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

UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIESVIETNAM - NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS THE IMPACT OF FREE TRADE AGREEMENT ON TRADE FLOW OF GOODS IN VIETNAM B

UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES

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 - 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 MrChinh, my classmates at class 19 Without their support and sharing, it is really difficult tocope with the huge pressure in finishing thesis on time

Relating to the methodology, two main problems discussed in gravity modelare endogeneity of FTA and zero-value in trade Firstly, the thesis points out thatFTA is exogenous variable in the gravity model Secondly, sample selection model,Poisson Pseudo Maximum Likelihood, and Fixed-effect model are used to solve thezero problems in model The empirical results from all estimation models areconsistent with each other in term of sign of FTA’s coefficient.

For policy implication, the thesis proposes that FTA is a good trade policyfor Vietnam because it can help to improve the total bilateral trade value amongFTA members However, FTA does not impact on trade flow only, but it also haseffect 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

Closer Economic RelationEuropean Economic CommunityEconomic and Monetary UnionFree Trade Agreement

North America Free Trade AgreementTrans-Pacific Partnership

Vietnam-Japan Economic Partnership Agreement

the United States of America

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

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

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

Source: Author’s Construction

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Relating to academic perspective, the free trade is espoused in improving thetrade and welfare of signing countries This belief is developed from the absoluteadvantage by Adam Smith, comparative advantage by David Ricardo, Heckscher-Ohlin model by Eli Heckscher and Bertil Ohlin to Paul Krugman with economies ofscale and product differentiation On the other hand, Viner (1950) not only acceptedthe gain from free trade but he also pointed out the loss if countries build tradingblocs 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 isaffected by her free trade agreements

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

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

of AFTA is not significant Agricultural sector gets benefit from that free tradebecause of exporting opportunity to ASEAN market, while some other industries ishurt and need to be protected due to ASEAN competitors The paper appliedsimulation methodology to draw the conclusion, and does not analyze the dynamiceffect of AFTA Therefore, this thesis will depict the role of free trade agreement onbilateral trade in goods of Vietnam by applying gravity model approach, and paneldata 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 gainfrom trade is attributed to the efficiently reallocation resource within country throughthe absolute advantage of country Each country will be more effectively andefficiently produce certain kind of commodities than those of other countries, thus theabsolute production cost will be lower in country Therefore, country will reallocate itsresources to specialize in producing commodities which have absolute advantage, andexchange for product with absolute disadvantage (Salvatore, 2012) In final, bothcountries can consume the greater number of commodities than those of before trade.Besides the increase in volume of consumption, Schumacher (2012) asserted thatAdam Smith theory also attributed the gain from trade to the increasing ininternational competitiveness This is not equivalently discussed in many textbooks.However, absolute advantage is claim for its explanation why one country whoseabsolute advantage is completely unavailable can trade with other countries That isthe problem solved by theory called comparative advantage, or Ricardian model

Another influential theoretical foundation developed based on absoluteadvantage is comparative advantage, or Ricardian model named after Ricardo, the firsteconomist mentioned the concept In Ricardian model, the difference in relative laborproductivity is the primary reason for international trade between countries, becausethe model assumes that labor is only one factor of production; and labor can movefreely between sectors within country Although the model is claimed as its simplifiedassumption, its contribution is considerable on explaining trade pattern of countries.Firstly, Ricardian model pointed out that country exports a good to other countrybecause 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 absoluteadvantage can also gain from trade, in other words, the central determinant in trade isrelative productivity of goods within country in compare to that of other country Incomparative advantage, international trade can benefit trading countries becauseimport activities in the model are considered similarly to indirect production(Krugman, Obstfeld, & Melitz, 2012) Indirect production means that country canspecialize 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 lowerwage, and then leads to lower cost relative to cost in high productivity country Thisconcept is the explanation for notion that high wage country can export goods to lowwage country because of high productivity compensation in high wage Finally,Ricardian model implies that all countries can benefit from trade based on itsdisputing assumptions

According to Ricardian model, countries will certainly benefit fromparticipating in international trade; however, the counter argument is that the “onefactor assumption” is unrealistic Therefore, the specific-factors model breaks onefactor assumption of Ricardian model by extending specific factor of production ineach sector within a country Together with mobile labor, each sector consists of oneproduction factor which cannot move to other sector The simple specific factor modelexploits capital and land as two specific factors The specific- factor model presentsthat the country can be potentially better off by trading In details, there are winnerwho gain and loser who lose from trade The model stated that specific factor in theexporting sector of each country gains from trade, whereas specific factor in importingsector 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 thatinternational trade benefits countries as a whole because an increase in the widerchoice for consumption can compensate the sector hurt In conclusion, the income

distribution effect helps to explain the benefit and cost of international trade, and givereason why many countries maintain the trade barrier to protect their domestic sectorfrom foreign comer.

Jones & Neary (1982) asserted that specific-factor model explained theinternational trade in short run, and could transform to Heckscher- Ohlin modelbecause specific factors are mobile in the long run The Hechscher- Ohlin model is themodel 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 ofnation’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 whosefactor is well endowed and relatively intensive Well endowed means that the relativeratio of factor productions in country is higher than that of its partner countries whilerelative intensive explicates that relative ratio of that factor to other factor used toproduce that good is higher than that of producing other good H-O model providesthat international trade will impact on income distribution as a result of changerelative 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 monopolisticcompetition Krugman (1979) developed a trade-related theory based on economies ofscale 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 othercountries leads to specialization, and created concentrated location of production Inthat case, countries can achieve cost advantage through mass- production which is notbased primarily on comparative advantage The question put here is that howcountries decide which industries they will produce in large scale in order to competeand 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 forwhole 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’sresource and technology but also the economies of scale, and yet there is arelationship between the Ricardian model, H-O model and economies of scale inexplaining the international trade pattern.

2.1.2 Free Trade Agreement

The standard theory of international trade is built on the assumption of tradehaving no cost arise when deliver goods from exporting country to destinationcountry Samuelson (1962), for instance, wrote a paper on analyzing the benefit fromfree trade, and concluded that free trade potentially better for trading countries inwhich winners can allocate benefit to the hurt; yet, the trade cost occur oninternational trade and impact on the pattern of bilateral trade (Krugman, Obstfeld, &Melitz, 2012) Anderson & van Wincoop (2004) analyzed the impact of trade cost ontrade flow between countries, and concluded that trade cost is greatly in trade betweencountries They are reasons for the existing of free trade agreement among tradingcountries The economic benefits of free trade are discussed in the international tradetheory, 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 warbetween countries and interest group problem within country because free tradeprovide certain rule and principle in trade agreed by both countries, and is difficult toviolate 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 forglobal free trade agreement The paper indicates that free trade agreement can benefitparticipants by reducing the consumer’s distortion, increase the power in trade to othercountries, and creating the efficient in production Krugman (1991) also mentionedthe notion of ‘natural trading bloc’ which explains free trade agreement as a naturalprocess of countries located near together Free trade agreement also establishedbetween countries having similar economic characteristics in order to increase itstrading value (Baier & Bergstrand, 2004) World Trade Organization defined freetrade agreement is an accord between signed countries on the significant reduction ontrade 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 asmall 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 ishigh enough, A will produce clothing herself However, A is assumed to form acustom union with B As a result of those policies, price of clothing imported from Bwithout tariff is cheaper than C’s with tariff; and, A will import clothing from B Thisphenomenon is called trade diversion of A from C to B Lipsey (1957) analyzed that acustoms union causing trade diversion by change the trading pattern in favor ofcustom union suppliers Lipsey (1960) mentioned that more likely the occurrence oftrade creation is the greater difference in the cost of production the same commoditybetween two countries Bhagwati (1971) clarified that a shift of importing goods fromlower cost supplier to higher cost one is called trade diversion While Lipsey (1960)advocate that trade-diverting customs union could not decrease the welfare ofimporting countries because of the substitution in consumption, Bhagwati (1971)pointed out substitution is not a sufficient conditions; yet, trade diversion effect canreduce economic welfare under the assumption of fixed imported level In details, thechange in import pattern due to formation of customs unions creates two oppositeeffect on the welfare The first one is the loss in term of trade The second one is thegain from consumption and production, which is the rise in trade flow among membercountries (Bhagwati, 1971)

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

by member’s low-cost goods Johnson (1974) stated these above movements willbalance the increasing-welfare Lipsey (1957) and Bhagwati (1971) defined the tradediversion as the change in the locus of production from initial lower supplier to highermember suppliers Johnson (1974) argued that trade diversion can give a transfer fromlocus of production which negatively impact on welfare, and create a substitutioneffect 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 membersuppliers Finally, the change in term of trade is an attributable to a rise in demand ofsubstitute 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 lowsubstitution elasticity of foreign goods, so they demand the exporting goods Thesecond reason is the economies of scale, so one country can produce goods in lowercost than other countries in order to become least cost supplier in world trade Themodel 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, theimpact 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 isreduced, aggregate trade flow can increase because all firms raise their exportingcapacity 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 thevariable costs such as transportation cost but also fixed cost which is independent tothe number of goods exported As a result of that, Melitz (2003) built up a model tofind the static equilibrium of firms’ exporting in countries which expose tointernational market, the paper concluded that trade liberalization effects on the tradepattern of firm and reallocation resources within exporting industries through theincrease in number of importing countries, and the decrease in trade cost, bothvariable cost and fixed cost Firstly, the rise in trading countries is a condition toincrease in the productivity requirement for exporting firms The least productivefirms can be forced to exit out of the market; the survival firms will increase itsvolume of export to current and new destinations (Melitz, 2003) Secondly, thedecrease in trade cost can impact on trade pattern through the emergence of newexporters 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), theauthors considered the trade cost as an exogenous factor of term of trade The paperconcluded that the trade cost decreasing as a result of trade liberalization primarilyimpacts on the change of trade volume through the extensive margin The reason isthat countries will face a growth in number of firm exports, and decrease inproductivity breaking points.

Furthermore, Chaney (2008) supported the argument of Melitz (2003) byimposing the intensive margins and extensive margins effect of trade cost on tradeflow He pointed out that firm is different in productivity and suffers fixed cost intrading besides variable cost By adding new assumptions, Chaney (2008) stated thatchange in trade flow due to trade barrier shock can be explained through twomechanisms 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 ofexporter in different sectors In general, trade barrier reduction such as free tradeagreement between two countries leads to the change in the number of good each firmexports, and new exporters can enter the market Crozet and Koenig (2010) confirmedthe theory in heterogeneous firms established in Chaney (2008) The paperdisintegrated effect of trade cost on trade flow in to intensive margin and extensivemargin as follow:

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

trade

From the above theoretical foundation, the impact of free trade agreement on

flow can be summarized in the following figur

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TRADEVOLUMEOF

+

CURRENTFREE

BARRIERS TRADE WITH

EXPORTINGFIRMSAGREEM

ENT

MEMBERTRADING

+

TOTALTRADE FLOW

+

-Source: Constructed by the Author

Page | 13

Figure 2-1 presents the theoretical foundation to answer research questions ofthe thesis The first one is that what the impact of free trade agreement on total tradeflow between signing countries is Secondly, how that impact happens, or whatchannels 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 tariffequivalent barriers among member states The other purpose is to build an integratedregional 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 barriersgoes down, the trading cost also decreases both in variable cost and fixed cost Thedecrease in trade cost is a condition for two trading activities The first one is the tradediversion 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 membertrader is the least cost supplier Therefore, there is the decrease in the trade flowbetween member countries and non-member countries

Trade with Member Countries and Exporting Firms:

The reducing trade cost between free trade countries will increase demand ofcommodities export from member countries to other member countries This leads tothe intensive margin and extensive margin effect in trade pattern Firstly, the currentexporter will increase their volume of trade due to the increase in demand and lowercost The intensive margin effect will influence positively on trade flow between twocountries However, this effect will be lower in more heterogeneous productivityindustries Secondly, there will be new firms enter exporting market Those new firmswill affect positively in the trade flow between countries The more heterogeneousproductivity 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 firmsexport, while the extensive margin will attract more firms come into the newexporting market Although the impacts of intensive and extensive margin are not asthe same level, in sector whose products substitution elasticity are high, extensivemargin impact will dominate intensive margin’s effect However, both effects are toincrease 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 firstauthor which applied the theory of gravity model in order to estimate the effect ofEuropean Economic Community (EEC) and European Free Trade Association(EFTA) on the import and export of member countries In his model, he proposed anumber of indicators for conceptions in the theoretical model The dependent variablewas export value The independent variables were Free trade agreement, Income ofexporting countries, Income of Importing countries, Distance between tradingpartners 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 tradeflow, which is the dependent variable in this thesis The second part is indicators forindependent variables which are Free Trade Agreement (FTA), exporter’s income,importer’s income, and distance between trading countries

xij  a  byi  cy j  ddistij  eDUMMYij  uij

(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 traderesistance variables which are called multilateral resistance terms (MRTs) Andersonand Wincoop (2003) proposed a new estimated model as follow:

(2.3)The model also used the export from countries i to j as the dependent variablefor trade flow The differences with McCallum (1995) are the variables , themultilateral resistance terms The meaning of MRTs is that it indicated the averageprice of export country to the rest of the world’s price The definitions of MRTs are asfollow:

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

On the other hand, Jugurnath, Stewart, and Brook (2007) did not exploit theexport 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 reportsits import value for the tax purpose, so the import value is more correct than exportvalue

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:

t  b d p

ij ij ij

bij indicates the border effect in his analysis The variable will take the value of 1 if

two regions is in same country, otherwise, it is equal to one add trading tax Although

the paper did not mention about FTA, the paper has been applied by later researcher

Baier and Bergstrand (2007) estimated the impact of FTA on trade flow of countries

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:

log IMPORT ij  aX    RTA ik RTA kj   RTA ki RTA kj (2.7)

In the model, i is the importing country, j is exporter, and k indicates the

Regional Trade Agreement (RTA) k Unlike in Baier and Bergstrand (2007), there are

separate RTAs for two countries to analyze the trade creation and trade diversion of

RTAs The paper concluded that regional trade agreement of ASEAN, CER are trade

creation while APEC, MERCOSUR, and NAFTA have a tendency to increase trade

within regional member or may be trade diversion Furthermore, Yang and

Martinez-Zarzoro (2014) estimated the relationship between ASEAN-China (ACFTA) on trade

flow of member countries The model of paper set up three types of FTA dummy

variables The first FTA variable is equal one if both export and import countries are

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 inACFTA FTA dummy variable is applied to measure free trade agreement effect inHur, Alba, and Park (2010) Objectives of the paper are to answer two questions Thefirst question is the effect of FTA on trade by using dummy variable FTA as in Baierand Bergstrand (2007) The second question is the hub and spoke nature of FTA Datacovered 96 countries in the world in 40 years from 1960 By applying fixed effectpanel data in estimation, the paper pointed out that the increase in export of countrieswhich are in same free trade agreement.

In conclusion, indicator for Free Trade Agreement is the dummy variabletaking value of 1 if two countries is in same FTA, otherwise, FTA equal to 0 Thecoefficient 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 asmeasurement of income concept in international trade This indicator for income hasbeen accepted by other empirical papers Anderson and Wincoop (2003) chose thegross domestic production as a proxy for income of trading countries The nominalgross domestic production also used in paper of Jugurnath, Stewart, and Brooks(2007) However, Baier and Bergstrand (2007) divided nominal GDP by the GDPdeflator in order to obtain real GDP There was no clear argument between choosingnominal GDP or real GDP as an indicator for income In all mentioned papers, bothincome of exporting country and importing countries have been found to impactpositively 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 infrastructurehas 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, andthen found out that the change in the value of distance elasticity of trade flow Theauthors stated that the mean effect of distance is approximate 0.9 meaning that 10percent increase in the distance of two countries; the trade value will decrease 9percent

Carrère and Schiff (2005) conducted a paper to answer for puzzle in distance oftrade 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, anddistance 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 totrade to foreign countries locating at varied distance depends on the combination ofnon-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 rosethroughout the period.)

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

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 withinempirical studies Rose and Wincoop (2001) did a research on the effect of currencyunion on European countries on the trade flow The paper used Economic andMonetary Union (EMU) as an indicator for no exchange rate volatility in internationaltrade In the paper, if the EMU impacts positively on the trade flow of membercountries, 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 appliedgravity model adding EMU dummies variable for estimation The result indicated thatthe trade between EMU countries is higher than those without in EMU In detail,EMU increased trade within European countries approximately 250% to 400% Roseand Wincoop (2001) posed the importance of currency barrier in trade flow.McKenzie (2002) conducted a paper reviewing previous researches on the risk ofexchange rate’s effect to trade The papers also found out the conclusion supportingRose and Wincoop (2001); the result is that exchange rate volatility impact negatively

on international trade, yet the degree of impact varying among the paper Theexplanation for this problem came from the issue in measuring exchange ratevolatility There are many techniques to calculate the value of the fluctuation inexchange rate between countries; however, the author suggested that the application ofAutoregressive Conditional Heterogeneity (ARCH) can produce the efficient andconsistent 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 tradeoccurring in other models The impact of exchange rate change seems to be lower inmodel without correcting the selection bias and asymmetric trade than in model withthose problems Finally, the result of paper pointed out that exchange rate volatilitycoefficient 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 ofcountry

GDP of exporting country have ambiguous impact on trade flow of countryPopulation of importing country has positive relationship between twocountries, while the population of exporting country may impact positively ornegatively on exporting value

The distance effect of trade flow is negative

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

Figure 2-2: Conceptual Framework

FREE TRADE

+ AGREEMENT

Baier and Bergstrand (2007);

Jugurnath, Stewart, and Brooks (2007);

Yang and Martinez-Zarzoro (2014)

DISTANCE

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

2.2.5 Empirical study on estimation model

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

in gravity Baier and Bergstrand (2007) used gravity model in order to investigate theeffect of FTA on trade flow 96 trading countries from 1960 to 2000 It finds out thataverage treatment affect of FTA on trade flow is significant and unbiased The authorsobtained the result after depicting and solving the empirical problem posed intheoretical gravity model developed by Anderson and Wincoop (2003); the FTAvariable can be an endogenous variable First reason for the problem is omittedvariables and selection bias; the argument is that the unobserved factor in error termsmay correlate to FTA, and countries can choose to join FTA because of unobservableeconomic and political motivations The second reason is simultaneity bias in whichtrade 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 methodologywhich is believe to create an efficient and unbiased estimated coefficient for FTA Themain estimation models in the paper are:

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

Furthermore, the model (2.8) can be considered as standard model use inempirical 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 toovercome by fixed effect regression The paper investigates the Hub-and-Spokeproblem of Free Trade Agreement on Trade Flow by applying the fixed effect paneldata Moreover, Tongzon (2005) asserted that free trade agreement between ASEANcountries 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 marketthrough agricultural products Empirically, Yang & Martinez- Zaroso (2013) appliedthe fixed-effect in panel data to estimate the average impact of ASEAN-China FreeTrade 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 fortrade 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 intechnologies within countries and among countries The model draws that the value ofbilateral 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 technologyparameter cannot be observed directly Furthermore, Caliendo & Parro (2012) appliedthe Ricardian model to estimate the effect of NAFTA on trade and welfare Thepapers find out that NAFTA increase the trade and welfare of its members

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 sixcountries (Brunei Darassalam, Republic of Indonesia, Malaysia, republic of thePhilippines, Republic of Singapore, and Kingdom of Thailand) Until now, AFTA issigned 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 membercountries The member countries have to agree on reducing their trade tariffs based onthe Common Effective Preferential Tariff Agreement (CEPT) sign on 1992 The tariffband is in 0%- 5% at the end of tariff reduction scheme The products exported orimported have to be in complying with rule of Country of Origin described in Annex3- Product Specific Rules of CEPT Agreement

Vietnam joined the AFTA on July 28 1995 As a member state, Vietnam hasobligation in practicing the CEPT articles In details, Vietnam has to finish reducingits 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 EffectivePreferential 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 andASEAN countries is as following

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

0 -5000000000 -10000000000 -15000000000 -20000000000

Total Export to ASEAN Total Import from ASEAN Trade Balance with ASEAN

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

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

Myanmar

PERIOD

Source: Author’s Construction

Figure 3-2 shows the change in trade flow between Vietnam and ASEANcountries 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 axismeasures 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 inperiod (t-1) The trade value is in 2005 US dollar The index indicates the relativechange in trade with the previous year of Vietnam and one partner In details, theindex greater than one means trading in the present period is higher than that of

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

Period 1990-1994 presents trading before Vietnam had joined AFTA Aftersigning AFTA, the total trade between Vietnam and six original AFTA countriesincreased significantly, while the trade with Cambodia, Laos, which were not themember of AFTA in the same period, rose in lower index There are two periods facedthe 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 AsianFinancial Crisis in 1997-1998 and Global Financial Crisis in 2008 After joiningAFTA in 1997, the increase in trade between Laos and Vietnam is not clearly highbecause of the 1998 crisis, so it is difficult to see the impact of FTA on Laos andVietnam in that periods Cambodia is a member of AFTA in 1999; from the graph, thetrade 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 goodsbetween 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 ASEANmembers and China By signing the agreement, Vietnam accorded to the tariffelimination 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