WORLID BANK LATIN AMERICANAND CARIBBEAN STUDIES

Viewpoints

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WORLD BANK LATIN AMERICANAND CARIBBEAN STUDIES

Viewpoints

The Impact of the Euro on

Latin America

Dorte Verner

The World BankWashington, D.C.

( 2000 The International Bank for Reconstructionand Development / THE WORLD BANK

1818 H Street, N.WWashington, D.C. 20433, U.S.A.

All rights reservedManufactured in the United States of AmericaFirst printing February 2000

The findings, interpretations, and conclusions expressed in this paper are entirely those of the author(s)and should not be attributed in any manner to the World Bank, to its affiliated organizations, or to membersof its Board of Executive Directors or the countries they represent. The World Bank does not guarantee theaccuracy of the data included in this publication and acccpts no responsibility whatsoever for any consequcnceof their use. The boundaries, colors, denominations, and other information shown on any map in this volumedo not imply on the part of the World Bank Group any judgment on the legal status of any territory or theendorsement or acceptance of such boundaries.

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The complete backlist of publications from the World Bank is shown in the annual Index of Publications,which contains an alphabetical title list (with full ordering information) and indexes of subjects, authors, andcountries and regions. The latest edition is available free of charge from the Distribution Unit, Office of thePublishcr, The World Bank, 1818 H Street, N.W, Washington, D.C. 20433, U.S.A., or from Publications, TheWorld Bank, 66, avenue d'1ena, 75116 Paris, France.

Library of Congress Cataloging-in-Publication Data

Verner, Dorte.The impact of the Euro on Latin America / Dorte Verner.

p. cm. - (World Bank Latin American and Caribbean studies)Includes bibliographical references.ISBN 0-8213-4620-21. Latin America - Foreign economic relations - European Union countries. 2. European Union

countries - Foreign economic relations - Latin America. 3. Euro. I. Title. II. Series.

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Table Al. EU-11, 1996 .............................................................. 29Table A2. EU-15, 1996 .............................................................. 29Table A3. LAC Countries, 1996 .............................................................. 30

LIST OF FIGURESFigure 1. Trade Openness: The EU, the U.S., and Latin America, 1997 .................................4Figure 2. The EU Countries' Openness to Trade, 1997 ............................................................5Figure 3. LAC Countries' Trade Openness ............................................................... 6Figure 4. Mercosur Exports in 1997 ............................................................... 7Figure 5. Distribution of Foreign Direct Investment Flows to LAC in 1997 ....................... 10Figure 6. The Euro Real Exchange Rate .14Figure 7. LAC Countries' Foreign Debt in 1997 .17Figure 8. LAC Countries' Foreign Debt Share in Different Currencies in 1997 .17

THF IMPACT OF THE EURO ON LATIN AMERICA * V

SUMMARY FINDINGSThe key finding is that the euro is not likely to exports for LAC. It could also lead to increasedcause any single major change in Latin America financial flows between the regions.and the Caribbean (LAC). There will, however, bea lot of small effects-in different directions-in * LAC debt is mainly denominated in U.S.the short and long run. In the main, the impact of dollars. No significant appreciation of the eurothe euro on Latin America is expected to be of sec- relative to the initial value is expected. Thus, theondary importance, since no structural trade immediate impact of the introduction of the eurochange is expected. on debt value and debt service is expected to be

The Latin American and the Caribbean coun- small. The euro will, however, create the oppor-trics are very hetcrogeneous. The European Eco- tunity to rcalign the currency composition of for-nomic and Monetary Union (EMU) and the euro eign exchange reserves in light of trade flows,are therefore likely to impact countries differently. other transactions, and, possibly in the longerCountries and regions with strong links-cultur- term, portfolio diversification and political con-ally and geographically-to the United States (such siderations.as Mexico and Central America) are likely to beless affected than countries with weaker links. * LAC countries may become more attractive

The main findings in this paper are the fol- as destinations for European investors seekinglowing: diversified portfolios, includinig higher return comi-

ponents and as intra-European investments show* Increased competition and efficiency should converging returns.

increase economic growth in the European Union(EU), which in turn should increase imports from * LAC and Mercosur' cannot be seen asthe LAC region, given that the trade diversion optimal currency areas at this time; therefore, ateffect is not likely to be very important. this stage the euro does not serve as a blueprint for

Latin America.* LAC countries are highly dollarized, and we

do not expect a major change immediately with the A prosperous EMU is expected to con-launching of the euro (though the longer term tribute to greater trade and financial flows betweeneffect is much harder to predict). LAC and the EU. Currency certainty, low inflation,

increased trade, and more efficient markets all* For LAC countries, the main impact of promise large benefits for the EU as well as some

the unified European market and the single cur- benefits for Latin America. Furthermore, a pros-rency is likely to come through financial linkages. perous EMU requires sound financial structural

policies, including reforms of both labor markets* Increased financial deepening in Europe and public spending. Over the long term, this

could have some positive effect on growth in should also benefit other countries, including thoseEurope and could lead to a small increase in in the LAC region.

THE IMPACT OF THE EURO ON LATIN AMERICA * Vii

ACKNOWLEDGMENTS

The Impact of the Euro on Latin America is a prod- Vargas edited and processed a large part of thisuct of LCSPR and was prepared by Dorte Verner. document.Eliana Cardoso helped in developing the project Thanks are due to various commentators,and advised during the production. Background including Luis Serven, Katherine Bain, Anthonypapers were provided by Rudiger Dornbusch Ody, Mads Zacho, Nicolai Kristensen, Torsten(Massachusetts Institute of Technology), Eduardo Sl0k, and the LCR Publications Committee.Levy-Yeyati (Universidad Torcuato Di Tella, Special thanks is due to Eliana Cardoso. HerBuenos Aires), and Federico Sturzenegger (Uni- continued advice and support made this studyversidad Torcuato Di Tella, Buenos Aires). Hazel possible.

1

INTRODUCTION

THE INTRODUCTION OF THE EURO and the establishment of stage three of the European

Economic and Monetary Union (EMU) will produce important changes in exchange and financial

markets and affect economic activities around the world. Recent analyses have focused on partici-

pating European countrics and their neighbors and Africa.2 This report is a first attempt to con-

sider the impact of the euro on Latin America and the Caribbean (LAC).

On January 1, 1999, a new era of the EMU began The macroeconomic stability effects emerge fromwhen 11 of the 15-member countries of the Euro- greater discipline in economic policies that maypean Union (EU) irrevocably fixed their exchange lower risk premia in interest rates and enhancerates and replaced their national currencies with a investment. Furthermore, the EU economies havesingle currency, the euro. The EMU will produce been converging over the past decades; hence, aimportant changes in exchange and financial mar- higher degree of synchronization of the businesskets, affect economic activity around the world, and cycles has occurred, and even higher degrees of syn-should help in underpinning European integration chronization are expected in the future. These find-and increased efficiency and growth. ings are ascribed to two elements: increased interde-

Different effects are taking place in the EU as pendence emerging from expanded trade and capitala result of the introduction of the new currency and flows arnong the EU economies, and increasedits development toward the EMU. The European coordination and convergence in economic policy.Commission suggests that important micro- and For developing countries, the EU is an impor-macroeconomic effects of the monetary union tant trading partner, a counterpart in economicinclude efficiency gains and stability effects. The cooperation, and a significant donor of develop-microeconomic efficiency gains emerge from the ment aid. Therefore, over time the impact onelimination of transaction costs and exchange rate developing countries may be substantial. Theuncertainty within the euro area. This should stim- extent to which each country will benefit variesulate trade and increase output withiin the region. from country to country and depends on factors

2 * THE IMPACT OF THE EURO ON LATIN AMERICA

such as the trade intensity and financial relations The first part of this paper covers the currentwith the euro area as well as on the conducted economic situation, including trade flows betweenexchange rate policy in the third country. Europe and Latin America. The second part pre-

Latin American and Caribbean countries are sents financial flows together with foreign directlargely heterogeneous despite similarities on vari- investment and portfolio allocations. The paperous fronts. They remain quite closed in real terms, then provides a short description of the value andbut for the most part they are open financially and, volatility of the euro, followed by an analysis oftherefore, vulnerable to changes in the direction of the financial implications of the euro, includinginternational capital flows. Some questions raised in the banking system and foreign debt and reservethis paper are the following: What are the risks and management. It then addresses whether the euroopportunities facing the LAC region from the can be seen as a blueprint for LAC and whetherintroduction of the euro? Will the replacement of active dollarization is a solution for LAC. The lastthe European currency basket by the euro have real part summarizes the paper's conclusions. Thereeconomic effects, or will it be little more than an are limitations to this study's analysis, and it doesaccounting phenomenon? The principal message of not take into account all the possible spilloverthis paper is that the euro carries implications for effects. Nor does it address all the effects that feedLatin America's financial markets and debt manage- back to the EU. The report does, however, give ament, but it will have only a marginal impact on broad picture of the impact that the euro mayLatin America's trade with Europe. have on the LAC region.

3

ECONOMIC RELATIONS BETWEEN

THE EU AND LATIN AMERICA

KEY ECONOMIC INDICATORS CAN SKETCH THE IMPORTANCE of global economic

areas and their relationship to one another. This section considers the market, globalization, and

trade in goods and services between the euro area and Latin America. The size of the region's under-

lying economy and the extcnt of its external trade may determine the global role of a currency.

THE MARKET of world output) compared to $2,972 billion in theLAC region. The large income disparity between

The significance of a market can be assessed by look- the EU and LAC becomes apparent when consider-ing at the numiiber of potential consumers and their ing the average per capita income; in the EU itpurchasing power. The 1 1-country euro region's amounts to 20,554 international dollars, comparedpopulation of 290 million exceeds the population of with 5,347 international dollars in Latin America.the United States by about 22 million. As the poorereuro-area countries catch up and expand to include T R A D Ecountries such as Great Britain, Scandinavia, Greece,and the Central and Eastern European countries, the The scale of trade openness of each individual EUeuro area could easily become far larger than the country is far higher than in any Latin AmericanU.S. dollar area. This compares with a population of country. The average of merchandise exports and487 million in the 41 countries of Latin America and imports as a share of GDP was 63 percent in thethe Caribbean.3 At present, the LAC region accounts EU and 28 percent in the LAC region in 1996 (seefor 8.4 percent of the world's population, while the Figures 1, 2, and 3). Since the beginning of theEU accounts for 5.1 percent (see economic indica- 1990s, however, the latter increased by 76 percent,tors for EU and LAC in the appendix). while the former increased by only 10 percent. If

Another market size variable is a country's we consider the euro area as one economy andGross Domestic Product (GDP). The EU coun- deduct the intra-euro area trade, the openness fig-tries produce $7,386 billion of output (22 percent ure drops considerably, to 23 percent, which is only

4 * THE IMPACT OF THE EURO ON LATIN AMERICA

Figure 1Trade Openness: the EU, the U.S., and Latin America, 1997 (percent)

70.0

60.0 -

50.0-

40.07

LAC /

30.0-

US

20.0-

10.0-

0.0 - _ ; -_

1970 1971 1972 1973 1974 197, 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995

Source: Author's calculaT on us ng VYorld Bank data.

a few percentage points higher than the figure for various countries and the availability of financing tothe United States. cover current account deficits.

Trade between the EU and developing coun- External factors helped raise the import capacitytries is important. Approximately 22 percent of the in the LAC region, including debt relief, increasedEU's exports go to developing countries, while 20 extraregional capital flows, and decline in worldpercent of the EU's imports originate in those interest rates. Additionally, real currency appreciationcountries. More specifically, trade between Latin in sorrie countries facilitated enhanced imriports.America and the EU has ballooned in recent times. The intraregional trade became more impor-Latin America's exports to the EU tripled over the tant in the EU and LAC in the 1990s than in earlierlast two decades, and today they aniount to US$38 decades. In Latin Armerica a larger share of the indi-billion. Exports in the other direction expanded vidual countries' exports remain within the regioneven more: since 1977, exports from Europe to (21 percent). The same holds for the EU countriesLatin America have quadrupled, and they continue where the share of interregional trade represents 60to rise: between 1990 and 1997, EU exports to LAC percent of the EU's total trade. Trade at subregionalincreased from an annual US$27 billion to US$54 levels also expanded, and interregional importbillion. The EU's exports exceed LAC's exports by growth is higher than import growth from outside30-40 percent. the region in most subregions in LAC. The intra-

The degree of trade integration between the Andean4 trade increased by an average of 29 percentEU and LAC countries reflects decades of trade and annually between 1990 and 1995, but only accountedfinancial cooperation. The increase in trade flows for 11 percent of the subregion's total exports.over the past decade has been facilitated by the Total exports from the Mercosur countriesinternational financial integration on the part of the increased by more than 60 percent in the 1990s.

THE IMPACT OF THE EURO ON LATIN AMERICA N 5

Figure 2The EU Countries' Openness to Trade, 1997 (percent)

130

Ireland

110/110 X /Netherlands

90, A ~~~Sweden

~~~~~~~\\ / ~~~~~~~~Denmark70Auti 70 , ~~~~~~~~~~~~~~~~~~~~~~~~~~~Finland

50 ~~~~~~~~~~~~~~~~~~~~~~~~~Germiany50 France

Portugal

30 Greece

10

1991 1992 1993 1994 1995 1996

-10

Snur-e: Aurhor's calculation using World Bark data.

Furthermore, inter-Mercosur trade increased three- trend in the composition of trade flows with thefold, to 21 percent of exports. Fifty percent of Mer- United States, which, with the exception of Mex-cosur's trade was with countries outside the Ameri- ico, also shows declining export shares and rela-cas; therefore, Mercosur is the least dependent on tively stable import shares.U.S. markets in Latin America. Figure 4 shows that Latin American countries still encounterthe EU is the most important export market for the restrictions on foreign trade. The debt crisis causedMercosur countries. a sharp decline in imports in LAC and a partial

As mentioned in Levy-Yeyati and Sturzenegger reversal in the opening up of trade as tariffs(1999a), the export shares from the six biggest Latin increased and trade restrictions were reimposed,American economies5 to EMU members declined due mainly to a lack of external financing. But sincein all cases in the 1990s. In Argentina, this coeffi- the beginning of the 1990s, many protectionistcdent decreased from 31.2 percent to 13.5 percent in policies have been removed. Today, the trade andonly seven years. A similar decline took place in investment regimes in Latin American countries areChile and Mexico (from 27.6 to 17.0 percent, and more liberal than in East Asia.6

from 7.2 to 2.9 percent, respectively), with a minor How will the introduction of the euro affectdrop in Brazil (from 27.6 to 23.9 percent). How- trade between the EU and LAC? One clear if rela-ever, the shares of Latin America's imports from tively minor advantage is that Latin Americans willEMU remained stable. The same can be said of the be able to take advantage of invoicing in a single

6 * THE IMPACT OF THE EURO ON LATIN AMERICA

Figure 3LAC Countries' Trade Openness (percent)

30

Mexico

25

Uruguay

20 E

Venezuela

15-Argentina

10 BaiColombia

5-

0-1987 1988 1989 1990 1991 1992 1993 1994 1995 1996

Source: Author's ca culaton us ng World Bank data,

currency when trading with different European scale because the gains in competition and effi-partncrs. On a larger scale, if European economic ciency are likely to be relatively small. As such, thegrowth does indeed pick up as a consequence of consequent positive impact on trade from Latinincreased efficiency and competition in Europe, America is also unlikely to be large.

and as a consequence of less uncertainty, then On the other side of the ledger, it is theoreti-

increased import demand in the euro area will cally possible that the improvement in euro-areaincrease exports from LAC.7 But, as Levy-Yeyati competitiveness could take place in part at the

and Sturzenegger (1999b) show, the elasticities are expense of exporters from other regions, includingrelatively small. LAC. As exchange-rate risk and transaction costs

The euro is already making Italy, Spain, and are eliminated within Europe, a trade-diversioneven France safer for investors and compressing effect could emerge from increased competitivenessrisk premia. The decline in risk premia in turn is within the euro area, leading to reduced import

reflected in lower interest rates and should promote flows from third countries. Thus we have the pos-

higher trend growth in these countries. Further- sibility of an offsetting effect, whereby LAC exportsmore, the euro reinforces finanicial deregulation. It could be negatively affected by trade diversion

should thus help the development of a broader, (though this would apply only to the restricteddeeper capital market in Europe (more similar to range of products where European and Latin Amer-U.S. capital markets), contributing to improved ican producers are in competition with each other).corporate governance and improving the perfor- To summarize, we expect both the expansionarymance of European companies. But the euro's influence from possibly faster European growth,direct contribution to European growth and and any dampening impact from trade diversion, toemployment will probably not be very significant in be relatively marginal.

THE IMPACT OF THE EURO ON LATIN AMERICA * 7

Figure 4

Mercosur Exports in 1997 (in US millions $)

14,000

Brazil->EU

12,000

10,000Brazil->USA

8,000

6,000

Argentina->

EU4,000 -. EU ....

Argentina->USA

2,000 77-77

Argentina-> Bai-MERCOSUR UMRCOSUR Uruguay->

0. 1 -- LEU Uruguay-> Uruguay->USA MERCOSUR

0 i

Source: Author's calculat on us ng International Monetary Fund data

8

| TE FINANCIAL RELATIONSTWEEN EU AND

| LAIN AMERICA

THE MOVEMENT TOWARDS FINANCIAL LIBERALIZATION in the Latin American and

Caribbean region during the 1990s increased its dependence on international capital flows and

deepened the process of integration of local capital markets with major financial centers. On

average, the region has been a net recipient of international capital flows and, therefore, highly

sensitive to fluctuations in global market conditions. This subsection considers foreign direct

investment (FDI) and the role that international The financial systems in the EU are differentinvestors played in financing private investment in from country to country and are far from deregu-LAC countries. Portfolio management issues are lated and competitive as in, for example, thealso considered. United States With the introduction of the euro,

With a successful introduction of the euro, we should expect accompanying deregulation andrelated financial developments could have a increased competition within the euro area. Thegreater international impact than the trade conse- concrete actions expected are the following: (1)quences of thc curo. But the financial linkages larger firms will movc towards raising funds on thebetween the EU domestic financial markets and euro bank market and away from commercial bankthe rest of the world are difficult to measure and financing. They may even move their bankingevaluate. Currently, the European domestic finan- activities from the local banks to banks across bor-cial linkages with the rest of the world rank a dis- ders,8 (2) households will not only borrow in thetant second vis-a-vis the United States as mea- local consumer credit market but also in the eurosured by the relative sizes of domestic financial credit market, favoring the more cost-efficient ofmarkets and the magnitude of gross international the two. Furthermore, households and firms willportfolio flows, gross international banking flows, find themselves obtaining real estate loans in aand gross international financial and banking euro-securitized market. Finally, depositors willclaims. diversify deposits between bank deposits and

THE IMPACT OF THE EURO ON LATIN AMERICA * 9

money market fund deposits, and (3) banks will the largest recipient of FDI among developingface increased competition and, consequently, more countries, accounting in 1997 for nearly 40 percentmergers are expected across bordcrs in Europe. The of all FDI flows to developing countries (US$45implications for the bank customers will depend on billion out of a total US$120 billion).the strength of the banks. In the short term, the The new regionalism in LAC (see below) hascustoImier in a strong bank may experience cheaper proceeded together with unilateral trade liberaliza-credit, while the customer in a weak bank may face tion and the opening to FDI (Burki and Perry,credit rationing. Eventually, the weak bank will 1997). Private sector activity has been helped bytend to disappear. structural reforms, which have promoted invest-

Some economists, for example, in Morgan ment and trade, and a good share of gross domesticStanley, predict that between now and 2010, US$13 investments have been financed by FDI. Further-trillion will flow to European equity markets, more, FDI partly promotes exports and providestripling the size. This inflow is considerable, as access to international markets. But FDI has oftentoday's total capitalization of the world's stock mar- been undertaken to avoid tariffs, and a large sharekets is around US$20 trillion. A boom is expected of FDI in LAC went to nontradables.in every area of investment banking: mergers and European FDI in the LAC rcgion increasedacquisitions, share and bond issues, securities trad- dramatically over the last decade, and this effect ising, and fund management. This may happen at the considered to be highly beneficial. This is bothexpense of European commercial banking. because FDI is more stable than portfolio invest-

International bond issues by LAC countries ments and because of the transfer of technologyamounted to US$46 billion in 1996, and euro- and managerial know-how as well as the positivedenominated bonds accounted for 44 percent of all impact on competition within LAC countries. Theinternational issuance,9 which is just the same as main elements behind the rise in FDI includedollar-denominated bonds. Hence, the bond mar- increased privatization, notably in Brazil; improvedkets are already operating in a dual-currency world. economic performance; and continued progress onThe pace of European bond market activity is sur- liberalization.prising considering the euro's weakness against the The net inflow of foreign direct investment todollar since its launch. This has discouraged U.S. LAC amounted to US$38 billion in 1997, amount-and Japanese investors from putting money into the ing to 32 percent of total global FDI, with the largeeuro-denominated bond markets for fear that any countries in LAC receiving the largest share (seerise in the price of the securities they hold would Figure 5). The EU's FDI in Latin America amountsbe offset by the depreciation in the currency. Thus, to US$13 billion.10 Furthermore, Europeans travelmainly domestic European investors, such as pen- to LAC countries, which earned the region US$26sion and insurance funds, have driven the growth billion in tourism income.in the market.

PORTFOLIO FLOWS,FOREIGN DIRECT INVESTMENT DIVERSIFICATION, AND

REALLOCATIONIn LAC, the majority of capital controls and capitalaccount restrictions from the 1980s were elimi- The EMU is likely to influence portfolio flows.nated during the 1990s. Hence, in tlhe 1990s. for- Although compiled information on the origin ofeign direct investment and portfolio investment total portfolio flows is unavailable, the point can beincreased dramatically. illustrated by data on international bank lending

Althouglh most private investmienit continues compiled by thie Banlk for International Settlemnentsto be financed by domestic savings, access to for- (BIS). Levy-Yeyati and Sturzenegger (1999a) write:eign sources of capital is playing an increasingly "Whereas the share or bank flows originated inimportant role for the private sector in Latin Amer- EMU jumped from 37 percent in 1994 to 46 per-ica. Indeed, in the l 990s the LAC region has been cent in 1997, the share corresponding to banks in

10 THE IMPACT OF THE EURO ON LATIN AMERICA

Figure 5Distribution of Foreign Direct Investment Flows to LAC in 1997 (percent)

Costa RicaBolivia 1%

Dominican Republic 1% Ecuador1% 1%

Other ~~~~~~~Trinidad and Tobago)

Vcniezuela5%O/

Colombia 27l

Peru l"'2'gi---

9%

Argentina11%

Cbile11%

Scurce:'; Norld Bark

the U.S., Japan and Canada declined from 39 per- populations are expected to continue seeking supe-cent to 32 percent. On the other hand, flows to rior investment returns by building exposure toLatin America have represented an important but faster growing developing countries, including LACrelatively stable share of total European bank out- countries. Additionally, if Europe grows faster, its

flows. On average, EMU banks have directed savings should also increase. Private institutions innearly one-fourth of their total foreign lending to the euro area, such as pension funds and insuranceLatin American markets, or 40 percent of their companies, may shift a larger share of their portfo-lending to developing countries, during 1994-97."l1 lio into Latin American countries, once investmentThc authors further statc that "net foreign lending within the euro area is no longer classified as "for-flows of European banks in recent years have more eign" investment in terms of risk classifications.than doubled those of Canada, the U.S. and Japan Thus, the EMU is likely to soften the constraintscomi-bined. Thus, the growing significance of imposed by currency-exposure requirerflellts.

Europe as a source of foreign funds is not specific Another positive consequence could occur asto Latin America but rather a general trend towards a result of companies feeling squeezed competi-international portfolio diversification common to tively in the euro area, causing them to search formost European banks. Reasons underlying this new places to expand, either through mergers andtrend could be found in the relatively low interest takeovers or new investments.rates in Europe, and the reduction in the scope for Private portfolio holdings may be greatly

diversification within European markets as a result affected by the launching of the euro. It will createof the convergence in interest rates and the increas- a new and one of the largest single-currency finan-ing correlation of intra-EMU returns." cial markets in the world. The EU bonds, equities,

With the introduction of the euro, LAC may and bank loans in European capital markets totaledexperience an enhanced inflow of investment from more than $27 trillion in 1995, compared to theEurope, partly reflecting portfolio shifts. Growing U.S. capital market's $23 trillion andJapan's $16pools of savings in European countries with aging trillion (see Peter Bekz, 1998).

THE IMPACT OF THE EURO ON LATIN AMERICA * 11

It is difficult to assess the potential scope of a large compared with EMU returns, LAC becomesreallocation of international portfolios following the an attractive region.introduction of the euro. European currencies'share of world private portfolios increased nearly INTEREST RATE SENSITIVITY OFthreefold in 15 years, reaching 37 percent in 1995. SHORT-RUN CAPITAL FLOWSThe dollar's share declined 7 percentage pointsover the same period, to around 40 percent. The Levy-Yeyati and Sturzenegger (1999a) have studiedEuropean currency share in the international bond the sensitivity of Latin American capital flows toportfolios accounts for 37 percent of the interna- variations in EMU interest rates. Their analysistional bond portfolios. At present, banks assume an shows that capital flows to Latin America are highlyimportant role in continental Europe, and the capi- sensitive to fluctuations in foreign interest rates. Intal markets play only a marginal role. the 1990s the short-term inflows to Latin American

Table 1 shows that the U.S. dollar is dominant countries demonstrated a common behavior inti-in all areas of currency shares in global finance. But mately linked to the behavior of U.S. interest ratesthe currency composition of reserves, loans, bonds, (Calvo et al., 1993). Calvo and others conclude thatand other assets is likely to change in the future. since a large part of the capital account surplusesSome economists believe that the launch of the obeys to temporarily low interest rates abroad, aEMU will result in an important rebalancing of reversal of these flows is to be expected as soon asfinancial portfolios away from U.S. dollars and foreign interest rates pick up."2 The remainder oftowards the euro. If that happens, other economists this section draws on the paper of Levy-Yeyati andexpect that it will do so progressively. The private Sturzenegger. Besides diversification effects, theasset holding is anticipated to move more rapidly convergence of long-term interest rates in southernand by larger shares than the official reserves. Levy- European countries like Spain or Portugal towardsYeyati and Sturzenegger (1999b) mention that the the low levels prevailing in Germany may promptEMU banks have directed nearly 25 percent of investors to rebalance their portfolios towards mar-their foreign lending to Latin American markets, or kets, searching for the moderate yield/risk profiles40 percent of their lending to developing countries formerly offered by these countries. An importantduring 1994-97. determinant of the extent to which those factors

The recent process of financial liberalization may result in a stronger demand for Latin Ameri-makes the large countries in LAC sensitive to can assets is the level of country risk assigned bychanges in the determinants of international capital international rating agencies. These ratings influ-flows. The increased convergence in European ence not only the degree of substitution of invest-interest rates and stock market activity limits the ment assets in Europe and in the Latin Americanscope for diversification within Europe. Diversifica- region, but also how the region fares relative totion opportunities are thus sought outside the competing emerging economies. The risk levelsEMU. Since Latin American financial returns are assigned to Latin American economies generally

Table 1Currency Shares in Global Finance in 1997 (percent)

All EU USD DEM JPYLAC foreign debt denomination 8.7a 66.6 5.8 6.3Official foreign exchange reserves 26 .9b 67.3 15.1 5.8- of which developing countries 19.0 66.9 11.2 5.2Foreign holdings of bank deposits 39.6 50.8 14.8 5.5Intl. debt security issues (1992-97) 38.2 41.1 - 16.4Foreign exchange market turnover ('95) 35.0 41.5 18.5 12.0

Sources: IMFAnnual Report (1998), p. 111; BIS 68th Annual Report, pp. 116, 149; World Bank GDF Database, BIS Central Bank Survey of Foreign Exchange andDerivatives Market Activity (1996), p. 8.a. FRE. DEM, and GBP only.b. FRF DEM, GBP NLG, ard ECL.

12 * THE IMPACT OF THE EURO ON LATIN AMERICA

exceed those of other emerging markets. In 1998, Since EMU countries have supplied an increas-for example, according to Moody's, Latin American ingly important portion of foreign investmentcountries received, on average, a Ba2 rating, or two flows to the region, one would expect scnsitivity oflevels below investment grade, while the average Latin American capital flows to European interestrating for the rest of the emerging markets was Bal. rates in the latest years. Levy-Yeyati and Sturzeneg-Similarly, the average rating assigned by Standard ger test the previous intuition by regressing inter-and Poor's to Latin America (BB+) is one notch national reserves and the real effective exchangebelow that for other emerging economies (BBB-).13 rate for Argentina, Brazil, Chile, Colombia, Mex-The sovereign risk of Latin American countries has ico, Peru, and Venezuela on U.S. and DM three-not witnessed important improvements recently. month T-bill rates. The results indicate that whileArgentina, Colombia, Ecuador, Uruguay, and the U.S. rate is in most cases significant and wasVenezuela all have the same ratings as they had in the main influence in the evolution of reserves in1994. Mexico went down two levels as a result of the early 1990s, the DM rate becomes the mainthe 1994 crisis, improving one notch in 1998. On explanatory factor in the recent period. In particu-the other hand, Brazil, Chile, and Peru advanced lar, with the exception of Colombia, the DM inter-one level. As of 1998, the only Latin Amcrican est ratc has p-values below 10 percent, and thcircountries that had investment grade were Chile, coefficients display the correct sign. Moreover,Colombia, and Uruguay. Moreover, with the cur- they are associated with lower probability valuesrent macroeconomlic context in the region, Levy- thani thie U.S. rate. The only exception is Mexico,Yeyati and Sturzenegger conclude that it is difficult which, as expected, continues to display a strongto foresee any of the remaining countries reaching negative link with the cycle in the United States.investment grade any time soon. The authors' conclusion from this preliminary

As the process of European integration exploration is that the future evolution of capitalstrengthens, European interest rates are likely to flows to Latin America may reflect the evolution ofmove increasingly closer to each other, and hence the euro interest rate more closely than is usuallycapital flows from and to the euro area will display believed. The launch of the euro can only amplifystronger co-movement and sensitivity to changes this effect and hence Latin American prospectsin EMU-wide interest rates than they did to may be significantly linked to the European busi-changes in interest rates in individual countries. ness cycle.

13

VALUE AND VOLATILITY

OF THE EUROw

THE FINANCIAL CHALLENGES FACING THE EMU ARE REAL. Exchange rate volatility

could lead to portfolio shifts both into and out of the euro area. Table 2 indicates that in the past

two decades exchange rates have been quite stable. Furthermore, the real exchange rate of the euro

has less variability than the bilateral rates, for example, the DM/$ rate. In the 1990s the euro has

just half the variability of the 1980s (see Table 2 and Figure 6).

Economists' views on the effect of the EMU on 1998. The depreciation has given a welcomelong-term exchange rate volatility vary considerably. boost to hard-pressed European exporters strug-Since its introduction, the strength of the euro has gling to recoup business losses after a slowdownbeen reduced by 5 percent on a trade-weighted induced by the crisis in Asia and Russia. The eurobasis and by 10 percent against, for example, the weakened mainly because of its economic perfor-dollar. Hence, the prediction by some economists mance when compared to the boom in thethat the euro would appreciate against the dollar United States, and the EU's proximity to the con-from the initial value in the short term did not flict in Kosovo.materialize in the first four months of the euro'sexistence. The argument was that national savingsin Europe would increase and lead to a currentaccount surplus. Furthermore, in the first months Table 2the euro has not been more volatile than former Exchange Rate VariabilityEU currencies in the preceding period. 1976-79 1980 89 1990-99

On the other hand, four months after the Yen/$ 0.16 0.25 0.08

launch, the euro is no weaker than the European DM/$ 0.22 0.21 0.12Real Euro 0.08 0.09 0.04

currencies it subsumed a year ago. 'VJhat it gave Source: Dornbusch (1999). Variability is measured by the coefficient of

up were onrly the gainis notched up iri thc fall of varation.

14 * THE IMPACT OF THE EURO ON LATIN A-MERICA

Figure 6The Euro Real Exchange Rate

(JP Morgan Index 1990=100)

110.0 -

105.0 -

100.0

95.0 f V 90.0

85.0 "AA

75.0 -

70.0 IIII 111111 ill III 1111111 II I I I 11111 11 LI

Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan70 72 74 76 78 80 82 84 86 88 90 92 94 96 98

Source: Dornbusch (1999).

Clearly, the policies and credibility of the region where high unemployment levels haveEuropean Central Bank (ECB) and the strength been a source of grave concern for more tlhan aof its determination to pursue price stability decade.have an important influence on the euro's inter- In the future the relative strengths of thenational value. Uncertainty about the ECB and dollar and the euro will, in addition to the credi-European politics weakened the euro in the bility of the ECB, depend on market sentiments,early days of the EMU. A less strong euro growth prospects, and the mix of fiscal and mon-would probably spur demand for labor in a etary policy on both sides of the Atlantic Ocean.

15

FINANCIAL

IMPLICATIONS

INCREASED FINANCIAL COMPETITION IN THE EURO REGION is expected to acceler-

ate the trend towards banking consolidation and concentration. This effect is already reflected in

the ongoing process of internationalization of financial intermediation in the LAC region. This

sector considers the financial implications of the introduction of the euro currency in the banking

system, foreign debt, and reserve management.

B A N K I N G S Y S T E M ation of a single and liquid market in euro-domi-nated corporate bonds takes place, the introduction

The introduction of the euro will work as a catalyst of the euro will make it even harder to lend moneyto the development of integrated money and bond profitably to bigger firms. The deposit and moneymarkets in Europe. It will increase competition market business will also encounter difficulty, sinceamong banks and between banks and other sources corporate customers will no longer need accountsof funds. Furthermore, the implied greater compe- in various European currencies, reducing the vol-tition between banks and financial systems in gen- umes. Banks will likewise lose profits from theeral should lead to efficiency gains in terms of money market as interest-rate differentials betweenresource allocation, which will ultimately stimulate euro-area currencies are eliminated.investment and job creation. The above-mentioned areas are examples of

Foreign exchange trading, corporate banking, where business is anticipated to be eliminated orand government-bond trading together account for reduced. But the EMU should create profitableover half the profit of a typical large commercial new business as well; for example, the market forbank. It is expected that European bank reserves euro-denominated bonds and banks' profit fromwill be reduced by 20 percent over the next decade bond and equity trade could increase.14

in these three business areas. Corporate banking is How will these developments in banking sys-another sector with difficulties ahead. As the crc- tems in Europe affect Latin America? It seems pos-

16 * THE IMPACT OF THE EURO ON LATIN AMERICA

sible that the short- and long-term effects may go cient supervision. As in any other industry,in opposite directions. Recent years have seen a foreign competition, by negatively affectingsubstantial expansion in the involvement of Euro- overall bank profitability, may amplify exist-pean banks in Latin America. The share of bank ing fragility. In addition, bank competitionassets intermediated through foreign-owned banks may create incentives to engage in excessiveballooned in the past couple of years. In the imme- risk taking as a way of "gambling for resur-diate future, the euro may encourage a moderation rection." Therefore, inasmuch as the open-in this trend, as nationally based banks in Germany ing of banking sectors in the region appearsand elsewhere have traditionally attached top prior- to be an unavoidable consequence of theity to expanding their base across the EMU. In the removal of capital account restrictions, it islonger term, however, as the competitive situation crucial that it be accompanied by the neces-within Europe heats up, and margins are competed sary prudential safeguards, possibly includ-down, a renewed expansion into more profitable ing an active intervention of the supervisorynon-European markets may again look more authority to prevent disruptive competitionappealing. during the transition.

Levy-Yeyati and Sturzenegger have considered (Levy-Yeyati and Sturzenegger 1999b)the pros arid cons of internationalization in thebanking sector. Their discussion suggests that

DEBT MANAGEMENTforcign pcnctration can be considered as thenatural outcome of the opening of formerly An economy has to decide how much public for-protected sectors to more efficient institu- eign debt to hold and how to diversify among cur-tions, as well as the response of increasingly rency denominations and optimal structure ofvulnerable domestic banking systems that maturity. The stock of external debt amounted tocannot compete equally with better capital- US$618 billion in Latin America in 1997. Brazilized and more widely diversified institutions and Mexico alone account for more than half ofbacked by more reliable lender-of-last-resort this figure (see Figure 7). Comparing the debt tofacilities in parent countries. In addition, GDP ratio shows large variations across countries;economies of scale in supervision technolo- for example, the ratio is 19 percent, 29 percent, 17gies motivate the willingness of monetary percent, and 23 percent for Brazil, Argentina,authorities in small open economies to Chile, and Mexico, respectively.import supervision services by transferring The share of EU currencies in Latin Amer-the responsibility to the parent countries. ica's outstanding external debt is only 8 percent.Finally, risk pooling consideratioins make it The debt in Deutscliemark and franc francaisrelatively less costly for central banks in amounts to 6 percent and 2 percent, respectivelythese economies to provide emergency assis- (see Figure 8). The U.S. dollar share is by far thetance to internationally diversified financial largest and accounts for 67 percent. As long as Latininstitutions. But, the cost of this strategy American external debt continues to be largelyshould not be underestimated. First, it is not denominated in dollars, debt payments are hardlyobvious the extent to which the parent insti- affected by euro interest rates and exchange ratetution would be willing to incur the costs of developments.effectively insuring their foreign operations. LAC countries could offset adverse effects ofThere is certainly a limit beyond which the economic shocks by changing their debt-manage-financial costs of bailing out foreign affiliates ment policies, which the new euro currency facili-exceed the reputation cost of letting them tates. The currency composition of foreign debtfail. More important, however, are the should be related to the composition of earningsshort-run costs of financial opening in a from foreign trade. The share of euro debt maycontext of weak domestic banks and ineffi- well increase, since the share of total foreign trade

THE IMPACT OF THE EURO ON LATIN AMERICA N 17

Figure 7LAC Countries' Foreign Debt in 1997 (in US millions $)

Venezuela MENEM

Uruguay

Trinidad and Tobago

Peru

Paraguay

Panama

Nicaragua

Mexico

Jamaica

Honduras

Haiti

Guatemala

El Salvador

Ecuador

Dominican Republic

Costa Rica

Colombia

Chile

Brazil - - - - --Bolivia

Argentina

0 20,000 40,000 60,000 80,000 100,000 120,000 140,000 160,000 180,000 200,000

Source: Author s calcu ation using World Bank data,

Figure 8LAC Countries' Foreign Debt Share in Different Currencies in 1997 (percent)

600%

400/i * DEM80%

9~~~~~~~~~~~# FX,a

Source: Author's calculation us ng World Bank data.

18 * THE IMPACT OF THE EURO ON LATIN AMERICA

with Europe is increasing. Hence, hedging strate- tinue to favor the dollar. Latin Americans are famil-gies may need to be reassessed. iar with the U.S. currency, and many in both the

In the longer term, a shift in euro interest private and public sectors may be influenced byrates will have an effect on the foreign debt service established personal, cultural, business, and politi-of countries in Latin America and the Caribbean cal links to the United States. A process of hemi-because part of their debt will be denominated in spheric economic integration is, albeit haltingly,euros. In the near term, however, the impact would now under way. On the other hand, if the euro canbe minor because the current share of the 11 euro- acquire a reputation for stability, some in Latinarea countries' national currencies in Latin Ameri- America may see reasons, such as a hedge againstcan debt is small (around 8 percent). For the same terms-of-trade changes, for portfolio diversificationreason, the debt payments are not expected to be to increase their euro holdings. Nor should oneparticularly affected by interest rate developments ignore the ambivalence of some Latin Americanin the EU. Levy-Yeyati and Sturzenegger (1999a) feelings towards the United States or the motiva-calculate that a percentage point increase in euro tions of some Latin American leaders to look tointerest rates would imply additional debt pay- closer links to a stronger Europe, partly as a coun-ments for Latin American countries that range tervailing measure to offset the traditional hemi-from around 0.11 percent to 0.17 percent of total spheric dominance of the United States.export earnings (or 0.02 to 0.03 percent of GDP). The reserves held in Latin America amount toAlthough not negligible, these numbers do not about US$170 billion, and the average reserverepresent a significant increment in debt service holding in months of imports is around US$4.2costs, mainly because of the relatively small share billion. As with the foreign debt, the majority ofof external debt that is currently denominated in the reserve holdings are in dollars (apart fromeuros. reflecting the trade role of the United States, the

Furthermore, countries in the LAC region dollar held a proxy role), but the trend has beencould offset the adverse effects of economic shocks downward in the past decade. The shares increasedby changing their debt-management policies. This in Deutschemark and yen due to the United States'will be easier to do with a single European cur- falling share of global GDPrency. But the emergence of the euro and a major Rudiger Dornbusch has explained why coun-European capital market is not creating important tries hold reserves and the complications thatnew prospects in the near term for access to capital result:for the LAC region.

Countries that peg exchange rates or wish toRESERVE MANAGEMENT limit the extent of fluctuations of rates hold

reserves to provide a cushion in case netThe EU intends for the euro to become a major external cash flow, on current and capitalreserve currency, competitive with the U.S. dollar, account, turns negative. Reserves are a sub-and there has been considerable controversy among stitute for adjustment when shocks are tem-observers as to how far this effect could go and its porary and hence justify financing ratherimplications. Will Latin American countries sub- than adjustment. They also, in the case ofstantially diversify their reserve holdings? This is persistent disturbances, help bridge untilboth an economic and in part a political question. the appropriate adjustment can be accom-If Europe succeeds in making the euro competi- plished. In a world where there is only a sin-tive, it could cut into the seignorage currently gle outside currency, say the dollar, the onlyaccruing to the United States (this gain would, relevant issue is to determine the appropri-however, have to be balanced against the domestic ate level of reserves. The determinants arepolicy considerations-employment, etc.-men- likely to be, in addition to the scale of thetioned above). The forces of inertia (and uncer- economy, the volatility of net cash flows astainty about the new currency) will at first con- well as the opportunity cost of holding

THE IMPACT OF THE EURO ON LATIN AMERICA * 19

reserves as measured by the differential associated with the holding and management of abetween the return on reserves and the cost reserve position and are therefore replaced by aof capital. The cost of disruptive adjustment proxy currency.or unwanted exchange rate movements cer- The advent of the euro will eventually create atainly enters the optimal level of reserves. deep and liquid capital market in Europe. The very

(Dornbusch, 1999) size of the market will attract competition andreduce spreads and, hence, offer holders of euro

But, of course, the world is not structured on assets higher returns and better transaction poten-a single outside currency, so the question of how tial. As a result, the euro achieves equality with thereserves are to be held is also a critical part of the U.S. dollar as a reserve asset. In other words,discussion. Not surprisingly, the first pass at this reserve management enjoys the opportunity toquestion is to hold a diversified portfolio of come closer to target, gain higher returns, and, for areserves in various currencies in which the portfo- more diversified portfolio (in terms of risk expo-lio shares represent the shares of the respective sure), still have a more liquid position than wascountries in the trade pattern. There is, accordingly, previously possible. All of this is achieved becausea sort of indexing in which reserve holdings mirror of the emergence of a European single capital mar-trade patterns. ket. That is surely the central effect, and it implies

Furthermore, Dornbusch states that in prac- that, over time, as the capital market develops andtice the extensive indexation is too cumbersome. becomes attractive, reserve holdings will shift fromCurrencies of small-partner countries or the cur- dollars (and yen as Japan's public finance goesrencies of countries with retarded or unstable capi- bankrupt and Japan can no longer offer a hard cur-tal markets are likely to have high transaction costs rency and relatively risk-free asset) to the euro.

20

REIONAL

INTEGRATION

REGIONAL INTEGRATION WAS REVIVED IN THE EARLY 1990s as governments in LAC

decided to liberalize their economies. Some positive benefits of regional integration in Latin

America are expected: (1) reduction in average level of protection, (2) expansion of the market

size, which would promote specialization and industrialization through economies of scale, (3)

political credibility and trust building across countries, and (4) preparation for increased unilateral

liberalization. The question is whether expected benefits outweigh expected costs. The costs

encountered could be in the form of: (1) delayed interest in unilateral trade liberalization and (2)

trade directed away from more efficient production in countries outside the trade block.

The experience from the Mercosur region is The limited macroeconomic harmonizationthat trade has been created, but not much trade between the large countries in Mercosur has leddiversion has taken place. Furthermore, tariffs have to strains within the trade block. Exchange-rate-been reduced. Economic policies are not coordinated based stabilization and sharp exchange-rate move-in the trade zones, and this may prevent the full gains ments associated with loss of monetary or fiscalfrom trade from being realized. The main causes are control have created political fears of free tradeexcess exchange rate and relative-price volatility. within the region.These disincentives may cause producers to allocate In the short term, policy measures to regu-resources along the lines of comparative advantages late international capital flows will improve gov-and, in the worst case, lobby for protection. Feasible ernments' ability to stabilize exchange rates in thepolicy coordination is likely to be guided towards Mercosur region. In the longer term, there willharmonizing guidelines and policy rules. be a need for macroeconomic policy coordina-

THE IMPACT OF THE EURO ON LATIN AMERICA N 21

tion. Possible coordination of policy is likely to related not to the change in regional parities, butinitiate with exchange rate policy, including a sin- to changes in the exchange rates with countriesgle currency, common currency board peg, or outside the region. Both factors reduce the poten-harmonization of the rules and regulations that tial gains in terms of financial sector integrationguide the policy formulation. and reduced volatility of capital flows, which

were decisive in stimulating the European inte-IS THE EURO A BLUEPRINT FOR grationprocess.THE LATIN AMERICAN REGION? On the fiscal side, Mercosur economies have

not yet discussed the need for fiscal policy coor-Does it make sense for Mercosur to think of a dination, which is not surprising given that theymonetary union similar to that implemented in still have not solved the fiscal federalism prob-Europe? According to Levy-Yeyati and Sturzeneg- lems at the national level. Mercosur not onlyger (1999b), Mercosur does not, at this point, lacks targets that coordinate fiscal policies but alsoqualify under the conditions identified by the supranational institutions that can centralizeoptimal currency theory (OCT) for establishing transfers to those areas affected by adverse eco-an independent monetary area with a common nomic shocks.currency for the member countries (see Table 3). The benefits that could arise from the elimi-When considering the degree of integration in the nation of speculative attacks will depend upon thereal sector, interdependence is very low in LAC in credibility that the common central bank can sus-comparison to that of the EU. When the first tain. However, the associated benefits are seri-stage towards monetary union was completed, the ously limited by the fact that Mercosur does notaverage exports to partner countries accounted for have currencies with a lasting stable tradition or a14 percent of GDP in the EU, but, in the case of country that can bolster the other members inMcrcosur, this figure reached only 4.1 percent in casc of spcculative attacks during the transition1997. Although it is true that the integration process.process of Mercosur is not completed, the view is On this basis, it is reasonable to believe thatnot optimistic when it comes to forecasting an European experience suggests, if anything, theincreasing level of integration in the near future convenience of a monetary union with thebecause of the structure of the economies. More- United States, as opposed to one that onlyover, labor markets are not integrated, and large involves the countries within the region.differences in income levels between the coun- Although an analysis of the preconditions identi-tries prevail. As a result, in the short term free fied by the OCT theory could lead to an even lessmobility of labor is not going to be welcomed by optimistic result for a monetary union with theall countries (especially Argentina). This reduces United States than with Mercosur countries, thethe scope of the labor market to absorb asymmet- great advant, ge of this integration would stemric shocks, which also seem to be likely (and from gains *n terms of credibility in the conduitlarger) in Mercosur than in the NAFTA or EMU of monetarj policy and some reduction in cur-regions. The banking sector has become increas- rency speculation, which could reduce signifi-ingly international, but financial sectors remain cantly the volatility in capital flows to which thesegmented, and prudential regulation is still very region would be exposed.different. This would lead to moral hazards-in It should be noted that the democratic sys-the case where there was a common central tem in the integrating countries within Mercosurbank-both at the level of individual banks and is still in the building stage. Therefore, fosteringbetween countries, if they were to engage in regu- economic relations between the member coun-latory competition. Macroeconomic shocks tries can help consolidate democratic institutionsappear to be correlated in the short run, and capi- in the those countries, thereby constituting a sig-tal flows associated with currency instability are nificant positive factor for regional integration.

22 * THE IMPACT OF THE EURO ON LATIN AMERICA

Table 3Evaluation of Monetary Union

Factors What does the theory say? Where is Europe? Where is Mercosujr?Trade Integration The larger, the h gher the High degree of ntegration. Low degree of integration

benefits of monetary union Exports to partners were 14% exports to partners were 3.8%of GDP at the signing of of GDP in 1996.Maastricht

Productive Labor The larger the degree of factor Low integration relative to the No integrat on.Factors Market market integration, less is the U.S.

need to use the exchange rateas an adjustment instrumentand, therefore, the larger thebenefits of monetary union.

Banking Integrated. Highly internationalized butSector with important differences in

regulation.

Capital Integratsd. It has also been Unilaterally open (each coun-Markets effective as a mechanism to try has opened the capital

eliminate exchange rate account, though scme main-real gnments. tain restrictions). Exchange

rates between countries arenot very relevant (what is rele-vant are the parities with thedollar, the euro, or the yer);thus currencies will continueto experience speculativeattacks.

Reduces the possibility ofspeculative attacks andtherefore ncreases thebenefits of monetary union.

Shock symmetry The more symmetric are Symmetr c shocks. Large and asymmetric shocks.shocks, the lower the needto change the exchange rateand the bigger the benefitsof monetary union.

Fiscal Policy Monetary union imposes Maastricht achieved Stronc divergence in fiscalrestrictions upon the con- balances persists.sistency of fiscal policyamong members.

Fiscal Transfers The larger the transfers the Exist, Do not exist.among men ber countries larger the possibility of

smoothing regional shocksanc the larger the benefitsof monetary union.

Credibility Monetary union may generate There is a gain in credibility Credibility gains are unlikelybenefits in terms of increased because the ECB emulated due to the strong d sparity incredibility. the Bundesbank. the use of monetary policy

and the lack of tradition inkeep ng inflation in check.

Political Integration Monetary union ar ses as the This process is under way. The process is just starting.result of a common politicaproject.

Source Levy-Yeyati and Sturzenegger (1999b).

The monetary union seems unrealistic in be no fluctuations of the respective currenciesthe short run, as it requires a political commit- vis-a-vis one another. But the cost is high for thement that is not present in Mercosur today. The individual countries of a currency board; itsame is true for the common currency board. implies a reduction of the tools in the policymak-The benefit of pegging the currencies to another ing tool kit, which is desired, since it is whatcurrency, say the U.S. dollar, is that there would contributes to credibility. Furthermore, it limits

THE IMPACT OF THE EURO ON LATIN AMERICA N 23

the capacity of the authorities to act as lenders of have implemented de-dollarizing policies with onlylast resort. partial success. Levy-Yeyati and Sturzenegger

If a Latin American country and the United (1999b) mention three ways of de-dollarizing: (1)States shared a currency, they would have to be maintaining artificially high domestic currencyexposed to the same kinds of shock, and their busi- returns, (2) introducing an artificial wedge in dollarness cycles would need to be in line and their eco- returns, and (3) putting legal restrictions on the usenomic structures alike. If asymmetric shocks arrive, of the dollar for financial transactions and, in thethe countries must be able to adjust, for example, limit, outright prohibition of dollar-denominatedwages and prices or transfers of income. Pan Amer- financial assets.ica does not remotely resemble an optimum cur- The lack of success of de-dollarization has ledrency area, as asymmetric shocks are frequent, and some Latin American countries to debate dollariza-more are expected. tion as an active policy as, for example, in the case

of Argentina in which a currency board agreementD O L LA RI Z AT ION was implemented by legitimizing and deepening

the dollarization process, generating the credibilityThe recent episodes of financial instability have put that previous efforts had lacked. Many economistsdollarization back on the agenda in Latin American do not believe giving up the monetary policy tool iscountries. Two types of dollarization are at play: the proper solution. One economist that does ispassive and active. The active dollarization policy Dornbusch. Dornbusch (1999) suggests that Latinoriginates from policymakers, and passive dollariza- America should follow the Argentine example of ation is a result of decisions taken by economic currency board on the dollar or outright dollariza-agents as an answer to inflation. tion. Calvo (1999) argues that full dollarization is

Latin American countries display a significant advantageous for countries with large dollar debtslevel of passive dollarization, both financial and real and criticisms by these economies against full dol-dollarization. Financial dollarization is in the form larization are largely unwarranted. These countriesof financial assets such as CDs and bank loans. This are likely to face lower interest rates because theis normally combined with real dollarization in devaluation risk is eliminated. Furthermore, theywhich the dollar becomes a unit of account and a are better shielded from contagion, and as a resultstore of value parallel with the national currency. might enjoy higher and more stable economicDollarization has taken place in Latin America; growth. Calvo also notes that dollarization cannotcountries have experienced long periods of high stand alone: it must be supported by policies thatinflation iii which agents shifted toward the use of ensure the solidity of the domestic financial sectorthe dollar as a reference currency. Governments and a long maturity structure for the public sector.

24

CONCLUSION

THE PRINCIPAL CONCLUSION OF THIS PAPER is that the euro is not likely to cause any

single major change in Latin America. There will, however, be a lot of small effects-in different

directions-in the short and long run.

A large part of the impact of the euro in Latin cult to provide definitive answers or to quantify theAmerica is expected to be of secondary importance, possible impacts, but we argue that the introduc-as no structural trade change is expected. For exam- tion of the euro is likely to have a positive, althoughple, increased competition and efficiency should limited, effect on the LAC region. The main find-increase economic growth in the EU, which in ings are the following:turn should increase imports from the LAC region,given that the trade diversion effect is not likely to * Increased financial deepening in Europebe very important. At least in the short run, Latin could have some positive effect on growth inAmerica and the Caribbean are highly dollarized, Europe, and could lead to a small increase inand we do not expect a major change immediately exports for LAC. It could also lead to increasedwith the launching of the euro (though the longer financial flows between the regions.term effect is much harder to predict).

Latin Amcrica and thc Caribbcan countries are * LAC debt is mainly dcnominatcd in U.S.very heterogeneous. The impact of the EMU and dollars. No significant appreciation of the euro isthe euro is therefore likely to impact countries dif- expected. Thus, the immediate impact of the intro-ferently. Countries and regions with strong links- duction of the euro on debt value and debt serviceculturally and geographically-to the United States is expected to be small. The euro will, however,(such as Mexico and Central America) are likely to create the opportunity to realign the currency com-be affected less than countries with weaker links. position of foreign exchange reserves, in light of

For LAC countries, the main impact of the trade flows, other transactions, and possibly-in theunified European market and the single currency is longer term-portfolio diversification and politicallikely to come through financial linkages. It is diffi- considerations.

THE IMPACT OF THE EURO ON LATIN AMERICA * 25

LAC countries may become more attractive A prosperous EMU is expected to contribute toas destinations for European investors seeking greater trade and financial flows between LAC and

diversified portfolios, including higher return com- the EU. Currency certainty, low inflation, increasedponents, and as intra-European investments show trade, and more efficient markets-all promise large

converging returns. benefits for the EU as well as some benefits for LatinAmerica. Furthermore, a prosperous EMU requires

* LAC and Mercosur cannot be seen as opti- sound financial structural policies, including reforms

mal currency areas at this time, therefore, at this of both labor markets and public spending. Over thestage the euro does not serve as a blueprint for long term, this should also benefit other countries,

Latin America. including those in the LAC region.

26

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28

NOTES

1. Argentina, Brazil, Paraguay, and Uruguay. 9. Capital Data BondWave.2. See Daniel Cohen, Nicolai Kristensen, and 10. Brazil received the largest share-35 per-

Dorte Verner (1999). cent of the total; Argentina 18 percent; Chile and

3. Excluding 18 countries with less than one Venezuela 12 percent; Colombia 10 percent; and

million inhabitants, the total is 483 million in the Mexico 9 percent.

LAC-23 region. The LAC-23 countries are 11. These numbers, however, mask deep dif-Argentina, Bolivia, Brazil, Chile, Colombia, Costa ferences in Latin American exposures of EMURica, Cuba, Dominican Republic, Ecuador, El Sal- partners. For 1997, while the share is only 14 per-vador, Guatemala, Haiti, Honduras, Jamaica, Mex- cent in the case of Belgium, it reaches 88 percent

ico, Nicaragua, Panama, Paraguay, Peru, Puerto for Spain, and 55 percent for Italy in 1997.Rico, Trinidad and Tobago, Uruguay, and 12. Although this conclusion was largely con-

Venezuela. firmed by the process leading up to the 1994 Mexi-4. Bolivia, Colombia, Ecuador, Peru, and can crisis, recent crises in Asia, in a context of flat

Venezuela. or declining interest rates, run counter to this argu-5. Argentina, Brazil, Chile, Colombia, Mex- ment (see Levy-Yeyati and Sturzenegger, 1999a).

ico, and Peru. 13. Moody's debt ratings: (investment grade)6. The average mean tariff in East Asia is 16 Aaa-Aa-A-Baa, (noninvestment grade) Ba-B-Caa-

percent, while in Latin America it is 12 percent. C. Standard and Poor's debt ratings: (investment7. It is hard to disentangle the different grade) AAA-AA-A-BBB, (noninvestment grade)

sources of European growth, since the economy BB-B-CCC-CC-D.grows due to both euro- and non-euro-related fac- 14. LAC raised about $US25 billion commer-tors. cial bank loans in 1996, US$17 billion from private,

8. The latter normally bear a higher return US$0.6 billion from sovereign, and other public,than the former. US$8 billion.

29

APPENDIX

Table AlEU-11, 1996

Inflation, TradePopulation GDP PPP GDP growth GDP PPP consumer prices (% of GDP)

(miil.) (mill.) (annual %) per capita (annual O/q) 1995Austria 81 174,888 1 1 21,701 1.8 78.22Belgium 10 2 225,428 1 4 22,190 2.1 140.39Finland 51 96,540 33 18,837 0.6 68.20France 58 4 1,260,031 1 3 21,585 2.0 44.57Germany 81 9 1,737,521 21,212 1.5 46.43Ireland 36 67,747 73 18,684 1.7 134.08Itay 574 1,155,551 0.8 20,139 4.0 50.94Luxembourg 04 13,385 39 32,211 1.4 172.32Netherlands 15 5 318,140 2.7 20,503 2.1 100.16Portugal 9.9 134,399 3,0 13,535 3.1 73.86Spain 39.3 608,498 22 15,499 3.6 46.94EU-11 2898 5,792,129 2.7 20,554 2.2 87

Source: Author's calculat on based on World Bank data.

Table A2EU-15, 1996

Inflation, TradePopulation GDFP PPP GDP (growth GDP PPP consumer prices (% of GDP)

(mi/I.) (mill.) (annual %) per capita (annual %) 1995Austria 8.1 174,888 1.1 21,701 1.8 78.2Belgium 10.2 225.428 1 4 22,190 2.1 140.4Denmark 5.3 119,422 25 22,695 2.1 64.2Finland 5.1 96,540 3.3 18,837 0.6 68.2France 58.4 1,260,031 1.3 21,585 2.0 44.6Germany 81,9 1,737,521 . 21,212 1.5 46.4Greece 105 130,691 26 12,476 8.2 43.4Ireland 36 67,747 7.3 18,684 1.7 134.1Italy 574 1,155,551 0,8 20,139 4.0 51.0Luxembourg 04 13,385 3.9 32,211 1.4 172.3Netherlands 15.5 318,140 2.7 20,503 2.1 100.2Portugal 9.9 134,399 3.0 13,535 3.1 73.8Spain 39.3 608,498 2.2 15,499 3.6 46.9Sweden 8.8 173,219 1.1 19,588 0.5 75.5United Kingdom 58.8 1,170,754 2.2 19,917 2.5 57.7Total EU-15 373.1 7,386,215 2.5 20,051 2.5 79.8

Source: Author's calculation based on World Bank data.

30 * THE IMPACT OF THE EURO ON LATIN AMERICA

Table A3LAC countries, 1996

PoDulation GDP PPP GDP growth GDP Inflation, Trade r/o of(mill) (mili) (annual I%), per capita, consumerprices GDP PPP),1996 1996 1995 PPP 1995 (annual °/0) 1995

Argentina 35.2 322,898 -4.6 9,287 0.2 12.3Bolivia 7.6 21,596 3.7 2,913 12.4 12.0Brazil 161.4 953,113 3.0 5,986 15.8 10.1Chile 14.4 158,620 8.5 11,162 7.4 20.2Colombia 37.5 254,574 5.3 5,915 20.2 9.3Costa Rica 3.4 22,328 2.4 6,618 17.5 32.7Cuba 11.0 - - - -Dominican Republic 8.0 33,202 5.0 4,244 5.4 26.4Ecuador 11.7 56,952 2.3 4,970 24.4 15.0E Salvador 5.8 15,844 6.3 2,798 9.8 28.6Guatemala 10.9 37,368 4.9 3,518 11.1 14.0Haiti 7.3 8,092 4.5 1,129 20.6 13.9Honduras 6.1 12,559 3.9 2,120 23.8 37.0Jamaica 2.5 9,257 0.5 3,670 26.4 48.1Mexico 93.2 695,499 -6.2 7,592 34.4 22.9Nicaragua 4.5 8,921 4.3 2,039 11.6 17.2Panama 2.7 18,538 1.7 7,046 1.3 67.5Paraguay 5.0 17,043 4.8 3,530 9.8 23.9Peru 24.3 107,622 7.0 4,518 11.5 12.8Puerto Rico 3.8Trinidad and Tobago 1.3 8,285 2.4 6,437 3.4 50.3Uruguay 3.2 23,072 -2.2 7,246 28.3 21.6Venezuela 22.3 186,643 3.4 8,544 99.9 17.0

LAC-23 483.1 2.972,027 2.9 5,347 18.8 24.4EU-15 373.1 7,386,215 2.5 20,051 2.5 79.8EJ-11 289.8 5,792,129 2.7 20,554 2.2 87.0

Source: Author's calculation based on World Bank data,

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