Trading Blocks Concept in International Economics

The post-second World War period has seen a growing interest in integrating national economies at regional levels. The efforts to form regional groupings, trade blocks and treaties have often floundered due to political differences and unforeseen economic hurdles.   The motivation arises out of the realization of the limitations imposed by national frontiers and the expected benefits of a wider market, consisting of several national economies.

Regional trade agreements represent an attempt by a group of countries to increase the flow of trade and investment by reducing direct and indirect trade barriers between them, as well as implement similar trade policies vis-à-vis outsiders. Multinational trade blocks are a major global trend. Most of these blocks are formed by geographically close countries, and revolve around a small group of larger economies. This is further testament to the importance of closeness and proximity in establishing network structures. Proximity in this case refers to both geographic as well as economic and social similarities among countries. Such trade and economic conglomerations give the group a bigger role in the world economy, and insures that smaller member countries are not marginalized. In a recent study of future high growth areas, it was shown that world trade and regional trade conglomerations such as NAFTA, ASEAN, and the EU will fuel economic growth.

The common trading policies and preferential treatment for member countries created by a trade agreement have the double effect of promoting intra-regional trade, while, at the same time, putting outsiders at a disadvantage. This has two major implications for investors. First, due to the liability of being an outsider, many companies decide to set up shop inside a trade area in order to benefit from the intra-regional preferential arrangements. Second, in most cases, countries do not stop at homogenizing their trade policies, but rather move towards greater trade and economic integration. This is further evident in the continuously increasing degree of integration between the economies of Western Europe. Such trends create greater market similarities as laws and business practices are standardized within the region. Market similarities have been identified in the literature as an important determinant in foreign market selection decisions. In addition, costs associated with international commerce can be reduced when doing business in similar markets as harmonization of trade practices reduces the need for adopting different trade approaches for different markets.

The rapid growth of regional trading relationships in Europe, Asia, and Latin America has raised policy concerns about their impact on excluded countries and on the global trading system. Some observers worry that the multilateral system may be fracturing into discriminatory regional blocs. Others are hopeful that regional agreements will go beyond what was achieved in the Uruguay Round and instead become building blocks for further global liberalization and WTO rules in new areas. Jeffrey Frankel shows through extensive empirical analysis that the new breed of preferential trade arrangements is indeed concentrating trade regionally. He then assesses whether regional blocs are “natural” or “supernatural”–that is, whether they enhance or reduce global welfare. He concludes that a move to complete liberalization within blocs, with no reduction in barriers between blocs, would push the trading system into the super natural zone of an excessive degree of regionalization. More balanced patterns of liberalization, however, give favorable outcomes. He considers regionalism at two levels: both the formal trading arrangements that are already in effect, and the broader continent-sized groupings that are under discussion (the Americas, Europe, and the Asia Pacific). Frankel’s study also assesses the political and economic dimensions of regionalization and its implications for world economic prospects and public policy. In conclusion, Frankel proposes several policy prescriptions for pursuing partial regional liberalization among blocs as a stepping-stone toward global free trade.

Conditions for Success of Trading Blocks

One of the questions that are raised these days is whether the World Trade Organization, the European-Mediterranean agreements, and the Arab common markets are complementary or substitute arrangements. This question is not only interesting, but also relevant and provocative: It is interesting because the answer is not obvious. For instance, many hold the view that countries may lock themselves into regional trade agreements and might not necessarily feel the pressure to open up their markets beyond those agreements. It is relevant – and not merely academic – as all countries in the Middle East and North Africa region are dealing with it or will have to deal with it in the immediate future. In fact, these countries have been liberalizing their trade regimes, simultaneously negotiating with the EU and, for some time, trying to integrate into an Arab common market. And it is provocative because, in trying to answer it, many people might end up supporting the Euro-Med agreements rather than an Arab common market, which would make others unhappy.

The question of whether trade agreements are compliments or substitutes to the WTO depends in part on whether they are building or stumbling blocks toward full liberalization. It also depends on whether these agreements are favorable to countries’ development. In this connection, three conditions seem to make these agreements beneficial.

First, these agreements work when countries have both the economic and political incentives to conclude them. Here the main issue is that even when the economic incentives are present, political realities might offset them, and vice versa. For example, for some time, countries in the Arab region have been trying to create a common market. Although the political incentives are probably there, perhaps the economic incentives are not strong enough to push countries in that direction. As a result, there is no Arab common market. At the same time, over the last two years, Morocco and Tunisia have signed trade agreements with the EU, Egypt is about to sign one, and other Arab countries are negotiating similar deals.

Why are these countries signing trade agreements with the EU? The reason is that the economic incentives are present and, at the same time, there are no political considerations constraining them. In other words, it is hard to find convincing arguments for these countries not to sign trade agreements with the EU. Moreover, the proximity between Europe and the Middle East and the lack of competition between their respective production structures act as positive factors towards trade cooperation – the latter element being absent among Arab countries, where the production structures are very similar.

Second, trade agreements are successful when complementary domestic reforms are simultaneously undertaken. For instance, if a country such as Egypt signs a trade agreement with EU, as tariff barriers are removed, its domestic industry will face increasing competition from European producers. Although the country might at first have a comparative advantage in terms of labor costs, the transaction costs of domestic production may eventually prove to be too high – even as European inputs become cheaper – to the point where Egyptian exporters would not be able to penetrate European markets. For that reason, for Egypt or any other country to take full advantage of a trade agreement with the EU, it will need to reduce these transaction costs – which include shipping and communications, processing and even bribes. In addition, investments will converge in those areas where production costs are cheap and export markets are large. Therefore, to the extent that transaction costs are high and that domestic reforms are not undertaken to reduce them, investors will tend to look elsewhere. In sum, domestic reforms are an essential condition for the success of trade agreements.

Third, some trade agreements that do not appear advantageous in the short term may be beneficial in the long term. This relates to the fact that “vertical integration” – or trade agreements between countries in the region and the EU – and “horizontal integration” – or trade agreements among countries in the region – can be reconciled in time. On the basis of the existing economic and political incentives, it may appear that it is in the interest of a country such as Egypt to open up its economy first to a large trading partner such as the EU than to other countries in the region. After all, Egypt’s exports to and imports from the EU represent some 50 percent and 40 to 50 percent of the total, respectively.

In contrast, the country’s trade within the region accounts for less than 10 percent of its total trade. Therefore, based on strict reveled preferences, it does not appear that integration within the region is nearly as attractive as integration with the EU now. Moreover, as Egypt, Morocco and Tunisia move towards greater economic integration with the EU, investors from the EU and possibly all three countries will choose to locate where they can serve a larger market – that is, the EU, which will in turn reduce even further the appeal of horizontal integration. However, at a later stage, to the extent that these countries become more open and attractive for investors, it will be beneficial for them to integrate horizontally, as that would create a larger market, which would further attract investors to the region. In other words, while horizontal integration may not appear attractive in the short term on economic grounds, the likelihood is that, in the long term, it will become beneficial, mostly as a result of the economic effects of vertical integration with the EU.

Forms of Trading Blocks

There are four different forms of trading blocks:

1. Free Trade Area: If the members of a preferential trade arrangement go so far as to eliminate all tariffs and quantitative import restrictions among themselves (100 percent preferences), then they form a free trade area (FTA). Typically, they retain varying levels of tariffs and other barriers against the products of nonmembers. Uncompetitive industries in the more highly protected member countries may have sufficient clout to prevent their shields from being lowered to the same levels as in the less-protected member countries.
2. Customs Union: The next level of integration occurs when the members of an FTA go beyond removing trade barriers among themselves and set a common level of trade barriers vis-à-vis outsiders. This at a minimum entails a common external tariff. A full customs union would also harmonize quantitative restrictions, export subsidies, and other trade distortions. Indeed, it would set all trade policy for its members as a unified whole. It would, for example, engage in any future trade negotiations with other countries with a single voice.
3. Common Market: Beyond the free exchange of goods and services among members, a common market entails the free movement of factors of production: labor and capital. The dividing line is admittedly sometimes blurred between the free exchange of services and the free movement of factors: labor includes services such as construction or consulting, and capital includes banking and other financial services. The free movement of capital applies to portfolio capital as well as to foreign direct investment (FDI), which is the purchase and sale across national boundaries of real estate, plant, and equipment. This is deep integration in that it impacts some laws and institutions that could have been preserved as domestic prerogatives even with a high level of trade integration.
4. Economic Union: Going beyond the free movement of goods, services, and factors, economic union involves harmonizing national economic policies, including typically taxes and a common currency. There is a unified central bank and a common currency. The fiscal as well as monetary policies are well co-coordinated, some of them being decided by the central bank. The decision of the European Community to change its name to the European Union in 1994 represented a determination to proceed to this higher stage of integration. The countries forming an economic union have to give up a lot of economic and social freedom in favor of the central decision-making authority.