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CHAPTER3 Intra-Industry Trade of Arab Countries: An Indicator of Potential Competitiveness Oleh Havrylyshyn and Peter Kunzel The recent signing and ongoing discussions of bilateral agreements to liberalize trade between the EU and several Arab countries raise the question as to how the latter will fare in a more competitive environment.' Most Arab countries have traditionally been dependent on their natural resources. As a consequence, they have had fewer pressures to diversify and specialize their industrial base. As Nsouli, Bisat, and Kanaan (1996) point out, some Arab countries are more able to adapt to new trade opportunities, whereas others have less flexibility to adjust to new market opportunities and increased competition. In the trade literature, the amount of intra-industry trade (IIT), or trade that a country does in similar goods, is often taken as a measure of the diversity, degree of specialization, and degree of technical sophistication of its industrial sector. This can be used to infer the country's ability to compete in a changing environment. This chapter analyzes the evolution of IIT over the period 1984-94 to shed light on the level of industrial specialization for Arab countries and the implied potential to compete with industrialized economies in a more open trade setting. IIT Theory and Competitiveness Implications for Arab Countries The factor proportions theory as posited by Heckscher and Ohlin predicts that patterns of trade will be based on the relative abundance and intensity of factors used in the production process. Trade flows between countries occur in complementary goods, owing to the comparative advantage based on differing factor endowments in a perfectly competitive trading environment. Grubel and Lloyd 82 CatchingUp withthe Competition (1975) first observed and analyzed an apparent anomaly: a high proportion of industrial country trade is a two-way exchange within the same group of goods, presumably with the same factor intensity. This trade, which they labeled IIT, describes trade in similar but slightly differentiated products, based on imperfect competition, or trade in close substitutes demanded from consumers in different countries who may have distinct tastes or preferences. Early critics of this analysis argued that IIT was merely a statistical artifact, •representing aggregation of Heckscher-Ohlin trade. This implies that if SITC product categories were disaggregated to further levels, all resulting trade would simply reflect original products based on unique factor ratios. However, this view-point has been countered both theoretically and empirically. Most recently, Bhagwati (1994), starting from the Heckscher-Ohlin model, has considered IIT from a production position as two-way trade in commodities that are similar in factor intensity. The explanation for this new theory relies on scale economies at the firm level and imperfect competition as opposed to factor endowments or intensities. Bhagwati demonstrates that it is always possible to find endowments for which 100 percent of trade is intra-industry so that large shares ofIIT may not be contradictory to the factor endowments theory. Furthermore, it can be shown that trade in differing products is in commodities with the same factor intensity and hence also non-Heckscher-Ohlin trade. As to empirical tests, Gray (l 979) demonstrates that whereas calculations of more disaggregated IIT data show decreased values, the IIT phenomenon does not disappear. Many studies after Grubel and Lloyd have found that the more advanced and developed an economy, the more specialized its trade structure will be.2 Thus, industrialized countries tend to have greater levels ofIIT than developing countries, with a rough continuum where middle-level income countries show IIT levels higher than low-income ones but below those of industrial countries. Also, successful exporters (e.g., East Asia, other Newly Industrialized Countries) exhibit a speedy and substantial increase in the levels of IIT. From this it can be inferred that higher IIT levels reflect a greater ability to compete in a changing trading environment and that large changes in IIT also reflect flexibility in adapting to competition. Thus, simplifying this interpretation, one could say that those potential signatories ofa liberalizing agreement with the EU,3which have a relatively high or at least recently increased levels of IIT, are perhaps better positioned to be successful in adapting to a new trading environment. For those Arab countries with still low levels of IIT, the gap between their IIT levels and those of the EU is a measure of the opportunity and challenge of establishing the necessary policy background which would stimulate new investment, greater efficiency, and hence higher IIT. IIT is a result or effect of increased...

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