the price of the good in question in country H in the range between Tp (P s minimum supply price) and Th (the tariff-inclusive price of perfectly elastic world supply as an alternative source) in combination with P s maximum capacity to supply. The price in country P under the FTA continues to be Tp since this is the tariff-inclusive price of perfectly elastic world supply in P. The fact that the price in H (depending on H s demand and P s capacity to supply) can range from Tp to Th and the price in P remains at Tp leads to the possibility of price differences between the markets of H and P, which is not possible in a customs union (Zimmermann 1999, p. 16). El-Agraa (1989, p. 63), however, stresses that in the long-run a price differential for an identical product is neither theoretically nor practically feasible under the specified circumstances as producers in P will have an incentive to expand their production capacities due to the excess profits in H s market. In the case of the example presented, after the free trade area is formed, H consumes at the price Tp the quantity 0L of domestic production and imports the quantity L N from P. At the price of Tp consumers in P consume the quantity 0M, of which 0L is produced domestically and L M is imported from the rest of the world. The quantity of P s production that is exported to H (L N ) equals P s imports from the rest of the world (L M). This effect of P exporting to H and satisfying its own consumption needs of equal quantity by imports from the rest of the world is called indirect trade deflection (Robson 1998, p. 30; Schiff and Winters 2003, p. 81). Unlike pure trade deflection, indirect trade deflection cannot be prevented by rules of origin since P s exports to H are commodities that originated within the free trade area. Just like it is done in traditional customs union theory, trade creation and trade diversion effects can be shown for the partial equilibrium analysis of the two FTA member

20 12 Preferential Trade Arrangements: Forms, Development and Implications countries in figure 3. Trade creation refers to the positive effect on resource allocation from a shift from higher-cost domestic products to lower-cost partner country products. Trade diversion refers to the negative resource allocation effect from a shift from lowercost imports from the rest of the world to higher-cost imports from the partner country (Johnson 1960, p. 68.). The overall welfare effect induced by economic integration depends on the balance between trade creation and trade diversion (Zimmermann 1999, p. 11; Schiff and Winters 2003, p. 35). Due to the lower prevailing price of Tp in H after the FTA consumers in H enjoy an increased consumer surplus constituted by the area between Th and Tp to the left of the demand curve (Dh) in figure 3. The decreased domestic production of 0L leads to a decreased producer surplus equal to the area between Th and Tp to the left of the supply curve (Sh). Since H does not import from the rest of the world anymore the government in H will face a loss of tariff revenue shown by the area b and the rectangle above b. The trade creation for H is therefore represented by the triangles a and c. Trade diversion is shown by the rectangle b in figure 3. Since in our example the triangles a and c are larger than the rectangle b the home country experiences a net welfare gain after the free trade area is formed. In country P the price remains unchanged at Tp after the FTA enters into force and consequentially there are no changes in consumer or producer surplus. As P starts to import from the rest of the world when the free trade area is formed P s government receives tariff revenue represented by the rectangle between Tp and Pw between L and M. Due to the effect of indirect trade deflection the partner country enjoys a net welfare gain. The FTA would also lead to an improved position for the rest of the world as exports to the newly formed free trade area increase due to indirect trade deflection and make up for the loss in H s market (L M > LN). Within the scope of comparative static partial equilibrium analysis the main difference between the effects of a tariff-averaging customs union and a free trade area lies in the existence of indirect trade deflection. Due to trade diversion when a free trade area is formed the rest of the world can face decreased exports to the FTA member countries with higher tariffs for a certain good. Through the effect of indirect trade deflection, however, imports from the rest of the world enter the free trade area at the more

21 1 Preferential Trade Arrangements: Forms, Development and Implications 13 efficiently producing countries (with assumed lower tariffs) making up for the shortfall in domestic products in these countries due to their increased intra-fta exports. Unlike in the case of a tariff-averaging customs union with a common external tariff in a free trade area imports from the rest of the world cannot be diverted completely (assuming that the rest of the world is in fact the least-cost source for imports and that the partner countries supply is not perfectly elastic). In fact, in the setting of a static partial equilibrium model the rest of the world can gain from the creation of the free trade area through the effect of indirect trade deflection (Zimmermann 1999, p. 18). A glance at the theoretical structure of international trade and the directions of trade flows, however, reveals that in real life the outcomes of the model cannot be observed with the accuracy suggested by traditional customs union theory. The static partial equilibrium model and the effect of indirect trade deflection e.g. suggest that for a given commodity one of the following two scenarios should hold true: Scenario A: The quantity produced in P is sufficient to satisfy H s demand for imports. Therefore the prevailing price in H s market is lower than Th and P is the exclusive source of imports in H. Scenario B: The quantity produced in P is not sufficient to satisfy H s demand for imports. Therefore the prevailing price of the commodity in H is Th and H imports from the partner country up to its maximum capacity to supply and imports the remaining quantity from the rest of the world. Consequently, P s entire production is sold to H. In the real world though we can observe that usually countries do not import from one exclusive source only and that countries do not tend to sell their entire domestic production abroad either. The reason for the incongruence of the model s suggestions with our observations may well lie in the model s assumptions. According to Schiff and Winters (2003, p. 31) the static partial equilibrium analysis is based on a view of the world in which intercountry trade is driven entirely by differences in productivity and factor endowments. Parting with the assumption of homogeneous goods and assuming product differentiation instead allows for the existence of intra-industry trade, which makes up a good part of actual international

22 14 Preferential Trade Arrangements: Forms, Development and Implications trade. Allowing for product differentiation might lead to monopoly power or imperfect competition among the producers, which would contradict the assumption of perfect competition. Whereas the model assumes constant returns to scale there are many products for which economies of scale can be exploited during the production process. In fact, reaping economies of scale in production is often seen as one of the main benefits of the access to an expanded market through economic integration (Kreinin and Plummer 2002, p. 24; Robson 1998, pp ). Another point often stressed is that economic integration increases competition and therefore leads to the elimination of internal inefficiencies increasing productivity levels (Schiff and Winters 2003, p. 50). In the world depicted by a static partial equilibrium model, however, this would not be feasible since it is assumed that all factors of production at all times are used optimally so that there are no inefficiencies to be eliminated. Furthermore the existence of transport costs in the real world is not taken into account by static partial equilibrium models either and might help to explain why there must be limits to the effect of indirect trade deflection. Being static in nature the model presented also disregards some dynamic effects that are key elements within the forces that affect economic activity, such as technological advances and decisions concerning the location of investment and its rate of growth (Robson 1998, p. 37). In fact, regional integration might induce changes in investment behavior and frequently leads to a temporary investment boom in the newly integrated area (Kreinin and Plummer 2002, p. 28; Schiff and Winters 2003, pp ). Investment opportunities in the partner country might be perceived as more attractive due to strategic decisions to locate new production facilities in the partner country market and, possibly, due to a more clearly defined investment environment after the implementation of a PTA. Assuming international mobility of capital and a finite volume of investable funds investments may be made within the economic integration area that otherwise would have been more efficiently made outside the integration area. Although all issues mentioned above have been discussed in more recent literature on customs union theory no model has emerged that seems as illustrative as the classic way to show the effects of trade creation, trade diversion and indirect trade deflection with the help of a static partial equilibrium analysis. El-Agraa (1989, p. 27) concludes that most of the effects not included in the standard static partial equilibrium analysis

23 1 Preferential Trade Arrangements: Forms, Development and Implications 15 are long term in nature and, with the exception of internal economies of scale, cannot be tackled in orthodox economic terms. (For examples on the effects of internal economies of scale in customs unions see El-Agraa 1989, pp or Robson 1998, pp ) Taking into account the various limitations of the assumptions of this approach, special care has to be taken when interpreting the results of the static partial equilibrium analysis presented in this section (Jovanović 2006, p. 30). As Robson (1998, p. 18) puts it: taking into account the character of modern production and trade [ ] the outcome of customs unions (and other trading blocs) may significantly differ from the predictions of orthodox theory. It therefore remains up to debate if the entering into force of a FTA might displace exports of the rest of the world to the free trade area. Depending on the question if demand for the exports of the rest of the world changes terms of trade changes would have to be considered as well. In the case that after the economic integration of two countries the displacement of exports of the rest of the world occurs, it seems relevant to dedicate a few sentences to the situation of these third parties. According to orthodox theory a displacement of exports of the rest of the world does not matter as far as the welfare of the rest of the world is concerned. The resources used to produce the exports can be redirected to the production of goods that are consumed domestically and since factors are perfectly mobile within national borders there will be an immediate and costless adjustment to the new situation. In the real world in contrast we might find that adjustment processes do not run quite as smoothly as workers trained for export industries might have to change workplaces and fixed capital has to be transferred to different industries. Furthermore, there might be a welfare loss for the rest of the world incurred if the factors used for one unit of exports create larger welfare as exports than the same factors redirected to alternative uses. According to Schiff and Winters (2003, p. 214) this might be the case if exporting generates supernormal profits because of imperfectly competitive export markets, if the decrease in exports leads to a loss of economies of scale in production or if exports have positive externalities. Since no general statement about the economic impact of a free trade agreement can be derived theoretically the effects on trade patterns and welfare have to be studied on a case-by-case basis. Using the example of the proposed FTA between the U.S. and the

24 16 Preferential Trade Arrangements: Forms, Development and Implications Republic of Korea an analysis of estimated welfare effects and possible changes in trade flows will be performed in the following chapter.

25 2 The KorUS FTA and its Impact on Latin American Exports to the U.S. and Korea The proposed FTA between the U.S. and the Republic of Korea is an interesting example for the analysis of economic integration for various reasons. First of all, the economic size and importance of the FTA members draws attention. A FTA between the world s largest economy and the world s 13 th largest economy (ranked by GDP in 2006 according to the World Bank s World Development Indicators database) leads to the expectation of a sizeable impact of the KorUS FTA on worldwide trade relations. In fact, the KorUS FTA would be the largest bilateral accord America has struck since NAFTA was passed in 1993, as well as the first with a large Asian economy (Economist 2007). Secondly, being a bilateral and cross-regional FTA the agreement between the U.S. and Korea demonstrates the main characteristics of the form of economic integration most commonly chosen by trade partners in the recent wave of proliferation of PTAs. In addition, the U.S. and the Korean market play both interesting as well as differing roles as a destination for Latin American exports. Whereas the U.S. market is a rather established destination for Latin American countries exports and in many cases is of vital importance, the Korean market could offer an interesting opportunity for diversifying export partners and for taking advantage of the Asian economic development. In the following this chapter provides some background information on the development and basic provisions of the KorUS FTA. Subsequently, the expected effects of the agreement on the member countries are presented starting with an overview of the state of current U.S.-Korea trade relations and moving on to the summary of the results of different economic impact studies. As chapter 1 has

26 18 The KorUS FTA and its Impact on Latin American Exports to the U.S. and Korea demonstrated FTAs can also have a profound impact on third countries not party to the FTA since the FTA partners preferential market access can lead to increased competition and altered trade flows. Therefore the chapter closes with an analysis of current Brazilian, Chilean, Costa Rican, Mexican and Peruvian exports to the U.S. and the Korean market in order to subsequently draw conclusions on the magnitude and areas of impact of the entering into force of the KorUS FTA. 2.1 History and Basic Facts of the KorUS FTA Based on the extensive trade relation between the U.S. and Korea some business groups as well as single politicians and the academia had been discussing a possible FTA between the two countries for several years and in late 2004 trade officials started exploratory trade talks (Schott 2006). Only in February 2006, however, the U.S. and the Republic of Korea announced that they intended to launch the official negotiation of a FTA, which was to start in May 2006 (USTR 2006). From there negotiations proceeded at an accelerated pace and after only ten months and eight rounds of negotiations the successful conclusion of a FTA was reached on 1 April 2007 (USTR 2007). Due to the speedy negotiations and the immediate notification of the U.S. Congress the KorUS FTA became the last U.S. trade agreement still eligible for the so-called fast-track procedures (Schott 2008, p. 83). In order to be eligible for fast-track procedures the U.S. president has to notify Congress 90 days in advance about any trade agreement he plans to sign and President Bush s trade promotion authority was to expire the end of June The fast-track rules require Congress to limit debate and cast a yes or no vote on a trade agreement without being able to single out any provision of the agreement (Economist 2007/2007a). The KorUS FTA was finally signed by the two countries representatives on 30 June 2007 (USTR 2007a) and is still awaiting its ratification by the U.S. Congress and the Korean National Assembly. After the U.S. International Trade Commission had submitted its required report (USITC 2007) on the FTA the formal legislative process could have begun in the U.S., but since then things have been moving rather slowly. Schott (2008, p. 79) sees the ratification of the agreement as a major challenge for both governments in He points to three main reasons for the slow progress which he sees in U.S. reservations concerning Korea s ban of American beef exports, tariff-

27 2 The KorUS FTA and its Impact on Latin American Exports to the U.S. and Korea 19 structures for automobile exports to Korea and the U.S. presidential primaries (Schott 2008, p. 84). The campaigning for the U.S. presidential elections makes a passing through Congress of the KorUS FTA unlikely in the near future as especially the Democratic majority seems reluctant to support trade agreements (Economist 2007a). Furthermore Korea s 17 th National Assembly has not ratified the KorUS FTA before the elections in April 2008 so that the 18 th National Assembly had to start a new debate on the topic, which is expected to lead to time-consuming disputes (Cheong 2008). However, the Korean president Lee Myung-bak said that he is confident that the U.S. Congress will ratify the Korea-U.S. free trade agreement by the end of this year after having met President Bush for consultations in April (Korea.net 2008). Additionally, the Korean government lifted the ban on imports of U.S. beef (USTR 2008). The recent violent protests in South Korea, however, cast a shadow on the progress towards the ratification of the KorUS FTA (Sang-hun 2008, Economist 2008). If ratified by the two countries legislative bodies, the FTA between the U.S. and South Korea will cover more trade than any other U.S. trade agreement except NAFTA (Schott et al. 2006, p. 17) and will encompass a wide range of topics. Of the over 10,000 tariff lines of the two countries on commodities currently 38% of U.S. and 13% of Korean tariff lines are free of duty under MFN treatment. Upon entry into force of the KorUS FTA an additional 45% of U.S. tariff lines and 67% of Korean tariff lines will become free of duty immediately for the respective FTA partner country. Over the five years following the entry into force of the KorUS FTA the total number of dutyfree tariff rates will rise to over 90% for both countries and will eventually reach 99% for U.S. tariff lines and 98% for Korean tariff lines ten years after the trade agreement s implementation (USITC 2007, pp. 1-7 to 1-8). Thereby within the area of industrial and consumer products almost 95% of bilateral trade will become duty-free within three years of the KorUS FTA s entry into force. The U.S. government also estimates that over 50% of current U.S. agricultural exports will become duty-free immediately while many of the remaining agricultural products will enjoy two- or five-year tariff phaseouts (USTR 2007b).

28 20 The KorUS FTA and its Impact on Latin American Exports to the U.S. and Korea Furthermore under the KorUS FTA the U.S. and Korea will grant each other market access to almost all major service sectors and expand the obligations to open government procurement processes beyond their WTO commitments among each other. The KorUS FTA will also establish a stronger legal framework and broader protection for investments among the member countries. Additionally, the FTA includes provisions promoting greater protection of intellectual property rights and their enforcement. Through the exchange of comments, the establishment of working groups and dispute settlement mechanisms the KorUS FTA also seeks to improve transparency and coordination in the area of regulations and technical barriers to trade. 2.2 The Impact of the KorUS FTA on the Member Countries Since a possible FTA between the U.S. and the Republic of Korea had been discussed for several years the effects that can be expected by the member countries upon the entry into force of such an agreement are well studied. There is a rich set of literature and economic impact studies on the topic that gives valuable input to the evaluation of the likely effects of the KorUS FTA on its member countries. Although the impact studies reviewed part from very different liberalization scenarios and use different methods, models and database inputs, in the following a short literature summary presents the most important findings of these contributions. But before the different studies are presented it is essential to take a look at the status quo of U.S.-Korea trade relations in order to get an impression of the base that leverage is to be brought to bear on by the proposed KorUS FTA. Therefore in the following section the quantity and characteristics of trade between the U.S. and the Republic of Korea are analyzed. The main focus of analysis is on trade in commodities since trade data is more readily available and classified in more detail in contrast to trade data in services. Unless otherwise stated in the following all trade data is obtained from the United Nations Commodity Trade Statistics Database in the classification of SITC Rev.3.