Sunday, November 20, 2005

Understanding FTAs: going back to the basics
Korea Herald
By Lee Si-wook Associate fellow at Korea Development Institute, November 14, 2005

Despite being a late starter in pursuing bilateral free trade agreements, Korea has been actively seeking Free Trade Agreement talks with its trading partners around the world. Recently, Korea signed FTA pacts with Chile, Singapore and the European Free Trade Association, while official negotiations with the Association of Southeast Asian Nations, Japan and Canada are in proress.

Groundwork typically preceding official talks, such as joint feasibility studies and exploratory talks, is also underway with several other trading partners, including India, Mexico, Russia, the United States and China.

However, despite such efforts, the current process of free trade talks seems to be largely stalled. In contrast to the Korean government’s ambitious plan to sign bilateral FTAs with at least 15 countries by 2007, the Korea-Chile FTA is the only one in effect so far.

Negotiations with ASEAN have recently come to a standstill due to the disagreement over the scope of trade liberalization in manufacturing products. Agricultural issues and the territorial dispute over Dokdo are also holding up progress in FTA talks with Japan.

Why is this happening? Is it something unexpected or is it inherently inevitable, indicating an overly ambitious plan on the part of the Korean government? To answer this question, we need to first go back to the basics of FTAs and understand their nature and effects.

Why FTAs?
The rationale for economists and policymakers who support FTAs could be summarized by the following; the vast majority of residents in member countries are ultimately better off by trade liberalization.

One of the most obvious benefits is that consumers can purchase more goods and services at cheaper prices with trade than without, thanks to the removal or reduction of tariffs and non-tariff barriers to the imported goods. On the production side, an FTA induces a member country to devote its resources to sectors in which it has a comparative advantage vis-a-vis its counterparts.

Consequently, less competitive sectors contract and less efficient firms exit out of the market. Coupled with economies of scale, this process ultimately contributes to enhancing efficiency of the entire economic system and increasing living standards.

Note that the scope of FTA negotiations nowadays is not confined to merely removing tariff and non-tariff barriers to trade. Rather, it covers virtually all important economic transactions, including foreign direct investment, migration, technology cooperation, coordination of domestic policies, etc.
For instance, an FTA offers the chance to create larger regional markets that are more attractive to foreign direct investment, which stimulate domestic investment and technological progress.

Winners and losers
An unfortunate fate of an FTA, however, is that not everyone is automatically better off from trade liberalization. There are losers as well as gainers from trade liberalization. For instance, owners of specific factors in contracting-industries will be unambiguously worse off, while those in expanding industries tend to gain more from trade.

In this regard, economic theory tells us that, with some mobility across population groups and with programs to permit the entire population to share in a country’s income, most people are expected to be better off in the long run.

A practical problem here is that such long-run gainers are unlikely to be the same people who currently suffer from trade liberalization. The descendants of today’s losers are likely to be tomorrow’s winners, benefiting from the current strands of FTAs.

Nonetheless, it is at best of second or third order importance for those whose lives are directly intruded and threatened by FTAs right now. This explains a lot why pursuing FTAs is such a difficult and painful task.

How about not engaging in trade liberalization? Historical evidence shows that most underdeveloped countries today have been distinctive in the extent to which they have remained relatively closed off from world markets. More importantly, regarding bilateral or regional FTAs, many studies suggest that trade liberalization will bring economic benefits to all member countries, often at the cost of non-member countries.

Obviously, the reductions of tariffs and non-tariff barriers implemented through bilateral FTA negotiations are concentrated in sectors in which the tariff-reducing countries stand most to gain as exporters.

Non-members are at a disadvantage because an FTA tends to divert trade away from them and thereby makes them worse off. This partly explains a huge surge in recent FTA negotiations all around the world. This also suggests that pursuing FTAs for Korea is not an option but a matter of survival and prosperity.

Critics of FTAs argue that:
First, many firms in developing countries cannot compete against foreign rivals without protection afforded by tariffs and non-tariff barriers. Protection provides "infant industries" the opportunity to prepare for freer trade by becoming more productive. Well, it sounds great, but empirical evidence suggests that such arguments largely fail to hold. Protected firms often do not achieve the best-practice productivity that protection is intended to afford.

Technological learning is insufficient and investments are often inefficient. Even in cases where firms become more efficient, they tend to engage more in political lobbying in order to seek longer periods of protection. Korea should not forget the lessons from the 1997 crisis on the effects of the excessive protection and intervention.

The second criticism relates to those who are directly threatened by trade liberalization. This is both understandable and heartbreaking. As discussed earlier, however, in principle the overall benefits from trade liberalization would outweigh the costs for the entire economy. Furthermore, pursuing FTAs is no longer an option, but a must for ourselves as well as our descendants.

Hence, critics should not be merely opposed to FTAs. Rather, more efforts should be given to design and implement specific policies that could potentially compensate and assist those whose lives are threatened by trade liberalization, making everyone better off.

Consistent FTA strategies
Given our discussions so far, let’s make some policy recommendations to speed up the currently-stalled FTA negotiations of Korea.

First, the Korean government should establish consistent FTA strategies and comprehensive negotiation guidelines, which are firmly based on a long-term vision of the national economy. If individual FTA negotiations are facilitated in a case-by-case basis, this weakens our negotiating power and ultimately undermines industrial competitiveness.

The government needs to enunciate its overall stance regarding several issues such as the scope of the market-opening and domestic structural reforms, which serves as a basic guideline at every negotiating table.

In doing so, we could gain full credibility from our negotiating partners and speed up the discussions. Recall that it took almost 5 years to conclude the Korea-Chile FTA, while it is generally a 2-year process in FTA cases in other countries.

Second, there has been growing concern about the sequence of FTAs. With the recognition that Korea is a late starter, the government has been pursuing FTA talks simultaneously with many trading partners. Recently, the pros and cons of such a government approach are being weighed.
Some suggest that the Korea-U.S. FTA should be given top priority because it would produce the greatest welfare gains.

Others argue that FTAs with developing countries, including China and ASEAN, should take precedence. They worry that FTAs with Japan or with the U.S. force Korea to permanently specialize in sectors that have relatively little opportunity for technological learning.

The claim is that FTAs with developing countries should be the priority and may make sense if substantial time gaps are expected between launching FTAs with developing countries and advanced countries.

Given the current active participation of both groups in FTA negotiations, I am doubtful if this will be the case. In addition, the emphasis on FTAs with developing countries carry risks, one of which is that trade may be diverted from more efficient non-members to less efficient members.

There are several advantages in pursuing FTAs on a simultaneous basis; this approach makes coordination among domestic interest groups easier, because the effects of individual agreements can both offset or complement each other. For example, it is relatively easier to persuade farmers if we advance free trade talks with Japan and China simultaneously.

Furthermore, an FTA with one country creates pressure for other neighboring economies and consequently promotes further trade deals.

Nonetheless, one thing that worries me most at the moment is the shortage of FTA specialists in the government, compared with the extensive FTA negotiations underway with our many trading partners.

The government should therefore recruit and utilize more experts to ensure that its FTA policy is more successful. Otherwise, I believe that a certain degree of "selection and concentration" among FTAs is required, based on the extent of the economic impacts and long-term implications.
Third, trade liberalization could be fully justified and smoothly facilitated when a comprehensive compensation scheme for those who lose out from trade liberalization is prepared.

Owners of contracting-industry specific factors should be a major source of concern. The government should identify complementary policies that facilitate the adjustment process to more productive activities, and any compensatory policies that alleviate the transitional losses that insecure groups may otherwise have faced.

In this respect, the government should consider the establishment of a comprehensive adjustment assistance program, like the United State’s Trade Adjustment Assistance (TAA).

At the same time, the government should maintain a formal communications channel with interest groups. Unless the FTA policy gains consensus and support amongst the people, it is likely that negotiations would be substantially delayed, as was the case with Chile.

Last but not the least, domestic structural reforms to upgrade the economic system should be also pursued together with FTAs. In doing so, our FTA policy would be more effective.

Since the FTA policy shares similar implications with industrial policies on the industrial structure adjustment, harmonization with other domestic policies is required. Trade liberalization and structural reforms are often thwarted by vested interests, and cooperation between FTA partners makes them easier to achieve.

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