What Makes for an Effective Free Trade Agreement? Examination of Theory and Evidence

Abstract

Surprisingly, little research has been done on what factors make for an effective free trade agreement. By examining the theory and evidence, the author considers it may be possible to construct a model that sheds light on these factors. An index model, based on trade theory and evidence comprising 112 bilateral country trade pairs (including FTAs), has been developed to predict change in a nation’s 5-year growth of bilateral trade relative to the growth in world trade. The use of an index model allows inclusion of those variables considered to have an important influence on the dependent variable – bilateral trade growth (BTG ratio) without requiring significant amounts of quantitative data to estimate model coefficients. The 24 variables in the model are binary, and the variable weights (model coefficients) are determined judgmentally from trade theory. An out of sample test of forecast accuracy was conducted on around half of the country pairs in the sample, and the result of a positive correlation between the dependent variable and the growth index was found. This adds weight to the validity of the author’s model using the index method and confirms the view, supported by the literature, that growth in bilateral trade is driven by the variables such as GDP of the partner country, shipping costs, trustworthy institutions and strength of the FTA. If this research has unearthed a set of causal variables that can be used for prediction purposes by trade policymakers at minimal cost, then the resources devoted to this paper will not have been in vain.