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What’s News
Maryam Ishaq* and Muhammad Atiq Ur Rehman
Surmounting the Individual: Establishing a Common Currency in Asia – A Case Study of East Asian Economies
Abstract: In the Ministerial meeting of ASEAN held in 1998, the devastation caused
by Asian financial crisis remained the point of contemplation. The participants
enthusiastically discussed the need to establish common currency and exchange
rate system in order to counter any financial crisis anticipated. The ever-growingfinancial crisis threatening every region in the world has compelled the economists
to acknowledge the elevating need of financial cooperation in their respective
territories. This is certainly meant to ensure economic stability at both economic
and political level. The authors, in the course of this paper, have focused the need
to materialize the ideal of promoting monetary integration in the major economies
of South, South East, and North East Asia. Calculating Optimum Currency Area
(OCA) Index, the authors in a way present costs and benefits associated with the
adoption of this currency union. Demand and supply sides of each economy aretested as a pre requisite of OCA in order to provide a good rationale in favor of
selection of regions. For this purpose, Structural VAR Analysis (SVAR) method was
employed and innovation accounting is done through variance decomposition of
forecast errors, impulse response function and correlation matrix. The theory of
OCA has been tested by (i) calculating the OCA index estimated by simple OLS
method and (ii) following Bayoumi and Eichengreen extrapolating the variability
of exchange rate data. The common consensus drawn from the two approaches
adopted implies that there is a good potential in the region excluding China to
construct a currency union particularly amongst South and North East Asianeconomies. It is worth mentioning, however, that some of these will have to
work harder to join and become an effective member of this currency merger.
Keywords: intraregional trade, macroeconomic shocks, variance decomposition,
impulse response function, optimum currency area
*Corresponding author: Maryam Ishaq, Hajvery University, Lahore 54660, Pakistan,
E-mail: [email protected]
Muhammad Atiq Ur Rehman, Punjab University, Lahore 54890, Pakistan,
E-mail: [email protected]
doi 10.1515/gej-2012-0018 Global Economy Journal 2013; 13(1): 63–88
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1 Introduction
Asian financial crisis was such a shock for the South Asian countries which
certainly compelled them to adopt a cautious attitude towards both short andlong term exchange rate volatility. At this point, the names of those five coun-
tries are worth mentioning which confronted a sharp devaluation in their
nominal and real exchange rate immediately after this crisis. These names
include Thailand, Malaysia, Indonesia, and Philippines from South East Asia
and Korea from North East Asia. This was an intensely horrifying experience for
all of them since it made these to revise their strategy regarding exchange rate
regime, capital convertibility, directive of financial institutions and macroeco-
nomic policy options.
All these issues are far greater than that of economic integration. In this
connection, one can easily trace out the deep and direct relationship existing
between exchange rate market movements and Regional Trade Agreements
(RTAs). The idea of monetary union strikes one’s mind which can be of good
and help in confronting the macroeconomic problems, reserving the transaction
costs and minimizing the exchange risks associated with RTA member econo-
mies. Besides, if one closely looks at the most obvious rationale of Optimal
Currency Area (OCA), one realizes that abrupt response extended by national
economies towards the foreign ones in terms of macroeconomic shocks thatacted as the strongest explanation for a monetary integration.
Defining monetary union or common currency, it can be taken as a common
legal tender to be used in multiple countries. This legal tender can either be the
currency of any of union member countries or the one which has achieved a
certain level of permanence and acceptance at global level. In a way, the
establishment of monetary union can be taken as the establishment of a pact
among a group of countries according to which all the participants submit to a
single currency and a common Central Bank. The bank must be autonomous
enough to issue currency and frame monetary policy for all the member econo-
mies. Such monetary unions are found rare. European Monetary Union (EMU),
the monetary union between Switzerland and Lichtenstein, CFA Franc Zone and
Eastern Caribbean Currency Union (ECCU) which comprises of two groups: West
African’ Economic and Monetary Union and Central African Economic and
Monetary Union.
At present, a number of economic policy makers from South East Asia have
emphasized the profitability of monetary integration for the region. These
include Kurdo (2004) and Chino (2004) remarkably. Both are of the view that on account of invariably and elevating economic interdependence of
major East Asian economies, intraregional exchange rate stability has become
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indispensable. This ideal can be materialized only through the adoption of
shared currency only.
2 Key channels of economic integration in
East Asia
The economic linkages between East Asian Economies are growing stronger with
every passing day. Through the market-driven channels of cross border trade,
Foreign Direct Investment (FDI) and finance, we are indebted to multilateral and
unilateral trade liberalization by the virtue of which, there has been a rapid
growth in FDI activities and exchange of goods and services during last 20 years.
Owing to the removal of various cross border trade barriers and geographical
closeness, there occurred spontaneous economic linkages among East Asian
countries.
2.1 Integration through trade and FDI
The expansion of intraregional trade has been remarkable for last three decades.East Asia’s share in intraregional trade grown from 37% in 1980 to reach 54% in
2007.This clearly indicates the reduced dependence of region on United States
and European markets for its final goods. The dependence is expected to
decrease even more in the years to come. The basic motivation for this economic
integration channelized through trade and FDI is those intraregional business
activities of multinational manufacturing companies which initially came from
United States, Japan, and Europe. This initiative promoted such an encouraging
business environment in the region that following these countries many East
Asian countries also came into the field. All over the East Asia, these multi-
national companies developed such closely organized production networks and
supply chains which are linked up with international goods market in a very
broad manner. Here the role of China is worth mentioning who is one of the
leading market recipients of FDI inflows in the region. Today China is playing a
highly effective role in developing regional production networks. Besides, the
country is continuously striving to prove itself as a responsible and reliable
platform for regional and global manufacturers. China is importing capital
equipments, industrial material and intermediate inputs from its neighbor coun-tries and in return exports finished manufactured goods. Hence, China on one
side is establishing complementary linkages with its East Asian trading partners
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and on the other hand is promoting very healthy competition in the region
through the aggressive exchange of goods and services. Thus, it may be con-
fidently claimed that the exchange rate movement of Yuan against other East
Asian currencies is of growing importance in the context of regional and globaltrade and FDI activities.
2.2 Financial integration and capital mobility
Like goods markets, East Asian financial markets are also getting integrated with
each other at a very fast pace. Basic reasons include deregulation of domestic
financial institutions, opening up of financial services and continuous relaxation
of capital and exchange controls. Besides, establishment of various commercialand investment banks into East Asia by developed countries and portfolio
investments made by institutional investors are some of the other major reasons
for integrating domestic financial markets of the region. Here the role of com-
mercial banks is of vital importance as they are increasingly aggressively
extending their banking services to neighbor countries. As a result, world
witnessed an unusually growing cross-country correlations of regional interest
rates and stock market returns.
From a closed analysis of data, it is evident that during the Asian financialcrisis of 1997–1998 cross-market differentials in the interest rates and bond yield
in the region grew very rapidly but started dropping during 1999. However, the
integration through regional financial systems and capital mobility is less pro-
minent as compared to that by which came through trade and FDI. According to
a report published by IMF on the region, for the entire decade of 2000, the
volumes of cross border equity investment flows grew very speedily in the region
but the volumes of intraregional portfolio investment flows are still quite low
and are approximated around 8% only. On the other hand, the counter parts like
European Union and North American Free Trade Agreement are standing at 62%
and 16%, respectively. For these limited levels of intraregional investments, one
of the probable reasons can be besides Japan, Korea and Hong Kong there are
still some of the East Asian countries who are affectively practicing capital and
exchange controls and other kinds of financial restriction in their economies.
The practice is proving to be one of the biggest obstacles in the way of free
movement of financial capital. Particularly, China from North East Asia and
some of the low-income AEAN economies are still insistent to employ heavy
financial controls and regulations. Besides, relatively weak and instable finan-cial market structures of many of the East Asian countries can also be one of the
core causes which keep the local investors away from thinking on the idea of
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investing their assets within the region. Rather, they are found more inclined
towards directing their international portfolios towards European and North
American financial markets.
2.3 Labor market integration
In East Asia, labor market linkages are relatively less evident, even lesser that
through trade, FDI, and financial markets. Here the names of Japan and Korea
from North East Asia are noteworthy who are imposing tight restrictions on labor
market integration as compared to rest of the countries of this region. However,
in South East Asia labor mobility is considerably liberal specifically in Malaysia,
Thailand and Singapore. Bayoumi and Eichengreen (1988) and Hamad and Gota(2000) found that during the 1980s and 1990s, the intraregional labor mobility in
South East Asia was much free than that in Europe. Such a moderate policy may
indicate towards the unusually pleasant and unique nature of macroeconomic
environment of the region that is high capability of making good adjustments
towards and economic shock. As a result, it can be anticipated that possibly the
region would not have to pay much huge cost for its initiative towards perma-
nently fixing the exchange rate and foregoing monetary policy autonomy by
each country.
3 Review of the literature
In 1961, Robert Mundell was the first one to present the theory of OCA. In actual,
it was his attempt to examine how the economies engaged in cross border trade
may be benefited from the establishment of a monetary union amongst them.
Nevertheless, the establishment of a single currency area is the other name of
exterminating the option of combating asymmetric shocks with the help of
exchange rate and monetary policies. The countries will, however, remain in a
position to take help from structural policies, so that they may cope their short
term and long term macroeconomic disturbances.
On presenting all the things in a very ideal setting, Mundell claimed that the
economies joining a monetary union will be benefited by two types of compe-
titive efficiencies: (a) labor mobility (b) wage flexibility. These efficiencies pro-
vide participant countries with an opportunity to re-equilibrate about
automatically to counterbalance the effects of asymmetric shocks.For instance, the growth in exports of Country A will boost up its aggregate
demand but at the cost of exports of Country B. This will make the aggregate
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demand curves of both the countries to shift in the opposite directions. However,
equilibrium can be restored if the labor of depressed economy brings down their
wage rates. This will make the aggregate supply curve to shift downwards;
hence, equilibrium employment level of the economy will be reinstated onceagain. Besides, the resultant fall in price levels will make the exports of Country
B more competitive in comparison to Country A, thus, pushing the aggregate
demand curve of Country A to shift downwards. In this way, the actual equili-
brium position will be restored. Besides, due to perfect labor mobility, the
unemployed man-power of Country B would get an opportunity to find employ-
ment in Country A. This will once again help both the countries to re-equilibrate
their current accounts. The current account surplus which was created in boom-
ing country as its citizen were more in a position to save, will be counter-
balanced by the inflow of migrants from Country B. On the contrary, for the
country with relatively smaller export base, the reduction in spending levels will
be not as much as fall in exports. Reason is, due to social security benefits
extended to unemployed will help to maintain almost similar levels of consump-
tion as before, thus, making the country to face current account deficits in
long run.
As it is quite obvious that the above stated conditions may be imagined for
developing countries but for developed economies these are least probable.
Hence, it may be concluded that the establishment of a monetary union willnot be of much worth for the region where member states are faced with
asymmetric macroeconomic shocks.
In contrast, European Commission is of the view that single currency area
may serve as a high way to contest the future macroeconomic shocks. On
constitution of a common currency and monetary union, with lowered trade
barriers and sequential stepping towards a single market would indeed take the
members countries to increased convergence in terms of economic activity, thus,
paving the path for combating anticipated future shocks.
Researching the same arguments, Kenen (1969) proposed that the lessened
significance of national borders in a free trade area has an obvious implication
that symmetric shocks must be felt in same industry of each member country. As
they would be selling their product in a single market, so it distinctively a
common issue which has always been presented in the form of multiple con-
cerns. So this must be deal with an only toll, that is, formation of a monetary
union.
By presenting an opposing view, Krugman (1993) said that monetary union
can hardly work for eliminating the asymmetric nature of systematic shocks. Thebasic reason behind this is the consolidation of various industries which will
emerge as a consequence of faster economic linkages between member
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countries. In order to get benefited from economies of scale, countries will opt
for the practice of geographically concentrated sectors. This means that country
hitting up of a demand shocks to a specific sector of some specific country; this
would indeed be an absolutely disproportionate attitude towards that country where she will be the only sufferer amongst all the union member states.
3.1 Are macroeconomic disturbances symmetrical in East Asia
In the context of evaluation of OCA, the work done by Bayoumi and Eichengreen
(1992, 1994) is commendable. By using aggregate demand aggregate supply
(AD-AS) model they developed Structural VAR (SVAR) model for the sake of
identification of demand and supply shocks. Following Blanchard and Quah
(1989) they regarded supply shocks of greater importance as compared to
demand shocks. In their view, the supply side of the economy is less affected
by the stabilization policies. Secondly, supply side is more likely to be invariant
with respect to various international monetary regimes. Hence, in order to
inspect the economic organization of any region, supply shocks are more con-
sistent measure as compared to demand shocks. Keeping this in view, Bayoumi
and Eichengreen found that if the region is experiencing systematic supply shocks, then the region would be a plausible nominee for OCA.
Zhang et al. (2004) empirically attempted to evaluate the aptness of East
Asian economies for a probable monetary integration using various macroeco-
nomic data. Using a model consisting of demand shocks (represented by domes-
tic output), monetary shocks (represented by real effective exchange rate) and
supply shocks (represented by domestic price levels), Structural VAR (SVAR)
model was applied in order to make out the underlying shocks in each economy.
The authors came up with quite a strange finding that as a whole East Asian
region is not a good nominee for monetary integration. Although some small sub
regions may be potential candidates for sharing a single currency as their
macroeconomic disturbances, they are somewhat correlated with mild severity.
Due to these reasons, these groups of countries are displaying a good tendency
to adjust rapidly to macroeconomic shocks, showing their hidden propensity to
establish a single currency.
On criticizing Bayoumi and Eichengreen, Chow and Kim (2003) commented
that the most difficult thing proposed in their model is the non-specification of
the nature of supply shocks; whether they global, regional or domestic. As dueto the hasty adoption of export-oriented growth policies by East Asian countries,
the intraregional trade in the region has progressed promptly. So the
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fluctuations occurring in the domestic output in the region may be transmitted
through the business cycles taking place in the economies of trading partners.
So, Chow and Kim applied three-variable model in their study. By employing the
series of global, regional, and domestic outputs, the authors tried to highlightthe possible channel from which the economy is being shaken. The study
presented that the East Asian economies are strongly stroked by country specific
shocks during the period 1970–1999. However, here, the point raised by Frankle
and Rose (1998) is noteworthy that as the intraregional trade gets deeper, it is
more likely that the countries will suffer from the shocks of similar nature. So,
most probably, the countries of the region would be hit by common systematic
shocks, as with the every passing day from 1980s, the intraregional trade and
economic linkages are growing amongst member states.
Kawai and Motonishi (2004) observed East Asian macroeconomic variables,
so they may assess the degree of macroeconomic interdependence in the region.
They checked for the cross-country correlation against the various financial and
price variables for various economies. Employing a sample period of 1980–2002
they experimented on ASEAN+3. Besides, they included Australia, India, New
Zealand, United States, and European Union in their study. Their results suggest
that in comparison to other region the cross-country correlation among macro-
economic variables is considerably significant excluding China and low income
ASEAN states. Afterwards, the authors tested the magnitude of convergence of macroeconomic variables for East Asian vis-à-vis non East Asian economies with
the help of Principal Component Analysis. Both the cross-country correlations
and convergence results proved that there exist strong real and financial macro-
economic linkages amongst East Asian economies except some of the countries
mentioned above. In the last, the study attempted to highlight those underlying
shocks which are significant in impacting macroeconomic environment of the
region. Employing Structural VAR (SVAR) model the results positively speak in
favor of existence of strong correlation amongst supply shocks which explain
the profound factual macroeconomic interdependence present between East
Asian states.
Achsani and Partiswi (2010) tested for the feasibility of establishing a single
currency area in ASEAN+3. Working on some selected economies of North and
South East Asia, the authors tried to judge the viability of a currency union in
the region. The analysis was carried by employing two different techniques;
exchange rate variability based on OCA index and hierarchical clustering ana-
lysis. Using quarterly data from 1997 to 2003, authors tried to find some good
evidence in the favor of this notion that the currency with lowest value of OCAindex, most stable its currency would be. Results suggested that Singapore
dollar is the most secure currency in the entire region. Both the above mentioned
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techniques suggest that by starting with Singapore and Malaysia, the region is
quite a suitable candidate for currency union, excluding Indonesia whose cur-
rency characteristics are quite far removed from those of other currencies of the
region.Taguchi (2010) examined the economic achievability of developing a regio-
nal currency block in Asia. By employing Generalized Purchasing Power Parity
(GPPP) approach, author tried to map out those common macroeconomic trends
which were experienced by each specific group of countries. Taking up a sample
of 17 Asian economies the author came up with a conclusion that China, Japan
and Korea are least capable of making an currency block in the region. As on
employing bi-lateral Co-integration the fact was revealed that countries are
sharing a negligible Co-integration amongst their macroeconomic variables.
Nevertheless, the author found good evidence for the presence of multilateral
Co-integration among the member state of SAARC and high income ASEAN
countries. Finally, the author recommended that the direct and comprehensive
formation of currency union in Asia appears to be untimely and impulsive in the
sense of deficiency of likeness amongst the primary macroeconomic variables of
member countries. This inference supports the implication of smaller local sub
groups along with multi speed policy towards a long-term goal of regional
currency block in Asia.
4 Macroeconomic and structural convergence:
exploring underlying shocks
The theoretical framework for optimum currency area (OCA) advocates that there
are three different criterions to gauge the suitability of a country to be a
candidate for optimum currency area. These factors include the patterns of
trade, the size and correlations of macroeconomic shocks, and the similarity of
economic development and financial systems, in the countries under considera-
tion (Bayoumi and Mauro 2001).
Precisely, macroeconomic and structural convergence has never been
amongst the criterion of OCA. It is certainly not inevitable for the establishment
of a single currency area. But once a common currency union is established it
becomes obligatory for member countries to guarantee macro economic conver-
gence and symmetric patterns of macroeconomic variables. The basic need
behind the fulfillment of this condition is that without achieving this propor-tionality, countries with differential inflation rates and fiscal deficits, it would be
very hard for them to agree upon a mutual non-inflationary monetary policy.
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For the purpose of preliminary evaluation, the demand and supply shocks
are taken into account. Following Bayoumi and Eichengreen (1998) and
Gyeongsang et al. (2006), demand shocks are represented by real GDP growth
rates and the supply shocks are given through the growth rates of GDP deflatorreflecting the general price level of the economy, respectively. For the purpose of
study the Nine East Asian economies are taken into consideration. These include
Singapore, Thailand, Malaysia, Indonesia, and Philippines for South East Asia
and China, Japan, Korea, and Taiwan from North East Asia. The study period
employed here is from 1992 to 2010. According to Johan Taylor, the demand
shocks lead to the expansion and contraction of the economic activity or output.
The countries with similar demand shocks can be good candidates for the
common currency area. A group of countries facing symmetric economic shocks
will be better candidates for a common currency area.
4.1 Measures of innovation accounting
4.1.1 Variance decomposition of forecast errors
In order to account for the short run innovation accounting and for supplemen-
tary conclusions, variance decomposition test (VDC) and impulse responsefunction (IRF) are the most suggested tools.VDC and IRF serve the purpose of
assessing the dynamic connections and magnitude of causal relations among
system variables. The forecast errors of VDC will reveal the percentage of
demand and supply series forecast error variance credited to their own shocks
versus the shocks from other competitor states. Thus, VDC is a short run tool to
calculate the comparative significance of global cyclical conditions in explaining
fluctuations in domestic macroeconomic variables.
Table 1 and Figure 1 states the variance decomposition of forecast errors of
supply series in percentage form at four and twenty quarters forecast horizon for
some of the selected high income North and South East Asian economies. It is
clearly evident from the statistics that China is noticeably dominant and is
accounting for 56% for Singapore, 56% for Thailand and, 51% for Malaysia
and 40% of Japan’s total variations. Hence, it may be deduced that China’s
economic conditions are most influential amongst all the other members. The
fact also points towards the deepening trade linkages of China with rest of the
region exhibiting her as the most prominent economy of the region. This finding
is in line with that of Frankle and Rose (1998) who pointed the importance of intraregional trade linkages in the context of symmetric shocks region wide.
Although the growing importance of domestic shocks for each of the economy
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can also be judged from the 20th horizon forecast errors, the change is occurring
at a very sluggish pace.
Table 2 and Figure 2 represent the importance of global cyclical conditions
in explaining the variations in domestic output for each of the country. Here, the
role of China and Japan are of great significance. Looking at the fourth horizonforecasts for both the economies, one can clearly make out the dominant role of
Japan followed by China in explaining the demand side disturbances for each of
the other country. However, at 20th horizon the contribution of Japan falls
sharply with a significant development in the role of China. Once again, this
behavior of domestic output of various countries of the region can be confidently
attributed towards growing participation of China in goods, services, and finan-
cial markets of the region. Although trade is never a zero sum game, never-
theless, the emergence of China as the main driver of East Asian trade linkageswill make many other regional partners to lose their market shares in streamlin-
ing their trade patterns.
Table 1: Variance decomposition (% of forecast error variance of supply series).
Quarters China Japan Singapore Thailand Malaysia
Quarters relative variance of ChinaChina 4 70 14 3 12 0.2
10 64 15 10 10 0.3
20 63 13 13 11 0.4
Quarters relative variance of Japan
Japan 4 41 48 3 9 0.3
10 32 45 13 9 0.4
20 40 36 14 9 0.4
Quarters relative variance of Singapore
Singapore 4 54 26 8 12 0.310 53 22 15 9 0.4
20 56 17 16 10 0.4
Quarters relative variance of Thailand
Thailand 4 63 22 8 7 0.1
10 52 27 14 10 0.3
20 56 17 16 11 0.4
Quarters relative variance of Malaysia
Malaysia 4 54 8 12 25 0.4
10 49 18 12 21 0.4
20 51 16 14 19 0.5
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Figure 1: Variance Decomposition of Forecast Errors of Supply Series.
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4.1.2 Impulse response function
The IRF maps out the directional responses of a variable to a one standarddeviation shock of another variable. This means that we can observe the trend,
extent, and persistence of demand and supply shocks to innovations in global
cyclical conditions and variations.
The procedure adopted for the assessment of each of the macroeconomic
disturbance by IRF is as follows. At the first stage, the Autoregressive (AR)
model for each of the demand and supply series is estimated after the
appropriate selection of AR lags for each country. The residuals calculated
from AR regression are used as dependent variables for the estimation of
moving average (MA) equation. Afterwards Impulse response function isemployed to assess the symmetry of shocks between the countries.
Table 2: Variance decomposition (% of forecast error variance of demand series).
Quarters China Japan Singapore Thailand Malaysia
Quarters relative variance of ChinaChina 4 37 28 6 17 13
10 49 28 7 10 7
20 50 26 10 8 6
Quarters relative variance of Japan
Japan 4 48 46 4 0.5 2
10 59 33 9 1 1
20 57 28 13 1 1
Quarters relative variance of Singapore
Singapore 4 32 57 7 1 3
10 52 34 11 1 1
20 55 27 15 1 1
Quarters relative variance of Thailand
Thailand 4 29 53 8 8 3
10 53 31 12 3 1
20 56 25 16 2 1
Quarters relative variance of Malaysia
Malaysia 4 29 55 7 6 310 55 29 13 2 1
20 57 24 17 2 1
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Figure 2: Variance decomposition of forecast errors of demand series.
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If Z t is the structural shocks to an economy, the AR process in which each element
of Z t is regressed on lagged values of all the elements of Z t can be written as
Z t ¼ 1Z tÀ1 þ 2Z tÀ2 þ Á Á Á þ nZ tÀn þ "t
where "t represents the residuals from the AR equation for the demand and
supply shocks each. We can denote the residuals individually as "t d for demand
and "t s for supply equation. Following Bayoumi and Eichengreen (1994), we
consider a system in which the true model can be represented by an infinite
moving average of and an equal number of shocks "t . The error from AR process
can be shown as a linear combination of current and past structural shocks by
the following moving average process:
"t ¼ 0t þ 1tÀ1 þ 2tÀ2 þ Á Á Á ¼X
Liit
The matrix i represents impulse response functions of the shocks to the elements
of Z t .
Precisely, macroeconomic and structural convergence has never been
amongst the criterion of OCA. It is certainly not inevitable for the establishment
of a single currency area. But once a common currency union is established it
becomes obligatory for member countries to guarantee macro economic conver-
gence and symmetric patterns of macroeconomic variables. The basic needbehind the fulfillment of this condition is that without achieving this propor-
tionality, countries with differential inflation rates and fiscal deficits, it would be
very hard for them to agree upon a mutual non-inflationary monetary policy.
Supply shocks are “generally more relevant” than demand shocks, since supply
shocks are “more related to underlying private sector behavior” (Bayoumi and
Mauro 2001, 943) and “unaffected by changes in demand-management policies
and are more likely to be invariant with respect to alternative international
monetary arrangements” (Bayoumi and Eichengreen 1994, 23).
Countries experiencing symmetric macroeconomic shocks are likely to favorsimilar policy responses and make themselves good candidates for a common
currency area. The Structural Var approach allows us to identify the underlying
shocks affecting the observed macroeconomic variables. It is assumed that if the
correlation of structural shocks is positive, the shocks will be considered to be
symmetric and if negative or insignificant they are asymmetric. A group of
economies – if identified to have higher correlations of macroeconomic shocks
with each other – may well qualify for an OCA.
Figures 3 and 4 are representing the dynamic effect of one standard deviationstructural shock on domestic output over a 24-quarter period for all of the states
under study. One may observe that the path of response is much parallel. Hence, it is
Establishing a Common Currency in Asia 77
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evident that the long run response of both supply and demand series for each of the
economy rouse by regional member states is positive for most high-income North
and South East Asian countries but with varying magnitudes. Almost all the
countries are taking an approximate time of 4–
6 periods to make adjustments
Singapore
Figure 3: Impulse response function.
China
Japan
Korea
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Indonesia
Figure 3: (Continued)
Thailand
Malaysia
Philippines
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towards equilibrium except China who is exhibiting an extra ordinary rate speedy
adjustment (approximately 2 periods). So, these findings imply that adjustment
process of supply and demand variables of each country is very much alike in the
region.
Korea
China
Japan
Singapore
Figure 4: Impulse response function.
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Indonesia
Figure 4: (Continued)
Thailand
Malaysia
Philippines
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4.2 Correlation analysis
A very obvious and affective tool of assessing the issue of symmetry of macro-
economic shocks across the member countries of a region is to calculate the
correlation coefficients of underlying macroeconomic shocks. In order to make a
judgment, it is assumed that if the correlation coefficients are positive the
identified shocks will be symmetric. Conversely, if the shocks are found to be
negative, minor, or trivial the shocks would be asymmetric. The correlation
coefficients of supply and demand shocks East Asian countries are given in
tables below.
As reported in Tables 3 and 4, positively and highly correlated shocks are
found for East Asian countries both for supply and demand shocks except for China
who is showing relevantly smaller correlation for the entire period. One may attribute these highly significant correlations towards the export orientation poli-
cies adopted by regional member states and opening up of their economies towards
each other, particularly after getting hardly hit by Asian financial crisis of 1998. So,
these correlations reconfirm our previous findings, that is, the existence of
Table 3: Correlation matrix of supply shocks generated by IRF.
China Indonesia Japan Korea Malaysia Philippines Singapore Thailand
China 1
Indonesia 0.4497 1
Japan 0.4915 0.7353 1
Korea 0.3230 0.7139 0.7468 1
Malaysia 0.2047 0.5971 0.2129 0.6380 1
Philippines 0.2688 0.6996 0.7306 0.9983 0.6370 1
Singapore 0.4680 0.9707 0.8753 0.7741 0.5000 0.7598 1
Thailand 0.3093 0.6755 0.9795 0.7358 0.1654 0.7303 0.8311 1
Table 4: Correlation matrix of demand shocks generated by IRF.
China Indonesia Japan Korea Malaysia Philippines Singapore Thailand
China 1
Indonesia 0.3590 1
Japan 0.5872 0.2566 1
Korea 0.4099 0.7232 0.6632 1
Malaysia 0.3614 0.9827 0.3736 0.7287 1
Philippines 0.2540 0.975 0.2750 0.7142 0.9775 1
Singapore 0.3023 0.9373 0.4992 0.8565 0.9662 0.9503 1
Thailand 0.3707 0.9772 0.4001 0.7358 0.9995 0.9740 0.9695 1
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symmetry in macroeconomic environment amongst the economies of the region
excluding China who is showing somewhat secluded behavior in this respect. So,
one may take this conclusion as the costs associated with opting for a common
currency for the region are relatively small as were anticipated before. This willpositively cut down the probable commotions caused by global business cycles
under bilateral fixed exchange rates amongst the member economies.
5 Computation of optimum currency area
(OCA) index
This part of paper aims at estimating the variability of exchange rate behaviors
of East Asian economies by formulating OCA index. The index is formed by the
ordinary least square (OLS) method. All the currencies are taken against US
dollar. It is hypothesized that smaller the value of OCA index will be for a
country more stable its currency would be and vice versa.
Originally, the model of exchange rate variability was proposed by Vaubel
(1977). He employed the model for the sake of estimating OCA index for various
economies of European region. The magnitude of variability was then calculated
by measuring the standard deviation of exchange rate fluctuation between twocountries. The index is also very functional in the sense that it gives a very
comprehensive picture of costs and benefits associated with the establishment of
a single currency area.
5.1 Defining variables
Using the improved version of Bayoumi and Eichengreen model devised by
Hovert (2003) and further used by Achsani and Partiswi (2010), for each of theparticipant country, following linear equation will be estimated.
LEXR ij ¼ INFij þ SIZEij þ BUSij þ MRKTij þ DISSij þ TIij þ OPENij þ U t
(a) LEXR = Logarithm of bilateral exchange rate volatility between countries i
and US, that is, the OCA index. Volatility is calculated by taking the standard
deviation of projected values of exchange rate. The variable is calculated at
market rate and the period averages are taken.
(b) INF = Inflation = Growth rate of Consumer Price Index (CPI) calculated with
the base year 2005.
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(c) SIZE = Size of the Economy = Growth rate of the difference between GDP
(PPP) 2005 for country i and GDP (PPP) 2005 for US.
Size ¼ GrowthfGDP ðPPPÞ
i
g
fGDPðPPPÞUS
g
(d) BUS = Business Cycle Synchronization=Standard deviation of the growth
rate of difference between GDP Constant (2005) for country i and GDP
Constant (2005) for US.
BUS ¼ SD Growth GDPi Constant ð Þ À GDPUS Constant ð Þf g½
(e) MRKT = Market Capitalization of listed companies representing financial
liberalization.(f) DISS = Dissimilarity in Economic Structure in Comparison to US. Here, three
of the main sectors (agriculture, manufacturing, and services) contributing
to GDP is taken into account. Growth rate of the summation of absolute
values of difference between agriculture, manufacturing, and services value
added of country i and US. Value added is taken at constant 2005 US dollar.
Diss ¼ Growth Agrii À AgriUSð Þ þ Manui À ManuUSð Þ þ Ser i À Ser USð Þf g
(g) TI = Trade Intensity
TI ¼ExpiUS þ ImpiUS
Expi þ Impi þ ExpUS þ ImpUS
where ExpiUS and Imp
iUS are bilateral exports and imports of country i to US,
respectively. Expi, Imp
i, ExpUS and ImpUS are total exports and imports of
country i and US, respectively. The series is afterwards generated by taking
the growth rate of this ratio.
(h) OPEN = Trade Openness=Growth rate of the ratio between bilateralexports and imports of country i to US and total imports and exports
of country i.
Open ¼ExpiUS þ ImpiUS
Expi þ Impi
(i) U i = Error Term
After taking stationarity into account, ordinary least square method is used to
estimate the model for the data ranging from 1992 to 2010. This practice will
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provide with the general behavior of all the explanatory variables for the
entire period of study. Now, to forecast the dependent variable the projec-
tions of exchange rate volatility will be constructed from the period 2010–
2015. These extrapolated values for independent variable will be generatedthrough auto-regressive moving average (ARMA) process. The forecast values
are then used to predict the dependent variable values for the period 2011–
2015. The standard deviation of the predicted values of dependent variable is
Optimum currency area index for each country. According to Bayoumi (1996),
the value of OCA index can be up to 0.03. The countries under consideration
are ranked according to the values of OCA index. Lower the value of OCA
index, higher is the probability of a country to be a suitable candidate for
optimum currency area.
5.2 Results
Table 5 reports the OCA index value for each of the country under discussion.
Here, US dollar is taken to be the bench mark currency as all the currencies are
taken against US dollar. The results show that Philippines Peso is the most
stable currency amongst all followed by Indonesian Rupiah, Japanese Yen,
Thailand’
s Bath, Korean Won, Singapore dollar and Malaysian Ringgit. Theonly outlier economy is of China with a highly divergent value of OCA index
with 0.1368. However, the results are quite different from previous findings in
which times most of times Malaysian Ringgit and Singapore dollar are found to
be the most stable currencies of the region Achsani and Partiswi (2010), Telisa
(2003), etc. The difference may be attributed towards the usage of extrapolated
data before or during the period of global financial crisis of 2007–2008 which
altered the behaviors of American, European, and Asian macroeconomic vari-
ables altogether.
Table 5: OCA index values calculated for extrapolated data from 2010 to 2015.
Years China Indonesia Japan Korea Malaysia Philippines Singapore Thailand
2011 1.0051 3.8244 2.0722 3.003 0.6038 1.6129 0.184 1.6104
2012 0.9018 3.8253 2.0714 3.0173 0.5885 1.6116 0.1881 1.6075
2013 1.0992 3.8252 2.073 3.0138 0.6243 1.6126 0.1868 1.6026
2014 0.7395 3.8239 2.0737 3.0215 0.599 1.6118 0.1874 1.6017
2015 1.0043 3.8243 2.0737 3.0098 0.6141 1.6119 0.1706 1.6017
OCA 0.1368 0.0006 0.0009 0.0071 0.0137 0.0005 0.0073 0.0039
Establishing a Common Currency in Asia 85
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6 Concluding remarks
The study was basically aimed at two major objectives (i) identification of
underlying macroeconomic shocks using a two-variable VAR model by employ-ing almost two decades of annual data (ii) testing the possibility of establishing
a single currency area among East Asian high income countries.
The results suggest that exchange rate of East Asian economies are relatively
stable. Most of them are exhibiting a consistent pattern of GDP growth proven by
highly significant values of correlation analysis. Supply shocks are also signifi-
cantly correlated particular amongst those economies which are most directly hit
by Asian financial crisis of 1998. But except for China who is displaying quite a
contrary attitude in comparison to its neighbor economies. So it may be con-cluded that, on the average, structural shocks are remarkably symmetric with
high magnitudes. The speed of adjustment towards these shocks is quite
encouraging in the sense that on the whole all the economies are displaying a
good tendency of reverting back to their equilibriums after a short period of
time, probably due to relatively flexible labor market and less rigid wage rate,
providing them with a good potential of adjusting themselves towards macro-
economic and structural disturbances, thus, proving them to be capable of
making a good currency union amongst each other.
The empirical results drawn from the calculation of OCA index display strong support in favor of establishing an optimum currency area in the region
excluding China. Taking start with Philippines, Indonesia and Japan the region
proves itself to b a potential candidate for currency union. As the macroeco-
nomic disturbances are highly correlated and countries are exhibiting good
adjustments towards equilibrium, we may expect to see relatively mild cost of
this single currency adoption. However, this all must be done in a sequential
and cautious manner.
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