CHAPTER 4. LEGAL ASPECTS OF REGIONAL INTEGRATION

Whether RTAs have favored or conflicted with the mutual development of the multilateral trading system, that is, whether RTAs have functioned as ‘building blocks’ or ‘stumbling blocks’ vis-à-vis the multilateral process, has been heavily debated in recent years.

Those concerned with the negative effects of the trend towards regionalism stress its potential to fragment the multilateral trading system (MTS) into a number of closed, competing blocs. As these blocs expand, so does their market power and thus the incentive to influence the terms of trade in their favor, providing an incentive to use trade policy to restrict imports. This argument assumes that the trade blocs are customs unions and have a common trade policy, when in fact the emerging continental blocs tend to take the form of free trade areas (FTAs). Also, there is no evidence to date to suggest RTAs have pursued this incentive to raise external barriers.

As noted above, regionalism also has a tendency to beget regionalism as outsiders attempt to minimize the costs of trade diversion by becoming insiders. This has given rise to the new phenomenon of overlapping RTAs which increase their complexity and their relationship with the MTS. One highlighted issue is the negative effects on trade of differing rules of origin, and the way in which rules of origin can be designed to have a protectionist impact. There is also the danger that, as countries pursue deeper integration within RTAs, dispute settlement provisions contained in the ‘new generation’ RTAs could build jurisprudence conflicting with that of the WTO.

The positive view of the relationship between RTAs and the MTS is based on a number of arguments. First, it is argued that RTAs, by moving at a faster pace than WTO rules, while sharing its goals, represent a way of strengthening the latter. Second, smaller regional groupings may be more effective in tackling new areas such as services, investment, intellectual property protection, cooperation in competition policy, technical standards and government procurement compared to multilateral rule-making. By acting as laboratories to try out alternative rules and strategies to encompass these issues, it is argued that they can ease the reaching of agreements on these issues at the multilateral levels.

Third, despite the fears of trade diversion, the empirical evidence suggests that trade-creating effects dominate in major RTAs thus enhancing world welfare. A study conducted by the WTO Secretariat showed that there had been a definite trend toward broader as well as faster market access liberalization on non-tariff measures in RTAs, in parallel to developments in the MTS (WTO, 1995). Also, although on a simple static analysis third parties may be disadvantaged by trade diversion, this is less obvious in a dynamic context if overall growth, and hence the demand for imports, is increased as a result of the integration process (Crawford and Laird, 2000). Fourth, it is argued that RTAs have had a positive effect by facilitating the integration of developing countries into the world economy.

The fact that this debate exists highlights the importance of WTO rules governing the establishment of RTAs to minimize their adverse systemic effects on the MTS. This chapter summarizes the current rules which RTAs should meet before WTO approval for such arrangements is granted, as well as highlighting some of the controversies around these rules. The chapter also argues that current rules lack clarity in addressing the particular problems of integrating WTO commitments on reduced agricultural support in RTAs. The chapter concludes by arguing that developing countries have a particular interest in seeing strengthened rules on RTAs in the WTO in the current development round.

What the WTO rules say about RTAs

Despite the potential dangers of regionalism to the multilateral trading system, from its inception the GATT - and now the WTO - has allowed member countries to conclude customs unions and free-trade areas as an exception to the fundamental principle of non-discrimination set out in the most-favored-nation provision of Article I. Conditions to be met for trade in goods in RTAs are set out in GATT Article XXIV. During the Uruguay Round, Article XXIV was clarified to some extent and updated by an Understanding on its Interpretation. For trade in services, the conclusion of RTAs (referred to in GATS as economic integration agreements, EIAs) is governed by GATS Article V. Preferential trade arrangements on goods between developing country members are regulated by an “Enabling Clause” dating from 1979.

Non-reciprocal preferential agreements involving selected developing and developed countries require WTO members to seek a waiver from WTO rules. Examples of such agreements which have received a waiver include the US-Caribbean Basic Economic Recovery Act, Canada’s offer of non-reciprocal duty-free access to most Caribbean countries, the US - Andean Trade Preference Act and the Cotonou Agreement between the EU and the ACP countries.

Proposed RTAs are examined to determine their compatibility with these rules. During the GATT years, the examination of RTAs was conducted in individual working parties. In order to ensure consistency in their examination, the General Council established in February 1996 a single Committee to oversee all RTAs, the Committee on Regional Trade Agreements (CRTA). The mandate of the CRTA is to carry out the examination of agreements referred to it by the Council for Trade in Goods (agreements under Article XXIV of the GATT 1994), the Council for Trade in Services (agreements under Article V of the GATS) and the Committee on Trade and Development (agreements notified under the Enabling Clause). The Committee is also mandated to develop procedures to facilitate and improve the examination process and to ensure that the reporting on the operation of the regional agreements is adequately carried out by the parties to the agreements. In addition to examining individual regional agreements, the Committee is also charged with considering the systemic implications of the RTAs for the multilateral trading system and the relationship between them.

Criteria to be met by RTAs

The main requirements of the WTO rules on RTAs can be summarized as follows:

The neutrality of trade restrictiveness requirement. For trade in goods, Article XXIV:5(a) provides that, with respect to a customs union, the “duties and other regulations of commerce imposed at the institution of any such union ...in respect of trade with contracting parties not parties to such union or agreement shall not on the whole be higher or more restrictive than the general incidence of the duties and regulations of commerce applicable in the constituent territories prior to the formation of such union...”. With respect to a free trade area, Article XXIV:5(b) makes the same requirement for the trade policy of each of the countries which are party to such an agreement.

The 1994 Understanding made clearer the methodology to be used to judge this requirement in the case of a customs union. With respect to tariffs and duties, the evaluation should be based on an overall assessment of weighted average tariff rates and of customs duties collected. The calculation is done by the WTO Secretariat based on import statistics for a previous representative period on a tariff-line basis using the methodology used to compute the tariff offers in the Uruguay Round negotiations. Importantly, it is specified that the duties and charges taken into consideration should be the applied rates of duty. For non-tariff measures, individual examination to assess whether their overall trade restrictiveness has increased or not should be undertaken.

The substantial coverage requirement. Article XXIV:8(b) specifies that duties and other restrictive regulations of commerce, except as otherwise permitted under GATT rules, should be eliminated on substantially all the trade between the constituent territories. Article 5:1 of the GATS has similar language that an agreement should have substantial sectoral coverage, which is defined in terms of the number of sectors, the volume of trade affected and modes of supply. Specifically, to meet this condition, agreements should not provide for the a priori exclusion of any mode of supply.

The reasonable time requirement. Article XXIV:5(c) requires that any plan to form a customs union or free trade area must show that it will be completed within a reasonable length of time. In the 1994 Understanding, this is defined as not exceeding 10 years except in exceptional cases. The GATS does not contain an equivalent provision with respect to a regional agreement covering trade in services.

The compensation requirement. If, in forming a customs union, it is necessary for a Member to raise a bound rate of duty, other Members have a claim for compensatory reductions in bound tariffs on other goods. The 1994 Understanding specifies that, in calculating the amount of compensation required, due account should be taken of reductions of duties on the same tariff line made by other parties to the customs union upon its formation. The idea of compensation is not provided for in the GATS with respect to regional trade agreements covering services. However, Article V:6 does provide that nationals or firms of any WTO Member which engage in substantive business operations in the territory of parties to a regional agreement are entitled to whatever special treatment is provided for in that agreement. There is no reciprocal obligation on third countries which benefit from a reduction of duties following the formation of a customs union, or from more liberal market access under an EIA services agreement, to offer any tariff or other concession to its members.

Special and differential treatment for developing countries. With respect to trade in goods, the Enabling Clause permits “regional or global arrangements entered into among less-developed contracting parties for the mutual reduction or elimination of tariffs and... non-tariff measures, on products imported from one another”. Two aspects of this provision can be highlighted. First, it allows for preferential trade agreements which fall short of either an FTA or a customs union. That is, it does not require the elimination of duties, nor does it require that substantially all trade should be liberalized. Second, the only constraints on the operation of preferential trade arrangements between developing countries are that (i) they shall be designed to facilitate and promote the trade of developing countries and not to raise barriers or to create undue difficulties for the trade of any other contracting parties, and (ii) they shall not constitute an impediment to the reduction or elimination of tariffs and other restrictions to trade on a most-favored-nation basis. This language is less demanding than the corresponding injunction in Article XXIV that the post-agreement trade policies shall not be more restrictive than the trade policies in force in the constituent countries prior to the formation of the agreement. Finally, there is no requirement for any indicative timetable for such liberalization with respect to trade in goods.

With respect to trade in services, where the Enabling Clause does not apply, Article 5:3 of the GATS provides special and differential treatment for developing countries, in two dimensions. First, where developing countries are party to an EIA involving services, flexibility can be shown, particularly with respect to the requirement that substantially all discrimination must be removed in the service sectors covered by the EIA, in accordance with the level of development of the countries concerned, both overall and in individual sectors and subsectors. Second, in the case of EIAs involving only developing countries, more favorable treatment may be granted to juridical persons owned or controlled by natural persons of the parties to such an agreement.

The notification requirement. All RTAs concluded by WTO Members require notification. RTAs involving developed countries are sent to the CRTA for examination, while RTAs among developing countries under the Enabling Clause are notified to the Committee on Trade and Development. Some WTO Members argue that the Enabling Clause is not appropriate to deal with RTAs which take the form of either a customs union or FTA which should be covered by Article XXIV. According to this view, the Enabling Clause should be confined to preferential trade agreements which stop short of an FTA or customs union.

Controversies in the interpretation of WTO rules

There are a number of controversies in the interpretation of these requirements. These have been summarized by the WTO Secretariat in two documents dealing with “systemic” issues related to RTAs (WT/REG/W/16 and WT/REG/W/37). A summary of the issues discussed in these documents is reported here to give a flavor of the debate.

The neutrality of trade policy

Measuring the neutrality of before and after trade policy. While the 1994 Understanding clarified the methodology to be used in evaluating tariff policy in a customs union, questions still remain.

For a customs union, a global assessment of tariff neutrality is not necessarily relevant to an individual country whose exports may be concentrated in particular sectors. Economists also point out that it is still possible for trade diversion to occur even if tariffs are reduced. Some observers have proposed using trade levels as a better indicator of whether or not trade diversion occurs as a result of an RTA, but this test is only feasible ex post and does not help in an ex ante assessment of the compatibility of an RTA with WTO rules. Other proposals to ensure the neutrality of trade policy effects include requiring an open accession clause that would minimize the possibility of trade diversion and the ‘hub and spoke’ effect of multiple RTAs, or requiring the use of the lowest pre-CU tariff rate as the common external tariff. The growing scope and importance of non-tariff measures covered by RTAs, such as anti-dumping, preferential rules of origin, technical standards, subsidies and countervailing measures, also makes it more difficult to evaluate damage to third countries when a customs union is formed or extended.

While the neutrality of tariff policy in a customs union is to be evaluated on the basis of applied rates, there is disagreement as to whether applied or bound rates are relevant when evaluating an FTA.^[10] With respect to non-tariff barriers in FTAs, there is disagreement whether preferential rules of origin come within the scope of the “other regulations of commerce” concept in Article XXIV. The possibility that preferential rules of origin may lead to trade diversion is used as an argument for their inclusion. Some Members object to this on the grounds that rules of origin merely determine which goods qualify for preferential treatment and thus cannot be considered a regulation of commerce.

Is the introduction of new quantitative restrictions justifiable when a country or countries join or form a customs union? This issue highlights a potential conflict between paragraph 8 of Article XXIV (which requires all members of a customs union to apply substantially the same trade policies to third countries) and paragraph 5 (which requires that non-tariff barriers should not be more restrictive on average). In the WTO Turkey-Textiles case, the Appellate Body ruled that new restrictions could be defended provided it was part of integrating into a customs union and that the party demonstrates that the formation of that customs union would be prevented if it were not allowed to introduce the measure at issue. However, the burden of proof lies with the defendant to show that the customs union meets the requirements of Article XXIV and that there were no alternative means available to it that would be compatible with the formation of the customs union. Where non-tariff barriers are extended in this way, the issue arises of how to compensate third countries so as to maintain the overall neutrality of trade policy before and after.

Substantial coverage

The substantial coverage requirement. This has been a major source of difficulty in the examination of RTAs by GATT and now WTO. Essentially, there are two views on how to interpret “substantially all trade”. The quantitative view proposes a statistical threshold on the proportion of trade covered (such as 95 per cent of all HS^[11] tariff lines at the 6 digit level, or 90 per cent of all existing trade between the partners). Objections to this procedure include the fact that a ‘one-size-fits-all’ approach may not have the flexibility to take into account case-by-case circumstances, that a volume of trade measure may be biased by the existence of high trade barriers in the base period, and that it does not allow for the possible expansion of trade over time as a result of the RTA. The alternative qualitative view argues that the provision should be interpreted as meaning that no sector (or at least no major sector) should be left out of intra-RTA trade liberalization. But this approach may simply push the controversy back to the definition of a sector. In practice, the debate revolves around the exclusion of agriculture, or agricultural products, from the regional integration process. We return to this point below.

The recent EU-South Africa Trade, Development and Co-operation Agreement sets out an explicit understanding of the WTO requirements. The Agreement has interpreted ‘substantially all’ as meaning an average of 90 per cent of the items currently traded between the two partners. All three italicized items could be challenged (Stevens, 2002). The averaging procedure is used to permit an asymmetrical agreement under which the requirements on South Africa are less onerous than those on the EU. Hence, while 94 per cent of the goods imported into the EU will be covered by the FTA, only 86 per cent of those imported into South Africa will be so covered (Stevens, 2002). Stevens wonders about situations where the imbalance would be even greater, raising the question whether the lower figure fulfils the ‘substantially all trade’ criterion.

Notification and examination

The notification and examination process. Issues arise over the timing of notifications, the amount of information which should be supplied, and non-compliance with the notification requirement. Despite the flexibility allowed to Members in the timing of the notification of RTAs, the WTO Secretariat notes that a large number of RTAs in force today have not (yet) been notified to the WTO. There is no provision for counter-notification of agreements under current WTO rules. Even the status of those agreements which have been notified and examined remains unclear. Only one of the reports on the examination of RTAs adopted to date (the Czech Republic-Slovak Republic Customs Union) states clearly that the RTA is fully compatible with the relevant GATT rules. Opinions differ on the status of the remainder. One view is that where reports are adopted without recommendations to the parties, such RTAs are tolerated or deemed compatible by the WTO. Others argue that, in the absence of a conclusive report, WTO Members retain the right to challenge an agreement under dispute settlement provisions.

Given these controversies, in the Doha Declaration, WTO Members agreed to initiate negotiations to clarify and improve RTA-related disciplines and procedures. While recognizing that RTAs can play an important role in promoting trade liberalization, WTO Members stressed the need for a harmonious relationship between the multilateral and regional processes.

WTO rules on regionalism and agricultural trade liberalization

Agricultural trade liberalization within RTAs could be influenced by any changes to WTO rules to ensure a better synergy between regional and multilateral trade liberalization. Three obvious areas relate to the interpretation of the substantial trade coverage requirement, any clarification of the methodology used to aggregate Members’ market access, domestic support and export subsidy commitments under the Agreement on Agriculture when forming or enlarging a customs union, as well as problems of inconsistency between individual RTA and WTO rules governing agricultural trade. The fact that it is becoming more difficult to obtain a WTO waiver for non-reciprocal preferential trade agreements with selected groups of developing countries will also impact on agricultural trade.

Agriculture in RTAs

The inclusion of agriculture in RTAs. Many, if not the majority, of past RTAs have made use of the let-out that only “substantially all trade” need be covered by an agreement to exclude significant parts of agricultural trade. More often than not, agricultural commodities or food products were classified as “sensitive” and subjected to reduced concessions, longer transition periods or excluded altogether from the scope of RTAs.

RTAs formed in the past decade are more comprehensive in their treatment of agriculture. NAFTA and MERCOSUR have removed nearly all agricultural trade barriers to their members, although commodity exceptions remain including sugar, dairy, poultry and eggs in the bilateral pacts within NAFTA, and sugar in MERCOSUR. Agriculture is also included in the FTAA Agreement although much remains to be negotiated in this chapter.^[12] The EU’s recent bilateral FTAs also include some agricultural trade liberalization, although again there are limitations. The Free Trade Agreement between the EU and South Africa is a typical example. This Agreement provides South African exporters with progressive tariff reductions phased in over a ten-year period on a range of agri-food products. However, in addition to a safeguard clause to protect against import surges, the Agreement also exempts certain sensitive product areas from inclusion and subjects other products to quota-limited duty-free access.

Although the economic logic of the “substantially all trade” requirement was to prevent the creation of bulwarks of protectionism, there may be an economic rationale to leaving agricultural trade out of RTAs. Where agricultural sectors are uncompetitive, their exclusion from an RTA may help to prevent trade diversion. Simulation results reported by Scollay and Gilbert (2001) indicate that the exclusion of agriculture from a Japan-South Korea FTA unambiguously improves the welfare outcome both for those two countries and for their trading partners. This logic suggests that it might be self-defeating for other members to insist on too rigorous a definition of this requirement in any rules revision in the Doha process.

Aggregating Agriculture Agreement commitments

Agriculture Agreement reduction commitments. Uruguay Round agricultural market access commitments, as well as reduction commitments on domestic support and export subsidies, are contained in each Member’s WTO Schedule. To comply with the requirement in Article XXIV:8(a)(ii) which requires that “substantially the same duties and other regulations of commerce are applied by each of the members of the union to the trade of territories not included in the union”, the commitments of individual Members forming (or joining) a customs union may need to be changed or, at least, unified. However, there is no agreed-upon methodology as to how to translate Member’s commitments limiting agricultural subsidization into common commitments. The Agreement on Agriculture has no procedures with respect to this matter.

On market access commitments, Crawford and Laird (2000) point to a potential conflict between the Uruguay Round methodology of computing arithmetic averages of tariffs to establish commitments in the agricultural sector and the import-weighted average of tariffs set out in the Understanding to Article XXIV to determine the WTO-consistency of an RTA. A country required to harmonize its tariff schedule on joining a customs union could show that it met the Article XXIV requirement but its new tariff schedule might no longer fulfil its reduction commitments under the Agriculture Agreement.

The aggregation of tariff rate quota commitments could also be problematic. Assume that two countries A and B form a customs union AB and that country C remains outside the union (a country, in this context, could represent an existing RTA). Where tariff rate quotas (TRQ) are offered by country A in its WTO Schedule and where part of this TRQ is filled by exports from country B prior to forming an RTA, should the AB union’s obligation be to offer the gross addition of TRQ amounts in participating countries, or just the net addition? This problem is raised particularly in the case of current access TRQs. These are bilateral or plurilateral quotas opened in the Uruguay Round to maintain current access commitments. Many of the EU’s TRQs had their origins in this way. If the countries benefiting from access under these EU TRQs now become members of the EU, are these TRQs extinguished or should they be maintained and transferred to other countries?

Similar issues arise in the aggregation of export subsidy commitments. Assume that A has an entitlement to use a specific volume of export subsidies in its WTO Schedule. Assume also that in a previous representative period (the base period) A exported an agricultural commodity to both B and C with the aid of export subsidies. How should the export subsidy entitlement of the customs union AB be calculated? Should it be the sum of the individual entitlements of A and B? Or should it be the sum of the individual entitlements of A and B net of intra-trade between A and B on which export subsidies were paid in the base period? If B also had export entitlements in its Schedule, the definition of the commodities in the two Schedules may not be the same, also giving rise to problems of aggregating them.

Unifying domestic support commitments poses a similar problem. Suppose that A had an AMS entitlement in its WTO Schedule but B did not. Under Agreement on Agriculture rules, B would in future be limited to de minimis levels of trade-distorting support. Suppose further that at the time of forming the new customs union A was not using all of its AMS entitlement. In the new customs union AB, trade-distorting support could be extended to agriculture in B up to the limit of the unused AMS entitlement in country A. Would this increase in the overall volume of trade-distorting support in the union run counter to the requirement in Article XXIV:5(a) that the trade policy of the union overall should not be more trade restrictive than that of its constituent parts? Even if A was fully utilizing its AMS entitlement prior to forming the union, if total trade-distorting support in B was below the de minimis level, this would still permit an overall increase in the volume of trade-distorting support in the union.

Consistency of RTA rules

Consistency of RTA and WTO rules governing agriculture. The growing propensity of RTAs to pursue deeper integration including regulatory co-ordination has already been noted. This trend may require changes in domestic rules affecting agricultural and food products, particularly with respect to the application of sanitary and phytosanitary measures. Where RTAs make provision for the harmonization of rules or mutual recognition of testing procedures, there is a danger that the rules developed may be inconsistent with those in the WTO multilateral rules. With more RTAs now incorporating dispute settlement provisions, this could lead to different jurisprudence being developed around similar issues. These developments could lead to problems with forum-shopping to settle disputes, as well as raising the question whether a WTO Member’s existing rights are affected by an RTA. Some RTAs make specific provision that RTA rules should be consistent with the relevant WTO provisions in an attempt to minimize this problem.

Future of the Cotonou commodity protocols

Greater stringency on WTO waivers. Much North-South agricultural trade that benefits from preferential access takes place under non-reciprocal preferential trade arrangements. Apart from arrangements legitimized under the 1979 Enabling Clause, these schemes require a waiver from GATT rules and particularly the non-discrimination clause in Article I. In the past, such waivers were freely granted but they are now more vigorously contested. The basic problem is that preferences to groups of developing countries, other than those recognized in the Enabling Clause (either all developing countries or the least developed countries) result in discrimination between one group of developing countries and another. This issue came to a head in the successive challenges by various Latin American countries (and the US) to the EU’s banana regime designed to provide preferential market access to ACP bananas. The resulting difficulty in getting a waiver for the post-Lomé trade arrangements was one of the factors which persuaded the EU that these arrangements in future should be WTO-compatible. The implications of the Cotonou Agreement for regional integration in Africa are considered in detail in Chapter 6. The main point to highlight here is the uncertainty about the future of the commodity Protocols which were attached to the Lomé Conventions. Discriminatory access under current access TRQs has been de facto permitted in the TRQ schedules submitted as part of the Uruguay Round, but the EU has not chosen to protect the ACP preferential sugar or banana imports in this way. This could become an issue in the current Doha Development Round.

Implications of WTO rules for developing countries

Developing countries have a number of interests in any revision of WTO rules on RTAs. First, as beneficiaries of a rules-based multilateral trading system, they will want to ensure that regionalism contributes to its strengthening and not its fragmentation. Under this heading, clarification of the rules regarding the required trade coverage, tightening of the requirement for trade neutrality, and ensuring that rules created under regional arrangements are compatible with the multilateral system and are transparent, will be important objectives.

Second, developing countries will want to ensure that the new rules permit them the flexibility to form the regional integration arrangements they desire. Under the Enabling Clause, agreements exclusively between developing countries must meet lower requirements for approval. However, as developing countries opt for agreements favoring wider trade integration, there is a trend for these agreements to be notified under Article XXIV.^[13] Thus any changes to the rules under this Article, such as a requirement (however achieved) that agricultural trade cannot be excluded from RTAs, will also have implications for developing countries. With the growing number of North-South RTAs, and given that agriculture continues to be highly protected in the North, it would appear to be to the advantage of developing countries to seek a tightening of the ‘substantial coverage’ requirement, even though this would then also apply to purely developing country RTAs if they were notified under Article XXIV in the future.

A third issue in North-South RTAs is that asymmetric trade liberalization commitments have become the norm as an implicit ‘special and differential treatment’ provision. Developing country partners are granted greater scope for exemptions and longer time periods for compliance. Although these provisions are consistent with special and differential treatment, there is no explicit provision for this in the WTO rules on RTAs, something which might also be addressed in the negotiations.

Finally, this section raised the question of how to aggregate AoA commitments when countries form or join a customs union. Because relatively few developing countries have AMS, TRQ or export subsidy commitments, this issue affects industrialized countries in the first instance. However, the rules will have implications for the market access of third countries including developing countries and thus any negotiations on these issues should be carefully followed. The future of the commodity protocols in the Cotonou Agreement was also specifically highlighted as an issue.