The Impact of Trade Integration on Business Cycle Synchronization for Mercosur Countries

1. Introduction In the past few decades there has been a progressive movement towards regionally-based free trade areas (FTAs) in North America, such as the North American Free Trade Agreement (NAFTA), Common Market for Eastern and Southern Africa (COMESA) in Africa, Asean Free Trade Area (AFTA) and South Asia Free Trade Agreement (SAFTA) in Asia, and Mercado Comun del Sur (Mercosur) in South America, among others. The possibility that Mercosur may eventually lead to a more ambitious integration project suggests the usefulness of analyzing the viability of a potential monetary union. Moreover, there has been renewed interest in the theory of Optimum Currency Areas (OCAs), since the creation of the European Monetary Union. There are a number of motives for Mercosur to form a monetary union. Firstly, the monetary policy of each country in Mercosur (Argentina, Brazil, Uruguay and Paraguay) has been relatively ineffective because of its little credibility. Instead of losing sovereignty over monetary policy, a regional central bank may actually adopt credible monetary policy that could react effectively to external shocks. Secondly, due to the poor macroeconomic management of member economies, their credit ratings for international debt are poor, and therefore the cost of such debt is very high. Thirdly, a monetary union provides the possibility of a reduction in the cost of central bank reserves and may create a currency that could be used by other foreign central banks as a reserve currency. Finally, bargaining as a regional bloc could be an advantage in international negotiations. According to the traditional literature by Mundell (1961) and McKinnon (1963), three criteria must hold to form an OCA. The first criterion relates to the degree of trade integration between the members of the currency union. Gains from monetary unification stem from lower transaction costs and the elimination of exchange rate volatility. Thus, the more a pair of countries trade, the more that pair will benefit from the reduction in the transaction costs. The second criterion is the high degree of business cycle synchronization. Losses come from the inability to pursue independent adjustment policies and their extent depends on the size and incidence of shocks. If these are symmetrically distributed across countries, symmetrical policy responses will be enough, eliminating the need for policy autonomy. Finally, the third criterion relates to the degree of labor mobility and wage flexibility in the economies. If the case of asymmetric shocks is considered and the possibility of independent monetary policy is foregone, labor mobility and wage flexibility would allow for a faster and less costly adjustment. The aforementioned literature on this subject treats these criteria as exogenous. However, more recent literature has further investigated this issue since many have asserted that trade linkages could affect business cycle comovements. Krugman (1991) pointed out that as trade linkages among countries increase a la Ricardian comparative advantage, the specialization effect prevails, generating less synchronized business cycles. On the contrary, the European Commission (1990) states that more trade is occurring within the same industries. Hence, the effect of an increase of trade integration should result in more synchronized shocks among the economies. Frankel and Rose (1998) analyzed the issue empirically. In particular they tested the hypothesis that more integration can be expected to lead to more highly correlated business cycles. They found evidence of a positive impact of increased regional trade on business cycle synchronization for 21 industrialized countries. This research aims at testing this hypothesis for the Mercosur countries (with the exclusion of Paraguay). More specifically, it analyzes empirically the impact of reduced trade barriers and increased trade on the synchronization of the business cycles. …