Analysis of FTA’s Potential Economic Effects on China

LiChunding(李春顶),GuoZhifang(郭志芳)andHeChuantian(何传添)

Abstract: As part of its further opening-up initiatives for the 13th Five-Year Plan period (2016-2020), China will accelerate the implementation of free trade agreement strategies and create free trade area networks with high standards - in which the development of mega-regional trade agreements (mega-RTAs) is a key component. This paper creates a large global general equilibrium numerical model system comprising 29 economies, and precisely models the free trade agreements’ effects based on the progress of ongoing regional trade agreement negotiations. Then, a counterfactual simulation method is employed to quantitatively evaluate and compare the potential economic effects of China’s existing large regional trade agreement negotiations. Simulated results lead to the following findings: (1) All these free trade agreements will increase China’s welfare, output, employment and trade. Among them, the trade effect is the strongest, followed by output and employment effects, and welfare effect is relatively small. (2) Other members out of the free trade agreements all benefit. In comparison, smaller and more export-dependent economies benefit more, while China will dominate the negotiations given its comparative gains and contributions.

Keywords: mega-RTAs, China, numerical general equilibrium, welfare, trade

JEL Classification Codes: F53; F47; C68

DOI:1 0.19602/j .chinaeconomist.2018.11.04 0.19602/j .chinaeconomist.2018.09.02

1. Introduction

As part of its new-round opening-up initiatives, China will accelerate the implementation of free trade area agreement (FTA) strategy for common regional and global economic prosperity. The 17th CPC National Congress (2007) elevated the FTA strategy into a national strategy; the 18th CPC National Congress (2012) made the decision to “accelerate the implementation of the FTA strategy in response to a new wave of regional economic integration”; the Third Plenum of the 18th CPC Central Committee (2013) reaffirmed the priority to “implement the FTA strategy in the neighboring regions to build a network of high-standard free trade areas facing the rest of the world.” Later, the fourth, fifth and the sixth plenums of the 18th CPC Central Committee all highlighted the FTA strategy. The 19th CPC National Congress Report (2017) sets the vision to “create a new pattern of opening-up” in which the

development of free trade agreementsis an important element. According to the Outline of the 13th FiveYear Plan, China should “create a new pattern of comprehensive opening-up through land and sea type internal and external linkage, and east-west type two-way opening” and “develop regional and bilateral trade systems, implement free trade agreement strategy, and create a high-standard free trade agreement network”.

Since the global financial crisis, a new wave of regional economic and trade integration has been in the making, and China is an important participant and advocate in this process. To date, China has signed and implemented 14 free trade agreements involving 22 economies, and is negotiating nine other agreements involving 26 economies which include the Regional Comprehensive Economic Partnership (RCEP), China-GCC Free Trade Agreement (CGCC), China-Japan-South Korea Free Trade Agreement ( CJK), and bilateralfree trade agreementswith Sri Lanka, Pakistan, Maldives, Georgia, Israel and Norway. China is deliberating six bilateral free trade agreements involving six countries, which are India, Colombia, Moldova, Fiji, Nepal and Mauritius. It is also deliberating the Free Trade Area of the Asia-Pacific (FTAAP) .

As the second largest economy and the largest commodity trading nation in the world, China will profoundly influence the world economy through its participation in bilateral and regional trade agreement negotiations, especially mega-regional free-trade agreements (Mega-RTAs). China’s megaRTAs are an important element of its free trade agreement strategy that may usher in a new round of opening-up and sustained, healthy and rapid economic growth. Very few systematic quantitative analyses and comparisons have been carried out to investigate the economic effects of China’s megaRTAs. Most studies deal with individual trade agreements. In addition to the lack of depth, these studies do not capture the characteristics of new trade agreement negotiations that attach importance to new rules and institutional openness. Given these deficiencies, this paper offers a comprehensive quantitative evaluation of the economic effects of China’s mega-RTAs, and compares different FTAs to provide policy support and references for China’s free trade agreement strategy. This study also expands and enriches the methods for quantitative analysis on regional trade agreements.

Based on the current status of China’s existing mega- RTAs, this paper conducts a systematic analysis on four major agreements, including the Regional Comprehensive Economic Partnership (RCEP), China-GCC Free Trade Agreement (CGCC), China-Japan-South Korea Free Trade Agreement (CJK), and the Free Trade Area of the Asia-Pacific (FTAAP). These four mega-RTAs involve 31 economies including China.

The Regional Comprehensive Economic Partnership (RCEP) is a regional economic integration arrangement proposed and dominated by ASEAN. RCEP’s members include 10 ASEAN countries and six countries that have signed free trade agreements with ASEAN respectively, i.e. China, Japan, South Korea, India, Australia and New Zealand. ASEAN plans to negotiate the accession of the United States and Russia after the conclusion of the agreement. RCEP’s goal is to eliminate internal trade barriers, create and improve a free investment environment, and expand trade in services. RCEP involves various areas including intellectual property rights protection and competition policy, and the degree of its trade liberalization is higher than the free trade agreements concluded between ASEAN and the six countries. Currently, RCEP is still in the negotiation process, but substantive progress has been made. Negotiations are expected to be concluded to reach an agreement in the near future.

China-Japan-South Korea Free Trade Agreement’s (CJK) first round of negotiations started in March 2013. Due to political and diplomatic twists and turns among the three countries, no substantive progress has been made in the negotiations, and no agreement is expected to be reached in the near future.

China-GCC Free Trade Agreement (CGCC) is a free trade cooperation area negotiated between China and the GCC, whose members include UAE, Oman, Bahrain, Qatar, Kuwait and Saudi Arabia. The negotiation started in 2004, was interrupted after the global financial crisis in 2009, and restarted in 2016 with the expectation to be concluded within the same year.

Free Trade Area of the Asia- Pacific ( FTAAP) is a free trade agreement initiative with the participation of 21 members under the Asia-Pacific Economic Cooperation (APEC) mechanism. The FTAAP was proposed at an APEC meeting in 2006. In 2014, APEC Beijing meeting reached a consensus on the Beijing Roadmap for APEC’s Contribution to the Realization of the FTAAP. In 2016, APEC Peru meeting affirmed the Asia Pacific Free Trade Zone Collective Strategy Research Report. Currently, the FTAAP’s development remains in the research stage, and is yet to start negotiation.

This paper builds a global general equilibrium numerical model system comprising 29 economies to evaluate the economic effects of mega-RTAs in which China participates. The model’s production structure is a constant elasticity of substitution (CES) production function, and demand structure is a two-layer nested CES consumption function. The Armington assumption of product heterogeneity by country is also introduced. Trade cost is introduced in trade structure and decomposed into tariff and non-tariff barriers. While tariff brings revenue, non-tariff barriers only cause the sunk cost of trade. The model creates an endogenous trade imbalance structure by introducing inside money. Regional trade agreements influence trade between members and non-members by lowering tariff and non-tariff barriers, and thus influence countries’ domestic production, consumption, welfare and employment.

2. Structure of Global General Equilibrium Model

This paper builds a global general equilibrium model system for a counterfactual quantitative simulation of regional trade agreements’ possible effects. A basic structure of the model is an economic system that contains M countries, where each country manufactures N types of products using T types of production factors, and , , and .

As for production structure, a standard CES production function is specified, and can be expressed as: (1)

Where, i is country, l is sector, and s is production factor. is output from sector l of country i ; is demand from sector l of country i for factor s; is the parameter for the production size of sector l of country i; is the parameter for the share of factor s’s input in the production of sector l in country i ; and is the elasticity of substitution for input factor in the production of sector l in country i . With the first-order condition of output maximization, we may arrive at the specific factor input demand.

With respect to consumer demand structure, we specify a two-layer nested CES utility function, and the first-layer structure is demand for various products, which can be expressed as:

(2)

denotes consumer demand of country i for product l ; is the parameter for the share of consumption of product l by country i ; is the elasticity of consumption substitution of different products for country i . If consumer products are tradable product, they come from different countries. We introduce the Armington assumption, i.e. products of the same type made by different countries

are heterogeneous and have certain elasticity of substitution. Thus, consumption structure will exist at the second layer, i.e. consumer demand for different products is selected at the level of products from different countries. Still assuming CES demand equation structure, we have:

(3)

Similarly, is the parameter for the consumption of goods by country i from country j which is a share in its total consumption; is the demand substitution elasticity of country i for products from different countries; denotes the consumer demand of country i for product l made by country j; is the consumption of domestic product; is the demand of country i for the consumption of commodities from country j. Of course, if a product is non-tradable, there is no such second-layer consumption structure. From utility maximization optimality under budget constraint, we may solve the demand for the two layers of consumption.

Regional trade agreements policies aim to reduce tariff and non-tariff barriers between members. Previous trade agreement negotiations focused on tariff reductions. However, recent round of regional trade agreement negotiations after the global financial crisis in 2008 centered around new rules, standards and systems, i.e. reduction of nontariff barriers. Therefore, it is important to reasonably and accurately measure the effects of the reduction of non-tariff barriers. Existing literature on general equilibrium model primarily takes into account tariff barriers while neglecting nontariff barriers. For one thing, previous trade agreement negotiations were indeed primarily concerned with tariff reductions without specifically considering nontariff barriers. For another, it is more complicated to measure and model nontariff barriers compared with tariff barriers. To more precisely capture the economic effects of mega-RTAs to which China has acceded, we introduce trade cost into our model, and decompose it into tariff barriers and nontariff barriers to examine the economic effects of simultaneous reductions of tariff and nontariff barriers.

Tariff barriers are expenditures formed by import tariffs. The import tariff rate of country i is set to be it ; nontariff barriers include costs of transportation, standards and certification, as well as language and institutional barriers, and the nontariff barrier rate for country i to import products from country j is set as to be . When tariff barriers and nontariff barriers are simultaneously introduced, the import of products by country i from country j influences consumer price in country i through the following mechanism:

(4) Where, is the consumer price for country i’s consumption of product l made by country j ; is the production price of product l made by country i . Revenues from import tariff are owned by the government and distributed to domestic consumers. Ri denotes the import tariff revenue of country i :

(5) Unlike tariff barriers, nontariff barriers will not generate government tax revenues, and are sunk costs such as the costs of transportation and export inspection. Therefore, the costs of nontariff barriers need to be covered by physical commodities or services. Based on the reality, we assume that the costs of nontariff barriers are covered by nontrade sectors such as service sector of importing country. NRi denotes the costs of country nontariff barriers, which can be expressed as:

(6)

In this manner, the effects of tariff and nontariff barriers on trade and economic systems are incorporated into the model system, and fully depict the mechanism and channels of such effects.

Further, endogenous trading balance mechanism is introduced into the model system. Traditional standard general equilibrium model assumes trade equilibrium, which is obviously inconsistent with the world economy’s reality. This is particularly true for the analysis of China, a country with large trade surpluses. Methods for modelling trade imbalance include: (1) exogenous fixed trade imbalance modelling, i. e. assuming constant trade imbalance of an individual country; ( 2) endogenous trade imbalance modelling introducing money supply, i.e. through creation of a constant money supply, trade imbalance is endogenously determined by the difference between money supply and actual consumption transaction demand. In counterfactual policy analysis, the result of actual simulated application is unstable under endogenous trade imbalance structure that introduces money supply. Thus, we employ endogenous trade imbalance modelling method of inside money, which not only features a more stable model structure but can depict the reality that an individual country has a certain preferences for trade surplus.

Our approach for modelling endogenous trade imbalance structure with inside money originates from the inside money equation used by Patinkin (1971) and Archibald and Lipsey (1960). This equation includes future consumption (held money) or future consumption liabilities (issued money) into utility function as the increment of future consumption saved in current period. Any country may use its current income to purchase claims from another country for payment for future consumption. A country with positive claims is a country with trade surplus; otherwise, it is a country with trade deficit. Whalley et al. (2011) and Li and Whalley (2014) further apply this endogenous trade imbalance modelling approach in the general equilibrium model structure. Specific modelling method is to specify a product with “inside money” into consumption demand function, and the value of such “inside money” is the level of trade imbalance. When a country is in trade surplus, the value of “inside money” is positive, i.e. the country is using its current money to pay for future consumption; otherwise, the value of “inside money” is negative, i.e. the country is overdrawing future consumption through money issuance.

Income sources for consumer budget constraint of country i are primarily the value of factor endowment and tariff revenue, i.e.

(7)

Where, is the price of factor s in country i ; is endowment of factor s in country i ; Ii is the total consumer income of country i .

Equilibrium condition of model needs to satisfy the condition of simultaneous clearing of product market and factor market, then:

(8) (9)

Under the market environment of perfect competition, it also needs to satisfy the zero profit condition, i.e. the output value of production equals the sum of costs of production factors, i.e.

(10)

In addition, global trade also needs to be cleared, i.e. aggregate trade imbalance is 0, then

(11)

By now, we obtain a mathematical general equilibrium model system, and employ real-world data to calibrate, calculate and estimate model parameters. In this manner, we are able to obtain the numerical model system based on mathematical model, with which we are able to simulate the counterfactual effects of policy changes for regional trade agreements.

3. Data and Parameters Calibration

Based on the theoretical model framework, we collect real economic and trade data of countries, and reversely calibrate or estimate parameter values using such data. In this manner, the mathematical modelling system can be developed into a numerical model system. The effects of regional trade agreements are more often a static problem, and models employed in most studies are static systems that do not involve multi-phase iteration. Thus, we only need to collect data of one year as benchmark. This paper choose the data of the year 2013.

Based on the needs of our research topic and the feasibility and complexity of creating data system, this paper creates a system comprising two sectors and two production factors of 29 countries and regions, which include Australia, Bahrain, Brazil, Brunei, Canada, Chile, China, EU, India, Indonesia, Japan, South Korea, Kuwait, Malaysia, Mexico, New Zealand, Oman, Papua New Guinea, Peru, the Philippines, Qatar, Russia, Saudi Arabia, Singapore, Thailand, United Arab Emirates, United States, Vietnam, and rest of the world (ROW). The two sectors are tradable manufacturing sector and nontradable nonmanufacturing sector. The two production factors are capital (K) and labor (L).

3.1 Data Sources and Processing

Most production structure data are from the World Development Indicator (WDI) database of the World Bank in US dollar. The output value of sectors can be determined by the GDP data of countries and the output values of primary, secondary and tertiary industries as a share in GDP. Then, the capitalto-output ratio data and shares of labor input for various countries are employed to determine the input of production factors. However, the WDI database does not specifically single out a dataset for the European Union as a whole. Hence, EU data are from the Eurostat. Consumption structure data are indirectly calculated using production structure data and trade data. As for the virtual ceiling of inside money in consumption structure, the value is set to be 1,000 billion US dollars; such value only needs to ensure that the sum of trade imbalances of all countries plus this value is greater than 0. Trade structure data are primarily from the UN Comtrade database.

As for the data sources of tariff and nontariff barriers, import tariff rate is from the WTO’s tariff database, and ROW’s tariff rate is the simple average tariff of the rest countries. All tariff rates are mostfavored nation tariffs. The tariff rate of nontariff barriers is indirectly estimated. First, trade cost is estimated, and then, import tariff rate is subtracted from trade cost to obtain nontariff barrier rate. Novy’s (2013) method is employed to estimate trade cost.

3.2 Parameter Calibration and Estimation

Parameter calibration method is originally developed from validation using measurement equipment in natural sciences. They are introduced by economists into economic modelling for the determination and validation of model parameters and variables. For a complete general equilibrium model system, the calibration process is roughly as follows: First, we create a mathematical model system to find parameter values to be determined in the model, such as the parameter for the share of product consumption and elasticity of substitution between products in consumption demand function, as well as scale parameter and elasticity of factor substitution in production function, etc. Second, the benchmark solution of

model is selected based on economic status and availability of data. Normally, actual economic data of a specific year is employed. Third, the benchmark solution is introduced into the model, and parameter is regarded as one. Model variables are regarded as known constants, and parameters’ specific numeric values are determined through technical treatment and software optimal solution. After parameter determination, the mathematical model system is transformed into numerical model system that can be used to simulate counterfactual policies’ economic effects.

4. Simulated Economic Effects of Trade Agreements

In this section, we conduct a quantitative evaluation of the potential economic effects of four mega-RTAs dominated or participated by China. These four mega-RTAs are Regional Comprehensive Economic Partnership (RCEP), China-Japan-South Korea Free Trade Agreement (CJK), China-GCC Free Trade Agreement (CGCC) and Free Trade Area of the Asia-Pacific (FTAAP).

It is difficult to quantify the extent to which trade agreements can mitigate nontariff barrier rate - not even with specific negotiation goals. At the tariff level, almost all agreements aim to achieve zero tariff between members. Thus, we specify that all regional trade agreements can eliminate 100% tariff barriers between members and 50% nontariff barriers between members, and conduct policy effect simulation under such an assumption.

4.1 Economic Effect of Regional Comprehensive Economic Partnership (RECP)

First, effects on China’s economy: RECP will significantly increase China’s welfare and foreign trade, and trade effects outweigh welfare effects; welfare increase is negatively correlated with elasticity of substitution, while import growth is positively correlated with elasticity of substitution. The reason that trade effects outweigh welfare effects is that regional trade agreements first affect trade barriers and foreign trade before influencing welfare, production and consumption. While China’s GDP, manufacturing output and manufacturing jobs increase, non-manufacturing output will reduce. A primary reason is that model structure is specified as full employment and will substitute non-manufacturing output when manufacturing output increases.

Second, effects on more indicators of more countries and the world as a whole: world welfare and trade will significantly increase by 0.289% and 3.393% respectively; GDP reduction is caused by falling manufacturing product prices, and is nominal GDP reduction, while total product will increase. As for effects on other countries or regions, member countries will benefit and most non-member countries will suffer but some will also benefit. Specific result is related to the country or member’s trade status (see Table 1).

4.2 Economic Effects of China-Japan-South Korea Free Trade Agreement (CJK)

For China’s welfare and trade benefits, utility, export and import will all significantly increase, and trade effects outweigh welfare effects. Improvements of both welfare and trade are all positively related to elasticity of substitution. Specifically, China’s welfare will increase by 0.232% on average, and trade will increase by 5.356% on average, including 5.031% for export and 5.731% for import. In addition, China’s GDP, manufacturing output and employment will increase by 0.132%, 1.493% and 1.359% respectively. Effects on more indicators of more countries and the world as a whole: World welfare and trade will grow by 0.057% and 1.215% respectively, and GDP, manufacturing output value and employment will all increase. Reduction of non-manufacturing output value is caused by an increase in manufacturing output value under the assumption of full employment. As for effects on other countries, FTA members generally benefit, while most other economies suffer (see Table 1).

4.3 Economic Effects of China and the Gulf Cooperation Council (GCC) Free Trade Agreement

(China-GCC FTA)

China- GCC FTA significantly increase welfare and trade, and trade effects outweigh welfare effects. Meanwhile, welfare and trade growth is positively correlated with elasticity of substitution. As for the effects on other indicators of other countries and the rest of the world, both world welfare and trade increased, and manufacturing output and employment also increase. GDP reduction is caused by a decrease in nominal price, and non-manufacturing output reduction stems from the crowding-out effect of manufacturing expansion under the assumption of full employment. Specifically, world welfare, trade and manufacturing output increase by 0.026%, 0.376% and 0.184% respectively, and employment increase by 0.136%. Both manufacturing output value and employment increase, but GDP and nonmanufacturing output value drop. The reason is also the crowding-out effect arising from nominal price reduction and manufacturing expansion. For specific values, China’s manufacturing output value and employment will increase by 0.378% and 0.560% respectively. For other countries, while member countries benefit, most of non-member countries suffer (see Table 2).

4.4 Economic Effects of Free Trade Area of the Asia-Pacific (FTAAP)

First, we examine FTAAP’s effects on China’s economy. Compared with benchmark status, China’s welfare and trade significantly will increase, and trade effects significantly outweigh welfare effects. Moreover, export growth effects outweigh import growth effects. Trade growth is positively correlated with elasticity of substitution, but welfare growth has a U- shaped relationship with elasticity of substitution.

Next, we analyze FTAAP’s effects with more indicators on the rest of the world and other countries. World welfare, output, trade, manufacturing output value and employment will all increase. Trade effects outweigh output effects, and output effects outweigh welfare effects. Under the full employment assumption, nonmanufacturing output value would be reduced under manufacturing’s crowding-out effect. Changes in specific values are as follows: World welfare will increase by 0.58%, GDP by 0.654%, trade by 8.152%, manufacturing output value by 4.637%, manufacturing employment by 3.640% and non-manufacturing output value by -1.267%. Except for non-manufacturing output value, all other indicators will increase. China’s GDP, manufacturing output value and employment all increase by 1.873%, 6.609% and 4.649% respectively. Other members all benefit, and in particular, Brunei, Vietnam, Malaysia, the Philippines and Mexico benefit the most. Most non-member countries suffer, but negative effects are all limited. Countries suffering the most are India, the European Union and Brazil (see Table 2).

5. Concluding Remarks and Policy Implications

This paper builds a global general equilibrium model system comprising 29 economies, includes both tariff and non-tariff barriers affected by the trade agreements into the model, and introduces trade imbalance structure into the model by introducing “inside money.” Using actual world economy data of 2013, we calibrate and estimate model parameters, and create a numerical general equilibrium system to simulate the potential effects of the Regional Comprehensive Economic Partnership (RCEP), ChinaJapan-South Korea Free Trade Agreement (CJK), China-GCC Free Trade Agreement (CGCC) and Free Trade Area of the Asia-Pacific (FTAAP). Simulationresults show that the four mega-RTAs will all significantly benefit China’s welfare, trade, GDP, manufacturing output value and employment. Comparatively, trade effects outweigh output and employment effects, while output and employment effects outweigh welfare effects.Meanwhile, most member countries will benefit, while most nonmember countries will suffer. The simulation results generate policy implications.

Policy implications from RCEP: First, RCEP members all significantly benefit from trade agreements, which explains that the negotiations have favorable common economic interests; second, China’s relative gains are smaller compared with other major economies, and China enjoys significant

power of discourse in negotiating the agreement; third, RCEP benefits the entire world and most other countries in terms of welfare and trade, and more countries are expected to seek membership in the future. Hence, RCEP should be a priority in China’s development of free trade agreement network.

Policy implications from China-Japan-South Korea Free Trade Agreement (CJK): First, the CJK negotiations are based on common economic interest, and South Korea and Japan will benefit more. China should take a more proactive position in the negotiations; second, despite the CJK’s significantly positive effects on the three countries involved, the lack of harmonious political and diplomatic relations among China, Japan and South Korea poses a barrier reach the trade agreement; third, there is an existing free trade agreement between China and South Korea, and the three countries are included in the RCEP. For this reason, the CJK’s economic value for the three countries can be achieved through alternative means. This is even more unfavorable to CJK’s conclusion. Foreseeably, all the three countries will give more prominence to the RCEP, and may seek progress in CJK negotiations only in case that RCEP negotiations stall.

Policy implications from analysis of China and the Gulf-Cooperation Council (GCC) Free Trade Agreement (China-GCC FTA): First, the FTA has positive effects on all its members, which provides the economic basis for negotiation, and GCC members will benefit more, giving China a stronger position in negotiation; second, the FTA is favorable to the world as a whole, and few countries are negatively affected, so that other countries may not oppose or interfere; third, despite the FTA’s limited positive effects on China, GCC members are important oil exporting nations that are of great importance to China’s energy security, and China-GCC FTA is also very important to China.

Policy implications from analysis of Free Trade Area of the Asia-Pacific (FTAAP): (1) FTAAP is an agreement conducive to Asia-Pacific integration and benefits all 21 member economies and other nonmembers. It is an important initiative for development. (2) FTAAP involves various countries and will be difficult for negotiation. Once concluded, it will have significant influence and contribute to regional and world economy. Relevant consultation procedures should be explored and initiated as soon as possible. FTAAP should play a key role for China’s long-term FTA strategies..