Currency Unions and
Foreign Trade
Anders Mølgaard Pedersen, Economics
Introduction
Recent years have seen growing interest in how currency unions affect the participating countries' foreign trade. According to new studies, a currency union may considerably boost trade among the participating countries without reducing their trade with the rest of the world. Other studies indicate that increased foreign trade is associated with higher economic growth and may affect the correlation of countries' business cycles.
The Economic and Monetary Union (EMU) in Europe that took effect on 1 January 1999 is an example of a currency union. Initial experience suggests that the single currency has increased intra-euro area trade, in accordance with the results of the general studies. Furthermore, there are no indications that the euro area member states are trading less with countries in the rest of the world.
The EU member states not participating in EMU may also expect growing trade with the euro area member states in connection with introduction of the single currency. Last year, when HM Treasury assessed the British government's five economic tests for UK membership of EMU, this was emphasised as one of the most important long-term benefits of EMU entry (HM Treasury (2003))[1]. Recently, in an analysis of the 10 new EU member states the International Monetary Fund, IMF, also pointed out the importance of the trade effects of subsequent EMU participation (Köhler (2004)).
The effect of currency unions on trade and economic activity
If two or more countries establish a currency union, trade among the countries may increase because
- exchange-rate uncertainty is eliminated,
- trading costs are reduced,
- prices across borders are easier to compare.
Exchange-rate uncertainty normally has a dampening effect on foreign trade as most business enterprises are adverse to the risk of fluctuations in the value of future payments in foreign currency. In certain instances, the business enterprises may eliminate this risk by buying or selling currency forward. However, this is usually only possible within a limited time horizon, e.g. up to one year, and in countries with more advanced foreign-exchange markets.
Trading costs are reduced in a currency union because business enterprises no longer need to exchange currency when trading with enterprises from other participating countries. Thus, they save the difference between the currency's market rate and the bank's fixing rate plus a charged commission. In addition, the enterprises may reduce their costs of managing foreign-exchange risks. The reduced trading costs contribute to increasing trade between the participating countries.
Prices in different countries are easier to compare in a currency union as they are expressed in the same currency. Consumers and business enterprises comparing prices in different participating countries do not have to convert from one currency into another. This strengthens competition in markets for traded goods and services and increases foreign trade.
The effect of increased trade on total output
Trade among countries may have a positive impact on their total output for several reasons[2]. For instance, foreign trade facilitates exploitation of economies of scale in production due to the increased sales opportunities. Foreign trade also strengthens competition between business enterprises, leading to ongoing improvement of production methods, which enhances output growth. Furthermore, foreign trade may entail dissemination of new production technology, which could also boost output growth.
Several empirical studies confirm that a positive link exists between a country's foreign trade and output growth. Thus, Frankel and Rose (2002) conclude that an increase by 1 percentage point in a country's trade-to-GDP ratio is associated with an increase in GDP per capita of 1/3 per cent in the long term. Other previous studies show evidence of a stronger link between foreign trade and economic growth.
The effect of increased trade on the correlation of business cycles
Trade between two countries may also affect the correlation of their business cycles. Normally, a rise in trade will lead to stronger co-variation in economic activity. This is due to the fact that a change in demand for goods and services in one country has stronger effects on demand in the other country, the greater the bilateral trade between them.
However, increased trade among countries may also result in more specialised industrial production. In that case increased trade will be reflected in more inter-industry trade (trade in goods from different industries) as opposed to intra-industry trade (trade in goods from one industry). If the countries become more dependent on different industries, their business cycles may eventually be less correlated[3].
The relation between trade and the correlation of business cycles is especially important in a currency union with a common monetary policy. Frankel and Rose (1998) argue that a currency union does not lead to more cross-country specialisation in production. Instead, it increases countries' intra-industry trade which is most sensitive to differences in prices. In an empirical study they also show that countries with closer trade links tend to have more tightly correlated business cycles.[4]
Recent studies
Until a few years ago, participation in a currency union was considered to have a relatively modest effect on a country's foreign trade. According to empirical studies, exchange-rate uncertainty only had limited trade effects[5]. This type of study, however, has been associated with a number of problems, e.g. regarding how to measure exchange-rate uncertainty.
A study by Rose, published in 2000, changed the perception of currency unions' effect on countries' foreign trade. Rose based his study on the so-called gravity model, which tries to explain the size of foreign trade between two countries, cf. Box 1. His remarkable conclusion was that countries with a common currency trade more than three times as much with each other than countries with separate currencies. The result was robust to inclusion in the model of a number of other variables which may effect trade between two countries.
|
Rose's gravity model
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Box 1
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|
The gravity model was originally developed by the English physicist and mathematician Isaac Newton (1642-1727) as an explanation of gravitation. In economic science the model has been used in studies of countries' foreign trade. In its basic form, trade between two countries depends positively on their total income and negatively on the distance between them. The model may then be extended to include other variables, depending on the purpose of the study. Rose (2000) estimated an extended gravity model along the following lines ln Hij = b0 + b1 ln (YiYj) + b2 ln Dij + b3 MUij + b4 Xij4 + … + bn Xijn + eij where Hij is the total trade between country i and country j, Yi the income in country i and Dij the distance between country i and country j. MUij is a dummy variable that takes on the value of 1, if country i and country j participate in the same currency union, or else the value 0. The variables Xij4 to Xijn are other variables that may affect the trade between country i and country j, e.g. measures of exchange-rate volatility and dummy variables expressing if country i and country j participate in the same free trade area, have a common language or belonged to the same colonial power. Data in Rose's study were country-pair observations for a total of 186 countries for 5-year intervals during the period 1970-90. The observations were included in the estimation as cross-section data, i.e. without consideration of the time dependency between observations of the same country pair. In total approximately 1 per cent of the country pairs had a common currency while the rest had separate currencies. Rose's main purpose was to examine the effect of a common currency on countries' mutual trade links (expressed as b3). The estimated model showed that two countries with a common currency trade more than three times as much with each other as countries with different currencies. Furthermore, it appeared that countries in the same free trade area also trade considerably more with each other than other countries. On the other hand, according to the estimated model exchange-rate volatility only has a limited effect on trade between two countries, which is in line with previous empirical studies. |
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Since Rose's article, several other studies of the effect of currency unions on trade have been published. The Appendix summarises some of these studies, and the results are shown in Chart 1. Most of the studies arrive at a lower estimated trade effect of a common currency than Rose's original estimate, but still a considerable effect. According to Rose (2003), the mean value of the different studies' estimates of the trade effect of a currency union corresponds to roughly a doubling of trade among the participating countries[6].
| Studies of the effect of currency unions on trade among countries |
Chart 1
|
 |
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| Note: An * states that the estimated effect is not statistically significant. The dotted line is Rose's (2003) calculated mean value of the estimates of the trade effect of a currency union according to 24 studies. The Appendix comprises a short review of the studies reported. | |
An important question is how participation in a currency union affects countries' trade with non-participating countries. A distinction is often made between a currency union's trade-creating and trade-diverting effects. A currency union has trade-diverting effects if it reduces participating countries' trade with the rest of the world. This will dampen the total increase in the participating countries' foreign trade and reduce other countries' foreign trade. In general, neither Rose (2000) nor other studies find that currency unions reduce participating countries' trade with the rest of the world.
The effect of EMU on euro area trade
As EMU has existed for more than five years, it is now relevant to examine its effects on euro area member states' foreign trade[7]. A possible indication of EMU's trade effects is given in Chart 2 showing the development in intra-euro area trade as a percentage of euro area member states' total trade with selected industrialised countries[8]. Until 2000 this measure of intra-euro area trade followed a declining trend, but since then it has been increasing. Viewed in isolation, this development is in accordance with the hypothesis that EMU has contributed to increasing intra-euro area trade.
| Intra-euro area trade as a percentage of the member states' total trade |
Chart 2
|
 |
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| Note: The euro area member states are exclusive of Greece. The member states' total trade is the sum of intra-euro area trade and the euro area member states' trade with the other EU member states (including Greece but excluding the 10 new EU member states), Australia, Canada, Iceland, Japan, New Zealand, Norway, Switzerland and the USA. | |
| Source: OECD, Monthly Statistics of Foreign Trade. | |
The rising trend in intra-euro area trade cannot be related to one or a few large euro area member states. Chart 3 shows the development in selected euro area member states' trade with other member states as a percentage of their total trade. Since 2000 all the euro area member states have gradually increased their share of trade with other member states. For most of the member states this follows a declining trend for several years, but for Spain and Portugal, which joined the EU in 1986, this increasing trend has been apparent for a number of years.
The measure of intra-euro area trade applied in Charts 2 and 3 has also been influenced by other factors than the introduction of the single currency. For instance, an important factor could be differences in economic growth between the euro area and the rest of the world. In a period of relatively high growth in the rest of the world, intra-euro area trade as a ratio of total trade will tend to decline. The high growth in the 1990s in some of the euro area's major trading partner countries, e.g. the UK and the USA, as well as more moderate growth in recent years may thus also explain part of the development in the two Charts.[9]
| Selected euro area member states' trade with other euro area member states as a percentage of their total trade |
Chart 3
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 |
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| Note: See note in Chart 2. | |
| Source: OECD, Monthly Statistics of Foreign Trade. | |
Several empirical studies have formally examined the effect of EMU on the euro area member states' trade, cf. Table 1. The results of these studies are not directly comparable since the data period varies. All studies conclude, however, that the single currency has had a positive effect on intra-euro area trade. The measured effects so far are relatively modest compared with the estimates in Rose (2000) and other studies, but they have been increasing since the introduction of the euro. In addition, the different studies do not indicate that the single currency has contributed to reducing the euro area member states' trade with the rest of the world (see e.g. Micco et al. (2003)).[10]
| Empirical studies of the effect of emu on intra-euro area trade |
Table 1
|
|
| Study |
Effect
(per cent) |
Data
|
| De Nardis and Vicarelli (2003) |
9-10
|
Data for 32 countries
for 1980-2000 |
| Bun and Klaasen (2002) |
10
|
Data for all EU member
states, the USA, Japan and Canada for 1965-2001 |
| European Commission (2003) |
7-18
|
Data for all EU member
states for 1991-2002 |
| Micco et al. (2003) |
4-16
|
Data for 22 industrialised
countries for 1992-2002 |
| Baar et al. (2003) |
29
|
Data for all EU and EFTA
member states for 1978-2002 (1st quarter) |
The effect on intra-industry trade in the euro area
A country's intra-industry trade with other countries can be measured by the Grubel-Lloyd index, cf. Box 2. The index may vary from 0 to 1. The closer the index is to 1, the greater is a country's intra-industry trade with other countries.
|
The grubel-lloyd index for measuring intra-industry trade
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Box 2
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|
A country's intra-industry trade with other countries is often measured by using the so-called Grubel-Lloyd index (see e.g. OECD (2002)). For country A the Grubel-Lloyd index vis-à-vis country B for industry i may be calculated as GL(A)iB = ( (X(A)iB + M(A)iB) - |X(A)iB – M(A)iB| ) / (X(A)iB + M(A)iB) where X(A)iB and M(A)iB is country A's exports to and imports from country B, respectively, of goods from industry i. The value of the index may vary from 0 to 1. If all trade between country A and country B in goods from industry i consists of exports from country A to country B (X(A)iB > 0, M(A)iB = 0), the index will be equal to 0. The same applies if all trade in goods from industry i consists of imports to country A from country B. If exports from country A to country B of goods from industry i equal imports the other way (X(A)iB = M(A)iB), the index is 1. Similar indices can be calculated for country A's trade with other countries and for other industries. A total Grubel-Lloyd index for country A may then be calculated by summing up these indices weighted by country A's trade distributed on the different countries and industries. The total index gives a measure of country A's intra-industry trade, as an index closer to 1 is equivalent to a higher degree of intra-industry trade with other countries. The value of the total Grubel-Lloyd index depends on the detail level of the specified industries. The more detailed the specification, the lower the calculated index. When calculating the indices in Chart 4, a detail level corresponding to the 2-digit level of SITC (Standard International Trade Classification), revision 3, has been used. This comprises nearly 70 different product groups. |
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Chart 4 shows for every euro area member state (except Greece and Luxembourg) a Grubel-Lloyd index for the trade with other euro area member states calculated for 1996 and 2001. The value of the index varies significantly between the individual member states, with France and Portugal as the two extremes. However, for almost all of the member states the index is virtually unchanged or higher in 2001 compared to 1996. Viewed in isolation this does not indicate that EMU participation has resulted in increased specialisation of the member states' production at the risk of less correlated business cycles.
In practice, the intra-industry trade among euro area member states is only an indicator of the degree of specialisation in different industries. Thus, increased specialisation of the euro area member states' production may have taken place without being reflected in less intra-industry trade[11]. Furthermore, the correlation of business cycles also depends on other factors than the composition by industry of the member states' production. In general, it is too early to draw conclusions as to the effect of EMU on the correlation of the euro area member states' business cycles.
| Grubel-lloyd index for euro area member states' trade with other euro area member states |
Chart 4
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 |
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| Note: The closer the index is to 1, the higher the degree of the member state's intra-industry trade with other euro area member states. The calculation of the index is described in Box 2. | |
| Source: OECD, International Trade by Commodity Statistics. | |
Conclusion
Until a few years ago the effect of participating in a currency union on a country's foreign trade was considered to be relatively modest. However, recent studies indicate that countries with a common currency trade considerably more among themselves than other countries. According to several studies, a currency union may lead to a doubling of trade among the participating countries, without affecting their trade with the rest of the world. In addition, other studies show that increased foreign trade is linked to higher economic growth and may lead to more uniform business cycles in the individual countries.
The experience of the euro area so far is basically in accordance with these studies. Several empirical studies confirm that the euro area member states have increased trade among themselves since EMU took effect, without this resulting in less trade with countries in the rest of the world. The measured effects on intra-euro area trade are still relatively modest but have been increasing since the introduction of the euro. Furthermore, there are no indications that the single currency has resulted in more inter-industry trade and specialisation of member states' production at the risk of less uniform business cycles.
These results are of relevance to EU member states not participating in EMU. They may expect that joining EMU at a later stage will increase their trade with the euro area member states and have positive effects on economic growth. For instance, HM Treasury estimates that over a longer time horizon EMU participation will increase the UK's trade with the euro area member states by up to 50 per cent (HM Treasury (2003)). Similarly, IMF (2004) finds that several of the new EU member states may increase their foreign trade by up to 60-70 per cent by introducing the euro. These estimates are associated with significant uncertainty but should be part of an overall assessment of the consequences of participating in EMU.
Appendix: Recent studies of the effect of currency unions on countries' foreign trade
Already before Rose (2000) a few studies had indicated that a single currency might have strong trade effects. For instance, McCallum (1995) estimated a gravity model for the trade among a number of Canadian provinces and US states. He showed that a typical Canadian province trades approximately 20 times more with another Canadian province than with a US state of the same size and at the same location (distance). An important reason may be that the separate currencies of Canada and the USA act as a barrier for trade between the two countries.
Since Rose (2000) several similar studies of the trade effects of currency unions have been published, including by Rose himself (see e.g. Frankel and Rose (2002) as well as Rose and van Wincoop (2001)). These studies typically focus on the significance of various aspects of Rose's data and method. Table A1 comprises a list of selected studies and the estimated trade effects of participation in a currency union.
| Studies of the effect of currency unions on trade among member countries |
Table A1
|
|
| Study |
Data
|
Effect
(per cent)1 |
| Rose (2000) |
Cross-section data, 1970-1990
|
235
|
| Rose and van Wincoop (2001) |
Cross-section data, 1970-1995
|
136
|
| Frankel and Rose (2002) |
Cross-section data, 1970-1995
|
290
|
| Melitz (2001) |
Cross-section data, 1970-1995
|
101
|
| Persson (2001) |
Cross-section data, 1970-1990
|
66*
|
| Levy Yeyati (2001) |
Cross-section data, 1970-1990
|
65
|
| Nitsch (2002) |
Cross-section data, 1970-1990
|
127
|
| Tenreyro (2001) |
Panel data, 1978-1997
|
60*
|
| Alesina et al. (2002) |
Panel data, 1960-1997
|
376
|
| Glick and Rose (2002) |
Panel data, 1948-1997
|
92
|
| Pakko and Wall (2001) |
Panel data, 1970-1990
|
-31*
|
| Thom and Walsh (2002) |
Panel data, 1950-1992
|
10*
|
| Flandreau and Maurel (2001) |
Cross-section data, 1880-1913
|
2192
|
| López-Córdova and Meissner (2001) |
Panel data, 1870-1910
|
105
|
| 1 An * states that the estimated effect is not statistically significant. 2 This estimate refers to Flandreau and Maurel's estimate of the trade effect of the currency union between Hungary and Austria. |
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Several studies have examined the significance of possible systematic differences between countries in currency unions and other countries. Rose includes various explanatory variables in his model, but cannot allow for all these differences. If any of the omitted variables are important to countries' trade, the trade effect of a common currency could be overestimated.
Melitz (2001) emphasises that countries in a currency union often participate in the same political union or free trade area, which may also have a positive impact on their trade. In Rose's model, this may lead to overestimation of the trade effect of a currency union[12]. Melitz examines this possibility by disregarding currency unions that are also political unions or free trade areas. This reduces the estimate of the trade effect of a currency union from just over a tree-fold increase to a two-fold increase.
Persson (2001) attempts to isolate the differences between countries in currency unions and other countries by means of a match method that is normally used in medical studies. The method means comparing the results of a "control group" and a "treatment group", distinguished only by participation in a currency union. Using this method, Persson arrives at a considerably lower estimate of the trade effect of a currency union than Rose.
Levy Yeyati (2001) and Nitsch (2002) also find that Rose's high estimate of the trade effect of currency unions is attributable to variables that are not part of the model. Levy Yeyati divides the currency unions in Rose's study into unilateral and multilateral unions[13]. He shows that Rose's estimates are suitable for unilateral currency unions only, while countries in multilateral unions only trade approximately 65 per cent more among themselves than other countries. Using a similar approach, Nitsch finds that Rose's estimates do not hold true as regards currency unions with the US dollar as the common currency.
Other studies have focused on the causality behind Rose's results. For two countries the gains in terms of saved exchange costs from entering into a currency union will be greater, the more they traded with each other prior to entry. In principle, some of the countries in Rose's study may have decided to form a currency union because they already had strong trade links. If this is the case, the results cannot be used to draw conclusions as to the trade effects of establishing a currency union.
Two examples of such studies are Tenreyro (2001) and Alesina et al. (2002). Tenreyro estimates in one system of equations the probability that two countries establish a currency union as well as the effect of the currency union on their bilateral trade. She finds that this method reduces the estimate of the trade effect of a currency union to approximately 60 per cent.[14] Conversely, Alesina et al., using another method, get a higher estimate of the trade effect of a currency union than Rose.
Rose (2000) and most of the above studies are based on cross-section data. This implies that observations of the same country pair in different periods are in principle treated as independent observations. This type of study may be less suitable for measuring the consequences of two or more countries establishing a currency union. Studies based on so-called panel data, where each country pair is followed over time, is often a more useful approach for this purpose.
Glick and Rose (2002) study the trade effect of currency unions by using panel data for 217 countries from 1948 to 1997. The data set comprises a total of 16 currency union formations between country pairs and 130 dissolutions. They conclude that formation (dissolution) of a currency union between two countries almost doubles (halves) their bilateral trade. Another example of a similar study is Pakko and Wall (2001) who do not find evidence that the formation of a currency union results in increased trade. However, this study is based on a more limited data set than in Glick and Rose.
Another frequently stated reservation regarding Rose's study concerns the type of countries in the identified currency unions. Almost all country pairs in these currency unions consist of at least one small developing country. Special factors may apply to these countries so that generalisation of the results to major industrialised countries, e.g. the euro area member states, is controversial.
Thom and Walsh (2002) examine the consequences for the trade between Ireland and the UK, when Ireland in 1979 gave up its fixed one-to-one exchange rate vis-á-vis the pound sterling in order to join the European Monetary System, EMS. They conclude that this did not have any particular impact on the trade between the two countries. One interpretation of this study could be that currency unions appear to have no significant impact on industrialised countries' foreign trade. However, this is contrary to the results of the initial studies of the effect of EMU on intra-euro area trade, cf. Box 1 in the article.
Finally, some studies are based on more historical data. This applies to e.g. Flandreau and Maurel (2001) and López-Córdova and Meissner (2001) who include currency unions from before World War I. This enables studying the trade effects of defunct currency unions like the Scandinavian and Latin currency unions[15]. Both studies conclude that these currency unions were of great importance to the trade among the participating countries.
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[1] HM Treasury's assessment of the five tests is described in Box 3 in Recent Economic and Monetary Trends, Danmarks Nationalbank, Monetary Review, 3rd Quarter 2003.
[2] A review of the theoretical arguments for a positive connection between foreign trade and economic growth is given in HM Treasury (2003), Annex B.
[3] This argument is presented by e.g. Eichengreen (1992) and Krugman (1993).
[4] Frankel and Rose describe the criteria of a so-called optimum currency area as endogenous. These criteria include inter alia considerable trade among countries and correlated business cycles, cf. Mundell (1961). If a currency union strengthens these trade links and leads to more correlated business cycles the participating countries will to a higher degree meet the optimum currency area criteria over time.
[5] For instance, earlier studies of the EU member states have shown that elimination of the exchange-rate uncertainty would increase trade among the countries by only 5-15 per cent, cf. e.g. Dell'Arricia (1999).
[6] Rose's calculation is based on a total of 712 estimates from 24 studies. The mean value of these estimates corresponds to a trade effect of 86 per cent. Excluding the estimates from Rose's own studies, the mean value of the estimates of a currency union's trade effect can be calculated at 65 per cent.
[7] Rose has called for caution in transferring his results to the euro area member states since the currency unions in his studies are primarily made up of small developing countries that differ from the euro area member states in several respects (Rose (2000), p. 15).
[8] Only trade with selected industrialised countries is included in the denominator to get a more accurate picture of the effect of EMU on intra-euro area trade. Thus, the effect is not overshadowed by a trend towards increased trade with countries in e.g. Eastern and Central Europe and certain Asian countries.
[9] Another reason for the development in the applied measure of intra-euro area trade may be changes in the member states' competitiveness as a result of e.g. exchange-rate fluctuations. Since changes in competitiveness usually influence exports and imports with different signs it may be difficult to estimate the net effect on total trade.
[10] Buiter and Grafe (2003) question these estimates, which they think will only be realised over a longer period. They e.g. point out the difficulties of distinguishing between the effects of the single currency and the EU internal market that took effect as from 1992.
[11] Various measures of the EU member states' output by industry indicate increased specialisation from the beginning of the 1980s until 1997, while in the same period there was an increase in the member states' intra-industry trade (European Commission (2002)).
[12] Rose includes a dummy variable for whether two countries participate in the same free trade area, cf. Box 1. If the relationship is not linear – as claimed in Rose's model – this variable, however, does not capture the entire effect of two countries participating in the same free trade area.
[13] A multilateral currency union comprises two or more countries that have jointly decided to introduce a single currency. A unilateral currency union emerges when a country independently adopts another country's currency as legal tender, which is also often referred to as "dollarisation".
[14] In part, this reduction is attributable to Tenreyro – unlike Rose and other studies – including observations of a bilateral trade of 0. This reduces the estimate of the trade effect of a currency union to approximately 100 per cent.
[15] The Scandinavian Currency Union comprising Denmark, Sweden and Norway was established in 1875. The Latin Currency Union was originally established by France, Belgium, Switzerland and Italy in 1865 and later enlarged to include other countries. Both currency unions were de facto discontinued at the outbreak of World War I, cf. Abildgren (2004).