The Euro and Trade: Is there a Positive Effect?

1. The Euro and Trade: Is there a Positive Effect? Tamara Gomes Chris Graham John Helliwell (UBC) Takashi Kano John Murray Lawrence Schembri International Department Bank of Canada April 2006 For presentation at the 2006 EUSA Economics Interest Section Workshop: Whither EU Integration and Cooperation?, 28 April 2006. The views expressed in this paper are those of the authors and not the Bank of Canada.

2. Introduction & Motivation • Several recent studies examine the impact of euro on intra-EMU trade & majority find small positive effect • Outburst of research reflects 2 factors: • Issue’s importance for prospective EMU members • EMU is a natural experiment to test result of Rose (2000): -> A common currency between two countries has a HUGE (300% -> 60%) effect on bilateral trade. -> The EU15 consisted of: 12 EMU members [Core: Germany, France, Netherlands, Italy, Belgium/Luxembourg, Austria;Periphery: Portugal, Spain, Ireland, Finland, Greece] & 3 nonEMU members (U.K., Sweden & Denmark)

3. Purpose • To probe the robustness of the results of Micco, Stein & Ordonez (Economic Policy 2003) • MSO (2003) find a significantly positive impact of roughly 5%-10% with only 4 years of data (2002 is an estimate) • Issue #1: Their evidence that euro “caused” trade is not convincing • Issue #2: They typically find that that euro had a bigger impact on trade than trade liberalization via EEC/EU in Europe -> MSO (2003) is unable to disentangle the two effects

4. What is the Bank of Canada’s interest? • Ongoing debate on adopting a common currency with the U.S. • Choice set: Status quo (clean float + inflation targeting) versus unilateral dollarization (+ some aspects of a monetary union) • Other options: fixed ER, currency board, “amero” are not feasible nor desirable • We want to better understand the benefits & costs of a common currency • Canada faces the traditional trade-off between macroeconomic stability (commodity exporter) versus micro-efficiency gains • The increase in trade from a common currency was thought to be small (< 0.5% of GDP). The Rose & borders results raise doubts.

5. Our Hypotheses • Hypothesis #1: The EMU joiners were committed to increased European integration & trade: -> thus, trade “caused” euro – (fundamental endogeneity problem) • Hypothesis #2: “Two track” approach to European integration; integrate at different speeds -> “fast track”EMU joiners – the core 7 and the periphery 5, each group has different incentives, but are committed to integration -> “slow track” EMU nonjoiners; affluent periphery countries; their incentives to integrate quickly are not as strong

6. What do we do? • We start with the MSO specification of the gravity model: where Tij is real bilateral trade (imports & exports) between countries i and j Y is real GDP in each country FTA is a dummy variable for membership in a free trade area EU is a dummy variable for EU/EEC members EUTREND - ongoing liberalization within the EU RER is the real ER between each country & the US

7. What do we do? (continued) • Extend the MSO sample forward to 2003 & backward to 1980. • Insert annual EMU dummies to determine when “EMU” effect actually began. • Insert annual & trend dummies for EU members that do not join the EMU to “test” the hypothesis trade -> euro • The paper also includes an extensive literature review Data Notes: • Two samples: developed countries (EU15 + Japan, Canada, Switzerland, Norway, U.S., Australia, New Zealand ) & EU15

22. Concluding Remarks: Key Findings • The key empirical results of the paper are: • Replicate key MSO findings: • a positive effect of the euro on intra-EMU trade & little effect of membership in an FTA, the EU or ongoing EU integration • Using 1980-2003 sample, the apparent effect of the euro on intra-EMU trade began in 1986 or 1987, well before 1999 & found greater impact of EU • By allowing for different trends in trade integration, we find evidence consistent with the “two track” hypothesis

23. Concluding Remarks: Reconciling Results • How do we reconcile conflicting findings in MSO and our study? The endogeneity of EMU(self) selection! • The core & periphery countries that adopted the euro were committed to European economic (& political) integration, but for different reasons Core EMU countries wanted economic integration to further political integration Periphery EMU countries economic integration to accelerate economic development • Thus, the adoption of the euro was but one of a host of other ongoing measures that these countries adopted to facilitate integration and trade

24. Graph: EU Trade Integration Trade Integration EMU Joiners 1999 2005 1980 1987 EMU Non-joiners

25. Concluding Remarks: Reconciling Results • Three nonjoiners (esp. UK & Sweden) did not face same incentives & were not as committed • Their level of trade with the rest of EU was always lower • The UK joined the EEC in 1973 and, apart from a tumultuous period in the early 1990s, never participated in the ER systems • Sweden joined the EU in 1995

26. Bottom Line • EMU dummy is a proxy for commitment to European integration & not a measure the impact of a common currency per se Next Steps in Research Program • Further research into the level of commitment • Try to better understand decision to adopt or not adopt the euro