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Can FTAs support ‘Factory Asia’?

Can FTAs Support ‘Factory Asia’?

Author: Jayant Menon, ADB and ANU

Free trade agreements (FTAs) have been proliferating in Asia for more than a decade. International fragmentation of production and the resultant cross-border production networks have been growing for a much longer period. Although FTAs are not necessary for the formation of production networks, can they support their further growth or spread? Empirical studies cannot provide a clear-cut answer as they produce mixed results, possibly reflecting dual causality- growth in fragmentation trade may be inducing FTAs, or vice-versa. Therefore, a qualitative approach that carefully examines the characteristics of product fragmentation trade and FTAs in Asia to ascertain possible linkages, taking into account the presence of other trade policies that can affect the relationship, is warranted.

We find the link between the two to be tenuous for a number of reasons. Rather than supporting ‘Factory Asia’, it is more likely that fragmentation trade has prospered despite the noodle bowl of overlapping FTAs in the region. First, most product fragmentation trade already takes place at zero or low tariffs because of the International Technology Agreement, various duty-drawback or bonded warehouse schemes, and the location of most multinationals in duty-exempt export processing zones. These schemes operate against a backdrop of low and falling tariffs on parts and components, which have more to do with unilateral actions than preferential ones. As a result, the trade-weighted preference margin for intra-ASEAN trade in 2008, for instance, was a mere 2.3 percent, while 72.9 percent of trade traveled at a zero MFN rate, according to the WTO. This is further evinced by very low utilization rates of Asian FTAs.

Second, much of fragmentation trade is unlikely to benefit from FTA tariff concessions given the inability to satisfy rules of origin (ROOs) because of limited value-addition, which is the very nature of such processing trade. Even ROOs based on the tariff-line shifting criterion generally fails because trade in parts and components usually remains within the same HS-6 digit tariff code despite undergoing processing across borders. Basically, FTAs are designed to promote trade in final goods, or goods which are produced from beginning to end in a given country, and not the type of fragmentation trade involving parts and components and final assembly within production networks.

Third, almost all FTAs involving Asian countries are relatively shallow, and there are still many non-tariff barriers (NTBs) and other behind-the-border issues that impede this trade. In a major study assessing FTAs, the WTO concludes that most Asian FTAs show relatively limited WTO-plus or GATS-plus commitments in their design. If FTAs are largely redundant when it comes to reducing tariffs on product fragmentation trade, then they have proven largely incapable of addressing trade facilitation and other aspects that matter when it comes to promoting this type of trade in Asia. Even if they were to deepen over time, it is difficult or costly to remove NTBs or facilitate trade in a preferential manner. Many of these types of reforms share public goods characteristics of non-excludability and non-rivalry. In addition, the global nature of supply chains suggest that regional approaches to liberalization are bound to be of limited value- most of what Factory Asia produces continues to be consumed outside the region. On the supply side, selective or geographically constrained liberalization can also choke-off the natural spread of such networks. A comparison of the experience of Vietnam and India confirms the point- while the former has emerged as a major player in production networks through a host of national reforms and unilateral or multilateral liberalization, the latter’s aggressive pursuit of bilateral and regional FTAs, with limited domestic reforms, has left it a laggard.

So, what kinds of reforms are needed to support the growth or spread of production networks? The WTO can still play a role if members can conclude a multilateral agreement on trade facilitation, expected at the Ministerial Summit in Bali in December 2013. It is estimated that such a deal could cut overall logistics costs by half, to an average of 5 percent of total trade costs- the equivalent of removing all current tariffs. But national liberalization actions that deal with incumbency issues are probably the key. National regulatory reforms in the services and investment areas that address market access issues and barriers to entry, irrespective of nationality, would be the best way to support the growth of production networks in current participants and their spread to new ones.

Jayant Menon is Lead Economist at the Office of Regional Economic Integration, Asian Development Bank, and Adjunct Fellow at the Arndt-Corden Department of Economics, the Australian National University.

A longer version first appeared in VoxEU, based on the following paper:

Menon, J (2013), “Supporting the Growth and Spread of International Production Networks in Asia: How Can Trade Policy Help?”, ADB Working Paper Series on Regional Economic Integration No. 114, Manila, ADB
The views expressed in this paper are those of the authors and do not necessarily reflect the views and policies of the Asian Development Bank, or its Board of Governors or the governments they represent.

 source: VoxEU