Trade Adjustments to Exchange Rates in Regional Economic Integration: Argentina and Brazil

Abstract

Currency devaluation is one of the most commonly used economic policies when a country faces a trade imbalance. By making exports more competitive in world markets and imports more expensive in terms of local currency, devaluations should induce trade balance improvements at the aggregate and bilateral levels. This dynamic behavior known as the J-curve has been tested in numerous empirical papers that have generated mixed results. This literature has not formally addressed the role played by regional economic integration among the countries under examination. Since almost all countries are engaged in some sort of regional economic integration, this dissertation examines the trade effects of devaluations when countries are part of a regional integration agreement. First, Chapter 1 discusses the challenges raised by regionalization and introduces the case study by describing the Southern Cone Common Market (Mercosur) and the exchange rate regimes implemented in Argentina and Brazil. Chapter 2 investigates the effects devaluations on countries’ trade balances and examines potential trade diversion effects. Chapter 3 looks at gravity models of trade to test for potential trade diversion effects of currency devaluations. This chapter also investigates whether these trade adjustments are a consequence of changing demand structures as proposed by Linder (1961). Chapter 4 presents the overall conclusions and policy implication issues. Each chapter has its own literature review, theory, and empirical sub-sections. All empirical work concentrates on Brazil and Argentina, the two major economies of Mercosur. Brazil devalued its currency in January 1999 and Argentina followed in January 2002. While both devaluations generated aggregate trade surpluses, unexpected adjustments emerged at the bilateral level. Although the empirical results are based on countries within a specific trading bloc, the economics behind them is subject to generalization.