The Contribution of Trade conditional on Human Capital, Financial Development and Institution to Economic Development. Evidence from ASEAN Nation

TABLE OF CONTENTS

DECLARATION

ACKNOWLEDGEMENTS

ABSTRACT

LIST OF ABBREVIATIONS

LIST OF FIGURES AND TABLES

CHAPTER ONE: INTRODUCTION
1.1. Research Backgrounds
1.1.1 Economic Cooperation in ASEAN
1.1.1.1. ASEAN Free Trade Area (AFTA)
1.1.1.2 The ASEAN Economic Community (AEC)
1.2. Research Motivations
1.3. Research Objectives and Intended Contribution
1.4. Thesis Structure

CHAPTER TWO: LITERATURE REVIEW
2.1. The Effects of Foreign trade on Economic Development
2.2. The Effects of Institutions on Foreign trade and Economic Development
2.3. The Effects of Financial Development on Trade and Economic Development
2.4. The Effects of Human Capital on Foreign trade and Economic Development

CHAPTER THREE: THEORETICAL FRAMEWORK
3.1. Foundations of Trade Theories
3.2. Why Do Nations Trade? Is trade good for a country?
3.3 Theories of complementary factors to trade openness and growth
3.4 Human Capital in the Theoretical Perspectives
3.5 Institutions in the Theoretical Perspectives
3.6 Financial Development in the Theoretical Debates
3.7 An Illustration of an Endogenous Growth Model
3.8 Proposed Research Hypothesis

CHAPTER FOUR: METHODOLOGY
4.1 Pooled OLS Estimation
4.2 Fixed-Effect Estimation
4.3 Random Effect Estimation
4.4 The Endogeneity problems and Instrumental Variable
4.5 Model Specifications
4.5.1 Pooled OLS Regression:
4.5.2 Fixed-effect Regression
4.5.3 The regressions of the roles of trade complementarities on GDP

CHAPTER 5: DATA
5.1 Data sources and Definition of selected variables
5.2 Descriptive Statistics
5.3 General Trends of some most important variables
5.3.1 Gross domestic product (GDP) trend across ASEAN members
5.3.2 The trend of trade openness across ASEAN countries
5.3.3 The trend of financial development across ASEAN countries
5.3.4 The trend of stock of institutions across ASEAN countries
5.3.5 The trend of human capital across ASEAN countries

CHAPTER SIX: RESEARCH ANALYSIS AND RESULTS
6.1 Panel Correlation and Baseline Regression Results
6.2 Results of Growth benefits from trade interacted with policy complementarities
6.2.1 Growth benefits from trade conditional on Human Capital and Financial Depth
6.2.2 Growth benefits from trade conditional on Quality of Institutions

CHAPTER 7: CONCLUSIONS
7.1 Summary of findings
7.2 Policy Implications of the Research Findings
7.3 Suggestions for Future Works

REFERENCES

Appendix

ACKNOWLEDGEMENTS

First of all, I would like to give my deep thanks to my thesis supervisor, Professor Shanzi Ke, PhD, who guided me through the process of my study as a master student in Hunan University. He taught me an Econometrics course which helps me to build a technical foundation to conduct my thesis research. He helped me choose research topic, construct a research plan, and search important references. He usually stood aside me whenever I had problems. I really appreciate his time and advices in this thesis.

My second deep thanks go to the Director of International Postgraduate Programme, Dr. Yang Jingjing, PhD, who has usually facilitated my courses of studies including issuing my transcript and other tasks. I really appreciate her International Business Class; it was interesting.

My third appreciation would be delivered to the Chinese Government Scholarship (CSC) that supported my costs of studies and living in China to earn this Master’s degree.

Also, I would like to thanks the Rector of the Hunan University, board of committee, Professors, and especially to the staffs of the International Student Office, who always supported me whenever I had problems related to my living conditions in the Hunan University.

What I will never forget is to give my highest respect and thanks to my family who has always encouraged me to study and agree to take my responsibilities to do all the housework. Your time in life is highly appreciated in my life.

My last thanks would be delivered to other professors who taught me different courses:

Dr. Ming He, the Professor of Macroeconomics and Microeconomics Dr. Xu Yi, the Professor of International Trade and International Marketing Dr. Hua Wang, the Professor of Research Methods Dr. Huang Ping, the professor of International Finance

ABSTRACT

of

The Contribution of Trade conditional on Human Capital, Financial Development and
Institution to Economic Development: Evidence from ASEAN Nations

by

KHIM SAMITT

This thesis addresses the relationship between economic development and trade openness as well as some structural factors (i.e., human capital, financial resources and institution) in the ASEAN countries. This thesis has three objectives. First, it attempts to qualitatively describe the ASEAN cooperation in order to promote interest in ASEAN. Second, it quantitatively estimates the effect of international trade on economic development of the ASEAN nations. Finally, it investigates how the effect of international trade on economic growth varies as a result of differences in human capital, financial resources and institution across the ASEAN nations.

To accomplish these tasks, panel dataset on the ASEAN nations from 1980 to 2010 are collected and pooled OLS, fixed-effect and instrumental variable models are applied to the dataset. Taking into account a variety of specification issues as well as endogeneity of trade openness, the research results show that trade openness plays an extremely important role on economic development of these countries. In addition, the benefit from trade openness is greater in countries that have more educated workers, deeper financial resources and better quality of institution. In conclusion, this thesis suggests that these structural factors need to be strengthened in order to benefit more from international trade.

Key words: International trade; human capital; financial development; institution; ASEAN; fixed effect; instrumental variable; policy reforms

JEL code: C13, C15, F14, F15, F63, O10

LIST OF ABBREVIATIONS

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LIST OF FIGURES AND TABLES

Table 1 : The details of date of each individual member to join ASEAN

Table 2: ASEAN’s Merchandise trade (US$ billion, 2001-2010)

Table 3: Selected Basic ASEAN indicator

Table 4: Data summary

Table 5: Correlation between Trade Openness and Economic Development

Table 6: Baseline Regression Results under Different Estimation Techniques

Table 7: The GMM Estimates of the Joint Roles from Financial Depth and Human Capital. 52 Table 8: The GMM Estimates of the Joint Roles from Institutions

Figure 1: Average CEPT Rate from 1993-2008

Figure 2: ASEAN Merchandise trade (US$ Billion, 2001-2010)

Figure 3: Total FDI Inflows to ASEAN from 2000 to 2009 (in million USD)

Figure 4: GDP Growth Rate of the ASEAN countries, 1980-2010

Figure 5: Trade Openness across ASEAN members

Figure 6: Finanical Depth as % of GDP, 1980-2010

Figure 7: Total stocks of Institutions across ASEAN members

Figure 8: Total stocks of Institutions across ASEAN members

CHAPTER ONE: INTRODUCTION

1.1. Research Backgrounds

In the past several decades, more and more countries have considered international trade in an increasingly integrated world a necessary avenue to realize comparative advantages and to grow national economy. Recently there have been multiple free trade agreements and regional integration agreements. Celderon and Poggio (2010) found that the world trade has grown as fast as world output over the last two decades and as a result economic integration is accelerated. Regional economic integration in turn plays important role in many nations’ economic development and reform.

Many trading blocs have actively facilitated trade and economic welfares in the respective nations. For example, the European Union (EU) is a trading bloc in Europe which can be considered as the oldest one in the word. EU was historically formed after the World War II as the European Economic Community (EEC) by the six countries^[1] in 1958^[2]. In the American Hemisphere, there are several active regional trading blocs, namely, the North American Free Trade Area (NAFTA), the Southern Common Market (SCA), the Dominican Republic—Central American Free Trade Area (CAFTA) and the Caribbean Community, etc. In Asia, there are also several regional trading blocs, namely, the Asia-Pacific Economic Corporation (APEC) and the Association of Southeast Asian Nations (ASEAN. The later bloc has continuously expanded by including more countries in East Asia. The process of expansion began in 1997, forming the ASEAN + 3^[3] which contains the former ten countries in Southeast Asia and three East Asian countries: China, Japan and South Korea. The purposes of expansion are to strengthen their cooperation in the areas of food and energy security, financial cooperation, trade facilitation, disaster management, people-to-people contacts, narrowing the development gap, rural development and poverty alleviation, human trafficking, labor movement, communicable diseases, environment and sustainable development, and transnational crime, including counter-terrorism. Moreover, regional trading blocs are also created in Africa, such as the ten Caribbean British colonies and other regions. Regardless of so many trading blocs in the world, the geographic scope of this study will be limited to the Association of Southeast Asian Nations (ASEAN).

ASEAN was found on 08 August 1967 in Bangkok, Thailand by the first five founding countries, namely, Indonesia, Thailand, Singapore, Philippine and Malaysia. These five countries signed the ASEAN Declaration, also known as the Bangkok Declaration. Subsequently, a new member, Brunei, joined the regional trading organization in 1984. A decade later, Vietnam, a communist country, decided to transform its economy to a market economy and joined ASEAN in 1995. The remaining countries in Southeast Asia, namely, Cambodia, Laos, and Myanmar (CLM) joined ASEAN in 1999 and 1997, respectively. Tablel lists the member countries and the dates they joined the organization.

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Source: Author’s Compilation, using the information about the ASEAN’s establishment on http://www.asean.org/about_ASEAN.html (accessed on March 20, 2012)

As ASEAN Declaration articulates, the purpose to form ASEAN organization are to strengthen the foundation of economic cooperation and to promote a prosperous and peaceful community by facilitating economic growth, social progress, and cultural development and by carrying forward the spirit of equality and partnership. ASEAN promotes not only economic growth, but also peace and social stability in the region. The organization respects the rule of law in the region as well as the United Nation Charter (UNC).The member countries are to help each other in sharing research facilities and in training in the fields of administration, education, profession as well as technology. Among all these purposes of ASEAN organization, the most obvious and important one is to expand the trade among the member countries. Accordingly, my thesis will focus on the trade and its contribution to economic growth, given each member country’s endowments of human capital, financial situation, and quality of institution.

1.1.1 Economic Cooperation in ASEAN

As ASEAN Vision 2020 stated, ASEAN has set its goals as “a stable, prosperous and highly competitive ASEAN economic region in which there is a free flow of goods, services and investment and free flow of capital”. To reach these goals and more specifically to expand intra-regional and inter-regional trade and strengthen the economic development, the member countries formed the other agreements and implemented specific strategies. I will describe only those agreements and communities which are related to the scope of this thesis.

l.l.l.l. ASEANFree Trade Area (AFTA)

The ASEAN Free Trade Agreement (AFTA) was successfully signed on 28 January 1992, in Singapore. It is a crucial tool to enhance intra-ASEAN economic cooperation and to sustain the economic growth and development of all member countries. This agreement is an important factor to the stability and prosperity in the region. In addition, this free trade agreement serves as an instrument to help the ASEAN economies achieve greater trade and investment competitiveness in the world economy. The ultimate goal of AFTA is to “increase ASEAN’s competitive edge as a production geared for the world market through trade liberalization and closer economic integration” (Thangavelu & Chongvilaivan, 2009). The attraction of the ASEAN region to regional and foreign investors would be made through the pooling of the resources and the market. Likewise, the domestic industries could be supported by being offered the possibility of a larger market (Bowles Paul, 1997) and by the lower costs of doing business in the region under AFTA (ASEAN Secretariat, 2002). Consequently, foreign companies locating in ASEAN would be able to exploit scale economies and renationalize production, allocating different segments of the value chain, production processes, and products among the ASEAN countries based on their respective competitive advantage (Chia Siow Yue, 1997). In fact, AFTA focuses on the liberalization of trade in goods within the ASEAN region by implementing the Common Effective Preferential Tariff (CEPT). The preferential tariff can be regarded as the cornerstone of AFTA with the general provisions for the removal of tariffs and non-tariff barriers and the exploitation of non-border areas of cooperation such as harmonization of standards, reciprocal recognition of tests and certification of products, removal of barriers to foreign investments, macroeconomic consultations, fair competition rule, and promotion of venture capital^[4]. The ultimate target of AFTA is to eliminate all import duties by 2010 for the ASEAN-6 (the first five founding countries plus Brunei, and by 2015 for CLMV, i.e., Cambodia, Lao PDR, Myanmar and Vietnam. Figure 1 illustrates the Average CEPT rate from 1993 to 2008. The Average CEPT rate in ASEAN-6 has been decreasing sharply from 12.78% in 1993 to 0.79% in 2008 while the CEPT for CLMV has been decreasing from 7.51% in 1993 to 3.69% in 2008.

Figure!: Average CEPT Rate, from 1993-2008

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Source: Economic and Social Commission for Asia and the Pacific, 2009 (Trade and Investment Division, Staff Working Paper 01/09)

However, according to the study of Chia Siow Yeu (1997), tariffs may not represent the most serious obstacle to intra-regional trade and may not have substantive impact on trade growth. He argued that the quantitative restrictions and other non-tariffs barriers are often more serious deterrents to intra-regional trade than tariffs. Following Yeu (1997) and Thangvavelu and Chongvilaivan (2009), non-tariff barriers are the serious challenges to ASEAN’s trade while tariffs are also major constraints to trade. The reduction in tariff is not rational to the increasing in trade and income distribution. In this context, traders may have problems with some border barriers such as tedious import documentation and procedures, and disputes over arbitrary customs valuation and rules of origin, as well as the other non-border obstacles such as a lack of harmonized standards, sanitary regulation, and labeling and packaging requirements. The implementation of AFTA has also confronted other problems. Bowles (1997) pointed out that the expansion of its membership, the desire to move beyond simply freeing trade, the issues of non-tariff barriers, macroeconomic coordination and investment policy are the big confrontations He also argued that the big challenges are the fear of investment diversion in terms of the increasing mobility of capital and the competition from other countries. Moreover, Soesastro (2005) considered that the lack of private sector awareness, the lack of clarity in the application of the Rules of Origin (ROO), problems with custom procedures, and the lack of the dispute settlements are also the big problems in the implementation of AFTA In order to facilitate the economic integration in the region, ASEAN has been trying to implement policies and agreements (e.g. ASEAN- CEPT) that may help overcome these obstacles. After all, ASEAN recognizes that trade liberalization should be undertaken without hesitation because it is the main driver of the integration process. Removing tariffs and non-tariff barriers is the crucial catalysts for the ASEAN countries to gain greater efficiency and long-term competitiveness and to attract the investment inflow from the globe. Consequently, the final benefits would be given to ASEAN consumers with a wider choice of better quality consumer products.

1.1.1.2 The ASEAN Economic Community (AEC)

To achieve its vision 2020, that is, ‘to transform ASEAN into a stable, prosperous, and highly competitive region with equity economic development, and poverty reduction as well as socio-economic disparities, all ASEAN leaders have decided to adopt the ASEAN Economic Community as an integral pillar and as the goal of regional economic integration to conceive and contemplate the future possibility of ASEAN community. Consequently, the ASEAN Economic Community Blueprint was created on 20th November 2007 in Singapore. It is served as an instrument, in addition to AFTA, to transform ASEAN into a region with free movement of goods, services, investment, skilled labor and capital (ASEAN secretariat, 2008)[4]. This blueprint can also be a tool to coordinate many efforts to drive the process of integration. It implies opening up of regional economic integration to greater public scrutiny. It has clear characteristics to make ASEAN as (1) a single market and production base, (2) a highly competitive economic region, (3) a region of equitable economic development and (4) a region fully integrated into the global economy. In this context, some new mechanisms and measures as well as a clear timeline have been made in the compliment to the existing ones.

5It has comprehensive plan with 17 core elements and 176 priority actions to be undertaken within four implementperiods of 2008-2009, 2009-2011, 2012-2013 and 2014-2015.

Previous study also suggested some ideas on the process to develop the region as a single production base and a single market. Soesastro (2005) suggested some elements needed to be taken into account such as free and open investment, trade and freeing flow of goods, selective services sector liberalization, infrastructure development and intuitional mechanism. Some other cooperation are also needed to be incorporated such as human resources development and capacity building, recognition of professional qualifications, macroeconomic and financial policies, trade financing measures, infrastructure and communication connectivity’s, e-ASEAN, integrating industries and enhancing private sector involvement.

As stated earlier, free flow of goods is a crucial mean to achieve a single market and production base. As I mentioned in the previous parts, the zero tariff which is stated in the AFTA-CEPT is not the only way to accomplish the free flow of goods, but also the other non-tariff barriers to trade facilitation, and the commitment to remove all non-tariff barriers (NTBs) has already been done in 2010, and in 2012 for Philippines, and will be done by 2018 for Cambodia, Laos, Myanmar and Vietnam (CLMV). The Table 2 below shows the flows of trade both intra and extra trade of the ASEAN. The ASEAN trade volume increased sharply with the export volume is larger the import volume. It seems that ASEAN trade depends much more on the outside world rather than its member countries since the volume of extra­trade is larger than that of intra-trade. China, EU-27, and USA continued to be ASEAN’s major trading partners in addition to increasing intra-trade. Meanwhile China was the fastest growing trade partner an upsurge of more than ten-fold in trade with ASEAN since the Asian financial crisis in 1997. Intra-ASEAN trade comprised one-fourth of ASEAN’s total trade. China, EU-27, Japan and USA continued to be the four major trade partners of the ASEAN. However, the combined share of EU-27, Japan and USA to ASEAN’s total trade has dwindled from 48.7% in 1998 to 40.4% in 2003 to 29.4% in 2010^{[5] [6]}.

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Table 2: ASEAN’s Merchandise trade (US$ billion, 2001-2010)

Source: ASEAN Secretariat, Merchandise trade Data 2010 Figure 2: ASEAN’s Merchandise trade (US$ Billion, 2001-2010)

Source: Author’s Drawing using data from Table 2

Likewise, free flow of investment is also an important key to attract foreign direct investment (FDI) as well as intra-ASEAN investment. Sustained inflows of new investment and reinvestment would promote dynamic development of ASEAN economies (ASEAN secretariat, 2008). To achieve this, some agreements have been signed as crucial tools such as the ASEAN Investment Area (AIA), which signed in 1998. The main objective of AIA is to realize more comprehensive and obligation such as investment protection, facilitation and cooperation, promotion and awareness to increase the investor confidence. Moreover, the region should think about its location advantages that are the factors needed to be improved by the ASEAN governments in order to attract more export-oriented foreign investment. The study of Soesastro (2005) suggested that some factors that affect location advantages are needed to be taken into account such as trade protection, the formation of industrial clusters and sufficient public resources and the efforts to foster local firms. To make this region as an attractive economic and investment area, measures to enhance transparency and predictability are also the key factors for investors.

Figure 3: Total FDI inflows to ASEAN from 2000 to 2009 (in million USD)

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Source: ASEAN Secretariat, FDI Database

From Figure 3, capital formation through foreign direct investment is largely different among the new members and the old ones. It reveals that the new members in CLMV seem to have something less to attract foreign direct investment than the old members whose economies are more developed. This is true to the studies of Soesastro (2005) regarding the determinants which matter location advantage.

1.2. Research Motivations

The theories of growth determinants and policy complementarities to trade addressed the issue of mapping from principles to policies by assessing the role of complementarities between trade and other structural reforms in stimulating growth (Calderon & Poggio, 2010;

Calderon and Fuentes, 2006; Wacziarg & Welch, 2008; Macedo, Martins & Rocha, 2010; Dennis, 2006; Chang et al., 2009) This work attempts to take some structural factors that might put constraints to growth benefited from trade into account to empirically show the role from those trade complementarities in facilitating trade openness to enhance growth of these nations. This task might help this region knows how important the trade complementarities are in reducing income gap that might benefits from trade openness in the region.

Previously, there were several works which studied on the costs and benefits as well as the general assessment of ASEAN countries. However, those studies seemed to ignore the interaction between trade openness and structural factors. The previous works on ASEAN studies from Soesastro (2005), Bowles (1997), Thangvavelu and Chongvilaivan (2009), Chia Siow Yue (1997) only used the descriptive approach to show the situation in regionalism and trade flows of this region without the exact empirical investigation to find the effect of foreign trade and the roles of trade complementarities on economic development of these nations.

This thesis is different from previous studies (Soesastro, 2005; Bowles, 1997; Thangvavelu and Chongvilaivan, 2009; Chia Siow Yue, 1997; Frankel and Romer, 1999; Linh, 2009) in several dimensions. First, unlike Frankel and Romer (1999), who studied many countries around the world and captured the average effect in many different countries. This thesis uses a sample data specifically for ASEAN members. Therefore, the research results are more relevant to ASEAN countries. Second, other researchers (Soesastro, 2005; Bowles, 1997; Thangvavelu & Chongvilaivan, 2009; Chia Siow Yue, 1997) conducted qualitative research to analyze the weaknesses and strengths as well as the procedures and the performance of the ASEAN cooperation. In contrast, this thesis will quantitatively estimate the effect of foreign trade on economic performance of ASEAN nations. Third, although some of the early studies (e.g. Linh, 2009) intended to find whether or not the quality of institution has significant impact in foreign trade and income distribution for these nations. In this thesis, I will study the effect of not only quality of institution, but also other governance. Moreover, I will also study whether financial deepening and human capital are significant contributors to foreign trade and economic development of these nations. Fourth, I will investigate the joint effects of foreign trade and other complementary factors on economic performance of ASEAN nations.

1.3. Research Objectives and Intended Contribution

This thesis has three main objectives. The first objective is to

(1) qualitatively describe and highlight ASEAN cooperation to promote interest in ASEAN. The second objective is
(2) to quantitatively investigate the effects of international trade on economic development of the ASEAN members. The third objective is
(3) to empirically evaluate the effects of several important structural factors include human capital, financial deepening, and quality of institutions. In particular, this thesis will investigate the joint effects of these structural factors and foreign trade.

This thesis will contribute to the study of foreign trade and economic development in ASEAN nations. First, ASEAN contains different backgrounds of economies. These economies are classified into two groups: ASEAN-6 and CLMV. Economic disparities between these two countries need to be solved. This thesis will provide empirical evidence how trade integration and structural factors may affect the disparities between these nations.

In recent years, ASEAN is more open to the world major economies, including China, Japan, South Korea, EU and US. Thus the evidence provided by this study can be used as a reference to improve foreign trade policy in ASEAN nations.

In sum, this thesis is different from the early studies by quantitatively investigating foreign trade and economic development, while controlling other structural factors. This study takes into account the interactive effects of foreign trade and structural factors on economic performance of ASEAN nations. The research findings will be a useful reference for not only the general scholars in ASEAN studies but also for the ASEAN’s practitioners.

Like most studies, this thesis has some limitations. I will study only the ten countries in the region and not to cover the other partners of ASEAN. There might be some measurement errors in the study since I may not have the exact variables which can show the exact effects. For example, I will adopt the good governance indicators to show institutional quality while there might be several other variables which can represent the institution in other studies. I will select specific time frame based on the data availability.

1.4. Thesis Structure

This section shows how this thesis is organized. It is basically divided into seven chapters as follows:

The first chapter deals with the general introduction of the thesis starting with the general introduction of the growth of regionalism and world trade for some areas around the world. Some regionalism and free trade agreements are discussed. Then it continues with the discussion of the recent situations of the ASEAN regions, for example, the AFTA and the AEC, etc. The research motivations as well as problems, research objectives and research significance and limitation are shown in this section also.

The second chapter shows the general stylized facts in the previous literatures regarding the openness of trade and economic growth. Some argumentation of the relationship between trade openness, quality of institutions, human capital, financial development and economic growth are also presented in this chapter.

The third chapter simply deals with some trade theories from books and empirical paper. The trade theories regarding gains from trade, how trade contributes to growth and why nation trades are presented in this chapter. Basically, proposed research hypotheses are also made here subject to previous literatures and empirics.

The fourth chapter shows the research methodology which is basically dealt with econometric methods and models used to deal with regression models in order to estimate the results.

The fifth one deals with data collection. Several important things such as data sources, variables definition, how people measure those variables are also shown here.

The sixth one dealts with the discussion and analysis of the research results from different methods. This chapter basically interprets the research results and firmly looks at the variables coefficients and relationship across variables.

The last chapter concludes the thesis with some useful remarks and summarizes this thesis shortly. It also gives some useful policies implication drawn based on the research results and previous studies in the literatures.

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Source: ASEAN Statistics, 2011

[...]

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^[1] Those six countries are Belgium, France, West Germany, Italy, Luxembourg, Nederland

^[2] The European Union: http://en.wikipedia.org/wiki/European_Union (Accessed on: March 15, 2012)

^[3] The overview ofthe ASEAN plus Three Cooperation http://www.aseansec.org/16580.htm (Accessed on March 15, 2012)

^[4] the details of the provisions are presented in Article 5 of the CEPT-AFTA

^[5] The clear timeline and the priority actions are presented in the section of Strategic Schedulefor ASEAN Economic Community of the ASEAN Economic Community Blueprint, p.30-35)

^[6] See ASEAN community in figure 2011, p. 14-15