Effect Of Globalization On Canada's International Trade Pattern

Canada’s International Trade Pattern
Final Draft
April 2013

Introduction
Canada with per capita GDP of US$ 42, 734 (PPP adjusted) is ranked 9th in the world, according to the IMF WEO estimates. The total size of Canada’s economy, as of 31 March 2012, stands at US$ 1,446 billion (PPP) (Cheung, 2009) as per IMF figures and ranked at 13 in the world. The country’s merchandise trade rebounded after 5 years of slump and has been in the growth path since 2010. The reversal had been bolstered by better consumer preference for Canadian products globally. The exports (merchandise) expanded to $399.4 billion (2010) while for imports; the figure touched $403.3 billion. However, there is a pitfall in Canada’s trading pattern. It is heavily concentrated
on a handful of trading partners. The top 10 export destination countries account for 90% of Canadian merchandise exports, while 10 biggest exporters to Canada makes up 80% of the country’s imports. A very static pattern of trade rankings of the partner nations (in terms of trade size) pervades the trading trajectory of Canada. The biggest 9 export partners of Canada from 2008-2010 had been unchanged as has been the biggest 8 import partners.
In gravity model we shall establish the factors affecting the exports of Canada and their degree of influence. We will take the standard factors like GDP of the exporting nations, their population, and distance between the countries and the regional trade blocks (as dummy) and determine how much these factors affect the export movement of Canada.The results of our finding can have both short term and long term bearings on the country’s trade policies and export trajectories.

The Gravity Equation

Here we shall study the Gravity Equation (Bergstrand, 1985) with respect to bilateral trade volume, the size of the GDP for the countries involved and distance between them.

The crux of the Gravity equation suggests the bilateral trade expands on the expansion of GDP level of the trading countries and contracts with increase of distance between them.

However, there has been criticism of the validity of Gravity Model as in it is not in sync with the real economic functioning of the world. It is also in direct conflict with some of the most famous and practiced economic theories.

We present a couple economic models that are mostly used and practiced throughout the world.

Ricardian Model
Ricardian Model propagates comparative advantage. It talks about productivity of labor that forms the cornerstone of trade practices across all economies. Ricardian model also negates the impact of GDP size as a factor that shapes productivity.

HOS Model
This model talks about factors of production as guiding principle ofr trade. And like Ricardian Model, this model too nullifies any role of GDP size as differentiators for trade practices.

Gravity Model in International Trade

The simplest model of Gravity Equation in bilateral trade is based on conditions: a) Monopolistic Competition 2) Return maximization
The equation is as follows.
Xin= Nipinqin= Nipi= pin wLn -------- pni-ó qin= pin wLn -------- pni-ó This equation signifies country i exporting to country n and the export figure in the trade.

Value of R2 in Gravity Model

As stated above it is the measure of international trade through the endowment of various factors that is taken as independent variables in the equation. This forms a regression equation and is the source of estimation of R2. As in regression, the intercept α and slope ß are generally valued around 1 and ó is negative. The regression equation tests the hypothesis of expected trade and whether the actual trade deviates from the hypothesis and by what measures.

The Role Trade Policies

The role trade policies and its effect on foreign trade is part and parcel of the gravity equation. The trade zones also affect trade volumes and are generally considered that formation of trade zones expands trades. For that dummy variables are included in the hypothesis of gravity equation to study the impact of trade zones in export and import levels. Therefore, in the given study, we will estimate trade impact by Canada’s inclusion in OECD and NAFTA.

Sharing Common Borders

Canada’s biggest trade partner is USA.
It is advocated in gravity equation that common borders enhances trade between the two nations. We will find how much the sharing borders of Canada with USA impacted in their trade volume.

Distance and Globalization

It will be ascertained whether distance is still a major factor for trade levels or whether the effect of globalization has narrowed it down.

The Effect of Comparable GDP

It is interpreted in Gravity Model that countries with comparable GDPs enhances trade. For instance, Canada, being an advanced economy, tends to export more with other advanced economies. And if the GDP of the advanced economies increases the export of Canada is likely to increase as well. And if the trade takes place between a rich and poor country, for example between Canada and India, it will be marked by comparative advantage of one way or the other. Therefore, the gravity equation suggests that there is chance of biasness in trade practices among countries of same income classes.

Now let’s get down to business and find out how the Gravity Equations work in different
situations.

Situation1

In a scenario where a bilateral trade of goods have no transportation cost and products produced in the countries have comprehensive specialization.

The gravitation equation is as follows:

log(Xij) = log(Iw) + log(Ii) + log(Ij)
Where,
Ii = Income of country i
Ij = Income of country j
Iw = Income of the world
Xij = exports of goods (k) from i to j
Xij = IiIj/Iw

Condition:
The goods are exported from country i to country j
The bilateral trade is between countries with identical liking for the goods (k) traded.

Interpolating the equation for our Chosen country, we find the following.
Since in the equation, the income of both i and j (marked by Ii and Ij) are independent variables, it indicates that the increase Ii will, as well, increase the exports of country i. Therefore exports of Canada increases if Income of any of its trade partner increases or even its own income increases.

GDP Movement of Canada’s Major Trading Blocks & United States

Table 3

Export Movement of Canada
Table 4

Year | Canada 's Export | 2009 | -14.975 | 2010 | 6.927 | 2011 | 4.956 | 2012 | 5.021 |

Source: IMF, WEO

The above data clearly shows that as Income (GDP) advanced in different trading partners of Canada and groups, However, Canada’s export did not always followed the trail. It may be because Canada’s export volume is concentrated heavily on few countries only and the movement of GDP on those countries are likely to factor in Canada’s trade movement. However, we are not sure about that and will find out later in the study.

Situation 2

In our endeavour to add variations in the analysis through gravity model we delved into the papers published by Soloaga and Winters (1998) who studied trade within regional blocks in 1990s, Piani and Kume (2000) with his investigations on grade volume flows with a few regional blocks, like, NAFTA, ASEAN, UE among others and Blavy (2000) boasting of studying factors and scope Mashrek.

The generic gravity equation states that trade between two nations are positive function of their GDPs and a negative function of the physical distance between the two. Some dummies are added to according specifications. Accordingly, an equation is formed as follows.

Where

Xij = Export between countries i and j
Yi = GDP of the exporting nation
Yj = GDP of the importing nation
Ni = Population of the exporting nation
Nj = Population of the importing nation
Du = Distance between the capitals of two nations
Au = Additional factor that either boost or chokes trade between the two given nations
Uij = standard error
The above equation is modified in order to make the estimation process easier in the following form.

Here,
In = natural logs
= the trade dummy of the variable Pijh, = 1 when criteria are, fulfilled i.e. that is the countries belong to a trade block, and Pijh = 0 when they do not belong.
Let’s add few more dummies like using common language and sharing same border that will give a perfect taste of preferential trading agreements’ effect.
The high GDP of the exporter indicates high production level and consequent high availability of goods for export. That means β1> 0. Similarly high income of the importer indicates that β2 >0 too. Β3 can either greater than or less than zero depending whether a big country exports more or less. Similarly, β4 can be >or < 0 for the same reason but this time for the importing country. The β5 would be < 0 since it is the deputation of trade costs.
Therefore, deriving from the above we arrive at the empirical equation as follows.

Xijt = Export between countries i and j at period t
Yit = GDP of the exporting nation at t
Yjt = GDP of the importing nation at t
Nit = Population of the exporting nation at t
Njt = Population of the importing nation at t
Du = Distance between the capitals of two nations
Pijt = Preferential trade zones (dummy)
Uij = standard error

Findings

Overview

Before we enter the findings of the report, it must be categorical that gravity equation is very commonly used modules in international economics, even though with limitations. It will give the estimate of Canada’s international trade and whether our hypothesis taken in Situation 2 is successful. It will depend on the R2 and whether it is high or low. A High R2 tells a high responsiveness of Canada’s trade to the factors stated (Situation2) while a low R2 figure portend the opposite.
Estimates

Regression Statistics | Multiple R | 0.178146 | R Square | 0.031736 | Adjusted R Square | -0.02359 | Standard Error | 1.118935 | Observations | 38 |

ANOVA | | | | | | | df | SS | MS | F | Significance F | Regression | 2 | 1.436265 | 0.718133 | 0.573582 | 0.568711 | Residual | 35 | 43.82051 | 1.252015 | | | Total | 37 | 45.25677 | | | |

| Coefficients | Standard Error | t Stat | P-value | Lower 95% | Upper 95% | Lower 95.0% | Upper 95.0% | Intercept | -2.07874 | 27.61286 | -0.07528 | 0.940419 | -58.1358 | 53.97835 | -58.1358 | 53.97835 | ln GDP | -1.17742 | 3.185901 | -0.36957 | 0.713927 | -7.64515 | 5.290298 | -7.64515 | 5.290298 | ln Population | 3.728524 | 14.27113 | 0.261263 | 0.795421 | -25.2434 | 32.70046 | -25.2434 | 32.70046 |

Assumptions: | | | | | | Trade volume is taken as the ratio of the Export and Import | | The Export origin is shifted by 15; the import origin is shifted by 18 | There is no influence of distance | | | | Other factors are covered in the error term | |
|

In the assumption, even though, distance is a factor ( and is inversely proportional to the trade volume) the sum of merchandise exports and imports are taken hence it is not possible to extrapolate the distance data.

Analysis

From the obtained data and a low R2 reflects low responsiveness of the dependent variable on the change of independent variable.

In other words if the factors stated in the gravity equation (2) such as regional blocks, population and GDPs of importing countries change the consequent change of Canada’s export level would be moderate. Therefore, Canada’s membershipto NAFTA, OECD…et al doesn’t speak much on its effect in the country’s export movement pattern. However, R2 is not zero and hence there is reasonable influence on the trading pattern but not substantially. The table 3 & 4 clearly demonstrate the point where income of major groups as well as Canada’s biggest trading partner, United States; and Canada’s export volume in certain periods (not always) moves at an opposite direction.

There is sometimes criticism of R2 usage that it can be increased by increasing the variables. To offset that Adjusted R2 is used, which in our study is negative. That indicates that responsiveness of Canada’s exports is not affected by factors such as GDP of other economies, population, and dummy of regional blocks . We have seen, between 2010 and 2011, the economies of all the major block and United States increased but Canada’s export contracted (refer. Table 2 and Table 3). So, there is a negative correlation between Canada’s export and GDP of other nations (in that particular year). And that is precisely what is portrayed in our findings.

Limitations
There are some genuine limitations to this model. The justification of this model in the world has presaged disputes. The geographical factor in the model is not supported by the majority of important economic theories and there is no substantive evidence in the age of globalization that it holds true. Also, the factor of size of the economy and other factor of abundances is not conclusively proved in the real world. We have proved that through our estimation that gravity equation predictions are insulated from 21st century’s trade pattern.

Conclusion

The findings and their analysis put a blot (somewhat) on the considered factors of trade growth. That means Canadian policy makers should not be too much concerned about the size of GDP, population growth or trade zones and instead look for other factors like market, growth of market, purchasing power, cost of labor…et al which are less oblique differentiators in export trajectory of Canada. In the age of globalization distance is a weak factor as supported in the gravity equation and should be isolated from the export growth parameters.

Note: Please refer Sheet 1-3 in the Excel file attached for data

References:

1. Cheung, Yin-Wong (2009). "purchasing power parity". In Reinert, Kenneth A.; Rajan, Ramkishen S.; Glass, Amy Jocelyn et al. The Princeton Encyclopedia of the World Economy I. Princeton: Princeton University Press. p. 942. 2. Bergstrand, Jeffrey H. “The Gravity Equation in International Trade: Some Microeconomic Foundations and Empirical Evidence.” The Review of Economics and Statistics, Vol. 67, No. 3. (Aug., 1985), pp. 474–481.