Economic Similarity and Bilateral Trade

1. Economic Similarity and Bilateral Trade By I-Hui Cheng (鄭義暉) Department of Applied Economics, National University of Kaohsiung, Taiwan

2. Summary • This research uses the bilateral trade information from 1986 to 2008 and the common types of trade gravity models, such as the traditional cross-sectional model, three-way fixed effects model, and bilateral fixed effects model, to re-examine bilateral trade flow determinants. • This article assumes that the trading economies’ similarity and the bilateral trade volumes’ similarity in percentage over foreign trade with each other, contribute to the parties’ willingness to be involved in the same regional trade group. • Economic similarity does matter in the formation of REI. • Using endogenous REI dummies leads to different results.

3. The current trend in world economy • Regional economic integration • As of May, 2012, there have been 489 regional trade agreements proposed to WTO; 357 of which have been notified according to the 24th clause in General Agreement on Tariffs and Trade (GATT); 92 of them was proposed according to the 5th clause in the General Agreement for Trade of Service (GATS) and 31 of them were proposed according to the enabling clause • Trade within the region occupies a high proportion of the total trade value.

4. The current trend in world economy

5. The current trend in world economy

6. The literature • The Dummy Variable Approach • Integration schemes in western Europe [Aitken, 1973; Mayes, 1978; Nelsson, 2000] • Imperfect competition [Bergstrand, 1985,1989] • Currency volatility [Thursby & Thursby, 1987; Frankel and Wei, 1998]. • Different regional blocs [Bayoumi & Eichengreen, 1997; Frankel et al., 1995,1998; Egger, 2004] • 2-stage REI dummies [Baier & Bergstrand, 2007]

7. The literature • The Heterogeneity Does Matter • Helpman (1987): Imperfect competition • Hummels & Levinsohn (1995): Monopolistic competition + IIT. • Mátyás, L. (1997) : The heterogeneity of trader • Cheng & Wall (1999,2005)&Feenstra (2002): The heterogeneity of bilateral trade relationships • Baltagi et al (2003): The heterogeneity of bilateral trade relationships, and traders. • Egger: 2SLS approach: use REI twice.

8. The bilateral trade model • The gravity-type equation of bilateral trade • Pöyhönen (1963), Linnemann (1966). • Typical type: • Frictionless type:

9. Discussion on Relative distance as the proxies of transport costs • Relative distance between two places • The cost of overcoming the friction of absolute distance, • Social, cultural and economic connectivity. • Conventional explanatory variables include: • Distance, language, common border, economic agreement, political alliance, religion, etc. • How to find better ones?

10. On the statistical specification • Available Models • Cross-sectional Model • Single CS • Pooled CS [in this paper] • Difference Model • Fixed-effect Model • Two-way FE [in this paper] • Three-way FE [in this paper]

11. The empirical gravity-type models • The basic model(Mátyás (1997), Model FEM) • Cheng & Wall (1999,2005),Feenstra (2002) (Model FCW) : • Carr, Markusen & Markus (2001),Anderson & van Wincoop (2003),Baltagi, Egger & Pfaffermayr (2003) (Model BEP) :

12. Arbitrary preferences Deardorff (1998): • λk: good k’s share of the world market • αik: exporter i’s production share • βjk: importer j’s consumption share • “~”: the difference between the average.

13. Impeded trade Deardorff (1998): • where • tij: transport cost of the Samuelson iceberg form • θh: country’ share of the world income • ρij: the TC weighted with the average distance δ,

14. Economic similarity • Economic size: • Per capita GDP • Bilateral export • Bilateral import

15. Related empirical topics • Linder hypothesis • Intra-industry trade • Dispersion or similarity • Openness

16. The data • The exporting value of 41 exporting countries and 57 importing countries, from 1986 to 2008, 52,486 obs.; 2282 pairs. • Data resources: IMF DOTS, 1986-2008 ; The WDI Indicators 2010. • REI dummies: The European Union (EU), The Euro Zone (EURO), North American FTA (NAFTA), the South American Common Market (MERCUSOR), and the ASEAN Free Trade Area (AFTA).

17. Correlation matrix of economic similarity variables

18. The empirical results • Basic model ＋ REI dummies ＋ similarity • Modified model ＋ REI dummies ＋ similarity • Bilateral trade in East Asia (exercise)

19. The estimation results

24. The estimation results (using IV)

25. The estimation results (using IV)

26. The empirical exercise for research students

27. The empirical exercise(Model FCW (ij, t), I.)

28. The empirical exercise(Model FCW (ij, t), II.)

29. The empirical exercise Model FCW (ij, t), I: using instrument variables.

30. The conclusion • Economic similarity does matter in the formation of REI. • Using endogenous REI dummies leads to different results.

31. References • Anderson, J. E., (1979) “A Theoretical Foundation for the Gravity Equation,” American Economic Review, 69, 1, 106-116. • Anderson, J., and van Wincoop, E., (2003) “Gravity with Gravitas: A Solution to the Border Puzzle,” American Economic Review, 93, 170-192. • Baier, S. L. and Bergstrand, J. H., (2007) “Do Free Trade Agreements Actually Increase Members’ International Trade?” Journal of International Economics, 71, 72-95. • Baltagi, B., Egger, P. H. and Pfaffermayr, M., (2003) “A Generalized Design for Bilateral Trade Flow Models,” Economics Letters, 80, 3, 391-397. • Bergstrand, J. H., (1985) “The Gravity Equation in International Trade: Some Microeconomic Foundations and Empirical Evidence,” Review of Economics and Statistics, 67, 474-481. • Brada, J. C. and Mendez, J. A., (1985) “Economic Integration among Developed, Developing and Centrally Planned Economies: A Comparative Analysis,” Review of Economics and Statistics, 67, 4, 549-556. • Carr, D. L., Markusen, J. E. and Markus, K. E., (2001) “Estimating Knowledge-Capital Model of the Multinational Enterprise,” American Economic Review, 91, 3, 691-708.

32. References • Deardorff, A.V., (1998) “Determinants of Bilateral Trade: Does Gravity Work in a Neoclassical World?” in J. A. Frankel, Ed., The Regionalization of the World Economy, University of Chicago Press, Chicago. • Feenstra, R. C., (2002) Advanced International Trade, Princeton University Press, Princeton, New Jersey. • Frankel, F., Stein, E. and Wei, S., (1995) “Trading Blocs and Americas: The Natural, the Unnatural, and the Super-natural,” Journal of Development Economics, 47, 61-95. • Helpman, E., (1987) “Imperfect Competition and International Trade: Evidence from Fourteen Industrial Countries,” Journal of the Japanese and International Economies, 1, 1, 62-81. • Hummels, D. and Levinsohn, J., (1995) “Monopolistic Competition and International Trade: Reconsidering the Evidence,” Quarterly Journal of Economics, 110, 3, 799-836. • Mátyás, L., (1997) “Proper Econometric Specification of the Gravity Model,” The World Economy, 20, 363-368.

33. Thank you very much.