Is an Optimum Currency Area Feasible in East and South East Asia?

Abstract

In the backdrop of the recent economic crisis in the European Union, this study attempts to assess the degree of regional integration and the suitability of a monetary union in the East and South-East Asian (ESEA) region. For this purpose, we analyse the issue in a variety of ways. First, a long-run linkage of real output of the countries is tested using the cointegration analysis. Results suggest that real output of most of the countries in the region is cointegrated and move together in the long-run. To analyse the issue in detail, we focus on the impact of three different shocks, namely global, regional and country-specific, on real output of the countries. Results of impulse response and variance decomposition analysis reveal that regional shocks do not dominate in the sample countries, which is an indication of unfavourable condition to form an optimal currency area (OCA) in the region. These results are further confirmed by the outcome of computation of the modified Bayoumi and Eichengreen's Indices. Finally, we employ the concept of Generalized Purchasing Power Parity (G-PPP), which however reveals that the bilateral real exchange rate of ESEA countries move together in the long-run and share a common stochastic trend, which in turn provides some empirical support for an OCA in the region.

Keywords:

• OCA
• output shocks
• G-PPP
• East and South-East Asian
• monetary union

Keywords:

• F36
• F42
• F33
• C32

Acknowledgements

We thank two anonymous referees of this journal for their useful comments and helpful suggestions on the previous version of this article. Any errors or omission are solely ours.

Notes

1. OCA and monetary union is used interchangeably in this study.

2. It is also argued that with greater regional monetary and exchange rate stability, the region may become more attractive for foreign investment (Benassy-Quere, 1999). However, the formation of OCA would lead to the loss of monetary autonomy. This will restrict countries to follow export-led catch-up strategy, which worked effectively before the 1990s (see Fabella, 2000). Another problem is the great diversity (in terms of culture and religion, etc.) among countries in the region which could potentially create some serious problems in the formation of the OCA (see Kawai & Takagi, 2000). The historical facts also suggest that the pattern of use of stabilization policies in the region varies significantly.

3. See, for example, Park and Park (1990), Frankel (1991, 1993), Bayoumi and Eichengreen (1994), Taguchi (1994), Kwan (1998), Chow and Kim (2003) and Shirono (2007), just to name a few in the long list of recent studies.

4. In the last decade ASEAN countries have increased their trade and financial relationship with China, Japan, and India. Many agreements have been signed between these economies in direction of free trade zone and monetary cooperation, for instance, ASEAN-China free trade zone, Tokyo Declaration, ASEAN-India Trade in Goods Agreement (TIG) and other AIFTA-related Agreements.

5. Further, in a relatively narrow sense some other important conditions for the formation of an OCA are (1) a large market size, (2) high degree of openness in trade, (3) high degree of intra-regional economic interdependence, (4) symmetry between shocks across countries, and (5) less dependence on exchange rate as an instrument for correcting macro-economic imbalances (Kwan, 1998). Further, some authors have also argued for a supra-national government body able to conduct interregional transfers (see De Grauwe, 1997).

6. Although the idea is theoretically appealing, empirical literature on trade and international finance has not reached a consensus as to whether a large degree of trade relationship between countries will result in correlated business cycles (see Hallett & Richter, 2006). In this regard, evidence presented by Kose et al. (2003) reveals that international trade relationship does not necessarily lead to the synchronization of business cycles.

7. To conserve space, we do not report results of unit root test here but would be made available upon request.

8. It is noteworthy that Bayoumi and Eichengreen (1993, 1997) have consider four factors – the SD of relative output growths, the dissimilarity of the composition of exports, the extent of bilateral trade, and the average size of the economy for constructing the index of exchange rate variation. We have broadly followed Kim and Chow (2003) and have taken the variation of exchange rates.