With time and experience, even geographically and culturally distant countries can establish strong trade links.
For decades the world has been shrinking under the power of technology and engineering. Airplanes are taking people to more and more places at prices unthinkable just 20 years ago. Developments in logistics, supply chains and e-commerce offer consumers a mind-boggling array of products. And over the past year, millions of people have discovered that thanks to video conferencing tools, meeting and talking with someone halfway around the world has never been easier. But there is one essential human activity for which distance matters even more than you might think: trade.
Since the 1960s, economists have noted a remarkable trend in bilateral trade – that trade between two countries is proportional to the size of their economies and inversely proportional to the distance between them. Economists call it trade gravity theorynamed by analogy after Newton’s law.
While economists can easily explain how economic size shapes international trade flows, they struggle to account for the persistent and even growing impact of distance and bordersdespite massive improvements in transport links and logistics and a proliferation of free trade agreements that have reduced tariff barriers.
To complicate matters, the exchange of goods between countries does not just decrease with distance; it takes a hit borders. For example, exchanges between Ontario and British Columbia, more than 2,000 km apart, will be much greater than exchanges between Ontario and its American neighbour, New York State.
We should take physical boundaries and geographic distance seriously, but not literally. These are approximations for a host of unmeasured and even unknowable business costs. Again making an analogy with physics, they have been dubbed “dark trading costs”. In other words, borders and distance capture unmeasured factors such as historical legacies, cultural differences, informational constraints, and lack of commercial and social networks.
The big question is not the size and form of hidden trade costs, but how countries can overcome them. In a new release papermy colleagues and I show that as two countries gain experience through bilateral trade, they learn more about the costs of dark trade and overcome them over time.
The “dark” costs of trade
For our study, Ana Maria Santacreu, Daniel Traca and looked at over a million trade observations for some 30,000 country pairs drawn from the International Monetary Fund. Our sample covered the period between 1948 and 2006 and represented 99% of world trade. We have also considered various forms of preferential trade agreements using data from the World Trade Organization.
We measured trade experience in two ways: the number of years of strictly positive exports and the cumulative value of past exports. In our sample, 5% of country pairs had no trading experience with each other over the entire period, while 5.6% of country pairs had traded for exactly one year.
Of those who traded for more than a year, 23% showed continuous trading, with the remaining 77% recording at least one break in trading experience. Such variation in experience across country pairs over time allowed us to gauge the importance of experience.
We have taken for granted that there are unobserved or shadow trade costs. When a country starts exporting to a new destination, a significant portion of trade costs are related to the novelty and uncertainty of selling in an unfamiliar environment, learning about customer preferences, liaising with shipping and customs agents and shipping laws and regulations. With time and experience, exporters become more knowledgeable and build relationships, reducing trade costs and expanding two-way trade.
Using equations derived from the gravity model, we found that during the first three years, the experience has an insignificant impact on bilateral trade. Beyond that, the benefit of the experience quickly becomes apparent. For a pair of countries with the median level of experience (six years), an additional year of trade increases long-term bilateral exports by 4.6%. A decade of experience increases bilateral trade by 32% in the short term and 68% in the long term, compared to a pair of countries that have not yet initiated trade.
To put things in perspective, the bilateral trade boost of seven years of experience is akin to a pair of countries sharing a common currency; at nine, that’s the equivalent of joining a preferential trade agreement. However, for countries at the 75th percentile of experience (19 years), an additional year of trade increased bilateral exports by only 1.88%, indicating a depreciation and diminishing returns to experience.
We also show that experience matters more for country pairs that are geographically distant, have no colonial ties, and do not share a common language or common legal system. Previous work has used all of these measures as proxies for unobserved trade costs. The experience therefore helps countries overcome hidden trade costs.
Our analyzes further indicate that experience increases the number of products exported, what economists call the extensive margin of trade. In other words, experience allows countries to expand their trade by exporting more different products rather than more existing products. This finding suggests that business experience spreads across firms and industries, perhaps in part because employees transfer know-how when they change employers or start their own export-oriented firms.
Our results allow us to provide solutions to an important problem of economic development. Looking at the growth experience across countries and regions, we find that only a subset of countries, mostly in Asia, have achieved rapid and sustained export-led growth. The inevitable question is why these countries have managed to join global value chains and become export engines while countries in Latin America and Sub-Saharan Africa have not.
Our study suggests that since experience reduces the variable costs of trade, initial policy differences (export-oriented policies in Asia versus import-substitution policies elsewhere) can lead to large and persistent differences in trade and participation in global value chains.
It follows that policies that support early exporters, even temporarily, and facilitate experience sharing will reduce unmeasured trade costs for all domestic firms and encourage more of them to venture into global markets. The depreciation and diminishing returns of experience mean that over time, countries in Latin America and sub-Saharan Africa can still overcome the advantage of traditional exporting powers.
Pushan Dut is Shell Fellow of Economic Transformation and Professor of Economics and Political Science at INSEAD. He also directs the Leading Business Transformation in Asiaprogram.
INSEAD Knowledge is now available LinkedIn. Join the conversation today.
Follow INSEAD’s knowledge of Twitter and Facebook.