Economic Analytical Unit - Department of Foreign Affairs and Trade

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ASEAN Free Trade Area: Trading Bloc or Building Block?ASEAN Free Trade Area:
Trading Bloc or Building Block?

Executive Summary

ASEAN's role in the world economy is at a watershed. The ASEAN Free Trade Area (AFTA) aims to unify the ASEAN market across a wide range of manufactured products. Its principal objective is to boost ASEAN's attractiveness to foreign investors, particularly as a base for production for global markets.

In its current form, however, AFTA will only have a limited impact. Its proposed tariff changes for manufactures need to be supported by the inclusion of a wider range of goods and key services, early progress in reducing non-tariff barriers, which are a more important obstacle to trade, and the extension of the benefits of liberalisation to other trading partners. This would also benefit Australia's economic integration with the region.

Trade and investment diversion as a result of AFTA's proposed tariff changes will have a marginal overall impact on Australia. These effects will be offset by the benefits of increased growth of ASEAN markets as a result of AFTA-related stimulus to investment and consumption. Economic fundamentals, including projected strong growth in ASEAN and complementarities with the Australian economy will ensure that ASEAN continues to increase in importance as a major market for Australia.

In responding to AFTA, the Australian Government should urge ASEAN to regard AFTA as a step towards more comprehensive liberalisation, not as a substitute for it. It should also consider proposing the establishment of a dialogue between AFTA and the Australia-New Zealand CER arrangement, in order to assist AFTA's development and facilitate consideration of a possible link between the two arrangements.

ASEAN has been among the fastest growing parts of the world economy. The ASEAN economies' collective growth rate is likely to continue to out-perform the rest of the world economy during the 1990s. Reform and restructuring have been under way in many areas of these economies. Foundations have been laid for sustained industrialisation and economic development.

ASEAN has transformed itself into an important economic player in the region. It absorbs between 30 and 65 per cent of the Foreign Direct Investment (FDI) portfolios of emerging regional capital exporters (compared to 2 to 3 per cent of the portfolios of the top 5 international capital exporters). Among multinational corporations (MNCs) there is growing interest in regionalisation of production and sourcing. Companies are starting to redraw their maps of Asia, just as they redrew their maps of Europe in past decades. They are giving less weight to political boundaries and more to efficient production, sourcing and distribution operations.

Despite ASEAN's strong economic performance and extensive cooperation in non-economic areas of activity, economic cooperation within the ASEAN framework has proceeded slowly. Institutional efforts to boost intra-regional trade and investment have had, at best, a marginal effect on economic activity. Agreement in early 1992 to form AFTA marked a departure from earlier forms of cooperation and was met by a degree of scepticism about its implementation and impact. Many of the sceptics have since adjusted their views, as did the authors of this report during the process of its preparation.

AFTA involves phasing intra-regional tariffs down to 0-5 per cent over a 15-year period from 1 January 1993 for a wide range of manufactured products, via a common effective preferential tariff (CEPT) mechanism, with allowance for fast-track tariff cuts and temporary and permanent exclusions. It also proposes to eliminate non-tariff barriers for these manufactures but has not yet established a mechanism for doing so.

Initially AFTA's prospects for success appeared uncertain. ASEAN countries failed to meet deadlines for lodging schedules and adopted differing approaches to the timing of preferential tariff reductions. Non-publication of the AFTA's tariff reduction schedules limited its impact on private sector perceptions and behaviour. However, in October 1993 ASEAN economic ministers took decisive steps to relaunch AFTA, agreeing to bring forward ASEAN countries' tariff reductions on highly protected items to 1 January 1994 and to publish full details of the AFTA scheme.

AFTA's Impact On ASEAN

Regional trade arrangements (RTAs) can create a larger internal market, which can deliver lower prices, attract investment and allow for specialisation of production and economies of scale. In the case of AFTA, the reduction of high tariffs will facilitate trade in intermediate products and encourage an international division of labour in industrial production within ASEAN. AFTA could enhance the process of economic integration in East Asia, which is primarily being driven by trends such as the relocation offshore of Japanese production in response to rising domestic costs and barriers to Japanese imports in major markets.

AFTA's impact on investment flows is likely to be positive for ASEAN, particularly if it encourages corporations to replace country-specific strategies with regional plans. ASEAN's appeal to international investors planning their regional strategies will be enhanced by AFTA and the prospect of ASEAN as an integrated market. This was a major objective of AFTA given increased international investor interest in competing destinations, particularly China. However, investors will continue to be discouraged by remaining barriers to imported inputs from internationally competitive non-ASEAN producers.

AFTA's impact on trade is more ambiguous. All RTAs contain elements of both freer trade and protectionism. They create trade when high-cost domestic producers in member countries lose out to more competitive suppliers in other member countries. On the other hand, they can divert trade, and impose costs, if suppliers outside the arrangement can no longer compete against suppliers within. The risk of diversion is obviously lower if participants in the RTA are already competitive with those outside, or if barriers to external trade are low.

On current indications, AFTA's diversionary impact on trade is likely to be minimal, and will be offset by AFTA-related growth in ASEAN creating additional demand for imports from outside the region. The implementation of AFTA could increase intra-ASEAN trade by 10 per cent over its fifteen years of operation. Total ASEAN exports may increase by 2 per cent overall as a result, increasing GDP size by 2 per cent. Trade diversion could, however, be substantial in some industry sectors where very high tariffs apply. Implementation of Uruguay Round settlements on market access may ameliorate this in some cases.

It needs to be borne in mind that non-tariff barriers impose a more significant impediment to intra-regional trade and investment than do tariffs. Without progress on this front, the potential direct trade and investment benefits of AFTA for ASEAN countries will remain fairly marginal, as will trade diversion effects.

There are also some missing requirements for continued economic development within ASEAN - most notably some raw materials; competitively priced highly skilled workers, managers and professionals; infrastructure, including power supply and business and financial infrastructure; and strong research and development capacity. Expanding AFTA's membership to draw in some of these elements would enhance ASEAN's ability to play a major role in regionalised production chains.

In the view of the authors of this report, the potential benefits of AFTA for its members would be significantly enhanced by ensuring liberalisation of trade with non-participants continues. Most of ASEAN's trade is with economies outside ASEAN (80 per cent of exports in 1992). It is therefore in ASEAN countries' interests to pursue trade liberalisation on a wider basis.

AFTA's success would also be enhanced by extending its product coverage to include other sectors in addition to the current list of manufactures, embarking on reduction of non-tariff barriers in accordance with the Agreement, and welcoming additional participants, particularly those with a high degree of complementarity in terms of production output and trade.

AFTA's Impact On Australian Business

ASEAN already absorbs around 14 per cent of Australian exports, making it Australia's second largest overseas market behind Japan. Rising consumer incomes, the emergence of more sophisticated manufacturing and the need for infrastructure development in ASEAN will open up new opportunities for Australian exporters. ASEAN is likely to continue to increase in importance as an Australian export market.

Modelling work commissioned for this report indicates that Australian exports will be relatively lightly affected by AFTA. AFTA's preferential tariff cuts will have a slight negative effect on Australian exports. Nevertheless, some products and firms could be affected adversely. A static analysis of the direct effects of these tariff cuts indicates that Australian exports could be 2.4 per cent lower than they would have been without AFTA, by 2005-06. Exports from the United States, Japan and other North Asian economies to ASEAN could be over 4 per cent lower than they otherwise would be, over the same period.

Trade diversion losses for Australia are relatively small overall because raw materials and unprocessed agricultural commodities - products which are formally excluded from the AFTA scheme - account for a large proportion of Australian exports to the region. However, if AFTA is broadened to include these sectors, trade diversion costs for Australia will rise. This possibility cannot be discounted. Already, some ASEANs have nominated these goods for intra-regional tariff cuts.

The burden is likely to fall more heavily on elaborately transformed manufactures (ETMs) such as electrical machinery, office machinery and telecommunications equipment. This is a possible source of concern for Australia since exports of ETMs to ASEAN have been increasing strongly over recent years, contributing to important structural changes for Australian manufacturing industries. Other product groups which may suffer from ASEAN preferences include non-ferrous metals, primary plastics and inorganic chemicals.

The above estimate of the impact of trade diversion does not take into account AFTA's indirect positive effects on trade. AFTA is likely to stimulate greater economic growth in ASEAN, which will generate increased demand for products not cheaply available within the region - ranging from basic inputs to sophisticated consumer goods. As a result, the net impact of AFTA on Australia and other external suppliers' exports will be smaller than the modelling work suggests. Also, in a considerable number of niche areas, Australian suppliers will continue to face no competition from within ASEAN, regardless of the new preferential arrangements.

AFTA's impact on investment flows is difficult to quantify. To the extent that AFTA stimulates greater economic growth and greater regional integration it will create attractive investment opportunities. But to the extent that barriers to non-ASEAN countries remain high, some of that investment may be articifially and inefficiently allocated on the grounds of 'getting behind tariff walls'. This may involve investment diversion, including from Australia.

Three hundred Australian businesses were surveyed to gauge marketplace perceptions of AFTA. This survey revealed that while three-quarters of respondents were aware of AFTA, relatively few thought AFTA would have adverse implications for their business, and fewer still had adjusted corporate plans in response to this initiative. Interviews with selected Australian companies with investments in ASEAN served to illustrate a range of implications AFTA will have for outsiders.

Recommended responses to AFTA

Australian Businesses

Assessing the impact of AFTA at the company level will not be a straight-forward exercise. Tariff reduction schedules set out year-to-year intra-ASEAN tariff reductions for each ASEAN member across over 5,000 product groups. Each member country is granted considerable leeway to pace their own cuts providing they all reach the 0-5 per cent tariff finishing line by 2008. They are also free to exclude 'sensitive' products for up to eight years.

Companies which are faced with possible export diversion as a result of AFTA can take a number of steps, including joint venture production with an ASEAN-based partner, productivity and pricing improvements, and product innovation and differentiation to maintain market share. In many cases, the new tariff arrangements will not significantly affect the competitiveness of Australian products.

This report sets out a checklist of questions which companies should ask when trying to assess the impact of AFTA on their existing exports and investments.

Australian companies will also need to take account of the opportunities which AFTA presents for investment. The investment environment in ASEAN may be improved substantially by AFTA, particularly where inputs for production are competitively sourced from more than one ASEAN country.

There may also be increased opportunities for Australian companies to provide services to MNCs establishing new production networks in ASEAN. The Australian and ASEAN business communities could benefit enormously from joint pursuit of the benefits of regionalised production and sourcing plans.

Australian Government

The Australian Government should encourage ASEAN to regard AFTA as a 'building block' which should contribute to trends towards increased liberalisation of trade in the region, and not as a substitute for further reform.

The Government should consider establishing a formal dialogue between CER and AFTA. There are a number of significant parallels between the two institutions, although CER has a longer history and is at a more advanced stage of development. And CER has been a most successful, GATT-consistent RTA, which has delivered benefits to its participants without incurring overriding trade diversion costs. Secondment to the ASEAN Secretariat of an Australian/New Zealand official with CER experience could be of considerable benefit to AFTA. Such a dialogue would also facilitate further consideration of a possible linkage between AFTA and CER, as discussed by the Prime Ministers of Australia and Thailand in April 1994.

The Government should ensure that the outcomes of consultations and research on AFTA are passed to the Australian business community.

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