Case Study Objective

Now with ECFA signed and become effective, Taiwan is facing new opportunities and challenges in the regional integration as well as global trade. The first object of this study will compare and contrast the similarities between ECFA and Closer Economic Partnership

Arrangement (CEPA), the free trade agreement that is preferential in nature and signed between Hong Kong and China under the WTO terms. Second objective of, this study will evaluate and analyze the implication of how CEPA had effect on Hong Kong economy, and based on that what will be the effect of ECFA on Taiwan economy. Finally, since ECFA is part of the East Asian regional economic integration trend that started off by the formation of ASEAN free trade area, the presence of marginalization effect based on trade figures with ASEAN will also be evaluated.

The main questions of this thesis are:

1. Based on the impact that CEPA had to Hong Kong economy, what are the implications of ECFA to Taiwan economy?

2. How will ECFA benefit or dis-benefit to Taiwanese industries, particularly the manufacturing industry?

3. By integrating Taiwan economy with China under the terms of ECFA, how does it or does not promote foreign investment in Taiwan?

4. By signing ECFA with China, will it help promote Taiwan's accession to the

regional economic integration as to begin negotiation on free trade agreements with other countries in the region as well as with other members of WTO?

5. Is Taiwan really under the marginalization effect of not being part of the regional economic integration trend?

- 7 - 1.3 Importance of this Study

This case study was conducted for a number of reasons. First of all, Taiwan depends on the growth of export for its GDP growth. Ever since Taiwan began its indirect trade and indirect investment with mainland China, as a market, China has become a major trading partner and investment destination for firms that are based in Taiwan. Just like Hong Kong, much of Taiwan’s export and investment destination is China. It is worth the effort to understand the implication on economic integration of Hong Kong with China, especially before and after the implementation of CEPA on January 1, 2003. In order to understand the impact, background and implication of CEPA that revive Hong Kong economy to its current state will be in the

examination.

Secondly, for the national security and commerce reason, Taiwan imposes strict restrictions on goods that are imported from China as well as restrictive investment policies toward China while China imposes little. The main obstacle is that Taiwan and China are still under serious sovereignty dispute. As ECFA become effective on Jan 1, 2011, a step for Taiwan to integrate economy with China, this study in attempt to foresee the opportunities and threats that are forthcoming. There will be profound issues and challenges that are going to be faced by the Taiwan economy.

Thirdly, although Taiwanese was not involved in the regional economic integration trend in East Asia, Taiwan is still an important trading country in the region. By sign the ECFA with China, Taiwan has begun to integrate with regional economies in East Asia. This study will examine, without being involved in the regional economic integration in East Asia, the existence of marginalization on Taiwan export within the region, particularly with ASEAN free trade area.

The extension of this question is to identify the potential and target FTA candidate that Taiwan should work on in the future.

- 8 - 1.4 Framework of the Study

This study is a case analysis of how ECFA will impact on Taiwan economy particularly on the export manufacturing industry as a whole and Taiwan’s standing on regional economic integration.

The first section presents a background of this study followed by explanation of the objectives and the importance of this study. The second chapter contains a review of relevant theoretical papers, which will elaborate explain how free trade agreement may benefit the countries that’s involved and how the benefits were measured. The second section contains review of the relevant international trade theories regarding the regional integration and the evaluation of regional integration. This section will also present a brief description of levels of economic integration and the reason behind them. The third section will investigate and compare the similarity and difference between CEPA and ECFA. This section will offer an overview on both CEPA and ECFA and follow up with their development, content, supplement and major topics. For comparison purpose, both context of CEPA and ECFA will examined and compared.

The fourth section will evaluate the implication of CEPA on Hong Kong after CEPA had become effective. The implication of ECFA on Taiwan thus far will also be evaluated. Important event that is relevant to economic development to both Hong Kong and Taiwan will be reviewed. The comparison purpose, relevant economic performance with before and after the implementation of CEPA based on macroeconomic data and trade indicators that provided by the Censes and

Statistic Department of Hong Kong Special Administrative Region of People’s republic of China statistical department will be evaluated. Statistical data from statistical departments of Taiwan government will be analyzed. The fifth section will survey the trends in regional integrations or regional free trade agreement that began with the formation of ASEAN and its FTA. The purpose of ASEAN plus one and ASEAN plus three will be accessed. The international trade structure of ASEAN will be evaluated. Additionally, based on recent years of trade data between

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Taiwan and the ASEAN countries, evaluation of marginalization within the East Asia economic integration will be evaluated. The sixth section will be the concluding remark of this case study.

This section will address the issues uncovered by this study, and will offer suggestion for future cross-strait ECFA related negotiations as well as outlook on regional integration for Taiwan economy

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2. Literature Review

2.1 Levels of Economic Integration and why Countries Pursuit Them

There are several levels of economic integrations possible in theory and they can be broadly divided into five categories: 1) Economic Union, 2) Common Market, 3) Customs Union, 4) Free Trade Area (FTA), and 5) Preferential Trade Agreements (PTA) (Pal, 2004). The

relationship between the various levels of regional agreements is depicted graphically in figure 1.

Figure 1, Levels of Economic Integration

Source: Pal 2004

For the purpose of this will only preferential trade area and free trade area will be emphasis on. A preferential tread area (PTA) is a union in which member countries impose lower trade barriers on goods produced within the union, with some flexibility for each member country on the extent of the reduction. A Free Trade area is a special case of PTA where member countries completely abolish trade barriers (both tariff barriers and non-tariff barriers) for goods origination within the member countries (Pal, 2004). All levels of economic integration under the WTO are reciprocal agreements between two or more partners, that is, bilateral or multilateral.

The reason behind the formation of these integrations was, according to Pal, there are 1) the Welfare Impact of RTAs, 2) Dissatisfaction with the Current Multilateral Trade Regime, 3)

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Bandwagon Effect of Regionalism, which also known as the marginalization effect, and 4) The Other Factors.

First of all under the welfare impact of RTAs, RTA enhances efficiency and increases welfare (Pal, 2004). The traditional theory of gains from trade suggests that removal of trade barriers allows consumers and producers to purchase from the cheapest and most competitive source of supply. This enhances efficiency and increases welfare.

As with dissatisfaction with the current multilateral trade regime, there is an emerging consensus among economists that frustration with the multilateral trading system is one of the prime reasons behind the current growth of regionalism (Pal, 2004). Krugman suggested that countries find regionalism an easier alternative because large number of participants in multilateral trade negotiations reduces the cost of non-cooperation and creates rigidity in the system. Also according to Krugman, modern trade barriers are much more complicated to negotiate in a multilateral forum and most countries find it easier to deal with these issues on bilateral or regional level (Krugman 1993).

For the bandwagon effect of regionalism, according to, that many big developed countries like the Unites States and the European Union are increasingly getting involved in FTAs with developing countries on a bilateral or regional level (Bhagwati 1993). This has encouraged many developing countries to seek participation in FTAs with developed countries as a defensive necessity against a possible exclusion from these markets (Pal, 2004). The

motivation to go for an FTA with a developed country will be particularly strong for a developing country if other countries which it is competing to supply similar goods to the developed market, are part of a preferential trade agreement with the developed country. If these non-member countries unable to form a free trade area with the developed country, they attempt to create their own market by joining a regional trade agreement among excluded members. This creates a bandwagon effect where no countries want to be left of some major regional groupings (Pal,

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2004); such phenomenon is also known as the marginalization effect.

On the situation of other factors-Among other important economic factors are foreign direct investment (FDI) and the advantages associated with economies of scale. According to the World Trade Report 2003 (WTR 2003) access to large regional markets is one of the key

determinants of FDI in developing countries. As FDI has become the most important source of foreign capital inflow for developing countries, the WTR 2003 suggests that countries join regional agreement to attract FDI. On somewhat similar reasons, it has also been suggested that smaller countries join regional trade agreements because it can offer domestic firms the

advantage of economies of scale (Pal, 2004).

Political factors also motivate countries to join regional trade agreements. Trade linkages between economies can increase the cost of conflict and improve cross border cooperation. For this reason, regional trade agreements are used as a strategic move to consolidate peace and increase regional security among member countries. Regional trade agreements are often used by developed countries to forge geopolitical alliances and build up diplomatic ties. By providing increased discriminatory access to a larger market, these countries seek to garner increased support on political front. It is apparent that most political regional trade agreements are not driven by economics, however, in the political regional trade agreement arrangements, particularly where a large developed is involved, there is always the possibility that the interests of smaller countries would be of secondary concern (Pal, 2004).

2.2 Evaluation of Free Trade Agreements and Marginalization Effect

Plummer, Cheong and Hamanaka offered Methods for Ex-Ante Economic Evaluation of Free Trade Agreements on their paper for Asia Development Bank Methodology for Impact Assessment of Free Trade Agreements. They provided practical methods to policy makers for evaluating the potential economic effects of an FTA, defined as the preferential liberalization of

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trade within a group of countries. They discusses how to apply three methods: trade indicators, SMART (software for market analysis and restrictions on trade) in WITS (world integrated trade solution), and the GTAP (Global Trade Analysis Project) model.

According to Plummer, Cheong and Hamanaka, the main strengths of using trade

indicators is that they are relatively easy to understand, their data requirements are easily satisfied, and their computation is straightforward. However, their main limitation is that, since these indicators are atheoretical, interpretation of the results may be difficult. In addition, for the indicators presented in the trade indicators section, the results may be meaningless if the

indicators are computed for trade categories that are too aggregated or unsuitably classified. To obtain more relevant information from these trade indicators, trade data could be reclassified according to a country’s production structure and the computations could be performed at a more disaggregated level (Plummer, Cheong & Hamanaka, 2010).

On the same paper by Plummer, Cheong and Hamanaka, the strengths of the SMART model are that it is easily learned and implemented together with the WITS database, it yields important quantitative results on the trade and tariff revenue effects of an FTA, and the analysis can be performed at the most disaggregated level of trade data. However, the main limitation of the SMART model is that it is a partial equilibrium model, which means the results of the model are limited to the direct effects of a trade policy change only in one market (Plummer, Cheong &

Hamanaka, 2010). The model, therefore, ignores the indirect effects of trade policy changes in other markets (inter industry effects) and feedback effects (the effects due to a trade policy change in a particular market that spill over to related markets and return to affect the original market). In addition, SMART does not return results on an FTA’s effects on domestic production, which may be of interest to policy makers, nor does it consider the possibility of new foreign exporting countries serving the domestic market. Finally, SMART’s results may be sensitive to the modeling assumptions and parameter values used. Although SMART does not provide a

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built-in sensitivity analysis, users may perform this manually by changing parameter values over a reasonable range (Plummer, Cheong & Hamanaka, 2010).

The Global Trade Analysis Project (GTAP) model, originally formulated by Hertel (1997), is the most widely used CGE model for analyzing trade policy which was developed by Dixon (Dixon, Parmente & Vincent 1982). The theory underlying the GTAP model was based on the ORANI model of the Australian economy. The model is multi-market, with markets for final goods, intermediate goods, traded goods, and factors of production. It is also multiregional, with a region representing a country or a group of countries. The quantity of endowments—land, skilled labor, unskilled labor, natural resources, and initial capital—in each region is fixed exogenously within the GTAP model (Plummer, Cheong & Hamanaka, 2010). The main agents in this model are producers, consumers, and the government. These agents are styled according to standard neoclassical axioms, but the GTAP model contains particular production and utility functions (Hertel 1997). Furthermore, the model assumes perfect competition, and that prices will adjust to clear all markets. As the labor supply within each region is fixed and not mobile across regions, market clearing implies that there is no unemployment (Plummer, Cheong &

Hamanaka, 2010).

The strengths of the GTAP model include (i) as a general equilibrium model, it accounts for economic changes in all sectors; (ii) it is relatively accessible compared to other CGE models;

(iii) it comes with a peer-reviewed and fully documented database and software suite; and (iv) it is widely used by trade policy researchers, who can easily try to replicate and verify the results of any GTAP study. On the other hand, the GTAP model faces the same limitations as other CGE models of trade policy: (i) it is constrained by the availability of data, and a lack of data may severely compromise the scope and relevance of a study and the researcher’s ability to model certain trade policies; (ii) it involves many parameters, which may be difficult to estimate and validate; and (iii) it contains assumptions or characteristics that may not reflect real-world

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features. For instance, in analyzing FTAs, the GTAP model’s use of the Armington assumption creates a bias against findings of trade diversion and, therefore, a bias in favor of FTAs (Lloyd &

Maclaren 2004).

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3. Comparison Between CEPA and ECFA

3.1 CEPA Overview

On June 29th 2003 the Special Administrative Region (SAR) of Hong Kong and mainland China signed a bilateral trade agreement, known as Closer Economic Partnership Arrangement (CEPA). This agreement is the result of an initiative on the part of business circles and more particularly by the Hong Kong General Chamber of Commerce (HKGCC), in response to anxieties about the future of the SAR as a gateway between China and the rest of the world, which were caused by the economic slowdown since the unification of 1997. Despite its reservations, the government of Hong Kong backed the initiative and obtained, in December 2001, an agreement in principle from the central government. The CEPA conforms to Article 24 of the GATT (General Agreement on Tariffs and Trade) on bilateral agreements and is

compatible with the rules of the WTO, which was an essential condition of its application, since both parties are separate members of the WTO. This is the first bilateral agreement to be signed by Hong Kong and the first to be signed by mainland China with member of the WTO [3].

It took eighteen months to conclude the CEPA. The CEPA was made up of three major sections: 1) tariff reductions on 273 categories of goods that Hong Kong exports to China; 2) a preferential opening of Chinese market to Hong Kong service providers in 17 sectors; and 3) a series of measures aimed at facilitating bilateral exchanges of goods capitals and people. Also there are 6 Annexes signed to complement the CEPA. The Annex I to III deals with trade in goods and defines, in particular, related rules, the origin of the goods and the procedures for registration and verification of certificates of origin (Cabrillac 2004).

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Annex II defines the definition of the “rules of origin” of products. There are about 67%

of the 273 products covered by the agreement (including jewelry, textiles, clothing, cosmetics, paper, and plastics) are covered by the criteria of origin currently in force in Hong Kong, in conformity with Article VII of the GATT which requires “substantial transformation,” defined case by case. In 17% of categories, among them chemical and metal products and certain electronic products, this “substantial transformation” must be significant enough to lead to a change in tariff heading, according to the international four-digit nomenclature. The agreement thus uses the provision, which is fairly widespread in matters of product origin, of Change in Tariff Heading. Finally, for the remaining 16% of categories (among them watch and optical components) the production or transformation costs in Hong Kong (including product

development costs) must represent at least 30% of the FOB (Free on Board) export price. While Hong Kong had to make concessions to the Chinese on this percentage (their objective had been to set this at 25%), they were nevertheless successful in having development costs included in the calculation (Cabrillac 2004).

The Annex IV and V deal with the second section of the arrangement, with the addition of the telecommunications sector and define the term “Hong Kong service provider.” Annex VI defined six fields for special co-operation between Hong Kong and China.

CEPA includes trade in goods, services and trade and investment facilitation. To China and Hong Kong, compared with other free trade agreements, the category of goods covered are wide and tariff rate reduction are fast, including wide field of trade in services, trade and comprehensive investment facilitation, multifaceted cooperation on the bilateral economic and trade fields to develop the institutional measures, expanding the field of a free trade agreement.

In all account, CEPA is a comprehensive free trade arrangement.

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Hong Kong being a duty-free region, by the content of CEPA are agreed to by China are of a unilateral in character. Although China and Hong Kong are formally linked, in this

arrangement, Hong Kong agrees not to impose any restrictions on imports coming from the China.

In addition, both parties also agreed not to take any mutual protective measures nor engage in

In addition, both parties also agreed not to take any mutual protective measures nor engage in