The Potential Challenges of ASEAN Trade in AFTA

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THE POTENTIAL CHALLENGE OF ASEANS T RADE

IN THE ASEAN FREE TRADE AREA

-A GRAVITY MODEL APPROACH-

____________________________

A Thesis

Submitted to the Graduate School

of Economic Sciences of Hiroshima Shudo University

In Partial Fulfillment of the Requirements for the Degree of

Master in Economics

Student ID: 0874102

Written by: Sithanonxay Suvannaphakdy

Supervised by: Prof. Toshihisa Toyoda

____________________________

Hiroshima Shudo University

2010


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ABSTRACT

Since the 1990s, the regional integration has been increasingly popular

through trade, investment and financial markets. Among others, ASEAN can

be considered as one of the most important regional trading blocs in the East

Asia. To achieve ASEANs targets of stimulating intra- and extra-regional

trade, improving the investment climate and enhancing the competitiveness

of industrial performance of its member countries, its members agreed in

1992 to formulate the ASEAN Free Trade Area (AFTA). AFTA is expected

to make manufacturing sectors in ASEAN more efficient and ready to

compete in the global market for trade in goods and investment.

The momentum toward regional trading blocs in the Southeast Asia like

ASEAN raises many issues that are important not only for the effect of the

regional trade agreement (RTA) on trade, but also for the economic tools

used to investigate it. Since ASEAN has intensively traded with non-

members countries also, it is unclear whether the formation of AFTA has

potentially promoted trade flows of its members. In order to investigate such

impact, the gravity model has been extensively applied. While trade is a

dynamic process at least in theory, there are very few literatures on ASEAN

trade which apply the dynamic gravity model.

The main objectives of this research are to evaluate the determinants of

bilateral exports in ASEAN applying the extended gravity model; and todevelop the static panel gravity model into the dynamic model. Panel data

framework is used to estimate and evaluate the empirical resu lts based on the

data of 43 countries from 1989 to 2005. The primary research question

addresses what factors enhance and impede ASEAN trade. In addition, it also

seeks to address whether the dynamic gravity model could provide a

comparable result to the static gravity model in analyzing trade flows.


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The research is conducted in two scenarios: intra-ASEAN and extra-ASEAN.

The former consists of 10 ASEAN countries while the latter contains 43

countries. Both scenarios are investigated by applying static and dynamic

panel gravity models. The static model is specified based on the

conventional gravity model. The dynamic model is formulated based on two

economic hypotheses: the partial adjustments and adaptive expectations

hypotheses.

The static model is esti mated by the error-component two-stage least squares

(EC2SLS) whereas the dynamic model is estimated by the system of

generalized method of moment (system-GMM). Both the static and dynamic

models treat GDPs of both exporter and importer as endogenous variables. In

order to estimate the static model by the EC2SLS, populations of the

exporter and importer are used as instruments for their GDPs. Since

estimating the dynamic model by the system-GMM uses the second and

higher lags of the endogenous variable as instruments, no instruments

outside the system are required.

The results show that intra-ASEAN trade is determined by the market sizes

of the ASEAN members, transport costs, historical links, and RTA. Extra-

ASEAN trade is determined by the market sizes of ASEAN and its trading

partners, as well as transport costs, cultural and historical links,

geographical proximity and RTAs. Among several variables, the market sizesboth in ASEAN and in its main trading partners play an important role in

determining the bilateral trade flows in ASEAN. The findings also confirm

that AFTA has increased trade flows of its members.

Moreover, estimating the static gravity model using the EC2SLS and the

dynamic one using system-GMM yields plausible results. This supports the

claim that the gravity model can be used to investigate trade determinants.


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However, the long-run coefficients obtained from the dynamic model are

generally higher than the coefficients obtained from the static model.

In addition, the empirical results show that formulating the dynamic gravity

models based on the partial adjustments and adaptive expectations

hypotheses provides similar results. Both models indicate that trade is

indeed a dynamic process. This suggests that lagged trade flows should be

included as one of the explanatory variables of the gravity model when one

estimates the gravity model.

This thesis is consisted of fi ve chapters. Chapter 1 presents the introduction,

the motivation, and the objectives of the research. Chapter 2 describes the

patterns of ASEAN trade from 1989-2005 by means of the share matrix of

world trade and the trade intensity matrix. The chapter also reviews some

key literature on the theoretical foundations and the applications of the

gravity models.

Chapter 3 aims at discussing the conceptual framework of the gravity model

specifications. These include the specifications of both static and dynamic

gravity models. The chapter then explains the estimation methods for both

the static and dynamic gravity models. The methods employed are EC2SLS

for the static gravity model, and the system-GMM for the dynamic gravity

model. Moreover, the chapter explains the data collection, and some relatedtechnical issues needed to adjust the data. Finally, Chapter 3 summarizes the

conceptual framework for evaluating ASEAN trade.

Chapter 4 presents the results of the research and discusses the research

findings. The results are divided into two main groups, intra- and extra-

ASEAN trade. The former represents the analysis of trade flows of 10

ASEAN countries. The latter considers trade flows of 10 ASEAN countries


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associated with their main trading partners. Both groups are estimated in

terms of both static and dynamic gravity models.

Chapter 5 summarizes the research results and provides the conclusions

regarding the research questions.

Key words: ASEAN, dynamic, Gravity Model, regional integration, trade


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ACKNOWLEDGEMENTS

Several people have made intellectual and personal assistance to this study;

without their support this accomplishment would not have been achievable.

The best I can do is to give a special appreciation to all of my supporters

here.

Firstly, I would like to express my highest appreciation to my supervisor,

Professor Toshihisa Toyoda, for the incalculable contributions he has made

to this study. He has provided me with invaluable knowledge and ideas. His

friendly advice, constant encouragement, criticism and the confidence shown

to me during this study are sincerely appreciated.

Secondly, I highly appreciate Professor Chris Czerkawski and Professor

Tadashi Inoue for their constructive comments and suggestions on this

thesis.

In addition, I would like to express my special acknowledgement to the

graduate school of economic sciences that greatly facilitates the success of

this thesis.

Furthermore, I wish to thank Associate Professor Khamleusa Nuansavanh,

Dean of the Faculty of Economics and Business Management, the National

University of Laos, in permitting my study leave to complete this studymission. I am indebted the Japanese Government, Monbukagakusho (MEXT),

for her financial support and contribution.

I would also wish to express my special acknowledgement to Associate

Professor Phouphet Kyophilavong for invaluable suggestions on selecting my

research topic at the initial stage.


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Last, but not least, I would like to acknowledge the constant support of my

family for their faith, understanding and encouragement during my studies.

Sithanonxay Suvannaphakdy


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CONTENTS

Page

CONTENTS .............................................................................................. i

LIST OF TABLES .............. ................. ................ ................. ................ ... iv

LIST OF FIGURES ............... ................. ................ ................ ................. vi

ABBREVIATIONS ................................................................................. vii

CHAPTER 1: INTRODUCTION ....................... ................ ................ ....... 1

1.1 Research Background ......................................................................... 1

1.2 Motivation of the Research ................................................................ 4

1.3. Purpos e of the Resear ch ............... ................ ................. ................ .... 5

1.4 Thesis Organization ........................................................................... 5

CHAPTER 2: LITERATURE REVIEW....... ................ ................. ............ 7

2.1 Key Concepts on the Regional Economic Integration ........................... 7

2.1.1 Types of Regional Economic Integration (REI) .............................. 7

2.1.2 Regional Economic Integration a nd its Effects ............................... 8

2.2 An Overview on ASEAN and AFTA ................................................... 9

2.2.1 An Overview on ASEAN ............................................................... 9

2.2.2 An Overview on AFTA ............................................................... 10

2.3 Trade Flows in Intra- and Extra-ASEAN ........................................... 12

2.3.1 Trade Share Matrix ..................................................................... 12

2.3.2 Trade Intensity among ASEAN Countries .................................... 16

2.4 International Trade Theory ............................................................... 20

2.4.1 Physical Characteristics of Countries ........................................... 20

2.4.2 Population .................................................................................. 21

2.4.3 Capital ....................................................................................... 21

2.4.4 Distance ..................................................................................... 22

2.4.5 The Political Factor .................................................................... 22

2.4.6 Stage of Economic Development. ................................................ 23

2.5 International Trade and Gravity Model ............................................. 23

2.5.1 Literature on the Theoretical Foundation of the Gravity Model ..... 23


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2.5.2 Theoretical Foundations of the Gravity Equation .......................... 32

2.5.3 Literature on the Econometric Method of the Gravity Model ......... 38

2.5.4 Literature on the International Trade Analyses Applying the

Gravit y Model ............... ................ ................. ................ ................ ..... 41

2.5.5 Previously Related Studies on Trade Flows of ASEAN ................. 47

2.6 Summary ......................................................................................... 53

CHAPTER 3: EMPIRICAL MO DELS AND METHODOLOGY .. ........... 55

3.1 Summary of Variables Used in the Gravity Model ............................. 55

3.2 Specifications of Static Panel Gravity Models ................................... 58

3.2.1 Cross-section Gravity Model versus Panel Gravity Model ............. 583.2.2 Specification of Static Gravity Model for Intra-ASEAN Trade ...... 61

3.2.3 Model Specification for Extra-ASEAN Trade: Static Gravity

Equation .................................................................................... 65

3.3 Specifications of Dynamic P anel Gravity Models .............................. 67

3.3.1 Dynamic Panel Gravity Model: P artial Adjustments Hypothesis .... 68

3.3.2 Dynamic Panel Gravity Model: Adaptive Expectations

Hypothesis .......................................................................................... 72

3.4 Estimation Methods ......................................................................... 79

3.4.1 Estimation Method for Static Panel Gravity Model ....................... 79

3.4.2 Estimation Method for Dynamic Panel Gravity Model .................. 80

3.5 Data Used in the Research ............................................................... 84

3.5.1 Data Sources .............................................................................. 84

3.5.3 Summary Statistics of Data ......................................................... 853.6 Summary ......................................................................................... 87

CHAPTER 4: EMPIRICAL RESULTS AND DISCUSSION ............... ..... 89

4.1 Static Panel Gravity Model of Intra-ASEAN Trade ............................ 90

4.2 Static Panel Gravity Model of Extra-ASEAN Trade ........................... 94

4.2.1 Static Gravity Model of Extra-ASEAN Trade in the Baseline

Context ..................................................................................... 94

4.2.2 Static Gravity M odel of Extr a-ASEAN Trade in the FTA context .. 98


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4.3 Intra-ASEAN Trade versus Extra -ASEAN Trade ............................. 102

4.4 Dynamic Panel Gravity Model of Intra-ASEAN Trade ..................... 105

4.5 Dynamic Panel Gravity Model of Extra-ASEAN Trade .................... 109

4.5.1 Dynamic Gravity Model of Extra-ASEAN Trade in the Baseline

Context ................................................................................... 109

4.5.2 Dynamic Gravity Model of Extra-ASEAN Trade in the FTA

Context ................................................................................... 114

4.6 Summary ....................................................................................... 121

CHAPTER 5: CONCLUSIONS AND POLICY IMPLICATIO NS .......... 122

5.1 Summary and Empirical Results ..................................................... 1225.2 Policy Implications of the Research Findings .................................. 126

5.3 Limitations of the Study ................................................................ 127

5.4 Contribution to the Related Studies ................................................ 128

5.5 Suggestions for Future Research .................................................... 130

APPENDIX .......................................................................................... 132

Appendix A......................................................................................... 132

Appendix B ......................................................................................... 133

REFERENCES ..................................................................................... 135


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LIST OF TABLES

Page

Table 2.1 Average CEPT Tariff Rates, by Country, 1998-2003 .................. 11Table 2.2 Percentage Share Matrix of World T rade for 1989-2005

Average ................................................................................... 14

Table 2.3 Intensity of Trade for 1989-2005 Average ................................. 18

Table 2.4 Summary of the Key Tr ade Literature Applying the Gravity

Model ...................................................................................... 45

Table 2.5 Summary of Key ASEAN T rade Literature Applying the

Gravity Model ......................................................................... 51

Table 3.1 Variables Used in the Gravity Model ......................................... 56

Table 3.2 Estimated Short-run Elasticity and Long-run Elasticity Based

on Partial Adjustments Hypothesis ............................................ 71

Table 3.3 Estimated Short-run Elasticity and Long-run Elasticity Based

on Adaptive Expectations Hypothesis ....................................... 77

Table 3.4 Variable Descriptions and Predicted Signs ................................. 78

Table 3.5.a Summary Statistics of the Most Important Variables of

Intra-ASEAN Trade, 1989-2005 ................................................ 86

Table 3.5.b Summary Statistics of the Most Important Variables of

Extra-ASEAN Trade, 1989-2005 ............................................... 87

Table 4.1 Determinants of Intra-ASEAN Trade: Static Model .................... 93

Table 4.2 Determinants of Extra-ASEAN Trade in the Baseline

Context: Static Model .............................................................. 97

Table 4.3 Determinants of Extra-ASEAN Trade in the FTA Context: Static

Model ...................................................................................... 99

Table 4.4.a Determinants of Intra-ASEAN T rade: Dynamic Model ........... 106

Table 4.4.b Long-run Determinants of Intra-ASEAN Trade ..................... 107

Table 4.5.a Determinants of Extra-ASEAN Trade in the Baseline Context:

Dynamic Model Based on Partial Adjustments Hypothesis ....... 110


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Table 4.5.b Long-run Determinants of Extra-ASEAN Trade in the

Baseline Context: Partial Adjustments Hypothesis ................... 111

Table 4.6.a Determinants of Extra-ASEAN Trade in the Baseline Context:

Dynamic Model Based on Adaptive Expectations Hypothesis ... 112

Table 4.6.b Long-run Determinants of Extra-ASEAN Trade in the Baseline

Context: Adaptive Expectations Hypothesis ............................ 113

Table 4.7.a Determinants of Extra-ASEAN Trade in the FTA Context:

Dynamic Model Based on Partial Adjustments Hypothesis ....... 116

Table 4.7.b Long-run Determinants of Extra-ASEAN Trade in the FTA

Context: Partial Adjustments Hypothesis ................................. 117 Table 4.8.a Determinants of Extra-ASEAN Trade in the FTA Context:

Dynamic Model Based on Adaptive Expectations Hypothesis ... 119

Table 4.8.b Long-run Determinants of Extra-ASEAN Trade in the FTA

Context: Adaptive Expectations H ypothesis ............................ 120

Table 5.1 Variables Affecting the Determinants of Intra- and Extra-

ASEAN Trade ........................................................................ 125


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LIST OF FIGURES

Page

Figure 1.1 Organization of Thesis .............................................................. 6

Figure 2.1 Share of Intra-ASEAN Exports ................................................ 15

Figure 2.2 Intra- and Extra-ASEAN Exports ............................................. 16

Figure 2.3 Trade Intensity of Intra-ASEAN .............................................. 19

Figure 3.1 Conceptual Framework for Evaluating ASEAN Trade Flows ..... 88


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ABBREVIATIONS

AEE = Adaptive Expectations Hypothesis of Extra-ASEAN Trade

AEI = Adaptive Expectations Hypothesis of Intra-ASEAN Trade

AFTA = ASEAN Free Trade Area

APEC = Asia Pacific Economic Cooperation

ARDL = Autoregressive Distributed Lag

ASEAN = Association of Southeast Asian Nations

CAFTA = China-AFTA

CEPT = Common Effective Preferential Tariff

CES = Constant Elasticity of Substitution

CGE = Computable General Equilibrium

CMEA = Council of Mutual Economic Assistance

EAFTA = East Asia Free Trade Area

EC2SLS = Error Component Two-stage Least Squares

EEC = European Economic Community

EFTA = European Free Trade Association

EMU = Economic and Currency Union

ESI = Export Similarity Indices

FDI = Foreign Direct Investment

FEM = Fixed Effects Model

FTA = Free Trade Area

GATT = General Agreement on Tariffs and Trade

GDP = Gross Domestic Product

GEL = General Exception List

GMM = Generalized Method of Moments

GSP = Generalized System of Preferences

ICI = International Competitive Indices

IL = Inclusion List

LAFTA = Latin American Free Trade Association


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MERCOSUR = Southern Common Market

NAFTA = North American Free Trade Area

OECD = Organization for Economic Co-operation and Development

OLS = Ordinary Least Squares

PAE = Partial Adjustments Hypothesis of Extra-ASEAN Trade

PAI = Partial Adjustments Hypothesis of Intra-ASEAN Trade

REI = Regional Economic Integration

REM = Random Effects Model

RTA = Regional Trade Agreement

SAARC = South Asian Association for Regional Cooperation

SITC = Standard International Trade Classification

TEL = Temporary Exclusion List

WH = Western Hemisphere

WTO = World Trade Organization


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CHAPTER 1

INTRODUCTION

1.1 Research Background

Since the 1990s, the regional integration has been increasingly popular

through trade, investment and financial markets. These include the foundations

of ASEAN free trade area (AFTA, 1992), European Union (1993), North

American Free Trade Agreement (NAFTA, 1994), South Asian Free Trade

Area (SAFTA, 2004) and so on. The rise of regional trading blocs brings about

challenges for economists in international trade. One fundamental question

posed by this is the aggregate welfare effects of regional trade liberalization.

Another question giving rise to this research is how important RTAs actually

have been for the pattern of trade. It is therefore crucial to evaluate

econometrically the trade effect of the RTAs.

Among others, ASEAN can be considered as one of the most important regional

trading blocs in East Asia. To achieve ASEANs targets of stimulating intra - and

extra-regional trade, improving the investment climate and enhancing the

competitiveness of industrial performance of its member countries, its members

agreed in 1992 to formulate the AFTA. In 2005, the bloc spanned over an area of

4.46 million km2 with a combined GDP (nominal) of about USD 896.5 billion

growing at an average rate of around 5.6% per annum. AFTA is expected to

make manufacturing sectors in ASEAN more efficient and ready to compete in

the global market for trade in goods and investment. Obviously, the

establishments of ASEAN will serve as the building blocks for a possible

establishment of an East Asia Free Trade Area (EAFTA) in the near future.


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Analyzing regional trade in AFTA represents a useful laboratory not only to

apply economic tools for international trade analysis, but also to map out

policy of ASEAN trade when the trading bloc has become to be more

integrated with differentiated countries in sizes, and levels of economic and

institutional development. Regarding the international trade analysis, some

reliable international models are going to be chosen and tested based on

ASEAN and related data set. After deriving an appropriate model of ASEAN

trade, policy analysis can be done. From the policy point of view, recognizing

possible factors affecting trade flows plays a crucial role in designing

international trade policy. Furthermore, policy makers may wish to draw an

exact conclusion whether AFTA has increased trade flows for its members. To

sum up, the factors determining trade flows and the impact of AFTA on its

members are essential to be analyzed precisely.

While regional economic integration (REI) covers a wide range of issues, this

thesis focuses on trade. Forecasting or measuring the impact of economic

integration by means of its effect on trade is a very challenging task. The

classical method of welfare analysis is to apply the Computable General

Equilibrium (CGE) model. However, formulating this model requires not only

much time and efforts, but also the results of which are not always easily

interpretable. Moreover, method of regression analysis which yields simply

interpretable results cannot be used to estimate the welfare effects directly. In

short, it seems to be a methodological trade-off between simple estimationmethod and easily interpretable results regarding the sensitive questions posed

by welfare effects of REI.

Fortunately, there has been a simple but powerful model of international trade

called a gravity model. It has been regarded as the workhorse to explain the

impact of regional integration in terms of trade. The model relates bilateral

trade flows positively to their GDPs, and inversely to the transaction costs


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(approximated by distance between exporting and importing countries). After

having been originally proposed by Tinbergen (1962), while the gravity model

has been widely used to analyze international trade flows, it has been criticized

for lacking of any theoretical foundations. This criticism has gradually

diminished after the publication of the work by Anderson (1979) on the

theoretical foundation for the gravity equation. Furthermore, there are other

key literature that have been published, e.g. Bergstrand (1985, 1989, 1990),

Deardorff (1998), and Anderson and van Wincoop (2003).

The gravity model has gained its popularity because of three fundamental

reasons. First, international trade flows play a crucial role in all aspects of

economic relationships, it is therefore essential to understand what normal

trade flows should be. Second, data set used for estimating the gravity model is

available to all researchers. Third, several famous papers have established the

gravity models regarded by economists as being proper, correct, and good (e.g.

Anderson, 1979; McCallum, 1995; Frankel, 1998; Rose, 2000; Anderson and

van Wincoop, 2003).

The gravity models empirical success has expanded its empirical applications

to cover a variety of issues, such as the impact of RTA, national borders, and

currency unions on trade. This requires accumulating many countries over long

time period to enable the analysis of interest. As a consequence, one of the

new waves of the academic profession in the development of the gravity modelis concentrating on finer econometrics approach. And this thesis is mainly

devoted to do just that.

Up to this point, three issues have been highlighted: (1) the importance of

evaluating factors enhancing and impeding international trade flows; (2) the

impact of regional economic integration, especially AFTA, on trade flows of

its members; and (3) the way forward to develop the gravity model by


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attributing its characteristics with econometric techniques. This thesis is going

to integrate all three key issues together and use them to draw conclusions

regarding ASEAN trade.

1.2 Motivation of the Research

This research has been concentrated on investigating the determinants of

ASEAN trade applying the gravity model. Previous research addressed factors

determining ASEAN trade and the effects of AFTA on trade flows of ASEAN

countries (see Roberts, 2004; Elliott and Ikemoto, 2004; Kien and Hashimoto,

2005; Hapsari and Mangunsung, 2006; Siah et al., 2009). However, these

studies focused only on the application of static gravity model. To the authors

knowledge, no research has analyzed ASEAN trade utilizing the dynamic panel

gravity model.

The dynamic panel gravity model is worth to be brought into consideration due

to three fundamental reasons. Firstly, the empirical results of Eichengreen and

Irwin (1998) indicated that trade patterns tend to change relatively slowly over

time even the change in RTAs or political links is sudden. Toward this

situation, they suggested to include lagged trade variables in the gravity

equation. The importance of the dynamic gravity model is also emphasized by

Bun and Klaassen (2002). They applied the system-GMM and fixed-effects

model to estimate the dynamic panel gravity model. They confirmed that

ignoring the lagged trade variable can lead to incorrect model specifications.

Furthermore, the tools that have been employed to estimate the gravity

equation in panel data framework have evolved over time, as the results of

both developments in panel econometrics and changes in the specific questions

posed by the theoretical models. This increases the availability of econometric

tools for estimating the gravity model in the panel data framework. Finally, the

author is very interested in the art of econometric modeling.


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In conclusion, this thesis is highly motivated by the valuably empirical

research, the beauty of international trade theory represented by the gravity

model, and the art of econometric modeling. The author believes that the

research results can at least pave the way for a new direction in developing the

panel gravity model of international trade.

1.3. Purpose of the Research

The general objective of this research is to evaluate the determinants of

bilateral exports in ASEAN. This research seeks to address the following

primary research questions: what are the factors enhancing and impeding

ASEAN trade? And has the formation of AFTA really increased trade flows of

its members? The specific objectives of this research include:

(1)To provide an overview on the specifications of the panel gravity models oftrade;

(2)To extend the static panel gravity model into the dynamic model;(3)To draw policy implications regarding the promotion of ASEAN trade.1.4 Thesis Organization

This thesis is consisted of five chapters. Chapter 1 presents the

introduction, the motivation, and the objectives of the research. Chapter 2

describes the patterns of ASEAN trade from 1989-2005 by means of the share

matrix of world trade and the trade intensity matrix. The chapter also reviews

some key literature on the theoretical foundations and the applications of the

gravity models.

Chapter 3 aims at discussing the conceptual framework of the gravity model

specifications. These include the specifications of both static and dynamic

gravity models. The chapter then explains the estimation methods for both the

static and dynamic gravity models. The methods employed are EC2SLS for the

static gravity model, and the system-GMM for the dynamic gravity model.


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Moreover, the chapter explains the data collection, and some related technical

issues needed to adjust the data. Finally, Chapter 3 summarizes the conceptual

framework for evaluating ASEAN trade.

Chapter 4 presents the results of the research and discusses the research

findings. The results are divided into two main groups, intra- and extra-ASEAN

trade. The former represents the analysis of trade flows of 10 ASEAN countries.

The latter considers trade flows of 10 ASEAN countries associated with their

main trading partners. Both groups are estimated in terms of both static and

dynamic gravity models.

Chapter 5 summarizes the research results and provides the conclusions

regarding the research questions. The organization structure of this thesis is

illustrated in Figure 1.1.

Figure 1.1 Organization of Thesis

Chapter 1

Introduction

Chapter 2

Literature Review

Chapter 3

Empirical Models

and Methodology

Chapter 4

Gravity Model Results

Chapter 5

Summary and Conclusions


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CHAPTER 2

LITERATURE REVIEW

This chapter is aimed to form the basic idea on how to investigate international

trade flows analytically in chapter 4. It reviews the relevant literature to

explain ASEAN trade flows. Section 2.1 provides some key concepts of

economic integration. Section 2.2 presents historical overview of ASEAN and

AFTA. Section 2.3 descriptively analyzes the overall patterns of intra- and

extra-ASEAN trade. Section 2.4 describes factors possibly affecting

international trade flows. Section 2.5 is devoted to the literature of the gravity

model. Section 2.6 summarizes the chapter.

2.1 Key Concepts on the Regional Economic Integration

2.1.1 Types of Regional Economic Integration (REI)

It is interesting to ask what it means by Regional Economic Integratio n

(REI). According to Marrewijk (2002), REI is typically defined as the

elimination of tariff and non-tariff barriers within a group of countries. There

are five main types of REI.

(i) Preferential trade agreement (PTA). The PTA occurs when the members of

the agreement reduce tariffs or other trade restrictions on some goods or

services within a group of countries. This is sometimes done unilaterally.

However, the treatment of trade restrictions is remained the same to non-

members of the agreement.

(ii) Free trade area (FTA). The FTA agreement occurs when the members of an

FTA eliminate tariff and non-tariff barriers restricting trade among members,

without any common trade policy relative to other countries.

(iii) Customs union. The customs union occurs when the members of a group

not only abolish internal tariff and non-tariff barriers, but also develops a

common trade policy (i.e. common external tariffs) relative to other countries.


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(iv) Common market. The common market occurs when the members of a

group allow not only for the free movement of goods and services, but also for

the free movement of factors of production (i.e. capital and l abor).

(v) Economic union. The economic union is resulted from an extension of the

common/internal market, in which the institutional framework is harmonized

relating to competition policy, procurement, etc., and a fair degree of policy

coordination.

2.1.2 Regional Economic Integration and its Effects

REI has two main effects, such as trade creation and trade diversion,

originally described by Viner (1950). Trade creation refers to the emergence of

new trade flows among member countries of a trading bloc replacing domestic

production; and trade diversion refers to the substitution of imported goods

from non-member countries (low-cost products) with member countries (more

costly products).

The notions of trade creation and trade diversion involve not only in the partial

equilibrium market, but also in the general equilibrium and dynamic effects.

General equilibrium effects are consisted of terms of trade, wage rate, and

other factor return changes. Dynamic effects are composed of economies of

scale, growth, and innovation. Growth effect occurs when the REI induces

changes in trade balances in the partner countries on their macroeconomic

equilibriums. If all countries were to improve their trade balances through the

combined effects of trade creation and trade diversion, then this would be amacroeconomic shock on their output growth. One aspect of any change in

output growth would in turn have an impact on import demand from both

partner and non-partner countries. Another aspect of output growth is that it

leads to dynamic gains through higher investment and innovation.

According to Hassan (2001), the REI in the form of a customs union has the

following effects:


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(i) Static effects:

a) Trade creation effects, resulted from both production and consumption

gains;

b) Trade diversion effects, caused by replacing cheaper imports with

members of the same trading agreement due to the elimination of tariff

and non-tariff barriers within the group;

c) Increase in international bargaining power due to the larger economic

size;

d) Decrease in administrative expenditures among member countries; and

e) Less smuggling among member countries.

(ii) Dynamic effects:

a) Increase in production efficiency due to higher competition;

b) Decrease in average production costs due to economies of scale in

larger markets;

c) Higher international investment, resulted from an increase in

investment opportunities and lower uncertainty and risks; and

d) Promotion of technological change resulted from higher competition.

2.2 An Overview on ASEAN and AFTA

2.2.1 An Overview on ASEAN

The Association of Southeast Asian Nations or ASEAN was founded on 8

August 1967 in Bangkok by the five original Member Nations, respectively,

Indonesia, Malaysia, the Philippines, Singapore, and Thailand. Brunei

Darussalam joined on 8 January 1984, Vietnam on 28 July 1995, Lao PDR and

Myanmar on 23 July 1997, and Cambodia on 30 April 1999. Consequently,

there are currently 10 member countries in ASEAN.

The formation of ASEAN is intended to strengthen and sustain key regional

issues. The first issue is to accelerate economic growth, social progress and

cultural development in the region. Another is to promote regional peace and


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stability through abiding respect for justice and the rule of law in the

relationship among countries in the region and adherence to the principles of

the United Nations Charter.

To sustain its rapid economic growth and development into the decade of the

1990s, ASEAN has had to respond to the external challenges of maintaining

strong economic relations with its major trading partners, thereby ensuring its

market access to the United States, Japan, and Europe. ASEAN, as a whole and

for its constituent member countries, also has had to sustain international

competitiveness in terms of attracting the flows of foreign direct investment

(FDI), to reduce production costs, and to maintain other advantages. As a result,

AFTA was established in 1992. The AFTA is such a collective strategic response

to pursue ASEANs goals of stimulating intra - and extra-regional trade,

improving the investment climate and enhancing the competitiveness of

industrial performance of its member countries.

2.2.2 An Overview on AFTA

AFTA is a trade bloc agreement by ASEAN supporting local manufacturing

in all ASEAN countries. The AFTA agreement was signed on 28 January 1992 in

Singapore. When the AFTA agreement was originally signed, ASEAN had six

members, namely, Brunei, Indonesia, Malaysia, Philippines, Singapore and

Thailand. Vietnam joined in 1995, Laos and Myanmar in 1997 and Cambodia in

1999. AFTA now comprises the ten member states of ASEAN. All the four

latecomers were required to sign the AFTA agreement in order to join ASEAN,

but were given longer time frames in which to meet AFTAs tariff reduction

obligations.

The primary goals of AFTA are to increase ASEANs competitive edge as a

production base in the world market through the elimination of tariffs and non-

tariff barriers within ASEAN; and to attract more FDI into ASEAN. The


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elimination of tariff and non-tariff barriers among member countries is expected

to promote greater economic efficiency, productivity, and competitiveness.

The primary mechanism for achieving the goals given above is the Common

Effective Preferential Tariff (CEPT) scheme, which established a schedule for

phased initiated in 1992 to increase the regions competitive advantage as a

production base geared for the world market.

Under the CEPT Scheme, all import duties will be eliminated by 2010 for the six

original members of ASEAN and by 2015 for the new members. The scheme hasbeen implemented on the basis of four product lists: the Inclusion List (IL), the

Temporary Exclusion List (TEL), the Sensitive List (SL), and the General

Exception List (GEL). Table 2.1 illustrates that the average regional CEPT rate

for products in the Inclusion List in 1998 has fallen to 5.05% from 12.76% in

1993. As of 1998, no product in the Inclusion List of the first six ASEAN

countries can have CEPT tariff rates higher than 20%. The average CEPT rate

for the region was scheduled to fall to 3.74% by the year 2000 and then to 2.63%

by the year 2003.

Table 2.1 Average CEPT Tariff Rates, by Country, 1998-2003Country 1998 1999 2000 2001 2002 2003

Brunei Darussalam 1.35 1.30 1.00 0.97 0.94 0.87

Indonesia 6.12 5.29 4.57 4.36 4.10 3.69

Laos 5.00 5.00 5.00 5.00 5.00 5.00

Malaysia 3.40 3.00 2.57 2.40 2.27 1.97

Myanmar 4.47 4.45 4.38 3.32 3.31 3.19Philippines 7.43 6.54 5.27 4.79 4.53 3.62

Singapore 0.00 0.00 0.00 0.00 0.00 0.00

Thailand 10.56 9.75 7.40 7.36 6.02 4.64

Vietnam 3.92 3.90 3.38 2.97 2.72 1.78

ASEAN 5.05 4.59 3.74 3.54 3.17 2.63

Source: ASEANSecretariat

As a result of the successful implementation of the CEPT scheme, trade among

ASEAN countries had grown from USD 44.2 billion in 1993 to USD 352.7


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billion in 2006, illustrating an average annual increase of 17.96%. Before the

Asian financial crisis struck in mid-1997, intra-ASEAN exports had been

increasing by 29.6%. This is considerably higher than the rate of increase of

total ASEAN exports, which grew at 18.8% during the same period (ASEAN

Secretariat, 2002).

2.3 Trade Flows in Intra- and Extra-ASEAN

Explaining trade flows within a region or among regions during a given time

period could provide a basic understanding on to what extent trading interaction

among them take place and in which direction they are going to be. While thereare many ways to describe bilateral trade flows, this section has employed two

basic tools of international trade. These are trade share matrix and trade

intensity. The former is attempted to provide a rough measure about how trade

interaction between two regions has been, whereas the latter can be used to

interpret more precisely how much bilateral trade between two regions has been

intensified.

2.3.1 Trade Share Matrix

Table 2.2 summarizes the world trade, averaged over 1989-2005, in the form of

trade share matrix. It illustrates the percentage share of a countrys or regions

exports to another country or region relative to its total exports. Table 2.2

consists of six trading blocs where some blocs are constructed by the author

for the purpose of more detailed analysis in the following chapters. These

blocs are ASEAN, EU13, NAFTA, MERCOSUR, OTHERS, and ROW. ASEA N

is composed of 10 countries, such as Brunei, Cambodia, Indonesia, Laos,

Malaysia, Myanmar, the Philippines, Singapore, Thailand, and Vietnam. Since

the primary purpose of this thesis is to investigate the determinants of intra-

and extra-ASEAN, only 13 countries of the EU which are the main trading

partners of ASEAN have been included. These 13 EU countries are Austria,

Denmark, Finland, France, Germany, Greece, Ireland, Italy, the Netherlands,


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Portugal, Spain, Sweden, and the United Kingdom. NAFTA is consisted of

Canada, Mexico, and the United States of America. MERCOSUR is composed

of Argentina, Brazil, Paraguay, and Uruguay. OTHERS refers to countries

that do not belong to any RTA. It is consisted of Australia, Bangladesh, Chile,

China, Hong Kong, India, Japan, Korea, New Zealand, Norway, Pakistan,

Switzerland, and Turkey. The term ROW stands for Rest of the World. ROW

is included only for the sake of completeness of describing world trade in this

section. This means, it will be excluded in the empirical analysis of chapter 4.

To describe the world trade using trade share matrix, it is crucial to highlight a

fundamental characteristic involved in this table. As shown in Table 2.2, the

row shows the percentage share of exports to each of the countries in the

column, relative to the total exports of a country in the row. Although there

are six blocs in Table 2.2, the following interpretation will mainly focus on

trade relations of intra- and extra-ASEAN. Intra-ASEAN trade accounted for

23.1% of their total exports, or amounted to USD 77,361 million (not reported

in Table 2.2). This was approximately twice less than the corresponding ratio

in EU13 and NAFTA (55% and 51%, respectively), but it was larger than trade

of intra-MERCOSUR by almost 30%. Exports from the 10 ASEAN countries to

the world were 6% of the world exports in 1989 -2005 averages, or amounted to

USD 334,342 million (not reported in Table 2.2). Obviously, among regional

blocs, ASEAN had traded more with OTHERS accounting for nearly 34% of

her total exports, and it could increase trade flows further if the East Asia FreeTrade Area would be established.

Regarding the intra-ASEAN trade in Table 2.2, the important point to be noted

is that compared to the other ASEAN countries, 57% and 33% of total exports


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Table 2.2 Percentage Share Matrix of World Trade for 1989-2005 Average

a b c d e f g h i j k l m n o p q

Brunei Cambodia Indonesia Laos Malaysia Myanmar Philippines Singapore Thailand Vietnam ASEAN EU13 NAFTA MERCOSUR OTHERS ROW WORLD

a Brunei 0.00 3.04 0.00 1.40 0.00 1.02 6.64 9.34 0.01 21.44 1.62 6.03 0.00 69.24 1.66 100.00

b Cambodia 0.00 0.13 0.11 1.48 0.00 0.10 4.85 6.08 5.26 18.01 19.33 48.61 0.01 8.06 5.97 100.00

c Indonesia 0.05 0.11 0.00 2.82 0.12 1.30 9.41 1.81 0.64 16.27 12.49 14.31 0.48 45.04 11.41 100.00

d Laos 0.00 0.01 0.19 0.07 0.00 0.02 0.41 29.91 26.19 56.80 26.27 3.37 0.07 10.67 2.82 100.00

e Malaysia 0.31 0.06 1.26 0.00 0.23 1.32 18.08 3.94 0.54 25.75 12.72 21.07 0.39 30.62 9.45 100.00

f Myanmar 0.02 0.00 1.41 0.00 3.15 0.27 6.59 21.41 0.31 33.15 11.41 9.91 0.07 30.27 15.20 100.00

g Philippines 0.01 0.01 0.45 0.01 3.96 0.01 6.30 2.88 0.56 14.20 17.23 29.68 0.13 30.07 8.70 100.00

hSingapore 0.64 0.27 2.83 0.02 16.33 0.41 2.06 4.86 1.43 28.85 13.27 17.72 0.39 30.85 8.93 100.00i Thailand 0.08 0.60 1.80 0.59 4.00 0.35 1.39 9.01 1.16 18.98 14.38 20.65 0.40 31.45 14.15 100.00

j Vietnam 0.00 0.90 2.08 0.43 1.96 0.04 2.12 7.47 2.12 17.12 16.63 12.88 0.15 37.62 15.60 100.00

k ASEAN 0.31 0.25 1.68 0.12 6.93 0.27 1.49 7.82 3.29 0.96 23.14 13.51 19.10 0.37 33.45 10.44 100.00

l EU13 0.03 0.00 0.26 0.00 0.36 0.01 0.16 0.62 0.33 0.06 1.82 54.96 9.61 0.88 11.48 21.26 100.00

m NAFTA 0.02 0.00 0.33 0.00 0.89 0.00 0.62 1.62 0.60 0.05 4.13 14.47 51.31 1.85 16.40 11.84 100.00

n MERCOSUR 0.00 0.00 0.47 0.00 0.56 0.00 0.31 0.44 0.66 0.07 2.52 22.25 21.36 16.28 16.46 21.13 100.00

o OTHERS 0.02 0.03 1.24 0.01 1.64 0.07 1.07 2.82 1.77 0.43 9.11 20.79 22.93 0.84 31.25 15.09 100.00

p ROW 0.00 0.01 0.34 0.00 0.47 0.01 0.45 1.42 0.85 0.22 3.78 38.05 14.21 0.90 19.07 24.00 100.00

q WORLD 0.04 0.03 0.59 0.01 1.16 0.04 0.58 1.86 0.97 0.22 5.49 34.43 21.21 1.23 19.52 18.11 100.00

Exports to

Exports from

Source: Authors calculation using data from IMFs Direction of Trade (CD-ROM, 2006).

ASEAN: Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, Philippines, Singapore, Thailand, and Vietnam.

EU13: Austria, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Netherlands, Portugal, Spain, Sweden, and the United Kingdom.

NAFTA: Canada, Mexico, and the United States of America.

MERCOSUR: Argentina, Brazil, Portugal, and Uruguay.

OTHERS: Australia, Bangladesh, Chile, China, Hong Kong, India, Japan, Korea, New Zealand, Norway, Pakistan, Switzerland, and Turkey.

ROW (Rest of the World): other coun tries in addition to ASEAN, EU13, NAFTA, MERCOSUR, and OTHERS.


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of Laos and Myanmar, namely, had been sent to the ASEAN market. On the

other hand, only a small fraction of the total exports of Cambodia, Indonesia,

the Philippines, Thailand, and Vietnam were sold in ASEAN market. This data

has been shown graphically by Figure 2.1.

Figure 2.1 Share of Intra-ASEAN Exports

0

10

20

30

40

50

60%

Brunei

Cambodia

Indon

esia

L

aos

Mala

ysia

Myan

mar

Philipp

ines

Singapore

Thailand

Vietnam

Share of Intra- ASEAN Exports

Source: drawn from Table 2.2

Now, it is noteworthy to consider the trading interaction between ASEAN and

other trading blocs. As obviously seen from Table 2.2, while 23% of the

ASEAN exports were sold in the ASEAN market herself, 34% went to the

OTHERS. Other important export markets of ASEAN were EU13 and

NAFTA, which accounted for 19% and 14% of ASEANs total exports,

namely. Among other trading blocs, MERCOSUR was the smallest market for

ASEAN exports which could absorb only less than 1% of the total ASEAN

exports. Figure 2.2 depicts the percentage share of ASEAN exports to ASEAN

herself and to other trading blocs.


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Figure 2.2 Intra- and Extra-ASEAN Exports

0

5

10

15

20

25

30

35

%

ASEAN EU13 NAFTA MERCOSUR OTHERS ROW

Exports of ASEAN


Turning to the exports of other trading blocs to ASEAN, about 9% of the total

exports of the OTHERS went t o ASEAN. EU13 exported only 1.8% of her

total exports to ASEAN which was the smallest percentage compared to

others.

2.3.2 Trade Intensity among ASEAN Countries

The intensity and character of trade among ASEAN countries and their

trade with other regional blocs may be examined more closely using the

concept of intensities of trade proposed by Brown (1947) . The extent to

which Laos, for example, trades more or less with particular countries may be

measured by intensity of trade indices. The intensity of Laoss trade withanother country is measured by the ratio of that countrys share in Lao exports

to its total share in world imports. Mathematically, the formula for calculating

trade intensity can be expressed as

100

l

i

l

li

li

MW

M

X

X

TI (2.1)


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where

liTI is the index of trade intensity of Laos ( l) and country i

liX is the Lao exports to country i

lX is the total Lao exports )( i

liX

iM is the total imports by country i

lM is the total import by Laos

Wis the total world imports

If the intensity of Laoss exports is 100 with all countries, then Laoss exports

will be distributed by country exactly in proportion to each countrys share in

total world trade. World trade may be taken as representative of the structure

of world demand in tradable commodities. In fact, however, trade will never

be distributed in precisely this way. An exports intensity of more (less) than

100 indicates that Laos is exporting more (or less) to a particular country than

might be expected from that countrys share in total world imports. Laos can

therefore be said to have developed her export markets more (or less)

intensively in that country than in some other country. Likewise, the intensity

of other countrys export to Laos indicates the extent to which Laos takes

more imports from a particular country than might be expected from that

countrys share in world trade. The greater the intensity of both Laoss exports

and import trade with a particular country, the more complementary their

industrial structures are likely to be, the closer they are likely to begeographically, historically, and culturally, and the lower trade barriers are

likely to be between them.

As shown in Table 2.3, the intensity of intra-areal trade, exports as well as

imports, of each member country of ASEAN was more than 100 in 1989-2005.

Ten countries traded with each other intensively. In exports, the order of

intensity was 1,034 for Laos, 603 for Myanmar, 515 for Singapore, 463 for


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Table 2.3 Intensity of Trade for 1989-2005 Average

a b c d e f g h i j k l m n o p

Brun ei Cambodia Indon esia Laos Malaysia Myanmar Ph il ippines Singapore Tha il an d Vietnam ASEAN EU13 NAFTA MERCOSUR OTHERS ROW

a Brunei 1 511 1 121 1 177 357 958 4 390 5 28 0 355 9

b Cambodia 4 22 1114 128 6 17 261 624 2341 328 56 229 1 41 33

c Indonesia 134 408 18 243 328 225 503 185 284 294 36 67 39 229 63

d Laos 0 45 32 6 0 3 22 3069 11667 1034 76 16 6 55 16

e Malaysia 833 210 210 20 628 227 961 400 236 463 37 98 32 155 52

f Myanmar 65 9 237 0 272 46 354 2196 137 603 33 47 6 155 84

g Philippines 38 37 75 96 341 37 337 294 247 257 50 139 10 153 48

h Singapore 1710 989 468 205 1386 1094 350 489 625 515 38 82 31 155 48

i Thailand 219 2210 299 5894 342 949 239 480 513 342 41 96 32 160 77

j Vietnam 12 3307 349 4329 169 106 367 401 217 311 48 61 12 192 86

k ASEAN 790 883 267 1169 567 694 245 398 320 406 37 85 29 162 54

l EU13 49 9 28 11 20 10 18 22 22 17 22 30 47 39 77

m NAFTA 41 8 44 3 61 4 85 68 49 17 59 33 119 66 52

n MERCOSUR 2 4 79 2 48 5 54 23 67 31 45 64 99 83 115

o OTHERS 48 104 168 61 114 156 149 122 146 155 133 49 87 55 67

p ROW 5 37 47 9 33 27 64 63 71 81 56 90 55 60 80

Exports to

Exports from

Source: Authors calculation using data fromIMFs Direction of Trade (CD-ROM, 2006).

ASEAN: Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, Philippines, Singapore, Thailand, and Vietnam.

EU13: Austria, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Netherlands, Portugal, Spain, Sweden, and the United Kingdom.

NAFTA: Canada, Mexico, and the United States of America.

MERCOSUR: Argentina, Brazil, Portugal, and Uruguay.

OTHERS: Australia, Bangladesh, Chile, China, Hong Kong, India, Japan, Korea, New Zealand, Norway, Pakistan, Switzerland, and Turkey.

ROW (Rest of the World): other coun tries in addition to ASEAN, EU13, NAFTA, MERCOSUR, and OTHERS.


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Malaysia, 390 for Brunei, 342 for Thailand, 328 for Cambodia, 311 for

Vietnam, 294 for Indonesia, and 257 for the Philippines. These data have been

shown in Figure 2.3. As compared with exports, the intensity of imports was

generally higher. This means that each of the ten countries imported more

heavily from the market within the area while each exported more heavily to

the outside region. The results can, therefore, lead to an intuitive inference

that there is room for increasing exports within the area by diverting from

outside blocs.

Figure 2.3 Trade Intensity of Intra-ASEAN

0

200

400

600

800

1000

1200%

Brunei

Cambodia

Indonesia

Laos

Malaysia

Myanmar

Philippines

Singapore

Thailand

Vietnam

Trade Intensity of Intra-ASEAN


Laos-Vietnam trade was very intensive (index was 11,667 and 4,329).

Thailand and Laos trade was also intensive which indicated by the indices

5,894 for Thai exports and 3,069 for Lao exports. Moreover, Cambodia and

Vietnam also showed trade intensity accounting for 2,341 for Cambodias

exports and 3,307 for Vietnams exports. These high intensities are naturally

due to special neighborhood relations. However, some bilateral trade relations

had not existed or existed but less intensive, such as, Brunei-Cambodia,


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Brunei-Laos, Brunei-Myanmar, Brunei-Vietnam, Cambodia-Indonesia, Cambo-

dia-Myanmar, Cambodia-Philippines, Indonesia-Laos, and so on.

Trade relations with other Asian countries (denoted by OTHERS) were also

intensive for ASEAN taken together (162 for her exports and 133 for

OTHERS). Brunei had the most intensive trade relations with OTHERS

although there was a large imbalance in indices between 355 for Bruneis

exports and 48 for OTHERS exports. In addition, trade intensity between

Indonesia and OTHERS was also noteworthy, reported at 2 29 for Indonesian

exports and 168 for OTHERS exports. Nonetheless, trade intensities of

Cambodia and Laos with OTHERS were very low.

2.4 International Trade Theory

Section 2.3 described the patterns of ASEAN trade. It also illustrated that

some countries traded more or less intensive with one another. It is thus

important to understand why countries engage in international trade, how they

select their trading partners, and which commodities are to be traded and in

what quantities. Answering these questions requires us to consider the basic

natures of the factors affecting international trade. According to Thomas et al.

(1968), there are six potential factors determining international trade flows.

They are physical characteristics of countries, population, capital, distance,

politics, and stage of economic development.

2.4.1 Physical Characteristics of Countries

A countrys physical attributes plays direct and indirect impacts on its

trade with the rest of the world. The first noteworthy consideration is the area,

containing both positive and negative implication. Some countries with large

area have abundant resources, have the technical capabilities to transform their

resources, and are hence able to export a huge volume of product to the world


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market. Nevertheless, some large countries failed to be on the list of the

leading global trade.

Another important consideration is that countries in different regions differ

largely in their agricultural capabilities and biotic resources. This relates to

the global patterns of climates and soils.

Although the sizable portion of the worlds trade depends on the differences in

resources, it is important to note that the full utilization of such resources

requires other factors of production, respectively, capital, and labor. In

addition, even though the physical environment significantly serves as the

main driving force of international trade, trade flows between industrialized

countries occur despite having little natural endowment needed to produce the

exported products.

2.4.2 Population

Population serves a multiple role in international trade. It is the source of

labor force determining both a countrys ability to exploit its resources and the

kinds of goods it will export and import.

A countrys population also provides its market. How good a market that

country will be for its foreign suppliers is largely determined by the size, per

capita income, and culture of the population. Some kinds of commodities may

be strictly limited to be imported into one country due to cultural attributes of

the population. More specifically, the dietary laws of the Jews of Israel, the

Moslems of the Pakistan, and the Hindus of India have a substantial impact on

trade of those countries.

2.4.3 Capital

Capital determines both the sorts of commodities traded and their

quantity. Most advanced countries tend to export capital intensive products.


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Merchandise trade can also be affected either positively or negatively due to

the international capital flows. When a country sets up a branch plant in a

country that it formerly exported, trade is ordinarily decreased. By doing so,

the exports of goods are replaced with the exports of capital.

2.4.4 Distance

Distance may affect trade in two ways: the movement of goods and

people, and the communication of information. Although a country may enjoy

the cost advantages due to its abundantly natural resources, such as plentifully

skilled labor, and an ample capital, its competitiveness in the world market

may be impeded by great transport costs. Nonetheless, thanks to the

technological development, the long-term downward trend in transport costs

has increased the range of commodities entering international trade.

Distance may also have an impact on trade through the communication of

information. Lack of information because of unfamiliarity with foreign places

and people, can result in indecisive action to good business opportunities.

Distance and information appear to be relatively correlated, since a country

knows the most about its nearest neighbors. Consequently, two countries trade

if they share common border due to not only the savings in cost, but also the

greater knowledge. As in the case of transport costs, technological

advancement is gradually reducing the information barrier by ways of

improved air travel, radio, cable, telephone and internet.

2.4.5 The Political Factor

Governments play a decisive role in expanding or contracting

international trade flows. This can be done through the tools of its

international trade policy, including tariffs, quotas, and other related non-tariff

barriers. When a country faces the balance of payment problems, the

government may attempt to increase its exports while impose some restrictions

on imports. To increase the exports, countries engage in trade-promotion


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activities such as fairs and exhibitions, associated with various types of

financial and technical assistances to exporters. Since the Second World War,

another way of the governments to exert their influences is the formation of

economic integration. Despite the important roles of the governments in

international trade, several economists prefer the so-called free trade.

2.4.6 Stage of Economic Development.

Per capita income is one of the measures of the stage of economic

development. It provides an indicator to the kind of market that a country may

offer to prospective foreign suppliers. A country with a high level of income

tends to be associated with mass consumption and thus indicates the best

possibility, while the low level of income indicates the least opportunity.

Nevertheless, many countries at a low stage of development can be the

attractive markets because of the enormous size of the population and the

existing total aggregate demand.

2.5 International Trade and Gravity Model

2.5.1 Literature on the Theoretical Foundation of the Gravity Model

The gravity model was originally founded on Newtons physical theory

which states that two bodies attract each other in proportion to their masses

and inversely by the distance between them. The application of the gravity

model to international trade theory aims at explaining the bilateral trade flows

between two economies by regarding them as an organic body that attracts

each other in proportion to their economic size (GDP) and inversely to their

distance. The earlier works only observed the tendency for the volume of

international trade flows to be negatively related to distance between trading

partners, and demonstrated this either with simple graphical techniques (Isard

and Peck, 1954) or rank correlation techniques (Beckerman, 1956).


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always close to unity. This implied that export flows were almost proportional

to the incomes of the exporting and importing countries.

The subsequent work proposed by Pyhnen (1963) differed in detail rather

than substance from Tinbergen (1962). The author used transport cost terms

instead of physical distance. Then the empirical result from estimating 10

European countries in 1958 yielded the coefficient of determination about

0.94. Furthermore, in the studies of 62 non-communist countries over 1948-

1960, he included two additional variables, one to indicate a countrys trading

area, and the other to represent meteorological conditions. The latter dummy

was generated based on the assumption that the larger the differences between

mean temperatures, the greater the need to exchange commodities.

Nevertheless, the explanatory power of the model had been improved a little.

Linnemann (1966) examined 6,300 commodity trade flows between eighty

non-communist countries in 1959. The key feature that distinguished

Linnemanns work from the previous ones did not lie in testing the model, but

in his effort to propose stronger theoretical underpinnings. He argued that the

explanation on trade flows can be accounted for by three groups of variables:

factors determining the total potential supply of the exporting country;

determinants of total potential demand of the importing country; and the

impediments to trade flows. The ratio of the potential international trade was

defined as the ratio of exports plus imports to GNP, and was hypothesized todepend on the differences in population size between countries. This

hypothesis was then used to test two assumptions: economies of scale and the

diversification of demand at higher levels of income. More precisely, the

hypotheses were: (i) the foreign trade ratio was negatively related with

population; (ii) a countrys foreign trade was independent of its per capita

income.


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Focusing on the analysis of trade resistances, Linnemann (1966) argued that

trade flows are prevented by transport costs, time, socio-cultural distance, and

artificial trade obstacles (tariffs, quotas, etc.). The former three factors were

collectively measured by geographical distance. At the same time, he

criticized Beckerman (1956) and Balassa (1962) for claiming that the

difference between FOB prices for particular commodities could be used as a

measure of economic distance. He argued that this measure could only be

applied to commodities actually traded, but it ignored commodities that were

not traded due to too high transport costs. That is, economic distance was

underestimated by this measure. Linnemann (1966) suggested that the artificial

trade impediments between country pairs were normally and randomly

distributed while preferential trade agreements were not. As a result, he

included the preferential trade variable into his empirical gravity model.

The basic Linnemanns gravity equation can be represented as:

654321

0

ijijjijiij PDNNYYEX (2.2)

where iN and jN denote the number of the exporting and importing countries

population, respectively;ijP is the preferential trade factor; and other variables

are defined as in equation (2.1). The coefficients on population are assumed to

be negative. His empirical model showed that the coefficient of determination

was around 0.8.

These contributions have been followed by several more formal attempts to

derive the gravity equation from models that assumed product differentiation.

The first work supporting this area is Anderson (1979). He laid out a

theoretical foundation at an aggregate level to the gravity model from the

properties of expenditure systems. To do this, Anderson assumed that each


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country only produced one particular good and had identical Cobb-Douglas

preference. Neither tariffs nor did transport costs appear in this model.

Anderson also reconsidered the same case under CES preference attached in

the appendix. He concluded that his application of the gravity model was an

alternative method to study cross-section budget. However, the model was

mainly limited by the fact that it only held for countries with similar

preferences for traded goods, and identical structure in terms of trade tax and

transport cost.

Helpman and Krugman (1985) indicated that consumers had variety of

preferences where each firm produced a product that was imperfect substitute

for another product and had monopoly power in its own product, under the

condition of imperfect competition. They concluded that when two countries

had similar technologies and preferences, they would naturally trade more with

each other in order to expand the number of choices available for

consumption. Helpman (1987) proved this issue by applying his test on OECD

countries trade data. H is results supported the argument that the gravity

equation could be applied to the trade flows among industrialized countries

where intra-industry trade and monopolistic competition were well developed.

Jeffrey Bergstrand has immensely contributed to the theoretical foundations of

the gravity equation. He derived the gravity equations that could be used to

explain the international trade phenomena in the frameworks of world trademodel (Bergstrand, 1985), Hecksher-Ohlin (H-O) theory and Linder hypothesis

(Bergstrand, 1989), and intra-industry trade theory (Bergstrand, 1990). Each of

these is reviewed in the subsequent paragraphs.

Bergstrand (1985) employed a general equilibrium model of world trade to

derive a generalized gravity equation. One of the important assumptions

made for this framework was that aggregate trade flow was differentiated by


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place of origin. On demand side, consumers in the importing country were

assumed to maximize their utility in the form of the constant elasticity of

substitution (CES) utility function, subject to their incomes. On supply side,

firms in the exporting country maximized their profit function subject to their

resources, say labor. Then, the general equilibrium condition to solve for the

reduced form of trade flows equation was found by equating demand and

supply functions. However, the reduced form of the trade flow model could

not be seen as the typical gravity model, since it excluded importer and

exporter incomes that were treated as endogenous variables.

In order to derive the gravity equation associated with importer and exporter

incomes, Bergstrand (1985) proposed the small market assumption, implying

that bilateral trade flows were small relative to the rest of the worlds markets.

Consequently, the variation in trade flows and price of this bilateral trade have

negligible impacts on the incomes and prices of the exporters and importers.

Under the small market assumption, the reduced form of the aggregate trade

flows could be expressed as a function of the exporters income, importers

income and other price variables. Since the gravity equation was estimated

using cross-sectional data, the assumptions of identical utility and identical

production functions were made to ensure that the estimated parameters were

constant across all country pairs.

Under the small market, identical utility and identical production functionsassumptions, Bergstrand (1985)s trade flow equation was known as the

generalized gravity equation. The term general comes from the fa ct that the

specification treated exporters income and importers income as exogenous

variables but imposed no restrictions on parameter values, except for being

identical across all country-pairs. Finally, his empirical finding suggested that

the inclusion of the price and exchange rate variables were necessary when

applying gravity equation for international trade analysis.


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Furthermore, Bergstrand (1989) provided an explicit theoretical foundation of

the gravity equation to explain the H-O and Linder theories. Bergstrand s

(1989) work utilized the generalized gravity equation, derived in Bergstrand

(1985). The resulting gravity equation related the bilateral trade flows to

exporters income, importers income, and per capita GDP. The economic

interpretation of these variables is that exporter s GDP was a proxy of the

national output of the exporting country; exporter s per capita GDP

represented the capital-labor endowment ratio of the exporter; importer s GDP

was the importers national income; and finally, importers per capita GDP

was explained as importers per capita income . Finally, Linder hypothesis was

interpreted as the changes in importer s income and per capita income,

reflecting the alternations of expenditure capabilities and taste preferences.

The final paper of Bergstrand reviewed in this thesis is concerned with the

derivation of the gravity equation in the framework of intra-industry trade. The

set up of demand and supply frameworks in Bergstrand (1990) was similar to

Bergstrand (1989).

In order to express the gravity equation in the intra-industry framework,

Bergstrand (1990) substituted the equation of the aggregate trade flows into

the formula of the Grubel-Lloyd index. This yielded a complex function but

far-reaching outcomes, showing explicitly how average levels of and

inequalities between two countries GDPs, per capita GDPs, capital -laborratios, and tariffs influence their degree of intra-industry trade.

Deardorff (1998) derived equation for the value of bilateral trade from

frictionless and impeded trade in the Heckscher-Ohlin framework. For

frictionless trade, the absence of all barriers to trade in homogenous products

caused producers and consumers to be indifferent among trading partners. He

firstly analyzed by assuming that each country has an identical and homothetic


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preferences. Then, generalizing the result to arbitrary preferences, he found

that the gravity equation still held on average. In the case of impeded trade,

the author obtained gravity equation containing trade costs under the

assumption that each country produced different goods.

Anderson and van Wincoop (2003) argued that the commonly estimated

gravity model is not theoretically grounded. They had developed the

methodology which was based on existing gravity theory by simplifying a

variety of assumptions. They claimed that their derived method consistently

and efficiently estimated a theoretical gravity equation. More details of the

gravity model derived by Anderson and van Wincoop (2003) have been

discussed in section 2.5.2.

Having discussed some key papers concerned with the theoretical foundation

of the gravity equation, it might be useful to turn our attention to the

theoretical foundation of the gravity equation in terms of the empirical data.

While almost all economists in international trade accept that the gravity

model plays an important role in explaining international trade relationship,

the estimation involving zero trade flows is still ambiguous whether to include

the country pairs that do not trade with one another in the data set. Dropping

one country out of the panel of bilateral trade data can dramatically decrease

the number of observations. In addition, international trade theory as well as

the gravity model are utilized to investigate the phenomena of , why twocountries trade more with one another, why there is only unilateral trade (one

country just either exports to or imports from the other), and why both

countries do not trade to each other at all. Including the interesting mystery of

zero trade flows into data set of the gravity equation might provide possible

answers to these questions. Unfortunately, the linear estimation methods

(ordinary least squares (OLS), fixed-effects model (FEM), random-effects


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model (REM), GMM) for the traditional gravity equation cannot exploit any

extra information from the panel data framework of ze ro trade flows.

Recently, Helpman et al. (2008), among others, proposed a simple but

powerful gravity model of international trade with heterogeneous firms that

were compatible with a number of stylized features of the data, especially in

predicting zero trade flows across country-pairs. They introduced a two-stage

estimation procedure that used an equation for selection into trade partners in

the first stage and a trade flow equation in the second stage. Their empirical

results showed that traditionally estimated coefficients from the gravity model

were biased, largely due to the omission of the number of firms. Finally, they

indicated that large variation in trade particularly occurred in trade between

developed and less developed countries and between pairs of less developed

countries.

In conclusion, before the late 1970s, the gravity model had been used for

empirical analysis of trade flows without any rigorously theoretical

foundation. However, the popularity of the gravity model during that period

had been gained due to its simplicity and high explanatory power. Claims that

the gravity model had been applied without any economic foundation have

been gradually diminished since the work of Anderson (1979). So far, the

theoretical foundation of the gravity model has been provided in many leading

theories of international trade, such as the H-O theory (Deardorff, 1998), andthe new trade theory (Helpman and Krugman, 1985; Helpman, 1987).

Furthermore, theoretical foundation of the gravity model for estimating zero

trade flows in panel data framework is also provided (Helpman et al., 2008).

These have paved the way for further development of the gravity model

regarding the estimation methods. It is, therefore, essential to understand the

econometrics of the gravity model, the literature of which has been reviewed

in section 2.5.3.


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2.5.2 Theoretical Foundations of the Gravity Equation

Having been discussed a variety of theoretical foundation of the gravity

model in subsection 2.5.1 over the period 1962 to 2008; it may be useful to see

how rigorous foundation of the gravity model can be made. This section

illustrates the detailed derivation of the theoretical gravity equation. The

discussion mainly follows Anderson and van Wincoop (2003) and Anderson

and van Wincoop (2004) in deriving the equation under monopolistic

competition, or product differentiation by region of origin. We begin with a

standard CES utility function for country j

1

111

iji

ij CU (2.3)

which is maximized by consumers subject to

i

ijijj CpY (2.4)

where

i is the CES share parameter

ijC is the consumption of goods from i by consumers in j

jY is the nominal income of consumers in j

ijp is the CIF price of goods from i in region j

Applying the Lagrangean method to the maximization problem, equation (2.3)

and (2.4) can be written as


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)(),(111

i

ijijjijii

ij CpYCCL

(2.5)

The first order condition with respect toij

C is

01

11111

ijijii

iji

ij

pCCC

L

(2.6)

and the solution to the maximization problem becomes

i

iijij

j

iijpp

yC

1

1

)((2.7)

Now, assume that prices differ between locations due to transportation costs,

and define ip as the exporter FOB price and 1ijt as the trade cost factor

between i and j, so that iijij ptp . This is the iceberg cost model of

transportation costs, where a fraction )1( ijt of each unit shipped melts along

the way. This formulation implies that the CIF value of exports from i to j is

composed of two parts: value of production at the origin (FOB value) and the

shipment cost. The total income of an exporting country i under market

clearance is therefore

j

ijiji

j

ijiijijij

j

ijij

j

iji CtpCptCpCpEXY ))1(( (2.8)

where ijEX is the exports from i to jvalued at importers prices, such that

ijijiij CtpEX (2.9)


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Inserting equation (2.7) into (2.9) yields the solution for bilateral exports

j

i

iij

iiji

i

iijij

j

iijiij Yp

tp

pp

Y

tpEX

1

1

1

1

)(

)(

)( (2.10)

Specifying the aggregate price index as

1

1

1)(i

iijh p (2.11)

Substituting equation (2.11) into (2.10) results in

j

h

iiji

ijY

tpEX

1

(2.12)

We can now re-write the market-clearing condition in the first part of equation

(2.8) as

j h

ij

jii

j h

iiji

j

j

iji

tYp

tpyEXY

11

1)( (2.13)

In order to derive the gravity equation, we will use equation (2.13) to solve for

the scaled prices ii p and insert the solution into equation (2.12). Re-arranging terms in equation (2.13), we obtain:

1

1

1

)(

j h

ij

jiii

tYYp

(2.14)

Substituting equation (2.14) into (2.12) we get


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1

1

h

ij

j h

ij

j

ji

ij

t

t

Y

YYEX (2.15)

Denoting world income j

jw YY and dividing both the numerator and

denominator of the right-hand side of equation (2.15) by wY , we obtain

1

1

1

h

ij

j h

ij

w

jw

ji

ij

t

t

Y

YY

YYEX (2.16)

Define a price indexjP such that

1

1

1

111

j h

ij

j

j h

ij

w

j

j

tt

Y

YP (2.17)

wherej denotes share of country js income to the world income.

Substituting equation (2.17) into (2.16) yields

1

jh

ij

w

ji

ijP

t

Y

YYEX (2.18)

Notice that the price index, h , in equation (2.11) can be re-written as


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1

1

11

1

11

1

11)()(

i

j h

ij

j

iji

i

iiji

i

iijh

tY

tYtpp

and dividing both the numerator and denominator by wY , we have

1

1

1

1

1

1

11

i

j h

ij

j

ij

i

i

j h

ij

w

j

ij

w

ih

t

t

t

Y

Y

t

Y

Y

1

11

i j

ij

ihP

t(2.19)

where i denotes share of country is income to the world income.

Assuming that trade costs are symmetric )( jiij tt or, alternatively, allowing

jiij tt to represent the average trade costs in both directions, leads to a

simplification ih P . Therefore, we can re-write equation (2.19) as

111

i j

ij

iiP

tP (2.20)

which gives us the gravity equation

1

ji

ij

w

ji

ij PP

t

Y

YY

EX (2.2

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