Simulation scenarios

3.1 Simulation design

To explore the implications of global rebalancing and China-Japan-US economic integration, we considered three simulation scenarios. The first scenario examined the effects of consumption evaporation and growth slowdown in the US on East Asia and the rest of the world. In this scenario, it is assumed that US personal consumption declines by 5% of GDP and that the economy-wide total factor productivity (TFP) of the US goes down by 1% relative to the baseline. The assumption that US consumption evaporates by 5% of GDP is based on the observation that US consumption likely expanded excessively, above the norm by about 5% of GDP, because of the housing price bubble of 2003–2006. The assumption that the US growth rate goes down by 1% reflects the possibility that the US potential growth will likely decline by this magnitude in the post-recovery period. Assuming full employment in the model, this scenario, called USAdj, can provide information on the needed adjustment in the patterns of production and trade of East Asia (and the rest of the world) in the face of a diminishing role of the US economy as an important growth engine for East Asia.

The second scenario, which is built on the first scenario, considered the impact of domestic reform in East Asia's services sector. Given that the domestic-oriented service sectors are generally underdeveloped in most East Asian economies, structural reform to boost service sector productivity will be useful to mitigate the negative impact of a decline in US demand and to facilitate a more balanced economic growth. In this scenario, we introduced a 3% TFP hike in the service sectors of all East Asian economies in addition to the original shocks in the first scenario. This scenario, labeled as SevTFP, aims at examining the effects of East Asia's domestic structural reform on its welfare and macroeconomic balance.

The third scenario looked at the impacts of forming a free trade agreement (FTA) on the welfare of East Asian economies. An FTA may further support East Asia's economic growth by stimulating trade amid the rebalancing process.⁶ Here we simulated three sub-scenarios. The first sub-scenario focused on an FTA among the three giants, the PRC, Japan, and the US, and labeled as FTA-CJUS. The second sub-scenario considered an East Asia-wide FTA (FTA-EA), where the PRC, Japan, the Asian NIEs (Hong Kong, China; Korea; Singapore; and Taipei,China) and key ASEAN countries (Indonesia, Malaysia, Philippines, Thailand, and Viet Nam) form a regional FTA. The third sub-scenario combined the two FTA sub-scenarios above, that is, a broad East Asia–US FTA (FTA-EAUS) which is a trans-Pacific FTA linking both East Asia and the US.

In these three sub-scenarios, all bilateral import tariffs and export subsidies for merchandise trade are eliminated between the FTA partners.⁷ Moreover, bilateral fixed trade costs within each FTA are assumed to go down by half for both the manufacturing and the service sectors.⁸ Fixed trade costs may represent firm expenditures associated with entering foreign markets, such as learning and adapting to the foreign country's legal framework and business environment, and establishing distribution channels. As some of these costs arise due to restrictive government regulatory requirements, the integration scenarios that incorporate a reduction in fixed trade costs attempt to capture the effects of “deep integration” accompanied by behind-the-border institutional changes, thus going beyond the “shallow integration” of dismantling border trade barriers. This “deep integration” is likely to be an important feature of the process of future regional integration around the world. The three FTA sub-scenarios are built on the second scenario of an East Asian service sector productivity hike (SevTFP).

3.2 Effects of consumption evaporation and growth slowdown in the US

The long-run economic effects of the “evaporation” of US consumption together with a growth slowdown—the USadj scenario—are reported in Table 3A. The table indicates that the “transfer effect” associated with shrinking US consumption depressed the US terms of trade, i.e. the price of US products relative to those produced in other parts of the world. This is a reflection of the real depreciation of the US dollar. As summarized in Table 3A [ PDF 115.3KB | 1 page ], under this scenario the US terms of trade indeed fell by 6.1% and all other economies' Consumer Price Index (CPI) adjusted real exchange rates against the US dollar appreciated by 2.2–4.7%. Consequently, the US current account deficit shrank by 3.8% of GDP.⁹ The falling US trade deficit led to adjustments in trade balances around the world, with a relatively large reduction in trade surpluses in Thailand and Japan due to their larger increases in domestic investment. In all the non-US economies, terms of trade improved and domestic absorption expanded in response to the declines in US consumption and growth. The terms of trade in East Asian economies improved by up to 2.3% (Japan).

As a result of the dollar's real depreciation, US exports expanded by 16.8% and its imports declined by 13.7%. The trade adjustment was large for Japan, as it is a major trade partner of the US and its currency experienced the largest appreciation against the US dollar. Japan exports dropped by 7.8% and its import increased by 6.4%. The trade impacts on other East Asian economies were more modest, but still notable. For most East Asian economies, their total export fell by 1.0-3.0% and their total imports increased by around 1.0%.

The reorientation of demand from the US market to domestic sources led to adjustment in the sectoral structure of trade and production. Table 3B [ PDF 103.5KB | 1 page ] presents changes in output for 12 sectors of East Asian economies under the USadj scenario. Given that manufactured goods dominate East Asia's export to the US, it is not surprising to see that the region experienced output contraction in most manufacturing sectors. For East Asia as a whole, textiles, apparel, and vehicles were the three sectors with the largest reductions in output. This is because these sectors have high degrees of export dependence on the US market and, as a result, are likely hit most by shrinking US demand and their loss of international price competitiveness due to currency appreciation. But there were large variations across the economies in the region. The vehicle sector experienced the largest output decline in Japan. In other East Asian economies, the textile and apparel sectors were the most-affected, due to the heavy dependence of their textile and apparel exports on the US market.

In addition to exports, changes in domestic demand also played a role in determining the changes of sectoral output. This is evident in the output expansion of service sectors in all East Asian economies and of some manufacturing sectors such as vehicles and machinery in the PRC and ASEAN6 (Indonesia, Malaysia, Philippines, Singapore, Thailand, and Viet Nam). Despite a fall in exports and a rise in imports in these sectors, higher domestic investment boosted their outputs in these economies. Although the percentage changes are small, the expansion of services is significant in absolute size for each economy, as the service sector is generally the largest segment of economic activity.

3.3 East Asia's structural reform to boost services sector productivity

Table 4A [ PDF 122.8KB | 1 page ] presents the economic impacts of a service sector productivity hike in East Asia (SevTFP), building on the first scenario (USAdj). As shown in the first column, higher productivity in the service sector brings significant welfare gains (measured as equivalent variation) for East Asian economies. These gains are especially large for economies with the service sector accounting for a high share of GDP, such as Hong Kong and Japan. Domestic consumption increases with the increase in real income. Rising service productivity also boosts the returns on capital, leading to higher investment in East Asian economies. As a result, private absorption increased by 1.5–5.1%. This consequently raised the demand for imports, which increased by around 1–2% for most East Asian economies. Reflecting the increased domestic demand, the current account of most East Asian economies deteriorated. The CPI of East Asian economies fell by 0.2–0.5%, relative to the US CPI, due to declines in services prices, leading to real exchange rate depreciation. Although the magnitude is small, this result suggests that the development of domestic market-oriented services sectors in East Asia would facilitate the correction of external imbalances with a relatively modest adjustment in the current account and real exchange rates.

The change in sectoral output reported in Table 4B [ PDF 201.4KB | 1 page ] indicates that, not surprisingly, the service sector in East Asia is the largest winner of services productivity improvement. Its production generally expanded by 2.5–3.5% in East Asian economies. The agricultural and manufacturing sectors also benefited from the spillover effects of services productivity hikes, because rising income increases demand for products in these sectors, and less-expensive intermediate service inputs lower their production costs. Within the manufacturing industry, vehicles, electronics and machinery experienced the largest increases in output, reflecting their relatively high demand elasticities to income.

3.4 FTA scenario for the PRC, Japan and the US

Table 5A [ PDF 201.4KB | 1 page ] summarizes the results and major impacts of the three FTA sub-scenarios on welfare and terms of trade, which are reported as changes relative to the second scenario (SevTFP).

First, as shown in the first column of Table 5A [ PDF 201.4KB | 1 page ], a PRC-Japan-US FTA produced a net welfare gain for the world as a whole of US$52 billion (2004 prices). This welfare gain is not distributed evenly across countries. Among the FTA partners, the welfare of the PRC and Japan rose by 1.0–1.3% of GDP, while that of the US rose by 0.2% of GDP. The gain for the US is smaller than that for Japan and the PRC, because of its large economic size, its already low tariff rates, and negative impacts on its manufacturing sector. In general, the trade dependence of larger economies on smaller economies is smaller than vice versa, hence the potential gain of a large economy—such as the US—from an FTA with a smaller economy is limited. The US is a highly open economy with generally low tariff rates—except for those on a limited number of products such as textiles, apparel, and processed food—so that its efficiency gains from the removal of distortions are small. The formation of a PRC-Japan-US FTA on the one hand expands the US agricultural sector, largely due to reduced import protection in the Japanese agriculture sector, but on the other hand reduces the manufacturing sector due to larger imports of manufactured products, thereby diverting resources out of manufacturing toward agriculture. Table 5B [ PDF 292.6KB | 2 page ] indeed shows that the US agricultural sector was the major beneficiary of a PRC-Japan-US FTA, with an average output expansion of 4.3%. But the manufacturing activity of the US shrank by 0.8%, with virtually no change in the service sector. Since the manufacturing sector is assumed to operate under an increasing returns to scale technology, its output contraction has negative welfare implications because of the loss of agglomeration and variety effects.

With the exception of Hong Kong, China, economies excluded from the PRC-Japan-US FTA all experienced declines in welfare, because of lower export demand and deteriorating terms of trade faced by them. Although the adverse effects on these economies were largely modest, those in East Asia suffered more than the economies outside the region, with their welfare losses generally ranging from 0.2% to 0.7% of GDP. Viet Nam experienced a very large welfare loss, equivalent to 1.9% of its GDP, mainly because of a significant contraction of its textile and apparel output. The textile and apparel sectors account for 17% of Viet Nam's gross output and one third of its exports. Around 40% of Vietnamese textile and apparel exports go to Japan and the US. The PRC is Viet Nam's largest competitor in these two sectors. The preferential market access under the PRC-Japan-US FTA provides a strong competitive advantage for the PRC's textile and apparel exports, thereby reducing Viet Nam's export of textiles and apparel to the US and Japan, and consequently its textile and apparel output. Given the high share of the textile and apparel sectors in Viet Nam's manufacturing activity, its manufacturing output fell by 3.5%, much higher than other excluded East Asian economies. Besides the textile and apparel sectors, electronics is another key loser in most East Asian economies from the creation of a PRC-Japan-US FTA.

Table 5C [ PDF 169.6KB | 2 page ] summarizes the results of the FTA scenario for the adjustment in export flows for East Asian economies and the US induced by the PRC-Japan-US FTA. The results show that trade among the three giants expanded significantly. For example, exports from the PRC to Japan and the US, and those from Japan to the US rose by 56–66%, whereas exports from Japan to the PRC, and those from the US to Japan and the PRC more than doubled compared with the scenario SevTFP. Exports of East Asian economies that are excluded from the FTA generally fell, reflecting the trade diversion effects, with some variations across economies. All these excluded East Asian economies experienced a large drop in exports to the US, because their export product composition in the US market is relatively similar to that of the PRC and Japan. In the Japanese market, their exports are not much affected, with the exception of Viet Nam and Thailand, which suffer large export declines. Viet Nam's exports to Japan are concentrated in processed food and apparel, and Thailand also has a large amount of processed food exports to Japan. The processed food and apparel sectors in the Japanese market face stronger competition from inexpensive imports from the US and the PRC, so Thailand's and Viet Nam's exports to Japan shrank significantly. The exports of other regional economies to Japan concentrate on either electronics (Korea; Taipei,China; the Philippines; Malaysia; and Singapore) or primary goods (Indonesia), and they are less affected by the establishment of a PRC-Japan-US FTA.

Differences in export product composition also explain the different performance of excluded East Asian economies' exports to the PRC. Hong Kong, China's exports to the PRC rose by 5.6%, mainly driven by the expansion of trade-related service exports to the PRC. A large part of exports from Viet Nam and Indonesia to the PRC are primary goods. As a result, their exports to the PRC increased. For other excluded East Asian economies, manufactured goods—such as chemicals, electronics, and machinery—account for the majority of their exports to the PRC. Their exports to the PRC declined, ranging from 4.4% for the Philippines and Thailand to 6.2% for Korea.

Second, the formation of a regional FTA among all East Asian economies (FTA-EA), which excludes the US, creates a larger gain of US$110 billion for the world as a whole than does a PRC-Japan-US FTA (Table 5A). As is expected under this scenario, all East Asian economies gained from participating in the East-Asia-wide FTA. This gain is the largest in terms of GDP for Viet Nam (25.1% of GDP) followed by Malaysia-Singapore, Thailand, and Hong Kong, China.¹⁰ What is striking is that Japan's gain is slightly smaller and the PRC's gain is significantly smaller than in the case of the PRC-Japan-US FTA. This result can be explained by the triangular trade pattern in East Asia. Under this pattern, the PRC serves as a major importer of intermediate goods from neighboring East Asian economies, and the bulk of its exports are final goods going to the US and European markets. The regional FTA among East Asian economies would increase the PRC's demand for intermediate goods from the region, raising the prices of the PRC's imports, but not the prices of final goods exported by the PRC. This induces deterioration in the PRC's terms of trade. As shown in Table 5A, the PRC's terms of trade improved by 1.9% under the scenario of a PRC-Japan-US FTA, but deteriorated by 0.1% under the East Asia-wide FTA. The loss in the terms of trade limits the PRC's potential welfare gains from a regional FTA.

Another factor contributing to the PRC's low welfare gains from an East Asia-wide FTA is the limited expansion of the country's manufacturing sector (Table 5B). Under the regional East Asia-wide FTA, Japan and Korea would open their highly protected agricultural markets to members. This would significantly boost the PRC's agricultural exports and output. The simulation results for sectoral output shows that the PRC's agricultural output increased by 0.9% under the East Asia-wide FTA, while its manufacturing sector contracted by 0.6%. As in the case of the welfare results for the US, the structural change toward non-manufacturing can limit gains in welfare.

Third, a trans-Pacific FTA between East Asian economies and the US (FTA-EAUS) provided the largest welfare gain of US$183 billion for the world as a whole (Table 5A). Japan, Korea, and the PRC reaped substantial welfare gains under this scenario, and so did other East Asian economies. Indeed all members of the East Asia–US FTA were better off in comparison with both the PRC-Japan-US FTA and the East Asia-wide FTA. By comparing the welfare gains across the three FTA sub-scenarios, it is interesting to see that the PRC and Japan captured nearly 80% of their benefits accruing from an East Asia–US FTA through a PRC-Japan-US FTA. By contrast, for other East Asian economies, a regional East-Asia-wide FTA accounts for 80–90% of the welfare gains they reaped from the East Asia–US FTA.

Clearly, the PRC benefited most from an FTA with the US. In this sense, the PRC has a large stake in the US markets, and should be interested in deepening economic integration with the US. In contrast, other emerging East Asian economies—particularly Korea; Taipei,China; and ASEAN countries—are more dependent on intra-Asian trade, with primary interests lying in integration within Asia. Japan is somewhere in between; its gain from a PRC-Japan-US FTA was larger than that from an East-Asia-wide FTA and its gain from an East Asia–US FTA was substantially large. These results highlight the potential differences in the positions of East Asian economies toward regional integration.

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