Exchange Rate Policy for MERCOSUR:- Lessons from the European Union

Front matter

SCHRIFTEN ZUR WIRTSCHAFTSTHEORIE UND WIRTSCHAFTSPOLITIK

Exchange Rate Policy for MERCOSUR: Lessons from the European Union

SCHRIFTEN ZUR WIRTSCHAFTSTHEORIE UND WIRTSCHAFTSPOLITIK

Table of Contents

LIST OF TABLES

LIST OF FIGURES

LIST OF CHARTS 1. CHAPTER 1: OVERVIEW 2, CHAPTER 2: A THEORETICAL APPROACH 2.1 Introduction 2.2 The Mundell-Fleming Model 2.2.1 Flexible Exchange Rate

Introduction

Review of the European Exchange Rate Agreements The Origins

The EMS: the Quest for Stability

The Institutional Arrangements

The Turbulent EMS: 1979- 1987

The EMS without Realignments 1987- 1992

1992 The Crisis

Some Explanations of the Crisis of 1992

Effect of the EMS on Price Stability

Credibility and Inertia Inflation

Review of the Empirical Literature

The Unemployment-Inflation Trade - Off

The Effect of the EMS on the Dynamic Exchange Rate Responses to Nominal and Real Shocks: An Econometric Analysis

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3.4.1

3.4.2

4.2.1

4.2.2

4.4.

Variability of Nominal and Real Exchange Rates Model Specification Analysis Univariate and Bivariate Analysis

Unit Root Tests

Test for Cointegration

Granger Causality Test

VAR Analysis

The Methodology

Empirical Results

Impulse Response Analysıs

EMS Wide Bands 1993.07-1994.04 Forecast Error Variance Decomposition Concluding Remarks

Appendix 3.1

Appendix 3.2

CHAPTER 4: THE LATIN AMERICAN EXPERIENCE

Introduction

Review of Economic integration in Latin America from the Import-Substitution to the

Washington Consensus

Regional Integration within a Protectionist Framework LAFTA

New attempt of integration: LAIA

Other Free Trade Agreements among Latin American Countries The Andean Pact

Economic Integration in Central America

The New Integration Approach

The Integration between Argentina and Brazil

The Enlargement of the Agreement to Paraguay and Uruguay MERCOSUR: The Asuncion Treaty

Institutional Aspects of MERCOSUR

The Transition Period

Macroeconomic Profile of MERCOSUR

Structure and Evolution of Regional GDP

Fiscal Sector

Monetary Sector

Exchange Rates and Capital Inflows

Foreign Sector

Recent MERCOSUR Relevant Experiences with Fixed Exchange Rates

Stabilization Plans Anchored on Fixed Exchange Rates

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4.4.1

XII

The Argentinian Currency Board System The Effect of the Currency Board

on the Argentinian

Economy

Recent Developments and Evaluation The Brazilian Real Plan

Recent Developments

Appendix 4.1

CHAPTER 5: CONCLUSIONS AND ECONOMIC POLICY

RECOMMENDATIONS

REFERENCES

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183 185 186 188 189 196

List of Tables

Table 2.2 Table 2.3

Table 3.2.2 Table 3.2.3 Table 3.2.4 Table 3.2.5 Table 3.2.6 Table 3.2.7 Table 3.2.8 Table 3.2.9 Table 3.3.1 Table 3.3.2 Table 3.3.3 Table 3.4.1 Table 3.4.2 Table 3.4.3 Table 3.4.4 Table 3.4.5 Table 3.4.6 Table 3.4.7 Table 3.4.8

Two Country Mundell Fleming Model

Effect of a Domestic Shock on Foreign Variables Two Country Dombusch Model

Long Run Effect of Monetary and Fiscal Policy Shocks Chronological History of the Snake

Relative Openness of the Countries

Realignments

Consumer Price Index

CPI Average EMS Countries

Current Account as % of GDP

Public Debt

Fiscal Deficit

The 1992 Crisis

Money Market Rates

Monetary Aggregates

Public Debt as % of GDP

Nominal Exchange Rates

Real Exchange Rates

Correlation Coefficients

Unit Roots Tests 1973.03-1994.04 ADF Test

Unit Roots Tests 1973.01-1979.03 ADF Test

Unit Roots Tests 1987.03-1992.09 ADF Test

LR Cointegration Tests

Granger Causality Test between Nominal Exchange Rate and Real Exchange Rate

Variance Decomposition. Snake 1973.01-1979.03 Variance Decomposition Hard EMS 1987.03-1992.09 Variance Decomposition Wide Bands

Latin American Current Regional Integration Schemes MERCOSUR Reduction Tariff Program

Basic Indicators

Structure and Evolution of the Regional Economies Manufactured Added Value

Real Gross Domestic Product (GDP)

GDP Structure

Distribution of the Population

Gross Domestic Investment/ GDP

Gross Domestic Savings/GDP

Real Exchange Rate

Openness of the Economy

Exports of Goods and NFT / GDP

Intra- MERCOSUR Countries Exports

Argentina: Impact of MERCOSUR Countries

on Imports 19751994

Brazil: Impact of MERCOSUR Countries

on Imports 1975-1994

Paraguay: Impact of MERCOSUR

Countries on Imports 1975-1994

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XIV

Uruguay: Impact of MERCOSUR

Countries on Imports 1975-1994

Foreign Debt Position

Selected Cases of Exchange Rate Based Stabilizations Alternative Stabillzation Plans

Selected Cases of Exchange Rate Stabilizations: Results

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174 174 177 177 178

List of Figures

Figure 2.2.1.1 Figure 2.2.1.2 Figure 2.2.2.1 Figure 2.2.2.2 Figure 2.3.1.1 Figure 2.3.1.2 Figure 2.3.1.3 Figure 2.3.1.4 Figure 2.2.1.5 Figure 2.2.1.6 Figure 2.2.1.7 Figure 2.4.1 Figure 2.4.2 Figure 2.4.3 Figure 3.3.1 Figure 3.3.2 Figure 3.3.3 Figure 3.3.4 Figure 3.3.5 Figure 3.3.6 Figure 3.3.7 Figure 3.3.8 Figure 3.3.9 Figure 3.3. 10 Figure 3.3. 11 Figure 3.3.12 Figure 3.3.13 Figure 3.4.1 Figure 4.3.1 Figure 4.3.2 Figure 4.3.3 Figure 4.3.4 Figure 4.3.5 Figure 4.3.6

Figure 4.3.7 Figure 4.3.8 Figure 4.3.9 Figure 4.3.10

Flexible Exchange Rate. Fiscal Policy Flexible Exchange Rage. Monetary Policy Fixed Exchange Rate. Fiscal Policy

Fixed Exchange Rate. Monetary Policy Money Market Equilibrium Condition Goods Market Equilibrium Condition Saddle Path

Monetary Policy

Time Path of the Variables. Monetary Policy Fiscal Policy

Time Path of the Variables. Fiscal Policy Money Market Equilibrium in a Two Country Model Symmetric Solution

Asymmetric Solution

Inflation Rates

CPI Group 1

CPI Group 2

Interest Rates 1973-1979 and 1979-1992 Deficit as Proportion of GDP

Phillips Curve Germany

Phillips Curve UK

Phillips Curve Belgium

Phillips Curve Denmark

Phillips Curve France

Phillips Curve Italy

Phillips Curve Canada

Phillips Curve USA

Nominal and Real Exchange Rates 1960.4-1994.04 Real GDP Growth

Productive Structure

Public Sector Overall Balance

Monetary Sector. Domestic Credit Consumer Price Index

Monetization Ratios. Money Supply (M 1) as Percent of GDP

Interest Rate

Balance of Payments. Capital Account

Total Intra- MERCOSUR trade

Relation Between Argentinian Brazilian Trade Balance and Currency Parities

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List of Charts

Chart 3.4.1 Impulse Response Function. Snake 1973.03-1979.03 130

Chart 3.4.2 Impulse Response Function. Hard EMS 1987.03-1992.09 132

Chart 3.4.3 Impulse Response Function. EMS wide bands 135 XVI Silvia Marengo - 978-3-631-75137-4

Chapter 1 Overview

In January 1995, four Latin American countries, Argentina, Brazil, Uruguay and Paraguay joined their destinies within a common and ambitious enterprise called MERCOSUR!. MERCOSUR’, the Common Market of the South, represents an important economic integration area that generates a GDP of $US 600 billion, providing a market of 200 million people? spread over an area of 12 million square km. It comprises 70 percent of the total land mass of South America, stretches from the tropical jungles of northern Brazil to the sub-Antarctic zone of Argentina, and includes some of the world's most important agricultural and mineral resources. It constitutes the Latin American response to the overall trend towards regional economic integration which includes NAFTA, EU and ASEAN.

Although economic integration is not a new issue in Latin America, this new integrationalist trend is significantly different from previous Latin American experiences of economic integration, such as LAFTA (Latin American Free Trade Association), LAIA (Latin American Integration Association), because of the economic philosophy which underlies it. Whilst past attempts at integration were based on an import-substitution strategy of development, with an infant industry approach playing a decisive role, a new development model has gained popularity within the region, labeled by Williamson (1991) as the "Washington consensus", with the new economic policies being primarily based on a neo-liberal model with the emphasis on market forces Consequently, Latin American states are facing important structural economic reforms. Markets are being opened to international competition; the goods, labor and capital markets are being deregulated; and central governments are undergoing restructuring. Thus, governments have recognized the importance of achieving macroeconomic stability as a precondition for faster growth. MERCOSUR constitutes an important factor within this process. It increases the efficiency and competitiveness of member countries by enlarging the size of the market, taking advantage of economies of scale and increasing retums. This facilitates the acceleration of economic development across the region through a more efficient use of available resources.

Initially, MERCOSUR performance has been more than successful, as intra-MER- COSUR trade has increased significantly, and, since the widened market has attracted foreign direct investment, the member countries have been able to enjoy investment at a higher level than their national saving rates would make possible. However, some difficulties within the process have been introduced by the high variability of the intra- MERCOSUR exchange rate, and in particular by the real exchange rate between the Argentine peso and the Brazilian real. If a process of trade integration is to be successful, it seems inevitable that member countries must agree to maintain a l , MERCOSUR i in Spanish, Mercado Común del Sur, also MERCOSUL in Portuguese. ? MERCOSUR was created in March 1991 by the Treaty of Asunción, which called for the signatories to establish a full common market arrangement among its members by January 1995. 3 Almost one third of total South America's population.

Silvia Marengo - 978-3-631-75137-4 l Downloaded from PubFactory at 01/11/2019 07:53:19AM via free access relatively stable intra-currency relationship Although the Treaty of Asuncion" mentions as one of the main four objectives of MERCOSUR the necessity to coordinate macroeeconomic policies, no explicit consideration has been paid to this issue. Hence, the MERCOSUR countries have adopted unilateral exchange rate agreements with respect to the US dollar, but they have not developed any explicit link among their own currencies. While Argentina has operated a currency board system since 1991, which is an extreme version of a fixed exchange rate system, Brazil applies a fixed exchange rate system with a permissible band of fluctuation around a central value, Uruguay a crawling peg, and Paraguay allows the domestic currency to float. Exchange rate corrections take place in a fully unilateral and discretionary way without taking into account the other MERCOSUR currencies The elimination of intra- MERCOSUR tariffs will not be efficient if at the same time the sharp variability of nominal exchange rates artificially affects the relative prices of different products. Thus, high exchange rate volatility introduces a negative effect on trade within the region, discouraging the integration process. The question as to the choice of the optimal exchange rate system to be adopted among MERCOSUR countries becomes critical if MERCOSUR states attempt to go further along the path of increasing their trade flows of goods and services.

Although there exists a "general consensus" in the academic as well as in the political world concerning the necessity of some kind of exchange rate coordination, no valid response to the problem has as vet been made. In the Treaty of Asuncion”, monetary and exchange rate agreements have been neglected, and until now there has not been any research undertaken in this specific field. Hence, the purpose of this study is to contribute to filling this gap by providing some alternative answers to this issue. The analysis is based on three pillars: a theoretical review of exchange rate systems; a review of the European experience; and an analysis of the Latin American experience. The study is organized as follows. In Chapter 2, first, I will analyze the interdependence effect among countries when they are linked under two extreme exchange rate regimes, fixed and floating. 1 will develop a two-country Mundell-Fleming-Dornbusch model and 1 will compare the effects of fiscal and monetary policy on the individual country implementing them and on the neighbor country. I will discuss the coordination problem that arises in the presence of fixed exchange rates, which is known in the literature as the N-1 problem. I will then review the time-inconsistency approach. 1 will introduce a theoretical model that allows comparison of the inflation outcome that results from a binding rule and that which arises from a discretionary monetary policy, and I will discuss some solutions for overcoming the time-inconsistency problem.

In chapter 3, a review of the European experience is presented. The European integration process was followed by the introduction of different exchange rates agreements. Thus, in the opinion of the European Commission, some fixity across exchange rates had to be introduced if the full benefits of integration were to be reaped. Although the argument also applies to the MERCOSUR case, no exchange rate agreement has as yet been introduced in that context. The experience of the European Union constitutes an excellent example of a successful economic integration process. It has been working for more than three decades, and it thus becomes important to draw

* See footnote 2. 5 See footnote 2.

2 Silvia Marengo - 978-3-631-75137-4 Downloaded from PubFactory at 01/11/2019 07:53:19AM via free access some lessons from this experience. Although at first sight there are important differences between the EU and MERCOSUR in the degree of industrialization, average GDP per capita and size of the market, some similarities also exist, especially between the Southern European members of the EU and the MERCOSUR countries. But the main resemblance is probably to be found in the overall integration process, in the historical and political basis that gave impulse to the economic integration. In both cases, member states decided to follow a new path after having faced a political and economic disaster, in Europe the Second World War, in Latin America the debt crisis of the 1980s and several authoritarian regimes. The European Economic Community began as a joint cooperation between two countries, Germany and France, who had historically been traditional enemies during the last two world wars, and afterwards was opened to other European countries. MERCOSUR began with cooperation between two countries, Brazil and Argentina, whose permanent political and military rivalry had in the past imposed restrictions upon economic cooperation and had created obstacles to trade between them. At a later date, it was opened up to their two closest neighboring countries, Uruguay and Paraguay, and recently to Chile and Bolivia as associate members. Other similarities are present with respect to rigidities in labor markets, as well as to the existence of different attitudes towards inflation rates among the member countries, due mainly to past experiences with hyperinflationary processes. In this chapter, an analysis of the historical experience makes it clear that the search for stability among the domestic currencies of European members was a constant theme since the break down of the Bretton Woods system destroyed the underlying net. The search for appropriate exchange agreements has persisted over more than three decades. During this period, different agreements have been introduced, the Snake being followed by the European Monetary System, with discussion now being centered upon the achievement of a single currency. It has been a "trial and error” process, and it has not yet been completed. In this chapter, I will also analyze in some detail the results delivered by the European Monetary System as regards price and exchange rate stability. Especially, I will investigate the dynamic response of nominal and real exchange rates to monetary and real shocks by inquiring whether the EMS has introduced some significant changes in those responses.

In Chapter 4, I will analyze the Latin American experience. First I will review previous attempts at integration, as well as the economic circumstances under which they were undertaken, and the reasons for their failure. Second, I will present some stylized facts of the macroeconomics profile of the MERCOSUR countries that permits the underlying asymmetries and the problems that they raise to be seen. Third, I will examine the relevant MERCOSUR experience with fixed exchange rate agreements. To do so, I will analyze the circumstances under which they emerged: they have primarily formed part of stabilization plans, and therefore I will review the factors that have been common to them. Finally, I will present the two most recent experiences with exchange rate agreements between Argentina and Brazil. They constitute two original and ingenious mechanisms to cope with currency substitution and inertial inflation and have attracted the attention of other Latin American countries and non- Latin American countries as well. Additionally, taking into account the fact that Argentina and Brazil constitute the two largest partners in MERCOSUR, from the political point of view a common exchange rate agreement will not be feasible without the support of these two members. Even more, in thé past they fave experienced the

Silvia Marengo - 978-3-631-75137-4 3 Downloaded from PubFactory at 01/11/2019 07:53:19AM via free access most serious macroeconomic imbalances and therefore the role of stabilization plans and exchange rates is crucial for them.

The last chapter introduces three alternative proposals regarding the exchange rate policies for the MERCOSUR countries: a currency board system, target zones with a peg to the US dollar, and a peg to a basket of currencies, the last of which in my view follows from the overall analysis of this study.

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