Analysis of ASEAN FTA in the Dynamic East Asian Perspective: A Gravity Equation Approach Arisyi Fariza Raz

Institute for Development Policy and Management (School of Environment and Development), University of Manchester, Manchester, United Kingdom Email: arisraz@me.com

Analysis of ASEAN FTA in the Dynamic East Asian Perspective: A Gravity Equation Approach

ASEAN economies are amongst the emerging economies in the developing world. Thus, it is necessary to investigate the impact of AFTA on East Asian trade flows. Meanwhile, the revival of the gravity equation in the recent years has turned it into a better tool in analysing regional trade flows. Therefore, the main purpose of this paper is to analyse the determinants of trade in ASEAN 6 economies and the significance of AFTA in the East Asian regional trade by augmenting the traditional gravity equation with new variables. The contribution of this paper is three-folds. First, the empirical methodology used in this paper corrects a major shortcoming that exists in the literature by introducing fixed effects and random effects models. Second, it finds the main determinants of trade flows in ASEAN 6 economies. Third, it shows the long-run impact of AFTA on East Asian economies is net welfare gain. Keywords: International trade, gravity equation, fixed effects and random effects, ASEAN Free Trade Area, trade creation, trade diversion.

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1. Introduction Over the last two decades, the number of countries that have signed an FTA (Free Trade Agreement) has dramatically increased. A report by the World Trade Organisation (2000) identified that there were 148 free trade agreements in force and other 67 agreements were under negotiation. This indicates that regions around the world have found it necessary to strengthen economic cooperation through formal trade agreements in order to increase the competitiveness of local products in the world market through the elimination of trade barriers. Even though, as suggested by Plummer (2009), regional cooperation in East Asia has been characterised by non-formal and marketdriven integration, this increasing competition within international trade has made East Asian countries realise the importance of establishing formal regional cooperation agreements. As the consequence, ASEAN (The Association of South East Asian Nations) was established in August 1967 and became the major regional organisation. Initially aimed at strengthening regional political security cooperation, since 1970s, however, ASEAN member countries started to realise the importance of strengthening regional economic cooperation through the coordination of industrial policies and the promotion of intra-regional trade (Elliott and Ikemoto, 2004). In 1977, its member countries established preferential trading arrangements (PTAs) to promote intra-regional trade. Nevertheless, empirical studies suggest that the PTAs achieved very limited success (see e.g. Ariff, 1994; Edwards and Skully, 1996; Garnaut and Drysdale, 1994). In this regard, a study by Cuyvers and Pupphavesa (1996) points out that the disappointing results of the PTAs are due to the following factors: 1) the small number of products included under the PTAs relative to the total number of products traded by ASEAN member countries and 2) the long exclusion lists maintained by

ASEAN member countries because they could easily exclude group products from the PTAs. Figure 1. Intra-ASEAN Trade Flows (US$ Million)

150,000! 120,000! 90,000! 60,000! 30,000! 0! 1993!1994!1995!1996!1997!1998!1999!2000!2001!2002!2003!2004!

Exports!

Imports!

Source: ASEAN Secretariat (2005)

However, rapid changes in global competition during the 1980s and 1990s forced the ASEAN member countries to develop more serious regional economic cooperation. In addition, the emergence of Chinas economy intensified the competition for attracting FDI from developed countries (Elliott and Ikemoto, 2004). Consequentially, in January of 1992, six ASEAN member countries, Brunei Darussalam, Indonesia, Malaysia, Philippines, Singapore and Thailand, signed a declaration to achieve AFTA within 15 years.1 One year after the 1997 Asian Financial Crisis, these countries agreed to move forward with trade liberalisation and thus AFTA came into force among the ASEAN 6 countries at the beginning of 2002. The initial goal of AFTA was to reduce tariffs on intra-ASEAN trade to between 0-5%. The mechanism used to achieve this goal has been the reduction of the Common Effective Preferential Tariff (CEPT), which includes agricultural products, manufactured goods

and services (Cuyvers and Pupphavesa, 1996). In this regard, some authors suggest that the reason that AFTA is more encompassing than the previously established PTAs is because the former is easier to achieve because the approach of CEPT is reciprocal and sectoral, whereas the latter adopted a product-by-product approach (Pangestu et al., 1992; Elliott and Ikemoto, 2004). Table 1. Shares of exports from the ASEAN 6 economies (value in US$ thousands)
Partner
Value ASEAN 6 Share 14% 20% 24% 21% 22% 24%

1989
17,315,001

1992
36,595,575

1995
74,756,056

1998
64,866,815

2001
79,708,262

2003
104,425,666

Korea, China, Japan

Value

35,358,707

39,506,324

62,597,095

55,323,682

79,859,305

98,974,995

Share

30%

22%

20%

18%

22%

22%

Value ROW Share

66,968,247

104,395,395

173,992,587

194,896,019

203,770,589

238,890,177

56%

58%

56%

62%

56%

54%

Value World Share

119,641,955

180,497,294

311,345,738

315,086,516

363,338,156

442,290,838

100%

100%

100%

100%

100%

100%

Source: Authors calculation based on United Nations COMTRADE Statistics Database

After the establishment of FTA in 1992, there were changes in the direction of the exports and imports of AFTA intra-regional trade as well as trade dependency with outside trading partners. One obvious intra-regional effect of AFTA was the rapid increase of intra-ASEAN trade flows. Figure 1 shows that the volume of intra-ASEAN exports and imports were quadrupled in 2004 relative to the volume in 1993. Nevertheless, statistics also show that there is a decreasing share of trade from the ASEAN 6 member countries to the rest of the world. Table 1 presents the changing
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shares of exports from the ASEAN 6 economies. It supports the statistics shown in figure 1 by showing that there was an increasing trend of export shares of the intraASEAN 6 economies from 1989 to 2003. On the other hand, during the same period, the share of exports from the ASEAN 6 economies to China, Japan and South Korea showed a downward trend, while the share of exports to the rest of the world tended to be constant. Despite these statistics, however, it is necessary to conduct a formal examination in order to measure the welfare effect of AFTA. From the previous literature, one of the most applicable methods for examining intra-regional and extra-regional economic integration is to use the gravity equation. Since the revival of the gravity equation, many authors augment the traditional gravity equation with some of the above variables, depending on the data and purpose of the study. Further, the econometric methods have also been improved from time to time, by estimating the equation with a more sophisticated technique instead of ordinary least square, thus provides better justification for the use of the model. The rest of the paper is as follows. The next section provides the literature review regarding gravity equation, section 3 discusses the methodology and estimates the augmented gravity equation. Section 4 and 5 provide the estimated results and further analysis, respectively, while the last section concludes this paper.

2. The Gravity Equation of International Trade 2.1. Review of the Previous Studies The concept of the gravity equation in economics has been borrowed from Newtons law of gravitation. According to this law, the gravitational force that exists between two celestial bodies depends positively on their mass and negatively on their

distance. In the 20th century, Tinbergen (1962) and Linneman (1966) adopted and popularised this concept in the field of international economics to examine the patterns of bilateral trade flows among developed countries. In contrast to its simple application in physics, the application of the gravity equation in economics can be more complicated. In this regard, Filippini and Molini (2003) suggest that there are two important facts that are worth considering: 1) the concepts of distance and mass have to be reinterpreted according to socio-economic phenomena, hence it is important to consider the proxy carefully in estimating the equation; and 2) the relationship between the dependent variable and the independent variables in the equation needs to be clearly specified, usually in the form of natural logarithms in order to make the relationship become linear. By taking into account these two facts, the gravitational force is translated economically as the flows of goods from one country to another country. Since its adoption, the gravity equation has become one of the most popular methods used to investigate the flow of bilateral trade. One of the first and most celebrated empirical works is a study by McCallum (1995), which investigates how the Canada-US border affects regional trade patterns. After the work by McCallum (1995) many economists used the gravity equation to find the determinants of trade of a country. A study by Jugurnath et al. (2007) suggests that, in addition to the traditional variables in the gravity model (i.e. GDP, distance, population, physical area and cultural similarity), exchange rate movements and taxation rates also affect bilateral trade flows in the Asia-Pacific region. Currency depreciation encourages exports and discourages imports, whereas higher tax rates decrease bilateral trade. Most of other studies also support the findings of Jugurnath et al. (2007) with respect to the relationship between currency depreciation and trade flows (for instance, see Thursby and Thursby, 1987; Carrre, 2006; Eita and Ashipala, 2008).

Melitz (2007) further investigates the role of geographical distance in the gravity equation by deriving it into two variables: level of remoteness and internal distance. In this regard, he suggests that internal distance has a significant negative influence on trade flows, whereas remoteness of a country appears to be of only modest significance. On the contrary, some other studies suggest that the remoteness of a country is significantly and positively correlated with trade flows (Krueger, 1999; Carrre, 2006). Moreover, Carrre (2006) also points out that countries with better levels of infrastructure will trade more, while landlocked countries will trade less. Some studies also analyse the role of adjacency in affecting trade flows. Most of these studies find evidence that countries sharing the same border will have a greater propensity to trade with one another (Endoh, 1999; Melitz, 2007). Further, Filippini and Molini (2003) introduced technological distance into the equation to examine whether a technological gap between two countries affects these countries trade flows. The results suggest that countries tend to exchange more goods when they have less of a technological gap. Other studies also investigate whether Linders (1961) hypothesis is really an important determinant of trade flows. According to Linder (1961), two countries will trade more with one another if they have more similar demand structures. The first study to include the Linder hypothesis into the gravity model was that of Thursby and Thursby (1987). The findings of this support the truth of the Linder hypothesis for developed countries where manufactured goods account for a large proportion of exports. This finding is also supported by that of Hallak (2006), who tested the prevalence of the Linder hypothesis on bilateral trade amongst 60 countries in 1995. Moreover, since the investigations of the Linder hypothesis usually use data from developed countries, McPherson et al. (2001) argue that it is also necessary to test its significance in developing countries. Their study examines the prevalence of the Linder

hypothesis in the traded manufactured goods in African countries and also concludes that countries with similar per capita income levels tend to trade more intensively. The gravity equation is also used to examine whether RTA causes trade creation or trade diversion. Trade creation occurs when a trade alliance increases the trade flows between member countries, which brings benefits to the member countries of the trade alliance and thus increases their welfare. On the other hand, trade diversion is a shifting of trade flows from being between a member country and a non-member country to being between one member country and another member country of the trade alliance. It decreases the welfare of the countries that do not belong to the trade alliance. A trade alliance is working properly if the welfare-increasing effect is larger than the welfaredecreasing effect, i.e. it causes a net increase in welfare. In the gravity equation, trade creation and diversion can be measured by adding RTA dummies into the model. Krueger (1999) investigates the trade effect under NAFTA and concludes that it was trade-creating and not trade-diverting. The argument that RTA causes trade creation is also supported by Endoh (2000), who investigated economic integration under APEC. In his paper, he concludes that APEC promotes both trade with outer regions and trade within APEC economies. Vicard (2011) conducted a global-scope case study that covers five RTAs: the Andean community, AFTA, the EU, MERCOSUR and NAFTA. In his study, he argues that the trade creation effect is higher if countries in the RTA share many similar characteristics. In addition, he also adds that bilateral trade creation between two members of an RTA is more efficient when the potential trade creation among other partners is lower. On the other hand, Carrre (2006) suggests that an RTA results in strengthened intra-regional trade, but it causes both import and export trade diversions when a country trades with another country that does not belong to the same RTA.

Some amount of literature also uses the gravity equation to study the main determinants of trade flows in the ASEAN countries. Similar to many other gravity studies, these studies also augment the traditional form of the gravity equation with some new variables in order to test the determinants of trade. For example, a study Kien and Hashimoto (2005) augments the equation with exchange rate in order to investigate whether it plays an important role in determining trade in ASEAN. The result suggests that currency depreciation in a country will increase its export competitiveness and thus stimulate trade flows. A study by Hapsari and Mangunsong (2006) investigates the role of tariff barriers in trade and suggests that tariff reduction has a significant effect on increasing the bilateral exports of ASEAN member countries. It also points out that a greater number of products may need to be included in the CEPT list to improve the effectiveness of AFTA. Some studies also suggest that the so-called complementary index of factor endowments is a significant factor in promoting trade flows in ASEAN (Elliott and Ikemoto, 2004; Hapsari and Mangunsong, 2006).2 In addition to investigating the determinants of trade, the intra-regional and extra-regional effects of AFTA also have been investigated. Elliott and Ikemoto (2004) suggest that the effect of AFTA on trade flows was not immediate following the signing of the AFTA agreement in 1992. They argue that this was due to the emergence of credible competition for market share from the new exporting powers, such as China and various South American countries. However, this result is contradictory to that of Kien and Hashimoto (2005), who found that AFTA had an immediate impact on its members trade flows in the years subsequent to 1992. Moreover, most gravity equation studies also investigate whether AFTA causes trade creation or trade diversion. The result shows strong empirical evidence that AFTA causes trade creation among its country members (Elliott and Ikemoto, 2004; Kien and Hashimoto, 2005; Hapsari and

Mangunsong, 2006). Nevertheless, the evidence regarding whether AFTA exhibits some trade diversionary effects is mixed. Hapsari and Mangunsong (2006) argue that AFTA causes trade diversion and thus a shifting of trade from countries outside the trade alliance to AFTA member countries. In spite of that, other studies suggest that there is no clear evidence that supports the existence of trade diversionary effects after the establishment of AFTA (see e.g. Elliott and Ikemoto, 2004; Kien and Hashimoto, 2005).

2.2. Gravity Equation and Economic Theories As presented above, the gravity equation has gained empirical success because it fits the data well. However, despite its empirical success, the gravity equation has been criticised due to its lack of theoretical grounds. As a consequence, this leads to biased estimations and a lack of understanding of what is causing the results (Anderson and van Wincoop, 2003). To solve this problem, economists have been trying to find a theoretical foundation for the gravity equation. Anderson (1979) was the first to derive the gravity equation from economic theory. In his paper, he rearranges the CobbDouglas expenditure system to derive the gravity equation by assuming that each country produces only one specialised good and prices are the same in all countries. Given these assumptions, the gravity equation can be obtained when consumers across countries have identical homothetic preferences, subject to the incomes of both the exporting and importing countries and costs related to distance. After the work of Anderson (1979), more authors attempted to provide a link between trade theories and the gravity equation. A study by Bergstrand (1989; 1990) puts emphasis on product differentiation among firms rather than among countries in order to explain bilateral trade flows. He suggests that the monopolistic competition approach (and thus horizontal differentiation) might be a better model to explain trade
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flows between similar countries. On the other hand, Deardorff (1995) conducted a study from the neoclassical perspective, within a perfect competition setting. By using the Hecksher-Ohlin (H-O) model, he argues that trade flows can be explained if product differentiation exists at the national level. Therefore, his study is better suited to a case in which factor endowments are different and intra-industry trade is limited, such as a North-South type of trade. A more recent work by Evenett and Keller (2002) further extends the idea of product specialisation proposed by Anderson (1979) by focusing on intra-industry trade. Their paper suggests that there are three types of trade models that differ in obtaining product specialisation in equilibrium: 1) Ricardian models, 2) H-O models and 3) increasing returns to scale (IRS) models. According to the logic of international trade, countries around the world conduct exporting and importing activities because their productions and demands are not equal in quantity and/or quality. In the process, each country specialises itself in producing particular goods due to the different advantageous factors acquired by each country. Evenett and Keller (2002) support this proposition by suggesting that the volume of international trade is determined by the extent of product specialisation, which can be due to any of the following factors: technology differences (Ricardian models), different factor endowments (H-O models) or increasing return to scale in production (IRS models). In this regard, they propose that imperfect specialisation better explains the variation of trade flows, because perfect specialisation requires large factor proportion differences, which are unnecessary. With respect to this, they suggest that IRS models are the best theory in the gravity equation context since they are consistent with the absence of factor proportion differences.3 Another reason why IRS models are the preferred models is that these models take into account intra-industry trade, whereas H-O models only predict inter-industry trade.

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In short, this part has shown that the gravity equation can be derived from a large class of theoretical models. Nevertheless, trade flows cannot be solely determined by any of these models since different theoretical models account for large proportions of the observed trade flows in different circumstances (for instance, see Evenett and Keller, 2002). Due to this, the empirical use of gravity equation to test any of these theories is not necessary (Deardorff, 1995). Instead, many authors argue that empirical study of the gravity equation should be focused on clarifying the determinants of trade flows (for instance, see Filippini and Molini, 2003).

3. Methodology 3.1. Model Identification In its traditional form, the gravity equation suggests that trade flows from country i to j are positively related to the income of two countries and negatively related to the distance between these two countries. For the purpose of estimation, this paper assumes that the gravity equation is linear in natural logarithms, thus yielding the following equation: ln Xij = o + 1 ln Yjt + 2 ln Yit + 3 ln Njt + ln 4 Nit + ln 5 Dij + ln uijt (1)

where Xij is the exports from country i to j, Y is income of both country i and j, N is the population of both country i and j, and Dij is the geographical distance from country i to country j and u is the error term. Further, this paper also augments this traditional model of gravity equation with some new variables to interpret the concepts of distance and mass from the economic perspective in order to better analyse the trade performance of the ASEAN member countries from an East Asian perspective. The first variable is income gap, which is represented by the difference in GDP per capita between the exporting and importing
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countries. The purpose of introducing this variable is to test the so-called Linder hypothesis. In this case, per capita income is used as a proxy for the demand structure of a country. Thus, countries with a smaller income gap will have more incentives to trade with one other. In other words, this variable can be obtained by using the following formula: incgapijt = |GDP per capitait GDP per capitajt| (2).

In addition to the income gap, this paper also includes two distance variables. In its traditional form, the gravity equation only includes geographical distance to represent the term distance. Nevertheless, this paper introduces three more distance variables in addition to geographical distance because some authors argue that geographical distance alone is not enough to represent the distance between the exporting and importing countries (see e.g. Filippini and Molini, 2003; Melitz, 2007; Herrera, 2010). The first variable is the cultural distance, which is represented by a language dummy. The second is adjacency, which is characterised by a border dummy. The third is the technological distance. Following the work of Filippini and Molini (2003), this dissertation defines technological distance as the absolute difference of technological indicators (TI) between the exporting and importing countries: techdistijt = |TIit TIjt| (3). In this regard, Archibugi and Coco (2004) suggest that the TI or technological capabilities of a country consist of three main dimensions, which are the creation of technology (CoT), the technological infrastructure and the development of human skills (i.e. TI is a simple average of these three dimensions). Firstly, the creation of technology is a countrys capacity to produce technology. It is defined by estimating the following formula: (4)
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where EXhtit are the high-tech exports of country i at time t, EXttlit are the total manufactured exports of country i at time t, EXhtwt are the world high-tech exports at time t and EXttlwt are the world total manufactured exports at time t. Secondly, technological infrastructure is represented by a simple average of Internet penetration, telephone penetration and electricity consumption. Lastly, the development of human skills is calculated as a simple average of secondary and tertiary enrolment rate plus literacy rate. To make the second and third dimensions such that they can be expressed as a value between 0 and 1, this dissertation adopts the formula used by Filippini and Molini (2003) by converting these dimensions into indices, as follows: (5) where the actual value is the value of country i at time t, the maximum value is the USAs value at time t and the minimum value is zero. Moreover, it is important to note that recent studies usually include the remoteness of a country as another proxy for distance in order to take into account the fact that some countries are located much further away from their trading partners than other countries (see e.g Krueger, 1999; Anderson and van Wincoop, 2003; Carrre, 2006). Nevertheless, since this paper is concentrated on the ASEAN countries, which are located in one geographic region, the inclusion of the remoteness of a country becomes unnecessary (for instance, see Elliott and Ikemoto, 2004).

3.2. Econometric Specification After taking into account the new variables presented in the previous section, the augmented gravity equation is expressed in natural logarithmic form, as follows:

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ln(exportsijt) = 0 + 1 ln(gdpjt) + 2 ln(gdpit) + 3 ln(popjt) + 4 ln(popit) +

5 ln(distanceij) + 6 ln(techdistijt) + 7 ln(incgapijt) + 8

language + 9 border + ij + ijt (6)

where ln(exportsijt) is the value of exports from country i to country j in year t, ln(gdpjt) is the GDP of the importing country j in year t, ln(gdpit) is the GDP of the exporting country i in year t, ln(popjt) is the population of the importing country j in year t, ln(popit) is the population of the exporting country i in year t, ln(distanceij) is the geographical distance between the capital cities of exporting country i and importing country j, ln(techdistijt) is the technological distance between exporting country i and importing country j in year t, ln(incgapijt) is the gap in GDP per capita between country i and country j in year t, language is a dummy variable that is 1 if two countries speak the same official language and 0 otherwise and border is another dummy variable that is 1 if two countries share a common land border and 0 otherwise. 0 is the unknown constant, ij is either a fixed or random unobserved country-pair effect and ijt is the log normally-distributed idiosyncratic error term, where E(ijt) = 0. From the estimation output of Equation (6), the predicted coefficients of GDP and distance are clear due to the basic theory of gravity equation, i.e. positive correlation for the former and negative correlation for the latter. However, in contrast to GDP and distance, which have clear relationships with exports, the relationship between exports and population is more complicated. If a large population represents a greater reliance on a large domestic market because of the benefits from a large endowment of resources, then a negative coefficient is expected. On the contrary, a positive coefficient is expected if this huge domestic market gives an incentive for the exploitation of economies of scale. Nevertheless, this paper assumes that the former has more influence on trade, and thus population is expected to be negatively correlated with exports. This

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paradox also applies to technological distance. In one hand, technological distance could be a barrier to trade, since goods produced in one country might not be technologically fit to be used in the other country. Nevertheless, it might also become an incentive for trade, like the case of the four Asian Tigers with the developed world. Hence, the expected coefficient of technological distance can be either positive or negative. Further, the coefficient of income gap could also be positive or negative. The sign depends on the prevalence of the Linder (1961) hypothesis in the ASEAN countries. If the hypothesis is applicable to the ASEAN member countries, then the sign of the income gap is expected to be negative. Otherwise, it is expected to be positive. Further, the coefficients of border and language are intuitive, i.e. countries that share the same language communicate smoother, where countries that share the same border can trade less costly. In addition to these main variables, we augment this model further with some other dummy variables in order to examine whether AFTA causes trade creation or trade diversion in terms of the trade interrelationships with other East Asian countries. The first dummy is the AFTA dummy, which is 1 if both i and j countries belong to AFTA and 0 otherwise. This paper selects a dynamic way of introducing the AFTA dummy, following Kien and Hashimoto (2005). The objective is to capture the dynamic formation, expansion or contraction effects of AFTA. The second and third dummies are trade diversion dummies, i.e. AFTAim and AFTAex. The former reflects import trade diversion (or extra-regional import bias) that occurs due to changes in the import structure of AFTA. It equals to 1 if the importing country belongs to AFTA and 0 otherwise. On the other hand, the latter is meant to characterise the export trade diversion (or extra-regional export bias) of AFTA to other East Asian countries. It equals to 1 if the exporting country belongs to AFTA and 0 otherwise. In addition to

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these FTA dummies, this paper also includes three country dummies: China03-09, Korea03-09 and Japan03-09 to investigate whether there is a change in trade patterns between the ASEAN member countries and their largest trade partners in the region.

4. Econometric Results and Interpretations Equation (6) is estimated by using two sets of data. The first data set covers the ASEAN 6 member countries only. This data set consists of 30 bilateral trade flows. The use of this data set in the estimation is aimed at seeking the main determinants of trade amongst the ASEAN 6 economies. The second data set covers all nine countries (ASEAN 6 + 3) and consists of 72 bilateral trade flows. From this data set, the purpose of estimation is to examine the extra-ASEAN effects of AFTA in East Asia.

4.1. Determinants of Trade in ASEAN This part presents the estimation results from the ASEAN 6 data set. As mentioned earlier, the objective of this estimation is to seek the main determinants of the intraASEAN trade flows. Nevertheless, before proceeding to the estimation results of Equation (6), it is important to justify the stationarity of the variables included in the model and thus unit root test is necessary. Following Carrre (2006) and Eita and Ashipala (2008), this paper performs the Levin, Lin and Chu (2002) test for unit root to test the stationarity of the following series: bilateral exports, GDP, population, technological distance and income gap. In this test, the null states that the variable contains a unit root. Table 2 below shows that the null of a unit is significantly rejected at the 1% level for all variables, i.e. this confirms the stationarity of these variables. This result implies that the cointegration test is not necessary. Thus, Equation (6) can be estimated by using the fixed effects or random effects model.

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Table 2. Levin Lin Chu test for panel unit root (ASEAN 6 data set)
Variables ln(tradeijt) ln(gdp) ln(pop) ln(techdistijt) ln(incgapijt) t-star 16.265 13.498 5.309 14.503 11.002 t-value 11.241 8.968 3.770 8.145 5.565 p-value 0.000 0.000 0.000 0.000 0.000

Table 3 below shows the panel estimation results of Equation (6) for the ASEAN 6 countries. The results of the fixed effects estimation are shown in the first column (Reg. I) and those of the random effects estimation are shown in the second column (Reg. II). As mentioned earlier, this paper intends to use the fixed effects model because it allows heterogeneous effects in errors. The results of the F test strengthen this argument because it strongly rejects the null, implying the presence of fixed effects. Moreover, the Hausman test is also performed to ensure that the fixed effects are more favourable than the random effects in estimating the model. Since the null is significantly rejected at the 1% level, the test shows that fixed effects estimation is more efficient for this model. Table 3. Modified gravity equation: determinants of ASEAN regional trade
Variables Constant ln(gdpit) ln(gdpjt) ln(popit) Reg. I 24.467 *** (6.909) 1.667 *** (0.315) 2.693 *** (0.315) 1.425 * (0.791) Reg. II 39.792 *** (3.540) 1.794 *** (0.171) 1.740 *** (0.171) 0.570 *** (0.119) Reg. IIIa 24.467 (32.387) 1.667 (1.262) 2.693 *** (0.577) 1.425 (3.838)

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ln(popjt) ln(distanceij) ln(incgapijt) ln(techdistijt) language border

2.256 *** (0.791) 0.326 *** (0.108) 0.293 *** (0.050)

0.578 *** (0.119) 0.856 *** (0.302) 0.357 *** (0.091) 0.283 *** (0.050) 0.390 (0.315) 0.063 (0.361)

2.256 (1.767) 0.326 ** (0.126) 0.293 ** (0.134)

F-test LM test Hausman test R within R between R2 overall No. of obs (NT) No. of bilateral (N)
2 2

85.29 726.06 35.47 0.45 0.01 0.03 660 30 0.44 0.84 0.74 660 30

80.62

0.45 0.01 0.03 660 30

***, ** and * are significant at the 1%, 5% and 10% levels respectively and standard errors are presented in parentheses.
a

For the third column, the figures in parentheses are the cluster-robust standard errors for the

fixed effects estimator.

Given the results of these specification tests, the interpretation is focused on the fixed effects model. Reg. I shows that the results of the fixed effects estimation are consistent with economic theory and expectations. The positive and significant signs of the GDP of both the exporting and importing countries imply that wealthier countries trade more. On the contrary, the coefficients of the population variables are negative and significant, showing that large domestic markets represent bigger absorption effects and less reliance on imported goods. Income gap is also statistically significant and negatively correlated with exports, favouring the prevalence of the Linder hypothesis in

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the ASEAN member countries. In other words, the ASEAN member countries that have more similar levels of income per capita tend to trade more. Moreover, the coefficient of technological distance shows a positive and significant sign at the 1% level. This result is consistent with that of Filippini and Molini (2003) and implies that greater technological gaps discourage bilateral trade flows. In addition to these time-variant variables, there are three time-invariant variables in the model: geographical distance, language and border. Nevertheless, these variables are dropped from the model because the fixed effects model does not allow for estimating time-invariant variables. To ensure that this result is consistent and unbiased, it is necessary to confirm that the estimates do not suffer from serial correlation and/or heteroscedasticity. The presence of either of these two problems violates one of the assumptions of the fixed effects model: constant variance, i.e. V(ui|Xi, ci) = I, where > 0 and < .

Therefore, the Wooldridge test for autocorrelation and the modified Wald test for groupwise heteroscedasticity were conducted. The results show strong rejections of the null in both tests and therefore confirm the presence of serial correlation and heteroscedasticity in the data (see Appendix 1 for details). As the consequence, the result of fixed effects estimation becomes inconsistent, and the estimated variances (and thus standard errors) are no longer valid. To correct these problems, this dissertation follows the approach used by Melitz (2007) by treating each country pair as a cluster in order to estimate the correct standard errors with the Huber/White cluster-robust covariance estimator. The results of this model are shown in the third column of Table 3 (Reg. III). Since this estimation causes the standard errors to be bigger, some variables become insignificant, even though the signs remain the same. The coefficient of the exporting countrys GDP becomes statistically insignificant. However, the coefficient of the

19

importing countrys GDP remains significant at the 1% rejection level. The populations of both the exporting and importing countries are also no longer statistically significant. Nevertheless, income gap and technological distance are still significant at the 5% rejection level. The F-test also strongly rejects the null, which justifies the presence of a correlation between the explanatory variables and heterogeneous effects in errors. In short, this section of the dissertation has investigated the determinants of intra-ASEAN trade. The estimation results in this part show that the importers GDP is positively correlated with trade flows and statistically significant. In addition, it also shows that more similar levels of technological advancement and per capita income will increase the flow of trade between countries.

4.2. AFTA: Trade Diversion or Trade Creation? Now, the focus of the estimation shifts from intra-ASEAN trade to extra-ASEAN trade. Thus, the objective of the following estimations is to evaluate the impact of AFTA on its member countries and their trade interrelationships with other East Asian countries. Therefore, in addition to the ASEAN 6 member countries, it also includes three additional non-member countries: China, South Korea and Japan. Since this data set is different from the previous one, another Levin, Lin and Chu (2002) test for the unit root is conducted. Table 4 shows the results of this test. Similar to the previous results, this test significantly rejects the null of the unit root for all variables. As the stationarity of the series are confirmed, this dissertation can now proceed to the panel data estimation, without conducting a cointegration test. Table 4. Levin Lin Chu test for panel unit root (ASEAN 6 + 3 data set)
Variables ln(tradeijt) t-star 15.670 t-star 8.605 p-value 0.000

20

ln(gdp) ln(pop) ln(techdistijt) ln(incgapijt)

9.828 4.547 32.947 10.287

5.503 3.169 26.506 3.287

0.000 0.000 0.000 0.000

Table 5 presents the panel estimation results of Equation (6) that are augmented with the AFTA and country dummy variables. First, the estimation is focused on the impact of AFTA on the trade activities of the ASEAN member countries. To do this estimation, three dummy variables are included in the model: AFTA, AFTAim and AFTAex. Later, the model includes country dummies to investigate the changes in trade patterns with China, Japan and South Korea. Table 5. Modified gravity equation: Trade creation and trade diversion
Variables Constant ln(gdpit) ln(gdpjt) ln(popit) ln(popjt) ln(distanceij) ln(incgapijt) ln(techdistijt) Reg. IV 33.906 (5.419) 1.276 (0.108) 1.765 (0.108) 0.352 (0.369) 1.616 (0.369) 0.185 (0.057) 0.040 (0.026) language border AFTA AFTAim *** *** *** *** *** Reg. V 31.081 (2.336) 1.288 (0.074) 1.556 (0.074) 0.349 (0.078) 0.484 (0.078) 0.654 (0.228) 0.240 (0.052) 0.038 (0.026) (0.089) 0.551 (0.164) 0.024 (0.113) *** 1.271 (0.360) 0.275 (0.505) 0.512 (0.161) 0.059 (0.103) *** *** 0.551 (0.240) 0.024 (0.136) ** 1.238 (0.271) 0.240 (0.381) *** 1.238 (0.380) 0.240 (0.549) *** *** *** *** *** *** *** *** Reg. VIa 33.906 (21.256) 1.276 (0.346) 1.765 (0.248) 0.352 (1.613) 1.616 (0.760) 0.185 (0.088) 0.040 ** ** *** *** *** Reg. VII 41.305 (4.658) 1.036 (0.120) 1.438 (0.120) 0.457 (0.341) 0.464 (0.395) 0.180 (0.056) 0.032 (0.025) *** *** *** *** Reg. VIII 26.916 (1.881) 1.244 (0.065) 1.388 (0.065) 0.326 (0.064) 0.387 (0.064) 0.755 (0.169) 0.243 (0.050) 0.019 (0.026) *** *** *** *** *** *** *** Reg. IXb 26.916 (13.621) 1.244 (0.083) 1.388 (0.138) 0.326 (0.104) 0.387 (0.122) 0.755 (0.264) 0.243 (0.068) 0.019 (0.087) *** *** *** *** *** *** ***

21

AFTAex China03-09 Japan03-09 Korea03-09 F-test LM test Hausman test R2 within R2 between R overall No. of obs (NT) No. of bilateral (N)
a b 2

0.510 (0.113)

***

0.324 (0.103)

***

0.510 (0.255)

**

0.518 (0.111) 0.195 (0.085) 0.097 (0.091) 223.04 ** ***

0.482 (0.098) 0.213 (0.088) 0.075 (0.090) 7832.72 ** ***

0.482 (0.206) 0.213 (0.085) 0.075 (0.073) ** **

221.04

117.57

7377.67 37.78 0.57 0.19 0.21 1584 72 0.57 0.70 0.67 1584 72 0.57 0.19 0.21 1584 72 15.23 0.57 0.48 0.47 1584 72

0.57 0.70 0.67 1584 72

0.57 0.70 0.67 1584 72

***, ** and * are significant at the 1%, 5% and 10% levels respectively and standard errors are presented in parentheses. For the third column, the figures in parentheses are the cluster-robust standard errors for the fixed effects estimator. For the sixth column, the figures in parentheses are the cluster-robust standard errors for the random effects estimator.

Similar to the test results in the previous estimation, the results of the Hausman test imply that the fixed effects model is the preferred model for this estimation. Hence, the results interpretation is more focused on the fixed effects model (Reg. IV). Overall, the results are consistent with the previous estimation. The coefficients of the GDPs of both the exporting and importing countries remain significant at the 1% level. The coefficient of the population of the exporting country becomes positive, but statistically insignificant. Nevertheless, the population of the importing country remains negatively correlated with exports and significant at the 1% level. Income gap has a negative coefficient and is statistically significant, implying that the presence of the Linder hypothesis is still remarkable in the East Asian context. Technological distance, however, is statistically insignificant, despite the negative coefficient. The AFTA dummy, as expected, is significant and has a positive sign, thus implying the presence of trade creation. The AFTAim dummy, however, is not

22

significant, despite the positive coefficient. This result shows that there is no evidence of extra-regional import bias after the establishment of AFTA. On the other hand, AFTAex is statistically significant with a negative sign, which implies export trade diversion after the establishment of AFTA in 1992. In other words, this result suggests that there has been a shift in the pattern of exports since some trade flows between the ASEAN member countries and non-member countries were replaced with trade flows amongst the ASEAN member countries. Next, specification tests are conducted to check for the presence of heteroscedasticity and serial correlation. This time, both heteroscedasticity and serial correlation also exist because the nulls of homoscedasticity and no serial correlation are strongly rejected at the 1% level (see Appendix 1.2). Hence, similar to the previous cases, the model is re-estimated with the cluster-robust covariance estimator to obtain the correct standard errors. The results of this estimation are shown in the third column of table 5 (Reg. VI). Even after treating the problems of heteroscedasticity and serial correlation, the results do not show any significant changes. All variables that were significant in the ordinary fixed effects model are also significant in the clustered fixed effects model. In short, this result confirms that there was trade creation among the ASEAN member countries after the establishment of AFTA in 1992. Furthermore, it also verifies the presence of export diversion, because the coefficient of AFTAex remains statistically significant after the cluster treatment. The last estimation in this dissertation includes all the country dummies in the model and also follows the same estimation procedure and specification tests. After estimating both the fixed effects (Reg. VII) and random effects (VIII) models, the Hausman test is conducted. This time, the test fails to reject the null at the 5% level. Therefore, the random effects estimators are used because the fixed effects estimators

23

have become inefficient. To support this result, the Breusch-Pagan Lagrange Multiplier test is undertaken and the result rejects the null significantly at the 1% level, implying that there is not equality of the individual effects, i.e. it accepts the presence of random effects. Consequentially, the random effects model is used because it does not model each individual effect explicitly. Moreover, similar to the previous results, the specification tests show that heteroscedasticity and serial correlation are also present in this estimation (see Appendix 1.3). As a consequence, the random effects model is reestimated using the Huber/White cluster-robust covariance estimator in order to obtain the correct standard errors. The results are presented in the last column of table 5 (Reg. IX). Despite the bigger standard errors due to the clustering treatment, most of the variables are still significant. The GDP coefficients of both the exporting and importing countries are significant at the 1% level. The population coefficients are also statistically significant with negative signs. However, a closer investigation shows that the magnitude of the importing countrys population is much smaller as compared to that in Reg. VI. Other variables show relatively similar results as compared to Reg. VI: income gap is statistically significant with a negative coefficient, while technological distance is statistically insignificant. In addition, since the random effects model can estimate the time-invariant variables, it takes into account the variables that are dropped from the fixed effects model. These variables are geographical distance, language and borders. The coefficient of geographical distance appears to be negative and statistically significant, as expected. Hence, this result suggests that greater geographical distance causes higher transportation costs and thus discourages bilateral trade between two countries. In contrast, language, which represents cultural distance, is positively correlated with

24

exports and significant at the 1% level. In other words, language similarity allows both countries to communicate more easily, hence it eases the process of trade transactions. Another time-invariant variable is border. However, it is statistically insignificant, even though it has a positive coefficient. Another important factor is the country dummies. The coefficient of China is positive and statistically significant. The coefficient of Japan is negative and significant at the 5% level. This result is evidence that, from 2003 to 2009, Japan exhibited a general negative propensity to export to and import from East Asian countries. On the other hand, the rise of China has enabled it to take over larger shares of East Asian markets from Japan during the same period of time. Lastly, the Korea dummy shows a positive sign, but is not statistically significant. To sum up, this section of the dissertation has shown the determinants of trade in the ASEAN 6 + 3 economies. Most of the included variables are statistically significant and have the expected signs. Moreover, it also detected the presence of both trade creation and trade diversion after the establishment of AFTA, even though the magnitude of trade creation is larger than that of trade diversion. Further, it shows intensified trade flows between China and other East Asian partners between 2003 and 2009.

5. Further Discussions and Analysis This part presents further discussion to clarify some of the issues found in the previous section. First, even though the fixed effects estimations cannot include time-invariant variables in the model, the random effects estimation (Reg. IX) shows that geographical distance and language are significant determinants of trade in the context of the ASEAN 6 + 3 economies. While geographical distance represents the main impediment to trade flows, language similarity increases the flow of trade. One remarkable fact is that, even
25

though global transportation infrastructure has been improving rapidly in the last decades, some ASEAN member countries still have inadequate transportation infrastructure. Improved transportation infrastructure, such as providing more efficient customs, logistics and transportation procedures, may be able to reduce the effect of geographical distance as an obstacle to trade. On the other hand, the positive coefficient of language implies that two countries that speak the same language will be able to communicate and conduct international transactions efficiently and thus increase trade flows The second discussion regards the significance of income gap. The negative relationship between trade and income gap shows that this estimation is in favour of the Linder hypothesis not only in the case of trade among the ASEAN 6 countries, but also in trade interrelationships among the ASEAN 6 + 3 countries. Therefore, this result supports most of previous studies that tried to detect the presence of the Linder hypothesis in the flows of trade (see e.g. Thursby and Thursby, 1987; McPherson et al., 2001; Hallak, 2006). In this regard, however, McPherson et al. (2001) point out that there is one important note that is worthy of consideration regarding the inclusion of the income gap variable into the gravity equation. In their paper, McPherson et al. (2001) argue that the Linder hypothesis was originally intended to be applicable only to manufactured goods. Thus, in the case where manufactured goods do not play an important role in the flows of trade, the use of the income gap variable may lead to a biased conclusion in regard to accepting or rejecting the presence of the Linder hypothesis. In the case of the East Asian region, rapid industrialization in most East Asian countries, which was followed by improved technological capability, has made the region able to increase the share of manufactured goods in terms of total exports. According to UN COMTRADE database (2011), manufactured goods accounted for

26

more than 60% of total traded commodities between 1988 and 2009 in ASEAN + 3 countries. As the consequence, this large share of manufactured goods in terms of total exports confirms that the test to check for the presence of the Linder hypothesis is appropriate for this study. Third, unlike the income gap, technological distance is only significant in Reg. III. One possible explanation for this result is due to the limited availability of data. As mentioned earlier, the use of linear interpolation in filling in the missing values might affect the data quality and estimation result. From a theoretical point of view, however, this result requires further investigation. Lastly, the discussion is aimed at analysing the effects of AFTA on trade in East Asia. Kitwiwattanachai et al. (2010) point out that FTAs in general result in both trade creation and trade diversion, and if there are more countries that join the FTA, then both of these effects tend to become larger. Therefore, what is more important is to examine whether the establishment of AFTA has increased or decreased net welfare. The net change in welfare can be obtained by calculating the difference between trade creation and trade diversion. Reg. VI shows that the establishment of AFTA has increased intraregional trade flows to a higher level of 0.551, which implies that the intra-ASEAN 6 trade flows have increased by 73.5% since the establishment of AFTA, i.e. this result shows that AFTA partners prefer to trade with other AFTA partners. This result is smaller than that of the study by Elliott and Ikemoto (2004), but consistent with a more recent study by Kien and Hashimoto (2005). One possible explanation for this difference is partly due to the pooled cross-sectional model used by Eliiott and Ikemoto (2004). As mentioned earlier, pooled cross-sectional models neglect the unobserved heterogonous factors in errors. Thus, they may lead to a different estimation result.

27

In addition to trade creation, the estimation in this dissertation also shows the presence of export trade diversion after the establishment of AFTA. The results in Reg. VI exhibit the fact that extra-regional exports under AFTA have decreased to a lower level of 0.510. In other words, it implies that AFTA has reduced export flows from the ASEAN 6 economies to China, Japan and South Korea by as much as 66.5%. This result meets the expectation of Cuyvers and Pupphavesa (1996) and supports the finding of Hapsari and Mangunsong (2006), but is inconsistent some other studies (Elliott and Ikemoto, 2004; Kien and Hashimoto, 2005). Elliott and Ikemoto (2004) argue that the lack of any trade diversionary effects in their study is due to changes in the real exchange rates of the ASEAN member countries after the 1997 Asian Financial Crisis. The devaluation of the ASEAN currencies following the crisis that struck in 1997 caused exports to become less expensive and imports to become more expensive. This might have increased the products competitiveness of the ASEAN member countries and increased the flows of exports from these countries to other East Asian countries. Nevertheless, their paper uses data that only cover the period between 1983 and 1999. Therefore, the estimation results only capture the impact of AFTA until two years after the 1997 Asian Financial Crisis, when the ASEAN economies were still severely affected by the crisis. On the other hand, this paper covers a longer time period. Thus, it captures the effects of AFTA over a longer term in order to give a more comprehensive understanding. Appendix 2 shows that, after they recovered from the crisis, there was a modest currency appreciation in the ASEAN 6 countries between 2003 and 2008 (prior to the 2008 Global Financial Crisis), particularly in Brunei Darussalam, Malaysia, Singapore and Thailand. This appreciation might have reduced the export competitiveness of the ASEAN member countries and led to export trade diversion. Another explanation is simply that countries are usually averse to FTAs in which they

28

are not included (Kitwiwattanachai et al., 2010). In this case, since China, Japan and South Korea are not member countries of AFTA, this aversion occurs and causes the trade diversionary effect. In summary, from a welfare perspective, AFTA has increased the welfare of its member countries through trade creation and simultaneously reduced the welfare of non-member countries through trade diversion, particularly if the diversion is caused by the shifting of the more efficient countries from outside the bloc to the less efficient countries inside the bloc. Nevertheless, from the perspective of the overall East Asian region, the net welfare impacts of AFTA are still welfare-increasing because the effects of trade creation are still bigger than those of trade diversion.

6. Conclusion This study has revealed important findings about the main determinants of trade in the ASEAN 6 countries and the impacts of AFTA on East Asian trade flows. The main finding of this paper shows that AFTA has brought many benefits to its member countries through the rapid creation of trade. Nevertheless, the benefits to its member countries have come at the expense of non-member countries, in this case: China, South Korea and Japan. In order to minimise these trade diversionary effects on other East Asian counties, this paper proposes the establishment of a broader scope FTA, such as an ASEAN 6 + 3 FTA. Fortunately, an attempt at achieving this goal has been made by expanding the FTA in the East Asian region through the aggressive formation of ACFTA. Therefore, further studies should investigate whether AC-FTA can reduce the impacts of trade diversion on the East Asian region. In addition, it also should be facilitated by more complete data availability in order to allow for a more sophisticated study and obtain more efficient results.

29

Newer ASEAN members (Cambodia, Lao PDR, Myanmar and Vietnam) also joined AFTA in the following years. These countries were given some flexibility in achieving its goals, due to their less developed economies.

The complementary index is a variable used to examine whether factor endowments between two countries are complementary. The positive and significant result of this variable in the equation shows that higher complementariness of factor endowments of two countries intensifies bilateral trade in these countries (for instance, see Deardorff, 1984; Ng and Yeats, 2003).

In their paper, Evenett and Keller (2002) contend that product specialisation in the IRS models occurs for arbitrary differences in factor proportions, whereas H-O models require large differences in factor proportions to encourage product specialisation. Since the assumption of large factor proportions differences is unnecessary, they suggest that IRS models are preferred in the gravity equation context.

30

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Appendices Appendix 1. Specification Tests Appendix 1.1. Specification tests for Reg. I Reg. III
Wooldridge test for serial correlation in panel data Null Hypothesis No first order serial correlation F-test 74.219 p-value 0.000

Modified Wald test for groupwise heteroscedasticity Null Hypothesis Constant variance (homoscedastic) 2 32508.65 p-value 0.000

Appendix 1.2. Specification tests for Reg. IV Reg. VI

Wooldridge test for serial correlation in panel data Null Hypothesis No first order serial correlation F-test 83.733 p-value 0.000

Modified Wald test for groupwise heteroscedasticity Null Hypothesis Constant variance (homoscedastic) 2 61364.21 p-value 0.000

36

Appendix 1.3. Specification tests for Reg. VII Reg. IX

Wooldridge test for serial correlation in panel data Null Hypothesis No first order serial correlation F-test 82.832 p-value 0.000

Modified Wald test for groupwise heteroscedasticity Null Hypothesis Constant variance (homoscedastic) 2 87333.84 p-value 0.000

37

Appreciation

Depreciation

0.5! 1! 2! 0! 1! 2!

1.5!

4.5! 4! 3.5! 3! 2.5! 2! 1.5! 1! 0.5! 0!

0.5!

1.5!

0!

Malaysia!

Brunei Darussalam!

Singapore!

1993! 1994! 1995! 1996! 1997! 1998! 1999! 2000! 2001! 2002! 2003! 2004! 2005! 2006! 2007! 2008! 2009! 1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009

1993! 1994! 1995! 1996! 1997! 1998! 1999! 2000! 2001! 2002! 2003! 2004! 2005! 2006! 2007! 2008! 2009!

Appendix 2. ASEAN 6 Official Exchange Rates

Source: World Bank World Development Indicators online database

38
10! 0! 20! 30! 40! 50! 10! 20! 30! 40! 50! 60! 0!

10000!

12000!

2000! 0!

4000!

6000!

8000!

Philippines!

Thailand!

Indonesia

1993! 1994! 1995! 1996! 1997! 1998! 1999! 2000! 2001! 2002! 2003! 2004! 2005! 2006! 2007! 2008! 2009!

1993! 1994! 1995! 1996! 1997! 1998! 1999! 2000! 2001! 2002! 2003! 2004! 2005! 2006! 2007! 2008! 2009!

1993! 1994! 1995! 1996! 1997! 1998! 1999! 2000! 2001! 2002! 2003! 2004! 2005! 2006! 2007! 2008! 2009!