Trade Creation and Diversion Effects of the East African Community Regional Trade Agreement: a Gravity Model Analysis
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RESEARCH SERIES No. 112 Trade Creation and Diversion Effects of the East African Community Regional Trade Agreement: A Gravity Model Analysis ISAAC SHINYEKWA & LAWRENCE OTHIENO December 2013 RESEARCH SERIES NO. 112 Trade Creation and Diversion Effects of The East African Community Regional Trade Agreement: A Gravity Model Analysis ISAAC SHINYEKWA & LAWRENCE OTHIENO DECEMBER 2013 Copyright © Economic Policy Research Centre (EPRC) The Economic Policy Research Centre (EPRC) is an autonomous not-for-profit organization established in 1993 with a mission to foster sustainable growth and development in Uganda through advancement of research –based knowledge and policy analysis. Since its inception, the EPRC has made significant contributions to national and regional policy formulation and implementation in the Republic of Uganda and throughout East Africa. The Centre has also contributed to national and international development processes through intellectual policy discourse and capacity strengthening for policy analysis, design and management. The EPRC envisions itself as a Centre of excellence that is capable of maintaining a competitive edge in providing national leadership in intellectual economic policy discourse, through timely research-based contribution to policy processes. Disclaimer: The views expressed in this publication are those of the authors and do not necessarily represent the views of the Economic Policy Research Centre (EPRC) or its management. Any enquiries can be addressed in writing to the Executive Director on the following address: Economic Policy Research Centre Plot 51, Pool Road, Makerere University Campus P.O. Box 7841, Kampala, Uganda Tel: +256-414-541023/4 Fax: +256-414-541022 Email: [email protected] Web: www.eprc.or.ug Trade Creation & Diversion Effects of the East African Community Regional Trade Agreement: A Gravity Model Analysis ABSTRACT The paper investigates the potential impact of the EAC (a South-South Regional grouping) on trade creation and diversion. The paper seeks to establish whether the EAC Regional Trade Agreement has diverted or created trade using an expanded (augmented) gravity model. The paper departs from the conventional estimation approach that uses average combined trade flows as the dependent variable which is prone to errors and uses exports. We estimate static and dynamic random effects models using a panel data set from 2001 to 2011 on seventy countries that trade mainly with the EAC partner states. Results suggest that indeed the implementation of the EAC treaty has created trade contrary to widely held views that South- South RTAs largely divert trade. There is thus evidence that the EAC, a south-south RTA has been a more trade creating than trade diverting as espoused in the literature. The paper explains the possible measures that have helped generate the trade underscored; formulation and implementation of EAC medium term development strategies, removal of internal tariffs and adoption of a CET structure. The paper further highlights that although progress has been made in other areas, there are challenges that need to be addressed to deepen the EAC integration: persistence of NTB; lack of a common policy with regard to partner states’ trade policies to non-partner states; the lack of standardised customs formalities; the lack of harmonised procedures; and different approaches to investment and export promotion. It is recommended that; the region adopts a legally binding approach to NTBs, harmonises trade policies and standardises documentation and procedures. Key words Gravity model, imports, exports, intra and extra EAC,trade creation, trade diversion, trade flows, RTA,regional integration Economic Policy Research Centre - EPRC i Trade Creation & Diversion Effects of the East African Community Regional Trade Agreement: A Gravity Model Analysis TABLE OF CONTENTS ABSTRACT i 1.0 INTRODUCTION 1 1.1 Intra EAC trade 2005 - 2010 2 1.2 EAC trade with the rest of the world 3 1.3 Objectives 3 1.3 Policy Relevance 4 2.0 REVIEW OF LITERATURE 5 3.0 ANALYTICAL FRAMEWORK AND METHODS 8 3.0 Introduction 8 3.1 Finger-Keinin Index (FK) 8 3.2 The gravity model 8 3.3. The estimation procedure 11 3.4 Diagnostic tests 11 3.5 Data 12 4.0 FINDINGS 13 4.1 Introduction 13 4.2 The FK index results 13 4.3 Estimation results 14 4.4 Results in the perspective of EAC integration progress 17 5.0 CONCLUSION 20 REFERENCES 21 APPENDIX A1 24 Table A1:Total intra-EAC trade, 2005-2011 (US$ million) 24 APPENDIX A2 25 Table A2: The countries that are included in the study 25 EPRC RESEARCH SERIES 26 ii Economic Policy Research Centre - EPRC Trade Creation & Diversion Effects of the East African Community Regional Trade Agreement: A Gravity Model Analysis 1.0 INTRODUCTION In the last two decades international trade has is composed of five partner states; Burundi, experienced dramatic increase in Regional Kenya, Tanzania, Rwanda and Uganda4. Trade Agreements. At least every country on the globe subscribes to some sort of a A number of provisions to increase the EAC bloc and substantial amount of trade in the intra-trade are enshrined in the treaty leading world takes place within such agreements. to the formation of the EAC. Article 75 of the Between 1948 and 1994 there were only 124 Treaty and the Customs Union (CU) Protocol Regional Trade Agreements notifications, provides a number of elements including however between 1995 and 2008, there (i) elimination of internal tariffs and other were additional 300 notifications made. By charges of equivalent effect (ii) elimination January 2012, about 511 RTAs, (taking goods of non-tariff barriers; (iii) establishment of and services notifications separately), had a Common External Tariff (CET); (iv) duty notified the GATT/WTO1. At that same date, drawback, refund and remission of duties 319 agreements were in force2. Governments and taxes, among others. It was anticipated have the liberty to pursue two broad options that implementation of these provisions when seeking to liberalize trade; namely would increase the value and volume of trade unilateral and preferential liberalization within the EAC. The rationale for regional (Kandogan, 2005). In both instances, there are integration include among others the benefits welfare improving end points especially when of trade creation, greater economies of scale trade creation takes place. Trade liberalization based on profitable competition, increased has been an important part of East Africa’s investment, and improved bargaining power. policy agenda since the countries embarked Article 25 of the EAC CU protocol highlights on liberalising their inter-state trade as the commitment of Partner States to support part of the regional integration process. export promotion schemes in the Community This is exemplified by the number of trade for the purposes of accelerating development, initiatives, specifically economic integration promoting and facilitating export oriented agreements that the region is involved in, investments, producing export competitive such as the East African Community (EAC), the goods and attracting foreign direct Common Market for East and Southern Africa investment. These and others are among the (COMESA) and South African Development efforts to boast intra-EAC trade. Corporation (SADC) for Tanzania3. The EAC There are conflicting views with regard to 1 General Agreement on Tariffs and Trade/World Trade Organisa- trade diversion and creation in South-South tion Regional Trade Areas (RTAs). Yeats (1998) 2 http://www.wto.org/english/tratop_e/region_e/region_e.htm (December 3rd 2012) expresses a pessimistic view arguing that 3 All EAC countries belong to the African Union (AU). Kenya and Uganda belong to the Inter-Governmental Authority on Devel- promoting intra-regional trade has potential opment (IGAD); Burundi, Kenya, Rwanda, and Uganda belong to the Common Market for Eastern and Southern Africa (COMESA); and Tanzania belongs to SADC. Kenya and Tanzania are also ac- tive members of the Indian Ocean RimAssociation for Regional 4 The Treaty for the establishment of the EAC was signed on 30th Cooperation (IOR-ARC). Burundi and Rwanda similarly par- November 1999 and came into force on 7th July 2000. The EAC ticipate in the Economic Community of Great Lakes Countries Customs Union Protocol was signed on 2nd March 2004 and (CEPGL). came into force on 1st January 2005. Economic Policy Research Centre - EPRC 1 Trade Creation & Diversion Effects of the East African Community Regional Trade Agreement: A Gravity Model Analysis adverse effects on member countries and tural services, mainly physical infrastructure on third party countries and have a negative (roads and rail), and high costs of energy, re- effect on Africa’s industrialization and growth. sulting in high costs of doing business that make it difficult to boost trade. Figure 1 dem- A World Bank, (2000a) report argues that onstrates that Kenya is the largest contributor South-South RTAs generate trade diversion to intra-EAC exports (57.2 percent of the total especially when CETs are high and the member in 2010) and Uganda is the largest regional states are poor. Others who hold similar views importer (37 percent of intra-EAC imports in include Park (1995), and Schiff (1997). On the 2010). Kenya overall contributed to an aver- other hand Cernat (2006) argues that, South- age share of over 40 percent of total intra- South RTAs are not more trade diverting than EAC trade and enjoyed a trade surplus with other RTAs implying that it is case by case. its EAC partners during the period. This view is supported by Elbadawi (1997) who argues that integration in Africa is key The region has undertaken a number of trade to generating the threshold that can trigger policy measures to increase and boost in- growth through complementarities. Using tra-EAC trade and trade with the rest of the a Computable General Equilibrium model, world: The Internal Tariffs (IT) along borders Evans (1998) found a net positive effect of the of partner states have been fully removed Southern Africa regional integration initiative.