The Overall Impact of ACFTA on FDI

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Chapter 4 The Industry Impacts of ACFTA on FDI

Introduction

Recent studies show that China has started to lose its appeal with MNCs as a result of rising costs, more intense competition from local firms and other reasons (Ianchovichina, Hertel, & Walmsley, 2014). This observation is echoed in a study of the profiles of inward FDI in China by Davies (2012), which shows that although China remains the pre-eminent recipient of inward FDI among developing countries, other developing countries, such as Indonesia and Viet Nam, are starting to steal China’s thunder, offering themselves as cheaper alternatives. Along with the shift of foreign affiliates from China to other low-wage countries, policy emphasis in China itself is switching from attracting labor-intensive, low-technology investment toward more efficient, more productive and less polluting investment. At the same time, the Chinese national and sub-national investment promotion agencies will remain active in their efforts to encourage FDI in activities considered important for China’s rapidly growing economy and its sustainable development.
Chapter 3 finds a positive FDI effect of ACFTA, suggesting that forming FTA could be an effective way for China to keep its attractiveness to MNCs. This chapter explores the mechanism of how ACFTA positively impacts on FDI, with an aim to increase our understanding about the correlation between FTA and FDI and to shed lights how to select FTA partners to facilitate FDI. In theory, FTAs are found to positively correlate with FDI through a market expansion effect and a vertical fragmentation effect. But there has no empirical evidence for the existent of the two effects. This study will provide an empirical test of the two effects through an FDI industry model.
An FDI industry model can help to detect the two effects because I assume that ACFTA impacts on different sectors through different effects. The market expansion effect relates to market-seeking FDI, and thus this effect mainly affects sectors which have extended domestic market to partners’ through export expansion. These sectors are termed export-increasing sectors. The vertical fragmentation effect relates to vertical FDI, and thus this effect mainly affects sectors where it is easy to split production processes. These sectors are termed pro-fragmentation sectors. The FDI industry model requires industrial FDI data. Due to the availability of sectoral FDI data in China’s manufacturing industry, this study focuses on 30 manufacturing sectors of China (Appendix A.3).23
I identify the pro-fragmentation sectors and the export-increasing sectors via trade study. Trade in intermediate goods is an indicator of production fragmentation, and thus could be used to find the pro-fragmentation sectors (Ando and Kimura, 2005). A study of trade in intermediate goods between China and ASEAN suggests that the pro-fragmentation sectors concentrate in machinery and electrical goods (4 sectors according to China’s industrial classification). A study of total trade finds 14 export-increasing sectors, among which textiles, metal products, furniture and culture, education & sport (CE&S) articles show the most significant increases in exports to the ASEAN market. Results from trade studies display a clear-cut separation between the export-increasing and the pro-fragmentation sectors, which makes it easy to isolate the market expansion and the vertical fragmentation effects.
After identifying the pro-fragmentation and the export-increasing sectors, I adopt an FDI industry model developed by Caves (1974) to test the impact of ACFTA on them. The model explains the industry distribution of FDI from a perspective of entry barriers to industry based on the argument that MNCs tend to enter sectors with entry barriers because of the disadvantages to them of operating away from their home base. To detect industry effects of ACFTA, I extend the model to include sector group dummy variables and their interaction terms with ACFTA. The sector group dummy variables indicate the various sector groups, including one group of pro-fragmentation sectors and four groups of export-increasing sectors.
Results show that both of the market expansion and the vertical fragmentation effects exist. The market expansion effect exists in the sectors with international competitiveness, suggesting that these sectors benefit from ACFTA in terms of both export expansion and FDI increases. The vertical fragmentation effect exists in the pro-fragmentation sectors. Liberalization of trade in intermediate goods reduces production costs for and improves accessibility to intermediate goods of MNCs operated vertically in production value chain.
In the following part, section 4.2 analyzes trade data between China and ASEAN, with an aim to revealing the export-increasing sectors and the pro-fragmentation sectors. Section 4.3 introduces the FDI industry model and applies it to the study of ACFTA. The results are presented and discussed in section 4.4. Section 4.5 provides a summary.

Trade Facts
Exports from China to ASEAN

This subsection examines exports from China to ASEAN by total and by sector to find the market expansion of Chinese firms to the ASEAN markets and the export-increasing sectors. ASEAN, as an integrated market, is one of China’s top export destinations.24 From 2004 to 2010, ASEAN moved up from the 5th to 4th largest export market of China, overtaking Japan. The upward movement reflects increasing closeness of the economic relations between China and ASEAN. The ASEAN-China free trade agreement is a result of the close relationship, thus further promoting bilateral trade.
Figure 6 shows a steep increase in China’s exports to ASEAN in recent year. From 2000 to 2008, the exports of China increased from US$17 billion to 114 billion. The strong growth trend was stopped by the Global Financial Crisis (GFC). The exports from China to ASEAN dropped to US$106 billion in 2009, but recovered immediately and strongly, reaching US$170 billion in 2011. Along with the expansion of exports from China to ASEAN, ASEAN’s share of China’s total export markets has grown from 7% to 9%. The growth of ASEAN’s share has mainly occurred since 2006. In the first six years (2000-2006), ASEAN’s share increased by only 0.5%. After 2006, it rose from less than 7.5% to 8% in 2007 and further to 9% in 2010. The significant increases coincide with ASEAN’s steps in tariff reduction under the provisions of ACFTA. In 2007 ASEAN almost halved MFN tariff rates on imports from China, resulting in far more goods than previously being able to move across the borders of China and the ASEAN states. Export expansion pushed up ASEAN’s share of China’s total export market. When tariffs on 90% goods were eliminated in 2010, ASEAN’s share increased even further.25
Figure 6 Exports from China to ASEAN, in billions of US$; and shares of ASEAN in China’s total exports, by percentage.
Data source: UNComtrade
Despite the fact that ASEAN has gained a share of China’s exports to the global market, nevertheless, sectoral exports from China to ASEAN display diverse patterns. The export expansion by sector is measured in percentage terms.26 In order to ascertain ASEAN’s share of China’s export total by sector, I aggregated the sectoral exports to ASEAN and to the world respectively from UNComtrade 4-digit Database of Trade in Commodities. Among the 30 sectors in the manufacturing industry of China, 14 sectors show increases in shares with a possible association with ACFTA from 2000 to 2010.
The remaining sectors show either no change or increase in total export shares prior to the establishment of ACFTA; thus their level of export expansion is unlikely to correlate with the trade agreement. I have plotted the shares of the 14 sectors in Figure 7 and classified them into four groups according to their patterns of increase. All sectors are listed in Appendix A.3.
Figure 7 ASEAN’s share of China’s total exports to the global market by sector group (%).Note: CE&S Articles refer to Culture, Education & Sport Articles
Data Source: UNComtrade
Among the four sector groups, Group I shows a clear connection between export increases and ACFTA. There are four sectors in Group I, namely, furniture, metal products, textiles and CE&S articles.27 The increase rates of exports in all four sectors accelerate after 2006. The most dramatic increase in export share for ASEAN is in furniture. ASEAN’s share of China’s furniture export market increased from 2% to 8% in 2010; 2% was the level at which it had been since long before 2006. Similarly, ASEAN’s share in metal products had fluctuated below 2% for a long period of time before starting to increase in 2006. By 2010, ASEAN was taking up 4% of China’s international sales total for metal products. Textiles and CE&S articles fluctuated at a higher level, 6%~8%. After 2006, ASEAN’s shares in both sectors of the Chinese export market rose to over 8%. The significant and simultaneous increases in ASEAN’s share in the four sectors coincided with tariff reduction steps in the corresponding sectors under ACFTA. Thus, the four sectors in group I are regarded as export-increasing sectors.
Groups II, III & IV also show export increases following the establishment of ACFTA; however the growth trends are less steady and less clear in these groups relative to Group I. In Group II, petroleum processing levelled off after a surge in 2009. Sectors in Group III took off in 2005 and peaked either in 2008 or in 2009, depending on the sector being referred to. The sectors in Group IV show fluctuations with modest increases overall. The modest or short-term increases in Groups II, III & IV could be the result of uneven reductions in tariffs across sectors and ASEAN states. For the automobiles in Group III, while Malaysia cut its tariff rates dramatically, most ASEAN states did not. Sectors in Group IV received a relatively small tariff reduction as the pre-FTA rates were already very low.
Given the less clear links between export increases and ACFTA in these groups, sectors in Groups II, III & IV are still regarded as export-increasing sectors. The export-increasing sectors include all the sectors showing export increases, in order to avoid the case that we miss any chance to capture the market expansion effect.

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China’s Imports of Intermediate Goods from ASEAN

This subsection examines China’s imports of intermediate goods from ASEAN in order to ascertain the pro-fragmentation sectors and explore the possible effect of ACFTA on trade in intermediate goods.28 Following Vezina (2010) and Ando and Kimura (2005), intermediate goods are defined as all HS6 digit product lines whose definitions contain the words “parts” or “components”. Examples include fittings for plastic tube, pipe or hose, pneumatic tyres for motor cars or various integrated circuits. Six hundred and forty intermediate goods are drawn from more than 6600 products in China’s tariff reduction schedule under ACFTA. The majority of intermediate products come from machinery components and parts (HS-84), electrical parts (HS-85) and automobile components (HS-87). The remaining intermediate goods consist of chains and springs (HS-73), objective lenses for camera and other optical products (HS-90), and movements and other parts for watches and clocks (HS-91), etc.
The export data of intermediate goods from ASEAN to China are drawn from the UNComtrade HS 6-digit database from 2000 to 2010.29 The data show that over 90% of trade in intermediate goods occurs in the areas of machinery and electrical goods. According to the industry classification of China, there are four sectors comprising machinery and electrical goods; these are presented in Appendix A.3 under the heading “Pro-fragmentation Sectors”.30
Having ascertained the pro-fragmentation sectors, we wish to establish whether ACFTA had facilitated trade in intermediate goods. If trade in intermediate goods has increased by the initiative of trade liberalization, then ACFTA may have promoted the development of vertical fragmentation in the area. In turn, we would hypothesis that the vertical fragmentation effect on FDI exists for ACFTA.
Intermediate goods are separate into goods with zero tariffs before ACFTA and goods with non-zero tariffs. China’s tariff reduction schedule shows that a considerable number of intermediate goods were already traded freely with ASEAN prior to the introduction of ACFTA. To the contrary, the remaining goods had high tariffs imposed on them under China’s MFN commitments to WTO. Following the establishment of ACFTA, the high tariffs were gradually reduced, and then eliminated for most goods. Thus, tariff liberalization may have boosted trade in goods that used to be blocked. However, it could no longer facilitate trade in the goods that had been previously freely traded. Figure 8 shows exports of the two types of intermediate goods and in total from ASEAN to China.
Prior to 2006, the export of zero-tariff goods completely dominated total exports. The exporting totals for non-zero-tariff goods were almost zero. After 2006, the exporting of non-zero-tariff goods surged and then dropped a little before growing steadily after 2008. Meanwhile trade in zero-tariff goods dropped continuously until 2009. After that it fluctuated between US$10~20 billion. In 2009, trade in non-zero-tariff goods overtook trade in zero-tariff goods. By 2010, the exports of non-zero-tariff goods reached US$22 billion. In the period of 2006 ~ 2011, total trade of intermediate goods has increased from US$27.9 to 39.4 billion given the switch between zero- and non-zero-tariff goods. The switch between zero- and non-zero-tariff goods could infer that firms had gained efficiency by choosing the most suitable types of intermediate goods after the increase in varieties allowed through trade liberalization.31
The strong increase in the exports of non-zero-tariff goods after 2006 forms a very clear comparison with the previously occurring long-term zero growth; thus it is likely to reflect the component trade impact of ACFTA identified by Sheng, Tang, and Xu (2014). Sheng et al. (2014) find that ACFTA has a significant trade creation effect on component trade between China and ASEAN, which seems stronger than the trade creation effect on final goods. The author concludes that the large trade flows in parts and components imply that industries in ASEAN and China will become more closely integrated. Put another way, the production value chain in the free trade area will thrive after the establishment of ACFTA. Based on the fact that vertical MNCs are the main users and drivers of production value chain, we could hypothesis that vertical FDI would increase in the production value chains of this area.
The exporting of intermediate goods to China, in other words, the importing of goods by China, can be linked to China’s policy of export tax rebating. Since 1994, in order to promote exports, the Chinese government has refunded domestic taxes for all inputs for the production of final export products to firms, including the import tariffs on intermediate goods from overseas. This means that import tariffs on intermediate goods used for the production of export products are refundable following their exportation. This being the case, the preferential tariffs under ACFTA should have no impact on trade in intermediate goods in instances in which most of imported parts and components are used for the production of export goods. However, Figure 8 shows that non-zero-tariff goods respond significantly to tariff reduction, suggesting that the export tax rebate does not alter the expectation for ACFTA. A partial explanation for this could be that some of imported intermediates are not used to produce export goods; however, the more likely reason is that in practice, firms prefer to import zero tariff goods, in order to avoid administrative costs in relation to the tariff rebate.
In summary, section 4.2 examines total exports from China to ASEAN and the importing of intermediate goods of China from ASEAN. The trade study finds 14 export-increasing sectors and 4 pro-fragmentation sectors. Within the 14 export-increasing sectors, the sectors in Group I show the most significant export expansion following the establishment of ACFTA. Trade in intermediate goods liberalized by ACFTA also responded dramatically. Having identified the export-increasing and the pro-fragmentation sectors, the next aim is to detect the market expansion and the vertical fragmentation effects through econometric models.

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Table of Contents
Abstract
Acknowledgements
List of Figures
List of Tables
Chapter 1 Introduction 
1.1. The FDI Study of ACFTA
1.2. The FDI study of RCEP
1.3. Thesis Outline
Chapter 2 Literature Review 
2.1. Evolution of East Asian Regionalism
2.2. Theoretical Studies about the Impact of FTA on FDI
2.3. Econometric Studies about the Impact of FTA on FDI
2.4. CGE Studies about FTA and FDI
2.5. Summary
Chapter 3 The Overall Impact of ACFTA on FDI
3.1. Introduction
3.2. ACFTA Agreements and FDI
3.3. The Impacts of ACFTA on FDI
3.4. Data and Methodology
3.5. Results
3.6. Summary
Chapter 4 The Industry Impacts of ACFTA on FDI
4.1. Introduction
4.2. Trade Facts
4.3. Model
4.4. Results
4.5. Summary
Chapter 5 Analyzing Effects of RCEP on FDI in a Firm Heterogeneity CGE Framework 
5.1. Introduction
5.2. Literature Review
5.3. Model
5.4. Data and Calibration
5.5. Model Tests and Results
5.6. Summary
Chapter 6 Conclusion 
6.1. The Study of ACFTA
6.2. The Study of RCEP
6.3. Limitations and Further Study
References
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The Effects of East Asian Free Trade Agreements on Foreign Direct Investment

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