Trade Agreements, Exchange Rate Disagreements

1
Trade Agreements, Exchange Rate Disagreements

• Eduardo Fernandez-Arias
• Ugo Panizza
• Ernesto Stein
• Inter-American Development Bank

2
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

3
Motivation

• Europe
• Following 1992 ERM crisis we saw
• Relocation of FDI from France to the UK
  (laffaire Hoover)
• Reduction of exports to depreciating countries
• Strong tension between France and Italy and the
  UK
• Strong pressure on the French franc

4
Trade between France and Italy
32000
Exports from Italy to France
30000
28000
26000
Exports from France to Italy
24000
22000
20000
18000
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
5
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

6
Trade between Brazil and Uruguay
1000
900
Exports from Brazil to Uruguay
800
700
600
Exports from Uruguay to Brazil
500
400
300
200
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
7
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

8
Exchange rate misalignments within regional
integration agreements may be threat to RIAs

• McKinnon (1973) on necessity of coordinating
  policy

9
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)
10
Exchange rate misalignments within regional
integration agreements may be threat to RIAs

• McKinnon (1973) on necessity of coordinating
  policy
• Eichengreen (1993) on European Union

11

• 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)

12
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

13
yes, but

• Emerging markets may have problems accessing
  capital markets and
• XR swings are not similar

14
Multilateral RER (Month before episode 100)
105
100
95
90
85
80
t-12
t-11
t-10
t-9
t-8
t-7
t-6
t-5
t-4
t-3
t-2
t-1
t
t1
t2
t3
t4
t5
t6
t7
t8
t9
t10
t11
t12
France
Uruguay
Argentina
15
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

16
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

17
Overall (multilateral) exchange rate
overvaluation causes

• Less exports
• Less FDI inflows
• More currency crises

18
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

19
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

20
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.

21
Effect of misalignment on total exports

• We start from the following specification
• ln(EXPi,t) a bRERi,t qln (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) a b REGi,t g NOREGi,t qln
  (Yi,t) ai tt ui,t

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Multilateral exchange rate overvaluation reduces
total exports...
16
14
12
10
(EXP)
8
6
4
2
0
All Countries
Total Misalignment (10 percentage points)
23
but more so if it comes from RIAs...
16
14
12
10
(EXP)
8
6
4
2
0
All Countries
Total Misalignment (10 pp)
Regional Misalignment (10 pp)
Non Regional Misalignment (10 pp)
24
offering high protection
35
30
25
20
EXP
15
10
5
0
All Countries
High Protection Regional Misalignment
Low Protection Regional Misalignment
Non Regional Misalignment
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Table 1 Exports and Real Exchange Rate
Misalignments
All
All
Developing
Developed
All
Log(GDP)
0.433
0.433
0.23
0.42
0.429
(6.89)
(6.85)
(1.93)
(7.30)
(6.81)
0.613
Total Misalignment
(3.09)
1.449
2.649
0.602
(a) Reg. Mis.
(2.19)
(2.31)
(1.20)
0.347
-0.115
-0.304
0.321
(b) Non Reg. Mis.
(1.35)
(0.30)
(0.86)
(1.25)
2.9
(c) High x Reg Mis
(2.93)
(d) Low x Non Reg Mis
0.572
(0.72)
Observations
394
394
208
185
394
R-squared
0.79
0.8
0.79
0.91
0.8
Tests on difference between coefficients
(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
26
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.

27
Effect of real exchange rates on FDI

• We use the following specification
• ln(FDIi,t /FDIj,t) a b ln(Yi,t /Yj,t) q
  (OPENi,t - OPENj,t) g
  (NOFTAi,t)(RERij,t) d (FTAi,t)(RERij,t)
  uij eij,t

28
Impact of bilateral XR on FDI location larger
between countries with RIA
20
18
16
14
12
FDI ratio
10
8
6
4
2
0
All Countries
South-South
North-South
North-North
Same RIA
Not Same RIA
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Table 2 FDI and RER
All
S-S
N-S
N-N
1.5169
1.1501
1.7225
2.0372
Relative GDP
(16.386)
(5.843)
(13.513)
(10.031)
0.001
-0.0127
0.0036
0.0143
Relative Openness
(1.01)
(6.829)
(2.650)
(6.488)
1.2991
0.7891
0.7142
1.8943
(a) FTA x RER
(5.973)
(2.604)
(0.64)
(5.234)
0.119
0.097
0.304
0.4806
(b) NOFTA x RER
(1.17)
(0.55)
(2.097)
(1.23)
Observations
6120
1654
3139
1327
Number of pairs
630
171
323
136
R-squared
0.094
0.096
0.127
0.107
Tests on difference between coefficients
(a)-(b)
1.18
0.69
0.41
1.41
0.000
0.010
0.355
0.000
30
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 a b REGi,t g NOREGi,t dXi,t
  eij,t

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Multilateral exchange rate overvaluation
increases the risk of currency risk...
4.5
4.0
3.5
3.0
2.5
Marginal Effect of 10 overvaluation
2.0
1.5
1.0
0.5
0
A crisis is a real depreciation greater than 5
Multilateral Misalignment (10 percentage points)
32
but more so if it comes from within a RIA
4.5
4.0
3.5
3.0
2.5
Marginal Effect of 10 overvaluation
2.0
1.5
1.0
0.5
0
A crisis is a real depreciation greater than 5
Multilateral Misalignment
Regional Misalignment
Non-Regional Misalignment
33
Table 3 Real Misalignments and Currency Crisis.
Probit Estimates (marginal effects reported)
5 5 10
-0.2288
(a) Multilateral Misalignment
(8.180)
-0.4046
-0.3388
(b) Regional Misalignment
(4.183)
(3.800)
-0.1652
-0.0598
(c) Non-Regional Misalignment
(4.285)
(2.298)
-0.0194
-0.0188
-0.0035
(f) Access to foreign credit
(3.040)
(2.977)
(0.868)
0.0157
0.0166
0.0147
(g) Government Change
-1.486
-1.563
-1.814
Observations
3848
3848
3848
Rsquared
0.1368
0.137
0.158
Tests on difference between coefficients
(b) - (c)
-0.24
-0.28
0.046
0.005
34
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)

35
Trade Agreements, Exchange Rate Disagreements

• Eduardo Fernandez-Arias
• Ugo Panizza
• Ernesto Stein
• Inter-American Development Bank