Zhou 2017

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Pacific Economic Review, ••: •• (2017)

doi: 10.1111/1468-0106.12198
HAVE FREE TRADE AGREEMENTS CREATED TRADE?

EVIDENCE FROM CEPA
YONGHONG ZHOU* Jinan University
Abstract. This paper revisits the issue of trade creation effects in multi-stage free trade agreements
(FTA). In contrast to the empirical studies that use the gravity equation to study trade creation
effects, we apply a triple difference in differences approach to resolve their shortcomings, including
factors being omitted and endogeneity. After the identification of treatment and control groups at
the eight-digit Harmonized System (HS) code product level, the regression analysis results show that
there are no significant trade creation effects with the FTA, suggesting that the role of FTA may be a
signalling beyond trade.
1. INTRODUCTION
Trade creation is not a new topic in the study of international economics.

Originally, trade creation effects referred to the increase in trade brought about
through integration among members of a trading community (Balassa, 1967). Over
the past 40 years, the development of free trade arrangements (FTA)1 has pro-
moted regionalism around the world. Many published papers have examined the
trade creation brought about by FTA empirically; however, the results are mixed.
Since Balassa (1967), Aitken and Lowry (1972) and Aitken (1973), many re-
searchers have studied the trade creation brought about by FTA, including those
involving the European Economic Community (EEC)/the European Community
(EC), the European Free Trade Association (EFTA), the European Union (EU),
the Latin American Free Trade Association (LAFTA), the Central American
Common Market (CACM), the World Trade Organization (WTO) and its prede-
cessor the General Agreement on Tariffs and Trade (GATT). Some researchers
have found evidence for trade creation over their respective integration periods,
while others have not or have just found the trade creation effects to be fragile.
In the early studies, Balassa (1967), Aitken and Lowry (1972) and Aitken
(1973) found evidence of trade creation for LAFTA, CACM, EEC and EFTA.
Recently, Baier and Bergstrand (2007) analysed trade creation effects in 52 FTA
covering 96 countries and asserted that FTA approximately doubled two
*Address for correspondence: Department of Economics, Jinan University, and China Center for
Economic Development and Innovation Strategy of Jinan University, 601 Huangpudadao West,
Guangzhou, Guangdong 510632, China. E-mail: tzhouyhjnu@jnu.edu.cn. I am very grateful to Yi
Lu (National Singapore University) for his help. I thank the Editor, two anonymous referees, Anping
Chen (Jinan University), Bing Wang (Jinan University) and Peng Chen (Jinan University) for their
encouragement and constructive remarks. I gratefully acknowledge financial support from the
National Natural Science Foundation of China (71103075, 71273116 and 71203077) and the
Fundamental Research Funds for the Central Universities of Jinan University (12JNYH002,
12JNKY001 and 15JNQM001).
1
In reality, there are numerous types of international economic integration agreements, including
free trade agreements, regional trade agreements (RTA), customs unions, common markets and eco-
nomic unions. For ease of reference, we use the term ‘free trade agreements’ generally.
© 2017 John Wiley & Sons Australia, Ltd

2 Y. ZHOU
members’ bilateral trade over 10 years. A study by Anderson and Yotov (2011)
covered the period 1990–2002 for a total of 41 trading partners, which included
40 separate countries and the rest of the world, and showed evidence for trade
creation in FTA. Eicher et al. (2012) based their study on 164 importers and
177 exporters and spanned from 1960 to 2000, and the empirical results also
showed a strong trade creation effect. Estimates by Frankel and Wei (1993) sug-
gest that a country joining the EC in 1980 would have experienced an increase of
68% in trade with other members, but there was no such effect observed for the
EFTA. Based on the gravity model, the extreme bounds analysis carried out by
Ghosh and Yamarik (2004) tested the robustness of the trade creation hypothe-
sis and showed that the trade creation effect of most RTA was fragile. Rose’s
(2004) study covering 50 years and 175 countries also showed that there was
little evidence to support trade creation effects for the WTO/GATT.
Furthermore, the influence of FTA may go beyond conventional trade impacts.
Fernandez (1997) examined the benefits other than traditional gains produced
through regional trade arrangements, including credibility, signalling, bargaining
power, insurance and coordination. Antkiewicz and Whalley (2004) investigated
China’s recent cooperation in a wide range of FTA and implied that there was a
clear linkage between seemingly conventional trade interests and China’s interests
in wider economic, diplomatic and strategic relationships. Banda and Whalley
(2005) evaluated the competition policy, investment, mutual recognition, move-
ment of persons and broader cooperation provisions in FTA. Hur and Park
(2012) found no significant effect on growth performance but an upward trend
in the gap between the growth rates of per capita GDP of countries within an
FTA, which implied that uneven effects existed among countries within FTA.
Furthermore, they pointed out that technology transfer and trade diversion played
key roles in economic growth. FTA often convey information about governments’
consideration of economic support for the regional economy, integration or future
policies. Such information can change market expectations and investors’
decisions. Therefore, the effects brought about by FTA would be quite great. In
fact, the purpose of FTA’s policy-makers would be possibly more than trade.
With the results of studies on trade creation being mixed, this paper will
conduct an analysis using both the nonparametric method and a quasi-natural
experiment with product-level data. We will apply triple difference in differences
(triple DID; also known as DDD (difference in differences in differences)) to un-
dertake our empirical study. In the empirical literature, most researchers esti-
mate the trade creation effects using the gravity equation or other similar
methods (see Aitken and Lowry, 1972; Frankel and Wei, 1993; Rose, 2004; An-
derson and Yotov, 2011; Eicher et al., 2012). In such regressions, the dependent
variable is bilateral trade flow. The core dummy variable of FTA on the right-
hand side is used for identifying the average treatment effect (ATE). Other var-
iables include GDP, population, area, bilateral distance2 and dummies for
2
In a special case, Aitken and Lowry (1972) added the distance of the Latin American countries
from the United States to be control variables to measure the attraction and competitiveness of
the United States in international trade in these regions.

HAVE FREE TRADE AGREEMENTS CREATED TRADE? EVIDENCE FROM CEPA 3
controlling, for instance, two parties sharing the same language or land borders.
However, the FTA dummy is likely to represent other unobserved factors that
influence trade and, moreover, the endogeneity leads to an inaccurate estimate
of the causality between FTA and the trade creation generally. These problems
may bias the coefficient estimates (Anderson and Wincoop, 2003; Rose, 2004;
Baier and Bergstrand, 2009). Baier and Bergstrand (2009) and Hur and Park
(2012) used a nonparametric matching approach to obtain unbiased estimates
of ATE. In view of the problems of factor omission and endogeneity, we employ
an alternative nonparametric method, triple DID, to eliminate such bias caused
by omitted factors and non-random selection of FTA.
The Mainland 3 and Hong Kong’s Closer Economic Partnership Arrangement
(hereinafter referred to as ‘CEPA’) implemented since 2004 can provide us a
quasi-natural experiment to apply triple DID. With the rapid economic growth
of China, more and more investors from abroad are finding business opportuni-
ties in the Mainland. Because of its independent political system, adjoining loca-
tion to the Mainland and excellent business environment, Hong Kong plays a
unique role in the linkage between the Mainland and the world, especially in
relation to trade (Young, 1992; Feng, 1996; Feenstra and Lin, 2002; Feenstra
and Hanson, 2004; Li et al., 2009; Ching et al., 2012). Has the implementation
of CEPA reduced trade barriers between the Mainland and Hong Kong and
benefited trade? The eight-digit HS code trade data from the Census and Statis-
tics Department of the Government of Hong Kong will help us conduct our anal-
ysis at product-level. We believe that such a product-level analysis would be more
accurate in describing the micro behaviour than those at macro or regional level.
The present paper proceeds as follows. Section 2 provides a background for
trade between the Mainland and Hong Kong, and describes the framework of
CEPA. Using the triple DID method, Section 3 examines whether the FTA
influence merchandise trade. Finally, Section 4 concludes.
2. BACKGROUND
Since its economic take-off in the 1970s, Hong Kong has been an important port
for the rest of the world, and plays a unique role as a bridge to the Mainland be-
cause of its independent political system and adjoining location to the Mainland.
With this bridge to the Mainland, many investors from abroad have found busi-
ness opportunities in the Mainland market, and Hong Kong has also been able
to achieve solid economic performance. Since the commencement of economic
reform in 1978, China has maintained rapid economic growth. In particular,
during the recent years of economic downturn worldwide, China has played
an important role in the global recovery. Increasing numbers of investors are
seeking opportunities in Mainland China’s large market, and, meanwhile, more
Chinese enterprises are eager to reach out to the global market. Under such a
situation, the role of Hong Kong in the greater Chinese market has become
more significant. Through, for instance, distributing the exports of the Mainland
3
Here ‘Mainland’ refers to Mainland China (hereinafter referred to as ‘the Mainland’).

4 Y. ZHOU
and re-exporting the materials needed in manufacturing in the Mainland, the

trade related to the Mainland accounts for a major portion of Hong Kong’s
international trade and, thus, influences Hong Kong’s economy deeply.
Since the return of Hong Kong to China in 1997, the governments of China
and Hong Kong SAR have been devoted to promoting the economic integration
of the Mainland and Hong Kong. CEPA is the first FTA ever concluded by the
Mainland and Hong Kong. The main body of CEPA was signed on 29 June
2003. CEPA covers three broad areas: trade in goods, trade in services, and
trade and investment facilitation. For trade in goods, all goods of Hong Kong
origin exporting into the Mainland enjoy tariff-free treatment, upon application
by local manufacturers and the CEPA rules of origin being agreed to and met. In
relation to trade in services, Hong Kong service suppliers enjoy preferential
treatment in entering the Mainland market in various service areas. Professional
bodies of Hong Kong and the regulatory authorities in the Mainland have also
signed a number of agreements and arrangements relating to mutual recognition
of professional qualifications. In regards to trade and investment facilitation,
both sides have agreed to enhance cooperation in various trade and investment
facilitation areas to improve the overall business environment.4 The free trade
arrangements for goods are the most important part of CEPA because merchan-
dise trade always plays a key role in the trade between the Mainland and Hong
Kong (hereinafter ‘trade’ is referred to ‘merchandise trade’). As it is shown in
Figure 1, the trade between the Mainland and Hong Kong plays an important
role in Hong Kong’s international trade. Even in 1997, the proportion of the
trade between the Mainland and Hong Kong reached 36% of Hong Kong’s total
international trade, and in 2013, it accounted for more than 51%.
CEPA and its Annexes were signed on 29 June 2003 and 29 September 2003,
respectively. From 1 January 2004, in stages, the Mainland implemented zero
tariffs on imported goods of Hong Kong origin. Supplement and Supplement
II were signed in 2004 and 2005, respectively, to expand the range of products
enjoying zero tariffs. Therefore, in the triple DID method, the policy years of
CEPA include 2004, 2005 and 2006. Pursuant to CEPA, Hong Kong continues
to apply zero tariffs to all imported goods of Mainland origin. Because of its free
port status, Hong Kong had already applied zero tariffs to the imported goods
of Mainland origin before CEPA and, in fact, the establishment of CEPA does
not provide benefits for imports from the Mainland to Hong Kong directly.
Table 1 shows the change in tariff rates for exporting into the Mainland for
the three stages of implementation of CEPA, in 2004, 2005 and 2006. From
Table 1 we know that 273 kinds of products could enjoy zero tariffs from
2004, and 184 and 261 more kinds of products could enjoy the arrangement
from 2005 and 2006, respectively.
The results of studies on trade creation and FTA are quite mixed. If there
were trade creation effects, we would see an increase in domestic exports from
Hong Kong to the Mainland after 2004. We conduct a comparative analysis
4
For more information about CEPA, please visit http://www.tid.gov.hk/.

Figure 1. The international trade between Mainland China and Hong Kong.
Note: The vertical axis represents the total volume of trade including exports,
imports and re-exports. Source: The Census and Statistics Department of the
Government of Hong Kong. Please visit http://www.censtatd.gov.hk/.
Table 1. The change of tariff rates

Tariff rates, most favoured nation
Number Tariff rates,
Year of items Maximum Minimum Mean CEPA
2004 273 35.0 1.5 13.1 0

2005 184 53.6 2.0 11.2 0
2006 261 35.0 1.5 14.0 0
Data for 2004 and 2005 are collected from Annexes, Supplement and Supplement II to CEPA. Please visit
Trade and Industry Department, Hong Kong SAR (website: http://www.tid.gov.hk/english/cepa/index.
html). Data for 2005 is collected from the Customs Import and Export Tariff of the People’s Republic of
China (2005 and 2006). The tariff rates do not include specific duties.
to explore this issue. Figure 2 shows the domestic exports to the Mainland, the
United States and the rest of the world. We use the United States for contrast
here because the United States is Hong Kong’s second largest trade partner.5
5
From 1985, the positions of the Mainland and the United States in Hong Kong’s international
trade reversed. The Mainland came to be the largest partner of Hong Kong, followed by the
United States.

6 Y. ZHOU
Figure 2. The domestic exports of Hong Kong.

Source: The Census and Statistics Department of the Government of Hong Kong.
Please visit http://www.censtatd.gov.hk/.
From the figure, although we see an increase in domestic exports to the

Mainland in 2004, there was also an increase in exports to the rest of the world.
However, the difference of the value between the Mainland and the United
States became greater after 2005. Therefore, there appears to be trade creation
when we make a comparison with the United States but there is no such result
when we consider the rest of the world. We undertake an empirical analysis
in the next section to consider whether CEPA has, in fact, led to the creation
of real trade.
3. EMPIRICAL STUDY
3.1. Method and data

In the traditional method using the gravity equation to study trade creation
effects, the dummy variable for FTA on the right-hand side of the equation is
likely to represent other unobserved factors that influence trade but are omitted.
Moreover, FTA themselves would be the result of the booming trade among
those countries. Factors being omitted and endogeneity lead to bias in the
estimates of the causality between FTA and trade creation. To solve these
problems, we apply a nonparametric method, triple DID, to complete our
analysis. In fact, DID is widely used in the analysis of policy effects. However,

we are likely to face some difficulties in applying the DID method in this study.
As mentioned above, CEPA is not just an FTA covering merchandise trade;
it also includes arrangements for trade in services and investment facilitation.
Therefore, a change in trade flows could possibly be the result of other
factors, such as an increase in services and investment in the Mainland from
Hong Kong or foreign companies, and not necessarily derive from of an
increase in merchandise trade. If we apply the DID method with other
trades as the control, we cannot identify the direct trade creation effects
from the broad impact. In such a situation, the triple DID method (an
additional difference in DID) can separate these simultaneous factors. The
basic equation with the triple DID framework can be summarized in
equation 1:
ypct ¼ α þ β0 CEPApct
þβ1 τ 1pt þ β2 τ 2pt þ β3 τ 3pt þ β4 μp þ β5 ηc

þβ6 τ 1pt μp þ β7 τ 2pt μp þ β8 τ 3pt μp (1)

þβ9 τ 1pt ηc þ β10 τ 2pt ηc þ β11 τ 3pt ηc

þβ12 μp ηc þ εpct
In the ordinary least squares (OLS) regression, the dependent variable ypct
in equation 1 is ln(Valuepct), the natural logarithm of the value of domestic
exports of Hong Kong in product p, year t and destination c. Because some
products report zero domestic exports in our samples, these observations
would be excluded from OLS regressions because the dependent variable,
the natural logarithm of the value of domestic exports, has missing values
for these products. Besides, in some exports, ypct swing between zero and
non-zero, and may be not continuous. For example, the quantity of exports
of a certain product would possibly change from 0 to 1 box, 2 boxes or 3
boxes etc. If the price per box is 10 dollars, the value would jump from 0
to 10 dollars, 20 dollars or 30 dollars discretely. To address these issues,
we apply the Poisson pseudo-maximum-likelihood estimation (PPML)
proposed by Santos Silva and Tenreyro (2006, 2010), replacing the
dependent variable with domestic exports, Valuepct.6 Finally, to obtain a
robust result, we also apply OLS regression with Valuepct as a dependent
variable. On the right-hand side of the equation, CEPApct is the core
dummy indicating that the domestic exports enjoy benefits as a result of
CEPA. Because there are three batches of products which began to enjoy
6
Santos Silva and Tenreyro (2006, 2010) provide evidence on the good performance of PPML by
allowing for a large fraction of zeros. This method is commonly used in papers accounting for this
problem in international trade, including Anderson and Yotov (2010), Sun and Reed (2010),
Handley (2014), Fally (2015), Heid and Larch (2004) and Bertho et al. (2016).

8 Y. ZHOU
the benefits of CEPA in 2004, 2005 and 2006, respectively, the dummy is set
as below:
8
> 1; for t ≥ 2004; p in the first batch; c for the Mainland
>
>
< 1; for t ≥ 2005; p in the second batch; c for the Mainland
CEPApct ¼ (2)
>
> 1; for t ≥ 2006; p in the third batch; c for the Mainland
>
:
0; otherwise
Meanwhile, there are three points in time for policy implantation here:
2004, 2005 and 2006. Thus, we must use dummies τ ipt (i = 1,2,3) to control
the difference between post-policy and pre-policy in each batch. τ ipt is set as:
8
> 1; for i ¼ 1; t ≥ 2004; p in the first batch or control group
>
>
< 1; for i ¼ 2; t ≥ 2005; p in the second batch or control group
τ ipt ¼ (3)
>
> 1; for i ¼ 3; t ≥ 2006; p in the third batch or control group
>
:
0; otherwise
All estimates include a product dummy μp (see eqn 4) that controls the
mean difference between the exports enjoying CEPA and those not enjoying
CEPA, a destination dummy ηc (see eqn 5) that controls the mean difference
between the exports to the Mainland and other regions, and the interaction
terms among the dummies we have set above:

1; for p in one of the three batches
μp ¼ (4)
0; otherwise

1; for c for the destination of the Mainland
ηc ¼ (5)
0; otherwise
Therefore, equation 1 provides an unbiased estimate of the average treat-

ment effect of CEPA using coefficient β0:
nh i

β0 ¼ E ypct μp ¼ 1; ηc ¼ 1; τ ipt ¼ 1 E ypct μp ¼ 0; ηc ¼ 1; τ ipt ¼ 1
h io

E ypct μp ¼ 1; ηc ¼ 0; τ ipt ¼ 1 E ypct μp ¼ 0; ηc ¼ 0; τ ipt ¼ 1
nh i (6)

h io

Here, β0 measures the average difference between the value of the first DID
term with the samples of the Mainland-Hong Kong trade, and the value of the
first DID term with the samples of other region-Hong Kong trade.

Next, of key importance in the processing of data is the matching of export

products based on a multiple classification scheme. The international HS code
has only six digits and any countries add additional digits for more detailed clas-
sification. The Mainland provides a list of products that can enjoy zero tariffs
with the Mainland’s eight-digit HS codes. However, the Mainland’s eight-digit
HS code system is not completely consistent with that of Hong Kong. Therefore,
Hong Kong’s exporters need to illustrate which Mainland HS codes their prod-
ucts match when they apply for zero tariffs. Therefore, we must match the HS
codes of domestic exports of Hong Kong with those of the Mainland before re-
gression, so that we can identify which products enjoy zero tariffs and which do
not. Based on the following facts, we believe that it is reasonable to match the
codes between the Mainland and Hong Kong by using only the initial six digits
of HS codes.
First, because Hong Kong already applied zero tariffs to the imported goods
of Mainland origin before CEPA, one of the important purposes of CEPA is to
support Hong Kong’s domestic exports to the Mainland as much as possible.
Therefore, Mainland policy-makers were willing to cover all the related Hong
Kong domestic exports according to the list. Second, when Hong Kong ex-
porters have applied for zero tariffs, they have used Mainland HS codes on
the list of preferential products as far as possible to save on costs. Therefore,
we believe that it is reasonable to match the codes for Mainland China and
Hong Kong using only the initial six digits. We also manually checked the
matching results and found that the matching is acceptable. Table 2 lists an ex-
ample of the matching results for Mainland and Hong Kong HS codes. In this
example, there are two related items in Hong Kong’s HS code, ‘21050010’ and
‘21050090’, that match the initial six digits of the Mainland code: ‘21050000’.
From the description in Hong Kong Imports and Exports Classification List
(Harmonized System), we know that they match exactly.
Finally, Hong Kong’s eight-digit HS code data is provided by the Census and
Statistics Department of the Government of Hong Kong. Following the subprime
crisis in 2006, trade experienced negative shock as the crisis spread to most in-
dustries over the following 1 to 2 years. To avoid this disturbance, we just use
the data from 2000 to 2007 in our sample. As mentioned above, only domestic
Table 2. Example of matching

Mainland’s Hong Kong’s
Harmonized Harmonized
System code Description System code Description
Ice cream and other

21050000 edible ice, whether or 21050010 Ice cream
not containing cocoa 21050090 Other
The descriptions are quoted from the Trade and Industry Department, Hong Kong SAR (website: http://
www.tid.gov.hk/english/cepa/index.html) and the Hong Kong Imports and Exports Classification List
(Harmonized System; 2007 edition; website http://www.censtatd.gov.hk/hkstat/un/class/hkhs/index.
jsp).

10 Y. ZHOU
Table 3. Descriptive statistics of domestic exports
Variable Destination Mean SD Minimum Maximum N
Mainland 23 498.23 717 642.35 0 92 799 398 32 332

Value United States 11 484.77 120 299.50 0 3 482 219 32 332
(thousand HKD) The rest of the world 41 522.25 612 015.84 0 61 816 466 32 332
Total 25 501.75 549 085.42 0 92 799 398 96 996
exports are used in our sample and re-exports are not included in the analysis.
Domestic exports include the natural produce of Hong Kong or products that
have subject to manufacturing process in Hong Kong that has permanently
changed the shape, nature, form or utility of the basic materials. Processes such
as simple diluting, packing, bottling, drying, simple assembling, sorting and dec-
orating do not constitute Hong Kong origin. Re-exports are products that have
previously been imported into Hong Kong and that are re-exported without
having undergone a manufacturing process in Hong Kong that has permanently
changed the shape, nature, form or utility of the product.7 Therefore, only do-
mestic exports can possibly meet the requirement of the zero-tariff arrangement
of CEPA. Table 3 presents descriptive statistics of the value of domestic exports
of Hong Kong. There are 96 996 observations in total in the pool, and 32 332
observations with the destination being the Mainland, the United States or the
rest of the world.
Table 4 illustrates the progress of execution of CEPA, matching HKHS codes
with Mainland codes. From 2004 to 2006, the number of HKHS codes which
are affected by the CEPA arrangement increased from 242 to 474, with the value
exporting to the Mainland increasing from HKD22 198.19 million to HKD
25 100.15 million.
3.2. Basic understanding

Here we use the triple DID approach to arrive at a basic understanding of the
average effects of CEPA. As we know that when eliminating the unobserved si-
multaneous factors, the coefficient β0 measures the average treatment effect of
CEPA, shown in equation 6. From Figures 3–5, we can observe the value of
β0 intuitively: the change of the lines with time t changing. These figures give
the value Yt in equation 7 for the 2004 batch, the 2005s batch and the 2006
batch, respectively:
h i
Y it ¼ E Valueipct μp ¼ 1; ηc ¼ 1 E Valueipct μp ¼ 0; ηc ¼ 1
h i (7)
E Valueipct μp ¼ 1; ηc ¼ 0 E Valueipct μp ¼ 0; ηc ¼ 0
7
Please see: Trade Analysis Section Census and Statistics Department Hong Kong, Merchandise
Trade Statistics - Domestic Exports and Re-exports, December 2006.

Table 4. Progress of execution of CEPA

2004 2005 2006
CEPA Non CEPA Non CEPA Non
Number of
242 1508 336 1423 474 1285
items (HKHS)
Mainland 22 198.19 16 138.99 25 716.90 19 509.28 25 100.15 18 339.98
Value United States 25 699.74 12 967.40 26 762.03 11 107.71 23 613.07 9667.91
(million HKD) The rest of 51 171.10 66 120.40 49 856.15 60 855.53 51 045.84 82 346.73
the world
In number of items, ‘CEPA’ refers to the number of actual HKHS items that enjoy CEPA’s arrangement
by that year, while ‘non’ refers to those have not enjoyed CEPA. Value refers to the value of domestic
exports.
Figure 3. The value of Yt: 2004 batch.
Compared with equation 6, equation 7 does not control τ ipt and, thus, it gives
the value of the first DID term. In detail, i refers to the ith batch of the preferen-
tial list, Value refers to the value of domestic exports. The samples in each figure
include the products enjoying the preferential arrangements in the ith batch and
the products in control groups. Therefore, Yt gives us the difference between the
average value for destination of the Mainland and other regions (the United
States or the rest of the world) in difference between the treatment group and
the control group. Let’s say that T denotes the policy year. Because Yt does

12 Y. ZHOU

not control the time trend, we know that if β0 is significant, there must be significant
difference between Yt = T 1 and Yt = T. In other words, we would observe a signif-
icant jump from T 1 to T in these figures if there were trade creation effects.
Figures 3, 4 and 5 describe the trend of Yt for the 2004, 2005 and 2006 effects,
respectively. Unfortunately, although there is slight change of Y from T 1 to
T, we do not see a significant jump in the figures in year 2004 in Figure 3, 2005 in
Figure 4 or 2006 in Figure 5. There appear to be no trade creation effects at all. To
confirm this, we conduct another empirical analysis in the following subsection.
3.3. Estimates
In this empirical analysis we apply estimates with standard errors clustered at
product level. Table 5 reports the estimates of equation 1. Unfortunately, the
coefficients of CEPApct are not significant, regardless of whether using OLS or
PPML regression, or using the exports to United States or those to the rest of
the world as a control.
However, we may wonder whether it is possible that CEPA takes some time
to affect trade because of information or administrative delays. In other words,
are delayed effects possible? To check this, we apply 1-year delay estimates mod-
ified from equation 1. The results are reported in Table A.1 of Appendix A.
Here, the policy years used for the dummy CEPApct in equation 1 are modified
to 2005, 2006 and 2007 so that we can observe the 1-year lag effect. We can see
that although the coefficient in column (1) is significant at 10%, coefficients are
not significant in other columns. Therefore, there is no strong evidence for
delayed effects.
Table 5. Regression results of value of domestic exports

(1) (2) (3) (4) (5) (6)
ln(Value) Value Value ln(Value) Value Value
(OLS) (OLS) (PPML) (OLS) (OLS) (PPML)
CEPA 0.247 2216.227 0.001 0.105 9598.673 0.256

(0.182) (8984.821) (0.282) (0.157) (15 759.749) (0.293)
μp ; ηc ; τ ipt ; μp τ ipt ; τ ipt ηc ; μp ηc Yes Yes Yes Yes Yes Yes
Constant Yes Yes Yes Yes Yes Yes

2
R 0.090 0.023 0.023 0.083 0.008 0.008
Observations 26 140 41 356 41 356 32 842 41 356 41 356
Destination in control United States The rest of the world

Sample period 2000–2007
‘Yes’ denotes that the variables are included in regressions. Standard errors clustered at product level are
reported in parentheses. Estimates of value of domestic exports: 1 year lag effect. The regression here is
modified from equation 1, with the policy years 2004, 2005 and 2006 replaced by the supposing policy years
2005, 2006 and 2007.*p < 0.10,**p < 0.05,***p < 0.01.OLS, ordinary least squares; PPML, Poisson
pseudo-maximum-likelihood.

14 Y. ZHOU
Appendix B provides triple DID estimates of trade creation for each batch.8
Appendix Table B.1 tests the trade creation effect for the first preferential batch
of 2004, using the exports without zero tariff as control. Similarly, Appendix
Tables B.2 and Table B.3 report the effects for the 2005 batch and the 2006
batch, respectively. Furthermore, we run the regressions with a narrower
sample window and a more cross-sections in the control group in Appendix
Tables B.4–6. For the effect of the 2004 batch, the sample period is only from
2003 to 2004; the exports in the 2004 list belong to the treatment group (the mod-
ified μ’p = 1) and, therefore, the remaining exports in the pool are not affected by
other policies during this period and can be regarded as the control group (the
modified μ’p = 0). The results are reported in Appendix Table B.4. Similarly, we
use the exports in the 2005 batch as the treatment group and the remaining
exports as the control group, setting 2005 as the policy year with a sample period
from 2004 to 2005 (see Appendix Table B.5). Finally, we use the exports in the
2006 batch as the treatment group and the remaining exports as the control
group, setting 2006 as the policy year with the sample the period from 2005 to
2006 (see Appendix Table B.6). Most coefficients of CEPApct are not significant.
Therefore, these regressions cannot give us any credible evidence of trade
creation effects.
4. CONCLUSION
Trade creation effects due to FTA have been studied extensively over the past
half century. However, a consensus has not yet been reached regarding whether
there are, indeed, trade creation effects. We revisit this issue in this paper with
two new views. First, different from the traditional method using the gravity
model, we apply the triple DID method for solving the problems of factor omis-
sion and endogeneity. Second, it makes the estimates more credible that we use
data at eight-digit HS code level to retest the trade creation effects. Given the
importance of China’s economy, we believe that the study of CEPA, the FTA
between Mainland China and Hong Kong, is meaningful.
With the triple DID estimates, we use the domestic exports to the Mainland
with zero tariffs as the treatment group, and other exports and those to other
regions as the control group. We found no evidence of trade creation effects in
our triple DID analysis.9 The results are not surprising. Because the domestic
exports of Hong Kong only account for a small portion in the trade between
the Mainland and Hong Kong, we believe that, for policy-makers, there are
other important purposes of CEPA, including sending the signal of a close rela-
tionship between the Mainland and Hong Kong.
8
The regression equation is given by equation (B.1) in Appendix B.
9
However, the triple DID method may not distinguish the effects of trade creation from the effects
of trade diversion. Both trade creation and trade diversion effects raise the trade volumes in a coun-
try after signing the FTA. Fortunately, this paper shows that there is no significant increase in trade
volumes from the CEPA effect. Therefore, we can conclude that neither trade creation nor trade
diversion exists in this case.

However, although the Mainland’s HS eight-digit code system and

Hong Kong’s HS eight-digit code system are both derived from international
HS 6-digit code, there is no official means of converting the two sets of codes.
Therefore, in the triple DID analysis, we match the two-code system using the
initial six digits to identify treatment and control groups. Of course, this
matching rule would possibly lead to underestimation if there were trade crea-
tion effects, because the treatment group would possibly cover some observa-
tions in the control group. Given the intent of policy-makers (benefiting Hong
Kong’s exports as far as possible) and the behaviour of exporters (minimizing
the cost of exports), we believe the matching is feasible.
Looking at the empirical results, it is no surprise that there is no trade creation
effect for domestic exports, because it is re-exports and imports that play major
roles in Hong Kong’s international trade, and not domestic exports. We believe
that the inelasticity in export supply and demand can partially explain the results
here, but, what’s more important, the government may has other objectives ——
to achieve integration through CEPA. Through CEPA, the Chinese Govern-
ment is sending a signal to the world regarding its stance on regionalism, deeper
opening and the support of Hong Kong as a bridge to Mainland China. Hence,
the possible trade creation effect may not have been the primary issue that the
government considered when they planned the arrangement. If this is the case,
it is, indeed, an interesting and important topic deserving further study.
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APPENDIX
APPENDIX A: ESTIMATES OF LAGGED EFFECTS
Table A.1. Estimates of value of domestic exports: 1 year lag effect

(1) (2) (3) (4) (5) (6)
CEPA1 year lag 0.348* 4190.674 0.183 0.229 5382.400 0.059

(0.203) (10 382.311) (0.374) (0.173) (16 874.455) (0.332)
μp ; ηc ; τ ipt ; μp τ ipt ; τ ipt ηc ; μp ηc Yes Yes Yes Yes Yes Yes

2
R 0.080 0.020 0.020 0.074 0.007 0.007
Observations 26 140 41 356 41 356 32 842 41 356 41 356

reported in parentheses.*p < 0.10,**p < 0.05,***p < 0.01.

APPENDIX B: TRIPLE DIFFERENCE IN DIFFERENCES REGRESSIONS OF EACH

BATCH
The regression equation for estimates of each batch is shown below. The depen-
dent variables are ln(Value) and Value, respectively. i = 1 for 2004, 2 for 2005
and 3 for 2006:

ypct ¼ α þ β0 CEPApct þ β1 τ ipt þ β2 μp þ β3 ηc þ β4 τ ipt μp þ β5 τ ipt ηc (B:1)

þβ6 μp ηc þ εpct :
Table B.1. Regressions of value of exports: 2004 batch

(1) (2) (3) (4) (5) (6)
CEPA 0.058 249.879 0.432 0.064 62 935.165* 0.291

(0.240) (18825.514) (0.324) (0.212) (35 609.425) (0.453)
μp ; ηc ; τ 1pt ; μp τ 1pt ; τ 1pt ηc ; μp ηc Yes Yes Yes Yes Yes Yes

2
R 0.143 0.041 0.041 0.117 0.006 0.006
Observations 22 329 35 720 35 720 36 598 46 522 46 522

Cross-sections in control Out of the lists of three batches
Cross-sections in treatment The first batch
Policy year 2004

18 Y. ZHOU

(1) (2) (3) (4) (5) (6)
CEPA 0.053 1705.337 0.275 0.437 23465.829 0.551

(0.432) (2678.098) (0.474) (0.379) (16612.158) (0.599)

2
R 0.011 0.001 0.001 0.002 0.001 0.001
Observations 19573 32348 32348 32241 41814 41814
Destination in control United States the rest of the world

Cross-sections in treatment The second batch
Policy year 2005

(1) (2) (3) (4) (5) (6)
CEPA 0.514** 19541.187 0.330 0.552** 22853.179 0.533

(0.260) (2052.101) (0.336) (0.230) (19541.187) (0.580)

2
R 0.012 0.001 0.001 0.007 0.001 0.001
Observations 21346 34888 34888 34726 44986 44986

Cross-sections in treatment The third batch
Policy year 2006

Table B.4. Regressions of value of exports with narrower window: 2004 batch
(1) (2) (3) (4) (5) (6)
CEPA 0.095 934.998 0.111 0.112 519.486 0.111

(0.234) (8993.506) (0.218) (0.177) (16344.291) (0.218)
μp ; ηc ; τ 1t ; μ0 p τ 1t ; τ 1t ηc ; μ0 p ηc Yes Yes Yes Yes Yes Yes

2
R 0.056 0.010 0.010 0.049 0.003 0.010
Observations 5783 9258 9258 7334 9258 9258

Cross-sections in control Except the first batch
Cross-sections in treatment The first batch
Policy year 2004
reported in parentheses.*p < 0.10,**p < 0.05,***p < 0.01
(1) (2) (3) (4) (5) (6)
CEPA 0.446 2080.494 0.341 0.022 3881.454 0.378

(0.378) (2489.923) (0.286) (0.294) (6042.196) (0.267)

2
R 0.017 0.001 0.001 0.006 0.002 0.002
Observations 5711 9326 9326 7306 9326 9326

Cross-sections in control Except the second batch
Cross-sections in treatment The second batch
Policy year 2005

20 Y. ZHOU
(1) (2) (3) (4) (5) (6)
CEPA 0.182 3925.528 0.319 0.023 8113.571 0.084

(0.266) (4394.424) (0.195) (0.233) (10454.819) (0.216)

2
R 0.013 0.000 0.000 0.002 0.001 0.001
Observations 5640 9408 9408 7286 9408 9408

Cross-sections in control Except the third batch
Cross-sections in treatment The third batch
Policy year 2006

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Paciﬁc Economic Review, ••: •• (2017)

HAVE FREE TRADE AGREEMENTS CREATED TRADE?

YONGHONG ZHOU* Jinan University

Trade creation is not a new topic in the study of international economics.

© 2017 John Wiley & Sons Australia, Ltd

© 2017 John Wiley & Sons Australia, Ltd

© 2017 John Wiley & Sons Australia, Ltd

and re-exporting the materials needed in manufacturing in the Mainland, the

© 2017 John Wiley & Sons Australia, Ltd

Table 1. The change of tariff rates

2004 273 35.0 1.5 13.1 0

© 2017 John Wiley & Sons Australia, Ltd

Figure 2. The domestic exports of Hong Kong.

From the ﬁgure, although we see an increase in domestic exports to the

3.1. Method and data

© 2017 John Wiley & Sons Australia, Ltd

© 2017 John Wiley & Sons Australia, Ltd

Therefore, equation 1 provides an unbiased estimate of the average treat-

© 2017 John Wiley & Sons Australia, Ltd

Next, of key importance in the processing of data is the matching of export

Table 2. Example of matching

Ice cream and other

© 2017 John Wiley & Sons Australia, Ltd

Table 3. Descriptive statistics of domestic exports

Variable Destination Mean SD Minimum Maximum N

Mainland 23 498.23 717 642.35 0 92 799 398 32 332

3.2. Basic understanding

© 2017 John Wiley & Sons Australia, Ltd

Table 4. Progress of execution of CEPA

CEPA Non CEPA Non CEPA Non

Figure 3. The value of Yt: 2004 batch.

© 2017 John Wiley & Sons Australia, Ltd

Figure 4. The value of Yt: 2005 batch.

Figure 5. The value of Yt: 2006 batch.

© 2017 John Wiley & Sons Australia, Ltd

Table 5. Regression results of value of domestic exports

CEPA 0.247 2216.227 0.001 0.105 9598.673 0.256

Constant Yes Yes Yes Yes Yes Yes

Destination in control United States The rest of the world

© 2017 John Wiley & Sons Australia, Ltd

© 2017 John Wiley & Sons Australia, Ltd

However, although the Mainland’s HS eight-digit code system and

© 2017 John Wiley & Sons Australia, Ltd

Table A.1. Estimates of value of domestic exports: 1 year lag effect

CEPA1 year lag 0.348* 4190.674 0.183 0.229 5382.400 0.059

Constant Yes Yes Yes Yes Yes Yes

Destination in control United States The rest of the world

© 2017 John Wiley & Sons Australia, Ltd

APPENDIX B: TRIPLE DIFFERENCE IN DIFFERENCES REGRESSIONS OF EACH

Table B.1. Regressions of value of exports: 2004 batch

CEPA 0.058 249.879 0.432 0.064 62 935.165* 0.291

Constant Yes Yes Yes Yes Yes Yes

Destination in control United States The rest of the world

© 2017 John Wiley & Sons Australia, Ltd

Table B.2. Regressions of value of exports: 2005 batch

CEPA 0.053 1705.337 0.275 0.437 23465.829 0.551

Constant Yes Yes Yes Yes Yes Yes

Destination in control United States the rest of the world

Table B.3. Regressions of value of exports: 2006 batch

CEPA 0.514** 19541.187 0.330 0.552** 22853.179 0.533

Constant Yes Yes Yes Yes Yes Yes

Destination in control United States the rest of the world

CEPA 0.514 19541.187 0.330 0.552 22853.179 0.533