Trading Blocs

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TRADING BLOCS

An evolving trend in international economic activity is the formation of multinational trading blocs. These blocs are made up of a group of contiguous countries that decide to have common trading policies for the rest of the world in terms of tariffs and market access but have preferential treatment for one another. Organizational form varies among market regions, but the universal reason for the formation of such groups is to ensure the economic growth and benefit of the participating countries.

Regional cooperative agreements have proliferated since the end of World War II (1939–1945). Among the more well-known ones are the European Union and the North American Free Trade Agreement (NAFTA). Some of the lesser-known ones include the Mercosur (Southern Cone Free Trade Area) and the Andean Group in South America, the Gulf Cooperation Council in West Asia, the South Asian Agreement for Regional Cooperation in South Asia (SAARC), and the Association of South East Asian Nations (ASEAN). The existence and growing influence of these multinational groupings implies that nations need to become part of such groups to remain globally competitive. To an extent, the regional groupings reflect the countervailing force to the increasing integration of the global economy—it is an effort by governments to control the pace of the integration.

Trading blocs take many forms, depending on the degree of cooperation and interrelationships, which lead to different levels of integration among the participating countries. There are five levels of formal cooperation among member countries of these regional groupings, ranging from a free trade area to the ultimate level of integration, which is political union.

Before the formation of a regional group of nations for freer trade, some governments agree to participate jointly in projects that create economic infrastructure (such as dams, pipelines, and roads) and that decrease the levels of barriers from those that allow little or no trade to those that encourage substantial trade. Each country may make a commitment to financing part of the project, such as India and Nepal did for a hydroelectric dam on the Gandak River. Alternatively, they may share expertise on rural development and poverty-alleviation programs as well as lower trade barriers in selected goods, as did SAARC, which consists of Bangladesh, Bhutan, India, Maldives, Nepal, Pakistan, and Sri Lanka. These types of loose cooperation are considered a precursor to a more formal trade agreement. The evolutionary path for the development of various forms of trading blocs is shown in Figure 1.

FREE TRADE AREA

A free trade area, which has a higher level of integration than a loosely formed regional cooperative, involves a formal agreement among two or more countries to reduce or eliminate customs duties and nontariff trade barriers among partner countries. Member countries, however, are

free to maintain individual tariff schedules for countries that do not belong to the group.

One fundamental problem with this arrangement is that a free trade area can be circumvented by nonmember countries, which can export to the member nation having the lowest external tariff and then transport the goods to the destination member nation without paying the higher tariff that would have been applicable if the goods had gone directly to the destination nation. In order to prevent foreign companies from using this export method to avoid tariffs, local content laws are usually introduced. These laws require that in order for a product to be considered "domestic" and thus not subject to import duties, a certain percentage or more of the value of the product should be sourced locally within the free trade area. Thus, local content laws are designed to encourage foreign exporters to set up their manufacturing locations in the free trade area.

A free trade area is not necessarily free of trade barriers among its member countries. Although it is an attempt by treaty to develop freer trade among the member countries, trade disputes and restrictions nonetheless frequently occur.

NAFTA

NAFTA is a comprehensive free trade agreement among Canada, Mexico, and the United States, and is an attempt to progressively eliminate most tariff and nontariff barriers to trade among these countries over a transition period that began on January 1, 1994 and concludes on January 1, 2008. The agreement also facilitates cross-border investment, requires that sanitary and phytosanitary standards for trade be scientifically based, and expands cooperation regarding the environment and labor.

NAFTA was preceded by a free trade agreement between Canada and the United States that went into effect in 1989. The United States has a free trade agreement with Israel as well. Mexico also signed a transatlantic free trade agreement with the European Union in 2000 without U.S. involvement. Likewise, Canada signed a trade deal with the Andean Group in 1999 as a forerunner to a possible free trade agreement.

The three NAFTA countries are very different in their economic structure, development, and size. The U.S. economy boasted a gross domestic product (GDP) of $11.8 trillion and a population of 295 million in 2004. While Canada's per-capita income is similar to that of the United States, its economy is only $1 trillion, or about 9

percent that of the United States because of its much smaller population of 33 million. On the other hand, thanks primarily to its NAFTA trade, Mexico's economy, which had been little more than 5 percent of that of the United States in 1998, grew to the size of the Canadian economy, or $1 trillion in 2004, although it has a relatively large population of 106 million.

Despite the different sizes of their economies, Canada and Mexico are the largest and second-largest trading partners of the United States. Nevertheless, trade between Canada and Mexico remains insignificant, while both the Canadian and the Mexican economies are dependent on the U.S. economy as their primary export markets. Both Canada and Mexico shipped about 87 percent of their respective total exports to the United States in 2004. For both countries, almost half of their trade with the United States takes place on an intrafirm basis, with parent companies and their subsidiaries shipping parts and products among their own corporate units.

European Free Trade Association (EFTA)

EFTA is another well-known free trade group; established in 1960, in 2005 it consisted of Iceland, Liechtenstein, Norway, and Switzerland. Although Austria, Finland, and Sweden used to be EFTA member countries, they joined the European Union (discussed later in this entry), and Switzerland has applied to become a member. It appears that EFTA will gradually merge into the European Union.

Southern Common Market (Mercado Común del Sur or Mercosur)

Established in 1991, Mercosur is a free trade area consisting of Brazil, Argentina, Uruguay, and Paraguay, with an automatic schedule for the lowering of internal trade barriers and the ultimate goal of creating a customs union. Chile, in 1996, and Bolivia, in 1997, became associate members. More recently, Peru, in 2001, and Venezuela, in 2004, also became associate members.

As can be seen from these free trade areas, their trading relationships are far from stable. Mexico also established a formal transatlantic free trade area agreement with the European Union without U.S. involvement in 2000. On the other hand, on December 11, 2002, the United States and Chile also reached a free trade agreement.

The Proposed Free Trade Area of the Americas

Possibly the most ambitious free trade area plan is also in the works. The Free Trade Area of the Americas (FTAA) was proposed in December 1994, by thirty-four countries in the region as an effort to unite the economies of the Western Hemisphere into a single free trade agreement. A framework similar to that of NAFTA would be extended southward, potentially opening a free trade umbrella over 800 million people who accounted for $17 trillion in GDP in 2004. Whether FTAA will materialize in the near future, however, remains moot. It is quite a challenge to reach an agreement among thirty-four countries (Cuba is excluded at the United States's insistence and French Guiana, officially part of France, is not taking part).

Regional cooperative agreements in the 1990s such as NAFTA and Mercosur have made trading within the continent much easier, but the South America markets are still less open than those of East Asia. Although many people doubted the U.S. government's power to stand up to domestic industries crying for protection, many are seeing FTAA as more than a remote hypothesis and are already preparing for it.

CUSTOMS UNION

The inherent weakness of the free trade area concept may lead to its gradual disappearance in the future, although it may continue to be an attractive stepping stone to a higher level of integration. When members of a free trade area add common external tariffs to the provisions of the free trade agreement, then the free trade area becomes a customs union.

Therefore, members of a customs union not only have reduced or eliminated tariffs among themselves but also have imposed a common external tariff on countries that are not members of the customs union. This prevents nonmember countries from exporting initially to a member country that has a low external tariff with the goal of sending the exports on to a member country that has a higher external tariff. The ASEAN is a good example of a currently functional customs union whose eventual goal is formation of a common market. The Treaty of Rome of 1958, which formed the European Economic Community (which evolved into the European Union), created a customs union made up of West Germany, France, Italy, Belgium, the Netherlands, and Luxembourg.

COMMON MARKET

As cooperation increases among the countries of a customs union, they can form a common market, which eliminates all tariffs and barriers to trade among its members, adopts a common set of external tariffs on nonmembers, and removes all restrictions on the flow of capital and labor among member nations. The 1958 Treaty of Rome that created the European Economic Community had the ultimate goal of creating of a common market—a goal that was substantially achieved by the early 1990s in Western Europe, known as the European Community (Austria, Belgium, Denmark, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, and the United Kingdom). German banks can now open branches in Italy, for example, and Portuguese workers can live and work in Luxembourg. Similarly, South American countries, led by the Mercosur and the Andean Group, are actively seeking to create a common market of more than 300 million consumers.

MONETARY UNION

A monetary union represents the fourth level of integration among politically independent countries. In strict technical terms, a monetary union does not require the existence of a common market or a customs union, a free trade area or a regional cooperation for development. Nevertheless, it is the logical next step after a common market, because it requires the next higher level of cooperation among member nations.

In Europe, the Maastricht Treaty, which succeeded the Treaty of Rome and called for the creation of a union (and hence the change in name from European Community to European Union), created a monetary union and has the ultimate goal of creating a political union, with member countries adopting a common currency and a common central bank.

The European Union keeps expanding, however. When it was founded in 1993, the European Union originally consisted of twelve countries (Belgium, Denmark, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, and the United Kingdom). As of mid-2005, the European Union had expanded to twenty-five countries (with the addition of Austria, Finland, and Sweden in 1995; and Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia, and Slovenia in 2004). Bulgaria, Croatia, Romania, and Turkey were likely candidates to join the European Union.

As part of the European Union movement, on January 1, 1999, the eleven countries of the so-called euro-zone (excluding then–European Union members Denmark, Greece, Sweden, and the United Kingdom) embarked on a venture that created the world's second-largest economic zone, after the United States. In 2000 Greece also joined the euro-zone as the twelfth member country. The ten new member countries that joined the European Union in 2004 were not members of the euro-zone in 2005.

The Euro

The seeds for the euro were sown in 1969. That year, Pierre Werner, a former prime minister of Luxembourg, was asked to chair a think tank on how a European monetary union (EMU) could be achieved by 1980. The Werner Report, published in October 1970, outlined a three-phase plan that was very similar to the blueprint ultimately adopted in the Maastricht Treaty, signed on February 7, 1992. Like the Maastricht Treaty, the plan envisioned the replacement of local currencies by a single currency. The EMU, however, was put on hold following the monetary chaos created by the first oil crisis of 1973.

The next step on the path to monetary union was the creation of the European monetary system (EMS) in the late 1970s. Except for the United Kingdom, all member states of the European Union joined the exchange rate mechanism, which determined bilateral currency exchange rates. Currencies of the, by then, nine member states could still fluctuate, but movements were limited to a margin of 2.25 percent. The EMS also led to the European currency unit (ecu)—in some sense the predecessor of the euro, though the ecu never became a physical currency.

The foundations for monetary union were laid at the Madrid summit in 1989, when the European Union member states undertook steps that would lead to free movement of capital. The Maastricht Treaty, signed shortly afterward, spelled out the guidelines toward creation of the EMU. Monetary union was to be capped by the launch of a single currency by 1999. This treaty also set norms in terms of government deficits, government debt, and inflation that applicants had to meet in order to qualify for EMU membership. All applicants, with the exception of Greece, met the norms, though in some cases (e.g., Belgium and Italy) the rules were bent rather liberally. These eleven countries forming the euro-zone surrendered their right to issue their own money starting in January 1999.

Monetary policy for this group of countries is now run by the European Central Bank, headquartered in Frankfurt, Germany. Three of the European Union member states—the United Kingdom, Sweden, and Denmark—decided to opt out and sit on the fence. Until 2002 the euro was in a "twilight zone"—existing as a virtual currency, but not existing physically. During this transition period, stocks, bonds, and government debt were denominated in the euro. Companies could use the euro for their transactions and accounting procedures. In 2002 the euro became a physical reality and went into circulation in all EMU member states. During the first half of 2002, local currencies and the euro coexisted. After July 1, 2002, the euro replaced local currencies, which then were no longer accepted as legal tender.

POLITICAL UNION

The culmination of the process of integration is the creation of a political union, which can be another name for a nation when such a union truly achieves the levels of integration described here on a voluntary basis. The ultimate stated goal of the Maastricht Treaty is a political union. In 2005 Britain remained the principal opponent of ceding any part of the sovereignty of the nation-state to any envisaged political union. Even the leading proponents of European integration—Germany and France—had reservations about a common defense and foreign policy.

Sometimes countries come together in a loose political union for reasons of common history, as with the British Commonwealth, consisting of nations that were once part of the British Empire. Commonwealth members received preferential tariffs in the early days, but when Britain joined the European Union, this preferential treatment was lost. The group now exists only as a forum for discussion and an expression of common historical ties.

The best-known political union that exists today is the United States. The individual states went through a process similar to the evolutionary path for the development of various forms of trading blocs in the early years after declaring independence from Great Britain in 1776.

see also European Union ; International Trade