Trade Agreements, Exchange Rate Disagreements

Eduardo Fernandez-Arias

Ugo Panizza

Ernesto Stein

Inter-American Development Bank

Motivation

• We study problems that arise when countries with trade agreements have exchange rate disagreements

• Exchange rate disagreements: large swings in bilateral real exchange rates or, more generally, divergent exchange rate policies.

• We identify four types of problems– Increased protectionism / scaling back of trade agreement

– Effects on trade flows

– Relocation of investments

– Exchange rate crises

Motivation• Europe• Following 1992 ERM crisis we saw:

– Relocation of FDI from France to the UK (l’affaire Hoover)

– Reduction of exports to depreciating countries

– Strong tension between France and Italy and the UK

– Strong pressure on the French franc

Trade between France and Italy

18000

20000

22000

24000

26000

28000

30000

32000

1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

Exports from Italy to France

Exports from France to Italy

Motivation

• Mercosur• Following 1999 Real devaluation we saw:

– protectionist pressures, protectionist measures in Argentina

– reduction of exports to Brazil (some difficult to relocate elsewhere)

– relocation of firms to Brazil

– eventually contributed (among other factors) to end of convertibility

– Uruguay hit by double whammy

– talks of negotiating FTA with US outside of Mercosur

Trade between Brazil and Uruguay

200

300

400

500

600

700

800

900

1000

1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

Exports from Brazil to Uruguay

Exports from Uruguay to Brazil

Two reasons to worry about signing RIA without considering exchange rate divergence

• Protectionist backlash and unraveling of RIA

• Joining a RIA would increase vulnerability to exchange rate misalignments

Exchange rate misalignments within regional integration agreements may be threat to RIAs

• McKinnon (1973) on necessity of coordinating policy

There is less need for independent monetary policies within the bloc and strong case to be made for imposing the uniform discipline that a common currency system would provide. Independent national policies are neither necessary nor desirable if exchange rate changes can upset carefully negotiated tariff, tax, and pricing policies.

R. I. McKinnon (1973)

Exchange rate misalignments within regional integration agreements may be threat to RIAs

• McKinnon (1973) on necessity of coordinating policy

• Eichengreen (1993) on European Union:

If national industries under pressure from removal of barriers to intra-European trade find their competitive position eroded further by a sudden exchange rate appreciation, resistance to the implementation of the Single European Act would intensify. The SEA might be repudiated. In this sense, and this sense alone, monetary unification is a logical economic corollary of factor- and product-market integration

Eichengreen (1993)

…but are these considerations important for all RIAs?

• The EU is a full blown single market with no restrictions of factor flows, no subsidies for domestic industries, no national preferences for public procurements

• Therefore, the impact of currency swings on firms’ profitability is larger than in less complete RIA

• .. and the larger the lobbying for protection and subsidies

…yes, but

• Emerging markets may have problems accessing capital markets and

• XR swings are not similar

Multilateral RER (Month before episode = 100)

80

85

90

95

100

105

t-12t-11t-10t-9 t-8 t-7 t-6 t-5 t-4 t-3 t-2 t-1 t t+1t+2t+3t+4t+5t+6t+7t+8t+9t+10t+11t+12

France Uruguay Argentina

…yes, but:

• Emerging markets may have problems accessing capital markets and

• Currency swings are not similar

• EU has more power to enforce rules

• So more potential for protectionism in emerging markets

Two reasons to worry about signing RIA without considering exchange rate divergence

• Protectionist backlash and unraveling of RIA

• Joining a RIA would increase vulnerability to exchange rate misalignments

Overall (multilateral) exchange rate overvaluation causes

• Less exports

• Less FDI inflows

• More currency crises

Are effects more severe if the source of overvaluation is the RIA bloc?

We conjecture that:

• Overvaluation effects on exports are more severe when source of overvaluation is RIA bloc

• Overvaluation effects on FDI are more severe when source of overvaluation is RIA bloc

• Overvaluation effects on currency crises are more severe when source of overvaluation is RIA bloc

How do we test these conjectures?

TOTAL EXCHANGE RATE MISALIGNMENT =

REGIONAL MIS + NON-REGIONAL MIS

computed for 37 countries in 6 RIAs: EU, NAFTA, Mercosur, Andean Community, CACM, ASEAN, between 1989 and 2000

Conjecture 1: Misalignment effect on

exports more severe within RIAs • In particular, when external barriers are high, RIAs may allow

countries to export to their regional partners goods in which they are not competitive

• We call these goods “regional goods”

• Example: exports of autos from Argentina to Brazil

• If demand from partner falls, difficult to redirect regional goods to other markets

• Trade with other (non-RIA) partners should involve less “regional goods”, thus should be easier to redirect.

• We need to look at effects of overvaluation on total exports, not bilateral exports.

Effect of misalignment on total exports• We start from the following specification:

ln(EXPi,t) = + RERi,t + ln (Yi,t) + ai + tt + ui,t

• We decompose the misalignment into a regional and a non-regional component:

RERi,t wi R_RERi,t + (1- wi ) NR_RERi,t

• We define

REGi,t = wi R_RERi,t ; NOREGi,t = (1-wi) NR_RERi,t

• Finally, we estimate

ln(EXPi,t) = + REGi,t + REGi,tln (Yi,t) + ai + tt + ui,t

Multilateral exchange rate overvaluationreduces total exports...

0

2

4

6

8

10

12

14

16

All Countries

% (

EX

P)

Total Misalignment (10 percentage points)

…but more so if it comes from RIAs...

0

2

4

6

8

10

12

14

16

All Countries

% (

EX

P)

Total Misalignment (10 pp)Regional Misalignment (10 pp)Non Regional Misalignment (10 pp)

0

5

10

15

20

25

30

35

All Countries

% E

XP

High Protection Regional MisalignmentLow Protection Regional Misalignment

Non Regional Misalignment

…offering high protection

All All Developing Developed AllLog(GDP) 0.433 0.433 0.23 0.42 0.429

(6.89)*** (6.85)*** (1.93)* (7.30)*** (6.81)***0.613

(3.09)***1.449 2.649 0.602

(2.19)** (2.31)** (1.20)0.347 -0.115 -0.304 0.321(1.35) (0.30) (0.86) (1.25)

2.9(2.93)***

0.572(0.72)

Observations 394 394 208 185 394R-squared 0.79 0.8 0.79 0.91 0.8

(a)-(b) 1.102 2.764 0.906[0.09]* [0.02]** [0.09]*

(c)-(d) 2.328[0.025]**

(c)-(b) 2.579[0.009]***

(d)-(b) 0.251[0.39]

Total Misalignment

(d) Low x Non Reg Mis

Tests on difference between coefficients

(a) Reg. Mis.

(b) Non Reg. Mis.

(c) High x Reg Mis

Table 1: Exports and Real Exchange Rate Misalignments

Conjecture 2: Real exchange rate effects on

FDI larger within RIAs • RIAs can create a space of intense competition for the

location of FDI.

• With economies of scale, elimination of trade barriers within RIAs induce firms to serve extended market from single location.

• Better market integration makes FDI more “footloose”.

• Thus, we expect relative FDI between RIA members to be more sensitive to exchange rate changes which affect relative costs.

Effect of real exchange rates on FDI

• We use the following specification:

ln(FDIi,t /FDIj,t) = + ln(Yi,t /Yj,t) + (OPENi,t - OPENj,t) +

(NOFTAi,t)(RERij,t) + (FTAi,t)

(RERij,t) + uij + ij,t

Impact of bilateral XR on FDI location larger between countries with RIA

0

2

4

6

810

12

14

16

18

20

All Countries South-South North-South North-North

% F

DI r

ati

o

Same RIA Not Same RIA

All S-S N-S N-N1.5169 1.1501 1.7225 2.0372

(16.386)*** (5.843)*** (13.513)*** (10.031)***0.001 -0.0127 0.0036 0.0143(1.01) (6.829)*** (2.650)*** (6.488)***

1.2991 0.7891 0.7142 1.8943(5.973)*** (2.604)*** (0.64) (5.234)***

0.119 0.097 0.304 0.4806(1.17) (0.55) (2.097)** (1.23)

Observations 6120 1654 3139 1327Number of pairs 630 171 323 136R-squared 0.094 0.096 0.127 0.107

(a)-(b) 1.18 0.69 0.41 1.41[0.000]*** [0.010]*** [0.355] [0.000]***

Tests on difference between coefficients

Relative GDP

Relative Openness

(a) FTA x RER

(b) NOFTA x RER

Table 2: FDI and RER

Conjecture 3: Misalignment effect on crises more severe within RIAs

• Misalignments within RIAs generate larger effects on the balance of payments both via trade and FDI.

• Thus, it can generate more pressure on the currency

• Especially when credit is not available to cope with stress

• Definition of crisis: monthly multilateral real depreciation of at least 5% (or 10%)

• We use the following specification:

EPi,t = + REGi,t + NOREGi,t + Xi,t + ij,t

Multilateral exchange rate overvaluation increases the risk of currency risk...

0

0.51.01.5

2.0 2.5

3.0

3.5 4.0 4.5

A crisis is a real depreciation greater than 5%

Mar

gin

al E

ffec

t o

f 10

% o

verv

alu

atio

n

Multilateral Misalignment (10 percentage points)

…but more so if it comes from within a RIA

0 0.5

1.01.5

2.0 2.5

3.0 3.5

4.0 4.5

A crisis is a real depreciation greater than 5%

Mar

gin

al E

ffec

t o

f 10

% o

verv

alu

atio

n

Multilateral Misalignment

Regional Misalignment

Non-Regional Misalignment

Table 3: Real Misalignments and Currency Crisis. Probit Estimates (marginal effects reported)

-0.2288(8.180)***

-0.4046(4.183)***-0.1652

(4.285)***

-0.0194 -0.0188 -0.0035(3.040)*** (2.977)*** (0.868)

0.0157 0.0166 0.0147-1.486 -1.563 -1.814

Observations 3848 3848 3848Rsquared 0.1368 0.137 0.158

(b) - (c) -0.24 -0.28

[0.046]** [0.005]***

Tests on difference between coefficients

5% 5% 10%(a) Multilateral Misalignment

(b) Regional Misalignment

(c) Non-Regional Misalignment

(f) Access to foreign credit

(g) Government Change

-0.3388(3.800)***-0.0598

(2.298)**

Exchange rate consistency is key for sustainable trade agreements:

• Unilateral policies (partner selection, XR regime, regional good policy)

• Policy coordination (macro coordination, currency union, RIA flexibility)

• Supporting international financial architecture (IMF monitoring/conditionality, regional Fund)

Trade Agreements, Exchange Rate Disagreements

Eduardo Fernandez-Arias

Ugo Panizza

Ernesto Stein

Inter-American Development Bank