FRBSF Economic Letter
2005-19; August 12, 2005
Does Europe's Path to Monetary Union Provide Lessons
for East Asia?
Pacific Basin Notes. This series appears on an occasional basis.
It is prepared under the auspices of the Center
for Pacific Basin Studies within the FRBSF's Economic Research Department.
In 1999, eleven European countries
adopted the euro as their common currency (Greece followed
in 2001). This followed
a long period of gradually tying their national currencies
together more tightly by limiting exchange rate fluctuations
among member countries, culminating in the European Monetary
Union (EMU). The experience of Europe has raised the question
as to whether countries in other regions of the world can
and should follow a similar path towards adopting a common
currency.
East Asia, with some of the most dynamically growing
economies in the world, has long been considered a possible
candidate
for a regional monetary union. This Economic Letter addresses
three questions that help frame the issue. First, is
it desirable for East Asia to adopt a common currency like
the euro? Second, does Europe's experience provide any
lessons for East Asia about how to attain a common currency?
Third, how does the economic integration path that East
Asia is now following differ from the path Europe followed?
Is
a common currency desirable for East Asia?
Joining a monetary
union can benefit a country's economy in a number of
ways. First, it eliminates exchange
rate risk with other monetary union members, which
facilitates trade among them. Second, it makes price differences
in member countries more transparent and, therefore,
sharpens
competition. Third, it may increase policy discipline;
specifically, an individual country's central bank
may
become more credible in its commitment to price stability
by delegating authority for monetary policy to a
regional
central bank. Related to this third benefit, however,
is the principal cost of joining a monetary union—by
delegating
authority for monetary policy to a regional central
bank, an individual country's central bank loses independent
monetary policy control and, therefore, the ability
to
stabilize the economy when it is hit by a shock.
The
benefits of joining a monetary union may outweigh the
cost, depending on how great the cost is. Specifically,
according to the so-called optimum currency theory,
the cost, or the need for independent monetary
policy
control,
is greater when member countries are exposed to
different shocks and lesser when they are exposed to the
same
or similar shocks. One factor that reduces the
likelihood of different shocks is high trade integration
among
member
countries. Other considerations, such as high labor
mobility and a system of intraregional fiscal transfers,
also
lessen
the cost.
 Does East Asia satisfy the criteria for
a lesser cost to joining a monetary union? Much research
has explored
this
question, and the empirical evidence suggests
that this region does, more or less. For example, as
Figure 1 shows,
East Asian countries do trade a lot with each
other. (Note: this figure is adapted from Kawai and Motonishi
2004.)
By themselves, countries within the Association
of Southeast Asia Nations (ASEAN), which includes
Indonesia,
Malaysia,
Philippines, Thailand, and several other smaller
countries, do not trade much with each other;
likewise,
by themselves,
the countries within the Newly Industrialized
Economies (NIE) grouping—Korea, Hong Kong, Taiwan, and
Singapore—do
not trade much with each other. But taking these
emerging countries of East Asia together with
China, about 40%
of trade was intraregional in 2003, up from 20%
in 1980. When
Japan is included, more than 50% of trade is
intraregional, up from about 35% in 1980. This is comparable
to
the more than 60% intraregional trade within
the European
Union
(EU).
More supporting evidence for the plausibility
of an East Asian currency area comes from looking
at the
correlation
of demand and supply shocks. Kwack (2004) and
Zhang
et al. (2004) recently applied the Blanchard-Quah
methodology to identify demand and supply shocks
from movements
in
prices and output. They find evidence of high
correlations of demand and supply shocks, although
the correlations
for Japan and China, the two largest countries
in the region, are somewhat lower. Still, in
general, the
correlations are not much different from those
across
Europe in the
early 1990s (see Bayoumi and Eichengreen 1994).
(It should also be noted that these correlations
are
partly endogenous;
that is, the adoption of a monetary union of
itself can lead to more trade integration which,
in turn,
raises
the
cross-correlations.)
Does Europe's experience
provide any lessons about how to get a common currency?
Though East Asia has moved toward satisfying the optimal
currency area criteria, the region
remains
very different
from Europe in ways that make it difficult,
if not impossible, to follow the European
path. Four differences
stand out.
First, East Asian economies have
much less in common than European nations generally
do in
terms of
income levels,
stages of development, and economic structure.
The implication is that achieving any
monetary arrangement,
including
a common currency, is much more difficult
in East Asia.
Second, East Asia is less
economically self-contained than Europe. To be sure,
as economies in
East Asia have developed,
intraregional trade has grown—from
about 20%-30% of total exports in the 1980s
to about 40%-50%
in 2002.
But about
half of the intraregional trade is
trade in raw materials and intermediate components
that
ultimately
are exported
outside of the region. For example,
they trade chips and hard disks, but they
sell the assembled
computers
in the
U.S. and Europe. So, indirectly and
directly, East Asian countries still depend much
more heavily on exports to
countries outside the region. Thus,
East Asia must
be more concerned than Europe about
exchange rate stability against
currencies outside the region as well
as within the region.
Third, the two
regions differ in terms of interest in political integration.
In Europe,
a monetary
union was
achievable
primarily because it was part of
the larger process of political integration.
Most
European countries
share a history of intellectual belief
in the benefits of
integration
and political democracy. The experiences
of World War I
and II generated a desire to forge
deeper political, as well as economic,
links
in order to prevent
a recurrence of country conflicts.
These political desires were
indispensable for the success of
the EMU in particular and the EU more
generally. There is no apparent desire
for political integration
in East Asia, partly because of the
great differences among those countries
in
terms of political
systems, culture,
and shared history. As a result of
their own particular histories, East
Asian
countries remain particularly
jealous of their sovereignty.
The
fourth difference is that, in contrast
to Europe, East Asian governments
appear
much more
suspicious
of strong
supranational institutions. Early
on, European countries were willing
to
contemplate compromises
of national
sovereignty to achieve the goal
of greater integration. The European
Coal and Steel Community was established
way back in 1952 and was given
significant power
to close
down
segments of national steel industries.
Later came the European
Commission,
the European Parliament (which
has very considerable power to shape
competition policies, social
policies, and so
on, for EU member states). All
these institutions preceded establishment
of
the European
Central Bank; they were
indispensable to providing the
popular support for delegating monetary
decisions to a common central bank.
In contrast, in East Asia, sovereignty
concerns
have left
governments reluctant
to delegate significant authority
to supranational bodies, at least
so far.
What path is East Asia following
towards greater economic integration?
It
is not at all clear that East Asia is on a path to a
common currency. But it
is very
clear
that
it is following
a different path from Europe's.
First,
in contrast to Europe, East Asia has not pursued formal
trade
liberalization as
its first
priority
in integrating the region's
economies. Europe pursued
formal trade liberalization,
first through a customs union
and free trade
area, well before it focused
on monetary cooperation.
In East Asia,
formal trade liberalization
has been
slower to materialize. Negotiated
trade agreements
generally
involve only
the smaller countries or
bilateral agreements
between
a large
country and a small country;
no broad free trade agreements
have been achieved among
the largest
countries in the region,
Japan, Korea, Taiwan, and
China.
A second key difference
is the timing of liberalizing
capital
accounts.
Most European
countries did
not fully liberalize
capital flows until the
late 1980s or very early 1990s,
after their
domestic financial
markets
were well developed
and the integration process
was well along. In contrast,
many
countries in
East Asia
(China is a notable exception),
liberalized their capital
accounts before their financial
markets
were
well developed.
This
has
heightened
the region's vulnerability
to destabilizing capital
movements, which,
if not the cause of the
East Asia
financial crisis, were
at least factors that
made it worse. Clearly,
capital
mobility makes it difficult
to
sustain either a single
currency peg or a common basket currency
peg,
which some have advocated
as a useful stepping
stone to
an East Asian
monetary union.
Third, East
Asia does not appear
to have an obvious
candidate
for an internal
anchor currency
for
a cooperative exchange
rate arrangement. Most
successful new currencies
have been
started on the
back
of an existing
currency, establishing
confidence in its convertibility,
thus linking the old
with the new. In the
approach towards
adoption of the
euro,
European exchange rates
were tied to an internal
anchor,
the deutsche
mark.
But
the choice
of an internal
currency
anchor is not so clear
in East Asia. The yen
was an
obvious
candidate, but Japan's
economic
problems
over
the past
decade and wide swings
in the yen-dollar exchange
rate
have
lessened its
appeal.
As for China,
its currency
is not convertible for
capital account transactions
and
its financial system
is not well
developed. Moreover,
East Asia's heavy dependence
on exports outside
the region
implies that an external
currency anchor now has
more merits
than an internal anchor.
Conclusion
Asia's history and current circumstances—the
differences among its countries, its dependence on extra-regional
trade, its political diversity, its lack of strong
collective institutions, and its capital mobility—imply
that exchange
rate stabilization and monetary integration are unlikely
in the near term. Nevertheless, East Asia is integrating
through trade, even without an emphasis on formal trade
liberalization agreements. Moreover, there is evidence
of growing financial cooperation in the region, including
the development of regional arrangements for providing
liquidity during crises through bilateral foreign exchange
swaps, regional economic surveillance discussions,
and the development of regional bond markets. These kinds
of cooperation do not yet require the same compromises
of sovereignty that seem to preclude adopting a common
East Asian exchange rate policy.
Finally, it must be
acknowledged that the European Monetary Union and the
adoption of the euro was a project
that was
fifty years in the making. In time, East Asia might
also proceed along the same path, first with loose agreements
to stabilize currencies, followed later by tighter
agreements,
and culminating ultimately in adoption of a common
anchor—and, after that, maybe an East Asia dollar.
Reuven
Glick
Group Vice President, International Research
References
Bayoumi, Tamim, and Barry Eichengreen.
1994. "One
Money or Many? Analyzing the Prospects of Monetary Unification
in Various Parts of the World." Princeton Studies
in International Finance No. 76.
Kawai, Masahiro, and
Taizo Motonishi. 2004. "Is East
Asia an Optimum Currency Area?" Paper delivered
at the conference on Financial Interdependence and
Exchange Rate Regimes in East Asia sponsored by the
Japan Ministry
of Finance Policy Research Institute, December 2-3,
2004.
Kwack,
Sung Yeung. 2004. "An Optimum Currency Area
in East Asia: Feasibility, Coordination, and Leadership." Journal
of Asian Economics 15(1) (February) pp. 153-169.
Zhang,
Zhaoyong, Kiyotaka Sato, and Michael McAleer. 2004. "Is
a Monetary Union Feasible for East Asia?" Applied
Economics 36(10) (June) pp. 1031-1043.
Opinions expressed in this newsletter
do not necessarily reflect the views of the management
of the Federal Reserve Bank of San Francisco or of the
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