Revisiting the Theory of Regional Integration in Light of the AfCFTA

NTMs is associated with an increase in GDP of at least 5 percent on average across the region by 2027. Even with significant tariff reduction, Africa will not achieve significant gains in growth and welfare without a substantial reduction in NTMs and improved harmonization of customs procedures regionwide.

Revisiting the Theory of Regional Integration in Light of the AfCFTA

The theory of regional integration draws closely from the theories of customs unions and FTAs. There is an inherent theoretical ambiguity in the welfare impacts of regional trade agreements or FTAs (Krugman 1991). The classic theoretical framework (Viner 1950) for analyzing the impact of an FTA or customs union suggests that the welfare impact is ambiguous because of the contrasting welfare impacts of trade creation and trade diversion. Viner (1950) notes that trade creation increases welfare, and trade diversion reduces it—pointing out that an FTA could leave countries worse off as a consequence.

However, this finding has largely focused only on the static gains from trade, without due regard to the dynamic and possibly more important long-term effects (Balassa 1961; Cooper and Massell 1965). The classical analysis of welfare impact relies solely on production effects and ignores the consumption effects associated with consumer surplus resulting from price reductions (Lipsey 1960). It also considers the impact on global welfare and the efficient allocation of resources without duly considering to whom the benefits are accruing and the global distribution of income.

Overall, the modern consensus is that FTAs are considerably better in practice than in theory, particularly when viewed as alternatives to multilateral trade liberalization (Bergsten 1991; Krugman 1991). When considering the welfare impact of an FTA or regional bloc engaged in regional integration schemes, the practical evidence shows that the results are largely positive and significant for the regional blocs forming FTAs.

Trade Creation versus Trade Diversion Effects of FTAs

An FTA, by allowing competition between its members owing to reduced trade barriers, may promote a more efficient (re)allocation of resources within the FTA. This reallocation is associated with what is often referred to as trade creation. That is, the locus of production will shift from a high-cost producer to a low-cost, relatively more efficient producer within the FTA. And this shift brings a welfare gain associated with reduced prices, increased consumer surplus, and an overall improvement in production efficiency within the FTA.

Trade creation is hence associated with two distinct effects—the production effect and the consumption effect, both of which are expected to increase welfare. On the production side, there are greater efficiency gains, which in turn contribute to declining prices (the consumption effect) and hence to increased societal welfare.

However, another possibility is trade diversion—that is, a shift in the locus of production from more-efficient producers among nonmembers of the FTA to inefficient producers within the FTA, depending on the extent of the external tariffs. The impact of trade diversion could be stronger if FTA members raise external tariffs because, although high external tariffs exacerbate trade diversion, low external tariffs will reduce it (Freund and Ornelas 2010). Within the traditional theoretical framework, trade diversion is harmful because of the global efficiency losses. However, the effect within the FTA could be positive if the production gains of the new exporter outweigh the loss in consumer welfare. FTA countries that are now importing from the relatively efficient (within-FTA efficient) FTA country would have lost tariff revenue that would have been collected from the more efficient external producer, because the tariffs are very low or zero within the FTA.

The net impact of an FTA depends on the totality of trade diversion and trade creation, which is largely an empirical question. For low- to middleincome regions such as Africa, this framework alone is inadequate for understanding the impact of regional integration schemes such as the AfCFTA.

An Analytical Framework for FTAs in the African Context

In the context of African economies, the impacts of trade creation and trade diversion are expected to be minimal relative to the long-term objectives embodied in the AfCFTA. This is because, in the context of the low productivity, very high unemployment, and low investment regimes most Africans face, the previous theory is very restrictive in evaluating the impact of regional integration or FTAs.

A more suitable framework for analyzing the impacts of regional integration is to examine the welfare impacts arising from increased employment, productivity, incomes, investment, and overall structural transformation of low- and middle-income economies into, respectively, middle-income and high-income economies. The dynamic effects of an FTA such as the AfCFTA would far outweigh the static effects because it supports the growth of a strong, competitive manufacturing sector and provides economies of scale from both trade diversion and creation. In practice, it is typically countries outside the FTA that are expected to face negative trade diversion effects.

In addition, welfare impact analysis that is biased toward a globally efficient allocation of resources ignores the existing income distribution. In the wake of trade diversion, countries outside the FTA bear the brunt of the negative effects. If, through trade diversion, an FTA shifts the distribution of income or wealth in favor of the poorer economies, it would be a favorable outcome. Still, with the substantial fall in tariffs and other trade barriers globally, trade diversion may not be as predominant an outcome as expected with FTA formation. In practice, the trade diversion effects tend to be minimal (Clausing 2001; Freund and Ornelas 2010; Magee 2008). By contrast, the evidence for substantial trade creation associated with FTAs is overwhelming (Freund and Ornelas 2010). An FTA encompassing natural

trading partner countries—countries with geographic proximity to each other and an already significant bilateral trade—tends to increase trade much more than otherwise (Magee 2008). This has important implications for the AfCFTA.

Arguably, the most important gains of an FTA are the dynamic gains (Baldwin 1992) associated with benefits from increased competition, foreign direct investment (FDI) inflows, economies of scale, transfer of knowledge and technology, increased productivity, and economic diversification. For FTA members in Africa and other low- and middle-income economies, the dynamic gains from trade diversion could be positive because of the production effects, leading to increased investment, job creation, and associated increases in productivity.

An important gain from regional free trade in practice arises from the increased size and hence productive efficiency and competitiveness of markets subject to economies of scale (Krugman 1991). After the European Common Market was formed in 1958, “What turned arrangement into a strong economic success was the huge intra-industry trade in manufactures, and the associated rationalization of production, that the Treaty of Rome made possible” (Krugman 1991, 9). Another benefit of an FTA, even when there is trade diversion, is that it typically enhances the region’s terms of trade at the expense of the rest of the world. Given the meager size of most African economies, the regional bloc provides a much-desired improvement in their terms of trade versus the rest of the world.

Prospective Benefits from the AfCFTA

The most important motivation for the AfCFTA is the economic transformation of countries across the African continent—focused on the need to exploit economies-of-scale advantages, enlarge the size and efficiency of markets, promote industrialization, and foster transfer of production technology and knowledge. For Africa, the gains from regional integration following the AfCFTA go beyond the traditional welfare analysis. Some examples are described below.

Resilience. Intraregional trade is expected to be more resilient to global shocks. Building the resilience of national economies has become a key goal of policy makers since the 2008–09 Global Financial Crisis and emerging uncertainties in global trade. Regional integration, particularly of intraAfrica trade, has been found to strengthen the capacity of economies to absorb global shocks and build resilience to shocks emanating from highincome economies (Brixiová, Meng, and Ncube 2015).

Diversification. Regional integration promotes exchange in a more diverse set of goods (compared with trade in more concentrated primary goods). Countries in Sub-Saharan Africa, for example, that are not highly dependent on natural resources tend to be more integrated in regional trade blocs than those with greater natural resource dependence. Oil exporters are less integrated than non-oil economies with other Sub-Saharan African economies, for which intraregional exports of oil represent a mere