Trade Agreements, Exchange Rate Disagreements

Problems often arise when partners in regional integration agreements (RIA) have divergent exchange rate policies, as has happened in recent years with the Southern Cone Common Market (Mercosur). The January 1999 devaluation of the Brazilian real strained the relationship between Argentina and Brazil, setting off a series of events that included protectionist measures in Argentina, Argentine businesses threatening to relocate or actually relocating in Brazil, and additional pressures on the Argentine peso. These events contributed along with many other factors to the end of the convertibility plan in December 2001. Problems such as these are not unique to Mercosur. They typically emerge when countries have trade agreements but exchange rate disagreements. Similar problems have occurred between Venezuela and Colombia, or even in the European Union after the exchange rate mechanism (ERM) crisis of 1992. But there is a difference. In Europe, the crisis occurred in spite of—or as a result of the failure of—attempts to coordinate exchange rate policy among member countries.1 In contrast, there have been no such efforts to coordinate exchange rates in most RIAs in the Americas or around the world. This chapter looks at the circumstances and the types of RIAs under which exchange rate disagreements may arise, as well as the policy responses that can help alleviate such problems.2 Throughout the discussion of the potential problems, it is important to ask whether there is something special about being members of the same regional integration agreement that makes exchange rate disagreements particularly harmful, or whether similar problems can be expected following devaluation in non-member trading partners. Types of problems that emerge include the following: • Increased protectionism and the scaling back or elimination of trade arrangements: The country that loses competitiveness as a result of a real exchange rate appreciation vis-à-vis its trade partners may resort to increased protectionism. The existence of an RIA may preclude the country from increasing tariffs within the bloc. As a result, the country may increase protection vis-à-vis the rest of the world, resulting in trade diversion, or it may increase protection vis-à-vis the bloc partners, resorting to less transparent methods such as antidumping, sanitary restrictions, or other administrative measures. This last course of action defies the objective of increased trade integration within the bloc, an objective that may be hurt further if increased protection brings about retaliation. Countries may also choose to scale back or abandon their trade arrangements altogether. • Reduction in trade flows: Exchange rate disagreements can lead to reduced exports from the country that loses competitiveness to its partner. If the disagreement occurs in the context of an RIA with high