SETI PROJECT SERVICE EXPORT FLOWS: EMPIRICAL EVIDENCE FOR THE EUROPEAN UNION

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1 Sustainable growth, Employment creation and Technological Integration in the european knowledgebased economy SETI PROJECT SERVICE EXPORT FLOWS: EMPIRICAL EVIDENCE FOR THE EUROPEAN UNION By Sara Barcenilla & Jose Molero. Universidad de Zaragoza. Universidad Complutense de Madrid. May, Introduction Trade in services is going to be a very active field of research in applied economics next years. There are several reasons that justify such a concern: first, services represent a growing share of output and employment in developed economies. Second services trade flows are a key factor in relaxing, or indeed eliminating, current account deficits in such economies. Third, service trade has been growing rapidly inside an overall trend in the globalisation of economies. More precisely, over the last quarter of the twentycentury real service exports grew in the EU at a 3.8% average annual growth rate. Among these countries Ireland experienced the highest growth rate, with an average annual growth rate of 10% and Mediterranean countries Spain, Portugal and Greece showed an important advance, all of them with growth rates over 5%. As can be seen in Figure 1, this growth has been especially intense in the last years of the period considered.

2 Table 1. Average annual change in services exports COUNTRY Austria Belgium Denmark Finland France Germany Greece Ireland Italy Netherlands Portugal Spain Sweden United Kingdom UE_15 AVERAGE ANNUAL GROWTH RATE ,43 4,06 4,66 3,74 2,83 3,35 6,46 10,10 3,47 4,34 6,10 5,81 4,78 2,49 3,77 OECDEUROSTAT Service trade statistics. Data are expressed at the prices levels and exchange rates of Figure 1 also shows the relative importance of service trade volumes in different countries. France, Germany, Italy and the United Kingdom are by far the most important exporters in this area, followed by Spain, Netherlands, Belgium and Austria, which display intermediate positions over the period. Finally Finland, Denmark, Greece, Sweden, Portugal and Ireland have the smallest and generally increasing flows Chart 1. Services exports in European Countries at the price levels and exchange rates of (Millions of US$) Belgium Luxemburg Denmark Finland France Germany Greece Irland Italy Netherlands Portugal Spain 0 Sweden UnitedKingdom Austria 2

3 Although the growing economic relevance of services trade is widely recognised, service imports and exports have inspired little empirical analysis. In this regard, two studies carried out on USA data deserve specific mention, Hung and Viana (1995) and Deardoff et al (2001). Until now, the empirical research has focused almost exclusively on manufactures trade flows analysis. This is so, because commercial protectionism has been especially intense in this sector and also as a consequence of a lack of comparable data on service trade. The aim of this paper is to provide new evidence on this subject testing a dynamic model in order to identify which are the main determinants of service exports both in the short and in the long run. To achieve this, we have estimated the model for a sample covering fifteen European countries which nowadays conform the UE15 over the period , with starting years form 1970 to The paper is organised as follows. In the first section, we present the traditional demand framework to study the evolution of trade flows. In the second section we analyse the time series properties of the data and present the cointegration techniques used to estimate the model. In the third section the model is tested empirically with respect to European economies cited above. The fourth section presents a review of the main conclusions. 1. Traditional demand framework We want to know if the evolution of services exports responds to the same factors that export of manufactures. To that end, the model is posed with reference to the traditional framework for the determination of trade volumes: the consumer demand theory. Traditional demand framework states that if prices in one country grow faster than abroad, exports are reduced. Nevertheless this is so only if some degree of imperfect substitutability between the different goods is assumed (Magnier and ToujasBernate, 1994) 1. In this case export demand functions represent the quantity demanded as a function of relative prices and foreign income. However, following the now classical work of Kaldor (1978) empirical evidence shows frequently that the effect of relative prices on export flows is weak or even sometimes contrary to what is expected So differences in prices level are not enough to explain differences in export performance between countries. Then, it is necessary to consider the influence of nonprice factors and some recent theoretical and empirical developments state that such factors are included through income elasticities. Indeed, the meaning of significant price and income 1 Indeed in the neoclassical framework of perfect competition, home and foreign goods are perfect substitutes, and the Law of one price holds because there is a prices and quantities adjustment mechanism. 3

4 elasticities has been profusely debated in empirical literature. Following Thirlwall (1986) and Mc Combie (1989, 1992, 1993) differences in the coefficient of income variable when this is estimated from export and import functions that only include relative prices and income like arguments reflect disparities in nonprice competitiveness 2. Additionally, nonprice competitiveness reflects such supplyside characteristics as quality, after sales service, the effectiveness of distribution networks and so on. If this interpretation of income elasticities is correct the technologically most advanced countries which have greater capacity of compete in non price factors will show a higher value of the income elasticity of demand for exports. Additionally, by the comparison of income elasticities and prices elasticities we can conclude if non price competition is more important in service sector or, on the contrary prices are the main factor in explaining the evolution of service balance. Taking into account these arguments in our model we assume that services are imperfect substitutes and the explanatory variables of service export flows are those representing two traditional factors: prices competitiveness and incomey. Additionally, price competitiveness is integrated by two components: exchange ratee and relative pricesp. X = f ( Y, E, P). where X= Real service exports of a country. Y= Real Income of OECD countries. E= Euro/$ exchange rate. P= Domestic GDP deflator over GDP deflator of OECD countries Exports are expected to depend positively on foreign income and Euro/$ exchange rate and negatively on relative prices when these are defined as the ratio of domestic over foreign prices. Frequently it is consider that an increase in the demand of services is a consequence of a growing manufacturing sector. To study this relation, another variable has been included in an alternative model in order to capture the capacity of manufacturing sector to carry service sector forward in the short run namely the percentage of manufacturing absolute value added over GDP VP. Of course, it is assumed that demand for service exports responds positively to domestic share on GDP of manufacturing. 1991) 2 The defence of another interpretation of income elasticities can be seen in McGregor and Swales (1985, 1986, 4

5 We use data on15 European countries for the years Trade data come from OCDE EUROSTAT (2001) Services Trade Statistics. The output, price and exchange rate data are taken from OCDE National Accounts, vol 1 (1999) and the web page of OCDE statistical compendium. The source for value added data is STAN database (OCDE, 2001). 2 Methodology Our analysis uses cointegration techniques to approach the question of modelling export flows and derive both long and short term effects of prices and income variables on the evolution of service exports. It is well known that regression analysis will yield efficient estimates provided that the variables are stationary. However, frequently exports (X), exchange rates (E), relative prices (P) and income variables (Y) are not stationary and so conventional regressions could lead to spurious relationships among variables. In this paper, we use the Augmented Dickey Fuller unit root test to analyse if the series are stationary. The level of augmentation has been chosen taking into account the Akaike information Criterion. The results of the test (with constant and trend) are reproduced in table 2. Table 2. Augmented DickeyFuller unit root test Variable Germany Austria Belgium Denmark Spain Finland France X Y E P Table 2 (Cont). Augmented DickeyFuller unit root test Variable Variable Greece Netherl. Italy Ireland Portugal Sweden UK X EXP Y INCO E EXCH P REPRI The 5% critical value for Augmented Dickey Fuller Test for 25 observations equals 3.60 so with the only exception of the income variable in France, and relative prices in Germany, the null 5

6 (unit root hypothesis) can not be rejected. Nevertheless, given the small number of degrees of freedom we go ahead and estimate the model for every country. Having found evidence about the nonstationarity of the data, the next step is to investigate whether there is a cointegration relationship between them. If this is the case, cointegrated nonstationary variables can be used to formulate an error correction mechanism model (ECM), which allows us to incorporate both the long run equilibrium relationship between the variables and the short run disequilibrium behaviour. The error correction mechanism describes how the system adjusts in each time period towards its long run equilibrium state. In the shortrun deviation from the long run equilibrium will feed back on the changes in the dependent variable in order to force its movements towards long run equilibrium state. The presence of cointegration is commonly tested in empirical investigations by applying the twostep procedure proposed by Engle and Granger (1987). This procedure is also characterised by a Dickey Fuller (DF) statistic used to test for the existence of a unit root in the residuals of a static cointegrating regression. Alternatively, the presence of cointegration can be tested using the singlestep dynamic model procedure, which is based upon the tratio of the error correction term in the associated dynamic model. Kremers et al. (1992) have demonstrated that the second procedure is preferable because it uses information more efficiently than the DickeyFuller test 3. In the error correction framework the dynamic model is stated as: dy t n n = + αidyt i + β idx + 1 i= 1 i= 0 t i ( yt 1 γxt ) ε t µ + (1) Where denotes the first difference operator, y t is the dependent variable, x t represents the explanatory variables, u is a constant and ε is the error term. So the ECM model includes lags of the first difference of the dependent variable, contemporaneous values and lags of the first difference of explanatory variables and another term, which reflects adjustment process to the long run. The parameter is the error correction coefficient, which measures the speed of adjustment to the long run values. The variables y t and x t are cointegrated or not depending upon whether <0 or =0. In the ECM approach the equation (1) is estimated by OLS and the tratio based on the estimated value of 3 For most countries, the ADF test did not reject the hypothesis of cointegration. Nevertheless given the low power of the ADF and the small number of degrees of freedom we went ahead and estimated the services export demand functions in an error correction model. 6

7 , is used to test the null that =0, i.e. that y t and x t are not cointegrated. The variables are specified in loglevel form. An alternative model has been estimated in order to take account for exceptional years in which economic factors have altered the normal evolution of trade flows. Years in which normalised residuals take a value over 2, have been considered outliers and are represented by the corresponding dummy variable in each country. 3. Empirical Test As a first step, the regressions are estimated by adding two lags to economic variables in first differences to allow for the possibility of lagged effects. Following the general to specific approach we drop those variables in differences with a tvalue of less than one. The results of the final models are presented in Table 3. Table 3. Regression results of service export demand function Austria Coeff. t C Y E E(2) P Y(1) E(1) P(1) Belgium Coeff. t C X(1) Y Y(1) Y(2) E(1) E(2) P P(1) P(2) dum Y(1) E(1) P(1) Denmark Coeff. t C X(2) Y(1) E(2) P(1) P(2) Y(1) E(1) P(1) Finland Coeff. t C X (1) Y(1) P Y(1) E(1) P(1) R R R R

8 Table 3. Regression results of service export demand function France Coeff. t C X(1) X(2) Y Y(1) E E(1) E(2) Y(1) E(1) P(1) Greece Coeff. t C X(1) X(2) Y(1) P(1) Y(1) E(1) P(1) Holland Coeff. t C VP(1) E E(1) P P(1) Y(1) E(1) P(1) Ireland Coeff. t C Y Y(2) E(1) P P(1) Y(1) E(1) P(1) R R R R Italy Coeff. t C Y Y(2) E( 1) E( 2) P P( 2) Y(1) E(1) P(1) Table 3. Regression results of service export demand function Portugal Coeff. t stude nt C X( 1) X( 2) E E(1) P(1) Y(1) E(1) P(1) Spain C Y Y( 2) E E( 2) P P( 1) Y(1) E(1) P(1) Coeff t UK C E E( 1) P P( 1) Y(1) E(1) P(1) Coeff t studen t Swede n C Y( 2) E E( 1) dum7 9 dum8 6 Y(1) E(1) P(1) Coeff. t R R R R R They all have high coefficients of determination, indicating that they are well specified with a suitable goodness of fit. For every country the error correction term,, is statistically significant, 8

9 indicating that there is a cointegration relationship between the dependent and the explanatory variables. The unexpected and ambiguous results with respect to Germany invalidate the model for this country and are not showed in Table 3. Empirical results by explanatory factor The evidence of a long run relation among exports and foreign income is strong. The income variable is significant and shows the correct sign in every country. This result confirms the usual finding that income elasticity of demand for exports is highly significant and takes a value that is over one in the majority of countries considered exceptions are Finland, France, Netherlands and the United Kingdom. More precisely, in Austria, Denmark, Greece and Italy the income elasticity is over two. The long run effects of price and exchange rate variables on service export performance are weaker, and some times perverse. Price elasticities and exchange rate elasticities are significant and show the correct sign for eight countries. The influence of exchange rate on export performance is perverse in Belgium and Italy, and this is so in Greece for relative prices. The coefficients of the first difference regressors indicate the short run influences of the explanatory variables on service exports. Because of the adjustment process, the sign of the lags of first differences must be the opposite to that observed in the long run. In the short run, foreign income plays an important role only in seven countries, which is in one half of the countries in which the variables had a dominant role in the long run. Changes in exchange rates are significant and show the correct sign in five countries. On the contrary the influence of relative prices is similar to that observed in the long run. The current or lagged values of changes in relative prices are significant and show the correct sign in seven countries. Again, the signs of the estimated coefficients are contrary to what we expected in three countries for each variable: Belgium, Denmark and Italy for the exchange rate, and Austria, Belgium and Ireland in the case of relative prices. Empirical results by country In seven countries, Belgium, Finland, Greece, Italy, Spain, United Kingdom and Sweden the three variables considered show significant elasticities that explain the long run performance of service exports. There are only three cases relative prices in Greece, exchange rate in Belgium and exchange rate in Italy in which the sign of the parameter estimates is contrary to that expected. The 9

10 long run sensitivity of service exports to foreign income is higher in Belgium, Italy, Spain and Sweden. On the contrary prices play a dominant role in United Kingdom and Finland. Finally, Greece represents a very special case with the highest income and exchange rate elasticities and very significant and positive price elasticity. In other five countries, Denmark, France, Netherlands, Ireland and Portugal, long run behaviour is explained by only two variables. Income seems to be a major factor in explaining service export performance in Denmark, Ireland and Portugal. The relative importance of exchange rate with respect to income is higher in France. In the case of Netherlands, relative prices show the highest elasticity. Finally there is only one country Austria in which long run behaviour is explained exclusively by foreign income. With respect to the short run, three or four explanatory variables are significant in seven countries. In Belgium, Denmark, Finland, Spain and Italy the parameter estimates of first differences and lagged values of the income variable are higher than for price competitiveness variables. In France, the exchange rate plays the dominant role and in Finland this role corresponds to relative prices. As can be seen at Table 3, the Netherlands are the only country out of this sample of fourteen 4 countries for which a significant and positive correlation is found between service exports and the variable representing the relative importance of manufacturing sector in domestic economyvp. The coefficient associated to lagged values of the first difference of the dependent variable is significant in Belgium, Finland and France. Finally is important to notice that often the sign of the coefficient associated to the exchange rate is difficult to interpret. (Belgium, Denmark or Italy). Two variables explain the short run behaviour in Austria, Ireland, Portugal and Sweden. In Austria relative prices play an important role, but show the incorrect sign. In Ireland, the higher short run coefficient corresponds to the income variable. Portugal is the only country where past behaviour of the dependent variable is clearly significant and in Sweden is important to notice the relevance of dummy variables corresponding to 1979 and To conclude, in Greece and United Kingdom short run behaviour is only explained by the variable that represents relative prices. 4 Data of Luxemburg are included in Belgium 10

11 4. Conclusion Despite the increasing importance of service sector as determinant of the evolution of current account, empirical research has dedicated little empirical research to this sector. The aim of this paper is to provide new evidence on this subject through the estimation of an export demand function using cointegration techniques to take into account the time series properties of the data. The effect of rising foreign income on the volume of exports is positive for all countries considered. Furthermore, the values of income elasticities are very large for several of the European countries. Nevertheless, our results don t confirm the hypothesis that income elasticities reflect the capacity to compete in nonprice factors. Indeed, the higher values of income elasticities correspond to countries that can not be considered technological leaders. On the contrary we offer evidence in favour of another interpretation of income elasticities that considers that different values of them are a consequence of a different pattern of service trade and different values that specific sector elasticities adopt in different countries. Price and exchange rate elasticities are significant in most of the countries considered. Even so rather few estimates of unitary elasticity were obtained, with a majority of values well below one. Sometimes growing relative prices and an appreciation of the currency have a positive influence in the evolution of export flows. Nevertheless this result can have an unambiguous economic interpretation in the case of relative export prices if we recognise that a higher price can reflect higher quality and as a logical consequence can be associated with a growth in exports. So a priori the effect of price cannot be signed. REFERENCES Hung, JH. and S.Viana (1995): Modelling U.S. Services Trade Flows: A Cointegration ECM Approach, Federal Reserve Bank of New York Research Paper, Deardoff, A.V, Hymans S.H., Stern, R.M. and C. Xiang (2001): Forecasting U.S. Trade in Services in Services in the International Economy, ed. R.M. Stern, Ann Abor; Michigan Press, Magnier, A and J. ToujasBernate (1994): Technology and Trade: Empirical Evidence for the Major Five Industrialized Countries, Weltwirtschaftliches Archiv, 130, 3, Kaldor, N. (1978): Futher Essays on Economic Theory, London, Duckworth. Thirlwall, A. (1986) Balance of Payments Constrained Growth: a Reply to McgGregor and Swales, Applied Economics, 18,

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