CHAPTER 2. ECONOMIC ASPECTS OF REGIONAL INTEGRATION

The academic literature on regionalism covers the contributions of economics, international relations and international political economy. Typical questions asked by these disciplines in the regionalism literature are summarized in Table 3. There is not space in this paper to pursue all of these questions. We focus on the contributions of economists who investigate the potential and actual economic impacts of forming regions. Economists’ analysis of regions begins with the classic theory of customs unions formulated by Viner, Meade and others and has been developed more recently in the context of imperfect competition (see Baldwin, 1997 for an accessible overview on which we draw in this section, as well as the recent volume by Schiff and Winters (2003) which summarizes the results of World Bank research on regional integration and development). This traditional theory is contrasted with the ‘developmental regionalism’ espoused by some theorists concerned with developing countries and still dominant among those concerned with African regionalism. With the trend towards deeper integration, we summarize the emerging literature on the gains from integrating services trade and from regulatory integration. The lessons for developing countries from the literature surveyed are summarized in conclusion.

Table 3 - Debates about regionalism

The traditional approach to regional trade arrangements

The traditional economic approach to regional trade integration assumes perfect competition in markets and is concerned with the implications of forming a region for the allocation of resources in a static sense. This static analysis distinguishes between the trade creation and trade diversion effects of regional trade integration.

Unilateral tariff reductions lead to trade creation

In order to understand these concepts, it is helpful to begin with the analysis of a country which unilaterally eliminates tariffs on all imports. As a result, the domestic price falls to the world price. Domestic production falls, domestic consumption increases and total imports increase. The reduction in tariffs leads to additional trade, or trade creation. The effect of the tariff reduction on economic welfare can be decomposed into three effects: the gain to consumers from lower domestic prices, the loss of profits to producers and the loss of tariff revenue to the government. Under the standard assumptions that resources remain fully employed and that prices reflect marginal costs and benefits, it is easily shown that the consumer gain exceeds the producer and government loss from reducing tariffs and that there is an overall gain in national welfare as a result of this policy change.

In some cases, the barriers to trade are not rent-creating policies such as tariffs but policies which raise the real cost of importing. Typical examples of such policies are complicated and slow customs procedures, or the imposition of spurious health, safety or technical standards. Resources which could be employed productively elsewhere in the economy are tied up (wasted) as a result of these barriers. The removal of such cost-increasing barriers magnifies the gain in national welfare from their elimination.

Discriminatory tariff reductions lead to trade creation and trade diversion

Now consider the consequences when a country (the home country) eliminates trade barriers with its regional partners but maintains them on trade with third countries. This complicates the analysis because it may lead the home country to switch its source of import supplies. If the partner country is already the low-cost supplier, then preferential trade liberalization leads to the same trade creation effect as earlier identified for unilateral trade liberalization. Trade creation takes place when preferential liberalization enables a partner country to export more to the home country at the expense of inefficient enterprises in that country.

But preferential liberalization, by maintaining tariffs against the rest of the world, may cause enterprises in the home country to switch supplies from the rest of the world to higher-cost suppliers in the partner country. The partner country again increases its exports to the home country but this time at the expense of exports from third countries. Trade diversion occurs when imports from a country which were previously subject to tariffs are displaced by higher cost imports which now enter tariff-free from partners. While trade creation contributes positively to welfare in the home country, trade diversion results in a welfare loss. The consumer gain on the volume of imports previously imported from third countries is less than the tariff revenue lost by the government (because, if the partner country is a less efficient supplier, the domestic price in the home country does not fall to the world price level).

This example focuses on the experience of a single partner in an RTA. It is possible that one or more partners in an RTA can gain from trade diversion in their favor. This is more likely if a country initially has lower tariffs or smaller imports from its partner. However, trade diversion is always a loss for the RTA overall. A simple numerical example of this proposition can be found in the appendix to this chapter.

A third effect comes into play in the traditional analysis if the RTA is large in world market terms, so that a change in its demand for imports influences the price at which those imports can be purchased. If, as a result of the formation of an RTA, the demand for imports in competitive markets is switched from third countries to a partner country, this leads to a decline in the price of third country imports and improves the union’s terms of trade vis-à-vis the outside world. In imperfectly competitive markets, there may be collective gains if regional integration makes it possible to shift rents away from third countries. Rents exist if firms in the Rest of the World (ROW) can exercise market power and price above marginal cost. Forming an RTA increases the amount of competition in the market and this affects not only domestic firms but also ROW firms which will find their ability to extract these rents eroded. Consumers and the RTA as a whole gain from the movement in the terms of trade in their favor.

Not only market power but also bargaining power can be increased by forming an RTA. To the extent that an RTA increases the joint bargaining power of its members, it may be more successful in obtaining tariff reductions from its trading partners (or avoiding the imposition of trade sanctions such as ‘Super 301’ threats)^[4]. This assumes that the countries making up an RTA have a sufficient economic size relative to the third countries with which they must negotiate, and this requirement limits the relevance of this argument in the case of developing countries. A nice example (though based on regional cooperation rather than a regional trade arrangement) is noted by Schiff and Winters (2002). They point out how the Organization of Eastern Caribbean States (OECS) wanted to impose waste disposal charges on cruise ships to prevent ocean dumping of solid waste which was threatening the fragile ecosystems on which the tourist revenue of the islands depends. The cruise lines warned the OECS governments that any island that imposed waste disposal charges would lose cruise tourism because the lines would move their business to other islands. However, by acting together (and, it should be noted, with some arm-twisting by the World Bank and other donors) the islands were able to face down the cruise lines and a pollution charge was introduced.

The importance of transfer effects

Economic analysis has emphasized the overall welfare consequences of regional integration at the expense of the distributional or transfer implications which are often crucial in determining its political sustainability. Transfers occur between members of a trade bloc because the removal of tariffs between them means that exports obtain better prices in the partners’ markets (a positive transfer), while the costs of imports net of tariffs increase (a negative transfer) (Hoekman and Schiff, 2002). Assume that the home country continues to import from ROW following formation of the RTA. Thus, the domestic price continues to be the world price plus the tariff on third country imports. The partner country, which previously would also have had to sell at the world price, now can sell at the domestic price in the home country. The home country loses the tariff revenue it previously collected on imports from its partner, and pays its partner more for its imports than it did previously. This amounts to a transfer from the home country to its partner exporting country. If the partner country also happens to be more developed or better off than the home country, then such transfers are clearly regressive and, over time, will call into question the sustainability of the integration arrangement.

Conditions for a positive welfare outcome...

The fact that the welfare outcome of preferential trade liberalization is ambiguous, the net result of the trade creation and trade diversion effects, has spawned a huge literature on the circumstances needed to ensure a net overall gain. As trade diversion is most likely when countries do little trade with each other prior to integration, one rule of thumb, although not an infallible one, is that regional integration between countries which trade little with each other should not be encouraged. Other circumstances favoring net trade creation include:

• Where tariffs and non-tariff barriers of member countries are high prior to integration, since this maximizes the likelihood of trade creation.

• Where members are geographically close, since this reduces transactions costs such as transport and communications.

• Where tariffs and non-tariff barriers to extra-regional trade are low after the region is formed since this minimizes the likelihood of trade diversion.

• Where members have complementary economic structures (dissimilar patterns of production) since there will be scope for inter-industry specialization.

These criteria led to the traditional view that the ideal grouping for economic integration includes countries at comparable levels of development but with disparate, complementary resource bases. Such countries would have the maximum to gain from integration but little to worry about in terms of the distribution of benefits in favor of rich countries at the expense of poor countries within the grouping.

Trade diversion costs should be measured relative to sustainable equilibrium world price levels. In the case of agricultural products it is widely recognized that world prices are distorted by various policy interventions, in particular the high subsidy levels paid by OECD countries. Any assessment of the trade diversion costs of an RTA with respect to agricultural trade should take into account the possible divergence between current world market prices and long-run social opportunity costs, particularly if the consequence of current depressed world prices as a result of trade-distorting policies results in irreversible loss of production capacity or changes in the local economy.

...are amplified if barriers are of the cost-increasing type

If the barriers restricting trade are cost-increasing rather than rent-creating barriers, the welfare analysis is quite different. Here, there is no tariff revenue accruing to the home country government before integration, and thus any reduction in domestic prices arising from sourcing supplies in a partner country can only have positive, trade-creating effects. As Baldwin (1997) notes with respect to African regional integration (p. 38):

“It would seem that trade within Africa has been hobbled by a very long list of cost-raising barriers. For instance the transportation system for intra-African trade is less developed than the one for extra-regional trade. The same is true of telecommunications and postal services. The implication is that removing cost-raising barriers on a regional - as opposed to multilateral - basis cannot lead to a worsening of welfare due to trade diversion”.

However, this argument is not a carte blanche to invest in regional infrastructure to ease trade between partners. Such funds have an opportunity cost, and the returns from integrating with the rest of the world may well be higher.

Modern contributions

Further welfare gains under imperfect competition

The trade creation gains identified in the previous section arise even under perfect competition because resources are re-allocated within the home country in line with its comparative advantage. In more recent analysis of welfare effects, the perfect competition assumption has been relaxed in models that allow for imperfect competition, economies of scale and product differentiation. These new analytical perspectives on market integration emphasize the pro-competitive effects of larger markets rather than comparative advantage. The additional sources of welfare gain under imperfect competition include:

• In many small countries the domestic market may not support a large number of firms and thus there is a tendency for firms to collude and raise prices at the expense of consumers. Reducing trade barriers may encourage firms to eliminate excess ‘fat’ (so-called X-inefficiency) as well as force them to price more in line with marginal cost (more competitors increases the elasticity of demand for a firm’s products and makes it more difficult for them to charge margins in excess of marginal costs).

• Larger markets as a result of regional integration may allow firms to exploit economies of scale, thus driving down costs and prices to local consumers.

• Larger markets may increase the range and variety of products which are available to consumers. In well-integrated customs unions such as the EU, much of the increase in intra-regional trade takes the form of intra-industry trade (the exchange of similar products such as Renault cars for Mercedes cars between France and Germany) rather than the classical inter-industry trade (such as the exchange of cars for wine between Germany and Portugal) which would be predicted on the basis of comparative advantage.

Additional gains from integration

Modern theory also highlights a number of other consequences of regional trade arrangements:^[5]

• Accumulation or growth effects. If closer integration improves the efficiency with which factors are combined it is also likely to induce greater investment. While this additional investment is taking place, countries may experience a medium-term growth effect. If such investment is associated with faster technical progress or accumulation of human capital as identified in the new endogenous growth models, long-run growth rates may also be improved.

• Investment effects. More emphasis is now given to the impact of regional integration on production via the effect on foreign direct investment and investment creation and diversion.

• Transactions costs and regulatory barriers. The traditional theory of customs unions was developed in the context of tariff reductions but, as noticed above, the welfare effects of integration can be quite different if the barriers removed are cost-increasing barriers. Following the EU’s experience with implementing its Single Market program, there is now greater awareness of the importance of barriers which raise transactions costs in inhibiting trade, and of the value of removing them.

• Importance of credibility. Many of the effects identified in the modern theory, especially those related to or requiring investment, assume that the integration effort is credible and will not be reversed. If credibility is lacking, and there is uncertainty among investors, their behavior is unlikely to be influenced. The emphasis on credibility assumes the existence of enforcement mechanisms which will ensure the implementation of commitments entered into when a country joins a regional integration scheme. The way in which access to a Northern country market might be used to enforce policy commitments has led to a new literature outlining the advantages of North-South rather than South-South integration arrangements on grounds quite different to the traditional allocation or accumulation effects.

Developmental regionalism

The traditional efficiency advantages of removing barriers to economic activities are likely to appeal to industrialized countries with large, diversified industrial structures where significant scope to re-allocate resources among alternative activities exist. Page (2000) points out that this source of gain is unlikely to be so important in developing country integration, and it has not normally been the objective of developing country groups.

“Their existing industrial structures are small relative to their economies or to their planned development, and the static gains from rationalising these among member countries by easing flows of trade are correspondingly small” (op. cit. p. 25).

Inward-looking regional strategies ...

For developing countries, the rationale for economic integration has often been structural in nature. They have been concerned with the development of new industries through cross-border coordination to exploit the advantages of economies of scale which a larger home market permits. Thus, much thinking in developing countries on the advantages of regional integration sees it as a development tool and specifically as a tool of industrial policy (Asante, 1997). The advocates of import-substitution industrialization strategies could see the problems of pursuing these strategies in the context of small home markets, and saw regional integration as the way to establish these industries on a more competitive footing. The implicit assumption was that the choices made within the regional context would be efficient, and that member countries would accept the resulting pattern of industrial specialization (Page, 2000). To avoid uneven levels of industrialization between the member countries, regional integration schemes were often accompanied by an explicit framework of measures designed to ensure an equitable allocation of new complementary investment. Positive discrimination in favor of the less advantaged countries was implemented through complementarity agreements.

...have proved ineffective...

The experiences of developing countries with regional integration schemes designed on this basis were disappointing. An OECD study examined the performance of 12 regional trading arrangements among developing countries which had been in existence for some time (York, 1993).^[6] Most resulted in only a very low level of economic integration, particularly in terms of trade relations. This failure was due both to political and economic reasons.

“In political terms, the ineffective nature of these arrangements is linked to the lack of commitment in adhering to and/or implementing the programs for regional trade liberalization and the inability of member countries to put regional goals ahead of national ones. For many countries - including some that were at the time recently independent nations - surrendering of (some) sovereignty for economic development was a sacrifice they were not prepared to make. When liberalization programs were put into place, many governments resorted to using unilateral and restrictive trade measures when import surges created pressures for domestic adjustment. Adjustment problems also led to conflicts between partners over the distribution of the costs and benefits to regional integration.

In economic terms, the ineffective nature of these arrangements for developing countries has been linked to a host of factors, including most prominently: differences in initial conditions such as disparate levels of income and divergent rates of industrial development that made the gains from trade uneven; low levels of initial integration that characterized many groupings, similar structures of production and resource endowments; inward-oriented industrial policies, and macroeconomic imbalances that made domestic adjustments and adjustments to mutual integration even more onerous” (op. cit., p. 10).

...and imposed large costs on poorer member countries

The developmental approach to regionalism among developing countries has been heavily criticized within the trade creation/trade diversion framework (Bhagwati and Panagariya, 1996). In this framework, the larger the share of third country imports in total imports, the bigger the tariff revenue loss when a region is formed. Similarly, trade partners with initially higher tariffs lose more when a region is formed because more tariff revenue is redistributed away from them. Since developing countries often have high extra-regional trade dependencies and initially high tariffs, they will tend to lose from forming regions. The costs in terms of trade diversion will be high with a high probability that not only individual partners but also the RTA as a whole will lose overall.

From this perspective, the failure of so many developing country regional groupings is not surprising. Poorer or less industrialized members found themselves in the position of subsidizing the inefficient industry of their neighbors and doing so without adequate compensation since the relative wealth of their partners did not permit extensive income transfers.

The new regionalism

Outward-oriented regionalism

The new regionalism is occurring in a very different policy context. It typically involves countries that have already committed themselves to lower tariff barriers and are pursuing outward-looking strategies. These policies reduce the scope for trade diversion costs. Moreover, static trade creation benefits are no longer the primary motivation. The new economics of regionalism stresses the potential gains from reduced administrative and transaction costs and other barriers to trade. These show up for an economy in increased inter-firm competition and a reduction of production costs and monopoly rents. To achieve these gains, however, much more than a simple free trade arrangement is called for if transactions and administrative costs are to be significantly reduced and market segmentation is to be overcome. But why could countries not seek these lower costs in the world market directly? One answer may be the lower transactions costs involved in producing for the regional market compared to the world market. Information on prices and consumer preferences are more readily available, and transport costs are lower.

The new regionalism also stresses that schemes of North South integration are likely to be more beneficial to developing countries (Venables, 1999). The first argument is that because industrialized countries are likely to be among the more efficient global suppliers, the costs of trade diversion (switching from cheaper global to more expensive partner imports) will be minimized. Schiff and Winters (2003) qualify this conclusion by pointing out that even small cost disadvantages for Northern firms can be costly for Southern partners because of the large amount of trade which will be involved. Also, if the Southern partner continues to import from the rest of the world over significant tariff barriers, prices in its market will not fall to the Northern partner price. Instead, there will be a substantial transfer of rents from Southern consumers to the Northern exporting firms.

A second argument favoring North-South RTAs is based on credibility. If developing countries want to establish the credibility of their policy reforms, locking these in through agreements with a Northern partner may be more convincing to investors (both domestic and foreign). The argument assumes that the costs of backsliding in the case of a Northern partner will be greater than for Southern partners. Again, the premises behind this assumption may not stand up to examination. While the Northern partner may have the market power to wield credible sanctions, it may not have the will (think of the public relations problems for the EU if it were to withdraw market access from a traditional African supplier because the latter introduced some discriminatory economic policy) or the motivation (the market of the Southern partner may be so insignificant that the Northern country has no material interest in retaining access to it).

Open regionalism is the logical conclusion of the new regionalism

A number of Asian and Latin American countries claim to be pursuing open regionalism. This is defined as regionalism that contains no element of exclusion or discrimination against outsiders. It implies that negotiated tariff reductions between members are agreed on an MFN basis and thus passed on to third party members of the WTO. The regional dimension consists in undertaking these cuts on a jointly agreed phased basis. In this process, open regionalism is a co-operative arrangement rather than a rules-based community. It has aptly been called ‘concerted unilateralism’. By definition, it avoids the trade diversion costs which have troubled developing country regional groups in the past. The recent experience of APEC, perhaps the best-known agreement of this type, suggests that such informal commitments may be vulnerable to breakdown in the absence of a wider forward momentum of multilateral liberalization.

Regionalism and services trade

A feature of the new generation of RTAs is that many of them aim to go beyond liberalizing trade in goods and include commitments to liberalize trade in services. The question can be posed whether trade in services has any characteristics which would lead to a modification or change in the conclusions reached about the impact of preferential trade liberalization in the case of goods. Mattoo and Fink (2002) have addressed this question and their conclusions are summarized here.

Extending preferences to trade in services extends conventional theory in two ways. First, because trade in services often requires that the producer be close to the consumer, the traditional analysis of cross-border trade needs to be extended to foreign direct investment and foreign individual service providers. Second, preferential treatment in the provision of services is rarely granted through tariffs, but through the discriminatory application of rules and regulations, or restrictions on the movement of capital or labor. For example, if there are limits on the number of telecommunications firms, banks or professionals that are allowed to operate, partner countries may receive preferred access to licenses or quotas. Or restrictions on foreign ownership, the number of branches, etc. could be relaxed on a preferential basis. The question is whether the use of instruments of this kind to implement preferential trade agreements, rather than tariffs, raise new issues for the welfare evaluation of RTAs.

Inclusion of services trade in RTAs likely to be beneficial

Mattoo and Fink’s conclusions are that, compared to the status quo, a country is likely to gain from preferential liberalization of services trade at a particular point in time. This is a stronger conclusion than is reached in the analysis of preferential trade in goods. The main reason is that barriers are often prohibitive and not revenue-generating, so there are few costs of trade diversion. In their words,

“Where a country maintains regulations that impose a cost on foreign providers, without generating any benefit (such as improved quality) or revenue for the government or other domestic entities, welfare would necessarily be enhanced by preferential liberalization. However, non-preferential liberalization would lead to an even greater increase in welfare nationally and globally because the service would then be supplied by the most efficient locations” (op. cit., p. 9).

Because restrictions on services trade in developing countries are much more pervasive than restrictions on trade in goods, the gains from removing these restrictions are likely to be a multiple of those obtainable from further goods trade liberalization. However, multilateral liberalization under the GATS is likely to be a more efficient way of ensuring these gains than regional integration. The reason again is the danger of trade diversion when liberalization takes place on a regional basis. This danger is particularly great in the case of RTAs between developing countries because the most efficient services suppliers are likely to be ROW firms.

Regulatory co-ordination: towards deeper integration

Governments introduce regulations to deal with problems arising from market failure, such as asymmetric information, externalities or natural monopoly. As tariff barriers have fallen, differences in national regulations have appeared as potentially significant barriers to trade. While differences in national regulations may reflect differences in social preferences, there is also the danger of ‘regulatory capture’ where domestic producer interests lobby for regulations which have a de facto protectionist effect. Parallel with the efforts being made in the multilateral trading system to develop international rules to reduce the protectionist impact of regulations, some RTAs now pursue a strategy of regulatory co-ordination to minimize the market-segmenting impacts of differences in national regulations. The best-known example of this process is the Single Market program pursued by the European Union since 1986. In many cases, RTAs are acting as laboratories in which different approaches to regulatory co-ordination are being tried, the lessons from which are feeding back into the multilateral negotiations under WTO auspices.

The question of regulatory co-operation is often presented as a choice between harmonization of regulations and standards or mutual recognition of the standards embodied in national rules.^[7] Harmonization removes the segmenting effect of differences in national standards by adopting the same regulations and standards throughout the RTA. As the EU’s experience showed, it can be a painfully slow process. The alternative approach is to encourage mutual recognition of the national standards and conformity testing procedures in place in each member state of an RTA. In both instances, states must have confidence in each other’s testing and enforcement procedures, but the mutual recognition approach involves, in addition, the possibility of competition among rules leading to a ‘race to the bottom’. This may occur if firms within the RTA lobby for less stringent regulation in the face of competition from firms located in more lax regulatory jurisdictions, or threaten to relocate from high- to low-standard countries. The extent to which competition among rules leads to convergence of standards in practice, or whether national diversities can continue, is an empirical matter on which there is limited evidence to date. In practice, harmonization and mutual recognition may be complementary rather than alternatives. EU experience suggests that mutual recognition will only be accepted as the basis for accommodating different national rules when the difference between national approaches is not too great.^[8]

There is little empirical evidence on the benefits from regulatory co-operation. Mattoo and Fink (2002) point to the following considerations as being important:

• If national standards are not optimal, then international harmonization can be a way of improving national standards.

• If national standards have been captured by protectionist interests, then international harmonization can be a liberalizing device.

• If national standards are optimal, then there is a trade-off between the gains from integrated markets and the costs of departing from nationally optimal standards. This trade-off is likely to be most severe in RTAs involving both developed and developing economies. The low-income country may have a low level of mandatory standards reflecting its optimal trade-off between price and quality, while the high-income country may have higher standards. Harmonization of standards produces the benefit of greater competition in the integrated market, but necessarily at a social cost in at least one of the partner countries. The problem may be particularly severe in the case of social or environmental standards where there may be sound economic reasons why differences in standards exist (Schiff and Winters, 2003). Because the aggregate costs of harmonization depend on the distance between the policy-related standards of the countries, Mattoo and Fink propose the concept of an optimum harmonization area composed of the set of countries for which aggregate welfare would be maximized by regulatory harmonization.

Mattoo and Fink conclude that there are gains for a country from regulatory co-operation, but also costs.

“The former will dominate where national regulation can be improved, as in the case of financial services, or is excessively burdensome in all countries, as in the case of professional services. Once national regulations are optimal, the benefits of international harmonization in terms of greater competition in integrated markets must be weighed against the costs of departing from nationally desirable regulations.” (op. cit., p. 22).

For developing countries, an important issue is whether harmonization on international standards is not likely to be the first-best alternative rather than trying to create regional standards. Indeed, many RTAs expressly provide for the use of international norms where they exist.

Implications for convergence

Fears over distribution of integration gains...

A crucial issue in the success of integration schemes is the equitable distribution of the gains from integration between countries. Locational effects have been important in many sub-Saharan African regions. Fouroutan (1993) argues that a common reason for the failure of regional integration in Africa is the concern among the poorest African countries that the removal of trade barriers may cause the few industries which they possess to migrate to industrially more advanced countries. The new economic geography throws light on the location decisions of firms by focusing on the interaction between scale economies (which favor concentrating production in one or a few locations) and trade costs (of which transport costs are the most important but which include any costs of moving goods to and keeping in touch with consumers). If production costs are equal, firms will want to locate close to consumers where the largest markets are. But there is a circularity here. The largest markets will be where firms are located because of the importance of other businesses and employees as customers. Baldwin (1997) explains this as follows:

“Accordingly there is a mutually amplifying interaction between transport-costs-avoidance and market size determination. Firms’ desire to be near customers tends to concentrate demand for intermediate and final products. And this agglomeration of firms’ and workers’ purchasing power tends to attract more firms. Thus there is a circular mechanism involving transport-costs-avoidance (firms’ wish to be near large markets) and market size (firms’ location decisions influence market size). We refer to this as ‘circular causality’.” (ibid., p. 49)

If some factors are immobile in the peripheral region, then a growing unevenness in dispersion of production will be accompanied by increasing wage differentials. Eventually, the attraction of relatively low wages may attract sufficient new investment to begin a process of cumulative growth and catch-up with the more prosperous regions (the experience of the Republic of Ireland in the EU during the 1990s may be an example of this effect). The impact of regional integration on this process is likely to be ambiguous.

...require specific redistribution mechanisms

Whether there is a tendency for countries within a region to converge is explored in the new growth theories which also emphasize the potential for catch-up (see Schiff and Winters, 2003). The simple theory outlined above suggests that whether convergence is observed or not will depend on the balance of opposing forces at a point in time. Jenkins (2001) provides evidence from the Southern African region that poorer members catch up with (converge on) richer ones through the process of trade. The more general lesson, however, is that relocation is inevitably part of the process of regional integration and, if it is politically unacceptable, integration schemes need to include mechanisms which minimize or offset these effects.

Implications for developing countries

The past experience of developing countries with regional integration schemes is not a happy one. The reasons for this can be illuminated with the aid of the simple theory of customs unions outlined in this chapter. Preferential trade arrangements give rise both to trade creation and trade diversion effects, as well as to transfers between the member countries. The design of RTAs among developing countries in the past tended to maximize the costs of trade diversion (because of high external tariffs) and also encouraged regressive transfers from poorer to better-off members of such arrangements.

The recent more favorable assessment of regional integration arrangements involving developing countries is based on the following considerations. Regionalism will lead to net trade creation as long as it is coupled with a significant degree of trade liberalization and where emphasis is put on reducing cost-creating trade barriers which simply waste resources. Regional economic integration may be a precondition for, rather than an obstacle to, integrating developing countries into the world economy by minimizing the costs of market fragmentation.

Regional integration may also be pursued to provide the policy credibility which is necessary to attract investment inflows. For those who emphasize this effect, North-South arrangements are to be preferred to South-South agreements which are unlikely to generate significant credibility gains.

The ‘hub and spoke’ configuration of the emerging structure of RTAs was highlighted in Chapter 1. Not surprisingly, the US and the EU appear at the center of many of the new integration arrangements, raising the specter of a world of trade mega-blocs (Crawford and Laird, 2000). The negotiating strength of hubs and spokes is likely to be unequal. Any economic gains for countries that are successful in creating an RTA with one of the larger economies will come partly at the expense of countries which are unable or unwilling to do so. A ‘domino’ effect may drive outsiders to seek their own preferential agreement at a later stage. The addition of these latecomers may be resisted by the incumbents who might interpret a widening of the RTA as diluting their earlier welfare gains. Crawford and Laird (2000) argue that the emerging mega-blocks ignore, for the most part, the least-developed countries, particularly those in sub-Saharan Africa and South Asia. The EU’s willingness to transform non-reciprocal preferences under the Cotonou Agreement into reciprocity-based Economic Partnership Arrangements is an obvious exception to this generalization. Their conclusion must also be qualified by noting that both the US and the EU offer non-reciprocal preferential access to many of these countries through, for example, GSP schemes, the Cotonou Agreement, the US Trade and Development Act, and the EU’s Everything But Arms initiative. However, these preference schemes are unilateral and do not extend to the deeper areas of integration now increasingly common in RTAs.

North-South RTAs have been seen as more likely to result in gains to developing countries as compared to South-South RTAs, on the grounds that they minimize trade diversion costs and maximize the gains from policy credibility. Closer examination of these arguments, however, suggest that the assumptions on which they are based may not always stand up. Positive economic outcomes will depend on the deliberate design of these agreements, and cannot simply be assumed.

The growing propensity of RTAs to include aspects of policy integration also poses a challenge for developing countries. Although these aspects are most common in RTAs involving high-income countries, a growing number of North-South agreements now have broad integration objectives. The removal of non-tariff barriers which act to segment markets can be potentially beneficial, but whether this turns out to be the case in practice will depend on the nature of the policy integration. The costs to developing countries of harmonizing inappropriate policy regulations may exceed the benefits of encouraging greater market access.