Terms of trade and global efficiency effects of free trade agreements, 1990–2002

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Highlights

  • We infer the terms of trade effects of free trade agreements implemented 1990–2002.

  • Panel data methods resolve two way causality between trade and FTAs.

  • Some members gain over 5% of real manufacturing income.

  • Some non-members lose less than 0.3%.

  • Global efficiency rises 0.9% using novel distance function measure.

Abstract

This paper infers the terms of trade effects of free trade agreements (FTAs) implemented in the 1990s. We estimate large FTA effects on bilateral trade volume in 2 digit manufacturing goods from 1990–2002, using panel data gravity methods to resolve two way causality. The terms of trade changes implied by these volume effects are deduced for 40 countries plus a rest-of-the-world aggregate using an endowments general equilibrium model. Some countries gain over 5% of real manufacturing income, some lose less than 0.3%. Global efficiency of manufactures trade rises 0.9% based on a distance function measure of iceberg melting.

Introduction

The proliferation of free trade agreements (FTAs) in the 1990s alarmed many trade policy analysts and popular observers. Trade diverted from non-partners harms their terms of trade. Losses to non-partners could even outweigh the gains to partners, reducing the efficiency of the world trading system. This paper estimates the effects of trade agreements implemented in the 1990s on manufacturing real incomes using the gravity model. Large inferred volume effects of FTAs are attributed to non-tariff cost reductions, since they exceed reasonable attribution to tariff changes. Terms of trade changes inclusive of such effects measure national gains. For the world as a whole, global efficiency is equal to the change in how much of the iceberg melts, a natural interpretation in the gravity context. The results are reassuring: FTAs delivered benefits while negligibly harming outsiders. Some countries gain over 5%, a few lose less than 0.3% and global efficiency rises 0.9%.

Theory gives prominence to the terms of trade effects of trade agreements and simulation models provide numerical measures of terms of trade changes due to tariff changes induced by particular FTAs. In contrast, there is little empirical evidence on the effect of trade agreements on the terms of trade, because terms of trade are notoriously hard to measure and causation faces difficult inference problems.1 Our empirical approach is to estimate the volume effects of the FTAs implemented in the 90s using the gravity model with panel data methods to deal with two way causality, and then use the estimated volume effects to simulate the terms of trade implications of a hypothetical FTA implementation in 1990.

Our estimation methods extend an empirical gravity literature on the trade volume effects of FTAs. Notable studies include Frankel (1997), Magee (2003) and Baier and Bergstrand, 2002, Baier and Bergstrand, 2004, Baier and Bergstrand, 2007. Early findings on the effects of FTAs and trading blocs on bilateral trade flows were mixed,2 but recent developments deal effectively with two way causality and show that trading blocs and FTAs have large direct effects on aggregate bilateral trade between member countries relative to non-member countries. Baier and Bergstrand (2007) find that, on average, a FTA induces approximately a 100% increase in bilateral trade between member relative to non-member countries within ten years from their inception. Volume changes like these, larger than explicable by tariff changes, are plausible because FTAs typically induce unobservable actions that effectively reduce trade costs. Various regulatory policy barriers typically fall between FTA partners3 while the enhanced security of bilateral trade induces relationship-specific investment in trade with partner counter-parties.

We infer the volume effects of FTAs implemented between 1990 and 2002 for 40 separate countries and an aggregate region consisting of 24 additional nations (none of which entered FTAs). The inference is drawn from estimated gravity equations at the 2 digit ISIC level in manufacturing, a disaggregation that contrasts with the aggregate trade focus of much of the empirical gravity literature. We find large volume effects comparable to the aggregate estimates of Baier and Bergstrand (2007) but varying across sectors. We further extend the original specification of Baier and Bergstrand (2007) to allow for differential FTA effects depending on whether an agreement was formed between countries with low most-favored-nation (MFN) tariffs or between countries with high MFN tariffs. We find that FTA effects are much stronger for country pairs with high MFN tariffs.

We then calculate the terms of trade changes implied by hypothetically implementing all the FTAs of the 90s in the 1990 base year. Our simulation approach belongs to the family of recent small scale computable general equilibrium models based on structural gravity. See the survey by Costinot and Rodriguez-Clare (2014). In contrast to papers based on the Eaton and Kortum (2002) extension of the Ricardian model (Caliendo and Parro, 2015 and Ossa, 2014), we use an endowments model of manufacturing sectors4 extending the Anderson and van Wincoop (2003) one good model (used also by Egger et al., 2011). The Ricardian approach imposes infinite elasticity of transformation between tradable goods sectors while the endowments approach imposes zero elasticity. Either simplification avoids the complexity of data, specification and parameter estimation requirements of large scale computable general equilibrium models.5 The two approaches share a common gravity structure of trade flows with its robust fit to data. In contrast to the simulation literature using tariff changes (e.g., the NAFTA studies of Romalis, 2007, and Caliendo and Parro, 2015), our approach focuses on volume changes induced by FTA effects that include more than tariffs while treating the entire set of FTAs and countries simultaneously.

Equilibrium sellers' prices are calculated from market clearance equations for each national variety in each sector. Intermediate input demand is given by a two level Cobb–Douglas/CES system. Sectoral CES demand systems are consistent with a gravity model for each sector while the upper level Cobb–Douglas aggregator is a common simplification in the literature referenced in the preceding paragraph. Supply is assumed fixed in each sector and country, a simplification that implies the results are (quasi-) general equilibrium measures of impact effects. A technical Appendix A explains how manufacturing demand and supply endowments are related to other sectors by embedment in national GDP functions with more sectors.

National gains are measured by the terms of trade. The numerator is a fixed weight sellers' price index of the equilibrium sellers prices. The denominator is a Cobb–Douglas/CES buyers' price index of equilibrium buyers' prices, where buyers' prices equal sellers' prices times trade cost factors modeled as iceberg costs (this definition of the terms of trade as the ratio of sellers' price index to buyers' price index differs slightly from the standard one because it includes internal trade in both numerator and denominator. Ours is the relevant concept in the gravity model).

The results show that the 1990s FTAs significantly increased real manufacturing income of most economies in the world. 8 out of the 40 countries had terms of trade gains greater than 5% and 3 of those countries enjoyed gains greater than 9%, including Mexico with gains of close to 15%.6 Losses were smaller than − 0.3% and confined to countries that did not enter into FTAs: Australia, China, Korea and Japan (and the rest of the world aggregate), and Iceland.

The national gains measure in the benchmark case does not allow for rents in the trade costs. The no rents assumption avoids measuring and modeling many unobservable rents on inward and outward trade and their division between buyers and sellers. Terms of trade effects are one component of the full national gains. Our main conclusions are robust to the alternative extreme assumption that the only rents are tariffs and all tariff revenues are fully rebated locally. National gains on balance remain for almost all partners.7 Some big gains remain (e.g. Poland) and some other big gains are considerably reduced (e.g., Mexico). This robustness is because tariff revenue changes are a very small part of the income changes because tariffs are generally low.

The global efficiency effect of FTAs is naturally quantified as the change in how much of the iceberg melts due to FTAs. The basis is an application of the distance function (Deaton, 1979; itself an application of Debreu's coefficient of resource utilization, 1951) to the gravity model. It provides intuitive and consistent aggregation of gains across countries and sectors, a feature that seems useful for many trade policy applications. In our FTA case, global efficiency rises in each manufacturing sector (ranging from 0.42% for Paper to 2.1% for Textiles) with an overall efficiency gain of 0.9%.

Global efficiency is also equal to the utilitarian aggregator of national real income changes measure by terms of trade changes. Its positive sum contrasts with the usual zero-sum implication of terms of trade effects in simple trade policy theory. The non-zero sum property of the global efficiency measure arises for two reasons. Directly, less of the iceberg melts in bilateral shipments between FTA partners due to a reduction in border frictions. Indirectly, general equilibrium forces change inward and outward multilateral resistance for each country, respectively changing the denominator and the numerator of the terms of trade. In principle, the indirect effect could be negative and could even outweigh the first effect. For the 1990s implementations of FTAs the net effect is positive (rents are omitted from global efficiency because they are transfers with the zero sum property).

Section 2 presents the theoretical foundation. Section 3 discusses the estimation of the gravity equation and the trade volume effect of FTAs. Section 4 presents the terms of trade and global efficiency effects of switching on the FTAs of the 1990s in the base year 1990. Section 5 concludes with some suggestions for further research.

Section snippets

Theoretical foundation

Manufacturing trade is the focus of this paper, taking country/sector endowments within manufacturing as given. A technical Appendix A details how manufacturing fits into a much larger world economy under the endowment restriction.

Let pijk denote the price of origin i goods in class k delivered to region j buyers. pi k denotes the factory-gate price at i. Equilibrium arbitrage implies pijk = pi ktijk, where tijk  1 denotes the ‘trade cost’ factor on shipment of goods in class k from i to j.8

Econometric specification

The standard procedure to infer FTA effects on bilateral trade flows accounts for the presence of free trade agreements with a fixed effect, interpreted as part of the unobservable trade costs tijk. The trade cost power transform in the structural gravity Eq. (10) is modeled as:tijk1σ=expβ1kFTAij+β2klnDISTij+β3kBRDRij+β4kLANGij+β5kCLNYij+β6kSMCTRYij.

Here, FTAij is an indicator variable for a free trade agreement between trading partners i and j. ln DISTij is the logarithm of bilateral

Real income effects of FTAs

The terms of trade and global efficiency effects of the FTAs that entered into force between 1990 and 2002 are calculated applying the theory of Section 2 and the inferred trade costs of Section 3. Sellers' and buyers' price effects in each country are reported and combined into the change in the terms of trade. Global efficiency measures are reported. Finally, we analyze the counterfactual experiments of switching off NAFTA and of eliminating all FTAs for Mexico.

Conclusion

The numbers presented in this paper portray a regional integration process in the 1990s that increased global efficiency in each manufacturing sector, provided many integrating partners with substantial gains and inflicted small losses on a few countries that did not enter FTAs.

The methods developed here should be useful for other purposes. For example, as in Ossa (2014), multi-dimensional (country, commodity, and time) simulated comparative statics of trade policy can be examined for patterns

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    We are grateful to Scott Baier, Jeff Bergstrand, Rick Bond, Yoosoon Chang, Carlos Cinquetti, Thibault Fally, Joseph François, Tomohiko Inui, Paul Jensen, Mario Larch, Nuno Limao, Vova Lugovskyy, Vibhas Madan, Thierry Mayer, Peter Neary, Maria Olivero, Joon Park, Javier Reyes, Robert Staiger, Costas Syropoulos and Daniel Trefler for helpful comments and discussions. We also thank participants at the Western Economic Association Meetings 2009, the Fall 2009 Midwest International Trade Conference, the 2011 Canadian Economic Association Meetings, the 2011 NBER Summer Institute, the 2011 Econometric Society European Meeting and the LACEA-TIGN III Annual Conference, as well as department seminar participants at Boston College, Clemson University, Drexel University, Fordham University, Indiana University, Oxford University, Paris School of Economics/Sciences Po, the University of Delaware, the University of Nottingham, the University of Toronto and the World Bank. All errors are ours only.

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