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Home Bias in Investments

Open Posted By: surajrudrajnv33 Date: 18/02/2021 Graduate Coursework Writing

Home Bias in Investments

Category: Accounting & Finance Subjects: Finance Deadline: 12 Hours Budget: $120 - $180 Pages: 2-3 Pages (Short Assignment)

Attachment 1

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Sergey Savchenko1 Olena Sukach2

Volume 29 (5), 2020

HOME BIAS AND EUROPEAN INTEGRATION The article estimates the size of home bias between 28 EU states between 2010 and 2018 and its variance between 17 industries. The assumption of the work is that home bias can be treated as a measure of integration: the smaller it is, the more countries are integrated. The aim of the article is to analyze bilateral trade flows of 28 EU states, and using Poisson pseudo-maximum-likelihood method calculate border effect for trade between these countries. Disaggregation of data into 17 production sectors will help to estimate the border effect more precisely. The methodology of the research is based on the gravity model estimation of panel data for 17 sectors, 28 countries and 9 years. Using gravity model approach, it has been detected that the home bias is still present within the EU; however, it is decreasing with time, proving that the level of integration between states has increased. Another finding of the research is the diversity of home bias between sectors: it varies between 86.48 and 2.58, which can be explained by the difference in the rate of substitution between goods of domestic and foreign origin across industries. JEL: F02; F13; F47

Introduction

The European Union has passed a long historical way of integration. From divided by the aftermath of World War the II European countries, it developed into the union with common principles and mutual solidarity. Results of integration are clearly visible: the EU has a share of almost a quarter of the World's GDP and stands in line with the global leaders: US and China. Free movement of labour and capital together with common economic policies have definitely increased trade between member states. Implementation of the common currency has removed currency exchange risk, which had a positive impact on trade flows as well. 1 Sergey Savchenko, Doctor of Economics, professor, Vice-rector for Research, East European University of Economics and Management, phone: +38(050) 464-15-39, e-mail: [email protected] 2 Olena Sukach, PhD in Economics, Associate Professor of the Department of Finance, Banking and Insurance, East European University of Economics and Management. Corresponding Member of the Academy of Economic Sciences of Ukraine, phone: +38(067)994-98-25, e-mail: [email protected], ORCID: https://orcid.org/0000-0001-7150-0262, ResearcherID: http://www.researcherid.com/rid/E-7418-2019.

– Economic Studies (Ikonomicheski Izsledvania), 29 (5), p. 60-78.

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However, despite the long way of adjustments and integration of Europe, intra-EU trade is still not homogeneous, as it may be expected from the solid economic union. The Common Market is fragmented. It has been noticed that there is a tendency of countries to prefer intra-national to international trade, even if a distance with a neighbour is small and there are no trade barriers. That preference towards intra-national trade is known as home bias or border effect phenomenon. Wei (1996) has found that the EU bias average is smaller than in the rest of the countries in the world and shows a decreasing pattern. (Roman, Calvo, 2012) have also detected decreasing pattern in the home bias for EU states, the estimated coefficient was detected to be 2.7. The Border effect can be computed as an exponential of dummy estimate coefficient (exp^2,7), so Roman and Calvo's research has shown that countries' intra-national trade for EU exceeds international by more than 14 times. That result is surprising, because the distances in the EU are relatively small and there are no tariffs and almost no limits to trade.

1. Literature Review

1.1. Stages of Economic Integration

Home bias is assumed to measure the level of integration between states: the higher it is, the less integrated countries are. There was no connection found between the presence of the home bias and the specific integration stage; however, its size is directly connected to the latter.

There are several stages which several countries need to pass to become an economic union. Despite the fact that there are many ways of possible integration paths, we consider it appropriate to summarize them in 3 key stages.

Free Trade Agreement (FTA) is the first stage of economic integration. Member-countries of FTA are eliminating trade tariffs against each other, and create an institution which regulates and resolves disputes. Elimination of the tariffs can be applied to a single sector or the whole economy; however, free movement of people and capital is not a must.

On the basis of FTA, countries may decide to integrate their economies further and to sign Customs Union agreement (CU) which requires member-countries to develop and maintain a common external trade policy (Holden, 2003). That is usually done by limiting 3rd countries' access to the CU by adding quotas or creating additional external tariffs. All members of CU are presented as one unity during the economic summits or negotiations.

Under the CU, re-exportation from one member-country to others is impossible, due to the common tariff for all of them. So, instead of re-selling foreign goods, countries have to develop their own production.

Despite the benefits, joining the CU means restrictions of independent trade and foreign policies for its members. Previous trade connections are challenged by the new barriers of trade, which of course may damage relations with other non-member neighbours.

After passing steps of FTA and CU, member-countries may decide to complete the integration process and create an Economic Union. The Union includes free movement of

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the labour force and capital, one single foreign trade policy and unified product regulations. Moreover, it has a common social and economic policy implemented in every member- country. Of course, it is unlikely that all of the members will be on the same level of economic development, so there is a system of regulation and balancing economies. Weaker countries are receiving donations from the common fund. The size, frequency and purpose of these donations are regulated by the Institution, in which every state is proportionally presented.

The idea of the union in Europe was born before the World War II, e.g. Stresemann, Herriot and many other politicians and economists proposed an idea of "United States of Europe" in the early 1930 s. "Pan-Europa", published in 1923 by Richard Coudenhove-Kalergi, showed a possible way of integrating Europe around three pivots of power: Germany, France, and the UK. It claimed that the Holy Roman Empire, with the up-to-date amendments, will cause another Golden Age of Europe. First integration thoughts resulted as the aftermath of World War I, and several political contradictions between potential member states.

Obstacles to integration between European states evolved into "casus belli" for Germany, there was no political power or will to resolve confrontation peacefully, and the World War II started.

Despite the severity of the Great War, the "common" Europe idea began to grow as fast as never before, and no one expected that the War would result in such a dramatic political change on the continent.

9th May 1950 is known now as Europe Day. That is the date of the famous French foreign minister's, Robert Schuman's speech. He managed to bring the new perspective on Franco- German relations after several centuries of opposition, and he proposed to replace nationalism with cooperation. "The coming together of the nations of Europe requires the elimination of the age-old opposition of France and Germany" (Schuman, 1950). He proposed real actions to be taken as first steps to further integration: coal and steel production in both countries was said to be regulated by the common institution. At that time, coal and steel were the main resources of the industrial growth, so the integration of those spheres of industry solved several problems at once.

On 18th April 1951, less than a year after the Schuman's speech, the Treaty of Paris was signed by six countries: Germany, France, Luxemburg, Belgium, the Netherlands, and Italy. According to Article 2 of the agreement, its aim was to create a common market for coal and steel, to support the economic development of the countries, resolve after-war unemployment puzzle and to increase living standards.

Probably, the most important step to complete EU integration was made in 1992. The Maastricht Treaty declared the creation of the European Union, based on EEC. The Treaty had a three-pillar structure, developing achievements of previous agreements and creating new ones. The integration process has turned the EU into one of the three biggest economies in the world in line with China and US.

To sum up, 50 years of economic integration had led the EU to the top of world best economic performers chart. Out of separate states, a solid economic union with common

– Economic Studies (Ikonomicheski Izsledvania), 29 (5), p. 60-78.

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values and policies has been created. Obviously, joined efficiency and output of 28 countries is significantly higher than in every single member alone. However, even in such a well-integrated union, there are limits to integration, such as home bias, which will be described and tested in the next chapters of the work.

1.2. Development of Trade Theory

Home bias is defined as a preference of country of internal over international trade. The size of the bias can be presented as a ratio of intra-national to international exports. It is noticeable from the current literature on home bias topic that results of different authors may vary dramatically. The reasons of discrepancies are in the basic background of the research. Models to reveal and measure home bias are based on trade theory as a milestone. The outcome of the investigation into the home bias phenomenon depends on assumptions and methods of research.

Theories of trade were created to study and explain the basis of trade between the countries, and its effects for both domestic and foreign economies. Depending on if the effects are positive, mixed or negative, the government can create a policy to stimulate or limit trade flow.

The absolute advantage theory was created by the "father of economics", Adam Smith (1776). According to the author, absolute advantage is achievable, when a country produces certain good at a lower cost than the other ones. Having an absolute advantage, the country should focus on the production of that good or specialize in it to have the maximal benefit from foreign trade.

Smith's idea was later on refined by David Ricardo (1817). He argued that there is no need to have an absolute advantage to benefit from trade. To address some issues that were not answered in the absolute advantage theory, the theory of comparative advantage was propounded by David Ricardo (1817). Ricardo argued that countries would mutually benefit from trade even if one achieved an absolute advantage over the other in producing all of the goods that they trade.

The Heckscher–Ohlin Theorem (H-O model) was developed on the basis of the Ricardian model by E. Hecksher and B. Ohlin (Bergstrand, 1990). Each country in pair has two factors of production in their endowments: labour and capital. The model is based on the assumptions of unequal distribution of resources between countries. One country is capital- abundant, which is a scarce factor for the other one. Each country specializes in the production of a good that intensively uses an abundant factor of production and imports a good which intensively uses a scarce production factor. That specialization is the main basis of trade between countries and represents a comparative advantage (Blaug, 1992). One of the main assumptions of H-O model is immobility of factors of production between the states, whereas within the country factors behave as imperfect substitutes of each other.

The new trade theory (NTT) was created by Paul Krugman (1979). He assumes that the increasing returns to scale and network effects are the main drivers of trade flows. Companies which first achieved increasing returns to scale receive the first mover

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advantage, as they could manipulate prices and behave as a monopolist. Krugman argues that if there are enormous economies of scale and increasing returns to specialization in an industry, the global demand for goods and services may cause a number of firms to decrease. That means that in the long run firms would require benefits from the state to enter the market and maintain competitiveness, playing against first movers. The Krugman's model is based on several assumptions: firstly, there are two identical countries (home (H) and foreign (F)) and these countries share the same preferences and technologies. Secondly, labour is presented as the only non-tradable factor of production; both countries have the same endowment of labour. Consumer preferences are identical, as well.

According to Krugman, intra-industry trade occurs when countries exchange varieties of similar but not identical goods. Krugman (1979) argues that the gains from trade arise due to a larger number of varieties of goods available to consumers. Greater production of each type results in higher real income as prices are reduced due to increasing market size and competition. Krugman maintains that the comparative advantage does not only depend on the differences in factor endowments; it rather depends on the economies of scale and network effects that occur in the critical industries.

Home bias is an international trade phenomenon, so the trade theory should explain it. Depending on the selected theoretical framework, home bias may be explained differently. The article is focused on the integration of EU countries with no economic barriers to trade; thus, from the variety of described models, Tinbergen type is the most appropriate, as it does not take trade barriers into account.

Border effect or a home bias can be defined as excision of intra-national trade over international even under the condition of no trade barriers. Home bias is detected and measured by comparing internal and external trade flows of a country. To detect bias estimation with the dummy variable is used. The latter takes value 1 only if intra-trade has occurred. Depending on means and methods of the research, bias takes the value between 5 and 20, meaning that the country tends to trade with itself 5 to 20 times more.

The border puzzle was first noticed by McCallum (1995). The research was done just after the North American Free Trade Agreement's (NAFTA) implementation in 1994. NAFTA was aimed to remove trade barriers between the US, Canada and Mexico and to make trade more intensive. The author used data of 1998 to see how trade barriers are affecting the trade between the US and Canada. Moreover, Canada and the US were especially interesting, as those are close to each other geographically and culturally. As a methodology, Tinbergen (1962) type gravity model with distances, shipments of goods from importer to exporter and dummy variable, which indicated inter-province trade, was chosen. Research had a solid background of 693 observations and a promising theoretical foundation.

The result was surprising: it turned out that Canadian provinces strongly prefer to trade with each other than with foreign ones. Intra-province trade for Canada turned out to be up to 20 times higher than the trade with the US. Such a high number could not be explained by cultural difference, distance or trade barriers. The author suggested that due to that fact implementation of NAFTA will not change much in the volumes of trade.

– Economic Studies (Ikonomicheski Izsledvania), 29 (5), p. 60-78.

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Helliwell (1996) did the same research as McCallum, but data was taken for different period: 1993-1996. So, the period covered both times before and after NAFTA came into force. Research proved previous findings; however, the size of the effect turned out to be smaller and is equal to 18.

Wei (1996) was among other economists who thought McCallum's and even Helliwell's home bias coefficients were too high. He tested home bias among OECD countries using 9 years. Wei assumed that home bias dummy can be taken as export of the county to itself; in his work, he presented it as total production of the country minus exports to the rest of the world. The research concluded that the actual number for home bias for tested countries did not exceed 2.5. However, after adding several control variables, part of the trade pattern deviation was still not explained, so the bias should not only be explained by the trade barriers. Wei detected a link between the demand elasticity for goods produced in different countries and home bias, which goes in line with Armington. But the most important finding of the work was that there was the overall tendency of the bias to decrease. Especially it was visible in case of the EU states, as border effect in those decreased by half between 1982 and 1994.

Home bias, in general, can be interpreted as a marker of integration: the more integrated countries are, the lower the value of the home bias coefficient will be observed between them.

2. Methodology

2.1. Development of Gravity Model

The gravity model was first to detect the home bias problem and is now most frequently used to investigate it. Gravity models help to estimate trade flows between countries on the basis of distance and corresponding trade barriers between them. Since the EU has abolished borders, it is interesting to use the gravity model and see how countries are trading without trade barriers.

The gravity model of trade represents the application of the Newtonian Gravity Law to the trade between countries (Anderson, 2016). The key assumption of the model is that there will be a direct connection between the trade flow and size of exporting and importing countries, and that there is a negative relation between trade flows and distance between the countries. According to the Newton's Law, flow Xij from an exporting state i to an importing state j is described by the equation below.

i j ij 2

ij

Y E X = G

D (1)

Where: G is the gravitational constant, Yi is the relevant economic activity mass at origin country, Ej is the relevant economic activity mass at the destination country, Dij is the distance between the country of origin and the destination.

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The first breakthrough in the gravity models was achieved by Tinbergen in 1962. His equation states that there is a direct link between the economic size of two countries and trade volume. Moreover, the latter is inversely related to the distance between these states. Tinbergen took GDP as a proxy of the economic size of countries.

Equation can be presented in the following form (Tinbergen, 1962): α β

i j ij γ

ij

Y E X = A

D (2)

Where: α – elasticity of GDP of country-importer, β – is the elasticity of GDP of the country exporter, A – is a constant, γ – elasticity of geographical distance between countries.

The model holds up under the assumption that there is a dependence between the amount of exports and the economic size of the country. The country with relatively small GDP cannot export the same amount as a more productive one; this is the basis for the interaction of countries' economic masses. The economic size can also be taken as GDP per capita or as population; thus, it helps to capture not only the production level of the country, but also the value of consumption. This is important because the gravity of the economy has three "components" which create pressure on other countries: domestic supply of goods, which interacts with foreign demand force and the other way around, between home demand and foreign supply. These two pairs of interacting forces will shape trade flows between the economies (Tinbergen, 1962).

Chaney (2014) criticizes early gravity models, because distance elasticity in those models is mostly presented as a linear variable. The geographical distance itself does not include or somehow present any type of economic or technological barriers. The type of the transport used, political preferences, and the nature of the traded good itself are emitted variables.

The next step in gravity models' development was made by Armington in 1969. He was the first to come up with the hypothesis that not only the type of product (e.g. machinery, chemicals, and energy carriers) matters for consumers, but also the country of product's origin (Armington, 1969). According to his studies, there is a country of origin bias, which appears due to the historical or gained preferences of consumers.

Armington hypothesis expanded an understanding of the gravity modelling mechanisms as he suggested to split all goods traded between the countries in several classes. He also proposed to distinguish between tradable and non-tradable goods; tradable goods were said to have different trade costs, depending on the country of origin.

Anderson (1979) applied Armington's approach and integrated it into his model. As a basis of his model, he used traditional gravity equation of the Tinbergen type. The model was extended by the addition of the following assumption: both trading countries produce two types of goods: tradable and non-tradable one. That was done to make the model more realistic, as before it was restricted to only one differentiated good per country. The assumption on transportation cost, indicating a trade barrier, was also added to make the

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– Economic Studies (Ikonomicheski Izsledvania), 29 (5), p. 60-78.

69

2.2. Home Bias as a Trade Phenomenon

Nowadays, there are many approaches to the estimation of gravity models; the paper focuses on Poisson Pseudo-maximum likelihood (PPML). The very first estimation of the gravity model of Tinbergen type was done in the log-linear form: both parts of the regression were transformed into the natural logarithm form. It helped to smooth data and to overcome problems of scaling (too big and too small values included in one equation) and unit roots. However, despite the obvious benefits of having regression in the log-linear form, there are disadvantages of this approach as well. First of all, the gravity model estimation requires a relatively big data set, and some values may be missing or have zero value. The Log-linear method will ignore and omit those observations, adding restrictions on the data set. Moreover, Silva and Tenreyro (2006) have detected that using natural logarithms may cause the presence of heteroscedasticity in the model. In a multiplicative model, the natural logarithm of the error term includes the variance of itself. The expected value of the error term will depend on several variables, if the error term is heteroscedastic, which breaks the crucial assumption of OLS. Thus, OLS estimator will be biased and will not be the best possible for this kind of model.

The "Log of Gravity" proposed by Silva and Tenreyro presented the new approach: PPML. According to their study, PPML shows better …