Regional Economic Integration: Volume 12

Two fundamental reasons that account for the domestic bias of consumption are distance and borders. Distance proxies for unobservable trading costs, which include, among other things, transport and administrative costs. Distance is a powerful deterrent to international trade. This fact is illustrated by considering the situation of Bahrain and Qatar, Belgium and India, and Indonesia and Guyana, which are, respectively, the closest (55.5mi), the median (4,414.7mi), and the farthest (12,351.1mi) country pairs in a large sample of bilateral trade flows (see Chapter 2). For Bahrain and Qatar, distance is estimated to reduce the estimate of bilateral trade flows by 39%; for Belgium and India, the reduction is 58%; for Indonesia and Guyana, the reduction is 121% (it exceeds the value of bilateral transactions). The success of the gravity model in explaining bilateral trade flows is due, to no small measure, to distance. For example, the standard trade model of complete specialization, without trading costs, makes two strong predictions. The first is that a country will import goods from all other countries in the world and the second that bilateral trade flows are proportional to the income of the two countries. Both predictions are way off the mark. Countries import from a small fraction of the potential pool of exporters and incomes alone over-predict actual trade flows by a large margin.

National borders are a hurdle to the expansion of the open economy. Integration today remains imperfect because national borders translate into trading costs, including differences in monetary regimes. Political borders shelter many goods and services from external competition and, consequently, represent a critical exogenous force in the integration process. Small economies face thicker borders than large economies. Regional trade arrangements have softened or, in some cases, pushed outward national borders, but in the process new borders have emerged. Borders affect also finance and monies. While the speed of financial integration suggests currency consolidation and a decline in the ratio of independent monies to sovereign nations, the formation of multilateral monetary unions (MUs) pushes the ratio toward unity.

This chapter reviews the evolution of thinking about regional trade agreements (RTAs) and the policy developments reflected in three waves of RTAs during the last half century. Desirable and undesirable features of RTAs can be identified, but the central message concerns the ambiguity of outcomes. The chapter concludes with a discussion of the role of the nation state and of multilateral institutions and the scope for intermediate levels of organization created by RTAs.

The paper discusses recent changes in conventional wisdom about the optimality of fixed and flexible exchange rates. It develops the important difference between traditional and hard currency fixing. The main part of the paper analyzes the traditional benefits and costs of fixed currencies, how they are changed by first modifications of and second fundamental challenges to the Keynesian paradigm. The last part reviews empirical finding that fixed currencies hard currency fixing leads to a higher economic growth.

Can changes in the trade of the world's largest trading countries be considered more global? Or should they be labeled as more regional? We investigated these questions for the G7 countries for the time period from 1980 to 1997. We found that the usual dichotomy of global–regional is not rich enough to answer these questions because globalization can be measured in terms of both physical and cultural distance. Our new taxonomy allows for testing these separate impacts on world trade and suggests that trade changes are best described as regional, though with some qualification. With respect to physical distance, we find that trade is clearly becoming more regional. On the cultural dimension, however, we find conflicting results. These results are robust to a series of tests. We find the same pattern at industry level, except for paper products and motor vehicles. The regionalization pattern holds for both imports to and exports from the G7, but it is stronger for exports.

This study presents evidence of increasing regionalization of international trade among 10 South American countries from 1980 to 2001. Regionalization of trade in South America is best described as an increasing trade among Spanish-speaking countries and increasing trade within the two regional agreements, the Andean Community and Mercosur. There is also evidence of border erosion in the continent, especially among the Mercosur members. These results emerge from a simple statistical analysis and are also economically significant when tested in a consistent gravity equation that controls for a set of macroeconomic and geographic variables.

This chapter is an extension of a recent work that has examined the intra-regional sales of large multinational enterprises (MNEs). First, we examine the interaction between the performance of MNEs and four proxies for their firm-specific advantages (FSAs). This includes: firm size, knowledge (as represented by research and development (R&D)), marketing ability, and industry type. We find that FSAs in R&D and service sector type are best exploited within the home region. In contrast, the FSA firm size is better exploited by global and bi-regional firms. Second, we find that a service MNE tends to be more home-region oriented and has a higher proportion of intra-regional sales than a manufacturing firm.

China, Japan, and South Korea have been discussing and investigating, through communiqués and their governmental research institutes, the feasibility of a free trade agreement (FTA) among them. Separately, Japan and Korea have announced that they will finalize an FTA by the end of 2005. A China and Korea FTA may follow. For all three countries, and for Korea particularly, a tripartite FTA, termed here FEAFTA (Far Eastern Asia Free Trade Agreement), will be the best arrangement to truly reduce trade barriers in all sectors including agricultural industry. Statistical analysis shows that trade and gross domestic product (GDP) (particularly for Korea) will increase substantially. The trade talk background, trade negotiations, trade issues, and the impacts of such an FEAFTA are discussed.

Of the 75 Asian firms with data on regional sales, only three are global whereas 66 have the majority of their sales in their home region. Why is this? Despite a large literature extolling the global success of Asian firms, especially the Japanese, why does the evidence suggest that most Asian firms operate regionally? This study explains how most large Japanese firms have firm-specific advantages, which are based in their home region.

This paper shows that terrorism reduces bilateral trade flows, in real terms, by raising trading costs and hardening borders. Countries sharing a common land border and suffering from terrorism trade much less than neighboring or distant countries that are free of terrorism. The impact of terrorism on bilateral trade declines as distance between trading partners increases. This result suggests that terrorism redirects some trade from close to more distant countries. Our findings are robust in the presence of a variety of other calamities, such as natural disasters or financial crises.

The international business literature presents an interesting intellectual puzzle regarding the effect of political instability and political risk on foreign direct investment (FDI). Survey evidence shows that multinational executives take into account political instability in making investment decisions, while econometric studies produce conflicting findings. In this paper, I offer a new theory that explains how political violence, an extreme form of political instability, affects FDI. The new theory differs from previous arguments on three points. First, the theory considers how rational expectations and uncertainty on the part of foreign investors affect the ways in which political violence influences investment behaviors. Second, the new theoretical argument argues for the need to investigate separately the effects of different types of political violence (civil war, interstate war, and transnational terrorism). Third, I consider FDI inflows as resulting from two distinct but related decisions, including the investment location choice and the decision on investment amount, and sort out statistically the separate effects of political violence on these two processes. The empirical analysis of FDI inflows covers about 129 countries from 1976 to 1996. The statistical findings largely support my theoretical expectations. My theory helps reconcile the inconsistent econometric findings on the effect of political instability on FDI flows.

The purpose of this appendix is to provide documentation of the data sources and methodology underlying the empirical tests done in Chapters 2, 5, 6, 8, and 10 of the volume; the actual databases can be downloaded from the homepage of the Indiana University Center for International Business Education and Research (http://www.kelley.indiana.edu/GPO/research.cfm). The databases for multinational enterprises used in Chapters 7 and 9 are described in Chapter 9 and are not covered in this appendix.

The gravity equation applied to international trade uses, among the explanatory variables, basic factors, such as income and distance, and other factors, such as cultural and institutional variables. The basic factors are treated in the first section and other factors in the second.