Can trade deals spur economic reforms?

The number of preferential trading agreements (PTAs) in the world economy has grown rapidly during the past two decades. From 1990 to 2009, more than 500 preferential trading agreements were formed by countries of all stripes, according to the Desta dataset (Dür et al., 2014). However, both the depth and scope of these agreements vary widely. Some agreements are vague, symbolic statements about the importance of trade. Others prescribe deep economic reforms, often only indirectly related to trade liberalisation.

Why do countries form treaties that commit them to difficult, politically contentious reforms? Do these treaties actually promote reforms? Although there is a large body of literature on the causes and consequences PTA formation and implementation (Baier and Bergstrand 2004; Mansfield and Milner 2012), previous studies mostly ignore the non-trade effects of these agreements.

Our book Cutting the Gordian Knot of Economic Reform (Baccini and Urpelainen 2014) shows that the non-trade reform effects are central to understanding the causes and consequences of the recent PTA wave. Developing country leaders use deep, legally binding trade agreements with major economic powers, especially the US and the EU, to enact and implement politically controversial domestic reforms.

Trade agreements and economic reform in developing countries

If a leader prefers economic reform but faces domestic political opposition, she faces a dilemma. Failure to implement economic reforms could have disastrous political and economic consequences, but efforts to implement economic reforms could also backfire.

First, international institutions contain legally binding provisions that enhance the credibility of commitments to economic reform. For example, if the leader of a developing country were to renege on commitments to economic reforms written in a PTA, such as a commitment to enact new legislation to protect intellectual property rights, the leader would be in breach of the PTA. The PTA contains reciprocal commitments and is enforced by the EU or the US. The EU and the US are major powers with the ability to withhold trade concessions of substantial value to exporters in the developing country. They are also willing to negotiate PTAs that contain reform commitments, because these reform commitments allow them to influence economic policies in partner countries. A leader who reneges on a PTA induces retaliation by the EU or the US, and thus pays a high domestic political cost. Given the anticipation of a costly punishment, the leader’s incentive to renege in the first place is diminished. Moreover, this diminished incentive to renege also applies to future leaders, so an EU or US PTA can enhance the credibility of reform beyond the current leader’s own tenure.

Second, international institutions can help the leader create domestic political support for economic reform. In the absence of international institutionalisation, reform is difficult if the constituencies and interest groups who stand to lose from economic reform are more vocal than those who expect gains. An international institution can tilt the balance in favour of the reformers. The rules of the international institution cannot be implemented without economic reform, and if these rules are not implemented, the international institution does not produce benefits for domestic constituencies. Therefore, the leader of a developing country can strategically use the international institution to create benefits for influential constituencies and interest groups. In turn, these constituencies support economic reform to ensure the implementation of the rules of the international institution.

This argument applies well to South Africa during its democratic transition and under the first years of Nelson Mandela leadership. While Mandela was under pressure to boost economic growth, there were sharp divisions among the government coalition on the type of policies to be implemented. For instance, the Growth Employment and Redistribution, which was a crucial economic strategy to re-launch a sluggish economy, faced strong criticisms from the Congress of South Africa Trade Unions and the South Africa Communist Party. The EU-South Africa trade agreement negotiated in the second half of the 1990s eases the implementation of such reform. Indeed, after the formation of a PTA with the EU FDI inflows from European countries to South Africa grew substantively in the early 2000s. Such inflows of FDI were crucial to create new job opportunities, especially among the black majority, and more generally to redistribute resources to black constituencies in the post-apartheid era.

A PTA with a major power is particularly helpful. Although nominally trade agreements, EU and US PTAs contain a range of provisions that prescribe deep economic reforms across the board. These treaties constrain public subsidies to domestic companies, expand the coverage of patent protection, mandate dispute resolution between foreign investors and the state upon a dispute between the two, and pry open the financial sector for European and US banks. Unless a developing country complies with these reform requirements, it cannot reap the benefits of enhanced market access to the EU and the US. Similarly, failure to comply means that the developing country forgoes the benefits of increased foreign direct investment. The combination of market access and legally binding commitments to economic reform allows leaders to simultaneously enhance the credibility of reform and build domestic political support for liberalisation. And since the EU and the US have a clear interest in promoting liberalisation in developing countries, the door to negotiations is usually open, which makes PTA negotiations a flexible strategy for promoting liberalisation at home.

The formation of North-South agreements

To test our theory, we analyse the relationship between leader change, democratisation, and the initiation of PTA negotiations between developing countries and the EU or the US. In the theoretical part of the book, we argue that leader change should be positively associated with the difficulty of reform, while democratisation should, on average, increase a leader’s willingness to pursue various economic reforms. New leaders are politically vulnerable and unable to push through controversial reforms (Baccini and Urpelainen 2014b). Democratisation, on the other hand, creates demand for liberalising reforms that generate economic reform (Milner and Kubota 2005).

Given these expectations, we expect the simultaneous occurrence of leader change and democratisation to cause a large increase in the probability of PTA negotiations. We use data for 140 developing countries and the years 1990-2007. The results provide strong empirical support for our hypotheses. The combination of leader change and democratisation has a substantively large and statistically significant effect on the probability of PTA negotiations. This result is robust to matching on key economic covariates. If we replicate the analysis for PTA negotiations between developing countries without the EU or the US, the result disappears.

The qualitative analysis on four case studies validates strongly our statistical analysis. Take Croatia, for instance. After Tuđman’s death Croatia became a parliamentary democracy, but the process of democratisation was not an easy one due to nationalism, the recent civil conflict, and especially to the economic downturn. The decision of forming a PTA with the EU was strategically taken by the newly elected Croatian government, which could only rely on a highly fractional­ised majority and was under pressure to reform a deeply troubled econ­omy. These reforms were opposed by key interest groups who benefited from the crony privatisation implemented by Tuđman. After a decade of successful economic growth as well as important economic and political changes, Croatia was ready to join the EU on 1 July 2013.

Effects of North-South agreements

We next show that EU and US PTAs have promoted ambitious reforms in intellectual property rights, privatisation, and service liberalisation. Using various statistical methods, such as rolling regressions and difference-in-differences, we investigate PTA-negotiating countries and compare their reform patterns with a matched sample of non-negotiating countries that are comparable along various political and economic dimensions. The evidence is weaker for capital account liberalisation, the one macroeconomic reform under consideration. We also explore the effects of WTO membership and IMF programs, finding that the multilateral trade regime has also promoted intellectual property rights protection, while the effects of the IMF on microeconomic reform are weak. In addition to the aforementioned cases studies on Croatia and South Africa, qualitative analyses on Chile and Colombia confirm our statistical findings. In each of the four countries we found a clear link between the formation of trade agreements with the EU and the US and important records of economic reform.

Concluding remarks

In right circumstances, PTAs can allow leaders to pursue their preferred liberal economic reforms – in particular, microeconomic liberalisation – despite political opposition and the resulting lack of credible commitment to effective implementation over time. When a national leader prefers to reform the economy, be it to redistribute wealth from political opponents to supporters or to create economic growth, her efforts are often stifled by people and interest groups who expect to lose. Even on a good day, economic reforms are difficult. The beneficiaries of previous state intervention attempt to mobilise to prevent economic reforms that would deprive them of their prior privileges. Thus, economic reforms suffer from a dual problem: a lack of credibility and the difficulty of implementation due to domestic political opposition. As we have shown, a PTA with the EU or the US can solve this dual problem.

Our findings show that the recent wave of PTAs has shaped economic governance well beyond trade liberalisation. Developing countries have formed deep agreements with the EU and the US to pursue challenging reforms, and this strategy has been successful. In the future, a similar strategy could help leaders in countries such as Tunisia or Serbia pursue faster economic growth and modernisation. If the EU and the US are interested in supporting the reforms of these countries, leaders in Washington, D.C. and Brussels should leave the door open to new trade agreements.

References

Baccini, L and J Urpelainen (2014), Cutting the Gordian Knot of Economic Reform: When and How International Institutions Help, New York: Oxford University Press.

Baccini, L and J Urpelainen (2014b), “International Institutions and Domestic Politics: Can Preferential Trading Agreements Help Leaders Promote Economic Reform?”, Journal of Politics 76, 195-214

Baier, S L and J H Bergstrand (2004), “Economic Determinants of Trade Agreements”, Journal of International Economics 64, 29-63

Dür A. L Baccini and M Elsig (2014), “The Design of International Trade Agreements: Introducing a New Dataset”, Review of International Organization, 9, 353-375

Mansfield, E D and H V Milner (2012), Votes, Vetoes, and the Political Economy of International Trade Agreements, Princeton: Princeton University Press.

Milner, H. V and K Kubota (2005), “Why the Move to Free Trade? Democracy and Trade Policy in the Developing Countries”, International Organization 59, 107-143

This article is published in collaboration with VoxEU. Publication does not imply endorsement of views by the World Economic Forum.

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Author: Leonardo Baccini (PhD, Trinity College Dublin) is Assistant Professor of International Political Economy at the London School of Economics and Political Science.

Image: A container ship departs Burrard Inlet in Vancouver, British Columbia March 6, 2009. REUTERS/Andy Clark.