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Global Connectedness and Bilateral Economic Linkages - Which Countries? - WP 04/09

5.3  Developing criteria for selecting CEP partners—some are better than others

CEPs are an opportunity to remove tariff barriers on a bilateral basis and to deepen economic integration across the wider trade and investment relationship.

Selecting candidates for CEPs is complicated. A CEP raises welfare if it creates trade by allowing cheaper products from partners to substitute for more expensive domestic production. This is trade creation. CEPs can divert trade by allowing firms in partner countries to displace imported goods from outside the bloc that were cheaper when both faced equal tariffs. This is trade diversion. The tariff advantage over third countries allows high-cost firms in partner countries to win sales. While trade creation contributes positively to welfare in the home country, trade diversion results in a welfare loss.

The balance between trade creation and trade diversion is the key determinant of the benefits of a CEP and who is and is not a good potential partner. Trade diversion offsets trade creation because CEP members start to import goods from each other that they could have imported at lower cost from other countries in the absence of a preferential tariff. Little is gained if consumers pay much the same prices as before the CEP and tariff revenues are lost to make way for higher-cost imports from a partner country.

The welfare effects of CEPs vary from deal to deal: members split the gains from higher export prices but incur higher import prices. In those deals where there is trade diversion, a member pays more for imports, with the increase financed by what had previously accrued as tariff revenues. New Zealand collected $285 million in customs duty in the year to 30 June 2003, with $155 million in duty on textile, clothing and footwear imports. A poor choice of partner could lose millions in duty with few retail price benefits.

Studies of individual free trade agreements have produced a wide range of results. The previous empirical literature, as reviewed Schiff and Waters (2003) and Adams et al (2003) suggests that the nine CEPs studied (including CER) are modestly trade diverting, which is a relatively benign result. However, new empirical work undertaken by the Australian Productivity Commission (Adams et al 2003) suggests that of the 18 recent preferential trading agreements examined in detail, 12 have diverted more trade from non-members than they have created among members. What is more, some of the apparently quite liberal agreements—including EU, NAFTA, CER and MERCOSUR—have failed to create significant additional trade among members (relative to the average trade changes registered among countries in the sample). Overall, the empirical literature suggests that there is weak evidence that trade is smaller than it otherwise might have been in at least some of the blocs researched. However, the picture is sufficiently mixed that it is not possible to conclude that trade diversion has been a major problem.

In the early 1990s, analytical attention turned to the notion that free trade agreements (FTAs) should be formed between natural trading partners. Natural trading partners are countries which already trade a lot with each other. As most of the proposed partner’s trade is already with each other, there is little additional trade to divert. A close variant of the ‘natural trading partner’ hypothesis is that FTAs are more likely to be beneficial when they are among geographic neighbours because transport costs will be lower.

The natural trading partners criterion for CEP partners has been criticised. The welfare effects of FTAs depend on the volumes of trade actually diverted, which need not be proportional to initial trade shares. That a trade flow is already large says nothing about the need to stimulate it. Some flows are large because of existing distortions and may need to be curtailed rather than boosted. Importantly, the larger the initial volume of trade, the larger the amount of tariff revenue that is to be foregone under a CEP.

Figure 5 – Top 20 import sources, New Zealand, year to December 2003
Figure 5 – Top 20 import sources, New Zealand, year to December 2003.
Source: Statistics New Zealand

The practical value of proximity and volume of trade as CEP partner selection criteria may be restricted. Many countries have diversified trade and trade extensively with far away countries. Australia, our CER partner, only accounts for slightly more than one fifth of New Zealand’s trade (see figures 5 and 6). After that, the EU big 4, the USA and Japan account for 10 to 15% each of imports and exports (see figures 5 and 6). After these few countries, (see figures 5 and 6), New Zealand’s trading partners are a long tail.

Figure 6 – Top 20 export markets, New Zealand, year to December 2003
Figure 6 – Top 20 export markets, New Zealand, year to December 2003.
Source: Statistics New Zealand

Fortunately, trade diversion is a minor policy risk because 95% of imports by value land duty free. Customs collected $285 million in duty in the year to June 03, with $155 million of that duty collected from textile, clothing, and footwear (TCF) imports. That is not to say that there are no risks. A poor choice of partner, a partner with a high-cost TCF export expansion capability could forego significant amounts of customs duty.

With 95% of imports landing duty free into New Zealand, a CEP partner selection criterion based on proximity (with the TCF caveat) reasserts itself. Scollay (2003) has suggested that small and medium sized economies gain substantially from CEPs with large economies. This suggests that more CEPs along the Asia-Pacific Rim would take advantage of inherent cost advantages related to proximity. Other factors that should be taken into account are the export growth prospects of given markets, market size, the receptiveness of countries to trade liberalisation offers and comparative advantage.

An advantage of concentrating on the Pacific-Rim (USA, Japan, Australia and China) is that larger CEP partners are more likely to satisfy New Zealand’s import demand without increasing their export prices. These countries have such large domestic markets that they are less likely to stop importing goods from the rest of the world that compete with New Zealand’s exports and thus reduce their internal price of these goods below the world price plus their tariff on the third country imports. The price on New Zealand exports may continue to be the world price plus the tariff on third country imports.

As a small country exporting to large markets, preferential access would allow New Zealand exporters to win market share and raise export prices without depressing the consumer price in that export market, which is the world price plus the tariff. Modelling of the gains from a trade agreement with the USA assumes that U.S. prices will change little after a trade agreement so New Zealand exporters will gain market share and sell at a price that is higher than before the agreement. That price need only match the prices of competitors outside the trade agreement, who will be charging the world price plus the tariff. New Zealand exporters receive that price too, but have the advantage of not having to pay any tariff. The free trade agreement brings New Zealand exporters inside the tariff wall of the partner country and allows them to share in the price premiums of that tariff wall that are usually enjoyed by the import-competing industries in the partner country.

The horizon countries for deeper trade linkages would be South Korea and the ASEAN countries (particularly Thailand and Malaysia), and Mexico. New Zealand is currently undertaking joint studies of the possibility of a CEP with Thailand and with China. Closer economic partnerships with Mexico and with Chile have been discussed.

5.4  Deepening relationships short of CEPs

CEPs are not the only form of agreements through which New Zealand can seek to deepen trade links with focus countries. Trade and investment framework agreements and trade facilitation protocols can address non-tariff impediments.

Deeper economic relationships can also cover unilateral initiatives such as increased promotion of exports (including tourism and educational services). The Brand New Zealand programme is an example of efforts to increase global connectedness that can be used to deepen relationships with the focus countries by unilateral means. A number of government programmes support businesses building international networks. World Class New Zealanders, run by New Zealand Trade and Enterprise (NZTE), provides opportunities for high potential New Zealand businesses to learn from top offshore businesses, improve their business capabilities and establish networks of overseas experts and strategic partners. NZTE has sponsored the Kiwi Expatriates Abroad (KEA) network, under which talented New Zealanders living overseas help New Zealand businesses establish a presence in offshore markets and share their knowledge.

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