Integration, Interdependence, and Regional Goods: An Application to Mercosur

By the early 1990s, the world economy was becoming increasingly regionalized as a result of the formation of the North American Free Trade Agreement (NAFTA) in 1993 and the European Economic Area in 1992. This trend coincided with the growing globalization of the world economy and the push toward liberalized trade across the Americas. Despite previous unsuccessful integration attempts, the countries of Argentina, Brazil, Paraguay, and Uruguay signed the Treaty of Asunción in 1991, formally launching the Southern Cone Common Market (Mercosur). The foremost objective of the treaty was to guarantee access to each other's markets and improve bargaining power vis-à-vis NAFTA and the European Union in order to facilitate integration into the world economy.

The formation of Mercosur resulted in an important decrease in tariff and nontariff barriers in the region. From 1990 to 1996, average tariff rates fell from 22 to 13 percent in Argentina, from 32 to 9 percent in Brazil, from 16 to 9 percent in Paraguay, and from 28 to 10 percent in Uruguay.¹ This tariff reduction resulted in an unprecedented expansion of trade in the Mercosur region. Total trade by Mercosur countries grew from U.S.$75 billion in 1990 to almost U.S.$187 billion in 1997, or an average rate of increase of about 14 percent a year. During the same period, intra-Mercosur trade increased even more dramatically, from U.S.$8 billion in 1990 to U.S.$82 billion in 1997, resulting in an increase in the share of intra Mercosur trade in total trade from 11 to 22 percent during the period. In this regard, the Mercosur strategy appears to have been successful.

The mere increase in trade flows, however, does not guarantee improvements in welfare. It is well known at least since Viner that the formation of a customs union can lead to a decrease in welfare if the trade diversion outweighs the trade creation effect.² Work in this area suggests that the creation of Mercosur has not led to a decrease in welfare.³ Even so, this does not mean that Mercosur is the best possible outcome. Nin and Terra employ a computable general equilibrium model to analyze the effects of alternative trade liberalization experiments: unilateral uniform trade reduction, preferential trade reduction (while keeping the common external tariff constant), and a combination of both (which is what actually happened in Mercosur).⁴ They find that while all policies lead to an increase in intraregional trade and welfare, unilateral trade reduction is the best policy for Argentina.

In this paper we argue that to evaluate the benefits of commercial integration, one needs to go beyond the static framework implicit in the trade creation versus trade diversion analysis. Two key facts must be taken into account. First, Brazil represents 70 percent of the region's gross domestic product (GDP), making it the dominant partner in the agreement. Second, trade in the remaining three Mercosur economies is largely concentrated with Brazil: 31 percent of Argentina's exports of goods, 34 percent of Uruguay's, and 38 percent of Paraguay's go to Brazil. Consequently, policymakers have expressed concern regarding the vulnerability of Argentina, Paraguay, and Uruguay (henceforth, referred to as the smaller economies) to devaluations in Brazil. These concerns have become so widespread that the Argentine media regularly refer to the dangers of what they call Brazil-dependence. In Uruguay the same phenomenon is called Merco-dependence, highlighting the fact that it is not only the direct effects of Brazil that matter for Uruguay, but also the indirect effects through the Argentine economy.

Does the fact that a substantial share of Argentina's, Paraguay's, and Uruguay's trade is concentrated with Brazil necessarily mean that these countries are severely exposed to sharp and discontinuous changes in Brazil's real exchange rate? The short answer is not necessarily. Suppose Argentina exports oil to Brazil (which it does in substantial amounts, since 42 percent of Argentina's oil exports go to Brazil). What would happen if Brazilian demand for Argentine oil...