At the APEC Leaders Conference held in Auckland last September it was announced that New Zealand and Singapore had agreed to establish a free-trade area (FTA). Chile also announced that it would consider joining the area and the US Trade Representative, Charlene Barshefsky, and our then Trade Minister, Lockwood Smith, discussed the possibility of including the US as well (which, in turn, increased the interest of Australia in the whole idea). The result is what is currently being referred to as the Pacific Five (P5) free-trade pact.

To date, nothing concrete has been signed up and the whole P5 idea may yet come to nothing, but it does raise the question of whether this would be good for New Zealand or not and it is the aim of this article to throw some light on the matter.

But first, what exactly is an FTA? In broad terms it is an example of a regional trade agreement. Other examples include customs unions, common markets and economic unions. More specifically, an FTA involves two or more countries agreeing to essentially eliminate barriers (like tariffs, quotas, etc.) on their bilateral trade. There is free trade between the group of countries in question but each member country maintains its original trade barriers against non-member countries. The Closer Economic Relations (CER) agreement, which has existed between New Zealand and Australia since 1983, is an example of such an arrangement.

A customs union, by contrast, goes a step further; there is free trade within the region as before, but now the member nations agree on a common set of trade barriers against the rest of the world. This was the arrangement employed by the European Economic Community (EEC) from its creation in 1957 until the late 1980s. In the 1990s the Europeans went further by allowing free movement of labour and capital, so producing a common market. At present, following their recent introduction of a single currency, they have taken a step towards achieving full economic union. To complete this process they would still need to centralise their fiscal and social welfare policies.
A key point about these various regional trade arrangements is that they all result in a country giving preferential treatment to the goods and services imported from the other members of the region. Therefore, the implications (both positive and negative) that they have for international trade are much the same. We will have a look at these now.

Basically, any type of regional trade agreement can have two main effects on a participating economy: trade creation and trade diversion. Each of these can affect a country's exports or its imports but as the consequences are much the same in both cases we will focus on imports alone for simplicity. Moreover, to illustrate these concepts, suppose that there are three countries (A, B and C). A has just formed an FTA with B so imports from B now enter A tariff free. Imports from C, however, still attract a tariff.

Trade creation simply relates to any expansion in the quantity traded between A and B of goods that A was previously importing from B (or vice versa). If A imported computers from B prior to the creation of the FTA, any expansion of that trade following the removal of the tariff on B's computers would constitute trade creation.

On the other hand, if by removing the tariff against B (but keeping it in place against C) country A switches its source of supply from C to B, this is trade diversion. As can be seen in Table 1, B's car manufacturers cannot compete with those in C when both pay the tariff but, once B's cars are able to enter A tariff free, they now out-compete C's cars.

Trade creation is a key benefit of an FTA. More specifically, although some groups (like domestic producers of goods that compete with imports) are made worse off as a result of lowering tariffs, on balance the economy as a whole benefits from the resulting increase in imports. This is essentially because trade creation implies that relatively-inefficient domestic production is being replaced by relatively-efficient foreign production. The actual cost of making the goods ourselves was greater than the cost of importing them, but previously domestic consumers bought from the high-cost domestic producer because the tariff had artificially inflated the cost to the consumer of the foreign good.

Trade diversion, however, is an undesirable feature of FTAs. We can see that it actually makes the country involved worse off by using the data in Table 1. Firstly, we can see that country C is the most efficient producer of cars. When all foreign suppliers have to pay a 25% tariff (which, in this example, is not enough to make it profitable for firms in A to make cars), C is still the cheapest source of supply. Note, however, that although consumers in A have to pay $25,000 for each car they import from C, $5,000 of this goes to the government of A in the form of tariff revenue, so the true cost to country A is still $20,000.

When tariffs are lowered against B following the creation of the FTA, car firms in B are now able to undercut C's firms. Consumers in A now only pay $24,000 to buy a car, so why is this not seen as a good thing? The point is that this car enters A tariff free. Consumers in A may have saved $1,000, but their government loses the tariff revenue ($5,000). The country as a whole loses $4,000 on every car bought from B that would normally have been bought from C. By giving B preferential access to A's market, a low-cost supplier (C) has been replaced with a high-cost supplier (B).

So, FTAs are not necessarily a good idea. If they cause considerable switching of trading partners, then there is a real chance that the participating economies will be worse off as a result. Is this likely to be the case for New Zealand in relation to P5? Fortunately, the answer is almost certainly 'No' for several reasons.

First, the other four potential members of P5 already account for over 40% of New Zealand's imports. Since we are already buying a wide range of goods from them, they presumably have a comparative advantage in these goods. Any extra we import will represent trade creation rather than trade diversion. Second, our trade barriers (with very few exceptions) are already very low and so the advantage that US firms would gain over, say, Japanese firms in our market would be quite small. There would be little incentive to divert trade. Moreover, Australian goods already enter NZ tariff free under CER, so P5 could actually help matters by reversing some of the trade diversion that has taken place as a result of that agreement. On balance, trade creation seems likely to dominate trade diversion if P5 goes ahead.

P5 is expected to generate other benefits as well. Its proponents argue that an agreement like this will put pressure on other countries to lower their trade barriers. At present, although committed to achieving free trade by 2010, some APEC members (e.g., Japan) have been reluctant to lower their barriers. But if their exporters are significantly disadvantaged by a regional agreement like the P5 pact (i.e., through trade diversion), then this increases their incentive to negotiate lower trade barriers generally in order to reduce that disadvantage.

So, the only remaining question is 'Will the P5 pact become a reality?' As indicated above, there is a strong chance that it will not. Recent reports indicate that the US Department of Agriculture is resisting the pact because of the implications it would have for US farmers who at present are protected from our dairy and Australian sugar exports. A further problem is the US presidential election to be held in November. President Clinton is reportedly in favour of the pact, but his successor may not be and with the US trade deficit currently running at over US$300 billion (about NZ$580 billion) protectionist sentiment is likely to grow in the US.

Some questions to think about

1. If P5 goes ahead, what would be the effect on the relative importance of trade creation versus trade diversion if the free trade area was subsequently expanded to include more countries? Would this be a good thing or a bad thing from New Zealand's point of view?

2. Identify the groups within New Zealand who would gain from the creation of a free trade area. Who would lose from such an agreement?

Contact: GHargreaves@business.otago.ac.nz Page maintained by Martin Richardson and Gordon Hargreaves. Last modified: 7 January 2000