MFN Obligation

Introduction

“The MFN Obligation is fundamental to trade liberalisation and to understand the obligation is to travel a good distance down the road of understanding much of GATT.”

Once we get past the question, by answering or simply ignoring, of why liberalise trade, it may be said that the most favoured nation (“MFN” clause) has been conceived by the GATT as a means of liberalising trade (such as tariffs) as well as any domestic instrument which affects trade has to respect this principle. MFN trade is one of the most practical ways of going about liberalising trade is put forward by Schwarz and Sykes who argue that in the absence of MFN lay the risk of what is called “concession erosion” (the value to country A of concessions negotiated between countries A and B, risks being eroded through subsequent negotiations between countries B and C if country B concedes to country C more than it did to country A).

The meaning of “Most Favoured Nation principle”, under the WTO agreements, is that countries cannot normally discriminate between their trading partners. If a country chooses to grant someone a special favour (such as a lower customs duty rate for one of their products) it is bound to do the same for all other WTO members. Its significance can be inferred from the fact that it is the first article of the General Agreement on Tariffs and Trade (“GATT”), which governs trade in goods. MFN treatment is also a priority in the General Agreement on Trade in Services (“GATS”) (Article 2) and the Agreement on Trade-Related Aspects of Intellectual Property Rights (“TRIPS”) (Article 4), although in each agreement the principle is handled slightly differently. Together, those three agreements cover all three main areas of trade handled by the WTO. Although this project is limited to discussing the MFN with respect to GATT only, the concept of MFN itself is nothing new and has been common to bilateral trade agreements prior to GATT as is evident from a plethora of writings on the subject of its history and evolution. Around the 1930s, a number of forces were responsible for choking the MFN principle. This broke up the world into trade blocs and culminated in the World War II. After this, the GATT permanently included the MFN clause on a multilateral basis and contributed to the stability of trade around the world. Post-GATT, regional integration and such exceptions allowed under the WTO should be formulated prudently without any contravention of the MFN principle as a fundamental principle of WTO. There are permissible exceptions to the MFN clause in the WTO. For example, countries can set up a free trade agreement that applies only to goods traded within the group — discriminating against goods from outside. Special access granted to developing countries into the markets is another significant exception. Countries can raise barriers against products that are considered to be traded unfairly from specific countries. And in services, countries are allowed, in limited circumstances, to discriminate. There are strict conditions applicable to these exceptions. In general, MFN means that every time a country lowers a trade barrier or opens up a market, it has to do so for the same goods or services from all its trading partners — whether rich or poor, weak or strong. After signing the GATT, the choice of imposing differential tariffs, in a very important sense, no more rests with countries. It is a voluntary contract that surrenders such a right and not to engage in acts that either violate the terms or are not in conformity, even if they do not violate, with the expectation of mutual gains each party has about the behaviour of others.

Even in the absence of conformity, an act by one contracting party has to be viewed as discriminatory if and only if the act is ‘unfavourable, injurious or calamitous’ in the sense of reducing the gains of one or more of the other contracting parties. Any such agreement, if it is to be meaningful, has to include a definition of an adverse discriminatory act and specify a remedial action. The determination of the adverseness or otherwise of an act from the perspective of the agreement will naturally depend on an identification of their interests that parties view as being promoted (and protected) by the agreement. The focus of this project is to examine whether the MFN rule has truly encouraged non-discrimination amongst various countries, which was its purpose to start with.

The project is confined to studying the MFN rule and any other provisions of the WTO which may also be closely related to the non-discrimination principle, unless directly related to MFN, will not be an interest to this study. Secondly, MFN treatment will not be discussed in the context of bilateral agreements. However, the aspect of non-discrimination being eroded on account of preferential-trade agreements allowed under the WTO will be of crucial interest to this study since this is the primary area that conflicts with the MFN principle. Another significant focus of this project will be the exceptions allowed in respect of the MFN in the GATT and the bearing it has on the goal of non-discrimination.

The Concepts Of MFN And Non-Discrimination And Their Interrelation

Although the ambitious statement on MFN which states that no less favourable treatment may be granted to one foreign product than to any other foreign like product is present in Article I:1 of the GATT provisions, there are a number of other provisions which incorporate various other aspects of MFN: Article III:7 (internal mixture requirements); Article IV (b) (cinema films); Article V:2, 5-6 (transit of goods); Article IX:1 (concerning marks of origin); Article XIII:1 (concerning permissible quantitative restrictions); Article XVII:1 (concerning state trading enterprises); Article XVIII:20 (concerning governmental assistance to economic development); Article XX (j) (concerning good short in supply). In a very brief sense, the obligations under A.I:1 is one of non-discrimination, i.e. no WTO member is to discriminate on international trade matters against another or other WTO members. It might be useful to study the MFN principle and its relationship with the non-discrimination principle after a concrete conceptual understanding of the two.

Origins Of The Non-Discrimination Principle

For the first time in the nineteenth century, non-discrimination articles began appearing in trade treaties being negotiated. In the mid-1940s, the League of Nations drafted two model tax treaties that each included a broadly-worded non-discrimination provision. A subsequent non-discrimination provision was included in an Organisation for Economic Cooperation and Development (“OECD”) model, and this time, the concept of non-discrimination had become much more limited. In its comments on the draft clause, the Fiscal Committee of the OECD remarked by way of explanation as to the purpose of the clause that “it is important that Member countries’ adhesion to the principle of no discrimination for nationality reasons should be clearly embodied in the texts of their double taxation Conventions in view, particularly, of the force of example that this can have for their relations with third countries”.

The WTO members bind their classic trade instruments and are free to define unilaterally all other policies which might affect trade (that is, even external), provided that they respect the principle of non-discrimination. The term “Trade instruments” is understood as tariffs and quantitative restrictions, of which the latter are prohibited on the import as well as the export side and the former are first bound and then reduced through unilateral negotiations. Under the GATT, an act by one contracting party has to be viewed as discriminatory if and only if the act is ‘unfavourable, injurious or calamitous’ in the sense of reducing the gains of one or more of the other contracting parties. Any such agreement, if it is to be meaningful, has to include a definition of an adverse discriminatory act and specify a remedial action. The determination of the adverseness or otherwise of an act from the perspective of the agreement will naturally depend on an identification of their interests that parties view as being promoted (and protected) by the agreement.

The Basic MFN Obligation: A Brief Overview

The best starting point for a discussion on the MFN obligation would be Article I.1 of GATT:

“With respect to customs duties and charges of any kind imposed on or in connection with importation or exportation or imposed on the international transfer of payments for imports or exports, and with respect to the method of levying such duties and charges, and with respect to all rules and formalities in connection with importation and exportation, and with respect to all matters referred to in paragraphs 2 and 4 of Article III, any advantage, favour, privilege or immunity granted by any contracting party to any product originating in or destined for any other country shall be accorded immediately and unconditionally to the like product originating in or destined for the territories of all other contracting parties.”

It is an easy inference that non-discriminatory tariff treatment applies only if “like products” are at issue, and only if such products are imported from another, or other, contracting parties – i.e., WTO Members. J. Jackson, while relating the MFN with economic rationales writes that MFN often causes a generalisation of liberalising trade policies, so that overall more trade liberalisation occurs (the multiplier effect of the MFN clause).

However, there are number of difficulties in making a general argument in favour of MFN: a. such analysis inherently involves the comparison of distorted equilibria; b. we lack a discernible measure of the degree to which a structure fulfils MFN; c. there is no one-to-one relationship between MFN and the context (bilateral or multilateral) which it is agreed upon.

Article I does not contain an exhaustive list of policies that should come within its purview, but merely states standards that will provide legislative guidance to interested parties as regards its scope. One has to rely extensively on case laws to seek clarifications. The policies covered by Article I have been divided into two categories:

1. Border measures: These measures can be fiscal in character; for eg., customs and duties of any kind imposed in connection with importation or exportation. It includes omissions, methods of levying, anti-dumping duties and counter-vailing measures. It can also be non-fiscal in character and include rules and formalities in connection with importation or exportation. For eg., the use of a less complicated licensing procedure was considered an advantage within the meaning of Article I.1 of GATT.
2. Internal measures: By referring explicitly to Article III.2 and III.4 GATT, it is made amply clear that the MFN clause extends to cover internal measures as well. For eg., tax exemptions for products purchased by public bodies.

There is no burden on the complainant to show actual trade effects in order to establish a violation of Article I of GATT. It has been made clear by the panel in its report in EC – Regime for the Importation, Sale and Distribution of Bananasthat if favourable opportunities are created only for some members of the WTO, a WTO member violates its obligations under Article I GATT. It is also unnecessary to prove an intent to discriminate as long as the treatment afforded to two imported like products is differential.

The Free-Rider Problem

No discussion on MFN can be complete without taking into account the relevant justifications and problems. One such problem, described as the “free-rider problem” results from unconditionality of the MFN treatment. To borrow the illustration offered by Prof. Bhala, if, let us say, India has an arrangement of reciprocal relations with say, China, India does not have the liberty to extend its best tariff and non-tariff barrier treatment to China alone. It is instead, under an obligation to extend the same treatment to all other Members automatically, without taking into consideration whether they are willing to grant such concessions to India. The defence that is advanced in this regard is that if India feels that – say Singapore and Sri Lanka – are free-riding on its concessions, then it may choose not to offer these concessions to China in the first place, at least not unless it can manage to bring Sri Lanka and China to the discussion as well. The consequence of the MFN obligation not existing at all is less desirable: If India seals a deal with China, whereby China grants improved access to India, the concession might be eroded if China offers – say Pakistan – access on better terms compared to India.

There is a growing realisation that there is a fundamental need for a more balanced and informed debate within WTO member countries about the benefits as well as costs of reducing national barriers to trade. In the absence of more information about the costs of protection to the wider community, sectional interests in those countries – whether they be American steel millers, French cheese farmers or Japanese rice growers – will continue to meet with success at the cost of their own economies as well as ours. Emphasis should be given to the fact that the contribution of the GATT/WTO system has come as much from the order and stability that it brought to international trading relations – following the chaos of the 1930s – as from the reductions in trade barriers through successive negotiating rounds, important as these have been.

In particular, the 1st Article of the General Agreement — the MFN or non-discrimination clause — has played a key role in reducing trade conflict among nations, promoting efficient trade flows and reducing transaction costs.

Limitations And Exceptions To The MFN Rule

The discussion on exceptions to the MFN rule will depend largely on the parameters which define what constitutes an “exception”. A simple example of this would be the debate on Article XX, the chapeau of which requests WTO members to apply their laws in a non-discriminatory manner across jurisdictions where the same conditions prevail. However, the more well-established exceptions to the MFN rule are the preferential trade agreements (“PTAs”), the enabling clause which allows countries to treat developing countries in a preferential manner, the system of waivers etc. The concept of PTAs will be discussed in detail in the next chapter. The other exceptions will be the focus of this chapter.

The Chapeau And Provisions Of Article XX

Article XX lists general exceptions, under which countries may undertake measures that are necessary to protect public morals, human, animal or plant life or health; relating to importations or exportations of gold and silver; necessary to secure compliance with law, necessary to secure compliance with laws or regulations which are not inconsistent with the provisions of this Agreement, including those relating to customs enforcement, the enforcement of monopolies operated under paragraph 4 of Article II and Article XVII, the protection of patents, trade marks and copyrights, and the prevention of deceptive practices; relating to the products of prison labour; imposed for the protection of national treasures of artistic, historic or archaeological value, relating to the conservation of exhaustible natural resources if such measures are made effective in conjunction with restrictions on domestic production or consumption; undertaken in pursuance of obligations under any intergovernmental commodity agreement, involving restrictions on exports of domestic materials necessary to ensure essential quantities of such materials to a domestic processing industry during periods when the domestic price of such materials is held below the world price as part of a governmental stabilization plan; essential to the acquisition or distribution of products in general or local short supply.

The chapeau of Article XX is an instance of exceptions in the GATT, which take into account the prevalent international conditions at the time when it was drafted. The text of the chapeau reads:

Subject to the requirement that such measures are not applied in a manner which would constitute a means of arbitrary or unjustifiable discrimination between countries where the same conditions prevail, or a disguised restriction on international trade, nothing in this Agreement shall be construed to prevent the adoption or enforcement by any contracting party of measures…

The Appellate Body in its report on United States – Shrimp laid down the standards for compliance with the chapeau:

1. Not amount to an arbitrary discrimination between countries where the same conditions prevail;
2. Not amount to an unjustifiable discrimination; and
3. Not to be a disguised restriction to trade either.

On the subject of “between countries where the same conditions prevail”, the Appellate Body asked the question as to whether this clause should be understood as referring only to exporting countries or both importing as well as exporting countries in United States – Gasoline. However, since there was no challenge by Belgium or Venezuela to the United States’ interpretation of this clause as inclusive of both exporting and importing countries, the Appellate Body saw no reason to decide the application. This inevitably, leads to the construction that a state cannot treat its own products any differently than it treats the products originating in other WTO members, in case the conditions prevalent across the countries are the same. In the US – Shrimp report, the Appellate Body observed that because the United States had offered international negotiations to resolve problems encountered by the enactment of US Section 609 to some countries but not all. This was found to be inconsistent with the chapeau and subsequently, US had to give the same opportunity to all other shrimp exporters as well. As for the clause “disguised restriction of trade”, the panel in its report on EC – Measures Affecting Asbestos and Asbestos-containing Products held that the term effectively outlaws interventions that aim to promote interests that are not mentioned in the sub-paragraphs in the guise of protection of one of the grounds mentioned in the sub-paragraphs of Article XX of GATT. The panel emphasised that the key to understanding the clause is in the word “disguise” rather than “restriction” and therefore, any measure that falls within the purvey of Article XX would be scrutinized as a restriction if it attempts to abuse the Article.

Special And Differential Treatment To Developing Countries: The Enabling Clause And Part IV Of The GATT

If establishing an equal basis for competition for export markets was one of the goals of GATT agreement, the developing countries felt that this was in danger since the MFN rate provided for non-discriminatory access to export markets, regardless of the level of development of the exporting country. This was followed up by a resolution during the second session of UNCTAD on 26 March 1968, which set up a Special Committee on Preferences with a mandate to settle GSP arrangements. Thereafter, as per the GSP arrangements set up by the Committee, the GATT granted a 10-year waiver on 25 June 1971. Before the expiry of the waiver, the Contracting Parties adopted a decision on “Differential and More Favourable Treatment, Reciprocity and Fuller participation of Developing Countries” on 28 1979, which is known as the Enabling Clause. The Enabling Clause is now a permanent feature of the GATT and the WTO set-up. As a consequence of this, developing countries can avail of tariff preferences.

Although, it did not appear in the first edition of GATT, Part IV of the GATT demonstrates the intention to favour the weaker members of the agreement who did not start from the same line as others. The Harberler report circulated in 1958 came out in support of the assertion that the then existing rules on trade liberalisation would not necessarily work to the advantage of the less developed nations. The report was largely responsible in driving home the point to all the members that the trading partners had to be sensitive to the relative disadvantages that the lesser developed nations were afflicted with. Development was not to be understood without taking into account these countries. These observations received the required momentum with the coming of the Kennedy round of international trade negotiations (1962-1967) which led to the Part IV coming into effect with three new legal provisions:

1. Principles and Objectives (A.XXXVI GATT)

The relevant part of the Article which summarises its objectives states that the developed contracting parties do not expect reciprocity for commitments made by them in trade negotiations to reduce or remove tariffs and other barriers to the trade of less-developed contracting parties.

2. Commitments (A.XXXVII GATT)

It is a general clause recommending various actions that the developed countries should take in order to promote the interests of the developing countries, primarily incitation to reduce the gap between barriers on processed goods and barriers on primary products. The Uruguay Round made it legally binding upon the developed countries to have special regard to the trade interests of the developing countries and take into account all the possibilities before applying countervailing or anti-dumping measures.

3. Joint Action (A.XXXVIII GATT)

Rather than binding legal obligations unless explicitly stated so, Part IV is to be construed as “best endeavours clauses”. Towards the objectives sought to be achieved by this part, institutional arrangements were to be made with the help of collaborating with the United Nations and its organs to monitor the rate of the growth of the trade in developing countries.

Waivers

Article XXV.5 GATT provided the possibility of nations having their obligations “waived” for a predefined period of time, provided the voting requirements were met. Article IX now regulates the granting of waivers, with the advent of WTO.

Ptas As An Impediment To The Effectiveness Of Multilateral MFN Trade

Preferential Trade Agreements are what have for long been known under the name of “regional integration”. There is evidence of a sudden proliferation of Preferential Trade Agreements. The strategic objectives of Preferential Trade Agreements are not entirely in line with the objectives of MFN. However, the presence of the two in the same treaty leads to interesting consequences, to say the least.

The First Sparks Of Preferential Trade Agreements

The term “regional integration” often used in trade-related literature can be misleading if understood as conveying geographical proximity. As a matter of fact, one-third of free trade areas currently under scrutiny are cross-regional; significant examples being The European Community – Mexico, the Singapore – New Zealand, the Mexico – Japan free-trade areas (“FTAs”). The term “preferential trade agreements” (PTAs) better reflects the objective of these arrangements. The burgeoning number of PTAs is a recent phenomenon, most of them having come into existence only after 1993. The European Community was the earliest trailblazer of this trend and the two reasons why it pioneered this practice are first, it saw some of these countries as candidates for accession into the vestibule of the European Community and some were ex-colonies of individual members of the European Community; secondly, this practice reaffirmed the unified European persona in the eyes of the world.

In the initial days of PTAs, economists viewed them with much scepticism, arguing that they would divert trade more than create it. Infact, there was empirical backing for such an argument. However, the Kemp-Wan theorem showed that trade diversions could be eliminated by reducing external tariffs so as to keep trade with non-PTA members unchanged and also the countries participating in the PTAs would be better-off, although there was no real welfare-maximization from the world perspective. Summarily, the chief motivation for countries to enter into PTAs was there frustration with the slow pace of liberalisation at the multilateral level.

Free Trade Areas And Customs Unions

The United States took a leaf out the European Community’s copybook in that it forged a series of agreements with states in the American Continent; it started with Canada, went through NAFTA and culminated in the FTAA (Free Trade Area of Americas).

The primary distinction between Free Trade Areas and Customs Unions is that the latter, in addition to freeing trade among themselves, must set the same external tariff for imports from countries that are not members of the CUs.

The GATT does not concern itself directly with the motives of countries entering into PTAs or the welfare implications of such arrangements. The Article XXIV merely lays down a yardstick for determining the consistency of a FTA or a CU as against multilateral rules. Para 4 of the Article somewhat sets the theme for PTAs:

The contracting parties recognize the desirability of increasing freedom of trade by the development, through voluntary agreements, of closer integration between the economies of the countries parties to such agreements. They also recognize that the purpose of a customs union or of a free-trade area should be to facilitate trade between the constituent territories and not to raise barriers to the trade of other contracting parties with such territories.

The consistency of any FTA or CU can be reviewed with help of the following tracks:

Track I: WTO members have to notify all regional schemes to the WTO Committee on Regional Trade Arrangements (CRTA).

Track II: The WTO members may challenge the consistency of the scheme with the multilateral rules through panel proceedings under the DSU.

The WTO members should not raise their protection vis-à-vis their non-PTA trading partners in a general sense. This is known as the external requirement and they vary for FTAs and CUs. There is also an internal requirement that is common to both FTAs and CUs alike. Article XXIV.8 GATT lays down that WTO Members wishing to enter into CU or FTA will have to eliminate duties and other restrictive regulations of commerce with respect to substantially all trade in products originating in the constituents of the regional integration scheme.

The Practical Bearing Of Ptas On MFN

PTAs routinely specify that the MFN obligation is subject to reservations and exclusions and is not absolute. In so-called “top-down” (like NAFTA) PTAs where all investment and services trade are covered unless specifically excluded in a schedule of non-conforming measures, the MFN obligation does not apply to the non-conforming measures listed. Some Special Sectoral Undertakings also exclude the MFN obligation. Naturally, the basic purpose of including an MFN obligation in the services or investment chapters of a PTA is to ensure that a party’s investors and services providers should never be disadvantaged in relation to those of a non-Party in the event that the other party to the PTA negotiates a different and better regime for investment and services with some non-Party.

The Sutherland Report includes GSP schemes in its definition of PTAs. As argued by the report, PTAs have transformed the matrix of trade relations into some sort of a “spaghetti bowl” to the extent that MFN itself has become exceptional and can barely be considered the central principle of WTO any longer. Infact, it is argued that the term must be better known as “least-favoured nation”. As an example, the report points to the fact that the EU’s MFN tariffs apply fully to only nine trading partners including Japan, while all other trading partners are granted concessional market access under GSP schemes, FTAs or others, ironically highlighting the reality that MFN tariff rates are, in many cases, the least favourable rates.

Conclusion

The point most often ignored is that the very reason why MFN clauses came about was out of necessity – the need to avoid troublesome and repetitive procedures by applying the same conditions to all trade partners. Early MFN clauses functioned as instruments to generalize concessions, while present-day clauses work as means to actualise non-discrimination.

The success of WTO will be in rejuvenating its original goals by harmonising the interests of developed and developing countries. At the Doha Ministerial meeting of the WTO in 2001, a number of decisions were taken that were regarded by developing countries as being controversial if not unhelpful. Significant among these is the issue of competition policy. Specifically in this regard the Doha declaration noted the following:

We recognized the needs of developing and least-developed countries for enhanced support for technical assistance and capacity-building in this area, including policy analysis and development so that they may better evaluate the implications of closer multilateral cooperation for their development policies and objectives, and human and institutional development. To this end, we shall work in cooperation with other relevant intergovernmental organizations, including UNCTAD, and through appropriate regional and bilateral channels, to provide strengthened and adequately resourced assistance to respond to these needs.

The controversial nature of non-discrimination and reciprocity partly stems from the fact that trade policy has always been oriented towards pursuing national interests and it has become problematic to pursue MFN treatment and trade liberalization through reciprocal bargaining at the same time. The departures from MFN such GSP could promote the exports of developing countries and should be seen as a short-term measure towards realising the long-term goals of GATT, instead of being condemned.

In conclusion, it is stated that if multilateralism is the chosen route, there are strong reasons to reinforce the belief that MFN encourages non-discrimination, provided it is not entirely subverted by the bogie of PTAs. Temporary deviations may be allowed to make it more amenable for the developing countries to compete fairly with producers from developed countries. The key is to create appropriate stepping stones to the ultimate goal and not lose sight of it in the maze of momentary setbacks.

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