Home Bias in Investments
2-3 pages summary
60
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.
61
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
Savchenko , S., Sukach, O. (2020). Home Bias and European Integration.
62
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.
63
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
Savchenko , S., Sukach, O. (2020). Home Bias and European Integration.
64
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.
65
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.
Savchenko , S., Sukach, O. (2020). Home Bias and European Integration.
66
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
model close
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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 …
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