Problems surface as AFTA deadline nears

Vietnam's AFTA process is approaching a critical point. With only a few years left before completion, tariff reduction must be accelerated significantly so that regional free trade will be realized by January 2006. Up to now, tariff reduction was largely cosmetic--placing items with already low tariffs in the inclusion list and cutting tariffs which had little impact on producers. Some sensitive products were shoved into the exclusion list to avoid a final decision. But in the last stretch of AFTA implementation, Vietnam faces a real challenge. The remaining process will hurt.

In July 2003, the Vietnamese government announced a revised CEPT schedule. The significance of the 2003 CEPT revision is that it heralds serious industrial adjustments as regional free trade begins to bite. What has been just talk is now becoming reality. Effects on domestic price structure and industries are emerging.

In 1996, when Vietnam pledged full adherence to the 10-year AFTA process, Prof. Shigeru Ishikawa, co-leader of the MPI-JICA joint research project, feared that the road would be very tough for Vietnam. A decade was hardly enough for a poor country like Vietnam to prepare for free trade within ASEAN, where multinational corporations from industrial countries compete fiercely. Prof. Ishikawa suggested a partial renegotiation of AFTA to extend moderate protection beyond 2006 for a limited number of targeted industries with potentiality. Meanwhile, all available resources (including FDI and ODA) should be mobilized to enhance their competitiveness. His proposal assumed a realistic and concrete industrial strategy. But after seven years, no such industrial strategy has been designed or implemented. Now the problem of weak competitiveness is coming home to roost.

Vietnam is entering an age of regional free trade with little industrial preparation. Is it too late? The situation would have been much better if the last several years had been more usefully spent. From now on, industrial promotion must be conducted under greater external constraints. But there are still much to do even at this late stage of AFTA. Besides that, negotiation for WTO accession is still on the way.

Free trade for exporters and parts makers

In designing industrial strategies, it is essential to distinguish export-oriented industries and import-substitution ones. Conditions surrounding them are sharply different, and so are the appropriate policies. By volume, export-oriented manufacturing industries are currently dominated by foreign-invested firms boasting high technology and relatively large production scale. In contrast, import-substitution industries consist of a broad spectrum of producers including FDI firms, SOEs, private companies, and small family-owned establishments.

For export-oriented industries, the appropriate policy is provision of open and free trade environment and the low cost of doing business. To export, it is necessary to be international competitive. Multinational corporations are extremely sensitive to any additional or unnecessary cost. After careful research, they choose the best location in the entire world to build their factories (or the second best location, if risk diversification is needed). The host country should offer a superb locational advantage if it is to attract top-class businesses. Once such industrial agglomeration is created in any country, it tends to grow rapidly at the cost of all other countries with inferior conditions.

With respect to trade policy, the prescription is straightforward: let exporting firms operate in free trade environment. For this, remove all tariffs on imported inputs. Similarly, all non-tariff barriers, including hidden costs, unreasonable delays and administrative harassment, should be eliminated. Here, partial liberalization is of no use since it cannot produce any dramatic announcement effect. If true free trade is unavailable, multinational corporations will simply leave the country for a better location. In effect, Vietnam already simulates such a climate by exonerating 100% exporters from import tariff payments. However, zero tariffs on all industrial inputs regardless of purchasers are far superior to such a conditional privilege.

But if parts are not protected, how can a country promote supporting industries? (This is a question frequently raised in policy discussion with Vietnamese officials.) Our answer is that it is quite possible to attract parts producers even without tariff protection. For foreign parts producers, tariff protection is only a minor factor in making an investment decision. In general, they are already globally competitive even without protection. Liberal business environment and the existence of assemblers who procure their products are far more important to them. These two conditions are also crucial for domestic parts producers who must eventually compete under free trade as well. If qualifying domestic candidates find it hard to improve technology quickly, temporary support measures can--and should--be offered to them.

It is also important that parts producers themselves are exempted from tariff payments on their inputs..

Another crucial policy action for attracting FDI is the reduction of domestic cost components across the board, including administrative burden, land use, residence, transportation, electricity, water, waste treatment, telephone, internet, and so on. It is not enough to just lower their costs. These costs must be among the lowest in the world and come with high and consistent quality. If free trade climate is combined with domestic low costs, and if these advantages are impressively advertised abroad, the country will surely attract industrial investors worldwide and begin to enjoy the virtuous circle of "investment inviting more investment."

Tariffs for import substitution industries require skill

Compared with export-oriented industries which are already competitive, designing tariff reduction for import substitution industries is much harder. Here, the industries in question are generally weaker under the walls of protection. While AFTA and WTO usually stimulate the growth of export-oriented industries, such trade liberalization often threatens the survival of import substitution industries. It is in this context that unemployment and bankruptcies become a social problem and political resistance to free trade arises.

Some say domestic industries should continue to be protected. Others argue that they should be immediately exposed to global market pressure to weed out inefficiencies. We reject both views as extreme, simplistic and too uniform. The policy toward uncompetitive import substitution industries should be conditional, dynamic, and backed by up-to-date information on individual industries and the global market.

The most crucial thing is to pre-announce the tariff reduction schedule for each product which is clear, realistic, and unchanging. Removal of protection should proceed at the right speed to bestow incentives to do better while maintaining social cohesion. It should be neither too fast to cause massive unemployment nor too slow to protect inefficient industries forever. This is indeed a very delicate task.

Moreover, the tariff roadmap should be designed consistently with the overall policy framework for that industry. The industry's own effort, the master plan, and the tariff reduction schedule must be harmonized to produce the desired outcome.

In extending the period of protection for import substitution industries, a serious problem of political capture may occur. Inefficient industries claiming to become competitive in the future or appealing to the seriousness of job displacement demand continued protection. Such protection often becomes permanent as the performance of the industry never improves. This is a perennial problem in all countries including industrialized ones. Deeply ingrained in the socio-political system, this type of protectionism saps the vitality of the national economy. To avoid the hijacking of trade policy by interest groups, strong resolve by the highest leadership is required. Consistency of the overall policy design also helps to defend the trade liberalization process. Temporary protection must be ended according to the pre-determined schedule regardless of whether the targeted industry has achieved the intended result or not.

Finding new jobs for displaced workers is another big social issue. Every government has the responsibility to squarely deal with this problem. In a dynamic, globally integrated economy, workers should seek new jobs in emerging sectors rather than keeping or shifting jobs within declining sectors. This is a painful process especially older workers, but permanent protection is far more damaging to long-term economic growth. In an ultimate sense, successful industrialization can be considered the best social protection policy.

Rules for setting tariffs

There are several rules to be observed in designing the tariff reduction schedule. Needless to say, these rules must be pursued within the constraints of international trade agreements.

1. Tariff policy must be embedded in the long-term industrial strategy

At present, Vietnam's trade policy is reactive and short-sighted. Annual tariff adjustments remain confusing since no long-term vision or policy priorities are indicated. This leaves the investment community without predictability, consistency or confidence. Instead of continuously solving the problems at hand, policy modality should shift to long-term goal setting and mobilization of resources to achieve that goal. In this process, domestic and foreign enterprises must be fully engaged in policy formulation. While there is no need to accept all of their demands, tariff policy which ignores the current situation of the industry and the market is harmful to industrial development.

2. Vertical consistency -- cascading tariff structure

At any point in time, tariffs on inputs should be lower than (or at least equal to) the tariff on the finished product. More generally, tariffs on products that are vertically linked through input-output relations should have a cascading shape from high to low according to their position in the production process. If this rule is violated, producers caught in the reverse tariff gap are penalized (taxed) for producing in Vietnam (the effective protection rate is negative). As competitiveness is eroded, they may well exit from Vietnam. If this happens, it will also be damaging to the development of supporting industries that produce for them.

3. Securing minimum profitability

In addition to vertical consistency, tariff designers must make sure that firms making proper effort do not face undue difficulties. This is particularly important in the dynamic context of emerging industries or global price instability. Newly built factories initially have a higher cost due to debt service and gradual startup. Also, if some countries dump subsidized exports in the world market, domestic producers will suffer. In either case, a temporary and measured support (including tariffs and import surcharges) is warranted while the event lasts. To do this properly and avoid excessive protection, policy makers must possess a good knowledge of the industry as well as the global market.

4. Adverse cost effects on consumers and downstream users

In a vertically linked industrial structure, protecting one industry often hurts others. Upstream protection impairs the competitiveness of downstream industries through higher cost. Protection is also against the interest of consumers. This trade-off must be borne in mind in tariff policy formulation. To strike a balance between two interests, information about the industry, including rough estimates of the costs and benefits of protection, is again valuable.

5. No tariffs on inputs of exporting firms

As argued above, inputs of export industries should not in principle be taxed. This is also in line with the requirement of cascading tariff structure. More generally and ideally, all industrial inputs, regardless of whether they are purchased by exporters or not, should have zero or near-zero tariffs. If domestic parts producers need some time to become competitive, supporting measures other than tariffs should be used.

Tariff design: an illustration

To visualize the policy suggestions above, hypothetical tariff reduction scenarios are shown below. It is assumed that these are actual rates paid by producers (localization policy and other regulations sometimes make actual payments higher than published tariff rates).

Scenario 1

This is the basic scenario in which the CEPT rate on the finished product follows the AFTA commitments (5% by 2006 and 0% by 2015) while the non-AFTA tariff ("MFN rate") starts at a much higher level and is reduced only gradually. Tariffs on all inputs are set to zero throughout. The decline of the non-AFTA rate may be accelerated depending on the concessions made in WTO accession or if the industry gains competitiveness sooner than expected.

Scenario 2

This is a more aggressive scenario in which both AFTA and non-AFTA rates are reduced as per AFTA commitments without discrimination. At the same time, intermediate inputs are protected mildly for only three years. This scenario is suitable for an industry which has already achieved (or will soon achieve) international competitiveness.

Scenario 3

In this case, it is judged that time is too short for a domestic industry (with potentiality) to develop before 2006. Therefore, the government negotiates an AFTA extension while intensively supporting this industry and its supporting industries in the next several years. The 2006 deadline is missed, but the output tariff is gradually reduced to meet the zero requirement for 2015. Throughout the promotion period, cascading tariff structure between output and inputs is maintained. This is close to what Prof. Ishikawa had in mind in 1996. However, it is uncertain whether AFTA renegotiation is acceptable and politically worthwhile at this late stage. It can at least be said that the existence of a convincing industrial strategy is the minimum condition for such a renegotiation.

These scenarios are for illustrative purposes only. No doubt there are other possible variations. For our concrete tariff proposals for electronics and steel products, please see respective subpages in this web.