This is the third article in a series of four explaining trade agreements and why they are important. You can find the first article covering the Principles of Free Trade Agreements here and the second article covering the General Agreement on Tariffs and Trade (GATT) and World Trade Organisation (WTO) here.
Quite apart from the General Agreement on Tariffs and Trade, aka WTO Terms, that we explored in Part 2, there are over 400 active bilateral and multilateral Free Trade Agreements in force today.
Some are recent – for example, the ones that the EU has struck with Canada and Japan (the one with Mercosur now needs ratification by all countries, so that’ll probably be a few years more before it comes into force). Some, though, date back several decades.
For this series, I’ve been reading up the studies that have been done into their impact – the successes and failures – to see what can be learnt. Such lessons are useful from two points of view.
One is governmental – when it comes to negotiating new Trade Agreements, what risks need to be avoided and which opportunities grasped. You, our audience, many of you entrepreneurs, all of you consumers and taxpayers, will be more interested in the second reason for looking at the history of trade deals – which is to strip away exaggerated optimism and doubts, and get a better informed understanding of what benefits can realistically be expected, and, especially for the business people amongst you, the risks you need to be aware of that could turn a trade deal negative for you.
Studies of past trade agreements
Most of the academic studies of past trade agreements have either related to the big US deals with developed countries, or with those between major economies and developing nations such as countries in Africa.
The first type started with the sole intention of growing international trade between the parties, whilst the second type was also planned to incorporate a significant element of international aid. All of them bring up interesting points that could affect any future trade deal. It’s a vast subject, and there are many studies, a lot of which, perhaps influenced by the organisations that undertook or funded them, show clear elements of bias. I’ve done my best to strip that out and stick with facts.
One would hope that facts are easy to come by, but I should admit that it’s quite easy to bring opinion, and with it bias, into any study of Trade Agreements.
That’s simply because, over the life of an FTA, there are always so many political and economic events going on that impact trade. The most significant example that’s a factor in all the studies is the “crash” of 2007-2008. That affected different countries in different ways, but generally speaking consumption went down.
Where it was possible, consumers in rich countries switched to cheaper products, often imported from lower cost countries with which their country has a Free Trade Agreement, whilst businesses in developing countries cut back on expensive imports from richer countries.
How can one separate out the effect of the Free Trade Agreement from that of the financial crash?
One can’t. All the studies that attempt it have to make big assumptions, and – even if the researchers do their best to be objective, many readers will see bias in their conclusions.
But let’s do our best here to be objective. There’s certainly enough common ground between the studies to be certain of many things.
I’m going to start by talking about NAFTA, the North American Free Trade Agreement, that dates back to 1994 and eliminated most of the trade barriers between the USA, Canada and Mexico. Even if you’re not in North America, you’ll probably have heard of it – that’s the first of the ones that Trump wanted to get out of or renegotiate because he claims it’s unfair to the USA.
Nevertheless, from most points of view, NAFTA has been a resounding success. Over the 25 years since it was agreed, cross-border trade has more than doubled in real terms. Of course, not all of that is attributable to NAFTA, nor has that cross-border trade turned out to be what was originally expected.
From our viewpoint, which is studying the effects of free trade deals and what we might expect from future ones, the most significant relate to industrial employment and place of manufacture. It’s true that US unemployment is much lower now than it was in 1994 when NAFTA started, but the actual mix of jobs is entirely different – manufacturing has reduced dramatically whilst services have grown exponentially.
The example that’s usually cited, and indeed the easiest to understand, is car manufacturing. NAFTA was indeed intended to encourage US manufacturers to build plants in Mexico. The belief was that by providing well-paid jobs in Mexico, the economy would converge with that of the USA and illegal immigration to the US would reduce. That didn’t work.
One reason was that the introduction of NAFTA coincided with a recession in Mexico. Another was that the Mexican government of the day didn’t use the new tax revenues they got from the new US manufacturing plants to build new infrastructure, as they had promised in the negotiations.
But the important factor resulting from NAFTA, now often overlooked, is that the elimination of tariffs on agricultural products made it uneconomic for Mexican farmers to grow corn. The original idea was that they’d plant new and more profitable crops, but instead they just stopped farming altogether.
But back to car manufacturing. The big US manufacturers built plants not only in Mexico but in Canada. In Mexico, labour costs were much lower. In Canada, labour costs were about the same, but other costs such as health insurance for employees meant that it was still cheaper than the USA. In both countries, other operational costs were also lower.
The plants, being new, also incorporated the latest technology and so the productivity was much higher than the old US plants – so not so many employees were needed. Their supply chain – other manufacturers of components – had to follow their customers to Mexico and Canada. Smaller companies that couldn’t or wouldn’t relocate over the borders lost out, and many simply folded.
So, in summary, it made sense for the car manufacturers to close their old plants in the USA, build in Mexico or Canada instead and import the finished product tariff-free.
A similar situation occurred in textiles and many other sectors of the industrial economy. There were industrial jobs still left in the USA, but they were fewer in number and increasingly more skilled.
The economic and political impact in the USA itself was considerable but complicated.
Tens of thousands of auto workers in Michigan, steel workers in Ohio and Pennsylvania and textile workers in Louisiana found themselves out of jobs. As the jobs moved out, the power of the unions declined dramatically. Millions across the whole country benefited, though – all found their cars and clothes to be a bit cheaper, and US corporations saw their profits rise.
Overall, measured as national GDP, the economy gained; at local level, however, the effect was devastating. Recently, the disaffected have risen up – the news is regularly full of the effects of “populism” and backlashes against “globalisation”. Meanwhile, the numbers of people trying to cross the Rio Grande into the USA has continued to grow, although only a minority now are themselves Mexican.
Most studies conclude that these unwelcome trends could largely have been avoided had the relevant governments followed through on the good intentions they had set out when NAFTA was being negotiated. Just as Mexico didn’t invest in infrastructure or other improvements, the USA did nothing to assuage the industrial job losses. Instead of investing, governments chose to reduce taxes. The rich got richer.
Many thousands of words have been written about NAFTA, and there are many other things that could be said about it. But from our point of view, let’s summarise some lessons relevant to those of us in developed countries seeking to negotiate and benefit from new trade agreements – especially those of you who manage or work in SMEs.
Lessons to be learnt from NAFTA
Firstly, any trade deal with a significantly lower cost economy will mean that manufacturing will progressively move there.
If you’re in the cheaper country, that’ll mean that companies from the other country will move operations and jobs towards you. If you’re in the more expensive country, operations and jobs will move out. Big businesses always chase opportunities to increase profits.
If you’re in an SME, you’ll probably be anticipating being able to export more of your products. However, the opportunity is only significant if either the other country has a demand for your product (and there’s no better value local alternative) or the current tariff barrier is very high. The risks come if you are part of a supply chain and the major focal point customer moves out. You need to be ready to follow – or, perhaps better, sense the opportunity and move first.
It’s not just about manufactured goods. Agriculture is just as significant.
Even though Mexico was – and is – poorer than the USA, the elimination of tariffs that came about with NAFTA decimated Mexican corn growing, chicken rearing and other food production – US farmers were, and are, simply more efficient and have a more productive combination of landscape and climate. So the lesson here is to beware, even if you’re in the cheaper country – more efficient producers from the other country can easily over-run you.
Thirdly, though this is a big and probably hopeless hope, the participating governments need to anticipate and plan to manage the labour displacement that will inevitably ensue, whether that’s manufacturing or agricultural jobs.
What about services?
And what if you’re in the services sector – 80% of the UK economy and nearly as big in the USA? Well, little or none of this is relevant, as services are outside the scope of most trade agreements. That’s because tariffs aren’t really relevant – what is, is regulation, or the elimination of it. In the case of NAFTA, the three countries kept their own services regulations and, although the cross-border trade in these has grown massively over the years, that’s not attributable to NAFTA.
Results of other trade agreements
Moving away from NAFTA, studies have shown similar results from other US trade agreements, plus some additional interesting points.
With the benefit of an agreement implemented in 2011, South Korea has managed to double its exports to the USA, whilst keeping imports more or less level. The reasons look complicated to me, but critics point to local protection measures within Korea that fall outside the scope of the FTA and that make it too difficult for US producers to compete. On the other hand, that might be sour grapes from the Americans – the EU-South Korea deal of the same year increased UK exports to the country by over 50% in three years.
The USA doesn’t have a trade agreement with China, but as we all know from other Trump tirades, has a huge trade deficit. The imposition of tariffs has had limited impact, mainly because the Chinese currency, the Renmimbi, is not free floating, so the government could simply devalue it. There are many other – but obviously smaller – countries around the world where there is some opportunities for governments to benefit their exports and impede imports simply by manipulating their currency, which in the case of a Free Trade Agreement could easily mean that the results are very different to those that had been anticipated by the other country.
In the last few years, Canada and the EU have implemented a Free Trade Agreement, and that has already brought up an interesting, if possibly apocryphal, example of the need for strict Rules of Origin clauses – in this case, they’re there, but obviously incomplete. The example I’m referring to is of Mercedes cars. The story goes that demand for a certain model was so high that the German plant couldn’t keep up, so they wanted to source the cars from a plant in South Africa. In order to keep the “Made in Germany” label, all they had to do was to perform QA on some of the components in Germany and ship those first to South Africa to be built into the cars, that were then transported to Canada with the benefit of the EU trade agreement.
Trade agreements between rich and developing countries
What about trade agreements between rich and developing countries? In almost every case, the richer countries have promoted such agreements as primarily to help the development of the poorer countries, never more so than in the case of those between the EU or North America and African countries.
Almost every retrospective analysis has demonstrated these to be disastrous for Africa.
As we explored in Episode 1, a key element of Free Trade Agreements is supposed to be the elimination of protectionist measures in the participating countries. Countries such as those in the EU and the United States point to and complain about protectionist measures in countries like India and Zimbabwe, but that’s somewhat hypocritical. Elimination of protectionist measures should level the playing field so that the lower cost economies benefit by not only being able to export without hitting walls of tariffs, but also that they don’t have to go up against subsidised producers in the richer countries.
In the case of the EU, that’s never been the case though. Agriculture is heavily subsidised. African countries, which have huge potential for agricultural development and, unlike Europe, a large workforce willing to plough the fields, can produce more cheaply – but not sufficiently so to compete with EU subsidised prices.
Developing countries often rely heavily on import duties as the easiest and most reliable taxes that they can collect. It’s often not easy – or even possible – to replace the revenue elsewhere.
Especially in the case of Africa, the Foreign Direct Investment and Technology Transfers referenced in the Free Trade Agreements have never actually happened, probably largely because they rely on companies, who simply don’t trust that their investments in those countries will be safe and generate a return, FTA or no FTA.
Meanwhile, FTAs coupled with Foreign Aid are often used to strongarm developing countries into buying equipment and arms from richer ones.
So a small number of very large companies in rich countries benefit, whilst the population of the developing country gain little or nothing.
Looking away from Africa, but still at EU trade deals, Rules of Origin have been applied really strictly and have, in some cases, more or less negated the value of the agreements to the other country. Balkan countries such as Albania and Bosnia-Herzogovina hoped to grow their clothing industries when they signed trade agreements with the EU. However, the Rules of Origin state that not only must the clothes be made in the country, but the fabric itself must either be made in the country or in the EU. So clothing manufacturers have added bureaucracy to prove and document where the fabric originated, and can’t use fabric imported from China or India, for example. It’s claimed that’s cut the expected benefit by 98%.
Trade Agreements in the rest of the world
I’ve looked at studies of other FTAs in other parts of the world, and found that the lessons are generally the same.
There’s huge economic benefit to be had from free trade agreements. But there are significant risks too
Those risks need to be understood in advance and properly managed – not only by government, but by businesses large and small too. FTAs have never proved to be a “silver bullet”, but, done right, they’re well worth the years of negotiation that go into them.
In the last part 4 in this series on Trade Agreements, we wrap up by exploring the reality of opportunities and drawbacks that future trade deals for the United Kingdom outside the EU. Given that the UK economy is 80% services, that’s also a reason for exploring the role of Free Trade Deals for the services sector and, realistically, what can and can’t be achieved in the short term.
Oliver Dowson and the producers of the Grow through International Expansion platform welcome all and any comments that you may have – and Oliver is always open to individual discussions of any points you’d like to explore further – just get in touch using our contact page