Regionalism versus Multilateral Trade Arrangements (National Bureau of Economic Research-East Asia Seminar on Economics)

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Regionalism versus Multilateral Trade Arrangements

NBER-East Asia Seminar on Economics Volume6

National Bureau of Economic Research Korea Development Institute Chung-Hua Institution for Economic Research Tokyo Center of Economic Research

Regionalism versus Multilateral Trade Arrangements

Edited by

Takatoshi Ito and Anne 0. Krueger

The University of Chicago Press

Chicago and London

TAKATOSHI ITOis professor of economics at Hitotsubashi University, senior advisor in the research department of the International Monetary Fund, and a research associate of the National Bureau of Economic Reis Caroline L. and Herald L. Ritch Professor search. ANNE0. KRUEGER of Economics at Stanford University. She is also director of Stanford's Center for Research in Economic Development and Policy Reform and a research associate of the National Bureau of Economic Research.

The University of Chicago Press, Chicago 60637 The University of Chicago Press, Ltd., London 0 1997 by the National Bureau of Economic Research All rights reserved. Published 1997 Printed in the United States of America 06050403020100999897 1 2 3 4 5 ISBN: 0-226-38672-4 (cloth)

Library of Congress Cataloging-in-Publication Data Regionalism versus Multilateral Trade arrangements I edited by Takatoshi It0 and Anne 0. Krueger. p. cm. - (NBER-East Asia seminar on economics ; v. 6) Sponsored by the National Bureau of Economic Research and other organizations. This volume contains edited versions of papers presented at the NBER-East Asia Seminar on Economics sixth annual conference, held in Seoul, Korea, 15-17 June 1995. Includes bibliographical references (p. ) and index. ISBN 0-226-38672-4 (cloth : alk. paper) 1. Trade blocs-East Asia-Congresses. 2. East Asia-Foreign 3. Regionalism-East Asiaeconomic relations-Congresses. Congresses. 4. International economic integration-Congresses. 5 . International economic relations-Congresses. I. ItG, Takatoshi, 1950- . 11. Krueger, Anne 0. 111. National Bureau of Economic Research. IV. NBER-East Asia Seminar on Economics (6th : 1995 : Seoul, Korea) V. Series: NBER-East Asia seminar on economics (Series) ; v. 6. HF1418.7.R445 1997 97-7794 382'.9 1-dc2 1 CIP

@ The paper used in this publication meets the minimum requirements of the American National Standard for Information Sciences-Permanence of Paper for Printed Library Materials, ANSI 239.48- 1984.

National Bureau of Economic Research Officers John H. Biggs, chairman Carl F. Christ, vice chairman Martin Feldstein, president and chief executive officer Gerald A. Polansky, treasurer

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Association Charles Lave, American Economic Association Rudolph A. Oswald, American Federation of Labor and Congress of Industrial Organizations Gerald A. Polansky, American Institute of Cert@ed Public Accountants Josh S . Weston, Committeefor Economic Development

Directors Emeriti Moses Abramovitz George T. Conklin, Jr. Thomas D. Flynn

Franklin A. Lindsay Paul W. McCracken Geoffrey H. Moore

James J. O’Leary George B. Roberts Eli Shapiro

Since this volume is a record of conference proceedings, it has been exempted from the rules governing critical review of manuscripts by the Board of Directors of the National Bureau (resolution adopted 8 June 1948, as revised 21 November 1949 and 20 April 1968).

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Contents

Acknowledgments

ix

Introduction Takatoshi Ito and Anne 0. Krueger

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1.

Problems with Overlapping Free Wade Areas Anne 0. Krueger

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The Political Economy of Mexico’s Entry into NAFTA Aaron Tornell and Gerard0 Esquivel Comment: Wontack Hong

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vii

Social Policy Dimensions of Economic Integration: Environmental and Labor Standards Kym Anderson Comment: Menzie D. Chinn Comment: Chong-Hyun Nam EU, NAFTA, and Asian Responses: A Perspective from the Calculus of Participation Junichi Goto and Koichi Hamada Comment: Tamim Bayoumi Comment: Wontack Hong Open versus Closed Trade Blocs Shang-Jin Wei and Jeffrey A. Frankel Comment: Taeho Bark

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viii

6.

7.

8.

9.

Contents

Is Regionalism Simply a Diversion? Evidence from the Evolution of the EC and EFTA Tamim Bayoumi and Barry Eichengreen Comment: Francis T. Lui Comment: Chong-Hyun Nam

Asia Pacific Capital Markets: Integration and Implications for Economic Activity Menzie D. Chinn and Michael Dooley Comment: Koichi Hamada Comment: Aaron Tornell Recent Developments of APEC: Issues and Prospects of the Osaka Agenda Ippei Yamazawa Comment: Chia Siow Yue A Perspective on the Effects of NAFTA on Korea Honggue Lee Comment: Tain-Jy Chen

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203

223

10.

Regionalism and Subregionalism in ASEAN: The Free Trade Area and Growth Triangle Models 275 Chia Siow Yue Comment: Mario B. Lamberte Comment: Shang-Jin Wei

11.

Globalization and New Industrial Organization: Implications for Structural Adjustment Policies Sung Hee Jwa Comment: Mahani Zainal-Abidin Comment: Philip Lowe

12.

13.

Bilateral Negotiations and Multilateral Trade: The Case of Taiwan4J.S. Trade Talks Tain-Jy Chen and Meng-chun Liu Comment: Sang-Woo Nam Comment: Hank Lim Economics and Politics of Rice Policy in Japan: A Perspective on the Uruguay Round Yujiro Hayami and Yoshihisa Godo

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37 1

Comment: Ammar Siamwalla Comment: Kym Anderson

Contributors

405

Name Index

409

Subject Index

413

Acknowledgments

This volume contains edited versions of papers presented at the NBER-East Asia Seminar on Economics sixth annual conference, held in Seoul, Korea, 15-17 June 1995. We are indebted to Chong-Hyun Nam and Tzong-shian Yu, who served as members of the program committee, for organizing the conference and to Martin Feldstein for his support of the conference series. We also thank IGrsten Foss Davis for her tireless efforts in making conference arrangements, and Deborah Kiernan for overseeing the editorial work in preparing the volume for publication. Our special thanks go to Basant Kapur and the Department of Economics and Statistics, National University of Singapore, who hosted the conference this year. All participants praised the host for organizing an efficient but hospitable conference. The National Bureau of Economic Research provided logistical support, for which we are grateful. We are also indebted to the Chung-Hua Institution, the Korea Development Institute, the National Bureau of Economic Research, and the Tokyo Center of Economic Research (TCER) for their financial assistance. Takatoshi Ito and Anne 0. Krueger

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Introduction Takatoshi It0 and Anne 0. Krueger

For the entire world, but especially for East Asia, the rapid growth of the open multilateral trading system after the Second World War was invaluable, as the economies in that region chose a growth strategy involving integrating their economies with the rest of the world. Exporters from the region were able to expand their sales rapidly, in part because their domestic costs enabled them to export profitably, but also in part because world markets were expanding rapidly. Especially in the newly industrialized economies (NIEs) of Hong Kong, Korea, Singapore, and Taiwan, exports increased dramatically in absolute terms, and rapidly as a percentage of GNP. No observer of these economies can doubt the importance of an open multilateral trading system in accounting for their past performance or in determining their future prospects. Until the 1980s, conventional wisdom was that an open multilateral trading system was the wave of the future; except for the European Community (now Union), attempts at forming preferential trading arrangements (PTAs) had largely failed or had been outer oriented and had little impact on trade flows (as in the case of the Association of Southeast Asian Nations-ASEAN). And the motivation for European preferences was clearly at least as much political as it was economic. In the 1980s, however, PTAs again began to emerge as significant factors affecting world trade. After the Canada-U.S. Free Trade Agreement, Mexico quickly signaled its desire to enter into a free trade agreement, and the North American Free Trade Agreement (NAFTA) was the result. Within a short time after that, the American authorities announced their intention to extend NAFTA to a Western Hemisphere-wide arrangement; Brazil, Takatoshi It0 is professor of economics at Hitotsubashi University, senior advisor in the research department of the International Monetary Fund, and a research associate of the National Bureau of Economic Research. Anne 0. Krueger is Caroline L. and Herald L. Ritch Professor of Economics at Stanford University.She is also directorof Stanford’s Center for Research in Economic Development and Policy Reform and a research associate of the National Bureau of Economic Research. 1

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Takatoshi Ito and Anne 0. Krueger

Argentina, Uruguay, and Paraguay formed a preferential arrangement under MERCOSUR; many of the countries whose economies were in transition announced their desire to enter into the European Union, and the idea of a European economic area was enunciated; and the countries associated in the Asia Pacific Economic Forum announced their intention to find means for closer association. By 1995, the World Trade Organization (WTO) could claim that it had already received notification of more than 90 PTAs and that virtually all members of the WTO were signatory to at least one, and sometimes several, PTA. For the entire world economy, the emergence of these arrangements raises important questions. Will these regional trading arrangements be “building blocs” toward more open multilateral trade? Or will economic integration within regions instead create “stumbling blocs” and take place at the expense of further multilateral liberalization? What factors are conducive to “open regionalism” and further strengthening of the multilateral system? And what sorts of arrangements and policies will instead detract from the global system? For East Asian economies, integrated as they are with the rest of the world, understanding the factors that will determine answers to these questions is crucial. For several years, research has been underway, in the East Asian region and elsewhere, as to the factors affecting regionalism and its likely effects. The sixth annual NBER-East Asia Seminar on Economics (NBER-EASE) conference was therefore held on the subject in June 1995. This volume contains the papers presented at the conference, along with discussants’ comments. The first group of papers analyzes some key issues regarding PTAs. The first paper, by Anne 0. Krueger, provides an overview of regionalism and outlines some of the concerns regarding regional arrangements. Krueger starts by pointing out that, unlike across-the-board trade liberalization, liberalization of trade preferentially among several countries that leaves external trade barriers unaffected has two effects. On one hand, there is the classic “trade creation,” by which each partner country’s high-cost industries (previously protected by a tariff) face competition from lower-cost firms in other countries party to the preferential arrangement. On the other hand, there is also “trade diversion,” as partners to the agreement may shift from importing from third countries (outside the arrangement) to higher-cost partners whose products are not subject to duties. Whereas trade creation can be expected to increase real incomes and benefit the members of the PTA without hurting the rest of the world, trade diversion is costly to the importing country (which loses tariff revenue and pays higher real costs for its imports) and to the rest of the world. Although PTAs in recent years have largely been regional, there is nothing in economic theory that suggests that regional arrangements will have any advantages relative to other kinds of PTAs, unless countries entering into a PTA have comparative advantages such that there will be much trade creation and little trade diversion. For the United States and Canada, the fact that Canadian exports to the United States consisted 80 percent of primary commodities

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Introduction

while U.S. exports to Canada consisted 80 percent of manufactured goods, combined with the fact that the United States was by far Canada’s largest trading partner (and Canada a large, but not so predominant, partner for the United States), suggested that the free trade agreement (FTA) might be a “natural.” Other cases are not so clear, however. Krueger goes on to note that the differences between customs unions and FTAs may be important in determining whether the FTA is conducive to further multilateral liberalization (although both are permitted under WTO rules). In particular, under FTAs, countries retain their own individual external tariffs, and so FTA agreements must contain “rules of origin” to prevent “trade deflection” under which goods would be imported into a low-tariff country and transshipped to ones in which higher tariffs are applied. This, in turn, implies that third countries wanting to join an FTA cannot do so without negotiation of new rules of origin, which in itself is likely to limit the extent of ETAS, as contrasted with customs unions. In the second paper, Esquivel and Tornell analyze the motives underlying Mexican entry into NAFTA. In that case, the motives of Mexican policymakers were largely of a “political economy” variety-they hoped to lock in the trade liberalization that had already been undertaken. The authors note that forecasts of the direct benefits from Mexican entry into NAFTA were not large (because so much trade liberalization had already been undertaken multilaterally) and argue that Mexican entry into NAFTA should be viewed as part of a long history of efforts toward trade liberalization. They show that the trade liberalization of the 1980s required the breakup of two powerful domestic interest groups, operators of state-owned enterprises and private producers in importcompeting industries. Once oil prices declined, these two groups no longer colluded to support earlier import substitution policies, and once these were weakened, President Salinas was able to liberalize trade. The Salinas government pushed NAFTA in order to make a strong commitment for the future so that reversal of the liberalization would be extremely costly. The authors argue that NAFTA was partly responsible for aggravating some political problems, such as devaluation of the peso in 1994. But after the devaluation crisis at the end of that year, the authors argue, NAFTA was helpful in securing the U.S. support package and contributed to Mexico’s ability to weather the crisis. In the third paper, Kym Anderson considers the impact of intensified concerns about environmental issues and labor standards on the multilateral trading system and on PTAs. This issue is of great concern for NIEs and developing countries. NAFTA was the first agreement to bring developing and developed countries into the same PTA and was ratified only after “side agreements” were negotiated between the United States and Mexico with respect to labor standards and the environment. Some hold that the ability to “experiment” with new areas of trade regulation, such as labor and the environment, is an advantage of PTAs. Others, however, fear that such regulation may restrict trade, especially for developing countries.

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Takatoshi Ito and Anne 0.Krueger

As Anderson notes, the comparative advantage of developing countries derives in significant part from low labor costs. If “labor standards” are developed to raise labor costs in poor countries, it will be tantamount to increasing restrictions on trade with them. The same sorts of issues arise with respect to the environment. Anderson examines the reasons why these issues are becoming more significant in international trade negotiations. He then analyzes their potential impact on developing countries. As with so many other issues regarding PTAs, Anderson shows that these issues could be resolved in ways that need not adversely affect developing countries. He shows that the direct effects of these measures are likely to be small, but that the use of these measures could result in the erosion of the WTO system, to the detriment of developing countries. The latter would eventuate to the extent that protectionist interests align themselves with those advocating, say, labor standards, in order to use them as a device for protecting labor in developed countries. In the fourth paper, Goto and Hamada examine incentive problems of forming or joining a free trade bloc in a game-theoretic framework. Suppose there are (say, four) symmetric nations that produce differentiated products under increasing returns to scale and monopolistic competition. When some (say, two) countries form a free, preferential trading bloc, the welfare of those countries will increase while the welfare of countries outside the bloc decreases. Then countries outside the bloc will have an incentive to form a “counterbloc.” The authors proceed to consider a case of trade war between a large bloc and a small bloc in a Nash equilibrium setting. They conclude that “the hegemon has the capability to manipulate the terms of trade to its advantage. Therefore, it is optimal for the larger bloc to impose a higher tariff rate.” Although we do not typically observe a trade war with increased tariffs, the paper points out the potential political danger of PTAs. The second group of papers analyzes the economic effects of preferential regional trading arrangements. The first two papers in this group examine PTAs using conventional tools of analysis-the “gravity” equation for estimating trade flows. The next four papers focus on effects specific to East Asian countries. The gravity equation relates bilateral trade flows to such variables as distance between trading partners (presumably as a proxy for transport costs), sizes of trading partners, and relative per capita incomes. Wei and Frankel examine the “openness” of regional trading blocs (explicit or implicit) using various versions of the gravity equation: trade between countries i and j is regressed on per capita incomes, distance, and dummy variables for (1) countries that are adjacent to each other, (2) countries with a common language, (3) countries in a common regional bloc, and (4) two countries, one of which is in a regional trading bloc and the other not. A negative coefficient on trading bloc variables is interpreted as “trade diversion,” while a positive coefficient is interpreted as “trade creation,” with its positive welfare effect. Wei and Frankel find that Western Europe and East Asia (treated as an im-

5

Introduction

plicit trading bloc) are “trade creating” while APEC and the Western Hemisphere are “trade diverting” blocs. When changes in the dummy variables over time are examined, these same conclusions hold, and East Asia appears to have grown more open over time. Bayoumi and Eichengreen use the gravity equation to analyze the effects of the European Union. They argue that, for some purposes, the usual form of the gravity equation is biased, in that the dummy variables may pick up any factors not directly measured and, thus, are suspect in their use as indicators of the effects of PTAs only. The authors therefore use a difference approach, estimating coefficients on dummy variables when it is changes in trade levels that are examined, rather than the levels themselves. They examine the formative period for the European Economic Community (EEC) and European Free Trade Association (EFTA) and find that trade among the EEC countries grew little more rapidly than would have been predicted by the other variables in the gravity equation. However, in the period after it started, from 1959 to 1961, the coefficient is much larger, which they interpret as implying considerable trade creation. For the period 1953-73 as a whole, they estimate that trade among the original six countries in the EEC grew 3.2 percent per annum faster than it would have without the Treaty of Rome. There is a slight reduction in EC trade with the rest of the world. Bayoumi and Eichengreen then estimate the extent to which there was trade creation and trade diversion for EFTA, and for various periods with other industrialized countries. They also consider the effects of enlargement of the Community with the entry of the United Kingdom, Ireland, and Denmark. They estimate that between 60 and 90 percent of new trade with the European Community was trade creation, although some trade diversion also occurred. Overall, Bayoumi and Eichengreen conclude that the European arrangements significantly affected trade and that most of the effect was in the initial years. They find enough trade diversion that they believe there is an “important caution” for countries in other regions contemplating forming or joining PTAs. The next four papers examine these issues in the context of East Asia and the Pacific. Chinn and Dooley examine the channels of impact of capital flows from advanced and emerging markets to domestic financial markets. Their working hypothesis is that (1) capital inflows tend to increase bank credit; (2) the increase in bank credit means that more risky projects are likely to be funded, so the financial system will likely become less robust; and (3) expansion of bank credit, rather than money, results in increases in investment. Yamazawa’s paper gives an overview of the developments in the Asia Pacific Economic Cooperation (APEC). APEC, which started as a loosely connected consultative group, seems to be heading toward a kind of trading arrangement. In November 1994, APEC leaders agreed and declared (the Bogor declaration) that free and open trade and investment in the APEC region would be achieved by 2020 (or 2010 for industrialized countries). It was presumed that the liberalization would be achieved without preferential arrangements (i.e., most-

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Takatoshi Ito and Anne 0. Krueger

favored-nation [MFN] status would be extended to the rest of the world). It remains unclear, however, how quickly countries will lower tariffs and whether the MFN principle will always be maintained. APEC members are divided on the question of whether implementation of the Bogor declaration requires a binding commitment with a target date for each step or whether it should be left to unilateral actions based on peer pressure. Yamazawa’s paper analyzes political and economic arguments on some of the controversial points and describes the extent of the APEC initiative envisioned currently. Lee’s paper examines the effects of Mexican entry into NAFTA on Korean trade with the United States. He points out that, although the overall effects of Mexican entry into NAFTA on third countries were estimated to be small initially, they might be significant for countries whose exports to the United States compete more directly with those of Mexico. In that regard, Japan might be expected to be much less affected than Korea, as Japanese exports compete much less with Mexican exports in the U.S. market. Lee computes an export similarity index for trade between East Asian economies, Mexico, and the United States and finds that Korean exports competed relatively little with those from Mexico; the index is far higher for Taiwan and other East Asian economies. Other measures, such as revealed comparative advantage and trade elasticities, tend to confirm this result. He thus concludes that, at least on a static basis, there does not appear to be much evidence that Korea will suffer from trade diversion to Mexico under NAFTA. He qualifies his conclusions, however, by noting that he did not examine any “dynamic” effects and that these may be important. In her paper, Chia analyzes the economies belonging to ASEAN and examines the various types of regional integration that affect them. She starts by noting that ASEAN had noneconomic objectives, especially as a security bloc, and that any analysis of ASEAN must take those goals into account. She then notes that ASEAN countries have always been highly open and outer oriented and that efforts at PTAs only started in 1977, and even then with very mild preferences; by 1986 only 2.6 percent of items were granted tariff preferences within the region. The ASEAN Free Trade Area (AFTA) was designed to further economic integration, with common effective preferential tariffs to be phased in over 15 years, although there are questions, reviewed by Chia, as to how effective these will in fact be. ASEAN countries have also cooperated on a variety of issues, although competition between economies has limited the extent of cooperation. Chia considers the concept of ASEAN “growth triangles” as subregional areas in which cooperation might proceed considerably further. She believes that growth triangles can sometimes overcome some of the problems encountered in extending regional cooperation, and she lists some of their advantages. As Wei notes in his comments, however, this is a preliminary finding and subject to a number of questions. The third group of papers takes up trade-related issues of individual coun-

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Introduction

tries or products in relation to institutional trading relations. The paper by Jwa provides an overview of the Korean industrial structure and policy issues related to it. The conventional wisdom in Korea is that Korean firms are “overdiversified” into technologically unrelated sectors. Yang’s international comparison supports this view. The Korean government therefore wants to encourage specialization, believing that it is necessary if Korean firms are to be competitive in world markets. Jwa argues that the structure of Korean firms may be rational, and not overly diversified given the Korean context. He provides empirical evidence as to the extent of scale and scope economies in individual Korean industries, and in the Korean economy as a whole. One aspect of the question of NAFT’s effects on East Asian countries concerns the likely impact on U.S. bilateral trade relations with those countries. Chen and Liu consider the effects of U S . bilateral trade relations on Taiwan’s exports. The United States and Taiwan have entered into a series of bilateral negotiations (as has also been true for Japan, Korea, and other countries, although Taiwan has not been a member of GATT). Various products were put under voluntary export restraints in response to U S . pressure in the 1960s and 1970s. In the 1980s, more disputes centered on the opening of the Taiwanese market to U.S. products. Chen and Liu document several instances of preferential treatment of U.S. imports, as well as the number of cases in which tariff concessions were requested by the United States and granted by Taiwan. They then undertake regression analyses to search for the determinants of U.S. demands and Taiwanese concessions. The most remarkable finding is that Taiwan’s high-tech industries are more likely to be targeted by the United States but they are the industries where Taiwan is most likely to resist pressure. The authors conclude that “the United States tends to refrain from demanding tariff concessions in sectors dominated by public enterprises in Taiwan and in sectors in which wages are relatively low in Taiwan. “The United States tends to demand tariff cuts in sectors in which the United States has revealed comparative advantage. They also find that “existing tariff and nontariff barriers in Taiwan, which are important determinants of U.S. demands for tariff cuts, are not as important in determining the final outcome of negotiations.” In the final paper, Hayami and Godo consider some aspects of Japan’s trade policies with respect to rice. This is another instance in which bilateral trade relations between the United States and a major trading partner have been important. Rice was a major stumbling block for Japan’s agreement to the outcome of the Uruguay Round. Japan had maintained a total ban on imports of rice until 1993, when emergency imports became necessary to augment a poor domestic crop. In the second half of the 1980s, the American Rice Millers’ Association petitioned the U.S. Trade Representative to take action against Japan’s rice import ban. The petition was turned down on the condition that the issue be resolved in the Uruguay Round trade negotiations. On the domestic front, the Japanese Diet had adopted resolutions to oppose any imports. With this backdrop, how to deal with opening up rice imports was a major policy

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Takatoshi Ito and Anne 0. Krueger

issue for Japanese trade authorities at the height of the Uruguay Round negotiations. Hayami and Godo survey the debate in Japan and argue that tariffication of the barriers to rice imports would have had a number of advantages over the minimum access route (which specified that a certain small percentage of Japan’s consumption should be imported) that was the compromise in fact chosen. Since the June 1995 NBER-EASE conference, there has been some slowdown in the momentum for further regional movements. However, the issues analyzed in the papers presented here, as well as additional questions that arise in the context of overlapping PTAs and relationships between the WTO and FTAs, will remain central to analysis of trade policies for the global economy.

1

Problems with Overlapping Free Trade Areas Anne 0. Krueger

Preferential regional trading arrangements are in vogue. As of the end of 1994, GATT had received notification of 33 new agreements since 1990. Most of these arrangements are for free trade areas (FTAs), although the European Union has also been enlarging its membership. As of 1994, there were few members of GATT that did not belong to at least one preferential trading arrangement, and many belonged to more than one.’ Additional FTAs are currently under discussion and, in a number of cases, officially endorsed. Moreover, it is contemplated that some of these FTAs might be overlapping. The United States, for example, is already a member of NAFTA, also has an FTA with Israel, and has declared its intention to participate in an Asia Pacific (APEC) FTA. The APEC countries have announced that they will become an FTA by 2010 (for the developed countries) and 2020 (for the developing).* In the spring of 1995, there was even discussion of a North Atlantic Free Trade Area, which might entail U.S. membership in yet another FTA. In addition, the United States extends preferences unilaterally to countries eligible under the Caribbean Basin Initiative (CBI) and tariff preferences to developing countries under the Generalized System of Preferences. Chile, which has sought negotiations to enter into an FTA with NAFTA, has announced its intention to join APEC and to enter into an FTA with the European Anne 0. Krueger is Caroline L. and Herald L. Ritch Professor of Economics at Stanford University. She is also director of Stanford’s Center for Research in Economic Development and Policy Reform and a research associate of the National Bureau of Economic Research. The author is indebted to Richard Blackhurst, Takatoshi Ito, and conference participants for helpful comments on an earlier draft of this paper. Roderick Duncan provided able research assistance. I . World Trade Organization (WTO 1995, 1). Notable exceptions, pointed out by the WTO, were Japan and Hong Kong, who belonged to no reciprocal preferential arrangement, although Japan did and does extend tariff preferences to developing countries. 2. From the communiquis from APEC, it is unclear whether “free trade area” means a discriminatory, preferential trading area or an area all of whose members practice free trade.

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Anne 0. Krueger

Union. Countries already signatory to MERCOSUR (which is a customs union among Brazil, Argentina, Uruguay, and Paraguay) have indicated their intention to join NAFTA. In supporting the formation of FTAs, political leaders have generally reasserted their support for the open multilateral system and indicated that WAS are intended to be “GATT-plus’’ (now “WTO-plus”) arrangements that would go beyond the agreements already existing multilaterally and seek even freer trade among “like-minded trading nation^."^ A number of economists have taken this view, regarding the formation of PTAs as a step along the way to liberalizing trade m~ltilaterally.~ Supporters of the open multilateral trading system, with its most-favorednation (MFN) principle implying an absence of discrimination among trading partners, have raised questions about preferential trading arrangements. These questions have been based on the concern that the emergence of regional trading arrangements, including both FTAs and customs unions (especially the European Union), would erode support for the open multilateral trading system and hence serve as a WTO substitute, rather than as a WTO-plus arrangement. If this happened, the emergence of regional trading blocs would be accompanied by increasing trade frictions and perhaps rising trade barriers between blocs. When attention is given to overlapping preferential trading arrangements, additional issues arise. Those concerns are the focus of this paper. To set the stage, section 1.1 reviews the prevalence of preferential trading arrangements as of the inauguration of the WTO. Section 1.2 reviews the salient issues that arise with respect to FTAs and customs unions in assessing the extent to which they are WTO-plus and likely to be conducive to further multilateral trade liberalization. Section 1.3 then points to the additional complexities that are likely to arise if overlapping FTAs become the order of the day. Next, consideration is given in section 1.4 to East Asia’s interests in the international economy and the choices open to East Asian nations if the trend toward FTAs continues. Section 1.5 summarizes the argument.

1.1 Preferential Trading Arrangements Referential trading arrangements can take any number of forms. They may consist of unilateral preferences or reciprocal preferences. They may be partial or total with respect to the degree of preference extended to members. And they may be partial or total with respect to those portions of international trade 3. It is not clear why regional arrangements began proliferating in the 1980s.In part, the success of the European integration was a factor, as is discussed below. Historically, the United States announced its change of position after the GAlT Ministerial of 1982, when the U.S. Trade Representative (USTR) was frustrated by failure to agree on the start of a new round of multilateral trade negotiations. 4. Lawrence (1991) has been perhaps most closely associated with a defense of regional arrangements.

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Problems with Overlapping Free Trade Areas

to which preferences pertain. They may be restricted to trade in goods or in goods and services, or they may apply also to factor mobility. And they may be limited to border measures, or they may entail setting rules and discipline for domestic regulations. For the purposes of this paper, focus will be on reciprocal preference^.^ Among these, two especially will be considered: customs unions and free trade agreements. For, in terms of the major trading countries and the Asia Pacific region, it is these two forms that are currently contemplated. And, although arrangements with respect to factor flows and harmonization can take place under either an FTA or a customs union, the essential differences center on the fact that a customs union entails a common external tariff among its members whereas a free trade arrangement allows each member to retain its own tariff structure. Moreover, attention will be devoted only to arrangements that are 100 percent preferences, since those are the ones that are contemplated under NAFTA, APEC, and any North Atlantic Free Trade Area.6 That difference, however, is crucial. It is crucial for two reasons. First, it is likely that FTAs are less suited to being WTO-plus arrangements than are customs unions. Second, it is not possible to have overlapping customs unions.’ Countries are either inside a wall of common external tariffs or they are outside of it. Hence, the problems raised by overlapping preferential arrangements could not arise if they were customs unions. Attention returns to this point in section 1.3. Table 1. I gives a list of the reciprocal integration agreements in effect as of January 1995. The most striking feature of table 1.1 is the number of arrangements that already exist, including overlapping FTAs. Israel, for example, has FTAs with both the United States and the European Union. Norway is in the European Free Trade Association (EFTA) and has FTAs with the European Union and the Baltic states. A second striking feature of table 1.1 is that, with the exception of the IsraelU.S. FTA, the arrangements are all regional.* While there is no reason in principle why preferential trading arrangements should be r e g i ~ n a lthe , ~ vast ma5. This leaves out the Generalized System of Preferences, Lome Convention, CBI, and other one-way extension of preferences. It may be argued that acceptance of these preferential arrangements contributed to the erosion of the nondiscriminatory aspects of the world trading system, but it seems clear that concerns now center on reciprocal relationships, such as NAFTA and the European Union. 6. In theory, the optimal preference (if any) probably lies between zero and 100 percent. 7. A country can enter into a free trade agreement with a customs union. This has, in effect, been done by many countries in Eastern Europe and the former Soviet Union. 8. “Regional” does not always imply contiguous. Switzerland’s agreements with the Baltic states and with other EFTA countries are not all geographically proximate. 9. Many earlier preferential arrangements were not regional. The system of Commonwealth preferences is perhaps the best-known example. Regional arrangements do take advantage of the fact that trading partners are closer to each other and hence face relatively low transport costs for cross-border transactions. However, in the 1990s, with transport costs accounting for a very small percentage of the value of trade, the advantage gained by proximity is probably quite small.

Table 1.1

Integration Arrangements as of January 1995

Europe European Community (Customs Union) Austria Belgium Denmark Finland France Germany Greece Ireland Italy Luxembourg Netherlands Portugal Spain Sweden United Kingdom EC free trade arrangements with Estonia Iceland Israel Latvia Liechtenstein Lithuania Norway Switzerland EC association agreements with Bulgaria Cyprus Czech Republic Hungary Malta Poland Romania Slovak Republic Turkey” European Free Trade Association (EFTA) Iceland Liechtenstein Norway Switzerland Norway and Switzerland each have FTAs with Estonia Latvia Lithuania Central European Free Trade Area Czech Republicb Hungary Poland Slovak Republicb Nonregional Israel-U.S. Free Trade Agreement

13

Problems with Overlapping Free Trade Areas

Table 1.1 ~~~~

(continued) ~

North America Free Trade Area Canada Mexico United States Latin America Caribbean Community and Common Market (CARICOM) Central American Common Market Latin American Integration Association Southern Common Market (MERCOSUR) Middle East Economic Cooperation Organization (ECO) Gulf Cooperation Council (GCC) Asia Australia-New Zealand Closer Economic Relations (CER) Bangkok Agreement‘ ASEAN Preferential Trade Agreement Source: WTO (1995,26). “Turkey entered into a customs union (in nonagricultural goods) with the European Union on 1 January 1996. bThe Czech Republic and the Slovak Republic have entered into a customs union, and each has a free trade agreement with Slovenia. ‘Thailand also has preferential trade agreement with Lao Democratic Republic.

jority of those to date have been. Even the proposed FTA encompassing the APEC countries, which spans both sides of the Pacific, is billed as being regional in nature. As already noted, there are FTAs under discussion in addition to those listed in table 1.1, which were already notified to GATTNTO by January 1995. Those arrangements would greatly increase the coverage of FTAs and, in addition, would change the “overlapping” aspect of FTAs from being an occasional phenomenon to being the rule rather than the exception.

1.2 Salient Aspects of Preferential Arrangements Under Article 24 of GATT/WTO rules, preferential arrangements were and are permissible as long as preferences (1) are 100 percent, (2) cover substantially all trade, (3) do not raise protection against third countries, and (4) have a definite timetable for implementation. However, GATT panels deciding on whether particular arrangements meet these tests have seldom been able to reach decisions, and the legal requirements for satisfying these criteria are therefore subject to considerable debate. lo De facto, however, when the United 10. See WTO (1995, chap. 1, esp. 5-18). Because GATT panels have often been unable toreach decisions regarding the conformity of proposed arrangements with Article 24, there are a number of suggestions for changing the rules in order to make the standards clearer. Insofar as the problems raised in this paper (and elsewhere-see Krueger 1995) are deemed serious, consideration might be given to restricting coverage of Article 24 to customs unions.

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Anne 0. Krueger

States or the European Union decides to enter into such an agreement or to enlarge an existing one, it is a sufficiently important member of the WTO that its decision will be endorsed, or at least not be found to be in contravention of the articles.” Traditionally, analysis of the welfare effects of preferential trading arrangements has centered on the positive welfare effects of trade creation (when highcost production in one member country is shut down as lower-cost competing goods from a partner country displace it) and the negative welfare effects of trade diversion (when a member country replaces imports from a low-cost source in the rest of the world with imports from a higher-cost member). The analysis has been extended in a variety of ways, including the potential increase in welfare in the case of trade diversion that might result from consumers’ gain from lower prices for the imported good that might partially or more than totally offset the welfare costs of trade diversion, the possibility that increased competition will result in greater efficiency and lower costs for individual producers, and under increasing returns to scale the larger market that might result for goods produced under conditions of imperfect competition. Nonetheless, because formation of a preferential trading arrangement is clearly second-best to free trade, analysis of its welfare effects is necessarily ambiguous. That a customs union will in general increase potential welfare more (or reduce it less) than an FTA has been pointed out elsewhere (see Krueger 1995). It is important, however, to note the reason, since it is central to understanding some of the difficulties that arise when contemplating overlapping free trade agreements. That is, rules of origin (ROOs) are a far more central feature of free trade agreements than they are of customs unions. That is because of the possibility of “trade deflection” that arises under an FTA and not under a customs union.I2 Rules of origin, while inherently a part of FTAs, can serve protectionist purposes. The “triple transformation” rule, used by the United States with respect to Mexican textiles and apparel, for example, extends preferential treatment to Mexican exports of apparel only if the raw material has been transformed into thread, the thread into cloth, and the cloth into a garment, all within the FTA. It may be that such a rule is designed to ensure that foreign apparel does not enter through Mexico, but it is more likely that Mexican apparel producers may be enticed to purchase textiles from the United States, and even perhaps 11. The language of Article 24 is also very vague, so that few GATT panels charged with assessing the consistency of an FTA with the GAlT have been able to reach a conclusion. 12. Without ROOs, any FTA would in fact become a customs union. This can be most easily seen by assuming the absence of transport costs. If there were no ROOs in an FTA, importers would import goods through the country with the lowest tariff and then transship them (i.e., “deflect” them) to the country where they were in demand. As such, the tariff actually paid on each good would be the same throughout the FTA (and it would be the lowest tariff prevailing in any of the member countries).

15

Problems with Overlapping Free Trade Areas

divert textile imports from East Asian or other sources, in order to qualify for duty-free entry into the U.S. market.13 Rules of origin can be set in one of several forms.14These include a “substantial transformation” criterion, a change in tariff heading (CTH) criterion, a value-added criterion, and a specified process criterion. The substantial transformation criterion is essentially a common law criterion and, when contested, is decided by the courts. The CTH criterion appears somewhat more formulaic but in fact requires specification of what level of tariff heading is involved (eight-digit, four-digit, three-digit, etc.) and requires tariff headings to be updated with changes in technology.’5Even the value-added Criterion, which appears to be a more standardized way of proceeding,16raises enforcement diffi~ulties,’~ as accounting methods must be agreed upon and audits are necessary to ascertain whether ROOs have in fact been met. And, of course, any process criterion (e.g., triple transformation) must be specified for each individual product. As Palmeter (1993) has pointed out, all of these rules give rise to problems of bureaucratic implementation and interpretation. In an important sense, however, the CTH criterion (by virtue of the ability to have a “not elsewhere classified” category) is the most inclusive. Under other criteria, new rules must be devised for new products. Rules of origin are naturally far more important in FTAs than in customs unions, where there is already a common external tariff and so trade deflection is much less of a problem. They are also more important, the higher the external tariffs of member countries.18 Moreover, they provide an opportunity for representatives of individual interest groups to lobby to avoid competition from imports. These groups can pressure to obtain an “export of protection” (through an ROO that will make it profitable to buy higher-priced intermediate goods in the partner country to satisfy the ROO), or they can lobby to ensure

13. See Krueger (1993) for a demonstration that ROOs can “export” the protection policies of one trading partner-in this case, U.S. protection of its textile industry-to the other, i t . , the Mexican producers who now find it worth their while to purchase U.S. textiles even if they cost more. 14. See Palmeter (1993) for a more complete discussion of these categories. IS.As pointed out by Palmeter (1993), agreeing on new tariff classifications across countries (predominantly in new high-tech industries) entails disputes about what the relevant tariff classifications should be. And, even under existing tariff schedules, there are many disputes over the appropriate tariff category for imported items. 16. See Lloyd (1993). who advocated exclusive reliance on a value-added criterion that, in his view, should be the same in all preferential trading arrangements. Difficulties with the value-added criterion include accounting problems that inevitably arise in allocating costs, problems that arise with respect to exchange rate changes, and the apparent discrimination against developing countries, whose relatively low wage rates for unskilled labor may imply that value added will be a smaller fraction of output price than is the case for goods produced in richer countries. ASEAN countries have a value-added (40percent) ROO in their agreement. 17. There are also criteria couched in physical terms, as when cigarette producers in Australia were required to use 50 percent domestic tobacco in the production of cigarettes. 18. There are, nonetheless, ROOs in customs unions. E.g., semiconductors are considered to originate in the European Union only if the diffusion process is undertaken in the Union.

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Anne 0. Krueger

very stringent ROOs (thus preventing imports in some cases). Clearly, when U.S. auto parts producers insisted on a high percentage of value added (62.5 percent) as a criterion for conferring origin, the intent was to ensure that Mexican assemblers found it profitable to use U.S., and not foreign, auto parts. Textile producers presumably achieved a similar victory with their triple transformation rule. But when it was decided that using milk produced in one signatory to NAFTA to make cheese in another signatory did not confer origin, the intent was clearly protectionist for the dairy industry. Even when ROOs are not highly protectionist in intent, they increase producers’ costs and require administrative surveillance. It is estimated that when EFTA countries’ producers provided documentation on origin to enter EU markets duty-free, the costs of providing the documents were the equivalent of 3-5 percent of the delivered cost of the goods. Producers chose on occasion to pay the duties rather than provide the documentation necessary to establish origin (see Herrin 1986). Accounting for joint costs, providing records as to which inputs were used in what goods, and otherwise establishing a record of costs sufficient to satisfy origin is not simple, unless the CTH criterion is used to establish origin. Before turning attention to problems with overlapping FTAs, one last phenomenon should be noted. The European Union, by far the most successful, visible, and long-lasting preferential trading arrangement, was mostly of the GATT-plus variety, at least until the 1980s (when the protectionist effects of the Common Agricultural Policy [CAP] began to outweigh the trade liberalizing effects of successive rounds of multilateral trade reductions). That is, while the members of the European Union were eliminating trade barriers among themselves, they were also reducing external trade barriers. Thus, although intra-EU trade grew very rapidly after the Treaty of Rome, EU trade with the rest of the world also rose rapidly. Indeed, until the late 1970s EU external trade as a percentage of EU GDP rose during the period of increasing European integration. In 1958,just as the Treaty of Rome was taking effect, intraregional European trade constituted 52.8 percent of its total trade, and extraregional trade 47.2 percent. By 1993, the intraregional share was 69.9 percent, and correspondingly, the share of European trade with non-EU countries had fallen to 31.1 percent. However, in 1958, extraregional trade of the members of the European Community accounted for 15.8 percent of GDP; in 1979, the figure was 16.1 percent. Only in the late 1980s did the share of European GDP accounted for by external trade begin to fall (WTO 1995, 39,40). Much of the European Union’s increased trade with the rest of the world was attributable, of course, to the multilateral tariff negotiations conducted under GATT auspices, with their liberalizing impact on trade f l 0 ~ s . I ~ 19. That European external trade as a percentage of GDP has fallen may be accounted for by several factors. One is probably the decrease in oil prices after the mid-1980s, which no doubt reduced the recorded importance of petroleum imports in Europe’s overall trade. It is likely, however, that pressures associated with mounting production and declining imports of agricultural commodities resulting from the CAP were also a significant contributor to this decline.

17

Problems with Overlapping Free Trade Areas

It is likely that the European success in integrating internally while simultaneously liberalizing externally accounts for a large part of the apparently uncritical acceptance of preferential trading arrangements by much of the rest of the world.20Indeed, for the United States to endorse preferential trading arrangements in the 1980s was a significant reversal of policy,21and one that would probably not have occurred had preferential trading arrangements not been associated in policymakers’ minds with continuing external liberalization.

1.3 Prospective Difficulties with Overlapping FTAs It was already noted that there cannot be overlapping customs unions: by definition, a common external tariff means that countries are either members and maintain the common external tariff or they do not. By contrast, overlapping FTAs are possible precisely because each member of an FTA retains its own external tariff. For that reason, the problem of overlapping preferential trading arrangements is one that arises under F T A S . ~ ~ It has elsewhere been shown that ROOs under FTAs can be trade diverting and, indeed, can “export” protection from one trading partner to another. To see this, assume that the United States has a tariff on automobiles and negotiates an ROO on Mexican assemblers of automobiles.Assume further that, prior to the FTA, Mexican auto assemblers imported parts from third countries with no tariffs. It is easy to see that it could well become attractive for Mexican assemblers to import (high-cost, protected) U.S. auto parts in order to qualify for tariff exemptions when exporting their autos to the United States. As such, in entering an FTA with Mexico, the United States could “export” its protection of auto parts to cover the Mexican market as welLZ3 With one FTA, the problems associated with ROOs are already troublesome, in that they are complex and highly opaque.24As can be seen from the discussion in section 1.2, there is no uniform way to set ROOs comparable to concepts such as a “uniform tariff.” Moreover, since ROOs are adapted in each 20. In the late 1980s. when “Europe 1992” and the creation of the Single Market was under way, there was some alarmist discussion of the possibility of “Fortress Europe.” Since most decisions made under the 1992 initiative were liberalizing, this concern rapidly diminished. 21. At the Bretton Woods conference and subsequently, the United States supported the open multilateral trading system and initially insisted on no exceptions. The United Kingdom, however, wanted to continue its Commonwealth preferences, and the resulting compromise was Article 24 of the GATT articles. See Dam (1970,42). 22. There can, of course, be an FTA between a customs union and nonmembers. There was an FTA in manufactures between the European Community and EFTA. 23. The same result could occur if Mexico agreed to a common external tariff higher than that which had prevailed prior to the preferential trading arrangement. Such an increase in tariffs, however, is transparent and could be appealed under G A T T W O mles. Under an FTA, there is no similar mechanism for compensation (by the lowering of other tariffs) since no tariff has been raised! 24. Rules of origin take up around 200 pages of the NAlTA agreement. Bargaining over them was prolonged, and the final NAFTA agreement resulted only when exact formulas for ROOs for automobiles and textiles and apparel had been agreed upon.

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Anne 0. Krueger

case to the particular tariff structures of the trading partners in an FTA, negotiations must take place on new ROOs for each new applicant to join the FTA. That property of a single FTA is a major problem with overlapping FTAs. Each new entrant provides an occasion for lobbyists to seek insulation (through restrictive ROOs) and to generate delays as each applicant seeks admission. While in principle very liberal ROOs might result (with a consequent lowering of average protection), the lack of transparency of the process, combined with the necessity for detailed negotiations, renders it likely that special interest groups will seek at each negotiation to secure ROOs they perceive to be favorable to them. Consider, then, how much more difficult the case as the number of FTAs in which a country has membership increases. ROOs agreed upon under NAFTA, for example, might differ from those agreed upon in APEC. And, should APEC expand, the ROOs there could change in unpredictable ways. Representatives of individual industries would pressure for ROOs serving their particular interests in ways that even the most ardent free trade negotiators would have difficulty disentangling. A minor example of this possibility recently arose in the United States, when California winegrowers discovered that Mexico’s FTA with Chile provided for Mexican tariffs on imports of Chilean wine to go to zero on 1 January 1997, while NAFTA provides a later date for zero tariffs on U.S. wines. The USTR dispatched negotiators to both Chile and Mexico in an effort to “correct” this problem! For ROOs that are not the same across all trading partners, similar problems are likely to emerge.25 Under U.S. trade law, it is already true that a particular commodity can have different “origins” for purposes of NAFTA, the CBI, labeling, and the MultiFiber Arrangement! Trade lawyers specialize in litigation over the origins of particular imports even without overlapping JTAs. With overlaps, even more export of protection and disputes with customs over origin and satisfaction of ROOs would likely result. Inevitably, the customs clearance process itself would become more complex, if not more prolonged.26And possibilities for further integration through “borderless” preferential arrangements and the elimination of border barriers (presumably one of the raisons d’gtre for the regional nature of a preferential trade agreement) would be eliminated. In addition to these problems, the political economy of preferential trade agreements is less conducive to further trade liberalization than is that of customs unions. For, insofar as protection is exported through FTAs, all the re25. There is also a problem that successive entrants may result in repeated trade and investment diversion. There are already reported instances of factories that moved to the Caribbean to take advantage of U.S.-extended preferences under the CBI that then relocated in Mexico under NAFTA. One can well imagine yet further moves if countries such as Chile, Colombia, Brazil, and Argentina enter sequentially. 26. The existence of different rates of duty for imports from different countries also gives rise to additional scope for false invoicing (to show origin in the country subject to lower duties) and to corruption, as officials may misclassify goods to give lower rates of duty.

19

Problems with Overlapping Free Trade Areas

sulting increase in trade represents an increase in the economic size, if not the number, of producers who have (and can readily perceive) a vested interest in opposing moves toward trade liberalization and the open multilateral system.27 Thus, FTAs are suspect simply because of the greater complexity of ROOs under them than under customs unions. Overlapping FTAs are doubly suspect, in light of the additional complexity and opacity they bring to trade measures.2s When it is recognized that overlapping FTAs would also lead to competition among producers facing different costs of production (because of the imported items subject to duty at different rates in the individual countries), further questions arise. A particular type of overlapping FTA system has been referred to in the literature as the “hub and spoke” system-under which producers in a country that has multiple FTAs may have cost advantages over producers in each of the “spokes,” which have FTAs only with the center country.29Whenever there are “artificial” cost differences (due to differences in tariff height in this case) between competitors or between locations, economic inefficiencies must result, and FTAs-especially overlapping ones-seem by their very nature to be likely to be conducive to these inefficiencie~.~~ To be sure, if producers in country A are aware that their competitors in country B are advantaged because some imported inputs cost less by virtue of B’s membership in an FTA of which A is not a member or because B has lower tariffs on imports from the rest of the world, they may put pressure on their government to reduce its own external tariffs.31However, insofar as new activities are located, or existing firms choose expansion locations, in particular countries because of artificially lower costs, there will be two consequences. First, economic inefficiencies associated with different costs will result. Second, there will arise further pressure against subsequent multilateral trade liberalization as those choosing locations on the basis of these artificial cost differences oppose measures that reduce their advantages. There is even the possibility (although one suspects that pressure groups are sufficiently aware 27. For those exporters who would support free trade, the value of further multilateral trade liberalization is diminished with every new entrant into a preferential trade arrangement, so that exporters’ support for multilateral liberalization is likely to diminish as vested interests profiting from trade diversion increase. 28. It has been reported that despite Chile’s uniform tariff, there are increasing delays in customs as officials attempt to determine which preferential schedule, if any, a particular imported consignment should enter under. As Chile has extended preferential arrangements, the problem has increased in seventy. 29. See Hoekman and Leidy (1993) for further discussion. The issue was earlier raised in considering Korea’s interests in an FTA with the United States. See Park and Yo0 (1989). 30. If producers in different countries with different input costs continue competing, one of the competitors may be able to use the “artificial” lower costs to offset part of the “natural” comparative advantage the other producer has. 31. This has already happened in Canada, where tariffs were reduced on a number of items because Canadian producers recognized that they were confronted with cost disadvantages vis-Lvis American producers because of lower American tariffs. It is also reported that some Australian producers have demanded lower tariffs on imported inputs as they face competition from New Zealand producers.

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Anne 0. Krueger

of their interests to avert it) of repetitive trade diversion as new members are added with new ROOs to an FTA, or as a member of one FTA then joins a second one! Related to the above, questions arise about the pulls for foreign investment under overlapping FTAs. The same considerations that may bias location choice for local producers will surely affect potential foreign investors as they seek out low-cost locations. While comparative advantage for a particular activity may be sufficiently large in a particular country that distortions introduced by different cost structures (determined by each country’s particular FTA memberships) do not affect location, there are surely instances in which differences in input costs (among goods whose prices ought to be similar except for transport cost margins) would dominate the decision. Again, it must be concluded that possibilities for the play of special interest groups, increased trade diversion, and consequent opposition to further multilateral trade liberalization are likely to increase as the prevalence of overlapping FTAs mounts. Questions may also be asked about different FTAs in which members have different macroeconomic balances. The evidence from the past 50 years clearly demonstrates that more open economies (such as Mexico’s in 1994 and Europe’s in 1992) are more vulnerable to even small differences in macroeconomic and exchange rate policies. Countries whose major trading partners have very different inflation trajectories already have problems with exchange rate management. With overlapping FTAs, these problems can only increase. Successful FTAs will be trade liberalizing among members, but that in turn implies that they must increase the sensitivity of producers within the FTAs to differences in macroeconomic policies. One can only ask what the consequences would be for a country affiliated with two FTAs, if in one FTA price levels were reasonably stable and in the other the inflation rate was 5-10 percentage points higher. With shifts in macropolicy among FTA partners in one or the other bloc, individual producers would surely be subject to greater shocks than would be the case were macroeconomic policies more closely aligned. While this consideration carries force in FTAs and customs unions generally, the possibilities for differing policies among countries in different, but overlapping FTAs seem to offer even more scope for difficulty.

1.4 Implications for East Asian Countries East Asian countries have been successful in reaching high levels of productivity and economic growth in part because of their willingness to integrate with the international economy. In part, that willingness itself originated in the early recognition that trade was essential for those countries in light of their own factor endowments and comparative advantages. Continued growth in East Asia, as elsewhere, will depend on a variety of factors, including measures to increase the efficiency with which markets function and to reduce regulatory burdens. But no one can doubt that East Asia’s

21

Problems with Overlapping Free Trade Areas

future growth prospects will be much brighter with a healthy international economy than they would be were the international economy to stagnate. For that reason, East Asians have a strong stake in the open multilateral trading system. Political support for the WTO and leadership in strengthening the open multilateral system constitute perhaps the most important line of defense against the possibly protective effects of regional trading arrangements. This would entail support for settling the “new issues” on the WTO agenda, strengthening disciplines in services and agricultural trade, and facilitating the achievement of multilateral agreements on these issues. Beyond that, it is important for East Asian countries to ensure that their own regional arrangements do not discriminate preferentially. Asia as a whole has a lower share of intraregional trade than does Europe, and an index of the intensity of intratrade (taking into account both the share of regional trade in total trade and the share of total trade in GDP) gives Asia a much lower index than the United States (Anderson and Horheim 1994, 134). Moreover, East Asia’s growth has been associated with a reduced share of intraregional trade (see Petrie 1994, 118). In part, that is because much of the intraregional trade historically was in raw materials. As countries began developing manufactured exports, the scope for trade within the region lessened. Worldwide markets would appear to be especially vital to the prospects of developing countries in Asia, as they grow through an outer-oriented trade strategy. The APEC initiative, which has promised free trade for the developed countries in the region by 2010, and for the developing countries by 2020, raises interesting questions. On one hand, leaders have been careful to talk about “open regionalism,” which implies the absence of preferences. If countries will individually adopt free trade multilaterally and remove all tariff and other trade barriers by those target dates, there will clearly be no preferences, but there then arises the question as to why the grouping is “regional.” If the region had a higher than average share of intraregional trade to start with, removal of remaining tariff barriers multilaterally might nonetheless strengthen trading ties within the region relative to those with the rest of the world. Given the region’s below-average intraregional trade, however, it is difficult to understand how the arrangement would be regional. Despite these questions, there is little doubt that Asia’s interests lie in an open trading system among all nations of the world and that preferential arrangements within Asia would, in Asia’s self-interest, need to be “building blocs,” and not “stumbling blocs,” to further liberalization of trade globally.

1.5 Conclusion It has elsewhere been argued that customs unions, which do not raise protection against nonmembers (and are therefore consistent with WTO rules), cannot be any less economically efficient than FTAs and will be more conducive to support for further multilateral trade liberalization (Krueger 1995). They

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Anne 0. Krueger

also greatly reduce the opportunities for supporters of protection to exercise influence whenever accession of a new member to the agreement is proposed. The arguments appear to apply with even more force to overlapping FTAs as contrasted with customs union enlargement. The initial vision behind the U.S. switch in stance toward support for preferential arrangements that are GATT-plus was that these agreements would be conducive to such large gains that others would be induced to join, thereby achieving further liberalization of trade. It is difficult to imagine that a series of overlapping FTAs, with different ROOs attendant for different countries’ access, the need for individual producers to know and keep records for a variety of ROO requirements, and the complications associated with negotiations for accession of additional members, will lead to that WTO-plus world. If, instead, a customs union were formed, requirements for accession would be straightforward: adopt the same external tariff. Moreover, trade diversion within the union must be less, and there cannot be uneconomic choices induced by tariff differentials that then increase resistance to further liberalization (although trade diversion and, with it, resistance to liberalization can still occur). One can imagine enlargement of a customs union until it encompasses the entire world and, with it, increased trade liberalization the entire way. If, instead, more and more overlapping FTAs form, with complex ROOs, no further accessions are straightforward, and the end of the process is not membership of all and an open multilateral free-trading If all that remained were requirements that producers satisfy ROOs, that would nonetheless require border inspections, more complex customs procedures, and costs to producers for providing the documentation. The problems of proliferating overlapping FTAs deserve considerably more critical attention than they have so far received.

References Anderson, Kym, and Hege Horheim. 1994. Is world trade becoming more regionalised? In Asia Pacifc regionalism: Readings in international economic relations, ed. Ross Gamaut and Peter Drysdale. Pymble, Australia: HarperCollins. Anderson, Kym, and Richard H. Snape. 1994. European and American regionalism: Effects on and options for Asia. London: Centre for Economic Policy Research. Dam, Kenneth. 1970. The GA7T Chicago: University of Chicago Press. Henin, Jan. 1986. Rules of origin and differences between tariff levels in EFTA and in 32. Even if every country were in at least one FTA with every other country, the existence of ROOs would protect some aspects of each country’s tariff structure. There are also concerns that as FTAs proliferate, there would be a tendency for countries to use their antidumping and antisubsidy measures (which are GATT sanctioned) more vigorously on countries not party to their preferential arrangements. If that happened, the protectionist content of preferential arrangements could significantly increase.

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the EC. EFTA Occasional Paper no. 13. Geneva: European Free Trade Association, February. Hoekman, Bernard, and Michael Leidy. 1993. Holes and loopholes in integration agreements: History and prospects. In Regional integration and the global trading system, ed. Kym Anderson and Richard Blackhurst, 218-69. New York: St. Martin’s. Jackson, John. 1993. Regional trading blocs and GATT. World Economy 16, no. 2 (March): 121-31. Krueger, Anne 0. 1993. Free trade arrangements as protectionist devices. NBER Working Paper no. 4352. Cambridge, Mass.: National Bureau of Economic Research. . 1995. Free trade agreements versus customs unions. NBER Working Paper no. 5085. Cambridge, Mass.: National Bureau of Economic Research, April. Lawrence, Robert Z. 1991. Emerging regional arrangements: Building blocks or stumbling blocks? In Finance and the international economy, vol. 5, ed. Richard O’Brien. New York: Oxford University Press. Lloyd, Peter J. 1993. A tariff substitute for rules of origin in free trade areas. World Economy 16, no. 6 (November): 699-712. Palmeter, David. 1993. Rules of origin in customs unions and free trade areas. In Regional integration and the global trading system, ed. Kym Anderson and Richard Blackhurst, 326-43. New York: St. Martin’s. Panagariya, Arvind. 1994. East Asia and the new regionalism. World Economy 17, no. 6 (November): 817-39. Park, Yung Chul, and Jung Ho Yoo. 1989. More free trade areas: A Korean perspective. In Free trade areas and U S . trade policy, ed. Jeffrey Schott, 141-58. Washington, D.C.: Institute for International Economics. Petrie, Peter. 1994. The East Asian trading bloc: An analytical history. In Asia Pac$c regionalism: Readings in international economic relations, ed. Ross Garnaut and Peter Drysdale. Pymble, Australia: HarperCollins. World Trade Organization (WTO). 1995. Regionalism and the world trading system. Geneva: World Trade Organization, April.

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2

The Political Economy of Mexico’s Entry into NAFTA Aaron Tornell and Gerardo Esquivel

2.1 Introduction Typically, computable general equilibrium (CGE) models predict that Mexico’s gains from NAFTA will be small. This is because Mexico has already opened the manufacturing sector of its economy, and U.S. and Canadian import tariffs are already very low. However, if NAFTA promised only a minimal gain for Mexico, why did President Salinas take such great pains in 1993 and 1994 to ensure that the agreement was signed? Did Salinas simply ignore facts and knowingly waste political and financial energy on a useless project? We do not think so. We believe that the CGE models analyzing NAFTA’s effects have missed an essential element of the agreement: its role as a commitment mechanism. We will argue that the Salinas government’s ardent pursuit of NAFTA was motivated by the desire to ensure that necessary future economic and political reforms would be carried out. To fully understand NAFTA’s implications, one should view the agreement not as an isolated event, but as one part of the process of economic liberalization in Mexico. The exploration of this process provides three lessons that can be applied to other cases. First, deep reforms like trade liberalization are not likely to happen by government decree. Instead, they usually come about when the unanimous blocking of reform by powerful elites breaks down. In the case of Mexico, this happened during a fiscal crisis, when some groups tried to Aaron Tornell is assistant professor of economics at Harvard University and a faculty research fellow of the National Bureau of Economic Research. Gerardo Esquivel is a graduate student in the department of economics at Harvard University. The authors thank John Coatsworth, Michael Dooley, Jonathan Fox, Wontack Hong, Takatoshi Ito, and John Womack for helpful discussions, and Adrian Ten-Kate and Roberto Bello for providing them with statistical information. They also thank the David Rockefeller Center for Latin American Studies at Harvard University for financial support. Jessica Pepp provided excellent research assistance.

25

26

Aaron Tornell and Gerard0 Esquivel

displace other groups in order to capture a greater share of fiscal revenue. Second, in the presence of entrenched elites, the sustainability of reform depends on the existence of new groups that benefit from the new status quo and have enough power to defend it. Thus, the speed of successful reform is determined by the speed with which new groups are consolidated. Initially, Mexico limited radical liberalization to the manufacturing sector. The government has only recently begun to undertake serious liberalization in the services and agriculture sectors. The third lesson we take from Mexico is that the importance of formal agreements like NAFTA lies not so much in the ability of these agreements to reduce average import tariffs among their parties and improve their terms of trade vis-&-,is the rest of the world, as claimed by the optimal tariff literature, but in their usefulness as commitment devices to force reforms to continue. Let us examine how the Mexican experience illustrates the first lesson. By the late 1960s, it was recognized in Mexico that the country had to abandon the import substitution development path it, like many other countries, had been following: trade and the economy had to be liberalized (see Ortiz Mena 1970). No strong steps toward liberalization were taken, however, until the debt and oil crises of the mid-l980s, when trade in manufactures was liberalized. This course of events presents a puzzle that has also arisen in the reform processes of many other countries: why is it that deep reforms tend to take place during bad economic times (the mid-1980s for Mexico) but not during more favorable periods, like the oil boom years of the late 1970s, when adjustment costs are more affordable? The explanation we give in this paper is that as fiscal resources plummeted in the 1980s, the two powerful elites in the manufacturing sector-the statist elite and the private import-competing elitetried to weaken each other in order to gain access to a greater share of fiscal transfers. The statist elite induced expropriations, and the private elite responded by inducing trade liberalization. This move was costly for the private elite in the short run because it forced a reallocation of fixed factors. At the same time, however, trade liberalization weakened the statist elite, as we will explain below. The private elite did not block trade liberalization in the 1980s as it had in the 1970s because in the 1980s its trade-off was not between trade liberalization and the status quo but between trade liberalization and being further expropriated. Now we consider the second lesson. In order to sustain reform, the Mexican government limited radical liberalization to the manufacturing sector. It did not radically restructure agriculture and services because alienating all powerful groups in society could have derailed economic reform altogether. Instead, during 1985-94 the government focused its energies on forming new coalitions in the manufacturing sector-a new export elite and a new group of foreign investors-and weakening the statist elite and the old private elite.’ The 1. Throughout this paper we identify a group or elite by the fixed factors it controls, not by the identity or historical background of its members. Thus, when we say that a group was weakened

27

The Political Economy of Mexico’s Entry into NAFTA

government accomplished the transformation of the power structure through privatization, deregulation, and the enactment of more friendly foreign investment rules. Next we explore the third lesson, that NAFTA’s greatest importance lies in its use as a commitment device. NAFIA is a commitment by the Mexican government to eliminate protection in agriculture and services within the next 15 years (the agreement also entails a marginal reduction in protection for the already liberalized manufacturing sector) in exchange for a decrease in U.S. and Canadian protectionist barriers and a reduction in the uncertainty associated with trade disputes. A formal agreement like NAFTA is very important for Mexico because radical liberalization of its economy (indeed, of any economy) is bound to have deep political effects. The ability of Mexico’s ruling party (the PRI) to capture the agricultural vote has ensured its ability to pursue reforms in the manufacturing sector without major political obstruction. The broader liberalization promised by NAFTA will greatly erode this electoral machine because it will alienate the agricultural sector. In principle, one could argue that this imminent erosion will threaten the reform in two ways. First, uncertainty about the political future could tempt politicians in the future to delay further liberalization indefinitely. Second, there is the danger that when the PRI’s power erodes, new political forces will arise and overturn the reforms. In this paper, however, we argue that the policies implemented by former presidents de la Madrid and Salinas make it very unlikely that such pessimistic scenarios will unfold. The first scenario is unlikely because NAFTA has already set the liberalization agenda; thus, it is not left to political discretionthis might be the reason Salinas pursued NAFTA so feverishly. The second scenario is unlikely because, by the time total trade liberalization has been implemented and the PFU machine has eroded, the new export and foreign investment groups will have consolidated their power and will find it optimal to use their economic resources to ensure that the reforms do not get derailed. The bailout that the Mexican government received in early 1995 after the financial panic of December 1994 exemplifies the last point. Given that in early 1995 Mexico did not have enough liquidity to repay its dollar-denominated short-term debt, a default was likely. This default might have forced the government to follow inward-looking policies and increase anew the power of traditional elites, risking the derailment of reforms. The network of U.S. firms with investments in Mexico used their political clout to induce an unprecedentedly speedy response from the U.S. government and international organizations. This support allowed Mexico to repay its short-term debt and even to resume borrowing in international markets by mid-1995. This paper is organized as follows: In section 2.2 we trace the evolution of trade protection and the tradable sector in Mexico during the past two decades. we do not necessarily mean that all persons belonging to that specific group were weakened or impoverished. Instead, they may simply have shifted their ownership of fixed factors to other sectors. As a result their interests now lie with a new group.

28

Aaron Tornell and Gerard0 Esquivel

In section 2.3, we examine some effects of trade reforms on the Mexican economy. In section 2.4, we present a political economy interpretation of the Mexican reforms and expand on the three lessons discussed above. In section 2.5 we analyze NAFTA. Finally, in section 2.6 we present our conclusions.

2.2 Trade Liberalization In 1970 the Mexican economy was very protected. In that year, 65 percent of items in Mexico’s tariff structure were subject to import permits, and these items accounted for 59 percent of the total value of imports. By the late 1960s some voices were already calling for a change in this pattern. It was not until the mid-l970s, however, that the Mexican government initiated a mild program of liberalization, which substituted ad valorem tariffs for import permits. But despite these changes, the economy remained basically closed. At last, in 1979, it seemed that trade liberalization would soon be a reality. In that year, President Lopez Portillo announced Mexico’s intention to accede to the GATT. A few months later, however, after “consultations,” Lopez Portillo announced there would be no accession. Moreover, with the balance-of-payments problems of the early 1980s, trade barriers were increased again, and Mexico became an almost impenetrable economy. By the end of 1982, 100 percent of imports were subject to permits. Finally, in 1985, the government announced accession to the GAlT as well as a new liberalization program. Since then, the opening process has continued without interruption. In 1985 the share of items in the tariff structure subject to import permits was reduced to 10 percent, and by 1994 the share was only 1 percent. The opening is also illustrated by the change in the percentage of total value of imports accounted for by imports subject to permits. This share fell from 83 percent in 1984, to 35 percent in 1985, to 10 percent in 1994, as shown in table 2.1. 2.2.1

Manufactures

Liberalization in the manufacturing sector took place very rapidly. In terms of nontariff protection, about 92 percent of domestic production in manufactures was covered by import permits in June 1985. By the end of that year, less than 50 percent of manufactures remained subject to import permits. By 1990, this indicator dropped to only 11 percent, leaving only a handful of products still subject to this kind of protection. Figure 2.1 traces this indicator for various industries between 1985 and 1990. It shows that by 1990 only the tobacco industry was substantially protected by an import license requirement, whereas the transportation equipment and food industries were mildly covered and in all other sectors protection had been entirely dismantled. Tariff protection also fell drastically after 1985. The average tariff rate for manufactured goods fell from 34 percent in 1985 to 14 percent in 1990. The industries that suffered the largest tariff reductions were the beverage, glass, apparel, footwear, and transportation equipment industries. Figure 2.2 traces

The Political Economy of Mexico’s Entry into NAFTA

29

Indicators of Protection

Table 2.1

Domestic Product Covered by Import Production-Weighted Permits Average Tariff Maximum Tariff

Imports Subject to Permits

Fraction Subject to Permits

Year

(%)

(%)

(%)

(%I

(%)

1980 1985 1986 1987 1988 1989 1990 1991 1992 I993 1994

64.0 92.2 46.9 35.8 23.2 22.1 19.9 18.6 17.0 16.5 n.a.

22.8 23.5 24.0 22.7 11.0 12.8 12.5 12.5 12.5 12.5 n.a.

n.a. 100.0 45.0 20.0 20.0 20.0 20.0 20.0 25.0 25.0 n.a.

n.a. 35.1 27.8 26.8 21.2 18.4 13.7 9.1 10.8 21.5 10.6

n.a. 10.4 7.8 3.9 3.4 1.8 1.7 1.6 1.6 1.6 1.3

Sources: SECOFI and unpublished information provided by Adrian Ten-Kate.

average tariff rates for different industries from 1985 to 1990. Figures 2.1 and 2.2 confirm that the opening process had profound effects on the entire manufacturing industry (see also table 2.2). 2.2.2 Agriculture Mexican agriculture is composed of two sectors: a traditional sector and a modem sector. The former remained closed until 1994. The modern sector, on the other hand, has been liberalized since 1987. This sector includes products such as tomatoes and citrus and tropical fruits. Mexico is highly competitive in the production of these goods. In the traditional agricultural sector, the two most important crops are maize and beans. These two products account for as much as 70 percent of Mexico’s arable land and for about 35 percent of its rural employment. Historically, maize and beans have been fiercely protected. Until 1993, maize was subject to import permits and received a governmental support price well above the world market price (Levy and Van Wijnbergen 1991 compute a 70 percent wedge). The argument for this protection is one of distributional equity: maize is the crop that generates the most rural employment (29 percent) and uses the most arable land (42 percent). The same argument has been used for the production of beans, which were also subject to import permits until 1993. Historically, Mexican agriculture has been protected mainly through nontariff barriers, usually import permits. Figure 2.3 shows the evolution of the share of agricultural and total output covered by these permits. This figure shows that agriculture maintained a high degree of nontariff protection until very recently and that this sector was not affected by the first set of liberalization measures enacted in 1985. The reduction in the use of agricultural import per-

Transportation Equipment Nonilectrical Equipment Electrical Equipment Metal Products Non-Ferrous Metals Iron and St wl Non-Metallic Minerals Cement Glass Tires and Plastics Basic Chemical Paper and Pnnting wood Footwear Apparel Textiles Tobacco Beverages Food

0

20

40

60

80

100

Percentage Fig. 2.1 Industrial output protected by import permits Source: Table 2.2.

I

Transportation Equipment Non.Electrical Equipment Electrical Equipment Metal Products

fn

a,

' E c fn

a

-c '0

Non-Ferrous Metals Iron and Steel Non-Metallic Minerals Cement Glass Tires and Plastics Basic Chemical Paper and Printing wood Footwear Apparel Textiles Tobacco Beverages Food

0

i 20

40

60

Percentage Fig. 2.2 Average tariff rate by industry Source: Table 2.2.

80

100

Igg0

31

The Political Economy of Mexico’s Entry into NAFTA

Table 2.2

Manufacturing Industry Protection Output Protected by Import Permits (%)

Average Tariff Rate

Industry

1985

1990

1985

1990

Food Beverages Tobacco Textiles Apparel Footwear Wood Paper and printing Basic chemical Tires and plastics Glass Cement Nonmetallic minerals Iron and steel Nonferrous metals Metal products Electrical equipment Nonelectrical equipment Transportation equipment

95.2 99.6 100.0 90.8 100.0 97.8 99.9 85.6 81.2 98.2 96.9 100.0 93.4 90.7 71.9 72.4 79.8 97.1 99.3

19.7 2.6 100.0

20.3 84.7 50.0 34. I 49.8 42.6 38.3 26.2 30.5 36.5 52.7 10.0 36.9 13.4 22.2 35.9 21.0 32.9 41.1

11.3 19.6 20.0 15.0 20.0 16.2 16.9 8.7 13.6 15.8 16.5 10.0 16.5 10.1 12.4 14.5 15.6 17.1 16.0

1.o

0.0

0.0 0.0 0.0 1.5 0.0 0.0 0.0 0.0 0.0 0.0 1.1 3.1 0.0 37.6

Source: Tybout and Westbrook (1995)

mits, which started in 1987, initially left more than 60 percent of agricultural output still covered by import permits. Between 1987 and 1993, this indicator decreased steadily, though it was always above 45 percent (see table 2.3). On the other hand, tariff protection has played a relatively minor role in the history of the Mexican agricultural sector. Figure 2.4 shows the evolution of the average tariff for both agriculture and the whole economy between 1985 and 1993. During this period, agriculture kept a relatively low but constant level of tariff protection (see table 2.3). Figure 2.5 summarizes the different patterns of liberalization between the agricultural and manufacturing sectors. This figure presents the import penetration rates by sector for the period 1981-91. The pattern is clearly dual: the import penetration rate in agriculture remained relatively constant at about 10 percent, while the same indicator for manufactures rose constantly from 28 percent in 1985 to 59 percent in 1991.

2.3 Effects of Trade Liberalization Trade liberalization had a sizable effect on the volume of trade. Exports increased from $3 billion in 1975 to $34.5 billion in 1994 (see table 2.4). The increase from 1975 to 1985 is explained by an increase in oil revenues. The

100

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88.1 89.1 90.1 Year and Semester

87.1

86.1

92.1

93.1

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Fig. 2.3 Output covered by import permits Source: Table 2.3.

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Protection in the Agricultural Sector

Table 2.3

Output Covered by Import Permits (%)

Year and Semester

Average Tariff Rate (%)

Agriculture

All Sectors

Agriculture

All Sectors

98.5 93.5 93.8 85.6 85.6 63.0 63.0 63.0 63.5 56.7 56. I 56.1 51.6 47.6 47.6 47.6 47.6

92.2 47.1 46.9 39.8 35.8 25.4 23.2 22.1 22.1 20.3 19.9 17.9 18.6 17.0 17.0 16.5 16.5

7.6 7.7 7.4 9.6 10.0 6.0 6.0 5.8 8.2 8.2 8.2 7.4 7.4 7.5 7.5 7.5 7.5

23.5 28.5 24.0 24.5 22.7 11.8 11.0 10.2 12.6 12.5 12.5 12.4 12.5 12.5 12.5 12.5 12.5

1985.1 1985.II 1986.1 1986.11 1987.1 1987.11 1988.1 1988.H 1989.1 1989.11 1990.1 1990.11 1991.1 1991.11 1992.1 1992.11 1993.1

-P

Source: Unpublished information provided by Adrian Ten-Kate. 60

F--/

50:-

a 40

\ 9

22 30 20 CI

10

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0 -

I

[+ Fig. 2.5

c

Agriculture

+ Manufacturing

Import penetration rates by sector Source: Unpublished information provided by Adrian Ten-Kate

1

Exports by Q p e of Good (millions of dollars)

Table 2.4

Oil Goods

Nonoil Goods

Year

Total Goods

Total Oil Goods

Crude Oil

Other

Total Nonoil Goods

Agricultural

Extractives

Manufactures

1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994

3,062 3,655 4,650 6,063 8,818 15,512 20,102 2 1,230 22,312 24,196 21,664 16,031 20,656 20,565 22,842 26,838 26,856 27,515 30,032 34,564

480 563 1,037 1,863 3,975 10,441 14,573 16,477 16,017 16.60 1 14,767 6,307 8,630 6,711 7,876 10,104 8,167 8,307 7,418 7,393

438 540 988 1,774 3,765 9,449 13,305 15,623 14,793 14,968 13,309 5,580 7,877 5,883 7,292 8,921 7,265 7,420 6,485 6,572

42 23 50 90 210 993 1,268 855 1,224 1,634 1,458 727 753 828 5 84 1,183 902 887 933 82 1

2,582 3,092 3,613 4,200 4,843 5,071 5,529 4,753 6,295 7,595 6,897 9,724 12,026 13,854 14,966 16,734 18,689 19,208 22,614 27,171

892 1,175 1,313 1,502 1,779 1,528 1,481 1,233 1,189 1,461 1,409 2,098 1,543 1,670 1,754 2,162 2,373 2,112 2,504 2,678

207 209 217 213 338 512 686 502 524 539 510 5 10 576 660 605 617 547 356 278 357

1,483 1,708 2,083 2,485 2,726 3,030 3,360 3,018 4,583 5,595 4,978 7,116 9,907 11,523 12,608 13,955 15,769 16,740 19,832 24,136

Source: Banco de Mexico, Zndicadores Economicos (Mexico City, various issues).

The Political Economy of Mexico’s Entry into NAFTA

35 25

-

20

-=K? 15 0

0

c (D

2 -z 10 5

0

,

1975

/

1

l

1977

l

1979

I

l

l

1981

I

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1983

I

I

1985 Year

Agricultural

I

l

1987

--e

1

1989

1

l

1991

I

,

I

1993

Oil

Fig. 2.6 Exports by type of good Source: Table 2.4.

increase from 1985 to 1994, however, is explained by an increase in manufacturing exports. This is illustrated in figure 2.6, which charts the evolution of Mexican exports by type of good from 1975 to 1994. Oil exports reached a peak in 1982-84 and fell considerably starting in 1986. Manufactured exports began an upward trend in 1985, and by 1994 they were five times what they had been just 10 years before. Their share of total exports grew from 17 percent in 1982 to 70 percent in 1994. Imports also increased very rapidly during this period. They grew from $7 billion in 1975 to $59 billion in 1994 (see table 2.5). Figure 2.7 shows how the composition of imports changed. Consumption imports grew relative to capital and intermediate goods imports. This suggests that producers of consumer goods, which grew during the 1950s and 1960s, have been hurt by trade liberalization. 2.3.1 Production Trade liberalization induced important transformations within the manufacturing sector. Figure 2.8 charts the production volume indexes for some industries from 1980 to 1994. Figure 2.8A presents the evolution of some of the industries that were hurt by trade liberalization, such as tobacco, fibers and textiles, wood products, shoes, and electrical machinery. Figure 2.8B shows

36

Aaron Tornell and Gerardo Esquivel

Table 2.5

Imports by Type of Good (millions of dollars)

Year

Total

Consumption Goods

Intermediate Goods

Capital Goods

1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994

2,328.3 2,255.5 2,762.1 3,892.4 6,148.6 6,699.0 6,300.0 5,704.0 7,917.0 11,980.0 18,897.0 23,948.0 14,437.0 8,551.0 11,254.0 13,212.0 11,432.0 12,223.0 18,898.0 25,438.0 31,272.0 38,184.1 48,192.6 48,923.6 58,881.4

177.8 209.6 304.0 395.1 367.5 56 1.O 564.0 503.0 650.0 1,002.0 2,450.0 2,807.0 1,517.0 614.0 848.0 1,082.0 846.0 768.0 1,921.O 3,498.0 5,098.6 5,834.3 7,744.1 7,842.4 9.5 11.O

1,059.0 1,023.4 1,253.5 1,918.4 3,504.7 4,241.0 3,806.0 3,7 19.0 5,285.0 7,404.0 11,274.0 13,566.0 8.4 17.0 5,740.0 7,833.0 8,965.0 7,632.0 8,824.0 12,950.0 17.17 1.O 19,383.8 23,762.3 28,892.8 30,025.3 36,048.6

1,091.4 1,021.o 1,199.8 1,563.0 2,25 1.4 1,897.0 1,930.0 1,482.0 1,982.0 3,574.0 5,173.0 7,575.0 4,503.0 2,197.0 2,573.0 3,165.0 2,954.0 2.63 1.O 4,027.0 4,769.0 6,789.6 8,587.5 11,555.7 11,055.9 13,321.8

Source: Banco de Mexico, Indicadores Economicos (Mexico City, various issues). Note: Figures do not include imports from maquiladoras.

the performance of some of the industries trade liberalization benefited, such as vehicles, engines and auto parts, glass, cement, and chemicals. With the exception of vehicles, no “winner” industry seems to have been hurt by the 1982 crisis. The vehicle industry, one of Mexican trade liberalization’s biggest success stories, is currently the most important contributor to Mexican manufacturing exports. The adjustment this industry went through in the early 1980s allowed it to grow at a very high rate after 1987-not coincidentally, the first high-tech auto plant became operational and exports of vehicles took off during this year (see Berry, Grilli, and Lopes-de-Silanes 1993). Contrary to popular predictions, trade liberalization did not destroy the Mexican manufacturing industry. Rather, it seems that the industry as a whole adapted relatively easily to the new competition. This is reflected in the composition of Mexican external trade. Esquivel (1992) found that between 1981 and 1990 the Grubel and Lloyd index of intraindustry trade increased from 28 to 54 across all kinds of goods and that the same index for manufactured goods

The Political Economy of Mexico’s Entry into NAFTA

37

200

1970

1972

1974

I-

1976

1978

1982

1980

1984

1986

1988

l9sO

1992

1994

Year

Consumption --e Intermediate --t Capital

1

Fig. 2.7 Imports index by type of good (1985 = 100) Source: Table 2.5.

rose from 33 in 198I to 63 in 1990. Figure 2.9 traces the evolution of this index for the one-digit categories of the Standard International Trade Classification. Table 2.6 shows that 72 percent of the trade between Mexico and the United States in 1981 was predominantly interindustrial. By 1990, this situation had L I I L L I I ~ G UlLLUlLLLll)’.

dUUUL lldll LIIG p I U U U L L S W G I G ULLUGU 11111dlllUUbLlldlly,

LLL-

counting for 7 1 percent of foreign trade. 2.3.2 Productivity Although many studies have been done on the subject, it is still not clear what the impact of trade liberalization on the productivity of the Mexican manufacturing industry has been. Most studies have found an overall productivity increase in the industry during the second half of the 1980s. Estimates range from 1.1 percent per year (Luttmer 1993) to 5 percent per year (HernandezLaos 1992). Clavijo (1992) found an increase in productivity of about 2.4 percent per year, while Qbout and Westbrook (1995) found an increase of 1.8 percent per year. 2.3.3 Foreign Direct Investment Until 1989 Mexico had been reluctant to accept foreign direct investment (FDI) as a major element in its economic development. In 1973, then-president Luis Echevema enacted an FDI law entitled “Law to Promote Mexican Invest-

A 120

100 --t

Tobacco

r

-*

80

Fibres and Textlles

II

0

-

*

t K

$-

Wood Products

60

* Eledrlcal Machinery -t

40 '\

Shoes

i

' r

20 1980 81 02 83

84

05 00

07 08

89

90 91

92

93

94

Year

100

140 &

-

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120

-c

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Englnes, Auto Parts

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0 II

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+

8

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X

-

80

Cement &

Chemicals

00

4

0

)

,

,

,

,

,

l

,

,

,

,

,

,

,

l

Fig. 2.8 Production volume index (relative to overall manufactures). A, Industries hurt by trade liberalization. B, Industries benefiting from trade liberalization. Source: Banco de Mexico.

39

The Political Economy of Mexico’s Entry into NAFTA

Food and Animals Beverages and Tobacco Crude Materials Fuels and Lubricants Animal and Vegetable Oils

i

Chemicals Manufactures

1990

Machinery and Equipment Other Manufactures

t Total

0

20

40 Index

60

80

Fig. 2.9 Mexico-U.S. intraindustry trade index Source: Esquivel(l992).

ment and Regulate Foreign Investment.” As the name indicates, this law was intended more to promote Mexican investment than to attract foreign investment.* In 1989, the government changed the regulations in an attempt to attract FDI. Specifically, the government lowered the high degree of discretion and removed the 49 percent ceiling on foreign capital in several sectors. Until 1983, with the exception of the peak years of the oil boom, FDI was not very important to the Mexican economy in terms of size, making up only about 10 percent of total investment. By 1987, the FDI flow was about 20 times what it had been in the early 1970s. At the end of 1993, with the passing of NAFTA by the U.S. Congress, there was a new increase in the flow of FDI to Mexico (see figs. 2.10 and 2.11). In fact, the amount of FDI in 1994 was about $8 billion, more than twice the average for the 1987-92 period. In 1994 the role of FDI in the Mexican economy seemed to be more important than ever. During the administration of Carlos Salinas (1988-94), multinational firms consolidated to form a major player in the economy. FDI’s share of gross fixed investment reached its highest ever (30 percent) in 1994, despite the major political difficulties Mexico faced that year. As of September 2. According to some authors, the immediate effect of the 1973 law was to reduce FDI. Others argue that the negative effects are not obvious and that there is not enough evidence to suggest that FDI was reduced. See Peres (1990).

40

Aaron Tornell and Gerardo Esquivel

Table 2.6

Manufacturing Industry by Q p e of Trade with United States Q p e of Trade Intraindustry Trade Number of sectors Share of total exports (%) Share of total imports (%) Share of foreign trade (%) Interindustry Trade Number of sectors Share of total exports (%) Share of total imports (%) Share of foreign trade (%)

1981

1990

46 48.8 19.8 27.3

82 72.3 70.7 71.4

104 51.2 80.2 72.7

84 27.7 29.3 28.6

Source: Esquivel(l992). Note: Sectors with a Grubel and Lloyd index of intraindustry trade above 50 percent are considered to have intraindustrial trade. The Grubel and Lloyd index is defined as Br = 1 - (IX, - M,I)I (X, + M J , where X,and M , are exports and imports of sector i.

1993, firms with FDI accounted for 27 percent of formal employment in the manufacturing sector and for almost 100 percent of employment in the metallic products, machinery, and equipment sector (see Secretaria de Comercio y Fomento Industrial [SECOFI] 1994). 2.4 A Political Economy Interpretation of the Mexican Reforms NAFTA is just one part of the process of liberalization of the Mexican economy. To fully understand NAFTA, it is necessary to consider the entire sequence of liberalization events that have taken place in Mexico during the past decade. Before presenting our argument we summarize the main facts (discussed in other sections) that we want to rationalize: It had been evident since the late 1960s that Mexico had to abandon its import substitution strategy and liberalize trade. However, attempts to liberalize trade and implement a fiscal reform during the 1970s were unsuccessful. For instance, in 1979, President Lopez Portillo announced that Mexico would accede to GATT, but after “consultations” he announced in 1980 that Mexico’s economy would remain closed. Surprisingly, in the midst of the worst economic crisis since the 1930s and in the wake of Mexico’s most damaging earthquake in this century, President de la Madrid (1982-88) announced Mexico’s accession to GATT in 1985. By 1987, trade in manufactures was liberalized. Trade liberalization did not destroy the manufacturing sector, although it did induce a strong reallocation within that sector. Trade liberalization in manufactures was followed by a tax reform, a radical

I0

8

E

2 -

6

V 0 *-

UI

0

E

is

4

2

94

Year

Fig. 2.10 Flows of foreign direct investment Source: SECOFI (1994).

800

600

400

200

0

91-1 II

Ill IV

924 II

Ill IV

934 II

Ill

IV

944 II

Year and Quarter

Fig. 2.11 Foreign direct investment (average monthly flow) Source: SECOFI (1994).

Ill IV

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privatization program, a deregulation program, and a structural transformation of the economy during President Salinas’s administration (1988-94). Also during Salinas’s presidency, Mexico made two radical breaks with the past. First, it eased restrictions on foreign investment. Second, it enacted a major constitutional change in land tenure legislation. Unlike in manufactures, there was no across-the-board liberalization of trade in agriculture and services during the Salinas administration. During the last part of his presidency, Salinas made NAFTA the main policy objective of his administration. His efforts to have Mexico accede to the agreement generated significant political and economic costs. NAFTA is a commitment by Mexico to a future total liberalization of trade in agriculture and services in exchange for easier access to the United States and Canada for Mexican goods. We will address the following questions about the Mexican reforms. First, we ask why trade liberalization took place in the economically and politically strained environment of the 1980s instead of during the oil boom years when Mexico more easily could have afforded such reform. Second, why did the Salinas government pursue NAFTA so feverishly? What were the expected gains from accession, given that Mexico had already liberalized trade in manufacturing, U.S. tariff levels were quite low, and NAFTA entailed significant costs? Third, why did the government decline to completely open trade in agriculture and services early on, given that this measure would have reduced input prices and made manufactures more competitive? More generally, we hope to derive broad lessons from the Mexican reform process. In particular, we will address the questions of when trade liberalization is most likely to take place, under which conditions it is most likely to be sustainable, and what the role of a formal agreement like NAFTA is in sustaining a reform process. 2.4.1 Historical Background Let us first present a brief historical overview to put the Mexican reform process in perspective. The Mexican political system centers on a president who has many formal powers but cannot be reelected and on an official party (first called PNR, then PMR, and now PRI) that has won every presidential election for the past 60 years. The Mexican president, however, is by no means an all-powerful autocrat, nor is the PRI a monolithic party in which everyone follows the president’s instructions. The roots of this political structure can be found in the process of Mexico’s state formation. During the 1920s, Mexico was basically in a state of anarchy: several powerful local elites and armies held the only real control over each region. After president-elect Alvaro Obregon was assassinated in 1929, then-president Calles formed the PNR as an emergency agreement with powerful groups and local bosses across the country to comply with the formalities of presidential elections (see Meyer

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1978). In several states, the existing bosses (caciques) and parties agreed to franchise the PNR name but did not yield any effective power to the central government. The state of Chiapas is a clear example of this. The process of state formation, which paralleled the formation of the official party, consisted of transforming the independent local armies and power groups of each region into members of a national corporation. In order to induce them to accept this corporatization, the government conferred on these groups monopoly rights over certain industries or geographical areas in exchange for loyalty. This consolidation process was enforced by an aggressive industrialization policy centered on import substitution and the undertaking of large infrastructure projects that generated significant rents for these groups. In addition, the government granted generous tax exemptions and implemented favorable wage policies. President Cardenas (1934-40) took this corporatization process one step further. First, he implemented an ambitious land reform through the ejido program. This program gave the right to use land (but not ownership rights) to a vast number of peasants and absorbed the defeated peasant movements (Zapatistas) into the political corporation, minimizing the risk of future rebellion^.^ Second, the government gained control of the labor movement through the Confederacion de Trabajadores Mexicanos (CTM), which is still a pillar of the PRI. Last, the military was incorporated into the party (see HernandezChavez 1979). These policies generated social peace and high growth from the 1940s through the 1960s. A by-product was the entrenchment of powerful rentseeking groups. By the late 1960s one could distinguish two elites in the manufacturing sector: the private import-competing elite and the statist elite. In addition, the regional bosses who controlled the PRI voting machine and distributed government subsidies to agricultural production constituted a rural elite. The statist elite was composed of networks associated with state-owned enterprises, such as managers, union leaders, and suppliers. 2.4.2 Why Did Trade Liberalization Occur? We turn now to the puzzle of why trade was not liberalized during the 197Os, when it was considered necessary (Ortiz Mena 1970) and when economic conditions could have supported it, but was instead enacted in the midst of the economic crisis of the mid-1980s. As discussed above, the political system in Mexico is such that no president had the autonomy to liberalize trade by decree, since such liberalization implied the dismantling of a major part of the 3. The ejido is a communal tenure system that prohibits the selling of land. T h i s program limits peasants’ access to credit and improvements in production and, in the long run, undermines agricultural productivity. Ultimately, the rural sector was polarized into two sectors, a modem and highly productive agricultural sector with large-scale operation and access to exports markets and a backward sector formed mainly by ejido lands that remained isolated and scarcely linked to the market economy.

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apparatus that generated rents for the strong elites. Therefore, in rationalizing trade liberalization events, we must bear in mind that government actions do not reflect only the will of an all-powerful autocrat, nor are they solely determined by the will of a majority of atomistic voters. In addition to those of the president and the people, the interests of powerful elites exert a major influence over government actions. In all likelihood, all three interests influence most political events. In this paper, however, we will emphasize the role of powerful elites. That is, we will explain the events in Mexico solely as the outcome of a game among powerful elites. We will assume that the president can take action and implement reform only if it is not blocked by powerful local elites. As mentioned above, in the 1960s, 1970s, and 1980s, there were two strong groups within the Mexican manufacturing sector: the private import-competing elite and the statist elite. The political process guaranteed both elites almost unlimited access to fiscal revenue. They enjoyed subsidized inputs and profited from convoluted regulations and strict trade barriers, which increased the profitability of the fixed factors they owned. So why did these manufacturing sector elites not unanimously block trade liberalization in the economically strained 1980s as they had done during the 1970s boom? The argument by Tornell (1995) addressed this issue-the following is a summary of that argument. To understand the process that led to trade liberalization, think of both the private import-competing elite and the statist elite as interacting in a preemption game. At every instant, each group has the opportunity to eliminate the other group’s power by incurring a once-and-for-all cost. The group that incurs this cost becomes the “leader” and attains the power to monopolize fiscal transfers in the future. The other group becomes the “follower” and loses all access to future fiscal transfers. If both groups incur the cost simultaneously, that is, if they “match,” both see their power to extract fiscal revenue diminished, but neither one loses relative to the other. The cohabitation equilibrium that sustains the status quo breaks down when the payoff of becoming the leader exceeds the payoff of maintaining the status quo. Moreover, if the payoff of matching is greater than the payoff of following, then both groups weaken each other. In this case, the government becomes relatively autonomous and is not beholden to elites anymore. Therefore, it becomes free to implement a reform. But when does the payoff of becoming the leader exceed the payoff of remaining in the status quo? To address this issue we note that all payoffs are functions of the fiscal revenue available for redistribution. As fiscal revenue declines, the marginal utility of gaining a greater share of it increases. Thus the payoff of leading increases relative to the payoff of remaining in the status quo, and the payoff of matching increases relative to following. For a sufficiently big decline in fiscal revenue the payoff of leading becomes greater than the payoff of the status quo, and the payoff of matching becomes greater than the payoff of following. As a result, each group tries to displace the other in

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order to get a greater share of the lower fiscal revenue. Hence, when fiscal revenue is low, the status quo collapses and the potential for reform exists. Now we apply this argument to the Mexican experience of the 1970s and 1980s. After the students’ riot of 1968 the government of President Echeverria (1970-76) tried to reestablish legitimacy and assuage demands for a reduction in poverty and income inequality by expanding public investment. This expansion significantly strengthened the statist elite. Although Echeverria had a strong antibusiness rhetoric, he did not take any measure to reduce the rents received by the private import-substituting elite. For instance, in 1971 he tried to implement a tax reform to increase tax revenues, which made up 8 percent of GDP, but he soon abandoned that move. Also, in 1973 Echeverria enacted a law that limited foreign investment, benefiting the private elite. Echeverria’s antibusiness rhetoric created a strain between the government and the private sector. President Lopez Portillo, elected in 1976, set out to relieve this strain. After the 1977 discovery of significant oil reserves, and after the price of oil had increased, the government enacted a free-for-all fiscal policy that benefited both elites. The increase in fiscal transfers showed up in the form of an increase in government expenditures, from 10 percent of GDP in 1970 to 22 percent in 1982. An example of increased transfers to the private sector was the 1981 half-billion-dollar bailout of Grupo Alfa, the biggest private company in Mexico at the time. Other specific actions funded by the expansion included the acceleration of the investment program in governmentowned enterprises, the subsidization of oil, gas, and electricity prices, and the establishment of an ambitious antipoverty program, the Mexican Alimentary System (SAM). SAM, which supported grain production and was intended to benefit the poorest citizens of Mexico, provided subsidies that were mostly captured by the rural elite (Fox 1992). Lopez Portillo’s expansionary policies caused the fiscal deficit to jump from 10 percent of GDP in 1977 to 17 percent in 1982. During the 197Os, fiscal revenue remained high enough to finance all this additional government spending. Government subsidies increased the profitability of fixed factors owned by the statist elite and the private importsubstituting elite. The elites were satisfied with the transfers they were receiving, so no powerful group had an incentive to push for the structural reforms that were needed. During the boom years of the 1970s, no group found that the benefit of ensuring itself a large share of future fiscal revenue outweighed the short-run costs of weakening the other groups. Therefore, all powerful elites unanimously blocked reform during those years. During the 1980s, falling oil prices and an interruption in foreign lending forced cutbacks in Mexico’s generous government transfer programs-fiscal revenue could no longer cover the demands of all interest groups. This reduction in the size of the pie increased the marginal utility of gaining a greater share of it and increased the payoff of becoming the “leader” (recall the preemption game discussed above).

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The statist elite made the first move, inducing the government to expropriate all Mexican private banks. The banks channeled much fiscal revenue to the private sector (through subsidized credit and implicit guarantees of their borrowings from foreign banks), and their owners constituted one of the strongest groups in the private elite. Lopez Portillo announced the banks’ expropriation in September 1982, three months before he left office, in a dramatic address to Congress during which he cried over his failure to help the poor. Simultaneously with the expropriation of the banks, capital controls were imposed and Miguel Mancera, orthodox governor of Mexico’s Central Bank, resigned. The private sector responded to these blows by announcing that a national strike would take place on 8 September, but representatives canceled the strike a few days later.4 The private import-competing elite matched the statist elite’s first move. Aware that trade liberalization would be a mechanism by which they could destroy the power of the statist elite, the private elite did not oppose trade liberalization in the 1980s as it had in the 1970s. This time, the private elite’s choice was not between trade liberalization and the protectionist status quo, but between trade liberalization and becoming the follower, which would mean being further expropriated by the statist elite. When President de la Madrid took office in December 1982, members of the private elite feared that under his tenure expropriations would continue and statism would increase-after all, he had been minister of budget and planning under Lopez Portillo and had budgeted the massive increase in investment in state-owned enterprises. Moreover, de la Madrid assumed the presidency before the Thatcher and Reagan revolutions repopularized free market policies. Trade liberalization has been painful for the private sector in that it has forced many firms into bankruptcy and has forced fixed factors to be reallocated, both of which have generated short-run adjustment costs. In addition, the private elite has lost the rents from protection it received before liberalization. Because of reallocation, it has also suffered from the loss of political power associated with the ownership of fixed factors in well-established industries. The extent of these reallocation costs was illustrated in the previous section. Despite these drawbacks for the private elite, trade liberalization could drastically reduce the power of the statist elite to further expropriate the private elite and extract fiscal subsidies. This would occur through three channels. First, free trade will create new powerful groups of exporters and foreign investors with incentives to defend the new status quo. Thus, an expropriation would draw opposition not only from those new export groups but also from 4.It has been argued that the expropriation of the banks was really a bailout. Indeed, the banking system was insolvent, and the government took over all of its liabilities. However, the point we want to stress in this paper is that the bankers lost the “right” to operate banks and thus lost access to future bailouts, as well as the right to obtain other types of fiscal transfers.

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foreigners. Since the potential cost of confronting powerful foreign firms will be high, it is unlikely that the government will engage in further expropriations. Second, free trade abolished the complex system of import licensing and multiple tariffs, replacing it with one or two rates that apply across the board. This more transparent system quickly highlights rent-seeking behavior, allowing other groups to block such behavior right away. Last, agreements signed by a country as part of trade liberalization (such as GATT and NAFTA) impose limits on the extent of subsidization to specific industries and rent-generating regulations that a government can impose. Ultimately, both elites became weaker and worse off after the expropriation of the banks and trade liberalization. It is important to note that there was no uncertainty beforehand that this would happen. Both groups induced this outcome because, as a result of decreased government revenue in the early 1980s, the payoff of unilaterally deviating from the status quo at that time by trying to become the leader exceeded the payoff of maintaining the status quo. Note that the Coase theorem does not apply in this case because there is no third party with the power to enforce an agreement between the two elites.

2.4.3 Reform of the State Once both groups in the manufacturing sector weakened each other, the de la Madrid and Salinas governments attained “relative autonomy.” They used this autonomy to implement a tax reform, a radical privatization program, and a deregulation program that eliminated many privileges and monopolies conferred during the consolidating years of the PRI. The puzzling point we wish to highlight and the one we will try to rationalize is that these governments did not fully liberalize agriculture and services. From an economic standpoint, this is an incongruity. If a government’s objective is to promote manufactured exports, the right policy is to liberalize agriculture and services. Liberalizing agriculture frees unskilled labor and reduces unskilled wages. Liberalizing services reduces interest rates, transport costs, and communication costs. Since unskilled labor and services are inputs in the manufacture of exports, the government would certainly promote exports by liberalizing agriculture and services, thereby driving down the costs of these inputs. Why did the two governments choose not to follow such obviously advantageous policies? Our next point is that the decision not to open trade in agriculture and services fully was necessary to ensure that the reform process would not be derailed. Reformers needed two things to continue pursuing reform. First, they had to be reelected, which could be difficult given that initially the reform did not have much support in the population. Second, they had to avoid alienating all powerful groups simultaneously. With respect to the first requirement, reelection, the reformers depended heavily on the rural vote in the 1988 and 1994 presidential elections because reforms in the manufacturing sector

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had damaged the urban electoral machine and elections in urban areas had become more contested. With respect to the second requirement, delaying liberalization of agriculture and services allowed the government to avoid alienating all powerful elites simultaneously, while building new elites to support the new strategy of export promotion and private property. Let us elaborate on the first requirement, the issue of reelection. A few months before the presidential elections of 1988, some members of the statist elite who had split from the PRI combined with leftist parties to form the Partido de la Revolucion Democratica (PRD) and captured a third of the vote. Also, the private elite increased its involvement in politics following the 1982 expropriation of the banks. This involvement broke the private elite’s implicit agreement with the government by which the private elite stayed out of politics and the government in turn ensured a profitable investment climate (see Maxfield and Anzaldua 1987). As a result, elections in urban areas became more contested. Therefore, the PRI had to rely more on the rural electoral machine to win presidential elections. For instance, Salinas, who received 50.5 percent of the total vote, won only 34 percent of the votes in “very urban” areas, while he received 77 percent in “very rural” areas (see Fox 1994).The rural electoral machine is closely linked to the network that administers protection to the agricultural sector. Opening trade in agriculture and thus dismantling this protectionist network might have destroyed the rural machine, and with it the presidential hopes of reformers like Salinas and Zedillo. To expand on the second requirement above, one can view the second parts of the de la Madrid administration and the Salinas administration as having been devoted to creating new elites that would support the export promotion and private property strategy. Two new elites were formed under these administrations: the private export elite and the foreign investors elite. Deregulation, privatization, and new rules for foreign investment were used as instruments in promoting these elites. Deregulation eliminated the convoluted rules that allowed some groups to enjoy monopoly rents (on this see Fernandez 1995). Through privatization, the government transferred to the new private elite virtually all the firms in the manufacturing sector, with the exception of the energy sector. Through less discretionary rules the government attracted a significantly greater amount of FDI than it had historically. These actions further weakened both the statist elite and the old private import-competing elite. Several investors who had not been in the big leagues during the 1970s and 1980s were able to acquire government assets that transformed them into what one might call “new strong groups.” The steel industry illustrates this point. Before privatization there was only one private integrated steel producer in Mexico-Hylsa (a subsidiary of Alfa, beneficiary of the 1981 bailout discussed above). After the privatization of the steel sector, the relative power of Alfa diminished drastically-now it is only one among five major steel producers. The others are GAN, a consortium of a former pharmaceutical group,

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a small mining group, and a Dutch steel producer; IMSA, a group of former medium-sized steel processors; ISPAT, a group from India; and Villacero, a group of former medium-sized steel traders. It is interesting to note that in response to the increased competition induced by privatization, Alfa recently opened a new steel plant that is internationally competitive. Prior to privatization, it is likely that Alfa would simply have sought more protection and received it, threatening to close down if it did not. Today, shutdown threats from a single steel producer could not effectively induce protection because other domestic producers are available to fill the employment and production gaps a shutdown would create. Another indicator of the dilution of power within the private elite that Salinas’s reforms have brought about is the increased number of Mexican billionaires. According to Forbes, there was only one billionaire family in Mexico in the late 1980s-the Garza Sada family, Alfa’s major shareholder. In 1994, there were 24 Mexican billionaires, according to Forbes. Outstanding examples are Roberto Gonzalez, Carlos Slim, and Salinas Pliego. Gonzalez developed the market for tortilla flour and is the biggest producer of tortillas in the United States. In the recent privatization of the banks he acquired Banorte. Slim controls Telefonos de Mexico, the telephone monopoly, in association with Southwestern Bell and France Telecom. Salinas Pliego is the top Mexican retailer of household appliances. He recently bought from the government Television Azteca and has a joint venture with NBC, which makes him the only private competitor of Televisa, Mexico’s other television network. It is worth noting that 10 years ago none of these men were billionaires-they did not even rank among the country’s richest. We should clarify that the new elite was not formed totally by newcomers: in fact, many of its members had familial or historical links to the old elite. The important point is that the new group is defined not by the historical background of its members, but by their interest in defending the new set of property rights. This common interest is in turn determined by the fact that they own and control fixed factors whose profitability depends on exports. Summing up, the policies followed by the government during the period 1985-94 (trade liberalization, deregulation, opening to FDI, and privatization) had the effect of weakening the statist elite and the private import-competing elite and inducing the formation of two new powerful groups: the export elite and foreign investors. Since these new elites will benefit from the new set of property rights that has been imposed, once their power is consolidated in the near future they should expend resources to ensure that these property rights are maintained. We should emphasize that the executive branch has played a critical role in this process as a coalition builder, not as an authoritarian central planner. This does not mean that the administrations of de la Madrid and Salinas did not push hard for unpopular policies designed to establish the new property rights

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regime that would support an efficient export economy. Important examples of their efforts in this direction are the tax reform, the privatization program, and the deregulation program.

2.5 NAFTA As we will describe in subsection 2.5.2, most CGE models predict gains for Mexico from NAFTA on the order of 1-3 percent of steady state GDP. When capital inflows are allowed, possible gains increase to 5-8 percent. Would even an 8 percent increase in steady state GDP be worth the sizable costs President Salinas was willing to incur to ensure NAFTA’s approval by the U.S. Congress? The answer is probably no. We think that CGE models’ predictions fail to capture all the benefits derived from the role of NAFTA as a commitment device and therefore tend to underestimate the benefits of NAFTA. As we will describe in subsection 2.5.1, trade liberalization in services and agriculture will not be immediate but will happen gradually over the next 10 to 15 years. This gradual liberalization will be a blow to the elite associated with traditional agriculture, which derives its power from the distribution of subsidies to inefficient producers. This is a serious concern because the PRI vote comes largely from rural voters, and to a great extent, the agricultural elite controls the machine that produces this vote. Thus, trade liberalization will destroy an important part of the PRI voting machine over the next decade. This creates a good deal of uncertainty about who will gain power in the future. The Chiapas uprising on 1 January 1994, the day on which NAFTA was enacted, symbolizes this uncertainty. Regardless of whether the uprising originated in the peasantry or was induced by an elite that opposes trade liberalization, it proved that there are opponents to the new regime (see Hinestrosa and Tornell 1994). The uncertainty regarding who will gain political control once the PRI’s agricultural voting machine is weakened will make it politically expedient to delay indefinitely further liberalization or to derail reform altogether. Our point is that NAFTA is the commitment device that will ensure that such delay will not occur and that reform will continue. This will happen in two ways. First, there are huge political and economic costs associated with breaching an international agreement such as NAFTA. Second, NAFTA will consolidate the power of the new export groups that have an interest in defending the new set of property rights. NAFTA will benefit and strengthen the new Mexican export elite for two reasons. First, it will facilitate the establishment of links with foreign firms interested in the maintenance of policies that support free trade. Second, it will allow the Mexican export sector to grow faster and become a bigger player in the domestic arena. NAFTA will achieve this outcome by reducing the uncertainty generated by trade disputes and by facilitating U.S. and Canadian access to Mexican goods. Also, NAFTA will reduce the cost of inputs, making Mexi-

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can exports more competitive. Liberalizing trade in agriculture will increase the supply of unskilled labor, thus reducing the real wages of unskilled workers (Venables and Van Wijnbergen 1993); liberalizing trade in services will reduce interest rates, transport costs, and communication costs. By the time the reforms stipulated by NAFTA take effect, the new export groups should have already consolidated their power. Thus, they should be able to defend the new status quo, ensuring that reform is not derailed in the transition. The new groups will be able to defend the new status quo in several ways. For instance, they can finance the campaigns of politicians who favor the status quo as opposed to expropriation and inward-looking policies. Also, should the government in place try to renege on reforms, they can finance opposition groups. Thus, regardless of what parties form and win elections in the future, they will find it costly to alter the development path established by the de la Madrid-Salinas regime. Thus, once the new groups have consolidated their power, the probability of derailment will be very small. The bailout that the Mexican government received in early 1995 after the financial panic of December 1994 exemplifies this point. Given that in early 1995 Mexico did not have enough liquidity to repay its dollar-denominated short-term debt, a default was likely.5This default might have forced the government to follow inward-looking policies and increase anew the power of traditional elites, risking the derailment of reforms. The network of U.S. firms with investments in Mexico used their political clout to induce an unprecedentedly speedy response from the U.S. government and international organizations. Within a few weeks approximately $50 billion in credit lines and loan guarantees was in place. This support allowed Mexico to repay its short-term debt and even to resume borrowing in international markets by mid-1995. Moreover, the Mexican government responded to this crisis with an acceleration of the privatization program and the opening of the financial system. The fact that the U.S. network used its power to save Mexico from a reformendangering situation suggests that Salinas was successful in inducing the creation of groups that would defend the reforms begun by de la Madrid. 2.5.1

What Is NAFTA?

When NAFTA was enacted on 1 January 1994, tariffs for about half of all import categories were eliminated immediately. Most of the remaining tariffs will disappear within a period of 5 years, and only a few of them will remain in effect for a maximum period of 15 years. In 1993, the average Mexican tariff was about 12 percent while the average U.S. tariff was about 4 percent. Therefore, in terms of tariff reduction, the expected changes are relatively small and the bulk of the reductions will be in tariffs on Mexican imports. Still, NAFTA includes restrictions that will reduce the impact of tariff reduction on Mexican products. These measures are aimed at compensating Mexico for the 5. For an analysis of the Mexican crisis of 1994, see Sachs, Tornell, and Velasco (1995)

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obvious asymmetry in level of development among the three countries involved.

Agriculture. Agriculture is heavily protected in all three countries. But, while farmers are a very small fraction of the U.S. and Canadian labor forces (3 percent in the United States and less than 5 percent in Canada), as much as 26 percent of the Mexican labor force is dependent on agriculture. This suggests that the Mexican economy will face very significant adjustment problems as a result of NAFTA. In those cases where import licenses were still present, they were replaced by ad valorem tariffs. For instance, tariff protection on corn, wheat, and beans will be phased out over a period of 10 to 15 years. Textiles. Quota restrictions on Mexican textile imports from the United States will be removed gradually over a 10-year period. In this sector the rules of origin will play a very important role in deciding which exports are eligible to be traded.

Automobiles. In the automobile sector, Mexico will immediately eliminate its tariffs on light trucks and reduce by 50 percent tariffs on passenger cars. The remaining tariffs will be phased out over a period of 10 years. In this sector, rules of origin were negotiated such that a minimum 62.5 percent North American parts and labor content will be required for access to the benefits from the agreement (compared to the 50 percent requirement under the Canada-U.S. agreement). Importing used cars from the United States into Mexico will be allowed in 10 years. Financial Sector. Initially, there will be some restrictions on the financial sector in Mexico. Individual firms will face a cap of 1.5 percent of the market, and on the aggregate, Canadian and U.S. financial firms will face a ceiling of 8 percent. This aggregate cap will gradually increase until the year 2000, after which most of the restrictions will disappear, unless foreign firms have more than 25 percent of the market and the Mexican government decides to apply some restrictions. Side Agreements. The Free Trade Commission was established by NAFTA to

supervise the implementation of the agreement and to resolve disputes about its interpretation. In addition, there will be binational panels for the resolution of antidumping and countervailing duty determinations. These side agreements will further reduce uncertainty in trade relationships among the three countries involved, which from the Mexican standpoint is one of the most important issues. NAFTA does not entail either free labor mobility or environmental harmonization requirements. There are, however, supplemental agreements on labor and environmental cooperation, as well as about the establishment of a North

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American Development Bank. The two supplemental agreements state that each country will have the right to determine its own regulations but must commit itself to ensuring their correct implementation. 2.5.2

Computable General Equilibrium Models of NAFTA

The basic conclusion of CGE models is that NAFTA will have small welfare effects. These models suggest this because for the most part they do not include the effects on foreign investment and because import tariffs in Mexico (at least in the manufacturing sector) have already experienced a steep decline, because a structural transformation has already occurred (between 1987 and 1993) in Mexico and because tariff rates in the United States and Canada are already low. Here we summarize the results of these models. According to Brown (1992), these models can be grouped in three categories: static models with constant returns to scale technology and perfectly competitive goods markets, static models with increasing returns to scale, and dynamic models. In the first set of models the predicted effects are as follows. If there were a removal of tariffs only, Mexico’s real income would increase by 0.11 percent. If the agreement were to include nontariff barrier reduction, the predicted gain would vary between 0.3 and 2.28 percent. If, in addition, we allow for an increase in capital inflows, Mexico’s real income could increase between 4.6 and 6.4 percent (or 6.8 percent if we also allow for endogenous migration). Most of these models also predict an increase in the trade deficit with both the United States and the rest of the world. The predicted effects range from an increase of 0.33-1.49 percent if no capital inflows are considered to an increase of 6.6 percent in the case of capital inflows. The second set of models allows for increasing returns to scale and therefore a non-perfectly competitive market structure. Its predictions are similar to those of the first set: effects on Mexican real income range from 1.6 to 3.3 percent depending on the market structure and are as much as 5 percent if capital inflows are allowed. Predicted effects on employment are bimodal: some models predict effects ranging from 1.7 to 2.4 percent; others predict an increase between 5.1 and 5.8 percent. Finally, the last group of models predicts gains for Mexico ranging from 0.6 to 2.6 percent. When there is a reduction in the interest rate (as a result of a lower degree of uncertainty) from 10 percent to 7.5 percent, these models predict gains for Mexico as high as 8.1 percent of steady state real income.

2.6 Conclusions In retrospect, the sequence of reform policies adopted in Mexico is fascinating. No step resulted from the decree of an all-powerful autocrat, and each step both had the support of a powerful group and generated new powerful groups that would support further reforms. The first step was to liberalize trade in manufactures. The government under-

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took this action not as soon as it realized its necessity, but only when the unanimity of the powerful groups within the manufacturing sector broke down in the 1980s. The second step was to consolidate the power of emerging elites with an interest in export promotion, an objective that the government achieved through privatization and deregulation. The third step in the sequence was the signing of NAFTA, and the fourth step will be actually to dismantle protection in the agricultural and services sectors. The trade liberalization process was not a historically predetermined outcome, but was brought about largely through the decisive contributions of former presidents de la Madrid and Salinas. De la Madrid recognized the window of opportunity created by the economic hardships of the mid-1980s and began liberalization at the start of his administration. He also recognized the limitations of this opportunity and did not try to liberalize the entire economy. Salinas consolidated the power of the new export group and, by signing NAFTA, committed Mexico to total liberalization in 15 years. Chances are that if all these steps had been taken at once, Mexico’s powerful groups would have colluded and blocked the reform. We can see this from the Venezuelan experience, an interesting contrast to the Mexican one. In 198992, Venezuelan president Carlos Andres Perez tried to implement many reforms simultaneously. All the powerful groups in the population opposed him, forcing him to resign. His successor, President Caldera, backtracked on many of Perez’s reforms. NAFTA should be understood as a commitment device that guarantees there will be no delays in the continuing reform process. This commitment device, combined with the influence of the new elites that benefit from export promotion, greatly increases the likelihood that trade liberalization in Mexico will not be derailed.

References Berry, S., V. Grilli, and F. Lopes-de-Silanes. 1993. The automobile industry and the Mexico-US. Free Trade Agreement. In The Mexico-U.S. Free Trade Agreement, ed. P. M. Garber. Cambridge, Mass.: MIT Press. Brown, D. 1992. The impact of a North American free trade area: Applied general equilibrium models. In North Americanfiee trade: Assessing the impact, ed. N. Lusting, B. Bosworth, and R. Z. Lawrence. Washington, D.C.: Brookings Institution. Clavijo, E 1992. La eficiencia productiva del sector manufacturer0 Mexicano, 19851990. Mexico City: Office of Economic Advisors to the President. Mimeograph. Esquivel, G. 1992. Comercio intraindustrial Mexico-Estados Unidos, 1981-1990. Estudios Economicos, no. 13. Mexico City: El Colegio de Mexico. Femandez, A. 1995. Deregulation as a source of growth in Mexico. In Reform, recovery, and growth, ed. R. Dombusch and S. Edwards. Chicago: University of Chicago Press. Fox, J. 1992. The politics of food in Mexico. Ithaca, N.Y.: Come11 University Press.

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. 1994. Political change in Mexico’s new peasant economy. In The politics of economic restructuring, ed. M. L. Cook et al. San Diego: University of California, Center for US.-Mexican Studies. Hernandez-Chavez, A. 1979. La Mecanica Cardenista. Historia de la Revolucion Mexicans, vol. 16. Mexico City: El Colegio de Mexico. Hernandez-Laos, E. 1992. Evolucion de la productividad total de 10s factores en la economia Mexicana. Mexico City: Universidad Autonoma Metropolitana. Mimeograph. Hinestrosa, P., and A. Tornell. 1994. Las condiciones economicas como factor de descontento social: El caso de Chiapas. In Chiapas: Una Radiograjia, ed. Maria Luisa Armendariz. Mexico City: Fondo de Cultura Economica. Levy, S., and S. Van Wijnbergen. 1991. Maize in the Mexico-United States Free Trade Agreement. Washington, D.C.: World Bank. Luttmer, E. 1993. Productivity in Mexican manufacturing industries. Washington, D.C.: World Bank. Mimeograph. Maxfield, S., and R. Anzaldua, eds. 1987. Government andprivate sector in contemporary Mexico. San Diego: University of California, Center for US.-Mexican Studies. Meyer, L. 1978. Los inicios de la institucionalizacion: La politica del Maximato. Historia de la Revolucion Mexicana, vol. 12. Mexico City: El Colegio de Mexico. Ortiz Mena, A. 1970. El Desarrollo Estabilizador. El Trimestre Economic0 37 (146): 1-48. Peres, W. 1990. Foreign direct investment and industrial development in Mexico. Paris: Organisation for Economic Co-operation and Development. Sachs, J., A. Tornell, and A. Velasco. 1995. The collapse of the Mexican peso: What have we learned? NBER Working Paper no. 5142. Cambridge, Mass.: National Bureau of Economic Research. Secretaria de Comercio y Foment0 Industrial (SECOF). 1994. Resultados de la nueva politica de inversion extranjera en Mexico, 1989-1994. Mexico City: Miguel Angel Porma Editorial. Tornell, A. 1995. Are economic crises necessary for trade liberalization and fiscal reform? The Mexican experience. In Refom, recovery, and growth, ed. R. Dornbusch and S. Edwards. Chicago: University of Chicago Press. Tybout, J. R., and M. D. Westbrook. 1995. Trade liberalization and the dimension of efficiency change in Mexican manufacturing industries. Journal of International Economics 39 (1-2): 53-79. Venables, A,, and S. Van Wijnbergen. 1993. Location choice, market structure and barriers to trade: Foreign investment and the North American Free Trade Agreement. Washington, D.C.: World Bank. Mimeograph.

Comment

Wontack Hong

According to Tornell and Esquivel, trade liberalization, deregulation, privatization (excluding oil firms), opening to foreign direct investment (FDI) with new rules, and the formation of NAFTA during the period 1985-94 have weakened the private import-competing (PIC) elites and the state-owned enterprise (SOE) elites within the manufacturing sector and at the same time have inWontack Hong is professor of economics at Seoul University

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duced the formation of new export elites and FDI elites that are taking advantage of the government’s new set of property rights. These new elites, once their power is consolidated in the near future, are expected to have strong incentives to defend the new rules of the game. Tornell and Esquivel have indeed mentioned that many of the new elites have links to the old elites. And yet, their emphasis is still on the problem of new elites defending new property rights in face of old elites trying to derail the liberalization program. The real curiosity is why the traditional elites have not themselves more actively attempted to expand the scope of their operations into the new export activities or to form strategic alliances with FDI. Were there any political or institutional barriers that inhibited traditional elites from converting themselves into new elites, in spite of the wealth and power they had accumulated over the past several decades? By creating new billionaires, the Mexican government seems to have reduced the concentration of economic power, making the Mexican economy more competitive and enhancing the sense of participation at least among the narrowly limited upper classes. Has there been any effort to spread the sense of participation down to small entrepreneurs by lowering entry barriers against labor-intensive export production activities? If there occurs liberalization of trade in agricultural and service sectors according to the timetable set by NAFTA, one might well expect input prices (including the wages of unskilled workers) to fall and the manufacturing sector to become more competitive. On the other hand, it is likely that ejido agriculture (which constitutes the mainstream rural vote) will be completely ruined and that the services sector will be dominated by FDI. Tornell and Esquivel state that even a gradual liberalization would be a blow to the elite associated with traditional agriculture. However, there have been fairly productive largescale non-ejidu agricultural sectors that maintain access to export markets. One may have to examine the possible impact of liberalization on this large-scale non-ejido agriculture. If an export orientation enhances the interests of the nonejido agricultural elite, then they too must be examined systematically, together with the interests of the SOE, PIC, export, and FDI elites in manufacturing. According to Tornell and Esquivel, NAFTA was not established to increase the bargaining power of North America against the rest of the world; it was simply a product of Mexican internal politics and was aimed to transform the Mexican economy into a truly market economy. This view might represent a Mexican perspective, but I am not so sure that it can represent the U.S. perspective.

3

Social Policy Dimensions of Economic Integration: Environmental and Labor Standards Kym Anderson

Despite the conclusion of the Uruguay Round negotiations in 1994 and the conversion during 1995 of the GATT Secretariat into the more influential World Trade Organization (WTO), trade tensions between nations remain considerable. Part of the tension continues because of social policy differences across countries: differences in worker rights and standards, in human rights more generally, in technical standards of production, in natural resource and environmental policies, in animal welfare issues, in education and health policies, in support for national culture or exclusion of foreign cultural influences, and so on. Some countries have sought to use trade policy as a stick or carrot to induce other countries to adopt something closer to their social policy standards. The United States, for example, routinely does this in its dealings with China over human rights. It has also used trade policy with Mexico in pursuit of animal welfare (the famous dolphin-tuna case) and with Vietnam in pursuit of the interests of U.S. families of missing-in-action soldiers. Apparently, social policy differences are becoming more important in disputes between countries. Why? Under what circumstances (if any) is trade policy an appropriate instrument for resolving such disputes? What are the implications for the global trading system, for regional trading arrangements, and for their interaction? What if anything should East Asian countries and perhaps APEC do about this development? These questions are addressed in this paper Kym Anderson is professor of economics and director of the Centre for International Economic Studies, University of Adelaide, and a research fellow of the Centre for Economic Policy Research, London. This chapter draws on the author’s paper for the World Bank Conference on Implications of the Uruguay Round for Developing Countries, Washington, D.C., 26-27 January 1995. Thanks are due especially to John Black, Richard Blackhurst, Menzie Chinn, Jane Drake-Brockman, Bernard Hoekman, Takatoshi Ito, Anne Krueger, Will Martin, Chong-Hyun Nam, David Richardson, and Dani Rodrik for helpful comments, and to the World Bank, NBER, Korea Development Institute, and Australian Research Council for financial support.

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by focusing mainly on environmental issues and trade, since their entwining in policy circles is arguably the most controversial and the matter is already on the WTO’s work agenda. Some discussion of the trade and labor standards issue also is included in the paper, partly because it parallels the trade/environment debate to some extent, partly because the United States and France would like to see it added to the WTO’s agenda, and partly because it is already included in some major regional trade agreements. In fact, both issues arose in a significant way in the NAFTA negotiations of the early 1990s, to the point where it appeared the U S . Congress was not willing to ratify that agreement without accompanying supplemental agreements on environmental and labor standards. Since the 1950s these issues also have been part of Western European integration negotiations, most recently with heated debate among EU member governments at Maastricht over a “social charter” relating to labor standards. The paper is structured as follows. Section 3.1 looks at why social policies in general are becoming subjected to more international scrutiny, both regionally and globally. Section 3.2 then asks why environmental issues in particular are becoming more entwined with trade policy. Section 3.3 examines the relationship between economic growth, trade, and the environment. Section 3.4 discusses the nature and extent of entwining of GATT and the environment. This is followed, in section 3.5, by some speculation on what lies ahead for the WTO in its relationship with existing and prospective multilateral environmental agreements. Section 3.6 is devoted to discussing GA’ITNTO and labor standards, showing why their entwining has become an issue in the mid-1990s and how in some (but by no means all) respects the issue of trade and labor standards is similar to the trade/environment issue. Both issues have a distinct North-South dimension, which is why developing countries are becoming more concerned about them. The final section of the paper focuses on what developing countries and APEC could do in response to these developments.

3.1 Why Social Policies Are Coming under Closer International Scrutiny Social policy differences across countries are to be expected. Partly they reflect per capita income differences: as communities become richer, so does their demand for social policies and higher standards. Policy differences exist also because of differences in tastes and preferences. Indeed, one of the key reasons for nationhood is to bring together and distinguish one grouping of people whose preferences are more similar to each other than to those of neighboring groups (Alesina and Spolaore 1995). In the case of environmental policies, they also reflect differences in per capita endowments of natural resources and environmental amenities. A diversity of social policies therefore contributes to differences in countries’ comparative advantages in trade and therefore to the gains from trade.

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As economic integration proceeds, though, pressure increases to reduce differences in social policies that have economic consequences. This has clearly happened within countries in the course of their economic development: numerous local, state, or provincial policies and standards have gradually been replaced by national standards and conformance assessment (National Research Council 1995). The motivation is not just to reduce administrative and conformance costs. It also results from concerns in high-standards regions that costs of production for some firms and industries are higher in their region than in regions with lower standards, causing them to be less competitive. These differences become ever more important as traditional barriers to trade and investment between regions fall (notably transport and communication costs). Harmonization of those standards could go in either direction, however, with winners and losers in each region trying to influence the outcome. And there is no reason to presume that overall national economic and social welfare will improve because of those social policies’ being harmonized: it all depends on how close the most influential groups’ standards are to those of the median voter. Similar forces to those intranational ones are also at work in the international arena. There have been substantial reductions in recent decades in traditional barriers to foreign import competition, including international transport and communication costs, tariffs, and other governmental border policies that inhibit flows of goods, services, and capital across national borders.’ The resulting extra exposure of national economies to competition from abroad-in part due to the very success of the GATT in promoting trade liberalizationhas caused attention to focus more sharply on domestic policies, including cost-raising social policies and standards, that continue to reduce the international competitiveness of some firms and industries in each country (Bhagwati 1996). These harmed producers are especially likely to protest when significant new players with lower standards become competitors. This has happened increasingly during the past quarter-century, first with the growth of Asia’s newly industrialized economies and then with the opening-up of China and numerous other transitional and developing countries. It has been suggested that one of the driving forces behind regional integration initiatives has been the tardiness of the GATT in taking up social policy issues among its large and diverse group of contracting parties (Lawrence 1995). Achieving agreement to harmonize social policies and otherwise coordinate trade- and investment-related domestic policy reforms is easier the more 1. These reductions are reflected in the fact that the volume of merchandise trade has been growing nearly twice as fast as the volume of merchandise output globally (3.9 compared with 2.1 percent per year during 1980-92), and trade in commercial services has grown even faster (raising its share of global exports of goods and commercial services from 17 to 21 percent during 1980-92-see GATT 1994). Direct foreign investment, meanwhile, has grown nearly twice as fast as international trade globally over the past decade or so, following the deregulation of many countries’ financial markets and the revolution in communications and data transmission.

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similar are the per capita incomes, tastes, and preferences of the countries concerned. Hence, we observe the formation of trade blocs more among similar than among disparate economies. We also observe the inclusion of social in addition to trade policies more in integration agreements involving richer countries than in those between poorer countries, presumably because ( 1 ) the demand for social policies is income elastic and ( 2 ) barriers to trade and investment flows (both natural and governmental) between countries tend to be lower among rich countries than between them and poorer countries or among poorer countries. When dissimilar countries have sought to join such blocs (e.g., Mediten-aneans to the European Community, Mexico to NAFTA), advocates for higher standards have endeavored to tie market access to the upward harmonization of social policies. To a considerable extent they have succeeded in doing so in the European Union. And in the case of NAFTA they were also successful after President Clinton came into office, to the extent that side agreements on environmental and labor standards were added to NAFTA in the closing hours of the negotiations. As for trade outside these blocs, we tend to observe advocates for high standards supporting import restrictions on like products from lower-standard countries. Why? Because such restrictions simultaneously reduce opposition by local firms to the raising of standards at home and increase the incentive for foreign firms and their governments to adopt higher standards abroad (out of fear of losing market access). However, such uses of trade policy are both discriminatory and protectionist. That brings advocates for higher standards both into direct conflict with supporters of liberal world trade and into coalition with traditional protectionist interests. Fear of the latter’s gaining superficial respectability in arguing against trade liberalization has led to claims that “social correctness” is becoming the New Protectionism (Steil 1994).

3.2 Why Environmental Issues Are Becoming More Entwined with Trade Policy The list of environmental concerns with international or global dimensions has grown rapidly in recent years. In addition to worries about air, water, soil, and visual pollution at the local, national, and regional2 levels, some of that pollution is believed to be also damaging the environment on a global scale, for example through ozone depletion and climate change. Some in rich countries are concerned that these problems will be exacerbated as economic growth takes off in newly industrialized countries with laxer environmental standards. More and more people worry also about resource depletion, species 2. Transborder pollution issues affecting adjoining countries of a region are not discussed in what follows since they are usually resolved by intergovernmental agreement without having to resort to trade policy measures, the free-rider problem being absent because of the small number of countries typically involved.

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extinction, and animal welfare at the global level, regardless of national boundaries. Ongoing integration of the world economy also brings with it new health and safety concerns by consumers of imported products. Needless to say, personal values play an important role in debates on these issues. Hence, there is considerable scope for friction between countries with different preferences, resource endowments, incomes, and knowledge about how different activities and policies affect the environment, and therefore different perceptions of optimal national and global environmental and resource policies. Fluctuate though they might with the business cycle, these heightened concerns about resource depletion and the environment are likely to keep growing. One reason is that, even though uncertainties remain, the scientific basis for many of these concerns is perceived to be more solid now than was the case 20 years ago. Another is that both the world‘s population and its real per capita income continue to increase at very high rates by historical standards. Unfortunately, though, the supplies of most natural resources and environmental services are limited, and markets for many of them are incomplete or a b ~ e n t . ~ Markets are underdeveloped because of disputed, ambiguous, or nonexistent property rights or because of the high cost of enforcing those rights. It is true that the more advanced economies have established institutional structures to help handle the tasks of arriving at a social consensus on what are appropriate environmental or sustainable development policies for that society, of allocating property rights, and of enforcing policies. The same is true in some traditional societies before they begin to “modernize” and their resources come under pressure because of declining mortality rates. But it is less true in the newly “modernizing” economies, where the world’s population and consumption growth are expected to be concentrated for the foreseeable future. And, at the multilateral level, cooperative intergovernmental mechanisms in the environmental area have only recently begun to be formed and will take some time before they become very effective, especially where free-rider problems are rife. So, with sufficient forums yet to be fully developed for multilateral environmental dialogue, and with the problems increasingly being perceived as urgent as new scientific evidence becomes available, there is growing interest among environmental groups-especially in the more advanced economies-in using one of the few policy instruments apparently available to their governments, 3. This does not apply equally to all natural resources and environmental services, of course. The doomsdayers such as Meadows et al. (1972) have been shown to be spectacularly wrong in predicting the exhaustion of minerals and energy raw materials, e.g., because they have failed to take into account economic feedback mechanisms. Beckerrnan (1992) noted that the cumulative world consumption of many minerals during the past quarter-century exceeded “known reserves” at the beginning of the period, yet today’s revised “known reserves” nevertheless exceed those of 25 years ago! The same cannot be said for tropical hardwoods and some fish species, however, although in these cases there is scope to move further from the current “hunter-gatherer” technology to using land or water more intensively in planting trees for timber or practicing aquaculture in the same way as agriculture uses land to produce most other forms of food and fiber.

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namely trade restrictions, to influence environmental outcomes both at home and abroad. Environmental groups perceive trade policy as a means both of raising national environmental standards at home and abroad and of inducing countries to become signatories to and abide by international environmental agreements. On the first, these groups are aware that, unless compensated, firms will oppose the raising of domestic standards if competitors abroad are not subjected to similar cost increases. But since the loss of competitiveness can be offset by import restrictions on products from lower-standard countries, such restrictions can at the same time remove opposition by local firms to higher standards at home and increase the incentive for foreign firms and their governments to adopt higher standards abroad. Not surprisingly, those features make trade policy very attractive to environmentalists. On the second, with respect to international environmental agreements, a major attraction of trade measures is that they can be used effectively as sticks or carrots because they are relatively easy to use and are immediate in their impact. Even the threat of trade sanctions can have a rapid and persuasive effect in encouraging a country to join an international environmental agreement and subsequently to abide by its rules. Already we have seen the use of discriminatory trade restrictions affecting particular targeted products (e.g., in the Montreal Protocol on CFCs-substances that deplete the ozone layer). There have also been proposals to use trade sanctions against unrelated products. These aim chiefly at persuading developing countries to adopt stricter environmental standards (e.g., threats to provide less open access to textile and other markets in industrial countries unless logging is curtailed or managed on a more sustainable basis).

3.3 The Relationships between Economic Growth, Trade, and the Environment The standard theory of changing comparative advantages in a growing world economy, which has been developed without consideration of environmental concerns, can readily be modified to incorporate at least some of those concerns. As espoused by Krueger (1977) and Learner (1987), this theory suggests that when a developing country opens up to international trade, its exports initially will be specialized in primary products. This is because its stocks of produced capital relative to natural resources are comparatively low. Should those nonnatural capital stocks per worker (including human skills) expand more for this country than globally, the country’s comparative advantage will gradually shift to more capital- and skill-intensive activities (particularly manufactures and services). If such countries are relatively land abundant, some of that produced capital and new or newly imported capital-intensive technology may be employed profitably to extract minerals or farm the land. But in most such countries the new capital will encourage the expansion of nonprimary

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sectors and shift these countries’ comparative advantage away from primary products. Thus countries that are lacking in natural resources or that are densely populated will tend to industrialize at an earlier stage of economic development, and their nonprimary exports will tend to be more intensive in the use of unskilled labor initially. In the case of manufactures, the process of upgrading to more capital-intensive production over time leaves room in international markets for later-industrializing countries also to begin with labor-intensive export-oriented manufacturing. If national boundaries were such that there were no international environmental spillovers, and there were no global commons, this story need be complicated only slightly to incorporate nonmarketed environmental services and pollution by-products. The complication required is simply to allow for the fact that as a country’s per capita income and industrial output grow, the value its citizens place on the environment increases and with it their demands for proper valuation of resource depletion and environmental degradation, for the assigning and better policing of property rights, and for the implementation of costly domestic pollution abatement policies that may induce the production and dissemination of less-pollutive technologies-at least after certain threshold levels of income or pollution are reached? Beyond those threshold points the severity of such abatement policies is likely to be positively correlated with per capita income, with population density, and with the degree of urbanization. If all economies were growing equally rapidly, the progressive introduction of national environmental taxes and regulations would tend to cause pollutionintensive production processes to gradually relocate from wealthier or more densely populated countries to developing or more sparsely populated countries.5They would also slow or reverse the growth in the quantity demanded of products whose consumption is pollutive, and more so in wealthier or more densely populated countries, where taxes on such products would tend to be highest. If the more advanced economies are net importers (net exporters) of products whose production (consumption) is pollutive, these countries’ optimal environmental policies would worsen their terms of trade to the benefit of poorer economies, and conversely (Siebert et al. 1980; Anderson 1992b). Thus 4. Recent papers reporting evidence in support of the claim that the demand for implementing and enforcing pollution abatement policies is income elastic include Radetzki (1992). Grossman and Krueger (1993, 1995), Seldon and Song (1994), and Grossman (1995). See also Deacon and Shapiro (1975) on the correlation between income levels and voter attitudes toward environmental priorities. Studies aimed at explaining this transition (sometimes called an environmental Kuznets curve) are now beginning to emerge. Beltratti (1995) has sought to explain it in terms of transitional dynamics of endogenous growth models, while Jones and Manuelli (1995) have provided a positive political economy model. 5 . The term “pollution-intensive production processes” should be broadly interpreted to include activities such as mining in pristine areas or leisure services that may attract undesired local or international tourists. The presumption is that industries are not affected equally by the progressive raising of environmental standards and charges, for otherwise there would be little change in the pattern of a country’s trade.

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even countries without (or with unchanged) environmental policies will be affected through foreign trade and investment by the development of environmental policies that accompany growth in other economiesP The extent of international relocation of productive activities due to the raising and enforcement of environmental standards should not be exaggerated, however. Recent studies suggest the effect of such policies on comparative costs may be quite minor.’ The story becomes more complicated, however, when account is taken of policy reactions to international environmental problems such as the global commons, species depletion, or animal rights. The ban on ivory trade under the Convention on International Trade in Endangered Species (CITES) provides an extreme example: the strong comparative advantage that southern African nations had in elephant products virtually disappeared when the ban was introduced in 1989. Another is the recent ban, adopted under the Base1 Convention relating to hazardous waste, on exports of so-called hazardous recyclables from industrial to developing countries: that ban threatens the growth prospects for recycling industries in developing countries. A third example is the proposed limitation on imports into some high-income countries of tropical hardwoods, the aim of which is to discourage deforestation. An import ban of this kind would reduce export growth in logs and perhaps sawn timber in those developing countries still well endowed with hardwood forests, while improving the terms of trade of other net importers of hardwood such as Japan, Korea, and Taiwan. In addition, the Montreal Protocol on phasing out the use of ozone-depleting CFCs incorporates discriminatory trade provisions designed to limit the relocation from signatory to nonsignatory countries of industries producing or using CFCs, as well as to encourage nonsignatories to accede to the protocoL8And there is the infamous example of the U.S. ban on the importation of Mexican tuna, which U.S. authorities deem to have been caught in dolphin-unfriendly nets: domestic U.S. regulations affecting the use of dolphin-unfriendly nets on U.S. registered fishing vessels, if implemented alone, would have boosted Mexican competitiveness in tuna fishing, but the subsequent ban on tuna imports instead reduced it. As is clear in the latter 6. Similarly, if as they grow economics were to institutionally shorten working hours per week, raise wages for time worked outside those hours, or otherwise increase the cost of labor time in attempting to raise labor standards, that would speed the transformation of those economies’ comparative advantages away from labor-intensive activities. If those institutional changes affected mainly unskilled labor, the competitiveness of less developed economies in unskilled-laborintensive products would strengthen even faster-see section 3.6 below. 7. See, e.g., Leonard (1988). Low (1992), and Jaffe et al. (1995). As well, Tobey (1990) found little evidence of actual changes in patterns of trade specialization in response to the imposition of environmental regulations since the 1960s. However, as noted by Hoekman and Leidy (1992), changes in trade patterns may be absent because import barriers were raised to offset any decline in the competitiveness of affected industries. 8. For details of the Montreal Protocol, see, e.g., Benedick (1991) and Enders and Porges (1992). A list of the other major international environmental agreements with trade provisions is provided in GATT (1992, app. 1) and Esty (1994, app. D).

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two examples, the motive for trade policy action is often a mixture of national competitiveness concerns and concerns-especially in wealthier countries (typically not shared to the same extent by developing countries)-for the global commons and for animal welfare. Two facts therefore need to be recognized. The first is that there are important international environmental spillovers beyond the simple transborder ones that can be handled through negotiations between governments of affected neighboring countries. Those spillovers are of two sorts: in addition to the physical damage our activities can do to the global environment regardless of the location on the globe of those activities, there are-for want of a better tern-psychological spillovers as well. For example, I may grieve if another country’s activities threaten a particular animal or plant species in its jurisdiction. Or I may grieve if I believe your desires for higher environmental standards in your country are not being recognized sufficiently by your national government (a political market failure). Controversial though such views are,9 many people perceive a need for multilateral action to reduce these spillover problems, and that is where trade policy measures enter the debate: they are seen by environmentalists as providing powerful carrots and sticks for attracting signatories and penalizing nonsignatories to bilateral or multilateral environmental agreements, as well as for encouraging other countries to adopt better national environmental policies for the sake of their own citizens and environment. The other fact that needs to be recognized is that one country’s environmental policy choice is not independent of the choices of other countries. Why? Because the imposition of higher standards or pollution charges at home alters the international competitiveness of industries, in particular by harming the more pollution-intensive industries. If their competitors abroad were not subjected to similar cost-raising policies, such industries would lobby against the imposition of higher standards at home. And while it is true that the lesspollutive industries at home would benefit from higher environmental standards, they are more diffuse and so are not likely to add much support to the environmentalists’ lobbying. It was because of this latter fact that trade policy first entered the environmental picture, back in the latter 1960s when the first wave of widespread concern for the environment began in industrial countries. As already mentioned, environmental groups perceived that, since the loss of competitiveness of pollution-intensive industries could be offset by restrictions on imports from 9. Some would argue that psychological spillovers are less worthy of consideration than physical spillovers, not least because they are less measurable and hence less “objective.” Hence, the scope for traditional protectionists to “capture” environmentalists concerned with psychological spillovers is considerable. Others would counter that there is so much uncertainty about the extent and effects of physical spillovers that they too are subjective and hence are qualitatively no different from psychological spillovers. Both exist in people’s minds, and there is no reason a priori to presume that one is more important than the other in some “willingness-to-pay” or popularity

sense.

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lower-standard countries, such restrictions could at the same time reduce opposition by such industries to higher standards at home and increase the incentive for foreign firms and their governments to adopt higher standards abroad to avoid being subjected to anti “eco-dumping” duties. The demand for unilateral use of trade policy for this latter reason has grown over time with the internationalization of the global economy, in two ways. One is that, with the decline in traditional trade barriers (tariffs, transport and communication costs, etc.j, any given environmental charge is becoming relatively more important as a determinant of international competitiveness, ceteris paribus. And the other is that, with the deregulation of financial markets and direct foreign investment of the 1980s, the possibilities for firms to disinvest in high-standard countries and relocate their factories in lower-standard countries (“pollution havens”) have increased markedly. Environmental groups fear this will result in governments’ delaying the introduction or enforcement of environmental policies-and possibly even lowering standards in a “race to the bottom”-in their attempts to attract or retain investments and hence jobs. Both types of environmental uses of trade policy-unilaterally, and to increase the workability of multilateral environmental agreements-raise potential conflicts of interest between rich and poorer countries; and the fact that discriminatory trade measures are increasingly being used to achieve the environmental objectives of rich countries, without regard to legitimate economic development concerns of poorer countries, increases the likelihood of environment-related trade disputes. There is even dispute over what constitutes the global commons: some would argue that a country or region should not have to bow to international pressure to preserve endangered species in its territory (or at least not without adequate compensation), while others would argue that such countries are merely the custodians of those resources for the benefit of humankind generally. The increasing use of discriminatory trade measures to address environmental issues should concern the world at large, and developing countries in particular, for at least four reasons. First, trade policy measures typically will not be the first-best instruments for achieving environmental objectives. This is because trade sanctions or the threat of trade sanctions do not directly affect the root cause of the environmental problem. Their use in place of more efficient instruments reduces unnecessarily the level and growth of global economic welfare as conventionally measured and may even add to rather than reduce global environmental degradation and resource depletion.l o 10. The ban on ivory trade again provides a case in point. By lowering the value of elephant products, the ban reduces the incentive for rural Africans to tolerate elephants trampling their crops and so ultimately could result in more rather than less culling of elephants in some areas. In other areas, the ivory trade ban has reduced the value of the animal so much that it is no longer profitable to cull the herd. An unfortunate consequence is that bushland in national parks is being decimated by the increased number of elephants, which is of course endangering other species (Barbier et al. 1990). Even the threat of trade restrictions can be environmentally counterproductive. The talk of Euro-

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The second reason for concern is that producer interest groups and some environmental groups are nevertheless finding it mutually advantageous to use environmental arguments in support of their claims for unilateral import restrictions, particularly following the costly imposition of stricter environmental standards on domestic producers." In this sense, the environment can provide a convenient additional excuse for raising trade barriers-and one that is socially respectable. Unfortunately, such protectionist action reduces real incomes not just at home but elsewhere too, especially in developing and natural-resource-abundant countries. Third, insofar as this can lead to an escalation in trade disputes-as is almost inevitable, especially given the North-South dimension involved and the fact that environmental uses of trade policy are inherently discriminatory-it could be followed by retaliatory and counterretaliatory action, the end result of which would be an undermining of the rules-based open global trading system on which the dynamism of developing economies continues to depend. And the fourth reason to be concerned is that there is another important sense in which aspects of environmentalism are putting at risk the global trading system. It is that, in addition to proposing the use of trade restrictions, some environmentalists also oppose trade and investment liberalization. They oppose the GATT's attempts to reduce barriers on at least two grounds: that freer trade means more output and income, which they presume means more resource depletion and degradation of the natural environment; and that freer trade and investment encourages the relocation of environmentally degrading industries to countries with lower environmental protection standards or more fragile natural environments and leads to greater transportation activity, which contributes to further environmental damage. Neither of these assertions is unambiguously supported by empirical evidence, however. The first, that income increases mean greater damage to the natural environment, may be true initially for some poorer countries (in which case any additional environmental damage has to be weighed against the marginal economic benefits of higher incomes for poor people), but once middleincome status is reached people tend to alter their behavior in ways that reduce pressures on the environment. A key change is in family size: higher incomes lead in time to lower population growth rates (Baldwin 1995).This, along with the increased employment opportunities resulting from trade liberalization, is likely to have a major effect in reducing the rate of environmental degradation ~~~

pean import bans on tropical hardwood logs (together with tariff escalation on timber product imports) has encouraged Indonesia to ban log exports. But since felling has been allowed to continue, this policy has lowered the domestic price of logs and thereby raised effective assistance to Indonesia's furniture and other timber-using industries to extremely high levels (GATT 1991, 127). At that lower log price and with possibly lower-quality sawmilling techniques it is not surprising that less of each tree is now used, leading possibly to nearly as many trees being felled as before the log export ban. 1I . See the discussions in Hillman and Ursprung (1992) and Hoekman and Leidy (1992), as well as the empirical evidence analyzed by Van Grasstek (1992) of voting behavior of U.S. senators.

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due to population pressures in developing countries. In rural areas it means fewer people denuding hillsides to eke out a subsistence income, while in urban areas it means fewer un- or underemployed squatters in shanty towns with poor sanitation and water. Another common behavioral change as economies open up and incomes rise is that the demand for education expands, and with more income and education comes more skillful management of all resources, including the environment, and more forceful demands on governments to improve the establishment and policing of private property rights and of more stringent environmental policies (see n. 4 above). As well, the political cost of implementing such policy reforms tends to fall because of increased opportunities for businesses to meet stricter standards by acquiring more and cheaper environmentally benign production processes and products from abroad. One might therefore expect that as trade and investment liberalization leads to upward convergence in incomes around the world, there would be an upward harmonization of environmental standards (Casella 1996). That realization points to the inappropriateness of the blanket call by some environmental groups for trade liberalization to follow the upward harmonization of standards, since liberalization may in fact induce harmonization. And third, the increase in the value of poor people’s time in developing countries will alter household activities in another way that is especially important for the environment. It is that the relative price of wood (in terms of time spent gathering it) as a source of household fuel rises. Since about threequarters of the timber harvested in developing countries is used as household fuel, this change could have a major beneficial impact in reducing deforestation and CO, levels. The other major assertion by environmentalists, that the global environment is necessarily harmed by the relocation of production following trade and investment liberalization, also is questionable. We know from the law of comparative advantage that not all industries will be relocated from rich to poor countries when the former’s trade barriers are lowered: some industries in the North will expand at the expense of those industries in the South, and conversely. In any case, it should not simply be assumed that relocating some production to the South necessarily worsens the environment. Recent preliminary examinations of the likely environmental effects of reducing government assistance to two of the North’s most protected industries, coal and food, reveal that in both cases the global environment may well be improved by trade liberalization, especially if complementary environmental policies are in place (Anderson 1992a; Steenblik and Coroyannakis 1995). Nor need the risk of environmental damage from transport activity increase with trade reform. The lowering of import barriers to processed primary products, for example, would allow more raw materials to be processed in resource-rich countries, so reducing the bulkiness of shipments. But, evidently, many more empirical studies will be required before the more extreme environmental groups alter their perception of

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and publicity against multilateral trade reform as an environmentally unfriendly activity.

3.4 The GATT/WTO and the Environment How “green” are the rules of the GATT and how have they been adapted over time?I2 From the outset the GATT has been a conservationist institution in the sense that its purpose has been to reduce trade barriers and thereby the inefficiency in the use of the world‘s resources. The heart of the GATT, agreed to by 23 original contracting parties in 1947 and since then by another 100 or so countries, is the nondiscrimination requirements of Articles 1 and 3. These oblige parties to treat imports from any GATT contracting party no less favorably than other imports (the “most-favorednation” requirement) and no less favorably, after border taxes are paid, than similar domestic products (the “national treatment” requirement). Article 20 provides exceptions to these general rules, however, including provisions for some environmental regulations. Specifically, parts (b) and (g) of Article 20 allow trade restrictions “necessary to protect human, animal, or plant life or health” and “relating to the conservation of exhaustible natural resources if such measures are made effective in conjunction with restrictions on domestic production or consumption,” subject to the requirement that such restrictions “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.” The latter has been interpreted to mean that the measure must be primarily for a conservation purpose (rather than for a mixture of motives) and must be necessary in the sense of being the least GATT-inconsistent measure available. These provisos have ensured that Article 20 has been rather narrowly interpreted, which is partly why some environmental groups have felt further greening of the GATT is required (Charnovitz 1991; Esty 1994). But there is nothing in the GATT that prevents a country from adopting production or consumption measures to offset environmental externalities associated with either of those sets of activities. And since trade itself is almost never claimed to be the root cause of an environmental problem, supporters of the institution see little need to consider trade measures as part of the solution to those problems. As already mentioned, widespread public interest in trade and environmental issues first surfaced in rich countries in the late 1960s and early 1970s. At that time concern focused mainly on industrial pollution within and between neighboring advanced economies. The foreign trade and investment issues raised at that time were centered on how the imposition of pollution standards at home that were stricter than those abroad might damage the international 12. For detailed legal assessments, see, e.g., Farber and Hudec (1996). Hudec (1996), and Esty (1994).

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competitiveness of the home country’s firms and how to avoid such damage through border protection measures. Where the environmental damage caused by production is purely local, the calls by disadvantaged firms for trade restrictions or subsidies to offset the decline in their international competitiveness, because standards have been raised, has no economic logic: such assistance would tend to offset the desired effect of limiting by-product p01lution.I~Nor is it reasonable to conclude that other countries are engaging in eco-dumping if the imports they are able to supply are produced with laxer environmental standards, if those lower standards are consistent with the preferences and natural resource endowments of those exporting countries (e.g., because those countries are poorer or less densely populated and less urbanized). Even so, claims for protection against eco-dumping have political appeal and may result in higher import barriers or export subsidies than would otherwise be the case in advanced economies. Leading up to the UN Conference on the Human Environment, held in Stockholm in June 1972, the GATT Secretariat produced a background paper on those issues (GATT 1971), and a Working Group on Environmental Measures and International Trade was established. But no significant changes to the GATT occurred during the Tokyo Round as a result of the expression of these concerns, and it was two decades before the working group met for the first time. Trade policy actions are more likely to occur, and to be more difficult to dismiss as inappropriate, when environmentalists in such countries view particular damage to the environment as unacceptable regardless of’the nation in which the damage occurs. This case is even more problematic if the damage is not just psychological (as with animal rights) but also physical, for then the relocation of production to a country with laxer environmental standards may worsen animal welfare, or the environment at home, in addition to reducing the profitability of the home firms. The U.S.-Mexican dispute over the use of dolphin-unfriendly nets by tuna fishermen again comes to mind, In that case the GATT ruled against the U.S. ban on imports of tuna from Mexico, partly because the ban did not discriminate according to which type of net was used-as it cannot, because an aspect of the production process rather than the final traded product itself is what is considered objectionable. The GATT panel ruled against the ban because to do otherwise would have created a huge loophole in the GATT for any country unilaterally to apply trade restrictions as a means of imposing its environmental standards on other countries. Such a loophole would work against the main objective of the multilateral trading system, which is to provide stable and predictable nondiscriminatory market ac13. See, e.g., Baumol (1971), Siebert (1974), and Walter (1975, 1976). Such protection from import competition cannot be justified on economic efficiency grounds (nor for that matter on environmental grounds), because the environmental policy is aiming to eliminate an unjustifiable (implicit) subsidy arising through undervaluation of environmental resources, rather than to add an unjustifiable tax (Snape 1992).

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cess opportunities through agreed rules and disciplines and bound tariffs on imports. Following a lull in interest brought on by the economic disruptions of the 1973-82 oil shock period, the current wave of public concern for the natural environment, leading up to and following the UN Conference on Environment and Development (UNCED) held in Brazil in June 1992, is much more intense, more widespread, and more likely to be sustained and to affect a much broader range of countries than was the case prior to the latter 1980s. The Uruguay Round agenda was set by 1986, before the current wave had built up, so the trade/environment issue was not a separate item for negotiation. Nor was there an environmental impact assessment of the Round as a whole. However, the Working Group on Environmental Measures and International Trade that was formed in 1971 was activated for the first time in 1991 and has met frequently since then. As well, several of the Uruguay Round agreements contain provisions that relate to the environment and build on articles in the General Agreement. The most fundamental provision in the Round is in the preamble to the agreement to establish the WTO, which refers to the WTO’s objective as enabling all contracting parties the maximum opportunities for “expanding the production and trade in goods and services, while allowing for the optimal use of the world‘s resources in accordance with the objective of sustainable development, seeking both to protect and preserve the environment and enhance the means for doing so in a manner consistent with their respective needs and concerns at different levels of economic development.” To give initial effect to that, a decision was taken on trade and environment by ministers meeting in Marrakesh in April 1994 to sign the Final Act of the Uruguay Round. They agreed to establish a Committee on Trade and Environment to report to the first biennial meeting of ministers (probably in late 1996). The other main features of the Uruguay Round agreements with environmental provisions relate to technical barriers to trade, sanitary and phytosanitary measures, and the agreements on subsidies and countervailing duties and on trade-related intellectual property rights. Overall, the trade liberalization to result from the Uruguay Round is likely to conserve resources and reduce environmental degradation rather than be unfriendly to the natural environment (see Anderson 1995 for details).

3.5 The GATTNTO and Multilateral Environmental Agreements The other way in which trade policy is being called upon to help achieve environmental objectives has, as mentioned above, more validity. It is as a carrot or stick to entice countries to sign and abide by multilateral environmental agreements. In the case of combating global environmental problems such as ozone depletion or climate change, the free-rider problem arises. One of the more obvious and possibly more cost-effective ways to reduce the free-rider

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problem is to write trade provisions into the agreement, as was done in the 1987 Montreal Protocol on reducing the use of CFCs and halons to slow ozone depletion. To date, no GATT contracting party has formally objected to that use of trade policy. Nor have they to the bans on trade in ivory and rhino horn and tiger products that are part of the CITES or to the trade provisions in the Base1 Convention on trade in hazardous wastes. Conflicts may well arise in the future, however, if trade provisions are drafted into more contentious multilateral environmental agreements (e.g., to impose a global carbon tax). That is why this matter figures importantly on the agenda of the new WTO Committee on Trade and Environment. Discussions so far in the GATTNTO have centered on the idea of providing waivers on a case-by-case basis or, alternatively, of providing an “environmental window” for multilateral environmental agreements within the GATT exceptions clause (Article 20). To help assess the appropriate role for trade policy in multilateral environmental agreements, it is helpful to recall that supporters of trade liberalization and of environmental protection share a common goal: to improve social welfare. They also share a common problem: the need to foster multilateral cooperation to fully achieve that objective, because in each sphere (the economy and the environment) there is considerable and increasing interdependence among nations. But the two groups differ in the important respect that supporters of liberal world trade have understood its virtues for two centuries and have been active for more than 50 years in building institutions such as the GATT and WTO to help achieve their goal, whereas widespread concerns about the environment are relatively new and supporters of environmental protection entered only recently as significant players in international policy arenas. Understandably, supporters of liberal trade and the GATTNTO resent the encroachment of these “new kids on the block” on what they perceive as their hard-won territory, especially when they genuinely believe that reducing trade barriers is likely to be environmentally friendly and consistent with sustainable development in the long run in the sense that it allows the world to use its resources more efficiently.I4Equally, advocates for greater environmental protection are frustrated that international agreements as important as those resulting from the GATT’s recent Uruguay Round can be implemented without being subject to environmental impact assessments or environmental safeguards. Clearly, there is scope for greater understanding and altered strategies on both sides. More than that, there is the distinct possibility that, by working 14. See the literature review in, e.g., Ulph (1994). Liberal traders should acknowledge, however, that opening up to trade can lead to overexploitation of common property resources (e.g., via deforestation of tropical forests) in the absence of adequate property rights, environmental charges, or policing, in which case there may be a second-best case for restricting trade until those problems are resolved (Chichilnisky 1994). In such cases all other distortions or market failures need to be corrected at the same time as trade is being liberalized in order to achieve unequivocal global welfare improvement. Even then, theory tells us that some countries may be made worse off and the environment may still be harmed (Copland and Taylor 1995).

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together, both groups’ objectives will be further enhanced-a “win-win” outcome. Some observers believe that it may ultimately require a World Environment Organization (WEO) to set rules, incorporate existing international environmental agreements and negotiate new ones, monitor compliance, and settle disputes over environmental policies-in the same way that the GATT has presided over trade rules and policies for the past five decades (Esty 1994). And just as the GATTNTO strengthens the capacity of governments to resist the demands of domestic vested interest groups seeking higher import taxes, so a WE0 may help governments resist interest group demands to set low environmental standards (Deardorff 1995). The advantage of a W E 0 for traders, Esty has argued, is that it could redirect environmentalists’ attention away from trade policies and toward ensuring the implementation of more efficient policy instruments for achieving environmental objectives, allowing both sets of policies to contribute more effectively toward the common goals of sustainable development and improvement in the quality of life. Even so, the issue of whether the WTO or the WE0 would have precedence would need to be resolved. It is noteworthy that the side agreement to NAFTA gives a surprising (to me, given that it is a trade agreement) degree of precedence to environmental concerns relative to trade concerns. What needs to be recognized is that where the two are in conflict, achieving the optimal welfare-maximizing outcome requires both to compromise somewhat. Thus without doubt the trade policy community needs to be involved in negotiating multilateral environmental agreements that are likely to include trade provisions, and to develop criteria by which WTO members could assess in advance the extent to which trade restrictions within such agreements are acceptable. Some of the relevant criteria were enunciated at UNCED. It is important, first, to ensure that trade provisions are strictly necessary and effective in achieving the environmental objectives involved. For the reasons outlined earlier, there will often be an alternative, more effective instrument than trade restrictions. Where trade instruments are required in the absence of superior policy measures, they should be used only in proportion to the size of the associated environmental problem and should be the least trade-restrictive measure available. The measures ought to be transparent and not be protectionist in impact and where possible should be consistent with both the GATT principles of nondiscrimination (most favored nation and national treatment) and the key environmental principles such as the polluter pays and the precautionary principles. If those conditions are met, WTO members would be unlikely to object to the use of trade measures in multilateral environmental agreements (witness the absence of objections by GATT contracting parties to the trade provisions in the Montreal Protocol and the CITES). Hence, even the possible need to use trade provisions in multilateral environmental agreements does not provide sufficient reason to amend GATT Article 20 to allow in the list of exceptions the use of trade measures for environmental protection.

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3.6 The GATT/WTO and Labor Standards An even more questionable entrant onto the WTO’s potential agenda than the environment, and one that has an even clearer North-South dimension, is the issue of labor standards (Bhagwati and Dehejia 1994). Government or labor union actions in setting minimum labor standards are often considered necessary to reduce the risk of exploitation of (particularly low-skilled) workers by capitalists. As with environmental standards, labor standards differ between countries and tend to be lower or enforced less in developing countries. The direct effect of such things as shorter working weeks, higher overtime pay, longer annual leave, and safer and healthier working conditions may be to raise worker welfare, but they also raise the cost of employing labor-otherwise they would have been adopted voluntarily and so there would be no need for government or union action.I5They are therefore similar to other taxes on production that differ across industries in that their indirect effects need to be considered as well (Ehrenberg 1994). Specifically, they effectively make (particularly low-skilled) labor scarcer. That tends to raise the cost of production in labor-intensive industries most in high-standard countries, thereby reducing the capacity of those industries to compete with producers in low-standard countries while enhancing the capacity of other industries to so compete, along Rybczynski (1959) lines. The owners of firms in harmed industries can respond to demands for higher labor standards by lobbying against their imposition or by demanding protection from imports from lower-standard countries until standards in the latter are raised. Thus one country’s choice of standards is not independent of the choices of other countries, nor is the country’s trade policy independent of that relationship. As with environmental standards, the demand for unilateral use of trade policy for this reason has grown over time with the internationalization of the global economy: the decline in traditional trade barriers has ensured that any given cost-raising standard is becoming relatively more important as a determinant of international competitiveness, and the deregulation of direct foreign investment abroad has increased the possibilities for firms to relocate their factories from high- to lower-standard countries. To what extent is there a parallel claim with the environment issue for placing labor standards on the WTO’s agenda because of international spillovers? Many economists would say there is none, because they perceive no physical spillovers of the global-warming or ozone-depleting kind. At least one minor spillover may be present at some times and in some places though. It is the effect of high standards for low-skilled workers in attracting unwanted migrants from less developed economies across borders that may be difficult to 15. So-called neoinstitutionalists argue that higher labor standards would raise worker productivity (see, e.g., Hanson 1983, 53-63), but it is reasonable to assume that firms will have already recognized any such possibilities and incorporated them into their work practices. If not, the first-best role for government is to subsidize the provision of information about those opportunities.

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police. I 6 Furthermore, there is the possibility also of psychological international spillovers. People may grieve because of abuse of what they perceive as worker rights or poor working conditions abroad just as they may for low environmental standards or abuse of human rights generally. But, again as with the environment, while that may provide justification for action of sume sort at the international level, there are very few circumstances in which multilateral trade measures are worthy of consideration as sticks or carrots for encouraging other countries to raise their standards. One is in cases where, as happened in the NAFTA negotiations, there comes a point when significant negotiating parties refuse to enter further multilateral trade negotiations unless labor standards are on the agenda. Should that happen, a judgment would have to be made by the other negotiating parties as to whether it would be worth continuing under such a condition. Another is when aggrieved high-standard countries can find no lower-cost ways to influence the policies of lower-standard countries, but even there the psychological benefits to the North may be insufficient to warrant the costs to consumers and exporters in the high-standard countries (not to mention the net costs to the affected low-standard countries). And a third possible circumstance is when there might otherwise be a reluctance to raise one’s own national standards so as not to erode the competitiveness of those domestic industries harmed by an increase in the gap between labor standards at home and abroad. The concern in high-standard countries ostensibly is not so much the average wage level difference but rather such things as occupational health and safety standards, worker rights to form unions and seek a minimum wage level and other improved conditions of employment, the use of child or prison or forced labor, and the derogation from national labor laws in export-processing zones. The United States and France, for example, were at pains to make clear at Marrakesh that their push for the WTO to consider tradeflabor issues was very much focused on differences in labor standards other than wages. Human rights activists and development nongovernmental agencies often add support to union calls for higher standards in developing countries, believing that they would improve the quality of life there-even though in fact the raising of labor standards in the formal sector is more likely simply to drive employment into the informal sector (where labor standards are even lower) or to lengthen the queues of unemployed people seeking high-paid, high-standard formal sector jobs.” In the case of young women displaced from their jobs by higher labor standards, they may to have to marry and bear children earlier than otherwise, or even to enter prostitution, in order to survive.I8 16. My thanks go to David Richardson for offering this suggestion. Needless to say, the firstbest response to such a possibility may be to adopt measures to reduce illegal immigration. 17. This could easily be shown using a Harris-Todaro type of model as modified, e.g., by Corden and Findlay (1975). The consequences of raising labor standards in a multigood, multicountry world can be quite complex and sometimes counterintuitive, depending on the assumptions adopted. See the excellent theoretical analysis of several possibilities by Brown, Deardorff, and Stem (1996). 18. I am grateful to Anne Krueger for suggesting this possibility.

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As with environmental standards, traditional protectionist forces in highincome countries are prompt to support any such calls for import restraint by high-standard countries against goods from lower-standard countries. They sometimes bolster their case by quoting simple trade theory (the factor price equalization and Stolper-Samuelson theorems) in support of their argument that liberal trade leads to factor price convergence and in particular to a drop in low-skill wages in high-wage countries-even though those theorems have been shown to be not very robust when more than two countries, goods, and factors are involved (Falvey 1995) and are not supported by empirical simulation results of trade liberalizations such as the Uruguay Round.I9There is also a risk that support for openness in low-standard countries could come under challenge if those who lose from the forced raising of those standards lobby domestically against their country’s exposure to other societies through having a liberal trade regime. The International Labour Organisation ( L O ) has been writing labor standards for 75 years. Why has this issue suddenly become entangled with the GATTWTO and trade policy issues? In fact, the entwining of trade and labor standards is not new,zobut it raises its head mainly when the trading system is in the news and particularly if labor markets are in trouble at the time. It became an issue when the International Trade Organization was being conceived in 1947,2’and again at the end of the Tokyo Round, and now once more as the WTO establishes itself and the Uruguay Round starts to be implemented at a time of poor labor market performance in industrial countries (with unemployment above 10 percent in Europe and relative earnings of unskilled labor in the United States deteriorating). Over time, though, the issue is coming under increasing discussion. This is partly for the reason mentioned earlier of declining trade and investment barriers, which mean that cost-raising standards become relatively more important as determinants of international competitiveness and plant location. But a further implication of falling communication costs is that citizens of highstandard countries are increasingly able to get information on labor (and envi19. In their recent simulation work, Francois, McDonald, and Nordstrom (1995) found real wages in all country groups to increase as a result of implementing the Uruguay Round. Using a similar global computable general equilibrium model, Qers and Yang (1995) found through both backcasting and projecting forward that expanding imports from Asia do contribute to wage dispersion and possibly lower real wages or increased unemployment in the United States and European Union, although only to a minor extent. Significantly, they also found that restricting imports from Asia would be an ineffective response since its impact through contracting the global economy is to lower real rewards to all types of labor in industrial countries. 20. The history is patchy but goes back more than a hundred years (Hanson 1983, 11; Chamovitz 1987). The text of the GATT itself mentions labor only briefly, in Article 20(e), which allows contracting parties to exclude imports of goods produced with prison labor. 21. Article 7 of Chapter II of the 1948 (Havana) Charter of the International Trade Organization addresses the issue as follows: “The members recognise that unfair labour conditions, particularly in the production for export, create difficulties in international trade, and accordingly, each member shall take whatever action may be appropriate and feasible to eliminate such conditions within its territory.” See Cbamovitz (1987,566-67).

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ronmental) standards in other countries. That, together with the ever greater sense of integration among the world’s people (the “global village” idea), allows and encourages the concern for human rights to spread beyond national boundaries, a tendency that might therefore be expected to continue indefinitely as global economic growth and integration proceed. Around that upward trend in concern will be fluctuations that are opposite to the business cycle: the worse the labor market is performing in high-wage countries (especially in the lower-skill categories), the more likely it is that imports from low-wage countries will be blamed22-notwithstanding clear evidence that such imports are at most only a very minor contributor (Lawrence 1994; Burtless 1995; Tyers and Yang 1995). And that likelihood is exacerbated by the computer and information revolutions that, together with other forces, are increasing the demand for skilled relative to unskilled workers (Wood 1994). Another reason why the labor issue has become more prominent in the multilateral trade arena once again is that it has succeeded recently in penetrating regional integration agreements. Specifically, a Protocol on Social Policy was annexed to the Treaty of Maastricht signed by EU member governments in February 1992 (Sapir 1996). As well, labor became the subject of a side agreement to NAFTA in 1993-a price President Clinton paid to buy off opposition from labor groups to NAFTA’s passage through the U.S. Congress. Having been encouraged by their success in those regional economic integration settings, and before that in some minor trade and investment agreements in the 1980s (see Lawrence 1994 for details), the advocates of that NAFTA side agreement are now, like the environmental lobby groups, seeking to have an influence at the multilateral trade level. In both situations, the desire of the GATT’s contracting parties to conclude, ratify, and implement the Uruguay Round agreements on trade liberalization was to a considerable extent simply being used opportunistically by these groups to further their own causes, despite the tenuous connections of those causes with trade. Their relative success to date is in large part due to the superficial popular appeal of their causes, while the downside in terms of the potential risk to the global trading system is far from obvious to the layperson. To conclude this section, it is instructive to examine the progress of labor policies in the subglobal arena of the European Union. A recent assessment by Sapir (1996) has concluded that in Europe there have always been optimists who believe economic integration breeds greater economic growth and equality of social policies (led by the Ohlin Report to the ILO at the tie of the formation of the European Economic Community-see ILO 1956) and pessimists who believe upward harmonization needs to be imposed on lower-standard countries to improve citizens’ conditions there and to avoid “social dumping” though trade. In practice, relatively little has been imposed effectively on the 22. This is the opposite to the case of the environment, concerns for which tend to fluctuate procyclically.

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poorer member countries of the European Union; the most that has been agreed to is the adoption of some minimum standards and mutual recognition. Yet standards have risen rapidly with the acceleration of income growth in the poorer EU countries. Where standards have risen even faster than normal they have been accompanied by large “economic and social cohesion” payments from Brussels. However, since explicit side payments are not as readily available at the multilateral level, and since the number and diversity of lowerstandard countries is far greater globally than within the European Union, the likelihood of major action through the WTO (much less the ILO or a WEO) seems slight.

3.7 What Could and Should Developing Countries and APEC Do about These Developments? The demands for greater harmonization of domestic policies for competitiveness reasons, coupled with the greening of world politics and the growing interest in worker and other human rights beyond national borders, are likely to put the WTO and trade policy under pressure to perform tasks for which they were not designed and to which they are not well suited-and at a time when the WTO needs first to consolidate its role in the world and ensure the implementation of the Uruguay Round before moving into these more thorny issues that are only peripherally connected with trade.23 The pressure on the WTO to become more entwined with issues of environmental and labor standards is and should be of considerable concern to developing countries. The reason is not so much that the imposition of higher standards themselves would be costly to them. In fact, middle-income, midstandard countries may well be net beneficiaries if low-income, lowstandard countries were required to raise their standards more than them to reach minimum acceptable levels. Even the negative direct effect for lowincome economies of having to raise their standards could be offset somewhat, at least for the most labor-abundant poor countries, by a terms-of-trade improvement if many countries were to raise their labor standards multilaterally and if that reduced the global supply of low-skilled labor time. Nonetheless, people in developing countries are suspicious of the motives of OECD countries and object to what they perceive as social imperialism and a denial of their national sovereignty. While they are not being targeted per se, the fact is that such standards tend 23. The suggestion has been made, e.g., that the WTO become active in monitoring and enforcing agreed minimum social standards. That presumably would involve the review of environmental and labor standards as part of the GATTNTO regular Trade Policy Reviews (TPRs). Given that the WTO’s TPR mechanism is already stretched to its limit in covering even the major trade policies of contracting parties, such an addition to its workload would require a very substantial addition to its resources-not to mention the extra burden on those employed in national capitals when the reviews are under way. An even greater potential increase in workload would result for the WTO’s dispute settlement mechanism.

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to be applied less in developing countries because they are poorer. That, together with the fact that their comparative advantages often are in labor-, natural-resource-, and pollution-intensive industries, means those countries are vulnerable either to being pressured to enforce stricter standards or to facing less market access for their exports to stricter-standard countries. Furthermore, should the use of trade policy to try to harmonize standards upward lead to trade retaliation and counterretaliation, the end result could be a weakening of the multilateral trading system on which developing countries are coming to depend increasingly as they liberalize their economies. One possible consequence is that developing countries could seek refuge from antidumping (eco or social) duties via association with or accession to the European Union or NAFTA, where they might expect to receive greater compensation for raising their social standards. In such cases, any net gain they might enjoy could well be at the expense of excluded developing countries. However, since the entwining of these social issues with trade policy is more likely to tighten than to disentangle in the foreseeable future, the question arises as to how developing countries and forums such as the Asia Pacific Economic Cooperation (APEC) ought to respond. One response is to point out that industrial countries had lower standards at earlier stages of development and that, since developing countries have contributed a disproportionately small amount per capita to global environmental problems such as the greenhouse effect, they should be compensated for contributing to their solutions rather than have that contribution demanded of them under threats of trade sanctions. Compensation would be even more justified in cases where industrial countries are demanding responses by other countries to reduce the psychological international spillovers mentioned earlier. Another response by developing countries is to disseminate more widely the sound arguments for not using trade-restrictive measures to achieve environmental or labor objectives: that differences in standards are a legitimate source of comparative advantage insofar as they reflect differences in resource endowments and societies’ preferences and abilities to afford the good things in life; that standards rise with per capita income and liberal trade promotes income growth; that theory and empirical evidence provide little reason to expect that differences in standards contribute significantly to differences in costs of production and hence to trade and investment patterns, nor that downward harmonization of standards (a “race to the bottom”) is occurring;24that if freer trade were to worsen welfare of, say, low-skilled workers, adjustment assistance programs such as retraining subsidies provide much cheaper solutions than trade restrictions, as do nontrade measures such as labeling (“dolphin-friendly tuna” or “made with unionized labor”) that allow consumers to exercise their prefer24. Surveys of the relevant theory can be found in Bhagwati and Srinivasan (1996), Wilson (1996). and Brown et al. (1996). For empirical evidence, see, e.g., Tobey (1990), Low (1992), Jaffe et al. (1995). and Levinson (1996) on environmental standards and Krugman and Lawrence (1994), Bhagwati (1993, and World Bank (1995) on labor standards.

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ences through the market; that the GATT rules-based multilateral trading system is threatened by the risk that environmental or labor groups will be captured by traditional protectionist groups in high-standard countries, and by the risk that resulting trade restrictions and pressure to involuntarily raise standards will be used by protectionist groups in lower-standard countries to argue against their countries’ export-oriented development strategies. Helpful though such argumentation could be, more dialogue and compromise between high-income and developing countries is likely to be needed. One suggestion is the following. If developing countries were to commit themselves to enforcing minimum standards and to raising those standards over time according to a specified schedule, in return for gradual improvements in OECD market access, vocal interest groups in high-income countries would be less able to deny that improvements in social standards are positively related to income and trade growth. That would be using trade policy as a carrot rather than a stick. Likewise, if developing countries were seen to be enforcing reasonable standards especially effectively on their foreign investors, concerns about capital outflows to “pollution havens” or “cheap labor havens” and the consequent loss of jobs in high-standard countries would be less justifiable. Alternatively or additionally, developing countries could transfer the onus back to high-standard countries to insist that their firms accede to the same high standards when they invest in developing countries as in more advanced economies. And anxiety over deforestation could be reduced if developing countries were able to demonstrate that they can police restrictions on felling and are prepared to do so in return for adequate compensation in the form of greater access to OECD markets or aid (e.g., via the UNDP/UNEP/World Bank Global Environment Facility administered by the World Bank). A more controversial suggestion has been made by Rodrik (1994). He believes a case can be made for high-standard countries to take action against a trading partner if trade with that country violates a widely held social standard (i.e., one that is accepted by export and consumer interests in those countries in addition to aggrieved import-competing producers and environmental or labor groups). The case rests on the point that an erosion of confidence in the “fairness” of the trading system may ultimately be more costly to the world economy than the action against the offending trading partner. He suggests that the Safeguards Agreement of the Uruguay Round could be broadened to allow a “Social Safeguards” clause whereby in such cases a country could restrict the offending imports and compensate the trading partner. Rodrik recognizes that this could do more harm than good (not least because it would formalize a link between trade policy and social standards). Even so, he argues that its merits need to be weighed against the other options available to developing countries to minimize the damage from the encroachment of social issues into the trade policy domain. The sobering history of abuse of the GATT’s other safeguards clauses, though (see Finger 1995), leaves little room for enthusiasm for this proposal to amend the Uruguay Round‘s Agreement on Subsidies and Countervailing Measures.

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Finally, what about the role of APEC? Since a complete decoupling of social issues from trade policy seems unlikely in the foreseeable future, it is important for developing countries to consider what principles ought to govern the design of trade policies and trade-related environmental and labor policies to ensure equitable and sustainable development. Several have been mentioned above in passing. Even if developing countries were simply to discuss such a list with higher-standard countries, the resulting dialogue may itself be productive in diffusing some of the concerns expressed by environmental and labor groups (Zarsky and Drake-Brockman 1994). APEC, with its diffuse but relatively small membership, provides an obvious forum for such discussion before the much larger WTO membership debates the issues. In the same spirit, APEC might also begin to monitor trade-related environmental measures as part of its overall compilation of trade impediments in the Asia Pacific. As well, it might actively seek, as a priority in its trade facilitation and liberalization initiatives launched at Bogor in November 1994, the removal of trade policies that incidentally harm the environment-again, providing a regional example for what might eventually be achievable globally through the WTO.

References Alesina, A,, and E. Spolaore. 1995. On the number and size of nations. NBER Working Paper no. 5050. Cambridge, Mass.: National Bureau of Economic Research, March. Anderson, K. 1992a. Effects on the environment and welfare of liberalizing world trade: The cases of coal and food. In The greening of world trade issues, ed. K. Anderson and R. Blackhurst. Ann Arbor: University of Michigan Press. . 1992b. The standard welfare economics of policies affecting trade and the environment. In The greening of world trade issues, ed. K. Anderson and R. Blackhurst. Ann Arbor: University of Michigan Press. . 1995. The entwining of trade policy with environmental and labor standards. In The Uruguay Round and the developing countries, Discussion Paper no. 307, ed. W. Martin and L. A. Winters. Washington, D.C.: World Bank. Baldwin, R. 1995. Does sustainability require growth? In The economics ofsustainable development, ed. I. Goldin and L. A. Winters. Cambridge: Cambridge University Press. Barbier, E. B., J. C. Burgess, T.M. Swanson, and D. W. Pearce. 1990. Elephants, economics and ivoiy. London: Earthscan. Baumol, W. 1971. Environmental protection, international spillovers and trade. Stockholm: Almqvist and Wiksell. Beckerman, W. 1992. Economic growth and the environment: Whose growth? Whose environment? World Development 20 (4): 48 1-96. Beltratti, A. 1995. Can a growth model with defensive expenditures generate an environmental Kuznets curve? Paper prepared for a workshop on Designing Economic Policy for Management of Natural Resources and the Environment, Venice, 12-13 May. Benedick, R. E. 1991. Ozone diplomacy. Cambridge, Mass.: Harvard University Press.

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Bhagwati, J. N. 1995. Trade and wages: Choosing among alternative explanations. Federal Reserve Bank of New York Economic Policy Review, January. . 1996. The demand to reduce domestic diversity among trading nations. In Fair trade and harmonization: Prerequisites forfree trade? vol. 1, ed. J. N. Bhagwati and R. E. Hudec. Cambridge, Mass.: MIT Press. Bhagwati, J. N., and V. H. Dehejia. 1994. Freer trade and wages of the unskilled: Is Marx striking again? In Trade and wages: Levelling wages down? ed. J. N. Bhagwati and M. H. Kosters. Washington, D.C.: American Enterprise Institute Press. Bhagwati, J. N., and T. N. Srinivasan. 1996. Trade and the environment: Does environmental diversity detract from the case for free trade? In Fair trade and harmonization: Prerequisites forfree trade? vol. I, ed. J. N. Bhagwati and R. E. Hudec. Cambridge, Mass.: MIT Press. Brown, D. K., A. V. Deardorff, and R. M. Stem. 1996. International labor standards and trade: A theoretical analysis. In Fair trade and harmonization: Prerequisites for free trade? vol. 1, ed. J. N. Bhagwati and R. E. Hudec. Cambridge, Mass.: MIT Press. Burtless, G. 1995. International trade and the rise of earnings inequality. Journal oj Economic Literature 33 (2): 800-16. Casella, A. 1996. Free trade and evolving standards. In Fair trade and harmonization: Prerequisites forfree trade? vol. I, ed. J. N. Bhagwati and R. E. Hudec. Cambridge, Mass.: MIT Press. Charnovitz, S. 1987. The influence of international labour standards on the world trading regime: A historical review. International Labour Review 126 ( 5 ) :565-84. . 1991. Exploring the environmental exceptions in GATT Article XX. Journal of World Trade 25 (5). Chichilnisky, G. 1994. North-South trade and the global environment. American Economic Review 84 (4): 851-74. Copland, B. R., and M. S. Taylor. 1995. Trade and transboundary pollution. American Economic Review 85 (4): 716-37. Corden, W. M., and R. Findlay. 1975. Urban unemployment, intersectoral capital mobility and development policy. Economica 4259-78. Deacon, R., and P. Shapiro. 1975. Private preference for collective goods revealed through voting on referenda. American Economic Review 65:943-55. Deardorff, Alan. 1995. International externalities in the use of pollution policies. Discussion Paper no. 383. Ann Arbor: University of Michigan, School of Public Policy, November. Ehrenberg, R. 1994. Labour markets and integrating national economies. Washington, D.C.: Brookings Institution. Enders, A., and A. Porges. 1992. Successful conventions and conventional success: Saving the ozone layer. In The greening of world trade issues, ed. K. Anderson and R. Blackhurst. Ann Arbor: University of Michigan Press. Esty, D. C. 1994. Greening the GAIT: Trade, environment, and the future. Washington, D.C.: Institute for International Economics. Falvey, R. 1995. International trade and factor price convergence. Working Paper no. 290. Canberra: Australian National University, August. Farber, D. A., and R. E. Hudec. 1996. GATT legal restraints on domestic environmental regulations. In Fair trade and harmonization: Prerequisites for free trade? vol. 2, ed. J. N. Bhagwati and R. E. Hudec. Cambridge, Mass.: MIT Press. Finger, J. M. 1995. Legalized backsliding: Safeguard provision in the GATT. In The Uruguay Round and the developing countries, Discussion Paper no. 307, ed. W. Martin and L. A. Winters. Washington, D.C.: World Bank. Francois, J. F., B. McDonald, and H. Nordstrom. 1995. Assessing the Uruguay Round. In The Uruguay Round and the developing countries, Discussion Paper no. 307, ed. W. Martin and L. A. Winters. Washington, D.C.: World Bank.

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GATT (General Agreement on Tariffs and Trade). 1971. Industrial pollution control and international trade. GATT Studies in International Trade, no. 1. Geneva: GATT Secretariat. . 1991. Trade policy review: Indonesia. Geneva: GATT Secretariat, August. . 1992. International trade 1990-91, vol. 1. Geneva: General Agreement on Tariffs and Trade. . 1994. International trade statistics 1994. Geneva: GATT Secretariat. Grossman, G. M. 1995. Pollution and growth: What do we know? In The economics of sustainable development, ed. I. Goldin and L. A. Winters. Cambridge: Cambridge University Press. Grossman, G. M., and A. B. Krueger. 1993. Environmental impacts of a North American free trade agreement. In The Mexico-US. Free Trade Agreement, ed. P. M. Garber, 13-56. Cambridge, Mass.: MIT Press. . 1995. Economic growth and the environment. Quarterly Journal of Economics 110 (2):353-78. Hanson, G. 1983. Social clauses and international trade: An economic analysis of labour standards in trade policy. New York: St. Martin’s. Hillman, A. L., and H. N. Ursprung. 1992. The influence of environmental concerns on the political determination of trade policy. In The greening of world trade issues, ed. K. Anderson and R. Blackhurst. Ann Arbor: University of Michigan Press. Hoekman, B., and M. Leidy. 1992. Environmental policy formation in a trading economy: A public choice perspective. In The greening of world trade issues, ed. K. Anderson and R. Blackhurst. Ann Arbor: University of Michigan Press. Hudec, R. E. 1996. GATT legal restraints on the use of trade measures against foreign environmental practices. In Fair trade and harmonization: Prerequisites for free trade? vol. 2, ed. J. N. Bhagwati and R. E. Hudec. Cambridge, Mass.: MIT Press. International Labour Organisation (ILO). 1956. Social aspects of European economic cooperation. Report by a group of experts (Ohlin Report). Geneva: International Labour Organisation. Jaffe, A. B., S. R. Peterson, P. R. Portney, and R. N. Stavins. 1995. Environmental regulation and the competitiveness of U.S. manufacturing: What does the evidence tell us? Journal of Economic Literature 33 (1): 132-63. Jones, L. A., and R. E. Manuelli. 1995. A positive model of growth and pollution controls. NBER Working Paper no. 5205. Cambridge Mass.: National Bureau of Economic Research, August. Krueger, A. 1977. Growth, distortions and patterns of trade among many countries. Princeton, N.J.: Princeton University, International Finance Section. Krugman, P., and R. Z. Lawrence. 1994. Trade, jobs, and wages. ScientiJc American 270 (4): 44-49. Lawrence, R. Z. 1994. Trade, multinationals, and labour. In International integration of the Australian economy, ed. P. Lowe and J. Dwyer. Sydney: Reserve Bank of Australia. . 1995. Regionalism, multilateralism, and deeper integration. Washington, D.C.: Brookings Institution. Leamer, E. E. 1987. Paths of development in the three factor, n-good general equilibrium model. Journal of Political Economy 95 ( 5 ) : 961-99. Leonard, N. J. 1988. Pollution and the strugglefor worldproduct: Multinational colporations, environment and international comparative advantage. Cambridge: Cambridge University Press. Levinson, A. 1996. Environmental regulation and industry location: International and domestic evidence. In Fair trade and harmonization: Prerequisitesfor free trade? vol. 1, ed. J. N. Bhagwati and R. E. Hudec. Cambridge, Mass.: MIT Press. Low, P. 1992. Trade measures and environmental quality: The implications for Mexico’s

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exports. In international trade and the environment, Discussion Paper no. 159, ed. P. Low. Washington, D.C.: World Bank. Meadows, D. H., et al. 1972. The limits to growth. New York: Universe. National Research Council. 1995. Standards, conformity assessment, and trade into the 21st century. Washington, D.C.: National Academy Press. Radetzki, M. 1992. Economic growth and environment. In International trade and the environment, Discussion Paper no. 159, ed. P. Low. Washington, D.C.: World Bank. Rodrik, D. 1994. Developing countries after the Uruguay Round. Paper prepared for the Group of 24. New York: Columbia University, August. (CEPR Discussion Paper no. 1084. London: Centre for Economic Policy Research, December 1994.) Rybczynski, T. M. 1959. Factor endowment and relative commodity prices. Economica 22 (84): 336-41. Sapir, A. 1996. Trade liberalization and the harmonization of social policies: Lessons from European integration. In Fair trade and harmonization: Prerequisites for free trade? vol. 1, ed. J. N. Bhagwati and R. E. Hudec. Cambridge, Mass.: MIT Press. Seldon, T. M., and D. Song. 1994. Environmental quality and development: Is there a Kuznets curve for air pollution emissions? Journal of Environmental Economics and Management 27 (2): 147-62. Siebert, H. 1974. Environmental protection and international specialization. Welwirtschaftliches Archiv 110:494-508. Siebert, H . , J. Eichberger, R. Gronych, and R. Pethig. 1980. Trade and environment: A theoretical enquiry. Amsterdam: Elsevier. Snape, R. H. 1992. The environment, international trade and competitiveness. In The greening of world trade issues, ed. K. Anderson and R. Blackhurst. Ann Arbor: University of Michigan Press. Steenblik, R. P., and P. Coroyannakis. 1995. Reform of coal policies in Western and Central Europe: Implications for the environment. Energy Policy 23 (6): 537-54. Steil, B. 1994. “Social correctness” is the New Protectionism. Foreign Affairs 73 (1): 14-20. Tobey, J. A. 1990. The effects of domestic environmental policies on patterns of world trade: An empirical test. Kyklos 43 (2): 191-209. Tyers, R., and Y. Yang. 1995. Trade with Asia and skill upgrading: Effects on factor markets in the older industrial countries. Canberra: Australian National University, October. Mimeograph. Ulph, A. 1994. Environmental policy and international trade-A survey of recent economic analysis. Paper presented to the Workshop on Designing Economic Policy for the Management of Natural Resources and the Environment, Crete, 7-9 September. Van Grasstek, C. 1992. The political economy of trade and the environment in the United States. In international trade and the environment, Discussion Paper no. 159, ed. P. Low. Washington, D.C.: World Bank. Walter, I. 1975. The international economics of pollution. London: Macmillan. , ed. 1976. Studies in international environmental economics. New York: Wiley. Wilson, J. D. 1996. Capital mobility and environmental standards: Is there a theoretical basis for a race to the bottom? In Fair trade and harmonization: Prerequisites for free trade? vol. 1, ed. J. N. Bhagwati and R. E. Hudec. Cambridge, Mass.: MIT Press. Wood, A. 1994. North-South trade, employment and inequality: Changing fortunes in a skill-driven world. Oxford: Clarendon. World Bank. 1995. World development report 1995. New York Oxford University Press. Zarsky, L., and J. Drake-Brockman. 1994. Trade, environment, and APEC. CAPA Report no. 18. San Francisco: Asia Foundation, December.

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Comment

Menzie D. Chinn

Review of Main Conclusions In this paper, Kym Anderson asks three key questions. “Why are social policy differences becoming more important in disputes between countries? Under what circumstances (if any) is trade policy an appropriate instrument for resolving such disputes? What are the implications for the global trading system, for regional trading arrangements, and their interaction?’ Briefly put, the answers are respectively (1) because other formal trade barriers are low, (2) almost never, and ( 3 ) in general bad. In addressing these issues, the paper provides an excellent overview of the rising prominence of social issues in debates surrounding trade policy and makes a series of cogent arguments dispelling several myths about trade, the environment, and growth. Anderson has done us an important service, exactly because there is a lot of misunderstanding about such issues. Take for instance the recent NAFTA debate. Both labor standards and environmental concerns figured prominently in the negotiations and in the domestic political debate; I know that among my noneconomist, but educated friends, the issue of alleged labor repression and lax environmental regulations in Mexico was sufficient reason to oppose NAFTA. The same could also be said, with somewhat less force, about the GATTNTO. Since what people think is almost as important as what is the case, clear reasoning is at a premium. Let me first recount what I take as several key points made in the paper and then add my observations. First, Anderson points to the very success of the GATT as a partial explanation for the rising prominence of social standards-as the level of tariff protection has fallen, the presence of nontariff barriers (NTBs) has become more apparent. However, these NTBs are social standards that (perhaps) are not intended to impede trade. Moreover, environmental concerns are following a secular upward trend because the process of environmental degradation seems to be more concrete than in past decades. Hence, there are increased spillovers of both a physical and a psychological nature (although I suspect most economists would be a bit queasy with the latter concept). The second major point, and one that few of us would dispute, is that trade policy measures are usually not first-best instruments for addressing distortions. If pollution is a problem, then a tariff is an extremely blunt, and perhaps counterproductive, instrument to use in affecting behavior (see the discussion in Beghin, Roland-Holst, and Mensbrugghe 1994). Third, unilateral trade measures are a bad idea, in the sense that they can be coopted by interest groups, lead to escalation and retaliation, or erode the multilateral trade regime by giving false credibility to the trade-development versus environmental-protection dichotomy. Menzie D. Chinn is assistant professor of economics at the University of California, Santa Cruz, and a faculty research fellow of the National Bureau of Economic Research.

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Last, Anderson argues for a reasonable policy of education and of limited compromise. This first endeavor appeals to the idea that enlightened people will “do the right thing.” The latter is a pragmatic response, which seeks to defuse environmental or labor activist concerns via a “demonstration effect”-if growing less developed countries adopt minimum labor standards, developed country electorates will see that standards do rise with income. I cannot say that I disagree with any of the conclusions that are drawn in the paper, so let me make some observations regarding how Anderson’s analysis relates to the Asia Pacific region.

Social Policies and Regionalism First, it is interesting to recall that over two decades ago, Richard Cooper (1976) noted that the logic of regional economic integration had to be rooted in the presence of collective or public goods because the optimal area for the integration of trade in the private goods market was the world. (Ignore for the sake of argument recent caveats about the optimal size of free trade areas.) While regionalism in the Asia Pacific region has up until now taken the form of increasing linkages in trade and capital flows, the increase in levels of pollution potentially gives rise to another rationale for regionalism. China is a major producer of air pollutants such as sulfur dioxide, carbon monoxide, and suspended particulates, which are involved in the formation of acid rain. In 1990 China produced a staggering 20 million tons of sulfur dioxide (UN Environmental Program 1994). Japan, which in comparison produced only 1.1 million tons, was the most visible victim of the resulting acid rain. I am not as sanguine as Anderson that all the spillover from such transborder pollution can be dealt with by bilateral agreements between affected parties. This is a clear case of domestic policies having externalities for other countries. The air pollution largely is caused by inefficient energy production and consumption. China has a producer subsidy for coal of about 20 percent and a consumer subsidy for electricity of 60 percent. The argument could be extended to other types of pollution. For instance, soil degradation or erosion and consequent water pollution can be ascribed to overuse of irrigated water. China shows up here again, with an 80 percent consumer subsidy, but so too do the Philippines (80 percent) and Indonesia (90 percent; figures from World Bank 1992,69). One could easily expand this list to encompass other concerns. I mentioned that all this was a potential rationale for regionalism. Cooper argued that another impetus for regional grouping would be similarity in preferences among member states for clean air and water. This makes both the desirability and feasibility of regionalism much less definite, given the wide disparity in levels of economic development in the East Asian area (let alone the APEC region). For similar reasons, labor standards appear to be an even less plausible rationale for regionalism.

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Capital Market Integration A second interesting issue, but only alluded to, is the role of increasing capital mobility in fostering concerns about social standards. For Americans, this concern is embodied in Ross Perot’s prediction of American jobs going to Mexico in the wake of NAFTA. This view holds that hot-footed capital in the form of direct investment can easily, and will readily, relocate manufacturing facilities in search of laxer environmental and labor standards. The dire predictions of NAFTA opponents did not come to pass (although the collapse of the peso means that a controlled experiment was not performed). Moreover, the statistical evidence for a relocation effect due to environmental regulations is scant (see the recent survey by Jaffe et al. 1995).The elusiveness of the relationship could be explained by the relatively small magnitude of pollution abatement costs, less than 2 percent of value added for U.S. industry. Even with the reductions of capital controls, as long as uncertainty about the future tax liabilities of foreign investment remains-ranging from future emplacement of environmental controls to expropriation-mobility of physical capital is likely to remain substantially less than infinite.

Is the Multilateral Approach a Viable Alternative? Anderson makes an appeal for more education-essentially the idea that one can win the day by the sheer weight of studies and clear reasoning and that educated electorates will then select instruments that directly address the issues of concern. However, while economists find the concept of first-best solutions a powerful one, I am,like the author, not too sanguine about the prospects for education alone to carry the day. It seems to me that a more aggressive approach to the environmental issue could be pursued in the multilateral agencies. Not only could greater access to the Global Environmental Facility be used as a carrot. The World Bank could push even harder for removing those distortions that have environmental implications. For instance, lending for the electricity sector could be made conditional on even greater rationalization of energy prices than heretofore. In many instances, liberalizing regulations and eliminating subsidies are consonant with better environmental conditions.

References Beghin, John, David Roland-Holst, and Dominique van der Mensbrugghe. 1994.A survey of the trade and environment nexus: Global dimensions. OECD Economic Studies 23 (Winter): 167-92. Cooper, Richard N. 1976. Worldwide regional integration: Is there an optimal size of the integrated area? In Economic integration: Worldwide, regional, sectoral, ed. Fritz Machlup. London: Macmillan.

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Jaffe, Adam B., Steven R. Peterson, Paul R. Portney, and Robert N. Stavins. 1995. Environmental regulation and the competitiveness of United States manufacturing: What does the evidence tell us? Journal of Economic Literature 33:132-63. UN Environmental Program. 1994. Environmental data report 1993/94. Oxford: Blackwell. World Bank. 1992. World development report 1992. New York: Oxford University Press.

Comment

Chong-Hyun

am

Anderson’s paper is an excellent survey of the controversial and complex issue of environmental and labor standards in relation to trade policy. The paper tries to be rather unprejudiced in addressing these sensitive issues by examining all the important arguments related to the subject. I have three comments. First, it appears that the issue of environmental standards can best be addressed as an externality problem, if one wants to analyze it in terms of economics. In that case, economic theory suggests that externality problems can be cured most effectively by internalizing external costs through, for example, tax-cum-subsidy schemes aimed at the root cause of the problem. Suppose there is an environmental problem without an international spillover effect. Then an important question is whether one can measure the externality associated with that environmental problem well enough that a detailed tax-cum-subsidy program can be applied. If one can, then an essentially domestic environmental problem can largely be resolved in an optimal way. If not, however, there would be a lot of problems. In general, as Anderson suggests, the benefits from an improved environment tend to increase as people’s incomes rise. For that reason, rich countries tend to have tighter environmental standards than do poor countries. Therefore, differences in environmental standards across countries are a quite natural outcome that correctly reflect the production and consumption conditions of a particular product in a particular country. It is, therefore, very dangerous for advanced countries to attempt to apply their own environmental standards to developing countries. Developing countries would thus be justified in arguing that differentiated environmental standards are needed if one wants to be fair about the issue. Suppose now that the environment-induced externalities have international spillover effects across neighboring countries or on a global scale. A multilateral regime would certainly be required to deal with such a complicated problem. The key issue is again how to determine who is going to bear the external costs and how much. One approach would be to establish an international body Chong-Hyun Nam is professor of economics at Korea University.

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such as a World Environmental Organization, mainly to set the rules, negotiate multilateral agreements, and settle disputes over spillover effects across countries, in much the way the GATT has done for trade over the past half-century. My second comment addresses what the World Trade Organization (WTO) can do regarding environmental standards. First of all, the WTO can emphasize that trade policy cannot solve the complex issue of environmental externalities and thus cannot be used as an instrument to enforce environmental standards, except in extreme cases where no other policy measure is available and, of course, following a multilateral consensus even in those cases. The WTO can also oversee or monitor an individual country’s environmental policy so as to prevent abuses of trade policy in the name of environmental protection. In this regard, I think, it would be very useful if Anderson could document and provide some quantitative evidence of the economic costs involved in cases where trade policy was misused in the name of environmental protection. Even one such example would suffice to warn policymakers about how much such a trade policy can hurt an economy without improving environmental conditions. Finally, my comment on labor standards will be brief since this issue entails no externality argument, and hence there is no international spillover effect of externalities associated with labor standards. By that, however, I do not mean that there is no case for governmental involvement with labor standards. Governmental interest in such areas as health and safety standards, the right of workers to form unions, and the use of child or prison labor is evident, but these concerns are basically motivated by humanitarian or educational desires and would be more effectively handled by the International Labour Organisation than by the WTO. However, I think it might be desirable for the WTO to be equipped with some kind of safeguard mechanism against any possible abuse of trade policy in the name of labor standards.

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4

EU, NAFTA, and Asian Responses: A Perspective from the Calculus of Participation Junichi Goto and Koichi Hamada

4.1 Introduction It is safe to say that over the past 10 years, the Asia-West Pacific area has had the most active and fastest growing economy in the world. It is a site of great ferment. The Asia-West Pacific area encompasses a wide variety of regions, starting in the south with Oceania and extending across South Asia, the ASEAN countries, the NIEs, China and other transitional economies of Asia (TEA), and Japan. By comparison, the European Union is relatively compact, and the North American Free Trade Area (NAFTA), though it may extend farther south in the future, does not yet have the same geographic scope. According to the Nomura Research Institute (1989), in 1987 the combined GNP of all West Pacific economies (excluding South Asia) was nearly $6.34 trillion. This figure is comparable to those for the European Community (with a GNP of $6.04 trillion) and North America (with a GNP of $7.17 trillion). Further, it is expected that recent appreciation of the currencies of some West Pacific countries has increased the relative economic sizes of these countries. Thus, the regional economies of the West Pacific, Europe, and North America are similar in size. In terms of growth rate the Asian performance has been remarkable. Table 4.1 shows the growth rate of GDP for developing member countries (DMCs) of the Asian Development Bank. On average, these Asian and Pacific economies grew almost 8 percent through the 1980s. In particular, China achieved double-digit growth in the 1980s, and its growth rate for recent years has exceeded 13 percent. Growth rates for the NIEs and ASEAN countries were also Junichi Goto is professor of economics at Kobe University and a visiting fellow at Yale University. Koichi Hamada is professor of economics at the Economic Growth Center, Yale University. The authors appreciate helpful comments from Tamim Bayoumi, Wonkack Hong, Takatoshi Ito, Anne 0. Krueger, and Ippei Yamazawa. The opinions and any errors are those of the authors.

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Table 4.1

Growth Rate of GDP (percent per annum) Average 1971-80

Average 1981-90

1991

1992

I993

Newly Industrializing Economies Hong Kong Korea Singapore Taipei, China

9.0 9.3 9.0 7.9 9.3

8.3 7.2 8.8 6.3 8.5

7.4 4.1 8.5 6.7 7.2

5.5 5.3 4.8 5.8 6.6

5.7 5.5 4.7 9.9 6.2

People’s Republic of China and Mongolia China Mongolia

7.9 7.9 7.1

10.4 10.4 5.6

8.0 8.0 -9.9

13.2 13.2 -7.6

13.4 13.4 -1.3

Southeast Asia Cambodia Indonesia Laos Malaysia Philippines Thailand Vietnam

7.4

6.1

-

-

7.7

5.5

7.9 7.1

6.4 1.6 6.9 4.0 8.7 -0.5 8. I 6.0

6.1 7.0 6.4 7.0 7.8 0.1 7.6 8.3

6.4 5.7 6.5 4.0 8.0 1.7 7.8 8.0

South Asia Bangladesh Bhutan India Maldives Myanmar Nepal Pakistan S r i Lanka

4.0 5.8

5.7 4.1 7.4 5.8 12.1 -0.1 5.0 6.2 3.9

2.1 3.4 1.9 1.2 7.6 - 1.0 4.6 5.6 4.6

4.5 4.2 5.3 4.0 6.3 10.9 2.1 7.7 4.3

3.8 4.5 5.0 3.8 6.1 5.8 2.9 3.0 6.1

6.6 7.0 0.7 2.8 0.6

6.4 11.0 2.9 3.1

10.1 1.2 1.8 2.9

-

1.2 5.8 1.7 -0.6 10.1

0.1

-

-

-

-

-

-

1 .o

-

3.4

8.5 8.2 -3.7 8.9 -0.1 -4.2

14.4 6.0 0.0 8.7 2.0 4.8

7.4

7.4

Country

Pacific Islands Cook Islands Fiji Kiribati Marshall Islands Micronesia Papua New Guinea Solomon Is!znds Tonga Tuvalu Vanuatu Western Samoa Average

-

-

7.8 6.0 7.9

5.2

-

-

3.7

4.7 3.2 5.2 4.3

-

4.3

-

1 .o

-

-

-

-

13.4 1.6 1.o

9.5 3.2 5.8 11.4 3.5 - 1.6

6.8

7.8

6.3

-

Source: Asian Development Bank (1995).

-

93

EU, NAFTA, and Asian Responses

high. By contrast, in the past several years, the Philippines recorded relatively low growth rates, but it is reported to have experienced remarkable growth in 1994. Though similar in their growth experience, the Asia-West Pacific countries show great diversity in ethnicity, religion, political systems, history, and economic mechanisms. The diversity is well illustrated in the case of religion. Christianity is prevalent in Australia, New Zealand, and the Philippines and fairly influential in Korea. Islam is the main religion of Pakistan, Bangladesh, Malaysia, and Indonesia. Indeed, Indonesia has the largest Moslem population in the world. Elsewhere, Hinduism and Buddhism are influential. And across the Asian Pacific, the ethic of Confucianism lies in the background.' The association between growth and Confucian thinking was a very appealing idea in the past decade, when the NIEs and Japan were growing very fast. Now, however, given the remarkable growth records of many diverse Asian countries, one wonders whether Confucianism really is the main driving force. Political systems vary as well. Many NIEs were under dictatorships, and even now these countries have powerful central governments. In the postsocialist countries, or TEAS, the political systems are often close to dictatorial. The state of human rights in some countries is criticized by developed nations. Objectively speaking, history seems to show that dictatorship does not necessarily obstruct rapid economic growth. We are not advocating dictatorship, of course, and we cannot attribute the high growth rates of the Asia-West Pacific area to dictatorial governments. History creates important and varying preconditions in the Asian Pacific countries. The Philippines have a history of American colonial influence; the South Asian countries, Singapore, and Hong Kong were under British colonial rule; and Korea and Taiwan were under Japanese influence. It would be interesting to study how local ethnic, social, and economic systems have interacted with colonial legal and economic infrastructures in these countries. In any discussion of the formation of a free trade area in South Asia, the fact should be noted that the South Asian countries formed a single country until the colonial control of Great Britain ended (Srinivasan 1994). Finally, although most of the Asian Pacific countries now have market economies, the degrees of openness of these economies are also diverse. TEA countries are by definition in transition from socialist to market economies. The pleasant surprise in Asia is that such transitional economies have been doing well on average, and extremely well in some particular cases. In external trade, 1. Morishima (1982) maintained that the ethic of Confucianism played the same role as that of Protestantism did in the development of capitalism. However, his interpretation of Confucianism emphasized the hierarchical distinction between superior and subordinate, a view that seems to have been somewhat conditioned by his navy experience in Japan and to neglect the various facets of Confucianism. In one country the emphasis of Confucianism may be on its liturgical aspects, and in another country Confucianism may be regarded simply as a way to be successful in the bureaucracy and to justify including family and friends in the government in a manner similar to the spoils system in the United States.

94

Junichi Goto and Koichi Hamada

Indirect Tax Bangladesh

',1

\\! \

Pakistan Nepal India*

SnLanka,

.Philippines Papua New Guinea

.

',

'\

\

' ,Tax on Trade etc

Fig. 4.1 Tax revenue triangle Source: Hamada (1994).

Singapore and Hong Kong are free ports, pursuing free trade systems, and both have benefited from this orientation. Other countries have some protectionistic elements. A tax revenue triangle is presented in figure 4.1. A country's position in the triangle indicates the degrees to which the country depends on direct taxes, indirect taxes, and trade-related taxes such as tariffs and levies. Clearly, it is difficult to single out an explanation for the economic success of the Asia-West Pacific region. At least, however, one may note that all the countries of this region border on the Pacific or the Indian Ocean and thus have access to transportation by oceanic routes. For this and other reasons, the degree of intraregional trade is quite high-as measured either by the trade intensity index or by the trade dependency index, defined as the ratio of the sum of exports and imports to GNP (for details, see Goto and Hamada 1994, 370, 374). Asian countries have been watching the European Union and NAFIA carefully, and sometimes nervously. As analyzed by Jacob Viner (1950), the establishment of a free trade area or a customs union gives rise to trade creation effects within the union but to trade diversion effects outside the union. If the trade diversion effects of the European and North American coalitions are too strong, Asian countries worry, the economic vitality of Asia may be considerably impaired. There are at least two movements toward economic integration within Asia. One is the East Asian Economic Caucus (EAEC); another is the Asia Pacific Economic Cooperation (APEC). EAEC is led by Premier Mahathir of Malaysia. He proposes that the ASEAN countries and East Asian nations such as

95

EU, NAFTA, and Asian Responses

Korea, Japan, and Taiwan create an economic community of more or less strong economic ties. The United States, of course, does not like Asian integration from which it is excluded. Japan, which depends heavily on trade with the United States, has therefore shown ambivalence toward EAEC. The most recent news is that Japan will not join the caucus. APEC was created in 1989 by U.S. initiative, and perhaps at Japan’s implicit suggestion. It is a loose economic integration of the entire Pacific Economic Basin-embracing the United States, Canada, Mexico, and all the Asian and West Pacific countries including Australia and New Zealand. In 1994, APEC members agreed to realize free trade in the region by 2010 for developed countries and by 2020 for developing countries. If it proceeds, the United States will at the same time be a member of NAFIA, a formal free trade area, and a member of APEC, a presumably weaker, but nevertheless solid integrated area. The purpose of this paper is to assess the economic conditions that the Asian countries face with the formation of the European Union and NAFIA. The following questions are addressed: Is it desirable for Asia to form its own trading area? If desirable, is it better to have a closed union like EAEC or a more open union like APEC? In order to analyze these questions, we rely on public economics and strategic considerations that clarify the rational incentives nations have to participate or not participate in economic unions or other forms of economic cooperation. In sections 4.2 and 4.3 we present two related but different types of models of tariffs and trade. In section 4.2, we analyze a model of symmetric nations (or symmetric groups of nations) that produce differentiated products under increasing returns to scale and monopolistic competition. We assume that some group of nations is deciding whether to unite into a free trade area and study the incentive problem in this group. In section 4.3, we again consider a trade model with differentiated products under increasing returns to scale and monopolistic competition. We vary the sizes and the number of countries, however, and show that properties of the Nash equilibrium depend on the number of countries, the relative sizes of countries, and in particular the relative size of the leading country, namely, the hegemon. In any case, the noncooperative Nash equilibrium usually differs from the Pareto-optimal configuration. In section 4.4, we use the calculus of participation to analyze tariff policy strategy. In other words, we ask how a country may be motivated to join a regional agreement or coalition. In section 4.5, we come back to reality and in the light of these theories discuss the incentive structure concerning Asian counteractions to regionalism in Europe and North America and concerning the formation of EAEC and APEC.

4.2 Implications of a Symmetric Tariff Bloc Model We would like to summarize briefly the results of Goto and Hamada (1993, which studies the symmetric world with differentiated products with increasing returns and monopolistic competition.

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Junichi Goto and Koichi Hamada

Suppose there are four symmetric countries or four symmetric groups of countries that produce differentiated products with increasing returns, namely, with fixed cost. Accordingly, monopolistic competition prevails as the market structure. This is a variant of the new trade models that have been studied extensively by Dixit, Krugman, Lancaster, and many others. For a more detailed formal model of the analysis in this section, see appendix A of this paper. Using the model presented in appendix A, we compare the welfare level of each of the four countries in the following three stages in order to understand the incentive-theoretic political economy of regional economic integration in Asia and the Pacific: Stage 1. Before integration In this original stage, the four countries engage in trade with each other, and all imported products are subject to the same tariff rate t. Stage 2. Initial integration In this second stage, countries 1 and 2 are integrated, and there are no tariffs on trade between these two countries. Country 3 and country 4 are still separated, however. Therefore, trade of countries 3 and 4 with the free trade area, as well as trade between country 3 and country 4, is subject to the original tariff rate t. Stage 3. Counterintegration (twopolar blocs) As will become clearer in the following analysis, country 3 and country 4 are worse off after the integration of countries 1 and 2, and there is an incentive for country 3 and country 4 to form a counterbloc (e.g., the Mahathir Plan after EC92 and NAETA in the real world). In this third stage, countries 1 and 2 form one economic bloc, and countries 3 and 4 form another. Trade within each bloc is subject to no tariff, while trade between blocs is subject to the common external tariff (t). We start, after making the simplifying assumption of constant elasticity of demand, with four regions that have not formed any free trade areas and that each levy an identical tariff rate on products from outside regions (stage 1). A region is either a country or a group of countries within which trade is free. Four regions are trading with each other with levying a constant tariff rate. With the simplification used by Krugman that the elasticity of demand for each differentiated product can be regarded as a constant, production decisions are predetermined by technology regardless of the value of tariffs. Note that, as do Krugman and many others, we assume a large number of differentiated products (N) and therefore neglect the second term in the denominator of equation (5) in appendix A. Therefore, the number of types of differentiated products and the elasticity of substitution among them are the same before and after the integration. In other words, while the model captures a terms-of-trade effect, it does not capture a possible positive effect of regional integration resulting from more exploitation of increasing returns to scale technology. Trade is bene-

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EU, NAFTA, and Asian Responses

Table 4.2

Welfare Implication of Regional Integration Stage 1

Before Integration 1. Terms of trade Countries 1 and 2

Countries 3 and 4 2. Welfare Countries 1 and 2 Countries 3 and 4

Stage 2 3

Initial Integration

a

F

I

I

F

8

I F

I

Stage 3 Counterintegration

Source: See Goto and Hamada (1995) for details.

ficial because it allows the consumption of a more balanced composition of differentiated goods. In future work, we will investigate this issue more thoroughly by incorporating variable elasticities as well as changes in terms of trade. The role of tariff rates is thus to give preferential prices to domestic products and, after integration, to the products of other countries in the free trade area to which a particular country belongs. Consumers prefer consuming as evenly as possible both domestic and foreign products. However, because foreign products are subject to tariffs, consumers are compelled to consume more domestic (or within-region) goods than foreign goods. The unevenness in consumption created by tariff rates is the cost of protection. Conversely, a balanced consumption basket of differentiated products is the source of the gains from trade. In this setting, suppose two regions unite without changing tariff rates on goods from outside the bloc (stage 2). Then each region will give preferential treatment to the other region in the tariff bloc. Therefore, the regions in the integrated area will gain as a result of trade creation effects. However, those regions excluded from the integrated area will suffer as a result of trade diversion effects. More trade will take place within the integrated area, so that other countries will find it more difficult to compete with goods in the united regions. We find that with a given tariff rate, an integration of two countries will never fail to have negative effects on the rest-of-world countries left behind. The impact of regional integration on welfare levels, based on the formal model shown in appendix A, is summarized in table 4.2. While we omit the proof, due to space limitations (readers interested in the proof, see Goto and Hamada 1995), note that the unambiguous results in table 4.2 do not depend on the parameter values of the model. Article 24 of the GATT stipulates that countries that are uniting into a customs union or free trade area should not raise tariffs. Judging from the results described above, however, Article 24 is not good enough as a safeguard against the rest-of-world loss generated by a free trade area. Thus incentives emerge for the rest of the world to unite into a customs

98

Junichi Goto and Koichi Hamada

union or free trade area. After this countervailing integration, the symmetric structure is restored, with two integrated areas each of which has two regions (stage 3). The situation of the rest of the world improves, and the situation of the first free trade area deteriorates from the position its members obtained when the other countries were not integrated. This will be an incentive, and possibly a justification, for the Asian countries to integrate to form their own free trade area. Needless to say, when the four countries form a single union (i.e., when totally free trade prevails in the world), the welfare level of each country is higher than under stage 3. For this reason, we cannot conclude from the above analysis that it is optimal for the Asian countries to form their own countervailing trading bloc. Instead, the above analysis merely suggests that the welfare of the Asian countries is higher when they form a countervailing free trade area than when they are left out of existing trading blocs. Since the analysis based on the model predicts that the welfare of the Asian countries will increase even more if they are united with the Western Hemisphere, as well as with each other, APEC, which includes countries on both sides of the Pacific as its members, seems to be a promising option.

4.3 Optimal Tariffs and the Relative Size of Regions In the above model, the regions are identical in size, and tariff rates are constant. Of course, the relative size of the free trade area will affect the motivations of regions to join an integration. Also, regions normally choose the most desirable tariff rates, which also depend on the relative size of a tariffimposing region. This is not the place to develop all the mathematics of optimal tariffs and retaliation processes, but in order to give the reader an idea of what is involved we sketch the results obtained by Gros (1987) and interpreted by Krugman (1991). The question is, what is the optimal tariff structure in the world where differentiated goods are produced under increasing returns and monopolistic competition? In other words, what is the reaction curve of a region given other regions’ tariff rates? This question was solved by Gros, and then a simplified derivation was developed by Krugman in such a way as to be applied to economic integration. Krugman (1991) and Stein (1994) considered the effect of dividing the whole world into various blocs of equal sizes and asked what the optimal number of symmetric blocs was. In this section, we instead consider the world where the relative sizes of bloc are variable and ask what the incentives are for each country or region to create or join a bloc. We believe that this approach is at least complementary to and more realistic than h g m a n and Stein’s. Consider the case in which the world is divided into two blocs of different sizes. We can derive a formula for the optimal tariff rate of bloc I with respect to a given tariff rate of bloc I1 (Gros 1987). The tariff rate of the home country

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EU, NAFTA, and Asian Responses

is nonzero even if the country is infinitesimally small. This reflects the product differentiation and monopolistic competition assumed in the new trade model. On the other hand, the optimal tariff is a decreasing function of the tariff rate of the trading partner and an increasing function of the relative size of the home country. In order to understand the effect of monopolistic or monopsonistic power on tariff-setting behaviors of countries that differ in size, a formal model is presented in appendix B. To make the point as clear as possible, appendix B presents a Ricardian model of trade; however, readers familiar with trade theory will easily understand that properties similar to those obtained in the appendix will hold for the Heckscher-Ohlin model with variable factor proportions. It can be shown that similar conclusions can be extended to a model with increasing returns to scale and monopolistic competition. In our model with a large country (a hegemon) and a small country (or countries) summarized in appendix B, the implication of the sizes of countries is obvious. In short, in international trade with tariffs as policy instruments, the hegemon has the capability to manipulate the terms of trade to its advantage. Therefore, it is optimal for a larger bloc to impose a higher tariff rate. Thus, if two blocs engage in a tariff war, the larger bloc gains more by imposing a high tariff. The great exploits the small! One can extend this analysis to the case of a many-country world where a large group of countries will find it more profitable to impose a higher tariff rate. If economic integration proceeds, there is an incentive for a group of nations like the European Union or NAFTA to impose a higher rate of tariff. Article 24 of the GATT would work against this. The article is a safeguard agreement to prevent such monopolistic behavior. Our results in section 4.2 indicate, however, that simply keeping the original tariff rate could still be harmful for the rest of the world. Consider a situation in which a large country and many small countries impose a minimum level of tariff, but the large country can choose to react in such a way that it becomes the Stackelberg leader. This country would create a larger and larger free trade area. The larger group will find it more profitable to impose an optimal tariff. Article 24 of the GATT prohibits this, but the analysis of the last section shows that in spite of this GATT provision it would be profitable for countries to unite. Of course, this process cannot go all the way. If there are hardly any other countries remaining in the rest of the world, the optimal tariff may not yield any gain because there is hardly anyone left to exploit. So, at some point, the process should stop. In such a world, where all nations are united except, say, Monaco, there is nothing to exploit from Monaco, whatever optimal tariff the bloc members charge.

4.4 The Calculus of Participation We would like to apply the calculus of participation to the formation of free trade areas. The calculus of participation, sometimes called the theory of clubs,

100

Junichi Goto and Koichi Hamada

regards the decision of a nation as a rational decision among various alternatives and subject to various constraints. Nations are supposed to decide whether to join a coalition or group by calculating the national costs and benefits of joining the coalition or group. The incentive problem of forming or joining an economic union can be analyzed from the standpoint of the calculus of participation. Olson (1965) developed an analysis of collective action, but the analysis is of limited significance in the study of economic integration because it assumes a predetermined membership. Buchanan (1964) developed an economic theory of clubs that allows for variable size of membership. Although his analysis was directed mainly at the problem of efficiency rather than the political structure of conflict, it provides a useful tool for analyzing collective action with variable members. As indicated in Hamada (1985), international economic relations can be characterized as a two-stage game. The first stage requires players to agree on a system or rule, and the second involves the interplay of economic policies under a given rule. The second stage is analogous to the prisoner’s dilemma; the first to the battle of the sexes. Recently, in the theory of participation, the tools of public economics have been applied to political science, providing the theoretical basis for associating group behavior with individual rationality.2 The rational theory of participation (see, e.g., Riker and Ordeshook 1973, chap. 3) indicates that an individual decision unit decides to participate in a collective action if the anticipated benefit is larger than the cost. The rational decision for a country contemplating membership in an economic union is to join if the benefits from participation are larger than the costs. When the benefits of collective action exhibit a public-good character, however, the amount of collective action may be less than optimal, where optimality is judged by the Paretian standard. Olson showed this by applying the theory of public goods to collective action (Olson 1965). Suppose there is a single public good whose benefits are commonly shared by participating agents. The rational decision by an individual agent is to equate the marginal private benefit from the public good to the marginal cost of supplying a unit of the public good. However, the optimal outcome from the point of view of society as a whole is to equate the marginal cost to the social benefit, which is the sum of the individual benefits. Thus, the supply of the public good may be less than optimal because the individual decision unit does not take account of the external effect on other decision units. Therefore, even when a consensus exists concerning the objective of a collective action, the amount produced may be too small. The interesting testable hypothesis about group behavior is that the behavior of a large group will be different from that of a small group; a 2. The application of tools developed in economics to politics requires caution, but recent developments in political science have shown that the application of economic analysis can clarify the political analysis of economic conflicts.

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shortfall in supply is more likely the larger the group because the free-rider problem intrinsic in the supply of public goods without the possibility of exclusion will be more acute if each member shares in the common benefit to only a small degree. A second hypothesis is that the decision unit that receives a relatively large proportion of the benefit of public goods will be likely to bear more than a proportional share of the cost. In other words, if each participant behaves rationally according to the private benefit-cost calculation, a small decision unit can exploit a large one. The same argument can be applied to the analysis of public “bads” as well. If costs are incurred in preventing the generation of public bads, then there is a tendency to overproduce public bads, inasmuch as the marginal social harm of public bads is larger than their marginal private harm. Olson’s theory of collective action, interesting as it is, is subject to several criticisms. First, as pointed out by Wagner (1966) and developed in more detail by Frohlich, Oppenheimer, and Young (1971), the theory of collective action neglects the role of political entrepreneurship or leadership in integrating the individual benefits from a collective action. If an agent with political entrepreneurship can persuade the group of the effectiveness of collective action in spite of the apparent excess of individual cost over individual benefit, then the proper amount of collective goods may be supplied, with some leadership surplus being left over for that agent. Second, the analysis assumes passive behavior on the part of each participant and accordingly neglects the leader-follower relationship analyzed in von Stackelberg (1934). If a participant picks the most profitable point on the opponent’s reaction curve, then he behaves as a leader and can enjoy the leadership or exploitation solution. (To avoid complication arising from the two uses of the word leadership, this case will be called exploitation, while leadership in the sense of political entrepreneurship will be called political entrepreneurship.) An economic theory of clubs with variable group size and with possible exclusion of nonmembers from enjoyment of collective goods was developed by Buchanan (1964). According to his analysis, collective goods are supplied optimally provided appropriate charges are imposed on the use of the service and provided the services of the collective goods can be exclusively supplied to members of the group. This approach has more relevance to monetary integration since the benefits of integration are public in that their enjoyment by a particular member does not diminish the enjoyment of others but at the same time most of the benefits are enjoyed almost exclusively by the countries participating in the monetary union. In short, there exists nonrivalry in the consumption of the services of a monetary union but not nonexclusiveness. The decision of countries considering whether to participate in an economic union is based on a comparison of the gains from joining the union with the costs. The resulting implication is straightforward: if there are externalities in increasing the size of membership, an individual nation’s participation decision

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Junichi Goto and Koichi Hamada

based on a rational calculation may lead to a smaller than optimal economic union even if the country is fully aware of the costs and benefits. The problem is that an individual nation’s decision is based on a private benefit-cost calculation, while the public benefit to the group as a whole includes the gains to the countries that are already in the union. In the case of a free trade area, a nation decides whether to form a free trade area (or to join an existing one) by comparing the benefits with the costs. In the tariff case, however, the common tariff is the public good. In other words, the joint consumption good is the optimal tariff for the coalition to impose on the rest of the world. What are the costs to coalition members? There can be costs on the political dimension, which we will go into later, but aside from these, the sacrifice is not so great because small countries cannot effectively retaliate. Therefore, the common tariff will be the optimal tariff from the point of view of the union. The result would be that each country in the union would like to extend the free trade area up to the point at which the rest of the world cannot be exploited further. On the other hand, if the tariff is restricted by Article 24 of the GATT, the dominating union cannot reach its optimal size but must stop somewhere before that point. Thus, by limiting tariff strategy, GATT Article 24 keeps countries from creating extraordinarily large free trade areas. So far, we have been concerned with the situation in which the national interest is united. But it is sometimes difficult to agree on “the national interest.” And there is a need to consider the effect of domestic conflicts and sectoral opposition to the formation of a free trade area. During the NAFTA negotiations, for example, labor unions in the United States opposed the creation of a free trade area. In developing countries, many sectors oppose joining a free trade area because import-competing industries fear loss of profit due to foreign competition without tariff protection. Therefore, even in a world in which a country can impose the optimal tariff for national advantage, there will still be opposition to a free trade area from labor unions and various sectors. When a nation cannot choose the optimal tariff, there will be more problems for any movement against the formation of a free trade area. Such an area may obstruct international trade, but at the same time it will block the formation of a large free trade area that will exploit the rest of the world by its monopolistic power. These discussions are related to the hegemonic stability theory, a favorite topic of political scientists. The incentives of small countries and the incentives of a hegemon can be analyzed from this point of view. The solution differs greatly between the case in which monopolistic power of trade is concerned and the case in which the creation of common public goods is involved. In the former case of private goods, the large exploits the small; in the case of public goods, the small exploits the large. Ideally, the calculus of participation would be able to predict the dynamic

103

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process of coalition formation among countries. We understand the effect on a particular country of integrating several countries (or regions). We do not fully understand why a group of nations emerges as an economic union and how the process of integration evolves. N-person game theory gives only a partial explanation. In order to answer these questions, we probably need a multidimensional approach incorporating geography and military relations, in addition to economic factors.

4.5 The Future of the Asian Community From these discussions the following observations about the Asian situation emerge. First, EAEC, under the leadership of Malaysia, can be considered a natural response by the Asian countries to the two big blocs in the world, the European Union and NAFTA. It is also natural that Americans would not like this move because the formation of an exclusive economic bloc in Asia would have a negative economic impact on non-Asian countries. But we do not exactly understand why many Americans show such an emotional attitude toward the EAEC proposal, claiming that it is racist, anti-Caucasian, and economically vague. Premier Mahathir addressed a letter to the readers of the Yomiuri, the largest newspaper in Japan, asking why Americans have allowed Europeans to create a common market but have opposed such a measure in Asia. The authors found this argument quite persuasive. Second, it is natural for the United States to promote opposing coalitions like APEC to nullify the possible economic impact of EAEC. APEC is supported by Japan as well. At the moment Japan is leaning away from joining EAEC. The Japanese economy is interwoven very closely by way of trade and foreign investment with the U.S. economy. Thus, even though in recent years Japan’s trade with Asia has surpassed its trade with the United States, the trade tie between Japan and the United States is strong. Therefore, although some Japanese wish to go “out of the West to Asia”-in contrast to the motto of the Meiji Restoration period, “out of Asia to the West”-Japan is obliged to remain neutral. Because of this Japanese ambivalence and persistent American meddlesomeness the world over, APEC is expected to turn the vast Asian Pacific region into an enormous economic community with yet to be specified (probably loose) economic integration. This attitude (opposition to EAEC) of the United States gives us an impression of a declining hegemon. In more objective terms, however, we should also note that APEC has a different structure than NAFTA or the European Union. The United States belongs to NAFTA and at the same time intends to place itself under the same umbrella as all the Asian Pacific countries. It gives the set of integrations throughout the world a rhizome rather than a tree structure, so to speak. Therefore, if we may take an optimistic view, through the United

104

Junichi Goto and Koichi Hamada

States the tightness of the NAFTA trade bloc may be broken as by a wind vent, and there may be some possibility of creating a superimposed regional integration of North America and the Pacific. Thus, compared with the situation in which Asia creates an independent trading bloc and counteracts the European Union and NAFTA, American acquisitiveness and the loose structure of APEC may yield a result that is beneficial to both the American and the Pacific region^.^ Perhaps APEC is a way toward international free trade.

Appendix A A Symmetric TarifS Bloc Model This appendix briefly summarizes the symmetric tariff bloc model of Goto and Hamada ( 1995).4 In the model, consumers of a representative country k ( k = 1,2,3,4) possess the following individualistic social utility function (U,):

where C,, is the amount of consumption of the ith differentiated product in country k and N is the number of types of differentiated products available to consumers. Consumers maximize their utility subject to the budget constraint

where 4 is the domestic price (i.e., tariff-inclusive price) of the ith differentiated product in country k and Ykis the national income of country k. From the above utility maximization problem, we obtain the following inverse demand functions:

where N

(4)

Zk =

I:cg,. I=

I

3. This is a natural conclusion of our analysis in section 4.2. Namely, in a world of four countries (or regions), the welfare level of each country is higher when all four countries unite into a single union than when there are two polar blocs. 4. While the basic model developed in Goto and Hamada (1995) can incorporate any number of countries, differences in country size, and, to some extent, asymmetric tariffs, the model in this appendix is a simplified version that assumes four identical countries and symmetric tariffs.

105

EU, NAFTA, and Asian Responses

From equation (3) the elasticity of demand for the ith differentiated product ( E l , ) is & I.k

=

1

~-

_____

(1

-

p> + pcP,/z,'

If we assume large N and the symmetry of each differentiated product, as Krugman (1979) and Dixit and Norman (1980) did, we can simplify the problem; for example, equation ( 5 ) reduces to the following:

(5')

&

=

p).

1 /(1 -

Note that we now omit the subscripts i and k for E because the demand elasticity of the products turns out to be the same for all products due to the symmetry assumption. The producer of the ith differentiated product in country k is characterized by the following cost function:

(6)

TC,, = W,F

+ W,m

c, 1

cC,J ,

where TC,, and are the total cost of the ith producer and the wage rate in country k, respectively; m is the labor input requirement per unit of output, while F is a fixed amount of factor input necessary for any positive amount of production. The producer maximizes the following profit function:

(7) where nr is the profit of the ith producer and t] is the tariff rate imposed by country j on the imported differentiated product. Note that due to the assumption of a symmetric tariff, tJ is the same for all j , except for the case o f j = k. Needless to say, there are no tariffs imposed on domestic goods. From the profit maximization problem, we obtain the following profit maximizing price for the ith producer in country k, as shown in equation (8). Note that without loss of generality, country k is assumed to produce the first nktypes of differentiated products. (8)

(/

=

Ym(1

+ tJp.

Further, we assume free entry and free exit. Therefore, the profit of each existing firm is forced to zero. Hence, equation (9) holds in equilibrium:

The demand for labor by the ith producer (1J is obtained: (10)

I! = F

-+ m

4

J=

I

CU.

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Junichi Goto and Koichi Hamada

The domestic labor supply is assumed to be constant; that is, there is no wage-leisure trade-off. Therefore, the sum of labor input in all firms in country k is equal to the amount of the domestic labor supply in that country (L): “k

(11)

D, = L,

i=l

where n, is the number of firms in country k. The tariff revenue accrued to the government is assumed to be distributed to domestic consumers in a lump-sum fashion. Since there is no profit in equilibrium, national income consists of factor payment and tariff revenue.

where tk is the tariff rate imposed by country k on its imports. The above model is complete, and the above specification gives equilibrium conditions for a representative country k. We can solve the model, once the values of the parameters (m, F, f3, tk,L ) are identified. Using the above model, we compared the welfare level of the three stages discussed in the main text, (1) before integration, (2) initial integration, and (3) counterintegration. While we omit the proof, due to space limitations (readers who are interested in the proof, see Goto and Hamada 1993, using the above model, we can rigorously demonstrate the pattern of welfare change shown in table 4.2.

Appendix B The Size of Countries in a Model of Tanfs Let us start from a two-country situation of the Ricardian model where labor is the only factor of production. To produce two goods 1 and 2, the larger country (hegemon) has input coefficients a,, a*, and the smaller country has input coefficients a:, a;. The larger country has a comparative advantage in producing good 1 so that a,/a, < a:/a;. The two countries have labor endowment L and L*, and the larger country is large enough to warrant max(L/a,, L/ a,) > max(L*/a:, L*/a;). The utility function of a representative consumer is expressed as a function of per capita consumption c,, c2, and c f , c; as U(c,, c2)and Cr(cT, c;). Both governments are assumed to conduct their tariff policies in such a way as to maximize the utility of the representative consumer. Then the offer curves are drawn as in the figures. Figure 4B. 1 indicates the case where the hegemon is so large that the smaller country’s offer curve intersects with that of the hegemon on the straight line (with slope a,/a,) through the origin. Then the smaller country satisfies the definition of a “small country”

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Offercurve I of HegemonI

Good2 i

I

I

Trade Indifference Curve of Hegemon

a,/a2

/

Offer Curve of the Smaller Country

ip__

7

ay/a

~

Good 1

Fig. 4B.1 Offer curves of hegemon and small country Good2

Offer Curve

I

~

I

Good 1

Fig. 4B.2 Size of small country and gains to hegemon

and thus cannot take advantage of the elasticity of the hegemon. The hegemon can impose an optimal tariff to exploit its monopolistic power in exports, or monopsonistic power in imports, in such a way to make its trade indifference curve tangent to the offer curve of the smaller country, that is, at T. If the size of the smaller country is very small, the gain in terms of trade does not bring substantial welfare gain because the amount of trade is limited (see point S in fig. 4B.2). Unless the smaller country is capable of exercising its monopolistic (monopsonistic) power, the gain from the tariff is larger if the smaller country occupies some space in the world economy (see point M). Now we can relax our two-country assumption. Suppose there are one hegemon and n smaller countries. Figure 4B.3 illustrates the case with n = 2. Since

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Junichi Goto and Koichi Hamada

Offer Curve

Good 2

1

of Hegemon I

/

M , --h_ \

Combined Offer Curve

"\ of Two Small Countnes _

0

_

_

_

_

~ ~

Gmd 1

Fig. 4B.3 Offer curves of hegemon and many small countries

Tariff of Smaller Country t* Reacbon Curve of Hegemon

'F ~

I

Reaction Curve of Smaller Country

I

I ~

0

N/i t

Tariff of Hegemon

t

Fig. 4B.4 Reaction curves of hegemon and small country

there is no incentive for smaller countries to become Stackelberg leaders as long as they cannot change the terms of trade offered by the hegemon, the same point M will be enjoyed by the hegemon, and the smaller countries are both left at point S. We can depict the strategic situation by reaction curves in the space of the tariff rate of the hegemon t and that of the smaller country (or countries) t* (fig.4B.4). In this Ricardian situation the reaction curve of the smaller country (or countries) coincides with the horizontal axis. The reaction curve of the hegemon starts with the optimal tariff f in the absence of retaliation upward. Therefore the Nash solution N is the combination (f, 0), which coincides with

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the Stackelberg solution with the hegemon as the leader. The smaller country (or countries) does not have any incentive to be a leader. We all know that when the two (or more than two) countries are of similar size, then more complex situations emerge in which a tariff imposed by one country triggers retaliation by the other, and in which each country strives to be a Stackelberg leader. In our model with a hegemon and a small country (or small countries), the implication of the sizes of countries is obvious. In short, in trade of goods situation with tariffs as instruments, the hegemon has the capability to manipulate the terms of trade to its advantage. In the Heckscher-Ohlin model with variable factor proportion, there is no longer a linear segment in the offer curve. However, since the large country has an almost linear segment, our results will apply without significant modification.

References Asian Development Bank. 1995. Asian development outlook. Manila: Asian Development Bank. Buchanan, J. M. 1964. An economic theory of clubs. Economica 32:l-14. Dixit, A., and V. Norman. 1980. Theory of international trade. Cambridge: Cambridge University Press. Frohlich, N., J. A. Oppenheimer, and 0. R. Young. 1971. Political leadership and collective goods. Princeton, N.J.: Princeton University Press. Goto, Junichi, and Koichi Hamada. 1994. Economic preconditions for Asian regional integration. In Macroeconomic linkage, ed. T. It0 and A. Krueger. Chicago: University of Chicago Press. . 1995. Economic integration and the welfare of those who are left behind: An Asian perspective. Paper presented at the annual meeting of the American Economic Association, Washington, D.C. Gros, Daniel. 1987. A note on the optimal tariff, retaliation and the welfare loss from tariff wars in a framework with intra-industry trade. Journal of International Economics 23:351-61. Hamada, Koichi. 1985. The political economy of international monetary interdependence. Cambridge, Mass.: MIT Press. . 1994. Broadening the tax base: The economics behind it. Asian Development Review 12: 59-84. Krugman, Paul. 1979. Increasing returns, monopolistic competition, and international trade. Journal of International Economics 9:469-79. . 1991. Is bilateralism bad? In International trade policy, ed. E. Helpman and A. Razin. Cambridge, Mass.: MIT Press. Morishima, Michio. 1982. Why has Japan “succeeded”? Western technology and the Japanese ethos. London: Cambridge University Press. Nomura Research Institute. 1989. Nomura medium-term economic outlook for Japan and the world. Tokyo: Nomura Research Institute. Olson, M., Jr. 1965. The logic of collective action: Public goods and theory of groups. Cambridge, Mass.: Harvard University Press.

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Riker, W. H., and P. C. Ordeshook. 1973. An introduction to positive political theory. Englewood Cliffs, N.J.: Prentice-Hall. Srinivasan, T. N. 1994. Regional trading arrangements and beyond: Exploring some options for South Asia. South Asia Region Report no. IDP-142. Washington, D.C.: World Bank. Stein, Ernesto. 1994. Essays on the welfare implications of trading blocs with transport costs and on political cycles of inflation. Unpublished Ph.D. dissertation, University of California, Berkeley. von Stackelberg, H. 1934. Marktform und Gleichgewicht. Vienna: Julius Springer. Wagner, R. E. 1966. Pressure groups and political entrepreneurs: A review article. In Papers on non-market decision making, ed. G . Tullock. Charlottesville: University of Virginia, Thomas Jefferson Center for Political Economy.

Comment

Tamim Bayoumi

This paper deals with the important issue of how Asian countries should respond to the formation of large free trade zones in Europe (the European Union) and North America (NAFTA). As the title suggests, the approach taken is to look at the incentives of the various participants, and to use this to analyze the optimal Asian response to these initiatives. The workhorse of the paper is the model of trade with increasing returns to scale. Some intellectual history may be useful. In an extremely elegant paper, Krugman (1991a) analyzed the implications of free trade areas by loolung at how welfare changed as the world was divided into symmetric free trade zones. He found that the lowest level of welfare occurred when there were three zones, essentially because as the free trade zones became larger they gained more market power, and hence the optimal tariff that they were assumed to charge rose. The trade-diverting impact of these higher tariffs with the rest of the world generally dominated the trade-creating impact of lower tariffs within the free trade zones themselves, leading to lower welfare. Goto and Hamada use the same basic model, but rather than looking at the impact of symmetric trade zones, they look at the implications of asymmetric behavior. In particular, they consider the impact on the rest of the world if a specific group of countries forms a free trade area. They find that the formation of the free trade area lowers welfare for the rest of the world even if the countries within the free trade area maintain their current level of tariffs, rather than exploiting their increased market power to raise external tariffs. In short, the very existence of the free trade area causes trade diversion, even if external tariffs remain unchanged. If they do raise tariffs, as the optimum tariff argument would imply, then the costs would certainly be higher, as is discussed in a following section of the paper. I will limit my comments to two issues. The first has to do with a subsidiary Tamim Bayoumi is senior economist in the Central Asia Department of the International Monetary Fund and a research associate of the Centre for Economic Policy Research, London.

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Table 4C.1

lkade Patterns in 1992

Korea Exports GDP Export ratio Percentage of exports going to U.S./Canada Percentage of exports going to EU Percentage of GDP going to U.S./Canada Percentage of GDP going to EU France Export ratio Percentage of GDP going to U.S./Canada Percentage of GDP going to Asia Canada Export ratio Percentage of GDP going to EU Percentage of GDP going to Asia

59,823 billion won 240,392 billion won 24.9% 26.4% 13.0% 6.6% 3.2% 17.8% 1.3% 1.3% 23.6% 1.7% 2.3%

result that Krugman also derived. Having shown in the first paper that three free trade blocs was the worst possible solution, he wrote another paper in which it was the best solution (Krugman 199lb)-thereby setting up what Frankel, Stein, and Wei (1993) characterized as the Krugman versus Krugman debate. The crucial difference is that in the second paper there were assumed to be three continents, and while the costs of transportation are low within these continents they are high between them. As a result, there is relatively little trade between continents, and hence forming free trade areas within the continents generates relatively little trade diversion. In this case, the benefits from the trade creation within a continent outweigh the losses from trade diversion with the rest of the world. Even in this world, the experiment of Goto and Hamada in which one continent forms a free trade area and the other one does not would still generate a fall in welfare. However, the fall in welfare would be relatively small as there is not much trade to be diverted. A crucial factor in discussing the marginal impact of forming a free trade bloc on existing welfare is therefore intrabloc trade. Table 4C. 1 shows some data on this. It measures the percentage of output in 1992 exported to other potential trade blocs for three broadly comparable countries, Korea, Canada, and France. Korea exports 6.6 percent of its output to North America (defined as the United States and Canada) and 3.2 percent to the European Union. By contrast, France sends 1.5 percent of its output to Asia (broadly defined to include Australia, New Zealand, and the Indian subcontinent) or to North America. Finally, Canada sends around 2 percent of its output to both Asia and the European Union.' 1. While these are three specific economies, I am reasonably sure that the results are relatively general. See Sterne and Bayoumi (1993) for a more general analysis of intra- and interbloc trade in Europe, North America, and East Asia.

Correlations of Supply Disturbances across Different Geographic Regions

Table 4C.2

A. Western Europe Ger

Fra

Net

Be1

Den

Aus

Swi

Ita

UK

Spa

Por

Ire

Swe

Nor

Fin

Germany 1 .OO France 0.52 1.00 Netherlands 0.54 0.36 1.00 0.62 0.56 1.00 Belgium Denmark 0.68 0.54 0.56 0.37 1.00 Austria 0.41 0.28 0.38 0.47 0.49 1.00 Switzerland 0.38 0.25 0.58 0.47 0.36 0.39 1.00 Italy 0.21 0.28 0.39 0.15 0.06 -0.04 1.00 United Kingdom 0.12 0.12 0.13 0.12 -0.05 -0.25 0.16 0.28 1.00 0.07 0.20 0.01 1.00 Spain 0.33 0.21 0.17 0.23 0.22 0.25 0.13 0.22 0.27 0.51 1.00 Portugal ! l & -0.04 J -0.03 0.21 0.33 0.11 Ireland 0.05 -0.15 0.01 1.00 0.11 -0.02 -0.32 -0.00 -0.21 0.08 0.08 0.14 Sweden 0.44 0.46 0.41 0.20 0.39 0.10 1.00 0.31 0.30 0.43 0.06 0.35 0.01 Norway -0.27 -0.11 -0.39 -0.26 -0.37 -0.21 -0.18 0.01 0.27 -0.09 0.26 0.08 0.10 1.00 0.07 -0.13 -0.23 -0.10 -0.08 1.00 Finland 0.06 -0.32 -0.04 0.11 0.22 0.12 -0.25 0.06 0.30 ~

~

~~~

~

~

-=

~~

B. East Asia Jap Japan Taiwan Korea Thailand

I .00 0.61

Tai

Tha

1.00

0.46

0.54

0.32

0.59

~

Kor

1.00 0.36

1.00

HK

Sin

Ma1

Ind

Phi

Aul

NZ

Hong Kong Singapore Malaysia Indonesia Philippines Australia New Zealand

0.29 0.28 -0.10 0.25 -0.02 0.06 0.14 -0.03 0.10 0.37 0.12 0.21 0.01 0.19

0.05 0.31 1.00 0.02 0.29 0.63 1.00 -0.03 0.35 0.47 1.00 _ _ -0.71 -0.10 0.13 0.53 0.55 0.52 1.00 -0.11 -0.06 0.05 0.05 -0.03 0.03 1.00 0.19 0.14-0.16-0.22 0.030.09 0.23 1.00 -0.25 0.15 -0.12 0.13 -0.11 0.01 -0.06 -0.41 1.00 C. The Americas

US United States Canada Mexico Colombia Venezuela Ecuador Peru Brazil Bolivia Paraguay Uruguay Argentina Chile

Can

1.00 -0.47 1.00 -0.59 0.35 -0.02 0.05 0.09 0.34 -0.02 0.37 -0.40 0.05 0.24 0.13 -0.65 0.72 -0.34 0.45 0.27 -0.31 -0.30 0.08 -0.18 0.03

Mex

Col

Ven

1.00 0.25 -0.42 0.27 0.37 -0.08

1.00 0.15 1.00 0.20 0.36 0.07 0.10 0.07 0.13 0.65 0.18 0.00 0.37 0.06 0.12 -0.26 -0.35 0.05 -0.18 0.10 0.27 0.23 0.09 -0.33

Source: Bayoumi and Eichengreen (1994). Nore: Significant positive correlations are underlined.

Ecu

Per

Bra

Bol

Par

UN

Arg Chi

1.00 0.28 1.00 0.40 0.38 1.00 0.29 0.54 0.17 1.00 -0.07 0.16 0.22 0.39 1.00 -0.21 0.01 -0.06 -0.20 -0.08 1.00 -0.01 0.36 0.34 0.06 0.06 -0.48 1.00 -0.41 0.19 -0.23 0.17 0.21 -0.33 0.21 1.00

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An important asymmetry between the three regions of the world, therefore, appears to be in their patterns of trade. Asia is heavily dependent on trade with North America (and, to a lesser extent, with Europe) in a way that none of the other blocs are with each other. Clearly, Asia has considerably more to lose from trade diversion than the other two blocs, but the opposite is much less true. This explains the relative indifference in Europe and North America about moves to greater regional integration in Asia, compared with the concern within Asia about the European Union and NAFTA. Because North Americans and Europeans do not trade much outside of their own blocs, trade diversion is simply not a big issue. Given this fact, I would be wary about the conclusions reached in the paper that it would benefit Asia to form its own free trade bloc in opposition to NAFTA and the European Union. Asia clearly has most to lose from the potential regionalization of trade, and resulting trade diversion, that such a strategy might generate. As it is best to include all of one’s major trading partners within one free trade area in order to minimize the potential for welfare losses from trade diversion, I would have thought that APEC is currently a more logical regional choice for Asian nations. Of course, if Asia carries on growing at the very fast pace we have seen recently, intraregional trade is likely to continue to grow faster than trade with the rest of the world. However, given the very heavy dependence of many Asian nations on the North American market currently, I would be surprised if intra-Asian trade became sufficiently regional over the next few years to change the analysis significantly. My second point has to do with one of the building blocks of the analysis, namely, the optimal tariff argument. Optimal tariffs have excellent theoretical credentials, but I find it very difficult to relate them to the world around me. They imply that large and important countries should have higher tariffs than small ones. Yet both Britain before 1914 and the United States since 1945 have been champions of free trade. Indeed, the very existence of a relatively free trading system seems to me to be a refutation of the importance of the optimal tariff argument. If large countries really were thirsting to raise tariffs against the rest of the world, then I very much doubt that Article 24 of the GATT would have stopped them. Rather, it appears generally to be smaller and less developed countries that have traditionally had high tariffs and many import restrictions, and the rich and large countries that have tried to prize markets open-sometimes irresponsibly, as the opium wars of the nineteenth century between Britain and China amply illustrate. Why is there such a difference between theory and observation? The optimal tariff argument deals largely with the gains to consumption from trade. As the tariff rises, the terms of trade of the country improve, and consumers benefit. But another element in trade is that it opens producers to international competition. Successful countries are generally happy to face such competition as they believe that their products will be preferred. By contrast, many small countries believe that they have to protect their industries from foreign competitors in

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order to stimulate domestic development. This, I believe, is the reason that the optimal tariff argument appears to fail in practice. Finally, a word about long-term prospects for regional cooperation in Asia when its trade dependence on North America has diminished. The theory of optimum currency areas tells us that countries are most likely to form a currency union if their underlying disturbances are relatively similar, as in these circumstances the cost of losing the ability to run an independent monetary policy is smaller. A similar argument could be made that a free trade zone is easier to maintain if underlying disturbances are similar, as the likely cost of not being able to use tariff policy is lower. Such an argument would certainly fit the European Union. Bayoumi and Eichengreen (1994) analyzed the correlations of underlying disturbances across Europe, the Americas, and East Asia, reproduced as table 4C.2. Significant positive correlations are underlined. As one can see, there are few significant correlations in the Americas, but at least two groups of countries with highly correlated disturbances in East Asia. This suggests that in the long run, regional cooperation in Asia may prove to be more successful than such moves in the Americas.

References Bayoumi, Tamim, and Barry Eichengreen. 1994. One money or many? On analyzing the prospects for monetary un$cation in various parts of the world. Princeton Studies in International Finance, no. 76. Princeton, N.J.: Princeton University, International Finance Section. Frankel, Jeffrey, Ernest0 Stein, and Shang-JinWei. 1993. Continental trading blocs: Are they natural, or super-natural? NBER Working Paper no. 4588. Cambridge, Mass.: National Bureau of Economic Research, December. Krugman, Paul. 1991a. Is bilateralism bad? In International trade and trade policy, ed. E. Helpman and A. Razin. Cambridge, Mass.: MIT Press. . 1991b. The move toward free trade zones. In Policy implications of trade and currency zones, a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, August. Sterne, Gabriel, and Tamim Bayoumi. 1993.Regional trading blocs, mobile capital, and exchange rate coordination. Bank of England Working Paper no. 12. London: Bank of England, April.

Comment

Wontack Hong

It is difficult to agree on “the national interest.” It is, however, more difficult to agree on the precise definition of “free trade (area).” Nonhegemonic small countries may be more concerned about the content of free trade than establishing a free trade area itself. Wontack Hong is professor of economics at Seoul University.

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It is argued that since tariff strategy is restricted by GATT Article 24, countries may not be able to reach the optimal “size” of dominating union. However, since an optimal tariff has to include tariff-equivalent gray measures, GATT Article 24 itself may not be a real constraint on the size of a free trade area. Perhaps the optimal size of the party (country group) to be exploited may be the only principal constraint on the size of a dominating union (see the Monaco story). The optimum size of a free trade “gang” that is to exploit excluded outsiders [by imposing a higher tariff rate) has to be clearly defined. The “emotional” attitude of Americans accusing the EAEC proposal of being racial or anti-Caucasian is criticized. The authors, however, use equally emotional expressions, such as “greedy” or “acquisitive.” There seems to be a gap or jump between what the Goto-Hamada model says and what the authors say about the real world. One can deduce from their model something like the following: (1) the larger a block, the higher the optimal tariff can be, and ( 2 ) there are incentives in establishing a countervailing free trade area to make two polar blocs. In analyzing the real world, however, they address the problem of whether it is better to create a countervailing block against the European Union and NAFTA, such as the East Asian Economic Caucus [EAEC), or to promote APEC [including EAEC and NAFTA within the block) against the European Union. Furthermore, such statements as “APEC might be better than EAEC if APEC can loosen the tightness of the NAFTA bloc” cannot be inferred from their model. In many cases, for nonhegemonic small countries, the question is not whether to participate in an economic union, but how to say yes and mean no or how to sabotage coercion by a hegemonic country seeking leadership exploitation. One may argue that as far as nonhegemonic small countries are concerned, the worst possible multilateral solution (or free trade arrangement) would still be better than the best possible bilateral solution with a dominating country such as the United States. That is, the larger the scope of multilateralism (in terms of the number of countries involved), the less may be the exploitation by the leader country in any free trade arrangement. The smaller the number of countries included in a union, the greater may be the danger of exploitation by a (local) hegemonic country To nonhegemonic small countries, the World Trade Organization (WTO) arrangement might be the best possible one they can expect at this point in time. While pushing the WTO, the European Community established the European Union and the United States established NAFTA, apparently in order to make the WTO system less effective and to impose the so-called optimal tariff. It is very natural for Japan to push the countervailing EAEC through Mahathir (say, by telepathy) and also very natural for the United States to try to abort this hidden Japanese effort by having opposing coalitions like APEC. Since Japan (“at the moment”) still cannot say no to the United States, it can only hope for the realization of the “optimistic view” described by Goto and Hamada (i.e., through the acquisitive attitude of the United States the tightness of

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the NAFTA bloc may be broken while making APEC a loose integration). For other small economies in East Asia, the nightmarish situation is to decide whether to join EAEC or NAFTA in a final showdown (i.e., picking the lesser of the two evils). One solution for them might be the proper functioning of the WTO, and the alternative might be the proper functioning of APEC against the European Union, including both the United States and Japan in this Pacific union and hoping that such an APEC is a way to realize a truly free trading world under WTO. I wish Goto and Hamada would modify their model so as to amplify the aspects pointed out here-for example, the larger the number of countries involved in a free trade negotiation, the less might be the exploitation by the leader country,

This Page Intentionally Left Blank

5

Open versus Closed Trade Blocs Shang-Jin Wei and Jeffrey A. Frankel

5.1 Introduction Against the general background of increasing regionalization of trade, there is renewed debate about the welfare implications of trade blocs. Recent theoretical studies (e.g., Krugman 1991a; Frankel, Stein, and Wei 1995) have provided intellectual support for the worry that the current pattern of trade regionalization is likely to be welfare reducing relative to the preregionalization pattern because trade diversion is likely to outweigh trade creation. One possible condition on regionalism that may substantially reduce its cost and thus enhance the probability of a welfare improvement is what is called “open regionalism.” The meaning of the term is not entirely standardized. In this paper, we define an “open regional bloc” as one where, upon its formation, member countries choose to lower trade barriers to countries outside the bloc even if the degree of extrabloc liberalization may not be as thorough as with respect to fellow member countries. We have several objectives in this paper. First, we would like to clarify the meaning of the phrase “open regionalism.” Second, using a large, updated data set, we seek to examine degrees of openness as well as intragroup biases in various trade blocs. Third, we investigate the effect of foreign direct investment (FDI) on trade and identify the degree to which previous results that did not take direct investment into account may need modification. Shang-Jin Wei is associate professor of public policy at Harvard University’s Kennedy School of Government and a faculty research fellow of the National Bureau of Economic Research. Jeffrey A. Frankel is professor of economics at the University of California, Berkeley, and research associate of and director of international finance and macroeconomics at the National Bureau of Economic Research. The authors thank Taeho Bark, Richard Blackhurst, Anne Krueger, and other seminar participants for helpful comments. They also thank Jungshik Kim, Greg Dorchak, and Esther Drill for efficient research and editorial assistance.

119

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Shang-Jin Wei and Jeffrey A. Frankel

The organization of the paper is in line with the research plan outlined in the last paragraph. Section 5.2 provides an overview of the general issues. Section 5.3 explains the basic empirical framework and discusses degrees of inward bias and openness in various trade blocs around the world. In section 5.4, we turn our attention to implicit continental trade blocs. In section 5.5, we explore the connection between FDI and trade. And, finally, we offer some concluding thoughts in section 5.6.

5.2 An Overview of the Issues There are several stages in the intellectual discussion of the desirability of regional trade blocs. The classical dichotomy between trade creation and diversion as advanced by Viner (1950) and Meade (1 955) and its modifications have dominated people’s thinking for many decades. It is clearly recognized that regional trade blocs have the potential to be welfare reducing. The actual welfare implications of a particular pattern of regionalization, it was thought, have to be determined on a case-by-case basis. At the beginning of the 199Os, parallel to a renewed interest in regional blocs in the policy world, a sudden and loud warning about the possibility of welfare deterioration was emitted in a simple and elegant paper by Krugman (1991a). Using a model of trade blocs based on preference for variety and increasing returns to scale, the author demonstrated through simulation that three blocs may be the worst scenario in a world with symmetric countries and no transport cost. Given the suspicion that the world is indeed moving toward a three-bloc pattern, this theoretical result seems particularly alarming. To counterbalance the fear, Krugman (1991b) soon supplied an equally ingenious if somewhat extreme example in which three continental regional blocs may be welfare improving if intercontinental transport cost is very high. The intuition is simple: if transport cost is prohibitively high between continents, then world trade will take place primarily between countries on the same continent even under global free trade. Therefore, a world network of continental free trade blocs must be welfare improving since this is basically the best one can achieve in any case. For this reason, continental trade blocs are referred to as “natural trade blocs” by Krugman, as opposed to “unnatural trade blocs”-that is, free trade agreements between countries that are far apart. Of course, the real world is somewhere between zero transport cost (the first Krugman case) and infinite transport cost (the second Krugman case). Do the welfare implications of continental blocs depend monotonically on intercontinental transport cost? If so, is the transport cost in the real world above or below the threshold? Frankel, Stein, and Wei (1995) have shown that the answer to the first question is yes: there is a threshold value of intercontinental transport cost, above which continental blocs are likely to be welfare improving and below which the reverse is true. Furthermore, the best estimate of the actual intercontinental

121

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transport cost (about 15 percent of trade) is below the threshold. Hence, the current pattern of regionalization is likely to be excessive and welfare reducing. Frankel et al. call this type of continental bloc, which is nevertheless welfare subtracting, a “supernatural bloc.” It has been noted that if one allows neighboring countries to have complementary resource endowment that is nearly complete for the countries as a group, then a system of regional blocs among neighbors can also be welfare improving (Deardorff and Stem 1994). This is a point well understood by now. On the other hand, it is a strong assumption to make that the resource endowment of neighboring countries is so nearly complete that they do not need to trade with outside countries.’ In any case, factor-endowment-based models do not seem to fit the bilateral trade data as well as a gravity model that ignores endowment. We should note that the above discussion centers on static efficiency gains or losses. Dynamic gains (or losses) are often more important (Baldwin 1992). Finally, one can also evaluate the welfare implications of regional blocs from the political economy angle. There is a debate about whether regional blocs have acted as stepping stones or stumbling blocks to global free trade (Bhagwati 1993; Lawrence 1996; Levy 1994; Wei and Frankel 1996). The issue is not resolved yet. The concept of open regionalism was formally introduced during Asian Pacific Economic Cooperation (APEC) discussions. It is thought to entail a structure that minimizes trade diversion. The term at first sight is an oxymoron. Regionalism is a departure from the most-favored-nation (MFN) principle because it discriminates in favor of members at the expense of nonmembers. How can it be open at the same time? To clarify, let us entertain four possible definitions of open regionalism. 1. Open membership. Entry rules are transparent so that any country currently outside the bloc can choose to join the bloc as long as it satisfies the entry criteria. The extremist version of open membership does not permit current members to veto the entry of any eligible newcomer. Of course, almost no existing regional bloc has this degree of open membership. A weaker version of open membership requires agreement among existing members (using unanimity, majority vote, or some such voting rule) whenever a new member is to be admitted. 2. Selective liberalization and open benefits. Member countries can focus on liberalizing, on an MFN basis, those sectors in which they dominate world trade so that they do not need to have preferential treatment versus nonmember countries. In the context of APEC, an influential observer noted that APEC “could avoid preferential treatment altogether on some issues, perhaps includ1. Haveman (1992) derived a model that marries endowment consideration with differentiated product consideration. He found in his simulation that the negative effects of regional trade blocs are likely to dominate.

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ing competition policy and new industrial standards. It could do so when liberalizing in sectors where the APEC countries dominate world trade, such as computers” (Bergsten 1994, 24). 3. Nonprohibition clause. A regional trade agreement can automatically allow any member country to liberalize unilaterally, in particular, to extend the benefits of a regional agreement to nonmember countries. For example, Mexico has unilaterally extended some of its investment obligations under NAFTA to nonmember countries. 4. Reduction in external barriers. Members of a regional trade bloc should collectively lower their external barriers on goods from nonmember countries.* The degree of liberalization with respect to nonmembers need not be as high as that among members. In our view, the first three characteristics, while desirable, do not have enough firepower in the sense that they are likely to apply to most blocs anyway. Open membership is certainly better than “closed membership”-a regional bloc with a predetermined size. It is a necessary condition if regional blocs are not to be stumbling blocks to global free trade. Furthermore, it is possible to cook up theoretical models in which regional blocs choose to decline any new member after reaching a certain size (20 out of 30 in Saxonhouse 1993; 16 out of 30 in Stein 1994). But almost all regional blocs, past, present, or currently in negotiation, have some degree of open membership. That does not seem to reduce trade diversion in any significant way. Open benefits (to nonmembers) in selected industries are also desirable. If open benefits only apply to industries in which the members of a bloc dominate the world, as the definition suggests, then tautologically, they would not incur opposition from interest groups in the member countries. Such freebies would naturally be part of any regional bloc. For example, many computer-related industries, from memory chip production, to hard disk manufacture, to computer assembly, have been identified as being dominated by APEC members in world trade. It requires no great imagination to think that APEC, when it chooses to establish free trade in those products among its member countries, most likely will not maintain high barriers against products from outside the region. The problem is that APEC is almost unique relative to other regional blocs in terms of the vast number of countries it covers and the large number of sectors in which its member countries have comparative advantage. Many smaller blocs may have greater difficulty in identifying industries in which they clearly dominate world trade. Moreover, as the pattern of comparative advantage shifts over time, there is no guarantee that the currently dominating industries will not be the subjects of future protectionist movements by lobbying groups. In conclusion, selective liberalization in dominating industries 2. We do not distinguish between customs unions and free trade areas. Krueger (1995) has argued that customs unions are (almost) always welfare superior to free trade areas. Moreover, in terms of political economy, customs unions are less likely to be stumbling blocks to further global trade liberalization than free trade areas.

123

Open versus Closed Trade Blocs

certainly works in the direction of reducing trade diversion. But for most regional blocs, the number of nondiscriminating sectors would be too small to have a major impact on the overall trade diversion of the blocs. The nonprohibition clause is also a highly desirable feature of any regional trade bloc. But we know of no bloc that does not in fact, if only implicitly, have such a clause. If a member country of a bloc wants to liberalize unilaterally, other member countries may not like it, but it is rare to see those countries try to block the trade liberalization of their neighbors. So the problem of most regional blocs is not that members are prohibited from extending the benefits to nonmembers, but that they do not choose to liberalize often enough. After extolling an implicit nonprohibition clause in the APEC discussion, Bergsten (1994) immediately added that “in general, however, the strategy would open APEC arrangements only to nonmember countries that undertake corresponding obligations.” Again, unilateral liberalization as a result of a regional agreement is rare enough to counter the trade diversion effect of regional blocs. This brings us naturally to the last definition of open regionalism, which calls for reducing external barriers at the same time as member countries lower barriers among themselves. Kemp and Wan (1976) proved that if members of a trade bloc maintain the same level of trade with nonmembers after the formation of the bloc, then world welfare always increases. In fact, the required degree of extrabloc liberalization may be lower than the Kemp-Wan rule in many instances. Wei and Frankel (1995) have shown that even a relatively small partial liberalization by regional blocs with respect to countries outside, which may still result in a lower amount of trade between members and nonmembers, can usually ensure a welfare increase for the world. So this is desirable from an efficiency point of view. But how likely is it that regional blocs would do this? There are reasons to think that the odds are against even such limited liberalization. Import-competing industries certainly would not volunteer to liberalize. Exporting industries may not push very hard for liberalization either if there is no corresponding liberalization in countries outside the bloc. Furthermore, Article 24 of the GATT, which sets out rules on the formation of regional blocs, does not require a simultaneous reduction of external barriers, only an absence of an increase in their average level. So far, we have said that the first three possible characterizations of open regionalism are desirable but likely to happen in any case. If the last characterization is desirable but unlikely to happen no matter what, then open regionalism is basically an empty concept. We are more optimistic than that, however. Using a simple but abstract example, we have demonstrated the following possibility (Wei and Frankel 1996): there are cases in which an outright acrossthe-board trade liberalization may offend too many powerful groups; a regional trade bloc may be used to break the opposition groups so that further liberalization on goods from nonmember countries becomes politically feasible. In Wei and Frankel (1995), we showed that in a world of continental blocs, a small degree of external liberalization-the fourth definition of open regionalism-

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is usually sufficient to improve world welfare. How relevant are these theoretical possibilities for the real world? A major part of this paper (in particular, section 5.4) looks for evidence that some regional blocs may indeed work to enhance the overall openness of their member countries.

5.3 Open Regionalism and Existing Trade Blocs 5.3.1 Empirical Norm of Trade Volume The key to detecting and quantifying possible intraregional trade bias is to establish a “norm” of trade volume based on economic, geographic, and cultural factors. A useful framework for this purpose is the gravity modeL3 A dummy variable can be added to represent the case in which both countries in a given pair belong to the same regional grouping. One can then check how the level of trade and time trend in, for example, East Asia compares with that in other groupings. The dependent variable in our gravity estimation is the bilateral volume of total trade (exports plus imports), in logarithmic form. One would expect the two most important factors in explaining bilateral trade flows to be the geographical distance between the two countries and their economic sizes. These factors are the essence of the gravity model (and indeed are the presumed source of its name, by analogy with the formula for gravitational attraction between two masses). A large part of the apparent bias toward intraregional trade is certainly due to simple geographical proximity. Indeed, Krugman (1991b) suggested that most of it may be due to proximity, so that the three trading blocs may be welfare improving because they are “natural” groupings (as distinct from “unnatural” trading arrangements between distant trading partners, such as the United Kingdom and a Commonwealth member). Despite the obvious importance of distance and transportation costs in determining the volume of trade, empirical studies surprisingly often neglect to measure these factors. Our measure is the log of the distance between the two major cities (usually the capitals) of the respective countries. We also add a dummy “Adjacency” variable to indicate when two countries have a common land border. Entering GNPs in product form is empirically well established in bilateral trade regressions. It can easily be justified by the modem theory of trade under imperfect competition. There are reasons to believe that GNP per capita also has a positive effect, for a given size: as countries become more developed, they tend to specialize more and to trade more; further, more developed countries have better ports and communication systems, which facilitate goods trade. 3. For a discussion of its theoretical foundation, see Anderson (1979), Helpman and Krugrnan (1985), Helpman (1987), Bergstrand (1989), and Deardorff (1984, 1995).

125

Open versus Closed Trade Blocs

A common language can facilitate trade partly because it directly reduces transaction (translation) costs and partly because it enhances exporters’ and importers’ understanding of each other’s culture and legal system, which indirectly promotes trade. To capture this effect, we also include a dummy that takes the value 1 if the two countries in question have a common language or have a previous colonial connection. We consider nine languages: English, French, German, Spanish, Portuguese, Dutch, Arabic, Chinese, and Japanese. A representative specification is log (1)

r,

+ I3 log (GNP,GNP,) + P,log[(GNP/pop,)(GNP/pop,)] + P,log(Distance) + P, (Adjacency) + p, (Language)

= a,

+ Y , (EC,) + y2 (Andean,l) + y3 WEAN,,) + u~,. The last five explanatory factors are dummy variables. EC (European Community), Andean in the Western Hemisphere, and ASEAN in East Asia are examples of the dummy variables we use when testing for the effects of membership in a regional grouping. Our data set covers 63 countries (or 1,953 country pairs) for the 1970-92 period (1970, 1980, 1990, and 1992). The sources are the United Nations trade matrix for 1970 and 1980 and the International Monetary Fund’s Direction of Trade Statistics for 1990 and 1992. We employ the panel regression technique that allows for year-specific intercepts. Unlike usual panel regressions, we do not include country pair dummies since that would undermine our effort to detect possible intraregional biases (and the effects of some of the gravity variables that do not change over time). 5.3.2

Open Regionalism and Existing Trade Blocs

In this subsection, we look for suggestive evidence that open regionalism may be practiced by existing trade blocs. We emphasize that our findings are illustrative. We do not explicitly investigate the mechanism through which openness (or lack of it) is achieved in a trade bloc. Presumably, the balance of political economy forces determines the orientation of a trade bloc. For a summary of political economy forces within a trade bloc in terms of its openness to nonmember countries, see Frankel and Wei (1995). An open bloc lowers trade barriers against countries outside the bloc at the same time that it reduces barriers among members. On the other hand, a closed bloc would maintain or even raise barriers against outsiders as it liberalizes internally. In an open regional bloc, trade creation is more likely to dominate trade diversion. So the bloc is more likely to be welfare improving. In this section, we turn to an empirical examination of the issue. Using data covering 1970-92, we look at the following seven trade blocs: the European Community (EC, now called European Union), the European Free Trade Area (EFTA), the North American Free Trade Area (NAFTA), MERCOSUR and the Andean Group, both in South America, the Association of Southeast Asian

Open versus Closed Blocs (total trade, 1970-92)

Table 5.1

GNP GNP/pop Distance Adjacency Language Region2 variables" EC2 EFTA2 NAFTA2 MERCOSUR2 Andean2 ASEAN2 East Asia minus ASEAN2 ANz2 Region1 variablesb EC 1 EFTA 1 NAFTA 1 MERCOSURI Andean 1 ASEANI

0.785** (0.009) 0.187** (0.011) -0.612** (0.020) 0.573** (0.086) 0.568** (0.046)

0.755** (0,010) 0.250** (0.013) -0.784** (0.024) 0.468** (0.088) 0.570** (0.046)

0.151** (0.053) 0.030 (0.104) 0.005 (0.182) 0.930** (0.215) 0.200 (0.188) 1.965** (0.178)

-0.145* (0.059) 0.222* (0.105) 0.359** (0.203) 0.707** (0.240) 0.259 (0.196)

1.322** (0.191) 1.632** (0.131)

0.638** (0.196) 1.554** (0.143)

1.318**

(0.166)

0.180** (0.045) -0.382** (0.050) -0.195** (0.061) 0.259** (0.056) 0.065 (0.053) 0.767** (0.050)

East Asia minus

ASEANI ANZl

0.741** (0.052) 0.021 (0.075)

127 Table 5.1

Open versus Closed Trade Blocs (continued)

N Adjusted R2 Standard error of regression

6,102 0.162

6,102 0.787

1.179

1.114

Notes: Dependent variable is total trade (T,). Data cover 1970, 1980, 1990, and 1992. All variables except dummy variables are in logs. All regressions have an intercept and year dummies not reported here. "Region2 variables take the value 1 if both countries (i and j ) in the pair are in the region. bRegionl variables take the value I if the pair includes a country in the region. #Significant at the 90 percent level. 'Significant at the 95 percent level. **Significantat the 99 percent level.

Nations (ASEAN), and the Australia-New Zealand Closer Economic Relations agreement (ANZ). We note that the seven groupings have very different degrees of intended integration, from nascent free trade areas to customs unions or common markets. We will examine their trade orientations separately. As a benchmark for comparison, we first examine the degree of trade integration in these groupings. The results are reported in column (1) of table 5.1. We first note that the gravity variables are all statistically significant and with expected signs. The coefficient on GNP is 0.8: as economic size increases, so does trade. Distance has a negative coefficient: a 1 percent increase in distance is associated with 0.6 percent less trade. On the other hand, two countries with a common land border tend to trade 50 percent more than an otherwise identical pair of countries. Countries with a common language or colonial connection also tend to trade 50 percent more than otherwise. We now turn to evidence of intraregional trade bias. The coefficients for all the regional dummies are positive. In addition, EC, MERCOSUR, ASEAN, and ANZ are statistically different from zero at the 1 percent level. For example, two EC countries tend to trade 15 percent more than a random country pair outside the region. More astonishingly, ASEAN countries tend to trade several times more than the prediction of the gravity modeL4 We should emphasize that the coefficients on the bloc dummies in column (I) of table 5.1 measure the amount of trade among member countries of a group in excess of that among countries that do not belong to any bloc. We note that if all countries in a particular group are more open than an average country, then the trade among these countries would be higher than the model 4. This partly reflects the high degree of openness of all East Asian countries, as suggested by the large and significant coefficient for the dummy for the non-ASEAN countries in the region. See also Frankel and Wei (1993) and section 5.4 of this paper.

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prediction even if none of the countries has any discriminatory policies or institutions. In other words, the results in column (1) do not distinguish between general openness and discriminatory institutions or policies. We address this issue in column (2). Define EC1 as a dummy for any bilateral trade that involves at least one EC country, and EC2 as a dummy for trade between any two EC countries. Define EFTAl, EFTA2, and so on, analogously. In a gravity regression with these dummies, one may interpret the coefficient on EC 1 as the extent of abnormal trade between an EC country and a country outside the region relative to u random pair of countries that are not members ofany bloc. A negative coefficient implies that trade between a member of the bloc and a nonmember is smaller, on average, than that between two otherwise identical countries. This is indicative of possible trade diversion. On the other hand, a positive coefficient implies that trade between EC countries and countries outside the region is higher than what one would have expected from their economic, geographic, and linguistic positions. Thus, a positive coefficient is taken as possible evidence of an open trade bloc. Relative to column (l), the coefficient on the EC2 dummy requires a different interpretation: it now represents any extra amount of trade between two EC countries relative to their trade with countries outside the region. In other words, even if trade between Sweden and Finland is the same as that between two identical countries outside the group, the coefficient on EFTA2 could still be positive if Sweden, Finland, and other EFTA countries trade less, on average, with countries outside the group. We can interpret the coefficients on other bloc dummies in a similar way. In column (2), the coefficients on the basic gravity variables are not very different from before. Hence, we focus our discussion on the bloc dummies. In Europe, averaging over the two-decade period, the countries in the European Community tend to be more open than an average country: their trade with outside countries is 18 percent higher than the prediction of the model, as reflected by the coefficient on the EC1 variable. Once one controls for the European Community’s general openness and the member countries’ economic and geographic characteristics, intra-EC trade is no longer unusually high. In fact, it is 15 percent less than the prediction of the model (the EC2 coefficient). In contrast, the EFTAl dummy has a negative coefficient (-0.38): over the sample, the EFTA countries tend to trade 38 percent less with countries outside relative to a random group of countries in the world. At the same time, the EFTA countries also trade 22 percent more among themselves than a random group. This suggests that EFTA may build up its intragroup trade concentration mainly by diverting trade away from outside countries. We now turn to the three blocs in the Western Hemisphere. NAFTA was not established until the very end of the sample period. Nevertheless, the three countries in the group on average trade 20 percent less with outside countries than the model’s prediction, but 36 percent more among themselves than a random group that does not belong to any bloc. In contrast, while MERCO-

129

Open versus Closed Trade Blocs

SUR countries exhibit an intragroup trade bias during the sample, they also trade more with all countries in the world than the model’s prediction. The Andean group members, on the other hand, show no unusual trade among themselves or with outsiders. In the Asia Pacific region, the ASEAN countries, which constitute the only explicit bloc in East Asia, trade substantially more among themselves than a random group that does not belong to any bloc. At the same time, these countries are also more open in general as they have more trade with outside countries than one would predict based on their economic and geographic characteristics. We should further note, however, that the ASEAN group’s trade pattern may not be substantially different from that of the rest of East Asia. The rest of East Asia, though lacking a formal bloc, also tends to be very open to all countries in the world and, at the same time, trades particularly intensively with other East Asian countries. Australia and New Zealand, connected by their Closer Economic Relations treaty, apparently generate higher trade between themselves than one would expect based on the gravity model. It is worth noting, however, that their trade with other countries, averaging over the two decades, does not seem to suffer too much from their cozy relationship.

5.4 Open Regionalism and Implicit Continental Blocs The openness of existing trade blocs was examined in section 5.3. In this section, we turn our attention to a different classification of country groups. It has been observed that many continents may constitute implicit trade blocs. For example, it is sometimes alleged that there is an implicit trade bloc in East Asia, possibly centered on Japan. Opaque institutions and informal rules and cultures, possibly encouraged by implicit policies, may operate in the same way as tariffs, encouraging countries to trade more intensively with members of the “club” at the expense of outsiders. Frankel and Wei (1993) found some evidence of intracontinental trade biases in East Asia, Western Europe, and the Western Hemisphere. In some cases, once one controls for continental biases (e.g., an intra-East Asia bias), trade within subregions (e.g., among ASEAN members) no longer seems unusually high. The continental nature of trade blocs could have important welfare implications that are different from those of a bloc formed by a random group of countries (Krugman 1991b; Frankel et al. 1995, 1996). Following Frankel and Wei (1994), we will consider four implicit continental blocs: Western Europe, the Western Hemisphere, East Asia, and APEC. Again, what we are looking for is not so much the effects of explicitly discriminatory tariffs, but those of opaque institutions, cultures, or implicit policies (i.e., nontariff barriers broadly defined). The basic results are presented in table 5.2. For comparison, column (1) reports a regression that includes only the dummies for within-bloc biases. The results with this more up-to-date data set are broadly similar to those in our earlier papers: There is evidence of intraregi-

Table 5.2

Open versus Closed Continental lkade Blocs (total trade, 1970-92)

Intercept 1980 Dummy 1990 Dummy 1992 Dummy

GNP GNP/pop Distance Adjacency Language Region2 variables” W.Eur.2 bloc E.Asia2 bloc APEC2 bloc W.Hem.2 bloc

-9.355** (0.236) - 1.030** (0.049) - 1.323** (0.055) -5.278** (0.153) 0.762** (0.009) 0.194** (0.011) -0.586** (0.021) 0.663* * (0.080) 0.443** (0.045)

-9.520** (0.331) -1.075** (0.054) - 1.389** (0.065) -5.332** (0.169) 0.761** (0.009) 0.214** (0.013) -0.61 I** (0.028) 0.624**

0.167** (0.053) 0.899** (0.101) 1.147** (0.063) 0.355** (0.070)

0.120** (0.053) 0.786** (0.102) 0.937** (0.071) 0.637** (0.079)

Region1 variablesb W.Eur. 1 bloc

0.517** (0.045)

0.101* (0.048) 0.715** (0.056) -0.276** (0.059) -0.082” (0.044)

E.Asia1 bloc APECl bloc W.Hem.1 bloc N Adjusted RZ Standard error of regression

(0.081)

6,102 0.924

6,102 0.927

1.137

1.114

Notes: Dependent variable is total trade (q,).Data cover years 1970, 1980, 1990, and 1992. All variables except dummy variables are in logs. “Region2variables take the value 1 if both countries (i andj) in the pair are in the region. bRegionl variables take the value 1 if the pair includes a country in the region. ‘Significant at the 90 percent level. *Significant at the 95 percent level. **Significant at the 99 percent level.

131

Open versus Closed Trade Blocs

onal bias in each of the four potential blocs in question. Based on data for the period 1970-92, two Western European countries trade 17 percent more than two otherwise identical non-Western European countries. The Western Hemisphere shows a slightly higher intraregional bias (about 40 percent extra trade). East Asia shows a much higher bias: two East Asian economies trade 145 percent (exp(.899) - 1) more than two otherwise identical economies outside the region. The group that exhibits the highest inward bias is APEC, with a coefficient of 1.15. Our central interest is the evidence regarding the openness of these groupings. In column (2), we include the dummies that represent trade between members of a group and nonmember countries. As it turns out, based on data for the period 1970-92, both the Western Europe and East Asia groups are “open” in the sense that their trade is in fact higher than one would expect from their economic, geographic, and cultural characteristics. A Western European country tends to trade 10 percent more with all countries in the world than an otherwise identical country. Interestingly, East Asia is more open than Europe even though it also has a very high intraregional bias. An East Asian country trades 100 percent (exp(.715) - 1) more with a country outside the region than two random countries outside East Asia. To be sure, these results do not mean that Western Europe and East Asia do not favor trade among themselves relative to trade with outsiders. What they mean is that, for both regions, the formation of (an implicit if not explicit) trade bloc has not led to a substantial amount of trade diversion from countries outside the regions. Indeed, the trade blocs in these regions appear to have promoted their openness in general, even though trade among themselves may have grown faster. In contrast, both the Western Hemisphere and the APEC group display signs of trade diversion away from countries outside the regions. Trade between a Western Hemisphere country and an outsider during the period 1970-92 appears to be lower by 8 percent than one would expect based on their economic and geographic characteristics. The APEC group appears in the estimates to have a greater degree of trade diversion: trade between an APEC member and a nonmember is lower by 24 percent than trade between two random countries outside the region. So far, we have looked at a period average of the intraregional bias and openness of the four groupings over the entire two-decade horizon. It may be of interest to examine how these indicators have changed over time. To do this, we create a variable “Trend,” which is equal to the year of the observation minus 1970. We add interaction terms between this variable and regional bias and openness dummies. The coefficients on the interaction terms can be interpreted as annual percentage changes in the relevant indicators. The results are reported in table 5.3. Again, column (1) only has the intraregional bias dummies (and their interaction with Trend). Although all four groups exhibit inward trade biases (as we have seen from table 5.2), there is

Table 5.3

Trend in the Openness of Continental Trade Blocs (total trade 1970-92)

Variable

(1)

Intercept

-9.410** (0.236) - 1.062** (0.050) - 1.378** (0.058) -5.358** (0.154) 0.763** (0.009) 0.198** (0.011) -0.585** (0.021) 0.667** (0.078) 0.445** (0.045)

1980 Dummy 1990 Dummy 1992 Dummy

GNP GNFVpop Distance Adjacency Language Region2 variablesb W.Eur.2 bloc E.Asia2 bloc

APEC2 bloc W.Hem.2 bloc

0.236** (0.072) 1.360** (0.226) 0.841** (0.134) -0.237* (0.099)

(2)"

(4)"

-9.806** (0.343) - 1.006** (0.068) -1.242** (0.107) -5.181** (0.188) 0.762** (0.009) 0.222** (0.013) -0.605** (0.028) 0.633** (0.079) 0.519** (0,044) -0.006 (0.004) -0.032* (0.013) 0.021** (0.008) 0.045* * (0.007)

Region1 variables' W.Eur. 1 bloc E.Asia1 bloc

APEC 1 bloc W.Hem.1 bloc

N Adjusted R2 Standard error of regression

(3)

0.117 (0.078) 1.360** (0.226) 0.824** (0.146) 0.021 (0.116)

-0.001 (0.004) -0.040 (0.013) 0.006 (0.008) 0.047** (0.008)

0.303** (0.075) 0.363** (0.106) -0.079 (0.089) -0.014 (0.072)

-0.016** (0.004) 0.026** (0.006) -0.016** (0.005) -0.006 (0.004)

6,102 0.924

6,102 0.928

1.133

1.107

Notes: Dependent variable is total trade (q,).Data cover years 1970, 1980, 1990, and 1992. All variables except dummy variables are in logs. "Coefficients (standard errors) for the interaction between the region variables and a trend variable (defined as year minus 1970). bRegion2 variables take the value 1 if both countries (i andj) in the pair are in the region.
133

Open versus Closed Trade Blocs

quite a bit of variation in terms of their dynamics. For Western Europe, the bias started high (24 percent) in 1970 and more or less remained that way to the end. East Asian bias started very high (290 percent = exp(1.36) - 1) and declined steadily over the next 23 years at the rate of 3.2 percent per annum. Intra-APEC bias started high (130 percent = exp(.84) - 1) and continued to grow over the period at the rate of 2.1 percent per annum. In contrast, two Western Hemisphere countries at the beginning of the 1970s actually traded 27 percent less than two random countries outside the region. Over time, intrahemisphere trade increased at a high rate of 4.5 percent a year so that a strong intraregional bias can easily be detected over the entire 23-year period. Column (3) reports trend changes in the degree of openness of various trade groups. At the beginning of the sample, both Western Hemisphere countries and members of the current APEC group traded less with countries outside their regions than would be indicated by the predictions of the gravity model, although the differences are not statistically significant. Somewhat surprisingly, over the period 1970-92, the point estimates of the degree of trade diversion appear to have increased for both groups. The change is statistically significant for the APEC group (a reduction in trade at the rate of 1.6 percent per annum). Western European countries were quite open at the beginning of the sample. Their trade with countries outside the region in 1970 was 30 percent higher than trade between two random non-Western European countries. Over time, however, their trade with countries outside the region actually fell at the rate of 1.6 percent per annum. So, at least during this 23-year period, there appears in these estimates to be a steady diversion of trade away from countries outside Western Europe toward countries inside the region. Because of their high degree of openness in 1970, average trade between Western Europe and outside countries over the entire sample was still higher than the prediction of our gravity model. However, at the end of the sample, trade between Western Europe and countries outside the region was below what one would have expected based on economic, geographic, and cultural characteristics. East Asia is unique relative to other groups. It was very open at the beginning of the sample: trade between an East Asian economy and a country outside the region in 1970 was more than 36 percent higher than that between a random pair. The indicator of East Asian openness actually grew at the rate of 2.6 percent a year over the next two decades. Hence, to the extent that there may be an implicit trade bloc in East Asia, this bloc appears to have promoted trade creation and openness as opposed to trade diver~ion.~ Let us summarize. Article 24 of the GATT only requires members of a trade bloc to refrain from raising external tariffs against nonmembers. It does not 5 . We caution readers that our empirical strategy does not formally distinguish between two possibilities: (1) all East Asian economies liberalize unilaterally independent of the implicit bloc in the region versus (2) they do so by collective regional action or by conscientiously following each other’s example.

134

Shang-Jin Wei and Jeffrey A. Frankel

explicitly require trade liberalization. The normal logic that the optimal tariff increases with country size would imply that a trade bloc naturally has incentives to raise external barriers to trade with nonmembers disregarding Article 24. With or without an increase in external tariffs, one normally would expect to see a certain amount of trade diversion away from countries outside a bloc. This indeed appears to be the case for many blocs we have investigated. One notable exception is East Asia, which has maintained a high degree of openness and in fact appears to have engaged in steady trade liberalization with respect to countries outside as well as inside the region. Part of the reason may be that many East Asian countries are resource poor and have small domestic markets so that they have to rely heavily on imports and exports, including trade with countries outside the region. A second possibility is the power of imitation: openness is often alluded to as an important reason why the four Asian Tigers have succeeded economically; their neighboring countries then follow these examples with zeal. Another possibility is that when countries choose to liberalize their trade with their neighbors, it may also facilitate their liberalization in general. For a formalization of this idea in a simple political economy model, see Wei and Frankel (1996).

5.5 Trade Blocs and Direct Investment: Does Trade Follow FDI? One issue often raised in the context of trade bloc estimation is the role of

FDI.Many authors (e.g., Encarnation 1992) have emphasized the importance of transactions within multinational corporations for international trade. In particular, FDI may generate trade as subsidiaries abroad (e.g., Honda USA) tend to buy more inputs from the home country (Japan) than an otherwise identical firm in the host country (Ford). It is sometimes hypothesized that the high volume of trade between Japan and other East Asian economies and that between Hong Kong and Mainland China are closely related to Japan’s and Hong Kong’s heavy direct investment in their respective trading partners. We should note that, in principle, FDI can also displace trade as the sales of foreign subsidiaries (e.g., Honda USA) in the host country (United States) may reduce the source country’s (Japan’s) exports to the host country.6Whether FDI promotes or displaces trade depends on the balance of these two competing effects. The net effect of FDI on trade and the degree to which the high integration of trade in Asia reflects an usually high level of intraregional direct investment should be subject to empirical examination. We rarely see such studies, partly because systematic data on FDI were not available until recently. For 1990, we now have assembled bilateral FDI data from 15 source countries to a large 6. Note that for countries with a flexible exchange rate system, FDI has a minimum effect on bilateral trade balance in any case, if the exchange rate can move to offset any net change in trade balance that occurred at the initial level of the exchange rate.

135

Open versus Closed Trade Blocs

number of host countries. Wei (1995, 1996) used the data to establish a model of direct investment and to examine whether China is an underachiever as a recipient country. In this section, we augment our basic trade regression in table 5.2 to include a measure of stock of direct investment. Taking into account the special structure and availability of the FDI data, we make several modifications to our basic gravity specification. First, we use trade in 1992 as the dependent variable and the stock of FDI in 1990 as an added regressor. With this time lag, we can reasonably assume that the FDI stock is predetermined with respect to trade flows. Second, since a few countries supply most of the direct investment in the world, it makes more sense to look at corresponding exports from these source countries to the recipient countries of FDI. The regression results are presented in table 5.4. For comparison, we replicate the regressions in table 5.2 on this restricted subsample. With substantially fewer observations (347 now, relative to 6,102 in table 5.2), we can still detect intraregional trade biases for most of the regions. Moreover, both the Western Hemisphere and the APEC group show evidence of trade diversion, whereas both East Asia and the European Community display higher than normal trade with outside countries. In columns (3) and (4),we add as an additional regressor the stock of FDI from the exporting country to the importer. The coefficients on the new regressor in both equations are positive and statistically significant at the 1 percent level. Using the point estimate in the last regression, we find that a 1 percent increase in the stock of FDI is associated with an increase in trade by 0.17 percent after one takes into account other economic, geographic, and cultural characteristics of the country pairs. This lends support to the notion that the net effect of FDI on flows of goods trade is positive. The coefficients on other variables change slightly. In particular, we observe that East Asia becomes more open to outsiders in terms of goods trade once one takes into account the FDI factor. This is so probably because FDI from East Asia to other areas in the world is relatively small and mostly concentrated in North America. On the other hand, the extent of trade diversion for the Western Hemisphere is more pronounced once we take FDI into account. One possible reason is that the United States is a major investor in many parts of the world. Relative to its position as a source country of direct investment, the United States does not actually trade as much as one would have expected. 5.6

Concluding Remarks

The welfare effect of the formation of a regional trade bloc is ambiguous in general. However, an open bloc that liberalizes imports from countries outside the bloc as well as from inside is more likely to be welfare improving because trade diversion will be minimized. This is one possible interpretation of “open

Table 5.4

Intercept

Distance Adjacency Language

Do Exports Follow FDI?

-15.565** (1.356) 0.734** (0.043) 0.591** (0.032) -0.191' (0.105) 0.096** (0.036) -0.591** (0.053) 0.500** (0.125) 0.247* (0.110)

- 17.368**

(1.612) 0.747** (0.042) 0.604** (0.034) -0.119 (0,103) 0.105** (0.034) -0.556** (0.068) 0.477** (0.129) 0.355** (0.108)

Stock of FDI ( 1990),, Region2 variables" E.Asia2

APEC2

W.Hem.2 EC2

0.156 (0.197) 0.997** (0.114) 0.246 (0.157) 0.323** (0.114)

Region1 variablesb E.Asia1

W.Hem. 1

EC 1

- 10.689**

(1.552) 0.669** (0.039) 0.503** (0.032) -0.522** (0.117) 0.074* (0.035) -0.525** (0.050) 0.421** (0.115) 0.134 (0.097)

(1.617) 0.6892** (0.038) 0.513** (0.030) -0.530** (0.110) 0.083* (0.033) -0.478** (0.063) 0.341** (0.116) 0.265** (0.090)

0.142** (0.021)

0.169** (0.019)

0.194 (0.179) 0.863** (0.109) 0.165 (0.147) 0.23 I * (0.109)

-0.046 (0.198) 0.783** (0.138) 0.630** (0.178) 0.156 (0.108) 0.397** (0.110) -0.127 (0.148) -0.477** (0.107) 0.003 (0.113)

0.315* (0.122) -0.067 (0.169) -0.380** (0.116) 0.155 (0.126)

APEC 1

N Adjusted R2 Standard error of regression

-0.029 (0.219) 1.059** (0.150) 0.711** (0.196) 0.270* (0.113)

**

-9.4 15

347 0.793

347 0.817

347 0.816

347 0.847

0.677

0.638

0.639

0.581

Notes: Dependent variable is 1992 exports from i toj. All variables except dummy variables are in logs. Standard errors are heteroscedasticity-consistent. "egion2 variables take the value 1 if both countries (i andj) in the pair are in the region. bRegionl variables take the value I if the pair includes a country in the region. 'Significant at the 90 percent level. *Significant at the 95 percent level. **Significant at the 99 percent level.

137

Open versus Closed Trade Blocs

regionalism.” From a normative point of view, one useful reform in the international trading system would be to modify Article 24 of the GATT to require all new regional blocs to lower external baniers. From a positive point of view, the dynamic welfare effect of trade blocs depends on whether political economy forces in the process of regional bloc formation, on balance, tend to encourage or inhibit further trade liberalization. Using an updated data set that covers more than one thousand country pairs over the period 1970-92, we have reached three main conclusions. First, among the seven explicit trade blocs we have examined, almost all show intrabloc trade biases. However, their openness toward outside countries differs dramatically. The European Community, MERCOSUR, and ASEAN countries tend to trade more with all countries in the world than one would have predicted based on their economic and geographic characteristics. The Andean group and the Australia-New Zealand pair at least did not trade less with outsiders than the predictions of the gravity model. In contrast, the EFTA and NAFTA countries were less open to outsiders in the sense that their trade levels with other countries were below the model’s predictions. Second, when we considered implicit continental trade blocs, we also discovered differing degrees of openness. Averaging over the period 1970-92, we found that Western Europe and especially East Asia were more open to imports from outside the regions than predicted by a gravity model. The Western Hemisphere and the APEC group traded less with outside countries than predicted by a gravity model. However, in terms of trend change, East Asia is the only grouping that started out open and became more open over the sample. Western Europe started open but gradually became trade diverting. The APEC group has managed continuously to shift trade away from countries outside in favor of those inside. And finally, FDI appears to have promoted trade on average. Once we have taken into account the FDI effect, East Asia seems even more open to outsiders than otherwise.

References Anderson, James. 1979. A theoretical foundation for the gravity equation. American Economic Review 69 (1): 106-16. Baldwin, Richard. 1992. Measurable dynamic gains from trade. Journal of Political Economy lOO(1): 162-74. Bergsten, C . Fred. 1994. APEC and world trade. Foreign Affairs 73 (3): 20-27. Bergstrand, Jeffrey. 1989. The generalized gravity equation, monopolistic competition, and the factor-proportions theory in international trade. Review of Economics and Statistics 71 (I): 143-52. Bhagwati, Jagdish. 1993.Regionalism and multilateralism: An overview. In New dimensions in regional integration, ed. J. de Melo and A. Panagariya. New York: Cambridge University Press.

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Deardorff, Alan. 1984. Testing trade theories and predicting trade flows. In Handbook of international economics, ed. R. Jones and P. Kenen, 1: 467-517. Amsterdam: Elsevier. . 1995. Determinants of bilateral trade: Does gravity work in a neoclassical world? NBER Working Paper no. 5733. Cambridge, Mass.: National Bureau of Economic Research, December. Deardorff, Alan, and Robert M. Stem. 1994. Multilateral trade negotiations and preferential trading arrangements. In Analytical and negotiating issues in the global trading system, ed. A. Deardorff and R. M. Stem, 22-51. Ann Arbor: University of Michigan Press. Encamation, Dennis J. 1992. Rivals beyond trade: America versus Japan in global competition. Ithaca, N.Y.: Comell University Press. Frankel, Jeffrey, Emesto Stein, and Shang-Jin Wei. 1995. Trading blocs and the Americas: The natural, the unnatural, and the super-natural. Journal of Development Economics 47:61-95. . 1996. Continental trading blocs: Natural or super-natural? American Economic Review 86 (2): 52-54. Frankel, Jeffrey, and Shang-Jin Wei. 1993. Trade blocs and currency blocs. NBER Working Paper no. 4335. Cambridge, Mass.: National Bureau of Economic Research. . 1994. Yen bloc or dollar bloc: Exchange rate policies of the East Asian economies. In Macroeconomic linkage: Savings, exchange rates, and capital jlows, ed. Takatoshi Ito and Anne Krueger, 295-329. Chicago: University of Chicago Press. . 1995. Regionalization of world trade and currencies: Economics and politics. Paper presented at the NBER conference on the Regionalization of the World Economy, Woodstock, Vermont, 20-2 1 October. Haveman, Jon David. 1992. On the consequences of recent changes in the global trading environment. Ph.D. dissertation, University of Michigan, Ann Arbor. Helpman, Elhanan. 1987. Imperfect competition and international trade: Evidence from fourteen industrial countries. Journal of the Japanese and International Economies 1:62-8 I. Helpman, Elhanan, and Paul Krugman. 1985. Market structure andforeign trade. Cambridge, Mass.: MIT Press. Kemp, M. C., and Henry Y. Wan. 1976. An elementary proposition concerning the formation of customs unions. Journal of International Economics 6:95-97. Krueger, Anne 0. 1995. Free trade agreements versus customs unions.” NBER Working Paper no. 5084. Cambridge, Mass.: National Bureau of Economic Research, April. Krugman, Paul. 1991a. Is bilateralism bad? In International trade and trade policy, ed. E. Helpman and A. Razin. Cambridge, Mass.: MIT Press. . 1991b. The move toward free trade zones. In Policy implications of trade and currency zones, a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, August. Lawrence, Robert. 1996. Regionalism, multilateralism, and deeper Integration. Washington, D.C.: Brookings Institution. Levy, Philip. 1994. A political-economic analysis of free trade agreements. New Haven, Conn.: Yale University. Unpublished manuscript. Meade, James. 1955. The theory of customs unions. Amsterdam: North-Holland. Saxonhouse, Gary 1993. Pricing strategies and trading blocs in East Asia. In Regionalism and rivalry: Japan and the United States in Pacz3c Asia, ed. Jeffrey Frankel and Miles Kahler. Chicago: University of Chicago Press. Stein, Emesto. 1994. Essays on the welfare implications of transport costs and on political cycles of inflation. Unpublished Ph.D. thesis, University of California, Berkeley. Viner, Jacob. 1950. The customs union issue. New York: Camegie Endowment for International Peace.

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Wei, Shang-Jin. 1995. Attracting foreign direct investment: Has China reached its potential? China Economic Review 6 (2): 187-99. . 1996. Foreign direct investment in China: Source and consequences. In Financial deregulation and integration in East Asia, ed. Takatoshi Ito and Anne 0.Krueger, 77-101. Chicago: University of Chicago Press. Wei, Shang-Jin, and Jeffrey Frankel. 1995. Open regionalism in a world of continental trade blocs. Faculty Research Working Paper Series, no. R95-26. Cambridge,Mass.: Harvard University, Kennedy School of Government. . 1996. Can regional blocs be a stepping stone to global free trade? A political economy analysis. International Review of Economics and Finance 5 (4): 339-47.

Comment

Taeho Bark

First of all, I would like to congratulate the authors for their excellent work. This paper greatly helps us to better understand the various definitions of open regionalism and the welfare implications of regional blocs. The empirical analysis presented in this paper will prove invaluable, particularly to those who are involved in the formulation of regional trade arrangements such as APEC. Since the analysis and the results of this paper are quite clear, I do not have many comments to make with regard to them. However, I have found one major problem in the consistency between the paper’s definition of the openness of regional trade blocs and its methodology for measuring the openness of regional trade blocs. Let me elaborate on this. According to the definition given in the paper’s introduction, in an open bloc, trade barriers set by members of the bloc against nonmembers are lowered at the same time that the barriers among the members are reduced. In the empirical analysis, a positive coefficient on the variable for trade between a member and a nonmember is taken as possible evidence of an open trade bloc. The problem with this is that the definition of an open trade bloc is based on the trade regimes of member countries with respect to outsiders while the empirical analysis is based on the trade volumes. Therefore, a positive coefficient can imply a case in which a member country trades more with outsiders, not because the member country’s trade regime with respect to nonmember countries is more open, but simply because it exports more to outsiders. I think the openness of East Asia should be carefully interpreted. The findings on the openness of the East Asian bloc in this paper could be misleading. Let me now turn to a few minor comments. First, I would like to comment on the authors’ idea that new regional blocs could be required to lower external barriers partially, for example, 10 percent of the degree of intrabloc liberalization. If this requirement were compulsory, intrabloc liberalization negotiations among members would become more difficult with an added dimension when Taeho Bark is vice president of the Korea Institute for International Economic Policy.

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they calculate the costs and benefits. Albeit a good idea, in reality, this proposal would be very difficult to implement. Second, I think it would be interesting to add an additional empirical analysis to this paper for measuring biases of trade between members of two different blocs, for example, between Western European countries and Western Hemisphere countries. Such an analysis can provide at least an empirical base for judging whether the recently raised idea of forming a trans-Atlantic free trade area is appropriate or not. Third, I think it will be useful in the future, when enough data become available, to do similar empirical analyses and compare the openness of actual trade blocs such as the European Union, NAFTA, EFTA, and MERCOSUR. These analyses will be more meaningful because we can examine the effects of actual trade blocs. Finally, I would like to ask whether the model specification in the paper is stable and whether there are possible multicollinearities in the regression model, particularly among dummy variables.

6

Is Regionalism Simply a Diversion? Evidence from the Evolution of the EC and EFTA Tamim Bayoumi and Barry Eichengreen

6.1 Introduction The difficulties of reforming international institutions and practices at the global level provide increasingly powerful impetus for regional economic arrangements. Readers hardly need to be reminded of the prominence of ASEAN and APEC in Asia and the Pacific or of NAFTA and MERCOSUR in the Americas, to list but a few of the familiar acronyms. Of these arrangements, the European Union is the one with the most far-reaching implications. It is the most long lived; in 1997 the Treaty of Rome will turn 40 and the European Union will have reached middle age. Having started life as a customs union (and an atomic energy consortium), the European Economic Community (EEC), as it was initially known, created a regional mechanism for limiting exchange rate flexibility in the 1970s and established an integrated internal market throughout which goods, services, capital, and labor could flow in the 1990s. The Maastricht Treaty negotiated in 1991 provides a framework for the creation of a single European currency, a European Central Bank, and the harmonized social and fiscal policies regarded as concomitants. Observers in other parts of the world thus have good reason to look to Europe in order to gauge the possible future evolution of their own regional arrangements or, for that matter, to identify distinctive features of their own integration processes. In this paper we take a step toward providing the historical perspective they require by reviewing the impact of regionalism in Europe. Tamirn Bayoumi is senior economist with the Central Asia Department of the International Monetary Fund and a research associate of the Centre for Economic Policy Research, London. Barry Eichengreen is the John L. Simpson Professor of Economics and Political Science at the University of California, Berkeley, and a research associate of the National Bureau of Economic Research. The authors thank the discussants, Professors Francis Lui and Chong-Hyun Nam,as well as Takatoshi Ito, Anne Krueger, Donogh McDonald, and Mark Griffiths for useful comments on an earlier draft of this paper.

141

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Since a customs union was the EEC's first economic initiative, trade creation and diversion are the logical starting points. The gravity model has long been the workhorse for empirical studies of the pattern of trade. As in the Newtonian equation after which it is named, attraction (trade) depends on mass (the product of economic size) and distance (geographic or economic).' Specifically, the volume of trade between two countries should increase with their real GDPs (the so-called gravity variable), since large countries should trade more than small ones, and with per capita incomes, since rich countries should trade more than poor ones. It should diminish with geographical distance because proximity reduces transportation and information costs. Since the dependent variable in the gravity model is bilateral trade between pairs of countries, each variable (other than distance) is entered in product form. Investigators then add dummy variables for participation in various preferential arrangements (Hamilton and Winters 1992; Frankel and Wei 1993). If one finds a positive coefficient on a dummy variable indicating that two countries participate in the same trading agreement, indicating that these countries trade more with one another than predicted by their incomes and distance, then the conclusion drawn is that the arrangement is trade creating for its members. If there is a negative coefficient on a dummy variable indicating that only one member of the pair participates in a particular preferential arrangement, this is taken as evidence of trade diversion vis-8-vis the rest of the world.2 Results obtained using this approach can be questioned on several grounds. One is that the coefficients on dummy variables for subgroups of countries will pick up all respects in which those countries differ in their trade performance that are not controlled for in the gravity equation. To take an example pursued by Frankel and Wei (1993), if all the countries in a region have a common language, then including a dummy variable for that region but not a measure of language will tend to spuriously attribute the effects of the shared language in encouraging economic links to commercial policy measures. More generally, dummy variables for preferential arrangements serve as catch basins for omitted factors. There is an analogy with early regression studies of the union wage premium in which a dummy variable for union membership was simply added to the wage equation, encouraging the attribution to unionization of the wage effects of unobserved heterogeneity among workers. Related to this is the difficulty of measuring economic distance independent of the trade flows that the investigator seeks to explain. The underlying theory appeals to transactions costs to trade, and in empirical implementation it is posited that such costs should rise with distance. But economic and geographic 1. See Anderson (1979) and Bergstrand (1985). Frankel, Stein, and Wei (1995) have provided a discussion of the theoretical underpinnings of the model. 2. This approach, which we also adopt, takes economic growth within the Community as given. It therefore ignores any benefits to the rest of the world from greater prosperity within Europe generated by the regional integration.

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Is Regionalism Simply a Diversion?

distance are not the same. Insofar as economic distance is mismeasured, its effects may be loaded into the dummy variables intended to capture the effects of regionalism (Bayoumi 1993). A further problem with the gravity model is the omission of third-country effects. It is generally assumed that bilateral trade depends only on economic conditions in the two countries considered. In practice, however, bilateral trade will also depend on competitiveness relative to other countries and markets. More generally, insofar as economic variables in third countries affect trade flows between other country pairs, gravity equations suffer from omittedvariables bias. A final problem arises from the practice of pooling data for industrial and developing countries. While this maximizes degrees of freedom, the relationship between trade and economic characteristics may vary between the two groups of countries. The income elasticity of trade may be different at high and low levels of income or for different types of goods, for example. Transactions costs may have very different structures in countries with more and less articulated markets. Results based on heterogeneous cross sections may therefore suffer from subsample instability and heteroscedasticity. In this paper we develop and implement an approach designed to meet these concerns. Our main focus is on a specification that, while compatible with the basic theory, departs from the standard model in important ways. We estimate our equation in differences rather than levels; thus, unobserved heterogeneity across countries that is constant over time will not contaminate our results. (To return to the analogy with the literature on the union wage premium, recent studies use panel data to estimate the wage equation in first-difference form, identifying the effects of unionism on the basis of the differential change in wages for workers whose union status has changed. Following the same workers minimizes the problems created by forms of unobserved heterogeneity that are constant over time. The same is true of our differenced gravity specification; it eliminates omitted-variables bias due to time-invariant sources of unobserved heterogeneity.) We augment the specification to include the real exchange rate vis-a-vis the United States to control for third-country effects. We limit our sample to 21 industrial countries to reduce the danger of conflating distinct industrial and developing country effects; it is the fact that the resulting sample is heavily European that leads us to focus on the European Community and the European Free Trade Association (EFTA). And we analyze successive cross sections as a way of identifying differences over time in the tradecreating and trade-diverting effects of European regionalism. The rest of the paper is organized as follows. Section 6.2 describes the data and specification used in our empirical analysis. Section 6.3 reports and discusses the results. Section 6.4 provides comparisons with other studies and presents our own results using the standard gravity formulation. Section 6.5 draws out the implications for regionalism in Europe and Pacific Asia.

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6.2 Data and Specification The typical gravity model specification relates bilateral trade to income, population (or per capita income), and distance between the trading partners: (1)

log(TRADE,,,) = a + B, log(Y,Y,J + B, lOg(e,q + B, (DIST,,),

where TRADE,, is bilateral trade between countries i andj at time t (measured in U.S. dollars), Y is real income (the so-called gravity variable), P is population, and DIST is distance. As trade is expected to increase with size and per capita income and to decline with distance, B, should be positive, B, and B, negative. We estimate this equation after adding a measure of the deviation of the exchange rate from purchasing power parity (PPP). One of the difficulties in measuring economic size across countries is that exchange rates appear to deviate from the values implied by the relative prices of goods, and it is unclear whether output should be measured in terms of current exchange rates or their PPP counterparts. Market rates measure current buying power more accurately. However, PPP rates provide a better measure of relative living standards. This is particularly true for the industrial countries, where recent research indicates a tendency for exchange rates to revert to PPP over the long term., And it is not clear whether the gravity term in equation (1) is properly based on a measure of income or wealth. In our specification, real output is measured at PPP levels and a term in the product of deviations of both exchange rates from PPP was added, resulting in the following equation:

(1')

WTRADE,,?) = a + B,log(Y,Y,) + B , l ~ g ( e , ~ , ) + B,(DIST,) + B,log(R,, R,,),

where R, is country i's real exchange rate vis-8-vis the United States and other variables are defined as above. Our alternative specification also uses bilateral trade data but focuses on changes over time:

(2)

dlog(TRADEE,,)= a

+ B , dlog(Y,Y,,)

+ B,

dlog(4, 4,) + 4 dlog(R*,R,,),

where d is the difference operator. Variables like DIST that are constant over time drop out of this specification. In the tradition of the gravity model, we add dummy variables for membership in preferential arrangements with the objective of analyzing their trade-creating and trade-diverting effects. Equation (2) has several advantages. First, to the extent that economic dis3. This is less true of a comparison of developing and industrial countries, where exchange rates appear to consistently deviate from PPP values due to differences in productivity between traded and nontraded goods sectors (the Balassa-Samuelson effect).

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Is Regionalism Simply a Diversion?

tance and other, unobserved country characteristics influencing the volume of trade are constant over time, problems related to their measurement or omission will not bias our results. Second, including the change in the real exchange rate allows us to analyze third-country effects. If the dollar falls against both currencies, then trade between other countries in terms of dollars will tend to rise. If the rise in the dollar value of trade is proportional, then B, in equation (2) will equal 0.5 (this is because the term is the product of both exchange rates). If dollar depreciation causes some trade to be diverted to other countries, then B, < 0.5. Finally, the constants in equation (2) shed light on the relationship between trade and growth. If the constant is small, this implies that trade and output grow proportionately. If the constant term is negative, then trade expands more than proportionately with changes in output, and conversely if the constant term is po~itive.~ We collected annual data on bilateral trade flows among 21 industrial countries from the machine-readable version of the International Monetary Fund's Direction of Trade Sfatisticx5The data cover the years 1953-92 and were converted to constant dollars using the U.S. GDP deflator.6 Real GDP and deviations of the exchange rate from PPP (which were also used to measure changes in the real exchange rate in our alternative approach) were drawn from the Penn-Wharton World Tables.' We averaged three years of successive, nonoverlapping annual figures to construct our data set. While it would have been possible to estimate the model using the annual data themselves, business cycle effects would have dominated the analysk8 We divided the sample into three overlapping periods: that of the formation of the EEC and EFTA (1956-73); that when the EEC was expanded to include the United Kingdom, Ireland, and Denmark and when the remaining EFTA countries concluded trade agreements with the Community (1965-80); and that when the Community was enlarged to include Greece, Portugal, and Spain (1975-92). We constructed each period so that it began just prior to the events 4.Eiq. (2) does have an important disadvantage. When the gravity model is estimated in levels, it predicts the level of trade. When the rate of change specification is used, it is only possible to analyze whether trade is growing faster or slower than expected. 5 . The countries were the United States, Japan, Germany, France, Italy, the United Kingdom, Canada, Australia, Austria, BelgiumLuxembourg, Denmark, Finland, Greece, Ireland, the Netherlands, New Zealand, Norway, Portugal, Spain, Sweden, and Switzerland. 6 . The U.S. GDP deflator rose nearly 1 percent per annum faster than the export deflator over the period. This should be borne in mind in interpreting the constant terms. 7. In the alternative approach we experimented with various methods of calculating the real exchange rate. As they made little difference, we chose to use the PPP values. Distances between major cities, which were needed for the traditional gravity model, were obtained from U.S. Air Force Aeronautical Charts for bilateral links in which one or both countries were outside of Europe, and from Rand McNally otherwise. Hence, distances within Europe were measured in terms of distances by road, those outside in terms of air miles. 8. Three-year averaging was a compromise between the desire to focus on secular rather than cyclical effects and the wish to distinguish as many separate periods as possible. We also experimented with four- and five-year averages, which in practice yielded very similar results.

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Table 6.1

Results from Traditional ‘‘Level’’ Gravity Model and from “Rate of Change” Version

Variable

Level of Trade

Change in Trade

Log of GDPs at PPP Log of populations Log of deviations from PPP Log of distance Constant

1.39 (.03)** -0.66 (.03)** 0.58 (.06)** -0.77 (.01)** -1.44 (.51)**

1.25 (.07)** -1.12 (.17)** 0.38 (.04)**

Dummy variables 1957-59 1960-62 1963-65 1966-68 1969-7 1 1972-74 1975-77 1978-80 1981-83 1984-86 1987-89 1990-92

-0.14 (.08) -0.29 (.08)** -0.50 (.08)** -0.71 (.08)** -0.85 (.08)** -0.99 (.09)** - 1.08 (.09)** -1.19 (.lo)** -1.16 (.09)** -1.18 (.09)** -1.37 (.lo)** -1.49 ( . I I ) * *

-0.09 (.07)** -0.08 (.03)** -0.10 (.03)** -0.14 (.02)** -0.08 (.02)** 0.01 (.03) -0.02 (.02) -0.03 (.02) -0.03 (.02) -0.03 (.02) -0.04 (.03) -0.05 (.02)**

Implied percentage reduction in trade due to time dummies (percent per annum)

-4.1

-1.9

R2

0.89

0.49

Note: All standard errors are adjusted for heteroscedasticity. #Significant at the 10 percent level. *Significant at the 5 percent level. **Significant at the 1 percent level.

in question; this enables us to examine whether the trends in trade commonly attributed to changes in preferential arrangements in these periods were in fact already evident in prior years.

6.3 Results We estimate both the traditional gravity model and our alternative specification over the entire three-decade period. For the traditional model, estimation runs from 1954-56 to 1990-92, while for the first-difference specification it runs from 1957-59 to 1990-92 (the first period being used in data construction). Table 6.1 reports the coefficients on the product of real GDPs, population, the real exchange rate, and, in the case of the traditional model, distance and the constant term, as well as dummy variables for each three-year period. The behavioral variables are correctly signed, highly significant, and plausible in

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Is Regionalism Simply a Diversion?

magnitude. In the traditional model, the coefficient on the gravity term is around 1.4. Since that term is the product of the two countries' GDPs, this implies an elasticity of trade with respect to changes in GDP of 3, consistent with the tendency for trade to grow faster than income over the postwar per i ~ dAt . ~-0.66, the coefficient on the product of the populations implies elasticities on both the product of GDP and the product of GDP per capita of twothirds. The coefficient on the deviation of the exchange rate from PPP is 0.58, about half the value of the gravity coefficient. This implies that both measures of relative GDP-at PPP exchange rates and at current exchange rates-matter for trade. The coefficient on distance implies that each percentage point increase in that variable reduces trade by 0.77 percent.'O The coefficients on the behavioral variables in the first-difference formulation are broadly similar to those in the traditional model, although their precision, as measured by the standard errors, is lower. The differenced specification gives rather more weight to per capita as opposed to aggregate GDP. The coefficient on the change in the real exchange rate against the dollar is also somewhat smaller. At significantly less than 0.5, it implies a role for thirdcountry effects in the determination of bilateral trade. The coefficients on dummy variables for each period from 1957-59 to 1990-92 are also reported. In the traditional model they imply that the constant in 1990-92 is 1.49 below the corresponding constant term in 1954-56, reflecting the steady downward trend of the constant over time. Apparently, the estimated coefficients on the behavioral variables overstate the growth in trade, other variables held constant, requiring a compensating fall in the constant, This reduction in the constant implies a 4.1 percent per annum fall in real trade after controlling for the other determinants featured in the standard gravity formulation, which seems implausibly large-too large, that is, to be explained by differences in the growth of the implicit deflators for trade and for overall GDP." This points to the likelihood of model misspecification. The results of estimating the constant terms in the first-difference formulation are also reported in table 6.1. The standard errors of the coefficients on the time-specific constants are significantly smaller than in the traditional formulation, a result that carries over when dummy variables for trade blocs are added (see below). While most of the time-specific constants are still negative, 9. For those, including ourselves, who regard this elasticity as implausibly large, this may be evidence of model misspecification. We return to this possibility below. Further evidence on the relationship between trade and growth in the industrial countries after World War I1 is provided by Irwin (1995). 10. Experimentation with alternative formulations of the distance variable, such as adding the square and cube of the logarithm of distance or including the absolute value of distance rather than its logarithm, produced some discernible changes in the estimated effect of distance. However, none of these alternative formulations significantly altered the coefficients on the other variables in the model. 11. Recall that the volume trade of trade is calculated using the GDP deflator for the United States.

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Table 6.2

Results from "Rate of Change" Gravity Model over Different Periods

Variable Change in GDP at PPP Change in population Change in real exchange rate vs. U.S. dollar Time-constant terms 1956-58 1959-6 I 1962-64 1965-67 1968-70 1971-73 1975-77 1978-70 1981-83 1984-86 1987-89 1990-92

1956-73

1966-80

1975-92

1.52 (.11)** -0.45 (.25)'

1.29 (.11)** -1.56 (.31)**

0.95 (.09)** -0.77 (.29)**

0.36 (.09)**

0.44 (.05)**

0.30 (.05)**

-0.19 -0.15 -0.18 -0.28 -0.25 -0.13

(.06)** (.06)** (.06)** (.05)** (.06)** (.06)*

-0.15 (.05)**" 0.03 (.06Y 0.00 (.05) -0.04 (.04) -0.08 (.04)*

-0.03 (.05) 0.03 (.04) -0.03 (.04) -0.03 (.04) -0.07 (.04)' -0.06 (.03)*

Note: All standard errors are adjusted for heteroscedasticity. "Period is one year later than indicated. 'Significant at the 10 percent level. *Significant at the 5 percent level. **Significant at the 1 percent level.

the implied fall in real trade over the period, at 1.5 percent per annum, is smaller than that suggested by the traditional formulation. There is a break around 1970, the constant terms being negative and significant prior to this but small and insignificant subsequently. This suggests a change in the relationship between trade and growth around the time of the breakdown of the Bretton Woods system and the New Protectionism that accompanied the slowdown in industrial country growth. Table 6.2 shows corresponding results for the first-difference specification distinguishing the three periods on which we focus in the remainder of the paper: 1956-73, 1966-80, and 1975-92. (These regressions add dummy variables to capture the impact of free trade agreements.) The coefficients on the behavioral variables are correctly signed for each subperiod. There is some evidence of a decline over time in the tendency for the growth of trade to outstrip the growth of income, consistent with the idea that trade has been catching up to its potential level following the tariff warfare of the 1930s and the Great Depression. The coefficient on population growth is less well determined, presumably reflecting limited variation in the growth of population over time. The coefficient on the real exchange rate is uniformly large and significant. While its value differs from period to period, there is some evidence on balance that third-country effects are important for bilateral trade flows. The

149

Is Regionalism Simply a Diversion?

constant terms follow the pattern observed in the regression for the entire sample. 6.3.1 The Formation of the EEC and EFTA Capturing the effects of preferential arrangements involves including dummy variables. For the regression covering the 1956-73 period, five dummies associated with the EEC and EFTA were added. These measure trade within the EEC,'* trade within EFTA,13 trade between the EEC and E R A , trade between the EEC and other industrial countries, and trade between EFTA and other industrial countries. Each dummy is then multiplied by the relevant time-specific constant terms to differentiate the impact of preferential arrangements over time. Consider first the results for the six founding members (EC6) of the EEC. There is little evidence in table 6.3 that trade among the Six was already increasing faster in the second half of the 1950s (prior to the founding of the EEC) than predicted by the arguments of the gravity model. The coefficient on the dummy variable representing trade among future EEC members, at 0.02 for 1956-58, is statistically insignificant. As the equation is in logarithms, this implies that trade among the six future members of the Community grew by a total of just 2 percent more between 1953-55 and 1956-58 than would have been predicted by their economic characteristics and the average behavior of countries in the sample. The coefficient for 1959-61, immediately after the founding of the EEC, is five times as large and significant at the 10 percent level. This contradicts widespread skepticism about the trade-creating effects of the EEC, commonly expressed on the grounds that long-standing economic ties and the legacy of prior regional initiatives like the European Payments Union and the European Coal and Steel Community (whose membership was coincident with the Six) caused these countries to trade disproportionately with one another not because of their nascent customs union but due to other, unobservable characteristics correlated with and spuriously attributed to EEC membership. Our results suggest that insofar as those unobservable characteristics were constant between 1956-58 and 1959-61, they cannot explain the increasing tendency for the six countries to trade with one another following the founding of the Community. Other potential explanations of this differential increase in trade, such as a beneficial trade structure (e.g., the income elasticity of trade in manufactures may be higher than the corresponding elasticity for primary goods), would also still have to explain why these effects would be so much smaller immediately prior to the formation of the EEC than they were immediately after. The coefficient on intra-EEC trade remains large and significant through 12. Comprising BelgiudLuxembourg, France, Italy, the Netherlands, and West Germany. 13. Comprising, over this period, Austria, Denmark, Finland, Noway, Sweden, Switzerland, and the United Kingdom. Iceland and Liechtenstein were also members but were excluded from the estimation due to their small size.

Table 6.3 Variable

Effects of European Free Trade Agreements: 1956-73 1956-5 8

1959-61

1962-64

1965-67

1968-70

.I1 (.06)# .02 (.06)

.I1 (.07)* .01 (.06)

.15 (.04)** .I6 (.04)**

.I3 (.05)** .21 (.05)**

1971-73

Implied Accumulated Percentage per Annurn

~~

EC6 with itself EFTA7 with itself

.02 (.06) .01(.06)

EC6 with EFTA7

.02 (.06)

-.09 (.06)

With other industrialized countries EC6 -.03 (.06) -.OO (.07) ERA7

-.I1 (.06)' -.I1 (.06)'

-.I0 (.06)

-.08 (.07) -.06 (.06)

-.02 (.03)

.02 (.04) .08(.My

- .02 (.03)

(.04) .02 (.W)

- .06

.04 (.04) .02 (.05)

3.2** 2.3**

- .05 (.04)

-IS*

-.05 (.04) .02 (.04)

- 1.7* -0.8

Notes: EC6 comprises BelgiumKuxembourg, France, Italy, the Netherlands, and West Germany. ERA7 comprises Austria, Denmark, Finland, Norway, Sweden, Switzerland, and the United Kingdom over this period. Other members of EFTA at the time, but not included in the estimation, are Iceland and Liechtenstein.All standard errors are adjusted for heteroscedasticity. #Significant at the 10 percent level. *Significant at the 5 percent level. **Significant at the 1 percent level.

151

Is Regionalism Simply a Diversion?

1970 before fading in 1971-73. As reported in the last column of the table, these estimates imply that trade among the Six grew 3.2 percent per annum faster than can be explained by their observable economic characteristics and the average behavior of countries over the full 1953-73 ~amp1e.I~ The next row focuses on the experience of the members EFTA (EFTA7). Although the Stockholm Convention founding EFTA was signed in 1960, the free trade area only came into operation in 1965. Again, we find evidence that the agreement caused trade among the participating countries to expand significantly. Up to 1964 the growth of trade between EFTA members was within 1 or 2 percent of the rate predicted by the gravity model. After the free trade area came into operation, however, trade within EFTA expanded faster than otherwise explicable, the cumulative increase reaching 45 percent by 1970. The growth of intra-EFTA trade then reverted to the levels predicted by the model. But since the model is in differences, the impact on the volume of trade of the creation of EFTA does not disappear in the 1970s and subsequently. Over the entire period, trade between members of EFTA is estimated to have expanded at a highly significant 2.3 percent per annum faster than predicted by the standard gravity variables, with nearly the entire spurt occumng in the late 1960s. The next row of table 6.3 shows the behavior of trade between the EEC and EFTA. After growing unexceptionally before 1959, trade between the two blocs fell in the five years following the formation of the EEC, the cumulated decline reaching exp(-.19) = -17 percent. Since EFTA did not come into operation until 1965, it seems reasonable to attribute this contraction to the formation of the EEC. The estimated coefficients on this variable remain negative after 1965, indicating a continued reduction in EEC-EFTA trade relative to what might be expected. However, the sizes of the coefficients decline after 1965, the implied reduction in the growth of trade per annum being only about one-third the earlier rate. Over the entire period, the growth of trade is 1.5 percent per annum slower than is explicable in terms of the other observable characteristics of the countries involved. The last two rows of table 6.3 report coefficients on dummy variables representing trade between the EEC and EFTA on the one hand and the remaining industrial countries on the other. For the EEC, where all but one of the estimated coefficients are negative, there is some evidence of trade diversion. But of the individual coefficients, only that for 1959-61, the period immediately after the formation of the EEC, differs significantly from zero (at the 10 percent level). For the period as a whole, trade between the EEC and industrial countries that were not members of the EEC or EFTA fell at a statistically 14. This value was calculated by an ancillary regression in which the EEC and EFTA dummy variables were included without time-specific dummies, which is equivalent to measuring the differential expansion in trade over the entire period. This is why the value is accompanied by an estimate of its statistical significance.

152

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Table 6.4

Industrial Country Trade Patterns for the EEC and EFTA, 195670 (percentageof trade with industrial countries)

Trade Measure

EC6 with EC6 EFTA7 Other industrial countries Implied growth per annum in overall trade With all industrialized countries Considering just EC6 Trade creation ratio

EFTA7 with EFTA7 EC6 Other industrialized countries Implied growth per annum in overall trade With all industrialized countries Considering just EFTA7 Trade creation ratio

1956-58

1962-64

1968-70

44.1

53.4 25.6 21.0

60.8 19.8 19.4

29.7 26.2 0.52 1.41 0.37 27.1 36.4 36.5

0.55 0.62 0.88

Memorandum Industrial country trade as a percentage of total trade EC6 66.3 EFTA7 70.0

0.97 1.71 0.57 29.1 40.2 30.7 0.68 0.67 1.01

73.3 71.7

1.32 1.95 0.68 32.3 38.0 29.1 0.64 0.74 0.86

75.7 74.0

significant 1.7 percent per annum relative to expectations, a reduction similar to that experienced by the EFTA countries themselves. While there was also a reduction in EFTA's trade with the rest of the world, relative to what would have been predicted by the gravity model, of around 0.8 percent per annum between 1956 and 1973, virtually all of this occurred prior to the creation of the free trade area in 1965. Indeed, the results indicate that trade with the rest of the world actually increased relative to expectations from 1965 to 1973. These results paint contrasting pictures of the early years of the EEC and EFTA. Both European arrangements promoted trade among their members. In the case of the EEC this appears to have been accompanied by a fall in trade relative to expectations with both EFTA and the remainder of the industrial world, suggesting trade diversion. For EFTA the evidence of trade diversion is less clear. EFTA trade with both the EEC and other industrial countries grew only slightly slower than expected over the period as a whole. Most of the reduction in both cases occurred in the early 1960s, prior to the EFTA free trade area's coming into operation. Table 6.4 reports a measure of the relative importance of trade creation and trade diversion. Its upper part shows the percentage of EEC trade with industrial countries destined for the EEC itself, for EFTA, and for other industrial

153

Is Regionalism Simply a Diversion?

countries. These percentages are then combined with the expansion or contraction of trade relative to expectations to calculate the implied increase in overall EEC trade. Using the trends in trade over the entire period in the last column of table 6.3, the overall expansion of EEC trade is estimated to have been 0.5-1.25 percent per annum, with the estimated value rising over time as an increasing proportion of EEC trade remains within the Community, where trade rises at a trend rate of 3.2 percent per annum. Meanwhile, a declining proportion of EEC trade takes place with EFTA and other industrial countries. This calculation is then repeated, taking into account only the expansion of trade with other members of the EEC. The figure that results represents the expansion in overall trade with industrial countries that would have occurred had no trade diversion taken place. The ratio of the two values represents the share of the expansion of intra-EEC trade that did not result in trade diversion. We refer to this as the “trade creation ratio.” Consider, for example, these calculations for 1962-64, which can be interpreted in the following way. If the 3.2 percent per annum expansion of trade within the EEC had been accompanied by no decrease in trade elsewhere, trade with all industrial countries would have grown annually by 1.8 percent. In fact, it increased at little over half this rate. Hence, around half the increase in intraEEC trade was offset by losses e1~ewhere.l~ As already noted, evidence of trade diversion is less strong for EFTA, as the relative decline in trade with the EEC and the rest of the world occurred largely prior to the formation of the free trade area in 1965. If there was no fall in trade with other countries, of course, then all of the increase in trade within EFTA reflects trade creation. Our calculations in table 6.4 assume that intraEFTA trade rose by 2.3 percent per annum, trade with the EEC remained constant, while trade with other industrial countries (excluding members of the EEC) fell by 0.8 percent per annum. On this basis, overall EFTA trade is estimated to have expanded by about 0.6 percent per annum and there is little or no trade diversion. All of these calculations refer exclusively to trade creation and trade diversion vis-8-vis industrialized countries. Table 6.4 also reports the share of trade with industrial countries in total trade for each group of countries and hence, by inference, trade with developing nations. The latter proportion declined for both the EEC and EFTA over the period, with a particularly large fall (from one-third to one-quarter) in the case of the EEC. This reduction could of course have reflected slower growth in this part of the world and differences in output elasticities between the manufacturing goods primarily produced by industrial countries and the primary goods more often produced by developing countries. Without expanding the scope of the study to include data on developing coun15. This calculation involves strong assumptions. All of the trend reduction in trade between the EEC and members of EFT’ is assumed to reflect trade diversion by the EEC, e.g. If some of the reduction in trade between the two blocs was caused by E R A , then the estimated rate of increase of actual trade, and hence the share of trade creation, would be higher.

154

Tamim Bayoumi and Barry Eichengreen

tries, no definitive answer can be given to this question. But it is conceivable that the results could be significantly affected. For the EEC, for example, if trade with the developing world lagged behind its expected rate of increase by the same 1.7 percent per annum found for trade with other industrial countries, this reduces the trade creation ratio to 20 percent.16 6.3.2 The First Enlargement Table 6.5 reports the dummy variable coefficients for the period 1966-80. The results focus on the United Kingdom, Denmark, and Ireland, the three countries that joined the EEC in 1973. (The United Kingdom and Denmark left EFTA, and several remaining EFTA countries negotiated free trade agreements with the Community at that time.) The first three rows report the coefficients on dummy variables for trade among the United Kingdom, Denmark, and Ireland, between these three countries and the six founding members of the EEC, and between the United Kingdom and Denmark and the remaining five members of EFTA. Prior to 1971, trade between these three countries and the EEC was falling, while that between the United Kingdom and Denmark on the one hand and the rest of EFTA on the other was rising. Trade among the three countries themselves shows no unusual trend. To the extent that trade between these countries and the founding members of the EEC expanded subsequently, this was not attributable to factors that had already caused trade among these countries to grow disproportionately in prior years. It should be noted that the trend increase in trade between the United Kingdom and Denmark and the other members of EFTA, as well as the trend decline in trade between the United Kingdom, Denmark, and Ireland and the EEC, was smaller than the corresponding trends for the remaining members of EFTA. Both the EEC and the other members of EFTA showed pronounced increases in internal trade (3.0 percent per annum within the EEC and 6.8 percent between the remaining five members of EFTA) and decreases in trade with each other, in line with the results for the earlier period in table 6.3. Insofar as these trends are less distinct for the United Kingdom and Denmark, it is possible to identify a sense in which these future EEC members behaved differently from the remaining EFTA countries.” Table 6.5 also reports results for a crumbling trade bloc: the British Commonwealth.’*Trade between the United Kingdom and the Commonwealth declined at a highly significant annual rate of 4.0 percent per annum prior to 1971. From these results it is clear that the disintegration of preferential ar16. This calculation uses 1962-64 weights. 17. Trade between the United Kingdom, Denmark, and Ireland and other industrial countries and that between the remaining members of E R A and other industrial countries show no particular pattern, while there is a significant fall compared to expectations in the equivalent trade for the EEC. 18. As only industrial countries are considered, the Commonwealth consists of Australia, Canada, and New Zealand.

Table 6.5

Effects of European Free Trade Agreements: 1966-80 Implied Accumulated Percentage per Annum

Variable

1966-68

1969-7 1

1972-74

.04 (.07)

.01 (.12)

-.18 (.08)*

1975-77

1978-80

1966-71

1972-80

-.09 (.14)

.14 (.09)

0.7

.22 (.05)** -.04 (.06)

.I6 (.05)** -.01 (.05)

-1.6 2.8*

5.9** -1.2

United Kingdom, Denmark, Ireland with each other United Kingdom, Denmark, Ireland with EC6 United Kingdom, Denmark with EFTAS

-.02 (.04) .12 (.04)**

-.07 (.07) .04 (.06)

- .06 (.04)

EC6 with itself EFTAS with itself EC6 with EFTA5

.13 (.03)** .22 (.05)** - .06 (.04)#

.05 (.06) .18 (.06)** -.I0 (.05)'

- .02 (.04) -.04 (.04)

.02 (.04) -.02 (.05) .04 (.04)

.02 (.04) -.06 (.04) .07 (.04)'

3.0** 6.8** -2.6*

-1.3 0.6

United Kingdom with Commonwealth

-.I3 (.04)**

-.I3 (.05)**

-.32 (.03)**

-.16 (.04)**

-.I5 (.03)**

-4.0**

-6.7**

With other industrialized countries United Kingdom, Denmark, Ireland EC6 ERA5

.01 (04) -.01 (.04) .05 (.04)

.01 (.05) -.lo (.05)" -.04 (.04)

.05 (.03) .01 (.03) -.02 (.04)

.03 (.04) .04 ( 0 4 ) -.01 (.05)

.I6 (.04)** .05 (.04) .01 (.04)

- 1.8"

.14 (.04)** .02 (.03)

0.0 0.0

-1.5

0.5

2.6** 1.o 0.0

Notes: EC6 comprises Belgiurduxemhourg, France, Italy, the Netherlands, and West Germany. EFTA5 comprises Austria, Finland, Noway, Sweden, and Switzerland. Iceland and Liechtenstein were also members of EFTA over this period. The Commonwealth comprises Australia, Canada, and New Zealand. Numerous other developing countries were also members of the Commonwealth over this period. All standard errors are adjusted for heteroscedasticity. "Significant at the 10 percent level. *Significant at the 5 percent level. **Significant at the 1 percent level.

156

Tamim Bayoumi and Barry Eichengreen

rangements can alter the direction of trade as powerfully as the formation of new ones. The results after 1972 are very different. Trade among the United Kingdom, Denmark, and Ireland declined after the accession of these countries to the EEC, most dramatically in the immediately subsequent years. Presumably because there existed a bilateral free trade arrangement between the United Kingdom and Ireland and because the United Kingdom and Denmark were both members of EFTA, EEC membership produced no direct gain in terms of trade creation within this group; indeed, trade fell relative to expectations formed on the basis of the gravity model. This decline plausibly reflects a reorientation of trade from within this group to the rest of the EEC. Trade between the three new members and the original six expanded significantly relative to expectations, at a rate of 5.2 percent per annum between 1972 and 1980. At the same time the exceptional expansion of trade among the Six came to an end. Trade between the United Kingdom and Denmark on the one hand and the remaining members of EFTA on the other declined after the two countries joined the EEC. This decline proceeded at almost exactly the same rate, however, as the decrease of trade among the EFTA countries themselves. The defection of the United Kingdom and Denmark, together with the signing of trade arrangements with the newly expanded EEC, appears to have created a trend decrease in the growth of intra-EFTA trade. However, these arrangements with the EEC do not appear to have reversed the earlier trend decline in trade relative to expectations between the two trade blocs. Rather, trade now moved in line with that predicted by the model. Trade between the United Kingdom, Denmark, and Ireland and the rest of the world grew significantly faster after 1972 than predicted by the model. Whatever the barriers to trade between the EEC and the rest of the world, in other words, these were generally less onerous than previous arrangements in these countries. The exception is trade between the United Kingdom and the Commonwealth, whose decline accelerated after Britain’s accession to the EEC; significant new impediments were apparently created in this case.I9 Table 6.6 analyzes the degree to which the EEC’s first enlargement created and diverted trade. It shows the proportion of the total trade of the three new member states and all industrial countries directed toward one another and toward the original six.2oThe implied increase in overall trade is then calculated using trends in trade from 1972 to 1980, reported in the last column of table 6.5. These calculations imply that between 60 and 90 percent of new trade with the EEC was trade creation.*’ 19. Trade between the original EEC countries and the remaining EFTA countries on the one hand and the rest of the world on the other shows no pattern over and above that predicted by the model. 20. It also considers trade between the United Kingdom and Denmark and the remaining EFTA members; between the United Kingdom and the Commonwealth; and between the United Kingdom, Denmark, and Ireland and other industrial countries. 21. Again, however, there appears to be a marked decrease i n the proportion of trade with developing countries.

157

Is Regionalism Simply a Diversion?

Table 6.6

Industrial Country lkade Patterns for the United Kingdom, Denmark, and Ireland: 1969-80 (percentage of trade with industrial countries)

Trade Measure

United Kingdom, Denmurk, Ireland With each other With EC6 United Kingdom, Denmark with EFTA5 United Kingdom with Commonwealth With other industrialized countries Implied growth per annum in overall trade: With all industrialized countries Considering just EC6 Trade creation ratio

Memorandum Industrial country trade as a percentage of total trade

1969-7 1

1978-80

16.2 29.7 18.8 12.4 22.9

14.7 44.7 16.3 4.8 19.5

1.05 1.75 0.60 69.3

2.41 2.64 0.91 74.0

6.3.3 The Second Enlargement The final period considered, 1975-92, spans the second enlargement of the European Community (as the EEC had by then renamed itself), Greece being admitted in 1981 and Spain and Portugal in 1986. As can be seen in table 6.7, Greek trade with the European Community had begun to expand unusually rapidly as early as 1975-77; this cautions against attributing the entire growth of Greece’s EC trade to the country’s admission to the Community. Greece was undergoing significant economic liberalization in the late 1970s, and trade with the rest of the world in fact expanded even faster than trade with the Community between 1975 and 1977. Trade with other industrial countries then went into decline between 1978 and 1983, around the time of EC admission, with a drop relative to expectations of exp(- .46), or 37 percent. This decline was not reversed subsequently. The growth of trade between Spain and Portugal and the European Community (including Greece) also accelerated prior to entry, although these increases became much more dramatic after 1986.22More striking than the growth of Spain and Portugal’s trade with the European Community was the very rapid expansion of their trade with one another. Between 1978 and 1992 the two countries’ bilateral trade grew by exp( 1.79), or 599 percent more than predicted by the model. The rapid increase in trade with other EC members was accomplished with little or no decrease in trade with other industrial countries. Clearly, this is a case where admission to the Community was strongly trade creating. Our other findings for the period of the second enlargement are generally plausible. The differential expansion of trade among the United Kingdom, 22. As in the case of Greece, this may reflect general liberalization of the trade regime.

Table 6.7

Effects of European Free Trade Agreements: 1975-92

Variable Greece with EC9 Spain, Portugal with each other Spain, Portugal with EClO EC6 with itself United Kingdom, Denmark, Ireland with each other United Kingdom, Denmark, Ireland with EC6 EFTAS with itself EC9 with EFl'A5 United Kingdom with Commonwealth

1975-77 .06 (.03)# -.I7 (.04)** -.08 (.04)'

.06 (.05) -.05 (.14) .26 (.05)** .04 (.05)

1978-80

1981-83

.07 (.09) .27 (.04)** .03 (.03) .01 (04)

-.07 (.04)

.01 (.09)

-.06(.10)

1984-86

1987-89

1990-92

.01 (.04) .28 (.03)** .09 (.03)**

.08 (.03)** .70 (.04)** .26 (.04)**

.09(.03)** .31 (.04)** .20 (.03)**

2.0** 8.9** 2.9**

0.0 1

.02 (.04)

.I2 (.03)**

.04(.03)

-.04 (.04)

.08 (.04)"

p.01 (.04)

.I2 (.05)* -.I0 (.05)*

Average over Period

-1.3

2.6**

.06 (.05)

.04 (04)

.01 (.04)

-.17 (.05)**

-.21 (.04)**

-.I5 (.04)

.I7 (.Il) -.07 (.M) .07 (.05) .05 (.05) .02 (.06)

-.23 (.08)** p.09 (.05)* -.01 (04) .09 (.04)* -.01 (.05)

- .04 (.06)

.I2 (.03)** -.02 (.07)

.06 (.03)*

1.9* 0.6

-.07 (.05)

-4.9** -1.7 -0.4 0.6 1.o 1.3'

With other industrialized couniries

Greece Spain, Portugal EC6 United Kingdom, Denmark, Ireland EFTA5

.04 (.07) .08 (.04)*

- .02 (.05)

.06 (.05)

.04(.03)

.05 (.02)**

-.02 (.06)

.03 (.04)

.I5 (.03)**

.02 (.05)

.10 (.04)*

Notes: EC6 comprises Belgiufiuxembourg, France, Italy, the Netherlands, and West Germany. EC9 adds Denmark, Ireland, and the United Kingdom to this group, while EClO also includes Greece. EFTAS comprises Austria, Finland, Norway, Sweden, and Switzerland. Other members of E R A at this time were Iceland and Liechtenstein. The Commonwealth comprises Australia, Canada, and New Zealand. Numerous other developing countries were also members of the Commonwealth over this period. All standard errors are adjusted for heteroscedasticity. #Significantat the 10 percent level. *Significant at the 5 percent level. **Significant at the 1 percent level.

159

Is Regionalism Simply a Diversion?

Table 6.8

Industrial Country Trade Patterns for Greece, Spain, and Portugal: 1978-92 (percentage of trade with industrial countries)

Trade Measure Greece with EC9 Other industrialized countries

Implied growth per annum in overall trade With all blocs Considering just EC9 Trade creation ratio Spain and Portugal wirh Each other EClO Other industrialized countries

Implied growth per annum in overall trade With all blocs Considering just EClO Trade creation ratio

1978-80

1984-86

1990-92

70.7 29.3

76.7 23.3

77.9 22.1

0.92 1.41 0.65 3.0 67.4 29.6 2.10 1.96 1.07

Memorandum Industrial country trade as a percentage of total trade 71.8 Greece Spain and Portugal 62.2

1.14 1.53 0.74 4.2 68.8 27.0 2.25 2.00 1.13

72.2 68.0

1.18 1.56 0.76 8.4 73.9 11.7 2.80 2.14 1.31

71.2 79.4

Denmark, and Ireland evident in the earlier period slowed in the 1980s,and EFTA began to show signs of unraveling. While EFTA's trade with the rest of the world showed some expansion in the 1980s, there was a differential decline in intra-EFTA trade after 1978. EFTA's trade with the European Community expanded, which can be interpreted in terms of EFTA's trade becoming increasingly multilateralized. Finally, the long decline in the relative importance of trade between the United Kingdom and other Commonwealth countries finally wound down in the mid-1980s. According to table 6.8, somewhere between two-thirds and three-quarters of Greece's additional exports to and imports from the rest of the European Community represented trade creation. Accession appears to have been supertrade creating for Spain and Portugal in the sense that the expansion of trade exceeded that implied by the increase in trade between these countries and the rest of the Community, a result that mainly reflects the expansion in trade between the two countries themselves. It is also worth noting, however, the particularly striking fall in percentage of trade with developing countries in this case. Overall, then, we find strong effects of preferential trade agreements on the pattern of Europe's trade. Intra-EEC trade increased from the Community's inception in ways that cannot be attributed solely to a history of intimate trade relations or other unobserved characteristics of the original six omitted from the gravity model. We find that the EEC stimulated the volume of intra-

160

Tamim Bayoumi and Barry Eichengreen

Community trade as early as 1959-61-that is, even while its customs union was still being completed. That intra-EEC trade barriers were progressively reduced over the first half of the 1960s provides a potential explanation. This expansion of intra-EEC trade relative to expectations was accompanied by declines in trade with the rest of the world, implying that the EEC caused some trade diversion in the 1960s. We similarly find evidence of trade expansion within EFTA in its early years. The same pattern is evident in the rapid expansion of trade between the United Kingdom, Denmark, and Ireland on the one hand and the original six EEC members on the other in the period following the first enlargement. Accession produced a pronounced rise in trade with the rest of the EEC, some of which reflected trade diversion, a pattern repeated with the entry of Greece. Only in the case of Spain and Portugal is there no evidence of trade diversion. By the time they joined the Community, however, the exceptionally rapid growth of intra-EC trade had begun to slow, and there were signs of the unraveling of the E R A bloc. Thus, our results confirm that preferential trade arrangements can strongly encourage trade and that the unraveling of such arrangements can reverse those effects. They paint a mixed picture of the trade-creating and trade-diverting effects.

6.4 Comparisons with Other Studies and Approaches It is interesting to ask how our results differ from those obtained in other In this section we therefore compare our findings with those of previous investigators and reestimate their specifications using our data. Three studies that have used gravity models to analyze the effects of the EEC and EFTA are Frankel, Stein, and Wei (1996), Aitken (1973), and De Grauwe (1988). Our results closely resemble those of Aitken and De Grauwe, who estimate the model in level form. Aitken, considering a sample of industrial countries, found that EEC membership had a significant effect on the volume of trade between member states starting in the 1960s. In parallel with our results, he turned up little evidence that membership in the European Coal and Steel Community had stimulated trade in the 1950s. De Grauwe considered bilateral trade flows among 10 industrial countries since the 1960s. He found that EC membership significantly increased trade among the six founding members in the 1960s but no longer had a discernible effect in the 1970s, a contrast that he attributed to increased trade diversion following the admission of the three new members in 1973. But he also found a strong trade-creating effect in the 1970s for the three new entrants themselves. Our results are consistent with his in these respects. Frankel et al. also estimated the gravity model in level form, using a large 23. We confine ourselves to studies using the gravity model methodology. For results from other approaches, see Jacquemin and Sapir (1988) and Balassa (1975).

161

Is Regionalism Simply a Diversion?

Table 6.9

Results for EC Trade of Estimation Using the Traditional Model

Variable EC6 with itself United Kingdom, Denmark, Ireland with each other EC6 with United Kingdom, Denmark, Ireland

1956-73

0.64 (0.12)**

1966-80

1975-92

0.45 (0.11)**

-0.45 (0.13)**

0.93 (0.24)**

-0.45 (0.13)**

-0.32 (0.11)**

-0.45 (0.13)**

Notes; The coefficient in other dummy variables are not reported. All standard errors are adjusted for heteroscedasticity. “Significant at the 10 percent level. *Significant at the 5 percent level. **Significant at the 1 percent level.

cross section of developing and industrial countries for every five years starting in 1965. They found that the European Community only gains significance as a trade-creating force in the 1980s. It is highly significant in 1985 and declines in importance thereafter. Their 1990 estimates suggest that if two countries are both EC members, their bilateral trade will be 70 percent higher than it would have been otherwise. Frankel et a1.k failure to find a significant effect of the European Community prior to 1980 stands in contrast to table 6.3 above. They attributed the pre- and post-1980 difference to the accession of Greece, Spain, and Portugal; our results suggest that this cannot be the entire story. And in contrast to our results, Frankel et al. failed to identify any trade-creating effects of E R A . One reason for the difference between the results of Frankel et al. and the others may be that the dummy variable Frankel et al. used for the European Community included all 12 countries who were members in the early 1990s, even if they were not members during earlier periods. Hence, their earlier regressions included countries in the EC dummy that were not members of the Community in the relevant year. Estimating our first-difference specification including their dummy variable produces exactly the results found by Frankel et al., namely, that the “EC” showed little or no differential trade expansion in the 1960s and 1970s and a significant expansion in the 1980s. Hence, Frankel et al. were correct in supposing that their results reflect the accession of Greece, Spain, and Portugal to the European Community, but only because these countries were also included in the “EC” in their earlier regressions. We also estimated the traditional gravity model on our data, adding dummy variables for preferential arrangements. To avoid a proliferation of results, table 6.9 only reports the results for dummy variables representing the relevant core EC members over the three full sample periods.24A first feature to note is that the standard errors on the dummy variables tend to be larger, although since 24. Complete results on all regressions are available from the authors on request.

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the coefficients are also generally larger, inferences are still possible. While the estimates for 1956-73 and 1966-80 suggest that EC members traded significantly more among themselves than would be expected on the basis of their observable characteristics, consistent with the conclusions drawn from estimates of our first-difference model, those for the 1975-92 period suggest that they traded significantly less-a difference in results that holds for the period for which the two samples overlap and that apparently comes from a large change in the estimated coefficient on income per capita in the 1975-92 regression. These significant differences in results are consistent with our concern that traditional gravity models are liable to misspecificati~n.~~ By contrast, the results using the first-difference specification appear reasonably consistent across overlapping sample periods. 6.5

Conclusions

The increasing number of sovereign nations and consequent problems with global economic institutions appear to be economic facts of life at the end of the twentieth century. Notwithstanding the creation of the World Trade Organization and the effort to establish commercial rules of the road at the global level, this gives grounds for thinking that regional economic arrangements, whose negotiation involves fewer transactions costs, will be the wave of the future. The rise of regionalism has understandably raised the specter of exclusionary blocs and concern over the danger of trade diversion. This paper has asked whether there are grounds for drawing such inferences from the history of regionalism in Europe. We have found that the formation of the EEC and EFTA free trade areas had significant impacts on Europe’s trade that cannot be attributed to the participating countries’ observable economic characteristics or even to unobservable factors, such as histories of intimate trade relations or beneficial trade structures, whose effects remained constant over time. For the founding members, these trade effects were concentrated in the early years of existence of their arrangements. EFTA was heavily trade creating, but the EEC promoted intrabloc trade through a combination of trade creation and trade diversion. This conclusion is reinforced by our results for the first two enlargements of the Community, for which we also find both trade creation and trade diversion effects (the accession of Portugal and Spain, by contrast, led to little if any trade diversion). This is an important caution to those contemplating regional initiatives in Asia and other parts of the world. At the same time, some limitations of the analysis should be recognized. 25. This may be particularly important for a region such as Europe, which includes a large number of countries that are geographically close to each other by the standards of the rest of the world, and hence where the distance variable may be particularly liable to misspecification.

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Is Regionalism Simply a Diversion?

The analytic framework takes no account of the potential impact of preferential trading arrangements on the growth of output in member countries or of the global trend to more openness to trade caused, in part, by a general postwar liberalization of trade. Within the methodology, several potential extensions of the underlying approach could also be considered. One is to differentiate trade in different types of products, such as food or manufactures. In addition to addressing concerns that the underlying behavioral coefficients may vary by type of good, distinguishing between these types of goods is of particular interest for the European community, where one particularly potent source of protection and trade diversion has been the Common Agricultural Policy. Another extension would be to expand the geographical coverage to include developing countries, possibly while allowing these countries to have different behavioral coefficients. Both of these tasks are on our agenda for the future.

References Aitken, Norman D. 1973. The effect of the EEC and EFTA on European trade: A temporal cross-section analysis. American Economic Review 63238 1-92. Anderson, James E. 1979. A theoretical foundation for the gravity equation.American Economic Review 69:106-16. Balassa, Bela. 1975. Trade creation and trade diversion in the European common market: An appraisal of the evidence. In European integration, ed. Bela Belassa, 79-1 18. Amsterdam: North-Holland. Bayoumi, Tamim. 1993. Comment on Frankel and Wei. In The monetary future of Europe, ed. Centre for Economic Policy Research. London: Centre for Economic Policy Research. Bergstrand, J. H. 1985. The gravity model in international trade: Some microeconomic foundations and empirical evidence. Review of Economics and Statistics 67:474-8 1. De Grauwe, Paul. 1988. Exchange rate variability and the slowdown in growth of international trade. IMF Staff Papers 35:63-84. Frankel, Jeffrey, Ernest0 Stein, and Shang-Jin Wei. 1994. APEC and regional economic arrangements in the Pacific. Berkeley: University of California. Unpublished manuscript. . 1995. Trading blocs and the Americas: The natural, the unnatural, and the super-natural.Journal of Development Economics 47:61-95. . 1996. Continental trading blocs: Natural or super-natural?American Economic Review 86 (2): 52-54. Frankel, Jeffrey, and Shang-Jin Wei. 1993. Trade blocs and currency blocs. In The monetary future of Europe, ed. Centre for Economic Policy Research. London: Centre for Economic Policy Research. Hamilton, Carl, and Alan L. Winters. 1992. Opening up trade with Eastern Europe. Economic Policy 14:77-117. International Monetary Fund. Various years. Direction of Trade Statistics. Washington, D.C.: International Monetary Fund. Irwin, Douglas. 1995. The contribution of the GATT to economic recovery in postwar

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Western Europe. In Europe’s postwar recovery, ed. Barry Eichengreen, 127-50. Cambridge: Cambridge University Press. Jacquemin, Alexis, and Andre Sapir. 1988. International trade and integration of the European Community. European Economic Review 32: 1439-49.

Comment

Francis T. Lui

This is an interesting piece of work that attempts to L-termine whe...er regional blocs are trade creating or trade diverting. I will comment on both the methodology and the results.

Methodology The paper tries to estimate a gravity model. However, when regressing volume of trade on the product of GDP of two trading partners and on the product of their populations, the paper uses growth rates rather than levels of these variables. This method has two main advantages. First, unobserved and observed heterogeneity across countries that remains stable over time (such as cultural factors and languages) can be eliminated from the gravity equation. Second, economic distance, which is difficult to measure but is constant over time, also disappears from the equation. This procedure is therefore less vulnerable to the contamination of missing factors. Some caution has to be taken, however. Since the growth rate rather than the level of trade is used, the results should be interpreted differently from those in the literature. For instance, imagine that a trading bloc does have some impact on trade, but that it is a once-and-for-all increase in the level of trade. In this case, the growth rate of trade may remain unaffected even though the trading bloc has some impact on the level. The growth rate of output (or per capita output) is treated as an explanatory variable. In the literature of endogenous growth, with which I am more familiar, this is universally modeled as a dependent variable. It is not hard to construct models that say that an increase in either the volume or the growth rate of trade will raise the growth rate of per capita output. The growth rates of trade and per capita output are both endogenous variables. The authors may need to use instrumental variables to do the estimation so as to avoid possible simultaneity biases. There is a class of endogenous growth models that exhibit the property of multiple equilibria; that is, some countries may be caught at a zero-growth stagnant equilibrium trap while others grow perpetually. These two groups of countries respond differently to changes in the environment. The set of counFrancis T. Lui is director of the Center for Economic Development, Hong Kong University of Science and Technology.

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Is Regionalism Simply a Diversion?

tries in the paper are all developed economies, and therefore none of them are likely to be in the trap. However, once the country set is enlarged, this may no longer be the case. Care must then be taken in the econometric implementation.

Results There are many results in the paper, but the one that deserves more attention seems to be the following. Immediately after the founding of the EEC, trade increased significantly between existing members, but this trade-creating effect waned after 1970. Moreover, the EEC reduced trade significantly with the rest of the world. The effects of EFTA are similar, although less clear. Some remarks can be made on these results. Why did the impact of the EEC on the growth rate of trade gradually die down in the 1970s? One possible answer is that the growth rate of trade was different from the level of trade. Assume that the EEC could raise the level, but not the growth rate. Then the apparent increase in growth rate in the beginning was only an illusion of transitional dynamics. Once the level had gone up, no more change in the growth rate was observed. Frankel, Stein, and Wei (1996), who used a level gravity model, found that regionalism did not have significant impact until around 1980. The timing of the impact was different from that found by Bayoumi and Eichengreen. There are several plausible explanations: (1) The sample periods are different. (2) Frankel et al. used a data set that includes developing countries. (3) One model employs the level gravity model while the other uses the growth rate (or firstdifference) model. (4)There may be simultaneity bias in the growth rate model. The authors seem to believe that item 2 is the explanation. While this may well be the case, further investigation seems to be necessary before a clearer answer is available.

Reference Frankel, Jeffrey, Ernest0 Stein, and Shang-Jin Wei. 1996. Continental trading blocs: Natural or super-natural?American Economic Review 86 (2):52-54.

Comment

Chong-Hyun Nam

This is an excellent piece of empirical work. In this paper, objectives are clearly stated, methodologies are carefully designed, and estimation results are interpreted with the utmost care. The findings and conclusions of the study Chong-Hyun Nam is professor of economics at Korea University.

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also look very convincing because they are based on a rich data set that has been accumulated over the past 40 years of experience with the European Community and EFTA. The highlight of the study is the finding that the creation of the European Community in the 1950s and the creation of EFTA in the 1960s did in fact alter the pattern of trade in a significant way. The impact of these blocs on trade creation and trade diversion turned out to be substantially greater than generally expected. I have a few brief comments on the paper: the first two concern the structure of the estimated equations, and the last is about the implications of the estimation results. First of all, I am a little uneasy about the theoretical foundation of gravity models to explain trade flows between countries. Although this study pursues a variation on the conventional type of gravity model by taking a firstdifference form in variables, the estimated equations are still based on the assumption that large and rich countries should trade more than small and poor countries. One can justify this kind of assumption if all bilateral trade flows represent an intraindustry type of trade with differentiated products. But I wonder whether that is true and whether one can safely ignore country differences in factor endowments or changes in them as determinants of bilateral trade flows. To the extent that these omitted variables are important, the gravity model suffers from misspecification. Such misspecification may be responsible for the unrealistically high value for the estimate of income elasticity of trade, at nearly 3. Second, I think it is an important deviation from ordinary gravity models to include a price variable like real exchange rates of the countries concerned visA-vis the United States as an explanatory variable for trade flows. But the potential contribution of this relative price variable in explaining trade flows is limited to effects through third countries. This is because imports and exports enter symmetrically in the estimating equations as a dependent variable. I feel uneasy about this symmetry assumption and think a test is needed to justify it empirically. Finally, although the gravity model lacks a strong theoretical foundation, it has long been recognized for its consistently high explanatory power with regard to trade flows between countries. So I do have much faith in the estimates of trade creation and trade diversion effects found in the study. According to the estimation results, there were in fact significant trade creation and trade diversion effects, though they were heavily concentrated within the few years immediately after the formation of the European Community and EFTA. The trade effects due to the accession of the United Kingdom, Denmark, and Ireland to the Community in 1972 proved more dramatic. For 1966-71, the annual growth rate of trade between these three countries and the European Community was 1.6 percentage points lower than could be explained by their observ-

167

Is Regionalism Simply a Diversion?

able economic characteristics, but for 1972-80, it was 5.9 percentage points higher than the expected value. These are important findings, particularly for countries who may be contemplating joining an existing trade bloc or forming a new one, possibly inciting them to rush to do so. It is unfortunate, however, that the study did not (or could not) include developing countries in its sample data. Certainly, it would be worthwhile to examine the trade impact of EC formation on developing countries as soon as data permit.

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7

Asia Pacific Capital Markets: Integration and Implications for Economic Activity Menzie D. Chinn and Michael Dooley

7.1 Introduction The measurement of capital market integration in the Pacific Basin typically takes the form of tests of interest rate parity conditions, the extent of interest rate covariations, or estimates of the savings retention coefficient of the Feldstein-Horioka type. Unfortunately, the conclusions derived from differing approaches typically do not agree. For instance, Chinn and Frankel (1994) and Dooley and Mathieson (1994) concluded that capital mobility is relatively high, although not complete, in most East Asian countries. Glick and Hutchison (1990) concluded, on the basis of real interest differentials, that capital mobility is increasing over time, although parity does not hold. On the other hand, Kim (1993) found that the savings retention coefficient indicates relatively low capital mobility for a number of these countries. In this paper, we attempt to reconcile these seemingly contradictory results by arguing that for some questions, the wrong asset returns have been examined. We appeal to the stylized fact that most firms in both developed countries and less developed countries (LDCs) rely on bank credit, rather than some type of tradable debt instrument such as commercial paper. Even in the United States, the share of business borrowing accounted for by commercial paper is only about 15 percent (Becketti and Moms 1993, 73). Moreover, recent work has demonstrated that access to this market is largely restricted to larger firms. Menzie D. Chinn is assistant professor of economics at the University of California, Santa Cruz, and a faculty research fellow of the National Bureau of Economic Research. Michael Dooley is professor of economics at the University of California, Santa CNZ, and a research associate of the National Bureau of Economic Research. Helpful comments were provided by the editors and the discussants, Koichi Hamada and Aaron Tornell, and by William Maloney. The authors thank Data Resources, Inc., and Carlton Strong of Morgan Guaranty for providing data, and Hui Miao for assistance in collecting the data. This research was supported by UCSC faculty research funds.

169

170

Menzie D. Chinn and Michael Dooley

Small firms rely much more heavily on bank loans (Gertler and Gilchrist 1994). Consequently, capital market integration depends on the extent to which bank credit is highly substitutable across different countries. Tests of covered interest parity using highly tradable money market returns will capture some relevant measure of capital market integration only to the degree that either ( 1 ) commercial paper supplies a large proportion of total business borrowing or (2) bank loans are highly substitutable for these assets. To the extent that bank loans constitute a large portion of borrowing, and neither of the above conditions holds, this type of asset nontradableness may explain an observed high savings retention coefficient (Dooley, Frankel, and Mathieson 1987). The issue of whether capital is effectively mobile or immobile has recently taken on increased prominence in light of recent debates regarding the optimal response to capital inflows. Calvo, Leiderman, and Reinhart (1993) have argued that sterilization of capital inflows is difficult because of high capital mobility. Reisen (1993) has argued, on the basis of East Asian experience, to the contrary. We argue that sterilization is possible because capital is not completely mobile (in contrast to Reisen), because the market in bank lending is not well integrated with either other domestic or international capital markets. The paper is organized as follows. In section 7.2 we update and review the evidence regarding capital market integration in East Asia. This assessment includes updated calculations of covered interest and interest differentials. We contrast and compare these results over time. In section 7.3, we describe the behavior of bank lending rates in these countries, especially as they compare to those in developed countries. Section 7.4 outlines a simple model in which to analyze the effect of capital inflows on bank lending. Empirical testing of this model is implemented, and the relationship between bank lending and economic activity (as compared to the role of money) is evaluated. The fact that credit has a greater effect than money provides a reason why capital mobility has been mismeasured in the past-the wrong interest rate has been examined. Section 7.5 assesses the role of capital inflows in inducing rapid expansion of bank lending and consequent financial fragility. Section 7.6 concludes.

7.2 What the Conventional Measures Imply The most common measure of capital market integration is the magnitude of the covered interest differential. For the case where political risk is zero and assets are exactly alike in default, liquidity, and maturity characteristics, covered interest rate parity should hold: 1. Frankel (1994) has suggested the nontraded aspect of bank loans as a possible reason why countries that have not liberalized their financial systems can sterilize.

171

Asia Pacific Capital Markets

Table 7.1

Covered Interest Differentials (percentage points) 1982:09-1988:04

Country

Mean

Australia Canada Hong Kong Japan" Malaysia New Zealand Singapore

-0.20 -0.01 0.11 0.08 -1.41 -0.49 -0.47

Mean Absolute

0.88 0.16 0.20 0.14 1.51

1.63 0.49

1988:05-1994:ll

Mean

Mean Absolute

0.27 0.10 0.14 0.01 -0.01 0.27 -0.91

0.29 0.22 0.17 0.05 1.28 0.30 0.9 1

Note: Figures in percentage points, estimated by regressing the end-of-month covered interest differential on a constant. TD-Euroyen differential. Data up to 1986:09 is Gensaki rate. Estimate is from a regression with a dummy for Gensaki series, so that the differential is interpretable as that pertaining to a CD rate.

where s, is the log spot exchange rate, f is the forward rate at time t for a trade k periods hence, i: is the k-period interest rate, and a superscript e(*)denotes a local (foreign) variable. In table 7.1, the mean and mean absolute covered interest differentials for seven Pacific Rim countries are reported for two subsamples: 1982:09-1988:04 and 1988:05-1994: 11. (The first subsample corresponds to that examined by Frankel 1990). The mean differentials indicate that the extent of political risk, assessed using money market rates,2 is quite low, and hence financial capital mobility is high but not complete. Since averages can mask deviations of opposite sign, we also report mean absolute deviations. Particularly in the early period, there are substantial differentials for Australia, Malaysia, and New Zealand. In the latter period, most of these figures are approximately the same or smaller. The exceptions are notable. Malaysia still appears somewhat insulated. Even more surprising, Singapore, typically thought of as well integrated into world markets via the Asian dollar market, evinces an increased absolute differential of approximately 1.25 p e r ~ e n t . ~ Since forward markets are usually well developed in cases where the extent of capital and exchange controls are minimal (and political risk, observable or unobservable, is low), the use of the covered interest parity criterion begs the question of capital mobility. In principle, one could try to assess the degree to which uncovered interest parity holds, using the rational expectations methodology of substituting the ex post values of depreciation for the ex ante. Such a 2. See appendix A for a description of the money market rates examined. 3. See Woo and Hirayama (1995) for a discussion of imperfect capital mobility in the cases of Malaysia, Singapore, and Indonesia.

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Menzie D. Chinn and Michael Dooley

Table 7.2

Interest Differentials (percentage points) 1982:09-1988:04

1988:05-1994: 11

Country

Mean

Mean Absolute

Mean

Australia Canada Hong Kong Indonesia Japan" Koreab Malaysia New Zealand Philippines Singapore Taiwan Thailand'

5.40 1.16 -0.64 9.24 -2.90 6.21 -0.51 9.63 10.47 -2.62 -2.64 2.05

5.41 1.27 1.51 9.24 2.90 6.21 2.13 9.64 10.47 2.62 2.69 2.51

4.20 2.51 0.28 10.94 -1.17 1.97 0.20 3.90 11.08 -2.02 1.04 2.85

Mean Absolute

4.20 2.51 0.38 10.94 1

.so

1.91 2.99 3.90 11.08 2.02 2.14 3.01

Note: Figures in percentage points, obtained by regressing the local minus O.S. Eurodollar interest differentials on a constant. aCD-Euroyen differential. Data up to 1986:09 is Gensaki rate. Estimate is from a regression with a dummy for Gensaki series, so that the differential is interpretable as that pertaining to a CD rate. bMonetary Stabilization Board (MSB) rate until 1991:12; call money rate thereafter. Estimate is from a regression with a dummy for call money series, so that the differential is interpretable as that pertaining to an MSB rate. 'Call money rate until 1991:12; Bangkok Interbank Offer Rate (BIBOR) thereafter. Estimate is from a regression with a dummy for BIBOR series, so that the differential is interpretable as that pertaining to a call money rate.

procedure yields implausibly negative estimates of the response of the domestic interest rate to the foreign plus expected depreciation (excepting the pegged case of Hong Kong). This result obtains because most variation in spot exchange rates is unanticipated. A different issue arises when the expected spot rate is proxied by a forecast from a rolling ARIMA. This procedure results in very small estimates of the coefficient, so that uncovered interest rate parity does not hold: One alternative is to adopt the assumption that the exchange rate is a driftless random walk (as in Faruqee 1992), so that expected depreciation is zero. Inspection of the local minus Eurodollar interest rate differentials, reported in table 7.2, indicates that there is scant evidence of convergence. Certain countries, notably Korea, Taiwan, and Malaysia, continue to show marked deviations. Other studies, also using money market rates, have shown increasing capital 4. An alternative approach is to use survey data to measure expected depreciation. In Chinn and Frankel (1994), uncovered interest rate parity was statistically rejected for all the Pacific Basin currencies examined.

173

Asia Pacific Capital Markets

Table 7.3

Hong Kong Indonesia" Japanb Korea Malaysia Philippines' Singapore Taiwan Thailand United States'

Sources of Credit, 1989

93 1,475 157.6 12,231 0 [211 0 135 Id

525.8

673

965.4 36,734 31 [go51 22.7 581 29.7*

5 1,942 524,380 80,795 68,219 1,988 48.8 3,723 926 2,715.3

14

-

-

3 0.2 15 0 n.a.

16 33 0 [21 0 23 3

0 4

0 19

Notes; End-of-year outstanding stocks, in billions of domestic currency units. Commercial paper and money market figures from Emery (1991). Total credit to private sector is from International Monetary Fund, Znternarional Financial Statistics (line 32d). "Data for 1989.111. b1990figures for commercial paper and money market from Takagi (1993). 'Commercial paper and money market figures are volume. dEstimate from Emery (1991). 'Total (financial and nonfinancial) credit from Post (1992).

mobility. Dooley and Mathieson (1994) demonstrated that foreign interest rates have had an increasing role in affecting various Pacific Basin interest rates. Jwa (1994) and Reisen and Ykches (1993) have applied similar methodologies to Korea and Taiwan and found episodic openings and closing^.^ A more fundamental question arises from the possibility that these interest rates are not representative of those that govern the economy, particularly investment behavior. These rates, typically interbank deposit or CD rates, are highly tradable and may obtain in extremely thin markets. Nonfinancial firms must borrow either through the commercial paper market or from the banking system. The commercial paper rate is likely to closely follow these interbank rates, ifthat market exists. However, in these countries most enterprise or firm borrowing is typically through the banking sector. As indicated in table 7.3, commercial paper constitutes a small fraction of total credit extended in most of these countries. Commercial paper is most visible in Korea and Taiwan (as measured by ratio to total credit extended by the consolidated banking system to the private sector). Perhaps this is because of the highly regulated nature of the banking sector in these two countries. Still, even the commercial paper market is regulated; data for Taiwanese commercial paper rates are not available, so the ex5. In contrast, Chinn and Maloney (1996) found individual and sustained breaks in the relationship between domestic interest rates and domestic determinants in these countries.

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Menzie D. chi^ and Michael Dooley

tent of intervention is difficult to assess. However, in Korea, the three-month investment and finance bilkommercial paper rate shows barely any variation over time. In most of the other countries, the commercial paper ratios are substantially smaller. We proceed under the assumption that most borrowing will be conducted through local banking systems. Foreign banking has some role, but by and large, in those countries with high proportions of foreign bank lending to nonbanks, most of that lending appears to be directed toward the public sector.6

7.3 Interbank Rates versus Bank Loan Rates A natural procedure would be to consider lending rate differentials, adjusted by the forward rate or expected depreciation, as the measure of capital mobility. Alternatively, one could examine how movements in offshore rates induce comovements in bank lending rates. Something like this approach was adopted in Browne and McNelis (1990) for the case of Ireland. They showed that bank rates are not very sensitive to changes in offshore rates, thereby suggesting that bank credit is an asset that is not very tradable. There are two key difficulties with this approach. First, LDC banking systems are usually highly regulated, thereby making the market-determined lending rate unobservable. Second, even in the absence of government intervention, bank loan rates are “sticky” due to the special functions performed by banks, specifically the screening and monitoring of projects (Stiglitz and Weiss 1981). Thus, even in the absence of banking sector liberalization, one would expect time variation in the spread between the riskless rate and the bank lending rate due to the agency costs of external finance (e.g., Gertler, Hubbard, and Kashyap 1991). This variation in “stickiness” is confirmed by visual inspection of timeseries plots of interbank and loan rates (see figs. 7.1-7.13). In the United States, the prime rate follows the Fed Funds rate, by and large. At the opposite pole is the Korean loan rate, which barely moves even as the interbank rate moves widely. In this latter case, the bank rate is obviously highly regulated and hence appeal to market-determined (although not necessarily market clearing) rates is clearly uncalled The same is true of the Taiwanese rate, while the Thai 6 . Indonesia, Malaysia, Korea, Australia, and New Zealand all exhibit declining ratios of foreign bank lending to the sum of domestic bank credit and foreign bank lending to nonbanks. For these countries, the presence of foreign bank lending represents about 30, 15, 5 , 15, and 10 percent, respectively, of total lending. Part of this pattern is due to the changing value of the dollar. Indonesia (at the end of 1992). in particular, exhibits an especially high ratio due to the large amount of borrowing by the state-owned oil enterprise. At the end of the Marcos regime the Philippines had a ratio of 60 percent (presumably mostly government borrowing). The ratio has since come down to under 20 percent. For purposes of comparison, the U.S. ratio is 8 percent. 7. Although Korea has implemented several banking reform efforts, they have been of a hesitant nature. See the discussion in Park (1994, esp. 147-54). The Taiwanese banking system has remained dominated by government-owned banks, so that despite interest rate decontrol, rates remain largely insulated from market pressures (Shea 1994, 259).

175

Asia Pacific Capital Markets

I

I

83 84 05 06 07 00 89 90 91 92 93 94

I_-~ IUS

IBLUS

1

Fig. 7.1 United States: interbank and loan rates (percent) Note: See appendix A for key to abbreviations.

01,

,

03 84 05 06 07 08 89 90 91 92 93 94 - IAU ... ...

IBLAU

-

Fig. 7.2 Australia: interbank and loan rates (percent) Note; See appendix A for key to abbreviations.

rate is a less extreme version. Between these two polar cases are the Singaporean, Indonesian, Malaysian, and Japanese series. Recently, Cottarelli and Kourelis (1994) have provided a measure of rate stickiness estimated from a regression of changes in bank lending rates on the change in the discount rate, on a distributed lag of changes in the money market rate, and on the changes in lagged bank rates. De Brouwer (1995) estimated a similar specification to several Pacific Basin countries. Using our data set

176

Menzie D. chi^ and Michael Dooley

21,

,

,

,

,

,

,

,

,

,

,

,

03 04 05 06 07 00 09 90 91 92 93 94

I - ICN

-.-...

J

IBLCN I

Fig. 7.3 Canada: interbank and loan rates (percent) Note; See appendix A for key to abbreviations.

03 04 05 06 07 00 09 90 91 92 93 94

1

--

IHK

IBLHK

1

Fig. 7.4 Hong Kong: interbank and loan rates (percent) Nore: See appendix A for key to abbreviations.

(which differs in sample period from the others), we estimate the following equation: ,=I

i= 1

where p is the bank loan rate and id is the discount rate. Table 7.4 presents the results, as well as those reported by de Brouwer. While the estimates differ somewhat, they show the same general pattern. Using these estimates, a reasonable categorization of covariability would be:

177

Asia Pacific Capital Markets

01,

,

,

,

,

a3 a4 a5 a6 a7

,

aa

r z x

,

,

,

,

a9 90 91 92 93 94 .

IBLSII

Fig. 7.5 Singapore: interbank and loan rates (percent) Nore: See appendix A for key to abbreviations.

10 Long-term prime rate

2i

CD rate

'b T

94

Fig. 7.6 Japan: interbank and loan rates (percent) Note: See appendix A for key to abbreviations.

Group 1 High covariability

Group 2 Medium covariability

Australia Canada Hong Kong Singapore United States

Japan Malaysia New Zealand Philippines

Group 3 No covariability -

~~

Indonesia Korea Taiwan Thailand

178

Menzie D. Chinn and Michael Dooley

16

Interbank deposit rate

14 12

8 6 4 1 2

I 0

l

I l BkaL;

i

G

83 84 85 86 87 88 89 90 91 92 93 94

I-

IMA

IBLMA~

Fig. 7.7 Malaysia: interbank and loan rates (percent) Note: See appendix A for key to abbreviations.

30 25

n

Bank bill rate

20 15 10

5

0

83 84 85 66 87 88 89 90 91 92 93 94

1-

INZ

IBLNZl

Fig. 7.8 New Zealand: interbank and loan rates (percent) Note: See appendix A for key to abbreviations.

The group 1 countries appear to coincide with countries believed to have small covered interest differentials and high capital mobility. Consequently, one might be tempted to deduce that the same conclusions would be obtained regardless of whether money market or bank lending rates were used. However, the group 2 countries of New Zealand and Japan also fall into the small covered differential camp. The stickiness in bank loan rates could be driven

179

Asia Pacific Capital Markets

01,

,

,

,

,

,

,

,

,

~

,

,

a3 84 85 a6 a7 88 a9 90 91 92 93 94

I --

IPH

IBLPH

j

I

Fig. 7.9 Philippines: interbank and loan rates (percent) Note; See appendix A for key to abbreviations.

1

Average lending rate

a3 a4 a5 86 a7

1-

aa IIN

I

a9 90 91 92 93 94

IBLlNl

Fig. 7.10 Indonesia: interbank and loan rates (percent) Note; See appendix A for key to abbreviations.

by differences in the portfolio of projects facing banks in these countries, by differences in monitoring technologies, as well as by bank rate regulations, none of which are factors typically identified with capital mobility. Hence, it is not possible to determine whether these markets are integrated by inspecting the correlations among lending rates. In fact, we take as our prior that these portions of the capital market are not well integrated with offshore markets

180

Menzie D. Chinn and Michael Dooley

I

Call money rate

\

1 Commercial paper fate 5

,

,

,

,

,

,

,

,

,

,

,

,

83 84 85 86 87 88 89 90 91 92 93 94 IK05

~

IK01

------

IBLKO

Fig. 7.11 Korea: interbank and loan rates (percent) Note: See appendix A for key to abbreviations.

Max. short-term lending rate

12

10

'

2 21,

'

lD-,ker'sacceptances v . Banker's acceptances b

,

,

,

,

,

,

,

,

,

,

83 84 85 86 87 88 89 90 91 92 93 94

Fig. 7.12 Taiwan: interbank and loan rates (percent) Note: See appendix A for key to abbreviations.

(and the rest of the economy). Recent work by Reisen (1993) has suggested that exactly because several East Asian countries have reversed the order of liberalization to put external reform before internal financial reform, sterilization is fairly easy. Frankel (1994) has pointed out that this result relies on assumptions about the nature of the disturbance affecting the country of interest.

41,

,

,

,

,

,

83 84 85 86 a7

ITH2

~

,

,

,

,

,

aa 89 90 91 92 93

,

94

1

IBLTHI

Fig. 7.13 Thailand: interbank and loan rate (percent) Note: See appendix A for key to abbreviations.

Table 7.4

Estimates of Bank Loan Rate Stickiness de Brouwer

Country Australia Canada Hong Kong Indonesia Japan (s) Japan Japan (I) Korea Malaysia New Zealand Philippines Singapore Taiwan Thailand United States

*z

X,*?

0.17 0.48 0.50 0.03 0.08 0.22 0.01 0.15 0.26 0.13 0.41 0.10 0.05 0.35

1.10

0.41

~

.05 0.37 0.54 0.08 0.01

Long Run

Impact

Long Run

0.91 1.04 0.86 0.50 1.09

0.59 0.69 0.57 0.06 0.63

0.95 0.94 0.87 1.25

0.68 0.05 0.82 0.76 0.80 0.69 0.44 0.72 0.85

-

0.10

0.64 0.13 0.18 0.10 0.78

-

0.75

0.66 0.84 0.63 0.55 0.63 0.97

Notes: Coefficients can be interpreted as elasticities. “Impact” is the within-quarter coefficient. “Long run” is the estimate obtained from 6,/6,. The de Brouwer estimates are averages for the suhsamples that most closely conform to that used in the estimates in the left-hand columns. Estimates for Japan are short-term (s), unspecified, and long-term (1).

182

7.4

Menzie D. Chinn and Michael Dooley

Application of a Simple Model

7.4.1 Derivation of a Model with Credit Consider an economy where bank credit is imperfectly substitutable for bond finance, as in Bernanke and Blinder (1988), augmented by allowing the credit supply to depend on a shift variable, the “riskiness” of the marginal investment project. Banks hold liabilities of deposits. On the asset side, banks hold loans, reserves, and domestic government debt. Loan demand is given by

Ld = L(p, i, y),

(3)

- + +

Loan supply is given by (4)

L” = X(p, i, Z)D(l + - -

- T),

where Z is a measure of the riskiness of the marginal investment project. The data-generating process of 2 is not modeled explicitly. The credit market equilibrium is given by equating loan supply and demand. The money market equilibrium is given by equating the demand for deposits with the supply; hence the LM schedule is D ( i , y ) = mR, -

where m is the money multiplier and R is the stock of reserves. (Excess reserves are ignored in this analysis.) The money multiplier is assumed constant. Allowing it to depend positively on the interest rate does not change the qualitative conclusions. The open economy IS curve is conventional, except that it depends on the bank lending rate as well as the interest rate:

where q is the real exchange rate. Substituting money market equilibrium into the loan market equilibrium yields (7)

U p , i, y) = X(p, i, z)mR(1 - 7).

Solving for the equilibrium loan rate, p, one obtains

In this formulation, the spread between the bank loan rate and the risk-free rate (proxied by a tradable interest rate), p - i, is a positive function of Z, the riskiness of the marginal project. The CC schedule is obtained by substituting equation (8) into equation (6):

183

Asia Pacific Capital Markets i

LM

BP = 0

cc 1

Fig. 7.14 CC-LM-BP model

(9) The external equilibrium condition is conventional:

(10)

BP = KA(i

-

i* - As",X)

+ TB(q,y) = 0,

where X is a vector of exogenous variables, such as default risk and so forth, which may shift the KA function. Assuming that the responsiveness of capital flows to the interest differential is not infinite, then the BP = 0 schedule is upward sloping, and domestic interest rates may deviate from the world interest rate. Such a model yields figure 7.14. This model resembles the conventional Mundell-Fleming model, except that unsterilized capital inflows cause increases in deposits, which in turn shift out both the LM and the CC schedules. The extent to which they shift out depends on the magnitudes of the parameters. (The solution to this model is presented in app. B.)*Also, the CC curve is drawn fairly steep, to reflect the presumption that economic activity is relatively insensitive to the interest rate on tradable assets. 7.4.2

Implications of a Capital Inflow for Bank Lending

Assume an exogenous shock lowers the rate of return in the rest of the world

(i*). Ceteris paribus, the BP = 0 schedule shifts down, and foreign capital will tend to flow into the country. The capital inflows take the form of a deposit in the home-country bank. Deposits rise, as do reserves. Since excess reserves yield zero interest, the bank will not hold any excess reserves. This means that bank loans increase, and both the CC and LM curves shift out. Interest rates 8. For a slightly different treatment, see Spiegel (1995).

184

Menzie D. Chinn and Michael Dooley

and lending rates may rise or fall depending on the parameters of the model. If expansion causes banks to undertake lending to riskier projects, this must drive up lending rates or drive down deposit rates. The second tendency will reestablish interest parity in the deposit market with perhaps small changes in domestic lending. The central bank can sterilize the capital inflow, but in this case the increase in the commercial banks’ assets consist of claims on the government rather than bank loans to the private sector. Since the government liability is riskless there is no change in the wedge between interbank deposit and loan rates. Thus, all the adjustment must come in the risk premium on domestic deposits, which is, of course, zero if domestic and foreign deposits are perfect substitutes. This is the risk premium that most research has been unable to findhence the belief that capital is mobile. The implication is that the central bank will give up since sterilization is not effective. In the typical model, domestic credit expands and domestic deposit and loan rates will fall to match foreign interest rates. In our model, the domestic deposit rate is driven down, but the domestic loan rate might rise with only a very small expansion of domestic bank loans. Thus, if we are interested in the effects of capital mobility, we should look directly at changes in bank credit rather than interest rates. Notice also that if the government does “sterilize,” the domestic money supply might rise with no change in bank credit to the private sector. If the view that bank credit is special is right, then there might be no impact on investment. We test two predictions of the model. First, in countries that have not undertaken sterilization policies the response of domestic lending to the capital inflow should be positive. Second, economic activity responds more strongly to bank lending than to money in countries where bank loans are not highly substitutable with other lending. The response of bank lending to the private sector is evaluated first. The change in bank credit to the private sector is regressed on current and lagged capital inflows (not including direct investment): 4

(11)

A(BCA‘),

= p,

+ xri(KA/Y)-i + quarterly dummies + u,, r=O

where BC is bank credit extended to the private sector, Y is gross domestic product, and KA is capital inflows minus direct investment. The results are reported in table 7.5. Impact parameters are reported in column (1). Column (2) is the sum of the inflow parameters. “Wald” denotes a chi-squared test statistic for the null hypothesis that the sum of coefficients on the inflows is zero. Notice that the proportion of variance explained is quite low in certain cases, notably Indonesia. The results confirm Glick and Moreno’s (1994) conclusion that Indonesia and Malaysia engaged in large-scale sterilization of capital inflows. That is, in response to capital inflows, some of the reduction of bank credit was manifested in a reduction in bank lending to the private sector. Taiwan, Korea, and

185

Asia Pacific Capital Markets

Table 7.5

Country Australia Canada Indonesia Japan Korea Malaysiab New Zealand Singapore Taiwan Thailandb

Response of Bank Credit to Capital Inflows ro ZK R2 D-W (1) (2) (3) (4) -0.584 0.186 -0.061 1.474 -0.788 0.175 1.200 1.805 -0.092 0.090

0.744 1.311 -0.790 -0.115 0.3 1 I -0.109 2.277 0.214 0.077 0.5 11

-0.01 0.22 -0.07 0.15 0.95 0.17 0.18 0.58 0.33 0.30

1.49 1.53 1.03 2.20 2.13 1.69 2.51 1.93 1.36 1.14

N (5)

Wale (6)

54 53 49 53 53 51 33 33 52 47

1.148 [.284] 11.054 [.001] 3.357 [.067] 0.013 [.908] 0.980 [.322] 0.225 [.635] 4.749 [.029] 0.280 [.597] 0.067 [.796] 11.483 [.001]

Note: Coefficients can be interpreted as elasticities. "Wald is an F-test for the null hypothesis that = 0 (p-values in brackets). bBankcredit data not available. Estimates for total domestic credit.

Z,r,

Malaysia evidenced short-run (within-quarter) reductions. Indonesia and Malaysia have negative long-run estimated impacts. These estimates of nonstructural relationships are seldom statistically significant. Only in a few cases are the positive parameters statistically significant (Canada, New Zealand, and Thailand). The negative effects are always statistically insignificant, except in the case of Indonesia, where something else appears to be going on. Certain accounts indicate that domestic banking crises caused rapid reductions in bank lending. To a certain extent, one would not expect statistically significant coefficient estimates because the change in bank lending to capital inflows depends on the intervention response function of the central bank, which is unlikely to be constant over time.

7.4.3 Bank Credit and Economic Activity Previous analyses have implicitly assumed that money and bonds are the only two domestic assets of importance in LDCs. Consequently, money market interest rates were the appropriate variables of analysis. In the framework adopted in this paper, there are three domestic assets of interest-money, bonds, and bank credit. We find that financial indicators of risk do seem to respond to capital inflows. We now investigate whether credit has significant effects on the economy, above and beyond the effect of money. Hence, we ask whether omitting the banking sector's behavior misses a crucial aspect of capital market integration. The role of credit has enjoyed a revival in the recent literature pioneered by Lown (1988) and extended by Romer and Romer (1990), Friedman and Kuttner (1993), and Loungani and Rush (1995). These researchers implemented nonstructural regressions, often in the tradition of the St. Louis monetary equations. Romer and Romer found that bank credit was a significant determinant

186

Menzie D. Chinn and Michael Dooley

of U.S. industrial o ~ t p u tFriedman .~ and Kuttner concurred, although they argued that relative prices (in particular the T-bilVcommercia1paper spread) matter as much as the credit quantities. More recent work involving structural VARs has been implemented by, among others, Fackler and Rogers (1993). They also have concluded that “credit is at least as important as any other variable in explaining movements in output, prices and interest rates” (223). To assess whether this conclusion also applies to Pacific Basin countries, we estimate the following regressions of changes in income on lagged changes in real bank credit or narrow money (Ml), real exchange rates, and income:

The results are reported in table 7.6 for those countries for which data are available. The results indicate that for Australia, Canada, New Zealand, Singapore, and Taiwan, money is more positively correlated with output than bank credit (although the sum of the coefficients is seldom statistically significantly different from zero). Of these countries, all have low degrees of bank rate stickiness, excepting Taiwan. Japan, Korea, and the Philippines show the reverse pattern and at the same time exhibit relatively high rates of stickiness. Unfortunately, three of the most interesting countries-Indonesia, Malaysia, and Thailmdare missing either quarterly bank credit data for a sufficiently long period or quarterly GDP data, thereby making comparisons for these countries impossible. Since savings-investment correlations have long occupied economists’ interest, we decided also to investigate the effects of money and credit on investment. Adequate data were available only for Australia, Canada, Japan, and Korea. Of these, two have low stickiness (Australia and Canada), one has intermediate (Japan), and one has a very high degree (Korea). Our prior expectations are therefore that Australia and Canada would have a higher association between money and investment than between bank credit and investment; on the other hand, Korea, and to a lesser extent Japan, should evidence the reverse. Regressions of changes of investment on lagged changes in narrow money or bank credit, GDP, and the real exchange rate were estimated: k

Ainv, = 0,

k

k

+ CB!A~C,-~ + C+,Ay,-, + Cq,Aq,-, + wr,

where inv is log real investment in plant and equipment. 9. In more recent work, however, Romer and Romer (1993) argued that due to decreased Fed reliance on credit controls, the influence of credit on economic activity has decreased.

Response of Output to Bank Credit or Money C,T, k' R2 LM(4)b N

Table 7.6 Country

-0.087 [.356]

Australia

0.173* r0.5251

Australia -0.462*** [0.0001

Canada

0.224*** [O.cW

Canada 0.487*** [0.003]

Japan Japan

0.110 [0.420] 0.090 [0.867]

Korea' Korea'

0.028 r0.8691

New Zealand

-0.121 [0.370]

New Zealand Philippines

0.022 [0.780] 0.088 [0.331]

Philippines Singapore

0.060 [OX591 -0.164 [0.254]

Singapore Taiwand

0.035 [0.654] -0.025 [0.499]

Taiwand

0.045 10.4481

6

-0.02

4

0.11

4

0.26

4

0.09

4

0.25

4

0.10

4

0.41

4

0.38

2

0.20

2

0.20

2

0.98

4

0.98

3

0.93

1

0.87

2

0.61

4

0.79

0.85 1 r0.0951 4.028 [0.402] 1.052 [0.902] 1.889 [0.756] 2.983 [0.561] 1.703 [0.770] 6.643 [0.156] 8.986 [0.062] 4.409 [0.354] 4.290 [0.368] 0.628 tO.4281 2.814 [0.589] 6.822 [O. 1461 2.814 [0.589] 7.601 [0.107] 7.076 [O. 1321

Sample

52

1981.IV-1994.III

54

1982.1-1994.III

53

1981.IEI 994.II

54

1981.11-1994.11

51

1981.D-1993.N

51

1981.II-1993.IV

47

1983.1-1994.III

47

1983.1-1994.JII

36

1985.IV-1994.m

36

1985.IV-1994.III

29

1987.II1-1994.IU

27

1988.1-1994.III

35

1985.III-1994.1

37

1985.1-1994.1

36

1983.m-1992.II

34

1984.1-1992.II

Nore: Coefficientscan be interpreted as elasticities. 'Number of lags in the regression. bBreusch-GcdfreyLM test for serial correlation of order 4 (p-values in brackets). 'Estimated using a filter of (1 - L4) (1 - L). dEstimatedusing a filter of (1 - L4). *Significant at the 10 percent marginal significance level according to an F-test for the null hypothesis that = 0 or Z,T,= 0 (p-values in brackets). **Significant at the 5 percent marginal significance level. ***Significant at the 1 percent marginal significancelevel.

c,a,

188 Table 7.7 Country Australia

Menzie D. Chinn and Michael Dooley Response of Investment to Bank Credit or Money

C,e, -0.267 [.356]

Australia Canada

0.438* [0.0601

0.509** [0.016]

Korea' Korea'

-

R2

LM(4)b

N

Sample

0.04

6.679 [O. 1541 7.478 10.1131 5.339 10.2541 7.987 [0.092] 2.168 [0.705] 7.537 [0.1 lo] 6.635 10.1571 3.697 [0.449]

54

1981.II-1994.III

54

1981.II-1994.III

53

1981.II-1994.11

54

1981.II-1994.11

51

1981.II-1993.IV

51

1981.II-I993.IV

46

1983.1-1 994.11

46

1983.1-1 994.11

0.27

0.29 0.46

1.505*** [O.OOO]

Japan

k'

0.22

-0.499 10.1691

Canada Japan

c,O,

0.452 LO. 1091

0.18 -0.02

0.269 10.7961 -0.048 [0.869]

0.09

Note: Coefficients can be interpreted as elasticities. aNumberof lags in the regression. bBreusch-GodfreyLM test for serial correlation of order 4 (p-values in brackets). *Significant at the 10 percent marginal significance level according to an F-test for the null hypothesis that CEO, = 0 or = 0 (p-values in brackets). **Significant at the 5 percent marginal significance level. ***Significant at the 1 percent marginal significance level.

The results are presented in table 7.7. They conform to expectations: for Australia and Canada, the money coefficients are jointly statistically significant, while the bank credit coefficients sum to a negative number and are not significant. For both Japan and Korea, bank credit is positively associated with investment, while money is not. However, it is important to note that only the Japanese bank credit coefficients are jointly significant.

7.5 Bank Lending and Increasing Financial Fragility A common view is that countries that rapidly expand their domestic lending to the private sector will tend to have riskier portfolios of investment projects. Thailand has large shares of bank credit extended to risky construction and real estate sectors, while both Indonesia and Malaysia have experienced problems with large amounts of nonperforming loans (see Folkerts-Landau et al. 1995, 37-39). Another means of assessing the riskiness of bank loan portfolios is to examine the spread between the lending rate and the risk-free rate. In this model, in the absence of bank rate regulation, the spread between the bank lending rate and the risk-free rate (p - i) is an increasing function of the riskiness of the

Asia Pacific Capital Markets

189 Table 7.8

Response of Spread to Growth of Bank Credit to Private Sector

-

Country Australia Canada Indonesia Japan New Zealand Philippines Singapore

KO

KI

0.038** (0.019) 0.009 (0.007) 0.043** (0.022) - 0.043* * (0.016) 0.019** (0.008) 0.012 (0.022) 0.090** (0.009)

-0.053 (0.121) 0.166** (0.066) -0.135 (0.156) 0.035 (0.087) 0.064** (0.029) 0.030 (0.073) 0.190** (0.084)

R?

D-W

N

- .04

0.76

49

0.24

0.66

48

0.03

1.14

44

-.08

1.13

48

0.25

0.69

31

- .09

1.23

26

0.3 1

0.62

31

Notes; Dependent variable is the spread between the bank lending and money market rates, in decimal form. All standard errors estimated assuming N/3 independent observations. *Significant at the 10 percent marginal significance level. **Significant at the 5 percent marginal significance level.

marginal investment project, Z. We posit that rapid expansion of bank credit is associated with riskier and riskier projects. This suggests that a regression of the spread on lagged bank lending will yield a positive coefficient (for countries where the bank lending rate is not regulated; hence Korea and Taiwan are omitted): (14)

(p - i), =

K,,

+ K ] [(BC/Y),-, - (BC/Y),_,]+ quarterly dummies + v,.

The results of these regressions are reported in table 7.8. Because there is evidence of serial correlation in almost all the regressions, the standard errors are calculated assuming N13 independent observations. Adoption of this procedure means that we have been extremely conservative in our inferences. For Australia, the estimate is negative but not statistically significant. For Canada, New Zealand, and Singapore, the estimates are statistically significant and positive. This pattern of results is reassuring because these are banking systems relatively free from rate regulation. In the cases of Indonesia, Japan, and the Philippines, the estimates are not statistically significant, although for the latter two they are positive. These results suggest that the rapid expansion of lending, in the absence of government regulation of bank lending rates, leads to increases in the spread between the lending rate and the interbank deposit rate. Since the results are not statistically significant, one would not wish to overinterpret the numbers; in fact, in many countries with more highly regulated banking sectors, the spread may depend more critically on differing money and nonmoney deposit

190

Menzie D. Chinn and Michael Dooley

reserve requirements. As is well known, manipulation of reserve requirements has been a favorite means of effecting sterilization in several of these economies. Dooley and Chinn (1995) have examined this issue.

7.6 Concluding Remarks The policy implications of opening capital markets continue to attract attention and debate primarily because we do not understand much about the transmission process for monetary policy in developing countries. It seems to us plausible that the “bank credit is special” argument, which has received considerable attention in the United States in recent years, is quite likely to be relevant in this transmission process. Moreover, developing countries that engage in large amounts of sterilized intervention provide a natural way to test the relative importance of money and credit. The model developed also provides a. plausible reason why interest differentials on traded bank deposits are a largely uninformative indicator of the degree of dependence of bank credit and in turn investment on foreign interest rates.

Appendix A Data Interest Rates Eurocurrency Deposit Rates The U.S., U.K., and Japanese three-month Eurocurrency deposit rates were the arithmetic average of the bid and offer rates in London at close of market, as reported by Bank of America up to 6 October 1986, and Reuters’ Information Service thereafter, and recorded by Data Resources, Inc. (DRI) in the DRIFACS database. Local Market Rates See table 7A. 1. Local Bank Lending Rates See table 7A.2.

Exchange Rates End-of-period exchange rates (except those indicated below) are London 3 P.M., arithmetic average of bid and offer rates as reported by Barclay’s until

191

Asia Pacific Capital Markets

Table 7A.1 Country

Local Market Rates Source"

DRI Code

United States

DRI

FIP90Y

United States Australia Canada

DRI WFM,DRI WFM,DRI

usw3 ADBBL90Q CACP90B.A

Hong Kong

WFM,DRI

HKM03B,A

Indonesia Japan

WFMr WFM,DRI

Japan Korea

DRI WFMr

Korea

WFMr

Malaysia New Zealand

WFMr WFM,WFMr

Philippines Singapore

WFMr (IFS) WFM,WFMr

Taiwan Thailand

WFMr

JAGBDS03 JACD03B,A JAD03

Description Financial paper, industrial firms, 90 days 3-month Eurodollar rate 90-day bank bill, quote 3-month prime finance company Paper 3-month interbank deposit rate corrected by FEER data I-month interbank deposit rate 3-month Gensaki bond rate 3-month CD rate IJP to 1986:09; IP2 thereafter 3-month Euroyen rate 3-month finance and investment bill rate; later same as commercial paper rate MSB until 1991:12; call money thereafter 3-month interbank deposit rate 3-month commercial bills to 1987:12; 90-day bank bills thereafter 3-month T-bill at tender 3-month banker's acceptances to 1987:08; 3-month commercial bills thereafter 90-day banker's acceptances Call money rate until 1991:12: BIBOR thereafter

Variable Name IUS

IEUS IAU ICN IHK IIN up

IJP2 IJP3 IEJP IKO 1

IK05 IMA INZ

IPH IS1

IT1 ITH2

Sources: DRI, Data Resources, Inc.; WFM, World Financial Markets, published by Morgan Guaranty; WFMr, Morgan Guaranty data, as provided by Carlton Strong; IFS, International Financial Statistics, published by the International Monetary Fund; FEER, Far Eastern Economic Review. aWheresource is both WFM and DRI, then WFM is source until 1989:10, at which time DRIFACS is source.

end of March 1990, at which time the series is no longer recorded by DRIFACS. Thereafter, the London close rate is used, as reported by Reuters Information Services. A consistent series is not used (i.e., the London close all the way) because these series only begin in 1986. The Taiwanese exchange rate series is from Ramon Moreno at the Federal Reserve Bank of San Francisco until 1991:12, and from DRIFACS thereafter. The market exchange rates for Indonesia, Korea, the Philippines, and Thailand were obtained from the International Monetary Fund's International Financial Statistics (IFS). (The Thai series is an official rate.) For conversion of dollar values to domestic currency, period average exchange rates from IFS (line rf) are used.

192

Menzie D. Chinn and Michael Dooley

Table 7A.2

Local Bank Lending Rates

Sourcea

Description

Canada Hong Kong Indonesia

WFMr WFMr (Reserve Bank of Australia, via Telerate) WFMr (Telerate) WFMr WFMr (IFS)

Japan Japan Korea

WFMr (Bank of Japan) WFMr (Bank of Japan) WFMr (Bank of Korea)

Malaysia New Zealand

WFMr (Bank Negara) WFMr (Reserve Bank of New Zealand) WFMr (IFS)

Prime rate, JP Morgan Overdraft rate of major trading banks Chartered bank prime rate Prime lending rate Weighted average lending rate working capital of nonproprietary sector Shoa-term prime rate Long-term prime rate Minimum lending rate charged to general enterprises by deposit banks Base lending rate Overdraft rate, prime borrowers Average commercial lending rate Overdraft rate of major banks Short-term lending rate; m a . for up to one year Minimum loan rate (MLR)

Country United States Australia

Philippines Singapore Taiwan Thailand

WFMr (Monetary Authority of Singapore) WFMr (Central Bank of China) WFMr (Bank of Thailand)

Variable Name IBLUS IBLAU IBLCN IBLHK IBLIN

IBLJPS IBLJPL IBLKO

IBLMA IBLNZ IBLPH IBLSI IBLTI IBLTH

Sources: See note to table 7A. 1. “Where source is both WFM and DRI, then WFM is source until 1989:10, at which time DRIFACS is source.

output Quarterly gross domestic product (output) in nominal and real terms are from ZFS (March 1995 CD-ROM). Nominal Malaysia, New Zealand, and Singapore GDP figures estimated via regression on real output and CPI. Indonesia and Thailand figures estimated via a four-quarter moving average of annual rates. Hong Kong GDP data from Census and Statistics Department, Revised Estimates of GDP, 1961 to First Quartel; 1994 (Hong Kong, August 1994). Taiwan data from Directorate-General of Budget, Accounting and Statistics, Executive Yuan, Republic of China, Quarterly National Economics Trends (Taipei, various issues).

Credit and International Banking Statistics Bank credit to private sector is from IFS (line 52d, if available; line 22d otherwise). Domestic credit to the private sector is from ZFS (line 32d). Foreign

Asia Pacific Capital Markets

193

credit to nonbanks (reported in n. 6 ) is from IFS (table 7yrd), converted to domestic currency using the average market exchange rate.

Capital Flows All figures are from IFS, except those for Taiwan, which are obtained from the Central Bank of China, FinanciaE Statistics (Taipei, various issues). The codes (in both cases) are line 77a.d IFS line 77bad IFS line 77bbd IFS line 77e.d IFS line 77g.d IFS

Current account Direct investment Portfolio investment Net errors and omissions Other capital, nie

The inflow measure used in the paper is constructed using the following formula:

INFLOW##l

=

XR X (PI

+ ER + OC)/GDP,

where PI, ER, and OC are portfolio investment, net errors, and other capital, respectively. XR is the period average exchange rate expressed as foreign currency units per U.S. dollar (IFS, line rf). Note that this definition excludes direct investment.

Appendix B Derivation of the Open Economy CC-LM Model Set dZ

=

0. The semireduced form equation representing the CC equation is Y = Y(i, p, 4).

(6')

Taking the total differential yields (Al)

dY

=

ydi

+ Yp(p,di + pvdY + pRdR) + Y&.

Rearranging, (A21

dY(l - Q,)

=

(I$,

+ q)di + YppRdR+ Td4.

The LM curve is obtained by differentiating equation (5): ('43)

dD = m(dR) = D,di m = DR.

+ D,dY,

194

Menzie D. Chinn and Michael Dooley

Solving for the deposit interest rate, di =

('44)

m(dR) - D y d Y

9

Substituting equation ('44) into equation (A2), ('45)

Solving for income,

A -[1 - Yppy+ (Yppi+ 13Dy/Q]. Rather than solving the system including the BP = 0 schedule, assume capital flows and real exchange rates to be exogenous. Then in the absence of sterilization, dR = dKA, so that the effect of an exogenous capital inflow on income is given by ('47)

As indicated in the text, both curves shift to the right in response to an unsterilized capital inflow:

References Becketti, Sean, and Charles Morris. 1993. Are bank loans still special? Federal Reserve Bank of Kansas City Economic Review 78 (3): 71-84. Bernanke, Ben, and Alan Blinder. 1988. Credit, money, and aggregate demand. American Economic Review 78 (May): 435-39. Browne, Francis X., and Paul McNelis. 1990. Exchange controls and interest rate determination with traded and non-traded assets: The Irish-United Kingdom experience. Journal of International Money and Finance 9:41-59. Calvo, Guillenno, Leo Leiderman, and Carmen Reinhart. 1993. The capital inflows and real exchange rate appreciation in Latin America: The role of external factors. IMF StafSPapers 40 (March): 108-50. Chinn, Menzie, and Jeffrey Frankel. 1994. Financial links around the Pacific Rim: 1982-1992. In Exchange rate policy and interdependence: Perspectivesfrom the Pa-

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cific Basin, ed. Reuven Glick and Michael Hutchison, 17-26. Cambridge: Cambridge University Press. Chinn, Menzie, and William Maloney. 1996. Financial and capital account liberalization in the Pacific Basin: Korea and Taiwan. NBER Working Paper no. 5814. Cambridge, Mass.: National Bureau of Economic Research. Cottarelli, Carlo, and Angeliki Kourelis. 1994. Financial structure, bank lending rates, and the transmission mechanism of monetary policy. IMF Staff Papers 41 (December): 587-623. de Brouwer, Gordon. 1995. The liberalization and integration of domestic financial markets in Western Pacific economies. Research Discussion Paper no. 9506. Sydney: Reserve Bank of Australia. Dooley, Michael, and Menzie Chinn. 1995. Financial repression and capital mobility: Why capital flows and covered interest rate differentials fail to measure capital market integration. NBER Working Paper no. 5347. Cambridge, Mass.: National Bureau of Economic Research, November. Dooley, Michael, Jeffrey Frankel, and Donald Mathieson. 1987. International capital mobility: What do savings-investment correlations tell us? ZMF StaffPapers 34 (September): 503-30. Dooley, Michael, and Donald Mathieson. 1994. Exchange rate policy, financial structure, and the transition from credit to monetary instruments. In Exchange rate policy and interdependence: Perspectivesfrom the Pacific Basin, ed. Reuven Glick and Michael Hutchison, 68-98. Cambridge: Cambridge University Press. Emery, Robert. 1991. The money markets of developing East Asia. New York: Praeger. Fackler, James S., and John H. Rogers. 1993. An empirical open-economy macro model with credit. Journal of Macroeconomics 15 (Spring): 203-24. Faruqee, Hamid. 1992. Dynamic capital mobility in Pacific Basin developing countries: Estimation and policy implications. IMF StaffPapers 39 (September): 706-17. Folkerts-Landau, David, Gany G. Schinasi, Marcel Cassard, Victor K. Ng, Carmen N. Reinhart, and Michael G. Spencer. 1995. The effect of capital flows on domestic financial sectors in APEC developing countries. In Capitalflows in the APEC region, IMF Occasional Paper no. 122, ed. Mohsin Khan and Carmen Reinhart. Washington, D.C.: International Monetary Fund. Frankel, Jeffrey. 1990. International financial integration, relations among interest rates and exchange rates, and monetary indicators. In International jinancial integration and US.monetary policy, ed. Charles Pigott, 17-49. New York: Federal Reserve Bank of New York. . 1994. Sterilization of money inflows: Difficult (Calvo) or easy (Reisen)? Paper presented at conference on Capital Inflows: Size, Nature and Policy Adaptations, Cartagena, Colombia, 29-30 July. Friedman, Ben, and Kenneth Kuttner. 1993. Economic activity and the short-term credit markets: An analysis of prices and quantities. Brookings Papers on Economic Activity, no. 2: 193-266. Gertler, Mark, and Simon Gilchrist. 1994. Monetary policy, business cycles and the behavior of small manufacturing firms. Quarterly Journal of Economics 109 (May): 309-40. Gertler, Mark, R. Glenn Hubbard, and Anil Kashyap. 1991. Interest rate spreads, credit constraints, and investment fluctuations: an empirical investigation. In Financial markets andjinancial crises, ed. R. G. Hubbard, 11-3 1. Chicago: University of Chicago Press. Glick, Reuven, and Michael Hutchison. 1990. Financial liberalization in the Pacific Basin: Implications for real interest rate linkages. Journal ofthe Japanese and Znternational Economies 4 (March): 36-48. Glick, Reuven, and Ramon Moreno. 1994. Capital flows and monetary policy in East

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Asia. Pacific Basin Working Paper no. PB94-08. San Francisco: Federal Reserve Bank of San Francisco, Center for Pacific Basin Monetary and Economics Studies, November. Jwa, Sung Hee. 1994. Capital mobility in Korea since the early 1980s: Comparison with Japan and Taiwan. In Macroeconomic linkage: Savings, exchange rates, and capitalfiows, ed. Takatoshi It0 and Anne Krueger, 123-65. NBER-East Asia Seminar on Economics, vol. 3. Chicago: University of Chicago Press. Kim, Sun Bae. 1993. Do capital controls affect the response of investment to savings? Evidence from the Pacific Basin. Federal Reserve Bank of San Francisco Economic Review, no. 1: 23-39. Loungani, Prakash, and Mark Rush. 1995. The effect of changes in reserve requirements on investment and GNF! Journal of Money, Credit and Banking 27 (May): 5 11-26. Lown, Cara. 1988. Credit-output link vs. the money-output link: New evidence. Federal Reserve Bank of Dallas Economic Review, November: 1-10, Park, Yung Chul. 1994. Korea: Development and structural change of the financial system. In Thejnancial development of Japan, Korea and Taiwan: Growth, repression and liberalization, ed. Hugh T. Patrick and Yung Chul Park, 129-87. Oxford: Oxford University Press. Post, Mitchell A. 1992. The evolution of the U.S. commercial paper market since 1980. Federal Reserve Bulletin 78 (December): 879-91. Reisen, Helmut. 1993. Macroeconomic policies towards capital account convertibility. In Financial opening: Policy issues and experiences in developing countries, ed. Helmut Reisen and Bemhard Fischer, 43-55. Paris: Organisation for Economic Cooperation and Development. Reisen, Helmut, and HBlBn Ybches. 1993. Time-varying estimates on the openness of the capital account in Korea and Taiwan. Journal of Development Economics 41 1285-305. Romer, Christina, and David Romer. 1993. Credit channel or credit actions? An interpretation of the postwar transmission mechanism. In Implications of changing capital markets, 71-116. Kansas City: Federal Reserve Bank of Kansas City. Romer, David, and Christina Romer. 1990. New evidence on the monetary transmission mechanism. Brookings Papers on Economic Activity, no. 1: 149-98. Shea, Jia-Dong. 1994. Taiwan: Development and structural change of the financial system. In The financial development of Japan, Korea and Taiwan: Growth, repression and liberalization, ed. Hugh T. Patrick and Yung Chul Park, 222-87. Oxford: Oxford University Press. Spiegel, Mark. 1995. Sterilization of capital inflows through the banking sector: Evidence from Asia. Pacific Basin Working Paper no. PB95-06. San Francisco: Federal Reserve Bank of San Francisco, Center for Pacific Basin Monetary and Economic Studies, June. Stiglitz, Joseph, and Andrew Weiss. 1981. Credit rationing in markets with imperfect information. American Economic Review 71 (June): 393-410. Takagi, Shinji. 1993.Introduction. In Japanese capital markets, ed. Shinji Takagi, 1-17. Cambridge, Mass.: Blackwell. Woo,Wing Thye, and Kenjiro Hirayama. 1995. Monetary autonomy in the presence of capital flows:And never the twain shall meet, except in East Asia? Paper prepared for fifth annual NBER-East Asia Seminar on Economics, Singapore, 15-18 June 1994.

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Comment

Koichi Hamada

It is a pleasure to comment on this paper because I think the authors are at least moving in the right direction with their approach to the Feldstein-Horioka (F-H) puzzle. The puzzle is that the correlation between national savings and investment is much higher than the value that the assumption of free capital mobility would imply. What I mean by the right direction is the way the authors try to decompose structurally capital movements into several components and the way they examine the economic mechanisms relating to each component. In addition, this paper relates the discussion of the F-H puzzle to two controversies, the effect of sterilized intervention in the exchange market and whether money or credit is more important as the determinant of national investment. Visualize the structure of the F-H puzzle as in the picture in figure 7C.1. Imagine two (or more) tanks full of water (savings) that are connected by various horizontal pipes. The inside of each tank is invisible from the outside. Some of the connecting pipes are transparent as channels of “covered interest parity,” where perfect arbitrage takes place in the absence of capital control, and some of the pipes are not so transparent. Even in the case of uncovered interest parity, the equalization of rates of return is much less obvious than for covered interest parity. In the case of foreign direct investment, we know little about the exact process of equalization of returns among direct investment projects that differ much in the degree of risks. If there are no obstacles or complications to prevent the movement of water in each tank, the water levels will be equalized if one complete pipe exists. Water flowing into one tank (increased savings in one country) will cause a substantial shift of water from another (capital movements to the other country). This ideal situation was contradicted by the evidence provided by Feldstein and Horioka. Many conventional analyses that have followed the F-H article have maintained the assumption of perfect capital mobility and have asked under what circumstances this paradox would occur in a world under perfect information and perfect individual rationality. The original F-H article stressed the imperfection of an international capital market, but followers have tried to show that the paradox can occur even under perfect mobility. They have argued that because of the intertemporal recurrence of shocks and international correlation of shocks, paradoxical observations could occur, or that because of the imperfection of econometric methodology, a paradox could emerge. I do not know how far these approaches can reach. On the other hand, the approach taken in this paper is to decompose the structure within one tank and to examine what happens inside these obscure pipes. I consider this is to be the right direction. This decomposition approach Koichi Hamada is professor of economics at the Economic Growth Center, Yale University. This comment is based on the version of the paper that was presented at the conference.

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Fig. 7C.1 Visible or invisible flow of funds

checks quantity variables of financial linkage of various kinds as well as the prices (rates of returns) of assets. The particular decomposition used in this paper is, of course, one among many alternative decompositions. Thus, I agree with the authors’ major methodology because, considering separately the linkages in different markets, one can detect where the equalization process of rates of return is blocked. Though I am sympathetic with the authors’ overall approach, I had many difficulties following the details of this paper.

Data

I wonder whether enough care was taken in acquiring the data. The longterm prime rate in Japan (fig. 7.6) is far higher than the actual value. (Japanese banks would have obtained enormous profits if the graph had been true.) According to my statistics at hand, the short-term rates fluctuated between 4.1 and 7.2 percent during the 1980s. The call rate, which is equivalent to the federal funds rate, fluctuated more. I wish this were the problem only with the Japanese data. Concepts and Institutional Considerations The decomposition used by the authors is a distinction between commercial paper or market instruments and bank loans. This decomposition is meaningful by itself, but dwelling on this classification narrows the scope of the paper. There are many important dimensions in the classification of financial assets

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and markets not covered by their decomposition. There are at least three types of distinctions. In general, one can classify a market according to whether it is reguhted by the government or unregulated with respect to assets and with respect to the price formation of the assets. An asset is transferrable in the market from one individual to another (market-oriented asset) or created only between two or more related parties (negotiable asset). Equities, bonds, and commercial paper are in the first category. Bank loans are in the second category. There is also a distinction between an asset that has a short-term maturity and an asset that has a long-term maturity. Some prices are volatile, and others are sluggish. In the paper most of these characteristics, in particular regulated or deregulated aspects, were neglected in the consideration of disaggregation of assets. Probably, the authors are comparing market-oriented, but regulated commercial paper with negotiable, nonregulated bank loans. But this crosscharacterization changes over time and across countries. (E.g., the interbank market in Japan was the least regulated market in terms of interest rates until the late 1970s, though it was a restricted one in the sense that only banks could participate.)

Theory The problem is containing a disequilibrium phenomenon within an equilibrium (equality) framework in equations (2) and (3). Since i and p are regulated, the notional demand and the notional supply are not equal. As Ito’s rigorous work on market disequilibrium indicates, for example, the analysis is difficult. But the authors should take account of disequilibria in a proper framework rather than compressing equations as if they were equilibriating equalities. Since i and p are regulated, the money market as well as the credit market should be credit rationed.

Empirical Results The paper argues that capital inflow will increase funds of banks and will increase bank lending. Consider, however, the case where domestic saving increases. Then, bank lending as well as capital outflow will increase. Thus, depending on where the exogenous shock is, the directions of movements are not obvious. Therefore, it is not surprising that “these estimates of nonstructural relationships are seldom significant”-although I admire the authors’ honesty. The paper also maintains that the spread between the bank lending rate and the commercial paper rate is an increasing function of the bank lending because riskier and riskier projects are undertaken. Again, one might argue that with modernization of the financial market, p - i declines along with the observation of increasing amount of present and past lending. Finally, I would like to comment on the last estimates on the validity of the money or credit paradigm in various countries. I view the controversy over the macroeconomic significance of money and credit as merely the difference in

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looking at the different sides of the balance sheet of the central bank. Thus, money and credit should give similar results in normal situations. If constraints are strongly binding on one side, then the constraint and, accordingly, the variable under the constraint should matter more. For example, if credit availability is under tight control, the credit paradigm will prevail. Because the asset side and the liability side often move together, it is expected again that the coefficients of estimated equations are not so significant, because of multicollinearity. In short, I would like to express my potential appreciation for this paper. If proper disaggregation is adopted upon a firm theoretical foundation, this kind of approach will contribute much to demystifying the Feldstein-Horioka puzzle. In its present form, though this paper gives some helpful insights, it leaves the reader with many doubts and mysteries.

Comment

Aaron Tornell

This paper attempts to reconcile two contradicting stylized facts about international capital market integration in Southeast Asia. On the one hand, savings retention coefficients indicate low capital mobility for the majority of Southeast Asian countries. On the other hand, tests of interest rate parity conditions indicate high capital mobility among these same countries. Typically, studies that test interest rate parity use tradable debt instruments such as commercial paper. In Southeast Asian countries, however, a majority of firms use bank credit. Therefore, these studies may not present an accurate picture of capital market integration, unless bank loans are perfect substitutes for commercial paper. The authors show that this is not the case for Southeast Asia on the whole. They find that the covariability of bank rates and the commercial paper rate is not perfect across all Southeast Asian countries. They identify three groups of countries: a group with high covariability (Australia, Canada, Hong Kong, Singapore, and the United States), a group with medium covariability (Japan, Malaysia, New Zealand, and the Philippines), and a group with no covariability (Indonesia, Korea, Taiwan, and Thailand). An important implication of this analysis is the determination of the extent to which monetary authorities can sterilize capital inflows. To the extent that bank lending is an important link, sterilization is feasible, as shown by the cases of Indonesia and Malaysia, which engaged in large-scale sterilization of capital inflows. The authors do not discuss the important issue of capital controls. Given that Aaron Tornell is assistant professor of economics at Harvard University and a faculty research fellow of the National Bureau of Economic Research.

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their evidence shows that there is not much medium- and long-term capital mobility in Southeast Asia, what is the optimal policy toward short-run capital flows? If capital inflows are short-lived by nature, should a country impose capital controls, and if so, would this be administratively feasible? In particular, given the importance of bank lending in these economies, what type of bank regulation would help stem short-run capital inflows?

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8

Recent Developments of APEC: Issues and Prospects of the Osaka Agenda Ippei Yamazawa

8.1 The Vision for APEC At Bogor, Indonesia, in November 1994, the leaders of the Asia Pacific Economic Cooperation (APEC) forum declared their commitment to “free and open trade in the region” and set a target date for its realization. At the ministerial meeting in Jakarta a number of facilitation and cooperation programs were reviewed. Many observers have noted that APEC has already moved down the road toward institutionalization. They do not seem to share a clear vision of APEC as a regional integration, however. The Eminent Persons Group (EPG) has outlined its views on APEC, and APEC leaders, both at Seattle in 1993 and at Bogor in 1994, seem to have endorsed the general direction set forth by the EPG (APEC 1993). At Seattle the leaders envisioned APEC as “a community of Asia Pacific economies,” and at Bogor they set as its agenda “a balanced package of trade liberalization, facilitation, and development cooperation” (APEC 1995d). The first task of those shaping the agenda for the APEC leader’s meeting in Osaka, then, was to identify a clear vision of regional integration for APEC. The absence of a clear common vision has prompted some typical criticisms of APEC. Some argue that APEC will be ineffective because of the diversity among its members. Others argue that East Asia would continue its rapid economic development even without an institution like APEC. Finally, some critics complain that nothing concrete was decided at Bogor. Ippei Yamazawa is professor of economics at Hitotsubashi University, Tokyo. The author represented Japan in the APEC Eminent Persons Group from 1993 to 1995. He has also worked on APEC in association with the PECC Trade Policy Forum, a tripartite organization of businesspeople, academics, and government officials seeking regional consensus on economic cooperation issues. Sections 8.3-8.5 of this paper are based on his study in collaboration with his PECC colleagues, Andrew Elek and Hadi Seosastro. Sections 8.7 and 8.8 were added after the APEC Osaka meeting.

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All of these criticisms are based on an EC- or NAFTA-type model. There is an alternative, however-a more flexible regional forum than the European Community and NAFTA. I call this model the “open economic association” (OEA).’ An OEA is (1) open in that its structure and policies do not lead to discrimination against the rest of the world in trade and investment, (2) economic in its primary policy focus, and (3) a voluntary association in that its members do not cede sovereignty to any supranational regional institution. Recognizing the increasingly sophisticated nature of international economic transactions, the scope of an OEA goes well beyond that of a traditional FTA. The tempo of trade liberalization may be less rapid than in traditional FTAs, but liberalization is applied to both members and nonmembers on a mostfavored-nation basis, and the gradual liberalization of trade in goods and services is supplemented by facilitation in dismantling all impediments to all international economic transactions, as well as development cooperation. This balanced program can address vast differences in stages of development, current levels of impediments to trade and investment, and preparedness for reform among association members. The highly interdependent, private-sector-driven growth of the Asia Pacific economies has been generated by active trade and investment in spite of remaining tariffs and nontariff barriers (NTBs). It is not necessary to further strengthen this market-driven integration but would be sufficient to have gradual trade liberalization, facilitating trade and investment and economic cooperation in order to create steady trade and investment expansion in the region. With this realistic concept of an OEA in hand, we can refute the criticisms of APEC noted above. First, an OEA is feasible within the vast diversity of the Asia Pacific region. Second, an OEA would enable continuation of the current 1. The term “open economic association” may not be widespread and may need further explanation. The author proposed the term for the first time in a journal article in 1992 (Yamazawa 1992) on the grounds that the conventional concept of free trade area (FTA) does not conform to the reality of the Asia Pacific region and a better concept should be invented. He elaborated this concept in Yamazawa (1993). The framework within which regional integration is normally analyzed is derived from the five developmental stages proposed by Balassa (1961). They are free trade area (FTA), customs union, common market, economic union, and complete economic union, with development taking place in this order. Balassa’s typology was developed by focusing on the elimination of discriminatory practices within a particular region. Two problems arise when we apply the Balassa typology to the Asia Pacific region. First, the earliest stage of integration (FTA) is usually accompanied by discrimination against nonmembers, but APEC does not intend to discriminate against nonmembers under “open regionalism.” Second, none of Balassa’s five stages capture APEC’s new type of integration, supplementing liberalization with facilitation and cooperation programs in its earliest stage. Balassa himself acknowledged the potential for international economic cooperation of various kinds, extending beyond the simple elimination of discriminatory practices. The EC Common Agricultural Policy has been in place since 1967, while cooperation in the steel and energy industries has been a feature of European life since before the founding of the Community itself. The cause of regional integration calls not only for the abolition of discriminatory practices but also for a large measure of policy and institutional cooperation and coordination. There has been a fair degree of success in policy coordination and economic cooperation among members of regional integrations.

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high growth rates of the region. Finally, at Bogor, APEC leaders did, in fact, commit themselves to an Asia Pacific OEA. The Osaka agenda aims to strengthen this vision of an Asia Pacific OEA. This is APEC’s vision of “a community of Asia Pacific economies.” If countries share the objective of sustaining regional growth and cooperate with each other toward that goal, the region will be worthy of the title “community.” There is already an evolving sense of community in the Asia Pacific region. This feeling of community can enhance the certainty and stability of the region, thereby attracting the private enterprises of members and nonmembers alike.

8.2 A Balanced Package Proposal The main aim of the Osaka agenda was to provide a feasible long-term program for implementing an Asia Pacific OEA. The Bogor declaration identified three elements of regional integration-trade liberalization, trade facilitation, and development cooperation-and APEC leaders at Osaka committed their support to all three in a balanced package (APEC 1995b). These three elements are interdependent; in particular, trade liberalization cannot be effectively implemented without the other two. First of all, the demarcation between trade liberalization and facilitation is not clear. At Jakarta, ministers adopted the nonbinding investment principle, which has often been classified as a facilitation program but is actually a liberalization of foreign investment. Harmonization of rules, standards, and import procedures are necessary before trade liberalization can be effectively implemented. Other facilitation programs recommended in the EPG report, including dispute mediation services and consultation on macroeconomic, environmental, and competition policies, all supplement the effective implementation of trade liberalization. The third element of APEC mentioned in the Bogor declaration, development cooperation, reflects the unique characteristics of the APEC membership. There are vast difference among members in stage of development, level of technology, and managerial and administrative capability. It is important to implement cooperation measures to fill these gaps, such as training customs officials, transferring advanced quarantine and testing technology, and so on. Development cooperation could go beyond those programs directly related to trade liberalization and facilitation to include measures relating to infrastructure, human resources, and entrepreneurship. Thus, trade facilitation and development cooperation support trade liberalization. But how can trade liberalization help trade facilitation and development cooperation? Trade liberalization provides a driving force for prompt and steady progress of the other two elements. Facilitation and development cooperation often fail to attract sufficient attention from the public and the media and tend to lose momentum as the result of various technical and administrative difficulties.

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The liberalization and facilitation agenda of APEC will be adopted by consensus, not through negotiations of GATT or FTA type, and implemented by the coordinated decisions of individual participants. Individual APEC governments will announce their own liberalization and facilitation programs voluntarily, on the basis of which a common guideline for APEC cooperation will be produced and adopted by consensus. Individual members will then implement policies according to their own domestic legislative processes. Unilateral efforts will be concerted through consultation within APEC, and actual implementation will be monitored and reviewed jointly so that unilateral efforts are encouraged.

8.3 Consistency with Multilateral Liberalization Regional integration has often been criticized in the past as inconsistent with multilateral liberalization. But it has now become almost a consensus view that regional integration and multilateral liberalization can be, and in many respects actually are, consistent. The recent report of the Organisation for Economic Co-operation and Development (OECD 1995) surveyed existing regional integrations such as the European Community, EFTA, and NAFTA and came to an interesting conclusion. That is, some aspects of regional integration, such as preferential tariff reductions and strict rules of origin, by their nature discriminate against nonmembers and indeed are contradictory to multilateral liberalization. However, these regional integrations have also implemented measures in such areas as harmonization of rules and standards, investment principles, trade in services policy, intellectual property rights, environmental protection, and industrial cooperation. These measures do not discriminate against others but serve as a laboratory, a halfway station in the effort to move from separate national standards to a single multilateral standard. APEC can focus on the nondiscriminatory aspects of regional integration and avoid those components that discriminate against nonmembers. Because of their high dependence on trade and investment links beyond the region, Asia Pacific economies have shown great interest in global trade liberalization and have participated actively in the Uruguay Round negotiations. APEC trade ministers could confirm their Uruguay Round agreements, reaffirm the “standstill” of their current restrictions, complete remaining negotiations in services, and accelerate the Uruguay Round liberalizations in a few significant areas. Coordinated action by APEC governments would enhance their collective capacity to promote global liberalization. The areas of accelerated or additional liberalization, beyond the minimum requirements of the Uruguay Round, will be governed by Article 1 of the GATT, and concerted unilateral liberalization by individual governments will be extended to members and nonmembers alike on a most-favored-nation basis. The implementation of the advanced liberalization package will be monitored and reviewed jointly to assure the continued attention of all members and to allow mutual encouragement.

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A fourth criticism of APEC is that the process of trade liberalization within the group is so slow that it will be buried under the progress of multilateral liberalization centered around the new World Trade Organization (WTO). However, all cautious observers realize that multilateral liberalization will not move forward unless certain key players work together. The APEC group, together with the European Community, is supposed to be a prime mover. APEC governments can talk to EU governments and others and encourage them to join in a similar accelerated implementation of the Uruguay Round outcomes. At a later stage, they could invite the Union to initiate, jointly with APEC, a new round of global liberalization within the WTO. The interaction between APEC and the European Community will be critical to this process. Unlike the Community, APEC does not aim to establish a formal supranational body but will instead remain a more flexible OEA for the next quarter-century. However, because its members include major economic powers and fast-growing newly industrialized economies, APEC will likely interact closely with EC members to build the WTO. The new WTO regime will certainly be affected by the liberalization program APEC adopts. Some suggest that APEC should threaten the European Community with discriminatory liberalization unless the Community accepts similar liberalization. But such a tit-for-tat approach may make the Community inward looking and may split the world economy into two groups. APEC, with its slogan of “open regionalism,’’ can instead encourage the Community to keep an outward-looking stance and promote mutual participation in each other’s development. APEC representatives will also cooperate to complete negotiations for the entry of non-WTO members of APEC into the WTO and to integrate the proposed liberalization efforts into a truly APEC-wide undertaking.

8.4 A Feasible Liberalization Program The Bogor declaration committed APEC leaders to trade and investment liberalization within APEC. However, details of implementation were left to ministers and senior officials, and they composed a major part of the Osaka agenda. The second EPG report did not articulate the modality and scope of APEC liberalization but only suggested that it should be up to individual members whether to apply the liberalization achieved within APEC to nonmembers on an unconditional most-favored-nation basis or on a reciprocal FTA basis (APEC 1994). Let me articulate a feasible program for APEC liberalization consistent with the WTO regime.* First, “free and open trade in the area” by 2020 means the elimination of all tariffs and NTBs and is intended to cover virtually the same sectors as the WTO. APEC’s long-term implementation program will provide a clear idea of the path for the elimination of tariffs and NTBs by 2020. 2. The author is indebted Andrew Elek and Hadi Seosastro, with whom he developed the ideas in the following two sections through their joint drafting of PECC (1995).

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A straightforward method would be a gradual across-the-board reduction of tariffs down to virtually zero, starting in 1996 and ending in 2010 for developed APEC countries and in 2020 for the rest of APEC. However, this was not feasible before the Osaka meeting for the following reasons. First, all members agree that APEC liberalization must be WTO-consistent. The WTO is brand new, and it is thought important to see whether its liberalization program, including farm products and textiles, will be implemented on schedule. Furthermore, the negotiation of some services was not completed under the GATT and must be continued under the WTO. It is thus not likely that APEC negotiators will start another round of across-the-board liberalization beyond the Uruguay Round agreements. Second, APEC will have to settle the philosophical debate over unconditional most-favored-nation versus reciprocal FTA liberalization if it wishes to keep its across-the-board liberalization consistent with the GATTNTO. The second EPG report left this question to individual countries. If an APEC member applies APEC liberalization on an unconditional most-favored-nation basis (which is the same as unilateral liberalization to nonmembers), it will be quite consistent with Article 1 of the GATT. But if an APEC member offers liberalized trade to nonmembers on a reciprocal basis, it is unclear whether this sort of preferential trading arrangement is permitted under GATT Article 24 unless all APEC partners enter into formal and binding agreement^.^ Third, it is relatively easy to envision a gradual reduction of tariffs, but NTBs are more problematic. Tariffs have become less important in developed countries and newly industrialized economies, which must now turn their attention to reducing NTBs, especially in services, intellectual property rights, and investment rules. Fourth, the negotiation of China’s entry into the WTO has not yet been concluded, and without China and Chinese Taipei in the WTO, APEC’s liberalization agenda will be incomplete. It will take some years to monitor the implementation of the WTO liberalization, to promote services negotiation, to elaborate the modality of eliminating NTBs, and to achieve full WTO membership of all APEC members. An alternative to across-the-board liberalization is sectoral liberalization. Sectoral liberalization within APEC could be conducted as an extension of the Uruguay Round negotiations in order to realize certain achievement in advance of multilateral liberalization under the WTO. It will not be easy for each member to draw up a complete across-the-board liberalization program in the first year of implementing the Uruguay Round liberalizations and announcing their accelerated schedule. But APEC members may be able to go beyond the Uruguay Round agreements in some well-prepared sectors and to implement in advance some areas to be completed in the continuing services negotiations. Individual members can announce their APEC liberalization programs volun3. See Yarnazawa (1994) for a comparison of the two approaches.

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tarily and implement them unilaterally on a most-favored-nation basis, consistent with GATT/WTO rules. In this process, individual APEC members will be encouraged by unilateral offers of fellow APEC members, and these liberalization offers will be summarized by the Committee on Trade and Investment in an APEC package of unilateral liberalization that goes beyond the Uruguay Round agreements. This package will be combined with APEC guidelines for consensus. Individual APEC members shall implement their liberalization offers according to these APEC guidelines, and implementation will be monitored and reviewed jointly. A sequence of sectoral liberalizations, starting with easy areas and moving on to more difficult areas, is certainly a pragmatic approach. However, this method may not provide an overall perspective of the entire process until 2020. A possible solution would be a combination of the two modalities in sequence; that is, start with the liberalization of easier sectors for some number of years, but switch to across-the-board liberalization at a later date, say 2000. While the Uruguay Round commitments are implemented on schedule, or ahead of schedule, additional unilateral liberalization by individual members will be a pragmatic way of maintaining the momentum toward free and open trade. By no later than 2000 for developed countries and 2005 for other participants, the completion of the Uruguay Round liberalization will be assured and substantial additional unilateral APEC liberalization will have accumulated. By that time, APEC members will be in a position to review the process and draw up an across-the-board program so that the liberalization commitment by APEC leaders can be fulfilled no later than 2010 and 2020. Thus, a feasible program for APEC liberalization can be summarized as follows: 1. APEC governments reaffirm their standstill commitments. 2. Each government sets out schedules for a. meeting its obligations under the Uruguay Round, b. accelerating its Uruguay Round liberalization, and c. extending beyond its Uruguay Round commitments.

The combination of these unilateral commitments would form the initial schedule of “concerted unilateral liberalization.”

3. APEC governments commit to the monitoring and review of progress of the trade liberalization mentioned above. 4. By no later than 2000 for developed members and 2005 for other members, APEC governments review progress and draw up an across-the-board liberalization program to meet the 2010 and 2020 targets. In all these stages, APEC would talk to the European Union and others and encourage them to make similar liberalization efforts to that serious free-rider problems could be avoided. This would be especially important in stage 4, when APEC proposes to take joint initiative for new WTO liberalization.

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The approach outlined above may be regarded as too slow. However, even under existing tariffs and NTBs, trade and investment have expanded rapidly enough for Asia Pacific economies to have achieved high growth rates over the past decade. Slow but steady liberalization will guarantee the certainty and credibility of Asia Pacific markets and factories and will attract business from members and nonmembers alike.

8.5 Facilitation of Trade and Investment The scope of the Bogor undertakings needs to be interpreted broadly. Traditional trade barriers, such as tariffs or quotas, are no longer the only strategic obstacles to the mutually beneficial integration of the Asia Pacific region. The reduction of these barriers needs to be accompanied by work to reduce transaction costs imposed by uncertainties and wide divergences in domestic regulations and administrative procedures that affect the ease or cost of trade, investment, and other economic transactions among APEC economies. Accordingly, APEC governments will need to address, comprehensively, the full range of impediments to such transactions, including (1) deficiencies in information about regional markets and policies and (2) policy-based impediments, such as barriers to transactions applied at borders, divergences in domestic policies influencing economic transactions, and uncertainties due to lack of transparency or arbitrary application of policy. There are some useful lessons to be learned from the EU experience. The European Union eliminated internal tariffs in the 1960s, but it was not until it tackled a much broader range of intraregional economic transactions, from 1985 to 1992, that the Union became anything like an effectively unified market or zone of production. The Union identified over 280 physical, technical, and fiscal barriers to transactions across the borders of its members in 1985 and abolished at once over 90 percent of them at the beginning of 1993 so as to create a single European market. Because of the vast diversity among its members, APEC may not be able to implement immediately a program of facilitation as ambitious as the European Union’s, but Asia Pacific governments can plan for such comprehensive facilitation and liberalization from the outset, while avoiding the creation of a regional bureaucracy. To ensure that attention is paid to all significant impediments to international economic transactions, simultaneous efforts will be needed to (1) understand the relative importance of all impediments to international economic transactions; ( 2 ) develop policy options that could reduce or, wherever feasible, eliminate these impediments; and (3) agree on timetables for taking these actions. There is an urgent need to build on APEC’s ongoing work to improve data on regional economic transactions and on the nature and cost of all nontariff obstacles to trade and investment. The study of impediments to trade and investment, carried out by the Trade Policy Forum of the Pacific Economic Cooperation Council (PECC) at the request of APEC senior officials, is a use-

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ful first step (PECC 1995). It could be followed up by a more comprehensive effort to sample the views of the private sector involved in intraregional commerce. The key to sustaining the momentum of APEC as a voluntary form of regional cooperation is to establish consensus on proposals for facilitation that will result in gains to all economies that choose to implement them. Through such consensus building, APEC governments have already adopted a nonbinding set of investment principles, as recommended by the seventh Trade Policy Forum of PECC in 1993. There is scope for building on this positive experience, by addressing important new areas that influence economic transactions among APEC members, including competition and environmental policies. APEC governments could also develop agreed-upon approaches to dismantling impediments to a gradually broader range of international economic transactions. Such a process of facilitation could be accelerated by the clearer definition of specific, operational objectives that need to be achieved in order to realize the vision of an effectively integrated and outward-looking economic region in the Asia Pacific. It should be possible to set operational, medium-term objectives for all aspects of trade and investment facilitation as well as for liberalization. With imagination, meaningful targets and action plans can be devised for the progressive dismantling of most impediments to most international economic transactions. Examples of ambitious medium-term objectives that are relevant to realizing the Bogor vision of APEC leaders include:

. .

International investment. National treatment of all firms; harmonization of fiscal incentives toward international investment; Trade in services. Full rights of establishment and no limits on travel related to the provision of services; Dispute settlement. An APEC code of practice to settle policy- or investmentrelated disputes, based on existing multilateral mechanisms; Competiiion policy. Following the adoption of regionwide minimum standards for competition policy, no antidumping actions among APEC participants; Administrative procedures. Full compatibility of customs data and procedures; Transport. An efficient and safe transportation system with minimum restriction on arrival; Telecommunications. Mutual recognition of all relevant technical standards and national treatment for access to local telecommunications networks; Tourism. “Smart card” passports and visa-free short-term travel; Professional qualijications. Procedures for APEC-wide accreditation of courses or tests of competence; Other standards. A program of mutual recognition and harmonization comparable in scope to that achieved by the European Union.

. . . . .. .

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These examples illustrate the relative importance of facilitation as a complement to trade liberalization with potential for very significant net gains to all economies involved. Setting and meeting such targets will require considerable political leadership, and some of the targets can only be achieved over the medium term. But to realize the vision of free and open trade and investment in the Asia Pacific region, all of these challenges need to be met no later than 2010 or 2020. As in the case of the initial nonbinding investment principle, early progress is likely to involve the gradual convergence of policies with GATT/WTOconsistent guiding principles such as transparency, nondiscrimination, and national treatment. In all cases, successful implementation will require considerable technical cooperation, to allow the sharing of information, technology, and expertise among APEC members, as discussed further in the next section.

8.6 Cooperation Programs Cooperation has been an integral part of regional economic integration in reality, although in textbook explanations such integration is often classified only by the degree of liberalization of border measures. The European Community started with the European Coal and Steel Community long before it pursued trade liberalization among its members in the 1950s. However, cooperation has not yet been well incorporated into the APEC agenda. in spite of the endorsement of a “balanced package” of liberalization, facilitation, and cooperation in the Bogor declaration. The Bogor declaration said “development cooperation,” but the Senior Officials Meeting changed the term to “economic and technical cooperation.” The fluctuating terminology reflects the fact that cooperation is yet to be conceptualized in APEC. Some members call for more development cooperation programs on the APEC agenda, while others insist that APEC is not an aid organization and agree only to technical cooperation. The debate has continued over the recent Japanese proposal, Partners for Progress (PFP), formulated along the former lines. Some cooperation programs are classified as “facilitation programs,” but they certainly aim beyond the exchange of information and consultation for transparency and harmonization. They would be better called “cooperation programs” if they aim to implement concrete action programs. Cooperation programs are needed in APEC in order to fill gaps in technology level, managerial and administrative capability, public infrastructure, and so on, resulting the diversity among APEC members. Both bilateral and multilateral development cooperation programs have been implemented to resolve these deficiencies, and they can be continued. However, new elements have evolved in these areas, and new types of cooperation programs may be needed that depart from conventional development cooperation of the bilateral donorrecipient type. APEC could define for itself a unique role in planning and implementing such new programs.

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Three types of cooperation programs are identified but they are treated differently in the APEC agenda. 1. Technical assistance in training customs officials, transfemng quarantine and testing technology, and improving administrative procedures. 2. Help to developing member economies in resolving bottlenecks in public infrastructures such as transportation, telecommunications, and utilities; human resource development; and small and medium-sized enterprises in supporting industries, agriculture, and fishery 3. Cooperation in specific areas such as currency stability and financial flow, secure supply of energy and its efficient use, and protection against regionwide environmental pollution. Program 1 supplements liberalization and facilitation. Deficiency in some members impedes efficient implementation of liberalization and facilitation programs. This is well recognized by all members, and technical cooperation is being implemented in APEC. Program 2 has been accepted in principle but is resisted by some developed members. However, new elements of cooperation have evolved in the Asia Pacific region recently. The infrastructure of developing members is now recognized as an integral part of the regionwide infrastructure, and its deficiency will affect all members. Private sectors and local governments can participate actively in building infrastructure. Cooperation among developing members has increased in some industrial cooperation. Such programs can be incorporated into APEC-wide joint undertakings. Program 3 was identified as an integral part of the APEC agenda in the Seoul declaration and a number of programs have been proposed in APEC work projects but, though implemented, have yet to produce any visible achievements. They are often classified as facilitation programs, but they may need to go beyond the exchange of information and consultation for transparency and harmonized policies, to action programs. APEC will review its cooperation projects in the light of needs recently emerging in the region. It will also set priorities so as to concentrate APEC’s limited resources on fewer projects and to highlight their visible achievements. APEC is also urging its member governments to promote deregulation and policy coordination so as to encourage active private sector participation. In order to avoid divisions within APEC and to ensure consistency with APEC’s basic principle of mutual respect, it is vital that APEC support technical cooperation projects in which all participants perceive mutual benefits, irrespective of the direction of information or technology flows.

8.7 The Osaka Action Agenda The APEC Osaka meeting was successfully concluded on 19 November with the adoption of the Osaka Action Agenda (APEC 1995a). The agenda consists of two parts: part I for trade liberalization and facilitation and part I1

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for economic and technical cooperation, all of which turned out to be, by and large, along the lines described earlier. Part I of the action agenda starts with general principles: comprehensiveness, WTO-consistency, comparability, nondiscrimination, transparency, standstill, simultaneous stadcontinuous proceddifferentiated timetables, flexibility, and cooperation. It is extensive, covering 15 areas: tariffs, nontariff measures, services, investment, standards and conformance, customs procedures, intellectual property rights, competition policy, government procurement, deregulation, rules of origin, dispute mediation, mobility of businesspeople, implementation of Uruguay Round outcomes, and information gathering and analysis. Its new modality for implementing liberalization and facilitation programs is “concerted unilateral liberalization,” as discussed earlier. This modality has been regarded as unassertive by comparison with the Western approach of negotiating (as in the GATT and WTO) a liberalization agreement that is legally binding so that the signatories will be punished and sanctioned if they fail to meet their commitments. This legalistic approach would not be accepted by Asian countries. On the other hand, APEC members have thus far implemented trade and investment liberalization unilaterally. The new modality is based on this past experience and calls for unilateral liberalization in a concerted manner within the Osaka Action Agenda. This is a practical way to maintain and build on the momentum for liberalization produced by the Bogor declaration. By contrast, any attempt to turn APEC to a negotiating body like the GATT or WTO would probably take several years. Japanese leadership should be credited for this pragmatic action agenda well accepted by many members, and continued Japanese initiative is vital to the success of this modality. If Japan proposes a substantial liberalization program, other members will follow with matching programs. With regard to time schedule, leaders and ministers agreed on the following procedure: 1. Submission of action programs of liberalization and facilitation to the 1996 ministerial meeting in Manila 2. Start of action program implementation in January 1997 3. Consultation between member governments on the content of liberalization and facilitation programs and regular review of progress In addition to this general approach, Osaka participants delivered some parts of their liberalization and facilitation programs in concrete form, as “initial actions” (APEC 1995~).To have done otherwise would have risked a loss of credibility, as others might perceive APEC nations as constantly saying they would liberalize “some day.” Two issues remained pending until the last minute. Both concerned the general principles of liberalization: one was comprehensiveness versus flexibility, and the other was nondiscrimination. Regarding flexibility, Japan proposed that considering the different levels

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and diverse circumstances in each economy, flexibility should be available in implementing liberalization programs, and special treatment should be allowed to some sectors. This proposal met strong objection from all members but three, Korea, China, and Chinese Taipei. Although flexible treatment may be necessary when the many members of APEC implement liberalization programs, the exclusion of some difficult sectors would mean a serious breach of the principle of comprehensiveness and would downgrade the Osaka Action Agenda. At Bogor, APEC leaders raised a banner of trade liberalization in order to encourage their officials to implement liberalization measures. Exclusions would cut a big hole in the banner, discouraging officials who had adjusted their attitude to liberalization following their leaders. At the last minute, the Japanese proposal was modified so that no sector would be excluded but flexible implementation would be allowed. Flexibility should be confined to flexible treatment but not flexible coverage. Another pending issue was the principle of nondiscrimination to be applied to all members of APEC. In the United States, the Jackson-Vanik law (1975) requires the Congress to examine each year whether nondiscriminatory treatment should be given to products from non-market-economy countries. The United States has refused to apply most-favored-nation treatment to China unconditionally because of China’s human rights problems and slow democratization. China complained about the U.S. intervention in domestic affairs and sought unconditional application of the nondiscrimination principle. MITI Minister Hashimoto mediated between the two countries, and the United States agreed to “endeavour to apply the principle of nondiscrimination” to China. Part I1 of the Osaka Action Agenda covers 13 areas of economic and technical cooperation: human resource development, industrial science and technology, small and medium-sized enterprises, economic infrastructure, energy, transportation, telecommunications and information, tourism, trade and investment data, trade promotion, marine resource conservation, fisheries, and agricultural technology. Environmental protection is not included as an independent area. A new modality of APEC cooperation was introduced based on the Japanese proposal, Partners for Progress (PFP). It emphasizes a departure from the conventional modality of a distinct donor-recipient relationship. Member governments contribute on a voluntary basis resources available to them, such as funds, technology, and human skills, and all gain from the cooperation program. Consistency with market mechanisms is emphasized, and participation by the private sector is encouraged. Prime Minister Murayama announced that Japan would commit a contribution of 10 billion yen for the promotion of PFP for the next several years. APEC has made a cautious start with technical cooperation in improving administrative capability in standards and conformance, intellectual property rights, and competition policy. These measures are indispensable for the successful implementation of liberalization and facilitation and are easily agreed

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upon. But technical cooperation will be extended gradually to building infrastructure, human resources, energy, and environmental protection. The Osaka Action Agenda is an important step forward, taking cooperation programs beyond seminars and studies.

8.8 APEC’s Tasks Ahead Member economies started forming their own voluntary liberalization programs along the lines of the Osaka Action Agenda in preparation for the ministerial meeting in Manila in November. Parts of the programs were announced in Osaka as “initial actions” and were included in the leaders’ statement. They included advanced implementation of tariff reductions committed to in Uruguay Round negotiations as well as privatization of government enterprises and deregulation of foreign investment. It is never easy to compare the liberalization effects of initial actions between individual members; there were both big and small packages of initial actions. Nevertheless, the Osaka initial actions as a whole turned out to be big enough to demonstrate that APEC had reached the stage of action. However, another difficult challenge awaits. As individual member governments implement domestic legislation in accordance with unilateral liberalization programs, they will face strong resistance from vested interest groups and officials. Strong political leadership will be needed to break through this opposition. The effectiveness of the new modality of concerted unilateral liberalization will be tested on many occasions. Japan, as a proponent of this modality, will likely have to lead the way through this difficult course of implementation with an ambitious package of liberalization. On 25 November 1996, at Subic, APEC leaders adopted the Manila Action Plans for APEC (MAPA). MAPA can be a good first step. All APEC members submitted their initial actions in spite of its unilateral modality, and it has begun to be implemented, only two years after the Bogor declaration. However, MAPA’s substance could be improved further. While short-, intermediate-, and long-term measures were suggested in each of 15 areas, only the short-term measures contain concrete policies with clear time frames. The intermediateand long-term measures consist of stating the intent to achieve the Bogor target or reviewing current measures for possible amendment. Even many short-term measures do not show a strong enough start to achieve the Bogor target. With regard to tariff reduction, both the United States and Japan have agreed to little more than their current commitments under the Uruguay Round. Indonesia, the Philippines, China, and Chile announced big tariff reductions toward 2000, but Thailand, Malaysia, and Korea specified no concrete figures. They may have been puzzled as to how much they should commit under this new modality of unilateral liberalization. With regard to nontariff measures, ser-

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vices, and investment, the current levels of impediments differ greatly between developed and developing members, and the latter group is by and large cautious about liberalization. The facilitation measures, on the other hand, can greatly reduce the cost of doing business in the Asia Pacific region, both through individual and through collective actions. APEC leaders are aware of the lack of a strong push toward the Bogor target in MAPA. Their joint statement admits that MAPA needs to be improved further under the rolling-plan formula and that the business sector should be invited to jointly review and strengthen MAPA. With its basic philosophy of consensus and voluntarism, APEC cannot be a quick process. But both the Bogor declaration and the Osaka Action Agenda have shown the future direction of changes in the Asia Pacific economic order.4

References Asia Pacific Economic Cooperation (APEC). 1993. A vision for APEC: Towards an Asia Pacific economic community. First Report of the Eminent Persons Group. Singapore: APEC Secretariat, October. . 1994. Achieving the APEC vision: Free and open trade in the Asia Pac$c. Second Report of the Eminent Persons Group. Singapore:APEC Secretariat,August. . 1995a. APEC economic leaders’ declaration for action. Document presented at the APEC Economic Leaders’ Meeting, Osaka, 19 November. . 1995b. The Osaka Action Agenda: Implementation of the Bogor declaration. Agenda adopted at the APEC Economic Leaders’ Meeting, Osaka, 19 October. . 199%. The Osaka initial actions. Document submitted to the APEC Economic Leaders’ Meeting, Osaka, 19 November. . 1995d. Selected APEC documents: 1989-1994. Singapore: APEC Secretariat, January. Balassa, Bela. 1961. The theory of economic integration. Homewood, Ill.: Irwin. Organisation for Economic Co-operation and Development (OECD). 1995. Regional integration agreements and the multilateral trading system: Are they compatible? TD/TC (93)15. Paris: Organisation for Economic Co-operation and Development . Pacific Economic Cooperation Council. (PECC). 1995. Implementing the APEC Bogor declaration: Draft PECC statement to the APEC. Report submitted to the eighth Trade Policy Forum, Taipei, April. Yamazawa, Ippei. 1992. On Pacific economic integration. Economic Journal 102 (415): 1519-29. . 1993. Economic integration in the Asia-Pacijc region and the option,for Japan. Tokyo: Ministry of Foreign Affairs, April. . 1994.Asia Pacific economic community: New paradigm and challenges.Journal of Asian Economics 5 (3): 301-12. . 1997. APEC’s liberalizationplans in Manila: An independent analysis.Australian Economic Review 30 (1): 98-102. 4. For further details, see Yamazawa (1997).

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Comment

Chia Siow Yue

Ippei Yamazawa was a member of the APEC Eminent Persons Group (EPG), which has provided the intellectual input that has helped shaped the APEC agenda. I have the following comments on his paper and on the outcome of the APEC ministerial and leaders' meetings in Osaka in November 1995.

Vision for APEC In the introductory part of his paper Yamazawa argues that a common vision of APEC seems to be lacking. However, the vision for APEC is contained in the first two reports of the EPG, the basic recommendations of which have been endorsed by the APEC governments. At Seattle in September 1993, APEC leaders adopted the vision of a community of Asia Pacific economies. At Bogor in November 1994, they set the goal of free and open trade and investment in the region. The issue is not the lack of vision, but how to realistically implement it among a large group of diverse economies and in the absence of a legal framework and binding agreement. The progress of APEC at Seattle and at Bogor was beyond the expectations of most observers and APEC enthusiasts. Even on the eve of the Bogor summit, there was no expectation that APEC members would agree to the goal of free trade and investment. The Bogor summit marked a great leap forward with the agreement to achieve free trade and investment in the region by 2010 for developed economies and by 2020 for developing economies and the adoption of the nonbinding investment principle.

Rationale for APEC To understand the pace of APEC and the issues facing the grouping, it is necessary to retrace the rationale for APEC, which is missing in the paper. The emergence of APEC was in response to a number of developments. First, East Asia and North America were concerned over the slow pace of the Uruguay Round negotiations and needed APEC as a bargaining chip with the European Union for a successful conclusion of the Round, and as an insurance and countervailing region should the negotiations collapse. Second, East Asian countries were concerned over the rise of regionalism in North America and possible U.S. withdrawal from the East Asian region. APEC would anchor U.S. economic and strategic interests in East Asia despite NAFTA and the Enterprise for the Americas. Third, the United States on its part did not want to see the formation of an East Asian economic bloc with Japan as hegemon, as this would lock the United States out of the world's most dynamic economic region. Fourth, Japan and Australia pushed hard for the APEC idea, Japan needChia Siow Yue is associate professor of economics in the Department of Economics and Statistics, National University of Singapore, and advisor on the APEC research program at the Institute of Southeast Asian Studies in Singapore.

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ing the U S . security presence in Asia and Australia not wanting to be excluded from the region should an East Asian bloc materialize. Fifth, economic cooperation, including trade and investment liberalization and facilitation, would help sustain the economic dynamism of the region and complement the unilateral liberalizations undertaken by various APEC economies. While the Uruguay Round has been successfully concluded, the other motivating factors for APEC remain.

Modality of APEC APEC members have been groping for an appropriate modality to realize the vision of an APEC community with free trade and investment. There is general support for the concept of open regionalism rather than the traditional discriminatory trading bloc or free trade area; this includes extending trade and investment liberalization to nonmembers, either in a lesser degree or in the same degree as accorded to members. However, APEC members are divided on whether this extension should be on an unconditional most-favored-nation basis or on a conditional reciprocal basis. Yamazawa proposes that APEC be characterized as an open economic association (OEA) rather than as a trading bloc or free trade area, that is, open in structure and policies, economic in focus, and voluntary in regional cooperation. I support Yamazawa’s proposal on three grounds. First, in view of the large membership and tremendous diversity among APEC members, particularly with respect to stage of development and level of industrial competence, it would be extremely difficult to negotiate an FTA. Second, the FTA concept is not commonly associated with unilateral liberalization, concerted or otherwise, nor with the extension of the benefits of liberalization to nonmembers, whether on a most-favored-nation or reciprocal basis. Open regionalism is consistent with and supportive of multilateral liberalization and the GATT/WTO. Third, an OEA also portrays better than a trading bloc the three pillars of APEC, namely, trade and investment liberalization, trade and investment facilitation, and development cooperation.

The Osaka Action Agenda Success at Bogor created APEC euphoria, and the Osaka summit in November 1995 had to produce an action agenda, short of which APEC’s credibility as a regional grouping would be seriously undermined. The Osaka Action Agenda did provide principles and action plans and consists of two parts, one dealing with trade liberalization and facilitation and the other with economic and technical cooperation. The action agenda for trade and investment liberalization and facilitation contained guiding principles, action plans in 15 specific areas, modalities for implementation, and time schedules. The guiding principles are comprehensiveness in coverage of sectors and impediments; WTO-consistency ; comparability of members’ action plans; nondiscrimination in treatment; transparency

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of laws, regulations, and administrative procedures; commitment to standstill on restrictive measures; simultaneous start of action by members, with continuous process and differentiated timetables; flexibility in dealing with issues in view of the different levels of economic development and diverse circumstances of member economies; and economic and technical cooperation to support liberalization and facilitation. There were difficulties in reaching consensus on the principles of comprehensiveness in coverage and on nondiscrimination of treatment. The action agenda would cover tariffs, nontariff measures, services, investment, standards and conformance, customs procedures, intellectual property rights, competition policy, government procurement, deregulation, rules of origin, dispute mediation, mobility of businesspeople, implementation of Uruguay Round outcomes, and information gathering and analysis; no agreement was reached on specific action on the environment. The modalities for implementing the action plans include both concerted unilateral liberalization in line with guidelines and collective actions. The former is an “Asian approach” initiated by Japan and viewed with reservation by the United States. The time schedules are submission of action plans to the APEC ministerial meeting in Manila in November 1996 for implementation in January 1997. To ensure that the action plans would be implemented under the principle of voluntarism, member countries were cajoled and persuaded to submit “initial actions” or down payments on liberalization and facilitation at Osaka. The action agenda on economic and technical cooperation covers 13 areas, namely, human resource development, industrial science and technology, small and medium-sized enterprises, economic infrastructure, energy, transportation, telecommunication and information, tourism, trade and investment data, trade promotion, marine resource conservation, fisheries, and agricultural technology. Notably it excludes environmental protection. By emphasizing economic and technical cooperation with member governments contributing on a voluntary basis funds, technology, and human skills, rather than the traditional development assistance programs, APEC has adopted a new modality that met the needs of developed countries (particularly the United States) for securing greater market and investment access and the needs of many developing countries for assistance to improve industrial competence, export capability, and absorptive capacity for investments and technology transfers. For a start, Japan announced its contribution of 10 billion yen to fund its program Partners for Progress.

Implementing the Osaka Action Agenda The Osaka summit produced an impressive list of action plans for implementation by APEC member economies individually and collectively. Individual APEC economies submitted the initial down payments at Osaka; they included the acceleration of Uruguay Round commitments as well as privatization of government enterprises and deregulation of foreign investment. Yamazawa concludes that there were both “big and small packages,” but that the

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entire set of initial actions was big enough to show convincingly that the stage of action had been reached. However, there are skeptics, given the modest offerings by the big powers. Member economies are expected to provide full action plans by the time of the Manila ministerial meeting in November 1996. It remains to be seen what specific actions can be achieved at the Manila meeting since the principles and time frames of Bogor and Osaka are only guidelines and are nonbinding. National governments may be expected to face strong resistance from vested interest groups, notwithstanding the shift in national strategies from protectionism to competitive liberalization, and strong political leadership will be needed. Japan and the United States will have to lead with ambitious packages to maintain credibility of the APEC style and process. Some contentious and problematic issues are noted below. First, the Osaka Action Agenda did not produce specific time schedules for trade and investment liberalization toward the 2010 and 2020 target dates. As the early experience in implementing the ASEAN Free Trade Area shows, setting target dates without any agreement and discipline on the starting date and time schedule will create political lobbies in individual member countries to delay implementation to the last. For APEC, how to achieve “concerted unilateral liberalization” is a challenge. The Pacific Business Forum (PBF) has recommended clear and agreed-upon time lines, with common starting dates and specific actions leading to 2020, arguing that unless the groundwork is laid in the first four years, the APEC process could stagnate. The PBF also recommends acceleration, deepening and widening of the Uruguay Round commitments, and progress reviews to compare implementation against commitments. The EPG also recommends accelerating the implementation of Uruguay Round commitments with the adoption of a 50 percent acceleration rule wherever possible, and deepening and broadening the Uruguay Round commitments in the areas of antidumping, competition policy, product standards and testing, and investment principles. Yamazawa advocates a sectoral approach rather than an across-the-board gradual liberalization schedule in the initial phase. However, apart from problems of WTO compatibility and sectoral resource distortions, there is the added problem of agreement on choice of sectors among APEC’s diverse economies. For example, trade and investment liberalization in agriculture, textiles, and services would be a priority for some countries but politically unacceptable to others. A less contentious approach might be different starting dates and schedules-immediate implementation for countries with low trade and investment barriers and later starting dates and slower progression for countries expecting higher adjustment costs. Second, to implement its concept of open regionalism, APEC has yet to settle the issue of unconditional versus conditional most-favored-nation treatment. Member countries would appear to have a choice of extending unilateral liberalization to nonmembers either on an unconditional or on a conditional basis. Yamazawa notes, however, that reciprocity may not conform with GATT

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Article 24 unless all APEC partners enter into a formal and binding agreement. Third, the APEC Nonbinding Investment Principles (NBIP) agreed upon at Bogor are a much watered-down version of the original Pacific Economic Cooperation Council investment code proposal and is even less ambitious than the Trade-Related Investment Measures (TRIMS), with only 5 of the 10 agreed-upon principles meeting or exceeding international norms. The EPG recommends strengthening and implementing NBIP by collective action and conversion into a voluntary code that members would accept as binding once they voluntarily agree to adopt it for their own economies. Likewise, the PBF recommends that NBIP be made legally enforceable and binding by incorporating them into domestic laws no later than the year 2000 for developed countries and 2005 for developing countries. Yamazawa seeks national treatment and harmonization of fiscal incentives. There is also strong pressure to introduce investment codes in the WTO and the OECD, incorporating the principles of right of establishment, national treatment, and most-favored-nation treatment. Many APEC countries do not appear to be ready to accept these principles. In particular, there is strong resistance to full right of establishment in “strategic” services. Finally, to create a community of Asia Pacific economies, there is a need to reduce the incidence of trade and investment conflicts in the region. Bilateral disputes between the United States and Japan and the United States and China have escalated in recent years. The EPG advocates an APEC dispute mediation service to supplement the WTO and address economic disputes not covered by the WTO or other existing international arrangements. The PBF proposes a trade and investment ombudsman for dispute resolution for each APEC country. Yamazawa proposes an APEC code of practice to settle policy- and investment-related disputes, based on existing multilateral mechanisms. Strong political leadership is needed for APEC to resolve these issues and produce meaningful individual action plans at the Manila meeting.

9

A Perspective on the Effects of NAFTA on Korea Honggue Lee

9.1 Introduction A free trade agreement (FTA) has significant implications for trade and investment flows in and out of the free trade area, as it reshapes the conditions of competition between member countries and outsiders. A regional preferential arrangement can induce the replacement of a higher-cost source in one member with a lower-cost source in another member, resulting in trade creation. On the other hand, a preferential arrangement often gives rise to the replacement of a more efficient source in a nonmember with a higher-cost source in a member, causing trade diversion. The members of the agreement are concerned with the net effect of trade creation and trade diversion. For member countries, preferential liberalization will improve welfare if trade creation exceeds trade diversion. By contrast, nonmembers are mostly concerned with the trade diversion effect. Trade diversion arises when an FTA generates a change in relative prices between the products originating in member countries and products originating in nonmember countries and a switching of import sources from relatively more efficient nonmembers to preferentially treated member suppliers. Nonmembers also worry about an increase in the level of protection against them by member countries. Often, the removal of trade barriers within large markets results in the raising of the actual or potential barrier against the outside world. The North American Free Trade Agreement (NAFTA) is an “expanded’ free trade agreement in the sense that it goes beyond the conventional reduction of tariffs and nontariff bamers. On top of dealing with general market access, NAFTA addressed an array of domestic policy issues ranging from local content requirements to rules of origin, competition policies, intellectual property rights, dispute settlement mechanisms, and foreign direct investment. As such, Honggue Lee is professor of international economics at Kon-Kuk University in Seoul, Korea.

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NAFTA could have both negative and positive effects on the rest of the world. Negative effects could stem from the diversion of trade and investment away from countries that do not belong to NAFTA. Negative effects would escalate into “trade suppression” should the agreement result in higher levels of protection against outsiders. On the other hand, positive effects could result from accelerated growth within the three NAFTA partners. The “growth dividend” of NAFTA could offset the agreement’s discriminatory effect in the long run. According to preliminary studies on the effects of NAFTA, the overall net effect for the rest of the world is relatively insignificant (see Primo Braga 1992 for details). NAFTA is not likely to have a serious impact on nonmember countries as far as trade flows are concerned. Moreover, the completion of the Uruguay Round is expected to mitigate the diversion effect of NAFTA. For instance, the average tariff rate of the United States, which stayed around 5 percent, is to be cut by one-third as the result of the Uruguay Round trade talks. This additional cut in tariff rates will reduce the discriminatory effect of preferential liberalization in North America. For another instance, bilateral quotas negotiated under the Multi-Fiber Arrangement (MFA) umbrella are to be phased out over 10 years after the conclusion of the Uruguay Round. This reform will lessen the discriminatory effect of eliminating quotas on Mexico against nonmember countries. Despite the small aggregate effect, however, the effects on specific sectors or individual countries could be significant. While NAFTA is a movement toward “freer” trade among its partners, it does not imply free trade within North America. Several nontariff barriers at the sectoral level will remain in the form of new rules designed for the benefit of member countries. Consequently, companies in those sectors where rules of origin or local content requirements are applied in a discriminatory fashion could be susceptible to severe losses resulting from trade diversion. At the same time, the (trade and investment) diversion effects of NAFTA are likely to be felt differently among nonmember countries. NAFTA is based on the experience of CUSFTA (the Canadian-U.S. Free Trade Agreement) or the terms of accession of Mexico to CUSFTA. Countries in Latin America and the Caribbean have shown less concern with the discriminatory effects of NAFTA, as they are more interested in the prospective Western Hemisphere Free Trade Area. By contrast, members of the US.-Caribbean Basin Initiative have been concerned with trade diversion, as their existing preferences could be eroded by NAFTA. Outside the Western Hemisphere, it is hard to identify the immediate “victims” of the discriminatory effects of NAFTA. Neither the European Union nor developing countries in Asia and Africa show great concern. Only the Asian newly industrialized economies (NIEs) and Japan seem to be directly concerned about the possibilities of trade and investment diversion. NAFTA’s effects on nonmember countries will depend on the pattern of their international specialization. For instance, the diversion of trade and investment away from Japan will be different from that away from Korea: Japan’s special-

225

A Perspective on the Effects of NAFTA on Korea

ization pattern is less like Mexico’s than Korea’s is; hence, Korea is more susceptible to the diversion effect than Japan. Like most industrialized economic partners of NAFTA that specialize in technology-intensive industries, Japan is less likely to be affected by Mexico’s accession in the U.S.-Canada Free Trade Area. On the other hand, Korea’s concern with NAFTA has to do with its potential or actual “rivalry” with Mexico in the U.S. market. Many of Korea’s major export items compete with Mexican products in the U.S. market. In view of the role that the United States has played as an outlet for Korean exports, Korea has reason to worry about the emergence of a potentially discriminatory NAFTA. Most adverse impacts of NAFTA for nonmembers are felt through trade diversion. Yet the main message of quantitative studies focusing on NAFTA highlights the importance of capital flows in determining the impact of NAFTA on both members and nonmembers. In particular, barriers to capital flows, including the cost of international financing, are expected to play a much larger role in shaping NAFTA’s welfare effects than its preferential trade liberalization components (see Primo Braga et al. 1994). While NAFTA consolidates a prior trend toward increased intraregional investment between the three countries, it also encourages inward direct investment from outside the region. Multinational firms from nonmember countries invest in North America in order to exploit the growth prospects of an enlarged market and to escape latent trade barriers. Despite recent economic turbulence resulting from its macroeconomic mismanagement, Mexico is likely to benefit from the increased confidence of investors in the expanded North American market. The projected capacity of intended investment well exceeds domestic demand. Many investments from outside are suspected of taking advantage of Mexico and Canada as export platforms from which to serve the North American market. Yet, other investments are being made to gain access to the Mexican market. In the following, the diversion effects of NAFTA are discussed in relation to Korea’s trade performance. In particular, the extent of trade diversion associated with NAFTA is investigated with regard to competition between Korea and Mexico in the U.S. market. For that purpose, a series of economic indicators, which draws on partial equilibrium analyses of competition between Korea and Mexico, is examined.

9.2 Korea’s Economic Ties with NAFTA Members 9.2.1 Trade Relations Exports and Imports

The amount of trade flow between Korea and NAFTA members started r i s ing rapidly in the early 1980s. It surpassed $30 billion in 1988 ($34 billion), peaked at $38 billion in 1991, and has stayed at $37 billion since then. While

226

Honggue Lee

Table 9.1

Korean Exports (billion U.S. dollars)

Year

NAFTA

Japan

ECll

APECll

United States

Canada

Mexico

1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993

1.682186 2.756692 3.312916 4.280469 4.656868 4.868155 6.035316 6.602964 8.792832 11.234928 11.886684 15.003972 19.594209 23.135853 22.766880 21.455263 20.804532 20.456137 20.37781I

0.999604 1.463806 1.518486 2.05 1529 2.642944 2.38299 1 2.739962 2.693962 2.689189 3.8089 12 3.766509 4.366943 7.058927 10.321734 11.841780 10.959775 10.909689 10.145717 10.271920

0.729258 1.101 120 1.341487 1.817312 2.301 39 1 2.602920 2.657748 2.79594 1 2.991306 3.192705 3.111112 4.173768 6.488212 7.992441 7.25462 1 8.721625 9.579618 9.114189 9.323735

0.416475 0.631974 0.755377 1.058086 1.479617 2.310194 2.746709 2.680638 2.639403 3.275508 3.610784 3.826197 5.310175 8.322185 9.527817 11.395328 14.125746 20.089892 24.011579

1.480498 2.433963 3.0021 17 3.943307 4.246108 4.48 1955 5.505332 6.118009 8.114244 10.338910 10.634998 13.709028 18.013200 21.168185 20.432270 19.172382 18.369764 17.941072 18.003603

0. I96794 0.313542 0.297261 0.326047 0.386378 0.341536 0.480015 0.441977 0.627750 0.876695 1,225603 1.244287 1,447860 1.688199 1.872945 1.724817 1.661005 1.608600 1.376907

0.004894 0.009187 0.013539 0.011115 0.024381 0.044663 0.049970 0.042978 0.050838 0.0 19323 0.026083 0.050657 0.133149 0.279470 0.461665 0.558064 0.773763 0.906465 0.997301

Source: Korea Customs Research Institute, Statisticnl Yearbook of Foreign Trade (Seoul, 1995).

Korea has maintained a strong economic relationship with the United States, its relationship with the other NAFTA members has been less substantial. The amount of trade flow (exports plus imports) between Korea and the other two NAFTA countries was less than $1 billion until 1983 (see tables 9.1 and 9.2). Korea’s major exports to North American markets are household electronic goods, industrial electronics (including semiconductors), textiles and apparel, machinery, and footwear. Korea’s major imports from North America include agricultural products, chemical products, metal products, and machinery. The United States constitutes the second largest source of imports for Korea. Yet its share began to decline recently as a result of a rapid increase in the import share garnered by Asian NIEs and ASEAN countries. The Asian NIEs and ASEAN countries as a group are becoming a major source of imports (see table 9.2).’ Korea’s market share in North America peaked in 1988; however, it began to decrease as products made in China and Southeast Asian countries rushed into these markets. This decline of Korea’s market share is attributable to a 1. The import market share of Asian NIEs has been increasing as more electric machinery and industrial electronic devices and parts are being imported from these countries. The import market share of ASEAN has increased as imports of raw materials have expanded. Australia’s import market share has also been on the rise as the result of an increase in demand for nonferrous metals and other raw materials. China’s share increased abruptly in 1991 to account for 5.7 percent of total imports. (China’s share was insubstantial in the 1980s.)

A Perspective on the Effects of NAFTA on Korea

227 Table 9.2

Korean Imports (billion U.S. dollars) -~

~~

Year

NAFTA

Japan

ECll

APECll

United States

1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993

1.003345 1.018761 1.334810 1.761153 2.961535 2.874717 3.546411 4.288328 4.391132 5.147443 4.916301 5.032281 6.734879 10.524139 14.207214 14.174441 17.059077 16.268878 16.306717

2.395788 3.031103 3.867749 5.895952 6.481254 5.622481 5.966598 5.123092 6.075369 7.478236 7.372691 10.714075 14.034761 15.953447 17.610135 17.829387 20.229941 18.635443 19.325485

0.539375 0.647458 0.786231 1.365201 2.072619 1.544028 1.875969 1,702774 2.121939 2.703215 2.966435 3.064150 4.733229 5.979241 6.513836 7.929549 9.284450 9.001606 9.601873

0.319125 0.281972 0.385788 0.631397 0.879439 1.251654 1.684179 2.126466 2.371375 3.034364 3.249493 2.466605 3.613989 4.779502 6.314504 8.674053 8.178432 11,373990 11.942687

0.876854 0.951402 1.248787 1.620344 2.759888 2.636908 3.204788 3.806494 4.009561 4.673832 4.514586 4.553151 6.167769 9.619804 13.044830 13.099968 15.747200 15.211794 15.236629

Canada

Mexico

0.124520 0.066805 0.085017 0.133945 0.195174 0.224002 0.321262 0.246683 0.209124 0.300976 0.288706 0.332956 0.436490 0.729283 1.033606 0.846514 1.109908 0.907984 0.939183

0.001971 0.000553 0.001006 0.006864 0.006472 0.013807 0.020360 0.235151 0.172447 0.172635 0.113009 0.146175 0.130620 0.175053 0.128779 0.227958 0.201969 0.149100 0.130904

Source: Korea Customs Research Institute, Srurisricul Yearbook ojForeign Trade (Seoul, 1995).

recession in the United States and Korea’s loss of competitiveness. At the same time, Korea’s trade surpluses triggered protectionist pressure from the United States. (Korea had continuously recorded trade surpluses with NAFTA countries.) However, Korea’s market share loss in North America has been supplemented by its market share gains in the Asian NIEs and ASEAN countries due to Korea’s market diversification efforts and the economic growth of these countries. Structure of Interdependence

The relative intensities of Korea’s trade linkages with NAFTA countries delineate a structure of interdependence between Korea and NAFTA. These intensities are often expressed in terms of gravity coefficients (or trade intensity indexes). The gravity coefficients summarize each country’s bias toward its trade partners. One version of gravity coefficients can be obtained from the ratio of an exporter’s share in a given market to its share in a given region, which can be expressed as follows:

where i and j denote the origin and the destination, respectively, and x the volume of trade. The coefficients have been calculated for the Asia Pacific economies with a

Table 9.3

Gravity Coefficients of APEC Countries in 1986 (import) Destination

Origin Korea United States Canada Mexico Japan China P.R. Indonesia Malaysia Philippines Thailand Brunei Singapore Taiwan Hong Kong Australia New Zealand

Korea U S . Canada Mexico Japan

1.23 1.25 0.23 0.21 1.78 0.81 1.75 0.66 1.15 1.60 0.40 0.34 0.49 1.60 0.75

2.04 2.00 1.31 0.49 0.65 0.46 1.08 0.73 0.08 0.85 1.43 1.09 0.40 0.64

0.41 3.59 0.35 0.30 0.14 0.05 0.07 0.14 0.15 0.09 0.30 0.31 0.18 0.26

0.04 3.76 0.18 0.30 0.13 0.07 0.06 0.01 0.01 -

0.04 -

0.04 0.12 0.37

1.51 1.63 0.46 0.51 1.66 4.04 2.24 1.93 1.68 4.99 0.79 0.99 0.38 3.02 1.74

China IndoSingaHong New P.R. nesia Malaysia Philippines Thailand Brunei pore Taiwan Kong Australia Zealand

0.75 0.27 0.10 1.70 0.51 0.29 0.61 0.99 0.00 0.85 -

5.69 1.72 1.11

0.40 0.72 0.17 0.02 1.30 0.85 0.25 0.38 0.76 0.03 4.56 0.75 0.29 1.55 1.12

0.64 1.05 0.11 0.01 0.98 0.76 0.73 1.81 4.78 0.04 8.11 0.68 0.74 1.82 1.41

0.98 1.47 0.08 0.04 0.86 0.71 1.53 2.47 0.73 1.04 1.39 1.23 1.88 1.41 1.53

0.76 0.89 0.13 0.13 1.41 0.93 0.41 2.65 1.36 8.41 3.96 0.85 0.61 0.85 0.70

Data Source: International Monetary Fund, Direction of Trade Statistics Yearbook (Washington, D.C., 1993).

0.26 0.70 0.01 0.01 0.87 0.57 0.37 3.42 0.32 3.86 14.28 0.51 0.49 1.14 0.51

0.74 0.93 0.04 0.01 1.06 1.81 8.39 1.26 3.89 2.32 0.94 0.94 0.84 0.74

0.43 1.36 0.18 -

1.66 0.77 0.85 0.86 0.75 0.51 1.20 1.54 1.41 0.61

1.09 0.45 0.05 0.02 0.93 8.24 0.29 0.40 0.92 1.26 0.01 2.04 1.75 0.60 0.47

0.66 1.46 0.22 0.07 1.28 0.49 0.52 0.72 0.62 0.97 0.23 1.30 0.93 0.88 8.36

0.42 1.12 0.26 0.06 1.16 0.21 1.19 0.30 0.45 0.42 -

1.47 0.54 0.00 8.09

229

A Perspective on the Effects of NAFTA on Korea

view to comparing them with NAFTA and East Asian countries. According to its gravity coefficients, Korea’s trade in North America has been concentrated mostly in the United States. Korea has maintained much less intense relations with Canada and Mexico. The situation has not changed over the years. By contrast, Korea’s trade relationship with APEC members has intensified. In 1986, Korea maintained intense trade relationships with only three regional partners (3 out of 15 countries): the United States, Japan, and Hong Kong (see table 9.3). That is, the gravity coefficient of Korea’s exports to its trading partners in the region is greater than 1 for these three countries. In 1992, the number of countries increased to seven, adding Indonesia, China, Thailand, and Singapore (see table 9.4). Small changes in Korea’s trade pattern with NAFTA members can be attributed to the absence of structural linkages with Canada and Mexico driven by intraindustry trade or intrasectoral comparative advantage based on differences in labor costs. Korea’s intensified trade linkages with China, Thailand, Indonesia, and Singapore have been established at the “expense” of Korean trade linkages with the United States. This development implies that Korean trade relations with APEC members (particularly East Asian countries) have become more diversified than before. Yet, Korea’s extended trade relations with member countries in the region cannot be attributed to geography or policy-related (horizontal) ties with these countries.* Instead, it resulted from the changing pattern of comparative advantage and specialization, reflecting increasing vertical linkages between Korea and other NIEs.~ 9.2.2 International Industry Linkages: Backward Linkages and Net Export Earnings Backward Effects The degree of trade interdependence can be measured further in terms of linkages between industrial sectors participating in international transactions and their domestic counterparts. The extent to which the Korean economy is integrated into the North American economy can be inferred from its standard input-output mat rice^.^ The input-output matrix contains information on a key aspect of economic integration: international linkages through imported inputs 2. Peter Petri (1993) has suggested three different kinds of structural linkages: geographical linkages, vertical linkages, and horizontal linkages. 3. Another version of gravity coefficient, calculated from the ratio of an exporter’s share in a given market to its share in all world trade, shows that Korea has maintained a very intense trading relationship with Asia Pacific countries and that its intensity increased during the 1980s. Korea has shown an increasingly strong regional bias: while Korea’s gravity coefficients were greater than 1 with 10 out of 15 countries in 1986, they were greater than 1 with 12 countries in 1990 (see tables 9.5 and 9.6). 4. An international input-output system would delineate detailed information on the economic structures of several national economies and on relationships among these economies. Yet, for the present purpose, only Korea’s input-output matrices are considered.

Gravity Coefficients of APEC Countries in 1992 (import)

Table 9.4

Destination

Origin

Korea U S . Canada Mexico Japan ~

Korea United States Canada Mexico Japan China P.R. Indonesia Malaysia Philippines Thailand Brunei Singapore Taiwan Hong Kong Australia New Zealand

~~

1.02 1.34 0.26 0.08 1.54 0.69 1.61 0.96 0.56 0.55 2.62 1.56 0.41 0.33 1.77 1.29

New China IndoSingaHong P.R. nesia Malaysia Philippines Thailand Brunei pore Taiwan Kong Australia Zealand

2.66 2.74 1.25 0.81 0.53 0.74 1.54 1.09 0.04 0.89 1.28 0.67 0.36 0.56

0.35 3.33 0.61 0.40 0.22 0.13 0.15 0.27 0.24 0.00 0.14 0.37 0.22 0.20 0.26

0.40 3.57 0.12 0.36 0.04 0.06 0.09 0.04 0.11 -

0.06 0.16 0.29 0.05 0.35

1.67 1.50 0.49 0.23

I .23 3.35 1.40 1.88 1.99 4.42 0.58 1.15 0.33 2.78 1.76

1.03 0.69 0.34 0.06 1.15 1.16 0.48 0.35 0.39 0.04 0.64 -

8.95 1.02 0.79

2.40 0.68 0.20 0.13 1.48 0.29 0.93 0.50 0.82 2.76 1.27 1.01 2.42 1.14

0.81 0.84 0.08 0.01 1.48 0.33 0.81 0.91 1.54 0.03 5.48 1.26 0.67 1.10 1.26

0.23 1.09 0.16 0.02 1.49 0.22 0.64 1.37 0.73 4.15 1.23 1.68 2.43 0.98 1.33

1.30 0.69 0.13 0.05 1.86 0.45 0.40 1.72 0.50 3.60 2.83 1.38 0.40 1.03 0.71

Data Source: International Monetary Fund, Direction of Trade Statistics Yearbook (Washington, D.C., 1993).

0.09 1.27 0.01 -

0.48 0.07 0.43 3.14 0.10 0.84 11.30 0.09 0.52 0.44 0.45

1.34 0.79 0.05 0.03 1.15 0.42 1.37 5.77 0.63 2.72 1.74

0.94 1.25 0.15 0.09 1.88 -

1.06 0.78 0.67 0.60 0.66 0.84

0.88 1.44

1.78 0.47

1.94 1.20 0.71

1.15 0.37 0.05 0.02 0.93 4.67 0.33 0.50 0.51 0.72 0.00 1.34 1.92

0.36 0.35

0.87 1.44

0.23 0.06 1.24 0.67 1.36 0.83 0.54 0.10 1.00 1.02 0.52 10.59

0.46 1.17 0.22 0.03 0.95 0.40 0.38 0.52 0.29 0.58 0.86 0.68 0.43 9.91

Gravity Coefficients in 1986 (export + import)

Table 9.5

Destination

Origin

Korea

U.S.

Korea United States Canada Mexico Japan China P.R. Indonesia Malaysia Philippines Thailand Brunei Singapore Taiwan Hang Kong Australia New Zealand

2.241 2.125 0.752 4.823 0.333 4.864 2.993 2.272 0.782 1.539 1.290 2.495 1.045 1.601 2.010 1.636 1.079 2.527 0.597 1.093 1.331 0.765 2.775 1.998 1.314 1.966 1.129 1.015 1.117

Canada Mexico 0.765 4.905 0.645 0.687 0.384 0.252 0.161 0.230 0.25 1 0.146 0.610 0.361 0.384 0.461

0.227 4.501 0.405 0.802 0.297 0.092 0.070 0.050 0.235 0.042 0.055 0.141 0.383

Japan 7.257 5.149 1.799 1.640

China P.R.

Indonesia

-

1.376 1.186 0.274 0.050 4.678 1.056

0.681 0.452 0.145 2.874

5.940 11.371 1.056 5.660 0.760 0.766 5.401 1.358 1.842 5.354 1.387 1.409 12.352 0.055 0.159 3.966 2.309 8.418 1.781 5.292 3.528 13.068 1.092 6.68 1 1.750 1.818 4.744 1.107 2.045

Malaysia 2.659 1.206 0.245 0.040 2.699 1.016 1.347 5.186 7.392 1.968 15.682 1.747 1.370 2.423 1.444

Philippines 1.911 2.071 0.289 0.061 2.121 1.254 2.784 4.614 2.238 1.881 2.725 2.574 3.035 1.861 1.734

Thailand

Brunei

1.749 1.118 0.333 0.165 2.495 1.692 1.119 6.293 1.912

3.844 0.534

14.572 7.493 1.641 1.739 1.439 0.859

Data Source: International Monetary Fund, Direcfion of Trade Statistics Yearbook (Washington, D.C., 1993).

Singapore

Taiwan

1.301 1.306 0.144 0.049 1.784 2.361

0.858 2.862 0.667

0.337 3.831 20.748 2.046 3.111 15.740 7.531 12.762 11.451 1.165 2.001 0.246 2.730 1.051 1.925 0.362 1.777

1.895 1.586 2.203 1.696 0.956 2.310

-

6.570 -

-

2.387 -

3.978 2.038 1.115

Hang Kong 2.155 1.375 0.369 0.050 1.533 14.413 1.356 1.033 2.970 2.177 0.191 3.337 3.580 1.350 0.925

Australia 2.046 1.136 0.468 0.133 3.008 1.707 2.048 1.989 1.469 1.446 0.555 1.933 2.196 1.375 14.338

New Zealand 0.944 1.160 0.525 0.272 2.181 1.167 2.341 1.123 1.590 0.760

1.849 1.110 0.490 12.981

Gravity Coefficients in 1992 (export

Table 9.6

+ import) Destination

Origin

Korea

Korea United States Canada Mexico Japan China P.R. Indonesia Malaysia Philippines Thailand Brunei Singapore Taiwan Hang Kong Australia New Zealand

1.758 0.586 0.494 2.61 1 1.402 3.485 1.798 1.774 1.515 3.363 2.542 1.092 1.763 2.394 1.533

U.S.

Canada

Mexico

1.679

0.566 5.297

0.550

5.503 5.481 1.933 1.198 0.964 1.255 2.021 1.298 0.793 1.305 1.956 0.794 1.152 1.053

5.444

0.801 0.776 0.756 0.508 0.340 0.253 0.420 0.313 0.013

0.640 0.089 0.193 0.138 0.060 0.165

0.518 0.257 0.403

0.092 0.285 0.274 0.116 0.460

Japan

2.691 1.963 0.739 0.631

China P.R.

1.579 0.784 0.441 0.116 1.984

Indonesia

3.000 0.943 0.341 0.194 3.793 1.191

1.735 4.006 1.552 2.487 0.852 1.721 2.785 0.594 1.133 3.108 0.855 1.146 4.341 0.147 1.729 1.198 4.759 2.080 2.549 1.637 14.184 1.121 3.038 1.240 3.217 1.963 0.871 1.206

Malaysia

1.693 1.300 0.219 0.128 2.570 0.744 1.824 2.437 3.358 3.094 11.967 2.079 1.251 1.932 2.392

Philippines

Thailand

Brunei

0.351 2.312 0.504 0.072 3.303 0.576 1.243 2.989

1.663 1.243 0.335 0.154 3.156 0.754 1.010 3.232 1.033

3.301 0.852 0.012

1.323 7.204 2.032 2.824 2.883 1.722 1.992

5.482 4.879 1.869 I . 123 1.757 0.897

Data Source: International Monetary Fund, Direction of Trade Statistics Yearbook (Washington, D.C., 1993).

-

Singapore

2.158 1.263 0.182 0.089 1.785 0.917

3.978 0.118 0.499 3.474 12.370 5.475 2.129 5.325 5.033 11.335 0.808 0.326 1.232 -

1.676 2.626 2.849 1.125

Taiwan

1.188 1.954 0.515

0.274 2.545 -

2. I85 2.159 2.386 1.978 0.818 2.075 1.630 4.023 1.923 1.215

Hang Kong

1.651 1.137 0.306 0.201 1.499 11.478 0.841 0.994 1.754 1.157 0.230 2.763 3.036 1.028 0.758

Australia

2.362 1.175 0.466 0.113 2.855 1.257 3.352 1.783 1.690 1.080 1.174 1.947 1.131 19.718

New Zealand 1S40

1.209 0.448 0.458 1.995 0.807 1.256 1.624 1.591 1.091

0.183 1.239 0.747 17.620 0.390

233

A Perspective on the Effects of NAFTA on Korea

and exported outputs. The information contained in the input-output matrix reveals the structure of “international production chains.” In particular, the input-output matrix can be used to infer “international backward linkages,” measures of which are very useful tools in assessing a relationship between trade and the domestic economy. International backward linkage measures indicate the direct and indirect import requirements of a particular demand sector (see Petri 1993 for details).

ZM

=

M(Z - A,)-’F,

where IM denotes the vector of imports due to a change in F (a final demand vector), A, is the domestic input coefficient matrix, and M is the import coefficient matrix. This measure indicates the amount of imports required to produce a unit of output in a particular industry, and hence the degree of dependence on foreign resources (see tables 9.7-9.10 for the following analysis). Korea’s imports from NAFTA (APEC) countries induced by the increase in its exports to these countries amounted to $5.6 billion ($11.2 billion) in 1990, while they were $3.14 billion ($4.97 billion) in 1985 (see table 9.9). In five years, Korea’s induced imports from NAFTA countries less than doubled, while its induced imports from APEC members more than doubled. The United States accounted for 56 percent of Korea’s total induced imports in 1985 and 44 percent in 1990. Canada accounted for 6.8 percent in 1985 and 4.0 percent in 1990. The combined share of these two countries declined from almost 63 percent to 48 percent. Mexico’s share rose to 1.3 percent in 1990. This change implies that Korea’s backward linkages with these countries have lessened a lot during the 1985-90 period. On the other hand, induced imports from Japan increased more than three times, while those from the United States less than doubled. These developments indicate that it will take time for Korea to expand the basis of its integration into North America (and into the APEC area as a whole) and that Korea’s dependence on Japanese inputs has indeed deepened despite Korea’s deliberate efforts to reduce its trade dependence on Japan. When it comes to sectoral linkages, induced imports from North America are largest in the metal products and machinery sector (see table 9.9). The chemicals and chemical products, primary metal products, and textiles and leather sectors follow the metal products and machinery sector in order of importance. Yet, the rate of increase between 1985 and 1990 was fastest in the food, beverages, and tobacco products sector. This sector is followed by the paper, printing, and publishing and lumber and wood products sectors in order of magnitude. Net Export Earnings

Given the structure of export supply, net export earnings reflect another aspect of international linkages. Net export earnings are export revenues net of imported inputs used for the production of exportables. Thus, sectoral contri-

234

Honggue Lee Korean Exports to APEC Countries (million US. dollars)

Table 9.7

Industry Country

1

2

3

4

5

6

7

8

9

Total

Year = 1990

401.1 63.6 945.4 13.6 257.3 1.6 23.5 109.4 10.8 64.5 Australia Brunei 0.2 0.1 0.0 0.0 0.0 0.0 0.0 1.0 0.0 1.5 806.4 86.6 1,724.8 19.0 648.4 2.6 7.0 106.3 11.2 37.3 Canada 78.9 133.9 4.5 579.6 China 3.6 107.1 5.4 37.0 194.3 15.0 195.3 1,221.3 177.6 3,659.6 Hong Kong 66.4 1,456.5 18.5 145.7 357.5 20.9 Indonesia 28.0 328.5 0.4 13.0 149.2 6.9 117.8 401.4 15.9 1,061.2 Japan 331.2 3,665.8 175.9 35.6 1,166.6 352.3 1,546.2 3,259.4 426.7 10,959.8 Malaysia 2.4 49.7 0.4 5.2 47.8 4.5 103.9 472.8 11.8 698.6 15.6 1.9 14.4 39.9 9.7 125.9 New Zealand 1.2 38.0 0.3 4.9 89.2 3.3 62.1 224.0 4.3 493.7 Philippines 1.8 100.9 2.3 5.8 Singapore 11.0 226.6 2.6 6.2 125.0 8.6 137.7 1,181.5 36.9 1,736.1 21.8 176.8 19.8 5.9 197.8 17.0 182.8 511.6 31.0 1,164.5 Taiwan 4.8 153.0 337.5 18.9 929.2 Thailand 3.3 216.5 0.7 9.5 185.0 700.0 9,187.7 1,350.7 19,172.4 United States 108.1 6,837.6 64.1 106.8 703.7 113.7 Mexico 17.4 139.5 0.8 1.1 15.7 0.7 16.1 344.9 21.8 558.1 628.9 14,249.4 295.5 407.1 3,463.3 571.7 3,410.1 18,524.5 2,259.9 43,810.4 APEC Year = 1985 Australia 7.2 0.0 Brunei 11.3 Canada China 0.0 20.8 Hong Kong Indonesia 0.2 157.2 Japan Malaysia 0.6 New Zealand 0.3 0.0 Philippines 2.1 Singapore Taiwan 2.6 Thailand 0.7 United States 62.0 0.0 Mexico APEC 264.9

125.5 0.0 392.3 0.0 408.5 20.1 1,095.7 18.2 19.2 21.3 116.2 27.8 18.6 4.1 15.0 12.2 6,390.6

0.9 0.0 0.6

0.0 5.6 0.2 45.9 0.3 0.0 0.1 2.9 0.2 0.0 42.1 0.0 98.9

3.7 35.5 2.8 46.4 0.0 0.0 1.5 2.5 38.0 8.5 35.7 1.6 0.0 0.0 0.0 0.0 24.6 148.7 23.3 121.9 42.5 68.9 2.5 0.5 9.2 841.3 93.0 468.8 2.8 17.0 5.0 27.6 3.9 0.2 3.3 0.1 0.7 96.3 1.6 33.6 4.1 37.3 13.7 22.0 1.0 56.1 0.6 38.6 23.7 1.0 60.5 0.8 47.1 460.3 98.6 602.2 0.1 0.5 0.0 3.4 95.9 1,875.4 253.2 1,461.3

115.2 29.1 366.3 0.0 4.8 0.5 688.3 49.3 1,225.6 0.0 0.0 0.0 745.2 47.6 1,546.1 53.8 0.8 189.6 946.1 109.4 3,766.5 2.6 444.3 370.2 7.1 2.1 36.3 82.4 0.2 236.2 276.9 5.2 480.3 38.1 4.4 169.5 29.4 2.5 137.3 4,445.0 762.6 10,635.0 26.1 8.5 1.3 7,806.6 1,017.2 19,264.0

Data Sources: Bank of Korea, Input-Output Tables (Seoul, 1985, 1990); Korean Customs Administration, Statistical Yearbook of Foreign Trade (Seoul, 1985, 1990). Note: Industries-1, food, beverages, and tobacco products; 2, textiles and leather; 3, lumber and wood products; 4, paper, printing, and publishing; 5, chemicals and chemical products; 6, nonmetallic mineral products; 7, primary metal products; 8, metal products and machinery; 9, miscellaneous manufactured products.

butions to net export earnings reveal the extent of sectoral import dependence. The export earnings ratio calculates the sectoral ratio of net export earnings to exports. For instance, a high export earnings ratio indicates low import dependence. Such sectoral net export earnings are obtained from the following formula:

235

A Perspective on the Effects of NAFTA on Korea Korean Imports from APEC Countries (million U.S. dollars)

Table 9.8

Industry Country

1

2

3

4

5

6

7

8

9

Total

Year = 1990 Australia 324.9 35.2 Brunei 0.0 0.0 Canada 23.6 21.7 China 159.9 572.3 Hong Kong 1.3 60.5 Indonesia 23.4 32.8 Japan 52.6 743.3 Malaysia 73.7 8.7 New Zealand 36.2 8.8 Philippines 34.6 5.1 Singapore 11.1 2.1 Taiwan 14.0 313.5 Thailand 191.8 12.2 United States 364.2 267.3 Mexico 1.1 3.2 APEC 1,312.4 2,086.7 Australia Brunei Canada China Hong Kong Indonesia Japan Malaysia New Zealand Philippines Singapore Taiwan Thailand United States Mexico APEC

90.3 0.0 6.9 0.0 1.1 23.2 41.3 43.3 29.9 25.3 13.1 11.7 22.5 72.3 0.0 380.9

0.5 10.6 86.9 2.6 508.3 62.5 4.1 1,035.5 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 3.6 175.6 122.8 3.5 808.2 18.8 168.8 269.8 8.5 0.4 328.7 201.9 236.2 42.8 36.4 1,587.2 2.1 11.6 27.2 6.0 25.2 432.6 14.1 580.5 292.5 28.3 112.0 12.2 36.8 9.7 9.3 557.0 60.7 171.5 3,482.6 257.2 1,806.9 11,048.3 207.0 17,830.2 128.3 0.3 76.5 4.3 58.1 164.3 0.9 515.0 0.0 53.2 1.8 0.0 214.7 6.9 39.2 68.4 0.5 59.0 1.5 46.2 70.5 3.8 223.3 2.2 4.0 9.4 354.6 5.5 42.5 448.6 2.2 880.2 3.6 45.6 166.5 28.3 193.1 537.6 52.9 1,355.1 3.4 1.7 15.8 8.3 3.8 87.5 1.6 326.1 116.9 787.7 2,783.1 96.5 1,202.5 7,326.3 155.1 13,099.5 0.1 160.0 0.5 1.4 112.7 2.2 31.8 6.9 649.0 1,277.0 7,943.6 630.2 4,420.1 20,362.3 491.0 39,172.4 Year = 1985

11.4 0.2 0.0 0.0 2.5 7.7 0.0 0.0 0.6 37.2 6.6 17.3 492.4 8.4 3.8 25.7 0.4 6.8 0.7 1.1 4.0 0.8 66.4 0.6 4.5 5.1 109.0 25.6 0.0 0.0 747.2 91.4

3.0 30.0 0.3 119.4 13.7 0.3 268.5 0.0 0.0 0.0 0.0 0.0 0.0 0.0 33.6 48.3 142.2 5.6 41.7 0.2 288.7 0.0 0.0 0.0 0.0 0.0 0.0 0.0 2.5 5.1 0.6 4.1 411.0 6.4 468.6 10.0 1.2 0.0 0.0 79.4 2.9 18.1 71.4 1,323.3 181.0 962.1 4,210.9 82.0 7,372.7 0.0 8.9 0.1 8.2 215.8 0.2 306.1 0.0 24.9 7.3 7.3 0.3 0.0 76.9 0.0 9.0 0.1 18.5 67.9 0.1 122.7 4.0 85.5 0.7 1.8 137.8 0.1 247.8 12.6 50.7 4.6 40.7 88.9 3.1 279.2 0.0 4.3 30.0 0.0 69.4 0.8 2.1 257.6 1,002.3 50.3 303.4 2,661.7 32.3 4,514.6 0.1 62.9 0.0 2.6 7.4 0.0 73.2 410.6 2,747.0 243.3 1,534.1 7,888.4 124.9 14,167.9

Data Sources: Bank of Korea, Input-Output Tables (Seoul, 1985,1990);Korean Customs Administration, Statistical Yearbook of Foreign Trade (Seoul, 1985, 1995). Note: See table 9.7 note for key to industries.

NX = E - M ( I - A,)-'E, where A, is the domestic input coefficient matrix, E denotes Korea's exports (to the Asia Pacific region), and M indicates the import coefficient matrix. Net export earnings ratios in North American markets were around 82-98 percent in 1990 (80-96 percent in 1985) in the textiles and leather, metal prod-

236

Honggue Lee Backward Effects of Korea’s External Linkages with APEC Countries (million U.S. dollars)

Table 9.9

Industry Country

1

2

3

5

4 Year

Australia Brunei Canada China Hong Kong Indonesia Japan Malaysia New Zealand Philippines Singapore Taiwan Thailand United States Mexico APEC

15.2 0.0 35.9 6.9 81.3 19.1 212.6 3.7 2.2 6.0 14.6 11.9 12.8 378.0 8.4 808.7

Australia Brunei Canada China Hong Kong Indonesia Japan Malaysia New Zealand Philippines Singapore Taiwan Thailand United States Mexico APEC

5.2 0.0 15.3 0.0 16.8 1.1 48.4 1.2 0.7 1.3 4.7 1.4 1.o

58.9 0.5 256.5

=

6

7

8

9

Total

1990

1.o 73.8 44.3 31.7 1.6 7.8 61.4 3.0 0.2 0.0 0.0 0.0 0.0 0.0 0.0 0.0 144.8 2.0 76.9 2.6 9.0 104.3 4.9 66.0 13.2 0.9 8.0 54.3 2.0 28.8 28.2 0.3 246.7 9.7 137.1 232.6 4.3 172.5 6.4 39.1 55.7 0.9 75.2 38.6 0.9 6.4 72.8 3.2 715.2 38.7 602.6 648.3 10.9 434.9 29.5 53.7 55.3 82.0 0.4 6.7 0.8 3.2 32.9 2.8 7.8 0.1 8.5 0.4 6.4 4.7 0.2 1.3 2.8 34.6 1.7 29.8 40.8 0.3 12.1 0.6 1.1 7.5 87.5 6.4 110.6 203.6 28.4 2.2 5.5 77.4 4.3 78.1 22.2 3.2 94.5 0.8 64.3 0.7 5.2 68.9 3.1 59.5 26.0 0.9 821.2 1,650.6 23.8 822.1 37.0 105.2 1,081.0 56.7 27.2 2.5 27.5 1.7 59.8 0.5 16.8 0.8 1,706.7 87.6 257.4 2,673.1 138.5 2,122.5 3,406.4 47.1 Year = 1985

239.9 0.4 446.3 142.7 929.7 272.7 2,746.3 187.8 31.8 128.8 461.9 297.7 241.4 4,975.7 145.3 11,248.1

1.O 17.3 24.8 0.6 0.2 0.0 62.2 134.6 2.9 0.0 0.0 0.0 148.8 3.0 85.2 11.8 0.2 13.3 209.7 7.9 178.7 70.2 0.2 34.4 1.7 0.1 1.3 17.1 0.2 13.7 53.9 0.8 26.4 8.8 0.2 11.3 6.8 0.2 7.5 908.3 31.0 492.2 1.8 0.0 1.4 945.5 1,598.4 47.9

91.1 1.1 336.5 0.0 409.3 46.2 882.7 132.5 8.9 57.6 130.5 40.6 31.8 2,792.8 6.9 4,968.5

15.6 0.4 0.0 0.0 1.3 45.9 0.0 0.0 48.7 1.7 2.9 0.1 131.7 4.4 2.8 0.5 2.2 0.0 3.2 0.1 13.5 0.5 3.7 0.1 2.7 0.0 49 1.7 13.3 1.4 0.0 765.9 22.6

23.4 2.0 0.0 0.2 5.5 62.2 0.0 0.0 9.8 87.0 15.2 0.8 16.7 269.8 17.6 2.1 0.2 2.5 1.0 19.8 2.5 25.3 0.8 13.4 0.7 12.4 53.6 593.9 0.1 1.5 95.9 1,144.3

1.6 0.0 6.6

0.0 8.2 1.0 15.4 3.4 0.1 1.1 2.8 0.8 0.6 49.8 0.1 91.5

Data Sources: Bank of Korea, Input-Output Tables (Seoul, 1985, 1990); Korean Customs Administration, Statistical Yearbook of Foreign Trade (Seoul, 1985, 1990). Note: See table 9.7 note for key to industries.

ucts and machinery, and miscellaneous manufactured products sectors (see table 9. lo). The high export earnings ratio implies that import dependence is quite low in these sectors. By contrast, import dependence is high in such sectors as food, beverages, and tobacco products; paper, printing, and publishing; chemicals and chemical products; and primary metal products. Their indexes

237

A Perspective on the Effects of NAFTA on Korea Net Export Earnings of Korean Exports to APEC Countries (million US. dollars)

Table 9.10

Industry Country

1

2

3

4

5

6

7

8

9

Total

Year = 1990 Australia Brunei Canada China Hong Kong Indonesia Japan Malaysia New Zealand Philippines Singapore Taiwan Thailand United States Mexico APEC Australia Brunei Canada China Hong Kong Indonesia Japan Malaysia New Zealand Philippines Singapore Taiwan Thailand United States Mexico APEC

225.6 -1.6 0.1 0.1 57 1.5 - 16.9 -3.3 93.9 - 14.9 1,284.1 8.8 289.9 118.6 3,230.9 -1.3 43.0 - 1.0 33.3 -4.3 88.8 -3.7 198.2 9.9 154.6 -9.4 190.5 -269.9 6,015.5 9.0 122.7 - 179.8 12,542.7

0.0 -0.0 0.0 4.5 12.1 -0.5 146.5 -0.3 0.0 1.7 0.3 16.6 -0.2 27.0 -0.0 207.9

110.0 0.5 2.0 0.0 0.0 0.0 -4.1 346.3 -0.6 0.0 0.0 0.0 359.7 3.9 4.0 -1.0 17.3 0.0 964.0 41.5 108.7 15.4 -0.2 -0.6 -0.4 0.0 17.0 - 1.3 18.1 -0.0 102.7 2.4 -2.6 0.0 24.1 1.1 15.9 -0.0 -0.4 -96.9 3,623.3 28.8 -0.4 10.8 -0.0 8.5 5,624.7 76.3

15.7 48.0 7.7 327.3 20.2 62.6 705.6 -0.0 0.0 0.0 -0.0 0.9 -0.0 1.1 -2.1 2.0 6.4 -28.7 661.7 84.6 1,278.5 29.0 140.0 13.0 4.2 436.9 50.1 105.6 106.5 110.9 11.2 988.7 173.3 2,730.0 58.1 6.6 76.5 3.7 62.2 326.3 15.0 788.4 -18.1 451.4 313.6 943.6 2,611.2 415.8 8,213.5 2.0 14.9 1.7 48.6 390.8 11.4 510.8 3.6 7.0 1.5 32.0 8.0 9.6 94.2 2.9 54.7 1.7 183.2 4.0 365.0 32.3 -1.3 37.5 2.2 27.1 35.8 1,274.2 978.0 0.4 120.4 12.7 104.8 417.1 30.2 866.8 4.3 116.0 1.8 273.1 93.5 18.2 687.8 1.6 -377.3 57.0 - 121.2 7,537.1 1,326.9 14,196.7 -1.4 -11.8 -1.0 -11.1 21.3 412.8 285.1 149.8 790.2 433.1 1,287.5 1x118.1 2,212.8 32,562.3 Year = 1985 0.8 23.0 2.1 0.0 -0.1 1.5 -3.9 -24.2 1.9 0.0 0.0 0.0 14.8 61.6 15.1 -0.2 53.8 1.6 -7.5 571.5 77.6 0.7 -0.6 1.6 -0.0 1.4 0.1 -0.2 76.4 0.4 1.6 11.9 10.9 0.2 42.7 -0.1 0.4 48.2 0.3 -6.6 -133.6 48.9 -0.0 -0.9 -0.0 -0.0 731.1 161.7

18.3 1.9 -26.5 0.0 36.7 29.2 290.1 -6.8 2.0 19.9 -4.4 27.2 16.2 110.0 2.0 515.8

90.4 0.3 553.7 0.0 596.4 42.0 736.4 300.0 5.4 65.3 222.9 29.3 22.7 3,536.7 6.7 6,208.2

28.1 275.2 0.0 3.8 46.5 889.1 0.0 0.0 44.6 1,136.8 0.6 143.4 101.4 2,883.8 2.4 311.8 2.0 27.4 0.0 178.6 4.4 349.8 4.2 128.9 2.4 105.5 731.6 7,842.2 1.2 19.2 969.3 14,295.5

Data Sources: Bank of Korea, Input-Output Tables (Seoul, 1985, 1990); Korean Customs Administration, Statistical Yearbook of Foreign Trade (Seoul, 1985, 1990). Nore; See table 9.7 note for key to industries.

were negative in both years (except for paper, printing, and publishing in 1990 and primary metal products in 1985). Several sectors have experienced a substantial increase in earnings ratio: nonmetallic mineral products, metal products and machinery, and miscellaneous manufactured products. This increase in earnings ratio implies that the

238

Honggue Lee

extent of these sectors’ import dependence has declined. On the other hand, export earnings indexes went down in the primary metal products and chemicals and chemical products sectors, reflecting an increase in dependence on these imported inputs. Yet, Korea’s overall dependence on imports from North America increased slightly during that period (from 73.6 percent in 1985 to 74.1 percent in 1990). It was not much different from Korea’s overall dependence on imports from Asia Pacific, which was 74.2 percent in 1985 and 74.3 percent in 1990. These results again show that Korea’s dependence on imports from APEC countries has not changed much and that there is room for Korea to deepen interindustry linkages with its neighbors in the region. 9.2.3

Foreign Direct Investment

The pattern of foreign direct investment reveals the extent to which the Korean economy is integrated into the North American economy. The majority of foreign direct investment in Korea has come from the United States, which accounted for more than 29 percent of the total investment stock ($11.2 billion) as of the end of 1993.5The U.S. share of investment inflows into Korea grew over the past three decades: 37 percent (1960s), 55 percent (1970s), and 48 percent (1980s). After 1989, however, U.S. investment flows declined rapidly until 1992. Since then, they have resumed their growth. Canada’s investment share is less than 1 percent of total inward direct investment to Korea (see tables 9.11 and 9.12). Similarly, Korea’s outward investment is destined for only a few countries: the United States, Indonesia, China, and Canada.6 The combined stock of Korea’s investment in the United States ($1.7 billion, or 31 percent of its total outward investment outstanding) and Canada ($409 million, or 7 percent) accounted for around 38 percent as of the end of 1993.’ (It was 47 percent in 1990.) By contrast, Korea’s investment in APEC countries constituted 79 percent of its total outward investment stock in 1990. APEC’s share, however, declined slightly to 75 percent in 1993. Almost half of Korea’s overseas investment went to the manufacturing sector ($2.7 billion), of which around 80 percent ($2.2 billion) went to APEC countries and 34 percent ($930 million) to NAFTA countries. A closer look at manufacturing subindustries reveals more information. Korea’s overseas investment went to selected industries in a limited number of countries. For instance, 5. The US. share remained at almost the same level in 1994 (28.5 percent of a total of $12.5 billion). 6. Although it tends to decline over time, the combined share of the top four host countries was around 68-74 percent in the late 1980s. Those countries are the United States, Indonesia, North Yemen, and Canada, in order of magnitude. Their combined share was 74 percent as of 1987,73 percent as of 1988, and 68 percent as of 1989. 7. Indonesia and China accounted for $796 million (14 percent of the total) and $475 million (8.5 percent of the total), respectively. Yet, these numbers do not properly reflect the importance of China as a Korean investment destination. While investment in China was a new phenomenon, it increased eightfold over the three-year period (199 1-93).

Table 9.11 Country

Korea’s Investment Relationship with APEC Countries (thousand U.S. dollars) 1986

United States Inward 71,379 Outward 58,477 129,856 Sum Canada Inward 112 Outward 20,728 Sum 20,840 Mexico Inward Outward 0 Sum 0 Japan Inward 246,021 1,968 Outward Sum 247,989 Inward China 0 Outward 0 Sum 0 Inward Indonesia 1,519 Outward Sum 1,519 Malaysia Inward 0 Outward 116 Sum 116 Philippines Inward 0 Outward 101 Sum 101 Inward Thailand Outward 45 Sum 45 Brunei Inward Outward Sum 0 Singapore Inward 113 Outward 0 Sum 113 Taiwan Inward 0 0 Outward Sum 0 Hong Kong Inward 876 Outward 3,354 Sum 4,230 Australia Inward 2,288 Outward 696 Sum 2,984 New Zealand Inward 18 Outward 0 Sum 18 APEC

1987

1988

1989

50,328 163,801 172,591 167,705 92,896 168,520 218,033 256,697 341,111 1,157 808 360 3,386 114,399 9,467 4,543 115,207 9,827 -

-

-

0 347 0 0 0 347 268,604 297,606 307,477 1,279 6,503 10,179 269,883 304,109 317,656 0 0 0 0 0 6,360 0 0 6,360 125,048 18,998 75,390 125,048 18,998 75,390 0 0 103 794 1,294 3,081 794 1,397 3,081 0 153 0 440 500 2,645 440 653 2,645 8,052 9,141 180 180 8,052 9,141 0 0 0 6,400 2,089 602 324 198 158 6,724 2,287 760 115 108 960 0 0 185 115 108 1,145 36,257 14,906 11,327 3,937 12,989 2,571 38,828 18,843 24,316 50 0 447 624 4,655 3,416 3,466 624 5,102 18 18 18 13 0 100 31 18 118

1990

1991

224,452 342,627 567,079 7,134 92,335 99,469 0 0 295,372 10,925 306,297 0 15,974 15,974 -

1992

213,488 395,244 608,732 953 68,066 69,019

245,242 346,872 592.1 14 2,990 44,770 47,760

-

-

10,835 10,835 173,310 14,934 188,244 0 42,468 42,468

324 324 165,355 63,617 228,972 0 141,161 141,161

-

-

163,979 163,979 181 17,529 17,710 0 32,147 32,147 12,807 12,807 -

170,075 170,075 0 69,555 69,555 280 48.269 48,549

-

-

0 12,536 2,777 15,313 66 1 2,007 2,668 16,260 4,568 20,828

0 2,542 5,526 8,068 287 3,972 4,259 6,095 13,193 19,288 0 8,758 8,758 18 44 62

164,408 164,408 0 23,661 23,661 0 20,508 20,508 26,357 26,357 0 2,291 13,426 15,717 0 5,163 5,163 8,371 44,460 52,831 0 16,385 16,385 18 3,797 3,815

0

14,829 14,829 18 0 18

-

32,489 32,489 -

Inward 320,789 362,114 479,923 496,302 561,112 396,955 425,529 Outward 87,004 311,237 136,388 408,149 712,504 883,428 914,909 Sum 407,793 673,351 616,311 904,451 1,273,616 1,280,383 1,340,438

Sources: Ministry of Finance, Trends in Foreign Investment (Seoul, July 1994); Bank of Korea, Overseas Direct Investment Statistics Yearbook (Seoul, 1993). Note: Inward (arrival basis); outward (arrival basis).

Table 9.12

Korea’s Investment Relationship with APEC Countries (share in percent) 1986

1987

1988

1989

1990

1991

1992

Inward Outward Sum Inward Outward Sum Inward Outward Sum Inward Outward Sum Inward Outward Sum Inward Outward Sum Inward Outward Sum Inward Outward Sum Inward Outward Sum Inward Outward Sum Inward Outward Sum Inward Outward Sum Inward Outward Sum Inward Outward Sum Inward Outward Sum

22.25 67.21 31.84 0.03 23.82 5.11 0.00 0.00 0.00 76.69 2.26 60.81 0.00 0.00 0.00 0.00 1.75 0.37 0.00 0.13 0.03 0.00 0.12 0.02 0.00 0.05 0.01 0.00 0.00 0.00 0.04 0.00 0.03 0.00 0.00 0.00 0.27 3.85 1.04 0.71 0.80 0.73 0.01 0.00 0.00

13.90 53.88 32.38 0.10 3.04 1.46 0.00 0.00 0.00 74.18 0.41 40.08 0.00 0.00 0.00 0.00 40.18 18.57 0.00 0.26 0.12 0.00 0.14 0.07 0.00 0.06 0.03 0.00 0.00 0.00 I .77 0.10 1.00 0.03 0.00 0.02 10.01 0.83 5.77 0.01 1.10 0.51 0.00 0.00 0.00

34.13 68.11 41.65 0.24 2.48 0.74 0.00 0.00 0.00 62.01 4.77 49.34 0.00 0.00 0.00 0.00 13.93 3.08 0.02 0.95 0.23 0.03 0.37 0.11 0.00 5.90 1.31 0.00 0.00 0.00 0.44 0.15 0.37 0.02 0.00 0.02 3.11 2.89 3.06 0.00 0.46 0.10 0.00 0.00 0.00

34.78 41.29 37.71 0.16 28.03 12.74 0.00 0.09 0.04 6 1.95 2.49 35.12 0.00 1.56 0.70 0.00 18.47 8.34 0.00 0.75 0.34 0.00 0.65 0.29 0.00 2.24 1.01 0.00 0.00 0.00 0.12 0.04 0.08 0.19 0.05 0.13 2.28 3.18 2.69 0.09 1.14 0.56 0.00 0.02 0.01

40.00 48.09 44.53 1.27 12.96 7.81 0.00 0.00 0.00 52.64 1.53 24.05 0.00 2.24 1.25 0.00 23.01 12.88 0.03 2.46 1.39 0.00 4.5 I 2.52 0.00 1.80 1.01 0.00 0.00 0.00 2.23 0.39 1.20 0.12 0.28 0.21 2.90 0.64 1.64 0.00 2.08 1.16 0.00 0.00 0.00

53.78 44.74 47.54 0.24 7.70 5.39 0.00 1.23 0.85 43.66 1.69 14.70 0.00 4.81 3.32 0.00 19.25 13.28 0.00 7.87 5.43 0.07 5.46 3.79 0.00 3.68 2.54 0.00 0.00 0.00 0.64 0.63 0.63 0.07 0.45 0.33 1.54 1.49 1.51 0.00 0.99 0.68 0.00 0.00 0.00

57.63 37.91 44.17 0.70 4.89 3.56 0.00 0.04 0.02 38.86 6.95 17.08 0.00 15.43 10.53 0.00 17.97 12.27 0.00 2.59 I .77 0.00 2.24 1.53 0.00 2.88 I .97 0.00 0.00 0.00 0.54 1.47 1.17 0.00 0.56 0.39 1.97 4.86 3.94 0.00 1.79 1.22 0.00 0.42 0.28

Inward Outward Sum

100.00 100.00 100.00

100.00 100.00 100.00

100.00 100.00 100.00

100.00 100.00 100.00

100.00 100.00 100.00

l00.00 lOO.00

100.00 100.00 100.00

Country United States

Canada

Mexico

Japan

China

Indonesia

Malaysia

Philippines

Thailand

Brunei

Singapore

Taiwan

Hong Kong

Australia

New Zealand

APEC

100.00

Sources: Ministry of Finance, Trends in Foreign Investment (Seoul, July 1994);Bank of Korea, Overseas Direct Investment Statistics Yearbook (Seoul, 1993). Note: Inward (arrival basis); outward (arrival basis).

241

A Perspective on the Effects of NAFTA on Korea

Table 9.13

U.S. Market Share

Country

1983

1985

1987

1989

1991

1993

Canada Mexico United Kingdom France Germany Italy Japan China Korea Taiwan Hong Kong Singapore

19.3 6.4 4.8 2.4 4.9 2.2 16.2 0.9 2.9

18.9

16.7 4.9 4.2 2.7 6.6 2.8 20.9 1.6 4.3 6.3 2.5 1.5

18.0 5.6 3.8 2.8 5.2 2.6 19.8 2.6 4.2 5.2 2.1 1.9

18.2 6.3 3.8 2.7 5.3 2.4 18.7 4.0 3.5 4.8 1.9 2.0

19.1 6.9 3.7 2.6 5.1 18.5 5.4 2.9 4.3 1.6 2.2

4.5

2.5 1.1

Source: OECD Trade Tapes

5.4

4.3 2.8 5.9 2.9 20.2 1.2 3.0 5.0 2.5 1.2

(database; Paris, various issues).

investment in textiles and apparel is mostly concentrated in China and Indonesia; food and beverages and petroleum in Indonesia; leather products and footwear in China; and nonmetals in the United States. But, investment in fabricated metals has been locationally diversified, going to the United States, China, Malaysia, Indonesia, Thailand, and the Philippines.*

9.3 An Assessment of the Effects of NAFTA 9.3.1 The Potential Extent of Trade Diversion: Evidence It is of interest to assess the extent of trade diversion attributable to NAFTA. From the Korean perspective, trade diversion is likely to arise because of preferential treatment granted to Mexico in the U.S. market. While it is difficult to measure directly the scope of trade diversion away from Korea, some useful indicators can be employed to assess indirectly the diversion effect. Market Share

Market share is a good indicator of competitiveness, as it reflects the relative strength of a trading nation in a given market. Korea’s share in the U.S. market increased to a peak of 4.6 percent in 1988 and declined continuously thereafter. In 1993, Korea’s market share was at the same level it had attained in 1983. The decrease in market share can be partly attributed to a slowdown in growth and delayed recovery of the U.S. economy, but it is more attributable to the emergence of China and the East Asian NIEs, which replaced Korea as major producers of “low value-added” products (see table 9.13). At the same time, market share changes in the United States can be indirectly attributed to trade diversion due to the accession of Mexico to CUSFTA. An increase in Mexico’s 8. See Bank of Korea (1994) for detailed statistical information.

242

Honggue Lee

market share seems to have contributed to declines in the market shares of its competitors. As shown in table 9.13, almost every country except China and Canada suffered a loss in market share after 1989-90. Although it is difficult to sort out the trade diversion effect from this data, it is not unreasonable to suspect that the scope of trade diversion will be substantial if the current trend continues. Export Similarity Index

The trade diversion effect is likely to depend on the degree to which the exports of Mexico and Korea to the U.S. market are similar to each other. The export similarity index quantifies the trade diversion effect by measuring the extent to which Mexico’s exports overlap Korea’s exports. In the following equation, one version of the export similarity index is employed to assess the intensity of competition in exports between various countries to the markets of the United States and Canada:9 SZ(U, b, C ) =

C I EX,(ac) - EX@c) +2 EX,(bC)I .

This formula measures the difference in the export patterns of countries a and b to market c. If the commodity distributions of the exports of a and b are identical, then the index will take on a value of zero. EXt(ac) is the share of commodity i in a’s exports to c. The data are from the OECD Series C import data available from 1981 to 1991. The data were disaggregated at the level of Standard International Trade Classification (SITC) two- to four-digit revision 3 categories. All calculations were made over manufactured exports and total exports. Export similarity indexes are reported in table 9.14 for 1981, 1986, and 1991 (or 1990). Although the Korea-Mexico indexes became smaller throughout the years (from 0.87 in 1981 to 0.70 in 1990), they were still very large in comparison with that of any other pair in each year considered. This implies that Korean and Mexican exports to the combined U.S.-Canadian market were not similar and that the intensity of the competition between Korea and Mexico in the combined market was less significant than the competition between any other pair in every year considered. Korea competed in the US.-Canadian market less with Mexico than with Taiwan, Japan, APEC 11, and China. Taiwan was Korea’s fiercest competitor in the U.S.-Canadian market in 1981, while Japan and APEC 11 (excluding Japan and NAFTA countries) replaced Taiwan as Korea’s major export competitors in 1990. Almost the same results were obtained for the U S . market alone. Similarity indexes were also calculated for selected sectors: (1) food and live animals (SITC 0), (2) mineral fuels, lubricants, and related materials (SITC 3), 9. Finger and Kreinin (1979) developed an index of export similarity that measures the proportion of a country’s exports matched by a competitor’s exports in the same product category.

243

A Perspective on the Effects of NAFTA on Korea

Table 9.14 Year

KR-MX

Similarity Indexes in the United States and Canada (total items) KR-CN

KR-JP

KR-TW

KR-APl1

KR-EC

EC-AP12

0.38417 0.57112 0.38570 0.44582 0.50819 0.47285 U.S. Market Alone

0.78384 0.66793 0.68935

0.65225 0.63382 0.67190

0.57634 0.44526 0.47079

0.79196 0.68406 0.69015

0.65254 0.64828 0.68200

Combined U.S.-Canadian Market 1981 1986 1990

0.87809 0.76635 0.69884

0.72818 0.63513 0.57381

0.49099 0.35603 0.38342

1981 1986 1991

0.87660 0.76258 0.70567

0.74097 0.64033 0.56148

0.49720 0.35760 0.39341

0.39183 0.38695 0.52811

Source: OECD, Foreign Trade by Commodities (Paris, various issues). Note: APll = AP12 - Korea.

(3) textile yarn, fabrics, made-up articles, n.e.s., and related products (SITC 65), (4) iron and steel (SITC 67), and (5) road vehicles including air-cushion vehicles (SITC 78). According to the results, reported in table 9.15, the export patterns of Mexico and Korea were very different in the agricultural (SITC 0) and primary input (SITC 3) sectors. The two countries showed highly dissimilar trade patterns even in the textiles and apparel (SITC 65) sector. Only in the automobiles sector were Mexico-Korea similarity indexes lower. Again, Mexico was not one of Korea’s major competitors in North America except in the automobiles sector. These results seem to imply that possible trade diversion caused by NAFTA would be limited in scope. Preferential treatment granted to Mexico would not then drastically reduce Korea’s market share in the North American market.’O Specialization Structure

Revealed comparative advantage (RCA) indexes show the pattern of sectoral comparative advantage. They can be used to infer whether Korea’s trade with NAFTA members is consistent with the principles of comparative advantage and whether its trade relationship with them is complementary or supplementary. RCA indexes, which are supposed to identify the structural sources of specialization, were initially constructed by Balassa (1965). The original Balassa index measures whether a particular product’s share of the exports of a certain 10. Similarity indexes reported in table 9.14 imply that Korea and Taiwan compete with each other increasingly less fiercely in U.S. and Canadian markets. At the same time, the sectoral similarity indexes selectively reported in table 9.15 do not show any tendency toward more serious competition between the two countries in these markets. Despite apparent similarity between their economic conditions, Korea and Taiwan do not seem to run against each other as serious contenders, at least in U.S. and Canadian markets. In this regard, Taiwan is likely to experience different sectoral impact effects of NAFTA than Korea. However, this does not imply that these two countries will face different levels of “total impact effects.” As one of the discussants indicated, Taiwan also experienced “the same lack of impact of NAFTA“ as Korea did.

244

HonggueLee

Table 9.15 Year

SITC"

Similarity Indexes in the United States and Canada (five items) KR-MX

KR-CN

KR-JP

KR-TW

KR-APl1

KR-EC

EC-AP12

Combined U.S.-Canadian Market 1981

0 3 65 67 78

0.89045 0.99950 0.84049 0.49494 0.69646

0.67159 0.76446 0.66491 0.98461 0.28711

0.77003 0.93525 0.47575 0.10535 0.20898

0.47536 0.46813 0.61729 0.30907 0.29075

0.79533 0.93685 0.60200 0.41529 0.23430

0.71219 0.88714 0.53684 0.56143 0.76302

0.69410 0.09430 0.54613 0.56439 0.75951

1986

0 3 65 67 78

0.81027 0.97304 0.69050 0.35671 0.60891

0.69330 0.76166 0.62070 0.86047 0.93284

0.58943 0.90009 0.40932 0.13989 0.33233

0.51171 0.99701 0.56801 0.41816 0.87432

0.61887 0.91095 0.53930 0.35364 0.87802

0.74578 0.74640 0.49605 0.35392 0.13948

0.64802 0.18731 0.50061 0.36051 0.24195

1990

0 3 65 67 78

0.85772 0.98999 0.73438 0.60730 0.29447

0.75642 0.99177 0.73438 0.95962 0.83333

0.63778 0.61579 0.56599 0.98955 0.98595 0.90192 0.5981 1 0.44983 0.59652 0.52175 0.24377 0.45847 0.66486 0.32060 0.79145 U.S. Market Alone

0.73902 0.97622 0.57052 0.57183 0.14080

0.7 1161 0.38001 0.54871 0.48116 0.263 19

1981

0 3 65 67 78

0.88592 0.99946 0.89104 0.50177 0.69295

0.71962 0.76690 0.76446 0.93527 0.65037 0.49787 0.98549 0.09586 0.29841 0.22784

0.51860 0.46813 0.65002 0.29390 0.30030

0.79277 0.93687 0.62010 0.39326 0.25915

0.71976 0.88342 0.60396 0.58715 0.76271

0.70265 0.09803 0.61905 0.58020 0.76365

1986

0 3 65 67 78

0.80245 0.97234 0.76680 0.35733 0.54706

0.69464 0.76166 0.60143 0.87252 0.92284

0.58671 0.90009 0.41450 0.14422 0.37535

0.50584 0.99701 0.56974 0.41749 0.90566

0.61766 0.91095 0.53259 0.35839 0.90422

0.74768 0.70490 0.58305 0.33264 0.12755

0.663 16 0.26131 0.55453 0.35226 0.29860

1991

0 3 65 67 78

0.86817 0.96423 0.79404 0.68364 0.31573

0.73150 0.97637 0.75346 0.95802 0.90805

0.67102 0.80388 0.49259 0.26028 0.36482

0.55826 0.72524 0.63426 0.48377 0.88184

0.69381 0.82328 0.64159 0.60212 0.70947

0.74741 0.69847 0.60329 0.59978 0.21101

0.71072 0.47661 0.60230 0.5077 1 0.26770

Source: OECD, Foreign Trade by Commodities (Paris, various issues). Note: APll = AP12 - Korea. a 0: Food and live animals 3: Mineral fuels, lubricants,and related materials 65: Textile yam, fabrics, made-up articles, n.e.s., and related products 67: Iron and steel 78: Road vehicles (including air-cushion vehicles)

economy is greater or less than the average of a given reference zone. This index is useful for understanding the trade pattern and the structure of comparative advantage. In the Balassa index the structural sources of specialization are revealed by actual trade data. On the other hand, a qualitatively same measure can be obtained from import data, except for the fact that it should be read

245

A Perspective on the Effects of NAFTA on Korea

in the opposite direction: the measures obtained indicate comparative disadvantage. Thus, the Balassa index can be used to infer whether a certain product meets the conditions for comparative advantage or disadvantage. Yet, the index can be contradictory if it is obtained from a different data set: while the export measure of a certain product shows comparative advantage, the import measure of the same product may show comparative disadvantage. In this case, a measure of comparative advantage based on the trade balance (the difference between the value of exports and imports) is more useful. This measure, the Lafay indicator, determines whether the item concerned has comparative advantage or disadvantage by comparing its attributed trade balance with its actual trade balance in relation to GDP. The attributed trade balance is calculated with reference to an equilibrium trade balance by allocating to each product a fraction of the overall surplus or deficit. This attribution is made on a pro rata basis in relation to the economy’s total trade. The Lafay indicator thus calculated can then be used for ranking products according to their comparative advantage status. Lafay’s point is that the comparative advantage for a given item will be enhanced when the production of that item in the country increases faster than domestic demand for it, other things being equal. In other words, the comparative advantage of the item concerned will improve when the difference between the export and import ratios or the self-sufficiency ratio increases.” Although it is not free from several methodological problems, the refined Lafay RCA index eliminates distortions inherent in the Balassa index by taking into consideration the evolution of intratrade flows, macroeconomic conditions, and a weighting scheme reflecting the characteristics of the product at the world leve1.I2 This Lafay indicator, Jlk, is defined as follows: l 3

where

11. Obviously not satisfied with the export-import ratio as an indicator of specialization, Lafay suggested taking account of domestic economic structure, emphasizing the importance of internal economic conditions in the evolution of specialization. 12. The data used here are compiled from the UN International Trade Statistics Yearbook and the Bank of Korea Economic Statistics Yearbook. The aggregation level is mostly SITC three-digit with a few SITC two-digit or SITC four-digit classifications. 13. World weights adjusted to a given base year would eliminate the impact of trade volume changes that are not specific to the economy in question. See Lafay (1992) for details.

Table 9.16

Lafay Indexes of Korean Industries (million U.S. dollars) SITC"

Year

1981 1982 1983 1984 1985 1986 1987 1988 1989 1990

51 -13.03 -13.07 -11.49 -12.47 -12.96 -14.22 -15.05 -16.18 -13.84 -10.24

52 -2.42 -1.52 -1.27 -1.76 -1.81 -1.82 -1.98 -2.01 -1.85 -1.84

651 7.17 4.81 4.90 4.60 4.17 2.05 -0.27 0.78 1.21 1.14

652-655

672-675

75

763

764

24.22 19.93 18.19 16.88 15.41 14.67 13.90 12.11 12.00 13.67

8.01 12.62 7.37 3.18 1.83 4.63 2.06 3.10 2.88 4.77

-2.36 -3.64 -2.42 0.91 1.97 1.48 4.91 4.76 5.36 4.34

1.62 1.28 0.28 0.17 1.93 3.55 5.33 6.75 6.13 5.27

-3.09 -5.14 -2.40 -2.07 -0.02 1.25 3.41 1.98 3.55 4.13

5 1: Organic chemicals 52: Inorganic chemicals 65 1: Textile yarn 652-655: Woven textiles 672-675: Ingots and plates of iron and steel 75: Office machinery 761: Television receivers 762: Radio receivers 763: Sound recorders and VTRs a

776

781

784

1.05 1.85 -1.82 2.34 1.05 -1.58 0.44 1.49 -1.80 1.51 2.54 -1.43 0.62 6.61 -0.83 -2.75 11.75 -2.01 -4.80 17.43 -2.74 -1.89 17.35 -2.27 2.59 9.50 -1.20 4.79 7.52 -0.87

764: Telecommunication equipment 775: Household electric equipment 776: Thermionic valves and semiconductors 781: Passenger motor vehicles 784: Motor vehicle parts 793: Ships and boats 84: Apparel and accessories 85: Footwear

793

761

762

775

84

85

10.63 20.73 19.21 18.25 13.51 13.80 5.42 9.16 7.22 9.01

13.15 10.24 12.86 14.31 10.50 11.36 12.59 9.17 7.36 6.29

5.91 5.29 5.87 6.82 5.76 6.10 7.57 6.69 5.87 5.73

1.51 1.49 1.82 3.54 3.32 4.61 5.26 6.38 4.75 3.16

99.58 82.46 70.04 70.51 64.35 54.93 53.11 46.93 41.74 33.25

25.50 23.17 21.10 19.88 20.47 20.06 20.44 21.60 18.36 18.42

247

A Perspective on the Effects of NAFTA on Korea

and is GDP, a is a constant, e; and i; are weights (W:/Wo)/(W;/W*), and W is the volume of world trade. The Lafay indexes reveal how the specialization structure ev01ves.'~In the case of Korea, apparel and accessories (SITC 84) ranked first in the list of RCA indexes in 1981 among the items that have comparative advantage (see table 9.16). It was followed by footwear (SITC SS), woven textiles (SITC 652655), television receivers (SITC 761), and ships (SITC 793). Among items with comparative disadvantage (with negative RCA indexes), organic chemicals (SITC 5 1) was the lowest. Telecommunications equipment (SITC 764), inorganic chemicals (SITC 52), and office machinery (SITC 75) in that order were among the next least advantageous items. In 1990, apparel and accessories, footwear, and woven textiles, in that order, still topped the list of items with comparative advantage. However, ships and passenger motor vehicles (SITC 781) ranked fourth and fifth, respectively; while television receivers ranked sixth, down from fourth. The ranking also changed on the comparative disadvantage side. Organic chemicals, inorganic chemicals, and motor vehicle parts (SITC 784) were still at the bottom. Yet two items, office machinery and telecommunications equipment, gained comparative advantage in the middle of 1980s. In sum, apparel, footwear, and fabrics remained the three most important items with comparative advantage throughout the 1980s. But, as revealed by the narrowing of their surpluses, their strength has declined. On the other hand, the organic chemicals group had the greatest comparative disadvantage. However, its deficit has been improving steadily. Textile yarn was the item whose comparative advantage was most seriously eroded. The comparative advantage of steel products such as iron ingots and plates also declined. Other items with declining comparative strength included television receivers, sound recorders and videotape recorders (VTRs), and household electric equipment. On the other hand, telecommunications equipment and passenger motor vehicles were the two most important items whose comparative advantages improved. Office machinery and semiconductors also enhanced their positions in the comparative advantage chain. During the I980s, Korea's comparative advantage structure changed dramatically. Most important, the spectrum (the range between the index values of the greatest comparative advantage and those of the greatest comparative disadvantage items) narrowed, and the rank order changed. The specialization patterns have "deepened" in the sense that product diversification became easier than before. These data suggest that Korea's trade structure changed rapidly in the 1980s-although less drastically near the end of the decade.I5 14. The RCA indices of the 57 major import and export items (SITC three-digit) have been calculated in accordance with the Lafay method for the period 1981-90. These indexes reveal the evolution of comparative advantage for Korea's industries in the 1980s. The RCA indexes of 17 major export goods are provided in table 9.16. 15. The results shown in Lafay (1992) indicate that West Germany and Japan are the two most stable economies in the sense that their pattern of dynamic comparative advantages remained

248

HonggueLee

Korea’s comparative advantage structure could be compared with the RCA indexes of NAFTA members. The comparison of the sectoral comparative advantage structure across countries should shed light on the patterns of Korea’s trade relationship with NAFTA countries. NAFTA members’ comparative strengths reflected in their respective trade data would reveal whether Korea’s trade with those countries is consistent with the pattern of comparative advantage and whether Korea’s trade relationship with NAFTA members is complementary or competitive.’6 RCA indexes should be comparable across different countries. For that purpose, 24 common export items (SITC three-digit) have been selected for which national rankings are given. The export items have been graded according to their RCA values for four selected years: 1980, 1984, 1988, and 1992. The chain of comparative advantage is listed in tables 9.17 and 9.18 for each of six countries and the European Community. As evidenced by the list, Korea was able to maintain comparative advantage in 12 to 14 sectors in the four selected years. For instance, Korea continued to have comparative advantage in footwear (SITC SSl), man-made fabrics (SITC 653j, ships and boats (SITC 793), and passenger motor vehicles (SITC 781). On the other hand, Korea had comparative disadvantage in petroleum products (SITC 334) and measuring and controlling instruments (SITC 874). Canada maintained comparative advantage in 10 to 11 sectors except for 1988, when it had comparative advantage only in 8 sectors. Canada continued to have comparative advantage in paper products (SITC 641j, crude oil (SITC 333), fertilizers (SITC 562), passenger motor vehicles (SITC 781), and iron (SITC 672-674). On the other hand, Canada’s greatest comparative disadvantage lay in labor-intensive manufactured goods. Canada imported laborintensive manufactured products and consumer goods from the Asia Pacific region and exported natural resources and resource-based products. The number of sectors in which Mexico had comparative advantage continued to increase from 4 in 1980 to 9 in 1988, but it declined to 5 in 1992. Mexico’s comparative advantage lay in crude oil (SITC 333j, textile yam (SITC 651), passenger motor vehicles (SITC 781), and internal combustion engines (SITC 713). Mexico had comparative disadvantage in motor vehicle parts (SITC 784), metalworking machine tools (SITC 736), and textile and leather machinery (SITC 724). unchanged over the 1967-86 period. On the other hand, Brazil exemplifies a rapidly changing economy with volatile comparative advantage chains. Comparative advantage is distinct from competitiveness. Two essential points can be identified. First, competitiveness is related to the relative strength or weakness of a country in producing a given product, while comparative advantage is related to the strength or weakness of products for a given country. Second, competitiveness is often subject to macroeconomic fluctuations (exchange rate or wage rate), while comparative advantage is structural. See Lafay (1992) for details. 16. The following discussion of RCA indexes draws on the background papers of APEC countries submitted to the Pacific Economic Outlook Structural Meeting, held in Osaka, 27-28 September, 1993. See Asia Pacific Economic Cooperation (1994) for details.

Table 9.17

Lafay RCA Rankings by SITC Code

EClO

us.

Canada

78 1 82 I 784 724 736 713 674 673 874 65 I 793 672 653 562 792 85 1 11 894 776 752 334 81 64 1 333

792 752 874 81 784 713 562 65 1 793 653 776 672 724 736 82 1 11 894 673 64 1 674 85 1 334 781 333

64 1 562 334 673 674 11 793 78 1 81 672 82 1 724 65 1 653 85 1 894 752 792 776 736 874 713 784 333

78 1 784 792 674 724 736 82 1 713 67 3 793 874 672 653 85 1 65 1 I1 562 894 776 752 81 64 1 334 333

792 874 81 752 784 562 65 1 793 713 653 11 672 724 736 776 821 673 894 64 1 85 1 674 334 78 1 333

641 78 1 333 562 11 334 674 673 821 81 672 793 724 792 65 1 653 85 1 894 736 776 874 752 713 784

(continued)

Mexico

Year = 1980 333 65 1 85 1 821 334 653 11 752 776 894 81 562 781 673 793 64 1 672 713 874 792 724 736 674 784 Year = 1984 333 334 713 781 65 1 894 85 1 672 82 1 673 653 81 64 1 792 11 724 674 752 874 776 562 784 736 793

Japan

China

Korea

78 1 674 793 673 653 784 713 776 736 672 724 65 1 894 64 1 874 562 82 1 752 85 1 81 792 11 334 333

894 874 85 I 82 1 793 792 784 78 1 776 752 736 724 713 674 673 672 653 65 1 641 562 334 333 81 11

85 1 653 65 1 674 894 562 673 793 64 1 781 821 11 81 776 752 784 874 724 736 672 713 792 334 333

78 1 674 793 784 673 653 736 776 713 752 724 894 874 672 65 1 64 1 821 562 85 1 81 792 11 334 333

894 874 85 1 82 1 793 792 784 78 1 776 752 736 724 713 674 673 672 653 65 1 64 1 562 334 333 81 11

85 I 793 653 894 65 1 674 562 673 334 78 1 82 1 752 64 1 776 I1 81 784 672 792 736 713 874 724 333

Table 9.17

(continued) ~

EClO

us.

Canada

78 1 784 793 674 724 776 736 673 792 874 713 821 65 1 653 11 672 851 894 81 752 562 641 334 333

792 81 874 562 752 793 65 1 11 653 736 724 672 776 713 673 784 674 82 1 641 894 85 1 334 78 1 333

333 641 78 1 562 11 334 673 81 82 1 672 793 724 674 65 1 653 85 1 736 894 874 776 752 713 792 784

I1 784 724 792 736 674 793 781 673 874 713 653 82 1 672 651 851 776 894 81 752 562 334 641 333

792 874 81 562 11 793 65 1 736 784 653 776 713 724 672 752 673 821 641 674 894 851 334 781 333

333 641 78 1 562 334 673 672 11 792 674 81 793 724 82 1 651 736 653 851 894 874 776 752 713 784

Mexico Year = 1988 333 713 78 1 65 1 673 752 851 562 334 641 821 894 672 776 793 653 674 81 874 736 724 792 11 784 Year = 1992 333 78 1 713 651 562 793 776 851 894 672 752 821 653 792 81 641 674 724 874 673 11 736 334 784

Japan

China

Korea

781 784 674 713 793 776 752 736 724 673 653 874 641 672 65 1 894 562 821 85 1 81 792 11 334 333

333 81 851 11 894 653 821 334 672 793 713 752 736 641 781 784 792 776 874 65 1 724 673 674 5 62

85 1 781 793 653 894 752 673 65 1 674 82 1 562 672 641 11 776 81 713 784 724 334 736 874 792 333

781 784 793 674 713 776 724 752 736 673 653 874 334 641 65 1 894 672 562 821 851 792 81 11 333

333 851 894 821 11 81 793 752 673 713 672 874 784 736 653 781 641 792 334 65 1 674 724 562 776

793 653 85 1 781 674 752 894 776 673 65 1 562 82 1 672 641 784 81 713 724 11 736 874 792 334 333

251

A Perspective on the Effects of NAFTA on Korea

Table 9.17

(continued)

Sources: United Nations, International Trade Statistical Yearbook (New York, 1984, 1992); International Monetary Fund, International Financial Statistics (Washington, D.C., 1994). 724: Textile and leather machinery 11: Meat 736: Metalworking machine tools 8 1: Animal feed 752: Automatic data-processing machines 333: Crude oil 776: Thermionic valves, tubes, photocells 334: Petroleum products 78 1: Passenger motor vehicles 562: Fertilizers 784: Motor vehicle parts 641: Paper products 651: Textile yarn 792: Aircraft 793: Ships and boats 653: Man-made fabrics 672: Iron, ingots 821: Furniture 85 1 : Footwear 673: Iron, steel shapes 674: Steel shapes and steel plates 874: Measuring and controlling instruments 713: Internal combustion engines 8Y4: Toys, games, and sporting goods

The United States had comparative advantage in 12 sectors in 1980. But since then it has maintained comparative advantage in only 7 to 9 sectors. The United States’ comparative advantage remained in aircraft (SITC 792), measuring and controlling instruments (SITC 874), and fertilizers (SITC 562). Automatic data-processing machines (SITC 752) was in the comparative advantage chain, but it lost its place in 1992. By contrast, motor vehicle parts (SITC 784) regained comparative advantage in 1992 after a lapse in 1988. On the other hand, the United States had comparative disadvantage in passenger motor vehicles (SITC 781), footwear (SITC 851), and iron shapes, plates, and sheets (SITC 673-674). While the comparative advantage chain of an individual country reveals its vertical structure of trade specialization, a comparison of comparative advantage chains between a country outside an FTA and member countries would reveal the extent to which one country’s export commodities could be eclipsed by “internal source exports.” The number of sectors in which both Korea and Mexico had comparative advantage was 6 (out of 16 sectors in which either had comparative advantage) in 1988: passenger motor vehicles, textile yarn, iron, steel shapes, automatic data-processing equipment, footwear, and fertilizers. But in 1992, Korea’s export commodities were matched by Mexico’s in only 3 (out of 17) sectors: passenger motor vehicles, textile yarn, and fertilizers. Korea and the United States had common comparative advantage in around 3 to 5 sectors (out of 19 to 24 sectors in which one country had comparative advantage). For example, in 1992 Korea’s commodity items overlapped U.S. commodity items in the automatic data-processing equipment, fertilizer, and textile yarn sectors. On the other hand, the number of matched export commodities between Korea and Canada was around 4 to 6 (out of 22 to 23). In 1992, Korea’s export items overlapped Canadian export items in 4 sectors: passenger motor vehicles, fertilizers, iron, and steel shapes and steel plates. In view of these results, the extent to which Korea’s export commodity items compete with those of the United States, Canada, and Mexico is limited. This

Table 9.18

Lafay RCA Indexes

SITC"

EClO

U.S.

11 81 333 334 562 64 1 65 1 653 672 673 674 713 724 736 752 776 78 1 784 792 793 821 85 1 874 894

-0.27 -1.16 -23.03 -0.67 0.08 -1.54 0.16 0.13 0.13 0.55 0.77 0.77 0.88 0.85 -0.49 -0.49 2.44 1.76 0.03 0.13 2.02 -0.00 0.25 -0.31

-0.27 1.01 - 15.45 -3.69 0.41 -0.46 0.21 0.14 0.02 -0.44 -0.58 0.57 -0.08 -0.12 1.43 0.05 -4.56 0.71 3.57 0.21 -0.26 -1.04 1.23 -0.37

11 81 333 334 562 641 65 I 653 612 673 674 713 724 736 752 776 781 784 792 793 821 851 874 894

0.02 -1.20 -22.32 -3.06 -0.11 -1.45 0.16 0.18 0.28 0.46 1.17 0.49 0.98 0.93 -0.72 -0.49 2.34 1.37 I .25 0.43 0.81 0.17 0.39 -0.23

-0.12 0.50 -11.97 -3.69 0.14 -0.78 0.02 -0.08 -0.14 -0.64 - 1.20 -0.08 -0.25 -0.30 0.44 -0.32 -4.67 0.23 1.92 0.02 -0.54 -1.18 0.70 -0.66

Canada

Mexico

Year = 1980 0.72 -0.20 -0.38 0.25 - 10.41 18.88 2.41 0.00 -0.46 3.57 -0.93 12.33 0.57 -0.75 -0.16 -0.89 -0.94 0.11 -0.61 0.97 -2.78 0.84 -1.07 -4.65 -1.68 -0.70 -1.86 -2.01 - 1.06 -0.23 - 1.25 -0.27 0.43 -0.52 -8.11 -5.73 - 1.23 -1.37 0.59 -0.75 -0.12 0.06 -0.90 0.16 -2.27 -1.11 -0.91 -0.29 Year = 1984 0.82 -0.31 -0.18 0.11 37.34 5.26 3.65 0.68 -0.64 3.19 -0.22 10.37 0.30 -0.60 -0.15 -0.81 0.03 -0.13 -0.15 0.49 -0.40 0.5 1 -2.62 3.05 -0.39 -0.52 -1.05 -0.91 -0.50 -1.58 -0.59 -0.99 0.44 7.74 -0.71 -7.31 -0.28 -0.52 -1.37 -0.38 -0.15 0.47 -0.82 0.09 - 1.07 -0.56 -0.89 0.30

Japan

China

Korea

-1.35 -0.5 1 -26.62 -5.71 0.05 0.31 0.61 2.11 1.17 2.86 4.55 1.54 1.11 1.22 -0.18 1.46 12.64 1.91 -0.85 3.70 -0.07 -0.20 0.14 0.55

0.14 -0.09 -57.39 -7.45 4.78 0.88 7.63 9.86 -2.80 2.71 5.88 -3.31 -2.40 -2.58 -1.31 -0.14 0.79 - 1.62 -3.43 2.12 0.47 13.17 -2.08 4.81

- 1.60

-0.68 -0.81 -74.99 1.55 2.29 -0.28 4.30 9.97 -1.32 2.04 3.21 -2.38 -2.81 -1.85 0.03 -0.29 1.51 - 1.08 - 1.62 10.50 0.63 12.19 -2.69 6.02

-0.34 -32.01 -4.41 -0.11 0.22 0.28 1.78 0.34 2.37 3.98 1.63 1.18 1.72 1.36 1.68 10.97 2.78 -0.61 3.11 -0.08 -0.21 0.34 0.39

Table 9.18

(continued)

SITC"

EClO

U.S.

11 81 333 334 562 641 65 1 653 672 673 674 713 724 736 752 776 78 1 784 792 793 821 85 1 874 894

0.00 -0.53 - 18.34 -2.29 -0.76 -1.15 0.10 0.04 -0.03 0.33 0.76 0.24 0.70 0.59 -0.67 0.70 1.32 0.93 0.33 0.82 0.16 -0.04 0.32 -0.32

0.01 0.58 - 14.88 -3.61 0.15 -0.63 0.06 -0.06 -0.14 -0.47 -0.52 -0.34 -0.12 -0.11 0.14 -0.17 -3.94 -0.51 2.34 0.08 -0.53 -1.02 0.53 -0.68

11 81 333 334 562 64 1 65 1 653 672 673 674 713 724 736 752 776 781 7x4 792 793 82 1 85 1 874 894

17.93 -0.53 -23.47 -0.82 -0.77 -1.07 0.00 0.10 0.05 0.34 0.46 0.14 0.78 0.48 -0.54 -0.35 0.45 0.86 0.50 0.46 0.09 -0.16 0.19 -0.36

0.22 0.57 - 19.59 -2.37 0.32 -0.32 0.06 -0.05 -0.17 -0.22 -0.40 -0.12 -0.13 0.01 -0.17 -0.11 -2.70 0.00 2.48 0.16 -0.30 -0.97 0.61 -0.57

Canada

Mexico

Year = 1988 0.50 -1.74 -0.69 0.00 67.12 8.24 0.05 0.32 I .63 0.09 7.75 -0.03 0.83 -0.48 -0.53 -0.52 -0.20 -0.24 0.29 0.29 -0.63 -0.40 -2.17 4.22 -1.00 -0.32 -0.71 -0.95 0.20 -1.27 -0.23 -0.81 1.51 3.43 -2.44 -5.13 -2.25 -1.05 -0.30 -0.24 -0.01 -0.11 -0.71 0.14 -0.80 -0.92 -0.75 -0.17 Year = 1992 0.28 -1.98 -0.87 -0.00 58.12 12.95 -3.69 2.04 0.32 2.67 -0.91 7.53 0.49 -0.21 -0.66 -0.38 -0.42 0.48 0.65 - 1.45 0.03 -0.92 -2.94 I .60 -0.19 -0.97 -0.34 -2.06 -1.15 -0.45 -1.00 -0.15 3.84 4.48 -4.30 - 10.08 0.13 -0.76 -0.06 -0.08 -0.19 -0.51 -0.69 -0.18 -0.89 - 1.37 -0.72 -0.4 1

Japan

China

Korea

-1.30 -0.24 - 16.57 -3.90 -0.11 0.04 -0.06 0.50 -0.04 0.59 1.64 1.24 0.65 0.88 0.90 1.13 5.44 1.90 -0.49 1.14 -0.15 -0.23 0.35 -0.07

1.02 1.76 25.56 0.11 -7.16 -0.85 -2.01 0.46 -0.10 -2.95 -5.02 -0.23 -2.37 -0.81 -0.45 -1.32 -1.11 -1.12 -1.16 -0.11 0.33 1.57 - 1.32 0.63

0.00 -0.87 -53.94 - 1.92 0.57 0.10 0.97 7.22 0.28 1.20 0.88 -1.14 1.71 -1.92 1.60 -0.19 10.01 -1.31 -5.87 7.48 0.64 10.62 -2.87 3.90

- 1.45 -0.44 -22.52 0.30 -0.09 0.11 0.06 0.44 -0.02 0.54 1.57 1.34 0.99 0.91 0.95 1.07 5.17 2.07 -0.41 1.76 -0.19 -0.28 0.43 0.01

0.72 0.20 9.95 -3.16 -9.11 -2.18 -4.19 -1.76 - 1.25 -0.93 -4.61 -1.12 -5.16 - 1.73 -0.11 -12.18 -2.08 - 1.42 -2.41 -0.10 1.09 5.64 -1.39 3.74

-1.36 -1.01 -85.66 -4.65 0.34 -0.24 0.46 7.35 -0.00 0.5 1 4.13 -1.20 -1.31 -2.68 1.06 0.80 4.59 -0.82 -3.02 8.28 0.11 5.17 -2.75 0.93

-

Sources: United Nations, International Trade Statistical Yearbook (New York, 1984, 1992); International Monetary Fund, International Financial Statistics (Washinton, D.C., 1994). 5 e e table 9.17 note for key to SITC numbers.

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HonggueLee

limited competition implies that Korea’s trade pattern is “complementary” to those of the United States, Canada, and Mexico.” As a result, the extent of overall trade diversion is expected to be limited. Trade Elasticities

Potential trade diversion away from Korea due to NAFTA is relatively weak, as evidenced by “qualitative” indicators. Yet, it remains to be seen to what extent the effects of NAFTA on Korea can be quantified. The scope of trade diversion is determined by the size of preferential treatment and the efficiency loss attributable to replacement of more efficient nonmember suppliers. Preferential liberalization within an FTA changes the relative prices of goods produced in member countries and goods originating outside the FTA. The import source is then switched from more efficient outside suppliers to less efficient, but preferentially treated, member suppliers. In this regard, it is of interest to assess the responsiveness of exports or imports to changes in relative prices. A production theory approach is a convenient way to measure the possible scope of trade diversion resulting from NAFTA. In this approach, price elasticities are derived from a restricted profit function that has aggregator functions as net outputs or from aggregator functions at the sublevel, both of which retain the properties of the neoclassical production function. Own price elasticity measures the extent of reduction in Korean exports directly attributable to a change in relative prices due to NAFTA. Cross-price elasticity assesses the substitution possibilities between, for example, NAFTA and other destinations. When the cross-price elasticity of two particular destinations is negative, exports to these two markets are substitutes rather than complements. That is, an increase of export price in one of these destinations will result in an increase in the amount of exports to the other. Thus, price elasticities combined with data on trade barriers can be used to infer the percentage reduction in Korean exports to NAFTA (see appendix tables 9A.1, 9A.2, and 9A.3 for the following discussion.) The own price elasticity of Korea’s export supply has ranged from 2.2 to 2.9 since 1980. Korea’s export supply has been very responsive to price change. For instance, in 1993 a 1 percent increase in the export price level would have increased Korea’s total export supply by 2.68 percent. But Korea’s import demand is not so elastic with respect to price change. The own price elasticity of Korea’s import demand was much less than 1 throughout the 1980s and early 1990s, reflecting the relatively inflexible demand for imports. In 1993, for ex17. Number of Sectors with Common Comparative Advantage 1980

1984

1988

1992

5/22 4/22 6/23

3/21 4/22 3/11

~

Korea4J.S. Korea-Canada Korea-Mexico

4/24 6/22 3/16

311 9 5/23 4/19

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A Perspective on the Effects of NAFTA on Korea

Table 9.19

Korean Exports to the U.S. Market, 1992

Export Type A. Korea’s exports to the United States B. Korea’s exports to the United States matched by Mexico’s C. No-tariff exports D. Mexico’s exports under GSP E. Exports directly affected by NAFTA

Amount Number of Items (million US.$) 5,003 3,921 361 2,444 1,122

16,230.638 14,419.833 2,899.200 6,032.518 5,488.115

Source; Ministry of Commerce and Industry, unpublished internal source (1994).

ample, a 1 percent increase in the import price level would have decreased Korea’s import demand merely by 0.06 percent. Elasticities with regard to export destinations (import sources) show regional response subject to a fixed aggregate labor input and a given level of aggregate exports (imports). Own price elasticities of Korea’s exports to North America have continuously stayed above 5.0 throughout the 1980s and early 1990s. Own price elasticities are much lower for Japan (1.65-1.84), the European Community (1.77-2. lo), and APEC (1.25-1.65) during the same period. These results imply that Korea’s exports to the North American market are more sensitive to relative price changes than its exports elsewhere. Imports from North America also exhibit a very high price responsiveness, with own price elasticities ranging from -2.48 to -3.87, while those from Japan range from -1.96 to -3.60. Own price elasticities are low for both the European Community and APEC. Price elasticities and the NAFTA tariff reduction schedule have been combined to calculate the impact effect of NAFTA on Korea’s exports to the U.S. market. The calculation has been applied to Korea’s exports to the U.S. market in 1992. As a proxy for the “NAFTA effect” on tariff rates, applied U.S. tariffs on East Asian exporters have been used.’*Obviously, the tariff margins are not translated into an increase in “net” export price. The net export price that the exporters face is likely to fall as a result of NAFTA. In the present calculation, it has been assumed that 50 percent of tariff margins are translated into depression of the net export price. The product of the price elasticity and the trade barrier figure yields the percentage reduction in Korean exports attributable to preferential liberalization of the North American market. Among all the export items in 1992, 1,122 items ($5.5 billion) would be directly affected by NAFTA (see table 9.19). The resulting reduction in Korea’s exports to the U.S. market would amount to around 1.7 percent ($274 million) of its total exports. Leather goods ($53 million) and textiles and apparel ($112 million) would be most seriously affected. Steel products ($36 million) and footwear ($29 million) would also be substan18. These data have been adopted from Pnmo Braga et al. (1994, tables 2 and 4).

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Honggue Lee

Table 9.20

Reduction in Exports, 1992 (million U.S. dollars)

Sector Chemical products Leather goods Textiles and apparel Footwear Steel products Nonferrous metals Machinery Electrical machinery Automobiles M i x . manufactures Total

Exports to United States (A)

Directly Affected by NAFTA (B)

Expected Reduction (C)

66 1 1,040 2,529 1,527 893 191 1.97 1 4,961 860 1,598

31 936 1,744 1,020 679 42 38 538 298 164

2 53 112 29 36 1 1 19 10 11

0.3 5.1 4.4 1.9 4.0 0.7 0.1 0.4 1.2 0.7

16,231

5,488

274

1.7

A/C (%)

Source: Ministry of Commerce and Industry, unpublished internal source (1994).

tially affected (see table 9.20). The results of the present calculation fall within the range suggested by other studies.I9 9.3.2 “Hidden Protectionism”: Selected Sectoral Impacts Prospective diversion effects due to NAFTA will be felt differently by each sector. Highly protected sectors are more likely to cause trade and investment diversion. The possibilities for trade and investment diversion are likely to be most pronounced in those sectors, such as agriculture, automobiles, textiles and apparel, and iron and steel, where existing trade barriers are relatively high or the rules of origin are strict. Textiles and Apparel

The textiles and apparel sector has been heavily protected in both Canadian and U.S. markets. As a result of NAFTA, however, all tariffs on textiles and apparel will be eliminated within 10 years. Tariffs between the United States and Mexico will be phased out in six years. Moreover, U.S. quotas on Mexican textile and apparel products will be immediately eliminated, provided that the Mexican products satisfy the new rules of origin. The elimination of tariffs and quotas on Mexican products will enhance Mexico’s price competitiveness vis8-vis Korea in low- to medium-priced products, whose competitiveness has already been eclipsed by China and East Asian NIEs. Mexico’s share in the U.S. market (apparel sector) increased from 2 percent in the early 1980s to 6 percent in 1992. On the other hand, the phasing out of the MFA in 10 years following the conclusion of the Uruguay Round will mitigate the adverse effect on the competitiveness of Korean producers vis-8-vis Mexican producers. 19. E.g., Noland (n.d.) reported export diversion losses in the range of 1-3 percent of Korea’s total exports.

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A Perspective on the Effects of NAFTA on Korea

While eliminating tariffs and quotas on intraregional trade, NAFTA established protective rules of origin for textiles and apparel. The new rules of origin make more difficult the conditions for preferential treatment. To qualify for NAFTA preferences, finished products must pass a “triple transformation test,” which virtually requires that products be made of North American fibers (Hufbauer and Schott 1993,44). This rule of origin is much stricter than the existing rule in CUSFTA, which requires a “double transformation” in order to qualify for FTA preferential treatment. Among 1,239 textile items (HS 10-digit) exported to the U.S. market in 1992, Korean producers have 586 items directly competing with Mexican products. When the items subject to duty exemptions or the Generalized System of Preferences (GSP) are excluded, 543 items ($1.74 billion) will be directly influenced by NAFTA. This adds up to around 43.8 percent (or 69.0 percent) of the total number (or the total amount) of textile products exported to the U.S. market. The corresponding amount of export reduction is estimated to be around $112 million (4.4 percent of the total amount).20 Korea’s market share of the footwear sector in the United States decreased from 26 percent in 1989 to 15 percent in 1992. Among 186 footwear products exported to the U.S. market, 87 items ($1.02 billion) are expected to be affected by NAFTA. The expected reduction in exports to the U.S. market due to the preferential treatment of Mexico amounts to around $29 million (1.9 percent of the total). The United States has maintained higher tariff rates on leather imports than the average tariff rate imposed on manufacturing goods. NAFTA will phase out tariffs on Mexican leather goods in 10 years. Most Korean producers of leather goods have not exported their products under their own brand names. With the rapid emergence of Chinese and Thai competitors in lower-end products, Korea’s market share in the United States decreased from almost 29 percent ($1.5 billion) in 1989 to 19 percent ($1.0 billion) in 1992. On the other hand, Mexico’s share slightly increased from 2.2 percent in 1989 to 2.7 percent in 1992. Korea exported 127 leather products, in 50 items ($936 million) of which Korea and Mexico directly compete with each other. The reduction in 20. As the fourth largest exporter of textiles to the U.S. market, Korea’s textile industry holds a large amount of quotas. At the same time, Korea’s quota utilization rate is so high that 90 percent of Korea’s textile goods were exported out of quotas in 1993.Thus, a question arises as to whether it is meaningful to estimate the effects of price changes on Korea’s textile exports to the United States. ’ b o excuses can be made for following the production theory approach in the current study: the equivalence between tariffs and quotas and the characteristics of the data used in the estimation process. In calculating “NAFTA effects,” “US. tariff margins on East Asian exporters” (Pnmo Braga et al. 1994) were used as approximate measures reflecting both tariff and nontariff barriers. This kind of exercise can be justified in the case where there exists a basic equivalence between tariffs and quotas in perfectly competitive markets. In this regard, U.S. tariff rates used in the calculation of NAFTA effects were indeed “tariff equivalents” of tariff and nontariff barriers. The production model used in the estimation process posits perfect competition. Given these constraints, however, the estimates on textiles and apparel reported in table 9.20 should be interpreted as at best firstorder approximation.

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Honggue Lee

leather exports due to NAFTA is estimated to be around $53 million (5.1 percent of the total). Electrical Machinery and Electronic Goods Korea’s market share of electrical machinery and electronic goods in the U.S. market was 8.9 percent ($5.2 billion) in 1989, but it was down to 7.3 percent ($5.0 billion) in 1992. On the other hand, Mexico’s share increased from 12.6 percent ($7.3 billion) in 1989 to 14.0 percent ($9.6 billion) in 1992. In 1992 Korea was the third biggest exporter of electronic components and accessories to the U.S. market with its market share of 9.6 percent ($2.18 billion). The top two exporters were Japan (28.9 percent, $6.6 billion) and Canada (10.7 percent, $2.4 billion). Korea was followed by Malaysia and Mexico, whose market shares were 9.5 percent ($2.17 billion) and 8.3 percent ($1.9 billion), respectively. Among other items, Korea has focused on semiconductors and related devices, and its share was 13.0 percent ($1.98 billion out of a total $15.3 billion).21 In 1992 Korea was the fifth largest exporter of computer equipment with a share of 4.3 percent ($1.4 billion). Korea was preceded by Japan (34.9 percent, $11.2 billion), Singapore (17.1 percent, $5.5 billion), Taiwan (13.7 percent, $4.4 billion), and Canada (6.9 percent, $2.2 billion). On 13 computer products that Korea exports, the United States maintains tariffs. However, as the United States had already given Canada and Mexico tariff exemptions before NAFTA, the effects of the preferential arrangement on Korean computer exports would not be substantial. On the other hand, the new rules of origin require thirdcountry producers to use electron tubes made in North America to be eligible for NAFTA preferences. But the huge fixed investment cost is likely to prevent Korean producers from setting up tube-producing plants. Korea exported 621 kinds of electronic products to the U.S. market in 1992, but it competed with Mexico in only 19 percent of those items (118 items, $537 million). The preferential treatment of Mexico is estimated to reduce Korea’s exports to the U.S. market by around $19 million (0.4 percent of the total). Steel Mill Products Korea has experienced a reduction in steel exports to the U.S. market due to the worldwide recession that began 1989 and a series of bilateral disputes that followed the expiration of a voluntary restraint agreement. Korea’s exports to the U.S. market were recorded at $893 million in 1992, which was less than the amount of previous years. On the other hand, Mexico has been successful recently in increasing its export volume in the U.S. steel market. Mexican steel exports increased from $481 million in 1989 to $656 million in 1992. The major Mexican steel exports to the U.S. market were mostly lower21. See the U.S. Department of Commerce (1994, chap. 15) for related statistics.

259

A Perspective on the Effects of NAFTA on Korea

quality steel products such as semifinished steel, pipe and tube, and other sheet and strip, which used to constitute Korea’s major exports. Mexico expanded its steel production on the basis of relatively lower labor costs, while Korea specialized in more capital-intensive production such as plates. As a result, the extent of direct competition in the U.S. steel market between Mexico and Korea is not likely to be significant. Among 335 steel products exported to the U.S. market, in 112 items (worth $677 million) Korea competed with Mexico. In view of this situation, the degree of export reduction is expected to be $36 million (4.0 percent of the total). Automobiles NAFTA rules of origin for the motor vehicles sector stipulates that assembled autos contain 62.5 percent North American content in order to be eligible for duty-free treatment. This new rule is stricter than the existing one in CUSFTA. Moreover, the new rule will eliminate duty-waiver programs for all U.S. imports of automotive products from Canada. This implies an end to preferential duty waivers for foreign transplant producers in Canada such as Hyundai, Honda, Toyota, and General Motors-Suzuki (see Hufbauer and Schott 1992, 161). As a result, the NAFTA rule of origin for the automotive sector will give the U.S. Big Three carmakers and their unionized workers an effective weapon with which to strike back at foreign transplant production in North America. Under NAFTA, the calculation of regional content will be based on a net-cost method that traces key foreign components to measure their North American content. Along with the stricter rules of origin, the new tracing test should eliminate the roll-up problem. Although rules of origin have become stricter, foreign producers who export assembled autos to the United States are likely to be less significantly affected by them than those foreign producers who export to Canada or Mexico. Foreign firms transplanted in North America will be forced to source more parts regionally if they want smoother access to the Canadian and Mexican markets. In 1992, Korea exported $860 million of automobile-related products to the United States, of which $101 million (12 percent of the total) were subject to the rules of origin test. On the other hand, Mexico exported $1.9 billion of automobile products to the United States, 37 percent of which were subject to the new origin rules. The high ratio of Mexican exports to Korean exports affected by the new rules of origin indicates that the possibility of trade diversion is great. The reduction in automobile exports would be around $10 million (1.2 percent of total automobile exports). 9.3.3

Investment Diversion

With respect to the possibility of investment diversion, an important question arises as to whether regional firms (particularly U.S. firms) prefer a location within the region or whether they are truly global when looking for an export platform to serve the U.S. market. Regional integration is a natural re-

260

Honggue Lee

sult of geographical and cultural proximity, not the outcome of political negotiations. Regional arrangements, often initiated by those producers (in large part, multinational firms) who aim at taking advantage of a regional division of labor, help expedite trade and investment with neighboring countries, which has been “suppressed” by political barriers. In this regard, NAFTA is not the cause but the effect of “corporate” integration efforts on the part of U.S. producers. Trade and investment are influenced by preferential arrangements, but institutional arrangements follow regional economic integration, not the other way around. No doubt NAFTA will invigorate intraregional investment, which is driven by the potential for a regional division of labor and by expectations of an enlarged market. Yet, export-oriented production in Mexico has enjoyed preferential treatment such as the GSP and the maquiladora program. These special treatments were allowed because U.S. multinationals wanted to use Canada and Mexico as export platforms. In view of this evidence, the amount of additional intraregional investment (and hence intrafirm trade) that would result from NAFTA should not be exaggerated. To the extent that geographical proximity is important in shaping patterns of trade and investment, the scope for investment (and intraregional trade) diversion is not likely to be substantial. Intrafirm trade in North America has always been regional. U.S. multinational firms have preferred neighboring countries. They account for most of the trade flow between the United States and Canada, which constitutes the largest bilateral trade flow in the world. These firms are also responsible for almost one-half of U.S. manufacturing imports from Mexico. American multinationals have long taken advantage of a regional division of labor through the U.S.-Canada Automotive Pact and the maquiladora program. At the same time, their Mexican affiliates are the most strongly oriented toward the U.S. market of affiliates in any major country. Thus, in the case of the North American market, there is clear evidence that regional firms have a regional bias in choosing their export locations to serve the U.S. market in almost all sectors. Even those firms that are regarded as global firms opt for a regional strategy, often resulting in multiregional production. For example, almost all U.S. intrafirm imports in the automotive sector come from Canada and Mexico. There is virtually no interregional trade among affiliates in the automotive sector. However, in other sectors, where standardized or “low value-added” products are traded, U.S. intrafirm imports are likely to come from countries other than Mexico and Canada. But in any case, interregional exports are less than what is sold locally and regionally. As multinational firms organize their production on a regional basis, intraregional trade prevails. Unless U.S. multinational firms are willing and able to pursue “complex integration strategies” and to change their structures accordingly, the geographical scope of their international production will be confined to regional

261

A Perspective on the Effects of NAFTA on Korea

clusters in North America and Latin America.22The same tendency has been the case in the European Community and in East Asia. Many multinational firms are achieving their global objectives through a regional organization of “value chains.” In the future, competitive pressures are likely to force multinational firms to spread their activities more widely around the world. At present, however, only a few firms are involved in integrating production beyond the regional level and for only a limited number of corporate functions (see United Nations 1993, chap. 5 ) . On the other hand, regional economic arrangements may restrict the growth of global strategies by establishing barriers to extraregional trade.23 9.4

Concluding Remarks

There are some signs of trade diversion away from Korea due to Mexico’s accession to CUSFTA. Yet the scope of trade diversion is not likely to be significant, as evidenced by the quantitative analysis of the present study. This observation, however, overlooks the structural changes associated with regional trade arrangements in which dynamic effects are generally much larger than static ones and in which potential effects are much larger than transitional and transformational realized effects. At the same time, regional arrangements are likely to have negative impacts on the perceptions and behavior of nonmembers. NAFTA is an ambitious vertical integration between disparate economies. Its success is likely to depend on market size effects applied at a regional or local level. Market size effects generate what amounts to an external economy, as they will eliminate uncertainty associated with increasing returns to scale.24 Porter ( 1990) has emphasized the point that international competitiveness is often the product of successful geographical clusters among countries. Geographic concentration is the most convincing evidence of the importance of external economies in real economies. In this regard, NAFTA will pose a great challenge for nonmembers, as it will enhance the competitiveness of the North American economy through externalities attributable to market size effects.

22. See United Nations (1993) for a discussion of strategies of multinational firms regarding integrated international production. 23. International trade is even more regionally concentrated than foreign direct investment (FDI). That pattern emerges from a comparison of shares of regional and other partners in international trade with their shares in FDI and, even more clearly, from a comparison of trade intensities with FDI intensities. Moreover, intrafirm trade between multinational parent firms and their affiliates represents the largest share of world trade. Intrafirm trade often constitutes the only way in which services, technology, and patents are internally transferred. 24. External economies are most likely to occur at the regional or local level rather than at the national or international level. Each individual manufacturing facility stayed within the manufacturing belt because of the advantages of being near other manufacturers. See Krugman (1993) for this interesting observation.

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Honggue Lee

Appendix Export Supply and Import Demand Elasticities For the estimation of price elasticities, a producer theory approach is employed. Drawing on an economy-wide GNP function that treats imports as an input to the production process and exports as an output, the producer approach generates export supply and import demand functions. These functions in turn can be used to calculate various elasticities with which the extent of trade replacement can be estimated. The production theory approach was initiated by Kohli (1978), who regarded imports as an intermediate input into the production process and exports as an output not destined for domestic use. When imported goods are treated as intermediate goods, only the private production sector of the economy needs to be modeled. Then the difficult problems associated with modeling the consumer sector can be avoided.25 In this study, a restricted profit function (the GDP function) was used, which had domestic sales supply, capital, exports, and imports as aggregate net output. Labor input was assumed to be fixed. In addition, exports and imports each were disaggregated into four destinations and origins (namely, NAFTA, Japan, the European Community, and APEC 11). Specifically, let the production possibilities set for a country in period t be a set T, = {(x, v)}, where x is a vector of net outputs and v is a vector of primary inputs.Z6Let p be the vector of domestic and international prices. Then the country’s restricted profit (GDP) function can be defined as

n ( p , L ) = max { p ’ x : (x,L ) E T } , where L is a vector of labor stocks utilized by the production sector in period t. The restricted profit function is supposed to satisfy the properties of the neoclassical profit function. Then, from Hotelling’s lemma, the net output supply functions are derived (from the derivatives of the restricted profit function with respect top):

x

=

V p r I ( p ,L).

The net supply vector is the vector of first-order derivatives of the restricted profit function with respect to the components of the price vector.27This system of equations contains the economy’s short-run domestic output supply, capital demand, export supply, and import demand functions. Constant returns to scale are assumed with respect to the labor stock. The functional form for the unit profit function adopted is the symmetric25. This approach no doubt falls short of taking account of general equilibrium effects. The resulting model is partial equilibrium in nature. Yet it is simple and straightforward. 26. The subscript t will be suppressed in the following to reduce notational complexities. 27. See Diewert and Momson (1988) for related discussion.

263

A Perspective on the Effects of NAFTA on Korea

normalized-quadratic function.**For the case of homogeneous labor, the restricted profit function in period t is defined as

where s is the exogenous parameter, the variable T is a time trend indicating technical progress, and B, a, and d are parameters to be estimated subject to the Slutsky symmetry and Cournot aggregation conditions. The form of corresponding net output supply functions is xz - P‘B

si p ’ B p 2 (p’s)’ ~

L

p’s

+ ai+ di* T .

The restricted profit function is supposed to be globally convex in prices p . This implies that the matrix of estimated coefficients B should be positive semidefinite. But when the estimated matrix is not positive semidefinite, the coefficient matrix is replaced by the product of a lower triangular matrix and its transpose to ensure the global convexity of the profit function. The estimated matrix B of the present model was not positive semidefinite: its eigenvalues were not all nonnegative. Thus, positive semidefiniteness had to be imposed on the coefficient matrix by a reparameterization that was designed by Wiley, Schmidt, and Bramble (1973). Reparameterization required replacing the matrix B by a product of two lower triangular matrices C and C’, where

B

=

C C’, C

= [c,]],

cv = 0 f o r j > i .

Then the reparameterized system was estimated by means of nonlinear regression methods (see table 9A.1). The export supply and import demand functions derived from the restricted profit functions are aggregator functions that can be disaggregated into components of exports and imports. With the assumption that exports and imports are weakly separable from the other inputs and outputs, a two-stage optimization process is possible in which the total demand for imports and supply of exports are estimated and then aggregate imports and exports are disaggregated in separate submodels. Again a symmetric-normalized-quadratic function can be adopted for the disaggregation of the aggregator function. Then the unit profit function for export or import aggregates takes the form

28. This is an adaptation of the generalized symmetric McFadden cost function defined in Diewert and Wales (1987).

Table 9A.1

Parameter Estimates Coefficient

Standard Error

T-Ratio

GDP function D1 1.5798 c11 0.2413 c 21 -0.7926 c22 -0.3784 0.1059 C3 1 C32 0.0661 c33 0.0518 B1 0.0202 D2 2.2268 B2 0.0140 D3 -0.1615 -0.0004 B3 D4 0.3437 B4 0.0115 Iteration number Log-likelihood function

0.0298 0.0475 0.0776 0.0995 0.0208 0.0362 0.0272 0.0033 0.2002 0.0250 0.0557 0.0021 0.0196 0.0007 124 143.6627

52.9340 5.0792 - 10.2080 -3.8037 5.0940 1.8247 1.9029 6.0969 11.1250 0.5582 -2.9010 -0.2055 17.5010 15.4040

Export aggregator F1 1.3403 Ell -0.4873 E2 1 -0.4524 E22 -0.2189 E3 1 -0.3468 E32 -0.1575 E33 0.1054 A1 -0.0071 F2 -0.4518 A2 -0.0021 F3 -0.5136 A3 -0.0027 F4 -0.2784 A4 0.0116 Iteration number Log-likelihood function

0.0324 0.0833 0.0494 0.1315 0.0642 0.1415 0.0329 0.0030 0.1106 0.0010 0.0927 0.0010 0.0572 0.0020 300 227.1960

41.3270 -5.8482 -9.1527 - 1.6644 -5.4011 - 1.1125 3.1995 -2.3690 -4.0843 -2.0475 -5.5395 -2.6022 -4.8692 5.6780

Import aggregator H1 0.7797 G11 1.0453 G2 1 -0.0014 G22 0.1272 G3 1 -0.0635 G32 -0.0347 G33 -0.0446 0.0101 B1 H2 -0.6640 B2 -0.0274 H3 0.1555 B3 0.0029 H4 0.2353 B4 0.0096 Iteration number Log-likelihood function

0.1066 0.0560 0.0133 0.0444 0.0447 0.0245 0.0411 0.0012 0.1621 0.0018 0.0176 0.0004 0.0369 0.0006 78 221.9865

7.3127 18.6660 -0.1037 2.8667 -1.4212 - 1.4161 -1.0851 8.4094 -4.0954 - 14.9700 8.8200 7.3249 6.3729 15.6030

265

A Perspective on the Effects of NAFTA on Korea

where s is the exogenous parameter, the variable 7 is a time trend indicating technical progress, and F, e , and g are parameters to be estimated subject to the Slutsky symmetry and Cournot aggregation conditions. The form of corresponding net output supply functions is given byz9

The disaggregation of aggregator functions can be made according to the types of commodities and services or the origins and destinations of exports and imports. For the purpose of assessing the scope of trade diversion, disaggregation based on the geographical distribution of foreign trade is more useful. A closer look at the geographical composition will uncover some information concerning the substitution possibilities between different origins and destinations as well as the own price elasticities of the supply of exports and demand for imports. In this regard, it is of interest to estimate the various elasticities of regional destinations or origins. The cross-price elasticity between regions i and j , given a constant level of exports (imports) and the share of export (import) in region j , sj, is obtained as

Ei

=

E$

+ s, Ef;,,

where EkXis the own price elasticity of aggregate exports (imports) for a given fixed labor For the export (import) aggregator function, the four export destinations (import sources) were formed. Only a subset of Korea’s major trade partners was included: North American countries, Japan, the European Community, and the APEC countries excluding Japan and NAFTA countries. Domestic supply, capital demand, export supply, and import demand elasticities are presented in table 9A.2. Both export and import component ownsupply elasticities are also listed in tables 9A.3 and 9A.4.

29. The iterative Zellner SYSTEM command in SHAZAM (version 6) has been applied to each of the three linear systems to obtain the maximum likelihood estimates. RESTRICT options were used to impose symmetry conditions. But the curvature properties of the production technology were not satisfied: for each system, the matrix of second-order partial derivatives was not positive semidefinite. With a reparameterization due to Wiley et al. (1973), the new parameters were estimated using the nonlinear command in SHAZAM. The systems converged from the differing starting coefficient values within 200 iterations. 30. For details, see Diewert and Morrison (1988) and Kohli (1991).

Table 9A.2

Net Output Elasticities XlPl 0.1376 0.1223 0.1125 0.1072 0.1120 0.1668 0.1583 0.1609 0.1915 0.2157 0.2513 0.2414 0.2409 0.2183 0.1994 0.2088 0.1940 0.1862 0.1852 X2P 1 -0.0333 -0.0302 -0.0283 -0.0263 -0.0283 -0.0443 -0.0438 -0.0447 -0.0492 -0.0523 -0.0569 -0.0552 -0.0546 -0.0510 -0.0485 -0.0507 -0.0486 -0.0473 -0.0467 X3P1 -1.9131 -2.0766 -2.1212 -2.2497 -2.1058 -1.6719

X1P2 0.0882 0.0808 0.0755 0.0733 0.0748 0.0686 0.0609 0.0577 0.0633 0.0694 0.0723 0.0767 0.0830 0.0860 0.0811 0.0751 0.0730 0.0729 0.0759

X1P3

X1P4

-0.2738 -0.2405 -0.2206 -0.2093 -0.2165 -0.2763 -0.2566 -0.2563 -0.2966 -0.3308 -0.3752 -0.3688 -0.3782 -0.3578 -0.3286 -0.3294 -0.3088 -0.2995 -0.3029

0.0480 0.0374 0.0326 0.0288 0.0297 0.0409 0.0374 0.0377 0.0419 0.0456 0.05 16 0.0507 0.0543 0.0535 0.0482 0.0455 0.04 17 0.0404 0.0417

X2P2

X2P3

X2P4

-0.0482 -0.0489 -0.0489 -0.0511 -0.0486 -0.0287 -0.0259 -0.0241 -0.0239 -0.0245 -0.0233 -0.0255 -0.0279 -0.0311 -0.0310 -0.0275 -0.0280 -0.0287 -0.0302

0.0984 0.0930 0.0899 0.0890 0.0884 0.0852 0.08 11 0.0802 0.0847 0.0887 0.0926 0.0932 0.0959 0.0961 0.0927 0.0902 0.0880 0.0874 0.0887

-0.0 168 -0.0139 -0.0127 -0.0116 -0.0115 -0.0122 -0.0114 -0.0114 -0.0116 -0.0118 -0.0123 -0.0124 0.0 134 -0.0139 -0.0132 -0.012 1 -0.0115 -0.0114 -0.01 18

X3P2 -1.8182 -2.1455 -2.3076 -2.6632 -2.2705 -0.7979

X3P3 4.5532 5.0148 5.2058 5.6992 5.0755 2.9112

-

X3P4 -0.8218 -0.7927 -0.7769 -0.7862 -0.6992 -0.4414

Table 9A.2

(continued) X3P1 - 1.6765 - 1.6879

- 1.5953 - 1.5426 - 1.4688 - 1.4776 - 1.4808 -1.5137 - 1.5482 - 1.5214 - 1.5436 - 1.5584 - 1.5640 X4P 1 -0.3508 -0.3019 -0.2677 -0.2411 -0.2389 -0.3110 -0.2872 -0.2758 -0.2930 -0.3009 -0.3 160 -0.2954 -0.2818 -0.2544 -0.2333 -0.2337 -0.2172 -0.2056 -0.2176

X3P2 -0.7365 -0.6817 -0.5856 -0.5489 -0.4604 -0.5186 -0.5702 -0.6850 -0.7292 -0.6174 -0.6616 -0.7012 -0.7440 X4P2 -0.3249 -0.2998 -0.2783 -0.2705 -0.2447 -0.1438 -0.1223 -0.1081 -0.1042 -0,1036 -0.0960 -0.1003 -0.1052 -0.11 17 -0.1064 -0.0917 -0.0899 -0.0892 -0.0999

X3P3

X3P4

2.8363 2.7906 2.5496 2.4352 2.2454 2.3227 2.4049 2.5971 2.6793 2.4904 2.5578 2.6195 2.6854 X4P3

-0.4233 -0.4209 -0.3687 -0.3437 -0.3163 -0.3264 -0.3539 -0.3984 -0.4019 -0.3516 -0.3526 -0.3599 -0.3775 X4P4

0.8598 0.7407 0.6635 0.6118 0.5781 0.5547 0.4976 0.4675 0.4796 0.4860 0.4947 0.4750 0.4690 0.4477 0.4133 0.3909 0.3672 0.3523 0.3811

-0.1842 -0.1390 -0.1 175 -0.1002 -0.0945 -0.0998 -0.0881 -0.0837 -0.0823 -0.0814 -0.0827 -0.0792 -0.0819 -0.08 15 -0.0736 -0.0655 -0.0601 -0.0574 -0.0636 -

Note: X1 = domestic sales, X2 = capital formation, X3 represent respective price indexes.

=

exports, and X4 = imports. Pl-P4

Table 9A.3

Export Destination Elasticities EXlPl 6.378 1 6.5705 6.3753 6.4301 5.9875 5.4895 5.4300 5.4027 5.5061 5.7156 5.7742 5.0614 5.0858 5.3824 5.3004 5.2286 5.3616 5.4404 5.3523 EX2P 1 -0.6927 -0.5391 -0.4210 -0.1758 -0.5289 - 1.6937 - 1.7599 -1.9014 -2.0391 -2.1097 -2.1942 -2.3156 -2.3581 -2.2857 -2.3474 -2.4947 -2.5114 -2.5494 -2.3852 EX3P1 - 1.0430 -0.9240 -0.8404 -0.6694 - 1.0773 -2.1739

EX 1P2

EX 1P3

EX 1P4

-0.4450 -0.3198 -0.2073 -0.0376 -0.1624 -0.8391 -0.8716 -0.8462 -1.0127 -1.1430 - 1.2298 -0.9500 -0.9412 -0.9986 -0.9474 -1.0005 - 1.0462 - 1.0677 -0.9982

-0.4326 -0.4002 -0.2877 -0.2051 -0.3040 -0.8701 -0.8901 -0.9552 - 1.0950 - 1.2207 - 1.3245 -1.0761 - 1.0748 -1.1249 - 1.0950 -1.1470 -1.1842 - 1.2062 -1.1221

-0.9472 -0.8357 -0.6745 -0.4883 -0.4456 -0.8691 -0.8319 -0.8108 -0.8488 -0.9167 -0.9745 -0.7126 -0.6649 -0.6618 -0.5787 -0.5908 -0.5733 -0.5470 -0.5465

EX2P2

EX2P3

EX2P4

2. I365 2.2223 2.2365 2.2942 2.1807 1.7774 1.7703 1.7589 1.7340 1.7082 1.6497 1.7049 1.7402 1.7746 1.8089 1.7921 1.8184 1.8433 1.8336 EX3P2 2.1249 2.2155 2.2377 2.3081 2.2102 1.7960

1.8928 2.0168 2.0164 2.1196 1.9874 1.5660 1.5476 1.5970 1.5530 1.5273 1.4890 1.5582 1.5904 1.6066 1.6497 1.6346 1.6443 1.6610 1.6468 EX3P3 2.0872 2.2314 2.2453 2.3886 2.2808 1.8201

1.2165 1.3148 1.3738 1.4611 1.4362 1.2614 1.2783 1.3361 1.3017 1.3093 1.3010 1.3752 1.4324 1.5016 1.5681 1.5583 1.6066 1.6646 1.5902 EX3P4 1.3840 1.4919 1.5631 1.6718 1.6619 1.4689

Table 9A.3

(continued) EX3P1 -2.2574 -2.4548 -2.5999 -2.6584 -2.7242 -2.9851 -3.0804 -2.9949 - 3.1294 -3.3207 -3.3640 -3.4430 -3.2008 EX4PI -3.9850 -3.3163 -2.7653 -2.2662 -2.1539 -2.5837 -2.3121 -2.1694 -2.0437 -1.8881 - 1.7779 -1.6120 - 1.4463 - 1.2464 - 1.0970 - 1.0828 -0.9764 -0.8773 -1.0001

EX3P2 1.7948 1.7913 1.7728 1.7452 1.6813 1.7682 1.8171 1.8503 1.9022 1.8980 1.9338 1.9705 1.9404 EX4P2 3.0855 2.9759 2.8475 2.7990 2.5408 1.9134 1.7948 1.6805 1.5708 1.4720 1.3524 1.3018 1.2651 1.2578 1.2193 1.1455 1.1265 1.1029 1.1908

EX3P3 1.8090 1.8884 1.8493 1.8183 1.7726 1.9054 1.9610 1.9694 2.0458 2.0507 2.0705 2.1039 2.0565 EX4P3 3.0496 3.0331 2.8823 2.9297 2.6334 1.9291 1,7942 1.7494 1.6130 1.5054 1.3951 1.3621 1.3187 1.2894 1.2539 1.1789 1.1452 1.1129 1.2042

EX3P4 1.4899 1.5657 1.5273 1.5301 1.5157 1.6342 1.7072 1.7723 1.8607 1.8623 1.9175 1.9881 1.8892 EX4P4 2.4032 2.3221 2.2412 2.2366 2.0552 1.6524 1.5594 1.5301 1.4095 1.3460 1.2758 1,2707 1.2674 1.2963 1.3031 1.2488 1.2626 1.2810 1.2906

Note: EX1 = exports to NAFTA, EX2 = exports to Japan, EX3 = exports to the European Community, and EX4 = exports to APEC 11. Pl-P4 represent respective price indexes.

Table 9A.4

Import Origin Elasticities IMlPl -2.4447 -4.0784 -4.3142 -4.0263 -3.6365 -3.0375 -3.1646 -2.4865 -2.8802 -2.9372 -3.1176 -3.8738 -3.8085 -3.7923 -3.5618 -3.3267 -3.3472 -3.0848 - 3.3172 IM2P1 1.3707 1.3864 1.4390 1.5061 1.5836 1.6877 1.7591 1.9272 1.9679 2.0646 2.1465 2.1575 2.2785 2.4083 2.5943 2.8216 3.0063 3.3422 2.8223 IM3P1 -0.0097 0.0396 0.0452 0.0452 0.0391 0.0278

IMlP2 2.6256 4.2927 4.5380 4.2416 3.8423 3.2619 3.3938 2.6476 3.0516 3.1063 3.3036 4.0197 3.9464 3.9176 3.6860 3.4640 3.4849 3.2147 3.4602

IMIP3

im1p4

-0.0054 0.022 1 0.0270 0.0255 0.0197 0.0129 0.0163 0.0126 0.0178 0.0175 0.0189 0.0311 0.0288 0.0288 0.0261 0.0245 0.0256 0.0230 0.0243

-0.3597 -0.3754 -0.3683 -0.3410 -0.3201 -0.3371 -0.3336 -0.2574 -0.2714 -0.2681 -0.2876 -0.2562 -0.2486 -0.2357 -0.2239 -0.2273 -0.2234 -0.2103 -0.2309

IM2P2

IM2P3

1m2p4

-1.7516

- 1.6630 -1.7187 - 1.8024 -1.9613 -2.0190 -2.1951 -2.2176 -2.3146 -2.4059 -2.3547 -2.4816 -2.6099 -2.8022 -3.0527 -3.2404 -3.5995 -3.0563

-0.0190 -0.0145 -0.0 124 -0.0 105 -0.0100 -0.0 105 -0.0093 -0.0085 -0.0086 -0.0088 -0.0091 -0.0090 -0.0095 -0.0097 -0.0084 -0.0070 -0.0060 -0.0053 -0.0066

IM3P2

IM3P3

-0.095 1 -0.0783 -0.0638 -0.0504 -0.0442 -0.0426

-0.1451 -0.1409 -0.1353 -0.1298 -0.1240 -0.1277

- 1.6360

0.2157 0.1251 0.1188 0.1229 0.1343 0.1844 0.1811 0.1927 0.1760 0.1774 0.1857 0.1270 0.1308 0.1297 0.1427 0.1726 0.1801 0.2051 0.1770 1m3p4

0.0658 0.0407 0.0363 0.0348 0.0346 0.0427

271

A Perspective on the Effects of NAFTA on Korea

Table 9A.4

(continued)

IM3Pl 0.0327 0.0309 0.0373 0.0362 0.0361 0.0499 0.0471 0.0466 0.0448 0.0434 0.0447 0.0425 0.0435 IM4P1

- 1.2908 - 1.4337 - 1.2228 -1.0183 -0.8591 -0.7084 -0.6549 -0.5601 -0.5476 -0.5154 -0.4905 -0,4976 -0,4692 -0.4465 -0.4170 -0.3886 -0.3716 -0.3496 -0.3870

IM3P2

IM3P3

-0.0357 -0.0287 -0.0289 -0.0274 -0.0274 -0.0276 -0.0273 -0.0257 -0.0203 -0.0152 -0.0122 -0.0094 -0.0144

-0.1247 -0.1211 -0.1219 -0.1186 -0.1194 -0.1185 -0.1166 -0.1147 -0.1105 -0.1085 -0.1069 -0.1045 -0.1085

IM4P2

IM4P3

1.4004 1.4488 1.2231 1.0168 0.8570 0.7 184 0.6613 0.5556 0.5343 0.4984 0.4721 0.4609 0.4298 0.4050 0.3819 0.3623 0.3480 0.3282 0.3628

0.0787 0.0842 0.0698 0.0569 0.0454 0.0375 0.0345 0.0285 0.0270 0.0237 0.0216 0.0209 0.0178 0.0157 0.0146 0.0142 0.0138 0.0126 0.0145

im3p4

0.0395 0.0353 0.03 11 0.0284 0.0280 0.0170 0.0149 0.0123 0.0124 0.0 147 0.0143 0.0139 0.0158 rh44P4 -0.3725 -0.2383 -0.1877 -0.1556 -0.1378 -0.1472 -0.1290 -0.1077 -0.0960 -0.0882 -0.0859 -0.0634 -0.0603 -0.055 8 -0.0530 -0.0534 -0.0503 -0.0487 -0.0539

Nure: IM1 = imports from NAFTA, IM2 = imports from Japan, IM3 = imports from the European Community, and IM4 = imports from APEC 11. Pl-P4 represent respective price indexes.

References Asia Pacific Economic Cooperation. 1994. Achieving the APEC vision: Free and open trade in the Asia Pacz3c. Second Report of the Eminent Persons Group. Singapore: Asia Pacific Economic Cooperation. Balassa, Bela. 1965. Trade liberalization and “revealed’ comparative advantage. ManChester School of Economic and Social Studies, no. 33. Bank of Korea. 1994. Overseas direct investment statistics yearbook. Seoul: Bank of Korea.

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Diewert, W. Erwin, and Catherine J. Morrison. 1988. Export supply and import demand functions: A production theory approach. In Empirical methods for international trade, ed. Robert C. Feenstra, 207-22. Cambridge, Mass.: MIT Press. Diewert, W. Erwin, and T. J. Wales. 1987. Flexible functional forms and global curvature conditions. Econometrica 55:43-68. Finger, J. M., and M. E. Kreinin. 1979. A measure of “export similarity” and its possible use. Economic Journal 89:905-12. Hufbauer, Gary Clyde, and Jeffrey J. Schott. 1992. North Arnericanffee trade: Issues and recommendations. Washington, D.C.: Institute for International Economics. . 1993. NAFTA: An assessment, revised edition. Washington, D.C.: Institute for International Economics. Kohli, Ulrich. 1991. Technology, duality, and foreign trade: The GNP function approach to modeling imports and exports. Ann Arbor: University of Michigan Press. Krugman, Paul R. 1993. The current case for industrial policies. In Protectionism and world welfare, ed. Dominick Salvatore. cambridge: Cambridge University Press. Lafay, Gerard. 1992. The measurement of revealed comparative advantages. In International trade modelling, M. G. Dagenais and P.-A. Muet, 209-34. London: Chapman and Hall. Noland, Marcus. n.d. Asia and the NAFTA. Mimeograph. Petri, Peter A. 1993. Deepening interdependence in the Pacific Rim: Challenges for international input-output analysis. In International industrial linkages and economic interdependency in Asia-Pacific region, ed. Taka0 Sano and Chiharu Tamamura. Tokyo: Institute of Developing Economies. Porter, Michael E. 1990. The competitive advantage of nations. New York: Free Press. Primo Braga, Carlos A. 1992. NAFTA and the rest of the world. In North American free trade, ed. Nora Lustig et al. Washington, D.C.: Brookings Institution. Primo Braga, Carlos A., et al. 1994. NAFTA’s implications for East Asian exports. World Bank Working Paper no. 1351. Washington, D.C.: World Bank. United Nations. 1993. World investment report: Transnational corporations and international production. New York: United Nations. U.S. Department of Commerce. 1994. US.industrial outlook 1994. Washington, D.C.: U.S. Department of Commerce. Wiley, D. E., W. H. Schmidt, and W. J. Bramble. 1973. Studies of a class of covariance structure models. Journal of the American Statistical Association 68:3 17-23.

Comment

Tain-Jy Chen

This is a comprehensive study of possible impacts of NAFTA on Korea. I enjoyed reading it and agreed with its major conclusion; that is, NAFTA is not likely to have a major impact on Korea’s trade with the United States. In fact, a study conducted by the Chung-Hua Institution for Economic Research on NAFTA’s impact on Taiwan reached a similar conclusion. The underlying reason for this conclusion is that the trade structures of Mexico and Korea (or Taiwan) are dissimilar, and therefore, the likely diversion arising from trade Tain-Jy Chen is professor of economics at National Taiwan University and a consultant to the Chung-Hua Institution for Economic Research.

273

A Perspective on the Effects of NAFTA on Korea

preferences extended by the United States to Mexico is minimal. My comments are focused on a few specific points made, and some points not mentioned, in the paper. The export structure of Korea has shifted rapidly over time, particularly in the 1980s. The share of NAFTA countries in Korea’s export decreased and that of East Asian countries increased. The author attributes this to changing comparative advantage and foreign direct investment (FDI). Although this reasoning seems plausible, it can not explain Korea’s rising exports to Singapore. There may be other reasons. Did policy not matter at all? For example, how much of this change can be attributed to the U.S. repeal of the General System of Preferences for Korea in January 1989?And to what degree is Korea’s trade diversification effort a response to U.S. antidumping and countervailing duty cases filed against Korea? How much of Korean FDI in the United States can be said to be a response to the formation of NAFTA? Although the author generally believes that trade diversion is small, in section 9.3.2, he calculates the degree of trade diversion based on export price elasticities and comes up with some fairly big numbers. For example, trade diversion for leather products amounts to 5.1 percent of trade volume in 1992, and for textiles and apparel, 4.4 percent. There seems to be a conceptual problem in using price elasticities based on the assumption of perfect competition. If the export market were a perfectly competitive market, then tariff preference in favor of Mexican products would wipe out all exports from Korea. An imperfect competition model within the framework of differentiated products seems to be more suitable for measuring the trade diversion effect. In that model, the degree of substitution between Mexican and Korean products matters. I wonder whether the assumption used here, that is, that a 1 percent tariff preference for Mexico leads to a 0.5 percent decrease in export price for Korean products, overestimates the substitutability. The author correctly points out the potential damage of investment diversion. He concludes that investment diversion among U.S. multinationals is likely to be small because the maquiladora program has been in place for many years. His conclusion on investment diversion among multinationals based elsewhere is unclear, however. My personal view is that the latter investment diversion effect could be substantial. Fears of trade protectionism coupled with rules of origin and regional content regulations may encourage substantial FDI from non-NAFTA countries, not only to Mexico, but to the United States and Canada as well. If this occurs, the agglomeration effect will make Mexican industries more competitive in a dynamic sense, and the trade diversion effect that we deemphasize today may loom larger in the future, particularly in hightechnology areas. For that matter, I wonder what Hyundai will do if it pulls out of Canada? Will it not consider investing in Mexico? It is recognized in the paper that the rules of origin embedded in NAFTA are important protectionist measures. It would have been nice had the paper

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Honggue Lee

presented an estimate of this hidden protective measure, that is, the equivalent tariff. From this, the paper could also have measured the adverse effect of these rules of origin on Korean exports of automobile parts and textile products. The paper argues that it is the lack of structural linkage between Korea and NAFTA that contributes to the declining share of Korean exports going to NAFTA. But the paper also estimates that each dollar of Korea’s export to the United States generates 44-56 cents of “induced import” from the United States. This can hardly justify the “lack” of structural linkage. Does Korea have a stronger structural linkage with Japan? Presumably. But Korea’s export to Japan does not seem to have increased much in recent years. The meaning of the term “structural linkage” needs to be clarified and its relationship with trade explained. Since the paper focuses on the negative impact of NAFTA, it may only be fair to also mention some possible positive impacts of NAFTA on Korea.

10

Regionalism and Subregionalism in ASEAN: The Free Trade Area and Growth Triangle Models Chia Siow Yue

10.1 Introduction The Association of Southeast Asian Nations (ASEAN) was established in 1967 by the noncommunist and market-oriented economies of Indonesia, Malaysia, the Philippines, Singapore, and Thailand. Brunei became a member in 1984. A new milestone was reached in July 1995 when Vietnam, a communist country undergoing transformation from a command to a market economy and a former adversary, joined ASEAN. The new ASEAN-7 is expected to expand to ASEAN-10 when the remaining countries of Southeast Asia, Cambodia, Laos, and Myanmar (CLM), join the grouping over the next few years. While the membership extension is expected to strain ASEAN's consensus-building style in the short term, it will contribute to regional peace, stability, and economic dynamism in the longer term. ASEAN-6 (excluding Vietnam) has been widely regarded as the most successful economic cooperation grouping among developing countries. It was also the world's most economically dynamic region during the past decade. The collapse of oil and commodities prices starting in the early 1980s led the ASEAN-4 economies (Indonesia, Malaysia, the Philippines, and Thailand) to embark on far-reaching economic reforms, with deregulation, liberalization, privatization, and promotion of export manufacturing and foreign direct investment. The economic successes of the ASEAN-6 countries are due to national efforts rather than directly attributable to regional economic cooperation. Regional trade liberalization efforts have had little effect on intraregional trade, and industrial cooperation schemes have had no noticeable impact on industrial development in the ASEAN countries. In fact, ASEAN has often been Chia Siow Yue is associate professor of economics in the Department of Economics and Statistics, National University of Singapore, and advisor on the APEC research program at the Institute of Southeast Asian Studies in Singapore.

275

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criticized as lacking meaningful economic integration. However, to judge ASEAN as a regional grouping only by the criterion of economic integration is to misunderstand the role of ASEAN as envisaged by its founding fathers. The initial objective in ASEAN’s formation was not economic integration based on the EC model, but the promotion of political stability and security in the region so as to provide the underpinnings for each country’s economic development efforts. Rapidly changing external and domestic environments, however, have led ASEAN to accelerate the process of economic integration since 1992 through the ASEAN free trade area (AFTA) and ASEAN growth triangles. These are not GATTNTO-inconsistent, as they seek to improve regional and national competitiveness rather than to protect the ASEAN economies against external competition. This paper first discusses the diversities among ASEAN economies, their external orientation, and the first 25 years of economic cooperation efforts, before proceeding to an analysis of AFIA and growth triangles as modalities of regional economic cooperation.

10.2 The ASEAN Economies 10.2.1 Regional Diversities The ASEAN-6 countries show considerable diversities in historical experience, sociocultural background, size, level of economic development, industrial structure, and trade orientation. Historically, Brunei, Malaysia, and Singapore were under British colonial rule, Indonesia under the Dutch, and the Philippines under the Spanish and Americans, while Thailand was never formally colonized. The colonial economies have been oriented toward the colonizing countries rather than toward Southeast Asia or East Asia, and postcolonial efforts to strengthen regional trading ties have been inhibited by similarities in resource endowment and in level of industrial competence and by limited linking infrastructure. Indonesia is the largest member of ASEAN in geographical area, population, and GNP (table 10.1). It has a population of 191 million, compared to Singapore’s 2.9 million and Brunei’s 300,000. However, it is the least economically advanced ASEAN economy, with a 1994 per capita income of U.S.$SSO, as against U.S.$23,360 for Singapore. Per capita income differences in ASEAN are larger than found in other developing country groupings. In ASEAN, the largest country is also the least developed so that differences in economic size are not as stark. Indonesia’s GNP in 1993, unadjusted for purchasing power parity (PPP), was only 2.5 times larger than Singapore’s; adjusted for PPP, however, Indonesia’s GNP was almost 11 times Singapore’s. Indonesia’s low profile as a regional hegemon has contributed to ASEAN harmony. The ASEAN economies, excepting Singapore, are rich in natural resources,

Table 10.1

Basic Indicators of ASEAN Economies

Indicator Land area (thousand sq. km) Population, 1994 (million) Total GNP, 1993 (million U.S. $) Per capita GNP, 1994 (US. $) PPP adjusted, 1993 GDP real growth rate (%) 1971-80 1981-90 1991 1992 1993 1994 1995 Agriculture/GDP share (%) 1975 1994 ManufacturingEDP share (%) 1975 1994 Total trade/GNP (%) 1975 1994 Direct investment inflowlGNP (a) 1980 1992

Brunei

Indonesia

Malaysia

Philippines

Singapore

Thailand

ASEAN-6

5.8 0.3 n.a. n.a. n.a.

1,919.4 190.7 136,990 880 3,150

329.8 19.5 60,060 3,520 8,400

300.0 68.6 54,610 960 2,670

0.6 2.9 55,370 23,360 19,510

513.1 59.4 120,240 2,210 6,260

3,062.9 341.4 427,270.0” 1,468’ n.a.

n.a. n.a. n.a. n.a. n.a. n.a. n.a.

7.7 5.5 6.9 6.4 6.5 7.5 7.6

7.8 5.2 8.7 7.8 8.3 9.2 9.3

6.0 1.o -0.5 0.1 2.1 4.4 4.8

7.9 6.3 6.7 5.8 10.1 10.1 8.9

7.9 7.9 8.1 7.6 8.2 8.7 8.6

n.a. n.a. n.a. n.a. n.a. n.a. n.a.

n.a. n.a.

31.7 17.4

27.7 14.5

30.3 22.0

1.9 0.2

26.9 11.1

n.a. n.a.

n.a. n.a.

8.9 23.9

16.4 30.1

25.7 23.3

23.9 27.0

18.7 27.0

n.a. n.a.

n.a. n.a.

40.8 49.4

82.2 179.3

40.9 54.5

236.1 289.6

36.9 67.8

n.a. n.a.

n.a. n.a.

0.3 1.4

3.8 8.6

0.0 0.5

9.7 9.7

0.6 1.9

n.a. n.a.

Sources: Asian Development Bank (1995, 1996) and World Bank (1995). aExcludes Brunei.

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and their economic development until the 1970s was largely resource based. Since then, the ASEAN-4 countries have been rapidly industrializing and reducing their dependence on primary products. As is common among developing countries, industrialization started with import substitution. The switch to export manufacturing was half-hearted in the 1970s, but the collapse of oil and commodity prices in the early 1980s led to a stronger export orientation. The import liberalization ratio (unrestricted imports to total imports) reached more than 95 percent in Malaysia and Thailand by 1985, 83 percent in the Philippines by 1986, and 84 percent in Indonesia by 1987 (World Bank 1987). The rapid growth of manufactured exports has been facilitated by massive inflows of foreign direct investment. The share of manufactures in total exports rose dramatically from 2 percent in 1970 to 53 percent in 1993 for Indonesia, from 7 percent to 65 percent for Malaysia, from 7 percent to 77 percent for the Philippines, and from 8 percent to 73 percent for Thailand (World Bank 1995). Brunei remains an oil-dependent economy, with industrialization prospects severely constrained by its small population base. Singapore with its strategic location and free trade policy has served as the regional entrep6t for centuries. It is the manufacturing base of multinational corporations (MNCs) and a regional commercial, transportation, and financial hub. 10.2.2 Intra- and Extraregional Trade and Investment Linkages The ASEAN-6 countries have highly open economies, as measured by trade-GNP ratios (table 10.1) and the extent of foreign investment penetration, with the smaller economies more open than the larger ones. However, extraregional trade and investment linkages are quantitatively more important than intraregional linkages. The main trading partners of the ASEAN-6 are the OECD countries, both for import sourcing and for export markets. For imports, the ASEAN-6 is most dependent on Japan, followed by the United States and the European Union (table 10.2). For exports, the ASEAN-6 is most dependent on the United States, followed by Japan and the European Union. The grouping is thus seriously concerned with rising regionalism in North America and Europe and possibilities of reduced market access. The asymmetrical and triangular relationship is most evident in the trade in manufactures; the ASEAN-6 is heavily dependent on Japan as a source of capital goods and on the United States as a market for manufactures. In 1992, Japan accounted for 26 and 10 percent of imports and exports, respectively, of manufactures of the ASEAN6, while the United States accounted for less than 15 percent of imports and over 20 percent of exports of manufactures. Although ASEAN has existed since 1967 and has implemented preferential trading arrangements since 1977, intra-ASEAN trade has neither become more important nor grown faster than extra-ASEAN trade, so that trade diversion has not been dominant. In 1993, intra-ASEAN trade accounted for 19.3 percent of the total trade of the ASEAN-6, with a share of 18.1 percent for imports and 20.7 percent for exports (table 10.2). While the intra-ASEAN share of ASEAN

Trade Matrix of ASEAN Economies, 1993

Table 10.2

Country

Brunei

Indonesia

Malaysia

Philippines

Singapore

East Asia"

Japan

EU

U.S.

World

World (million U.S. $)

0.0 0.5 0.3 0.4 1.3 0.3 0.7

76.1 55.7 54.5 34.9 51.0 26.9 47.8 65.1

54.2 30.3 13.0 16.3 7.3 17.0 15.3 32.3

17.9 14.4 14.5 16.9 13.7 17.0 14.8 19.6

1.2 14.2 20.3 38.3 19.9 21.6 20.1 0.0

100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0

2,373 36,843 47,080 11,279 75,864 37,111 210,550 3,018

2.2 2.4

38.3 9.2 19.8 9.6 24.4 12.0 18.1 29.5

0.0 0.1 0.2 0.1 0.4 0.2 0.3

45.7 46.7 60.4 49.4 58.5 55.2 55.9 83.7

5.4 22.1 27.5 22.8 21.0 30.3 24.3 13.1

27.1 19.9 11.6 10.3 11.0 14.9 13.2 11.2

20.2 11.5 17.0 19.8 15.7 11.7 15.0 0.1

100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0

2,601 28,333 45,552 17,965 88,765 46,065 229,281 5,394

4.9 1.1 3.1 1.2 4.7 0.0 2.7 2.4

29.3 11.3 23.9 8.5 24.4 13.8 19.3 25.2

0.0 0.3 0.2 0.2 0.8 0.2 0.5 0.0

60.2 51.8 57.4 43.8 55.0 42.6 52.0 77.0

28.7 26.7 20.1 20.3 14.7 24.4 20.0 20.0

22.7 16.8 13.1 12.8 12.3 15.9 13.9 14.2

11.2 13.0 18.7 26.9 17.6 16.1 17.4 0.1

100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0

4,974 65,176 92.632 29,244 164,629 83,176 439.83 1 8,412

Thailand

ASEAN-6

Vietnam

Exports (percentuge distribution)

Brunei Indonesia Malaysia Philippines Singapore Thailand ASEAN-6 Vietnam

0.0

0.1 0.4 0.0 0.8 0.1 0.4 0.0

1.2 0.4 2.4 0.5 1.2 1.2

0.1 1.6

1.4 13.8 2.8 5.8 2.8

2.3 0.8 1.o 1.8 0.5 1.1 0.4

8.3 9.2 21.7 3.4 12.0 8.9 10.6

8.6 1.3 3.6 1.5 5.6 3.2 2.6

19.3 12.9 27.9 6.7 24.4 16.0 20.7 17.6

Imports (percentage distribution)

1.8

Brunei Indonesia Malaysia Philippines Singapore Thailand ASEAN-6 Vietnam

0.0 0.0 0.3 0.2 0.4 0.2 0.0

Brunei Indonesia Malaysia Philippines Singapore Thailand ASEAN-6 Vietnam

0.0 0.1 0.2 0.2 0.5 0.3 0.3 0.0

1.6 0.6 3.8 1.1 2.1 3.5

8.0 1.8

0.1 0.2 0.5

2.0 15.8 3.6 7.3 2.8

0.6 0.4 0.4 0.8

4.2 1.7 0.0 1.8 14.9 3.3 6.6 2.8

1.1 0.5 0.8 0.0 1.1 0.5 0.8 0.7

26.8 6.3 15.3 5.7 6.4 5.9 20.0 Exports

1.o

0.0 1.4 0.5 3.1 0.9 1.7 2.7

18.0 7.9 18.5 4.8 0.0 8.9 7.3 16.6

1.5 0.8 2.5 1.o 4.0

+ Imports (percentage distribution)

Source: International Monetary Fund (1994). "East Asia = Japan, China, Hong Kong, South Korea, Taiwan, ASEAN-6, Vietnam, Laos, and Cambodia.

Table 103

Intra-ASEAN Trade Matrix, 1980 and 1993 ASEAN-6 (million

Country

Year

Brunei

1980 1993 1980 1993 1980 1993 1980 1993 1980 1993 1980 1993 1980 1993

Indonesia Malaysia Philippines Singapore Thailand ASEAN-6

Brunei Indonesia Malaysia

1980 1993 1980 1993 1980 1993

Brunei

Indonesia

0.0 0.2 0.0 0.9 0.8 1.4 0.8 0.3 5.3 3.4 0.9 0.6 2.4 2.1

I .2 4.1 28.2 5.8 17.9 9.7 22.2 3.4 10.1 5.9 0.3 4.8

0.0 0.0 0.1 0.0

4.6 8.0

Malaysia

Philippines

Exports (percentage distribution) 7.6 8.8 0.4 11.8 2.2 6.6 12.3 6.0 6.8 3.1 24.8 21.2 55.5 5.2 56.7 1.4 21.5 2.2 17.5 3.3 26.2 5.6 28.2 5.5 imports (percentage distribution) 15.6 1.9 20.9 0.3 2.7 6.7 19.9 2.2 6.0 2.4

Singapore

Thailand

ASEAN-6

51.4 42.8 90.0 70.9 84.8 17.9 29.6 50.9

32.3 44.8 1.3 9.8 6.4 12.9 16.6 21.8 16.1 22.8

100.0 100.0 100.0 100.0 100.0 100.0 100.0

47.2 15.1 45.4 42.8 12.6 70.0 69.3 68.9 71.3 71.0

us. $)

10.2 15.5

100.0 100.0 100.0 100.0 100.0

585 45 8 2,760 4,154 2,923 13,134 381 760 5,238 18,511 1,065 5,936 12,952 43,553

9.5 4.0 21.3 9.0 18.0 12.6

100.0 100.0 100.0 100.0 100.0 100.0

150 997 1,350 2,603 1,774 9,029

100.0 100.0

Philippines Singapore Thailand

ASEAN-6

1980 1993 1980 1993 1980 1993 1980 1993

9.9 3.5 3.0 1.o 20.1 3.2 4.1 1.1

33.4 6.1 37.9 15.6 4.1 9.3 24.4 11.5

29.0 21.1 50.7 64.9 27.1 30.3 33.5 40.5

23.7 59.2 1.1 2.3 2.2 3.3 2.6 2.3

46.5 53.8 25.7 32.4

3.9 10.I 7.2 16.2

9.8 12.3

100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0

559 1,729 6,556 2 1,652 1,105 5,516 11,494 41,526

100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0

735 1,455 4,110 1,357 4,697 22,163 940 2,489 11,794 130,479 2,170 11,452 24,446 85,079

Exports iImports (percentage distribution)

Brunei Indonesia Malaysia Philippines Singapore Thailand

ASEAN-6

1980 1993 1980 1993 1980 1993 1980 1993 1980 1993 1980 1993 1980 1993

0.1 3.4

0.0 0.9 0.5 0.9 6.2 2.5 4.0 2.1 10.6 1.9 3.2 1.6

2.4 5.7 31.3 6.0 29.0 12.9 13.1 6.2 16.8 8.6

9.2 14.4 2.3 15.0

27.3 21.1 52.8 61.1 21.3 23.7 29.6 34.2

7.4 3.9 6.6 4.6 6.5 3.2

3.0 4.7 2.2 3.3 4.2 3.9

55.7 61.4 83.2 10.2 79.1 11.5 26.1 56.6

46.9 64.9 36.1 37.7

Source: International Monetary Fund, Direction of Trade Statistics Yearbook (Washington, D.C., various issues).

27.6 16.8 7.9 9.6 10.8 12.8 9.0 13.7 11.2 19.2

10.0 13.9

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Chia Siow Yue

imports has grown significantly since 1970, the share for exports has not shown an upward trend. Singapore, the most trade-oriented ASEAN country and the region’s entrepet, accounted for the largest share of intra-ASEAN trade (table 10.3), followed by Malaysia, while Brunei and the Philippines combined accounted for less than 6 percent. Excluding Singapore, intra-ASEAN trade falls to less than 5 percent of ASEAN’s total trade. The bulk of intra-ASEAN trade is accounted for by bilateral trade between Singapore and Malaysia. Low trade linkages among the ASEAN countries (excluding Singapore) reflect low economic complementarity and similar levels of industrial competence. The countries produce largely similar processed resources and labor-intensive manufactures. They cannot absorb each other’s primary products and cannot supply each other’s needs for technology and capital goods. They compete with each other for markets in North America, Europe, and Japan. However, in recent years, trade linkages have expanded with the growth of FDI-related intraindustry trade. The ASEAN region has strong locational advantages and is a major recipient of FDI (table 10.4). Indonesia accounted for the largest share of the inward FDI stock, followed by Singapore, Malaysia, Thailand, and the Philippines. FDI inflows accelerated in the 1980s, particularly in the post-1987 period. The traditional sources of FDI were the United States and Western Europe. Japan became a major source in the 1970s and particularly after the sharp yen appreciation in the mid-1980s (Chia 1993). While Singapore has remained dependent on FDI from the Triad (United States, European Community, and Japan), the ASEAN-4 countries have experienced a surge in FDI from the Asian NIEs in recent years. Vietnam has also become a strong contender for FDI, both from the Asian NIEs and ASEAN and, more recently, from Japan. Intra-ASEAN investment (excluding Vietnam) remained small relative to inflows from outside the group, although it is suspected that a sizable amount of intraregional investment is not captured by official statistics. As shown in table 10.4, intra-ASEAN investment accounted for only 9.2 percent ofASEAN’s total FDI stock in 1992, with a 6.3 percent share of the inward investment stock and 33.3 percent share of the outward investment stock. The low level of intraregional industrial investment reflects the facts that the ASEAN economies depend on extraregional sources for capital and technology and ASEAN investors possess limited ownership advantages over local firms. As show in table 10.5, Singapore is the main regional investor, while Malaysia is the main recipient. Over 75 percent of the intraregional investment stock in 1992 is between Singapore and Malaysia. This strong bilateral investment link mirrors the strong bilateral trade link. The strong Singapore-Malaysia trade and investment linkages reflect common historical ties under British colonial rule, close geographical proximity (a common border), and strong economic complementarity.

Table 10.4 Country

Foreign Direct Investment Matrix of ASEAN Economies, 1992 Indonesia

Indonesia Malaysia Philippines Singapore Thailand ASEAN-5

3.6 n.a. 0.1 0.1 0.6

Indonesia Malaysia Philippines Singapore Thailand ASEAN-5

6.2 1.7 1.9 3.O 2.2

Indonesia Malaysia Philippines Singapore Thailand ASEAN-5

3.9 0.3 0.5 0.3 0.8

Malaysia

Philippines

0.2

0.0 0.2

0.3 3.9 0.4 1.1 34.5 5.1 22.1 1.1 19.3 1.5 1.2 8.3 0.4 3.1

Source: APEC Secretariat 1995.

0.3 0.1 0.1 0.0 0.6

0.6 0.0 0.5 0.0 0.2 0.3 0.1 0.2

Singapore

Thailand

ASEAN-5

East Asia

NIEs-3

Inward FDI Stock (percentage distribution) 3.3 0.2 3.7 43.7 19.3 10.4 0.3 14.5 60.3 23.7 1 .O n.a. 1.2 31.4 9.1 0.9 5.2 35.2 6.5 8.5 9.1 66.0 22.7 4.0 0.3 6.3 45.9 16.8 Outward FDI Stock (percentage distribution) 1.6 0.7 36.8 40.8 2.6 64.2 2.2 73.1 81.9 7.3 10.5 0.8 18.0 89.6 66.6 2.6 27.1 48.7 19.5 12.8 17.0 50.2 29.7 9.3 2.1 33.3 53.9 18.5 Inward + Outward FDI Stock (percentage distribution) 3.2 0.2 4.9 43.6 18.7 15.0 0.5 19.5 62.1 22.3 0.1 4.3 41.8 19.4 2.7 1.3 10.4 38.4 9.6 8.7 9.5 65.1 23.1 4.6 0.5 9.2 46.8 17.0

Japan

EU

U.S.

World

World (million U.S.$)

20.7 21.6 21.0 23.3 34.0 22.7

10.7 17.9 10.5 23.1 10.2 15.0

4.3 9.0 47.4 17.0 17.3 10.8

100.0 100.0 100.0 100.0 100.0 100.0

63,016 22,584 4,011 34,446 12,435 136,492

0.4 n.a. n.a. 0.4 0.6 0.4

49.2 0.3 2.5 7.2 5.4 12.0

4.2 3.5 7.8 9.0 35.3 8.6

100.0 100.0 100.0 100.0 100.0 100.0

2,383 2,104 874 10,786 705 16,852

20.0 19.7 17.3 17.6 32.2 20.2

12.1 16.4 9.1 19.3 10.0 14.6

4.3 8.6 40.3 15.1 18.3 10.5

100.0 100.0 100.0 100.0 100.0 100.0

65,399 24,688 4,885 45,232 13,140 153,345

Intra-ASEAN Direct Investment Matrix, 1980 and 1992

Table 10.5

Country

ASEAN-5 Year Indonesia Malaysia Philippines Singapore Thailand ASEAN-5 (million US.$)

Indonesia

1980 1992 Malaysia 1980 1992 Philippines 1980 1992 Singapore 1980 1992 Thailand 1980 1992 ASEAN-5 1980 1992 Indonesia

1980 1992 Malaysia 1980 1992 Philippines 1980 1992 Singapore 1980 1992 Thailand 1980 1992 ASEAN-5 1980 1992 Indonesia

1980 I992 Malaysia 1980 1992 Philippines 1980 1992 Singapore 1980 1992 Thailand 1980 1992 ASEAN-5 1980 1992

Inward FDI Stock (percentage distribution) 100.0 12.3 19.5 65.1 3.0 5.7 0.6 89.5 4.2 100.0 100.0 0.1 0.0 99.0 0.8 100.0 25.1 I .4 71.6 2.0 100.0 0.0 7.1 92.9 0.0 23.6 76.4 0.0 0.0 100.0 100.0 9.0 86.3 1.4 3.4 100.0 75.3 5.1 17.5 2.1 100.0 0.7 17.3 4.4 77.6 100.0 4.1 0.6 93.8 1.5 100.0 15.5 2.1 79.5 1.4 1.6 18.0 1.8 64.4 5.6 100.0 10.2 Outward FDI Stock (percentage distribution) 100.0 0.0 92.6 1.4 6.0 100.0 0.0 4.3 1.9 93.8 100.0 0.1 89.4 3.5 7.0 100.0 0.8 87.7 3.0 8.5 100.0 1.o 10.9 6.7 81.5 58.0 4.4 100.0 28.1 9.4 100.0 1.o 93.6 1.8 3.6 100.0 81.5 2.2 9.5 6.8 100.0 0.0 0.0 100.0 0.0 100.0 17.8 6.5 0.1 75.6 100.0 49.6 1.o 38.4 2.3 8.8 100.0 6.5 58.0 1.4 27.9 6.2 Inward + Outward FDI Stock (percentage distribution) 11.4 16.6 69.3 2.8 100.0 30.0 0.5 66.0 3.6 100.0 0.0 97.3 1.3 100.0 1.3 19.8 1.2 76.7 2.3 100.0 73.2 1.6 19.2 6.0 100.0 7.1 27.0 62.5 3.4 100.0 100.0 5.9 90.5 1.6 2.0 5.0 79.1 3.3 12.6 100.0 0.7 17.2 4.4 77.8 100.0 3.1 4.3 0.6 92.0 100.0 3.6 25.3 1.8 67.7 1.6 100.0 8.8 33.8 1.7 49.9 5.8 100.0

Source: APEC Secretariat 1995.

207 2,304 1,699 3,280 6 50 379 1,793 74 1,127 2,365 8,554 37 877 366 1,539 50 158 503 2,923 1

120 956 5,616 243 3,181 2,065 4,819 55 208 882 4,716 75 1,246 3,320 14,170

285

ASEAN: Free Trade Areas and Growth Triangles

10.3 Economic Cooperation Rationale and Modalities 10.3.1 Rationale for Cooperation ASEAN’s formation was motivated more by political and strategic than by economic considerations (Khoman 1992; Rajaratnam 1992). The Cold War, the Indochina conflicts, domestic communist insurgency activities, and fear of falling dominoes propelled the noncommunist countries of Southeast Asia to put aside territorial disputes and form a club to promote regional stability and security, with economic development providing the underpinnings. ASEAN, therefore, has both a political security dimension and an economic dimension. ASEAN is generally perceived to have been successful in achieving its political security goals. First, the grouping has made remarkable strides in promoting political cohesion and reducing territorial conflicts.’ Regional stability has provided the environment in which individual ASEAN countries can pursue their economic development goals. Second, ASEAN solidarity has enabled the grouping to play an increasingly influential role in the political and strategic affairs of the Asia Pacific. ASEAN has established regular formal dialogues with global and regional powers. ASEAN has also become a focal point for dialogues and arrangements on regional security with the establishment of the ASEAN Regional Forum in 1994. Third, ASEAN’s political influence has extended into wider regional and global economic forums, giving it influence out of proportion to its economic strength. This is particularly evident in the Asia Pacific Economic Cooperation (APEC) forum, where ASEAN positions carry considerable weight and ASEAN members alternate with other APEC members in assuming the annual leadership Perhaps ASEAN’s sustainability as a regional economic grouping lay in rejecting the EC economic integration model in its formative years, and in practicing the principles of accommodation and of consensus in decision making. For the first 25 years of ASEAN’s existence, official documents avoided the term “integration” and emphasized only “cooperation,” as ASEAN policymakers were not prepared to consider either a free trade area or a customs union as they pursued national import substitution strategies. Further, the agenda for economic cooperation, as laid out in the 1976 ASEAN Concord, was reached only nine years after ASEAN’s establishment. The Concord provided, inter alia, for economic cooperation in trade and industrial development, banking and finance, food and energy, tourism and transport, and joint approaches to international economic issues. ASEAN has been fairly successful in various 1. During 1963-65 Indonesia launched a confrontation against the newly formed Federation of Malaysia (which then included Singapore) in protest against the inclusion of the Borneo states of Sabah and Sarawak in the new federation. There are overlapping temtorial claims among all the ASEAN nations. 2. The United States hosted the first AF’EC summit and headed the AF’EC Secretariat in 1993, followed by Indonesia in 1994, Japan in 1995, and the Philippines in 1996.

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areas of functional cooperation and in maintaining a joint approach toward extra-ASEAN economic relations (Chia 1994). ASEAN economic ministers and officials meet regularly to exchange information and views, develop common positions, and initiate and review action programs. Aspects of economic cooperation other than trade and industrial cooperation will not be discussed in this paper.3The principles of accommodation and consensus in decision making have meant that those that wished to move at a faster pace had to accommodate the more cautious and smaller members need not fear the dominance of larger members. However, the resulting convoy effect has slowed the pace of economic cooperation. The less developed ASEAN member countries were reluctant to open their markets to competition from the more advanced members, and the more advanced countries were reluctant to enter into exclusive industrial cooperation arrangements with the inefficient industries of the less advanced members, which would adversely affect their overall competitiveness. In 1992, the ASEAN-6 reached a milestone agreement to form a free trade area and pushed for further subregional economic integration via formation of growth triangles. The changed mindset and more serious attempts at economic integration reflected the interplay of both external and domestic political and economic forces. The end of the Cold War and the Indochina conflict have weakened ASEAN’s political and strategic underpinnings; previously, ASEAN was of strategic interest to the global superpowers, and geopolitical interests also kept ASEAN members united and purposeful. At the same time, developments in the economic arena increased the acceptability of economic integration and a free trade area. First, the ASEAN-4 economies had been undergoing unilateral liberalization since the mid- 1980s, resulting in outward-looking trade and investment strategies, converging tariff levels, and increased FDI inflows directed at export manufacturing. The less developed ASEAN economies gained industrial competence, lessening the fear of competition from the more advanced ASEAN economies. With the growth of intraindustry trade, ASEAN economies became more complementary and integrated. Second, Fortress Europe, the emergence of NAFTA, and the slow progress of the Uruguay Round gave rise to concerns over market access for ASEAN’s rapidly growing exportoriented industries. A regional market provides a strategic fallback position and improves ASEAN’s bargaining leverage vis-2-vis trading blocs and protectionist trading partners. Third, ASEAN-6 faces growing competition from the transitional economies of Eastern Europe, China, and Indochina, as well as from the liberalizing economies in Latin America and South Asia. Trade liberalization removes price distortions, and an integrated regional market will enable ASEAN industries 3. For discussions of ASEAN cooperation in food and energy, banking and finance, and transport and tourism, see the articles by Cabanilla, Sharma, Schulze, Wong, and Naidu in Sandhu et al. (1992).

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to benefit from internal competition, economies of scale, and regional specialization according to comparative advantage. Intra-ASEAN trade liberalization could be a useful stepping stone toward multilateral liberalization and international competitiveness. Fourth, as the global competition for FDI intensified in the 1980s there was concern over possible investment diversion to China, Indochina, India, Eastern Europe, and Mexico, as many of these countries have either huge domestic markets or lower cost structures or both. An ASEAN free trade area will increase the attraction of ASEAN as a production base and as a market for MNCs. Intra-ASEAN trade liberalization could also exploit the trend of MNCs toward globalization of production, encouraging them to establish and expand production bases in ASEAN and develop intraregional production networks. 10.3.2 Trade and Industrial Cooperation during 1976-92 From the perspective of economic integration, the most important programs are those aimed at intraregional trade liberalization and industrial cooperation. However, perceptions of zero-sum competition and politically unacceptable distribution of benefits and costs have resulted in slow progress. The ASEAN Preferential Trading Arrangement (PTA) was introduced in 1977 as the main instrument to promote intraregional trade, but there was lack of serious intent as member countries continued to pursue national import substitution. The initial product-by-product approach and the requirement to periodically exchange a prescribed number of tariff preferences led to bizarre results that reduced the credibility of ASEAN economic cooperation. The tariff classification was disaggregated, and the number of tariff items subject to preferences ballooned without much growth in trade values. Further, negotiated items included products insignificant in intra-ASEAN trade or not even produced or consumed in ASEAN countries, such as nuclear reactors and snowplows. Subsequent attempts at limited across-the-board tariff reductions were largely nullified by exclusion lists that included many products with significant intra-ASEAN trade potential. Nontariff barriers further eroded the effectiveness of tariff preferences. As a result, the PTA scheme had only a marginal impact on intraASEAN trade, as reflected in the low PTA utilization rate. Out of a total of 12,783 items on the PTA list in 1986, only 337, or 2.6 percent, of the items were granted tariff preferences, and only 19 percent of the total value of these items satisfied the eligibility criteria and actually enjoyed tariff preferences (Pangestu, Soesastro, and Ahmad 1992). ASEAN also implemented three industrial cooperation schemes with limited success, namely, the ASEAN Industrial Projects (AIP), the ASEAN Industrial Complementation (AIC) scheme, and the ASEAN Industrial Joint Ventures (AIJV). The AIP was initiated in 1976 and was meant to be a showpiece of regional economic cooperation. However, the scheme led to contentious disputes between government officials over choice and location of regional projects. In the end only two projects were implemented. The AIC scheme was

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introduced in 1981 and modified into the Brand-to-Brand (BBC) scheme in 1988 to encourage regional production and exchange of automotive parts and components for specified automotive brand models. Some 70 BBC projects have been approved, involving more than 10 automotive manufacturers. The AIJV scheme was introduced in 1983 to encourage industrial investment through resource pooling and market-sharing activities. A total of 23 AIJV projects have been approved. Although the AIC, BBC, and AIJV schemes emphasized private sector participation, continuing government efforts to influence industrial location, the cumbersome and slow bureaucratic approval process, and nonparticipation by some countries reduced the attraction and viability of the schemes. The limited progress with the ASEAN trade liberalization and industrial cooperation schemes noted above reflects lack of economic complementarity, different levels of industrial competence, pursuit of national import substitution strategies, and perceptions of zero-sum competition. First, the structures of the ASEAN-4 economies were more competitive than complementary. Being at similar initial stages of industrialization, each ASEAN country wanted to protect its industries from foreign (including ASEAN) competition. Second, where economic complementarity did exist, as between Singapore and the ASEAN-4, there was fear of an unacceptable regional division of labor and distribution of benefits and costs if investment decisions were left to market forces. The perception was that Singapore, with the most advanced and competitive economy, would benefit most from regional free trade. Solution of the distributive issue in ASEAN was hampered by the fact that the largest economy, Indonesia, was also the least developed, while the richer economies of Brunei and Singapore were small and had limited capacity to fund regional structural adjustment and development cooperation programs. To resolve the deadlocks that resulted from applying the principle of consensus, ASEAN adopted the “6 minus x” principle, which allowed individual countries to opt out of participation in specific cooperation schemes. 10.3.3 ASEAN Free Trade Area (AFTA) The fourth ASEAN summit of January 1992 agreed to the establishment of a free trade area. AFTA is intended to help ASEAN economies achieve greater trade and investment competitiveness in the global economy. AFTA (including Vietnam) will have an integrated regional market of over 400 million people with a combined purchasing power of over U.S.$400 billion growing at 6-8 percent a year and embraces countries with a wide range of resource endowment and skills. The pooling of resources and markets would increase the attraction of the ASEAN region to regional and foreign investors. MNCs locating in ASEAN will be able to exploit scale economies and rationalize production, allocating different segments of the value chain, production processes, and products among the ASEAN countries according to their respective competitive advantages.

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AFTA focuses on the liberalization of trade in goods within the ASEAN region through implementation of the Common Effective Preferential Tariff (CEPT). However, the CEPT scheme as first agreed upon in January 1992 had several limitations. First, unlike NAFTA, which contained over 2,000 pages of technical details, the AFTA and CEPT agreements were brief documents of intent, lacking details regarding rules and procedures for tariff and nontariff reductions, harmonization of tariff codes, determination of local content, and mechanism for dispute settlement. The CEPT agreement was largely hammered out by government officials, without prior studies on feasibilities and impacts and little public debate on the issues. Second, the CEPT agreement had a time frame of 15 years (up to 2008) to bring tariffs down to 0-5 percent, covering manufactures (including processed agricultural products), but excluding unprocessed agricultural products. The time frame was too long and would render AFTA irrelevant in view of the agreements reached in the Uruguay Round, the proposals for APEC trade and investment liberalization, and the competitive challenges ASEAN countries face for export markets and foreign investments. As it was, the fall in investment commitments in 1992-93 in Indonesia and Malaysia was attributed in part to investment diversion to China and, to a lesser extent, to Vietnam. In recognition of these factors, in September 1994 the ASEAN governments agreed to shorten the time frame to 10 years (2003) and to extend the sectoral coverage to all goods, including unprocessed agricultural products. Third, the flexibility allowed in setting start-up dates and frequency and depth of tariff cuts to the 20 percent level in the first eight years provided the opportunity for individual countries to procrastinate. There were strong pressures in some countries to delay implementation, as industry groups fearful of regional competition lobbied for more time for adjustment. Press reports of such delays undermined the credibility of AFTA, and the flexible time schedule created uncertainty for business planning. This led to the subsequent decision that all countries would have to implement the CEPT by January 1994, with a six-month delay for Brunei. Fourth, in view of the reciprocity condition, very few CEPT items will reach commonality of preferences until the end of the implementation time frame; tariff preferences will be largely bilateral (Wisarn 1994). Likewise, the temporary exclusion list includes a large number of items in electrical machinery, automobiles, and parts and accessories, that is, tariff items that are of interest to the globalization strategy of MNCs. ASEAN countries urgently need to harmonize their tariff regimes to facilitate common preference accession and utilization, and the temporary lists should be reduced through more frequent reviews. Fifth, administering the 40 percent rule of origin (national and cumulative) and keeping some tariffs at the 5 percent level raise the transaction costs of intraregional trade. The 40 percent rule represented a compromise; too high a requirement would disqualify many products from the CEPT concessions, but

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too low a requirement would increase the probability of trade deflection, as extraregional imports would enter the ASEAN market via low-tariff countries and free trade zones. However, to the extent that the objective of the CEPT is to improve the competitiveness of ASEAN industries rather than to protect ASEAN markets, trade deflection should not be a contentious issue; ASEAN should not discriminate against lower-cost non-ASEAN sourcing of capital goods, intermediate inputs, and raw materials as these would help improve ASEAN competitiveness. For a product to enjoy CEFT concessions it must satisfy the following-be on the CEPT inclusion lists of both exporting and importing countries, have an approved tariff reduction schedule, and have at least 40 percent ASEAN content either on a single-country or cumulative-ASEAN basis; products that have tariff rates of 20 percent and below in the exporting country are eligible for concessions on these products in the importing country, while products that have tariff rates of over 20 percent in the exporting country can enjoy the concessions on these products in the importing country only if the tariffs on these products are also over 20 percent. Quantitative restrictions would be removed upon enjoyment of CEPT concessions, but other nontariff barriers would be eliminated only within five years from enjoyment of concessions. As is evident from table 10.6, there is a wide dispersion of tariff rates among ASEAN countries and among sectors. By 1995 Singapore had dismantled all CEPTs. Thailand has the highest average tariff level (16.9 percent), followed by the Philippines (13.8 percent), Indonesia (12.6 percent), Malaysia (7.3 percent), and Brunei (2.6 percent). There are no tariffs above 20 percent average at the sectoral level in Malaysia and Brunei. In Thailand, they are found on food products, plastics, wood and wood products, footwear, arms and ammunition, and miscellaneous manufactured articles; in Indonesia, they are found on foodstuffs, plastics, footwear, miscellaneous manufactured articles, and works of art and antiques; and in the Philippines, they are confined to arms and ammunition, miscellaneous manufactured articles, and works of art and antiques. The CEPT reductions follow a dual track schedule. Under the fast track schedule covering over 15 product groups, tariffs of 20 percent and below will be reduced to 0-5 percent by 1998, while those above 20 percent will be reduced to the same level by 2000.4 Under the normal track schedule covering all other CEPT product groups, tariffs of 20 percent and below will be reduced to 0-5 percent by 2000, while tariffs above 20 percent will be reduced in two stages, to 20 percent by 1998 and to 0-5 percent by 2003. For the first stage, there is no preagreed schedule of tariff reduction to the 20 percent level; indi4. Initially, 15 product groups were identified for the fast track, namely, vegetable oils, chemicals, fertilizers, rubber products, pulp and paper, wooden and rattan furniture, gems and jewelery products, cement, pharmaceuticals, plastics, leather products, textiles, ceramics and glass products, copper cathodes, and electronics. These have since been extended to include machinery and mineral products.

291 Table 10.6 HS

ASEAN: Free Trade Areas and Growth Triangles CEPT Rates by Country and Sector, 1995 Sector

Total 0 1-05 Live animal, animal products 06-14 Vegetable products 15 Fats and oils 16-24 Prepared foodstuffs, beverages 25-27 Mineral products Chemicals 38 39-40 Plastics 41-43 Hides and leather 44-46 Wood and wood products 47-49 Pulp and paper 50-63 Textiles, apparel 64-67 Footwear, umbrellas 68-70 Stone, ceramics, cement, glass Gems 71 72-83 Base metals, metal products 84-85 Machinery, electrical products 86-89 Vehicles 90-92 Optical, precision instruments Arms and ammunition 93 94-96 Miscellaneous manufactured articles 97-98 Works of art, antiques

Brunei

Indonesia

Malaysia

Philippines

Singapore

Thailand

2.60

12.64

7.28

13.82

0.00

16.90

0.00 0.00 0.00

20.60 13.24 7.44

12.05 2.58 1.60

19.00 13.36 18.10

0.00 0.00 0.00

27.06 26.60 20.09

0.04 0.00 0.70 0.25 0.73

24.62 3.74 7.86 2 1.76 14.13

6.08 1.61 1.31 10.88 4.96

17.39 6.56 8.53 16.85 15.60

0.00 0.00 0.00 0.00 0.00

25.70 9.68 12.20 22.24 14.70

7.89 0.00 3.85 3.40

16.70 14.07 13.74 32.82

14.18 8.34 10.19 11.24

11.94 10.56 18.22 16.83

0.00 0.00 0.00 0.00

21.63 19.88 19.50 24.61

0.57 2.55

17.97 13.25

7.61 3.64

17.01 5.77

0.00 0.00

19.98 15.07

0.09

12.18

5.52

14.77

0.00

13.08

7.97 0.00

10.59 6.97

5.15 10.35

11.08 6.08

0.00 0.00

11.84 16.72

1.50 0.00

11.35 0.00

2.90 8.46

11.45 22.50

0.00 0.00

13.59 28.06

0.00 0.00

28.70 24.69

8.56 7.50

26.10 2 1.64

0.00 0.00

24.58 15.83

Source: ASEAN Secretariat, unpublished data

vidual countries were given the freedom to decide on starting dates and frequency and depth of tariff cuts, which meant that cuts could effectively be postponed to as close to the deadline as possible. For the second stage, tariff reduction follows a preagreed schedule. The CEPT provides for two categories of exclusions. The general exclusion list includes products exempted on public policy grounds, such as national security, public morals, and protection of goods of artistic, historic, or archaeological value; most exempted products are armaments, animals and plants, and alcoholic beverages. A temporary exclusion list exempts certain sensitive items; however, these products will be transferred into the inclusion list in five equal installments starting in January 1996. The tariff items covered by the CEPT are shown in table 10.7. Of a total of 44,095 tariff items, 58.8 percent are in the normal track, 33.7 percent in the

Table 10.7

HS

Tariff Lines in the CEPT by Country and Sector Sector

Total 01-24 25-27 38-40 41-49 50-63 54-67 68-7 1 72-83 84-85 86-89 90-92 93-98

Live animals, food Mineral products Chemicals, plastics Leather, wood, paper Textiles, apparel Footwear Stone, ceramics, cement Base metals, metal products Machinery, electrical products Vehicles Optical, precision instruments Miscellaneous

Brunei

Indonesia

Malaysia

3,618

4,539

5,710

826 169 369 255 5 59 55 5 86 723 185 215 171

838 192 347 284 0 110 100 999 1,032 121 298 218

564 163 460 1,754 0 91 68 1,150 704 237 270 228

2,377

2,819

53 5 858 80

60 10 464 51

Philippines

Singapore

Thailand

ASEAN-6

3,473

5,146

25,918

294 117 347 232 400 35 62 675 784 96 243 145

776 149 295 249 0 59 53 623 750 124 227 151

490 204 696 350 0 112 85 1,217 1,143 264 387 166

3,788 994 2,513 3,124 405 466 423 5,250 5,136 1,027 1,640 1,079

2,985

960

2,183

3.53 1

14,855

157 4 1,228 108

8 7 607 35

40 5 75 1 82

74 5 1,201 146

392 38 5,109 502

Normal Track 3,432

Fast Track

Total 01-24 25-27 38-40 41-49

Live animals, food Mineral products Chemicals, plastics Leather, wood, paper

50-63 64-67 68-7 I 72-83 84-85 86-89 90-92 93-98

Textiles, apparel Footwear Stone, ceramics, cement Base metals, metal products Machinery, electrical products Vehicles Optical, precision instruments Miscellaneous

Total

01-24 25-27 38-40 4 1-49 50-63 64-67 68-7 1 72-83 84-85 86-89 90-92 93-98

Live animals, food Mineral products Chemicals, plastics Leather, wood, paper Textiles, apparel Footwear Stone, ceramics, cement Base metals, metal products Machinery, electrical products Vehicles Optical, precision instruments Miscellaneous

Source: ASEAN Secretariat (1995a)

1,009 0 144 8 220 0 0 0

1,803 0 248 0 156 0 0 27

236

1,648

0 9 95 0 0

193 6 850 310 27 I 12 57 48 129 8

0 0 0 72 0 60 0

5

990 91 0 0 132 107 1 1 345 94 0 0 0 0 20 10 Temporary Exclusion List 62 I 694 18 43 123 108 4 0 27 112 43 143 0 0

104

43 41 104 268 23 39 0 17 54 0 1

975 0 142 1 I65 0 0 22

1,758 0 20 1 2 144 0 0 0

6,626 0 974 13 1,124 0 0 79

1

122

3,322

0 0 0 0 0 0 0 0 0 0 1 0

28 0 0 0 0 0 0 3 34 57 0 0

343 103 1,109 522 299 24 78 172 214 383 59 6

294

Chia Siow Yue Average CEPT Rates by Country, 1996-2003

Table 10.8 Country

1996

1997

1998

1999

2000

2001

2002

2003

Brunei Indonesia Malaysia Philippines Singapore Thailand ASEAN-6

2.46 11.63 5.93 9.17 0.00 14.10 7.76

2.29 10.61 5.14 8.33 0.00 12.69 7.00

1.91 8.84 4.42 7.16 0.00 10.15 5.79

1.74 7.91 3.67 6.53 0.00 9.28 5.19

1.39 5.81 2.90 5.42 0.00 7.00 3.97

1.39 5.70 2.83 4.90 0.00 6.99 3.88

1.39 5.00 2.83 4.89 0.00 5.78 3.47

1.39 4.25 2.83 3.73 0.00 4.63 2.95

Source: ASEAN Secretariat (1995b).

fast track, and 7.5 percent in the temporary exclusion list.5The largest numbers of normal track tariff items are in base metals and metal products and machinery and electrical appliances. Almost half the fast track items are textiles and garments. The temporary exclusion lists represent sectors and products which the ASEAN countries are not yet ready to liberalize. They are concentrated in chemicals and plastics and motor vehicles. Among countries, machinery and electrical appliances ranked first in the exclusion list of Brunei, chemicals in Indonesia, textiles in the Philippines, and vehicles in Malaysia and Thailand. The simple average of the CEPT rates was 12.8 percent in 1993, ranging from a high of 22.6 percent for Thailand to a low of 0.4 percent for Singapore. The average CEPT rate for the ASEAN-6 will fall to 2.3 percent by 2003, ranging from 4.6 percent for Thailand to zero tariffs for Singapore (table 10.8). Intraregional trade in CEPT products grew rapidly in 1993-94. Intraregional exports of CEPT products reached U.S.$32.8 billion in 1993 and rose to U.S.$49.8 billion in 1994 (excluding Singaporean exports to Indonesia for which data are not available), recording 51.7 percent growth (table 10.9). Singapore accounted for 54.2 percent of the CEPT exports in 1994, followed by Malaysia (25.9 percent), Indonesia (10.1 percent), Thailand (6.6 percent), the Philippines (2.3 percent), and Brunei (0.9 percent). Singapore is the leading export destination for all the ASEAN countries, except for Brunei. Singapore and the Philippines experienced the fastest growth in CEPT exports of over 90 percent. For intraregional imports of CEPT products in 1994 (excluding Singaporean imports from Indonesia for which data are not available), Singapore accounted for 60.5 percent, followed by Malaysia (20.8 percent), Thailand (7.7 percent), Indonesia (5.6 percent), the Philippines (3.3 percent), and Brunei (2.1 percent). Singapore is the leading import source for all ASEAN countries except Thailand. The fifth ASEAN summit in December 1995 endorsed an accelerated tariff 5. The tariff lines are not strictly comparable across countries and sectors due to differences between levels of disaggregation. While Brunei, Indonesia, Malaysia, and Singapore have tariff codes disaggregated at the nine-digit level, those of the Philippines are disaggregated at the eightdigit level, and those of Thailand are a mixture of six-digit and nine-digit codes.

Intra-ASEAN Trade of CEPT Products, 1993-94 (million U.S. dollars)

Table 10.9 Country

Year

Brunei

Indonesia Malaysia Philippines Singapore Thailand ASEAN-6

1993 1994 % Growth 22 Indonesia 1993 39 1994 75.6 % Growth 143 1993 Malaysia 186 1994 % Growth 30 1 Philippines 1993 2 1994 83.3 % Growth 585 Singapore 1993 843 1994 44.1 % Growth 1993 Thailand 15 18 1994 18.4 % Growth 766 ASEAN-6 1993 1994 1,088 % Growth 42.0 Brunei

1993 1994 % Growth 1993 1 Indonesia 0 1994 % Growth -67.1 Malaysia 1993 2 1994 28 % Growth 1,559.3 Philippines 1993 0 1994 0 % Growth 352.5 Singapore 1993 216 1994 250 16.1 % Growth 217 Thailand 1993 150 1994 % Growth -30.9 435 ASEAN-6 1993 429 1994 % Growth -1.3 Brunei

Source: ASEAN Secretariat (1995b)

n.a. 0 n.a.

479 605 26 29 44 52.2 n.a. n.a. n.a. 84 136 61.4 591 785 32.7 n.a. 54 n.a.

441 627 42.2 212 246 15.9 n.a. n.a. n.a. 269 232 - 13.9 922 1,158 25.6

Exports n.a. 37 n.a. 496 600 20.9

125 166 33.5 9,187 19,484 112.1 27 8 316 13.7 10,085 20,603 104.3 Imports n.a.

225 n.a. 41 1 489 18.9

167 238 42.3 13,629 19,106 40.2 89 1 1,500 68.3 15,099 21,557 42.8

n.a. 28 n.a. 260 319 22.8 429 536 25

1,121 1,425 27.1 63 75 19.7 1,873 2,383 27.2 n.a. 2 n.a. 42 55 30.9 200 303 51.5

493 883 79.1 95 186 96.0 830 1,429 72.2

n.a. 198 n.a. 3,046 3,722 22.2 8,448 9,582 13 302 619 104.7

2,359 2,741 16.2 14,156 16,861 19.1 ma. 575 n.a. 1,543 1,631 5.7 5,469 6,799 24.3 635 795 25.2

936 1,213 29.6 8,583 11,013 28.3

n.a. 20 1 n.a. 430 333 -22.7 1,632 2,015 23 129 296 129.4 3,169 5,249 65.7

5,361 8,094 51.0 n.a. 60 n.a. 149 23 1 55.6 789 1,131 43.4 87 130 49.2 3,448 5,629 63.3

4,473 7,182 60.6

n.a.

464 n.a. 4,255 5,013 17.8 11,131 12,922 16 586 1,127 92.4 14,062 27,001 92.0 2,799 3,285 17.4 32,833 49,813 51.7 n.a. 916 n.a. 2,146 2,406 12.1 6,902 8,889 28.8 1,101 1,408 27.9 17,786 25,869 45.4 2,408 3,280 36.2 30,342 42,769 41 .O

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Chia Siow Yue

reduction schedule for 1996 that included the first installment of products previously in the temporary exclusion list, the bulk of unprocessed agricultural products, and the first package by Vietnam (which joined AFTA in January 1996). This package comprised 94 percent of the total number of tariff lines in ASEAN. AFTA cannot be inward looking. The ASEAN regional market is too small for inward-looking regionalism, so that the promotion of intra-ASEAN trade should not be at the expense of extra-ASEAN trade. Further, to the extent that ASEAN production is heavily dependent on extraregional sourcing of capital and intermediate inputs, focusing on intra-ASEAN trade liberalization alone would not significantly reduce production costs. ASEAN countries need to simultaneously reduce barriers on imports of production inputs from nonASEAN sources. Intraregional trade liberalization should be seen as the first step toward global liberalization. In fact, when Singapore implemented its AFTA obligations by removing almost all tariffs in 1993, it also decided to multilateralize its tariff concessions. More recently, Indonesia has announced a program of tariff reductions, lowering both CEPTs and most-favored-nation tariffs, though the latter were kept higher than the former. 10.3.4 Extending beyond the CEPT The 1992 AFTA agreement has the CEPT as its cornerstone, with general provisions for the exploration of nonborder areas of cooperation, such as the harmonization of standards, reciprocal recognition of tests and certification of products, removal of barriers to foreign investment, macroeconomic consultations, fair competition rules, and promotion of venture capital.h The AFTA agreement is much less comprehensive and specific than NAFTA, which has extensive and specific provisions on liberalization of nontariff barriers, trade in services, and investment flows and on protection of intellectual property. Since 1992, however, ASEAN has not only accelerated its tariff reductions but also progressively extended its liberalization and cooperation schemes to include these areas. The CEFT focuses on tariff reductions and intra-ASEAN trade liberalization in goods. Yet tariffs may not represent the most serious obstacle to intraASEAN trade, and tariff reductions may have no substantive impact on trade growth.’ Quantitative restrictions and other nontariff barriers are often more 6 . The ASEAN Secretariat was asked to look into nonborder areas of cooperation. Products at the HS seven- and nine-digit levels are being reviewed to ensure comparability of product nomenclature. The ASEAN Consultative Committee on Standards and Quality was established to work on harmonization of standards, testing of accreditation of laboratories, conformity assessment, and technical information. The Consultative Forum on Foreign Direct Investment was convened in February 1993 and meets on a regular basis to exchange views as to how to improve the investment climate in ASEAN. 7. One study by Imada, Montes, and Naya (1991) based on a partial equilibrium approach has shown that an assumed 50 percent tariff cut would increase intra-ASEAN trade as a percentage of

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serious deterrents to intra-ASEAN trade than tariffs.RTraders are discouraged by border barriers such as tedious import documentation and procedures and disputes over arbitrary customs valuation and rules of origin, as well as by nonborder obstacles such as lack of harmonized standards, sanitary regulations, and labeling and packaging requirements. Further, liberalizing intraASEAN trade alone may not be the best approach to fostering ASEAN export and investment competitiveness. Additionally, the focus on merchandise trade neglects the growing importance of trade in services and investment flows. In September 1994 ASEAN officials agreed on the harmonization of tariff nomenclature in ASEAN beyond the HS six-digit international uniform definition, that is at the HS eight- to nine-digit level. On nontariff barriers, officials are cooperating on customs valuation systems and procedures, including common customs declaration forms and import and export procedures; elimination of nontariff barriers relating to technical standards; and harmonization and mutual recognition of sanitary and phytosanitary measures for agriculture products. In April 1995 ASEAN officials agreed to work toward a Framework Agreement on Cooperation in Services, to include liberalization as well as cooperation in trade in services, the idea being to go beyond the Uruguay Round General Agreement on Trade in Services (GATS); to implement a Framework Agreement on Intellectual Property Cooperation and set up an ASEAN patent system and an ASEAN trademark system; and to explore cooperation in transport and communication as a trade facilitation measure. In December 1995, the ASEAN summit adopted the ASEAN Industrial Cooperation (AICO) scheme to replace the BBC and AIJV schemes. The approval process is simpler and speedier, with applications processed within two months. AICO products will enjoy immediate free market access rather than the scheduled tariff reductions under AFTA. To be eligible, a project has to involve at least two ASEAN countries and companies must have at least 30 percent national equity. In response to the growing concern regarding ASEAN’s competitiveness as an investment location, the ASEAN summit also agreed to establish an ASEAN Investment Area (AIA) to complement AFTA, to promote foreign and intraregional direct investments. A working group has been established to explore specific measures.

-

total trade by 2.3 percent for imports and 3.4 percent for exports. The biggest gainer on the import side would be Malaysia (4.4 percent) and on the export side Singapore (4.2 percent). To the extent that dynamic effects are not considered, the gains have been underestimated. The same study, using a general equilibrium trade-linked model, has shown the gains to be larger. Malaysia would have the largest share of intra-ASEAN exports (35.6 percent), while Singapore would have the largest share of intra-ASEAN imports (33.0 percent). 8. Kumar (1992) highlighted some of the nontariff barriers in intra-ASEAN trade, including standards testing procedures, customs classifications and valuation procedures, subsidy schemes for domestic producers and purchasers, local content rules, and health and safety standards.

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10.3.5 ASEAN Growth Triangles The Growth of Subregionalism Subregionalism is a growing phenomenon in East Asia, as manifested in the rapid emergence of subregional economic zones (SREZs), variously called growth triangles, transnational economic zones, and natural economic temtories. These are transnational investment zones that encompass geographically contiguous countries and subnational areas. The integration process has cut across not only political boundaries but also political and economic systems. The driving force is the private sector. Governments act as facilitators, removing the political and policy barriers to economic exchange, providing and promoting the development of physical infrastructure, and offering investment incentives to the private sector. SREZs exploit the advantages of geographical proximity and economic complementarity (Chia and Lee 1993). Geographical proximity is often linked with cultural and linguistic affinities, and together they reduce economic distance and transaction costs, but the removal of policies restricting border flows and the availability of facilitating transportation and telecommunications must still be addressed. Border restrictions have been tumbling in East Asia with the end of the Cold War and with political and economic reforms in socialist countries and trade and investment liberalization among market economies. For trade in goods, proximity reduces transport costs as well as delivery time, an important consideration with time-sensitive products, rapid changes in consumer tastes and shortened product cycles. For trade in services, direct contacts between producers and suppliers and between buyers and clients are often necessary for transactions to take place. For investment decisions, proximity reduces information costs, of particular importance for small and mediumsized enterprises without ready access to investment and market information, and for investors who have to operate in unfamiliar political, bureaucratic, and legal environments with complex and nontransparent rules and regulations, and deal with local business partners with different business and accounting practices. Transportation and telecommunications infrastructures are needed to enable cross-border movements of goods and people and flows of information. Supporting infrastructure is also needed to promote development of natural resources, tourism, and industries. Economic complementarity arises from differences in factor endowments and in stages of economic development and is reflected by differential factor prices and cost structures. As land and natural resources are immobile and governments continue to restrict cross-border labor flows, capital becomes the mobile factor and investments flow from the more developed core of the SREZ to the less developed periphery. The core also performs an intermediation role, channeling investments from other countries to the periphery, helping to import machinery and intermediate inputs needed by the periphery and exporting its products to the rest of the world.

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The most developed SREZ is the Greater South China zone encompassing Hong Kong, Taiwan, and China’s south coastal provinces of Fujian and Guangdong, where geographical proximity has been facilitated by ethnic, cultural, and linguistic affinities9In the ASEAN region, three growth triangles among member states have emerged, and national and subnational governments act as the major facilitators. IMS, IMI: and BIMP Growth Triangles

The IMS (Indonesia-Malaysia-Singapore) Growth Triangle (GT), more commonly known as the SIJORI (Singapore-Johor-Riau) Growth Triangle, was proposed in the late 1980s as an alternative mode of ASEAN economic cooperation to the more contentious FTA. It does not require the participation of all ASEAN countries (the “6 minus x” principle) and emphasizes resource pooling and investment cooperation rather than market integration. The IMSGT comprises the three contiguous areas of Indonesia’s Riau islands, Malaysia’s southern state of Johor, and the city-state of Singapore. The growth triangle enhances the investment competitiveness of the subregion by combining the resources and advantages of economically advanced and less advanced areas, integrating the availability of capital, technology, and human resources with the availability of land, natural resources, and labor. Such a combination of productive resources is generally not simultaneously available within a national contiguous area at a given time. For this reason, a transnational growth triangle is a much more attractive investment location than a national economic zone. At the subregional level, there are economies of scale and clustering and specialization according to comparative advantage. At the enterprise level, geographical proximity facilitates the establishment of production and distribution networks. Government support has been crucial in launching the IMS-GT. Indonesia proposed investment cooperation with Singapore to increase the attraction of Riau as an investment destination as its earlier effort to promote Batam island (part of Riau) as a logistics base and industrial export processing zone had met with limited success. The development of Riau also serves Indonesia’s strategy of developing its regional peripheries. For Johor, further integration with Singapore will enable it to exploit the metropolitan spillover effect to accelerate its economic and industrial development. For the Singapore city-state, Riau and Johor provide much-needed economic space. Land and labor shortages and accompanying rising costs necessitate the relocation of land- and labor-intensive industries and processes. Relocation nearby will enable foreign MNCs in Singapore to retain their higher value-added functions in Singapore and thus consolidate Singapore’s position as a manufacturing base and services hub. Relocation nearby by Singaporean enterprises will enable them to engage 9. For a comparison of ASEAN growth triangles and the Greater South China SREZ, see Chia and Lee (1993).

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in outward investments in a less unfamiliar environment, which reduces risks and helps economize on managerial and technical resources. Singapore’s cooperation is also strongly motivated by its heavy dependence on Johor for water supply and its search for new water resources in Riau. The liberalization of foreign investment regulations in Batam (where regulations are more liberal than found in the rest of Indonesia), Singapore’s participation in Batam’s infrastructural development, and strong Singapore government endorsement of Batam as an industrial location led to a surge of investment in Batam by foreign MNCs based in Singapore and by Singaporean companies. The success of Batam led to investment cooperation’s being extended to Bintan and other Riau islands. Singaporean investments include multibillion-dollarjoint ventures with the Indonesian private sector to develop industrial and tourism facilities in Batam and Bintan. Geographical proximity and economic complementarity are crucial factors in the development of IMS-GT. For businesses located in Batam-Bintan and Johor, doing business with and through Singapore is much more cost efficient and time saving as Singapore provides world class transportation, telecommunications, financial, and commercial infrastructures. Batam is only a 30-45minute ferry ride from Singapore, and Johor is linked to Singapore by a causeway (with another under construction). Investors can commute daily or frequently from Singapore to supervise operations and attend to production and distribution problems. Singapore offers a more comfortable and convenient living environment for business executives and their families. There are also strong economic complementarities between Singapore and Johor and Riau. Singapore has abundant financial resources, managerial and professional expertise, and well-developed financial, transportation, and telecommunications infrastructure. Riau and Johor can offer land and labor at lower cost than in Singapore. Their unique proximity to Singapore increases their attraction for regional and foreign investors. The success of the IMS-GT has prompted the implementation of two more growth triangles in ASEAN. The northern, or IMT (Indonesia-MalaysiaThailand), Growth Triangle covers contiguous areas of west Indonesia, north Malaysia, and south Thailand, with a larger geographical area and population base than the IMS-GT. The eastern, or BIMP-EAGA (Brunei-IndonesiaMalaysia-Philippines East ASEAN) Growth Area encompasses four ASEAN countries: Brunei, west Indonesia, east Malaysia, and south Philippines. It is larger than the IMT-GT in area and is geographically more dispersed. In both cases, facilitating transportation infrastructure is crucial to the development of subnational linkages.

Issues and Challenges The IMS-GT is a transnational phenomenon involving relations at many levels. The relocation of industries from the core to the periphery results in retrenchment of workers and possible industrial hollowing-out. However,

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Singapore’s outward investment in response to labor and land shortages and industrial upgrading will create domestic dislocations anyway, whether the growth triangle phenomenon exists or not. In a dynamic economy the retrenched workers can be readily redeployed, particularly if appropriate retraining programs are in place, and scarce domestic resources can be put to more productive use. In the peripheral areas of Johor and Batam, the influx of foreign investment and associated managerial and professional resources raises economic growth and employment and industrialization prospects. However, rapid foreign investment penetration has raised concerns about national sovereignty, the centrifugal forces that draw a country’s periphery to a foreign core, dilution of central-provincial government relations, and inadequate economic linkages with the domestic economy. The presence of foreign investors, managerial and professional personnel, and visitors also puts pressure on housing and infrastructure, and a large influx of workers from rural areas, particularly young female workers, can create social problems. The sustainability of the IMS-GT depends on the continuing investment attractions of Johor and Riau. For Johor an emerging problem is the worsening shortage of labor, and investors will have to move into non-labor-intensive industries. For Batam and Riau, the need to recruit labor from Java and the 30year land-lease system add to production costs and investor uncertainty. And as Indonesia liberalizes its investment regime, the special investment incentives for Riau are lost; Java has the strong attraction of a large labor pool and a large domestic market. A recent Indonesian government decision has extended the land lease to 80 years, and developments on Bintan are focusing on tourism and natural resource development as well. Geographical proximity and economic complementarity are less obvious in the IMT-GT and BIMP-EAGA than in the IMS-GT. A lack of transportation infrastructure linking the subnational areas, particularly in the BIMP-EAGA, has increased economic distance and transaction costs. The subnational areas in these two growth triangles are also more alike in terms of factor endowments and levels of economic and industrial development. Neither triangle has an equivalent to Singapore in the IMS-GT, a participant that provides metropolitan spillover and investment, financial, transportation, telecommunications, commercial, and managerial resources. In the IMT-GT, Penang acts as the metropolitan core, but Penang is much smaller than Singapore and its hinterland lies in Malaysia rather than across the border. In the BIMP-EAGA, Brunei is financially rich and Labuan (Malaysia) is an emerging offshore financial center, but the growth triangle lacks an industrial leader. The IMT-GT and BIMP-EAGA will thus need a different focus from the IMS-GT. Subregional cooperation will need to emphasize the joint development of infrastructure, natural resources, and tourism. This will enable the two subregions to enjoy economies of scale and agglomeration and to improve their competitiveness in securing investment. For common resources straddling land and sea borders, joint development can minimize ownership disputes and im-

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prove environmental management. However, the central challenge in the development of the IMT-GT and BIMP-EAGA is mobilizing the financial resources required for infrastructure-related development. Total infrastructure financing needs of developing East Asia over the next five to six years are estimated to be U.S.$l-2.5 trillion, and only a very small part of this is likely to be met from the resources of multilateral and regional development agencies and official development assistance programs. The bulk of financing required for investment in infrastructure development and in productive capacity in the IMT-GT and BIMP-EAGA will have to be mobilized from private sources. Both private loan financing and private investments have to meet stringent criteria regarding political and management risks and commercial viability. It remains to be seen how many of the ambitious schemes envisaged and proposed in the IMT-GT and BIMP-EAGA can meet such criteria.

10.3.6 Growth Triangle versus Free Trade Area The growth triangle has several advantages over the free trade area (FTA) as a modality of ASEAN economic cooperation. First, the growth triangle avoids some of the problems in regional economic integration faced by countries at different stages of economic development, and even different economic and political systems (as demonstrated by the Greater South China economic zone). The FTA is a formal institutionalized regional arrangement. Negotiations can be protracted, as they must cover a wide range of trade-related policies and regulations. Wide disparities in income levels, industrial competence, and trade policy create serious problems in reaching consensus on the pace and extent of trade liberalization and perception of distribution of benefits and costs. In contrast, the growth triangle exploits differences in factor endowments and levels of development to mutual advantage. Furthermore, the “6 minus x” principle is easier to implement in a growth triangle than in an FIA. Countries that see little benefit need not participate, but they do not spoil the chances for countries that wish to do so. Second, a growth triangle is more limited in geographical scope and thus politically more manageable and functionally more flexible. Existing growth triangles cover only parts of sovereign states, except for the small city-state of Singapore and the small sultanate of Brunei. For countries unready to open up across the board and lacking financial resources for infrastructural development of peripheral areas, participation in a growth triangle limits political risks and financial commitments. If the experiment in economic cooperation fails, the political risks can be well contained; if it is successful, the experiment can be replicated in different parts of the country and with different partners. The scope for cooperation is more flexible. It need not include or end with intratrade liberalization. In actual practice, cooperation has included joint investments in infrastructure, tourism, and industry and facilitation measures for investments and the flow of goods and people, and the integration process is

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deeper than in an FTA. It takes less time to implement specific cooperation schemes in a growth triangle, and the benefits are more directly visible. Third, for larger and geographically dispersed countries, a growth triangle helps promote balanced regional development, as peripheral areas of a country can be drawn into the mainstream of development by linking with more developed areas across the border. A country can participate in several growth triangles at the same time, with different modalities of cooperation and projects to meet specific local needs and conditions. Thus Indonesia is linking its northwestern, southern, and eastern peripheries to different growth triangles in ASEAN with different combinations of partners. Fourth, a growth triangle focuses on economic complementarity to attract investments to produce for the subregional and international markets rather than on enlarging the regional market and protecting it against external competition. A growth triangle is less likely to be perceived as a zero-sum game. Domestic enterprises are less threatened by more competitive goods from partner countries. And since a growth triangle is obviously not a discriminatory trading bloc, it is also more acceptable to nonmembers. In fact, nonmembers are actively encouraged to participate in the benefits of the triangle through the investment process. A growth triangle is thus consistent with the objectives of free trade and efficient resource allocation.

10.4 Conclusion Politically, ASEAN has succeeded in establishing regional stability by helping to overcome traditional sensitivities arising from differences in historical, ethnic, linguistic, and religious backgrounds, defusing border disputes, allaying the fears of smaller nations regarding their larger neighbors’ territorial ambitions, and providing the stable underpinnings for each member country to pursue economic development with minimal distraction. There is an emerging sense of an ASEAN community. ASEAN is also widely respected internationally for its moderating influence with respect to many political and economic issues and for its economic success. However, for the first 25 years, ASEAN’s progress in economic cooperation and integration had been less satisfactory, and the level of economic integration was low, except for regional connections to Singapore. To the extent that trade preferences have not promoted the growth of intra-ASEAN trade faster than extraregional trade, discrimination has not been trade diverting and has not imposed welfare loss on traditional trading partners. Whether intra-ASEAN trade liberalization and industrial cooperation have been directly welfare enhancing is debatable. The preferential trade agreement entailed endless meetings of ASEAN economic officials, with limited results. Likewise, industrial cooperation schemes contributed little to the industrial development of ASEAN countries. The growth triangle is more welfare enhancing. And to the

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extent that AFTA contributes to the lowering of most-favored-nation tariffs and nontariff barriers and increased investment improves growth performance, the trade creation effects should outweigh the trade diversion effects and regionalism should contribute to multilateralism. The ASEAN region was the world’s most dynamic over the past decade. The economies are expected to remain buoyant over the next decade. However, dramatic geopolitical and economic changes regionally and globally have confronted ASEAN and its economies with several challenges. Regional peace and security is being threatened by the rise of regional powers and temtorial disputes in the South China Sea. The purpose of the ASEAN Regional Forum is to defuse such tensions. On the economic front, ASEAN faces intensified regional and global competition for markets and investments. ASEAN countries want to enhance their competitiveness as a production base and investment location. Trade and investment liberalization and facilitation measures under AFTA, AIA, and the growth triangles will help achieve this objective. AFTA is too small to be inward looking. ASEAN has a population exceeding those of the European Union and NAFTA, but its GNP size is less than 10 percent of each of those two groupings. This has encouraged ASEAN to practice “open regionalism”; some member countries have multilateralized their trade liberalization under AFTA. ASEAN economic cooperation can move beyond AFTA and take advantage of the de facto economic integration process in the Asia Pacific that has resulted from growing trade and investment linkages forged by the private sector. To do this, ASEAN policymakers could reduce barriers to trade and investment flows through liberalization and facilitation measures, encourage their private sectors to be engines of growth, and develop strategic trade and investment linkages with other dynamic economies, subregions, and free trade areas. ASEAN’s active participation in the APEC forum and overtures to building linkages with Australia and New Zealand, NAFTA, and Western Europe are building blocks toward multilateralism.

References APEC Secretariat. 1995. Foreign direct investment and APEC economic integration. Singapore:APEC Secretariat. ASEAN Secretariat. 1995a. AFTA reader: Vol. 2, Questions and answers on the CEPT for AFTA. Jakarta: Association of Southeast Asian Nations. . 1995b. AFTA reade,: Vol. 3, Questions and answers on the CEPT for AFTA. Jakarta: Association of Southeast Asian Nations. Asian Development Bank. 1995. Key indicators of developing Asian and PaciJic countries 1995. Manila: Asian Development Bank. . 1996. Asian development outlook 1996 and 1997. Hong Kong: Oxford University Press. Batam Industrial Development Authority. 1993. Development data up to 31 December 1992. Batam Industrial Development Authority.

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Chia Siow Yue. 1993. Foreign direct investment in ASEAN economies. Asian Development Review 11 (1): 60-102. . 1994. ASEAN economic cooperation and external relations. In Economic interactions and interdependence in East Asia, ed. Sueo Sekiguchi and Makito Noda. Tokyo: Ushiba Memorial Foundation. Chia, Siow Yue, and Lee Tsao Yuan. 1993. Subregional economic zones: A new motive force in Asia-Pacific development. In PaciJc dynamism and the international economic system, ed. C. Fred Bergsten and Marcus Noland. Washington, D.C.: Institute of International Economics. Imada, Pearl, Manuel Montes, and Seiji Naya. 1991. Afree trade area: Implications for ASEAN. Singapore: Institute of Southeast Asian Studies. International Monetary Fund. 1994. Direction of trade statistics yearbook 1994. Washington, D.C.: International Monetary Fund. Khoman, Thanat. 1992. ASEAN: Conception and evolution. In The ASEAN reader, comp. K. S. Sandhu et al. Singapore: Institute of Southeast Asian Studies. Kumar, Sree. 1992. Policy issues and the formation of the ASEAN free trade area. In AFTA: The way ahead, ed. Pearl Imada and Seiji Naya. Singapore: Institute of Southeast Asian Studies. Myo Thant, Min Tang, and Hiroshi Kakazu. 1994. Growth triangles in Asia: A new approach to regional economic cooperation. Hong Kong: Oxford University Press. Pangestu, Mari, Hadi Soesastro, and Mubariq Ahmad. 1992. A new look at intraASEAN economic cooperation. ASEAN Economic Bulletin 8 (3): 333-52. Rajaratnam, S. 1992. ASEAN: The way ahead. In The ASEAN reader, comp. K. S. Sandhu et al. Singapore: Institute of Southeast Asian Studies. Sandhu, K. S., et al., comp. 1992. The ASEAN readel: Singapore: Institute of Southeast Asian Studies. Wisarn, Pupphavesa. 1994. AFTA: The state of play. Paper presented at the international symposium on the Deepening and Widening of ASEAN in the Post-Cold War Era, organized by the Institute of Southeast Asian Studies, Singapore, 22-23 September. World Bank. 1987. World development report 1987. New York: Oxford University Press. . 1995. World development report 1995. New York: Oxford University Press.

Comment

Mario B. Lamberte

Chia’s paper provides an excellent and objective review of ASEAN’s accomplishments in the area of trade and industrial cooperation in the past 25 years, the most recent of which are the ASEAN free trade area (AFTA) initiative and the formation of subregional economic zones or growth triangles. As accurately pointed out by Chia, AFTA was born without the benefit of the rigorous studies and long discussions that usually precede the birth of trading blocs. The ensuing intense debate carried out in each country o n the manner and scope of implementation of AFTA attests to this fact. More recently, some studies have been done to shed light on the effects of AFTA on members’ Mario B. Lamberte is vice-president of the Philippine Institute for Development Studies and coordinator of the Monetary and Banking Policies Research Program of the Institute.

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economies. It is worth mentioning some of them here to add flavor to Chia’s discussion. Using an ASEAN Multi-Country Model to perform a simulation analysis over a seven-year period under AFTA, Yap and Edillon (1993) found that intra-ASEAN trade increased, but that the increase favored only Singapore in terms of an improved trade balance. All ASEAN countries realized a net gain in terms of long-run GDP growth; however, this gain was very modest. Teh (1993) also performed a simulation analysis using a computable general equilibrium model, focusing on the impact of the Common Effective Preferential Tariff (CEPT) on the Philippine economy. His results suggest that the CEPT produces very little resource allocation or efficiency gains for the Philippines as reflected in projected share of trade with ASEAN, sectoral growth rates, income distribution, and pattern of capital or labor allocation across broad sectors of the Philippine economy. Chia extensively discusses the advantages of the growth triangle over AFTA as a mode of ASEAN economic cooperation. However, it is not clear to me whether she considers growth triangles within ASEAN as a substitute for AFTA or an intermediate step toward AFTA. This is important because even if the financial resources each participating country in a growth triangle commits are small, their economic and social costs and benefits still must be evaluated properly. This is especially important in the case of the BIMG-EAGA, where the major factors that made SIJORI a successful story are less obvious. ASEAN economic cooperation, of course, extends beyond AFTA and growth triangles. Let me mention existing ASEAN cooperative arrangements in the area of banking and finance, which were not mentioned in Chia’s paper. These are the ASEAN Swap Arrangement; the use of ASEAN currencies in intra-ASEAN trade; the ASEAN Finance Corporation; the ASEAN Fund; and ASEAN cooperation in insurance.’

The ASEAN Swap Arrangement This arrangement was established by the ASEAN central banks (excluding Brunei’s) in August 1977 to provide short-term swap facilities for member countries with temporary liquidity problems. It operates through swaps of U.S. dollars against the currency of the borrowing ASEAN country. Each member is supposed to contribute $40 million and may borrow up to $80 million. The arrangement is supposed to last for five years. Its success has already prompted the ASEAN central banks to renew it four times. The five ASEAN member countries take turns acting as managing agent. The arrangement provides a sort of last resort facility for ASEAN central banks. None availed themselves of it in the first few years, and in the past few years ASEAN central banks have had easy access to other facilities. But in times of great need, ASEAN countries have turned to this facility. The Philippines, for instance, availed itself of the arrangement at the height of its balance1. The following discussion draws heavily on Lamberte (1991).

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of-payments problem. But it has not accessed the facility in the past few years when other financing facilities have become available.

Liberalized Use of ASEAN Currencies in Intra-ASEAN Trade The idea originated in the ASEAN private banking sector, which proposed that ASEAN governments formally agree to permit ASEAN-based traders to use any ASEAN currency as the medium of exchange for intra-ASEAN trade. There are at least three advantages to this arrangement. First, it will conserve the hard currencies of ASEAN countries and at the same time promote intraASEAN trade. Second, it will ensure the supply of critical imports that can be readily supplied by ASEAN countries. And third, it will stimulate the expansion of intra-ASEAN banking activity with increased intra-ASEAN trade flows. This arrangement was not difficult to forge since two of the six ASEAN countries, namely, Singapore and Brunei, already have liberal foreign exchange policies that allow their traders to use any medium of exchange acceptable to the exporter. In other ASEAN counties, liberalization in the use of ASEAN currencies began in 1987 in response to the proposal of the private banking sector. The results of the liberalization have been encouraging. All ASEAN countries reported an increasing trend in the use of ASEAN currencies especially in those currencies that had not been accepted before as mediums of exchange. Reports of individual countries showed the following:

Brunei Darussalam. Ninety-five percent of accounts involving ASEAN trade were settled with ASEAN currencies. Available data on the value of intraASEAN currency settlements through the commercial banks showed that the Singaporean dollar accounted for 82 percent. But what is notable is the increasing use of Malaysian, Philippine, and Thai currencies in the settlements. Indonesia. Of the total trade transactions with ASEAN countries, less than 20 percent were settled in ASEAN currencies. The Singaporean dollar was the dominant settlement currency. Malaysia. Around 23-28 percent of its total receipts and 12-14 percent of its total payments were settled in ringgit. The Singaporean dollar was also widely used as a settlement currency, accounting for 5-7 percent of total receipts and about 10 percent of total payments. The rupiah, baht, and Bruneian dollar were also used to a lesser extent for trade settlement. Philippines. The available information on the value of intra-ASEAN currency settlements pertains to the Central Bank’s over-the-counter purchases of ASEAN currencies. The statistics indicate continuing growth in the use of ASEAN currencies. Still, the Singaporean dollar has dominated. What is more

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noteworthy is the significant rise in the Central Bank’s over-the-counter purchases of Malaysian, Bruneian, Thai, and Indonesian currencies during the period 1986-89.

Thailand. The proportion of trade settled in ASEAN currencies compared to the value of Thailand’s trade with other ASEAN countries rose by 11.5 percent in 1989 against 10.7 percent in 1988. So far, the available information suggests that with the liberalization in the use of ASEAN currencies, ASEAN countries were able to conserve their hard currencies in intra-ASEAN trade transactions. However, it cannot yet be ascertained whether the arrangement has induced more trade among ASEAN countries.

ASEAN Finance Corporation The ASEAN Finance Corporation (AFC) is one of the concrete manifestations of regional cooperation within the private banking sector under the leadership of the ASEAN Banking Council. It was set up in 1981 with five ASEAN countries contributing S$20 million each to the initial capital to finance ASEAN industrial cooperative projects and to provide venture capital to ASEAN entrepreneurs. Schulze (1988) has already made a thorough assessment of the AFC, and most of his conclusions still hold today. Specifically, the AFC is generally liquid and is characterized by slow’growth. Hence, it is not able to attract more equity funds. It is very much involved in money market activities. The AFC cannot be entirely be faulted for this since there were not enough industrial cooperative projects to support. But other serious weaknesses have been pointed out by Schulze. One is that the conflict of interest between shareholders and the AFC could have resulted in the latter’s accepting highly risky but less profitable ventures while the former take the less risky but more profitable ones. Another weakness is that being a private corporation, AFC could not tap cheap sources of funds usually given by donor foreign governments.

ASEAN Fund, Limited The ASEAN Fund is another project of the ASEAN Banking Council that was recently launched. It is cashing in on the worldwide popularity of mutual funds to raise capital in more developed countries for investment in shares of stocks in less developed countries. The objectives of the fund are to 1. provide a greater measure of liquidity for ASEAN stock markets, 2 . foster the development of unlisted small and medium-sized indigenous companies, 3. enhance visibility of the ASEAN countries, and 4. help promote the respective countries’ fund management industries.

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To attain the second objective, the fund will invest 20 percent of its initial proceeds in securities of emerging growth companies that are not listed on any securities exchange in ASEAN countries, while the remaining 80 percent will be invested principally in securities that are listed on a stock exchange in the ASEAN countries. The fund therefore provides a vehicle for investors seeking long-term capital appreciation through investments in securities of companies in the ASEAN countries. The fund is incorporated under the laws of Singapore.

ASEAN Cooperation in Insurance The ASEAN Insurance Council (AIC), which is composed of the insurance commissioners of ASEAN countries, was established in 1978. Its annual meeting has continuously provided an excellent forum for the promotion of ASEAN cooperation in insurance. One of the accomplishments of the AIC is the construction of the Unified Forms of Insurance Statistics. The objective of this project is to disseminate information on market conditions and practices prevailing in each member country and to promote intra-ASEAN trade in insurance. Another important accomplishment of the AIC is the Comparative Study of Insurance and Supervision including Tax Laws on Insurance. The objective of this project is to keep member countries informed of current developments in insurance legislation and regulation. The report contains comprehensive and detailed information on the regulations governing the operations of insurance companies in the ASEAN countries. The private sector was not to be left out of ASEAN cooperation in the insurance sector. Private companies established in 1982 the ASEAN Reinsurance Pool with three separate pools, namely, a treaty pool (nonmarine), an excessof-loss pool (nonmarine), and a facultative pool (nonmarine). The objective of the pool was to retain a significant proportion of reinsurance premiums that had been completely captured before by reinsurance companies of non-ASEAN countries. In 1989, it was decided to replace the ASEAN Reinsurance Pool with the ASEAN Reinsurance Corporation to give it greater flexibility. It was incorporated in Singapore with insurance companies in ASEAN as the stockholders. The governments of ASEAN countries have been providing support to the corporation. In the case of the Philippines, which used to have strict regulations on nontrade (invisible) payments in hard currencies before the 1991 foreign exchange deregulation, the insurance commissioner was given the authority to approve remittance of reinsurance premiums to reinsurance companies abroad.

References Lamberte, Mario B. 1991. Structure and prospects of the ASEAN financial and banking systems: A perspective from the Philippines. Working Paper no. 91-05. Makati City: Philippine Institute for Development Studies, April.

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Schulze, David. 1988. The ASEAN finance corporation. ASEAN Economic Bulletin no. 5. Singapore: Institute of Southeast Asian Studies. Teh, Robert R. 1993. Implementing the CEPT mechanism and Philippine trade and resource flows. In The ASEANfree trade area: Implications to the Philippines’ drive for growth and international competitiveness, ed. Mario B. Lamberte. Manila: Philippine Economic Society. Yap, Josef T., and Rosemarie G. Edillon. 1993. Simulating the effects of the ASEAN free trade area using multi-country model. In The ASEANfree trade area: Implications to the Philippines’ drive for growth and international competitiveness, ed. Man o B. Lamberte. Manila: Philippine Economic Society.

Comment

Shang-Jin Wei

In this informative and well-written paper, Chia (1) discusses the degree of economic linkage within ASEAN, emphasizing the distinction between “cooperation” and “integration,” and ( 2 ) advances economic and political economy arguments for growth triangles or subregional integration. I would like to comment on these two parts in turn.

ASEAN as a Bloc First, as Chia points out in her paper, ASEAN has achieved its objectives as an effective security bloc. I have a slight disagreement with her, however, when she goes on to say that ASEAN should not also be judged by its degree of trade integration. I think that it should, at least partly. After all, it is not the case that ASEAN countries have never tried to establish a preferential trade area or a free trade area. They have more than once. So how integrated are ASEAN countries in terms of trade? To see the actual degree of trade integration in ASEAN, we could look at the ratio of intra-ASEAN trade to ASEAN members’ total trade and how this ratio changes over time. If we do that, we find that that ratio has increased over time. But this ratio is not the best way to address the question. Many things can cause this ratio to change over time, many of which have nothing to do with concerted efforts by the ASEAN countries to increase cooperation in trade. For example, faster economic growth in the region can cause the ratio to rise over time. A better way to measure integration that can be more plausibly be attributed to collective action is, guess what, a gravity model. To illustrate, let me refer to table 1 of my paper with Jeffrey Frankel (chap. 5 in this volume). This is a panel regression on 1,953 country pairs over the period 1970-90. Let me just note that the adjusted R2 of the regressions is very high (over 70 percent). Once we control for the contributions of economic sizes, geographic distance, and cultural links, we can add an ASEAN dummy that takes the value of one for Shang-Jin Wei is associate professor of public policy at Harvard University’s Kennedy School of Government and a faculty research fellow of the National Bureau of Economic Research.

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trade between two ASEAN countries. The coefficient is 1.97, which implies that two ASEAN countries on average trade 600 percent (= exp(1.97) - 1) more than two otherwise identical economies. This is a strikingly large number. If we take into account the possibility that Singapore may be an entrep8t for much intra-ASEAN trade, the estimate is lowered only slightly (from 1.97 to 1.42). Before we conclude that ASEAN is highly integrated, we should entertain another possibility: East Asia in highly integrated, and ASEAN countries are no different from other East Asian economies. We can test this by adding a dummy for East Asia integration to the regression, and we find that this is indeed the case. Two East Asian economies trade many times more than two random countries outside the region. But once we have controlled for an East Asia effect, ASEAN countries no longer show any additional subregional trade bias. Hence, there is not a special ASEAN effect in (merchandise) trade. However, this is probably not something to worry about. Some computable general equilibrium (CGE) studies compared two scenarios for ASEAN: (1) ASEAN forms a bloc of its own versus (2) ASEANjoins an East Asia bloc. They found that the latter generates higher welfare for ASEAN. I would venture to suggest that, if we add a third scenario-ASEAN countries liberalize unilaterallythis would provide even higher welfare.

Growth Triangles My second comment concerns growth triangles. Integration involving subregions of various neighboring countries has not received much attention from academic economists. Therefore, I find Chia’s discussion valuable and thought provoking. Upon some thinking I find myself to have some disagreement with Chia’s analysis. Chia is clearly strongly in favor of growth triangles. She argues that growth triangles have advantages over free trade areas (FTAs) both on economic efficiency and political economy grounds. Her paper makes no mention of disadvantages of growth triangles relative to FTAs. I would like to suggest that efficiency gains of growth triangles are probably overrated. On the other hand, growth triangles can and often do play many useful political roles. To put it strongly, on efficiency grounds, I would suggest that subregional trade integration is almost always inferior to regional integration. Like FTAs, subregional trade integration involves trade diversion as well as creation. Moreover, as subregional schemes involve smaller regions, there will be more diversion and less creation. Of course, growth triangles involve more than just free trade. They also entertain the promotion of investment, improvement of infrastructure, and coordination of other economic policies. But the basic logic goes through. (As mentioned above, some CGE studies find that it is better for ASEAN to be part of a broader bloc than to be an exclusive bloc of its own.) To summarize, on economic efficiency grounds, subregional integration or

312

Chia Siow Yue

growth triangles are third best, inferior to global integration (the first best) and regional integration (the second best). Of course, just as multilateral liberalization is often more difficult politically than regional integration, regional integration is sometimes more difficult than subregional integration. Therefore, there are some good political arguments for growth triangles, as Chia has aptly outlined. One particular role that subregional integration can play is in helping to reduce political risks for politicians. However, we must keep in mind the compromise and trade-off involved in promoting growth triangles. Growth triangles should only be used as a building block or intermediate step toward further liberalization.

11

Globalization and New Industrial Organization: Implications for Structural Adjustment Policies Sung Hee Jwa

11.1 Introduction Today, globalization affects a full range of political as well as economic issues. Globalization is a phenomenon driven by the strategies and behaviors of individual economic agents, firms, banks, and people in the pursuit of profit and is usually identified with market deregulation, the spread of new information technologies, the intermeshing of financial markets, and innovations in industrial and production systems.' Globalization is the most critical and difficult challenge for modem firms. It has been observed that the advent of the globalization phenomenon and a crisis of existing production systems are taking place simultaneously. In the increasingly interdependent, complex, and dynamic business environment created through globalization, the major industrial and production systems-the American Fordist system, the German Craft system, and even the Japanese flexible and lean production system-all seem to be breaking down and subject to reassessment. This is sparking uncertainty about how a successful, modem firm should be organized and managed. The post-Fordist system, a new intra- and interfirm industrial organization that emphasizes innovation in work methods and product features, has brought the American Fordist mass production system into crisis with its competitive strength. The detailed compartmentalization of tasks and responsibilities in the Fordist system hinders application of new information technologies to the production process, integration of all levels of production and management, Sung Hee Jwa is president of the Korea Economic Research Institute. When this paper was written, he was a senior fellow at the Korea Development Institute. This paper won the 26th Economist prize (1996), awarded by the Maeil Business Newspaper to research on the Korean economy. I. Recently, Oman (1993,1994) endeavored to define the complex phenomenon of globalization along similar lines.

313

314

Sung Hee Jwa

and long-term investment in multiskilled workers.* However, even the German Craft system, once praised as a critical factor in German economic development, now exhibits rigidities. Its fixed skill-identity limits the speed with which new products and technologies can be introduced, while the bureaucratic elements in the system separate production from the development and design lab, as well as isolating various parts of production from one another (Hemgel and Sabel 1994). Further, the Japanese flexible and lean production system, praised as an important potential alternative to the Fordist system, is beginning to show weakness in the new global competitive arena. Its central characteristic is a vertical network supported by lifetime and seniority-based employment. However, if employment practice or some other part of the business environment changes as the result of globalization, as many believe it must, the Japanese system will also be pressured to change (Westney 1994). This study explores how globalization affects the structure of industrial organization in both individual economies and firms; searches for the optimal industrial organization, if any, in the globalized market; and examines future directions of structural adjustment in individual economies. However, to discuss systematically the implications of globalization for industrial organization, one has to conceptualize analytically “globalization.” In this study, globalization is characterized as a parameter, similar to a market price. Globalization is driven by microeconomic forces but is taken by individual firms as a parameter in making economic decisions on the optimal structure of industrial organization. While the globalization phenomenon encompasses many diverse characteristics in general, this paper concentrates only on those aspects of globalization most relevant to the current context and simplifies the concept so it can be easily incorporated into the following economic analy~is.~ First, we identify the globalization phenomenon with the integration of world economies into a single market, which in turn implies the following specific predictions for market environments: increase of potential market size and intensified competition for market share. In this sense, the challenge of globalization to individual firms is, on the one hand, how to deal with these larger markets. But as a corollary of the extended market size, globalization can also mean intensified competition in international as well as domestic markets, so that existing monopolistic producers may face the possibility of losing their market shares, on the other hand. Therefore, globalization gives access to greater market size in general but can also imply reduced market size for firms that have been enjoying unfair privileges under closed market environments. Second, we identify the globalization phenomenon with the introduction and spread of microelectronics-based information technology. Improvements 2. See Oman (1993, 1994) for further discussion of this point. 3. See East-West Center (1994); lengthy discussions on various aspects of globalization and the structures of industrial organizations in major developed countries can be found in the volume compiled by the East-West Center of the University of Hawaii. However, to some extent this paper stems from my dissatisfaction with the approaches taken by the various authors in that volume.

315

Globalization and New Industrial Organization

in information technology contribute not only to economic integration through better telecommunications but also to changes in production technologies and managerial relationships among various economic activities. Specifically, it is expected that scope economies among various economic activities will be strengthened through improved information technology and computer and automation systems4In addition, it may be the case that improved microelectronics-based information technology tends to create new synergistic managerial relationships among formerly unrelated economic activities and reinforces existing relationships by improving the information network system, making it increasingly difficult to isolate a particular economic activity from other activities. So, in this sense, the additional challenge of globalization may be how to respond to the enlarged economies of scope among various economic or industrial activities generated by the stronger technological and managerial synergy effects. This study employs a theory of endogenous industrial organization in deriving the general implications of globalization for the optimal structure of industrial organization. This theory will be constructed based on the theory of specialization (Stigler 1968) and the theory of multiproduct firms (Baumol, Panzar, and Willig 1982; henceforth, BPW). This study extends the discussion to the issue of Korea’s industrial structure by applying the general theoretical implications to the Korean case. In Korea, economic concentration in large business groups, so-called chaebols, and the issue of the optimal structure of industrial organization have long been subjects of debate. Not only the evaluation of the current structure but also the future direction of optimal structural adjustment for Korea’s chaebol-dominated industrial organization have continuously been given the highest priority on the industrial policy agenda. It is usually argued that Korean chaebols are excessively diversified and have grown too big, so that the Korean economy suffers from excessive ownership as well as industrial concentration. To curb the propensity of the chaebols to diversify and grow too big, many initiatives such as policies to promote business specialization and ownership diffusion have been undertaken. However, most of those policies have taken the form of regulating the business activities of chaebols, such as restrictions on entry, restrictions on ownership concentration and mutual assistance within the same business group, restrictions on bank borrowing, and measures to encourage business specialization, rather than directly attacking the sources or underlying reasons for the chaebols’ undesirable behaviors. Those policies have generally been 4. In general, the source of scope economies is the existence of public inputs, which are similar to public goods in consumption. “Information” is intrinsically of a public-input nature; therefore, diversification across different industrial activities utilizing the same information will benefit from economies of scope. In addition, improvement in computer and automation technologies will help develop multifunctional machinery that will become a public input to various related industrial activities, thereby creating or increasing economies of scope among those activities. All these possibilities suggest that economies of scope among economic activities will be strengthened as the result of technological innovations in the information industry.

316

Sung Hee Jwa

regarded as unsuccessful in achieving their stated goals, and a consensus seems to have been reached regarding the reformulation of industrial policies toward large business groups, especially in the emerging globalized economic environment. The paper organized as follows. Section 11.2 proposes a theory of endogenous industrial organization in order to investigate systematically the issues r a i ~ e dSection .~ 11.3 applies the theory in order to study the implications of globalization for industrial organization. Section 11.4 extends the discussion to the structure of Korea’s industrial organization, adds empirical evidence to the discussion by estimating scale and scope economies of Korea’s industrial activities, and speculates about future Korean industrial organization in a globalized market environment. Finally, section 11.5 provides concluding comments on industrial policy implications and the role of the government in industrial structural adjustment in the emerging globalized environment.

11.2 A Theory of the Scope of Industrial Activities 11.2.1 An Integrated Theory of Endogenous Economic Organization Stigler (1968) proposed a theory of the multiproduct firm based on Adam Smith’s theory of specialization. He suggested that a multiproduct firm’s scope of activities is determined by the interaction of production technology and market size. The most important concept in his theory is the economies of scale that characterize the production technology of the relevant industry. According to Stigler’s theory, activities subject to economies of scale tend to become detached from the remaining set of activities as the size of the market grows large enough to support a scale of production that realizes these economies. Conversely, activities subject to diseconomies or weak economies of scale tend to be integrated in-house. Even activities with economies of scale become integrated if the size of the market is limited or the remaining set of activities exhibits particularly strong diseconomies of scale that dominate the concerned activity’s economies of scale.6 Therefore, the equilibrium in a multiproduct industry consists of firms that either integrate various activities in-house or specialize in a single activity or subset of activities, depending on market size and the degree of (dis)economies of scale of the different activities. BPW developed a theory of the multiproduct firm,introducing the concept 5 . The theory presented in this section was originally developed in Jwa (1994). 6. See Stigler (1968): “Certain processes are subject to increasing returns; why does the firm not exploit them further and in the process become a monopoly? Because there are other functions subject to diminishing returns, and these are, on balance, at least so costly that the average cost of the final product does not diminish with output. Then why does the firm not abandon the functions subject to increasing returns, allowing another firm (and industry) to specialize in them to take full advantage of increasing returns? At a given time these functions may be too small to support a specialized firm or firms. The sales of the product may be too small to support a specialized merchant” (133).

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Globalization and New Industrial Organization

of economies of scope in addition to economies of scale. According to BPW, economies of scope are a necessary and sufficient condition for the existence of multiproduct firms (1982,248-49, props. 9B1 and 9B2). To facilitate discussion, we formally introduce the concepts of economies of scale and of scope through the following equations:

(1)

sN

=

c(y)

c y,

i= I

*

cc(y),

where S,, and S, measure the economies of scale for the full set of all products N and a subset of products T, respectively. SC, and SC, measure the economies of scope among all products N and between the subset products T and N - T, respectively. C(.) is the cost function; y is the full set of products, y = { y l , y2, . . . , y,}; where y , is the ith product; y , = { y,, . . . , yr, 0, . . . , 0 } , y,-, = ( 0 , . . . , 0, Y , + ~ ., . . , y”}, and y, = (0, . . . , 0, yz,0, . . . , 0). Cz(y)is the marginal cost of y , and [ C ( y ) - C(y,-,)] measures the incremental cost of the subset 7: Now, we can formally define economies of scale and scope using equations (1)-(4). S, > 1 implies overall economies of scale; S, = 1 implies constant returns to scale; and S, < 1 implies diseconomies of scale. Similarly, S, measures the product-specific economies of scale for the subset of products 7: If t = 1, S, measures the economies of scale for a single product. Similarly, SC, > 0 implies overall economies of scope; SC, = 0 implies constant returns to scope; and SC, < 0 implies diseconomies of scope. SC, defines the productspecific economies of scope between the subset of products T and N - 7: If t = 1, SC, defines economies of scope between a single product and the set of all other products. Using these concepts of economies of scale and of scope, BPW derived the following relationship (1982, 74):

(5)

s,

= [a,*

s, + (1 - a,) . S,-,]/[l

- SC,],

where

and S,-, measures economies of scale for the subset of products N - 7: BPW (1982, chap. 9) then discussed the competitive equilibrium configuration of a multiproduct industry. As a necessary and sufficient condition for the existence of a multiproduct firm, there must exist economies of scope among the subsets of products T and N - T :

318

Sung Hee Jwa

@-I) -_

(6)

---

- - _ - ~_ --..

\ 2

dT s T + ( l d T )

SN-Fl

sc, > 0.

To guarantee that potential economies of scale are fully exhausted in competitive equilibrium, the measure of overall economies of scale must show constant returns to scale in the neighborhood of the equilibrium: (7)

s,=

1.

One can integrate Stigler’s intuitive theory of specialization and BPW’s formal multiproduct firm theory into an endogenous theory of economic organization. Equation ( 5 ) can formally be interpreted as the equilibrium relationship between S, and S,-,, given the equilibrium conditions S, = 1 and SC, > 0, and can therefore be used as a framework for determining the feasibility of various types of multiproduct industry equilibria. Figure 11.1 shows a possible classification of various types of equilibria and associated ranges of S, and S+,. The negatively sloped, solid line representing equation ( 5 ) with S, = 1 and SC, = 0 (a,assumed to be 0.5 in this case) becomes an important reference line for classification. The region on and below this line can be called the multiproduct-firmdominant region. Stigler multiproduct firm equilibria, in which SC, = 0 and S,, = 1, coincide with the line and imply three possible cases: S, = 1 and S,-, = 1, S, > 1 and S,-, < 1, and S, < 1 and S,-, > 1. At the same time, BPW multiproduct firm equilibria, in which S, = 1 and SC, > 0, fall below the line and can, therefore, have three different cases: S, < 1 and S,-, <1 (Region I), S, > 1 and S,-, < 1 (Region 11-l), and S, < 1 and S,-, > 1 (Region 11-2). However, in no case are the simultaneous economies of scale S, > 1 and S,+, > 1 feasible in multiproduct firm equilibrium.

319

Globalization and New Industrial Organization

The region above the line, in which SC, < 0, could be called the singleproduct-firm-dominant region in which the equilibrium conditions S, = 1 and SC, > 0 cannot be satisfied. If t = 1 in this region, there can simultaneously exist single-product firms specializing in T and multiproduct firms with activities N - 1, given the multiproduct industry defined as a total set of activities N . The question of where the equilibrium points actually fall or what types of equilibria can emerge will be determined by the behavior of the industry cost surface (i.e., the production technology of the industry). BPW has shown that a multiproduct industry can have a representative firm competitive equilibrium only under very special assumptions about the cost surface. Otherwise, an equilibrium with a mixture of multiproduct and single-product firms will emerge.’ 11.2.2 Comparative Statics Exercises Changes in Market Size One can utilize the framework presented in subsection 11.2.1 to trace out the effects of a change in the scale of production due to a change in market demand. In equation (3,a,is defined as the share of output-weighted marginal costs of a subset of activities Tin the total set of activities N . Since marginal cost is equal to price in competitive equilibrium, a, can be interpreted as the ratio of the market values of y , to y,,., an increasing function of y , . Therefore, as market demand (size) for the set T of activities increases absolutely or relative to the set N - T of activities, the negatively sloped solid line in figure 11.1 will rotate counterclockwise (i.e., the absolute slope will decline) to the dotted line where a, = 0.8, for example, and region 11-1 defined by S, > 1 and S,-, < 1 will become smaller, implying that more activities in the set T of increasingly weaker economies of scale tend to become specialized. Under the same conditions, region 11-2 defined by S, < 1 and SN-, > 1 becomes larger, implying that more activities in the set N - T of increasingly stronger economies of scale tend to become integrated. Therefore, as market demand for specific activities increases, those activities are more likely to be specialized, and vice versa-exactly the implications of the Stigler theory. Changes in Production Technology In the case in which technological innovation creates greater degrees of economies of scope (SC,), S, becomes greater than 1 in equation (5). Therefore, the adjustment process will be analyzed depending on whether the newly created overall economies of scale can be easily exhausted. If market size is unlimited or large enough to allow the newly created overall economies of scale to be fully exhausted by scale expansion, then a new equi7. See BPW (1982, chap. 9, sec. 9D) for discussions about the existence and structure of multiproduct competitive equilibria. Propositions 9D6 and 9D7 specify the formal conditions for a single representative firm equilibrium.

320

Sung Hee Jwa

librium with S, = 1 and a higher SC, will be reestablished. As a result, under the new equilibrium, the activities will exhibit weaker scale economies, that is, lower S, and SN-=,than under the original equilibrium. In terms of figure 11.1, the line will undergo a parallel shift to the left, which in turn implies that only those activities subject to increasingly weaker scale economies remain feasible for integration. Another possibility is the continuation of disequilibrium due to the limited size of the market, since in this case the newly created overall economies of scale, S,, > 1, cannot be fully exhausted. If this case is combined with the implication of the Changes in Market Size exercise above, one can draw the conclusion that an industry with relatively small market size undergoing active technological innovation that creates larger SC, will tend to be subject to noncompetitive structure with excessive diversification or inadequate specialization.8 Therefore, as the degree of economies of scope among activities increases, the optimal scale of those multiactivity organizations and the potential to earn supranormal profits will increase, encouraging more multiactivity organizations. On the other hand, if activities that have not been part of multiactivity organizations experience a technological innovation that creates new economies of scope with the incumbent activities of those organizations, then they tend to be integrated within those organizations. In any case, the stronger or newly created economies of scope will imply the proliferation of multiactivity organizations.

11.3 New Industrial Organization under Globalized Markets One can summarize the main implications of the theory in a more simplistic way. First, as the size of the market increases, the optimal structure of industrial organization will be one with more specialization of activities under economies of larger scale and therefore with more specialized larger-size firms. Second, as technological innovation increases the degree of economies of scope, more diversified (multiactivity) firms will be encouraged. One can combine these two simple implications to derive an interesting hypothesis about the relationship between globalization and new industrial organization. Convergence of Industrial Organizations. Every economy will increasingly face identical potential market size and an identical set of available production technologies as the borderless global economy emerges. Therefore, as the world economy becomes more integrated and globalized, the optimal struc8. In fact, according to BPW (1982, chap. 7), overall economies of scale, S, > I , in the neighborhood of the initial equilibrium are neither necessary nor sufficient for cost subadditivity, which implies a natural monopoly. Therefore, while it is clear that the industry with S, > 1 becomes a natural monopoly in the single-product case, we can only conjecture that a noncompetitive industrial structure exists for the multiproduct case.

321

Globalization and New Industrial Organization

tures of industrial organization will converge among individual economies. This is because basically every firm in the fully integrated and globalized economy will eventually face identical market size and production technologies, that is, identical market and production envir~nments.~ Of course, individual firms may use their own business strategies, diverging from the optimal structure implied by and consistent with potential as well as existing market and technological opportunities, but those firms will ultimately be defeated by market conformists. However, there still exists the possibility that alternative structures targeting various markets could also survive, but only if they conform to the particular market aimed at-whether local, national, regional, or global.

Globalization and Large-Scale Production. Globalization is defined as an enlargement of potential market size, encouraging specialization of larger-scale production under strong economies of scale. According to this implication, one cannot definitively argue that the Fordist system will disappear, solely because of the largeness of production scale. Activities subject to strong scale economies will still survive in the large-scale production system in the globalized market environment. Market Share Competition and Small-Scale, Multiproduct Production. The intensified market share competition generated by globalization may imply reduction of market size for firms that are not successful in global competition. At the same time, as already mentioned, innovation in information technology increases economies of scope or network economies among various economic activities. If technology that reduces the optimal scale of production is introduced into this situation, the optimal structure of industrial organization may be small-scale, multiactivity production, which has been regarded as typical of the new post-Fordist, lean and flexible production system. Therefore, the background for the new system can be characterized as the following: As the market share of Fordist firms is reduced due to intensified market competition from new entrants, the large economies of scale that drove the old system become a burden, thereby motivating new efforts to amortize the large fixed costs associated with achieving the scale economies. These efforts will eventually help introduce multifunctional machinery, through auto9. This hypothesis may sound too strong if one insists that, for example, the nontradable sector will continue to be large and differences in resource endowments among economies will not easily disappear even in a fully globalized environment, as one of the commentators, Philip Lowe, suggested. Takatoshi Ito, the editor of this volume, also raised a similar point. However, what this hypothesis really intends to establish is that as firms in different economies face the same economic environment, the fittest survivors in these economies will be similar. In this sense, it can easily be understood that the persistent differences in economic environments will entail persistent differences in industrial organization. Therefore, the hypothesis amounts to assuming that economic environments, including such aspects as nontradable sector sizes and resource endowments, will converge among different economies as the economies become fully globalized.

322

Sung Hee Jwa

mation and other technological innovation, and multifunctional workers, both of which will help reduce the optimal scale by redistributing the large fixed costs to various multiactivities and at the same time help create strong economies of scope among those activities. The outcome will be the so-called smallscale, multiproduct flexible system.

Globalization and the Choices between Large-Scale and Small-Scale Production. According to the arguments made thus far, as the world economy becomes globalized, two opposing forces will emerge. One is the pressure for specialization due to growing market size, which may provide an improved environment for large-scale (i.e., Fordist) production systems. The other is the pressure for small-scale production and business diversification due to technological innovations creating larger scope economies and intensified market share competition, which will continue to provide a favorable environment for the new system. Therefore, globalization does not guarantee the diffusion of the new system, as claimed by Oman (1993, 1994). While the theory implies a convergence of industrial organization structures among national economies as globalization deepens, one cannot predict which system, Fordist or post-Fordist, will dominate. Depending on the size of a targeted market and the nature of technologies adopted by a particular industry, an optimal and efficient industrial and production system for that industry can be determined, however. One important result of this discussion is as follows: Private sector initiatives normally have a comparative advantage in determining the optimal structure for industrial organization in an increasingly globalized world economy. Because authorities are unable to sort out complicated implications or mixed signals from globalization phenomena and are unable to predict the exact optimal structure, deregulation or liberalization of the domestic economy may be an effective strategy in responding to globalization. 11.4 Globalization and Korea's Industrial Structure: Issues and Prospects In this section, we provide a brief discussion of the Korean industrial structure. We theoretically investigate the underlying forces driving that structure and discuss future prospects for the structure by estimating scale and scope economies of various industrial activities conducted by Korean business groups. 11.4.1 Brief Introduction to the Korean Industrial Structure'" In Korea, large business groups called chaebols consist of few lead companies and many subsidiary firms in various business areas under the control of a single owner-manager and his family members. The Korean industrial struc10. This section benefits greatly from Yo0 (1995).

323

Globalization and New Industrial Organization Chaebol Concentration Ratio: 30 Largest, Mining and Manufacturing (percent)

Table 11.1

~

~

~~________________

Ratio

1977 1981 1982 1983 1984 1985 1986 1987 1988 1989

Shipments Valueadded Fixed assets Employment

32.0 29.1 20.5

39.7 30.8 36.7 19.8

40.7 33.2 37.2 18.6

39.9 31.6 37.1 17.9

40.3 33.5 40.3 18.1

40.2 33.1 39.6 17.6

37.7 32.4 39.1 17.2

36.8 31.9 37.9 17.6

35.7 30.4 37.3 16.9

35.2 29.6 35.3 16.6

1990 35.0 30.0 32.2 16.0

Sources: Korea Bureau of Statistics; Korea Fair Trade Commission.

Table 11.2 Ratio Shipments Value added Fixed assets

Aggregate Concentration Ratio: 100 Largest Firms (percent) Korea (1990)

Japan (1984)

United States (1985)

West Germany ( 1984)

Canada (1983)

37.7 35.1 40.8

27.3” 33.0

-

33.0b 49.1

39.5 24.8 -

47.1 52.2

Source: Yo0 (1995). “1980. b1982.

ture has been dominated by the excessive industrial and ownership concentration and business diversification of these chaebols. Whether these observations are true is not clear. Nevertheless, Korean policy toward industrial organization has been framed on the premise that these observations are a true representation of the behavior of chaebols and that, furthermore, chaebols produce undesirable economic impacts on the efficiency of the national economy. Table 11.1 reports the economic concentration ratios of the 30 largest chaebols in the mining and manufacturing sector. The numbers suggest that the chaebols’ dominance has been declining since the mid-l980s, although the absolute degree of concentration seems still high indeed. To see whether the Korean case is exceptional by international standards, table 11.2 shows international data on aggregate concentration ratios that measure the weight of the 100 largest firms in the aggregate economy. This comparison shows that the Korean case is in fact not extraordinary. Korea’s concentration ratios in 1990 are comparable to those of developed countries in the mid-1980s. In the case of shipments concentration ratio, Korea’s value is higher than Japan’s for 1980 but comparable to West Germany’s. In the case of value-added concentration ratio, Korea’s value is comparable to that for the United States but much lower than Canada’s. Finally, the fixed assets concentration ratio suggests that Japan and Korea are low compared to the United States and Canada. Table 11.3 reports on the diversification behavior of chaebols. It turns out

324

Sung Hee Jwa

Table 11.3 Chaebol Top 5 Hyundai Sarnsung Daewoo LG Sunkyung Top 30

Number of Subsidiaries and Industries of Chuebols Subsidiaries”

Financial Companiesb

210 49 50 25 53 33 626

20 5 5

2 6 2 64

Industries Covere& (average)

30.4 36 34 27 32 23 19.1

Source: Korea Fair Trade Commission. *June 1994. bApril 1993. The numbers include only nonbank financial institutions because a chaebol cannot own more than 8 percent of the total outstanding stock of a commercial bank. In the manufacturing sector, chaebol companies are concentrated in KSIC 31, 32, 35, 37, 38 industries, although they are also present in other industries. ‘1993. The numbers are counted by two-digit KSIC industries.

that, on average, each of the five largest chaebols owns 42 subsidiaries, runs businesses in 30.4 nonfinancial industries, and owns 4 financial institutions. These numbers suggest that the extent of diversification of the largest chaebols is indeed extraordinary. In addition, table I I .4 is cited from Yang (1992) to investigate the nature of that diversification and to make an international comparison. According to this information, chaebols, compared to large firms in major developed countries, exhibit the highest weight of technologically unrelated diversification but the lowest weight of technologically related diversification. While Korea’s degree of diversification is very high among the sample countries, it is slightly lower than that of the United States. In sum, this comparison suggests that the overall picture of Korea’s diversification vis-2-vis developed countries could be characterized as a relatively high degree of diversification and an extraordinarily high degree of unrelated diversification. However, Yang ( 1992) observed that the overall degree of Korean diversification has been declining over time and that larger groups are consistently more diversified than smaller groups, implying that diversification has been the common chaebol strategy for business expansion. It is interesting, in this context, to note that in the United States from 1950 to 1975, the diversification behavior of large firms was much the same, with the major means of business expansion being diversification through mergers and acquisitions rather than internal growth (Scherer and Ravenscraft 1984). The high degree of business diversification may itself be a reflection of diversified ownership expansion and so could be interpreted as evidence of overall ownership concentration among a small number of people in the national economy. Table 11.5 provides data on degree of ownership concentration

325

Globalization and New Industrial Organization

Table 11.4

International Comparison of Degree of Business Diversification Based on the Rumelt Method (percent)

Q p e s of Diversification" Specialization Complete specialization (SR > 0.95) Partial specialization (0.95 > SR > 0.7) Diversification Related diversification (SR < 0.7, RR > 0.7) Unrelated diversification (RR < 0.7)

United United Korea Japan States Kingdom (1989) (1973) (1969) (1970)

West Germany France Italy (1970) (1970) (1970)

36.8

53.3

35.4

40.0

44.0

48.0

43.0

8.2

16.9

6.2

6.0

22.0

16.0

10.0

28.6

36.4

29.2

34.0

22.0

32.0

33.0

63.2

46.1

64.6

60.0

56.0

52.0

57.2

6.1

39.9

45.2

54.0

38.0

42.0

52.0

57.1

6.8

19.4

6.0

18.0

10.0

5.0

Source: Yang (1992, 13). The estimates are obtained by the method suggested in Rumelt (1986). Note: The number of business groups inclusive of vertical as well as horizontal business groups are 118 for Japan, 49 for Korea, and 100 for others. "SR (specialization ratio) = total revenues of the largest single business /total revenues of a whole business group. RR (related ratio) = total revenues of the largest subgroup of related businesses / total revenues of a whole business group.

Table 11.5 Ownership Within-group Family Subsidiary

Within-Group Ownership Concentration: 30 Largest Chaebols (percent) 1983.9

1987.4

1989.4

1990.4

1991.4

1992.4

1993.4

1994.4

57.2 17.2 40.0

56.2 15.1 41.1

47.2 14.7 32.5

45.4 13.7 31.7

46.9 13.9 33.0

46.1 12.6 33.5

43.4 10.3 33.1

42.7 9.7 33.0

Source: Korea Fair Trade Commission. Note: The table includes 616 subsidiaries of the 30 largest chaebols, out of which 164 companies are listed on the stock market as of the end of 1993, accounting for 56.8 percent of the total equity capital.

within the business groups themselves. According to these data, within-group ownership concentration was, indeed, high but has been declining since the mid- 1980s,which seems consistent with the trend of the chaebol concentration ratio observed in table 11.1. Looking at the composition, the family share has been steadily declining, but the share of subsidiaries through mutual stockholdings has been stable during the 1990s. These trends could be interpreted as a reflection of the following aspects: the rapid expansion of the capital market and the disincentive against individual share expansion in the case of family shares, and the general pattern of business expansion through diversification in the case of subsidiary shares.

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In sum, the facts about the Korean industrial structure seem to confirm the popular concern that it is not only highly concentrated in business and ownership but also highly diversified over wide areas of business. However, recent trends suggest that some of the problematic aspects of the Korean industrial structure have been alleviated. Especially, industrial concentration and ownership concentration are observed to be on the decline, probably reflecting the rapid growth of the Korean economy and the increased availability of sources of equity capital such as the capital market. In addition, it seems that although diversification has been and is still common as means of business expansion, it is not growing disproportionately either. Of course, it cannot be denied that various government regulations have also played an important role in generating these trends. Having discussed chaebol behavior, the corrective policies that have long been the subject of continuing controversy are now briefly discussed. One important problem with those policies has been the lack of attention paid to the substance, that is, the underlying causes, of chaebol problems and the measures needed to correct them. Rather, policies have tried to regulate the symptoms directly but without much success. All concerns about the various symptoms of chaebol behavior seem to boil down to the single most important phenomenon of excessive, octopus-like diversification.” That is because industrial and ownership concentration will be achieved through or will eventually end in business diversification one way or the other, and economic concentration due to specialization seems to be regarded as relatively benign and efficiency improving as reflected in the government policy emphasis toward specialization.12Therefore, regulatory measures against diversification have been the major focus of anti-chaebol policy, as follows: Industrial policy instruments such as entry regulations (including a license and permit system, ownership regulations, etc.) and business area regulations Regulations based on the credit control system, including prior approval requirements for investment, regulations on the purchase of land, and restrictions on entry into a new line of business Investment regulations to rationalize industries and to curb excessive or duplicative investments in many similar industries Designation and protection of small and medium-sized firms Regulations on total ceilings, such as basket control of credit supply (credit control system) and equity investment regulations (Fair Trade Act) 11. In Korea, chaebol diversification behavior has been nicknamed “octopus-like business expansion,” emphasizing the excessive degree of diversification. 12. Strangely enough, there is a widely held opinion among Korean policymakers that business expansion through specialization improves competitiveness but expansion through diversification does not. This is the background for the “industrial area specialization” policy, which is discussed below.

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Industrial area specialization policy (introduced in 1991 and reinforced in 1993): 30 largest chaebols advised to select their “core industries” and “core firms,” which then are allowed exemptions or preferential treatment in regulations such as credit control system, equity investment regulations, and so forth 11.4.2 Underlying Determinants of Korea’s Industrial Structure

One of the most intriguing aspects of Korean industrial policy, to begin with, is that it concentrates attention mainly on how to curb diversification without asking why chaebols tend to be so highly diversified. This aspect may explain why Korean chaebol policy has been of the symptom regulation type. However, why Korean firms are so “excessively” diversified is the most important question to be answered before any logically and empirically sound policy prescription can be made. Only in this way, can one rationally determine whether the current stance of the government’s industrial policy, the industrial area specialization policy that is intended to reduce the degree of business diversification of firms, can work or is an optimal policy. However, not much serious effort has yet been made to explain the diversification behavior of Korean business groups in a systematic way.I3 According to the theoretical discussions above, the following factors that form particular business environments for Korean business firms can explain the diversification behavior of chaebols. First, market size can be a critical factor. If the market for products subject to strong economies of scale is too small for the potential benefits of largescale production to be fully exploited, then a relatively high degree of diversification will result. Not only has the absolute size of Korea’s domestic market been particularly limited, but also the market share of Korean firms in the international market has been low despite Korea’s export promotion strategy from its early stage of development. Moreover, governmental support for industrial development in the form of easy policy loans gave major firms access to larger and larger resources. Therefore, in order to fully exhaust available resources, those firms pursued a diversification into various industrial activities that turned out to be individually underscaled. Second, the degree of economies of scope among industrial activities can be an important factor. Technological innovation during the past 30 years, including information technology, can be argued to have strengthened economies of scope or network economies among various industrial activities. This trend also promoted the diversification drive among Korean firms by alleviating the burden of otherwise inefficient diversification. 13. Yang (1992) has tested an implication of portfolio theory on the behavior of business diversification-that the possibility of reducing the variance of total profits of a business group by diversifying business activities can be an incentive for diversification-but has found that the empirical evidence is not consistent with this implication.

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Third, the business environment created by government policy can be an important factor. As shown in table 11.4, Korean firms diversify into technologically unrelated areas. This phenomenon cannot be easily analyzed within the theoretical framework of section 11.2. In order to explain this phenomenon, it seems necessary to grasp the nature of the business environment created by government industrial policy during the past 30 years. One salient feature of Korea’s interventionistic industrial policy is the government’s responsibility for a firm’s survival once the firm enters a designated business area.I4 Therefore, the government has taken every possible measure to revive those firms whenever they became inefficient and in danger of insolvancy. In this environment, the best choice for any firm may have been to make a preemptive move into a business area that is subject to government entry regulation because, once allowed to enter, the firm’s survival is guaranteed. I believe these three factors, individually or jointly, can explain the behavioral patterns of Korean firms or groups of firms with regard to business diversification. Unless these aspects are fully understood, one cannot determine whether the degree of diversification is excessive or not, and further, it will be difficult to devise a sensible policy prescription to alleviate the degree of diversification if it is indeed excessive. Judging from the above discussion, one may say that the current degree of diversification is rational given Korea’s particular business environment, including the pattern of national industrial policy. In this sense, therefore, one cannot definitively conclude that the degree of Korean firms’ diversification is excessive. Furthermore, even if the government judges the degree of diversification to be excessive for noneconomic reasons, rather the policy prescription would not directly set business boundaries for individual firms. One option is for the government to make an effort to change the business environment in order to induce the desired diversification level of firms. For example, if more specialization is desired, then the domestic market can be fully opened, and thereby firms’ efforts to globalize their business activities can be supported. Furthermore, the government’s policy of guaranteeing the fortunes of selected firms could be changed so that every firm is responsible for its own success or failure. This will help discourage not only so-called technologically unrelated diversification but also technologically related diversification behavior. 14. During the 1970s, when Korea pursued the so-called heavy and chemical industry promotion policy, the government actively intervened in selecting the firms or entrepreneurs to do business in specific areas and in providing the means to support them. If those selected firms were in danger of going bankrupt, the government intervened in arranging additional financial assistance or merger and acquisition procedures to save them. Since the 1980s, this pattern of government intervention has been mitigated but remains effective to some extent in a weaker form. The government still has strong influence on who can enter the business in the case of important industries such as automobiles, steel, etc. Concerning exit policy, the government has become much more lenient in letting noncompetitive firms to go bankrupt in recent years but is still very reluctant to see big firms in important industries fail. Therefore, the perception that “once allowed to enter, then easy to survive” has lessened but is still around.

Globalization and New Industrial Organization

329

Therefore, any antidiversification policy directly limiting the realm or range of business activities without correcting the business environment may not be effective and will create serious resource misallocation. 11.4.3 Globalization and Prospects for Korea’s Industrial Structure In this section, we estimate the scale and scope economies of industrial activities conducted by Korean business groups and speculate on future prospects for industrial organization in a globalized market environment. In order to estimate scale and scope economies, first, the following translog cost function of the 107 largest Korean business groups is estimated using 1992 and 1993 pooled data collected at the business group (firm) level:

where C, y, and p represent total costs, output vector, and input price vector, respectively, and ao,a,,P, , Y , ~ ,S,,, and g, are all parameters to be estimated; E is a disturbance term. Equation (8) is estimated with the following sets of restrictions: symmetry restrictions (9)

Yth

=

Yhr

and

‘11

=

‘I]

and linear homogeneity restrictions with respect to input prices K

(10)

cp,

,=I

K

=

1;

CS,,= 0 , 1

K

=

1,

. . . ,K ; c g ,

,=I

= 0, i = 1 , . . . , N ,

,=I

and with the following input share equation: K

(11)

K

sy = P, + c q/ w, + ,c gl, lny, + 57 =I I= I

where SH, is the share of expenditure on thejth input in total cost and E, is a disturbance term. The seemingly unrelated regression method is utilized, but one of the share equations should be dropped to avoid linear dependence due to the identity &YH, = 1.The joint estimation of equations (8) and (1 1) may help improve the efficiency of the estimates. Business activities are aggregated into seven groups, which are regarded as firms’ products, N = 7. The inputs are capital and labor, K = 2, but the capital share equation is dropped to avoid linear dependence. However, the rental price of capital input could not be measured and so has to be omitted. It is hoped that omitted-variables problems do not cause any serious bias in the estimation. Also, dropping the capital share equation in this case is hoped to alleviate possible problems due to the omission of capital input price. The list of product variables is reported in table 11.6. The estimation results for the cost function are reported in table 11.7. Based on the estimated cost function, scale and scope economies defined in

330

Sung Hee Jwa List of Variables

Table 11.6 Variable

Content

Total cost Sum of production cost, operating expenses, and nonoperating expenses

C

Products Textiles and wearing apparel Chemicals and chemical products Assembling metal products, machinery, and outfits, n.e.c. Other manufacturing Construction services Financial services Other services

Yi

YZ Y1

Y4

Y5 Y6

Y7

Input price Total wage fundkotal number of employees

PI

equations (1)-(4) are estimated and reported with respective Z-values in table 113. However, in the case of scale economies, instead of directly estimating the definitions given by equations (1) and (2), the inverse of those definitions are estimated because of the convenience in estimating Z-values in the latter case. Therefore, the interpretations given to the estimated scale economies should be appropriately changed. In addition, to investigate whether Korea’s industrial structure has a tendency toward natural monopoly, an estimation of the so-called concept of expansion path subadditivity is presented. Expansion path subadditivity (EPSUB), assuming two products, is given as follows:

(12) EPSUB

=

IC(y;4, Y ; )

+ C(Y;, Y:)

- C ( Y , ,YJI 1 C ( Y , , Y,),

where y , = yf + y ; and y z = y $ + y : , but y t l y ; , y y l y f , and yIIy2 are not necessarily identical. If EPSUB > 0, the industry tends to natural monop01y.~~ The estimates of EPSUB are also reported in table 11.8. The estimation results for scale and scope economies are especially interesting and can be summarized and interpreted as follows: 1. Almost all products are individually subject to constant returns to scale, but overall economies of scale turn out to be very strong. 2. Not only product-specific economies of scope but also overall economies of scope turn out to be very strong.16 15. See Berger, Hanweck, and Humphrey (1987). They suggested, as a criterion for a natural monopoly, the concept of expansion path subadditivity (EPSUB), which is an improvement on the concept of cost subadditivity. EPSUB allows product composition and output scale lo vary freely, whereas cost subadditivity can only be defined for a given composition and scale. 16. See n. 4 for a discussion of the general sources of scope economies. Figuring out the specific reasons for scope economies among various industrial activities in the current case would require highly technical investigation of various production technologies, which is beyond the scope of this paper.

Table 11.7

Estimation Results of ’Rams-log Cost Function

Independent Variable Constant InY, In Y 2 In Y , In Y4 In Ys In Y6 In Y7 In PI 1/2 (In yl)’ 1/2 (In yJ2 112 (In yJ2 1 /2 (In y,)* 1/2 (In yS)* 1/2 (Iny,)’ 112 (In y7)2 112 (InpJ2 In Y , . In y2 InY, ’ InY, Iny, . In y4 In y1 . In ys In YI ‘ In Y b In y , . In y7 In y2 . In y , In y2 . In y4 In Y? . In ys In y2 . In y6 In y2 . In y7 In y? . In y4 In y , . In ys In yi . In y, In Y , ‘ In Y7 In Y , . In y S In Y 4 ‘ In Y6 In y4 . In Y, In Ys ’ In Y6 In y s . In y7 In Yo ’ In Y7 I ~ P ,. l n y , In PI ’ In Yz In P , . In y 3 In P, . In Y& in Pi . In Y , In P , . In yb In PI ’ In Y7

Cost Function (eq. [8])

5.5841** (45.3209) -0.1026** (-1.9124) -0.0751** (-2.3191) -0.0259 (-0.9930) -0.0457 (-1.4427) -0.0177 (-0.4503) 0.1176** (2.9018) 0.0661** (2.1738) 0.1720** (9.6800) 0.0841** (6.3163) 0.0564** (6.7785) 0.0733** (11.3061) 0.0755** (9.8209) 0.0669** (6.2187) 0.0123 (1.1482) 0.0329** (4.0673) O.OOO4 (0.0466) -0.0081 ** (-2.4796) -0.0017 (-0.6749) -0.0025 (-0.9510) -0.0028 (-0.8272) -0.0050 (- 1.3874) -0.0092** (-2.8799) -0.0021 (-0.8431) -0.0011 (-0.4173) -0.0054** (-2.2057) - 0.0 125** ( - 3.8346) -0.0010 (-0.3409) -0.0062** (-2.8392) -0.0057** (-2.5835) -0.0075** (-2.3748) -0.0140** (-5.8224) -0.01 08** (-4.61 63) -0.0154** (-5.2947) -0.0073** (-2.8658) -0.0024 (-0.8665) -0.0116** (-4.1005) 0.0084** (2.3167) -0.0003 (-0.2961) -0.O004 (-0.4062) -0.0011 (-1.3669) -0.0019** (-2.1226) -0.001 1 (- 1.0597) -0.0004 ( -0.3918) -0.0049** (-5.1680)

Expenditure Share Function of Labor Input (eq. [Ill) 0.1720** (9.6800) -0.0003 (-0.2961) -0.0004 (-0.4062) -0.0011 (- 1.3669) -0.0019** (-2.1226) -0.0011 (-1.0597) -0.0004 (-0.3918) -0.0049** (-5.1680) 0.0004 (0.0466)

-

R2

SEE D-W

0.9443 0.3580 1.8737

Note: Numbers in parentheses are r-values. **Significant at the 5 percent level and above.

0.2099 0.0442 1.7491

332

Sung Hee Jwa Estimates of Economies of Scale and Scope

Table 11.8

A. Economies of Scalea

Overall Economies of Scale Estimate S.E.b Z

0.4426** 0.1476 3.7776

Product-Specific Economies of Scale yI

Y2

1.7949 1.6054 0.4952

Y3

0.3129 2.0049 -0.3427

-25.0824 86.0283 -0.3032

Ys

Y4

22.1624 56.3645 0.3755

-0.7157 3.0766 -0.5577

Yh

7.2440 10.9291 0.5713

Yl

8.4100 11.7893 0.6285

B . Economies of Scope'

Estimate S.E.b Z

Product-Specific Economies of Scope

Overall Economies ofscope

y,

2.7027* 1.4472 1.8675

0.5743** 0.2022 2.8402

YZ

0.5690** 0.2166 2.6268

Y3

0.6499** 0.3210 2.0248

YS

Y4

0.6779* 0.3977 1.7043

0.6942** 0.2702 2.5692

Yh

0.4398* 0.2440 1.8025

Y7

0.6129 0.4199 1.4595

C. EPSUB

Estimate S.E.b Z

EPSUB Id

EPSUB 11'

0.0002 0.0002 0.8779

-0.9891** 0.0068 - 145.298

"A scale economy here is measured by the inverse of the scale economy defined in section 1 I .2. Therefore, economies of scale, constant returns to scale, and diseconomies of scale are present if the estimate is less than, equal to, or greater than I , respectively, where Z is calculated as [(Estimate - I)/S.E.]. bAsymptotic standard error. cEconomies of scope, constant returns to scope, and diseconomies of scope are present if the estimate i n greater than, equal to, or less than zero, respectively. dEPSUB I = [ C ( y y , y;, Y;, Y:, Y;. Y:. Y'";) + c(y;-", y i p , yi-"', y p . yl-", yd-", ?;-"I - c(y:, y;, y;, Y;, Y;, YQ,Y;)]/c(Y;, Y;. Y ; , Y;, Y;, V ; , Y ; ) , where yyrepresents the sample minimum, Y ! represents the sample maximum, and f"' = y ! - y;. 'In the case of EPSUB 11, the sample mean is substituted for the sample minimum y y in EPSUB I. *Significant at the 5 percent level. **Significant at the 2.5 percent level.

3. Strong overall economies of scale may be present even without productspecific economies of scale because strong product-specific economies of scope are present. This possibility can be confirmed by the relationship among the concepts of economies of scale and scope given by equation (5). 4. Korean business groups' incentive for diversification can be seen to stem from particularly strong economies of scope present among various business activities because strong economies of scope imply cost savings through diversification.

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Globalization and New Industrial Organization

5. There does not seem to be a strong tendency toward natural monopoly in the Korean industrial structure since the estimated EPSUB is not significantly different from zero in one case (EPSUB I), implying no superiority of larger over smaller scale, or significantly less than zero in the other case (EPSUB II), implying the superiority of small over large scale. 6 . Globalization may not be effective in driving industrial structure toward more specialization because (1) almost all industrial activities are individually subject to constant returns to scale, and so the scale of production and the degree of specialization will not be very much affected by globalization in the sense of increased market size,” and (2) the economies of scope among industrial activities that are already strongly present will be further strengthened by globalization in the sense of innovation in information technology and microelectronics. Therefore, there exists the possibility that globalization will further strengthen the incentive for diversification over existing industrial activities. Furthermore, if domestic-market-oriented chaebols become losers in the market share competition with foreign exporters, they will tend to retreat from their existing specializations and move toward more diversification as already discussed. However, it is also possible that if globalization brings forth technological innovations that create new economies of scale for certain industrial activities, the specialization of those activities will be encouraged as the size of the market expands. The empirical evidence given in this section could be biased and misleading because the data are so highly aggregated that the estimated technological relationships among the seven groups of industrial activities could be particularly difficult to interpret sensibly. Furthermore, the omitted-variables problem due to the omission of capital input price could also be a cause for concern in this respect. However, having conceded those potential flaws, it is still interesting to observe that the actual diversification behavior of Korean business groups is not inconsistent with that implied by empirical measures of scale and scope economies. In other words, the empirical evidence suggests that chaebols in more technologically diverse business areas will dominate over specialized chaebols in limited lines of business, and the actual pattern of behavior seems to confirm this. Therefore, government efforts to reduce the degree of diversification may not be effective. However, in terms of the types of diversification, the empirical evidence summarized in item 4,above, strongly implies that the majority of diversification by Korean firms will be technologically related and so this diversification behavior may not be as worrisome as politicians, the general public, and economists in Korea believe it to be. But this evidence and its implications are incon17. It could also be the case that sales increase along the horizontal supply curve even under constant returns to scale as the demand curve shifts out. I am indebted to Takatoshi Ito for reminding me of this possibility. However, it is still the case that a firm with constant returns to scale will have less incentive to expand when the demand curve shifts out than one with increasing returns to scale.

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sistent with the evidence cited in table 11.4.18This empirical discrepancy could be an interesting issue to clarify in the future research.

11.5 Concluding Remarks It seems to have become popular recently for governments to experiment with one form or another of an industrial policy that has been adopted by successful East ‘isian economies such as Japan, Taiwan, and Korea.19This tendency becomes even more conspicuous in discussions of possible policy responses to the “unlimited competition” forced by globalization. An increasingly common view seems to be that the government should help business firms successfully compete in the international market-in particular, that the government should intervene, to a large extent, in adjusting industrial structure to a globalized competitive environment. The arguments made in this study suggest the following implications in relation to this new trend in industrial policy. Above all, globalization is a diversified and sometimes contradictory phenomenon that has different economic implications depending on the context. Therefore, it is especially difficult for a government to choose a particular industrial structure as optimal for its economy. One can further conjecture that economists’ search for an alternative industrial organization to the American Fordist, German Craft, and even Japanese network production systems will not yield any definitive, single answer. Therefore, instead of adopting an industrial policy that requires a tremendous volume of information and does not easily produce the right solution, an effective response to globalization may be to let the market order prevail in discovering an optimal business structure and, for this, let the private sector freely make structural adjustments. The basic viewpoint concerning the role of government economic policy taken in this paper is based on the Hayekian philosophy.20There exists a market order in the economy that arises endogenously and spontaneously, independent of outside intervention. Competition in the market order is a process of discovering the optimal outcome. Therefore, one cannot discover or dictate the market outcome in advance without going through the competition process. According to this view, the government’s role is confined to preserving the spontaneity and endogeneity of the market order and cultivating a better envi18. It may be the case that Korea’s unrelated diversification is overstated in table 11.4 as the result of using a cutoff relation ratio (0.7) that is too high. Note that a cutoff point of 0.7 was recommended by Rumelt (1986). but without much justification. However, no one can tell a priori which cutoff number will be right. 19. A lengthy discussion of the nature and characteristics of industrial policies in those East Asian economies is found in World Bank (1993). This study suggests that while government intervention was helpful under certain conditions, the most important factors in the East Asian Miracle were macroeconomic stability and the market-conforming economic policies followed by these economies. 20. See Hayek (1984, 1989) for his philosophical position on economic policy making.

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Globalization and New Industrial Organization

ronment for the working of the market order. To this end, the government may establish a regime of fair competition in the economic and social systems so that the discovery function of the market order can be cultivated to the maximum. To put it concretely, the role of the government in this framework is limited to defining the economic and social environments-that is, determining the exogenous variables for the market order, while the determination of the endogenous variables is left to the market order. If the government wants to influence the endogenous variables, it must participate in the market order in the same manner as private economic agents, or change the environment or incentive structure of the market order in such a way as to influence the endogenous variables in the desired direction.

References Baumol, William J., John C. Panzar, and Robert D. Willig. 1982. Contestable markets and the theory of industry structure. New York: Harcourt Brace Jovanovich. Berger, Allen N., Gerald A. Hanweck, and David B. Humphrey. 1987. Competitive viability in banking: Scale, scope and product mix economies. Journal of Monetary Economics 2O:SOl-20. East-West Center, ed. 1994. Globalization and regionalization: Implications and optionsfor the Asian NIEs. Conference Papers. Honolulu: University of Hawaii. Hayek, F. A. 1984. Competition as a discovery procedure. In The essence of Hayek. Stanford, Calif.: Hoover Institution Press. . 1989. The pretence of knowledge. American Economic Review 79:3-7. Herrigel, Gary, and Charles F. Sabel. 1994. Craft production in crisis: Industrial restructuring in Germany during the 1990s. In Globalization and regionalization: Implications and options for the Asian NIEs, ed. East-West Center. Honolulu: University of Hawaii. Jwa, Sung-Hee. 1994. Endogenous financial system: Theory and evidence. Seoul: Korea Development Institute. Mimeograph. Lawrence, Robert Z., Albert Bressand, and Takatoshi Ito. 1994. A new vision for the world economy. Brookings Project on Integrating National Economies. Washington, D.C.: Brookings Institution. Oman, Charles. 1993. Globalization and regionalization: The challenge for developing countries. Paris: OECD Development Centre. . 1994. Globalization and regionalization: Key issues and interactions. In Globalization and regionalization: Implications and options for the Asian NIEs, ed. EastWest Center. Honolulu: University of Hawaii. Rumelt, Richard P. 1986. Strategy, structure and economic performance. Boston: Harvard Business School Press. Scherer, F. M., and D. Ravenscraft. 1984. Growth by diversification: Entrepreneurial behavior in large-scale United States enterprises. Zeitschriftfur Nationaliikonomie, Suppl. 4: 199-218. Stigler, George J. 1968. The division of labor is limited by the extent of the market. In The organization of industry, ed. G. J. Stigler, 129-41. Homewood, Ill.: Irwin. Westney, D. Eleanor. 1994. The large Japanese industrial firm as a network organiza-

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tion. In Globalization and regionalization: Implications and options for the Asian NIEs, ed. East-West Center. Honolulu: University of Hawaii. World Bank. 1993. The East Asian miracle. New York: Oxford University Press. Yang, Won Keun. 1992. Daekiup JipDan eui Hyoyulsung Bunsuk (Analysis of the efficiency of large business groups). Research Report no. 250. Seoul: Korea Institute for Industrial Economics and Trade. Yoo, Seong Min. 1995. Chaebols in Korea: Misconceptions, realities, and policies. KDI Working Paper no. 9507. Seoul: Korea Development Institute.

Comment

Mahani Zainal-Abidin

Sung Hee Jwa proposes that under the condition of globalization, governments can allow their private sectors to respond freely to structural change forces. Market expansion and improvement in information technology will induce endogenous organizational change through economies of scale and scope, and this change will determine firms’ specialization and competitiveness. This proposal merits further examination, particularly in the context of developing countries. In many developing countries, for example Malaysia, industrial structure is dualistic. The export sector is dominated by large multinational firms while small-scale firms concentrate on the domestic sector. In Malaysia, foreign direct investment (FDI) constitutes more than half of total investment, and in 1994, 80 percent of FDI flowed into the manufacturing sector, the largest contributor to exports. FDI is mainly in the electronics industry. In most cases, one could also associate economies of scale with this pattern; large firms usually enjoy increasing returns to scale while smaller ones experience constant returns. The effect of globalization on existing production and the subsequent reaction through industrial policy must be viewed in this light. A large-scale production system will be able to take advantage of globalization conditions-its capital, skill, and technological capacity will be able to respond to competitive forces and its production system will develop increased specialization and scope of activities. It is possible that a Fordist system will not have to be reorganized into small-scale, multiactivity units but can instead become a large-scale specialized system with a very short product cycle. Small firms in developing countries, unlike those in developed countries, may be slower to respond. These firms usually engage in low-value-added activities, and many may lack full access to information technology and their unskilled labor may be incapable of moving to higher-skilled production processes. Furthermore, very few of these small firms operate or utilize R&D activities. In developing countries, this duality can have far more serious implications Mahani Zainal-Abidin is associate professor in the Division of Applied Economics at the University of Malaya, Kuala Lumpur.

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Globalization and New Industrial Organization

than in developed ones, in terms of the convergence of industrial organizational structures. The presence of nonhomogeneous firms may mean that the increased integration of the world economy will not result in individual economies’ moving toward the optimal industrial organizational structure. Those firms that can quickly compete and benefit from globalization and internationalization will grow much faster than those that need time to react. The duality will persist, and if convergence finally occurs it will be over a considerable adjustment period. In addition, most of the activities of multinational corporations in developing countries are still at the lower end of the technology and slulls range, while the industrial structure reorganization mainly requires changes at the top end of the value-added chain, namely, design and research. In such cases, competitive firms will be more likely to move production closer to design centers in order to minimize production time and cost. Unless developing countries upgrade their technology and skills, their industrial development will lag. The above considerations suggest the need for industrial policy to take account of the growth of globalization. As Jwa states, industrial policy among newly industrialized economies of identifying sectors to be promoted as “exports stars” is most probably inappropriate for coping with globalization. Jwa’s proposal, that the private sector determine the direction of structural adjustment, is thought to be most suitable to meet this challenge. A liberal environment is the best solution to rapid market change; policymakers and government take a longer time to respond to changes and should not be deeply involved. However, structural adjustments that result from private-sector-led industrial policy may not meet the broader needs of a developing economy. Any industrial policy has to balance these two objectives: to steer a well-founded industrial development that can also respond to rapid international reorganization. While old production systems aim at minimizing cost for a given product and process, the new ones should be geared to continuous improvement. A primary objective of most, if not all, industrial policies is to promote competition. Thus, industrial policies must minimize intervention while strengthening economic foundations such as labor skills and technological capability. Laws and regulations that disallow free entry and withdrawal, such as antitrust laws, cartels, and overprotection of workers, will delay industrial reorganization. In fact, entry into any industry should be facilitated by the ready availability of credit, competitor information, business services, arrangements for sharing physical infrastructure, and the existence of a network of suppliers (Best 1990). In addition, liberalization of financial markets and the tax regime will reduce the cost of capital and, thereby, the cost of doing business. The new industrial policy for both developed and developing countries should complement private sector efforts. It should not identify sectors (because governments may not have full information about which sectors to choose, and they are usually slow in reacting to market signals) but should provide an environment conducive to industrial growth. Yet, governments have

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to ensure balanced industrial development that will benefit all sectors of the economy. In particular, in an internationally competitive scenario, new indigenous firms developing without any information technology network will be at a competitive disadvantage. The government could encourage and facilitate the relevant information technology R&D that will help these firms to extend their economies of scope. R&D work is often too expensive to be borne by individual firms, whereas the use of government resources for this purpose will benefit the whole country. As mentioned earlier, one aspect of industrial development in developing countries that has raised concern is the overdependence on multinationals; can successful industrial development be achieved only by large firms? Here, the example of “Third Italy” is worthy of mention because it shows how small firms met the challenge and the positive role that can be played by the public sector. Developing countries should follow the example of a developed country (Italy) where globalization challenges can be met not only by large firms but also by small ones. “Third Italy,” located in the north central part of Italy, has many groups of small firms. Perhaps due to their small size, such firms have entrepreneurial tendencies and pursue a strategy of continuous innovation, deploy flexible production methods, and integrate planning and production work (Best 1990). Ninety percent of the manufacturing firms there employ under 100 persons, and they account for 58 percent of the total workforce. Over a third of the workforce is self-employed. This region accounts for approximately 10 percent of Italy’s exports and is famous for racing cars (Ferrari and Maserati), ceramics (40 percent of the world‘s ceramic tile exports), and textiles and clothing (Benneton). Two factors have helped to make this success story: firm organizational structure and extrafirm institutions. The lead firms that deal with external organizations are supported by two layers of internal firms. The first layer comprises traditional firms that produce for the local market. They supply highquality products to the lead firms for centralized production. The second are design-dependent firms that carry out subcontract work for the lead firms. There are also design-independent firms that are not formally linked to the production chain. Although the success of “Third Italy” was achieved without creating the managerial hierarchy normally found in large organizations, it was supported by an interfirm association with public sector functions. These quasi-public, nonprofit associations (e.g., the Confederazione Nazionale dell’ Artigionato) are formed to serve specific needs of member firms and are accountable to the government, but they are managed by the private sector. They supply administrative services and also lobby the government on behalf of their members. Thus, the ability of industrial structures to meet globalization challenges may not lie just in themselves but in a network of supportive firms and a government industrial policy that promotes cooperation rather than intervention. This paper has raised many very interesting and important issues about fu-

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ture challenges for industrial organizations and about the optimal way to meet these challenges. Their implications are far-reaching, and these issues will surely be further debated and deliberated.

References Barro, R. J., ed. 1989. Modern business cycle theory. Cambridge, Mass.: Harvard University Press. Best, M. H. 1990. The new competition: Institution of industrial restructuring. London: Polity. Douglas, S., and C. S. Craig. 1989. Evolution of global strategy: Scale, scope and synergy. Columbia Journal of World Business 24 (3):47-59. Henderson, J. 1989. The globalisation of high technology production. London: Routledge.

Comment

Philip Lowe

I found this a very interesting and stimulating paper. It addresses an issue that is bound to confront all governments that have run, or have a predilection to run, interventionist industrial policies. I think it also has some lessons for governments thinking about the implications of globalization for the formulation of domestic antitrust policy. As I interpret it, the central argument of this paper is that attempts by the Korean authorities “to encourage” a greater degree of industrial specialization may be unwise because there is no reason to believe that government officials are in a better position than the private sector to determine what is the optimal structure of a firm. Instead, governments should be creating an environment that does not distort private decisions about organization structure. The conclusion that is drawn is that deregulation of the economy may be the best response to globalization and that the government should not be trying to engineer a particular form of industrial organization. The paper argues that globalization will surely affect the optimal organizational structure of firms, but we are not sure in which way, and its impact will differ across industries depending on their cost structures. On the one hand, by allowing firms to exploit larger economies of scale, globalization might be expected to lead to fewer multiproduct firms, with more specialized large firms. On the other hand, the increased economies of scope that accompany the twin processes of globalization and improvements in information technology will lead to more multiproduct organizations. Either way, the prediction seems to be that globalization will lead to larger firms. I find it difficult to disagree with the broad conclusions of the paper-deregPhilip Lowe is chief economist in the Economic Analysis Department at the Reserve Bank of Australia.

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ulation is a good idea, and globalization makes it an even better idea. However, like a good economist I have two hands-just as deregulation of the financial sectors in many countries led to a number of unexpected and unwelcome consequences, the same is possible here. This does not mean that it should not be done, but rather, it means that one needs to be careful. The starting point from which deregulation occurs is important. Given that Korea starts with such a concentrated industrial structure, there is no guarantee that the private deregulated market will necessarily end up at the optimal industrial structure, whatever that is. The conglomerates may be able to use their market strength to protect their own position from changes that are in the best interests of the economy. Certainly, antitrust authorities in a number of countries do not see it as in their country’s interest to leave the industrial structure to be determined completely by the “free market.” Suppose for the sake of argument that the optimal industrial structure for the production of intermediate goods is one like Taiwan’s, with many smallscale horizontally integrated enterprises (see Rodrik 1988; Feenstra, Yang, and Hamilton 1993). Given that Korea is not starting with a clean slate in that large conglomerates already exist-and they exist not as the result of market outcomes but because of government intervention-would this optimal organizational structure come to exist in Korea if left solely to the free market? I do not know what the answer is, but there are reasons to suspect it is no! The conglomerates enjoy ready-made customer markets, contacts, and easier access to finance. This may make it harder for small firms producing innovative intermediate goods to establish themselves in the market. The financial depth of the conglomerates also allows them to withstand market forces for structural change for a lengthy period of time. This may not be in the country’s best interest. To my mind, the financial structure of the conglomerates is one of the areas where they have the greatest potential to cause difficulties-in a way, one can think about the problem as a negative economy of scope. The relationships within the group allow individual enterprises to run with higher levels of debt than would otherwise have been the case. They also allow long-term planning so that investment decisions need not be influenced by short-term funding problems or fluctuations in demand. This is often seen, quite rightly, as a considerable advantage. However, it brings with it a danger, a danger that is probably increased with internationalization. The danger is an increased susceptibility to shocks. The high level of leverage makes it more difficult to deal with various types of shocks and thus poses a risk to economic stability. The financial arrangements also create the possibility of less than objective monitoring of firms’ decisions. As the economy becomes increasingly integrated into the world economy, external shocks-for example, !arge changes in the exchange rate or a world recession-tend to become more important. High levels of debt can make it difficult to weather these macroeconomic shocks and can therefore increase the potential instability of the economy. What is going on now in Japan might have lessons in this regard.

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In thinking about the role that the government should play in promoting the most advantageous industrial structure, the privatization debates and experiences in a number of countries are also instructive. Over the past decade and a half, numerous governments have decided that large state-owned monopolies were not providing efficient low-cost, high-quality services. While the principle that the relevant activities are best undertaken by the private sector was widely accepted, governments did not just simply privatize the existing government monopoly. In many cases, they broke down the monopoly directly or gavehold licences to other private providers so that there were multiple firms providing the services or goods. Competition among the various firms has often been the key to gaining the large efficiency dividend. I do not feel qualified to provide any prescriptions for the Korean situation. It is sufficient to say that governments do have a role to play in creating an environment in which the free market delivers the highest gains from globalization. If the government steps back and is agnostic about industrial structure, we may end up with the right answer, but there is a strong chance that we will not. Antitrust departments around the world are evidence that governments find it in their interest to at least set some of the parameters within which competition occurs. The following comments relate to specific points made in the paper. The paper argues that the spread of information technologies and globalization are inextricably linked. While I am not sure which way the causation goes, the argument is surely right. Where I think there is more room for question is the next step in the argument; that is, improvements in information technology lead to stronger economies of scope between various economic activities and, thus, make it increasingly difficult to isolate a particular activity from other activities. I found this a thought-provoking proposition, but I would have liked to have seen a few examples and some more details of the type of economies of scope that Jwa has in mind. While the argument may well be right, it is possible that improvements in information technologies might actually reduce economies of scope. Let me provide an example. The increased use of computerized information technology makes it easier for firms to prepare detailed information on their operations. This information is obviously useful internally but may also be useful to other firms and financial institutions with which one is dealing. If this is the case, it may reduce the need for the monitoring of firms to be done internally. By improving information flows, firms may have greater access to external funding from unrelated sources. Given the importance that the financing side has played in the development of the conglomerates, better information flows may weaken the rationale for the existence of the conglomerates. One area where I think that globalization may actually increase economies of scope is unrelated to information technology. When firms enter foreign markets, brand or name recognition can sometimes be very important. If a firm is unknown, has no distribution network, and has limited information about the structure of the foreign market, entry can be quite difficult. On the other hand,

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if a conglomerate has entered a market with a particular product and established name recognition, it may be easier for it to enter with an unrelated product later on. If, for example, Samsung develops a car for export, previous success in exporting consumer electronics may make it easier to establish a position in the auto market. People know and trust the brand name “Samsung.” In a world where product differentiation within a product group is becoming more and more important, name recognition is also likely to become more important. There may also be economies of scope in terms of information collection by the firm. Conglomerates may be able to pass market intelligence information between divisions more easily and cheaply than could unrelated firms. To the extent that obtaining and assessing knowledge about foreign markets represents a substantial cost, information economies of scope may be quite important. On the empirical work in the paper I have only a few minor comments. First, the only cost of production included in the estimated trans-log cost function is labor costs. I appreciate the difficulties of getting a good measure of the cost of capital. However, the paper does not discuss raw materials costs, which tend to account for a fair share of manufacturing costs. Given the importance of raw materials, a couple of price indexes for key raw material inputs might be usefully included in the estimated equation. The second issue is whether all firms lie on the minimum cost curve. I know that in the finance industry differences in costs between firms of a given size and product mix are considerably larger than differences caused by scale economies. I do not know whether this is the case in Korean manufacturing, but it may be worth exploring. Having said that, in the finance industry, taking account of differences in “X-inefficiency” through using fixed effects estimation or other techniques makes little difference to conclusions about economies of scale and scope. Third, in the discussion of the empirical results I would like to have seen a little more discussion of why there are such strong and consistent economies of scope. In which industries are these economies of scope strongest, and what is it about the production technology that gives rise to these economies? How does increasing globalization affect these economies of scope? Finally, one minor point. In section 11.3 it is argued that as the world economy becomes more integrated, the optimal structure of industrial organization will converge across countries. I am not so sure about this for two reasons. First, despite the trend to globalization, many industries remain nontradable. In the nontraded industries, customs and institutions can be important. If these differ across countries or demand for various nontraded goods differs across counties, industrial structures may well also differ. A related point is that despite the growth in world trade, many industries in the economy are not subject to international competition. A consequence of this is that the existence of international competition should not be used to justify complacency about the degree of competition in nontraded industries where there are few domestic

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firms providing goods or services. The second, and probably more important, reason that I am doubtful about the convergence of optimal industrial structures is that each country has a different set of resource endowments. Different resource endowments mean that countries produce different goods. The fact that the product mix is different may well mean that the optimal industrial structure is also different.

References Feenstra, R., T.-H. Yang, and G. Hamilton. 1993. Market structure and international trade: Business groups in East Asia. NBER Working Paper no. 4536. Cambridge, Mass.: National Bureau of Economic Research. Rodrik, D. 1988. Industrial organization and product quality: Evidence from South Korean and Taiwanese exports. NBER Working Paper no. 2722. Cambridge, Mass.: National Bureau of Economic Research.

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12

Bilateral Negotiations and Multilateral Trade: The Case of Taiwan-U.S. Trade Talks Thin-Jy Chen and Meng-chun Liu

12.1 Introduction It is widely recognized that the multilateral trading system embodied in the GATT has played an instrumental role in expanding world trade and supporting the phenomenal economic growth the world has experienced since World War 11. Even a nonmember like Taiwan has benefited from access to increasingly open markets in industrial countries, particularly the United States. Immediately after the war, as a hegemonic power, the United States championed multilateralism in world trade and led the way in successive multilateral negotiations for trade liberalization. This effort created international public goods on which even a nonmember like Taiwan can ride free. Since the 1970s, however, the United States has resorted with increasing frequency to unilateral measures to solve trade problems. The 1974 U S . Trade Law provided the U.S. Trade Representative (USTR) with a set of weaponry for practicing unilateralism, such as the Section 301 provision, and strengthened safeguard measures. Armed with these weapons, the USTR undertook bilateral negotiations to achieve “orderly marketing arrangements,” such as voluntary export restraints and the Multi-Fiber Arrangement, to shield domestic U.S. industries from import competition. Antidumping and countervailing duty cases also became more commonplace, effectively deterring aggressive pricing strategies by importing countries. Unilateralism was heightened even further in the 1980s as the U.S. trade deficit rose to an unprecedented level. Reciprocity and the “level playing field” became catchphrases of U.S. policymakers. In addition to measures restraining Tain-Jy Chen is professor of economics at National Taiwan University and a consultant to the Chung-Hua Institution for Economic Research. Meng-chun Liu is an associate research fellow at the Chung-Hua Institution for Economic Research.

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imports, the USTR negotiated vigorously for access to foreign markets, with the targets being the former developing countries that had succeeded in industrializing. Bilateral talks on tariff concessions and other market access issues became regular tasks of the USTR. The enactment of the Super 301 and Special 301 provisions in the 1988 U.S. Omnibus Trade and Competitiveness Act brought unilateralism to a climax. It is generally believed that a bilateral approach to world trade problems is inferior to a multilateral approach. A bilateral approach may not even produce a second-best solution (Krueger 1993, 184). The economic costs of VERs and the MFA have been well documented (see, e.g., Hufbauer, Berliner, and Elliot 1986; de Melo and Tarr 1990; Cline 1990). The problems associated with safeguard measures have also been widely discussed (see, e.g., Boltuck and Litan 1991). In comparison, the bilateral approach to market opening has not been analyzed in great detail. Krueger’s (1993) exploration of the bilateral trade negotiations between South Korea and the United States and Ito’s (1993) analysis of those between Japan and the United States are exceptions. The basic conclusion of Krueger’s investigation is that forcing Korea to open its market under the threat of the Super 301 provision not only represents a departure from GATT principles but also conflicts with the general U.S. policy goals toward developing countries. The purpose of this paper is to examine bilateral trade arrangements between the United States and Taiwan, one of its major trading partners targeted for market access in the 1980s. Taiwan is similar to Korea in terms of its asymmetrical bargaining power vis-a-vis the United States. However, Taiwan may hold even fewer bargaining chips than Korea, making it more vulnerable to U.S. threats of trade sanctions. The United States generally prevailed throughout the bilateral negotiations. A study of the Taiwan-US. case may reveal whether the results of bilateral negotiations dominated by the United States conform to the multilateral principles espoused by the United States. The rest of the paper is arranged as follows. In section 12.2, we examine the history of bilateral trade arrangements between Taiwan and the United States, focusing on export restrictions and market access issues other than tariff concessions. The cases in which Taiwan practices trade preference are identified and their background discussed. In section 12.3, we present a political economy model to explain the results of Taiwan-U.S. bilateral negotiations on tariff concessions. It is found that, although the USTR may not consciously produce a list of demands for tariff concessions based on the political influence of domestic interest groups, the negotiation outcomes often reflect the lobbying power of these groups. U.S. commitment to the multilateral system, meanwhile, serves as an effective moral persuasion for Taiwan to follow a similar course of trade liberalization.

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12.2 Bilateral Trade Arrangements between Taiwan and the United States The United States first engaged Taiwan in a bilateral trade agreement in 1962, when Taiwan agreed to voluntarily restrict its exports of cotton textiles and apparel products to the United States. The agreement was negotiated under the auspices of the Long-Term Arrangement for Cotton Textiles, which is primarily an unilateral regulation instituted by the United States to curtail textile imports from Japan, Hong Kong, and Korea, as well as Taiwan. Despite this voluntary export restraint (VER) so agreed, Taiwan’s exports of textile products to the United States continued to increase rapidly, with man-made fiber products accounting for most of the growth. The United States, in turn, pressured Taiwan, along with Japan, Hong Kong, and Korea, in 1971, to enter into new bilateral agreements aimed at limiting their exportation of woolen and manmade textile and apparel products. These bilateral actions initiated by the United States turned into the Multi-Fiber Arrangement (MFA) in 1974 under the purview of the GATT, allowing other members of the GATT to follow suit in setting geographical quotas to restrict trade in textile and apparel products. The agreement, which is an obvious violation of multilateralism, prevails to this day. The frequency with which the United States used VERs to contain trade flow increased substantially in the 1970s. The backdrop of this increased unilateralism was the promulgation of the 1974 Trade Law, which empowered the USTR (under Section 301) to retaliate against U.S. trade partners who engage in unfair trade practices. Fearful of trade sanctions, trade partners, particularly those depending asymmetrically on the U.S. market for export, usually succumbed to U.S. pressure by “voluntarily” restraining those of their exports deemed (by the United States) injurious to an orderly domestic U.S. market. Taiwan agreed to a VER on nonrubber footwear in 1977 and a VER on color television sets in 1979. It has been shown theoretically and empirically that a VER may not hurt constrained exporters because it raises the price of the exported goods under the imperfect market assumption (Feenstra 1984; Harris 1985; Ries 1993). There is also the possibility that the quality of the export products will shift upward in response to such a quantity restriction, resulting in an upgrading of the industry (Falvey 1979). A study by Aw (1993) estimated the price increase of Taiwanese footwear during the VER-effective period of 1977-81 to be as high as 18 percent. A study by Aw and Roberts (1986) also confirmed significant quality improvement in Taiwanese footwear exports during the VEReffective period. It must be noted, however, that an abrupt restriction on the expansion of a booming industry just as it begins to show some prominence may undermine the incentive for further investment by existing firms in the industry and deter new entry. This may smother the industry before it has a chance to become

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truly internationally competitive. Taiwan’s TV industry, which was subjected to a VER in 1979-82 and shrank quickly after the mid-l980s, might have been a victim of such a “bud-picking” policy. In analyzing the impact of U.S. VERs on Korean exports, Nam (1993) also expressed concern over the adverse effect of VERs on the long-term competitiveness of the constrained industries. In addition to deferment of domestic investment, he also pointed out that allocation of export quotas may constitute an entry barrier that protects existing inefficient firms. U.S. unilateralism became even more aggressive in the 1980s as the United States suffered from increasing trade deficits and extensive unemployment at home. Under pressure from the National Machine Tool Builders Association, which pleaded for trade protection under Section 232 (safeguarding national security) of the Trade Expansion Act of 1962, the U.S. government engaged Taiwan, along with Japan, in bilateral negotiations aimed at restricting Taiwan’s export of machine tools to the U.S. market. The negotiations resulted in another VER agreement, which took effect in January 1987. The VER on machine tools was even more damaging to Taiwan’s industry than the VERs on textiles, footwear, and TV sets because the machine tool VER limited Taiwan’s market share instead of quantity or growth rate. Market share restrictions placed on individual product categories based on previous market performance severely restrict an industry’s potential for upgrading from low-end to highend products. Specifically, the VER accord on machine tools gave fairly sizable market shares to Taiwanese companies for conventional items, such as nonnumerically controlled lathes (24.70 percent) and milling machines (19.29 percent), but very small market shares for advanced items with good growth potential, such as numerically controlled lathes (3.23 percent) and machine centers (4.66 percent). The VER, which was originally due to expire in January 1992, was extended for another two years after a lengthy and friction-filled negotiation in 1992. Whether the VER has succeeded in protecting the U.S. machine tool industry is not clear. It is clear, however, that the VER has suppressed Taiwan’s market share along with Japan’s, allowing unrestricted competitors, notably Switzerland and Korea, to gain substantial market share during the restriction period. In addition to VERs, the United States has also resorted to safeguard measures to restrict Taiwan’s exports into the U.S. market. Between 1980 and 1990, there were seven countervailing duty and 29 antidumping cases filed against Taiwan by U.S. industries, making Taiwan one of the top countries among all U.S. trading partners blamed for the plight of U.S. industry. For Taiwanese exporters, which are typically small in size, the lengthy and costly legal process involved in these cases presents an effective deterrent to price competition.’ 1. Compliance with an investigation by the U.S. authorities in terms of providing detailed operation-related data in computerized form is a real challenge to small exporters (Krueger 1993). Costs of legal proceedings also often exceed the capacity of small exporters. These firms usually

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The most aggressive series of unilateral assaults launched by the United States in the 1980s, however, were intended to pry open the doors of its trading partners for U.S. access to domestic markets. Many developing countries had thrived on exports to the open U.S. market theretofore and had developed sizable domestic markets of their own that could be reciprocally open to U.S. imports. Therefore, U.S. trade representatives pressured these countries to liberalize their domestic markets. Both Taiwan and Korea were selected as primary targets. The United States used preferential tariffs afforded to Taiwanese and Korean exports under the Generalized System of Preferences (GSP) as the lever for bargaining. In fact, the negotiations undertaken were often called “GSP consultations,” although the agenda were largely focused on market opening. Ironically, despite continuous concessions by Taiwan and Korea, GSP preferences for these two countries were appealed in January 1989. Later, the U.S. trade representatives switched to the Super 301 and Special 301 provisions of the 1988 Trade Act as the main levers for bilateral bargaining. U.S. pressure for access to Taiwan’s market was heightened in the second half of the 1980s when the bilateral trade imbalance swelled to a historic level. Because the impulse of import liberalization often intruded into the domain of politically powerful domestic interest groups, trade friction became inevitable. As documented in table 12.1, between 1986 and 1988 there were at least four occasions on which Taiwan was on the brink of being subject to unilateral trade sanctions by the U.S. In May 1986, Taiwan was investigated by the USTR under the provisions of Section 307 of the 1974 Trade Law for its imposition of an export performance requirement on an investment project in Taiwan proposed by the Japanese automaker Toyota. According to this performance requirement, Toyota was to export no less than 30 percent of the cars assembled in Taiwan in the initial period, and the export ratio was to exceed 50 percent when production reached full capacity. Fearing that Toyota would “dump” these cars on the U.S. market, the USTR demanded that Taiwan remove the export performance requirement and invoked the Section 307 investigation to stage a credible threat. Taiwan succumbed to the pressure by removing the export performance requirement; but the action also killed the investment project because existing carmakers in Taiwan lobbied against the Toyota project for fear of being outcompeted if Toyota were allowed to sell freely in the domestic market.2 The United States also invoked Section 301 investigations twice in 1986, the year that Taiwan’s bilateral trade surplus with the United States reached a historic high of $13.6 billion. In August 1986, the first Section 301 investigation was undertaken after Taiwan refused to revamp its practice of assessing exit the U.S. market altogether when an affirmative decision is reached at the preliminary determination stage. They cannot afford the risk of an uncertain dumping margin that may eventually be imposed on them in final determination. 2. Toyota later made a smaller-scale investment in 1989 with no export performance commitment. The cars assembled under the project were all sold domestically.

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Table 12.1

Major Unilateral Actions Taken by the United States against Taiwan, 1986-93

U.S. Action

Issue

May 1986

Section 307 investigation

August 1986

Section 301 investigation

Export performance restriction on proposed Toyota investment in Taiwan Customs valuation

October 1986

Section 301 investigation

December 1988

Section 301 investigation

May 1989

Special 301 Priority Watch list

May 1992

Special 301 Priority Watch list

May 1993

Special 301 Priority Watch list

Time

Marketing restrictions on U.S. tobacco, beer, and wine in Taiwan Quota on imports of U.S. turkey meat to Taiwan Licensing requirement for U.S. films shown in Taiwan’s private movie parlors (MTV) Copyright protection of U.S. computer software Intellectual property right protection

Taiwan’s Concession Restriction removed

Abolishing customs price tables and assessing duties based on transaction values Restrictions removed

Quota removed

Copyright law changed to require licensing

Export inspection scheme installed on computer hardware Copyright law revised to prohibit parallel import of original works

Source: Compiled from Baldwin, Chen, and Nelson (1995)

customs duties on imported goods based on an official price table. Facing imminent Section 301 retaliation, Taiwan abolished the official price table and began assessing customs duties based on the transaction value. The first serious trade dispute concerning market access also arose in 1986, when Taiwan and the United States could not agree on the tariff levels to be imposed in Taiwan on U.S. cigarettes and the regulations concerning cigarette advertisement in Taiwan. Just one year earlier, Taiwan had reluctantly agreed to allow U.S. cigarettes, beer, and wine to be imported freely. The dispute on tariffs and advertising led the USTR to invoke Section 301 investigation for the second time in 1986. The action forced Taiwan to lower the tariff level,

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although Taiwan’s regulations on cigarette advertisement were enacted largely unchanged. Another serious dispute concerning market access arose in 1988, when Taiwan refused to remove an import quota on U.S. turkey meat. Strong protests against imported turkey meat were voiced by Taiwan’s chicken farmers, who demonstrated in front of the American Institute in Taiwan, the de facto U.S. embassy in Taipei, and who later staged a street rally that turned into a riot. Despite the strong resistance from local farmers, the Taiwanese government agreed to dismantle the import quota after being investigated under the Section 301 provision. After the enactment of the 1988 U.S. Trade Law, which empowered the USTR with the Special 30 1 provision, bilateral negotiations between Taiwan and the United States focused on the issue of intellectual property rights. The USTR has placed Taiwan on the Priority Watch list under the Special 301 provision three times since the law took effect (see table 12.1). Once placed on the Priority Watch list, Taiwan had to negotiate with the USTR for a settlement that would significantly improve the protection of U.S.-owned intellectual property within six months or face sanctions. Under this pressure, Taiwan revised its copyright law twice to meet U.S. demands, with some provisions now exceeding international standards in copyright protection. For example, the current version of the copyright law in Taiwan prohibits Taiwanese citizens from importing original works through unauthorized dealers or from thirdparty markets (i.e., parallel imports). Nevertheless, confrontation was the exception rather than the norm in Taiwan-U.S. negotiation^.^ Often, Taiwan succumbed to U.S. pressure without much resistance, particularly when the domestic interest groups at stake lacked political clout. In cases where the domestic interest groups to be affected were politically sensitive, such as agriculture, or politically powerful, such as the insurance and security industries, Taiwan often resorted to trade preference to reduce the impact on domestic industries. As in the case of Japan, U.S. pressure is sometimes useful in helping dismantle vested interest groups at minimum political cost (Ito 1993), but the practice of trade preference incurs extra costs on resource all~cation.~ Trade preference often takes the form of offering exclusive market access to American firms. Since Taiwan was not a member of the GATT, it was free to exercise discrimination, although this practice sometimes brought protests from other trading partners, such as the European coun3. Li (1994) argued that confrontation is likely to arise when preference distribution on both sides is homogeneous and when societal pressure is great. A homogeneous preference distribution (lack of opposition) and societal pressure (strong lobbying) eliminate room for compromise. He categorized the issues of agriculture and intellectual property rights in Taiwan-U.S. talks as being in this class. 4.Ito (1993) argued that in the case of Japan, businesses that lost vested interests under U.S. pressure were those that sided with Japan’s ruling party (LDP) and the United States in ideology. The situation is similar in Taiwan, where the losers are big private firms politically tied to the ruling party (KMT) and enterprises that are owned outright by the state and the ruling party.

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Table 12.2

Preferential Treatment of U.S. Imports to Taiwan

Import Items Fresh peaches and persimmons Tobacco, beer, and wine Turkey meat Beef Wheat, maize, and soybeans Insurance Securities Automobiles

Preference Exclusive market access Exclusive right to distribute in Taiwan Exclusive market access U.S. beef classified as “prime” or “choice” by U.S. standards is subject to lower tariffs Favored by Taiwan’s import cartels under government direction U.S. insurance firms are given exclusive rights to establish branches in Taiwan U S . brokerage firms are favored in license granting Imports are allowed for vehicles made in North America and Western Europe only

Source: Compiled by the authors.

tries. On such occasions, Taiwan would engage the complainant in a bilateral negotiation for a settlement. Since no other trading partner possessed the asymmetrical bargaining power that the United States did, bilateral negotiations with non-U.S. trading partners were not as lopsided. For the U.S. trade negotiators, who still proclaimed themselves the champions of multilateralism, Taiwan’s offer of unilateral trade preference put them in a dilemma. They could accept the offer for the benefit of American industries but at the expense of multilateralism, or they could reject the offer in favor of continued negotiations that were costly and whose results were uncertain. A simple rule seemed to guide the decisions of U.S. negotiators; that is, accept the offer when the beneficiary industries in the United States were concentrated or politically sensitive, and reject the offer when the domestic interests were diversified or the benefits from access to Taiwan’s market were hard to appropriate. Table 12.2 lists some major trade preferences that Taiwan has granted to the United States, most of which still prevail today. Among them, four are related to agricultural products, including fruit, turkey meat, beef, and grain. The others are related to tobacco, beer, and wine, automobiles, and the insurance and securities industries. Exclusive market access is granted to U.S. fresh peaches and persimmons, turkey meat, and insurance operators. U.S. tobacco, beer, and wine are allowed to be imported and distributed through agents designated by the manufacturers, whereas other brands can only be imported by the stateowned monopoly producer in Taiwan. U.S. beef classified as “prime” or “choice” by U.S. standards is subject to a lower tariff rate, whereas its main competitor, Australian beef, has been subject to a higher tariff rate that applies to low-grade beef. Importation of beef from other origins, such as Argentina, is prohibited for physiological and sanitary reasons. U.S. wheat, maize, and soybeans, meanwhile, benefit from a subtle preference scheme in which the

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Taiwanese government has created import cartels for the respective grains and directed these monopsonies to buy from the United States. At times, the “Buy American” missions organized by these import cartels have even been manipulated to favor particular states of the United States. In the case of the securities industry, the Taiwanese government has exercised favoritism in granting brokerage licenses to U.S. brokerage firms. These trade preferences have been effective in tilting economic benefits in favor of U.S. firms. For years, U.S. grain has accounted for more than 90 percent of Taiwan’s grain imports. Taiwan is the largest export market for American automobiles in Asia, and there are more U.S.-based insurance operators in Taiwan than indigenous ones. Trade preferences, however, have also incurred apparent economic costs via trade diversion effects. For example, suppression of cigarette imports from Japan has resulted in widespread smuggling of Japanese brands such as Mild Seven. Exclusive market access for automobiles made in North America and Europe has resulted in large numbers of Toyota, Honda, and other Japanese makes being imported from the United States rather than from Japan. The locking-out of European insurance firms has resulted in insurance policies written by Hong Kong branches of European firms being sold in Taiwan’s underground market, causing legal problems. In contrast with the issues in which relevant domestic U.S. interests are concentrated, the United States has usually insisted on multilateralism on the issues in which U.S. economic interests are dispersed. For example, U.S. negotiators repeatedly turned down Taiwan’s offer to enhance protection of U.S. trademarks, patents, and copyrights on an exclusive basis. In fact, in areas where Taiwan’s domestic market is dominated by large conglomerates and state-owned enterprises, whose political influence is formidable, the Taiwanese government seems to prefer bilateral agreements with the United States to allow exclusive access to American firms (hence partial liberalization) rather than full-scale liberalization under the multilateral prin~iple.~ At one point, Taiwan even proposed the formation of a free trade area with the United States to put all bilateral disputes to rest. The proposal was rejected, however.

12.3 The Political Economy of Tariff Concessions In addition to bilateral arrangements for constraining Taiwanese exports to the United States and for opening Taiwan’s market to U.S. exports, the United States also engaged Taiwan in negotiations for lowering Taiwanese tariffs on imports. Tariff negotiations are completely consonant with the multilateral 5. Granting exclusive market access to American firms may also forge partnerships between those American producers and Taiwan’s state- and party-owned enterprises, carrying political implications.

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Table 12.3

Number of Tariff Concessions Requested by the United States and Granted by Taiwan, 1978-89 Round 1978 1981 1984 1985 1986 1987 (April) 1987 (August) 1988 1989

Total

Requested

Granted

339 49 109 174 71 66 267 174 558

339 28 59 112 58 62 239 51 366

1,807

1,314

Note: Classification is based on Customs Import Tariff of the Republic of China (CTRN) code except for 1989, which is based on the Harmonized Commodity Description and Coding Systcm (HS Code). Numbers are counted at the eight-digit level.

principle as all concessions made by Taiwan are extended to all trading partners on a most-favored-nation (MFN) basis. The United States first engaged Taiwan in bilateral trade talks in 1978, aiming at obtaining concessions from Taiwan in exchange for U.S. extension to Taiwan of concessions it committed itself to in the Tokyo Round. In other words, the United States used bilateral negotiation to incorporate Taiwan, a nonsignatory of the GATT, into the multilateral system. The talks covered both tariff and nontariff trade issues. From 1978 until 1989, Taiwan and the United States engaged in tariff negotiations nine times. The negotiations then were recessed when Taiwan declared its intention to apply for GATT membership and filed an official application in 1990. Since bilateral negotiations following Taiwan’s GATT application would have had important implications for the GATT admitting procedure, the United States wisely halted the annual trade talks at that point.6 The purpose of this section of the paper is to examine the pattern of Taiwan’s tariff concessions. From this examination we hope to uncover the political economic explanations €or U.S. demands for tariff reductions and Taiwan’s responses. Table 12.3 lists the tariff concessions requested by the United States and eventually granted by Taiwan in these nine rounds of negotiations. It can be seen that a total of 1,807 tariff reductions were requested by the United States, 6. As admission to the World Trade Organization (WTO) needs to be unanimously approved by WTO members, the United States took the opportunity to produce a lengthy list of demands for liberalization and policy changes. The package was aimed at removing all remaining trade impediments in Taiwan. In previous negotiations, which were termed “informal consultations,” U S . negotiators had addressed the issues in a piecemeal and incremental manner, whereby a partial concession by Taiwan might be accepted with the expectation that further progress could be made in future negotiations. The negotiation pertinent to WTO admission was a one-shot deal, and the incrementalism principle was abandoned.

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Table 12.4

Sector" Agriculture Mining Food processing Textiles and apparel Wood and paper Chemicals Rubber and plastics Basic metal Fabricated metal' Nonmetal minerals Others

Total

Sectoral Distribution of Tariff Concessions by Taiwan, 1978-88 Number of Concessionsb (A)

Number of Tariff Items Affected

(B)

Total Number of Tariff Items (C)

BIC

("/.I

I27 3 29 1 44 I20 224 43 119 333 82 2

76 3 163 35 69 159 38 89 253 55 2

314 99 419 588 218 986 153 520 902 349 29

24.2 3.0 38.9 5.9 31.7 16.1 24.8 17.1 28.0 15.8 7.4

1,388

942

4,577

20.6

'Classification is based on Customs Import Tariff of the Republic of China (CTRN) code, at the eight-digit level. Some CTRN codes appear in more than one sector, making the total number of concessions in this table greater than the total number of granted concessions shown in table 12.3. bNumber of concessions is greater than tariff items affected because some concessions were made repetitively. 'Fabricated metal includes machinery, electronics, and transport equipment.

some repetitively on the same items, and a total of 1,314 concessions were actually granted. The success rate was 72.7 percent, although the amount by which the duty was actually reduced on each item might be smaller than the original demand. In addition to tariff concessions so granted, Taiwan also cut tariffs on its own initiative in order to bring the tariff structure in line with its own objectives, for example, to provide adequate effective rates of protection to strategic industries. As a result, the Taiwanese government rewrote the tariff law almost every year to bring the tariff schedule up to date. Successive concessions brought the average tariff burden down from 11.3 percent in 1978 to 6.3 percent in 1989.' The requesting and granting of concessions were not made randomly, they were based on political economic calculations. Table 12.4 lists the distribution of concessions across industries. It can be seen that in terms of the sheer number of concessions, the fabricated metal industry (encompassing machinery, electronics, and transport equipment) had the largest number, at 333, followed by 291 in the food-processing industry, and 224 in the chemical industry. It can also be seen from column (B) of the table that the number of tariff items affected was smaller than the number of concessions, indicating that some tariffs were cut repetitively. The last column of the table indicates the proportion of tariff items subject to tariff cut. It can be seen that during the 11-year negotia7. Average tariff burden is derived by dividing tariff revenue by value of total imports.

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tions, 20.6 percent of all tariff items were negotiated to come down at least once. The efforts of U.S. trade representatives toward reducing Taiwan’s trade barriers have to be admired. Among the broadly defined industry categories, the food-processing industry witnessed the highest proportion of tariff items targeted for tariff reduction (38.9 percent). This was followed by the wood and paper industry (31.7 percent) and the fabricated metal industry (28.0 percent). A large proportion of agricultural products (24.2 percent) were also earmarked for tariff cut, in addition to being frequent targets of negotiations for removal of nontariff trade barriers. We conducted a statistical test to see whether these tariff concessions were deliberately selected or randomly chosen. Comparing the frequency distribution of actual tariff concessions made across industries with the frequency distribution of the tariff population across industries, we obtained a chi-squared statistic of 266.6 under the null hypothesis that the two distributions are indistinguishable. Given that there are nine degrees of freedom, the statistic soundly rejects the null hypothesis, implying that the concessions were not made randomly. Presumably, U.S. trade negotiators chose items in which U S . producers possessed a comparative edge in Taiwan’s market. And, in fact, for the import items targeted by the United States for concessions and actually acted upon by Taiwan in the nine rounds of negotiations, the United States occupied a market share of 31.6 percent in 1977, one year before the negotiations commenced, compared to its 23.1 percent market share in Taiwan’s overall import market that same year. In 1990, one year after the last round of negotiations, the U.S. market share among these conceded import items rose to 45.0 percent, whereas the U.S. share in Taiwan’s total imports was 23.0 percent, virtually unchanged from the 1977 level. It is apparent that the import items targeted for negotiation and ultimately subjected to concession were those for which comparative advantage was moving in favor of U.S. producers or whose market potential in Taiwan was better for American products than the average. Therefore, although the United States created public goods by negotiating with Taiwan for tariff reduction, there was an intrinsic bias in the scope of reduction driven by U.S. self-interest. In the following, we will explore the interplay of this self-interest and Taiwan’s defense strategy. We envisage a political economy model in which interest groups in the United States motivate U.S. negotiators’ demands for specific tariff concessions. Taiwanese negotiators, on the other hand, react to these demands by deciding whether to concede based on political and economic costs at home. Until the later part of the 1980s, Taiwan had a basically autocratic government with limited influence from business interests. While maintaining a harmonious relationship with the United States was a predominant policy concern, the Taiwanese government’s decision rule at this time would probably have been to act so as to minimize adverse effects on economic development with little regard to private business interests at home. Multilateralism was probably of

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little relevance in bilateral negotiations, although it might have been used to legitimize the negotiators’ positions. For example, before the conclusion of the Uruguay Round of the GATT negotiations, there were no unified rules on agricultural trade. Taiwanese negotiators cited the widespread practices of GATT members in protecting their domestic agricultural products to justify Taiwan’s high tariffs on agricultural products. Based on the political economy model of trade policy formation expounded by Baldwin (1989) and Olson (1969, and considerations of bargaining strategy, we attempted to determine which factors were important in influencing the selection of tariff items that were targeted for negotiation by the United States and that were conceded by Taiwan. This was done with a regression model. We include the following variables in analyzing the determination of tariff concessions in bilateral talks. The explanatory variables are divided into two groups, one related to Taiwan and the other related to the United States. Taiwan-Related Variables

Public Enterprise (PUB). Public enterprises are a crucial factor in the determination of Taiwan’s structure of trade protection. A sector in which public enterprises have a larger output share is also more heedfully protected by tariff and nontariff measures (Chen and Hou 1993). Taiwanese government officials are likely to be more determined in defending the interests of public enterprises than private enterprises because the demise of public enterprises means decreasing governmental control over economic resources for political expediency. Their U S . counterparts, who understand the importance of Taiwan’s public enterprises, may also refrain from attacking sectors pertinent to the interests of public enterprises to avoid acrimony. The variable PUB is measured by the share of public enterprises in the output of each sector. Employment (EMP).In a democratic society, employment means voting power. Most studies suggest that the larger the employment size of the industry, the higher the expected level of protection (Baldwin 1989, 122). Taiwan, however, in the period that we studied here, was not yet a mature democratic society. To what extent employment mattered to policymakers and influenced negotiators is an empirical question. EMP is measured by the number of workers in each sector. Wages (WAGE).Wage rate may be an important factor in trade negotiations for two reasons. First, public officials may seek to protect workers whose wages are already relatively low from market pressures resulting from liberal trade policies out of egalitarian concerns (Baldwin 1989, 122). Second, wages are generally positively correlated with skills embodied in workers. As has been demonstrated in the trade literature, worker skills are important determinants of the comparative advantage of industrialized countries (Keesing 1966; Baldwin 1971). A high-skill-endowed, and hence high-wage, industry is likely to

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be an industry in which Taiwan was gaining comparative advantage, as the country was making the transition from a labor-abundant to a labor-shortage economy during the period studied. If Taiwan’s officials are concerned about protecting newly emerging industries more than declining industries, they may be more determined to resist trade liberalization in high-wage sectors. WAGE is measured by monthly wage per worker, in terms of NT (Taiwanese currency). TariffLevel (TB). U.S. negotiators are likely to target Taiwan’s high-tariff items for tariff cut. This makes economic sense because the potential benefit from trade creation is high. For example, U S . negotiators successfully forced Taiwan to reduce the tariff on imported automobiles from 50 percent to 30 percent, creating a buoyant market for imported cars. It also makes sense in terms of bargaining strategy because the rule of proportionate tariff concessions agreed upon by industrial countries in the Tokyo Round of GATT negotiations provides a “moral” ground for demanding that high tariffs be cut first. NontariffBarriers (NTB).Nontariff barriers may be used as substitutes or complements for tariffs as measures of trade protection. In Taiwan’s case, the two are shown to be substitutes (Chen and Liu 1993). The major nontariff barriers in Taiwan are licensing requirements, which tend to be more stringent for sectors in which tariff levels are lower. During the bilateral negotiations that we studied, licensing control was also a major issue on the negotiation agenda. Through the years of negotiation, licensing control was significantly lessened along with the reduction of tariffs. U.S. negotiators tended to treat tariff and nontariff barriers as strategic complements and attacked them at the same time. NTB is measured by a weighted index of various non-tariff trade protection measures as described in the appendix. In addition, the four-firm concentration ratio of Taiwanese industry was tried as an explanatory variable in the regression but was dropped for lack of significance. US.-Related Variables Changes in U S . Tariff Level resulting from the Tokyo Round Agreements (UTB). U.S. engagement with Taiwan in bilateral negotiations was initially aimed at integrating Taiwan into the Tokyo Round agreements. Therefore, the concessions that the United States made in the Tokyo Round might be used as the yardstick for negotiations or the basis for reciprocity. The United States might ask Taiwan to make a similar pattern of concessions to make the bilateral talks conform with multilateral agreements. UTB is measured by the percentage change in the nominal U.S. tariff rate as described in the appendix. Changes in U.S. Effective Rate of Protection resulting @om the Tokyo Round Agreements (UERP).The effective rate of protection may move in the opposite

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direction from the nominal tariff rate. Concessions in nominal tariffs are usually used to gauge the degree of trade liberalization, but the real indicator of government trade policy may be the effective rate of protection. The change in effective rate of protection may truly reflect the U.S. government’s concerns for domestic industry. It will be interesting to see whether the U.S. government sought to expand export markets through bilateral efforts to aid industries that were losing or gaining in effective rate of protection at home. UERP is also measured in percentage. Industry Concentration (UCR4). It is well documented in the political economy literature that industrial concentration is conducive to lobbying power and hence trade protection. Through bilateral negotiations on nontariff issues, we have witnessed the formidable political forces of the U.S. industries dominated by oligopolies, such as tobacco, automobiles, insurance, banking, and finance. We expect this influence to carry over to tariff negotiations. UCR4 is measured by four-firm concentration ratio of U.S. industry in 1987. Revealed Comparative Advantage (URCA). Aggregated data presented above suggest that the United States gained substantial market share in the sectors in which tariffs were reduced as a result of bilateral negotiations. We hypothesize that U S . negotiators chose the sectors targeted for tariff cuts in line with the comparative advantage of various U.S. industries. The index of revealed comparative advantage proposed by Balassa (1977) is used to measure the competitiveness of U.S. products in Taiwanese markets. This index is included in the regression analysis to see whether it exerts a systematic impact on the pattern of tariff concessions. We employ the above two sets of variables in a regression analysis to see to what extent each variable can help to explain the likelihood of each Taiwanese industrial sector’s being targeted by the United States for tariff cuts and the likelihood of its being actually subject to a cut. Industrial sectors are defined at the three-digit level in Taiwan’s official industrial classification (CIC). For our purposes here, all import and export commodities listed in the official tariff schedules (at the eight-digit level) are first classified into their proper industry sector and then the proportion of those commodity items subjected to tariff cuts or to demands for tariff cuts in each round of negotiation is taken as the dependent variable. Since the dependent variable lies between zero and one, we adopt a limited dependent variable model to conduct the regression analysis. The results are reported in table 12.5. We conducted regressions on two equations separately. The first is the U S . demand equation, in which the dependent variable measures the proportion of tariff concessions requested by U.S. negotiators at the beginning of the round. Data on initial U S . requests are available for the last five rounds of negotiations only (1986-89). The second equation is the final concessions equation,

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Table 12.5

Limited Dependent Variable Model for Tariff Concessions

Coefficient Estimates Explanatory Variable Constant PUB EMP WAGE TB

NTB UTB UERP

UCR4 URCA Log-likelihood

U.S. Demand for Concessions, 1986-89

Final Concessions, 1978-89

- 103.89

35.38 (2.6)** -0.081 (2.9)** -1.012 (1.5) -2.631 (2.3)** 0.087 ( 1.3) 0.097

(2.2)** -0.101 (2.2)** 0.389 (0.4) 9.252 (2.3)** 0.399 (4.3)** 0.233 (3.5)** -1.396 (1.3) 3.281 (1.6) 0.059 (1.2) 0.051 (3.4)** 85.05

( 1.9)* - 1.835

(2.5)** 3.620 (2.5)** 0.068 ( I .9)* 0.020 (I&* 141.9

Notes: Numbers in parentheses are asymptotic t-statistics. *Asymptotically significant at the 10 percent level. **Asymptotically significant at the 5 percent level.

in which the dependent variable measures the proportion of tariff concessions finally made by the Taiwanese government at the end of negotiations. Data on final concessions are complete for all nine rounds. It can be seen from table 12.5 that the set of independent variables exhibits different explanatory power in the two equations. For the U.S. demand equation, five independent variables, namely, Taiwan’s public enterprises (PUB), Taiwan’s wage rate (WAGE), Taiwan’s tariff level (TB), Taiwan’s nontariff barriers (NTB), and the revealed comparative advantage of U S . industry (URCA), are shown to be asymptotically significant. The United States tends to refrain from demanding tariff concessions in sectors dominated by public enterprises in Taiwan and in sectors in which wages are relatively low in Taiwan. “Respecting” Taiwan’s public enterprises and the roles pursued by them was the gesture shown by U.S. trade representatives in the negotiations on nontariff barriers. For example, in the negotiation on market access for U.S. tobacco, U.S. trade representatives never disputed Taiwan’s system of monopolizing tobacco production by the state. U.S. negotiators also never challenged Taiwan’s state-

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owned oil monopoly. Part of the reason may lie with the favoritism these public enterprises often exercised in the procurement of American products. This attitude may be extended to tariff negotiations. The fact that the United States also refrains from pressuring Taiwan’s lowwage sectors for trade liberalization can hardly be conceived of as due to a “social concern” for Taiwan’s poor workers. It is more conceivable that lowwage sectors are also declining sectors in which the United States sees little prospect for importing American products. High-wage sectors are targeted because their potential for sales of U S . products is good. The U.S. assault on high-tariff sectors came as no surprise. The United States also campaigned more vigorously for tariff concessions in sectors where nontariff barriers are high. Since many nontariff barriers also provide Taiwanese trade administrators with discretionary power to practice trade preference to the advantage of U.S. exporters, the benefits of tariff cuts in this area are likely to be captured by U.S. producers. This may explain why the United States treats tariff and nontariff barriers as strategic complements in bargaining. It is reassuring that the index of revealed comparative advantage is significantly and positively correlated with U.S. demands for tariff reduction. This suggests that U.S. negotiators target U.S. products that have been selling well in Taiwan and a tariff reduction may bring disproportionately large benefits to U.S. producers. It is interesting to note that the two variables related to the Tokyo Round agreements, changes in U.S. nominal tariff (UTB) and effective rate of protection (UERP), are not significant factors in shaping U.S. demands for concessions. The degree of industry concentration (UCR4) also turns out to be insignificant. In other words, U.S. negotiators compile the list of commodities for tariff negotiations mainly based on U.S. comparative advantage, with little regard to the lobbying power of the industry or to U.S. commitments in the Tokyo Round negotiations. The determinants of the final concessions, supposedly a result of the tug-ofwar between U.S. pressure and Taiwanese counterpressure, present a different picture. A U.S. request for a tariff concession will be granted only if U.S. pressure is high and counterpressure from Taiwan against such liberalization is low. In other words, nonpriority items on the U.S. demand list may be dropped if they are in strong conflict with Taiwan’s interests. On the other hand, nonpriority items from Taiwan’s perspective may be “sacrificed” to salvage the priority items. Table 12.5 shows that in the final concessions equation, public enterprises (PUB) remain significant and negatively related to the probability of tariff concession. This suggests that both sides share an interest in sparing statedominated sectors from tariff concessions. Taiwan’s wages (WAGE), however, exert a negative impact on the proportion of tariff reduction, contrary to its correlation with U.S. demands. The Taiwanese government seems to be deter-

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mined to withstand U.S. pressure to open up markets in high-wage sectors and appears to be successful in doing so. The complete reversal of the pattern of trade liberalization for these sectors is something remarkable, reflecting the strategic importance of Taiwan’s high-wage, and probably also high-skilled, sectors. Although export promotion is the major Taiwanese government policy toward developing strategic industries in Taiwan, protecting these industries from premature exposure to import competition is also considered important. In this regard, we can sense the importance of industrial development concerns on the part of Taiwan in trade negotiations. In fact, Taiwan’s Bureau of Industrial Development, which is in charge of industrial policy, played a pivotal role in each round of negotiations. Existing tariff and nontariff barriers in Taiwan, which are important determinants of U.S. demands for tariff cuts, are not as important in determining the final outcome of negotiations. The commodities that end up on the final list for tariff reduction are not necessarily high-tariff items. In fact, our analysis reveals that a higher level of tariff on a given item does not even increase the likelihood of that item’s being actually selected for tariff slicing, as the variable TB is not asymptotically significant. The variable for nontariff barriers (NTB), however, remains significant at the 10 percent level, although its statistical contribution to the likelihood of being finally selected for tariff cut is much smaller than its effect on the likelihood of being targeted by U.S. negotiators, judging by the much smaller coefficient estimate for NTB in the final concessions equation. Interestingly, tariff concessions agreed to by the United States in the Tokyo Round and the resulting changes in the effective rate of protection turn out to be important determinants of the final pattern of tariff concessions agreed to by Taiwan, although they do not significantly influence U S . negotiators’ list of requests. The variable of changes in U.S. nominal tariffs (UTB) is shown to be negatively related to likelihood of tariff concession, meaning that for industries in which the United States made more drastic cuts in tariffs, Taiwan also agreed to more cuts. In other words, U.S. commitments in the multilateral system seem to carry some power to persuade Taiwan to pledge a similar pattern of concessions. Perhaps Taiwan does not want to be seen as a free rider on the multilateral system. On the other hand, the final concessions made by Taiwan are positively related to changes in the effective rate of protection in U.S. industry (UERP). This implies that sectors that gain in effective rate of protection in the United States are also more likely to gain from easier access to the Taiwanese market. This is an apparent “strategic” trade policy aimed at boosting priority industries. It is also noticeable that the four-firm concentration ratio (UCR4), which is an unimportant factor in U.S. demands for tariff concessions, turns out to be important in deciding the final outcome of negotiations. This implies that concentrated industries flex their muscle through their lobbying power in the bargaining process, making their demands hard for Taiwanese negotiators to resist and hard for U.S. negotiators to compromise on.

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The revealed comparative advantage (URCA) of U.S. industry remains a significant factor in determining the final outcome of bilateral bargaining, although its importance is reduced, judging from a smaller coefficient estimate in the final concessions equation. Resistance by Taiwan’s negotiators seems to have attenuated its strength. The only variable that turns out to be insignificant in both equations is employment (EMP). It has a correct, negative sign in the final concessions equation, suggesting that Taiwan’s negotiators are somewhat concerned about the “voice” of industries with large numbers of employees. This concern has not been transformed into a significant factor for trade negotiators in a new-born democracy, however.

12.4 Conclusions This paper reviewed the history of bilateral trade negotiations between Taiwan and the United States. The question we posed at the outset was: Does bilateralism enhance or jeopardize multilateralism? The Taiwan-U.S. case suggests that a bilateral approach to obtaining export restriction or market opening by removing nontariff barriers tends to be in conflict with the multilateral principle. VERs divert economic benefits to nonrestricted exporters at the expense of the importing country and possibly also at the expense of exporters subject to such restriction. Bilateral negotiations for market opening under the threat of unilateral trade sanctions (Section 301 action) tend to encourage the practice of trade preference. This practice, while rendering maximum benefits to U.S. industries, is detrimental to multilateralism. It signals to the world that the United States is no longer interested in creating public goods for other members of the GATT and that those who are interested in entering Taiwan’s market ought to negotiate their own opportunities. The United States is more inclined to accept trade preference in areas where its domestic interests are concentrated. In this connection, state power is employed by oligopolistic firms to circumvent the competition process in gaining access to foreign markets. Even in the area of tariff negotiations, where any tariff reduction made by Taiwan is applied to other trading partners under the MFN principle, bilateralism does not necessarily enhance multilateralism. Since tariff concessions are made selectively, with domestic business interests underlying the selection process, trade liberalization resulting from these negotiations is also biased. On the other hand, we find that multilateral agreements are used as “moral standards” by asymmetrically weak negotiators like Taiwan to defend their positions. If the dominant negotiator adheres to multilateral principles, bilateral negotiations may complement multilateralism. But the temptation to act in one’s own self-interest seems to be too great to guarantee such a happy outcome. In any event the prospect of Taiwan’s joining WTO in the near future may significantly change Taiwan’s bilateral relationship with the United States. First of all, trade preferences, notably exclusive market access granted to U.S. pro-

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ducers, will have to be abolished once Taiwan is admitted to the WTO. To offset the loss from an elimination of trade preferences, U.S. negotiators have been particularly intransigent in demanding drastic tariff cuts in the related product categories during the bilateral consultations pertinent to Taiwan’s WTO admission. Second, losing the option of preferential trade arrangements reduces the opportunity set for compromise and may make future bilateral negotiations more difficult and more confrontational, although the resultant agreements will be less distortive. Meanwhile, private interests lobbying the U.S. government to negotiate bilaterally for access to Taiwan’s market will have to give up their attempts to monopolize Taiwan’s market and leave the market access issue to multilateral organizations. Third, Taiwan will improve its bargaining power, and the legitimacy of its refusal to accept terms of agreement beyond the WTO rules will be strengthened. In cases involving split U.S. interests, Taiwan may even challenge U S . demands presented through bilateral channels by taking them to the WTO dispute settlement mechanism, making the bilateral approach less effective for the United States in the future. In addition, Taiwan may also make use of regional forums, such as APEC, to fortify its position against the United States in solving trade-related problems.

Appendix Sources of Data PUB: The share of public enterprises in agricultural production is calculated from the Report on Agriculture and Fishery Census, Taiwan-Fukien District, the Republic of China (Taipei: ROC Directorate-General of Budget, Accounting, and Statistics [DGBAS], 1980, 1985, 1990); that in manufactured output is from Kung ch’ang chiao cheng chi ying yun tiao ch’a pao kao (Survey of Factory Registrations and Operations; Taipei: ROC Ministry of Economic Affairs, various issues). WAGE: Wages of manufacturing workers are from Yearbook of Earning and Productivity Statistics, Taiwan Area, ROC (Taipei: DGBAS, 1993); those of agricultural workers are from Report on the Survey of Family Income and Expenditure, Taiwan Province, ROC (Taipei: DGBAS, (1993). EMP: Employment size of manufacturing sector is from Yearbook of Earning and Productivity Statistics, Taiwan Area, ROC (Taipei: DGBAS, 1993); employment size of agricultural sector is from Agricultural Production Statistics Abstract, Taiwan District, ROC (Taipei: ROC Council of Agriculture, 1993). TB: Average nominal tariffs are based on 1986 levels and calculated from Customs Import Tariffs and Classijication of Import and Export Commodities of the Republic of China (Taipei: ROC Ministry of Finance, 1986).

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NTB: Nontariff barrier index is also based on 1986 levels. NTB is a weighted index of five forms of trade barriers: prohibition and control, produceronly import restriction, public-enterprise-only import restriction, sourcesof-import restriction, and administrative licensing control. For details of the calculation, see Chen and Hou (1993). CR4: Four-firm concentration ratio is calculated from 1986 Industrial and Commercial Census (databank; Taipei: DGBAS, 1986). UTB: U.S. concessions in nominal tariffs in the Tokyo Round are from Alan Deardorff and Robert Stem, “The Effect of Tokyo Round on the Structure of Protection,” in The Structure and Evolution of Recent U.S. Trade Policy, ed. Robert Baldwin and Anne Krueger (Chicago: University of Chicago Press, 1984). UERP: Same as UTB. UCR4: Four-firm concentration ratios are from 1987 Census of Manufactures (Washington, D.C.: U.S. Department of Commerce, 1987).

References Aw, Bee-Yan. 1993. Price discrimination and markups in export markets. Journal of Development Economics 42:3 15-36. Aw, Bee-Yan, and Mark Roberts. 1986. Measuring quality change in a quotaconstrained import market: The case of U.S. footwear. Journal of International Economics 21:45-60. Balassa, Bela. 1977. Revealed comparative advantage revisited: An analysis of relative export shares of the industrial countries: 1953-1971. Manchester School of Economic and Social Studies 45 (4): 321-44. Baldwin, Robert. 1971. Determinants of the commodity structure of U.S. trade. Arnerican Economic Review 61:126-46. . 1989. The political economy of trade policy. Journal of Economic Perspectives 3 (4): 119-35. Baldwin, Robert, Tain-Jy Chen, and Douglas Nelson. 1995. The political economy of U.S.-Taiwan trade. Ann Arbor: University of Michigan Press. Boltuck, Richard, and Robert Litan, eds. 1991. Down in the dumps. Washington, D.C.: Brookings Institution. Chen, Tain-Jy, and Chi-ming Hou. 1993. The political economy of trade protection in the Republic of China on Taiwan. In Trade and protectionism, ed. Takatoshi It0 and Anne Krueger. Chicago: University of Chicago Press. Chen, Tain-Jy, and Meng-Chun Liu. 1993. Tai-wan mou-i PO hu tse hsin chen (Determinants of trade protection in Taiwan). Academic Papers (Academia Sinica) 21 (1): 1-30. Cline, William. 1990. Thefuture world trade in textiles and apparel. Washington, D.C.: Institute for International Economics. de Melo, Jaime, and David Tan: 1990. Welfare costs of U.S. quotas in textiles, steel, and autos. Discussion Paper no. 401. London: Centre for Economic Policy Research. Falvey, Rodney. 1979. The composition of trade within import-restricted product categories. Journal of Political Economy 87: 1105-14.

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Feenstra, Robert. 1984. Voluntary export restraints in U.S. autos, 1980-1981: Quality, employment, and welfare effects. In The structure and evolution of recent U S . trade policy, ed. R. E. Baldwin and A. 0. Krueger, 35-59. Chicago: University of Chicago Press. Harris, Richard. 1985. Why voluntary export restraints are “voluntary.” Canadian Journal of Economics 18:799-809. Hufbauer, Gary, Diane T. Berliner, and Kimberly Ann Elliot. 1986. Trade protection in the United States: 31 Case studies. Washington, D.C.: Institute for International Economics. Ito, Takatoshi. 1993. U S . policy pressure and economic liberalization in East Asia. In Regionalism and rivalry: Japan and the United States in Pac$c Asia, ed. J. Frankel and M. Kahler, 394-420. Chicago: University of Chicago Press. Keesing, Donald. 1966. Labor skills and comparative advantage. American Economic Review 56:249-94. Krueger, Anne. 1993. Economic policies at cross-purposes. Washington, D.C.: Brookings Institution. Li, Chien-pin. 1994. Trade negotiation between the United States and Taiwan. Asian Survey 34 (8): 692-705. Nam, Chong-Hyun. 1993. Protectionist U.S. trade policy and Korean exports. In Trade and protectionism, ed. Takatoshi Ito and Anne Krueger, 183-218. Chicago: University of Chicago Press. Olson, Mancur. 1965. The logic of collective action: Public goods and the theory of groups. Cambridge, Mass.: Harvard University Press. Ries, John. 1993. Windfall profits and vertical relationships: Who gained in the Japanese auto industry from VER. Journal of Industrial Economics 41 (3): 259-76.

Comment

sang-woo Nam

Korea is no different from Taiwan in its vulnerability to bilateral trade pressure from the United States. As the proverb says, “Misery loves company.” We have full sympathy with Taiwan. During 1978-88, eight countervailing duty cases were filed against Korea by U.S. industries, 31 antidumping cases, and 15 cases of import relief on the part of the United States against Korean products. My comments focus on the analytical part of Chen and Liu’s paper: the political economic analysis of tariff concessions. Presented in table 12.5 is an equation of U.S. demand for concessions, in which the only significant U.S.related variable revealed is comparative advantage. In Taiwan, U.S. market share for import items targeted for concession is said to have increased from 31.6 percent in 1977 to 45 percent in 1990. Here, what I want to point out is that causality runs both ways between comparative advantage and demand for concessions: that is, the more concessions the United States obtains, the faster its market share rises. The authors tried the industrial concentration ratio of the United States to Sang-Woo Nam is senior fellow and director of the International Development Exchange Program of the Korea Development Institute.

367

Bilateral Negotiations and Multilateral Trade

see whether highly concentrated industries are better organized for pressuring the government. It would also be interesting to see whether Taiwanese industries with high concentration ratios would be effective at resisting U.S. requests for concessions. The motivation of concentrated industries to pursue lobbying efforts may be stronger for the country giving concessions than for the country requesting them. This is so because the Taiwanese market is likely to be small for U S . firms, and not all of them may actually benefit from concessions because of competition among them, while all Taiwanese firms are affected. The success rate for the United States is reported to be 73 percent, obtaining 1,314 concessions out of 1,807 requests. The success rate by industry would be valuable information for the purpose of analyzing how important political economic considerations were on the part of Taiwan. Finally, the sample periods for the two equations presented in table 12.5 are not the same. If an important missing variable specific to a particular period is closely associated with an explanatory variable, estimated coefficients may not be reliable. In Taiwan, where the structure of comparative advantage and the industrial structure have changed rapidly, this seems very possible. Even in the case where a lack of data is the problem, the second equation (final concessions) could be estimated for the same sample period as the first equation. This would make us more comfortable with comparing the estimated coefficients between the two equations.

Comment

Hank Lim

This paper provides a very interesting and useful empirical study of the relationship of bilateral negotiations between the United States and Taiwan to the multilateral trade regime. The purpose of this study is to reveal whether the empirical results of bilateral negotiations dominated by the United States conform to the established principle of multilateralism. It is generally believed that a bilateral approach to world trade issues and problems is inferior to a multilateral approach. Theoretically, a bilateral approach may not even produce a second-best solution. The economic cost of voluntary export restraints and the problems associated with safeguard measures have been widely discussed in the economic literature. In comparison, the bilateral approach to market opening has not been analyzed in great detail. This empirical study specifically attempts to examine the bilateral trade arrangements between the United States and Taiwan on market access and tariff and nontariff reductions under the framework of asymmetrical bargaining power between the two trade partners. Another interesting aspect of this study involves the incorporation of a politHank Lirn is professor of economics at the National University of Singapore.

368

Tain-Jy Chen and Meng-chun Liu

ical economy model to explain the results of bilateral negotiations between the two economies on tariff concessions. This was done through a regression model to determine which factors were important in influencing the outcome of negotiations. The statistical results were significant and functionally correlated as expected, except for the employment variable for the Taiwan-side equation. This variable does, however, have a correct negative sign in the final concessions equation, suggesting that Taiwan’s negotiators were somewhat concerned about industries with large numbers of employees. In the U.S.-side equation the results were equally significant and correlated. The statistical results of this study are consistent with Krueger’s earlier study on bilateral trade negotiations between the United States and South Korea (Krueger 1993). The basic conclusion of both studies confirms the hypothesis that bilateral trade negotiations between unequal partners tend to depart from the multilateral principle. In the case of Taiwan, there was a certain element of peculiarity in the sense that the Taiwanese government seemed to prefer bilateral arrangements with the United States for market opening rather than fullscale trade liberalization under the multilateral principle. This is due to the fact that Taiwan’s domestic market is dominated by large conglomerates and stateowned enterprises, and Taiwan is not a member of the GATT. The Taiwan-U.S. bilateral case as revealed in this study suggests that a bilateral approach to obtaining export restrictions or market opening tends to be in conflict with the multilateral principle. Furthermore, bilateral negotiations for market opening under the threat of unilateral trade sanctions tend to encourage the practice of trade preference. This practice, while rendering maximum benefits to U.S. industries, is detrimental to global multilateralism. The empirical evidence in this study also confirms the theoretical hypothesis that the United States is particularly inclined to accept trade preference in areas where its domestic interests are concentrated. There are, however, four points that require further clarification. They are as follows: 1. On wages, the paper needs to explain more fully how to reconcile the conflicting objectives of enhancing employment and protecting high-wage newly emerging industries. The regression model on the Taiwan side seems to show that Taiwanese officials were more concerned with protecting high-wage newly emerging industries. 2. On employment, the empirical results show that this explanatory variable is not important to Taiwanese policymakers. The paper should indicate the underlying structural and expedient factors behind this departure from the conventional theory. 3. On the assertion that existing tariff and nontariff barriers are not as important to the final outcome of negotiation, could it be that tariff and nontariff barriers in Taiwan are basically used to protect Taiwan’s industries from countries other than the United States? 4. On the assumption that different international trade policies adopted by

369

Bilateral Negotiations and Multilateral Trade

different U.S. administrations seem to have had no impact on the demand equation of the U.S. regression model, is this realistic?

Reference Krueger, Anne 0. 1993. Economic policies Brookings Institution.

at cross-purposes.

Washington, D.C.:

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13

Economics and Politics of Rice Policy in Japan: A Perspective on the Uruguay Round Yujiro Hayami and Yoshihisa Godo

13.1 Introduction Throughout the seven-year duration of the GATT Uruguay Round (UR), agricultural negotiation continued to be a major stumbling block. Because of domestic resistance to these negotiations, the Japanese and Korean governments were unable to play a sufficiently positive role in the Round despite the large benefits they are expected to receive from the successful conclusion of the Round.’ Their dilemma was clearly demonstrated by their evasion of the “tariffication” of rice, effectively violating of the principles of the GATT/ WTO. Tariffication, by which all existing nontariff barriers are converted into bound duties, is a key element regarding market access in the Agreement on Agriculture embodied in the Final Act of the Uruguay Round. Yet Japan managed to make rice exempt from tariffication for a six-year grace period from 1995 to 2000 by giving compensation in the form of increased “minimum access” import quotas, from 4 percent of its domestic rice consumption in 1995 to 8 percent by 2000; the minimum access obligation under tariffication is graduated only from 3 percent to 5 percent within the six-year period. Likewise, Korea agreed to increase minimum access imports from 1 percent of Yujiro Hayami is professor of international economics at Aoyama Gakuin University. Yoshihisa Godo is associate professor of economics at Meiji Gakuin University. 1. The Japanese government prohibited rice imports during the last quarter-century with a few notable exceptions. This import prohibition has occasionally been criticized as a violation of GATT rules at international talks. To take an outstanding example, the Rice Millers’ Association (RMA) of the United States filed complaints under Section 301 of the U.S. Trade Act calling for the opening of the Japanese rice market in 1986 and 1988. The U S . Trade Representative (USTR) substantially dismissed the claims by the RMA, presupposing that the rice issue would be resolved at the UR negotiations. Although there was great pressure on the rice market, the Japanese Diet adopted resolutions requiring the government to firmly maintain rice import prohibitions in 1980, 1984, and 1988.

371

372

Yujiro Hayami and Yoshihisa Godo

Table 13.1

Producer Subsidies and Consumer Burdens by Agricultural Protection Policies in Selected Economies, 1991-93 Grain Self-Sufficiency Rate (%) PSEYAgricultural output

Economy Japan (Rice) European Union United States Australia

(1)

-CSE/PSE (2)

1974-76 (3)

1984-86 (4)

69 (92) 48 22 10

112 (97) 74 45 29

40

33

86 157 348

114 159 426

Sources: Organisation for Economic Co-operation and Development, Agricultural Policies, Marketund Trade (Paris, 1985, 1991), and Food Consumption Sruristics (Paris, 1985, 1991). Note: PSE, producer subsidy equivalent; CSE, consumer subsidy equivalent; Grain selfsufficiency rate, total grain output/total grain consumption.

base-period domestic consumption to 4 percent during the 1995-2004 period with a 10-year postponement of rice market tariffication. Indeed, this experience in Japan and Korea demonstrated that rice in East Asia is not simply an economic good but a cultural heritage, and therefore, is easily influenced by political forces. The question to be addressed in this paper is: What political forces oppose the acceptance of the general agreements on agriculture of the Uruguay Round? We will try to find an answer mainly in reference to the case of rice in Japan, but the substance of this study is expected to apply to Korea, as well. The answer to this question will become a basis for projection to agricultural policies and trade regimes in northeast Asia for a decade following the Uruguay Round.

13.2 A Perspective on the Uruguay Round Agricultural Negotiations In order to understand the unique response of Japan (and Korea) to the UR agricultural negotiations, it is useful to compare its position in regard to agricultural protection with those of the European Union, the United States, and Australia (table 13.1). 13.2.1 Stylized Facts of Agricultural Protection Column (1) in table 13.1 compares the levels of agricultural protection in terms of the ratio of producer subsidy equivalent (PSE) to total agricultural output for 1991-93. PSE measures the increase in producers’ income owing to all protective policies, including both border protection and domestic subsidy payments. According to this measure, agricultural protection in Japan is very high, with the PSE ratio amounting to about 70 percent, as compared with

373

Rice Policy in Japan

about 50 percent in the European Union, 20 percent in the United States, and 10 percent in Australia. Especially high is the protection for rice, with PSE amounting to nearly 90 percent of output value. Note that these ratios use agricultural output values as denominators. If we assume value added from agriculture to be 60 percent of output value, Japan’s PSE for 1991-93 amounted to 115 percent of agricultural GDP, implying that the national income of Japan would have increased by 15 percent with the elimination of the agricultural sector.2 In table 13.1, strong inverse correlation can be observed between the PSE ratio in column (1) and the grain self-sufficiency ratios in columns (3) and (4). This inverse association seems to reflect the general tendency for countries with lower comparative advantage in agriculture to undertake higher protection. It is noteworthy, however, that both the United States and Australia, which obviously have high comparative advantage in agriculture, are engaging in agricultural protection to a significant degree. Again, assuming value added to be 60 percent of output value, the ratio of PSE to agricultural GDP is nearly 40 percent in the United States and 15 percent even in Australia. Thus, Japan’s high protection on agriculture is but one example of the stylized facts that (1) developed countries exercise high protection on agriculture and (2) the degree of protection is higher for countries with lower comparative advantage in agri~ulture.~ 13.2.2 The Common Interest of the European Union and the United States Another important observation in table 13.1 is the inverse correlation between the ratio of negative consumer subsidy equivalent -CSE to PSE in column (2) and the grain self-sufficiency ratios in columns (3) and (4). Income support for farmers as measured by PSE is considered to consist of income transfers from both consumers and taxpayers. Border protection increases the purchase price of agricultural commodities, and thus consumers experience a decrease in purchasing power or real income. CSE is therefore a measure of the extent to which consumers support protection via income reduction. On the other hand, the transfer from taxpayers takes the form of government subsidy payments. Thus, the ratio of -CSE to PSE measures how much agricultural protection is obtained at the expense of consumers relative to that from the government budget. 2. The ratio of gross value added to output value in rice is estimated to be a little less than 70 percent, using annual surveys by the Japanese Ministry of Agriculture, Forestry, and Fisheries on rice production cost (Kome Seisanhi Chosa). The sample of farmers in this survey is said to be biased toward high-yield farmers, and the profitability of rice exceeds the average level for other agricultural products. If we consider these points, the real ratio of gross value added in Japanese agriculture may be below 60 percent of total output value. Thus, the value added of Japanese agriculture is somewhat overestimated in the text. Nevertheless, it is concluded that GDP would increase if the agricultural sector were eliminated. 3. Such relations are also confirmed by econometric analysis in Honma and Hayami (1986a. 1986b. 1991).

374

Yujiro Hayami and Yoshihisa Godo

The high ratio of -CSE for Japan and the low ratios for the United States and Australia reflect the fact that in a major food-importing country like Japan, a high protection rate can be achieved mainly through border protection with relatively little pressure on the government budget, while major food exporters must rely on the treasury if they want to support the income of farmers. From this perspective, the critically important factor underlying the adoption of agricultural policy reform as an issue in the Uruguay Round could be identified as the change in position of the European Union from a net grain importer in the 1970s to a net exporter in the 1980s, as shown in columns (3) and (4). Since the formation of the European Community in 1957 until the 1970s, the European Union was a world-leading importer of grains and many other agricultural commodities. As long as import margins remained large, the Union could protect farmers at a target level mainly by means of the variable levies that produced revenue instead of cost to the EU government. However, as domestic agricultural production grew under heavy protection from the Common Agricultural Policy (CAP), imports progressively declined, resulting in a growing shortage of variable levy revenue relative to the needs of maintaining the CAP program. This shortage became more acute in the 1980s, when the Union became a net exporter. Because surplus commodities above domestic consumption were created by the heavy protection, producers could not find commercial outlets in the international market. Inadvertently, through export subsidies the European Union began overseas dumping activities. Under the pressure of surplus products, the budget cost of CAP loomed large and became politically intolerable, especially in the mid-1980s when the world food market was dampened. This was the reason why the European Union and the United States agreed to put agricultural policy reform on the agenda of the UR negotiations. In other words, once the European Union became a net exporter, it was in the same boat as the United States. It was no longer possible for the EU and U.S. governments to finance agricultural protection at the expense of consumers. Given the high political cost of raising taxes, it became an absolute necessity to reduce agricultural protection or, at least, to stop further growth of protection. If they had not shared this problem, it is difficult to envisage that negotiations on agricultural policy reform would ever have been undertaken. Surplus production due to excessive protection was the basic cause of looming budget costs in exporting countries. Thus, the UR agricultural negotiations could not be limited to the issue of trade rules and market access but had to be expanded to cover domestic agricultural policy and export subsidies. From this perspective, CAP reform in 1992 under the lead of EC Commissioner Ray McSharry would have been undertaken even in the absence of UR negotiations, although there is little doubt that the reform was facilitated by the Round.4 CAP reform was essentially a shift from the traditional EC policy 4. For more detail, see International Agricultural Trade Research Consortium (1994.46-51).

375

Rice Policy in Japan

of supporting farm prices by means of border protection to a protection structure similar to that of the United States, consisting of acreage control and subsidy payments to farmers. This policy shift has already demonstrated its effectiveness in curbing farm production, so export surpluses are likely to decrease in the future.

13.2.3 The Unique Position of Japan It is important to recognize that Japan has not been in the same situation as the European Union and the United States. As indicated in table 13.1, the import margin of grains has been widening, and the cost of agricultural protection has been almost completely covered by consumers. With increasing affluence, consumers are becoming more tolerant of high food prices, although most of them do not realize how high prices actually are. Their tolerance is especially high for rice, mainly because it has turned out to be an inferior good, whereby demand shrinks in response to increases in income level. As the share of rice in consumer expenditure is now less than 2 percent (compared with about 3 percent for vegetables), its effect on the cost of living has become insignificant. As a result, neither business employers nor labor unions are concerned about the price of rice. Thus, the countervailing force against agricultural protection has disappeared from Japanese s ~ c i e t y . ~ Consumer tolerance of agricultural protection is common in affluent societies. What makes Japan unique relative to the European Union and the United States is the relative absence of countervailing pressure from the Ministry of Finance; this is because Japan as a major food importer is able to charge consumers for the costs of protection. Under this unique condition Japan has had little political incentive to promote agricultural policy reform in the arena of the Uruguay Round. While the expected benefit from a freer trade regime is obviously very large, the benefit would be distributed widely but thinly among consumers, business concerns, and organized laborers. No interest group has sufficient incentive to exercise countervailing power against the strong political pressure of the farm bloc. Thus, it appears reasonable to hypothesize that Japan remained very passive in the UR agricultural negotiations and tried to evade as much as possible any agreement that would have provoked the anger of the farm bloc partly because the farm bloc is politically very powerful as it is disproportionately represented in the national Diet, but more importantly because no other political bloc dared to undertake the countermeasure of promoting the negotiations. Under such conditions, Japanese negotiators, who first tried to take the lead in advancing the Round when it began in 1986, failed to make active contributions as the negotiations dragged on. Instead, they were forced to adopt the usual Japanese stance of waiting for other nations to work out a solution and then accepting the agreement, making as few concessions as possible. 5. For more detail. see Hayami (1988, chaps. 1 and 3).

376

Yujiro Hayami and Yoshihisa Godo

13.3 Evasion of Rice Tariffication Now, the relevant question to ask is: Why was rice market tariffication so strongly opposed by the Japanese government?Would tariffication destroy Japanese agriculture and result in an unbearable burden on Japanese farmers as well as the demise of an agricultural heritage? In fact, this scenario seems unlikely from any calculations based on sound knowledge.

13.3.1 Possible Impact of Tariffication The tariffication plan outlined in the UR agreement is the following: replace in 1995 all nontariff barriers by tariffs at rates equivalent to the differences between domestic (wholesale) and international (import c.i.f.) prices and, then, reduce tariff rates by 36 percent on the average with a minimum of 15 percent reduction for individual commodities within the six-year period from 1995 to 2000. How would this scheme affect Japanese rice farmers? It is more than reasonable to assume that upon acceptance of this plan, the Japanese government would seek approval for the application of the minimum 15 percent tariff reduction on rice. This implies that the average reduction in rice tariff rates per year would be only 2.7 percent. The effect of the tariff reduction in lowering the domestic price of rice in the following six years can be calculated as follows. The average rate of reduction in the tariff rate ( a X 100 percent) needed to reduce the tariff rate by 15 percent within the six-year period is calculated as 2.7 percent ( a = 0.027) per year from following relation: (1 -

=

0.85.

If rice is allowed to be imported freely from abroad at the tariff rate o f t X 100 percent, the relation between the domestic price ( P )and the import c.i.f. price (R) of rice is established as P

=

R (1

+ t).

If t is reduced by a X 100 percent, the new domestic price ( P ' ) becomes

P'

=

R [l

+ t (1 - a ) ]

The rate of reduction in the domestic price (c) corresponding to this tariff reduction is calculated as c =

(P - P') at -~ P (1 t)'

+

In general, for a given value of a, the larger the value of t, the larger the value of c. However, even if the initial tariff rate is set at 700 percent ( t = 7), based on the rather high estimate of the tariff equivalent for rice in Japan made by the U.S. International Trade Commission (USITC 1990), and this rate is cut by 15 percent in six years or 2.7 percent (a = 0.027) per year, the domestic

377

Rice Policy in Japan

price is expected to fall only by 2.3 percent per year. Even if an unrealistically high rate of 1,200 percent ( t = 12) is assumed for the tariff equivalent, the rate of corresponding reduction in the domestic price is just 2.5 percent. On the other hand, if the tariff equivalent is determined to be 300 percent ( r = 3), according to the estimate by the Forum for Policy Innovation (1990), which seems to be a more reasonable estimate, as discussed in appendix A, the rate of decline in the domestic price corresponding to a 2.7 percent reduction in the tariff rate is only 2.0 percent per year. This means that, if rice farmers in Japan were able to reduce their production costs at the speed of 2.5 percent per year, they would incur no damage from the UR tariffication. Considering the fact that the producer price of rice under government controls was lowered on average by 2.5 percent per year during 1986-91, it is reasonable to expect that Japanese farmers would be able to withstand the UR tariffication. It must be noted that the above calculation is based on the assumption of “clean” tariffication, in which the initial tariff rate is set exactly equal to the domestic-border price difference. In fact, because it is technically difficult to determine the relevant prices for the domestic and international markets, it is relatively easy to set the initial tariff rate significantly higher than necessary to prevent imports from occurring, as the EU example seems to demonstrate.‘j 13.3.2 The Experience of Beef Tariffication Tariffication in itself would not cause imports to grow. The height of initial tariff rates and the speed of their reduction determine how well imports do. This is clear from the previous experience with the tariffications of beef. A quota system for imported beef was replaced by tariffication in 1991 through US.-Japan bilateral negotiation.’ Has this resulted in rapid growth of beef imports? The answer is no. As shown in table 13.2, while beef imports grew at an average annual rate of 20.4 percent over the five years that quotas were in effect, their annual growth averaged only 12.5 percent over the four years following the shift to tariffication. Meanwhile, annual domestic production remained almost constant at about 400 thousand tons.*If the level of initial 6. See International Agricultural Trade Research Consortium (1994, 40-46). Under the UR agreement the Food Agency of Japan is allowed to mark up the price of minimum access import rice to as high as 332 yedkg, which is eight times higher than the border price of Thai rice. Therefore, it is likely that if Japan were to have accepted tariffication, the tariff rate of 700 percent would have applied to rice. This rate is far higher than the real tariff equivalent, as discussed in appendix A. 7. The Japanese government imposed quotas on beef imports before 1990. The Livestock Industry Promotion Corporation (Chikusan Shinko Jigyodan), which is an extradepartmental organization of the Japanese Ministry of Agriculture, Forestry, and Fisheries, controlled beef imports. Beef and oranges have been treated as symbols of the closed nature of Japanese market in U.S.-Japan trade talks. which became esDeciallv heated in the 1980s. The Jananese government withstood increasing import quotas at first but finally agreed to undertake beef tariffication (beginning in 1991) in 1988. 8. For a discussion of the influence of beef tariffication on domestic beef production, see Mori and Gorman (1995). L

,

Y

378

Yujiro Hayami and Yoshihisa Godo Imports of Beef to Japan, 1985-94

Table 13.2

Tariff Rate

Year 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994

(%)

70

60 50 50

Import Quantity (thousand metric tons) 150.6 179.1 220.0 263.5 348.7 376.1 353.1 411.6 511.6 588.6

Rate of Increase from Previous Year

(%I 18.9 22.9 19.8 32.8 7.9

I

Average 20.4

,

Source: Japan Ministry of Agriculture, Forestry, and Fisheries, Monthly Statistics ofilgriculture, Foresfry, and Fisheries (Tokyo, various issues).

tariffs and the speed of tariff cuts are set appropriately, it can be argued that tariffication can be more effective in curbing imports than are quantitative import restrictions. In the case of beef, the tariff rate was reduced by about 30 percent within the two years from 1991 to 1993, which was six times faster than the minimum allowable rate of reduction of 15 percent over six years (equivalent to 5 percent over two years) in the UR agreement. If the tariff rate reduction for beef had been as small as 5 percent, the tariff rate in 1993 would have been 66 percent instead of the actual level of 50 percent. In this case, judging from the decrease in beef imports in the first years of tariffication under the tariff rate of 70 percent, it is unlikely that any significant increase in beef imports would have occurred after tariffication if the conditions of tariffication applied to beef were the same as those of the UR tariffication applicable to rice. 13.3.3 Effectiveness of Safeguards Often cited by opponents of tariffication was the danger of increases in rice imports due to sharp declines in border prices, which might arise from such factors as foreign exchange rate appreciation, changes in overseas supply conditions, and dumping by exporters. However, the UR agreement includes strong safeguard measures. One is the “special safeguards” provision that allows the importer to increase the tariff rate corresponding to the decline in border price or import quantity increase. Another could be the use of a specific duty instead of an ad valorem tariff. The safeguard power will be extremely strong for a commodity like rice in Japan, characterized by a large domestic-border price difference, if the price-trigger safeguard and the specific duty are combined. This is illustrated in table 13.3,

Rice Policy in Japan

379

Illustration of Safeguard Measures

Table 13.3

Ad Valorem Tariff

No Safeguard Border price Tariff (300%) Domestic price (A)

1

Border price Tariff (300%) Domestic price (B) Rate of domestic price decrease (%) = (B - A)/A

PriceTrigger Safeguard

Specific Duty QuantityTrigger Safeguard

-80

PriceTrigger Safeguard

QuantityTrigger Safeguard

10 166' 176

195' 205

- 12

3

50 yenlkg 150 200

50 yenlkg 150 200

10 30 40

No Safeguard

10 4@ 56

-72

10 39b 79

10

150 160

-40

-20

10

"Initial tariff plus 16.4 yenlkg: 16.4 =

5 x0 10%

~

(20 - 5) + -10%-40% --XO.3+---

(30 - '0) x 0.5 + (37 - 39) 40%-60% 60%-75% ~

X

0.6

(40 - 37) + above 75%

o,9

~

h30 X 1.3 (increase in the tariff rate by 30 percent when import quantity increases by 26 percent from the previous three-year average). '150 X 1.3 (as in note b).

in which as an extreme case the border price declines from 50 yen/kg to only 10 yen/kg, under the assumption of an initial tariff rate of 300 percent. Initially, the domestic price is assumed to be 200 yen/kg through the addition of a 300 percent tariff (150 yenkg) to the border price of 50 yen/kg. If the ad valorem tariff is applied, corresponding to the reduction in the border price from 50 to 10 yenkg, the domestic price will decline sharply from 200 to 40 yen/kg. Special safeguards will be of little help in this situation. However, if the specific duty is fixed at 150 yen/kg, the domestic price will decrease only slightly from 200 to 160 yen/kg despite the border price decrease from 50 to 10 yen/kg. If the price-trigger safeguard is applied in addition, the domestic price of imported rice will decrease only to 176 yen/kg. If the quantity-trigger safeguard is applied instead, the new domestic price of imported rice will be higher than the prior domestic price level, with no possibility of further increase in rice imports. 13.3.4 Vested Interests against Tariffication Thus, if the initial tariff rate is appropriately set to cover the domestic-border price difference and the safeguard measures are adequately combined, rice imports under tariffication can be kept much lower than the level of imports under increased minimum access. This is an easy conclusion to draw, about which capable government officials in Japan could hardly be ignorant. So why did

380

Yujiro Hayami and Yoshihisa Godo

Japan endeavor to make rice an exception to the general principle of the UR agreement? The answer appears to be because tariffication threatens to damage the vested interests that are protected by the nation’s food control ~ y s t e mIn . ~particular, it would eventually destroy the monopolistic control over rice marketing enjoyed by the Food Agency and agricultural cooperatives. Under the Food Control Law, all rice is supposed to be collected by village agricultural cooperatives and is sold either to the Food Agency (the “government rice” channel) or to licensed wholesalers (the “voluntary rice” channel) for further distribution at the retail level, even though some rice is, in practice, distributed illegally through the black market (“free rice”; see fig. 13.1). In order to establish riceselling rights through legal channels, rice farmers have to divert a certain portion of their paddy field area away from rice production; this acreage control program was created to maintain domestic rice prices far above the market equilibrium level under autarky. This system has been the major source of institutional rent for both agricultural cooperatives and the Food Agency. The rent partly goes to farmers through price increases. But it mainly goes to the Food Agency and the agricultural cooperatives in order to continually expand the size of these institutions. It should be noted that almost all farmers are members of agricultural cooperatives, yet there are cases in which the benefits received by individuals differ from the benefits received by cooperatives. Agricultural cooperatives, through their strong political power, oppose tariffication, although certain members within the cooperatives have different opinions on the issue. Introducing tariffication would be like drilling a hole in this food control system, in which all rice is controlled by the Food Agency. It is a step toward the market-oriented reform of the rice distribution system. In contrast, the minimum access import quota system, in which rice imports are all controlled by the Food Agency, presents no opportunity for such reform. It is conceivable that windfall profits from the mark-up sale of minimum access foreign rice at the high domestic price will be used in order to strengthen the present food control system. Under the present system, rice production in Japan is controlled by paying farmers subsidies to reduce the amount of farmland dedicated to growing the crop. This helps maintain high prices that far exceed the levels that would prevail under free market conditions. Also, acreage control is allocated almost equally among farmers, with the effect of preventing the concentration of rice production among more efficient growers. This is a major obstacle to exploiting in scale economies that have emerged in the agricultural industry since 9. Corresponding to the acceptance of the UR agreement, the government enacted in 1994 the so-called New Food Law to replace the Food Control Law. (The new law comes into effect 1 November 1995.) Similar to the old law, the new law is very general and abstract so that it is hard to judge how the rice distribution system will be changed. The future depends much on ministerial orders and administrative guidance. For details, see Godo and Honma (1997).

Rice Policy in Japan

381

/

/ 1

' '

Village-level agr!. coop.

/ - -

1

/'

//

National -level federation of agri. coop.

l'

I I

r

Free rice markyt

I

:

'

=\,

\

'---+

I ,

Food Agency

allotment

I

i

I \ '\---1; Wholesaler \ '\ v \ \

4 I

'- - - +

Jiyu Mai (free rice)

q * Consumer

Retailer

: Jishu Ryutsu Mai

$. (voluntary rice)

1 Seifu

Mai

(government rice)

Fig. 13.1 System of rice marketing under the Food Control Law Note; Wholesalers and retailers are licensed by region.

the large-scale progress in mechanization induced by sharp increases in wage rates in the 1970s. And because rice prices and marketing systems are inflexible, this prevents farmers from making the most of their entrepreneurial abilities (see Hayami 1988, chaps. 3 and 6 ) . One way of enhancing these abilities would be to remove government controls on rice marketing and to promote cost reduction by gradual reduction of domestic prices. By evading tariffication while keeping rice prices high by reducing rice acreage at a rate equivalent to the increase in minimum access imports, perhaps the incentive for reforms will be weakened. Indeed, the maintenance of high domestic prices by means of acreage control in response to shrinking domestic demand has been the continual policy mix in Japan and has consistently hindered the growth of Japanese agriculture. This policy mix is likely to continue in an accentuated manner with increased minimum access imports. If the evasion of tariffication is harmful rather than beneficial to agriculture, one could maintain that it has been adopted because it protects the vested interests of the Food Agency and agricultural cooperatives. In order to support the arguments above we will try to show, by means of a simple simulation analysis, the likely course of the rice sector after the Uruguay Round under the traditional policy mix in contrast with possible other courses under alternative policy mixes.

382

Yujiro Hayami and Yoshihisa Godo

13.4 The Political Economy Dynamics of the Rice Market As a background to the simulation analysis, this section tries to identify the goals and means of traditional rice policy in Japan in terms of the policy’s consequences. 13.4.1 Policy-Induced CyclesIo The revealed objective of Japan’s rice policy since the 1960s, when Japan joined the group of high-income countries, appears to be the support of domestic producer prices within the constraints of the government budget. Various policy means designed to achieve this goal, when interacted with market forces, have created major fluctuations in the rice market as shown in figure 13.2. Government efforts to increase the producer price of rice were intensified especially in the early 1960s when high economic growth (kodo keizai seicho) widened rural-urban income disparity. Because all rice was then procured by the Food Agency through agricultural cooperatives, the producer price could be increased by raising the government purchase price. Corresponding rapid rises in the purchase price created a deficit for the Food Agency because the government sale price increase had a time lag of a few years. However, the extremely rapid increase in the government deficit during the 1960s resulted more from the response of the market to the increased price than from the increase in the negative government marketing margin. The increased producer price stimulated production and market supply. From 1960 to 1968, total rice output increased by 14 percent (from 12.5 to 14.2 million tons), while total sales to the Food Agency rose faster, by as much as 67 percent (from 6.0 to 10.0 million tons). Given the negative marketing margin, the deficit from the food control program increased in proportion to the increase in rice procurement by the Food Agency. More serious was the accumulating surplus in government storage. During the 1960s, rice became an inferior good with respect to per capita income rises; average per capita rice consumption per year declined steadily from a peak of 118 kilograms in 1962 to 100 kilograms in 1970. In addition to negative income elasticity of demand, the increased price probably also contributed to the decline in rice consumption to some extent. With the bumper crop in 1967, the excess supply of rice became especially evident in the form of a sharp increase in the quantities of old rice in government stocks. The multiplying financial burden arising from excess supply forced the government to introduce three simultaneous measures in 1968: (1) restraint on the price of rice, (2) acreage control, and (3) disposal of surplus rice.’’ For the subsequent three years, the producer price was kept the same. 10. This section draws heavily on Hayami (1988, chap. 3, sec. 2). 11. The first disposal of surplus rice occurred in 1971-74, with government expenditure reaching 1 trillion yen (for the second instance, see n. 12). About 7.4 million metric tons were exported at low prices or crushed and used for feed or food processing.

383

Rice Policy in Japan

Prcduc t i on

15.000 14.000

1

1

15.000 14.000

13.000 12,000

11.000

10.000

3.000 8.000

7.000

L

J 7.000

,-..

Old rice stock

"\

I\

I

900

/--

.-.. 1

Paddy area diverted frm production

Goverment sale price Government purchase prlce,

I. 200

0

1. 000 2

=

- 800

-s-

- 600

2

8

400

Government marketing deficit t hrea control cost

..

--.--L..

-

Area control cost

200 0

Fig. 13.2 Policy-induced cycles in the rice market Sources: Japan Ministry of Agriculture, Forestry, and Fisheries (JMAFF),Shokuryo Kanri Tokei Nenpo (Annual report of food control statistics), Norin Suisun Sho Tokeihyo (Statistical yearbook of JMAFF), Shokuryo Jikyu Hyo (Food balance sheets), Nogyo Hakusho Fuzoku Tokei Hyo (Statistical appendix to the Agricultural White Paper) (Tokyo, various years).

In the short run, demand remains relatively price inelastic because rice is still culturally the staple food of the Japanese diet. Furthermore, the the shortterm supply of rice is mostly influenced by weather conditions and may not necessarily increase in response to price rises. Therefore, excess supply does not become especially significant even if the price is raised above the market equilibrium. In such a situation, irrespective of how much the producer price is raised, it would not cause much financial burden to the government if the consumer price were raised in parallel even with a few years' time lag. In the long run, however, an excess supply of rice becomes inevitable as long as the government continues to support the price of rice. On the supply

384

Yujio Hayami and Yoshihisa Godo

side, the increased price stimulates the application of fertilizers and other inputs, and as a result, supply increases. Furthermore, on the demand side, consumers over time gradually substitute toward relatively cheaper, wheat-based products such as bread. When excess supply is created as the result of longrun adjustments to the price support in demand and supply, the resulting extra costs, such as storage and surplus disposal costs, can no longer be passed on to consumers. During the 1960s, average per capita income rose very rapidly, to the extent that it doubled in a decade in real terms, and rice consumption declined gradually both absolutely and relative to total household consumption expenditure. The increase in the consumer price of rice was therefore not strongly resisted, and in particular, there was no substantial political movement against the increase in rice prices. In the short run, since it was possible to pass on a large part to consumers, the rice price support was raised without too much stress on the treasury. But over the long run, due to the response of the market, it became an increasingly unbearable burden on the government. It may seem strange that the rice price began to be raised again in 1973, as soon as the disposal of surplus rice was completed and demand-supply equilibrium was restored by the success of the acreage control program.’2 This was partly due to the outbreak of the so-called world food crisis of 1973-74. Sharp increases in world food prices, coupled with the U.S. soybean embargo, stirred up anxiety in the p~b1ic.I~ The farm bloc took advantage of this situation in their lobbying for a price increase by advocating greater food self-sufficiency and security. However, another factor underlying the second surge of rice price support was perhaps that policymakers were slow to predict the creation by market forces of a large surplus in response to further price increases. Even if they foresaw this, it might have been difficult for them to present sufficiently strong reasons to counter the pressure for the price increase. Or it might have been the case that, given politicians’ high rate of discount on future costs and benefits balanced against their immediate need to stay in office, it was to their advantage to yield to pressure from the farm bloc. At any rate, the price support was raised, and the acreage control program was relaxed. There followed a repetition of the experience of the 1960s. With increasing excess supply, surplus stock was accumulated, and the government deficit escalated, forcing a price freeze and a strengthening of acreage control in the late 1970s. The policy-induced cycles thus created have involved a large waste of re12. The second disposal of surplus rice occurred in 1979-86. A volume of about 6 million metric tons was exported or sold for feed or food processing in just the same way as in the first disposal. In this instance, government expenditure was 2 trillion yen. 13. During the world food crisis, the United States invoked a soybean embargo from 27 June to 8 September 1973 as a measure to counter inflation. As Japan is a major soybean importer, this created considerable turmoil and placed pressure on food prices.

385

Rice Policy in Japan

sources. An obvious example is the accumulation of surplus rice and its disposal at huge cost. Another example is that paddy fields that, in response to high prices, had been converted from upland fields through large investments for the installation of irrigation systems were diverted from rice production back to upland crops just when construction was completed. This suggests that social losses may result from state intervention when decisions are made without appropriate consideration of market forces. 13.4.2 Emergency Rice Imports in 1993-94 Emergency rice imports in 1993-94 in Japan, the first in two decades and ironically coinciding with the conclusion of the Uruguay Round, can be understood as an extension of the policy-induced cycle. When the second surplus had somehow subsided by 1984, the government rice stock began to rise again, partly because production was stimulated by high prices and partly because domestic consumption continued to shrink. A third surplus did emerge in 1986-89, but on a much smaller scale than in the previous two instances because the government was quick to strengthen acreage control based on its experiences with the previous failures, with the reduced area amounting to nearly one-quarter of the total paddy field area. In retrospect, it is clear that the government became overly cautious about the possibility of another major surplus. Acreage control was maintained at such a high level that the government rice stock was below the normal operational inventory level when the rice crop was severely affected by adverse weather conditions in 1993. (The official rice yield index declined by 26 percent.) Thus, the Food Agency had no option but to organize large-scale import activities. The shortfall of the 1993 rice crop was quickly replaced by a bumper crop in the next year. The 1994 crop was stimulated by both high prices in the previous year (especially in the black market) and relaxation of acreage control. By the end of the 1994 rice year (October 1995) the government rice stock reached a level of 1.6 million tons, nearly three-quarters of the 1987 level, which was the peak of the previous surplus era. Yet, it will not be easy for the government to curtail production for the next few years. A reduction in producer prices does not seem politically feasible because the farm bloc is demanding instead price hikes as compensation for the acceptance of the UR agreement. The same argument applies to acreage control. A likely course in the short run will be for the government to hold the surplus in stock. Financial constraints on increasing the inventory carryover can be mitigated to some extent by Food Agency profits from the mark-up of minimum access import rice. Thus, it is not improbable that the government’s inventory accumulation will reach the levels of the previous two surpluses of the 1970s and 1980s and that the government will thereafter return to the normal policy mix of high price support and increasing acreage reduction. If this happens, a large waste of government resources in the form of stock-carrying cost

386

Yujiro Hayami and Yoshihisa Godo

and capital loss from surplus disposal will be inevitable, and productive investments, such as agricultural research and extension, that are necessary for the revitalization of agriculture in the post-UR regime will have to be curtailed.

13.5 A Simulation Analysis This section contrasts the economic implications of Japan’s postponement of tariffication on rice with those of other policy options by means of a simple simulation analysis. 13.5.1 Alternative Scenarios The three options to be compared are: A. Evade tariffication by increasing minimum access import quotas gradually from 4 percent of domestic consumption in 1995 to 8 percent in 2000; this external commitment is coupled with the domestic policy of strengthening acreage control to reduce rice production by the amount of minimum access imports so as to maintain the domestic price at the baseline level. The three variants of this scenario after 2000 are: A-a. Continue to exempt rice from tariffication by increasing minimum access to 12 percent in 2006. A-b. Shift to tariffication in 2001 and thereafter follow scenario B. A-c. Shift to tariffication in 2001 and thereafter follow scenario C. B. Start tariffication in 1995 with a pledged reduction in the tariff rate by 15 percent until 2000, and gradually increase minimum access import quotas from 3 percent to 5 percent of domestic consumption within the six-year period; this external commitment is coupled with the domestic policy of strengthening acreage control to reduce rice production by the amount of minimum access imports so as to prevent the domestic price from falling faster than the decrease resulting from the tariff cut. After 2000, the tariff rate will be reduced by another 15 percent within the next six years, while minimum access imports will be increased to 7 percent of domestic consumption, which will be counteracted by an equivalent increase in acreage reduction. C. Start tariffication in 1995 with the same external commitment as in scenario B, coupled with the domestic policy of relaxing acreage control by 1 percent per year of total paddy field area throughout the period until 2006. In all three scenaios it is assumed that all the losses in producer surplus will be compensated by direct government payments to individual producers in a “decoupled” manner proportional to either their operational landholdings or their marketing volumes in the base period. Participants in acreage control programs also will be compensated so as to maintain their welfare position. Scenario A represents the likely course of the rice sector in Japan because the external commitment explained is the actual situation and the domestic

Rice Policy in Japan

387

D,

Price

: Domestic demand minus minimum access

sz: Domestic Supply (Increased acreage reduction by minimum access)

s,:

Domestic supply (Base-level acreage reduction)

W(1tt)

=

W[lt(l-r)t] =

f

R U

S O : Domestic supply (no acreage reduction)

import price W

[

Quantity

Fig. 13.3 Effects of rice market opening in Japan

policy outlined is the one most likely to be pursued in the medium run, even though in the short run a build-up of government inventory may precede the strengthening of acreage control. Scenario B would have been the likely course had tariffication been chosen because, judging from the revealed preference of the government to support domestic producer prices as much as possible within budgetary constraints, it seems reasonable to expect that domestic policy will be designed so as to minimize the price decline after tariffication. For that reason, scenario C is unrealistic because its policy mix is unlikely to be chosen. It may, nevertheless, be a policy direction that would promote the survival and revitalization of Japanese agriculture in the international market. The simulation analysis traces changes in the domestic price and output of rice as well as government costs and producer and consumer welfare under three alternative policies.

13.5.2 Model and Parameters Our analysis is based on a simple Marshallian partial equilibrium framework under a small-country assumption. The model of the rice market in Japan is shown in figure 13.3, with the vertical axis representing price and the horizontal axis representing quantity.I4 D, represents the domestic demand schedule and So represents domestic 14. The model used here is a revision of the model developed by Y. Hayami and K. Otuska in Forum for Policy Innovation (1993).

388

Yujiro Hayami and Yoshihisa Godo

supply in the absence of acreage control, implying that a is the point of free market equilibrium under autarky. Rice policy in Japan for the past three decades has aimed at raising the domestic price above a. The resulting excess supply has been avoided by shifting the supply curve to the left by means of acreage control. The baseline (pre-market-opening) equilibrium is considered to be at point b, at which domestic demand (Do)and domestic supply under acreage reduction (S,) intersect. If minimum access imports are enforced in this situation and if the imported rice is discharged to the market, demand for domestic rice will shift from Do to D , with the price lowered to U, which corresponds to equilibrium point c. The price can be maintained at P, however, if acreage control is strengthened so as to shift domestic supply from S, to S,. This is the policy response assumed in scenario A. In this case there is little need for compensation to producers since their welfare position decreases only slightly, while there is no increase in consumer surplus. The government (Food Agency) gains by area bdzy, the mark-up margin of minimum access rice. If tariffication is introduced instead, there is no immediate impact on the domestic price because the difference between the domestic price ( P ) and the import price (W) will be levied as a tariff ( t percent of W). Minimum access imports will have the same effect as in scenario A, although their impact is quantitatively smaller. However, even if acreage control is strengthened so as to shift domestic supply from S, to S,, as assumed in scenario B, the domestic price cannot be maintained at level P for long, as the tariff rate will be reduced at the rate of 15 percent over six years. As the initial tariff rate ( t ) is reduced by r ( X 100) percent, the domestic price is bound to decline from P to R and imports to increase by efabove the minimum access quota @). In contrast, if acreage control is not strengthened while minimum access imports are undertaken, market equilibrium is established at c. At this point, if the market price of domestic rice (V) is lower than the price of imported rice after tariff payment (R), as illustrated in figure 13.3, no additional imports will emerge beyond the minimum access amounts. Scenario C represents the case in which acreage control is relaxed instead of being left unchanged. Therefore, the likelihood of no additional imports occurring is higher than in the case of no changes in acreage control, represented by equilibrium point c. For simplicity of presentation, we represent scenario C as the case of no change in acreage control. Gains in consumer welfare measured by consumer surplus can be calculated by taking integrals of Do with respect to price over the range from P to R for scenario B and from P to U for scenario C. Corresponding changes in producer surplus can be calculated by taking integrals of S, (for scenario B) and of S, (for scenario C). For specific computational formulas, see appendix B. As for basic parameters, we use 0.4 for the price elasticity of domestic supply and -0.2 for the price elasticity of domestic demand. These are commonly

389

Rice Policy in Japan

used values for the analysis of the rice market (see Otsuka and Hayami 1985). For the sake of simplicity, we assume the baseline level of domestic consumption before the UR market opening to be I0 million tons of brown rice (which can be converted to milled rice by applying a factor of 0.9). The baseline price of domestic rice at the wholesale level is assumed to be 329 yenkg of brown rice, which is the 1992 average of free market (black market) rice prices based on the survey by the Ministry of Agriculture, Forestry, and Fisheries (1994). The baseline ratio between domestic and import c.i.f. prices is assumed to be 4 to 1, for the reasons discussed in appendix A. 13.5.3 Findings Results of the simulation analysis are summarized in table 13.4 and figure 13.4. It must be remembered that the three alternative scenarios for which the simulation analysis is carried out are equivalent in terms of producer welfare because any welfare loss is supposed to be compensated for by government payment in a decoupled manner. Scenario A: No Tarification + Increased Minimum Access Acreage Control

+ Increased

Scenario A is the current situation, and it is likely to continue in the future. According to this scenario, although the domestic price can be maintained at the baseline level, domestic output will continue to shrink. Under high price support and strengthened acreage control, no momentum can possibly arise for structural adjustment geared toward improving farm efficiency. Possible gains in social welfare from this market-opening scheme will be negligible unless tariffication is accepted after 2000, since consumers receive no benefit because of the maintenance of high prices. Nevertheless, this is an attractive scenario for the government. Food Agency revenue from the mark-up of minimum access import rice will amount to nearly 200 billion yen in 2000 and reach as much as 400 billion yen in 2006 if tariffication is avoided after 2000. The increased revenue, along with a corresponding expansion in the organization and power of the Food Agency in the area of rice trading, will be a bonanza for bureaucrats in the Ministry of Agriculture, Forestry, and Fisheries. For the Ministry of Finance, which is so concerned about balancing budgets, this scenario is highly attractive because the compensation payment to farmers can be more than fully financed by the markup revenue with no danger of increasing transfers from the general account to the Food Control Special Account under the administration of the Food Agency. It is also attractive for politicians because they can easily present the maintenance of high prices with the rejection of tariffication as their success in working strongly for the protection of farmers. Because of the preferences of bureaucrats and politicians, it is highly probable that this scenario will continue even after 2000 (scenario A-a) instead of shifting to tariffication (scenario A-b or A-c). In short, scenario A implies the

Results of the SimulationAnalysis

Table 13.4

Increase Inc

Imports'

Scenario"

Domestic Priceb (1) (2)

Baseline level

Domestic Outputc (3)

Total (4)

Minimum Access (5)

Over Secondary Tariff (6)

329

(100)

10,000

0

0

0

1995 2000 2006 2006 2006

329 329 329 255 255

(100) (100) (100) (78) (78)

9,867 9,200 8,800 8,128 8,850

400 800 1,200 2,395 1,673

400 800 1,200 1,000 1,000

0 0

0 1,395 673

B

1995 2000 2006

(98) (89) (78)

9,842 9,057 8,399

413 1,184 2,124

300 500 700

113 684 1,424

C

1995 2000 2006

323 292 255 319 275 243

(97) (84) (74)

9,978 9,866 9,924

300 500 700

300 500 700

0

A A-a A-b A-c

0 0

Additional Acreage Reductiond (7)

Tariff/ Mark-up Revenue (8)

Producer Surplus (9)

Consumer Surplus (10)

Budget Cost (11)

Social Welfare (12)

0

0

0

0

0

-31 - I88 -282 - 869 -737

0 0

2

33 197 296 413 289

0 758 758

-2 -9 - 14 456 449

2 9 14 302 309

0.83 5 7

47 248 367

-80 -461 - 820

62 374 758

33 212 453

28 162 305

20 96 112

- 75 -412 -626

99 550 883

56 316 514

43 234 369

0 I .33 8 12 10

-1 -6 - 12

"A: No tariffication + increased minimum access imports + equivalent increase in acreage reduction. A-a: Continue the same policy after 2000. A-b: Shift to tariffication after 2000 + increase in acreage reduction. A-c: Shift to tariffication after 2000 + decrease in acreage reduction. B: Tariffication + increase in acreage reduction equivalent to minimum access imports. C: Tariffication + decrease in acreage reduction by 1 percent per year of total paddy field area. byen per kilogram. Thousand metric tons. dPercentage of total paddy field area. ?Billion yen

i. Domestic rice price (1)

340 r

ii.

0

A-C

-

8.500 v

8.000

' w m m

-

I

'

' m m

m

100

Domestic rice output(3)

-

-

'

'

'

'

h m m O - N O I m m m o o o o m m m o o o o -

...

111.

-

N

N

N

N

N

l r J ~ o o o o o o

N

N

Additional budget cost (11)

r

h

8x -100

-200 2 -300 B -400 v C

-

-500 -600

iv.

Increase in social welfare (12)

400

0

Fig. 13.4 Results of the simulation analysis Note: Numbers in parentheses correspond to column numbers in table 13.4.

392

Yujiro Hayami and Yoshihisa Godo

continuation of traditional Japanese agricultural policy geared toward charging the cost of agricultural protection to consumers with a minimal burden on the treasury. Scenario B: Tariftication + Increased Acreage Control

Scenario B would have been the likely situation had tariffication been accepted at the conclusion of the Uruguay Round. In this scenario, the domestic price will decline from the baseline by a modest 11 percent over the first six years, entirely as a result of a reduction in the secondary tariff rate, and by another 1 1 percent over the next six years if the same rate of tariff cut is applied. The corresponding shrinkage in domestic output will be the largest among the three alternative scenarios, by about 10 percent by 2000 and 16 percent by 2006. Loss in producer surplus is expected to be large, but nearly half of the income compensation required from the government can be financed by the tariff/mark-up revenue from increased imports. Still, the additional budget requirement will amount to about 200 billion yen in 2000 and 450 billion yen in 2006. Yet social welfare will increase by about 160 billion yen in 2000 and by 300 billion in 2006. Scenario C: Tariftication + Decreased Acreage Control

A very different picture will emerge under tariffication if acreage control is relaxed instead of strengthened. Scenario C will see the largest decline in domestic price, but domestic production can be maintained at almost the baseline level right through to 2006. This is because the increased supply of domestic rice will result in a larger price decline than the decline that results from the prescribed tariff cut, and thus the importation of foreign rice will be prevented from increasing above the minimum access quota. The decline in prices, together with greater freedom in land use, is expected to encourage structural adjustment in order to improve farm efficiency. The budget costs of 3 16 billion yen in 2000 and 514 billion yen in 2006 may appear to be very large but are modest when compared with the new six-year agricultural support program recently approved, which includes a budget appropriation of 6 trillion yen as compensation to farmers for rice market opening due to the UR agreement. Social welfare gains from this market-opening scheme will be the highest among the three alternatives because of the large gain in consumer surplus. For bureaucrats, however, Food Agency revenue from the tariff/mark-up will be small and thus will fall far too short of compensation payments to farmers. In other words, this scenario reduces the consumer burden of agricultural protection at the expense of the treasury. For this reason, despite its large contribution to the social welfare of the nation as well as its encouragement of domestic rice production, this scenario is unlikely to be adopted.

393

Rice Policy in Japan

13.6 Conclusion In general, agriculture tends to be protected in high-income countries largely because consumers in affluent economies tolerate high food prices. Japan is no exception to this rule. Furthermore, Japan is no exception to the tendency that the lower a country’s comparative advantage in agriculture, the higher its agricultural protection. This tendency emerges partly because agricultural industries that have declining comparative advantage face more serious adjustment problems and, thereby, demand more government assistance. But an equally or even more important reason appears to be that it is much easier for the importer of agricultural commodities to charge the cost of agricultural protection to consumers by means of border protection, resulting in less pressure on the treasury. However, agricultural protection by the exporter tends to be more constrained because it relies heavily on government expenditure, which can be politically costly. From this perspective, the UR agricultural negotiations geared toward curtailing agricultural protection are considered to have been undertaken and somehow successfully concluded because the European Union began to share an interest with the United States in the fact that it has become a major exporter of agricultural commodities since the early 1980s. In contrast, Japan has continued to be a major importer and, hence, has not been subject to such severe pressure from the treasury to reduce agricultural protection. In the absence of domestic support arising from the point of view of budget savings, Japanese negotiators chose the option of waiting for the other two major players to work out a solution and then accepted the agreement to a minimal extent; this was achieved with the exemption of rice from tariffication. One could guess that the reason this formula is acceptable at home is not because it protects the interests of farmers. Possible negative effects of rice tariffication on domestic agriculture are expected to be very modest by all calculations and can be eliminated altogether if countered by appropriate domestic policies. As suggested by the results in this paper, the increased minimum access import quotas to which Japan committed itself for the purpose of compensation could have more adverse effects than tariffication. The decision to avoid rice tariffication could be interpreted as a move to protect the vested interests of the Food Agency and agricultural cooperatives, who have strong control over rice marketing. Avoiding tariffication, when coupled with increased acreage reductions equivalent to minimum access imports, will make it difficult for consumers to enjoy any benefits from the opening of the rice market. But because it does not require additional budget expenditure, this scheme is likely to meet with the approval of the Ministry of Finance and related political circles. This would suggest that the traditional policy mix of supporting producer prices while curtailing domestic production via acreage control will continue in the future that

394

Yujiro Hayami and Yoshihisa Godo

is, scenario A in our simulation. Under such a policy, little momentum will emerge for inducing structural adjustments in agriculture in order to close the productivity gap with overseas producers. In contrast, options like scenario C in the simulation analysis (i.e., accepting tariffication and relaxing acreage control) are less likely to be adopted because of opposition from the aforementioned political groups and the treasury. Within certain groups it is often said that the international competitive power of Japan's agricultural industry will weaken without certain changes in government agricultural p01icy.'~However, the evasion of tariffication could mean that the present course will continue at least for the time being.

Appendix A On the DifSerence between Domestic and Border Prices in Japan During the autarky with respect to rice ending in 1993, it was difficult to estimate the tariff equivalent for rice because of a sheer absence of border prices. An early attempt to estimate the border price was made in the report by the USITC (1990). Based a comparison between the average government sale price in Japan and the ex mill price of medium-grain rice in California plus the cost of shipment to Japan, the USITC concluded that the tariff equivalent for rice would amount to as much as 600-700 percent. However this USITC calculation is considered to be a gross overestimation, partly because quality differences were not considered, but more critically because several important cost components such as interest and insurance charges were not counted (Godo and Owens 1995). Estimates by Y. Hayami that incorporate all possible marketing costs turned out to range from 200 to 300 percent depending on assumptions about quality differences (see Forum for Policy Innovation 1990). The emergency imports that occurred in the 1993 rice year as a result of domestic crop failures produced an opportunity for the evaluation of foreign rice in the Japanese market. Even though this market test could not be especially accurate under such conditions, it is still useful information for a broad estimation of the tariff equivalent. Column (1) in table 13A.1 reports government sale prices to wholesalers of imported rice from various countries. These prices were determined by the Food Agency when it began to sell imported rice in November 1993. Relative to the price of Japanese rice, imported rice of Japonica type from U.S.15. For details, see Forum for Policy Innovation (1990, 1993) and Godo (1994).

395 Table 13A.1

Rice Policy in Japan Comparison between Government Sale Prices and Import c.i.f. Price of Foreign Rice, 1993 Rice Year (November 1993-October 1994) Government Sale Price

Origin

Initial" (1)

Revisedb (2)

Japan

302.1d (100)

302. Id (100)

United States California South

236.5 208.9

(78) (69)

240.7 (80) 137.9 (46)

(74)

242.6

Import c.i.f. Price' (3)

(1~3) (4)

(2~3) (5)

65.9

Australia

223.1

China Dongbe Xiaozham Changshu Thailand

3.6" 3.2

3.7' 2.1'

(80)

71.3

3.1

3.4

205.6 (68) 218.6 (72) 213.6 (71)

128.1 (42) 144.3 (48) 128.1 (42)

52.8

3.9f 4.1' 4.0'

2.4' 2.7' 2.4'

199.98 (66)

106.59 (35)

55.69

3.6

1.9

Sources: Government sale price, announced by the Food Agency; import c.i.f. price, Japan Ministry of Finance, Customs Bureau, Nihon Boeki Geppyou (Japan exports and imports) (Tokyo, various issues). Nofee.Prices are brown rice prices in yen per kilogram. "Effective before 26 August 1994. hEffectiveafter 26 August 1994. 'Average for November 1993-October 1994. dAveragefor government rice, grades 1-5. 'Divided by the average c.i.f. price for the United States. 'Divided by the average c.i.f. price for China. XPrice in milled rice.

California, Australia, and China had prices that were about 20 percent lower, while the prices of Indica rice from U.S.-South and Thailand were more than 30 percent lower. These prices are considered the Food Agency's expectations of the market value of imported rice. Yet the sale of foreign rice, especially of the Indica type, proved to be slow at these prices despite sharp rises in the price of domestic rice in the free (black) market in the first half of 1994. With the growing expectation that a large stock of foreign rice would be left unsold by the end of the 1993 rice year (actually the stock in October 1994 turned out to be 980 thousand tons, about one-third of total imports), the Food Agency decided in August 1994 to lower the sale prices of Indica rice and low-quality Japonica rice from China, as indicated in column ( 2 ) . It is obvious that the initial government sale prices in column (1) represented overestimates of market-clearing prices of foreign rice in Japan. It is not so obvious whether the revised prices in column ( 2 ) were also overestimates under normal market conditions, even though the stock of foreign rice has remained large under these prices. The unusual glut of foreign rice, especially

396

Yujiro Hayami and Yoshihisa Godo

of the Indica type from Thailand, has been created by the Food Agency's scare purchase of an amount far exceeding the absorptive capacity of the Japanese market. If Thai rice had been imported commercially in an appropriate quantity under normal market conditions, its price could have been higher than that shown in column ( 2 ) . It may not be unreasonable to expect that market prices of foreign rice at the wholesale level in a normal situation would be somewhere between the initial and the revised prices. Columns (4) and (5) are obtained by dividing the initial and the revised government sale prices by the import c.i.f. prices in order to develop a range of estimates of the domestic-border price ratio for rice. The domestic-border price ratios thus calculated were lower than 4 (except that for Chinese rice) before the revision in August 1994. The c.i.f. prices of 1993-94 in column (3) could have been much higher than normal because of the effect of sudden large-scale purchases by Japan on the volatile world rice market. On the other hand, in a normal year, when the supply of domestic rice is abundant, foreign rice could only have been sold at much lower prices than the government set in this situation. Moreover, to be exactly comparable with the government sale price of domestic rice at the wholesale level, border prices must include various marketing costs of moving rice from the port to the government warehouse in addition to the c.i.f. price. According to our rough calculation, this additional cost would amount to about 25 yen/kg. To that extent, the domestic-border price ratios in columns (4) and (5) may involve a 30-50 percent overestimation. Considering all such possibilities, it is highly unlikely that the domesticborder price ratio of rice in Japan today (the first half of 1995) would exceed 4 with a tariff equivalent of 300 percent. In our simulation analysis this upperend estimate is used so as not to underestimate the impact of tariffication on the domestic rice market.

Appendix B Formulas for the Simulation Analysis This appendix specifies formulas used for the simulation analysis whose results are shown in table 13.4 and figure 13.4. The demand and supply functions are specified as Demand: qd = yp-", Supply: q, = 6 A p P , where qd and q, are quantities of demand and supply, respectively; p is price; A is area planted in rice; -a and p are price elasticities of demand and supply, respectively; and y and 8 are constants. While p and q are supposed to be

Rice Policy in Japan

397

determined at the market equilibrium, A is considered to be exogenously determined by the government acreage control program. The elasticities (Y and p are assumed to be 0.2 and 0.4, respectively. We measure price and quantity in units of yen per kilogram and thousand metric tons, both in brown rice terms. Then the baseline (pre-market-opening) price and quantity for the Japanese rice market are p = 329 yenkg and q = 10,000 metric tons. Normalizing A in the baseline year as 1, y = 3 1,868 and 6 = 985. If all minimum access import rice is supplied to the domestic rice market, its price falls drastically. Thus the Japanese government will likely keep some minimum access import rice for several years after the begining of minimum access import activities, as stock or for foreign aid. We assume that only after 1999 will all of the minimum access imports be supplied to the domestic rice market. Until 1999 the volume of minimum access imported rice sold in the domestic rice market in year t measured in thousand metric tons (m) is calculated as follows: m=

m

=

t - 1994 -~ X 800 for scenario A, 6

---

t - 1994 6

X

500 for scenarios B and C.

In our simulation the cost of accumulation of rice stock or foreign aid is abstracted out. The import price of foreign rice of the same quality as Japanese rice is assumed to be one-quarter of the baseline domestic price. The equation numbers for the different scenarios indicated below correspond to column numbers in table 13.4:

(1) is the solution forp in the equation 6 (1 - 0.01 X ( 7 ) ) A p + (6) + m = yp-"

for all scenarios.

(2) = 100 X (1)/329 for all scenarios. (3) = 6 (1 - 0.01 X ( 7 ) ) A p p for all scenarios. (4) = (5) + (6) for all scenarios.

+ (800 - 400) X ( t - 1995)/5 fort = 1995-2000forscenarioA. = 800 + (1,200 - 800) X ( t - 2006)/6 fort = 2000-2006 for scenario

(5) = 400

A-a. =

=

+

800 (1,000 - 800) X ( t - 2006)/6 for t = 2000-2006 for scenarios A-b mdA-c. 300 + (500 - 300) X ( t - 1995)/5 fort = 1995-2000 for scenarios B and C.

Yujiro Hayami and Yoshihisa Godo

398

=

+

500 (700 - 500) X ( t - 2006)/6 fort = 2000-2006 for scenarios B and C.

(6) = 0 for t = 1995-2000 for scenario A. =0

for t = 2000-2006 for scenario A-a.

[O, y q -LI - 6 (1 - 0.01 X (7))A q P - (5)] fort = 2000-2006 for scenarios A-b and A-c.

= max

= max

(0, y q-" - 6 (1 -0.01

X

( 7 ) ) Aq P - (5)) for scenarios B and C,

where q=329X

[

1+3

x o.i5)], (I----------i994

which is the import price of rice including tariff.

(7)

(8)

=

m/lO,OOO for t = 1995-2000 for scenariosA and B.

=

(5)/10,000 fort = 2000-2006 for scenarios A-a, A-b, and B.

=

800/10,000 - ( t - 2000) fort = 2000-2006 for scenario A-c.

=

-

( t - 1994) fort = 1995-2006 for scenario C.

= 0.001 X ((6)

+ m) X ((1) - 329/4)

(9) = 0.001 X ((1) X (3)

-

for scenarios B and C.

329 X 10,000)/(1

yp-" dp

+ p)

forall scenarios.

for all scenarios.

The reason for multiplying by 0.001 in equations (8), (9), and (10) is to express the answer in units of billion yen.

(1 1) = (8) + (9) for all scenarios. (12) = (8)

+ (9) + (10)

for all scenarios.

References Forum for Policy Innovation. 1990. Toward tarification for opening the rice market in Japan. Tokyo: Forum for Policy Innovation. . 1993. Korne shijo kaiho to zaisei futan (Rice market opening and fiscal burden). Tokyo: Forum for Policy Innovation. Godo, Y. 1994. Nochi kisei nochi zeisei no mondaiten to kaizenhoko (Problems and policies of farmland regulations and taxation). Tokyo: Forum for Policy Innovation. Godo, Y., and M. Honma. 1997. Japanese rice policy with the Uruguay Round agreement. Mimeograph.

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Rice Policy in Japan

Godo, Y., and L. Owens. 1995. An estimation of the border price ratio of rice in Japan. Mimeograph. Hayami, Y. 1988. Japanese agriculture under siege. London: McMillan. Honma, M., and Y. Hayami. 1986a. The determinants of agricultural protection levels: An econometric analysis. In The political economy of agricultural protection, ed. K. Anderson and Y. Hayami, 39-49. Sydney: Allen and Unwin. . 1986b. Structure of agricultural protection in industrial countries. Journal of international Economies 20: 115-29. . 1991. Causes of growth in agriculturalprotection. In The agricultural development of Japan, ed. Y. Hayami and s. Yamada, 221-39. Tokyo: University of Tokyo Press. International Agricultural Trade Research Consortium. 1994. The Uruguay Round Agreement on Agriculture: An evaluation. IATRC Commissioned Paper no. 9. St. Paul: University of Minnesota, International Agricultural Trade Research Consortium. Japan Ministry of Agriculture, Forestry, and Fisheries. 1994. Noson bukka chinnginn tokei (Statistics of prices and wages in rural areas). Tokyo: Japan Ministry ofAgriculture, Forestry, and Fisheries. Mori, H., and W. D. Gorman. 1995.The Japanese beef market following liberalization: What has and has not happened? Journal of Rural Economics 67 (1): 20-30. Otsuka, K., and Y. Hayami. 1985. Goals and consequences of rice policy in Japan, 1965-80. American Journal of Agricultural Economics 67529-38. U.S. International Trade Commission (USITC). 1990. Estimated t a n 8 equivalents of nontariy barriers on certain agricultural imports in European Community, Japan and Canada. Washington, D.C.: U.S. International Trade Commission.

COlllIIlent

Ammar Siamwalla

The paper by Hayami and Godo asks why the Japanese government was willing to trade an extra minimum access quota for the right not to tariff. It has accepted a minimum access amount of imports that starts at 4 percent, rising to 8 percent, compared to other advanced countries, which are allowed to set their minimum access level at 3 percent, rising to 5 percent. In exchange, Japan (and Korea), unlike other signatories to the World Trade Organization, does not have to bind tariffs for the amount in excess of the minimum access amount. The answer the authors give to this question lies in the special objective function of the government. The government is asserted to have to trade off between the budget cost (and revenues) from different policy measures and the benefits to producers, with consumers having negligible weight within that objective function. Since the domestic support is to be manipulated so as to maintain farmers’ welfare intact, the main criterion left is the minimization of the budget cost of the new arrangement. With these assumptions, the authors show that the main benefit from the point of view of the government is that the minimum access route lowered the Ammar Siarnwalla is Distinguished Scholar at the Thailand Development Research Institute.

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Yujiro Hayami and Yoshihisa Godo

budget cost relative to the tariffication route. The main benefit does not come from revenue from the quota rent because, by the authors’ calculations, the minimum access route actually reduces that. Rather the main benefit is from saving on domestic supports, as farmers do not suffer as severe a price cut or output fall with the minimum access route. My problem with the authors’ exercises is with the particular model used. First of all, it is not clear whether the conventional supply model is quite relevant to the task at hand. The presence of set-asides would imply that farm output is not on the supply curve. The use of the supply elasticity in this context is therefore highly questionable, even if the estimate were obtained correctly. The second problem is that the authors make no explicit assumption as to the future course of world prices and the yen-dollar exchange rate. Demand and supply conditions in Japan may be such that the stationary characterization that the authors have chosen is appropriate. This lack of consideration of longterm changes carries a message to which I shall return. My next problem is the omission of the kind of considerations that motivated Weitzman in his classic piece on “Prices vs. Quantities” (1974). The choice of the minimum access instrument is basically a choice of the quantity instrument (as is, of course, the set-aside instrument), whereas tariffication is a choice of the price instrument. There are uncertainties in the government’s perception of the future course of demand and supply and above all of the future course of world prices. Of course, the Weitzman analysis is relevant for a government that is intent on maximizing efficiency, which is not the case with the Japanese government. But the central point made in that paper, that it is uncertainty that makes for a substantive difference in the two modes of policy is, I think, quite robust. Let me play devil’s advocate and argue the case from the Japanese government’s point of view. I would then maintain that we all, including Japanese bureaucrats, are quite uncertain about the future course of world dollar prices and of the yen-dollar exchange rate. By this I do not mean the uncertainty that arises from yearly fluctuations that would necessitate fine-tuning and invocation of the safeguard measures allowed for in the Uruguay Round outcome. Rather, I mean the mistakes that the government could make about the secular trends of these variables. After all, one of the main reasons why Japanese rice prices are now stuck at such a high level relative to the world price is that the real exchange rate of the Japanese yen has gone up by so much. There is no permanent safeguard to counter such a miscalculation of trends. Now if domestic supply and demand curves do not shift much, the management of the domestic price support program would produce fewer surprises in the domestic price level, and therefore in the budget, with a known amount of minimum access than with tariffication.

Reference Weitzrnan, M. L. 1974. Prices vs. quantities. Review of Economic Studies 4:477-91

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Comment

Kym Anderson

This is a wonderful case study on a very important aspect of the Uruguay Round. It has direct relevance for the political economy of other rice markets (most notably Korea’s) and for other state-trading situations (e.g., BULOG in Indonesia). The economic consequences of the policy outcome it focuses on are important not only for Japan but also for other rice-trading nations, both exporters and importers. And since this perennial issue of agricultural protectionism is bound to continue to be thorny in subsequent multilateral, regional, and bilateral trade negotiations, getting a better understanding of why governments intervene in the ways they do remains an important research topic. The paper is in the spirit of the neoclassical theories of politics, of bureaucracy, and of regulation generally. It provides yet another illustration of the difficulty of reversing ever rising complexity in regulatory control, as analyzed recently by Krueger and Duncan (1994): when policies are not working well, the tendency of governments is to add another layer of intervention rather than dismantle the existing problematic regulations. It was a phenomenon that led Harry Johnson to say to policymakers in such situations, “Don’t just do something; stand there!” But the frequency with which such pleas are ignored reminds us of Stigler’s view that “a policy adopted and followed for a long time, or followed by many states, could not usefully be described as a mistake. . . . To say that such policies are mistaken is to say that one cannot explain them” (Stigler 1975, x). Clearly, Hayami and Godo, following Stigler, have begun with the assumption that the Japanese government opted not to tariffy its rice policy because this choice was in some domestic constituency’s vested interest. They argue that it is the Food Agency that stands to gain from the slight opening-up of the Japanese rice market with imports controlled administratively rather than by tariffs. The authors mention that the benefits to that group come in two forms: one of continuing to be the monopoly distributor of what will be an expanded volume of rice in the country and the other of being able to retain the large difference between domestic and import prices. That revenue can then be shared with farmers via payments to the agricultural cooperatives. The authors might also have mentioned that by controlling rice imports the Food Agency can manipulate the quality of imported rice available for sale (e.g., placing only inferior imported rice on the domestic market so as to give the [incorrect] impression that only Japanese farmers know how to produce rice for Japanese palates). Tariffication, on the other hand, would mean that the revenue from that price difference would go to the Finance Ministry instead of the Food Agency. That would more obviously expose for debate the questions of why Kym Anderson is professor of economics and director of the Centre for International Economic Studies, University of Adelaide, and a research fellow of the Centre for Economic Policy Research, London.

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the tariff and hence consumer prices of rice should be so high, why so much money should be transferred from the budget to farmers, and why the Food Agency’s monopoly on rice distribution should continue. Tariffication would also make it less easy for the government to manipulate the source of imports (e.g., so as to placate aggressive unilateral pressure from the United States). The authors use the simplest possible model of the market for rice to make their key economic points. That seems perfectly appropriate. Obviously, if one wanted more precise estimates of the magnitude of those effects, one would distinguish Indica from Japonica varieties and take into account the impact Japan’s purchase of Japonica rice from California or Australia might have on the international price of that type of rice. But for present purposes their simple model is quite adequate. Less adequate, however, is their implicit model of the political market. It involves just rice producers and consumers, plus the Food Agency, cooperatives, and the treasury. The authors point out that the importance of rice in household consumption (and of farmers in total employment) has fallen to such low levels in Japan that the impact of holding up the consumer price of rice on real wages is very slight. Hence, they claim, there is no effective opposition to rice protectionism from nonagricultural employers (unlike early in this century-see Hayami 1975). Perhaps the authors are right to ignore the impact of rice policy and associated zoning of land use on the price of land in Japan. Large though it is, it may nonetheless create little effective opposition to farm policy because the losers are so dispersed. Likewise, the widespread negative effect of farm protection on producers of nonfarm tradables, via its strengthening of the yen, may have become too small per industry group to make it worth their while to try to overcome the free-rider problem of getting together with other industry groups to oppose farm protection. Those are standard general equilibrium effects of sectoral assistance to declining industries in the course of economic development (Anderson 1995). However, this is a closed model of the political market. It ignores the increasing reality of international pressures on domestic politics as internationalization proceeds. The Uruguay Round offered a major new opportunity for commercial diplomatic pressures to be used to upset domestic political market equilibria around the world (Anderson 1992). Evidently it was not enough to bring about rice tariffication in Japan. Why not? And at what price? One of the additional, external reasons as to “why not” may be that the United States perceived its interests to be better served with greater market opening (8 rather than 5 percent of domestic sales to be imported by 2000) and a chance to pressure Japan to buy a disproportionately large share of those imports from the United States if quantitative import restrictions remained. Moreover, the price Japan is to pay for being allowed not to tariffy may be far from trivial. Indeed, Japan has already paid a high price in the form of reduced influence in the final Uruguay Round agreement. More specifically,

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Rice Policy in Japan

by being seen to be unwilling to compromise on its agricultural policy, Japan’s capacity to obtain greater market access abroad for Japanese exporters was severely curtailed. To see this, consider the insights from the political economy models developed by Grossman and Helpman (1995) and Hillman and Moser (1995). Those models suggest that trade negotiations can be perceived as an exchange of market access. Assume each country has a closed polity and its political market for protection is in equilibrium (with import-competing sectors enjoying more political power than exporter interests, for the reasons canvassed in Krueger 1989). Then assume the opportunity to enter into trade negotiations arises. It may then pay each country’s government to reduce import protection somewhat in exchange for market access abroad for the country’s exporters. That is, the new opportunity offered by the Uruguay Round increases the incentive for exporters to lobby against import protection at home if that can lead, as a quid pro quo, to less protection abroad against their export products. The irony is that Japan is committed to providing considerably more rice import access than it would have had to under tariffication, and yet it has left the impression that it is unprepared to play by the same rules as other Uruguay Round signatories. Had it not left that impression, it is unlikely that its confrontation with the United States over trade in autos and parts would have progressed to the extent that it had by June 1995. The authors are fairly pessimistic about further rice policy reform after the turn of the century. To the extent that the above point has validity, perhaps their pessimism is excessive. As well, the APEC forum will add to unilateral pressures from the United States and others for “fairer” trade practice by Japan. A further reason for the authors’ pessimism-based on the experience to date with beef tariffication-also is questionable. From inspection of their table 13.2, the authors conclude that had beef tariffication followed the Uruguay Round rules, it would not have been followed by increased beef imports. They base this on the absence of an increase in beef import growth after tariffication. That prompts three points. First, the volume of imports was growing at 20 percent per year from 1986 because of pressure from the United States and others to expand import quotas and in the expectation that liberalization was inevitably to be required as part of the Uruguay Round accord. Second, when tariffication looked likely to be part of the Uruguay Round agreement, Japan may have chosen to tariffy beef early so it could be at a higher rate than after further import quota expansion. In addition, it might have hoped that early beef tariffication would make a postponement of rice tariffication less objectionable. And third, apart from 1991, import growth after tariffication has been almost as rapid as in the previous six years-and it is expected by those in the trade to continue at that high rate for the remainder of the decade as the tariff continues to drop from 50 to 30 percent. In short, the beef case is one of phenomenal import liberalization, and one that cannot be reversed because the tariffs are bound at these progressively lower levels. Tariffication therefore

404

Yujiro Hayami and Yoshihisa Godo

should not be underestimated, even if the initial tariff levels have a lot of “water” in them. And because tariff revenue goes to the Finance Ministry, any attempt to use it to subsidize farm incomes requires that it go through the annual budget process, making the assistance more transparent and open to budget scrutiny every year-unlike the case for rice at present in Japan. One final point: Is there anything else about beef that facilitated the substantial liberalization of that market? In fact there is. During recent years there have been substantial investments by Japanese firms in beef feedlots abroad. Over time that has given birth to a domestic constituency with a direct interest in beef import liberalization. It seems unlikely that such a development will have a rice parallel to the same extent, in which case it is all the more necessary for Japan’s exporters of manufactures to mobilize more lobbying against rice protectionism if they are to avoid the trade skirmishes of the sort we saw in mid-1995 between the United States and Japan over auto trade.

References Anderson, Kym. 1992. International dimensions of the political economy of distortionary price and trade policies. In Open economies: Structural adjustment and agriculture, ed. I. Goldin and L. A. Winters. Cambridge: Cambridge University Press. . 1995. Lobbying incentives and the pattern of protection in rich and poor countries. Economic Development and Cultural Change 43 (2): 410-23. Grossman, Gene, and Elhanan Helpman. 1995. Trade wars and trade talks. Journal of Political Economy 103 (4): 833-50. Hayami, Yujiro. 1975. Rice policy in Japan’s economic development. American Journal of Agricultural Economics 54 (1): 19-31. Hillman, Ayre L., and Peter Moser. 1995. Trade liberalization as politically optimal exchange of market access. In The new transatlantic economy, ed. M. Canzoneri, W. Ethier, and V. Grilli. Cambridge: Cambridge University Press. Krueger, Anne 0. 1989. Asymmetries in policy between exportables and importcompeting goods. In The political economy of international trade, ed. Ronald W. Jones and Anne 0. Krueger. Oxford: Blackwell. Krueger, Anne O., and Roderick Duncan. 1994. The political economy of controls: Complexity. CIES Seminar Paper no. 94- 10. Adelaide: University of Adelaide, Centre for International Economic Studies, October. Stigler, George J. 1975. The citizen and the state. Chicago: University of Chicago Press.

~~

Contributors

Kym Anderson Department of Economics University of Adelaide Adelaide, S.A. 5005 Australia

Michael Dooley Department of Economics Social Science I University of California Santa Cruz, CA 95064

Taeho Bark Vice President Korea Institute for International Economy Policy P.O. Box 235, Sucho Seoul, 137-062 Korea

Barry Eichengreen Department of Economics 540 Evans Hall University of California Berkeley, CA 94720

Tamim Bayoumi 5-320 International Monetary Fund Washington, D.C. 2043 1 Tain-Jy Chen 21 Hsu-chuo Road Department of Economics National Taiwan University Taipei, Taiwan Chia Siow Yue National University of Singapore Department of Economics 10 Kent Ridge Crescent Singapore 05 11 Menzie D. Chinn Department of Economics Social Sciences I University of California Santa Cruz, CA 95064 405

Gerard0 Esquivel 2 Peabody Terrace 709 Cambridge, MA 02138 Jeffrey A. Frankel Department of Economics University of California 549 Evans Hall, 3880 Berkeley, CA 94720 Yoshihisa Godo Department of Economics Meiji Gakuin University 1-2-37 Shiroganedai Minato-ku, Tokyo 108 Japan Junichi Goto Research Institute for Economics and Business Kobe University Rokko Nada Kobe 657 Japan

406

Contributors

Koichi Harnada Economic Growth Center Department of Economics Yale University P.O. Box 208269 New Haven, CT 06520 Yujiro Hayarni SIPEB, 5th F1. Bldg #8 Aoyama Gakuin University 4-4-25 Shibuya Shibuya-ku, Tokyo 150 Japan Wontack Hong School of Economics College of Social Science (Room 16-616) Seoul University Seoul 151-742 Korea Takatoshi It0 Research Department International Monetary Fund 700 19th Street NW (IS 12-908) Washington, D.C. 20431

Sung Hee Jwa Senior Fellow Korea Development Institute P.O. Box 113 Chongnyang, Seoul Korea Anne 0. Krueger Department of Economics Stanford University Stanford, CA 94305 Mario B. Lamberte Philippine Institute for Development Studies NEDA sa Makati Bldg. 106 Amorsolo Street Legaspi Village, Makati Metro Manila, Philippines Honggue Lee Kon-Kuk University College of Commerce and Economics Institute of Economics and Management Department of International Trade Seoul, Korea

Hank Lim Department of Economics and Statistics National University of Singapore 10 Kent Ridge Crescent Singapore 05 11 Meng-chun Liu 75 Chang-Hsing Street Chung Hua Institution for Economic Research Taipei, Taiwan Philip Lowe Economic Analysis Department Reserve Bank of Australia 65 Martin Place Sydney, NSW, 2000 Australia Francis T. Lui Department of Economics Hong Kong University of Science and Technology Clear Water Bay Kowloon, Hong Kong Chong-Hyun Nam Department of Economics Korea University 1,5-Ga, Anam-dong, Sungbuk-ku Seoul, 136-701 Korea Sang Woo Nam Korea Development Institute P.O. Box 113 Chongnyang, Seoul Korea Ammar Siamwalla Thailand Development Research Institute 565 Soi Ramkhamhaeng 39 (Thepleela 1) Ram Khamhaeng Rd., Wangthonglang Bangkapi, Bangkok 10310 Thailand Aaron Tomell Department of Economics Littauer M-6 Harvard University Cambridge, MA 021 38

407

Contributors

Shang-Jin Wei JFK School of Government Harvard University Cambridge, MA 02138 Ippei Yamazawa Department of Economics Hitotsubashi University Kunitachi, Tokyo 186 Japan

Mahani Zainal-Abidin Faculty of Economics and Administration University of Malaya 50603 Kuala Lumpur Malaysia

This Page Intentionally Left Blank

Name Index

Ahmad, Mubariq, 287 Aitken, Norman D., 160 Alesina, A., 58 Anderson, James, 124n3, 142nl Anderson, Kym, 21,63,68,71,402 Anzaldua, R., 48 Asian Development Bank, 92t, 277t Asia Pacific Economic Cooperation (APEC), 203,205,207,213,214 Aw Bee-Yan, 347 Balassa, Bela, 160n23, 243, 359 Baldwin, R., 67 Baldwin, Richard, 121 Baldwin, Robert, 350t, 357, 365 Barbier, E. B., 661110 Baurnol, William, 70n13, 315, 316-17,319n7, 320118 Bayoumi, Tamim, l l l n l , 112-13t, 115, 143 Beckerman, W., 61113 Becketti, Sean, 169 Beghin, John, 85 Beltratti, A,, 63n4 Benedick, R. E., 64118 Berger, Allen N., 330n15 Bergsten, C. Fred, 122, 123 Bergstrand, Jeffrey, 124113, 1421-11 Berliner, Diane T., 346 Bemanke, Ben, 182 Berry, S., 36 Best, M. H., 337, 338 Bhagwati, J . N., 59,74,79n24, 121 Blinder, Alan, 182

409

Boltuck, Richard, 346 Bramble, W. J., 263 Brown, D., 53,75n17,79n24 Browne, Francis X., 174 Buchanan, J. M., 100, 101 Burtless, G., 77 Calks, Plutarco E., 42 Calvo, Guillermo, 170 Ckdenas, Lazaro, 43 Casella, A,, 68 Chamovitz, S . , 69, 76nn20, 21 Chen Tain-Jy, 35&, 357, 358,365 Chia Slow Yue, 282,286,298,299n9 Chichilnisky, G., 72n14 Chinn, Menzie D., 169, 172114, 173115, 190 Clavijo, F., 37 Cline, William, 346 Cooper, Richard, 86 Copland, B. R., 72n14 Corden, W. M., 751117 Coroyannakis, P., 68 Cottarelli, Carlo, 175 Darn, Kenneth, 17n21 Deacon, R., 63n4 Deardorff,A. V., 73,751117, 121, 124n3 de Brouwer, Gordon, 175 De Grauwe, Paul, 160 Dehejia, V. H., 74 de la Madrid, 27,40,46,48 de Melo, Jaime, 346 Diewert, W. Erwin, 262n27,263n28,265n30

410

Name Index

Dixit, A,, 104 Dooley, Michael, 169, 170, 173, 190 Drake-Brockman, J., 81 Duncan, Roderick, 401 East-West Center, 3 14113 Echeverria, Luis, 37, 45 Edillon, Rosemarie, 306 Ehrenberg, R., 74 Eichengreen, Barry, 112-13t. 115 Elliot, Kimberly AM, 346 Emery, Robert, 173t Encamation, Dennis, 134 Enders, A,, 64118 Esquivel, G . , 36, 39f, 40t, 41f Esty, D. C., 64n8, 69, 73 Fackler, James S . , 186 Falvey, Rodney, 76,347 Farber, D. A,, 691112 Faruqee, Hamid, 172 Feenstra, Robert, 340,347 Fernandez, A,, 48 Findlay, R., 751117 Finger, M., 80,242119 Folkerts-Landau, David, 188 Forum for Policy Innovation, Japan, 377, 3871114,394 Fox, J., 45.48 Francois, J. F., 761119 Frankel, Jeffrey, 111, 119, 120, 121, 123, 125, 127114, 129, 134, 142, 160, 165, 169, 170, 171, 172n4, 180 Friedman, Benjamin, 185 Frohlich, N., 101 General Agreement on Tariffs and Trade (GATT), 59nl,64n8,66-67n10.70 Gertler, Mark, 170, 174 Gilchrist, Simon, 170 Glick, Reuven, 169, 184 Godo Yoshihisa, 380n9,394 Gorman, W. D., 377n8 Goto Junichi, 94, 95.97, 104, 106 Grilli, V., 36 Gros, Daniel, 98 Grossman, G. M., 63114,403 Hamada Koichi, 94,95,97, 100, 104, 106 Hamilton, Carl, 142 Hamilton, G., 340 Hanson, G.,74n15,76n20 Hanweck, Gerald A., 3301115

Harris, Richard, 347 Haveman. Jon David, 121nl Hayami Y., 373n3,375115,381,382n10, 3871114,402 Hayek, Friedrich, 334n20 Helpman, Elhanan, 124n3,403 Hernandez-Laos, E., 37,43 Herrigel, Gary, 3 14 Hemn, Jan, 16 Hillman, Ayre L., 67nl I , 403 Hinestrosa, P., 50 Hirayama Kenjiro, 17In3 Hoekman, Bernard, 19n29,64n7,67nIl Honma M., 373n3,380n9 Horheim, Hege, 21 Hou Chi-ming, 357, 365 Hubbard, R. Glenn, 174 Hudec, R. E., 691112 Hufbauer, Gary, 257,259,346 Humphrey, David B., 3301115 Hutchison, Michael, 169 Imada, Pearl, 296n7 International Agricultural Trade Consortium, 377116 International Labour Organisation (ILO), 76,77 International Monetary Fund (IMF), 279t, 280-8 1t Irwin, Douglas, 147n9 Ito, Takatoshi, 346, 351 Jacquemin, Alexis, 1601123 Jaffe, A. B., 64n7.791124, 87 Johnson, Hany, 401 Jones, L. A,, 63114 Jwa Sung Hee, 173.3 16n5 Kashyap, Anil, 174 Keesing, Donald, 357 Kemp, M. C., 123 Khoman, Thanat, 285 Kim Sun Bae, 169 Kohli, Ulrich, 262.2651130 Kourelis, Angeliki, 175 Kreinin, M. E., 242119 Krueger, Anne O., 13n10, 14, 15n13,21,62, 122n2,346,348n1,365,368,401,403 Krugman, P., 791124, 96,98, 105, 110, 111, 119, 120, 124, 129,2611124 Kumar, Sree, 297118 Kutner, Kenneth, 185

411

Name Index

Lafay, Gerard, 2451113,247-481115 Lamherte, Mario B., 306111 Lawrence, Robert Z., 10n4,59,77,79n24, 121 Learner, E. E., 62 Lee Tsao Yuan, 298,299n9 Leidennan, Leo, 170 Leidy, Michael, 19n29,64n7, 67nll Leonard, N. J., 64117 Levinson, A., 79n24 Levy, Philip, 121 Levy, S., 29 Li Chien-pin, 35 1 n3 Litan, Robert, 346 Liu Meng-chun, 358 Lloyd, Peter J., 151116 Lopes-de-Silanes, F., 36 Lopez Portillo, Jose, 28,45-46 Loungani, Prakash, 185 Low, l?, 64117,791124 Lown, Cara, 185 Lutmer, E., 37 McDonald, B., 76n19 McNellis, Paul, 174 McShany, Ray, 374 Mahathir, Datuk S., 94, 103 Maloney, William, 173n5 Mancera, Miguel, 46 Manuelli, R. E., 63114 Mathieson, Donald, 169, 170, 173 Maxfield, S., 48 Meade, James, 120 Meadows, D. H., 61n3 Mensbrugghe, Dominique van der, 85 Meyer, L., 42-43 Ministry of Agriculture, Forestry, and Fisheries, Japan, 389 Montes, Manuel, 296n7 Moreno, Ramon, 184 Mori H., 377118 Morishima Michio, 93111 Morris, Charles, 169 Morrison, Catherine J., 2621127,2651130 Moser, Peter, 403 Nam Chong-Hyun, 348 National Research Council, United States, 59 Naya Seiji, 296n7 Nelson, Douglas, 350t Noland, Marcus, 256n19 Nomura Research Institute, 91

Nordstrom, H., 76n19 Norman, V., 104 Obregon, Alvaro, 42 Olson, Mancur, 100,357 Oman, Charles, 313nl,314n2, 322 Oppenheimer, J. A., 101 Ordeshook, P. C., 100 Organisation for Economic Co-operation and Development (OECD), 206 Ortiz Mena, A,, 26,43 Otsuka K., 3871114 Owens, L., 394 Pacific Economic Cooperation Council (PECC), 210-1 1 Palmeter, David, 15 Pangestu, Mari, 287 Panzar, John C., 315,316-17,319n7,320n8 Park Yung Chul, 191129, 174n7 Peres, W., 39n2 Petrie, Peter, 21, 229112, 233 Porges, A,, 64118 Porter, Michael E., 261 Primo Braga, Carlos A,, 224,225,255118, 2571120 Radetski, M., 63114 Rajaratnam, S., 285 Ravenscraft, D., 324 Reinhart, Carmen, 170 Reisen, Helmut, 170, 173, 180 Ries, John, 347 Riker, W. H., 100 Roberts, Mark, 347 Rodrik, Dani, 80, 340 Rogers, John H., 186 Roland-Holst, David, 85 Romer, Christina, 185, 186n9 Romer, David, 185, 186119 Rumelt, Richard P., 3341118 Rush, Mark, 185 Ryhczynski, T. M., 74 Sabel, Charles F., 3 14 Sachs, J., 51115 Salinas, Carlos, 3, 25, 27, 39.42, 48 Sandhu, K. S., 286113 Sapir, Andre, 77, 160n23 Saxonhouse, Gary, 122 Scherer, F. M., 324 Schmidt, W. H., 263 Schott, Jeffrey, 257, 259

412

Name Index

Schulze, David, 308 Secretaria de Comercio y Foment0 Industrial (SECOFI), 40 Seldon, T. M., 63n4 Shapiro, P., 63n4 Shea Jia-Dong, 174n7 Siebert, H., 63,70n13 Snape, R. H., 70n13 Soesastro, Hadi, 287 Song D., 63n4 Spiegel, Mark, 183118 Spolaore, E., 58 Srinivasan, T. N., 79n24,93 Steenblik, R. P., 68 Steil, B., 60 Stein, Emesto, 98, 111, 119, 120, 122, 142n1, 160, 165 Stem, R. M., 75n17, 121 Sterne, Gabriel, l l l n l Stigler, George J., 315,316,401 Stiglitz, Joseph, 174 Tam, David, 346 Taylor, M. S., 721114 Teh, Robert R., 306 Tobey, J. A., 64n7.79n24 Tornell, Aaron, 44,50,51n5 Tybout, J. R., 37 Vers, R., 76n19.77

Velasco, A,, 51n5 Venables, A., 5 1 Viner, Jacob, 94, 120 von Stackelberg, H., 101 Wagner, R. E., 101 Wales, T. J., 2631128 Walter, I., 701113 Wan, Henry Y., 123 Wei, Shang-Jin, 111, 119, 120, 121, 123, 125, 127n4, 129, 134, 142, 160, 165 Weiss, Andrew, 174 Weitzman, M. L., 400 Westbrook, M. D., 37 Westney, D. Eleanor, 314 Wiley, D. E., 263 Willig, Robert, 315,316-17,319n7,320n8 Wilson, J. D., 79n24 Winters, Alan L., 142 Wisam, Pupphavesa, 289 Wood, A., 77 Woo Wing Thye, 171113 World Bank, 79n24,86,277t, 278, 334n19 World Trade Organization (WTO), 9n1, 13, 16

Ulph, A,, 72n14 United Nations Environmental Program, 86 Ursprung, H. N., 67nll U.S. International Trade Commission (USITC), 376

Yamazawa Ippei, 204nl,207n3 Yang T.-H., 340 Yang Won Keun, 324, 325t, 3271113 Yang Y., 76n19,77 Yap, Josef T., 306 Ykches, HCltn, 173 Yo0 Jung Ho, 19n29 Yo0 Seong Min, 322n10 Young, 0. R., 101

Van Grasstek, C., 67n 11 Van Wijnbergen, S., 29,51

Zarsky, L., 8 1 Zedillo, Ernesto, 48

Subject Index

AFTA. See ASEAN Free Trade Area (AFTA) Agricultural sector: protection and liberalization in Mexico, 29-35; protection in NAFTA countries, 52; rice production and marketing in Japan, 380-86, 389-92. See also Common Agricultural Policy (CAP) American Rice Millers’ Association, 7, 371111 APEC. See Asia Pacific Economic Cooperation (APEC) ASEAN Concord (1976), 285 ASEAN Free Trade Area (AFTA), 6,276, 288-89; compared to NAFTA, 296; trade under Common Effective Preferential Tariffs, 289-96 Asian economies: GDP growth rates (197193). 91-93; moves toward economic integration, 94-95. See also East Asian countries Asia Pacific Economic Cooperation (APEC): commitment to free and open trade, 203; cooperation programs, 21 2-1 3; criticism of, 206-7; expectations for, 103; factors influencing emergence of, 5-6,218-19; free trade initiative, 21; Manila Action Plans, 216-17; as move toward integration, 94-95; Nonbinding Investment Principles, 222; objectives based on Bogor commitment, 5.21 1; open regionalism in, 121-22; Osaka Action Agenda, 205-7, 213-17, 219-22; proposed FTA, 9; proposed liberalization program, 207-10; response to proposed trade-related social

413

policy, 79-81; role of ASEAN in, 285; scope of, 122 Association of Southeast Asian Nations (ASEAN): ASEAN Fund, Limited, 308-9; Common Effective Preferential Tariff (CEPT), 289-96; currency arrangements in intra-ASEAN trade, 306-8; deterrents to trade within, 296-97; economic integration, 276; economies of, 276-78; Finance Corporation, 308; growth triangle concept, 6; impact of, 303; initiatives of, 296-97; Insurance Council, 309; intra-ASEAN trade, 278-81; political, strategic, and economic objectives, 285; Preferential Trading Area (1977), 287; present and future members, 275; Swap Arrangement, 306-7 Balassa index of comparative advantage, 243-45 Bank rates, local, 192t Bogor Declaration (1994): APEC Nonbinding Investment Principles, 222; cooperation concept, 212; related to free and open trade and investment, 5-6, 203,205,207 British Commonwealth trading bloc, 154-56, 158-59 Brunei: as ASEAN member, 275; colonial past, 276; growth triangle participation, 300-303; intra-ASEAN trade, 282, 290-96 Business groups, Korea. See Chaebols, Korea

414

Subject Index

Calculus of participation, or theory of clubs, 99-103 Canada-U.S. Free Trade Agreement, 1 CAP. See Common Agricultural Policy (CAP) Capital flows: Asian capital markets, 169-72; implications of capital inflows, 183-85, 199-200 Capital markets: covered interest differential as measure of integration, 170-71; effect of social policy concerns on, 87; integration in Pacific Basin, 169-71. See also Credit; Interest rates: Investment Caribbean Basin Initiative (CBI), 9 CBI. See Caribbean Basin Initiative (CBI) CEPT. See Common Effective Preferential Tariff (CEPT) Chaebols, Korea: industrial policy for, 315-16; in industrial structure, 322-27 Chile, 9 CITES. See Convention on International Trade in Endangered Species (CITES) Coase theorem, 47 Collective action: benefits with public-good feature, 100; criticism of theory of, 101; in theory of clubs, 101 Common Agricultural Policy (CAP): protectionist effects of, 16, 374; reform (1992), 374-75 Common Effective Preferential Tariff (CEPT), ASEAN, 289-96 Comparative advantage: of many APEC member countries, 122; revealed comparative advantage (RCA) indexes, 243-54; theory of changing, 62-64 Confederacih de Trabajadores Mexicanos (CTM), 43 Convention on International Trade in Endangered Species (CITES), 64,73 Cooperation: APEC agenda, 212-17; ASEAN banking and finance arrangements, 306-9; ASEAN Insurance Council, 309 Country size, in model of tariffs: in decision to join free trade area, 102, 116-17; in Ricardian model of trade, 99, 106-9; in WTO, 116 Credit: Asian interbank and bank loan rates, 174-81; Asia Pacific sources of, 172-73; effect of capital inflows on, 183-85; effect on economic activity, 185-87; model with, 182-83; risks in lending, 188-90 Currency in intra-ASEAN trade, 306-8 Customs unions: cannot overlap, 11, 17; common external tariffs of, 11, 17.22; consis-

tent with WTO rules, 2 1 ; differences from FTAs, 3; EEC initiative, 141-42; incentives to form, 97-98, 100; potential for trade liberalization under, 18-19; as regional trading arrangements, 10; rules of origin in, 14-15 Data sources: Asia Pacific capital market analysis, 190-93, 198; departure from standard gravity model, 144-45; for FDI, 134-35; gravity model of existing intraregional trade bias, 125; of trade bias in implicit trading blocs, 125, 127, 129-30; for trade policy formation model, 364-65 Deregulation as response to globalization, 339-40 Developing countries: actions related to traderelated social policy, 78-81; industrial development in, 338; U S . tariff preferences to, 9 EAEC. See East Asian Economic Caucus (EAEC) East Asian countries: open multilateral trading system for, 20-2 1; subregional economic zones, or growth triangles, 298-99 East Asian Economic Caucus (EAEC), proposed, 94-95, 103, 116 Economic integration: APEC as move toward, 94-95; ASEAN nations, 276; Asian economies' moves toward, 94-95; capital markets in East Asia, 169-70; East Asia and ASEAN, 310-1 1; globalization with, 314-15; reciprocal trade agreements as, 11-13; regional integration consistent with multilateral liberalization, 206; social policy with, 59-60; stages in symmetric tariff bloc model, 95-98; subregional growth triangles, 299-303, 311-12; welfare levels with, 96-98 Economic performance: ASEAN nations, 275; Asia-West Pacific economies (197 1-93), 91-93; relation to environment and trade policies, 62-69 Economies of scale: definition of, 316-17; estimates of Korean firm, 329-34 Economies of scope: definition of, 316-17; estimates of Korean firm, 327,329-34; with globalization, 341-42 EFTA. See European Free Trade Association (EFTA) Elites, Mexico: effect of NAFTA on new export elites, 50-54; during fiscal crisis,

415

Subject Index

25-26; new private export elite and foreign investors, 26,48-50; trade preemption game of old manufacturing elites, 26,44-47; weakening of old group of, 47-49 Eminent Persons Group (EPG): advocacy of APEC dispute mediation service, 222; recommendations for APEC, 22 1-22; views on APEC, 203 Environmental issues: considered along with trade policy, 60-62; differences in policies, 58; in GA7T provisions, 69; relation to growth and trade, 62-69 European Coal and Steel Community, 149, 212 European Community (EC): extraregional trade (1958, 1979), 16; second enlargement of former EEC (1975-92), 157-60 European Economic Community (EEC), or Common Market: regional exchange rate mechanism and internal market of, ,141-42; trade among original six members, 149-51; trade with EFTA members (1956-73), 150-53; trading pattern and volume with larger membership (196680), 154-57. See also European Community (EC) European free trade agreements: with addition of members (1966-80). 154; EEC and EFTA trade (1956-73). 149-54 European Free Trade Association (EFTA): initiation of free trade area (1965), 151; intramember trade (1956-73), 150-51; trade pattern and volume (1966-92). 5, 154-60; trade with EEC members (1956-73), 5, 150-53 European Payments Union, 149 European Union (EU): effects as preferential trading area, 5; harmonization of social policies in, 60; intraregional European trade, 16-17; labor policies in, 77-78; as regional preferential trading arrangement, 1-2, 10, 16 Expansion path subadditivity concept, Korea, 330,332-33 Exports: of Korea to APEC countries, 233-38; link to FDI, 135-36; in Mexico with liberalization, 3 1-40

FDI. See Foreign direct investment (FDI) Firms: behavioral patterns of, 327-29; economies of scale in multiproduct firms (Stigler), 316; economies of scope and

scale (Baumol, Panzar, Willig), 316-17; success of small- and medium-sized, 338. See also Chaebols, Korea Food Agency, Japan, 402 Food Control Law, Japan, 380-81 Foreign direct investment (FDI): to ASEAN nations, 282-83, 336; Korean overseas, 238-41; in Mexico, 37, 39-41; in trading bloc environment, 134-37 Free-rider issue, 101 Free trade agreements (FTAs): Common Effective Preferential Tariff of ASEAN Free Trade Area, 289-96; to form ASEAN free trade area, 286; hub and spoke system, 19; potential for and problems of overlapping, 9, 17-20; proposed North Atlantic and APEC, 9; reciprocal, 11-13; regional aspects of, 10; rules of origin under, 3, 17-18; tariffs of individual countries under, 3, 11. See also European free trade agreements; European Free Trade Association (EFTA); European Union (EU) Free trade areas: ASEAN Free Trade Area (AFTA), 276, 288-89; calculus of participation in formation of, 99-103; conditions for improved welfare with, 120; incentives to form, 97-98, 100; symmetric and asymmetric, 110-1 1 General Agreement on Tariffs and Trade (GATT): Article 1 liberalization areas, 206; Article 24 tariff strategy restrictions, 102, 116, 123, 133-34; conflict of U.S. Super 301 provisions, 346; Mexico as member of, 28; nondiscrimination requirements and exceptions, 69; rulings related to environmental issues, 69-73; Uruguay Round, 80,206,297,37 1,376-77 Generalized System of Preferences (GSP), U.S. preferences to developing countries under, 9 Globalization: characterization of, 3 13-14, 334; definition of, 321; large- and smallscale production with, 322 Government role: in environment of globalization, 340-41; in framework of Korean industrial policy, 334-35 Gravity model: EEC and E R A trade patterns and volume (1956-92), 149-60; EECEFTA model compared to other approaches and studies, 160-62; firstdifference specification, 143-49, 166; in-

416

Subject Index

Gravity model (continued) traregional trade bias and welfare, 124-29; problems of, 142-43; specified for third-country effects, 14-45; standard traditional specification, 144, 146-47 Group behavior, small and large groups,

International Labour Organisation (ILO) Ohlin Report (1956). 77 Investment: intra-ASEAN, 282,284; potential in NAFTA trade for diversion, 259-61, 273; proposals to facilitate APEC trade and, 210-12. See also Foreign direct investment (FDI)

100-101

Growth triangles: ASEAN integration with, 276; ASEAN region, 299-303, 311-12; East Asia, 298-99. See also Subregional economic zones (SREZs) Hub and spoke system, 19 Imports: of Korea from APEC countries, 233-38; in Mexico with liberalization, 3 1-40 Import substitution, Mexico, 26 Incentives: to form customs union or free trade area, 97-98; to join tariff bloc, 98-99 Indonesia: as ASEAN member, 275; colonial past, 276; growth triangle participation, 299-303; interbank and loan rates, 179f; intra-ASEAN trade, 290-96; inward FDI, 282 Industrial cooperation schemes, ASEAN, 28788,308 Industrial organization: business groups (chaebols) in Korea, 315-16; with globalization, 320-21; Korea, 322-27; Malaysia, 336 Industrial policy: ASEAN nations, 277-78; characterization of Korean, 327-29.334; Korean regulation of chaebols, 3 15-16, 326-27; objective and role of, 337 Industrial sector: Fordist and post-Fordist, 313,321; German Craft system, 313-14; protection in NAFTA trade, 256-61 Industry, multiproduct: competitive equilibrium of (Baumol, Panzar, Willig), 317-19; firms within (Stigler), 316-19 Information technology: economies of scope in global environment, 321; globalization with, 314-15,341 Institutional Revolutionary Party (PRI), Mexico, 42-43 Interest groups: elites in Mexico, 3, 44-47; environmental groups focus on trade policy, 61-62; Japanese rice farmers, 380-86. See also Elites, Mexico Interest rates, 170-74

Japan: agricultural protection levels, 372-74; cost of agricultural protection in, 375; domestic and border rice price differences, 394-96; Food Control Law, 380-8 1; interbank and loan rates, 177f; price of rice with proposed tariff reduction, 376-77; rice farmers as interest group, 380-86; rice production and marketing, 380-86, 389-92; simulation analysis of Japan’s tariff change policy on rice, 386-93, 396-98 Korea: chaebols, role in industrial organization, 315-16,322-27; effect of NAFTA trade on, 241-61; export competition with Mexico, 225; firm economies of scale and scope, 327-34; foreign direct investment, 238-41; industrial structure, 322-27; interbank and loan rates, 180f; trade flows with NAFIA members (1 975-93), 225-27; trade interdependence with NAFTA members, 227-29 Labor standards: in multilateral trade negotiations, 74-78; WTO potential agenda for, 74 Lafay index of comparative advantage, 245-54 Land reform, Mexico, 43 Long-Term Arrangement for Cotton Textiles, 347 Maastricht Treaty (1992): framework of, 141; Protocol on Social Policy, 77 Malaysia: as ASEAN member, 275; colonial past, 276; growth triangle participation, 299-303; industrial structure, 336; interbank and loan rates, 178f; intraASEAN trade, 282,290-96; inward FDI, 282, 336; leadership in proposed EAEC, 103 Manufacturing sector: effect in Mexico of liberalization, 37; protection and liberalization in Mexico, 28-35 Markets: predictions in global environment,

417

Subject Index

314. See also Capital markets; Money market rates; Rice market, Japan MERCOSUR (Mercado Comun del Con0 Sur): members’ intentions to join NAFTA, 10; preferential arrangement, 2 Mexico: effect of NAFTA trade on, 241-61; export competition with Korea, 225; financial bailout (1995), 27; interest groups with trade liberalization, 3; protection (1980-94), 28-31; reforms of de la Madrid administration, 48-5 1; trade liberalization agenda, 3; using NAFTA as commitment device, 25-27 Money market rates, 191t Montreal Protocol (1987), 62, 64, 73 Most-favored-nation (MFN) principle: implications of, 10; regionalism as departure from idea of, 121 Multi-Fiber Arrangement (MFA), 347 New Zealand: interbank and loan rates, 178f Nontariff barriers, 85, 358 North American Development Bank, 52-53 North American Free Trade Agreement (NAFTA): as commitment device, 25-27; effect of, 241-61; effect on Mexico’s new export elite, 50-5 1; formation, 1; Free Trade Commission, 52-53; harmonization of social policies in, 60; labor unions’ opposition to, 102; Mexican entry into, 3; proposed extension to Western Hemisphere, 1,224; side agreements, 3-4,52-53,60,77 North Atlantic Free Trade Area, proposed, 9 OECD nations, ASEAN trading partners, 278-79 Ohlin Report (1956), 77 Omnibus Trade and Competitiveness Act (1988), United States: Super and Special Section 301 provisions, 346, 351 Open economic association (OEA): commitment of APEC to an, 205; definition and scope, 204,219 Optimal currency area theory, 115 Osaka Action Agenda, 213-17,219-22 Pacific Business Forum (PBF), 221-22 Pacific Economic Cooperation Council (PECC): investment code proposal, 222; Trade Policy Forum, 210-11 Pacific island economies, GDP growth rates ( 1971-93), 9 1-93

Participation theory, 100 Partido de la Revoluci6n Democrltica (PRD), Mexico, 48 Partners for Progress proposal, 212,215 Philippines, the: as ASEAN member, 275; colonial past, 276; growth triangle participation, 300-303; interbank and loan rates, 179f; intra-ASEAN trade, 282, 290-96; inward FDI,282 Preferential trading areas (PTAs): ASEAN Preferential Trading Area, 287; EU attempts to form, 1; reciprocal preferences, 10-1 1; regional, 9; as step toward liberdizing multilateral trade, 10; Western Hemisphere, 1-2 Preferential trading arrangements: essential components of, 14-17; forms of, 10-11 Privatization, Mexico, 48-49 Productivity, Mexico, 37-38 Protection: for agriculture in four economies (1991-93). 372-73; Japan’s food control system, 38041,389-92; Mexico (197094), 28-35; in sectors of NAFTA trade, 256-61.273-74; in some rules of origin, 14-19; trade barriers in closed and open regional blocs, 125 PTAs. See Preferential trading areas (PTAs) Public goods theory, 100 Regionalism: ASEAN Common Effective Preferential Tariff (CEPT), 289-96; characteristics of Asia-West Pacific countries, 91-95; social policy as rationale for, 86. See also ASEAN Free Trade Area (AFTA); Subregional economic zones (SREZs) Regionalism, open: APEC implementation of, 221-22; definitions, 119-24, 135, 137; evidence in existing trading blocs, 125-29; in implicit continental blocs, 129-34; support for concept of, 219 Regulation: Asia Pacific capital markets, 169-74; banking in less-developed countries, 174; of Korean chaebols, 315-16, 326-27; NAFTA side agreements as, 3-4 Rice market, Japan: domestic and border rice price differences, 394-96; monopoly, 380-86, 389-94,402; with shift to proposed Uruguay Round tariff setting plan, 389-94; traditional rice policy, 382-86 Rules of origin (ROOs): change in tariff heading criterion (CTH), 15; in customs unions, 14-15; in NAFTA, 273-74; prob-

418

Subject Index

Rules of origin (continued) lems of overlap in FTAs, 3, 14-15, 17-19; protectionist features of some, 14-18; specified process criterion, 15; substantial transformation criterion, 15; value-added criterion, 15 Salinas administration, Mexico, 48-5 1 Singapore: as ASEAN member, 275; colonial past, 276; growth triangle participation, 299-303; interbank and loan rates, 177f; intra-ASEAN investment by, 282; intraASEAN trade, 282,290-96; inward FDI, 282 Social policy: APEC response to trade-related, 79-81; differences across countries, 57-60; Maastrict Treaty Protocol on, 77; regionalism as rationale for, 86-87. See also Environmental issues SREZs. See Subregional economic zones (SREZS) Stockholm Convention (1960), 151 Subregional economic zones (SREZs), 6,298, 311-12 Subsidies, Japan, 380-81 Taiwan: bilateral trade arrangements with United States, 347-53; interbank and loan rates, 18Of; preferential treatment of U S . imports, 352-53; tariff negotiations with United States, 353-57; as U S . trading partner, 346 Tariff rate, setting: effect on rice markets of proposed Uruguay Round rate reduction, 380-81; simulation analysis of Japan’s rate reduction policy, 386-93 Tariffs: under ASEAN Common Effective Preferential Tariff agreement, 289-96; country size in trading bloc model, 106-9; customs union common external, 11, 17,22; gradual elimination under NAFTA, 51-52; in Mexico with liberalization, 28-40; multilateral negotiations under GATT, 16; in nation’s decision to join free trade area, 11, 102; optimal, 114-16; optimal tariff bloc, 98-99; retention of individual country, 3, 11; summary of tariff bloc model results, 95-98; symmetric tariff bloc model, 95, 104-6; Taiwan-U.S. negotiations (1978-89), 353-57. See also Protection

TEAs. See Transitional economies of Asia (TEAs) Thailand: growth triangle participation, 300303; interbank and loan rates, 181f; intraASEAN trade, 290-96; inward FDI, 282 Theory of clubs. See Calculus of participation, or theory of clubs; Free trade areas Trade: asymmetry in patterns of world, 111-14; diversion away from Korea, 26 1; EEC and E R A (1956-73), 150-53; effect of FDI in trading bloc environment, 134-37; environment-related discriminatory restrictions, 62,66; European external, 16; intracontinental biases in, 129; intra-European Union, 16-17; preferences extended by United States, 9; production theory analysis of diversion, 254-56, 262-71, 273; proposals to facilitate APEC investment and, 210-12; Ricardian tariff model of, 99, 106-9; summary of symmetric tariff bloc model, 95-98; symmetric tariff bloc model, 95, 104-6. See also Protection Trade Act (1974), United States: investigation of Taiwan under Section 307 (1986), 349; Section 301 provisions for unilateral trade actions, 345,347 Trade agreements: reciprocal integration agreements (January 1995), 11-13; Taiwan-U.S. bilateral, 347. See also ASEAN Free Trade Area (AFTA); Canada-U.S. Free Trade Agreement; European free trade agreements; Free trade agreements; General Agreement on Tariffs and Trade (GATT); North American Free Trade Agreement (NAFTA); World Trade Organization (WTO) Trade Expansion Act (1962), United States, 348 Trade flows: Korea and NAFTA members (1975-93). 225-27; U.S. use of voluntary export restraints to limit, 347-48 Trade index, Mexico-U.S. intraindustry, 36 Trade liberalization: APEC commitment, 207-10; APEC members’ voluntary, 216-17; effect of interest group influence on, 40-50; Mexico (1980-94), 28-35; Mexico’s agenda for, 3; Mexico’s elite preemption game in instituting, 43-47; Mexico’s path toward, 26-40; in Mexico under NAlTA, 50-54,56; under preferential trade agreements, 18-19; re-

419

Subject Index

gional agreement unilateral, 123; sequence of Mexican, 40,42; within trading bloc, 139-40; trading bloc unilateral, 122-24 Trade policy: ASEAN Common Effective Preferential Tariff, 289-96; changes in ASEAN, 278; environmental issues considered along with, 60-62; under GATT/ WTO environmental policy, 7 1-73; GA'lTiWTO labor standards, 74-79, 85; Mexican protection and liberalization (1970s), 28; relation to environmental issues and growth, 62-69; U.S. unilateral, 345 Trade policy formation model, 357-63, 367-68 Trading arrangements, regional: in multilateral trading system, 1-2; preferential, 9-10. See also Preferential trading areas (F'TAs); Regionalism Trading blocs: countries with dissimilar social policies in, 60; implicit continental, 129-34; openness and intrabloc biases in existing and implicit, 137 Trading blocs, regional: incentives related to forming or joining, 4; openness, 4-5, 119; potential for conflict with, 10 Trading system, multilateral: East Asian stake in open, 20-21; growth of open, 1-2; labor standards in negotiations, 74-78; with most-favored-nation (MFN) concept, 10 Transitional economies of Asia (TEAS),91, 93-94 U.N. Conference on Environment and Development (UNCED), 71.73 United States: bilateral trade arrangements with Taiwan, 347-53; endorsement of

preferential trading arrangements, 17, 22; opposition to proposed EAEC, 103, 116; tariff negotiations with Taiwan, 353-57; trade preferences in CBI, 9; unilateral trade actions against Taiwan (1986-93), 347-50; USTR under Section 301 of Trade Act (1974), 345, 347 Uruguay Round: agricultural negotiations, 371; General Agreement on Trade in Services (GATS), 297; proposed amendment to Agreement on Subsidies and Countervailing Measures, 80; tariff reduction plan (1995), 376-77; trade liberalizations of, 206 Vietnam: as ASEAN member, 275; as member of ASEAN Free Trade Area (AFTA), 288 Voluntary export restraints (VERs), 347-48 Welfare levels: with asymmetric free trade zones, 110-1 1; before and after integration in symmetric tariff bloc model, 96-98; open and closed regional blocs, 125, 135-37; of regional trading blocs, 120-21; with symmetric free trade zones, 110-11,120 World Environment Organization (WEO), proposed, 73 World Trade Organization (WTO): Committee on Trade and Environment, 72; environmental policy initiatives, 71-73, 89; notification of preferential trade agreement to, 2, 13; political support for, 21; proposed actions related to labor standards, 74-78.89; small nonhegemon countries in. 116-17 Zapatistas, Mexico, 43