doi 10.

1515/gej-2012-0018

Global Economy Journal 2013; 13(1): 6388

Whats 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-growing financial 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 are tested 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 Asian economies. 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: economist_macro@hotmail.com Muhammad Atiq Ur Rehman, Punjab University, Lahore 54890, Pakistan, E-mail: a_r_qamar786@yahoo.com

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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 and long term exchange rate volatility. At this point, the names of those five countries 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 macroeconomic 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 ones 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 economies. 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 that acted 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 economies. 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 Asias 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 multinational 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 countries 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 confidently claimed that the exchange rate movement of Yuan against other East Asian currencies is of growing importance in the context of regional and global trade 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 commercial and 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 commercial 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 financial crisis of 19971998 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 prominent 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 financial 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 permanently 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 competitive efficiencies: (a) labor mobility (b) wage flexibility. These efficiencies provide 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 once again. 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 equilibrium position will be restored. Besides, due to perfect labor mobility, the unemployed man-power of Country B would get an opportunity to find employment 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 booming country as its citizen were more in a position to save, will be counterbalanced 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 consumption 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 will not 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 concerns. 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. The basic 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 consistent 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 macroeconomic data. Using a model consisting of demand shocks (represented by domestic 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 due to 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 highlight the 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 19701999. 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 19802002 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 macroeconomic 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--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 macroeconomic 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 analysis. 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 OCA index, 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 currency characteristics are quite far removed from those of other currencies of the region. Taguchi (2010) examined the economic achievability of developing a regional 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 consideration (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 convergence and symmetric patterns of macroeconomic variables. The basic need behind the fulfillment of this condition is that without achieving this proportionality, 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 deflator reflecting 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 supplementary conclusions, variance decomposition test (VDC) and impulse response function (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 Japans total variations. Hence, it may be deduced that Chinas 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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Table 1: Variance decomposition (% of forecast error variance of supply series). Quarters China Japan Singapore Thailand Malaysia

China

4 10 20

Quarters relative variance of China 70 14 3 64 15 10 63 13 13 Quarters relative variance of Japan 41 48 3 32 45 13 40 36 14 Quarters relative 54 53 56 variance of Singapore 26 8 22 15 17 16

12 10 11

0.2 0.3 0.4

Japan

4 10 20

9 9 9

0.3 0.4 0.4

Singapore

4 10 20

12 9 10

0.3 0.4 0.4

Thailand

4 10 20

Quarters relative variance of Thailand 63 22 8 52 27 14 56 17 16 Quarters relative variance of Malaysia 54 8 12 49 18 12 51 16 14

7 10 11

0.1 0.3 0.4

Malaysia

4 10 20

25 21 19

0.4 0.4 0.5

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 horizon forecasts 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 financial markets of the region. Although trade is never a zero sum game, nevertheless, the emergence of China as the main driver of East Asian trade linkages will make many other regional partners to lose their market shares in streamlining their trade patterns.

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Figure 1: Variance Decomposition of Forecast Errors of Supply Series.

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Table 2: Variance decomposition (% of forecast error variance of demand series). Quarters China Japan Singapore Thailand Malaysia

China

4 10 20

Quarters relative variance of China 37 28 6 49 28 7 50 26 10 Quarters relative variance of Japan 48 46 4 59 33 9 57 28 13 Quarters relative 32 52 55 variance of Singapore 57 7 34 11 27 15

17 10 8

13 7 6

Japan

4 10 20

0.5 1 1

2 1 1

Singapore

4 10 20

1 1 1

3 1 1

Thailand

4 10 20

Quarters relative variance of Thailand 29 53 8 53 31 12 56 25 16 Quarters relative variance of Malaysia 29 55 7 55 29 13 57 24 17

8 3 2

3 1 1

Malaysia

4 10 20

6 2 2

3 1 1

4.1.2 Impulse response function The IRF maps out the directional responses of a variable to a one standard deviation 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 is employed to assess the symmetry of shocks between the countries.

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Figure 2: Variance decomposition of forecast errors of demand series.

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If Zt is the structural shocks to an economy, the AR process in which each element of Zt is regressed on lagged values of all the elements of Zt can be written as Zt 1 Zt1 2 Zt2 n Ztn "t where "t represents the residuals from the AR equation for the demand and supply shocks each. We can denote the residuals individually as "td for demand and "ts 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: X Li i t "t 0 t 1 t1 2 t2 The matrix i represents impulse response functions of the shocks to the elements of Zt . 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 convergence and symmetric patterns of macroeconomic variables. The basic need behind the fulfillment of this condition is that without achieving this proportionality, 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 favor similar 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 deviation structural 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

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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 46 periods to make adjustments

China

Japan

Korea

Singapore
Figure 3: Impulse response function.

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Thailand

Malaysia

Philippines

Indonesia
Figure 3: (Continued)

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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.

China

Japan

Korea

Singapore
Figure 4: Impulse response function.

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Thailand

Malaysia

Philippines

Indonesia
Figure 4: (Continued)

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4.2 Correlation analysis

A very obvious and affective tool of assessing the issue of symmetry of macroeconomic 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 policies 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 China Indonesia Japan Korea Malaysia Philippines Singapore Thailand 1 0.4497 0.4915 0.3230 0.2047 0.2688 0.4680 0.3093 Indonesia Japan Korea Malaysia Philippines Singapore Thailand

1 0.7353 0.7139 0.5971 0.6996 0.9707 0.6755

1 0.7468 0.2129 0.7306 0.8753 0.9795

1 0.6380 0.9983 0.7741 0.7358

1 0.6370 0.5000 0.1654

1 0.7598 0.7303

1 0.8311

Table 4: Correlation matrix of demand shocks generated by IRF. China Indonesia China Indonesia Japan Korea Malaysia Philippines Singapore Thailand 1 0.3590 0.5872 0.4099 0.3614 0.2540 0.3023 0.3707 Japan Korea Malaysia Philippines Singapore Thailand

1 0.2566 0.7232 0.9827 0.975 0.9373 0.9772

1 0.6632 0.3736 0.2750 0.4992 0.4001

1 0.7287 0.7142 0.8565 0.7358

1 0.9775 0.9662 0.9995

1 0.9503 0.9740

1 0.9695

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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 will positively 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 two countries. 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 the participant country, following linear equation will be estimated. LEXRij INFij SIZEij BUSij MRKTij DISSij TIij OPENij Ut (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 Growth fGDP PPPi g fGDPPPPUS 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 SDGrowthfGDPi Constant GDPUS Constantg (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 fGrowthAgrii AgriUS Manui ManuUS Seri SerUS g (g) TI = Trade Intensity TI ExpiUS ImpiUS Expi Impi ExpUS ImpUS

where ExpiUS and ImpiUS are bilateral exports and imports of country i to US, respectively. Expi , Impi , 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 bilateral exports and imports of country i to US and total imports and exports of country i. Open ExpiUS ImpiUS Expi Impi

(i) Ui = 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 projections of exchange rate volatility will be constructed from the period 2010 2015. These extrapolated values for independent variable will be generated through 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, Thailands Bath, Korean Won, Singapore dollar and Malaysian Ringgit. The only 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 20072008 which altered the behaviors of American, European, and Asian macroeconomic variables altogether.

Table 5: OCA index values calculated for extrapolated data from 2010 to 2015. Years 2011 2012 2013 2014 2015 OCA China 1.0051 0.9018 1.0992 0.7395 1.0043 0.1368 Indonesia 3.8244 3.8253 3.8252 3.8239 3.8243 0.0006 Japan 2.0722 2.0714 2.073 2.0737 2.0737 0.0009 Korea 3.003 3.0173 3.0138 3.0215 3.0098 0.0071 Malaysia 0.6038 0.5885 0.6243 0.599 0.6141 0.0137 Philippines 1.6129 1.6116 1.6126 1.6118 1.6119 0.0005 Singapore 0.184 0.1881 0.1868 0.1874 0.1706 0.0073 Thailand 1.6104 1.6075 1.6026 1.6017 1.6017 0.0039

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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 employing 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 significantly 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 concluded 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 macroeconomic 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 macroeconomic 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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