The impact of free trade agreement on trade flow of goods in vietnam

UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES HO CHI MINH CITY THE HAGUE VIETNAM THE NETHERLANDS VIETNAM - NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS THE IMPACT OF

UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES

HO CHI MINH CITY THE HAGUE

VIETNAM THE NETHERLANDS

VIETNAM - NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

THE IMPACT OF FREE TRADE AGREEMENT

ON TRADE FLOW OF GOODS IN VIETNAM

BY NGUYEN QUANG HUY

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

HO CHI MINH CITY, DECEMBER 2014

UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES

VIETNAM THE NETHERLANDS

VIETNAM - NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

THE IMPACT OF FREE TRADE AGREEMENT

ON TRADE FLOW OF GOODS IN VIETNAM

A thesis submitted in partial fulfilment of the requirements for the degree of

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

By

NGUYEN QUANG HUY

Academic Supervisor:

Assc Prof Dr NGUYEN TRONG HOAI

HO CHI MINH CITY, DECEMBER 2014

I would like to give a great thank to Ms Xuan Hong, Mr Tam, Mr Huy, and Mr Quy

in supporting and providing information, lab room for my writing and preparation

On my writing process, I received great support from Ms Yen, Mr Anh, and Mr Chinh, my classmates at class 19 Without their support and sharing, it is really difficult to cope with the huge pressure in finishing thesis on time

ABSTRACT

This study devotes to analyze the effect of free trade agreement on

Vietnam’s trade flow of goods by establishing gravity model for 184 trading

partners between 1990 and 2012 Basing on the theoretical foundation and previous

empirical papers, the FTA is expected to have positive relationship with trade flow

of member countries In details, two countries being in a same FTA will trade much

more than those without in a same FTA The results from the current study also find

out that FTA’s estimated coefficients are consistently positive

Relating to the methodology, two main problems discussed in gravity model

are endogeneity of FTA and zero-value in trade Firstly, the thesis points out that

FTA is exogenous variable in the gravity model Secondly, sample selection model,

Poisson Pseudo Maximum Likelihood, and Fixed-effect model are used to solve the

zero problems in model The empirical results from all estimation models are

consistent with each other in term of sign of FTA’s coefficient

For policy implication, the thesis proposes that FTA is a good trade policy

for Vietnam because it can help to improve the total bilateral trade value among

FTA members However, FTA does not impact on trade flow only, but it also has

effect on other aspects of Vietnam economy such as wage structural, investment

Those issues are beyond the objective of this study

Key words: Free Trade Agreement, gravity model, total bilateral trade

TABLE OF CONTENTS

CHAPTER 1 INTRODUCTION 1

1.1 Problem Statement 1

1.2 Research Objectives 4

1.3 Research questions 4

CHAPTER 2 LITERATURE REVIEW 5

2.1 Theoretical literature 5

2.1.1 Trade Theories 5

2.1.2 Free Trade Agreement 8

2.1.3 The role of free trade agreement 9

2.2 EMPIRICAL LITERATURE 16

2.2.1 Trade Flow 16

2.2.2 Free Trade Agreement 18

2.2.3 Control ling factors 19

2.2.4 Conceptual Framework 21

2.2.5 Empirical study on estimation model 24

CHAPTER 3 OVERVIEW OF VIETNAM’S FREE TRADE AGREEMENT 26

3.1 ASEAN Free Trade Agreement (AFTA) 26

3.2 ASEAN-People’s Republic of China Comprehensive Economic Cooperation Partnership (ACFTA) 28

3.3 ASEAN- Australia and New Zealand Free Trade Agreement (AANZFTA) 31

3.4 ASEAN-India Free Trade Agreement (AIFTA) 33

3.5 ASEAN-Republic of Korea Comprehensive Economic Cooperation Agreement (AKFTA) 34

3.6 Japan-Vietnam Economic Partnership Agreement (VJEPA) 37

CHAPTER 4 RESEARCH METHODOLOGY 39

4.1 Model Specification and Estimation Method 39

4.1.1 Model for solving endogenous problem 41

4.1.2 Model for Solving Heteroscedasticity and Zero-Trade Value 44

4.1.3 Log-form gravity model: 45

4.1.4 Multiplicative-form gravity model 49

4.2 Variable Definition 51

4.2.1 Dependent Variable in Model Specification 51

4.2.2 Independent variables in the Model Specification 51

4.3 Data Collection 56

4.3.1 Sources of data 56

4.3.2 Sample Selection 56

CHAPTER 5 EMPIRICAL RESULT 60

5.1 Testing Results 60

5.1.1 Endogenous testing for FTA 60

5.1.2 Testing for Multi-collinearity 60

5.2 Empirical Results 60

5.2.1 Log-form gravity model 60

5.2.2 Multiplicative-Form Gravity Model 66

CHAPTER 6 CONCLUSION 70

6.1 Conclusion 70

6.2 Policy Implication 72

6.3 Limitation 72

REFERENCE 74

LIST OF TABLES

Table 3-1:ACFTA's Tariff Elimination schedule for Vietnam 29

Table 3-2: Preferential Tariff Rate commitment by Vietnam for AKFTA 35

Table 4-1: Model Specifications Summary 50

Table 4-2: Variable Definition 58

Table 4-3: Variables Descriptive Statistics 59

Table 5-1: Testing endogeneity of FTA 60

Table 5-2: Regression Result for Fixed-Effect Model 62

Table 5-3: Regression Result for Sample Selection Model 65

Table 5-4: Testing Results for Collinearity Problem in sample selection model 66

Table 5-5: Testing results for Interaction Terms in Sample Selection Model 66

Table 5-6: Regression Results for PPML model Dependent variable Tvjt 67

LIST OF FIGURES Figure 1-1: Trade share of FTA countries and non-FTA countries 1

Figure 1-2: Trade share among Vietnam FTAs 2

Figure 1-3: Trade Share of FTA countries, EU, and USA 2

Figure 2-1: The Relationship Between FTA and Trade Flow 13

Figure 2-2: Conceptual Framework 23

Figure 3-1: Trade Pattern between Vietnam and ASEAN Members, 1990-2012 26

Figure 3-2: Change in Trade Flow Vietnam and ASEAN Countries, Excluding Brunei 27

Figure 3-3: Trade Pattern between Vietnam and ACFTA members, 1990-2012 30

Figure 3-4: Change in Trade Flow between Vietnam and ACFTA Members 31

Figure 3-5: Trade between Vietnam and Australia-New Zealand, 1990-2012 32

Figure 3-6: Change In Trade Flow Between Vietnam And AANZFTA Members 33

Figure 3-7: Trade between Vietnam and India, 1990-2012 33

Figure 3-8: Change in Trade between Vietnam and India, 1990-2012 34

Figure 3-9: Trade between Vietnam-Korea, 1990-2012 36

Figure 3-10: Change In Trade Flow Between Vietnam And AKFTA Members 36

Figure 3-11: Trade Between Vietnam and Japan, 1990-2012 37

Figure 3-12: Change in Trade Flow Between Vietnam and Japan 38

Figure 4-1: Total Bilateral Trade between Vietnam and US 43

Figure 4-2: ASEAN Trade Balance with China 44

ABBREVATION

ASEAN Association of Southeast Asian Nation

VJEPA Vietnam-Japan Economic Partnership Agreement

CHAPTER 1 INTRODUCTION

1.1 Problem Statement

According to World Trade Organization, Vietnam is now official member of

eight free trade agreements which are signed and into force; and, Vietnam is also launching negotiation with a number of countries and economic groups to establish

free trade agreement such as TPP, ASEAN-EU FTA In 2012, trade balances between Vietnam and other members of ASEAN Free Trade Agreement (AFTA), recorded at -

US $3.443 billion, and Vietnam – China trade balance, members of ACFTA, is – US

$16.397 billion (Customs Handbook on International Merchandise Trade Statistics of Vietnam, 2012) In stark contrast, the net export of Vietnam to the Australia and New

Zealand, members of ASEAN-ANZ FTA, is US $ 1.2258 billion in 2012(computed

base on Customs Handbook on International Merchandise Trade Statistics of Vietnam,

2012 It can be observed that trade patterns of Vietnam among FTA partner are

different

As can be seen from the Figure 1-1, share of FTA countries was around 50 percent of Vietnam total trade over the period of 1990-2012, thus the FTA-trading partners play essential role in the trade of Vietnam However, from 2000 afterwards, the share of non-FTA countries gradually rose; this can be explained by the increase in

trade between Vietnam and European countries and the United States of America

Share of FTA countries Non-FTA share

Figure 1-1: Trade share of FTA countries and non-FTA countries

Source: Author’s Construction

Furthermore, among Vietnam FTAs, AFTA share was decreasing from around

30 percent in 1996 to 15 percent in 2012 The decreasing trend can be attributed from

the increase in share of AFTA plus For instance, the trade between Vietnam and

China, member of ASEAN- China FTA, increased nearly three times from 2000 to

2012 Another positive change after signing FTA is with Korea to establish

ASEAN-Korea FTA Yet, the change in trade share of other AFTA plus are not significantly

Therefore, a question posed is that whether the impact of FTA on Vietnam trade flow

Share of FTA countries US share EU share Other

Figure 1-2: Trade Share of FTA countries, EU, and USA

Figure 1-3: Trade share among Vietnam FTAs

Source: Author’s Construction Source: Author’s Construction

Relating to academic perspective, the free trade is espoused in improving the trade and welfare of signing countries This belief is developed from the absolute advantage by Adam Smith, comparative advantage by David Ricardo, Heckscher-Ohlin model by Eli Heckscher and Bertil Ohlin to Paul Krugman with economies of scale and product differentiation On the other hand, Viner (1950) not only accepted the gain from free trade but he also pointed out the loss if countries build trading blocs The “trade diversion” is the terminology for the diverting trade from countries

to countries Therefore, question should be asked is how trade flow of Vietnam is affected by her free trade agreements

There are many papers investigated the relationship between free trade agreement and bilateral trade On the one hand, Hur, Alba &Park (2009) conducted a research to evaluate the Hub-and-Spoke problem in free trade agreements by using panel data analysis of 96 countries from 1960 to 2000; and concluded that in spite of the existing of overlapping free trade agreement, export also increased Other relevant paper by Baier & Berstrand (2009) which gives comprehensive contribution to the empirical model to investigate the effect of free trade agreement on international trade flow also found the positive linkage On the other hand, Aitken (1972) does an empirical research on trade creating and trade diverting after the establishment of EEC and EFTA He found that EEC increase trading value of member countries significantly by trade creating and external trade diverting, whereas the effect of EFTA is not considerably because of trade diverting Besides, Bhavish, Jugurnath, Stewart & Brooks (2007), evaluate ASEAN FTA, APEC, CER, MERCOSUR and NFTA, assert that ASEAN FTA, CER increase significantly its members’ trade, while MERCOSUR, NFTA and APEC created the trade diversion As a result, the demand for study for international trade effect on specific context needs a critical exploration However, papers analyses the linkage between free trade agreement and trade flow in Vietnam is limited For instance, Thai (2006) used gravity model to calculate the trade between Vietnam and twenty-three European countries The paper found the determinants in trading such as economic characteristics, exchange rate volatility and the demand of destination However, Free trade Agreement is not mentioned in the paper because Vietnam and those countries have not signed Free trade Agreement yet

Other paper investigates the impact of ASEAN Free Trade Agreement (AFTA) on Vietnam’s economy is by Fukase & Martin (2001) The authors concluded that impact

of AFTA is not significant Agricultural sector gets benefit from that free trade because of exporting opportunity to ASEAN market, while some other industries is hurt and need to be protected due to ASEAN competitors The paper applied simulation methodology to draw the conclusion, and does not analyze the dynamic effect of AFTA Therefore, this thesis will depict the role of free trade agreement on bilateral trade in goods of Vietnam by applying gravity model approach, and panel data which developed by previous papers

1.2 Research Objectives

The main objective of thesis is:

 To investigate the impact of free trade agreement on trade flow of goods in Vietnam

1.3 Research questions

To attain the research objective of this thesis, there are two primary research questions are as follow

1 Do free trade agreements impact on trade flow of goods in Vietnam?

2 How much free trade agreements impact on trade flow of goods in Vietnam?

CHAPTER 2 LITERATURE REVIEW

2.1 Theoretical literature

2.1.1 Trade Theories

The first theoretical theory on international trade come from the idea of Adam

Smith in his book named “An Inquiry into the Nature and Causes of the Wealth of

Nations”, published in 1776 Adam Smith disagreed with the ideas of mercantilists

who believed that trade only benefit to the home country at the cost of trading partner

By conceding that countries can gain from trade, Adam Smith pointed out that gain from trade is attributed to the efficiently reallocation resource within country through the absolute advantage of country Each country will be more effectively and efficiently produce certain kind of commodities than those of other countries, thus the absolute production cost will be lower in country Therefore, country will reallocate its resources to specialize in producing commodities which have absolute advantage, and exchange for product with absolute disadvantage (Salvatore, 2012) In final, both countries can consume the greater number of commodities than those of before trade Besides the increase in volume of consumption, Schumacher (2012) asserted that Adam Smith theory also attributed the gain from trade to the increasing in international competitiveness This is not equivalently discussed in many textbooks However, absolute advantage is claim for its explanation why one country whose absolute advantage is completely unavailable can trade with other countries That is the problem solved by theory called comparative advantage, or Ricardian model

Another influential theoretical foundation developed based on absolute advantage is comparative advantage, or Ricardian model named after Ricardo, the first economist mentioned the concept In Ricardian model, the difference in relative labor productivity is the primary reason for international trade between countries, because the model assumes that labor is only one factor of production; and labor can move freely between sectors within country Although the model is claimed as its simplified assumption, its contribution is considerable on explaining trade pattern of countries Firstly, Ricardian model pointed out that country exports a good to other country because its amount of other good given up to produced that good in exporting country

is lower than that in partner country; this concept is called comparative advantage Comparative advantage has helped to explain why a country having no absolute advantage can also gain from trade, in other words, the central determinant in trade is relative productivity of goods within country in compare to that of other country In comparative advantage, international trade can benefit trading countries because import activities in the model are considered similarly to indirect production (Krugman, Obstfeld, & Melitz, 2012) Indirect production means that country can specialize in a good, and then export that good in exchange for importing other good

at lower relative cost than domestic producing Secondly, the comparative advantage

is an initial concept in order to develop the cost advantage of country (Krugman, Obstfeld, & Melitz, 2012) In details, the relative low productivity country has lower wage, and then leads to lower cost relative to cost in high productivity country This concept is the explanation for notion that high wage country can export goods to low wage country because of high productivity compensation in high wage Finally, Ricardian model implies that all countries can benefit from trade based on its disputing assumptions

According to Ricardian model, countries will certainly benefit from participating in international trade; however, the counter argument is that the “one factor assumption” is unrealistic Therefore, the specific-factors model breaks one factor assumption of Ricardian model by extending specific factor of production in each sector within a country Together with mobile labor, each sector consists of one production factor which cannot move to other sector The simple specific factor model exploits capital and land as two specific factors The specific- factor model presents that the country can be potentially better off by trading In details, there are winner who gain and loser who lose from trade The model stated that specific factor in the exporting sector of each country gains from trade, whereas specific factor in importing sector loses from trade; besides, mobile factor, namely labor, may gain or lose which

is depend on the consumption of labor on goods in each sector (Krugman, Obstfeld, & Melitz, 2012) In general, Krugman, Obstfeld, & Melitz (2012) asserted that international trade benefits countries as a whole because an increase in the wider choice for consumption can compensate the sector hurt In conclusion, the income

distribution effect helps to explain the benefit and cost of international trade, and give reason why many countries maintain the trade barrier to protect their domestic sector from foreign comer

Jones & Neary (1982) asserted that specific-factor model explained the international trade in short run, and could transform to Heckscher- Ohlin model because specific factors are mobile in the long run The Hechscher- Ohlin model is the model in which all factors of production move freely between sectors In the model, the reason country trade with each other is determined by the difference in ratio of nation’s resources, and in technology, the combination of factors to produce a good H-O model explain that country will gain from trade if it exports product in whose factor is well endowed and relatively intensive Well endowed means that the relative ratio of factor productions in country is higher than that of its partner countries while relative intensive explicates that relative ratio of that factor to other factor used to produce that good is higher than that of producing other good H-O model provides that international trade will impact on income distribution as a result of change relative price of goods, and the relative factor price (Krugman, Obstfeld, & Melitz, 2012)

The theoretical models discussed above are based on the competitive market, yet there are other types of markets such as monopoly, oligopoly, and monopolistic competition Krugman (1979) developed a trade-related theory based on economies of scale in monopolistic competition market The economies of scale is internal to firm, that means firm get profit when increases its scale of output Trading with other countries leads to specialization, and created concentrated location of production In that case, countries can achieve cost advantage through mass- production which is not based primarily on comparative advantage The question put here is that how countries decide which industries they will produce in large scale in order to compete and export in world market Krugman (1979) suggested that the market structure may

be a contributed factor For instant, in oligopoly market, there are few suppliers for whole market, and this is an appropriate condition for economies of scale However, the question arising is that how domestics firms can compete to foreign firms in world

market Therefore, the reason that country trade is not only the differences in nation’s resource and technology but also the economies of scale, and yet there is a relationship between the Ricardian model, H-O model and economies of scale in explaining the international trade pattern

2.1.2 Free Trade Agreement

The standard theory of international trade is built on the assumption of trade having no cost arise when deliver goods from exporting country to destination country Samuelson (1962), for instance, wrote a paper on analyzing the benefit from free trade, and concluded that free trade potentially better for trading countries in which winners can allocate benefit to the hurt; yet, the trade cost occur on international trade and impact on the pattern of bilateral trade (Krugman, Obstfeld, & Melitz, 2012) Anderson & van Wincoop (2004) analyzed the impact of trade cost on trade flow between countries, and concluded that trade cost is greatly in trade between countries They are reasons for the existing of free trade agreement among trading countries The economic benefits of free trade are discussed in the international trade theory, yet there is still political determinant of free trade between countries According to Krugman (1987), free trade agreement is a tool to prevent the trade war between countries and interest group problem within country because free trade provide certain rule and principle in trade agreed by both countries, and is difficult to violate The issue posed is that how to approach a free trade in real world Krugman (1991) mentioned increasing trend of bilateral free trade agreement as substitution for global free trade agreement The paper indicates that free trade agreement can benefit participants by reducing the consumer’s distortion, increase the power in trade to other countries, and creating the efficient in production Krugman (1991) also mentioned the notion of ‘natural trading bloc’ which explains free trade agreement as a natural process of countries located near together Free trade agreement also established between countries having similar economic characteristics

in order to increase its trading value (Baier & Bergstrand, 2004) World Trade Organization defined free trade agreement is an accord between signed countries on the significant reduction on trade tariff and other trade regulation

2.1.3 The role of free trade agreement

2.1.3.1 Trade Creation and Trade Diversion Effect

Lipsey (1957) built a simple model with three countries A, B, and C A is a small country which produces wheat; B and C produce clothing In an open economy,

A will import clothing from C because C’s relative price of clothing is lower than that

of B Assume that A sets a tariff on clothing import from both B and C If the tariff is high enough, A will produce clothing herself However, A is assumed to form a custom union with B As a result of those policies, price of clothing imported from B without tariff is cheaper than C’s with tariff; and, A will import clothing from B This phenomenon is called trade diversion of A from C to B Lipsey (1957) analyzed that a customs union causing trade diversion by change the trading pattern in favor of

custom union suppliers Lipsey (1960) mentioned that more likely the occurrence of

trade creation is the greater difference in the cost of production the same commodity

between two countries Bhagwati (1971) clarified that a shift of importing goods from

lower cost supplier to higher cost one is called trade diversion While Lipsey (1960) advocate that trade-diverting customs union could not decrease the welfare of importing countries because of the substitution in consumption, Bhagwati (1971) pointed out substitution is not a sufficient conditions; yet, trade diversion effect can reduce economic welfare under the assumption of fixed imported level In details, the change in import pattern due to formation of customs unions creates two opposite effect on the welfare The first one is the loss in term of trade The second one is the gain from consumption and production, which is the rise in trade flow among member countries (Bhagwati, 1971)

After establishing a customs union, member countries can shift import from higher-taxed suppliers to lower-no taxed suppliers; and domestic goods are substituted

by member’s low-cost goods Johnson (1974) stated these above movements will balance the increasing-welfare Lipsey (1957) and Bhagwati (1971) defined the trade diversion as the change in the locus of production from initial lower supplier to higher member suppliers Johnson (1974) argued that trade diversion can give a transfer from locus of production which negatively impact on welfare, and create a substitution effect which positively impact on welfare Furthermore, Michaely (1976) asserted that

trade liberalization impacts on the trade pattern of signing countries in three ways First effect is the increase in new trade flow between bloc’s members Secondly, reducing trade barrier can divert the import from non-member suppliers to member suppliers Finally, the change in term of trade is an attributable to a rise in demand of substitute commodity

2.1.3.2 The intensive margin and extensive margin effect

In Krugman (1980), the pattern of trade is explained by two reasons Firstly, consumers in each country have different preferences on commodities with the low substitution elasticity of foreign goods, so they demand the exporting goods The second reason is the economies of scale, so one country can produce goods in lower cost than other countries in order to become least cost supplier in world trade The model of Krugman assumed that firms are the same, and can export to every country The only trading cost is transportation cost As a result of those assumptions, the impact of trade barrier on trade flow is explained by the change in level of exporting

of incumbent firms, which is called intensive margin In details, if the trade barrier is reduced, aggregate trade flow can increase because all firms raise their exporting capacity of goods; so, every firm is equally impacted by trade policies changes Melitz (2003) stated that firms wanting to enter exporting market encounter not only the variable costs such as transportation cost but also fixed cost which is independent to the number of goods exported As a result of that, Melitz (2003) built up a model to find the static equilibrium of firms’ exporting in countries which expose to international market, the paper concluded that trade liberalization effects on the trade pattern of firm and reallocation resources within exporting industries through the increase in number of importing countries, and the decrease in trade cost, both variable cost and fixed cost Firstly, the rise in trading countries is a condition to increase in the productivity requirement for exporting firms The least productive firms can be forced to exit out of the market; the survival firms will increase its volume of export to current and new destinations (Melitz, 2003) Secondly, the decrease in trade cost can impact on trade pattern through the emergence of new exporters New exporter and current exporter capture the higher demand from export

market, and leads to an increase in volume of trade In Ghironi and Melitz (2005), the authors considered the trade cost as an exogenous factor of term of trade The paper concluded that the trade cost decreasing as a result of trade liberalization primarily impacts on the change of trade volume through the extensive margin The reason is that countries will face a growth in number of firm exports, and decrease in productivity breaking points

Furthermore, Chaney (2008) supported the argument of Melitz (2003) by imposing the intensive margins and extensive margins effect of trade cost on trade flow He pointed out that firm is different in productivity and suffers fixed cost in trading besides variable cost By adding new assumptions, Chaney (2008) stated that change in trade flow due to trade barrier shock can be explained through two mechanisms The first mechanism is the intensive margin mentioned by Krugman (1980) The second one is the extensive margin which is the change in the number of exporter in different sectors In general, trade barrier reduction such as free trade agreement between two countries leads to the change in the number of good each firm exports, and new exporters can enter the market Crozet and Koenig (2010) confirmed the theory in heterogeneous firms established in Chaney (2008) The paper disintegrated effect of trade cost on trade flow in to intensive margin and extensive margin as follow:

 is the trade cost elasticity of internal margins

Crozet and Koenig (2010) concluded that the change in trade flow due to fluctuation in trade cost varied across the industries In details, the reducing in trade barrier impacts on trade level greater in homogenous industries than more heterogeneous industries Extensive margin effect can dominate the intensive margin

  

effect in industry with high differentiated product Moreover, Helpman, Melitz, and

Rubinstein (2008) stated that the profitability of firm export is higher if the importing

countries’ demand is higher, and lower trade costs On the other hand, firm will not export if the profit of firm is negative That can explain the zero value in export between two countries He showed the primary bias in estimating impact of trade barrier on trade flow is attributed to ignoring extensive margin effect The reducing in trade friction may not only lead to the expansion of trade between existent country pairs, but also to create new trading partners

From the above theoretical foundation, the impact of free trade agreement on trade flow can be summarized in the following figur

Source: Constructed by the Author

MEMBER TRADING PARTNER

TRADE VOLUME OF CURRENT EXPORTING FIRMS

NEW EXPORTING FIRMS

TRADE WITH MEMBER TRADING PARTNER

NON Figure 2-1: The Relationship Between FTA and Trade Flow

-

Figure 2-1 presents the theoretical foundation to answer research questions of the thesis The first one is that what the impact of free trade agreement on total trade flow between signing countries is Secondly, how that impact happens, or what channels free trade agreement effect the change in trade flow

FTA and Trade Barriers:

FTA by its objectives is to eliminate the tariffs, quota and other tariff equivalent barriers among member states The other purpose is to build an integrated regional economy, so FTA will facilitate the reduction in other non-trade barrier such

as technical barrier, capital flow, cross border transit and human movement

Trade Barriers and Trade with Member Countries and Non-member Countries:

According to trade creation and trade diversion theory, when the trade barriers goes down, the trading cost also decreases both in variable cost and fixed cost The decrease in trade cost is a condition for two trading activities The first one is the trade diversion Non-member countries suffer the full import tariff from a member country, while other member countries are in favor of tax reduction In details, the trading cost

of member partner is lower than that of non-member countries, so making member trader is the least cost supplier Therefore, there is the decrease in the trade flow between member countries and non-member countries

Trade with Member Countries and Exporting Firms:

The reducing trade cost between free trade countries will increase demand of commodities export from member countries to other member countries This leads to the intensive margin and extensive margin effect in trade pattern Firstly, the current exporter will increase their volume of trade due to the increase in demand and lower cost The intensive margin effect will influence positively on trade flow between two countries However, this effect will be lower in more heterogeneous productivity industries Secondly, there will be new firms enter exporting market Those new firms will affect positively in the trade flow between countries The more heterogeneous productivity between firms the more positive effect of extensive margin on trade flow

Exporting Firms and Total Trade Flow:

The intensive margin will impact positively on the level of goods existing firms export, while the extensive margin will attract more firms come into the new exporting market Although the impacts of intensive and extensive margin are not as the same level, in sector whose products substitution elasticity are high, extensive margin impact will dominate intensive margin’s effect However, both effects are to increase the trade volume with the member countries

2.2 EMPIRICAL LITERATURE

From the theoretical mechanism built in theoretical literature, this section aims

to provide empirical indicators used by previous researches Aitken (1973) is the first author which applied the theory of gravity model in order to estimate the effect of European Economic Community (EEC) and European Free Trade Association (EFTA) on the import and export of member countries In his model, he proposed a number of indicators for conceptions in the theoretical model The dependent variable was export value The independent variables were Free trade agreement, Income of exporting countries, Income of Importing countries, Distance between trading partners Those indicators have been used by latter researches on observing the impact

of FTA on trade flow of countries

There are two main parts in this section The first part is indicator for trade flow, which is the dependent variable in this thesis The second part is indicators for independent variables which are Free Trade Agreement (FTA), exporter’s income, importer’s income, and distance between trading countries

2.2.1 Trade Flow

In empirical papers, there are three indicators for trade flow between countries

Firstly, McCallum (1995) used the shipment value from one country to other country

as the representative for trade flow In his paper, he analyzed the impact of trade border effect in the trade between The United States of America (USA) and Canada The idea of research is that within-provincial trade of Canada is greater than the trade with USA’s states, or foreign trade By applying the gravity model as follow:

(2.2) Where xij is the total export from region i to region j

Anderson and Wincoop (2003) examined the results obtaining from McCallum (1995) The authors argued that the result is overestimated because it omitted trade resistance variables which are called multilateral resistance terms (MRTs) Anderson and Wincoop (2003) proposed a new estimated model as follow:

40 years from 1960 In the model, dependent variable is real exporting value, the nominal exporting value divided by GDP deflator However, Yang and Martinez-Zarzoso (2014) estimated whether ASEAN-China Free Trade agreement is trade creation or trade diversion In the paper, current export level in US dollar represent for trade flow concept in international trade

On the other hand, Jugurnath, Stewart, and Brook (2007) did not exploit the export value as an indicator for trade flow Instead of that, current import value is use

as a dependent variable in the model The reason is that country often strictly reports its import value for the tax purpose, so the import value is more correct than export value

2.2.2 Free Trade Agreement

The primary effect of FTA on trade flow is through the elimination of trade tariffs, so many research papers has analyzed trade cost as a tool for evaluation the impact of FTA Anderson and Wincoop (2003) use the following measurement:

by using variable FTA as a dummy variable The variable FTA took value of 1 of exporter and importer are in the same free trade area, unless FTA was equal to 0 The paper use panel data and fixed effect estimation to find the FTA’s coefficient, and the result showed that there is positive relationship between FTA and trade flow Basing

on Baier and Bergstrand (2007), Jugurnath, Stewart, and Brooks (2007) also used FTA as dummy variable in their paper However, the paper not only estimated the impact of FTA on trade flow, but also intent to find the trade diversion and trade creation effect of FTA Therefore, they set up more dummies variable to separate the diversion and creation effect in trade The model is as follow:

in same FTA This variable showed the trade increase between member countries as

the effect of ACFTA The second dummy FTA is equal 1 if exporter is in the ACFTA, and importer is not in ACFTA The final dummy FTA is equal 1 if only importer is in ACFTA FTA dummy variable is applied to measure free trade agreement effect in Hur, Alba, and Park (2010) Objectives of the paper are to answer two questions The first question is the effect of FTA on trade by using dummy variable FTA as in Baier and Bergstrand (2007) The second question is the hub and spoke nature of FTA Data covered 96 countries in the world in 40 years from 1960 By applying fixed effect panel data in estimation, the paper pointed out that the increase in export of countries which are in same free trade agreement

In conclusion, indicator for Free Trade Agreement is the dummy variable taking value of 1 if two countries is in same FTA, otherwise, FTA equal to 0 The coefficient of FTA variable is expected to be positive

Hypothesis 1: FTA relates positively to trade flow of goods

2.2.3 Control ling factors

2.2.3.1 Income of exporting and importing countries

Aitken (1973) took the nominal GDP of exporting and importing countries as measurement of income concept in international trade This indicator for income has been accepted by other empirical papers Anderson and Wincoop (2003) chose the gross domestic production as a proxy for income of trading countries The nominal gross domestic production also used in paper of Jugurnath, Stewart, and Brooks (2007) However, Baier and Bergstrand (2007) divided nominal GDP by the GDP deflator in order to obtain real GDP There was no clear argument between choosing nominal GDP or real GDP as an indicator for income In all mentioned papers, both income of exporting country and importing countries have been found to impact positively on the trade flow

Hypothesis 2: Income of countries relates positively to trade flow of goods 2.2.3.2 Distance

The development of information technology and transportation infrastructure has leaded to a decrease in transport cost between countries, yet the question arose is

whether the distance effect on trade flow is important or not Disdier and Head (2008) analyzed the distance effect on trading between two countries The paper collected

1467 coefficients of distance on trade flow from the estimation of 103 papers, and then found out that the change in the value of distance elasticity of trade flow The authors stated that the mean effect of distance is approximate 0.9 meaning that 10 percent increase in the distance of two countries; the trade value will decrease 9 percent

Carrère and Schiff (2005) conducted a paper to answer for puzzle in distance of trade In the paper, the authors decomposed the components of transport cost into non-distance trade cost whose costs do not related to distance of goods export, and distance cost By analyzing the transport cost of data from 150 countries between

1962 and 2000, Carrere and Schiff (2005) stated that the decision on how much to trade to foreign countries locating at varied distance depends on the combination of non-distance cost and distance cost Although the paper did not solve which costs can

be dominance factors, the measurement showed that the distance’s role in trade is rose throughout the period.)

Relating to measure distance variable in empirical study, Baier and Bergstrand (2007) measured the distance variable by the distance between economic center of countries, while Yang and Martinez-Zarzoso (2014) estimate the distance variable by calculating the great circle distance from capital of exporting countries to capital of importing countries In both papers, the expected impact of distance on trade flow is negative

Hypothesis 3: Distance relates negatively to the trade flow of goods

2.2.3.3 Exchange rate

The role of exchange rate in international trade is an ongoing argument within empirical studies Rose and Wincoop (2001) did a research on the effect of currency union on European countries on the trade flow The paper used Economic and Monetary Union (EMU) as an indicator for no exchange rate volatility in international trade In the paper, if the EMU impacts positively on the trade flow of member countries, the exchange rate volatility has negative relationship on export and import

value By using data on trade of 200 countries from 1970 to 1995, the paper applied gravity model adding EMU dummies variable for estimation The result indicated that the trade between EMU countries is higher than those without in EMU In detail, EMU increased trade within European countries approximately 250% to 400% Rose and Wincoop (2001) posed the importance of currency barrier in trade flow McKenzie (2002) conducted a paper reviewing previous researches on the risk of exchange rate’s effect to trade The papers also found out the conclusion supporting Rose and Wincoop (2001); the result is that exchange rate volatility impact negatively

on international trade, yet the degree of impact varying among the paper The explanation for this problem came from the issue in measuring exchange rate volatility There are many techniques to calculate the value of the fluctuation in exchange rate between countries; however, the author suggested that the application of Autoregressive Conditional Heterogeneity (ARCH) can produce the efficient and consistent result of exchange rate volatility Recently, Al-Rashidi and Lahiri (2013) used heterogeneous firm-selection model to estimate that relationship The argument

of this model is that it can solve the problem selection bias and asymmetric trade occurring in other models The impact of exchange rate change seems to be lower in model without correcting the selection bias and asymmetric trade than in model with those problems Finally, the result of paper pointed out that exchange rate volatility coefficient in model is statistically significant

Hypothesis 4: Exchange rate volatility relates negatively to the trade flow of goods

GDP of importing country is expected to impact positive on trade flow of country

GDP of exporting country have ambiguous impact on trade flow of country Population of importing country has positive relationship between two countries, while the population of exporting country may impact positively or negatively on exporting value

The distance effect of trade flow is negative

The exchange rate volatility is impact negatively on the value of trade between countries

Figure 2-2: Conceptual Framework

F +

FREE TRADE

AGREEMENT

F +

EXCHANGE RATE VOLATILITY

Baier and Bergstrand (2007);

Jugurnath, Stewart, and Brooks (2007);

Yang and Martinez-Zarzoro (2014)

Rose and Wincoop (2001); McKenzie (2002); Al-Rashidi and Lahiri (2013)

DISTANCE

Disdier and Head (2008); Carrère and Schiff (2005); Baier and Bergstrand (2007); Yang and Martinez-Zarzoso (2014)

2.2.5 Empirical study on estimation model

Jugurnath, Stewart, & Brooks (2007) conducted an empirical research on the impact of regional free trade agreements between Asian Pacific countries by gravity model with panel data From the paper’s conclusion, ASEAN Free Trade Agreement does not improve trading between its members The authors argue that member countries have similar comparative advantage, so they tend to trade with non-member countries However, the methodology in paper does not solve the endogenous problem

in gravity Baier and Bergstrand (2007) used gravity model in order to investigate the effect of FTA on trade flow 96 trading countries from 1960 to 2000 It finds out that average treatment affect of FTA on trade flow is significant and unbiased The authors obtained the result after depicting and solving the empirical problem posed in theoretical gravity model developed by Anderson and Wincoop (2003); the FTA variable can be an endogenous variable First reason for the problem is omitted variables and selection bias; the argument is that the unobserved factor in error terms may correlate to FTA, and countries can choose to join FTA because of unobservable economic and political motivations The second reason is simultaneity bias in which trade flow can also impact on the formation of FTA between two or more countries

To solve endogenous problem, the paper apply fixed effect panel data methodology which is believe to create an efficient and unbiased estimated coefficient for FTA The main estimation models in the paper are:

(2.8) However, the estimation models do not work on the general equilibrium comparative statics approach addressed in Anderson and Wincoop (2003) The drawback is indicated in paper by Baier & Bersgstrand (2009) The paper provides a method to adjust explanatory variables in the right hand side in order that the model can address the equilibrium condition in calculating multilateral resistance terms, and estimate coefficient consistently and unbiased

Furthermore, the model (2.8) can be considered as standard model use in empirical study on impact of free trade agreement on trade flows For instance, Hur, J., Alba, J D., & Park, D (2010) proved that model set up in Baier and Berstrand (2007) provide unbiased estimation because endogenous FTA problem are able to overcome by fixed effect regression The paper investigates the Hub-and-Spoke problem of Free Trade Agreement on Trade Flow by applying the fixed effect panel data Moreover, Tongzon (2005) asserted that free trade agreement between ASEAN countries and China provides both opportunities and threat to ASEAN countries, because they do not attain competitive advantage to China China may export products

to Asian countries with lower price, while Asian countries can access to China market through agricultural products Empirically, Yang & Martinez- Zaroso (2013) applied the fixed-effect in panel data to estimate the average impact of ASEAN-China Free Trade Area The authors find out that free trade agreement increase the trade volume

of its members

Another approach to estimate the bilateral trade flow is from Eaton & Kortum (2002) The paper applies the Ricardian model to establish an estimation model for trade flow Eaton & Kortum (2002) built its model based on the model of Dornbusch, Fischer, & Samuelson, (1977) Unlike model in Anderson &van Wincoop (2004), Eaton& Kortum (2002) explained the trade between countries by the differences in technologies within countries and among countries The model draws that the value of bilateral trade depends on the geographic barrier, expenditure of importing countries, and market size of importing countries The advantage of Eaton

& Kortum’s model is the involvement of distribution technology of countries; however, it is rather complicated to estimate that model because the technology parameter cannot be observed directly Furthermore, Caliendo & Parro (2012) applied the Ricardian model to estimate the effect of NAFTA on trade and welfare The papers find out that NAFTA increase the trade and welfare of its members

Total Import from ASEAN Trade Balance with ASEAN

CHAPTER 3 OVERVIEW OF VIETNAM’S FREE TRADE

AGREEMENT

3.1 ASEAN Free Trade Agreement (AFTA)

ASEAN Free Trade Agreement (AFTA) was established in 1992 by six countries (Brunei Darassalam, Republic of Indonesia, Malaysia, republic of the Philippines, Republic of Singapore, and Kingdom of Thailand) Until now, AFTA is signed officially by ten member states, six original countries plus Vietnam (1995), Lao and Myanmar (1997), and Cambodia (1999) The purposes of AFTA are to create

a stronger competitive region with completely trade opening among member countries The member countries have to agree on reducing their trade tariffs based on the Common Effective Preferential Tariff Agreement (CEPT) sign on 1992 The tariff band is in 0%- 5% at the end of tariff reduction scheme The products exported or imported have to be in complying with rule of Country of Origin described in Annex 3- Product Specific Rules of CEPT Agreement

Vietnam joined the AFTA on July 28 1995 As a member state, Vietnam has obligation in practicing the CEPT articles In details, Vietnam has to finish reducing its products tariff in Inclusion List into 0-5% band in 2006, product in Sensitive List

in 2013 The quantitative restriction and other non-tariff barrier have to be eliminated

in 2013 However, “Protocol to Amend the Agreement on the Common Effective Preferential Tariff (CEPT) Scheme for the ASEAN Free Trade Area (AFTA) for the

Elimination of Import Duties” signed in 2003, has amended the time for Vietnam to

fulfill its import duty elimination until no later than January 2015, with the expansion

of sensitive products until January 2018 The trading pattern between Vietnam and

Figure 3-1: Trade Pattern between Vietnam and ASEAN Members, 1990-2012

As can be seen from the graph, the export to and import from ASEAN of Vietnam faced gradually increasing trend from 2003 afterwards In details, the export value in 2003 is US$2,952,700,000 then increased to US$17,312,112,370 in 2012 However, trade balance is deficit throughout periods; and, the value of trade deficit has been rose significantly That means ASEAN countries is supplying commodity greater than consuming Vietnam

Source: Author’s Construction

Figure 3-2 shows the change in trade flow between Vietnam and ASEAN countries Brunei Darussalam is not included in the Figure because the countries’ data

is not available in 1990-1994, 2002-2008, and 2009 periods The vertical axis measures the change index of total bilateral trade between Vietnam and each country

in ASEAN, and is calculated by the total trade in period t divided by total trade in period (t-1) The trade value is in 2005 US dollar The index indicates the relative change in trade with the previous year of Vietnam and one partner In details, the index greater than one means trading in the present period is higher than that of previous one If the trade change index is less than one, the trade value in current

period is lower than that of previous period The index is equal to zero meaning that there is no trade between Vietnam and that country in current period

Period 1990-1994 presents trading before Vietnam had joined AFTA After signing AFTA, the total trade between Vietnam and six original AFTA countries increased significantly, while the trade with Cambodia, Laos, which were not the member of AFTA in the same period, rose in lower index There are two periods faced the considerably decreased in trade change index are from 1997-1998 to 1999-2001, and from 2002-2008 to 2009 The decreasing trend can be attributed to the Asian Financial Crisis in 1997-1998 and Global Financial Crisis in 2008 After joining AFTA in 1997, the increase in trade between Laos and Vietnam is not clearly high because of the 1998 crisis, so it is difficult to see the impact of FTA on Laos and Vietnam in that periods Cambodia is a member of AFTA in 1999; from the graph, the trade increase steadily throughout 1999-2001, and 2002-2008 periods In conclusion,

it may be concluded that the FTA has impact positively on the trade flow of goods between Vietnam and other members by descriptive statistics

3.2 ASEAN-People’s Republic of China Comprehensive Economic

Cooperation Partnership (ACFTA)

Asean-China Free Trade Agreement was signed in 2002 by all ten ASEAN members and China By signing the agreement, Vietnam accorded to the tariff elimination scheme built by all countries In details, Vietnam has to finish reducing all

tariff lines to the 0-5% in Inclusion List no later than January 2015 In “Agreement on

Trade in Goods of the Framework Agreement on Comprehensive Economic operation between the Association of Southeast Asian Nations and the People’s Republic of China, Vientiane, 29 November 2004”, there was an agreement on

Co-timeline for Vietnam to reduce its tariff as follow table

Table 3-1:ACFTA's Tariff Elimination schedule for Vietnam

is presented in following graph

Source: Author’s Construction

The change in trade index is described in the section 3.1 of this Chapter, so it

will not be defined in this and next sections again As can be seen from the Figure 3-4,

before being in Free Trade Agreement with Vietnam, China has increased the trade significantly in periods 1990-1994 to 1995-1996, namely 2.98 times (Author’s calculation); then, the trade increase slowly due to the Asian Financial Crisis 1997-

1998 1999-2001 periods witnessed a recovery of trade between Vietnam and China, while trade of Vietnam with ASEAN is still in low increase After signing free trade agreement with ASEAN member states, Vietnam-China bilateral trade from 2002 to

2008 increased 3.06 times in compare to trade value in period 1999-2001, this may be

a sign for positive effect of FTA on trade flow of goods The next two periods indicate

a slowly increase in trade between Vietnam and China; ASEAN’s trade is in similar trend This may be explained by the Global Financial Crisis happened in 2008

-40,000,000,000

-20,000,000,000

- 20,000,000,000

Figure 3-3: Trade Pattern between Vietnam and ACFTA members, 1990-2012

Figure 3-4: Change in Trade Flow between Vietnam and ACFTA Members

Source: Author’s Construction

3.3 ASEAN- Australia and New Zealand Free Trade Agreement

(AANZFTA)

AANZFTA is signed in 2009 by ASEAN countries and Australia and New Zealand in order to establish a free trade area in goods, services, investment, and human movement; the Agreement is in force for Vietnam from January 2010

According the “Agreement Establishing the ASEAN-Australia-New Zealand Free

Trade Area, Cha-am, Thailand, 27 February 2009”, Vietnam will eliminate its tariff

rates beginning in 2010, and ending in 2020 (all the tariff rates in tariff lines have to

be equal to zero)

Before signing AANZFTA, from 1990 to 2009, the average value of Vietnam export to Australia and New Zealand were US$ 1,280,890,700 and US$ 26,141,800 respectively The average value from 2010 to 2012 is US$ 2,821,416,435 for Australia, and US$ 152,737,869 for New Zealand The average value of import also rose from US$ 383,718,850 to US$ 1,779,697,639 for import from Australia, while

that of New Zealand are from US$ 81,500,150 to US$ 373,925,166 The detail trade between Vietnam and Australia-New Zealand is as follow

Figure 3-5: Trade between Vietnam and Australia-New Zealand, 1990-2012

Source: Author’s Construction

Vietnam and Australia- New Zealand Free Trade Agreement is in force from

2010, the change in trade between Vietnam and Australia-New Zealand trade from Figure 3-6 is not high in period after FTA in force, 2010-2012, 1.22 times with Australia and 1.45 times with New Zealand in compare to year 2009 This can be explained by the time-effect of FTA (Baier & Berstrand, 2007) It required longer time for Vietnam and Australia and New Zealand to eliminate their tariff lines, which

is committed to finish in 2020 Therefore, it may not conclude the effect of FTA on trade flow of between Vietnam and Australia-New Zealand FTA in the reported periods by descriptive statistics The change in the trade between Vietnam and Australia and New Zealand is shown in the following Figure

-1,000,000,000

0 1,000,000,000

Trade Balance with Australia

Trade Balance with New Zealand