Trade Creation, Trade Diversion, and Endogenous Regionalism

This paper examines whether considerations about trade creation (TC) and diversion enter into the decisions countries make about joining free trade areas. Estimates of trade creation and diversion for each new trade agreement started between 1985 and 1994 are generated by comparing trade flows between country pairs at the 4-digit SITC industry level with a counterfactual prediction of trade flows that would have occurred in the absence of the preferential agreement. I then estimate the determinants of trade creation and trade diversion (TD), which provides a test of the proposition that trade diversion is less severe among countries with significant bilateral trade prior to a preferential agreement. The estimation uses a selection correction procedure to account for the fact that TC and TD are observed only for countries that sign new trade agreements during this time. Political economy predictions about which countries are likely to form preferential agreements are used as instruments in the selection equation. Finally, the estimated determinants of trade creation and diversion can be used to predict what these values would be for country pairs that do not form preferential agreements. Thus, the paper can provide a preliminary estimate of whether TC and TD are lower among country pairs that sign agreements than among those that choose not to do so