This paper attempts to strengthen the understanding of the effect of currency union by testing whether the effect of currency union on trade varies across levels of financial development. First, significantly more countries with low levels of financial development adjust their exchange rates and. An understanding of the effect of financial development on international trade helps to provide a theory for the role of financial development in the effect of currency union.
Another theory of the role of financial development in the trade-exchange rate relationship is hysteresis. The theories of exchange rate hedging, hysteresis and fixed cost financing all help to strengthen the understanding of the role of financial development in the effect of currency union. However, to date, no research has studied the role of financial development in relation to the effect of currency union.
Empirical Results
Pooled OLS
CCB_HH represents the interaction of currency union and trade between countries with high commercial bank assets. CCB_LL denotes the interaction dummy for currency union and trade between countries with low levels of commercial banking assets. PC_HH represents the interaction of currency union and trade between countries with high levels of private credit.
PC_HL represents the interaction dummy for currency union and trade between country pairs where one partner has low levels of private credit and the other high levels of private credit. PC_LL denotes the interaction dummy for currency union and trade between countries with low levels of private credit. Under the pooled OLS model, the currency union effect is predicted to be 137 percent weaker for countries with higher levels of private credit.
LL_HH represents the interaction of currency union and trade between countries with high levels of liquid liabilities. LL_HL represents the interaction dummy for currency union and trade between country pairs where one partner has low levels of liquid liabilities and the other has high levels of liquid liabilities. LL_LL denotes the interaction dummy for currency union and trade between countries with low levels of liquid liabilities.
The inclusion of a dummy variable accounting for trade between countries with low levels of liquid liabilities increases the effect of currency union by 112 percent. The pooled OLS model predicts a stronger currency union effect for countries with a lower level of liquid liabilities by 107 percent.
Fixed Effects
First, the effect of commercial bank assets on the currency union effect is tested under the fixed effects model. The inclusion of a dummy variable for trading partners that both have high levels of commercial bank assets is also significant. The findings imply that when countries that both have high levels of financial development trade together, the currency union effect drops by 52 percent.
This model also predicts that the effect of currency union is 34 percent stronger when both trading partners have a low level of financial development. Estimates of the impact of the currency union for the 10 economies with the highest commercial bank assets are now compared to the 10 economies with the least commercial bank assets. Using a fixed-effects model, the paper finds that the effect of currency union is 73 percent stronger for countries with the least developed financial systems.
Similar to the initial hypothesis, the results estimate that the effect of currency union will be 62 percent stronger for the 10 countries with the least amount of private credit. The interaction term between liquid liabilities and the currency union model turns out to be insignificant for the cumulative level of liquid liabilities. When the regression includes a dummy variable for trade between two partners with low levels of liquid liabilities or two countries with high levels of financial development, the interaction is also insignificant.
A significant interaction is found by including a dummy for trade between one partner with high levels of liquid liabilities and one partner with low levels of liquid liabilities. In this case, the model estimates that the currency union effect falls by 80 percent; however, the results are only significant at the 5 percent level.
Time-Fixed Effects
When both trading partners have high levels of trade assets vis-à-vis the central bank, the effect of the currency union drops by 47 percent and actually leads to a negative trade effect. When both countries have low levels of financial development, the currency union effect is 28 percent stronger. Next, time-fixed estimates of the net effect of currency union for the 10 countries with the highest levels of commercial bank assets are compared to the estimate of the effect of currency union for countries with the 10 highest levels of central bank assets.
According to the time fixed effects model, the 10 least financially developed economies have a currency union effect that is 63 percent stronger than for the 10 most financially developed economies. Trade between partners with low levels of private credit increases the effect of currency union by 18 percent (significant only at the 5 percent level). Finally, for trade between a nation with high levels of private credit and a nation with low levels of private credit, the effect of currency union is 96 percent smaller (significant only at the 5 percent level).
Under the time-effects model, levels of liquid liabilities have no significant effect on the impact of the currency union on trade with one exception: trade is expected to decline by 74 percent for partners where one nation has high economic development and the other has low financial development development ( only significant at the 5 percent level). Consistent with theory, the currency union effect for the 10 countries with the lowest level of liquidity responsibilities is expected to be 20 percent higher than for the 10 most financially developed economies.
Time-Fixed and Entity-Fixed Effects
Specifically, when two trading partners have high ratios of commercial to central bank funds, the currency union effect is reduced by 47 percent. For countries with a low level of financial development, the effect of the currency union is higher by 26 percent. According to this model, the effect of financial development on the effect of currency union is insignificant for trade between an economy with high financial development and an economy with low financial development.
The findings suggest that the currency union effect increases trade by less than 1 percent for the 10 most financially developed economies (e.g. In contrast, the currency union effect on trade increases by 64 percent (e.49= 1.64 ) for countries with the 10 lowest levels of commercial bank assets. The model shows that accounting for cumulative levels of private credit reduces the currency union effect by 22 percent.
No significant effect of the level of private credit on the effect of a currency union on trade between partners with a high level of financial development is found. For trade between one economy with a high level of private credit and one economy with a low level of private credit, the effect of the currency union is reduced by 90 percent. The effect of currency union is 21 percent larger for trade among economies with low levels of private credit.
Under the model of time-fixed and entity-fixed effects, levels of liquid liabilities do not seem to have a significant effect on the currency union effect. The effect of currency union for the 10 countries with the lowest level of liquid liabilities is 35 percent greater than for the countries with the 10 highest levels of liquid liabilities.
Conclusion and Policy Recommendations
In economies with well-developed financial systems, the decision to join a currency union should be taken very carefully. The findings of this paper suggest that the effect of currency union on trade for these countries will still be positive, but only marginally so. Given the significant loss of power and seignorage associated with the abandonment of national currencies, the creation of a currency union may even have a negative effect on some countries.
First, the pooled OLS model predicts a larger currency union effect for trading partners with a high level of financial development. Secondly, there is a persistently large negative impact on the effect of the monetary union when one trading partner has a low level of financial development and the other has a high level of financial development. In the case of the ratio of commercial assets to central bank assets, all forty observations in which a trading partner with high financial development joins a currency union with a country with low financial development come from former French colonies in Africa , using the CFA franc. .
For private credit observations involving a high financial development partner joining a currency union with a low financial development nation, 50 of the 51 observations come from Latin American nations adopting the US. Similarly, for observations of liquid liabilities where a currency union exists between a partner with high economic development and a partner with low economic development, 91 out of the 96 observations come from Latin American trade with the United States. These results suggest that there may be specific circumstances and policies that counteract the impact of the currency union on trade in these observations.
In addition, data from the Eurozone, as the most studied currency union in the recent literature, would increase the power of the current research. Recent evidence on the currency union effect also points to the importance of historical events in the effectiveness of currency unions, arguing that currency unions can have very little effect on trade (Campbell 2012). In addition, to further clarify the findings of this paper, a dataset with country-level trade data instead of bilateral trade data can better capture the effect of financial development for both countries rather than relying on findings based on paired trade data.
The Estimated Effects of the Euro on Trade: Why Are They Lower than the Historical Effects of Monetary Unions Among Smaller Countries?” NBER Working Paper No.
