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Factors Affecting Trade Volume

Paper Type: Free Essay Subject: Finance
Wordcount: 5442 words Published: 24th Feb 2017

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The area of research for this thesis focuses on empirical study determinants of trade volume of Asian developing economies; which constitute the success of global trade. The relationship among determinants of trade studied in the context of developing economies which includes: Pakistan, India, China, Bangladesh and Sri Lanka. Factors those affects on trade includes: Tariff, Import duty, Inflation, Foreign Direct Investment (F.D.I), Exchange Rate, Transportation Cost and Gross domestic Product (G.D.P) affect on trade volume, based on gravity equation framework in which foreign trade depend in between countries. To accomplish this purpose by using standard gravity model, study comprises multivariate regression on trade of Asian economies.

Study found that trade depend on distance in between countries, wealth, tariff and non tariff barriers (N.T.Bs) like exchange and capital control. Export volume of an economy measures trade volume of a particular country to indicate economic growth of a particular country (Tamirisa, 1999).

An Economy that have positive balance of trade, improve economic growth of a particular country due to effective economic and financial performance. Besides this basic affects exchange and capital controls influence trade through other channels, for example, transaction cost, exchange rate, foreign exchange risk and trade financing. Capital control in particular country affect on trade in goods by reducing inter temporal trade and portfolio diversification, which may substitute or complement intra temporal trade (Tamirisa, 1999). Therefore, this thesis aim’s to study determinants of trade volume based on developing economies.

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A restricted trade policies imposed by a government is harm for a trade. Study found that world trade organization (W.T.O) rules & regulations foster trade volume based on strategic planning of global trade at this competitive era. Despite the net economic and social benefits; most governments reduce subsidies and open economic trade. It has been realized in this study manufacturing tariffs remained high in developing countries. However; subsidies and trade policies affects on agricultural, textile and service industries of both rich and poor countries which continued hamper efficient resource allocation, economic growth and poverty alleviation (Anderson, 2004).

Fundamentally, capital controls affects on trade by decreasing inter temporal trade and portfolio diversification. The impact of trade in goods depends, if trade in goods and trade in factors are substitute (for example, as found in the basic Heckscher-Ohlin model) the volume of trade in goods likely to fall. If trade in goods and trade in factors are complement (as, for example, in some models with increasing returns to scale), the volume of trade in goods increases (Tamirisa, 1999).

The empirical evidence indicates that foreign direct investment tend to increase host countries’ export and import due to liquidity in a financial market. Foreign direct investment and exports are alternative strategies in this case. Since multinational companies (M.N.Cs) avoid to pay tariff. They initiate subsidiary companies at the host country to cross subsidize in other countries based on strategic management. Capital controls often limit business opportunities for hedging foreign exchange risk and trade financing, thus inhibit trade (Tamirisa, 1999).

The gravity equation is one of the most empirically successful studies. It relates trade flow to GDP, distance and other factors that affects on the volume of trade (Anderson and Wincoop, 2003). For this purpose, the overall effects of trade barriers on Asian developing economies empirically studied, analyzed, tested and resulted.

Justification For The Research

This study is timely significant for theoretical, methodological and practical reasons. With regards to theoretical significance; this study contributes to the literature based on their specification. Determinants of trade volume of Asian developing economies comprises, Pakistan, India, China, Bangladesh and Sri Lanka to identify their trade issues with respect to other regions based on gravity equation framework.

As mentioned in empirical literature, determinants of trade volume contribute their significance at this competitive era, where lot of resistance exists at global market. While competition indicate threat for any type of business either manufacturing or service industry. On other hand trade barriers like Tariff, Import duty, Capital Control through Foreign direct investment (F.D.I), Transportation cost and Inflation raise more critical issues to survive in this competitive era.

This study also practically signifies from management prospective for those entrepreneurs intending to cross subsidize their business at global market to retain their leading market share. Results of this study provide guidelines for entrepreneurs to identify their, Economic and Socio-Cultural issues that lead to trade barriers for their investment. This study support them based on empirical understanding about trade barriers of developing economies and how it affects on trade. Finally, this study will benefit on ‘strategic decision making’ to implement trade policies in global market.

This chapter comprises the foundation of this study. It introduces research objective and focus on trade and its determinants based on theoretical & practical justification of this research. Then major terms used in this study are discussed comprehensively.

Literature Review

This chapter based on comprehensive literature review, those are useful for this study. The objective is to evaluate determinants of trade volume in the context of literature review. To this end, this chapter divided into three sections.

First section deal broadly with trade and it’s determinants for which this thesis first explains determinants of trade and then model based empirical finding those are relevant to this research.

The second section will investigate theoretical perspective and determinants of trade.

The third section interlinks determinants of trade with empirical findings based on Asian developing economies.

In short, this thesis first discuss trade theories as mentioned in the literature and then pertinent model present; which will not only explain trade theories but also highlight the link determinants of trade and developing economies.

Overview Of International Trade

It is a well accepted idea that free trade benefits all countries around the world; it is also a well known fact that hardly any country has always been practice free trade policies. Traditionally trade theories contend that government intervenes on foreign trade because of political pressure from interest groups. Since import can pose a threat to domestic industries, these industries lobby intensely for trade protection (Krueger, 1974, Pincus 1975, Mayer 1984). Other studies suggest that governments are tempted to use trade bargaining to gain larger share from global trade (Morishima, 1989); [Cheng, Liu, and Yang, 1999].

International trade is more or less substitute of foreign investment. On the contrary factor proportion hypothesis [Helpman, 1984; Markusen, 1984; Helpman and Krugman, 1985; Ethier and Horn, 1990] seems to predict that international trade and investments are complement as firms take advantage of factor price differences through cross border vertical integration. According to Aizenman, Joshua and Ilan Noy (2005), it is common to expect bidirectional linkage between FDI and trade. However, it is difficult to indicate whether inflows and outflows of FDI affect directly on trade in different types of goods and services. Study found there is strong feedback relationship between FDI and trade; especially in manufacturing industries. There is some evidence indicate trade enhancement lead to extensive competition in domestic and global market at this era (S. and W. Chaisrisawatsuk, 2007).

Economic integration promises to raise trade volume through trade creation by engaging trade agreements. At micro level, interdependence between international trade and investment is magnified through intra firm trade (trade among foreign affiliates), outsourcing of raw material, intermediate goods, output and firm’s vertical integration behavior (S. and W. Chaisrisawatsuk, 2007).

Since trade liberalization implies a liberated (less costly) movement of goods and services while investment liberalization implies better environment for movement of resources. Increasing international trade based on sustainable comparative advantage is a key condition for countries to realize gain from global trade. If trade and investment are complementary, FDI inflow supposed to enhance gain from trade. In addition, FDI inflow to the host country expected to improve efficiency and productivity of factors production, therefore it enhances the country’s competitiveness (S. and W. Chaisrisawatsuk, 2007).

This study applies gravity model approach to investigate the relationship between international trade and foreign investment. Generally, countries with similar resources produce similar products. However, existence of two way trade (Bilateral Trade) in similar products and two way investments among developed as well as developing economies indicates that there is a room for trade and investment. Thus, simultaneous equation estimate is more appropriate approach used in order to capture feedback effects between trade and investment in order to examine relationships between trade and investment (S. and W. Chaisrisawatsuk, 2007).

Factors Influence International Trade

Study found that tariff, inflation, transportation costs are critical factors affect on trade of developing economies. The empirical evidence indicates foreign direct investment tends to increase host countries’ exports, although the impact on imports is relatively weak. In the presence of tariff barriers, however restrictions on foreign direct investment distort trade.

According to the static general equilibrium model, trade is determined by the wealth and size of countries. While distance has a negative effect on trade, in a part because of trade costs (e.g., transportation and communication) are likely increase with respect to distance. Tariff barrier in the importing countries also tend to have a negative, albeit insignificant effect on exports into these countries. While Per capita, G.D.P and Population, on other hand, have significant positive effects on exports (Tamirisa, 1999). Factors those affect on trade justify in detail below.


A tariff is a tax on import which is collected by the federal government to build infrastructure of a particular country. Tariff usually aims first to limit import and second to raise government revenue, that’s reason multinational corporations (M.N.Cs) avoid to pay tariff. And initiate subsidiary companies at host country through cross subsidization to retain their leading market share at global market. Empirical studies found tariff lead to trade distortion due to it have a negative effect on trade which raises the cost of trade. Due to tariff rates significantly reduce export of developing and transition economies (Tamirisa, 1999).

Model predicts the presence of trade barriers, such as tariffs and non-tariff barriers (N.T.Bs) diminish trade volume. The empirical study found tariff rate interact with the estimated share of free trade. Since trade distortions caused by tariffs; which indicate low growth rate in a country that needs to import more under free trade regime. Government intervenes in foreign transactions by imposing tariff on import of foreign goods. Therefore, tariff has two effects on economy, namely distortion of resource allocation and the transfer of revenue. Thus, distortion effects of tariffs on the growth rate evidently hinge free trade (Lee, 1993).

Empirical study found large variation in trade, caused by tariffs and transportation cost. Tariff liberalization shift trade from rich to poor and domestic to global countries, this estimates imply that elimination of tariff create more trade for poor countries. It is also implies that tariff elimination would divert trade away from continental to preferential trading areas. It has been studied in empirical literature tariffs, distance and production costs are important factors affect on trade; study found tariffs reduce trade significantly. Where low tariff rate is exists among organization of economic cooperation and development (O.E.C.D) countries. While high tariff is exist among Non-O.E.C.D countries. Therefore elimination of tariff rate would raise global trade significantly (Lai and Zhu, 2004).


It has been realized in comprehensive literature review inflation tends to hamper the volume of trade and slow down economic growth. The initial effects arise from decreased in domestic demand. Thus, result rises in price fluctuation relative to those competing or importing countries (Lovasy, 1962).

The initial affects of inflation is an increase the price of goods and services in domestic market, which makes selling on that market more profitable than export. Since market price influence a volume of trade. However inflationary affects tend to encourage such change with a view to raise the price of commodity and maintain it high level. The creation of substitute adversely affects on the volume of trade. If inflation prolong over a period of years, trade will adversely affect through structural changes in an economy (Lovasy, 1962).

The affects of inflation on exports may be counteracted by government actions in various forms like: adjustment of exchange rates, retention quota, subsidies on exports (either straight or through multiple rate practices). In other hand devaluation or gradual depreciation of exchange rate will raise the prices of trade (Lovasy, 1962). Since many other factors influence export, inflation can be a visible affects if it lead the price out of line with price in competing countries or importing areas (Lovasy, 1962). On the other hand, extensive empirical research such as Levine and Renelt (1992), Levine and Zervos (1993), Stanners (1993), Bruno and Easterly (1998) and Easterly (2003) indicate negative relationship between inflation and economic growth (Chowdhury and Siregar, 2004).

Transportation Cost

Transportation cost is one of the significant factor affects on trade. The importance of geography has been recognized by Moneta (1959) as well as by Hummels (1998). It was found that distance is a critical factor in-between country, whether they share common border or they are landlocked. The infrastructure depends on transport and communications network. Study found that infrastructure is quantitatively important factor to determine transport cost (Limão and Venables, 2001). Generally these types of cost associated in foreign trade.

1. Physical Shipping cost.

2. Time related cost (Lead Time).

3. Cost of cultural unfamiliarity.

Among these costs physical and shipping cost obvious with respect to distance in a trade (Frankel, 1997 quoted from Linnemann, 1996).

Generally neighbor countries have more integrated logistics network that reduce number of trans-shipments. Second, neighboring countries are more likely to have transit and custom agreements that reduce transit time and translate into lower shipping and insurance cost. This suggests that distance affects trade volumes through transportation costs and through other channels such as information, which is often associated with distance. It has been realized that poor communication network leads to higher transportation cost, which significantly affect on the volume of trade (Limão and Venables, 2001).

Transportation cost negatively affect on trade volumes due to complex geographical location, infrastructure, administrative barriers and the structure of shipping industry. Based on comprehensive literature review, land locked countries face transportation cost fifteen percent higher and lower trade volumes than representative coastal countries (Limão and Venables, 2001).

Exchange And Capital Control

Study found that most countries have liberalize policy on transfers payments; since economic policy is increasingly shifting toward liberalize transaction. Exchange control acts as a tax on foreign currency required for purchasing goods and services. Besides this basic effect, exchange and capital controls influence trade through other channels as well, for example, transaction cost; exchange rates, foreign exchange risk and trade financing. Study found that exchange and capital control often raise transaction cost (Tamirisa, 1999).

Furthermore, exchange and capital controls can reduce trade by limiting the transfer of technology, managerial expertise and skills through foreign direct investment. Capital controls often limit business opportunities for hedging foreign exchange risk and trade financing. Thus inhibit trade volume in the presence of capital control. Exchange and capital control on other hand, often associated with an overvalued exchange rate, which inhibit trade. Moreover capital controls help to retain domestic savings and higher saving leads to higher investment in export sectors; thus trade may increase (Tamirisa, 1999).

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Study found that capital controls are critical barrier to export into developing and transition economies; but not to industrialized countries. These findings attribute to capital controls, which noticeably reduce export into developing and transition economies and have only a minor negative impact on export for developed economies. Reason is that industrial economies have relatively liberal regimes for global capital movement. While many developing and transition economies continue maintain various capital controls (Tamirisa, 1999).

Exchange and capital controls affect trade through interrelated channels, including transaction cost, and volatility of exchange rate, inter temporal trade, and portfolio diversification. Study realized exchange and capital control have a negative impact on export. However, this result varies depending on the level of development in the country and type of exchange and capital control. These results may reflect the extent, to which restrictions on current payment and transfers have been liberalized (Tamirisa, 1999).

Gross Domestic Product

Trade cost operates primarily via price. In the context of monopolistic competition model, difficulty is created by the complexity of constant elasticity substitution (C.E.S) price index in the presence of asymmetric trade costs. To resolve this difficulty, three approaches have been taken:

1. G.D.P price indexes are used to capture the price effects in the gravity equation as Bergstrand (1985, 1989) and Baier and Bergstrand (2001).

2. Estimated border effects are used to measure the price effects, as in Anderson and Wincoop (2003) and Balistreri and Hillberry (2001).

3. Fixed effects are used to account for the price effects, as in Harrigan (1996), Hummels (1999), Redding and Venables (2002), and others (Lai and Zhu, 2004).

Turn to an empirical investigation export from one country to other trading partners depends on gross domestic product (G.D.P). By using [Rauch’s, 1999] classification sample consist in groups: homogeneous goods, differentiated goods in between categories. On the basis of gravity equation framework trade in each of these groups move from homogeneous to differentiated goods; studies found elasticity of export with respect to G.D.P rise significantly. These findings are empirically significant both economically and statistically. The G.D.P of exporting country is found to be a powerful explanatory variable to explain trade relations.

There are demographic variables such as G.D.P and population which relate to the size and stage of economic development based on export and import in between countries. These factors are included in the study despite controlling the effect of dependent variable to determine whether size of an economy has an independent influence on trade relations (Feenstra, Markusen, and Rose, 2001). The ratio of trade volume to real G.D.P is often used as an indicator of an economy’s openness to international trade (Prasad and Gable, 1998).

Import Duty

Import duties refer to a tax in which importer pay to the government in order to bring foreign products in a particular country. Most of the import duties are figured in a percentage on declared value of the commodity. An import duty differs from product to product and depends on commodity is being imported. It’s declared value of origin country. While product group used to assess import duties in between two countries (Sampson and Yeats, 1976).

The competitiveness of domestic manufacturers adversely affected vis-à-vis import because importer liable to pay additional charges due to execution of projects financed by a trading partners (Mukhopadhyay, 2002). Like India fetched excessive price because of banning imports on some goods, they charged very high duty running around the price of goods. These non traditional goods (mainly consumer durables) provided great stimulus to the contraband trade. However, when there is a massive scale of contraband trade, country face substantial loss in term of revenue (Sarvananthan, 1994).

Foreign Direct Investment

Study found foreign direct investment change industrial structure and trade flow across a country. Since FDI help in cost reduction and export promotion at host countries through up date technology. Foreign direct Investment (FDI) also provides financial resource for investment at a host country. In other hand it provides foreign exchange that’s positively affect on the balance of trade. Indeed, in the wake of debt crisis, FDI has come to be viewed as an increasingly important source of revenue for developing countries (Goldar and Ishigami, 1999).

Advantage of FDI is that it assists the host country to improve its export performance. By raising the level of efficiency and the standards of product quality, FDI makes a positive impact on the host country’s export. Furthermore, it provides better access to export in foreign markets. According to the Hymer-Kindleberger theory (Kindleberger, 1969) foreign owned firms investment at the host country; if it possesses competitive advantage which allows them sustainable growth. Foreign direct investment plays significant role to promote export and to change industrial structure of Asian countries through transfer of technology. Dunning’s eclectic theory of international trade (Dunning, 1988) explain overseas market served by enterprises in different geographical location around the world. According to this theory, firms invest in a country if following conditions are satisfied:

Firm possesses some ownership advantages vis-à-vis firms with other nationalities serving particular markets.

It is more beneficial for the firm to produce in foreign country due to update technology and Infrastructure of a particular country (Goldar and Ishigami, 1999).

FDI contribute on economic growth of the region through cost reduction and export promotion. On other hand, rapid growth is being attained by the region due to update technology and infrastructure for a particular country. As growth leads to expansion of both domestic and global market (Goldar and Ishigami, 1999).

FDI flow in Asia has shifted over a time from Asian Newly Industrialize Economies (N.I.Es) to A.S.E.A.N. While china and Japan have became persistent source of FDI in developing countries (Goldar and Ishigami, 1999). During the past two decades, Taiwan, South Korea, Singapore, and Hong Kong witnessed most rapid economic growth in all developing countries. Their export oriented strategy emphasis on foreign investment and trade is considered the main cause for their success (Amirahmadi and Weiping Wu, 1994).

Many countries established Export Processing Zones and Special Economic Zone to promote foreign investment and export to other countries. These zones have preferential treatment in manufacturing process. Their products are targeted for export market. Taiwan and China are the chief example; where these zones have become major attractions of FDI (Amirahmadi and Weiping Wu, 1994).

Exports and FDI is complementary instrument in economic growth [Veugelers and Yamawaki, 1991]. Increasing import and inward FDI increase competition on domestic market and reduce domestic firms’ profitability. FDI allow transfer of technology to produce and sell goods on foreign market. Empirical study found import have positive effects on competitive behavior of domestic firms and have negative effects on their profitability; it has been analyzed theoretically (e.g. by Caves [1985], Jacquemin [1982]) and empirically in the literature (e.g. by Levinsohn [1991], Pugel [1978, 1980], Turner [1980]); (Bertschek, 1995).

Based on export oriented group of countries, foreign investment is a more powerful driving force in economic growth process rather than domestic investment. According to this supplementary hypothesis the elasticity of output with respect to foreign capital is predicted as exceeding with respect to domestic capital (Balasubramanyam, Salisu and Sapsford, 1996).

Model For Study.

Study comprises factors affecting trade volume of developing economies based on gravity equation framework. Foreign trade relation play vital role for economic development. Foreign trade is influenced by multinational corporation (M.N.Cs). These underlying relationships explain the effects, trade barriers of developing economies based on foreign trade relation.

This section present trade model and its key concepts used in this study. Determinants of trade and its relationship with trade theory have been identified, tested and resulted. On the basis of comprehensive literature review; it observed that ‘tariff, inflation and transportation cost are significant factors affects on trade volume of Asian countries. The trade model tested based on developed hypotheses in the next section of this research.

Trade Theory

Based on comprehensive literature following are the facets of trade theories focus on various concepts associated with global trade in terms of theories expanded by the scholars.

Gravity Model Of Trade Theory

Study found that international trade flow well described by a “gravity equation framework” indeed, gravity equation is one of the empirical accomplishment stories in economics and trade theories (Feenstra, Markusen and Rose, 1999).

The gravity equation framework is one of the most popular empirical evidence for the whole range of spatial relations in economics and international trade over a period of time. Generally it apply to study determinants of trade volume and to assess various regional economic integration with respect to developing economies (Cieslik, 2007).

In the context of international trade, gravity equation in its basic form nominate the amount of trade in-between two countries increases in their size and proportion to their national income, and inversely decreases by the cost of transport between them, (As measured by distance between their economic centers). This relationship closely look like Newton’s (1687) law of gravitation which states that every atom in the universe attracts other atom with a force that is comparative to the product of their masses and inversely comparative to the distance among particles (Cieslik, 2007).

Although gravity equation in its basic form performs a good job to justify foreign trade based on size of trading countries and distance between them. Therefore, in order to improve performance of the gravity equation in empirical studies of trade; one should take into account the impact of other factors that affects on volume of trade (Cieslik, 2007).

Theoretical Foundation Of Gravity Model

The concept of the gravity model based on Newton’s Law of Universal gravitation which relate the force of attraction between two objects with their combined masses and distance between them. The application of gravity model in social sciences empirically proposed by James Stewart in the 1940s (Fitzsimons et al., 1999). And then originally applied to international trade by Tinbergen (1962), the gravity model predicts trade flow between any two countries as a function of their size and distance between them (Walsh, 2006).

Economic size is measured by gross domestic product, population and per capita income. Distance typically calculated through transportation cost between countries’ capital cities. In some studies this is replaced by the measures of remoteness through G.D.P or measure distances relative to the country’s average distance with all trading partners. Extension of this approach is to calculate trade cost with respect to barriers. And other restrictions on trade flow by comparing predicted and actual levels of trade volume (Walsh, 2006).

As the empirical applications of the gravity model has grown theoretically over a period of time; foundation of this model have also developed. Beginning with Anderson (1979); who illustrates gravity equation framework is consistent with a model of trade in which products are differentiated by the country of origin (Walsh, 2006).

The gravity model is being established in a literature and measure potential trade between countries. The gravity model; defined by the Newton’s Law of Gravitation, explain trade flow between two countries. It is one of the most popular empirical associations in economics and international trade. Earlier studies have estimated difference between observed values and predicted values those are calculated through O.L.S estimate of gravity model (Baldwin, 1994; and Nilsson, 2000); (Kalirajan and Singh, 2007).

Justification Of The Gravity Model

The Newton’s physician primarily justify gravity model based on theoretical justification with their combined masses. Second justification for the gravity model was analyzed by Linneman (1966); (Rahman, 2003).

Anderson (1979), Bergstrand (1985, 1989), Thursby (1987), Helpman & Krugman (1985) share this view. Their studies identify number of variables. However, price and exchange variables can be omitted when products are perfect substitutes for one another in consumer preference. This structure of course, obtains the standard Heckscher-Ohlin (H-O) setting (Jakab 2001); (Rahman, 2003).

Empirical Study

Study found the gravity model in the context of international trade applied, first time independently by Tinbergen (1962) and Pöyhönen (1963) but they didn’t have any theoretical justification at the beginning. The earliest but not completely successful attempts provide a theoretical justification for the gravity equation by Linneman (1966), Leamer and Stern (1970) and Leamer (1970). However, origin of the gravity equation from a model was not possible till the product homogeneity assumption; since early neoclassical trade literature was relaxed at that time (Cieslik, 2007).

The first formal attempt to derive the gravity equation directly from theoretical point of view made by Anderson (1979) based on Armington hypothesis which argues that products differentiated by the country of origin. Anderson (1979) demonstrated to derive gravity equation by using properties of Cobb Douglas expenditure system when goods produced by a country. Anderson’s (1979) approach subsequently applied and extended by Bergstrand (1985) who derived and summarize equation in terms of trade flow (Cieslik, 2007).

An alternative method proposed by Helpman (1987) who completely departed from neoclassical assumptions of traditional Heckscher-Ohlin-Samuelson model. Which assume monopolistic competition and product differentiation among various firm in all industries rather than countri


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