The Trade and Investment Regime in the First Decade of the 21st Century

Paper for the Confederacao Nacional da Industria
The Future of Industry at the Onset of the 21st Century
Brasilia, Brazil

March 23, 1999


Obstacles to Liberalization

The most successful institution created at Bretton Woods a half century ago was the General Agreement on Tariffs and Trade (GATT), now the World Trade Organization (WTO). The GATT started life as a weak child compared to the powerful International Monetary Fund (IMF) and International Bank for Reconstruction and Development (now the World Bank). But today, the IMF plays little role in the monetary and fiscal affairs of rich countries; and the IMF has not handled the Asia/Russia/Brazil crises of 1997-99 with distinction. The World Bank has taken on such a broad array of tasks that it is hard to define its central mission-beyond helping poor countries.

By contrast, eight major negotiating rounds held under GATT/WTO auspices have lead to a marked reduction of trade and investment barriers, and a huge expansion of world commerce. Regional agreements have also stimulated trade and investment-the European Union for several decades, NAFTA and Mercosur more recently. The past success of the WTO compared to its Bretton Woods sisters, and the recent vitality of some regional groups, do not however provide assurance for the future. The next decade looks especially rough. Several obstacles lie in the path of further liberalization. Individually, none of them is insurmountable; but collectively they are daunting.

  • The success of past GATT/WTO negotiations has attracted some heavy baggage. Many environmental and labor groups view trade talks as "the only game in town". As a condition of further liberalization, they insist that trade sanctions be imposed on countries and companies that violate core standards.

  • Success has created another obstacle. The mercantilist bargain at the foundation of past GATT/WTO negotiating rounds is wearing thin, at least for industrial tariffs. On the whole, the OECD countries have tariff rates averaging 4 to 6 percent (with some notable spikes), while many emerging countries have tariffs averaging 10 to 25 percent. This disparity makes equivalent tariff "concessions" more difficult to negotiate.

  • Meanwhile, it is much harder to calculate the political and economic arithmetic of mercantilist "reciprocity" for non-tariff measures, both because they differ qualitatively from sector to sector, and because they exert protection far behind the customs border.

  • Many large firms based in Europe, Japan and the United States have decided to spend their efforts attacking specific restrictions that limit their own trade and investment opportunities, rather than backing broad-based efforts to reduce a wide array of barriers. It is thus difficult to marshal business groups in support of the Millenium Round, the FTAA, or other broad liberalization initiatives.

  • Within the United States, trade liberalization has come to be identified (wrongly from an analytic standpoint, but strongly from a political perspective) with flat or falling compensation for the bottom half of wage earners. In Europe, liberalization is associated (again wrongly, but also strongly) with persistently high unemployment. For the first time since the Second World War, opponents of liberalization have a clear message and a semi-coherent organization.

  • Even though the crises in Asia, Russia and Brazil reflect the failure of exchange rate regimes and misbehavior by some large financial institutions and corporations, not weaknesses in the international trade system, these crises have called into question the entire liberalization agenda.

In various ways, the assorted obstacles are beginning to show up in public policy. To be sure, once ratified, trade and investment agreements have proven very durable in the face of macroeconomic shocks. Obligations undertaken in the GATT and the WTO have survived many shocks over the past fifty years. Durability has also been demonstrated by the European Community in the wake of the oil crisis of 1973-74; by the NAFTA following the peso crisis of 1994-95, and most recently by the Mercosur in the weeks after the real devaluation of 1999.

But at best, durability ensures a standstill, not forward motion. President Clinton has three times failed to secure new negotiating authority (first when he submitted the Uruguay Round accords to the Congress in 1994; then in November 1997; and most recently in September 1998). The European Union is anguishing over the pace of its own enlargement to the east. And, blocked by Japan, APEC could not agree on a menu of Early Voluntary Sectoral Liberalization at Kuala Lumpur in November 1998.


Prizes of Liberalization

While the obstacles are severe and their toll is already evident, the prizes for travelling the difficult path of trade and investment liberalization are well worth the effort. Let me tick off the potential gains, for the world as a whole and for Brazil as a nation, if business and government work together to prolong the "open markets show".

Greater density of transactions. The density of international transactions has, of course, increased greatly since the Second World War. A few comparisons between 1970 and 2000 are worth noting. (For these comparisons, 1970 values are multiplied by 3.9; this factor reflects the rise in the US GDP price deflator since 1970.) Over this period, world GDP has expanded from about $16 trillion to about $35 trillion-about 2.2 times in year 2000 values. Meanwhile, world merchandise trade has expanded from $1.1 trillion to $6.2 trillion, or 5.6 times. The stock of world foreign direct investment grew from $600 billion to $2.8 trillion, or 4.7 times. Global telecommunications and finance increased by multiples of 10 or more.

As impressive as these statistics are, far more expansion of international trade, investment and communications lies ahead. We know this by comparing the density of international transactions between countries with interregional transactions within a single large country. The density of merchandise trade flows between New York and Chicago, between Quebec and Ontario, or between Rio de Janeiro and Sao Paulo, is estimated to be ten times or more than greater than trade flows that cross international borders, holding constant economic size and distance between source and destination. Much the same is true of direct and portfolio investment. At the end of 1996, for example, plant and equipment investment within the United States by U.S. firms had a replacement cost of about $7.7 trillion, whereas foreign direct investment by U.S. firms had a cost of about $0.9 trillion. The U.S. economy accounted for about 25 percent of the world's total economy in 1996, but U.S. firms had invested about 90 percent of their tangible assets at home. Similarly, U.S. pension funds place less than 10 percent of their assets in foreign securities.

The very strong home country bias of economic transactions, emphasized by John Helliwell (1995) and others, suggests a huge potential volume of trade and investment-when countries actually dismantle all their assorted tariff and non-tariff barriers. Indeed, the potential volume of international transactions is far larger than the volumes predicted by standard gravity models (e.g., Jeffrey A. Frankel 1997).

An example illustrates the potential trade growth from regional integration alone. In 1994, Quebec exported $41 billion of merchandise to the rest of Canada, but only $34 billion to the United States. Yet U.S. GDP is about 15 times the size of Canadian GDP (excluding Quebec). In other words, per billion dollars of GDP in the importing region, Quebec' exports to the rest of Canada are about 18 times its exports to the United States. This example suggests that U.S.-Canada trade will grow many times, once the effects of NAFTA are fully reflected in business decisions. The same arithmetic could, of course, be applied to Mercosur, the European Union, and other vital regional groups.

The same potential exists for international investment. With further liberalization, the home country bias of direct and portfolio investment will mellow, if not disappear, as firms find their best niche in the world economy and as pension funds diversify their holdings. Meanwhile, the internet and the world wide web will create global communities of professionals, and global markets for computer-driven services. In the 21st century cyber-economy, workers will be able to live where they choose (or where they were born) and sell their services almost anywhere.

Convergence of per capita income. What difference will the greater international density of economic transactions make to our standards of living? With closer trade and investment relations, per capita income levels will converge between rich and poor countries, and the convergence will reflect rising incomes in poorer areas, not falling incomes in richer regions. This story is worth telling.

In the early 1960s, Charles Kindleberger (1962), among other scholars, challenged the prevailing import substitution industrialization (ISI) strategy. However, the connection between export orientation and growth in developing countries was accorded little recognition until Bela Belassa published a series of persuasive empirical studies, beginning in the late 1970s (Belassa, 1977). Broadly speaking, this literature established an important proposition: developing countries that adopted outward-oriented policies enjoyed both faster merchandise export growth and higher GDP growth. This literature undercut the prevailing ISI strategy; but it did not make the broader case for an open economy, covering services, imports and investment, as well as merchandise exports.

A few years later, analysts turned their attention to long-run per capita income convergence between states, regions and countries that started with different initial levels of income. Robert J. Barro (1991) alone and with Xavier Sala-I-Martin (1991) carried out pioneering work. They established four broad propositions (Barro 1994):

  • Among states of the United States and regions of Japan and Europe, poorer geographic areas have exhibited a long-run tendency to catch up with richer areas at a rate (measured in terms of closing the initial income gap) of about 2 percent per annum.

  • Between a large cross-section of countries, poorer countries tend to catch up with richer countries at a rate of about 1.5 percent per annum.

  • As between countries, higher investment shares of GDP and more schooling accelerate growth; while higher government consumption (excluding education and defense) and more frequent revolutions or coups reduce growth.

  • More open trade and investment policies-measured by lower tariff rates and lesser black market premiums on foreign exchange-accelerate growth.

Two of these propositions have special relevance in counting the benefits of liberalization. The first is the observation that the long-run per capita income convergence has been about 0.5 percent per year faster (in terms of closing gaps) within highly integrated areas-the United States, Japan and Europe-than between countries that exhibit a much lower degree of integration. This observation suggests a bonus payoff for poorer regions that join strong free trade areas or customs unions.

The second significant observation underscoring the benefits of liberalization is the proposition that measures of openness-low tariffs and low black market premiums-are strongly associated with faster rate of income convergence (supporting this proposition, also see Sala-I-Martin, 1997, pp. 178-183).

Of course association does not prove causation. It has been argued that growth is the cause of openness, rather than the other way around (e.g., Colin Bradford Jr., 1994; Dani Rodrik, 1994). However, in a joint paper, Jeffrey A. Frankel, David Romer and Teresa Cyrus (1996) used an instrumental variables approach to show convincingly that causation runs from trade openness to growth among East Asian countries. And Dan Ben-David (1995) demonstrated that income convergence within artificial groups of countries created on the basis of their trade intensity is significantly greater than convergence within artificial groups created without regard to trade intensity.

Finally, there is the question whether policy-as opposed to geography, history and other factors-is important in determining the extent of a country's integration with the world economy. Evidence shows that policy matters. In addition to the findings of Barro and Sala-I-Martin, already cited, we have the work of Georgios Karras (1997), Dan Ben-David and Michael B. Loewy (1995), among others, which detect faster income convergence in regions with a stronger policy commitment to integration. These scholars find strong convergence in Europe (where the European Union has been the driving force). By contrast, they find mild convergence in Latin America (where free trade areas and customs unions did not amount to much before the 1990s), and practically no convergence in Southeast Asia (where ASEAN has played a larger role politically than economically).

Liberalization in Brazil. How does this lofty analysis play out in the Brazilian context? The first point to emphasize is that Brazil, like Indonesia and China, and the United States of the 19th century, is a vast country with disparate regions that trade and invest relatively little among themselves. The academic lessons from the international economy thus have a great deal to say about interregional transactions and convergence within Brazil. Over time, better internal communications and transportation will enormously expand domestic commerce and sharply narrow regional disparities. Politicians sometimes focus on fiscal transfers as a favored means of reducing regional disparities. Based on U.S. experience, my guess is that the increasingly dense network of internal trade, investment, communications, together with internal migration, did far more to equalize per capita income among the 50 states during this century than the substantial fiscal transfers mediated by the federal government.

International commerce will also play an important role in raising the Brazilian standard of living. To illustrate the near-term potential, I will draw on calculations from a recent paper that compared the external economies of Mexico and Brazil, with a focus on merchandise trade and direct investment (Hufbauer and Oegg, 1998). Between 1982 and 1997, the world stock of foreign direct investment in Mexico (measured at historical cost) grew by a factor of 7.9, while the world stock of FDI in Brazil grew by a factor of 5.6. Because Brazil has a larger internal market with about twice the Mexican GDP, and a higher per capita GDP, Brazil is inherently a more attractive location for multinational corporations. But over the past fifteen years, Mexico rapidly slashed its import barriers, and quickly dismantled the "keep out" signs that frightened foreign investors. For these reasons, the FDI stock in Mexico expanded faster than in Brazil.

In my judgment, the FTAA or its commercial equivalent might increase the FDI stock in Brazil by 30 to 40 percent within five years, over the levels that would otherwise be reached. Typically, multinational enterprises pay higher salaries and introduce more new technology than their domestic competitors. Moreover, FDI is essential to closer trade relations, since trade between affiliated firms accounts for at least 30 percent of world commerce. (Indeed, U.S. affiliates operating in Brazil nearly doubled their share of Brazilian exports to the United States between 1982 and 1994, and now account for about one-fifth of Brazilian exports.) However, it is worth noting that U.S. firms would probably not dominate the investment expansion that would follow a Hemispheric agreement. In Mexico over the past fifteen years, FDI from countries other than the United States grew faster than FDI from the United States.

In the near term, the FTAA or its commercial equivalent will expand the scope of merchandise and services trade-in addition to its boost to investment. Again the comparison with Mexico is suggestive. In 1997, two-way merchandise trade between the United States and Mexico was six times larger than two-way trade between the United States and Brazil ($157 billion vs. $25 billion). Taken alone, the respective GDP and GDP per capita figures for Brazil and Mexico would point to larger U.S-Brazil than U.S.-Mexico trade, for the simple reason that Brazil has the larger economy and the higher per capita GNP. However, in addition to GDP and GDP per capita, there are other important determinants of bilateral trade flows: geographical proximity, a common border, a common language, and common trade bloc (Frankel, 1997).

All-in-all, adjusting for these assorted differences in size and geography, gravity model parameters can be used to predict that two-way U.S.-Brazil merchandise trade flows could reach $56 billion if the two countries were linked in a free trade area. The fact that U.S.-Brazilian trade flows in 1997 were only $25 billion suggests that the FTAA-effect is potentially large-perhaps a doubling of trade. While we did not perform similar calculations for Mercosur-EU trade, my guess is that these volumes would also double if a comprehensive free trade pact (covering agriculture and services as well as industry) could be negotiated between the two customs unions. Likewise, while a gravity model has not yet been constructed for trade in business services, my guess is that they too would double with an FTAA. In the case of U.S.-Brazil trade in business services, this would mean an expansion from $8.5 billion to $17 billion annually.


Negotiating Paths, or How to Reach the Prize

I will not dwell on the political frustrations of 1999, beyond offering a few commonplace observations. It seems highly likely that the Millenium Round of WTO talks (which might instead be named the Seattle Round or the Clinton Round) will indeed be launched at Seattle in November 1999. It seems far less likely that the U.S. Congress will give negotiating authority to this Administration during its last two years in office. That prospect will dampen trade talks, but not stop them altogether. Preparatory work for the Millenium Round and the FTAA will go ahead; and the Mercosur will survive Brazil's financial crisis. If the political scene in Cuba suddenly changes, a new and powerful lobby could emerge from Florida calling for NAFTA expansion. Meanwhile, it is possible that a CBI Enhancement bill and an African Trade and Investment bill will emerge from the U.S. Congress.

Shape of the negotiating table. Scholars have written a great many books and articles about the respective merits of unilateral liberalization, bilateral trade agreements, regional agreements, and multilateral agreements. The gloss I would put on this debate is to recommend that trade negotiators practice "opportunistic liberalization". They should follow their instincts and negotiate with willing partners on soluble topics.

Some scholars take issue with this advice. They worry that, when a few countries liberalize among themselves, they create vested interests that will slow down external liberalization to a wider group of countries. The feared foot-draggers in this scenario are low-cost producers within the region-producers who benefit from access to neighboring markets but are at risk from still lower-cost competitors outside the region. A concrete example illustrates this fear. Within NAFTA, Mexico is the low-cost sugar producer. But compared to several Caribbean countries, and Brazil, Mexico is a rather high-cost producer. Ergo, Mexican sugar producers can be expected to oppose the opening of NAFTA's markets to additional countries in the Western Hemisphere.

This is not an idle fear. But in most cases a stronger force is at work: namely, the fact that each helping of liberalization creates an appetite for the next. A decade ago, I labeled this force the magnetism of regional trade groups. More recently, Fred Bergsten has coined the label competitive liberalization. Whatever the label, the underlying explanation is straightforward. Producers that buy industrial components and raw materials, and that compete on world markets, are eager to buy from the cheapest source possible. Likewise, chain retailers that sell to the mass market want to offer the merchandise at the lowest possible price. These firms form a permanent lobby for lowering trade barriers. To carry the sugar example further, Coca-Cola and other consumer product firms are energetic lobbyists for the cheapest possible sugar. Likewise, General Motors wants to buy hot rolled steel from the cheapest suppliers.

In the terminology coined by Jagdish Bhagwati, in most cases regional groups more often act as building blocks than stumbling blocks. If political considerations recommend a regional initiative, such as an EU-Mercosur accord, or a sectoral deal, such as the Information Techology Agreement, no great harm will come to the multilateral WTO system, and indeed the prior accord may open new vistas for WTO talks.

Hence, in my view it makes no great difference whether the Millenium Round of WTO talks is launched while preparatory work is still underway in the FTAA, or if interim agreements are reached on the nine sectors on APEC's wish list. Nor does it matter whether the Mercosur signs up South America in free trade agreements before embarking on market access negotiations with NAFTA.

Scope of negotiations. I am more concerned about the scope of negotiations than the various forums where they take place. By "scope", I am not referred to agriculture vs. services, or procurement vs. tariffs, but rather the wider agenda of fashionable new topics that go well beyond the customary mandate of trade ministers. Those who have spent their careers as trade negotiators generally favor a narrower rather than a broader range of topics. But important constituencies are demanding that new issues be addressed. They point out that Uruguay Round, in fact, represented a major advance: services, investment, and intellectual property were covered, as well as traditional trade barriers.

At a pragmatic level, the issues are simple. First, what is the minimum breadth of topics necessary to get talks launched? Second, what results are necessary to secure approval by ministers, and ratification by parliaments?

An interesting feature of contemporary political life is that the launch loads are lightest for purely sectoral talks (e.g., fishery negotiations) and heaviest for regional pacts (e.g. widening the EU or NAFTA). A new WTO round would entail an intermediate launch load.

Labor and environment. In terms of the Millenium Round, I believe that labor and environmental standards should not be negotiated in the WTO. Instead, the standards should be designed and adopted by other international forums, including ad hoc groups. Provided the standards in question are adopted by a large number of countries, representative of the world community, I would not object to WTO approval of back-up trade sanctions. However, trade sanctions should remain a last resort, not a first remedy. Labeling requirements, supplier certification and civil damages should be employed well before trade sanctions come into play. With those critical qualifications, I would not object to inclusion of labor and environmental issues in the WTO launch load.

Monetary relations. Additional topics that should be pursued, loosely in parallel with the next generation of trade and investment talks, are sustainable exchange rate regimes and the appropriate surveillance of financial institutions. Starting with the Mexican peso crisis of 1994-95, and extending to the Asia/Russia/Brazil crises of 1997-99, it is evident that monetary failures have greatly damaged the cause of open markets. Neither the United States nor any other requirement is likely to require a revamped monetary regime as the sine qua non of improved trade and investment agreements. However, without significant improvements in monetary arrangements, the thin consensus in favor of an open economy may well evaporate.

This is a large topic and I will only note the highlights. In the decade ahead, many small and medium-sized economies are likely to conclude, in their own interests, that they should either choose to peg rigidly to the currency of another country (usually, the euro or the dollar), or to freely float. Recent financial crises demonstrate how hard it is to sustain managed floats, crawling bands, and similar intermediate exchange rate regimes. These intermediate regimes are not technically infeasible, but they require very large reserves (scaled in terms of public and private external liabilities, not just imports), and considerable willingness to adjust monetary and fiscal policy to defend the exchange rate. In light of the severe criticism leveled at the IMF over the past two years, it seems likely that countries that peg or adopt intermediate regimes will need to accept much closer scrutiny of their central bank practices-including funds management, reserve positions, and the like. This scrutiny is likely to be the price of reliance on the Fund for emergency assistance.

Likewise, more attentive surveillance of financial institutions and large corporations has become an urgent matter. The technical aspects of prudent financial management and sound regulation are reasonably well known; but in many cases the incentives favor excessive risk and lax surveillance. The open markets agenda over the next decade requires urgent attention to these matters, even though the outcome will be far more intrusive financial inspection than national governments customarily endure.



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