Colombia - South korea free trade agreement - effects on the vehicle industry

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UNIVERSIDAD DE LOS ANDES

Colombia – South Korea Free Trade

Agreement

Effects on the Vehicle Industry

Diego Camilo Núñez Cortes

November of 2012

This thesis will assess the possible effects of a free trade agreement between South Korea

and Colombia on the vehicle industry from the Latin American country. To achieve this

goal, this paper develops a partial equilibrium model in order to estimate the price –

demand elasticity of imported cars in Colombia, and therefore, the possible consequences

on the amount of imported cars from the Asian country. The G – 3 trade agreement serve as

point of reference for all calculations. Results show a price – demand elasticity of .58 for

the vehicle industry in Colombia, and an average increase of 39% per annum of imported

cars from South Korea.

Key words: Free trade agreement, automobile industry, Colombia, South Korea

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I. Introduction

The world economy has led to a series of new commercial and economic relationships

between countries, supported by the increasing amount of free trade agreements among

them. Latin America has been an active participant in these bilateral and multilateral

settlements. For instance, the GATT1, now the WTO, has the purpose to reduce barriers to commercial activities in frontiers between countries, as well as to intensify and define rules

for international business, both national and international. There is also the ALADI2, which allows the creation of regional agreements. MERCOSUR3 has the purpose of create a free trade zone for those countries that belong to the agreement. The CAN4 promotes commerce between countries from the Andes region through tariff elimination. And finally, the recent

free trade agreements between Peru and Colombia with the USA. But another free trade

agreement is now being negotiated, this time between South Korea, the fifth car producer in

the world, and Colombia.

The purpose of this thesis is to study, analyze and evaluate the possible effects of a free

trade agreement (FTA) between South Korea and Colombia, on the vehicle industry of the

Latin American country. In order to calculate these effects, the partial equilibrium model

will be used to estimate both the effects of a reduction of import tariffs in the balance of

trade, and the effects on the vehicle market in Colombia caused by changes in prices of the

vehicles due to a reduction on import tariffs. Data of the amount of vehicles imported from

Mexico, before and after the G – 3 trade agreement5, will be used as a proxy to calculate the effects on the balance of trade; data will be gathered from WiserTrade and LegisComex

databases.

The main contributions of this paper are three. Firstly, Goldberg (2005) mentions the lack

of econometrical studies that quantify the effects of economic trade policies, i.e.,

1

General Agreement on Tariffs and Trade, 1948. Its objective is to reduce tariffs between countries. The last meeting was in 1994 in Uruguay where the GATT was transformed into the WTO.

2_{Asociación Latinoamericana de Integración.}

3_{Mercado Común del Sur}_{, agreement between Brasil, Paraguay, Uruguay and Argentina (1991). Venezuela}

and Bolivia have joined the agreement.

4_{Comunidad Andina de Naciones}_{, the members are Perú, Bolivia, Ecuador, Colombia, Perú and Venezuela.} 5_{Free trade agreement between Mexico, Venezuela and Colombia.}

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commercial policies over specific industries. He also argues that the vehicle industry is a

proper example to explore and quantify these effects, since the amount of studies for the

economic sector is short.

Secondly, these type of studies, which determine and quantify effects of economic policies

on a specific industry, are very useful to companies that belong to the sector, since they

provide valuable information of how the industry might behave in the short run. With this

information, managers are able to create new strategies that will benefit their organization,

taking into account the results of these studies.

Thirdly, the amount of existing papers similar to this is, i.e., studies regarding international

trading policies and the Colombian vehicle industry, is limited.

This paper is divided in six sections. It starts with a literature review about the partial

equilibrium model, emphasizing in the properties of the model and why different authors

have used it for their own purposes, as well as a review of different papers concerning

studies of the vehicle industry and international trade.

The next segment contains a background of the vehicle industry in Colombia and also,

detailed information about the G – 3 trade agreement, the Colombia – USA FTA, and what

is known of the Colombia – South Korea FTA, highlighting relevant aspects that are shared

among the agreements, as well as those key points in which they differ. Stylized facts of the

free trade agreements concerning the vehicle industry will be presented, as well as a

comparison and analysis. Information about all free trade agreements will be collected

directly from the Ministry of International Commerce. Available information of the

Colombia – South Korea FTA, which is not yet approved, will be gathered from the

Ministry of International Commerce; since there is no official document published with the

details of the agreement, information will be emulated from the Colombia – USA FTA to

fill in the missing gaps.

The following section will present the theoretical framework in which this study is based on

to calculate the effects mentioned above, explaining all of its components, followed by a

segment with the empirical implementation. The next segment will have the results of the

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II. Literature Review

Many papers have been written regarding free trade agreements and their effects on the

economy, and so, the amount of methodologies available to calculate and quantify these

effects is numerous. Still, there are some methodologies that are most common in the

exercise of quantifying the already mentioned effects. According to Youngshin (2011), the

General Equilibrium Model, the Partial Equilibrium Model, Macroeconomic Quantitative

Studies, and the Computable General Equilibrium (CGE) model are the most commonly

used models or methodologies to calculate trade agreement’s effects on the economy.

Youngshin uses the partial equilibrium model to determine the effects the FTA between

South Korea and Chile had on Chile’s agricultural sector. According to the author, this

model was appropriate to calculate these effects as it focuses on a specific industry of the

economy. The outcome of the study is a positive effect on the exports of Chilean products

to South Korea, due to an increase in the elasticity of products that belong to the

agricultural sector.

Durán Lima, Ludeña, Alvarez, & de Miguel (2008) also use the partial equilibrium model

to calculate expected changes in levels of exports and imports between Central American

countries and the European Union; they determine which products from Central America

will benefit the most from a trade agreement with the European Union. The authors

highlight the simplicity of the model as well as its caipability to cuantify effects on

specifical products or industries. They conclude that with full tariff elimination from the

Eurpoean Union, exports of agricultural products will experience an increase of 11.4% -

12%; sugar would be the highest beneficiary.

On the other side, Tonconi (2007) addresses the plausible effects of the Colombia – USA

FTA on the agricultural sector, specifically in Colombia’s corn. To estimate and quantify

the mentioned effects, the author uses the partial equilibrium model since it allows to

specifically calculate effects on a given sector or industry. As a result, the author achieves

two possible outcomes, since he calculated two possible scenarios. The first scenario states

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social welfare of US$ 31.62 million. In the second scenario, corn’s price decreases only

23.76%, generating a net gain in social welfare of US$ 20.44 million.

Berry, Grilli & Lopez (1992) estimate USA’s national demand of mexican cars taking into

account a possible free trade agreement between USA and Mexico, this free trade

agreement is now called NAFTA6. The authors establish that once the free trade between both countries is effective, mexican car producers will be replaced by northamerican

producers, as for Mexico’s demand will double.

Goldberg (1995), based on the partial equilibrium model, estimates the effects of

“Voluntary Export Restraint” (VER) on the NorthAmerican vehicle market, as well as price

sensitivity of the cars due to changes in the exchange rate. He uses a discrete choice model

to calculate the demand, and a differentiated production oligopoly to describe the supply.

To estimate the maket equilibrium, the author uses Nash’s strategic equilibrium.

Goldberg’s results show that sales of american vehicles encreased; domestic producers

captured 54% of Japanese sales.

Tovar (2005) for its part, develops an analysis of Colombia’s trade liberalization and its

vehicle industry based on a partial equilibrium model. In his work, he evaluates the effects

of tariff removal on consumers’ wellbeing. As a result, the author establishes that consumers’ welfare encreased due to a reduction in prices, as well as an increase of the

variety of products. Also, Tovar concludes that national assembly lines had success when

competing to international car producers.

Restrepo (2008) also uses the partial equilibrium model to calculate and analyze the effects

of the G – 3 trade agreement on the Colombian vehicle industry, but this time, the author

does an import quota approach. In his work, Restrepo finds that average market prices

decrease in no more than 3%, comparing the case without the G-3 trade agreement, and

6_{North American Free Trade Agreement. The members are Canada, United States and Mexico. It was}

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Mexican cars reduce their price on 20%, still, these reductions in prices had no effects

whatsoever in prices of domestic and other imported cars.

III. Background and Stylized Facts

After Colombia eliminated the import substitution model7 in 1991, a series of policies in

favor of trade liberalization have been implemented. As a consequence, consumers have

had access to a numerous type of products that were not available before the already

mentioned change in trade policies, mainly because their price was too high in order to be

sold massively.

With economic policies promoting trade liberalization, automobiles gained high importance

in the balance of payments of Colombia since the imports of these type of products started

to increase. Today, imported cars have gained an important place in the national market;

national cars have reduced their participation in national sales (see exhibit 1).

Colombia imports vehicles mainly from Asia, Mexico, South America and Europe (see

Exhibit 2). After the G – 3 Agreement with Mexico, the import quota of vehicles from the

last has increased substantially in the last few years, especially since 2009 when the base

tariff was completely eliminated (see Exhibits 3,4,5).

For its part, the amount of cars imported from Asia has not been that substantial as the

amount of vehicle parts (see Exhibits 6,7,8). Imports from both Asia and Mexico,

especially in vehicle parts declined dramatically in the from 2008 to 2009, probably a

consequence of the international financial crisis.

7_{Refers to a series of trade and economic policies intended to replace foreign imports with national}

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G – 3 Trade Agreement

The agreement between the countries for the vehicle industry, which started in

2005, established an annual export quota of vehicles from Mexico to Colombia. The

quota starts in 3.000 units, increases in 1.000 units per year, reaching an export

quota of 8.000 by 2010. Also, the base import tariff for all vehicles traded within the

limits of the quota is 10%8. This tariff will decrease by 2% each year, reaching 0% in 2009. Exported vehicles that exceed the quota will have a base import tariff of

30%, 13.2% or 2.4%9, depending of the subheading10 they classify into.

Colombia – USA FTA

For the vehicle industry, the import tariffs will decrease at a constant rate each year

for the next 10 years, taking in consideration the base import tariff which depends

on the type of vehicle. Only 4x4 vehicles will enjoy complete tariff elimination once

the agreement starts (May 2012). 51% of the subheadings have a base import tariff

of 15%, 46% have a base import tariff of 35%, and only 3% have a base import

tariff of 20%. Vehicles imported from USA to Colombia have no quota11.

Colombia – South Korea FTA

The current negotiations between South Korea and Colombia have established base

import tariffs of 35%, 15%, and 10% for vehicles exported from South Korea to

Colombia. These tariffs will reduce by a constant rate yearly, for 10 years, until the

import tariff reaches 0%12. Rules of origin establish that at least 55% of the vehicle and its parts must be from the country it is being imported from; these rules apply to

8_{Available at}_{http://www.tlc.gov.co/publicaciones.php?id=11963}_{. Consulted the 20/08/2012}

9_{Available at}_{https://www.mincomercio.gov.co/publicaciones.php?id=10386}_{. Consulted the 20/08/2012} 10

A subheading is a classification of a given article or product.

11_{Available at}_{http://www.tlc.gov.co/publicaciones.php?id=1274}_{. Consulted the 20/08/2012}

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the FTA of South Korea – Colombia, the FTA USA – Colombia and the G - 3 trade

agreement13.

IV. Theoretical Framework

In order to estimate the effects of a reduction of import tariffs in the balance of trade, as

well as the effects on the vehicle market in Colombia caused by changes in prices of the

vehicles, this paper will quantify the price – demand elasticity of imports concerning

vehicles and the possible effects in the balance of payments of Colombia, specifically in the

quantity of cars imported from South Korea once the FTA is active.

Methodology to calculate the price – demand elasticity.

To estimate the price – demand elasticity of the vehicle industry, this paper will use

the methodologies presented by Youngshin (2011) and Duran Lima et al. (2008),

modifying control variables in the equation that estimates the amount of car imports.

First, we must define the price – demand elasticity of the vehicle industry,

Where Ɛ is the price – demand elasticity, is the changes in the levels of imports,

the base level of imports, changes in the price and the base level price. The

base level price comes from,

Having as the base level tariff and as the international price of the vehicles.

For we have,

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In which is the tariff applied to a vehicle once the FTA is active. With all the

above equations, we can estimate the changes on imports ,

Finally, to calculate the price – demand elasticity, we have the following equation,

Where is the amount of imported cars over time, the price of imports over

time, the income of the country that imports the vehicles, the exchange

rate over time.

This last equation will allow determining the significance of each control variable as

well as their coefficients.

Methodology to calculate the effects on the balance of payments.

In order to estimate the effects of the FTA on the balance of payments from

Colombia, the time series data corresponding to the amount of imported cars from

Mexico will be used to do a prediction of the amount of cars that will be imported

from South Korea after the FTA is active.

To accomplish this objective, a deterministic model would be the most appropriate

since the number of observations is not high enough to use an exponential

smoothing14technique.

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Econometric technique aimed to create forecasts from a time series or to produce smoothed data for presentation. This technique assigns exponential decreasing weights to the set of time series in order to obtain the desired forecast.

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Limitations

Every methodology has its own limitations and flaws. In this case, the model relies

on a data base which serves as a proxy in the calculations. On the other hand, these

type of methodologies focus exclusively in the industry or sector that it tries to

analyze, hence, external factors that may distort the possible effects of the FTA in

the automobile industry are not contemplated. But then again, this disadvantage is

also it’s the advantage of the methodology.

One of the main external factors that may affect the consequences of the South

Korea – Colombia FTA over Colombia’s automobile industry is the already signed

USA – Colombia FTA. Still, the American car manufacturers produce a different

type of automobile that the ones produced in South Korea, i.e., USA produces

automobiles targeted to a different type of consumer than the ones produced by

South Korea, and the amount of vehicles imported from the American country is

close to zero (see Exhibit 2).

V. Data Description

As mentioned before, all data concerning the amount of imported cars from Mexico to

Colombia, which serves as a proxy for the amount of imports from South Korea to

Colombia, was gathered from both WiserTrade and LegisComex databases. Data is

available from 2002 to 2011. These databases provide the exchange rate (COP – USD) to

which each batch of cars was imported.

As for the country’s income, data was collected from Colombia’s Administrative

Department of National Statistics. Data was interpolated in order to find the country’s

monthly income.

Although data regarding the amount of imported cars from Mexico to Colombia was

available in a monthly period, data of Colombia’s income was available for every three

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compatible with the periodicity of the data concerning the county’s income, reducing even

more the number of observations available for calculations.

VI. Results

All independent variables have a significance at a 99% level, and their coefficients have the

expected sign, i.e., the coefficients have the projected effect on the dependent variable (see

Exhibit 10). After running the Ramsey test on this first regression, it proved the proper

specificity of the model (see Exhibit 11). Another regression was done, this time adding the

GDP as a lagged variable. In this case, the model kept its results, proving its robustness (see

Exhibit 12).

The price – demand elasticity is 0.58, which is very high for a product that does not belong

to the basic consumption set of products.

In order to predict the amount of imported vehicles from South Korea, the tendency of the

time series corresponding to the quantity of vehicles imported from Mexico was calculated,

using the Hodrick – Prescott filter (see Exhibit 9). Finally, with a deterministic tendency

approach, the change of imported cars was calculated. As a result, an average increase of

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VII. Conclusions

As proven above, the South Korea – Colombia FTA will have a noticeable positive effect in

the quantity of imported vehicles; 39% average increase per annum. Such an effect will

certainly reduce even more the market participation of vehicles produced in Colombia,

leading to a possible crisis for the assembly lines of the country; the automobile market

grew 15% during the last three years15, less than a half of what the imports are expected to grow.

On the other hand, market variables such as exchange rate and national income are highly

important in order to determine changes in the balance of trade; for this case, a healthy

economy and a re – evaluation of the exchange rate are factors that provide conditions for

an increase in the imports of vehicles.

As for how the USA – Colombia FTA may affect the results from this study, the United

Stated produces cars focused on a customer different from that of South Korea. Also, as

previously stated, the number of cars imported from the USA to Colombia is really limited,

mainly because those American manufacturers who want to sell their automobiles to

Colombia, have established assembly lines in Mexico where they can take advantage of the

tariff elimination that the country enjoy with Colombia.

Finally, Colombian consumers are very price sensitive, as proven with a price – demand

elasticity of 0.58. This shows the consumer’s willingness to take advantage of price

opportunities that the market offers, as a consequence of international trading policies, and

the attractiveness of Colombia’s vehicle market for international automobile manufacturers.

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VIII. Bibliography

Berry, S., & Grilli, V. (1992). The Automobile Industry and the Mexico - US Free Trade Agreement. Cambridge: National Bureau of Economic Research.

Durán Lima, J. E., Ludeña, C., Alvarez, M., & de Miguel , C. (2008). Acuerdo de Asociación Centroamérica - Unión Europea: Evaluación utilizando Equilibrio General Computable y Equilibrio Parcial. Santiago de Chile: Naciones Unidas.

Goldberbg, P. K. (Jul. 1995). Product Differentiation and Oligopoly in International Markets: The Case of the U.S. Automobile Industry. Econometrica, 891-951.

Lee, C.-S., & Moon, D. (2012, December). Impacts of Sequential Free Trade Agreements in East Asia: A CGE and Political Economy Analysis. Global Economic Review, pp. Vol. 39, No.4, 365-381.

Mandal, R. (2007). Microeconomic Theory. New Delhi: Atlantic Publishers & Ltd.

Restrepo, M. A. (2009). Los Efectos de la Política Comercial: El caso G-3 y la Cuota de Importación en el Mercado Colombiano. Bogotá D.C.: Universidad de los Andes, Facultad de Economía.

Tonconi, J. (2007). Efectos del Tratado de Libre Comercio entre Colombia y Estados Unidos: Un Enfoque de Equilibrio Parcial para el Sector Agrícola . Bogotá D.C.: Universidad de los Andes, Facultad de Economía.

Tovar, J. (2012). Consumers' Welfare and Trade Liberalization: Evidence from the Car Industry in Colombia. World Development, Vol. 40, No. 4, pp 808-820.

Youngshin, A. (2011). Cuantificando los efectos en el sector agrícola chileno del TLC con Corea del Sur. Bogotá D.C.: Universidad de los Andes, Facultad de Economía.

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IX. Annexes

Exhibit 1.

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Exhibit 3.

Source: WiserTrade

Exhibit 4.

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Exhibit 5.

Exhibit 6.

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Exhibit 7.

Exhibit 8.

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Exhibit 9.

Exhibit 10.

7

8

9

10

11

2002m1 2004m1 2006m1 2008m1 2010m1 2012m1

tiempo

ln cantidad slni_lni_sm_1

_cons -1.518625 3.823705 -0.40 0.692 -9.09631 6.059061 lnipbeta -1.020432 .0613725 -16.63 0.000 -1.142058 -.8988062 lnpib 2.596722 .2268155 11.45 0.000 2.147227 3.046217 lntrm -1.244706 .2068041 -6.02 0.000 -1.654543 -.8348688 lni Coef. Std. Err. t P>|t| [95% Conf. Interval] Total 28.9806072 113 .25646555 Root MSE = .21178 Adj R-squared = 0.8251 Residual 4.93340843 110 .044849168 R-squared = 0.8298 Model 24.0471988 3 8.01573292 Prob > F = 0.0000 F( 3, 110) = 178.73 Source SS df MS Number of obs = 114

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Exhibit 11.

Exhibit 12.

Prob > F = 0.2552 F(3, 107) = 1.37 Ho: model has no omitted variables

Ramsey RESET test using powers of the fitted values of lni

_cons -2.537207 4.391111 -0.58 0.565 -11.24301 6.168598 lnlagpib .9417336 .2403816 3.92 0.000 .4651537 1.418314 lnprecios -1.039246 .056426 -18.42 0.000 -1.151116 -.9273763 lnpib 1.734643 .2641419 6.57 0.000 1.210956 2.25833 lntrm -1.206128 .2173791 -5.55 0.000 -1.637103 -.7751524 lni Coef. Std. Err. t P>|t| [95% Conf. Interval] Total 26.5749379 110 .241590344 Root MSE = .19208 Adj R-squared = 0.8473 Residual 3.91098351 106 .036896071 R-squared = 0.8528 Model 22.6639544 4 5.66598859 Prob > F = 0.0000 F( 4, 106) = 153.57 Source SS df MS Number of obs = 111

Colombia - South korea free trade agreement - effects on the vehicle industry