990_comparing_thABSTRACT This paper examines factors that determine Uganda’s trade flows and specifically compares the impact and performance of the different trade blocs on Uganda’s trade patterns and flows. The empirical question is whether Uganda’s trade is getting more integrated in the East African Community (EAC) region or is still dominated by other trading blocs, namely European Union (EU), Asia and Common Market for Eastern and Southern Africa (COMESA)? Two analytical approaches are used, namely: trade indicators and estimation of the gravity models using data extracted from COMTRADE for the period 2001 – 2009 (panel). We estimate determinants of export and import trade flows separately using static random, dynamic random and IV GMM models. The results suggest a strong relationship between belonging to a trading bloc and trade flows. Likewise, Uganda’s import and export trade flows have conspicuously adjusted to the gravitational forces of the EAC during the progress of the integration. Whereas exports are being integrated more in the EAC and COMESA regions, imports are more integrated in the Asian and EU trading blocs. Therefore, strong links with trading blocs outside the EAC (i.e. EU and Asia) with regards to imports still exist. The trade indicators demonstrate that Uganda exports largely primary products and imports manufactured products. It is imperative for Uganda to target implementation of regional trade agreements to expand the country’s export markets. The EAC region should attract investment in production of high technology products to increase intra-EAC imports and reduce imports from Asia and the EU.

REVIEW OF RELATED LITERATURE

The recent proliferation of Regional Trade Agreements (RTAs) among countries characterised by overlapping tendencies known as the ‘spaghetti bowl’ has generated debate on the future of the stalled multilateral process given the growing regionalism. RTAs have spread and deepened across both the North and South. Yeats (1997) raised empirical questions whether RTAs stimulate growth and investment, facilitate technology transfer, shift comparative advantage towards high value activities, induce political stability or divert trade in inefficient channels and undermine the multilateral trading system. Trade theories explain the sources and possible scenarios that underpin this proliferation.

Trade theories that explain gains from integration are as old as when trade shifted from autarky to international trade. The theories explain why countries seek to integrate: The classical trade theory put forward by Richardo argues that trade raises a country’s potential income (welfare) compared to autarky through specialization according to comparative advantage. Countries thus shift resources to production of goods where they efficiently produce and import goods where they are less efficient. However, the existence of tariff and non-tariff barriers distorts the final consumer price. Although the model explains the source of comparative advantage which motivates countries to trade; it assumes that labour is the only factor of production which is not true. It assumes perfect

competition and yet imperfection exists, and many countries are small and are price takers. Furthermore, the assumption that transport costs do not exist is unrealistic.

The Heckscher-Ohlin (H-O) model on the other hand, explains international trade based on the country’s factor endowments, that is, the relative quantities of capital and labour available for production. It assumes that countries have access to the same technology. In this way, countries with relatively large quantities of labour will shift production to labour-intensive production and export these goods and import capital-intensive goods. This implies that developed countries that are capital intensive will always dominate developing countries that are likely to be labour intensive. This perhaps explains why South-South RTA dominated by production of labour intensive goods and importing capital intensive products are likely to stall intra-trade. The model assumes that factors of production are only mobile within a country and immobile outside the country, implying that it is even more difficult for labour intensive countries to access capital intensive technology. Raul Prebisch and Hans Singer6 explained the disadvantage of countries being segmented into exports of either manufacturers or primary commodities. Accordingly, countries exporting primary commodities will suffer terms of trade decline driven by low income and price elasticities of demand.

Other theories that incorporate market imperfections and explain the role of economies of scale in trade have been proposed. DeRosa (1998) extensively reviewed regional integration literature spanning the modern static theory and the extensions. For small countries the author argues that intra-regional trade will increase among member countries as long as they are predominantly least-cost producers of export goods. However, in cases where diversion will increase costs, non-member countries are likely to continue supplying imports to member countries which will negatively impact intra-trade. The following examples shed light on the empirical evidence over time.

Frankel et al. (1995) establish that intra-regional trade as a share of total trade among the Andean countries7 increased between 1965 and 1990 from 0.8 percent to 2.6 percent. There is a higher performance among the East Asian countries from 20 percent to 29 percent during the same period. The intra-EC trade as a share of total EC exports increased from 35 percent in 1960 to 49 percent in 1970 (DeRosa, 1998). After the expansion of the EC from 6 to 9 countries 8 from 1970 to 1981, intra- EC trade as a share of total trade grew from 49 percent to 52 percent. The EC12 saw even more intra-trade. The decomposition the effects using a gravity model reveal a highly statistically significant relationship between regional integration and growth in intra-regional trade. A number of other studies have demonstrated an increase in intra-regional trade among integrating countries (for example, Vollrath, 1998 for Association of Southeast Asia Nations (ASEAN) Free Trade Area (AFTA), Asia-Pacific Economic Cooperation (APEC), Canada-United States Free Trade Agreement (CUSTA) and the European Union (EU). Sherman and Karen (1999) observe that much of the increases in trade occurred among developed countries, with developing and developed countries experiencing limited trade and developing countries experiencing even less intra-regional trade.

Other studies have painted a rather pessimistic picture of RTAs especially in developing countries (South-South). It is argued that the similarity of resource endowment of the partner members and the frequent failure by these countries to implement fully the terms of their regional integration agreement makes it hard for them to increase intra-regional trade. In some cases there has been deliberate undermining of the integration agreements. Naya and Plumber (1991) reported that the ASEAN after a decade of existence failed to increase intra-bloc trade much above its level of 15 percent to 20 percent of total ASEAN trade. In Latin America, the expansion of intra-regional trade in manufactures and all goods failed to match that in the EC and out-ward oriented East Asian Newly Industrialized Countries (NICs) of Korea, Hong Kong, Singapore and Taiwan. Nogues and Quintanilla (1993) report that the intra-regional trade in manufactures during 1965 to 1990 by the out-ward-oriented Asian NICs grew from 2 percent of GDP to 6.9 percent of GDP and the intra-regional trade in manufactures during the same period by the ANDEAN9 Pact countries grew from 0.1 percent of GDP to 0.6 percent of GDP.

A World Bank study on regionalism argues that South–South RTAs are non-edifying (World Bank 2001). Rather than reaping economic benefits like increase in intra-trade, they generate trade diversion which reduces welfare in circumstances when tariffs are high. Yeats (1998) looking at trade data from Sub-Saharan Africa argues that intra-regional trade has a potential to create adverse effects especially on third party member countries and concludes that intra-trade is likely not to make an important impact on the partner countries and may negatively impact Africa’s industrialization. A most radical view about RTAs in the South was put forward by Schiff (1997). He argues that RTAs between small countries increase the likelihood of partners switching from cheaper imports from low cost third party members to higher cost partner members. Perhaps Park (1995) argument like Derosa (1998) reveals the source of this problem. The authors argue that when the intra-regional trade shares are small in total trade, there are more chances of trading blocs diverting trade.

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Trade LiberalizationIn this chapter, I will discuss trade liberalization more deeply and consider how the regionaltrade agreements have developed during the years. This chapter, as the thesis, concentrates ondiscriminatory tariff reduction. First, I will present the features of the trade liberalization to beable to understand the context of this thesis.

2.1 DescriptionEconomic co-operation and integration have a long history. Formal and informal tradeagreements have existed wherever people have traded. (Plant & Taghian 2008, 1.) In the half–century before World War I some countries already enjoyed free trade in Europe. Though,this system of free trade did not emerge from any continent-wide agreement. Instead, mainlythe series of bilateral treaties were established. (De Melo & Panagariya 1996, 122.) Laterbroader trade liberalization began when the European integration started to develop in the1950 in the form of European Economic Community (EEC) that nowadays is known asEuropean Union. (Berry & Hargreaves 2007, 1-8.) The European integration led throughcontagion and imitation effects on the trade liberalization continue steadily. (Pomfret 2007,924.) Since the early 1990s regional trade integration has been the main form of tradeliberalization. (Calvo-Pardo, Freund & Ornelas 2009, 2). These days, the most knownregional trade agreements are EU (European Union), NAFTA (North American Free TradeAgreement), MERCOSUR (Southern Common Market), ASEAN (The Association ofSoutheast Asian Nations) and COMESA (The Common Market for Eastern and SouthernAfrica) (WTO a, 30.1.2011).

Trade liberalization is a form of trade policy. In the trade liberalization, the countries thathave opened their trade to international trade remove both tariff barriers and non-tariffbarriers to trade. The trade liberalization increases by the formation of new trade areas or bythe expansion of the existing trade areas.

In the trade liberalization, the agreement can be (Crawford & Fiorentino 2005, 4):i) Between two countries (bilateral)ii) Between a country and already existing regional trade area (bilateral) oriii) Between many countries (plurilateral).

The trade liberalization is implemented through regional trade agreements and the aim is toremove both tariffs and non-tariff barriers (import quotas, export restraints, and exportsubsidies) to trade. A tariff is a tax on either imported or exported good. The effect of importtax is symmetrical to the effect of export tax. (Sawyer & Sprinkle 2004, 132-133.) A tariff isthe oldest form of trade policy and traditionally it has been a source of government income,even though the main purpose has usually been to protect domestic industries (Krugman &Obstfeld, 2009, 183). There are different types of tariffs as specific tariffs, ad valorem tariffsand compound tariffs (Sawyer & Sprinkle 2004, 132-133). The importance of tariffs hasdecreased recently and governments prefer to protect domestic industries through a variety ofnontariff barriers (Krugman & Obstfeld 2009, 183). The reasons to establish regional tradeagreements and the benefits of forming RTA have been defined mostly by economic terms

that will be gone through in Chapter 3. (Plant & Taghian 2008, 1.)

The Levels of IntegrationThere are different levels of integration. Economic integration can apply to only productmarkets as well as the integration can be deepened to the markets of production (labor andcapital) and services as it is done in the custom union such as European Union where there isa free move of goods, services, labor and capital (Berry & Hargreaves 2007, 4-5). When thefirst trade liberalization, the establishment of ECC, took place, only tariffs and quotas wereremoved. This was the lowest level of integration. The ECC is the origin of European Union.(Berry & Hargreaves 2007, 6.)When discussing the trading blocs, the main concept is regional trading agreements (RTA). Inthe literature terms preferential trade area (PTA), free trade area (FTA) and custom union(CU) are often used. Both Free Trade Area (FTA) and Custom Union (CU) are forms ofregional trade agreements. From the regional trade agreements, approximately 90 % are free trade areas and 10 % are custom unions. (WTO a, 30.1.2011.) From Figure 1 below the levelsand typical characteristics of economic integration can be observed for different levels ofeconomic integration.

The differences between the levels of economic integration can be noted in the vertical axisfrom Figure 1 above. In the horizontal axis, there are the different levels of economicintegration. The economic union is the deepest form of economic integration when thepreferential trade agreement is the loosest. The economic union includes all the looser formsof economic integration. European Union is an excellent example of the economic union. Inpreferential trade agreement only some tariffs are removed, but in custom union all theintragroup tariffs are removed and countries in the bloc set a common external tariff. (Sawyer& Sprinkle 2004, 207.) Therefore, depending on the level of economic integration, differentcharacteristics are typical for the agreement. This thesis concentrates in both literature reviewand empirical part only the three least restrictive levels of economic integration known asPTAs, FTAs and CUs.

The Development of the Regional Trade LiberalizationOne of the main international developments in recent years has been the growth of regionaltrade agreements (RTA). WTO announced there were overall 2835 regional trade agreementsthat include either or both goods and services, in force and 191 under negotiation in July 2010(WTO a, 30.1.2011). As Figure 2 below depicts, the number of RTAs has increasedconstantly. It is interesting to perceive that the world trade has grown in the same pace. Thefigure is based on the agreements that can include either goods or both goods and services andare in force according to WTO.

It can be noted from the above Figure 2 that there have been three peaks in the developmentof the regional trade areas that are gone through in the following paragraphs. The tradeliberalization expanded to developing countries in the 1970s when the Generalised System ofPreferences (GSTP) was established in 1971. Therefore, the extensions of tariff preferencesfor developing countries become possible. (Pomfret 2007, 924.) Since 1970 the amount ofRTAs has been on the increase.

Therefore, the first peak of agreements was before the 1980s. (OECD 2009, 2.) In the 90s, the

amount of agreements again started to rise remarkably (2nd peak). This trade integration hasincreased the globalization in terms of trade integration meaning that more and morecountries belong to at least one trading bloc. In addition to that, countries have reachedbilateral agreements. However, skepticism about trade liberalization came in the picture late1990s and some signals of decreasing trade liberalization were noticed. (OECD 2009, 4.)Still, the growth of regional trade agreements and world trade has always correlated strongly.In the early 2000s, the trade liberalization in Asia can be seen as a third wave of agreements(Pomfret 2007, 925). In East Asia, the regional integration started to increase in the year of1985. The integration was more market driven than policy driven. (Pomfret 2007, 936.)Despite the ASEAN free trade area (AFTA) there were not many significant bilateral orplurilateral agreements before to 2000. However, in Asia, there are currently at least dozenmajor free trade areas.Significant changes were noticed when the trade liberalization took place in Asia. Forinstance, the countries started to establish more bilateral agreements compared to plurilateral.Besides, the bilateral agreements were no more formed with countries in the samegeographical area which is the reason for the decrease of regionalism. (Plummer 2007, 1772.)China, for example established regional trade agreement with Peru and India with Chile.Despite the crisis in the 2008-2009, the trend of the increasing regional trade agreementscontinued. As Figure 2 above represented, the trend in the world trade has followed the trendin regional trade agreements. Except during the financial crisis while the world trade in totalwas decreasing.

The Recent TrendsAs it has already been discussed the trade liberalization in Asia and emerging economiesbrought significant changes to the trade liberalization. Around the year 2005, four trends related to regional trade agreements were noticed (Crawford & Fiorentino 2005, 2). First,countries started to make regional trade agreements the centerpiece of their commercialpolicy. Second, the complexity of regional trade agreements started to increase because of theincreased amount of agreements, both bilateral and plurilateral. Third, reciprocal preferentialtrade agreements between developed and developing countries began to increase. Also theagreements between key developing countries started to increase which meant that the socalled South-South trading patterns began strengthening. Fourth, the number of cross-regionalregional trade agreements started enhancing, but also the regional trading areas on a continentwide were on the rise. (Crawford & Fiorentino 2005, 2). Some of these trends and theunderlying reasons can be noticed also in practice.

The signs of more diverse and complex RTAs can be noticed in the configuration of theagreements. The overlapping agreements and networks of regional trade areas have beenreaching within and across continents at the regional and subregional levels. In addition,compared with plurilateral agreements more bilateral agreements are nowadays established.This change can be seen especially in the agreements of India and China (WTO b, 12.8.2011).

The complexity of the RTAs originates in the intersecting agreements. Both China and India,for instance are at the center of systems of bilateral RTAs. In addition to SAFTA membershipIndia has for instance bilateral regional trade agreements with Nepal, Bhutan and Afghanistanand India has signed regional trade agreements with Japan and EFTA, for instance (WTO b,12.8.2011). This kind of system of arrangements that India and China have, is known as “hub

and spoke” RTA, where India and China are the hub nations and the partner countries in thebilateral agreements are spoke nations as it can be seen from Figure 3 below.

In general, the role of the increased amount of bilateral agreements is a significant trendbecause of the trade effects of the “hub and spoke” –system. Researchers have suggested thatthe benefits of the hub nations are greater than the benefits of the spoke nation. This isbecause a hub country, India, forms a hub and spoke system with Afghanistan and Bhutan.This may lead to trade diversion for spoke countries Afghanistan and Bhutan, but not for hubcountry India. If the model is extended to include more spoke countries such as Nepal, eachnew spoke country leads more trade creation for the hub, India. However, the welfareimplications for existing spoke countries depend upon whether the exports of the new spoke,Nepal, are complements or substitutes to those of old members, Afghanistan and Bhutan. Ifthey are substitutes, the old spoke nations can be harmed by erosion of their degree ofpreference in the system. In a case of complements, the initial member countries also tend togain. (Baldwin & Venables 1995, 1634-1635.) These kind of hub and spoke arrangementshave increased the complexity in the system and as well have changed some typicalcharacteristics of the trading partners such as geographical distance.

The Economic Impacts of Trade LiberalizationThe goal of this thesis is to study in the empirical part the trade effects of the regional tradeagreements by using data from the emerging economies. Within the researchers, there issignificant disagreement about the consequences of the trade liberalization (Ornelas 2005b,472). Viner was the first researcher who presented his theory on general trade effects dividingthe effects into two: trade creation and diversion in the traditional, static welfare analysis “TheCustom Union Issue”. After Viner trade creation has been represented by many researchers aswell as the overall positive effects of the regional trade agreements have been questioned.(See Bhagwati, Krishna, & Panagariya 1999, 105-118.)

In general, as Viner (See Bhagwati, Krishna, & Panagariya 1999, 105-118) discovered, bothtrade creation and diversion are possible consequences of the trade liberalization. Therefore inthis chapter both of them are carefully gone through. The main goal is to consider the effectsof the trade liberalization on the trade of the member countries. The factors that are taken intothe consideration when establishing the agreement operate a base of the analysis. In addition,at the end of this chapter, in Chapter 3.3, I talk through the relationship betweennondiscriminatory and discriminatory tariff reduction. This causal relationship functions as abase for the influences of RTA on trade flows and is also one of the consequences of the tradeliberalization in the model of Ornelas. In addition, the influence of partner countrycharacteristics on trade creation and diversion is reviewed, because some of the researcherssuggest that these may have influence on what kind of trade effects the established RTA mayhave.

The Influence of Discriminatory Tariff Reduction Broader LiberalizationAs Ornelas (2005b, 471) model for trade creation drops a hint of the positive relationship ofdiscriminatory and nondiscriminatory tariff reduction also other researchers have paidattention to that. In this chapter it is shortly reviewed some viewpoints within this issue.

In general one of the three goals of the World Trade Organization (WTO), the successors ofGATT (General Agreement of Tariffs and Trade), is the trade opening via multilateral trading system13. However, countries are establishing RTAs themselves and removing bilateraltariffs. Because these two actions take place at the same time, the question under review hasbeen, whether one helps another?Baldwin and Venables (1995, 1636) studied, if the membership of a RTA leads the countriesto set higher external trade barriers which may cause a breakdown of the multilateral tradingsystem. They pointed out that external tariffs are set to maximize the welfare of the countriesor region. By using this idea, Ornelas (2005b) in his oligopolistic-political economy modelthat was used in Chapter 3.1 to explain trade creation suggested that the reduction ofdiscriminatory tariffs enhances the reduction of external tariffs. In addition Ornelas (2005b,480) depicts that the larger the RTA in question, the larger are the reductions of externaltariffs. Therefore, Ornelas (2005b, 474) concludes that the regionalism can be regarded as ablessing for the world trading system because of the trade creation effect and decrease ofexternal tariffs.

The study of Estevadeordal, Freund and Ornelas (2008, 1532-1537) supports the fact thatRTAs lead to a decrease in nondiscriminatory tariffs. They justify this with the empiricalresult. In addition they state three facts why the RTAs are positively correlated with externaltrade liberalization having their stress on developing countries. First, RTAs are seen to havegreater impact on multilateral tariff reduction in the developing countries because thus far theimpact of multilateral system on tariff reduction has been small in developing countries towhich BIC-countries are still categorized according to IMF. Second, as the theory predictshigh external tariffs gives more motivation to reduce external tariffs and this way the politicalinterest moves away from protectionism and multilateralism spreads. Third, some productsmay be easier to liberalize than others which means that trade in these products is oftenliberalized both regionally and multilaterally.

In their studies Richardson (1993) and Bagwell and Staiger (2001) obtain results that are inline with Ornelas’ (2005b) proposition of the relationship. One difference in the models is thattheir results were obtained in a competitive framework. According to their studies, the tariffrevenue and terms of trade enforces governments to lower external tariffs under a RTA.

Ornelas (2005a) sheds light to a viewpoint of a negative relationship of nondiscriminatory anddiscriminatory tariff reduction. Ornelas (2005a, 1717) suggests that the reduction ofprotection against the non-members is done to generate overall trade creation. This causes theaccess of non-member countries to integrating markets to increase. In unison, the extra gainsfrom multilateral liberalization decrease because the costs of multilateralism are keptconstant. Therefore, this trade creation may reverse the support of the excluded countries tomultilateral liberalization. This means that RTAs may cause harm to multilateral tradingsystem by causing the non-members to hinder multilateralism.

To conclude, the opinions of this relationship between trade liberalization and multilateralismfluctuate. No unambiguous conclusion is possible to drawn in this topic. However, a commonfactor that connects the opposite viewpoints is the reduction of external tariffs that occurs inboth of the situations.

The Role of the Characteristics of the Country pairs in Trade LiberalizationThe role of the characteristics of the partner countries in the regional trade agreement issignificant. The characteristics influence on both the probability of the establishment of theagreements and the influence of the agreement on non-member countries. Since Viner, thetheoretical studies have shown that the welfare effects of the regional trade agreements can bepositive or negative depending on the countries involved in the trade bloc. (Magee 2003, 1.)In this chapter, the importance of characteristics is reviewed as a base for the empirical part.

When a term optimal partner country is mentioned in the context of regional tradeagreements, it is meant that it is more likely that countries with specific characteristics, eithereconomic or non-economic, sign on an agreement. Many researchers have tried to find outwhich characteristics of partner countries make more likely to reach the regional tradeagreement. Bair and Bergstrand (2004), Krueger (1999) and Lee and Shin (2006)concentrated on economic factors. Magee (2003) studied the role of both the economic andnon-economic factors. I discuss each approach in turn, with my focus on non-economicfactors.

There are some explanations for the use of the economic factors of the partner countries indetermining regional trade agreements. In their study Baier and Bergstrand (2004), examined econometrically the key economic factors influencing the likelihood of country pairs forminga free trade agreement. According to their study, country pairs tend to have particulareconomic characteristics that according to theory should foster the country pair’s net tradecreation and welfare. They divided the economic determinants of trade creation and diversioninto three groups. The first is the economic geography factors. Trade creation is larger thecloser two countries are, and trade diversion is less the further two continental tradingpartners are from the ROW. The second category is intra-industry determinants. The tradecreation is greater the larger and more similar are the economic sizes of the two countries andtrade diversion is less the smaller is the economic size of the ROW. The third category is theinter-industry trade determinants. Trade creation is greater the wider are the relative factorendowments between two countries, and trade diversion is less the smaller the differencebetween the relative factor endowments of the pair and that of ROW. (Baier & Bergstrand2004, 33.) They found empirical support for all three groups of characteristics predictingFTAs.14 The economic characteristics can predict correctly 85 % of the 286 FTAs existingamong 1431 country pairs in 1996. (Baier & Bergstrand 2004, 50.)

Magee (2003) also studied which countries are expected to establish regional tradeagreements having the same assumption about the endogeneity of bilateral trade flows andregional trade agreements with Baier and Bergstrand (2004). In addition to economic factors,he concentrated on political factors. Magee (2003, 7) found out that countries are more likelyto form RTA if they already have significant bilateral trade, are similar in capital-labor ratios,are similar in size as well as are both democracies. Therefore, the results indicate that botheconomic and political factors are important in shaping the agreements. The findings ofMagee (2003) about the economic size of the countries are in line with the findings of Baier

and Bergstrand (2004). In addition, Magee (2003, 14) assumes that countries that have largebilateral trade flows are considered natural trading partners.

As Baier and Bergstrand, Krueger (1999, 116) studied how the economic similarity influenceson regional trade agreements. He states that regional trade agreements between a developedand developing country are more probable to improve welfare than an agreement between twodeveloping or two developed countries. The reason for this assumption is that in the international trade theories, such as Ricardian and Heckscher-Ohlin, countries with aliketechnologies and capital-labor ratios receive no gains from trade with each other. Therefore,similar countries have less possibilities for gains from trade based comparative advantage,which is opposite to the findings of Magee (2003).

There are few explanations for the use of the non-economic factors of the partner countries indetermining regional trade agreements. (Magee, 2003) In general, culture is thought to haveinfluence on economic outcomes by affecting personal traits such as honesty, thrift,willingness to work hard, and openness to strangers. (Barro & McCleary 2003, 2.) Therefore,it can be assumed that similar culture has positive influence on determining regional tradeareas. In addition to Magee (2003), Rose (2000) underlines that the existences of regionaltrade agreements have to be explained by non-economic factors, even though he does notspecify non-economic factors more carefully.

In previous research cultural variables are as well used as instruments for trust, which is seento correlate with the regional trade agreements. Among others Rose (2000) and Baldwin(2006) support the fact that cultural factors can be used as instruments for regional tradeagreements. Rose (2000) finds that historically regional trade agreements have increased tradeby 235% by studying countries that have very close cultural roots. Baldwin (2006) insteadonly finds an increase of 9 % in trade as a consequence of regional trade agreements. In hisstudy, the countries were not as culturally close. Therefore, from the non-economic factorssimilar culture enhances the born of regional trade agreements, which is why culturalvariables could be excellent instruments for RTAs in the IV-estimation.

Other researchers have also had attempts to find out the characteristics that make regionaltrade agreements more trade creating or more trade diverting.15 For this Frankel (1997)created the idea of natural trading partners, countries that already trade significantly. Bynatural trading partners it was meant the geographically close countries that may have thesame culture that often leads to trade creation. In his theory, Frankel (1997, 40) listscharacteristics of the countries that usually encouraged countries to trade. Features are such asgeographically close countries and countries that share cultural characteristics. According toFrankel (1997) if two countries have these features the trade will be trade creating, which isalso a consequence of trade unions. Lee and Shin (2006, 284) used geographical proximity asan indicator to trade creation and diversion. They created variable that show how much common language, geographical distance, land border between the member countries and areainfluence on trade creation and diversion. As a result, they found that if countries share theborder and language and are geographically close the possibility of trade creation increasesand trade diversion decreases. In Chapter 6, the country characteristics that influence on tradecreation and diversion are studied in a case of BIC-countries.

Review of the Empirical LiteratureThe literature and research about regional trade agreement started to develop in the 1950. Inthe 1960s as a consequence of the European integration, the research started to increase.Among others Bela Balassa studied integration from many perspectives.16 Furthermore, thewave of regionalization in the eighties increased the amount of research of regionalization inthe theoretical and empirical literature. (Caporale, Rault, Sova & Sova 2008, 1.) From theeconomics point of view, the most common topics of research in regional trade agreementshave been the influence of different regional trade agreements on trade.

The increase in regionalism and the development of the regional trade agreements started toincrease interest and significance among economists. Also the interest among other sciencesappeared. Researchers of social science studied the topic trying to find out which countriesare expected to form regional trade agreements (See Magee 2003).

However, the empirical research about regional trade agreements started to increase in thebeginning of the 1960s, when Tinbergen (1962) applied the gravity model to studyinternational trade flows. He included the RTA dummy variable in the gravity equation andwas the first to estimate the effects of regional trade areas on trade. In his first study, he foundsignificant positive effects among members of British Commonwealth although insignificantfor Benelux RTA. After Tinbergen (1962) various results about the influence of RTA havebeen found out. After Tinbergen (1962) numerous empirical analysis has used the gravitymodel and conducted to provide various verifications and conclusions to international trade.17

Since the 1990s important changes in the research were noticed when the gravity modelgained a lot of attention in the analysis of international trade. This was as a result of renewedinterest in economic geography and increased interest on other kinds of factors of economicactivities as well as the rapid expansion of free trade agreements in the 1990s. (Urata &Okabe 2007, 7.)

The researches made in the 2000s have still mainly concentrated on major trade blocs. Newaspects have been the interest in new members to European Union as well as the regional trade areas in Asia.18 This was partly because trade liberalization took place in Asia latercompared to other continents. (Pomfret 2007, 925.) Also new aspects such as the effect ofregional trade areas in different sectors have appeared.

Overall, the previous literature has concentrated mainly on the largest regional trade areassuch as European Union, Mercosur, Nafta and ASEAN and most of them have used thegravity model as a research method. It is actually surprising that the trade liberalization ofemerging countries has not been analyzed more profoundly in terms of trade integrationwithin last few years, as it would obviously provide a rather profitable and exceptionalframework for research. The number of empirical analyses of China, India and Brazil aremodest as well.

The first part of this chapter presents the most important studies related essentially to tradeliberalization. Literature about the relationship of discriminatory and nondiscriminatory tariff

reduction is excluded from the review. Despite the studies, where the relationship is analyzedalong with the trade effects of the regional trade agreements, are expectations though. Secondpart of this chapter then covers empirical studies on trade liberalization that deal withemerging countries, specifically with BIC-countries. Most of the emerging country studieshave concentrated predicting the trade potential of the countries.

Empirical Studies on Trade LiberalizationThe study performed by Calvo-Pardo, Freund and Ornelas (2009) represents one of the mostinteresting ones in the category of trade liberalization. Even though the scope of this study isin the trade effects of the ASEAN Free Trade Agreement, its findings appear rather interestingalso from the nondiscriminatory viewpoint of trade liberalization. Specifically, Calvo-Pardo etal. examined how the ASEAN Free Trade Agreement influenced the trade with non-membersand external tariffs facing non-members. They studied the influences during the period of1992-2007 across HS 6-digit level industries by dividing the yearly data into six three-yearperiods. As a result, they found a positive influence of the ASEAN free trade agreement(AFTA) on imports inside the bloc. In addition, it seems that tariff reduction does not havelower import growth from non-members. Therefore, AFTA has had positive impact on trade among members without trade diversion. Also as a consequence of the lower internal tariff,the members of AFTA have lowered their external tariffs. This means that a causalrelationship between preferential and MFN tariff reduction is found. Therefore, thepreferential tariff reduction in AFTA has influenced on broader liberalization.

Another interesting study on trade liberalization is provided by Baier and Bergstrand (2007).Baier and Bergstrand (2007) studied the influence of free trade agreements on trade in a newway. In their study, they criticize the assumption that free trade area is exogeneous variable.Therefore, they were the first ones to address the endogeneity of free trade agreements. Thepanel data that they use from 1969-2000 adjusts the endogeneity well. With this assumptionBaier and Bergstrand (2007) found that after ten years free trade area has approximatelydoubled the trade between two members, which is seven times the effect estimated usingOLS. Therefore, if regional trade agreements are assumed to be endogenous, most of theprevious studies of the effects of RTAs on trade flows may be biased. (Baier & Bergstrand2007, 74.)

Also, Caporale, Rault, Sova and Sova (2008) shed light on the endogeneity of the free tradevariable. They focused in their study free trade agreements between European Union (EU-15)and the Central Eastern European countries (CEEC-4 i.e. Bulgaria, Hungary, Poland andRomania). To address these issues a dummy variable that represents the associationagreement is introduced. In addition, the robustness of the agreement variable is studied intwo different ways. First, an extended sample of countries including three countries (Belarus,Russian Federation and Ukraine) that did not sign the FTA with EU-15 even though countriesbelonged to the Communist bloc is considered. Second, different estimation methods areused. As a method, they used the fixed effect vector decomposition (FEVD) technique to beable to isolate and eliminate the potential endogeneity bias of the agreement variables and toobtain more robust results. The sample period spans the period 1987-2005. When Caporale etal. examined the bilateral trade effects between EU-15 and CEEC-4 countries, the positiveand significant effect of regional trade agreements on trade. Countries that signed the FTAwith EU-15 exceeded the trade growth by 14 % of the control group of countries which did

not become members.The study performed by Lee and Shin (2006) also represents an interesting aspect to the tradeliberalization. Even though the scope of this study is to examine the possible trade creationand diversion effects in East Asia, Lee and Shin (2006) also pay attention to the country characteristics that influence the RTA more likely to be trade-creating or trade-diverting. Tobe able to study the trade diversion effects, Lee and Shin (2006) introduce RTA dummy thatgets value unity if another of the countries belongs to some regional trade area. With the samemethod both Urata and Okabe (2007) and Lee and Shin (2006) were able to capture the tradecreation and diversion effects in their studies. The panel data covers 175 countries from 1948-1999. To be able to capture how the characteristics of member countries affect trade creationand diversion, Lee and Shin (2006) define interaction terms between intra- and extra-blocRTA dummies and variables such as distance, border, and language. Lee and Shin (2006)found in their study that in East Asia the regional trade agreements tend to be more tradecreating than diverting. In line with the natural trading partner theory, Lee and Shin (2006)were able to show that country characteristics have significant impacts on trade creation anddiversion. According to their findings, the countries that are located close and share a landborder are more probably trade creating and less trade diverting.

The study performed by Urata and Okabe (2007) is one of the most relevant studies about theimpacts of free trade agreements on trade flows. They examined the impacts of free tradeagreements on trade using two approaches. The first approach is to study the changes in tradepatterns before and after an FTA by using the indicators of intra-FTA interdependence.Specifically, they measure the extent of dependency on foreign trade between and amongFTA members. The second approach is to estimate the gravity equation to determine theimpacts of FTA, such as trade creation and trade diversion, on trade flows. To be able to studythis, they add two additional FTA dummies to the equation: FTAtononFTA andNonFTAtoFTA. Urata and Okabe (2007) extend the previous studies in the second approachby enlarging the sample size in terms of time-period and they also disaggregate the trade datato different sectors, because they assume that the impact of FTA is different for differentsectors. Urata and Okabe (2007) found that FTA increased the trade in almost all the cases.By using the aggregate data, they found trade creation effect, but the trade diversion effectwas limited. Both of these effects depended on the regional trade agreement in question. Thepositive trade creation was found for NAFTA, AFTA and MERCOSUR. Therefore, the tradediversion effect was found for all FTAs except MERCOSUR, EU-Mexico, and Japan-MexicoFTAs. With the disaggregated data, trade diversion was found only in EU, MERCOSUR andNAFTA.

In the interest of researchers has also been how integrated two trading blocs are. Hellvin andNilsson (2000) in their study examined the level of integration between EU, Asia and NAFTAand possible extra-regional bias in the trade between the blocs. In the study, the actual tradeflows were compared with projected trade based on gravity model estimation using OECDcountries as a reference group. The estimation is done using the average of the years 1995 and1996 to be able to avoid possible temporary shocks. As a result, it was found that EU’s andNAFTA’s trade trade integration with Asia is above the average level of integration amongthe OECD countries. Instead, the integration is the weakest between EU and NAFTA andstrongest between Asia and NAFTA. The integration between EU and Asia has beenstrengthened with the ASEM (Asia-Europe Meeting) meetings every two years.

In the interest of Martinez-Zarzoso and Nowak Lehmann (2003) has also been the tradebetween two trading blocs, Mercosur and European Union. They use a panel data analysis todisentangle the time-invariant country specific effects and to capture the relationshipsbetween the relevant variables over time. The time period under study goes from 1988 to1996. They found that the fixed effect model is preferred over the random effect model. As aresult, it was discovered that belonging to one of the two regional trade area fosters trade.

natia_shamugia_masterthesis

IntroductionRegional Trade Agreements (RTAs) are an important determinant of economicintegration, since they institute free trade among a number of nations in a specific area orregion. Developing and transition countries widely participate in RTAs. The existing RTAs arebeing updated every day and are continuing to increase their membership.The number of RTAs increased significantly during the past several years. According tothe WTO RTAs database, “by July 2010, 474 RTAs have been notified to the GATT/WTO” (WTO,Regional Trade Agreements, accessed April, 2011,http://www.wto.org/english/tratop_e/region_e/region_e.htm). The overall number of RTAs in forcehas been increasing steadily since then. Currently, almost all the world countries are membersof at least one RTA, and the majority of them are members of several such treaties.

RTAs usually bring about some costs but there are also a number of benefits associatedwith these types of agreements. First, RTAs create free trade within a given bloc. Some otherbenefits include increased competition and greater efficiency, which leads to the creation of alarger market with economies of scale. Such effectiveness of the market contributes to thegrowth of domestic as well as foreign investment. Thus, the result is increased inflows of FDIinto the economy.

040309_dissertation

Trade Creation and Trade DiversionTheoretical insights into the allocation effects of RTAs were first given by Viner andByé; their contributions in the 1950s laid the analytical foundation for the Customs Union(CU) theory (Viner 1950; Byé 1950). Before that, economists mostly regarded regionalism asa step towards free trade.3 The idea behind this perception is that global free trade allowsconsumers to purchase from the cheapest source of supply, so that production can be locatedaccording to comparative advantages. Trade barriers, in contrast, discriminate against foreignsupply and divert consumption to the output of domestic industries, even though produced at higher costs. As a consequence, a partial liberalisation through RTAs, reducing at least sometariffs, was widely assumed to generate gains from trade.

Viner questioned the free-trade perception of regional integration arguing that afractional reduction of trade barriers leads only to a shift, but not to an elimination of thediscrimination of different sources of supply. The change in the location of productionfollowing the establishment of a CU is accompanied by two opposing effects, the neteconomic effect of which depends on whether the diversion of purchases is in favour of loweror higher money-cost sources of supply (Viner 1950: 42). In his famous contribution “TheCustoms Union Issue”, Viner clearly distinguished between trade-creating and trade-divertingeffects of CUs.

Trade creation is associated with the portion of the new trade between membercountries that is wholly new resulting from an improvement in the international resourceallocation. It occurs when subsequent to the formation of a CU, domestic production at highcosts is replaced by lower-cost sources from the new partner country. This shift has twoaspects: first, it leads to a reduction or elimination of higher-cost domestic production ofgoods which can now be imported from the more efficiently producing partner country. Thissaving in real costs is called the production effect. Second, the shift induces a rise inconsumption of those goods now being imported at lower costs from the partner country thathad to be consumed at higher costs prior to the trade deal. The resulting gain in consumersurplus is called the consumption effect.

Trade diversion refers to the part of the new trade between member countries that isonly a substitute for trade with third countries. It describes a situation in which thepreferential trade liberalisation causes higher-cost production from the new partner country toreplace imports from low-cost sources in the ROW. In this case, the resource allocation isworsened. Here again, two effects can be distinguished: first, the production effect consiststhis time of a cost increase for those goods initially imported from an efficient producer in anon-member country and now taken from the new trading partner. Second, the consumptioneffect comprises a loss in consumer surplus due to the substitution of lower-cost goods fromoutside the CU for higher-cost goods from the partner country (Lipsey 1957: 40).

According to the above portrayal of orthodox theory of CUs, trade diversion isassociated with a loss of exports for the ROW and thus, its reduced ability to purchaseimports.4 Trade creation, in contrast, is associated with an increase in exports for the RTAmember states. Since every CU will be trade-creating in some and trade-diverting in other

sectors, Viner suggested that the net impact of the tariff reduction depends on the relativemagnitude of the two opposing effects. He recognised, however, that even if trade-creatingforces are predominant, the outside world loses in the short run due to the reduction in trade,while, in the long run, it may benefit from the worldwide diffusion of the increased propensity(Viner 1950: 44). This aspect was formally assessed only in the context of the new tradetheory.

The Gravity Equation to International TradeTwo methods have in the past been used to quantify the effects of regional integrationon international trade patterns – Computable General Equilibrium (CGE) and gravity models.CGE models are typically used in ex-ante simulations to forecast the effect of trade policy.Their general equilibrium character reflects the manifold interdependencies between sectors,policy fields and market actors well. On the one hand, the CGE models’ rigorous andcomplex theoretic underpinnings help reproducing the various relationships and interlinkageswithin an economy; on the other hand this intricacy makes the model hard to tackle forresearchers and policy makers. Since CGE models are very sensitive to the parametersincluded, the data used and the assumptions made about the model structure, they have to beinterpreted accordingly (Piermartini and Teh 2005).6

An alternative to CGE models are empirical gravity models, mostly employed in expostanalyses of trade policies. This thesis uses and develops gravity equations to capture theeffects of trade creation and diversion throughout the process of European integration of theCEECs. Whilst gravity models can appraise with traditional econometric criteria, they do notaim to capture the various interactive effects associated with the formation of an RTA. Their static nature makes them subject to the Lucas critique.7 Other more specific points of critiquethat apply to this method will be discussed in the respective sections.Tinbergen (1962), Pöyhönen (1963) and Linnemann (1966) were among the firstauthors to apply the physics’ gravity equation to international trade. Despite the lackingtheoretical support at the beginning, the model’s high explanatory power turned it quickly intoa popular instrument for the empirical analysis of trade flows. The basic idea is that theintensity with which a pair of countries trades is subject to pull factors like their respectiveGross Domestic Products (GDPs) and push factors like trade impediments in the form ofcustoms duties or the geographic distance between them. In its simplest form, the equationtakes the form

'proceeding-4-21-1524

IntroductionRegional economic integration is one of the main trends in the development ofinternational economic relations in the last few decades. There are multiple examples,practically everywhere in the world, which demonstrate that it is not an isolated event, butan actual global phenomenon. The opportunities that are presented by the differentforms of economic integration arrangements are growing and so are the means andways for their utilization.There is a clear distinction between the integration processes among developedcountries where mainly the classic static and dynamic effects described by classic andnew integration theory are sought, and those among developing and least developedcountries – where the reasoning, the expected benefits and the clear constrains to theparticipation in integration arrangements are different.

Economic integration – definition and typesAccording to Balassa (Balassa, 1961, p. 1) economic integration can be defined as “theabolition of discrimination within an area”. Kahnert defines it as “the process of removingprogressively those discriminations which occur at national borders” (Kahnert et al,1969). This is why measures that only decrease discrimination among countries arereferred to as economic cooperation and not as economic integration. Allen (Allen, 1963,p. 450) claims that every researcher understands economic integration differently. That iswhy according to him one of the main contributions of Balassa is that he definesintegration and shows its difference from cooperation – integration is a restriction ofdiscrimination while cooperation just reduces its negative effects.

According to Lipsey economic integration theory “can be defined as that branch of tarifftheory which deals with the effects of geographically discriminatory changes in tradebarriers” among countries (Lipsey, 1960, p. 460).

Integration according to Machlup (1977) is the process of combining separate economiesinto a larger economic region. Machlup (1977) and Staley (1977, p.243) further arguethat integration is concerned with the "utilization of all potential opportunities of efficientdivision of labour".

Different Bulgarian researchers also define integration differently. According to Shikovaeconomic integration can be defined as a process of economic cohesion of nationaleconomies (Shikova, 2011, p.11). V. Marinov characterizes integration as a coordinatedby the concerned countries process of deep coalescence of their national productionprocesses that is objectively irreversible and leads to the gradual creation of a relativelyunited economic complex (Marinov, 1999, p.10). Panusheff defines economic integrationas the process of integrating national economies to common mechanisms of interactionin which their independent functioning becomes an element of an upward developmentand source of dynamism. Savov connects economic integration with the formation of regional economic blocs ... resulting in increasing their economic interdependence(Savov, 1995, pp. 467-468 ).Despite the differences in these definitions one could formulate the following simpledefinition of economic integration: it is the process of elimination of discrimination in trade

relations between countries. A more complete definition describing economic integrationwith its main characteristics could be that it is an economic agreement between two ormore countries that aims at improving welfare, which is characterized by a reduction orelimination of tariff and non-tariff barriers to trade, as well as by coordination ofeconomic, monetary and fiscal policy, with the ultimate objective to achieve fullintegration, including monetary, fiscal, social and economic policies managed bysupranational institutions.

Typology of integration schemesEconomic integration has many and various forms. A great contribution to theclarification of this issue is the book of B. Balassa "The Theory of Economic Integration"(1961), which is widely cited in all subsequent studies of economic integration -theoretical and in terms of the policy implementation. According Balassa there are fourdifferent stages of economic integration - free trade area (FTA), Customs Union (CU),common market and economic union.

Forms of economic integration are evolutive – each scheme of higher rank contains boththe characteristics of the lower and new elements that expand the scope and content ofthe integration process. Stages can be regarded as steps of a process that has as itsultimate goal (as far as is desired by the participating countries) to achieve full integration– common monetary, social and economic policies and supranational institutions whosedecisions are binding on member-states.

As far as each more advanced form of integration is related to giving more nationalsovereignty by the participating countries, they themselves set the goals in theintegration process. "The transition from one stage to another higher one meansexpanding the areas of economic life – the subject of integration ..." (Marinov, 1999,p.51). Although the process of integration has evolutive nature, countries that believethat this is achievable and consistent with the objectives can start the process done fromone of the higher levels.

So far, there is no consensus in economic theory on the exact number andcharacteristics of the development forms (stages) of economic integration. In this paper Isuggest a classification including eight stages of integration, based mainly on Balassa’sapproach of determination of their content and the differences between them.

According to Panagariya (Panagariya, 2000, с.288) the lowest form of integration is thepreferential trade agreement (PTA). It is an arrangement between two or more countriesin which goods produced within the union are subject to lower trade barriers than thegoods produced outside the union. A good example are the Economic partnershipagreements between the European Union and the African, Carribean and Pacificcountries.

A Free Trade Area (FTA) is a PTA in which member countries do not impose any tradebarriers (zero tariffs) on goods produced within the union. However, each country keepsits own tariff barriers to trade with non-members. This is usually referred to as "tradeintegration" (Hosny, 2013, с. 134). FTA are defined in paragraph (8) of article (XXIV) ofthe General agreement on trade and tariffs (GATT) as follows: A free-trade area shall beunderstood to mean a group of two or more customs territories in which the duties and

other restrictive regulations of commerce ... are eliminated on substantially all the tradebetween the constituent territories in products originating in such territories“. A goodexample is the North American Free Trade Agreement (NAFTA) formed by USA,Canada, and Mexico in 1993.

A Customs Union (CU) is an FTA in which member countries apply a common externaltariff on a good imported from outside countries. This common external tariff can differacross goods but not across union partners. Paragraph (8) of article (XXIV) of the GATTdefines a Customs Union as follows: „A customs union shall be understood to mean thesubstitution of a single customs territory for two or more customs territories, so that: (i)duties and other restrictive regulations of commerce ... are eliminated with respect tosubstantially all the trade between the constituent territories of the union or at least withrespect to substantially all the trade in products originating in such territories, and, (ii) ...substantially the same duties and other regulations of commerce are applied by each ofthe members of the union to the trade of territories not included in the union". The mostfamous example is the European Community (EC), formed in 1957 by West Germany,France, Italy, Belgium, the Netherlands, and Luxembourg.

A Common Market (CM) is a CU which further allows free movement of labour andcapital among member nations. Besides this, to achieve this level of integration, it isnecessary for the member-states to remove all trade barriers (including non-tariffrestrictions), as well as to have a certain level of coordination of some of the economicpolicies. This is usually referred to as "factor integration". At the beginning of 1993, theEU achieved the status of a CM.

Economic union (EcU) is an even more deep form of integration in which monetary andfiscal policies of individual countries are harmonized and even unified. On the basis ofthe common market economic policies in different areas are integrated, commonapproaches are formed and coordinated funding is provided. Eliminating discrimination islinked to a certain degree of coordination of national economic policies in order toremove the differences between them. This stage is often called "integration of policies".

The ultimate goal of the Economic union is the Economic and monetary union (EMU). Itestablishes a common exchange rate mechanism, which grows into a common currencythat functions on the common market. There is a common monetary policy andcoordination of macroeconomic policies of the member-states. An example of EMU is theEurozone within the EU, which since 2001 has a common currency - the Euro.Balassa speaks of another stage of the integration process – the full economicintegration (FEI), which "implies the unification of monetary, fiscal, social and anti-cyclicalpolicies and requires the establishment of supranational authorities whose decisions arebinding on the member-states" (Balassa, 1961, p.2). Here the formulation andimplementation of economic policy is an exclusive competence of the institutions of theintegration community.

Some researchers claim that there is another stage of the integration process, whichhowever, is political. In it the ultimate political goal of integration is to achieve a politicalunion (PU) where integration is carried out also in areas that affect national sovereignty.So far, no integration community has achieved this stage of integration, although the EUmakes efforts to deepen political integration in order to become a real political union –

with the introduction of the common citizenship and the attempts for implementation ofcommon policies in foreign affairs, security, justice and internal affairs.

Classic and new theories on economic integration effectsMany authors claim that economic integration theory goes through two developmentstages each of which addresses the political and economic issues relevant for its time.The first stage includes the traditional theories of economic integration, which explain thepossible benefits of integration and are often referred to as static analysis. The secondstage includes the new economic integration theories, which are developed in changedeconomic conditions and trade environment – they are referred to as dynamic analysis ofeconomic arrangements.

3.1 Static analysisResearch of trade integration and the explanation of theoretical issues related topreferential trade agreements are based on the seminal book by Jakob Viner “TheCustoms Union Issue” (1951), which is often referred to as the first study of the benefitsof economic integration that analyses them critically from an economic point of view(Catudal, 1951, p.210; Salera, 1951, p.84).

Viner’s study is the first one to define specific criteria for the distinction of the pros andcons of economic integration. His so-called static analysis of economic integrationdistinguishes the now well-known effects of trade creation and trade diversion.

One speaks of trade creation when with signing a trade agreement between twocountries trade is shifted from a higher cost producer to a lower cost producer amongmember-states. Trade diversion occurs when imports are shifted from a lower priceproducer from a third country, which is not a part of the integration agreement to a higherprice producer from a member-state. This happens when a common customs tariff isapplied if the integration agreement protects the higher cost supplier from a memberstate.

Viner claims that trade creation increases a country’s welfare while trade diversionreduces it. When speaking about the role of Customs unions on increasing economicwelfare he says: “…customs union is only a partial, uncertain, and otherwise imperfectmean of doing what a world-wide non-discriminatory reduction of trade barriers can domore fully, more certainly, and equitably…” (Viner, 1950, с. 135). What Viner’s theorypractically means is that countries would have motivation to participate in integration if itwould possibly bring more benefits than costs, or, in other words – when integrationleads to more trade creation than trade diversion.

Many researches add on to Viner’s static analysis by addressing different issues ofintegration effects. All of them come to the conclusion that no one-sided answer could begiven to the question of whether customs unions increase global welfare or not. AsMeade says, “Our main conclusion must be that it is impossible to pass judgment uponcustoms union in general. They may or may not be instruments for leading to a moreeconomic use of resources. It all depends upon the particular circumstances of the case”(Meade, 1955, с. 107).

Dynamic analysisEven back in the 60’s, it becomes clear that static analysis of trade creation and trade

diversion is not sufficient. Viner comes to the conclusion that an unpreferential trade policy(free trade) is a far better way to liberalise trade than a customs union, or, in other words

the better allocation of resources is no longer applicable as a rationale for the creation of acustoms union. Static effects analysis cannot fully assess the impact of integration onwelfare, thus Bella Balassa introduces a new instrument to analyse the effects ofeconomic integration on welfare – dynamic effects analysis – as a better means ofexplaining the reasons and economic rationale behind the creation of customs unions andeconomic integration schemes as a whole. A main thesis in international economics is thatfree trade on competitive markets enables production and consumption efficiency globallyas well as in every single country. At first, the creation of preferential trade agreementsmotivated by the ideas of static effects analysis is viewed as a shift towards free trade andthus is perceived as a tool to increase real income. However, this turns out not to be true –this type of analysis does not give simple answers and principles, thus the attention shouldbe put on the dynamic analysis of economic integration (Sheer, 1981, p.53).

Balassa (Balassa, 1962) and Cooper and Massell (Cooper and Massell, 1965) are thefirst researchers that introduce the concept of the dynamic effects of economicintegration, which adds a new dimension to the research in this area. Balassa defines themain dynamic effects of integration: “large-scale economies, technological change, aswell as the impact of integration on market structure and competition, productivity growth,risk and uncertainty, and investment activity” (Balassa, 1961, p.117). Schiff and Winterssummarise the definition of the dynamic effects of economic integration as anything thataffects the rate of medium and long term economic growth of the participating in theintegration agreement member-states (Schiff and Winters, 1998, p.179).

So far a number of recent studies (Sheer 1981; El-Agra 1988; De Melo and Panagariya1993; Fernandez 1997; Lawrence 1997; Burfisher, Robinson, and Thierfelder 2003;UNCTAD 2007, p.54) have referred to the static effects and developments of the theoryof economic integration (Viner and developments) as "old regionalism", while "newregionalism" is represented by dynamic effects such as increased competition,investment flows, economies of scale, technology transfer, and improved productivity”(Hosny, 2013, p.139). Some researchers call the two theories “first and second”regionalism, while others seek the difference in the time frame in which the effects applyto the economies: “Short-term static effects are related to the initial shift in the behaviourof economic actors,… while long-term restructuring effects are related to theimprovement of the condition for the functioning of companies and their efficiency… andcompetition” (Panusheff, 2003, p. 37).

New theories of economic integration are developed together with the change in globaleconomic conditions. Lawrence (Lawrence, 1997, p.18) rightly claims that the drivingforces behind previous integration efforts (simple trade creation and trade diversion) aredrastically different from the factors that stand behind recent integration development,such as private sector participation, foreign direct investment, an increasing role ofservices, etc. Together with these, among the main effects and factors that dynamicanalysis regards as coming from the participation in integration agreements are, asfollows: economies of scale (Corden,1972; Balassa and Stoutjesdijk; etc.), economies of scope (Panusheff, 2003), investment creation and investment diversion (Baldwin, Forslid,and Haaland,1995), increase of competition (Marinov, 1999), etc.

The only obvious setback of dynamic analysis is that, unlike the static one, there is noreliable method for quantitative assessment of dynamic effects.

Dynamic analysis of the effects of economic integration comes from the characteristics oftoday’s free economy. Because of their deeper scope dynamic effects have a largerimpact on economic processes than static ones. The dynamic effects of economicintegration can be summarized as follows: increase of investment expenditure,sustainable increase of demand, consolidation of production and increase of itsspecialization, improvement of the organization and management of production andproduction technology, rationalisation of territorial distribution and utilization of resources,increase of production efficiency, creation of economic growth, etc. (Marinov, 1999).

Master_Thesis_Mads_EspersenIntroductionRegional Trade Agreements (RTA) have seen a revival for the past 25-30 years. ByMay 2011, 489 RTAs have been notified to the World Trade Organization (WTO) with297 currently in force (WTO 2011) and the year-long discussion on global free tradeversus regional trade has been overtaken by pure facts: regionalism is the favouredapproach to international trade in the new millennium. The intent of RTAs is to createbilateral reductions in domestic barriers that multilateral agreements and negotiationshave not been able to attain and figure 1 clearly illustrates the growing preference forregional agreements:

According to Ethier (1998), the growing number of RTAs is caused by the newregionalism. New regionalism can be described through six characteristics: 1) smallcountries link up with a larger country; 2) the small countries are making or have madesignificant unilateral reforms; 3) the degree of liberalization is modest; 4) liberalizationis primarily achieved by the small countries; 5) regional agreements often involve deepintegration1; and 6) regional agreements are regional geographically. A countlessnumber of authors have examined the effects of regional economic integration indeveloped regions through studies of the EU, NAFTA etc. These studies have in general found mixed effects on trade while studies of similar regional agreements in developingregions have found no or very limited effects (Robson 1993). The regional agreementsare, however, still thought to have a positive effect on welfare in developing regions. Inits Strategy for Denmark’s Development Cooperation, The Danish InternationalDevelopment Cooperation (DANIDA) states the importance of well functioningregional markets in developing regions:

“Well-functioning local and regional markets are important steps on the road towardsgreater integration in the global economy, and there is great potential in liberalizingregional trade. Increased regional integration will create larger domestic markets andincrease the competitiveness of the regions in the global markets. However, the localinterstate trade between, for example, African countries is extremely limited at present.Denmark will therefore give greater priority, especially in Africa, to the work ofpromoting regional free trade initiatives such as the East African Community’s effortsto create a common regional market through, among other things, simplifyingregulations and provisions for promoting imports and exports.”(DANIDA 2010:18)

And, furthermore, DANIDA stresses the importance of specialization among thedeveloping countries:“Increased regional economic integration will create larger domestic markets, therebyincreasing the potential for specialization and economic growth as well as enhancingthe region’s competitiveness on the global markets. Both international and regionaleconomic integration are therefore important measures for improved growthprospects.”(DANIDA 2005:20)Thus, liberalizing trade among developing countries at a regional level is expected toincrease the intraregional trade among developing countries as well as increase theirintegration into the global trading system. The first objective is the focus of this paper.Three developing regions are examined: sub-Saharan Africa, East Asia and the Pacificand Latin America. Appendix 1 summarizes the regions included. As is clear fromfigure 2, all three regions have experienced relative increases in intraregional trade since the 1980s, though the increases are very modest for Latin America and sub-SaharanAfrica:

Whether this relative increase in intraregional trade and the strengthening of theregional markets is a result of the increase in RTAs under the new regionalism is thetopic of this paper. Furthermore, the attention in most of the previous econometricstudies is on the impact of particular RTAs (World Bank 2005:62) and consequently,the presence of a RTA has been treated as a black box (Lee and Park 2007; Grant andLambert 2008; Magee 2003). Baier and Bergstrand (2007) further argued that the effectof a FTA is likely to differ depending on the type of agreement and considers this to bea useful extension for future research. Therefore, in this paper the effect of differenttypes of RTAs under the WTO trading system is examined. Three hypotheses are testedin this paper:1. The presence of a RTA will have a positive effect on intraregional trade indeveloping regions.2. The higher the level of mutual obligation in the construction of RTAs, the higherthe positive effect on trade in developing regions.3. The level of bilateral trade differs significantly from region to region.

Furthermore, the effect of different types of agreements in the three regions included inthis paper is studied. The objective here is not so much to compare the different regionsas it is to understand which types of agreements have had the most significant effect onintraregional trade in each region.

This paper estimates the different average treatment effects of RTAs in developingregions using the gravity equation first proposed by Tinbergen (1962) and developedtheoretically by Anderson (1979). Recently, the correctness of different estimationtechniques using the gravity equation has been questioned (Anderson and van Wincoop2001). Consequently, this paper examines the effects of different RTAs using multipleestimation techniques. Furthermore, the question of missing values and zero trade flow

observations are discussed and the presence of zero trade flow observations is found tohave a significant effect on RTA estimates. This problem is largely ignored in previousstudies using the gravity model and is thus a valuable addition to the existing literatureon the effect of RTAs.

Findings in this paper will act as valuable knowledge for DANIDA and other policymakers in their decision making processes on how to strengthen regional domesticmarkets in developing regions and to increase intraregional trade.

The paper is organized as follows: a brief literature review is presented in section 2offering a first overview of the most important findings in previous studies of the effectof RTAs. In section 3 the theoretical foundation for the empirical analysis is presented.This includes the role for RTAs under different trade theories as well as the legalframework under the WTO and a short description of RTAs in force in the three regionsexamined in this paper. Section 3 furthermore describes the gravity equation in details.In section 4 the model for the empirical analysis is constructed. Furthermore, apresentation and discussion of different data structures and estimation methods isprovided while section 5 summarizes the data collected. Empirical results are found insection 6 while section 7 concludes and puts the findings into a policy perspective.

Literature reviewIn the following literature review some of the most important findings in past studies onthe issue of trade agreements’ effect on trade are outlined.In his famous book “The Customs Union Issue” Viner (1950:45) argued thatPreferential Trade Agreements (PTAs), which liberalize trade for only chosen membercountries, can create trade between members or divert trade from non-members. Vinerargued that trade is often diverted from low-cost non-members to high-cost members

causing a negative welfare effect while the trade creation effect caused by an increase intrade volume has a positive effect on general welfare. Viner (1950) further argued that acustoms union would be less welfare reducing if member countries had a large degree ofoverlapping sectors while complementary countries forming a customs union wouldexperience a relatively higher negative welfare effect.

Tinbergen (1962) was the first to publish an econometric study using the gravityequation for international trade flows which included an evaluation of the effect of aPTA dummy variable on trade but with insignificant average treatment effects. Thegravity equation first proposed by Tinbergen furthermore lacked theoretical foundation.Lipsey (1970) showed through a general-equilibrium model that if substitution inconsumption were allowed, then countries forming a trade-diverting customs unioncould experience welfare-improvements in opposition to Viner’s (1950) belief in whichtrade-diversion would always cause a negative welfare effect. Lipsey (1970) argued thatViner (1950) had overlooked the potential welfare-improvement of trade-diversion dueto an implicit assumption of consumption being fixed. Based on Lipsey’s (1970)studies, Bhagwati (1971) further argued that a sufficient condition for a trade-divertingcustoms union to be welfare-reducing is that the level of imports (not consumption) isfixed. Kemp and Wan (1976) found that the creation of PTAs can eventually lead toglobal free trade as there, after the formation of a PTA, always will be an equilibrium inwhich each country, whether a member or non-member, will not be worse off thanbefore the formation of the PTA.

Magee (2003) and Baier and Bergstrand (2007) addressed the endogeneity of FreeTrade Agreements (FTA). By using panel data, Baier and Bergstrand (2007) find after

accounting econometrically for the endogeneity that the effect of FTAs on trade flow has been significantly underestimated in previous studies. Grant and Lambert (2008)further developed the approach by Baier and Bergstrand (2007) to include an analysis ofdifferent sectors and length of phase-in periods. Following the findings of Magee (2003)and Baier and Bergstrand (2007), the fragility of estimated FTA treatment effects hasbeen questioned in recent years. Ghosh and Yamarak (2004) used extreme boundanalysis to test the robustness of FTA dummy coefficient estimates and found that mostFTA coefficients are fragile. Consequently and perhaps not surprisingly, empiricalresults using the gravity equation to explain the effect of PTAs have been mixed.McCallum (1995) studied the regional trade between Canada and the U.S. and foundthat the Canadian-U.S. border has a highly significant negative effect on trade withtrade between Canadian provinces being 22 times higher than trade between U.S. statesand Canadian provinces. Brada and Mendez (1985) estimated the European Community(EC) to have a positive effect on members’ trade while Frankel (1997) found significantnegative effects of the EC. Recently, several studies have examined the effect ofEconomic Integration Agreements (EIA) covering agreements on trade in services.Baier et al. (2008) find that trade in services double 10 years after the entry into forcewhile Guillin (2010) estimate the effect of an EIA to 18-28%.

Studies of RTAs in developing countries is a subject on its own and first receivedattention by Cooper and Massell (1965). Robson (1993) provides an interestingoverview of developments in regionalism in developing areas since then. According toRobson (1993), the formation of regional RTAs in developing countries is significantlydifferent from FTAs in advanced countries as the structural context differs.Furthermore, especially regional agreements in Africa have suffered from protectionist

and inward-looking bias of the participating countries. Recent studies have foundconflicting estimates of regional agreements in developing countries, e.g. theMERCOSUR, ASEAN and CER. Krueger (2000) found significant and positive effectsof the ASEAN agreement while Hassan (2001) found significantly negative effects.Simultaneously, Finger, Ng and Soloaga (1998) estimated the MERCOSUR to have asignificantly negative effect while Frankel (1997) found a large, positive effect. Dharand Panagariya (1994) and Sharma and Chua (2000) found only insignificant estimatesof the ASEAN.

Theoretical background3.1 DefinitionsIn section 3 two main theoretical aspects of this paper are covered: 1) the theory ofregionalism and 2) the gravity model. However, a clear definition of some commonlyused terms on regional trade is needed before proceeding.Regional Trade Agreements (RTA) is here used as joint description of a case in whichtwo or more countries form a trade agreement between them. The RTAs can be dividedinto three groupings: a) a Partial Scope Agreements (PSA) is defined as an agreementbetween two or more countries in which certain goods are subject to lower trade barriersthan other goods; b) a Free Trade Agreement (FTA) is a RTA in which membercountries do only impose trade barriers on goods produced outside the union and not oninternally produced items. Thus, the difference between a PSA and a FTA is thatinternally produced items can only be subject to a tariff under a PSA. Finally, c) aCustoms Union (CU) is a FTA in which member countries apply a common externaltariff (CET) on a good imported from countries outside the union (Panagariya 1999).Consequently, the level of mutual obligation between the participating countries rises asillustrated in figure 3:

Viner (1950:5) further defines a CU through three criteria: the complete elimination oftariffs between the member territories; the establishment of a uniform tariff on importsfrom outside the union and apportionment of customs revenue between the members inaccordance with an agreed formula. It can be argued that common markets, in whichmembers countries also allow free movement of factors of production, and economicunions, in which there is also significant harmonization of the institutional framework,are also to be seen as separate types of regional agreements. Furthermore, monetaryunions in which countries share a common currency are also a way of creating regionalintegration (van Marrewijk 2007). I will return to the different types of agreements insection 3.2.2 and 3.2.3 and will further add the EIA in section 3.2.2.

The theory of regionalismIn the following section two important aspects of regionalism is presented: thetheoretical framework behind international trade and the current trading system with afocus on the WTO and regional trade agreements.

3.2.1 Trade theory and RTAsThe formation of RTAs is based on the theory of comparative advantage first developedby David Ricardo who argued that the relative factor endowment would make itadvantageous for all countries to trade (Ruffin 2002). The Ricardian model of trade onlyincluded one factor of production and was further developed by Heckscher, Ohlin andSamuelson who attributed disparities in comparative costs to the relative scarcity orabundance of production factors and criticized the classical Ricardian trade theoryassumption of immobile factors as well as the single-dimension production factor(Ohlin 1967). According to the theory of comparative advantage countries will havecomparative advantages in the production of particular goods and international trade

will arise as countries use these advantages to trade with each other regardless of anycountry having an absolute advantage or not. The Heckscher-Ohlin-Samuelson generalequilibrium model has a few basic assumptions: there are free trade in goods, differingfactor endowments but factor price equalization and identical technologies andpreferences across countries (Feenstra 2004). Furthermore, there is costless labour andcapital movement within countries but immobility between countries. In the Heckscher-Ohlin model, perfect specialization results only when bilateral differences in factorproportions are large enough. Countries with relative abundant labour will exportlabour-intensive products while countries with relative capital abundance will importthe labour-intensive products in exchange for the capital-intensive products.

Consequently, by trading, countries will reach a new equilibrium in which each countryis allowed to focus its primary production on the sector in which it has relative factorabundance. Thus, compared to autarky, countries will benefit from international trade.

Leontief (1953) tested the Heckscher-Ohlin-Samuelson theorem with data for U.S.import and export and found, surprisingly as the U.S. economy is thought to be capitalabundant, that the capital/labour ratio was higher for imports than exports. According toLeontief (1953), $1 million worth of export would require $13,700 while thecorresponding number for import would be $18,200. This finding, which is referred toas the Leontief Paradox, was later questioned by Leamer (1980). Instead of comparingcapital/labour in export to capital/labour in import as done by Leontief (1953), Leamer(1980) suggested that capital/labour in net export should be compared to consumption.Leamer (1980) thus argued that the Leontief Paradox was only a result of a badlyperformed test and suggested that an alternative test should be performed based on the

factor-content version of the Heckscher-Ohlin model. This version was developed byVanek (1968) and has multiple countries, factors and goods but the model still assumessimilar technologies among countries as well as factor price equalization. TheHeckscher-Ohlin-Vanek theorem focuses on the country endowment of productionfactor relative to that of the World and states that a country with capital abundance musthave a higher capital/labour ratio for production than for consumption. The Heckscher-Ohlin-Vanek theorem, however, still suffers from an unrealistic assumption of equaltechnology among countries. To avoid this assumption, Trefler (1993) further developsthe model to allow for differences in productivity of factors caused by technology andfinds a strong correlation of 0.9 between labour productivity and relative wages across30 countries with the U.S. as benchmark and further allows factor requirements to differacross countries (Trefler 1995).

All models up to this point has assumed constant return to scale in production. Newertrade theories, however, allow for increasing return to scale in which an expandedmarket size leads to decreasing average costs of production and thus a role for firms asincreasing return to scale is not possible under perfect competition. Dixit and Stiglitz(1977) introduced the concept of love of variety in which a consumer demands differentvarieties of a specific good. This approach has been tested in a general equilibriummodel by Krugman (1979) who find evidence of a selection effect in which companies are forced to leave the market as well as a scale effect caused by expanding outputamong the surviving firms. The empirical evidence is, however, weak. Tybout andWestbrook (1995) study the Mexican economy after its 1985-shift towards a moreliberal international trade strategy but find no significant scale effect. Davis (2008), onthe other hand, in a recent study finds a significant scale effect while Todo (2003) finds

scale effects caused by foreign direct investments (FDI). According to newer tradetheories, as a result of selection effect the least efficient companies will exit the marketthus creating higher average industry productivity.

No matter if benefits from trade arise due to static or dynamic effects, it is broadlyrecognised that trade between countries is favourable. A multilateral agreementincluding all countries would in its perfect form create a Pareto optimum in which nocountry would be better off by leaving the agreement. There are, for multiple reasons,only small chances of reaching such an agreement primarily due to political reasons e.g.protectionism (El-Agraa 1999). Furthermore, Krugman (1993) explains the failure ofglobal negotiations by the large number of participating countries in these negotiationsas well as the increasing scope of negotiated topics as both increases the complexity.Consequently, the formation of RTAs can be viewed as a second-best solution.According to Kemp and Wan (1976), given any initial trade equilibrium, every newcreation or enlargement of RTAs can be Pareto improving. Consequently, at least onecountry - member or non-member - should benefit from the agreement while nocountries will be worse off. This view is in line with Viner’s (1950:51) initial theorythat a CU can be beneficial not only for the member countries but also for non-membersif a set of conditions is fulfilled. There is, on the other hand, an ongoing discussion onwhether RTAs will function as “building” or “stumbling” blocks in the process ofachieving free world trade (Krueger (2000) and Panagariya (1999)). This discussion isbeyond the scope of this paper.

While the potential increase in bilateral trade caused by fewer internal restrictions isoften seen as the main objective of forming RTAs, other reasons might explain the

formation of RTAs too. Whalley (1996) points to the fact that RTAs can be formedbased on strategic considerations e.g. as a need to strengthen domestic policy reforms:by committing to a multilateral agreement, participating countries are less exposed tofuture reversals of domestic policy reforms. Furthermore and perhaps more important, forming a RTA can improve access to foreign non-member markets. Chia andSussangkarn (2006) highlights the opportunities for ASEAN member countries in the2005 PSA and 2007 EIA agreement with China. Through ASEAN, East Asiandeveloping countries received favourable access to the growing Chinese market due totheir joint negotiation position. Park (2007) on the other hand argues that while a RTAbetween ASEAN and China might be beneficial, the ASEAN countries and China stillremains economic competitors in competition for foreign market export as well as FDIsfrom developed countries. Park (2007) concludes, however, that internal and externalcompetition will lead to investments in physical and human capital and thus strengthenthe competitiveness of all participating countries.

The United Nations Conference on Trade and Development (UNCTAD) further arguesthat regional trade carries a large potential in areas with little hope of reachingagreements on a global level (UNCTAD 2007:51). Though it might be best fordeveloping countries to integrate with advanced regions this is a distant goal as mostadvanced regions and trading blocs are not ready and willing to open up theireconomies for low cost producers (Melo and Panagariya 1992). Some theorists (e.g.Krugman (1991) and Summers (1991)) have – after investigating different types ofRTAs – even argued that RTAs between geographically proximate countries should befavoured.

To conclude, the theory explaining the formation of RTAs is in many ways similar to

the theory explaining global trade. Due to obstacles in reaching global trade agreements,however, the RTAs become second-best options. Furthermore, regional agreementsmight serve other purposes such as regional stability and security policy issues.

3.2.2 WTO and regional trade agreementsThough free trade under any of the above mentioned theories is expected to be welfareincreasing, international trade is subject to various impediments. The World TradeOrganization (WTO) and the previous General Agreement on Tariffs and Trade(GATT) attempt to lift these restrictions at a non-discriminatory basis and the generalprinciple of Most-Favoured-Nation-Treatment (MFN) is a cornerstone in this work.Article I of the 1947 (and 1994) GATT agreement thus states that any advantage,favour, privilege or immunity granted to any member of the treatment must also be granted other members (GATT 1986:2). The principle of MFN applies to both importand export and includes customs duties such as tariffs, surcharges taxes etc. Theprinciple furthermore covers laws and legislation affecting domestic sales and the like.Though on first sight violating the important MFN principle, RTAs are an integratedpart of the WTO trading system and included both in GATT and the later GeneralAgreement on Trade in Services (GATS). Member countries of the WTO are allowed toform different types of RTAs2 as long as they fulfil certain conditions.

Article XXIV of GATTUnder the Article XXIV of GATT, members are allowed to form either a CU or a FTAas long as they follow three obligations imposed: a) countries forming a FTA or CUmust notify the agreement to the WTO; b) countries forming such agreements mustliberalize substantially all trade and not just trade in certain goods; and 3) countriesforming such agreements must not raise the overall level of protection and increase the

limitation of the access of product from non-member countries (GATT 1986:41).

When joining a FTA, countries retain their sovereignty over external protection incontrast to a CU in which the same external duties and other regulatory instruments areapplied by each member of the union. Furthermore, as quantitative restrictions are notallowed under GATT art. XI; other regulations become the focus of FTAs (GATT1986:17). In particular the rules of origin are a specific topic of interest as rules oforigin have a potentially large effect on trade flows within a FTA and on the importfrom third countries. Non-member exporters will have an incentive to ship goods to themember countries with the least restrictive import barriers and if the rules of origin ofthese products cannot be specified this can lead to serious trade diversion (Serra 1997).Augier, Gasiorek and Lai-Tong (2005) showed that reducing the restrictiveness of rulesof origin had a significant effect on intraregional trade in the EU.

Trough CUs countries agree on common external restrictions which in total must not bemore restrictive to non-members than before the formation of the union. There are, onthe other hand, possibilities of applying higher restrictions than prior to the agreementfor certain goods. This might be the case if one member previously applied a certain external restriction. If this country is not willing to give up this restriction after theformation of the union even though other members have no such restriction, the newexternal restriction towards non-members might be higher than before for thesecountries. The GATT art. XXIV allows this as long as the overall restrictions towardsnon-members are not increased (Matsushita et al. 2006:564). As of August 2011, 15CUs and 167 FTAs are in force under GATT art. XXIV (WTO 2011).

Enabling clause

The Enabling Clause3 was a result of the 1979 Tokyo Round of GATT negotiations andthe purpose of the agreement was to allow RTAs between developing countries thatwould otherwise violate the MFN principle: “Notwithstanding the provisions of ArticleI of the General Agreement, contracting parties may accord differential and morefavourable treatment to developing countries, without according such treatment to othercontracting parties” (GATT 1979:191).

The developing countries were already given special attention in GATT Part IV articleXXXVI on Trade and Development from 19654. In article XXXVI it is thus stated thatdeveloped countries do not expect reciprocity from developing countries for thedeveloped countries’ commitment to remove or reduce tariffs and other restrictions(GATT 1986:54) and this principle is repeated in the Enabling Clause (GATT1979:192). Through the Enabling Clause (and with the support of the UNCTAD) theGlobal System of Trade Preferences (GSTP) were set up and now includes 46developing countries but has not had significant effect (Matsushita et al. 2006:777)5.Through the Enabling Clause, countries can form a CU, a FTA or a PSA. As of August2011, 8 CUs, 11 FTAs and 15 PSAs are in force under the Enabling Clause (WTO2011).

Article V of GATSThe General Agreement on Trade in Services (GATS) entered into force in 1995following the Uruguay Round. The GATS supplements the GATT and through GATS,WTO-member countries are allowed to form preferential EIAs. As for trade in goods, the MFN principle still applies and EIAs must have substantial sectoral coverage andprovide for the absence or elimination of substantially all discrimination in order not toviolate the MFN principle (GATS 1995:288).

One final point should be made here: as there is no limitation to the number of RTAs a

country can sign, the overlapping RTAs create a spaghetti bowl of trade agreements andChong and Hur (2008) identify this as a hub-and-spoke function. The region becomes ahub linking up the different FTAs in which countries (spokes) trade on a preferentialbasis. Countries with several memberships will have preferential access to moremarkets and the RTAs thus create a multilayered discrimination (Lloyd and Maclaren2004).

13.Trade_effects_of_Regional_Economic_Integration_-_SSD

REVIEW OF THE LITERATURE2.1 DefinitionThe term ‘integration’, literally means to bring parts of an object in to a complete whole, while ineconomic terms, it would indicate, in narrowest sense, the coordination of economic activitieswith in a nation for the purpose of improving the development of that particular nation(Mutharika, 1972). Mutharika further renders the term a wider meaning, and indicates that it

implies the process of integration of various economies in a given area or region into a single unit for the purpose of regional economic development. In a more precise way, economic integrationoccurs when two or more nations carry out policies that result in greater mutual economicinterdependence. It follows that if such countries emanate from a single region or regionaleconomic integration activities and/or process, these activities or process will be termed ‘regionaleconomic integration’.

Regional integration ,or more crudely ‘regionalism’ is “any policy designed to reduce tradebarriers between a subset of countries regardless of whether those countries are actuallycontiguous or even close to each other” (Winter ,1996) . Integration aims at abolishingdiscrimination between local and foreign goods, services and factors. (Salvatore, 1997:97)

Economists have defined the term ‘economic integration’ in various ways over period. Economicintegration is a process of eliminating restrictions on international trade, payments and factormobility (Carbaugh, 2004). Economic integration thus results in the uniting of two or morenational economies in regional trading agreements .According to Biswaro (2003), regionaleconomic integration involves the process of trade, economic and financial convergence ofintegrating states.

The economic integration literature clearly distinguishes between regional economic integrationand regional economic cooperation. Regional economic cooperation is seen more as an ad hocand temporary scheme, which is mainly based on contractual agreements with regard to projectsof mutual interest between member states. Such projects could involve two or more countries inthe region. On the other hand, regional economic integration involves agreements that are morepermanent.

The classical trade- oriented economic integration sees regionally coordinated development of

infrastructure as an issue of cooperation rather than integration. Balassa (1961) point out thateconomic cooperation denotes the suppression of discriminatory practices is usually embodied intrade agreements, and like Carbaugh (2004), he agrees that economic integration implies anelimination of trade restrictions. In addition, other economists argue that there can not beintegration with out cooperation. However, it is clear from these descriptions that both theseconcepts are means to an end, and not ends in themselves. According to Mutharika (1972), theprocess of economic integration can be at various stages in its development, embrace someaspects of economic cooperation efforts which are fully supported by this study.

Biswaro (2003) points that regional integration is characterized by the establishment of jointinstitutional mechanisms and a degree of shared sovereignty .Although this may be true in theory,the practicality of it is very difficult, particularly in Africa, as it involves ceding a percentage ofthe country’s power to take decisions. This is confirmed by Biswaro (2003), when he argues thatexisting regional integration schemes in Africa function in a governmental rather than asupranational mode, and the actual sharing of sovereignty is minimal.

The term ‘economic integration’ also has other applications which do not require membercountries to be from the same region or neighbors. In other words, the generic form of the termcan also refer to establishing and developing ties between countries that may or may not begeographically linked.

Effects of Regional Economic IntegrationThis section analyzes the theory on effects of regional economic integration .It further reviewsthe existing empirical findings on this topic, in order to grasp some practical insights in thisregard.

2.1.1 Theoretical Framework on Effects of Regional Economic Integration

Entry in to a regional integration scheme can have both static effects , which is as a result ofresource allocation in response to changing relative prices ,and dynamic effects ,come from achanges in efficiency ,ability to exploit economies of scale ,and in level of investment andgrowth.Much of theoretical literatures belong to the static effects of trade integration, specifically in thecontext of a customs union. The current study also biases more towards reviewing the staticeffects of regional integration effects. However, dynamic effects are more significant given thatthe changes they constitute are cumulative rather than simply once and for all adjustments (Hine,1994).Again, although these dynamic factors are identified as potentially importance, there is noconsensus as to a single adequate model to treat the issues. Despite the fact that dynamic effectsare more difficult to model, recent theoretical developments enable us to distinguish some of thekey issues. But, now we confine to the static, resource allocation effects. Next, we devote inpresenting dynamic effects briefly.

Static EffectsLiberal economic theoretical framework is relied on the assumption that ‘productive efficiency’is enhanced if states undertake economic production in areas where they have relative advantageto others, thus rationalizing costs and prices. In general, economic theories view existence oftariffs and quotas as hostile to free flow of goods within a region. Realizing this fact andunwilling to adopt complete free trade liberalization for various reasons , states form variousregional schemes as the ‘second best’ trade policy to minimize distortions in trade flows andenjoy the fruits out of it. As it is mentioned at the out set of this subsection, these regionaleconomic integration schemes result in both static and dynamic effects.

The static impact refers to changes occurred in the equilibrium market price and quantity beforeand after the creation of the economic bloc. This can be a trade creation or a trade diversion. For

a given product, trade creation appears when high cost production is substituted by low costproduction because of regional integration while economic diversion occurs when low cost production is substituted by high cost of production. Nevertheless, besides to trade creation andtrade diversion effects, the static effects of regional integration can involve other impacts. Thus,we are going to look at these static effects by classifying in to traditional (trade creation anddiversion) and non- traditional static effects in broader sense.

Viner takes into account only trade-creation and trade-diversion effects, which are considered byCline (1978) as traditional static gains. On top of these traditional static effects, Cline (1978)provides additional non-traditional static effects from regional trade integration, which are asfollows: Labour opportunity effect1, economies of scale effect2 and foreign exchange savingeffect 3

Further studies also discover more static gains from regional trade integration, depending on themodels used. Following the classification of Baldwin and Venables (1995) and that of Lloyd andMaclaren (2004), the models assuming perfect competition and constant returns to scale identifythat trade volume, trade cost and terms of trade as beneficial effects of regional trade integration.However, models assuming imperfect competition and increasing returns to scale identifiedbenefits from regional trade integration in the form of out put, scale and variety effect.

Welfare EffectsAcross the globe, there is a fierce debate about the merits of regional trading agreements. Whilesome herald such agreements as stepping stones towards worldwide free trade, others fear thatthese initiatives will be stumbling blocks, acting primarily to divert trade from other countries tothose countries receiving preferential treatment. Although these issues are essential for the futureof the world's trading relationships, a number of obstacles prevent economists from reaching anyconsensus on the effects of preferential trading agreements.

The second-best nature of tariff liberalizations under preferential trading arrangements makes itvery difficult to assess a priori whether the welfare effects from a preferential trading arrangement will be positive, even for the members of the arrangement. In addition, the empiricalworks fail to provide firm conclusions on even the most basic issue regarding preferential tradingagreements: whether trade creation outweighs trade diversion (Clausing, 2001).

Dynamic EffectsThe effects considered in the above subsection are purely static responses of producers andconsumers in more general models to changes in relative prices owing to changing patterns oftariffs4. Besides these effects, however, there are also a variety of potential dynamic effects.These may be felt more gradually but will be longer lasting and in some cases continued.

First, there is the competition effect, brought about by freeing imports from partner countries.Second, there is the investment effect, which appears when there are new foreign and domesticinvestments that have not occurred in the absence of regional trade integration. Third, the largermarket provides greater possibilities for the exploitation of economies of scale. Fourth, there is aneffect on capital formation, possibly through various channels: reduction on barriers to diffusion,technological transfer, externalities from export growth, rising marginal product of capital and soon. Fifth, the union members acting as a group may be more able to influence the terms of tradethey face. Lastly, there is the structural transformation effect, which is a shift from traditionalprimary-products export to new industrial-products export.

In contrast to the static effect of regional trade integration, the dynamic effects are presumed tocontinue to generate annual benefits, even after the withdrawal of a country from the union .Forinstance, a rising in the growth rate made possible by integration will have continued effectsprovided that it is sustained5. They likely constitute stronger arguments for regional integration

than the static arguments based on resource allocation arguments addressed above. Moreprecisely, dynamic effects, if present, are likely to dominate static effects.

2.1.2 Empirical Findings on Regional economic integrationThe above section presents a brief overview of the theory on regional trade integration, whichhelps to understand how regional trading agreements work and through which mechanisms theyprovide benefits to member countries. At this subsection, the focus is switched to reviewing ofthe existing empirical evidences on the effects of regional economic integration.

Thus, for analytic purposes, it is useful to classify the researchers’ findings on the topic accordingto the type of methodology they approach to examine the impacts of forming regional economicintegration on trade flows , viz descriptive approach, simulation approach(Computable GeneralEquilibrium),or econometric approach(gravity model and others ) as well as the nature of datathey employ , namely cross section, time series , panel based on aggregate or sectoral level.Next, empirical works of selected researchers on the topic are reviewed in line with the aboveclassifications.

CGE ModelThe simulation approach uses a static Computable General Equilibrium (CGE) model or adynamic inter –temporal general equilibrium model. The model specifies economic structuresand behaviors of agents in detail and, using the frame work, simulate the economic effects ofexisting or proposed regional blocs. Simulation based on the general equilibrium models usuallyfinds substantial potential gains from trade liberalization between members of RTA.

There are a large number of ex ante CGE studies of trade agreements that examine what effectscan be expected from preferential trading arrangements (for instance , Brown et al , 1992; Brownand Stern ,1989a; Haaland and Norman, 1992). More recently, Hertel et al (2006) applies CGE

analysis in order to better evaluate the likely outcome of a Free Trade Area of the Americas(FTAA) and they find that that imports increase in all regions of the world as a result of theFTAA, and this outcome is robust to variation in the trade elasticities. Moreover, they concludethat there is great potential for combining econometric work with CGE-based policy analysis inorder to produce a richer set of results that are likely to prove more satisfying to the sophisticatedpolicy maker.

One weakness or imperfection of CGE studies is that their results are very sensitive to theassumptions, parameters, and data used in the model, and have to be interpreted accordingly.Besides, they do not allow an investigation of the questions we are concerned with here6.Krueger (1999) also mention that CGE studies have been prospective rather than retrospective. InCGE model, the sectoral aggregation also does not permit analysis of specific markets. As ofMckitrick (1998), policy information is usually outdated, and base line scenarios are far fromfacts and based on the older data. CGE methods are also very data demanding and tending not tobe applied with high levels of data disaggregation (Milner and Sledziewska, 2005:7).Therefore,the validity of the results of CGE studies is questionable in some case. While CGE models areuseful for speculating what effects of a particular agreement might be? But with out firmevidence.

Descriptive ApproachA descriptive approach is also another methodology pursued in the literature to examine theeffects of regional economic integration on trade patters (for example, Anderson and Norheim,1993; Yeats, 1998; dell’Aquila et al, 1999). These studies use different indicators to measure theregional concentration of trade. A descriptive approach implicitly assumes that the share of tradehappening with the partner nation would not have changed in the absence of the agreement. This

method depends on a static frame work and the results are dependent on the level of aggregation7.Further more, a descriptive approach misses the ability to analyze trade creation and tradediversion effects and, hence, the welfare implications of RTAs (Jayasinghe and Sarker, 2004).

Gravity ModelDeveloping an accurate counterfactual of Ex post studies of how much trade would haveincreased in the absence of a given free trade agreement or customs union has proved difficult.For instance, Balassa (1967, 1975) constructs a counterfactual of how trade would have changed in the absence of European integration by calculating pre-integration income elasticities that were assumed to continue post-integration.

It was later exhibited, however, that income elasticities vary substantially pre- and postintegration, making these results sensitive to the sample period. Some (including Frankel andWei, 1995; Frankel and Kahler, 1993; Frankel, 1997; Krueger, 1999; Aitkin, 1973; Aitkin andObutelewicz, 1976; Willmore, 1976) apply gravity model to assess the impact of preferentialarrangements on trade flows8. Schwanen (1997) undertakes a comprehensive study of changes inCanadian trade patterns, considering the effects of both CUSFTA and NAFTA between 1989 and1995. He compares trade in sectors that have been liberalized by these agreements to trade inother sectors, finding that trade growth with the United States was much faster in liberalizedsectors.

Helliwell et al (1998) use two types of evidence in their approach to assess the impact of the FTA on inter provincial trade. First, they develop a gravity model to explain inter provincial andprovince-state trade flows. Then, they analyze new industry-level data to estimate the extent towhich tariff changes in Canada and the United States help explain inter-industry differences inthe growth of inter provincial trade.

At the aggregate level, their results show that the FTA increased north-south trade relative to east

west trade. After adjusting for appropriate factors, the gravity model suggests that in 1996, interprovincial trade would have been 13 percent higher than it actually was if the1988 trade structurehad remained unchanged. However, since the FTA also affected the provinces general economicgrowth, it is hard to calculate the FTA’s net effect on the overall 15 percent increase in interprovincial trade between 1988 and1996.The disaggregated results of Helliwell et al (1998) suggest that the FTA-related reduction inCanadian tariffs led to increases in imports from the United States and to reductions in interprovincial trade. On the other hand, reductions in U.S. tariffs led to increases in exports to theUnited States and to increases in inter provincial trade. Overall, the authors calculate that FTA- induced tariff cuts led to reductions in inter provincial trade by about 7 percent, only about half of the total reduction previously calculated with aggregate data.

Regional dummy variables (inter and extra) have been used in gravity models (using ex-postapproaches) to try to capture separate trade creation and diversion effects. The estimatedcoefficients on the dummy variables may capture a range of policy and other (includingmisspecification) effects rather than the regional trade policy effect under investigation. It is alsothe case that gravity modeling is invariably used to model total trade flows or at least broadaggregates of trade9.

However, the existing empirical literatures on the topic exhibit that most of the researchers’findings are based on aggregated data level .Nonetheless , there is firm argument that estimationrelied on aggregated data could mask changes that may be occurring at disaggregated level. Inaddition, the use of more disaggregated data allows one to exploit the variation in the extent oftariff liberalization under the agreement with out utilizing such variable. It is difficult to identifythe effects of tariff liberalization on different sectors. Thus, sectoral variation could make adifference in the welfare outcome.

Realizing this deficiency in the existing literature on the topic, using a simple supply and demandframework specification analysis, Clausing (2001) employ data at the commodity level and theresults indicate that CUSFTA had substantial trade creation effects, with little evidence of tradediversion. Further, he argues that unlike the approaches of many previous studies of preferentialtrading agreements that have relied on aggregate data, disaggregate data are used to analyze howactual tariff changes affect trade flows. Without utilizing the variation in the extent ofliberalization across goods, it would be far more difficult to distinguish the effects of anagreement from other influences affecting trade flows. Here, the current study agrees with theabove notions.10

Similarly, Jayasinghe and Sarker (2004) conduct a study that analyze trade creation and tradediversion effects the North America Free Trade Agreement (NAFTA) on trade of six selectedagri food products from 1985 to 2000. Their investigation estimates an extended gravity modelusing pooled cross –sectional time –series regression and generalized least squares methods .As aresult, they find that share of intra regional trade is growing with in NAFTA and that NAFTA has displaced trade with the rest of world . Using panel data econometric models analysis applied to highly disaggregated trade data, Milner and Sledziewska (2005) come out with the result thatshows the European Agreement had transitory but significant trade diverting effects for Poland’simport; the trade diversion substantially dominating the trade creation.

The panel gravity model for trade has often been estimated with out taking account of the effectsof past trade and income on current trade flows. However, there are numerous economic reasonsthat show trade is dynamic process11. As a remedy for the observed weakness of static panelgravity model, Bun and Klassen (2002) apply a dynamic panel model by extending the staticmodel with lagged regressors incorporating lags of trade and income. Consequently, using a

panel of 221 annual bilateral OECD trade flows over 48 years, they explore that the dynamics are significant and note that static models are misspecified.

In African context, there are huge empirical works that analyze the impacts of regionalintegration. Among these, Alemayehu and Haile (2002), on their study for COMESA, show thatbilateral trade flows among the regional groupings could be explained by standard variables asdemonstrated by the results of the conventional gravity model, while regional groupings have had insignificant effect on the flow of bilateral trade. Further, they suggest that the performance of regional blocs is mainly constrained by problems of variation in initial condition, compensation issues, real political commitment, overlapping membership, policy harmonization and poor private sector participation.

Khorana et al (2007), using a partial equilibrium model, assess the implications of the transitional measures for products sensitive from the Ugandan perspective. The simulation results question the underlying rationale for these arrangements. They also discuss whether the regional trading arrangements confer any real benefits on the stakeholders and suggest alternative approaches that may increase the benefits for Uganda from trade liberalization within the customs union .At this juncture, in depth analysis of specific regional bloc would be worthwhile because the existing empirical findings on the effects of regional economic integration on partner nations’ trade flows may vary from one region to other regions even with in Africa .

Dissertation

BaierBergstrandFTA2Oct2004