Multinational Business Review
Fall 2002
Vol. 10, No. 2

Iksu Jurn
(isjurn@mail.svsu.edu)
Saginaw Valley State University

Hong Y. Park
Saginaw Valley State University

The effects of the regional trade bloc on non-member countries are examined. Using the case of Mercosur, we examine the trend of intra-regional trade flows and of extra-bloc trade flows with the selected two countries, Canada and U.S., after formation of Mercosur in 1991. After employing the trade intensity indices of non-members, which controls for the overall growth in members' trade relative to world trade, we find that the remarkable growth of the intra-regional trade of Mercosur has been accompanied by simultaneously increasing trade flows with non-member states such as Canada and U.S.

The effects of the regional trade bloc on non-member countries are examined. Using the case of Mercosur, the trend of intra-regional trade flows and of extra-bloc trade flows with the selected 2 countries, Canada and the US, after formation of Mercosur in 1991 is examined. After employing the trade intensity indices of non-members, which controls for the overall growth in members' trade relative to world trade, it is found that remarkable growth of the intra-regional trade of Mercosur has been accompanied by simultaneously increasing trade flows with non-member states such as Canada and the US.

Regional trade agreements have become much more popular during the last decade. Along the continental lines, the North American Free Trade Agreement (NAFTA) and the Common Market of the Southern Cone (Mercosur), involving Argentina, Brazil, Paraguay and Uruguay, were created in the Americas, while the ASEAN Free Trade Area (AFTA) was formed in 1992 in Asia. In Europe, the European Union (EU) and the European Free Trade Association (EFTA) finalized their membership after Sweden, Finland and Austria withdrew from EFTA to join the EU in 1995. Between 1990 and 1997, according to Chang and Winters (1999), 87 regional agreements were notified to the WTO. At present, almost all WTO members belong to at least one regional arrangement.¹

With regard to the growth in importance of regional trading bloc, two issues have been raised in the literature. One is the question of what would happen to world welfare if the world economy could become fragmented. Another issue is whether the regional trade blocs contribute to further trade liberalization with non-members countries or undermine it.

On the welfare impact of the formation of regional trading blocs, Kemp and Wan (1976), for example, show that if countries form into trading blocs by eliminating the barriers to internal trade and imposing a set of common external tariffs (CET) on imports from all countries outside the bloc, the welfare of the union as a whole improved and that of the rest of the world did not fall. Krugman (1991), on the other hand, has developed a simple economic model to conclude that world welfare is not maximized unless the number of blocs is either one or very large. He suggests that world welfare is generally minimized especially when there are three blocs. Although Krugman's model ignores transport costs, Frankel, Stein and Wei (1995) show that world welfare could be reduced for certain values of inter-continental transport costs even if blocs are formed along continental lines.

It has been also controversial whether the regional arrangements help or hinder multilateral liberalization. Baldwin (1995), among others, suggests that the formation of a trade bloc can have a "domino effect". As regional integration increases, excluded countries will lose competitiveness and seek to join the bloc. If the bloc enlarges, the cost to the non-members increases since they face a cost disadvantage in an even greater number of markets. This second round effect will lead to further enlargement of the regional trading bloc. Krishna (1998), however, employs an oligopolistic model to show that when regional blocs foster trade diversion, in which efficiently produced goods from outside blocs are replaced by inefficiently produced goods inside, each member of the bloc will undermine its incentive to liberalize trade with the rest of the world. Many, including Bhagwati (1993) and Nagarajan (1998), attribute the negative side of regional trade blocs on nonmember countries to ambiguity of the rule governing regional arrangements of the WTO. Article XXIV of the GATT requires that when a group of WTO members form a regional arrangement among themselves, the arrangement must not raise the tariffs "applicable" on imports from third countries. It is not clear, however, whether the term "applicable" refers to "bound" or to "applied" tariff rates.³ Because of this ambiguity, according to Nagarajan (1998), Mexico was able to raise applied tariffs within bound ceilings on imports from non-member countries as a reaction to the peso crisis, while tariffs on imports from other NAFTA countries were not affected.

In order for regional arrangements to help greater multilateral liberalization, two concepts have been proposed. The concept of "open regionalism" was introduced during the APEC discussion. Although the precise definition was not provided, it suggested, according to Jeffrey and Wei (1998), that any outside country could choose to join the bloc as long as it satisfies the entry criteria and the benefits of a regional arrangement should be extended to non-member countries. Closely related to open regionalism, McMillan (1993) also proposed changing Article XXIV to require that there be no decrease in trade volume between member and non-member countries after the formation of a bloc. The imports by members from non-members, especially, are required to be the same as before the formation of blocs.

We explore the effects of the regional trade bloc on non-member countries. Using the case of Mercosur, we examine the trend of intraregional trade flows and of extra-bloc trade flows with the selected two countries, Canada and U.S., after formation of Mercosur in 1991. Section 2 provides a brief history of Mercosur and the overview of Mercosur economies. The Intra-Mercosur trade effects and the effects of Mercosur on non-members after formation of Mercosur in 1991 are examined in Section 3. In Section 3, a measure of trade intensify index is employed to control for the overall growth in members' trade relative to world trade. Section 4 offers concluding remarks.

After numerous commercial protocols, Argentina and Brazil signed the Treaty for Integration, Cooperation and Development (TICD) in November 1988, setting the stage for a common market between them within ten years. Its objective was the elimination of all tariff and non-tariff barriers on the trade in goods and services by a gradual process. A significant increase in trade flow between both countries motivated them to accelerate the integration process. Paraguay and Uruguay later in 1990 were invited to participate and the four countries signed an agreement, to be known as the Treaty of Asuncion, to create a common market in March 1991. The Treaty, which was ratified in November 1991, created Mercosur (the Mercado Comun del Cono Sur, the Common Market of the Southern Cone).⁴ The purpose of Mercosur is to create a common market in which goods, services and people can be freely moved among member countries and macroeconomic policies can be coordinated and harmonized in order to ensure free competition. The Mercosur has been taking a two-stage integration process, involving (i) Free Trade Area; and (ii) Customs Union;

The Asuncion Treaty signed in 1991 gave a transition period of four years to establish a free trade area by achieving zero internal tariffs and the elimination of non-tariff barriers by the end of 1994. Forty seven percent of the internally applied tariff rates were reduced immediately after the ratification of the Treaty and subsequent preferential reductions were scheduled to achieve 100 percent by December 1994.⁵

Mercosur member countries also signed the Protocol of Ouro Preto in December 1994 to create a custom unions, in which members apply a Common External Tariff (CET) to imports from third countries, starting on January 1st, 1995.⁶ Mercosur's CET has 11 different levels, from zero to 20 percent. According to Olarreaga and Soloaga (1998), the average CET was close to 11 percent in 1996, while it was 30 percent before integration. With the temporary exceptions list allowed to each member, this customs union is scheduled to come into full effect by 2001 for Argentina and Brazil, and 2006 for Paraguay and Uruguay.

Mercosur widened the scope of its free area by signing association agreements with Chile and Bolivia in 1996. An average tariff of 6 percent was applied for most products traded between Mercosur and Chile in 1996. This tariff will be gradually reduced to zero within 8 years. Bolivia would function as a bridge between Mercosur and the Andean Community. Mercosur also signed in December 1995 an economic cooperation agreement with the European Union, seeking a broader free trade area by progressively liberalizing trade between the two regions.

Mercosur, consisting of Argentina, Brazil, Paraguay and Uruguay, has an area of 12 million sq. kms., which is about 59% of the total area of Latin America and is greater than that of Europe. It has the third largest market with over 200 million inhabitants and is the fourth Geo-economic area in the world with over a trillion US dollars of combined GDP after NAFTA, E.U. and Japan. Members of Mercosur share some common economic characteristics. Primary products, such as agricultural production, meat production and mineral resources, are their major exports. They follow similar economic policies in order to contain inflation, attract foreign investment and modernize infrastructure. As shown in Table [1], Mercosur has become one of the most dynamic growing areas since 1990. The average growth rate of Mercosur as a whole was about 2.88 percent per year for the last decade. The member states growth rate varied from 4.4 percent in case of Argentina to 1.78 percent in case of Brazil.

The Argentina economy, with a population of 37 million people and a 1999 GDP of US$ 296 billion (constant 1995 US$), has grown annually at the average of 4.4 percent in the period of 1990 to 1999, ranged from a -3.2 percent growth in 1999 to a 12.7 percent growth in 1991. Although it went into recession and negative growth of -2.85 percent in 1995 as a fall out of the Mexican crisis, it registered positive growth rates thereafter.

Main exports of Argentina are agro-products such as wheat and soybeans, raw materials and petroleum crude. Argentina's exports have increased from US$ 12.4 billions in 1990 to US$ 26.4 billion in 1977, although they dropped to US$ 23.3 billion in 1999. Imports have increased from US$ 4.1 billion in 1990 to US$ 31.4 billion in 1998, and then decreased to US$ 25.5 billion in 1999. After having a trade surplus of US$ 8.3 billion in 1990 and US$ 3.7 billion in 1991, Argentina has experienced a trade deficit for the most of 1990's, ranged from US$ 2.6 billion in 1992 to US$ 5.9 billion in 1994. Most exports went to members of Mercosur, EU and NAFTA, while most imports came from members of Mercosur, NAFTA and EU.

Brazil is the eighth largest economy in the world with a GDP of US$ 752 billion (in 1999, constant 1995 US$) and with a per capita income of US$ 7,037. It is the fifth largest country in the world in area (8.5 million sq. kms) and population (168 million people).

Brazil has a diversified industrial base. Its automobiles and steel industries are within the top ten in the world. Brazil is also a major producer of natural resources, minerals and agricultural products. It is well known that Brazil is the world's largest producer of sugarcane, coffee and orange juice.

The foreign trade of Brazil in 1999 was US$ 100 million with exports of US$ 48 billion and imports of US$ 52 billion. Exports had been steadily increasing from US$ 31 billion in 1990 to US$ 53 billion in 1997, before decreasing to US$ 48 billion in 1999. Brazil's import also had been increasing from US$ 23 billion to US$ 65 billion in 1997, before they dropped to US$ 52 billion in 1999. Brazil enjoyed a trade surplus of about US$ 9 billion every year for the period of 1990 - 1994. In 1995, however, Brazil registered a trade deficit of US$ 7 billion, which has increase to over US$ 12 billion in 1997 and dropped to US$ 4 billion in 1999.

The largest trading partner of Brazil is European Union, followed by USA, members of Mercosur, Japan and Korea. Concerned by the growing trade deficit after 1995 and in response to the pressure from local industry for protection, Brazil initiated to impose some restrictions and increase custom duty in case of some imports from these countries.

After showing national economic stagnation in the eighties because of such problems as inflation, fiscal deficits and depressed foreign exchange reserves, Paraguay has achieved a slight increase in the nineties with the average 2.2 percent annual growth rate, as shown in Table [1]. The annual per capita GDP in 1990 was US$ 3,941, increasing to US$ 4,384 in 1999.

As exhibited in Table [1], Paraguay's exports, after reaching a maximum historic level of US$ 960 million in 1990, went through a process of significant decline until 1993. Recovery began after that year and another maximum level was reached by the end of 1997 with US$ 1.09 billions, and then recessed to US$ 741 million in 1999. Table [1] also confirms the historic trend towards deficits of the Paraguayan balance of trade.

Although Table [1] reports the registered (official) trade information, no Paraguayan foreign trade analysis could be valid if unregistered trade levels are not taken into account. A large informal sector (which is illegal for the most part) is involved in the triangulation border trade. That is, Paraguay imports the so-called "tourist goods" and reexports to neighboring countries. When official estimates of unregistered imports and re-exports are added, as shown in Table [2], the trend of deficits continues. It should be also observed that unregistered imports and re-exports were beginning to reduce since 1996.

Uruguay is a small country with a population of 3.3 million. Early economic opening and liberalization, however, created a pattern of economic growth that, in capita terms, has been one of the highest in Latin America. Its GDP was approximately US$ 21 billion in 1999, which represented US$ 8,880 per capita, after growing by an annual average of 3.15 percent during the nineties, including a higher rate of 8 percent in 1992 and a slight fall in 1995 as a result of the regional crisis triggered by Mexico at the end of 1994.

With a high level of exports diversification, exports of goods rose to an average 30 percent between 1990 and 1999, amounted to US$ 2.2 billion in 1999. The most significant were those of the refrigeration, rice mills and wool and textile products. Since imports also had been steadily increased, Uruguay experienced the trade balance deficit during the nineties. The deficit reached US$ 1.1 billion in 1999. Brazil is the largest trading partner, followed by Argentina, EC and USA.

Although the crisis that hit the Mercosur member states after mid-1998 drastically exacerbated the decline in trade flows, the intra-Mercosur trade have steadily increased since the formation of Mercosur in 1991, as shown in Table [3]. It can be observed that the process of trade integration between member states has been clearly progressed. All member states have increased intra-Mercosur trade substantially, except exports of Paraguay to member states. In case of Paraguay, however, the registered (official) trade, which is reported in Table [3], did not tell the whole picture because of significant amounts of the unregistered trade.

Argentina has increased its exports to member states from US$ 1.8 billion in 1990 to US$ 9.6 billion in 1997 and back to US$ 7.1 billion in 1999. It was an average annual rate of 18.4 percent for the decade. Its imports from member states, on the other hand, have been also substantially increased from US$ 0.8 billion in 1990 to US$ 5.8 billion in 1999 with the highest of US$ 7.4 billion in 1998. Its imports grew remarkably at an average annual rate of 28.4 percent for the 1990s. Brazil's exports to members also have been increased at the annual rate of 22.7 percent, while its imports from members have been increased at the rate of 14.2 percent. In case of Uruguay, its exports to member states have been steadily increased at the average annual rate of 6.8 percent and its imports from member states grew at the rate of about 13 percent. The member states of Mercosur therefore have become increasingly more dependent upon each other.

By focusing on trends in export and import amounts, however, one can fail to capture the significant growth in trade with the rest of the world. Table [4] reports the intra-regional share in the total trade of each country. On the export side, the intra-regional share in the total export of each country has been remarkably increased. In case of Argentina, the share grew from 15 percent in 1990 to 36 percent in 1997 and reduced to 30 percent in 1999. Between 1990 and 1999, the intra-regional share in the total exports of Brazil also grew from 4.2 percent to 14 percent in 1999 with the highest 17 percent in 1997 and 1998. Table [4] also exhibits the fact that relatively small size countries, Paraguay and Uruguay, which were involved heavily in the regional trade, were more dependent on the region since 1990.

Turning to the import side, it can be observed that the regional share in total imports has been relatively stable in 1990s. Argentina has imported around 22 percent of its total imports from the region, while Brazil has imported around 13 to 14 percent. This stable share of imports should be noted since many researches, such as Yeats (1998), on the effects of regional unions have focused only on the intra-regional exports. Concentrating on the share of intra-Mercosur exports in total exports (rather than the share of intra-Mercosur imports in total imports) tends to overstate the relative importance of growing trade between the Mercosur countries and underestimate their growing trade with the rest of the world.

Table [5] reports the calculated trade intensity indices for each country of Mercosur. As we expected, Paraguay and Uruguay have been dependent more on the regional trade than Argentina and Brazil. The trade intensity index of Paraguay has been increased from 35.8 in 1990 to 40 in 1999, while from 34.8 in 1990 to 32.2 in 1999 in case of Uruguay. On the other hand, Argentina and Brazil have intensified their trade to the region since 1990. Indices for Argentina and Brazil have been changed from 14.7 in 1990 to 20.2 in 1999 for Argentina and from 3.6 to 9.6 for Brazil. From the increased intensity indices in 1990s, therefore, it can be concluded that all member states of Mercosur have increased their trade flows within the region since the Treaty of Asuncion in 1991.

The classical model of regional integration economics generally posits that the global welfare effects of such arrangements may be determined by examining whether they are net trade-creating or trade-diverting, as defined by Jacob Viner. If there is increase of trade among members that exceeds the level of trade lost with non-members, then there is a net positive global economic welfare effect. If level of lost trade with non-members exceeds the increase in trade among members, then there is a net negative global welfare effect.

To study the global welfare effects of Mercosur, we examine the trade effects on non-members of Mercosur. As an example of the trade with non-member states, we select Canada and U.S. U.S has been one of the top five trade countries, while Canada hasn't involved heavily in trade with members of Mercosur. Table [6] exhibits the trade follows and the trade intensity indices of Canada and U.S. with Mercosur countries for 1990s. It can be observed that the trade flows of Canada and U.S. with Mercosur states have been notably expanded since 1990.

Canada's exports to Mercosur grew from US$ 492 millions in 1990 to US$ 1.5 billions in 1997 and reduced to US$ 874 millions in 1999, while its imports from Mercosur expanded from US$ 844 millions in 1990 to 1.2 billions in 1999. They are equivalent to an average annual growth of 7.5 percent in exports and 4.4 percent in imports, respectively.

Exports of U.S. to Mercosur amounted to US$ 6.7 billions in 1990, increasing to US$ 23.2 billions in 1997, and then decreasing to US$ 19.2 billions in 1999, which was a 14.1 percent annual growth. On the imports side, the imports of U.S. from Mercosur grew at the annual average rate of 4.8 percent in 1990s.

The trade intensity indices of Canada and U.S. with Mercosur, however, remained relatively stable in 1990s. This indicates that the remarkable growth of the intra-regional trade of Mercosur has been accompanied by simultaneously increasing trade flows with nonmember states such as Canada and U.S. It can be thus claimed that the regional bloc such as Mercosur did not contribute trade diversion to non-members such as Canada and U.S.

The increase in trade volume between members and non-members and the stable trade intensity indices of non-members after formation of Mercosur clearly demonstrates that the regional trade bloc such as Mercosur does not much deviate from the proposed McMillan (1993) rule. Before concluding the effects of Mercosur on non-member states, however, it should be warned that the trade statistics for ten years do not permit a complete evaluation of the Mercosur's net effect on non-members.

We explore the effects of the regional trade bloc on non-member countries. Using the case of Mercosur, we examine the trend of intraregional trade flows and of extra-bloc trade flows with the selected two countries, Canada and U.S., after formation of Mercosur in 1991. The data indicates that the trade flows within the region have been expanded remarkably in 1990s, and the trade flows with non-members also have been increased significantly.

After employing the trade intensity indices of non-members, which controls for the overall growth in members' trade relative to world trade, however, we find that the remarkable growth of the intra-regional trade of Mercosur has been accompanied by simultaneously increasing trade flows with non-member states such as Canada and U.S. It can be thus claimed that the regional bloc such as Mercosur did not contribute trade diversion to non-members, such as Canada and U.S.

Although we do not attempt to provide an explicit account of the trade effects on non-member countries of Mercosur, it is suggestive that the regional trade bloc does not necessarily deviate from the proposed McMillan rule. Since Mercosur is still in its infancy, however, one cannot expect to evaluate fully its welfare implications by examining data for a limited time period.

1 | Only Japan, Korea and Hong Kong China do not belong to any regional agreement.

2 | See also Panagariya and Krishna (2001) in case of Free Trade Areas (FTAs).

3 | See Nagarajan (1998) for more details.

4 | See Laird (1997) for more details.

5 | Approximately 95 percent of intra-regional trade was duty-free by 1995, although temporary exceptions have been given for trade in groups of products considered sensitive by each member.

6 | Member countries in a Free Trade Area (FTA) may maintain member-specific external tariffs, while, in a Custom Union (CU), member countries maintain a common external tariff against non-members. See Panagariya and Krishna (2001).

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