Vertical Trade Specialization and PTA Formation

During the last two decades, the number of preferential trade agreements has grown almost exponentially to reach over 270 by early 2010. In contrast to earlier periods, when countries of similar levels of economic development tended to form trade agreements, today’s PTAs bring together countries of different size and level of development. The economic rationale of such PTAs, however, is not obvious. To explain this last wave of PTAs, this paper presents a general framework based on a model of vertical production specialization. The globalization of manufacturing leads to the rapid growth of vertical intra-industry trade, or the exchange of similar goods differentiated by unit values. Countries with a relatively higher income per capita export more capital-intensive goods, while more labor-intensive goods are exported by relatively poorer countries. This kind of specialization, I argue, creates incentives for governments to support bilateral trade agreements. I test this model using a new measure of vertical intra-industry trade calculated on the basis of highly disaggregated trade flows. The findings provide strong evidence that growing vertical trade specialization promotes PTA formation. Many agreements formed since the end of the Cold War should therefore be seen as part of the movement of manufacturing beyond the developed world. The author would like to thank Daniel Adshead, Mariana Perez-Levesque and in particular Oana Ciobanu for excellent research assistance, Eric Neumayer for detailed comments on an earlier draft, and participants at APSA 2009, the LSE Political Economy seminar, and IPES 2009 for their insightful comments. Matt McKeon deserves special mention for superb data munging and for introducing the author to the exciting world of SQL. All remaining errors are the author’s. This research was supported by Grant No. 2007-NP-114251 from the programme Établissement de nouveaux professeurs-chercheurs of the Fonds québécois de la recherche sur la société et la culture (FQRSC). 1 The Post-Cold War Proliferation of PTAs The explosive growth of preferential trade agreements since the early 1990s, concurrent with stalled negotiations at WTO, suggest that regionalism has replaced multilateralism as the principal venue of trade liberalization. By 2010, more than 270 agreements, counting only those dealing with trade in goods, covered a majority of world trade. Remarkably, the most common form of agreement signed since the early 1990s and the majority of those under negotiation are either agreements that include a developed and one or more developing countries, or agreements between a developed and a formerly communist transition economy, a category referred to as “asymmetrical PTAs” in this paper.2 Although recent research has offered much insight into the factors that promote trade agreements in general, the conspicuous popularity of deals between economically unequal countries has attracted less scholarly attention. What, then, explains the explosive growth of these PTAs? This study argues that a central driving force is the specialization of manufacturing exports according to the level of economic development of a country. More specifically, when intra-industry trade is shaped by different factor endowments, it creates incentives to form PTAs. Comparative advantage implies that the gains from trade should be greatest between countries with very different factor endowments exporting entirely different goods. And yet, decades of research in political economy tell us that liberalizing trade between countries with very different endowments should be particularly difficult. Mutual trade liberalization would expose the least competitive sectors in capital-abundant countries to imports, so unless these sectors can retain protection, liberalization with labor-abundant countries may not be feasible. The stark asymmetries between developed and developing countries in bilateral negotiations make it even less likely that sunset industries in the North will be forced to shut down. A typical instance of such protection are the quotas for 2 Crawford and Fiorentino (2005, 7)