What is a free trade agreement? A complete guide

Alibaba.com SEPTEMBER 23, 202110 MIN READ
What is a free trade agreement? A complete guide

Trade between countries is inevitable. There are so many reasons for this. Among the reasons include the fact that it’s unlikely for a country to produce every single product or service that its citizens need. Another important reason is that available products produced in-country may not be able to satisfy the market demand of the citizens. Of course, the list is endless.

Countries trade with one another; that’s a fact. Many countries have put in place policies or trade barriers to regulate products to and fro within their borders. These policies not only inhibit the free flow of goods, but they may also make the cost of doing business higher.

For ease, many countries have introduced policies to lessen the ‘bureaucracy’ between them and other countries. This policy is generally known as a “free trade agreement” or a free trade treaty.

What is a free trade agreement?

A Free Trade Agreement (FTA) or Treaty is an international agreement to form a free-trade area between agreeing countries. FTAs are trade pacts that seek to ease the regulation, tariffs, and duties that governments impose on imports and exports.

In other words, any policy may be called a free trade agreement (FTA) if it is a ‘pact’ between two or more countries concerning the lessening of some obligations that affect trade in goods and services. This also includes protections for investors and intellectual property rights.

The general aim of FTAs is to encourage international trade and promote a stable investment environment by reducing or eliminating trade barriers.

Aside from establishing an agreement for preferential tariff treatment, free trade agreements also often include treaties on the facilitation of trade in areas such as investment, intellectual property, government procurements, standards, sanitary and phytosanitary matters.

For manufacturers, investors, wholesalers, or retailers of goods, FTAs will allow ease of access to consumers or businesses in other countries. By creating an entry for you into the global marketplace through zero/reduced tariffs, among other provisions, FTAs make it easier and cheaper for you to export or import products and services to other countries.

Types of free trade agreement

Trade agreements can be in three forms: unilateral, bilateral, or multilateral.

  • Unilateral Trade Agreement

    A country on its own can formulate a trade ‘agreement’ to bind other countries. These kinds of agreements are called unilateral free trade agreements. This may happen if a government unilaterally eases trade restrictions. A country may make these kinds of free trade agreements because they want to solve a particular need. It may also be to encourage foreign direct investments (FDIs).

  • Bilateral Trade Agreements

    Unlike unilateral agreements, bilateral agreements involve two countries that agree to set policies that ease trade restrictions or barriers. Products popularly involved in trade agreements include protected or government-subsidized domestic industries, especially those in the genre of automotive, oil, or food production industries. Bilateral free trade agreements expand business relationships or opportunities between the two countries.

  • Multilateral Trade Agreements

    Free trade agreements may also be on a broader scale and involve more than two countries. These are called multilateral agreements – and are usually the most complex to negotiate. This is, no doubt, because multilateral agreements cover a wider geographic area. All the countries in the pact grant one another mutual trade tariffs, terms, or concessions.

Levels of free trade agreement

In addition to being unilateral, bilateral, or multilateral, FTAs also come in variations based on the form or nature of the agreements. Some of these are identifiable as:

  1. Regional trade agreement (RTA) or “free trade area”;
  2. Special trade agreements
  3. Customs unions;
  4. Common markets; and
  5. Economic unions.
  • Regional trade agreements: These are a form of multilateral free trade agreements. Here, FTA countries promote transparent trading among one another. They do this by forming an international pact towards facilitating the movement of goods and services between them.
  • Special Trade Agreements: Most trade agreements cover broad products or services. Special trade agreements are specific and only concern lessening or eliminating trade barriers on a particular product. A country may agree with another country for the importation of only the named goods/product.
  • Customs Unions: These are arrangements between more than two countries to allow free trade on products within the customs union. A customs union is different from a regional trade agreement because the parties agree to a “common external tariff” (CET) on imports from non-member countries.

    One example of a customs union is the trade pact between Russia, Belarus, and Kazakhstan formed in 20101. However, note that the ease of ‘regulations’ is on products; customs unions policies do not cover the free movement of capital and labor among member countries.

  • Common markets: Similar to customs unions, common markets work towards eliminating tariff barriers between members and adopting collective external barriers against nonmembers. Unlike customs unions, however, common markets policies include regulations like the free movement of resources and labor among FTA countries. The economic policies of the Economic Community of West African States (ECOWAS) is a typical example of a common market.
  • Economic Union: This is unarguably the highest level of free trade agreements. In an economic union, two or more countries agree to formulate policies that ease the free movement of goods and services as well as factors of production, such as capital and labor. Additionally, the FTA partners also share standard financial and fiscal policies. Not only are communal internal barriers and tariffs eliminated, but the FTA countries also adopt common economic policies and mutual external barriers. The European Union (EU) is a popular example of an economic union.

How do free trade agreements work?

The main goal of free trade agreements is to enhance trade relationships on the import and export of goods and services. The agreement is often initiated unilaterally or by the formal and mutual agreement of the FTA parties involved. In most cases, enforcements of FTAs are managed by the World Trade Organization (WTO).

On a large scale, FTAs allow countries or foreign markets to focus on producing or selling the goods they have in abundance; while allowing other producers to import products that are scarce or unavailable in their country. Local production of goods and foreign importation of goods often work together to boost the economy of an FTA country.

However, it is often argued that the best free trade policy may simply be the absence of any trade barrier. A country without barriers or restrictions can be said to be practicing a ‘laissez-faire’ or trade liberalization unilateral trade agreement. Nonetheless, most countries already have conditions or development of product standards on imports and exports to protect their local economy.

An FTA can be actualized through two distinct ways:

  • Reduction of trade barriers, such as tariffs and quotas; and
  • Imposition of regulations or standards for products.

Governments with free-trade policies or agreements in place do not necessarily abandon all control of imports and exports or eliminate all protectionist policies. Also, a country may allow free trade with another country, with exceptions that forbid some products. In reverse, the FTA might have policies that exempt some products from tariffs.

It should, however, be noted that free trade agreements can also cover a wide variety of government activities and include policies on the free movement of individuals. In the E.U, for instance, FTAs mean that individuals from the FTA countries can travel and work in any other EU country.

5 advantages and 3 disadvantages of free trade agreement

Free trade agreements have their pros and cons, depending on where you’re looking at them from. Here are some of the advantages of FTAs:

  1. Economic Growth – Whether there’s total free trade or lessened barriers on imports and exports, FTAs will generally lead to steady economic development.
  2. Increases Consumer options – Restrictions like tariffs and quotas are often placed on the importation of goods to protect local businesses. While this is ideal, such restrictions may lead to over-inflation of the value of the incoming products. Free trade agreements increase the competition, which will eventually lead to less expensive products for consumers.
  3. Transfer of Technology and Expertise – Products with higher technology and efficiency in other countries will be available. Other than products, an FTA will also offer the local workforce the opportunity to be trained by multinational companies with new skills, technology, and infrastructure.
  4. Reduced government spending – The implementation of free trade policies will ultimately lead to reduced government spending, especially on the necessary goods subsidized by the government due to their high cost.
  5. Increases Foreign Direct Investment (FDI) – Lesser trade restrictions equal more extensive relationships between local and foreign businesses.

As with advantages, free trade agreements also have several disadvantages. Some of the major ones are highlighted here:

  1. Outsourced jobs or business opportunities – A significant criticism of free trade agreements is that by lessening restrictions on importations rather than protecting local businesses, local jobs will be lost to foreign countries.
  2. The curse of transfer of technology and expertise – Even though tech transfer is an advantage, it also has its cons. Intellectual property rights in a developed country may not be as effective in less developed countries. Intellectual theft or ‘copycat’ is the other side of the coin. Foreign companies with superior-tech or expertise frequently fight competition with knock-offs or imitations of their products.
  3. Reduced Revenue – Governments forfeit huge revenues in tariffs, taxes, or dues when they enter into a free trade agreement. Developing countries with lesser manufacturing capacity relying on income from imported goods will have to find alternative means.

Examples of free trade agreements

Almost every country has entered into all types of free trade agreements. Most countries have implemented unilateral free trade policies to allow for the importation of necessary products or services.

An example of bilateral FTAs is the trade pact the U.S made with several countries in 20192. Also, Australia and the U.S also have an AUSFTA pact that eliminates tariffs on a range of agricultural and textile exports and imports between the two countries. Another prominent example of a bilateral trade agreement is that of China and the Association of Southeast Asian Nations (ASEAN)3. It is a regional trade agreement signed in 2002 and implemented in 2005.

As said earlier, multilateral trade agreements involve more than two countries. The North American Free Trade Agreement (NAFTA) is a popular example of a multilateral treaty. NAFTA was signed in 1992 between the U.S., Mexico, and Canada.4 It allows free movement of goods, without export or import tariffs, among the FTA countries.

Other prominent regional or multilateral trade agreements exist between:

  • Association of Southeast Asian Nations (ASEAN) which provides the free exchange of trade, service, labor, and capital across ten independent member nations;5
  • The Asia-Pacific Trade Agreement (APTA);6
  • The Central American Free Trade Agreement (CAFTA) covers most of the nations of Central America (Costa Rica, Dominican Republic, Guatemala, Honduras, Nicaragua, and El Salvador);7
  • The United States-Mexico-Canada Agreement (USMCA) was signed to replace the North American Free Trade Agreement (NAFTA).8

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The existence of free trade agreements among countries means that you can sell your products to businesses or consumers in another country. This may even be at a higher profit compared to what you would sell them for locally.

To access foreign businesses, however, you need an e-commerce platform that eases the cost of doing business.

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1. https://www.ucentralasia.org/Content/Downloads/UCA-IPPA-WP12-TradeCreationAndDiversion-Eng.pdf
2. https://ustr.gov/trade-agreements/free-trade-agreements
3. https://www.tid.gov.hk/english/ita/fta/hkasean/index.html
4. https://www.international.gc.ca/trade-commerce/trade-agreements-accords-commerciaux/agr-acc/cusma-aceum/index.aspx?lang=eng
5. https://archive.unescwa.org/association-southeast-asian-nations-free-trade-area
6. https://www.unescap.org/apta
7. https://www.sieca.int/index.php/economic-integration/economic-integration/free-trade/free-trade-agreements-in-central-america/?lang=en
8. https://ustr.gov/trade-agreements/free-trade-agreements/united-states-mexico-canada-agreement