Economic impact of a potential free trade agreement (FTA) between the European Union and South Korea
Economic Impact of a Potential Free Trade Agreement (FTA) Between the European Union and South Korea
Short study by Copenhagen Economics & Prof. J. F. Francois
March 2007
Full report (575kb PDF): http://trade.ec.europa.eu/doclib/html/134017.htm
Executive/Non-Technical Summary
South Korea is EU’s fourth largest non-European trading partner. Until recently, Korea only
held trade discussions on a multilateral level through the WTO. Lately, there has been a
change of mind, partly as a result of the economic decline in the wake of the Asian financial
crisis, and partly as a result of the failure in Cancun. This change of mind, has led Korea to
launching an offensive in bilateral trade talks. Since the first bilateral trade agreement with
Chile, effective in 2004, Korea has also signed free trade agreements (FTAs) with EFTA,
Singapore, and ASEAN. Korea is currently negotiating and/or considering FTAs with a number
of other countries, among these important trading partners such as the US, Canada and India.
Furthermore, Korea is currently negotiating with ASEAN to extend the goods trade agreement,
to services and investment. A potential agreement with China is undergoing a study, while talks
with Japan have been suspended for two years.
The purpose of this study is to analyze the effects of potential measures to liberalize trade
between the European Union (EU25) and South Korea (hereafter Korea). Using a computable
general equilibrium (CGE) model of world trade, incorporating the most recent GTAP database,
we have evaluated two scenarios for an EU-Korea free trade agreement (FTA) and compared
it to the maximum potential given by a full free trade agreement.
We show that a realistic FTA scenario (called “Partial 1”) yields a total gain for the two
economies of 26 percent of the potential in a full FTA. If liberalization of trade in services is
taken a step further, as in our more ambitious scenario (called “Partial 2”), total gains increase
to 46 percent of the total potential from a full FTA between EU and Korea.
Our results shows that both economies stand to gain economically from all analyzed levels of
trade liberalization, but the gains are unevenly distributed. Korea will obtain two-thirds of the
total gains from an EU-Korea FTA in all scenarios, basically because the Korean economy
initially is more protected from international competition than the EU economy, and therefore
will benefit more from increased competition.
In agriculture and in manufacturing we look at tariffs and we do not consider non-tariff barriers.
In agriculture tariffs are cut by 40 percent and in manufacturing remaining tariffs are cut to
zero. This implies that we do not simulate the effect that in both agriculture and manufacturing
additional gains from an FTA can come from the removal of non-tariff barriers. Some evidence
suggests that in some of these sectors, e.g. automotives, non-tariff barriers are more important
than tariffs. In the service sector we analyse the effect of reducing existing barriers with 25
percent in Partial 1, with 50 percent in Partial 2 and entirely in the full FTA.
It comes as no surprise that the gains from liberalization are shown to be higher, the more
barriers to trade are removed. Hence, the economic gains are expected to be biggest for a full
trade agreement and smallest in the realistic Partial 1 trade agreement, while a Partial 2 trade
agreement yields intermediate, albeit still positive, gains from trade liberalization.
It is perhaps more surprising, just how important service liberalization is to the overall effect of
an EU-Korea FTA. Separating the effects of different measures taken to liberalize trade, we
find that most of the economic gains are attributable to liberalizing trade in services. This is
central, not least for the EU, where 70 percent of the economic gains in a Partial 1 scenario
can be traced back to liberalization in services. We show that the EU is expected increase
exports to Korea in the following key tradable service sectors: wholesale and retail trade,
transport services, communication, financial services and banking, other business services and
other services. The estimated increase in the value of exports to Korea is between 40 and 60
percent of the baseline values in these sectors. The reason for such dramatic increases is that
Korea needs these advanced services to fuel the growth of their own economy, and that the
Korean service sector is highly protected by non-tariff barriers.
Service trade is not only important to the EU. In Korea, 53 percent of the gains in real income
in the Partial 1 scenario can be attributed to opening up their economy to trade in services.
Korea gain from service trade liberalization even tough we predict the Korean service sector to
shrink in the short-term, as a result of an FTA with the EU. Opening up its economy to foreign
service-providers will, however, benefit the Korean economy through significant positive
spillovers on the Korean manufacturing sector. Today, the Korean service sector is much
sheltered from international competition, as documented by substantial ex-ante tariff
equivalents in services, and the resulting high prices for services as well a limited supply of
varieties are hampering the growth of the Korean economy as such, and in particular its
competitive and globally oriented manufacturing industry1. We show that a large part of the
expected output expansion for Korean manufacturing (especially in electrical machinery and
other machinery, but also in motor vehicles) is actually generated by better access to the key
competitive services in the global economy, namely transport, communication and business
services, which could be provided by the EU under a free trade agreement.
Comparing the outcomes for different levels of trade liberalization, we find that the Korean
export gains are sensitive to the degree of services liberalization taking place. This implies that
as the scope for services liberalization is reduced, the Korean export gains in manufacturing fall accordingly. Put in short: by succeeding in exporting advanced services, the EU can help
Korea succeed in exporting advanced manufacturing. A free trade agreement can make this
possible - to the benefit of both economies.
However, service is not the only matter on the agenda. Reducing tariff on non-food products
yield almost all of the remaining effects in EU. In EU 28 percent of the gain in the Partial 1
scenario is due to lower tariffs on non-food. For Korea this share is even higher. In Korea 43
percent of the gain in the Partial 1 scenario is resulting from non-food tariff reductions.
While output on average will increase in both economies, on industry level, some industries in
both economies will in fact expand while others are expected to contract. In general, as could
be expected, the domestic industries with higher ex-ante levels of import protection are those
expected to decrease as a result of increased trade and thus competition. With regards to
expected changes in sector output, a pattern emerges where there is a drop in merchandise
production for the EU, while the output for European services will increase. For Korea, the
effects of increased trade are expected to be the opposite. The Korean merchandise sector will
expand, while the service sector is expected to contract as a result of increased international
competition. The picture is however more complex.
According to our study, the Korean motor vehicles sector will exhibit the largest increase in
production, while the largest decrease is found in the sectors for processed food. For the EU,
we predict a mirroring pattern: the relatively largest decline is found in the motor vehicles
sector, while processed food sectors are expected to grow. The largest drops in output in the
EU are found in two sectors where ex-ante European trade barriers were higher than their
Korean counterparts, namely in motor vehicles and electrical machinery. These sectors show a
contraction of output corresponding to 1 percent and 0.5 percent respectively. It should be
noted that these sectors enjoys high a priori import protection, and therefore removing tariffs is
having stronger impact in these sectors for the EU. Our study also predicts a growth in iron and
steel sector in Korea, and a decline within the EU.
In our baseline without Korea engaging in other FTAs, EU has a 17.5 percent share of total
Korean imports from all countries (measured in values). If Korea concludes FTAs with other
partners (US, Canada, India, China, ASEAN and Japan), but not with the EU, the EU25 will
lose a market share of total Korean imports of 2.8 percentage points, making EU25 share of
total Korean imports go down to 14.7 percent. We show that the isolated drop in EU25 market
share from other Korean FTA is not a bad thing for EU. The explanation is very simple. When
Korea opens up trade with other trading partners, but not with the EU, two things are likely to
happen: One, Korea will import more goods and services. Two, Korea will import relatively
more from the other trade partners compared to the EU.
We predict that the loss in market share will be compensated by an increase in the total market
size of Korean imports from world, and our simulations show that the value of EU exports to
Korea will increase if Korea engages in FTAs with other partners than the EU. So even if the
EU market share in Korea should decline, the growth in the value of the Korean import market
more than compensates for this decline in share, and our study suggest the net result to be an
increase in EU exports to Korea. This result also holds for the main sectors, except in
agriculture and processed food, where we predict that the income effect will not be strong
enough to compensate for the loss in market share, and the net result for Korean imports of EU
agriculture and food will be negative if Korea engages in other FTAs and not with the EU. This
is not surprising, since agriculture and food are the less income sensitive than manufacturing
and services.
What is most important is that in the realistic scenario (Partial 1) EU25 market share of total
Korean imports will increase by 5,8 percentage points from the baseline level with the other
FTAs (from 14,7 percent to 20,5 percent of total imports), when including the effect of other
Korean-centered FTAs. At the same time we predict that the entire Korean market, measured
by the total value of Korean imports, will go up by an estimated 6 percent alone due to the EU-
Korea free trade agreement. So even in the most moderate of the three scenarios, EU25 will
not only regain its share of the growing Korean market, it will also expand its market share vis-
a-vis its competitors.
Koreas import from the EU will increase by 19.1 billion Euros, or 48 percent if the EU engage in
a Partial 1 agreement with Korea (and Korea also concludes the other FTAs as predicted). The
largest trade impacts for the EU are found within business services (22% of the total increase
in the value of Korean imports from EU25), machinery (16% of the gain) and processed food
(11%). These three sectors account for nearly half of the total trade impact on EU25. Twelve of
the 36 aggregated sectors in our simulations account for more than 90 percent of the total
trade impact on the EU25 in Korea (the remaining 24 sectors sum up to a mere seven percent
of the total change in EU imported value to Korea).
EU25 imports from Korea will increase by 12.8 billion Euros, or 36 percent if EU and Korea
engages in a Partial 1 agreement. For Korea, motor vehicles account for 40 percent of the total
increase in import value, making it by far the most important traded sector for Korea-EU
relation. Motor vehicles are followed by electrical machinery, which accounts for 13,5 percent
of the total increase in EU25 imports from Korea, textiles with 9 percent, transport with 6
percent, other machinery with a little less than 6 percent, and processed food and clothing,
accounting for around 4 percent.
We finally find that the measures taken with regards to increase trade in agriculture are
expected to have little overall effect of the results of a potential trade agreement for Korea’s
part, and a larger, but still very limited effect for the EU, primarily driven by an important
increase in EU market share in processed food.
Our analysis is based on the last available and most detailed data on input-output relations,
trade and final demand structures for the world economy. On top we include expected changes
to the trade policy environment in the basic dataset. We include the ATC phase-out and
China’s accession to the WTO in our model. Moreover, changes similar to those of the Doha
round will most likely give some results before a potential EU-Korean trade agreement is
realised. Therefore, we implement a stylized realistic representation of the Doha-round in our
baseline.
In addition, we also take into account that five other Korean-centered FTAs, namely with the
US, Canada, China, India, Japan, ASEAN and EFTA, are expected to take place. We assume
that the various Korea-centered FTAs include limited trade liberalization in agriculture, a full
trade agreement in manufacturing, and a 25 percent reduction in services. All results in this
study are based on this base setting. However, the results given here are in general not very
sensitive to these underlying assumptions about these other FTAs, and our conclusions hold
even if none of the Korean-centered FTAs are effectuated.
Comparing our results with a previous study from The Korea Institute for International
Economic Policy, KIEP (Kim, 2005) show similar results, at the aggregate level, and results are
pointing in the same direction. However, there are differences at the more detailed sector level.
Compared to the KIEP study, our study has more sectoral detail.
