On the 23rd of June 2016, the British people decided to leave the EU, the only geographical area that almost completely fits the textbook definition of free trade, i.e. “the economic policy of not discriminating against imports from and exports to foreign jurisdictions.”. They made this decision official on the 27th of March, and lots of interrogations remain about the new agreements between the EU and Great Britain. In fact, a NatCen study shows that 88% of Britons back free trade, but 69% of them also support customs check and a harder immigration policy. This, associated with a lot of privileges like passporting no longer being available to British based companies, would push talents away, and ultimately entail less growth and innovation in Great Britain. But this is only one of the many possible scenarios. As said before, the EU is the only really integrated area. In the rest of the world, there exist many obstacles to free trade such as quotas, restrictions, subsidies or prohibitions. Barriers like the ones named here do not seem to negatively impact economic growth or innovation: China has practiced protectionism since 1978 when it decided to become a market economy, and yet its GDP is still growing at a rate of about 7%!

China GDP

Even developed economies have used protectionism and strong barriers to free trade to develop: during the 18th and 19th centuries (and even until WWII for the US), protectionism was seen as the only way to increase wealth and protect your interests against the ones of other countries. International trade was not seen as a win-win game but more as a zero-sum game, where for someone to win, someone must lose.

tariff rates

Anyway, already in the 19th century economists such as David Ricardo or Adam Smith declared and proved that free trade is the best possible solution for economies to thrive and grow. In response to their research, and because economies started to open up as a result of industrialisation and the facilitation of commerce and transportation, free trade became the norm and regulation became lighter and lighter. For instance, tariffs shifted from an average of 50% of the total imports in the US in 1830 (sometimes even more depending of the product) to an average of 3.8% in developed countries. After the Uruguay round of 1995, the proportion of imports into developed countries from all sources facing tariffs rates of more than 15% declined from 7% to 5% and the WTO set up piles of regulation on tariffs. (The WTO tariff agreement report is 22,500 pages long!)

The creation of the WTO in 1995 combined with globalisation really helped reduce the obstacles to free trade, but some still exist. In this article, we will therefore analyse the still existing obstacles to free trade and more importantly their impact on the global economy. Free trade is first and foremost a political choice, and consequently the largest part of the obstacles to free trade are political too and can take the form of quotas, tariffs, or other restrictions.

According to Robert Feenstra in Advanced International Trade, they are three main reasons why a country would impose tariffs: to protect fledging domestic industries from foreign competition, to protect aging and inefficient domestic industries or to protect domestic producers from dumping by foreign companies or governments. These three justifications of some level of protectionism can seem inoffensive, but as reported by the World Bank, if all barriers to trade were eliminated, the global economy would expand by about 830 billion dollars.

When looking at such number, it seems evident that it comes from the extra costs induced by the countries which are imposed with tariffs, but countries imposing tariffs also generate extra costs that usually outweigh the benefits. Indeed, when imposing a tariff, countries usually expect a rise in production and prices (due to lower competition), and this should induce producers to hire more workers which will automatically cause consumer spending to rise. But in the vast majority of cases, the rise in price will mean a decrease in purchasing power for the consumer. As a response, he will either buy less of the good which price has increased or less of another good. In any case, the increase in price will affect negatively global demand, and logically, it will also impact growth. Let’s think of the UK for instance: Brexit has become official of the 27th of March, but it should not be completed before 2019, and yet prices already started to rise[1], and growth expectations are rather negative[2].

Furthermore, tariffs and other restrictions can be used as a very powerful weapon in an economic battle. Such battle started for instance between the EU and the US in 1989, when the EU decided for sanitary reasons to impose heavy restrictions on American beef grown with hormones. In the first year after the tariff was instituted, about $140 million worth of American beef was blocked.  In 2008, the WTO decided that the EU had no legitimate reasons to impose and maintain such restrictions, and therefore the US were allowed to impose retaliatory import duties on EU products if the ban was not lifted. The EU decided not to lift the ban, and the US imposed supplementary restrictions to European products such as canned tomatoes, French cheese or ham. All products banned had a market value of $38 million but under the WTO ruling, the US could raise the tariff barriers to a value of $116.8 million, that is an additional $79million. These numbers show immediately what countries can lose due to tariffs and other restrictions, but the real victims of such games are consumers. As said before, because of tariffs which induce lower competition, price increases, but in addition to higher prices they are also confronted with less choices: in the USSR for instance, which is an extreme example of what barriers to free trade can do to an economy, people had very few choice for basic products such as dairy products or linen etc. even if due to communism they did not face higher prices. This lack of choice, associated to an increasing attraction towards western products, was one of the reasons for social unrest in the USSR and eventually for its collapse.

However, even if on the long run tariffs and barriers to free trade are harmful for the global economy, they do not only have a negative impact; they have always been used (and still are) by developing countries to increase government revenue and boost investment and growth. The strategy China used for its development nicely clarifies this statement.

It started developing in 1978, when it initiated market reforms and shifted from a centrally-planned economy to being market-based. GDP growth has averaged nearly 10 percent a year and has lifted more than 800 million people out of poverty. To achieve that, China has used a classical technique that we could describe as the “infant industry” argument. As said before, tariffs can be used to protect a domestic industry against foreign competition. When countries start to develop, it is common knowledge that they should protect domestic industries until they become profitable: at the beginning of its development, China imposed heavy restrictions and tariffs, with absolutely no subtlety. Some western products were simply banned with no further explanation. When it joined the WTO in 2001, it had to change its policy and adapt to the standards of the organisation, but restrictions are objectively still very heavy. The Custom General Administration (CGA) assesses and collects tariffs, which are divided in two categories: the general tariff, and a minimum one for “most-favoured” nations such as the US, who have a commercial agreement with China. On top of paying tariffs, imports are also subject to a VAT of 17% or a business tax.

Quotas also still limit over 40 categories of products such as watches, automobiles, or and in 1996, China introduces tariff rate quotas (TRQ) on imports of wheat, corn, rice, soybeans, and vegetable oils and out-of-quota rates can still be as high 121% of the market value of the product. Certain commodities still have an automatic registration process, the inspection standards (especially for commodities) are very high while the legal framework is much more general than in most OECD countries, which allows the Chinese government to use it in a very flexible way. This may result in inconsistency and companies have real trouble understanding whether they are breaking rules. Certain sectors such as textiles also have to pay extra import taxes. Services remain even more regulated, since it is a sector that China wants to develop and protect from foreign competition. As a matter of fact, foreign services providers are largely restricted to operations under the terms of selective “experimental” licenses, and have to face strict restrictions on entry and on the geographical scope of the activity. This severely limits the profitability and growth of such activities.

GDP by sector

As we can observe from this graph, this strategy of the “infant industry” was very efficient for China and allowed it to experience the fastest sustained expansion by a major economy in history. But as research as shown, protectionism can only be a temporary policy; in order to have a sustainable growth, a country has to open up and reduce barriers to free trade as much as possible. And de facto that is exactly what China is trying to do. At the end of January 2017, China’s State Council announced it would further open some sectors such as mining or services to foreign investments. Besides, China is expected to import $8trillion worth of goods and services within the next five years, and Chinese outbound investment should reach $750 billion over the same period.

Ultimately, free trade seems to be the path that all nations should follow to maintain sustainable and strong growth as China demonstrates. Even though physical obstacles to free trade still exist under the form of restrictions, quotas, etc. China is willing to reduce them and to open its doors to foreign companies and investments. As President Xi Jinping said in Davos: “China will keep its doors wide open. We hope that other countries will also keep their doors open to Chinese investors and maintain a level playing field for us.”. This last sentence was a direct attack to President Donald Trump, who some days earlier declared a trade war against China which he accuses of toying with its currency.

The election of Donald Trump, whose campaign slogan was “Make America great again”, and who intends to fulfil this by instating a much more protectionist policy, as well as Brexit are two symptoms of a greater illness. In fact, if free trade has not won over the entire world yet, it is mainly because people are afraid of foreign competition. They have the feeling foreigners will try to take their place and replace them, leaving them with no jobs and no opportunities. Especially in countries such as the UK or the US, where income inequalities are important and have increased since the financial crisis of 2008[4], people tend to show more protectionist tendencies. Populists such as Donald Trump or even Marine Le Pen in France have understood this phenomenon and use it in their campaigns to win over voters. But as Xi Jinping said during the World Economic Forum in Davos this year, “many of the problems troubling the world are not caused by economic globalisation. During the same event, his compatriot Jack Ma, founder of Alibaba and richest man in Asia agreed, saying that globalisation is good. But he also said globalisation should be improved, it should become inclusive in order to guarantee that everyone can benefit from it.  Especially in a context of slowing growth, the voices against globalisation are easier to hear, because the benefits are harder to distribute, but we should not forget that globalisation has powered global growth, and facilitated advances in sciences, technology and civilisation. Xi Jinping concluded this way, and so will we: “Pursuing protectionism is just like locking oneself in a dark room; while wind and rain may be kept outside so are light and air. No one will emerge as a winner in a trade war.”

Author: Elsa Leger

[1] Oil prices have gone up since the officialization of Brexit on 27th of March, growing from around £48 a barrel to £53 on 10th of April.

[2] Fitch Ratings still grades the UK AA but decided to put a negative outlook after the 27th of March.

[3] It is probably no coincidence that this new policy was decided when China’s growth started to slow down due to a decrease in domestic demand.

[4] According to the Gini Index, which ranks countries in accordance with the level of inequalities, The UK and US have a coefficient of 0.34 and 0.37 respectively. The European average is about 0.3, and Turkey has a coefficient of 0.40.

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