Making Regionalism Safe

Robert D Hormats. Foreign Affairs. Volume 73, Issue 2, March/April 1994.

Coping with New Competitors

The answers to two great questions will soon set the direction of the word economy. One: Will the industrialized democracies cooperate to sustain an open, market-oriented world trade and financial order? To do so, they must rise above the different ways they practice capitalism and mounting domestic pressures for economic nationalism. Two: Can these countries integrate into such an order those countries that are turning from state controls toward market capitalism?

The second challenge, on which this article focuses, requires vision, will and a comprehensive strategy. Established powers normally have difficulty coping with new competitors: France with Britain in the early nineteenth century, Britain with America later, and most recently the United States with Japan. Now, as a group, the industrialized democracies must integrate into the world economy not one but many developing countries, some with enormous economic potential. This process is producing acute concerns among established powers. Will jobs be lost, wages lowered, investment capital diverted? Can workplace and environmental standards be maintained, much less improved?

Despite the frictions of getting from here to there, expanding the participation of these nations in the world economy will greatly enhance the economic growth of developed democracies. Such was the case for the United States in the decades after World War II when farsighted assistance helped revive and reintegrate Japan and West Germany into the world economy. In the next few decades, phasing into a global economic order the newly market-oriented countries of Asia, Latin America and formerly communist Europe would harness the enormous productive capacity and market potential of some three billion people. The result would be an unprecedented transformation and growth of the global economy and a powerful antidote to divisiveness and instability.

But unlike the post-World War II years, no encompassing system like Bretton Woods exists, and no dominating power like the United States was at the time can impose a new order on the world economy. Today’s driving forces are private trade and investment flows. They are vital to growth, technological progress and job creation. These flows are creating inexorable momentum toward the further integration of economies within and across regions. How rapidly that integration proceeds, on what terms and in which parts of the world will shape the new global economic order. The challenge for governments is to reinforce these market trends to harvest long-term benefits while resisting pressures to protect against the short-term adjustments needed for future growth.

The arduously wrought compromises that proved necessary to complete GATT’S Uruguay Round and the North American Free Trade Agreement (NAFTA) amply illustrate that resistance to freer trade has increased. Within developed countries, sentiment is growing that inherent unfairness results from trading with poorer countries where low labor costs are assumed to be the primary source of comparative advantage. And many Americans and Europeans share the apprehension that rising imports from Asia eliminate domestic jobs.

Thus political tolerance would be in short supply for another global trade negotiation soon after the seven-year Uruguay Round. Just fixing the terms for a new round would be time-consuming, and obtaining new fast-track legislation from the U.S. Congress would be problematic. A successor round of global negotiations involving GATT’S more than 100 members will not likely occur until the next century, if ever. In the meantime, many of the issues the Uruguay Round left unresolved—environmental regulations, investment rules, intellectual property protection and access for suppliers of services—lend themselves better to bilateral and regional settlements, where direct reciprocity between countries is a more compelling motivator and lowest common denominator resolutions are more avoidable.

Two Tracks to Liberalization

The choice need not be between a seamless free trade world, desirable as that may be in the long term, and antagonistic regional blocs. A greater dispersal of economic power will mark the post-Cold War order. Different layers and categories of trade relationships—multilateral, regional, subregional and bilateral—will coexist. This web of relationships can incorporate newly market-oriented countries into the global system in different ways and on different schedules. The new order is likely to evolve on two broad tracks.

One track will emphasize regional negotiations between newly market-oriented economies as well as between them and industrialized market economies. The greatest progress in opening foreign markets is likely to occur through these regional relationships before the turn of the century. Commercial opportunities will flow from initiatives and expansion of the European Union (EU), Asia-Pacific Economic Cooperation (APEC), the Association of South East Asian Nations (ASEAN), NAFTA and other western hemisphere free-trade arrangements. Additional opportunities will flow from the evolution of natural, subregion trading areas like those comprising China’s coastal provinces and their offshore neighbors.

The other track will consist of efforts—short of a global negotiating round—to strengthen international rules and organizations so that sub-global arrangements wiLl. be consistent with the nondiscrimination and accountability required of open world markets. Countering centrifugal forces and assuring shared responsibility for the world economy will demand much from international organizations such as the new World Trade Organization (GATT’S successor), the World Bank, the International Monetary Fund, the Group of Seven (G-7), and the Organization for Economic Cooperation and Development (OECD). Orchestrating the cooperation required to ensure consistency between global and regional trade expansion will demand strong American leadership, as the salvaging of the Uruguay Round demonstrated. The burden of such leadership should seem lighter given America’s clear self-interest. As the world’s largest exporting nation, the United States loses if regional blocs are allowed to become protectionist.

Regionalism, while more the focus of upcoming trade negotiations, is not a unified concept and cannot by itself be the organizing principle for a new global economic order. For example, the EU with its common agricultural policy and common external tariff is far more institutional than NAFTA, which has no common internal policies or common external tariff. Both contrast with East Asia, where the private sector has driven economic integration. Second, regionalism does not answer how trade should be conducted among regions, nor does it ultimately provide a basis for integrating large economies like China, India and Russia into the global economy. Third, many countries will not likely be part of a major regional group in the near future. Finally, geographic regions are not necessarily natural trading areas; witness the greater U. S. trade with Malaysia, Singapore and Thailand in 1992 than with all of South America.

The Regional Advantage

While not a paradigm for it, regional trade zones can contribute importantly to a new global economic order. Regional free trade agreements can improve resource allocation by enlarging markets, expanding investment Flows, and creating economies of scale. In some cases such agreements reinforce already close private investment and trade links by further lowering barriers and improving cooperation on domestic policies. Public attention often focuses on tariff reductions in regional negotiations, but business finds equally important the protection of investment and intellectual property, and improvements in the security of market access. Without these provisions, conflicting national laws can undermine the ability of corporations to integrate production processes and support services efficiently.

Regional negotiations can serve as laboratories for experimenting with new rules. For example future multilateral negotiations could adopt as prototypes NAFTA’S investment protection codes, dispute settlement arrangements and environmental provisions. The EU’s harmonization of competition policy and product standards are so appropriate as models. Additionally. the emulation effect has encouraged progress toward regional free trade arrangements because an agreement among one group of countries makes others feel compelled to do likewise to improve their attractiveness to traders and investors.

Much of the impetus for regionalism results from a breakdown of the two major global divisions that artificially obstructed trade and investment among regional neighbors for decades. The first division was a philosophical one between the market-oriented industrialized world and the state control-oriented Third World. The second division was military and ideological, symbolized by the Iron Curtain in Europe. Removal of these barriers during the 1980s has allowed geography to play a greater role in determining trade and investment flows.

In Mexico and much of Latin America the debt crisis led to rejection of import substitution policies in favor of internal liberalization, privatization and unilateral tariff cuts. These policies opened the way for NAFTA and broader regional trade. Through market reforms China became a major regional trading partner, while East and Central Europe became open to opportunities for the West after the demise of communism and of the restrictive Council for Mutual Economic Assistance.

NAFTA and the EU-East European association agreements bear witness to the new incentives for industrialized and emerging economies to negotiate free trade agreements. Through NAFTA, Mexico linked up with its largest market and source of capital, while the United States realized more direct reciprocity in regional trade than it might have obtained from GATT negotiations. For similar reasons, the EU and Eastern Europe have concluded association agreements, which are steps toward full EU membership. In both cases, the industrialized partners recognized that more purchases from and investment in regional emerging economies would ultimately reduce the threat of destabilizing emigration. Yet another consideration is the framework that economic integration provides for alleviating environmental problems, which the public increasingly demands as a part of trade agreements.

For developing countries that are casting off state controls, free trade agreements with industrialized nations can provide critical stepping-stones into the world market. Developing countries can attract additional foreign investment and still phase in the exposure of their industries to competition, first at the regional and then the global level. Free trade agreements can also gird up domestic reforms. Mexico hopes that NAFTA obligations will lock in its new market-oriented laws, and the governments of Poland, Hungary and the Czech Republic look to EU membership to have the same reinforcing effect that it had for Spanish and Portugese reforms in the 1970s.

Newly market-oriented countries see trade agreements among themselves as increasing economies of scale and luring capital that might otherwise go elsewhere. For example, the ASEAN countries hope to avoid diversion of investment capital to China and Vietnam by reducing intraregional trade barriers. South American countries, sensing the benefits of NAFTA for Mexico and eager to appeal to investors preoccupied with Asia, are creating free trade zones. In 1989 members of the once-protectionist Andean Pact agreed to establish a free trade area by 1995. In 1990 the moribund Central American Common Market was transformed into a free trade area. In 1991 Argentina, Brazil, Paraguay and Uruguay agreed to establish a common market by 1995. With different degrees of intensity Turkey and republics of Central Asia, South Africa and countries to its north, and Israel and its Arab neighbors are also contemplating free trade areas.

One result of economic internationalization is the development of subregional trade links across national borders, such as ties between the U.S. Pacific Northwest and British Columbia and, as previously mentioned, between coastal Chinese provinces and their offshore neighbors. China’s enormous size has led to a transition that is integrating coastal provinces into the world market at a faster pace than inland provinces. Guandong province and the Shenzen Special Economic Zone have established bonds with Hong Kong, their primary source of capital and main channel to Western markets. Fujian province has close nongovernmental trade and financial relations with Taiwan, to which it is tied by language, and northeastern provinces are building on cultural affinities to attract investment from and accelerate trade with South Korea and Japan.

Plans were begun in 1990 to establish a subregional growth triangle to combine Singapore’s technology and financial power with the labor and resources of the Riau archipelago in Indonesia and Malaysia’s southern state of Johore. Similar efforts to strengthen commercial ties are linking Bohemia in the Czech Republic, Saxony in Germany and Silesia in Poland. Other subregional ties are emerging between the Lombardy region of Italy and contiguous areas of France and Switzerland and among an increasingly autonomous Russian far east, Japan, northern China and South Korea. Closer to home the American Southwest and northern Mexico are establishing commercial bonds.

Regionalism’s Other Face

Unless structured to complement the global thrust for open markets, regional fee trade groupings could turn inward and erect protectionist barriers that would cripple the potential growth of the world economy. In itself, parochialism could be a source of major fiction and conflict hence the need for strong countervailing leadership during the hiatus between multilateral negotiating rounds. While the GATT’S progressive lowering of world tariffs over 40 years has reduced the external barriers that can shield regional trading zones, nontariff barriers imposed by regions can have a similarly restrictive effect. High regulatory barriers can divert purchases away from competitive external producers. Product standards can be used to discriminate against outsiders. So can rules-of-origin requirements, which prevent goods produced with foreign materials in excess of a specified level in one member of a free trade area from qualifying for duty-free access to the market of another.

Business and labor often convince their governments to impose such restrictions as the price for granting their support. Under NAFTA, Mexican-made apparel will only qualify for the elimination of U.S. duties and quotas if produced from textiles and yarn made in North America. The EU has similar provisions. When competitive imports threaten a sensitive industry in a free trade area there is a tendency to protect the industry at the expense of outside imports. Foreign fears of losing regional markets often divert investment into those markets for defensive reasons. Free trade areas also can divert energies from the effort required to reduce barriers globally. The EU’s internal preoccupations drew attention and political capital away from the Uruguay Round; for a time the Clinton administration’s effort to secure congressional passage of NAFTA did likewise.

Regional free trade groupings are not much help to the poorest of nations. Such nations have weaker bargaining power in any type of negotiations with industrialized nations. And many of them, such as the small market states of Africa, are not likely to be grouped in free trade areas with major economic powers. Even developing countries several notches above the poorest must struggle, as Eastern European countries have with the EU, to obtain desired market access. They have had to acquiesce to restrictive safeguards by limiting exports into the EU if volumes increase rapidly. Mexico had to accept unilateral American demands for changes in NAFTA to secure passage by the U.S. Congress.

Recessions and structural uncompetitiveness can turn a trade region’s vision inward. Both factors weighed heavily in the EU’s resistance in the Uruguay Round to liberalization in key sectors. Looking ahead, high unemployment in the EU countries could stimulate more aggressive restrictions on imports. Europeans and Asians fear harm from NAFTA’S rules-of-origin requirements, particularly if the agreement is extended to include other western hemisphere countries. Americans and Europeans are afraid that tighter intra-Asian trade and investment linkages will be disadvantageous to nations outside Asia. So far, increased trade and investment in Asia has been market-driven. More than any other part of the word Asia has practiced open regionalism. Given the size and vitality of its economic activity, Asia’s future attitude toward regional integration could influence the world economy more profoundly than that of any other region.

The Need for Global Negotiations

Friction among regions will result unless an overarching framework prevents the conduct of commerce within regions from discriminating against outsiders. Such a framework must assure expanded market and investment access to all regions and enforce international accountability for regional and national policies. In most instances, modifying existing institutions and procedures can accomplish this efficiently.

A crucial test will face the new World Trade Organization It must fulfill its assignment of enforcing the implementation of Uruguay Round agreements and not allow a repeat of lax compliance as occurred with the subsidies agreement reached in the Tokyo Round in the 1980s. New multilateral trade rules will lose credibility unless deals made in the Uruguay Round are faithfully implemented and dispute resolution procedures work fairly and expeditiously. To assure itself a good start, the WTO should develop coalitions of the willing—it should mobilize small groups of countries to further liberalize. market access among themselves in key areas such as services and telecommunications and invite other countries to sign on as they make appropriate commitments. A sparing use of the conditional most-favored-nation concept, which the United States introduced in financial services negotiations of the Uruguay Round, would potentially be useful. This concept, or variants of it, could achieve breakthroughs in areas in which the majority of WTO members are not yet prepared to liberalize. The tool addresses the “free rider” issue by discouraging countries from holding back on liberalization in the hope of increasing foreign market access without improving access to their own markets.

Modification also would increase the effectiveness of the OECD, a group of 23 industrialized democracies. Opening membership to Mexico, South Korea and Singapore, as well as to selected East European states, would bolster the OECD’S relevance in the emerging economic order. A few of these countries have a greater impact on world trade and finance than some current OECD members. Several areas lend themselves to OECD leadership: liberalizing the treatment of foreign investment, harmonizing environmental practices, formulating guidelines to ensure that freer trade and improved environmental practices are not in conflict and resolving differences in competition policies to ensure against anticompetitive business practices impeding market access.

Annual meetings of top officials of the WTO, IMF and World Bank could coordinate policies and objectives concerning trade, investment, currency and development issues. Last September’s meeting to promote the Uruguay Round was a prototype. Region-by-region reviews between top officials of these institutions and ministers representing major free trade areas could confirm that regional trade, investment and exchange rate policies were consistent with global rules and a well-functioning world economy. Reviews now take place for individual countries. The IMF’S surveillance procedures evaluate national monetary and fiscal policies. The GATT conducts similar reviews under its trade policy review mechanism.

The Group of Seven (G-7) also needs to examine guidelines for ensuring that regional trade agreements not only open regional markets but also advance global trade liberalization. In recent years the G-7 appropriately focused on the Uruguay Round, but now it must chart the future evolution of multilateralism and how multilateralism interacts with regionalism and subregionalism. Little thought has been devoted to the implications of regionalism for world commerce or international political and security cooperation. Summit governments must forge a consensus on the type of international economic order they will support in the post-Cold War period and not drift into it through uncoordinated actions that could lead to conflict. Like the OECD, the G-7 can leaven its primarily European membership by inviting the leaders of key emerging states like China and regions like Eastern Europe to post-summit discussions on a new global. order. And a meeting the day before summit deliberations with the heads of the IMF, World Bank and WTO would reinforce the roles of these institutions and focus attention on priority global issues.

The centrality of U.S. Policy

the United States’ centrality to the shaping of the post-Cold War economic order stems from its commanding worldwide economic and political status. American influence, although less dominant since the rise of other economies, particularly those of Asia, is still the driving force for expanding world trade. As in clinching completion of the Uruguay Round, the United States must continue its vigilant championing of global institutions and open international markets. A pluralistic global economy also will require more active multiregional economic diplomacy. Last fall the Clinton administration effectively utilized the “fear of exclusion” factor. Concerns that NAFTA would limit their access to the North American market induced a number of Asian countries to take a more forthcoming attitude toward APEC. In turn, the Seattle summit of APEC induced the EU to become more accommodating in the Uruguay Round to prevent closer American trade ties to Asia.

The United States can influence the dynamics of future negotiations by opportunistically pursuing bilateral and regional arrangements that promise to expand America’s market access in key foreign sectors and areas. The United States and the EU can liberalize access to one another’s financial services markets and invite Asian countries to sign on later if they did likewise. Similarly any U.S.-Asian agreements on mutual recognition of product standards and testing could be opened to the EU.

The United States will have to manage a wide spectrum of regional relationships. Already the president holds semiannual summits with leaders of EU countries, and he is scheduled to attend annual summits of APEC leaders over the next several years. These and ministerial-level meetings provide opportunities to propose changes in international institutions and rules.

Abroad, NAFTA will be closely watched. Whether the United States seeks to add new members to NAFTA, whether rules of origin regulations are implemented fairly and whether hemispheric trade relations are pursued at the expense of multilateral relations will affect policies of other regions. Pressures are growing on Japan, which is now emphasizing closer political and commercial ties with its Asian partners, to participate in an intra-Asian trade group. If Asia faces growing discrimination in this hemisphere or in Europe, calls for a more institutionalized form of regional economic cooperation will grow.

President Clinton’s new trade agenda, which places priority on environmental protection, antitrust regulation and labor standards, will also be closely watched. The challenge will. be to support higher workplace and environmental standards in emerging economies while simultaneously broadening global trade opportunities.

American leadership will be crucial in advancing a strategy that combines the proven benefits of open trade and investment with the new realities and advantages of regional and cross-regional trade arrangements. That requires adapting existing institutions to expand market access around the world and to align the policies of regions, subregions and nations with the goal of open markets. Inaction would leave the field open to the temptations of protectionism and thus would undermine the current, promising opportunities to craft a prosperous and secure order going into the 21st century.