Erosion of the Non-discrimination Principle Through Waves of Preferential Trade Agreements: A Warning from the Sutherland Report
Consulting Fellow, RIETI
In January 2005, the World Trade Organization unveiled a report entitled "The Future of the WTO: Addressing Institutional Challenges in the New Millennium" [PDF:484KB] (the "Sutherland Report"), which was drawn up by a consultative board chaired by former WTO Director-General Peter Sutherland. In this column, I would like to focus on the concerns raised in this report with respect to preferential trade agreements (PTAs) such as regional trade agreements.
According to the WTO, more than 200 regional trade agreements (RTAs) - a collective term for free trade agreements (FTAs), service agreements and customs unions - have been notified to the WTO, 30 or so RTAs are slated to come into effect in the near future, and some 60 are under negotiation or study. This article examines the accelerating global trend toward RTAs and why the WTO consultative board has voiced concerns about PTAs and RTAs.
"Least-favored-nation" treatment: The erosion of the non-discrimination principle
The principle of non-discrimination is the bedrock of the WTO regime under which WTO member countries are required to treat products from all WTO member countries equally. This principle with respect to trade in goods is embodied in the most-favored- nation (MFN) clause in Article I of the General Agreement on Tariffs and Trade (GATT). MFN requires the advantage, favor, privileges and immunities granted to products from any WTO member country be accorded immediately and unconditionally to those from all other member countries. For instance, if Japan lowers the tariff rate on an import from the United States, the same must be done for the other WTO members, such as the member countries of the European Union. It is said that the introduction of the MFN principle at the inception of the GATT was prompted by an awareness that the rise of economic blocs and subsequent discriminatory tariff regimes of the early 20th century were an indirect cause of World War II.
RTAs - discriminatory arrangements under which any tariff reduction or elimination agreed to by party countries to an RTA applies only to trade between these countries - are regarded as an exception to the principle of non-discrimination under the WTO. The Generalized System of Preferences (GSP), a scheme under which developed countries grant non-reciprocal preferences such as tariff reductions to developing countries, is also treated as an exception to the principle of non-discrimination. Thus, the Sutherland Report includes GSP schemes in its definition of PTAs. Due to the "spaghetti bowl" of PTAs, most-favored-nation (MFN) treatment has become so exceptional, the report argues, that it has virtually ceased to be the central principle of the WTO and the term might now be better defined as "least-favored-nation." As an example, the report points to the fact that the EU's MFN tariffs apply fully to only nine trading partners including Japan, while all other trading partners are granted concessional market access under GSP schemes, FTAs or others, ironically highlighting the reality that MFN tariff rates are, in many cases, the least favorable rates.
RTA consistency with the GATT rules
The Sutherland Report acknowledges some benefits of RTAs, noting that they are politically and diplomatically meaningful, and also liberalization initiatives undertaken by groups of willing nations, which are broader and deeper than those easily achieved under a multilateral framework, can act as spurs to liberalization efforts by WTO members as a whole. At the same time, however, the report points to a number of drawbacks. First, it says, the existing provisions that require RTAs to be recognized as an exception to MFN treatment under the WTO rules are not working as a brake on the formation of RTAs. At present, RTAs are subject to examination and consensus-based assessment in the WTO Committee on Regional Trade Agreements (CRTA). When developed countries form an RTA regarding trade in goods, they are required to eliminate tariffs and other trade-restrictive regulations of commerce on "substantially all the trade" in principle within a 10-year period as required under Article XXIV of the GATT. This article also prohibits parties to an RTA from raising tariffs and other trade barriers against countries outside the agreement. In reality, however, because the definition of the phrase "substantially all the trade" is not clear from the text of Article XXIV, interpretations vary from one country to another. Presenting its views on the WTO consistency of RTAs, the EU has said that only the CRTA or a WTO dispute settlement panel can judge such consistency. The EU also argued, however, that "substantially all the trade" is understood to have both qualitative and quantitative dimensions, meaning that no less than 90% of all trade between contracting parties without excluding any major sectors. The CRTA is currently discussing the definition of the "substantially all the trade" clause. Meanwhile, the opinions expressed at the CRTA reveal sharp divisions between party countries to various RTAs and non-party countries over the GATT consistency of the agreements: Those belonging to a particular RTA assert that it is consistent with the GATT, while those outside it insist otherwise; the resulting CRTA report thus ends up presenting the two opposing arguments in most cases. Consequently, there are very few cases in which the CRTA gives qualified endorsement to an RTA in regard to GATT consistency. In most cases, RTAs go into effect with the question of GATT consistency unsettled.
On the other hand, RTAs between or among developing countries - the FTA between China and the Association of Southeast Asian Nations (ASEAN), the ASEAN Free Trade Agreement (AFTA) and so forth - are subject to the so-called Enabling Clause of the GATT, which simply provides for mutual reduction or elimination of tariffs and non-tariff measures on products imported from other party countries. Unlike provisions under Article XXIV, the Enabling Clause does not require that "substantially all the trade" be covered or that tariffs on such trade be eliminated in principle within 10 years. Also, rules concerning the examination of such RTAs remain ambiguous. For the moment, reporting to the WTO Committee on Trade and Development is about all that is required. With respect to RTAs between or among developing countries, "early harvest" schemes have been seen as problematic. Such early harvests seek tariff reductions on specific items before laying down measures and timetables for eliminating tariffs on all the trade items. In the case of the China-ASEAN FTA, an early harvest scheme was implemented in January 2004 to liberalize trade in specific agricultural products while negotiations are still under way regarding tariffs on industrial products. The underlying concept is to selectively eliminate tariffs in areas where it is possible to do so. This is contrary to the objective of Article XXIV of the GATT, which is supposed to put a brake on the proliferation of RTAs; concerns are now being raised about abuse of the Enabling Clause.
Problematic aspects of RTAs from the viewpoint of economics
The Sutherland Report also questions the validity of PTAs from the viewpoint of economics. Previous studies in international economics have analyzed the effects on the economic welfare of nations - both in terms of trade creation and trade diversion - assuming a condition where only one PTA exists. In contrast, the report points out a number of problematic aspects of RTAs. The report notes that the current spread of PTAs, which apply multiple preferential tariff rates to various trading partners under different timelines, has greatly complicated tariff application and created preferential rules of origin that are both complex and inconsistent. The report also points out that the unregulated proliferation of PTAs tends to impede meaningful multilateral liberalization, even though there is some truth to the idea that participation in PTAs promotes liberalization on multiple fronts. Citing observations from the Doha Round negotiations, the report says that many developing countries hesitate to support ambitious objectives on MFN tariff reductions, which they fear would erode the margin of preferences (i.e., a gap between the MFN tariff rate and the corresponding preferential tariff rate). The report further warns that the diversion of skilled and experienced negotiators to PTA negotiations, particularly in the case of developing countries, may hamper adequate focus on multilateral trade negotiations.
Indeed, when we look at the example of the Japan-Mexico Economic Partnership Agreement (EPA), we can see that the rules of origin under this agreement differ from the rules of origin under the GSP or those of the Japan-Singapore EPA. Also, Japan applies different preferential treatments to the same trade item, depending on whether it is imported from Mexico or Singapore. Importers need to be quite familiar with the terms and conditions of each agreement, as well as the tariff mechanisms currently in effect. Likewise, customs authorities have to apply the mechanisms properly. Additional costs are incurred in issuing certificates of origin, as well as in verifying certificates issued by other party countries. According to media reports, Taiwan's ambassador to the WTO said in January the costs incurred for the issuance and verification of certificates of origin, if executed strictly, would offset the trade diversion effect when the gap between the MFN tariff rates and FTA tariff rates is 5% or less. This remark is quite interesting.
Returning to the principle of nondiscrimination?
The Sutherland Report notes that governments need to take into account the damage being done to the multilateral trading system before embarking on new discriminatory initiatives, and urges them to refrain from pursuing such initiatives simply out of an instinctive desire to "catch up" with others. And if the existing PTAs cannot be scrapped and new ones cannot be prohibited, the long-term remedy to the "spaghetti bowl" problem would be through the effective reduction of MFN tariffs and non-tariff measures in multilateral trade negotiations, the report says, underlining the need for developed countries to seriously consider making a commitment to establish a date by which all their tariffs will move to zero. Another approach to PTAs the report proposes is to clarify the language of Article XXIV and to improve the means of administering its provisions.
Although the report calls for countries to restrain their urge to "catch up" with others by joining FTAs, in reality it is difficult to deter them. When a group of countries conclude an RTA, it inevitably generates a domino effect that compels those outside to follow suit and seek similar preferences so as to offset the negative impact of the RTA. At the same time, however, concluding an RTA is no easy task and negotiations often drag on, as has been the case with the Free Trade Area of the Americas (FTAA) and the EU-Mercosur free trade agreement. Meanwhile, many developing countries are left outside the RTAs. Faced with all these problems, both developed and developing countries may now be coming to recognize once again the importance of the Doha Round.
In the wake of the EPAs with Singapore and Mexico, Japan has reached a framework agreement on another EPA with the Philippines, and similar negotiations are under way with South Korea, Thailand and Malaysia. In December 2004, the government unveiled its "Basic Policy Towards Further Promotion of Economic Partnership Agreements (EPAs)," which says that the government "shall endeavor to ensure that the promotion of EPA negotiations will facilitate Japan's negotiations at the WTO." In promoting EPA negotiations in the future, Japan needs to abide by this policy, take into account the concerns about RTAs raised in the Sutherland Report, and exert efforts toward the successful conclusion of the WTO Doha Round. The outcome of the WTO ministerial meeting in Hong Kong in December will serve as a touchstone for the future of the multilateral trade regime and RTAs.
March 2, 2005