THE POTENTIAL CHALLENGE OF ASEAN’S TRADE

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 R equirements for the Degree of
Master in Economics

Student ID: 0874102

Written by: Sithanonxay Suvannaphakdy
Supervised by: Prof. Toshihisa Toyoda

____________________________
Hiroshima Shudo University
2010
 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 ASEAN‟s targets of stimulating intr a- 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 t he

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

used to investigate it. Since ASEAN has intensively trade d 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 to

develop 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.

ii
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 varia bles. 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 i nstruments, 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 sizes

both 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.

iii
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 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. 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

iv
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 t he conclusions

regarding the research questions.

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

v
 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 study

mission. 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 ini tial 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

vii
 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. Purpose of the Research .................................................................... 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 Integr ation and 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

i
 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

Gravity Model ..................................................................................... 41

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

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

CHAPTER 3: EMPIRICAL MODELS 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 ............. 58

3.2.2 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 Panel Gravity Models .............................. 67

3.3.1 Dynamic Panel Gravity Model: Partial 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 ......................................................... 85

3.6 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 Ex tra-ASEAN Trade ........................... 94

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

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

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

ii
 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 IMPLICATIONS .......... 122

5.1 Summary and Empirical Results ..................................................... 122

5.2 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

iii
 LIST OF TABLES

Page

Table 2.1 Average CEPT Tariff Rates, by Country, 1998-2003 .................. 11

Table 2.2 Percentage Share Matrix of World Trad e 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 Trade 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 P redicted 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 Trade: 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 Hypothesis ............................ 120

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

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

v
 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

vii
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

viii
 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 foundation s

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 ASEAN‟s 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 km 2 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 compe te 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.

1
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 economi c 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 f or 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 o nly

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 estimation

method 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

2
(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 e quation. 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 understa nd 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 model‟s 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 model

is 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

3
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 author‟s

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 s pecifications.

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.

4
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 of

trade;

(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 foundation s 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.

5
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 Chapter 3
Literature Review Empirical Models
and Methodology

Chapter 4
Gravity Model Results

Chapter 5
Summary and Conclusions

6
 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.

7
(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 labor).

(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 a

macroeconomic 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:

8
(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

9
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 ASEAN‟s 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, AS EAN 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 AFTA‟s tariff reduction

obligations.

The primary goals of AFTA are to increase ASEAN‟s 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

10
elimination of tariff and non-tariff barriers among member countries is expected

to promote greater economic efficiency, productivity, and competitivene ss.

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 “region’s 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 has

been 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 2 0%. 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, 1998-2003

Country 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 3.19
Philippines 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: ASEAN Secretariat

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

11
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 wh at extent trading interaction

among them take place and in which direction they are going to be. While there

are 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 country‟s or region‟s

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. ASEAN

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,

12
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 Free

Trade 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

13
Table 2.2 Percentage Share Matrix of World Trade for 1989-2005 Average
Exports to a b c d e f g h i j k l m n o p q
Exports from 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
h Singapore 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 8.93 100.00
i 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

Source: Author‟s calculation using data from IMF’s 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 countries in addition to ASEAN, EU13, NAFTA, MERCOSUR, and OTHERS.

14
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

Share of Intra- ASEAN Exports

%
60

50

40

30

20

10

0
Philippines

Thailand
Brunei

Vietnam
Myanmar
Malaysia
Indonesia

Singapore
Cambodia

Laos

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 ASEAN‟s 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.

15
Figure 2.2 Intra- and Extra-ASEAN Exports
Exports of ASEAN

%
35

30

25

20

15

10

0
ASEAN EU13 NAFTA MERCOSUR OTHERS ROW

Source: drawn from Table 2.2

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

exports of the „OTHERS‟ went to 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 ma y be

measured by „intensity of trade‟ indices. The intensity of Laos‟s trade with

another country is measured by the ratio of that country‟s share in Lao exports

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

trade intensity can be expressed as

X li
Xl
TI li   100 (2.1)
Mi
W  Ml

16
where
TI li is the index of trade intensity of Laos (l) and country i
X li is the Lao exports to country i

X l is the total Lao exports (  X li )

i

M i is the total imports by country i

M l is the total import by Laos

W is the total world imports

If the intensity of Laos‟s exports is 100 with all countries, the n Laos‟s exports

will be distributed by country exactly in proportion to each country‟s 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 country‟s 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 country‟s export to Laos indicates the extent to which Laos takes

more imports from a particular country than might be e xpected from that

country‟s share in world trade. The greater the intensity of both Laos‟s exports

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

industrial structures are likely to be, the closer they are likely to be

geographically, 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

17
Table 2.3 Intensity of Trade for 1989-2005 Average

Exports to a b c d e f g h i j k l m n o p
Exports from Brunei Cambodia Indonesia Laos Malaysia Myanmar Philippines Singapore Thailand 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

Source: Author‟s calculation using data from IMF’s 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 countries in addition to ASEAN, EU13, NAFTA, MERCOSUR, and OTHERS.

18
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

Trade Intensity of Intra-ASEAN

%
1200

1000

800

600

400

200

0
Philippines

Thailand
Brunei

Vietnam
Myanmar
Malaysia
Indonesia

Singapore
Cambodia

Laos

Source: drawn from Table 2.3

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 Cambodia‟s

exports and 3,307 for Vietnam‟s 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,

19
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 Brunei‟s

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, populatio n, capital, distance,

politics, and stage of economic development.

2.4.1 Physical Characteristics of Countries

A country‟s 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

20
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 world‟s 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 country‟s ability to exploit its resources and the

kinds of goods it will export and import.

A country‟s 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.

21
Merchandise trade can also be affected either positively or negatively due to

the international capital flows. When a country sets up a branc h 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 tariff s, 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

22
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 t he 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 M odel

The gravity model was originally founded on Newton‟s 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).

23
Over time, a considerable amount of gravity model literature has been

published to explain trade flows. The work of Tinbergen (1962) has been

regarded as an important initiative of the empirical gravity model to

investigate trade flows. He used multiple regression analyses to estimate trade

flow equation according to a pure gravity model. For example, the preliminary

Tinbergen tests implemented on eighteen countries in 1958. The simple gravity

model proposed by Tinbergen (1962) can be expressed as:

EX ij   0Yi 1Y j2 Dij3 (2.1)

where EX ij denotes the export flows from country i (exporting country) to

country j (importing country);  0 is a constant; Yi and Y j represent the national

income (usually GDP) of the country i and country j, respectively; and

Dij denotes the geographical distance between the economic center s (usually
the capitals) of country i and country j. 1 ,  2 and  3 are the parameters of the

corresponding variables. The variable „distance‟ was used as a proxy variable

of transport costs and an index of information about export markets. Altho ugh

this basic model was formulated by incorporating only three independent

variables, the model‟s explanatory power, measured by the coefficient of

determination, was surprisingly high, recorded about 0.82. In further tests,

dummy variables were added to capture the effects of (i) preferential trade

agreements, and (ii) neighboring countries. In a further detailed examination

of the trade between forty-two countries in 1959, a test of the original gravity

model (equation 2.1) with an adjacency dummy for ne ighboring countries gave

a coefficient of determination of 0.81. Moreover, another series of tests also

used a Gini coefficient of export commodity concentration as a measure of the

degree of export diversification, but this yielded low explanatory power. In all

the tests, the coefficient on distance had an expectedly negative sign, whereas

the volumes of the coefficients on incomes of country i and country j were

24
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 PÖyhÖnen (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 est imating 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 country‟s 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

Linnemann‟s 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 o f 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 to

depend 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 country‟s foreign trade was independent of its per capita

income.

25
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 Linnemann‟s gravity equation can be represented as:

EX ij   0Yi 1Y j2 N i3 N j 4 Dij5 Pij6 (2.2)

where N i and N j denote the number of the exporting and importing countries‟

population, respectively; Pij 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 different iation.

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

theoretical foundation at an aggregate level t o the gravity model from the

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

26
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. His 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 trade

model (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

27
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 world‟s 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 exporter‟s income, importer‟s

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 producti on functions

assumptions, 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 exporter‟s income and importer‟s 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 internation al trade analysis.

28
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

exporter‟s income, importer‟s 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 importer‟s national income; and finally, importer ‟s per capita GDP

was explained as importer‟s 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 -labor

ratios, 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 tradi ng partners. He

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

29
preferences. Then, generalizing the result to arbitrary prefer ences, 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 consis tently

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 drama tically decrease

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

the gravity model are utilized to investigate the phenomena of , why two

countries 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

30
model (REM), GMM) for the traditional gravity equation cannot exploit any

extra information from the panel data framework of zero 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 coeff icients 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 de veloped

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 be en provided in many leading

theories of international trade, such as the H-O theory (Deardorff, 1998), and

the 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.

31
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
1   1  1
 
U j    i Cij  
 
(2.3)
i 
 

which is maximized by consumers subject to

Y j   pij Cij (2.4)

i

where
 i is the CES share parameter
Cij is the consumption of goods from i by consumers in j
Y j is the nominal income of consumers in j
pij 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

32
 
1   1  1
 
L(Cij ,  )     i  Cij     (Y j   pij Cij ) (2.5)
i 
  i

The first order condition with respect to Cij is

1
1  1   1  1
L  1

 i 
Cij   i Cij    pij  0
 
(2.6)
Cij i 
 

and the solution to the maximization problem becomes

yj
Cij   i1 (2.7)
pij  ( pij  i )1 


Now, assume that prices differ between locations due to transportation costs,
and define pi as the exporter FOB price and tij  1 as the trade cost factor

between i and j, so that pij  tij pi . This is the „iceberg‟ cost model of

transportation costs, where a fraction (tij  1) 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

Yi   EX ij   pij Cij   ( pij Cij  (tij  1) pi Cij )  pi tij Cij (2.8)

j j j j

where EX ij is the exports from i to j valued at importer‟s prices, such that

EX ij  pi tij Cij (2.9)

33
Inserting equation (2.7) into (2.9) yields the solution for bilateral exports

Yj ( pi tij  i )1 
EX ij  pi tij  i1   Yj (2.10)
pij  ( pij  i )1  ( p  )ij i
1 

i i

Specifying the aggregate price index as

1
  1 
 h    ( pij i )1  (2.11)
 i 

Substituting equation (2.11) into (2.10 ) results in

1 

 pt  
EX ij   i ij i  Y j (2.12)
 h 

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

(2.8) as

1  1 

 pt    t 
Yi   EX ij   y j  i ij i   (  i pi )1 
j Y j  ij  (2.13)
j j  h   h

In order to derive the gravity equation, we will use equation (2.13) to solve for
the scaled prices  i pi and insert the solution into equation (2.12). Re -

arranging terms in equation (2.13), we obtain:

1
 
1 

 t 
(  i pi )1  Yi   Y j  ij  

(2.14)
 j  h 
 

Substituting equation (2.14) into (2.12 ) we get

34
 1 

YiY j  tij 
EX ij  1 
  (2.15)
 t   h 
j Y j  ij 
 h

Denoting world income Yw  Y j

j and dividing both the numerator and

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

1 

YiY j 1  tij 
EX ij  1 
  (2.16)
Yw Y  t  
 h
j Y j  ij 
w  h 

Define a price index Pj such that

1 1
 Y  t  1  1
1  1 

Pj    j  ij       tij  
  j  (2.17)
 j Yw   h   
  
j  h  

where  j denotes share of country j‟s income to the world income.

Substituting equation (2.17) into (2.16) yields

1 

YY  t 
EX ij  i j  ij  (2.18)
Yw   h Pj 


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

35
 1
  1 
1 1  
  1    1   Yi tij1  
 h    ( pij  i )1      ( pi tij  i )1     1 

 i   i   i  tij  
  Y j   
 j  h  

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

1 1
 1   1 
   
 Y tij1    tij1  
h   i 1 
   i 1 

 i Yw Y  t    i  t  
 j Y j  ij    j  j  ij  
 w  h     h 

1
1  1 
  tij  

  h   i   (2.19)
 i P  
  j 

where  i denotes share of country i‟s income to the world income.

Assuming that trade costs are symmetric (tij  t ji ) or, alternatively, allowing

tij  t ji to represent the average trade costs in both directions, leads to a

simplification  h  Pi . Therefore, we can re-write equation (2.19) as

1
1  1 
  tij  

Pi   i   (2.20)
 i P  
  j 

which gives us the gravity equation

1 

YY  t 
EX ij  i j  ij  (2.21)
Yw  Pi Pj 


36
Note that the gravity equation (2.21) is a generalization of a multiple product

categories model, where eim represents region i‟s expenditure on product class

m and Yi m represents the region i‟s output of that product. The gravity equation

with M product classes is

1 m
Yi me mj  tijm 
EX  m  m m 
m
(2.22)
Yw  Pi Pj 
ij

with the price indices defined as

1
 e m  t m 1 m  1 m
Pj    jm  ijm  
m
(2.23)
 i Y P  
w  i 
 

The final step in arriving at an empirically testable version of the gravity

equation is to specify a relationship between the unobservable trade cost factor

tij and distance between trading partners i and j. Assume that trade costs are
proportional to distance so that

K

tij  ( Dij ) ij  zijk (2.24)
k

where Dij is the bilateral distance and the vector zij is a set of parameters

controlling for all other factors that may affect trade costs between i and j.

Substituting equation (2.24) into (2.21), writing the resulting equation in

natural logarithms, and expressing world income as a constant    ln Yw , we

derive the final version of the gravity equation

K
ln EX ij    ln Yi  ln Y j   ij (1   ) ln Dij  (1   ) ln zijk (2.25)
k 1

 (1   ) ln Pi  (1   ) ln Pj

37
2.5.3 Literature on the Econometric Method of the Gravity Model

The previous two sections dealt with the theoretical framework of the

gravity model. Since the gravity model had been applied to estimate trade flow

using cross-sectional data at the early stage, there is not many to worry about

the method of estimation. However, the gravity model has been modified and

estimated in the panel data framework recently. An important advantage of

using panel data is that it allows researchers to control for unobservable

heterogeneity, that is, systematic differences across cross-sectional units.

Regressions using aggregated time series and pure cross section data are likely

to be contaminated by these effects, and statistical inferenc es obtained by

ignoring these effects could be seriously biased.

With such heterogeneity, a country may trade different amount from two other

countries even though the two markets have the same incomes and are

equidistant from each other. This may occur due to historical, cultural,

political or geographical factors that affect the level of bilateral trade flows

and are correlated with the explanatory variables included in the gravity

equation. Consequently, the standard econometric estimation, such as ord inary

least square, is likely to provide biased estimates.

The tools that have been employed to estimate the gravity model in panel data

framework have evolved over time, as the results of both developments in

panel econometrics and changes in the specifi c questions posed by theoretical

models. Followings are some key literature to estimate the gravity model of

international trade.

Sanso et al. (1993) evaluated whether the typically used log -linear form in

empirical gravity model is appropriate. To do so , the authors utilized the Box-

Cox transformation which assumes that for any variable X it is true that:

38
 ( X   1) / 
 for  0
X  (2.26)
ln X for  0

Therefore, it is possible to rewrite equation (2.25) in section 2.5 .2 in a more

general form:

EX ij0    Yi 1  Y j2   ij (1   ) Dij3  ...  uij (2.27)

The log-linear form is a special case of equation (2.27) when all   0 . If it is

not the case, one has to firstly adjust the data using lambdas, and then it is

possible to estimate the original f orm.

Using the Maximum Likelihood estimation, Sanso et al. rejected the

hypothesis of all lambdas being equal to zero. That is, the log -linear form

applied to the gravity model is not valid. However, the Box -Cox

transformation has not become popular due to the inconvenience and time

consuming to carry out. The authors also indicated that the log-linear form is a

very good approximation of the real functional form.

Mátyás (1997) proposed that the specification of the gravity models with

exporting country‟s effect, importing country‟s effect, and time effect. This is

a kind of a three-way fixed-effects model. The author assumed that these

effects are observable from the data and therefore adopted a fixed effects

specification. Mátyás (1997) illustrated that without these effects the estimated

parameters of the model could lead to incorrect inference as their values may

artificially be inflated or deflated by this misspecification.

Harris and Mátyás (1998) revealed a unified framework in the econometric

methodology for gravity models, and refined the estimation techniques to

account for any possible simultaneity bias. In order to specify the efficiency of

39
each estimation method, the authors applied the REM and FEM to analyze

export flows in the Asia Pacific Economic Cooperation (APEC) region. The

empirical results obviously suggested that it is important to properly specify

the model in terms of importing and exporting countries‟ effects, and business

cycle (time) effects. Moreover, Harris and Mátyás also indi cated that REM

might be preferred to FEM in policy analysis. They explained this for two

reasons. First, REM does not reduce the effects of explanatory variables in

case of containing a number of dummy variables. Second, the dynamic

specification can be used in the REM.

Cheng and Wall (1999) found that in the presence of country-pair

heterogeneity the standard pooled-cross-section methods for estimating the

gravity model suffers from estimation bias due to omitted or unspe cified

variables. They suggested that this problem can be eliminated by using the

two-way FEM, in which country-pair and time dummies were used to reflect

the bilateral relationship between trading partners.

Egger (2000) provided a note on the proper econometric specification of the

gravity equation. His research was tempted to clarify whether the REM or

FEM should be used in panel framework to investigate trade flows of the

gravity model. He revealed that using REM would suffer from the unobserved

fixed effects. The unobserved effects are due to omitted variables that are

specific to across-sectional units or to time effects. Therefore, the author

suggested that the proper econometric specification of a gravity model should

account for country fixed effects and time effects. Finally, he concluded that

the FEM is consistent, while the REM is not.

In conclusion, there are two issues to be highlighted. The first issue is that the

appropriate functional form the gravity model is the log -linear form. The other

issue is that the FEM seems to outperform the REM in analyzing the gravity

40
model in panel data framework. However, which method should be applied

depends on the purpose and data set to be investigated.

2.5.4 Literature on the International Trade Analyses Applying the Gravity

Model

Section 2.5.3 reviewed the literature on how the gravity model can be

estimated. In this section, we are going to see how the gravity model can be

applied to investigate international trade flow. While there are enormous

studies of international trade utilizing the gravity model, the following

literature mainly focuses on how the gravity model has been extensively used

to investigate the trade effects of RTA. According to Greenaway and Milner

(2002), most gravity analyses of RTAs typically seek to address one or more

of the following research questions:

(1) Is there a regional bias to trade? In other words, do countries which are

located in the same region tend to trade more?

(2) Is there an identifiable RTA effect? In other words, although there is a

regional bias to trade, is intra-regional trade stimulated by the formation of

an RTA?

(3) What is the trade potential associated with integration? In other words, can

we estimate how much more trade take place, or might take place, as a

result of a particular RTA?

(4) Is there a „domino effect‟ of RTAs on non-members? In other words, does

an RTA trigger less trade with non-members and thus, increasing the

likelihood of them joining the RTA?

This section reviewed the studies of regional trade flow regarding the above

four questions in a gravity model framework. The studies addressed at least

one issue of whether intra-regional trade is stimulated by membership of an

RTA.

41
Aitken (1973) applied the gravity model to investigate and to predict trade

creation and/or trade diversion of European trade relations during 1951-1967.

The sample consisted of five European Economic Community (EEC) countries

(Belgium-Luxembourg, France, Germany, Italy, and the Netherlands) and

seven European Free Trade Association ( EFTA) countries (Austria, Denmark,

Norway, Portugal, Sweden, Switzerland, and the United Kingdom). In order to

capture the effect of the EEC and EFTA on European trade, Aitken (1973)

included two dummy variables of the RTAs, such as EEC and EFTA. He

employed OLS to estimate the cross-sectional gravity equation for each year.

The empirical results showed that both the EEC and EFTA have cumulatively

increased in the gross trade creation over the period of study. The gross trade

creation of the EEC was significantly larger than that of the E FTA.

McCallum (1995) investigated the impact of the Canada -U.S. border on

regional trade patterns in 1988. He estimated the gravity equation using data

for all 10 provinces of Canada and 30 states of the U.S., accounted for 90 % of

Canada-U.S. trade. In order to capture the border effect, a dummy variable was

included into the basic gravity model proposed by Tinbergen (1962). This

dummy variable was defined as one for inter -provincial trade and zero for

state-province trade. The research showed that Trade between Canadian

provinces was more than 20 times larger than trade between Canadian

provinces and states of the United States. McCallum (1995) concluded that

border matters in international trade flows.

Frankel et al. (1995) examined bilateral trade of all trading blocs in the world

from 1965 to 1990, applying the gravity model. The results showed that intra-

regional trade flows in the Western Hemisphere (WH), MERCOSUR and the

Andean Pact countries illustrated to be significantly independent trading area s.

They also found that a rapid increase in the intra -MERCOSUR trade bias had

occurred during 1980s. However, Frankel et al. (1995) indicated that a rise in

42
intra-East Asia trade could be completely explained by the rapid growth of the

economies.

Frankel et al. (1998) applied the gravity model to investigate the impact on

trade of the explicit and implicit regional tradin g arrangements. The study

covered sixty-three countries of three continental blocs: the European

Community, the Western Europe, and the E ast Asia, over 1970-1990. The

research found that each of three continental blocs: the European Community,

the Western Hemisphere, and East Asia, showed an intraregional bias to trade.

Frankel et al. (1998) then developed a theoretical framework for evaluating the

welfare implications of the regionalization of trade. Based on this new

framework and the empirical results obtained from the gravity model, they

found that the European Union was indeed close to enter the supernatural

zone, that is, of exceeding the extent of regional preferences that could be

justified on natural geographic grounds.

Eichengreen and Irwin (1998) utilized the gravity equation to study the effects

of regional trading arrangements in a historical perspective. They argue d that

the dummy variables of the regional arrangements can capture only

intraregional concentrations of trade that exceed what can be explained by the

economic fundamentals: country size, income per capita, and distance between

the country-pairs in question. They pointed out that the trading patterns tend to

slowly change over time, even when there exists a sudden change in regional

trading arrangements or political links. Eichengreen and Irwin (1998) put

much effort to include lagged values of bilateral trade in their gravity equation

for thirty-four countries from 1928 to 1965. They found that trade links among

British colonies in 1954 and 1964 were the lagged effects of trade flows of

1949, when countries belonged to the British Empire. They also indicate d that

a positive correlation between the predominant direction of trade flows in the

past and membership in preferential arrangements in the present may possibly

43
exist. This resulted in a tendency to overstate the effect of the preferential

arrangements. The authors therefore suggested including lagged trade flows

when estimating the gravity model.

Endoh (1999) analyzed the effect of RTAs on three economic organizations,

such as the EEC, the Latin American Free Trade Association (LAFTA) and the

CMEA, over the period 1960-1994. The distinguishable feature of Endoh‟s

gravity model from the previous literature is that, the author introduced the

Vinerian specification of integration effects with three -different sets of

dummy variables per FTA to capture the effects of trade creation and trade

diversion. The results showed that both trade creation dummies and trade

diversion dummies had statistically significant coefficients, which depicted the

suitability of this new approach (adding three new dummies into the gravity

model). The study also indicated that the effects of trade creation and trade

diversion of each regional trading bloc had been generally declining during the

1990s.

Sapir (2001) used the gravity model to test the domino effects in Western

Europe over the period 1960 to 1992. In order to do so, the author included

three groups of countries, such as the EEC, the EFTA, and four countries

(Finland, Greece, Ireland and Spain) belonging to neither EEC nor EFTA. The

author attempted to address whether the more inte nsified in the intra-EEC had

a negative impact on non-members and thus encouraged them to become

members of the EEC. Estimating the gravity model annually over the period

1960 to 1992, the research found that an increase in intra -EEC trade in the late

1980s had led to the domino effects on EFTA members.

44
Table 2.4 Summary of the Key Trade Literature Applying the Gravity Model

Author(s) Title Countries Time Period RTA Analyses Methods Results of the Study
RB RTA TP DE
Aitken(1973) The Effect of the EEC and EFTA on EEC, EFTA 1951-1967   OLS - Both the EEC and EFTA have experienced an
European Trade: A Temporal Cross- increase in the gross trade creation.
Section Analysis - The gross trade creation of the EEC greatly
dominated that of the EFTA.

Frankel, Stein and Trading Blocs and the Americas: All RTAs 1965-1990   OLS - Intra-regional trade flows in the WH,
Wei (1995) The Natural, the Unnatural, and the MERCOSUR and the Andean Pact countries
Super-Natural illustrated to be significantly independent trading
areas.
- A rapid increase in the intra-MERCOSUR trade
bias had occurred during 1980s.
- An increase in intra-East Asia trade could be
completely explained by the rapid growth of the
economies.

Frankel, Stein and Continental Trading Blocs: Are They EC, WH, EA 1970, 1980,  OLS - Each of three continental blocs: the European
Wei (1998) Natural or Supernatural? 1990 Community, the Western Hemisphere, and East
Asia, shows an intraregional bias to trade.
- The European Union is indeed close to enter the
supernatural zone, that is, of exceeding the extent
of regional preferences that can be justified on
natural geographic grounds.

Note: RB, RTA, TP and DE refer to whether the studies investigate regional bias, the trade effects of RTAs, trade potentials and domino effects, respectively.

45
Table 2.4 Summary of the Key Trade Literature Applying the Gravity Model (Continued)

Author(s) Title Countries Time Period RTA Analyses Methods Results of the Study
RB RTA TP DE
Eichengreen and The Role of History in Bilateral EC, British 1928-1965  OLS, - Trade links among British colonies have been
Irwin (1998) Trade Flows Colonies TOBIT resulted from the lagged effects of trade flows.
- The authors suggested to include lagged variables
in the gravity quation to capture the historical
factors.

McCallum (1995) National Borders Matter: Canada- Canada, U.S. 1988   OLS - Trade between Canadian provinces was more
U.S. Regional Trade Patterns than 20 times larger than trade between Canadian
provinces and states of the United States.

- The border matters in international trade flows.

Hassan (2001) SAARC, ASEAN, 1996, 1997   GLS - SAARC member countries have not achieved
Is SAARC a Viable Economic Bloc? NAFTA, EEC trade-creating benefits yet.
Evidence from Gravity Model

Endoh (1999) Trade Creation and Trade Diversion EEC, NAFTA, 1960-1994   OLS
in the EEC, the LAFTA and the CMEA - Both trade creation dummies and trade diversion
CMEA dummies had statistically significant coefficients.
- The effects of trade creation and trade diversion
of each regional trading bloc had been generally
declining during the 1990s.

Sapir (2001) Domino Effects in Western EU, EFTA 1960-1992  OLS

European Regional Trade - An increase in intra-EEC trade in the late 1980s
had led to the domino effects on EFTA members.

Note: RB, RTA, TP and DE refer to whether the studies investigate regional bias, the trade effects of RTAs, trade potentials and domino effects, respectively.

46
Hassan (2001) applied the gravity model to investigate the intra-South Asian

Association for Regional Cooperation (SAARC) trade. The data set consisted

of 27 countries in 1996 and 1997. The study showed that SAARC member

countries have not achieved trade-creating benefits yet. The author suggested

that the elimination of tariff and non -tariff barriers is essential to liberalize

border trade and to strengthen bilateral trade relations in the framework of

South Asian Preferential Trading Arrangements.

Table 2.4 presents a summary of the empirical trade literature applying the

gravity model. These studies have been discussed in section 2.5.3.

2.5.5 Previously Related Studies on Trade Flows of ASEAN

This section reviews the literature on the analyses of ASEAN trade

applying either gravity model or other similarly related methods. These

literatures have been described in subsequent paragraphs.

Tho (2002) studied the trade effect of AFTA in the dynamic context of the

East Asian economy in the 1990s. For the application, the author calculated a

trade matrix confining on manufactured products for five major ASEAN

countries (Indonesia, Malaysia, Philippines, Singapore, and Thailand) and

three major non-partners (China, Japan, and Korea) for 1992 and 1999, a set of

international competitive indices (ICI) of Thailand and China in 15

manufacturing sectors for the period 1998-1999, and a set of export similarity

indices (ESI) for Thailand-China, Thailand-Korea and Thailand-Japan, based

on three-digit SITC manufactured products. The research demonstrated that

the trade and FDI effects of the AFTA have not been as strong as the theory of

a free trade area predicts. Intra-ASEAN trade has indeed expanded, but

ASEAN trade with non-partner countries in East Asia has expanded at a higher

rate. Another conclusion of the paper was that, among non-partner countries,

China has imposed strong impacts on ASEAN economies since the

47
development process and the comparative advantage structure in China have

resembled those of most ASEAN countries, typically Thailand . The results

suggested that while AFTA has been contributing to the increasing confidence

and stability of ASEAN countries, its effects on the development of these

countries were not as important as the interdependence and dynamic division

of labor between ASEAN and other economies in East Asia.

Elliott and Ikemoto (2004) extended the gravity equation to evaluate the

bilateral trade flows of ASEAN and its trading partners. A special attention

was made to clarify how the intra- and extra-ASEAN trade has changed in

response to the formation of AFTA. Another purpose was to investigate

whether the Asian economic crisis in 1997 impeded or enhanced the ASEAN

trade. Sample of the study was consisted of 35 countr ies, including five

ASEAN countries. The study covered seven years, from 1983 -1990. To capture

the effect of AFTA on intra- and extra-ASEAN trade, Elliott and Ikemoto

(2004) included the regional dummy variables as specified by Endoh (2000)

and Soloaga and Winter (2001). Then the gravity equation was estimated using

OLS. The study found that AFTA has not immediately affected ASEAN trade

after the signing of the AFTA agreement in 1992. They also indicated that

AFTA has stimulated the extra-ASEAN trade. Finally, the results showed that

the Asian economic crisis triggered the intensity of intra -ASEAN trade.

Roberts (2004) utilized the gravity model of trade to explain trade flows with

China-AFTA (CAFTA) and to map out policies and strategies to bring about

convergence in these countries‟ income levels in order to maximize benefits

from the proposed free trade area. OLS was used to estimate the model of

eleven CAFTA economies over 1996-2000. The results demonstrated that the

more developed CAFTA economies–Singapore, Malaysia, Thailand, and

China–have an important role to play if integration is to benefit the less –

developed economies of Cambodia, Laos, Myanmar, and Vietnam. The

48
research findings also indicated that the differences in demand patterns would

have to be alleviated and in the process of integrating area could achieve

equalization in factor prices which will finally have an effect on the economic

geography of production and trade within the sub -region.

Kien and Hashimoto (2005) applied the Hausman-Taylor estimation to

investigate the determinants of trade flows of AFTA applying a gravity model

specified in the two-way error component form. This study employed a panel

data of 39 countries (ASEAN and its main trading partners) for the period

1988-2002. The estimated results showed that GDPs positively affected export

flows among two countries, and countries with identical preferences trade d

more to each other than those with different differences. Moreover, the

findings also indicated that AFTA has only generated the trade creation among

its members. Finally, the study suggested that trade facilitation policy has an

important role to support the targets of preferential trade agreement.

Lee and Park (2005) examined the economic effect of the possible East Asia

FTA. The panel data set covered 186 countries from 1955 to 1997, containing

13 major RTA. They applied the FEM and REM to estimate the panel gravity

model. The empirical results showed that the trade creation effect possibly

brought by the proposed East Asia FTAs such as an ASEAN+3 will be equal or

larger than the trade diversion effect. The authors also suggested that the East

Asian FTA tends to be a building block for a global free trade.

Lee and Shin (2006) applied the gravity model to test whether the

geographical proximity contributes to welfare improvement of non -member

countries of the RTAs. The panel data set accounted for 17 regional trading

blocs, consisting of 175 countries from 1948 to 1999. Estimating the empirical

gravity model with the REM and FEM, the authors concluded that the

geographical proximity plays an important role in enhancing trade not only

49
among members of an RTA, but also between members and the rest of the

world. The authors further investigated the trade effect of the East Asian

trading blocs and found that these blocs tend to increase trade among members

without diverting trade from non-members. Lee and Shin (2006) also indicated

that the RTA of ASEAN+3 will gain the highest benefit among East Asia blocs

since it contains the largest members among proposed East Asian RTAs.

Hapsari and Mangunsung (2006) investigated the determinants of export flows

of AFTA members, including the impact of trade creation of AFTA on its

intra-regional and extra-regional trade flows. To assess the impact of AFTA on

its member, the authors developed an augmented gravity equation which

contains basic gravity variables, the complementarity and the similarity

indices. Dummy variables of ASEAN and AFTA were also added to capture

the regional effects. The model was estimated by OLS using the panel data of

19 countries over 1993-2003. The research found that per capita GDPs and

GDPs of both importing and exporting countries, distance, language, common

border, landlocked, and tariff, have significant ef fects on the bilateral exports

of ASEAN members. The empirical results also suggested that AFTA may be

causing some trade diversion and shifting trade from countries outside the

trade bloc to possibly less efficient countries inside the trade bloc.

Furthermore, the findings confirmed the more complementary the supply and

demand of countries, the more they would trade.

Siah et al. (2009) investigated the possibility of AFTA in promoting intra -

ASEAN trade. They utilized a modified gravity model and estimated it in an

autoregressive distributed lag (ARDL) framework. The data set was consisted

of five ASEAN countries (Indonesia, Malaysia, Philippines, Singapore, and

Thailand), collected over 1970 to 2001. Instead of pooling these countries

50
Table 2.5 Summary of Key ASEAN Trade Literature Applying the Gravity Model

Author(s) Title Countries Time Period Purposes Methods Results of the Study
Tho (2002) AFTA in the Dynamic ASEAN, China, 1992, 1999 - To study the trade effect of AFTA in Descriptive - Trade and FDI in AFTA have not been as strong as
Perspective of Asian Trade Japan, Korea the dynamic context. theory suggests.
- China, Japan, and Korea had strong impact on
ASEAN.

Elliott and Ikemoto AFTA and the Asian Crisis: ASEAN, EU, 1983-1999 - To examine the trade effects of AFTA OLS - AFTA has stimulated extra-ASEAN trade.
(2004) Help or Hindrance to ASEAN APEC, NAFTA on intra- and extra-ASEAN. - Asian economic crisis helped to increase intra-ASEAN
Intra-Regional Trade? trade.

Roberts (2004) A Gravity Study of the ASEAN, China 1996-2000 - To test the suitability of the gravity OLS - The gravity model exhibited a good fit in explaining
Proposed China – ASEAN model to the proposed RTA. trade flows of China-AFTA.
Free Trade Area - To draw the policy implication from - The China-AFTA would benefit from the proposed
the proposed RTA and the multilateral FTA.
trade system. - The proposed FTA of China-AFTA may not
potentially result in trade creation among its members
due to high trade distance.

Kien and Hashimoto Economic Analysis of EU, AFTA, 1988-2002 - To apply the Hausman-Taylor Hausman- - Export flows increase proportionately with GDPs.
(2005) ASEAN Free Trade Area: By NAFTA, estimation to investigate trade flows of Taylor - AFTA has produced the trade creation among its
a Country Panel Data MERCOSUR AFTA. members.
- Trade facilitation policy is important to achieve the
targets of FTA.

51
Table 2.5 Summary of Key ASEAN Trade Literature Applying the Gravity Model (Continued)
Author(s) Title
Free Trade Areas in East
Lee and Park (2005) Asia: Discriminatory or Non-
discriminatory ?
Does Regionalism Lead to
Lee and Shin (2006)
More Global Trade
Integration in East Asia ?
Determinants of AFTA
Hapsari and
Member‟s Trade Flows and
Mangunsong (2006)
Potential for Trade Diversion
Siah et al. (2009) AFTA and the Intra-Trade
Patterns among ASEAN-5
Economies: Trade-Enhancing or
Trade Inhibiting ?
Countries Time Period Purposes Methods Results of the Study
186 countries 1955-1997 - To examine the economic effect of the REM & - Trade creation effect possibly brought by the proposed
possible East Asia FTA. FEM East Asia FTAs will be equal or larger than the trade
diversion effect.
- The East Asian FTA tends to be a building block for a
global free trade.
175 countries 1948-1999 - To test whether the geographical REM & - The geographical proximity plays an important role in
proximity contributes to welfare FEM enhancing trade not only among members of an RTA,
improvement of non-member countries but also between members and the rest of the world.
of the RTAs.
- To investigate the trade effect of the - The East Asian trading blocs tend to increase trade
East Asian trading blocs. among members without diverting trade from non-
members.
ASEAN, ASEAN's 1993-2003 - To investigate the determinants of OLS - Per capita GDPs, GDPs, distance, language, common
trading partners trade flows in AFTA border, landlockedness, and tariff, had significant
- To examine whether AFTA has effects on the bilateral exports of ASEAN members.
resulted in either trade creation or trade
diversion. - AFTA may be causing some trade diversion.
ASEAN 1970-2001 ARDL - The size of the economy had either positive or negative
- To evaluate the possibility of AFTA impact on bilateral trade flow in ASEAN, depending on
in promoting intra-ASEAN trade. the country-specific.
- AFTA played an important role in enhancing intra-
ASEAN trade.
52
together, the authors estimated the gravity model for each country. The

findings showed that the size of the economy had either positive or negative

impact on bilateral trade flow in ASEAN, depending on the country -specific.

The results also suggested that AFTA played an important role in enhancing

intra-ASEAN trade.

Table 2.5 presents a summary of the ASEAN trade literature applying the

gravity model. These studies have been discussed in section 2.5.4.

2.6 Summary

This chapter has discussed five issues, such as the economic of regional

integration, the brief history of ASEAN and AFTA, the empirical trade flows

of ASEAN, international trade theory, and the literature of the gravity model.

The REI is generally defined as the cooperation of at least two independent

countries in order to liberalize their economic relationship. The resulting

integration usually brings about two economic effects: static effects and

dynamic effects. The former consists of trade creation effects, trade diversion

effects, increasing in international bargaining power, lower administrative

expenditure, and decreasing in smuggling. The latter includes improving

production efficiency, economies of scale, higher FDI, and promoting

technological change.

Due to the importance of such REI, ASEAN was founded in 1967. It has

intended to strengthen and sustain key regional issues: accelerating economic

growth, social progress and cultural development in the region ; and promoting

regional peace and stability. ASEAN trade is one of the main engines to drive

regional economic growth. The formation of AFTA is a collective strategic

response to pursue ASEAN‟s goals of stimulating intra- and extra-regional

trade, improving the investment climate and enhancing the competitiveness of

industrial performance of its member countries.

53
Using the data of ASEAN trade flow, the intra-ASEAN trade had been

intensified during 1989-2005. Each of the ten countries imported intensively

from the market within the area while each exported intensively to the outside

region. Regarding extra-ASEAN trade, ASEAN had intensively traded with

developing and developed nations in Asia, compared to EU, NAFTA, and

MERCOSUR.

The trading phenomenon of ASEAN and its partners can be explained in the

framework of international trade theory. Factors affecting international trade

include physical characteristics of countries , population, capital, distance,

political factors, and stage of economic development. To investigate trade

flow analytically, a unified framework is needed to relate trade flow to factors

affecting it. This was accomplished by the so -called „gravity model‟, proposed

by Tinbergen (1962).

Since the work of Tinbergen (1962), the gravity model of international trade

has been developed over time in terms of theoretical foundation and empirical

works. The theoretical foundation involved in the gravity mo del includes the

H-O model and the new trade theory. The gravity model has been applied to

analyze various areas, such as border trade, regional economic integration,

impact of WTO, and impact of currency union on trade.

Together with the growing number of the theoretically econo mic support to the

gravity model, various methods of econometrics have been used to estimate

the gravity model. These methods include ordinary least squares, method of

IV, REM, FEM, H-T model, and ARDL model. Almost all of the studies

reviewed in the literature have been estimated in static form. However, the

theory suggests that trade is a dynamic process which adjusts over time. The

next chapter discusses the methodology of formulating and estimating the

static and dynamic gravity models.

54
 CHAPTER 3

EMPIRICAL MODELS AND METHODOLOGY

This Chapter discusses conceptual framework of formulating and estimating

the static and dynamic gravity models. Section 3.1 presents an overview on

variables frequently used in gravity model specifications. Section 3.2

discusses the generalization of the theoretical gravity model provided in

Chapter 2 (Section 2.5.2) into the empirical model. It also provides the

specifications for static panel gravity models of intra - and extra-ASEAN trade.

Section 3.3 presents the specification for the dynamic gravity models of intra-

and extra-ASEAN trade based partial adjustments and adaptive expectations

hypotheses. Section 3.4 describes the estimation methods for both the static

and dynamic panel gravity models of intra - and extra-ASEAN trade. Section

3.5 explains data sources and data manipulation. Section 3.6 summarizes the

chapter.

3.1 Summary of Variables Used in the Gravity Model

A variety of variables has been included into the extended gravity model

according to the research questions. The extended gravity model has been

extensively used to address the issues of international trade, economic and

currency union (EMU), linguistic identity, international border, WTO, and

regional economic integration (REI). Since this thesis is intended to evaluate

the impact of AFTA, most reviewed literatures were focused on only the latter

issue (REI).

Empirical research on bilateral trade flows applying the gravity model have

been conducted based on the proposition that trade flows from one countr y to

another country are determined their incomes and their geographical distance.

Table 3.1 provides a summary of the variables typically used in the gravity

55
Table 3.1 Variables Used in the Gravity Model
Theoretical specification Empirical Specification

Kien & Hashimoto

Hutchinson (2002)
Linnemann (1966)
PÖyhÖnen (1963)

Bergstrand (1985)

Bergstrand (1989)

Bergstrand (1990)

McCallum (1995)

Elliott & Ikemoto

Tinbergen (1962)

Siah et al. (2009)

Krugman (1985)

Roberts (2004)
Eichengreen &

Hassan (2001)
Aitken (1973)
Helpman et al

Endoh (1999)
Variables Used in the Gravity Model

Frankel et al.

Frankel et al.

Mangunsung
Irwin (1998)

Sapir (2001)
Helpman &

Hapsari &
(2008)

(1995)

(1998)

(2004)

(2005)

(2006)
Dependent Variables
Trade      
Export               
Import  
Independent Variables
Basic gravity variables
Income (Yi , Yj)               
Product of incomes (Yi × Yj)      
Population (Ni , Nj)    
Product of population (Ni × Nj) 
Per capita income (YCi , YCj)       
Product of per capita income (YCi × YCj)    
Capital-labor ratio ((K/L)i , (K/L)j) 
Difference in income (|Yi - Yj|) 
Difference in per capita income (|YCi - YCj|)    
Difference in capital-labor ratio (|(K/L)i - (K/L)j|) 
Similarity in country size 
Distance                  
Relative distance 
Transport costs  

56
Table 3.1 Variables Used in the Gravity Model (Continued)

Theoretical specification Empirical Specification

Kien & Hashimoto

Hutchinson (2002)
Linnemann (1966)
PÖyhÖnen (1963)

Bergstrand (1985)

Bergstrand (1989)

Bergstrand (1990)

McCallum (1995)

Elliott & Ikemoto

Tinbergen (1962)

Siah et al. (2009)

Krugman (1985)

Roberts (2004)
Eichengreen &

Hassan (2001)
Aitken (1973)
Helpman et al

Endoh (1999)
Variables Used in the Gravity Model

Frankel et al.

Frankel et al.

Mangunsung
Irwin (1998)

Sapir (2001)
Helpman &

Hapsari &
(2008)

(1995)

(1998)

(2004)

(2005)

(2006)
Additional Independent variables
Lagged Trade 
Physical characteristics
Adjacency              
Landlocked  
Island  
Border effects 
Price variables
Exchange rate   
Inflation rate  
Government policy
Government, legal system 
Tariff  
Inequality of tariff levels 
Cultural factors
Language       
Religion 
Historical Links
Colonial ties 
Regional Trade Arragements
GATT/WTO  
RTA              
Currency union 

57
model. The first half of Table 3.1 shows the model specifications based on the

theoretical models and the second half illustrates the specifications based on

the empirical models. As can be seen from Table 3 -1, the export variable is

widely used as the dependent variable of the gravity model. The commonly

used independent variables are separate uses of GDPs of two countries, per

capita income, and dummies of adjacency, language, and regional trade

arrangement.

3.2 Specifications of Static Panel Gravity Models

3.2.1 Cross-section Gravity Model versus Panel Gravity Model

This section introduces the theoretical gravity model proposed by

Anderson and van Wincoop (2003), which has been applicable only to cross-

sectional data (see section 2.5.2), into a panel data framework. The following

discussion is fundamentally based on Baldwin and Taglioni (2006). Baldwin

and Taglioni (2006) argued that the gravity equation (2.21) is only applicable

for cross-sectional analysis, but not for panel data framework due to the
assumption of symmetric transport costs (tij  t ji ) . The restriction  h  Pi is

true if and only if trade costs do not vary. Since we are going to generalize the

Anderson and van Wincoop model for panel data, there must be no doubt that
trade costs are changing over time in which case  h  Pi cannot be held 1 .

Baldwin and Taglioni (2006) derived a simple gravity model which is similar

to equation (2.18) and is expressed as

1  YiY j
EX ij  tij (3.1)
Yw h Pj1

1
According to Baldwin (2006, pp. 4), h is called a country‟s market potential in the

economic geography literature since it is measured by the sum of its trade partners‟s real

GDPs divided by bilateral distance.

58
where  h  Pi1 . The trade costs (tij ) are defined as in equation (2.24). Thus,

substituting equation (2.24) into (3.1) we have

YiY j  ij (1  )
K
EX ij  ( Dij ) ( zijk )1  (3.2)
Yw h Pj1  k

The next step is to rewrite equation (3.2) in an estimably econometric model:

 ij (1 ) uijt
EX ijt  Ywt1YitY jt  ht1Pjt 1 ( Dij ) e (3.3)

where the unobserved trade costs have been absorbed into the error terms uijt .

The subscript t denotes time. It has been added in order to generalize the

economic model into the panel gravity model. Writing equation (3.3) in natural
logarithms, and expressing world income as a constant    ln Ywt , we derive

the final version of the panel gravity equation

ln EX ijt    ln Yit  ln Y jt   ij (1   ) ln Dij  ln it  (   1) ln Pjt  uijt (3.4)

According to Baier et al. (2007), the panel gravity model (3.4) can be suffered

by the endogeneity bias. The potential endogeneity of the right -hand side

(RHS) variables can lead to serious estimation problems. It occurs when one or
more variables on the RHS is correlated with the error term s, uijt , and OLS

method yields biased and inconsistent estimates. Potential sources of

endogeneity bias fall under three categories: omission of relevant variables,

simultaneity, and measurement error (see Wooldridge, 2002, pp. 50 -51). In the
gravity model, the unobserved bilateral trade costs (tijt ) can lead to
endogeneity bias by mean of omitted variable bias . Bilateral trade costs are

composed of natural barriers (bilateral distance, adjacency, land bord er,

landlocked, island, etc.), policy-related barriers (free trade agreements, etc.),

cultural barriers (common language, religion, etc.) and hi storical ties (colonial

59
 K
ties, etc.). As shown in equation (3.4), the term ( zijk )1  which has been
k

absorbed into the error terms is part of the unobserved bilateral trade costs

(hereafter, „multilateral trade resistance‟, Anderson and van Wincoop, 2003).

The big problem is that the omitted terms are correlated with the general price
indices, because tijt is one of the RHS variables of the equations
for  it and Pjt (see equation (2.19) and (2.17), respectively). This correlation

results in the biased estimates of trade costs and all its determinants including

the FTA dummy. More precisely, GDPs are biased downward; and the FTA is

biased upward. Baldwin and Taglioni (2006) referred to this problem as the

„gold medal‟ since it is the most important issue in estimating the panel

gravity model. They proposed that the omitted variable bias can be solved by

including dummies of trading-pairs and time.

Another important issue is the simultaneity problem in the panel gravity

model. The gravity equation can be suffered by the simultaneity bias due to

the causal relationship between GDP and net exports. In this case, GDP is

potentially endogenous to bilateral trade flows. This suggests that the panel

gravity model should be estimated by instrumental variable (IV) methods such

as two-stage least squares (2SLS) to obtain consistent parameter estimates.

The last issue is related to the deflation of bilateral trade data. Since the GDPs

are expressed in terms of base-year dollars, the trade flows are usually

deflated by the base year using the US price index such as the CPI (this thesis

also follows this method). Baldwin and Taglioni (2006) argued that the

deflation of nominal trade values by the CPI of the US is inappropriate since

the global trends in inflation rates may trigger biases via spurious correlations.

Fortunately, Baldwin and Taglioni (2006) stated that this bias is small and can

be corrected by including a time dummy whenever every bilateral trade has

been deflated by the same price index.

60
In conclusion, three issues have been discussed. First, the panel gravity model

can be reformulated from the final version of the cross -section gravity model

(equation 2.21). This is done by removing the assumption of the equality

between trade costs from country i to country j and from country j to country i.

Second, the omitted bias due to the multilateral trade resistance can be solved

in adding dummy variables of the trading -pairs and time into the panel gravity

model. Finally, the simultaneity problem between GDPs and bilateral trade

flows can be solved by estimating the panel gravity model with the

instrumental methods. These key issues are going to be discussed in section

3.4 regarding the estimation methods of the panel gravity models.

3.2.2 Specification of Static Gravity Model for Intra-ASEAN Trade

In this Section, we specify the empirical panel gravity model for intra -

ASEAN trade based on three fundamental characteristics. First, the gravity

model of intra-ASEAN trade is formulated based on the panel gravity model

derived in Section 3.2.1. Second, since the main purpose of this thesis is to

investigate the determinant of ASEAN trade, we include additional variables

to the panel gravity model suggested by the international trade theory in

Chapter 2 (Section 2.3) and in accordance with what has been summarized in

Section 3.1. Third, because another main purpose of this thesis is to evaluate

the impact of regional trade agreement on trade flows of its members, we

specify this variable based on the t heory in Chapter 2 (Section 2.1.2) and the

empirical research summarized in Section 3.1. The panel gravity model of

intra-ASEAN trade can be used to provide answers for questions like what are

the determinants of ASEAN trade if there are only 10 ASEAN countries trade

to each other? And to what extent that ASEAN can increase trade flows of it s

members given other factors outside ASEAN trading blocs ?

The following explains how to modify the panel gravity model appeared in

equation (3.4) to investigate intra-ASEAN trade. Then, two-way mixed error

61
component form of gravity model is discussed to account for the endogeneity

bias posed by the unobserved trade costs. The so-called „mixed error

component‟ comes from the fact that we treat the unobserved time effects as

fixed parameters to be estimated whereas treating the unobserved trading -

partners effects as random error terms.

According to the gravity model of trade in equation (3.4), the real exports
between pairs of countries EX ijt is a function of their incomes (GDPs), their

geographical distance, and a set of dummies, as shown by

ln EX ijt    t  1 ln Yit   2 ln Y jt  3 ln Dij   4 adjij

 5comcolij  6langij  7 ASEAN ij  ij  eijt
or
ln EX ijt    t  1 ln Yit   2 ln Y jt  3 ln Dij   4 adjij
 5comcolij  6langij  7 ASEAN ij   ijt (3.5)

where „ln‟ denotes variables in natural logs, EX ijt is the real bilateral exports

from country i to country j in period t. Omega  is a constant term which is

common to all years and trading pairs. Yit and Y jt indicate the real GDP of

countries i and j, respectively, in period t. Dij is a geographical distance

between countries i and j. A high level of income in the exporting country, Yit ,

indicates a high level of production, which increases the availability of goods

for export. Thus, we expect the coefficient of Yit to be positive. The coefficient

of Y jt is also expected to be positive since a high level of importer‟s income

leads to more imports. Note that the empirical panel gravity model has not

imposed any restriction on the coefficients of GDPs, 1 and  2 2 .

2
According to the theoretical gravity model (2.21), 1 and  2 should equal to unities.

62
The distance coefficient is expected be negative since it is a proxy of all

possible trade cost sources. These include transport cost, communication and

transaction costs.

The model includes dummy variables for trading partners sharing common
land border ( adjij ), common colonizers ( comcolij ), and common language

( langij ), as well as‟ common trading bloc dummy variables (defined

as ASEAN ij ). The first three dummies are additional variables which

potentially affect the determinants of ASEAN trade. The latter, common

trading bloc dummy, is aimed to capture the trade effect of the formation of
ASEAN on its members. The dummy variable adjij is defined as one if the two

countries share a common land border and zero otherwise. We expect the
coefficient of adjij to be positive since two countries will trade more since they

have more information about each other, and goods may be easily transported

from one country to another.

The dummy variable ASEAN ij is defined as one if the two countries are

members of ASEAN in time t. In order to avoid confusion arising from the

specification of ASEAN ij dummy, it is important to note that although we are

considering only ten ASEAN countries in the gravity model (3.5),

ASEAN ij dummy is created taking into account the year in which a country
formally signed the accession treaty to become members of ASEAN. If the

trading pairs became members of ASEAN in different years, the specification

of ASEAN ij dummy is based on the latest entrant, by definition. Coefficient

of ASEAN ij dummy measures the extent to which trade among members is

higher than normal levels due to the elimination of trade barriers. We ,

therefore, expect that the sign of ASEAN ij coefficient should be positive.

The dummy variable langij is defined as one if a language is spoken by at least

9 % of the population in both trading partners. The coefficient of langij is

63
expected to be positive since it captures cultural familiarity, in the sense that

the trading partners find it easier to communicate and share information.

The dummy variable comcolij is defined as one if two countries have ever had a

common colonizer after 1945. It is used as a proxy variable of historical link s

between a country-pair. Since two countries will trade more if they have had
good historical links, the coefficient of comcolij is expected to be positive. On

the other hand, it can be negative if such historical link reflects the historical

conflicts.

Here, we introduce the panel econometric technique into our gravity model
(3.5) by defining the composite error terms as uijt  t  ij  eijt . t are

unobserved specific time effects that control for omitted variables that are
common for all trade flows but vary over time. t are assumed to be fixed-

parameters to be estimated.  ij are unobserved country-pair effects that control

for omitted variables that are common for all time periods but vary over
trading partners. The error terms  ij of the gravity model have been usually

treated as fixed-parameters to be estimated (literature review in Section 2.5 .3).

If we treat  ij as fixed parameters to be estimated, 89 dummy variables of the

country-pairs have to be included into the gravity model (3.5). This leads to

the loss of degrees of freedom. Another problem with the fixed -effects model

is that it eliminates all time-invariant variables. Since our panel gravity model

contains many time-invariant variables (distance, adjacency, common

language, and common colonizers), employing fixed -effects model will

decrease the explanatory variables for investigating the determinants of

ASEAN trade. Alternatively, one can solve the problem of unobserve d

country-pair effects by assuming them be to random. Since our sample is

relatively large (1,530 observations), the random effect method is applicable to

the gravity model (3.5).  ij are therefore assumed to be normally distributed as

ij ~ (0,  2 ) . eijt are the error terms that are common to both country -pairs and

64
times, assumed to be normally distributed as eijt ~ (0,  e2 ) .  ij and eijt are

independent of each other and among themselves. The composite error terms
( ijt  ij  eijt ) of the gravity model (3.5) exhibit a homoscedastic variance
var(  ijt )   2   e2 for all country-pairs and time, and have serial correlations
over time only between the error terms of the same trading-pairs. To show

this, let the trading-pair ij be defined as k. That is,

cov( kt ,  ls )   2   e2 for k  l , t  s

  2 for k  l , t  s

and zero otherwise. Although some of the characteristics (unobserved trading -

pair effects) of the panel gravity model have been changed, we still prefer to

remain using its old name, the „panel gravity model‟.

To sum up, the panel gravity model has been included additional va riables

based on what has been suggested by the theory and empirical research. It has

been then modified to be compatible with the panel data mo del, called two-

way mixed error-component model. The resulting panel gravity model is

composed of three main characteristics, s uch as trade theory, empirical

research and econometrics theory. Consequently, we believe that applying this

panel gravity model provides reliable results for policy implications.

3.2.3 Model Specification for Extra-ASEAN Trade: Static Gravity

Equation

We have formulated the panel gravity model for intra-ASEAN trade in

Section 3.2.2. This model ignores the effects of ASEAN trade with non -

member countries. As can be seen from Table 2.2 (see Chapter 2), intra-

ASEAN exports account only 23 % of their total exports. That is, 77 % of their

total exports have been sent to the rest of the world. This implies that any

change in the world economy could have a dramatic impact on ASEAN trade

65
flows. As a result, modeling ASEAN trade with the rest of the world can

precisely provide the determinants of ASEAN trade and the effect of ASEAN

on its members.

By considering ASEAN countries with their main trading partners, we have a

sample with 43 countries in total. Although formulating the panel gravity

model of extra-ASEAN trade is not very different from that of intra -ASEAN

trade, there are two issues needed to be discussed. First, the dummy of

ASEAN should be replaced by the dummy of AFTA. The reason is that both

tariff and non-tariff barriers of intra-ASEAN have been eliminated through the

implementation of AFTA. Furthermore, AFTA may encourage its members to

trade more compared to non-members. Second, dummies of the free trade areas

(FTAs) of the rest of the world should also be added into the model with

similar reason as provided for AFTA. Modifying equation (3.5) associated

with the specification of the regional trade agreement dummies based on

Frankel et al. (1995), the panel gravity model of ex tra-ASEAN trade can be

expressed as

ln EX ijt    t  1 ln Yit   2 ln Y jt  3 ln Dij   4 adjij

 5comcolij   6langij   7landlockedij  8 AFTAij
(3.6)
 9 EU ij  10 MERCOSUR ij  11NAFTA ij   ijt

where the dummy variable (landlocked) is added to capture the impact of

geographical location of the trading -pairs. It is defined as one if both trading

partners are landlocked countries and zero, otherwise. AFTAij , EU ij ,
MERCOSUR ij , and NAFTA ij are four of the dummy variables we use when
testing the effects of membership in a common regional trading group,

standing for ASEAN Free Trade Area, European Union, Southern Common

Market, and North American Free Trade Agreement. Other variables are

defined as in Section 3.2.2.

66
3.3 Specifications of Dynamic Panel Gravity Models

Section 3.2 discussed about formulating static panel gravity model s. The

implication of the coefficients estimated from the static panel gravity model is

that bilateral exports respond contemporaneously to any of its explanatory

variables. In other word, bilateral exports adjust to the equilibrium within one

period. Eichengreen and Irwin (1998) argued that past trade patterns influence

current trade flows due to sunk costs invested by the exporting countries in the

importing countries. Bun and Klaassen (2002) supported this idea by

estimating the dynamic panel gravity model. The authors confirmed that

lagged trade plays an important role in formulating gravity model.

Furthermore, Zarzoso et al. (2009) showed that the estimated results from the

dynamic panel gravity model are significant and robust in explaining the

regional trading agreements.

There are many ways in formulating the dynamic panel gravity model. Some

authors directly introduced lagged bilateral exports (trade) into the static panel

gravity model (i.e., Eichengreen and Irwin, 1998; Zarzoso et al., 2009); and

some specified the model based on the autoregressive distributed lag model

(i.e., Bun and Klaassen, 2002; Siah et al., 2009). Instead of following these

literatures, this thesis develops the dynamic panel gravity model in a new

direction. That is, we formulate it based on the expectation hypothesis.

Expectations play a prominent role in almost every economic activity. Some

key examples are: production depends on expected sales; investment depends

on expected profits; and long term interest rates depend on expected short -

term rates, expected inflation rates, and so on. While there are different

models of expectation formation, such as partial adjustments models, adaptive

expectations models and rational expectations models, this thesis mainly

focuses on formulating the panel gravity models of expectations based the first

two models, partial adjustments and adaptive expectations models. The

67
resulting formulation of the gravity model is known as the dynamic gravity

model. Although the notions of partial adjustments and adaptive expectations

are not new, including them into the panel gravity model can pave the way for

a new direction of the gravity model development.

3.3.1 Dynamic Panel Gravity Model: Partial Adjustment s Hypothesis

The partial adjustment model is typically used to formulate the

adjustment of a variable to desired levels. There are numerous economic

arguments suggesting that trade is a dynamic process. In our gravity model, we

use bilateral exports rather than trade to be the dependent variable. By

formulating the dynamic panel gravity model, we intend to address the

following research questions i) How long does it take for ASEAN bilateral

exports adjust to its equilibrium given the existing determinants of ASEAN

trade? What are the short-run and long-run impacts of the determinants on

bilateral exports? And to what extent the effect of regional trade agreement

might have on the bilateral exports flows of its members? In other word, the

partial adjustment hypothesis can be considered as how the producers adjust

their levels of production if when some changes in demand for their products
or other trade determinants have been anticipated. Let EX ijt* be the desired

output level. Now the desired level of the intra-ASEAN bilateral export flows

appropriate to the levels of incomes of the exporting and importing countries,

geographical, cultural and historical factors, can be expressed in constant

elasticity form as

7
(1 )(   k Zijk )

EX *ijt  e  t Yit1 Y jt 2 Dij 3 e

k 4
(3.7)

where „e‟ is the exponential. Z ijk is a set of four dummy variables, such as

adjacency, common colonizer, common language, and ASEAN, respectively.

Other variables are defined as in section 3.2.2. In the gravity model, firms in

68
country i have to adjust their level of production exporting to country j,
denoted by EX ijt . But the process of adjustment cannot be completed

immediately. Defining EX ij*,t  EX ij ,t 1 is the desired change. The partial

adjustment model states that the actual change is only a fraction of the desired

change. Following Johnston (1991, pp. 349), a partial adjustment process is

typically specified as

1
 EX ijt   EX ijt* 
   e
 ijt
0   1 (3.8)
 EX   EX 
 ij ,t 1   ij ,t 1 

where  denotes the speed of adjustment and is between zero and one . Notice

that there is no disturbance term in the calculation of the desired level of

bilateral exports in equation (3.7), but it is essential to include one in the

specification of the actual bilateral exports in equation (3.8). Combining the

two relations produces

7
(1 )(   k Z ijk )  ijt
EX ijt  e (1 )(  t ) EX ij ,t 1 Yit(1 ) 1 Y jt(1 )  2 Dij(1 )  3 e k 4
e

which, using the lower case letters to denote natural logarithms of the

continuous variables, gives

exijt  (1   )  t (1   )  exij ,t 1  1 (1   ) yit

  2 (1   ) y jt   3 (1   )d ij   4 (1   )adjij
  5 (1   )comcolij   6 (1   )langij
  7 (1   ) ASEAN ij   ijt

or exijt  c0  t  c1exij ,t 1  c2 yit  c3 y jt  c4 dij  c5adjij

 c6comcolij  c7langij  c8 ASEANij   ijt (3.9)

69
where  is a set of coefficients of year dummy variables, and
c0   (1   ) c3   2 (1   ) c7   6 (1   )
a 1   c4   3 (1   ) c8   7 (1   )
c1   c5   4 (1   )
c2  1 (1   ) c6   5 (1   )

Since equation (3.9) is double logarithmic, the coefficients represent

elasticities. Therefore, the short-run elasticity of exijt with respect to yit , for

example, is 1 (1   ) , while the long-run (or full adjustment) elasticity is seen

from equation (3.7) to be 1 . If the estimated form of equation (3.9) is denoted

by


exijt  c0  t  c1exij ,t 1  c2 yit  c3 y jt  c4 dij  c5adjij

 c6comcolij  c7langij  c8 ASEANij

Then the estimated adjustment parameter is c1 . The estimated short-run

elasticity and long-run elasticity are shown in the first two columns of Table

3.2.

Similarly, the dynamic panel gravity model of extra-ASEAN trade formulated

based on the partial adjustment hypothesis can be specified as

exijt  (1   )  t (1   )  exij ,t 1  1 (1   ) yit

  2 (1   ) y jt   3 (1   )d ij   4 (1   )adjij
  5 (1   )comcolij   6 (1   )langij   7 (1   )landlockedij
  8 (1   ) AFTAij   9 (1   ) EU ij  10 (1   ) MERCOSURij
 11 (1   ) NAFTAij   ijt

70
Table 3.2 Estimated Short-run Elasticity and Long-run Elasticity Based on

Partial Adjustments Hypothesis

Intra-ASEAN trade model Extra-ASEAN trade model

(3.9) (3.10)
Short-run Long-run Short-run Long-run
Variables elasticity elasticity elasticity elasticity
(coefficients) (coefficients) (coefficients) (coefficients)
c2 2
y it c2 2
1  c1 1  1
c3 3
y jt c3 3
1  c1 1  1
c4 4
d ij c4 4
1  c1 1  1
c5 5
adj ij c5 5
1  c1 1  1
c6 6
coml ij c6 6
1  c1 1  1
c7 7
lang ij c7 7
1  c1 1  1
c8
ASEAN ij c8
1  c1
8
landlocked ij 8
1  1
9
AFTA ij 9
1  1
10
EU ij 10
1  1
11
MERCOSUR ij 11
1  1
12
NAFTA ij 12
1  1

71
or exijt  0  t   1exij ,t 1  2 yit  3 y jt  4 dij  5adjij

 6comcolij  7langij  8landlockedij  9 AFTAij

(3.10)
 10 EU ij  11MERCOSURij  12 NAFTAij   ijt

where  is a set of coefficients of year dummy variables , and

0   (1   ) 4   3 (1   ) 9  8 (1   )
 1   5   4 (1   ) 10   9 (1   )
1   6   5 (1   ) 11  10 (1   )
2  1 (1   ) 7   6 (1   ) 12  11 (1   )
3   2 (1   ) 8   7 (1   )

If the estimated form of equation (3.10) is denoted by


exijt  0  t   1exij ,t 1  2 yit  3 y jt  4 dij

 5 adjij  6comcolij  7langij  8landlockedij

 9 AFTAij  10 EU ij  11MERCOSURij  12 NAFTAij

Then the estimated adjustment parameter is 1 . The estimated short-run

elasticity and long-run elasticity are shown in the last two columns of Table

3.2.

3.3.2 Dynamic Panel Gravity Model: Adaptive Expectations Hypothesis

Section 3.3.1 formulated the dynamic panel gravity model based the

partial adjustment hypothesis. The resulting model is regarded as how

producers adjust their production when they expect changes in factors

affecting bilateral exports. Instead of constructing the dynamic panel gravity

model from the perspective of the producers, this Section introduces how the

model can be formulated from the perspective of the consumers. To do so, we

72
construct the dynamic panel gravity model based on the adaptive expectation

hypothesis.

Economists are interested in the impact of permanent incom e rather than

current income on permanent consumption. This notion has been known as

Friedman's Permanent Income Hypothesis. Friedman hypothesized that

permanent income is subject to an adaptive expectations process, permanent

income at time t being updated by a proportion of the difference between

actual income and permanent income at time t –1. In our gravity model,

although there are two kinds of incomes (importer‟s income and exporter‟s

income), we will solely focus on the importer‟s income . Furthermore,

permanent consumption is referred to bilateral export flows in the gravity

model.

For intra-ASEAN trade, a producer may base its level of production on the

expected importer‟s income, given other factors potentially affecting bilateral

exports. Consequently, one may specify

7
(1 )(   k Zijk )
 ijt
EX ijt  e  t Yit1 Y jt* 2 Dij 3 e
k 4
e (3.11)

where „e‟ is the exponential. Z ijk is a set of four dummy variables, such as

adjacency, common colonizer, common language, and ASEAN, respectively.

*
Other variables are defined as in Section 3.2.2. Y jt denotes the expected

(permanent) income of the importer. Taking natural logs to both sides of

equation (3.11) and using the lower case letters to denote natural logarithms of

the continuous variables, equation (3.11) is rewritten as

exijt    t  1 yit   2 y *jt   3d ij   4 adjij

 5comcolij  6langij  7 ASEAN ij   ijt (3.12)

73
Equation (3.11) is different from equation (3.7) in that it includes the

composite errors to allow accidental over or under achievement of the

production target. Equation (3.12) is not generally statistically operational

since there is no information on the expected income of the importer.

However, this problem can be solved by applying the adaptive expectation

hypothesis. Adaptive expectation is the expectations that get updated each

period based on the latest information about the actual value of the variable.

According to Johnston (1991), the formal specification of the adaptive

hypothesis applied to importer‟s income is

1
Y jt*  Y 
  *jt  0  1 (3.13)
Y j*,t 1 Y 
 j ,t 1 

In equation (3.13), Y jt* denotes the expectation formed at the end of period t,

when the information about the current level Y jt has become available.

If   0 in equation (3.13), the expected value adjusts period by period to the

current observation and all past history is irrelevant. If   1 , then the

expectations formed remain unchanged regardless of current or earlier

observations. The positive  means that expectations get adjusted each period

by some proportion of the difference between the latest observation and the

expected period. Low value of  indicates considerable adjustments i n

expectations, and large value of  implies slow change in expectations. Taking

natural logs to both sides of equation (3.13) and using the lower case letters to

denote natural logarithms, equation (3.13) is rewritten as

y *jt  y *j ,t 1  (1   )( y jt  y *j ,t 1 )

1 
or y*jt  y jt (3.14)
1  L

74
where L is a lag operator. Substituting equation (3.14) into equation (3.12)

yields

exijt  (1   )  t (1   )  exij ,t 1  1yi ,t 1  1 yit

  2 (1   ) y jt   3 (1   )dij   4 (1   )adjij
  5 (1   )comcolij   6 (1   )langij   7 (1   ) ASEAN ij
 ( ijt   ij ,t 1 )

or exijt   0  t  1exij ,t 1   2 yi ,t 1   3 yit   4 y jt

  5 dij   6 adjij   7 comcolij   8langij
(3.14)
  9 ASEAN ij  ( ijt   ij ,t 1 )

where  is a set of coefficients of year dummy variables , and

 0   (1   )  3  1  7   5 (1   )
 1    4   2 (1   )  8   6 (1   )
1    5   3 (1   )  9   7 (1   )
 2  1  6   4 (1   )

The resulting dynamic panel gravity model of intra-ASEAN trade in equation

(3.15) which has been formulated based on the adaptive expectation hypothesis

yields the model associated the moving average of order one or MA (1) in

error process. If the estimated form of equation (3 .15) is denoted by


ex ijt   0  t  1exij ,t 1   2 yi ,t 1   3 yit   4 y jt

  5dij   6 adjij   7comcolij   8langij   9 ASEANij

Then the estimated adjustment parameter is  1 . The estimated short-run

elasticity and long-run elasticity are shown in the first two columns of Table

3.3.

75
Similarly, the dynamic panel gravity model of extra -ASEAN trade formulated

based on the adaptive expectation hypothesis can be derived as

exijt   (1   )  t (1   )  exij ,t 1  1yi ,t 1  1 yit   2 (1   ) y jt

  3 (1   )d ij   4 (1   )adjij   5 (1   )comcolij
  6 (1   )langij   7 (1   )landlockedij   8 (1   ) AFTAij
  9 (1   ) EU ij  10 (1   ) MERCOSURij  11 (1   ) NAFTAij
 ( ijt   ij ,t 1 )

or exijt  0  t  1exij ,t 1  2 yi ,t 1  3 yit   4 y jt

 5 d ij  6 adjij  7 comcolij  8langij

 9landlocked  10 AFTAij  11 EU ij (3.15)
 12 MERCOSURij  13 NAFTAij  ( ijt   ij ,t 1 )

where  is a set of coefficients of year dummy variables , and

0   (1   ) 4   2 (1   ) 9   7 (1   )
  1   5   3 (1   ) 10   8 (1   )
1    6   4 (1   ) 11   9 (1   )
2  1  7   5 (1   ) 12  10 (1   )
 3  1 8   6 (1   ) 13  11 (1   )

If the estimated form of equation (3.15) is denoted by

exijt  0  t  1exij ,t 1  2 yi ,t 1  3 yit   4 y jt

 5 d ij  6 adjij  7 comcolij  8langij

 9landlocked  10 AFTAij  11 EU ij
 12 MERCOSURij  13 NAFTAij

Then the estimated adjustment parameter is 1 . The estimated short-run

elasticity and long-run elasticity are shown in the last two columns of Table

3.3.

76
Table 3.3 Estimated Short-run Elasticity and Long-run Elasticity Based on

Adaptive Expectations Hypothesis

Intra-ASEAN trade model Extra-ASEAN trade model

(3.14) (3.15)
Short-run Long-run Short-run Long-run
Variables elasticity elasticity elasticity elasticity
(coefficients) (coefficients) (coefficients) (coefficients)

y i,t-1 2 2

2  3  2  3
y it 3 3
1  1 1  1
4 4
y jt 4 4
1  1 1  1
5 5
d ij 5 5
1  1 1  1
6 6
adj ij 6 6
1  1 1  1
7 7
coml ij 7 7
1  1 1  1
8 8
lang ij 8 8
1  1 1  1
9
ASEAN ij 9
1  1
9
landlocked ij 9
1  1
10
AFTA ij 10
1  1
11
EU ij 11
1  1
12
MERCOSUR ij 12
1  1
13
NAFTA ij 13
1  1

77
Table 3.4 depicts the variables‟ definitions and hypothesized signs. Exporting

country‟s GDP, for example, is hypothesized to have a positive impact on

export flows.

Table 3.4 Variable Descriptions and Predicted Signs

Predicted
Variables Definitions
Signs
Dependent Variable
Log of Exports LnEXij,t Logarithm (ln) of bilateral exports, over time (t).

Independent Variables
Continuous time-varying
variables
Log of Exporter's GDP LnYit Logarithm (ln) of exporting country's GDP, over time (t). +
Log of Importer's GDP LnYjt Logarithm (ln) of importing country's GDP, over time (t). +

Continuous time-
invariant variable
Log of Distance LnDij Logarithm (ln) of distance between the exporting and importing
-
countries.

Dummy variables
Common Language langij Dummy variable accounting cultural similarity; langij = 1 if a language
is spoken by at least 9 percent of the population in both trading partners, +
and langij = 0 otherwise.
Common Colonizer comcolij Dummy variable capturing historical link, comcolij = 1 if two countries
have ever had a common colonizer after 1945, and comcolij = 0 +
otherwise.
Landlocked landlockedij dummy variable capturing the impact of geographical location,
landlockedij = 1 if both trading partners are landlocked countries, and -
landlockedij = 0 otherwise.
Adjacency adjij Dummy variable accounting for common border; adjij = 1 if the
exporting and importing countries share common border, and adjij = 0 +
otherwise.
ASEANij ASEANij Dummy variable capturing the impact of ASEAN on intra-regional
trade; ASEANij = 1 if both trading pairs are members of ASEAN, and +
ASEANij = 0 otherwise.
AFTAij AFTAij Dummy variable capturing the impact of AFTA on intra-regional trade;
AFTAij = 1 if both trading pairs are members of AFTA, and AFTAij = 0 +
otherwise.
EUij EUij Dummy variable capturing the impact of EU on intra-regional trade;
EUij = 1 if both trading pairs are members of EU, and EUij = 0 +
otherwise.
MERCOSURij MERCOSURij Dummy variable capturing the impact of MERCOSUR on intra-regional
trade; MERCOSURij = 1 if both trading pairs are members of +
MERCOSUR, and MERCOSURij = 0 otherwise.
NAFTAij NAFTAij Dummy variable capturing the impact of NAFTA on intra-regional
trade; NAFTAij = 1 if both trading pairs are members of NAFTA, and +
NAFTAij = 0 otherwise.

78
3.4 Estimation Methods

3.4.1 Estimation Method for Static Panel Gravity Model

As have been discussed in Section 3.2, the panel gravity model is suffered

from omitted bias of trade costs variables, and from the simultaneity proble m

caused by the casual relationship between GDPs and bilateral exports. The

primary objective of this Section is to provide method of estimation of the

static panel gravity model that yields unbiased and consistent estimates.

We start with the first issue, omitted bias of trade costs variables. It may be

useful to reproduce the static panel gravity model of intra -ASEAN trade in

equation (3.5)

exijt    t  1 yit   2 y jt  3dij   4 adjij

 5comcolij  6langij  7 ASEAN ij  ij  eijt (3.5)

where lower case letters denote the natura l logarithms of the continuous
variables, and  ijt has been decomposed into two unobserved error
terms,  ij and eijt .  ij are unobserved specific effects associated with each

trading-pair. Part of the unobserved trade costs variables that are time -
invariant have been absorbed into  ij .  ij are therefore used to control for all

the omitted variables that are specific to each bilateral export flows and that
are time-invariant. By controlling for  ij , we typically treat them either as

fixed parameters to be estimated or as unobserved random error process es. For

reasons given in section 3.2.2, this thesis treats  ij as unobserved random error

processes. eijt represents the error term that is assumed to be well behaved.

Furthermore, t are unobserved specific time-effects. Unobserved trade costs

variables that are time-varying has been partially absorbed into t . t are

therefore used to control for all the omitted variables that are time-varying.

79
Since our panel data contains short time period , we treat t as fixed parameters

to be estimated.

Another issue is the simultaneity caused by the causal relationship between

GDPs ( yit and y jt ) and bilateral exports ( exijt ). Estimating the model involving

this issue requires instrumental method like two-stage least squares method.

By doing so, we use the population of the two countries (exporter‟s population

and importer‟s population) as the instruments for the endogenous variables,

GDPs.

In order to estimate the static panel gravi ty model of intra-ASEAN trade

containing the above two issues (omitted variables bias and simultaneity

problem), we apply the error component two -stage least squares (EC2SLS)

method which has been proposed by Baltagi (1981). The same estimation

method has been applied to the static panel gravity model of extra -ASEAN

trade. In conclusion, in the face of the omitted variables bias and simultaneity

problem, the static panel gravity models of intra - and extra-ASEAN trade are

estimated using the EC2SLS method.

3.4.2 Estimation Method for Dynamic Panel Gravity Model

As have been extensively discussed in several sections that the

unobserved fixed effects cause serious estimation problem not only in static

model but also in dynamic model. In this section, we discuss the generalized

method of moment (GMM) for estimating the dynamic panel gravity model.

3.4.2.1 Dynamic Panel Gravity Model Formed by Partial Adjustment

Hypothesis

Arellano and Bond (1991) suggested transforming the model either by

first differences or orthogonal deviations, to remove the unobserved fixed

effects and to run it by using the two-step GMM estimator. The second and

higher lags of the endogenous variable in levels are suitable instruments to

80
solve the estimation problem. The dynamic panel gravity models of intra- and

extra-ASEAN trade (equations (3.9) and (3.10), namely) transformed in first

differences are given in equations (3.17) and (3.18 ), respectively.

The resulting dynamic panel gravity model after making first differences on

equation (3.9) is

 exijt  c0  t  c1exij ,t 1  c2 yit  c3y jt  c4 ASEAN ij  eijt (3.17)

And the resulting dynamic panel gravity model after making first differences

on equation (3.10) is

exijt  0  t   1exij ,t 1  2 yit  3y jt

 4 AFTAij  5 EU ij  6 MERCOSURij
(3.18)
 7 NAFTAij  eijt

where  denotes first differences and small letters denote variables in natural

logarithms (except dummy variables). Notice that the first difference

eliminates all time-invariant variables (including  ij ) in both models. The

composite error term  ijt  ij  eijt has been reduced into the well -behaved

error term, eijt . Then, the two-step GMM method can be applied to equations

(3.17) and (3.18).

Although the first-differences-GMM estimator proposed by Arellano and Bond

(1991) has been commonly used in the literature of dynamic panel data

estimations, the proposed method has two drawbacks. First, it cannot be used

to estimate model containing time -invariant variables. Second, when data are

highly persistent, as in the case of bilateral exports flows, the instruments

81
using second and higher lags of the endogenous variable become weak.

Arellano and Bover (1995) and Blundell and Bond (1998) argued that these

problems can be overcome by using the system-GMM estimation, which

supplements the equations in first differences with equations in levels. That is,

the first differences equations are instrumented by the lagged levels and the

equations in levels are instrumented by the lagged differences. Equations

(3.19) and (3.20) are the dynamic panel gravity models of extra-ASEAN trade

in first differenced equation and in level equation, respectively.

 exijt  c0  t  c1exij ,t 1  c2 yit  c3y jt  c4 ASEAN ij  eijt (3.19)

and exijt  c0  t  c1exij ,t 1  c2 yit  c3 y jt  c4 dij  c5adjij

 c6comcolij  c7langij  c8 ASEANij   ijt (3.20)

And, equations (3.21) and (3.22) are the dynamic panel gravity models of

extra-ASEAN trade in first differenced equation and in level equation,

respectively.

exijt  0  t   1exij ,t 1  2 yit  3y jt

 4 AFTAij  5 EU ij  6 MERCOSURij
(3.21)
 7 NAFTAij  eijt

and exijt  0  t   1exij ,t 1  2 yit  3 y jt  4 dij  5adjij

 6comcolij  7langij  8landlockedij  9 AFTAij

(3.22)
 10 EU ij  11MERCOSURij  12 NAFTAij   ijt

82
3.4.2.2 Dynamic Panel Gravity Model Formed by Adaptive Expectation

Hypothesis

We prefer system-GMM estimators rather than differenced GMM

estimators with reasons given above. System-GMM estimators are applied in

dynamic panel gravity model formed by adaptive expectation hypothesis as

well. Following the steps mentioned above, we derived the final versions of

the dynamic panel gravity models as follows. Equations (3.23) and (3.24) are

the dynamic panel gravity models of intra-ASEAN trade in first differenced

equation and in level equation, respectively.

exijt   0  t  1exij ,t 1   2 yi ,t 1   3yit   4 y jt

  5 ASEAN ij  (eijt  eij ,t 1 ) (3.23)

and exijt   0  t  1exij ,t 1   2 yi ,t 1   3 yit   4 y jt

  5 dij   6 adjij   7 comcolij   8langij
(3.24)
  9 ASEAN ij  ( ijt   ij ,t 1 )

Similarly, equations (3.25) and (3.26) are the dynamic panel gravity models of

extra-ASEAN trade in first differenced equation and in level equation,

respectively.

exijt  0  t  1exij ,t 1  2 yi ,t 1  3yit  4 y jt

 10 AFTAij  11EU ij  12 MERCOSURij  13 NAFTAij
(3.25)
 (eijt  eij ,t 1 )

and
exijt  0  t  1exij ,t 1  2 yi ,t 1  3 yit   4 y jt

 5 d ij  6 adjij  7 comcolij  8langij

 9landlocked  10 AFTAij  11 EU ij (3.26)
 12 MERCOSURij  13 NAFTAij  ( ijt   ij ,t 1 )

83
3.5 Data Used in the Research

3.5.1 Data Sources

The sample consists of 43 countries observed for 17 years (1989 -2005) 3 .

Our panel data of bilateral trade flows cons ists, therefore, of 90 trading pairs

(10 × 9) with 1,560 observations (90 × 17) for intra-ASEAN trade, and of 1806

trading pairs (43 × 42), with 30,702 observations (1806 × 17) for extra-

ASEAN trade. The data used contains bilateral export flows of each country

pair, GDPs, population, distance, and several dummy variables including

adjacency, common language, ASEAN membership, common colonizer,

landlocked countries and free trade areas.

The nominal values of bilateral exports are obtained from the International

Monetary Fund (IMF)‟s direction of trade CD-ROM (2006). The data for the

U.S price index (CPI) and nominal GDPs in USD are taken from the World

Economic Outlook (WEO) Database of the IMF‟s site. The value of bilateral

exports and GDPs are converted into constant price USD using the US price

index like CPI using the year 2000 as the base year. The population‟s data are

collected from the IMF‟s International Financial Statistics CD-ROM (2006).

The data for distance, common language, common colonizer, l andlocked

country and adjacency are taken from the online database, available at the

Research Center in International Economics 4 (CEPII)‟s site, available online

(http://www.cepii.fr). The specifications of FTA dummy variables are based

3
For the list of countries, see Table A1 of Appendix A

4
CEPII stands for the Centre D'Etudes Prospectives et D'Informations Internationales. It is

the main independent French institute for resea rch into international economics. CEPII was

established in 1978, consisting of around 30 economists. There are four main research areas:

factor markets and growth; the international financial and monetary system; EU economy;

international trade models.

84
on the data from the online encyclopedia, available at the Wikipedia‟s site

(http://en.wikipedia.org).

3.5.3 Summary Statistics of Data

Some summary statistics of our panel data are reported in Table 3.5.a, and

b. Table 3.5.a illustrates the statistics of bilateral exports of intra-ASEAN,

their GDPs and population both in level and logarithmic form. The first

column of Table 4.1.a shows that the real aggregate trade flows of 10 ASEAN

countries is on average 2,209 million USD. The fact that the minimum value of

the real aggregate trade flows is zero means that at least one country pair has

not traded with each other. More precisely, 273 observations out of the total

1530 observations contain zero export flows.

There are many reasons that give rise to this problem. Firstly, s ome country

pairs have not traded with one another at all during the period of study 5 .

Secondly, there may be zero exports from i to j but positive exports from j to i

for some country pairs. Furthermore, some country pairs trade in both

directions in some years during the period of study. Finally, zero trade flows

may occur due to the data unavailability, but this data source of data problem

accounts relatively small fractions.

In fact, bilateral export flow is a very significant variable served as a

dependent variable of the gravity model for ASEAN trade analysis throughout

this thesis. Despite the fact that the existence of zero trade flows in the

dependent variable may not provide any additional information in explaining

international trade phenomenon, it plays a prominent role in keeping large

sample size. Since our panel data is generated in terms of bilateral trade,

5
We say that a country pair i and j do not trade with one another if i does not export to j and j

does not export to i.

85
dropping one country out of the sample can result in a dramatic decrease in

our observations.

The second and third columns of Table 3.5.a also depict the figures of GDP

and population in terms of their means, standard deviation, minimum and

maximum. One interesting point can be drawn from this is that the maximum

values of GDP and population are substantially higher than their minima,

about 573 times for GDP and 891 times for population. The last three columns

of Table 4.1.a illustrate exports, GDP, and population in logarithmic forms.

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

ASEAN Trade, 1989-2005

Exports GDP Population Distance Ln(Exports) Ln(GDP) Ln(Population) Ln(Distance)

(in millions of (in millions of (in thousands) (Kilometers)
2000 USD) 2000 USD)
Mean 892.18 62734.01 49452.24 8347.10 3.65 10.07 9.81 8.72
Std. deviation 2875.39 66663.90 57621.73 5143.49 2.96 1.68 1.82 0.93
Minimum 0.00 480.70 250.00 76.96 0.00 6.18 5.52 4.34
Maximum 26809.80 275257.70 222780.00 19629.50 10.20 12.53 12.31 9.88

Sources: IMF‟s DOTS Browser, IMF‟s IFS (CD -ROM, 2006), CEPII.

Table 3.5.b presents the statistics of the extra -ASEAN trade including

variables similar to those appeared in Table 3.5.a. However, the former

contains 43 countries whereas the latter includes only 10 ASEAN member

states. The sample of extra-ASEAN trade contains 1703 observations which

have zero trade flows due to similar reasons given above. As can be obviously

seen from the second column of Table 3.5.b, expanding the data set to account

for ASEAN trading partners (43 countries) dramatically widens the gaps

between the highest and lowest value of real GDP as well as population. More

specifically, under the period of examination, the maximum is greater than the

minimum about 22,883 times for GDP and 5,263 times for population.

Summary of statistics of all variables are shown in Table A2 of Appendix A.

86
These variables play significant roles in our gravity model of trade, which we

will be discussed in Chapter 4.

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

ASEAN Trade, 1989-2005

Exports GDP Population Distance Ln(Exports) Ln(GDP) Ln(Population) Ln(Distance)

(in millions of (in millions of (in thousands) (Kilometers)
2000 USD) 2000 USD)
Mean 2208.94 672415.00 98164.78 1610.17 4.84 12.01 10.15 7.26
Std. deviation 9237.19 1524252.00 231950.40 705.98 2.81 1.87 1.65 0.53
Minimum 0.00 480.70 250.00 315.54 0.00 6.18 5.52 5.75
Maximum 266776.00 11000000.00 1315840.00 3023.31 12.49 16.21 14.09 8.01

Sources: IMF‟s DOTS Browser, IMF‟s IFS (CD -ROM, 2006), CEPII.

3.6 Summary

This chapter provides the conceptual framework for formulating and

estimating both static and dynamic panel gravity models. We start with the

cross-section gravity model and then remove the assumption of trade costs‟

equality from country i to j, and vice versa, to allow for the use in panel data

framework. The resulting model is known as „panel gravity model‟.

The panel gravity model has been applied to investigate ASEAN trade which

has been analyzed in two scenarios. First, only ten ASEAN countries are

considered. Second, both ASEAN and its main trading partners have been

added into the data set. ASEAN trade has been evaluated in terms of both

static and dynamic panel gravity models. The former is directly specified from

the modified theoretical gravity model. The latter is specified based on the

partial adjustments and adaptive expectations hypotheses.

In order to overcome the omitted variables bias caused by unobserved trade

costs, both country-pairs and time dummy variables are included into the

model. For static panel gravity model, we apply the error component two -stage

least squares method to overcome the omitted variables bias and the

simultaneity problem resulted from the causal relationship between GDPs and

87
bilateral exports. For dynamic panel gravity model, both REM and FEM yield

biased results since our panel data is constructed with short time period. We

therefore apply system-GMM to estimate the dynamic models. Figure 3-1

illustrates the framework has been discussed through this chapter.

Figure 3.1 Conceptual Framework for Evaluating ASEAN Trade Flows

Theoretical Gravity Model ASEAN Trade

Econometric Models

EC2SLS System-GMM

Static Gravity Models Dynamic Gravity

Models

Intra-ASEAN Extra-ASEAN Intra-ASEAN Extra-ASEAN

Structural Analysis

88
 CHAPTER 4

EMPIRICAL RESULTS AND DISCUSSION

This chapter reports the results of the empirical models which have been

estimated by the econometrics software called „StataSE 10‟ and discusses the

findings. The empirical models have carried out for the intra- and extra-

ASEAN trade in the period 1989-2005, applying the gravity models outlined in

the Chapter 3. Efforts made in the empirical models attempt to clarify the

following research questions:

(1) What are the determinants of ASEAN trade?

(2) Does AFTA significantly have a positive impact on trade of its members?

In other words, has the FTA formed by ASEAN actually increased trade

flows of its member states?

(3) And finally, does the dynamic specification of the gravity model yield

different results compared the static model?

The discussion refers to ASEAN trade flows, the theoretical issues, the prior

research on trade flows discussed in Chapter 2; and to the methodology in

Chapter 3.

Chapter 4 is organized as follows. The results of the determinants of bilateral

export flows in intra- and extra-ASEAN, applying the static panel gravity

models, are discussed in Sections 4.1 and 4.2, respectively. Section 4.3

compares the results obtained from Sections 4.1 and 4.2. The results of the

dynamic panel gravity models for bilateral export flows in intra - and extra-

ASEAN are presented in Sections 4.4 and 4.5, namely. Finally, Section 4.6

summarizes the empirical findings and answers the research questions

mentioned above.

89
4.1 Static Panel Gravity Model of Intra-ASEAN Trade

This section presents the results of the determinants of the bilateral

exports for 10 ASEAN countries over 1989-2005. The empirical model is

based on Equation (3.5). The estimated results are shown in Table 4.1. The

extended gravity model is estimated using seven alternative specifica tions,

which includes seven variables: Exporter‟s GDP, Importer‟s GDP, ASEAN,

Language, Common Colonizer, and Adjacency. Model (i) shows the estimated

coefficients of the basic gravity model which is comprised of the market size

(GDPs) and the geographical Distance. The model estimates the effects of

macroeconomic status among 10 ASEAN countries. Models (ii) to (v) illustrate

the results when each of the variables, such as ASEAN, Language, Common

Colonizer, and Adjacency, is gradually included into the basi c gravity model

(Model (i)), respectively. They investigate the effects of regional trade

integration, cultural factors, historical links, and geographical proximity.

While Model (v) provides the full specification for the static panel gravity

model of the intra-ASEAN trade, Model (vi) is a restrictive one in which its

variables are selectively included based on their statistical significance.

Moreover, all models are estimated using the EC2SLS method.

The results in Table 4.1 depict that almost all of th e estimated coefficients

have the hypothesized signs and are statistically significant. The explanatory

powers of all six models (R 2 ) are also moderately high, recorded between

49%-56%. Moreover, the F-statistics are highly statistical significance at any

conventional levels.

After controlling for country-pair and time effects, most of the variables have

the expected signs. Nonetheless, Distance (in Models (iii) to (vi)) and

Language (in Models (iii) to (v)) are not statistically different from zero .

GDPs are included in estimating Equation (3.5) to capture the impact of the

90
size of economies among ASEAN countries. GDPs of both exporter and

importer are positive and statisticall y significant at the 1% level of

significance in all models except for the importer‟s GDP in Model (i). When

the regional integration variable (ASEAN) is included in Models (ii) to (vi),

the coefficient values of GDPs become larger in Models (ii) to (vi) than in

Model (i). This indicates that the bilateral export flows within ASEAN ar e

influenced by other factors in addition to GDPs. The significantly positive

signs on GDPs suggest that intra-ASEAN trade is strongly oriented toward

capturing its local markets. This implies that the larger the market size in

ASEAN, the greater the bilateral trade flows among them.

The coefficient of Distance is negative and statistically significant at the 10%

level of significance in Model (i) and 5% level in Model (ii). However, it is

not statistically significant in Models (iii) to (vi) . One possible reason for this

is that to some extent the Distance is correlated with the Adjacency, Common

Language, and Common Colonizer (see Table B1 of Appendix B). Thus, the

explanatory power of the Distance has been shifted to these explanatory

variables when they are added. One way to solve this multicollinearity

problem is to drop these three variables out of the model. By doing so,

Equation (3.5) reduces to Model (ii). The Model (ii) is therefore represented

the static panel gravity model of intra -ASEAN trade.

Based on the results estimated by Model (ii) in Table 4.1, GDPs for both

exporter and importer are viewed as income elasticities because bilateral

exports and GDPs are specified in logarithms. That is, the elasticity of

bilateral exports with respect to GDPs of exporter and importer are exp(2.52)

= 12.43% and exp(1.42) = 4.14%, respectively 6 . This implies that the size of

the exporter‟s economy plays more important role than that of the importer‟s

6
The term „exp‟ stands for „exponential‟.

91
economy in driving bilateral exports of intra -ASEAN. Furthermore, the

elasticity of bilateral exports with respect to Distance is exp(1.67) = 5.31%.

That is, a 1% increase in transport cost reduces bilateral export flows by

5.31%. This implies that transport cost is still a key issue to be solved for

promoting intra-ASEAN trade. Finally, the coefficient of ASEAN i s highly

statistical significance at any conventional levels. In fact, it is almost invariant

in Models (ii) to (vi). The significantly positive sign on ASEAN dummy

variable confirms that the formation of ASEAN has really increased trade

flows of its members during the period of study.

In summary, Equation (3.5) examines the determinants of ASEAN trade with

alternative ways of specifications. The GDPs, Distance, memberships of

ASEAN, and Common Colonizer have significant effects on the bilateral

export flows of intra-ASEAN. The full specification of Equation (3.5) led to

the statistical insignificance of Distance‟s coefficient due to the

multicollinearity problem. An alternative specification of Equation ( 3.5) is

Model (ii), which is chosen as the best among others. Throughout this thesis,

the term „best model‟ is used to indicate the estimated model which includes

only important variables that are statistically significant in the previous

specifications in the same table of results.

The empirical results suggest that intra -ASEAN trade is largely determined by

the GDPs of exporter and importer, where the former dominates the latter.

This implies that intra-ASEAN trade is mainly driven by exporting country.

Moreover, one potential challenge of intra -ASEAN trade is the transport costs,

measured by distance. Intra-ASEAN trade reduces more than proportional to

an increase in transport costs. Finally, the regional trading bloc like ASEAN is

essential to enhance growth in regional trade flows.

92
Table 4.1 Determinants of Intra-ASEAN Trade: Static Model

(i) ( ii ) ( iii ) ( iv ) (v) ( vi )

Dependent variable: Common
Ln(exports) Benchmark ASEAN Language colonizer Adjacency
Ln(GDP Exporter) 2.31 2.52 2.46 2.74 2.72 2.71
[ 4.84]*** [ 6.52]*** [ 6.18]*** [ 7.55]*** [ 7.47]*** [ 7.83]***
Ln(GDP Importer) 1.2 1.42 1.36 1.65 1.63 1.62
[ 2.53]** [ 3.67]*** [ 3.41]*** [ 4.54]*** [ 4.47]*** [ 4.67]***
Ln(Distance) -1.42 -1.67 -1.45 -1.00 -0.68 -0.92
[ -1.66]* [ -2.04]** [ -1.62] [ -1.26] [ -0.62] [ -1.25]
ASEAN 1.27 1.28 1.16 1.17 1.16
[ 3.52]*** [ 3.53]*** [ 3.22]*** [ 3.23]*** [ 3.22]***
Language 0.86 -0.34 -0.33
[ 0.67] [ -0.30] [ -0.28]
Common colonizer 4.49 4.36 4.42
[ 4.30]*** [ 4.01]*** [ 4.40]***
Adjacency 0.57
[ 0.43]
Constant -11.46 -14.22 -14.93 -24.19 -26.30 -24.27
[ -1.53] [ -2.17]** [ -2.25]** [ -3.85]*** [ -3.20]*** [ -3.88]***

Groups 90 90 90 90 90 90
Year Periods 17 17 17 17 17 17
Observations 1530 1530 1530 1530 1530 1530
R-squared 0.49 0.50 0.50 0.56 0.56 0.56
Wald Chi-square (k) 293 396.7 398.04 437.9 437.31 438.73
Country-pair effects Yes Yes Yes Yes Yes Yes
Year fixed effects Yes Yes Yes Yes Yes Yes

Notes: a.) *, **, *** denote coefficients significant at 10 %, 5%, 1%, respectively. And t-

statistics are shown in the brackets.

b.) Model (i) represents the basic specification of the gravity model. Model (ii) extends

Model (i) to investigate the trade effect of the formation of ASEAN.

c.) Models (iii) and (iv) extend model (ii) to evaluate the impact of cultural and

historical links, namely. Model (v) provides full specification of Equation (3.5).

d.) Model (vi) is an alternative specification of Model (v) to test whether dropping the

Language and Adjacency can improve the coefficient on Distance.

e.) The term „Yes‟ in the last two rows for Country -pair and Year fixed effects means

that we have controlled for unobserved effects that are time-invariant and time-

varying. The former has been treated as random error whereas the latter has been

treated as fixed parameters to be estimated.

f.) GDPs of both exporter and importer are treated as endogenous variables which are

instrumented by their populations

93
4.2 Static Panel Gravity Model of Extra-ASEAN Trade

This section evaluates extra -ASEAN trade utilizing the static panel

gravity model based on Equation (3.6). The data set used for the empirical

model covers 43 countries of which 30 are members of fo ur FTAs,

respectively, AFTA, EU, MERCOSUR, and NAFTA over 17 years, 1989 -2005.

The estimated coefficients of the determinants of the bilateral exports are

provided in two contexts. Firstly, Equation (3.6) is estimated excluding any

institutional dummy variables as the baseline context. That is, all coefficients

of the FTA dummy variables are assumed to be zero. Secondly, the full

specification of Equation (3.6) is estimated with an attempt to measure the

impact of AFTA on its bilateral export flows . Table 4.2 represents the

restrictive form of Equation (3.6) in which AFTA has no any impact on

bilateral export flows of ASEAN. Table 4.3 provides the full specifica tion of

Equation (3.6) with several alternative specifications.

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

The restrictive form of Equation (3.6) is estimated using five alternative

specifications. The model includes seven variables: Exporter‟s GDP,

Importer‟s GDP, Language, Common Colonizer, Landlocked, and Adjacency.

Model (i) shows the estimated coefficients of the basic gravity model which is

comprised of the market size (GDPs) and the geographical Distance. The

model estimates the effects of macroeconomic status among 43 countries.

Models (ii) to (v) illustrate the results when each of the variables,

respectively, Language, Common Colonizer, Landlocked, and Adjacency, is

gradually included into Model (i). They investigate the effects of cultural

factors, historical links, country‟s physical characteristic, and geographical

proximity. All models are estimated using the EC2SLS method.

94
The results in Table 4.2 show that almost all of the estimated coefficients have

the hypothesized signs and are statistically significant. The explanatory

powers of all five models (R 2 ) are also moderately high, recorded between

60%-61%. Moreover, the F-statistics are highly statistical significance at any

conventional levels. This rejects the null hypothesis that all coefficients are

jointly zero.

Unlike in the static panel gravity model of intra -ASEAN trade, GDPs of both

exporter and importer, and Distance in Table 4.2 are robust to every

alternative model specifications. In other word, their coefficients are invariant

to changes in additional variables. They have expected signs and are highly

statistical significance at any conventional levels. Furthermore, the Language

and Common Colonizer dummy variables are statically significant at 1% l evel

of significance and have expected sign. Nonetheless, the Landlocked and

Adjacency dummy variables are not statically different from zero 7 . The best

model among several alternatives is therefore Model (iii).

According to Model (iii) in Table 4.2, the elasticities of exports from country i

to j with respect to GDPs of exporter is exp(1.62) = 5.05% and of importer is

exp(1.16) = 3.19%, respectively. The estimated coefficients of GDPs imply

that an increase in GDP of either exporter or importer will incr ease bilateral

export flows in ASEAN and its trading partners. Furthermore, the elasticity of

exports from country i to j with respect to Distance is exp(1.06) = 2.89%. The

significantly negative sign of distance implies that a 1% increase in

geographical distance reduces bilateral export flows about 2.89%. Moreover,

the Language dummy variable is statistically significant at 1% level of

7
In fact, there are some multicollinearity problems between Distance and Adjacency, and

between Distance and EU. The correlation matrix of these variables is shown in Table B2 of

Appendix B.

95
significance. It is defined as one if a language is spoken by at least 9 % of the

population in both trading partners. The significantly positive sign of

Language implies that common language matters in promoting ASEAN trade.

Finally, the Common Colonizer dummy variable is statistically significant at

1% level of significance. The highly significant estimate of Common

Colonizer confirms that the historical links among ASEAN and between

ASEAN and its trading partners could have substantially positive impact on

their bilateral export flows.

Based on Model (iii) in Table 4.2, our results illustrate that income elasticities

of trade are completely different from Elliott and Ikemoto (2004) in terms of

magnitudes but are consistent with the previous studies by Martinz -Zarzoso

and Nowak-Lehmann (2003) and Kien and Hashimoto (2005) who support that

controlling the heterogeneous effects in errors is likely to increase the

estimates of GDPs. One possible reason for this is that growth in volume of

exports is partly resulted from unobserved errors that are ignored by the

Pooled OLS 8 .

In summary, there are five factors affecting the extra-ASEAN trade in the

baseline context: exporter‟s GDP, importer‟s GDP, geographical Distance,

Language, and Common Colonizer. Income elasticities of exports are greater

than unities. The geographical distance affects bilateral export flows of

ASEAN almost proportional. Cultural factor (i.e. language) and historical tie

(common colonizer) play a prominent role in shaping ASEAN trade.

8
The term „Pooled OLS‟ is simply similar to an OLS method. It is used when OLS is applied

to estimate the panel data.

96
Table 4.2 Determinants of Extra-ASEAN Trade in the Baseline Context:

Static Model

(i) ( ii ) ( iii ) ( iv ) (v)

Dependent variable: Common
Ln(exports) Benchmark Language colonizer Landlocked Adjacency
Ln(GDP Exporter) 1.64 1.62 1.62 1.61 1.61
[ 29.49]*** [ 29.50]*** [ 29.57]*** [ 29.23]*** [ 29.31]***
Ln(GDP Importer) 1.17 1.16 1.16 1.16 1.15
[ 21.14]*** [ 21.09]*** [ 21.17]*** [ 20.91]*** [ 20.94]***
Ln(Distance) -1.19 -1.13 -1.06 -1.06 -1.05
[-19.54]*** [-18.90]*** [-17.30]*** [-17.28]*** [-15.38]***
Language 1.48 1.37 1.37 1.37
[ 8.41]*** [ 7.65]*** [ 7.67]*** [ 7.53]***
Common colonizer 1.74 1.72 1.70
[ 5.12]*** [ 5.04]*** [ 4.96]***
Landlocked -0.92 -0.94
[ -1.32] [ -1.35]
Adjacency 0.11
[ 0.37]
Constant -6.13 -6.35 -7.08 -7.00 -7.01
[ -5.63]*** [ -5.94]*** [ -6.33]*** [ -6.17]*** [ -6.00]***
Groups 1806 1806 1806 1806 1806
Year Periods 17 17 17 17 17
Observations 30702 30702 30702 30702 30702
R-squared 0.60 0.60 0.61 0.61 0.61
Wald Chi-square (k) 4051.75 4292.82 4381.61 4407.18 4424.59
Country-pair effects Yes Yes Yes Yes Yes
Year fixed effects Yes Yes Yes Yes Yes

Notes: a.) *, **, *** denote coefficients significant at 10%, 5%, 1%, respectively. And t-

statistics are shown in the brackets. Model (i) represents the basic specification of

the gravity model. Models (ii) and (iii) extend model (i) to evaluate the impact of

cultural and historical links, namely. Model (iv) investigates the effect of

landlockedness on bilateral export flows.

b.) Model (v) provides the full specification of Equation (3.6) assumed that there is no

any impact of regional trading blocs on bilateral export flows.

c.) The term „Yes‟ in the last two rows for Country-pair and Year fixed effects means

that we have controlled for unobserved effects that are time -invariant and time-

varying. The former has been treated as random error whereas the latter has been

treated as fixed parameters to be estimated.

d.) GDPs of both exporter and importer are treated as endogenous variables which are

instrumented by their populations.

97
4.2.2 Static Gravity Model of Extra-ASEAN Trade in the FTA context

Section 4.2.1 estimated the restrictive form of Equation (3.6) assuming no

impact of regional trading blocs on trade. This section shows the estimated

results of full specifications of Equation (3.6). However, to see how the model

changes when additional variables are included, seven alternative model

specifications based on Equation (3.6) are provided in Table 4.3. The model

includes 11 variables: Exporter‟s GDP, Importer‟s GDP, Language, Common

Colonizer, Landlocked, Adjacency, AFTA, EU, MERCOSUR, and NAFTA.

Model (i) shows the estimated coefficients of the basic gravity model which is

comprised of the market size (GDPs) and the geographical Distance , after

controlling for the possible effects of regional trading blocs . The model

estimates the effects of macroeconomic status among 43 countries. Models (ii)

to (v) illustrate the results when each of the variables, respectively, Language,

Common Colonizer, Landlocked, and Adjacency, is gr adually included into

Model (i). They investigate the effects of cultural factors, historical links,

country‟s physical characteristic, and geographical distance. Model (v)

represents the full specifications of Equation (3.6). Model (vi) is estimated

based on the selective variables that are statistical significant in the former

models. All models are estimated using the EC2SLS method.

The results in Table 4.3 depict that after controlling for country-pair effects

and time effects, most of the variables have the expected signs except EU and

NAFTA (in Models (i) and (v)). However, Landlocked (in Models (iv) and

(v)), Adjacency (in Models (v)), and MERCOSUR (in all models) are

insignificant. The explanatory powers of all six models (R 2 ) are also

moderately high, recorded between 60% -61%. Moreover, the F-statistics are

highly statistical significance at any conventiona l levels.

98
Table 4.3 Determinants of Extra-ASEAN Trade in the FTA Context: Static

Model

(i) ( ii ) ( iii ) ( iv ) (v) ( vi )

Dependent variable: Common
Ln(exports) Benchmark Language colonizer Landlocked Adjacency
Ln(GDP Exporter) 1.56 1.56 1.58 1.57 1.57 1.59
[ 31.22]*** [ 31.89]*** [ 31.87]*** [ 31.60]*** [ 31.63]*** [ 30.70]***
Ln(GDP Importer) 1.10 1.11 1.12 1.12 1.12 1.13
[ 22.05]*** [ 22.62]*** [ 22.71]*** [ 22.49]*** [ 22.51]*** [ 21.83]***
Ln(Distance) -1.15 -1.10 -1.04 -1.04 -1.04 -1.00
[-19.00]*** [-18.30]*** [-16.89]*** [-16.87]*** [-15.23]*** [-16.30]***
Language 1.48 1.37 1.38 1.38 1.38
[ 8.58]*** [ 7.88]*** [ 7.91]*** [ 7.81]*** [ 7.75]***
Common colonizer 1.44 1.42 1.42 1.53
[ 4.42]*** [ 4.34]*** [ 4.33]*** [ 4.56]***
Landlocked -1.05 -1.05
[ -1.54] [ -1.54]
Adjacency 0.16
[ 0.06]
AFTA 1.34 1.33 1.31 1.31 1.31 1.34
[ 11.61]*** [ 11.54]*** [ 11.42]*** [ 11.41]*** [ 11.41]*** [ 11.65]***
EU -0.34 -0.30 -0.28 -0.28 -0.28
[ -3.70]*** [ -3.31]*** [ -3.07]*** [ -3.08]*** [ -3.08]***
MERCOSUR 0.5 0.39 0.46 0.46 0.45
[ 1.28] [ 0.99] [ 1.17] [ 1.16] [ 1.14]
NAFTA -0.30 -0.41 -0.40 -0.40 -0.40
[ -0.69] [ -0.96] [ -0.92] [ -0.92] [ -0.92]
Constant -4.62 -5.44 -6.35 -6.25 -6.27 -6.99
[ -4.91]*** [ -5.93]*** [ -6.50]*** [ -6.33]*** [ -6.11]*** [ -6.76]***
Groups 1806 1806 1806 1806 1806 1806
Year Periods 17 17 17 17 17 17
Observations 30702 30702 30702 30702 30702 30702
R-squared 0.6 0.61 0.61 0.61 0.61 0.61
Wald Chi-square (k) 4633.97 4977.51 5017.20 5040.27 5049.06 4754.94
Country-pair effects Yes Yes Yes Yes Yes Yes
Year fixed effects Yes Yes Yes Yes Yes Yes

Notes: a.) *, **, *** denote coefficients significant at 10 %, 5%, 1%, respectively.

b.) t-statistics are shown in the brackets.

c.) The term „Yes‟ in the last two rows for Country-pair and Year fixed effects means

that we have controlled for unobserved effects that are time -invariant and time-

varying. The former has been treated as random error whereas the latter has been

treated as fixed parameters to be estimated.

d.) GDPs of both exporter and importer are treated as endogenous variables which are

instrumented by their populations.

99
One of the primary objectives in this thesis is to investigate the impact of

individual RTA membership on trade flows. As obvi ously seen from Table 4.3

that FTA regime affects the regional trading blocs differently. It has had

positive impacts on AFTA and MERCOSUR whereas it has brought negative

impacts on EU and NAFTA. The coefficients of EU and NAFTA contradict to

the expected signs. The former is statistically significant at 1% level of

significance in all models while the latter is not significantly different from

zero even at the 10% significant level. A possible reason for the contradicted

sign of EU might be that only some EU countries are included into the sample

under investigation based on countries being the main trading partners of

ASEAN. Kien and Hashimoto (2005) also found that the coefficient of intra -

EU trade is negative and statistically significant. These mysterious results

might be influenced by other unobserved factors, such as political instability

or regional shocks as indicated by Lee and Park (2005).

In Table 4.3, since the Landlocked, Adjacency, MERCOSUR and NAFTA

dummy variables are not statistically sign ificant at any conventional levels,

dropping them out of the Equation (3.6) has no any effect on the results.

Moreover, since the EU dummy variable provides unexpected sign, dropping it

out of the model will see how other variables will respond to. By doin g so, we

derive Model (vi) which is very similar to Model (iii). Coefficients of GDPs,

Language, Common Colonizer, and AFTA are slightly higher whereas

coefficient of Distance is a little bit lower in Model (vi) than in Model (iii). It

is, therefore, possible to conclude without loss of generality that the best

model for extra-ASEAN trade in the FTA context is Model (vi).

Based on Model (vi) in Table 4.3, the estimates of all explanatory variables

are similar to the baseline context. The estimates of GDPs and Distance are

slightly smaller in the FTA context than in the baseline context. More

precisely, income elasticities of exports with respect to exporter and importer

100
are exp(1.59) = 4.9% and exp(1.13) = 3.1%, respectively. The elasticity of

exports with respect to distance is exp(1) = 2.72%. This implies that transport

costs become less important trade impediment in the FTA context. However,

our result is inconsistent with Kien and Hashimoto (2005) who found that the

coefficients of GDPs and Distance are higher in the FTA context than in the

baseline context.

Moreover, the key variable in Model (vi) is the AFTA dummy variable which

is statistically significant at 1% level of significance. Our result illustrates the

trade creation in AFTA which is similar to Elliott and Ikemoto (2004) and

Kien and Hashimoto (2005). More precisely, the intra -ASEAN trade in the

context of AFTA has increased to a higher level of 1.34, implying that AFTA

members have traded with one another about (exp(1.34)-1)*100 = 281% above

the level predicted in the baseline context. Our estimated coefficient on AFTA

is more than twice larger than that of Kien and Hashimoto (2005), and is

almost three times bigger than that of Lee and Shin (2006). One possible

reason for this is the difference in sample under investigation.

Finally, both Language and Common Colonizer dummy variables in Model (vi)

are statistically significant at 1% level of significance. This implies that both

cultural and historical links matter in strengthening ASEAN trad e.

In summary, the best model representing the extra -ASEAN trade in the FTA

context is Model (vi). Factors determining the extra -ASEAN trade include:

exporter‟s income, importer‟s income, geographical distance, common

language, common colonizer, and AFTA. The removal of the Landlocked,

Adjacency, EU, MERCOSUR, and NAFTA dummy variables from Equation

(3.6) does not result in a loss of the explanatory power of the model. These

variables do not have a significant effect on extra -ASEAN trade.

101
The empirical results suggest that extra-ASEAN exports are largely

determined by the income elasticity of export with respect to exporter. This

implies that exporter plays an important role in promoting growth in regional

trade. The results of this study also show that AFTA is essential to facilitate

ASEAN trade. Furthermore, supporting related -cultural exchange programs

and promoting good historical relationships can greatly improve trade flows in

ASEAN.

4.3 Intra-ASEAN Trade versus Extra-ASEAN Trade

This section compares the results of intra-ASEAN trade (represented by

Model (ii) in Table 4.1 9 ) and extra-ASEAN trade (represented by Model (vi) in

Table 4.3) which have been estimated in Sections 4.1 and 4.2, namely. This

section also provides further discussions and imp lications.

Firstly, intra- and extra-ASEAN trade flows are determined by different

factors. Intra-ASEAN trade is determined by GDP, geographical distance, and

memberships of ASEAN. Extra-ASEAN trade is determined by GDP,

geographical distance, common language, common colonizer, and

memberships of AFTA. Both of them share the same characteristics in that

they are affected by the sizes of the economies, transport costs, and regional

trading bloc. However, extra-ASEAN trade is additionally determined by

cultural links (i.e. common language) and historical ties (i.e. common

colonizer) while intra-ASEAN trade is not.

Secondly, income elasticities of exports in both intra - and extra-ASEAN are

elastic. Intra-ASEAN trade has income elasticity higher than extra -ASEAN

trade. Moreover, income elasticity of exports with respect to exporter is higher

9
Model (ii) is chosen because all basi c gravity variables are statistically significant whereas

the comparable results of Model (vi) are not.

102
than that of the importer. This implies that ASEAN trade is significantly

influenced by its local producers. However, the local markets in ASEAN are

cumulatively small relative to those outside the regional trading blocs. As

shown in Table 2.2 (Chapter 2), ASEAN‟s internal markets can absorb only 23

% of its total exports while external markets absorb 67 % of ASEAN‟s total

exports. Therefore, the strategic trade policy for ASEAN should focus on

improving investment climate in ASEAN to become the regional export -

oriented production hub associated with maintaining and expanding external

markets.

Thirdly, the elasticity of exports in extra-ASEAN with respect to the

geographical distance is smaller than that of intra -ASEAN. This implies that

transport costs become less important as bilateral exports have been expanded

to other regions. A possible reason for this is that more efficient transport

equipments may be available to trade with non-members of ASEAN. This

seems to be true since new ASEAN countries like Cambodia, Laos, Myanmar

and Vietnam, still have poor infrastructure for transportation. Up to this point,

one may infer that transport costs in ASEAN trade can be reduced by

intensively exporting to non -members of ASEAN. However, this will leave

new ASEAN members to stay backward. To solve this problem, old ASEAN

countries like Brunei, Indonesia, Malaysia, the Philippines, Singapore and

Thailand, have a significant role to play in developing trade facilitation in the

new ones. By doing so, ASEAN countries will not only be improved in terms

of the investment climate, but also be enhanced in terms of the

competitiveness of industrial performance of its member countries. As a

consequence, ASEAN as a whole will be ready for competing in the global

market.

Furthermore, another implication of distance is that our result seems to

support the findings of Lee and Shin (2006) who argued that the geographical

103
proximity is important in enhancing trade between members and the rest of the

world. In fact, the geographical proximity is measured by distance and

common land border. In our gravity model of intra -ASEAN trade, since there

is a multicollinearity problem between distance and adjac ency dummy

variable, only distance variable exists in Model (ii) of Table 4.1. The fact that

the negatively significant coefficient of geographical distance is higher in

intra-ASEAN (-1.67) than in extra-ASEAN (-1.00) implies that a 1 % decrease

in transport costs tends to increase around exp(1.67) = 5.37 % for intra-

ASEAN trade and exp(1) = 2.72 % for extra-ASEAN trade. Obviously, the

former is almost twice as large as the latter. To sum up, there is still room for

growth in bilateral trade of ASEAN provid ed that the transportation network

has been improved.

Fourthly, both the common language and common colonizer have an impact in

extra-ASEAN trade but not in intra-ASEAN trade. A possible reason is that

most of the ASEAN countries have their own languages . The coefficient on

language dummy suggests that the more similar the culture in the trading

partners, the more the volume of trade between them. Moreover, the

coefficient of the historical link represented by common colonizer implies that

improving and maintaining historical relationship can contribute to an increase

in ASEAN trade.

Finally, our analysis on export flows aims at evaluating the impact of AFTA

on ASEAN trade associated with other FTA. It is noteworthy that not all FTAs

have positive impact on their members. Having been analyzed four regional

trading blocs, only AFTA and MERCOSUR yield positive effect on trade of

their members. Nonetheless, the MERCOSUR dummy variable is not

statistically different from zero. The other two regional trading b locs, EU and

NAFTA, have negative impact on trade of their members, but the NAFTA

dummy variable is not statistically different from zero.

104
4.4 Dynamic Panel Gravity Model of Intra-ASEAN Trade

This section provides the results of the dynamic panel gravi ty model of

intra-ASEAN trade based on the partial adjustments and adaptive expectations

hypotheses in Equation (3.9) and (3.14), respectively. The first three columns

of Table 4.4.a show the estimated results based on the partial adjustments

hypothesis whereas the last three columns illustrate the estimated results based

on the adaptive expectations hypothesis.

Since the Adjacency and Language dummy variables are not statistically

significant in the static model as well as the dynamic model, they have b een

dropped out of the models considered in this section. As a result, there are six

explanatory variables in the dynamic model based on the partial adjustments

hypothesis: lagged one year of export (EX ij,t-1 ) exporter‟s GDP (Y it ),

importer‟s GDP (Y jt ), geographical distance (D ij ), ASEAN, and common

colonizer. Furthermore, there are seven explanatory variables in the dynamic

model based on the adaptive expectations hypothesis, where six of them are

the same as those in the dynamic model based on the partial adjustments, and

an additional one is the lagged one year of exporter‟s GDP (Y i,t-1 ).

In the partial adjustments and adaptive expectations hypotheses, Model (i) is

specified as the benchmark model; Model (ii) is an extension of Model (i) by

adding the ASEAN dummy variable; and Model (iii) includes the Common

Colonizer dummy variable into Model (ii). The estimated results in Table 4.4.a

show that Chi-square statistics are statistically significant at 1% level of

significance in all models, meaning that the coefficients are jointly significant

in each model.

In order to compare the results between the static model (Model (ii) in Table

3.1) and dynamic models (in Table 4.4.a) , long-run impacts have been reported

105
Table 4.4.a Determinants of Intra-ASEAN Trade: Dynamic Model

Partial Adjustments Adaptive Expectations

Dependent variable: PAI( i ) PAI( ii ) PAI( iii ) AEI( i ) AEI( ii ) AEI( iii )
Common Common
LnEXij,t Benchmark ASEAN Colonizer Benchmark ASEAN Colonizer
LnEXij,t-1 0.56 0.56 0.55 0.56 0.56 0.56
[23.66]*** [23.59]*** [23.39]*** [23.77]*** [23.70]*** [23.51]***
LnYi,t-1 0.76 0.77 0.77
[ 1.98]** [ 2.02]** [ 2.01]**
LnYit 1.33 1.29 1.31 0.60 0.54 0.56
[ 6.16]*** [ 5.86]*** [ 5.64]*** [ 1.40] [ 1.27] [ 1.28]
LnYjt 1.06 1.02 1.05 1.06 1.03 1.05
[ 5.08]*** [ 4.81]*** [ 4.45]*** [ 5.10]*** [ 4.84]*** [ 4.45]***
LnDij -2.28 -2.24 -2.17 -2.34 -2.30 -2.25
[ -2.27]** [ -2.23]** [ -2.10]** [ -2.33]** [ -2.29]** [ -2.18]**
ASEAN 0.32 0.31 0.30 0.29
[ 0.92] [ 0.88] [ 0.87] [ 0.83]
Common Colonizer 0.42 0.32
[ 0.26] [ 0.19]
Constant -1.39 -0.07 -1.07 -0.32 -0.01 -1.46
[ -0.06] [ -0.01] [ -0.13] [ -0.05] [ -0.002] [ -0.18]

Groups 90 90 90 90 90 90
Year Periods 16 16 16 16 16 16
Observations 1440 1440 1440 1440 1440 1440
Wald Chi-square (k) 1267.15 1269.00 1269.00 1284.42 1286.11 1285.86

Notes: a.) *, **, *** denote coefficients significant at 10 %, 5%, 1%, respectively.

b.) t-statistics are shown in the brackets.

c.) Year dummy variables are included into all models.

d.) All models are estimated by system-GMM.

106
Table 4.4.b Long-run Determinants of Intra-ASEAN Trade

Partial Adjustments Adaptive Expectations

Dependent variable: PAI( i ) PAI( ii ) PAI( iii ) AEI( i ) AEI( ii ) AEI( iii )
Common Common
LnEXij,t Benchmark ASEAN Colonizer Benchmark ASEAN Colonizer
LnYit 3.02 2.93 2.91 3.09 2.98 3.02
( 37.95)*** ( 34.34)*** ( 31.81)*** ( 5.88)* ( 5.69)* ( 5.68)*
LnYjt 2.41 2.32 2.33 2.41 2.34 2.39
( 25.81)*** ( 23.14)*** ( 19.80)*** ( 26.01)*** ( 23.43)*** ( 19.80)***
LnDij -5.18 -5.09 -4.82 -5.32 -5.23 -5.11
( 5.15)** ( 4.97)** ( 4.41)** ( 5.43)** ( 5.24)** ( 4.75)**
ASEAN 0.73 0.69 0.68 0.66
( 0.85) ( 0.77) ( 0.76) ( 0.69)
Common Colonizer 0.93 0.73
( 0.07) ( 0.04)
Constant -3.16 -0.16 -2.38 -0.73 -0.02 -3.32
( 0.004) ( 0.00) ( 0.02) ( 0.003) ( 0.00) ( 0.03)

Rate of Adjustments 2.27 2.27 2.22 2.27 2.27 2.27

Note: a.) Calculated from the dynamic models in Table 4.4.a

b.) *, **, *** denote coefficients significant at 10 %, 5%, 1%, respectively. Chi-square

statistics are reported in parentheses. The nul l hypothesis is that the long-run

coefficient is equal to zero.

in Table 4.4.b. After comparing the results, one may conclude that the

predicted long-run impacts are different in the static and dynamic models but

have the same signs.

The dynamic specifications suggest that export is indeed a dynamic process.

The length of adjustment based on the partial adjustments as well as the

adaptive expectations is about 2.27 years. In other word, any innovation exerts

its effect completely in about two years and t hree months. This implies that

both producers and consumers in intra -ASEAN trade seem to respond to any

shock on the levels of production and consumption similarly. Our result

confirms the importance of the dynamic gravity model suggested by

107
Eichengreen and Irwin (1998), Bun and Klaassen (2002), Zarzoso et al. (2009),

and Siah et al. (2009).

According to Table 4.4.b, the corresponding coefficients of each model are

very similar regardless of the hypothesis used to formulate them. The long -run

impact of the exporter‟s GDP is about 2.93 in PAI (ii) and 2.98 in AEI (ii) 10 .

They are slightly higher than the one estimated by Model (ii) in Table 4.1.

Consequently, if the dynamic specification is correct, the static model seems

to slightly underestimate the exporter‟s GDP. Similarly, the static model

seems to underestimate the long-run impact of the importer‟s GDP: the

dynamic models estimate the long-run impact at 2.32 for partial adjustments

and at 2.34 for adaptive expectations, which are much higher than in the static

model. The impact of transport costs based on partial adjustments and adaptive

expectations (measured by distance) is twice as large as the one estimated by

Model (ii) in Table 4.1. Interestingly, however, neither the ASEAN nor the

Common Colonizer dummy variable is statistically different from zero. One

possible reason is that the dynamic characteristic of the dynamic model has

absorbed all of these effects whereas the dummy variables (ASEAN and

Common Colonizer) in the static model are partially ab sorbing the persistent

effect.

In summary, the intra-ASEAN trade in the dynamic context is determined by

the basic gravity variables: GDPs and geographical distance. The empirical

results suggest that trade is indeed a dynamic process. Moreover, the exer tion

of any innovation on intra-ASEAN trade takes about two years and three

months, regardless of whatever the hypothesis is.

10
PAI and AEI stand for the Partial Adjustments Hypothesis of Intra -ASEAN Trade and the

Adaptive Expectations Hypothesis of Intra-ASEAN Trade, respectively.

108
4.5 Dynamic Panel Gravity Model of Extra-ASEAN Trade

This section evaluates extra-ASEAN trade utilizing the dynamic panel

gravity models based on Equations (3.10) and (3.14). The data set used for the

empirical models cover 43 countries of which 30 are members of four FTAs,

respectively, AFTA, EU, , MERCOSUR, and NAFTA over 17 years, 1989 -

2005.

The estimated coefficients of the determinants of the bilateral exports are

provided in two contexts. The first context is that Equations (3.10) and (3.14)

are estimated excluding any institutional dummy variables as the baseline

context. In other word, all dummy variables of FTA are assumed to be zero.

Another context is that the full specifications of Equations (3.10) and (3.14)

are estimated to measure the impacts of AFTA on its bilateral export flows.

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

Context

This section provides the estimated results of the determinants of extra -

ASEAN trade based on Equations (3.10) and (3.14), where all FTAs are

assumed to have no any impact on trade of its members. The results of the

dynamic panel gravity models in the baseline contex t are shown in Table 4.5.a

and 4.5.b for the partial adjustments hypothesis, and in Table 4.6.a and 4.6.b

for the adaptive expectations hypothesis.

Table 4.5.a shows seven alternative specifications of the restrict forms of

Equation (3.10), aiming to find the best model. Almost all variables are

statistically significant. To see these results precisely, the long-run impacts of

the extra-ASEAN trade in the baseline context are calculated in Table 4.5.b.

According to Table 4.5.b, all variables exhibit exp ected signs except for the

Common Colonizer dummy variable (in PAE (iii)). The dynamic specifications

109
suggest that export is indeed a dynamic process. The length of adjustment is

about 1.75 years. That is, any innovation exerts its effect completely in abo ut a

year and nine months. Among several alternative models, PAE (vi) and PAE

(vii) seem to represent the best dynamic panel gravity model s of extra-ASEAN

trade based the partial adjustments hypothesis in the baseline context 11 .

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

Dynamic Model Based on Partial Adjustments Hypothesis

PAE( i ) PAE( ii ) PAE( iii ) PAE( iv ) PAE( v ) PAE( vi ) PAE( vii )

Dependent variable: Common
LnEXij,t Benchmark Language colonizer Landlocked Adjacency
LnEXij,t-1 0.43 0.43 0.43 0.43 0.43 0.43 0.43
[ 71.88]*** [ 71.88]*** [ 71.73]*** [ 71.76]*** [ 71.67]*** [ 71.91]*** [ 71.72]***
LnYit 1.04 1.00 0.91 1.01 1.01 1.00 1.03
[ 32.65]*** [ 28.69]*** [ 23.69]*** [ 28.91]*** [ 28.77]*** [ 28.65]*** [ 31.34]***
LnYjt 0.84 0.81 0.71 0.83 0.83 0.81 0.84
[ 24.53]*** [ 22.13]*** [ 17.52]*** [ 22.44]*** [ 22.42]*** [ 22.28]*** [ 24.23]***
LnDij -0.16 -0.50 -0.53 -0.30 -0.43 -0.60 -0.24
[ -1.33] [ -2.88]*** [ -3.06]*** [ -1.66]* [ -2.34]** [ -3.42]*** [ -1.96]*
Language 1.71 3.18 0.07 1.18 2.51
[ 2.71]*** [ 4.65]*** [ 0.09] [ 1.38] [ 3.80]***
Common colonizer -5.33
[ -5.54]***
Landlocked -13.4 -9.51 -12.89
[ -3.68]*** [ -2.47]** [ -4.32]***
Adjacency 5.27 6.65 4.26
[ 3.07]*** [ 4.11]*** [ 2.75]***
Constant -10.99 -7.39 -4.88 -9.18 -8.42 -7.08 -10.28
[ -7.76]*** [ -3.80]*** [ -2.45]** [ -4.59]*** [ -4.17]*** [ -3.64]*** [ -6.82]***

Groups 1806 1806 1806 1806 1806 1806 1806

Year Periods 16 16 16 16 16 16 16
Observations 28896 28896 28896 28896 28896 28896 28896
Wald Chi-square (k) 13793.40 13801.36 13844.82 13824.72 13808.24 13789.29 13813.24

Notes: a.) *, **, *** denote coefficients significant at 10 %, 5%, 1%, respectively.

b.) t-statistics are shown in the brackets.

c.) Year dummy variables are included into all models.

d.) All models are estimated by system-GMM.

Comparing the static model (Model (iii) in Table 4.2) and the dynamic model

(PAE (vi) in Table 4.5.b), we find that income elasticities of exports with

11
PAE is used to refer to the Partial Adjustments Hypothesis of Extra -ASEAN Trade.

110
respect to exporter and importer are higher in the latter than the former. Again,

if the dynamic specification is correct as suggested by Eichengreen and Irwin

(1998) and Bun and Klaassen (2002), the static model underestimates the

income elasticities of exports. However, both models yield similar results on

the coefficients of distance, which are 1.06 and 1.05 for the static and dynamic

models, respectively. Moreover, the Language dummy variable in the dynamic

model is statistically significant at 1% level of significance, con firming the

positively important impact of cultural similarity on ASEAN trade flows.

Surprisingly, the Adjacency dummy variable appears to be statistical

significance in the dynamic model. This implies that two countries trade more

if they share common land borders.

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

Context: Partial Adjustments Hypothesis

PAE( i ) PAE( ii ) PAE( iii ) PAE( iv ) PAE( v ) PAE( vi ) PAE( vii )

Dependent variable: Common
LnEXi,t Benchmark Language colonizer Landlocked Adjacency
LnYit 1.82 1.75 1.60 1.77 1.77 1.75 1.81
(1066.02)*** ( 823.12)*** ( 561.22)*** ( 835.79)*** ( 827.71)*** ( 820.82)*** ( 982.20)***
LnYjt 1.47 1.42 1.25 1.46 1.46 1.42 1.47
( 601.72)*** ( 489.74)*** ( 306.95)*** ( 503.55)*** ( 502.66)*** ( 496.40)*** ( 587.09)***
LnDist -0.28 -0.88 -0.93 -0.53 -0.75 -1.05 -0.42
( 1.77) ( 8.29)*** ( 9.36)*** ( 2.76)* ( 5.48)** ( 11.70)*** ( 3.84)*
Language 3.00 5.58 0.12 2.07 4.40
( 7.34)*** ( 21.62)*** ( 0.01) ( 1.90) ( 14.44)***
Common colonizer -9.35
( 30.69)***
Landlocked -23.51 -16.68 -22.61
( 13.54)*** ( 6.10)** ( 18.66)***
Adjacency 9.25 11.67 7.47
( 9.42)*** ( 16.89)*** ( 7.56)***
Constant -19.28 -12.96 -8.56 -16.11 -14.77 -12.42 -18.04
( 60.22)*** ( 14.44)*** ( 6.00)** ( 21.07)*** ( 17.39)*** ( 13.25)*** ( 46.51)***

Rate of Adjustments 1.75 1.75 1.75 1.75 1.75 1.75 1.75

Note: a.) Calculated from the dynamic models in Table 4.5.a

b.) *, **, *** denote coefficients significant at 10 %, 5%, 1%, respectively. Chi-square

statistics are reported in parentheses. The null hypothesis is that the long -run

coefficient is equal to zero.

111
Table 4.6.a depicts seven alternative specifications of the restrict forms of

Equation (3.14), aiming to find the best suitab le model under the adaptive

expectations hypothesis. Almost all variables are statistically significant at

least at 10% level of significance. To see these results precisely, the long -run

impacts of the extra-ASEAN trade in the baseline context are calculated in

Table 4.6.b.

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

Dynamic Model Based on Adaptive Expectations Hypothesis

AEE( i ) AEE( ii ) AEE( iii ) AEE( iv ) AEE( v ) AEE( vi ) AEE( vii )

Dependent variable: Common
LnEXij,t Benchmark Language colonizer Landlocked Adjacency
LnEXij,t-1 0.43 0.43 0.43 0.43 0.43 0.43 0.43
[ 71.96]*** [ 71.95]*** [ 71.79]*** [ 71.84]*** [ 71.74]*** [ 71.97]*** [ 71.78]***
LnYi,t-1 0.38 0.38 0.41 0.37 0.36 0.37 0.36
[ 4.86]*** [ 4.91]*** [ 5.22]*** [ 4.79]*** [ 4.66]*** [ 4.71]*** [ 4.64]***
LnYit 0.66 0.61 0.49 0.63 0.64 0.63 0.66
[ 7.85]*** [ 7.19]*** [ 5.63]*** [ 7.40]*** [ 7.47]*** [ 7.35]*** [ 7.81]***
LnYjt 0.84 0.80 0.70 0.82 0.82 0.81 0.84
[ 24.57]*** [ 22.12]*** [ 17.36]*** [ 22.40]*** [ 22.38]*** [ 22.26]*** [ 24.22]***
LnDij -0.15 -0.51 -0.54 -0.32 -0.45 -0.6 -0.24
[ -1.26] [ -2.94]*** [ -3.12]*** [ -1.76]* [ -2.40]** [ -3.44]*** [ -1.92]*
Language 1.80 3.36 0.24 1.28 2.55
[ 2.86]*** [ 4.91]*** [ 0.31] [ 1.50] [ 3.87]***
Common colonizer -5.65
[ -5.86]***
Landlocked -12.76 -9.12 -12.78
[ -3.51]*** [ -2.37]** [ -4.28]***
Adjacency 4.95 6.28 3.86
[ 2.88]*** [ 3.87]*** [ 2.49]**
Constant -11.03 -7.23 -4.58 -8.94 -8.23 -6.95 -10.24
[ -7.78]*** [ -3.72]*** [ -2.30]** [ -4.47]*** [ -4.08]*** [ -3.57]*** [ -6.80]***

Groups 1806 1806 1806 1806 1806 1806 1806

Year Periods 16 16 16 16 16 16 16
Observations 28896 28896 28896 28896 28896 28896 28896
Wald Chi-square (k) 13818.45 13826.82 13873.43 13848.57 13832.41 13814.41 13837.82

Notes: a.) *, **, *** denote coefficients significant at 10 %, 5%, 1%, respectively.

b.) t-statistics are shown in the brackets. Year dummy variables are included into all

models. All models are estimated by system-GMM.

112
As can be seen from Table 4.6.b, all variables exhibit expected signs except

the Common Colonizer dummy variable (in AEE (vi)). The dynami c

specifications show that the length of adjustment is about 1.75 years, which

are the same as what predicted by the dynamic models in Table 4.5.b. Among

several alternative models, AEE (vi) and AEE (vii) are likely to be the best

dynamic panel gravity models of extra-ASEAN trade based the adaptive

expectations hypothesis in the baseline context 12 .

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

Context: Adaptive Expectations Hypothesis

AEE( i ) AEE( ii ) AEE( iii ) AEE( iv ) AEE( v ) AEE( vi ) AEE( vii )

Dependent variable: Common
LnEXij,t Benchmark Language colonizer Landlocked Adjacency
LnYit 1.82 1.74 1.58 1.75 1.75 1.75 1.79
( 85.24)*** ( 75.80)*** ( 58.95)*** ( 77.70)*** ( 77.52)*** ( 76.21)*** ( 82.53)***
LnYjt 1.47 1.40 1.23 1.44 1.44 1.42 1.47
(603.68)*** (489.29)*** (301.37)*** (501.76)*** (500.86)*** (495.51)*** (586.61)***
LnDij -0.26 -0.89 -0.95 -0.56 -0.79 -1.05 -0.42
( 1.59) ( 8.64)*** ( 9.73)*** ( 3.10)*** ( 5.76)** ( 11.83)*** ( 3.69)*
Language 3.16 5.89 0.42 2.25 4.47
( 8.18)*** ( 24.11)*** ( 0.10) ( 2.25) ( 14.98)***
Common colonizer -9.91
( 34.34)***
Landlocked -22.39 -16.00 -22.42
( 12.32)*** ( 5.62)** ( 18.32)***
Adjacency 8.68 11.02 6.77
( 8.29)*** ( 14.98)*** ( 6.20)**
Constant -19.35 -12.68 -8.04 -15.68 -14.44 -12.19 -17.96
( 60.53)*** ( 13.84)*** ( 5.29)** ( 19.98)*** ( 16.65)*** ( 12.74)*** ( 46.24)***

Rate of Adjustments 1.75 1.75 1.75 1.75 1.75 1.75 1.75

Note: a.) Calculated from the dynamic models in Table 4.6.a

b.) *, **, *** denote coefficients significant at 10 %, 5%, 1%, respectively. Chi-square

statistics are reported in parentheses. The null hypothesis is that the long -run

coefficient is equal to zero.

12
AEE is used to refer to the Adaptive Expectations Hypothesis of Extra -ASEAN Trade.

113
Comparing the static model (Model (iii) in Table 4.2) and the dynamic model

(AEE (vi) in Table 4.6.b), we find that income elasticities of exports with

respect to exporter and importer are higher in the latter than the former. Again,

if the dynamic specification is correct as suggested by Eicheng reen and Irwin

(1998) and Bun and Klaassen (2002), the static model underestimates the

determinants of extra-ASEAN trade. Since most of the estimated coefficients

of AEE (vi) are similar those explained in PAE (vi), comparing the static

model and AEE (vi) are the same as provided above.

In summary, the dynamic specifications based on the partial adjustments or

adaptive expectations hypotheses provide similar results. Long -run

determinants of extra-ASEAN trade in the baseline context are GDPs,

geographical distance, language, adjacency, and common colonizer. The

empirical results suggest that extra-ASEAN trade is indeed a dynamic process,

which takes about a year and nine months in order to adjust to the equilibrium.

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

This Section provides the results of extra -ASEAN trade in the FTA

context. The empirical models are based on Equations (3.10) and (3.14). The

estimated coefficients of the dynamic models based on the partial adjustments

hypothesis are illustrated in Table 4.7.a and 4.7.b, whereas those based on the

adaptive expectations hypothesis are depicted in Table 4.8.a and 4.8.b.

Table 4.7.a shows the estimated results of factors affecting extra-ASEAN

trade, assuming to follow the partial adjustments hypothesis. As shown in

Table 4.5.a of Section 4.5.1, models like PAE (vi) and (vii) are considered as

the best. We thus use these models as the benchmark for analyzing ASEAN

trade in FTA context. By doing so, we estimated four alternative mo dels: the

first two columns for PAE (vi) and the last two columns for PAE (vii). Both

PAE (vi) and (vii) are estimated in two contexts: (1) only the AFTA dummy

114
variable is included; and (2) all FTA dummy variables are included. Almost all

variables are statically significant at 1% level. Moreover, the Wald Chi-square

statistics are very high, implying that the coefficients in each model are jointly

statistical significance.

In Table 4.7.a, PAE (vi.a) represents the estimated results of PAE (vi) of Table

4.5.a when the AFTA dummy variable is added. The results are still stable.

However, including additional three FTA variables, such as EU, MERCOSUR,

and NAFTA decreases the magnitude of AFTA‟s coefficient almost by half,

from 0.78 to 0.44, while other key variables remain the same. This implies that

the effect of AFTA on ASEAN trade is reduced in the face of competing with

other regional trading blocs. In other word, AFTA is still young compared to

the other trading blocs. The same explanation is applied to PAE (vii.a) and

(vii.b).

The long-run impacts of the determinants in Table 4.7.a are calculated in

Table 4.7.b. Again, trade is indeed a dynamic process with the length of

adjustment about 1.75 years or a year and nine months.

Among other alternative models, PAE (vi.a) is selected to represent the

dynamic model which is formulated based on the partial adjustment s

hypothesis. This dynamic model is then used to compare with the static model

(vi) of Table 4.3. After comparing, we find that the long-run impacts of

income elasticities of exports with respect to exporter and importer shown in

Table 4.7.b are higher than those estimated in the st atic model (vi) of Table

4.3. Furthermore, it is essential to note that the short -run coefficient of AFTA

is 0.78 (shown in Table 4.7.a) which is twice as small as that of the static

model (which is 1.34). Nonetheless, its long-run impact is the same as what

estimated by the static model, 1.37 and 1.34 for the dynamic and static models,

respectively.

115
Table 4.7.a Determinants of Extra-ASEAN Trade in the FTA Context:

Dynamic Model Based on Partial Adjustments Hypothesis

Dependent variable: Model PAE( vi ): Benchmark Model PAE( vii ): Benchmark

LnEXij,t PAE( vi.a ) PAE( vi.b ) PAE( vii.a ) PAE( vii.b )
LnEXij,t-1 0.43 0.42 0.43 0.42
[ 71.93]*** [ 70.50]*** [ 71.76]*** [ 70.39]***
LnYit 1.03 1.04 1.05 1.06
[ 28.95]*** [ 33.23]*** [ 31.60]*** [ 31.81]***
LnYjt 0.84 0.85 0.86 0.88
[ 22.67]*** [ 22.90]*** [ 24.56]*** [ 24.86]***
LnDij -0.49 -0.74 -0.20 -0.46
[ -2.79]*** [ -3.93]*** [ -1.61] [ -3.23]***
Language 2.09 2.03
[ 3.13]*** [ 2.99]***
Landlocked -11.00 -10.49
[ -3.65]*** [ -3.43]***
Adjacency 7.17 7.39 5.15 5.42
[ 4.41]*** [ 4.53]*** [ 3.29]*** [ 3.41]***
AFTA 0.78 0.44 0.77 0.43
[ 4.25]*** [ 2.27]** [ 4.17]*** [ 2.22]**
EU -0.94 -0.93
[ -5.26]*** [ -5.26]***
MERCOSUR -0.18 -0.11
[ -0.26] [ -0.15]
NAFTA -3.42 -3.34
[ -3.37]*** [ -3.31]***
Constant -8.60 -6.64 -11.21 -9.16
[ -4.35]*** [ -3.19]*** [ -7.36]*** [ -5.52]***

Groups 1806 1806 1806 1806

Year Periods 16 16 16 16
Observations 28896 28896 28896 28896
Wald Chi-square (k) 13806.75 13900.68 13826.99 13919.11

Notes: a.) *, **, *** denote coefficients significant at 10 %, 5%, 1%, respectively.

b.) t-statistics are shown in the brackets.

c.) Year dummy variables are included into all models.

d.) All models are estimated by system-GMM.

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

Context: Partial Adjustments Hypothesis

Dependent variable: Model PAE( vi ): Benchmark Model PAE( vii ): Benchmark

LnEXij,t PAE( vi.a ) PAE( vi.b ) PAE( vii.a ) PAE( vii.b )
LnYit 1.81 1.79 1.84 1.83
( 838.10)*** (1104.23)*** ( 998.56)*** (1011.88)***
LnYjt 1.47 1.47 1.51 1.52
( 513.93)*** ( 524.41)*** ( 603.19)*** ( 618.02)***
LnDij -0.86 -1.28 -0.35 -0.79
( 7.78)*** ( 15.44)*** ( 2.59) ( 10.43)***
Language 3.67 3.50
( 9.80)*** ( 8.94)***
Landlocked -19.30 -18.09
( 13.32)*** ( 11.76)***
Adjacency 12.58 12.74 9.04 9.34
( 19.45)*** ( 20.52)*** ( 10.82)*** ( 11.63)***
AFTA 1.37 0.76 1.35 0.74
( 18.06)*** ( 5.15)*** ( 17.39)*** ( 4.93)**
EU -1.62 -1.60
( 27.67)*** ( 27.67)***
MERCOSUR -0.31 -0.19
( 0.07) ( 0.02)
NAFTA -5.9 -5.76
( 11.36)*** ( 10.96)***
Constant -15.09 -11.45 -19.67 -15.79
( 18.92)*** ( 10.18)*** ( 54.17)*** ( 30.47)***

Rate of Adjustments 1.75 1.72 1.75 1.72

Note: a.) Calculated from the dynamic models in Table 4.7.a

b.) *, **, *** denote coefficients significant at 10 %, 5%, 1%, respectively. Chi-square

statistics are reported in parentheses. The null hypothesis is that the long -run

coefficient is equal to zero.

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Table 4.8.a illustrates the estimated results of the determina nts of extra-

ASEAN trade, assuming to follow the adaptive expectations hypothesis.

Similar to Table 4.7.a, we use AEE (vi) and (vii) from Table 4.6.a as the

benchmark for analyzing ASEAN trade in FTA context. The long -run impacts

of the determinants in Table 4.8.a are calculated in Table 4.8.b. The length of

adjustment is about 1.75 years or a year and nine months.

Among others, Model AEE (vi.a) is chosen to compare with the static model

(Model (vi) in Table 4.3). We then focus on the magnitude of the coef ficient

of AFTA. In short run, coefficient of AFTA is 0.74 (shown in Table 4.8.a)

which is twice as small as that of the static model (which is 1.34).

Nonetheless, its long-run impact is the same as what estimated by the static

model, 1.30 and 1.34 for the dynamic and static models, respectively.

In summary, several alternative specifications of the dynamic panel gravity

models in the FTA context provide similar results regardless of what

hypothesis is used to formulate them. The determinants of ASEAN trade in the

dynamic models are GDPs, transport costs (distance), cultural similarity

(language), historical links (common colonizer), common border (adjacency),

and memberships of AFTA. Since ASEAN trade is indeed a dynamic process,

any shock to the model leads to the adjustment toward the equilibrium within a

year and nine months.

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Table 4.8.a Determinants of Extra-ASEAN Trade in the FTA Context:

Dynamic Model Based on Adaptive Expectations Hypothesis

Dependent variable: Model AEE( vi ): Benchmark Model AEE( vii ): Benchmark

LnEXij,t AEE( vi.a ) AEE( vi.b ) AEE( vii.a ) AEE( vii.b )
LnEXij,t-1 0.43 0.42 0.43 0.42
[ 71.99]*** [ 70.54]*** [ 71.82]*** [ 70.43]***
LnYi,t-1 0.37 0.37 0.36 0.36
[ 4.70]*** [ 4.72]*** [ 4.65]*** [ 4.66]***
LnYit 0.66 0.67 0.68 0.69
[ 7.63]*** [ 7.79]*** [ 8.04]*** [ 8.20]***
LnYjt 0.84 0.85 0.86 0.88
[ 22.61]*** [ 22.86]*** [ 24.53]*** [ 24.85]***
LnDij -0.50 -0.75 -0.20 -0.46
[ -2.85]*** [ -3.97]*** [ -1.59] [ 3.22]***
Language 2.15 2.08
[ 3.23]*** [ 3.07]***
Landlocked -10.99 -10.39
[ -3.64]*** [ -3.40]***
Adjacency 6.76 7.01 4.70 5.02
[ 4.16]*** [ 4.29]*** [ 3.00]*** [ 3.15]***
AFTA 0.74 0.39 0.73 0.38
[ 4.03]*** [ 2.03]** [ 3.97]*** [ 1.99]**
EU -0.95 -0.95
[ -5.37]*** [ -5.38]***
MERCOSUR -0.26 -0.19
[ -0.37] [ -0.27]
NAFTA -3.42 -3.33
[ -3.37]*** [ -3.30]***
Constant -8.43 -6.45 -11.13 -9.08
[ -4.21]*** [ -3.10]*** [ -7.30]*** [ -5.47]***

Groups 1806 1806 1806 1806

Year Periods 16 16 16 16
Observations 28896 28896 28896 28896
Wald Chi-square (k) 13830.51 13927.62 13850.43 13945.69

Notes: a.) *, **, *** denote coefficients significant at 10%, 5%, 1%, respectively.

b.) t-statistics are shown in the brackets. Year dummy variables are included into all

models. All models are estimated by system-GMM.

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

Context: Adaptive Expectations Hypothesis

Dependent variable: Model AEE( vi ): Benchmark Model AEE( vii ): Benchmark

LnEXij,t AEE( vi.a ) AEE( vi.b ) AEE( vii.a ) AEE( vii.b )
LnYit 1.81 1.79 1.82 1.81
( 80.31)*** ( 82.96)*** ( 86.26)*** ( 88.96)***
LnYjt 1.47 1.47 1.51 1.52
(511.21)*** (522.58)*** (601.72)*** (617.52)***
LnDij -0.88 -1.29 -0.35 -0.79
( 8.12)*** ( 15.76)*** ( 2.53) ( 10.37)***
Language 3.77 3.59
( 10.43)*** ( 9.42)***
Landlocked -19.28 -17.91
( 13.25)*** ( 11.56)***
Adjacency 11.86 12.09 8.25 8.66
( 17.31)*** ( 18.40)*** ( 9.00)*** ( 9.92)***
AFTA 1.30 0.67 1.28 0.66
( 16.24)*** ( 4.12)*** ( 15.76)*** ( 3.96)***
EU -1.64 -1.64
( 28.84)*** ( 28.94)***
MERCOSUR -0.45 -0.33
( -0.14) ( -0.07)
NAFTA -5.90 -5.74
( 11.36)*** ( 11.36)***
Constant -14.79 -11.12 -19.53 -15.66
( 17.72)*** ( 9.61)*** ( 53.29)*** ( 29.92)***

Rate of Adjustments 1.75 1.72 1.75 1.72

Note: a.) Calculated from the dynamic models in Table 4.8.a

b.) *, **, *** denote coefficients significant at 10 %, 5%, 1%, respectively. Chi-square

statistics are reported in parentheses. The null hypothesis is that the long -run

coefficient is equal to zero.

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4.6 Summary

This chapter analyzes ASEAN trade applying both static and dynamic

panel gravity models. The determinants of intra-ASEAN trade include GDPs,

transport costs, membership of ASEAN, and historical links. The determinants

of extra-ASEAN trade consist of GDPs, transport costs, cultural similarity,

historical links, and membership of AFTA.

Based on the estimated results of both static and dynamic models, AFTA is

confirmed to have a positive impact on ASEAN trade. In other word, AFTA

plays an important role in enhancing the regional trade. However, AFTA effect

is decreased in the face of other regional trading blocs.

The coefficients estimated by the dynamic panel gravity models are larger than

those estimated by the static models. The fact that lagged export is statistically

significant indicates the importance of the dynamics of the panel gravity

models. ASEAN trade is indeed a dynamic process which adjusts toward the

equilibrium about two years and three months for intr a-ASEAN trade and

about a years and nine months for extra -ASEAN trade. The reasons why they

adjust differently are required for further research.

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 CHAPTER 5

CONCLUSIONS AND POLICY IMPLICATIONS

This chapter summarizes the empirical results and further issues required to be

studied. Section 5.1 discusses the conclusions drawn from the empirical

results. Section 5.2 presents the policy implications of the research findings.

Section 5.3 identifies the limitations of the study. Section 5.4 discusses the

contribution of the thesis and Section 5.5 provides suggestions for future

research.

5.1 Summary and Empirical Results

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 ASEAN‟s 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, 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 proces s at least in theory, there

are very few literatures on ASEAN trade applying the dynamic gravity model.

122
Thus, examining the determinants of trade in the static and dynamic frameworks

is an important element to obtain accurate results for drawing policy

implications.

The primary objectives of this study are to investigate the determinants of

ASEAN trade; and to evaluate the effect of AFTA on trade flows of its

members. In addition, this study also introduces the formulation of the

dynamic panel gravity model based on economic hypotheses.

The first and second research objectives are provided by utilizing the static

gravity models in panel data framework, covering the time period of 1989 -

2005 and 43 trading partners. The third objective develops the static p anel

gravity model into the dynamic one based on the partial adjustments and

adaptive expectations hypotheses. Both static and dynamic models are

conducted in two scenarios: intra -ASEAN trade and extra-ASEAN trade.

The explanatory variables in the analysis of intra-ASEAN trade include GDP,

Distance, and dummy variables of Language, Common Colonizer, ASEAN and

Adjacency. The explanatory variables in the analysis of extra-ASEAN trade

consist of GDP, Distance, dummy variables of Language, Common Colonizer,

Landlocked, RTAs (AFTA, EU, MERCOSUR, and NAFTA) and Adjacency.

Estimating the static gravity model using in the form of the mixed-error

component model using the EC2SLS and the dynamic model using the system -

GMM yields plausible results. The empirical results support the claim that the

gravity model can be used to investigate factors determining intra - and extra-

ASEAN trade.

Table 5.1 illustrates the summary of the estimated results of the intra - and

extra-ASEAN trade models both in static and dynamic models. There are three

points needed to be highlighted. First, factors determining intra-ASEAN trade

123
are less than those determining extra -ASEAN trades. Second, the dynamic

model appears to have more statistically significant variables than the static

model. Third, the dynamic model formulated on the hypothesis of partial

adjustments is similar to the one formulated on the hypothesis of adaptive

expectations. Table 5.1 summarizes the estimated results of ASEAN trade as

follows:

 GDP, Distance, Common Colonizer, and ASEAN are found to be significant

in intra-ASEAN trade. The model reveals that intra-ASEAN bilateral trade

flows are influenced by the market sizes of the ASEAN members, transport

costs, historical links, and RTA.

 GDP, Distance, Language, Common Colonizer, Adjacency, Landlocked,

AFTA, EU, and NAFTA are found to be significant in extra -ASEAN trade.

The model shows that extra-ASEAN bilateral trade flows are influenced by

the market sizes of ASEAN and its trading partners, as well as transport

costs, cultural and historical links, country‟s physical characteristics and

RTAs.

 The models suggest that market sizes both in ASEAN and in its main trading

partners play an important role in determining the bilateral trade flows in

ASEAN. This implies that ASEAN trade is driven not only by ASEAN

economies, but is also influenced by their trading partners.

 The key dummy variable, AFTA, exhibits to have a positive impact on

ASEAN trade; and its result is robust in all models (both in static and

dynamic models). This shows that AFTA has increased trade flows of its

members.

 Only the dummy variables of Adjacency and Landlocked in the dynamic

models appear to have an impact on ASEAN trade. This seems to be that the

dynamic model outperforms the static model.

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

ASEAN Trade

Static Gravity Models Dynamic Gravity Models

Variables Intra-ASEAN Extra-ASEAN Intra-ASEAN Extra-ASEAN
Partial Adaptive Partial Adaptive
Adjustments Expectations Adjustments Expectations
(1) (2) (3) (4) (5) (6)
Exporter's GDP + + + + + +
Importer's GDP + + + + + +
Distance - - - - - -
Language 0 + + +
Common Colonizer + + 0 0
Landlocked 0 - -
Adjacency 0 0 + +
ASEAN + 0 0
AFTA + + +
EU - - -
MERCOSUR 0 0 0
NAFTA 0 - -

Notes: a.) The static gravity model of intra -ASEAN trade (column (1)) is based on Models

(ii) and (iv) of Table 4.1.

b.) The static gravity model of extra-ASEAN trade (column (2)) is based on Model

(iii) of Table 4.3.

c.) The dynamic gravity model by the partial adjustments hypothesis of intra -ASEAN

trade (column (3)) is based on PAI ( iii) of Table 4.4.b.

d.) The dynamic gravity model formulated by the adaptive expectations hypothes is of

intra-ASEAN trade (column (4)) is based on AEI (iii) of Table 4.4.b.

e.) The dynamic gravity model formulated by the partial adjustments hypothesis of

extra-ASEAN trade (column (5)) is based on PAE (vi.b) and (vii.b) of Table

4.7.b.

f.) The dynamic gravity model formulated by the adaptive expectations hypothesis of

extra-ASEAN trade (column (6)) is based on AEE (vi.b) and (vii.b) of Table

4.8.b.

g.) (+), (-) and (0) represent positive, negative and no significant effect, respectively.

h.) Variables that are excluded from the models are left blanks.

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5.2 Policy Implications of the Research Findings

The findings of this study have important implications for policy makers

and investors both inside and outside ASEAN. The findings obtain some

suggestions for policy makers to enhance and to sustain bilateral trade flows in

ASEAN.

With respect to trade determinants, the empirical results identify structural

differences between intra- and extra-ASEAN trades, where the latter is

determined by more factors than the former. One of the commonly determining

factors between them is GDPs of exporter and importer. Both intra- and extra-

ASEAN trade analyses show that income elasticity of export is higher with

respect to the exporter than the importer. This e vidence is confirmed not only

by the static models, but also by the dynamic models. The fact that the higher

income elasticity of export with respect to exporter compared to importer

suggests that ASEAN exports are largely determined by the GDP of the

export-oriented economies rather than by that of the import-oriented ones. In

other words, any change in income of the exporter has stronger influence on

ASEAN bilateral exports than that of the importer. This implies that if the

investment climate can be improved, ASEAN bilateral exports will also be

increased more than proportional to any positive shock of exporter‟s GDP. As

a result, there is a room for ASEAN to become one of the successful exporters

in the global market. This success may be seen as an increase in ASEAN

export flows. These flows can be potentially generated by ASEAN‟s

economies. In other words, ASEAN trade is partially driven by the supply -side

(GDP of exporter) of ASEAN itself, where this driving force seems to

dominate other factors affecting ASEAN tr ade flows. If this is the case,

ASEAN economies can be developed by means of exports -led-growth. The

strategic trade policy for ASEAN should therefore focus on improving

investment climate in ASEAN to become the regional export -oriented

126
production hub associated with maintaining and expanding external markets.

Furthermore, supporting related-cultural exchange programs and promoting

good historical relationships can greatly improve trade flows in ASEAN. The

combining effects generated by the bidirectional causal relationships between

GDP and trade in ASEAN may become one of the main engines in driving

ASEAN into global market successfully.

With respect to the regional integration, not all FTAs have positive impact on

their members in the sample under investigation. The empirical findings show

that AFTA is essential to enhance ASEAN trade. The findings also indicate

that intra-ASEAN trade may be greatly improved provided that transport costs

(measured by distance) can be brought down. This means that ASEAN trade is

facing two contradicting factors: trade enhancing factor like AFTA and trade

impeding factor like transport costs. Reducing transport costs by means of

developing land transportation network, for example, is a very challenging

task for less developed countries like new ASEAN members (Cambodia, Laos,

Myanmar, and Vietnam). As a result, in order to reap the maximum benefit

brought by AFTA, old ASEAN countries like Brunei, Indonesia, Malaysia, the

Philippines, Singapore and Thailand, have an important ro le to play in

developing trade facilitation of the new ones. In other words, ASEAN trade

can be improved by means of comprehensive development of the land transport

infrastructure, especially among least developed ASEAN economies .

5.3 Limitations of the Study

There are limitations in this study due to the data set, the estimation

techniques, and the variables used.

Although the panel data sample is relatively large, some missing data appear

in the data set, especially for the least developed countries . The availability of

these data would improve the research results.

127
The multicollinearity problem in intra -ASEAN trade models results in difficult

model specifications. Although solving this problem by providing several

alternative specifications, selecting the best model requires more sophisticated

econometric techniques like Monte Carlo simulation.

There are many estimation methods for panel data model and each of them

seems to provide different results. Deciding which method is the most

appropriate is difficult. Moreover, the consistent estimation method for panel

gravity model is limited by its variables like time-invariant variables.

As shown in Table 5.1, the ASEAN dummy variable is not significantly

different from zero in the dynamic model, whereas it is statistically significant

in the static model. Furthermore, the dummy variables of EU and NAFTA in

the dynamic model are statistically significant but show unexpected signs.

These inconsistent results should be interpreted with caution. It may be

essential to estimate the model in terms of both static and dynamic frameworks

to yield comparable results.

The FTA dummy variable is partially influenced by the institutional factors

like government and positive trend of trade prior to the formation of regional

trading bloc. Treating it as exogenous variable may lead to bias the estimated

result.

5.4 Contribution to the Related Studies

The previous studies on ASEAN focus on factors such as GDP, exchange

rate, geographical distance, adjacency, common language, and regional trading

blocs affect intra- and extra-ASEAN trades (see Elliott and Ikemoto, 2004;

Kien and Hashimoto, 2005; Hapsari and Mangunsong, 2006). These studies

largely applied OLS to estimate the static gravity model, except for Kien and

Hashimoto (2005) who applied the Hausman-Taylor estimation method to their

128
model. One potential problem associated with the application of OLS on panel

data model is that it cannot account for the error component that are time -

invariant and time-varying in the model. To address this issue, this study

utilizes the static gravity model in mixed error -component form to investigate

the determinants of intra- and extra-ASEAN trades. The model is then

estimated by the error-component two-stage least square method. By doing so,

our model can account for at least two potential problems. First, in panel data

model, ignoring the unobserved time -varying effects and the unobserved

country-pair specific effects can lead to serious estimation problems. We solve

this problem by applying the mixed error-component form for the gravity

model. This is done by treating the unobserved time -varying as fixed

parameters to be estimated and the unobserved country-pair effects as random

error terms. Second, the endogeneity problem that may occ ur due to the causal

relations between GDP and export can be overcome by estimating the model

with the two-stage least square method. Taking together the first and second

issues, the gravity model in the mixed -error component form which is

estimated by the EC2SLS provides plausible results, at least in theory.

Moreover, there are very few literatures analyzing trade flows applying the

dynamic panel gravity model. In order to formulate the dynamic gravity

model, some authors directly introduced lagged bilat eral exports (trade) into

the static panel gravity model (i.e., Eichengreen and Irwin, 1998; Zarzoso et

al., 2009); and some specified the model based on the autoregressive

distributed lag model (i.e., Bun and Klaassen, 2002). In the case of ASEAN

trade analysis, only Siah et al. (2009) applied the dynamic gravity model. The

model is formulated based on ARDL. But this study examined only 5 ASEAN

countries and estimated the dynamic gravity model country by country. That

is, each country was estimated separat ely using time series data. The dynamic

gravity model applied in this thesis is different from the previous studies in

that our model is formulated based on the two dynamic specification

129
hypotheses: partial adjustment and adaptive expectations hypotheses. This

allows us to explain the results obtained from the dynamic model in the

perspectives of both producer (implied by partial adjustment hypothesis) and

consumer (implied by adaptive expectation hypothesis).

5.5 Suggestions for Future Research

To improve the empirical models and results of this study, this section

provides some recommendations for further research. There is still limited

number of studies on ASEAN trade, applying the panel gravity model. In this

study, the extended static and dynamic pan el gravity models are employed to

evaluate the bilateral trade flows among ASEAN and its members over 1989 -

2005. The following issues may require to be addressed for future study.

Firstly, our empirical results show that there are some inconsistent result s

estimated by the static and dynamic models. Further study should investigate

rigorously to decide which one is preferred, using more sophisticated

econometric techniques like Monte Carlo simulation.

Secondly, analyzing trade flows containing zeros in the panel data framework

is important not only for keeping a large number of observations, but also for

exploiting additional information from them. To do so, the binary panel data

models like Probit or Tobit model, are necessary as suggested by Helpman et

al. (2008).

Thirdly, the possible endogeneity problem of the FTA dummy variable should

be accounted for by some econometric methods. It may be interesting to

perform the simulation to measure the extent of bias due to endogeneity

problem in the gravity model.

130
Finally, the panel data set of trade flow analysis should be extended into

longer time frame to allow for the application of the time series panel

econometrics. This can pave the way for new direction of the gravity model

development.

131
 APPENDIX

Appendix A

Table A1 Members and Non-members of RTAs Used in the Analysis

Agreement Members Date of

Entry
AFTA ASEAN Free Brunei Darussalam, Cambodia, Indonesia, Laos, 1992
Trade Area Malaysia, Myanmar, the Philippines, Singapore,
Thailand, and Vietnam
EU European Union Austria, Denmark, Finland, France, Germany, Greece, 1993
Ireland, Italy, the Netherlands, Portugal, Spain, Sweden,
and UK

MERCOSUR Souther Common Argentina, Brazil, Paraguay, and Uruguay 1991

Market

NAFTA North American Canada, Mexico and the United States 1994
Free Trade
Agreement

Non-members of any RTAs

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

Table A2 Summary of Statistics for Intra- and Extra-ASEAN Trade

(1989-2005)

(1) Intra-ASEAN (2) Extra-ASEAN

(N = 1,530) (N = 30,702)
Mean S.D. Mean S.D.
Log of Exports 14.725 7.465 17.715 5.190
Log of GDP 10.069 1.681 12.008 1.871
Log of Distance 7.263 0.532 8.720 0.933
Common Language 0.178 0.382 0.118 0.323
Common Colonizer 0.200 0.400 0.034 0.182
Landlocked 0.007 0.081
Adjacency 0.244 0.430 0.051 0.220
ASEAN 0.678 0.467
AFTA 0.031 0.172
EU 0.062 0.241
MERCOSUR 0.006 0.076
NAFTA 0.002 0.048

132
Appendix B

Table B1 Correlation Matrix of Variables for Intra -ASEAN Trade

Log of GDP Log of Population Log of Distance Adjacency Language Common colonizer ASEAN
Log of GDP 1.000
Log of Population 0.534 1.000
Log of Distance 0.136 0.096 1.000
Adjacency -0.082 0.003 -0.727 1.000
Language 0.188 -0.156 -0.289 0.277 1.000
Common colonizer -0.170 -0.221 -0.274 0.362 0.203 1.000
ASEAN 0.314 0.032 0.062 -0.012 0.262 -0.020 1.000

133
Table B2 Correlation Matrix of Variables for Extra-ASEAN Trade

Log of GDP Log of Population Log of Distance Adjacency Language Common colonizer Landlocked AFTA EU MERCOSUR NAFTA
Log of GDP 1.000
Log of Population 0.535 1.000
Log of Distance -0.017 0.023 1.000
Adjacency -0.016 0.050 -0.466 1.000
Language 0.074 0.027 -0.103 0.196 1.000
Common colonizer -0.139 -0.012 -0.221 0.205 0.138 1.000
Landlocked -0.075 -0.071 0.010 0.043 0.012 -0.015 1.000
AFTA -0.151 -0.029 -0.273 0.152 0.060 0.157 -0.015 1.000
EU 0.126 -0.061 -0.428 0.093 -0.074 -0.048 -0.021 -0.046 1.000
MERCOSUR -0.037 -0.016 -0.140 0.273 0.091 -0.015 -0.006 -0.014 -0.020 1.000
NAFTA 0.059 0.039 -0.058 0.136 0.082 -0.009 -0.004 -0.009 -0.012 -0.004 1.000

134
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