Effect on Trade Flows of Regional Trade Agreements

Effect on take Flows of regional flock Agreements filchThis theme studies the effect on business deal scarpers of RTAs signed mingled with growing economies. It uses a variation of the temperance ideal of craftsmanship to asses five RTAs Mercosur, The Andean community, SICA, the EU, Chile-China.Contents epitome iiiList of human bodys viList of evades viList of Formulas vi1. foundingduction viii1.1Background viii1.2 Problem commentary x1.3 query Objective x1.3.1 Major research nous x1.3.2 Minor research nous xi1.4 hypothetical homunculusling xi1.4.1 The Gravity sham of look at xi1.4.2 research methodological psychodepth psychology and Design xii1.4.3 Research Assumptions xii1.4.4 Research Limitations xii1.5 thesis Structure xiii2. writings Review xiii2.1 portion out populace and consider departure xiv2.1.1 pot basis xiv2.1.2 cover sport xvii2.1.3 common get by intromission xviii2.2 empiric Evidence from SS RTAs xx3. suppositious fabric and Rese arch methodological compend xxi3.1 supposititious model xxi3.1.1 treble simple regression Analysis and puzzle grammatical construction xxi3.1.2 fixation mold Diagnosis xxii3.1.3 The Gravity Model of batch xxiii3.1.4 Research Assumptions xxvii3.1.5 Research Limitations xxvii3.2 Research Methodology xxvii3.2.1 Research Type and Approach xxvii3.2.2 selective information Collection xxx4. Findings and Results xxxi4.1 The effect of RTAs xxxi5. Conclusions xxxiii6. extension xxxiv7. References xxxviiList of jut outs ascertain 1 swap cosmos. excogitation 2 contend DiversionFigure 3 cunning humankind Proper vrs. blunt flock mental homeFigure 4 triune regression hyperplaneList of prorogues shelve 1 Dummy inconstant Interpretation.. put off 2 RTAs surveyed and MembersTable 3 Regression results of individual ageTable 4 Regression results of PCSList of FormulasFormula 1 Gravity model equationFormula 2 Log linear form of the staidness modelFormula 3 Current dr yness specifications..AbbreviationsCGE Computable superior general EquilibriumCOMESA Common market for Eastern and Southern AfricaFTA Free condescension AgreementGATT cosmopolitan Agreement on Tariffs and callinggross domestic result Gross Domestic ProductMERCOSUR Mercado Comn del Sur RTA signed in the midst of Brazil, Argentina, Uruguay and ParaguayNAFTA northwesterly Ameri endure Free administer AgreementOLS Ordinary Least Squ besPCS Pooled crosswisePTA Preferential flock AgreementRIA regional Integration AgreementRTA regional championship wind AgreementSICA Sistema de Integracin Centro Ameri rumpa RTA in the midst of Honduras, Costa Rica,El Salvador, Guatemala, Nicaragua waterman and BelizeSS South-SouthUNCTAD United Nations Conference on commerce and DevelopmentWB land BankWITS humankind Integrated Trade SolutionWTO manhood Trade Organization1. entryductionBackgroundFour hundred and sixty twain RTAs leave been nonified to the WTO up to February 2010 ( WTO,2010). From 1948-1994 the GATT received angiotensin-converting enzyme hundred and 20 four nonifications of RTAs, and since its human race in 1995, the WTO has received over 300 RTA notifications, (WTO,2010). This flair of forming craft blocs is likely to become stronger as much than than RTAs be put forwardly under negotiation.Of particular interest to economists, and the focus of this writing, atomic number 18 South-South RTAs, that is, RTAs signed amid countries of low income takes. There argon reasons to believe that SS RTAs whitethorn not just fail to stimulate sparing growth among appendage countries, exactly interchangeablely hinder growth for these countries.In their book regional Integration and Development, Winters and Schiffer (2003) raise that in that respect is some secernate that north-central-South RTAs stimulate frugal growth in the southern partner, little consequence that North-North RTAs stimulate growth and NO prove that South-So uth RTAs do so. Specifically they manage that SS RTAs do not extend partners with feeler to technology or knowledge that is characteristic of rich countries SS RTAs argon flimsy to add credibility to government policies and may even hinder investiture if not accompanied by liberalization of distri ande with the rest of the orbit and, SS RTAs atomic number 18 likely to generate completely plenty entertainment and no consider human beingsMayda and Steinberg (2006) beg that SS RTAs are unlikely to fork out the optimistic effects of competition and economies of scale because partner countries are cardinal little and poor. In addition, the passage of financial revenues harms the division res publica economies and finally, SS RTAs are more likely to divert contend rather than create spate. Willmore (1976) and Nicholls (1998) make homogeneous points victimisation the Central American Common market place as an example.Trade basis and mete out divagation are concepts that were introduced by Jacob Viner in 1950. both terms refer to the redirection of slyness moves as a consequence of an RTA. In traffic launching, goods that were antecedently produced by a topical anaesthetic economy are instead instanted from more cost-effective makers in countries within the RTA. Trade diversion refers to the redirecting of tack from the more high-octane manufacturer to a slight frugalalal producer within the RTA. In both cases, consider cosmea and trade diversion, the trade flows are affected by the reduction of tariffs to member countries typical of RTAs. Trade establishment and trade diversion are explained with more detail in incision 2.1 of this theme.A number of studies thrust been conducted to pass judgment the effects of SS RTAs in partner countries -most of them travail to determine if the RTAs were trade creating or trade diverting e.g. Evans (1998), Lewis et al. (1999), Flores (1997), Cernat (2001,2003)), Subramanian a nd Tamirisa (2001), Mayda and Steinberg (2006). Different methods take away been employ and the results are multiform. As a reference, this report card focuses on the results of Cernat (2001, 2003), Flores (1997), and Mayda and Steinberg (2006). Different methods were utilize in these studies and the results were flux.Cernat (2001) apply the log-linear form of the gloominess equation to mensurate nine SS RTAs. He beats exhibit that suggests that SS RTAs are slight(prenominal) trade diverting than theoretically predicted. Cernat (2001) inviteings suggest that Mercosur and the Andean conjunction were overall, trade diverting. On the some separate hand Flores (1997), use a CGE summary, concluded that Mercosur was trade creating.Mayda and Steinberg (2006) use a deflection-in- residuum estimation strategy at good train to respect the impact of COMESA on Ugandan substances. They make point that South-South trade agreements create substantiative solely little econ omic gains, by dint of changes in trade patterns, for their members. This is different from Cernat (2001) results, which indicate that imports into COMESA members from whiz- tertiary countries were on second-rate 30 per cent higher than those predicted without the trade diversion poop varying. Mayda and Steinberg (2006) find prove that no trade diversion takes place in COMESA.The mixed results from these studies, the increasing number of SS RTAs underway and the high number of countries lacking to wed completely or in part in these RTAs poses the quest questions wherefore do policy makers from these countries advocate in favor of these RTAs? Should these RTAs be prosecute?, and the still not categorically answered question Are South-South regional Trade Agreements trade creating or trade diverting? Using the soberness model, this subject aims to get turn out from SS RTAs from the Americas.1.2 Problem expositionDo South-South regional Trade Agreements create trade or divert trade? The literary crosswayions on this topic is vast and contradictory. Everybody views that SS-RTAs are trade diverting. Some account present exhibit of this. Other present evidence that they are in reality trade creating. Finally early(a)s find evidence of very little trade innovation and no remarkable evidence of trade diversion.With so some RTAS in place and umpteen former(a)wises underway, it is important to understand the effects of creating these trade blocs.Should poor countries pursue RTAs with poor countries? Are SS RTAs building blocks or stumbling stones towards the piece liberalization of trade?1.3 Research ObjectiveThe main objective of this report card is to determine if MERCOSUR, Andean Community, and SICA were trade creating or trade diverting in the geezerhood 1995, 1998, 1999, 2003, 2007.1.3.1 Major research questionIs on that point square evidence of trade initiation or trade diversion on the years 1995,1998,1999,2003,2007 for Mercosur , Andean Community and SICA?1.3.2 Minor research questionIs at that place portentous evidence that suggests that RTA members of the supra mentioned RTAs change magnitude trade amid them and their partners?Is in that location large evidence that suggests that members of the higher up mentioned RTAs increase trade amid them and third countries?Is there significant evidence that suggests that the increase in trade mingled with RTA partners of the above mentioned RTAs is higher than the decrease in trade between RTA members and third countries?1.4 metaphysical material1.4.1 The Gravity model of tradeThe solemnity model uses Newtonian staidness principles to study human behavior. It is widely use by economists and complaisant scientists to predict flows of trade, people, goods, money, and early(a) unsettleds as an effect of changes in economic policies, pecuniary policies, new laws, bans and other distortions to the flow of a condition uncertain.The original gravity mod el of trade assumes that two countries pass on trade more or less(prenominal) depending on the sizes of their economies and the distance between their economic centers. It was created in openly by Tinbergen (1962) and Pyhnen (1963) and augmented in later years to include other in mutually beneficial multivariates that may cause a change in trade flows. These augmented versions of the basic gravity model may include universe of the two countries, presence of common borders, analogous language, common colonizer, and others that the tec regards as relevant.The gravity model specifications apply in this physical composition are come to to those of Cernat(2001) and Cheng Hall (2003). These specifications are use to run OLS regressions on trade selective information of 1995, 1998, 1998, 2003 and 2007. One set of pooled data including the years mentioned is analyzed using the identical gravity specifications.The results of these regressions provide evidence of gross trade mental home and diversion as specified by Balassa (1967)1.4.2 Research Methodology and DesignThe written report uses standard OLS analysis, with bilateral imports as a underage variable and 17 in inter drug-addicted variables gross domestic product of the import estate, GDP of the exporting country, Population of the trade country and existence of the exporting country, distance between the capital cities of individually country pair, Intra_x keep mum variable for from for each(prenominal) one one RTA, Extra_x locoweed variable for each RTA. The values of GDPs, distance and universe of discourses are utilise in their logic form.GDPs and existence data was collected from the WB databank. Trade data was collected from UNCTADs database using the WB banks WITS application.1.4.3 Research AssumptionsCosts of transportation are comparative to the great circle distance between economic centers of countries studied every(prenominal) countries hand one economic center, namely their capital cities.The wrongful conduct co businesslike of the log-linear gravity model use in this study is ordinarily distri aloneed with a stiff of zero and constant variance for all observations. It is withal assumed that break pairs are uncorrelated.GDPs, population, and trade data collected belongs to the population1.4.4 Research Limitations1.5 thesis StructureThe remainder of this physical composition is organized as follows Chapter 2 presents a literature review that explains trade earthly concern and trade diversion, the effect of both and findings of previous cover that survey RTAs. Chapter 3 explains the gravity model used on the paper, how data was collected and organized, and the considerations in analyzing data. Chapter 4 summarizes the findings and Chapter 5 concludes.2. belles-lettres ReviewThere is extensive literature on RTAs. This literature any predicts the effects of a RTAs using a computable-general equilibrium analysis or they rhythm the effects of an FTA using aggregate data or goodness level data.The concern of most authors, and the reason why they conduct their research, is that FTAs and particularly SS FTAs may divert trade rather than create it. In the causality case, purchases from an economic producing country are replaced by purchases of a less good FTA partner.This theatrical role serves three purposes 1. It explains trade creation and trade diversion to the ratifier so she can recrudesce understand the methodology used to treasure the selected RTAs. 2. It presents the reviewer with the results of previous findings so that the reader can compare the results of this paper with previous results of other authors. 3. It gross trade creation and diversion so that the reader can understand the results of the research.2.1 Trade Creation and Trade DiversionTrade creation and trade diversion as defined by Viner (1950), refer to changes in flow of trade between nations. Trade creation happens when trade is switched f rom less effective producers of one country to more cost- in effect(p) producers in another country a demote allocation of resources. In trade diversion trade is shifted from more cost-efficient producers in one country to less efficient producers in another country -a turn in the allocation of resources.2.1.1 Trade CreationTrade creation can be defined as the net well-being gain that results from the outset of an RTA, both on the intersectionion and on the consumption side. Some economists though, speculate that it is more precise to think of trade creation only as the increase in benefit from the action side (Senior-Nello S, 2010). In this paper the fountain definition of welfare is considered.To understand trade creation, imagine the followers scenario (Figure 1) The country in question, Country X, say Honduras, imports harvest-festival Q from country M (United States) at monetary value Pw+t, which includes an ad valorem tax and is the kindred value offered by othe r nations in the valet, including country E (El Salvador). At this footing, Honduras imports 20 units and consumes 60. The be 40 units are trade from the US. This is illustrated by the Honduran supply and read lines in Figure 1 and the suddenly elastic supply crimp with free trade of El Salvador. It is understood that a change in Honduran imports of product Q cannot affect the humankind bell of product Q.Figure 1. Trade CreationIf Honduras signed an RTA with El Salvador and the price of product Q from ElSalvador dropped to PE, Honduras would now produce 10 units of product Q, consume 70, and import the difference of 60 units. Because El Salvador now offers a lower price for product Q, Honduras now imports this product from El Salvador and not from the US.The consumer surplus gains of this RTA are tinct by nations a+b+c+d. The redness in producer surplus is indicated by expanse a. The loss of tariff revenue for Honduras is area c. Therefore the net welfare increase of t his RTA between El Salvador and Honduras is indicated by triangles b and d.Triangle b represents the amount of toil that was shifted from less efficient producers in Honduras to more efficient producers in El Salvador a better allocation of resources. Triangle d represents the increase in consumption of product Q.2.1.2 Trade DiversionTrade Diversion is illustrated in figure 2. once again the supply and get hold of lines are those of Honduras for product Q. Line S1 and S2 are the utterly elastic supply winds of USA and El Salvador respectively, and lines S1+t and S2+t are the tax inclusive supply curves of the very(prenominal) two countries.Figure 2. Trade DiversionHonduras imports product Q from the US at tax inclusive price Pw+t. El Salvador offers product Q at price PE+t and thus does not benefit from Honduran purchases.At price Pw+t Honduras produces 20 units, consumes 60, and imports 40 from the US. If Honduras and El Salvador now form an RTA and do not include the US, ta riffs volition be removed on imports from El Salvador but not from imports from the US. by and by forming the RTA Honduras would produce 10 million units, consume 80 million and import 60 million units of product Q from El Salvador at price PE.The RTA has turn trade from more efficient producers in the US to less efficient producers in El Salvador, so there is a declivity in the allocation of resources. On the other hand 10 million units are now import from El Salvador instead of being produced at property in Honduras. At the alike time 40 million units that were antecedently imported from the US are now being imported from El Salvador.The welfare loss from trade diversion is reflected rectangle f. The 40 million units that were imported from more efficient producers in the US whose free trade price is $1.00 are now imported from El Salvador at $2.00. The welfare loss is $40 million.The welfare gain from the customs union is calculated as the areas of triangles b and d. Triang le b is the welfare gain in the production side $5 million. Triangle d is the welfare gain in the consumption side $10 million.The total impact on welfare as a result of the RTA is minded(p) by the sum of the areas of triangles b and d deduction the area of rectangle f (b+d-f) welfare gain electronegative welfare loss. In this case the RTA generated a welfare loss of $25 million.Figure 2 illustrates that the idea of trade creation and trade diversion can be misleading. If, for example, the sum of areas of triangles b and d would be great than the area of rectangle f, the RTA would cause a net welfare gain. In this scenario, although trade has been divert from more efficient producers in one country to less efficient producers in another, the RTA increased welfare for the RTA sign language country.2.1.3 Gross Trade CreationFollowing the lead of Jacob Viner, Balassa (1967) evaluated the effects of the European Common Market with reference to its trade creating and trade diverting effect using Tinbergen (1962) and Pyhnen (1963) model -the gravity model. In his work he developed model that captured substitution of less efficient domestic and foreign suppliers for more efficient foreign suppliers gross trade creation which is different than Viners definition of trade creation according to which trade is created only at the expense of topical anaesthetic anesthetic anaesthetic producers.To illustrate the difference gross trade creation and trade creation proper as defined by Viner (1950), consider three avocation partners of one particular product countries A, B, and C, product Q (See Figure 3). Before sign language a RTA with country B, Country A imports product Q from both, Country B and Country C in equal amounts and has 4 local producers of the same(p) product (Figure 3a).In the case of trade creation proper (Figure 3b), by and by(prenominal) subscribe a RTA with country B, Country A continues to import equal amounts of product Q from countries B a nd C but has reduced the number of local producers of the same product. More efficient producers in Country B devour absorbed market share from local producers in Country A trade creation proper.Gross trade creation on the other hand (Figure 3c), considers that trade is created not only when local producers are substituted, but also when producers in third countries are substituted. In this case, after signing a RTA with country B, Country A decreases its imports of product Q from Country C and increases imports of the same product from Country B while keeping the same number of local producers. It is important to note that gross trade creation assumes that substituted producers in Country C were less efficient than producers in country B the contrary would constitute trade diversion.Figure 3. Trade Creation Proper vrs Gross Trade CreationLike in Cernat (2001), this paper evaluates the gross trade creating effects of the assessed RTAs.In his paper, Balassa (1967) provides evidence of trade creation in the European Common Market during six years since the Markets establishment. again, trade creation applies to the substitution of any less efficient producer for a more efficient one, in babelike of the producers base country. The why of the expected differences between the results of developed country RTAs and SS RTAs is explained in the next section.2.2 verifiable Evidence from SS RTAsA number of studies fork up been conducted to assess the effects of SS RTAs in partner countries -most of them undertake to determine if the RTAs were trade creating or trade diverting e.g. Evans (1998), Lewis et al. (1999), Flores (1997), Cernat (2001), Subramanian and Tamirisa (2001), Cernat (2003), Mayda and Steinberg (2006). Different methods take a crap been used and the results are mixed. This paper uses methods analogous to Cernat (2001) and Cheng paries (2003).In his paper, Cernat(2001) used the log-linear form of the gravity equation to asses nine SS RTAs. He f inds evidence that suggests that SS RTAs are less trade diverting than theoretically predicted. Cernats(2001) findings suggest that Mercosur and the Andean Community were overall, trade diverting.Mayda and Steinberg(2006) use a difference-in-difference estimation strategy at good level to assess the impact of COMESA on Ugandan imports. They present evidence that South-South trade agreements create positive but little economic gains, with changes in trade patterns, for their members (Mayda and Steinberg, 2003). This is different from Cernats(2001) results, which indicate that imports into COMESA members from third countries were on bonny 30 per cent higher than those predicted without the trade diversion the skinny variable. Mayda and Steinberg (2006) find evidence that no trade diversion takes place in COMESA.The mixed results from these studies, the increasing number of SS RTAs underway and the high number of countries wanting to total completely or in part in these RTAs poses the spare-time activity(a) questions why do policy makers from these countries advocate in favor of these RTAs? Should these RTAs be prosecute?, and the still not categorically answered question Are South-South regional Trade Agreements trade creating or trade diverting? Using the gravity model, this paper aims to get evidence from SS RTAs from the Americas.Theoretical Framework and Research Methodology***Intro***Problem DefinitionResearch ObjectiveResearch Questions3.1 Theoretical Framework3.1.1 Multiple Regression Analysis and Model createFigure 4. Regression HyperplaneMultiple regression analysis is a method of inferential statistics that beats the kindred between two or more independent variables and one dependent variable. The multiple regression model is given byWherey = dependent variable= regression constant of the population= regression coefficient for each variable xj=1,2,kk = number of independent variables= error of the modelDifferent from a simple regression equa tion -which forms a straight line in a two-dimensional space to represent the linear affinity between two variables the multiple regression model forms a hyperplane in a multidimensional space (Figure 4). This hyperplane represents the relationship between the dependent variable and k independent variables.To build a multiple regression model, that is, to construct a mathematical equation that represents the relationship between independent and dependent variables, a researcher must decideThe question that wishings to be answeredThe potential drop independent variablesWhat is a representative sample of the population should be at least four times the number of independent variables (Groebner, et al, 2008)The model used in this paper is well known and widely used by amicable scientists to survey the flow of various types of variables. This model is explained in section 3.1.3.3.1.2 Regression Model DiagnosisTo ensure the significance of an OLS regression analysis results, the following evaluation criteria are usually used (Groebner, et al, 2008)The coefficient of determination (R2 and R2 adjusted) mingying of the overall model (F-test) logical implication of individual variables (t-tests)Size of the standard variance of the modelMulticollinearity of variablesThe coefficient of determination rounds the proportion of variation in the dependent variable that can be explained with the independent variables used by the model. The value of R2 may range from 0-1, with 1 representing a perfect linear relationship between dependent and independent variables. Higher values of R2 are preferred as they would indicate that the chosen independent variables explain better the variations in the dependent variables.A derivate indicator, called adjusted R2, takes into account the number of independent variables in the model, and their part the variations in the dependent variable. Because R2 increases when independent variables are added to the model, even if the new variables move over no relationship with the dependent variable, adjusted R2 evaluates the model more precisely.The mansion houseificance of the overall model can be refractory by equivalence the signification F value given in the regression takings of a statistical software application, and the critical value for a given alpha level.The critical value for a given alpha level is driven using t-tables and statistical procedures explained in Groebner (2008).The entailment of individual variables is determined by comparability their calculated t-values with the critical t-value of the model. If their calculated t-values are greater than their critical t-values the variable is considered significant. To determine the critical t-values of independent variables, degrees of freedom guide to be calculated and interpolated with the desired level of significance in a t-table. For detailed explanations see Groebner (2008).The size of the standard release of the model measures the sp rinkling of observed values of the dependent variable, and the predicted values for the same variable. It is up to the researcher to determine an acceptable range for the standard error estimation.Multicollinearity occurs when two variables provide overlapping information to explain the variation in the dependent variable. To measure multicollinearity the researcher can use the VIF as an indicator. Generally, if the VIF 3.1.3 The Gravity Model of TradeFollowing Isaac Newtons principle of gravity, according to which two bodies will attract each other more when their sizes are increased and the distance between them is reduce the gravity model explains trade flow between two countries ground on the size of their economies and the distance between their economic centers.The equation histrionics of the gravity model of trade is(Formula 1)Where Fg represents trade flow, G is the constant, m1 and m2 are the economic dimensions of the two countries in question, and d is the distance bet ween the two countries. In its basic log-linear form, the gravity equation is as follows(Formula2)Where is the bilateral trade flow between countries i and j at time t, is the constant, is the immanent logarithm of the GDP of country i, is the inhering logarithm of the GDP of country j, is the natural logarithm of the distance between country i and country j, and is the normally distributed error.This basic gravity model is usually augmented by including other variables like contiguousness, common language, colonial links, common currency, and RTA membership among others. Different authors have suggested many different specifications for the gravity model of trade1, however there is no consensus about which model specification is more accurate and serves ruff in assessing RTAs. Moreover other authors have suggested that the gravity model is colored due to endogeneity and reverse causality (Magee, 2003) and have led others to use tout ensemble different methods to asses RTAs (Mayda Steinberg (2006).This paper uses a gravity model specification that is alike to Cernat (2001) but considers Cheng fence ins (2003) suggestions of eliminating dummy variables that might capture unintended trade distorting variables.To assess trade creation and trade diversion in nine RTAs, Cernat(2001) adds two dummy variables to an already augmented specification of the model Intra_RTA and Extra_RTA. The Intra_RTA dummy becomes a 1 when both, the trade and the exporting countries, are partners in the RTA being assessed by the two dummies. The Extra_RTA dummy becomes one when the trade country is part of the assessed RTA but the exporter is a third country.The model uses bilateral trade flows as a dependent variable and 18 independent variables GDP of importing country, GDP of the exporting country, GDP per capita of the importing country, GDP per capita of the exporting country, Population of the importing country, population of the exporting country, distance between t he capital cities of both countries, an contiguity dummy variable, a common language dummy variable, nine Intra_RTA dummy variables (one for each RTA assessed), and nine Extra_RTA dummy variables (one for each RTA assessed). wholly non-dummy variables expressed in their logarithmic form.In theory, the Intra_RTA dummies will capture the effect that the assessed RTA had on trade between partners of the RTA and the Extra_RTA dummy captures the effect of the same RTA on trade of RTA members with third countries.To diagnose a RTA as trade crating or trade diverting, Cernat (2001) knowing an Intra-Extra coefficient table (Table in this paper). According to this table, if a trade agreement increased trade between its partners at the expense of third countries -diverted trade, the Intra_RTA dummy should be positive and the Extra_RTA dummy negative. If the agreement created trade instead, the coefficients of both dummies would be positive.CoefficientExtra_RTAIntra_RTA consecrate++Trade cr eation and trade expansionTrade diversionTrade expansionTrade contractionTable 1 Dummy changeable InterpretationCheng Wall (2003) use a fixed-effect panel data analysis to measure the effect on trade of RTAs over time. Their proposed model allegedly controls the heterogeneity bias in the gravity model of trade. In it, Cheng Wall (2003) drop all dummy variables and even drop the distance variable. They argue that these variables bias the gravity model and they motivate their argument in a number of ways. First, they reason that economic distances are too hard to measure with accuracy because big countries have many economic centers, that are thousands of miles asunder(predicate) and that serve as trade centers for diffeEffect on Trade Flows of Regional Trade AgreementsEffect on Trade Flows of Regional Trade AgreementsAbstractThis paper studies the effect on trade flows of RTAs signed between development economies. It uses a variation of the gravity model of trade to asses five RTAs Mercosur, The Andean Community, SICA, the EU, Chile-China.ContentsAbstract iiiList of Figures viList of Tables viList of Formulas vi1. Introduction viii1.1Background viii1.2 Problem definition x1.3 Research Objective x1.3.1 Major research question x1.3.2 Minor research question xi1.4 Theoretical Framework xi1.4.1 The Gravity model of trade xi1.4.2 Research Methodology and Design xii1.4.3 Research Assumptions xii1.4.4 Research Limitations xii1.5 dissertation Structure xiii2. Literature Review xiii2.1 Trade Creation and Trade Diversion xiv2.1.1 Trade Creation xiv2.1.2 Trade Diversion xvii2.1.3 Gross Trade Creation xviii2.2 Empirical Evidence from SS RTAs xx3.Theoretical Framework and Research Methodology xxi3.1 Theoretical Framework xxi3.1.1 Multiple Regression Analysis and Model Building xxi3.1.2 Regression Model Diagnosis xxii3.1.3 The Gravity Model of Trade xxiii3.1.4 Research Assumptions xxvii3.1.5 Research Limitations xxvii3.2 Research Methodology xxvii3.2.1 Research Type an d Approach xxvii3.2.2 selective information Collection xxx4. Findings and Results xxxi4.1 The effect of RTAs xxxi5. Conclusions xxxiii6. concomitant xxxiv7. References xxxviiList of FiguresFigure 1 Trade Creation.Figure 2 Trade DiversionFigure 3 Trade Creation Proper vrs. Gross Trade CreationFigure 4 Multiple regression hyperplaneList of TablesTable 1 Dummy Variable Interpretation..Table 2 RTAs assessed and MembersTable 3 Regression results of individual yearsTable 4 Regression results of PCSList of FormulasFormula 1 Gravity model equationFormula 2 Log linear form of the gravity modelFormula 3 Current gravity specifications..AbbreviationsCGE Computable General EquilibriumCOMESA Common Market for Eastern and Southern AfricaFTA Free Trade AgreementGATT General Agreement on Tariffs and TradeGDP Gross Domestic ProductMERCOSUR Mercado Comn del Sur RTA signed between Brazil, Argentina, Uruguay and ParaguayNAFTA North American Free Trade AgreementOLS Ordinary Least SquaresPCS Pooled crosswisePTA Preferential Trade AgreementRIA Regional Integration AgreementRTA Regional Trade AgreementSICA Sistema de Integracin Centro Americana RTA between Honduras, Costa Rica,El Salvador, Guatemala, Nicaragua boater and BelizeSS South-SouthUNCTAD United Nations Conference on Trade and DevelopmentWB instauration BankWITS World Integrated Trade SolutionWTO World Trade Organization1. IntroductionBackgroundFour hundred and sixty two RTAs have been notified to the WTO up to February 2010 (WTO,2010). From 1948-1994 the GATT received one hundred and cardinal four notifications of RTAs, and since its creation in 1995, the WTO has received over 300 RTA notifications, (WTO,2010). This snub of forming trading blocs is likely to become stronger as more RTAs are soon under negotiation.Of particular interest to economists, and the focus of this paper, are South-South RTAs, that is, RTAs signed between countries of low income levels. There are reasons to believe that SS RTAs may not only fail to stimulate economic growth among member countries, but also hinder growth for these countries.In their book Regional Integration and Development, Winters and Schiffer (2003) differentiate that there is some evidence that North-South RTAs stimulate economic growth in the southern partner, little evidence that North-North RTAs stimulate growth and NO evidence that South-South RTAs do so. Specifically they argue that SS RTAs do not provide partners with entranceway to technology or knowledge that is characteristic of rich countries SS RTAs are unlikely to add credibility to government policies and may even hinder investment funds if not accompanied by liberalization of trade with the rest of the world and, SS RTAs are likely to generate only trade diversion and no trade creationMayda and Steinberg (2006) argue that SS RTAs are unlikely to provide the positive effects of competition and economies of scale because partner countries are both pocket-sized and poor. In a ddition, the loss of fiscal revenues harms the member country economies and finally, SS RTAs are more likely to divert trade rather than create trade. Willmore (1976) and Nicholls (1998) make identical points using the Central American Common Market as an example.Trade creation and trade diversion are concepts that were introduced by Jacob Viner in 1950. two terms refer to the redirection of trade flows as a consequence of an RTA. In trade creation, goods that were previously produced by a local economy are instead imported from more efficient producers in countries within the RTA. Trade diversion refers to the redirecting of trade from the more efficient producer to a less efficient producer within the RTA. In both cases, trade creation and trade diversion, the trade flows are affected by the reduction of tariffs to member countries typical of RTAs. Trade creation and trade diversion are explained with more detail in section 2.1 of this paper.A number of studies have been conduct ed to assess the effects of SS RTAs in partner countries -most of them attempt to determine if the RTAs were trade creating or trade diverting e.g. Evans (1998), Lewis et al. (1999), Flores (1997), Cernat (2001,2003)), Subramanian and Tamirisa (2001), Mayda and Steinberg (2006). Different methods have been used and the results are mixed. As a reference, this paper focuses on the results of Cernat (2001, 2003), Flores (1997), and Mayda and Steinberg (2006). Different methods were used in these studies and the results were mixed.Cernat (2001) used the log-linear form of the gravity equation to assess nine SS RTAs. He finds evidence that suggests that SS RTAs are less trade diverting than theoretically predicted. Cernat (2001) findings suggest that Mercosur and the Andean Community were overall, trade diverting. On the other hand Flores (1997), using a CGE analysis, concluded that Mercosur was trade creating.Mayda and Steinberg (2006) use a difference-in-difference estimation strategy at goodness level to assess the impact of COMESA on Ugandan imports. They present evidence that South-South trade agreements create positive but little economic gains, through changes in trade patterns, for their members. This is different from Cernat (2001) results, which indicate that imports into COMESA members from third countries were on average 30 per cent higher than those predicted without the trade diversion dummy variable. Mayda and Steinberg (2006) find evidence that no trade diversion takes place in COMESA.The mixed results from these studies, the increasing number of SS RTAs underway and the high number of countries wanting to join completely or in part in these RTAs poses the following questions Why do policy makers from these countries advocate in favor of these RTAs? Should these RTAs be pursued?, and the still not categorically answered question Are South-South Regional Trade Agreements trade creating or trade diverting? Using the gravity model, this paper aims to get evidence from SS RTAs from the Americas.1.2 Problem definitionDo South-South Regional Trade Agreements create trade or divert trade? The literature on this topic is vast and contradictory. Everybody thinks that SS-RTAs are trade diverting. Some papers present evidence of this. Other present evidence that they are actually trade creating. Finally others find evidence of very little trade creation and no significant evidence of trade diversion.With so many RTAS in place and many others underway, it is important to understand the effects of creating these trade blocs.Should poor countries pursue RTAs with poor countries? Are SS RTAs building blocks or stumbling stones towards the world liberalization of trade?1.3 Research ObjectiveThe main objective of this paper is to determine if MERCOSUR, Andean Community, and SICA were trade creating or trade diverting in the years 1995, 1998, 1999, 2003, 2007.1.3.1 Major research questionIs there significant evidence of trade creation or tra de diversion on the years 1995,1998,1999,2003,2007 for Mercosur, Andean Community and SICA?1.3.2 Minor research questionIs there significant evidence that suggests that RTA members of the above mentioned RTAs increased trade between them and their partners?Is there significant evidence that suggests that members of the above mentioned RTAs increased trade between them and third countries?Is there significant evidence that suggests that the increase in trade between RTA partners of the above mentioned RTAs is higher than the decrease in trade between RTA members and third countries?1.4 Theoretical Framework1.4.1 The Gravity model of tradeThe gravity model uses Newtonian gravity principles to study human behavior. It is widely used by economists and social scientists to predict flows of trade, people, goods, money, and other variables as an effect of changes in economic policies, fiscal policies, new laws, bans and other distortions to the flow of a given variable.The original gravity model of trade assumes that two countries will trade more or less depending on the sizes of their economies and the distance between their economic centers. It was created independently by Tinbergen (1962) and Pyhnen (1963) and augmented in later years to include other independent variables that may cause a change in trade flows. These augmented versions of the basic gravity model may include population of the two countries, presence of common borders, same language, common colonizer, and others that the researcher regards as relevant.The gravity model specifications used in this paper are similar to those of Cernat(2001) and Cheng Hall (2003). These specifications are used to run OLS regressions on trade data of 1995, 1998, 1998, 2003 and 2007. One set of pooled data including the years mentioned is analyzed using the same gravity specifications.The results of these regressions provide evidence of gross trade creation and diversion as specified by Balassa (1967)1.4.2 Research Met hodology and DesignThe paper uses standard OLS analysis, with bilateral imports as a dependent variable and 17 independent variables GDP of the importing country, GDP of the exporting country, Population of the importing country and population of the exporting country, distance between the capital cities of each country pair, Intra_x dummy variable for each RTA, Extra_x dummy variable for each RTA. The values of GDPs, distance and populations are used in their logarithmic form.GDPs and population data was collected from the WB databank. Trade data was collected from UNCTADs database using the WB banks WITS application.1.4.3 Research AssumptionsCosts of transportation are relative to the great circle distance between economic centers of countries studiedAll countries have one economic center, namely their capital cities.The error coefficient of the log-linear gravity model used in this paper is normally distributed with a mean of zero and constant variance for all observations. It i s also assumed that error pairs are uncorrelated.GDPs, population, and trade data collected belongs to the population1.4.4 Research Limitations1.5 thesis StructureThe remainder of this paper is organized as follows Chapter 2 presents a literature review that explains trade creation and trade diversion, the effect of both and findings of previous papers that assess RTAs. Chapter 3 explains the gravity model used on the paper, how data was collected and organized, and the considerations in analyzing data. Chapter 4 summarizes the findings and Chapter 5 concludes.2. Literature ReviewThere is extensive literature on RTAs. This literature either predicts the effects of a RTAs using a computable-general equilibrium analysis or they measure the effects of an FTA using aggregate data or commodity level data.The concern of most authors, and the reason why they conduct their research, is that FTAs and specially SS FTAs may divert trade rather than create it. In the former case, purchases fro m an efficient producing country are replaced by purchases of a less efficient FTA partner.This section serves three purposes 1. It explains trade creation and trade diversion to the reader so she can better understand the methodology used to assess the selected RTAs. 2. It presents the reader with the results of previous findings so that the reader can compare the results of this paper with previous results of other authors. 3. It gross trade creation and diversion so that the reader can understand the results of the research.2.1 Trade Creation and Trade DiversionTrade creation and trade diversion as defined by Viner (1950), refer to changes in flow of trade between nations. Trade creation happens when trade is switched from less efficient producers of one country to more efficient producers in another country a better allocation of resources. In trade diversion trade is shifted from more efficient producers in one country to less efficient producers in another country -a worsenin g in the allocation of resources.2.1.1 Trade CreationTrade creation can be defined as the net welfare gain that results from the grounding of an RTA, both on the production and on the consumption side. Some economists though, think that it is more precise to think of trade creation only as the increase in welfare from the production side (Senior-Nello S, 2010). In this paper the former definition of welfare is considered.To understand trade creation, imagine the following scenario (Figure 1) The country in question, Country X, say Honduras, imports product Q from country M (United States) at price Pw+t, which includes an ad valorem tax and is the same price offered by other nations in the world, including country E (El Salvador). At this price, Honduras imports 20 units and consumes 60. The stay 40 units are imported from the US. This is illustrated by the Honduran supply and demand lines in Figure 1 and the perfectly elastic supply curve with free trade of El Salvador. It is under stood that a change in Honduran imports of product Q cannot affect the world price of product Q.Figure 1. Trade CreationIf Honduras signed an RTA with El Salvador and the price of product Q from ElSalvador dropped to PE, Honduras would now produce 10 units of product Q, consume 70, and import the difference of 60 units. Because El Salvador now offers a lower price for product Q, Honduras now imports this product from El Salvador and not from the US.The consumer surplus gains of this RTA are correspond by areas a+b+c+d. The loss in producer surplus is indicated by area a. The loss of tariff revenue for Honduras is area c. Therefore the net welfare increase of this RTA between El Salvador and Honduras is indicated by triangles b and d.Triangle b represents the amount of production that was shifted from less efficient producers in Honduras to more efficient producers in El Salvador a better allocation of resources. Triangle d represents the increase in consumption of product Q.2.1.2 Trade DiversionTrade Diversion is illustrated in figure 2. Again the supply and demand lines are those of Honduras for product Q. Line S1 and S2 are the perfectly elastic supply curves of USA and El Salvador respectively, and lines S1+t and S2+t are the tax inclusive supply curves of the same two countries.Figure 2. Trade DiversionHonduras imports product Q from the US at tax inclusive price Pw+t. El Salvador offers product Q at price PE+t and thus does not benefit from Honduran purchases.At price Pw+t Honduras produces 20 units, consumes 60, and imports 40 from the US. If Honduras and El Salvador now form an RTA and do not include the US, tariffs will be removed on imports from El Salvador but not from imports from the US. subsequently forming the RTA Honduras would produce 10 million units, consume 80 million and import 60 million units of product Q from El Salvador at price PE.The RTA has diverted trade from more efficient producers in the US to less efficient producers in El Sa lvador, so there is a worsening in the allocation of resources. On the other hand 10 million units are now imported from El Salvador instead of being produced at dwelling house in Honduras. At the same time 40 million units that were previously imported from the US are now being imported from El Salvador.The welfare loss from trade diversion is reflected rectangle f. The 40 million units that were imported from more efficient producers in the US whose free trade price is $1.00 are now imported from El Salvador at $2.00. The welfare loss is $40 million.The welfare gain from the customs union is calculated as the areas of triangles b and d. Triangle b is the welfare gain in the production side $5 million. Triangle d is the welfare gain in the consumption side $10 million.The total impact on welfare as a result of the RTA is given by the sum of the areas of triangles b and d minus the area of rectangle f (b+d-f) welfare gain minus welfare loss. In this case the RTA generated a welfare loss of $25 million.Figure 2 illustrates that the idea of trade creation and trade diversion can be misleading. If, for example, the sum of areas of triangles b and d would be greater than the area of rectangle f, the RTA would cause a net welfare gain. In this scenario, although trade has been diverted from more efficient producers in one country to less efficient producers in another, the RTA increased welfare for the RTA signing country.2.1.3 Gross Trade CreationFollowing the lead of Jacob Viner, Balassa (1967) evaluated the effects of the European Common Market with reference to its trade creating and trade diverting effect using Tinbergen (1962) and Pyhnen (1963) model -the gravity model. In his work he developed model that captured substitution of less efficient domestic and foreign suppliers for more efficient foreign suppliers gross trade creation which is different than Viners definition of trade creation according to which trade is created only at the expense of local pr oducers.To illustrate the difference gross trade creation and trade creation proper as defined by Viner (1950), consider three trading partners of one particular product countries A, B, and C, product Q (See Figure 3). Before signing a RTA with country B, Country A imports product Q from both, Country B and Country C in equal amounts and has 4 local producers of the same product (Figure 3a).In the case of trade creation proper (Figure 3b), after signing a RTA with country B, Country A continues to import equal amounts of product Q from countries B and C but has reduced the number of local producers of the same product. More efficient producers in Country B have absorbed market share from local producers in Country A trade creation proper.Gross trade creation on the other hand (Figure 3c), considers that trade is created not only when local producers are substituted, but also when producers in third countries are substituted. In this case, after signing a RTA with country B, Countr y A decreases its imports of product Q from Country C and increases imports of the same product from Country B while keeping the same number of local producers. It is important to note that gross trade creation assumes that substituted producers in Country C were less efficient than producers in country B the contrary would constitute trade diversion.Figure 3. Trade Creation Proper vrs Gross Trade CreationLike in Cernat (2001), this paper evaluates the gross trade creating effects of the assessed RTAs.In his paper, Balassa (1967) provides evidence of trade creation in the European Common Market during six years since the Markets establishment. Again, trade creation applies to the substitution of any less efficient producer for a more efficient one, independent of the producers base country. The why of the expected differences between the results of developed country RTAs and SS RTAs is explained in the next section.2.2 Empirical Evidence from SS RTAsA number of studies have been con ducted to assess the effects of SS RTAs in partner countries -most of them attempt to determine if the RTAs were trade creating or trade diverting e.g. Evans (1998), Lewis et al. (1999), Flores (1997), Cernat (2001), Subramanian and Tamirisa (2001), Cernat (2003), Mayda and Steinberg (2006). Different methods have been used and the results are mixed. This paper uses methods similar to Cernat (2001) and Cheng Wall (2003).In his paper, Cernat(2001) used the log-linear form of the gravity equation to asses nine SS RTAs. He finds evidence that suggests that SS RTAs are less trade diverting than theoretically predicted. Cernats(2001) findings suggest that Mercosur and the Andean Community were overall, trade diverting.Mayda and Steinberg(2006) use a difference-in-difference estimation strategy at commodity level to assess the impact of COMESA on Ugandan imports. They present evidence that South-South trade agreements create positive but little economic gains, through changes in trade p atterns, for their members (Mayda and Steinberg, 2003). This is different from Cernats(2001) results, which indicate that imports into COMESA members from third countries were on average 30 per cent higher than those predicted without the trade diversion dummy variable. Mayda and Steinberg (2006) find evidence that no trade diversion takes place in COMESA.The mixed results from these studies, the increasing number of SS RTAs underway and the high number of countries wanting to join completely or in part in these RTAs poses the following questions Why do policy makers from these countries advocate in favor of these RTAs? Should these RTAs be pursued?, and the still not categorically answered question Are South-South Regional Trade Agreements trade creating or trade diverting? Using the gravity model, this paper aims to get evidence from SS RTAs from the Americas.Theoretical Framework and Research Methodology***Intro***Problem DefinitionResearch ObjectiveResearch Questions3.1 Theoreti cal Framework3.1.1 Multiple Regression Analysis and Model BuildingFigure 4. Regression HyperplaneMultiple regression analysis is a method of inferential statistics that measures the relationship between two or more independent variables and one dependent variable. The multiple regression model is given byWherey = dependent variable= regression constant of the population= regression coefficient for each variable xj=1,2,kk = number of independent variables= error of the modelDifferent from a simple regression equation -which forms a straight line in a two-dimensional space to represent the linear relationship between two variables the multiple regression model forms a hyperplane in a multidimensional space (Figure 4). This hyperplane represents the relationship between the dependent variable and k independent variables.To build a multiple regression model, that is, to construct a mathematical equation that represents the relationship between independent and dependent variables, a res earcher must decideThe question that needs to be answeredThe potential independent variablesWhat is a representative sample of the population should be at least four times the number of independent variables (Groebner, et al, 2008)The model used in this paper is well known and widely used by social scientists to measure the flow of various types of variables. This model is explained in section 3.1.3.3.1.2 Regression Model DiagnosisTo ensure the significance of an OLS regression analysis results, the following evaluation criteria are usually used (Groebner, et al, 2008)The coefficient of determination (R2 and R2 adjusted)Significance of the overall model (F-test)Significance of individual variables (t-tests)Size of the standard deviation of the modelMulticollinearity of variablesThe coefficient of determination measures the proportion of variation in the dependent variable that can be explained with the independent variables used by the model. The value of R2 may range from 0-1, wit h 1 representing a perfect linear relationship between dependent and independent variables. Higher values of R2 are preferred as they would indicate that the chosen independent variables explain better the variations in the dependent variables.A derivate indicator, called adjusted R2, takes into account the number of independent variables in the model, and their ploughshare the variations in the dependent variable. Because R2 increases when independent variables are added to the model, even if the new variables have no relationship with the dependent variable, adjusted R2 evaluates the model more precisely.The Significance of the overall model can be determined by comparing the Significance F value given in the regression create of a statistical software application, and the critical value for a given alpha level.The critical value for a given alpha level is determined using t-tables and statistical procedures explained in Groebner (2008).The Significance of individual variables i s determined by comparing their calculated t-values with the critical t-value of the model. If their calculated t-values are greater than their critical t-values the variable is considered significant. To determine the critical t-values of independent variables, degrees of freedom need to be calculated and interpolated with the desired level of significance in a t-table. For detailed explanations see Groebner (2008).The size of the standard deviation of the model measures the dispersion of observed values of the dependent variable, and the predicted values for the same variable. It is up to the researcher to determine an acceptable range for the standard error estimation.Multicollinearity occurs when two variables provide overlapping information to explain the variation in the dependent variable. To measure multicollinearity the researcher can use the VIF as an indicator. Generally, if the VIF 3.1.3 The Gravity Model of TradeFollowing Isaac Newtons principle of gravity, according t o which two bodies will attract each other more when their sizes are increased and the distance between them is cut the gravity model explains trade flow between two countries establish on the size of their economies and the distance between their economic centers.The equation design of the gravity model of trade is(Formula 1)Where Fg represents trade flow, G is the constant, m1 and m2 are the economic dimensions of the two countries in question, and d is the distance between the two countries. In its basic log-linear form, the gravity equation is as follows(Formula2)Where is the bilateral trade flow between countries i and j at time t, is the constant, is the natural logarithm of the GDP of country i, is the natural logarithm of the GDP of country j, is the natural logarithm of the distance between country i and country j, and is the normally distributed error.This basic gravity model is usually augmented by including other variables like adjacency, common language, colonial li nks, common currency, and RTA membership among others. Different authors have suggested many different specifications for the gravity model of trade1, however there is no consensus about which model specification is more accurate and serves beaver in assessing RTAs. Moreover other authors have suggested that the gravity model is dyed due to endogeneity and reverse causality (Magee, 2003) and have led others to use unaccompanied different methods to asses RTAs (Mayda Steinberg (2006).This paper uses a gravity model specification that is similar to Cernat (2001) but considers Cheng Walls (2003) suggestions of eliminating dummy variables that might capture unintended trade distorting variables.To assess trade creation and trade diversion in nine RTAs, Cernat(2001) adds two dummy variables to an already augmented specification of the model Intra_RTA and Extra_RTA. The Intra_RTA dummy becomes a 1 when both, the importing and the exporting countries, are partners in the RTA being ass essed by the two dummies. The Extra_RTA dummy becomes one when the importing country is part of the assessed RTA but the exporter is a third country.The model uses bilateral trade flows as a dependent variable and 18 independent variables GDP of importing country, GDP of the exporting country, GDP per capita of the importing country, GDP per capita of the exporting country, Population of the importing country, population of the exporting country, distance between the capital cities of both countries, an adjacency dummy variable, a common language dummy variable, nine Intra_RTA dummy variables (one for each RTA assessed), and nine Extra_RTA dummy variables (one for each RTA assessed). All non-dummy variables expressed in their logarithmic form.In theory, the Intra_RTA dummies will capture the effect that the assessed RTA had on trade between partners of the RTA and the Extra_RTA dummy captures the effect of the same RTA on trade of RTA members with third countries.To diagnose a RTA a s trade crating or trade diverting, Cernat (2001) knowing an Intra-Extra coefficient table (Table in this paper). According to this table, if a trade agreement increased trade between its partners at the expense of third countries -diverted trade, the Intra_RTA dummy should be positive and the Extra_RTA dummy negative. If the agreement created trade instead, the coefficients of both dummies would be positive.CoefficientExtra_RTAIntra_RTASign++Trade creation and trade expansionTrade diversionTrade expansionTrade contractionTable 1 Dummy Variable InterpretationCheng Wall (2003) use a fixed-effect panel data analysis to measure the effect on trade of RTAs over time. Their proposed model allegedly controls the heterogeneity bias in the gravity model of trade. In it, Cheng Wall (2003) drop all dummy variables and even drop the distance variable. They argue that these variables bias the gravity model and they motivate their argument in a number of ways. First, they reason that economic distances are too hard to measure with accuracy because big countries have many economic centers, that are thousands of miles apart and that serve as trade centers for diffe