Prospects for regional monetary integration in Latin America: a view from the EU (1).
Since the early 1960s, a number of regional trade and economic integration processes involving Latin American countries have developed. They include, in historical order, the Central American Common Market (CACM), the Andean Community, Mercosur, and the North American Free Trade Agreement (NAFTA). Some of these regions have recently launched initiatives to strengthen macroeconomic convergence among their members and envisage monetary integration as a long-term goal.
The likely future direction of trade integration in America is far from clear, with the creation of a Free Trade Area for the Americas sometimes seen as an alternative to some of the regional integration processes examined in this paper. Some parallel proposals also point towards the conclusion of free trade agreements (FTAs) between some of these integration areas (eg, between the Andean Community and Mercosur or between the CACM and NAFTA). Chile, which left the Andean Community in 1977, has signed FTAs with the NAFTA countries, but also has an FTA with Mercosur and has in the past expressed interest in joining Mercosur. There is also a series of other bilateral FTAs connecting the countries in the continent. In addition, Mexico, Chile and Mercosur have concluded or are negotiating FTAs with the European Union (EU), and both the CACM and the Andean Community have recently expressed interest in negotiating such an agreement with the EU. In short, there is a complex set of trade agreements involving Latin American countries and a high degree of uncertainty about the future shape of trade and economic integration within the continent.
Trying to assess the advisability or determine the likelihood of the different roads to economic integration in the American continent is well beyond the scope of this paper. Rather, the paper aims at evaluating the degree of integration already achieved by the main existing regions and their suitability for engaging in some form of monetary integration, including joint official dollarisation.
The paper is organised as follows. The first section describes the macroeconomic convergence schemes put in place by some of the regions under study and the attitude of these trade blocks towards possible monetary integration. The second section applies the criteria proposed by the traditional theory of optimum currency areas (OCAs) to the four regions. The situation of these regions with respect to the OCA criteria is also compared with that of the euro area, which provides a useful benchmark. (2) The analysis is then refined by introducing some additional considerations emphasised by the recent literature on the choice of exchange rate regimes, including the degree of de facto dollarisation and the existence of credibility problems. The final section sums up the main conclusions of the paper.
MACROECONOMIC CONVERGENCE INITIATIVES AND MONETARY INTEGRATION DISCUSSIONS IN LATIN AMERICA
In recent years, the Andean Community, Mercosur and the CACM have launched initiatives to foster macroeconomic convergence among their member countries. They hope that these schemes will contribute to limit fluctuations in their exchange rates, which have had disruptive effects on intra-regional trade and financial flows in the past. These schemes are sometimes seen as a first step towards an eventual monetary integration, but official discussions on monetary matters remain vague and speculative. In the case of NAFTA, no macroeconomic convergence framework has been set up and there is, for the time being, little political appetite for any monetary integration proposal. Before examining whether these regions constitute OCAs, it is worth describing these initiatives, or the reasons for their absence. This is done in what follows.
The Andean Community
The Andean Community was born in 1969 with the signing of the Cartagena Agreement and currently comprises Bolivia, Colombia, Ecuador, Peru and Venezuela. This Agreement called for the 'harmonisation of exchange rate, monetary, financial and fiscal policies' (Article 51). The Andean Community has recently been trying to make progress in this direction as a precondition for creating a common market by 2005. In 1997, it set up the so-called Advisory Council of Finance Ministers, Central Bank Presidents and Economic Planning Officers with the mandate of preparing a working agenda in this area. In 2001, this Council defined macroeconomic convergence criteria on inflation, the fiscal deficit and public debt that are similar to those of the EU's Maastricht Treaty. These are summarised in Table 1. The idea of monetary union was, however, absent from the Cartagena Agreement and, although some tentative proposals have been discussed in the past, it is not part of the current agenda of the Andean Community.
Since its creation in 1991, Mercosur (comprising Argentina, Brazil, Paraguay and Uruguay) has suffered from recurrent trade tensions among its member countries caused by divergent macroeconomic developments and sharp fluctuations in their real exchange rates. To try to tackle this problem, Mercosur set up in 2000 a Macroeconomic Monitoring Group made up of high officials from the ministries of finance and central banks. This Group is in charge of putting forward proposals aimed at strengthening macroeconomic coordination. In September 2000, the Mercosur countries started publishing harmonised indicators for the fiscal deficit, the public debt and inflation and, at the summit of Florianopolis of December 2000, they agreed on a set of common targets for those variables (see Table 1).
The founding treaties of Mercosur foresee the coordination of macroeconomic policies, but do not make any reference to the eventual establishment of a monetary union among its member countries. Although some economists and politicians have proposed exchange rate stabilisation mechanisms or the monetary unification of Mercosur, (3) monetary integration has remained off Mercosur's integration agenda until recently due to a divergence of views between Argentina and Brazil on the appropriate exchange rate regime. While a history of high inflation and a high degree of dollarisation had led Argentina to prefer a hyper-fixed regime, Brazil (a larger and much less dollarised economy) preferred to maintain the floating regime introduced in early 1999.
Following Argentina's decision to abandon its currency board arrangement (CBA) in January 2002 and Uruguay's decision to float its currency fully in June 2002, however, all the Mercosur countries now have flexible exchange rate regimes. Moreover, as discussed below, Argentina may now have a new interest in monetary integration with Mercosur as a way of re-establishing a credible monetary regime. In January 2003, the newly elected Brazilian President, Lula da Silva, and President Duhalde of Argentina agreed to intensify Mercosur's macroeconomic coordination efforts and proposed the creation of a 'Monetary Institute of Mercosur' to examine the steps necessary for the possible introduction of a common currency. Given the current preference of Mercosur countries for flexible exchange rates, it is understood that such a common currency would float. Although this idea remains very preliminary, it suggests that the debate on Mercosur's monetary integration may be gathering momentum.
The CACM currently comprises Costa Rica, El Salvador, Guatemala, Honduras and Nicaragua, but Panama and the Dominican Republic are expected to join soon. Established in 1960 with the aim of creating a common market among its member states, it also envisages as a medium-term goal the creation of an integrated financial and monetary area in Central America.
In 1964, the CACM countries created the Central American Monetary Council, made up of the governors of their central banks. Its main objectives are to foster the coordination of the monetary, exchange rate and financial policies of its member countries and to propose steps aimed at deepening their financial and monetary integration. Since 1994, the Monetary Council has been using a set of eight indicators, including inflation, the budget deficit and the public debt, to monitor macroeconomic convergence in the region. For each of these indicators, it defines a reference parameter every year (see Table 1). These parameters, however, are not politically binding. They only provide guideposts toward which countries are expected to aim.
Much of the recent work of the Monetary Council has focused on the development of an integrated capital market in Central America. The discussions on possible options for monetary unification, however, have been revived by the decisions recently taken by El Salvador to officially dollarise its economy and by Guatemala to legalise the use of the dollar alongside the quetzal (see below). With Panama also being officially dollarised and other Central American countries showing a high degree of de facto dollarisation, these decisions have led some politicians, business leaders and academicians to propose the joint adoption of the dollar as legal tender as a way to achieve monetary integration in the region. The Central American Parliament has recently recommended the adoption of a medium-term plan for the monetary integration of the region. In the Parliament's recommendation, however, this is to be achieved not by jointly dollarising but, rather, by converting the Monetary Council into a regional central bank that would issue a common Central American currency (Parlamento Centroamericano, 2001).
The NAFTA, signed in 1992 by Canada, Mexico and the United States, does not foresee any form of macroeconomic policy coordination or monetary integration. These countries do not consider that macroeconomic coordination is necessary and, while some economists (eg, Courchene, 1998) have proposed the creation of a North American Monetary Union or the unilateral dollarisation of the Canadian and Mexican economies, the official position of Canada and Mexico is that monetary integration is not desirable at this stage. Both countries believe that it is in their best interest to maintain the flexibility provided by their floating exchange rate regimes, which are combined in both cases with inflation targeting schemes. Mexico introduced its floating regime in 1995, following the Tequila crisis, and believes that it has served it well. Canada, for its part, is to a large extent an exporter of basic commodities and, therefore, its export structure is very different from that of the US, which results in a high incidence of asymmetric shocks relative to the US (see the next section). (4) The reluctance of Canada and Mexico to give up their own currencies and monetary sovereignty also reflects deep national feelings. Nor does the US seem keen to make Canada and Mexico new districts of the Federal Reserve.
APPLYING THE OCA CRITERIA TO LATIN AMERICA'S INTEGRATION AREAS
Let us now look at how the regions under analysis score in terms of the traditional criteria proposed by the OCA literature.
The higher the degree of trade interdependence of a group of countries, the more sense it will make for them to stabilise their intra-regional exchange rates, including by establishing a monetary union. The importance of intra-regional trade linkages is, in turn, a function of the degree of openness and the share of trade the countries in the region conduct with each other. These two factors can be combined by looking at the ratio of intra-regional trade over GDP.
Table 2 provides 2000 data on the degree of openness and the direction of trade in percent of GDP for the regions under analysis and the euro area. Data for the euro area refer to 1998, the year before the launch of EMU. Figure 1, for its part, displays historical series on the share of intra-regional trade in percent of total trade. The picture that emerges from these data is that, with the exception of NAFTA, the degree of trade integration of these regions is much lower than what the euro area showed just before EMU.
Canada and Mexico trade between one-quarter and one-third of their GDPs with their NAFTA partners, ratios that are by far the highest among the countries in the sample and significantly above the euro area's average (about 20 percent). This reflects both the very high share of their trade that they conduct with the US (about 80 percent in both cases) and their high degree of openness. As Figure 1 shows, NAFTA has consolidated the strong process of reorientation of Mexican and Canadian trade towards the US that was already visible before this agreement was signed. The US is less dependent on its NAFTA trade than Canada and Mexico, but the share of trade it conducts with its regional partners has also shown an upward trend since NAFTA entered into force.
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Mercosur countries only traded with each other, on average, about 6 percent of their GDPs in 2000. This reflects the closed nature of most Mercosur economies and the fact that they have only achieved an intermediate degree of mutual trade penetration. Although the ratio of Mercosur's intra-regional trade over total trade is significantly higher than those of the Andean Community and Central America, it compares poorly with those seen in NAFTA and the euro area. This ratio has shown, however, a clear upward trend since the creation of Mercosur (see Figure 1).
The picture of trade interdependence is even bleaker for the Andean Community. Its member countries only trade about 3 percent of their GDP with each other. This is explained by the combination of an intermediate degree of openness and an intra-regional trade orientation that is the weakest among the four regions and has only exhibited a timid upward trend since the Cartagena Agreement was signed. The Andean countries trade predominantly with NAFTA and also significantly with the EU (trade with the EU exceeds intra-regional trade). Some also trade significantly with Mercosur (especially with Brazil).
The CACM countries also trade relatively little with each other (only about 15 percent of their trade and 6 percent of their GDP in 2000). They conduct about half of their trade with NAFTA, including a non-negligible amount with Mexico. This weak intra-regional orientation reflects in part, however, the negative effects of two decades of conflicts in the region. In the early 1970s, these countries conducted about 25 percent of their trade with each other but, in the 1970s and 1980s, political tensions between Honduras and El Salvador and the civil wars of El Salvador, Nicaragua and Guatemala seriously disrupted intra-regional trade (see Figure 1). The end of these military confrontations has resulted in a recovery of intra-zone trade, but the shares still remain below their early 1970s peak. Following the adoption by the CACM in March 2002 of an ambitious plan to create a customs union by 2004, it seems reasonable to expect that intra-regional trade will eventually return to at least the levels of the early 1970s.
In sum, when one looks at trade interdependence, and with the exception of the NAFTA zone, one finds little support for monetary integration at the regional level in the American continent.
Likelihood of asymmetric shocks
As argued in the OCA literature, a high incidence of asymmetric shocks makes it more costly to do away with the exchange rate as an adjustment instrument. Available econometric research suggests that supply and demand disturbances in Latin America are likely to be asymmetric and relatively large. This criterion, therefore, does not provide much support for the creation of currency unions in the American continent either.
In a well-known study, Bayoumi and Eichengreen (1994) used a structural vector auto-regression approach to identify aggregate demand and supply disturbances and thus assess the advisability of monetary unification in different parts of the world. They found little correlation of disturbances across any group of countries in the American continent during the period 1969-89. In addition, they found that disturbances tended to be relatively large, making it even less advisable for the American regions (or for the continent as a whole) to consider monetary union. Bayoumi and Eichengreen concluded that, apart from the regions of the US (which already have a common currency), only the core EU countries and two groups of Asian countries were suitable for monetary union on this criterion.
A problem with the study by Bayoumi and Eichengreen is that their period of observations for the American countries only covered up to 1989, that is, a few years before the creation of Mercosur and NAFTA. Since then, the degree of integration within NAFTA and Mercosur has, as noted, increased substantially, which might tend to reduce the likelihood of asymmetric shocks in these regions. To overcome this limitation, Arora (1999) updated the estimates using data through 1998, but he reached the same negative conclusions as Bayoumi and Eichengreen.
Studies focusing on the relationship between Canada and the US are consistent with the results of Bayoumi and Eichengreen and Arora (DeSerres and Lalonde, 1994; Roger, 1991; Murray, 1999). They indicate that, although these two countries are highly integrated, they tend to experience frequent asymmetric shocks. This partly reflects deep structural differences between them. Although Canada has become much less reliant on natural resources since World War II, basic commodities still represent more than 35 percent of its exports and 10 percent of its GDP. As a result, Canada is much more exposed to terms of trade shocks than the US. Furthermore, because Canada is a net exporter of primary commodities whereas the US is a net importer, their terms of trade often move in opposite directions in response to changes in international commodity prices (Roger, 1991).
Econometric work on the Mercosur and Andean countries has also detected little correlation of either shocks or cyclical conditions (Licandro Ferrando, 1998; Fernandez Valdovinos, 2002; Pineda and Pineda, 2002). Some studies (eg, Licandro Ferrando, 1998; Carrera et al., 1998) found that output correlation coefficients in Mercosur increased during the 1990s, suggesting that deeper integration within Mercosur may be rendering shocks less asymmetric. However, these studies do not capture the Brazilian crisis of 1999 and the recent Argentinean crisis, which have affected Brazil and Argentina with very different intensities. Nor do they capture the fact that the Brazilian economy recovered strongly in 2000, while Argentina (and Uruguay) remained in recession. Expanding the studies to these years may therefore show lower correlations for the recent period.
Overall financial openness
Most Latin American countries have a relatively open capital account. Although many reintroduced restrictions on capital movements (particularly outflows) during the debt crisis of the 1980s, in the 1990s most countries engaged in a strategy of capital account liberalisation. This is true in particular for the five major Latin American countries. Argentina fully liberalised its capital flows during the 1990s in the context of the 'Convertibility' regime, although it reintroduced temporary restrictions during the recent crisis. Mexico has also removed most capital controls since the mid-1990s, as part of the commitments stemming from its membership of NAFTA and the OECD. In 1998-2001, Chile did away with its remaining capital controls, which were aimed at restricting short-term speculative flows. Brazil maintains restrictions on some capital flows, largely short-term flows and certain transactions involving securities, but its capital account regulations are, on the whole, rather liberal.
The IMF (2001) has calculated two measures of capital account openness for a large sample of countries, as well as averages for the main regions, for the period 1970-1998. One is a restriction measure that reflects the regulations on capital flows reported to the IMF by its member countries and summarised in its Annual Report on Exchange Arrangements and Exchange Restrictions. The other one is an openness measure that looks at the stocks of gross foreign assets and liabilities as a percentage of GDP, the assumption being that the higher the degree of financial openness, the larger those stocks will tend to be. The results obtained for Latin America are reproduced in Figure 2. On both measures, Latin America scored better than the average of the developing countries. Both measures also confirm that, following a period of reintroduction of restrictions in the first half of the 1980s, there has been a rapid increase in Latin America's financial openness.
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In sum, Latin American economies have reached a relatively high degree of overall financial openness. This has at least two implications for the advisability of, and prospects for, monetary integration in the continent. First, Latin American regions should refrain from trying to stabilise intra-regional exchange rates through adjustable pegging systems because, in the presence of high international capital mobility, such regimes are highly vulnerable to speculative attacks, particularly if they are not backed up by firm institutional commitments. (5) Second, the opening of their capital accounts may accelerate the process towards monetary unification in some Latin American regions because, like it happened in the EU in the 1990s, they may increasingly regard it as the only feasible way to prevent recurrent exchange rate disruptions within their free trade areas.
Intra-regional financial integration
The theory of OCAs suggests that a high degree of intra-regional factor mobility is an important prerequisite for creating a monetary union (Mundell, 1961). This refers to both capital and labour mobility. This section looks at the issue of intra-regional financial integration and the next one examines labour mobility. Overall financial openness should be distinguished from intra-regional financial integration. Whereas, as noted, a high degree of international capital mobility provides an argument against fixed-but-adjustable exchange rates, a high degree of intra-regional financial integration smooths the adjustment to asymmetric shocks, thus reducing the costs of forsaking the exchange rate as a policy instrument.
As emphasised by Ingram (1973), within an area that is financially integrated, when demand shifts from one region to another temporarily, capital mobility facilitates the financing of the transitory current account deficit in the former region and can, therefore, be a partial substitute for an exchange rate adjustment. According to Ingram, this explains the apparent ease of inter-regional payments adjustment within countries and a similar process can work across countries provided they have reached a high degree of financial integration.
Unfortunately, with the exception of NAFTA, all the regions under analysis seem to combine a relatively high degree of overall financial openness with a low degree of intra-regional financial integration. Mexico's high and growing financial integration with NAFTA contrasts starkly, for example, with Mercosur's low degree of intra-regional financial integration. While Mexico receives the bulk of its capital inflows, including about two-thirds of foreign direct investment, from the US and Canada, intra-regional flows in Mercosur are very modest compared to the flows with countries outside the region. For example, about 80 percent of the international banking flows received by Mercosur countries in the second half of the 1990s came from the EU, the US, Canada and Japan (Levy-Yeyati and Sturzenegger, 2000b).
Moreover, unlike in the EU, the ongoing internationalisation of Latin American banks is taking place not through the consolidation of national banking sectors across each region but, rather, with institutions from major extra-regional financial centres that benefit from lower operating costs and a stronger reputation. The only exception is Mexico, where the acquisition of local banks by US banks is increasing NAFTA's financial integration. In Mercosur, by contrast, this process is making the financial sector increasingly integrated with those of the US and the EU. (6) Also from this point of view, therefore, Mercosur would seem less well suited for monetary integration than NAFTA.
Although only partial information is available for the Andean and Central American countries, it appears that the international acquisitions of financial institutions in these countries have also been largely undertaken by institutions from key OECD financial centres. (7) In the case of Central America, the links with financial institutions from the US are in some cases rather significant. This is particularly true for Panama, where 100 years of official dollarisation, the full liberalisation of foreign entry into the financial system and the strong economic and political presence of the US have contributed to create strong links between the banking and payments systems of both countries (Moreno-Villalaz, 1999).
A high degree of intra-regional labour mobility can be helpful for a group of countries establishing a monetary union because if a shock affects one country, leading to a decline in its output and real wages, its workers may migrate to other countries in the region, thus facilitating the adjustment process. This is important when countries in the monetary union have rigid labour markets and sticky wages. While the situation varies considerably across countries, there is partial evidence suggesting that Latin American labour markets tend to be rigid. (8) Latin America's relatively high unemployment rates also provide indirect evidence of rigid labour markets and insufficient downward wage flexibility (Temprano-Arroyo, 2002).
To what extent is this rigidity compensated by a high degree of intra-regional labour mobility? In contrast with the EU, the regions under analysis have made little progress in liberalising the intra-regional flow of labour. NAFTA, in particular, does not include any provision to that effect. In fact, one of the motivations behind NAFTA was precisely to try to limit the flow of illegal Mexican emigrants into the US by liberalising trade and fostering economic development in Mexico. In the case of the Andean Community, the CACM and Mercosur, although their founding treaties do establish as a common objective the free movement of labour and the gradual harmonisation of social security instruments across their member countries, the practical implications of these provisions have so far been modest.
Despite this relatively restrictive legal framework, however, intra-continental migratory flows, including flows from Latin America to the US, have been rather important. This suggests that labour mobility (especially within NAFTA) may be underestimated by simply looking at immigration regulations. The number of Latin American immigrants residing in the US increased by 2.7 million in the 1970s and by an additional 4 million in the 1980s. Of the nearly 8.4 million Latin American immigrants living in the US in 1990, over 50 percent were of Mexican origin and 13 percent came from Central America. According to the US Current Population Survey, the number of Latin American immigrants living in the US had increased to 13.1 million by 1997 (an increase of 4.7 million compared to 1990), representing already about half of the foreigners residing in that country (Villa and Martinez Pizarro, 2000).
One Latin American region that shows a particularly high rate of international labour mobility relative to its population is Central America (see Table 3). Although most Central American emigrants have as destination the US, there have also been substantial labour flows across Central American countries.
In sum, while there has been little progress in liberalising and facilitating the movement of labour, actual migratory flows suggest that there is a significant degree of labour mobility, particularly within NAFTA, between Central America and NAFTA and within Central America. These results are almost the opposite to what seems to be the case in the EU, where despite the full liberalisation of regional labour flows and significant progress in harmonising national social security systems, labour mobility remains low.
How can these paradoxes be explained? It seems that language and cultural differences, housing market constraints in the cities, generous unemployment benefit systems and a higher degree of synchronisation of economic cycles tend to reduce the willingness and necessity of workers to migrate within the EU. In Latin America, by contrast, language and cultural affinity facilitate migration, while frequent (and asymmetric) political and economic shocks, in combination with underdeveloped social welfare systems, often oblige people to leave their countries in search of a better life despite immigration rules that are not always welcoming. In the case of migration to the US, the cultural affinity argument does not apply but per capita income gaps are so large and the prospect of economic success so appealing that they seem to more than compensate for this difficulty and for the restrictive immigration rules. Moreover, the language and cultural problem is becoming much less of a determinant as Latin American immigrants develop communities in the US cities where they recreate in part their culture and way of life, speak their language and maintain family ties. These communities act as 'poles of attraction' for new immigrants from those countries, thus increasing international labour mobility.
Intra-regional fiscal transfers
Another traditional OCA criterion refers to the existence of a mechanism of fiscal transfers among the countries wanting to share the same currency. Such a mechanism can be used to alleviate the effects of asymmetric shocks within the region and can, therefore, reduce the costs of giving up intra-regional exchange rate adjustments. The existence of a federal system of fiscal transfers with strong regional stabilising properties is considered a key factor explaining the success of the US' monetary union (see Sala i Martin and Sachs, 1992).
Unfortunately, there are no inter-country fiscal arrangements in any of the regions under examination. It should be noted, however, that the EU's fiscal system is not much integrated either. The EU has created the structural (agricultural, regional and social) and cohesion funds but the EU budget remains small (it still accounts for less than 2 percent of its GDP) and is, therefore, not designed to be used as a buffer for asymmetric regional shocks.
Macroeconomic convergence and volatility
It is normally argued that, before moving into some form of monetary integration, a group of countries should achieve a minimum degree of macroeconomic convergence. Tables 4 and 5 provide recent data on the levels and standard deviation of the fiscal deficit/GDP ratio, the public debt/GDP ratio and the inflation rate for the four regions under analysis. These three convergence indicators are emphasised by both the macroeconomic convergence schemes discussed in the previous section and the EU's Maastricht Treaty. For comparison, the tables also show these indicators for the euro area in the year before EMU was launched.
In recent years, Latin American countries have made a great deal of progress in reducing inflation levels and differentials. Nonetheless, in 2001, both inflation levels and inflation dispersion remained, in all regions except NAFTA, between four and eight times larger than in the euro area in 1998. Moreover, inflation accelerated sharply in Argentina, Paraguay, Uruguay and Venezuela in 2002, reflecting the sharp depreciations experienced by their currencies in the context of their recent financial crises.
Regarding fiscal convergence, the best-performing region was again NAFTA, with lower deficits and debt as well as lower fiscal dispersion indices than the euro area. At the other extreme lay Central America, which scored considerably worse than the euro area in terms of both levels and dispersion. Mercosur and the Andean Community had in 2001 lower debt ratios and lower fiscal dispersion indicators than the euro area in 1998, but their deficits were significantly higher. Furthermore, both deficits and debt ratios shot up again in the crisis-ridden countries of these two regions in 2002.
In sum, with the exception of NAFTA, the degree of nominal macroeconomic convergence attained by the regions under analysis remains insufficient to consider monetary integration. In addition, Latin American countries are characterised by a high degree of macroeconomic volatility. Economic growth and inflation in Latin America are about twice as volatile as in the industrial economies and more volatile than in any developing region other than Africa and the Middle East (IADB, 1995; Gavin et al., 1996). In particular, GDP growth volatility in Latin America has been much higher than in the euro area. While the standard deviation of euro-area growth rates averaged 2.4 in the period 1970-2001 and declined below 2 in the last two decades, that of Latin America averaged 4.4 in 1970-2001 and shows no discernible trend (Buti and Giudice, 2002).
This macroeconomic instability partly reflects Latin America's precarious and volatile access to international capital markets, its high dependence on international commodity exports, and the pro-cyclical nature of fiscal policies in the region. (9) In combination with the insufficient degree of intra-regional macroeconomic convergence and the high degree of financial openness, it warns against attempting to stabilise exchange rates within Latin America's regions by means of fixed but adjustable pegs.
INTRODUCING OTHER RELEVANT CRITERIA
We have just seen that, based on the traditional theory of OCAs, Mercosur, the Andean Community and the CACM are not ready for monetary integration. The situation within NAFTA is somewhat different. The NAFTA countries present a high degree of trade and financial integration, and have achieved a high degree of macroeconomic convergence and stability. They also exhibit substantial de facto labour mobility, even though Mexican citizens continue to face serious legal obstacles to work in the US. From all these points of view, the NAFTA countries may be considered to be close to an OCA. On the other hand, they are characterised by very different productive and export structures, which results in a high incidence of asymmetric shocks, and they have not established any mechanism of intra-regional fiscal transfers. NAFTA policy-makers and part of the economic literature have tended to focus on the high likelihood of asymmetric shocks to argue against monetary integration within this region.
The traditional OCA criteria, however, do not take into account a number of relevant aspects. The conclusions on the advisability of monetary integration may change, at least for some of these regions, once other factors stressed by the more recent literature, such as the degree of the facto dollarisation, the need to import monetary credibility and the endogeneity of some of the OCA criteria, are taken into consideration. They may also need to be modified once the trade interdependence criterion is extended to consider the possible adoption by the region of the currency of a major and stable trading partner. After incorporating these criteria, this section concludes that not only NAFTA but perhaps also Central America may meet the conditions for dollar-based monetary integration.
The degree of de facto dollarisation
As stressed by the recent literature on dollarisation, when an economy presents a high degree of de facto dollarisation, the advantages of having a floating exchange rate are seriously reduced (Berg and Borensztein, 2000; Hausmann et al., 1999; Bogetic, 2000). First, highly dollarised economies have a large proportion of their liabilities denominated in dollars. In particular, a high share of the banks' loan portfolio is denominated in, or indexed to, the dollar. Under these conditions, a depreciation of the currency can cause serious damage to the banking sector, as illustrated by the recent Argentinean crisis. Even though banks' direct foreign exchange position may be hedged, when the domestic currency depreciates sharply many enterprises and households will no longer be able to service their dollar-denominated debts to the banks, pushing some banks into bankruptcy. Also, because much of the public debt is in dollars, the depreciation will sharply increase the government's debt service obligations, which could result in a marked deterioration of the fiscal position. Second, when an economy is highly dollarised, the depreciation of the exchange rate will tend to feed quickly into inflation because domestic wages and prices normally present a high degree of indexation to the exchange rate (the prices of many domestic contracts are denominated in dollars). Under these circumstances, the nominal depreciations will only produce an ephemeral depreciation of the real exchange rate and will, therefore, have little impact on the trade balance. They will simply lead to higher domestic inflation and may push the economy into an inflation-currency depreciation spiral.
These considerations are relevant because many Latin American economies show a high and, in some cases, growing degree of de facto dollarisation. A survey conducted by Balino et al. (1999) found that, in 1995, five of them (Argentina, Bolivia, Costa Rica, Peru and Uruguay) were 'highly dollarised', as measured by a share of foreign currency deposits at domestic banks over broad money above 30 percent. More recent data indicate that dollarisation ratios continued to increase or remained at high levels in many Latin American countries during the second half of the 1990s and the early 2000s. This was particularly true for the most highly dollarised economies of South America, including Argentina until the recent government decision to reconvert bank loans and deposits into pesos (see Figures 3 and 4). In Uruguay and Bolivia, dollar deposits accounted for about 90 and 80 percent, respectively, of broad money at end-2001. In Peru and Argentina, these ratios were closer to 60 percent. The dollar is also used widely as a unit of account for the pricing of durable goods such as cars and apartments and, in some cases, as a means of payment. In Peru, for example, about one-third of the cash withdrawn from ATMs and of credit card transactions are in dollars (Armas, 2002).
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Dollarisation ratios have also increased significantly in Central America since the mid-1990s. According to the data compiled by the Central American Monetary Council, the average share of dollar-denominated quasi-money in M2 in the Central American countries (excluding Guatemala and Panama) rose from 27 percent in 1995 to 55 percent in 2001. Moreover, Central American countries have their stocks of public debt highly dollarised (see Table 6).
In addition to this high degree of de facto dollarisation, four Latin American countries have declared the dollar legal tender: Panama has been fully dollarised since it signed the 1904 Treaty of Monetary Association with the US; (10) Ecuador announced the official dollarisation of its economy in January 2000, in the middle of a deep economic and financial crisis; in December 2000, Guatemala decided to allow the dollar to be used freely alongside the quetzal; and, in January 2001, El Salvador decided to fully dollarise its economy and it is estimated that, by the end of that year, the dollar accounted for over 80 percent of M2 (see Table 6). The authorities of other Latin American countries, including Costa Rica and Argentina under the Menem administration (see below), have also expressed, in the past, some interest in official dollarisation.
On the other hand, it should be noted that in Brazil and Mexico, the two largest Latin American countries, as well as in Chile, dollarisation ratios now stand at moderate levels. In Mexico, the ratio fell from over 25 percent during the Tequila crisis to about 5 percent at end-2001 (see Figure 5). Brazil's weak dollarisation contrasts starkly with the high degree of dollarisation shown by some of its Mercosur partners. One factor that seems to have contributed to keep dollarisation ratios at moderate levels in these three countries is the widespread use of financial instruments denominated in local currency but indexed to the inflation rate or the dollar exchange rate (Balino et al., 1999).
[FIGURE 5 OMITTED]
The high rate of dollarisation shown by many Latin American countries and the problems it poses under floating exchange rates have led some economists to propose joint dollarisation as a strategy for regional and even continental monetary integration. (11) The debate has gathered momentum during the Argentinean crisis, with official dollarisation often being presented as the main alternative to the flotation and repesification strategy chosen by the Duhalde government in early 2002. Already in early 1999, when Argentina was suffering contagion from the Brazilian crisis, president Menem had launched the idea of adopting the dollar as the sole legal tender. While this was partly a tactical threat to the markets to limit devaluation speculation, the Argentinean authorities did discuss this possibility with the US Treasury and Federal Reserve. Until now, the US government has generally taken a neutral stance on dollarisation in public. While it has not excluded the possibility of concluding bilateral agreements with dollarising countries for the sharing of seigniorage, it has so far rejected the possibility of granting lender-of-last-resort services or extending banking supervision to them. (12)
The success of the repesification strategy chosen by Argentina hinges on whether the authorities will manage to persuade the population to give up the dollar and take back the peso as the sole domestic money. As Figure 3 shows, during the 2 years that preceded the fall of the de la Rua government in December 2001, the share of dollar deposits in M3 had increased markedly reflecting devaluation fears. Confidence in the peso may prove hard to re-establish, particularly in the current context of exchange rate uncertainty and financial crisis. Given the lack of public trust in the peso, the compulsory repesification of banks' balance sheets and other contracts (eg, lease contracts) decided by the government has had to rely in part on the indexation of contracts to the inflation rate.
The difficulties the Argentinean authorities face in their attempts to repesify the economy reflect a general phenomenon observed in many developing and transition countries, namely the strong inertial forces or hysteresis governing the currency substitution process. Empirical evidence suggests that, once currency substitution develops, it is hard to reverse (see Box 1). This phenomenon has been observed in quite a few Latin American countries, as discussed by Guidotti and Rodriguez (1992), Savastano (1996) and Balino et al. (1999). In Latin America, dollarisation developed during the high inflation episodes of the 1970s and 1980s but, as noted above, continued and, in some cases, even intensified during the 1990s and early 2000s despite drastic and lasting reductions in inflation. As Figures 3 and 4 show, this asymmetric behaviour of currency substitution has been particularly pronounced in Argentina, Bolivia, Peru and Uruguay. (13)
Box 1. Hysteresis in Currency Substitution (CS): Conventional CS models predict that CS should rise when inflation and the rate of currency depreciation increase but that, once macroeconomic and exchange rate stability are restored and the rate of return on domestic currency assets improves relative to that on foreign currency assets, the process should be reversed. In fact, however, this reversibility of CS is not what has been observed in many dollarised economies in the last three decades. Instead, CS ratios have remained stubbornly high, and have often increased, in many countries even after inflation was brought back under control. The CS process, therefore seems to be characterised by hysteresis or the existence of ratchet effects. As discussed in the main text, the phenomenon of CS hysteresis has been observed in many Latin American countries. It has also been detected in other developing and transition countries. Many former Soviet Union countries, in particular those in the Caucasus and Central Asia, have seen rising CS ratios during the 1990s despite considerable progress in macroeconomic stabilisation. The same is true for Mongolia, the transition countries of Indochina, Cuba (after the de-penalisation of the use of the dollar in 1993), Haiti and certain high inflation Middle East countries such as Lebanon and Yemen. CS ratios also remain very high in some South Eastern European countries despite successful stabilisation. In Croatia, for example, which has kept inflation at industrial country levels since 1994, three quarters of the banks' balance sheets are still denominated in or indexed to foreign currencies, mostly the euro (Kraft, 2002). On the other hand, there are some examples of a significant and lasting reduction in CS levels following stabilisation. This is the case of some Eastern European countries such as Poland and Estonia, Egypt, and, as noted, Mexico. Several complementary explanations have been proposed for the observed persistence of CS. Some authors, such as Gudotti and Rodriguez (1992) and Dornbusch et al.(1990), have attributed it to financial innovation. The argument is that in high inflation countries economic agents develop ways of economising on real domestic currency balances, including by switching to foreign currency assets. This is a costly process and, once the fixed costs implied by these CS techniques have been borne, the money substitutes remain in place even after inflation and depreciation rates decline again. CS hysteresis may also reflect the persistence of credibility problems, that is, it may take time for the authorities to regain their credibility after they have restored macroeconomic stability. Finally, Ize and Levy-Yeyati (1998) have developed a portfolio model in which hysteresis occurs when the expected volatility of inflation is high relative to that of the real exchange rate. The basic idea is that when inflation volatility increases relative to real exchange rate volatility, domestic currency assets become more risky relative to foreign currency assets, which induces investors to increase the weight of the latter in their portfolios. This model predicts that CS will tend to rise when the economy becomes more open because openness increases the price pass-through of exchange rate movements, which should increase price volatility relative to real exchange rate volatility. This may help explain why many countries have experienced rising CS ratios at a time when they were both reducing inflation and increasing their international economic integration.
Figures 3-5 also suggest that administrative measures are not an effective way to curb dollarisation. The decisions taken by Bolivia and Mexico in 1982 and by Peru in 1971 and 1985 to re-impose severe restrictions on the holding of foreign currency deposits and to forcibly reconvert the existing ones into domestic currency had only a temporary effect on dollarisation ratios. When the restrictions were eventually lifted, dollarisation ratios shot up again. Moreover, the effect of these administrative measures was weaker than Figures 3-5 suggest since the dollarisation ratios shown there do not include foreign currency deposits held abroad, which increased significantly in reaction to the prohibition of local foreign currency deposits (Savastano, 1996). Rather than reduce the demand for foreign currency, therefore, this type of measures may simply induce capital flight and push the dollarised economy underground. (14)
The observed hysteresis in the dollarisation process implies that, although for closed Latin American economies that do not trade much with the US the first-best strategy might be to de-dollarise and float their currencies, this may prove hard to implement. In this case, and given the disruptions floating rates can cause under high de facto dollarisation, some of these countries may decide that they are better off maintaining a stable exchange rate vis-a-vis the dollar. But with soft currency pegs not being sustainable under conditions of high capital mobility, they may be left with three basic options: official dollarisation, a dollar-based CBA and monetary union with the US. As the collapse of the Argentinean CBA shows, however, CBAs are also vulnerable to speculative attacks, particularly if they are not supported by appropriate policies. Moreover, under the strict reserve-backing rules of the CBA, these attacks lead to a shrinking monetary base and higher interest rates, which slows down economic activity and puts strains on the banking system. (15) While CBAs have a number of advantages over official dollarisation (the country maintains its own currency, which may be considered politically important, does not lose its seigniorage revenues and retains an exit option), they have the same disadvantages in terms of rigidity (loss of the exchange rate as an adjustment instrument) and the loss of the lender-of-last-resort role of the central bank without however providing the advantage of eliminating the possibility of currency crises. And, in any case, after the negative experience of Argentina with its CBA, there seems to be little support in Latin America for this type of regime nowadays. If dedollarisation fails, therefore, some highly dollarised countries in Latin America may end up considering official dollarisation or monetary union with the US.
For countries suffering from a deeply entrenched lack of monetary credibility, it may be worth adopting a regime that will allow them to import anti-inflationary reputation from a foreign central bank with well-established anti-inflationary credentials. This could in principle be done by adopting any type of strong and credible peg vis-a-vis the currency issued by a reputable central bank. However, given the problems with adjustable currency pegs and the recent experience with the Argentinean CBA, the most obvious options open to Latin American countries wanting to import monetary credibility and stability from abroad are the adoption of a hard currency as legal tender and the participation in a monetary union with a large strong-currency country. (16)
The Argentinean debacle illustrates well the challenges a country may face when it is experiencing a credibility problem. Argentinean governments have altered so frequently the monetary regime, sometimes making contradictory announcements, freezing bank deposits, forcibly converting deposits and loans into pesos at non-market exchange rates and defaulting on their debt obligations, that they are perceived to have seriously damaged their credibility. Some argue that, under these circumstances, even the best-conceived monetary regime is unlikely to be credible for as long as the authorities maintain discretionary power over it and that, therefore, only the effective transfer of monetary control to a reputable outside institution will restore credibility. (17)
The problem of insufficient monetary credibility in Latin America is not limited to Argentina, however. For decades, many countries in the region have suffered from recurrent episodes of high inflation and macroeconomic and political instability. In fact, Latin America is the developing country region that has shown, by far, the highest average inflation rate and inflation volatility in recent decades (Alesina et al., 2002). Latin American countries may, therefore, be seen as likely candidates for the adoption of currency regimes aimed at importing monetary credibility from abroad.
Importing credibility from the German Bundesbank was one important reason why most EU countries decided to join the EMS and, eventually, the euro area. With the exception of NAFTA, however, none of the regions under analysis includes a large country with a solid track record of monetary stability from which credibility could be 'imported'. This is a key difference with the euro zone and a serious drawback of those proposals that aim at establishing monetary unions a la EMU in some of the Latin American regions. It is believed that one reason why Argentina and Brazil are currently toying with the idea of a common currency is the possible interest of the Argentinean government in increasing the credibility of its new floating regime by being part of a Mercosur monetary union. However, despite the stabilisation progress achieved by Brazil since 1999 and Argentina's current low level of credibility, it is unlikely that Argentina would be able to import much credibility from such a monetary union.
Within the American continent, the only country from which Latin American countries could realistically import anti-inflationary credibility is the US. The two dollar-based regimes with which those credibility gains could be larger are a monetary union with the US and official dollarisation. While the first option would have the advantage of allowing the country in question to participate in the Federal Reserve's decision-making bodies, access its discount window and be covered by the US financial supervision system, it might not enjoy the political backing of the US. Official dollarisation, by contrast, could be decided unilaterally, although it would seem preferable to do it in agreement with the US in the context of a bilateral monetary treaty that may grant certain privileges to the dollarising economies, such as the sharing by the US of its related seigniorage gains.
The possible credibility gains from monetary union with the US or official dollarisation, and the advantages of stabilising the exchange rate and eliminating currency crisis, must be set against the costs of these regimes, in particular the loss of the exchange rate instrument and the difficulties to exit these regimes should economic developments diverge too much from those in the anchor country. In the case of official dollarisation, there are in addition, as noted, the costs of losing the lender of last resort and seigniorage revenues. (18)
Latin American countries in search of borrowed credibility could also in theory adopt the euro as legal tender or temporarily adopt a hard peg to the euro or to a basket of currencies including the euro and the dollar. While the European Central Bank's track record is shorter than that of the US Federal Reserve, its statutory independence and goals, the prudent fiscal framework provided by the EU's Stability and Growth Pact, and the reputation it has inherited from the Bundesbank make it a similarly credible institution. Moreover, it could be argued that, whatever their absolute merits, euro-based exchange rate regimes (or a peg to a dollar-euro basket) make in fact more sense than dollar-based regimes for countries that, like the Mercosur countries, trade more with the EU than with the US. When comparing the relative merits of euroisation and dollarisation, however, it should be noted that dollarisation would have the advantage of building on the existing high degree of de facto dollarisation in Latin America. From a practical point of view, euroisation would be more complicated because Latin American countries are not euroised but dollarised. It would require to convert a larger share of the stock of currency in circulation and to change the currency of denomination of a much larger stock of financial assets and contracts. Moreover, even though the euro is regarded as a strong and trustworthy currency, the success in convincing the local population to switch from the dollar (and the domestic currency) to the euro would not be guaranteed.
Another limitation of the analysis based on the traditional OCA criteria is that it does not take into account the fact that monetary integration may, by itself, trigger changes in the structure of the participating economies that will move them closer to meeting the OCA criteria. In other words, even if a country fails to meet ex ante the criteria for joining a currency area, it may meet them ex post. In particular, participation in the currency union may deepen trade and financial integration and increase the correlation between the business cycles of the country in question and the currency area. There is some empirical evidence supporting this view. (19) According to some economists, however, the opposite may also be true: an area may fail to meet ex post the OCA criteria even if it met them ex ante. (20)
In the context of the dollarisation debate, some economists have indicated that official dollarisation should trigger structural reforms or changes that will tend to reduce the costs of dollarisation. Thus, for example, the loss of the lender of last resort could reduce moral hazard effects on banks from the expectation of a bailout by the central bank. Also, full dollarisation may strengthen banks by eliminating currency mismatches in the private sector and the risk of banking crises provoked by currency crises. Finally, full dollarisation, like formal currency unions, may increase trade and financial integration with the US because it eliminates transaction costs related to currency conversion and the hedging of currency risk and because it increases the links with US banks and capital markets. (21) Eichengreen (2002), however, takes a more sceptical view about the endogenous forces that official dollarisation might set in motion, concluding that it should be preceded by reforms aimed at limiting its costs.
Trade interdependence reconsidered
Finally, another refinement of the analysis in the previous section consists of extending the trade interdependence criterion to include not only intra-regional trade but also the share of trade conducted with the main trading partner from outside the region, which for the regions under analysis is either the US (CACM and Andean Community) or the EU (Mercosur and NAFTA). The argument is that if a region trades extensively with an external partner (or other countries using its currency), its combined share of trade with that country and intra-regional trade may be high enough to justify the adoption of that partner's currency even though intra-regional trade might be too low for the region to adopt its own common currency. (22) Obviously, this would only make sense if that trading partner issues a strong and stable currency, which is true for the four regions considered. In the case of NAFTA, however, since its member countries trade predominantly among themselves and already include a country with a solid anti-inflationary reputation like the US, the adoption of the currency of the main external trading partner (the EU) would not be in principle advantageous and, therefore, the enlargement of the trade interdependence criterion is not relevant.
As discussed in the previous section, Central American countries do not trade enough among themselves to justify a monetary union. These countries conduct, however, about 45 percent of their trade with US. If they were to jointly adopt the dollar as their currency, therefore, they would be stabilising their exchange rates against a group of trading partners (their CACM neighbours and the US) accounting for over 60 percent of their foreign trade. And since the CACM economies are very open, this would represent 26 percent of their GDP, a share that is well above the average share of GDP euro-area countries trade with each other (see Table 2). These ratios could be significantly higher if intra-CACM trade continued to recover or if Mexico, with which the CACM countries trade substantially, and Canada were to join the dollar area someday.
Given the high share of GDP Central American countries trade with the US and each other, their high degree of de facto or official dollarisation, the weak credibility of monetary institutions in some of them, and their significant labour mobility vis-a-vis the US, joint dollarisation (or other forms of dollar-based monetary integration) may make some sense for these countries despite their poor scoring in some of the OCA criteria. Central American countries would benefit from importing monetary stability from the US. (23) Moreover, the elimination of exchange rate volatility would probably set in train endogenous processes that, over the medium term, would increase integration both within the CACM and between the CACM and the US. Trade between the CACM and the US would also increase if the plan, currently under negotiation, to sign an FTA between the two areas went ahead.
The Andean Community countries, taken as a group, also trade predominantly with the US. However, because they show even weaker mutual trade links and a much lower degree of openness than the CACM countries, their trade with the US and Andean partners combined only accounts for 12 percent of their GDP. Jointly adopting the dollar would, therefore, not stabilise the region's exchange rate against a sufficiently significant part of its GDP. Despite this, some economists have noted that Ecuador's decision to officially dollarise, the very high rates of de facto dollarisation of Bolivia and Peru, and the widespread need to build up monetary credibility in the region provide strong arguments in favour of joint dollarisation. However, a closer examination reveals that, while Peru and Bolivia are very highly dollarised, their trade with the US represents a small proportion of their GDPs. These considerations, and the poor scoring of the Andean Community in most of the OCA criteria, seriously limit the attractiveness for this region of dollar-based monetary integration.
In the case of Mercosur, the extension of the trade interdependence criterion is much less relevant because this region conducts less than 20 percent of its trade with its main trading partner (the EU). Since most Mercosur economies are also very closed, their trade with the EU and their intra-regional trade combined only represent 9 percent of their GDP. The joint adoption of the euro by Mercosur countries would, therefore, not stabilise their exchange rates vis-a-vis a sufficiently important share of their GDP. The high rate of dollarisation of Argentina and Uruguay and Argentina's credibility problems have sometimes been used as an argument in favour of joint official dollarisation in Mercosur. However, the highly dollarised countries in Mercosur only conduct between 10 and 15 percent of their trade with the US. As illustrated by Argentina's dollar pegging under the CBA, full dollarisation would therefore subject their effective exchange rates to substantial fluctuations. Moreover, Brazil's low level of dollarisation, the closed nature of its economy and its strong trade connections with Europe all argue against official dollarisation in Brazil and in favour of maintaining its flexible exchange rate regime. This regime, which like the Mexican one has been combined with an inflation targeting regime, has served Brazil well, allowing it to reduce inflation markedly since 1999 without preventing a significant expansion of economic activity and providing the authorities with a useful buffer during the Argentinean crisis.
The Brazilian authorities are keen to maintain this exchange rate flexibility and seem right to do so. Brazil may be interested in allowing their Mercosur partners to join its floating regime through a currency union. This would eliminate intra-Mercosur exchange rate disruptions without affecting Brazil's flexibility vis-a-vis the rest of the world. However, Brazil is likely to oppose any monetary integration plan for Mercosur that limits that flexibility. Even the possibility of pegging a common Mercosur currency (or the four Mercosur currencies jointly) to a basket of currencies including the dollar and the euro is likely to be opposed by Brazil because, although this would ensure some stability of its effective exchange rate, it would remove Brazil's desired room for using the exchange rate as an adjustment instrument. Moreover, given the strength and volatility of international capital flows into the Mercosur countries, this type of pegging systems is, as noted, likely to be subject to periodic attacks and realignments. (24) As Mercosur trade is proportionally much less important for Brazil than for Argentina, Paraguay and Uruguay, Brazil is much less concerned about intra-Mercosur exchange rate volatility than its Mercosur partners and, therefore, is probably not willing to sacrifice its exchange rate flexibility vis-a-vis the rest of the world for the sake of ensuring exchange rate stability within Mercosur.
This leaves Mercosur for the time being with a floating common currency as the only monetary integration option that could enjoy political support from all its member countries. Unfortunately, such a regime may create serious problems for Argentina and Uruguay due to their high degree of dollarisation, unless these countries succeed in repesifying their economies.
SUMMARY AND CONCLUSIONS
This paper has examined whether it makes sense to consider monetary integration in any of the four main American regions of integration. The analysis based on the traditional OCA criteria suggests that Central America, the Andean Community and Mercosur are not OCAs. In particular, their trade, financial and labour market integration remains low, the likelihood of asymmetric shocks high and none of these regions has established a system of intra-regional fiscal transfers that could be used to smooth out asymmetric disturbances. Furthermore, despite the macroeconomic coordination schemes put in place, these regions continue to show a high degree of macroeconomic divergence and volatility. And their political integration and commitment to the integration project are still weak.
Based on these criteria, therefore, none of these three regions should engage in monetary integration, at least not for the time being. Rather, they should concentrate on deepening their integration and macroeconomic convergence. They should, in particular, not try to stabilise intra-regional exchange rates through adjustable pegging systems because, although they have not achieved much intra-regional financial sector integration, they exhibit a high degree of overall financial openness. Their capital account regulations are very liberal and they have experienced since the early 1990s very powerful and volatile capital inflows. In this context, and given these countries' weak institutional commitments, these systems are likely to be very vulnerable to speculative attacks.
The case of NAFTA is less clear-cut. The Canadian and Mexican economies are highly integrated with the US and, despite the existence of legal restrictions, labour mobility between Mexico and the US has de facto been high. Moreover, NAFTA countries can boast substantial macroeconomic stability and convergence. On the other hand, they show a high incidence of asymmetric shocks, have not set up any mechanism of intra-regional fiscal transfers and have until now expressed little political support for monetary integration.
The traditional OCA theory, however, does not take into account some relevant aspects underlined by the recent literature. First, the existence of a high degree of de facto dollarisation, the hysteresis that characterises currency substitution processes and the problems floating exchange rates pose for highly dollarised economies have led some authors to propose the joint adoption of the dollar as a monetary integration strategy for at least some American regions.
Second, given their inflationary history and lack of solid monetary institutions, many Latin American countries would benefit from importing monetary credibility from a large and stable country. Unfortunately, among the regions examined, only NAFTA contains such a country. This reinforces the case for a monetary integration in NAFTA based on the adoption of the dollar and further reduces the case for a classical approach to monetary integration in the other three regions. At the same time, however, it provides an argument in favour of the adoption by these three regions of the dollar or the euro as a strategy for simultaneously importing monetary stability and achieving monetary integration.
Third, the consideration of possible endogenous forces tends to improve the assessment of the advisability of any regional monetary integration proposal for Latin America.
Finally, although intra-regional trade in the areas examined is, with the exception of NAFTA, insufficient to justify monetary integration, in the case of the Central American countries trade with the US is so important and the economies are so open that a joint adoption of the dollar (or a joint pegging to the dollar) would stabilise the region's exchange rate vis-a-vis a very important share of the region's GDP. Coupled with the high degree of dollarisation of these countries, the frailty of monetary institutions in some of them and their significant labour mobility towards the US, this suggests that dollar-based monetary integration may make economic sense for the CACM.
Although some of the economies in the Andean Community and Mercosur are also highly dollarised and suffer from deeply entrenched credibility problems, the share of GDP these regions trade with the US is too low to justify a joint adoption of, or joint pegging to, the dollar. Mercosur trades in fact more with the EU than with the US, although not enough to make the adoption of the euro a reasonable proposition either. Moreover, Brazil, the largest commercial power in South America, is unlikely to show much interest in dollar-based monetary integration or, for that matter, any monetary integration plan that does not preserve its exchange rate flexibility vis-a-vis the rest of the world.
The situation in Mercosur, however, is not that simple because Argentina's credibility problems and the possible resistance of its population to abandon the use of the dollar as parallel currency may lead this country to end up embracing official dollarisation unilaterally as a way to re-establish monetary order, which could have similar implications for Uruguay, another highly dollarised economy suffering a serious financial crisis. It is still too soon to tell whether Argentina's de-dollarisation programme will succeed. If it does, Mercosur may one day decide to issue a common currency and let it float vis-a-vis the rest of the world. If Argentina's repesification strategy fails and the country ends up dollarising, by contrast, monetary integration within Mercosur is likely to be postponed indefinitely because Brazil will not want to also dollarise. Whatever the final outcome of the Argentinean crisis, the analysis in this paper suggests that, unless Mercosur's integration deepens importantly, the economic arguments for adopting a common currency in Mercosur will remain weak.
Table 1: Macroeconomic convergence targets and reference parameters CACM (a) Andean Community Mercosur Maximum annual 9 Single digit by For 2002-2005, 5% inflation rate (%) December 2002 for headline inflation; from 2006 onwards, 4% for headline inflation and 3% for core inflation (b) Ceiling on public 2.5 3% of GDP by 2002, 3.5% for 2002-2003 sector deficit but could be and 3% from 2004 (% of GDP) raised to 4% in onwards 2002-2004 Ceiling on public 50 50% by 2015 40 % by 2010, but debt (% of GDP) convergence paths must be defined from 2005 onwards Average real 9 interest rate (end-of-year) (%) Annual real 5 GDP growth (%) Real exchange rate 90-110 index (December 1997-100) Net international 100 reserves of the central bank in percent of monetary base Maximum current 3.5 account deficit (% of GDP) (a) Reference parameters for 2001. (b) Paraguay has been allowed to converge towards the targets for 2006 in a more gradual way. Sources: Consejo Monetario Centroamericano (2002), Andean Community (2001) and Mercosur (2000) Table 2: Trade interdependence, 2000 (average of exports and imports--as a percentage of GDP) Trade conducted with: Openness Rest of the subregion US EU Andean Community 20.1 3.1 9.3 3.5 Bolivia 16.7 2.7 3.8 2.9 Colombia 15.2 2.3 6.4 2.7 Ecuador 35.2 5.5 12.3 6.4 Peru 13.2 1.2 3.8 2.8 Venezuela 20.2 1.2 9.4 1.6 Central America 45.5 5.8 20.3 4.5 Costa Rica 38.7 3.7 19.1 9.4 El Salvador 28.8 5.7 14.1 3.1 Guatemala 26.9 3.9 12.0 2.3 Honduras 77.1 5.7 48.7 4.6 Nicaragua 55.9 14.1 20.0 5.0 Panama 21.7 1.8 7.7 2.4 Mercosur 14.5 6.1 2.0 2.6 Argentina 9.1 2.8 1.4 1.9 Brazil 9.4 1.3 2.2 2.4 Paraguay 25.1 14.0 3.1 3.4 Uruguay 14.4 6.3 1.3 2.5 NAFTA 25.3 18.7 -- 2.2 Canada 36.1 28.4 27.7 2.6 Mexico 29.7 24.6 24.0 1.9 United States 10.2 3.3 0.0 2.0 Memorandum item Euro area (a) 35.4 19.5 (a) Simple average of the ratios euro-area countries showed in 1998. Sources: Direction of Trade Statistics Yearbook, 2001, IMF and Eurostat Table 3: Rates of migration in Latin America, 1990 (a) Andean Community 1.0 Mercosur 0.5 Central America 3.7 of which: Costa Rica 1.4 El Salvador 8.3 Guatemala 2.6 Honduras 2.3 Nicaragua 4.6 Panama 3.3 Mexico 4.5 Memorandum item Latin America 2.0 (a) Stock of migrants to other American countries in percent of the population of the country of origin. Source: ECLAC Table 4: Macroeconomic convergence indicators (a) (in percent) Fiscal deficit/GDP (b) 1999 2000 2001 Andean Community -3.8 -1.1 -3.5 Central America -3.3 -3.7 -5.2 Mercosur -5.4 -4.1 -3.9 NAFTA -1.3 0.4 -0.2 Memorandum item Euro area (1998) (d) -2.1 Public debt/GDP 1999 2000 2001 Andean Community 62.0 55.4 54.8 Central America 95.0 93.7 94.3 Mercosur 42.3 44.8 48.5 NAFTA 58.2 53.0 50.7 Memorandum item Euro area (1998) (d) 73.4 Inflation (c) 1999 2000 2001 Andean Community 19.3 24.0 8.6 Central America 5.6 6.2 5.9 Mercosur 4.2 4.8 4.6 NAFTA 5.9 5.2 2.2 Memorandum item Euro area (1998) (d) 1.1 (a) For the regions, simple averages of the indicators of their member countries. (b) For most countries, deficit of the consolidated public sector. (c) End of period rates. (d) For inflation, Harmonised Index of Consumer Prices published by the European Central Bank. Sources: IMF, European Commission, European Central Bank and national authorities Table 5: Macroeconomic dispersion indices, 2001 (standard deviation of member countries' values) Fiscal deficit/GDP Public debt/GDP Inflation Andean Community 2.9 15.9 8.2 Central America 4.3 98.2 4.0 Mercosur 2.1 9.3 3.9 NAFTA 2.6 8.1 1.6 Memorandum item Euro area (1998) 2.1 30.4 1.0 Sources: Author's calculations based on data from the IMF, the European Commission and the national authorities Table 6: Rates of dollarisation in Central America (in percent) Share of the dollar in Share of foreign currency assets in M2 public debt 1995 1996 1997 1998 1999 2000 2001 1998 Costa Rica 32.6 33.5 34.9 38.9 40.0 40.7 44.3 45.1 El Salvador 4.7 6.0 7.6 7.9 8.0 8.3 81.4 57.2 Guatemala n.a. n.a. n.a. n.a. n.a. n.a. 2.5 84.7 Honduras 16.2 23.4 21.3 22.1 22.9 24.2 28.1 91.9 Nicaragua 54.7 60.3 61.4 64.6 63.1 65.6 66.6 n.a. Simple average 27.0 30.8 31.3 33.4 33.5 34.7 55.1 69.7 for the region excl. Panama Sources: Consejo Monetario Centroamericano. For public debt data, Stein et al. (1999)
(1) Paper presented at the 8th Dubrovnik Conference on 'Monetary Policy and Currency Substitution' organised by the Croatian National Bank, Cavtat, 27-29 June 2002. The views expressed are the author's only and should not be attributed to the European Commission.
(2) For a discussion of the relevance for Latin America of the EU's experience with Economic and Monetary Union (EMU), see Temprano-Arroyo (2002).
(3) See Giambiagi (1997), Lavagna and Giambiagi (1998) and Eichengreen (1998). The idea of a common Mercosur currency was first suggested by the former Argentine president, Carlos Menem, at the Mercosur presidential summit of April 1997. Subsequently, following the crisis of the Brazilian real of early 1999, president Menem also suggested the possibility of a joint official dollarisation by all the Mercosur countries (see below).
(4) For a vigorous presentation of the arguments in favour of maintaining Canada's floating exchange rate regime, see Laidler (1999) and Murray (1999).
(5) The crisis experienced by the European Monetary System in the early 1990s provides a clear warning in this respect (see Temprano-Arroyo, 2002).
(6) Although there are some minor cases of bank interpenetration between Argentina and Brazil, most acquisitions of local banks in Mercosur have been undertaken by OECD countries. See Levy-Yeyati and Sturzenegger (2000a).
(7) For Colombia, see Barajas et al. (1999).
(8) See, for example, the studies by Marquez (1997) and Galiani and Nickell (1998), which compare labour market rigidity in Latin America with that of developed countries.
(9) Gavin et al. (1996) argue that these factors interact in a negative way to produce a vicious circle.
(10) For a discussion of the experience of Panama with official dollarisation, see Moreno-Villalaz (1999).
(11) For example, Levy-Yeyati and Sturzenegger (2000b) suggest this possibility for Mercosur, and Stein et al. (1999) and Berg et al. (2002) for Central America. Barro (1999) and Hausmann (1999) propose official dollarisation for the entire American continent.
(12) See US Senate (1999a). In November 1999, two US senators introduced a legislative proposal to encourage full dollarisation in emerging markets through the possibility of sharing seigniorage revenues with the dollarising economies, but this proposal was never formally discussed by Congress (see US Senate, 1999b,c).
(13) The persistence and high rates of dollarisation in Uruguay are partly explained by the role its banking system has traditionally played as an off-shore safe haven for residents of other countries in the region.
(14) They may also exacerbate the process of disintermediation from the domestic financial system and reduce the country's international reserves.
(15) During the 1990s, the Argentinean CBA suffered this type of problem several times as a result of contagion effects from the Mexican, Brazilian and other emerging market crises.
(16) The issue of importing credibility has figured prominently in the recent literature on exchange rate regimes. For a formal incorporation of this criterion into a model of OCAs, see Alesina and Barro (2000).
(17) See, for example, Sachs (2002), referring to the Argentinean crisis.
(18) For a comprehensive analysis of the pros and cons of official dollarisation, see Berg and Borensztein (2000).
(19) See, in particular, Frankel and Rose (1998) and Rose (1999). Also, empirical studies show that bordering US and Canadian states are significantly less integrated with one another than the US states despite the virtual absence of tariff and other barriers to trade, suggesting that the existence of separate currencies can have a non-negligible impact on trade integration (see McCallum, 1995).
(20) Krugman (1993) and Bayoumi and Eichengreen (1994) have argued that participation in a currency area may encourage productive specialisation, making its member countries more vulnerable to region-specific shocks.
(21) Parsley and Wei (2001) find that official dollarisation and CBAs promote goods market integration far beyond what is associated with exchange rate stability alone.
(22) This could also provide a justification for jointly pegging the currencies of the members of the region against that of their main external trading partner. However, given the problems with intermediate pegs and the negative experience with Argentina's CBA, this section focuses on the possible adoption by the region of the currency of the main trading partner (either unilaterally or in the context of a monetary union).
(23) This view is shared, for example, by Stein et al. (1999), who also show that those Central American countries that had less flexible exchange rates during the 1990s tended to have lower and less volatile inflation and interest rates and a less volatile real exchange rate.
(24) On this point, see also Eichengreen (1998).
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