Regionalism versus Multilateralism: Evidence for the Natural Trade Partners Theory from the Euro-Mediterranean Region?

The slow pace of multilateral negotiations has given a greater impetus to regional trade arrangements (RTA) as countries are eager to take advantage of welfare enhancing trade creation effect of trade liberalization. At the same time, this approach raises concerns as due their discriminatory nature, RTAs lead to welfare reducing trade diversion from third countries. The paper develops a modified triple-indexed gravity model to measure the trade creation and diversion effects of the preferential trade agreements in the Euro-Mediterranean region. The model is applied to different components of imports, since the welfare implications of each component is expected to be different. Using these measures, the paper proceeds to look for evidence for the Natural Trade Partners Theory using three definitions of natural partners. Results show that there is support for the theory when geographical distance or initial trade volumes are used to define naturalness only for intra-industry componenets. Stronger support is found when complementarity is used to identify natural partners.