Why MFN matters – a message to the UK Government

There have been reports this week that the UK Government is considering lowering its tariffs on cars imported from the US, in an attempt to strike a trade deal. This has not been officially confirmed but neither has it been explicitly ruled out. It would be extremely difficult, however, for the UK to do so and remain compatible with the World Trade Organization (WTO) rules. In a recent blog, we suggest five steps that countries should take in the face of the pressure from the United States, and maintaining compatibility with WTO rules is one of those. The UK Government is strongly urged to follow these five steps.

The MFN clause stands for ‘most favoured nation’. It is a simple but extremely powerful principle. It basically enjoins countries not to discriminate between each other in their trade policies. Hence, setting an import tariff of 10% on the imports of widgets from India, and a tariff of 20% on the imports of widgets from China would contravene the MFN clause. Under that clause, the tariff that a country offers the most favoured nation (India in this example) also has to be offered immediately and unconditionally to all other countries that are members of the WTO (China in this example).

The MFN principle underpins the international trading system we have today. It is worth noting that the WTO does not force this upon countries. The principle is one that the countries agreed between themselves to adopt, and countries choose whether or not to be a member of the WTO. There are currently 166 countries which are members covering close to 98% of world trade.

The MFN principle is important for several reasons:

1. Economic efficiency

• Take the widgets example above, and suppose China was a more efficient producer of widgets. If the tariff on China was higher than the tariff on India, the importing country could end up importing from India, even though China is a more efficient producer. The differential tariffs would result in countries buying from less efficient producers, which in turn is not good for the importing economy. The MFN principle has been a key element in the economic growth we have witnessed since World War II.

• If discrimination between countries were allowed, to levy the correct tariffs countries would also need to be able to prove the country of origin of each good. Rules of ‘origin’ would thus be needed. This is bureaucratically complex and significantly raises costs for firms.

2. Predictability: Treating all countries the same makes the world trading system, not only more stable but also much more predictable, which in turn is more likely to stimulate investment and future economic growth.

3. Trade barrier reduction: The MFN clause encourages countries to negotiate and sign multilaterally, which results in agreements that apply to all, and is a means to lowering trade barriers globally, which encourages specialisation and boosts productivity and economic growth.

4. Stability: Not adhering to the MFN principle, and discriminating between countries, makes it more likely that trade disputes will arise as countries vie for ‘better’ access. It is thus much more likely to lead to protectionist trade wars. Indeed, the fact that trade has been liberalised under the GATT and subsequently the WTO for over 70 years without extensive trade wars is in good part a result of adhering to the MFN principle.

5. Fairness: Treating countries equally makes it more likely that smaller, weaker developing countries are not discriminated against by the larger more powerful economies.

Allowable exceptions to the MFN principle

There are allowable exceptions to the MFN principal under WTO rules. Most notably Free Trade Agreements, if they cover ‘substantially all trade’ (with zero internal tariffs) allow for a greater degree of liberalisation between the partner countries. ‘Substantially all trade’ is not clearly defined but is typically accepted to mean that 90% of the trade between the partner countries is covered. Hence, it would not be possible to sign an agreement which just covered one industry, say cars, and call this a WTO compatible FTA. Countries may also offer preferential access to developing countries, provided again this is not done in a discriminatory manner between the developing countries.

Countries are also allowed under the WTO to levy discriminatory tariffs against countries under a set of well-defined circumstances. These are on (narrowly defined) grounds of national security; in the event of a sudden surge of imports from another country which is causing injury to the domestic industry (safeguard measures); or where firms from a country are ‘dumping’ its products in another country at less than market value (anti-dumping duties), and or because of unfair subsidies (countervailing duties). There are also some narrowly prescribed exceptions for non-economic objectives necessary to protect public morals, human, animal or plant life or health, or to the conservation of exhaustible natural resources but these cannot be levied on a discriminatory basis.

The US ‘reciprocal tariffs’

From the preceding it is clear how the action of the US administration runs counter to the rules of the WTO along several dimensions. First, they contravene the MFN principle. The reciprocal tariffs announced on April 2nd by President Trump explicitly levied differential tariffs on different countries; more recently, there are reports that car producers in the US may be exempt from some of the tariffs on China – hence there would be differential tariffs not just by country but also depending on which industry is doing the importing. Secondly, they ignore or contravene the WTO rules for the invoking of any of the exceptions.

Having one major player in the world trading system – the US – ignore the rules of the game is bad enough. What is even worse is that the US is encouraging its trading partners in response to sign up to deals which may also contravene the WTO rules. This would be a major mistake for countries to make.

If the UK did want to lower its tariffs on imports of cars from the US, to be WTO compatible, the UK would either need to lower its tariffs for all countries – hence upholding the MFN principle, or would need to sign a free trade agreement that covered substantially all trade. Both these outcomes would appear unlikely - hence the reports that the government is considering this are concerning.

Once countries start to flout the WTO rules this is likely to have a domino effect with extremely damaging consequences for the international trading system, and for future economic stability and economic growth. This is a time for collective action, and a key element is to play by the rules of the game as much as possible even under current unprecedented circumstances.