Free Trade Agreements Episode 1 – The Principles Explained
In this episode we’re only talking about Free Trade Agreements for tangible goods – not just manufactured items but agricultural products like food as well. The situation for Services is almost totally different, so we’ll be discussing that in a separate podcast and article later in this series.
When politicians talk about trade deals, they usually only mean those that relate to Goods – even in the UK, where 80% of the economy lies in the Services sector.
Free Trade Agreements (FTAs) are treaties between two or more countries that dictate the tariffs, taxes and duties imposed on imports and exports, and the regulations that are applied on quality, safety and other relevant matters.
Not all Trade Agreements are free – and even in a Free Trade Agreement, it’s not necessarily the case that all imports and exports are zero-rated. Nevertheless, the term is invariably used – and the “free” is just one of the many wrong assumptions and misunderstandings that many people (including many politicians) have.
The reasoning behind FTAs is that eliminating duties makes both imports and exports cheaper. That should increase economic activity and help business growth, jobs and living standards. However, whilst they can significantly benefit some sectors of the economy, they can equally disadvantage others. The various pros and cons are different for each pair of countries; and they become more emphasised where one country is notably less developed than the other.
Let’s start by understanding the three kinds of Trade Agreement.
- Unilateral. This is where one country imposes its own restrictions with no negotiation or agreement with the other country or countries. Although this is technically a kind of Trade Agreement, in practice it’s just one country restricting imports (or theoretically making them easier, though that’s very rare). In fact, the only time Unilateral Agreements ease trade can be considered as a type of foreign aid, typically applied by a developed country to help an emerging country grow its domestic industry or agriculture – but frankly, that’s only ever seen where that’s no threat to the host country’s own economy. Most commonly, Unilateral Agreements are restrictive – typically increased duties to try to prevent or reduce “dumping” of cheaper product that prejudices the country’s industry or agriculture.
- Bilateral. These are the most common type of FTA, negotiated between two countries, who both agree to reduce or remove tariffs, or simplify regulations, in order to grow trade between them. They seem logical, but are problematic to negotiate, because there’s always one or more sectors of each country’s economy that could be threatened, perhaps because it’s subsidised or just that it’s very fragile and has many jobs relying on it.
- Those are agreements negotiated between 3 or more countries. If Bilaterals are hard to negotiate, just imagine how complex a Multilateral one is! Every country has its own priorities and concerns. However, where these can be overcome, the resulting trade deal will be very powerful and give great advantages to the participating countries. Examples are the North American Free Trade Agreement (NAFTA) and the Trans Pacific Partnership (TPP). They’re the ones that President Trump wants out of, where he thinks that the original negotiators from the US side gave away too much. The latest – and potentially the most important – is the EU-Mercosur treaty, completed in late June 2019, that removes most of the barriers to trade between Europe and major South American countries; that still needs to be ratified by national governments, where it is not immune to objections. It has taken 20 years to negotiate! Of course, if Brexit happens and the UK does leave the EU, it won’t be able to benefit and will have to start again to negotiate its own FTA.
Now let’s look at the theoretical advantages and disadvantages of FTAs.
- Increased economic growth – by eliminating tariffs, both imports and exports increase
- More competitive business – by eliminating protectionism, companies are forced to become more competitive
- Reduced government spending – by removing subsidies to local industries and agriculture, that money can be spent elsewhere or taxes reduced
- Increased Foreign Direct Investment – businesses and investors from third countries are likely to use the countries that are parties to the FTA as a springboard to trade with others
- Expertise and Technology Transfer – companies in one country should benefit from the skills and knowledge shared by the other
Both good and bad sides:
- Offshoring of jobs. It’s an advantage because it reduces the costs of the end product; it’s a disadvantage because it can result in unemployment in the richer country. The elimination of import duties makes it much more attractive to manufacture in the other country if its labour costs are lower. Very often, that means that components, rather than whole products, are manufactured abroad and imported for final assembly – because imports and exports also include products manufactured by foreign subsidiaries of domestic firms. This situation is most obvious in the car industry; in North America, US manufacturers have shifted production of labour-intensive components such as gearboxes and engines to Mexico. The same happens within the EU, where a high proportion of components are manufactured in Eastern countries such as Romania and Bulgaria where labour costs are much lower than Germany, France or the UK.
- Reduced tax revenues, if economic growth, and hence domestic income and corporation taxes and sales tax and VAT, does not compensate for the loss of tariff revenues
- Reduction in quality standards, where regulations in one country are eased to match those in the other
- Intellectual Property theft; knowledge transfer is usually an intrinsic element of trade deals, with the good intention of enhancing the skills in the other country, but that’s obviously open to the risk of IP theft
- Category Killers, where established smaller companies in one country simply cannot compete with larger players that enter the market from the other country as a result of trade barriers being removed
- Labour exploitation in the cheaper country, if jobs are transferred there and employment protection does not meet the other country’s standards
- Environmental issues and Natural Resource plundering. The risks most often cited are deforestation and destructive mining, but arguably the greater risk is that manufacturing is offshored to countries that use more polluting energy sources; for example, India, where most electricity is generated from coal, produces over twice as much carbon per unit of electricity than the EU average.
Generally, governments agree that the advantages of FTAs outweigh the disadvantages. But are they always right? As mentioned before, Trump is pulling out of some deals that previous US governments spent years pursuing. There’s a body of opinion in the UK that believes that walking away from the many trade deals negotiated by the EU and relying on WTO terms would be better, even if only as a stopgap until something better can be negotiated.
However, we’re trying to take a studied and pragmatic view here. In a future episode we’ll make a detailed review of the benefits and downsides that have come from some of the established trade deals, both bilateral and multi-lateral.
But before that, there’s still plenty of detail that we need to understand. In the next episode we’ll look at the role and history of the World Trade Organisation plays, and clarify key concepts such as Most Favoured Nation (MFN) status and the General Agreement on Tariffs and Trade (GATT).
To discuss how this is relevant to businesses planning or active in international expansion, contact the author Oliver Dowson [email protected]