Prospects for the Doha Round -Major Challenges in the Multilateral Trading System and their Implications for Japan-

ISHIKAWA Jota, Faculty Fellow, RIETI/Professor, Graduate School of Economics, Hitotsubashi University, began by giving a presentation on the "Strategy and Benefits of Multilateral Versus Regional Trade Liberalization."

This presentation has two purposes. One is to elucidate the benefits of free trade from the viewpoint of economics. This is necessary because some people talk about free trade without regard to economics and these people tend to be blind, ideological adherents to the concept of "free trade." The other purpose of this presentation is to examine the means of trade liberalization, specifically multilateralism versus regionalism. In particular, I would like to consider, given the rapid increase in the number of FTAs, how free trade can be further promoted, and the various advantages and disadvantages of the two approaches.

Theoretical support for trade itself begins with the arguments in the Ricardian model and goes on to the Heckscher-Ohlin model and the specific factors model. These traditional models basically tell us that the laissez-faire system allocates resources optimally from the view point of Pareto efficiency. This is, however, a greatly simplified theory. It works only under the assumptions of perfect competition, constant returns to scale, and the absence of externalities. The theory also requires consideration of the compensation principle, by which groups that benefit from free trade compensate those that lose, as well as the principle of equity, which addresses the issue of how the economic pie should be divided up.

Then, should free trade be supported even though there are market failures? Yes. First, if foreign trade is liberalized in an imperfectly competitive economy, competition will be promoted as domestic firms are forced to compete with foreign firms. Moreover, free trade enables consumers to choose their goods from greater variety even if the producers of those goods have some market power. If there exist economies of scale, international trade will expand the markets and a country's economies of scale can be exploited. As for externalities, trade in goods and services may lead to spillovers of technologies and knowledge across countries. The "second best theory" suggests that free trade may reduce economic welfare when there are some distortions in a market. However, under such conditions, it is important to adopt policies that directly address such distortions in order to correct them and thus promote the benefits of free trade.

Some other advantages of free trade can be mentioned from the viewpoint of political economy. For one thing, the commitment of a government to free trade narrows the opportunity for rent-seeking. For another, if the purposes of the government are distorted by rent-seeking due to electoral inefficiencies, for example, these distortions can be eliminated. In addition, the advantages of a commitment to free trade can be explained by the facts that even when a government intends to maximize economic welfare, this can be impeded by imperfect information and that there is a risk that specific groups may lobby the government to manipulate trade policies.

Having established the benefits of free trade, the question arises of how best to promote it. Some support multilateralism, in which a multilateral trade system is designed to encourage free trade. Others prefer regionalism, which is embodied in the RTAs, the number of which has been increasing since the 1990s. A typical type of RTA is a customs union. In a customs union, tariffs and other trade barriers are eliminated, and outside it, common tariffs are applied. Another typical type is an FTA. This can be termed "conditional liberalization." Each member of an FTA imposes its own tariffs on countries that are not party to the agreement, and rules of origin are adopted to prevent the circumvention of such tariffs. Recently the number of FTAs has been increasing much faster because the process of concluding an FTA is more flexible than that of a customs union. The problem concerning regionalism is whether FTAs are a building block or a stumbling block to global free trade.

Although RTAs violate the most-favored nation principle of the WTO, Article 24 of GATT allows RTAs as an exception if the following three conditions are met: (i) duties and other restrictive regulations of commerce shall not be higher or more restrictive than those prior to its formation; (ii) duties and other restrictive regulations of commerce are eliminated between contracting parties with respect to substantially all trade; and (iii) any interim agreement shall include a plan and schedule for the formation of a customs union or of such a FTA within a reasonable length of time. GATT, in addition, has an "enabling clause" which stipulates the conditions for RTAs concluded between developing countries. Thus, when developing countries conclude an RTA, the problem arises as to whether Article 24 of GATT or the enabling clause applies.

Why are an increasing number of countries concluding RTAs? The major reason is that the WTO negotiations have been prolonged due to the increase in the number of member states, and these protracted negotiations prevent members from reaching significant new agreements, which has virtually paralyzed the functions of the WTO. This gives members an incentive to form RTAs in order to deal with investment accords, economic cooperation, movement of natural persons, and protection of intellectual property. These comprehensive agreements are called Economic Partnership Agreements (EPAs), not FTAs, since they are not limited to goods and services. In addition, some countries form RTAs with the intent of making its rules a fait accompli , and to acquire benefits before others, or from the political motive of securing leadership in the region.

Why then is the number of RTAs growing? One reason is that some countries, especially developing countries, have adopted more liberal economic policies, hoping to emulate the rapid growth of the East Asian economies. Another is that the collapse of the Soviet Union has driven "economies in transition" (i.e., the former Soviet bloc) in the direction of free trade, and these countries have begun to strengthen ties with their neighbors. In addition, developing countries also hope to attract foreign direct investment. Finally, some point out that because RTAs can harm those outside the agreement, as more RTAs are concluded, those left out have an incentive to join the RTAs (the domino effect).

What are the effects of RTAs? In 1950, the well-known theory of the trade-creation and trade-diversion effects was advocated by Viner. The conclusion of an RTA also brings about trade modification, which changes the pattern of imports and exports of complements or substitutes among those covered by the RTA, and affects the terms of trade due to changes in import and export prices. In addition, the promotion of competition through economies of scale and investment creation, as well as diversion, should also be mentioned.

What are the advantages of RTAs? RTAs cover not only goods and services, but also a wider range of commercial activities including intellectual property protection and movement of natural persons. Negotiations for an RTA are more flexible than multilateral negotiations because they are carried out between only two or a relatively small number of countries, so they take less time. In addition, the formation of RTAs strengthens the commitment of the members to free trade, which assists all countries that are promoting free trade. Once an RTA is concluded, a developing country may be able to promote structural reforms because the RTA will help it attract more foreign direct investment and accumulate capital more rapidly.

However, RTAs also pose problems. First, RTAs do not always improve economic welfare. There is a risk that only the benefits and losses to producers will be emphasized. Second, once an RTA has too many exceptions or complicated rules, such as rules of origin, and these become entangled, the RTA itself may not be able to expand any further. Jagdish Bhagwati refers to this as the "spaghetti bowl phenomenon." Others point out that RTAs may prevent free trade from expanding because some RTA members may consider their markets to be large enough to obviate the need for further expansion of trade. "Our market is large enough," is one frequently heard claim. They may also wish to avoid further opening of markets, which may attract competition from foreign firms into markets that were previously protected (the "these are our markets" syndrome). In addition, the expansion of RTAs is a drain on the human resources available for multilateral trade negotiations. Moreover, the WTO's RTA committee (Committee on Regional Trade Agreements) may not have sufficient capacity to screen these agreements. Determining who should settle disputes under an RTA is also problematic.

Regionalism should be seen as complementary to multilateralism. To achieve this, it is important to come to a consensus concerning the interpretation of GATT Article 24; to clarify the interpretation of the wording "substantially all trade," and to ensure the rules of RTAs with regard to Article 5 of GATS are not ambiguous, thus allowing clauses and other provisions to be clearly applied so that the articles and rules themselves can be applied with certainty. It is also important to improve the capacity of WTO to examine RTAs and to make the rules clearer and simpler so that they will be consistently applied. If necessary, GATT Article 24 itself should also be amended.

In response to Professor Ishikawa's presentation, UEDA Hideshi, Director, Multilateral Trade System Department, Trade Policy Bureau, METI, commented as follows.

I was in charge of the WTO Doha Round, and took part in the negotiations for the Japan-Philippines FTA and the Japan-Thailand FTA. I would like to talk about what I personally concluded from these negotiations.

The traditional concern that FTAs might promote the formation of economic blocs seems to be diminishing. Japan used to support only the WTO. However, by the late 1990s it had changed its policy. On the other hand, the Doha Round is not going smoothly, even though it has gathered some momentum recently. Nevertheless, the prospects for further FTA negotiations seem to be improving.

What are the differences between the WTO and FTAs? First, it seems clear that FTAs are effective in eliminating tariffs and that a considerable degree of liberalization can be achieved through FTAs. On the other hand, negotiations in services have not been going smoothly. There are several reasons for this, including the fact that Article 5 of GATS has not worked as a means of leverage in promoting liberalization. Negotiations on services have also met with strong resistance among legislators in many countries, because they often entail deregulation that touches on domestic legal systems. Moreover, many ministries and agencies are involved in negotiations on services. In particular, since the terrorist attacks of September 11, 2001, many countries, especially developed countries, are cautious about movements of people across international borders. However, as shown by the budding liberalization of movements among certain groups, such as among nurses between Japan and the Philippines, an FTA, unlike the WTO, allows parties to tailor the negotiations to their individual needs. This is one of the great merits of FTAs. Moreover, negotiations on investment have not been carried out successfully by the WTO, while FTA negotiations have achieved some results.

Stipulations regarding rules of origin are being unified, since de facto standards prevail. Worryingly, however, the stipulations still vary between the three regions of the EU, NAFTA and the Asian nations. This has inevitably placed a burden on small and medium-size enterprises and other businesses.

KIKUCHI Tsutomu, Professor of International Political Economy, School of International Politics, Economics and Business, Aoyama Gakuin University, then made the following comments.

I study international relations, mainly the various types of systems formed in the Asia-Pacific region, including FTAs. I would like to ask about the relationship between the WTO and regional trade agreements.

Professor Ishikawa stated that the malfunctioning of the WTO has accelerated regional liberalization, but I wonder how well this explains the actual situation. Singapore, for example, seems to have an incentive to pursue regional liberalization apart from liberalization at the level of GATT or the WTO.

I agree that in order to conclude comprehensive regional trade agreements, it is very desirable to strengthen Article 24 of GATT, for example. However, now that countries around the world have concluded or are negotiating regional agreements, what is the political incentive to amend Article 24 or to take a different course of action?

Currently, most of the RTA negotiations are between developed countries and developing ones. What incentives do the developed countries have in pursuing these agreements? Does the domino effect provide a complete explanation?

There is an enormous imbalance of power between the developed and developing nations that enter into an FTA or a regional trade agreement. This seems to have a considerable influence on their relative bargaining power. How do you assess the distortions in FTAs due to such imbalances in power? When a country wants to conclude a bilateral FTA with Japan, for instance, how can it convince Japan to liberalize its agricultural markets?

MUKUNOKI Hiroshi, Associate Professor, Faculty of Economics, Gakushuin University, commented as follows.

I agree with Professor Ishikawa that RTAs and FTAs might be a stumbling block. However, as countries are now scrambling to conclude FTAs, the increasing number of FTAs is a trend in the world economy. We should realistically accept this as a given and talk about how we can make FTAs work as building blocks. From this point of view, I would like to ask three questions.

The first question concerns the division of the roles between the WTO and FTAs. I don't agree that WTO and FTAs should be left incompletely specialized and that negotiations under the WTO and FTAs should be carried out in parallel. I think, rather, they should be completely specialized and that negotiations should be carried out on the basis of the comparative advantage of the two frameworks, the WTO and FTAs. What is your opinion on this point?

I agree that it is necessary to strengthen discipline with regard to FTAs. However, how do you think Article 24 of GATT, for example, should be amended specifically?

In order to expand free trade through FTAs, an important challenge is how developing countries can be encouraged to liberalize trade. This raises the question of which countries should be chosen as priority partners for FTAs? If, for example, you were to draft an FTA strategy for Japan, what would your concrete criteria for a future strategy be?

The following issues and questions were raised from the floor.

When I calculated the overall economic effects of RTAs, the numbers were not so significant. The model I used lacked some variables, such as the effect of economies of scale and investment-creation. How about the current models?

I am now negotiating with the WTO, governments of our EPA partner countries, and businesspeople. Some, especially those in developing countries with higher tariffs, have considerable concerns that lower tariffs might reduce direct investment and adversely impact local production. Is there any economic logic that would help to show that this will not happen?

When many goods have a trade-diversion effect, the liberalization of "substantially all trade" of a country might reduce its economic welfare. If we assume Article 24 of GATT will be amended, should the "substantially all trade" language be maintained or not?

Professor Ishikawa responded to the preceding comments as follows.

Although the stipulations on rules of origin are being unified within ASEAN, each FTA has substantially different rules. Another problem is that different sets of rules apply for different FTAs, and that different goods are subject to different rules. Stipulations on the rules of origin should be made as simple as possible. The WTO is now working to harmonize the stipulations for rules of origin as applied to nonpreferential areas. Basically, they should be in the form of a template.

As Professor Kikuchi pointed out, politics is one of the major factors behind the rising number of RTAs. However, the fact that the number of RTAs has been increasing, particularly since 1995, seems to indicate that this increase is not unrelated to the deadlock in the WTO negotiations.

The wording of GATT Article 24 is very ambiguous. For instance, there is no consensus regarding the definition of "substantially all the trade." This, among other ambiguities, must first be clarified. Another issue pointed out by Professor Kikuchi concerns whether Article 24 can actually be strengthened. This has been taken up in the Doha Development Agenda and we should carefully watch developments in this regard.

I agree, as Professor Kikuchi pointed out, that with respect to FTAs between developed and developing countries, the agricultural market cannot be liberalized through a bilateral FTA. As for the issue that Professor Mukunoki mentioned, division of roles between the WTO and FTAs, agricultural problems should be dealt with by the WTO.

Actually, FTAs between the developed and developing countries can create distortions, as Professor Kikuchi pointed out. However, as seen in the case of the FTA negotiations between Japan and Mexico, we cannot conclude that developing countries have no bargaining power.

As for the question raised by Professor Mukunoki concerning Japan's free trade strategy, I believe that if Japan continues to promote RTAs with Asian countries, it should conclude an FTA with South Korea from the standpoint of the domino effect. There is a risk, on the other hand, that if China concludes FTAs with ASEAN countries, enabling clauses might be applied.

With regard to the question of whether lower tariffs make concessions by high-tariff countries less likely, I would suggest another possibility, namely that because FTAs cover foreign direct investment and other fields, developing countries may have an added incentive to conclude FTAs.

One member of the audience asked about calculating the effects of FTAs. I think current computable general equilibrium (CGE) models include such variables as the effect of economies of scale and investment-creation.

Another member of the audience asked whether lower tariffs reduce the benefits of foreign direct investment. Actually, this possibility cannot be denied. However, at the same time, lower duties may make intermediate goods and raw materials cheaper, and encourage the exchange of technology, which will improve productivity.