Report

5 Estimation of Potential Trade under
SAFTA with the Gravity Model
INTRODUCTION AND REVIEW
OF LITERATURE
The possibility of higher intra-regional trade has been
revealed by the competitiveness, complementarity and
intra-industry indices. The effective additional market
access that countries may get due to SAFTA also
indicates that SAFTA has an economic rationale. To
further substantiate this argument we estimate the trade
potential created under SAFTA using the standard
gravity model. The difference between the predicted
trade by the gravity model and the actual trade reflects
the potential trade.
Since Tinbergen (1962) and Pöyhönen (1963), it
has been well known that the simple gravity equation,
in which the volume of trade between two countries is
proportional to the product of their masses (GDPs) and
inversely related to the distance between them, is able
to explain bilateral trade to a large extent. In the
literature, the basic gravity equation has been extended
by a number of economists. In extended the Gravity
Model, other explanatory variables typically included
are level of development represented by per capita GDP
and dummy variables reflecting contiguity; geographical
and cultural proximity such as common borders
and common language, and also participation in
various regional trading arrangements. However, it is
often argued that the Gravity Model suffers from the
absence of a cogent derivation based on economic
theory. Bhagwati (1992, 1993) and Panagariya (1995)
have argued against proximity being an important
determinant of international trade. On the other hand,
there are several economists who have provided
theoretical foundations for the Gravity Equation
[Linnemann (1966), Anderson (1979), Bergstrand
(1985, 1989), Helpman and Krugman (1985), Eaton
and Kortum (2002), Harrigan (2002)]. Despite the
existing debate, gravity models have produced
statistically consistent results for the applied analysis
of international trade. It offers a systematic framework
for measuring the patterns of bilateral as well as
regional trade throughout the world and can be easily
amenable to the analysis of regional influence in
international trade (Frankel, Stein and Wei 1995).
With respect to the SAARC countries, there is a
stream of literature which predicts potential trade in
the region using different variations of gravity model.
Hassan (2001) using 1997 data found that under
SAFTA, the seven SAARC economies will not only
reduce trade among themselves but also with the rest
of the world (ROW). The study uses both panel and
cross sectional data for 1996–2002 period to estimate
trade creation and trade diversion effects under the
present SAFTA regime, using the gravity model. This
study found evidence of trade creation among the
SAARC member countries, without any trade diversion
with the rest of the world. Srinivasan (1994) and
Srinivasan and Canonero (1995) used gravity models
to estimate the gains of preferential trade agreement to
South Asian countries and arrived at the results
indicating that unilateral trade liberalisation may yield
more gains for the region as compared to preferential
trade agreement. Rahman et al. (2006) investigates the
trade creation and trade diversion effects and find that
intra-bloc export increases at the costs of reduction in
extra-regional export. The extent of intra-bloc export
creation in SAPTA member countries was found to be
much lower than that of several other notable RTAs,
viz., NAFTA, SADC, CAN, EAC and MERCOSUR.
Mehta and Bhattacharya (2000) have used the
Srinivasan and Canonero (1993) type model to estimate
the future trade flows, if SAPTA turns into SAFTA. In
this model, bilateral trade has been regressed on GNP,
per capita GNP, distance, tariff rates and real exchange
rate. A log-linear version of unbalanced panel data
model has been estimated, along with a cross-section
and time-specific coefficients. The simulation results
of this study show that the complete removal of tariffs