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, but international fragmentation of production and resultant cross-border production networks have been growing for a much longer period.

It is by using those networks that Asia first became known as the world’s factory.

So it appears that FTAs are not necessary for the formation of production networks. But can FTAs support the further growth or spread of fragmented manufacturing? Empirical studies cannot provide a clear-cut answer as they produce mixed results, possibly reflecting dual causality — growth in FTAs may be inducing fragmentation of trade, but it could also be the other way round. A qualitative approach can help answer the question, however, especially if it carefully examines the characteristics of product fragmentation trade and FTAs in Asia, taking into account the impact of other trade policies that could affect the relationship between the two.

A qualitative approach suggests that it is more likely Asia’s fragmentation of trade has prospered despite the ‘noodle bowl’ of overlapping FTAs in the region, not because of it. One reason for this is that when companies trade the components of products internationally they already do so at zero or low tariffs. The International Technology Agreement means taxes on electronics components are generally zero, various duty-drawback or bonded warehouse schemes provide duty or tax rebates for re- exports, and most multinationals locate themselves 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. If exporters within ASEAN traded according to preferential rules in 2008 they would have saved on average a mere 2.3 per cent as against standard rates. It’s not surprising, then, that 72.9 per cent of trade travelled at a zero most-favoured nation rate, according to the WTO, or that Asian FTAs are scarcely used by producers.

Second, much of the fragmentation trade is unlikely to benefit from FTA tariff concessions because manufacturers are unable to satisfy rules of origin. Each step in the production chain adds limited value due to the very nature of the processing trade. Even rules of origin that attempt to track the way parts change – the tariff line shifting rule – generally fail to help manufacturers because components usually remain within the same product classification despite undergoing processing across borders. FTAs are basically designed to promote trade in goods that are produced from beginning to end in a given country, and not 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 and other behind-the-border issues that impede trade. In a major study assessing FTAs, the WTO concluded that most Asian agreements show relatively limited commitments that build on WTO-plus obligations or the General Agreement on Trade in Services (GATS). So not only are FTAs largely redundant when it comes to reducing tariffs on product fragmentation trade; they have also been unable to promote this type of trade in Asia.

Even if FTAs were to deepen over time, it is difficult or costly to remove non-tariff barriers or facilitate trade in a preferential manner. Many reforms to remove behind-the-border barriers share public goods characteristics of non-excludability and non-rivalry; once removed, they are available to all, and use does not reduce availability. In addition, the global nature of supply chains suggests that regional approaches to liberalisation 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 liberalisation can also choke off the natural spread of production networks, as a comparison of Vietnam and India confirms. While the former has emerged as a major player in production networks through a host of national reforms and unilateral or multilateral liberalisation, 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 its members can conclude a multilateral agreement on trade facilitation, which is 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 per cent of total trade costs — the equivalent of removing all current tariffs. But national liberalisation actions that deal with incumbency issue of first-mover advantage that concentrates market power, irrespective of nationality, 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.

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 of this article was first published here, on VoxEU. The article was based on this paper.

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, its Board of Governors or the governments they represent.