La géographie nous sépare-t-elle ? Prolégomènes à une union économique et monétaire entre la République dominicaine et Haïti

Policy Research Working Paper 5241 Till Geography Do Us Part? Prolegomena to an Economic and Monetary Union between the Dominican Republic and Haiti Emmanuel Pinto Moreira The World Bank Latin American and the Caribbean Region Poverty Reduction and Economic Management March 2010 WPS5241 Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Produced by the Research Support Team Abstract The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent. Policy Research Working Paper 5241 This paper offers a preliminary assessment of the potential benefits and costs of an economic and monetary union (EMU) between the Dominican Republic and Haiti— two countries sharing the same island but whose history is one of conflict and divergent economic prospects in recent decades. After a brief review of the historical context, it examines the nature of these potential benefits and costs. It then conducts a preliminary analysis (using basic statistical techniques) of some key criteria for the formation of an economic and monetary union between the two countries. A more formal analysis of business This paper—a product of the Poverty Reduction and Economic Management, Latin American and the Caribbean Region—is part of a larger effort in the department to understand the issues associated with economic and monetary unions between developing countries in the region. Policy Research Working Papers are also posted on the Web at http://econ.worldbank. org. The author may be contacted at epintomoreira@worldbank.org or epintomoreira@imf.org. cycle synchronization, based on basic and extended integrated vector auto-regression models with exogenous variables (VARX), is developed next. Overall, the analysis suggests that at this stage several economic criteria are not satisfied for the two countries to fully benefit from an economic and monetary union. At the same time, however, the endogeneity of most of these criteria (including the degree of business cycle synchronization) militates in favor of an aggressive medium-term agenda for integration between them. Till Geography do us Part? Prolegomena to an Economic and Monetary Union between the Dominican Republic and Haiti Emmanuel Pinto Moreira*  *Senior Economist, Latin America and Caribbean Region, World Bank and Middle-East Central Asia Department of the International Monetary Fund. I am grateful to Pierre-Richard Agénor (University of Manchester and Centre for Growth and Business Cycle Research) for many helpful discussions and comments on a preliminary draft, and to Issouf Samake (International Monetary Fund) for support. The views expressed in this paper are my own and do not necessarily represent those of the World Bank. 2 Table of Contents I. Introduction II. Historical Background III. Benefits and Costs of an EMU between Haiti and the Dominican Republic 1. Nature of an Economic and Monetary Union 2. Benefits and Costs of an Economic and Monetary Union IV. Criteria for an EMU: Preliminary Data Analysis 1. Volatility of Bilateral Exchange Rates 2. Similarity of Inflation Rates 3. Degree of Price and Wage Flexibility 4. Degree of Labor Mobility 5. Scope for Discretionary Fiscal Policy V. Degree of Symmetry of Shocks: A VARX Analysis 1. VARX Methodology 2. A Basic VARX Model 3. An Expanded VARX Model VI. Summary and Policy Implications References Appendix A—Benefits and Costs Associated with a Currency Union Appendix B—Data Sources and Unit Root Tests 3 I. INTRODUCTION Haiti and the Dominican Republic opened bilateral trade only 20 years ago with the hope of creating economic integration. Trade and migration have increased significantly, and the two nations are now taking steps to establish systems and structures to manage this relationship, with support from various quarters. In July 2008 for instance, the U.S. government and the Organization of American States provided funding for a new program aimed at increasing economic growth and cooperation along the 193-mile border between Haiti and the Dominican Republic. The program, called “Fwontye Nou/Nuestra Frontera” in Creole and Spanish (“Our Border” in English), aims to provide training, technical assistance, and conditions to foster cross-border projects and productive investments for both countries. The European Union has also begun to finance joint projects along the border. The remainder of the paper is organized as follows. Section II provides a review of the historical context. Section III discusses the potential benefits and costs of an economic and monetary union between the two countries. Section IV offers a preliminary analysis of some key EMU criteria, using basic statistical techniques (unconditional correlations), as in some other contributions (see for instance Karras (2007) and Furceri and Karras (2008)). Section V develops a more formal analysis of business cycle synchronization based on two integrated (two-country) VARX models: A “basic” model involving output gaps and inflation (measured in terms of deviations with respect to US inflation) in the two countries, and the US output gap, and an extended model, which adds other “external” variables (the world price of oil and the US real interest rate) and domestic variables (bank credit to the private sector as a share of GDP and bilateral real exchange rates). The models are used to analyze the response of domestic output and inflation to external and domestic shocks. Section VI draws together the policy implication of the analysis and offers some concluding remarks. II. HISTORICAL BACKGROUND History and geography bind the Dominican Republic and Haiti. On December 6, 1492, Christopher Columbus discovered an island that he qualified as “marvelous” and named it Hispaniola. The formation of these two states and their accession to independence is a long story marked by wars and reconciliations, open or hidden hostility and alliances against common dangers. History shows many attempts of unification of these two states, though unsuccessful. On October 1 st 1798, Toussaint Louverture took control of the whole island after ousting foreign troupes, both English and French 1 . On August 1 st 1800, he became the only 1 On October 1 st 1798, English troupes left the place “Mole Saint Nicolas”, last area under their control. On October 22, 1798, Toussaint Louverture obliged French Governor General Hedouville to leave the island for France. 4 master of the French part of Santo Domingo after defeating his rival, General Rigaud. On January 26, 1801, he took control of the Spanish part of Santo Domingo and became the only commander in chief of the entire island. He legitimized his power by elaborating a constitution, approved on July 7, 1801, which gave him all the powers, legislative and executive and allow him to serve as Governor for his lifetime. But Toussaint Louverture’s power was short lived. The French troups sent by Napoleon Bonaparte, under the commandment of his brother-in-law General Victoire- Emmanuel Leclerc, entered in a two-year war with Toussaint Louverture’s army. The war ended with the death of General Victoire-Emmanuel Leclerc on November 2 nd , 1802 and the captivity, deportation, and death in prison of Toussaint Louverture on April 7 th 1803. These events were followed by the granting of independence to Haiti on January 1 st , 1804. After a year of peaceful relationships, in 1805, General Jean-Jacques Dessalines, first President of Haiti after the country gained its independence, launched a new war against the East cost of the island (Santo Domingo). But the war was short-lived as General Dessalines feared retaliation by the French Government. In 1820, a new unification attempt was launched by President Jean-Pierre Boyer. At that time, Spanish people of Santo Domingo were divided between two groups on the choice of their political regime. One group was in the view that independence of the Spanish part of the island was illusory because of the small population. Some advocated a union with Colombia, which had just gained independence. Others called for a fusion with Haiti. In this context, President Boyer used his diplomatic skills to convince Dominicans to go with the unification of the island. On February 1822, his troups entered in Santo Domingo. However, his policy of “Haitianization” of the whole island disappointed many inhabitants of the island including Haitians themselves. In January 1843, a revolution called “Revolution Praslin” under the commandment of Riviere Herard took place. After being defeated, President Boyer left the country on March 13, 1843, after 25 years of power. Dominicans ultimately proclaimed their independence on February 1844, following Riviere Herard’s decision to close all ports of the East Coast to external trading. After a war launched by Riviere Herard to constrain Dominicans to renounce to independence in 1845, and the invasion of the Dominican Republic in March 1849 by Faustin Soulouque (who succeeded President Jean Baptiste Riche), the Dominican Republic reinforced its independence by approving a national constitution. The following years were marked by attempts to sign agreements between the two countries. On November 9, 1874, the two countries signed the first treaty of peace, friendship, trade, and extradition of criminals between them. This treaty established the principle of a customs union between the two countries. It also confirmed the economic and trade dominance of Haiti over its East neighbor. This resulted in Dominicans using Haitian trade and port services for their external trade. The treaty also entailed a financial support of the Haitian Government to the Dominican Republic, with a view to avoid that DR search for financial assistant to compensate for land losses. 5 However, these trade union efforts were stopped by the US occupation of the island for 19 years on the Haitian side (July 28, 1915 to August 21 st , 1934) and 8 years on the Dominican side (October 29, 1916 to October 21, 1924). Following the departure of the US from the DR and the election of President Horacio Vasques on March 15, 1924 and Louis Borno on April 10, 1922, the issue of borders was sorted out. A treaty was signed on January 21 st 1929 and approved by Congress in the Dominican Republic on February 7, 1929, which establishes the borders between the two countries. The treaty was ratified by Haiti on February 15, 1929 and by the Dominican Republic on February 25, 1929. Despite being independent countries, DR and Haiti share common characteristics. They share the same island space (Quisqueya or Hispaniola 76 780 km 2 , the second largest in the Caribbean). They display similarities in natural resources endowments and exhibit clear common traits, both cultural and socio-economic. The two countries have always maintained intense commercial exchanges and cultural ties, whether formal or informal, legal or illegal. Haiti is the third largest export market for the Dominican Republic; conversely, the DR is the first export market for Haiti. Haiti is the primary source of migrants for the DR. For thousands of Haitians, migration provides the way to employment in the DR as well as an escape valve for the pressure created by overpopulation and land scarcity at home; for others, political instability at home (n addition to economic needs) has led to voluntary exile in the DR. During the 1990s, some 30,000 Haitians were entering the DR each year, and about half that number was repatriated. Some 150,000 Haitian who remained from the previous 20 years would make a total of 250,000-300,000 emigrés , and these would join the estimated 100,000 Dominicans born of Haitian parents. The presencia haitiana in Dominican society could therefore involve, by this reckoning, some 350,000-400,000 persons of Haitian descent, whether born in Haiti or in the DR. Cultural and intellectual exchanges between the two countries have always been intense, especially along the border as well as among the elites at the national level. The Dominican economy needs Haitian labor and its industry depends largely on this source of manpower. A scarcity of land on the Haitian side continues to push peasants toward the east and to the north. The frontier markets and contraband trade indicate that, despite the stereotypes and notwithstanding the barriers to immigration, a vigorous economic life has created borderland ‘communities”, which offer a flexible pattern of culture more accommodating of otherness than that of the interior zones. There is a fluidity and seeming ease with social interactions, including exchange of language (Haitian Kreyol and Spanish). Another type of exchange involves money, the Haitian gourde being valued here as is the Dominican peso. Intermarriages occur frequently, mostly of Dominican men with Haitian women. The exchanges of the borderlands remind people of the two countries that they share a background that embraces the history of colonialism, the experience of underdevelopment, and the struggle to survive. 6 Despite similarities and common traits, however, the growth patterns and outcomes achieved by the countries in recent decades have been widely different. The DR has gone successfully through a transition to lower middle-income status with substantial economic growth. Haiti has lagged behind in all aspects of socio-economic development. However, articulations and interdependencies are already a fact. With such interdependencies in mind, Muñoz (1995) correctly states that the “superstructural frame” that integrates countries into multinational blocs is not nationalities, but rather markets. Although “national identity and consciousness, by their own nature, cannot be negotiable”- in the sense that they have their own dynamic coherence – they do have functions within the nation-state system articulated by economics and migration. 2 In fact, it may be argued that the sheer differences between the two countries create mutually beneficial situations building on their individual comparative advantages. Hence, by acting jointly and/or in a coordinated fashion in key areas, individual growth outcomes can be enhanced. Interdependence and cultural exchange continue within the asymmetrical frame of the Haitian and Dominican Republics. The problem of their contiguous coexistence, together with the flow of migrants across the shared border, expresses the situation of two states whose populations must seek the ad hoc solutions to social ills by mean of emigration. Integration could be realized in a fair and efficient regulation of the commercial traffic between the two countries. Such regulation would facilitate trade while providing for the revenue needed to develop each country’s infrastructure. Thriving commerce in the frontier towns already indicates ways in which a less encumbered cross-border trade can profit the two national economies. In the Haitian southeast, Haitians and Dominicans come to do business at the rural market of Fonds-Verettes, Situated at a crossroads of major access routes. The market draws farmers, hawkers, and retail dealers from towns like Perdernales, Saltrou, Neiba, and Barahona. As illustrated in the example of Fonds-Verettes, informal linkages of commerce and culture have blurred the division between nations. They also point to the fact that Haitian and Dominican “sister towns” have become interdependent. Such pairings include not only Dajabón and Ouanaminthe, but also Elías Piña and Belladères; Jimani and Fonds Parisien; and Pedernales and Anses-à-Pitres. By transcending the limits of sovereign states, the two countries could define a new, holistic mapping of Hispaniola which could serve as a new paradigm of cooperation, interdependence, and collaboration between nations. Its articulation of insular counterpoints can legitimate and support initiatives for joint plans and projects for expanding commerce between Haiti and the Dominican Republic. 2 Mu ñoz, Maria Elena. Las Relationes Dominico-Haitianas: Geopolitica y Migracion. Santo Domingo: 7 III. BENEFITS AND COSTS OF AN EMU BETWEEN THE DOMINICAN REPUBLIC AND HAITI During the past few decades, the economic performance of the Dominican Republican and Haiti has diverged markedly. As shown in Figure 1, using 1963 as a base year, by 2007 real output in the Dominican Republic had increased almost ninefold (more than twice the increase in the United States during the same period), compared to quasi stagnation in Haiti. In per capita terms, real GDP tripled to about US$2,500 between 1960 and 2005 in the Dominican Republic, whereas it halved to US$430 in Haiti (Jaramillo and Sancak (2007)). This divergence in economic performance has put the two countries at the opposite ends of the spectrum in Latin America and the Caribbean. Figure 1 Dominican Republic and Haiti: Real GDP Index, 1963–2007 ___ Dominican Republic ___ Haiti --- United States 0 100 200 300 400 500 600 700 800 900 1,000 1963 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003 2007 Source: World Bank. Editora Alfa & Omega, 1995. 8 In the last three years, the governments of the Dominican Republic and Haiti have taken several steps to strengthen their commercial ties and set up a bilateral commission on trade. Indeed, there appears to be greater recognition now on both sides of the benefits of regional economic integration. After defining the nature of an economic and monetary union (EMU), this section offers a brief overview of the potential benefits and costs that such a union could bring two countries that are geographically as close as the Dominican Republic and Haiti. The next section will examine the various economic criteria that have been proposed to assess whether these countries should form an EMU. 1. Nature of an Economic and Monetary Union An EMU between two countries can be defined as a single market with a common currency, managed by a single monetary authority. In turn, the adoption of a common currency is generally considered to be the final stage of a gradual process of economic integration, which typically involves the following stages: a ) the elaboration of a preferential trading area (PTA), which usually allows preferential access to select goods within the block via a reduction in tariffs, but not necessarily by abolishing them; b ) a free trade area (FTA), which involves removing tariffs and quantitative restrictions for trading of most goods amongst members themselves, if production structures are largely complementary; c ) a customs union , which involves the formation of a common trade area with a common external tariff policy (and possibly import quotas and a common competition policy); d ) a common market , which is formed with the objective of removing barriers for the free movement of capital, goods, services and labor, while retaining a common external trade policy. Once a single market has adopted a common currency, it is termed an EMU. 3 Put differently, an EMU differs from a mere currency union because it involves a single market. The adoption of a single currency requires free movement of capital across member states, and the creation of an independent and supranational central bank responsible for implementing a common monetary policy. An EMU also involves harmonizing taxation and 3 The final stage of economic integration, often referred to as “complete economic integration,” leads to a near complete harmonization of fiscal and monetary policies among members. It also amounts to a loss of political independence of member nations as they are unable to use the monetary and fiscal policies independently. 9 technical standards, with the objective of bringing in greater efficiency in resource allocation and enhancing competition. 2. Benefits and Costs of an Economic and Monetary Union The fundamental reason for creating an EMU is to bring in greater efficiency in resource allocation and enhanced competition. This is a particularly important consideration for the Dominican Republic and Haiti, given the small size of these economies taken individually. For instance, the formation of a PTA or an FTA could allow firms in the two countries to spread the costs of research and development over a larger market, thus reducing unit costs and encouraging greater innovation and technical progress. This could, in turn, generate positive spillovers as successful innovations are applied more broadly. Integration could boost productivity growth by allowing increased specialization, whereas increased competition could increase efficiency gains—possibly reinforced by foreign direct investment between the two countries. These benefits are further increased with a customs union and especially a common market (through the free movements of factors), although the use of a common external tariff policy may reduce scope for discretionary policy. At the same time, it is well recognized that PTAs and FTAs can entail some costs (see Bhagwati and Panagariya (1996)). In particular, they may lead to trade creation, by replacing relatively high-cost domestic production with lower-cost imports from partner countries. They may also lead to trade diversion, which occurs when imports are switched from efficient nonmember suppliers to less efficient member countries benefiting from tariff preferences. Higher trade volumes between member countries that result from the agreement may also lead to greater, not smaller, losses to an individual member A who joins the agreement from a higher initial set of tariffs, because joining the agreement at a common lower tariff leads to a redistribution of tariff revenues from A to other member countries with initially lower tariffs. Nevertheless, it has been recognized that PTAs and FTAs are worth pursuing for countries whose ultimate goal is complete dismantling of barriers to labor and capital mobility, and complete economic integration with the formation of an EMU. The benefits and costs associated with the final stage of an EMU, the creation of a currency union, has been the focus of much debate. As discussed in more detail in Appendix A, the traditional literature has focused on the reduction in transactions costs and reduced exchange rate uncertainty as the main benefits of a monetary union. Such a union entails a reduction of transaction costs, a reduction in uncertainty about financial variables and macroeconomic policy, and promotes integration of both financial and goods markets. At the same time, however, the formation of an EMU has important implications for national economic policies. It entails the loss of the exchange rate as an adjustment mechanism to combat any deterioration in competitiveness. Members are therefore deprived of one instrument to respond to shocks. At the same time, monetary policy autonomy is 10 “surrendered” to the common Central Bank. Fiscal management and the degree of labor mobility become therefore key factors in the response to adverse shocks. IV. CRITERIA FOR AN EMU: PRELIMINARY DATA ANALYSIS The conditions under which two countries should form an EMU and reap the associated efficiency gains have led over the years to a number of broad economic criteria. For the last stage of an EMU, in particular, these criteria relate to whether these countries can or should form a Common Currency Area (CCA) or a currency union. 4 These criteria include the volatility of bilateral exchange rates, the similarity of inflation rates, the degree of correlation between economic shocks across countries, the degree of price and wage flexibility, the degree of labor mobility, and the scope for discretionary fiscal policy. 5 In what follows we examine some of the these criteria especially the behavior of some of these variables in the context of the Dominican Republic and Haiti, especially inflation, business cycle synchronization, fiscal policy and public debt, exchange rates, and bilateral trade. Of course, the examination of historical data may provide a misleading indication of suitability of membership in a CCA, given that some of the criteria listed above are interrelated—or endogenous, as discussed later. Nevertheless, this discussion still provides valuable insights and will be complemented in the next section by a more formal analysis. 1. Volatility of Bilateral Exchange Rates It is now well recognized that exchange-rate volatility can be as harmful for intraregional trade (if not more) than tariff barriers. By blurring signals associated with relative price changes, exchange rate volatility (whether nominal or real) may hamper the ability of producers to reallocate resources production. Thus, the formation of a CCA can help to foster trade integration. 6 4 The criteria are generally grouped under the header “theory of optimum currency areas” (or OCAs). Essentially, the theory of OCAs—first presented by Mundell (1961), in the context of the debate between fixed and flexible exchange rates of the 1960s. Note that a currency area is typically defined as a group of countries that undertake to fix their exchange rates, at least within narrow bands. In contrast, a currency union is typically defined as an area where a single currency circulates. The bilateral exchange rates are fixed and cannot be changed without a country quitting the union and reintroducing its own currency. In practice, however, the difference between a currency union and a currency area is probably smaller than in principle, given that in both regimes capital mobility constrains monetary policy independence. 5 Ishiyama (1975) provides an early review of the literature. Subsequent discussions include Masson and Taylor (1992), Tavlas (1993), Mongelli (2002), and De Grauwe (2007). See Appendix A for a more detailed review of the costs and benefits of a monetary union. 6 As an example of this growing awareness, in January 2008 members of the East African Community (consisting of Kenya, Tanzania, Uganda, as well as Burundi and Rwanda since July 2007) announced their intention to bring forward, to 2012 from 2015, the formation of their planned monetary union, in an effort to 11 Figure 2 shows the evolution of the bilateral nominal exchange rate between the Dominican Republic and Haiti during the period January 1979-September 2007, using monthly data. It suggests that the exchange rate between the two countries has been quite volatile—especially after the countries switched to a flexible exchange rate (19- for the Dominican Republic and 19- for Haiti) and during periods of financial crisis. 7 Thus, the reduction in exchange rate volatility and transactions costs in foreign exchange that a CCA could bring would entail substantial benefits for the two countries. 2. Similarity of Inflation Rates The similarity of inflation rates (at levels consistent with overall macroeconomic stability) is one of the most common criteria used to evaluate the viability of a CCA. If inflation rates diverge too much between two potential members of a union, the ability to implement a common monetary policy (which follows from the adoption of a common currency and the shared goal of price stability) may be significantly hampered. bring about greater exchange rate stability among themselves and boost intraregional trade. 7 With higher frequency data (weekly or daily), the data would show even higher volatility during certain periods. 12 Figure 2 Dominican Republic and Haiti: Bilateral Exchange Rate, 1979–2007 (Dominican pesos per gourde) 0.00 0.50 1.00 1.50 2.00 2.50 1990M1 1991M5 1992M9 1994M1 1995M5 1996M9 1998M1 1999M5 2000M9 2002M1 2003M5 2004M9 2006M1 2007M5 2008M9 Source: International Monetary Fund. Figure 3 shows the behavior of annual inflation—measured in terms of the consumer price index—in the Dominican Republic and Haiti during the period 1963-2007, measured as deviations from US inflation. The figure shows that inflation has displayed significant spikes and considerable volatility at times in both countries—for the Dominican Republic for instance, most recently following the financial crisis and sharp exchange rate depreciation in 2003-04. The correlation between the two series is also quite high at times. These results suggest that although both countries could gain from a CCA in terms of price stability, their medium- and long-term performance in that regard does not appear to have been sufficiently effective and comparable to envisage a rapid transition toward such an arrangement. At the same time, however, it is important to note that convergence in inflation does not need to be complete (in the sense of very narrow differentials among members) before adopting a CCA; as discussed later, the very process of union formation may bring about greater similarity in inflation between member countries—in part through greater integration in goods markets. 13 Figure 3 Dominican Republic and Haiti: Consumer Price Inflation Deviations from US Inflation, 1964-2007 ___ Dominican Republic ___ Haiti -0.4 -0.2 0 0.2 0.4 0.6 0.8 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Source: World Bank. 3. Degree of Symmetry of Shocks As noted earlier, when a country joins a CCA or a currency union in the last stage of an EMU, the exchange rate becomes unavailable to act as a buffer when shocks hit the economy. A key issue is therefore the extent to which the exchange rate is, to begin with, a “shock absorber.” In general, the larger the degree of asymmetry of shocks across a potential currency union the greater the need to absorb shocks at the country level. Put differently, if the potential partners to a CCA have a common business cycle (in the sense that they tend to be affected by shocks in similar ways) rather than divergent business cycles, the costs of fixing the exchange rate across the union will be smaller. By contrast, if members of a currency union are often at different stages of the business cycle, then a common monetary 14 policy for the entire area would not be appropriate to all of them and could be very costly for some of them. 8 A reason why countries may face asymmetric (or idiosyncratic) shocks is that they have different commodity export baskets. The likelihood of asymmetric shocks tends to be smaller if a potential union partner is, to begin with, a key bilateral trading partner. This is because a boom in the union partner B will tend to increase demand for country A’s exports, while rising demand in country B will also tend to reduce their exports to country A. More generally, a high ratio of bilateral trade to total trade implies that the exchange rate is a relatively ineffective means of securing macroeconomic adjustment, so that foregoing its use (as required in a CCA) is relatively less costly. Put differently, if two countries trade a lot with each other, they are likely to benefit from low transaction costs and the elimination of exchange rate risk. Thus, the extent of bilateral trade is an important consideration in any assessment of the net benefits associated with a CCA. To examine the degree of symmetry of shocks between the Dominican Republic and Haiti, a preliminary approach is therefore to look at the correlations of output gaps in the two countries, the extent of bilateral trade between them, and the behavior of their terms of trade. Figure 4 shows the behavior of the output gap in the two countries during the period 1963- 2007. The output gap is measured by the logarithm of the ratio of real GDP and its trend value, measured itself by the modified Baxter-King filter (see Christiano and Fitzgerald (2003)). The figure does not suggest much correlation between the output gap in the two countries; the actual correlation coefficient is only 0.03. In fact, the correlation between output gaps in the Dominican Republic and the United States is in fact higher, reflecting a greater degree of synchronization between them. 8 The idea that different regions within a currency union will sometimes be subject to shocks that cause their business cycles to diverge is hard to dispute; the key issue, however, is how often divergences occur and how significant they are. This is an empirical issue, which is discussed further later, in the context of Latin America and the Caribbean. 15 Figure 4 Dominican Republic and Haiti: Output Gap, 1963–2007 ___ Dominican Republic ___ Haiti --- United States -0.1 -0.05 0 0.05 0.1 0.15 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Source: Author’s calculations based on World Bank data. See Appendix B for calculation method. The evolution of bilateral trade between the Dominican Republic and Haiti, using the IMF’s Directions of Trade statistics, suggests that measured trade between the two countries remains very low. There are a number of factors that may help to account for this. The first is that any assessment of the extent of trade between Haiti and DR faces a major problem—the coverage of the data. Frontiers between the two countries are highly permeable and informal trade is of great significance, being equivalent according to some estimates to as much as total recorded trade. Nevertheless, even allowing for such effects, the consensus remains that trade between the two countries accounts for only a small fraction of their total trade. One reason why this may be so is related to the non-complementary production structures of these economies, with exports consisting of goods and services (primary products, tourism in the case of the Dominican Republic) heavily in demand by the industrial countries, whereas imports consist mainly of raw materials and finished investment and consumer goods that are not produced domestically. Alternatively, the low level of trade may be explained by the relatively poor transportation and communications networks between the 16 two countries; these networks are mainly geared toward maintaining links with each country’s main partner, the United States, rather than between them. There are also historical reasons, as well as language and cultural barriers that may be relevant. However, while the level of trade between the two countries may be undoubtedly lower than one would expect based on their degree of proximity, from a normative standpoint it does not follow that it is somehow too low. Clearly, to make such a judgment requires an assessment of the optimal level of bilateral trade, based on the relevant structural and economic characteristics of the two countries. Although there are no formal studies focusing on this issue, standard trade models would suggest that in fact the level of trade between the Dominican Republic and Haiti is no lower than would be predicted given their structural characteristics. Indeed, it is probable that the low level of bilateral trade is well explained by the low trade potential of these countries, which in turn is a reflection of their very small economic size. 9 Figure 5 shows the behavior over the past four decades of the terms of trade for the two countries. Clearly, there does not appear to be any sizable degree of correlation between the behavior of these variables. This reflects to a large extent differences in the composition of exports of the two countries, rather than the structure of their imports. 9 It should also be kept in mind that the overall degree of openness (as measured by total trade ratios) also matters from the perspective of a CCA. The reason is that the more open an economy, the more devaluation becomes a source of imported inflation; this may reduce significantly the benefits associated with an adjustment via currency changes because domestic inflation will then mitigate the initial effect of a nominal depreciation on the real exchange rate. 17 Figure 5 Dominican Republic and Haiti: Terms of Trade Index (2000=100), 1963–2007 ___ Dominican Republic ___ Haiti --- United States 0 50 100 150 200 250 300 350 400 1963 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003 2007 0 200 400 600 800 1000 1200 1400 Source: IMF and World Bank. All three indicators suggest therefore that the Dominican Republic and Haiti are in general affected by asymmetric shocks. By itself, this would suggest that the formation of a CCA between these countries would not be advisable. However, before reaching this conclusion, there are two issues worth highlighting. First, in general two countries might exhibit low business cycle synchronicity not because using different currencies creates underlying structural asymmetries, but simply because the two monetary authorities are following different policies. Conversely, two countries might exhibit a relatively high level of synchronicity only because they are subject to common external shocks. What is needed therefore is to look at conditional business cycle correlations, instead of simple correlation coefficients; this is what is done in the next section. Second, the existence of asymmetric shocks (which are likely to remain, even in a well integrated union) is not sufficient to establish the case for retaining a separate currency. A CCA may still be viable in the presence of asymmetric shocks as long as there are alternative adjustment mechanisms available to deal with them. These mechanisms include most notably the degree of wage and price flexibility, the degree of labor mobility, and the scope for discretionary fiscal policy—as discussed next. 18 4. Degree of Price and Wage Flexibility Adjustment to asymmetric shocks requires in general an adjustment of the real exchange rate. If, as is the case in a currency union, the nominal exchange rate cannot adjust to cope with these shocks, a real exchange rate adjustment may come through movements in prices and wages. If wages are perfectly flexible, a reduction in nominal wages is essential similar to a nominal depreciation in its adjustment role. By contrast, when wages are rigid downward (as a result, for instance, of government interference through minimum wages, or the existence of trade unions), adjustment through wage reductions is much slower and more costly, to the extent that it may be accompanied by periods of high unemployment. Thus, a high degree of wage rigidity makes preserving nominal exchange rate flexibility and monetary independence more desirable. Price flexibility may also bring about an adjustment in the real exchange rate. However, in practice the degree of price flexibility is often limited. The slow response of prices to shocks may be caused by, for instance, price-setting behavior by firms and backward-looking expectations. More generally, it is often difficult in practice to judge whether a country has a sufficient degree of price and wage flexibility to facilitate smooth adjustment to idiosyncratic shocks. In the case of the Dominican Republic and Haiti, there are few studies documenting directly the degree of flexibility. In the case of the Dominican Republic for instance, estimation results by Hernández (2008) suggest that there is some significant degree of nominal inertia in price setting. At the same time however, both countries have a sizable informal sector; According to estimates by Gasparini and Tornarolli (2007, Table 3.2) for instance, informal employment as a share of total employment represented 51.3 in the Dominican Republic in 2004, 82.1 percent in Haiti in 2001. This suggests a high degree of nominal wage flexibility, at least for unskilled workers. 5. Degree of Labor Mobility When labor is mobile across union borders, asymmetric shocks to any individual member can in principle be absorbed through migration, without requiring relative price changes. Labor mobility may thus be particularly important in the presence of wage rigidities. For instance, if the real exchange rate does not adjust following a shift in relative demand across countries, unemployment may increase in the country where demand has been reduced; migration toward the other country where demand has increased may mitigate the problem. 10 10 In the United States, labor mobility has been identified as the key regional adjustment mechanism for adjusting to regional unemployment, although migration does not seem to occur only in response to wage differentials. In contrast, labor movements across Europe are very limited compared to those across United 19 In the case of the Dominican Republic and Haiti, there has always been quite a significant degree of labor mobility at the border—although mostly illegal. In addition, mobility has taken the form of mostly unskilled labor flows. However, beyond that mobility has been limited, to a large extent for cultural and historical reasons. There is also evidence that the formal labor market in these countries suffers from a number of imperfections and distortions—including labor regulations that raise the cost of hiring and firing workers (see Inter-American Development Bank (2003)). Thee are also challenges related to youth unemployment, the mismatch between the educational system and the needs of the labor market, the creation of jobs, low levels of productivity coupled with relatively high wages, and sustained emigration flows of skilled labor from the region. This “brain drain” has helped to strengthen the economic links between each country and the United States. In addition, language is likely to remain a persistent barrier between the two countries. Labor mobility is therefore unlikely to provide much scope for absorbing shocks, thereby making wage flexibility and fiscal policy all the more important. 6. Scope for Discretionary Fiscal Policy As noted earlier, countries participating in a CCA must give up the use of monetary policy and the exchange rate. But when a country is subjected to an asymmetric shock, automatic fiscal stabilizers “kick in” and may ease the burden. In addition, discretionary fiscal policy (involving borrowing or lending) within nations could be as effective as centralized institutions in cushioning external shocks. Figure 6 shows the evolution of the overall fiscal balance in the Dominican Republic and Haiti over the period 1960-2007. The figure suggests that neither one of these countries has managed to maintain surpluses for long; on the contrary, both countries have experienced persistent periods of high deficits, which have fueled the accumulation of public debt. This discrepancy between fiscal outcomes makes it difficult to envisage a CCA between the two countries; limits are typically built in CCAs on debt levels and deficits. For instance, the Maastricht Treaty criteria required a 3 percent maximum fiscal deficit and a ratio of public debt to GDP inferior to 60 percent. There are also divergent domestic medium-term considerations that may guide fiscal policy in both countries, such as the need to engage in fiscal consolidation in order to reduce constraints on the financing of private investment, or the need to satisfy qualitative criteria, such as improving tax collection (a key issue in both countries) and/or implementing a better arbitrage between current and investment expenditure. These considerations may severely reduce the scope for discretionary policy actions in response to shocks. States regions. 20 Figure 6 Dominican Republic and Haiti: Overall Fiscal Balance (percent of GDP), 1960-2007 ___ Dominican Republic ___ Haiti -12 -10 -8 -6 -4 -2 0 2 4 6 8 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Source: IMF. The foregoing discussion provides only mixed evidence (at best) in support of a CCA between the Dominican Republic and Haiti. However, it must be kept in mind, as noted earlier, that simple (unconditional) correlations can be misleading for assessing the degree of comovements between variables. In the short run, unconditional correlation coefficients can vary in response to a wide variety of macroeconomic factors. The analysis performed in the next section (which introduces a number of control variables in a multivariate framework) provides more accurate measures of business cycle synchronicity. More importantly, the criteria used may be endogenous , as a result of the very existence, and induced effects, of a CCA. For instance, it has been argued that similarity of inflation rates may be promoted by participating in a currency union. Hoffman and Remsperger (2005) for instance have found that, for the Euro area, the degree of persistence in inflation differentials fell significantly following the adoption of the common currency in 1999. Similarly, once two countries choose to form a CCA, their business cycle may become more synchronized, as the elimination of currency fluctuations may spur trade between them. There is also evidence suggesting that the 21 formation of a monetary union may foster macroeconomic integration. 11 We will return to this issue in the concluding section of the paper. V. DEGREE OF SYMMETRY OF SHOCKS: A VARX ANALYSIS The foregoing discussion has provided a conceptual and preliminary statistical analysis of the various criteria that may be relevant in considering whether the Dominican Republic and Haiti could form an EMU. We now turn to a more formal analysis, based on vector autoregression (VAR) models, with a focus on understanding how the two countries respond to external and domestic shocks. We begin with ha description of the VARX methodology. We then present and analyze two VARX models, which differ by their degree of complexity. 1. VAR and VARX Methodology In general, a standard linear VAR model can be written in the structural form 12 (1) where is a vector of n endogenous variables; is a vector of p exogenous variables (the first of which is a constant term); 11 See Fielding and Shields (2005) for the CFA franc Zone and Gil-Pareja, Llorca-Vivero, and Martínez- Serrano (2008) for the Euro Zone. 22 is a vector of n random shocks that are uncorrelated over time and mutually uncorrelated, with a (diagonal) variance matrix  . To simplify, we will assume that all variables in this system are stationary, and that the exogenous variables only enter contemporaneously (that is, they are dated at period t). The elements of matrix A, of order n×n (respectively C, of order n×p) are the structural parameters related to endogenous variables (respectively, exogenous) and B(L) is a matrix polynomial which depends on the lag operator L, defined so that L k z t = z t-k , that is where m+1 is the number of lags and the matrices B i are of order n×n. Matrix A captures instantaneous causality links (or, more generally, contemporaneous interactions) between endogenous variables. A reduced form of the above system is given by (2) where The matrices D, of order n×n, and E, of order n×p, are nonlinear functions of the structural parameters on the contemporaneous endogenous variables, A, and the contemporaneous response of endogenous variables to the exogenous variables, C. Let  denote the variance-covariance matrix of the reduced-form shocks  t ; exact identification of the parameters of the structural form equations from the estimated parameters of the reduced- 12 See for instance Lütkepohl (2006) for a detailed presentation of standard VAR models and their properties. 23 form equation requires that the number of “free” parameters in A and  be equal to the number of independent parameters in  . It can be shown that, if the diagonal elements of A are normalized to unity, n(n-1)/2 restrictions on the coefficients of A are needed to achieve exact identification (see for instance Lütkepohl (2006)). Consider for instance the case where n = 3, p = 2, and m = 0; the reduced-form VAR is therefore given by (3) If there are no restrictions on the coefficients d ij and e ij in matrices D and E, we must estimate 3 2 + 3×2 = 15 parameters. The problem this number rises rapidly with the number of variables and the number of lags, thereby leading quickly to problems of degrees o