Regional Trade Agreement: Meaning, Types, Pros, and Cons

What’s it: Regional trade agreement is a trade agreement between various countries in a specific geographic area. The agreement is usually about the elimination of trade barriers between these countries.

Such agreements can take various forms, ranging from the simplest such as the free trade area to the most complex, an economic union, or a monetary union.

The agreements usually include various internal rules, which apply only to member countries. When dealing with non-member countries, they may apply uniform rules. Or, members may have different trade policies with non-member countries, as in free trade area agreements. It depends on what stage they reach an agreement.

Importance of regional trade agreements

Trade agreements are important because they generally seek to reduce trade barriers between member countries. It allows for more significant trade flows, provides business growth opportunities, and increases consumer choice.

In many regional trade agreements, the agreement not only removes barriers to trade in goods and services but also factors of production. Labor and capital are free to flow to member countries.

So, if designed efficiently, the agreement can increase trade traffic, investment, promote economic growth, and social welfare. World Bank research shows that regional trade agreements increase trade in goods by more than 35% and trade in services by more than 15%.

Types of regional trade agreements

There are six stages of a regional trade agreement. Among others are:

1. Preferential trading area
2. Free trade area
3. Customs union
4. Common market
5. Economic union
6. Monetary union

Preferential trading area

The preferential trade area requires the lowest level of commitment to reducing trade barriers. Member states do not remove trade barriers. Instead, they only lowered rates and provided preferential access to certain products.

Free trade area

Under the free trade area agreement, member countries agree to remove trade barriers in goods and services between them. Therefore, they can freely transact goods and services between members without trade protection.

However, each member still maintains its own policies regarding non-member countries. So, they may apply different tariffs when trading with non-member countries.

Non-member countries may exploit the difference for their own benefit. For example, they will export products to a member country that has the lowest tariffs. Then, to sell to other member countries, they will ship it from that member, instead of sending it outright. That way, they only bear the one-time tariff because trade between member countries is zero tariffs. This phenomenon is what we call trade deflection.

Customs union

Under a customs union, member countries remove barriers to trade in goods and services between themselves and adopt uniform external trade policies. So when they set import tariffs, they will adopt one tariff.

Apart from increasing the flow of goods and services, a customs union’s goal is to eliminate the trade deflection inherent in the free trade area.

Common market

The common market is a further stage of the customs union. In this case, the free trade flow is not only for goods and services but also for production factors.

The main features of the common market are:

• Free flow of trade in goods and services
• Free flow of capital and labor (production factors)
• Uniform policy when trading with nonmembers.

Economic union

Economic unions combine all aspects of the common market plus adopt common economic policies, both fiscal and monetary. They form economic institutions to coordinate joint economic policies. An example is the European Union Economic Union.

If members decide to adopt a common currency, it is also known as a monetary union. Eurozone is an example, which consists of European Union members that adopt the Euro currency.

Pros and cons of regional trade agreements

Impacts of regional trade agreements depend on the extent to which the agreement is still in the free trade area or has formed an economic union.

Benefits of regional trade agreements

In general, the benefits of regional trade agreements are:

• Wider market access. Companies can more easily sell to member countries and compete fairly with others because there is no trade protection. 
• Encouraging economic growth. Member countries take advantage of the free flow of goods and services to increase exports and domestic production.
• Creating more jobs. The wider market encourages businesses to increase production. They end up creating more jobs and income in the domestic economy. When free flow includes production factors, workers can find work in other member countries, increasing their mobility.
• Better access to cheaper and more abundant capital. If capital flows freely between member countries, it makes it easier for companies to raise cheaper funds to finance investments.
• Stronger position in international treaty negotiations. The formation of an economic union, for example, increases the size and strength of the European Union economy. It increases its bargaining power in non-member country trade agreements.
• More choices. Consumers benefit from the free flow of trade. They have more access to higher quality and cheaper products. The elimination of trade barriers increases not only the supply and variety of products but also lower prices.
• Quality improvement and innovation. Trade agreements open up competition. Increased competition forces businesses to remain competitive to survive in the market. That leads to innovation, a variety of quality, or less expensive products.

Drawbacks of regional trade agreements

Critics point out that selective elimination of tariffs may not improve welfare. This is because tariff preferences can shift trade from efficient producers in non-member countries to less efficient producers in member countries.

For example, east Asian textile exporters found themselves at a disadvantage in competing with Mexican suppliers in the US market after NAFTA was signed. NAFTA benefits Mexican companies even though they are less efficient than Asian exporters.

Some of the other downsides of regional trade agreements are:

• Trade deflection. If the agreement reached only the free trade area stage, non-member countries would take advantage of the tariff differences for their own benefit.
• Increase economic dependence. When a member country goes into recession, it can quickly spread to other member countries. The Eurozone debt crisis in late 2009 is an example. The crisis started in Greece and then immediately spread to countries such as Italy and Spain.
• Reduction of economic sovereignty and independence of economic policies. Under economic unions, member states adopt joint economic policies. It may be unsuitable to the economic interests of individual member countries. Policies may favor member countries with large economies and tend to ignore the interests of other members.
• Domestic industry bankruptcy. Increased competition kills the domestic industry due to inefficiency and low competitiveness. The pressure is getting heavier if the industry absorbs a significant workforce. Labor mobility is also low if regional trade agreements are only at the free trade area stage.