Possible Downfall In The Road Of a Promising Future?

Introduction:
This paper will take a deep look into a trade agreement created in March 1991 between Argentina, Brazil, Paraguay, and Uruguay, called Mercosur (Mercado Común del Sur, or Southern Common Market). After understanding what a trade agreement is and what are the benefits and disadvantages of being part of one, I will analyze how the agreement changed the economy and overall welfare of the countries involved and how did their interactions changed ever since. Not only will the countries that are part of the agreement be analyzed, but also neighboring countries, which are not part of the agreement, that could have had their own trading environment affected. I will show how the agreement was first created and what the reasons for it to be developed were.

Mercosur has contributed significantly to regional trade liberalization, what provides huge incentives to grow in the past. But by encouraging trade within the group at the expense of trade with nonmembers, Mercosur may limit member countries’ access to high-technology imports, an important stimulus to growth. And I will show data to support this argument. By the end of this paper I should be able to conclude, are the countries involved into Mercosur in fact better off by adopting the trade policies established and by being part of the agreement? Or would they be better off now if they had not engaged into Mercosur at all? How it was created:

Mercosur was established in March 1991, formalized in the Treaty of Asuncion, and countries members were Argentina, Brazil, Paraguay, and Uruguay. These four countries had been engaged in multilateral trade liberalization for three years before making the agreement. The treaty called for the elimination of all tariffs on intra Mercosur trade by the end of 1994 but mandated that member countries impose a common external tariff on goods imported from countries outside the union. The tariffs first began to be lowered in June 1991, and by early 1997, around 90 percent of intra-Mercosur trade was free of tariffs. (Connolly and Gunther, 1999) The trade agreement has extended its range by joining forces with Chile and Bolivia, (they are tied to MERCOSUR members by an FTA, although they do not participate in the CET) even though these countries currently have associate member status also with Colombia, Ecuador, and Peru.

After the impeachment of the previous president of Paraguay, Fernando Lugo, by the Paraguayan Senate, this country was suspended from Mercosur, and Venezuela was finally admitted as a full member effective July 31, 2012, after years in negotiations. In a term of four years, Venezuela will have to have fully adapted to the trade bloc regulations. (The Economist, 2012) The union’s sheer size gives it considerable market power and influence over trade developments worldwide. If Mercosur was successful, member countries would gain from greater production rationalization, more efficient resource allocation, and expanded consumption opportunities.

Literature Review
In Mercosur: Implications for Growth in Member Countries, 1999, Michelle Connolly and Jenessa Gunther brought up the argument that members of Mercosur, given some of the regulations applied, were not only better off with the agreement, but also brought some disadvantages. “A balanced assessment of Mercosur’s effectiveness must include some recognition of the union’s potential drawbacks… Mercosur is diverting trade in manufactured goods from lower cost nonmembers to higher cost members”. They also point out another potential drawback when examining the membership of Mercosur, as it how it “may impede growth by limiting the participants’ access to the advanced technologies of developed countries. These considerations suggest that had Argentina, Brazil, Paraguay, and Uruguay undertaken a similar degree of trade liberalization in a multilateral setting, they might have realized even greater benefits from their efforts to open up trade”.

Even though such disadvantages could mean that the agreement made the countries members worse off, the authors explicitly suggest that this is not the point. “Mercosur has clearly provided a political framework that has helped to advance regional trade liberalization. In addition, the customs union may have promoted lower average tariff rates on goods from all countries and increased the credibility of the participating governments’ commitments to trade reform”. The article Mercosur: Integration and Industrial Policy from 1995 by Leipziger, Frischtak, Kharas, and Normand brings two general conclusions to it and discuss them, the first being that the welfare effects of the trade agreement, even though not being large in the short term, are still positive and the second one is that industrial policy interventions weren’t aggressive, but were happening and still there. What the authors were trying to established was that the major implications of those conclusions was that Mercosur would have to continue to grow and show progress in order to maximize its welfare-enhancing effects.

The article also brought five key things that the authors believed were useful guidelines for Mercosur countries, those being transparency of industrial policy activities, rapid phase-out of subsidy programs, limit admissible types of intervention, to consider only functional interventions, and to anticipate requests for assistance from declining industries. By stating “as Mercosur finds itself involved in more multilateral and bilateral negotiations, momentum for Mercosur should be expected to build” the article shows to believe in Mercosur’s success. Mercosur RIP? Is an article brought by the magazine “The Economist”, published July 2012, that talks about a potential downfall in the South American integration. After bringing a little history behind how the custom unions was first originated, the article brings ongoing struggles that Mercosur has been dealing with for the past few years, as well as what has led to such struggles.

The article concludes its point by criticizing choices some of the countries involved in the treaty have made, saying that now the group “consists of little more than bear-hugs and kisses among compañeros serves little purpose in a harsher world”. Mercosur: Objectives and Achievements, June 1997, written by Sam Laird from the World Trade Organization mainly focus on where Mercosur is heading to, and on what they have already accomplished since becoming a customs union. After discussing all norms and regulations from the agreement, all of Mercosur’s future intentions are discussed and analyzed. The most interesting one is the adoption of free circulation of goods around the union, which was being postponed because of administrative difficulties. “Free circulation would mean that, once imports from third countries enter one MERCOSUR country, they should be able to cross internal frontiers into other MERCOSUR countries simply by showing that the duty under the CET has been paid at the first port of entry”, what is not only logical but fair. Purpose, Objectives, and Characteristics:

Even though the main purpose of the agreement was to enforce trade liberalization, to coordinate labor, monetary, trade, Research and Development, monetary, regional development, and industrial policy, as of January 1995, all countries had adopted a common external tariff, or CET, what was initially set to equal a weighted average of the national tariffs levied by the member countries before the formation of Mercosur. This external tariff could range from 0 to 20 percent by product type. (Mercosur) A more concise illustration of how the tariffs were originally installed can be seen in the table below. For raw materials and food ranged from 0 to 9 percent; for agricultural products and semi processed goods it ranged from 10 to 15; for textiles, manufactured goods, and consumption goods it could range from 15 to 20 percent (Frischtak, Leipziger, and Normand 1996). The average external tariff between all different products was 12 percent. By December 1997 it had increased to 15 percent. (Garay and Estevadeordal 1995);

The main argument supporting this tariff was the infant industry argument, which justifies the prolongation of these generally greater tariffs on the grounds that home producers of these goods needed more time to prepare for foreign competition. The protection afforded by this provision of the agreement appears to have helped domestic producers expand their trade operations within the Mercosur group: the products exempted from the common external tariff until 1999 accounted for almost half of intra-Mercosur trade. (Connolly and Gunther, 1999) After Brazil’s devaluation in 1999, what caused Argentina to implement emergency restraints on imports from there, “politically negotiated exceptions to the block’s rules became the norm”, and eventually in 2010 a common customs code was finally agreed on, what avoids international goods having to pay tariffs more than once. (The Economist, 2012)

Mercosur’s Effects on Tariff Rates and Trade Volume:
The main point of creating Mercosur was to remove tariff barriers between member countries following the agreement, what incentives more general trade liberalization, sharply reducing the countries’ average tariff rates, as we can see in the chart below.

The biggest change can be seen in Brazil, where the average tariff rate tumbled from a high of 69 percent before 1990 to 13 percent in 1995. Because the common external tariff, previously mentioned, its adoption actually increased the average tariff rates for some countries above 1991 levels. As expected, by lowering the internal trade barriers under the terms of the Mercosur led to an expansion in trade among countries that are members of the treaty. As shown in the chart below, a percentage of total trade, intra-Mercosur trade rose from roughly 12 percent in 1991 to a high of about 19 percent in 1994. (Connolly and Gunther, 1999)

Intra-Mercosur exports showed especially strong growth, advancing from 11 percent of total exports in 1991 to 20 percent in 1996. The rising share of trade claimed by Mercosur members clearly came at the expense of non-Mercosur countries, as shown in the chart below, but even trade with nonmembers increased in absolute terms after Mercosur was formed. However, it is important to remember that this outcome cannot be compared with the aggregate trade pattern that would have been observed if the treaty had not be formed, or even if Argentina, Brazil, Paraguay, and Uruguay instead continued their efforts to liberalize trade multilaterally. (Connolly and Gunther,1999)

Mercosur allowed trade liberalization which led to rapid trade expansion. The chart below shows that in 1988, all the member countries were relatively closed to trade, with total GDP averaging 15.1 percent. After Mercosur was implemented, the ratio fell to 14.9 percent in 1995 despite trade expansion of 13.3 percent per year. The table shows that trade between member countries increased not only in value but also as a percentage of total share, however the percentage of total share of exports and imports from Mercosur countries with the rest of the world decreased from 1988 to 1995. “Trade within Mercosur countries grew at 25 percent, more than double the rate of trade with the rest of the world, of 10 percent, but even in 1995 intra-Mercosur trade amounted to only one-fifth of the total trade of the bloc”. (Frischtak, Leipziger, and Normand 1996)

However, because of more protectionist measures adopted by Brazil and, especially, Argentina trade between Mercosur countries and with the rest of the world are not growing at such significant rates as seen in the previous decade. “They have come to see Mercosur as a fortress, rather than a bridge”, for around ten years, the only trades realized by Mercosur outside South America were with Israel and the Palestinian Authority. Another illustration of the matter appears when we look at negotiations with the European Union, which first started in 1999, have deteriorated. Although intra-Mercosur trade has continued to grow as a whole, “it represents a much smaller share of each member’s total exports than at its peak in 1997”, as the table below shows. A main reason for such effects is partly because the commodity boom has raised Mercosur’s exports to the rest of the world. On the other hand, it also because the group has not advanced into the “seamless single market its founders dreamed of” (The Economist, 2012)

Argentina has been, for the past few years, in a very difficult economic situation, what obviously affects the group as a whole. Since January 2011 the country has increased to 600 the items for which import licenses are not automatic, which allows countries to detain imports for up to 60 days. Countries exporting to Argentina protest that the delays are even more than that at some cases. “Since February, it has required importers to swear an affidavit with the tax agency before ordering goods. That has prompted a host of complaints against Argentina at the WTO”. What happens when measures like these are taken by a country member of a customs union is that such actions did not exempt its partner countries. Up to date, Brazil’s exports to Argentina declined by 15% than what they were exactly one year ago, while Uruguay’s have declined by 10%. As expected, retaliation happens, so “Brazil has responded by imposing some barriers on Argentine exports”, creating major restraints and ignoring all of what the treaty stands for, and avoiding trade liberalization. (The Economist, 2012) Trade Creation versus Trade Diversion

A problem commonly discussed when looking into trade agreements is the argument of trade creation versus trade diversion. What Mercosur and other free trade agreements entail is different treatment for countries that are members than for those that are nonmembers. What this differentiated treatment can cause and usually does cause is a shift in the source of supplies for the member countries. Consequently this shift can increase or decrease those countries terms of trade, or in other words, make the cost of supplies/goods lower or higher respectively. For example, trade creation would benefit members by allowing them to adopt lower trade barriers with other Mercosur members and could allow them to import cheaper from one another goods that were produced domestically by that country at a higher cost before.

Trade creation “allows for greater efficiency in production and lower consumption prices, benefits that enhance economic welfare and national income”. (Connolly and Gunther,1999) On the other hand, a trade diversion could happen by imposing a common tariff on the goods produced by nonmembers, what may cause member countries to import products for a higher price from a partner country instead of from a nonmember that can produce the good for a lower cost. “A trade diversion reduces tariff revenues and essentially subsidizes less efficient producers”. (Connolly and Gunther,1999) An example could help understanding how trade diversion works. Imagine Argentina imposes a 30 percent tariff on all imports before Mercosur is formed. After joining the trade agreement with Brazil, Argentina eliminates the tariff on Brazilian imports while keeping the tariff on goods produced by a nonmember like the United States. If before the tariff on imports the price of U.S. cars was $25,000 and of Brazilian cars, $27,000, Argentina will stop importing American cars for $32,500 (the price of 25,000 plus the 30 percent tariff of 7,500) to start importing Brazilian cars for $27,000 after joining Mercosur.

The $7,500 loss in tariff revenues incurred by the Argentinean government by shifting imports from the United States on each car will be partially offset by the reduction in the price paid by the Argentinean consumer, but the rest of the lost revenue from the tariff amounts to an indirect production subsidy for Brazil’s car producers. Lower prices will induce Argentinean consumers to buy more cars. The increase in car purchases may be large enough to offset the national income loss from trade diversion. Therefore, whether trade diversion boosts or reduces member country income depends on which effect is more dominating. “Either way, however, the external tariff acts as a protectionist measure for member nation industries that may not produce goods as efficiently as their counterparts in other countries”. (Connolly and Gunther,1999) What is also important to remember is that Argentinean consumers could be buying even more if there were no tariffs on U.S. imports, and the price was still the lowest at $25,000. Conclusion

The purpose of Mercosur was to create an agreement among Argentina, Brazil, Paraguay, and Uruguay, to form a customs union which combines the removal of barriers to inter-Mercosur trade among member countries with the adoption of common external trade tariffs and policies toward non-members. Trade deflection, therefore, is not a major issue in a customs union since member countries treat non-members in a uniform manner; however is a common external tariff the best thing to be adopted by a union of developing countries? Also, according to the WTO, “the fastest-growing part of South America is the free-trading Pacific countries (Chile, Colombia, and Peru), which have shunned full membership of Mercosur”. Maybe the best alternative would be to try to bring these countries into the mix, instead of keeping them from full member status.

Mercosur went from having emerged as “one of the most dynamic and imaginative initiatives on the world stage today” during the end of the last decade, and from having every indicator to a successful development given its level of surging trade, rising investment, and expanding output to a group that now, according to The Economist, “consists of little more than bear-hugs and kisses among compañeros, and serves little purpose in a harsher world”. Right now, Brazil that is experiencing good economic growth has selected as its main partners protectionist countries such as Argentina and Venezuela, which follows a dated state socialism.

“To revive economic growth, Brazil needs to put more stress on competitiveness and market-opening trade diplomacy”. Mercosur once aspired to do precisely that. (The Economist, 2012) It is impossible to determine where the countries involved in Mercosur would be today if the agreement had never been established, but I do believe that they lost track along the way what the purpose of the agreement was two decades ago. I believe Mercosur would have huge potential for expansion by engaging in multilateral trade and by remembering what the treaty was all about.

WORKS CITED

Connolly, M. (1999, May 1). Mercosur: Implications for growth in member countries. Retrieved from

Leipziger, D., Frishtak, C., Kharas, H., & Normand, J. (1997). Mercosur: Introduction and industrial policy. Blackwell Publishers Ltd. Retrieved from http://siteresources.worldbank.org/INTPREMNET/Resources/Mercosur.pdf

Mercosur rip?. (2012, Jul 14). Retrieved from http://www.economist.com/node/21558609

Ruggiero, R. (2007, June 16). Mercosur heads of state summit, paraguay. Retrieved from http://www.wto.org/english/news_e/sprr_e/mercos_e.htm

Laird, S. (1997, May 23). Mercosur: Objectives and achievements. Retrieved from http://www.wto.org/ENGLISH/res_e/reser_e/ptpr9702.pdf