OCCASIONAL PAPER SERIES

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1 OCCASIONAL PAPER SERIES NO. 4 / DECEMBER 5 WHAT DOES EUROPEAN INSTITUTIONAL INTEGRATION TELL US ABOUT TRADE INTEGRATION? by Francesco Paolo Mongell, Ettore Dorrucc and Ita Agur

2 OCCASIONAL PAPER SERIES NO. 4 / DECEMBER 5 WHAT DOES EUROPEAN INSTITUTIONAL INTEGRATION TELL US ABOUT TRADE INTEGRATION? by Francesco Paolo Mongell, Ettore Dorrucc and Ita Agur* In 5 all publcatons wll feature a motf taken from the 5 banknote. Ths paper can be downloaded wthout charge from the s webste ( or from the Socal Scence Research Network electronc lbrary at * Ths paper benefted from the comments and suggestons of Matteo Cccarell, Andrew Rose, Sean Holly, Phlppe Moutot, Peter Welz, Lorenzo Cappello, Chara Osbat, two anonymous referees, and several partcpants to a presentaton at the. The vews expressed n the paper are those of the authors and do not necessarly reflect the vews of the. We are fully responsble for any error or omsson.

3 European Central Bank, 5 Address Kaserstrasse Frankfurt am Man Germany Postal address Postfach Frankfurt am Man Germany Telephone Webste Fax Telex ecb d All rghts reserved. Any reproducton, publcaton and reprnt n the form of a dfferent publcaton, whether prnted or produced electroncally, n whole or n part, s permtted only wth the explct wrtten authorsaton of the or the author(s). The vews expressed n ths paper do not necessarly reflect those of the European Central Bank. ISSN (prnt) ISSN (onlne)

4 CONTENTS ABSTRACT 4 CONTENTS NON-TECHNICAL SUMMARY 5 1 INTRODUCTION 6 2 THE INDICATOR OF INSTITUTIONAL INTEGRATION AND THE ENLARGEMENT OF THE EEC/EU 8 3 DIVERSE MEASURES OF TRADE DEEPING 11 4 SOME DESCRIPTIVE LINKS BETWEEN INSTITUTIONAL INTEGRATION AND TRADE INTEGRATION 16 5 TESTING THE LINKS BETWEEN INSTITUTIONAL INTEGRATION AND TRADE DEEPING 18 6 CONCLUSION 21 APPENDIX 23 A: Results of the prelmnary tests for the Vector Error Correcton Model 23 B: An exploratve Vector Error Correcton Model (VECM) 26 C: A varance decomposton 29 STATISTICAL ANNEX 31 BIBLIOGRAPHY 38 LIST OF OCCASIONAL PAPERS 41 Occasonal Paper No. 4 December 5 3

5 ABSTRACT The start of the European Economc and Monetary Unon (EMU) has spurred a new nterest n the debate on the effects of monetary unons on regonal economc ntegraton. Ths lterature ether nvestgates past epsodes of monetary unons or attempts to gauge any effect wth a few years of EMU data. Ths paper takes nstead a more general perspectve: t nvestgates the lnk between economc ntegraton and the overall nsttutonal process of regonal ntegraton n Europe of whch monetary ntegraton was only one step over the last 5 years. We look manly at two dmensons: European nsttutonal ntegraton whose man steps were the customs unon n 1968, the sngle market n 1993 and the sngle currency n 1999 and ntra-european trade. We pay specal attenton to the successve EU enlargements whch took place n 1973, 1981, 1986, and Dfferent facets of openness and trade lnkages are presented. After lookng at some descrptve lnks between nsttutonal and trade ntegraton, the paper uses some causalty tests to assess the drecton of causalty and magntude of mpact. The evdence provded s consstent wth the dea that the nteracton between regonal nsttutonal and trade ntegraton before monetary unon matters. Such nteracton runs n both drectons, although the lnk from nsttutonal to trade ntegraton domnates. Many open questons reman, however. JEL classfcaton: E42, F15, F33 and F41. Key words: Optmum Currency Area, Economc and Monetary Integraton and EMU. 4 Occasonal Paper No. 4 December 5

6 NON-TECHNICAL SUMMARY The start of the European Economc and Monetary Unon (EMU) has spurred a new nterest n the debate on the effects of monetary ntegraton. One much debated queston has become whether sharng a sngle currency sets free some forces brngng about greater economc and fnancal ntegraton among the partcpatng countres. Much of the mert for havng brought forward ths debate on the endogenety of Optmum Currency Areas (OCAs) goes to Andrew Rose and Jeffrey Frankel. By studyng the effects of several currency unons that have occurred n the past 25-3 years they show that monetary ntegraton can lead to very sgnfcant trade deepenng. Gven ts recent begnnng, EMU s not ncluded n ther analyss. Ths paper takes nstead a more general perspectve: t nvestgates the lnk between economc ntegraton and the overall nsttutonal process of regonal ntegraton n Europe of whch monetary ntegraton was only one step over the last 5 years. It looks manly at two dmensons: European nsttutonal ntegraton (n partcular the creaton of a free trade area n 1958, a customs unon n 1968, the sngle market n 1993 and the sngle currency n 1999) and ntra-european trade. It also pays specal attenton to the varous waves of EU enlargements. Whle European nsttutonal ntegraton was advancng, nne other countres joned the European Unon (EU) durng four successve rounds of enlargement n 1973, 1981, 1986 and We nclude these rounds n our analyss, whereas we do not consder the most recent accesson by ten new members. A systematc nvestgaton of the lnk between European nsttutonal ntegraton and regonal trade s provded by usng the ndex of nsttutonal ntegraton frst developed n Dorrucc, Frpo, Fratzscher and Mongell (2 and 4). Ths ndex allows us to uncover several stylsed facts relatng to the lnk between effectve progress n jont nsttuton buldng and regonal trade. The degree of trade deepenng s measured by usng several ndcators, ncludng trade openness (.e., blateral trade data normalsed by GDP), the share of ntraregonal trade n total trade, and deflated trade values smlar to those used by Frankel and Rose (1997) and Rose (). Several descrptve lnks are presented, together wth a few prelmnary formal tests. It turns out that the EU wtnessed a very sgnfcant deepenng of ntra-regonal trade among ts member countres over a long perod.e., about 5 years for the sx foundng countres. These ncreases exceed the estmates put forward by the lterature on the endogenety of OCA launched by Rose and Frankel. Hence, n the European case the relevant tme horzon seems to extend beyond the establshment of a monetary unon as EMU occurred relatvely recently and cover the whole process of nsttutonal ntegraton (nvolvng steps such as the removal of tarff and non-tarff barrers, ntegraton of factor markets, monetary cooperaton and monetary ntegraton). Moreover, prelmnary tests (Granger-causalty and varance decompostons based on a vector error correcton model) suggest that the causal lnk between nsttutonal ntegraton and trade deepenng runs both ways, although the lnk from nsttutonal ntegraton to trade deepenng s far more pronounced. In concluson, whle the evdence presented s far from conclusve, ths paper suggests that the nteracton between nsttutonal and trade ntegraton before currency unon may matter. Such an nteracton would seem to run n both drectons, although n the European case the lnk from nsttutonal to trade ntegraton appeared to domnate. Many open ssues, however, reman for future research, such as: the ncluson of more condtonng varables and some ad hoc econometrc technques to deal wth our nsttutonal varable, whch has uncommon propertes, and to account for the successve waves of EU enlargements. One NON-TECHNICAL SUMMARY Occasonal Paper No. 4 December 5 5

7 could also check the valdty of our prelmnary fndngs when a smlar analyss s appled to the nsttutonal arrangements n other regons of the world (e.g. Latn Amerca, East Asa and Sub-Saharan Afrca). One open queston s whether the hypothess of endogenety of OCA may be extended and generalsed: however, much further work would be needed n ths drecton. 1 INTRODUCTION The start of the European Economc and Monetary Unon (EMU) has spurred a new nterest n the debate on the effects of monetary ntegraton. One much debated queston has become whether sharng a sngle currency sets free some forces brngng about greater economc and fnancal ntegraton among the countres sharng the sngle currency. Much of the mert for havng brought forward ths debate on the endogenety of OCA goes to Andrew Rose and Jeffrey Frankel. 1 By studyng the effects of several currency unons that have occurred n the past 25-3 years (excludng EMU) they show that monetary ntegraton can lead to very sgnfcant deepenng of trade, even n excess of 3 percent. Rose (4) conducts a meta-analyss of a large number of other studes on the effects of currency unon on trade. He shows that the combned estmates mply that a blateral currency unon ncreases trade by between 3 percent and 9 percent. The mplcaton for EMU, accordng to Frankel and Rose, s that the euro area may turn nto an OCA after the launch of monetary ntegraton even f t was not an OCA before, or countres whch jon EMU, no matter what ther motvaton may be, may satsfy OCA propertes ex-post even f they do not ex-ante! (Frankel and Rose 1997). Hence, the expectaton for the European countres that have adopted the euro n 1999 s that ther recprocal trade may also rse qute sgnfcantly n the future. It s too early to assess the effects of the euro on euro area trade (though t s nterestng to note that extra-euro area trade has ncreased more that ntra-regonal trade snce 1999). Rather, ths paper deems t useful to nvestgate to what extent European trade ntegraton may have been affected by the progress made n European nsttutonal ntegraton before the advent of EMU. To ths am, we defne: () Actual economc ntegraton as the degree of nterpenetraton of economc actvty among two or more countres belongng to the same geographc area as measured at a gven pont n tme. Whle the expresson economc actvty ncludes both real aspects of an economy (such as trade and labour moblty) and fnancal/monetary aspects (such as fnancal flows and exchange rate developments), we here focus on trade ntegraton only; () Insttutonal ntegraton as the polcy decsons taken by two or more governments of countres belongng to the same geographc area n order to promote economc co-operaton n terms of deepenng and/or wdenng the spheres of co-ordnaton under the terms of an agreed pact. Pacts may vary wdely n form, rangng from nter-governmental agreements on sectoral co-operaton to economc and monetary unons wth transfer of soveregnty to supranatonal nsttutons. In the case of Europe, the nsttutonal ntegraton process started already 48 years ago wth the 1957 Treaty of Rome, when sx countres founded what was then called the European Economc Communty (EEC). 2 The process of ntegraton ntally amed to the establshment of a free trade area and customs unon, an objectve that by 1968 had been 1 See Rose (1 and 4), Frankel and Rose (2) and several references theren. 2 Of course, one may argue that the process of ntegraton started even earler. It seems, however, reasonable to start the analyss from the Treaty of Rome. 6 Occasonal Paper No. 4 December 5

8 already reached. It then took 25 years to acheve a (stll mperfect) common market where non-tarff barrers and restrctons on factor movement are abolshed. In the meanwhle, progress was beng made n the buldng up of an economc unon where natonal macro and mcroeconomc polces are co-ordnated and/or gradually harmonsed n lne wth supranatonal laws. Fnally, n January 1999 EMU commenced and the euro was establshed as the sngle currency of eleven European countres. Greece later joned on 1 January 2. It s noteworthy that, whle European nsttutonal ntegraton was advancng, nneteen other countres joned the sx founders at dfferent ponts n tme. The EU thus now ncludes 25 members. Over ths long perod economc ntegraton has deepened among all EU countres. We observe n ths paper that the recprocal trade among EU members has rsen, over tme, by a large multple of the ncreases found by Rose (1997) as well as several other studes that he revews (see Rose (4)). From our prelmnary analyss t turns out that such ncreases could have far exceed the maxmum gans prevously estmated. However, such gans have been stretched over a very longer perod,.e. almost 5 years. Another remarkable feature s that non-ntra EU trade also ncreased dramatcally over the sample perod:.e., there s an ncrease of both nternal and external openness. The paper focuses on the followng sub-perods that are lnked to the man enlargement dates n the past: , whch s only relevant for the EU-6 foundng countres (.e., Belgum, France, Germany, Italy, Luxembourg and the Netherlands, whch started ntegratng n 1957); , wth Denmark, Ireland and the Unted Kngdom becomng members of the EU-9 snce 1973 and Greece jonng n 1981, thus formng the EU-1; , wth Portugal and Span formng the EU-12 together wth the other ten members; and , wth Austra, Fnland and Sweden jonng the EU-12, thus leadng to the EU-15. Ten new member countres have joned the EU n May 4, but they are not dscussed n ths paper as comparable data are not avalable for them (see Angelon, Flad and Mongell (5)). The paper s organsed as follows. Secton 2 presents the ndex of nsttutonal ntegraton descrbng how European regonal cooperaton proceeded over tme n terms of depth (.e., by removng trade barrers, settng ncreasngly ambtous nsttutonal objectves, etc.) and geographcal scope (.e., new members). Secton 3 presents several ndcators of trade deepenng, ncludng trade openness (.e., blateral trade data normalsed by GDP), the share of ntra-regonal trade n total trade and deflated trade values smlar to those used by Frankel and Rose (1997) and Rose ()). Some other measures of economc and fnancal ntegraton are also presented, ncludng busness cycle synchronsaton, fnancal market ntegraton and nomnal convergence. Such measures are used as controls n subsequent sectons. Secton 4 presents several descrptve lnks between nsttutonal ntegraton and trade 3 Some alternatve sub-perods may also be consdered: March 1957-August 1971: Bretton Woods system of fxed exchange rates; September 1971-February 1979: very volatle exchange rates and faled attempt to establsh an exchange rate mechansm (the Snake ), plus a major recesson n ; March 1979 August 1987: Soft ERM wth frequent realgnments, especally untl 1983; September 1987-December 1992: Hard ERM : no realgnments (apart from a realgnment assocated to the lra enterng the narrow ERM band n January 199) untl the EMS crss n September 1992; ntegraton of factor markets, culmnatng n the establshment of the European Sngle Market n January 1993; January 1993-December 1998: Pre-EMU, wth enhanced nomnal convergence and run-up to monetary unon; and January 1999 onwards wth EMU. 4 We wll also llustrate some selected results for the EU-6 countres usng data for ntra-trade. 1 INTRODUCTION Occasonal Paper No. 4 December 5 7

9 ntegraton. Secton 5 and the related appendx present some more formal tests of the lnks between nsttutonal ntegraton and trade ntegraton. Fnally, Secton 6 presents some conclusons and qualfcatons. Appendces A, B and C contan an exploratve vector error correcton model (VECM) and a varance decomposton exercse. There are several lmtatons and caveats to our analyss. Frst, the focus of ths paper s exclusvely on Europe untl 3. Second, we concentrate on the two aforementoned dmensons of European ntegraton,.e., nsttutonal ntegraton and the degree of trade deepenng. Thrd, and more mportantly, European ntegraton dd not occur n a vacuum, and a host of other varables and developments affected, drectly or ndrectly, both nsttutons and trade, thus playng a role n shapng European ntegraton. Examples are gven by fnancal ntegraton, global geopoltcal developments and, foremost, the sustaned global growth n trade and outputs. Furthermore, the paper excludes trade n servces, whch has also grown at sustaned rates and now accounts for a sgnfcant share of GDP (about 6-7 percent for EU countres). However, long tme seres for trade n servces on a comparable bass are not avalable. Some other techncal and methodologcal caveats are mentoned n the next sectons. 2 THE INDICATOR OF INSTITUTIONAL INTEGRATION AND THE ENLARGEMENT OF THE EEC/EU Ths secton presents the ndex of nsttutonal ntegraton, whch tracks the country-specfc path of each member of the European Unon (defned here as EU-15,.e. pror to the enlargement completed n 4) toward everdeeper economc, fnancal and monetary ntegraton wth the other Unon s members. Ths ndex was frst presented n Dorrucc, Frpo, Fratzscher, and Mongell (2 and 4). The ndex follows the semnal contrbuton of Balassa (1961), whch dentfed the followng fve man stages of regonal ntegraton 5 : Stage 1. Free Trade Area (FTA) An area where tarffs and quotas are abolshed for mports from area members, whch, however, retan natonal tarffs and quotas aganst thrd countres. An example, s the European Economc Communty snce 1957; Stage 2. Customs Unon (CU) A FTA settng up common tarffs and quotas (f any) for trade wth non-members. An example s the European Economc Communty snce 1968; Stage 3. Common Market (CM) A CU abolshng non-tarff barrers to trade (.e., promotng the ntegraton of product and servce markets) as well as restrctons on factor movement (.e., promotng the ntegraton of captal and labour markets). An example s the European Communty snce 1993 (wth the establshment of the European Sngle Market). The CM was already set up as an objectve under the Treaty of Rome (so-called four freedoms ); Stage 4. Economc Unon (EUN) A CM wth a sgnfcant degree of co-ordnaton of natonal economc polces and/or harmonsaton of relevant domestc laws. An example s the European Unon nowadays; and Stage 5. Total Economc Integraton (TEI) An EUN wth all relevant economc polces conducted at the supranatonal level, possbly n complance wth the prncple of subsdarty. To ths am, both supranatonal authortes and supranatonal laws need to be n place. An example s the euro area (.e., 12 out of 25 EU members), whch can be currently classfed somewhere between an EUN and a TEI. However, some supranatonal authortes and jont rule 5 It s mportant to observe that poltcal unon may be seen as an ultmate step gong beyond the fve stages dentfed by Balassa. However, that step s not dscussed n ths paper. 8 Occasonal Paper No. 4 December 5

10 makng were establshed already wth the Treaty of Rome n 1957, and subsequently enhanced. The overall degree of nsttutonal ntegraton at a gven pont n tme durng can be quantfed by assgnng scores to the level of ntegraton recorded for each of these fve stages (see Dorrucc, Frpo, Fratzscher, and Mongell (2 and 5)). In partcular, scores from to 25 are assgned to the degree of regonal ntegraton acheved over tme n the development of, respectvely, a Free Trade Area/Customs Unon (FTA/CU, consdered jontly), a Common Market (CM), an Economc Unon (EUN), and an area wth Total Economc Integraton (TEI). By summng up the scores acheved n each moment n tme, a monthly ndex of nsttutonal regonal ntegraton s obtaned whch can range between (no economc ntegraton at all) and 1 (full economc ntegraton, ncludng monetary and fnancal ntegraton). 6 At the same tme t should be emphassed that ths ndex cannot capture all elements, partcularly some unlateral nformal ntatves mpngng on nsttutonal ntegraton. An example s the de facto monetary unon between Austra and Germany that started much before Fgure 1a llustrates the paths of nsttutonal ntegraton of the sx aforementoned founders of the EU (then called EEC) from 1957 untl 3. The development of the EU-6 as a whole sets the benchmark for ths study as, wth the excepton of a few temporary relapses n nsttutonal ntegraton by France and Italy, ths group has both poneered and marked the pace of European nsttutonal ntegraton. The fgure also shows that we can dstngush three sub-perods n the process of regonal ntegraton. The frst perod, charactersed by faster ntegraton, proceeds from March 1957 (Treaty of Rome) to July 1968 (completon of the customs unon). By that tme more than half of the overall nsttutonal ntegraton process Fgure 1a Index of nsttutonal ntegraton of the EU-6 (.e., Belgum, France, Germany, Italy, Luxembourg, and the Netherlands), whch started ntegratng n EU-6 France (specfc) Italy (specfc) Common Agrcultural Polcy Customs Unon EMS Italy and France abandon the snake Monetary Unon Common Market Italy: EMS crss and partcpaton n Schengen only at a later stage Italy has wde band wthn EMS / ERM had been already completed. However, that was also due to the fact that n July 1968 the EU was ndeed much more than just a customs unon, snce t already had some genune characterstcs of subsequent Balassa stages, for nstance supranatonal nsttutons and Communty laws enforced by the courts. The second perod can be dentfed between the start of the 197s and the md-198s, and s charactersed by sluggsh ntegraton, wth the noteworthy excepton of the EMS start n March Fnally, n the thrd, most recent perod a new, consderable acceleraton n regonal ntegraton can be observed wth the launch of several ntatves and the start of EMU: as a result, the EU/euro area can currently be classfed somewhere between an EUN and a TEI. Fgure 1b llustrates the path of nsttutonal ntegraton of Denmark, Ireland, and the Unted Kngdom wth the EU-6 core group. 6 In Dorrucc, Frpo, Fratzscher, and Mongell (2) scores are assgned on the bass of a set of specfc ndcators and crtera (see Appendx 1, pp ). To the extent possble scores are not assgned on the bass of the year when a certan decson was taken (e.g. Treaty of Rome n 1957), but rather the year and month when a decson started beng actually mplemented. Moreover, some Balassa stages tend to develop n parallel, whch mples that some stages evolve at the same tme. For nstance, when t became a customs unon (1968), EU-6 had already one fundamental characterstc of total economc ntegraton,.e. a number of supranatonal nsttutons and the structurng of ntegraton through Communty law. Ths entals that numbers can be assgned n parallel for each of the fve stages. Occasonal Paper No. 4 December 5 2 THE INDICATOR OF INSTITUTIONAL INTEGRATION AND THE ENLARGEMENT OF THE EEC/EU 9

11 Fgure 1b Index of nsttutonal ntegraton: EU-6 compared to Denmark, Ireland and the UK (that joned n 1973) EU-6 Denmark Ireland UK Fgure 1c Index of nsttutonal ntegraton: EU-9 compared to Greece (that joned n 1981), Portugal and Span(that joned n 1985) EU-9 Span Portugal Greece These three countres joned the EU n The chart llustrates that nowadays Ireland s fully ntegrated wth the EU-6 members, whereas Denmark and, to a larger extent, the UK, present a lower degree of ntegraton. Fgure 1c llustrates the path of nsttutonal ntegraton of Greece, Portugal and Span wth the EU-9 countres. The chart llustrates that Greece (whch joned the EU n 1981) requred qute a long tme to catch up wth the rest of the EU, whle at the same tme the EU as a whole was leapng forward. The same phenomenon holds, but to a lesaser extent, for Portugal and Span: they joned the EU n 1985, leapt to a medum level of nsttutonal ntegraton and then made the fnal leap a few years later. It should be noted that n the graph these three members actually overtake the EU-9 taken as a whole n recent years. The reason for ths s that the EU-9 also ncludes Denmark and the UK, whch are at a lower level of nsttutonal ntegraton. Fnally, Fgure 1d llustrates the path of nsttutonal ntegraton wth the EU-12 countres of Austra, Fnland and Sweden, all of whch joned the EU n All n all, the fgures above llustrate a number of overarchng features of the European process of nsttutonal ntegraton. Frst, certan countres already scored ponts n ther process of nsttutonal ntegraton even pror to ther EU accesson, owng to ther trade agreements such as the European Free Trade Agreement (EFTA) wth the EU. Second, n specfc cases EU accesson requred some tme for a complete nsttutonal catch-up by the new entrants. Both observatons wll allow us to defuse the mpact of entry n the EEC/EU and assgn some of the gans n trade deepenng also to other arrangements (such as EFTA). As a general rule, however, the countres that joned at a later stage requred less tme to catch-up (nsttutonally speakng) wth the rest. The reason for ths looks straghtforward: whle the founders of the EU have wrangled and wrestled for decades to reach the current nsttutonal settng, those jonng later were only requred to ncorporate the acqus communutare nto ther system of rules and laws. Thrd, and most mportantly, the fgures also pont to the relatvely hgher mpact of certan events on the process of nsttutonal 7 In Fgure 1d the nsttutonal ntegraton measure only shows Austra as becomng sgnfcantly ntegrated from 1995 onwards (.e., when t joned the EU). In ths regard, t may be argued that Austra s close lnk wth the German D-Mark has ncreased ts ntegraton wth Germany and the other EMS members substantally before that. However, our ndex does not focus on unlateral ntatves by ndvdual countres, but only on multlateral regonal decsons. 1 Occasonal Paper No. 4 December 5

12 Fgure 1d Index of nsttutonal ntegraton: EU-12 compared to Austra, Fnland and Sweden (that joned n 1995) EU-12 Austra Fnland Sweden ntegraton. The custom unon of 1968, the common Market of 1993, and the monetary Unon of 1999 look as the most nfluental steps. In the followng, we wll seek to verfy whether some of these nsttutonal features and frst of all the degree of nsttutonal deepenng had any sgnfcant mpact on trade-deepenng. 3 DIVERSE MEASURES OF TRADE DEEPENING The second varable nvestgated n ths paper s trade. We make use of the OECD-MFTS Database coverng blateral trade data n current US dollars from 196 onward. 8 Three complementary measures of trade deepenng are obtaned from these data. The frst measure s based on the rato of ntra-regonal trade to GDP as an ndcator of trade openness. 9 Ths measure captures the genune ncrease n recprocal trade among the countres nvestgated. Intra-regonal trade openness (TO) s defned here as the total trade of a country wth the group to whch t s accedng (e.g. EU-6 for UK, whch jons n 1973, but EU-12 for Austra, whch jons n 1995) over the GDP of the accedng country. By keepng the group sze constant, any bases due to future group enlargement are avoded. We defne the varable TO as: TO EUj EUj ( X + M ) EUj t, t, t, =, GDPt, where are the accedng countres (.e. DK Denmark, UK Unted Kngdom, etc.) and j denote the successve enlarged EUs (.e, EU-6, EU-9, EU-1, EU-12). By normalsng trade flows by GDP the effects of busness cycle fluctuatons are also reduced somewhat. The second measure hghlghts the degree of regonal trade ntegraton as the rato of ntraregonal trade to total trade. The mert of ths measure s that t may reveal evdence of trade dverson. The potental drawback of ths measure s nstead that ths rato may not ncrease even f ntra-regonal trade rses strongly because of an even hgher growth rate n extra-regonal trade. For the analyss below ntra-regonal trade ntegraton (TI) s defned as the total trade of a country wth the group to whch t s accedng, dvded by the total trade of that country wth the rest of the world, or: TI EUj t, EUj EUj ( X t, + M t, ) World World ( X + M ) =. t, Ths ndex has been constructed for the EU-6 as a whole and for each ndvdual accedng country. We refer to ths varable as II. The thrd measure, or real trade, s akn to that presented n the paper by Frankel and Rose (1997), whch looks at real trade deepenng usng US dollar-denomnated blateral trade data deflated by the USD Chan prce ndex (wth bass 1996 = 1 n our case). Ths permts to obtan a measure of real trade data. For the analyss below, deflated trade (DT) s 8 I.e., the rest of ths analyss s based upon blateral trade data of every EU country vs-à-vs each other. Trade wth the non- EU s also consdered to compute some of the ndcators below. Unfortunately, these data do not nclude trade n servces whch has ncreasngly acqured greater mportance n total trade. Only for the EU-6 countres we possess trade data also for the perod. 9 The adjectve ntra-regonal s mportant so as to dstngush t from the common meanng of trade openness:.e., total trade ncludng extra-regonal trade over GDP. t, 3 DIVERSE MEASURES OF TRADE DEEPENING Occasonal Paper No. 4 December 5 11

13 a measure of real trade flows obtaned by dscountng nomnal trade by the US GDP Chan Prce Index. Ths measure s ncluded to allow for a comparson wth the fndngs of Frankel and Rose (1997). Mathematcally we can defne t as: DT EUj EUj ( X + M ) EUj t, t, t, =, Indext where Index stands for the Chan Prce Index (base year s 1996). The mert of ths measure s that t permts to gauge a dmenson of trade deepenng comparable to the dverse comparsons of the lterature on the endogenety of OCA that followed Frankel and Rose (1997) paper. At the same tme ths measure has several drawbacks and must be nterpreted wth cauton. Usng a USD-based deflator may underestmate the effectve deepenng of European trade as average US nflaton exceeded average EU nflaton. Stll ths ndcator produces several seemng outlers, wth very consderable ncreases n trade volumes that would deserve to be taken as ndcatve (and requre further analyss). The followng prelmnary fndngs emerge from Table 1 and Fgure 2, concernng the ndcator of trade openness TO (.e., ntraregonal trade to GDP): 1 TO rses wth successve enlargements of the EU (as more ntra-eu trade s factored n); The overall ndex rses albet wth some cyclcal varatons for every sub-perod,.e. for every EU composton. Between 196 and 2 TO doubles on a twelve months movng average bass. The ncrease s more pronounced n the earler sub-perods (.e., untl the md- 197s) and than contnues rasng, though subject to cyclcal fluctuatons. Trade openness for the EU-15 as a whole rose from about 16 percent of GDP n 196 to above 32 percent of GDP n 2. For the Fgure 2 Trade Openness of EU6, EU9, EU12, and EU Nov Trade Openess EU-9 (1973) Trade Openess EU-6 (1957) Trade Openess EU-12 (1986) Trade Openess EU-15 (1985) Nov Nov. 198 Nov Nov. 3 current euro area countres as a whole the rato rses from about 12 percent of GDP n 196 to over 26 percent n 2. Each EU composton (.e., group of countres such as EU-6, EU-9, and so on) shows a dome-lke shape: t dsplays a tendency to ncrease and then declne somewhat (probably as more trade takes place vs-à-vs the new member countres). A more recent example of ths s the fast deepenng of trade between Germany and the new EU Member States; EU accesson processes are generally accompaned by clear advancements n trade openness (see Fgure 3). Furthermore, Table 1 (Part B) shows very sgnfcant ncreases n ntra-regonal trade openness 5-years pror to accesson compared wth 5-years after accesson. Concernng trade ntegraton (TI), defned as a rato of ntra-regonal trade to total trade, Table 1 and Fgure 3 show that also TI rases wth successve enlargements of the EU (as more ntra-eu trade s factored n). Durng TI has ncreased for every EU composton, albet wth some reversals for the 1 Please note that Table 1 refers to perod averages whle the Fgures show yearly averages of monthly data Occasonal Paper No. 4 December 5

14 Fgure 3 Trade Integraton of EU-6, EU-9, EU-12 and EU-15 Fgure 4 Stacked lnes of dscounted trade: groups per enlargement dates 3 DIVERSE MEASURES OF TRADE DEEPENING EU-6 EU-9 EU-12 EU month movng average (EU-6) 12 month movng average (EU-9) 12 month movng average (EU-12) 12 month movng average (EU-15) Nov Nov Nov Nov Nov Dec Dec Dec. 197 Dec Dec Dec Dec Dec countres that ntegrated earler than others (.e., from 9.1 percent for the EU-6, to over 25 percent for the EU-15). Ths suggests that EU counterparts have become preferental tradng partners over the long tme perod. Concernng real US-dollar-denomnated blateral trade (subject to the aforementoned caveats): n the sample were subject to the General Agreement on Tarffs and Trade (GATT); As explaned, our measure of real blateral trade s only ndcatve; and The reasons for the uneven and cyclcal progresses over tme should also explored n future extensons of ths project. The ncreases n real trade values s very large for every group of countres: we are n the range of four- or fve-folds ncreases wth respect to those measured by Rose () and Frankel and Rose (1997):.e., 1,-1,4 percent vs-à-vs 3 percent. However, the ncreases we measure unfold over about 5 years: those by Rose () and Frankel and Rose (1997) requre less tme; It ncreases at uneven rates durng the varous sub-perods postng the most sgnfcant growth durng and for all EU compostons; One mportant reason why trade deepenng developed also pror to offcal EU accesson s the exstence of trade agreements between the EU and future accesson countres pror to accesson (e.g., EFTA). Furthermore, all countres Occasonal Paper No. 4 December 5 13

15 Table 1 Selected measures of trade deepenng, (Part A) Average levels of ntra-regonal trade openness: ntra-trade/gdp Total Denmark Ireland UK Greece Portugal Span Austra Fnland Sweden EU-6 1) EU-9 EU-1 EU-12 EU-15 Euro vs. vs. vs. vs. vs. vs. vs. vs. vs. Area EU-6 EU-6 EU-6 EU-9 EU-1 EU-1 EU-12 EU-12 EU Percentage change n ntra-regonal trade openness: ntra-trade/gdp Total Denmark Ireland UK Greece Portugal Span Austra Fnland Sweden EU-6 1) EU-9 EU-1 EU-12 EU-15 Euro vs. vs. vs. vs. vs. vs. vs. vs. vs. Area EU-6 EU-6 EU-6 EU-9 EU-1 EU-1 EU-12 EU-12 EU Average levels of trade ntegraton: ntra-trade/total trade Total Denmark Ireland UK Greece Portugal Span Austra Fnland Sweden EU-6 1) EU-9 EU-1 EU-12 EU-15 Euro vs. vs. vs. vs. vs. vs. vs. vs. vs. Area EU-6 EU-6 EU-6 EU-9 EU-1 EU-1 EU-12 EU-12 EU Percentage change n trade ntegraton: ntra-trade/total trade Total Denmark Ireland UK Greece Portugal Span Austra Fnland Sweden EU-6 1) EU-9 EU-1 EU-12 EU-15 Euro vs. vs. vs. vs. vs. vs. vs. vs. vs. Area EU-6 EU-6 EU-6 EU-9 EU-1 EU-1 EU-12 EU-12 EU Percentage change n Total Trade dscounted by USD GDP Chan Prce Index Total Denmark Ireland UK Greece Portugal Span Austra Fnland Sweden EU-6 1) EU-9 EU-1 EU-12 EU-15 Euro vs. vs. vs. vs. vs. vs. vs. vs. vs. Area EU-6 EU-6 EU-6 EU-9 EU-1 EU-1 EU-12 EU-12 EU ,652. 1,227. 1, , , , , , , , , Insttutonal ntegraton: average GDP-weghted score n nsttutonal ndex Total Denmark Ireland UK Greece Portugal Span Austra Fnland Sweden EU-6 1) EU-9 EU-1 EU-12 EU-15 Euro vs. vs. vs. vs. vs. vs. vs. vs. vs. Area EU-6 EU-6 EU-6 EU-9 EU-1 EU-1 EU-12 EU-12 EU Source: Trade data from OECD-MFTS; GDP data from IMF-IFS; and Chan Prce Index from BEA, NIPA Tables 7.1, 7.2, 7.14 and GDP Press Release. All data are tll 3. except Greek trade data. Untl 1999 Belgum and Luxembourg reported all trade data together. 1) For the EU-6 the data start from The data for were obtaned from the European Commsson, supplemented wth IFS data. 14 Occasonal Paper No. 4 December 5

16 Table 1 Selected measures of trade deepenng, (Part B) 3 DIVERSE MEASURES OF TRADE DEEPENING Percentage change n ntra-regonal trade openness: ntra-trade/gdp Total Denmark Ireland UK Greece Portugal Span Austra Fnland Sweden EU-6 1) EU-9 EU-1 EU-12 EU-15 Euro vs. vs. vs. vs. vs. vs. vs. vs. vs. Area EU-6 EU-6 EU-6 EU-9 EU-1 EU-1 EU-12 EU-12 EU-12 total: post-ems: Pre-EMU ( )- Post-EMU (1999-3) y. before and 5-y. after jonng Specal Perods Bretton Woods 1/196 tll 8/ Floatng rates 9/1971 tll 2/ Soft ERM 3/1979 tll 8/ Hard ERM 9/1987 tll 12/ Pre-EMU 1/1993 tll 12/ EMU 1/1999 tll 12/ Percentage change n Total Trade dscounted by USD GDP Chan Prce Index Total Denmark Ireland UK Greece Portugal Span Austra Fnland Sweden EU-6 1) EU-9 EU-1 EU-12 EU-15 Euro vs. vs. vs. vs. vs. vs. vs. vs. vs. Area EU-6 EU-6 EU-6 EU-9 EU-1 EU-1 EU-12 EU-12 EU-12 total: ,781. 1,13.6 1,1.3 1,38.2 1, , , , , , , post-ems: Pre-EMU ( )- Post-EMU (1999-3) y. before and 5-y. after jonng Specal Perods Bretton Woods 1/196 tll 8/ Floatng rates 9/1971 tll 2/ Soft ERM 3/1979 tll 8/ Hard ERM 9/1987 tll 12/ Pre-EMU 1/1993 tll 12/ EMU 1/1999 tll 12/ Source: Trade data from OECD-MFTS; GDP data from IMF-IFS; and Chan Prce Index from BEA. NIPA Tables 7.1, 7.2, 7.14 and GDP Press Release. All data are tll 3. except Greek trade data. Untl 1999 Belgum and Luxembourg reported all trade data together. 1) For the EU-6 the data start from The data for were obtaned from the European Commsson, supplemented wth IFS data. Occasonal Paper No. 4 December 5 15

17 Table 2 Insttutonal Integraton and Trade Deepenng durng Successve EU Enlargements, 1958/6-3 1) Insttutonal Trade Trade Dscounted European Unon (EU) Integraton (II) Openness (TO) Integraton (TI) Trade (DT) Enlargements 2) (Score 1=max) (Share of GDP n %) (Share of total trade) (1996 US$ bllon) EU Enlargement Ireland Denmark Unted Kngdom EU /85 Enlargement Greece 3) Portugal Span EU Enlargement Austra Fnland Sweden EU Sources: IFS, OECD MTFS Database, European Commsson and authors calculatons. 1) Data s 12 months averages of the year. 196 data s 12 months average December 196-November OECD annual trade data, supplemented wth IFS data. 2) Trade deepenng of acceedng countres vs-à-vs the EU at the tme of the enlargement. E.g., n the case of UK t s trade deepenng wth EU-9. 3) Greece joned the EU-9 n SOME DESCRIPTIVE LINKS BETWEEN INSTITUTIONAL INTEGRATION AND TRADE INTEGRATION Ths secton presents some llustratons of the lnk between nsttutonal and trade ntegraton. We also look at what happened around the date of EU accesson and snce the start of Stage 3 of EMU. 4.1 SPECIFIC EFFECTS OF ACCESSION The above Table 1 (Part B) llustrates that accesson s charactersed by sgnfcant trade deepenng. Takng the respectve accesson years as a pvot, and computng the ndcators of trade deepenng 5-years pror to accesson wth respect to 5-years after accesson, we fnd the followng effects. The ndcator of trade openness (.e., ntraregonal trade to GDP) exhbts ncreases by 18.6 percent for Denmark, percent for 16 Occasonal Paper No. 4 December 5

18 Fgure 5a Insttutonal ntegraton and trade openness, 196-3, all EU countres Fgure 5b Insttutonal ntegraton and trade openness, 196-3, EU-6 vs. Denmark, Ireland and the UK EU-6 DK, IE, UK Lnear (DK, IE, UK) 4 SOME DESCRIPTIVE LINKS BETWEEN INSTITUTIONAL INTEGRATION AND TRADE INTEGRATION Trade Openness Insttutonal Index Trade Openness Insttutonal Index Fgure 5c Insttutonal ntegraton and trade openness, 196-3, EU-9 vs. Span, Portugal and Greece EU-9 GR, ES, PT Lnear (GR, ES, PT) Fgure 5d Insttutonal ntegraton and trade openness, 196-3, EU-12 vs. Austra, Fnland and Sweden EU-12 AT, FI, SE Lnear (AT, FI, SE) Trade Openness Trade Openness Insttutonal Index Insttutonal Index 1. Ireland, percent for the UK, 32.4 percent for Greece, 23.7 percent for Portugal, 73.5 percent for Span, 14.3 percent for Austra, 42.2 percent for Fnland, and 16.1 percent for Sweden. Concernng the real US dollar-denomnated blateral trade, we observe ncreases by 8.3 percent for Denmark, percent for Ireland, percent for the UK, 55.1 percent for Greece, percent for Portugal, percent for Span, 5.4 percent for Austra, 17.5 percent for Fnland, and 3.9 percent for Sweden. 4.2 SPECIFIC EFFECTS OF STAGE 3 OF EMU (I.E., THE INTRODUCTION OF THE EURO) Table 1 (Part B) llustrates that upon the launch of the euro n 1999, trade openness rose by 4.8 percent for euro area countres vs-à-vs a 3.3 percent ncrease for EU-15 countres. Deflated real trade rose by 8.4 percent vs-à-vs a 5.4 percent ncrease n the EU-15. The followng scatter dagrams descrbe the possble lnk between nsttutonal ntegraton and the three trade measures. The relatonshp s clearly postve. However, a few may even be downward based by the fact that ntra-regonal Occasonal Paper No. 4 December 5 17

19 Fgure 6a Insttutonal ntegraton and trade ntegraton, 196-3, all EU countres Fgure 6b Insttutonal ntegraton and trade ntegraton, 196-3, EU-6 vs. Denmark, Ireland and the UK EU-6 DK, IE, UK Lnear (DK, IE, UK) Trade Integraton Insttutonal Index Trade Integraton Insttutonal Index Fgure 6c Insttutonal ntegraton and trade ntegraton, 196-3, EU-9 vs. Span, Portugal and Greece Fgure 6d Insttutonal ntegraton and trade ntegraton, 196-3, EU-12 vs. Austra, Fnland and Sweden EU-9 GR, ES, PT Lnear (GR, ES, PT) EU-12 AT, FI, SE Lnear (AT, FI, SE) Trade Integraton Trade Integraton Insttutonal Index Insttutonal Index 35. trade ncreases wth successve accesson waves but trade deepenng of any group may retrench somewhat over tme: for nstance, trade deepenng among the EU-6 declned as the EU grew larger. In future extensons of ths work, a correcton wll be requred for ths effect. 5 TESTING THE LINKS BETWEEN INSTITUTIONAL INTEGRATION AND TRADE DEEPENING In ths fnal secton we use some smple tools to gauge some drecton of causalty between nsttutonal and economc ntegraton. For nsttutonal ntegraton we use the ndex of nsttutonal ntegraton as defned n Secton 2. Before commencng our formal test, however, we need to perform a few data transformatons. As a standard procedure, we take the natural logarthms of all four varables (II, TO, TI and DT). Moreover, as monthly trade data contan strong seasonal components, t s necessary to seasonally adjust the varables TO, TI and DT. Vsual nspecton of seasonal stacked lnes of the varables confrms that the means are dfferent n dfferent months, ndcatng the presence of seasonalty. The procedure we use to perform seasonal adjustment s the standard TRAMO/ SEATS. 18 Occasonal Paper No. 4 December 5

20 Box LIST OF VARIABLES AND ABBREVIATIONS USED TO Trade Openness TI Trade Integraton DT Deflated Trade 5 TESTING THE LINKS BETWEEN INSTITUTIONAL INTEGRATION AND TRADE DEEPENING II Insttutonal Integraton AU Austra DK Denmark ES Span FI Fnland GR Greece IE Ireland PT Portugal SE Sweden UK Unted Kngdom ln natural logarthm 5.1 OPTIMAL LAG LENGTHS AND COINTEGRATION RANKS The level of ntegraton of all varables s checked wth the Adjusted Dckey-Fuller tests. All varables for all countres are, n fact, I(1). The varable II does not requre seasonal adjustment as nsttutonal ntegraton, whch s a poltcal process, does not contan a seasonal component. Vsual nspecton of seasonal stacked lnes confrms ths. 11 That s, they are all non-statonary n levels and statonary n frst dfferences. In nearly all cases, moreover, these results are not senstve to the ncluson of a determnstc trend n the test specfcaton: the varables are not trend statonary ether. In order to avod spurous regressons, therefore, the contegraton approach s the correct way to proceed. We then look at the optmal lag length and determne the rank of contegraton of each set of endogenous varables. The sets of endogenous varables are as follows: DT and II; TI and II; and TO and II. That s, we want to run a VECM for each combnaton of nsttutonal ntegraton and the three proxes of trade deepenng. Algebracally we can use the vector formulatons: dt to t, t, = ln EUj ( DTt, ) ( II ) t, EUj ( TO ) ( ) t, IIt, ln ln = ln ( ) ( ) EUj ln TI t,, t = and t, ln IIt, The optmal lag length can be estmated by runnng unrestrcted VARs and then applyng a standard crteron for lag length selecton. The VARs can be defned as follows: (1) dtt, = α + β1dtt 1, + K+ β pdtt p, + εt (2) tt, = α + β1tt 1, + K + β ptt p, + εt (3) tot, = α + β1tot 1, + K + β ptot p, + ε t 11 It s nterestng to note, however, that t s not a necessary condton for all varables to be ntegrated of the same order when runnng a VECM. One can also nclude varables that are I() (Hayash, ). Occasonal Paper No. 4 December 5 19

21 Here α s a vector of constants; β 1,..., β p are matrces of coeffcents to be estmated; and ε t s a vector of nnovatons that may be contemporaneously correlated, but are uncorrelated wth ther own lagged values and uncorrelated wth the rght-hand sde lagged varables. There are several crtera that can be used for the selecton of the optmal lag length, whch we call p *. All are smlar n that they mprove as R 2 ncreases, but, ceters parbus, degrade as the model sze ncreases and degrees of freedom are lost. We apply the Schwarz (Bayesan) crteron consstently to all unrestrcted VARs. 12 The results can be found n Table A.1 n Appendx A. Optmal lag lengths range from 1 to 4 lags. Havng determned the optmal lag length, we can proceed to the contegraton tests. We use the standard Johansen test (Johansen, 1995). We allow for a determnstc trend n the levels data. Subsequently, we use the Trace statstc to test whether the rank of contegraton s 1 (.e. there s one contegratng vector). Snce we have only two varables, the contegraton rank cannot exceed 1. The results at 5% sgnfcance are reported n Table A.3. In just over half the cases the contegraton rank s 1. The cases where no contegratng vectors were found are most concentrated n the varables of deflated trade (DT). For trade openness and trade ntegraton, on the other hand, the vast majorty of varable pars do possess contegratng vectors. For those varables whch have a rank of zero, no VECM can be run. 5.2 GRANGER CAUSALITY TESTS TO GAUGE ENDOGENEITY We use Granger Causalty tests to check whether nsttutonal ntegraton and trade deepenng may be qualfed as endogenous to each other. Agan, we make use of the optmal lag length, p *, as determned by our unrestrcted VARs. The full results (at 5% sgnfcance) are reported n Table A.2. Table 3 below provdes a summary. As we can see, n 56% of the cases nsttutonal ntegraton Granger causes trade deepenng, whereas n 26% of the cases trade deepenng Granger causes nsttutonal ntegraton. These prelmnary results would appear to ndcate that the lnk from nsttutonal ntegraton to trade deepenng s stronger than the reverse lnk. Nevertheless, the reverse lnk cannot be entrely dscarded. Interestngly, however, the results become far more pronounced when we only take the frst group of accedng countres that joned the EU n 1973: the UK, Ireland and Denmark. When we look only at these three countres nsttutonal ntegraton Granger causes trade deepenng n 89% of the cases, whereas the reverse only holds for 11% of the cases. A prelmnary Vector Error Correcton Model (VECM), whch captures both the short-run dynamcs and the long-run trends n the equatons, s gven n Appendx B, whle a varance decomposton analyss s presented n Appendx C. 12 For a comprehensve descrpton of the Schwarz crteron and other crtera of lag length selecton, see Greene (3). Table 3 Summary of results from Granger-causalty tests For all Trade Varables: Trade deepenng Granger causes Inst. Integraton Inst. Integraton Granger causes Trade deepenng (all varables) Total 26% Yes 56% Yes Only early joners DK, UK, IE 11% Yes 89% Yes Occasonal Paper No. 4 December 5