The aim of this paper is to analyse the existence of price convergence in Mercosur. Two variables are considered, Consumer Price Indices to assess convergence in the goods and services markets and real interest rates, to analyse convergence in the money markets. The univariate analysis points only to convergence in real interest rates, whilst the multivariate analysis provides evidence of common trends in both markets.Mercosur, economic integration, unit roots, nonlinearities, co-trending.

Javier Ordóñez

Juan Carlos Cuestas

English

Research Papers in Economics

   
 
 
 
 
DISCUSSION PAPERS  
IN 
APPLIED ECONOMICS AND POLICY 
 
 
 
 
No. 2007/1    ISSN 1478-9396 
 
TESTING FOR PRICE CONVERGENCE AMONG 
MERCOSUR COUNTRIES 
 
Juan Carlos CUESTAS and Javier ORDOÑEZ 
 
May 2007 
    
 
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 Testing for price convergence among Mercosur
countries
Juan Carlos Cuestas¤ Javier Ordóñez
Nottingham Trent University Jaume I University
15th May 2007
Abstract
The aim of this paper is to analyse the existence of price con-
vergence in Mercosur. Two variables are considered, Consumer Price
Indices to assess convergence in the goods and services markets and
real interest rates, to analyse convergence in the money markets. The
univariate analysis points only to convergence in real interest rates,
whilst the multivariate analysis provides evidence of common trends
in both markets.
J.E.L. Classiﬁcation : C32, F15.
Key words: Mercosur, economic integration, unit roots, nonlin-
earities, co-trending.
¤Corresponding author: Nottingham Business School, Nottingham Trent Univer-
sity, Economics Department, Burton Street, NG1 4BU, Nottingham, UK. e-mail:
juan.cuestas@ntu.ac.uk. The authors gratefully acknowledge the ﬁnancial support from
the CICYT and FEDER project SEJ2005-01163, the Bancaja project P1.1B2005-03 and
the Generalitat Valenciana Complementary Action ACOMP06/047. The authors are mem-
bers of the INTECO research group. The usual disclaimer applies.
11 Introduction
Mercosur (Mercado Común del Sur in Spanish) was created in 1991 with
the signing of the Asunción Treaty, aiming to boost freedom of movement of
goods, labour and currency. The countries that signed this agreement were
Argentine, Brazil, Uruguay and Paraguay. Since then, most of the Latin
American countries have become associate members (e.g. Chile and Bolivia)
or even full members, e.g. Venezuela in 2006.
After the creation of Mercosur, the question of whether the creation of
a monetary union would be appropriate has aroused a debate among both
economists and politicians alike, although there seems to be general agree-
ment to the contrary, based especially on the Optimal Currency Areas theory
(see Levy-Yeyati and Sturznegger, 2000, among others).
Notwithstanding it is worth analysing the degree of economic integration
within the area. There are several ways to measure the degree of economic
integration between countries. For instance, Purchasing Power Parity (PPP
hereafter) can be understood as a measure of economic integration (Frenkel,
1981; Choudhury, McNown and Wallace, 1991; Wei and Parsley, 1995, and
Laureti, 2001). Furthermore, under freedom of movements of currency be-
tween two countries, real interest rates should converge.
In this paper, we aim to analyse prices in a common currency and real
2interest rates convergence in the Mercosur countries, i.e. Argentine, Brazil,
Chile1, Paraguay and Uruguay, following the Bernard and Durlauf (1995)
deﬁnition of convergence and common trends.
2 Econometric Methodology
In deﬁning convergence (both in goods and money markets) we follow Bernard
and Durlauf (1995) deﬁnition of convergence. These authors establish that a
set of countries i = 1;:::n converge if the long-term forecasts of the variable
of interest yt are equal at a ﬁxed time t:
lim
k)1
E(y1;t+k ¡ yi;t+kjIt) = 0: (2.1)
In words, convergence implies that the countries have identical long-run
trends, either stochastic or deterministic.
Rejection of convergence as deﬁned in (2.1) does not necessarily imply
that individual prices are explained exclusively by country-speciﬁc factors.
Prices might still respond to the same common trends but with proportional
rather than identical stochastic components. This gives to the following
deﬁnition of common trends: if the long-term forecasts of the variable of
1Although Chile is only an associate member of Mercosur we have included it in the
sample due to her high degree of economic interaction with the remaining countries of the
South Cone.
3interest yt are proportional at a ﬁxed time for two countries, i and j, say,
then they share a common trend:
lim
k)1
E(y1;t+k ¡ ®yi;t+kjIt) = 0: (2.2)
These deﬁnitions for convergence and common trends can be empirically
tested using cointegration techniques (see Bernard and Durlauf, 1995). Thus,
according to deﬁnition (2.1), for the individual price series to converge there
must be one common (stochastic or deterministic) long-run trend, that is,
n ¡ 1 cointegrating vectors, where n is the number of variables. If there are
fewer than n¡1 cointegrating vectors, there is evidence of common stochastic
elements in the long-run behaviour of prices across countries, though not full
convergence. Finally, absence of cointegration would lead to individual prices
being explained exclusively by idiosyncratic factors.
Cointegration (and therefore convergence) in a pair of variables can be
tested using unit root test (Camarero, Flôres and Tamarit, 2006): if the
price diﬀerential between two countries i and j is stationary, convergence
is accepted across both countries. A proper test for convergence requires,
however, the use of multivariate techniques to test for either convergence or
a common trend. Accordingly, in this paper we apply two groups of tech-
niques. Firstly, we apply Ng and Perron (2001) and Kapetanios, Shin and
4Snell (2003) (KSS hereafter) unit root tests. Ng and Perron (2001) propose
modiﬁcations of several (linear) unit root tests in order to improve their per-
formance, i.e. power and size. Kapetanios et al. (2003) develop a unit root
test in order to take into account nonlinear adjustment of variables towards
equilibrium. The reason for applying the latter is that linear unit root tests
might suﬀer from lack of power in the presence of nonlinearities in the dy-
namics of the variables (Kapetanios et al., 2003) and, hence, they might not
be able to distinguish between unit root and nonlinear stationary process.
Thus, this test analyses nonstationarity under the null hypothesis against
nonlinear but globally stationary exponential smooth transition autoregres-
sive (ESTAR hereafter) processes under the alternative, i.e.
¢yt = °yt¡1f1 ¡ exp(¡µy
2
t¡1)g + ²t (2.3)
where ²t » iid(0;¾2). The test consists of analysing H0 : µ = 0 versus
the alternative H1 : µ > 0. Nevertheless, in practice, this test cannot be
performed directly, since ° is not identiﬁed under the null. Kapetanios et
al. (2003) propose the following Taylor approximation to the ESTAR model
under the null,
¢yt = ±y
3
t¡1 + !t (2.4)
5where !t is a stochastic error term. Therefore, it is possible to test the null
of nonstationarity H0 : ± = 0 against nonlinear stationary ESTAR process,
H1 : ± > 0.
Secondly, in order to analyse whether there is a unique common trend
among all the countries, we apply Bierens (2000) nonlinear co-trending non-
parametric test. Bierens (2000) shows that this test does not distinguish
between nonlinear co-trending from cointegration. That means that if the
variables are I(1) processes rather than stationary, the test becomes a coin-
tegration test. The advantage of Bierens’ approach is that, since it is a
nonparametric test, nonlinear trends and any serial correlation process do
not have to be speciﬁed.
3 Empirical Results
In order to test price convergence (in goods and money markets) in Mercosur
we consider two types of variables; prices in common currency (US dollar),
pt say, and real interest rates, rt say, in order to test convergence in prices in
the markets of goods and services and convergence in the price of money in
Argentine, Brazil, Chile, Paraguay and Uruguay.
Data have been obtained from the International Financial Statistics CD-
Rom, from the IMF. Consumer Price Indices have been transformed to a
6common currency, pt, using nominal exchange rates versus the US dollar. The
frequency of the data is monthly and spans from 1980:1 to 2006:4. The real
interest rate, rt, has been computed as nominal interest rate minus inﬂation.
The nominal interest rates considered for the analysis are the following; for
Argentine, Brazil and Paraguay, Money Market Rate; for Chile and Uruguay,
Deposit Rate and Discount Rate respectively. We have also used monthly
data and spans from 1990:10 to 2006:4.
In Tables 1 and 2 we display the results for the Ng and Perron (2001)
and KSS unit root tests2 for the price diﬀerential, dpt, and real interest rate
diﬀerential, drt, versus the benchmark country, Argentine. The results show
that for the price diﬀerentials there is poor evidence of convergence, since
we are only able to reject the unit root hypothesis with the KSS test for the
case of Brazil. The opposite results are found for the interest rate diﬀerential.
We reject the null hypothesis of unit root with the KSS test in all cases and
also with the Ng and Perron’s test in Brazil and Uruguay. Therefore, taking
into account the possibility of nonlinear adjustment of the real interest rate
diﬀerential, we ﬁnd evidence of convergence in real interest rates.
We next present the results of the multivariate analysis, i.e. Bierens’
(2000) co-trending analysis. Previously, applying Bierens (1997) unit root
2Note that only an intercept has been included as deterministic component in the
auxiliary regressions of the tests, since the introduction of a time trend and the rejection
of the null in this case will not imply convergence, i.e. the series must be stationary, not
only in variance but also in mean.
7test, the order of integration of the variables has been tested, since, in order
to perform this analysis, all the variables have to be integrated of the same
order. The results3, indicate that all the variables in levels are unit root
processes. In this case, the nonparametric co-trending analysis becomes a
nonparametric cointegration test (Bierens, 2000). The null hypothesis of
this test is that there are r cointegrating vectors versus the alternative of
r ¡ 1. The results are displayed in Table 3 and point to the existence of
four cointegrating vectors (r = 4) and one common stochastic trend for both
variables, hence, the existence of a unique common trend implies a certain
degree of convergence in prices and real interest rates in Mercosur.
This conclusion highlights the fact that the elimination of trade barriers
and the opening of the capital account have boosted price convergence in the
South Cone.
4 Conclusions
In this paper, we have analysed whether there exists price convergence (in
goods and money markets) among Mercosur countries, applying nonlinear
unit root tests and co-trending analysis. The results support the hypothesis
of price convergence, not only in the markets of goods but also in the money
3Available on request to the authors.
8markets for this group of countries.
References
Bernard, A. B. and S. N. Durlauf (1995): “Convergence in international
output”, Journal of Applied Econometrics, vol. 10, pp. 97–108.
Bierens, H. J. (1997): “Testing the unit root with drift hypothesis against
nonlinear trend stationarity, with an application to the U.S. price level and
interest rate”, Journal of Econometrics, vol. 81, pp. 29–64.
Bierens, H. J. (2000): “Nonparametric nonlinear co-trending analysis, with
an application to inﬂation and interest in the U.S.”, Journal of Business
and Economic Statistics, vol. 18, pp. 323–337.
Camarero, M., R. G. Flôres and C. R. Tamarit (2006): “Monetary union and
productivity diﬀerences in Mercosur countries”, Journal of Policy Model-
ing, vol. 28, pp. 53–66.
Chowdhury, T., R. McNown and M. Wallace (1991): “Purchasing power
parity and the Canadian ﬂoat in the 1950s”, Review of International Eco-
nomics, vol. 34, pp. 20–43.
Frenkel, J. A. (1981): “The collapse of purchasing power parity during the
1970’s”, European Economic Review, vol. 16, pp. 145–165.
9Kapetanios, G., Y. Shin and A. Snell (2003): “Testing for a unit root in the
nonlinear STAR framework”, Journal of Econometrics, vol. 112, pp. 359–
379.
Laureti, L. (2001): “Purchasing power parity and integration: Empirical evi-
dence in the Mediterranean Countries”, Journal of Policy Modeling, vol. 23,
pp. 731–751.
Levy-Yeyati, E. and F. Sturzenegger (2000): “Is EMU a blueprint for Mer-
cosur?”, The Latin American Journal of Economics, vol. 110, pp. 63–99.
Ng, S. and P. Perron (2001): “Lag selection and the construction of unit root
tests with good size and power”, Econometrica, vol. 69, pp. 1519–1554.
Wei, S.-J. and D. C. Parsley (1995): “Purchasing power disparity during
the ﬂoat rate period: Exchange rate volatility, trade barriers and other
culprits”, Working Paper 5032, NBER.
10Table 1: Ng and Perron (2001) unit root tests results
Country Variable MZGLS
® MZGLS
t MSBGLS MP GLS
T
Brazil dpt 1.48 1.16 0.78 50.07
drt -22.31 -3.33 0.14 1.11
Chile dpt 1.95 2.00 1.02 86.93
drt 0.01 0.01 1.09 65.73
Paraguay dpt -1.37 -0.57 0.41 12.14
drt 0.15 0.19 1.25 87.68
Uruguay dpt -1.37 -0.57 0.41 12.14
drt -9.60 -2.11 0.22 2.85
Note: The order of lag to compute the test has been chosen using the modiﬁed AIC
(MAIC) suggested by Ng and Perron (2001). Rejection of the null hypothesis is given in
bold. The critical values for the above tests have been taken from Ng and Perron (2001):
Model with constant
MZGLS
® MZGLS
t MSBGLS MPGLS
T
1% - 13.80 -2.58 0.17 1.78
5% -8.10 -1.98 0.23 3.17
10% -5.70 -1.62 0.27 4.45
Table 2: KSS nonlinear unit root test results
Country Variable lags KSS statistic
Brazil dpt 11 -2.97
drt 3 -10.09
Chile dpt 0 -1.15
drt 2 -5.12
Paraguay dpt 0 -1.15
drt 2 -4.78
Uruguay dpt 0 -1.18
drt 5 -4.43
Note: The test has been computed including only a constant as deterministic component.
The order of lag for the auxiliary regression has been selected by the AIC. Critical values
at the 10%, 5% and 1% are -2.62, -2.92 and -3.50, respectively and have been computed by
Monte Carlo simulation with 5,000 replications. Rejection of the null hypothesis is given
in bold face.
11Table 3: Bierens (2000) nonlinear co-trending analysis
Variable r Test statistic Critical Value 10% Critical Value 5%
pt 1 0.043 0.351 0.465
2 0.073 0.535 0.674
3 0.176 0.703 0.860
4 0.407 0.861 1.034
5 1.677 1.014 1.219
rt 1 0.043 0.351 0.465
2 0.075 0.535 0.674
3 0.133 0.703 0.860
4 0.327 0.861 1.034
5 1.801 1.014 1.219
Note: The null hypothesis is the existence of r co-trending vectors against the alternative
that there are r ¡ 1 co-trending vectors. Acceptation of the null in bold.
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Purchasing power parity and the Canadian ﬂoat in the 1950s”,

Tamarit (2006): “Monetary union and productivity diﬀerences in Mercosur countries”,

Testing for a unit root in the nonlinear STAR framework”,

Testing the unit root with drift hypothesis against nonlinear trend stationarity, with an application to the U.S. price level and interest rate”,

The collapse of purchasing power parity during the 1970’s”,

Testing for convergence among Mercosur countries

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Testing for convergence among Mercosur countries

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