Bayesian gravity model for digitalization on bilateral trade integration in Asia

Jayasooriya, S. P. Working Paper Bayesian gravity model for digitalization on bilateral trade integration in Asia ADBI Working Paper Series, No. 1232 Provided in Cooperation with: Asian Development Bank Institute (ADBI), Tokyo Suggested Citation: Jayasooriya, S. P. (2021) : Bayesian gravity model for digitalization on bilateral trade integration in Asia, ADBI Working Paper Series, No. 1232, Asian Development Bank Institute (ADBI), Tokyo This Version is available at: https://hdl.handle.net/10419/238589 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. Terms of use: Documents in EconStor may be saved and copied for your personal and scholarly purposes. You are not to copy documents for public or commercial purposes, to exhibit the documents publicly, to make them publicly available on the internet, or to distribute or otherwise use the documents in public. If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by-nc-nd/3.0/igo/ ADBI Working Paper Series BAYESIAN GRAVITY MODEL FOR DIGITALIZATION ON BILATERAL TRADE INTEGRATION IN ASIA S. P. Jayasooriya No. 1232 March 2021 Asian Development Bank Institute The Working Paper series is a continuation of the formerly named Discussion Paper series; the numbering of the papers continued without interruption or change. ADBI’s working papers reflect initial ideas on a topic and are posted online for discussion. Some working papers may develop into other forms of publication. Suggested citation: Jayasooriya, S. P. 2021. Bayesian Gravity Model for Digitalization on Bilateral Trade Integration in Asia. ADBI Working Paper 1232. Tokyo: Asian Development Bank Institute. Available: https://www.adb.org/publications/bayesian-gravity-model-digitalization-bilateral- trade-integration-asia Please contact the authors for information about this paper. Email: [email protected] S. P. Jayasooriya is a Chartered Economist (Economic Policy) at Innovation4Development Consultants in Sri Lanka. The views expressed in this paper are the views of the author and do not necessarily reflect the views or policies of ADBI, ADB, its Board of Directors, or the governments they represent. ADBI does not guarantee the accuracy of the data included in this paper and accepts no responsibility for any consequences of their use. Terminology used may not necessarily be consistent with ADB official terms. Working papers are subject to formal revision and correction before they are finalized and considered published. Asian Development Bank Institute Kasumigaseki Building, 8th Floor 3-2-5 Kasumigaseki, Chiyoda-ku Tokyo 100-6008, Japan Tel: +81-3-3593-5500 Fax: +81-3-3593-5571 URL: www.adbi.org E-mail: [email protected] © 2021 Asian Development Bank Institute ADBI Working Paper 1232 S. P. Jayasooriya Abstract The impact of globalization in terms of bilateral trade is a renowned theoretical underpinning in the literature. Nevertheless, testing a trade integration model of bilateral trade is not sufficiently well estimated with the Bayesian approach to provide pragmatic evidence of trade integration from the digitalization in Asia. Moreover, in identifying the factors determining trade integration, testing for digitization using the Bayesian gravity equation is vital. After performing a series of simulation experiments, a relationship between import volume and simulated trade determinants was predicted for the digitalized trade model. The results of the estimated coefficients on GDP in the country of origin and GDP of the country of destination are positively significant predictors of the import growth. The distance between the countries has a negatively significant estimation that implies barriers in trade. The model predicts trade integration, especially towards the trade digitalization in Asia. The Bayesian approach of the gravity model gives robust estimates for determining the impact factor for the importation of trading countries, including the fact that the elasticities of total trade inflow with respect to distance, population, and area of the country of destination and the exchange rate of the country of origin are negative while the proxies of digitization are positively significant. Further, economic size, area, and exchange rate of the destination, and population and area of the country of origin are positively predicted by the model. The estimated parameters are directly the elasticities, in which increases in GDP in a reporter country is consistent with the higher import volumes. Further, evidence of the gravity equation is used for understanding trade potential, and after some integrations, the estimation is applied for the real trade. The measures of bilateral trade resistance or costs associated with the trade flow of the digitization has influenced the expanding of the digital indicators in the model in the Asian economies. Finally, digitalization of trade integration can be implemented across Asia with evidence and robust estimates of the gravity model, including robustness checking. The Bayesian experiment for the estimation of the impacts of the trade integration in Asia predicts an increase of GDP, digitalization proxies, population, exchange rate, and area of the destination as predominant predictors in the Bayesian gravity model. Thus, the results revealed that digitalization has affected the plausible trade agreements for trade integration in Asia. Keywords: Bayesian gravity model, digitization, import growth, trade integration JEL Classification: F11, F14, F15, F62 ADBI Working Paper 1232 S. P. Jayasooriya Contents 1. INTRODUCTION ............................................................................................................ 1 1.1 Targeting Trade-Related Integration ................................................................. 1 2. LITERATURE REVIEW ................................................................................................. 2 3. DATA AND EMPIRICAL METHOD................................................................................ 3 3.1 Data .................................................................................................................... 3 3.2 Empirical Method ............................................................................................... 4 3.3 Gravity Model ..................................................................................................... 4 3.4 Bayesian Approach ............................................................................................ 5 3.5 Poisson Pseudo-Maximum Likelihood Estimator .............................................. 6 4. RESULTS AND DISCUSSION ...................................................................................... 6 4.1 Gravity Model Estimator .................................................................................... 7 4.2 Poisson Pseudo-Maximum Likelihood Estimator ............................................ 10 5. CONCLUSION ............................................................................................................. 12 REFERENCES ........................................................................................................................ 13 ADBI Working Paper 1232 S. P. Jayasooriya 1 1. INTRODUCTION Impacts of globalization result in trade integration since it is advantageous in many developing economies. Adapting to bilateral trade is fundamental for the trade facilitation and integration process by digitizing, considered a key determinant for international trade policies, and the potential of digitizing is an essential source of comparative advantage for Asia. Theoretical structures for the nexus between trade flow and trade integration determinants are studied in a number of seminal studies using the gravity model. Increased import and export has accelerated the integration of trade among countries in Asia, where countries have continued to implement open economic policies with a greater direction to open the markets. They have made extensive efforts to implement economic integration not only with their neighboring countries but also with other countries in different regions of Asia. Since 1990, many Asian countries have been involved in regional trade agreements (RTAs), with more than 30 agreements, including multilateral and bilateral RTAs, in Asia. Among these, ASEAN, AFTA, SAARC, and SAFTA, with a focus on trade volume and economic growth, are significant in terms of integration. Within the wide range of literature, Frankel (1994), Ramasamy (1995), Endoh (1999), Thorn and Goglio (2002), Elliott and Ikemoto (2004), and Siah (2009) investigated the effects of ASEAN and AFTA, while Hassan (2001), Hirrantha (2004), Batra (2004), Rahman, Shadat, and Das (2006), and Gul and Yasin (2011) examined SAARC and SAFTA. To facilitate open economic policies in terms of trade integration, this study analyzes the Bayesian Gravity Model for Asian countries to thoroughly evaluate the determinants of import volume. From an economic growth standpoint, open economic policy analysis has been devoted to explaining the relationships with trade integration at the aggregate level. Nevertheless, the literature shows a gap in Asian countries in providing empirical evidence to foster open economic policies for trade integration. International trade is associated with individuals, sectors, and regions in increasing prosperity for long-term economic growth. Opening the national economy always consists of winning parties as well as losing parties with a focus on trade policymakers attempting to maximize the positive net gains. This suggests that the trade integration of those sectors needs to be considered with careful analysis and evaluation of policies for open economic scenarios, mainly because of the high risks and heterogeneous impacts of the countries in economically opening to the distribution of income, assets, and opportunities. The free trade can be slowed down, stopped, or prevent others from benefiting due to political influences. Nonetheless, if potential adverse effects are controlled, an open economy can achieve positive impacts at national, sectoral, and individual levels. Generally, these kinds of policies are related to trade-related integration, enhancing the distribution from economic opening. 1.1 Targeting Trade-Related Integration Open economic policies have been applied in many Asian economies with different intensities, frameworks, and strategies. However, a limited review on trade integration on open economic policy for developing countries can be perceived in the underpinning literature. Trade integration is defined as measures and policies, including financial factors, focusing on the implementation of trade reforms and trade policies between countries. Trade integration measures and policies include using other measures to eradicate the deficit in the balance of payments, adjusting to the world trading conditions and changing commodity prices. Further, trade integration supports ADBI Working Paper 1232 S. P. Jayasooriya 2 activating target transformation and enhancing the competitiveness of import while measuring the burden of trade liberalization. This study aimed to provide pragmatic evidence of trade policies in the Asian countries for already established trade agreements. The quality of the executed policies and reforms is highly varied among these countries which need studying the trade integration. Based on the above discussion, the purpose of this paper is to examine the trade integration with the evidence of trade policies under the digitalization of Asian countries. It investigates the contribution of trade facilitation and integration in promoting a country’s trade integration for fostering growth. The paper is organized as follows. In the second section, a review of the literature is presented, and in the third, there is a brief discussion on the specification for the gravity model. In this section, a Bayesian gravity equation is developed, which accounts for more econometric issues than in previous studies for robust estimation of the impacts. The fifth section provides the simulated and estimated results along with discussions. Subsequently, concluding remarks follow the empirical results section. 2. LITERATURE REVIEW International trade is accelerated under multilateral free trade negotiations providing a theoretical foundation for accepting substantial part of trade is bilateral among developed countries, which makes the impact of trade liberalization uncertain. Thus, the literature proposes numerous theories for trade integration in line with digitalization. Numerous theories and models on trade integration explain the advantage of bilateral trade in developed and developing economies for gaining maximum benefits with open economic policies. The gravity model, at the macroeconomic level, predicts the effects of trade liberalization on the economies fostering economic growth. The literature provides a number of seminal studies on the application of the gravity-based model for trade integration. The literature includes the contributions of Tinbergen (1962) and Pöyhönen (1963). Accordingly, the new trade theory supports validations of the theories for building the models with increasing returns of scale, competition, and transport costs (Anderson 1979; Bergstrand 1989; Helpman and Krugman 1985). Tinbergen (1962), Pöyhönen (1963), and Linnemann (1966) applied the gravity model analogy for trade relationships among various countries. Furthermore, Bayomi and Eichengreen (1995) designed the model that was used for an expanded period to determine the variations of trade in numerous studies. Therefore, the empirical results of the overall gravity model are considered robust and best fitted to the data for empirical evidence and open economic policies. Although the empirical progress of the gravity model is advanced over time, Baldwin (1994) and Leamer (1994) disapproved the gravity model on the basis of not the existing theoretical insight of the relationships. In general, the gravity model determines the trade patterns and potentials of factors such as transport costs, border and nonborder barriers, geographical and cultural features, and other regulatory constraints that impact the trade between countries. Therefore, a theoretical foundation for the gravity model was developed to best-fit results. Thus, a reduced form of gravity models based on trade theories such as Heckscher-Ohlin’s models is developed. ADBI Working Paper 1232 S. P. Jayasooriya 3 Many economists derive the foundation for the gravity model using the theoretical perspective of trade including Ricardian, Heckscher-Ohlin, and New International Trade Theory (Anderson 1979; Helpman and Krugman 1985; Deardorff 1995, 1998; Feenstra et al. 2001; Eaton and Kortum 2002; Anderson and van Wincoop 2003). But Anderson (1979) presented a gravity model from all types of product differential models. Later, Bergstrand (1989) derived the Heckscher-Ohlin model. Helpman and Krugman (1985) developed the monopolistic competition model with increasing returns and transport costs. Recently, the gravity model has been extended on the basis of traditional models and reached more robust and consistent conclusions (Deardorff 1995; Anderson and van Wincoop 2003; Helmers and Pasteels 2005). The gravity model is used in data samples to investigate bilateral trade flows considering their incomes, bilateral distance, and dummy variables for a common language, common borders, and any of the regional or bilateral agreements. Last, trade potential between partner countries at the sectoral level is estimated by Baroncelli (2005) by incorporating the simulated SAFTA-bound future tariffs. However, it contains some methodological flaws such as endogeneity and violations of assumptions of Jensen’s inequality. On the other hand, digitization has made an enormous impact on the trade between countries. Digital trade includes digitally enabled transactions in goods and services. Thus, growing digital connectivity is also enabled, increasing radiational or supply chain trade in goods. According to Miroudot and Cadestin (2017), as a consequence of digitization, trade in minor, low-valued physical packages and digitally delivered services is growing. In addition, digitization changes how companies interact with their customers, other companies, and government; a globalized world with hyperconnectivity, production, design, delivery, and consumption is geographically detached through trade and constantly connected through digital networks (Lopez- Gonzalez and Jouanjean 2017). The digitization of trade has brought changes in terms of the scope, scale, and speed of trade. Undoubtedly, digitalization changes the many economic activities of the industries through digital retailers, associated firms with joining supply and demand matching services, are increasingly providing, or facilitating access to warehousing, logistic, e-payment, credit, and insurance services with a supportive environment. Asian open economies are largely dependent on the integration of bilateral trade for economic growth. Overall, this has the effect of boosting the efficiency and production capacity of domestic firms, thereby enhancing their competitiveness in the global markets. Digitalization has become the key factor on this basis, which helps international trade to be smooth and fast. 3. DATA AND EMPIRICAL METHOD 3.1 Data Forty-three countries over the period 1995‒2018 in Asia are considered for the database. Based on the availability of data, annual data on GDP, population, area, exchange rates, and other influential variables and trade agreements of the country of origin and destination are generated from assorted years of the World Bank; all nominal values of the variables are converted to constant 2015 US dollars using the CPI. All nominal variables are expressed in real terms. Under this study, the CEPII Bilateral Trade Database from 1995‒2018 compiled along with the World Development Indicators of the World Bank is used, with bilateral import flow as the key dependent variable. Further, those data are supported by the CEPII Geodist dyadic data set and the CEPII gravity data set (Head and Mayer 2013). The data on GDP and population ADBI Working Paper 1232 S. P. Jayasooriya 4 have been updated with the World Bank Development Indicators. The areas of the country of origin and destinations were measured in km2. Dummy variables are used to measure whether the two countries are contiguous, sharing a common language or common religion. Additionally, the data was gathered on five variables measuring digitalization data from the Global Competitiveness Index Report of the World Economic Forum, namely: (i) mobile telephone subscriptions/100 people; (ii) mobile-broadband subscriptions per 100 people; (iii) fixed-broadband Internet subscriptions per 100 people; (iv) fixed telephone lines/100 people; and (v) Internet users’ percentage of adult population. 3.2 Empirical Method This empirical method follows the previous empirical studies on the gravity application and is then extended to the estimation of the Bayesian approach with econometric specifications. This empirical method is employed to control for econometric issues for robust estimations. The trade flows in Asian economies are not necessarily related to the long-run equilibrium since Asian economies are still in the transition market economy. In this section, the “gravity” specification model for trade volumes and trade partners is used to estimate the equation to provide a benchmark. Much of the economic literature devoted substantial efforts to producing trade theories and describing and predicting the subsequently observed export and import flows. One such empirical attempt is to model the gravity models, which have become the pillar of the empirical literature on the determinants of international trade (Anderson 2011). The standard gravity model provides all bilateral flows of trade at time t between the reporter and the partner. In brief, a gravity equation explains the trade with the size of the economies and their distances, suggesting a stable relationship between the size of the economies, proximity, and trade among countries to infer trade flow potentials and to estimate the effects on trade of institutions such as customs unions, monetary agreement, exchange rate mechanism, ethnic ties, linguistic identity, and international borders. Physical distance is an explanatory variable for trade measure resistance issues such as transaction costs, transport costs, perishability/loss of goods during transport, synchronization costs, communication costs, and cultural distance. 3.3 Gravity Model A number of theoretical frameworks and models are presented in the literature to show the determinants of trade flow. Although the gravity model is designed on the basis of Newton’s gravity law, several adjustments to the model are made in the form of trade integration analysis (Grogger and Hanson 2007. These approaches are widely used in the analysis of trade exports or imports because of their robust forecasting characteristics (Fertig and Schmid 2000; Karemera et al. 2000; Kim and Cohen 2010). With the use of different full and push factors, gravity models are deepened by the inclusion of more variables (Volger and Rotte 2000; Hatton and Williamson 2002; Gallardo-Sejas et al. 2006; Mayda 2010; Ortega and Peri 2013). The gravity model is widespread with the specification with the time invariant fixed effects with the time shocks, and origin and destination country to account for the unobserved heterogeneity. Bertoli and Fernandez-Huertas Moraga (2013) found that without specifying the fixed effects, the models suffer biases because of multilateral resistance to trade. ADBI Working Paper 1232 S. P. Jayasooriya 11 Table 6: Results of the Poisson Estimates of a Fixed-Effects Gravity Model Variables: Log of Import Eq 1 Eq 2 Log of GDP of country of origin 0.31*** (0.02) 0.11** (0.03) Log of GDP of country of destination 0.54*** (0.03) 0.18*** (0.01) Log of distance between countries –0.82** (0.02) –0.03*** (0.00) Log of mobile telephone subscriptions/100 people – 0.07*** (0.00) Log of mobile-broadband subscriptions per 100 people – 0.06*** (0.01) Log of mixed-broadband Internet subscriptions per 100 people – 0.14*** (0.01) Log of fixed telephone lines/100 people – 2.03** (0.02) Log of Internet users’ % of adult population – 0.11** (0.00) Log of population of country of origin 0.11** (0.00) –0.18*** (0.01) Log of population of country of destination –0.18*** (0.01) –0.03*** (0.05) Log of area of country of origin 0.03*** (0.00) 0.07*** (0.02) Log of area of country of destination –0.07*** (0.00) –0.06*** (0.01) Log of exchange rate of country of origin 0.06*** (0.01) 0.14*** (0.01) Log of exchange rate of country of destination 0.14*** (0.01) 0.03** (0.12) Constant –7.03** (0.01) –7.03** (0.02) Number of observations 6,298 6,184 R-squared 0.44 0.54 F-value 176.01 124.90 p-value 0.0000 0.0000 * denotes statistical significance at the 10% level, ** denotes statistical significance at the 5% level, and *** denotes statistical significance at the 1% level. Source: Author’s estimations. A robustness check of the gravity model has been conducted with estimation of an alternative gravity model using the Poisson pseudo-maximum likelihood estimator. The results revealed that the digitization indicators, such as mobile telephone subscriptions/100 people, mobile-broadband subscriptions per 100 people, fixedbroadband internet subscriptions per 100 people; fixed telephone lines/100 people, and Internet users’ percentage of the adult population, are significant at the 5% level. Similar results can be found in the Poisson pseudo-maximum likelihood estimator in estimating the gravity model with respect to the Bayesian gravity model. The effects of the trade inflow and GDP of the country of origin and destinations are positive while the distance between countries is negative. ADBI Working Paper 1232 S. P. Jayasooriya 12 5. CONCLUSION The Bayesian gravity analysis was conducted to estimate the degree of impacts of determinants on international bilateral trade providing pragmatic evidence for trade integration in Asian economies. Further, the gravity model was aimed at identifying the regional trade integration with a robustness scenario for the aptness of the trade integration in the region. The Bayesian gravity model reveals that the estimated coefficients on GDP in country of origin and GDP in country of destination, population, and area of the country of origin are positively significant predictors of the import growth. The distance between the countries has a negatively significant estimation showing barriers in trade. The model predicts the trade integration especially towards the trade inflow process in Asia with the rest of the world. The Bayesian approach of the gravity model gives the robust estimates for determining the impact factor for the importation of the trading countries, including the elasticities of total imports with respect to distance and area of destination, and the exchange rate of origin are negative, while the proxies of economic size, areas are negative. The exchange rate of the destination is positive. The estimated parameters are directly the elasticities, in which increases in GDP in a reporter consistent with higher import volumes. The digitization of the regions has a tremendous influence on the trade as depicted in the results, which indicate that digitalization indicators are significant in all equations. The trade inflow in the model analyzes the “trade creation” and “trade diversion” effects of Regional Trade Agreements. In simulating the scenarios for international trade integration according to explanatory indicators quantify trade potential between two partners. The gravity model is modified for international trade integration according to changes in key determinants; quantify trade potential between two countries and measure the trade costs term instead of trade inflows and to express these costs as a function estimating the barriers for trade integration with the assistance of digitalization. Finally, trade integration can be facilitated across Asia with evidence and simulated scenarios for the estimation of the impacts of the trade inflow in Asia. Therefore, combining all the results of the Bayesian gravity model, one of the significant pieces of evidence of this study is that trade integration can be promoted with the increase of particular significant variables at the country level, while stimulating those towards innovative approaches to trade facilitation in the digitizing process plays a significant role in the policymaking in these economies. 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