Freund and Ornelas argue (full paper here) that regional trade agreements (RTAs) are more of a blessing than a burden. This runs counter to Jagdish Bhagwati’s argument that RTAs undermine free trade. They find that trade creation tends to be the norm in RTAs, which counts to nearly 300 now, and trade diversion an exception; and when trade diversion is observed, its magnitude is relatively small.
It means that there is more trade creation than trade diversion with RTAs.Why so? They argue that it is because governments choose partners well considering factors such as proximity, similarity in GDP and its composition, and difference in factor endowments. Moreover, RTA partners not only lower tariffs on trade between/among them but also lower tariffs on imports from countries outside the bloc. In fact, RTAs go beyond the mandate of trade liberalization among the partners.
The RTA creates “leakage” in the trade-policy redistributive channel. External protection also becomes more costly, because of the costly trade diversion that accompanies the RTA. As a result, external tariffs tend to fall after the formation of an RTA, both because the economic marginal cost of external protection rises and because the political-economy marginal gain from external protection falls.
[…] The increasing wave of regionalism has been largely beneficial to the world trading system. Most empirical analyses indicate that trade creation, not trade diversion, is the norm, both because governments choose well when forming RTAs and because they adjust other trade policies to moderate the distortions from discrimination.
