An EU-US trade deal: Good or bad for the rest of the world?

Aaditya Mattoo, 10 October 2013

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The recent launch of negotiations on a transatlantic trade and investment deal has been widely welcomed. The prime minister of the UK, David Cameron, called it a “once-in-a-generation prize” and produced numbers on why everyone should be happy; gains of £100 billion for the EU, £80 billion for the US and £85 billion to the rest of the world. A Financial Times (2013) editorial reassured us, “The common objection that bilateral deals divert trade as well as create new trade has little force when ‘bilateral’ already covers half the world economy.” But the focus on benefits, and more recently on impediments, is obscuring a serious downside. Developing-country exporters could be hurt by this deal unless a special effort is made to protect their interests.

The aspect of the deal that provokes the greatest excitement – its focus on regulatory barriers like mandatory product standards – should evoke the greatest concern. Since tariffs in the EU and US are low – on average less than 3% – the preferential lowering of these tiny tariffs will not seriously disadvantage outsiders except in some high-tariff products like shoes. But with mandatory standards, such as those pertaining to safety, health, the environment, or simply compatibility, the conditions of market access are brutal and binary. Either you can meet the agreed standard and sell or you can’t and don’t. And what you can do depends entirely on how the agreed standard is set.

The voluminous research on regionalism with its almost exclusive focus on tariffs and quotas provides only limited illumination on the implications of regional agreements on standards. Baldwin (2000) presented a useful analytical framework for the analysis of mutual-recognition agreements, but assumed identical countries with identical costs of complying with standards. Few previous studies have empirically explored the impact of shared standards on trade (see for example Swann et al. 1996, Moenius 2004, Shepherd 2007, Reyes 2011 and Oreficea et al. 2012). I draw here on my research with Maggie Chen (Chen and Mattoo 2008).

There are three main types of agreements dealing with technical barriers to trade.

  • The simplest, and potentially most powerful, is the mutual recognition of existing standards, whereby a country grants unrestricted access of its market to products that meet any participating country’s standards.

This was the approach taken in principle by the EU, with the spur of the Cassis de Dijon judgmeent of the European Court of Justice. Mutual-recognition agreements are, however, not likely to be an option if there is a significant difference in the initial standards of the countries, as became evident in the context of the EU.

  • The second is a certain degree of harmonisation as a precondition for countries to allow products of other countries to access their markets.

The most important example of such harmonisation is the New Approach of the EU, which resulted in a set of directives from the European Commission setting out essential health and safety requirements for most regulated products. Available evidence suggests that harmonisation within the EU tended toward the high range of initial standards due to pressure from the EU’s richer and more powerful members (see Vogel 1995)
In many other cases, neither mutual recognition nor harmonisation of substantive standards may be deemed feasible or desirable.

  • The third type of agreement concerns mutually recognising each other’s testing (conformity assessment) of each other’s standards.

In such agreements country A trusts country B to certify that the products made by country B conform to country A’s standards. Examples of such initiatives are the intra-EU mutual-recognition agreements on some non-harmonised industries and the EU’s agreements with a number of other countries. A key element of these agreements is the rule of origin.

Examples

Previous mutual-recognition agreements between the EU and US and between the EU and Canada specify that conformity assessment done in one of the countries, in which products are manufactured or through which they are imported, is accepted throughout the entire agreement region. Other agreements, such as the one the EU has concluded with Australia and New Zealand, impose restrictive rules of origin which require that third country products continue to meet the conformity assessment of each country in the region. That is also true of the EU’s previous recognition agreements on professional services standards. While a Brazilian orange admitted for sale in Portugal can be sold anywhere else in the EU – thanks to the European Court of Justice’ 1979 Cassis de Dijon ruling – a Brazilian engineer or accountant licensed in Portugal must still jump through separate hoops in other EU countries.

To intuitively see the potential implications of these different approaches, it is useful to draw a partial analogy between standards harmonization and mutual recognition, on the one hand, and a customs union and a free trade area, on the other. As in the case of a customs union, the economic impact of standards harmonisation depends on the level at which the harmonised standard is set. Unlike the case of a customs union, standards harmonisation has a market integration effect that creates scale-economy benefits for the firms not just of participating but also third countries. The impact on the firms of a specific country depends on how the costs of meeting the new harmonised level of the standard compare with the benefits from economies of scale in integrated markets. If firms from some countries have a higher variable cost of meeting a standard and reap fewer scale-economy benefits in integrated markets than firms from other countries, then the former can suffer a decline in exports to the integrated market when harmonisation raises some destination countries’ standards.

As in the case of a free trade area, the economic impact of a mutual-recognition agreement depends critically on the choice of rules of origin. For the participating countries, an mutual-recognition agreement is in effect a downward harmonisation of standards since firms are now free to meet the least costly of the initial standards. Trade is stimulated not only by market integration but also by the reduced stringency of the standard. The analytical implications for imports from third countries differ dramatically with rules of origin. If firms of third countries are denied the benefits of the mutual-recognition agreement and must continue to meet the original standard in each market, then they will face unchanged absolute conditions but suffer a decline in relative competitiveness – and hence a decline in exports to the region. In contrast, if the firms of non-participating countries are also entitled to access the entire region by conforming to the least costly standard, then they too reap benefits.

New evidence

In order to test the empirical validity of these propositions, we constructed a dataset that directly identified policy initiatives of different types on standards for manufacturing industries in 42 countries over the period of 1986-2001. These include all OECD countries and 14 developing countries that are the largest exporters of manufactured goods outside the OECD and account for over 80% of non-OECD manufactured exports. The policy measures include each harmonisation directive and mutual-recognition agreement concluded between the countries in the set. We matched the policy measures, which often pertain to a specific attribute (e.g. safety) of a variety of products, with trade data at the SITC (revision 2) three-digit industry level. We then estimated the significance of the impacts of these measures on bilateral trade across countries and over time, controlling for other influences.

Our evidence broadly confirms the intuitive results spelled out above.

  • Regional harmonisation significantly increases intra-regional trade in affected industries. Exports to the region of excluded developed countries also increase, but exports of excluded developing countries decline.

These asymmetric effects may arise because developing-country firms are hurt more by an increase in the stringency of standards and benefit less from economies of scale in integrated markets.

Otsuki et al. (2001) also found that when the EU decided in the late 1990s to harmonise aflatoxin standards across member states, eight states (including Italy, the Netherlands and Spain) drastically tightened previously acceptable national standards and as a result, African exports to Europe of cereals, dried fruits and nuts may have declined by as much as $670 million.

Chen and I also found that mutual-recognition agreements promote trade both within the region and with the rest of the world. But if they contain restrictive rules of origin, then intra-regional trade increases at the expense of trade with other countries, and developing-country exports suffer most.

Policy issues

Multilateral rules on trade have taken a permissive approach to regional agreement on mandatory standards. While it is neither feasible nor desirable to restrict the freedom of countries to harmonise or mutually recognise their standards, more could be done to strike a better balance between the interests of integrating and excluded countries. This is particularly important because few of the agreements on standards include developing countries, and the big differences in social preferences over issues such as safety and the environment suggest that few developing countries are likely to be party to such agreements with industrial countries in the foreseeable future.

Even in the absence of international rules, however, the EU and US could take two steps to avert any adverse consequences.

  • First, they could generally favour mutual recognition, which is a more powerful liberalising tool and agree not to impose any restrictive rules of origin.

Just as producers in the EU and US would be able to supply both markets by fulfilling either the EU or US requirements, so would producers in third countries.

  • Second, where they do consider harmonisation, there would be a presumption in favour of the less stringent of the original standards.

And any decision to harmonise their standards upward would require credible evidence that the less strict standard is not adequate to meet the relevant regulatory objective. This is akin to a test the WTO already applies to departures from established international standards.

With these two commitments in place, the rest of the world could follow the EU and US negotiations with hope rather than trepidation.

References

Baldwin, Richard (2000) "Regulatory protectionism, developing nations and a two-tier world trade system", CEPR Discussion Paper 2574.

Financial Times (2013) “Eyes on the prize in EU-US trade”, 18 June.

Moenius, Johannes (2005) "Information versus product adaptation: the role of standards in trade", mimeo, University of Redlands.

Oreficea, Gianluca Roberta Piermartini and Nadia Rocha (2012), "Harmonization and mutual recognition: What are the effects on trade?", mimeo., WTO.

Chen, Maggie Xiaoyang and Aaditya Mattoo (2008), Regionalism in standards: good or bad for trade?, Canadian Journal of Economics, vol. 41, 838–863.

Otsuki, Tsunehiro, John S Wilson and Mirvat Sewadeh (2001), "Saving two in a billion: quantifying the trade effect of European food safety standards on African exports", Food Policy 26, 495–514.

Reyes, J-D (2011), "International Harmonization of Product Standards and Firm Heterogeneity in International Trade", Policy Research Working Paper 5677, World Bank, Washington DC.

Shepherd, B (2007), "Product Standards, Harmonization, and Trade: Evidence from the Extensive Margin", Policy Research Working Paper 4390, World Bank, Washington DC.

Vogel, David (1995), Trading Up: Consumer and Environmental Regulation in a Global Economy (Cambridge, MA: Harvard University Press).

Topics: International trade
Tags: free trade agreements, harmonisation, standards

Aaditya Mattoo
Research Manager, Trade and Integration, World Bank