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Understanding the WTO and its recent deal at Bali

Monday, 6 January 2014 - 10:00am IST | Agency: dna

This article revisits the role of the WTO following last month's breakthrough in Bali, focusing on posited raisons d'etre, channels of influence and issues at the forefront recently.

In December 2013, the World Trade Organisation (WTO) finally arrived at its first major multilateral agreement since its inception in 1994, replacing the General Agreement on Tariffs and Trade (GATT). There had been considerable pressure on negotiators going to the Bali meet to arrive at an understanding, the very relevance of the WTO at stake. Bali was the latest instalment in the Doha round of talks, which began in 2002 and had consistently met stumbling blocks despite the avowed emphasis on developing nations’ interests.

The proliferation of regional trade agreements (RTAs) was understood to be correlated with the failure to reach a breakthrough in the multilateral meets, yet several of the more prominent disputing nations, including India, were keen to arrive at a WTO accord.

While one should accept the historic nature of the deal, it is important to realise that several knotty issues, like freer trade in services, did not figure in the list of agreements. There has been considerable disagreement about services trade even within the bloc of developing countries, with nations like India that have an extensive and competitive services sector naturally pushing for greater openness in trade.

It has often been argued that a slower pace of progress is inevitable as more amenable areas like tariff liberalisation have already been significantly dealt with in earlier rounds, and fundamentally divisive areas like trade in services and agriculture remain relatively untouched. The recent agreement has been dominated in particular by issues like domestic subsidies and trade facilitation.

India was a highly prominent player in the events that transpired, and was often accused by several other nations of impeding progress, and by other developing nations of being unrepresentative of their own concerns and motivated by domestic political considerations. After details of the deal became available, some authors have challenged the triumphalist message of the Indian team (recently endorsed by the Cabinet) by arguing that India effectively kicked the can down the road at the cost of significant commitments toward streamlining its trading infrastructure.

In what follows, I first consider explanations for why a world trading system must exist at all. I then look at the disputes surrounding the Bali deal, focusing on India’s arguments and its positional motivations. A list of the references used follows thereafter.

Why the WTO?
The great exhalation of relief, euphoria and tears following the deal implied a keen interest in keeping the WTO functional. It behoves us to consider why the WTO exists at all. The Ricardian story of comparative advantage (i.e. differing national productivities would result in gains from trade) and fundamental welfare theorems (competitive equilibria are efficient) are powerful arguments for free trade but say nothing about how nations arrive at that end. In essence, understanding why trade agreements exist requires an understanding of the drawbacks of non-cooperative national policy.

The dominant explanation has been that individual, non-cooperative policies by nations fail to account for externalities imposed on other nations, resulting in inefficiency (‘beggar-thy-neighbour’). In this case, the externality is through terms-of-trade (ToT) effects. Theoretical results are also sensitive to market structure (i.e. perfect competition or otherwise), country size (small countries cannot affect world prices, so the ToT motive is absent for them) and the objectives of policymakers (citizen welfare and/or campaign contributions) etc.

Suppose governments have welfare functions that depend on ToT benefits (i.e. an improvement in terms-of-trade increases welfare). The choice of their policy instrument, i.e. the tariff in this case, affects other countries’ welfare as well. This is through the requirement of trade balance, which in turn would determine world and domestic prices, and hence the ToT. There is an incentive to shift some of the costs of the induced distortion onto foreign nations that in the absence of cooperation would be exploited. By this logic, a trade agreement is valuable if and only if the non-cooperative outcome is inefficient and can be improved upon. Theory shows the non-cooperative outcome is indeed inefficient, and can be improved upon if the involved countries agree to reduce their tariffs. Interestingly, if the terms-of-trade motivation is removed, the efficient outcome obtains.

Imperfect competition brings additional forces into play, like profit shifting and firm-delocation. For example, if firms located in different countries sell identical products (a monopolistic competition setting), domestic policy can result in foreign firms locating in the home country, benefiting domestic consumers at the expense of their foreign counterparts. In other settings, like oligopolistic competition, governments might care about the prices domestic firms face abroad and hence try to manipulate that price in order to improve firm profits. Under both these motivations, a non-cooperative policy will be inefficient. Removing the ToT motivations once again leads to efficiency.

There is some controversy about the actual importance of the ToT channel. It is argued that governments don’t actually incorporate ToT as a legitimate concern when determining policy. However, we can frame the language in terms of the concomitant effect of a reduction in foreign market access, which is more redolent of official jargon. Further, the ToT channel does not depend on a citizen-welfare based objective, so it extends to more realistic objectives, including political concerns.

Empirical results are also broadly supportive of this hypothesis. Countries’ tariff policies do affect their terms-of-trade. Further, they do exploit their market power (and ToT effects) while setting trade policies unilaterally. Finally, some findings suggest the tariff cuts negotiated in multilateral agreements were essentially those influenced by the ToT motive. 

There is another interesting channel of activity, wherein governments might enter into trade agreements to tie their hands and prevent policy manipulation by vested domestic interests. While lobbies exist to influence policy through various pecuniary and non-pecuniary incentives, the expectation that lobbies will influence policy will bring about its own distortions, incentivising the government to commit itself, e.g. through a trade agreement. The provisions of the agreement might also determine the extent of lobbying.

Channels of work and enforcement
How does a trade agreement lead to efficiency? The theoretical literature emphasises two main channels: Reciprocity and the Most Favoured Nation (MFN) provision.

Countries often negotiate seeking a balance of concessions. Further, WTO rules permit members to retaliate by withdrawing equivalent concessions in the event of a signatory reneging on an agreement. Such reciprocity is attractive when the ToT manipulation motive exists as changes in domestic trade policy must maintain the balance of trade, which in turn would imply unchanged ToT but higher trade volumes. Also, the possibility of renegotiation of a deal (or retaliation) would prevent a government from pursuing policies that were individually advantageous (e.g. that would improve its ToT). Empirical studies show tariff cuts by the US and EU reflect a reciprocal pattern of concession granting.

The MFN requirement requires non-discriminatory tariffs, i.e. identical treatment for trading partners. This essentially extends the results described above to a multilateral setting, and along with reciprocity, moves countries closer to the efficiency frontier.

Such an extension raises the question of ‘free-riding’ by indirect beneficiaries.  However, reciprocity and MFN together ensure that though other trade partners benefit from a bilateral negotiation through lower tariffs, their trade volume is unchanged as the negotiating partner’s firms benefit more from liberalisation.

Of course, preferential liberalisation through RTAs is allowed by the WTO, which would dilute this free rider issue (but affect claims of concession erosion) but comes with its own problems like ‘preference erosion’, the idea that RTAs block multilateral liberalisation.

The enforcement of provisions depends considerably on the threat of retaliation and a return to inefficient non-cooperative policy in the event of non-compliance. Smaller countries might find it difficult to invoke a comparable threat, which would explain the formation of blocs of similar nations. Of course, an accusation of non-compliance might itself result from a subjective interpretation of the rules, which has bedevilled the WTO given its often opaque jargon.

The Bali deal
In the run-up to Bali, there was considerable pressure on WTO members to arrive at an agreement. As it turned out, India played a significant role in the proceedings, though not always appearing in a positive light. The crux of the matter was domestic subsidies, provoked by the passage of the National Food Security Act (NFSA) in September. That act sought to establish an Indian citizen’s legal right to basic nutrition for sustenance. Understandably, the implications of such a sweeping act were debated considerably, with the emphasis being on the ability of the nation to pay for so widespread an expansion that was estimated to cost around 1.5% of India’s GDP.

In effect, the coverage of such an act would be extended to nearly two-thirds of the population, putting considerable pressure on producers with possible inflationary consequences and on the spectacularly wasteful Public Distribution System (PDS), meant to help citizens exercise their right, besides, of course, leading to considerable pressure on public finances owing to the extensive price support system in place to protect farmers from the vagaries of world prices as well as to ensure food security through the maintenance of adequate domestic stocks. Cash transfers, as tried out this year in a few pilot schemes employing the new UID facility, have been mooted and should reduce leakages vis-à-vis the proposed channel.

It is this Minimum Support Price (MSP) backed system that was the bone of contention between India and her fellow members. There is considerable support for the view that such a price floor is distortional, even leading to the substitution of production towards supported crops. The wedge between the support and market price has inevitably spawned arbitrageurs. The procurement commitment by the government also led to excessive stockpiling by an overextended Food Corporation of India (FCI), and unfavourable prices and occasional export bans meant export & open market sale channels for surplus stock were often unavailable, leading to rotting and wastage. This diversion away from the market has led to an increase in market prices, often hurting the numerous poor excluded illegitimately from the PDS. The Centre and various state governments also assist agriculture through irrigation, electricity and fertilizer subsidies.

An expansion of the support system as envisaged by the NFSA would inevitably lead to a higher subsidy bill, putting stress on the WTO limit of 10% of the total value of agricultural production for non-product-specific assistance, and 10% of the value of a good production for product-specific assistance. The Aggregate Measurement of Support (AMS) is calculated by multiplying the difference between ‘market’ price and support price by the quantity procured. Higher coverage would thus bring the AMS figure dangerously close to or even exceed the limit.

A ‘peace clause’ was negotiated between the disputants that gave developing countries a temporary reprieve from legal challenges and penalties, but it expired in 2003. India and her allies in a developing country bloc, the G33, sought to extend this deadline indefinitely by appealing to both the extensive support enjoyed by farmers in the US and EU, as well as by arguing that such subsidies were a domestic matter (curtailment of which was tantamount to interference in domestic policymaking) and would not impact trade flows. It should also be noted that the limits were based on prices in the 1986-88 period, which India and her allies argued required updating.

India’s obstinacy led to fissures within the bloc and accusations that her hard stance was based on electoral considerations. Ultimately, India and some of her remaining allies on the matter succeeded in their goal, albeit at the cost of more frequent and comprehensive checks on the magnitude of the subsidy and effective immunity only for existing programs. However, the deal has done little to silence claims that not much progress was made, indeed that the world is moving in the wrong direction.

Agricultural subsidies have been a contentious issue ever since the inception of the world trading system. It is often argued that the ultimate cost is borne by domestic consumers while producers benefit, which is more reasonable for countries like India that are dominated by the agricultural sector. However, they distort comparative advantage and make it difficult for nations to enjoy the gains from trade. In the Doha round, developing countries argued that their richer counterparts obtain an undue advantage particularly felt by poor importing nations (e.g. African countries that import US cotton). Reducing these subsidies would benefit consumers in countries with farmer support, but this is obstructed by the logic of collective action, i.e. the costs of agitating against farm lobbies are too widely dispersed while the benefits of having subsidies are concentrated.

Developing countries like India will have to make some accommodations in turn before they can enjoy the benefits from freer trade. Attempts to improve agricultural productivity or to facilitate the structural transformation that characterizes economic development are more difficult and less eye-catching (from an electoral point of view), but are arguably equally if not more necessary, particularly when one recalls that the Malthusian spectre has been staved off only through improvements in productivity. It is difficult to argue against providing citizens with at least the modicum of nutrition necessary for sustenance, but one could question the proposed implementation, and whether a reliance on domestic production alone would not introduce significant distortions.

Trade facilitation was the other big headline from the Bali meet. The ‘cost’ of India’s intransigence regarding food security, it is suggested, is that she and other underprepared nations will have to smooth out wrinkles (in some cases roadblocks) in the transport of items across their borders, mainly through customs reform. The procedural upgrade will likely be costly and perhaps unaffordable for some developing nations, as it would need more advanced technology and a skilled pool of operators alongside more mundane improvements to cut through red tape. The beneficiaries of such an agreement are likely to be the developed countries that were pushing for the deal.

While India has declined assistance in order to achieve the required capacity, some commentators have suggested poorer nations couple this requirement with the ‘Aid for Trade’ program that would allow them to become productive enough to repay the loans offered. Political parties in India have expressed their displeasure at this development, citing the considerable burden that India would have to face. A more streamlined system is hardly a disadvantage, however, as it could boost the export sector while benefiting domestic consumers (who could gain from the resulting increase in variety and cost reduction).

Agriculture and pharmaceuticals, which have suffered from delays in the past, stand to benefit. Further, the extremely long processing times recorded at most Indian ports have seen neighbouring countries usurp it as transit hubs. It is to be hoped compliance with the deal would increase competitiveness in this area as well. It might also increase the attractiveness of a country for foreign investors. It is worth noting India has been attempting to modernize this aspect of its trade practices for some time now.  The WTO has estimated the benefits from trade facilitation to be between $400 billion to $1 trillion (this figure has been contested by some authors).

The WTO has partially salvaged its reputation after the developments that unfolded in Bali. The road ahead is long and arduous, with extremely divisive topics like trade in services and fundamental reforms in agricultural trade still on the table. The achievement of a deal and the jubilation witnessed thereafter are heartening, suggesting that countries realise the importance of a multilateral forum despite the growth of regionalism.

References for the curious reader
I can scarcely do better than to refer the reader to the reportage and opinion columns of financial newspapers like The Economist, and websites like Vox and Project Syndicate. The section on theoretical approaches to the WTO relied heavily on the review paper, ‘The World Trade Organisation: Theory and Practice’ by Kyle Bagwell and Robert Staiger in the Annual Review of Economics (2), 2010; and ‘International rules and institutions for trade policy’ by Robert Staiger in the Handbook of International Economics (Vol. 3), 1995.

The numerous articles in the Handbook of Agricultural Economics, especially Volume 2, are indispensable for the reader who is interested in agricultural policy, including trade policy.

I have benefited from the writings of Bharat Ramaswami and Ashok Kotwal on the Right to Food Act, particularly their article (co-authored with M. Murugkar), The Political Economy of Food Subsidy in India’, and columns on the Ideas for India blog.

For an account of India’s experience with the WTO, see ‘India at the WTO: From Uruguay Round to Doha and Beyond’ by Kamal Saggi in the Oxford Handbook of the Indian Economy (2010). Some of the articles in the book, ‘WTO Negotiations on Agriculture and Developing Countries’, edited by Anwarul Hoda and Ashok Gulati, Johns Hopkins University Press (2007) are illuminating. Accounts straight from the horse’s mouth can be found in the various helpful papers and eBooks published by the WTO, the World Bank, OECD and the ADB.

Lalit Contractor has a MPhil in Economics from Oxford University and is curious about Economics and its interactions with politics and society.

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