Trade diversion in South America

Trade diversion in South America

Case study: Trade diversion in South America

In 1991, four South American nations, Argentina, Brazil, Paraguay and Uruguay, created a free trade area called Mercosur. The agreement had a drastic and immediate effect on trade: in four years the value of trade between these nations tripled. The region's leaders proudly affirmed that Mercosur was a great success, that it was part of a much larger package of economic reforms.

But while Mercosur has managed, with clear success, to increase intraregional internal trade, the theory of preferential trade areas tells us that even though agreements are working out, their outcome does not have to be positive: if the new trade occurs at the expense of trade that, in other circumstances, would have occurred with the rest of the world (if the pact diverts trade, instead of creating it) could, in fact, reduce welfare. Indeed, in 1996 a study prepared by the World Bank's chief trade economists concluded that, despite Mercosur's success in increasing regional trade (or, rather, precisely because this success has occurred at the expense of other trade) the net effects in the affected economies are probably negative.

In essence, the report affirmed that due to Mercosur, consumers in member countries were induced to buy expensive products from their neighbors instead of cheaper products bearing heavy tariffs from other countries. Specifically, due to Mercosur, Brazil's highly protected but relatively inefficient automobile industry has acquired a captive market in Argentina, displacing imports from elsewhere. "These conclusions”, stated the first draft of the report, “appear to constitute the most compelling and surprising evidence produced to date regarding the potential adverse effects of regional trade agreements."

But that was not what the final report that was published claimed. The initial draft was leaked to the press and generated an angry protest from the Mercosur governments, particularly from Brazil. Under pressure, the World Bank revised the publication, and ended up issuing a lighted-up version that included a series of allegations. Even so, in the published version, the report made a defense of the fact that Mercosur, if not totally counterproductive, has nevertheless produced considerable trade diversion.

Source: Krugman, P., Obstfeld, M. y Melitz, M. (2012) Economía Internacional. Teoría y política, 9ª Ed. Madrid: Pearson Educación.

Guiding questions

1. What are the advantages of regional trade agreements? List at least 5 advantages (in the social, economic, or political realms).
2. What are the disadvantages of regional trade agreements?
3. What positive and negative effects of Mercosur does the text mention?
4. Are these effects restricted to Mercosur or are they part and parcel of every regional agreement? Use arguments to explain your point of view.

1. What are the advantages of regional trade agreements? List at least 5 advantages (in the social, economic, or political realms).

1. Trade between these nations tripled.
2. Increase consumer choice
3. Creating more jobs
4. Better access to cheaper and more abundant capital
5. Quality improvement and innovation
6. Stronger position in international treaty negotiations

1. What are the disadvantages of regional trade agreements?

1. Domestic industry bankruptcy.
2. new trade occurs at the expense of other trade
3. Dispute settlement mechanism
4. Increase economic dependence
5. Reduction of economic sovereignty and independence of economic policies

1. What positive and negative effects of Mercosur does the text mention?

Positive effect:

• in four years the value of trade between these nations tripled
• increase intraregional internal trade
• the free movement of goods, services and factors of production,
• the creation of a common external tariff,
• the approximation of economic policies and the harmonization of legislation between members.

     Negative effect:

• “Brazil's highly protected but relatively inefficient automobile industry has acquired a captive market in Argentina, displacing imports from elsewhere.”
• Increase economic dependance for example if one of the country goes into recession, this latest can spread their economy slow down to other countries with whom they have a FTA due to the lack of consumption and reduction of production, trade, lack of cashflow…

1. Are these effects restricted to Mercosur or are they part and parcel of every regional agreement?

No, these effects are observed in other regional trade agreements such as North African, Australian, CEDEAO, eurozone…which are facing some hiccups but continue to work hand in hand for a brighter future of their populations.

Ex: In 2009, Grece entered in recession, and spreaded very quickly to spain and Italy.