Economic Journal of Emerging Markets.

Economic Journal of Emerging Markets.  August 2011 3(2)  139-151


INDONESIAN TRADE UNDER CHINA FREE TRADE AREA

Abstract 

This paper investigates the implementation of CAFTA (China-Asean Free Trade Area) on the international trade flows across Indonesia, China and the rest of ASEAN using a gravitation model. It finds the evidence that the influence of diversion and creation effects on China are significant, while the influence of both effects on Indonesia are not significant. It also finds that the diversion effect, which leads to a decrease in society’s wealth, is greater than that of the creation effect. As a consequence, the gap across countries involved in the trade agreement is wider. 

Keywords: CAFTA, gravitation model, diversion effect, creation effect 
JEL classification numbers: F13, F14, F15 


Abstrak 

Tulisan ini menyelidiki penerapan CAFTA (China-Asean Free Trade Area) pada arus perdagangan 
internasional antara Indonesia, China dan anggota ASEAN yang lain dengan menggunakan model 
gravitasi. Penelitian menemukan bukti bahwa pengaruh diversi dan pengaruh kreasi terhadap Cina 
adalah signifikan, sedangkan pengaruh kedua efek tersebut terhadap Indonesia adalah tidak 
signifikan. Penelitian ini juga menemukan bahwa efek diversi, yang mengarah pada penurunan 
kekayaan masyarakat, lebih besar daripada efek kreasi. Akibatnya, kesenjangan di negara yang 
terlibat dalam perjanjian perdagangan menjadi lebih luas. 

Keywords: CAFTA, model gravitasi, pengaruh diversi, pengaruh kreasi 
JEL classification numbers: F13, F14, F15 

INTRODUCTION 

ASEAN and China have agreed to implement CAFTA (China-Asean Free Trade 
Area), a comprehensive economic cooperation, in 2002. The implementation will be 
conducted gradually over a period of 10 years. CAFTA is a form of agreement between the member countries to realize a free trade area by eliminating trade barriers 
in goods, both tariff and non tariff, increasing market access services, investment 
rules and regulations, and improving aspects of economic cooperation to promote economic relations in order to improve welfare of the members. 

The created economic region has a market of 1.7 billion consumers, with a total GDP of 2 trillion dollars. Total trade that took place in this region is estimated to reach USD 1.23 trillion. CAFTA is anticipated as a free trade area which has the largest market share in the world. Another aim is to encourage trade between ASEAN and China. ASEAN and China since 2000 have experienced a dramatic growth rate. 
Theoretically, the implementation of CAFTA is beneficial for the countries involved in it. With the removal of trade barriers, economic inefficiency is expected to be minimal. 
Indonesia, as one former member of ASEAN along with Malaysia, Singapore, Thailand,Philippines and Brunei, began to implement CAFTA in full on January 1, 2010. ASEAN countries which joined later,







  namely Vietnam, Laos, Cambodia and Myanmar, will implement this agreement in 2015. 
The implementation has actually started in 2004. China and ASEAN countries are required to remove import tariffs in almost all agricultural commodities. CAFTA aims to increase trade by lowering trade barriers, both tariff barriers and nontariff. The implementation of this agreement was expected to increase trade flows among member countries of CAFTA. The increase in trade its creation and trade diversion effects as the result of this agreement has been reviewed by several researchers, such as Chen and Tu (2005) which conduct a study of the Chinese 
economy. 
The increase in trade flows is also influenced by various factors such as the 
magnitude of the trading economies, the distance between countries that are generally represented by the cost of transportation, population size, and similarity of cultural and linguistic factors. Methods of analysis used to test the determination of 
these factors also vary, such as Computable General Equilibrium (CGE) model, partial 
equilibrium model, simultaneous equation model, and grafity model. One of the most 
widely used instruments to test the determination of magnitude of this trade is the 
Gravity Model. 

Carrere (2006) uses a gravity model to assess ex-post regional trade agreements, 
including 130 countries and is estimated with panel data over the period 1962–1996. 
The analysis shows that regional agreements have generated a significant increase 
in trade between members, often at the expense of the rest of the world. 
Yuniarti (2007) conducts an empirical study to analyze the determinants of bilateral trade in Indonesia using a gravity approach. Analyses were performed using a panel data on 10 countries of Indonesia's main trading partners. She found that the domestic income and population have a positive influence on trade in Indonesia, while the distance negatively affects the trade. She also found that the factor endowment and the RTA (Regional Trade 
Agreement) have no significant effect on trade in Indonesia. 

Sattayunawat (2011) uses a gravity model with a Poisson Pseudo Maximum 
Likelihood (PPML) to estimate the magnitude of transportation costs and the influence of RTA on trade and FDI (Foreign Direct Investment). He found that the reduction in transportation costs can increase trade flows, with different decreasing coefficients over time. He also finds that regional trade in Southeast Asia are sensitive to distance, and that trade agreements affect trade. Another Important finding is that institutional quality, namely the security of transactions and contracts as well as the quality of public governance, have a strong influence on the increase of foreign direct 
investment entry in ASEAN countries. Srivasta and Green (1986) use a 
gravity model to analyze the determinants of international trade in 45 exporting countries and 82 importing countries. They developed a model of gravity by using the 
Trade Intensity Index (TII) as a proxy for the value of exports and add non-economic 
variables such as political instability, a common language, religion, and colonization status. They suggest that the type of products exported affect international trade. 
Chow and Zietlow (1995) use gravity model to find determinants of bilateral trade between the countries in the Asia Pacific region. The study was conducted in 1980 and 1989 at the APEC member countries (except Brunei). They make some adaptations in the gravity model using the Gross National Product to describe the 
magnitude of the exporter and importer markets. In addition, to analyze the effect of price on trading activity, they use export prices and import price indexes. Dummy variables are used to show cultural similarities between the exporter and importer Indonesian Trade Under China … countries, participating industrialized countries exporters as the New Country (NICs) and the participation of the importing country in ASEAN. They found that the market size (magnitude of GNP) of the importing country is the strongest factor that influences the trade. Level of political stability and importing countries in the ASEAN 
membership have smaller effect.

Helmers and Pasteels (2005) conducted a study using a gravity model to see the potential of trade in developing countries and countries that are in a state of economic transition. The research sample includes 132 exporting countries and 154 country importing countries for the period of 2000-2003. In contrast to the previous studies, although the model used in this study is mentioned as a model of gravity, but GDP and population variables that form the core of gravity models are not included. 
Other variables included in this test are the distance between countries and borders, import tariffs, interrelation of language, namely the political variables involved whether or not the country who trade in conflict situations, as well as geographic 
location between exporter and importer countries. The results of this study indicate that the tariff plays an important role that can hinder trade, especially for commodities such as recycled products manufacturing, rubber and plastics, as well as electronics and electrical equipment. The cost of transportation, geography and border also has significant effects. Bilateral conflicts may hamper trade but only for certain commodities, namely oil industry, motorcycle and means of transportation, while the cultural and linguistic factors have a 
positive influence on trade. Countries that use the same primary language have a 
greater trade. Chen and Tu (2005) conducted a study to build two models of gravity. This 
study uses panel data from 22 countries for the period 2000-2004. The study was conducted to analyze the effect of CAFTA implementation on China trade. The Gravity 
model used in this paper is focused on both China's bilateral trade with its trading partner along with its effects, both creation and diversion effects. They showed that the diversion effect is greater than the creation effect. 

Christie (2002), Rahman (2003), and Batra (2004) conducted studies on bilateral trade and trade potential. Christie (2002) analyzed the potential of trade in Southeast Europe using data from 1996 to 1999. The results showed that in the countries of the former Yugoslavia, the low low GDP, high unemployment, and military conflicts in the past led to distortions of trade. Croatia and former Yugoslavia trading in small quantities, but they do trade on a large scale with the appropriate entities with them in Bosnia. Simultaneously, they have a large trade potential in the future with the European Union. 
Rahman (2003) analyzed the potential of trade in Bangladesh using panel data. 
This study uses several economic factors such as the degree of openness and exchange rates. Trade intensity index shows that bilateral trade between IndiaBangaldesh is not as high as they should. Thus, there is room for expansion of mutually beneficial trade. To complete the trade between Bangladesh and India, both countries can develop vertical specialization 
through profit-sharing agreement. This allows both countries to strengthen their 
trade relations and achieve economies of scale through a focus on a specific production process in a value chain. Batra (2004) uses a gravity model to analyze the flow of world trade and use it to predict the trade in India. This study used cross-section data in 2000. The results showed that the benefits from intra-industry trade, vertical integration, and industry restructuring is greater than the gains from the expanded trade. The advantage of the SAFTA can be improved if the scope is extended in the long run by including infra-142







  structure development and investment liberalization and services. 
Cernat (2001) analyzed the effect of trade with the partial equilibrium model. 
The results obtained showed that in conditions of perfect competition, a regional trade 
agreement will increase trade volume among member countries, ie countries that 
have a cost structure that is less efficient and countries not members of which have a 
more cost efficient, which are the creation effects and the diversion effect of trade. The 
total effect of trade depends on the magnitude of both effects. Cernat (2001) uses a gravity model with panel data to analyze the effect of regional trade agreements (RTA) to 
the flow of trade between member countries of the RTA in developing countries. This 
study adds two variables to prove that the effect of creation and diversion effects resulting from RTA is efficient. The implementation of this agreement since 2004 should have increased trade flows among member countries of 
CAFTA. The magnitude of the trade increase and both trade creation and trade 
diversion effects as a result of this agreement have been reviewed by several researchers. Various studies are generally done to the economy of China (Chen and 
Tu, 2005), considering the size of China's economy and its economic influence 
throughout the world. However, empirical studies on the influence of thi agreement 
against Indonesia have not been widely discussed. This paper aims to analyze the 
effect of the implementation of CAFTA on the magnitude of trade flows and the factors of determination Indonesia's trade with ASEAN countries and China. 


METHODS 
The tool of analysis used in this study is 
developed from the gravity model. Gravity 
model has been commonly and widely used 
in analyzing trade between countries. Gravity model is used for several reasons. First, 
the gravity model is supported by various 
trade theories, including the classical trade 
theories and the new trade theories. Second, 
the gravity model can explain the influence 
of various variables of determination of 
trade, both macroeconomics variables such 
as aggregate income, per capita income, 
exchange rates, transportation costs, and 
social variables, such as population, political system, as well as cultural variables, 
such as the common language. Third, gravity models can be used to analyze the impact of a trade policy to the amount of 
trades flow. Policies that can be analyzed 
are the policy of cooperation (bilateral, 
multilateral, regional, financial, border), 
institutional policies, and other trade policies. 

Gravity Model in International Trade 
Model 
The Gravity model was first developed by 
Newton in 1687. This model shows the interaction between two particles, where the 
magnitude of the interaction is influenced 
by the mass and the distance between the 
particles. Newton's Universal Law of 
Gravitation can be written as follows: 

(1)

where F is the gravitation between two objects, M is mass, D is distance, and G is the 
constant for gravitation. 
This Newton's gravity model is then 
used to analyze the magnitude of trade 
flows between countries. Newton's gravity 
model specification for the trade can be described as follows: 

 (2) 

where Xij is export from i to j or total of 
trade, Y is size of economy (GDP, POP), 
and T is cost of trade. 


This model is then used by Tinbergen (1962) in the analysis of international 
trade. According to Reinert (2009), the use of gravity models in international trade has 
few development alternatives. In the trade model, the theory of Newtonian gravity is 
converted into natural logarithm form. 

lnGFij = lnMi+ lnMj - lnDij i  j (3) 

One form of the development of gravity 
models is to use per capita GDP of both 
countries to represent the mass of both particles (Mi
 and Mj
) while the power of gravity (GFij) between the two particles is represented by the value of trade or exports 
from country i to country j, and distance 
between the two particles (DIJ) is represented by the great circle distance calculation. Gravity models that have been developed can be written in the form of mathematical equations as follows: 

lnEij =  + 1ln( ) + 1ln( ) (4) 

where δ1 dan δ 2 < 0 indicate that the higher a country's population growth in the exporting country, the higher the production of the exporting countries, as for the importing countries, population growth indicates an increase in exports due to the larger export destinations (Reinert, 2009). 
This study aims to examine the effect of the implementation of CAFTA on 
the magnitude of the flow of Indonesia's trade with Asean countries and China for 
the period 2002-2010. The selected countries of the ASEAN are the initial members 
of the group, namely Malaysia, the Philippines, Singapore, Thailand, and Brunei Darussalam. This is because at the beginning of implementation (2004), these countries 
are the first time carry out an agreement, namely by removing all tariffs for agricultural commodities are traded. ASEAN members that joint later, namely VietnamLaos, Cambodia, and Myanmar, will implement this agreement in 2015. This paper 
will analyze the trade creation effect and the diversion effect. The model used is static gravity model modified from the study Chen and Tu (2005). The creation effect from a trade is a trade transfer process from the inefficient 
supplier to efficient rest members of the Regional Trade Agreement (RTA). In this case, a dummy variable will be used to measure the impact of CAFTA on the trade. This paper uses year 2004 as the starting point, since the agreement was first implemented in that year. Data pre 2004 are used to describe the flows o trade pre CAFTA implementation. 
The model used to analyse the determinant of trade and the creation effect in this paper is as follows: 

where is volume of export across Indonesia and its trade partners.  is GDP of Indonesia and its trade partners.  is distance from Indonesia and its trade partners.  is exchange rates of Rupiah against currencies of its trade partners.  is population of countries of 
Indonesia’s trade partners.  is dummy variable, 0 for years pre CAFTA, 1 otherwise. 
0 is constant 

1, 
2, …, 
5 is elasticity is error term 


Gross Domestic Product (GDP)represents the size of a country's economy.The larger the GDP, the greater the amountof goods and services can be traded, so the
expected value of is positive. Distance isused to measure transportation costs, time costs, synchronization fees, and transaction costs. The greater the distance between
countries, the greater the transportationcosts, the less the flow of trade that occurs,
so we expect a negative value of . As aproxy for distance, this study used the distance
across the capital cities. Exchangerate is one of the factors which may affect
trade; the more expensive the currency of acountry in relative terms, the more expensive
the goods and services originatingfrom the country. This increased prices will
reduce the amount of demand for goodsand services traded, so expect has a
negative value. Population effect on trade is positive. Increase in population led to increaseddemand for goods and services for both the production and consumption activities,so the expected value for is positive.

Trade data of exports and imports across Indonesia and China and other
ASEAN members are obtained from the Publication of Foreign Trade Statistics, Indonesia
Central Bureau of Statistics. The GDP and population data are obtained from
the World Bank. Data on exchange rate are from Bank Indonesia, and the data on distance across the two countries data obtained from www.indo.com.

RESULTS DISCUSSION

The Development of Trade between Indonesia, China and the Rest of ASEAN The development of Indonesia's trade with China and initial ASEAN members, namely Malaysia, the Philippines, Singapore, Thailand and Brunei Darussalam are presented in Figure 1 to 6. Figure 1 shows a positive trend of Indonesian exports and imports with China. From the pictures, it can be seen that from 2002-2007, the Indonesian trade balance with China is still a surplus Indonesia's exports to China is higher than Indonesia's
import from China), but from the years 2008 to 2010, Indonesia's trade balance against China is deficit. Although Indonesia's export to China increases, the increase in Indonesia's import from China is still higher. The biggest increase in imports ccurred in 2008, namely 44%.

CONCLUSION


This paper investigated the implementationof CAFTA (China-Asean Free Trade Area)
on the international trade flows across Indonesia,China and the rest of ASEAN usinga gravitation model. The determinantfactors for Indonesian trade were Gross Domestic Product, distance, and population size, but not the exchange rates and trade agreement on CAFTA. Diversion and creationeffects did not significantly affect trades in Indonesia. The elasticity of Indonesia's GDP to trade flows was greater than that of China. However, with a much smaller economy size, the flow of trade gap between both countries would be widen with the increasing GDP sizes in both countries.The diversion effect of trade was much larger than the creation effect in Indonesia.
The creation effect would increase prosperity while diversion effect would reduce
welfare. Indonesian high diversion effect indicated a great reduction in welfare
occurred in Indonesia's trade. However, since the analysis suggested that the influence
of CAFTA on trade is not real, the lowering welfare was more influenced by the inefficiency in domestic industry than the result of the agreement.
Indonesia should initiate efforts to enhance the creation effect from its international
trade, such as increasing efficiency in its production sector, particularly for the
traded goods. The results of this study were empirical facts that support the opinion of Indonesian Trade Under China … 
economists over the years. Efficiency could be boosted by improving infrastructure and
bureaucracy, decreasing economic costs, and increasing competitiveness, as had
been done by China and other ASEAN members, before these countries joint the
CAFTA. Otherwise, the prosperity gap between Indonesia and China, and between
Indonesia and ASEAN members, would be widen.


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