The wise use of dummies in gravity models: export potentials in the Euromed region

In this paper, we estimate a gravity equation properly accounting for omitted exporter and importer’s overall trade resistance, through country yearly dummies for exporter and importer countries. We find that the omission of time varying multilateral trade resistance terms in the estimation of a gravity equation introduces important biases in the results, although correcting them means we can only compute differences between actual and predicted export shares, instead of levels, as usually done. An application to the calculation of trade potentials in the Euromed region (Southern and Eastern Mediterranean countries) shows that the omission of time varying multilateral trade resistance terms greatly influences the computation of export potentials as well as the estimated effect of signing a free trade agreement. Overall, we find that, except for Algeria, Jordan and Lebanon, Euromed countries’ share of exports to the EU as a whole is at, or slightly above, those predicted by a correctly specified gravity model, although the share of exports to some individual EU countries is significantly below the predictions of the gravity model. Except for those three countries, we find significant opportunities for export growth to the US, instead.