Discussion Paper on
Development Assistance
No. 6

Trade / Investment Policies andDevelopment Assistance Policies of Japan:
A Note on Policy Coherence

Kazutomo Abe
Tokyo Denki University

March 2005

Table of Contents
1.

2.

Japan’s Trade and Direct Investment ･･･････････････････････････････････････ 2
1.1

Establishment of Production Networks in East Asia in the 1980s and 1990s ･ 2

1.2

China’s Accession to the World Trade Organization･･･････････････････････ 5

1.3

Trade and Investment with South Asia and Africa･････････････････････････ 5Role of Trade in Development: Survey ･･･････････････････････････････････････ 6
2.1

Free Trade Is Crucial for Development ･･･････････････････････････････････ 6

2.2

Static Effects of Trade Liberalization ･････････････････････････････････････ 6

2.3

The Medium-term Effects of Trade Liberalization: FDI and Capital
Accumulation ･･････････････････････････････････････････････････････････ 7

3.

4.

5.

2.4

Empirical Studies on Trade Openness and Long-term Growth ･･････････････ 8

2.5

Trade Liberalization and Income Inequality between Trading Partners ･････ 9

2.6

Trade Liberalization and Domestic Income Disparity ･････････････････････ 10Japan’s Trade Policy ･･････････････････････････････････････････････････････ 11
3.1

Trends in World Trade Policy ･･･････････････････････････････････････････ 11

3.2

Shift of Japan’s Trade Policy: From Multilateralism to Regionalism････････ 12

3.3

Japan’s FTA/EPA Policies Were Development-Neutral ････････････････････ 13

3.4

East Asia Is Japan’s Priority for Trade and Investment ･･･････････････････ 14

Quantitative Analysis of the Impact of Trade Policies on Developing Countries 14
4.1

Model Structure and Simulation Methodology････････････････････････････ 15

4.2

Simulation Scenarios and Model Specifications･･･････････････････････････ 16

4.3

Simulation Results – Scenarios I and II ･････････････････････････････････ 17

4.4

Simulation Results – Scenarios III, IV, V and VI ･････････････････････････ 21

Conclusion and Policy Recommendations ･･･････････････････････････････････ 23
5.1

Conclusion ････････････････････････････････････････････････････････････ 23

5.2

Policy Recommendations ･･･････････････････････････････････････････････ 25

References ･･･････････････････････････････････････････････････････････････････ 27
Table 1:

Export and Import Share of Japanese Trade ･･･････････････････････････ 2

Table 2:

Exports and Imports of the Countries and Region (Shares in the World) ･･ 3

Table 3:

Exports and imports Shares of Regions in East Asia ････････････････････ 4

Table 4:

Outflows and Inflows of Foreign Direct Investment ･････････････････････ 4

Table 5:

Welfare Gains from Various Combinations of FTAs ････････････････････18

Table 6:

Sector-base impacts on the Industrial Real Output of ASEAN5 +3 FTA(Selected countries) ･････････････････････････････････････････････････20

Table 7:

Welfare Gains from Various Scenarios ････････････････････････････････22

Table 8:

Example of Growth Function (APEC Economic Committee (1999)) ･･････32

Table 9:Assumed Parameters in the GTAP Model ･････････････････････････････39

Chart 1:

Conceptual Illustration of a Model Simulation ････････････････････････16

Chart 2:Graphical Presentation of Trade Volume Effect ･･･････････････････････30

This paper offers an analysis of Japan’s trade/investment and development assistancepolicies and the dynamic between them. A primary concern is whether these policies
are “coherent” in the sense that they do not undermine the economic development ofdeveloping countries. One of the main focuses of Japan’s trade policies in recent years
has become the negotiation of FTAs (free trade agreements) with a number of countries,
especially Asian countries. FTAs increase the welfare of the countries involved but
can create negative effects for countries that are not included in the agreement. This
paper looks at the relationship between trade and development1 with an emphasis on
FTAs. It reviews theories and empirical studies and, using computer simulations,analyzes the welfare impact for its trading partners, including developing countries, oftrade policies pursued by Japan. From this, it draws conclusions and offers policy
recommendations on how most effectively to pursue both trade and development
assistance efforts.
Trade/investment policies and development assistant policies have different underlying
objectives. Development assistance policies aim at furthering the development of thepartner countries. Trade/investment policies on the other hand — whether multilateral,bilateral or regional — are intended to have domestic benefit. Trade/investment
policies, however, may also have a strong impact on the economic development of the
trade/investment partner, as well as third countries. This means that increased
coherence between the two policies might well enhance the overall development impact
on poor countries. Disregard for coherence and to the development impact on partners
has tended to characterize the trade/investment policies of advanced countries, including
Japan. This is changing as part of international strategies to reach the Millennium
Development Goals by 2015. Consensus has emerged that attention to coherence isimportant and creating coherence is currently a priority among developed, aid-donor
countries.
The first section of this paper reviews trends and perspectives in trade and overseas
investment in Japan. The second section surveys the literature on the relationshipbetween trade openness, growth and income disparity. The third section discusses
Japan’s trade/investment policies. Quantitative analysis is conducted in the fourth

1“Development” here refers principally to economic development — economic growth,industrialization and reduced income disparity.

section on the impact on developing countries under six trade/investment policy
scenarios. The final section concludes the analysis with policy recommendations.
1.

Japan’s Trade and Direct Investment

Historically, Japan’s predominant trade and investment partners have been the UnitedStates among developed countries and East Asia2 among the less developed ones.
Geographic proximity and economic complementarity, as well as historic connection,
have predetermined a close relationship of Japan with these regions (Table 1). By
contrast, the South Asian and African shares in Japanese trade and investment have beenless significant, even negligible. This section examines trends and perspectives inJapan’s trade and investment, focusing on those with the developing economies in East
Asia.
Table 1: Export and Import Share of Japanese Trade(percent)
Exportsyear

Imports

1980

1985

1990

1995

2000

2003

1980

1985

1990

1995

2000

2003

World

100.0

100.0

100.0

100.0

100.0

100.0

100.0

100.0

100.0

100.0

100.0

100.0

United States

24.5

37.6

31.7

27.5

30.2

24.8

17.4

20.0

22.5

22.6

19.2

15.6

EU (EEC)

9.4

7.8

13.1

10.2

10.7

9.8

3.9

4.8

11.5

9.3

7.5

8.2

Other Industrial

11.5

12.1

13.4

11.2

9.5

9.6

12.3

14.7

16.1

15.0

12.2

12.3

China

3.9

7.1

2.1

5.0

6.4

12.1

3.1

5.0

5.1

10.7

14.6

19.7

ASEAN10

10.2

6.5

11.6

17.6

14.4

12.9

17.5

15.6

12.7

14.4

15.5

15.3

10.0

6.4

11.5

17.3

13.9

12.3

15.1

14.1

11.9

13.5

14.3

13.9

ASEAN5South Asia

1.5

1.6

1.1

0.9

0.7

0.8

0.9

1.3

1.1

1.1

0.7

0.6

Africa

4.0

1.7

1.6

1.4

0.9

1.0

2.8

2.3

1.6

1.3

1.3

1.7

Middle East

10.8

6.8

3.3

2.2

2.2

2.9

31.6

23.0

13.3

9.4

13.1

13.4

Rest of World

20.5

15.1

17.6

17.7

19.4

19.8

10.2

12.6

15.2

15.3

15.4

12.8

(Source) IMF “Direction of Trade Statistics”

1.1

Establishment of Production Networks in East Asia in the 1980s and 1990s

Japan recorded a high rate of economic growth in the 1960s and early 1970s and exports,
particularly those to the United States, were important contributors to that growth.
This growth trend continued until the early 1980s, when it began to slow.
Appreciation of the real yen exchange rate against the United States dollar after 1985
brought significant changes in Japan's trade and direct investment. Its share of world2

In this paper, the term “East Asia” is used to include Southeast Asian countries.
2

exports declined from 9.3 percent in 1985 to 8.3 percent in 1990 and to 7.5 percent in2000 (See Table 2). Meanwhile, after the mid-1980s, the developing economies ofEast Asia experienced remarkable expansion in their trade. The ASEAN103 excluding
Singapore increased their share of world exports from 2.7 percent in 1985 to 4.5 percent
in 2000 and their share of imports from 1.9 percent to 3.5 percent (see Table 2).
Table 2: Exports and Imports of the Countries and Region (Shares in the World)
World
United States
EU (EEC)ASEAN10+3
China
Japan
Korea
ASEAN10ASEAN5Indonesia
Malaysia
Philippines
ThailandSingapore
Vietnam

1980
100.0
11.6
24.4
12.0
0.9
6.7
0.9
3.4
3.4
1.1
0.7
0.3
0.3
1.0
-

Exports (Shares in world (percent))
1985
1990
1995
2000
100.0
100.0
100.0
100.0
11.5
11.4
11.4
12.3
23.3
27.1
27.7
23.5
16.0
16.0
20.1
20.8
1.4
1.8
2.9
3.9
9.3
8.3
8.6
7.5
1.6
1.9
2.4
2.7
3.6
4.0
6.1
6.7
3.6
4.0
6.1
6.4
1.0
0.7
0.9
1.0
0.8
0.9
1.4
1.5
0.2
0.2
0.3
0.6
0.4
0.7
1.1
1.1
1.2
1.5
2.3
2.2
-

2003
100.0
9.8
26.1
20.6
5.9
6.4
2.6
5.7
5.4
0.5
1.3
0.5
1.1
2.0
0.02

1980
100.0
12.7
25.6
12.3
1.0
7.0
1.1
3.2
3.1
0.5
0.5
0.4
0.5
1.2
-

Imports (Shares in world (percent))
1985
1990
1995
2000
100.0
100.0
100.0
100.0
17.8
14.6
14.8
19.2
21.7
25.3
25.0
21.8
13.5
14.6
18.2
17.3
2.1
1.5
2.5
3.4
6.6
6.6
6.5
5.8
1.6
2.0
2.6
2.4
3.2
4.5
6.6
5.6
3.2
4.5
6.6
5.3
0.5
0.6
0.8
0.5
0.6
0.8
1.5
1.2
0.3
0.4
0.5
0.6
0.5
0.9
1.4
0.9
1.3
1.7
2.4
2.0
0.2

2003
100.0
17.0
22.8
17.9
5.4
5.0
2.3
5.2
4.8
0.5
1.1
0.5
1.0
1.7
0.3

(Source) IMF “International Financial Statistics”
East Asia trade consisting of Japan and the developing economies of that region wascharacterized by an expansion of intra-regional trade. Trade between ASEAN5 andJapan (ASEAN5+J) increased the share of intra-regional exports in total exports from
21.4 percent in 1980 to 25.1 percent in 1995, and the share of intra-regional imports
from 21.3 to 27.5 percent. Since 1995 the share of intra-regional trade has declined,
due partially to the Asian financial crisis of the late-1990s and the emergence of China
as a large trading partner of Japan. (See Table 3)
The increasing trend toward intra-regional trade was reflected in the relocation ofJapanese production bases to East Asia, including both Southeast Asia, and also
Northeast Asia, i.e., China, Korea and Taiwan. The gradual establishment there of
production and procurement networks contributed to regional economic integration.

3

ASEAN (Association of South East Asian Nations) is an international body established in1967 to accelerate economic growth, social progress and cultural development in the region, andto promote regional peace and stability. There are now ten member countries (ASEAN10):
five original members (ASEAN5) -- Indonesia, Malaysia, Philippines, Singapore andThailand; and five newer members -- Brunei Darussalam, Vietnam, Laos, Myanmar andCambodia.
3

Table 3: Exports and Imports Shares of Regions in East Asia
Exports Shares (percent)
1980

1990

1995

Imports Shares (percent)

2000

2003

1980

1990

1995

2000

2003

ASEAN10+3

31.75

36.66

44.93

42.60

37.52

33.55

32.99

45.69

48.39

49.71

ASEAN10

18.64

18.87

24.64

23.00

22.06

14.45

9.27

18.30

23.32

22.57

ASEAN5+ Japan

21.35

19.65

25.08

23.50

21.89

21.28

19.80

27.52

27.29

25.28

ASEAN5

16.71

18.14

22.39

21.63

20.41

13.25

8.30

16.67

21.73

20.69

(Source) IMF “Direction of Trade Statistics”
Japanese multinational firms invested heavily in ASEAN economies — and more
recently in China — by means of Foreign Direct Investment (FDI)4. FDI inflows toEast Asian developing economies expanded rapidly after the early 1980s (Table 4).
FDI inflows to the ASEAN5 increased more than six fold between 1985 and 2003 andFDI inflows to China increased remarkably by more than 15 fold during the 1990s.
Table 4: Outflows and Inflows of Foreign Direct Investment
Outflows (million US$)
1980
World
United States
EU(EEC)ASEAN10+3
China
Japan
South Korea
ASEAN10ASEAN5Indonesia
Malaysia
Philippines
ThailandSingapore
Viet Nam
Other ASEAN

1990

1995

Inflows (million US$)

2000

2003

53,683 242,057 358,235 1,186,838 612,201
19,230 30,982 92,074 142,626 151,884
14,651 87,835 93,613 408,319 201,044
2,720 52,233 37,462
44,989 41,871
0
830
2,000
916
1,800
2,385 48,024 22,630
31,558 28,800
26
1,052
3,552
4,999
3,429
309
2,328
9,280
7,516
7,841
309
2,328
9,260
7,345
7,751
6
-11
1,319
150
130
201
129
2,488
2,026
1,370
1
22
98
-108
158
3
154
887
-22
557
98
2,034
4,467
5,298
5,536
0
0
0
0
0
0
0
20
171
90

1980

1990

1995

2000

2003

54,986 208,646 335,734 1,387,953 559,576
16,918 48,422 58,772 314,007 29,772
2,963
8,015 43,549
63,532 407,494
2,767 18,816 67,127
80,988 82,682
57
3,487 37,521
40,715 53,505
278
1,753
41
8,323
6,324
17
759
1,249
8,572
7,523
2,415 12,817 28,316
23,379 19,100
2,433 12,403 25,396
21,150 15,407
180
1,092
4,346
-4,550
-597
934
2,611
5,815
3,788
2,474
-106
550
1,574
1,345
319
189
2,575
2,070
3,350
1,802
1,236
5,575 11,591
17,217 11,409
0
180
1,780
1,289
1,450
-18
414
2,920
2229
3694

(Source) UNCTAD “World Investment Report” various issues.

After 2002, when it acceded to the World Trade Organization (WTO), China
experienced another FDI boom. By 2003, the developing economies in East Asia had
jointly become one of the largest FDI recipients in the world. This apparently was aconsequence of liberalization and facilitation measures on capital transactions which

4

Their increased intra-firm trade is shown in the growth in the region of components and partly
assembled goods (Urata 2003).
4

allowed higher returns on capital due to increased efficiency in the allocation of factors.
The resulting higher potential for profitability was attractive to FDI.
1.2

China’s Accession to the World Trade Organization

China’s accession to the World Trade Organization (WTO) in November 2002 had adramatic impact on trade and investment in East Asia. China produces the world’s
sixth largest GDP5 and receives one of the largest single country FDI inflows. The
massive FDI — mainly from Japan and South Korea6 — prompted a reorganization of
production networks in East Asia where the core production base began to shift toward
China. With its trade growing rapidly, China has become an important destination forexports from the rest of the region, including Japan. For developing countries, China
has emerged as a fierce competitor in third-country markets. No policymaker in East
Asia can ignore the presence of China.
As China emerged as a core production base in the reorganized production networks,
the trade profiles of East Asian countries have become more complementary. The
degree of complementarity for ASEAN10+3 — a designation for ASEAN plus Japan,
China and South Korea — is now becoming comparable to that within the EU or
NAFTA7.
1.3

Trade and Investment with South Asia and Africa

Japan’s trade with South Asia and Africa has been small, each region accounting forabout one percent of the total (see Table 1). Moreover, their shares of Japan’s exports
and imports both have trended down over time. These regions are remote from Japanand they lack markets large enough to attract Japanese FDI. Many gravity model
estimates empirically show that remoteness of potential trading partners discourages
bilateral trade and investment8. Although India has recently emerged as a good FDI
recipient, its trade and investment relationship with Japan remains weak.

5

IMF World Economic Outlook Data Base, April 2005. Estimate for 2005.
Bilateral data on FDI is not available, except for the national sources. However, the national dataof Japan and Korea shows that the two countries emerged as the major FDI suppliers to China.
7
In this context, political cooperation and competition between Japan and China co-exist within the
ASEAN10 +3 process.
8
See Frankel (1992), Abe (2005).
6

5

2.

Role of Trade in Development:

Survey2.1

Free Trade Is Crucial for Development

Most recent research appears to agree that trade openness has a positive effect on
economic growth9. In principle, trade openness means more efficient use of resources.
Moreover, recent research on trade liberalization stresses the importance of dynamic
economies of scale and the pro-competition effects of trade liberalization, especially inthe context of regional economic integration through trade. Trade liberalization andintegration of markets enhances competition, stimulates domestic investment,
encourages the international transmission of innovation and knowledge and promotes
more rational international specialization of production. As indicated in the previous
section, FDI acts as an engine to promote trade integration. Expanded markets canalso mean expanded returns to innovation, and hence greater incentive for it. In
addition, trade liberalization can create a healthier environment for savings andinvestment. These effects can, in turn, have important medium-run and long-run
implications for the economic development and growth. As such, trade is crucial tothe economic development of the trade partners.
A number of empirical studies have identified a significant positive trade-growth
relationship, including a path from economic integration to strengthened growth10:
Economic integration (i) provides strong incentive to mobilize inputs and to improvetheir quality; (ii) expands potential markets by allowing economies of scale and lower
cost production; (iii) provides incentive to increase management efficiency through theincreased pressure of competition; and, (iv) provides incentive to enhance technologicalinnovation. This list, of course, is not exhaustive.
2.2

Static Effects of Trade Liberalization

Liberalization of trade has a wide range of impacts, the core one of which is static
efficiency gain. Baldwin and Venables (1995) present varied economic effects bydecomposing an indirect utility function with respect to consumption expenditure.
Assuming that all trade barriers cause rents only to domestic agencies11, that all related
9

A recent survey of the relation between trade and growth is Borensztein et. al (1998).
APEC Economic Committee (1997).
11
In contrast, some trade barriers may be real trade costs or quotas under which foreigners capture
the quota rents.
106

countries are small, and that only constant returns to scale prevail, the sole effect oftrade volume is improved national welfare. That is the “trade volume effect”12.
The trade volume effect is defined as the sum of tariff wedges multiplied by changes intrade volume caused by the reduction of tariffs and other non-tariff measures (NTMs).
As Meade (1955) demonstrates, the welfare of a country improves if the tariff-weighted
change in the country’s trade volume is positive. This effect is related to the famous
literature of Viner (1950) in which he divides the effects of regional trade liberalization— typically taking the form of an FTA — into two types: trade creation and trade
diversion effects. The sum of the two effects produces mixed results. The trade
diversion effect reduces imports from non-FTA nations while the trade creation effectincreases total imports from both FTA and non-FTA countries.13 Trade diversion
results from discriminatory tariff reduction that causes private agents to import goods
from a supplier that is not the lowest cost source. Effectively this means that theimporting country government is subsidizing the exports of the FTA partner.
If bilateral tariffs are reduced only on imports from countries that are already thelowest-cost supplier, trade diversion does not occur. FTAs are likely to be beneficial if
the FTA partners initially account for large shares of each other’s imports, as would be
the case if they were low cost suppliers. In the cases of FTAs between East Asian
countries, the countries account for large shares of their trade partners’ imports, so thatthe trade diversion effects may be small.
2.3 The Medium-term Effects of Trade Liberalization:
Accumulation

FDI and Capital

Trade liberalization will affect growth if it changes the return on investment in capital— including human and knowledge capital — due to the accumulation effect of
spurring capital formation. According to Baldwin and Venables (1995), the change
may be transient if increased accumulation reduces the return to the accumulated stock
or it may be permanent if diminishing returns to accumulation are not encountered.
In the case of NAFTA, and as many in Mexico had hoped, a surge of foreign investment
was attracted to that country as the agreement became a reality. In the more recent
1213

For a more formal analysis, see Appendix 1.
According to Kowlczyk (1992), there are many other definitions of trade creation and diversion.
7

case of China, WTO accession accompanied by massive trade liberalization was
followed by a kind of direct investment boom from Japan and South Korea. China hasrecently declared its intention of entering into FTAs with other Asian economies,
perhaps for the purpose of drawing FDI as well as ensuring external markets to maintaingrowth. Trade liberalization and promotion of FDI are a set of strategies bydeveloping countries for pursuing outward oriented policies.
Trade liberalization will usually affect factor productivity and, therefore, factor prices,
including the rate of return on capital. When trade liberalization increases the demandfor capital in FTA member countries, this will stimulate an inflow of investment from
non-FTA countries under the assumption of perfect international capital mobility.
These capital flows will raise GDP in the trading partners through higher savings andinvestment rates, and lower it elsewhere.
According to Baldwin (1989; 1992), the improved efficiency brought about by tradeliberalization raises the rates of return of domestic capital stock. This makes domestic
investment more attractive and draws in foreign capital, some of which may be FDI.
The static efficiency effects will themselves increase welfare; but if the capital inflow isalso taken into account, the total welfare gain becomes even larger. A multiplier, theratio of total gain to static gain14, can describe the magnitude of these changes.
2.4

Empirical Studies on Trade Openness and Long-term Growth

A standard approach to estimating dynamic impact of trade openness on growth is to
assume a growth function and adopt econometric methods to estimate the function. A
study by Barro (1991) first provided an empirical estimate for the growth function of
per capita income and gave an empirical foundation to the convergence hypothesis15.
Subsequently, many studies confirmed empirical linkages between long-term growth
rates and a variety of political, institutional and economic policy indicators.

14

In the case of the EU this multiplier, takes the empirical values of 1.2 – 2.4 In the case of APEC
trade liberalization, this multiplier was estimated at approximately 3.5 (APEC Economic Committee(1997)).
15
Convergence in neoclassical growth theory applies when the growth rate of an economy ispositively related to the difference between the economy’s income level and its own “steadystate”. Absolute convergence, one of the two major definitions of convergence, means that poor
economies tend to grow faster than rich ones.

8Overall, a policy of trade openness will stimulate domestic investment and induce
policy improvements, leading to higher per capita GDP; a process called“convergence”16. The implication is that the governments of developing countries
should willingly open their trade in order to accelerate growth in their economies.
Multilateral and bilateral trade negotiations provide opportunities for them toaccomplish this while ensuring the market openness of their trading counterparts.
2.5

Trade Liberalization and Income Inequality between Trading Partners

In addition to increasing national income, achieving fair income distribution — or morenarrowly, reducing poverty — is an important purpose of economic development. In
this regard, there is concern at the potential posed by trade liberalization to widen
income inequality between trading partners. This is one of the concerns raised by antiglobalization activists.
In a perfectly competitive environment, lower trade barriers will reduce factor pricedifferences on average, as was proved in the “factor price equalization theorem”. Aslong as the countries’ endowments lie inside the same cone of diversification, economic
integration will equalize factor prices in the long run. For example, China and Japan
have widely differing endowments, but the integration of their economies will
eventually increase internationally traded goods and factors, which will increase the sizeof the cones of diversifications. Actually, average real wages in China have been
increasing rapidly, while those in Japan have somewhat declined.
However, if the “small country assumption”17 is inapplicable to one or both of the
trading partners, trade liberalization may aggravate their terms of trade and worsen theirlevels of welfare. This is the reason why some countries may fear that lowering theirtariffs will bring more imports at inflated prices.
Currently, among some economists, a dynamic location effect is causing concern about
widening income disparity between trading partners. Economic geography often
assumes imperfect competition and scale economies, which may imply undesirable
outcomes. Scale economies and economies of agglomeration mean that firms will not
distribute productive capacity evenly throughout a country or region; rather, the location
16
17

See Appendix 2 for an example the author undertook for the APEC Economic Committee (1999).
This assumes that a volume of trade may be so small that it does not affect world prices.
9decision of a firm will depend on the balance between production costs and trade costs.
This balance is dynamic and it changes as trade barriers are reduced but it is possiblethat industry will be drawn to high wage locations, increasing wage differentials
between trading partners. Large regional free trade areas, such as the EU and NAFTA,
take this problem quite seriously because the location effect affects their wider regions.
In the context of coherence between trade and development assistance policies, theeconomic effects of NAFTA on Mexico are relevant. A recent comprehensive study
by the World Bank (2003) concluded that NAFTA has helped Mexico approach thedevelopment levels of its NAFTA partners, the US and Canada. The research suggests,
for example, that Mexico’s global exports would have been about 25% lower without
NAFTA and that FDI would have been about 40% less. Also, the amount of timerequired for Mexican manufacturers to adopt US technological innovations was cut in
half. This underscores the importance of FDI and technology transfers between
trading partners. Regional trade liberalization may most effectively further thedevelopment of the lower income trade partners when improvement in the tradeenvironment stimulates FDI along with technology transfers.
2.6

Trade Liberalization and Domestic Income Disparity

Another serious concern about trade liberalization has been its potential for widening
domestic income disparity within both (or all) trading partners; although this may apply
mainly to the more advanced ones. Under the standard classical trade model, unskilledlabor in the advanced country will experience mainly a negative effect on real wages.
A more dynamic North-South model with innovation and monopoly (Krugman 1979)
implies that technology transfer — perhaps caused by trade and investment
liberalization — leads to reduced rents paid to unskilled workers in the more innovative
country.
By contrast, in a developing country such theories suggest trade liberalization
contributes to an increase in real wages among both skilled and unskilled labor. In thecase of NAFTA, trade probably deserves some credit for moderate declines in Mexican
poverty and likely has had a positive impact on the number and quality of Mexican jobs
(World Bank (2003)). Technical progress and increased GDP brought about theincrease in real wages and the national poverty rate seems to closely follow theirevolution.

10

Trade liberalization may also create adverse effects, increasing geographic income
disparity and aggravating poverty in the short- and medium-run. China’s WTO
accession recorded the most successful case of development in an economy. However,
one important byproduct has been a sharp widening of rural-urban income disparity as
well as geographical income disparity. This reflects the fact that the tradeliberalization under WTO attracted FDI inflows mainly to coastal cities, where
extremely rapid technical progress took place in manufacturing sectors. The benefits
did not extend to rural agricultural areas. Rural farmers constitute the major portion of
the impoverished in China and their situation deteriorated in some cases because theirnominal income was fixed by regulation while the general price level was allowed toinflate. Recently, the Chinese government has adopted more rural-friendly policies,
increasing the relative prices of agricultural products and the budget expenditures onrural health and education.
Sectoral and social policies such as these may be appropriately and effectively
implemented with development assistance. Development assistance policies may
provide measures to remediate adverse effect on income disparity. Trade andinvestment liberalization policies can effectively improve economic efficiency andnational income as a whole, but income disparity issues can more appropriately beallocated to the sectoral and social policies addressed by development assistance.

3.

Japan’s Trade Policy

3.1

Trends in World Trade Policy

In spite of serious concerns in terms of environmental and cultural sustainability, tradeliberalization or “globalization” is a major trend in the world economy. On themultilateral front, the WTO is seeking to conclude a new round of negotiations. The
developing countries have tended to argue for continued protection for their industrial
sectors through higher tariffs. Protection is also a major issue for the agriculture sector.
Japan and South Korea, among others18, have tended to be protectionist toward theiragricultural products19. The Uruguay Round of trade negotiations (which created the18

Both Japan and South Korea are members of the Group of 10 net agricultural importing countries
The import tariff rates of agriculture goods of Japan and Korea are well above average in theworld. For example, the tariff rates for rice of these countries are around 400 percent. This contrasts
in a striking way with their low tariff rates for industrial goods.
1911WTO) tried to achieve greater agriculture sector liberalization, but the eventualcommitments — incorporating various compromises and exemptions — reflect the
many arguments raised by protectionist interests. After the failed attempt in Seattle inlate 1999, the WTO Ministerial Meeting in Doha in November 2001 launched anagenda for a new comprehensive round of multilateral trade negotiations thatemphasizes development, named the “Doha Development Agenda” (DDA).
On the bilateral and regional fronts FTAs are spreading rapidly throughout the world.
At present, a significant proportion of world trade is conducted under the rules ofregional integration agreements, notably the two mega-blocs of EU and NAFTA, which
are continuing to expand their memberships. Historically, East Asia, including Japan,
focused multilaterally on trade liberalization under the GATT/WTO regime. Regional
integration arrangements — such as the ASEAN Free Trade Area (AFTA), establishedin 1992 with the objective of realizing free trade area in ASEAN by the year 2008 —were the exception. However, this traditional approach shifted around the year 2000
toward a “two-track” approach which gave increased emphasis to regional agreements.
This is evident in the Framework Agreement on ASEAN China Comprehensive
Economic Cooperation, signed in November 2002; in the effort to conclude an East
Asia–wide free trade agreement; in a recent proposal by Japan for an ASEAN+J free
trade agreement; and in bilateral agreements under negotiation, in particular by Japan,
Singapore, South Korea, and Thailand. Except for China and some ASEAN countries,
almost all the natural FTA/EPA counterparts of Japan are developed, industrialized or
wealthy countries.
3.2

Shift of Japan’s Trade Policy: From Multilateralism to Regionalism

Until 2000, the Japanese government espoused the strategy of liberalizing trade throughthe open multilateral system, namely GATT and its successor WTO. However, in 2000,
several years after the United States approved the North American Free Trade
Agreement (NAFTA), Japan’s trade strategy became more ambiguous and began
switching to a two-track approach. The Japan-Singapore Economic Partnership
Agreement (JSEPA), Japan's first FTA, became effective in November 2002. The
Japanese government promulgated the basic principles of FTA/EPA in December 2004
(Decision by Ministers Meeting to Promote Economic Partnership Agreements (2004)).
Japan’s shift in basic strategy was reflected in a worldwide trend toward regionalism.

12Japan made the shift in its approach out of intense concern regarding trade andinvestment diversion in Europe and North America. FTAs are exclusive, favoringsignatories only with negotiated (zero) tariffs. To reiterate Viner’s analysis of the tradecreation and trade diversion effects of regional trade arrangements (discussed above),
the trade diversion effects of an FTA reduce imports from non-FTA nations while thetrade creation effects increase the sum of imports from both FTA and non-FTA countries20.
Trade diversion invariably reduces the welfare of non-FTA countries by raising the costto them of consuming such goods. Regional trade arrangements also will lead to more
FDI activity in the region. As a result, FTA non-members will be at serious
disadvantage.21 This was the Japanese concern.
3.3Japan’s FTA/EPA Policies Were Development- Neutral

In the context of coherence with development assistance, the Japanese government’s
FTA/EPA policies appear to have been adopted in the absence of analytic input about
their impact on the trading partners. EPA principles mainly emphasize the politicaland economic benefits to Japan. The Decision of the Ministers to Promote EPA (2004)
contains no reference to development of the FTA/EPA partner. Trade negotiations
assume no provision for favoring the counterpart. And in principle, in the absence ofinternational guidelines, each party to the FTA/EPA may consider only its own interest.
While ostensibly an FTA accord confers favor on the signatories, in reality the countries
tend to seek their own benefits.
Nonetheless, and despite apparent indifference to development, Japan's trade andinvestment activity in developing countries, particularly those in East Asia, hashistorically promoted their industrialization. Japan’s trade liberalization in 1980s and1990s — both multilateral and unilateral — helped establish international production
networks in East Asia, as detailed above in the first section of this paper. This, in asense, demonstrated de facto coherence between trade policy and the development pathof the trading partners.
In the context of current WTO multilateral negotiations, the Japanese government isofficially paying attention to the interests of developing countries as a group. The
20

According to Kowlczyk (1992), there are many other definitions of trade creation and diversion.
In addition to this economic effect, enterprises whose country does not have an FTA
relationship with its trading partner sometimes suffer from discriminatory treatments ingovernment procurements, etc.

21

13

Doha Development Agenda explicitly attends to development, mandating that theindustrialized countries accept the principle that the developing countries will benefit
from the eventual agreement. The definition of “benefit” may differ among thedifferent perspectives. “Benefit” to a county may refer to maintaining protection
through high tariffs even though empirical studies show that protectionism poses an
obstacle to development rather than a benefit to the country.
3.4

East Asia Is Japan’s Priority for Trade and Investment

In terms of regions, the Japanese government has placed the greatest importance on
trade and investment with East Asia. As shown above, historically Japanesemultinational firms looking for bases for their production networks have preferred thecountries of ASEAN. Recently, China and Japan appear to be competing in offering toestablish FTAs with ASEAN members.
Japanese trade policies have placed considerably less importance on Africa and South
Asia. The Japanese government has no serious plans to establish FTAs with countries
in these regions in the short- or medium-run. However, in terms of development
assistance focus, Africa and South Asia have become the most important geographic
areas in the world.

4.

Quantitative Analysis of the Impact of Trade Policies on Developing Countries

This section explores the impact of six trade liberalization scenarios using a computable
general equilibrium (CGE) model as a simulation framework.22 The simulation allows
us to examine the benefits and disadvantages of trade liberalization for the economies ofdevelopment countries. The Global Trade Analysis Project (GTAP) at Purdue
University in the United States provides a standard international database for the CGE
model whose latest version is version 6-beta. The simulations focus on assessing thesectoral impacts on developing countries. See Appendix 3 for country/sector
classification in detail.

22

There are other approaches to quantify the relations between trade liberalization and poverty,
including cross-country regression, partial equilibrium/cost of living analysis, and the
combination of CGE and partial equilibrium analyses (see Reimer, J. (2002)).
14

4.1

Model Structure and Simulation Methodology

The CGE model is essentially an application of neoclassical economic theory and, in
its international trade dimension, of classical trade theory. A CGE model consists ofequations that represent demand and supply conditions of sectors of the economies.
The industrial sectors are explicitly linked together in value-added chains from primary
goods, through higher stages of processing, to the final assembly of consumer goods forhouseholds and governments. The sectors in the model are linked through various
economy-wide constraints. For example, because firms in different sectors compete
for a limited supply of labor, capital and land, an expansion in one sector will beaccompanied by a contraction in another sector, except when the expansion is the resultof resource accumulation or technological improvements that economize on the use ofresources.
Reflecting the nature of the classical framework, competition and resource allocation
are adjusted through the flexible movement of relative prices. Unemployment rates
are assumed to be constant, as the model reflects the changes between two equilibrium
states in each of which the unemployment rate would be at its “natural” level. Because
the main interest of the project is international trade, the CGE model used here includes
multiple countries and allows for linkage between the countries. While in principle achange in one part of the world economy has repercussions throughout, the effects
normally are greatest in the sector and economy where the policy change or shock is
initiated. The effects then spread through linkages to adjacent sectors at home and into
the markets of trading partners.
The policy measures to simulate are quantified as “shocks” applied to the model.
Generally, a model simulation requires a pair of inputs: the baseline data and the control
data reflecting the impacts of the shock. Each data set is fed to a model and, based oneach input, the model feeds back an output; for example, income, exports and imports,
welfare levels and production on a macroeconomic and sectoral base. The final result— i.e. the impact of the shock — is obtained by taking the differences between the two
hypothetical model outputs. Chart 1 illustrates a model simulation.

15

Chart 1: Conceptual Illustration of a Model Simulation

Welfare,etc.
Simulated
ImpactControlled
Baseline

Shock appliedtime

The model specification is the Baldwin type dynamic model that incorporates a capital
accumulation process. Trade liberalization will usually affect factor productivity andthe rate of return on capital. When trade liberalization raises the demand for capital in
FTA member countries, this will stimulate an inflow of investment from non-FTA
member countries — assuming perfect international capital mobility. These capital
flows will raise GDP through higher savings and investment rates in the trading partners
and lower it elsewhere.
4.2

Simulation Scenarios and Model Specifications

This section examines the possible impact of Japanese trade policies on the economies
of development countries. Our CGE simulation may provide us with rough estimatesof the effects of various hypothetical trade policy agenda on the sector base. Ourpolicy scenarios include the following six:
i).
ii).

(Scenario I) The programmed trade policy agenda for the next few years,
represented by Japan’s FTA with ASEAN5 countries — ASEAN5+J.
(Scenario II) Reflecting the medium-term target of its FTA policy, Japanestablishes an FTA with ASEAN5 plus China and South Korea — ASEAN5+3.

16iii).

iv).

v).

vi).

(Scenario III) As an extreme hypothetical case, Japan grants most-favored status
to all developing countries, opening up all sectors including agricultural andprocessed food sectors by eliminating unilaterally all the import tariffs for thedeveloping countries.
(Scenario IV) As an extension of the former scenario, all the developing countries
also eliminate their import tariffs to Japan. In other words, Japan establishes an
FTA with all developing countries.
(Scenario V) In a variation on Scenario III, the EU and NAFTA members andJapan open up all sectors by eliminating unilaterally all import tariffs for thedeveloping countries.
(Scenario VI) In a variation on Scenario IV, the EU and NAFTA members andJapan establish an FTA with all developing countries.

In all the simulation scenarios described above, the exogenous shocks to the model are
the lowering of the import tariff protection levels to zero. We aggregate the dataset
into 22 regions multiplied by 23 sectors (see Appendix 2)23. Because we focus on theeffects of trade policies on developing countries, as many developing regions as
possible are disaggregated.
According to a number of analyses, trade liberalization will be the most effective instimulating growth if it is accompanied by active FDI inflows. As mentioned above,
we adopt the Baldwin dynamic specification that incorporates the medium-term capital
accumulation effects of trade liberalization. This specification partially simulates themechanism by which trade liberalization in the economy improves efficiency and draws
FDI and other capital inflows.
4.3

Simulation Results – Scenarios I and II

In trade policy simulations, the change in economic welfare — usually measured byequivalent variation (EV) — represents one of the most important macroeconomic
indicators of impact. EV is expressed in terms of nominal incomes denominated in US
dollars, showing how much money the people could expect to obtain from the policychanges. In addition to the EV, changes in real production and real exports also
represent important indicators.
Gross Domestic Product (GDP) represents
macroeconomic real production. Sector base changes in real production have an
23

The original dataset of GTAP version 6-beta consists of 87 regions and 57 sectors.
17

important implication, particularly in the context of industrial adjustment that might benecessary in developing countries who have an abundance of unskilled labor andlimited mobility between sectors.
Table 5: Welfare Gains from Various Combinations of FTAs
EV (million US$), GDP (percent)

A5+J
All Items

A5+J
Without Grains

A5+CJKAll Items

A5+CJK
Without
Grains
EV
GDP
9385
1.4
11557
0.2
10600
2.9
-2649
-0.4
3775
2.7
3844
5.2
1365
2.5
2695
2.5
11981
12.3
-295
-0.7
-6
0.0
-423
0.0
-280
-0.1
215
0.0
-2640
0.0
186
0.0
-1205
0.0
-28
0.0
-47
-0.1
94
0.0
-4
0.0
-2249
-0.1
45871
--

EV
GDP
EV
GDP
EV
GDP
CHN
-413
0.0
-505
0.0
9062
1.3
JPN
3491
0.1
2882
0.1
12565
0.3
KOR
-262
0.0
-349
0.0
19274
5.6
XEA
-38
0.0
-132
0.0
-2498 -0.3
IDN
2578
1.9
2547
1.8
3817
2.7
MYS
3772
3.9
2707
4.1
4827
4.9
PHL
1218
2.1
1176
2.1
1403
2.5
SGP
1561
1.6
1634
1.6
2605
2.5
THA
9439
9.6
9438
9.6
11738 11.7
VNM
-33
0.0
-35 -0.1-333 -0.8
XSEA
137
0.2
121
0.2
15
0.1
IND
116
0.1
85
0.0
-379
0.0
XSAS
38
0.1
33
0.0
-259 -0.1
CAN
272
0.1
230
0.0
217
0.0
USA
3031
0.0
1981
0.0
-1529
0.0
MEX
740
0.1
512
0.1
520
0.1
EU15
3413
0.1
2403
0.1
181
0.0
SACU
14
0.0
16
0.0
-41
0.0
SADC
28
0.1
19
0.0
-57 -0.1
NAFK
123
0.1
101
0.0
110
0.0
XSSA
7
0.0
2
0.0
-1
0.0
XRW
1572
0.0
1011
0.0
-1853 -0.1
World
30804
-25877-59384-(Source) Author’s simulation, using GTAP version 6-beta and GEMPACK.
1. See Appendix 3 for the abbreviation of the country/regions.
2. “All Items” indicates that the tariffs on all the imported items are eliminated under the FTA.
“Without Grains” indicates that the tariffs on imported grains are not eliminated.

We first conduct simulations under Scenarios I and II. At present, they are on thepolitical agenda in the ASEAN5+3 process. Theoretically, an FTA will raise national
welfare in all the FTA members because of the trade creation effect. The removal ofbias allows the economies to expand trade volume and to use limited domestic resources
more efficiently. However, negative trade diversion effects may possibly emerge in
non-FTA member countries. Table 5 below summarizes the simulation result, showing

18

the welfare gain for each country/region in terms of equivalent variation (EV) andchange in macroeconomic production in terms of GDP.
As already mentioned, an FTA generally accords welfare and production increases to all
the members. ASEAN5+J (Scenario I) would increase the EV of all the membesr by
US$ 1bn –9bn, the US$ 9bn benefit going to Thailand. If the FTA is expanded toinclude China and South Korea, establishing an ASEAN5+3 FTA (Scenario II), thewelfare gains would increase. The result would be similar in cases where grains havebeen exempted from the list of tariff to be eliminated under the FTA. This exemption
will reduce welfare gains for countries with higher protection for grains, Japan inparticular.
In the case of an ASEAN5+J FTA (Scenario I), the welfare of non-FTA-member
countries would also increase because the trade volume effect is favorable fornon-members; however, China and South Korea, the countries having the closest traderelations with Japan, are exceptions to this. An ASEAN5+3 FTA (Scenario II) on theother hand, would create negative impacts on many non-member countries, particularly
the United States, because the combination of Japan and China would result in a strong
division of labor, and a very strong trade diversion effect would emerge for non-member
countries. In addition, most developing countries, as well as the world economy as awhole, would experience a reduction in welfare because of the trade diversion effects ofan ASEAN5+3 FTA (Scenario II).
The simulated impact on sectors clearly illustrates the effects of FTAs on the economies
of developing countries. Table 6 below indicates the percentage change in the real
production of the industrial sectors of the countries under Scenario II (ASEAN5+3
FTA). Among the FTA members, the competitive industries of each country tend to
expand, while the weak, protected sectors tend to shrink. It is interesting that thedeveloping member countries foresee expansion of some assembly manufactures,
including transportation equipment (TRN), electronic equipment (ELE) and otherequipment (OME). The expansion of these manufacturing sectors reflects anticipated
FDI inflows. Although not reflected in the simulation, inflows of FDI in these sectors
usually accompany technological progress, which ensures sustainable dynamic growth.
We may conclude that the FTA under Scenario II will bring about development in themember countries.

19

Table 6: Sector-base Impacts on Industrial Real Output of ASEAN5+3 FTA (selected countries)(Percentage Change)
GRN
AGR
FRS
FSH
MIN
PFD
TEX
APP
PPP
CHM
MTL
TRN
ELE
OME
OMF
EGW
CNS
TRD
TRS
CMN
FIN
OSP
OSG
GDP

CHN JPN KOR IDN MYS PHL SGP THA VNM IND XSAS CAN USA EU15 SACU SADC NAFK XSSA XRW
12.4 -10.0 -80.8
1.6 204.5 -3.0 16.2 17.6
-1.6 -0.1-0.1-0.9 -2.7
-0.3
-3.6
-0.2
-0.3
-0.3
-0.6
1.5 -1.2 13.5 -0.2 -36.2
3.6 -0.9 -0.7
1.0 -0.1-0.1-0.5 -0.4
-0.1
-0.1
0.0
-0.1
0.2
-0.2
-0.2 -0.5
4.9
5.3
2.4
2.7 -0.9
8.0
0.3
0.2
-0.1
0.0
0.2
0.1
0.1
0.0
0.1
0.0
0.3
0.7 -0.5
8.5
2.2
2.6
1.4
0.9
5.7
-0.9 -0.1
-0.1
-0.2
0.0
0.0
-0.2
-0.1
0.0
0.0
-0.1
0.2
0.0
-2.6
0.8
1.3
1.8
2.0
3.4
0.7
0.5
0.7
0.3
0.3
0.4
0.4
0.3
0.3
0.4
0.4
1.9 -1.9 43.1
2.8 12.0 -0.3 21.0
7.8
-2.2 -0.5-0.3-0.7 -0.3
-0.3
-0.6
-0.3
-0.2
-0.4
-0.6
-3.3 13.4 31.8
4.8 40.3
2.0
5.3
4.4
-7.1 -0.8-1.7-1.8 -0.7
-1.7
-0.8
-1.2
-1.0
-1.6
-1.0
6.5 -6.4 20.6
0.4 21.6
9.5 -3.6
9.3-3.9 -0.5
0.1-0.8 -0.5
-1.5
-1.4
-1.1
-0.7
-1.2
-0.7
-0.9 -0.1
6.3
6.9
5.1
3.0
2.8
9.7
0.6
0.2
0.3
-0.1
0.0
0.0
0.0
-0.1
0.0
-0.2
-0.1
-2.5
1.3
7.3
5.8
9.5
4.3
8.1 20.6-1.4 -0.2
0.0
-0.5
0.0
0.0
-0.2
-0.2
-0.4
-0.1
-0.5
0.5
1.9
1.6
3.1
5.2
3.5
7.7 13.0
-0.2
0.3
0.4
0.1
0.2
0.0
0.1
-0.6
-0.1
0.1
-0.3
-4.9
1.6
-1.8 -0.9
3.2 26.2 -9.0 11.1
-0.3
0.2
0.8
0.7
0.2
0.2
0.7
1.4
0.3
0.6
0.0
11.6 -1.5
0.8
7.6
2.6
2.3
2.4 28.5
1.3
0.3
-0.8
-1.1 -0.4
-0.8
0.0
-0.6
-1.0
-0.8
-0.4
-0.7
2.3
-1.2
9.9 15.0 13.5 13.1 27.2
0.5
0.3
0.7
0.3
0.2
-0.2
0.1
-0.1
0.0
-0.5
0.0
0.5
0.0
6.6 -1.5
7.7
2.5
1.4
8.6
-0.5
0.3
0.5
-0.3
0.0
-0.1
-1.0
-0.2
-0.3
-0.3
-0.1
0.1
0.5
5.9
3.3
6.3
3.0
4.2 11.3
-1.3
0.0
-0.4
0.0
0.0
0.0
-0.1
-0.2
0.0
-0.1
-0.2
2.9
0.5
7.9
4.3
5.7
3.9
4.5 17.4
-1.2
0.0
-0.3
0.1
0.0
0.1
-0.1
-0.2
0.0
0.0
-0.1
0.5
0.2
6.3
3.4
1.5
3.0
1.7 12.9
-0.2
0.0
-0.1
0.0
0.0
0.1
0.0
-0.1
0.0
0.0
0.0
0.7
0.0
0.5
3.1
3.2
2.6
0.5
8.1
0.6
0.1
0.1
0.2
0.2
0.6
0.2
0.1
0.3
0.2
0.4
0.8
0.1
3.6
3.0
1.7
1.8
1.9 11.3
0.7
0.0
0.2
0.1
0.0
0.1
0.0
-0.1
0.1
0.0
0.0
0.4
0.1
3.7
2.5
4.3
2.7
0.0 11.9
1.4
0.0
0.1
0.1
0.0
0.1
0.1
-0.1
0.0
-0.1
0.0
0.9
0.2
4.4
2.3
0.8
2.4 -0.6
8.9
-0.8
0.2
-0.1
0.1
0.0
0.1
0.0
0.0
0.1
0.0
0.0
0.6
0.1
1.9
1.0
2.9
1.1
2.1
4.6
0.0
0.0
0.0
0.1
0.0
0.0
0.0
0.0
0.1
0.0
0.0
1.3
0.3
5.6
2.7
4.9
2.5
2.5 11.7
-0.8
0.0
-0.1
0.0
0.0
0.0
0.0
-0.1
0.0
0.0
-0.1

(Note) Simulation by author using GTAP 6.0-beta.
See Appendix 3 for sector abbreviations.

20

By contrast, non-FTA-member developing countries, such as Vietnam (VNM), India(IND), other South Asian countries (XSAS) and African countries, will suffer reduced
production in several labor-intensive sectors, such as processed food (PFD), textile(TEX) and apparel (APP). The reduced production reflects the trade diversion effectand the resulting dislocation of labor in the adversely affected sectors. Whiletheoretically the abandoned workers are to be absorbed in other sectors over the longrun, they may be unemployed for some time. Generally in developing economies,
mobility of unskilled labor is limited, and the adjustment process may be serious andpainful.
ODA may work as a complementary measure to mitigate the adverse effects of trade
policies if the government of Japan recognizes the situation. Japan’s ODA can support
the industrial adjustment process by, for example, assisting with job training services forworkers in the adversely effected sectors and improving industrial infrastructure for theother more hopeful sectors.
4.4

Simulation Results – Scenarios III, IV, V and VI

What would happen if the industrialized countries were to grant most favored status toall developing countries by unilaterally opening up all sectors to them? The following
five scenarios (Scenarios III-a, III-b,, IV, V and VI) are based on two: (i) the group ofindustrial countries which open their trade includes either Japan only, or Japan plus the
EU and NAFTA; and, (ii) either the industrialized countries unilaterally open their tradeor they establishes FTAs with all the developing countries. The two version of
Scenario III assume either that Japan unilaterally opens only agricultural goods andprocessed foods markets (Scenario III-a) or that Japan unilateral liberalizes all traded
goods from developing countries (Scenario III-b).
Table 7 summarizes the impacts of the five scenarios in terms of the national welfare.
In Scenarios III-a and III-b, most of the developing countries receive welfare gains fromJapan’s unilateral actions. Scenario III-a — trade liberalization of agricultural goods
and processed food — increases the welfare of most ASEAN developing countries.
China, however, gains much less under Scenario III-a than under Scenario III-b becauseof the large decrease in Japan’s tariff rates for textiles, apparel and other labor-intensive
manufactured goods under Scenario III-b. The welfare gains are almost identicalbetween two scenarios for Malaysia (MYS), Thailand (THA) and the Southern African

21

Customs Union (SACU), where most of the benefits come from Japan’s liberalization ofagricultural products. These result suggest that Japan’s trade liberalization inagricultural goods and processed foods would have relatively greater impact on the highand middle income countries, such as Thailand, US, EU, and China, but rather limited
impact on the low income countries of South Asia and most African countries..
Table 7: Welfare Gains from Various Scenarios
EV (million US$), GDP (percent)Scenario III–a
Scenario III–b
Scenario IV
Scenario V
Scenario VI
EV
GDP
EV
GDP
EV
GDP
EV
GDP
EV
GDP
CHN
787
0.0
2249
0.1
3438
0.7 12576
0.7 20480
2.5
JPN
-884
0.0 -1454
0.1 18621
0.3
332
0.1
9768
0.1
KOR
70
0.0
25
0.0 -2608
-0.5
337
0.2
-5032
-1.0
XEA
263
0.1
472
0.1
-994
0.1
5174
0.8
3261
0.8
IDN
94
0.1
315
0.2
593
0.6
2818
1.8
2486
1.9
MYS
926
-0.2
991
-0.1
1534
1.1
1732
0.4
2682
2.7
PHL
80
0.1
173
0.2
-163
0.1
1725
2.4
1156
2.2
SGP
-85
0.0
-79
0.0
-748
-0.6
-74
0.1
-1412
-1.3
THA
2602
1.5
2718
1.6
5431
5.5
6026
4.0 10543
10.8
VNM
59
0.1
202
0.5
41
1.0
1240
3.0
828
3.5
XSEA
-24
-0.1
-33
-0.1
-7
0.0
1024
1.3
774
1.0
IND
138
0.0
197
0.0
329
0.3
2443
0.4
6708
2.3
XSAS
58
0.1
69
0.1
510
0.7
1711
1.0
2297
2.1
CAN
109
0.0
131
0.0
-91
0.0
493
0.1
-470
-0.1
USA
2219
0.0
2292
0.0 -4317
0.0
5340
0.1
-1773
-0.1
MEX
605
0.1
679
0.1
20
0.0
415
0.1
-5430
-0.9
EU15
2510
0.0
2445
0.0 -3553
0.0
6209
0.2
6363
0.0
SACU
634
0.4
651
0.4
649
0.5
1623
1.1
1717
1.7
SADC
-8
0.0
11
0.0
-5
0.1
1396
2.6
1802
4.8
NAFK
75
0.0
88
0.0
4317
2.3
562
0.2
5866
4.4
XSSA
5
0.0
6
0.0
-2
0.0
61
0.5
33
0.5
XRW
1408
0.0
1695
0.1 -3949-0.1
2983
0.1 -18762
-0.5
Total
11643
0.0 13843-- 19047-- 56146-- 43885-(Source) Simulation by the author using GTAP version6-beta.
1. (Scenario III--a) Japan eliminate all import tariffs on agricultural goods and processed foodsfrom developing countries;
2. (Scenario III-b) Japan eliminates unilaterally all tariffs on all imports from developing
countries;
3. (Scenario IV) Japan establishes an FTA with each developing country;
4. (Scenario V) The EU and NAFTA members, as well as Japan eliminate unilaterally all thetariffs to the imports from the developing countries.
5. (Scenario VI) The EU and NAFTA members, as well as Japan, establish an FTA with eachdeveloping country.

Under Scenario IV, the world EV increases substantially, because all developing
countries eliminate their own tariffs on imports from Japan. Trade volume between
Japan and the developing countries naturally increases due to the trade volume effect,22although some the developing countries imports are diverted to Japan. Overall, thepositive trade volume effect outweighs the negative trade diversion effect. However,Japan receives most of the world welfare increase between Scenario(s) III and Scenario
IV. Because of the trade diversion, Korea, Singapore, the United States and the EU15
all suffer under the Japan-Developing-Country-FTA,.
In Scenario V, the EU15 and NAFTA join Japan in unilaterally eliminating their tariffs
on the imports from all developing countries. This case reveals the most fortunate
outcome, almost all the countries gain in welfare and in real production. Scenario VI— large scale FTAs — on the other hand, brings about massive trade diversion resulting
in reduced world welfare and loss of welfare and real production in most non-member
industrialized countries. The simulation indicates that regional trade liberalization onsuch a large scale would be a poor approach. Multilateral liberalization involving all
countries would better achieve world-wide trade liberalization without producing
massive and negative trade diversion effects.

5. Conclusion and Policy Recommendations
5.1

Conclusion

In the context of coherence between development assistance and FTA/EPA policies, theJapanese government has paid little attention to the effects of its trade agreements on thedevelopment of its trading partners. While FTAs accord de facto favor to member
countries, countries tend to seek their own benefits under the agreements. In addition,
almost all the feasible FTA/EPA counterparts for Japan are developed, industrialized or
wealthy countries, the only exceptions being China and some ASEAN states. Despite
this inattention, historically Japan’s trade and investment with developing countries —particularly in East Asia — has promoted their industrialization. Japan’s tradeliberalization in 1980s and 1990s, both multilateral and unilateral, helped establish
international production networks in East Asia. Market-driven economic integration
contributed to the industrialization of East Asia, including ASEAN5 and China. In thissense, Japan’s trade policy has inadvertently been coherent and consistent with thedevelopment of her trading partners.

23

The geographic priority region of Japan’s ODA policy — East Asia — was selected atleast partly for economic considerations. Japanese trade policies have placed lessimportance on African and South Asian countries and the Japanese government has noplan to establish FTAs with these countries in the short- or medium-run. Nonetheless,
Africa and South Asia have become the most important geographic areas fordevelopment assistance. For the Japanese government to implement coherent policies
so that trade reinforces aid, efforts should be taken to increase trade and investment inthese regions. If there are insurmountable obstacles to this, .Japan might consider
boosting ODA activity in those two areas. On the multi-lateral front, Japan might
consider promoting coherence in conjunction with the Doha Development Agenda.
According to empirical studies, trade and investment openness contribute to long-term
economic growth. Trade and investment liberalization in developing countries
improves efficiency in resource allocation and attracts domestic investment and foreign
direct investment (FDI). As clearly seen recently in the Chinese economy, FDI
inflows can stimulate technological progress markedly.
However, as the present study shows, trade diversion effects are also important. The
simulation results suggest that an FTA between Japan and ASEAN5 (ASEAN5+J) andbetween Japan-China-South Korea and ASEAN5 (ASEAN5+3) generally accord
welfare and production increases to all the FTA members. However, in the case of theASEAN5+3 FTA, most developing countries outside the FTA as well as the world
economy would lose welfare because of the trade diversion effects.
On a sector basis, under the ASEAN5+3 FTA, developing member countries would see
expansion of some assembly manufactures. The expansion of these manufacturingsectors reflects anticipated inflows of FDI. Although not reflected in the simulation,
inflows of FDI to these sectors usually accompanies technological progress, thereby
ensuring sustainable dynamic growth. The FTA ASEAN5+3 will bring aboutdevelopment of the member countries but non-FTA-member developing countries will
suffer a reduction of production in several labor-intensive sectors. The government ofJapan should be aware of possible adverse outcomes and impacts on the economies ofdeveloping countries from its trade policies. ODA may work as a complementary tool
to mitigate adverse trade policy effects. Japan’s ODA can support the industrial
adjustment process by, for example, assisting with job training services to workers in
the adversely effected sectors and improving industrial infrastructure in other more24

hopeful sectors.
Moreover, under a hypothetical scenario in which Japan unilaterally eliminates tariffs onimports from developing countries, all developing countries obtain welfare gains. The
benefits accruing to developing countries will expand further if EU and NAFTA
members join and eliminate their tariffs. This serves to remind us of the importance ofmultilateral trade liberalization under the WTO.
5.2

Policy RecommendationsFirstly, when it makes decisions related to formulating trade and investment strategies,
the Japanese government should recognize the significant impact its trade andinvestment policies might have on the economies of developing countries. The
planned FTA with ASEAN5 will have some positive or negative impact on the growthand income disparity of developing countries outside ASEAN.
An accurate
assessment of that impact will remind policy-makers that coherence is advisable among
all policies and contribute to better decisions.
Secondly, the Japanese government can deliberately use its trade and investment
policies to stimulate development in its trade and investment partners. Somedevelopment effects might even be greater than those of normal ODA projects, as canbe seen in the significance of an ASEAN5+3 FTA to the Thailand economy.
Thirdly, to strengthen policy coherence, Japan’s ODA strategy should include an
explicit review process of trade and investment policies and their effects. Poverty
reduction and environmental improvement are key strategic targets and these targets areclosely linked with the industrial and market structures in developing countries. A
coherent policy mix for ensuring development is important; for example, if Japan’s
trade and investment policy looks likely to have an undesirable impact on some key
sector(s) of a developing country, Japan’s ODA to that country could be oriented toward
offsetting that impact.
Fourthly, on the multilateral front, Japan should consider playing an indirect role toimprove the policy coherence of other developed countries. As this study shows
through its simulations, multilateral trade liberalization by the industrialized countries
toward developing country trade partners will have large positive impact on the25

developing countries. In addition, Japan might be effective as a promoter of global
multilateral trade and investment liberalization. This will indirectly contribute to thedevelopment of economies in Africa, a region where both Japanese trade and ODA are
scarce. A cooperative strategy on the part of Japan in World Trade Organization
negotiations would raise its profile and improve the coherence of developed countries asa group.
Finally, trade and investment have become increasingly important in the development
process, as the case of China demonstrates. Japan’s ODA policy should take this into
account in reviewing sector strategies. If ODA is designed carefully to promote FDI
inflows, more efficient results will be achieved.

26

References
Abe, K. (2005) “The Patterns of Integration in Trade and Investment in East Asia,” in
Chapter 2 in Trade, Investment and Financial Integration in East Asia, ASEAN
Research Group Study.
APEC Economic Committee (1997) The Impacts of Trade Liberalization in APEC.
APEC Secretariat, Singapore.
--------- (1999) The Impact of Trade Liberalization in APEC: 1999 Update, APEC
Secretariat, Singapore
Baldwin, R.E. (1989) “The Growth Effects of 1992,” Economic Policy: A European
Forum, vol.9, 247-281.
Baldwin, R.E. (1992) “Measurable dynamic gains from trade,” Journal of Political
Economy, vol.100, 162-174.
Baldwin, R.E. and Venables, A.J. (1995) “Regional Economic Integration,” Handbookof International Economics, Vol.3, Chapter 31.
Borensztein, E, De Gregorio, J. and Lee, J-W. (1998), "How does foreign direct
investment affect economic growth?", Journal of International Economics.
Frankel, J., (1992) “Is Japan Creating A Yen Bloc in East Asia and the Pacific?”, NBER
Working Paper No. 4050.
Hook, S. W. and Zhang, G. (1998), “Japan’s Aid Policy since the Cold War: Rhetoricand Reality”. Pacific Affairs 71: pp. 1051-1066.
Japanese Government (2004), Decision by Ministers Meeting to Promote Economic
Partnership Agreements.
Krugman, P. (1979), “A Model of Innovation, Technology Transfer, and the World
Distribution of Income,” Journal of Political Economy 87:2: pp.253-266.
Levine, R. and Renelt, D. (1992), “A Sensitivity Analysis of Cross-Country Growth
Regressions,”, American Economic Review, 82:4: pp.942-963.
Meade, J.E. (1955) The theory of customs unions (North-Holland, Amsterdam)
Reimer, J. (2002), “Estimating the Poverty Impacts of Trade Liberalization,” GTAP
Working Paper No.20.
Urata, S. (2004), “The Shift from ‘Market-led’ to ‘Institution-led’ Regional Economic
Integration in East Asia in the late 1990s,” RIETI Discussion Paper Series
04-E-012.
Urata, S. and K. Abe (2004), “The Impacts of Japan-Korea FTA and CU on Economy,
Industry and Trade in Japan and Korea,” Bilateral Joint-research between Japanand Korea.

27Viner, J. (1950), The customs union issues (Carnegie Endowment for International
Peace, New York).
Wacziarg, R. (1997), “Measuring the Dynamic Gains from Trade,” Background Paper
prepared for Global Economic Prospects 1997, World Bank.
World Bank (2003), Lessons from NAFTA for Latin America and Caribbean Countries,
World Bank.

28

Appendix 1: Welfare Improvement Through Trade Liberalization
According to Baldwin and Venables (1995), suppose that the welfare of therepresentative consumer in a country can be represented by an indirect utility function
V = V ( p + t , E ) where p is border price vector, t is a vector of import tariff(domestically captured rent), and E is total expenditure on consumption. Total
expenditure is equal to the sum of factor income, profits and domestically accruing traderents including tariff revenue, net of investment. Therefore,
E = wL + rK + tm where L is labor, K is capital, w and r are wage and rental priceof capital, and m is the net import vector.
Totally differentiating V and dividing through by the marginal utility of
expenditure, and assuming perfect competition in the market for used capital, we find:dE ≈ dV / VE = tdm − mdp
The first term is trade volume effect, and the second, terms of trade effect. The terms oftrade effects should be zero, if all the related trading partners are small and cannot affectthe world price level. In the case of tariff elimination, like an FTA, the trade volumes
effect amounts to the following integral:
t0
0
dm
0
dt = [tm]t 0 − ∫ mdt = ∫ mdt − t0 m0
t0
t0
0
dt
0

dE ≈ ∫ twhere t0 is the level of import tariff before the tariff elimination, and m0 is theamount of import before the tariff elimination. In a partial equilibrium framework, thefirst term denotes the trapezoid sodod1s1, and the second term is the rectangular sodoba inthe chart below. The difference of the two terms is equal to two triangles soa s1 anddobd1.

29

Chart 2: Graphical Presentation of Trade Volume EffectP

Supply

s0
t0

d0

s1

Domestic
Price
d1

a

b
m0

30

BorderPrice
DemandQ

Appendix 2: Survey of Trade in Growth Function Analysis
A standard approach to estimating dynamic impacts is to assume a growth function andadopt econometric methods to estimate the function. Barro (1991) first provided anempirical estimate for the growth function of per capita income. Overall, trade policy
openness will stimulate domestic investment, as well as inducing policy improvements,
leading to higher per capita GDP. The implication is that the governments of developing
countries should open their own trade to accelerate growth of their macroeconomic
incomes. See the Table below, summarizing the study of APEC (1998).
However, Levine et al. (1992) found that almost all the empirical results were fragile.
They confirmed the robustness in the correlation between growth and the share ofinvestment in GDP and between the investment share and the ratio of international trade
to GDP. They adopted extreme-bound analysis to test the robustness of the various
variables of the growth function, including the proxies of openness of markets. The
proxies, often used, were imports per GDP, exports per GDP, or imports plus exports
per GDP. Their findings included:
Even if one substitutes imports or total trade for exports in cross-country growth orinvestment regressions, one obtains essentially the same coefficient estimate andcoefficient standard error. Thus, researchers who identify a significant correlation
using an export performance measure should not associate this result with exports
per se, because it could be obtained using a corresponding measure of imports or
total trade.
The share of trade in GDP is robustly positively correlated with the share ofinvestment in GDP.
When controlling for the share of investment in GDP, we could not find a robust
independent relationship between any trade or international price-distortion
indicator and growth. Therefore, the relationship between trade and growth may bebased on enhanced resource accumulation and not necessarily on the improved
allocation of resources.
The results are largely in line with Wacziarg (1997), which calculated that a one
standard deviation increase in an index of trade policy openness is associated with a 0.9
percentage point higher per capita GDP growth. The effect can be separated into
different components. The largest is the impact through domestic investment, which31amounts to about half of the total impact, 0.42 percentage points out of 0.93. Remaining
components include induced policy improvement (0.34 percentage points), such as the
improvement of macroeconomic environment and shrinkage of black market, andtechnology transfer (0.20 percentage points) through foreign direct investment andmanufactured exports. This study demonstrates that trade liberalization may stimulate
growth, not only through the accumulation of capital, but also through policy
improvements and technology transfer.
Table 8: Example of Growth Function (APEC Economic Committee (1999))
Dependent Variable is ∆ ln (GDP/POP) (growth rate between 1970 and 1990)

32

Appendix 3: Regions and Sectors in the GTAP Model
RegionSector

1 CHN

China

1 GRN

Paddy rice

2 JPN

Japan

2 AGR

Vegetables, fruit, nuts

3 KOR

South Korea

3 FRS

Forestry

4 XEARest of East Asia

4 FSH

Fishing

5 IDN

Indonesia

5 MIN

Coal

6 MYS

Malaysia

6 PFD

Vegetable oils and fats

7 PHL

Philippines

7 TEX

Textiles

8 SGP

Singapore

8 APP

Wearing apparel

9 THA

Thailand

9 PPP

Wood products

10 VNM

Vietnam

10 CHM Chemical,rubber,plastic prods

11 XSEA

Rest of Southeast Asia

11 MTL

Ferrous metals

12 INDSouth Asia

12 TRN

Motor vehicles and parts

13 XSAS

Other South Asia

13 ELE

Electronic equipment

14 CAN

Canada14 OME Machinery and equipment nec

15 USA

United States

15 OMF

16 MEX

Mexico16 EGW Electricity

17 EU15Austria

17 CNS

Construction

18 SACU South Africa CU

18 TRD

Trade

19 SADC South African Dev Com

19 TRSTransport nec

20 NAFK North Africa

20 CMN Communication

21 XSSA

Rest of sub-saharan Africa

21 FIN

Financial services nec

22 XRW

Rest of the World

22 OSP

Business services nec

23 OSG

PubAdmin/Defence/Health/Education

33

Manufactures nec

Appendix 4: Technical Outline of the GTAP Model
The CGE model simulations in this study were carried out on the basis of the standard
Global Trade Analysis Project (GTAP) model version 6.2, together with its Database
Version 6-beta database. This Appendix summarizes data and structure of the model,
including equations and parameters, taking excerpts from Global Trade Analysis:
Modeling and Applications (1996), edited by T. W. Hertel, and notes on subsequent
revisions of the models and databases.
1. DATAThe GTAP database consists of bilateral trade, transport, and protection datacharacterizing economic linkages among regions, together with individual and economy
input-output databases that account for intersectoral linkages within each region.
Trade Data
The trade data upon which the GTAP data base is built originates from United Nations
D-series trade statistics. COMTRADE (COMmodity TRADE) is the registered name ofthe database maintained by the UN Statistics Office. This database is one of the mostcomplete and exhaustive in terms of commodity and country coverage, but because of
the large size of the database, its reliability is questionable. Efforts have been made by
the United Nations to fill the data gaps and balance the bilateral trade and transport
matrices. The bilateral flows are also used to determine the pattern of trade in non-factor
services. The reconciliation method adjusts reported values based on “relative” biases
for bilateral transactions. For almost all the reporting countries there are only slightchanges in the total reported values. There are cases of severe under-reporting or
non-reporting in some countries. In most of these cases, the partners’ reported trade wasused, after adjusting for the international transport margins.
Protection Data
The support and protection data (SPD) is expressed in the form of ad valorem
equivalent, tariff, and non-tariff barrier, and they draw heavily on information submitted
to the GATT in connection with the Uruguay Round (UR) negotiations. The protection
data is broadly indicative of the level of protection prevailing prior to the UR. The
best-quality data in the SPD is that relating to tariffs. There remains considerable
bilateral variation in the applied tariff rates, aggregated over all merchandise trade.

34

Non-tariff information is most complete in the cases of agriculture and textiles/apparel.
Anti-dumping duties are incorporated for Canada, the European Union (EU) and theUnited States. Also, the export restraining effects of EU price undertakings are included.
However, the SPD is not comprehensive. Other trade measures, despite their importance,are very difficult to quantify in a useful way. Protection of, and support to the service
sector are especially difficult to quantify, and it is the only sector that is whollyneglected. It was thought better to do a solid job of incorporating tariff and selected
non-tariff information and leave other policy measures aside for the time being, given
the dubious information content of the latter.
Input-Output Data
The basic input-output (IO) data provide information about the individual regional
economies. Some of these were obtained from the Australian Industry Committee (IC),while others were contributed by members of the GTAP network. The IO tables making
up the regional databases refer to 2000. These economies present special problems forthe database because of prevalence of the re-exports. The original dataset of Hong Kong
includes a negative saving rate, which perhaps reflects an underestimate of re-exports orinvestment and an overestimate of consumption. Based on the actual figures for 2000,
some of the government consumption has been moved to investment, which amounts to
10 percent of GDP, as the minimum amendment.
2.

Model

The distinguishing features of the general equilibrium model include: the treatment ofprivate household behavior, international trade and transport activity, and global
savings/investment relationships.
Aggregation
The GTAP database consists of the 87 economies/regions and 57 disaggregated sectors
and, which are aggregated to the appropriate versions for simulations. In this study,
regions are aggregated into 22 regions and 23 areas.

35Model Structure
The GTAP model is a computable general equilibrium model that depicts the behaviorof households, governments, and global sectors across each region in the world. It is
composed of regional models linked through international trade. Prices and quantities
are simultaneously determined in factor markets and commodity markets by theaccounting relationships, the equilibrium conditions specified by the behavior of
economic agents, and the structure of international trade. The model includes threefactors of production: skilled and unskilled labor, capital; and natural resources andland.
i). Behavior of Firms
The GTAP model assumes that firms use constant returns to scale technology, andminimize the cost of inputs, given a level of output and technology. Firms’ behavior
depends largely on the assumptions of separability in the production structure. Firms are
assumed to combine a bundle of intermediate inputs in fixed proportion with a bundleof primary factors. The demand for each intermediate input is also assumed to vary in
fixed proportion with the level of output. That is, the production function in the GTAP
model has a Leontief structure. This production structure yields demand equations for abundle of primary factors and each intermediate input. In determining the demand forprimary factors, the constant elasticity of substitution (CES) functional form is assumed.
The CES production function yields the demand equations for each primary factor, andthe price of value-added in industry j in region r evaluated by firms. Firms purchaseintermediate inputs, some of which are produced domestically, and some of which areimported. Domestic and imported intermediate inputs are substituted according to a
constant elasticity of substitution. Similarly, a constant elasticity of substitution isassumed to capture the degree of substitutability between imports from different sources.
The two-level CES functional form yields the demand function.
ii). Behavior of Households
Regional household behavior is governed by an aggregate utility function specified overcomposite private consumption, composite government consumption, and savings. The
other feature of the regional households utility function is the use of an index of current
government expenditures as a proxy for the welfare derived from the government’s
provision of public goods and services to private households in the region. The GTAP
model employs a special case of the Stone-Geary utility function, in which all36

subsistence quantities are equal to zero. The share of private household expenditures,
government expenditures, and savings are constant in total income. Once the changes inreal government spending have been determined, spending is allocated across composite
goods and aggregate demand for the composite is allocated between imports anddomestic products under the assumption of constant elasticity of substitution. Privatehousehold demand has a non-homothetic nature. The allocation of private household
expenditures across commodities is based on the constant difference of elasticity (CDE)
expenditure functions.
iii). Global Banking Sector and Savings/Investment
The GTAP model introduces two global sectors. One is the global transportation sector
described below. The other is the global banking sector. The global banking sector
intermediates between global savings and investment. It creates a composite ofinvestment goods, based on a portfolio of net regional investment, and offers this toregional households to satisfy their savings demand. Therefore, all savers face acommon price for this saving commodity. A consistency check on the accounting
relationships involves separately computing the supply of the composite investment
goods and the demand for aggregate savings. If all other markets are in equilibrium, allfirms earn zero profit, and all households undergo budget constraints, then global
investment must equal global savings by virtue of Walras’ Law.
iv). Global Transportation
The global transportation sector provides the services that account for the difference
between fob and cif values for a particular commodity shipped along a specific route.
Summing all routes and commodities gives the total demand for international transport
services. These services are supplied by individual regional economies, which export
them to the global transport sector. In the GTAP model, transportation services areprovided via the Cobb-Douglas production function. Lacking the data that link exportsof transport services with specific routes, the services are combined into a single
composite of international transport goods. Then, the percentage change equation forthe composite price index given the demands for inputs to the shipping industry isderived under the Cobb-Douglas assumption. The GTAP model assumes that thecomposite of international shipping services is employed in fixed proportion with thevolume of a particular good shipped along a particular route.

37

3. Model Parameters
There are four types of behavior parameters in the GTAP: elasticities of substitution(in both consumption and production); transformation elasticities that determine thedegree of mobility of primary factors across sectors; the flexibilities of regional
investment allocation; and, consumer demand elasticities.
First, the SALTER24 project engaged in an extensive review of the literature and someoriginal empirical work to specify values for substitution elasticities on acommodity-specific, region-generic basis. Table below reports the parameters.
The first column describes the ease of substitution between the domestic goods and thecomposite import, by commodity. As such, it shows the composite import demand
elasticity. The second column determines the case of substitution among imports fromdifferent sources. In the SALTER parameter file, this is equal to twice the value of thevalue in the first column. The elasticities of substitution in the value-added aggregatesfor each sector are also reported in the third column of Table. The overall elasticity of
substitution among primary factors determines the ability of the economy to alter its
output mix in response to changes in relative commodity prices. These parameters also
play an important role in determining the sectoral supply response, in the presence ofsector-specific and sluggish factors of production. Elasticity of substitution in primary
production is relatively small and the greatest degree of substitutability arises in the
trade and transport sector.
Second, within each region, the model distinguishes between primary factors that are
perfectly mobile across productive sectors and those factors that are sluggish. In an
experiment with sluggish endowment commodities, it is important to determine howmuch of a disparity in relative sectoral returns can be sustained over the simulation
period. This disparity is governed by the elasticity of transformation.

24

The SALTER model, constructed by the Industrial Commission of Australia in the late 1980s,
was a pioneering work of international general equilibrium model, providing the origin of the
GTAP model.

38

Table 9: Assumed Parameters in the GTAP Model
1

2

3

1 GRN

3.54

5.96

0.24

2 AGR

2.53

5.21

0.30

3 FRS

2.50

5.00

0.20

4 FSH

1.25

2.50

0.20

5 MIN

5.26

12.69

0.20

6 PFD

2.37

4.83

1.12

7 TEX

3.75

7.50

1.26

8 APP

3.80

7.65

1.26

9 PPP

3.10

6.32

1.26

10 CHM

2.96

6.05

1.26

11 MTL

3.39

6.94

1.26

12 TRN

3.15

6.43

1.26

13 ELE

4.40

8.80

1.26

14 OME

4.05

8.10

1.26

15 OMF

3.75

7.50

1.26

16 EGW

2.80

5.60

1.26

17 CNS

1.90

3.80

1.40

18 TRD

1.90

3.80

1.68

19 TRS

1.90

3.80

1.68

20 CMN

1.90

3.80

1.26

21 FIN

1.90

3.80

1.26

22 OSP

1.90

3.80

1.26

23 OSG

1.90

3.80

1.26

(Note) 1 = Armington substitution elasticity between domestic and composite import goods.

2 = Armington substitution elasticity among import goods by source.
3 = Substitution elasticity of primary factors (land, labor and capital).

Third, there is another set of “mobility” parameters that determine the flexibility ofregional investment. It is possible to choose some regions where investment is quitesensitive to the changing rate of return, and others where this is not the case.

39

Fourth, the parameters that describe demand behavior in initial equilibrium for the
representative private household are region-specific. Consumer behavior in GTAP isbased on the constant difference elasticity (CDE) expenditure function, which is mostnaturally calibrated to income and own-price elasticities of demand.

40

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