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The Impact of the Customs Union Agreement on GCC Bilateral Trade, using Aggregated and Disaggregated Data

Sultan Alshammar
By Sultan Alshammar
2 weeks ago
The Impact of the Customs Union Agreement on GCC Bilateral Trade, using Aggregated and Disaggregated Data

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  1. WP /19/11 SAMA Working Paper: The Impact of the Customs Union Agreement on GCC Bilateral Trade, using Aggregated and Disaggregated Data December 2019 By Sultan Alshammari, PhD Economic Research Department Saudi Arabian Monetary Authority The views expressed are those of the author(s) and do not necessarily reflect the position of the Saudi Arabian Monetary Authority (SAMA) and its policies. This Working Paper should not be reported as representing the views of SAMA 1
  2. Impact of Customs Union Agreement on GCC Bilateral Trade , using Aggregated and Disaggregated Data Sultan B. Alshammari1 Economic Research Department July 2019 ABSTRACT This paper studies different aspects of trade integration among Gulf Cooperation Council (GCC) member countries by examining the effect of the GCC Customs Union (GCC CU) on trade in the region during 1995-2012 period. Different forms and specifications of the gravity model of international trade are applied to a set of bilateral trade flows among 38 countries representing GCC countries and their major trade partners during the 1995-2012 period. By investigating the effect of the GCC CU on aggregate and disaggregate trade, the findings of this paper have interesting implications. The use of disaggregated trade data is important in investigating the GCC CU, since the aggregate results may suffer from aggregation bias. In addition, it helps identify the sectors that benefit more from GCC CU, which is an important issue for GCC countries that seek the integration of their economies. The results of the disaggregated trade analysis suggest that the value added or advantage of GCC CU trade creation was more concentrated in sectors that exhibit lower shares of GCC intra-trade during 1995-2012. Keywords: economic agreements, integration, gravity model, international trade. JEL classification codes: C10, F15, F10. 1 Contact Detail: Sultan B. Alshammari, email: 2
  3. Impact of Customs Union Agreement on GCC Bilateral Trade 1 . Introduction: The Cooperation Council for the Arab States of the Gulf (GCC), is a political and economic group of six members namely; Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates (UAE). The GCC was established in the Emirate of Abu Dhabi, Capital of UAE, on 25 May 1981. The union comprised of Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the UAE. The unified economic agreement among the countries of the GCC was signed on 11 November 1981 in Abu Dhabi with the aim of supporting their economic, social and political ties among the GCC member countries by harmonizing regulations in the fields related to the economies, finance, trade, customs and tourism, inspiring scientific & technical cooperation, and encouraging the cooperation of their mutual private sectors. The similarities in political and cultural framework are favorable for the establishment of this unity among GCC members. The most important step of the GCC toward economic integration was achieved when the Unified Economic Agreement (UEA)2 was agreed upon. The UEA was set to coordinate and standardize the economic, financial, monetary, commercial, industrial, and customs regulations among the members with the ultimate goal of introducing a unified currency for the GCC countries. The UEA stages in which the economic integration path would follow included the establishment of a free trade agreement in May 1981 by the signing of the Economic 2 3 UEA has 28 articles, attached in the Appendix.
  4. Agreement in November 1981 . This agreement contained the main provisions of the GCC Free Trade Area. In 2001, the member’s countries approved a revised version of the UEA and referred to as the New Economic Agreement (NEA). The new version sets goals for further integration in order to achieve full financial, monetary and other aspects of economic integration in order to introduce a common currency. The creation of a customs union began in 2003 and was completed and fully operational on 1 January 2015. On 1 January 2008 the six GCC countries declared the creation of a common market in the GCC region. In January 2015, the common market was further integrated, allowing full equality among GCC citizens to work in the government and private sectors, social insurance and retirement coverage, real estate ownership, capital movement, access to education,health and other social services in all member states. However, some barriers remained in the free movement of goods and services. The coordination of taxation systems, accounting standards, and civil legislation is currently in progress.The interoperability of professional qualifications, insurance certificates and identity documents is also underway. Further to GCC CU, a Customs Union Authority was established on June 1, 2012, with the aim of completing the requirements of the Customs Union, which includes the mechanism of distribution of customs duties, customs protection, handling of American goods imported through the Kingdom of Bahrain and Oman, protection of the local agent, and unifying Customs procedures, and products of national factories in the free zones. The Customs Union Authority is entrusted with a timetable for the implementation of the 4
  5. final stage of the Customs Union , in fully operational bases, by January 1, 2015.3. Almoulani (2016) claims that there are ongoing plans to strengthen the implementation of the customs union agreement. For this purpose-, the customs union must pass several remaining challenges, including development of a plan for the fair distribution of customs duties taking into account issues relating to the port of entry and final destination of goods. In 2008, the GCC countries’ members established a common market with the ultimate aims of facilitating the movement of GCC citizens and capital among member states. The common market agreement emphasizes the free flows of factors of production among GCC member countries. The coverage planned for the common market includes several areas such as economic, investment, the stock market and the establishment of companies in both the public and private sectors included the provision for social insurance among GCC citizens. For a Currency Union (CU) to be achieved completely, there are elements that need to be attained. Trade integration is probably the most important step toward currency union, as members of the union gain from high levels of intra-trade after the establishment of a CU due to the elimination of exchange rate risk and transaction costs associated with multiple currencies. This paper aims to examine to what extent bilateral trade of GCC countries are integrated by assessing the impact of the GCC Customs Union on aggregate trade among GCC countries by applying the gravity forms on GCC members’ bilateral trade. The methodology is based on different models of gravity equations with the interaction of the importer/exporter effects and time 3 5 This study focuses on the effect of Custom Union on aggregate trade among GCC members
  6. effects model , the country pair effects and time effects model and importer effects and time effects, and exporter effects and time effects model to assess the impact between GCC FTA on trade among GCC countries. More details on these different models are provided in the methodology section. The empirical studies so far have not examined extensively the trade pattern in GCC countries especially the impact of custom union. Most of previous empirical research have focused mainly on the structure of foreign trade. Therefore, this paper provides an empirical study of gravity model and more broadly explore the GCC customs union. The current paper also aim to contribute for a more solid basis for future work on regional trade integration under trade agreements, by drawing concluding remarks on the general effect of trade laws and barriers. In addition, the paper documents the importance of custom unions to support the economic and trade integration. The following section provides a short literature review on empirical research has focused on the impact of Custiom union on the GCC. The rest of paper is structures as follows; Section 2 discusses the trade integration and the regional trade agreement. Section 3 provides an overview of the trade patterns of GCC countries. Section 4 discusses the problems related to the estimating the Gravity Equation. Section 5 presents the methodology, and Section 6 presents the data descriptions and results. Finally, the last section provides an overall conclusion. 2. Literature Review (Custom Union and Intra-Industry Trade) There have been some attempts to measure the effect of free trade agreements on disaggregate trade data. In addition to estimating the impact of Euro on aggregate trade (exports), Flam and Nordström (2006) studied the impact of Euro on one-digit Standard International Trade Classification (SITC) sector 6
  7. using gravity model-fixed effect . They have also aimed to explore the trade creation and Euro diversion effect of non-Euro partner. Their estimation shows that there are wider distribution and less economic meaningful results comparing to aggregate level. Al-Shammari (2007) investigated the impact of the announcement of the establishment of a Customs Union among GCC member in 2000. He applied an exporter, importer and time effects gravity model with panel data of the bilateral trade for 196 countries from 1990 to 2005. In addition, he examined disaggregate trade data at the (1-digit level) among GCC members. The author concluded that the announcement of the establishment of a customs union among GCC counties had a positive impact on some sectors. Boughanmi et al. (2010) investigated the effect of the GCC Free Trade Agreement on agri-food sectors in the period between 1990 and 2004 by applying the exporter and importer effects- gravity model- and pooled OLS to 2 –digit agri-food sectors. They concluded that the GCC Free Trade Agreement had a positive impact on the overall agri-food sector and a positive impact on trade among GCC countries in several 2-digit sectors such as dairy and meat preparatioin. Abdmoulah (2011) attempted to examine whether the GCC Free Trade Agreement has a positive or negative impact on sectoral trade among GCC countries between 2000 and 2007. He applied a zero-ainflated negative binominal gravity model (exporter and importer effects) to solve the problem of a zero trade-in date. He concluded that, for most sectors, the GCC Free Trade Agreement had no significant effect on trade among GCC countries between 2000 and 2007. 7
  8. Alawadhi (2014) investigated the impact of the GCC Free Trade Agreement on intra-industry trade among GCC countries using disaggregate trade data as he found that the use of aggregate level data might result in aggregation bias. In addition, he found that disaggregate data help to identify the sectors that benefit more from GCC Trade Agreement since GCC members are seeking diversification of their economies. He concluded that, under the GCC Trade Agreement, trade creation was more concentrated in sectors that exhibit lower shares of GCC intra-trade during the 1983-2010 period. 3. Overview of trade patterns among GCC countries The GCC members are considered to be open economies, since trade flows within the GCC members (intra-trade) and between the GCC and the rest of the world have rapidly increased since the GCC was established in 1981. Trade flows among the GCC members when the Council was established were $8bn and the total trade flows with the rest of the world were $252.3bn. In 2003, trade flows increased to $23bn among GCC states. By 2008, this level of flows had reached $67 bn that amounted to about 5.9% of the region’s total trade flows with the rest of the world. In 2012, intra-trade of the GCC jumped to around $100bn. The rapid increase in intra-trade of GCC over the last two decades is probably related to the establishment of the Customs Union and Common Market in 2003 and 2008 respectively (Bahrain’s Ministry of Trade and Industry (BMTI), 2016). According to BMTI, trade flows among the GCC countries as an economic bloc and the rest of the world have rapidly jumped over the last two decades as well. In 1984, the total trade of GCC countries with the rest of the world was $138bn and increased to $1.19 trillion in 2011. 8
  9. 4 . Problems with the Gravity Equation model estimation. The estimation of the log of the gravity equation faces several problems (Baier & Bergstrand, 2007). The main issues are; 4.1 Endogeneity Bias: Endogeneity occurs when one or more of the right–hand-side (RHS) variables are correlated with the error term. Main sources of endogeneity bias of righthand-side variables are: 4.1.1 Omitted Variable Bias (OVB) : Baier & Bergstrand (2007) consider that the omitted variables bias is the major source of endogeneity when estimating the effects of CU in gravity equation. This omitted variable bias occurs in the case of a significant variable of trade not existing in the RHS of the gravity equation and this variable correlates with other variable or endogenous variable especially the CU dummy used in this study. Baier & Bergstrand suggest three methods to avoid omitted variable bias. The first mothed consist of including the omitted variable or variables. However, it is not always feasible to include all omitted variables, and it is hard to measure some variables or there might be a lack of data for these variables. The second method is to solve the OVB in including fixed effects; however, including fixed effects will account for most time invariant omitted variables, and will interact with time effects that also account for most time invariant omitted variables. The third method consists of the use of instrumental variables (IV). They are used in order to remove the correlation between the omitted independent variables with the error term that where the instrument variable is a determinant of at least one independent variable and 9
  10. an omitted variable . The major task is to find an appropriate instrument variables. According to Baier and Bergstrand (2007), the instruments should be correlated with the FTA variable or the CU variable, but not with the other factors causing trade between countries; this condition is very hard to find, and the author suggest the use of fixed effects to removes most of the omitted variables bias. This appears to be the best practical solution for omitted variable problems. 4.1.2 Simultaneity Bias and Reverse Causality (RC) Bias When the impacts of a CU are measured by applying the gravity model, reverse causality origins from the fact that the effects of the CU are dependent on the level of trade between countries. In other words, the level of trade between countries might cause the countries to join a CU, and then the corresponding effects on trade may not be observed in the trade data of the trade levels between the CU members. Therefore, the larger trade between countries makes them more likely to form CU. A possible solution to reverse causality is to use instrumental variables. 4.1.3 Sample Selection Bias When there is no bilateral trade between countries, sample selection problems occur. In another words, this bias occurs when data have zero trade flows. As a consequence, the gravity model is usually estimated in log-linear form. Indeed, the log of zero trade flows is undefined, which can result in forth problems in estimation. The standard practice in dealing with zero trade flows is to drop such observations. In this context, dropping zeros means that data are selected concerning the value of the dependent variable that and not treated 10
  11. as missing observations ; hence, the sample that is selected from the population is not random, thus biasing the OLS estimates. In this paper, the data have no zeros trade flow; thus, we will not face sample selection bias problems in the estimation of the gravity model. 5. Methodology As discussed in the previous section, the estimation of the gravity model usually faces some problems. The best solution for OVB bias is to use the suggestion of Baier and Bergstrand (2007) and estimate the model using fixed effect estimation. In this paper, the estimation will be for different variations of two versions of the gravity model, the traditional gravity and the Anderson and van Wincoop (AvW) (1997), gravity equation; both versions are estimated via OLS. The advantage of using the AvW model is to eliminate any reverse causality (RC) that may occur in the regression between GDP and export trade. Since the model does not incorporate the inclusion of GDP per capita, it is necessary to augment different versions of the gravity equation with GDP per capita. Fortunately, the use of exporter-time and importer-time effects removes the need to include GDP or GDP per capita, since the estimation results for GCC CU are qualitatively the same whether including GDP and GDP per capita, including one of them or omitting both. In addition, time dummies are added for each year, these dummies control for variables such as globalization or shocks that affect the world economy. With large N=38 and small T=18, it is a good idea to allow for separate intercepts for each period. Doing so allows for aggregate time effects that have the same influence on all exporters (Wooldridge, 2001). The use of fixed effects helps to correct for omitted variables, especially multilateral resistance (Anderson and Van Wincoop ,2003). With fixed effects estimation, the study uses both 11
  12. the traditional and the AvW gravity models , where instead of solving internally for multilateral resistance the study uses exporter and importer fixed effects to account for it. It also uses the fixed effects instead of random effects in the light of the suggestions of Egger (2000), Rose (2005), Baier and Bergstrand (2007) and Shepherd (2008). According to Egger (2000), the use of fixed 4 effects is more appropriate when trade flows are estimated for a set of countries that are selected, while random effects usage is more appropriate when the countries are selected randomly. In case it is not clear which one should be used, fixed effects are consistent while random effects are not. Furthermore, the fixed effects method has less restrictive assumption compared with random effects (Shepherd, 2008). Exporter and importer effects are used to control for all unobservable time invariant country effects, and the time effects are used to control for all unobservable effects that are time variant and that affect all exporters and importers. In addition, the country pair effects are added to control for almost all possible unobservable interaction effects between exporter and importer. Finally, the interaction between importer effects and time effects, and exporter effects and time effects are added to control for almost all possible interactions between country specific effects and time effects5. 4 Equations 1, 2, 3, 4, and 5 illustrate different types of fixed effects that will be applied to the data. 5 These include time variation in multilateral resistance terms. 12
  13. For the importer/exporter effects and time effects model, the following equation will be applied: ln