Question

The biggest economic news in recent history is the formation of the biggest free trade area in the world (the African Continental Free Trade Area, AfCFTA). The UN asserts that the economic bloc currently have a combined business and consumer spending of $4 trillion.

a. Discuss how AfCFTA could be trade creating free trade area. What are the welfare gains? Support your answer with the relevant diagram

b. What if AfCFTA is a trade diversion free trade area? Will this worsen welfare for the bloc? Provide diagrammatic support for your response

Please note that all information is provided and that both parts require diagrams.

Answer 1

To answer the question we first understand that what actually is AfCFTA.

The African Continental Free Trade Area (AfCFTA) is a free trade area which, as of 2018, includes 28 countries.It was created by the African Continental Free Trade Agreement among 54 of the 55 African Union nations. The free-trade area is the largest in the world in terms of the number of participating countries since the formation of the World Trade Organization. Accra, Ghana serves as the Secretariat of AFCFTA and was commissioned and handed over to the AU by the President of Ghana His Excellency Nana Addo Dankwa Akuffo Addo on August 18, 2020 in Accra.

The agreement was brokered by the African Union (AU) and was signed on by 44 of its 55 member states in Kigali, Rwanda on March 21, 2018. The agreement initially requires members to remove tariffs from 90% of goods, allowing free access to commodities, goods, and services across the continent. The United Nations Economic Commission for Africa estimates that the agreement will boost intra-African trade by 52 percent by 2022. The proposal was set to come into force 30 days after ratification by 22 of the signatory states. On April 2, 2019, The Gambia became the 22nd state to ratify the agreement, and on April 29 the Saharawi Republic made the 22nd deposit of instruments of ratification; the agreement went into force on May 30 and entered its operational phase following a summit on July 7, 2019.

a. Method of Analysis:

The theoretical literature as summarized above shows that the net welfare (and trade effect) of a free trade agreement (FTA) such as the AfCFTA is an empirical question. For this purpose, we have employed two approaches. The first approach is based on the use of various trade indicator 8 indices to infer about the implications of the AfCFTA on the possibility of trade creation and diversion. Since this approach may not offer us a complete picture, we have complemented this by an econometric approach using a gravity model. It is hoped that the two approaches jointly will shed light on the implications of the proposed AfCFTA on African merchandise trade. The Trade Index-based Approaches Trade indicator indices are the simplest ex-ante methods for evaluating the economic effects of joining proposed FTAs. Using this approach, we will focus on answering the following questions: a) To what extent is African trade intra-regional? Or are African country’s exports of goods regionally oriented? b) How similar (or overlapping) or not are the exports of a given pair of proposed AfCFTA members? c) What is the comparative advantage of each AfCFTA members? The index-based empirical analysis in the first part of this study aims to answer the above questions using the indices summarized below. These indicators are important to evaluate the impact of AfCFTA because tariff reduction is the necessary but not sufficient condition for trade expansion. A positive evaluation of the potential trade effect using these indicators is among the sufficient conditions required to infer about the potential benefits of AfCFTA.

The Gravity Model-based Approaches

The gravity model has widely been used to identify determinants of bilateral trade, though it is often criticized for lacking a strong theoretical basis (Alemayehu and Edris, 2015). However, Anderson (1979), Bergstrand (1985), Deardorff (1998), and Feenstra et al (1998) have each developed the theoretical foundations to formally derive the model. With this development, in a typical gravity model, bilateral trade flows are determined by the size of the two economies and the distance between them. However, it is always possible to expand the model to include other relevant determinants of trade.

Once the model is estimated the model is used for a simulation exercise to evaluate the trade effect of tariff reduction among the members of the AfCFTA. This is done by examining the tradediversion and trade-creation effects by following a dummy variable approach (where the dummy is switched-on when pair of countries belongs to an FTA, and off when they don’t) and its use an in Carrera (2004). We also use the result from the import price elasticity included in the model.

This model is estimated using bilateral export panel data of African countries. The log-linear OLS estimates of gravity mode are found to be biased. Thus, the model will be estimated using Psedo 10 Poisson Maximum Likelihood (PPML) method that addresses the problems associated with the use of OLS and a log-linear model (Silva and Tenreyro, 2006).

The assertion by many policymakers that regional integration can strongly contribute to economic development is supported by economic theory and quantitative evidence. We also show in section 3 that, in the long run and at the aggregated level, African countries benefit from the CFTA

B.

A major potential challenge in harmonizing Africa’s heterogeneous economies under one agreement is the wide variation that exists in their levels of development. For example, over 50% of Africa’s cumulative GDP is contributed by Egypt, Nigeria and South Africa, while Africa’s six sovereign island nations collectively contribute just 1%.

The AfCFTA has the greatest levels of income disparity of any continental free trade agreement, and more than double the levels witnessed in blocs such as ASEAN and CARICOM.

Further challenges

1. Increased competitive pressure

Many emerging African markets are traditional economies that rely on farming for employment. These small family farms can't compete with large agri-businesses in high-income African countries such as South Africa, Kenya, Ethiopia, Egypt and Nigeria. As a result, they may lose their farms, leading to high unemployment, crime and poverty.

2. Choking of local SMEs

Consumers always prefer cheaper products. This may lead to local producers losing huge sales to foreign suppliers, because the latter can lower the cost of their products by leveraging the reduced tariffs imposed on imported goods.

3. Adverse working conditions and job losses

Labourers from poorer countries may be forced to work long hours and to live in shanties without basic amenities such as drinking water and electricity, in order to send money to their families. Some workers might even be forced to accept lower wages and be prevented from joining labour unions, under threat of losing their jobs.

This may explain why the Nigerian Labour Congress (NLC), in their refusal to endorse the agreement, describes the trade agreement as a "renewed, extremely dangerous and radioactive neo-liberal policy initiative".

4. Environmental depletion

Tough competition may lead some companies to disregard the environment when it comes to making products and disposing of waste, just so they can survive in their industry. Many SMEs are likely to cut costs, including those related to manufacturing and the proper dumping of waste.

5. Theft of intellectual property

Many African countries don't have laws in place that protect patents, inventions and new processes. The laws they do have aren't always strictly enforced. As a result, companies' ideas often get stolen. With the AfCFTA, this could get worse, leading SMEs to invest poorly in research and development.

Without comprehensive policy-making and preferential treatment for Africa’s most at-risk economies, the AfCFTA could prove to be a force for economic divergence, rather than a force for good. It is therefore important that participating countries build an efficient and participatory institutional architecture to avoid leaving any economies behind.

To increase the impact of the trade deal, industrial policies must also be put in place, especially those concerning SMEs and manufacturing. These must focus on productivity, competition, diversification and economic complexity.

Furthermore, individual countries under the agreement should introduce policies that address the concerns of labour unions, encourage healthy competition without killing local businesses, ensure strict adherence to waste disposal and protect intellectual property.