CHAPTER 5:
SMALL ECONOMIES AND THE CHALLENGE OF FREE TRADE

There are a number of challenges ... developing countries will face in an FTAA-WTO world. ... [M]embership, as they say, has its privileges, but it also has its obligations. ... [T]here are likely to be a lot of changes, particularly on the fiscal policy side, such as tax harmonization and doing away with export subsidies... [A] range of changes have to be made to trade and industrial policies in order for the country to have policies compatible with membership. [Rohinton Medhora, 28:1620]

Small Economies Defined

Although described in Chapter 2 as the most productive economic region of the world, the Western Hemisphere is made up primarily of small developing economies. For instance, when defining a small economy as a country whose gross domestic product (GDP) is less than, let's say, US$50 billion, which would incidentally include all those with per capita GDPs of less than US$2,000 and a few others - or, more succinctly, poor countries - they comprise all countries of Central America and the Caribbean, as well as a handful of countries from South America. In fact, of the 34 countries contemplating a Free Trade Area of the Americas (FTAA), 25 countries would qualify as a small economy using this definition. If one was more strict in this definition, say halve the GDP threshold to US$25 billion, the number of small economies would be unchanged. If, on the other hand, population was the operative parameter, a threshold of 10 million people would produce similar results. In this instance, 23 countries would qualify as a small economy; halving the threshold to 5 million people would reduce the number of qualifying countries only to 20. Clearly, some combination of GDP and population size would provide a basis for determining which countries qualify for small economy status, but even large differences in the definitional anchor do not provide for much choice - in number, the Americas are simply dominated by small economies.

Small economies are being singled out in negotiating and forming an FTAA precisely because a policy of free trade represents a far more significant political and economic challenge to them relative to their much larger counterparts. Indeed, the peculiarities of small economies, which will be described in brief below (for greater detail see Appendix 2), makes the move from an insular to a cosmopolitan state a difficult and onerous one. On the positive side, most countries contemplating an FTAA have already joined the World Trade Organization (WTO) and are meeting, or on track to meet, existing General Agreement on Tariffs and Trade (GATT) obligations. So an FTAA will impose only an incremental burden on them. The severity of this burden will, of course, depend on the rigorousness of the transition period required in meeting the negotiated obligations. To ensure that these obligations are reasonable, the FTAA process includes a Consultative Group on Smaller Economies (CGSE) specifically charged with addressing and making recommendations to the nine Negotiating Groups on issues and concerns of small economies. Its objective is to ensure that the transition period is as orderly, uneventful and painless as possible.

To the Committee, it makes eminent sense that the CGSE establish early in the negotiating process some workable definition of a small economy. In its absence, there will be a rush of countries demanding such status once the terms of the agreement are largely negotiated. Needless to say, a stampede, if it were to amount to this, could add unnecessary complications and unexpected costs to the negotiations and possibly destabilize it. The Committee wishes to avoid such an event from the outset and recommends:

8. That the Government of Canada instruct its negotiating officials to work with the FTAA Consultative Group on Smaller Economies to first identify a clear and workable definition of a small economy. That the Government of Canada debate financial and other resource assistance to small economies, appropriately defined, for the negotiation and implementation, including matters relating to dispute settlement, of a Free Trade Area of the Americas agreement.

Political-Economy Challenges to an FTAA

Small economies are traditionally open economies and, in the case of Latin America and the Caribbean, their exports of commercial goods and services account for more than 40% and approaching 50% of their GDPs. In fact, the value of trade can often exceed their GDP as is currently the case of the Caribbean (CARICOM and others) and Nicaragua (see Table 2.1). Together, small populations and geographies combine to make for many non-competitive firms, as they cannot sufficiently exploit extant economies of scale in the production of manufactures, and less diversified economies, dependent on one or just a few export commodities and services. In the case of the former, mostly agricultural products; in the case of the latter, tourism and banking. Some countries have been able to successfully add labour-intensive light manufacturing into their export mix, though this is more likely the result of trade diverting preferential trading arrangements (Caribbean Basin Initiative and CARIBCAN) and favourable domestic corporate tax regimes favourable to domestic enterprises than any comparative advantage they might possess.

These special circumstances have obviously conspired to produce very distinctive and externally dependent economies. Small populations and geographies usually entail inadequate endowments of natural and human resources in the context of providing satisfactory comfort levels of security in the case of an economic or natural disaster (i.e. sharp declines in the terms of trade in the case of the former; hurricanes, tornados, etc. in the case of the latter). Foreign aid (in some cases, foreign debt forgiveness as well) is often the only means of coping with these uncontrollable adverse external events. A second distinction of these economies would be that tariffs represent the most significant funding source of government-provided social programs. Small countries have relied on these tariffs primarily because of their inordinately broad tax base, their ease of administration at the port of entry and, as a hidden tax, they arouse little public opposition.

Macroeconomic stabilization of small open economies is also not without its own set of specific challenges. These less diversified economies with low savings rates traditionally run large current account deficits, financed by equally large capital account surpluses (if foreign currency reserves and their loan substitutes are not to be accumulated or run down). As they are price-takers in world commodities markets, they are particularly vulnerable to foreign shocks in demand and supply, and to gyrations in foreign capital and currency exchange markets. These external shocks can have a significant and immediate impact on their inflation, economic growth and employment performances compared to that of the larger economies with flourishing non-trade sectors. Finance ministers are, therefore, continuously challenged to provide attractive investment climates (i.e. premium interest rates and stable fixed currency regimes (pegged to the U.S. dollar)) and well-disciplined monetary and credit conditions. Moreover, as the government's fiscality is heavily dependent on tariffs, some measure of independence and manoeuvrability through fiscal policy is also lost, despite the greater vulnerability and instability of their economies.

The Committee heard many witnesses arguing that special status and treatment be granted to small economies. One such appeal went as follows:

Canada needs to take leadership in recognizing the great diversity of economies and size and development levels in the hemisphere, again, as others have pointed out, recognizing that this diversity of development needs and size requires a differentiated approach to trading rules. Rather than working for a kind of one-size-fits-all hemispheric trade agreement, we need to be arguing for particular kinds of policies and trade and investments that better suit smaller economies - different timetables for those economies that have different levels of, for example, indebtedness; different diversity of their export base. [Gauri Screenivasan, 23:1630]

In the Committee's opinion, special circumstances demand special considerations. If an FTAA is to include small economies, there must be attractive provisions, particularly given that most of these countries already have preferential access to North American markets under the Caribbean Basin Initiative and the CARIBCAN. The Committee is aware of a number of available options:

1. lower levels of obligations (on a product-by-product basis);

2. best endeavour commitments (similar to the WTO);

3. exemptions from commitment in certain areas (i.e. subsidies);

4. flexibility in the application of disciplines (similar to the WTO balance of payments exception clause); and

5. asymmetrical implementation (longer tariff and non-tariff barrier phase-out periods).

Each of these options have their own sets of advantages and disadvantages, but, to the Committee, it would be preferrable to have every country subject to the same rights and obligations, as an FTAA would be rather arbitrary otherwise. The Committee was told by Canada's FTAA Chief Coordinator:

The single undertaking concept means that at no matter what ... the elements, the final package is a whole ... It was decided that we would wait until we had the whole package, whereas the smaller countries are saying that they can agree ultimately to this but they'd like differential treatment in the number of years during which we would apply it. [Kathryn McCallion, 23:1145]

On principle, then, the Committee recommends:

9. That the Government of Canada maintain its current position that a Free Trade Area of the Americas agreement is a single undertaking, whereby signatories must accept all and not just parts of its negotiated terms. That this agreement include negotiated concessions to small economies.

Technical Challenges to an FTAA

The terms of a free trade agreement are not the only source of challenge to small economies, so is the negotiation stage of such an agreement. The Committee recognizes that trade agreements of any sort require the marshalling of substantial information and negotiating talent that are indeed scarce. Small economies are particularly burdened by the managerial requirements of identifying and pursuing their negotiating priorities; so much so that, from their perspective, an FTAA could be of dubious value. As one experienced witness succinctly put it:

Brazil has a capacity or resource problem in terms of negotiation. Brazilian magazines recently highlighted that whereas the Americans could mobilize 50 or 60 negotiators for each issue, the 15 Brazilians had to negotiate all of them. There are therefore problems of capacity, political will, strategy and support, both in the private sector and in the unions and organizations in the civil society. ... [B]eyond those countries, most of the economies in Latin America are rather small. We often forget, for example, that the Chilean economy is about the same size as that of the island of Montreal and that many other economies are smaller. These governments therefore have a very limited capacity in terms of negotiations and trade policy and must negotiate at the sub-regional, global and Free Trade Area of the Americas levels, and this places a heavy burden on them. [Jean Deaudelin, 27:1610]

While some cynics might suggest that this is not a problem for Canada, but is a Latin American and Caribbean problem, the Committee thinks otherwise.

We're asked sometimes if it isn't easier to negotiate with someone who doesn't know how to negotiate, and you could answer, "yes, it is, because we just overwhelm them," but the real answer is "no, it isn't" because there's no sense in having an agreement on paper if they're not ready to implement it. [Kathryn McCallion, 23:1145]

There were two identified solutions to this problem: (1) the pooling of resources among countries by sub-region and (2) trade-related technical resource and financial assistance.

[T]here is some kind of safety, if you will, in numbers or economies of scale in research. For the smaller Caribbean economies or some of the Central American economies, there is no alternative but to do a lot of their negotiations together. That's where capacity-building comes in. ... If in fact poor small countries are going to play in the larger FTAA and WTO process, there are going to be three prerequisites. One is a civil society where issues are debated openly and critically. The second is indigenous analytical capacities to assess policy change. The third is the financial, technical, and human resources countries will need to adapt to this change. [Rohinton Medhora, 28:1625-1650]

The Committee agrees, but more is still needed. Financial and other resource assistance is required for small economies of the hemisphere, but there need not be any new regional funding mechanisms and authorities created as a consequence. The region already enjoys plenty of them. The Committee, therefore, stands by Recommendation No. 8 as being sufficient to the task.