The Sri Lankan FTA debate: Substance and semantics: Part 1

A point often made by proponents of FTAs is exports from Sri Lanka are not growing fast because the country is lagging behind the fast-growing countries in Asia in signing FTAs. This observation is simply a misinterpretation of ‘coexistence’ as ‘causality’ – Pic by Shehan Gunasekara

The Government of Sri Lanka has embraced Free Trade Agreements (FTAs) as a key focus of the national trade and development strategy. The rationale of this policy choice has been intensely debated in Sri Lankan policy circles. The debate has reached a new heights following the release of the report of the Committee of Experts (CoE) appointed by the President to evaluate the Sri Lanka-Singapore Free Trade Agreement.

The purpose of this article is to assess this debate. It begins with as overview of the role of FTAs as an alternative to multilateral and unilateral liberalisation to provide the context for the Sri Lankan debate. This is followed by a preliminary assessment of the trade outcome of the Sri Lanka-India Free Trade Agreement (SLIFTA) and Sri Lanka-Pakistan Free Trade Agreement (SLPFTA). 

The next section makes some observations on the likely impact of the Sri Lanka-Singapore Free Trade Agreement (SLSFTA) and the recommendation made by the CoE. The closing section offers some concluding remarks. The article focuses solely on the economic rationale of FTAs ignoring political considerations.

 

FTAs in world trade system: An overview

FTAs and trade opening

By definition, a Free Trade Agreement (FTA) is a treaty between two or more countries under which all tariffs are eliminated on goods produced in member countries, while keeping tariffs on trade with non-member countries. However, in practice tariff concessions are given on a selective basis, depending on lobby-group pressure in the process of FTA negotiation and perhaps genuine concerns about industrial adjustment problems associated with trade opening. 

The coverage of the eligibility list varies significantly among FTAs. Even for the products included on the eligibility list, tariff preferences are not automatic but subject to meeting rules of origins (RoOs), which are an integral part of any FTA. For these reasons, the term ‘free trade agreement’ is, in fact, a misnomer; the more meaningful term, which is preferred by prominent trade economists, is ‘preferential trade agreement’ (PTA). However, in this article we stick to the popular term, FTA.

In an FTA, unlike in a customs union (CU), the participant countries maintain their own external tariffs, which usually differ between member countries, while offering concessional tariffs to the member countries. Thus, it is necessary to combine tariff concessions with RoO to prevent ‘trade deflection’, that is, transhipment of goods from non-member countries through the member country with the lowest external tariffs to other FTA members.  

If eligibility criteria imposed for the identification of the true originating of products are stringent and the related administrative mechanism is cumbersome or corrupt, then RoOs can diminish, or even render worthless, the preference margin offered to traders (Krishna 2006). There is always possibility to tweak RoOs or delay the approval process in response to lobby group pressure to undermine the expected trade opening under an FTA (Falvey and Reed 2002). 

Because of these reasons, how the RoO are designed and implemented matter a lot for understanding how much market access an FTA really confers. (A CU is an FTA with the member countries imposing a common external tariff on a given product (European Union (EU), Central American Common Market (CACM) and Caribbean Community (CARICOM) are examples). Given common external tariffs, transhipment is not an issue relating to CUs)

The RoO are set based on two criteria: regional value content (RVC) and change of tariff classification (CTC). The RVC criterion requires that the cost of material and processing cost within the FTA member countries represent a set minimum proportion of the value of the final product. The CTC criterion requires that the ‘non-originating material’ (that is, intermediate inputs imported from non-member countries) used in production belongs to a different commodity code (category) of the Harmonised System (HS). 

Until recently, the RVC criterion was by far the dominant norm used in setting RoO. Designing and application of RoOs have become increasingly complicated in recent years because of the rapid growth of international fragmentation of production: the geographical separation of activities involved in producing a good (or service) across two or more countries within vertically integrated production systems. It is difficult to apply the standard value-added criteria in a context where trade in parts and components and final assembly occur in different countries, because assembly in a given location within a production networks has a very thin value-added content. For this reason, most FTAs now use a mixture of the two criteria.

Within the limits set by the actual products coverage and RoOs, the actual trade outcome of an FTA depends on two key factors: ‘supply response’, and ‘trade compatibility’. The term ‘supply response’ here refers to capacity of an economy to increase supply of exports as well as to achieve productivity gains by facing import competition under an FTA. It depends on a wide range of factors, many of which fall outside the ambit of an FTA. These factors include not only trade and industry policy, but also the country’s trade-related institutional infrastructure, human resource development and all the other elements determining the flexibility of the economy responded to emerging opportunities in the global economy.

In the negotiation and implementation process of an FTA, the attention of policy makers is often distracted from these vital supply-side issues. This is because FTA negotiation has its own attractions to the political leadership and the high-level technocrats compared to domestic reforms. FTAs help attracting media attention (‘photo opportunities’) and foreign dignitaries visiting countries like (or request) to sign agreements. Negotiating FTAs is also relatively less cumbersome compared to handling messy domestic supply-side issues. 

Whatever the drivers may be, the policy bias in favour of FTAs has significant (but hidden) cost to the economy: in a country with limited technocratic and institutional capabilities. There is always the possibility of a costly trade-off between signing FTAs and undertaking much-needed supply-side reforms (Cattaneo 2009, Bhagwati et al 1998).

Trade compatibility is the extent to which the trade patterns of a given country match with that of its partner country: whether products exported by a given partner country are the ones mostly imported by the other partner country and the vice versa. The degree of trade compatibility depends on a country’s comparative advantage in international production, which intern depends on the nature of resource endowment and the stage of economic development. 

The economic size of the country also matters because larger counties generally tend to have a more diversified product mix. Most of the FTAs listed in the policy debate as ‘success’ cases (such as the North American Free Trade Agreement ( NAFTA), Vietnam – US FTAs and FTAs of Australia and New Zealand with China) are between countries with strong trade compatibility on both import and export sides.



Trade effects of FTAs

Over the past three decades, FTAs have become an integral and enduring part of the global trading system. The number of FTAs notified to the World Trade Organization (WTO) increased from 19 in 1990 to 292 by January 2019 (http://rtais.wto.org/UI/Charts.aspx).The share of world trade accounted for by member countries of FTAs increased from 28% in 1990 to over 55% by the end of the first decade of 2000s (WTO 2011). These figures are often misleadingly quoted in the Sri Lankan policy debate to imply that Sri Lanka is going to be marginalised in world trade unless get into the FTA game (Ratnayake 2017).

However, the recorded total trade of FTA partner countries is not the same as trade occurring under trade preferences offered by FTAs. According to calculations by the World Trade Organisation (WTO), only 30% of world trade takes place on preferential basis, but this figure drops to 16% when trade within the European Union (which is a CU) is excluded (WTO 2011). The available evidence on the operation of FTAs in Asian countries also suggests that the utilisation of tariff concessions offered under FTAs are rather low, ranging from 5% to 20% across different product categories (Cheongh and Choc 2009, Jongwanich and Kohpaiboon 2017, Menon 2014, ).

There is also evidence that the utilisation rates are often firm or industry specific. Normally, utilisation rates are high for large firms and firms with close trade and FDI ties or those located in specific industries where complying with RoO requirements are simple and straightforward. The upshot is that, not only the actual trade effect of FTA is low, but also FTAs are unlikely to have the potential to promote trade in a neutral and broad-based fashion.

Why the actual trade effect of FTAs is much lower than what the FTA enthusiast claim? First, much of the trade between FTA members is in goods on which MFN tariff rates are zero or rather small in the first place. Most countries also provide dusty free accession to imported inputs used in export production through Free Trade Zone (FTZ) schemes and duty drawback schemes. Second, goods that are subject to high tariffs are often excluded from the list of products earmarked for duty concessions in most FTAs. Third, world electronics trade is virtually free of duty thanks to WTO’s Information Technology Agreement ITA), which came into effect in 2006. Fourth, and perhaps more importantly, traders in many countries simply ignore FTA tariff concessions because of the administrative cost and other administrative complications.

The ITA, concluded at the WTO’s Singapore Ministerial Conference in 1996, is a pluralistic agreement that requires participant countries to eliminate tariffs on a specific list of information technology products (computers, semiconductors, semiconductor manufacturing and testing equipment, telecommunication equipment, computer software, and scientific instruments). So far 75 countries have signed the ITA. These countries account for about 97 % of world trade in IT products. IT products covered by the agreement amount to about 34% of total world manufacturing trade. A country that become a signatory to a pluralistic agreement opens its market to both member- and non-member countries.

A point often made by proponents of FTAs is exports from Sri Lanka are not growing fast because the country is lagging behind the fast-growing countries in Asia in signing FTAs. This observation is simply a misinterpretation of ‘coexistence’ as ‘causality’. These countries (and, in fact, all high performing countries in East Asia) had become dynamic exporting nations well before the new penchant for signing FTAs (Perkin 2013). In fact, South Korea and Taiwan achieved supper-past export growth in the 1980s in a hostile international environment with high tariffs and quantitative restriction in most destination countries. 

Broader unilateral reforms with emphasis on export orientation was the key to their export success (Rodrik 2018).In any case, as noted above, the available evidence suggests that only a small share of Asian countries’ trade occurs under the existing FTAs: FTAs are mostly ‘window dressing’. It is also important to note that most of these countries are signatories to the ITA and hence FTAs are virtually irrelevant for the electronics industry, which cover on average over a half of each of these countries exports.

The proponents of FTAs may ask why countries are so enthusiastic in signing FTAs if the actual trade flow effect is very low. This issue has been well addressed in the recent literature on FTAs (Rodrik 2018, Cattaneo 2009, Irvin 2018, Krishna 2014). 

First, countries sign FTAs as much for foreign policy and security reasons as for economic reasons. Second, there is the so-called ‘bandwagon’ effect, the tendency to follow others without considering actual economy implication. Third, as already noted, there is a tendency on the part of the politician and technocrats to place greater emphasis on the FTA path to trade opening for various non-economic reasons. In sum, an FTA is rarely, if ever, based on a single motive, the contracting parties to an FTA often have different and sometimes even conflicting objectives.

The proponents of FTAs often mention that the increased emphasis on signing FTAs reflects deep frustration resulted from the failure to make substantial progress with the Doha Round of Multilateral trade negotiation initiated in 2001. However, an inspection of the annual data on the reporting of FTAs to WTO clearly shows that proliferation of FTAs started around the time of successful completing of Uruguay Round negotiation that significantly brought down trade barriers worldwide under the newly restabled WTO. 

Over 60 of the existing FTAs care into effect between 1994 and the year of launching of the Doha Round (2001), when there were high hopes of further reforms under the WTO. It seems that the launching of the NAFTA in January 1994, a landmark in the history of regional trading arrangements, and positive prognoses made by some prominent economists of NAFTA’s trade effects (e.g. Summers 1991, Krugman 1991, seem to have had a significant demonstration effect on the proliferation of FTAs in the ensuing years.

Do FTAs play a vital role in attracting Foreign Direct Investment? The available empirical evidence on this issue are mixed, at best. Moreover, the available ‘positive’ evidence relates predominantly to FTAs involving developed and developing countries (Stevens et al. 2016). The best inference possible from the available evidence is that FTAs can play a role at the margin if and only of other preconditions required for making the country an attractive place for FDI are met. It is also important to note that signing bilateral investment protection treaties (BIPTs) is an alternative to FTAs for facilitating FDI. However, regardless of whether a country sign an FTA or a BIPT, the outcome depends on complementary supply-side reforms (Dollar et al 2005, Hallward-Driemeier 2003, Stevens et al. 2016).

There are possible untoward institutional implications of the newfound enthusiasm for signing FTAs. With the proliferation of FTAs, tariff structure of a country will become highly differentiated, giving rise to inefficiencies in resource allocation. Overlapping of the standard MFN tariff and FTA tariff concessions, and multiple ‘rules of origin’ attached to the later complicate customs of administration and weaken efficiency improvements in the custom system and opens up opportunities for corruption (Bhagwati 2008, Krishna 2014, Arvin 2008).

In recent years, FTAs have evolved and gone beyond eliminating restrictions on trade at the border into provisions for institutional harmonisation between the member countries relating to intellectual property, health and safety issues, labour standards, labour migration, investment proportion and protection, banking and finance, investor-state dispute settlement and others. 

These FTAs with multiple provisions are now popularly known as ‘modern FTAs’. The stated rationale for broadening the coverage of reforms is to achieve deep economic integration among the member countries going beyond what can be achieved through the shallow cross-border integration through trade reforms. There is, however, scepticism on how much deeper FTAs can go beyond the possibilities offered by the WTO process or unilateral reforms. Whether or not some of these provisions will have significant effects (whether) remains an open issue for further research. This issued has been widely debated relating, in particular, to provisions on cross border investment and cross-border labour migration (Krishna 2014). 

(Athukorala is Professor of Economics, Australian National University, and can be reached via [email protected]. 

Silva is former Ambassador and Permanent Representative to WTO and former Deputy Head UN-ESCAP New Delhi Office and can be reached via [email protected]. Silva’s contribution to the article comprise his own views and do not reflect the organisation that he is currently affiliated with. 

The full article with references is available on request from: [email protected].)

The Sri Lankan FTA debate: Substance and semantics: Part 1

The Sri Lankan FTA debate: Substance and semantics: Final Part