Shiro Armstrong, “Economics Still Trumps Politics Between Japan and China,”Kokusai Mondai(International Affairs), No.634, September 2014

Economics Still Trumps Politics Between Japan and China1

Shiro Armstrong
Australia-Japan Research Centre
Crawford School of Public Policy
College of Asia and the Pacific
Australian National University

1 I am grateful to Son Chu for his excellent research assistance and Rebecca Mendelsohn andPeter Drysdale for their suggestions and comments.

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Shiro Armstrong, “Economics Still Trumps Politics Between Japan and China,”Kokusai Mondai(International Affairs), No.634, September 2014

Background
Japan and China today share the third largest trading relationship globally. Whilethey are economically interdependent to a large degree, they also have acomplicated political relationship that stems from unresolved history. There islittle systematic evidence of political differences affecting trade and investment
in recent times. This paper will explain why that has been the case until now andmeasure whether the period of heightened political tensions in 2012 haveaffected trade thus far.
There have been a number of recent instances of political tension between Japanand China. For example, when Koizumi was Prime Minister of Japan between
2001 and 2006, leadership visits between Japan and China were temporarilysuspended. Then in 2005, we saw large-scale anti-Japanese protests in China that
included attempts at boycotting Japanese products. In 2010 there wereincreased tensions surrounding the Japanese arrest of a Chinese trawler captain.
There have also been a range of other episodes of political tensions. The
important point is that these political tensions do not appear to have had asignificant effect on economic relations between Japan and China. Bilateral andregional trade, as well as Japanese investment into China, has grown in spite ofthese tensions. Any adverse impact on trade or investment from the fraught
politics between 2001 and 2011 is difficult to find beyond anecdotal evidence.
The tensions that were precipitated by the territorial dispute over the
Senkaku/Diaoyu Islands in 2012 arguably represent the most serious wideningof political distance between the two countries in recent memory. In September
2012, the Japanese government purchased some of the islands from private
owners to circumvent their sale to a nationalist group. The object of the purchase
was to avoid the creation of further tension with China. The nationalisation of
the islands by the Japanese government instead had the opposite effect, with theescalation of tensions with China. In China, the acquisition was followed by antiJapanese protests that were larger and more extensive than those in 2005. The
protests resulted in the temporary closure of some Japanese factories andbusinesses.
Trade in both directions—from Japan to China and from China to Japan—hasgrown rapidly since the beginning of the Chinese reform period in 1978 when
the two countries signed the Long Term Trade Agreement and economic
relations were normalised. Trade grew from just over US$5 billion in 1978 toover US$342 billion in 2013.2 Japanese investment in China increased together
with expanded trade. Importantly, the large volume of Japanese investment in
China has been a key factor in enabling Japanese manufacturers to remaincompetitive. The offshoring of Japanese production to China and the rest of Asia,
and China’s role as the location for final assembly of the parts and components
traded in East Asia have meant that the bilateral relationship is a major driver of
2 Source: UN Comtrade database2

Shiro Armstrong, “Economics Still Trumps Politics Between Japan and China,”Kokusai Mondai(International Affairs), No.634, September 2014
East Asian production networks and regional economic integration despite thepolitical differences and tensions.
This paper first discusses why trade and investment between Japan and China
has flourished despite historical political tensions. This situation stands incontrast to other bilateral relationships where political differences have had amajor flow-on effect on economic relations.3 It then goes on to consider whether
there is any evidence to suggest that the most recent escalation of tensions in2012 had an impact on the bilateral trading relationship. This exercise involves
comparing trade in both directions to what we could otherwise expect given
what we know about the characteristics of both countries and the fundamental
determinants of trade.

The ballast of the global trading system for Sino-Japan ties
In contemporary times, there has not been a significant period in which Japanand China have enjoyed a close political relationship. The existence of acomplicated political relationship with unresolved historical issues can increaserisk such that traders and investors may instead prefer to trade with or invest inother countries with less cultural or political distance.
In the case of Japan and China, however, bilateral political tensions have notderailed the strong economic relationship that has developed since 1978. In fact,
the economic relationship has at times shaped the political relationship byhelping to prevent the intensification of political tensions. Tensions did notderail economic relations because of China’s commitment to opening its
economy and to entering the global trading system. This commitment
underpinned the economic relationship and gave both sides confidence inengaging commercially with one another (Armstrong, 2012).
China’s commitment to the global trading system through rapid tradeliberalisation in the 1990s was aimed at gaining accession to the General
Agreement on Tariffs and Trade (GATT), later the World Trade Organisation(WTO). The GATT accession process began in 1986 with major unilateralliberalisations and concurrent domestic reforms. That commitment toliberalisation and reform through the WTO placed constraints on Chinese
policymakers and was a deliberate step by Chinese leaders to deepen promarket reforms and the opening up of the Chinese economy. These constraints,
and rapid opening up of the economy, meant that state influence on domestic
and foreign companies waned.
China’s underlying commitment to GATT, and later to WTO entry, helped toinsulate its bilateral relationship with Japan from political tensions. It also meant

3 One pertinent example is the Pakistan–India relationship which, before partition, had freemovement of goods, capital and labour, shared the same institutions and had very few barriers,
but currently has a relatively non-existent economic relationship dominated by a bad political
relationship.

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Shiro Armstrong, “Economics Still Trumps Politics Between Japan and China,”Kokusai Mondai(International Affairs), No.634, September 2014
that the two countries’ economic relationship constrained and shaped thepolitical relationship.
Figure 1 China’s trade dependence and average tariff rate, per cent, 1990-2004
70
per cent

Total Trade/GDP

60

WTO

50

Average Tariff Rate

40
30
20
10
0
1990

1992

1994

1996

1998

2000

2002

2004

Source: Tariff data from MOFCOM website, http://china.org.cn, trade data from UN Comtrade
database, and GDP data from World Development Indicators, http://www.worldbank.org/data.

Figure 1 shows China’s average tariff rate and total trade (exports plus imports)
as a proportion of GDP, which is a common measure of openness. The figure
shows that the most significant tariff reductions did in fact occur in the 1990s,
but trade as a proportion of GDP did not rise significantly until around the timeof WTO accession in 2001. Significant liberalisation—both at the border andbehind the border—took place in the lead up to WTO accession, starting as earlyas 11 years prior to 2001, but in fact, the rapid increase in China’s trade only
occurred post WTO accession.
China’s WTO accession demonstrated a commitment to continued marketisation
and reform, which gave the international economic community and Japanese andother businesses confidence in engaging with China. In this way, economic
engagement between Japan and China could be based on the market forces andthose characteristics that drive economic relations between countries—
proximity of the two countries and their complementary economic structures—in a way that that has insulated against the vagaries of political distance.
There is considerable anecdotal evidence to suggest that recent episodes ofpolitical tension between Japan and China have had adverse economic effects.
There is also some systematic evidence of this. Fisman et al (2013) measure theimpact of political events (resulting in widened political distance) in 2005 and2010 on the sales and share prices of Japanese and Chinese firms with highexposure to the other country. During those periods of heightened politicaltension, they find that the Japanese firms that are adversely affected are those4

Shiro Armstrong, “Economics Still Trumps Politics Between Japan and China,”Kokusai Mondai(International Affairs), No.634, September 2014
with high exposure to Chinese industries in China in which state owned
enterprises are dominant. In the case of Chinese firms, the entities that are
disproportionately affected are those that sell directly to the Japanese consumer.
While some adverse effects of political distance can be expected, these results
are not identifiable in the aggregate trade or investment data (Armstrong, 2009;
Armstrong, 2012). The structure and scale of the relationship between Japan and
China is such that even quite large bilateral political differences and apparent
shocks to business confidence are marginal relative to the overall relationship.
Japan’s geographical proximity, capital, technology and know-how have been,
and continue to be, important for China’s economic modernisation. China’s rapid
growth, cheap production and its still-large market potential outweigh the risksof relatively low intensity political tension. Despite political tensions, not only
has Japan and China’s economic relationship not been derailed, but it hasflourished. This is because of the underlying confidence both sides have that theother is committed to the rules and norms of the global trading system. The
example of Japan and China stands in stark contrast to countless other casesaround the world, where political tensions have had a profound impact on
economic relations.
China’s WTO accession coincided with the six year period of Prime Minister
Koizumi where leadership visits did not occur and tensions were high. Yet not
only did trade continue to grow, Japanese business in China boomed. Figure 2
shows the rapid increase in the number of Japanese firms doing business in
China since 1993. Data is taken from the annual Japan Bank for International
Cooperation (JBIC) survey on Overseas Business Operations by Japanese
Manufacturing Companies. The figure shows an increase in the rate of growth ofJapanese affiliates in China since WTO accession in 2001 and China overtaking
the United States and Europe around 2003, and the largest five ASEAN countries4
together in 2005 to becoming the largest offshore location of Japanese businessaffiliates. The number of Japanese affiliates in China began to decrease in 2009,
but the trend appears similar for all other major overseas operating bases.

4 Indonesia, Thailand, Philippines, Malaysia and Singapore.

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Shiro Armstrong, “Economics Still Trumps Politics Between Japan and China,”Kokusai Mondai(International Affairs), No.634, September 2014
Figure 2 Number of Japanese overseas affiliates

Source: JBIC (2012)
A recent development outside of the Japan-China relationship has potential toundermine the current economic relationship. There has been a loss ofconfidence in the global trading system following the collapse of the Doha Roundof trade negotiations in the WTO and the global proliferation of preferential
trading agreements that undermine the core WTO principle of nondiscrimination. Beyond the WTO, there are no rules or frameworks that govern
economic exchanges between Japan and China 5. Hence an erosion of the global
trading system could have implications for the bilateral relationship.

Economic effects of recent ‘ice cold’ politics
The events that led to increased political tensions between Japan and China took
place at the beginning of the fourth quarter of 2012. The remainder of this paper
assesses whether the bilateral economic relationship suffered in that final
quarter of 2012. In making that assessment, trade in both directions will becompared against a counterfactual. But first, other aspects of the economic
relationship and some evidence of how politics may have affected the economic
relationship are discussed.
One important aspect of the economic relationship is direct investment fromJapan to China. Effects on investment decisions occur with a longer lag time thanwith trade as investment proposals, approvals and implementation take time.
Foreign direct investment (FDI) is also usually ‘lumpy’ as large projects distort
5 The Long Term Trade Agreement of 1978 and Bilateral Investment Treaty of 1988 areirrelevant to today’s economic relationship.

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Shiro Armstrong, “Economics Still Trumps Politics Between Japan and China,”Kokusai Mondai(International Affairs), No.634, September 2014
the data and shocks (or events) such as changes in regulatory rules or exchange
rate movements can take 12 to 18 months to flow through to FDI data
(Armstrong and Drysdale, 2011). Trade, on the other hand, can be impacted
quickly as buyers and suppliers can relatively easily switch countries whencircumstances change. It is the in-country commitment of FDI that makes it moresensitive to political differences between countries and country risk compared toarms-length trade (Armstrong and Drysdale, 2011).
This paper only focuses on the trade relationship between Japan and China but
the nature of production networks in the region, of which Japan and China aremajor part, mean that trade and investment are closely linked.
Beyond aggregate trade and investment, the share prices or sales of Japanexposed Chinese firms and China-exposed Japanese firms could be studied as
Fisman et al (2013) did for earlier periods. A similar result of an adverse effecton firms is to be expected: after all, bilateral political spats that result in a ban onleadership visits and large-scale protests and boycotts are not congenial to tradeand commerce between two countries. One difficulty with event studies thatmeasure the impact over an event period for the 2012 case is that while a startdate to the event can easily be identified, the time of resolution of politicaltensions is unclear and the ongoing low-intensity tensions could also have aneffect on the economic relationship.
This paper looks for any effect on the aggregate trade relationship between
Japan and China. The change in Japanese exports to China or Chinese exports toJapan is only part of the story. This paper uses a method that takes into accounttheir bilateral trade in the context of total Japanese or Chinese trade, changes in
the global economy, and other changes in key determinants of trade. It is difficult
to assess changes in the bilateral trading relationship without those factors. For
example, Figure 3 shows Japanese monthly trade with China as a share of total
Japanese trade. This can tell part of the story, but does not take into accountother characteristics of the Japanese and Chinese economies.

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Shiro Armstrong, “Economics Still Trumps Politics Between Japan and China,”Kokusai Mondai(International Affairs), No.634, September 2014
Figure 3 Share of total Japanese trade with China, per cent, 2007-2013
26
24
22

20
18
16
14
12

10

Imports

Jan-07
Apr-07
Jul-07
Oct-07
Jan-08Apr-08
Jul-08
Oct-08Jan-09Apr-09Jul-09Oct-09Jan-10
Apr-10Jul-10
Oct-10Jan-11
Apr-11
Jul-11
Oct-11
Jan-12
Apr-12
Jul-12Oct-12
Jan-13Apr-13
Jul-13Oct-13Jan-14Apr-14

Exports

Source: Author’s calculations from JETRO, http://www.jetro.go.jp/en/reports/statistics/

Figure 3 shows the cyclical nature of trade. Japanese imports from China fall
sharply for the month of February each year and seem to be high in the lastquarter of 2012 despite the tensions. Japanese exports to China as a percentage
of total Japanese trade appear less cyclical but appear to be on a downward
trend until the end of 2012 after which point they pick up.
Trade values and trade shares tell part of the story but are not sufficientthemselves for assessing whether trade was as high as one might expect or lower
than expected. To estimate what trade was expected to be, we need to compare
the volume of trade that actually eventuated against a counterfactual. That is,
without factoring in Japanese, Chinese, and third party GDPs (that change overtime), and other factors in the regional and global economy, it is not possible todraw any robust conclusions about the performance of trade relationships.
The gravity model of trade is one of the most commonly utilised and empiricallytested models in international economics. The model has successfully explained
trade flows, with distance and mass (or size) as the main explanatory variablesof trade. The model is based on the idea that trade volumes between two
countries depend positively on the size of the two countries and inversely on the
distance between them. The model should theoretically be able to predict thelevel of trade that can be expected given the characteristics of two trading
partners and the distance between them. Importantly, it falls short of being able
to do this.

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Shiro Armstrong, “Economics Still Trumps Politics Between Japan and China,”Kokusai Mondai(International Affairs), No.634, September 2014
The gravity model is widely used to explain trade determinants, but does not
perform well when seeking to measure the performance of actual trade against
expected trade as predicted by the model. Studies such as those conducted by
Gros and Gonciarz (1995), Egger (2002), and Batra (2006) show that the ratiosof actual to predicted trade can range from very small6 to over 35 times what themodel predicts. Such large and implausible results are common when using
traditional gravity models to predict potential trade. Indeed Egger (2002) has
concluded that in-sample prediction of this sort does not work, and that the
implausible results of actual trade being much higher than predicted trade meanthat those gravity models are incorrectly specified.
This study applies stochastic frontier analysis to the gravity model of trade inorder to construct a trade frontier that can be used to estimate potential trade.
The method shifts the benchmark or counterfactual from being measured as theaverage of all characteristics of trade flows (which is what a conventional gravity
model will produce) to an upper bound. The results are a single ratio for eachtrade relationship in each year. The stochastic frontier method was developed tomeasure agricultural productivity, and separates out the effects of shocks such as
drought or flood from the measure of efficiency (that is, actual to potential
output) for that farm (Aigner et al., 1977; Meeusen and van den Broeck, 1977).
Unlike the results generated using a conventional gravity model, this method
produces plausible results because stochastic frontier analysis separates out theresistances unique to the bilateral relationship from other shocks to the global
trading system.
Without the use of a stochastic frontier gravity model, it is difficult to forecast
expected levels of trade between Japan and China any given time – that is, notonly after the 2012 events. The use of the stochastic frontier gravity model
results in a measure of trade performance, which is actual trade as a ratio ofpotential trade. Potential trade is estimated as the highest possible value of trade– as if trade were occurring at the frontier – given the characteristics of the
trading partners and is at frontier value. In order to obtain accurate estimates of
the influence of bilateral characteristics of countries on trade and of third-party
country effects, a world trade frontier is estimated using a matrix of global tradeflows.
Trade performance is estimated for the period 2000 to 2013 but for 2012 and2013, only an ‘out-of-sample’ prediction can be made for Japan-China trade given
trade or GDP data for 2013 are not yet readily available for many countries. In
other words, the coefficient estimates from the model are applied to the GDP,distance and other data to estimate potential trade values for 2013. Gravity
models are usually estimated based on annual data. In this case, quarterly data isused for 2013 (and 2011 and 2012 to check for consistency) for the out ofsample predictions in order to identify any changes in 2012 and 2013. Whilemonthly trade data are available, GDP data are only available quarterly7.
6 This can be expected for some bilateral relationships.
7 Chinese quarterly GDP data is taken from the National Bureau of Statistics of China. Given the

short time series, it is difficult to seasonally adjust the data. There is an issue with the quarterly GDP

9Shiro Armstrong, “Economics Still Trumps Politics Between Japan and China,”Kokusai Mondai(International Affairs), No.634, September 2014
Details of the model specification, data sources and estimation results are
discussed in the Appendix. The main results are shown in Figure 4. Tradeperformance for trade in both directions rises until about 2006 or 2007 and thenfalls until 2009 with a jump in 2010.
Trade performance between Japan and China is higher than what we might
expect. Trade performance is higher than Japan’s average export performance(with all its trading partners) at 37 per cent and import performance at 33 percent of their potential. It is also higher than China’s average export performanceof 51 per cent and import performance at 41 per cent. The world average is 38
per cent, which is similar to previous studies using similar models (Armstrong
and Drysdale, 2011; Armstrong, 2012).
The full set of results is not presented here, but trade performance measures arecalculated for each trade flow in the model. Over the 12 year period, almost
147,000 bilateral trade flows are accounted for. The highest performing traderelationships are between countries or regions with free and open trading
regimes and high quality trade infrastructure such as Singapore and Hong Kong.

Figure 4 Trade performance results, 2000 to 2013
0.74
0.73
0.72
0.71
0.7
0.69
0.68
0.67
0.66
0.65
0.64

Chinese exports to Japan

Japanese exports to China

Source: Author’s calculation

The fall in the realisation of Japanese export potential to China in the fourth
quarter of 2012 coincides with the political difficulties between the twocountries. But the realization of Chinese export potential to Japan does not fall in
data, as the fourth quarter GDP data is 42 per cent and 40 per cent higher than the average of the first
three quarters of the year for 2011, 2012 and 2013 respectively. Such disparities distort the results, andtherefore in this study the imperfect assumption is made that Chinese quarterly data is stable over the
year.

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Shiro Armstrong, “Economics Still Trumps Politics Between Japan and China,”Kokusai Mondai(International Affairs), No.634, September 2014
that period. While there is a fall to close to 69 per cent of potential in the fourth
quarter of 2012, and that is the lowest since 2002 right after China joined theWTO, realization of trade potential rises in 2013. Tensions were highest in 2012
but the political impasse has yet to be resolved.
Further investigation is required to assess whether the events in September
2012 have adversely affected aggregate trade in contrast to the negligible effectof historical periods of political tension between Japan and China (for example,
in 2005 and 2010). A more comprehensive analysis can only be conducted withmicro, or firm-level data, and as more data become available. Given what we doknow, some other phenomena can go part of the way towards explaining thetrade performance.
Figure 5 Promising Countries/Regions for Overseas Business over the Medium-term(next 3 yrs. or so)

Source: JBIC (2013)
The nature of the economic relationship could be changing with factors outsideof the bilateral political relationship affecting the relative attractiveness of China
as a destination for Japanese business, for example.
Japanese firms surveyed in the JBIC survey (2013) suggest that China is nolonger the most promising country for overseas business in the medium term,
for the first time in the history of the survey, dating back to 1989 (Figure 4). The
number of companies responding that China was a promising country for
expanding business fell to a record low. For the 2013 survey, China ranks below
Indonesia, India and Thailand.
The same survey shows that in 2013, the biggest concern for Japanesecompanies doing business in China was rising labour costs and intensifiedcompetition. Over three-quarters of firms surveyed identified rising labour costs

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Shiro Armstrong, “Economics Still Trumps Politics Between Japan and China,”Kokusai Mondai(International Affairs), No.634, September 2014as a concern, compared to only 55 per cent of companies that identified a lack oftransparency in the legal system as an issue. Other issues that firms identified
included: intense competition with other companies; insufficient protection of
intellectual property rights; and security and social stability. The survey suggeststhat the issue of rising labour costs has assumed increasing importance overtime. Security and social instability is a concern for Japanese firms in othercountries, and until 2013 had not ranked among the top five sources of concern
for doing business in China (JBIC, 2012)8.
The JBIC survey (2012) observes that 65 per cent of respondent companies in
the automobile sector said that events surrounding the 2012 Senkaku/Diaoyu
Islands furore were hurting sales. In addition, 53 per cent of companies
responded that sales had declined during the protests and boycotts.

Conclusion
Rapid growth in trade between Japan and China has been achieved despite
unresolved history and political ups and downs. Measured against potential
trade, the bilateral trading relationship of Japan and China has been above andbeyond what they have achieved with other trading partners and the averagerealisation of potential globally. Trade has been driven by the two countries’
geographical proximity, their complementary economic structures, and the rapid
growth of China’s economy.
There is little evidence to suggest that political tension between Japan and China
affects aggregate trade and investment even during times of heightened tension.
The reason has been the commitment of both countries to the rules and norms ofthe global trading system and in particular because of the liberalisation andreforms that China committed to in its accession to the WTO.
Trade performance for Japanese exports to China fell in the last quarter of 2012
to their lowest since 2002. Nonetheless, it was still much higher than the average
Japanese and Chinese trade performances and also higher than the world
average. Trade performance from China to Japan remained steady in 2012. Tradeperformance for 2013 shows an upward trend with growing realisation of tradepotential in both directions. There is no clear evidence that the political tensions
have disrupted trade in 2012 or 2013.

8 The fall in Japanese investment to China in the first half of 2014 is often

attributed to the political tensions between the two countries (see, for example,
http://www.japantimes.co.jp/news/2014/07/15/business/economybusiness/japans-direct-investment-china-fell-half-first-half/) but total FDI into
China only rose 2.2 per cent in the same 6 months suggesting other investment
sources are also reducing FDI into China giving support to the results of the JBIC
survey which suggests the main driver of the reduction in FDI is due to risinglabour costs. There is yet to be decisive evidence produced that suggests any
significant portion of the fall in FDI is due to political tensions.
12Shiro Armstrong, “Economics Still Trumps Politics Between Japan and China,”Kokusai Mondai(International Affairs), No.634, September 2014
It is difficult to attribute the fall in realisation of trade potential in 2012 topolitical tensions, and it would be desirable for further work to be carried out inthis area once more data becomes available. There are coinciding factors such as
China becoming relatively less attractive to Japanese firms as a trading partner
and investment destination because of a number of factors, including risinglabour costs.
In the past, the economic relationship between Japan and China has constrained
and shaped the nature of the political relationship. It is notable that the tradeand investment relationship has not been derailed by the political tensions
arising from territorial or other disputes. But the politics are currently nothelping the economics, and if the economic relationship starts to suffer
significantly because of the politics, the bilateral relationship will lose somevaluable ballast.

References
Aigner, D., Knox-Lovell, C. A. and Schmidt, P., 1977. 'Formulation and estimation ofstochastic frontier production function models', Journal of Econometrics, 6(1):21–37.
Armstrong, S 2009, 'Japanese FDI in China: determinants and performance', Asia
Pacific Economic Papers, vol. 378.
Armstrong, Shiro, 2012. 'The politics of Japan-China trade and the role of theworld trade system', The World Economy, 35(9), 1102-1120.
Armstrong, S.P. and P.D. Drysdale. 2011. ‘The Inﬂuence of Economics and Politics
on the Structure of World Trade and Investment Flows.’ in S.P. Armstrong, The
Politics and Economics of Integration in Asia and the Paciﬁc, London: Routledge,
65–92.
Batra, Amita, 2006. ‘India's Global Trade Potential: The Gravity Model Approach’,Global Economic Review: Perspectives on East Asian Economies and Industries,
35:3, 327-361.
Battese, G.E. and Coelli, T.J., 1995. ‘A Model for Technical Inefficiency Effects in a
Stochastic Frontier Production Function for Panel Data’, Empirical Economics, 20:
325-32.
Egger, Peter, 2002. "An Econometric View on the Estimation of Gravity Models
and the Calculation of Trade Potentials," The World Economy, Wiley Blackwell,
vol. 25(2), pages 297-312, 02.
Fisman, Raymond, Yasushi Hamao and Yongxiang Wang (2013) ‘The impact of
cultural aversion on economic exchange: Evidence from shocks to Sino-Japaneserelations’, AFA 2013 San Diego Meetings Paper; Marshall School of BusinessWorking Paper No. FBE 4.13.
Gros, D., and Gonciarz A., 1996. ‘A Note on the Trade Potential of Central andEastern Europe’, European Journal of Political Economy 12(4): 709-721.
Japan Bank for International Cooperation (JBIC), 2012, Survey on Overseas
Business Operations by Japanese Manufacturing Companies, FY201213

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Japan Bank for International Cooperation (JBIC), 2013, Survey on Overseas
Business Operations by Japanese Manufacturing Companies, FY2013
Kodde D.A. and Palm A.C., 1986, “Wald criteria for jointly testing equality andinequality restrictions”, Econometrica, 54: 1243-1248.
Meeusen, W. and van den Broeck, J., 1977. 'Efficiency estimation from CobbDouglas production functions with composed error', International Economic Review,
18(2):435–44.

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Shiro Armstrong, “Economics Still Trumps Politics Between Japan and China,”Kokusai Mondai(International Affairs), No.634, September 2014

Appendix
Specification of Stochastic frontier gravity model of trade with trade inefficiency
determinants
Based on the approach suggested by Battesse and Coelli (1995), the stochastic frontier
gravity model of trade is defined asln X ijt (IMijt ) = b 0 + b1 lnYit + b2 lnY jt + b3 ln Dist ij + b4 trend + v ijt - uijt

(1)

where X ijt (IMijt ) are the volume of exports (imports) between country i (reporter)and country j (partner), Yi and Yj are GDP of countries i and j as economic mass
variables, Distij represents distance between two trading partners, and trend accounts
for changes in trade potential between them, v ijt is the random error term and uijt isthe one-sided non-negative random variable. By construction, the term uijt is definedas trade inefficiency effects, which cause actual bilateral trade between two trading
partners to deviate from their trade potential level. Trade inefficiency is assumed to afunction of natural and socio-economic factors and policy variables presented by thetrade inefficiency model as follows:
Inefficiency effect model

mijt = d0 + d1contigij + d2 comlang _ offij + d3 ln Rit + d4 ln R jt
d5 ANDEAN + d6 ASEAN + d7 APEC + d8 EU + d9 MERCOSUR + d10 NAFTA + wijt

(2)

These empirical models are estimated using the estimation procedure recently
developed by Belotti et al. (2012) that is based on the STATA program. The
estimation procedure uses the maximum likelihood estimation method. The
parameters of the stochastic trade frontier trade and trade inefficiency models are
simultaneously estimated for all countries with both positive import and export flows
with their trading partners.
The model is estimated for 177 of the largest exporters and importers globally for theperiod 2000-2011 and consequently, the estimated trade frontier model presents aworld trade frontier. Trade data are from the United Nations COMTRADE database,through the World Bank’s World Integrated Trade Solution (WITS), which is a data
extraction and consultation system. Trade data include export and import data for all
countries of interest in current USD. Data on GDP and GDP per capita as well as
simple average tariff rate are obtained from the World Bank World Development
Indicators database (WDI). Finally, data on bilateral geographical distances, common
borders, and common languages are extracted from the database of French Institutefor Research on the International Economy (CEPII). The bilateral geographicaldistance used in this study is the great-circle distance between major cities of eacheconomy. Data on various free trade agreements (FTAs) are created using informationon country membership available on the Wikipedia website 9.
9 https://en.wikipedia.org/wiki/Main_Page

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Shiro Armstrong, “Economics Still Trumps Politics Between Japan and China,”Kokusai Mondai(International Affairs), No.634, September 2014
Alternative hypotheses need to be tested to justify our stochastic frontier approach tomeasuring and modeling trade flows with the assumption on trade friction effects. As
suggested by Battese and Coelli (1995), generalized likelihood ratio (LR) tests are
required to confirm the functional form and specification. The relevant test statistic is

{

}

{

}

LR = -2 ln[ L(H0 ) /L(H1)] = -2 ln[ L(H0 )] - ln[L(H1)]

where ln(H0 ) and ln(H1)are the values of the likelihood function under the null andalternative hypotheses respectively. According to Coelli (1995), under the null
hypotheses on the maximum likelihood estimates, this test statistic has an
asymptotical mixed chi-square distribution. The critical values of the mixed chisquare distribution are obtained from Kodde and Palm (1986) at the 1 percent level ofsignificance with the degree of freedom equal to the number of parameters assumed to
be zero under the null hypothesis. The results of all hypothesis tests are reported in
the Table A3 below.
Table A3: Likelihood ratio tests of hypothesis of the trade inefficiency effects andtheir determinants
Null hypothesis

 02.99 avalue & df

Import flows model
Decision to 2 -stat
Ho

Export flows model
Decision 2 -statto Ho

8.27 (2)153880

Reject168999Reject25.55 (12)18773

Reject16090

Reject22.53 (10)3370

Reject3172

Rejectg =m=0(No trade inefficiency effects
and trade inefficiency factors
affect directly trade potential =Mean response function)g = d0 = d1 = ... = d10 = 0(All inefficiency effects and theirinfluencing factors are absent)

d1 = ... = d10 = 0(Trade inefficiency exists, butthere are no factors influence theterm)Note: (a) The critical values for the hypotheses are obtained from Kodde and Palm (1986), Table 1; (b)This critical value is at the 5% level of significance.
Source: Author’s calculations.

The first null hypothesis specifies that the inefficiency effects are not stochastic (thismeans the variance of the inefficiency effects  u2 is zero). The LR values for both
import and export flow models are much higher than the critical value of  02.99 ,leading us to strongly reject the null hypothesis. This implies that technical inefficiency
effects are very significant and the OLS estimates associated with the mean response
function are not appropriate in this case. The second null hypothesis, which states thatinefficiency effects and their determinants are absent from the model, is rejected at

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Shiro Armstrong, “Economics Still Trumps Politics Between Japan and China,”Kokusai Mondai(International Affairs), No.634, September 2014
the 1 percent level of significance with high values of the LR. The third null
hypothesis that natural, socio-economic factors as well as policy variables do notjointly have any impact on trade inefficiency is also strongly rejected at the 1 percent
level of significance.
FRONTIER MODELS WITH SFPANEL IN STATA
Variables

IMPORT FLOWS
CoefficientStandard errors

Trade Frontier
lngdpi0.828***
lngdpj0.963***
lndistw-1.014***trend-0.069***Constant-24.347***
Inefficiency Effects Modelcontig-15.244***
comlang_off-4.843***lnRi
0.220***
lnRj
1.439***ANDEAN-30.266***
ASEAN-2.962**
APEC-43.929***EU-10.864***
MERCOSUR-32.354***
NAFTA-3.779Constant-1.063***Usigma2.939***
Vsigma0.539***
N
146942EXPORT FLOWS
CoefficientStandard errors(0.00)(0.00)(0.01)(0.00)(0.10)

0.996***
0.794***-1.168***-0.061***-23.439***(0.00)(0.00)(0.01)(0.00)(0.10)(0.76)(0.16)(0.04)(0.06)(8.12)(1.35)(2.19)(0.56)(8.97)(18.39)(0.23)(0.02)(0.01)-25.304***-6.388***1.633***-0.053-28.892***-15.285***-35.344***-9.185***-23.329***9.478-1.831***2.818***
0.617***
146942(1.43)(0.22)(0.06)(0.05)(7.80)(4.02)(2.05)(0.52)(7.42)(13.23)(0.24)(0.02)(0.01)

Note: * p < 0.05, ** p < 0.01, *** p < 0.001
Source: Author’s calculations.

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