Free Trade: New Challenges Ahead

Free Trade: New Challenges Ahead

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.


Credibility of Central Banks – A comprehensive analysis of ECB and FED effectiveness

Credibility of Central Banks – A comprehensive analysis of ECB and FED effectiveness

On the 1st of January 1999, the ECB assumed responsibility for monetary policy in the euro area, with the primary objective of maintaining price stability, keeping the euro area’s target inflation rate (calculated using the Harmonized Index of Consumer Price, HICP) below, but close to 2% over the medium term. This objective has even been reinforced with the ratification of the Lisbon Treaty in 2007. Seventeen years later in 2008 the global financial crisis erupted causing the greatest economic recession since 1928. Since then the ECB has been put under additional pressure to advise on regulation and enforce banking supervision while fostering economic growth. Extremely unconventional monetary measures have been taken to achieve this objective and a recover of the economy and productivity.

On the 12th of November 2008, the first measure was implemented by cutting the interest rates for deposits, overnight loans and the Main Refinancing Operations. The two main objectives of this move were to provide greater liquidity to commercial banks and depreciating the currency against the US dollar, allowing a greater competitiveness.

Despite the large amount of capital lent through MROs and LTROs, banks preferred to buy bonds instead of lending to families and enterprises, not fulfilling their function as middleman between the ECB and the real economy.

On the 26th of July 2012, Mario Draghi famously announced that the ECB was willing to do “whatever it takes”. Consequently, launching new measures to support the countries, which were facing economic and financial difficulties. In September of that year the Outright Monetary Transactions (OMT) were introduced.

The OMTs key points were: Unlimited ex-ante bonds purchase quantity; one-year and three-year maturity bonds purchase; transactions performed in the secondary market sterilizing the exceeding liquidity. While this programme was initially controversial, as it questionably occurred outside of the ECB’s legal framework, it did achieve its expected outcomes, as bond yields in the weaker countries declined. On the 5th of June 2014, the ECB announced the first series of TLTROs (Targeted Long Term Refinancing Operations) which linked the amount borrowed and lent (expected mortgages) to private sector, aiming to incentivize banks to increase their lending.

Although the ECB had implemented all these unconventional measures, no significant positive effect had been seen.  The PMI index evolution show a soft recovery ignited by Draghi’s first moves.


That is why on 22nd January 2015 Mario Draghi introduced an extended Quantitative Easing program, the Asset Purchase Program (APP), which allows the purchase of Eurozone government bonds. This programme allowed for € 1,140 billion in bonds to be purchased and lasted 19 months (supposedly, from March 2015 to September 2016), injecting even greater liquidity into the market. The bond purchases provided greater monetary stimulus to the economy while the key ECB interest rates were kept at their lower bound. Furthermore, an easing of monetary and financial conditions occurred, making access to finance cheaper for firms and households. This tends to support investment and consumption, and ultimately aims at helping the economy reach its targeted inflation rate. This move was unexpected from market who rejoiced vigorously, pushing European stock indexes up to multiyear highs. DAX index, the one who benefited the most from the ECB’s new plan topped 12000 points.

After one year of the extended QE program some doubts arose about the effectiveness of the ECB’s monetary policy, raising the credibility of monetary policy issue and igniting criticism from some member states, such as Germany, mainly for the negative impact on people’s savings.

In response, the ECB surprised the markets in March 2016, by cutting key interest rates, expanding the asset purchase program to 80 billion monthly and deferring the end to March 2017. In addition, the percentage of bonds that can be purchased has changed from 33% to 50% and the purchase program includes also some high-rated companies’ shares other than covered bonds and asset-backed securities. Four new TLTROs (TLTRO II) are being issued every three months, starting from June 2016 with an interest rate, which is linked to the participating banks’ lending patterns. The more loans that participating banks issue to non-financial corporations and households (except loans to households for house purchases), the more attractive the interest rates on TLTRO II borrowings becomes.


In a recent statement at the ECON committee of the European Parliament on the 28th of November, Mario Draghi remarked that: “To increase the effectiveness of monetary policy, fiscal and structural policies are needed that reinforce growth and make it more inclusive”, while in his speech ten days before, stated that “Since the onset of the global financial crisis, 2016 has been the first full year where GDP in the euro area has been above its pre-crisis level. The economy is now recovering at a moderate, but steady, pace, while the employment is growing. We remain committed to preserving the very substantial degree of monetary accommodation, which is necessary to secure a sustained rise in inflation.” Despite Draghi’s reassurances, as well as the unconventional and largely expansive measures carried out by the ECB, one can observe that inflation levels are rising, but still at a too slow pace, currently at 0,5%. The same can be said for GDP growth.


The main question to ask is where is large amount of capital that is being injected into the economy flowing, and why is it not boosting growth?

Low interest rates – the rate on the deposit facility is -0.4% while the interest rate on the main refinancing operations is at zero level – should decrease the cost of financing of the banks and lower the attractiveness of government bonds inducing them to lend to enterprises and consumers. Unfortunately, many factors have contributed obstructing the transmission of money to the real economy and restrained the banks from granting loans. First, the banks are not inclined to lend money for three main reasons: the poorer margins on loans, squeezed by the rates at their lowest level; the necessity to keep risks under control which conflicts with the credit standards’ tightening, particularly on corporations, that can even be worsened by the forthcoming introduction of Basil IV, still under discussion, which is considering to impose the use of standardized credit scoring approaches, instead of the more flexible Internal Standards-Based Approach introduced by Basil II, change which will require higher provisions for risks; at last the harsher capital requirements set by Basil III in 2013, which induce banks to immobilize funds that could be alternatively lent.

It seems that the situation is getting better and banks are finally increasing the amount of loans granted. It is noticeable that the increase is faster since 2015, year of introduction of the Quantitative Easing program. The manufacturing PMI Index for euro area, which measures the performance of the manufacturing sector, is climbing up to the 2011 peaks. Therefore, the introduction of stricter credit rating approaches is highly questionable and more flexibility should be given to lenders.


It is also true that the low interest rate policy and the Asset Purchase Program have contributed to the increase in prices of assets and so the reduction of yields, inducing banks to take greater risks in return for higher returns. Indeed, fixed income prices are at their highest while the German 10Y bond yield is only 0,2%, having been even negative last June for a couple of months. 

Another reason behind the lack of effectiveness of the quantitative easing is that it could not have the impact desired, as interest rates at the inception of the program were already very low. The 3-months Euribor rate was hardly higher than zero.

The conclusion is that monetary policy does little to support growth, when not combined with adequate fiscal and regulatory policies. The IS-LM diagram, or Hicks–Hansen model, can help one better understand the current situation. Last but not least, the world today is in what can be deemed as a “liquidity trap”. A situation in which the central banks cannot reduce the interest rates even further, as doing so has no effect on inflation. Policymakers are pushing negative interest rate policies to stimulate growth. Lower rates are designed to spur savers to spend, redirect capital into higher-return (i.e. riskier) investments, and drive down borrowing costs. This is associated with a weaker currency, making exports more competitive. When a “liquidity trap” occurs and rates go negative, a squeeze on the speed at which money circulates through the economy, commonly referred to as the velocity of money, incurs. Therefore, each Euro generates less and less economic activity, increasing deflationary pressure. As consumers see prices decline, they defer purchases, and growth slows. Deflation also lifts real interest rates, which drives currency values higher. If the ECB persists in this policy, pumping more and more liquidity into the economy, then more negative rates could be on the way.


The austerity measures pursued by the European Union since the beginning of the European sovereign debt crisis at the end of 2009, have constrained the member states to lower their debts and the public spending, exacerbating the fiscal policy and worsening the economic downturn. By the way, it seems that, under the more insistent demand by many member states for more flexibility, EU is overshadowing the pursuit of lower deficits, to focus on the boost of economic growth.

On the 8th of December 2016, Draghi announced that the ECB would scale back the monthly bond purchases from € 80 billion to € 60 billion in March 2017, postponing the end until December 2017, reassessing the support of ECB to markets. Moreover, the ECB would consider (but not necessarily pursue) purchases of bonds with yields below the standing facilities deposit rate (i.e. -0,40%), thereby incurring losses for the central bank, if such purchases were to be made. This announcement provided a largely positive reaction on the European equity markets, while European bond market yields fell even lower and the Euro/Dollar had its largest drop since Brexit, depreciating by 1.5%. Following the announcement of the ECB’s future QE plans, reporters repeatedly questioned whether and when tapering would occur and Draghi insisted that members of the governing council unanimously did not consider such measures.

Europe, to help the ECB to fulfill its task, is considering several non-monetary measures. The Capital Markets Union (CMU), strongly supported by ECB, is expected to come into effect in 2018. Commercial banks are currently hesitating to issue new credit, particularly to SME’s – which account for 99% of all enterprises in EU – due to the size of their large balance sheets. The CMU would enable commercial banks to shift risks away from balance sheets by allowing investors (such as pension funds) to invest in securitized loans. However, it must be stringently regulated, to ensure that the quality of the debt being securitized and sold, meets certain standards. A lesson tragically learned by the recent financial crisis.

The harmonization of fiscal policies among EU member states seems still far away and hard to achieve. At last Europe is changing attitude in direction of a greater allowance for deficit spending and public debt, under the requests received by many member states, which questioned the austerity policy.

Unconventional and expansionary monetary policies have been implemented by the ECB in the past years in response to one of the greatest recession in history. The traditional policies are no longer effective and the Central Bank is now experimenting new solutions, which are contributing to the recovery, even if the results are not as good as expected and Europe has not recovered the pre-crisis economic level yet.

European bodies and the ECB are struggling to boost the economy and to increase the cohesion within the European boundaries through a process of continuous change.

However, many are the threats to the future of Europe. The forthcoming elections in France, Germany and perhaps Italy, on the wave of anti-European and nationalist movements, are likely to increase the uncertainties about the solidity and cohesion of the Union, even more after the stunning result of Brexit referendum. Cohesion that is already under pressure and exasperated because of the different interests and views of the member states about serious issues currently under discussion such as the actions to adopt in response of the massive migration wave that is hitting EU borders (and that can even worsen given the current tragic situation in Syria) or the necessity of austerity policies.

Second, the possibility that the extremely expansionary measures can lead to excesses and to a financial bubble likely to explode once there would be a tightening of the policy (house prices in healthier countries are rising sharply).

Furthermore, the effects of the enhanced divergence between the monetary policies pursued by the ECB and the Fed are still unknown and unforeseeable. The Fed has not surprised investors with the last adjustment on December, even if the signal sent by Janet Yellen was little more hawkish than market is used to. The immediate effect has been a strengthening of the dollar against other currencies and a sell-off European bonds, which showed a rise in yields. The Fed funds futures show that traders are now betting on a faster tightening by US Central Bank. Indeed, the Chairman has announced that there will be at least three more adjustments in 2017. It seems that the era of ultra-low yields is nearing its end in USA, where the economy is recovering strongly and even better are performing the financial markets (Wall Street has reached its historical peaks).

The effects for Europe are difficult to predict, but for sure, the quicker the dollar strengthens, the more destabilizing that is. For instance, a huge amount of emerging countries’ bonds is issued in dollars, thus it would be harder to repay it Moreover many commodities are priced in dollars so they would become much more expensive contributing to a slowdown of global economic activity that depends on the consumption of such resources, on the oil price, which is now recovering after having hit its lowest level at the beginning of 2016.


The ECB is dealing with a testing challenge: achieve a recovery of the European economy and productivity within a global environment characterized by slow economic activity and great uncertainties, while experimenting policies never pursued and whose results are difficult to predict. The difficulties and the threats that can obstacle the fulfilment of the mission are many, so are the opportunities that can be taken. There are too many uncertain factors that make useless and speculative every effort to make predictions. Draghi, which will be in charge until 2019, seems to have clear ideas about how to deal with the task and has already achieved very good results, despite the critics.

Would the ECB and EU bodies be able to face the forthcoming hard times, keeping the EU unity and cohesiveness and achieving finally the economic recovery? Stay tuned.


Conor Marriman, Niccolò Ricci and Alessandro Sicilia

Europe: A Turbulent Snatch? – European Citizen

Europe: A Turbulent Snatch? – European Citizen

In recent days, Europe has been a very dramatic battlefield. Talks between Greece and European officials are still going on, with Greek Ministers firmly stuck on their requests and European Officials unhappy and unsatisfied with Greece’s request. Tsipras does not want to change the pension system, contribution-based, still plenty of “baby retired”. Yesterday, Angela Merkel appeared as a Deus Ex Machina willing of peacefully solving the Greek Crisis. The main goal in Europe by now is to avoid the Euro Area break up, who can lead us into periods of unprecedented uncertainty and volatility, and can wreak havoc the entire Europe. Standard and Poor’s downgraded Greece Debt to triple CCC, following the postponement of the repayment to the IMF and the higher risk of default. Jeroen Dijsselbloem, the President of the Eurogroup, warned against the running out of time, and urged Athens and Europe to a peaceful resolution.

Many venerable European banks have been downgraded too because of the uncertainty over Europe’s financial health. Barclays Bank has been downgraded to A-, Deutsche Bank to BBB+ and RBS to A-, Commerzbank to BBB+ and Unicredit to BBB.

The bond market has been under severe attacks. 10-YR German Bund reached high yield of 1% yesterday. From the bottom in May at 0.05%, this means a 2000% increase. Bond traders are adjusting bond prices to looming spikes in inflation in the Eurozone.



Tancredi Viale