Estimating the Effects of Regional Integration

1. Estimating the Effects of Regional Integration Nigel Grimwade (LSBU)

2. Regional economic integration • Definition: the process whereby separate national economies are combined into larger economic regions • Two basic conditions:- • Free movement of goods and factors of production (labour and capital) • Absence of discrimination • Brought about in 2 ways:- • Negative integration – removal of discrimination (e.g. tariffs) and restrictions on movement • Positive integration – creation of common policies and institutions

3. Forms of regional economic integration Types of regional economic integration:- • Preferential trading agreements (e.g. EU’s Loméand CotonouAgreements) • Free trade agreements – elimination of tariffs on all trade between the member states (e.g. EFTA, NAFTA, AFTA) • Customs unions – internal free trade plus a common external tariff (e.g. EC/EU, Mercosur) • Common Markets – free trade in goods and services and free movement of capital and labour (e.g. SEM) • Monetary unions – adoption of a common currency, single central bank and common monetary policy (e.g. Euro zone)

4. Economic effects of regional integration • Static effects - short-run, once-and-for all increase/decrease economic welfare due to:- • Reallocation of resources due to trade-creation and trade-diversion • Terms of trade effects – change in the ratio of average export prices to average import prices • Dynamic effects – long run, on-going increase in national income due to:- • Economies of scale (static and dynamic) • Increased competition • Increased investment (domestic and foreign) • More rapid rate of technological innovation

5. Problems in estimating the effects of regional integration • Which effects to measure – effects on trade, national income, rate of economic growth • What time period to consider – short- or long-run • What types of integration to cover – tariffs, NTBs, services, factor mobility, monetary integration • How to estimate the counterfactual – what would have happened if integration had not taken place

6. Simple extrapolation • Most early studies were concerned with the static effects – trade-creation and trade-diversion • Focused on trade (exports and imports) between the members (intra-area trade) and trade with non-members (extra-area trade) • Made the simple assumption that intra- and extra-area exports/imports would have continued growing at the same rate had integration not happened (anti-monde) • Difference between actual trade and the anti-monde (the residual) is the integration effect • One major problem – this assumes that conditions in the post-integration period were the same as in the pre-integration

7. Intra- and extra-area trade share • A better approach is to extrapolate intra-area and extra-area exports/imports as shares of total imports (see diagram) e.g. Xij/Xi, Mij/Mi • Increase in actual intra-area export/import share compared with the anti-monde is evidence for an integration effect • But we have no way of knowing whether this is due to trade-creation or trade-diversion • Is greatly affected by (a) the number of countries involved and (b) the region’s share in total trade • Share may also be affected by an increase in the number of members over time

8. Residual imputation Intra- Regional Export Actual Share % Trend 0 T1 Time

9. Problems with simple residual models • Different factors may have affected intra- and extra area exports/imports in the pre- and post-integration periods, such as:- • Rate of economic growth – import demand • Phases of the business cycle • Changes in relative prices • Changes in the exchange rate • Structural changes • Reductions in multilaterally negotiated tariffs • So, we cannot assume that what happened in the pre-integration period would have happened in the post-integration period had integration not happened

10. Shares of intra- and extra-area trade in national income/consumption • Extrapolate share of extra- and intra-area imports in GNP/GDP or…. • Extrapolate share of extra- and intra-area imports in apparent consumption (domestic production less exports plus imports) • An increase in share of AC coming from domestic sources is evidence for gross trade-creation • An increase in share of AC coming from partner countries is evidence for net trade-creation • A decrease in share of AC coming from rest of the world is evidence for trade-diversion

11. Balassa’s income elasticity of demand for imports approach • Income elasticity of demand for imports (∆M/∆Y) is calculated for pre- and post-integration period • Rise in income elasticity of demand for imports for intra-area imports is defined as gross trade-creation • Increase in income elasticity of demand for imports from member states is net trade-creation • Decrease in demand for imports from non-member states is trade-diversion • Found evidence for net trade-creation following the formation of the EC – but some trade diversion in agricultural goods

12. Use of a control group • An alternative approach was to use a third country as a normaliser or control group • Assumption was that intra- and extra-area imports would have grown at the same rate as imports of the normaliser country • Necessary that normaliser country was a similar country not affected by any special factors • But such an approach is heavily dependent on the country chosen

13. Intensity of Trade Approach • Based on the idea that there exists some “natural” amount of trade that will take place between any two countries • If actual trade exceeds this natural amount, this suggests trade is biased by other factors • Such factors include membership of a regional integration scheme • Then, any increase in the degree of bias over time provides a measure of the effects of integration • Several studies have used an intra-regional trade intensity index or trade concentration ratio:- Iij = Xij/Mj÷ Mj/M • Where I isgreater thanone, this implies geographical bias in trade due to natural and institutional factors

14. Intensity of trade approach • Increase in the index over time measures the trade integration effect • But trend over time gives a confusing picture (see Table 2):- • No change in some cases e.g. EU, EFTA • Upward trend in others e.g. Mercosur and Andean Pact • Downward trend in others • Major weakness – lacks any proper measure of natural trade and fails to take account of possible changes in factors affecting natural trade

15. Gravity Models • Draws on Newton’s law of gravity in physics and the idea that there is some “natural” amount of trade taking placebetween any two countries, i and j (intensity of trade) • In the original gravity model, bilateral trade flows are affected by two forces or masses - trade potential and trade resistance • Trade potential is shaped by size of each country’s GDP/GNP and population – and thus by per capita GDP/GNP • Trade resistance is negatively related to distance between two countries • But newer versions of the gravity models have added other variables to increase the explanatory power of the model

16. Gravity Models • Newer versions of the gravity model have added other variables:- • Geographical size – negative relationship • Adjacency • Common language (or cultural affinity) • RTA membership • Landlocked or island economies • Common currency • Former colonies using a dummy variable for 2-7 • A simple form of the gravity equation might be:- log Xij = log A + β log Yi + β log Yj + μ log Hi + μ log Hj + γ log Ni + γ log Nj + α log Dij + log εij

17. Gravity estimation • Simple approaches is touse the gravity equation to estimate the amount of trade expected had integration not occurred • Actual trade is then compared with predicted trade – the residual measures the integration effect, • But this approach cannot distinguish between trade-creation and trade-diversion • Better approach is to estimate trade flows for integration period only, using dummy variables for membership/non-membership of the same trading bloc • Coefficient of the dummy variable will measure how much extra trade was trade-creation and trade-diversion

18. An example: Frankel, 1997 • Estimated the integration effects of 6 trading blocs between 1965 to 1994 • Found positive integration effect for all cases, with strongest effects for ASEAN and ANZCERTA • Strong effects were also found for Mercosur and the Andean Community • But there was no statistically significant effect for the EU until after 1985 • The EC bloc effect was stronger for the EC, but not significant until after 1980 • But the two EC enlargements of 1973 and 1985 had major effects

19. Computable General Equilibrium Models • Involve construction of complex computer models covering all the sectors in a country’s economy – including goods, services, firms, households, government, labour, etc. • Shows all the interconnections between different parts of the economy using a series of equations • Model is then calibrated for a particular year and the model is then subject to a shock to estimate the effects • Models may be single-country models (e.g. PRCGEM) or multi-regional (e.g. GTAP) • Models can be used to study the effects of regional integration

20. Uses of CGE Modelling • Were first used to analyse the effects of NAFTA and its enlargementto Central and Southern America • Were also used extensively to study the effects of APEC liberalisation • More recently, several models have been used to simulate the effects of the EU and its eastern enlargement • CGE models have also been used extensively to estimate the effects of multilateral trade liberalisation e.g. effects of the Uruguay Round • Can be used to predict what will happen (ex ante) as well as estimate what has happened (ex post)

21. Conclusions • Important to have some idea of the size of the effects from regional integration • Wide variety of different approaches have been used, but they give wildly different results • Methodology used in this research has progressed from the early days • No studies can tell us exactly what has happened or will happen because of the counterfactual problem • But the use of econometric methods can give us a fair estimate of the broad magnitude of these effects • CGE models are especially useful for estimating the long run effects on economic growth