6.10 Adjustment Paths Following Trade Liberalization

employment difficult and costly for displaced workers because moving into a different sector usually requires a change in skills. Economic integration enhances competition and thereby fosters structural changes. This leads to a better allocation of factors of production and productivity-enhancing innovations. Yet it could also impose certain transitional costs.

Many African countries lack the necessary financing and social protection programs to deal with the adjustment costs. Following trade, the fall in the level of output (Y[t]) below the initial level of output (Yo) during the first period (tyo) reflects the adjustment costs (figure 6.10). In panel a, output returns to pretrade level YT, where the adjustment costs are only temporary. However, the adjustment costs may persist such that output and hence employment might not return to the pretrade level. In panel b, the new longrun equilibrium would then shift from YT to YT,A, at lower levels of output and higher levels of unemployment. Increased trade may have distributive implications, with consequences for human development and welfare. This calls for national and regional active and passive labor market policies to reduce the costs of adjustment and support the transition of labor to the new, long-term equilibrium.

More recent studies have shown that, depending on labor market frictions and the mobility of capital, the duration of the transition could be longer, and the magnitude of the adjustment costs larger (Dix-Carneiro and Kovak 2017). Setting up programs in advance to address the problems arising from the adjustment costs is not only necessary to support the displaced and unemployed but also an important tool to maintain public support for the project. Recent upheavals in high-income economies, reflected in increased trade protectionism and political shifts

Figure 6.10 Adjustment Paths Following Trade Liberalization

a. Return of output to pretrade level after temporary adjustment costs Output

YT

YO t yo Y(t)

b. Long-term output reduction from persistent adjustment costs

Output

YT

YT,A

YO t yo Y(t)

Time Time

Source: Francois, Jansen, and Peters 2011. Note: Following trade liberalization, the fall in the level of output (Y[t]) below the initial level of output (Yo) during the first period (tyo) reflects the adjustment costs. If the adjustment costs have a persistent negative effect in the long run, the posttrade equilibrium (YT,A) will be at lower levels of output.

toward the right, reflect governments’ failures to address these key challenges.

Transitioning from RECs to the AfCFTA: A Sticky Process

About 80 percent of all intra-Africa trade flows through RECs and 20 percent flows outside, indicating that, although trade within the RECs is growing, intra-Africa trade across RECs has been minimal. Hence, increasing trade between the RECs remains a challenge. One of the AfCFTA’s 12 core principles, stated in its founding agreement, is that the RECs serve as building blocks for the AfCFTA, and the program aims to “resolve the challenges of multiple and overlapping memberships” between the eight RECs functioning at various levels of integration.8 The RECs may remain active during the operation of AfCFTA, although, “in the event of inconsistency, the AfCFTA agreement shall prevail.”

Still, the multiplicity of rules across RECs and their distinctions from the AfCFTA rules remain a big challenge. The transition from RECs to the AfCFTA is expected to be sticky, and members must develop strategies to maximize the gains from their existing RECs while restricting the costs resulting from divergent regulations and rules governing each REC in the transition to the AfCFTA.

Tension between National Industrial Policies and AfCFTA Ambitions

The AfCFTA’s success hinges on the member countries’ effort to make the regional strategy part of their national policy and address the tensions that arise between the two. Short of this, the agreement remains a policy document with no meaningful national implications. Moreover, the success of other technical policy reforms such as improving regional infrastructure and easing tariff and nontariff barriers, which are critical to unleash the benefits from increased economies of scale, depends on the extent of active national AfCFTA strategies. Political tensions, both between interest groups within a country and across member countries, will always be part of the process because countries often adopt divergent economic strategies.

For example, Nigeria’s early hesitation to join the AfCFTA signaled the concerns of local trade unions in manufacturing, for fear of competition from cheap imports. Nigerian President Muhammadu Buhari said in 2018 that his administration was in no hurry to enter any agreement that could make Nigeria a “dumping ground” for cheap imports from outside the FTA (Kolawole, Agbawuru, and Uzor 2018). Nigeria’s concerns speak to the risks that all countries in the region face as they ease restrictions on the movement of goods, services, and people. To address these concerns, governments should find the sweet spot that reinforces national economic goals and ensures maximum gains from increased integration.

Reaching this difficult balance would require countries to look beyond a static assessment of their priorities and policies. In addition, countries need to build local consensus around the long-term benefits of integration. This

is particularly important in the larger countries, which may have relatively more influence on regional decisions. National and regional initiatives to reconcile these interests would elicit a broad base of citizen support if they were preceded by an inclusive process of local consultations to evaluate the impacts of such initiatives.

(Mis)Design of Rules and Procedures

The gradual elimination of tariffs under the AfCFTA will make NTBs— including but not limited to the multiplicity of regulations across the region, such as customs clearance, standards and certification requirements, rules of origin, quotas, and export subsidies—more significant. As noted earlier, NTBs are high and prevalent in Africa and represent critical obstacles to trade in the region (Abrego et al. 2019; Mevel and Karingi 2012). These barriers generally include NTMs, infrastructure gaps, and other trade-related transaction costs. Among the NTMs, the most restrictive trade barriers in the region include sanitary and phytosanitary measures, including preshipment inspections and formalities; contingent trade-protective measures; licensing, quotas, and prohibitions; and price controls (Kee and Nicita 2016).

Underdeveloped physical infrastructure and high transaction costs due to excessive and unnecessary document requirements and unnecessary delays also remain among the main challenges of intra-Africa trade. Examining 45 AfCFTA countries, Abrego et al. (2019) find that NTB reduction has a much larger welfare effect than tariff reduction. They estimate that elimination of tariffs in Africa increases welfare by 0.05 percent, whereas an ad valorem equivalent reduction in NTBs increases welfare by 1.7 percent. A similar study by Mevel and Karingi (2012) highlights that the welfare and trade impacts of eliminating tariffs without addressing the barriers to trade would be very small and that the AfCFTA could not achieve its target of doubling the share of intra-Africa trade over the next decade without significant NTB reduction. A critical set of measures that could help in achieving the targeted outcome would be to address NTMs and improve trade facilitation.

In addition to the barriers, which are often categorized as NTMs, the AfCFTA’s rules and procedures pose challenges that require clarity and close examination. Elimination of tariffs does not automatically lead to increased trade because it also depends on whether the various rules and procedures underlying trade are satisfied, including the document requirements associated with such rules and customs procedures. The AfCFTA’s success depends on the ease of streamlining these rules across countries. The following discussion outlines some of the most important challenges.

Rules of Origin

The driving principle in establishing rules of origin is to ensure that firms comply with sourcing most of the intermediate and final goods from within the FTA while avoiding trade deflection or transshipment. This aims to strengthen regional value chains and support the emergence of Africa as

the next factory of the world—the next frontier of global manufacturing. These rules are natural barriers to trade, although they satisfy another important goal: rules of origin, which determine the origin of products traded across borders, ensure that goods satisfy the qualification for preferential tariff treatment. The design and implementation of rules of origin are critical for the nature of trade and the emerging regional and global value chains.

Designing the rules of origin involves an important trade-off—between making them too restrictive and complex and making them too flexible and simple. Complex and stringent rules raise the costs of compliance to the extent that they may discourage the use of the FTA preferences and hence constrain the development of regional value chains. Rules with stringent requirements are even costlier in Africa because of the costs of monitoring and verification, which could be higher than in other regions. The success of stringent rules also depends on the extent to which regional production provides low-cost alternatives to the very competitive, low-cost international supply of intermediate goods for production. This is similar to using rules of origin as substitutes for industrial policies that protect domestic firms. In this case, the cost margin between local and imported content of intermediate goods would play an important role in the overall objectives of the specific rules of origin. To maximize the gains, there is a need to build the capacity of the trade administrative apparatus to enforce and verify the rules. At the same time, rules that are too flexible, particularly regarding local content requirements, may fail to deepen local production links and may limit the development of effective regional value chains with a competitive regional manufacturing sector.

Most often, there are other factors in addition to the central trade-offs that inform the current AfCFTA rules of origin negotiations. For example, high disparity in the development of the manufacturing sector across economies may have contributed to the complicated negotiations. The AfCFTA is more likely to adopt product-specific rules than ones based on broad product classifications.9 Product-specific rules of origin are often considered more complex and require highly specified requirements for each product type, hence leading to stringent document requirements. Rules of origin that vary across products, especially at very low levels of classification, are likely to restrict the growth of regional value chains and regional industrial trade networks because production of a single item often requires multiple intermediate inputs with varying rules of origin requirements. This may impose significant costs of compliance and verification.

In addition to adopting simplified, general, and easier to administer rules, introducing an ex post verification system may help reduce the costs associated with exporting and importing. Given the multiplicity of the rules of origin across the various RECs, challenges are entailed whether in harmonizing the existing rules of origin across the RECs or in starting anew by introducing new rules of origin that govern trade within the AfCFTA.

With the newly minted AfCFTA, a more gradual approach that begins with more flexible, simpler, and easier rules of origin based on broad product classifications and then moving slowly to relatively less flexible rules seems relevant. Given the lack of a competitive manufacturing sector, stringent rules at the early stages would be too restrictive to build a vibrant regional value chain. If Africa is to become the next manufacturing frontier, very flexible rules of origin in the early phases of integration should be used to enhance production capacity and build the institutional muscle to monitor and verify the rules of origin requirements that would eventually become less flexible with increased development.

Sensitive Products and Exclusion Lists

As it stands, the AfCFTA faces uncertainties on core design issues, including the choice of the list of sensitive products (sensitive/exclusion) for tariff liberalization planned over different phases of the operation of the program. The trade-in-goods protocol has been completed. AfCFTA members have agreed to liberalize 90 percent of tariffs on goods over 10 years for least developed countries (LDCs) and over 5 years for non-LDCs. The AfCFTA is expected to have significant impacts in promoting trade and integration if tariffs are liberalized for at least 90 percent of the total value of imports corresponding to at least 90 percent of the tariff lines—that is, the double qualification approach that the AfCFTA employs.

Under the tariff line approach, the AfCFTA’s success in promoting trade will be restricted, because a significant share of trade is accounted for by a very small share of the tariff lines that could be excluded from liberalization. Still, even with the double qualification, a large share of trade occurs with tariff lines that account for less than 10 percent of the tariff lines. Hence, the risk of not effectively liberalizing trade is higher depending on the choice of the exclusion and sensitive list of products. The 90 percent tariff lines may effectively represent a very small share of the total value of trade or imports in the region, or the exclusion list may account for more than half the value of imports in some countries.

Intra-Africa trade is already low; hence, the exclusion of even a small set of tariff lines could effectively exclude a significant share of imports to a country. Although the agreement toward the double qualification approach is encouraging, there is still a need for an “anticoncentration” clause to restrict the prospects that a few selected tariff lines will fall under trade regimes that are not fully liberalized.

Enforcement and Resolution of Trade Dispute Settlement Mechanisms

There is a concern among the member countries about remedial action, dispute resolution, and enforcement mechanisms within the AfCFTA. The current dispute resolution mechanism adopts a framework that is similar to the one used under the WTO. The emphasis on the WTO dispute resolution mechanisms between “state parties” limits the scope of the potential