Trade Agreements, Exchange Rate Disagreements

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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 Main motivation: Mercosur Following 1999 Real devaluation we saw: protectionist pressures, protectionist measures in Argentina relocation of firms to Brazil eventually contributed to end of convertibility Uruguay hit by double whammy talks of negotiating FTA with US outside of Mercosur

pressures, protectionist measures in Argentina relocation of firms to Brazil eventually

3 Overall (multilateral) exchange rate overvaluation causes Less exports Less FDI inflows More currency crises

4 Here we ask: Are effects more severe if the source of overvaluation is the RIA bloc? 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

5 If so, 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

Protectionist backlash and unraveling of RIA Joining

6 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

overvaluation is RIA bloc Overvaluation effects on FDI are more severe

7 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.

Argentina to Brazil If demand from partner falls, difficult to redirect regional goods to other markets Trade with other (non-ria) partners

8 Multilateral exchange rate overvaluation % (EXP) reduces total exports... All Countries Total Misalignment (10 percentage points)

9 but more so if it comes from RIAs... % (EXP) All Countries Total Misalignment (10 pp) Regional Misalignment (10 pp) Non Regional Misalignment (10 pp)

10 offering high protection % EXP All Countries High Protection Regional Misalignment Low Protection Regional Misalignment Non Regional Misalignment

11 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.

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

12 % FDI ratio Impact of bilateral XR on FDI location larger between countries with RIA All Countries South-South North-South North-North Same RIA Not Same RIA

13 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%)

Thus, it can generate more pressure on the currency Especially when credit is not available

14 Multilateral exchange rate overvaluation Marginal Effect of 10% overvaluation increases the risk of currency risk A crisis is a real depreciation greater than 5% Multilateral Misalignment (10 percentage points)

15 but more so if it comes from within a RIA Marginal Effect of 10% overvaluation A crisis is a real depreciation greater than 5% Multilateral Misalignment Regional Misalignment Non-Regional Misalignment

5 0 A crisis is a real depreciation greater than 5%

16 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)

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

17 Trade Agreements, Exchange Rate Disagreements Eduardo Fernandez-Arias Ugo Panizza Ernesto Stein Inter-American Development Bank

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