Resolving trade policy uncertainty to promote trade and innovation

Hongyong Zhang 07 January 2016

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More than two years since the Japanese government’s formal announcement to participate in Trans-Pacific Partnership (TPP) talks in March 2013, concerned countries have finally reached a general agreement. Negotiations on the TPP were far from smooth sailing, leaving the outlook of Japan’s trade policy uncertain for some time. Based on the findings of recent research analysing free trade, this column examines the effect of the TPP agreement and the resulting resolution of trade policy uncertainty on the promotion of trade and innovation activities, which had not been discussed in detail until now.

Resolving trade policy uncertainty

A 2013 survey conducted by RIETI Vice President Masayuki Morikawa (2013) of listed companies in Japan revealed their concern about the uncertain outlook of the nation’s economic policies, particularly trade policy. They pointed out a significant impact of the policy uncertainty on companies’ judgement over capital investments and offshore business expansion.

Yet, corporate investment activities, including capital investment, are always accompanied by uncertainty over expected future profits. Firms make an investment decision by comparing their expected benefit against their sunk costs. However, increased uncertainty over irreversible investments has forced companies to delay implementation and await new information that is useful in assessing future profitability. This is known as the ‘wait and see’ effect. Bloom et al. (2007), using corporate-level data, pointed to a negative correlation between capital investment/R&D and policy uncertainty.

Handley and Limão (2015) conducted theoretical and empirical analysis on how the resolution of policy uncertainty affects trade and investment, based on the experience of Portugal prior to and after its accession to the European Community (EC) in 1986. According to their study, joining the EC lifted Portugal’s uncertainty over the future of preferential import tariffs, substantially expanding the country’s exports. Even in industries where the applied tariff rates did not fall, many Portuguese businesses entered into the EC market. 

If the TPP agreement resolves uncertainty over trade policy, the Japanese corporate environment should improve and facilitate mid- to long-term decision-making on capital investment, research and development (R&D), and offshore expansion. Exporting products overseas requires massive costs that cannot be ignored for tasks such as exploring sales channels and developing a distribution network. If the TPP resolves future uncertainty over the export market, it is expected that businesses will be encouraged to enter into exporting.

Trade and innovation activities

In association with the positive effect of a clear outlook in trade policy on investment and exporting, improved access to overseas markets has an effect of promoting innovation.

Lileeva and Trefler (2010) studied Canadian companies that began exporting around the time of the effectuation of the Canada-US Free Trade Agreement (FTA) in 1989, and found that those with lower productivity prior to it embraced new technologies and investments more aggressively and achieved higher productivity in the end. Such companies seem to have a lower rate of expected return from R&D while remaining in the domestic market, but once the FTA lowers the fixed cost for export participation, they have more incentive to conduct R&D to boost productivity and capture overseas markets. Bustos (2011) showed theoretically that the introduction of free trade which reduces trade costs lowers the cut-off point not only for export participation but also for R&D. She then demonstrated that in Argentina in the early 1990s when the Southern Common Market (MERCOSUR) went into effect, those firms that belonged to industries for which Brazilian import tariffs were substantially cut were the first to increase their technology-related spending.

Many worry that domestic industries may be hit hard by increased imports when competing directly with imported goods, but in many cases, increased imports encourage domestic firms to engage in innovation activities aiming for improved productivity and differentiation. Bloom et al. (2015) reported that the increase in imports from China triggered a surge in the number of patent applications, IT recruitment, and improved productivity on the part of European firms, shifting the focus of their activities to highly technological and knowledge-intensive areas. According to research on Japanese firms conducted by Sato et al. (2015), importing companies have higher productivity and profitability than those do not import

These research findings have significant policy implications in that free trade not only promotes domestic companies’ importing/exporting but also innovation. They also imply that the TPP brings a crucial growth opportunity for many small and medium-sized enterprises (SMEs) that face funding constraints in exporting and R&D.

Steps necessary to realise these effects

Yet, the recent TPP agreement does not immediately bring about these effects. The following specific steps must be taken:

  1. Comply with the policy objectives, timing of policy implementation, and common rules set out in the TPP agreement, while ensuring transparency in TPP-related policies, regulations, rules, and procedures. For example, it is necessary for the government to disclose information and support firms in obtaining more information by organising seminars on TPP for them.
  2. In addition to the effect of resolving policy uncertainty itself, it will become more effective for the government to provide firms with tax incentives on capital investment and R&D. In fact, when comparing the firms that are eligible for tax incentive programmes for R&D promotion with those that are not, such policy has the effect of increasing SMEs’ R&D investment by more than twofold, but Kobayashi (2011) shows that utilisation remains low. Going forward, it is necessary to be creative in enhancing utilisation by focusing on the relations between the TPP and R&D.
  3. There has always been emphasis on export promotion, but import promotion is just as important. Once the TPP reduces import-related costs such as tariffs, a greater number of Japanese companies, including SMEs, will find it easier to utilise intermediate goods imported from overseas, which would improve productivity and profitability. As firms start importing, information about overseas markets may spill over to other firms, exerting the effect of external economies. Thus, it is important for the government to provide SMEs with information regarding importing and policy assistance for human resources development.

Editor’s note: This column was reproduced with permission from the Research Institute of Economy, Trade and Industry (RIETI).

References

Morikawa, Masayuki, 2013, “What Type of Policy Uncertainty Matters for Business?,” RIETI Discussion Paper, 13-E-076.

Bloom, Nicholas, Stephen Bond, and John Van Reenen, 2007, "Uncertainty and Investment Dynamics" Review of Economic Studies, vol. 74(2): 391-415.

Handley, Kyle, and Nuno Limão, 2015, "Trade and Investment under Policy Uncertainty: Theory and Firm Evidence" American Economic Journal: Economic Policy, forthcoming.

Lileeva, Alla, and Daniel Trefler, 2010, "Improved Access to Foreign Markets Raises Plant-level Productivity...for Some Plants" Quarterly Journal of Economics, vol. 125(3): 1051-99.

Bustos, Paula, 2011, "Trade Liberalization, Exports, and Technology Upgrading: Evidence on the Impact of MERCOSUR on Argentinian Firms" American Economic Review, vol. 101(1): 304-40.

Bloom, Nicholas, Mirko Draca, and John Van Reenen, 2015, "Trade Induced Technical Change: The Impact of Chinese Imports on Innovation, Diffusion and Productivity" Review of Economic Studies, forthcoming.

Sato, Hitoshi, Hongyong Zhang, Ryuhei Wakasugi, 2015, “Imported Intermediates and Firm Performance: An empirical analysis using micro data from Japanese manufacturers,” RIETI Discussion Paper, 15-J-015.

Kobayashi, Yohei, 2011, “Effect of R&D Tax Credits for Small and Medium-sized Enterprises in Japan: Evidence from firm-level data,” RIETI Research Digest No.70. (in Japanese)

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Topics:  International trade

Tags:  TPP, trade policy, policy uncertainty

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