Policy options

At the end of June 2009, some signs of the global economic contraction bottoming appeared. The economic forces unleashed by the crisis, however, will probably run rampant for years. Although the frequency of ‘green shoots' reported in the news media has been increasing recent weeks, it is still hard to paint a reasonable growth trajectory extending beyond even few months (the IMF has been revising its growth forecasts almost every month since the onset of the crisis!). There could even be a “lost decade” for the US economy (and even for a few countries in Europe) like that suffered by Mexico in the 1980s or by Japan in the 1990s (Shiller 2008). The current economic downturn mainly reflects balance-sheet adjustments by both firms and households in the US, precipitated by a financial crisis. It is also unusually synchronized around the globe. These characteristics, when interpreted in the context of the accumulated evidence on recessions in developed countries since the 1960s, point to a process of a slow recovery and a subsequent longer period of slow growth (IMF 2009). After the recovery process sets in, the US and other crisisaffected developed countries will have to save more and import less in order to wind down their massive accumulated debts.

In the current global economic setting, there has been a growing emphasis in Asian policy circles on the need for rebalancing growth engineering a structural shift in aggregate domestic demand away from exports and toward domestic production (ADB 2009). The policy measures under consideration to achieve this include both measures to redress export bias in the incentive structure and various measures to reduce the propensity for high savings, with a view to boosting domestic demand (ADB 2009). The major focus of this policy advocacy is on the PRC.

The PRC's degree of export dependence is unusually high for a continental economy of its size. The PRC's export to GDP ratio (around 40%) grossly exaggerates its export dependence: assembly exports (or processed exports) which rely heavily on imported components accounts for over two thirds of total merchandise exports. .Even the available ‘net' trade decency estimates (around 20%), however, seem too high for the PRC's potential economic size. Moreover the unusually high domestic saving rate, the vast population base, and highly controlled domestic financial system, all indicate the vast potential for domestic demand-led growth in the PRC. However, the PRC faces a formidable political constraint in shifting policy emphasis away from export-oriented growth and toward domestic marketoriented growth: there is strong domestic pressure to maintain the momentum of employment-intensive growth through export orientation (Yu 2008, Gan 2008).

About half of the PRC's massive labor force is still engaged in agriculture, where productivity is, on average, barely one eighth of that in industry and about a quarter of that in the service sector. Agriculture still accounts for over 45% of total employment in the country even though agriculture's share in GDP is only 13%. GDP per capital in PRC is three times the value added per worker in agriculture. The country still remains very rural, with a rate of urbanization of about 40% of the total population, much lower than a ‘normal' level of 60% consistent with the PRC's income level. These features, coupled with the high skilledunskilled wage differential (which, according to some estimates, has risen from 1.3x to 2.1x over the past decade) suggest that the PRC still has much potential for moving unskilled workers out of agriculture and into manufacturing and other productive urban sector activities. Given that there is ample availability of unskilled and semi-skilled labor, and that capital involved in export-production is internationally mobile, export-orientation and importsubstitution (without imposing policy barriers to imports) are not mutually exclusive policy priorities for the PRC.

The pressure for maintaining export competition in a context of shrinking world demand could provide a fertile setting for mercantilist Trade policies. There are already some signs of such tendencies (Bradsher 2009). For instance, in late December 2008, PRC officials announced a series of measures to help exporters, including a new directive to state banks to expand lending, more particularly, to small- and medium-size exporters, setting up new government research funds to help exporters, and export tax rebates for the textile and garments sector. The latter initiative is a clear reversal of a government policy stance, declared a few years ago, to encourage textile and garments exporters to move away from those labor intensive product lines in an effort to set the stage for the PRC economy to climb the ladder of economic development. Municipal governments in the PRC have also stopped raising the minimum wage in an attempt to reduce pressure on costs for exporting firms.

These initiatives by the PRC are starting to cause concern in other Asian countries. For instance, Indonesia has already imposed a series of administrative measures to make it harder for PRC products to enter the Indonesian markets. Starting in 2010, PRC exports of garments, electronics, shoes, toys and food from slated for import into Indonesia are only allowed to be shipped from designated ports. Indonesian importers are also required to arrange for a detailed inspection of goods by the Indonesian Customs before they are loaded on ships or planes bound for Indonesia, and then have every single container inspected on arrival. There are also signs of political concern about unfair import competition from the PRC in other countries in the region such as Cambodia and Viet Nam.

This emerging trade policy reaction is not an isolated Asian development. Rather it is a manifestation of a wider global trend toward resurgence of “new protectionism” in the wake of the global economic contraction triggered by the financial crisis, which is reminiscent of the rise of “new protectionism” in developed countries in the slow growth period following the first oil crisis in the early 1970s (Bhagwati 1988, Erixon and Razeen 2009). The protectionist threat is perhaps greater this time, given the severity of the global economic downturn. There are already signs of countries increasingly resorting to disguising the means of protection, such as filing anti-dumping complaints and stringent implementation of technical, sanitary, and phytosanitary standards, in addition, of course, to the massive financial support to automobile manufacturers extended by the US and some other countries (Gamberoni and Newfarmer 2009).

What are the policy options available to governments in East Asian countries to avert the threat of new protectionism? One option under consideration is to form a region-wide free trade association (FTA), encompassing ASEAN, the PRC, Japan and Korea, and possibly India (Kawai and Wignaraja 2009, ADB 2009).

Trade within global production networks is generally more sensitive to tariff changes than is final trade (or total trade as captured in published trade data) (Yi 2003). Normally a tariff is incurred each time a good-in-process crosses a border. Consequently, a given reduction in tariffs on components imports leads to a decline in the cost of production of a vertically integrated good by a multiple of the initial reduction; this is not the case for a regularly traded good. Tariff reduction may also make it more profitable for goods that were previously produced entirely in one country to become vertically specialized. Consequently, in theory, the trade-stimulating effect of FTAs would be higher for network trade than for normal trade, other things remaining unchanged. In many East Asian countries (particularly in Indonesia, Malaysia, Thailand, Philippines and Korea and the PRC) tariff rates are high, particularly on electrical machinery and transport equipment (although rates on electronics have been notably reduced under the Information Technology Agreement (ITC) agreement in all these countries other than in Indonesia which is not yet a signatory to this agreement) (Table 9). At first blush, this appears to be an area where FTAs can potentially play a role in promoting trade in finished goods among economies in the region. As we have already noted, there is potential for growth in intra-regional trade in this dynamic product category under a duty free regime as income levels increase.

Even though rates on electronics have been notably reduced under the ITC agreement in all major East Asia countries other than in Indonesia which is not yet a signatory to this agreement, electrical appliances have not been included in the agreement. (ADB 2009: Box I.1) (Table 12 [ PDF 15KB | 1 page ]). At first blush, this appears to be an area where FTAs can potentially play a role in promoting trade in finished goods among economies in the region.

In reality, however, the effect on trade of any FTA would depend very much on the nature of rules of origin built into it. Trade-distorting effects of rules of origin (ROO) are presumably more detrimental to network trade than to conventional final-goods trade, because of the inherent difficulties in defining the ‘product' for duty exemption, and due to the transaction costs associated with the bureaucratic supervision of the amount of value-added in production coming from various sources. Hence, even small differences in ROOs among overlapping FTAs can raise business costs and divert trade and associated investment. In addition, at the highly disaggregate level, e.g. (6-digit level of the Harmonized System (HS) of trade classification, it is not easy for individual firms to identify HS codes for their related products (inputs and outputs) so that it creates room for policy discretion.⁹ Those costs are much more onerous for small- and medium-size trading firms in developing countries than they are for large corporations. There are two other complications involved in bringing network trade under FTAs (or other preferential trading arrangements.

First, formulating ROOs for network-related trade is rather complicated. The conventional value-added criterion is, essentially, not applicable to this trade because the products involved are low value-added by their nature. The only viable option is to opt for “change in tariff lines” based ROOs (that is, classifying a product which shift from an intermediate goods tariff line on the import side to a final good tariff line on the export side as eligible for FTA tariff concessions), but this leads to insurmountable administrative problems because electrical and electronics goods, and their related parts and components belong to the same tariff codes (at the HS-6 digit level, which is the normal basis for designing this type of ROO) (Kohpaiboon 2008: Appendix). For example, electrical appliances assembly plants is Thailand which use imported bare printed circuit boards (BPCB) together with other locally procured electronic components (e.g. diodes, integrated circuits, semi-conductors) for printed circuit board assembly (PCB) for export are not eligible for FTA concessions because BPCBs and PCBs belong to the same HS code 853690.

Second, the process of international production fragmentation and the network-based international production is characterized by continuous emergence of ‘new' products. Given the obvious administrative problems involved in revising ROOs for these new products, product invention and innovation naturally opens up room for unnecessary administrative delays and/or tweaking of rules as a means of disguised protection (Elek 2005). Moreover, given the importance of extra-regional markets for final goods to growth for production networks in Asia, maintaining barriers to trade against non-members (while allowing free trade among members) can thwart the “natural” expansion of fragmentation-based trade across countries.

The experience to date with FTA negotiations in the region (and beyond) clearly attests to the political power of producer interests in insulating a few heavily protected sectors against any attempt to cut tariffs through FTAs. The same sensitive products, which are proving hard to liberalise in the Doha Development Agenda of the WTO, or among APEC economies, are also routinely exempted from “free trade” deals. Furthermore, any marginal liberalization of border barriers to these products tends to be negated by product-specific ROOs and by retaining the right to impose less transparent forms of protection, such as anti-dumping actions. There is also the possibility that authorities use ROOs as a means of protecting import-competing industries, when a country pursues both export-promoting and import-substitution industrialization strategies simultaneously (as is the case with a number of countries in the East Asian region). Twisting ROOs for this purpose become easier when the production process involves procuring parts and components from a number of sources: tightening ROOs on the procurement of one critical input would suffice to protect competing domestic producers of the final (assembled) product.¹⁰

It is also important to note that the available evidence on the operation of current FTAs in the region (and beyond) augur well for the potency of a new region-wide FTA. The actual utilization rates of tariff concessions provided under these FTAs are rather low, raging from about 5% to 20% across different product categories (Takahashi and Urata 2008¹¹, Kawai and Wignaraja 2009, Kohpaiboon 2008). More importantly, there is evidence that the utilization rates are often firm and/or industry specific: Normally large firms and firms with close trade and FDI ties, or those located in particular industries where meeting ROO requirements are simple and straightforward, use FTAs. The upshot is that FTAs are unlikely to have the potential to promote trade in a neutral and broad-based fashion. Another relevant concern is that creating an Asia-wide trade bloc entails substantial risks given Asia's heavy reliance on extra-regional markets for its export dynamism. Such a strategy would invite swift retaliation by the US and EU.¹²

In any case, the chances of negotiating a region-wide FTA look rather slim given the ongoing crisis. In particular, the PRC may not want to get involved in such an endeavor, not only because of its new emphasis on domestic-oriented growth but also because of its official commitment to averting protectionist backlash against its exports from developed countries.¹³ Governments in Southeast Asian countries are also concerned that any regionwide attempt to liberalize trade would give an unfair advantage to the PRC, given its vast domestic economy, in attracting FDI for global production networks, accentuating regional differences in the cost of production.

There is, therefore, a strong case for devising strategies to fight new protectionism as part of a long-term commitment to nondiscriminatory multilateral and unilateral liberalization. The Information Technology Agreement which came into force in 1997 seems to be a promising example to follow (Elek 2008). There is also case to be made for Asia's G7 countries and the ASEAN Secretariat to consolidate their positions against protectionist tendencies;¹⁴ East Asian countries have benefited enormously from the process of multilateral trade opening over the past four decades, and averting policy backsliding while striving to finalize the incomplete reform agenda is vital for their recovery from the crisis and to sustain future growth.

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