Over the past three decades, countries and trading blocks around the world have undertaken substantial efforts to reduce barriers to trade. In recent years, these efforts have mainly taken the form of regional free trade agreements (RTAs) in which countries liberalise trade outside the multilateral framework of the WTO. Given the increasing importance of RTAs, it is not surprising that economists have tried to estimate the effects of such agreements on a wide range of variables, including productivity, firm exit and entry, employment, and wages (e.g. Pavnick 2002, Trefler 2004, Topalova and Khandelwal 2012).
Curiously, however, we still do not know much about the impact of RTAs on another important variable – firm-level profits. This is despite the fact that firms and their trade associations are among the most active lobbyists, both for and against specific trade agreements. Most citizens in developed countries also have substantial shareholdings in domestic firms, either directly or indirectly through pension and insurance funds. So whether the profits of specific groups of firms fall or rise after the implementation of an RTA will have important implications, both for the affected firms and the general public.
A small number of papers have looked at how accounting profits are correlated with tariff reductions in the years before and after a given RTA (e.g. Baggs and Brander 2006). One problem this approach faces is that accounting profits may only be weakly related to true economic profitability. Disentangling the effects of trade barrier reductions from other factors influencing profits over time horizons of several years is also often difficult. Finally, such ex post approaches cannot say much about the likely profit effects of agreements currently being negotiated, as extrapolation from past RTAs is usually difficult.
In a recent paper (Breinlich 2015), I propose to look at stock-market reactions to the announcement and implementation of RTAs to evaluate their profit effects. The idea is that the stock price of a firm reflects the information available to investors about the firm’s future discounted profits. By comparing the planned reductions in tariffs and other trade barriers across sectors to the movement of stock prices of firms in these sectors, one can get a good idea of whether and how much investors expect each of the barriers to matter for firm profits. Of course, individual investors might be wrong, but a stock’s price aggregates all the information available to different parties at the announcement or implementation date of an RTA and as such is our best guess for its profit impact.
I focus on one specific RTA which has proven popular in the existing literature – the Canada-US Free Trade Agreement (CUSFTA) of 1988. In principle, however, the same approach could be used for other RTAs as well, including agreements which are currently being negotiated. (See, for example, Rose and Moser 2011, who look at a wider range of RTAs but without looking at specific trade barriers.)
One significant advantage of CUSFTA is that its negotiation and ratification process provided particularly sharp swings in the probability that the agreement would eventually enter into force. The negotiation process was difficult, and when an agreement was finally reached on 3 October 1987, it came as a surprise to many market participants. Likewise, CUSFTA was very contentious in Canada and the Canadian general election of 21 November 1988 was essentially fought on whether or not to ratify the agreement. Both the election itself and swings in opinion polls during the election campaign provide a number of unexpected shifts in CUSFTA’s implementation probability.
For each of these events, I look at the stock price reactions of individual Canadian manufacturing firms and compare them to the planned tariff reductions in their sectors – all of which were publicly known at the time. I find that for events which increased the likelihood of CUSFTA’s implementation, firms in sectors with higher future import (i.e. Canadian) tariff reductions experienced lower stock market returns relative to other firms. Larger reductions in intermediate input tariffs, which determine the cost at which firms can source inputs from the US, led to positive stock returns. The picture was more complex for future US tariff reductions – here, only larger, exporting firms seemed to experience positive stock market returns. The overall picture that emerges is thus that firm profits seem to be hurt by lower domestic tariffs but are increased by cheaper access to intermediate inputs and, for the larger firms, better access to the foreign market.
If we are willing to make a number of additional assumptions, such as choosing a specific model for the link between stock prices and profits, we can not only determine the qualitative effects of trade barrier reductions, but also provide predictions for the exact profit impact of RTAs. Making these assumptions, I find that CUSFTA increased the overall yearly profits of Canadian manufacturing by 1.2%. While Canadian tariff reductions lowered profits, this was more than offset by lower intermediate input tariffs which increased profits by 2.6% per year across firms.
Admittedly, getting such precise predictions requires strong assumptions; but a similar criticism certainly applies to other forms of evaluating RTAs ex-ante, such as computable general equilibrium models (e.g. Breinlich and Cuñat 2013). As such, stock market event studies look like a promising addition to the evaluation toolkit for RTAs. Intuitively, they provide a way to harness and summarise the information available to a wide range of market participants, each of whom holds valuable information about the likely effects of an RTA.
Baggs, J. and J.A. Brander (2006),: “Trade Liberalization, Profitability, and Financial Leverage,” Journal of International Business Studies, 37, 196-211.
Breinlich, H. (2015): “The Effect of Trade Liberalization on Firm-Level Profits: An Event-Study Approach,” CEPR Discussion Paper 11011.
Breinlich, H. and A. Cuñat (2013), “Predicting the effects of regional trade agreements: Can heterogeneous firm models help?”, Vox EU.org, 7 September.
Pavcnik, N. (2002), "Trade Liberalization, Exit, and Productivity Improvements: Evidence from Chilean Plants," Review of Economic Studies, 69, 245-276.
Rose, A.K. and C. Moser (2011), “To agree or not to agree on regional trade? Hiring the stock market as an advisor”, VoxEU.org, 09 October.
Topalova, P. and A. Khandelwal (2011), "Trade Liberalization and Firm Productivity: The Case of India", Review of Economics and Statistics, 93(3), 995-1009.
Trefler, D. (2004): “The Long and Short of the Canada-U.S. Free Trade Agreement,” American Economic Review, Vol. 94, September, pp. 870-895.