77530 Business Cycle Synchronization and Regional Integration: A Case Study for Central America Norbert Fiess Deeper trade integration between Central America and the United States, as envisaged under the Central American Free Trade Agreement, is likely to lead to closer links between Central American and U.S. business cycles. This article assesses the degree of business cycle synchronization between Central America and the United States—relevant not only for a better understanding of the influence of important trading partners on the business cycle fluctuations in the domestic economy but for evaluating the costs and bene�ts of macroeconomic coordination. JEL codes: F15, F42. In early January 2003 the United States and Costa Rica, El Salvador, Guatemala, Honduras, and Nicaragua launched of�cial negotiations for the Central American Free Trade Agreement (CAFTA, renamed DR-CAFTA after the Dominican Republic joined the negotiations in 2004).1 Once rati�ed by all members, DR-CAFTA will expand trade barrier reductions similar to those in the North American Free Trade Agreement (NAFTA) to Central America. DR-CAFTA is part of a bigger project to promote regional integration through- out the Americas, with the ultimate aim of establishing a Free Trade Area of the Americas. An open question for any trade integration initiative is the macroeconomic consequences and so the implications for macroeconomic policies. Like NAFTA, DR-CAFTA contains no explicit provisions on macroeconomic policy. But just as NAFTA has affected Mexico’s macroeconomic dynamics (Lederman, Maloney, and Serven 2005), DR-CAFTA has the potential to change the macroeconomic dynamics between Central America and the United States, which could in turn alter the desirability to coordinate �scal and monet- ary policies between these countries. Norbert Fiess is the deputy director of the Centre for Development Studies in the Department of Economics at the University of Glasgow; his email address is n.�ess@socsci.gla.ac.uk. A supplemental appendix to this article is available at http://wber.oxfordjournals.org. 1. This article’s focus is limited to the initial CAFTA countries. THE WORLD BANK ECONOMIC REVIEW, VOL. 21, NO. 1, pp. 49 – 72 doi:10.1093/wber/lhl014 Advance Access Publication 24 January 2007 # The Author 2007. Published by Oxford University Press on behalf of the International Bank for Reconstruction and Development / THE WORLD BANK. All rights reserved. For permissions, please e-mail: journals.permissions@oxfordjournals.org 49 50 THE WORLD BANK ECONOMIC REVIEW Trade is often perceived as an important—if not the most important— transmission channel for business cycles from one country to another. Theoretically, the impact of trade integration on business cycle synchronization is unclear. Increased trade can lead business cycles to diverge or converge. If trade integration leads to increased interindustry trade as a part of a specialization process, business cycles are likely to diverge because shocks speci�c to particular industries will become responsible for shaping business cycles. But if trade inte- gration leads to a higher share of intraindustry trade, business cycles will converge because industry-speci�c shocks will affect trading partners in a similar way. If business cycles are similar and shocks are common, coordination of macroe- conomic policies can become desirable, with a common currency as the ultimate form of policy coordination. But if shocks are predominately country-speci�c, resulting in little business cycle synchronization, independent monetary and �scal policies are generally seen as important in helping an economy adjust to a new equilibrium. Clearly, if business cycles are affected predominately by country- speci�c shocks and are likely to continue to be so, intensi�ed macroeconomic coordination as part of regional integration might do more harm than good. Frankel and Rockett (1988) show that if macroeconomic coordination is based on the wrong economic model, it can make countries worse off than under noncooperation. The aim of this article is to come closer to the “true� economic model by providing information about the current trade structure and the degree of business cycle synchronization between Central America and the United States. Because both business cycle synchronization and trade structure are expected to change with trade integration, knowledge of the status quo will provide crucial information for future policy analysis. This article does three things. First, it uses state-of-the-art econometric tech- niques to measure the degree of business cycle synchronization between Central America and the United States—its main trading partner. Second, it calculates inter and intraregional trade for Central America to quantify the relationship among trade intensity, trade structure, and business cycle synchronization; this is followed by a discussion of how trade integration within DR-CAFTA is likely to shape future business cycle patterns in the region. Third, it offers policy advice on the appropriateness of macroeconomic coordination for Central America con- ditional on its trade structure. Given El Salvador’s unilateral dollarization in 2000, it seems highly relevant to inform the debate on this front. Restricted data availability for Central America seriously limits the scope for econometric analysis. To maximize inference about the level of business cycle synchronization and the link between trade structure and business cycle synchro- nization in Central America, two sets of data are analyzed: annual data on GDP from 1965 to 2005 and monthly data on economic activity from 1995 to 2005. The annual data span a longer time period and allow an analysis of changes in business cycle synchronization over time. Because business cycles are usually de�ned as 6–32 quarters, the higher frequency of the monthly data should provide additional insight into business cycle synchronization over the more Fiess 51 recent period. Most Central American countries went from extreme instability marked by hyperinflation and civil war to a period of peace and economic reform in the 1990s. Thus, the later, more tranquil period is likely to be more useful for predicting future developments in business cycle synchronization. Most of Central America’s trade structure is interindustry, and current business cycle synchronization with the United States is low. Thus, to date neither the trade structure nor the degree of business cycle synchronization of Central America appears to make a compelling case for macroeconomic coordination within Central America or between Central America and the United States. I . B U S I N E S S C Y C L E S Y N C H RO N I Z AT I O N IN CENTRAL AMERICA The degree of business cycle synchronization is important because it shows the necessity of independent �scal and monetary policy. If business cycles are similar and shocks are common, coordination of macro policies can become desirable, with a common currency as the ultimate form of policy coordination. But if shocks are predominately country-speci�c, independent monetary and �scal policies are usually seen as important in helping an economy adjust to a new equilibrium. Data and Methodology Because shocks are not directly observed, empirical studies rely on econometric methods for their identi�cation. Bayoumi and Eichengreen (1993) and Helg and others (1995) adopt a structural vector autoregression approach, whereas Artis and Zhang (1995) develop an identi�cation scheme based on cyclical com- ponents. Rubin and Thygesen (1996), Beine and Hecq (1997), and Beine, Candelon, and Hecq (2000) use a codependence framework. Filardo and Gordon (1994), Beine, Candelon, and Sekkat (1999), and Krolzig (2001) use a Markov switching vector autoregression model. This empirical work shows that it is important to distinguish between short- and long-run effects. Bayoumi and Eichengreen (1993), Helg and others (1995), and Rubin and Thygesen (1996) use differenced variables in the vector autoregression representation. However, such a speci�cation does not allow for a long-run relationship among the vari- ables. Beine, Candelon, and Hecq (2000) overcome this by investigating common trends and common cycles simultaneously, where evidence of a common European cycle is taken as evidence of perfect synchronization of shocks. Breitung and Candelon (2001) use a frequency domain common cycle test to analyze synchronization at different business cycle frequencies. The analysis here uses annual data on real GDP and trade �gures for 1965– 2002 and monthly data on industrial production and economic activity for 1995–2002. Data on GDP are from the International Monetary Fund’s International Financial Statistics database, data on industrial production are from each country’s central bank statistics, and data on trade are from the World Bank’s World Integrated Trade Solution database and the International Monetary Fund’s Direction of Trade Statistics database. 52 THE WORLD BANK ECONOMIC REVIEW The key variable is the degree of business cycle synchronization between countries i and j. Frankel and Rose’s (1998) approach is used to measure this variable; the correlation between the cyclical component of the output in countries i and j is computed, with a higher correlation implying a higher degree of business cycle synchronization. The cyclical component of output is obtained using different de-trending methods. Given the lack of consensus on the optimal procedure and the sensitivity of the cycle to the de-trending method, this approach should provide a robustness check of the results. For de-trending, �rst-differencing and band-pass �ltering (Baxter and King 1999) are used for the annual data and spectral analysis for the monthly data. Two aspects of business cycle synchronization are analyzed here. First is the degree of business cycle synchronization, which is measured using simple contemporaneous correlations between the cyclical components of economic activity (at monthly and annual frequencies) across countries. Regression analy- sis is then used to study whether the sensitivity of business cycles to develop- ments in major trading partners has changed over time. Second is the link between trade integration on business cycle synchronization, which is assessed using measures of bilateral trade intensity and trade structure in combination with the measure of the degree of business cycle synchronization. Measuring the Degree of Business Cycle Synchronization ANNUAL DATA: 1965–2005. Band-pass �ltered data, the preferred method for business cycle extraction in this section, show that in Central America business cycle synchronization is highest among Costa Rica, El Salvador, Guatemala, and Honduras (table 1). Nicaragua and Panama appear to follow a different cycle, as correlation across business cycles is in most cases negative, though not statistically signi�cant.2 Correlation with the U.S. business cycle is also high. In Costa Rica, El Salvador, and Honduras business cycle synchronization with the United States appears even higher than with regional neighbors, indicating that bilateral relationships with the United States through trade and remittances are more important than regional effects. Somewhat surprising, business cycle synchroni- zation between the United States and Panama, which adopted full dollarization in 1904, appears to be much lower than synchronization between the United States and the rest of Central America, except Nicaragua. On the basis of the business cycle synchronization, the rest of Central America would be better can- didates for a currency union with the United States than Panama would be. In fact, business cycle synchronization between the United States and Costa Rica, El Salvador, Guatemala, and Honduras is higher than the EU average (table 2). 2. Results based on �rst differences, reported in supplemental appendixes S-1 and S-2, broadly con�rm the band-pass �ltered results. The supplemental appendixes are available at http://wber. oxfordjournals.org. Fiess 53 T A B L E 1 . Business Cycle Synchronization, Band-Pass Filter, Central America Country Costa Rica El Salvador Guatemala Honduras Nicaragua Panama Costa Rica 1.000 El Salvador 0.604a 1.000 Guatemala 0.632a 0.238 1.000 Honduras 0.524a 0.442a 0.590a 1.000 Nicaragua 2 0.214 0.015 2 0.142 2 0.157 1.000 Panama 2 0.007 2 0.062 2 0.087 2 0.011 0.088 1.000 Argentina 0.354a 0.111 0.187 0.043 2 0.086 0.148 Brazil 0.350a 0.028 0.407a 0.174 2 0.162 2 0.001 Mexico 0.151 2 0.335 0.395a 0.168 2 0.255 0.323 Canada 0.621a 0.276 0.492a 0.359a 2 0.214 2 0.336 United States 0.687a 0.506a 0.463a 0.679a 2 0.163 2 0.148 France 0.239 0.113 0.394 0.152 2 0.170 2 0.138 Germany 0.167 0.107 0.308 0.107 2 0.138 0.280 Portugal 0.124 2 0.088 0.504a 0.423a 2 0.127 2 0.085 Spain 0.175 0.136 0.389a 0.057 0.167 2 0.218 United Kingdom 0.402a 0.479a 0.241 0.459a 2 0.268 2 0.323 Note: Displays bilateral correlations of the cyclical components of band-pass �ltered annual GDP data. a Signi�cant at the 5 percent level. Source: Author’s calculations based on data described in the text. Business cycle synchronization between Argentina and Brazil, two Common Market of the South (Mercosur) countries, is lower than among Costa Rica, El Salvador, and Guatemala. While business cycle synchronization is also substantial between Canada and the United States, it is surprisingly low between Mexico and the United States. Appendix table A-1 shows business cycle synchronization among Central American countries after controlling for the common impact of the U.S. business cycle using a two-step procedure. First, the cyclical component of GDP in Central America is regressed on a constant and then on the cyclical component of the United States. Second, the regression residuals are correlated to assess the degree of business cycle synchronization in Central America, which is independent from the U.S. business cycle.3 Once the common impact of the U.S. business cycle is removed, only synchronizations between Costa Rica and El Salvador, Costa Rica and Guatemala, and Guatemala and Honduras are affected by common factors other than the U.S. business cycle. Because these countries also account for the largest share of intraregional trade, this �nding supports the often postulated positive relationship between trade intensity and business cycle symmetry. 3. The regression was yi ¼ at þ yUS þ 1i, where yi is the cyclical component of the band-pass �ltered GDP in Central American country i, yUS is the component in the United States, and 1i is the ordinary least squares regression residual (which is orthogonal to the U.S. cyclical component). The regressions correct for serial correlation and heteroscedasticity. 54 T A B L E 2 . Business Cycle Synchronization, Other Free Trade Agreements Mercosur NAFTA European Union Country Argentina Brazil Mexico Canada United States France Germany Portugal Spain United Kingdom Costa Rica 0.354a 0.350a 0.151 0.621a 0.687a 0.239 0.167 0.124 0.175 0.402a El Salvador 0.111 0.028 2 0.335 0.276 0.506a 0.113 0.107 2 0.088 0.136 0.479a Guatemala 0.187 0.407a 0.395a 0.492a 0.463a 0.394a 0.308 0.540a 0.389a 0.241 Honduras 0.043 0.174 0.168 0.359a 0.679a 0.152 0.107 0.423a 0.957 0.459a Nicaragua 2 0.086 2 0.162 2 0.255 2 0.214 2 0.163 2 0.170 2 0.138 2 0.127 0.167 2 0.268 Panama 0.148 2 0.001 0.323 2 0.336 2 0.148 2 0.138 0.280 2 0.085 2 0.218 2 0.323 THE WORLD BANK ECONOMIC REVIEW Argentina 1.000 0.202 0.093 2 0.095 2 0.033 2 0.212 0.273 2 0.091 2 0.067 2 0.100 Brazil 1.000 0.122 0.514a 0.286 0.080 0.070 0.209 0.223 0.320 Mexico 1.000 0.161 0.086 2 0.007 0.156 0.159 0.013 2 0.290 Canada 1.000 0.771a 0.338a 2 0.088 0.170 0.370a 0.607a United States 1.000 0.337a 0.104 0.292 0.329 0.727a France 1.000 0.372a 0.656a 0.711a 0.482a Germany 1.000 0.328a 0.348a 2 0.044 Portugal 1.000 0.559a 0.431a Spain 1.000 0.429a United Kingdom 1.000 Note: Displays bilateral correlations of the cyclical components of band-pass– �ltered annual GDP data. a Signi�cant at the 5 percent level. Source: Author’s calculations based on data described in the text. Fiess 55 MONTHLY DATA: 1995–2004. The business cycle is usually de�ned in the range of 6–32 quarters, and thus the low frequency of annual data might be insuf�cient to fully assess business cycle synchronization. This section complements the analysis of the previous section by using monthly data, where output is proxied by seasonally adjusted monthly indices of industrial production and economic activity. Because the data cover a relatively short time span of less than 10 years, at most two to three business cycles are likely to be captured. Unfortunately, neither monthly nor quarterly data exist on a consistent basis prior to 1995. To make the most of the short time span, spectral analysis is used to estimate the correlation at different frequencies, and the average coherence at business cycle frequency (6–32 quarters) of year-over-year changes in monthly economic activity is used as a summary measure of business cycle synchronization (Anderson, Kwark, and Vahid 1999; Garnier 2004). The advantage of using cross-spectral densities over simple correlations in the analysis of business cycle synchronization is twofold. First, spectral analysis avoids possible business cycle distortions due to �ltering; it is well known that the cycles change with the de-trending method (Canova 1998). Second, contemporaneous correlation is unable to take lagged co-movement into account. Because coherence measures the correlation between two series in the frequency domain and provides infor- mation on the phase lead or lag, spectral analysis provides a richer analysis of business cycle dynamics. While the coherence shows to what extent two business cycles are dominated by the same frequency, the phase lag shows to what extent elements with the same frequency lag each other. In sum, a high degree of business cycle synchronization implies a high coherence and a low phase lag. Coherence and phase lag are calculated from the spectral density function.4 To calculate the average coherence at business cycle frequency, the spectral coherence rxy(v) is calculated between series x and y at each frequency, assum- ing that frequencies are independent across and between series: Fxy ðvÞ ð1Þ rxy ðvÞ ¼ pffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi : Fx ðvÞFy ðvÞ Frequencies outside the business cycle ranges are omitted, and the average coherence is then calculated as the average over frequencies within the business cycle band. A high average coherence consequently implies that two series are dominated by the same frequencies within the business cycle frequency bands. 4. The cross-spectral density Fxy(v) between series x and y is the Fourier transformation of the cross-covariance function Cxy(t), where 2 1 t 1 is the lag. The cross-spectral density Fxy(v) is de�ned as ð 1 1 Fxy ðvÞ ¼ eÀivt Cxy ðtÞdt: 2p À1 56 THE WORLD BANK ECONOMIC REVIEW The average coherence at business cycle frequency between year-over-year growth rates of economic activity between 1995 and 2004 broadly con�rms the �ndings of the previous section (table 3). Within Central America, business cycle synchronization is found to be the highest between Costa Rica and El Salvador, El Salvador and Guatemala, El Salvador and Nicaragua, and Honduras and Nicaragua. Business cycle synchronization with the United States is the highest for Costa Rica, El Salvador, and Honduras but lower than for NAFTA and Mercosur member countries.5 The higher level of business cycle synchronization between Mexico and the United States, as well as between Argentina and Brazil, is explained partly by the long time period (1965–2005) under consideration. Business cycle synchro- nization between Mexico and the United States has increased substantially since the mid-1990s, which Cuevas, Messmacher, and Werner (2002) attribute to increasing integration due to NAFTA.6 Changes in Business Cycle Synchronization over Time Except Costa Rica, Central American countries suffered deep crises prior to the 1990s: from hyperinflation in Nicaragua to civil war in El Salvador. These episodes, which led to low growth and high volatility, clearly marked business cycles, and are likely to have affected the degree of business cycles synchroniza- tion with the United States. A basic regression analysis is used to assess changes in business cycle synchro- nization. Annual growth rates of GDP in Central American countries were regressed against their lagged values and that of U.S. GDP growth. The regressions take the following general form, with coef�cient estimates reported in table 4: Dyi ¼ a0 þ dum90 þ b1 Dyi;tÀ1 þ b2 Dyi;tÀ1  dum90 X n þ d1;k DyUS;tÀk k¼0 X n ð2Þ þ d2;k DyUS;tÀk  dum90 k¼0 5. The phase lag is not reported here because it is very poorly estimated if the coherence is small, which is the case for most country pairings in table 3. 6. That business cycle synchronization can increase signi�cantly with structural reform has been documented in the case of Mexico and the United States. Cuevas, Messmacher, and Werner (2002) attribute higher business cycle synchronization between Mexico and the United States during the 1990s to increasing integration due to NAFTA. T A B L E 3 . Average Coherence at Business Cycle Frequency Country Costa Rica El Salvador Guatemala Honduras Nicaragua Argentina Mexico Canada France Costa Rica 0.381 El Salvador 0.524a Guatemala 0.381 0.534a Honduras 0.456 0.340 0.381 Nicaragua 0.393 0.510a 0.421 0.544a Mexico 0.332 0.453 0.242 0.366 0.288 0.537a 0.361 0.345 United States 0.454 0.427 0.336 0.421 0.322 0.486 0.468 0.554a 0.429 Brazil 0.318 0.322 0.382 0.319 0.272 0.500a 0.608a 0.467 0.319 Germany 0.510a 0.536a 0.604a 0.529a 0.248 0.355 0.447 0.584a 0.601a Note: Displays the bilateral average coherences of monthly data of economic activity. a Signi�cant at the 5 percent level. Source: Author’s calculations based on data described in the text. Fiess 57 58 THE WORLD BANK ECONOMIC REVIEW T A B L E 4 . Changes in Business Cycle Synchronization with the United States over Time GDP growth volatility (coef�cient of variation) Country d1 d2 d1 þ d2 R2 1965– 89 1990– 2005 Costa Rica 0.630a 0.808a 1.438 0.36 0.82 0.57 El Salvador 2 0.153a 0.552a 0.400 0.58 3.47 0.55 Guatemala 0.426a 0.308a 0.734 0.53 0.86 0.32 Honduras 0.790a 2 0.339 0.451 0.26 0.81 0.76 Nicaragua 2 0.295 0.842a 0.547 0.56 23.88 0.71 Panama 2 0.091 1.488a 1.397 0.46 1.50 0.60 United States 0.73 0.49 Mexico 0.432a 1.106a 1.538 0.62 0.83 1.04 [1990 – 95] 0.65 [1996 – 05] Note: Coef�cients d1 and d2 are from regression 2. Coef�cient d1 measures the sensitivity of economic developments in Central American countries to developments in the United States. Relationship (d1 þ d2) indicates how this sensitivity has changed over time. The last two columns compare volatility, based on the coef�cient of variation over two periods: 1965– 89 and 1990– 2005. A low coef�cient indicates a more tranquil period. Comparative statistics for Mexico and the United States are included. To account for Mexico’s Tequila Crisis of 1994– 95, the coef�cient of variation is calculated for two additional subperiods: 1990– 95 and 1996– 2005. The regressions for Mexico also include a dummy variable for the Tequila Crisis. a Signi�cant at the 10 percent level or higher. Source: Author’s calculations based on data described in the text. where Dyi is the annual GDP growth rate of Central American country i, DyUS,t is the annual U.S. GDP growth rate, dum90 is a bivariate dummy variable that takes the value of one from 1990 onwards. Several lag structures were explored, but additional lags of the dependent and independent variables proved generally insigni�cant even though contemporaneous lags are usually highly signi�cant. This simple regression allows two issues to be assessed. First is how sensitive the dependent variable is to developments in the United States (as given by d1). Second is how this sensitivity has changed over time (as given by d1 þ d2) and whether the changes are statistically signi�cant. The sensitivity to developments in the United States has generally increased over time and the negative co-movement with the United States for Honduras and Nicaragua (see table 4) appears to vanish in the 1990s, indicating that the end of the civil war most likely lessened the impact of country-speci�c shocks.7 For Costa Rica, Mexico, and Panama the sensitivity coef�cient becomes larger than one, which indicates that GDP in these countries may respond more than proportionally to changes in U.S. output.8 7. There also appears to be a positive link between the size of the sensitivity coef�cient and the macroeconomic volatility. The sensitivity coef�cient is generally higher during more tranquil periods. 8. Lederman, Maloney, and Serven (2005) report a similar �nding for Mexico. Fiess 59 Table 4 also explains an apparent contradiction between the correlation results of the longer, annual sample and the shorter, monthly correlation exer- cise reported in previous sections. Because business cycle synchronization between Mexico and the United States increased signi�cantly during the 1990s, it is not surprising to �nd substantially higher correlation in the more recent sample. Cuevas, Messmacher, and Werner (2002) attribute higher business cycle synchronization between Mexico and the United States during the 1990s to increased integration due to NAFTA. II. TRADE STRUCTURE AND BUSI NESS CYC LE SYNCHRONIZATION The impact of trade liberalization on business cycle synchronization is theoreti- cally ambiguous. Standard trade theory (Heckscher–Ohlin) predicts that removing trade barriers leads to an increasing specialization in production, which leads to interindustry trade patterns. As industry-speci�c specialization increases, industry-speci�c shocks—for example, a shock to commodity prices—will make business cycles more dissimilar and hence decrease business cycle synchronization. Experience from developed countries, however, shows a trend toward intraindustry rather than interindustry trade. If intraindustry trade is vertical— for example, particular countries specialize in different production stages of the same good—industry-speci�c shocks will make business cycles more similar. The same results occur if intraindustry trade is horizontal—for example, countries trade and compete with the same products. In that case industry- speci�c shocks are also expected to increase business cycle synchronization.9 To summarize, intraindustry trade, vertical or horizontal, is expected to increase business cycle synchronization. Central America’s Trade Structure Appendix tables A-2 and A-3 provide information about Central America’s trade structure. Trade patterns of NAFTA countries and some EU and Mercosur countries are again provided for comparison. Trade (measured as the ratio of bilateral exports to total exports) in Central America is not predomi- nantly intraregional as it is for EU, Mercosur, and NAFTA members. Even within the so-called Northern Triangle (El Salvador, Guatemala, and Honduras) and between El Salvador and Nicaragua, bilateral exports as a ratio of total exports barely exceed 10 percent. The United States is by far Central America’s most important trading partner, although trade with the European Union is somewhat signi�cant. As exports to the United States appear to be under-reported, U.S. imports from Central America are provided as an 9. The authors thank an anonymous referee for noting that horizontal intraindustry trade leaves the �eld open for asymmetric “taste� shocks to occur, such as shifts away from Fiat cars to BMWs. In this context business cycles would become less similar. 60 THE WORLD BANK ECONOMIC REVIEW alternative measure. On the basis of this measure, exports to the United States account for more than 60 percent of total exports in Costa Rica, El Salvador, and Guatemala. Appendix table A-4 provides information on the importance of intraindustry trade in Central America based on the adjusted Grubel–Lloyd intraindustry trade index, AIIT: Pn Pn ðXi þ Mi Þ À jXi À Mi j ð3Þ AIIT ¼ n i ni P ; P P n ðXi þ Mi Þ À Xi À Mi i i i where X is exports of industry i and M is imports. The AIIT, which adjusts for trade imbalances, can take values between zero (no intraindustry trade) and one (all trade is intraindustry). Intraindustry trade appears to be some- what important within Central America. But except Costa Rica (0.3), there is virtually no evidence of intraindustry trade with the United States. For El Salvador and Guatemala intraindustry trade appears to be quite high with Brazil and Mexico. Business Cycle Synchronization and Trade Empirical evidence on trade integration and business cycle synchronization is somewhat mixed. Frankel and Rose (1998), Choe (2001), Calderon, Chong, and Stein (2002), and Calderon (2003), to name a few, �nd that a higher trade intensity tends to increase business cycle synchronization. Shin and Wang (2003) �nd that increasing trade itself does not necessarily lead to more syn- chronized business cycles, with evidence for East Asia suggesting that only the expansion of intraindustry trade had such an effect. But Garnier (2004) �nds only weak or no relations between intraindustry trade and business cycle synchronization for 16 developed countries and concludes that intraindustry trade at most only partially explains business cycle transmission. The low correlations reported by Calderon, Chong, and Stein (2002) suggest a similar interpretation for trade intensity and business cycle synchronization. A cross-plot of bilateral export to GDP ratios and average coherence at business cycle frequency fails to show a positive relationship between trade intensity and business cycle synchronization (�gure 1), a �nding in line with other research.10 The slope of the regression line, however, is quite flat because most countries fall into a relatively narrow range of business cycle synchroniza- tion, independent of their level of trade intensity. For example, despite a big difference in trade intensity, France and Mexico have a similar degree of business cycle synchronization with the United States. This seems to support 10. The results are similar if bilateral exports as a share of total exports are used as a measure of trade intensity. Fiess 61 F I G U R E 1. Trade Intensity and Business Cycle Synchronization Note: Regression is based on country pairings based on countries listed in appendix table A-4. Numbers in parentheses are standard errors. Source: Author’s calculations based on data described in the text. Kenen’s (2000) argument that business cycle symmetry is only partly explained by trade intensity. In other words, for El Salvador to reach Mexico’s level of business cycle synchronization with the United States—which is only slightly higher in GDP terms—El Salvador would have to more than double its exports to the United States. Figure 2 shows a similar regression for trade intensity and intensity of intraindustry trade. As explained by Shin and Wang (2003) and Garnier (2004), the link between intraindustry trade and business synchroniza- tion is found to be stronger and more signi�cant. F I G U R E 2. Intraindustry Trade Intensity and Business Cycle Synchronization Note: Regression is based on country pairings based on countries listed in appendix table A-4. Numbers in parentheses are standard errors. Source: Author’s calculations based on data described in the text. 62 THE WORLD BANK ECONOMIC REVIEW Some studies argue that that macroeconomic coordination, and in particular exchange rate stability, per se can lead to higher trade and as a consequence more synchronized business cycles. Frankel and Rose (1998, 2002) show that larger trade flows are associated with greater business cycle correlation and argue that increased trade flows can be the result of monetary and economic integration. Fontagne ´ and Freudenberg (1999) establish a negative relation between intraindustry trade and exchange rate volatility and draw attention to the fact that monetary integration, by suppressing exchange rate uncertainty, has promoted intraindustry trade in Europe. If trade structure is a good proxy for output structure, business cycles should become more synchronized because cycles will be increasingly affected by the same shocks. Panama dollarized in 1990 and Argentina adopted a currency board that anchored the currency to the U.S. dollar between 1991 and 2001. Both countries fully eliminated exchange rate volatility with respect to the dollar during these periods. Given this high level of monetary integration, Frankel and Rose (1998) and Fontagne ´ and Freudenberg (1999) predict an increase in bilateral trade and intraindustry trade with the United States for both countries. But trade as a percentage of GDP as well as intraindustry trade with the United States declined, providing little empirical support that exchange rate stability alone promotes trade (�gures 3 and 4). This exercise is far from being conclusive. Nevertheless, this �nding might not be too surprising, given that Kenen (2000) and Hughes-Hallet and Piscitelli (1999) question a causal link F I G U R E 3. Trade between the United States and Argentina and the United States and Panama, 1997–2001 Source: Bilateral trade data from the U.S. Census Bureau. Fiess 63 F I G U R E 4. Grubel–Lloyd Index for Argentina and Panama, 1997–2001 Note: Calculation of the Grubel – Lloyd index uses data at the three-digit level of the Standard International Trade Classi�cation. Source: Intraindustry trade data from the Hamburg Institute of International Economics. between business cycles and trade, when countries are not similar enough. Hughes-Hallet and Piscitelli (1999) demonstrate that a currency union increases business cycle synchronization only after suf�cient symmetry exists in institutional structures and market responses across countries. This is likely to be the case for most Latin American countries and the United States (Lederman, Maloney, and Serven 2005). Business Cycle Synchronization and Remittances While trade is often perceived as the most important channel of business cycle synchronization, �nancial integration is increasingly being recognized as another. Worker remittances provide a growing �nancial link between Central America and the United States, and they are likely to increase even further in the context of CAFTA; in particular, if provisions are made for temporary or permanent migration of labor. This section assesses the impact of worker remittances on business cycle synchronization. There is little theoretical guidance on how worker remittances are expected to affect business cycle synchronization. Nevertheless, it seems plausible that under certain conditions worker remittances can contribute to synchronization between recipient and sending countries, with the adjustment taking place in the recipient country. For this to be the case, remittances would need to be countercyclical to economic activity in the recipient country, with remittances 64 THE WORLD BANK ECONOMIC REVIEW T A B L E 5 . Correlation between Remittances and GDP Correlation with Correlation with Remittances as share of Country own GDP U.S. GDP GDP in 2004 (percent) Argentina 2 0.270 (0.42) 0.460 (0.15) 0.2 Brazil 2 0.376 (0.08) 0.103 (0.65) 0.4 Mexico 2 0.650 (0.02)b 0.341 (0.11) 2.5 Costa Ricaa 1.6 El Salvador 2 0.147 (0.47) 0.284 (0.17) 16.1 Guatemala 2 0.656 (0.01)b 2 0.178 (0.52) 9.3 Honduras 2 0.230 (0.54) 0.210 (0.44) 15.4 Nicaragua 2 0.503 (0.12) 0.376 (0.25) 11.4 Panama 2 0.412 (0.05)b 0.112 (0.62) 0.9 Note: Numbers in parentheses are p-values. a Correlations are not reported because too few observations are available. b Signi�cant at the 5 percent level. Source: Author’s calculations based on data described in the text. increasing during times of crisis, and pro-cyclical with economic activity in the sending country, with a growing economy providing a larger outflow of remit- tances. This would create forces to pull the business cycle of the receiving country toward the business cycle of the sending country. But if remittances are uncorrelated with the economic activity in the sending country and pro- cyclical with economic activity of the recipient country, business cycles could become more dissimilar. Simple correlations between changes in remittance flows and GDP growth provide weak evidence that remittances are countercyclical (table 5). Correlations are signi�cant only in Guatemala, Mexico, and Panama. There is also some indication that remittance flows are positively correlated with econ- omic growth in the United States but not at a statistically signi�cant level. The observed correlation patterns suggests that except Guatemala, Mexico, and Panama, worker remittances do not appear to signi�cantly smooth asymmetric shocks. A general lack of signi�cant correlation with economic activity in the United States further suggests that remittances do not contribute in a major way to the synchronization of business cycles between Central America and the United States. III. SUMMARY AND CONCLUDING REMARKS This article offers the following �ndings: † Business cycle synchronization within Central America is quite low com- pared with synchronization in NAFTA and the European Union, but not compared with synchronization in Mercosur. Fiess 65 † Business cycle synchronization in Central America is highest between Costa Rica and El Salvador, El Salvador and Guatemala, El Salvador and Nicaragua, and Honduras and Nicaragua. † Costa Rica and Honduras have a higher degree of business cycle synchroni- zation with the United States than with any other Central American country. However, business cycle synchronization with the United States is still below the levels of business cycle synchronization among NAFTA and Mercosur members. † Central American countries have become more sensitive to developments in the U.S. economy. † Unlike trade in NAFTA, the European Union, and Mercosur, trade in Central America is not predominantly intraregional. The United States is by far Central America’s most important trading partner. † Except for Costa Rica, there is virtually no evidence of intraindustry trade between Central America and the United States. The level of intraindustry trade within Central America is comparable to that of Mercosur, but less than in NAFTA (Canada and the United States) and the European Union (France and Germany). † The degree of business cycle synchronization seems only weakly related to trade intensity and trade structure (intraindustry trade), although the relationship between intraindustry trade and business cycle synchronization is slightly stronger. As such, the gain in business cycle synchronization through trade expansion seems quite low. † Macroeconomic coordination per se is unlikely to promote business cycle synchronization or trade because institutional structures and market responses in Central America and the United States lack suf�cient symmetry. † Remittances provide a growing �nancial link between Central America and the United States. But there is little evidence that remittances lessen the impact of asymmetric shocks or contribute in a major way to the synchronization of business cycles between Central America and the United States. Neither Central America’s trade structure nor its degree of business cycle synchronization makes a compelling case for macroeconomic coordination within Central America or between Central America and the United States. Central America’s trade structure is predominately interindustry, and the current level of business cycle synchronization with the United States is not that high, despite an increase since the mid-1990s. Clearly, trade integration is a dynamic process, and as trade intensities and compositions of trade flows change so will business cycle patterns. To fully assess the consequences of closer trade integration for the conduct of 66 THE WORLD BANK ECONOMIC REVIEW macroeconomic policies, information about the future evolution of trade struc- tures in DR-CAFTA are needed. If trade becomes more intraindustry (vertical or horizontal), business cycles are expected to become more similar, and inde- pendence of macro policy will be less of a concern. However, if trade inte- gration takes the form of higher interindustry trade, business cycles are likely to diverge from current levels, and the ability to conduct independent macro policies will grow more important. While information about the future developments of trade patterns within DR-CAFTA is not available, Mexico’s experience in NAFTA might provide some guidance. Trade between Mexico and the United States has grown exponentially since the signing of NAFTA—from $89.5 billion in 1993 to $275.3 billion in 2004. The United States has become not only Mexico’s top trading partner but also its main investor. Since 1994 the United States has accounted for 62 percent of all foreign direct investment in Mexico. But the two economies are increasingly linked not only through trade and invest- ment but also through worker remittances. In 2005 worker remittances from the United States accounted for 3 percent of Mexico’s GDP. Closer econ- omic integration through NAFTA has had a clear impact on business cycle synchronization. Can ˜ as, Coronado, and Gilmer (2006) �nd that based on the coincidence indexes for economic activity for both countries the degree of business cycle synchronization since 1993 is about a third higher than in 1980–93. Since the signing of NAFTA there has also been a consistent upward trend in intraindustry trade between Mexico and the United States. According to Bruehlhart and Thorpe (2001), between 1980 and 1998 the unadjusted Grubel–Lloyd index for manufacturing products between Mexico and the United States grew from 0.36 to 0.61.11 Mexico’s dramatic shift in intraindus- try trade with the United States is explained mostly by increased vertical intraindustry trade in textiles and apparel and in auto industries (Bur�sher, Robinson, and Thierfelder 2001). The increase in vertical intraindustry trade has been accompanied by higher business cycle synchronization. Cuveas, Messmacher, and Werner (2002) claim that macroeconomic synchronization between Mexico and the United States has increased substantially due to NAFTA. Despite the higher level of business cycle synchronization between Mexico and the United States, Cuevas, Messmacher, and Werner (2002) and Lederman, Maloney, and Serven (2005) do not advocate adopting common stabilization policies in NAFTA. Most of their arguments transfer directly to DR-CAFTA. Despite increased sensitivity to the U.S. economy, idiosyncratic shocks continue to be important for Mexico, and idiosyncratic volatility remains higher in Mexico than in the United States. Lederman, Maloney, 11. For products at the three-digit level of the Standard International Trade Classi�cation. At the same time, intraindustry trade with Canada remained at a relatively constant low level of 0.17. Fiess 67 and Serven (2005) argue that nominal price and wage flexibility are lacking in Mexico, and NAFTA does not provide unrestricted labor mobility or mechanisms of �scal redistribution to facilitate Mexico’s adjustment to shocks in the absence of independent stabilization policies. A similar case can be made for Central America because idiosyncratic volatility is also higher and DR-CAFTA, like NAFTA, does not come with any built-in shock absorbers. Further, that the Mexican economy responds more than proportionally to shocks in the United States indicates that Mexico would require a higher dosage for the treatment of the same shock. A common policy response would not be able to effectively counteract output and employment fluctuations in Mexico. The picture is even more complex for Central America, where the same shock would require a larger policy response for Costa Rica and Panama, but a smaller dosage for the remaining countries. Finally, policy transmission channels are different and require the ability to apply stabilization policies in different quantities. Lederman, Maloney, and Serven (2005) argue that Mexico’s lower level of �nancial development and domestic credit to the private sector implies that interest and credit channels are less developed relative to United States, while exchange rate channels are more important for Mexico because trade accounts for a larger share of GDP. Central America appears an even greater mismatch in this respect; it lags far behind Mexico in terms of �nancial sector development but leads Mexico in terms of openness. APPENDIX T A B L E A - 1 . Business Cycle Synchronization, Orthogonal to U.S. Business Cycle Country Costa Rica El Salvador Guatemala Honduras Nicaragua Costa Rica 1.000 El Salvador 0.409a 1.000 Guatemala 0.488a 0.006 1.000 Honduras 0.104 0.157 0.421a 1.000 Nicaragua 2 0.141 0.115 2 0.076 2 0.063 1.000 Panama 0.134 0.014 2 0.021 0.118 0.065 Note: Displays bilateral correlations of the cyclical components of band-pass �ltered annual GDP data orthogonal to the U.S. business cycle. a Signi�cant at the 5 percent level. Source: Author’s calculations based on data described in the text. 68 T A B L E A - 2 . Central America’s Trade Structure: Bilateral Exports as a Share of Total Exports, 1995–2001 (percent) Country Costa Rica El Salvador Guatemala Honduras Nicaragua Argentina Mexico Canada France Costa Rica 4.4 3.5 1.1 4.8 0.1 0.2 0.0 0.0 El Salvador 2.3 9.9 3.1 11.1 0.1 0.2 0.0 0.0 Guatemala 3.2 12.4 2.5 2.8 0.1 0.4 0.0 0.0 Honduras 1.7 6.8 2.0 5.3 0.0 0.1 0.0 0.0 Nicaragua 2.9 3.8 3.1 2.2 0.0 0.1 0.0 0.0 THE WORLD BANK ECONOMIC REVIEW Mexico 1.1 0.7 2.3 0.3 2.8 1.2 0.5 0.4 Brazil 0.1 0.0 0.0 0.0 0.0 26.9 0.5 0.4 0.7 United States 21.3 11.1 50.7 61.1 38.0 9.4 87.1 85.3 7.3 Germany 3.6 6.1 3.3 3.8 9.9 2.3 0.9 0.9 15.7 European Union 16.0 10.7 10.4 12.2 23.1 18.5 3.6 4.9 61.6 Free trade zone 39.1 54.5 U.S. reported imports c.i.f. 62.4 68.1 66.3 Note: Data are averages for 1995 – 2001. The table should be read column-wise, where each row represents the share in total column-countries exports. As an example, the top-left �gure indicates that exports from Costa Rica to El Salvador represent 2.3 per cent of Costa Rica’s total exports. Source: International Monetary Fund’s Direction of Trade Statistics. T A B L E A - 3 . Central America’s Trade Structure: Bilateral Exports as a Share of GDP, 1995–2001 (percent) Country Costa Rica El Salvador Guatemala Honduras Nicaragua Argentina Mexico Canada France Costa Rica 0.8 0.7 0.6 1.2 0.01 0.05 0.01 0.01 El Salvador 0.8 1.8 1.5 2.9 0.01 0.05 0.00 0.01 Guatemala 1.1 2.3 1.2 0.7 0.01 0.11 0.01 0.00 Honduras 0.6 1.3 0.4 1.4 0.00 0.03 0.00 0.00 Nicaragua 1.0 0.7 0.6 1.1 0.00 0.01 0.00 0.00 Mexico 0.4 0.1 0.4 0.2 0.7 0.1 0.2 0.1 Brazil 0.0 0.0 0.0 0.0 0.0 2.4 0.1 0.13 0.1 United States 7.1 2.1 9.5 30.1 9.8 0.8 24.1 30.3 1.6 Germany 1.2 1.1 0.6 1.9 2.6 0.2 0.3 0.3 3.3 European Union 5.3 2.0 1.9 6.0 5.9 1.6 1.0 1.7 13.2 Free trade zone 13.0 10.1 U.S. reported imports c.i.f. 19.4 11.8 11.7 Note: Data are averages for 1995– 2001. Interpretation of this table is as follows. The table should be read column-wise, where each row represents the share of bilateral exports in the column-countries GDP. As an example, the top-left �gure indicates that exports from Costa Rica to El Salvador represent 0.8 per cent of Costa Rica’s GDP. Source: International Monetary Fund’s Direction of Trade Statistics and International Financial Statistics database. Fiess 69 70 T A B L E A - 4 . Intraindustry Trade, 2001 Country Costa Rica El Salvador Guatemala Honduras Nicaragua Argentina Mexico Canada France El Salvador 0.36 Guatemala 0.38 0.45 Honduras 0.40 0.27 0.33 THE WORLD BANK ECONOMIC REVIEW Nicaragua 0.34 0.15 0.21 0.15 Mexico 0.18 0.43 0.42 0.11 0.02 0.26 0.49 0.57 Brazil 0.30 0.05 0.05 0.06 0.02 0.10 0.46 0.66 0.56 United States 0.08 0.43 0.51 0.03 0.28 0.39 0.51 0.17 0.11 Germany 0.06 0.02 0.01 0.13 0.79 0.33 0.70 Note: A �ve-digit level of disaggregation is used. 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