Trade diversion

Topic: International Trade Policy, WTO and Intellectual Property · NCERT: Beyond NCERT

Meaning

Trade diversion happens when a country signs a free trade agreement (FTA) or customs union and then buys a good from a partner country that costs more to produce, instead of from a cheaper non-member. The partner wins only because it no longer pays import duty, not because it is more efficient. The idea comes from Jacob Viner (1950). It matters because a trade deal can make trade grow while the country and the world use resources less efficiently. So "more trade" does not always mean "more welfare".

Explanation

How it works

• An FTA is discriminatory (it treats countries differently). Partners pay zero or low duty. Non-members still pay the full MFN tariff (the normal duty charged to all WTO members).
• Chain of events:
• Before the FTA, every foreign supplier pays the same duty, so the cheapest producer in the world wins the sale.
• After the FTA, only the partner's duty goes to zero.
• The partner's price can now fall below the non-member's price even though its production cost is higher.

• Imports move from the efficient outsider to the less efficient partner.

• The world now spends more real resources to make the same good. This is the efficiency loss.

Worked example (India's tariff on outsiders = 25%)

Supplier	Cost price	Price in India before FTA	Price in India after an FTA with Vietnam
Domestic producer	₹110	₹110	₹110
China (non-member)	₹80	₹80 + 25% = ₹100 ← bought	₹100
Vietnam (partner)	₹90	₹90 + 25% = ₹112.5	₹90 ← bought

• Before the FTA: India buys from China, the lowest-cost producer, at ₹100.
• After the FTA: India buys from Vietnam at ₹90.
• Effects per unit:
• Cost to the world rises from ₹80 to ₹90, a loss of ₹10.
• The government loses ₹20 in customs duty, because Vietnamese goods pay no duty.

• Consumers gain ₹10, because the price falls from ₹100 to ₹90.

• Net effect for India: on the units India was already buying, the consumer gain (₹10) is smaller than the lost duty (₹20). That is a net loss of ₹10, the same as the extra real cost to the world. The lower price may lead people to buy some extra units, which brings a small gain. Whether India gains overall depends on which of these effects is bigger.

When diversion is more or less likely

• More likely when:
• the outside tariff is high, because removing it for the partner creates a big price advantage;
• the partner is not the lowest-cost producer in the world;

• the partners are competing economies that make similar goods (for example, manufacturing economies).

• Less likely when:

• outside tariffs are already low;
• the partner is itself the world's cheapest supplier;

• the economies are complementary (each makes what the other needs). Such deals tend to cause trade creation instead.

• Rule of thumb: a deal is good for welfare when trade creation is larger than trade diversion.

In India

• Legal cover: the WTO allows FTAs even though they discriminate against outsiders. For goods, the route is GATT Article XXIV, and among developing countries it is the Enabling Clause (1979) [1]. This legal permission is what makes trade diversion possible at all.
• India–ASEAN TIGA (2010): India's trade deficit (imports larger than exports) with ASEAN widened to about US$44 bn (2023-24). A review began in 2023. ASEAN members and India make many of the same manufactured goods, which raises the risk of diversion.
• RCEP exit (November 2019): India walked out partly because of its large trade deficit with China and weak rules of origin (rules that decide which country a product "comes from"). Weak rules could let Chinese goods in through other members.
• CAROTAR 2020: notified 21 August 2020, in force from 21 September 2020. It puts the burden of proof on the importer, who must show that goods really originate in the partner country [2]. It aims to stop Chinese goods routed through ASEAN and other FTA partners.
• Newer deals: India's recent FTAs are with high-income partners whose economies complement India's. These are EFTA TEPA (in force 1 October 2025) [3], the UK CETA (signed 24 July 2025) and the EU FTA (concluded 27 January 2026) [4]. Complementary partners make trade creation more likely. These deals also use phased tariff cuts over 5, 7 or 10 years in the EU FTA [4], along with safeguards and exclusion lists for sensitive goods.

Don't confuse with

• Trade creation (also Viner, 1950): costly domestic production is replaced by cheaper imports from a partner, so welfare rises. Trade diversion replaces a cheaper outside supplier, so welfare can fall.
• Trade deflection: goods are routed through the partner with the lowest outside tariff and then re-exported duty-free. It is a leakage problem in FTAs that rules of origin stop. Trade diversion is a welfare effect that rules of origin do not remove.
• Spaghetti bowl effect (Jagdish Bhagwati): the extra compliance cost of many overlapping FTAs with different rules of origin. It is not about moving imports from one supplier to another.
• Open regionalism (e.g. APEC, 1989): integration that does not raise barriers against outsiders, so it limits the discrimination that causes diversion.

Prelims Hooks

• Trade creation vs trade diversion is Jacob Viner (1950), not Bhagwati. Bhagwati gave "building blocks vs stumbling blocks" and the "spaghetti bowl effect".
• Trade diversion = imports shift from an efficient non-member to a less efficient FTA partner only because of the tariff preference. Welfare can fall.
• Diversion is more likely when the outside tariff is high and the partner is not the world's lowest-cost producer.
• Trap: rules of origin stop trade deflection, not trade diversion.
• FTAs in goods are allowed under GATT Art. XXIV. Deals among developing countries use the Enabling Clause (1979). Services use GATS Art. V [1].
• CAROTAR 2020 came into force on 21 September 2020 and put the burden of proving origin on the importer [2].

Mains Points

• Choosing partners: deals with complementary high-income partners are more likely to create trade. These include EFTA (2025) [3], the UK (2025) and the EU (2026) [4]. ASEAN/RCEP-type deals with competing manufacturing economies carried a higher risk of trade diversion and of Chinese goods being routed through partners. This supports a shift toward selective, carefully designed FTAs (GS-III).
• Building block or stumbling block? Trade diversion is the main economic case for calling RTAs stumbling blocks: outsiders face discrimination, and partners lose interest in multilateral (WTO-wide) tariff cuts. Ways to reduce it:
• lower MFN tariffs alongside FTAs, which shrinks the preference margin;
• strong but simple rules of origin;

• phased tariff cuts with safeguards (a safeguard is a temporary duty to stop a sudden flood of imports).

• Fiscal and consumer trade-off: diversion shifts gains between groups. Consumers pay less, but the government loses customs revenue, and in the note's example the lost revenue is larger than the consumer gain. Any assessment of an FTA should net these effects rather than count higher import volumes as success (GS-II/GS-III link).

Related concepts

• Stages of economic integration
• Preferential trade agreement
• Free trade agreement
• Customs union
• Common market
• Economic union
• Monetary union
• Trading bloc
• Regional economic groupings
• Regionalism

Read more

• Regionalism: stages of integration, FTAs and rules of origin