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