The impact of trade integration on business cycle synchronization for Mercosur countries.

• Author: Grigoli, Francesco
• Position: Report

1. Introduction

   In the past few decades there has been a progressive movement towards regionally-based free trade areas (FTAs) in North America, such as the North American Free Trade Agreement (NAFTA), Common Market for Eastern and Southern Africa (COMESA) in Africa, Asean Free Trade Area (AFTA) and South Asia Free Trade Agreement (SAFTA) in Asia, and Mercado Comun del Sur (Mercosur) in South America, among others. The possibility that Mercosur may eventually lead to a more ambitious integration project suggests the usefulness of analyzing the viability of a potential monetary union. Moreover, there has been renewed interest in the theory of Optimum Currency Areas (OCAs), since the creation of the European Monetary Union.

   There are a number of motives for Mercosur to form a monetary union. Firstly, the monetary policy of each country in Mercosur (Argentina, Brazil, Uruguay and Paraguay) has been relatively ineffective because of its little credibility. Instead of losing sovereignty over monetary policy, a regional central bank may actually adopt credible monetary policy that could react effectively to external shocks. Secondly, due to the poor macroeconomic management of member economies, their credit ratings for international debt are poor, and therefore the cost of such debt is very high. Thirdly, a monetary union provides the possibility of a reduction in the cost of central bank reserves and may create a currency that could be used by other foreign central banks as a reserve currency. Finally, bargaining as a regional bloc could be an advantage in international negotiations.

   According to the traditional literature by Mundell (1961) and McKinnon (1963), three criteria must hold to form an OCA. The first criterion relates to the degree of trade integration between the members of the currency union. Gains from monetary unification stem from lower transaction costs and the elimination of exchange rate volatility. Thus, the more a pair of countries trade, the more that pair will benefit from the reduction in the transaction costs. The second criterion is the high degree of business cycle synchronization. Losses come from the inability to pursue independent adjustment policies and their extent depends on the size and incidence of shocks. If these are symmetrically distributed across countries, symmetrical policy responses will be enough, eliminating the need for policy autonomy. Finally, the third criterion relates to the degree of labor mobility and wage flexibility in the economies. If the case of asymmetric shocks is considered and the possibility of independent monetary policy is foregone, labor mobility and wage flexibility would allow for a faster and less costly adjustment.

   The aforementioned literature on this subject treats these criteria as exogenous. However, more recent literature has further investigated this issue since many have asserted that trade linkages could affect business cycle comovements. Krugman (1991) pointed out that as trade linkages among countries increase a la Ricardian comparative advantage, the specialization effect prevails, generating less synchronized business cycles. On the contrary, the European Commission (1990) states that more trade is occurring within the same industries. Hence, the effect of an increase of trade integration should result in more synchronized shocks among the economies.

   Frankel and Rose (1998) analyzed the issue empirically. In particular they tested the hypothesis that more integration can be expected to lead to more highly correlated business cycles. They found evidence of a positive impact of increased regional trade on business cycle synchronization for 21 industrialized countries.

   This research aims at testing this hypothesis for the Mercosur countries (with the exclusion of Paraguay). More specifically, it analyzes empirically the impact of reduced trade barriers and increased trade on the synchronization of the business cycles. It uses a panel of bilateral trade and business cycles data spanning the three Mercosur countries over 72 quarters and controlling for macroeconomic policy coordination. The empirical findings indicate that closer international trade links result in more closely correlated business cycles across the countries.

   The paper structure is as follows. Section 2 introduces the history of economic integration in Mercosur and the motives for which a monetary union is desirable. The OCA theoretical framework and its criticism are presented in Section 3. Section 4 explores some of the main contributions in the literature studying the effect of trade integration on business cycle synchronization. Section 5 explains the methodology that is used to analyze the mentioned relationship, describes the data, and presents some descriptive statistics along with the results of the empirical estimations. Section 6 reports the paper's conclusions.

2. Economic Integration in Mercosur

   This section presents the steps that Mercosur has taken since it was created in 1991. It then analyzes why the area would benefit from further integration and thus a monetary union.

   2.1 A Historical Perspective

   Economic integration among the members of the Mercosur started long before its conception in 1991. The first official stage of integration was the Argentinean-Brazilian Cooperation and Integration Act signed in July 1986. This removed some sector trade barriers between the two countries. Due to concern over stability issues in 1987, the two governments signed the Gaucho Protocol (one of several signed under the Argentinean-Brazilian Cooperation and Integration Act), which initiated research into the possibility of a currency union between Argentina and Brazil. However, shortly after the signing of this Protocol, exchange rate crises in both countries dampened currency union integration efforts. In November 1988, the Integration Cooperation and Development Treaty was signed by Argentina and Brazil, which expanded the FTA created by the 1986 Act.

   By July 1990, the Argentinean-Brazilian Cooperation and Integration Act had set the date for the creation of an FTA between the two countries for late 1994. After diplomatic requests, the FTA was extended to include Paraguay and Uruguay. Thus, the Treaty of Asuncion was signed in 1991 by Argentina, Brazil, Paraguay and Uruguay and established a common market among these member countries effective on January 1, 1995. The 1991 Treaty demanded that by June 1991, 40 percent of the tariffs among the member countries would be removed. There then would be six monthly reductions in tariffs until they were completely eliminated and free trade was established. Mercosur aimed to establish the free movement of goods, services and factors of production among member countries, the setting of a common external tariff, the adoption of a common trade policy regarding the rest of the world and the ambitious coordination of macroeconomic and sector policies.

   In December 1994, the Ouro Preto summit modified the schedule set out in the Treaty of Asuncion and created the Ouro Preto Protocol, laying down the institutional structure of Mercosur. At this summit, member countries agreed to implement a customs union before implementing a common market. This customs union became operational on January 1, 1995, with the elimination of tariff and non-tariff barriers among the member countries and the setting of a common external tariff although its application was not immediately completed. (2) To ease the shift of Mercosur into a common market, a transitory schedule was established at the Ouro Preto summit, in which it was agreed that certain products traded within Mercosur were allowed to remain protected by member tariffs.

   In 1995, Mercosur members agreed to end this transition period by 2001, phasing temporary protectionary tariffs out in order to ensure entirely free trade between members by 2000. By 1996, tariffs were reduced by 25 percent, 50 percent by 1997, 75 percent by 1998, and eliminated by 1999 for Argentina and Brazil, while Paraguay and Uruguay were required to eliminate tariffs by 2000. In addition, permission was granted to allow 300 products per member to remain exempt from the common external tariff until 2001 for Argentina, Brazil and Uruguay, and 2006 for Paraguay. Hence, the Mercosur customs union became fully operational only in 2006. (3)

   Overall, the process of integration yielded some results. As estimated in Frankel (1997), the Mercosur bloc effect of bilateral trade is not significant during 1965-1975, but it becomes higher and statistically significant after 1990. (4)

   2.2 Motives for the Creation of a Monetary Union in Mercosur

   There are several motives for the monetary unification between the members of Mercosur. Recent history has proven that due to policy mismanagement and failed stabilization policies, no full member of Mercosur had the ability to implement a credible and effective monetary policy. In 1991, Argentina implemented a currency board, under the Convertibility Plan (5), which collapsed on January 10, 2002. Uruguay had a target zone until June 2002 that operated like a crawling peg as the exchange rate was frequently on the bottom of the set band. After that, it allowed the Peso to float freely. Brazil also had a target zone based on the Real Plan (6) that collapsed on January 14, 1999, after which the Brazilian central bank allowed the currency to float. (7) Overall, the improvement of the monetary stability and credibility of the monetary frameworks since the end of the 1990s renewed the countries' interest for a monetary union.

   Inflation stabilization policies have been implemented in Mercosur to reduce the notoriously high inflation (and in some cases hyperinflation) experienced by its economies. (8) Nonetheless, the inability to manage prices generated high volatility of the Argentinean and Brazilian real exchange rates with disruptive consequences. During recent years, inflation has still...