Economic Research Forum (ERF)

Euro-Med trade agreements, macroeconomic stability and income convergence

Economic relations between the European Union and their partner countries in the Southern Mediterranean are being reshaped by the New European Neighbourhood Policy and related trade negotiations. This column reports research on the likely impact of greater trade and financial integration on macroeconomic stability and income convergence between the two regions – and the implications for economic policy-makers in the MED countries.

In a nutshell

To achieve high economic growth, Southern Mediterranean countries should pursue policies that promote free trade and economic openness with the European Union.

For further trade and financial integration with Europe, individual countries need to devote more efforts to pursuing sound macroeconomic policies, coupled with institutional reforms aimed at developing the domestic financial sector.

The establishment of a Southern Mediterranean free trade zone will not only stimulate growth, but it will also enhance intra-regional trade, thereby reducing exposure to Europe’s business cycle.

Efforts to achieve greater economic and financial integration between the European Union (EU) and the Southern Mediterranean (MED) countries began with ‘cooperation agreements’, which granted total exemption from tariffs on industrial products. These efforts were subsequently enhanced by ‘association agreements’ launched under the Barcelona Declaration of 1995, which resulted in MED countries reducing or even eliminating tariffs on European industrial imports.

At the same time, MED countries have opened up considerably to other countries, either under the framework of the EU-Mediterranean trade agreements, or in the context of widespread reduction in tariffs through the signing of World Trade Organization agreements.

In early 2000, the Barcelona Process was replaced by the European Neighbourhood Policy, which then was revised in 2015 and became the New European Neighbourhood Policy. It is under this framework that economic relations between the EU and their Mediterranean partner countries are now being reshaped.

The New European Neighbourhood Policy provides a robust platform of assistance for deeper financial integration, greater access to the single European market and better institutionalisation of trade and financial relationships. The EU is also proposing a ‘deep and comprehensive free trade area’ that will address agriculture, services and non-tariff measures. Negotiations are underway with Morocco and Tunisia.

Within the context of this New European Neighbourhood Policy and the role of the EU in facilitating the modernisation, transition and international openness of the Mediterranean countries, our research assesses the degree of income convergence between the two groups of countries (EU and MED) resulting from the trade agreements. We also explore the effects on macroeconomic volatility in a selection of MED countries, as well as the winners and losers from the trade agreements.

In the first stage of our analysis, we use two concepts of convergence (Michelis and Neaime, 2004) to evaluate empirically the degree to which incomes have converged among a group of EU-MED countries over the period from 1980 to 2015. We then examine the implications of the Euro-MED partnership agreements for economic growth and macroeconomic volatility in a sample of MED countries.

We find evidence of real per capita GDP convergence over the whole period. For the period 1980-2000, there is evidence of weak conditional income convergence in the group of EU-MED (16) countries, and this evidence becomes much weaker for the MED countries between 2000 and 2015. The reason for these results lies in the negative effects of the European financial and debt crises on the Euro-MED region in general, and on the MED region in particular (Neaime, 2015a, 2015b; Mora et al, 2013).

Macroeconomic stability and economic openness turn out to be important factors and have the expected positive effect on economic growth in the MED countries. Indeed, the variable that is consistently the most significant is economic openness.

Of the other explanatory variables, population growth has the expected negative effect on economic growth, as found in previous studies of growth. Government spending also has a negative effect on growth.

The main policy implications that emerge from our empirical results are that if the MED countries wish to achieve high economic growth, they should pursue policies that further promote free trade and economic openness with the EU, as well as providing an anchor of macroeconomic stability by means of policies that keep fiscal and monetary policies under control.

Political and social unrest, as well as financial and debt crises (see Neaime, 2010, 2012 and 2016; and Guyot et al, 2014), have a negative effect on growth and convergence in the region. If possible, they should be dealt with by appropriate political and macroeconomic policy action.

Other empirical results point to the fact that MED countries may be less susceptible to EU financial shocks if the domestic MED market is larger and/or more regulated. Some MED countries have chosen to impose capital controls to deal with financial crises since it appears that the ‘culprit’ is international capital flows, but this policy practice may have undesirable long-term economic consequences.

Moreover, MED countries should improve their macroeconomic and financial policy coordination to cope effectively with the impact of greater trade and financial integration with the EU (Neaime and Gaysset, 2017; Neaime, 2008). This may be achieved, for example, through enhancing regional economic and financial integration.

The establishment of a MED free trade zone will not only stimulate growth, but it will also enhance intra-MED trade, thereby reducing exposure of these small open economies to macroeconomic developments in the EU (Mansoorian and Neaime, 2003; Neaime, 2000).

Research shows that large economies can better absorb and neutralise the effects of external shocks. Controlling for the effects of shocks, however, is particularly difficult in the case of the developing MED economies, which are smaller in size and dependent on exports to the EU of very few commodities and on the import of a huge number of commodities.

A direct consequence of an integrated capital market within the MED region will be to reduce the risks associated with greater EU-MED integration, and to dampen the vulnerability of MED countries, especially those with high levels of debt – such as Egypt, Jordan and Lebanon – to the effects of fluctuations in EU’s interest rates.

A larger MED financial market would lower the cost of raising capital, allowing MED governments to service their huge debt at lower costs on the one hand, and MED firms to rely more on the local market rather than tapping EU markets to raise capital on the other. Lower costs of raising capital will subsequently translate into more investment, consumption and GDP growth rates in the region.

The MED region should accelerate the process of trade, financial and economic integration with the EU in order to absorb the negative effects of external political, financial and/or economic shocks more effectively. Efforts should also be made to speed up the implementation of fiscal and monetary reforms so as to improve the inflow of portfolio and foreign direct investment into the region.

In short, for further trade and financial integration with the EU, individual MED countries need to devote more efforts to pursuing sound macroeconomic policies. This should be coupled with institutional reforms aimed at developing the financial sector.

Subsequently, MED countries should try to integrate horizontally while at the same time opening up further vertically (to the EU). Financial openness – as measured by gross capital flows relative to GDP – is associated with an increase in consumption volatility, contrary to the notions of improved international risk-sharing opportunities through financial integration. The inherently unstable macroeconomic environment, political and military turmoil, as well as unsound monetary and fiscal policies in the MED region may explain this empirical irregularity.

Another policy recommendation from our research is that MED countries need to be more, not less, integrated with EU’s financial markets to be able to reap the benefits of financial integration in terms of improved risk-sharing and consumption-smoothing opportunities. But this conclusion will require further analysis, as regional financial integration is associated with a variety of risks in the EU-MED region.

To minimise these risks, MED countries would need to implement sound macroeconomic and structural frameworks in tandem with further integration. For example, our findings emphasise the role of sound fiscal and monetary policies in averting excessive macroeconomic volatility. With regard to structural reforms, the development of the domestic financial sector is critical, as a high degree of financial sector development is associated with lower macroeconomic volatility.

The main source of this analysis is a FEMISE research project: ‘Income Convergence and the Impact of the Euro-MED Trade and Financial Integration on Macroeconomic Volatility’, with Thomas Lagoarde-Segot and Isabelle Gaysset.

Further reading

Guyot, Alexis, Thomas Lagoarde-Segot and Simon Neaime (2014) ‘Foreign Shocks and International Cost of Equity Destabilization: Evidence from the MENA region’, Emerging Markets Review 18: 101-22.

Mansoorian, Arman, and Simon Neaime (2003) ‘Durable Goods, Habits, Time Preference, and Exchange Rates’, North American Journal of Economics and Finance 14(1): 115-30.

Michelis, Leo, and Simon Neaime (2004) ‘Income Convergence in the Asia-Pacific Region’, Journal of Economic Integration 19(3): 470-98.

Mora, Nada, Simon Neaime and Sebouh Aintablian (2013) ‘Foreign Currency Borrowing by Small Firms in Emerging Markets: When Domestic Banks Intermediate Dollars’, Journal of Banking and Finance 37(3): 1093-1107.

Neaime, Simon (2000) The Macroeconomics of Exchange Rate Policies, Tariff Protection and the Current Account: A Dynamic Framework, AFP Press.

Neaime, Simon (2008) ‘Twin Deficits in Lebanon: A Time Series Analysis’, Lecture and Working Paper Series No. 2, Institute of Financial Economics, American University of Beirut.

Neaime, Simon (2010) ‘Sustainability of MENA Public Debt and the Macroeconomic Implications of the US Financial Crisis’, Middle East Development Journal 2: 177-201.

Neaime, Simon (2012) ‘The Global Financial Crisis, Financial Linkages and Correlations in Returns and Volatilities in Emerging MENA Stock Markets’, Emerging Markets Review 13(2): 268-82.

Neaime, Simon (2015a) ‘Sustainability of Budget Deficits and Public Debts in Selected European Union Countries’, Journal of Economic Asymmetries 12: 1-21.

Neaime, Simon (2015b) ‘Twin Deficits and the Sustainability of Public Debt and Exchange Rate Policies in Lebanon’, Research in International Business and Finance 33: 127-43.

Neaime, Simon (2016) ‘Financial Crises and Contagion Vulnerability of MENA Stock Markets’, Emerging Markets Review 27: 14-35.

Neaime, Simon, and Isabelle Gaysset (2017) ‘Sustainability of Macroeconomic Policies in Selected MENA Countries: Post Financial and Debt Crises’, Research in International Business and Finance 40: 129-40.

Neaime Simon, and Isabelle Gaysset (2018) ‘Financial Inclusion and Stability in MENA: Evidence from Poverty and Inequality’, Finance Research Letters 24: 230-37.

Neaime, Simon, Isabelle Gaysset and Nasser Badra (2018) ‘The Eurozone Debt Crisis: A Structural VAR Approach’, Research in International Business and Finance 43: 22-33.

 

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