A Monetary Union in East Asia is Advantageous
By: Ryan Pitylak
12/01/2005
University of Texas-Austin
Introduction
Regionalism encompasses different degrees of financial, trade, and political integration. According to Heribert Dieter (2000), the different levels of integration include: a free trade area, a customs union, a common market, an economic and monetary union, and a political union. An economic and monetary union uses a common currency and is also associated with an array of costs and benefits. East Asia is ready to being the transition process towards a monetary union. The protection against speculative attacks would be minimal, but the ability to avoid financial crises from temporary supply shocks will be an important advantage for the region.
Financial Integration: Monetary Union
Implementing a monetary union of this magnitude requires enormous political support. The political support is available because the East Asian Financial Crisis is fresh in policymakers’ minds. The high costs of completing this integration are prohibitive unless there are clear advantages to its accomplishment. One advantage is that member countries are part of an integrated region, which psychologically appears to be more stable by the people of both member and non-member countries. An additional benefit is that intra-regional trade will increase because transaction costs between member countries will be lower, and exchange rate fluctuations will no longer be an impediment to trade (Jong-Wha Lee, Yung Chul Park, and Kwanho Shin (2002)). Increased stability can have the benefit of helping to ward off potential speculative attacks. Furthermore, strong political support from policy makers of member countries can alleviate the concern that the monetary union is another fixed exchange rate regime, and mitigate the risk of speculative attack by aggressive agents in the international financial sector (IMF (1999)). The optimum currency areas theory explains that an additional benefit from the exchange rate stability is increased investment (IMF (1999)).
After the monetary union is established, speculative attacks should cease from people within the region based on the assumption that capital controls would also be phased out among member countries (Dieter (2000)). This is an additional benefit for each individual member country. Capital controls are broadly defined as any regulation that limits the cross-border flow of financial assets. The cost of losing the ability to implement capital controls is unclear, because moral hazard when capital controls are in place leads to increased currency crises and reduced banking crises (Charles Wyplosz (2001)). If capital controls are not increased for non-member countries, then financial linkages with should not be weakened (Lee, Park, and Shin (2002)).
One of the largest benefits of a monetary union is that it “reduces the cost of adjustment to shocks to demand and supply through facilitating migration of capital in the long-run and cross-border financing of current account imbalances in the short-run” (Lee, Park, and Shin (2002)). In the long-run, capital will be able to migrate freely across borders, assuming that capital controls are abolished, and this will allow industries to lower unemployment levels by utilizing unemployed capital. In the short-run, the main advantage of capital mobility is that temporary supply shocks, such as higher oil costs, are easier to finance. This helps by providing a sense of stability, because temporary supply shocks that cause current account deficits will not be seen as a cause for concern. (Lee, Park, and Shin (2002))
An individual country’s macroeconomic policy options are limited once a common currency is in place and independent monetary control is abolished (IMF (1999)). This limits the available steps a country can take to counter unexpected macroeconomic shocks. For example, when oil prices rise, a country cannot independently adjust its interest rates to minimize the effects of the supply shock. This loss of monetary control makes it difficult for a country to control its inflation (IMF (1999)). High inflation is curbed because money is no longer provided freely to the government. This can be implemented without a monetary union, but it is a necessary side-effect of a monetary union. In Europe, Germany was very important in deciding the monetary stance of the region, but the East Asian countries will have to cooperatively decide a monetary stance (IMF (1999)). The creditability of the region will increase when member countries work together to decide a monetary stance.
If the member countries of a monetary union are not be prepared for this level of integration, then the outcome of this union could be harmful to the region. It took 40 years of integration in the European Union before its member countries were ready for a common currency (Dieter (2000)). Lee, Park, and Shin (2002) have shown that the East Asian countries are ready to start the transition for several reasons. First, half of the fluctuations in an individual country’s output are based on regional factors, so East Asian countries are able to respond to quickly respond to shocks. This quickness is important because these economies would be able to transition away from independent monetary policy control. Second, the
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Figure 1
IMF (2005) |
terms of trade structure similarity was 0.64 in 2000, which was better than the European Union before it initiated the Euro. The common currency provides more benefit when the terms of trade structure are more similar because the countries’ business cycles can become synchronized. Figure 1 shows that increased trade will further unite the region. All of these factors provide |
evidence in support of a common currency for the East Asian region. (Lee, Park, and Shin (2002))
Even though a common currency should be beneficial if it is executed properly, several transitory steps must be accomplished first. Monetary and fiscal policies of the countries that are going to join the common currency need to be harmonized before creating a common currency (Dieter (2000)). The multi-polar nature of East Asia makes it similar to Europe, and therefore similar precursor criteria should be used (Kawai (2004)). These criteria are: existing public debt levels at or moving towards 60 per cent of GDP or less, an inflation rate that does not exceed 1.5 per cent above the inflation rate of the three countries that have the lowest levels of inflation, successful participation in the new monetary system created by the region, new public debt at 3 per cent of GDP or less, and long-term interest rates not to exceed 2 per cent above the highest interest rate of the lowest three countries (Dieter (2000)).
Financial Integration: The Chiang Mai Initiative
There exists a need for more financial integration than existed at the time of the East Asian Financial Crisis. At this time the counties did not have a liquidity fund that was able to keep protected from speculative attacks. Since then, The Chiang Mai Initiative created a liquidity fund that member
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countries are able to borrow from to fend off an attack. This is accomplished by providing counties that are in the midst of an attack with quick access to reserve currency (Dieter (2000) commenting on Frankfurter Allgemeine Zeitung (2000)). Figure 2 shows the current account surplus of China, India, Hong Kong SAR, Korea, Singapore, Taiwan Province of China, |
Figure 2
Source: IMF (2005) |
Indonesia, Malaysia, the Philippines, and Thailand. The liquidity fund should be effective because the amount of foreign reserves held exceeds that of any other region (Dieter (2000)). This fund is an important tool for fighting speculative attacks. One of the major benefits of this liquidity fund is that it releases the reliance on the IMF, which responded poorly in East Asian Financial Crisis (Masahiro Kawai (2004)). This fund is separate from any monetary union, but it illustrates why a monetary union alone is not sufficient in resolving all financial crises.
Conclusion
Even though the costs and benefits of a currency union are mixed, it appears that overall, the benefits supersede the costs. The psychological stability gained through this level of cooperation provides increased respect for the region. Increased trade and a unified central banking system will increase intra-region cooperation. The region is not ready for a monetary union now, but it should work towards this step. The main tool for avoiding speculative attacks comes from the liquidity fund. The additional benefit of a monetary union against these attacks appears to be minimal. The largest benefits of the monetary region will be that capital will be able to move freely, which will help to offset supply shocks. This will increase the regions ability to fight against financial crises that would have been caused by these shocks.
References
Dieter, Heribert (2000), Monetary Regionalism: Regional Integration without Financial Crises, Coventry, United-Kingdom: University of Warwick
IMF (1999), The Suitability of ASEAN for a Regional Currency Arrangement, Washington D.C.
IMF (2005), Asia-Pacific Regional Outlook—September 2005, Washington D.C.
Jeffrey Frankel and Andrew Rose (2002) “An Estimate of the Effect of Common Currencies on Trade and Income,” The Quarterly Journal of Economics, May 2002
Jong-Wha Lee, Yung Chul Park, and Kwanho Shin (2002), A Currency Union in East Asia, Seoul, South Korea: Korea University (unpublished)
Kawai, Masahiro (2004), Regional Economic Integration and Cooperation in East Asia, Tokyo, Japan: University of Tokyo
Kwanho Shin and Yunjong Wang (2004), Trade Integration and Business Cycle Synchronization in East Asia, Seoul, South Korea: Korea University
Rajan, Ramkishen S (2002), Exchange Rate Policy Options for Post-crisis Southeast Asia: Is There a Case for Currency Baskets?, Adelaide, Australia: University of Adelaide
Rana, Pradumna B. (2002), Monetary and Financial Cooperation in East Asia: The Chiang Mai Initiative and Beyond, Manila, Philippines: Asian Development Bank
Wyplosz, Charles (2001), A Monetary Union in Asia?: Some European Lessons, Geneva, Switzerland: Graduate Institute of International Studies