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BACHELOR THESIS
The Impact of ASEAN – China FTA on Indonesian
Farmers
Submitted:
Dimas Adi Perdana Nugroho
Student Number 5905966
International Economics
Faculty of Economics and Business
Supervisor: dr. ir. Marcel Boumans
Table of Contents
I. Introduction………………………………………………………………….. 3
II. Effects of International Trade
(i)
Static Effects……………………………………………………..…… 5
(ii)
Dynamic Effects…………………………………………………….... 6
(iii)
Measuring the Effects of Trade Liberalisation…………………..…… 6
III. Comparison to NAFTA……………………………………………….……… 6
IV. Literature Review
(i)
Loss to Indonesian Farmers……………………………………….…. 7
(ii)
Benefits to Indonesian Farmers……………………………………… 9
V. Conclusions………………………………………………..………………... 11
VI. Reference………………………………………………..………………...… 12
I. Introduction
The increasing need for trade liberalisation is marked by a milestone when the
Uruguay Round succeeded to establish the World Trade Organization (WTO). Trade
liberalisation aims at enhancing trade volume and value, a situation desired shared by
the majority of countries around the globe. The effect of trade liberalisation is
expected to support economic growth and make positive impact to the people’s
welfare. To initiate trade liberalisation, countries eliminate trade barriers in the form
of both tariff and non- tariff such as trade quota. Abolishing trade restrictions can
stimulate the flow of goods and services between nations.
The heart of discussion of this paper is the process of trade liberalisation in
Indonesia. For Indonesia, the implication of opening up the market to its trade
partners is two-sided. It has the opportunity to boost productivity and increase exports
to the partners. On the other hand, domestic made products are subject to more
competition coming from other countries. Indonesia has made its stride to trade
liberalisation by joining the ASEAN Free Trade Area (AFTA) and more recently, the
ASEAN China Free Trade Area (ACFTA). It facilitates trade between the 10 ASEAN
countries and China. The ACFTA framework was signed on November 2002 by the
representatives of the respective countries and tariffs were steadily reduced since 2005.
On January 2010, tariffs were completely eliminated in six original ASEAN countries
and China with the exception of highly sensitive goods, which are still protected by
trade duties.
The decision to sign the agreement has sparked major debate in Indonesia on
whether it can bring welfare to the people. With the massive influx that is expected
from the agreement, this situation would lead to rising unemployment because of
layoffs in the related industry. This is closely linked to the argument that domestic
industries still relies on the government to protect and ensure the existence of their
products. Productivity of Indonesian workers is considered to be less advanced
compared to the Chinese counterparts. Hence, exposing that weakness could further
deteriorate the quality of the human workforce in Indonesia.
Secondly, those who oppose the agreement are also concerned about the
stance of trade balance with China. They argue that the negative trade balance with
China in 2008 would worsen with the free trade in tact. This is a cause for concern
because the years prior, Indonesia had recorded trade surplus with China.
Another worry for Indonesia, as experts suggest, is the undervalued Renmimbi.
The Chinese government keeps the currency weak by pegging it to the US Dollar.
Indonesian goods are then perceived to be more expensive compared to Chinese
exports. Cheaper goods could push consumers to prefer goods coming from China and
neglecting the products manufactured domestically.
However, many still believe that the free trade could bring welfare to
Indonesia. By engaging in trade liberalisation, Indonesia can specialise in the
commodities that it has comparative advantage for. Cost of production for these goods
fall, spurring production at the same time, and exporting them to China at a lower cost
due to zero tariffs.
Indonesia is considered to have a strong point on agricultural commodities.
Many see this as the sector in the economy Indonesia can specialise on and benefit
from. The challenges for agricultural products, however, are the fact that it heavily
depends on other conditions such as weather and that it is inelastic in the short run.
Additionally, other ASEAN countries such as Malaysia and Vietnam are tough
competitors in this particular sector. In other words, if Indonesia wants to become a
key player in Chinese market for agricultural goods, it has to be able to produce more
efficiently than the other ASEAN countries.
According to existing international trade theories, a country engages trade with
other countries because it can reap benefits in the form of higher national income and
reduces cost of production. One of the major theories that support trade liberalisation
is the factor of endowments. The Heckscher- Ohlin model mentions two countries will
exchange goods because there is a difference in endowments between them. Different
opportunity costs to produce a certain good arise because the proportion of the factor
of production varies between countries. Furthermore, cheaper and higher number of
endowment factors gives the country an advantage because it can specialise and
export. On the contrary, countries with sparse endowment factors are less likely to
experience specialisation.
The exchange of goods will directly improve the welfare of consumers
because this will increase the availability of goods which gives them more choices for
goods. Trade pushes countries to specialise in a certain commodity. When a country
specialises, it can produce the commodity at a lower price. The high level of
production enables the country to export in exchange for other goods, which would be
more costly had it been produced domestically. This result in market expansion which
would likely raise national income, in turn, can spur productivity and output and
ultimately economic growth.
Secondary and indirect impacts after the increase of flow of goods could also
arise. Lowering trade barriers can boost and motivate producers to improve their
commodities to a higher standard. It would soon lead to a ‘chain reaction’ that first
shape up fair and tighter competition among producers of the same commodity
domestically. Better competition may start to attract foreign direct investment.
Ultimately, increase in investment can have a positive effect on a firm’s technological
advancement.
The question still remains, for this paper, on whether Indonesian farmers will
be better off with the abolishment of trade barriers.
II. Effects of International Trade
(i)
Static Effects
When a country engages in trade liberalisation, they may reallocate their factors of
production- namely land, labour and capital- to sectors they are relatively more
efficient at producing than other countries from those sectors they are relatively less
efficient. The more efficient sector is expected to have excess output that could be
exchanged with other countries’ excess output. World output increases as each
country specialises in the goods which it efficiently produces.
Terms of trade is also affected by liberalisation policy. A country’s terms of
trade is its price of exports divided by its price of imports. In other words, terms of
trade is the quantity of goods it must export to earn proceeds sufficient to purchase a
given quantity of imports (CBO Paper, 2006). When the amount of goods it must
export to purchase a given quantity of imports reduces, the country becomes better off.
Liberalising trade on agriculture can influence the terms of trade of a country.
By cutting domestic subsidies, farmers lose incentives and decreases supply on
commodities. In addition, the elimination of tariffs will increase the demand from
these markets. The combination of decreasing supply and increasing demand makes
for higher world price. In turn, the rise in price can improve the terms of trade with
respect to agricultural exports. However, it deteriorates the terms of trade with respect
to agricultural imports.
(ii)
Dynamic Effects
Trade liberalisation may also influence productivity growth and rates of investment.
A boost in investment would raise the rate of growth of the aggregate capital stock for
a period of time. One of the commodities that a country would invest in is capital
goods, which are goods that could increase productivity in the future. An increase in
productivity would eventually have a positive impact on output.
The dynamic effects of free trade tend to increase the magnitude of static
effects over time. Static effects are outcomes from reallocation of factors of
production and resources. Dynamic effects improve productivity of factors of
production and raises capital stock, which is one of the factors of production that is a
source of the static effects. In the long run, dynamic effects ought to make a country
better off. A negative net static effect can be compensated by dynamic effects and in
the long run, the sum of the effects can be positive due to the large positive dynamic
effect.
(iii)
Measuring the Effects of Trade Liberalisation
The change in economic welfare is the main measure of the success of free trade,
which is generally measured by the term equivalent variation. This is defined by the
rise in income that is necessary without free trade to make people better off
economically as they would be with free trade. The studies are conducted using either
general equilibrium or partial equilibrium.
General equilibrium models are models that simulate the pattern of the whole
economy of a country instead of just one particular sector. In contrast, partial
equilibrium models are models that simulate specific sectors, which is the one being
discussed and other sectors are not included.
III. Comparison to NAFTA
To estimate the success of the ACFTA, the discussion of NAFTA (North American
Free Trade Agreement) can be useful due to the similarities between Indonesia and
Mexico. This particular trade bloc integrated Mexico, a developing country, with two
of the most advanced economies in the world namely United States and Canada. The
biggest issue for Mexico came from the agriculture sector, specifically poor farmers
that produced corn.
According to Audrey et al (2004), hundreds of thousand jobs were lost in the
Mexican agriculture sector as a result of NAFTA. Subsidies that protected American
farmers lead to dumping and decreasing prices in Mexico and threatened the
competitiveness of the farmers (Oxfam, 2003).
On the other hand, Fiess and Lederman (2004) argued in a World Bank study
that corn prices in Mexico fluctuated together with that of the US. It was not evident
that Mexican imports from the US lead to declining prices. The decrease in price
occurred ten years up to the signing of the NAFTA, thus it was considered a trend and
not as a result of the agreement. Moreover, output of corn farmers actually increased
after NAFTA. In the end, there was not enough evidence that US subsidies and
imports were the main cause of rising unemployment farmers.
IV. Literature Review
The two core contributions of this paper looks at how free trade with China would
affect Indonesian farmers. Fabiosa (2008) analysed the benefits through lower
domestic prices. On the other hand, Park et al (2008) argued that these farmers are at
a disadvantage with the free trade in place.
(i)
Loss to Indonesian Farmers
The theory of customs union is crucial in understanding the free trade area framework.
The difference between the two is that in a customs union member countries set
uniform tariffs to nonmember nations whereas in a free trade area member countries
charge their respective tariff levels. In theory, both customs union and free trade area
will have positive effects and setbacks specifically resulting in trade creation and
trade diversion. Trade creation refers to one member country replacing higher cost
domestic made goods with lower cost imports from other member countries. On the
other hand, trade diversion is replacing lower cost imports from nonmember countries
with higher cost imports from member countries. This arises from the tariff
differential between member and nonmember countries. To say whether a free trade
area increases welfare depends on which effect is greater.
There are two set of factors that help in determining the effectiveness of a free
trade area, namely the static factors and the dynamic effects. Static factors are
discussed extensively in Park et al (2008).
The static factors include:
1. Market size: Larger collective economic size of the FTA encourages larger
possibility of trade creation.
2. Level of tariffs among members and nonmembers prior to the agreement:
A high initial intraregional tariff has a positive effect on trade creation.
Moreover, a higher level and variance of tariffs to nonmember countries
will lead to trade diversion.
3. Level of intraregional trade and extraregional trade prior to the union:
Important trade partners will likely benefit because of the elimination of
tariffs.
4. Levels of development: Similar levels of development of member
countries will make integration easier.
5. Geographical location and transport infrastructure: The chance of success
is greater in an area where the member countries are located closely, to
minimise transportation costs.
6. Substitutability of products between member and nonmember countries:
Trade creation is more likely when substitutability of products from
member countries for those of nonmembers is greater.
7. Complementarity in economic structures among member countries: Trade
creation is easier in regions where economic structures are competitive
before the agreement but complementary after the agreement is in place.
On the other hand, dynamic effects of a free trade area are more difficult to
analyse and they include: (1) Improved efficiency caused by greater competition, (2)
Benefits from greater specialization, scale economies, and learning-by-doing; (3)
Transaction costs are reduced among the member countries; (4) Provide protection
from adverse developments in the world markets; and (5) Increase in bargaining
power vis-à-vis industrialised countries.
Park (2008) has included a computable general equilibrium (CGE) analysis
that can estimate the gains and losses experienced by the participating countries. To
make this possible, a Global Trade Analysis Project model that is influenced by
Rutherford (2005) is used. The model takes into account three economic agents
namely producers, consumers and trading partners. Park (2008) incorporated seven
industries of the economy to be analysed by the model including the agricultural
sector. The underlying assumption is that zero profit condition and market clearance
define the equilibrium.
In line with the existing theory, total net trade creation for ACFTA is at 3.6%
while trade diversion is 3%. Indonesia is estimated to figure trade creation and trade
diversion of 30% and 6% respectively. Indonesia is expected to increase exports to
China by 80% and imports from China by 6% (Park, 2008). However, output and
welfare is expected to fall by 0.5%, which is a concern for the government.
Another big worry for the Indonesian government is that the agricultural sector
may be negatively affected by the ACFTA. Output in agriculture could increase by
2.78% but the focus of talks is the exports and imports in this sector. Exports are
estimated to decrease by 7.71 % and imports from China are expected to increase by
6.64%. The simulation of Park (2008) is something to be considered as there is
evident that free trade has adverse effects on Indonesian agriculture.
(ii)
Benefits to Indonesian Farmers
Fabiosa (2008) discusses the impacts of agricultural trade liberalisation. Firstly, free
trade in agriculture can spur economic growth by 0.43% in a developing country and
0.46% in a developed country. Food consumption of households with lower income is
more elastic to changes in income, so it can be estimated that food consumption will
rise in a free trade agreement.
World commodity prices are also expected to increase between 3% and 34%.
In developing countries, tariffs are normally higher hence lower domestic prices is
likely to be observed. Lastly, if small producers are harmed in net importing countries,
it will not be in a large scale and it will not be extensive because the substitution
effect is greater than the net income effect from decreasing domestic prices.
Free trade can bring major implications to prices and income for the
agriculture sector especially in developing economies such as Indonesia because a
considerable portion of the income is allocated to the mentioned sector. It was
mentioned in Fabiosa (2008), countries with GDP per capita higher than $21,323
derive less than 10% of their income from agriculture. Countries with lower GDP per
capita, for example $5,228, derive 10% to 20% of their household share of income
from agriculture. The proportion increases further to 20% to 30% for economies with
lower per capita income of $3,383. The poorest economies with per capita income of
$1,668 derive more than 30%, which makes it the highest share of their income from
the agricultural sector. Taking the most recent figures, income per capita in Indonesia
is $ 4,156 and its percentage of income derived from agriculture is 14.4%. Policy
changes such as ASEAN – China FTA can shift the producers’ and consumers’ total
welfare due to the huge importance of agriculture for the country.
Trade liberalisation can also bring changes in the world commodity price. Free
trade requires the member countries to reduce tariff or even eliminate them at once. In
turn, prices in the domestic market fall which would create more demand and less
production. Ultimately, this causes excess demand which would only be balanced
with more imports from other countries. Upward pressure of world prices would be
evident caused by the increase of imports. The impact of the change in world
commodity prices would not be clear cut because it would rely on how the increase in
world prices affects the market domestically.
Fabiosa (2008) discussed that net importing countries are worse off under free
trade because of higher world prices. The paper argued that world prices are higher
under free trade but the effectiveness of the policy is determined by the country’s
domestic price changes with the change in the world commodity price and border
protection. Net exporting countries are defined as whose autarkic price is lower than
the free on board price. Net exporting countries have the advantage of natural
protection that arises from lower cost of production thus border protection is
unnecessary. An increase in the world price because of free trade transforms into
higher domestic price which increases the welfare for the producers while its
consumers are worse off. The opposite is true for net importing countries. These
countries require strict border protection to limit imports because the domestic price
will be lower under after the elimination of tariffs. Therefore, domestic producers lose
welfare while domestic consumers benefit.
The central point of research is the model it uses to empirically measure the
impact of free trade in the agricultural sector. The model is developed by Sumner and
Chang in an earlier research:
(Sg-Sc) < │ηh│/ β
They stated, this condition is necessary to conclude that free trade can drive
domestic prices down. Sg denotes the share of revenue from a good produced by the
farm household to their total income. Sc denotes the share of expenditure of the same
good that is consumed by the farm household to their total expenditure. ηh is the
Hicksian own price elasticity and β is the income elasticity. A decrease in domestic
price after free trade will have a positive effect on consumption of farm household if
the substitution effect is larger than the income effect.
Running this model on Indonesian data, Fabiosa (2008) shows that the
Hicksian own price elasticity is -0.42 and income elasticity is 0.02, giving the right
hand value around 19. The condition is fulfilled because the left hand value ranges
from zero to one. In other words, the consumption of rice in Indonesia is inelastic to
income changes, thus the substitution effect is larger than the income effect.
Ultimately, rice consumption increases households when the domestic price of rice
falls because of liberalisation.
The study concludes that free trade alone can raise economic growth by 0.43
per cent in an emerging economy. It clearly states in the research the Indonesia will
benefit from the free trade through lower prices. Thus, there is evidence that poorer
households in developing countries, specifically Indonesia, will gain through higher
consumption after free trade.
V. Conclusions
Prior to the signing of the agreement, policy makers would have conducted a benefitloss analysis to calculate both the short run and long term effects to Indonesia. That
analysis, of course, should be thought of prior to every policy decided. If the analysis
suggests a net loss, the wise thing would be to abandon the policy. The full effect of
free trade of ACFTA to Indonesia cannot be concluded with a simple yes or no. The
findings of different studies, including the two discussed in this paper, seem to
suggest there could be a possibility for Indonesia to gain and to lose by agreeing to
liberalise trade with China.
The agriculture sector is perceived to be a ‘sensitive’ one due to the fact it
employs over 35 per cent of Indonesian labour even when it only contributes around
17 per cent to the Indonesian GDP (CIA World Factbook, 2011). Thus the sector is a
source of income to over one- third of Indonesians, signalling that it is a significant
part of the economy. The agreement with China brings all sectors in the economy
towards free trade, the agricultural included. In other words, it leaves all agricultural
commodities unprotected to compete against agricultural products that come from
China.
The two studies have reached contradicting outcomes. Park (2008) claimed
that in general welfare and output will decrease while Indonesian exports to China
will increase substantially. However, the attention of this paper is the impact of free
trade to agriculture. It is estimated by Park (2008) that agricultural output will
increase by 2.78 per cent, but the more important indicator reached a worrisome
figure. Exports of agricultural products will decrease by a significant 7.71 per cent
and imports will increase by 6.64 per cent. This will cause a serious dent in the
agricultural trade balance. Considering that it is a source of income for many, this free
trade contract can pose threat to poor people losing welfare and falling further to
poverty. On the other hand, Fabiosa (2008) claimed that poor households in
developing country benefit with the existence of free trade. This is measured by the
rise in consumption after a dip in domestic prices. Both researches have empirical
evidence to support their findings, which makes for a uniform conclusion even more
difficult.
It is the responsibility of the government to ensure that trade liberalisation
does not harm important sectors of the economy, especially when it concerns a huge
proportion of labour. A decline in net trade balance indicates that the agricultural
sector is not yet ready to compete with products from abroad. It is perhaps a bigger
rise in output that can turn a negative trade balance into a positive trade balance. A
country is expected to face huge inflow of products from trade partners when
engaging trade liberalisation. The government must make a solid foundation for
agriculture before it can compete fairly with agricultural commodities from China.
The improvement in infrastructure such as technological advancement can increase
productivity to dramatically raise output. This will ultimately prevent the estimated
negative trade balance. In addition, the government can increase incentives by
introducing subsidies to protect the sector.
Lessons can also be taken from existent free trade agreement. Mexican
farmers lost jobs after the signing of NAFTA. The reasons, though, are unclear
because while prices were falling, they benefited from rising output. To prevent the
same situation from occurring, Indonesian policy makers must take a closer look at
what the increase in imports may cause.
VI. Reference
Audley et al (2004), “NAFTA’s Promise and Reality: Lessons from Mexico for the
Hemisphere”, Washington, DC: Carnegie Endowment for International Peace.
Chirathivat, Suthiphand (2002), “ASEAN- China Free Trade Area: Background,
Implications and Future Development”, Journal of Asian Economics.
Fabiosa, J (2008), “What Effect Does Free Trade in Agriculture Have on Developing
Country Populations Around the World?”, Working Paper 08-WP 466, Iowa State
University
Fiess and Lederman (2004), “Mexican Corn: The Effects of NAFTA”, The World
Bank Group
Lijun, S (2003), “China-ASEAN Free Trade Area: Origins, Developments and
Strategic Motivations”, ISEAS Working Paper: International Politics & Security
Issues Series No. 1
OXFAM (2003), “Dumping without Borders: How U.S. Agricultural Policies Are
Destroying the Livelihoods of Mexican Corn Farmers”, OXFAM Briefing Paper 50.
Park, Donghyun(2007) “The Prospects of the ASEAN-China Free Trade Area
(ACFTA): A Qualitative Overview”, Journal of the Asia Pacific Economy
Park et al (2008), “Prospects of an ASEAN–People’s Republic of China Free Trade
Area: A Qualitative and Quantitative Analysis”, ADB Economics Working Paper
Series