The Trans-Pacific Partnership (TPP), the largest preferential trade agreement to date, has reinvigorated interest in understanding the impact of trade agreements. Recent academic research has thus far focused on ex ante analysis of trade policy changes, using computable general equilibrium (CGE) models to understand the impact of TPP. Due to the considerable uncertainties involved in ex ante models, there needs to be a renewed effort to understand the ex post impact of trade agreements. This is also crucial since ex ante models have typically underestimated the impact of trade agreements with the actual outcome turning out to be significantly better than model predictions (Kehoe 2003).
My recent paper fills a gap in the literature by employing synthetic control methods – currently popular in micro and macro studies – to understand the impact of past trade agreements (Hannan 2016). Synthetic controls are an econometric tool for comparative studies where the control unit is determined by a systematic, data-driven procedure. A synthetic (artificial) control unit is a weighted average or linear combination of the untreated units. The weights are chosen such that both the outcome variable and its observable covariates/determinants are matched with the treated unit before treatment. The evolution of the actual outcome of the treated unit post-treatment is then compared against the outcome of the synthetic unit, and the difference is interpreted as the treatment effect. Intuitively, synthetic controls use a weighted average of the outcome of the control units to estimate the counterfactual outcome of the treated unit. Previous studies have used this approach on a range of issues, including the effect of tobacco control programmes on tobacco consumption in California and the impact of German reunification on the economic growth of West Germany.
Why employ synthetic controls on trade agreements? To understand the impact of trade agreements, the literature usually uses a dummy variable in the right-hand side of the gravity equation for the presence of trade agreements. Earlier studies, assuming that the trade agreement was an exogenous variable, found no meaningful impact. However, later studies showed that trade agreements, in practice, are not exogenous random variables, but countries are likely to select endogenously into trade agreements for reasons not observable but correlated with the level of trade, hence biasing the results. The literature subsequently used various econometric techniques to address endogeneity problem arising due to selection bias.
The key advantage of synthetic controls in addressing this endogeneity problem is that it allows the effect of unobserved confounders to vary with time, as opposed to similar econometric methods like difference-in-differences models or matching estimators that can deal with time-invariant unobserved country characteristics only (Abadie et al. 2010). This is an essential feature in the context of trade agreements where the impact is studied over time. Estimating trade impacts using synthetic controls would thus be a novel way of addressing the endogeneity bias problem in trade literature.
Trade agreements can generate substantial export gains
In my research I look at 104 country pairs that had trade agreements in the period 1983–1995. For each of the 104 country pairs, the trade agreement is the ‘treatment’ while the country pair with the trade agreement is the ‘treated’ unit. The synthetic unit is the weighted average of untreated bilateral pairs, with weights chosen so that the resulting synthetic unit best reproduces the bilateral exports and relevant observed covariates of the treated unit before treatment. Following the gravity model, typically used to explain bilateral exports, the covariates include variables like distance between the bilateral pairs, bilateral real exchange rates and each pair’s GDP, GDP per capita, population, and remoteness. The covariates also include dummy variables for factors like common colonial history, common currency, and common legal origins.
Figure 1a shows the results for the average of the 104 country pairs, while Figure 1b looks specifically at NAFTA. The outcome variable, gross exports, is plotted over times, with t=0 when the agreement was enacted, t=-1,-2,…,-10 showing the outcome variable until ten years before the trade agreement, and t=+1, +2, …, +10 showing the outcome variable until ten years after the trade agreement.
Figure 1 The effect of trade agreements on gross exports
a. Average of 104 country pairs
b. Average of all country pairs in NAFTA
The divergence between the treated and synthetic lines in all the figures post trade agreement indicates substantial gains from trade. The average gross exports of countries with trade agreements was 80 percentage points higher over the next ten years on a cumulative basis, compared to the average synthetic counterparts (Figure 2). The annual export growth is 3.8 percentage points higher due to trade agreements. Overall, the export gains are even higher when the anticipation effect – trade increasing before the agreement is enacted – is accounted for. While previous studies have not differentiated trade gains across income groups, I show that trade gains can be substantially higher for emerging markets when they have a trade agreement with advanced markets. The gains are relatively less, compared to the average, for advanced economies exporting to emerging markets. The results also show that, contrary to some of previous key studies, each bilateral country pair involving Canada, Mexico and the US has generated more exports due to NAFTA. The average exports have increased by 79 percentage points over ten years due to NAFTA, with annual export growth 4.3 percentage points higher.
Figure 2 Export growth due to trade agreements
Overall, the study falls under a small group of literature that shows that, once the endogeneity issues are addressed, trade gains can be substantial due to trade agreements.
A peak at trade diversion
Finally, in my paper I briefly touch upon the issue of trade diversion – are the export gains at the expense of countries that are not part of trade agreement? For each country engaged in a trade agreement, synthetic controls are employed on the pair representing the country’s trade with its top trading partners (top exporter and top importer separately) that are outside the trade agreement. The synthetic unit in this scenario represents the counterfactual of how trade would have evolved with the third (non-signatory) country under the absence of trade agreement. The results show suggestive evidence of slight import diversion, with average imports from third countries 20 percentage points lower than their average synthetic counterparts over ten years. For export diversion, the results indicate that exports to third parties not in trade agreements could get a small boost due to trade agreements, with average exports to third countries 8 percentage points higher over ten years. The results of trade diversion should be interpreted with the caveat that this is based on a narrow analysis looking at the country’s top importer/exporter outside the trade agreement. While this gives some important clues regarding trade diversion, future research could expand this to include more country pairs that are not part of the trade agreement.
Figure 3 Trade diversion effects of trade agreements
a. Import growth of average treated over ten years, relative to average synthetic (cumulative, percentage points)
b. Export growth of average treated over ten years relative to average synthetic (cumulative, percentage points)
One might expect that the sheer number of trade agreements in the past decades would indicate that such agreements can boost trade. However, there is very little empirical support to this claim (Baier and Bergstrand 2007). The paper belongs to a small group of the literature that shows that, after accounting for endogeneity, trade agreements matter! This is particularly relevant for policymaking in the current context of a trade slowdown, and more work in understanding the impact of past trade agreements would be welcome.
Authors’ note: The views expressed herein are those of the author and should not be attributed to the IMF, its Executive Board, or its management.
Abadie, A., A. Diamond, and J. Hainmueller (2010). “Synthetic control methods for comparative case studies: Estimating the effect of California’s Tobacco control program”, Journal of the American Statistical Association, 105 (490), 493–505.
Baier, S.L. and J.H. Bergstrand (2007). “Do free trade agreements actually increase members’ international trade?”, Journal of International Economics, 71, 72–95.
Kehoe, T. J. (2003). “An Evaluation of the Performance of Applied General Equilibrium Models of the Impact of NAFTA”, Staff Report 320, Federal Reserve Bank of Minneapolis.
Hannan, S. A. (2016). “The Impact of Trade Agreements: New Approach, New Insights”, IMF Working Paper, WP/16/117.