A CGE Analysis: The Impact of ACFTA on

Indonesian Economy
by
Suryadi
Submitted as Partial Fulfillment of the Requirements for
The Degree of
Master of Economics, Planning and Public Policy
at
National Graduate Institute for Policy Studies, Tokyo,
Japan

September 2013

Acknowledgements
First of all, I would like to thank and praise to Allah SWT for all blessing so I
could survive and accomplish my study. I sincerely thank my advisor, Professor
Nobuhiro Hosoe, for his guidance, modeling skills, and helpful comments. Also, I
am grateful to Professor Hara Yonosuke, as Director of the Economics, Planning,
and Public Policy Program, for giving me an opportunity to study at GRIPS and
his direction. I would like to thank all the professors of the Academic Writing
Center who helped me with improving my paper. I would like to express my
thanks to all the professors in Gadjah Mada University who taught and gave me
an opportunity to deepen my understanding in economics and thank you to all
faculty members of Gadjah Mada University as well.
My deepest gratitude is to my beloved parents- alm.M.H. Kuswardiono and
Djuriah - for their support and their prayer for me to complete my study. Thank
you to all my sisters and my brother for caring for our mom since I started my
studies. Also, thanks to my boss, Yuli Aldrin, for his supports, and for my friends,
Surya Adam, who supported me when I was in Jogjakarta. I would also like to say
to a very dear friend, Yoichi Nozoe, who helped me
during my stay in Japan. Finally, thanks to all my wonderful friends for sharing
the memorable year and joyful living in Japan.

Abstract
This paper analyses the impact of the ASEAN-China Free Trade Agreement
(ACFTA) on the Indonesian economy by using a computable general equilibrium
(CGE) model. It uses the social accounting matrix based on the General Trade
Analysis Project (GTAP) 8 databases referring to the year 2007 as well as 129
regions for all 57 GTAP commodities. This study concludes that the ACFTA
would improve Indonesias social welfare. At a sectoral level, the study found that
the electric equipment industry and the chemical industry would benefit in
increasing output production, while the metal industry and the steel industry
would decline. The results indicate that the tariff elimination will have different
impacts on each sector involved in free trade agreements.

Keywords: ACFTA, computable general equilibrium, GTAP.

Table of Contents

Acknowledgements............................................................................................ii
Abstract..........................................................................................................iii
Table of Contents.........................................................................................iv
Introduction......................................................................................................5
Literature Review..............................................................................................6
Methodology....................................................................................................8
CGE Model...................................................................................................8
Source of Data.........................................................................................12
Analysis......................................................................................................12
Findings........................................................................................................13
Impacts of the ASEAN FTA............................................................................13
Impacts of the ACFTA...................................................................................16
Discussion......................................................................................................18
Conclusion.....................................................................................................19
References.....................................................................................................21
Appendix.......................................................................................................25

Introduction

The Association of Southeast Asian Nations (ASEAN) is a geopolitical

and economic organization formed in 1967. It consists of ten countries in two
subgroups: ASEAN6, composed of Indonesia, Malaysia, the Philippines,
Thailand, Singapore, Brunei Darussalam; and CLMV, composed of Cambodia, the
Lao Peoples Democratic Republic (Laos), Myanmar, and Vietnam. It aims to
establish mutually beneficial cooperation in all areas both regionally and
internationally. The ASEAN has undertaken many cooperative projects, one of
which is with China. As a non-member nation, China proposed a free trade area in
November 2001. One year later, the eleven nations signed a free trade agreement
(FTA) called the ASEAN-China Free Trade Agreement (ACFTA). ASEAN6
implemented it on January 1, 2010 and CLMV will in 2015.
Analysts expect the ACFTA to develop regional integration and to have a
significant impact on intraregional trade and investment. By accessing an
expanding and diversified market, the ASEAN countries should benefit from
Chinas economic growth and potential investment. Similarly, China will benefit
through access to the ASEAN countries natural resources and raw material. On
the other hand, ASEAN countries are predicted to face higher competition from
Chinas cheaper products in both domestic and international markets.
Many researchers have studied the economic impact of the ACFTA. They
found that most members gross domestic product (GDP) would grow due to the
FTA, but some members would not (e.g. Donghyun, Innwon, & Estrada, 2009).
Other research predicted a large trade effect due to the increases of total exports
(Yang & Chen, 2008). Some sectors, however, would have negative effects from
the ACFTA. Qiu, Yang, Huang, and Chen (2007) found that agricultural
development in southern China would suffer, and Donghyun, Innwon, and Estrada

(2009) found that Indonesian, Philippine, Cambodian, Laotian, and Burmese

(Myanmar) manufacturing sectors would probably suffer heavily.
These differing views have attracted deeper study. Most researchers have
studied the impact of the agreement by comparing it with other FTAs, such as the
East Asian, ASEAN-Japan, and ASEAN-Korea free trade agreements. Few studies
focus on one country in relation to the ACFTA. This paper will examine the
ACFTAs impact on the Indonesian economy (divided into 24 sectors), and
analyze it by a computable general equilibrium (CGE) model. The final part of
this paper will include some trade policy recommendations for the Indonesian
government.
Literature Review
This study analyzes the impact of the ACFTA on the Indonesian
economy. To do so, the paper employs the CGE model simulation analysis. The
CGE model is a numerical framework that describes an economy as a whole and
the interactions among economic agents including producer, government,
consumer, and foreign sector (Burfisher, 2011).
The CGE model has been used in empirical analysis and evaluating
recent economic policy such as general macroeconomic issues, fiscal policy
issues, international trade policy, regional and transport policy, environmental
policy, industrial and labor policy, and other various policies (Hosoe, Gasawa, &
Hashimoto, 2010). It was first applied by Johansen (1960). However, the structure
and application of the model was limited. Afterward, the CGE models began to be
developed and applied in various sectors of the economy.
The CGE model is based on the standard microeconomic theory where
price mechanism is important in an economy (Hosoe et al., 2010). According to

Lofgren, Harris, and Robinson (2002), the CGE model has been a very good
technique to analyze the changes and economic activities because it can capture
the economic transaction among agents in an economy.
Hosoe et al. (2010) cites some advantages and disadvantages of the CGE
model. The most impressive advantage is the small amount of data it needs. It is
suitable for analyzing developing countries where sufficient statistical data are not
available. It can also handle many data sets from many sectors. However, oneyear reference data does not capture the real equilibrium situation. One year may
be abnormal. Another disadvantage is that estimation of dynamic components
included in the model such as investments and savings makes a theoretical
inconsistency. Lastly, the model can only deal with relative prices, not absolute
prices.
Many researchers have studied the ACFTAs impact with the CGE model.
Although most used the General Trade Analysis Project (GTAP) database version
6, they came up with different results. Perhaps this is because of variance in the
aggregation of sectors and regions and the policy scenario analyzed.
Kitwiwattanachai, Nelson, & Reed (2010) found that under the ACFTA,
ASEAN countries would enjoy a net export creation of US$ 22.53 billion and net
import creation of US$ 24.61 billion, while China would gain net export creation
of $US 16.10 billion and net import creation of US$ 14.68 billion. He concluded
the more countries join in the FTA, the larger its effects.
Donghyun et al. (2009) discovered that the total output growth of
Singapore and Malaysia would increase substantially by 9.1% and 3.7%
respectively. Indonesia, the Philippines, Cambodia, Laos, and Myanmar would see
their total output growth marginally shrink.
Lakatos and Walmsley (2012) found that Malaysia, Singapore, and

Thailands trade would benefit from their falling import prices and increasing
export prices, while Vietnam and China would suffer from export price index
falling more than their import price.
Vanzetti, Setyoko, Que, and Trewin (2011) employed the GTAP version 6
databases. Their simulation indicated that at the sectoral level, Indonesia and
Vietnam could expect some reductions in output of some agricultural sectors, but
these changes are relatively small.
To sum up, the ACFTA has different impacts on its members and the
expansion of trade is likely to have a diverse effect on different sectors in each
country.
Methodology
This paper employs a static CGE model introduced by Hosoe et al.
(2010). Here, this study reviews it as an analyzing tool.
CGE Model
Generally, the model can be seen from the flows of goods and factors in
an economy (see Figure 1). For added realism, the model assumes firms use
intermediate inputs in their production process and the market is fully
competitive. The model separates the production process into two stages.
In the first, combining capital

FCAP , j and labor

F LAB, j produces the

composite factor Y j . This stage represents the behavior of a virtual factory,

which maximizes profit by choosing output level and input use based upon their
relative prices subject to the technology. The model assumes a Cobb-Douglas
production function that describes substitution between inputs. The technology of
the composite factor production described by a Cobb-Douglas production function
is the constraint in this first stage.

UU
(Cobb-Douglas)

Qj
Armingtons
Composite
Goods

QC j , HOH
+
Household
Consumption

(CES)

QC+j ,l 2

X i,j

l2

The Other Final Demand

Exports
Composite
Imports

QM j
(CES)

QD j

QT j , r , s

QT j , r , s

Domestic
Goods

'

(CET
)

QT j , s ,r

QT j , s , r

QE j

'

Composite
Exports

Imports
(CET)
Domestic
Output

Zj

QTS

Intl.Trans.Srv.
Exports

(Leontief)
Composite
Factor

Yj

X AGR , j

X SRV , j

(CES)
Intermediate Goods

FCAP , j

F LAB , j

Figure 1. The flowchart of goods and factors. UU represents utility of the

household in each region.
Note. Adapted from Model Structure of the CGE Model for Jordan by N.
Hosoe, 2001, p.11.
Second, the composite factor is combined with intermediate goods (
X AGR , j and X SRV , j ) to produce the domestic output Z j . In this stage, the
model assumes a Leontief production function. The function reduces the
complexity of the model to let it handle many data sets from many sectors without
slowing computation. The function also produces a rectangular isoquant, which is
a problem for numerical computation. To deal with this problem, the model

changes the function into a zero-profit condition. Then, this condition is

transformed into a simple expression of a unit cost function.
The model used in this paper is an open economy model. Concerning
international trade, the model differentiates two linked types of prices: domestic
currency and foreign currency, with export and import prices in foreign terms
treated as exogenous to the economy. The model also assumes that the economy
deals with the balance of payments constraint.
On the supply side, the model assumes that firms supply domestic output
into the international market ( QE j ) and domestic market ( QD j ). It also
assumes the supply of these goods is imperfect substitution, with a constant
elasticity of transformation (CET), making the export-domestic supply ratio more
sensitive to relative price changes. The model includes international transport
services QTS as distribution cost for exporting the domestic output to any
countries.
In an open economy model, domestically produced/ and consumed,
imports, and exports should be compared. The model uses Armingtons
assumption: that those goods are imperfectly substitutable each other. The model
also uses a constant elasticity of substitution (CES) as a parameter to measure the
degree of similarity among those goods. If they differ significantly, the elasticity
is small; if not, it is large.
The model assumes that imports from all countries (e.g. QT j , s , r and
QT j , s ' ,r ) form the home countrys composite imports QM j . As for exports,
the model includes the international transport services QTS for imports.
Domestic goods QD j and composite imports QM j combine when firms
produce Armingtons composite goods Q j . To assure the market equilibrium of
each good and production factor in terms of quantity and price, the model imposes

10

the market clearing condition.

The composite goods are distributed to the household consumption

QC j , HOH , the other final demand QC j ,l 2 (e.g. governments consumption,
l2
X i,j
investment), and the intermediate goods
. The model assumes that
i
households choose their consumption to maximize their utility subject to their
income constraints. Households incomes come from endowment of labor and
capital used in production by firms. Household savings and direct tax payments
determine the size of available incomes for the households consumption of
goods, QC j , HOH . In addition to direct taxes on the households income, the
model assumes indirect tax on domestic output, and import tariffs. It also assumes
the government uses tax and tariff revenue on consumption, and consumes each
good with a fixed proportion of its expenditure.
The open economy model introduces dynamic factors such as investment
and savings. It assumes investment agents collect funds to purchase investment
goods from households, the government, and the external sector. All agents
consume all savings to buy goods proportionately with a constant share. The total
of savings in an economy is assumed to be always equal to total investment. This
model also assumes the constant average propensities for savings determine
household and government savings. Foreign saving is exogenous to the economy
in this model.
At the top of Figure 1, the model shows the fictitious objective function
that is the utility function UU . The utility function UU

indicates the

households utility generated by consumption of the composite goods. The

household is assumed to maximize its utility. Utility is the direct measurement of
economic welfare. However, this measurement has some disadvantages. To cope

11

with these, the model uses expenditure function to convert the utility level into
expenditure level. It also uses a constant price such the Laspeyres price index to
control the effects of price changes. In this way, the model defines a welfare
index, called a Hicksian equivalent variation (EV). Through this indicator, the
model measures the changes of utility level in monetary terms. By dividing EV by
gross domestic products (GDP), the welfare changes relative to GDP can be
measured. This is useful for comparing the welfare impact between different
countries.
Source of Data
The study uses a social accounting matrix based on the GTAP 8 databases,
which have global production and trade data from 2007. They database embodies
129 regions and 57 GTAP commodities. This paper aggregated the GTAP 8
database into 4 regions (see Appendix A) and 22 sectors (see Appendix B). The
regions consist of (1) INA for Indonesia, (2) CHN for China, (3) ASEAN4 for
Malaysia, the Philippines, Singapore, and Thailand, and (4) ROW (Rest of World)
for other countries outside of those three regions.
This study mainly focuses on five of the six ASEAN countries: Indonesia,
Malaysia, the Philippines, Singapore, Thailand, and Brunei Darussalam. It does
not include Brunei Darussalam because GTAP databases classified the country as
the rest of Southeast Asia due to unavailability of its input-output table. Thus, this
paper divided ASEAN into two regions: INA and ASEAN4. Table 3 shows the
core of ACFTAs economic structure (see Appendix C).
Analysis

12

To analyze the impact of the ACFTA, this paper employed a world trade
CGE model by Nobuhiro Hosoe (2001). General algebraic modeling system
(GAMS) software with CONOPT solver executed the model to deal with the nonlinear equation. It kept government consumption, investment demand, and current
account deficits constant. Governments run zero deficits with lump-sum taxes on
households (Hosoe, 2001).
The study assumes complete elimination of import tariffs for countries
involved in the agreement. By this assumption, scenarios were created as follows:
(1) full tariff elimination among INA and ASEAN4, and (2) full tariff elimination
between INA, ASEAN4, and CHN. Scenario 1 was done because the ACFTA was
not fully implemented in 2007, the base year of the GTAP 8 database; thus, before
China entered the ASEAN markets, there were some positive trade barriers within
the ASEAN FTA. In fact, Indonesia joined the ASEAN FTA before it joined the
ACFTA. Hence, Scenario 2 presumes Scenario 1.
Findings
Impacts of the ASEAN FTA
At the macro-level, the simulation result showed the ASEAN FTA would
cause Indonesias social welfare to grow by 0.16% (see Table 4). This growth is
caused by the increasing percentage of changes in household consumption (see
Table 5, Appendix D). In terms of changes in trade, trade creation and trade
diversion would contribute to this small increase in social welfare (see Figure 2
and Figure 3).

13

At the micro-level, the agreement would increase production of domestic

output in the electric equipment (EEQ) industry and the textile and apparel (TXA)
industry, while decreasing domestic output in the service (SRV) sector and the
petroleum and coke (PTC) industry. The reasons are as follow.
Table 4. Changes in welfare (%)
Equivalent Variation
Welfare
Regions
GDP (GTAP)
ASEAN
ACFTA
ASEAN
ACFTA
INA
411.82
816.58
254,702.00
0.16
0.32
Note: Author's simulations. The welfare is measured by the Hicksian equivalent
variation expressed in a relative size to the base run GDP. Data source is
GTAP (2012)
5.00
4.00
3.00
INA
ASEAN4

2.00
1.00
0.00

0.53

0.42
0.03
(0.05)

(1.00)

Figure 2.ASEAN FTA: Changes in exports (%)

Note. Authors simulation

14

40.00
35.00
30.00
25.00
20.00

INA
ASEAN4

15.00
10.00
5.00

0.91

0.66

0.29

0.00

(0.07)

(5.00)

Figure 3. ASEAN FTA: Changes in imports (%)

Note. Authors simulation

Object 91

Figure 4.ASEAN FTA: Changes in domestic output (%)

Note. Authors simulation
Many ASEAN markets have a fascination with electronic equipment.
Tariff elimination would increase household consumption in ASEAN4,
accelerating EEQ exports in Indonesia, and spurring its domestic output
production in the industry (see Figure 4). Through the input-output relationship,

15

this rise would likely lead to expansion of domestic output production of

electricity from the energy industry (ENG).
Low cost of production and labor is the advantage of Indonesias textile
(TXA) industry. Increasing household consumption in ASEAN4 would expand
Indonesias exports in the TXA industry, spurring more domestic output in that
industry and intermediate input production of cotton and wool from agricultural
(AGR) and livestock and fishery (LIF) sector respectively.
Tariff elimination would decrease domestic output production in some
sectors. The SRV industry, though not included in the ASEAN FTA framework,
would decrease due to input-output sector relationship. The PTC industry would
also shrink, with falling production in oil and gas sectors and overall domestic
output production. Despite its rich natural resources, Indonesia would need to
apply new technologies to compete with ASEAN members.
Simulation 1 also noted the expansion of the EEQ and TXA industries
would increase demand of labor by these industries (see Table 7, Appendix E).
Impacts of the ACFTA
Thanks to tariff elimination on the ACFTA, Indonesia would have a trade
surplus, contributing to increases in social welfare (see Table 3). Household
consumption would increase 0.51% with the increase of income (see Table 6,
Appendix D). The ACFTA would influence industrial performances. Some sectors
would increase domestic output production; some would decrease it (see Figure
5). This paper analyzes the impact of first-time full implementation of the ACFTA
on the crucial sectors.

16

2.50
1.99

2.00
1.50

1.25

1.00
INA
0.50
0.05
0.00

ASEAN4

CHN

0.20
(0.02)0.05(0.05)

(0.20)

(0.50)
(0.75)

(1.00)

(0.86)

Figure 5.ACFTA FTA: Changes in domestic output (%)

Note. Authors simulation
As members of the industry with the most potential in the ASEAN
market, TXA executives are worried about Chinese competition. This result
indicated that this fear is well-founded. The TXA industry would lose domestic
output production, as indicated by the increase in textile imports (see Figure 6).
The reduction of output production would decrease demand for textile labor (see
Table 8, Appendix E).
High dependency on imported raw materials would hamper the steel
(STL) industry in the ACFTA. This industry would also lose domestic output
production, perhaps due to low iron ore production from other mining (OMN)
sectors and a decrease in STLs imports. Demand for steel labor would decrease.

17

40.00
35.00
30.00
25.00
20.00
INA

15.00
10.00

12.27

ASEAN4

CHN

6.67
3.05

5.00
0.00

(0.03)

(5.00)

Figure 6.ACFTA FTA: Changes in imports (%)

Note. Authors simulation
Other crucial industries are the food (FOD) industry and the wood (WPP)
industry. Both employ many unskilled workers in their production. The result
found these industries would benefit from tariff elimination. The FOD industry
would improve domestic output production due to an increase in its imports (see
Table 8, Appendix D). The WPP industry would similarly expand its output
production level, due partly to increased imports in the forestry (FRS) sector as an
intermediate input for WPP industry. This growth in WPP output production
would increase its exports (see Figure 7). Both industries would hire more
workers.

18

Object 99

Figure 7.ACFTA FTA: Changes in exports (%)

Note. Authors simulation
However, of all sectors, the most promising are the EEQ manufacturing
and the chemical (CHM) industry. These two industries would significantly
increase output production, net exports, and demand for labor. Indonesia should
not worry about these industries, but use them as investment in the future. It must
pay more attention to the metal (MET) and steel (STL) industries. These two
industries would experience the worst reduction in output production.
Discussion

The results of this study are generally consistent with Kitwiwattanachai et

al.s (2010) findings that the more countries join in the FTA, the larger its effects.
This study also extends previous findings (e.g. Donghyun et al., 2009) that
expansion of trade should affect diverse sectors in each economy. However, it
should be noted that the database the paper used is different from previous studies.
Therefore, the result might be different.
Simulation results of the ACFTA have shown tariff elimination, at the
macro-level,

would

increase

Indonesias

economic

welfare,

household

19

consumption, and trade surplus. This finding differs from Donghyun et al. (2009)
who said Indonesia would have a marginally negative output growth.
However, this papers findings do agree with Donghyun et al. (2009) that
the expansion of trade would affect diverse sectors in the economy. The ACFTA
simulation found that the EEQ and the CHM industries would benefit the most
while the metal industry and the steel industry would suffer the most. However,
this papers finding differs from Vanzetti et al. (2011) who found that the tariff
elimination would reduce output in the agricultural sectors. This paper indicates
that the agricultural sectors would benefit at the output production level.
In sum, this paper finds the ACFTA would benefit the Indonesian
economy, though it would have different effects at the micro-level. However, the
GTAP database has limitations imposed by the process of its construction, making
this papers results vary from others that used different models

Conclusion

This paper analyzed the impact of the ACFTA on the Indonesian economy
with the CGE model. To predict the impact of this agreement, the paper used data
based on GTAP 8 databases for 2007 and simulated tariff elimination. The main
purpose of this paper is to address the question of which sectors output
production levels would increase under ACFTA, and which would decrease.
The key finding of the simulations is that the ACFTA would improve
Indonesias social welfare. Through tariff elimination on the ACFTA framework,
domestic output production would increase in the electrical equipment and
chemical industries, offsetting losses in the metal and steel industries.

20

The government should continue to improve trade between ACFTA

participants. It should also adapt to national product standards for each country
involved in the ACFTA agreements, especially China, to facilitate access to the
ACFTA market. It should minimize the negative impact on sectors that will suffer
from ACFTA.
This papers simulations have produced interesting results. They assumed
complete tariff elimination in all sectors, including services. The complete tariff
elimination scenario in this paper may be too easy and simple. As a masters
thesis, this paper is only an exercise. More comprehensive work must be done to
explore the impact of ACFTA on each ASEAN countries.

21

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