Regional blocs in international trade

Government Role And Trading Blocks

8 Regional Economic Integration

Learning Objectives

After studying this chapter, you should be able to

1 Define regional economic integration and identify its five levels.

2 Discuss the benefits and drawbacks of regional economic integration.

3 Describe regional integration in Europe and its pattern of enlargement.

4 Discuss regional integration in the Americas and analyze its future prospects.

5 Characterize regional integration in Asia and how it differs from integration elsewhere.

6 Describe integration in the Middle East and Africa and explain the slow progress.

A LOOK BACK

Chapter 7 examined recent patterns of foreign direct investment. We explored the theories that try to explain why it occurs and saw how governments influence investment flows.

A LOOK AT THIS CHAPTER

This chapter explores the trend toward greater integration of national economies. We first examine the reasons why nations are making significant efforts at regional integration. We then study the most prominent regional trading blocs in place around the world today.

A LOOK AHEAD

Chapter 9 begins our inquiry into the international financial system. We describe the structure of the international capital market and explain how the foreign exchange market operates.

Nestlé’s Global Recipe

Vevey, Switzerland — Although based in small Switzerland, Nestlé (www.nestle.com) sells its products in nearly every country on the planet. Nestlé is the world’s largest food company. It operates across cultural borders 24 hours a day and earns just 2 percent of its sales at home.

Nestlé is known for its ability to turn humdrum products like bottled water and pet food into well-known global brands. The company also takes regional products to the global market when the opportunity arises. For example, Nestlé first launched a cereal bar for diabetics in Asia under the brand name Nutren Balance and is now taking it to other markets worldwide.

Nestlé must navigate cultural and political traditions in other countries because food is an integral part of the social fabric everywhere. Nestlé learned from its past and does all it can to ensure mothers use pure water to mix its baby milk formulas. Today, the company makes every effort to be sensitive to the traditional ways in which babies are fed. Nestlé must also watch for changes in attitudes due to greater cross-cultural contact caused by regional integration. Pictured above, a pharmacist in Rome, Italy, reaches for a package of Mio brand baby milk made by Nestlé.

Source: Alessia Pierdomenico/CORBIS-NY.

The laws of regional trading blocs also affect the business activities of Nestlé. When Nestlé and Coca-Cola announced a joint venture to develop coffee and tea drinks, they first had to show the European Union (EU) Commission that they would not stifle competition across the region. Firms operating within the EU also have to abide by EU environmental protection laws. Nestlé works with governments to minimize the packaging waste that results from the use of its products by developing and managing waste-recovery programs. As you read this chapter, think of all the ways business activities are affected when groups of nations band together in regional trading blocs.1

Regional trade agreements are changing the landscape of the global marketplace. Companies like Nestlé of Switzerland are finding that these agreements lower trade barriers and open new markets for goods and services. Markets otherwise off-limits because tariffs made imported products too expensive can become quite attractive once tariffs are lifted. But trade agreements can be double-edged swords for many companies. Not only do they allow domestic companies to seek new markets abroad, but they also let competitors from other nations enter the domestic market. Such mobility increases competition in every market that takes part in an agreement.

Trade agreements can allow companies to alter their strategies, sometimes radically. As we will see in this chapter, for example, nations in the Americas want to create a free trade area that runs from the northern tip of Alaska to the southern tip of South America. Companies that do business throughout this region could save millions of dollars annually from the removal of import tariffs under an eventual agreement. Multinationals could also save money by supplying entire regions from just a few regional factories, rather than have a factory in each nation.

We began Part Three of this book by discussing the gains resulting from specialization and trade. We now close this part of the book by showing how groups of countries are cooperating to dismantle barriers that threaten these potential gains. In this chapter, we focus on regional efforts to encourage freer trade and investment. We begin by defining regional economic integration and describing its five different levels. We then examine the benefits and drawbacks of regional trade agreements. Finally, we explore several long-established trade agreements and several agreements in the early stages of development.

What Is Regional Economic Integration?

The process whereby countries in a geographic region cooperate to reduce or eliminate barriers to the international flow of products, people, or capital is called regional economic integration (regionalism). A group of nations in a geographic region undergoing economic integration is called a regional trading blocs.

regional economic integration (regionalism)

Process whereby countries in a geographic region cooperate to reduce or eliminate barriers to the international flow of products, people, or capital.

The goal of nations undergoing economic integration is not only to increase cross-border trade and investment but also to raise living standards for their people. We saw in Chapter 5, for example, how specialization and trade create real gains in terms of greater choice, lower prices, and increased productivity. Regional trade agreements are designed to help nations accomplish these objectives. Regional economic integration sometimes has additional goals, such as protection of intellectual property rights or the environment, or even eventual political union.

Levels of Regional Integration

Since the development of theories demonstrating the potential gains available through international trade, nations have tried to reap these benefits in a variety of ways. Figure 8.1 shows five potential levels (or degrees) of economic and political integration for regional trading blocs. A free trade area is the lowest extent of national integration, political union is the greatest. Each level of integration incorporates the properties of those levels that precede it.

Free Trade Area

Economic integration whereby countries seek to remove all barriers to trade between themselves, but each country determines its own barriers against nonmembers, is called a free trade area. A free trade area is the lowest level of economic integration that is possible between two or more countries. Countries belonging to the free trade area strive to remove all tariffs and nontariff barriers, such as quotas and subsidies, on international trade in goods and services. However, each country is able to maintain whatever policy it sees fit against nonmember countries. These policies can differ widely from country to country. Countries belonging to a free trade area also typically establish a process by which trade disputes can be resolved.

free trade area

Economic integration whereby countries seek to remove all barriers to trade between themselves, but each country determines its own barriers against nonmembers.

FIGURE 8.1 Levels of Regional Integration

Customs Union

Economic integration whereby countries remove all barriers to trade among themselves, but erect a common trade policy against nonmembers, is called a customs union. Thus the main difference between a free trade area and a customs union is that the members of a customs union agree to treat trade with all nonmember nations in a similar manner. Countries belonging to a customs union might also negotiate as a single entity with other supranational organizations, such as the World Trade Organization.

customs union

Economic integration whereby countries remove all barriers to trade between themselves but erect a common trade policy against nonmembers.

Common Market

Economic integration whereby countries remove all barriers to trade and the movement of labor and capital between themselves, but erect a common trade policy against nonmembers, is called a common market. Thus a common market integrates the elements of free trade areas and customs unions and adds the free movement of important factors of production—people and cross-border investment. This level of integration is very difficult to attain because it requires members to cooperate to at least some extent on economic and labor policies. Furthermore, the benefits to individual countries can be uneven because skilled labor may move to countries where wages are higher, and investment capital may flow to where returns are greater.

common market

Economic integration whereby countries remove all barriers to trade and the movement of labor and capital between themselves but erect a common trade policy against nonmembers.

Economic Union

Economic integration whereby countries remove barriers to trade and the movement of labor and capital, erect a common trade policy against nonmembers, and coordinate their economic policies is called an economic union. An economic union goes beyond the demands of a common market by requiring member nations to harmonize their tax, monetary, and fiscal policies and to create a common currency. Economic union requires that member countries concede a certain amount of their national autonomy (or sovereignty) to the supranational union of which they are a part.

economic union

Economic integration whereby countries remove barriers to trade and the movement of labor and capital, erect a common trade policy against nonmembers, and coordinate their economic policies.

Political Union

Economic and political integration whereby countries coordinate aspects of their economic and political systems is called a political union. A political union requires member nations to accept a common stance on economic and political matters regarding nonmember nations. However, nations are allowed a degree of freedom in setting certain political and economic policies within their territories. Individually, Canada and the United States provide early examples of political unions. In both these nations, smaller states and provinces combined to form larger entities. A group of nations currently taking steps in this direction is the European Union—discussed later in this chapter.

political union

Economic and political integration whereby countries coordinate aspects of their economic and political systems.

Table 8.1 identifies each country involved in the European Union and the members of every regional trading bloc presented in this chapter. As you work through this chapter, refer back to this table for a quick summary of each bloc’s members.

TABLE 8.1 The World’s Main Regional Trading Blocs

EU

European Union

Austria, Belgium, Britain, Bulgaria, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greec e, Greek Cyprus (southern portion), Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, Netherlands, Poland, Portugal, Romania, Slovakia, Slovenia, Spain, Sweden

EFTA

European Free Trade Association

Iceland, Liechtenstein, Norway, Switzerland

NAFTA

North American Free Trade Agreement

Canada, Mexico, United States

CAFTA-DR

Central American Free Trade Agreement

Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua, Dominican

Republic, United States

Andean

Andean Community (CAN)

Bolivia, Colombia, Ecuador, and Peru

ALADI

Latin American Integration Association

Argentina, Bolivia, Brazil, Chile, Colombia, Ecuador, Mexico, Paraguay, Peru, Uruguay, Venezuela

MERCOSUR

Southern Common Market

Argentina, Brazil, Paraguay, Uruguay, Venezuela (Bolivia, Chile, Colombia, Ecuador, and Peru are associate members)

CARICOM

Caribbean Community and Common Market

Antigua and Barbuda, Bahamas, Barbados, Belize, Dominica, Grenada, Guyana, Haiti, Jamaica, Montserrat, St. Kitts and Nevis, St. Lucia, St. Vincent

and the Grenadines, Suriname, Trinidad and Tobago

CACM

Central American Common Market

Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua

FTAA

Free Trade Area of the Americas

34 nations from Central, North, and South America and the Caribbean

ASEAN

Association of Southeast Asian Nations

Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, Philippines, Singapore, Thailand, Vietnam

APEC

Asia Pacific Economic Cooperation

Australia, Brunei, Canada, Chile, China, Hong Kong, Indonesia, Japan, South Korea, Malaysia, Mexico, New Zealand, Papu New Guinea, Peru, Philippines, Russia, Singapore, Taiwan, Thailand, United States, Vietnam

CER

Closer Economic Relations Agreement

Australia, New Zealand

GCC

Gulf Cooperation Council

Bhrain, Kuwait, Oman, Qatar, Saudi Arabia, United Arab Emirates

ECOWAS

Economic Community of West African States

Benin, Burkina Faso, Cape Verde, Gambia, Ghana, Guinea, Guinea-Bissau, Ivory Coast, Liberia, Mali, Niger, Nigeria, Senegal, Sierra Leone, Togo

AU

African Union

Total of 53 nations on the continent of Africa

Effects of Regional Economic Integration

Few topics in international business are as hotly contested and involve as many groups as the effects of regional trade agreements on people, jobs, companies, cultures, and living standards. The topic often spurs debate over the merits and demerits of such agreements. On one side of the debate are people who see the bad that regional trade agreements cause; on the other, those who see the good. Each party to the debate cites data on trade and jobs that bolster their position. They point to companies that have picked up and moved to another country where wages are lower after a new agreement was signed, or to companies that have stayed at home and kept jobs there. The only thing made clear as a result of such debates is that both sides are right some of the time.

There is also the cultural aspect of such agreements. Some people argue that they will lose their unique cultural identity if their nation cooperates too much with other nations. As we saw in this chapter’s opening company profile, Nestlé tries to be sensitive to cultural differences across markets. But such large global companies are often lightning rods for those warning of cultural homogenization. Let’s take a closer look at the main benefits and drawbacks of regional integration.

Benefits of Regional Integration

Recall from Chapter 5 that nations engage in specialization and trade because of the potential for gains in output and consumption. Higher levels of trade between nations should result in greater specialization, increased efficiency, greater consumption, and higher standards of living.

Trade Creation

Economic integration removes barriers to trade and/or investment for nations belonging to a trading bloc. The increase in the level of trade between nations that results from regional economic integration is called trade creation. One result of trade creation is that consumers and industrial buyers in member nations are faced with a wider selection of goods and services not available before.2 For example, the United States has many popular brands of bottled water, including Coke’s Dasani (www.dasani.com) and Pepsi’s Aquafina (www.pepsi.com). But grocery and convenience stores inside the United States stock a wide variety of lesser-known imported brands of bottled water, such as Stonepoint from Canada. Certainly, the free trade agreement between Canada, Mexico, and the United States (discussed later in this chapter) created export opportunities for other Canadian brands.

trade creation

Increase in the level of trade between nations that results from regional economic integration.

Another result of trade creation is that buyers can acquire goods and services at lower cost after removal of trade barriers such as tariffs. Furthermore, lower-priced products tend to drive higher demand for goods and services because they increase purchasing power.

Greater Consensus

In Chapter 6 we saw how the World Trade Organization (WTO) works to lower barriers on a global scale. Efforts at regional economic integration differ in that they comprise smaller groups of nations—ranging from several countries to as many as 30 or more. The benefit of trying to eliminate trade barriers in smaller groups of countries is that it can be easier to gain consensus from fewer members as opposed to, say, the 153 countries that comprise the WTO.

Political Cooperation

There can also be political benefits from efforts toward regional economic integration. A group of nations can have significantly greater political weight than each nation has individually. Thus the group, as a whole, can have more say when negotiating with other countries in forums such as the WTO. Integration involving political cooperation can also reduce the potential for military conflict between member nations. In fact, peace was at the center of early efforts at integration in Europe in the 1950s. The devastation of two world wars in the first half of the twentieth century caused Europe to see integration as one way of preventing further armed conflicts.

Employment Opportunities

Regional integration can expand employment opportunities by enabling people to move from one country to another to find work or, simply, to earn a higher wage. Regional integration has opened doors for young people in Europe. Forward-looking young people have abandoned extreme nationalism and have taken on what can only be described as a “European” attitude that embraces a shared history. Those with language skills and a willingness to pick up and move to another EU country get to explore a new culture’s way of life while earning a living. As companies seek their future leaders in Europe, they will hire people who can think across borders and across cultures.

Drawbacks of Regional Integration

Although regional integration tends to benefit countries, it can also have substantial negative effects. Let’s examine each of these potential consequences.

Trade Diversion

The flip side of trade creation is trade diversion—the diversion of trade away from nations not belonging to a trading bloc and toward member nations. Trade diversion can occur after the formation of a trading bloc because of the lower tariffs charged between member nations. It can actually result in increased trade with a less-efficient producer within the trading bloc and reduced trade with a more efficient, non-member producer. In this sense, economic integration can unintentionally reward a less efficient producer within the trading bloc. Unless there is other internal competition for the producer’s good or service, buyers will likely pay more after trade diversion because of the inefficient production methods of the producer.

trade diversion

Diversion of trade away from nations not belonging to a trading bloc and toward member nations.

A World Bank report caused a stir over the results of the free trade bloc between Latin America’s largest countries, MERCOSUR (discussed later in this chapter). The report suggested that the bloc’s formation only encouraged free trade in the lowest-value products of local origin, while deterring competition for more sophisticated goods manufactured outside the market. Closer analysis showed that while imports from one member state to another tripled during the period studied, imports from the rest of the world also tripled. Thus the net effect of the agreement was trade creation, not trade diversion as critics had charged. Also, the Australian Department of Foreign Affairs and Trade released results of a study that examined the impact of the North American Free Trade Agreement (NAFTA) on Australia’s trade with and investment in North America. The study found no evidence of trade diversion following the agreement’s formation.3

Shifts in Employment

Perhaps the most controversial aspect of regional economic integration is its effect on people’s jobs. The formation of a trading bloc promotes efficiency by significantly reducing or eliminating barriers to trade among its members. The surviving producer of a particular good or service, then, is likely to be the bloc’s most efficient producer. Industries requiring mostly unskilled labor, for example, tend to respond to the formation of a trading bloc by shifting production to a low-wage nation within the bloc.

Yet figures on jobs lost or gained as a result of trading bloc formation vary depending on the source. The U.S. government contends that rising U.S. exports to Mexico and Canada have created a minimum of 900,000 jobs.4 But the AFL-CIO (www.aflcio.org), the federation of U.S. unions, disputes these figures and claims a loss of jobs due to NAFTA. Trade agreements do cause dislocations in labor markets; some jobs are lost while others are gained.

It is likely that once trade and investment barriers are removed, countries protecting low-wage domestic industries from competition will see these jobs move to the country where wages are lower. This can be an opportunity for workers who lose their jobs to upgrade their skills and gain more advanced job training. This can help nations increase their competitiveness because a more educated and skilled workforce attracts higher-paying jobs than does a less skilled workforce.5

Loss of National Sovereignty

Successive levels of integration require that nations surrender more of their national sovereignty. The least amount of sovereignty that must be surrendered to the trading bloc occurs in a free trade area. By contrast, a political union requires nations to give up a high degree of sovereignty in foreign policy. This is why political union is so hard to achieve. Long histories of cooperation or animosity between nations do not become irrelevant when a group of countries forms a union. Because one member nation may have very delicate ties with a nonmember nation with which another member may have very strong ties, the setting of a common foreign policy can be extremely tricky.

Economic integration is taking place throughout the world because of the benefits and despite the drawbacks of regional trade agreements. Europe, the Americas, Asia, the Middle East, and Africa are all undergoing integration to varying degrees (see Map 8.1). Let’s now begin our coverage of economic integration by exploring Europe, which has the longest history and highest level of integration to date.

Quick Study

1. What is the ultimate goal of regional economic integration?

2. What are the five levels, or degrees, of regional integration? Briefly describe each one.

3. Identify several potential benefits and several potential drawbacks of regional integration.

4. What is meant by the terms trade creation and trade diversion? Why are these concepts important?

Integration in Europe

The most sophisticated and advanced example of regional integration that we can point to today is occurring in Europe. European efforts at integration began shortly after the Second World War as a cooperative endeavor among a small group of countries and involved a few select industries. Regional integration now encompasses practically all of Western Europe and all industries.

European Union

In the middle of the twentieth century, many would have scoffed at the idea that European nations, which had spent so many years at war with one another, could present a relatively unified whole 50 years later. Let’s investigate how Europe came so far in such a relatively short time.

Early Years

A war-torn Europe emerged from the Second World War in 1945 facing two challenges: (1) it needed to rebuild itself and avoid further armed conflict and (2) it needed to increase its industrial strength to stay competitive with an increasingly powerful United States. Cooperation seemed to be the only way of facing these challenges. Belgium, France, West Germany, Italy, Luxembourg, and the Netherlands signed the Treaty of Paris in 1951, creating the European Coal and Steel Community. These nations were determined to remove barriers to trade in coal, iron, steel, and scrap metal so as to coordinate coal and steel production among themselves, thereby controlling the postwar arms industry.

The members of the European Coal and Steel Community signed the Treaty of Rome in 1957, creating the European Economic Community. The Treaty of Rome outlined a future common market for these nations. It also aimed at establishing common transportation and agricultural policies among members. In 1967 the community’s scope was broadened to include additional industries, notably atomic energy, and changed its name to the European Community. As the goals of integration continued to expand, so too did the bloc’s membership. Waves of enlargement occurred in 1973, 1981, 1986, 1995, 2004, and 2007. In 1994 the bloc once again changed its name to the European Union (EU). Today the 27-member European Union (www.europa.eu) has a population of about 495 million people and a GDP of around $18 trillion (see Map 8.2).

MAP 8.1 Most Active Economic Blocs

MAP 8.2 Economic Integration in Europe

Over the past two decades two important milestones contributed to the continued progress of the EU: the Single European Act and the Maastricht Treaty.

SINGLE EUROPEAN ACT

By the mid-1980s, EU member nations were frustrated by remaining trade barriers and a lack of harmony on several important matters, including taxation, law, and regulations. The important objective of harmonizing laws and policies was beginning to appear unachievable. A commission that was formed to analyze the potential for a common market by the end of 1992 put forth several proposals. The goal was to remove remaining barriers, increase harmonization, and thereby enhance the competitiveness of European companies. The proposals became the Single European Act (SEA) and went into effect in 1987.

As companies positioned themselves to take advantage of the opportunities that the SEA offered, a wave of mergers and acquisitions swept across Europe. Large firms combined their special understanding of European needs, capabilities, and cultures with their advantage of economies of scale. Small and medium-sized companies were encouraged through EU institutions to network with one another to offset any negative consequences resulting from, for example, changing product standards.

MAASTRICHT TREATY

Some members of the EU wanted to take European integration further still. A 1991 summit meeting of EU member nations took place in Maastricht, the Netherlands. The meeting resulted in the Maastricht Treaty, which went into effect in 1993.

The Maastricht Treaty had three aims. First, it called for banking in a single, common currency after January 1, 1999, and circulation of coins and paper currency on January 1, 2002. Second, the treaty set up monetary and fiscal targets for countries that wished to take part in monetary union. Third, the treaty called for political union of the member nations—including development of a common foreign and defense policy and common citizenship. Member countries will hold off further political integration until they gauge the success of the final stages of economic and monetary union. Let’s take a closer look at monetary union in Europe.

European Monetary Union

As stated previously, EU leaders were determined to create a single, common currency. European monetary union is the European Union plan that established its own central bank and currency in January 1999. The Maastricht Treaty stated the economic criteria with which member nations must comply to partake in the single currency, the euro. First, consumer price inflation must be below 3.2 percent and must not exceed that of the three best-performing countries by more than 1.5 percent. Second, the debt of government must be 60 percent of GDP or lower. An exception is made if the ratio is diminishing and approaching the 60 percent mark.

European monetary union

European Union plan that established its own central bank and currency.

Third, the general government deficit must be at or below 3.0 percent of GDP. An exception is made if the deficit is close to 3.0 percent or if the deviation is temporary and unusual. Fourth, interest rates on long-term government securities must not exceed, by more than 2.0 percent, those of the three countries with the lowest inflation rates. Meeting these criteria better aligned countries’ economies and paved the way for smoother policy making under a single European Central Bank. The 16 EU member nations that have adopted the single currency are Austria, Belgium, Cyprus, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain.

MANAGEMENT IMPLICATIONS OF THE EURO

The move to a single currency influences the activities of companies within the European Union. First, the euro removes financial obstacles created by the use of multiple currencies. It completely eliminates exchange-rate risk for business deals between member nations using the euro. The euro also reduces transaction costs by eliminating the cost of converting from one currency to another. In fact, the EU leadership estimates the financial gains to Europe could eventually be 0.5 percent of GDP. The efficiency of trade between participating members resembles that of interstate trade in the United States because only a single currency is involved.

Second, the euro makes prices between markets more transparent, making it difficult to charge different prices in adjoining markets. As a result, shoppers feel less of a need to travel to other countries to save money on high-ticket items. For example, shortly before monetary union a Mercedes-Benz S320 (www.mercedes.com) cost $72,614 in Germany but only $66,920 in Italy. A Renault Twingo (www.renault.com) that sold for $13,265 in France cost $11,120 in Spain. Car brokers and shopping agencies even sprang up specifically to help European consumers reap such savings. The euro has greatly reduced or eliminated this type of situation.

Enlargement of the European Union

One of the most historic events across Europe in recent memory was EU enlargement from 15 to 27 members. Croatia, Turkey, and the former Yugoslav Republic of Macedonia remain candidates for EU membership and are to become members after they meet certain demands laid down by the EU. These so-called Copenhagen Criteria require each country to demonstrate that it:

■ Has stable institutions, which guarantee democracy, the rule of law, human rights, and respect for and protection of minorities.

■ Has a functioning market economy, capable of coping with competitive pressures and market forces within the European Union.

■ Is able to assume the obligations of membership, including adherence to the aims of economic, monetary, and political union.

■ Has the ability to adopt the rules and regulations of the community, the rulings of the European Court of Justice, and the treaties.

Although it has applied for membership, negotiations for Turkey are expected to be difficult. One reason for Turkey’s lack of support in the EU is charges (fair or not) of human rights abuses with regard to its Kurdish minority. Another reason is intense opposition by Greece, Turkey’s longtime foe. Turkey does have a customs union with the EU, however, and trade between them is growing. Despite disappointment among some EU-hopefuls and despite intermittent setbacks in the enlargement process, integration is progressing. To learn a bit more about how entrepreneurs can do business in one EU country, see the Entrepreneur’s Toolkit titled, “Czech List.”

Structure of the European Union

Five EU institutions play particularly important roles in monitoring and enforcing economic and political integration (see Figure 8.2). Two other EU institutions (Ombudsman and Data Protection Supervisor) fulfill secondary and support roles and are not discussed here.

ENTREPRENEUR’S TOOLKIT Czech List

The countries of Central and Eastern Europe that belong to the EU represent a land of opportunity. But like doing business anywhere, opportunity must be balanced against the challenges of a particular location. Entrepreneurs who have succeeded in the Czech Republic offer this advice.

■ Formalities. Czech society is rather formal, and it is best to tend toward the more formal unless you know your colleague well. This includes using titles like “doctor” and “mister.” It’s rarely appropriate to use first names unless you’re close friends.

■ Business Relationships. Making money is obviously important and the ultimate goal for any business. Still, building personal relationships, establishing good references, and doing favors for others can smooth the way for newcomers.

■ Czech Partners. Being communist for 40 years before it became a capitalist democracy has left its mark on the Czech people and their culture. Finding a local partner who can handle the inevitable cultural difficulties that arise is crucial.

■ Local Professionals. It is a good idea to hire a Czech accountant or someone familiar with Czech laws, taxes (including a VAT tax of 19 percent), and red tape. An attorney who is bilingual can also interpret differences between Czech and U.S. laws.

■ Who’s in Charge. Companies need a “responsible person” (or jednatel in Czech) who is in charge of all aspects of the business. Some Czechs still feel more comfortable working with this jednatel rather than unfamiliar company reps.

Source: “Online Business Guide to the Czech Republic,” Price-waterhouseCoopers Web site (www.pwc.com/cz/eng/ins-sol/spec-int/taxguide), select reports; Czech Republic Web site (www.czech.cz), select reports; Moira Allen, “Czech List: Doing Business with Eastern Europe,” Entrepreneur Magazine (www.entrepreneur.com), July 2000.

FIGURE 8.2 Institutions of the European Union

EUROPEAN PARLIAMENT

The European Parliament consists of nearly 800 members elected by popular vote within each member nation every five years. As such, they are expected to voice their particular political views on EU matters. The European Parliament fulfills its role of adopting EU law by debating and amending legislation proposed by the European Commission. It exercises political supervision over all EU institutions—giving it the power to supervise commissioner appointments and to censure the commission. It also has veto power over some laws (including the annual budget of the EU). There is a call for increased democratization within the EU, and some believe this could be achieved by strengthening the powers of the Parliament. The Parliament conducts its activities in Belgium (in the city Brussels), France (in the city Strasbourg), and Luxembourg.

COUNCIL OF THE EUROPEAN UNION

The council is the legislative body of the EU. When it meets it brings together representatives of member states at the ministerial level. The makeup of the council changes depending on the topic under discussion. For example, when the topic is agriculture, the council is composed of the ministers of agriculture from each member nation. No proposed legislation becomes EU law unless the council votes it into law. Although passage into law for sensitive issues such as immigration and taxation still requires a unanimous vote, some legislation today requires only a simple majority to win approval. The council also concludes, on behalf of the EU, international agreements with other nations or international organizations. The council is headquartered in Brussels, Belgium.

EUROPEAN COMMISSION

The commission is the executive body of the EU. It comprises commissioners appointed by each member country—larger nations get two commissioners, smaller countries get one. Member nations appoint the president and commissioners after being approved by the European Parliament. It has the right to draft legislation, is responsible for managing and implementing policy, and monitors member nations’ implementation of, and compliance with, EU law. Each commissioner is assigned a specific policy area, such as competitive policy or agricultural policy. Although commissioners are appointed by their national governments, they are expected to behave in the best interest of the EU as a whole, not in the interest of their own country. The European Commission is headquartered in Brussels, Belgium.

COURT OF JUSTICE

The Court of Justice is the court of appeals of the EU and is composed of 27 judges (one from each member nation) and eight advocates general who hold renewable six-year terms. One type of case that the Court of Justice hears is one in which a member nation is accused of not meeting its treaty obligations. Another type is one in which the commission or council is charged with failing to live up to their responsibilities under the terms of a treaty. Like the commissioners, justices are required to act in the interest of the EU as a whole, not in the interest of their own countries. The Court of Justice is located in Luxembourg.

Romania’s president (left) and prime minister point to their country on a map of Europe during a welcoming ceremony for Bulgaria and Romania to the European Union. The EU grew from a grouping of just six nations to include 27 members today. To balance divergent national interests, the EU created a unique system of government and designed the role of each EU institution to reflect this balancing act.

Source: Nicolas Bouvy/CORBIS-NY.

COURT OF AUDITORS

The Court of Auditors comprises 27 members (one from each member nation) appointed for renewable six-year terms. The court is assigned the duty of auditing the EU accounts and implementing its budget. It also aims to improve financial management in the EU and report to member nations’ citizens on the use of public funds. As such, it issues annual reports and statements on implementation of the EU budget. The court has roughly 800 auditors and additional staff to assist it in carrying out its functions. The Court of Auditors is based in Luxembourg.

European Free Trade Association (EFTA)

Certain nations in Europe were reluctant to join in the ambitious goals of the EU, fearing destructive rivalries and a loss of national sovereignty. Some of these nations did not want to be part of a common market but instead wanted the benefits of a free trade area. So in 1960 several countries banded together and formed the European Free Trade Association (EFTA) to focus on trade in industrial, not consumer, goods. Because some of the original members joined the EU and some new members joined EFTA (www.efta.int), today the group consists of only Iceland, Liechtenstein, Norway, and Switzerland (see Map 8.2).

The population of EFTA is around 12.5 million, and it has a combined GDP of around $707 billion. Despite its relatively small size, members remain committed to free trade principles and raising standards of living for their people. The EFTA and EU created the European Economic Area (EEA) to cooperate on matters such as the free movement of goods, persons, services, and capital among member nations. The two groups also cooperate in other areas, including the environment, social policy, and education.

Quick Study

1. Why did Europe initially desire to form a regional trading bloc?

2. Describe the evolution of the European Union. What are its five primary institutions?

3. What is European monetary union? Explain its importance to business in Europe.

4. Briefly describe the European Free Trade Association.

Integration in the Americas

Europe’s success at economic integration caused other nations to consider the benefits of forming their own regional trading blocs. Latin American countries began forming regional trading arrangements in the early 1960s, but they made substantial progress only in the 1980s and 1990s. North America was about three decades behind Europe in taking major steps toward economic integration. Let’s now explore the major efforts toward economic integration in North, South, and Central America, beginning with North America.

North American Free Trade Agreement (NAFTA)

There has always been a good deal of trade between Canada and the United States. Canada and the United States had in the past established trade agreements in several industrial sectors of their economies, including automotive products. In January 1989 the U.S.–Canada Free Trade Agreement went into effect. The goal was to eliminate all tariffs on bilateral trade between Canada and the United States by 1998.

Accelerating integration in Europe caused new urgency in the task of creating a North American trading bloc that included Mexico. Mexico joined what is now the World Trade Organization in 1987 and began privatizing state-owned enterprises in 1988. Talks among Canada, Mexico, and the United States in 1991 eventually resulted in the formation of the North American Free Trade Agreement (NAFTA). NAFTA (www.nafta-sec-alena.org) became effective in January 1994 and superseded the U.S.–Canada Free Trade Agreement. Today NAFTA comprises a market with 445 million consumers and a GDP of around $16 trillion (see Map 8.1).

As a free trade agreement, NAFTA seeks to eliminate all tariffs and nontariff trade barriers on goods originating from within North America. The agreement also calls for liberalized rules regarding government procurement practices, the granting of subsidies, and the imposition of countervailing duties (see Chapter 6). Other provisions deal with issues such as trade in services, intellectual property rights, and standards of health, safety, and the environment.

Local Content Requirements and Rules of Origin

While NAFTA encourages free trade among Canada, Mexico, and the United States, manufacturers and distributors must abide by local content requirements and rules of origin. Although producers and distributors rarely know the precise origin of every part or component in a piece of industrial equipment, they are responsible for determining whether a product has sufficient North American content to qualify for tariff-free status. The producer or distributor must also provide a NAFTA “certificate of origin” to an importer to claim an exemption from tariffs. Four criteria determine whether a good meets NAFTA rules of origin:

■ Goods wholly produced or obtained in the NAFTA region

■ Goods containing non-originating inputs but meeting Annex 401 origin rules (which covers regional input)

■ Goods produced in the NAFTA region wholly from originating materials

■ Unassembled goods and goods classified in the same harmonized system category as their parts that do not meet Annex 401 rules but have sufficient North American regional value content

Effects of NAFTA

Since NAFTA went into effect, trade among the three nations has increased markedly, with the greatest gains occurring between Mexico and the United States. Today the United States exports more to Mexico than it does to Britain, France, Germany, and Italy combined. In fact, in 1997 Mexico became the second largest export market for the United States for the first time ever. Since then, however, China has taken over second place and bumped Mexico to third place in terms of exports to the United States.

Overall, NAFTA helped trade among the three countries to grow from $297 billion in 1993 to nearly $930 billion in 2007.6 Since the start of NAFTA, Mexico’s exports to the United States jumped an astonishing 275 percent, to around $150 billion, and U.S. exports to Mexico grew 170 percent, to more than $111 billion.7 As these numbers suggest, the United States has developed a trade deficit with Mexico.8 Over the same period, Canada’s exports to the United States more than doubled to nearly $300 billion, while U.S. exports to Canada grew 76 percent, to $176 billion. Canada exported very little to Mexico before NAFTA, but afterward exports grew more than threefold, to nearly $2.7 billion.9

The agreement’s effect on employment and wages is not as easy to determine. The U.S. Trade Representative Office claims that exports to Mexico and Canada support 2.9 million U.S. jobs (900,000 more than in 1993), which pay 13 to 18 percent more than national averages for production workers.10 But the AFL-CIO group of unions dispute this claim; they argue that since its formation, NAFTA has cost the United States over one million jobs and job opportunities.11

In addition to claims of job losses, opponents claim that NAFTA has damaged the environment, particularly along the United States–Mexico border. Although the agreement included provisions for environmental protection, Mexico is finding it difficult to deal with the environmental impact of greater economic activity. But Mexico’s Instituto Nacional de Ecologia (www.ine.gob.mx) has developed an industrial-waste-management program, including an incentive system to encourage waste reduction and recycling. The U.S. and Mexican federal governments have invested several billion dollars in environmental protection efforts since the creation of NAFTA.12

Expansion of NAFTA

Continued ambivalence among union leaders and environmental watchdogs regarding the long-term effects of NAFTA is delaying its expansion. The pace at which NAFTA expands will depend to a large extent on whether the U.S. Congress grants successive U.S. presidents trade-promotion (“fast track”) authority. Trade-promotion authority allows a U.S. administration to engage in all necessary talks surrounding a trade deal without the official involvement of Congress. After details of the deal are decided, Congress then simply votes yes or no on the deal and cannot revise the treaty’s provisions.

But there is little doubt that integration will expand some day in the Americas. In fact, it is even possible that the North American economies will one day adopt a single currency. As trade among Canada, Mexico, and the United States strengthens, a single currency (most likely the U.S. dollar) would benefit companies in these countries with reduced exposure to changes in exchange rates. Although this would be difficult for Canada and Mexico to accept politically, in the long run we could see one currency for all of North America. Ecuador, in fact, has already “dollarized” its economy.

Central American Free Trade Agreement (CAFTA-DR)

The potential benefits from freer trade induced another trading bloc between the United States and six far smaller economies. The Central American Free Trade Agreement (CAFTA-DR) was established in 2006 between the United States and Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua, and later the Dominican Republic.

Prior to its creation, CAFTA-DR nations had already traded a great deal. The Central American nations and the Dominican Republic are already the second-largest U.S. export market in Latin America behind Mexico. The CAFTA-DR nations represent a U.S. export market larger than India, Indonesia, and Russia combined. Likewise, nearly 80 percent of exports from the Central American nations and the Dominican Republic already enter the United States tariff-free. And Central American nations have already cut average tariffs from 45 percent in 1985 to around 7 percent today. The combined value of goods traded between the United States and the six other CAFTA-DR countries is around $32 billion.13

The agreement benefits the United States in several ways. CAFTA-DR aims to reduce tariff and nontariff barriers against U.S. exports to the region. It also ensures that U.S. companies are not disadvantaged by Central American nations’ trade agreements with Mexico, Canada, and other countries. The agreement also requires the Central American nations and the Dominican Republic to reform their legal and business environments to encourage competition and investment, protect intellectual property rights, and promote transparency and the rule of law. CAFTA-DR is also designed to support U.S. national security interests by advancing regional integration, peace, and stability.

A tractor pulls several trailers of picked pineapples on a farm in La Virgen, Costa Rica. Like any free trade agreement, CAFTADR has supporters and detractors. Supporters say that the agreement will encourage trade efficiency and promote investment that will bring good-paying jobs to the region. Yet others fear the agreement will benefit large U.S. companies and badly damage small businesses and farmers across Central America.

Source: John Coletti/JAI/CORBISNY.

Quick Study

1. What was the impetus for the formation of the North American Free Trade Agreement?

2. What effect has NAFTA had on trade among its member nations?

3. List the main benefits the United States obtains from the Central American Free Trade Agreement.

Andean Community (CAN)

Attempts at integration among Latin American countries had a rocky beginning. The first try, the Latin American Free Trade Association (LAFTA), was formed in 1961. The agreement first called for the creation of a free trade area by 1971 but then extended that date to 1980. Yet because of a crippling debt crisis in South America and a reluctance of member nations to do away with protectionism, the agreement was doomed to an early demise. Disappointment with LAFTA led to the creation of two other regional trading blocs—the Andean Community and the Latin American Integration Association.

Formed in 1969, the Andean Community (in Spanish Comunidad Andina de Naciones, or CAN) includes four South American countries located in the Andes mountain range—Bolivia, Colombia, Ecuador, and Peru (see Map 8.1). Today the Andean Community (www.comunidadandina.org) comprises a market of around 97 million consumers and a combined GDP of about $220 billion. The main objectives of the group include tariff reduction for trade among member nations, a common external tariff, and common policies in both transportation and certain industries. The Andean Community had the ambitious goal of establishing a common market by 1995, but delays mean that it remains a somewhat incomplete customs union.

Several factors hamper progress. Political ideology among member nations is somewhat hostile to the concept of free markets and favors a good deal of government involvement in business affairs. Also, inherent distrust among members makes lower tariffs and more open trade hard to achieve. The common market will be difficult to implement within the framework of the Andean Community. One reason is that each country has been given significant exceptions in the tariff structure that they have in place for trade with nonmember nations. Another reason is that countries continue to sign agreements with just one or two countries outside the Andean Community framework. Independent actions impair progress internally and hurt the credibility of the Andean Community with the rest of the world.

Latin American Integration Association (ALADI)

The Latin American Integration Association (ALADI) was formed in 1980 and consists of 11 countries today. Because of the failure of the first attempt at integration (LAFTA), the objectives of ALADI were scaled back significantly. The ALADI agreement calls for preferential tariff agreements (bilateral agreements) to be made between pairs of member nations that reflect the economic development of each nation. Although the agreement resulted in roughly 24 bilateral agreements and five subregional pacts, it did not accomplish a great deal of cross-border trade. Dissatisfaction with progress once again caused certain nations to form a trading bloc of their own—the Southern Common Market.