Thesis Riska Pujiati_Isi

8/10/2019 Thesis Riska Pujiati_Isi

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1.

INTRODUCTION

Background

In recent years, international trade has become a complex subject instead ofthe basic exchange of goods and services that it started out as. Moreover, tradeliberalization becomes a critical issue for the trade of goods between countries.During the globalization process, due to the development of communication,technology and transportation, international trade has increased dramatically.The report from the World Trade Organization (WTO) indicates that the totalvalue of worldwide trade is three times larger than it was in the year 2000. As of2012, international trade is estimated at around US$ 17.9 trillion, whereas it wasonly approximately US$ 6.4 trillion in 2000. Furthermore, 97 percent ofinternational trade involving the countries which engaged in preferential trade

agreement.Political factor and economic background becoming the reason for a country

to establish the agreement. Preferential trade agreement is manifestation ofeconomic integration among countries. The basic principal of integrationeconomic is to eliminate trade barrier and boost the flow of goods and services

between its member. The main goal is peoples welfare will be achieved by tradeefficiency and reduction in trade cost. Trade policy also set as a tools to create

broader market and it is expected to increase a countrys economy growth. Thelatest development is the establishment of regional trade agreements in each partof the world.

The sectors which contribute to the world trade are agriculture (9.3 percent),

fuels and mining (23.1 percent) and manufacturing (64.1 percent). The tradevalue has increased from US$ 0.5 trillion in 2000 to US$ 1.6 trillion in 2012 forthe agriculture sector (World Trade Organization [WTO] 2012). Internationalagricultural trade is important, especially in developing countries. The total shareof agricultural exports from developing countries increased slightly over the twodecades between 1990 and 2010, from 37 to 43 percent (Cheong et al. 2013).Agriculture plays an important role for developing countries as a primary sourceof income (Aksoy & Beghin, 2004). In many developing countries, agriculturealso becomes a strategic sector which absorbs a high number of employmentopportunities. Majority of emerging economy exporting raw agriculture product.

Southeast Asia is a region that consists of middle income developingeconomies, with two countries contributing as the regions major exporters,

Indonesia and Malaysia. In 2012, the value of the total agriculture exports reachedUS$ 45 billion for Indonesia and US$ 34 billion for Malaysia (WTO 2012). Themajor commodity which contributes to the high value of export is vegetable oilinitially originated from palm oil.

Palm oil is predicted to become an important commodity throughout theinternational trade community. Currently, the international trade values forMalaysian and Indonesian palm oil ranks second and third after the totalinternational trade value for soybeans in 2011. Due to the high demand in theinternational market, the combined value of palm oil between Indonesia and

Malaysia accounted for US $34 billion in 2011 alone (Food and Agriculture


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Organization [FAO] 2013). Figure 1 shows the performance of palm oil tradecompared to the five largest traded commodities in international market.

The figure 1 shows that the growth of the palm oil trade has increased from

2007 to 2011 for both Indonesia and Malaysia. The average annual growth ofIndonesian palm oil was 24%, whereas the average annual growth for Malaysian

palm oil was 17%. The total value of exports increased by more than 150 percentin 2011 compared to the value in 2007 for Indonesia, while for Malaysia itincreased by only 90 percent. The high growth of palm oil trade is also supported

by the increase in palm oil production in both countries.

Figure 1 Major Commodity Exporter

Problem Formulation

The extensive use of palm oil in various trade sectors such as the food, non-

food and energy sectors led to a high demand of palm oil in the internationalmarket. Palm oil is also considered to be the cheapest vegetable oil and has ahigher yield than soybean and rapeseed, which are also commonly used to

produce vegetable oil. Palm oil is exported in two primary forms: crude andrefined. Furthermore, there are more than 100 countries listed as the destination ofIndonesian and Malaysian palm oil. Figure 2 shows the palm oil market share for

both countries. According to the figure 2, Indonesia and Malaysia have differentshares of the palm oil market between the periods of 1989-2012. The EuropeanUnion (EU) was the primary trading partner of Indonesia with the total marketshare reach by 82 percent in 1989, this share dropped significantly to 14 percent in2012. For Malaysia, the share for the EU increased slightly from 8 percent in 1989to 13 percent in 2012. China is considered to be the new emerging nations, both in

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2007 2008 2009 2010 2011

Millions

Major Commodity Exporter

Soybeans, USA

Palm oil, MYS

Palm oil, IDN

Soybeans, BRA

Maize, USA

Source: FAO, accessed through FAOSTAT database, 2013


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economy and population, and is therefore showing a tremendous increase in theimport of the palm oil. For palm oil originating from Indonesia, the export shareto China reached 15 percent in 2012 compared to three percent in 1989, while forMalaysia, the export share to China reached 17 percent in 2012 compared to 9

percent in 1989. Another country which shows dramatic import increases of palmoil is India. In 2012, Indonesias palm oil export share reached 28 percent while in1989 the share was only 7 percent. Similar cases apply to Malaysia, where theexport share to India reached 15 percent in 2012, three times larger than in 1989 atonly 5 percent. Similar to China and India, the export share of Indonesias palmoil to countries grouped to the Association of Southeast Asian Nations (ASEAN)has increased to 14 percent in 2012. Contrary to Malaysia, the export share ofMalaysias palm oil to ASEAN market decreased from 25 percent in 1989 to 11

percent in 2012.

Figure 2 Market Shares of Indonesia and Malaysias Palm Oil Export


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The change of the palm oil export proportion is influenced in part by theestablishment of trade agreements among countries. Indonesia and Malaysia areinvolved in similar free trade agreements, which are part of the ASEAN FreeTrade Area (AFTA) Agreement. During the period between 2000 and 2012, there

has been an expansion of partnership with ASEAN; newly added countries are:China (2005), Korea (2007), Japan (2008), India (2010) and Australia/NewZealand (2010).

As two of the largest producers, joining the AFTA become an opportunityfor Indonesia and Malaysia to promote trade because of the reduction in trade

barriers. Although Indonesia and Malaysia produce similar products, involvementin the RTA will give different results in the flow of goods. Based on thedescription above, the research question of this study is:

What is the impact of the establishment of FTA on the Indonesian and Malaysian

palm oil trade flows, respectively?

Research Objective

According to the research question above, the purpose of this research is toanalyze the impact of the establishment of free trade agreements on Indonesia andMalaysias palm oil trade flows.

Research Benefit

This study is expected to give benefit as follow :

1.

Contribute as a source of information about regional trade and its impact tocommodity trade flow for student, researcher, and other related party

2. Give the stakeholder valuable information which can be used as a guidance totake important decision relates to international agricultural trade.

Research Scope

This study is emphasis on Indonesia and Malaysia as a largest palm oilexporter. This study uses disagregate palm oil export which is divided into crude

palm oil (HS 151110) and refined palm oil (HS 151190). The value of annual

bilateral trade of palm oil is from period between 1991 to 2011 to 77 partnercountries as an export destination.

The study is organized as a follow: Section 2 contains the previous studyon the impact of FTAs, the empirical studies of gravity estimation, and the

previous research concerning the international palm oil trade. Section 3 describethe theory related to the international trade, the gravity model, and the trade cost.Section 4 cover the explanation of methodology in this study . Section 5 is theoverview of palm oil and free trade agreements in southeast Asia region. Section6 present the result and discussion. Section 7 is the conclusion and policyrecommendations.


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2. LITERATURE REVIEW

This chapter contains an overview regarding empirical studies which relateto the economic impact of trade agreements, this chapter also looks at previous

studies pertaining to the use of the gravity model on international trade,particularly to examine the ex-post effect of the formation of trade agreements.Furthermore, this chapter also describes the international trade of palm oil inIndonesia and Malaysia.

Empirical Studies on Free Trade Agreement Impact

Following the recent proliferation of trade agreements, both bilateral andmultilateral, researchers have dedicated efforts to examining the welfare effect oftrade agreements. From this increase in interest regarding trade agreements, thequestion of trade enhancements or the potential generation of threats has arisen.

Viner introduced the terms trade creation and trade diversion in 1950; tradecreation refers to a shift of product origin from expensive domestic producers tomore efficient producers which are a member of trade agreement. Trade diversionoccurs when a member country transfers its imported goods from a country that isoutside of the trade agreement to a member country within the trade region(Feenstra & Taylor 2008). Trade creation is associated with welfare improvementand trade diversion is welfare reduction. This two concepts serve as the basis forthe majority of studies of regionalism and contributes to extensive theoreticalliterature (Magee 2004).

Research conducted by Aitken (1973) relating to the Regional TradeAgreements used gravity models to look at the differences between European

Economic Community (EEC) and the European Free Trade Association (EFTA)to shows that trade creation had occurred between member. Grinols (1984)analyzed the impact that joining the EEC had Britain in 1973. The resultsindicate that membership in the EEC caused a 2% decline in the Britain`s GDPfrom 1973 through 1980 (Feenstra 2007).

Due to the increasing number of trade agreements established in variousregions of the world, the research regarding the impact of trade agreements (bothmultilateral and bilateral) increased and was applied for various type ofcommodities. Krueger (1999) examined the impact of the regional tradeagreement called the North American Free Trade Agreement (NAFTA), whichincludes the United States, Canada, and Mexico. Her research found that NAFTAhad a weak impact during its first three years of existence. The gravity estimationusing three-digit Standard International Trade Classification (SITC) levels showthat the total world import originating from NAFTA decreased while tradewithin NAFTA increased. Subsequent research concluded that NAFTA displayedcharacteristics of trade creating rather than of trade diverting (Krueger, 2000).Jayasinghe and Sarker (2008) estimated the trade creation and trade diversioneffects on NAFTA by using disaggrerated trade data from six agrifoodcommodities consisting of red meat, vegetables, grains, sugar, fruits, andoilseeds within the period from 1985 to 2000. Their results show that there has

been a significant increase in trade between NAFTA members.


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Korinek and Melatos (2009) conducted the research on the effect of theASEAN Free Trade Agreement (AFTA), the Common Market for Eastern andSouthern Africa (COMESA), and the Southern Cone Common Market(MERCOSUR) in the aggregate agricultural sector. Their results from the

gravity model indicate trade creation for member of these agreements, and alsodisplayed no strong proof of trade diversion for countries outside the agreement.Upon the comparison of the result, it can be seen that the the effect onMERCOSUR is larger than the effect on both AFTA and COMESA.

Research performed by Gilbert, et al. (2001) focused on the regional tradein Southeast Asia. Their research on the agriculture, manufacturing, and servicesectors shows a positive effect for trade within the agriculture and manufacturingsector. More specific, they conclude that the ASEAN Free Trade Agreement(AFTA) only been boosted the trade in manufacturing through year, while theimpact on agriculture declined after 1992. The effect of the AFTA partnership wasexamined by Yang and Martinez-Zarzoso (2013), through their research on the

effect of the ASEAN-China Free Trade Area (ACFTA). The research wasconducted with the use of a panel data set from 31 countries from 1995 to 2010.Their research found that the ACFTA has a different impact for each product;there was a significant effect of trade creation applied to manufactured goods andchemical products, while for agricultural raw material, machinery goods andtransport equipment, the estimation report insignificant result. Overall, theACFTA had a positive result on trade among its members and even on countriesoutside the ACFTA.

Rose (2004) used panel data from 175 countries of the WTO over a 50 yeartime span (year to year) to determine the implications for a country that is joininga multilateral trade agreement. He concludes that the membership in the WTO hasno significant effect on trade. Two possible reason that exist for there being littleeffect to the member when joining the WTO : First, the WTO cannot force mostcountries to lower trade barriers, especially for developing countries and second,the WTO membership has little effect on trade policy. Another study wasconducted by DeRosa (2007), where he applied the gravity model on a panel dataset with annual data from 1970 to 1999 covering 156 countries and 46

preferential trade agreements. The research was conducted on manufactureproducts and the econometric estimation shows that major preferential tradeagreements tend to create trade rather than divert trade. This effect also applied tothe non -member countries.

Concerning agricultural commodities, Lambert and McKoy (2009)performed the research on the agricultural and food product on various FTAs.Their research covering three periods of data series, 1995, 2000 and 2004. Theirresults from the gravity model estimation indicate that FTA generally increasestrade in agriculture and trade sector. However, the trade diversion occurred for themembers of Caribbean Community and Common Market, the Central AmericanCommon Market, and COMESA.

Philippidis et al. (2013) examine the bilateral trade flow on 20 singleagricultural commodities between period 2001 to 2004 within 95 country by usinggravity model with Poisson Pseudo Maximum Likelihood (PPML) estimation.Their research result shows the various impact of the FTAs for different single


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commodities, the FTAs has significant impact to trade on wheat and other cerealgains; and paddy rice.

The Gravity Model for International Trade

The gravity model is one of the most established model for empirical studiesin international trade. Over the last decades, the gravity model has successfullyexplain the determinant of bilateral trade. Moreover the model has been used toasses capital flow, trade resistance, and the impact of regional trade agreements on

bilateral trade. The gravity model for international trade derived from theclassical gravity model of Newton.

The Gravity model began to be used as a tool to analyze social andeconomic interaction after the research conducted by Ravenstein in the 19 thcentury. Ravenstein (1885) explains that migration of population is influenced bythe absorption of centers of commerce and industry, but grow less with the

distance proportionately. The empirical application of Newtons gravity modelon international trade was introduced by Tinbergen (1962) in Shaping the WorldEconomy. According to this model, trade between countries is explained byeconomic sizes, populations, direct geographical distances and a set of dummyvariables. Tinbergen concluded that a countrys income and distance have astatistically significant affect on trade between countries.

Gross Domestic Product (GDP) as a measurement for economic countrysize is an important variable which helps to construct the gravity equation. GDPindicates the market size in both countries, as a quantifier of economic mass.

The market size of the importing country represents the potential demand forbilateral imports, while the GDP in the exporting country shows the potential

supply and variety of products. Helpman (1987) performed research thatstresses the effect of varied country size. His research applied to OECD countriesand he concluded that when a country is more similar in size, trade opportunitiesare expanded. Hummels and Levinsohn (1995) further develop Helpman`swork by including non-OECD member as a means of comparison. Debaere(2002) uses several different methods to determine the share of a countrys GDP,rather than using the nominal GDP, Debaere made these GDP conversions byusing nominal exchange rates, as well as Purchasing Power Parity (PPP) exchangerate. Furthermore the research also uses the populations of the countries as aninstrumental variable for GDP.

Bilateral distance helps to determine the trade relation between countries,

the closer two countries are, the greater thr amount of trade they will have(Feenstra & Taylor, 2008). According to (Head, 2003), there are severalexplanations for why distance variable is so important. First, distance representstransportation cost. Hummels (1999) has declared that the cost of shipping helpsto explain the importance of distance. The second explanation looks at the lengthof time during shipment which can have a significant effect on the final product.When looking at perishable goods, for example, the probability of damage or spoilis higher when the time is longer. Distance also influences synchronization costs,communication costs, transaction costs, and cultural gaps between countries(Head 2003). According to Hirsch and Hashai (2000), distance can be divided

into economic and geographical distance. The first refers to the differences in


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absolute income per capita between trading countries, the second is concernedwith kilometers or miles between destinations.

Disdier and Head (2008) estimated the effect of distance through the use ofthe gravity equation with data comprised of 595 regressions between 1928 to

1995, from 35 separated studies. The result shows that if distance is doubled, thentrade will decrease by one half. The effect of distance on regional trade wasdemonstrated by Martinez-Zarzoso and Lehmann D (2004). They conduct a studyfocused on MERCOSUR and EU trade. The result shows that for some industries,geographical distance has a high significant effect, this is also true in relation tothe economic distance.

Particularly, the gravity model has been augmented by the addition ofseveral critical variables by several author. Common variables which mightinfluence the bilateral trade are common borders, common language, coloniallinks and the presence of landlocked countries. regarding to the policies impact,the gravity model is widely used to estimate the influence of monetary unions and

regional trade agreements.

Empirical Study on International Palm Oil Trade

Extensive research has been conducted to examine the determining factor ofpalm oil trade in the international market. Suryana (1986), Tondok (1998),Ibrahim (1999), and Basiron (2001) analyzed the outlook of palm oil in theinternational market for Indonesia and Malaysia. Shamsuddin et al. (1997)examined the determinant and implication of policy instruments on the Indonesianand Malaysian palm oil. Lubis (1994), Shamsuddin et al. (1994), and Susila(1995) who examined Malaysias palm oil supply and demand system.

Yulismi and Siregar (2007) calculate the elasticity of price and income forIndonesian and Malaysian palm oil export. The research using annual data from

between year 1990 to 2004 analyzed through demand model. The result showsthat the price and income elasticity of Indonesian palm oil export are inelastic inIndia and elastic in Chinas market. For the Malaysian palm oil, the price andincome are elastic in India and China, while in the EU market the price is elastic.

The impact of the Free Trade Agreements (FTA) proliferation to acountrys overall trade especially palm oil was describe by Ernawati et al.(2006).The export of Indonesian palm oil was analyzed by using an Error CorrectionModel (ECM), along with having China, India, Europe, and rest of the world(ROW) as partner country. The simulation shows that a reduction of tariff in

export and import has varying impacts on partner country. The palm oil demandis influenced by price, as is the price of substituted commodities such as rapeseedoil and soybean oil; exchange rate and lag export, are also shown to be influencedin the simulation.

Rifin (2010) performed a study comparing the market share of Indonesianand Malaysian palm oil in Asia, Europe, and throughout Africa. The commoditieswere differentiated into crude and refined palm oil. The market share wasanalyzed by constant market share analysis (CMSA). The result show thatIndonesias market share increased during the period between 1999 and 2001 aswell as between 2005 to 2007 for both products in Asia and Africa region.

Indonesia has a higher level of competitiveness due to seeing an increase in


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market share in two regions instead of one, as was the case in Malaysia.Malaysias palm oil market share increased only in the Europe region.

Furthermore, another study concerning the impact of FTAs was conductedby (Balu & Ismail 2011). According to their descriptive research, for Malaysias

palm oil industry, the FTAs were a good opportunity because it helped to increasemarket share and tariff reduction lead to a higher profit. The competitiveness oftraded goods will likely enhance due to liberalization of tariffs.

3.

THEORETICAL AND OPERATIONAL FRAMEWORK

This chapter contains an overview about the theories which support thisstudy. The first part is about the theory of international trade, the second partstates the definition of Free Trade Agreements (FTAs) and its static and dynamic

impact. The third section explains about the theory development of the gravitymodel, and the final part gives an overview of trade costs

International Trade Theory and Free Trade Agreement Definitions

International Trade Theory

International trade is a part of international economics which refers to the

exchange of goods and services among the countries of the world (Reinert 2012)The theory of international trade was first developed by British economist, AdamSmith. Smith (1776) stated that trade among nations is influenced by its absolute

advantages (Reinert 2012). When a country has the best technology andspecialization in the production of one good it has an absolute advantage. Thecountry that has an absolute advantage will gain from export (Feenstra and Taylor2008).

Ricardo (1821) developed the theory of comparative advantage. This theorystate that even if a country has no absolute advantage in producing two types ofgoods than any other country, the beneficial trade can occur as long as the ratio of

prices between countries are different than in an autarky (no trade) situation. Asstated by Krugman (2012) A country has a comparative advantage in producing agood if the opportunity cost of producing that good in terms of other goods islower in that country than it is in other countries (p. 56). The classical trade

theory was developed to measure the economic efficiency of resource distributionin the production of goods.

The development of trade patterns proposed by Heckscher (1919) andOhlin (1924) explained that comparative advantage arises from differences in acountrys endowment factor. The Heckscher Ohlin (HO) theory is also called thefactor-proportion theory because it stresses on the interaction between thedifferent proportions of the countrys production factors, as well as the differences

in the usage of these factors on producing a wide range of items (Krugman,et al.2012). The assumption of this theory is that the technologies are the same across

both trading countries. The HO model predicts that a country tends to export thegood which uses its abundant factor intensively (Feenstra & Taylor 2008).


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The modification of assumptions on the HO and Ricardian models result ina new trade theory. For this modification, the assumption of homogenous goodschanges into differentiated goods. The market structure in this new trade theory isdifferent than with perfect competition. The concept of monopolistic competition

was introduced by Krugman (1980), and states that the two main assumption aredifferentiated goods and increasing returns to scale. By creating various types of

products, firms are able to control the products price, the firm also acts as a pricetaker. In monopolistic competition, a firm cannot set prices as high as in acomplete monopoly. The second point of interest is economies of scale. Byincreasing production, the average cost will be reduced, so the firm will sell morenot only in the domestic market, but also in the foreign market. Increasing returnsto scale is one of the primary reasons for doing international trade when thetrading countries have similar technologies and resources (Feenstra & Taylor2008). The monopolistic competition model is able to explain current trade

patterns such as intra industry trade, the gravity equation, and the impact of

regional trade agreements.The development of the new trade theory by Melitz and Bernard in 2003

focused on the presence and behavior of heterogeneous firms in the internationalmarket. The heterogeneity of the firms appears due to not all of the firms beinginvolved in export activities, only several firms are actively exporting. Moreover,not all firms export goods to all countries due to the higher costs involved with theinternational market than with the domestic market. Hence, only firms whichhave high productivity are able to cover all costs and export their products.Therefore, the bilateral trade flow may contain many zero values. The presence ofzero trade has an important implication on the gravity model.

Free Trade Agreement Definitions

Generally, according to the World Trade Organization (WTO), free tradeagreement is a contractual arrangement between two or more countries underwhich they give each other preferential market access, usually called free trade.In practice, free-trade agreements tend to allow for all sorts of exceptions, manyof them temporary, to cover sensitive products. In some cases, free trade is nomore than a longer-term aim, or the agreement represents a form of managedtrade liberalization. Researchers have noted that many recent free-tradeagreements have run to several hundred pages, whereas a true free-tradeagreement would require only a few lines. While free trade area stand for a

group of two or more countries or economies, customs territories in technicallanguage, that have eliminated tariff and all or most non-tariff measuresaffecting trade among themselves. Participating countries usually continue toapply their existing tariffs on external goods(WTO 2003).

The definition of customs union is an area consisting of two or moreindividual economies or customs territories which remove all tariffs andsometimes broader trade impediments between them. The members making up thearea then apply a common external tariff. The further level of custom union iscommon market. Common market describe as a more developed type of customsunion in which, in addition to the free movement of goods between member states,

labor, capital and services can also move without restriction. Common markets


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lead to highly integrated economies (WTO 2003).Due to the high number of proliferation of regional trade agreement in some

part of the world, WTO then define the term of regional trade agreement as theregional trade arrangement. The term define as a free-trade agreement, customs

union or common market consisting of two or more countries (WTO 2003).Presently, the number of regional trade arrangement which have been notified tothe WTO between 1947 and the present reach more than 200. The WTOestablished a Committee on Regional Trade Agreements to observe its effect onthe international trading system in early 1996.

Impact of Free Trade Agreement

Static Impact of Free Trade Agreement

As mentioned in chapter 2, the impact of trade agreements was first

introduced by Viner in 1950. Viners model is important because it refuses theconventional wisdom of Free Trade Agreements that they tend to improve welfarebecause they include some degree of trade liberalization. Viners model showsthat a regional trading agreement could have a negative impact on welfare. Hismodel remains important as part of the analytical framework because it lays outseveral conditions that determine whether an FTAs will be beneficial or harmful.The main concepts in his model are trade creation and trade diversion (Plummeret al. 2010). Both of which counted as the static impact of trade agreement.

The term trade creation indicates the benefit of a country by joining anFTAs. Countries begin to trade with one another, whereas they previously

produce all goods internally at a high cost. The definition of trade creation is the

converting of imports from a high cost producer to a low cost producer. Contraryto trade creation, trade diversion represents the negative efficiency effect of FTAs,when a country begins to trade, a country which had previously been importinggood from a non member with lower production costs must begin importing froma member country with higher production costs due to the establishment of tradeagreement (Feenstra & Taylor 2008; Reinert 2012). An illustration of tradecreation and trade diversion can be seen in Figure 3.

Figure 3 displays the demand and supply of a certain good in the domesticmarket, which is referred to as the home country, other FTAs-membercountries are referred to as partner countries, and non-member countries asoutsider. The assumption for home is a small economy, so that it is unable to

influence international prices; also, the import price is constant. Previously, theprice in the partner country is cheaper than in the outsider country. Before FTAs,Home has a set tariff (t) for unit good imported from both partner and outsider.Due to Ppartner + t < Poutsider + t, Home imports the goods from partner and theimport quantity at the beginning is ZHome. After Home joins the free tradeagreement with Partner, the tariff is eliminated from Partner. Due to Ppartner b + d), then the FTA reduces welfare in Home (Reinert2012).

Dynamic Impact of Free Trade Agreement

As has previously been mentioned, in assessing the impact of FTAs, themajority of researchers have focused only on the static (one-time) changes whileignoring the dynamic (medium and long-term) outcomes of FTAs. The dynamiceffects of an FTA are important to analyzed because the dynamic effect is moresubstantial and pervasive (Plummer, et al. 2010); it is necessary to consider what

the FTAs are and how they affect the countrys development. Some of theimportant dynamic effects in FTAs to consider are: economies of scale and variety,technology transfer and foreign direct investments (FDI), structural policy changeand reforms, as well as competitiveness and long run growth effects. These effectswill be discussed in more detail in the following segments.

a.Economies of scale and variety

Economies of scale are described as the reduction in average costs due to anexpansion in output. It will occur due to an improvement in technical efficiency inlarge-scale production, a higher ability to distribute administrative costs and

reduce overhead cost over a larger operation, dealers bulk discounts or better

ca

e


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logistic systems as the production volume increases. Economies of scale occursin the production of some agricultural, natural resource intensive, manufacturing,and service sectors. Due to the establishment of FTAs, the larger market that iscreated allows firms to take advantage of a larger customer base in domestic and

foreign markets. Firms will produce at a lower average cost and are thus able toset lower prices for existing customers, this is called the cost reduction effect(Plummer et al. 2010). As a consequence of lower costs, the firm has a highercompetitiveness in both home and foreign markets. Customers in each countrywill also enjoy a greater variety of goods because the firms in each country willhave access to a wider array of goods.

b. Impacts on foreign direct investment

The establishment of FTAs, both bilateral and regional create a moreintegrated marketplace and a larger risk sharing investment flow. Another benefit

for multinational corporations is that they can enjoy a regional division of labourwith lower transaction costs, further developing economies of scale. Due to theseeffects, many multinational corporations are interested in investing more into FTAmembers due to the dynamic of having a larger economy; this is calledinvestment creation. An FTA may encourage more FDI flows into the region by

working with other multinational countries located outside the region. This isanother reason that FTAs may also encourage intra-bloc investments by workingwith multinational companies of a specific regional origin.

However, if the multinational company chooses to invest in the membercountry not because of an increase in dynamism but because it will now have

preferential access to the FTA market, then it is called an investment diversion.

Although investing in an outsider country might have higher costs, themultinational company diverts investments to the FTA because of the regionalagreement.

c. Structural Policy Change and Reform

Several policiy changes have occurred as a result of the establishments ofFTAs. Changes relate to some of the following aspects : quality standards,corporate and public governance laws, customs procedures; the national treatmentof partner-country investors, competition policies, the reform of state-ownedenterprises, and other sensitive sectors which have an important influence on

the economy. The inclusion of these areas in FTAs shows the extent to whichFTA are shaping and harmonizing the member countrys policies. Generally,member country will respond to joining an FTA by improving the businessenvironment through cost reduction, extending the opportunity to join the FTA toforeign investors, and by pushing policy reforms to encompass best practices(Plummer et al. 2010).

d. Competitiveness and Long-Run Growth Effects

Although FTA members face lower trade barriers, there is still some level ofcompetition surrounding this issue. Firms which have a lower level of

productivity will be eliminated from the competition. The more productive firm


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will improve their structural efficiency, as well as their allocation of resources.The competitive market will give firms a greater incentive to invest in moreefficient productive processes and technology. The combination of effects ofincreased competition on productivity and efficiency will lead to long run growth

prospects among member countries. (Plummer et al. 2010).

Theoretical Gravity Model

The basic foundation of the gravity model in international trade is theclassical gravity model introduced by Newton. Newton (1686) states that thegravitational attraction between two objects is a function of the mass of eachobject and inversely relates to the distances square, resulting in the following

formula:

....(3.1)

Where F denotes the force between two masses, m1 refers to the mass ofthe first object, m2 represents the mass of the second object, r shows thedistance between two objects, and G is the gravitational constants. If the formulais applied to international trade, F denotes the flow of trade between country i andcountry j, G is constant, m1and m2refer to the a economic size of country i and j,and r represents the distance or trade cost between country i and j. The initialgravity model can expressed as :

()()..(3.2)where is the value of bilateral trade (export or import) in current US

dollars, and represent exporter and importers economic size, is thedistance between the two countries, is the disturbance term, and the s are theunknown parameters of the equation.

The initial development of the gravity model has presented a degree ofproblems because the formula is based more on physics than on economicanalysis. The gravity equation was not very well appreciated in the decade

between 1970 and 1980, due to lacking a strong theoretical foundation ineconomics. According to Deardorff (1984), the gravity equation has a theoreticalheritage which is dubious. In his subsequent research, Deardorff (1998) notedthat gravity model can be rationalized with many existing trade theory such as theRicardian and the HO models, as well as with monopolistic competition.

Anderson (1979) was the first who established a microeconomic foundationfor the gravity model. In Andersons theory the goods are differentiated by theirorigin. However, Andersons model was not really recognized by tradeeconomists (Head & Mayer 2013). The next theoretical foundation of the gravityequation set by Bergstrand (1985, 1989) who developed a connection betweenendowment factors and the bilateral trade model. Bergstrand (1989) shows thatthe gravity model is a practical example of the monopolistic competition theory asdeveloped by Krugman in 1980.


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The renowned work of Anderson and Van Wincoop (2003) gravity withgravitas has successfully laid the theoretical foundation of the gravity equation

and has been completed by many other researchers. Principally, the Anderson andVan Wincoop (AVW) gravity model originated from a demand function. The

structure of the model was based on the final formula of the constant elasticity ofsubstitution equation for consumer preferences. Consumers have love of variety,

by consuming a greater variety of goods, the overall utility increases. The secondassumption of the AVW gravity model follows Krugmans (1980) productionfunction; under the condition of increasing returns to scale, each firm producesone particular product. The large number of firms diminish the competition, the

price is constant and can cover firm the firms marginal costs and fixed costs. Ininternational trade, trade costs regularly occur and become somewhat of a barrier.

The AVW model shows the importance of controlling relative trade costs.Their results indicate that bilateral trade is influenced by relative trade cost.Country j imports from country i and must pay a price which is influenced by the

weighted average trade cost being paid to all other trading partners. Thederivation of the AVW model can be seen in the appendix. The cross sectionalgravity equation by AVW is summarized below :

.........(3.3)

Taking the logarithm on both sides:

ln

l n

+ l n

l n + 1 l n

....(3.4)

where is the trade value from country i to j, and represents the worldGDP. is the GDP of country i, is the GDP of country j, denotes theelasticity of substitution and represents trade costs. Two important features ofthe AVW model is the two additional variables, and . is called theoutward multilateral resistance, and is called the inward multilateral resistance.The outward multilateral resistance denotes the exports from country i to country

j depending on trade costs across all possible export markets. The inwardmultilateral resistance denotes the imports into country i from country jdepending on trade costs across all possible suppliers (Shepherd 2013). Generally,

these figures are low if a country is isolated from world market (Bacchetta 2012).Inward multilateral resistance is also called the price index and outwardmultilateral resistance is called competition (Fally 2012).

Trade Cost

Trade costs are an important feature that determines many other elements ofinternational trade. On the firm level, the term `trade cost is used to explain whythe firms pay great attention to their costumers location and why some firmsdecide not to reach out to buyers in other countries. Trade costs become animportant consideration in a firms decision to export because they are a major


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factor in diminishing export profits. (Krugman et al. 2012). A graphicalillustration of trade costs at the firm level can be seen in Figure 5 below.

Figure 5 Firms Decision to Export based on Trade Costs

It is assumed that the firm must set an extra cost (t) for every unit of outputwhich it sells to the buyer through the countrys border. The firms behavior in thedomestic and export markets are analysed separately. Accordingly, the firm willset a different price for the domestic and export markets, this will lead to the

difference in profit due to the quantities sold in each market. Taking intoconsideration that the firms marginal cost is constant, the firms decision to sellin domestic market will have no effect on the export market in terms of pricingand quantity sold.

There are two assumption that need to be considered for explain trade cost:First, there are two firms that both exist in the home country, and second, bothcountries are identical in consumer preference and technologies. Both firms facea similar demand curve in the foreign country as well as in the home country. Themarginal cost in the foreign country is higher than in the home country, the lineshifts upward from c1 to c1+ t for Firm 1 . For Firm 2, the cost shifts upwardfrom c2 to c2 + t. In accordance with a previous explanation, the higher the

marginal cost, the more a firms is encourage to raise its price, further reducing thequantity sold, and thus lowering profits. If the marginal cost is higher than c*, thefirm cannot operate effectively in that market due to a loss in profitability.

Figure 5 shows that firms 2 is able to operate effectively only in thedomestic market, because its costs are below c* (c2), but in the export market, thecost is higher than c* (c2+ t > c*). Contrary to Firm 2, Firm 1 is able to operateeffectively in both the domestic and export markets because its cost is lower thanc* (c1+ t < c*). The extended explanation is applied to all firms based on theirmarginal cost ci. The firms with the marginal cost lower than c* (ci< c*- t) willexport, the higher cost firms with c* - t < c i< c* will still operate in the domestic

market but will doing export, the firms which have highest cost with ci >c* are

source : Krugman,et al. ( 2012)

c2

Quantity

MC1

b. Export (Foreign) Market

c2+ t

c2

c

c1+ t

D

c*

c1

Cost (C),Price ( P)

Quantity

D

a. Domestic (Home) Market

MC2

c*

Cost (C),Price ( P)


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not able to operate in either market and will eventually quit (Krugman, et al.,2012).

The presence of trade costs in the gravity equation are modelled as icebergcost. This term is used to explain that not all of goods that are shipped will arrive

at the destination. The goods that do not arrive at the destination are considered tohave been lost (or melted) in transit. Definitely, if the CIF value is used tomeasure imports, trade flows are reduced by transport costs (Bacchetta 2012).Following the Anderson & Van Wincoop (2003) model, Shepherd (2013) hasderived the trade cost equation from the firm`s marginal cost equation :

...(3.5)where shows the variable cost, represents the wage rate, represents

country, and

denotes the firms sector. The terms in brackets are a constant

markup within the sector, because the numerator must be larger than thedenominator. Thus, there will be a positive wedge between the price at the firmsfactory gate and its marginal cost. Since the wedge is influenced by the sectoralelasticity of substitution, it remains constant for all firms within the sector.

This is true when a firm ships goods from country i to country j, it must

send 1 units in order for a single unit to arrive. The difference is seen asmelting (like an iceberg) towards the destination. At the same time the marginal

cost of producing one unit of a good in country i that is subsequently consumed in

country i is, but if the same product were to be consumed in country j thenthe marginal cost is instead . Hence, costless trade gives 1, and corresponds to one plus the ad valorem tariff rate. Since the size of the tradefriction associated with a given iceberg coefficient does not depend on thequantity of goods shipped, the iceberg costs are treated as variable (not fixed)costs.

Using two countries i and j, the incidence of iceberg trade costs occuringmeans that the price of goods in country j that are produced in country i isdetermined as follows :

....(3.6)

In a more general form, a countrys price index it can be written as follows:

....(3.7)

In the above equation, the index includes varieties in goods that are

produced and consumed in the same country: each terms is set to a point ofunity, that can indicate the absence of internal trade barriers.

Palm oil as a strategic commodity has high value in international market.Palm oil has many advantage rather than other vegetable oil such as cheaper price


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and high yield. Palm oil trade flow is affected by the establishment of free tradeagreements in the Southeast Asia region. The extension of economic cooperationwith several countries such as China (2005), Korea (2007), Japan (2008), India(2010) and Australia/New Zealand (2010) has made significant changes to the

bilateral trade flow for crude and refined palm oil. As a largest producer andexporter, Indonesia and Malaysia has different way to utilized the trade agreementto raise their own market and profit. The operational framework of this study can

be seen on Figure 6.

Figure 6 Operational Framework

4. RESEARCH METHODOLOGY

This chapter gives a brief description of the material concerning themethodological aspect of this research. First, the description regarding data typesand sources used in this study is given. Second, the estimation technique of the

gravity model is discussed and finally is the explanation of the modelling for the

Agriculturesector

Change Flow of Trade and Services Palm Oil(Crude & Refined)

Indonesia and Malaysiaas Major Exporter

Analyzed by gravity model of trade. The variable are :

1. Palm Oil Production Value2.

GDP of importer country,

3. Exchange rate PPP of importer country4. Distance5.

Dummy FTA

Policy recommendation in order to utilized FTA to

increase economic benefit of alm oil

Panel Data RegressionFixed Effect OLS and PPML estimation

Southeast Asia Region free trade agreement (AFTA) andpartnership with other neighboring countries such as :China (2005), Korea (2007), Japan (2008), India (2010),Australia/New Zealand (2010).

Economic Integration(Regional Trade Agreement)

International Trade

DestinationCountry

Export trend

Descriptiveanalyzes


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palm oil trade. The goal in this chapter is to utilize the gravity trade model foranalyzing the impact of regional trade agreements to the international palm oiltrade flows.

Data Types and Sources

This study uses secondary data available from various sources. The bilateral

trade of palm oil annual data from the period between 1991 and 2011 has been

generated from the United Nations Commodity Trade Statistic Database (UN

COMTRADE) and further incorporated with the World Integrated Trade Solution

(WITS) software. The data consists of a nominal value of bilateral trade from

Indonesia and Malaysia to 77 partner countries that have conducted trade more

than ten times within the 21 year period. The total palm oil and its fraction which

has Harmonized System (HS) code: 1511 differentiated into crude palm oil, HS

code: 151110 and refined palm oil but no chemically modified HS code: 151190.The geographical distance between countries was obtained from the Centre

dEtudes Prospectives et dInformations Internationales (CEPII), crude oil price

obtained from three sources, they are Dated Brent, West Texas Intermediate, and

Dubai Fateh, the GDP of importer countries and the exchange rate of Purchasing

Power Parity (PPP) data came from the World Bank, along with FTA information

from the Asia Regional Integration Centre (ARIC). The value of palm oil

production is generated from the FAO.

The Gravity Estimation Analysis

The gravity model estimation is utilized to analyze the research question ofwhether the regional trade agreement influences trade flow or not. The softwareused for the data processing in this study is STATA 12.

Ordinary Least Squares: Fixed Effect Estimation

Ordinary Least Squares (OLS) estimation has been widely used to estimatethe gravity equation. The basic form of the multiplicative gravity model is asfollowing:

()

()

....(4.1)Taking the natural logarithm, the baseline a log linear gravity model is as

follows:

ln + ln + ln + 3 ln + 4 + (4.2)where denotes the export value from country i to j, subscript i refers to

the exporter, while subscript j refers to the importer, D denotes the distancebetween countries and FTA is a binary variable assuming a value of 1 if i and j

has a free trade agreement and 0 otherwise,

is the error term.


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The objective of OLS is to obtain the value of by minimizing the sum ofsquare errors (Gujarati, 2011) The OLS estimation has to fulfill the followingcriteria to become the best and efficient estimator :

a.

The error term () must follow a normal distribution with zero mean andmust also be uncorrelated to the explanatory variableb. The variance of the error term must remain constant (homoskedastic)c. There must be no perfect linear relationships among explanatory variable (no

multicolinearity assumption)

If all three properties are fulfilled, then the OLS estimator is consistent,unbiased, and efficient. A consistent estimator means that the OLS coefficientestimation converges to population value when the sample size increases,unbiased means that the estimators are equal to their true values, and efficientmeans that there is no other estimation than OLS which has a minimum variance

of standard error.Furthermore, the use of panel data and panel econometrics in the gravity

model show an increasing trend. According to Baltagi (2009), panel data cancontrol individual heterogeneity, give more informative data, give a strongerdegree of freedom and efficiency, and is less likely to have problems withautocorrelation and multicolinearity than time series data. Panel data also dealswith time invariant omitted variable.

There are two estimation techniques for panel data, the fixed effect (FE) andrandom effect technique. The fixed effect model assumes that individualheterogeneity is captured by the intercept term which means that every individual

has his own intercept

while the coefficients along the slope remain the same.

The fixed effect is also known as the Least Square Dummy Variable due to theuse of a dummy variable (Gujarati, 2011). The fixed effects model has been usedin the majority of gravity estimation studies over the last decade and tends to

provide better results (Kepaptsoglou, et al., 2010).Concerning the unobservable multilateral resistance terms (MRTs), the

fixed effect technique can be used to control these MRTs1. Anderson and VanWincoop (2003) emphasized that the MRTs should be taken into account in orderto avoid a biased estimation of the model parameter. Fixed effect is applied by putthe dummy of country specific and country pair into the estimation. Countryspecific dummy variables are used to capture all of the time invariant individualeffects of exporters and importers that are excluded from the model specificationsuch as preferences, institutional differences, etc. Country pair dummies are usedto address the bias due to the correlation between the bilateral trade barriers andthe multilateral resistance. Furthermore, the time dummy variable will take intoaccount to control for macroeconomic effects such as the global economicrecession. The equation considering individual country specific effects, country

pair effects and time effects is specified as:

ln + ln + ln + 3 ln + 4 + + + + + .......(4.3)1.

From Martinez-Zarzoso (01/13/2014), lecture slides on Empirical Trade Issues, University of Goettingen p. 10


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where denotes export value from country i to j at time t, stands forthe fixed effect of country i (exporter fixed effects), represents the fixedeffect of country j (importer fixed effects),

denotes country pair fixed effects,

and refers to the time effect.According to Baier and Bergstrand (2007), one important econometric issuethat arises when estimating the impact of FTAs is endogeneity. The problem

arises due to the correlation between FTAs terms with the error term ). Manyresearchers wrongly assume that the FTAs is an exogenous random variable(Yang & Martinez-Zarzoso 2013), for example, a countrys decision to join atrade agreement is not related to unobservable factors. Following the hypothesesof natural trading partner as proposed by Krugman (1991), the countries preferto have trade agreements with partners who already have high value trade. Baierand Bergstrand (2007) also noticed that the FTA is not the only cause of bilateral

trade, but other unobserved factor such as non-tariff barriers, democraticrelationship, infrastructure and institutional characteristics also play a role. Theresearch by Baier and Bergstrand (2009) verified that a countrys decision to

join an FTAs depends largely on their economic size and the difference in factorendowments.

The endogeneity problem can be solved in several ways. Baier andBergstrand (2007) argue that instrumental variable can be applied to solve theendogeneity, but it is not easy to find appropriate variables for FTA. They suggestusing country-and-time effects and country pair fixed effects. Baldwin andTaglioni (2006) suggest that applying time varying country dummy variables cancounteract the endogenous bias, Martnez-Zarzoso et al. (2009) suggest using

country specific dummy variables in cross sectional data and bilateral fixed effectsto remove the endogenous bias.

Poisson Pseudo Maximum Likelihood Estimation

Several things need to be taken into consideration when using the gravitymodel to analyze disaggregated data, the first being the presence of zero trade. Insectoral trade, zero values appear more frequently than with aggregate data. Thereare two possible causes for zero trade, first, the high cost of transport due toexcessive distances and trading partners having small economy. Second, are the

consequences of firms self-selecting to export to a particular destination due tohigh fixed costs (Bacchetta 2012).

The zero value will automatically be dropped when using the OLS method,the implication of dropping the zero is that the useful information will be lostwhich will further lead to inconsistent result (Bacchetta 2012). There are threemain approaches to dealing with zero trade. The first option is an ad hoc solutionwhich is done by adding a small value (0.0001) to the trade data, so the zero isdefined by log (0.0001) and then the tobit estimation is used after this process.However, the ad hoc solution has no basic statistical theory. The secondcommonly used approach is the Poisson model, and the third is the Heckmanmodel.


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The Poisson Pseudo Maximum Likelihood (PPML) method was introducedby Gourieroux et al. (1984) and is commonly used for the count data model. Themost influential research concerning the use of PPML as a tool for estimating thegravity model was conducted by Santos Silva and Tenreyro (2006). They argued

that the log linear transformation result in an inconsistent bias in the presence ofheteroskedasticity, the result from the PPML estimation will provide better result

by including the zero value rather than truncating OLS.The PPML estimator has several properties which are desired for analyzing

the impact of policies (Shepherd 2013). First, it is consistent with the existence offixed effects; second, the Poisson estimator will include zero value observations,and third, the interpretation of the PPML is directly follows the OLS. Thesubsequent research by Santos Silva and Tenreyro (2011) shows that the PPML isconsistent and performs well in the presence of over dispersion (the conditionalvariance is not equal to the conditional mean) and excess zero values. The use ofPPML and Poisson family regression models such as the zero-inflated poisson

model, (ZIPPML), negative binominal model (NBPML), and zero-inflatednegative binominal model (ZINBPML) in disaggregate data, especially in singetrade commodity has increased. Following Burger et al. (2009), the assumptionfor bilateral trade flow between countries i and j has a Poisson distribution with

the conditional mean , which is a function of the independent variables. As is assumed to have a non-negative integer value, the exponent of the independent

variable is captured in order to assure that is zero or positive. The PPMLestimation takes the following form:

Pr[] ()

! , 0, 1, 2, ....(4.4)

where the conditional mean is connected to an exponential function of agroup of regression variables, exp + + + ) .....(4.5)

where is constant, is the 1 x k row vector of the explanatoryvariables that correspond to the parameter vector which represents trade

barriers,

is the exporter effect,

is the importer effect. The assumption of this

model is equi dispersion; the conditional variance of the dependent variable isequal to its conditional mean.

Sun and Reed (2010) was the first author who applied PPML on the effectof FTAs with disaggregated data for agriculture commodities. The result of PPMLis superior to the OLS result. Following Sun and Reed (2010), the empiricalmodel is specified as:

exp{ + ln + ln + 3 ln + 4 + + + + + }......(4.6)


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where denotes the export value from country i to j at time t, standsfor the fixed effect of country i (exporter fixed effect), represents the fixedeffect of country j (importer fixed effect), denotes the country pair fixedeffect, and

refers to the time effect.

The Regression Specification Error Test (RESET)

Ramsey (1969), introduced the regression specification error test (RESET)to check the significance of the regression of a residual on a linear function. Thisis done by assuming an approximation vector of mean residuals from the least-squares estimate of the dependent variable and a ranking of the squared residuals.RESET then basically checks whether the regression of the residual vector againstits rank is significant or not. This is why this test is also famously known as a rankcorrelation test.

RESET is generally used to test the specification of a linear regression

model by examining whether or not a non-linear combination of the fitted valuescan help with explaining the dependent variable. If the non-linear combination ofthe dependent variable is statistically significant, then the model is misspecified.The model is explained with the following equations:

| .....(4.7)The RESET Ramsey test then examines whether ,3,.., has

any influence on . This is performed by estimate the equation as follows:

+ +. . .+ + .....(4.8)afterwards, the significance of through is determined through the

use of an F-test. The null hypothesis is that the coefficient is equal to zero. Ifthe null hypothesis is rejected, then the model suffers from misspecification.

Econometric Modelling of International Palm Oil Trade

Estimating the gravity model for a single commodity can lead to biasedestimations if the GDP of exporter countries are used as a proxy for the economic

size of the exporter. Therefore, the production value of palm oil is usedin this study as a proxy for the exporters economic size. In order to examine theimpact of free trade, the dummy variable (FTAs) is divided into two parts one

before and one for after the year 2000. The main reason for splitting up thedummy variable is the proliferation of FTAs for both Indonesia and Malaysiaafter 2000, which have become more significant and has additionally expandedwith the countries located in Asia region. The list of FTAs can be seen in Chapter5. The gravity model of international palm oil takes the following form:

ln Yij + lnProdi + lnGDPj + 3 ln Dij + 4FTAs_early_MYSij +5FTAs_after_2000_MYSij + 7FTAs_early_IDNj +

8FTAs_after_2000_IDNj + 9lnppp_cnvrt j + ij + i + j ++ ij....(4.9)


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exp{ + lnProdi + lnGDPj + 3 ln Dij + 4FTAs_early_MYSij + 5FTAs_after_2000_MYSij + 7FTAs_early_IDNj +

8FTAs_after_2000_IDNj + 9lnppp_cnvrt j + ij + i + j ++ ij}....(4.10)Where

Yij = annual palm oil export from i to j at year t in US$Prodi = annual palm oil production value of i at year t inUS$GDPj = annual GDP of importer country (j) at year t in US$ = economic distance between countries in US$

ppp_cnvrtj = exchange rate variable, the ratio of the PPP

conversion factor over the exchange rate. PPPconversion factor describe the rates to which pricesof a typical of goods and services in differentcountries differ from the ones in the US. PPP incountry j at time tFTA_early_IDNij = Dummy variable for FTAs which established beforeyear 2000, 1 if Indonesia as an exporter and havesigned an agreement with importer country (j) and ineffect at year t, otherwise 0FTA_after_2000_IDNij = Dummy variable for FTAs which established afteryear 2000, 1 if Indonesia as an exporter and havesigned an agreement with importer country (j) and ineffect at year t, otherwise 0FTA_early_MYSij = Dummy variable for FTAs which established beforeyear 2000, 1 if Malaysia as an exporter and havesigned an agreement with importer country (j) and ineffect at year t, otherwise 0FTA_after_2000_MYSij = Dummy variable for FTAs which established afteryear 2000, 1 if Malaysia as an exporter and havesigned an agreement with importer country (j) and ineffect at year t, otherwise 0

With the above setting thus we expect positive sign for the coefficient ofimporters GDP and the coefficient of palm oil production. This means that theexport of palm oil will increase as long as there is growth in economy. Thedistance variable is expected to have negative sign because it is considered astrade barrier. The further destination country the less export quantity is expected.FTAs dummy variable is expected to have positive sign since the commencementof FTAs is meant to reduce trade barriers.


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5. OVERVIEW OF PALM OIL INDUSTRY AND FTAs IN

SOUTHEAST ASIA

History and Policy

Palm oil trees was first planted in the Bogor botanical garden in 1848. Later,in 1911, the Dutch colony set up the first large scale palm oil plantation in Deli,Sumatra. Looking at the progress of these seeds, the British traders also set up

palm oil plantations in Malaysia. Due to the second world war, when Indonesiagained its independence in 1945, Dutch plantation owners had no longer hadsupport from the Dutch colony which leads to the collapse of several plantations.Production declined further as the former Dutch colonys plantations weretransferred to the New State Plantation Company (Perusahaan Perkebunan

Baru) in 1957. The Indonesian government started more palm oil plantationsthrough state owned companies until 1968. In 1978, the Indonesian government

took the initiative to involve small farmers by introducing the PIR (PerkebunanInti Rakyat) or NES (Nucleus Estate and smallholder scheme) and various otherorganizations intended to encourage further establishment of palm oil plantations(Zen et al. 2006).

Accordingly, the government, or private owned, plantation (called Inti)planted palm oil trees and within three to four years the planted area wastransferred to the smallholder farmer this was called the plasma. During these

three to four years, farmers were actively working on the plantation. After the treeproduction, Inti had to purchase the Fresh Fruit Bunch (FFB) from the plasma andthen deduct the harvesting fund paid for the area transferred to the plasma. The

private plantation investment increased significantly after the Indonesia economiccrisis in 1997-1998. In 2001, the NES system was terminated, only the stateowned enterprise and private companies managed the plantation. (Zen et al. 2006).

In 1917, palm oil was established on a commercial level in Malaysia,however, this remained relatively unknown by the rest of the world until the1950s. From the 1950s to 1960s due to the nationalization of the palm plantationin Indonesia and the crisis in the Congo as the leading producer palm oil at thattime, the Malaysian palm oil industry grew significantly (Rifin, 2010). Majorcompanies including Unilever started to invest in Malaysia rather than inIndonesia. The government of Malaysia introduced the Federal LandDevelopment Authority (FELDA) in 1961 for managing oil palm plantation

(Rasiah & Shahrin 2006) FELDA has set the different scheme during severalyears. Malaysias government took control of the foreign palm oil company bybuying the companys share during 1970s until 1980s. The Industrial Master Plan

(IMP) was introduced by the Malaysian government in 1985 where its goal is toregulate the palm oil refining and fractionation in order to increase efficiency andcompetitiveness in the world market (Rasiah & Shahrin 2006). IMP I caused the

processing capacitys exceeded the supply of CPO. Hence, in 1996, Malaysian

government introduced the IMP II. It focused to increase the value added ofdownstream industry through focusing in biotechnology. Also, it encouragedMalaysian firms to seek raw material in the form of Crude Palm Oil from othersource, especially Indonesia. Malaysian companies acquired more than 1.3

million Ha of oil palm are in Indonesia in 1999 (Rasiah & Shahrin 2006).


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The difference between Malaysia and Indonesia policy is the Malaysia hasexport orientation policy, while Indonesia focused on the domestic consumption(Rasiah & Shahrin, 2006). One of the strategies for support the Malaysian palmoil export is the internationalization of its company. The Malaysian companies

has joint venture scheme in several developed and developing countries mainly inpalm oil refining and the downstream industry (oleochemical). Within themember of ASEAN, Malaysia has built the palm oil refinery factory in Thailandin 1981 and in Vietnam in 1995.

Plantation Area and Production

The oil palm plantation area in Indonesia was approximately 70,000hectares (ha) in early 1960, and then the plantation area had increasedtremendously reaching roughly 8 million ha in 2010. Half of the plantations arelocated in the Sumatra, 27% in Kalimantan (Borneo) and 23% in other areas. The

ownership of plantation area are divided into three groups: state owned enterprises,private companies, and smallholders. According to Indonesian Ministry ofAgriculture (MOA), 54% of total palm growing area is owned by privatecompanies, 38% by smallholders, with the state enterprises operate the remaining

by 8% in 2010. The large availability of land positions Indonesia as the top palmoil producer. In line with the expansion of the production area, the palm oil

production volume has grown from 150,000 tons in 1961 to 23 million tons in2012 (FAO 2013). Along with having the greatest proportion of the growing area,

palm oil originated from the Sumatra Islands contributes 65 percent of the totalproduction in Indonesia. Indonesias palm oil plantation area and productionvolume can be seen in Figure 7.

Figure 7 Indonesias Palm Oil Plantation Area and Production Volume

In early 1960, the oil palm plantation area in Malaysia was approximately

55,000 hectares (ha), it is had increased tremendously to 3.8 million ha in 2010.

0

5

10

15

20

25

1961

1963

1965

1967

1969

1971

1973

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

2011

Millions

Year

Indonesia`s Palm Oil Plantation Area and Production Volume

Harvested Area (ha) Production (tons)

Source : Authors elaboration with data from FAO, 2013


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0

2

4

6

8

10

12

14

16

18

20

1961

1963

1965

1967

1969

1971

1973

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

2011

Millions

Year

Malaysias Palm Oil Plantation Area and Production Volume

Harvested Area (ha) Production (tons)

Source : Authors elaboration with data from FAO, 2013

According to the Malaysian Ministry of Plantation Industries and Commodities,60% of the total palm oil plantation area is owned by private companies, 25% bystate enterprises, and 15% by the smallholders. Along with the expansion of the

production area, the palm oil production volume has grown from 94,000 tons in

1961 to 18.7 million tons in 2012 (FAO 2013). Malaysias palm oil plantationarea, and their production volume can be seen in Figure 8.

Figure 8 Malaysias Palm Oil Plantation Area and Production Volume

According to world agricultural outlook 2014 release by OECD and FAO,the average of palm oil production from Malaysia and Indonesia is expected togrowth by 2.9 percent per year. The slow growth of palm oil production is caused

by the environmental issue and high labor price as a constraint. The palm oilcultivation use 5.5 percent of global land and produced 32 percent of worldvegetable oil production.

Palm Oil Export and Import

The export of palm oil is classified into two groups: crude palm oil (CPO)and refined palm oil (RPO). In 1991, the proportion of CPO exports in Indonesiawas 92 percent. However, the share has decreased to 31 percent in 2013. Incontrast with CPO, the proportion of the RPO export increased from 8 percent to68 percent between 1991 and 2013. On the other hand, the proportion ofMalaysias CPO export was 2 percent in 1989, and increased to 24 percent in2013. Furthermore, the share of RPO export was 98 percent in 1989, the sharedecreased to 76 percent in 2013. The overall performance for Indonesias andMalaysia`s palm oil exports to the world market are shown in Figure 9.

For both exporter, the trend of export is fluctuated between the period from

1991 to 2013. The export of RPO and CPO tend to increase after year 2000. The


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0

2

4

6

8

10

12

14

16

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

US$

Billions

Palm Oil Export by Type

IDN,Crude IDN,Ref MYS, Crude MYS, Ref

Source : WITS, Integrated Data Warehouse (acessed December 1, 2013)

demand from palm oil was decline sharply in 2009 due to the global financialcrisis. The average growth of palm oil export during the observation period reach

by 24 percent for Indonesias export and 14 percent for Malaysia. Figure 8 alsoshows that the value of Malaysian RPO has higher value than Indonesian RPO,

this is one of example that the export of raw material has lower price thanprocessed one. The palm oil proportion in world vegetable oil export is predictedto reach 36 percent for Indonesia and 26 percent for Malaysia in 2023 (OECD-FAO 2014). Palm oil has competitive price compared to other vegetable oil ininternational market. The price of crude palm oil reach US$ 850 per ton while thesunflower oil reach US$ 1200 per ton.

Figure 9 Indonesias and Malaysias Palm Oil Export Performance

On the demand side, the palm oil consumption ranked first in the world fortotal vegetable oil consumption. In 2011, the proportion of palm oil consumptionreached 32.8 percent, followed by soybean oil (28.4%), rapeseed oil (16%) andsunflower oil (8.6%). Approximately more than half of all palm oil has beenconsumed for food products such as cooking oil, shortening, and margarine.While the rest has been used for industrial products such as chemicals ingredient

for soaps, detergents, toiletries, cosmetics, and candles soaps, detergents,toiletries, cosmetics and candles. The recent use of palm oil is for animal feed andfuels. The palm oil demand is projected from 51 million tons in 2012 to 75 milliontons in 2050 (OECD-FAO 2013). In 2012, the major importers of palm oil wereChina (16%), India (22%), the EU (13%) and the ASEAN countries (13%). Theincreasing per capita income is predicted to rise the vegetable oil consumption as1.3 percent in developing country. In 2023, the annual vegetable oil per capitaconsumption reach by 20.23 kg, while in developed country, per capitaconsumption reach 24-25 kg. Palm oil consumed by three billion people over 150countries. European Union counted as major palm oil consumer followed byIndonesia, China and India. Internationally, the use of palm oil as a source of

biodiesel production is projected to increase to 28.8 Million tons in 2023, or 50


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percent increasing from 2013. The palm oil importer countries can be seen inFigure 10.

Figure 10 Palm Oil Importer 2012

The International Oil Palm Production Chain

Currently, huge amount of palm oil are consumed all over the world. As aningredient of various products which made by large number of firms, palm oil

has complex production chain. To ensure the supply of palm oil reach industriesand their customers, an integrated world palm oil supply chain has been built overthe year. Figure 11 shows the supply chain of world palm oil production.

According to Figure 11, the first stage is the plantation which producedFresh fruit bunches (FFB). After harvesting, the FFB have to processed directly toCPO mill to avoid fast accumulation of free fatty acids. In the CPO mill, the fruitis automatically milled to extract Crude Palm Oil (CPO), and the kernel is sent toa crushing plant. Palm kernel oil has different chemical composition with palm oil.Palm kernel crushing plant can be found both in producer countries or consumercountries. The next stage of palm kernel crushing process produce Palm KernelOil (45%) and Palm Kernel Meal (55%).

Furthermore, the crude palm oil and palm kernel oil is processed inrefineries which can be located outside producer countries. There are three main

processes are taken in refinery, they are neutralisation, bleaching, and deodorizing.Neutralisation is carry out to eradicate free fatty acids which can cause the sourtaste of oil. The main goal of bleaching is to removes the colour and thecontamination. The last process is deodorizing which is use to get ride of any tasteand smell in the oil. The refinery process resulting refined, bleached anddeodorized palm oil (RBDPO) which is use in industry as cooking oil to cookchips, instant noodles, crisps and other snack foods. RBDPO is also the ingredientof shortenings, ice cream, condensed milk, soap and other products.

Africa

12%ASEAN

13%

China

16%

EU27

13%

India

22%

Middle East

5%

America

3%

Asia + Oceania

12%

ROW

4% Palm Oil Importer 2012

Source : Authors elaboration based on data from UN COMTRADE, 2013


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Source : Van Gelder (2004)

Figure 11 Overview of the Oil Palm Production Chain

The next step of palm oil refineries is fractionating of refined palm oil. Theresult of this process is palm olein and palm stearin. Both parts are used fordifferent final products. The fractionation process also applied for palm kernel oil

before it reach the final user. Some part of RBDPO are break down into theirchemical component in oleochemical plant. Hence, the main process in theoleochemical industry is to break up the triacylglycerols in separate fatty acids aswell as glycerine which can be used in various industries sector such as

pharmaceuticals, perfumery, food emulsifiers, cosmetic, etc. In 2000, the totalproduction volume of basic oleochemical reach 6.3 million tons, of which 36percent were produced in the ASEAN countries (2.3 million tons).

Current Status of FTAs in Effect in Southeast Asia

Formerly, Association of Southeast Asian Nations (ASEAN) was formed on

Bangkok in 8 August 1967, with the initial member are Indonesia, Malaysia,Philippines, Thailand, and Singapore. One of the objective is to accelerate theeconomic growth, social progress, and cultural development among its member.The main member of ASEAN is increased by the joining of Brunei Darussalam in1984, Vietnam in 1994, Cambodia, Lao, and Myanmar in 1995.

The ASEAN Free Trade (AFTA) agreement itself was established in 1992with focused on food commodity, energy, industrial cooperation, and regionaltrade. The network of AFTA member countries has grown steadily since. One ofthe major milestones for FTAs occurred in 2008 when the total effectuatedcountries reached 30 nations (Table 1). The FTA network was further enlargedthrough its integration with AFTA (This development would lead ASEAN to

become an important hub of FTA networks in Asia. Non-ASEAN countries such


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as Japan have both multilateral and bilateral FTAs with each ASEAN country.Furthermore, ASEAN member countries can have both multilateral and bilateralFTAs with many other countries in Asia, for example Singapore with Japan,Korea, China, New Zealand and India. The list of FTAs that all already enforced

can be seen in Table 1.The reason behind the establishment of AFTA is to facing worlds economy

uncertainty in early 1990. At that time the uncertainty caused by majority ofcountries could not reach an agreement in Uruguay Round, the establishment ofEuropean Union and NAFTA, and the polarization of economic force in UnitedState, Europe, and Japan. AFTA is important to raise economic growth and toreach the welfare among its members. Considerable economic union size isimportant to strengthen the influence in international level. Southeast Asia is theregion which has dynamic and rapid economic growth in the world and becomemain trade partner of developed nation. AFTA is expected to give a contributionin world forum regarding global economy situation.

AFTA has expand its partnership mostly with countries located in easternpart of Asia (China, Japan, South Korea). Historically, trade relation began beforethe world war II event. ASEAN+3 was signed on 4 November 2002 in PhnomPenh. Likewise, the trade agreement with ASEAN neighboring countries such asIndia, Australia, and New Zealand is come afterward. Some of AFTA member hassigned bilateral trade agreement with a countries mentioned above, for exampleSingapore, Thailand, and Malaysia.

Free trade agreements (FTAs) in the Southeast Asia region have a largeimpact on palm oil trade in Indonesia and Malaysia. Palm oil is a product that isalways traded without tariffs in the ASEAN region. Palm oil always include tothe reduction of tariffs. According to Shiino (2012), palm oil is listed as a mayoritem which utilizing FTAs in Malaysia. From the tariff elimination schedule as

presented in Table 2, six original members of ASEAN (Thailand, Indonesia,Malaysia, Philippines, Singapore and Brunei; or ASEAN6) had already eliminatedtariffs on 99 percent of tradable products by 2010. Meanwhile, the other four newmembers (Vietnam, Cambodia, Laos and Myanmar) will eliminate their tariffsgradually through 2015. The progress has been sufficient; for example, Vietnamcurrently has eliminated about 80% of its tariffs, with other countries havingreached approximately a 60% elimination rate. It is important to keep in mind thatASEAN6 has established a unique set of guidelines for AFTA members (allASEAN countries plus China, South Korea, Japan, Australia, New Zealand and

India) because the ASEAN6 had lowered the tariffs of their tradable items prior tothe establishment of AFTA. Countries in this region will continue lowering tariffsgradually, with the task being projected to be finished in 2020 (Shiino 2012).


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Table 1 Major FTAs in Effect in the Asia-Pacific Region

FTA Signed and in effect

Australia-New Zealand January, 1983

Laos-Thailand June, 1991AFTA January, 1993Singapore-New Zealand January, 2001Japan-Singapore November, 2002Singapore-Australia July, 2003ASEAN-China January, 2005Thailand-India September, 2004Thailand-Australia January, 2005Thailand-New Zealand July, 2005Singapore-India August, 2005Singapore-South Korea March, 2006

Trans-Pacific Strategic EconomicPartnership Agreement

May, 2006

Japan-Malaysia July, 2006ASEAN-South Korea June, 2007Japan-ThailandPakistan-Malaysia

November, 2007January, 2008

Japan-Indonesia July, 2008Japan-Brunei July, 2008China-New Zealand October, 2008ASEAN-Japan December, 2008Japan-Philippines December, 2008Singapore-China January, 2009Japan-Vietnam October, 2009ASEAN-Australia-New Zealand January, 2010ASEAN-India January, 2010South Korea-India January, 2010Malaysia-New Zealand August, 2010Hong Kong-NZ January, 2011Malaysia-India July, 2011Japan-India August, 2011Source: Shiino (2012)


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Table 2 Status of AFTA and ASEAN+1 FTAs

FTAStatus/Tariff Reduction and Elimination

Schedule

ASEAN (AFTA) Tariff reductions have been adopted bysome ASEAN members (Thailand,Malaysia, Indonesia, the Philippines, Bruneiand Singapore); meanwhile CLMVcountries (Cambodia, Laos, Myanmar andVietnam) will join later. The goal is toeliminate tariffs on almost all items by2015.

ASEAN China Starting in 2004, efforts to implement FTA

regulations have been applied foragricultural and fishery products. Non-agricultural/fishery products were includedstarting in July 2005. China and the originalASEAN members have eliminated tariffs onabout 90% of items; meanwhile CLMVcountries will eliminate tariffs on nearly allitems by 2015.

South Korea Starting in 2010, South Korea and theoriginal ASEAN member countrieseliminated tariffs on about 90% of items.

While CLMV countries will start toeliminate their tariffs beginning in 2016

Japan The process is still under ratification forsome countries, but Japan already has

bilateral FTAs in effect with Singapore,Malaysia, Thailand, Indonesia, Brunei, thePhilippines and Vietnam.

Australia NZ FTAs are already enforced for somecountries (Australia, New Zealand,Singapore, Thailand, Malaysia, Philippines,Vietnam, Brunei, Mynamar, Laos andCambodia). Other countries will join later,such as Indonesia in 2012 and CLMVcountries in 2020.

India Already enforced for India, Veitnam,Brunei, Myanmar, ASEAN and Laos;further tariff eliminations will comegradually until 2019. CLMBV (Cambodia,Laos, Myanmar, Brunei and Vietnam)countries will accomplish tariff eliminations

by 2021.

Source: Shiino (2012)


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6. RESULTS AND DISCUSSIONS

This chapter describes the trend of palm oil export and the result of thegravity estimation based on two different techniques, the OLS fixed effect (FE)

and the poisson pseudo maximum likelihood (PPML) method. This chapterorganized as the follow, first part is comparison between OLS and PPMLestimation result, and second part is PPML estimation for impact of FTA indifferent type of palm oil export, crude and refined. The separation of palm oiltype is to capture the differences between Indonesia and Malaysia palm oil

policies.

Trend of Indonesias and Malaysias Palm Oil Export

The trend of palm oil export is fluctuated between the period from 1991 to2013. Overall, the export from both Malaysia and Indonesia show an increasing

trend due to the expansion of palm oil plantation. The comparison of exportdestination countries from both exporter are analyzed as a follow.

Indonesian crude palm oil export to India ranked first in the term of exportvalue with the annual average growth rate reach by 30.16 percent from the period2000 to 2013. This result is contrary with the export of refined palm oil, while therefined palm oil export growth only 25.96 percent on the same period. India nowknown as the largest buyer of palm oil with the purchasing of crude palm valuealmost US$ 4.5 billion in 2011. The significant change is caused by theestablishment of trade agreement with the ASEAN in 2010. Another factor whichcause the high demand of palm oil is the high per capita consumption reach 15 kg

per year and the Indias population reach 1.2 billion in 2012. Majority of palm oil

consumed as household cooking oil. Currently, palm o

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