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May 1999

Volume 5 Number 7

Mercosur: Implications for Growth in Member Countries
Michelle Connolly and Jenessa Gunther

The South American customs union known as Mercosur has contributed significantly to
regional trade liberalization. But by encouraging trade within the group at the expense of trade
with nonmembers, Mercosur may limit member countries’ access to high-technology imports,
an important stimulus to growth.

In March 1991, Argentina, Brazil, Paraguay, and
Uruguay agreed to form a customs union called the
Mercado Común del Sur, or Southern Common Market.
The union—commonly known as Mercosur—created
an integrated regional market whose members were
committed to liberalizing trade with one another while
imposing a common tariff on goods imported from nonmembers. Currently the fourth largest integrated market
after the North American free trade area, the European
Union, and Japan, Mercosur has further extended its
scope by entering free trade agreements with Chile and
Bolivia. The union’s sheer size gives it considerable
market power and influence over trade developments
Like other regional trade arrangements that offer
preferential terms to member countries—arrangements
that include the North American Free Trade Agreement
and the European Union1 —Mercosur has generated a
fair amount of debate. This debate traditionally centers
on three issues: First, do regional trade blocs promote
or hinder multilateral trade negotiations? 2 Second, do
these blocs fortify or ease trade barriers for nonmember
countries? Third, do regional trade agreements create
trade by opening up new sources of low-cost imports or
divert trade by inducing members to import high-cost
goods from their partners in place of goods produced
more efficiently by nonmembers?

In this edition of Current Issues, we touch on a number
of these issues as we explore the impact of Mercosur on
the trade patterns and growth of the participating countries. Although we make no claims as to the net effects
of the customs union on national welfare, we do cite
some persuasive evidence that Mercosur has shifted
trade in many manufactured goods to higher cost member countries. In addition, our analysis breaks new
ground by considering the dynamic effects of regional
trade arrangements—that is, the effects of such
arrangements on member countries’ growth rates. A
recent study by Connolly suggests that exposure to
high-technology products from developed countries can
accelerate growth and innovation in the countries
importing those goods. Applying this finding to
Mercosur and other regional trade blocs composed
exclusively of developing countries raises an important
concern: Because these trade blocs promote intra-group
trade over trade with outsiders, they may reduce members’ access to high-technology imports from industrialized nations, limiting the opportunities for technical
diffusion and the potential for faster growth.
The Creation of Mercosur
Before establishing Mercosur in March 1991,
Argentina, Brazil, Paraguay, and Uruguay had been
engaged in multilateral trade liberalization for three


years. The Treaty of Asunción, which created the customs union, essentially continued this liberalizing trend
while narrowing it to the participating countries. The
treaty called for the elimination of all tariffs on intraMercosur trade by the end of 1994 but mandated that
member countries impose a common external tariff on
goods imported from countries outside the union.3

nonmembers (Economist 1999). The continuation of
national tariffs in these politically important industries
suggests that many of the changes in production and
trade expected from the formation of Mercosur have not
yet occurred.
Mercosur’s Effects on Tariff Rates and Trade Volume
The removal of tariff barriers between Mercosur
countries following the 1991 treaty, coupled with the
more general trade liberalization undertaken by these
same countries in 1988-91, sharply reduced the countries’ average tariff rates (Chart 1). Most dramatically,
Brazil’s average tariff rate tumbled from a high of 69 percent before 1990 to 13 percent in 1995. Nevertheless,
because the common external tariff was calculated as a
weighted average of the national tariffs of member
countries, its adoption actually raised the average tariff
rates for some countries above their 1991 levels.

Member nations began lowering tariffs in June 1991,
and by early 1997, fully 90 percent of intra-Mercosur
trade was free of tariffs. Most of the remaining
intra-trade tariffs—applied to products specified in lists
of exceptions for each country—are scheduled to fall to
zero by January 2000.
The common external tariff, or CET, was initially
set to equal a weighted average of the national tariffs
levied by the member countries before the formation
of Mercosur. As of January 1995, all members had
adopted the external tariff, which ranged from 0 to
20 percent by product type: 0 to 9 percent for raw
materials and some food stuffs; 10 to 15 percent for
certain agricultural products and semiprocessed goods;
and 15 to 20 percent for textiles, manufactured goods,
and consumption goods (Frischtak, Leipziger, and
Normand 1996). Across all product types, the average
external tariff was originally 12 percent (Garay and
Estevadeordal 1995); it was increased to 15 percent in
December 1997.

As expected, the lowering of internal trade barriers
under the terms of the Mercosur treaty has led to a
marked expansion in trade among members. As a percentage of total trade, intra-Mercosur trade rose from
roughly 12 percent in 1991 to a high of about 19 percent
in 1994 (Chart 2). Intra-Mercosur exports showed especially strong growth, advancing from 11 percent of total
exports in 1991 to 20 percent in 1996. The rising share
of trade claimed by Mercosur members clearly came at
the expense of non-Mercosur countries, but even trade
with nonmembers increased in absolute terms after the
customs union was formed (Chart 3). Nevertheless, we
cannot compare this outcome with the aggregate trade
pattern that would have been observed had Mercosur
not formed, or had Argentina, Brazil, Paraguay, and
Uruguay instead continued their efforts to liberalize
trade multilaterally.

Not all nonmember products, however, are currently
subject to the common external tariff. The terms of the
Mercosur agreement permitted each member country to
maintain its existing national tariffs on 300 specific
products—about 15 percent of all product types—until
early in the next century. The governments of the
Mercosur countries justified the continuation of these
generally higher national tariffs on the grounds that
domestic producers of these goods needed more time
to prepare for foreign competition. The protection
afforded by this provision of the agreement appears to
have helped domestic producers expand their trade
operations within the Mercosur group: the products
exempted from the common external tariff now account
for almost half of intra-Mercosur trade.

Chart 1

Average Tariff Rates in Mercosur Countries



Among the key industries affected by the national
tariffs are capital goods, computer hardware, professional electronics, and vehicles. National tariffs
imposed on capital goods produced outside the customs
union are scheduled to converge with the common
external tariff by 2001, while those levied on computer
hardware and electronics will not converge until 2006
(Frischtak, Leipziger, and Normand 1996). National
tariffs on vehicles were supposed to converge with the
common external tariff, but Brazil and Argentina are
maintaining tariffs of 35 percent on all cars produced by
















Source: Inter-American Development Bank (1996).
Note: Reform dates are as follows: Argentina, 1989; Brazil, 1990; Paraguay, 1989;
Uruguay, 1991.


Chart 2

Chart 3

Trends in Intra-Mercosur Trade

Changes in Mercosur Imports and Exports
Breakdown by Origin and Destination

Intra-Mercosur trade
as percentage
of total trade


Billions of 1990 U.S. dollars
Origin of Mercosur imports

Destination of Mercosur exports


Imports as percentage
of total imports




Exports as percentage
of total exports




1985 86











1985 86
Source: International Monetary Fund, Direction of Trade Statistics.





91 92





Source: Inter-American Development Bank (1996).

In the remainder of the article, we look at the
economic impact of Mercosur on the participating
countries. Specifically, is the customs union more likely
to improve or to hurt national welfare? The answer
depends in large measure on the dynamic effects of
“trade creation” and “trade diversion.”

incurred by the Paraguayan government on each car
will be partially offset by the reduction in the price paid
by the Paraguayan consumer, but the remainder of the
lost revenue amounts to a production subsidy for
Argentina’s car producers.
To be sure, lower prices will induce Paraguayan consumers to buy more cars. The increase in car purchases
may be large enough to offset the national income loss
from trade diversion. Thus, whether trade diversion
boosts or reduces member country income depends on
which effect dominates. Either way, however, the external tariff acts as a protectionist measure for member
nation industries that may not produce goods as
efficiently as their counterparts in other countries.

Trade Creation versus Trade Diversion
Because a customs union entails differential treatment
for member and nonmember countries, it typically
leads to a shift in the member countries’ sources of
supply. This shift can be either to lower cost or to higher
cost sources. For example, the lowering of trade barriers
within the customs union may prompt members to
import from one another goods they had previously produced at higher cost for themselves. This outcome—
termed trade creation—allows for greater efficiency in
production and lower consumption prices, benefits that
enhance economic welfare and national income.

Export Patterns as Evidence of Mercosur’s
Welfare Effects
Since we do not know how trade patterns would have
evolved in the absence of Mercosur, it is difficult to
observe and quantify the presence of trade creation
and trade diversion. Indirect evidence of these effects,
however, can be drawn from statistics on Mercosur
countries’ exports. In a 1997 study, Yeats assesses
observed changes in Mercosur countries’ exports in
relation to a measure of the countries’ efficiency in producing particular goods. His intention is to investigate
whether trade in the wake of the Mercosur agreement is
oriented toward those products in which Mercosur
countries have shown a competitive edge.

Conversely, the imposition of a common tariff on the
goods produced by nonmembers may cause member
countries to import products from a high-cost partner
country rather than from a low-cost nonmember. This
result—trade diversion—reduces tariff revenues and
essentially subsidizes less efficient producers.
An example may clarify how trade diversion operates. Suppose Paraguay initially imposed a 30 percent
tariff on all imports. After joining a customs union with
Argentina, Paraguay drops the tariff on Argentine
imports while maintaining the tariff on U.S. imports. If
the pre-tariff import price of U.S. automobiles was
$20,000 and of Argentine automobiles, $22,000,
Paraguay will shift from importing American cars for
$26,000 (the price including the 30 percent tariff) to
importing Argentine cars for $22,000 after joining the
customs union. The $6,000 loss in tariff revenues

Yeats seeks evidence on this point by determining
whether goods that account for an increasing share
of intra-Mercosur trade also perform well in markets
outside the group, where they receive no preferential
treatment. He finds significant discrepancies in the



product types appear to stem from the greater level of
protection afforded by the higher common external
tariffs, as well as nontariff barriers, in those industries.5

performance of goods in internal and external markets—most notably in the case of manufactured goods.
Manufactured goods have made dramatic gains in intraMercosur trade. Machinery and transportation equipment have shown particular strength, accounting for
almost one-third of all Mercosur exports in 1994 (Chart 4).
But while manufactured goods as a whole represent
63 percent of Mercosur members’ exports to one
another, they represent only 35 percent of Mercosur
exports to nonmembers. This comparison suggests that
members are importing from one another goods that
are not fully competitive in independent markets.

Yeats’ findings suggest that trade diversion is occurring in certain industries, particularly machinery and
transportation equipment. This is not surprising given
that manufactured goods such as autos, capital goods,
and telecommunications and information products are
still subject to national tariffs both within and outside
Mercosur. 6 Certainly, future convergence to the common external tariff will lower the tariff rates on some of
these products—as, for example, in Brazil, where tariffs
on consumer durables from non-Mercosur countries are
supposed to drop from 70 percent to 20 percent early in
the next century. Nevertheless, the common external
tariff of 20 percent will continue to protect these
domestic industries at a high cost to consumers for the
foreseeable future. Moreover, in the case of other products, future convergence to the external tariff will
actually increase protection for Mercosur industries.
For example, capital good imports into Argentina are
currently duty-free except for a 10 percent statistical
surcharge. Beginning in 2001, however, they will be
subject to a 14 percent common external tariff
(Frischtak, Leipziger, and Normand 1996).

To test this conclusion further, Yeats identifies thirty
product types that showed the fastest growth in intraMercosur trade as a percentage of extra-Mercosur trade
between 1988 and 1994. For each product, he then
derives an index of Mercosur’s competitiveness—or
“revealed” comparative advantage—by calculating the
ratio of 1) that product’s prevalence in Mercosur exports
to nonmembers to 2) its prevalence in world exports.4 A
high index suggests that the Mercosur product was created at sufficiently low cost to perform well in external
markets; a low index suggests that the same product
could be produced more efficiently by nonmembers.
Yeats finds that Mercosur countries lacked a comparative advantage in twenty-eight of the thirty fast-growing
product groups. Machinery and transportation equipment scored particularly low. Moreover, the indexes for
twenty-one of the thirty product groups fell between
1988 and 1994, suggesting that the Mercosur countries’
degree of competitiveness actually declined over the
period. Since comparative advantage does not seem to
be driving the changes in intra-Mercosur export patterns, the observed increases in trade for particular

Although the evidence that Mercosur countries are
importing some goods from higher cost member countries is persuasive, the trade-diverting effects of the
customs union must be evaluated against its tradecreating effects. Even if trade diversion dominates,
member nations may still be better off if consumer
prices decline sufficiently with the shift to intraMercosur import sources. Lacking adequate information
to resolve this issue fully, we make no judgments about
which effect is dominant in Mercosur. Still, given that the
industries in which trade diversion appears to be occurring are technology-driven industries, we must consider
how the growth of Mercosur countries may be affected.

Chart 4

Increase in Manufactured Goods as a Percentage
of Mercosur Exports

Dynamic Effects of Mercosur
So far, we have looked for evidence of welfare gains or
losses under Mercosur that are “static”—that is, gains
or losses that consist of onetime changes in national
income levels. Another approach is to consider how
Mercosur has affected the rate of income growth in
member countries. These “dynamic” gains or losses differ from static effects in much the same way that an
increase in a worker’s annual raise from 3 to 5 percent
differs from a single $5,000 increase in a worker’s
salary. Although largely neglected in earlier studies of
the risks and benefits of regional trade agreements,
dynamic effects merit particular attention because they
compound themselves over time, quickly overshadowing any static effects.

Exports of all manufactured goods to non-Mercosur countries
Exports of all manufactured goods to Mercosur countries
Exports of machinery and transportation equipment to
Mercosur countries





Sources: Inter-American Development Bank (1996); Yeats (1997).



Connolly’s findings suggest that if a country had
initial rates of domestic innovation and imitation of
1 percent, then a sustained 10 percent increase in hightechnology imports from developed countries as a share
of GDP would have increased the innovation rate during
the period to 1.13 percent and the imitation rate to
1.14 percent, all else equal. 8 Similarly, Connolly’s
results suggest that if the growth of high-technology
imports per capita increased from its average of 2 percent to 4 percent, then per capita GDP growth for the
average country would increase from its average of
2 percent to 2.2 percent. Interestingly, the growth of
high-technology imports has a significantly greater
impact on developing countries than on developed
countries. One interpretation of this finding is that trade
in physical goods is especially important for the diffusion of technology to developing countries because
such countries are often not highly integrated with
developed countries.

In theory, customs unions and other regional trade
arrangements may accelerate the rate of income growth
in the participating countries by increasing political
cooperation, enhancing the credibility of government
commitments to trade reform, and enabling industries
to achieve greater economies of scale in production.
Indeed, it is likely that the Mercosur countries have
benefited in these ways.
However, when considering dynamic effects, one
must weigh the potential benefits of greater integration
within the regional trade group against the potential
losses from less integration with the outside world. In
other words, the standard of comparison in evaluating
Mercosur must be multilateral trade liberalization—the
trend observed in Argentina, Brazil, Paraguay, and
Uruguay before the formation of the customs union.
In forgoing freer trade relations with the rest of the
world, the Mercosur countries lost one important means
of achieving dynamic gains—the technological diffusion that occurs through trade between developed and
developing countries. Because Mercosur includes only
developing countries, its members are less likely to be
exposed to the advanced technology embodied in
imports from developed countries. Indeed, the external
tariff that Mercosur applies to the rest of the world
heightens the union’s isolation from developed countries. Yeats’ suggestion that trade diversion is likely
occurring in technology-driven industries such as
machinery and transportation equipment further supports the conclusion that the opportunities to learn from
the advances of other countries are more limited under

If trade with developed countries enhances domestic
growth significantly—as the Connolly study suggests—
then the welfare effects of trade diversion on the
Mercosur countries may be far greater than generally
assumed. Any shift in import sources that reduces
access to advanced technologies will slow the rate of
economic growth in member countries. Thus, the trade
diversion that appears to be occurring in manufacturing
industries in Mercosur is cause for concern.
Of course, proponents of regional trade arrangements might point out that the external tariffs applying
to manufactured goods are not high enough to discourage all trade with nonmembers and are in some cases
lower than the national tariffs that prevailed before
Mercosur’s formation. Nonetheless, these tariffs are
sufficiently high to divert trade in these product types
from developed nonmember countries to member
countries. Consequently, relative to multilateral trade
liberalization, Mercosur’s preferential trade arrangement may ultimately have a cost. By paying higher
prices for certain imports, Mercosur consumers sacrifice income; by losing access to high-technology
imports from developed countries, Mercosur nations
risk slower growth.

Exposure to high-technology imports from developed countries can affect the growth of the importing
country in two ways. First, such imports raise a country’s output directly if they are used as intermediate
goods in the production of other goods. Consequently,
increased imports of high-technology goods from
developed countries should accelerate domestic output
growth. Second, exposure to this technology should
also encourage growth indirectly, by stimulating
domestic imitation and innovation. Firms that reverseengineer sophisticated imports learn to duplicate or
improve upon the technology embodied in these products. Thus, increased exposure to such imports should
benefit firms’ research and development efforts, further
encouraging growth.7

Our findings should not be construed to mean that
Mercosur countries are worse off overall than they had
been before the creation of the customs union.
Mercosur has clearly provided a political framework
that has helped to advance regional trade liberalization.
In addition, the customs union may have promoted
lower average tariff rates on goods from all countries
and increased the credibility of the participating
governments’ commitments to trade reform.

Previous work by Connolly (1998) finds statistical
evidence of a relationship between a country’s access to
technology and its rate of growth. Using data on forty
countries from 1970 to 1985, the study considers the
effects of high-technology imports from developed
countries on domestic innovation, imitation, and growth
in both developed and developing countries.




Nevertheless, a balanced assessment of Mercosur’s
effectiveness must include some recognition of the
union’s potential drawbacks. In this article, we have
looked at evidence suggesting that Mercosur is diverting trade in manufactured goods from lower cost
nonmembers to higher cost members. We have also
examined how the membership of Mercosur—a membership confined to developing countries—may impede
growth by limiting the participants’ access to the
advanced technologies of developed countries. These
considerations suggest that had Argentina, Brazil,
Paraguay, and Uruguay undertaken a similar degree of
trade liberalization in a multilateral setting, they might
have realized even greater benefits from their efforts to
open up trade.
1. Although all regional trade arrangements discriminate between
members and nonmembers, customs unions (such as Mercosur)
require members to levy a common tariff on imports from nonmembers, whereas free trade agreements (such as NAFTA) do not regulate the tariffs placed by members on nonmember goods.
2. Winters (1996) surveys the theoretical work on this issue.

6. The effect of retaining these tariffs is evident in a study of trade
restrictions and domestic regulations on the production of vehicles
(Chudnovsky, Lopez, and Porta 1996). The study finds that vehicles
produced within Mercosur are inferior in quality and higher in price
than comparable vehicles produced outside the customs union.
7. For a theoretical modeling of these concepts, see Connolly (1999).
8. To control for the endogeneity of imports and other variables,
Connolly uses two-staged least squares regressions with instrumental variables. The regressions also control for inflows of foreign
direct investment, the scale of the domestic economy, and general
measures of openness to trade.

Chudnovsky, Daniel, Andres Lopez, and Fernando Porta. 1996.
“Intra-Industry Trade and Regional Integration: The Case of the
Auto Industry in Argentina.” Working paper, University of
Buenos Aires. Cited in Yeats (1997).
Connolly, Michelle P. 1998. “The Dual Nature of Trade: Measuring
Its Impact on Imitation and Growth.” Duke University
Economics Department Working Paper no. 97-34.
———. 1999. “North-South Technological Diffusion: A New Case
for Dynamic Gains from Trade.” Duke University Economics
Department Working Paper no. 99-08.

3. If a good is to be traded tariff-free within Mercosur, 60 percent
of its raw material inputs must come from member countries.

Economist. 1999. “Double Parked.” January 9.

4. The comparative advantage index for good j is defined as

Frischtak, Claudio, Danny M. Leipziger, and John F. Normand.
1996. Industrial Policy in MERCOSUR: Issues and Lessons.
World Bank.

Cj = extra-Mercosur exports of good j world exports of good j ,
total extra-Mercosur exports
total world exports
where world exports exclude intra-Mercosur trade.
5. A few caveats apply to these findings. First, transportation costs
within Mercosur are likely lower than those between Mercosur and
the rest of the world. Second, trade barriers in third markets affect
Mercosur exports to those markets. Third, Mercosur countries might
be producing manufactured goods tailored to regional demand.
These caveats might explain why intra-Mercosur exports of manufactured goods are greater than manufactured goods exports to the
rest of the world. Still, Yeats is looking at changes in regional orientation, not levels of regional orientation. Hence, observed changes
in 1988-94 trade patterns are unlikely to stem from changes in transportation costs or changes in third-country trade barriers.

Garay, L. J., and A. Estevadeordal. 1995. “Protection, Preferential
Tariff Elimination and Rules of Origin in the Hemisphere.”
Integration, Trade and Hemispheric Issues Division, InterAmerican Development Bank, June.
Inter-American Development Bank. 1996. Economic and Social
Progress in Latin America.
Winters, L. Alan. 1996. “Regionalism versus Multilateralism.”
World Bank Policy Research Working Paper no. 1687.
Yeats, Alexander. 1997. “Does Mercosur’s Trade Performance Raise
Concerns about the Effects of Regional Trade Arrangements?”
World Bank Policy Research Working Paper no. 1729.

About the Authors
Michelle Connolly, formerly an economist in the International Research Function, is now an assistant professor
in the Department of Economics at Duke University. Jenessa Gunther, formerly an assistant economist in the
International Research Function, is currently a graduate student in economics at the University of Maryland.
The views expressed in this article are those of the authors and do not necessarily reflect the position of
the Federal Reserve Bank of New York or the Federal Reserve System.
Current Issues in Economics and Finance is published by the Research and Market Analysis Group of the Federal
Reserve Bank of New York. Dorothy Meadow Sobol is the editor.