The effect of a currency union on trade: Lessons from the Irish experience

Transcription

1 The effect of a currency union on trade: Lessons from the Irish experience Rodney Thom and Brendan Walsh, * Department of Economics, University College Dublin, Dublin 4, Ireland Exchange Rates, Economic Integration & the International Economy Ryerson University Toronto, May Abstract This paper studies the introduction of an exchange rate between Ireland and the UK in 1979 to shed light on the effects of a common currency on the composition of international trade. No evidence is found from time series or panel regressions that the change of exchange rate regime had a significant effect on Anglo-Irish trade. This finding is consistent with previous studies of currency unions between larger, developed countries but conflicts with findings based on more heterogeneous country groupings. The reasons for this discrepancy are discussed. JEL Classification: F15, F33. Keywords: Common currency, trade, exchange, rates * Correspondence address: Department of Economics, University College Dublin, Dublin 4, Ireland. Tel: / addresses: Rodney.Thom@ucd.ie, Brendan.M.Walsh@ucd.ie

2 1. Introduction * In a series of papers Rose (2000), Frankel and Rose (2000) and Glick and Rose (2001) present results suggesting that countries using the same currencies trade up to three times more with each other than similar countries using different currencies. If correct, these results have important implications for peripheral countries participating in monetary unions. For example, a significant proportion of Irish trade is with non-euro economies and the Irish business cycle is more closely correlated with the American and British cycles than with the European core. 1 Hence, on standard Optimum Currency Area criteria countries such as Ireland may find that the one-sizefits-all monetary policy is unsuited to their particular stabilisation needs. However, on the Rose et. al. hypothesis integration via a common currency will promote trade with the core economies leading to greater synchronisation with the European business cycle. In short, while countries such as Ireland may not satisfy the Optimum Currency Area criteria ex ante they may ex post. If correct, this hypothesis provides an economic rationale for Ireland s decision to participate in the euro and, at the same time, questions the British decision to opt-out on the grounds that the UK economy is not synchronised with the EU core. It also has implications for economies in Central and Eastern Europe and in Central and South America in relation to currency links with the euro and the dollar. The studies by Rose and his colleagues typically estimate gravity-type models using large data sets derived from cases in which currency unions have either been created or dissolved. 2 The present paper takes an alternative approach. Rather than using large multi-county data sets we present evidence from a single case study the currency union between Ireland and the UK * We are grateful to Vincent Hogan, Patrick Honohan, Phillip Lane, James Lothian, Colm McCarthy, Anthony Murphy, and Peter Neary for helpful comments. Alan Stuart provided valuable research assistance. 1 Current Irish CSO data estimate the share of non-euro imports at 70% and exports at 30%. 2 Using similar data sets but different model specifications, Nitsch (2001) and Pakko & Wall (2001) report much weaker evidence for the trade creating effects of currency unions. 1

3 which terminated in The justification for a case study approach is twofold. First, it offers an opportunity to study the effects of ending a currency union between countries that were developed, stable and independent at the time of the dissolution. In the case of Ireland and the UK, both were, and remained, members of the EU and OECD. Most importantly, free trade existed before and after the currency union was dissolved. Second, the ending of the currency union was not part of a wider breakdown of economic and political relationships between the former partners. By contrast, the Glick and Rose study is dominated by some of the poorest and least stable countries in the world - over 250 of their 376 unions involve at least one Sub-Saharan African country. All of the unions involving these countries and many others in Latin America, the Caribbean and the Pacific were, as was the Irish case, legacies of an explicit or implicit colonial past. However, unlike the Irish pound-sterling link, many of these unions ended as part of a bloody decolonising process followed by the adoption of Marxist/autarkic policies, bilateral trade deals with the Soviet Union or China, and a descent into economic chaos France and Algeria, whose independence was granted only after a bitter struggle; India and Pakistan, who ended their currency union after the war of 1965; Pakistan and Bangladesh, who split up after the war of 1971; South Africa and Southern Rhodesia (Zimbabwe) who were ejected from the Commonwealth and had trade sanctions imposed as they broke with sterling; the five Portuguese colonies in Africa, that broke with Portugal after wars of liberation followed by civil wars. In all these cases and many others it is very likely that trade between the former currency union partners would have collapsed regardless of the currency regime in force. The problem of isolating a currency union effect from these contaminating influences does not arise in the Irish case and enhances our ability to separate the effects of the change of exchange rate regime from extraneous influences. 2

4 The structure of the paper is as follows. The next section provides some relevant background information on the Irish Pound-Sterling currency link. Section three uses time series data on Anglo-Irish trade to assess the effects of joining/leaving a currency union. Section four presents evidence from panel data on Ireland s trade with its main trading partners. The final section discusses the main findings and their implications. 2. Background The Irish pound - introduced in 1927 was held in a 1:1 no-margins peg with sterling until During the discussions leading to the launch of the European Monetary System it was expected that Britain would join the ERM, allowing Ireland to maintain the sterling link as well as participating in the new monetary system. As a consequence Ireland was committed to going into the ERM when in December 1978 Britain announced it would not do so. Even at this late stage it was hoped that sterling would shadow the German mark, but its sudden rise against the continental currencies in the last weeks of March 1979 resulted in the end of its link with the Irish pound. While it was generally believed that trade diversification towards the continental countries was in Ireland s interest, this was not a prime motive for breaking the sterling link. The most important influences on this decision were the perceived political benefits, the promise of additional EU subsidies, and a desire to shift the currency s nominal anchor from sterling, then considered to be inflation prone, to the new zone of monetary stability based on the German mark. 4 Despite these possible advantages, many Irish economists believed that it was inappropriate to join a currency zone that accounted for only about one third of our trade. In fact sterling continued to influence Irish policy long after the formal link was broken, as may be 3 New Zealand was the only other member of the Sterling Area to have had a comparable relationship with sterling. Its link lasted until This hope was not realized. By 1981 the Irish pound in the ERM had fallen to Stg

5 judged from the fact that on the three occasions when the Irish pound was devalued in the ERM in 1983, 1986, and 1993 the action was taken in response to sterling weakness relative to the continental currencies. Bearing these points in mind we believe we are justified in treating the end of the sterling link as exogenous with respect to trade patterns. 3. Time series evidence As late as 1950 the UK accounted for over 90% of Irish exports and almost 60% of Irish imports. 5 However, as illustrated in Figure 1, there has been a pronounced downward trend in the UK share of Irish trade since the early 1950s. We hypothesis that this phenomenon may be related to a series of factors the post-war performance of the UK economy relative to other Western European countries, falling long-distance transportation costs, trade liberalisation between the UK, Ireland and other EU Member States and changes in the currency regime. We start by estimating the following simple model: 6 ln [(X/P x ) ij + (M/P m ) ij ] t = α 0 + α 1 ln(y i Y j ) t + α 2 VOL t-1 + α 3 SL + α 4 EU + α 5 AIFTA + α 6 Trend + ε t (1) Where i and j denote Ireland and the UK, t runs from 1950 to 1998, and X = Irish exports to the UK (average of Irish exports to UK and UK imports from Ireland) M = Irish imports from the UK (average of Irish imports from UK and UK exports to Ireland), P x = Irish export price deflator, P m = Irish import price deflator, Y i,j = Irish, UK real GDP in international $ (from the World Penn Tables Version 5.6 updated from national sources), VOL t = bilateral exchange rate volatility - the standard deviation over a year of the percentage 5 For convenience we use Ireland to refer to the present Republic of Ireland. In 1922 the island of Ireland was partitioned into the Free State (subsequently the Republic) and Northern Ireland. The latter continues to be part of the UK. 6 Alternative specifications of the model were explored (such as adding separate variables for income per capita as 4

6 change in the IEP/GBP exchange rate. VOL is zero until 1979, SL = shift dummy variable for the sterling link = , 0.25 in 1979, EU = shift dummy to control for Irish and British entry to the EU in 1973 (=0 prior to 1973 and 1 for ) AIFTA = shift dummy to control for the Anglo-Irish Free Trade Agreement signed in 1965 (=0 prior to 1965 and 1 for 1965 to 1998) Trade data and prices are taken from the Statistical Abstract of Ireland, Trade Statistics of Ireland, and the UK Statistical Abstract. The trend variable is included to capture the dwindling importance of Irish and British GDP in global GDP and falling long-range transportation costs that would be expected to slow the growth of Irish-UK trade relative to that with other countries. Its coefficient is expected to be negative. This simple model does a good job of summarizing the behaviour of Anglo-Irish trade over the period (Table 1). The key results are plausible and robust. The income variable is highly significant and its coefficient stable. The trend variable is negative as expected and significant at least at the 10% level. Over the full sample period the coefficient of AIFTA is positive and highly significant, while that of EU is negative and significant. This is important evidence of the trade diverting effects of joining the EU and has implications for the specification of the panel regression in the next section. The evidence that exchange rate volatility depresses trade is inconclusive the estimated coefficient on VOL is negative but not statistically significant. But the key result is the non-significant SL coefficient. To test for the possibility that its influence might be captured by the volatility variable, equation (3) shows the results excluding volatility. The coefficients of all the variables except SL become more significant, while the SL coefficient remains essentially zero. To test for structural stability well as total income) but not found to make any significant differences to the results. 5

7 equations 4 and 5 of Table 1 estimate the model over the sub-period Note that the equations are the same as equations 1 and 2 except for the omission of VOL and SL both of which are constant and hence collinear with the intercept over the sterling link period. Forecasts of Anglo-Irish trade for based on these equations easily pass the predictive failure test As an additional test on the time series data we re-specified equation (1) as an error correction model (ECM). 7 The form of the ECM estimated is: ln [(X/P x ) ij + (M/P m ) ij ] t = β 0 + β 1 ln(y i Y j ) t + β 2 ln[(x/p x ) ij + (M/P m ) ij ] t-1 + β 3 ln(y i Y j ) t -1 + β 4 EEC 1 + β 5 AIFTAA + β 6Trend + ε t (2) The results are reported in the first column of Table 2, which suggests that over 60% of the equilibrium error is corrected in a year. Once again the sterling link dummy variable is insignificant. The model estimated for the sterling link period (equation 2) passes the predictive failure test for the period Panel data evidence The previous section addressed the time series question, what is the trade effect of leaving a currency union? This section deals with the complementary cross-section question, does the use of a common currency explain why members of a currency union trade more with each other than with non-members? We use a panel of 43 annual observations ( ) on Ireland s trade with 19 countries that accounted for 89% of Ireland s total external trade in 1950 and 92% in Northern Ireland (NI) and Great Britain (GB) are treated as separate entities. This enables us both to control for the unique historical links between Ireland and the UK and for the land border between Ireland and part of the UK. The income data were taken from World Penn Tables Version 6.1 and the trade data from the sources described above. We adopt the following specification: 7 The trade and income variables were found to be integrated of order 1 and cointegrated using the ADF test. 6

8 ln [(X j /P x ) + (M j /P m )] t = δ 0 + δ 1ln(Y IRL Y j ) t + δ 2 ln[(y/pop IRL )(Y/Pop j )] t + δ 3 lndist irl j + δ 4 SLj + δ 5 EU jt + δ 6 EEC*UK jt + δ 7 UK t + δ 8 AIFTAA t + δ 9 Contiguity j + δ 10 English j + ε t (3) where X j /P x t, M j /P m t = Ireland s exports, imports from country j in year t deflated by the Irish export and import price indices, Y j t = real income in country j in year t, Y/Pop jt = real income per capita in country j in year t, Distance j = the distance between Ireland and country j, SL = a dummy variable equal to 1 for the years for GB and NI, 0 otherwise. EU j t = a dummy variable equal to 1 if country j was a member of the European Economic Community in year t (t 1973 when Ireland became a member) and 0 otherwise, UK = a fixed-effect for the UK, EU*UK t = an interaction term between membership of the EU and the UK, AIFTA = a dummy variable equal to1 for NI and GB over the period and 0 for all other observations, Contiguity j = a dummy variable equal to 0 for all countries except NI, English j = a dummy variable equal1 if the partner country is English and 0 for all other countries. A fixed effect term is included to allow for the fact that Ireland was formerly part of the UK. The interaction term between the UK and the EU is included because the simultaneous entry of Ireland and Britain to the EU in 1973 is expected to have only trade creating effects with the 8 The countries are the existing EU-15, USA, Canada, Japan and Australia. Belgium and Luxemburg are treated as a 7

9 continental member states but to have some trade-diverting effects on Anglo-Irish trade. The results of estimating this model are shown in Table 3. They are similar to those reported in numerous comparable studies. The income, income per capita, language, and distance variables are highly significant and the estimated coefficients plausible and robust. The contiguity variable is positive but not significant, suggesting that the level of trade between the two parts of Ireland is not exceptional. The EU variable is highly significant and implies that ceteris paribus Ireland trades twice as much with other members of the EU as with non-members. When no interaction term is included the SL variable is highly significant (equation 2). This is essentially the Rose and Rose and Glick finding. However, this equation may be misspecified because it fails to take account of possible trade diverting effects of joint Irish British entry to the EU in If this interaction term (UK*EU) term is omitted the implication is that entry to the EU had the same effect on Anglo-Irish trade as on Irish trade with Germany and France. Given that the AIFTA implied free trade between Ireland and the UK prior to EU membership such a uniform effect seems unlikely. Also, a principal anticipated benefit of entry to the EU was to help Ireland diversify away form the slow-growing British market. In equation (1) the sum of the EU and UK*EU coefficients implies that joining the EU had a small negative effect on Anglo-Irish trade and that when account is taken of this the SL coefficient is zero. Hence, the panel analysis supports the time series finding that the change of exchange rate regime had no significant effect on Ireland s trading patterns. 5. Conclusions. The results presented in this paper suggest that the use of a common currency was not significant in explaining the historical importance of the UK in Irish trade and that ending the link did not affect bilateral trade. Rather, any decline in the significance of the UK for Irish trade single country but GB and NI are separated. 8

10 is most likely due to the diminishing importance of the former in the global economy, and the trade diverting effect of EU membership. It should be noted that free trade existed between the UK and Ireland prior to both joining the EU in Hence, removing trade barriers lead to trade creation with new partner countries but trade diversion vis-à-vis the UK. Controlling for this effect eliminates any significance attached to the currency link. While this is just one case study, it is an important one because it deals with one of the very few currency unions between two independent, developed countries that ended under conditions that allow us to isolate the currency union effect. No comparable studies exist showing that entering or leaving a currency union had an important impact on the trade patterns of independent countries that enjoyed normal economic relations before and after the event. Subject to the caveat that the trade effects associated with ending or creating a currency union may not be symmetrical, the Irish experience nonetheless causes some scepticism about the likely effects of new currency unions between countries that are already trading freely with one another. 9

11 References Frankel, J. A., Rose, A.K., An Estimate of the Effect of Currency Unions on Trade and Growth. NBER Working Paper No Glick, R., Rose, A.K., Does a Currency Union Affect Trade? The Time Series Evidence. Mimeo. ISOM Dublin. Keating, W., Measuring the economy problems and prospects. Mimeo., Statistical and Social Inquiry Society of Ireland. Nitsch, V., Honey I just shrunk the Currency Union Effect on Trade. Mimeo. Bankgesellschaft Berlin. Persson, T., Currency Unions and Trade: How large is the Treatment Effect? Economic Policy forthcoming. Rose, A. K., One Money, One Market: Estimating the Effect of Common Currencies on Trade. Economic Policy 30, Rose, A. K., van Wincoop, E., National Money as a Barrier to International Trade: The Real Case for Currency Union. American Economic Review, Papers and Proceedings, 91,

12 Fig. 1. UK's share of Irish trade, %

13 Table 1 Regression of Anglo-Irish trade on Income, (t-ratios in parentheses) Dependent variable: ln [(X/P x ) + (M/P m )] t Sample period: Equation no: (1) (2) (3) (4) (5) Intercept (5.1) (3.2) (3.7) (4.2) (3.0) Ln (Y j Y j ) t AIFTA EU Trend VOL -1 SL 0.84 (34.1) 0.10 (3.9) (1.5) (1.3) (0.2) 1.01 (10.0) 0.10 (4.0) (1.9) (1.8) (0.9) (0.4) 1.04 (19.8) 0.10 (3.9) (2.1) (2.0) 0.01 (0.3) 0.88 (19.5) 0.07 (1.7) (1.9) 1.14 (7.6) 0.05 (1.2) (2.6) (1.8) R S.e.e D.W LM predictive failure test χ 2 (20) [P(χ 2 )] 17.7 [0.606] 14.3 [0.816] 12

14 Table 2 Error correction model of Anglo-Irish trade (t-ratios in parentheses) Dependent variable: ln [(X/P x ) + (M/P m )] t Sample period: Equation no: (1) (2) Intercept (2.4) (2.0) ln (Y j Y j ) t (5.5) (4.4) ln [(X/P x ) + (M/P m )] t-1 (5.0) (4.1) ln (Y i Y j ) t (4.1) (3.1) Trend (1.8) (1.5) AIFTA (2.8) (1.3) EU (1.7) (1.7) VOL (1.2) SL (0.8) R S. e. e D.W LM predictive failure test χ 2 (20) [P(χ 2 )] 8.37 {0.989] 13

15 Table 3 Gravity models of trade between Ireland and 19 countries, Number of observations = 817 Dependent variable: ln Trade with Ireland Equation (1) (2) Intercept ln Income ln Income per capita Ln Distance English AIFTAA EU Contiguity UK UK*EU (26.5) 0.62 (37.6) 0.53 (16.6) (14.5) 0.57 (7.3) (0.0) 0.71 (11.0) 0.09 (0.6) 1.83 (7.4) (4.6) (26.1) 0.63 (37.3) 0.53 (16.3) (14.8) 0.69 (4.9) 0.22 (1.3) 0.57 (7.2) 0.62 (10.0) 0.98 (5.9) SL (0.5) 0.69 (4.9) R 2 = S. e. e. = R 2 = S. e. e =