Understanding Trade Diversion, Rules of Origin, and Regional Trade Agreements

Understanding Key Concepts in International Trade

1. Trade Diversion and Trade Creation

Trade Diversion is a shift in the pattern of trade from low-cost world producers to higher-cost Custom Union or FTA members. It is often viewed as welfare-reducing for the world.

On the other hand, Trade Creation refers to the expansion in world trade that results from the formation of a preferential trade agreement.

2. Rules of Origin

Rules of Origin are the requirements that domestic producers or exporters must fulfill in order for their products to be considered as originating in a specific country and receive the benefits of tariff reductions. This measure is created to avoid trade deflection.

These rules define whether a good is eligible for duty-free treatment, based on whether it has sufficiently originated in the partner country. FTAs require rules of origin in order to eliminate trade deflection and to prevent exporting countries outside the FTA from taking advantage of the agreement.

3. Regional Trade Agreements (RTAs)

A Regional Trade Agreement refers to reciprocal trade agreements between two or more partners. They include free trade agreements and customs unions. These are agreements between states that aim to increase economic integration and reduce barriers to trade, resulting in increased movement of goods, services, people, and capital between them.

These reciprocal agreements between countries have the main goal of liberalizing trade and investment flows among them. Almost all states are part of at least one RTA. These states will ‘huddle together’ into an international community on the basis of these agreements, resulting in the increased movement of goods, services, people, and capital between them.

Four Major Waves of RTAs:

• Sub-regional trade pacts: Mercosur, Andean Community, Central American Common Market.
• Free Trade Agreements in the hemisphere: NAFTA, Canada-Costa Rica, Canada-Chile.
• Bilateral Transcontinental agreements: Colombia-Korea, Chile-Korea, Chile-E.U.
• Mega-trade agreements: TTP

4. Free Trade Area (FTA) vs. Customs Union (CU)

Free Trade Area (FTA): Tariffs are removed for FTA members. Each country imposes its own tariffs on non-members.

Trade Deflection: This refers to the practice of importing goods into an FTA member with a lower tariff, then exporting them duty-free into an FTA member with higher tariffs. This takes advantage of non-uniform tariffs.

Customs Union (CU): Removes tariffs among members and establishes common external tariffs (CET). This harmonizes external tariffs to prevent trade deflection.

Both FTAs and CUs remove tariffs between members. However, in FTAs, countries are free to maintain their own individual barriers to trade with other countries. In a CU, members agree to set up a common external tariff for non-member countries.