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Does Currency Union Increase Intra-regional Trade?
A Study on Euro
Shahriar Kabir
and
Sarwar R Chowdhury
The journey of the European cooperation started in 1951 with the
European Coal and Steel Community (ECSC). In 1999, after a long
journey of almost 50 years, European Union has successfully
implemented their common currency, Euro. The ultimate success of
European cooperation is not just implementation of Euro. The success
depends on the positive short-term and the long-term effects of Euro.
This paper estimates the short-term effects in terms of intra-regional
trade by comparing the post-Euro intra-regional trade with the pre-Euro
intra-regional trade. The overall finding of trade enhancement is 1.17
times of pre-union intra-regional trade.
Key Words: Currency Union, Intra-regional Trade, Trade Deepening
1. Introduction
The journey of the European cooperation started in 1951 through the European Coal
and Steel Community (ECSC). ECSC had six members- Belgium, West Germany,
Luxembourg, France, Italy and the Netherlands. In 1957, these six members formed
the European Atomic Energy Community (EURATOM) and the European Economic
Community (EEC) for further integration. At this stage, the members agreed on
removing trade barriers. In 1967, the three European communities were combined
together to form a single Commission. The European Parliament was developed as
the governing body of the Commission. With the light of the Maastricht Treaty, the
existing "Community" system was transformed into the European Union (EU) in
1992. As a result, membership in the organization increased from six to twenty five
by the year 2004. In parallel to dealing with intra-regional economy and policy
integration, the EU negotiates major trade and aid agreements with other countries.
The Union is developing a Common Foreign and Security Policy.
_______________
Department of Business Administration, The University of Asia Pacific (UAP), Dhaka, Bangladesh
Formation of Single Market at the end of 1992 by the EU members removed all the
trade barriers and ensured free movement of goods, services, people and capital
among the members. In the same year, the EU members decided to establish an
economic and monetary union (EMU) and to introduce a single European currency
managed by the European Central Bank (ECB). The purpose of the EMU is to bring
about the effective economic integration of EU members. The major motive of the
Integration is to promote growth and prosperity.
The single currency, Euro, was launched in 1999 as a result of successful regional
economic integration. ECB was given total authority to controlling the regional
monetary policy. In January 2002, twelve of the EU members replaced their national
currencies by Euro notes and coins. Euro reduces the cost of intra-regional business
and increases competition. Competition and comparability in turn lower the prices.
The cost of transferring money across the borders of Euro members reduces as well.
Moreover, the Euro has achieved recognition as an international currency and is
used for commercial transactions outside the Euro area. Central banks around the
world use the Euro as a reserve currency. Hence, the risk Euro faces as a currency
with regards to business has also reduced.
From the study of post-Euro situation, this paper aims to find the answer for the
following questions:
i.
Does Euro increase the trade among member countries?
ii.
How much additional intra-regional trade occurs with Euro?
iii.
What is the effect of the currency union on intra-regional trade deepening
(trade over GDP) in Euroland?
Rest of the paper is organized as follows: section 2 discusses the previous literature;
section 3 describes the model, section 4 explains the analysis and the findings while
concluding remarks are provided in the last section.
2. Literature Review
According to the OCA theory, there are some important criteria to be considered for
a regional currency union. These criteria include „symmetry of shocks across
countries‟, „trade and financial integration‟, and „labor mobility and wage flexibility‟
(Lee, Shin and Park, 2004). Some of the significant cases regarding currency union
are pointed out by Frankel and Rose (2002). The most substantial one was forming
the Euro by twelve European countries in 1999. Besides Ecuador abandoned their
national currency and went for dollarization in 2000 followed by El Salvador in 2001.
Hong Kong and Argentina tied their currency to the American dollar through currency
board schemes successively in 1984 and 1991. Recent formation of currency board
is done by Estonia, Lithuania, Bulgaria, and Bosnia.
Regional economic coordination normally begins with the formation of free trade
agreements and ends with the adoption of a common currency (Madhur, 2002).
Some major factors for successful adoption of currenc y union are the economic
costs and benefits of the member countries. The key economic cost for a currency
union is the loss of national autonomy on monetary policy (Madhur, 2002). On the
other hand, the major benefit of currency union is the reduction of transaction costs
in cross-border businesses and eliminating exchange rates volatility across the
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region (Madhur, 2002). This phenomenon increases the facilities for trade and
investment among the nations of the union. As a result, economic activities increase
within the region. A currency is like a language (Alesina and Barro, 2002). As a
common language helps in successful communication, a common currency benefits
trade and investment among countries (Madhur, 2002). It enhances intra-regional
economic growth.
Some economists argue that the primary effect of a currency union is reduction in
inflation. Frankel and Rose (2002) also mentioned currency union as a timeconsistent monetary policy followed by the members to maintain low inflation.
Conversely they wondered that beside the benefits of lower inflation, some costs
also exist regarding microeconomic stability. These costs are larger if the shocks of
the member countries are poorly correlated.
According to Mundell (1961), the major cost for a currency union is giving up an
independent monetary policy. This cost can be measured using asymmetric shocks
across the member countries (Lee, Shin and Park, 2004). Symmetric shocks are
usually measured by a correlation between countries. Under this system, an anc hor
country is chosen from the region. The correlation is calculated between the anchor
country and any other country in the region.
Different types of costs exist in international trade and commerce. Two of the major
costs are transaction cost and information retrieving cost (Madhur, 2002). These
costs reduce capital movement across borders. Moreover, under flexible exchange
rate regimes, exchange rates are more volatile than is warranted by the economic
fundamentals of an economy (Rose 1994, Williamson 1999, Bergsten and Henning
1996, Collignon 1999). This situation is risky for developing nations which have large
unhedged foreign currency liabilities (Madhur, 2002). Any strong economic shock in
the world market can create critical economic crisis for the nations with unhedged
liabilities. Besides, Currency risk is a major factor in cross-border trade. A regional
common currency offers the opportunity to eliminate the currency risk.
A flexible exchange rate is expected to act as a „shock absorber‟. In c ontrast,
“Market errors” and the consequent misalignments in exchange rates under floating
exchange rate regimes have been substantial (Breur, 1994). Disproportionate
volatility in exchange rates increases uncertainty, discourages trade, diminishes
investments, and reduces overall economic growth (Kenen and Rodrik, 1986,
Huizinga, 1994 and Corbo and Cox, 1995). Eventually, flexible exchange rate turns
out to be a „source of shocks‟ rather than a „shock absorber‟. Hedging removes the
instability arising from flexible exchange rates, equally increases the transaction
cost. A common currency diminishes some difficulties of a flexible exchange rate
system.
The optimum currency area (OCA) literature provides some guidelines for the
benefits of a currency union. These are referred as (i) greater flexibility in wages and
prices among the member countries, (ii) greater mobility of factors of production
(labor and capital) across countries, (iii) more symmetric shocks across countries,
(iv) more openness among the economies within the union, and (iv) larger share of
trade among the member nations (Madhur, 2002). This paper addresses the impact
of a currency union on intra-regional trade. Other anticipated effects of a currency
3
union such as capital flow, labor mobility and ability to absorb economic shocks are
outside the scope of this work.
3. Methodology
Glick and Rose (2002) estimated the common currency effect on trade using both a
time series and a cross-sectional variation. They also agreed on economically and
statistically significant effects of currency unions on trade. They took data of fifty
post-war years for a large number of countries. They discovered that over a hundred
pairs of countries dissolved their currency unions. They compared the trade before
and after the regime change and estimated the effect of a currency union on trade.
The result showed that bilateral trade between a pair of countries that have a
currency union is approximately double as compared to situation after the union is
dissolved.
Mundell (1961) described trade between common currency areas as cheaper and
easier than trade between nations with their own independent currency. Frankel and
Rose (2002) also found that common currency areas encourage trade and openness
by reducing the costs of international transactions. They used the gravity model to
estimate the negative effects of variations of the bilateral exchange rate on bilateral
trade. The size of the countries and the distance between the countries were
considered as important factors in this model. They concluded that the implication of
currency union enhances the trade. They estimated the incremental amount in trade
among members of currency union and proved that a common currency does not
affect the amount of trade with non-member countries. Consequently, the per capita
income for every member nation increases. They estimated that the per capita
income is increased by „one third of a percent‟ for every one percent increase in total
trade.
This research is relatively specific and has only one point of view. It evaluates the
impact of a currency union on intra-regional trade using the EU model. Event study
has been selected as the basic methodology of this paper. This methodology is
explained by Dasgupta, Laplante and Mamingi (1998). The methodology is described
with the assumption that the historical information is sufficiently capable to estimate
the effect of new information. The information is also referred to as event. The
method includes the following steps: (1) identification of the event of interest and
defining an event window (interval before and after the event), (2) selection of a set
of cases to include in the analysis, (3) prediction of a "normal" outcome during the
event window when the event is absent, (4) evaluation of the cumulative abnormal
outcome within the event window, (5) test for statistical significance of the cumulative
abnormal return.
The method is partly used in this paper. The implementation of EURO is selected as
the event with an interval of one year before and after the event. Trade data
represent the four EU members before and after the event window for the
implementation of the EURO. The total trade is then estimated as a percentage of
total GDP for the four countries over the observation period. The Euroland model for
this research consists of four European Union members, namely, France, Germany,
Italy and Spain. There are several reasons for selection of these four nations. Firstly,
all four members are neighboring countries. They had cross-border trade among
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them long before the currency union. Secondly, France, Germany and Italy are the
leading economic powers in the EU. The effect of the Euro is substantial on these
three countries. Thirdly, selection of a set of four sample countries gives the
computational expediency with greater accuracy.
The effect of EURO was calculated using the following equation:
E1
… … … (1)
F
E2
In equation 1, F denotes the trade enhancement factor. The trade enhancement
factor shows the effect of Euro on regional trade. E1 represents the trade as
percentage of GDP for the four European countries for pre-implementation of Euro
and E 2 represents the trade as percentage of GDP for these four countries for postimplementation of Euro. The factor trade as percentage of GDP can also be termed
as trade deepening. Equations for E1 and E 2 are given below:
E1
E2
Ti
… … … (2)
Gj
Tj
… … … (3)
Gj
Here T denotes the annual trade data and G denotes the annual data for GDP. i
ranges between 1994 and 1997 whereas j ranges between 2001 and 2003.
Statistical significance of the trade enhancement factor is tested using regression
with a dummy variable to denote the currency change intervention. The value of the
intervention dummy is set to unity for the post-Euro years, and to zero for the preEuro years. Regression analysis has an advantage over a simple t-test because of
the probability effect. The probability value shows the confidence level to reject the
null hypothesis.
4. Analysis and Result
In this research, trade and GDP information are taken from the secondary data
sources. Trade data of four European Union (EU) members, namely France,
Germany, Italy and Spain are taken from the United Nation (UN) trade database.
GDP for EU members have been collected from the IMF Financial Yearbook-2001
and OECD website.
All retrieved data were given in different terms of amounts and currencies. For the
simplicity of calculation, all data have been converted to billions of USD. GDP data
are real GDP at market rate. Purchasing power parity (ppp) data has not been
employed in this research.
4.1 Data Analysis
This research model uses the amount of trade as a percentage of GDP instead of
using the total amount of trade. The amount of trade is divided by the amount of
GDP. The calculation provides the amount of trade for a dollar of GDP which is
5
defined as trade deepening. The possible increase in trade for a dollar of GDP due
to the currency union is estimated from trade deepening.
Table 1: Trade as percentage of GDP for EU sample country
Pre-currency union
Post-currency union
1994
1995
1996
1997
Total
(199497)
2001
2002
2003
Total
(200103)
Export
2.67% 2.93% 2.92% 3.10%
2.91%
3.62%
3.54% 3.61%
3.59%
Import
2.56% 2.78% 2.74% 2.83%
2.73%
3.09%
2.99% 3.00%
3.02%
$1,219
$326
5.64%
6.72%
Total trade
(Value in
Billion USD)
Total trade
as % of
GDP
$259
$324
$326
$310
5.23% 5.71% 5.67% 5.93%
$344
$427
6.53% 6.61%
$1,097
6.61%
Source: Authors‟ calculation
Table 1 presents total trade over GDP for the four sample countries. An interval of
one year before and one year after the implementation of Euro is considered for the
evaluation of total trade over GDP. Since the European currency union was formed
in 1999, the data for the pre-currency union has been taken for the period of 1994 to
1997. The post-currency union data are taken from 2001 to 2003. The first two rows
represent the annual export and import as a percentage of GDP. The third row
provides the annual trade (combining export and import) for the four EU members
(France, Germany, Italy and Spain) in billion of USD. The fourth row represents the
annual trade as a percentage of GDP. The sixth column stands for the entire period
between 1994 and 1997. The column describes overall pre-currency union
performance of the four sample nations during the observation period. The last
column provides overall performance under the post-currency union environment
which includes the period of 2001 through 2003. The trade enhancement factor due
to Euro implementation is calculated for the four sample countries from the precurrency union trade deepening and the post-currency union trade deepening.
Total amount of trade as percentage of GDP before and after the currency union is
estimated for the Euroland model. Trade before the currency union is estimated at
5.64% of the total GDP. After the inception of a currency union, the amount of trade
increases to 6.61% of the total GDP. The difference between the two periods is
found to be 0.97%. Hence, for every dollar of GDP, implementation of the Euro has
increased the cross-border trade by 0.0097 dollars among these four members of
EU. The trade enhancement factor is estimated at 1.172 from the Euroland model.
Hence, increase in intra-regional trade deepening is almost 17.2 percent.
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4.2 Statistical Analysis
The probabilistic significance of the difference between trade for pre-currency union
and post-currency union is estimated for the Euroland. An intervention dummy
variable is used as the x variable and the annual trade deepening is used as the y
variable. Dummy variable has two values. Zero represents the years before the
currency union and unity represents the years after the currency union. Appendix 2
shows the result of the regression analysis. The null hypothesis (H 0) represents the
absence of difference in trade between pre-currency and post-currency union. The
alternative hypothesis (Ha) expects trade to be higher after the incorporation of a
currency union. The increase in trade is observed to be 0.97% or 0.0097. The Fstatistics value and p-value are reported as 30.12 and 0.00274 respectively. Hence,
the probability that we would observe this data if H 0 were true is 0.00274. It is highly
unlikely that we would arrive at this data if the H 0 were true. Therefore H 0 must not
be true. We reject H0 and conclude that the currency union intervention increases
intra-regional trade. A non-parametric test provides F-statistics value as 15 and the
p-value as 0.011724811, which also rejects the null hypothesis. The non-parametric
test gives a strong support to the regression analysis.
5. Conclusion and Recommendation
This research is performed with three perspectives: first, determination of increase of
trade among member countries after currency union; second, estimation of the
amount of additional intra-regional trade which occurred with Euro; and finally,
determination the effect of the currency union on intra-regional trade deepening
(trade over GDP) in Euroland. This paper finds significant positive response in every
perspective. The trade deepening of post-Euro is higher than the pre-Euro trade
deepening, while the estimated additional trade is 0.0097 dollars for every dollar of
GDP. Increase of intra-regional trade deepening is estimated as 17.2 percent.
The research demonstrates a positive impact of currency union on their intraregional trade. Formation of a common currency eliminates currency risk, transaction
costs and information costs. A currency union also increases specialization, FDI
inflows and reduces investment risk. Hence the economic activities increase and
result in more enhancement of intra-regional trade. Besides, the actual effect of the
currency union on trade is likely to be higher due to other effects which are not
considered in this paper. Our estimate is conservative, because, considerations of all
related factors are outside the scope of this work. The research concludes that a
common currency increases intra-regional trade. To that effect, an effective and
accurate future plan must be developed and implemented.
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Appendix 1:
Estimation Of Additional Intra-ASEAN Trade Due To Currency
Union
Total trade of sample countries before currency union = 5.64% of total GDP
Total trade of sample countries after currency union = 6.61% of total GDP
Increase in trade of sample countries due to currency union = 0.0661-0.0564
= 0.0097 dollar per dollar
of
GDP
Trade enhance factor = (6.61% / 5.64%) = 1.172131716
Appendix 2:
Inferential Statistical Test
A. Regression Analysis
Regression Input
Intervention
dummy (X)
0
0
0
0
1
1
1
Percentage of trade
(Y)
5.23
5.71
5.67
5.93
6.72
6.53
6.61
8
SUMMARY OUTPUT
Regression Statistics
Multiple R
0.9260843
R Square
0.8576322
Adjusted R Square
0.8291586
Standard Error
0.2349894
Observations
Coefficients
7
Standard
Error
t Stat
P-value
Intercept
5.635
0.117495 47.95962
7.44568E-08
X Variable 1
0.985
0.179476 5.488196
0.002740802
H0: (Trade/ GDP) post-currency union – (Trade/ GDP) pre-currency union= 0
Ha: (Trade/ GDP) post-currency union – (Trade/ GDP) pre-currency union > 0
Observation: (Trade/ GDP) post-currency union – (Trade/ GDP) pre-currency union= 0.97%
P-value= 0.00274 (<0.05)
Decision: Reject H0
Conclusion: Currency union is found to increase trade deepening.
B. Non-parametric test
Regression input:
Intervention dummy
(X)
0
0
0
0
1
1
1
Percentage of trade
(Y)
5.23
5.71
5.67
5.93
6.72
6.53
6.61
9
Rank
1
3
2
4
7
5
6
Summary output:
Regression Statistics
Multiple R
0.866025404
R Square
0.75
Adjusted R
Square
0.7
Standard Error
1.183215957
Observations
7
Coefficients
Standard
Error
Intercept
2.5
0.591608
4.225771 0.008281793
X Variable 1
3.5
0.903696
3.872983 0.011724811
t Stat
P-value
P-value= 0.011724811 (<0.05)
Decision: Reject H0
Conclusion: Currency union is found to increase trade deepening.
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