## 1. Past analyses of the TPP's effects

Estimates of the Trans-Pacific Partnership's (TPP) effects on the gross domestic product (GDP) have been conducted using various approaches. The most well-known for Japan was conducted by Kenichi Kawasaki, a visiting research fellow at the Economic and Social Research Institute of the Cabinet Office when he was a consulting fellow at RIETI. Kawasaki's estimate is based on a simulation utilizing the Global Trade Analysis Project (GTAP) model, a well-known macroeconomic model incorporating trade, and forecasts Japan's participation in the TPP to increase its real GDP by 2.4 trillion yen to 3.2 trillion yen, or 0.48% to 0.65% in its ratio to the GDP (National Policy Unit, 2010; and Kawasaki, 2011). Furthermore, according to Petri and Plummer (2012), using their extended GTAP-type model which incorporates other factors such as foreign direct investment (FDI), Japan's GDP in 2020 would be $95.5 billion (approximately nine trillion yen) or about 2% larger if Japan and Korea participate in the TPP.

## 2. The TPP's growth effects—"Two heads are better than one"

These estimates, however, undervalue the TPP's effects as they only focus on the direct impact—that the TPP will lower barriers for trade and investment, thereby increasing export and FDI and, in turn, domestic production. Nevertheless, the TPP's essential effect is to promote domestic innovation and technological improvement through economic globalization including trade and inward/outward FDI, which would encourage the Japanese people to connect with diverse human resources around the world and, thus, acquire new knowledge, broader perspectives, and inspiration from them.

Connections between diverse groups of people have long been recognized to lead to innovation as in the saying, "Two heads are better than one," which today is demonstrated in various empirical papers. Researchers' productivity, for example, is shown to be the highest in cases where they have strong ties within their specific research community as well as networks with "outsiders" with different specialties (Rost, 2011; and Tiwana, 2008). Furthermore, many studies including those at RIETI indicate that export and inward/outward FDI improve the growth rate of Japanese firms' productivity. For example, Kimura and Kiyota (2006), based on firm-level data, conclude that a firm's total factor productivity (TFP) increases by 2.4% when it starts to export (See Row 4 of Table 4 in the respective paper.). According to Todo (2006), FDI in research and development (R&D) to a given industry in Japan increases productivity of Japanese firms in the same industry through knowledge spillovers from FDI. The productivity of Japanese firms in an industry with an average level of inward FDI is about 4% higher than it would be without FDI. Furthermore, Japanese firms' FDI outflows in R&D and offshoring activities increase the productivity growth rate for their parent firms in Japan (Hijzen et al., 2010; Todo and Shimizutani, 2008).

Nevertheless, it is not being accurately recognized that the TPP will contribute to Japan's economic growth by enhancing the level of knowledge and technology through globalization. In particular, it is not fully understood that the TPP will not only temporarily increase GDP but also sustainably stimulate domestic innovation, leading to an increase in the GDP growth rate and exerting significant long-term effects. As the figure below shows, according to the past estimates including those by Petri and Plummer, the TPP will increase the absolute amount of GDP in the long run, but (without growth based on other factors) GDP will eventually stop growing and stabilize (as indicated by the red curve "A"). If, however, the TPP increases the economic growth rate by promoting innovation, GDP will continue to grow (blue curve "B"). Obviously, effects on the growth rate will bring about significantly larger consequences on a cumulative basis.

## 3. The TPP will increase the growth rate of GDP per capita by 1.5%

What, then, is the extent of such growth effects? Petri and Plummer (2012), who estimated the TPP's contribution to increase trade and FDI, made it possible to forecast the TPP's growth effect with greater accuracy. By combining their work with the thick literature on the effect of trade and FDI on economic growth accumulated in the 1990s and 2000s, the TPP's effect on the growth rate of GDP per capita can be estimated. The author has already attempted to project the TPP's growth effect (e.g., Todo, 2011), but has had to base it on strong assumptions because no accurate estimates on increases in FDI due to the TPP were available. On the other hand, this article's estimate is considered to be more accurate as it utilizes Petri and Plummer (2012) for the approximated increases in the volume of trade and FDI.

First, let's look at the effect of the increase in the trade volume. According to Petri and Plummer (2012), the TPP will increase Japan's trade volume (the sum of exports and imports) by $340 billion or 6.8 percentage points in its ratio to GDP in 2020. According to the estimate by Lee et al. (2004), an increase in the trade share (the ratio of the trade volume to GDP) by one percentage point will increase the growth rate of GDP per capita by 0.027 percentage point (See Table 5b in the respective article). Accordingly, the increase in the trade volume due to the TPP will raise the growth rate of GDP per capita of Japan in 2020 by 0.18 percentage point (= 6.8 * 0.027). This increase is significant given the nearly 0.8% growth rate in Japan's real GDP per capita over the past 20 years.

Furthermore, an even larger effect would be expected with an increase in FDI to Japan. Petri and Plummer (2012) estimate that the TPP will increase FDI to Japan by $155.6 billion or 3.1 percentage points in its ratio to GDP. According to Alfaro et al. (2004), inward FDI increases the growth rate of GDP per capita, and the effect is larger for countries with a more developed financial system. When the ratio of inward FDI to GDP increases by one percentage point, the growth rate of GDP per capita increases by 0.78 percentage point times the ratio of private credits to GDP in logs (See Row 4 of Table 4 in the respective paper.) Given that the ratio of private credits to GDP for Japan in 2010 was 1.72 (World Bank's World Development Indicators), the increase in FDI to Japan due to the TPP will increase the growth rate of GDP per capita by around 1.3 percentage points (= 3.1 * log1.72 * 0.78).

Consequently, combining the effects of trade and inward FDI, the growth rate of GDP per capita will increase by 1.5 percentage points. With the average growth rate of Japan's real GDP per capita over the past 20 years at 0.8%, the TPP could possibly realize a growth rate exceeding 2%. Thus, participation in the TPP could become the key policy measure for Japan's economic growth.

## 4. Some reservations and conclusions

These numbers are, however, estimates, and therefore we should interpret them with caution, allowing some ranges in the estimates. For example, the point estimate of Lee et al. (2004) mentioned above of the effect of the trade share on per capita GDP growth is 0.027 percentage point, but the 95% confidence interval ranges from 0.019 to 0.035. In other words, the effect is estimated, with a 95% probability, to fall within the range between 0.019 and 0.035 percentage point. Consequently, the TPP's growth effect through trade ranges from 0.13 percentage point (= 6.8 * 0.019) to 0.24 percentage point (= 6.8 * 0.035) with a mean of 0.18 percentage point. The TPP's effect through FDI to Japan has an even larger range, with its 95% confidence interval ranging from 0.35 percentage point to 2.27 percentage points.

Also, there is a large volume of research on the growth effects of trade and FDI. While this article is based on seminal papers (according to Google Scholar, as of March 11, 2013, Lee et al. (2004) and Alfaro et al. (2004) have been cited 143 times and 919 times, respectively, in other academic writings. Such large numbers of citations indicate the creditworthiness of their results), other studies reached different results using different methods and/or data. Furthermore, the estimate by Petri and Plummer (2012) on the effect of the TPP on trade and FDI will have different outcomes with different assumptions in the model. Taking these factors into account, the TPP's growth effects should be considered to have a significant range.

Nonetheless, even assuming the lowest limit of the 95% confidence interval of the estimates of Lee et al. (2004) or Alfaro et al. (2004), respectively 0.13 and 0.35 percentage point, and assuming further that Petri and Plummer (2012) overestimated the increases in trade and FDI volumes as being twice as large, the TPP would still increase the growth rate of GDP per capita by 0.24 percentage point (= (0.13 + 0.35) / 2). This would still be a sufficiently significant effect for Japan whose recent growth rate has been 0.8%.

Furthermore, the macro analysis in Section 3 above and the micro analysis in Section 2 seem to be consistent with each other. For example, Kimura and Kiyota (2006) demonstrated that exports increase the growth rate of the firms' TFP by 2.4 percentage points on average. If the TFP of all producers increases by 2.4 percentage points, GDP will also increase by 2.4 percentage points with the amount of employment and capital unchanged. As the TPP would lead to an increase in the number of exporting firms by prompting non-exporters to become exporters, the estimate of this article that the growth rate of GDP per capita increases by 0.18 percentage point through an increase in the trade volume would be reasonable. Also, Todo (2006) demonstrates that spillovers of knowledge and technology associated with FDI into Japan improve the productivity of Japanese firms in average industries by 4%. Thus, it is not surprising if increasing FDI to Japan due to the TPP raises the growth rate by approximately 1.3 percentage points.

Thus, the estimated result that the TPP, based on the effects of "two heads are better than one," will increase the growth rate of GDP per capita by 1.5 percentage points may not be necessarily inaccurate. Furthermore, although we should interpret the estimates allowing for a sufficient range, the TPP's effect, even using a low estimate, will still provide sufficiently significant growth effects for Japan.

It should be noted, however, that the estimate is based on an assumption that the TPP is completed without exceptions to the liberalization of trade and FDI. The more there will be of exceptions and regulations in the TPP, the less there will be of trade and FDI resulting between participating countries, thus the smaller the effects of the TPP. According to Petri et al. (2011), in the case that each participating country is allowed to have exceptions in three sectors, one-quarter of the TPP-generated increase in Japan's GDP would diminish (See the analysis of 2015 shown in Table 13 of the respective article). Therefore, it is in Japan's national interest that the Japanese government leads the TPP negotiations without setting excessive exceptions so that the country can maximally benefit from its growth effect based on "two heads are better than one" by fully utilizing ties with other participating countries.

The original text in Japanese was posted on March 12, 2013.

April 9, 2013