Free trade area or customs union? The case of the South American trade bloc Mercosur.

Maniam, Balasundram ; Leavell, Hadley ; Mehrens, Dorothy 等

ABSTRACT

The South American trade bloc, Mercosur, is made up of the four countries of Brazil, Argentina, Uruguay, and Paraguay, with associate members, Chile and Bolivia. Mercosur has recently experienced a number of setbacks that have called into question their stability and effectiveness as a preferential trade bloc. Brazil's dominant self-motivated leadership role and unilateral actions have weakened the unstable union. Argentina's severe recession and the devaluation of the Brazilian real have also contributed the downward spiral. The recent decision of Chile to forgo full membership in Mercosur due to the high common external tariffs for non-member countries, should serve as blatant warning that Mercosur needs to change its ways. Although the early 1990's proved to a successful period, the recent downward trends require immediate action if Mercosur is to continue to be the dominant trade area of South America.

This paper discusses the need for Mercosur to define itself multilaterally, as well as its future ambitions as a full customs union. Examination of an alternative trade bloc, a free trade area, as a feasible option for increasing growth and stability in the member countries is also discussed. Three critical steps are outlined that Mercosur must take to overcome its current unrest and instability, so that it can continue as the dominant trading power in South America.

LITERATURE REVIEW

The four South American countries of Brazil, Argentina, Uruguay, and Paraguay formed the trade bloc Mercado Comun del Sur or Southern Common Market--commonly known as Mercosur-in March of 1991. The primary objective of Mercosur was to create an integrated regional market whose members were committed to liberalizing trade with one another while imposing a common external tariff (CET) on goods and services imported from non-members (Connelly, 1999). In 1996,

Mercosur extended its boundaries to include Chile and Bolivia as associate members. This type of regional trade bloc is known as a customs union (CU).

The other type of regional trade bloc is known as a free trade area (FTA). In an FTA arrangement, there is free trade among country members, but each member sets its own tariffs with the rest of the world (Bandyopadhyay & Wall, 1999). Typically, FTAs are wide in scope and set up parameters for activity in fields as diverse as the free flow of capital goods, monetary policy, treatment of intellectual property, dispute resolution, anti-dumping, and rules of competition (Stinson, 1999). The North American Free Trade Agreement (NAFTA) between Mexico, the United States, and Canada is one of the largest and most sweeping economic agreements of this type.

Customs Union (CU)

The two most important characteristics of a customs union are the total or partial elimination of monetary and non-monetary trade barriers within the borders of the union, and the adoption of common tariffs and trade policies on products originating outside of the union (Nakos, 2001). The membership of a nation within the customs union could influence the trade of that nation in a variety of ways. Depending on the state of the international economy, the country could increase their trade with member countries because of the lower tariffs and yet receive higher costing lower quality products. A country could also be forced to reduce trade with a non-member partner due to the high tariffs mandated by the union while creating shortages of essential products that member countries do not have available for trade. On the other hand, the customs union could be a favorable move by neighboring countries to increase trade between them without jeopardizing trade with non-members.

Under either scenario, the customs union theory differentiates between two sources of increased trade: trade creation and trade diversion. Trade creation can occur when there is a restructuring of the production facilities with the member countries of the customs union such that a more efficient mode of operation is achieved (Nakos, 2001). This may allow member countries to focus more narrowly on a specific area of specialization. Trade diversion can occur when lower cost products from non-member countries are forgone for higher priced products from member countries. Although trade diversion may cause a temporary surge in a country's economy due to meeting the demands of its partners, it ultimately leads to a reduction in the country's economic welfare (Nakos, 2001). These types of trade disruptions to a country's economy may be or may not be easy to overcome.

Free Trade Areas (FTAs)

A free trade area consists of member countries that practice free trade among themselves but set their own foreign tariffs with other non-member trading partners. However, in a free trade area, there are economic issues beyond trade and tariffs that must be addressed. Typically, if a free trade area exists between economically asymmetrical countries, the country with the less developed economy will feel the benefits of free trade much more so than the more developed countries. These benefits can include job creation and economic growth. Trade agreements also serve as political instruments to effect the partnering country's domestic policies (i.e. lock in free market reforms) and to serve as a framework to mutually address other issues (Stinson, 1999).

The Mercosur Customs Union

Mercosur is composed of four member countries, Brazil, Argentina, Paraguay, and Uruguay, with Chile and Bolivia as associate members. By far, the largest member of the group is Brazil with more than 70% market representation.

[FIGURE 1 OMITTED]

Mercosur is currently the fourth largest trade bloc in the world, after the North American Free Trade Area (NAFTA), the European Union (EU) and Japan (Connelly, 1999). During its short existence, Mercosur has become the most important and successful economic association in Latin America. Mercosur has a market of over 200 million inhabitants, ranking it third after NAFTA and the EU and is the fourth largest geo-economic region in the world, following NAFTA, the EU, and Japan (ECI, 1999).

During the early 1990's, Mercosur experienced strong growth primarily from direct investment flows and a higher share of trade flows. The level of foreign direct investment (FDI) is rapidly growing with the area being the largest recipient of FDI in developing countries behind China. However, Mercosur's importance in the world market has been limited with total trade participation of only 2.8% in 1999.

[FIGURE 2 OMITTED]

[FIGURE 3 OMITTED]

Differing Currency Regimes

One problem that Mercosur faces is the two largest members have different currency regimes. Brazil's floating (or sinking) real has lost over 40% of its value since its forced devaluation in 1999. Argentina's peso is pegged to the U.S. dollar. Clearly, Brazil stands to gain an unfair economic advantage over Argentina by letting their currency continue to fall. Consideration has been given to developing a single currency for the four countries of Mercosur but there has been objection to this, primarily by Brazil. Argentina's former economy minister, Roberto Alemann commented that you cannot create a single currency out of four countries that do not have their own money. It would be like turning four sick people into one healthy person (Mandell-Campbell, 1998). Even so, the thought of creating a common currency, much like the European Union has done with the euro, is intriguing from an economic standpoint, but the reality is a distant dream.

Closely tied with currency issues and monetary policy is the exchange rate. The exchange rate is the most important price in any developing economy because it defines the purchasing power of the domestic economy, it effects the international competitiveness of local producers, and governs the relative attractiveness of domestic and international financial assets (Salazar-Xirinachs & de Araujo, 1999). In economies where the currency is overvalued, the country may have an artificial increase in the standard of living but the rise is not sustainable over time. If the currency is undervalued, a trade surplus may be generated overtime with an undue transfer of resources to the rest of the world. In the case of Brazil, exchange rate instability has been a major factor in rising costs (Murphy, 1998) contributing to the forced devaluation of the real in 1999.

Effect on Tariff Rates and Trade Volume

The removal of trade barriers, specifically tariffs, between Mercosur member countries has drastically reduced the average tariff rates. The most dramatic decline was seen in Brazil, whose tariffs fell from a high of 69% (pre-Mercosur) to 13% by 1995 (Connelly, 1999). However, in some cases, countries actually experienced an increase in their average tariff rate due to the Mercosur mandated non-member country tariffs. In spite of the positive effect of Mercosur on overall tariff rates among member countries, Argentina and Uruguay are soliciting for a lowering of these rates so that they can competitively negotiate with non-member countries.

As anticipated, the lowering of the trade barriers between the Mercosur member countries has led to an increase in trade in the region. Intra-Mercosur trade rose from 12% in 1991 to a high of 19% in 1994 (Connelly, 1999). The increase in trade among Mercosur members came at the expense of non-members, although absolute trade in the Mercosur countries has increased with non-members also.

Brazil the dominant Mercosur player

Brazil accounts for 71% of the Mercosur membership and is the leading voice for the trade bloc. Immediately following the devaluation of the Brazilian real in January 1999, there was speculation that Mercosur would collapse (Roett, 1999). Fortunately, this did not occur primarily because of the reform of the central bank's fiscal and monetary policies put into place by the Brazilian central bank president, Arminio Fraga. However successful Fraga's policies had been for reform in Brazil, there was significant short-term damage to the Mercosur trading partners. The failure of the administration of President Fernando Cardoso to consult with its Mercosur partners prior to the devaluation created a temporary crisis of confidence. These actions proved that Brazil would move forward unilaterally if its core interests were at stake without consideration of the other Mercosur economies.

The devaluation of the Brazilian real substantially affected its Mercosur trading partners. Argentina has been running a surplus in its $15 billion trade account with Brazil, however, with the devaluation of the real, the surplus is likely to reverse, putting great pressure on Argentina's weak export sector. The same type of trade inversion is likely with Uruguay. The Paraguay economy could eventually have its exports dry up if Brazil continues to turn inward for domestic goods (Roett, 1999).

Brazil has reaped the greatest benefits from being part of Mercosur. Trade surged from $4 billion in 1999 to over $18.5 billion in 2000 between the four countries, with Brazil accounting for more than three-quarters of all intra-regional trade (Wheatly, 2001). Brazil has also lured in a large amount of foreign direct investment, primarily under the premise of a unified South American market. However, Brazil's gains have often come at the expense of the other Mercosur members.

Extension of Membership to Chile

Chile has the most competitive and open economy in South America, with a single import-tariff rate of 9%, which is scheduled to fall by 1% per year until 2003 (Ogier, 2000). Mercosur has a common external tariff that typically ranges from 10% on capital goods to 15% for intermediate goods to 20% for finished goods. In order for Chile to accept full membership into Mercosur, the country would be expected to retreat from its more liberal trade regime on non-member countries, while participating in free trade with its neighbors. Faced with this dilemma, Chile has continued to opt for associate membership such that it does not have to change its import tariffs with the rest of the world

Chile maintained its position on liberal trade with non-member countries by announcing to Brazil in early 2001 that they are in trade negotiations with the U.S. and that Mercosur membership is currently not a topic of discussion. This announcement was met with outrage by Brazil, as they hoped to add Chile as a full member of Mercosur this year so that South America's largest economies would have a unified voice in talks for a Free Trade Area of the Americas (FTAA), a Western hemisphere trading bloc comprised of 34 countries, slated to come into force by 2005 (Wheatley, 2001). It is clear that Mercosur will have to make sacrifices in order to entice Chile to full membership. Is Mercosur a customs union?

Although trade has quadrupled among Mercosur's members since the trade bloc was created ten years ago, it has fallen since 1998 and only represents a fifth of the total trade in the member countries (Economist, 2001). It is apparent that members of Mercosur are not reaping the benefits of this arrangement and are actually striking out on their own. Although trade between the Mercosur countries is tariff-free for most items, there are a number of non-tariff barriers that still exist. Furthermore, Mercosur has claimed to be a customs union with a common external tariff. This has been challenged recently by the crisis-ridden Argentina who would like to suspend the Mercosur tariffs so it can abolish import duties on capital equipment and raise those on consumer goods to pull its economy out of recession (Economist, 2001). Brazil has reluctantly agreed to temporarily suspend the tariffs in the case of Argentina.

Talks with Argentina and Uruguay have hinted that these countries would support a suspension of the customs union of Mercosur for a free trade area. However, Brazil has maintained a hard core view on the relatively high tariffs in an effort to protect its domestic producers and manufacturers. This pattern of non-coordinance in trade talks has become commonplace among Mercosur members. Furthermore, Argentina and Brazil have recently talked separately with the Andean countries and with Mexico.

With the proposed Free Trade Area of the Americas, it is imperative that a unified Mercosur participate in these negotiations. Mercosur was able to maintain a commonality in talks with the European Union but since that time, Chile has broken from the trade bloc. It remains to be seen if Mercosur will unite as one voice in the talks with the FTAA. However, it is clear that Mercosur needs to internally examine its policies and re-evaluate the benefits of continuing as a customs union.

European Union and Mercosur

In spite of Mercosur's ongoing internal problems, they are continuing to forge an inter-regional agreement with the European Union that will be completely unfolded into a free trade area by the year 2003. Since the early 1990's, Europe has been the main destination for Mercosur product exports, more than 27% in 1994. This is compared with 17% exported to the U.S. (Bajo, 1999). Furthermore, Mercosur represented 53% of all Latin American exports to the EU during this time, although trade has decreased in the last few years. Figure 5 shows that Mercosur's percentage of trade with the EU is nearly three times greater than with other trade blocs

[FIGURE 5 OMITTED]

The advantages of the trade relationship between the EU and Mercosur are mutually beneficial. In 1994, EU exports to Mercosur were 94% industrial goods, while Mercosur exports to the EU were more than 50% agricultural products (Bajo, 1999). Thus, the relationship is primarily need based. Apart from trade and investment, the EU provides a common market model for Mercosur, as they are both customs unions. Mercosur can follow the "road map" that the EU has developed in becoming an economic union. Additionally, the relationship can serve as a stronger bargaining unit for advancement of the competition for world market share. This is probably a greater advantage for the EU, as they are competing with NAFTA and others, but Mercosur stands to gain also by the increasing power and recognition that it can gain by being a member of the free trade area.

DISCUSSION AND ANALYSIS

The Need for Mercosur to Define Itself

Although Mercosur provides a political framework that has helped to advance the regionalization of trade in the Southern Cone area, an assessment of Mercosur's effectiveness shows that the customs union has considerable drawbacks. Several questions remain as to the future of the trade bloc, primarily how Mercosur will define itself.

The four countries that make up the trade bloc continue to act unilaterally in economic and trade decisions. Mercosur lacks agreements that would allow the eventual freedom of trade in services and has not dealt with issues such as intellectual property and government procurement (Reid, 1996). Voting issues among members have also not been addressed. The style has been one of informality and consensus with no central secretariat to enforce decisions, as well as no true conflict solving mechanism (Roett 1999). Additionally, there are no agreed upon customs codes or competition and investment policies (Economist, 2001). Currently, most disputes are settled by presidential invention, as opposed to a governing body that has set forth rules that the countries agreed upon. Any deepening of cooperation among Mercosur will require a loss of sovereignty, a price that Brazil may not be willing to pay.

In order to begin to solve Mercosur's problems, Brazil must change its inward focus to a regional outlook. Brazil continually puts its own interest ahead of those of Mercosur and this has badly constrained relationships with other member countries. Brazil has continued to stifle efforts by the other members to lower the average tariffs on imports (Wheatley, 2001). This has resulted in member countries striking out on their own to negotiate trade talks with non-member countries.

In the case of Chile, an associate member of Mercosur, the message should have been clear to Brazil that the average tariffs on imports would have to be relaxed if the customs union is to expand. However, instead of working to overcome the internal division between its members, Brazil has not taken action and continues to stall on negotiations. The primary reason for this may be that Brazil is waiting to see how the FTAA will advance over the next few years. This is a very dangerous position for Brazil to take because Mercosur will certainly have more bargaining power in these talks if the members stand together as a united trade area. Each of the individual member countries will have less bargaining power if they continue to follow their own unilateral interests.

Customs Union or Free Trade Area?

The other issue that has continued to plague Mercosur is its inability to settle the dispute over whether it is a customs union or a free trade area. For all practical purposes, Mercosur has defined itself as a customs union but its actions are very different. Argentina and Uruguay have continued to be opposed to the customs union and instead opt for a free trade area. The fact that Mercosur is a customs union has created obstacles for the expansion of trade with other areas including NAFTA. Brazil's stance over devaluation, import quotas, and allegations of dumping have continued to bog down negotiations among the group and may be providing the fuel for other countries to continue to act unilaterally (Becker, 2001). Furthermore, Argentina has been granted a temporary waiver from Mercosur's common tariffs due to a severe recession in the country. This action may prove to be a final blow in Mercosur's efforts to become a full customs union.

Steps Needed to Rescue the Customs Union

In order for Mercosur to continue as a customs union, it must unify and solve its internal problems before continuing to negotiate with outsiders. Some efforts have been made, such as an agreement to harmonize economic statistics and set common targets for inflation and public debt, but only with modest progress. However, many issues remain.

The first step needed to get Mercosur back on track is the establishment of a unified body that will settle disputes among countries. This body should be granted the authority to make decisions multilaterally that will benefit all the countries of Mercosur. Each country should have weighted representation within the unified body. This is not to say that Brazil should continue to dominate Mercosur, as this strategy has not worked in the past. Perhaps a non-biased consultant from the EU should assist Mercosur in fairly establishing its ruling body.

The second step will require that Brazil relax its hard stance on the common external tariff. This is absolutely critical if the customs union is to survive. Brazil needs to weigh its options of keeping Mercosur together as a unified voice in negotiations with the FTAA or break away from the customs union to maintain and protect its internal production. Ultimately, if the FTAA comes into being, the internal production of Brazil will be affected. It is likely that Brazil will come out ahead in the long run by making some concessions now to unify Mercosur than to risk losing its strong voice in the negotiations with the FTAA.

Finally, the third step in rescuing the customs union will require an increased feeling of regionalism among members. This will foster a sense of political understanding and initiate economic reform. This step may also involve examining whether Mercosur should remain a customs union or modify its agreement to become a free trade area. All of the members, except perhaps Brazil, would benefit from allowing each country to set their own external tariffs with non-members. Although Brazil's fears of losing internal production and jobs due free trade may be warranted, this has not happened on a grand scale as predicted with NAFTA. If Mercosur does not take the initiative to define itself and work out its internal problems, the customs union is likely to drift into irrelevance as the new FTAA is unfolding.

CONCLUSION

This paper examines the underlying problems of the South American trade bloc, Mercosur. The primary problem is that Mercosur has not defined itself and its members continue to act unilaterally. This may not be altogether surprising since Brazil, the dominant player in the trade bloc, has continued to foster its own interests without regard for regionalism among the Mercosur members. Furthermore, Brazil has taken a hard stance against lowering the common external tariffs and creating a governing body to settle disputes among members of the union. The lack of regionalism and the ability to settle disputes has prompted members to continue to negotiate in their own interests and act unilaterally. It would appear that Brazil holds all the power in this relationship and is not willing to relinquish it, even if it is in the best interest of its trading partners. This type of behavior must change in order for Mercosur to solve its internal problems and forge ahead with negotiations and trade expansion with the rest of the world. First, the members of the union must consent that they are a free trade area, rather than a customs union. As the largest country, it is imperative that Brazil coordinate its interests with the region's interests. Brazil must agree to lower the common external tariffs and create a governing body to settle disputes. The other three countries must remain united to push Brazil into compliance for the overall good of the South American free trade bloc. A combined approach is inherently necessary for Mercosur to succeed.

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Balasundram Maniam, Sam Houston State University

Hadley Leavell, Sam Houston State University

Dorothy Mehrens, Sam Houston State University

Table 1: Summary Statistics of Tests of Equality in the Rates of
Returns by the Day-of-the-Week by Sub-Periods

[H.sub.o]: [R,sub.i] (Monday) = [R.sub.i] (Tuesday) = [R.sub.i]
(Thursday) = [R.sub.i] (Friday)

Number of Country 1980-1985 1986-1991 1992-1997 1998-
Indices where: 6/2002

[H.sub.o] of equal 13 (a) 14 (c) 7 (e) 2 (g)
returns is rejected:

[H.sub.o] of equal 6 (b) 8 (d) 16 (f) 21 (h)
returns is not rejected:

Total Number of Indices: 19 22 23 23

(NOTE: Due to space constraints, details of other sub-periods are not
reported.)

(a) The following indices are included in this group: Australia,
Belgium, Canada, France, Italy, Japan, the Netherlands, Singapore,
Spain, Sweden, Switzerland, the United Kingdom, and the World Index.

(b) The following indices are included in this group: Austria, Denmark,
Germany, Hong Kong, Norway, and the U.S.

(c) The following indices are included in this group: Belgium, Canada,
Finland, France, Hong Kong, Italy, the Netherlands, New Zealand,
Norway, Spain, Sweden, Switzerland, the United Kingdom, and the World
Index.

(d) The following indices are included in this group: Australia,
Austria, Denmark, Germany, Ireland, Japan, Singapore, and the U.S.

(e) The following indices are included in this group: Germany,
Hong Kong, Japan, the Netherlands, New Zealand, Singapore, and the
U.S.

(f) The following indices are included in this group: Australia,
Austria, Belgium, Canada, Denmark, Finland, France, Ireland, Italy,
Norway, Portugal, Spain, Sweden, Switzerland, the United Kingdom, and
the World Index.

(g) The following indices are included in this group: Finland and New
Zealand.

(h) The following indices are included in this group: Australia,
Austria, Belgium, Canada, Denmark, France, Germany, Hong Kong,
Ireland, Italy, Japan, the Netherlands, Norway, Portugal, Singapore,
Spain, Sweden, Switzerland, the United Kingdom, the U.S. and the World
Index.

Figure 4

MERCOSUR COMMON EXTERNAL TARIFF
-Average Tariff, Main Sectors-

Sector Tariff (olo)

Mineral Products 2,4%
Products of the Chemical Industry 7,2%
Agricultural Products 7,5%
Plastic Manufactures 11,9%
Electric Machinery 12,6%
Industrializad Foods and Beverages 14,7%
Transport Material 14,9%
Textiles 17,1%

Source: CB