By Dilip K. Das

A free trade agreement (FTA) is widely considered a win-win situation. As regards the impact of the EU-Korea FTA on the two partner economies, as Korea has higher trade barriers than the EU, greater gains are expected to accrue to the EU from the FTA.

The FTA created an opportunity for Korean firms to access the largest market in the world without trade barriers. This will be the principal source of welfare gains to the Korean economy, although absolutely unconditional market access is a theoretical concept. This deduction is logical and is premised on the fact that the Korean GDP is close to one-18th in size in comparison to that of the EU. Therefore, the EU market is far more important to Korea than the other way around.

To EU firms, the FTA provides better market access in the Korean markets. It is more meaningful for their exports in the services as well as in processed foods, meat, dairy and agricultural products.

Various empirical studies have analyzed the economic implications of the FTA. Most model-based analyses inferred that the welfare implications of the EU-Korea FTA will be positive, significant but not large. Magnitude of EU’s trade with Korea is only 2 percent to 2.5 percent of total extra-EU trade. The empirical analyses predictably concluded that of the two, the FTA will benefit the Korean economy relatively more in terms of welfare gains, while the EU only modestly.

As pre-FTA Korea has higher tariffs and NTBs in comparison to the EU, the impact of trade liberalization under the FTA will be relatively higher in Korea. For the most part EU economies will benefit from liberalization in trade in services. The miniaturization of overall welfare gains from the FTA is consistent with the fact that both the FTA partners have been highly open economies and well integrated with the global economy.

Additionally, the EU is already the largest group of 27 regionally integrated economies, which have formed an economic and political union. The two partner economies of the FTA will be influenced far more by the other factors and by other economies with which they have stronger trade and investment ties. Also, domestic factors like consumption, government spending and investment will have a large effect on them than that of the FTA formation.

Under the circumstances when the welfare impact of FTA formation is not large on the partners, one sagacious use of this instrument could be to focus negotiations on sectors. Some sectors of the economy that have entrenched protection built around them can be liberalized in FTA negotiations. Automobile is frequently one such sector in many economies, including the EU and Korea.

Macroeconomic impact

Indubitably further liberalizing trade and eliminating tariffs and non-tariff barriers (NTBs) benefits both the trading partners. That being said, gains for the EU would be modest. Empirical estimates based on computable general equilibrium (CGE) modeling, put gains to the Korean GDP in the order of 1 to 2 percent, while that for the EU in the vicinity of 0.05 percent.

Using GTAP world computable general equilibrium model, Breuss and Francois (2011) evaluated the economic impact of the FTA on the EU and Korea. Their results showed increases in total EU trade by 0.2 percent, extra-EU trade by 1.2 percent and welfare gains for the EU of merely 0.04 percent in terms of increase in the GDP. They are moderate by any measure. For Korea the gains in trade were substantive, 5.3 percent and welfare gains were 1.3 percent increase in the GDP.

It cannot be ignored that when CGE models are used to assess the welfare effect of FTAs, they tend to underestimate the dynamic role played by increased imports. They are the largest source of dynamic gains from trade. They not only provide access to a larger variety of goods and services, but also contribute to better utilization of domestic resources, which in turn improves the efficiency of resource allocation. When domestic products are forced to compete with imported products, domestic producers must behave in a more efficient and productive manner — or be extinct. These dynamic gains from an FTA are significant and are not calibrated by CGE models.

An early estimate made by Copenhagen School of Business showed an increase in real income, output and GDP in both the economies. The effect was found to be bigger for Korea, both in absolute and relative terms. This study used CGE models based on GTAP database and concluded that the EU-Korea FTA will yield a GDP increase of 1.01 percent for Korea and a modest 0.03 percent for the EU.

This result was based on less than totally free trade between the two partners. When an ambitious liberalization was considered, the Korean GDP was estimated to increase by up to 2.4 percent. The biggest gains were to come from liberalization in trade in services. The reason was that barriers to trade were assumed to be real resource costs. Liberalization in trade in services was estimated to yield as much as 2 percent gains in Korean real income.

A simulation exercise by the European Parliament estimated increases in two-way trade. EU exports to Korea were estimated to go up by 19 billion euros, which was a 48 percent increase in three years. Korean exports to the EU were found to increase by 13 billion euros, which is a 36 percent rise. Small quantitative increases are explained by the fact that for the EU business firms Korea is a small market.

Individual sectoral impact

Individual sectors will have large impact of the FTA in both partner economies. EU exporters in the following industrial sectors would increase as a result of the FTA: Pharmaceuticals, refined chemicals, auto parts, industrial machinery, electronic parts, large auto vehicles, agricultural products and processed foods. Empirical studies show strong gain for the last named sector in the EU, namely agriculture and processed foods.

An independent study conducted by IBM (in 2008) suggested substantial increases in the EU exports of cereals and beef, albeit it will not require a great deal of market adjustment in Korea because it will have taken place as a result of the Doha Round of multilateral trade negotiations. Similarly, EU exports of pork, horticultural products and processed food will also require only small market adjustments in Korea.

However, increases in EU wine and spirits exports will have trade diversion effects. Wine tariffs of 15 percent will be lifted immediately after the FTA goes into force, which will reduce Korean wine prices by 12 percent to 13 percent. Other trade partners of Korea that are currently exporting wine and spirits would suffer partial loss of their market.

Business firms in the services sector in the EU will gain markedly from the EU-Korea FTA. This applies to firms in the areas of retail and wholesale trade and transportation, financial and business services. FTA is going to further boost financial services exports of EU to Korea.

On the Korean side of the equation, manufacturers of automobiles, auto parts, ships, wireless telecommunications devices, chemical products and imaging equipments are likely to increase their exports to EU countries.

Korea is a net exporter of cars to the EU. IBM (in 2008) concluded that the auto industry in Korea will benefit far more from the EU-Korea FTA than companies in the EU. Expectations among Korean automakers regarding these gains are high. The present EU tariff on autos is 10 percent. Abolition of this tariff will reduce the purchase price of an average Korean car by 1,000 euros, making them more competitive in the EU markets.

Also, Koran automakers are preparing for production in the EU. The Czech Republic and Slovakia are two locales that are being considered at present. Assembly and export costs of Korean cars in the EU will be reduced if the 4.5 percent tariff on auto parts exported from Korea to the EU is eliminated, with the FTA coming into force.

Professor Dilip K. Das is Director of the Institute of Asian Business, SolBridge International School of Business, Woosong University, Daejeon.