The Determinants of EU Trade: Evidence from Panel Data Gravity Model

Abstract

The European Union is the biggest trading bloc in the world. It is the second-largest exporter and third-largest importer of goods. However, many challenges, such as the financial crisis, the migrant crisis, BREXIT, and the COVID-19 crisis, influence negatively the prospect of increased trade liberalization among countries. The member states are imposing restraints on internal trade flows, thus jeopardizing the positive effects of trade liberalization. This paper gives a detailed overview of the trade profile of the European Union and explores the determinants of EU trade. We apply the gravity model to estimate the aggregate benefits of intra-trade or benefits from free trade agreements with third countries. We measure the influence of GDP, population, land and capital endowment, EU membership, and signed free trade agreements with the trading partners on EU trade as a dependent variable. The analysis includes data for the 82 biggest EU trading partners (including members) over a period of 60 years (from 1960 to 2020). The European Economic Community was created in 1957, but the elimination of customs duties and measures that have an equivalent effect was achieved in 1968 with the creation of the Customs Union. Due to different stages in regional integration, in particular the creation of the internal market, we estimate subsequent equations with different time periods. The main research question of this paper is: can the internal market still be the driving force for economic growth, or is widening trade relations with third countries much more important for sustaining the dominant trading position of the EU? The results show that the EU’s trade is directly proportional to the trade partner’s GDP and population. Regarding the coefficient of EU membership, it does not significantly change its value as we shorten the time periods, proving that the average trade advantage due to EU membership increases over time. On the contrary, as we shortened the time periods in the analysis, we obtained a positive but decreasing coefficient for the variable free trade agreements. This confirms that trade exchange within the EU has had a more significant effect than extra-EU trade, especially since the creation of the Internal Market.