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Reduced 'Border effects', Free Trade Agreements and international trade

Reduced "Border Effects", FTAs and International Trade Sebastian Franco and Erik Frohm Sveriges Riksbank Working Paper Series No. 356 June 2018 Abstract This paper studies the role of reduced barriers to international trade from two dimensions: (i) the implementation of Free Trade Agreements and (ii) declining "border effects". Our empirical estimates suggest that diminished border effects accounts for the bulk of the increase in international trade in manufactured goods since 1970. The cost of a national border has fallen by around 10% per year for total exports, whereas it has declined by 13% for exports of final goods and 8% for intermediate inputs. The introduction of FTAs have an important role to play as well, raising international trade by 54% after 10 years according to our estimates. We also find evidence that more recent FTAs have a greater trade effect than those signed in earlier periods. Moreover, when estimating the effect of FTAs, we show that it is important to control for different border effects for final goods and intermediate inputs. Keywords: Border effect, Free trade agreements, international trade, global value chains. JEL codes: F13, F14, F15, F23 We are grateful to Ettore Dorrucci, Vanessa Gunnella, Jesper Lind, Isabelle Mejean, Karl Walentin and Thomas Zylkin for useful suggestions and feedback. We also wish to thank seminar participants at the European Central Bank and Sveriges Riksbank for useful comments. The opinions expressed in this paper are the sole responsibility of the authors and should not be interpreted as reflecting the views of Sveriges Riksbank. Ecole Polytechnique (CREST), Route de Saclay 91128 Palaiseau cedex France. E-mail: s..a@polytechnique.edut Sveriges Riksbank, SE-103 37 Stockholm, Sweden. E-mail: E..m@riksbank.se 1 Introduction The world has experienced an unprecedented rise in global trade over the past three decades. Exports and imports as a share of global GDP rose from 39% in 1990 to 56% in 2016 according to the World Bank. Massive trade liberalization initiatives with the signing of Free Trade Agreements (FTAs) and advances in information and communication technology (ICT) are often pointed out as the main drivers of this "second unbundling" of globalization (Baldwin, 2016). Several studies have documented the important role of FTAs for boosting international trade. Nevertheless, it was not until fairly recently that economists could actually claim reliable empirical support for the strong positive effect of FTAs. In a meta-analysis, Cipollina and Salvatici (2010) find a range of estimates between 12 percent and 285 percent. Baier and Bergstrand (2007) addressed a host of the econometric issues common in the earlier literature and showed that the quantitative estimates of the average effect of an FTA on bilateral trade is positive, strong (around 100 percent) and significant.1 The impact of other trade barriers is usually studied through the concept of the "border effect". It was first documented by McCallum (1995) who showed a significant home bias in Canadian-US trade.2 The bias is usually considered to embody a host of factors, such as preferences (Morey, 2016). It has been also understood as the inherent costs of moving a good or service across a border. For example, Anderson and van Wincoop (2003) used international border dummies to control for international trade costs relative to intra-national trade costs in a cross-sectional gravity equation with international and domestic sales. Unobservable fixed and variable export costs are especially important in the "New" New Trade Theory (see for instance Melitz 2003). 1Bergstrand et al. (2015) include a useful discussion on the preferred specification of the empirical gravity equation to obtain reliable empirical estimates of FTAs and border effects. It should include exporter-year, importer-year and country-pair fixed effects to control for endogenous prices, multilateral resistance terms and time-invariant pair-specific effects. It should be estimated with a Poison Pseudo Maximum Likelihood estimator and include intra-national as well as international trade flows and international border dummies to capture declining bilateral trade costs 2This finding gave rise to the puzzle of "home bias in trade" mentioned by Obstfeld and Rogoff (2000). 2 But the empirical estimates of the size of the border effect varies, and some even question the existence of it (Gorodnichenko and Tesar, 2009). In a recent paper, Bergstrand et al. (2015) find reduced border effects from 1990- 2002. In their framework, the cost of a national border is estimated to have decreased by around 2.5% per year and increased manufacturing exports by 34% relative to domestic manufacturing sales. However, they only consider a short time period when the "second unbundling" of globalization was already under way. Moreover, they do not consider that the border effect might be different for trade in final goods or intermediate inputs. It is important to distinguish between these different types of goods with the continuous rise of trade in global value chains (Feenstra 1998 and Baldwin and Taglioni 2014). This paper contributes to the literature by documenting diminished border effects over a longer period of time (1970-2009), their evolution for final goods and intermediate inputs and the trade impact of FTAs. We apply the most up-to-date and theory-consistent empirical gravity methods to provide precise estimates of their effects (Yotov et al., 2016).3 As already explained by Bergstrand et al. (2015), the reduction of the border effect plays a key role in boosting trade over time. According to our results, they have been the prime driver of the increase in international trade in manufacturing goods since the 1970s. We estimate that the cost of a national border has fallen by around 10 percent per year. This is illustrated in Figure (1) which highlights one of the main results of this paper: that the increase in exports of manufacturing goods relative to the rise in domestic manufacturing sales since 1970 has been dominated by reduced border effects. FTAs, comparative advantages, relative prices, multilateral resistances and other non-time varying country-pair factors are quantitatively much less important. This gives some sense of the magnitudes of the different factors traditionally thought to have driven the rise in global trade (Mussa 2000 and Baldwin 2016). Since we cover a longer time period than Bergstrand et al. (2015) and relax the 3We use a PPML estimation with high dimensional fixed effects (exporter-time, importer-time, and country-pair) to control for all confounding factors. The estimation strategy is carefully explained later in the paper. 3 Figure 1: Rise of international trade in manufacturing goods Note: The chart utilises the estimates from Table (2) which includes export-year, importer-year and country-pair fixed effects and controls for whether two countries have an FTA or not. The border effect is defined as a dummy which equals zero if trade is within a country and one if trade is between two countries. It is interacted with year-dummies (where 1970 equals zero). Further details are in Section (4). heavy restriction recommended by Cheng and J.Wall (2005) to use data in three or five years interval, we can look at the timing of the diminished border effects and gain some additional insights into its drivers. A key ingredient in our analysis is trade data on final goods and intermediate inputs covering both cross-border sales as well as domestic sales over a long period of time. When we distinguish the border effects for the two types of goods, we see that reductions in the border effect has expanded trade in final goods by more than in intermediate inputs. This likely reflect the fact that bilateral gross final goods exports embody a larger portion of gross imports of intermediate inputs from earlier steps of the supply chain than bilateral trade in intermediate goods. These goods must bear the full burden of trade costs (due to technological hindrances) added in previous steps in production.4 As these costs are reduced, final goods trade is likely to be 4Rouzet and Miroudot (2013) show that tariffs and other trade costs cumulate and that even 4 stimulated to a greater extent at the bilateral level.5 The differential impact on the two types of goods coincides with the ICT Revolution that started between 1986-1990 and drove the "second unbundling" of globalization and the expansion of global value chains (Baldwin, 2016). The bundle of technological advances during this period offers a deep motivation and timing for the reduction in trade costs and diminished border effects.6 Lowering these trade barriers have likely less to do with traditional trade policies and more to do with productivity enhancing technological innovations that allows goods, tasks and services to flow more freely across borders. This is not to say that trade policy does not matter. The introduction of FTAs have an important role to play as well, raising international trade by 54% after 10 or more years according to our estimates. We also find evidence that more recent FTAs have a greater trade effect than those signed in earlier periods. Moreover, when estimating the effect of FTAs, we show that it is important important to control for different border effects for final goods and intermediate inputs. The rest of the paper is structured as follows: Section (2) introduces the structural framework that we use and derive our empirical approach. Section (3) outlines the data used. Section (4) presents and discusses our results and Section (5) performs a number of robustness checks. Section (6) concludes. small trade costs can have adverse consequences when inputs are part of complex value chains that finally constitute final products. 5Antras and Chor (2018) also find that trade costs fell more for final goods than intermediates between 1995-2011. 6The ICT revolution lowered transport costs and was based on low computing and data storage costs, advances in the transmission of information, and the reorganization of production with new working methods and workplace organizations. This made it easier, cheaper, faster, and safer to coordinate separate complex activities spatially. The key here is not cost per se. Air shipments have been getting cheaper, but the speed is associated with certainty and this matters. When things go wrong in an international production network, air cargo allows the off-shoring firms to fix it in days. Finally, one should not forget about the strong reduction in transportation costs due of the introduction of the container in the 1960s that grew in importance in the 1970s and 1980s. 5 2 Framework and empirical approach Our empirical approach is derived from a structural gravity equation able to capture the different trade barriers we are interested in. The effect of the border effect and FTAs is studied with a PPML estimator that properly maintains the structural approach of the gravity equation and uses a high dimensional set of fixed effects that controls for the potential confounding factors that could bias the results. Also, the inclusion of the large set of fixed effects will make possible to track the evolution of the effect on trade of FTAs over time. 2.1 Structural gravity Structural gravity models are widely used in the trade literature. Head and Mayer (2014) show that the gravity equation is consistent with a very large number of theoretical foundations. To guide our analysis, we extend the gravity equation to account for different kinds of trade barriers and their differential effect on trade in final goods and intermediate inputs. Therefore, the bilateral exports between country i and j in good k {f inal, input}, Xk ij , is determined in the following expression: X k ij = b k ij 1