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Board of Governors of the Federal Reserve System International Finance Discussion Papers Number 637 June 1999 ON THE DYNAMICS OF TRADE DIVERSION: EVIDENCE FROM FOUR TRADE BLOCS Caroline L. Freund and John McLaren* NOTE: International Finance Discussion Papers are preliminary materials circulated to stimulate discussion and critical comment. References in publications to International Finance Discussion Papers (other than an acknowledgment that the writer has had access to unpublished material) should be cleared with the author or authors. Recent IFDPs are available on the Web at www.bog.frb.fed.us.

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Page 1: Board of Governors of the Federal Reserve System International … · 1999-06-22 · Board of Governors of the Federal Reserve System International Finance Discussion Papers Number

Board of Governors of the Federal Reserve System

International Finance Discussion Papers

Number 637

June 1999

ON THE DYNAMICS OF TRADE DIVERSION:EVIDENCE FROM FOUR TRADE BLOCS

Caroline L. Freund and John McLaren*

NOTE: International Finance Discussion Papers are preliminary materials circulated to stimulatediscussion and critical comment. References in publications to International Finance Discussion Papers(other than an acknowledgment that the writer has had access to unpublished material) should be clearedwith the author or authors. Recent IFDPs are available on the Web at www.bog.frb.fed.us.

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ON THE DYNAMICS OF TRADE DIVERSION:EVIDENCE FROM FOUR TRADE BLOCS

Caroline L. Freund and John McLaren*

Abstract: This paper studies the dynamics of trade reorientation experienced when a country joins a regionaltrade bloc. We find that the joining country’s trade orientation toward bloc countries typically rises along an‘S’-shaped path. We estimate the size, speed, and timing of this adjustment path for a ‘typical’ joining country,for four trade agreements. We find that, in the European Union (EU), the incumbent bloc countries’ share ofthe joining country’s trade typically rose by eighteen percentage points over the course of the adjustment; thatthis took twelve years; and that the adjustment began four years before the date of accession. MERCOSURshows a similar pattern in progress, but NAFTA and EFTA are more idiosyncratic. We argue that the dataprovide strong evidence of anticipatory sunk investments made to prepare for accession.

Keywords: regionalism, sunk costs.

*International Finance Division of the Federal Reserve Board and Columbia University, respectively. Theauthors would like to thank Shaghil Ahmed, Jagdish Bhagwati, Allan Brunner, Steven Cameron, PinelopeGoldberg, Ann Harrison, Jim Harrigan, Andy Levin, Arvind Panagariya, Peter Neary, Dani Rodrik, JohnRogers, Alan Winters, and seminar participants at the Federal Reserve Board, the NBER Summer Institute,University of Virginia, and the World Bank for helpful comments. They of course share no responsibility forany errors or deficiencies. Correspondence: Caroline Freund, International Finance Division, Federal ReserveBoard, Washington D.C. 20551, e-mail: [email protected]; John McLaren, Department of Economics,Columbia University, New York, NY 10027, e-mail: [email protected]. The views presented here aresolely the responsibility of the authors and should not be interpreted as reflecting the views of the Board ofGovernors of the Federal Reserve System or any other person associated with the Federal Reserve System.

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Page 41: Board of Governors of the Federal Reserve System International … · 1999-06-22 · Board of Governors of the Federal Reserve System International Finance Discussion Papers Number

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Page 42: Board of Governors of the Federal Reserve System International … · 1999-06-22 · Board of Governors of the Federal Reserve System International Finance Discussion Papers Number

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Page 43: Board of Governors of the Federal Reserve System International … · 1999-06-22 · Board of Governors of the Federal Reserve System International Finance Discussion Papers Number

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Page 44: Board of Governors of the Federal Reserve System International … · 1999-06-22 · Board of Governors of the Federal Reserve System International Finance Discussion Papers Number

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Page 45: Board of Governors of the Federal Reserve System International … · 1999-06-22 · Board of Governors of the Federal Reserve System International Finance Discussion Papers Number

Trade Shares

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7-3

6

-31

-26

-21

-16

-11 -6 -1 4 9 14 19 24 29

Core

SecondExpansionFirstExpansion

Trade Intensity Indices

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

1.8

2

-36

-30

-24

-18

-12 -6 0 6 12 18 24 30

Core

SecondExpansion

FirstExpansion

Figure 1: EU Median Trade Shares and Median Trade Intensity Indices

Note: since the second expansion occurred in 1986, the data end in mid-adjustment for those countries.

Page 46: Board of Governors of the Federal Reserve System International … · 1999-06-22 · Board of Governors of the Federal Reserve System International Finance Discussion Papers Number

Trade Share

0

0.05

0.1

0.15

0.2

0.25

0.3

0.35-8 -5 -2 1 4 7 10 13 16 19 22 25 28 31 34

Intensity Index

0

0.5

1

1.5

2

2.5

3

-12 -9 -6 -3 0 3 6 9 12 15 18 21 24 27 30 33

Figure 2: EFTA Median Trade Share and Median Trade Intensity Index

Page 47: Board of Governors of the Federal Reserve System International … · 1999-06-22 · Board of Governors of the Federal Reserve System International Finance Discussion Papers Number

Trade Share

0

0.05

0.1

0.15

0.2

0.25

0.3

0.35

0.4-1

9

-17

-15

-13

-11 -9 -7 -5 -3 -1 1 3 5

Trade Intensity Index

0

5

10

15

20

25

30

35

-19

-17

-15

-13

-11 -9 -7 -5 -3 -1 1 3

Figure 3: MERCOSUR Median Trade Share and Median Trade Intensity Index

Page 48: Board of Governors of the Federal Reserve System International … · 1999-06-22 · Board of Governors of the Federal Reserve System International Finance Discussion Papers Number

Trade Share

0.54

0.56

0.58

0.6

0.62

0.64

0.66

0.68

0.7

0.72

0.74-1

7

-15

-13

-11 -9 -7 -5 -3 -1 1

Trade Intensity Index

0

1

2

3

4

5

6

7

-31

-28

-25

-22

-19

-16

-13

-10 -7 -4 -1 2

Figure 4: NAFTA Median Trade Share and Median Trade Intensity Index

Page 49: Board of Governors of the Federal Reserve System International … · 1999-06-22 · Board of Governors of the Federal Reserve System International Finance Discussion Papers Number

EU Non-Members*

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

1.8

219

48

1951

1954

1957

1960

1963

1966

1969

1972

1975

1978

1981

1984

1987

1990

1993

Asia**

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

Figure 5: Median Trade Intensity Indices, Non-Unions

* Median trade intensity indices among European countries with core EU members, including: Finland,Norway, Sweden, and Switzerland.

** Median trade intensity index among East Asian Countries, including: Hong Kong, Korea, Thailand,and Japan.

Page 50: Board of Governors of the Federal Reserve System International … · 1999-06-22 · Board of Governors of the Federal Reserve System International Finance Discussion Papers Number

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

-5 -3 -1 1 3 5 7 9 11 13 15

INTEN

SHARE

-0.005

0.000

0.005

0.010

0.015

0.020

0.025

0.030

-5 -3 -1 1 3 5 7 9 11 13 15

Figure 6: Estimated Adjustment Profile for the EU

Figure 7: Estimate of First Differences in Shares for the EU

Page 51: Board of Governors of the Federal Reserve System International … · 1999-06-22 · Board of Governors of the Federal Reserve System International Finance Discussion Papers Number

-0.20

0.00

0.20

0.40

0.60

0.80

1.00

1.20

1.40

1.60

-5 -2 1 4 7 10 13 16 19 22 25

SHARE

INTEN

Figure 8: Estimated Adjustment Profile for EFTA

Page 52: Board of Governors of the Federal Reserve System International … · 1999-06-22 · Board of Governors of the Federal Reserve System International Finance Discussion Papers Number

Val

ue o

f ca

pita

l in

x-se

ctor

x (

λ ).

Capital inthe x-sector.

.

. .A

B

C0

Figure A1. The convex adjustment cost model.

S

S

λ = 0 withoutfree trade agreement.

o

λ = 0 withfree trade agreement.

o