DETERMINANTS OF TRADE AND INVESTMENT IN SOUTHEAST ASIA: AN APPLICATION OF THE GRAVITY TRADE MODEL by KANWANA HEMKAMON A thesis submitted to The University of Birmingham for the degree of DOCTOR OF PHILOSOPHY Department of Economics School of Social Sciences The University of Birmingham November 2007 ABSTRACT This study is an analysis of the determinants of bilateral trade and foreign direct investment in ASEAN at the time of the establishment of ASEAN Free Trade Area and its enlargement. Beginning with an economic perspective on ASEAN and a review of the literature, the theoretical underpinning of the model is then demonstrated. This confirms that the gravity trade model can be derived from several trade theories. The model is then used to assess ASEAN’s trade pattern in both aggregate and disaggregate level. The results show that, although there is trade diversion regarding its importing activities, the positive effect of ASEAN’s trade creation is higher than the negative effect of its trade diversion. Moreover, the impact of distance is not diminishing overtime. The disaggregate model shows that the products that are not convenient to transport have high distant effect. The results from FDI model confirm that the gravity variables are significant determinants of FDI. The negative effect of proximity suggests that there is Vertical-FDI in this region and FDI is complementary to trade. ASEAN should continue facilitate trade and capital movement among members in order to increase aggregate economic activities and bring economic prosperity to the region in a whole. ii DEDICATION To my family iii ACKNOWLEDGEMENTS I would like to express my gratitude to all those who made it possible for me to complete this thesis. In the first instance, I want to thank the Department of Economics at the University of Birmingham for giving me permission to commence this thesis. I would furthermore like to gratefully acknowledge the Ministry of Foreign Affairs of the Royal Thai Government and the Office of Educational Affairs at the Royal Thai Embassy in London, both for granting me a government scholarship and providing me their fundamental support. I would like to express my deepest respect and most sincere gratitude to my supervisor, Professor Somnath Sen, for his guidance and encouragement at all stages of my work. I am also deeply indebted to Mr. Richard Barrett for his kind consideration, as well as all his assistance on the theoretical chapter. Additionally, I am thankful to Professor V.N. Balasubramanyam and Mr. Nicholas Horsewood for giving me the valuable suggestions and corrections to this work. I also wish to express my special appreciation to Mr. Antonis Georges Fotiadis for his continuous encouragement and support. I would like to thank my uncle, Watchara, and his family for their unlimited enthusiasm to assist me in several essential matters. My deepest gratitude goes to my parents, Wasana and Sawad and my brother, Kriroek, for their inspiration, understanding and unconditional love through out my life. Last but not least, I owe my warm thanks to the rest of my friends and family in Thailand for their moral support all through the period of my study. iv TABLE OF CONTENTS CHAPTER 1 : INTRODUCTION...........................................................................................1 1.1 The Motivation and Importance of the Study..................................................................1 1.2 Objectives of the Study....................................................................................................6 1.3 Scope of the Study ...........................................................................................................8 1.4 Outline of the Study.........................................................................................................9 CHAPTER 2 : THE ASSOCIATION OF SOUTHEAST ASIAN NATIONS: THE GROWTH AND DEVELOPMENT OF ASEAN ECONOMIES ...................12 2.1 Introduction....................................................................................................................12 2.2 The Establishment of ASEAN.......................................................................................14 2.3 ASEAN’s Economic Cooperation and AFTA...............................................................19 2.4 Background of the ASEAN Countries...........................................................................23 2.5 ASEAN’s Trade Performance .......................................................................................35 2.6 Foreign Direct Investment in Southeast Asia ................................................................42 2.7 Conclusions and Remarks..............................................................................................45 CHAPTER 3 : LITERATURE REVIEW: GRAVITY TRADE MODEL ........................60 3.1 Introduction....................................................................................................................60 3.2 Theoretical Foundation of the Gravity Trade Model.....................................................62 3.3 Empirical Works of International Trade Flows based on the Gravity Trade Model .....72 3.4 Empirical Works on Foreign Direct Investment based on the Gravity Trade Model..107 3.5 Summary and Conclusions ..........................................................................................112 CHAPTER 4 : THEORY OF THE GRAVITY TRADE MODEL ..................................119 4.1 Introduction..................................................................................................................119 4.2 Microeconomic Foundations of the Gravity Trade Model ..........................................123 4.3 General Condition for Gravity.....................................................................................126 4.4 Conclusions..................................................................................................................138 CHAPTER 5 : DETERMINANTS OF ASEAN TRADE FLOWS: A GRAVITY MODEL APPROACH.......................................................................................................140 5.1 Introduction..................................................................................................................140 5.2 Model Identification ....................................................................................................142 5.2.1 The Traditional Model .........................................................................................142 5.2.2 The Modified Model ............................................................................................144 5.3 Regression Method ......................................................................................................148 5.4 The Year Chosen for Empirical Estimation.................................................................149 5.5 Countries Chosen for the Empirical Analysis..............................................................151 5.6 Industrial Sector Classified for Disaggregate Model...................................................154 5.7 Other Data’s Details and Measurements .....................................................................157 (1) Trade data.......................................................................................................157 (2) GDP and GNP ................................................................................................158 (3) Population Data..............................................................................................159 (4) Distance Data..................................................................................................159 (5) Preferential Trade Relations...........................................................................161 5.8 Summary of the Models...............................................................................................164 5.9 Empirical Results.........................................................................................................166 5.9.1 Aggregate Model..................................................................................................166 v 5.9.2 Disaggregate Model. ............................................................................................172 5.10 The Distance Parameter.............................................................................................176 5.11 Conclusions and Remarks..........................................................................................178 CHAPTER 6 : THE DETERMINANTS OF FOREIGN DIRECT INVESTMENT......228 6.1 Introduction..................................................................................................................228 6.2 FDI in ASEAN and its Sectoral Pattern.......................................................................229 6.3 The Theoretical Determinants of FDI..........................................................................233 6.4 FDI and Regional Integration Arrangement ................................................................242 6.5 The Empirical Setting and Research Method ..............................................................243 6.6 Descriptions of Data ....................................................................................................248 6.7 The Empirical Results..................................................................................................249 6.7.1 Aggregate Model..................................................................................................249