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	Table of Contents
p. 74 of 77 BACK | NEXT Foreword, Acknowledgments, Contents, Acronyms and Abbreviations, Definitions I. Developing Asia and the World II. Economic trends and prospects in developing Asia III. Routes for Asia's Trade Introduction The drivers of trade and integration in Asia The rise of bilateralism Trade scenarios: Potential benefits and risks An agenda for trade and integration in Asia Conclusions Endnotes and references Statistical appendix

Asian Development Outlook 2006 : III. Routes for Asia's Trade

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An agenda for trade and integration in Asia

The multilateral, regional, and bilateral trade liberalization scenarios illustrated in the previous section make the point that uncoordinated bilateral liberalization risks sacrificing gains, which could be captured either through cooperative multilateral approaches or through nondiscriminatory (open) regional agreements. The potential for trade diversion, as opposed to trade creation, is greater in a system of overlapping bilateral agreements. Crisscrossing bilateral agreements also risk marginalizing peripheral countries with small markets. Investment decisions are not easily reversible, and can have a cumulative influence on economic advantages. Therefore, even if bilateral preferences were to eventually give way to multilateral liberalization, the polarizing impacts of bilateralism could be long lasting (Baldwin 2002).

The proliferation of bilateral regional trade agreements in Asia reflects countries' strategic and political interests as well as their commercial interests in institutionalizing market-driven integration processes. But the pursuit of overlapping bilateral, regional, and plurilateral FTAs by Asian countries has resulted in multiple agendas for integration. Harmonizing these agendas to tap the potential of nondiscriminatory approaches to liberalization, and to expand the reach of integration, constitutes a significant challenge.

In this section, the practical question is addressed as to how bilateral FTAs might be best designed so as to maximize their potential leverage on the growth of trade and economic integration. At a minimum, FTAs should be consistent with the principle of not, on average, raising barriers to imports from nonmembers. They should also strive to be trade creating by actually lowering barriers to nonmembers. There are working examples of agreements that are pushing liberalization forward in "nontraditional" areas and moving outward the frontiers of economic integration into areas beyond WTO's jurisdiction. For example, Singapore's FTA with New Zealand provides more flexibility on rules of origin than traditional FTAs, leaving firms some choice in compliance and so lowering the costs of compliance. In addition, full-blown FTAs extend liberalization into new areas, such as investment.

Bilateral trade agreements as building blocks for integration

Asia's "noodle bowl" is already quite full and is spilling over regional boundaries. An important question is how to mitigate the damage that may be caused by a knot of agreements that differ in terms of their coverage, treatment, and ambitions, and that may contradict one another. On the ground, the problems associated with bilateral trade agreements have little to do with esoteric theories of the second best, and everything to do with bread and butter commercial decisions. As observed in The rise of bilateralism, above, rules of origin with high compliance costs may simply mean that businesses prefer to pay an MFN tariff, rather than attempting to establish that their goods qualify for preferences. Likewise, customs administration can quickly become bogged down when products have components that are assembled in multiple locations. Where administrative structures are weak, gray areas heighten incentives and opportunities for corruption, punishing honest businesses and leading to significant leakage of public revenues. For investors, decisions also become much more complex as cost considerations must now be weighed against current and expected future margins of preference all along the supply chain. However, these are not inevitable consequences of bilateral agreements, and steps can be taken to mitigate distortions and inefficiencies.

As Plummer (2005) points out, the scope for reducing distortions will depend critically on the "inclination" of bilateral accords. If they are intended to protect special interest groups and to turn countries inward, they are likely to act as a stumbling block to broader liberalization. Against this—and there is evidence that bilateral agreements are moving in this direction (The rise of bilateralism, above)—if they aim at deepening integration, they may present additional opportunities to those currently accommodated within the multilateral framework. Given these conditions, Plummer advocates a number of specific steps that, together, could constitute an approach to a "first best" solution (Box 3.8).

The WTO agreements impose relatively few requirements on member countries who wish to negotiate bilateral FTAs. Agreements between developing countries that are notified under the "Enabling Clause" have only to be formally notified to WTO. For industrial countries, there is the requirement under Article XXIV of GATT that an agreement: (i) covers substantially "all" trade in goods; (ii) does not raise barriers on average to nonmembers; and (iii) is notified to WTO. There are also limits of 10 years imposed on the time frame for implementation and, for any agreement that includes services, there is a notification requirement under the General Agreement on Trade in Services (GATS). WTO also conducts reviews of notified agreements to ensure that they are implemented in accord with the above requirements.

Full-blown FTAs are often designed to push liberalization between members beyond the limits of the WTO agreements. These "WTO+" FTAs are typically agreements between the advanced industrial economies, but increasingly involve middle- or upper-income developing countries. Plummer (2005) provides a checklist of features for such FTAs (Box 3.8 above). He also attempts to grade some recent FTAs involving Asian or Pacific countries accordingly.

From a developing country's perspective, some of Plummer's requirements appear onerous. A lack of capacity and technical expertise, missing institutions and laws, and weak enforcement mechanisms may seriously constrain what agreements can really deliver. In the case of agreements involving a developed-country partner, technical cooperation and assistance may gradually relax some of these constraints. The EU's experience shows that the deepening of trade agreements is a process that takes time, patience and, above all else, political commitment.

Connecting the spokes

The experiments outlined in Trade scenarios: Potential benefits and risks, above, underline the point that bilateralism resulting in many unconnected and isolated "spokes" poses the greatest risks, particularly to the spokes themselves. In a hub-and-spoke configuration, investors are likely to limit their interests to large hubs, with spokes benefiting only to the extent that they provide margins of preference, net of the compliance costs of rules of origin. As many countries have now learned, investors in search of preference margins can leave as quickly as they arrive.

Processes that connect the spokes are likely to be superior for overall trade creation and for the leveling of opportunities. In developing Asia, this suggests that there would be advantages to building a network or association of agreements around subregional hubs (ASEAN, SAARC). The "ASEAN+" agreements have this potential, as would plurilateral agreements between subregional alliances. But building such a network may be politically difficult, in view of the heterogeneity within such groupings and their asymmetric interests. The creation of separate bilateral agreements between an outside country and different countries within an emerging free trade area magnifies potential distortions. Customs unions are superior to FTAs in that they could further reduce distortions, but they require members to surrender their autonomy in trade policy. Hence, most countries choose FTAs so as to retain some independence in trade policy toward nonmembers.

It is also clear, however, that within existing regional groupings some countries are better prepared than others to make strides toward full-blown "WTO+" trade agreements as outlined above. This will make it difficult to move at a uniform pace and in a coordinated way. Indeed, Singapore has already closed deals along those lines with Australia, European Free Trade Association, Japan, Korea, New Zealand, and US. Likewise, Malaysia and Thailand are better positioned than Indonesia, Philippines, or Viet Nam, let alone the smaller, poorer countries like Cambodia and the Lao People's Democratic Republic.

Technical assistance, capacity building, and increased "aid for trade"

The binding constraints on the negotiation and practical implementation of full-blown FTAs involving DMCs reside precisely in the weak institutions and limited technical capacity of DMC governments and private sectors. Customs departments are often ill-equipped, their staff underpaid and prone to corruption, and lacking expertise both in valuation, and, of course, for efficient implementation of rules of origin and other complex facets of a full-blown FTA. Legal coverage and institutions are too frequently slow and weak, and this will not only pose limits on what agreements can do in terms of attracting investment, but will make dispute resolution fraught with uncertainty. In addition, lack of business experience with the accounting practices required to document production costs and purchases according to source, which are necessary to obtain certificates of origin, may result in paper agreements that are ignored in practice. Taking the "easy option" of paying the MFN tariff makes sense if the compliance costs of attaining certificates of origin are too high.

Similarly, talk of extending agreements to competition policy is meaningless in countries where systems for entry and exit of firms are opaque, where modern bankruptcy laws may not exist, or where bankruptcy proceedings are routinely used to expropriate legitimate and profitable firms (while shoring up loss-making state enterprises). The practical capability of small and low-income countries to negotiate beneficial agreements with numerous parties on the long list of technical matters raised above is negligible. Immediate efforts to build capacity to not only negotiate with partners, but also to "sell" such agreements to the private sector, bureaucracy, legislature, and public at large, are needed. These efforts must also be continued, determinedly, for several years if these agreements are to be worth more than the paper they are written on.

Ultimately, winners and losers will emerge from these agreements, and so there must be a way to make the adjustment process politically palatable. This is where "aid for trade" comes in. Provision of technical assistance by the more advanced to the less advanced partner is one obvious means of addressing the political economy problems. Producers in countries entering into FTAs with industrial countries or advanced developing countries could be given technical assistance to improve the quality of their products and to reduce unit costs. These producers still have to adjust, but they will become more competitive as a result.

Compilation of "best practices" with practical examples could provide officials responsible for negotiations with a tool that will serve them well in future trade talks. Enabling them to have a better understanding of WTO law and practice in numerous areas of trade and trade policy, particularly customs valuation, standards, intellectual property rights, government procurement, services, and agriculture would also provide valuable intellectual capital to the smaller countries in the region.

Reducing trade costs

One area in which bilateral agreements, especially if accompanied by technical and other assistance, may be able to promote deeper integration is through initiatives that help improve trade efficiency, thereby reducing trade costs. These measures help exporters get their goods to market more quickly and cheaply. Initiatives that help reduce trade costs are particularly attractive because they are nondiscriminatory and can generate "win-win" outcomes.

A constellation of factors may influence trade costs including: access to and the quality of infrastructure; port handling procedures; customs regulations and efficiency; the availability of trade credit; licensing, inspection, and regulatory requirements; and the efficiency of information and logistics networks. Trade costs include direct monetary costs associated with moving goods across borders as well as any indirect costs, including time costs. Time costs can be particularly important for perishable or other goods where delivery deadlines are important (Box 3.9).

A number of studies have attempted to assess the welfare impact of trade transactions costs. These studies estimate that for each 1% reduction of trade transaction costs, world income could increase by $30 billion—$40 billion (Francois et al. 2005, OECD 2003, APEC 2002). Typically, the benefits for developing countries are larger than for developed countries as the former are generally less efficient in trade. Case study evidence suggests that customs modernization programs can significantly increase trade flows and government revenues, as "lost" tariffs and duties are recouped. Hertel et al. (2001) analyze the impact of customs automation in the context of a bilateral FTA between Japan and Singapore and find that it would result in global gains of US$9 billion annually, with 70% of it accruing to Japan. A reduction in trade costs could also have a positive impact on foreign direct investment, but there would appear to be little direct empirical evidence for this (Engman 2005).

In Table 3.8, the results of an experiment are reported in which it is assumed that there are gains in trade efficiency in Asia. These gains may be compared with the tariff liberalization exercises reported above in Trade scenarios: Potential benefits and risks. For high-income countries in Asia, trade efficiency gains are assumed to be modest, but for low-income countries larger gains are assumed in recognition of lower initial levels of efficiency and enhanced opportunities for improvement and "catch-up." Between 2007 and 2025, frictional trade costs, i.e., the component that generates no counterpart income, are assumed to fall by 10% of baseline trade values in the lowest-income developing Asian countries, by 5% for middle-income developing Asian countries, and by 2.5% in higher-income countries in Asia. These cost reductions are applied to both exports and imports. It is assumed that reductions in the costs of exports are passed through to importers who now pay less for a given volume. Consequently, importers outside as well as inside Asia benefit from the assumed improvement in trade efficiency. The direct efficiency gains (or savings) to importers are shown in data column 3 of Table 3.8. These terms-of-trade gains then trigger adjustments in demand, supplies, trade flows, and relative prices across countries and regions. The upshot in terms of final changes in real income, measured relative to base, is summarized in data columns 1 and 2 of Table 3.8.

As a percentage of the baseline estimate of GDP, estimated impacts of the trade cost reduction scenario appear large. But a substantial portion of the gains is due to the assumed size of the disturbance (data column 4), which varies across countries and regions. Low-income countries, and countries with large initial trade shares, are most affected by a reduction in trade costs and have most to gain. A 10% reduction in the costs of trade is very large for an economy where trade accounts for over 100% of GDP. A more useful measure of the possible benefits of an increase in trade efficiency, which controls for the size of the disturbance, is the total income generated by each dollar saved on trade costs. For the global economy, each dollar reduction in trade costs raises income by $2.40, including the original direct saving of $1, as this constitutes the recovery of resources that were previously wasted. The additional $1.40 is generated by multiplier effects and by induced accumulation. In Asia, which is the assumed source of efficiency gains, each dollar saved in trade costs generates total income of $2.80. However, these estimates of the gains from improved trade efficiency are sensitive to model assumptions. For example, at a global level, if constant returns to scale better characterize technology, the estimated gains are $1.90 for each $1 of trade costs saved; if no accumulation accompanies rising income, this estimate falls to $1.20.

These results demonstrate the nondiscriminatory nature of increased trade efficiency. Despite the assumption that reductions in trade costs are confined to Asia, all regions benefit. This is a "win-win" outcome. Both Hong Kong, China and Singapore, for whom assumed reductions in trade costs are modest, also clearly benefit from improvements in trade efficiency of their major partners. Within Asia, the most significant benefits are seen for ASEAN. Although impacts on income are more modest in South Asia, because the subregion is not as open as East Asia and Southeast Asia, the additional income generated by each dollar saved is large. For example in India, a dollar reduction in trade costs generates total income of $3.40, partly because this reduction generates terms-of-trade gains for the country, adding significantly to the benefits of lower protection levels.¹⁴

Lower trade costs would likely change patterns of trade. One route would be further fragmentation of production across national borders to exploit economies of specialization and scale. Figure 3.6 shows growth of exports and imports in the current experiment. Reductions in trade costs induce greater trade expansion in modern manufacturing sectors such as chemicals, electronics, and machinery. The most striking change occurs in electronics. In the Asian free trade scenario, electronics exports from Asia decline relative to the baseline. But with the assumed reduction in trade costs, Asia's electronics trade (exports plus imports) rises by 70%. Asia's trade in electronic goods is largely driven by international vertical specialization and involves a large amount of "back and forth" trade in parts and components. Even moderate improvement in trade efficiency can substantially cut the costs of international supply chains, encourage the expansion of regional production networks, and boost intra-industry trade. Also, if trade efficiency can be improved in the Asian region, intraregional trade will play an increasingly important role in supporting long-term income growth. Under current assumptions, the estimated share of intra-Asian trade in global trade rises to 38.3% by 2025.

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