Impacts of afta on government revenue, external trade and FDI of Lao PDR

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The main objectives of this dissertation are twofold as follows: To review the economic performance of Lao PDR before and after participating AFTA; to estimate the impacts in implementing the Common Effective Preferential Tariff (CEPT) scheme under AFTA on the Lao PDR’s government revenue, external trade (exports and imports), and Foreign Direct Investment (FDI) flows.

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Nội dung Text: Impacts of afta on government revenue, external trade and FDI of Lao PDR

MINISTRY OF EDUCATION AND TRANING MINISTRY OF EDUCATION AND SPORT NATIONAL ECONOMICS UNIVERSITY NATIONAL UNIVERSITY OF LAOS VIETNAM LAOS ATHSAPHANGTHONG SIPHANDONE IMPACTS OF AFTA ON GOVERNMENT REVENUE, EXTERNAL TRADE, AND FDI OF LAO PDR A dissertation Submitted to the National Economics University, Vietnam and National University of Laos in fulfillment of requirements for the degree of Doctor of Philosophy in Economics Supervisor: Prof. Dr. TRAN THO DAT VIENTIANE – 2014
ii ACKNOWLEDGEMENT My sincere appreciation and heartfelt thanks are expressed to my supervisor, Professor Tran ThoDat, for his regular provision of invaluable pieces of advice, guidance, correction, and encouragement to me throughout this research. This dissertation could not have been successfully accomplished without his contributions and supports. Also, I would like to dedicate this success to my beloved parents and especially to my everlasting dearest wife, my lovely children, who all the time stay beside me with their love and caring. I would not be able to achieve this success without their continuous supports and great deal of encouragements.
iii TABLE OF CONTENTS ACKNOWLEDGEMENT ....................................................................................... ii TABLE OF CONTENTS ........................................................................................ iii LIST OF TABLES ....................................................................................................v LIST OF FIGURES ................................................................................................ vi ABBREVIATIONS AND ACRONYMS ............................................................... vi CHAPTER 1: INTRODUCTION ............................................................................1 1.1 Background ....................................................................................................1 1.2 Problem Statement ........................................................................................6 1.3 Objective.........................................................................................................8 1.4 Expected Outcomes .......................................................................................8 1.5 Significance of Study .....................................................................................8 1.6 Scope of Study................................................................................................9 1.7 Organization of the Dissertation ..................................................................9 CHAPTER 2: LITERATURE REVIEW ..............................................................11 2.1 Theoretical Literature Review ...................................................................11 2.1.1 Definition and Levels of Economic Integration ............................................11 2.1.2 Advantages and Disadvantages of Regional Economic Integration .............13 2.1.3 ASEAN and AFTA .......................................................................................17 2.1.4 Challenges and Opportunity for Lao PDR after Joining ASEAN ................28 2.2 Empirical Literature Review......................................................................30 CHAPTER 3: ANALYTICAL METHODOLOGY AND DATA COLLECTION ............................................................................................43 3.1 Analytical Methodology ..............................................................................43 3.1.1 Descriptive Approach ....................................................................................43
iv 3.1.2 Econometric Approach ..................................................................................44 3.2 Data Collection ............................................................................................51 CHAPTER 4: IMPACTS OF AFTA ON ECONOMIC PERFORMANCE, GOVERNMENT REVENUE, EXTERNAL TRADE AND FDI ........................53 4.1 Lao PDR Economic Performance During 1990-2012 ..............................53 4.1.1 Growth Rate ..................................................................................................53 4.1.2 Output Structure ............................................................................................58 4.1.3 GDP per Capita .............................................................................................61 4.2 Impacts on Government Revenue ..............................................................63 4.2.1. Total Revenue ...............................................................................................63 4.2.2. Tax and Non-Tax Revenue ...........................................................................66 4.3 Impacts on External Trade.........................................................................71 4.3.1. Exports, Imports and Trade Balance, 1990-2012..........................................71 4.3.2. Direction of Exports and Imports ..................................................................77 4.3.3. Degree of Trade Openness ............................................................................80 4.4 Impacts on Foreign Direct Investment ......................................................85 4.5 Empirical Evidence of Impacts of AFTA on Government Revenue, External Trade, and Foreign Direct Investment ......................................91 CHAPTER 5: CONCLUSION AND RECOMMENDATION .........................103 5.1 Conclusion ..................................................................................................103 5.2 Recommendation .......................................................................................106 REFERENCES ......................................................................................................108 APPENDIX ...........................................................................................................115
v LIST OF TABLES Table 2.1: Schedule for Tariff Reduction under CEPT Agreements .......................... 21 Table 2.2: Timetable for Accelerating AFTA for the Regional Six ASEAN Countries. ............................................................................................26 Table 3.1: Framework on Analyzing the Impacts of AFTA on Economic Performance, Government Revenue, Trade, FDI. ..............................43 Table 3.2: Summary of Expected Signs of Independent Variables .....................50 Table 3.3: Data Sources Used in Analysis ...........................................................51 Table 4.1: Directions of Exports, 1900-2012 ......................................................77 Table 4.2: Merchandise Exports of Lao PDR (% of Total Merchandise Exports) ...............................................................................................78 Table 4.3: Directions of Imports, 1990-2012 ......................................................79 Table 4.4: Merchandise Imports ..........................................................................80 Table 4.5: The World‘s most Opened and most Closed Economies in 1996 ......82 Table 4.6: Degree of Openness of ASEAN Member Countries, 1995-2012 .......83 Table 4.7: Intra-ASEAN Trade 2009 & 2010 ......................................................85 Table 4.8: FDI Net Flows to ASEAN ..................................................................87 Table 4.9: Percent Share of FDI in ASEAN ........................................................87 Table 4.10: FDI as Percent of GDP........................................................................88 Table 4.11: FDI by Countries, 2001-2010 .............................................................89 Table 4.12: Results of Regressions by Using Lao Data .........................................91 Table 4.13: Results of Regressions by Using the Weighted-Average Data (WAD) .................................................................................................95 Table 4.14: Comparing the regression results by using the Lao data and WAD ...99 Table 4.15: Regression Results by Excluding INFR in the EXP, IMP, and FDI Equations and EXR in the GOVR Equation. ....................................101 Table 4.16: Regression Results by Excluding INF and EXR in All Equations. ..101
vi LIST OF FIGURES Fig. 2.1: Levels of Economic Integration ......................................................... 12 Fig. 2.2: Tendency of ASEAN Members‘ Tariff Rates, 1993-2009 ................ 27 Fig. 2.3: Tariff Rates of ASEAN-6 and ASEAN-4, 1993-2009 ....................... 28 Fig. 4.1: Economic Performance of Lao PDR, 1990-2012. .............................. 55 Fig. 4.2: Resource Sector Contribution to GDP Growth, 2004-2012 .............. 57 Fig. 4.3: Structure of Output as Percent of GDP, 1990-2012. .......................... 59 Fig. 4.4: Growth Rates of Economic Sectors, 1990-2012. ............................... 60 Fig. 4.5: GDP per Capita of Lao PDR, 1990-2012 ......................................... 61 Fig. 4.6: GDP per Capita of ASEAN Members In 2012 .................................. 62 Fig. 4.7: Total Revenue of GOL, 1990-2012 ................................................... 63 Fig. 4.8: Annual Percent Change of Total Revenue and Grant, 1990-2012 ..... 65 Fig. 4.9: Tax and Non-Tax Revenue, 1990-2012. ............................................ 66 Fig. 4.10: Tax and Non-Tax Revenue and Grants as Percent Share of Total Revenue, 1996-2010. .......................................................................... 67 Fig. 4.11: Components of Tax Revenue, 1995/60-2009/10 ................................ 68 Fig. 4.12: Growth Rate of Import and Export Duties, 1996/97-2009/10. .......... 69 Fig. 4.13: Total Revenue, Tax Revenue, Total Expenditure, and Budget Balance as Percent of GDP, 1990-2012 ............................................. 70 Fig. 4.14: Tax Revenue and Tariff Rate, 1998-2012. ......................................... 71 Fig. 4.15: Exports, Imports, and Trade Balance, 1990-2012 ............................ 73 Fig. 4.16: Annual Change of Exports, Imports, and Trade Balance, 1990-2012 .... 74 Fig. 4.17: Exports and Imports as Percent Of GDP, 1990-2012. ....................... 75 Fig. 4.18: Lao Exports and ASEAN Averaged-Tariff rate, 1996-2013 .............. 76 Fig. 4.19: Lao Imports and Averaged-Tariff rate, 1998-2013 ............................ 76 Fig. 4.20: Exports Shared by Countries, 1990-2012........................................... 78 Fig. 4.21: Imports Shared by Counties, 1990-2012 ............................................ 80 Fig. 4.22: Degree of Trade Openness, 1990-2011 .............................................. 81 Fig. 4.23: Trends of Openness Degree of ASEAN Members, 1995-2012 ........ 84 Fig. 4.24: Foreign Direct Investment in Lao PDR, 1990-2012 ........................ 86 Fig. 4.25: FDI Project Numbers by Sectors, 2002-2010 .................................... 90 Fig. 4.26: Values of FDI by Sectors, 2002-2010 ............................................... 90
vii ABBREVIATIONS AND ACRONYMS ADB Asian Development Bank AEC ASEAN Economic Community AFC Asian Financial Crisis AFTA ASEAN Free Trade Area ASEAN Association of Southeast Asian Nations ASEAN-4 Cambodia, Lao PDR, Myanmar, and Vietnam ASEAN-6 Brunei, Indonesia, Malaysia, Philippines, Thailand, BOL and Singapore CEPT Bank of Lao PDR EXP Common Effective Preferential Tariff EXR Exports FDI Exchange Rate FTA Foreign Direct Investment FY Free Trade Agreement GDP Fiscal Year GDPF Gross Domestic Product GOL Foreign Income GOVR Government of Lao PDR GSP Government Revenue IMF Generalized Systems of Preferential IMP International Monetary Fund
viii INFR Imports Lao PDR Inflation Rate LIB Lao People‘s Democratic Republic MPI Liberalization NSEDP Ministry of Planning and Investment NTRs National Socio-Economic Development Plan ODA Normal Trade Relations RTAs Official Development Assistance TAXA Regional Trade Agreements TAXL Tariff Rate of ASEAN Member Countries VAT Value Added Taxes WAD Tariff Rate of Lao PDR WB Weighted-Averaged Data World Bank
1 CHAPTER 1 INTRODUCTION 1.1 Background Regional integration has become the main form of trade liberalization since the early 1990s. After the conclusion of the Uruguay Round in 1994, no significant progress has been made at multilateral liberalization. By contrast, a new regional trade agreement (RTAs) is announced almost every month. According to the World Trade Organization, more than 300 regional trade agreements (RTAs) are currently in force and all but one (Mongolia) of its 153 members participate in at least one of those arrangements. Given the rising prominence of bilateral and regional trade liberalization, it is important to understand the implications for world trade. This is even more important because, unlike multilateral liberalization, which most economists believe to be largely beneficial for both liberalizing countries and by standers, preferential liberalization is controversial. The reason comes from its inherent discriminatory nature: when forming an RTA, members agree to lower trade barriers to each other but their tariffs on imports from outsiders remain unconstrained. This can induce members to substitute inefficiently produced imports from bloc members for imports previously sourced efficiently from nonmember countries. Such trade diversion harms the nonmembers through lost markets, as well as the members through reduced tariff revenue. However, like broader trade liberalization, the RTA is also likely to enhance trade of the goods that are efficiently sourced within the bloc. This trade creation will enhance welfare. These two forces suggest that preferential liberalization can in principle be either welfare-enhancing or welfare-reducing. Ultimately, the result must be empirical, and may be different for different trading blocs. Trade creation forces may prevail over trade diverting ones in some cases, but the reverse could be true in other cases.
2 Progress of the integration has been very impressive in recent decades for a number of developing countries in Asia and, to a lesser extent, in Latin America. These countries have become successful because they chose to participate in regional and global trade, helping them to attract the bulk of foreign direct investment in developing countries. This is true of China and India since they embraced trade liberalization and other market-oriented reforms, and also of higher- income countries in Asia—like Korea and Singapore—that were themselves poor up to the 1970s (IMF, 2001). It has been realized since Viner (1950) that the formation of a free trade agreement (FTA) can lead to trade creation and/or trade diversion. The former arises when the FTA promotes trade among the members without disrupting trade with nonmembers, and tends to be efficiency-enhancing. By contrast, trade diversion arises when the FTA promotes trade among members at the expense of trade with bloc outsiders, and tends to be efficiency-reducing. There have been attempts to pin down theoretically the characteristics that make FTAs more trade creating or more trade diverting. Frankel (1997) develops the ―natural trading partners‖ hypothesis, which states broadly that agreements between countries that already trade significantly (in particular geographically close countries and those that share cultural characteristics that reduce transaction costs, such as language) are the ones most likely to be trade creating. Although theoretically this does not need to always hold, as Bhagwati and Panagariya (1999) point out, Frankel (1997) finds evidence consistent with the natural trade partners hypothesis in a number of regression analyses based on the gravity equation with country-level trade flows. Lee and Shin (2006) extend the approach of Frankel (1997) and estimate a gravity model with year dummies and with both random and fixed effects to assess trade creation and trade diversion in 175 countries using data from 1948 to 1999. The key trade creation variable is a dummy that is one if both countries are
3 members of a common RTA; the key trade diversion variable is a dummy that is one if one country belongs to an RTA and the other does not belong to that RTA. Lee and Shin interact these variables with geographical and common language variables to identify whether trade creation and trade diversion are different for ―natural‖ trade patterns. In most specifications, Lee and Shin (2006) confirm that RTAs increase bilateral trade between members. The magnitudes are around 50 percent, but if the countries share a common border this effect increases to up to 200 percent. Similarly, the closer the countries are from each other, the larger is trade creation. On the other hand, RTAs are never found to reduce trade between members and nonmembers significantly. In fact, in most specifications RTAs are estimated to increase trade between members and nonmembers, from 6 to 15 percent. Trade with nonmembers grows more for RTAs with a smaller average distance between their members and when more members of the RTA have common borders or share a common language. Having the trade creation and trade diversion estimates in hand, Lee and Shin then predict the average trade impact of several proposed RTAs in Asia. They find in particular that the trade effects of AFTA are significantly positive. There is a sizeable theoretical literature that explores the optimal external tariff response of countries following the formation of FTAs. In a standard model, with a welfare-maximizing government, optimal external tariffs are likely to fall in a free trade area precisely to limit the welfare costs of trade diversion [Bagwell and Staiger (1999), Freund (2000), Bond et al. (2004)]. The intuition is that the welfare cost of trade diversion induces governments to lower external tariffs to recapture tariff revenue and improve economic efficiency. When political-economy motives are incorporated, the results are ambiguous. For example, Richardson (1993) and Ornelas (2005) find that, upon the formation of a free trade area, lobbying will decline and external tariffs fall, as the
4 import-competing sector contracts and becomes weaker politically. This force will be more important, the greater the share imports stemming from the bloc partners. However, in a different model, Panagariya and Findlay (1996) find that countries in a free trade area will raise protection against outsiders because lobbying in favor of tariffs against the partner will be diverted to lobbying for a greater external tariff. Furthermore, it is not just existing trade blocs that matter. As Bagwell and Staiger (2004) show, the mere potential for a future trade agreement may affect the extent of current tariff reduction that can be negotiated multilaterally. The threat of ―bilateral opportunism‖ reduces the extent of multilateral tariff reduction because current global trade agreements can be later diluted by bilateral preferences. By contrast, the empirical literature on the effect of RTA formation on external tariffs is still in its infancy. Bohara, Gawande and Sanguinetti (2004) examine tariff adjustments in Argentina following the formation of Mercosur, finding some support for the hypothesis that the decline of industries driven by the formation of a trading bloc leads to lower external tariffs. Similarly, Estevadeordal et al. (2008) examine the direct impact of changes in preferential tariffs on changes in MFN tariffs in ten Latin American countries and one hundred industries over 12 years. Using a number of empirical techniques to extract causality, they find that preferences in free trade areas lead to a decline in external tariffs, whereas the effects are negligible in customs unions. In contrast, Limão (2006) finds that the United States was more reluctant to lower tariffs in the Uruguay Round for products where preferences were granted. His results imply that trade preferences lead to less multilateral tariff reduction. Limão and Karacaovali (2008) find similar results for the European Union. Recently, Lendle (2007) has developed the first analysis of the trade policy reactions to regionalism in Asia. Specifically, Lendle evaluates whether products receiving preferential treatment in Indonesia, Malaysia, Philippines and Thailand under the ASEAN Free Trade Agreement underwent greater reduction in MFN tariffs during the late 1990s and early 2000s than goods that did not receive
5 preferential treatment. The approach resembles that of Limão (2006), in that he estimates the change in the MFN tariff from the mid-1990s to the early 2000s (the precise years vary with the country in analysis due to data availability) on a dummy that represents whether the country offered preferential treatment under AFTA. Lendle finds evidence of tariff complementarity for Indonesia, the Philippines and Thailand, where the MFN tariffs of preferential products were reduced by more (between one and five percentage points) than for non-preferential products. In contrast, the results for Malaysia, which has the lowest average MFN among the four countries studied, are somewhat mixed, varying according to the specification. While Lendle‘s study is very instructive about the developments in internal and external liberalization in ASEAN, it does not take into account the variations in the extent and the speed of intra-bloc liberalization, which are significant. The impacts of free trade can be reviewed from different countries‘ case studies. One of the most directly related to the consequences of implementing ASEAN free trade area can be found in the study conducted by Menon (1999). In this paper, it examined the impact that membership of AFTA is likely to have on Lao's trade, government revenue and foreign investment flows. The findings show that (i) trade diversion is likely to be low, and that AFTA will provide the vehicle to negotiate market access issues with Thailand; (ii) the reduction in government revenue from trade taxes is likely to be low, particularly in light of the high share of informal trade and only low levels of trade diversion; and (iii) foreign direct investment (FDI) flows are likely to grow sharply in the future, as the legal, administrative and institutional framework in Lao develops to meet the ASEAN standard. Araya (2002) also analyzed the ways how new ASEAN member countries (CLMV) cope with revenue loss due to AFTA tariff reduction. Another recent studies of the impact of trade blocs have found that trade diversion has been less apparent than was previously assumed to be the case. A 1995 study by the OECD concluded that there was no evidence that these agreements had created trade diversion. While conceding that it was in some cases
6 difficult to assess diversion, the anecdotal evidence suggested that these agreements had probably served to stimulate trade liberalisation elsewhere, including through multilateral liberalisation. A study by the Department of Foreign Affairs and Trade of the impact of NAFTA concluded that there was no evidence that the trade agreement has had diversionary effects. According to Krueger (1999), the NAFTA experience lends weight to the conclusion that Free Trade Agreements between countries with low trade barriers. There are also a number of arguments on free trade. It can bring about several advantages and disadvantages. The benefits can be indicated in trade creation, increased exports, economies of scale, increased competition, make use of surplus raw materials, increased production, production efficiencies, benefits to consumers, foreign exchange gain, employment opportunities, and economic growth. Although free trade has benefits, there are a number of disadvantages such as changes in structural unemployment in the short term, increased domestic economic instability from international trade cycles, as economies become dependent on global markets, developing or new industries may find it difficult to become established in a competitive environment with no short-term protection policies by governments, free trade can lead to pollution and other environmental problems, free trade may raise government revenue by import taxes, but this will only be a small amount of money. 1.2 Problem Statement The Lao People‘s Democratic Republic (Lao PDR) - a landlocked country with a population of 6.7 million (MPI, 2012) - is classified to be one of the Least Developed Countries (LDCs) by the United Nations (UN) in the region with an estimated GDP per capita at current price of US$ 1,067 in 2011 (IMF, 2011). Lao PDR has, similarly to other LDCs, confronted with many chaotic circumstances in
7 developing its national development programs aimed at maintaining macroeconomic stabilities, achieving Millennium Development Goals in 2015 and graduating from LDC status by 2020 (MPI, 2010). The socio-economic impediments of Laos can be illustrated in two main factors. One of the most difficult constraints is geographic conditions of landlocked country with mountains covered two-thirds of total land areas which restrict both the quantity and quality of agricultural land and pose difficulty to the trade development, social infrastructure, and transportation and communication links. Second, though GDP per capita is low, consumption level is very high in both public and private sectors. The national saving rate is thus low, which is insufficient for infrastructure investment. This is also considered to be a severe limitation in the Lao socio-economic development process. Apart from this, the general present characteristics of Laos can be categorized by Human Development Index: low literacy rate of both adult and children enrollments – only 76 per cent of population age 15+ in 2010, low life expectancy, high fertility, crude birth and death rates – due to a lack of contraception and health care accession, and massive poverty. To solve the above-specified development difficulties and attain the long- term development goals, a sound national socio-economic development plan (NSEDP) needs to be identified and implemented. The government of Lao PDR has continued to set a five-year NSEDP in response to the development process requirement. During implementing the 6th NSEDP (2006-2010), the average annual GDP growth was 7.9 per cent, budget deficit accounted for 4.7 per cent of GDP, FDI accumulation amounted to US$ 8 billion, exports accounted for 20.72 per cent, imports covered 26.1 per cent and trade deficit represented 5.3 per cent of GDP, respectively. With respect to the economic integration with the regional and international counterparts, after having become a member of Association of Southeast Asian Nations (ASEAN) in 1997, Lao PDR has attempted through the implementation of a
8 policy of open foreign economic cooperation, on the basis of independence and mutual benefit. As a result, there has been expansion in cooperation in the fields of economy and commerce. International trade negotiations at the bilateral, regional, sub-regional and global levels have increased and strengthened. International integration includes multi-party trade cooperation, ASEAN and Regional Economic Cooperation, Trade Negotiation within ASEAN and related countries, and Asia- Pacific Trade Agreement (MPI, 2011). 1.3 Objective The main objectives of this dissertation are twofold as follows:  To review the economic performance of Lao PDR before and after participating AFTA;  To estimate the impacts in implementing the Common Effective Preferential Tariff (CEPT) scheme under AFTA on the Lao PDR‘s government revenue, external trade (exports and imports), and Foreign Direct Investment (FDI) flows. 1.4 Expected Outcomes Based on the above-specified objectives, the expected outcomes of this paper are as follows:  Be able to realize the current situation of AFTA‘s CEPT scheme of Lao PDR; and  Be able to measure the changes in the magnitude of the Lao government revenue, expansion of external trade to the regional markets, and growth of FDI after joining ASEAN in 1997. 1.5 Significance of Study The findings of this paper are considered significant for the author since it deepens more understandings on economic development policies, strategies and
9 growth in Lao PDR in the past and shades light on the future development directions. Moreover, the results will provide better knowledge on the repercussions of regional economic integration, particularly with ASEAN on the Lao government revenue, external trade directions, influx of FDI, and smuggling activities. In addition, this paper will be a useful reference for the scholars, researchers, and general interested groups who desire to analyze the similar issues in the different case studies, approaches, and time periods. 1.6 Scope of Study The scope of this study is to focus on the impacts of regional economic integration, namely AFTA on the Lao government revenue, external trade, and FDI. These indicators are selected as dependent variables to indicate the impacts during 1990-2012. These time periods cover several internal, regional, and international economic shocks, namely the implementation of NSEDP, membership of ASEAN and AFTA implementation of Lao PDR, Asian Financial Crisis in 1997, and global economic crisis in 2008. 1.7 Organization of the Dissertation For a scientific approach and systemic and chronological flows, this thesis is divided into five chapters, which will be further subdivided into sections, and they are organized in the following manner. The introductory part briefly presented problem statement, objective, anticipated outcome and significance, scope of study, and thesis organization, respectively as shown in Chapter 1. Chapter 2 will review both theoretical and empirical literature on regional economic integration. In the theoretical section, it firstly defines the levels of economic integration, followed by the pros and cons of such integration. Next, it will briefly review the background and objective of establishing ASEAN and
10 AFTA. After that, it will also describe the implementation of CEPT, especially the CEPT production list and products covered under the CEPT agreement. Finally, it will discuss the positive and negative impacts of AFTA that ASEAN member countries have experienced. In the empirical section, some of the previous researches on AFTA impacts in different countries‘ case studies will be summarized. Additionally, it will discuss the differences between the previous and this study in terms of the analytical methodology, models, and scope of study. Chapter 3 is concerned with the analytical methodology and data sources. In the section of analytical methodology, it will describe the method and model specifications used in analyzing the AFTA impact on Lao PDR‘s government revenue, external trade, and FDI. In the section of data sources, it will describe how data were collected from different sources and data modification in terms of weighted-average data. Chapter 4 will present the analytical results of AFTA impacts on the issues. It will firstly present the overall economic performance, followed by analytical results of AFTA impacts on government revenue, external trade, and FDI by using descriptive approach. Secondly, the results derived from utilizing econometric technique will be revealed. Chapter 5 will come up with the main conclusion of analyses and policy implications.
11 CHAPTER 2 LITERATURE REVIEW 2.1 Theoretical Literature Review 2.1.1 Definition and Levels of Economic Integration Economic integration is a process whereby countries cooperate with one another to reduce or eliminate barriers to the international flow of products, people or capital. The aim of economic integration is to reduce costs for both consumers and producers, as well as to increase trade between the countries taking part in the agreement. The more integrated the economies become, the fewer trade barriers exist and the more economic and political coordination there is between the member countries. There are six additive levels of economic integration: preferential trade agreement, free trade area, custom union, common market, economic union, and political union.  Preferential Trade Agreement (PTA) is the simplest form of economic integration which offers member countries tariff reductions in certain product categories. Discrimination or preferential treatment for some countries is not allowed as it is against the principle of Most Favored Nation (MFN) under the World Trade Organization (WTO).  Free Trade Area (FTA) is the second level of economic integration which tariffs (a tax imposed on imported goods) between member countries are abolished or significantly reduced. Each member country keeps its own tariffs in regard to the third countries. The general goal is to develop economies of scale and comparative advantages, which promotes economic efficiency.  Custom Union (CU) sets common external tariffs among member countries, implying that the same tariffs are applied to third countries. Custom unions are particularly useful to level the competitiveness playing field and address the problem of re-exports (using preferential tariffs in one country to enter another country).
12  Common Market (CM) is an advanced level of economic integration that factors of production, such a labor and capital, are free to move within member countries, expanding economies of scale and comparative advantages. Thus, a worker in a member country is able to move and work in another member country.  Economic Union (EC). In this level, monetary and fiscal policies between member countries are harmonized, which implies a level of political integration. A further step concerns a monetary union where a common currency is used, such as with the European Union (Euro).  Political Union (PU) represents the potentially most advanced form of integration with a common government and were the sovereignty of member country is significantly reduced. Only found within nation states, such as federations where there is a central government and regions having a level of autonomy. Fig. 2.1: Levels of Economic Integration