Competitive Devaluations in Commodity-Based Economies: Colombia and the Pacific Alliance Group

This paper investigates whether there is an S-Curve in Colombia using bilateral and disaggregated quarterly data for the period 1991-2014. More precisely, the short-run effects of a depreciation on the TB are analysed in 27 industries covered by the PAG Free Trade Agreement. The S-Curve found in sectors representing 30% of total industrial production suggests that in these cases competitive devaluations have a positive effect on the TB in the short run. However, the regression analysis using both OLS and FE methods shows that sizable ones are needed to produce the desired effects on trade flows. Our findings have important policy implications: since only large competitive devaluations can restore TB equilibrium, industrial restructuring would appear to be a more sensible strategy, though this cannot be achieved in the short run and is instead a medium/long-term goal.


Introduction
The recent sharp decline in oil prices has led to a significant deterioration of the trade balance (TB) in Colombia. Policy makers have responded by devaluing the currency and signing up to the Pacific Alliance Group (PAG) Free Trade Agreement (FTA). The aim of this study is to evaluate the effects on trade flows of this type of competitive devaluation in a commodity-based economy such as Colombia. According to the price elasticity approach a devaluation should increase exports by making them cheaper in terms of the foreign currency and decrease imports by making them more expensive in terms of the domestic currency. However, the empirical evidence is rather mixed. Magee (1973) reported considerable time lags. These could be even more significant in the case of a country such as Colombia, which is highly dependent on oil exports, that represent almost 80% of total exports. Figures 1 and 2 show that the Colombian TB is positively/negatively correlated to the oil price index/nominal exchange rate. It can be seen that during periods with higher oil prices (the first decade of this century) the TB is in surplus, and the nominal exchange rate appreciates.

. Colombia's Trade Balance vis-à-vis Its Main Trading Partners
Source: DANE (www.dane.gov.co) Figure 3 shows the Colombian TB vis-à-vis its PGA trade partners during the period 1995-2015. While it remained in surplus in all cases but vis-à-vis Mexico, overall there was a negative trend, with increasing deficits with respect to the US, China and other advanced economies.
The present study makes a twofold contribution. First, it analyses the short-run effects of a devaluation of the peso on Colombia's TB vis-à-vis its PAG trade partners, for which no previous evidence is available, during the period 1991-2014. Second, by using bilateral data disaggregated by commodity, it sheds light on the role played by different industrial sectors, an issue that has also been relatively neglected in the literature (Bahmani-Oskooee and Ratha, 2007c;Bahmani-Oskooee and Ratha, 2008). For this purpose, it follows the S-curve approach of Backus et al. (1994), which is based on the shape of the cross-correlation function. In addition, both OLS and fixed effects (FE) models are estimated. As emphasised by Magee (1973), Meade (1988), and Backus et al. (1994), price and trade dynamics are also determined by orders and time to delivery of imported goods, and the time required for exporters to change capacity.
The remainder of the paper is organised as follow: Section 2 briefly reviews the literature. Section 3 outlines the methodology. Section 4 describes the data and presents the empirical results. Section 5 offers some concluding remarks.

Literature Review
The literature on the TB effects of currency depreciations (appreciations) is extensive.
In addition, there exists an extensive literature on the effects of regional integration on trade flows. Most studies are based on Viner's (1950) framework and analyse the dynamic effects of geographical size, industry location, and economies of scale (see, e.g., Caporale et al., 2009). As Frankel and Wei (1998) pointed out, geographical proximity or distance is a key factor for Free Trade Agreements (FTAs) given the importance of transport costs (Helpman and Krugman, 1985).

Empirical Methodology
This study examines the short-run effects of devaluations on the Colombian TB as in Backus et al. (1994), namely using the cross-correlation function between the TB and the real bilateral exchange rate (RBER) of Colombia vis-à-vis each of its PAG partners (Chile, Ecuador, Mexico, and Peru). Backus et al. (1994) show that the cross-correlation coefficients between the current exchange rate and future (past) values of TB are positive (negative): if a real depreciation improves the TB, then the correlation coefficient must be positive.
The cross-correlation function is the following   Table 1 shows the industrial sectors examined by SITC code. It should be noted that these data do not allow to capture the effects on trade of any tariff and/or tax reductions resulting from Colombia signing up to the PGA FTA.

Regression Analysis
The S-curve analysis has shown that there is such a pattern in 30% of the industrial sectors. Next, in order to quantify the effects of a devaluation on the TB of the three sectors with the biggest deficits, we estimate both a baseline OLS regression and a fixed effects (FE) model for each of them. As shown by Egger (2002), the advantage of the latter is that it allows for unobserved factors affecting bilateral trade flows and also takes into account country-specific heterogeneity.  The bilateral real exchange rate (RBER) between Colombia and its PGA trading partners was also obtained from DANE 2 and is defined as the product of the nominal exchange rate and the relative price level, i.e.
where the price level in the home and foreign country is equal to and respectively, and is the nominal exchange rate between the currencies of the foreign country and the home country, expressed as the number of foreign currency units per unit of home currency, so that an increase in represents an appreciation of the domestic currency. The estimated panel model is the following: ( where is the annual TB measured in US dollars for sector i at time t ; is the corresponding annual real bilateral exchange rate expressed in log form, and is the gross domestic product, also in logarithmic form, which is included in order to control for endogeneity; is country i's fixed effects, and is an idiosyncratic error.
We expect a positive coefficient on and a negative one on i.e.
( )  since a RBER appreciation (depreciation) is expected to deteriorate (improve) the TB.
Tables 2, 3, and 4 show the estimation results. 34 The coefficients have the expected sign in all cases. From

Manufactures of Computer, Electronic and Optical Products
Country fixed effects have been included in all specifications. The dependent variable is RBER. ***Significant at 1% level; **Significant at 5% level; *significant at 10% level.
Finally, Table 4   Year FE YES Country fixed effects have been included in all specifications. The dependent variable is RBER. ***Significant at 1% level; **Significant at 5% level; *significant at 10% level.

Conclusions
This paper investigates whether there is an S-Curve in Colombia using bilateral and disaggregated quarterly data for the period 1991-2014. More precisely, the short-run effects of a depreciation on the TB are analysed in 27 industries covered by the PAG Free Trade Agreement. The sharp drop in 2014 in the price of oil, Colombia's main export, led to a significant deterioration of the TB. Competitive devaluations followed in an attempt to restore equilibrium. The S-Curve analysis suggests that indeed these had a positive effect on the TB in the short run in sectors representing 30% of total industrial production. However, the regression results obtained using both OLS and FE methods show that sizable ones are needed to produce the desired effects on trade flows.
Our findings have important policy implications: since only large competitive devaluations restore TB equilibrium, it would appear that a more sensible strategy would be to pursue industrial restructuring, though this cannot be achieved in the short run and is instead a medium/long-term goal.