The impact of free trade on domestic industries

December 1, 2017
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The impact of free trade agreements on the procurement behaviour of Japanese firms’ overseas affiliates

Many governments have engaged in free trade agreements to facilitate the growth of regional production networks and global value chains, but critics argue that such agreements damage domestic industries. This column uses Japanese evidence to show that free trade agreements can increase the significance of the domestic industry in a country’s supply chain networks through intra-firm trade, and restrain the hollowing-out of the domestic industry.

Multinational enterprises (MNEs) have built regional production networks to increase their competitiveness and resilience to external shocks in the global market. They have sliced up their production processes, located them in various countries following their comparative advantages, and linked them up in value chains by international trade. Inter-process trade has ballooned in the last few decades. Policies to encourage MNEs to develop overseas markets with such networks are important for increasing their competitiveness and exports. Free trade agreements (FTAs) are recognised as one such policy, and many countries, therefore, have promoted such agreements.

Japan is no exception to this global trend. Japanese MNEs have also developed their supply chain networks covering many parts of the world, especially in East Asia, through foreign direct investment (FDI), and have used various regional FTAs such as the North American Free Trade Agreement (NAFTA) to compete with their rivals. The Japanese government recognises that FTAs help to take in the dynamism of the global economy for its economic revitalisation and growth in a depopulation phase, and has enacted 15 FTAs with 18 countries since its first agreement with Singapore in 2002. Japan has focused on Asia and the Pacific rim in its FTAs hitherto, and is currently negotiating three mega-FTAs involving a large number of countries: the Japan-EU FTA, the Trans-Pacific Partnership (TPP) Agreement involving 11 countries in Asia Pacific excluding the US, and the Regional Comprehensive Economic Partnership (RCEP) involving 16 East Asian countries including China and India.

Contrary to the view that the development of overseas markets by Japanese MNEs would contribute to Japan’s economic growth, there is a view that an expansion of overseas activities would deepen the hollowing-out of domestic activities as resources would be shifted abroad. Following this line of argument, some argue that trade promotion policies such as FTAs would also have this effect.

In light of these two conflicting views of the impacts of FTAs on the Japanese economy, we investigated the effects of FTAs on the procurement behaviour of Japanese firms’ overseas affiliates in order to provide statistical evidence on the effects of FTAs on the domestic industry. We examined whether FTAs encouraged Japanese firms’ overseas affiliates to increase imports from Japan/Japanese parent firms in their total procurement. Our estimation results revealed that FTAs have statistically significant positive effects on their imports from Japan/Japanese parent firms in the manufacturing sector. Our results imply that FTAs are more utilised in intra-firm trade than inter-firm trade, because the coefficients for FTAs are larger in the regression of imports from Japanese parent firms than imports from Japan.

The positive effects of FTAs were also detected in the regression at the sub-industry level. There are statistically significant positive coefficients of FTAs on imports from Japan for food, textile, metallurgical, and miscellaneous industries, while we obtained statistically significant positive estimates of FTAs on imports from Japanese parent firms for food, textile, wood and paper, and electronic industries. These results imply that FTAs can increase the significance of the domestic industry in their supply chain networks by active utilisation of intra-firm trade, and restrain the hollowing-out of the domestic industry. In other words, FTAs are not only a trade policy device for export promotion, but also an industrial policy.

Today, the voice of free trade sceptics is growing louder as anti-globalisation movements surge.  The sceptics insist that their countries protect the domestic manufacturing industries from severe international competition. One recent example reflecting this view was the US exit from the TPP, which would have been the world’s largest FTA if the US had remained a member. Our work using the Japanese data, however, reveals that they are misled because FTAs possibly increase the significance of the domestic industry in the production networks. Economists should contribute to the debate about the impacts of FTAs on domestic industry and more generally about the impacts of free trade on the concerned economies, by adding further statistical evidence not only for Japan but also for other countries.

Editors’ note: The main research on which this column is based first appeared as a Discussion Paper of the Research Institute of Economy, Trade and Industry (RIETI) of Japan.

References

Ando, M, and S Urata (2015), “Impacts of Japan’s FTAs on Trade: The cases of FTAs with Malaysia, Thailand, and Indonesia”, REITI Discussion Paper 15-E-104.

Urata, S, and A Kato (2017), “The Impact of FTAs on Procurement Behavior of Japanese Firms’ Overseas Affiliates”, RIETI Discussion Paper Series 17-E-113.

Urata, S, and M Okabe (2014), “Trade Creation and Diversion Effects of Regional Trade Agreements: A Product-level Analysis”, The World Economy, 37(2), 267-289.

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