JSEPA: AN ECONOMETRIC EVALUATION Assessing the Impact of the 2002 Japan-Singapore

Free Trade Agreement

Mark Chesney

Dr. Gordon Hanson

Special Topics in International Trade: IRGN 435

School of International Relations and Pacific Studies

University of California, San Diego

June 8, 2015

International Relations and Pacific Studies

University of California, San Diego

June 8, 2015

Abstract Thirteen years after the signing of JSEPA—the Japan Singapore Economic

Partnership Agreement, the ensuing boost in trade witnessed between the two

nations has commonly been attributed to this policy act. Beneath the surface,

careful econometric measurement reveals that the impact of this free trade

agreement is not nearly as optimistic as politicians and business leaders would

hope. Regression coefficients show reductions of about 30% in the years

following JSEPA. With placebo tests turning up positive in the year 2000, it is

difficult to explain exactly from where the source of these trade losses come.

Mark Chesney

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1. Introduction JSEPA, the Japan Singapore Economic Partnership Agreement, is Japan's first free trade

agreement. It was signed by prime ministers Goh and Koizumi on January 13, 2002 in

Singapore, coming into effect on November 30, 2002. Beneath the surface of the signing and

enactment, talks over free trade between the two nations have begun as early as 1999.1 News of

the talks in the media prompted an important anticipation of free trade among the business

communities of both nations (see section 4: Econometric Challenges).

The greatest observed outcomes that chronologically followed this agreement were the

boosts in merchandise trade, private investments, and gross domestic product. In an overview of

Japanese exports to Singapore, the bulk of these industries are concentrated in machinery and

equipment. Meanwhile Singapore's exports to Japan are mostly in the services. Because so

much of this trade is intra-industry, the benefits of free trade come not just from tariff reduction

but from concessions in non-tariff costs.2 A snapshot of a breakdown of the bilateral trade

subsectors appears in Appendix A.

Trade agreements and their true impact have been a common subject for econometricians.

Treating the JSEPA as a treatment that began in late 2002 is the basis of this analysis. Of course

selection into JSEPA was not done randomly, as an ideal experiment would have it be. Rather,

JSEPA came out of a climate of easing economic relations between Japan and Singapore.

Further complicating the matter are agreements that followed JSEPA and fall into this time

frame. For example, the agreement between Singapore and New Zealand in 2000 was sure to

1 Terada, Takashi. The Making Of Asia’s First Bilateral FTA: Origins And Regional Implications Of The Japan–

Singapore Economic Partnership Agreement. Australia–Japan Research Centre: 2006. 2 Regional Trade Agreements. The Chinese University of Hong Kong. 2000. http://intl.econ.cuhk.edu.hk/rta/index.php?did=17

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have potential impact on Singapore’s trade flows—and arguably on Japan’s too. By teasing

apart the data available on economic trade, this study intends to investigate any true impact that

can be attributed to this particular treaty.

2. Data The data used in these gravity modeling is sourced from the World Trade Organization

(with pre-processing performed by Dr. Gordon Hanson). The raw data contain foremost dyadic

values of nominal trade flows in USD, which makes up the dependent variable selected for this

analysis. Also of primary importance are nominal GDPs and distances between pairs of 116

countries. The time range runs from 1984 to 2008.

Generated from these primary variables were input variables for the gravity models: log-

transformations of trade value, GDP product (of each importer and exporter), and distance.

Other major dummy variables were contiguity (sharing a land border), common official

language, historical colonial relationship, membership in the GATT or WTO, nation exporter,

nation importer, and exporter-importer pair.

Data Time Trends

Of critical importance is the underlying time trend of economic trade. To illustrate this

comparison of Japan and Singapore’s exports, two baseline comparisons are made. In addition

to the entire world export volume, a select comparison group was constructed. (The

methodology of the gravity-score matched set is described under the Model Specification section

of this report.)

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Figure 1—Export Value Time Trends

The time trend of exports shows how our target countries are increasing in export values. This is

true not just of the world as a whole, but as well as the two target countries here, and the gravity

score matched set.

Figure 2—GDP Time Trends

The GDP time trend makes it apparent that while the world as a whole is climbing at a gradual

pace, Singapore has gone through leaps and bounds in this study time period. This can explain

the increases in trade that is seen, particularly those after JSEPA is signed.

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3. Empirical Model Specification

A gravity model captures the effects due to trade liberalization under JSEPA on trade

volume. This model can take various forms; here it is as follows:

ln 𝑋𝑑𝑜𝑡 = 0+

1𝐽𝑆𝐸𝑃𝐴𝑑𝑜𝑡 +

2ln 𝑌𝑑𝑌𝑜 +

3𝐶𝑂𝑁𝑇𝐼𝐺𝑑𝑜 +

4𝐿𝐴𝑁𝐺𝑑𝑜 +

5𝐶𝑂𝐿𝑑𝑜 +

6𝐺𝐴𝑇𝑇

+ 7ln𝐷𝑑𝑜 + 𝑜𝐸𝑋𝑃𝑜 + 𝑑𝐼𝑀𝑃𝑑 + 𝑃𝐴𝐼𝑅𝑑𝑜 + 𝑡 + 𝑑𝑜𝑡

Variable List

X: bilateral trade volume

JSEPA: treatment of interest. JSEPA = 0 before 2002; JSEPA = 1 from 2002 onward.

YdYs: multiplicative product of nation-pair’s gross domestic product.

CONTIG = 1 if two countries share a land border (contiguity)

LANG: common language

COL: common colonial history

GATT: whether origin and destination country both belong to the GATT or the WTO

D: distance. Captures costs associated with transport (shipping duration, shipping risks,

communication, etc.)

EXPo: exporting country in a pair (dummy variable)

IMPd: importing country in a pair (dummy variable)

PAIR are the country pair dummies. They capture the average trade between the source

and destination countries

t: time trend, annual

Lastly, subscripts refer to: d (destination), o (origin), and t (time, year).

My gravity model specification consists of logarithm-transformed variables and binary

variables. The three log-transformed variables are annual total value of trade between a nation-

pair (in nominal US dollars), the multiplicative product of exporter and importer GDPs, and the

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distance between the two nations. (As with Baier and Bergstrand3, the distance is between two

countries’ economic centers, traced along great circles which are concentric with the earth’s

core.)

Binary variables are used to indicate whether the two nations share:

a border

a common official language

a colonial power

simultaneous membership in the GATT

the treatment, i.e. the Japan-Singapore FTA. Simply put, this variable jpn_sgp2002 = 1

for panel observations on or after 2002 in which Japan and Singapore are trading.

Specifications of Model Variations and Explanation of Counterfactuals

I perform four variations of my gravity model. These variations are:

1. Controlling for time trends, by including dummy variables for each year

2. In addition to (1), controlling for cross-sectional variation, by including dummy variables

for each exporter nation, and each importer nation.

3. Controlling for the interactions of importer time trends and exporter time trends.

4. Controlling for fixed effects among nation pairs by creating dummies for each pair.

Regression (1) Treatment Effect: Time Trends

This specification contains time trends (year dummy variables). This estimates the

average impact that JSEPA has on trade in years following its ratification in 2002. This

treatment effect is compared to all other observations beyond the treatment: bilateral trade with

other countries (where trade is not between Japan and Singapore), in addition to Japanese-

Singaporean trade in years prior to 2002.

3 S.L. Baier, J.H. Bergstrang / Journal of International Economics 71 (2007) 72-95

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One notable concern is that while this regression controls for the size of its nominal

economic activity (i.e. GDP), it does not control for specific, and quite possibly unobservable

traits of each nation. Traits specific to Japan as an exporter (or importer) could be unidentified

and yet crucial to the impact of trade with Singapore. I correct for this in the second regression.

Regression (2) Treatment Effect: Time Trends, Importer-Dummies, and Exporter-Dummies

This regression contains both time trends and dummy variables to control for each

importing country and each exporter. It controls for an exporter's trade on average, as well as

average imports per country. By this specification this regression estimates the impact that

JSEPA has on trade between Singapore and Japan, when compared to a) trade between the two

prior to JSEPA, b) trade between Japan and any other nations except Singapore, and c) trade

between Singapore and any other nations except Japan.

This regression is useful in controlling for the trade of each nation, whether as exporter or

importer, averaged over the 25-year time frame. To extend the explanatory power of the panel

data one step further, the next regression uses each year rather than averaging them.

Regression (3) Treatment Effect: Interaction between Time Trends and Importer/Exporter-

Dummies

This regression contains the interaction of time trends with dummy variables of each

importing and exporting country. In doing so, time trends that are specific to any nation are

capturing in this interaction term. However, the counterfactual for this regression still remains

very similar to that of the previous, and because of its complexity, it remains still too bulky in

discerning the effects of JSEPA on trade. The next regression helps to resolve this challenge.

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Regression (4) Treatment Effect: Country-Pair Fixed Effects

This regression contains dummies for each pair of countries. In doing so, this regression

measures the effect of JSEPA on Japan-Singapore trade after JSEPA (i.e. 2002 to 2008)

compared to Japan-Singapore trade before JSEPA (1984 to 2001). Though the establishment of

causality from JSEPA on trade between Japan and Singapore is not certain, it is more plausible

in this variation than in previous regressions that rest upon more complex counterfactuals.

Comparison Group Construction: Gravity Score Matching

The country-pair fixed effects regression is conditional on the gravity model variables. In

the process of constructing this comparison group, the gravity score between Japanese-

Singaporean trade was 14.5. Holding Singapore constant as the importer, only the USA scores

within 0.25 of Japan’s gravity score as exporter to Singapore. Performing the same gravity score

matching with Japan as importer returns an array of nations: Austria, Belgium, Denmark,

Finland, Norway, Philippines, Poland, and Turkey. These are all included into the matched

comparison group.

4. Econometric Challenges

Even in the most sophisticated model variation, in which I compare country pairs on the

various gravity characteristics, there are always the danger of potentially confounding global

events that influence both trade between Japan and Singapore and their gravity characteristics.

Exporter capability and importer demand conditions are fundamental to the gravity

model. As much as exporter and importer fixed effects can aid in capturing these conditions,

they will never be accurate enough for us to be certain that causality is identifiable from the

JSEPA onto trade flows. Though the fixed effects by their nature do not change over time, these

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true import and export conditions may change drastically, often in unobservable ways. This

caution is advised while interpreting econometric results.

Simultaneity bias and other similar forms of endogeneity may very well be present in this

analysis. As mentioned earlier, trade agreements are not exogenous because they are often

preceded by increases in trade flows. That is to say that two nations that initially trade very little

would have little incentive to form a trade agreement. No two nations randomly select

themselves into a trade agreement. Also mentioned is the great potential of anticipation for free

trade among business leaders. This could be expected to produce a reverse Ashenfelter’s Dip, or

an explanation of a placebo effect in years. Because improvements in bilateral relation can

influence trade, it is important not to credit the agreement disproportionately with advancing

trade.

5. Results

Table 1 shows the results of the four regressions discussed above. In column 1, the

regression barely takes advantage of the panel structure of the trade data. As a result, this naïve

model shows an impressive 2.066 log-point increase in trade. This amounts to exp(2.066) – 1 =

6.89 or a 689% increase in trade. Because this amount can appear questionable, we proceed to

column 2.4

4 The regressions with the entire world (N=251851) are not shown here, but they demonstrate the same effects as

seen in the gravity score matched comparison group.

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Table 1—Panel Data Regression Analysis

(1) (2) (3) (4)

JSEPA 2.066*** -0.418*** -0.116 -0.373***

(0.0671) (0.0844) (0.0939) (0.0723)

Observations 2746 (all four regressions)

R-squared 0.74 0.90 0.92 0.95

Standard errors in parentheses

*** p<0.01, ** p<0.05, * p<0.1

Notes: controls mentioned in model specification are included in regression but omitted from

table, as well as regression constant.

Column 2, controlling for importer and exporter dummies, shows a significantly reduced

correlation of trade in the years following JSEPA. This indicates a exp(-0.418) – 1 = 34%

reduction in trade. This is statistically significant to a high degree. Already the analysis shows

that trade outcomes may not be positive at all in the JSEPA years. Column 3, with time trend-

interacted importer and exporter dummies, is not statistically significant. This regression shows

a correlation that is not different from zero. Column 4 gives a very similar result to column 2—a

31% reduction in trade, to a high degree of statistical significance.

In light of the talks of free trade that preceded the actual signing, placebo tests are run to

check if the years leading up to JSEPA have a statistically significant change in trade volume.

We turn to those Falsification Tests now.

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6. Falsification Tests

Placebo Test: 2000

In this falsification test, we conduct a regression while imagining that a free trade

agreement was established in the year 2000. Of course, talks were well under way in this year.

With this placebo, we test whether the “effects of JSEPA” are significant in 2000, two years

prior to JSEPA. Each regression (1 through 4) corresponds to the preceding set of four

regressions. The results are in Table 2.

Table 2—Test for Placebo Effects

(1) (2) (3) (4)

Placebo in 2000 2.131*** -0.309*** -0.0812 -0.287***

(0.189) (0.0955) (0.0853) (0.0778)

JSEPA -0.0631 -0.118 -0.0384 -0.118

(0.200) (0.110) (0.0979) (0.0895)

Observations 2746 (all four regressions)

R-squared 0.74 0.90 0.92 0.95

Standard errors in parentheses

*** p<0.01, ** p<0.05, * p<0.1

Notes: controls mentioned in model specification are included in regression but omitted from

table, as well as regression constant.

What is most notable in this test is that the placebo effects are larger than those of

JSEPA. They are quite similar to the JSEPA coefficients of Table 1, and they are equally as

significant statistically as those of Table 1. As previously discussed, regression 1 has great

limitations in accuracy. However, regressions 2 and 4 show an interesting outcome: a reduction

of 27% and 25%, respectively, is correlated with the years from 2000 onward.

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This is a rather puzzling observation. By the definition of the counterfactual assumption

in regression 4, column 4 shows that the years following 2000 have significantly lower levels of

trade between Japan and Singapore than in the 20th

century.

7. Conclusion

Without question, deeper analysis of the trade data is necessary to produce a more

conclusive answer to the question of impact on trade due to JSEPA. This gravity model raises

questions as to what the true impact can be. Having constructing a gravity score matched set of

countries, and controlling for the average trade between pairs of nations, this analysis suggests

that trade was on the decline in the years leading up to JSEPA.

Though this falsification test is a solution to some of the econometric problems

anticipated in this analysis, the econometric problems do not stop there. The placebo effects can

be reiterated in further analysis to see if any particular year preceding 2002 holds the greatest

correlation with a decrease—or increase—in Singaporean-Japanese trade. And as mentioned

before, this correlation does not imply causality, due to the endogenous nature of all trade

agreements.

Nonetheless, at face value this analysis shows that trade goes down in the years before

JSEPA, and when JSEPA is signed, there is no coinciding change in trade—2002 trade onward is

no different from zero. It is important for policymakers and business leaders to recognize that

the important factors that influence trade go deep beyond the mere signing of a trade agreement.

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Appendix A

Japan's exports to Singapore: total of $20.1 billion, or 5.5% of its overall imports.

1. Electronic equipment: $4.8 billion

2. Machines, engines, pumps: $4.3 billion

3. Oil: $2.9 billion

4. Vehicles: $1 billion

5. Medical, technical equipment: $937.4 million

6. Gems, precious metals, coins: $837.7 million

7. Iron or steel products: $631.4 million

8. Plastics: $543.3 million

9. Iron and steel: $499.7 million

10. Other chemical goods: $366.9 million

Singapore's exports to Japan: total of $7.9 billion, or 1.0% of its overall imports.

1. Electronic equipment: $1.3 billion

2. Machines, engines, pumps: $1.2 billion

3. Pharmaceuticals: $1.1 billion

4. Medical, technical equipment: $707.7 million

5. Books, newspapers, pictures: $496.6 million

6. Plastics: $307.1 million

7. Other chemical goods: $269.5 million

8. Cocoa: $233.6 million

9. Cereal, milk preparations: $204.3 million

10. Oil: $188.1 million

Source: World’s Richest Countries.5

5 http://www.worldsrichestcountries.com/top_japan_exports.html