Determining Priority Among EPAs: Which trading partner has the greatest economic impact?

Consulting Fellow, RIETI

The catastrophic earthquake on March 11 has completely changed Japanese people's interest and mindset in the political, economic, and social spheres. As a result, the government's decision on whether to participate in the Trans-Pacific Partnership (TPP), one of the top priority goals of Prime Minister Naoto Kan, may be postponed. The rest of the world, however, remains as steadfast as ever in its move toward various forms of economic partnership agreements (EPAs). With what country or region, should a specific country?Japan for instance?seek to conclude a regional or bilateral EPA if the country is to derive the maximum economic impact from such an arrangement? In what follows, I would like to provide a comparative review of various possible cases to see differences in the optimal framework of an EPA for different countries.

Factors determining the impact of trade liberalization

When countries liberalize trade through the elimination of tariffs, trade in goods subject to tariff elimination will accelerate as their prices decline. In the exporting country, the export of those goods will increase thanks to their more competitive prices and, as a result, the production of those goods will also expand. Meanwhile, in the importing country, market distortions caused by trade barriers will be reduced, leading to a more efficient use of production resources. The combined action of these effects will raise the production and income levels in both countries.

The magnitude of the economic impact of trade liberalization basically depends on the level of tariff elimination and the degree of resulting price declines. In other words, the greater the degree of protection prior to trade liberalization, greater will be the economic impact of trade liberalization. Meanwhile, as a dynamic effect of trade liberalization, we can expect pro-competitive productivity growth in domestic industries prompted by lower prices of imported goods. The higher the tariffs, higher will be the pro-competitive effect of their elimination.

Also, the macroeconomic impact of trade liberalization is greater on countries whose economies are more dependent on trade. When a country's national income increases as a result of trade liberalization, part of the increased income will be saved and invested for a further increase in production. In an economy with a high saving ratio, the linkages among the national income, investments, and production will be stronger and so will be the macroeconomic impact of trade liberalization.

Impact of regional trade liberalization

It is generally expected that the magnitude of the macroeconomic impact of regional trade liberalization increases in line with the number of member countries and/or the scope of industries covered. Apart from negotiations on the TPP, member economies of the Asia-Pacific Economic Cooperation (APEC) have been engaged in liberalization talks under various regional frameworks, which include: a trilateral initiative of Japan, China, and Korea; ASEAN+3 which groups the member countries of the Association of Southeast Asian Nations (ASEAN) and the three East Asian nations of Japan, China, and Korea; and ASEAN+6 which includes Australia, New Zealand, and India in addition to ASEAN+3 countries. Table 1 below shows the estimated impact of trade liberalization under each of these frameworks on the real gross domestic product (GDP) of each member economy.

Table 1: Impact of regional trade liberalization on real GDPTable 1: Impact of regional trade liberalization on real GDP

In the case of Japan, the impact of trade liberalization measured in terms of an increase in real GDP is the greatest under the Free Trade Area of the Asia-Pacific (FTAAP) which includes all APEC member economies, followed by ASEAN+6, ASEAN+3, and the trilateral framework of Japan, China, and Korea. Thus, the greater the number of member economies, the greater the impact of trade liberalization insofar as these four frameworks are concerned. However, the impact of worldwide trade liberalization is estimated to be smaller than the impact of trade liberalization under the FTAAP. Trade liberalization surely accelerates trade between the countries concerned. From the viewpoint of third countries, this implies the possibility of their being replaced by other, more efficient exporters. Thus, depending on a tradeoff between trade creation and trade diversion effects, the participation of a greater number of countries in an EPA does not necessarily lead to a greater economic impact. For policymakers, the possibility that different countries may have different optimal regional frameworks has an important implication and will likely draw significant attention.

In contrast, for China, the impact on real GDP is expected to be far greatest when trade liberalization is undertaken on a worldwide basis, followed by under the framework of FTAAP and then ASEAN+6, in that order. This indicates that while ASEAN+6 and ASEAN+3 are high priorities for Japanese policymakers, it is important for their Chinese counterparts to pursue trade liberalization covering as many countries as possible, expanding the geographic coverage from ASEAN+3 and ASEAN+6 to FTAAP and even to all over the world.

It should be noted that the above observations are based solely on the comparative analysis of the impact of tariff elimination. Other factors?the impact of non-tariff barriers in the areas of service trade and investments, non-economic effects such as the strengthening of diplomatic ties with partner countries, and so forth?should be also taken into account in determining the priority among potential EPAs.

Impact of bilateral trade liberalization

A regional framework's relative importance differs across member countries because certain countries that are desirable as a trading partner for one country in terms of the impact of trade liberalization differ from those that are desirable for another. The impact of bilateral trade liberalization is estimated for APEC member economies, the European Union (EU), and some other countries, as shown in a matrix form in Table 2 below.

Table 2: Impact of bilateral trade liberalization on real GDPHighslide JS
[Click to enlarge]

For Japan, China is the trading partner that will likely have the greatest impact (0.66% increase in real GDP), indicating the importance of including China in a regional liberalization framework to derive greater economic impact. In contrast, for China, the EU will likely have the greatest impact (2.12% in real GDP), followed by the United States (1.56%) and Japan (1.40%), pointing to the aforementioned priority sequence among potential regional EPAs.

Meanwhile, the ranking of impactful EPA partners shows that China is the most important partner in terms of overall positive economic impact on other members, followed by the EU, Japan, the U.S., Korea, and India. Furthermore, when we look at the impact on specific countries and regions, we can see some interesting differences. First, China is estimated to be the most important partner not only for Japan and Korea but also for ASEAN member countries. Second, Japan is the most important partner for Australia and Canada, with which Japan is either negotiating or conducting a joint study on a bilateral EPA, and is the second most important partner for the EU, with which Japan is about to start EPA negotiations. Third, the EU is the most desirable partner not only for China but also for the U.S., India, and Russia. Fourth, India is relatively important for Australia and ASEAN countries such as Malaysia, Indonesia, and Singapore.

Which countries and/or regions are important for which country or region? Or conversely, which country or economy is important for which countries and/or regions? Keeping these perspectives in mind provides a critical piece of information to those directly engaged in the formation of trade policy as well as to third parties trying to gauge the future course of trade negotiations.

May 31, 2011

May 31, 2011