Multilateral vs. Regional Economic Integration? - The Middle East and North African Region

Diploma Thesis , 2009 , 115 Pages , Grade: 2,3

Business economics - Economic Policy

In this study it is intended to investigate today´s actual economic interdependence of what we would call the Middle East and North African (MENA) region and to analyze its economic interweaving, both among its member countries and into the global trading system.
Being aware of the complexity and breadth of this topic, the author has chosen only three subset economic integration agreements, both between the countries of the MENA region (intraregional) – also comprising a subregional agreement – and between the MENA region and other regions (interregional), for closer analysis.
Concerning the efforts made towards interregional economic integration, this thesis concentrates mainly on the so-called EU-MED Partnership which was initiated at the Barcelona Conference in 1995 and aims to establish an EU-Med Free Trade Area (EMFTA) by the year 2010 including the EU and the 12 so-called Mediterranean countries
which, apart from Malta, Cyprus and Turkey, all belong to the MENA region.
In contrast, on the intraregional level, the latest initiative in 1997 will be examined, where 17 out of 22 Arab League member states - all of which also belong to the MENA region apart from Sudan – joined to constitute a “Greater Arab Free Trade Area” (GAFTA, mainly to get rid of traditional trade barriers for goods.
On the smaller subregional level, the Gulf Cooperation Council (GCC), consisting of 6 Gulf countries, which plans the establishment of a common currency by 2010, will be examined more closely.
With GAFTA, GCC and the EU-MED Partnership all being in a different depth of integration and each representing one of the three different levels of integration (subregional, intraregional, interregional), the author holds the view that this choice reflects the actual state of integration in the region best.
In a nutshell, this study tests the compatibility and correlation of the two different integration trends – multilateral and regional – using the example of the MENA region. Are they supplements or substitutes? Does regional integration inhibit or facilitate multilateral integration or vice versa? Are the above-mentioned regional integration arrangements contradictory, compatible or even mutually dependent?
By approaching these questions the reader is to gain some insight into the so-called “Spaghetti Bowl” of cross-cutting integration agreements in the region.

TABLE OF CONTENTS

LIST OF FIGURES

LIST OF TABLES

LIST OF ABBREVIATIONS

INTRODUCTION

I. TRADE AND WELFARE

II. REGIONAL ECONOMIC INTEGRATION
a) Regional Economic Integration from a Historical Perspective
1. Old Regionalism
2. New Regionalism
b) Stages of Regional Economic Integration
c) Economic Causes and Effects of Regional Economic Integration
1. Static Effects of Regional Economic Integration
i. Trade Creation & Trade Diversion Effects
ii. Demand Side Effects
iii. Terms of Trade Effects
2. Dynamic Effects of Regional Economic Integration
i. Increased Competition
ii. Scale Effects
iii. Increased Efficiency
iv. FDI
v. Convergence/Divergence
vi. Agglomeration and Flow of Knowledge
d) Political Causes of Regional Economic Integration
i. Lobbies
ii. Domino Theory
iii. Bargaining Power
iv. Signalling, Credibility and Reputation
v. Security
e) Overlapping Regional Integration Agreements (RIAs) and the “Spaghetti Bowl” Problem

III. MULTILATERALISM AND THE WORLD TRADE ORGANIZATION (WTO)
a) The Emergence of the WTO
b) The Nature of the WTO
c) Principles of the WTO
1. The Most-Favoured Nation Treatment
2. The International Treatment Obligation
3. The Principle of Reciprocity
d) Structure of the WTO
e) Achievements and Omissions of the WTO

IV. MULTILATERALISM VERSUS REGIONALISM?
a) Regional Integration Agreements (RIA) and the WTO
1. GATT Article XXIV
2. Enabling Clause
3. GATS Article V
4. WTO Transparency Mechanisms for RIAs
b) Regional Integration Agreements as “Building Blocs” or “Stumbling Blocs”?
1. RIAs as “Stumbling Blocs”
2. RIAs as “Building Blocs”
c) RIAs and Trade in Services
d) The Potential of “South-South” Integration Agreements

V. THE MENA REGION
a) The MENA -Countries – One Region?
b) MENA ´s Economic Integration on a Regional and on a Global Level
c) The Arab League (AL) – The Forerunner of Arab Economic Integration
d) Regional Integration Agreements (RIA) in the MENA Region
1. The Gulf Cooperation Council (GCC) – Subregional
i. The Agreement
ii. Trade in Services
iii. Intellectual Property Rights (IPR) and Harmonization of Standards
iv. GCC and International Law
v. Supervision
vi. Rules of Origin
vii. Dispute Settlement
viii. Beyond the Border Measures
ix. Customs
2. The Greater Arab Free Trade Area (GAFTA) – Intraregional
i. The Agreement
ii. Trade in Services
iii. Intellectual Property Rights (IPR)
and Harmonization of Standards
iv. GAFTA and International Law
v. Supervision
vi. Rules of Origin
vii. Dispute Settlement
viii. Beyond the Border Measures
ix. Customs
3. The EU – Mediterranean Partnership (EMP) – Interregional
i. The Agreement
ii. Trade in Services
iii. Intellectual Property Rights (IPR) and Harmonization of Standards
iv. EMP and International Law
v. Supervision
vi. Rules of Origin
vii. Dispute Settlement
viii. Beyond the Border Measures
ix. Customs
4. Further RIAs in the Region

VI. PROBLEMS WITH OVERLAPPING RIAs IN THE MENA REGION

CONCLUSION

LIST OF FIGURES

Figure 1 – Production Facilities of Syria in an self-sufficient situation

Figure 2 – Production Facilities of Lebanon in an self-sufficient situation

Figure 3 – Syria – Lebanon Economic Partnership

Figure 4 – No. of RTAs worldwide

Figure 5 - Political Explanatory Approach for Regional Integration

Figure 6 - Comparison of GDP for the USA, Japan and the totality of Middle- and Low Income Countries

Figure 7 – WTO Structure

Figure 8 - Regional Exports as Percentage Share of World Exports (oil excluded)

Figure 9 - Share of Middle East Trade, Imports vs. Exports, 2003

Figure 10 – Share of Middle East Trade by Region, Imports and Exports, 2003

Figure 11 - Intraregional trade as a share of GDP in percent, 2002

Figure 12 – MENA Workers Remittances ($-billion), 1991 – 2003

Figure 13 - Share of Region’s Net FDI Inflows in the Region’s Total Investment (percent) for 1980-89, 1990-99 and 2000-02

Figure 14 - Map of the Arab League

Figure 15 - Map of the GCC

Figure 16 - MENA´s Countries Net Services Trade Position 2006

Figure 17 - MENA´s Countries Attitude towards Reform, as illustrated by GATS Commitments

Figure 18 - Ratio of Intraregional Trade to International Trade

in certain Regional Blocs, 2002 and

Figure 19 - Overlapping Bilateral and Regional Integration Agreements in the MENA Region

LIST OF TABLES

Table 1 – Opportunity Costs of Syria and Lebanon

Table 2 – Stages of regional integration

Table 3 – GATT/WTO trade rounds

Table 4 – Comparison of requirements under GATT Article XXIV and the Enabling Clause

Table 5 – Annual FDI inflows of MENA states, percentage of world total

Table 6 – Average Tariffs and Standard Deviations for Selected Countries

LIST OF ABBREVIATIONS

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“...the individual human being cannot by himself obtain all the necessities of life. All human beings must cooperate to that end in their civilization. But what is obtained through the cooperation of a group of human beings satisfies the need of a number many times greater [than themselves].”

Ibn Khaldun (1332-1406)

INTRODUCTION

When Ibn Khaldun – a medieval polymath of Arab descent from present-day Tunisia, often referred to as the father of sociology ¹ and a designated adept of the “Dar al Islam” ² – wrote the above statement on the benefits of the division of labour in his “Muqaddimah” ³, Adam Smith (1723-1790) and his idea of the “invisible hand” were still far from being born.

The person Khaldun and his thought is just one of the examples for the high agility which prevailed among the Islamic scholars both physically and intellectually during the Middle Ages, from which Europe benefited so greatly, and reminds us that the concept of so- called “globalization” is not a new one, neither in theory nor in practice. ^{4 5}

Yet primarily the exercise of this study should neither be the historical examination of the “Dar al Islam”, nor that of the phenomenon of globalization. Nevertheless one should bear in mind that – even in an economic analysis – historical and cultural background knowledge can certainly aid and deepen the comprehension of the “object of investigation”.

In this study it is intended to investigate today´s actual economic interdependence of what we would call the Middle East and North African (MENA) region ⁶ and to analyze its economic interweaving, both among its member countries and into the global trading system.

Being aware of the complexity and breadth of this topic, the author has chosen only three subset economic integration agreements, both between the countries of the MENA region (intraregional) – also comprising a subregional agreement – and between the MENA region and other regions (interregional), for closer analysis.

Concerning the efforts made towards interregional economic integration, this thesis concentrates mainly on the so-called EU-MED Partnership which was initiated at the Barcelona Conference in 1995 and aims to establish an EU-Med Free Trade Area (EMFTA) by the year 2010 including the EU and the 12 so-called Mediterranean countries ⁷ which, apart from Malta, Cyprus and Turkey, all belong to the MENA region.

In contrast, on the intraregional level, the latest initiative in 1997 will be examined, where 17 out of 22 Arab League member states ⁸ - all of which also belong to the MENA region ⁹ apart from Sudan – joined to constitute a “Greater Arab Free Trade Area” (GAFTA) ¹⁰, mainly to get rid of traditional trade barriers for goods,. ¹¹

On the smaller subregional level, the Gulf Cooperation Council (GCC), consisting of 6 Gulf countries ¹², which plans the establishment of a common currency by 2010, will be examined more closely.

With GAFTA, GCC and the EU-MED Partnership all being in a different depth of integration and each representing one of the three different levels of integration (subregional, intraregional, interregional), the author holds the view that this choice reflects the actual state of integration in the region best.

In a nutshell, this study tests the compatibility and correlation of the two different integration trends – multilateral and regional – using the example of the MENA region. Are they supplements or substitutes? Does regional integration inhibit or facilitate multilateral integration or vice versa? Are the above-mentioned regional integration arrangements contradictory, compatible or even mutually dependent?

By approaching these questions the reader is to gain some insight into the so-called “Spaghetti Bowl” of cross-cutting integration agreements in the region. ¹³

But before doing so, the reader will receive the basic theoretical configuration in the form of a review of the theory of economic integration and the concepts of regionalism and of multilateral liberalization respectively.

“By means of glasses, hotbeds, and hotwalls, very good grapes can be raised in Scotland, and very good wine too can be made of them at about thirty times the expense for which at least equally good can be brought from foreign countries. Would it be a reasonable law to prohibit the importation of all foreign wines, merely to encourage the making of claret and burgundy in Scotland?”

Adam Smith (1723-1790)

I. TRADE AND WELFARE

If one refers to history, countries have always been involved in trade. But why do they do that? Apparently because they benefit from doing so. Countries trade with each other basically for two reasons. First of all, countries are different in their endowment of resources and their factors of production. This means that some goods are simply not existent in one country or they cannot be produced because one or more factors of production are missing. In that case they have to be imported. ¹⁴ Yet even if a certain good is available in a country or it could be produced, it may still be beneficial to import it for reasons of economy.

Secondly, through trade, countries can achieve economies of scale in production. If each country focuses only on the production of certain goods – because it imports the rest from its trading partner – it has to produce a larger amount of the respective good, for its home requirements and for export. Consequently, the specialization and the higher volume in production allow for more efficiency.

It is generally accepted that it was the above-mentioned Adam Smith ¹⁵ with his Magnum Opus “The Wealth of Nations” ¹⁶ who laid the foundations for the theoretical understanding of trade and the mutual benefits for its participants, the so-called school of classical economic thought. ¹⁷

According to his theory, the concept of the international “division of labour” is accompanied by a more efficient factor, 'input', and therefore an increase in economic welfare for each country involved. Smith argued that each country should only produce those goods in which it had absolute cost advantages, which means that every country should specialize in producing only the good it can produce cheapest.

David Ricardo ¹⁸ advanced Smith´s theory of absolute cost advantages by proving that trade is even beneficial for those countries which have lower productivity than its trading partner in all industries. In the Ricardian Model, a country will export those goods its labour produces relatively efficiently and import goods that its labour produces relatively inefficiently. ^{19 20} The concept of comparative advantage was born. When Stanislaw Ulam ²¹

– a famous Polish mathematician – once asked the American neoclassical Nobel Prize- winning economist Paul Samuelson to name one theorem in all of the social sciences which is both true and not trivial, he answered: Comparative advantage. "That it is logically true need not be argued before a mathematician; that it is not trivial is attested by the thousands of important and intelligent men who have never been able to grasp the doctrine for themselves or to believe it after it was explained to them.” ²²

As there still seems to be the need for explanation, the theorem of comparative advantage will be illustrated and the question of whether economic cooperation can be profitable in principle will be answered in the following model.

We want to use a 2-country model mainly based on the explanations of Ricardo ²³ in which we compare the countries of Syria (S) and Lebanon (L) concerning their wine (w) and cloth (c) production. Both countries` production is subject to certain restrictions such as scarcity of resources which can be expressed in the following transformation curves:

S : w=600−2 c and L : w=700−c

Without trade, Syria produces and consumes according to its preferences 200 units of wine and 200 units of cloth.

Lebanon, by contrast, produces and consumes 300 units of wine and 400 units of cloth. Both countries use their entire resources for the period considered.

The following charts demonstrate the production facilities of the two countries in their self- sufficient situation.

Fig. 1: Fig. 2:

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As can be seen from the figures above, in this example Lebanon has absolute advantages in the production of both commodities. It could produce more wine as well as cloth than Syria. According to the theorem of comparative advantage, economic cooperation is even profitable when one country – the Lebanon in the case at hand – has an absolute advantage in the production of both commodities.

To understand this, we must consider the opportunity cost that these countries have to deal with. If a country decides to produce one more unit of a certain commodity, it has to forego a certain amount of units from the other commodity. These foregone benefits are the opportunity cost that this country has to face.

If we summarize the opportunity costs of the two countries in our example, we realize that even the “weak” country of Syria has an advantage.

Tab.1

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In this respect Syria has an advantage regarding the opportunity cost, as it has to forego only a ½ unit of wine to produce 1 more unit of cloth. By contrast, Lebanon has to forego the production of 1 unit of wine to produce 1 more unit of cloth.

This means that Syria has a comparative advantage in the production of cloth. Precisely this comparative advantage causes even the “strong” country of Lebanon to consider the economic cooperation with the “weaker” partner of Syria to be beneficial.

If these two countries specialize according to their comparative advantages in a Syria- Lebanon economic partnership, this will bring an extension in consumption possibilities for both countries and therefore an increase in economic wealth.

Without economic cooperation, both countries together produce 500 units of wine and 600 units of cloth. On the basis of the transformation curve of the Syria-Lebanon partnership we will demonstrate that an improvement through trade is possible for both countries.

If both countries direct all of their resources to the production of cloth, they could produce 1,300 units. If they want to enter wine production, they must consider who can do this at lower costs. In our example this is Lebanon, because it has a comparative advantage in the production of wine. For the production of 1 unit of wine it has to forego only 1 unit of cloth, by contrast with Syria, which would have to forego the production of 2 units of cloth to produce 1 unit of wine.

Up to a production of 700 units, only Lebanon will produce the need for wine in the community because it can do this at lower costs than Syria and the community has to face costs amounting to only 1 unit of wine for 1 unit of cloth. It is only when the community wants to produce and consume more than 700 units of wine that Syria has to enter wine production. This fact also explains the kink in the following transformation curve, because the community now has to pay with 2 units of cloth for the production of 1 unit of wine.

Fig. 3

illustration not visible in this excerpt

Source: Author

All the commodities in the orange box constitute an improvement compared to the situation of independence we had before. The transformation curve of the 2-country community runs through the area of improvement, which proves the extension of consumption possibilities through economic cooperation.

Therefore economic units – acting in an economy based on the division of labour – can benefit from trade in as much as they can get certain commodities cheaper than their own opportunity cost. If Syria and Lebanon both specialize in production according to their comparative advantages, it necessarily results in trade between both parties. Global demand and supply on the common market will determine the prices for wine and cloth. Due to the existing opportunity cost, the upper and lower price limit can be determined. Consequently the price ranges:

- between ½ and 1 unit of wine for 1 unit of cloth and
- between 1 and 2 units of cloth for 1 unit of wine.

The example becomes clear after the following consideration:

On the one hand, Syria will demand more than a ½ unit of wine for a unit of cloth, because otherwise it could produce this ½ unit of wine on its own and forego just 1 unit of cloth.

On the other hand, Lebanon will not be willing to pay more than 1 unit of wine for 1 unit of cloth because otherwise it could produce 1 unit of cloth on its own, foregoing only 1 unit of wine.

This first Ricardian approach was further developed by two Swedish economists, Eli Heckscher and Bertil Ohlin. ²⁴ While in the Ricardo model the relative cost differentials between the countries result from the differences in the productivity of the production factor (labour), Heckscher and Ohlin trace these differences back to the relative factor 'endowment' of the countries (land, labour and capital).

A country will produce and export exactly those commodities in relatively great quantities for which the factor used comparatively intensively in production is relatively abundant. According to this, countries with a relatively high endowment of land for instance are more likely to export land-intensive goods, while countries with a relatively high endowment of labour will export labour-intensive goods.

The owners of the abundant factor will benefit and the owners of the scarce factor will suffer losses. Therefore, foreign trade does not constitute winners only. However, from a holistic view, the overall gains from foreign trade are greater than the losses, so that losers could be compensated by the winners. According to the Kaldor-Hicks efficiency criterion, a change has an overall positive welfare effect if the potential winners could theoretically compensate the potential losers for their losses and there would be still a part of the original gains left for them. ²⁵

Both the Ricardian and the Heckscher-Ohlin models are helpful models to explain the causes and effects of external trade, although they have certain shortcomings if tested empirically. ²⁶ However, the basic finding holds true that trade brings gains in wealth for all countries involved via specialization and economies of scale.

`We see societies establishing themselves, nations forming themselves, which in turn dominate over other nations or become subject to them. Empires rise and fall; laws, forms of government, one succeeding another; the arts, the sciences, are discovered and are cultivated; sometimes retarded and sometimes accelerated in their progress, they pass from one region to another. Self-interest, ambition, vainglory, perpetually change the scene of the world, inundate the earth with blood. Yet in the midst of their ravages manners are gradually softened, the human mind takes enlightenment, separate nations draw nearer to each other, commerce and policy connect at last all parts of the globe, and the total mass of the human race, by the alternations of calm and agitation, of good conditions and of bad, marches always, although slowly, towards still higher perfection...`

Anne Robert Jacques Turgot ²⁷ (1727-1781)

II. REGIONAL ECONOMIC INTEGRATION

In the last 10 to 15 years, the number of Regional Trade Agreements (RTAs) on a global level increased sharply as shown in the figure below (Fig. 4).

In light of this fact and of the slow pace of progress in multilateral liberalization under the World Trading System (WTO) – which will be discuss later – it is not only a frequently asked but also a legitimate question – by economists and politicians alike – how the concepts of regional and multilateral economic integration interact.

However, as Winters points out, to clarify this issue, first of all it is necessary to define both concepts. Winters defines regionalism “loosely as any policy designed to reduce trade barriers between a subset of countries regardless of whether these countries are actually contiguous or even close to each other”. ²⁸ By contrast, for Baldwin and Venables the “geographically discriminatory trade policy is the defining characteristic of a regional integration agreement (RIA)”. ²⁹ This difference clarifies the importance of finding a common definition one can work with to avoid misunderstandings. As we are analyzing an actual geographical region in the second part of this study, we will use the term in the sense of the latter definition.

Fig. 4

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From http://www.wto.org/english/tratop_e/region_e/regfac_e.htm,

a) Regional Economic Integration from a Historical Perspective

Thus Regional Integration Agreements (RIAs) or Regional Trade Agreements (RTAs) ³⁰ are arrangements of countries mainly targeted at the reduction of barriers to trade between members.

They have a long tradition for example in conjunction with colonial trade agreements or as a level of development in the foundation of states such as the Deutsche Kaiserreich which emerged from the Deutsche Zollverein, an association of German federal states in the area of customs and trade policy.

From a historical perspective, degrees of integration among countries can vary from “shallow” to “deep”. Whereas “shallow” integration only includes the cutting back or the removal of barriers to trade in commodities, “deep” integration targets the harmonization of the national policies in order to enable and boost the internal factor of mobility. ³¹

1. Old Regionalism

The first wave of regionalism during the post-war period (20-30 years after World War II) was a phase of “shallow” integration, which is often called “Old Regionalism”. Immediately after the foundation of the European Economic Community (EEC), this concept gained a great deal of attractiveness, especially in developing countries. Facing the given protection of the industrialized countries, they were following the ideal of the EEC and thus hoped to bring down the costs of their own industrialization by liberalizing amongst each other. ³² The Common External Tariff (CET) for the member countries was an exogenous determined given, which made simultaneous multilateral and regional advancement impossible. This protectionist attitude was mainly induced by the import substitution strategy of the developed countries, which found its theoretical foundation in the “Infant industry argument” from Friedrich List ³³. Hence the “Old Regionalism” was quite a defensive concept – focused on protectionism – which seemed to present an alternative to the global trading system by assuring the trade relations to the most important partners at any rate. ³⁴

2. New Regionalism

With the second wave starting in the mid-1980s, as shown in Fig. 4, more and more RIAs with deeper integration qualities came into being, many of them between developed and developing countries. This second wave is called the “New Regionalism”. By contrast to its forerunner, the new wave of regionalism was much more a result of successful multilateral trade liberalization.

Burfisher et al. identified certain characteristics of New Regionalism, which are usually found in the deepest level of integration, the Total Economic Union. ³⁵ The characteristics are as follows:

- improved real and financial capital and labour mobility between the RIAs
- consorted regional tax and subsidy policies
- consorted macroeconomic policy including fiscal, monetary and exchange rate policy
- common institutions which control and alleviate the integration process, for example by setting standards and dispute settlement mechanisms
- advanced transport and communication infrastructure to boost the flow of goods and labour
- aligned legal regulation of goods and factor markets, for example anti-trust legislation, economic law and social partners etc.
- introduction of a common currency

b) Stages of Regional Economic Integration

Economic integration can be understood both as a dynamic process and as a static setting. According to Balassa ³⁶, the dynamic process consists of economic and political actions “designed to eliminate discrimination between economic units that belong to different national states”.The static setting “represents the absence of various forms of discrimination between different national states.” ³⁷

Balassa differentiates between 5 stages of regional economic integration ³⁸, listed with an increasing degree of integration in the table below. They comprise different degrees of discrimination between the partner countries themselves and between the partner countries and non-partner countries:

Tab. 2:

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Based on Hoekman and Schiff (2002).

Yet in reality, the different forms of integration cannot be separated so easily. Instead there exists a multitude of different hybrids which complicate clear differentiation.

c) Economic Causes and Effects of Regional Economic Integration

In the theory of economic integration, the causes and effects of integration are closely related, as the anticipated positive effects of integration actually cause countries to join an existing RIA or to co-found a new one.

Academic literature on the economic effects of integration generally distinguishes between static and dynamic effects of integration. Whereas the static effects are about the short term consequences, the dynamic effects are about the long-term consequences of integration measures. On closer examination of integration effects and attempting to measure them, one notices that it is quite complicated to actually determine which effects can be exclusively ascribed to measures of integration and which effects are at least partially the result of other political and economic measures or social events. ³⁹

In the following, some general economic motives for countries to integrate are elaborated, although each country may have its own specific reasons for joining an RIA. ⁴⁰

1. Static Effects of Regional Economic Integration

i. Trade Creation & Trade Diversion Effects

It was Jacob Viner with his publication on The Theory of Customs Unions (1950) who officially introduced the terms of Trade Diversion and Trade Creation, although Friedrich List had already alluded to the concept of Trade Creation in his analysis of the Deutsche Zollverein in 1841. ⁴¹

In Viner's day, the establishment of Customs Unions (CU) was generally considered to be welfare increasing and therefore had to be supported. This position was justified with the argument that global free trade would bring a maximum of global welfare, and since a CU was a step in the direction of global free trade, it should bring an increase in welfare after all.

It was especially Jacob Viner who doubted this idea, because a CU only meant free trade within its boundaries and a protectionist attitude against the rest of the world. According to Viner, this could lead to trade creation as well as trade diversion.

One speaks about an RIA as being trade creative if a member country of an RIA increases its imports from its partner countries without reducing its imports from the rest of the world. This occurs because the liberalization of trade within the RIA through the reduction of tariffs decreases the price of imports from other RIA member countries. In case the producers of the partner countries are more efficient than the home country, the price for the imported good will be lower than before the integration. As a result, consumption and imports increase while the less-efficient domestic producers stop producing. Hence the expensive domestic production is substituted by cheaper production from partner countries. Trade creation is beneficial because it does not have an impact on the rest of the world. The more efficient the production within the member countries of the CU compared with the rest of the world, the more likely trade creation is to occur. The lower the internal tariffs, transport and other trade costs, the larger the new market and the more effective the external tariff is in protecting the internal production, this stronger this effect becomes. ⁴²

One speaks about Trade Diversion when imports which came from the rest of the world in the past are substituted by more expensive imports from partner countries after the formation of the CU. After the formation of the CU, the partner countries do indeed have a price advantage because of the preferential treatment they experience (internal tariff reduction and common external tariff), but they do not necessarily have a cost advantage against the rest of the world. ⁴³ That means that trade is diverted from a more-efficient supplier outside of the CU towards a less-efficient supplier within the CU. That is why this effect is typically harmful.

Consequently the net welfare effect of a CU can be either negative or positive, depending on the relative strength of Trade Creation and Trade Diversion Effects. ⁴⁴

II. Demand Side Effects

Viner´s theory came under criticism because in his analysis he neglected the effects of integration on the internal relative prices. Hence he did not observe changes in consumer welfare triggered by integration. If these consumption effects are incorporated in the analysis, under certain conditions it can result in an increase in welfare even though the integration´s net effect is trade diverting. This applies for the case that the consumption or import structures are changing because of a shift in relative prices after integration.

Viner was accused of basing his analysis on constant consumption coefficients and therefore not accounting for the possibility of changing consumption volumes. In reality the creation of a CU does change the relative prices, which leads to a substitution of consumption to the relatively cheaper good. Therefore if the consumption effect is positive – because it can also be negative – and exceeds the negative trade diversion effect, a trade-diverting integration can still be welfare increasing for the member country. ⁴⁵

Others interpret Viner's work differently. Bhagwati, for example, assumed that Viner kept the import volume constant and not the consumption volume. In this case a trade-diverting integration leads to a reduction of welfare, because if there are no additional imports the consumers cannot benefit from lower prices, because there is nothing more to buy.

Bhagwati also showed that even if the consumption volume is kept constant, an increase in welfare is possible. This is the case if the change in relative prices causes a shift in production which means that more or less of a product is being produced. This applies only for the assumption of a variable production structure. In this case the specialization according to the comparative advantages leads to efficiency gains and therefore has welfare-increasing effects.

III. Terms of Trade Effects

The Terms of Trade (ToT) delineate the ratio of export prices and import prices. An increase in a country´s terms of trade has – ceteris paribus – welfare-increasing effects, because the country now has to export less to receive the same amount of imports in exchange. ⁴⁶⁴⁷

The fact that regional economic integration can change this ratio was already determined by Mundell in 1964 for instance. ⁴⁸ A trade diversion effect for the benefit of the RIA member countries results in less demand for imports from third countries. Also the introduction of import tariffs reduces the volume of imports from third countries, which in turn reduces the world price for the implied goods if the RIA has a large share in the world market. So the Terms of Trade for the non-member countries worsen and those of the RIA improve. ⁴⁹

2. Dynamic Effects of Regional Economic Integration

i. Increased Competition

Increasing competitive pressure between the companies of integrating countries can lead to rationalization of inefficient production processes and enable an improvement of technological efficiency, which again leads to cost savings and price reductions from which consumers can benefit. The cost savings also raise the international competitiveness of the producers of the integrating region, which again boosts its economic growth.

A larger market leads to higher demand and also allows a larger supply of efficiently producing suppliers. The reduction of import duties in an RIA for example then allows the substitution of home-produced goods through similar imports from partner countries. This substitution process helps to dissolve oligopolistic or monopolistic market structures in the referring countries. ^{50 51}

ii. Scale Effects

As already noted, an RIA joins the markets of the member states and thus a new expanded market emerges. This expansion allows firms to take advantage of economies of scale.

To use a common example, let us assume that two countries, of which each has two firms in a certain industry, form an RIA together. Before the formation of the RIA, those firms were exploiting their duopoly situation and were setting their prices above their marginal costs. After the formation, there are suddenly four firms and only one larger market.

This means that competition has increased. This process will sift the less-efficient companies out through mergers or bankruptcy. Let us assume that after the RIA formation, three companies are left, because two of the four previous ones merged. What we have as a result is more competition, fewer but larger firms – namely three – which can exploit their economies of scale now and therefore supply with lower costs. ⁵²

iii. Increased Efficiency

As already mentioned, an RIA results in a market expansion which fuels competition and forces companies into more efficiency. Manufacturers need to increase productivity and implement technological innovation to reduce costs and survive competition. As Zorob argues, this cutback of inefficiencies within companies can be quantitatively of much more importance than the trade-creating or diverting effects of traditional Customs Union Theory. ⁵³

iv. FDI

Foreign Direct Investment (FDI) – defined as “international capital flows in which a firm in one country creates or expands a subsidiary in another” ⁵⁴ – can have positive effects on the growth of the recipient economy directly through the accumulation of capital and indirectly through an increase in demand from upstream industries. Furthermore FDI can boost the transfer of technology and therefore triggers further spill-over effects, which again involve learning effects and positive externalities. Another possible effect that is also beneficial to the growth and welfare of the recipient country/region is the intensification of competition, because previous outsiders get into the market via FDI and therefore can become competing insiders. ⁵⁵

Regional Integration Agreements in turn can have effects on these investment flows into the integrating region. However, as Blomström and Kokko point out, these effects are hypothetical and they can take different forms depending on the initial situation the RIA starts from and the “environmental change” it brings along. ⁵⁶

To analyze how an RIA can affect FDI, first one has to be clear about the motives for FDI. Provided that trade and capital movements are considered to be substitutes, for example, tariff jumping can be a motive for FDI. As FDI – unlike exports – has no trade costs such as tariffs or transportation costs, a Multinational Corporation (MNC) may favour FDI over exports as long as the trade costs are high and make exports expensive. If regional integration results, and trade barriers such as tariffs are being removed or reduced, trade costs decrease and exports can become a more attractive instrument than FDI for MNCs to access the foreign market. In this context regional integration would lead to less FDI and more trade.

When discussing regional integration, it is necessary to distinguish between countries or firms belonging to the integrating region, the so-called “insiders”, and those not belonging to the region, the so-called “outsiders”. Depending on who is the potential investor – insider or outsider – investments are influenced differently by the integration process. According to the above-mentioned effects, for instance, intraregional investments in an integrating region should lead to less FDI because exports become relatively cheaper than FDI through integration and therefore economically more attractive. However, it would also be possible that the RIA creates additional trade which in turn calls for changes in the production structure of the region. As a result, this process could even foster intraregional investments if they become necessary or profitable.

Furthermore, the intensity of cross-border investments depends on the relative strength of the corporations in the RIA member countries. FDI flows will be less distinct if those companies which can benefit most from the new situation are already located in the investment region. In terms of interregional investment flows, the case seems to be more clear. FDI increases as more barriers of trade diminish and market size increases. However, the rise in FDI coming from outsiders does not have to be evenly distributed. In fact, investments basically condense only in a few areas which are the most beneficial.

Even trade diversion may have a positive influence on FDI because those exporting outsider companies that lose market share to insiders which have price advantages after integration may then try to access the market via FDI.

Taking a look at the influence of integration on FDI going out from the RIA to the rest of the world, the following scenario is possible. Under the assumption of unchanged trade policies in the rest of the world, a company which has only a limited capacity for FDI has to decide if it will invest within the RIA or outside of it. Supposed integration reduces the intraregional FDI and there is more capital left to be invested outside of the RIA. In this case, regional integration would lead to an increase in outward FDI.

An even stronger argument for FDI in the literature is that of optimal exploitation of intangible assets. An MNC which wants to invest overseas normally has to compete with local companies which have certain advantages because they have a better knowledge of their home market, including cultural, political and economical conditions. An MNC can normally balance its competitive disadvantages over the local companies with its specific intangible assets such as marketing, technical or management skills, which can be internalized through the formation of new foreign subsidiaries. However, even inflowing FDI which is motivated by internalization aspects is likely to be attracted and raised through a larger market. The actual dimension of FDI flows depends mainly on the relative strength of the outsiders compared to the insiders. Regarding FDI which is flowing out from an RIA, the correlation is not so clear. In a nutshell, regional integration is able to provide a positive investment climate and raise intra- and interregional FDI under certain conditions. However, the distribution of these investment flows cannot be determined properly yet. It seems to be obvious that investments are not going to distribute evenly over the entire integration area but are going to agglomerate in those regions which have the best investment conditions. ⁵⁷

v. Convergence/Divergence

When judging a regional integration project, another relevant question is whether or not intraregional disparities increase or decrease over time. In the former case we talk about convergence, and in the latter case we talk about divergence. Iancu ⁵⁸ distinguishes three different approaches to examine real convergence and its determinants. In the first one, convergence is seen as a natural process stimulated by the market forces. The larger the market and the better its functionality, the more successful the convergence process. This point of view is based on the neoclassical growth theory. This theory implies diminishing returns of the accumulative factor of capital. That is why an economy moves towards an equilibrium of growth (steady state) in the long term which is independent of its initial state (convergence hypothesis). Different rates of growth can only be explained as a result of differences in the exogenous rates of growth of technological progress. Under the assumption that the regions examined are located on the same long-term growth path, poorer countries grow faster than the richer ones. The reduction of trade barriers, also including transport and migration costs, through an RIA generally accelerates this convergence process. Although this theory is perfectly plausible, reality does not corroborate it. As Iancu is pointing out, poor countries normally do not have the necessary economic, scientific, technological or financial endowment and therefore are not capable of competing. This may be an explanation for the increasing disparities between poor and rich countries (divergence) which can actually be noticed in reality and which are in conflict with theoretical results. ⁵⁹

The second approach Iancu is stating rejects the idea of any convergence process between the poor and the rich countries in a competitive market because of the above- mentioned invalidity of the neoclassical model. Neither the hypothesis of diminishing returns nor the expected result of converging economies finds confirmation in reality. Divergence cannot only be ascribed to initial differences in factor endowment. That is why the new endogenous growth theory also considers long-term growth through technological progress and assumes that technological progress can be pushed via physical investment or investment in human capital. Technological know-how is a non-rivalling good which can be used by an infinite number of people at the same time. This creates positive external effects in the form of spill-over effects which allow economies with a better endowment of physical and human capital to grow faster than the others and consequently intensifies the divergence process.

The third approach regards convergence as a necessity which is only possible under a political and economic framework which helps to offset the negative effects of possible divergences.⁶⁰

[...]

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¹ Auer (2007), p.19.

² The “House of Islam”, a term from Islamic theology.

³ This means “The Prolegomena” and was intended to be the introduction to his historical book “Kitāb al-ibar”. Today it is considered to be an independent work.

⁴ Auer (2007).

⁵ Akbar (2002), p. 27.

⁶ According to The World Bank´s definition, the MENA region includes: Algeria, Bahrain, Djibouti, Egypt, Iran, Iraq, Israel, Jordan, Kuwait, Lebanon, Libya, Malta, Morocco, Oman, Qatar, Saudi Arabia, Syria. Tunisia, United Arab Emirates, West Bank and Gaza, Yemen. Other definitions include additionally Afghanistan, Somalia, Sudan, Libya or Turkey.

⁷ Algeria, Cyprus, Egypt, Israel, Jordan, Lebanon, Malta, Morocco, Syria, Tunisia, Turkey and West Bank/Gaza Strip (although not a state).

⁸ Bahrain, Egypt, Iraq, Jordan, Kuwait, Lebanon, Libya, Morocco, Oman, Palestinian National Authority, Qatar, Saudi Arabia, Sudan, Syria,Tunisia, United Arab Emirates and Yemen.

⁹ According to The World Bank´s definition.

¹⁰ It is also called the “Pan-Arab Free Trade Area” (PAFTA).

¹¹ They agreed on reducing their customs by 10% annually to reach an FTA by the end of 2007. 12 Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and United Arab Emirates.

¹³ In this manner the reader can obtain an overview of the economic relations in the region, hopefully lending inspiration for a deeper study of particular issues.

¹⁴ Provided that they are vital to its population or, as the case may be, are felt to be vital.

¹⁵ Scottish moral philosopher and the founder of modern political economy (1723-1790).

¹⁶ Adam Smith (1776): An Inquiry into the Nature and Causes of the Wealth of Nations.

¹⁷ Issing (2002), p. 67.

¹⁸ David Ricardo (1772-1823) was an English promoter of classical political economy.

¹⁹ Issing (2002).

²⁰ Krugman and Obstfeld (2000).

²¹ 1909-1984.

²² Samuelson (1969), p. 9.

²³ Krugman and Obstfeld (2000), pp. 55.

²⁴ In 1977, Ohlin shared the Nobel Memorial Prize in Economics with the British Economist James Meade “for their pathbreaking contribution to the theory of international trade and international capital movements.”

²⁵ Luckenbach (2000).

²⁶ Therefore see also Krugman and Obstfeld (2000), pp. 80 - 82 and pp. 13 - 119.

²⁷ French statesman and economist.

²⁸ Winters (1996).

²⁹ Baldwin and Venables (1997).

³⁰ In literature, the expressions RIA, RTA or PTA (Preferential Trade Agreement) are often used interchangeably. For reasons of uniformity, only the term `RIA´ will be used in this paper. Moreover, according to the author´s view, this term best recognizes the fact that arrangements between countries often go beyond the level of trade liberalization, often up to the point of political harmonization.

³¹ Burfisher, Robinson et al. (2003), p. 2.

³² Langhammer and Wößmann (2002), p. 10.

³³ Friedrich List (1789-1846) divided the historical development process of each economy into five levels. Not every country is located on the same level of development. According to List, these differences in the level of economic development among the countries would render the concept of one single “world economy” useless. In fact each country had to do everything within the realms of possibility to reach the highest level of economic process. Customs were a permitted instrument to protect the country's own economy from foreign competition as long as the advance gained was used to improve the own country's competitive capability. If all countries reached the same final level of development, a world federation could be established, where free trade and peace would dominate.

³⁴ Carlowitz (2003), p.15.

³⁵ Burfisher, Robinson et al. (2003), pp. 2-3.

³⁶ Béla Balassa (1928-1991) was a famous Hungarian economist.

³⁷ Balassa (1987), p. 43.

³⁸ Balassa (1961), p. 2.

³⁹ De Lombaerde (2005), p. 23.

⁴⁰ Carlowitz (2003), p. 25.

⁴¹ Carlowitz (2003), p. 27.

⁴² Taalouch (2007), p. 5.

⁴³ Carlowitz (2003), p. 27.

⁴⁴ El-Agraa (1997), p. 35.

⁴⁶ According to Zorob, there is still academic discord about the question of whether Terms of Trade effects rank among static or dynamic effects. (Zorob (2006), p. 136)

⁴⁷ Krugman and Obstfeld (2000), p. 112.

⁴⁸ Mundell, Robert (1964) “Tariff Preferences and the Terms of Trade”, Manchester School Economic Social Studies, in Winters (1997).

⁴⁹ WTO (2000), p. 94.

⁵⁰ Taalouch (2007), p. 7.

⁵¹ Zorob (2006), p. 165.

⁵² World Bank (2000), p. 31.

⁵³ Zorob (2006), p. 165.

⁵⁴ Krugman and Obstfeld (2000), p. 169.

⁵⁵ Carlowitz (2003), p. 68.

⁵⁷ Blomström and Kokko (1997), p. 5 – 9.

⁵⁹ Iancu (2008), p. 27 – 28.

⁶⁰ Iancu (2008), pp. 27.

• College: University of Hohenheim
• Grade: 2,3
• Author: Benjamin Hätinger (Author)
• Publication Year: 2009
• Pages: 115
• Catalog Number: V155911
• ISBN (eBook): 9783640694068
• ISBN (Book): 9783640695065
• Language: English
• Tags: Middle East, North Africa, Integration, Economic, Mena, versus, arab, arabic, islam