The effect of free trade agreements revisited: Does residual trade cost bias matter?

• Author: Paras Kharel
• Date: 01 February 2019
• Published date: 01 February 2019
• DOI: http://doi.org/10.1111/roie.12380

Rev Int Ecom . 2019;27:367–389. wileyonlinelibrary.com/journal/roie © 2018 John Wiley & Sons Ltd

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INTRODUCTION

There has long been an interest among economists and policymakers alike in the effect of regional

trade agreements, or free trade agreements (FTAs), on trade. The proliferation of such agreements

since the early 1990s gave an impetus to empirical investigations.1 As trade agreements continue to be

negotiated, interest in the subject is likely to sustain. The gravity model is the go‐to method for ex post

quantification of FTAs. FTA membership is one of the very few available observable proxies for trade

costs in a gravity equation that is naturally at the bilateral level, varies across bilateral pairs, exhibits

some variation over time and, importantly, is reflective of trade policy.

Received: 12 October 2017

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Revised: 14 July 2018

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Accepted: 22 August 2018

DOI: 10.1111/roie.12380

ORIGINAL ARTICLE

The effect of free trade agreements revisited: Does

residual trade cost bias matter?

Paras Kharel

South Asia Watch on Trade, Economics and

Environment (SAWTEE), Kathmandu, Nepal

Correspondence

Paras Kharel, South Asia Watch on Trade,

Economics and Environment (SAWTEE),

Baluwatar, Kathmandu, Nepal.

Email: paraskharelpk@gmail.com

JEL Classification

C23, F13, F14, F15

Abstract

This paper revisits a prominent gravity model‐based em-

pirical literature on the effects of free trade agreements by

accounting for a potential bias caused by unobservable

trade costs that operate through general equilibrium con-

straints. It embeds state‐of‐the‐art panel estimation tech-

niques in a recently proposed two‐step remedy that

features a constrained ANOVA‐type estimation. Using a

dataset on manufacturing trade flows in eight sectors in 40

countries and a rest‐of‐the‐world aggregate for the period

1990–2002, it finds evidence of significant residual trade

cost bias. The direction and magnitude of bias vary across

sectors, with the standard one‐step approach used in the

literature overestimating or underestimating the partial ef-

fect of free trade agreements by up to 110 percent. Overall,

coefficients on trade costs variables are jointly signifi-

cantly different between the standard method and the two‐

step method. The biases in partial effect estimates translate

into biases in general equilibrium effects.

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KHAREL

A key concern in estimating the trade effects of FTAs is endogeneity. A traditional source of en-

dogeneity is selection: the existence of unobservables that influence both the signing of FTAs and

trade flows, and the possibility of reverse causality (e.g., country pairs that have a high level of trade

may be entering into FTAs). The literature on the determinants of FTA formation provides robust ev-

idence of the endogeneity of FTAs to trade flows—for example, Baier and Bergstrand (2004), Magee

(2003), Baier, Bergstrand, and Mariutto (2014b) and Bergstrand, Egger, and Larch (2016). A num-

ber of methods have been employed in the literature to deal with such endogeneity concerns. One

approach is to use instrumental variables (IVs). A challenge this approach faces is to find a valid

instrument, that is, a variable that is not only strongly related to the FTA variable but affects the

outcome of interest only through the FTA variable. To avoid relying solely on functional form for

identification in their non‐linear model, Egger, Larch, Staub, and Winkelmann (2011), for example,

use as instruments three dummies denoting whether a country pair has ever had a common colonizer,

has ever been in a colonial relationship and has ever been part of the same country. Another route is

to use matching econometrics, as used by, among others, Baier and Bergstrand (2009a) and Egger,

Egger, and Greenaway (2008). Matching methods assume selection on observables. A third approach

is the use of panel data econometrics. Exploiting panel data on trade flows and FTA formation, papers

in this mold use country‐pair fixed effects to account for pair‐level selection into FTAs, assuming that

time‐varying bilateral unobserved heterogeneity is orthogonal to the FTA variable. Since Baier and

Bergstrand (2007), there has been a wave of empirical studies on the trade effects of FTAs using the

panel estimation approach—for example, Eicher and Henn (2011), Behar and Cirera‐i‐Crivillé (2013),

Dahi and Demir (2013), Baier, Bergstrand, and Feng (2014a), Bergstrand, Larch, and Yotov (2015)

and Anderson and Yotov (2016)—making it the most established method in this line of literature.

A common finding is that FTAs do increase trade substantially, albeit with heterogeneous effects.

Although a variety of methods have been brought to bear on the selection issues around the age‐old

topic of FTA‐trade relationship, an additional source of endogeneity remains ignored. It arises from

the general equilibrium structure of the gravity model, as demonstrated in Egger and Nigai (2015).

In this paper, I show that ignoring this endogeneity substantially biases the effect of FTAs on trade.

To understand the source of this bias, first note that the error term in a panel gravity equation can

be decomposed as a sum of (i) bilateral country‐pair fixed effects, which capture pair‐specific time‐

invariant heterogeneity, including time‐invariant bilateral trade costs; (ii) importer‐year fixed effects;

(iii) exporter‐year fixed effects; and (iv) residual or unobserved trade costs. The inclusion of pair fixed

effects speaks to the traditional endogeneity of FTAs discussed earlier, while the use of exporter‐year

and importer‐year fixed effects controls for multilateral resistance and other country‐time‐specific fac-

tors.2 As Egger and Nigai (2015) show, the country‐time‐specific factors are themselves endogenous

to residual trade costs. In a general gravity context, this endogeneity arises from the market‐clearing

general equilibrium structure underlying a gravity equation. Just as general equilibrium linkages yield

the now well‐appreciated importance of multilateral resistance, the same linkages also imply that the

country‐time‐specific factors are a function of, inter alia, residual trade costs. Egger and Nigai (2015)

demonstrate that this leads to biased estimates of total bilateral trade costs, country‐specific effects

and the partial effects of observable trade cost measures, while also biasing general equilibrium‐con-

sistent comparative statics. They suggest a two‐step remedy to this problem: first obtain unbiased

measures of total trade costs from a constrained ANOVA‐type (CANOVA) estimation of the gravity

model3 and then decompose them into their individual observable components.

To what extent residual trade cost bias is reflected in estimates of FTA effects—arguably the

most prominent policy effect analyzed with a gravity model—is the primary empirical question that

I attempt to answer. In their empirical illustration, Egger and Nigai (2015) take a balanced sample of

manufacturing trade flows in 31 OECD countries for the year 2005 and compare the estimates from