Can customs union members negotiate bilateral free trade agreements? Yes, with caution.
The trade bloc known as Mercosur has just reached its 30th anniversary, but its members (Argentina, Brazil, Paraguay, and Uruguay) are not in a celebratory mode. Long-standing divergent views on the bloc’s external trade policy have recently escalated, risking a split between three members that favor entering into free trade agreements (FTA) with third countries and Argentina, which opposes such a move.
How and whether Mercosur resolves this dispute is a topic of interest for no small number of countries. Mercosur is a type of trade bloc known as a customs union, in which member countries trade freely among themselves and impose a common external tariff (CET) on imports from nonmember countries. There are 17 customs unions involving developing countries in Africa, Central Asia, Latin America, and the Middle East. But individual member countries in these unions have negotiated some 40 bilateral FTAs, without the backing of their respective group members. One recent example is Kenya’s trade deal with the United Kingdom, which entered into force earlier in 2021 amid tensions with its customs union partners in the East African Community. Mercosur members may be headed in that direction if they cannot agree on a common approach.
General speaking, customs unions limit the ability of individual members to pursue FTAs with extraregional partners, unless all members agree to be part of the arrangement. Infighting is not uncommon in such situations. But except for the European Union, these groups are imperfect customs unions, at best. In the case of Mercosur, for example, 3,200 tariff lines, accounting for 32 percent of its tariff schedule, are exempted from the CET—that is, members impose different tariffs on imports from third countries. Moreover, goods do not circulate freely in the union, as they do in the European Union, but are subject to compliance with intraregional rules of origin.
The incentive for negotiating separate trade accords is considerable. FTAs can embody deep commercial disciplines, offering the opportunity to integrate into global value chains and increasing investment. Few developing countries can afford to pass up that promise, even if it means upsetting customs union peers. So, more countries, including members of Mercosur, are tempted to go solo.
But there are also valid concerns and drawbacks to fracturing customs unions with breakaway bilateral trade deals. Such negotiations can disrupt intraregional trade and integration, which can be an important driver of growth for developing countries, particularly given increased protectionist sentiment in advanced economies, and can also help members benefit from regional public goods.
The answer to this dilemma is for country groupings throughout the world to exhibit flexibility in trade negotiations with appropriate guardrails that address concerns by both camps.
Developing rules to facilitate bilateral FTA negotiations by customs union members
Some of the confusion over when and how a customs union member could enter into bilateral FTA negotiations could be clarified by the development of clear-cut rules to facilitate negotiations and address risks to intraregional trade. The goal would be to minimize frictions and potentially even to modernize and deepen the customs union. The objectives would include:
- Fostering transparency and engagement: At the outset and throughout the FTA negotiation, the customs union member seeking a trade agreement with an external country should share information and consult with other customs union members on the objectives, progress, and results of the negotiation. Consultation with peers can build trust and develop a shared understanding of the agreement.
- Reducing the common external tariff: A high CET rate will be increasingly at odds with bilateral FTAs and would increase opportunities for arbitrage within the customs union. Agreement on objectives could reduce CET rates, thereby improving the export competitiveness of the bloc.
- Preserving the ability of customs union members to collect the CET on imports of third parties: A customs union member that is not a party to the bilateral FTA should not suffer unintended consequences such as loss of tariff revenue resulting from goods entering the bloc through lower-tariff members. Duty collection, however, should not result in increased obstacles at the border.
- Sustaining and deepening trade facilitation measures to expedite cross-border transit: Improving intraregional trade is often an important goal of regional integration schemes. In the context of a bilateral FTA by one or more customs union members, border controls that slow or disrupt intraregional trade should be avoided. Priority trade facilitation measures could include a regional transit and guarantee system, usually involving computerized transit systems and electronic data exchange systems; regionally harmonized customs clearance software; regional authorized economic operator programs; and coordinated border management and one-stop border posts.
- Leveraging the bilateral FTA for the benefit of all customs union members: Flexible rules of origin and cumulation provisions that allow use of inputs and intermediaries sourced from other customs union members to manufacture goods that benefit from free trade under the FTA can open new opportunities for firms in these other countries and foster regional value chains.
- Facilitating accession of other customs union members to the FTA: Clear and expeditious rules for customs union members to join a bilateral FTA entered into by one member can lead to more competitive, integrated markets, expanded investment opportunities, and development of regional value chains.
- Building on the bilateral FTA to modernize and deepen the customs union: Deep bilateral FTAs often include disciplines or rules in new areas not covered in developing-country customs unions. While not all of them may be appropriate for the regional setting, others could help upgrade the customs union framework.
Making it hard for a customs union member to bilaterally negotiate FTAs could be destructive, leading to a negotiation failure or a breakup of the customs union. Neither outcome would be healthy. Setting up measures like these could help facilitate more flexible FTA negotiations, minimizing the impact on the customs union.