Small or Negative Trade Impact of Regional Trade Agreement: Fixed Export vs. Investment Cost
Japan recently signed a number of regional trade agreements (RTAs), including the Regional Integrated Economic Partnership (RCEP), which came into force in January 2022. The phenomenon known as ‘trade creation effect’. To test this effect experimentally, post-RTA studies have applied world trade data to the gravity equation, which explains the amount of trade between the two countries. However, not all studies have found such a positive effect on trade among RTA members.
Pre-post-analysis of RTAs has also been conducted in Japan, but there is little evidence of trade-offs. For example, in a recent study, Yamanouchi (2019) estimated the gravitational equation with a complete set of static effects. However, the average impact of RTA on Japan’s exports to partner countries was almost nil. Indeed, the effects of some RTAs, such as with Singapore, have been found to be negative and statistically significant. These results are not uncommon; Many pre-existing studies on Japanese exports have shown similar results. Such unexpected results are also found in other countries.
How can we explain the small or even negative effects of RTA on trade? The effects of small business creation may be driven by the fact that tariff reductions by RTAs are mostly gradual. Also, the non-tariff system (NTM) takes some time to realize the effects of elimination or change. However, this does not explain the negative impact on the export observed. One possible explanation is that RTAs may encourage countries to introduce new NTMs instead of reducing tariffs (e.g. Niu et al. 2020, Beverelli et al. 2019). If the negative impact of NTM is large, exports may decline once RTA becomes effective. However, after the termination of RTA with Japan, no such NTM was introduced in Singapore. Therefore, this NTM story does not explain the negative impact on Japan’s observed exports.
Against this background, in our new study (Baek and Hayakawa 2022), we would like to present a solution focusing on specific cost changes. Financial and non-financial costs have to be borne for international transactions such as international financing or customs procedures to start exporting. Similarly, when a firm starts outward foreign direct investment (FDI), it has to pay various expenses including management costs, installation costs and investment risk related costs. Suppose that the rate of tariff reduction through RTA is less, as in the case of Japan-Singapore RTA tariff reduction. If the various non-tariff chapters of the RTA contribute to a reduction in fixed costs for FDI to a greater extent than exports, it may encourage FDI in Japanese companies and their local production and sales in Singapore, rather than exports from Japan to Singapore.
To verify this estimate, we first calculate the fixed cost ratio for FDI for exports, called ‘fixed cost ratio’ (FCR). We solve an equation derived from the theoretical model of choice between export and FDI presented by Helpman et al. (2004). By applying this method to exports and FDI from Japan to 68 countries between 2002 and 2018, we solve the only unknown variable FCR of equations by country, industry and year.
Our queries can be summarized as follows. In terms of average quality, the FCR is estimated at approximately 10, indicating that the cost set for FDI is about ten times higher than the export. Furthermore, these median values decrease over time. In addition, relatively large values are found in the chemical, general equipment and transport equipment industries. By region, African countries have moderate values.
In the next step, we test the determinant of the calculated FCR by withdrawing the FCR on various observable variables. As a result, RTAs have negative and statistically significant effects on FCR, suggesting that RTAs reduce the specific costs of FDI to a greater extent than exports. Quantitatively, RTA has the effect of reducing FCR by about 36%. These effects appeared one year after the RTA became effective.
Finally, we conduct a simulation analysis by estimating an RTA between Japan and China. Based on the above regression results, we reduced the FCR in China by about 36%, set the tariff rate to zero for all industries from Japan to China, and calculated the ratio of FDI sales to exports using the basic equation mentioned above. As shown in Table 1, RTA between Japan and China is projected to increase local sales by FDI instead of export to all industries. In particular, high growth is expected in local sales of leather, office equipment and precision equipment products. This result indicates that an RTA between Japan and China will encourage Japanese companies to establish production in China and sell locally instead of exporting from Japan.
Table 1 Changes in the export ratio of FDI sales by Japan to RTA between Japan and China
Source: Bayek and Hayakawa (2022)
These results demonstrate one of the possible mechanisms of RTA’s negative impact on trade. Note that this analysis does not explain the effect on the absolute value of exports; This only indicates a relative increase in local sales. However, in the case of Japan’s RTA with Singapore, the amount of tariff reduction in Singapore is almost zero. Tariff reduction will also be minimal when concluding additional RTAs with existing RTA partner countries. For example, Japan has four RTAs with Vietnam, including Japan-Vietnam RTA, ASEAN-Japan Comprehensive Economic Partnership, Comprehensive and Progressive Agreement for Trans-Pacific Partnership (known as CPTPP), and RCEP. In such cases, the effect of creating a new RTA on trade through tariff reduction would be negligible. This will persuade exporters to switch to investing in partner countries, reducing the absolute value of exports.
Editor’s note: This column is based on a major study (Baek and Hayakawa 2022) that was first published as a dissertation by the Research Institute of Economy, Trade and Industry (RIETI) in Japan.
Baek, Y and K Hayakawa (2022), “Specific Expenditure on Exports and Investment”, Research Institute of Economy, Trade and Industry (RIETI), RIETI Discussion Paper Series 22-E-023.
Beverly, C. M. Boffa and A. Cake (2019), “Trade Policy Replacement: Theory and Evidence”, World Economy Review 155: 755–783.
Helpman, E. M. Mellitz and S. Yepel (2004), “Export vs. FDI with Heterogeneous Farms”, American Economic Review 94 (1): 300–316.
Niu, Z, C Milner, S Gunessee and C Liu (2020), “Ontariff Measurements and Tariff Alternatives? Some panel data evidence “, Review of the International Economy 28 (2): 408–428.
Yamanuchi, K (2019), “The Different Impact of the Free Trade Agreement: The Events in Japan”, Asian Economic Papers 18 (2): 1-20.