Trading agreements and blocs

Trade agreements are made between countries to reduce or remove any barriers to trade that exist between themselves and the countries they trade with.

Trading blocs exist when countries agree a common set of rules governing trade between bloc members. These rules will be laid down in a trade agreement.

The generally accepted first trading agreement was the Zollverein, (German for “Customs Union”) which was established in 1834 to create a free-trade area across Germany.

Trading blocs are commonly formed between countries located in a particular geographical region, and are referred to as regional trading blocs (RTBs).

Today, there are ten [1] major regional trading blocs in the global economy, and include ranging from simple preferential trade areas (PTAs) to more complex customs unions.

Important regional trading blocs (RTBs).

Europe's Economic Area (EEA), which includes the European Union (EU).

The North American Free Trade Agreement (NAFTA)

The Mercado Comun del Cono Sur or Southern Common Market (MERCOSUR)

The ASEAN Economic Community (AEC)

The Common Market of Eastern and Southern Africa (COMESA)

The Asia Pacific Economic Cooperation (APEC)

The South Asian Association for Regional Cooperation (SAARC)

The Indian Ocean Rim Association (IORA)

The Latin American Integration Association (ALADI or LAIA)

The Southern African Development Community (SADC)

Preferential trade agreement (PTA)

A Preferential Trade Agreement (PTA) is the most basic form of trading agreement, and exists when one country unilaterally offers another (or several) countries a reduction or removal of tariffs on selected goods.

Under WTO rules, these agreements are exempt from the Most Favoured Nation (MFN) rule which prohibits members of the WTO from discriminating against other members.

Hence, PTAs are a special case of limited trade agreements which circumvent the need to offer all members the same tariff reduction as 'the most favoured' nation.

Typically, these relate to reductions in tariffs given to developing countries by developed ones, but increasingly developing countries are creating PTAs beween themselves.

Free trade agreements (FTA)

Free trade agreements, or FTAs, are multi-lateral agreements between a group of countries (trade blocs) to trade freely with each other. Barriers to trade, such as tariffs and quotas, are reduced or eliminated by mutual consent.

Ladder of economic integration

Customs unions

A customs union is a type of free trade area where, as well as agreeing to reduce tariffs between themselves, they also agree to have a the same tariff against non-members (‘third parties’), known as a ‘common external tariff’ (or CET).

The European Union's custom union is the most well-known one, but fifteen other’ customs unions have been registered with the WTO [2].

A customs union requires a relatively high level of economic integration between members given that operating an individual trade policy is no longer possible.

Common market

A common market, or single market is a step further in terms of the integration of the economies in a trading bloc.

For a single market to operate effectively, all of the barriers to trade, including non-tariff barriers, need to be removed, so that goods can move freely ‘as if’ the members were a single geographical country.

For this to happen, there also needs to be free movement of the other mobile factors of production – so, free movement of labour and capital are also required.

Monetary union

A monetary union is a yet further step towards the integration of countries in a trading bloc.

Monetary union involves the agreement to share a single currency, which also means sharing the same central bank, and having a common interest rate.

While the Eurozone of the EU is the most well-known monetary union, there are others, including the Eastern Caribbean Currency Union (ECCU) where members shared the East Caribbean dollar, which is pegged to the US dollar. There are several other examples of countries sharing a common currency, but with less close economic integration, including four countries that share the South African rand [South Africa, Namibia, Lesotho and Eswatini.]

The success of monetary unions may depend upon the extent to which the member countries can converge. Without economic convergence, the currency zone will find it difficult to manage asymmetric shocks.

Optimal currency zones

The theory of optimal currency areas - proposed by Canadian economist, Robert Mundell in 1961, provides a set of criteria that would lead to successful monetary union between countries.

Mundell considered that for a currency area to be optimal countries in the aresa would have shared macro-economic goals, including low inflation and full employment, and a sustainable balance with other countries who have joined the area.

Specifically, Mundell identified some key attributes of an optimum currency area:

  1. Labour mobility between members of the area - which would reduce the need for flexible exchange rates [which no longer exist].
  2. Capital mobility, which would help dampen the effects of any external shocks.
  3. Wage and price flexibility.
  4. Convergence in the business cycles of members

The effect of an asymmetric shock

The succcess of a monetary union depends upon how it deals with an asymmetric shock - that is, a significant event that affects one country (or region) differently than another country.

For example, if a currency zone was made up of both oil importing and oil exporting countries, a sudden spike in the global price of oil (the shock) would have an uneven effect. The oil importing country would be worse off, and the oil exporting better off - a least before any adjustments were made.

In a monetary union, with no ability to have different monetary policies, the oil shock could result in a persistent imbalance bewteeen the two countries.

A currency union removes two of the key levers of macro-economic policy – the ability of a country to alter its interest rate and its exchange rate to achieve an external balance. For a monetary union to be an 'optimal' currency area it must find other ways to deal with asymmetric shocks.

Mobility of factors and flexbility of wages

Using a simple example, assuming the shock results in an increase in demand for a good or service in country B, but a reduction in country A, the expected result is that prices (and wages) in B will rise, and fall in country A, creating a disequilibrium.

With a shared currency [and no possibiity of interest rates or exchange rate adjustments], labour (and capital) mobility is required.

Optimal currency area

The effect of the wage adjustment if that labour is attracted into country B from country A, shifting the supply curve for country B to the right, and country A to the left.

The result is that prices (and eventually wages) will readjust until there is equilibrium between the two countries once more. Hence, factor mobility is essential for a common currency area to be an 'optimal' one.

Of course, while a monetary union prevents individual members from operating their own individual monetary policy, they may be free to implement different taxes rates and fiscal policy, which can be used to help reduce the impact of asymmetric shiocks.

Members of the Eurozone may call upon central funds to ease the impact of any asymmetric shock, as Greece did in 2010 - supported by the Eurozone's European Stability Mechanism (ESM), and the IMF.

Analysis of trading blocs

As a member of a trading bloc there will be an incentive to trade more with other members given that barriers to trade are likely to have been fully eliminated. Trade is likely to be based on national specialisation and the exploitation of comparative advantage. The gains from membership that come from free trade within the bloc is called trade creation.

The benefits of trading blocs

The gains from free trade

Members of trading blocs can gain from the reduction of barriers to trade that may have existed before membership.

    The gains from free trade

  1. Countries can apply the principle of comparative cost advantage, increasing specialisation and efficiency.
  2. Trade can be created that did not exist before any free trade agreement.
  3. Employment gains may result from trade creation.
  4. Prices of goods and services are likely to fall as a result of increased free competition.
  5. If members join a regional bloc, (which most blocs are) then gravity theory implies that the gains from trade will be greatest between countries of similar size and level of development.
  6. There may be other gains from increased competition, such as improvements in quality, and the breakdown of domestic monopolies, and cartels.
  7. Other gains can be derived from co-operation and collaboration, including joint research, shared intelligence, and joint educational projects and schemes. .

In addition there may be some benefits arising from protection from low prices non-members, or other countries who are deliberately 'dumping' cheap products onto international markets.

Over time, existing firms develop closer trading relationships with their partners, and new firms emerge as a result of new opportunities to trade. The net result is that trade flows between members are likely to increase

As trade increases ‘dynamic effects’ may appear, including costs reduction as a result of economies of scale, increased competition, and greater efficiency. Productivity is also likely to increase, and the GDP of bloc members will rise accordingly. The popularity of Gravity Theory has also lent weight to the ‘consensus’ that trade is created as a result of the existence of regional trading blocs and increases when they are enlarged.

Protectionism

While members of trade blocs can derived benefits from trade liberalisation between themselves, they can also benefit by protecting themselves from free trade.

There are several benefits of protectionism, which can provide a strong motive to join a trading bloc. 

    The gains from protection

  1. As a bloc of countries, barriers to trade can be erected against other countries to defend particular industries from unfair competition.
  2. Infant industries can be protected to enable them to develop and achieve economic of scale.
  3. Declining industries can be protected to enable them to run-down at a slower rate so that structural unemployment is minimised.
  4. Tariff revenue can be derived from imports into the bloc, which can be shared between members.
  5. Joint policies can be agreed which might limit the flow of migrants from non-members, although inward migration can provide considerable benefits. With a joint approach, migrants are less likely to 'target' a particular member.
  6. Members can gain strategic advantages from protectionism, including developing agriculture to achieve food security.

Methods of protection

The most obvious method of protection is to employ tariffs against goods that are relatively low priced.

Other methods include:

    Methods of protection

  1. Import quotas, where countries (or trading blocs) impose limits on the quantity (or value) of imports. Quotas are seen as the most damaging in that the importing country does not derive any tariff revenue.
  2. Subsidising domestic firms through 'state aid' - this reduces the likelihood of imports, and may help stimulate exports through lower prices.
  3. Non-tariff barriers, including discrimination against imports, health and safety regulations, additional bureaucracy ('red-tape') against imported goods, border delays and additional border checks.
  4. Public procurement policies - where governments favour domestic producers by awarding public contracts to favoured local producers.
  5. Competitive devaluations, where a country deliberately keeps its currency low to encourage exports and deter imports.

[1] Culturalrelations.org - http://culturalrelations.org/the-10-major-regional-trading-blocs-in-the-world-economy/

[2] Institute for Government - https://www.instituteforgovernment.org.uk/explainers/customs-union