Trade implications of the Euro in EMU countries: a panel gravity analysis

In this paper, we study the intra-EMU and intra-Euro area trade effects of the Euro adoption on 29 European Economic and Monetary Union countries (including 17 Euro area economies and Iceland) from the period 1994 through 2011. We employ a generalised gravity model that controls for an extended set of trade theory and policy variables. The gravity model is estimated using the robust panel data techniques that includes times effects, besides country-specific effects. The various econometric specifications of the gravity equation, on the whole dataset of 29 economies, yield positive and significant impact (to be around 14 percent) of the Euro currency adoption on bilateral trade flows. Next, Euro effect on bilateral trade and exports on a smaller dataset is estimated. The estimated results suggest that bilateral trade and exports increase by 20.81 and 18.57 percent, respectively, when both countries belong to the Euro area. This effect is larger than the one obtained when only one of the two trading partners uses the Euro as its currency. In addition, the validity of the assumptions of Heckscher-Ohlin (H-O) theory are checked for the countries under study. The estimated results reject the H-O theory in favour of Modern Trade theories. However, the low value of the coefficient on the respective variable suggests that, over the period, the type of trade among these countries has transited from inter-industry trade to horizontal intra-industry trade. This suggests that these developed European economies are on the path of economic convergence via intra-industry trade.