Free Trade Agreement - How Does It Work, Types & Benefits
A free trade agreement (FTA) is a treaty between two or more countries that aims at eliminating trade tariffs. These agreements are developed between countries as per international trade laws. They help to create an open yet competitive international marketplace by reducing the barriers to imports and exports between countries.
Read on to know what is a free trade agreement, its type and how it can benefit countries.
How Does an FTA Work?
The basic concept of free trade owes its existence to the idea of comparative costs or comparative advantage. A country engaging in mutual trade must have a comparative advantage in producing a commodity it exports.
For example, country A is in an advantageous position if it decides to obtain a product at a lower cost from country B than producing it at a higher cost and vice versa. A free trade agreement between two of these countries would be devoid of trade barriers like tariffs and quotas.
Now consider a country in its initial days of structuring its economy. A trade agreement will boost its living standards but drain its foreign exchange reserves. On the other hand, getting into a mutual free trade agreement with a country will help to mend the balance of payment accounts, thereby stabilising the economy.
What Are the Types of Trade Agreements?
Trade agreements aim to allow the import and export of commodities with little or no barriers. Many countries enter into mutual trade agreements that omit all barriers and help them maintain cordial relationships. These relationships can often be strategic, political, or simply to revive an economy.
The different forms of trade agreements include:
- Free Trade Agreement: Two countries may agree to enter into a partnership whereby they can freely trade with each other. Often these agreements tend to strengthen the strategic position of the involved parties, although FTA is more comprehensive than other agreements. For example, a free trade agreement in India with Sri Lanka and strategic conglomerates like ASEAN ensures zero trade barriers.
- Preferential Trade Agreement: When two or more partners allow preferential entry of certain products, it is a preferential trade agreement. In such agreements, the partners generally lift any duties on such products. It is crucial to note that all interested parties must agree to preferential access. For example, India maintains a preferential trade agreement with Afghanistan.
- Comprehensive Economic Partnership Agreement: Sometimes, trade agreements can ponder the regulatory aspects of trade and have many inclusions concerning trade negotiations. It also includes trade negotiations on investment, service provisioning, and other areas of potential economic partnership. India maintains CEPA with Japan and South Korea.
- Framework Agreement: True to its name, this form of agreement lays the framework and scope of potential agreements between partner nations. This provides scope for future liberalisation. India follows signed framework agreements with Japan and the ASEAN countries.
What Are the Advantages of Free Trade Agreements?
A free trade agreement sanctions free-flowing trade between two or more partner nations. Some major benefits of adopting such trade agreements include:
- Boost to economic growth: Free trade instruments include scraping off trade barriers like tariffs and quotas. These instruments target some specific commodities on which partner countries may offer tariff reductions of up to 100%. This gesture eases the economy from the final competitive prices of imports. The importing country can also provide tax deductions on these products to ensure demand fulfilment.
- Accessing new markets: Free trade partners engage in transforming the economic scenario of home and partnering countries. Thus, a mutual trade agreement between India and Malaysia, for example, will enable the latter to explore Indian markets. Such an agreement can create new trades and diversify the risks of trading with non-partner nations.
- Diversifying risks: Owing to tumultuous political situations, trade with many Gulf nations and Iran stopped abruptly. Thus, countries partnering with these countries faced the wrath of adverse political situations and lack of supply. Free trade agreements break the barrier and allow partnering countries to diversify their risks of trading with potentially unstable countries. FTA can essentially allow them to trade with different commodity baskets or swap partners.
- Competition and transfer of technological innovation: FTA allows countries to take advantage of market integration, thereby enhancing competition and stabilising the price structure. Additionally, competition leads to the transfer of technology and facilitates the transfer of skills.
What Are the Disadvantages of Free Trade Agreements?
Despite the new avenues created by free trade agreements between two or more countries, experts believe that FTAs can potentially block trade channels and present unhealthy working conditions. Some common disadvantages of free trade areas are as below:
- Threats to intellectual property: Many exporting nations complain of partnering countries deliberately copying their imports. Many domestic producers are accused of threatening the intellectual rights of imports. With an absence of legal repercussions, exporters have no say in the protection of their intellectual rights. This eventually leads to market failure and can negate an FTA right away.
- Rise in unemployment: Initially, countries partner with other nations to improve their living standards and boost their economic activity. However, the absence of trade barriers reduces employment in inefficient industries and makes the host country completely dependent on the exporting nation. Statistics imply a 20% drop in unemployment worldwide owing to FTAs.
- Currency manipulation: Countries with evil intent can aim to devalue their own currency to make it easier to intrude on other economies with FTA as a disguise. The 2019 fall of the US stock market owes its incidence to China's ingenious approach to devaluing Yen. Conversely, it implied that American consumers had to pay more for Chinese commodities.
How to Create Effective Trade Agreements?
Before structuring an ideal trade agreement, you must understand why countries enter into agreements. The global economy's interdependence makes it necessary for countries to engage in mutual trading. Trading helps nations reach an overall equilibrium whereby their balance of payment accounts adjusts itself.
An ideal trade agreement must follow certain rules. They are as below:
- Political or Strategic Support: Countries engage in mutual trade and aim to support their economies for various reasons. Despite the fact that the actual trade volume might not be large, countries simply engage in bilateral agreements to strengthen their political connections. Thus, it is imperative to maintain cordial relations through mutual trading.
- Trading Terms: Sometimes, countries design a trade agreement that prevents importing tropical or exclusive products. They instead concentrate on trading with regular household items to help partner countries improve their living standards.
- Conditional Trading: An effective trade agreement normally involves removing all trade barriers. Although this sounds over-ambitious, all trade agreements basically begin with such agreements. In reality, however, countries always aim to prevent the import of commodities that will destroy their local producers. Removing protection can lead to competition and the eventual weakening of such sectors.
- Beyond Commodity Trading: An ideal trade agreement must not concentrate solely on commodities but also on forming a framework for future trading. Countries may also pledge to allow trading in investment or services. This may extend to providing citizenship and a smoother labour movement.
What Is the Role of the World Trade Organisation (WTO) in Trade Agreements?
WTO's roles in forming free trade agreements are as below:
- WTO promises equal trading rights for all its members. Fair treatment is inclusive of providing equal tariff cuts for all partnering countries.
- WTO indulges in reciprocity and predictability in case of forming trade barriers. Reciprocity involves lowering taxes and trade barriers for all member nations. Predictability involves providing a stable business climate through enforceable regulations.
- WTO makes sure that free trade agreements are fair and transparent. It aims to remove unnecessary trade barriers and thereby lowers production costs.