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International trade, convergence and integration

Authors:
International trade, convergence and integration
Jianhong Zhang
University of Groningen
Eighth Meeting of the European Trade Study Group
Vienna, September 7th - 9th 2006
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International trade, convergence and integration
Abstract
This study develops a staging framework to predict the trade-convergence relation, which
harmonizes the contradicting results from existing studies. By using Granger-causality and
cointegration approaches, the study investigates the long-run relationship and two-way causal link
between international trade and convergence in three trade blocs, EU, ASEAN and NAFTA. The
empirical estimation results support our hypotheses, that is, the long-run and causality relation
between trade and convergence depends on the developmental stage of the countries concerned.
Specifically, if a country is at the stage of low developmental, free trade is associated with income
divergence between this country and its poor and rich trade partners; causality is bilateral, trade
causes divergence, and divergence causes trade. When a country surpasses a certain developmental
level, its trade with other countries in the same stage is associated with income convergence between
these countries; causality is bilateral, trade causes convergence, and convergence causes trade. Based
on these findings, the paper discusses the policy implications.
Key words:
International trade, convergence, divergence, causality, regional integration, cointegration.
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1. Introduction
While some economists argue that free trade enables developing country to gain more in terms of
social progress and eradication of poverty (Wolf 2004), anti-globalization protesters claim that the
free traders steal the developing world’s natural resources, wreck its environment and treat its
workers like slaves. The protesters damn free trade making the rich to get richer at the expense of the
poor (Newstatesman, 28 February 2005). Positive and negative effects of free trade have been
debated by economists, politicians and socialists for a long time. Although the static gains from trade
and losses from protection have been thoroughly established in trade theory, greater openness trends
on the one hand and the increasing income gaps between poor and rich on the other hand, has been
a source of heated debate on free trade- convergence relation.
The purpose of this paper is to investigate bilateral trade-convergence relation in both long run and
short run. Based on the existing studies, this study figures out the mechanism of the free trade and
development in difference development stages. By using three cases, the study investigates the long
run relationships and casual links between regional trade integration and regional convergence.
The literature on the relation of international trade and income convergence across economies has
proliferated in the past few decades. However, in both theoretical and empirical studies, the findings
are hardly conclusive. The literature review in this study shows that there are multi-dimension forces
driving the convergences towards different directions. However, existing studies normally have their
own assumptions and incorporate only a part of the forces in their models. As a result, these studies
found inconsistent evidences for trade-convergence relation. Therefore, any unconditional
hypotheses about the effect of trade on inequality make no sense. In addition, the existing studies fail
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to identify the two-way causality between trade and convergence1. Most studies only examine the
effect of trade on convergence by using regression and ignore the effect of convergence on trade.
Technically, the estimation may not be consistent unbiased due to the likelihood of two-way causality
(Rassekh 2004: 379). This study contributes to the literature by filling these gaps. First, this study
creates a staging framework to predict the effect of trade on income disparity across countries, which
harmonized the contradiction results from existing studies. Second, by using Granger-causality and
cointegration approaches, the study investigate the long term relationship and two-way causal link
between international trade and convergence. In order to test the hypotheses sourced from staging
framework, the paper exams the causality relation between regional trade integration and
convergence by using three cases, EU, ASEAN and NAFTA. In addition, the study also investigates
the relationship by using a large sample of countries as a reference.
Next section discusses theoretical links between trade and convergence. Section 3 presents a
conceptual framework and hypotheses. Section 4 describes the empirical model and estimation
methodology. Section 5 and 6 present and discuss the results of the empirical analyses. The last
section contains some concluding remark and policy implications.
2. Literature review
Causality from trade to convergence
Theoretical studies on trade-growth relationships mainly focus on two sequent questions. First
question is, does international trade have level and/or growth effect on national output (income)? By
and large, theoretical models agree upon that international trade increase income level and growth
1 As far as I know, there is one study ( Cyrus 2004) addressed two-way causality between trade and
convergence. But the methods used in this study are not convincing. First, the regression models used to test
causality fail to include lags. Second, it is questionable to use every five-year data to do causality test.
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rate (Rodrik 1996, Corden 1971, Rivera-Batiz and Rommer 1991, Grossman and Helpman 1990). 2
Then the second question is, does the growth effect is the same between the lower- and higher-
income economics? This question is directly related to this study, answering if trade has effect on
convergence. The following literature review mainly focuses on the studies concerned to this
question.
By applying international trade theory and neoclassical growth theory, many scholars developed
theoretical models to explain trade-convergence relations. Nevertheless, those models are not
unanimous with their predictions. One group of models shows that lower-income economies benefit
more from international trade than higher-income economies in terms of growth, which concludes
that international trade causes convergence. Another group of models maintains that developing
countries do not benefit from trade with rich countries. Consequently, international trade increases
the gap between rich and poor countries. The arguments underlining the two different predictions
can be summarized as following.
For the convergence group
Spillover effects. International trade serves as a conduit for the flow of technology, intermediate
goods and knowledge. Lower-income countries benefit from this knowledge spillover and experience
higher growth rate, because imitation is easier than invention (Grossman and Helpman, 1990, 1991;
Ben-David and Lowey, 1998; Mountfort, 1998; Murat and Pigliaru, 1998).
Price parity. Factor price equalization proposition is originated by Heckscher (1919) and Ohlin (1933)
and is later formalized by Samuelson (1948). This proposition predicts that under certain conditions,
free trade should lead to the equalization of commodity prices and then entail equalization of factor
prices. Ruffin (1988) goes further to show that equalization of the factors prices can usually be
considered as a catalyst for the equalization of the total income. As a consequence, free trade causes
income convergence.
2 For extensive review of this question, see Rassekh 2004.
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Human capital accumulation. When a lower-income country trades with a higher-income country, the
direct cost of education and the resource cost of human capital investment decline, since
international trade frees skilled workers and lowers the price of human capital. As a result, in lower-
income country, the human capital investment increases; and the increased human capital generates a
higher rate of technological change followed by higher growth rate (Eicher, 1999; Ranjan 2003).
Demand pattern. Because the demand pattern of the less developed countries is biased toward
developed countries’ products with less learning-by-doing potential, a advanced country can be worse
off after trading with a less developed country. In other words, a lower level of production reduces
technological progress and slows down the growth rate of the developed country (Spilimbergo 2000).
For the divergence group
Infant industry. Infant industry argument is one of the oldest arguments used to justify the protection
of industries from international trade. It was first formulated by Alexander Hamilton and Friedrich
List at the beginning of the 19th Century. This argument maintains that underdeveloped countries
need to build up a balanced industrial structure as existed in most developed countries to achieve
high per capita income level. For this purpose, infant industry needs to be protested. However, free
trade undermines development of infant industry (Criel 1985), hence hampers the development in
less developed countries.
Factor endowments. Based on Heckscher-Ohlin theory, Wood and Rodao-Cano (1999) argue that
specialization requires poor countries to specialize in products that intensively use unskilled labor and
rich countries to specialize in products that intensively use skilled labor. Then the wage of skilled
labor increases in rich countries, decreases in poor countries. As a result the difference of skill
endowment increases due to the elastic supply. Such widening difference in skill endowment would
cause income divergence.
Export pessimism. International trade promotes the production of primary products in
underdeveloped countries since they have comparative advantage in primary production. If an
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underdeveloped country is bound to produce primary goods due to the free trade, it would not have
chance to upgrade its economic structure, which makes its income stay in a low level. Consequently,
free trade hampers the development of less developed countries. In addition, low elasticity of
demand for primary products constricts the growth of export earning. Furthermore, classical
economists predict that the poor countries gain less from trade because of declining terms of trade of
primary product (Spraos, 1980; Singer, 1950).
Demographic transitions. Galor and Mountford (2006) argue that the expansion of international
trade is a prime cause of ‘Great Divergence’ in income per capita due to the fact that trade
significantly influences the demographic transitions across countries. Their analysis suggests,
“ international trade had an asymmetrical effect on the evolution of industrial and non-industrial
economies. While in the industrial nations the gains from trade were directed primarily towards
investment in education and growth in output per capita, a significant portion of the gains from trade
in non-industrial nations was channeled towards population growth” (Galor and Mountford, 2006: 1).
Spillover effects. Yong (1991) presents a model indicating that the benefits of learning by doing spill
over across goods produced within an economy but not between economies. Therefore, the technical
progress in underdeveloped countries cannot exceed that in developed countries, the technical gap
thereby persists. In their model with intersectoral spillovers of knowledge, Murat and Pigliaru (1998)
argue that in the absence of international spillovers, the growth rates of the trading countries diverge
according to their comparative advantage.
In line with these contradictory theoretical predictions on trade-convergence relation, empirical
studies exhibit inconclusive results. Some empirical studies show the evidence supporting the
convergence group (Sachs and Warner, 1995; Ben-David, 1996; Ben-David and Kimhi, 2004;
Rassekh 1992; O’Rourke and Williamson, 1999; Helliwell and Chung, 1990; Lane, 2001), some
studies find there is no significant link between trade and convergence (Slaughter, 2001; Wood and
Ridao-Cao, 1999). Some studies produce the mixed evidence (Parikh and Shibata, 2004; Cyrus, 2004).
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Causality from convergence to trade
While the literature finds the effect of trade on convergence, trade-convergence relation can be
described in two directions. Trade can impact convergence; on the other hand, the convergence may
also influence trade. A traditional theory that explains the causal relation from convergence to trade is
factor-proportions theory originated by Heckscher (1919) and Ohlin (1924). This theory argues that
differences between countries drive trade. The underlying reason is that the commodity patterns of
trade between two countries are shaped by relative factor endowment. Countries tend to produce and
then export relatively more of those goods that intensively use their abundant factors of production.
Thus, the theory establishes relative factor endowments as the determinant of industrial structure and
the source of comparative advantage (Port, 1990). Accordingly, countries will engage in trade only if
they have different factor propositions or different industrial structure, such as trade between
developed and developing countries. In general, advanced industrial structures associate with high
per capita income, and less advanced industrial structures associate with low per capital income. In
this case, convergence in per capita income reduces trade.
However, since World War II, more and more trade has taken place between similar countries. The
traditional theory does not explain this new phenomenon. To explain the trade among the similar
countries, Linder's (1961) approach suggests that since an important source of the determination of
trade and production is domestic demand, the closer countries are in their preferences and in their
demand patterns, the more similar will be their commodities composition of trade and the greater
will be the volume of their bilateral trade.
In 1960s, intra-industry trade was observed among the industrialized countries, which is difficult to
be explained by traditional trade theory. Since then intra-industry trade has increased very fast, not
only in developed countries but also in developing countries. The mechanism of intra-industry can be
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used to explain the effect of convergence on trade. The early work on intra-industry trade
concentrated on horizontal differentiation by applying the traditional monopolistic competition
approach (e.g., Grubel and Lloyd, 1975; Dixit and Stiglitz, 1977; Krugman, 1979, 1980, 1981;
Lancaster, 1979, 1980). These models emphasize the major role of scale economies and product
differentiation in determining intra-industry trade. They suggest that the more similar countries are in
terms of their incomes, the greater the share of intra-industry trade will be. The rationale behind this
assertion lies in two grounds. First, costumers prefer differentiated products. Second, production of
any particular product requires some fixed costs that are shared by products. The more quantity of
products are produced, the lower average cost is. Bergstrand (1990) expanded the earlier theoretical
work by using a gravity-like equation to explain intra-industry trade. His framework reveals how the
share of intra-industry trade relates to factor endowments and income levels. Specifically, important
determinants of the share of intra-industry trade in total trade are: (a) differences between both
countries in terms of their capital-labor endowment ratio, per-capita income, and economic size; and
(b) both countries’ averages in terms of developmental level, capital-labor endowment ratio,
economic size, and tariff levels. Briefly, the trade pattern between countries not only depends on the
similarity of these countries, but also depends on the average level of these two countries. Intra-
industry trade is likely happened in countries that are above certain development level.
The late work on intra-industry trade expended to vertical differentiation by applying Chamberlin-
Heckscher-Ohlin model. The models of Falvey (1981), Shaked and Sutton (1984), Falvey and
Kierzkowski (1987) and Flam and Helpman (1987) explain the two-way trade in products that are
differentiated by quality, which is called vertical intra-industry trade. The models indicate that the
relatively high-income and capital-abundant countries specialize in (and thus export) relatively high-
quality products, whereas the relatively low-income and labor-abundant countries focus on the
production (and export) of low-quality manufactures. In addition, the model by Flam and Helpman
(1987) emphasizes the effect of technology. They suggest that the quality differences between the
varieties from developing and developed countries originate from differences in technology.
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Therefore, vertical intra-industry trade is determined by comparative advantage, as in the traditional
Heckscher-Ohlin model. Thus differences in relative factor endowments between countries explain
this type of trade.
3. Conceptual model and hypotheses
Both theory and empirics leave us uncertain on the trade-convergence relation. However, there must
be some certainty. The key to convert uncertainty to certainty is to identify the factors that cause the
uncertainty.
The literature review in previous section indicates that the factors determining the effects of trade on
convergence are spillover effects, human capital accumulation (education), economic and trade
structure, and labor division. Among the factors, spillover effects and optimal economic and trade
structure are two essential factors. If spillover effect exists between trade partners, the trade-
convergence relationship appears; otherwise trade-divergence relationship turns up. A country with
an advanced economic and trade structure can benefit more from international trade than the trade
partners that have less advanced economic and trade structures. All these factors hereby subject to
the developmental level of the countries concerned. On the other hand, the impact of convergence
on trade is also determined by developmental level as concluded in last section. In accordance with
this conclusion, this paper argues that the trade-convergence relation depends on the developmental
level of countries concerned.
The study creates a simple conceptual model to describe trade-convergence relation, in the model it
tries to relate trade-convergence linkage to the developmental level of counties concerned (Figure 1).
The start point of the model is that the mechanism of the trade between rich counties is different
from that of poor countries according to new trade theory (Krugman, 1979; Helpman, 1981; and
Linder, 1961). At relatively low-income levels, a country will engage primarily in inter-industry trade
according to its comparative advantage. As development proceeds, a country has more capacity to
trade with other countries, and it engages increasingly in intra-industry trade. Its trade can be driven
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by not only comparative advantage but also the production differentiation and scale economies. Since
the features and determinants of trade change over the development stages, trade-convergence
relation could be different from one stage to another. This section discusses the differences by using
three trade integration cases, North-north trade, South-south trade and North-south trade.
[INSERT FIGURE 1 ABOUT HERE]
North-north trade
As it is stated above, comparative advantage cannot explain a large part of north-north trade;
similarity is an important determinant of the trade between developed countries. From perspective of
supply, trade is mainly explained by effects of differentiation and economies of scale as intra-industry
trade theory suggests. From perspective of demand, Linder hypothesis (1961) emphasizes the effect
of consumption similarity on trade. On the other hand, the trade pattern between rich countries
determines that the gap between rich trade partners can be reduced because of trade. An important
reason is, through trade technology and know-how can be easily transferred between rich countries
due to the small development discrepancy; a lagged country benefits from later-mover advantage.
Another reason is that high intra-industry trade between rich countries gives no chance for export
pessimism. These arguments lead to a conclusion that trade entails convergence and convergence
causes trade. When a free trade agreement signed by rich countries, the positive trade-convergence
relation will maintains or becomes more significant. The lower income countries would benefit more
from free trade. For example, in a free trade region, a lower income country that has more
comparative disadvantage in labor-intensive products gains more chances to export these products to
other member countries after integration due to the regional protection. A higher income country in
the region that has less comparative disadvantage in labor-intensive products, however, has to take
the loss derived from trade diversion. This is because the higher income country has to shift their
imports from other developing countries that offer the lowest price to its member countries which
price is relatively higher. In line with these arguments, the paper proposes the first hypothesis.
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H1. In case of north-north free trade, a) trade associates with convergence; b) causality is bilateral,
trade causes convergence, and convergence causes trade.
South-south trade
The trade of less developed countries can be explained by traditional trade theory. They trade mainly
with the countries that have different factor propositions or different industrial structure. In most
cases, a poor country trades with another poor country based on the differences of nature resources
endowment, and trades with a rich country based on the differences of human capital endowment.
When free trade happens between less developed countries because of free trade agreement between
these countries, their comparative advantage changed. Before integration, they both have
comparative disadvantage in manufactures, but the disadvantage is less for one of them than the
other. Before integration, all the members have some manufacturing because of high protection.
After integration, the country has the fewer disadvantages enjoys comparative advantage within the
free trade agreement area. This country will draw manufacturing production out of the other
counties.3 As a result, this country gains from the relocation, and the others lose. In this case, no
spillover effects, and one country gains from improving economic structure, the others lose. This
idea leads to the second hypotheses.
H2. In case of south-south free trade, a) trade associates with divergence; b) causality is bilateral, that
is trade causes divergence, and divergence causes trade.
North-south trade
According the traditional comparative advantage theory, the convergence reduces north-south trade
because trade is driven by discrepancy of factor proportion. Thus divergence entails north-south
trade. As for the effect of trade on convergence, all the arguments that support divergence group can
be applied in case of north-south trade, such as constraint of human capital, export pessimism, infant
3 The East African community (EAC) serves as an example. After integration in 1967, part of manufacturing
production was drawn from Uganda to Kenya, because Kenya has comparative advantage.
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industry. That is, trade causes divergence. However, new trade theory predicts the trade causes the
convergence because of spillover effects between the rich and poor countries. Therefore in case of
north-south trade, the trade-convergence relation depends on which theory applies. This study
follows the traditional trade theory to propose hypothesis 3.
H3. In case of north-south free trade, a) trade associates with divergence; b) causality is bilateral,
namely, trade causes divergence, and divergence causes trade.
4. Methodology and Data
Cointegration approach
One method often applied to investigate causal relationships between variables empirically is
Granger-causality analysis. The basic principle of Granger-causality analysis (Granger, 1969) is to test
whether or not lagged values of one variable help to improve the explanation of another variable
from its own past. Simple Granger-causality tests are operated on a single equation in which variable
A is explained by lagged values of variables A and B. It is then tested whether the coefficients of the
lagged B variables are equal to zero. If the hypothesis that the coefficients of the lagged values of B
are equal to zero is rejected, it is said that variable B Granger causes variable A.
However, the conventional Granger-causality test based on a standard vector autoregression (VAR)
model is defined conditional on the assumption of stationarity. If the time series are non-stationary,
the stability condition for VAR is not met, implying that the Wald test statistics for Granger-causality
are invalid. In this case, the cointegration approach and vector error correction model (VECM) are
recommended to investigate the relationships between non-stationary variables (e.g., Toda and
Philips, 1993). Engle and Granger (1987) pointed out that when a linear combination of two or more
non-stationary time series is stationary, then the stationary linear combination, the so- called the
cointegrating equation, could be interpreted as a long-run equilibrium relationship between the
variables.
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Nevertheless, this long-run equilibrium relationship cannot determine the direction of causality. The
direction can be obtained by estimating a VECM that explicitly includes the cointegrating relations.
In a VECM, long and short-run parameters are separated, which gives an appropriate framework for
assessing the validity of the long-run implications of a theory, as well as for estimating the dynamic
processes involved. The short-run dynamics of the model are studied by analyzing how changes in
each variable in a cointegrated system respond to the lagged residuals or errors from the
cointegrating vectors and the lags of the changes of all variables. Therefore, by adopting the
cointegration approach and corresponding VECMs, one can detect both long-run and short-run
relationships between non-stationary variables.
In the current study, tests shows that the series are non-stationary, and cointegration relationships
between trade and convergence are existed. Hence, it is possible to estimate the following two-
equation VECM to analyze causality:
t
n
iiti
n
iititCt tradeginiectcgini 1
1
11
1
1111
εγβα
++++=
=
=
t
n
iiti
n
iititTt tradeginiectcgini 2
1
12
1
1212
εγβα
++++=
=
=
(1)
where gini, trade are first differences of gini and trade, respectively; the error-correction term ect is a
vector of residuals from the long-run equilibrium relationships; c,
α
, β, and γ are parameters and the
ε’s are error terms. The error-correction terms reveal the deviations from the long-run relationships
between the three variables. The coefficients of ect,
α
C and
α
T, reflect the speed of adjustment of gini
and trade toward the long-run equilibrium. For example, the larger
α
C is, the greater the response of
gini to the previous period’s deviation from long-run equilibrium relation. Conversely, if
α
C is equal
to zero, gini does not respond to lagged deviations from the long-run equilibrium relationships. In
this case, gini is called weakly exogenous for the system. So, Granger-noncausality in case of
cointegrated variables requires the additional condition that the speed-of-adjustment coefficients are
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equal to zero. For example, for the {ginit} sequence to be unaffected by trade, not only all the γ 1i
must be equal to zero, but also the elements of vector
α
C.
The estimation comes of three steps. First, the study tests whether the two variables involved are
stationary with the Augmented Dickey-Fuller (ADF) unit root test. When the null hypothesis of non-
stationarity is not rejected by these two tests, it moves to the second step, the cointegration test in
Johansen’s (1991 & 1995) framework. If the first two steps indicate that the two variables are non-
stationary and cointegrated, the third step is taken: estimating the VECM of Equations (1), and
testing Granger-causality relationships between the two variables.
Data
The current study examines the relationships between income and trade data from 1960 to 2003 in
four cases EU, ASEAN, NAFTA and WORLD4. The countries are listed in appendix A. The two
time series are ratio variables. gini is gini index of GDP per capita among the countries concerned in
the four cases. trade is the ratio of intra-region trade to region’s GDP in case of EU, ASEAN and
NAFTA. In case of WORLD, in which 87 countries are included in estimation based on data
availability, trade is the average of the ratios of trade to GDP of all 87 countries. The reason that the
study uses the average ratio instead of real ratio of trade to GDP of all countries is that gini here is a
measure of inter-country inequality but not international inequality. The measure of inter-country
inequality treats each country as an individual, therefore measure of trade should also treat each
country as an individual without any weight. GDP per capita and GDP are obtained from the World
Bank database (WB 2006). Trade data are collected from IMF database (DOT).
5. Evidence
Unit root tests
4 Study period in ASEAN case is 1967-2003, NAFTA is 1965-2003, EU and WORLD is 1960-2003.
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Table 1 reports the results of the unit root tests for gini and trade using the ADF test. Two models
with different deterministic components are considered: the model with a constant only, and a model
with a constant and a trend. In these four cases, it is clear that the two variables have a unit root in
their levels. However, the null hypothesis of a unit root in first difference of the two variables is
rejected at the 1 and 5%-level in the two models. Therefore, according to the ADF test gini and trade
can be treated as integrated of order one in the samples, denoted I(1).
These results permit the study to proceed with the next step, cointegration tests to investigate the
long-run relationships between trade and convergence.
[INSERT TABLE 1 ABOUT HERE]
Cointegration test and long-run relationships
The purpose of the cointegration test is to determine whether the non-stationary time series are
cointegrated --that is, to detect whether there are long-run equilibrium relationships between the
variables. This study tests for cointegration using the methodology developed by Johansen (1991 &
1995). In order to estimate the VECM model, the optimal lag order and appropriate cointegration
model for constant and trend should be determined. Two methods are used for this purpose. One is
lag-exclusion Wald test, the other is the estimation of the five models considered by Johansen (1995:
80-84). In EU case, 4 lags and the model with interception are supported. In ASEAN case, 7 lags and
a model without trend and intercept are preferred. In NAFTA case, 6 lags and a model with trend
and intercept are supported. In case of WORLD, 5 lags is suggested, the first two models are
preferred. The results of the two models are similar. Here the model without trend and intercept is
presented.
[INSERT TABLE 2 ABOUT HERE]
We find one cointegration relation between the two variables in all the cases. Table 2 reports the
results of the cointegration test. Trace statistics and L-max statistics indicate that the null hypothesis
of no cointegration, r=0, is rejected at the 1% or 5%-level. The null hypothesis of two cointegrating
16
vectors, r = 1, is not rejected. Consequently, it can be concluded that there is one cointegrating
relationship between the two variables in the models in the all cases. Based on the normalization used
by Johansen, the cointegration vectors are:
EU: gini+11.29trade - 2.89
(4.50) (-4.82) (2)
ASEAN: gini - 2.87trade
(3.95) (3)
NAFTA: gini – 5.92trade+0.01trend-0.08
(4.00) (-3.38) (4)
WORLD: gini – 2.53trade
(36.79) (5)
The values in parentheses are t-statistics. These cointegration vectors are included in the error-
correction term (ect) in the VECM system of Equation (1). The results indicate (a) a long-run negative
relation between intra-region trade and gini index in EU; (b) a long-run positive relation between
intra-region trade and gini index in ASEAN, (c) a long-run positive relation between intra-region
trade and gini index in NAFTA, and d) a long-run positive relation between trade and gini index in
WORLD. These relationships imply, in long run, intra-region trade is associated with convergence in
the EU, but intra-region trade is associated with divergence in ASEAN, NAFTA and WORLD.
We must exercise caution, however, when interpreting this result. The reason is that, although the
cointegration implies positive or negative relations between the two variables, cointegration tests
cannot determine the direction in which causality flows. The causality relationships can be
ascertained from performing Granger-causality tests that incorporate the cointegrating relations in
VECM.
VECM and short-run relationships
Given the existence of one cointegrating relationships between trade and gini, Granger-causality can
be test by using the VECM of Equation (1).
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Table 3 reports the results of the VECM Granger-causality test. The second column defines the
equations of system (1). The other columns display χ2 (Wald) statistics for the joint significance of
each of the other lagged endogenous variables and the error-correction term in the associated
equation. In case of EU, the hypothesis that trade does not Granger-cause gini is rejected at the 5%-
level; the hypothesis that gini does not Granger-cause trade is also rejected at the 5%-level. In case of
ASEAN, the hypothesis that trade does not Granger-cause gini is rejected at the 1%-level; the
hypothesis that gini does not Granger-cause trade is also rejected at the 1%-level. In case of NAFTA,
the hypothesis that trade does not Granger-cause gini is accepted; the hypothesis that gini does not
Granger-cause trade is rejected at the 5%-level. In case of WORLD, the hypothesis that trade does
not Granger-cause gini is rejected at the 1%-level; the hypothesis that gini does not Granger-cause
trade is accepted.
[INSERT TABLE 3 ABOUT HERE]
6. Discussion
In case of the EU
, gini index is much lower than other regions, and income level is relatively high
(see Figure 2 and 3). It locates at top-left area of the figure 1, representing north-north trade. The
result of empirical study indicates that (a) the free trade between member countries associates with
convergence of income among the EU members in the long run, and (b) causality is bilateral, trade
causes convergence, and convergence causes trade. These results support the H1a and H1b. This
finding has two implications. First, the similarity of development level and economic structure is the
foundation of the trade that is driven by scale economies and differentiation, such as intra-industry.
Second, spillover effects function well among the EU countries.
Previous studies have documented Intra-industry trade level are considerably higher for intra-EU
trade than trade between EU and non-EU countries (Fukao, Ishido and Ito, 2003; Brulhart and
18
Elliott, 1998). In general, intra-industry trade arises from its basic characters. It need not be based on
comparative advantage; it is by and large driven by the fact that products are differentiated and
production requires fixed cost (Ruffin 1999). In case of the EU, the free trade policy and similarity of
income level and economic structure facilitates intra-industry trade. At the same time intra-region
trade is largely encouraged because the trade is not limited by comparative advantage, and similarity
serves as a driver of the trade. Figure 4 shows the high share of intra-EU trade. All these ideas and
figures explain the effect of convergence on trade.
In turn, intra-industry trade benefits to traders’ development because it stimulates innovation and
exploits economies of scale, and lowers the adjustment cost (Ruffin 1999). For the countries with
small income gap, like EU, this benefit is easy to be realized because the barrier of spillover effects is
lower. In addition, free trade normally associated with intra-firm trade and foreign direct investment
(FDI), which act as an important channel for the flow of technology, intermediate goods and
knowledge. Statistics show that the intra-EU FDI is higher than other regions (UNCTAD 1999 p40).
As a result, through the spillover effects, trade not only benefits to all EU countries but also
underpins the convergence between countries.
[INSERT FIGURES 2, 3 AND 4 ABOUT HERE]
In case of ASEAN
, the gini index is high and the income level is low (Figure 2 and 3). It should be
located in the bottom-right area of Figure 1, representing south-south trade. The finding of current
empirical study maintains that (a) the free trade between member countries associates with
divergence of income among ASEAN members, and (b) causality is bilateral, trade causes divergence
and divergence causes trade. These results support the H2a and H2b. This result implies that factor
proportion theory is sufficient to explain the trade, and arguments of divergence group are supported
by the case of ASEAN.
Compared with the EU, ASEAN is still in a low development stage. Its intra-ASEAN trade is
primarily driven by comparative advantage and global and regional production networks of MNCs.
19
Accordingly, the differences of income between the countries might be regard as major explanation
of intra-region trade. Statistics shows that the share of intra-ASEAN trade is low, about 20% (Figure
4). Intra-ASEAN trade mainly concentrates in several sectors. For an example, ICT accounts for the
largest share in total intra-ASEAN exports. Within ICT sector, intra-ASEAN trade is highly
concentrated to a few products, and they export and import the same product. This implies that each
economy is specializing in a particular segment of the production chain. This trade pattern is
attributed to liberal policy in the sector, which enables MNCs to spread their operation across the
region( Austria 2003).
Due to the regional production network of MNCs, there is intra-industry trade between ASEAN
countries. However, this kind of trade only concentrates in a few products in a few sectors, and these
sectors do not have strong linkages with the rest of economy. In addition, driven by global and
regional production network of MNCs, intra-region exports of lower income countries, such as
Philippines, are produced by the low-skill labor-intensive and import-dependent segment. This
situation keeps these countries in a low level in terms of industrial structure, and consequently the
value added remains small. Moreover, ASEAN countries are strongly dependent on FDI from
outside of the region. The share of intra-ASEAN FDI to the total FDI is small, ranging from 6.47
(Automotive sector) to 26.12 (agro-based sector) during the period 1995-2001. The share of the most
integrated sector, ICT, is only 11.6 (Austria, 2003). For all of these reasons, it can be concluded that
the spillover effect of intra-region and intra-firm trade is limited in ASEAN. As a result, free trade
between counties in ASEAN does not associate with income convergence, but divergence. This poit
explains the finding of the empirical analyses above.
In case of NAFTA
, integration includes one developing country and two developed countries, gini
index and average income level are in the middle compared with EU and ASEAN. According to the
nature of this region, it should be located in the middle of Figure 1, representing north-south trade.
Our empirical study finds that free trade between member countries is associated with divergence of
income among NAFTA members, and there is one-way causal from divergence to trade. These
20
results support the H2a and part of H2b. In certain degree, the lack of causal from trade to
divergence reflects the contradictory prediction of related theories.
While NAFTA took effect in 1994, this empirical estimation covers the 1965-2003 period. Therefore,
the study does not only mean to reveal the effect of free trade agreement on the convergence, but
aims to reveal the relation between multilateral trade and convergence among these three countries in
a long time window. Complication of this case lies in the fact that it includes countries with different
developmental level. Both traditional and new trade theory apply to the case. Difference between
Mexico and the other two high-income countries is the major source of disparity among the three
countries. Our empirical result shows that trade is associated with divergence, and causality is from
divergence to trade. This finding has two implications, a) comparative advantage is one factor for
intra-region trade; and b) the low-income country Mexico does not benefit more from trade than
United Stats and Canada through spill effect. This result is in line with some empirical studies. By
analyzing NAFTA trade data from 1992 to 2002, Vogiatzonlou (2005: 219) find that labor/resource-
intensive sectors show higher intra-industry trade between NAFTA countries, which suggests that
comparative advantage may be an important factor of intra-region trade. Ghannadian (2004) also
argues that Heckscher-Ohlin theorem applies to Mexico-US trade although the assumptions of this
theorem are too rigid to a complex economy. Briefly, in case of Mexico, United States and Canada,
our empirical result, among some previous empirical studies, find the evidence to support the
arguments of the divergence group, despite our empirical analysis does not find the causality from
trade to divergence.
In case of WORLD
the result of the empirical study shows that (a) the openness associates with
divergence of income, and (b) causality is one way from trade to income divergence. This result
implies that trade causes inequality in worldwide. The increased inequality may attribute two reasons.
First, the trade happening between rich and poor country does not have significant effect on catch-
up. Second, the disparity may be caused by the poor countries that do not integrate into the world
economy. This case is represented for a reference. Detail discussion on this general case is beyond
21
the scope of this study because the aim of this study is to investigate the trade-convergence relations
in specific situation.
7. Summary, policy implications and future study
Brief summary
This study investigates the two-way relations between trade and convergence by using three regional
cases. Although the cases have their own features, the generalized framework and hypotheses of this
study are supported by the case study. Trade does not increase income gaps of trade partners only
when 1) the trade partners reach a certain level in terms of development; 2) the openness of trade
partners reaches a certain level. Specifically, if a country is at low developmental stage, free trade
associates with income divergence between this country and its poor and rich trade partners; causality
is bilateral, trade causes divergence and divergence causes trade. When a country surpasses a certain
level, its trade with other countries in the same stage associates with income convergence between
these countries; causality is bilateral, trade causes income convergence, and convergence causes
increased trade.
Policy Implications
However, in case of divergence, this finding does not mean that a country below a certain level will
never catch up because of trade; in case of convergence, the result does not imply that lower income
countries grow at the expense of higher income countries. Theoretical models and empirical evidence
show that trade provides considerate contribution to economic development for both developed and
developing countries (e.g. Grossman and Helpman, 1990; Irwin and Tervio, 2002). Nevertheless,
trade liberalization does not guarantee improvement. Free trade is not sufficient condition to
increase export and hence economic growth. The government policy is needed to coordinate the
openness and development of domestic economy. Policy makers in low-income counties should
consider three important questions. The first is how to back up the backward-linkage from export
22
sector to other internal sectors. The second is how to assist spillover effects from rich countries to
poor countries. The third is how to upgrade the industrial structure.
Future studies
Despite the potential contribution, the staging framework developed in this study also presents
several limitations, which suggest at least three future directions. First, although the paper has
developed a realistic model about trade-convergence relations, it uses a very rough classification of
developmental level. A finer-grained framework needs to be developed. Second, more need to be
said about the effects of trade natures. Different kinds of trade, such as inter-industry trade, intra-
industry trade and service trade, possess different features; the different features may induce the
variety of trade-convergence relations. Third, future research on trade-convergence relation needs to
identify other important dimensions of convergence. While the paper focuses on the convergence of
GDP per capita, obviously, convergence of other socioeconomic aspects, such as productivity, wage
and innovation, should also interact with trade.
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Table 1. Augmented Dickey-Fuller unit root test
Area Variables Level First difference
With With constant With constant With constant
29
constant
and trend
only and trend only
trade -1.83(0) -1.40(0) -5.29***(0) -5.32(0)***
EU gini -1.41(0) -2.57(0) -5.21***(0) -4.18***(0)
trade -2.49 (0) -0.29(1) -8.21***(0) -8.14***(0)
ASEAN gini -2.78(0) -3.34**(0) -2.69*(0) -3.27**(0)
NAFTA trade -1.33(1) -0.20(1) -3.80***(0) -3.76***(0)
gini -1.75(0) -0.76(0) -6.49***(0) -6.26***(0)
trade -3.23*(0) -0.26 (0) -6.70***(1) -6.70***(1)
WORL
D gini -2.05(1) -2.67*(1) -4.12**(0) -2.23**(0)
Notes:
(1) ***, ** and * are significant at the 1%, 5% and 10%-level, respectively.
(2) Figures in parentheses are the number of lags that were selected by the Akaike Information
Criterion (AIC).
Table 2. Johansen’s cointegration tests
H
0=r Eigenvalue
λtrace 5% critical value λmax 5% critical value
0 0.389 21.76** 20.26 19.21** 15.89 EU
(4 lag) 1 0.0632 2.548 9.165 2.548 9.165
0 0.408 18.973*** 12.321 15.209*** 11.225 ASEAN
(7 lag) 1 0.122 3.765 4.130 3.765 4.130
0 0.534 32.500*** 25.872 24.462*** 19.387 NAFTA
(6 lag) 1 0.222 8.038 12.518 8.038 12.517
0 0.391 20.903*** 12.321 18.824*** 11.225 WORLD
(5 lag) 1 0.053 2.079 4.130 2.079 4.130
Notes:
(1) ***, **, and * are significant at the 1%, 5% and 10%-level, respectively.
(2) D92 is included as an exogenous variable.
Table 3. Results of the VECM Granger-causality test
Wald test statistics
30
(χ2)
Dependent variable
trade gini
EU trade 9.64**
gini 13.21**
ASEAN trade 18.95***
gini 18.95***
Nfta trade 5.978
gini 13.02**
WORLD trade 21.89***
gini 3.61
Note: *** and ** are significant at the 1% and 5%-level, respectively.
Figure 1. Framework of trade-convergence relation.
31
Figure 2 Gini indexes of EU, ASEAN, NAFTA and WORLD
1960
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
year
0.10
0.20
0.30
0.40
0.50
0.60
0.70
GINI index
EU
ASEAN
WORLD
NAFTA
Figure 3 Average GDP per capita of EU, ASEAN, NAFTA and WORLD.
Difference in development
Level of development
Divergence area
South-south trade
Convergence area
North-north trade
? North-south trade
32
1960
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
Year
0.00
5000.00
10000.00
15000.00
20000.00
25000.00
GDP per capita
EU
ASEAN
NAFTA
WORLD
Figure 4. the share of intra-region trade in EU, ASEAN and NAFTA
1960
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
year
0.10
0.20
0.30
0.40
0.50
0.60
0.70
Share of Intra-region trade
EU
ASEAN
NAFTA
Appendix A List of countries used in estimations.
33
EU
Austria, Belgium, Denmark, Finland, France, Germany, Greece,
Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain, Sweden,
United Kingdom
ASEAN Indonesia, Malaysia, Philippines, Singapore, Thailand
NAFTA Canada, Mexico, United States
WORLD
Algeria, Argentina, Australia, Austria, Bangladesh, Barbados, Belgium,
Benin, Botswana, Brazil, Burkina Faso, Burundi, Central African
Republic, Chad, Chile, China, Colombia, Congo Dem. Rep, Congo
Rep, Costa Rica, Cote d'Ivoire, Denmark, Dominican Republic,
Ecuador, Egypt Arab Rep., El Salvador, Fiji, Finland, France, Gabon,
Ghana, Greece, Guatemala, Guyana, Haiti, Honduras, Hong Kong,
Iceland, India, Indonesia, Ireland, Israel, Italy, Jamaica, Japan, Kenya,
Korea Rep., Kuwait, Lesotho, Luxembourg, Madagascar, Malawi,
Malaysia, Malta, Mauritania, Mexico, Morocco, Netherlands, Nicaragua,
Niger, Nigeria, Norway, Papua New Guinea, Paraguay, Peru,
Philippines, Portugal, Puerto Rico, Rwanda, Senegal, Sierra Leone, So
uth Africa, Spain, Sri Lanka, Sudan, Sweden, Switzerland, Syrian Arab
Republic, Thailand, Togo, Trinidad and Tobago, Tunisia, United
Kingdom, United States, Uruguay, Venezuela RB, Zambia.
Article
The Association of Southeast Asian Nations (ASEAN) is highly diverse. It is also divided. The most striking example is the development divide that separates ASEAN’s newer members of Cambodia, the Lao People’s Democratic Republic, Myanmar, and Viet Nam—the CLMV countries—from the organization’s original members, or ASEAN-6. More rapid growth in Cambodia, Lao People’s Democratic Republic, and Viet Nam since the 1990s—driven by trade, investment, and other market reforms—has reduced income differences between this grouping and ASEAN-6. Yet, while the development divide has narrowed, huge gaps remain. The further narrowing of these gaps will require an increase in the pace and breadth of policy reforms, and start addressing labor mobility. Although rapid growth has resulted in convergence among ASEAN members, it has also increased polarization within individual countries. This can threaten social cohesion and the sustainability of future growth. There is a pressing need to invest more in education and health, and to institute land reform.
Book
With the publication of his best-selling books "Competitive Strategy (1980) and "Competitive Advantage (1985), Michael E. Porter of the Harvard Business School established himself as the world's leading authority on competitive advantage. Now, at a time when economic performance rather than military might will be the index of national strength, Porter builds on the seminal ideas of his earlier works to explore what makes a nation's firms and industries competitive in global markets and propels a whole nation's economy. In so doing, he presents a brilliant new paradigm which, in addition to its practical applications, may well supplant the 200-year-old concept of "comparative advantage" in economic analysis of international competitiveness. To write this important new work, Porter and his associates conducted in-country research in ten leading nations, closely studying the patterns of industry success as well as the company strategies and national policies that achieved it. The nations are Britain, Denmark, Germany, Italy, Japan, Korea, Singapore, Sweden, Switzerland, and the United States. The three leading industrial powers are included, as well as other nations intentionally varied in size, government policy toward industry, social philosophy, and geography. Porter's research identifies the fundamental determinants of national competitive advantage in an industry, and how they work together as a system. He explains the important phenomenon of "clustering," in which related groups of successful firms and industries emerge in one nation to gain leading positions in the world market. Among the over 100 industries examined are the German chemical and printing industries, Swisstextile equipment and pharmaceuticals, Swedish mining equipment and truck manufacturing, Italian fabric and home appliances, and American computer software and movies. Building on his theory of national advantage in industries and clusters, Porter identifies the stages of competitive development through which entire national economies advance and decline. Porter's finding are rich in implications for both firms and governments. He describes how a company can tap and extend its nation's advantages in international competition. He provides a blueprint for government policy to enhance national competitive advantage and also outlines the agendas in the years ahead for the nations studied. This is a work which will become the standard for all further discussions of global competition and the sources of the new wealth of nations.