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Global Economic Review: Perspectives on East Asian Economies and Industries

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

Chandan Sharma & Ritesh Kumar Mishra
a a b

Department of Economics, National Institute of Financial Management (NIFM), Haryana, India

b

Department of Economics, GGS Indraprastha University, New Delhi, India Version of record first published: 20 Aug 2012.

To cite this article: Chandan Sharma & Ritesh Kumar Mishra (2012): Is an Optimum Currency Area Feasible in East and South East Asia?, Global Economic Review: Perspectives on East Asian Economies and Industries, 41:3, 209-232 To link to this article: http://dx.doi.org/10.1080/1226508X.2012.709991

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Global Economic Review Vol. 41, No. 3, 209 232, September 2012

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

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CHANDAN SHARMA* & RITESH KUMAR MISHRA**

*Department of Economics, National Institute of Financial Management (NIFM), Haryana, India & **Department of Economics, GGS Indraprastha University, New Delhi, India

ABSTRACT In the backdrop of the recent economic crisis in the European Union, this study attempts to assess the degree of regional integration and the suitability of a monetary union in the East and South-East Asian (ESEA) region. For this purpose, we analyse the issue in a variety of ways. First, a long-run linkage of real output of the countries is tested using the cointegration analysis. Results suggest that real output of most of the countries in the region is cointegrated and move together in the long-run. To analyse the issue in detail, we focus on the impact of three different shocks, namely global, regional and country-specific, on real output of the countries. Results of impulse response and variance decomposition analysis reveal that regional shocks do not dominate in the sample countries, which is an indication of unfavourable condition to form an optimal currency area (OCA) in the region. These results are further confirmed by the outcome of computation of the modified Bayoumi and Eichengreens Indices. Finally, we employ the concept of Generalized Purchasing Power Parity (G-PPP), which however reveals that the bilateral real exchange rate of ESEA countries move together in the long-run and share a common stochastic trend, which in turn provides some empirical support for an OCA in the region. KEY WORDS: OCA; output shocks; G-PPP; East and South-East Asian; monetary union JEL CLASSIFICATION: F36, F42, F33, C32

1. Introduction Exchange rate management has been the core of economic policy debate since the East Asian currency crisis. It is now widely recognized that the regime of soft-peg was the prime cause of the financial debacle in the Asian economies during the latter part of 1990s. In some sense, the crisis has exposed the inherent complications in managing the exchange rate individually and efficiently in a small open economy, especially in the presence of massive international capital inflows and outflows (see Wilson & Choy, 2007). The East and South-East Asian (ESEA) region is characterized by diverse, uncoordinated exchange rate arrangements. For instance, Japan and China, the two dominant countries in the region, have adopted an exchange rate regime akin to a pure float and a tightly managed US dollar-based regime, respectively. Most other economies in the region have adopted intermediate
Correspondence Address: Chandan Sharma, Department of Economics, National Institute of Financial Management, Sector 48, Faridabad 121 001, Haryana, India. Email: chandanieg@gmail.com 1226-508X Print/1744-3873 Online/12/030209 24 # 2012 Institute of East and West Studies, Yonsei University, Seoul http://dx.doi.org/10.1080/1226508X.2012.709991

210 C. Sharma & R. K. Mishra regimes such as managed float. The presence of different exchange rate regimes and strategies in the region has made it difficult to maintain intra-regional exchange rate stability through the dollar pegging. Therefore, it has become increasingly important for the countries to work in the direction of a similar exchange rate regime and ensure the intra-regional exchange rate stability. Following this and taking lessons from the Asian crisis, a group of researchers have proposed for the formation of an optimal currency area (OCA) in the East Asian region (e.g. Williamson, 1998; McKinnon, 2000; Mundell, 2003).1 Currency union, as discussed in the literature, has numerous real and monetary effects on the trading and economic environment of member economies. For example, with the formation of currency union the trading costs are expected to decline, and therefore it leads to increase in both output and consumption. The loss of independent stabilization policy has costs and benefits of different magnitude and importance attached to it. For example, a country that sacrifices its currency actually loses a stabilization device targeted to domestic shocks. But the country is also expected to gain credibility, and in so doing reduces undesired inflation (see Alesina & Barro, 2002). Moreover, in a correctly defined OCA, the forward (intra-regional currency) market premium will disappear, which in turn may raise the relative advantage of intra-regional trade against cross-regional trade in the region.2 A number of studies have investigated the economic and political feasibility of forming an OCA in the region in the post crisis period (1999 2008).3 Some studies have concluded that the economic and political benefits of adopting a single currency are far greater than the potential costs that its member economies are likely to incur. There is no denying of the fact that the degree of economic and financial integration among Asian countries has increased considerably, especially in the postcrisis (1999 2010) period. Over time the response to global shocks and symmetry in economic activities has also increased in the region. The recent American sub-prime crisis (2008) has provided some further confirmation in this concern. Most of the Asian countries experienced spillover effect of the crisis, and as a result they faced similar challenges such as capital outflows, currency depreciation, plunge in stock prices, credit crunch, and a sharp fall in export demand. The debate over formation of currency union in the Asian region has intensified and has taken on a new dimension, especially in the wake of the European Union debt crisis (2009 2010). Now a group of researchers are of the opinion that the crisis of Europe (2009 2010) is mainly the undesirable outcome of poor economic policies and heterogeneity of the monetary union (see Eichengreen, 2010), and it seems that the crisis is sowing the seeds of collapse of the union (Arghyrou & Tsoukalas, 2010). On the other side, a group of researchers (e.g. Dolls et al., 2010) argue that the monetary union has provided better mechanism and power to the European countries in handling the crisis through automatic stabilisers. In this situation, the debate of the OCA in Asia has taken a new turn, and it has become relevant and important to test the feasibility from a different perspective using the most recent data-set. Against this background, the present study aims to empirically assess the degree of regional integration and examine the suitability of an OCA in the ESEA region. We mainly focus on the period between post-Asian crises (1999) and the pre-American crisis (2008). Our analysis covers South Korea, Singapore, Malaysia, Indonesia, Thailand, the Philippines, China, Japan, and India.4 Most of the previous studies

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Currency Area in East and South East Asia 211 have followed any one empirical framework to test the feasibility. In the present study, we implement three important but alternative analysis techniques simultaneously to examine the feasibility of the OCA. Specifically, following Sato and Zhang (2006), we first adopt the cointegration technique to test whether there is any evidence of longrun co-movements of real output among the ESEA economies. If the real output of the sample countries is not cointegrated, it indicates that each countrys output moves randomly over a period of time and follows a different growth path. This scenario would indicate the existence of a high economic divergence among these economies. In the next stage, following Chow and Kims (2003), we estimate the output growth function subject to three different types of shocks. In other words, we attempt to decompose external shocks into three different levels, namely global shock, regional shock, and country-specific shock. The origin of these different shocks has significant and relevant policy implications, and this may indicate towards some degree of inter-linkage among the countries as well as the inter-relationship with the rest of the world. Further, to check the robustness of the results, we have also applied a modified version of Bayoumi and Eichengreens Indices. In the final stage, we apply Generalized Purchasing Power Parity (G-PPP), introduced by Enders and Hurn (1994), which is expected to provide further evidence for OCA in the region by analysing the behaviour of exchange rate. Rest of the study is organized as follows: Section 2 reviews the related literature whereas Section 3 contains discussion on data-related issues. Section 4 presents empirical models, methodologies and their estimation results. Section 5 provides conclusion of this study. 2. Review of the Related Literature The theory of OCA asserts that some crucial conditions should be satisfied for the formation and success of a common currency in a region. These conditions include: factor mobility and symmetry of shocks across countries (Mundell, 1961), openness of economies and trade integration (McKinnon, 1963) and well-diversified economies, and regional production pattern (Kenen, 1969). Therefore, from this viewpoint it could be argued that countries of ESEA are in position to satisfy at least some minimum standard criteria to form an OCA.5 Further, McKinnon (1963) emphasized on international openness of the country as an important criterion for the OCA. According to McKinnon, trade between two countries is an important channel of interdependence of economic activities through which economic shocks of one country may be transmitted to the others. Also, reduction in various transaction costs in the OCA region would further lead to more trade.6 Given that numerous economic merits of the OCA are theoretically well established in the literature, recently, a number of studies have tested the empirical viability of forming an OCA for various subsets of countries of the ESEA region using different econometric methodologies. The broad picture which emerges from the available literature is not very encouraging for the formation of an OCA in the near future in the region. Nevertheless, the favourable findings of some studies have kept the debate on scope for monetary cooperation among Asian countries still alive. Earlier studies by Frankel (1991, 1993) and Frankel and Wei (1994) show that a yen block does not exist in the East Asian region. They conclude that even though Asia has shown bias

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212 C. Sharma & R. K. Mishra towards intra-regional trade, but the degree of this intra-regional bias has not increased in the recent past. Similarly, Park and Park (1990) rejected the empirical viability of OCA, and raised doubt over the formation of a yen block between Japan and other East Asian economies. Chow and Kim (2003) investigated the feasibility of a common currency peg in the East Asian region with the context of Western European countries. Their findings suggest that domestic outputs of East Asian countries are strongly influenced by country-specific shocks whereas in the case of European countries regional shocks play a dominant role. Also, it appears that the East Asian economies are structurally different from each other and thus they are more likely to experience asymmetric shocks. Therefore, a common currency peg in East Asia may not be economically advantageous and sustainable. Following the same empirical methodology, Soo and Choong (2010) reached the conclusion that most of the Asian economies look highly segmented especially in the pre-crisis period. However, findings of the study suggest that the degree of segmentation among these economies has declined and the influence of Japanese economy on the performance of some Asian countries has increased in the recent past. On the other hand, some recent studies have reported encouraging evidence by giving some support to the proposition that a common currency union is feasible in Asia. For example, Bayoumi and Eichengreen (1994) reached the conclusion that a subset of nine East Asian countries satisfies the necessary economic criteria for the formation of an OCA almost similar to Western Europe. Zhang et al. (2004) investigated the suitability of East Asian economies for potential monetary integration. They find that empirical results do not offer any strong support for forming an OCA in the entire East Asian region. However, some small sub regions have the required qualities for becoming potential candidates of the OCA. By using the cointegration and common cyclical feature analysis, Sato and Zhang (2006) investigated the feasibility of a monetary union in East Asia and found that some pair of countries share synchronous movement of real output in both short- as well as long-run. Therefore, these countries are good candidates for forming a monetary union because their short-run dynamics is correlated and they share long-run output co-movements. Shirono (2008) focus on trade-creating and welfare effects of various common currency arrangements in East Asia. Interestingly, the study finds that formation of a single currency area in the region will stimulate the scale of regional trade considerably and regional currency arrangements that include Japan will create substantial welfare gains for the member countries. In another study, Shirono (2009) assessed the role of Japan, along with China and the USA, in the East Asian currency regime by estimating trade-creating effects and accompanying welfare gains of different currency arrangements in the region. Findings of the study suggest that currency union with China will generate higher average welfare gains for the East Asian countries than any other arrangement with Japan and China. Further, the study shows that the welfare gains of currency union associated with Japan are much higher than that of USA. Banik et al. (2009) investigate the feasibility of an OCA for South Asian countries and find that a small cluster of countries, namely Bangladesh, India, and Pakistan, appear to be good candidates for forming an OCA. Recently, Lee and Azali (2010) assessed the dynamic relationship between trade, finance, specialization, and business cycle synchronization for East Asian economies and reached the conclusion that there is good scope for formation of a monetary union. Similarly, on the basis of results of G-PPP Choudhry (2005) reached

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Currency Area in East and South East Asia 213 the conclusion that evidences are supportive of an OCA only in the post-Asian crisis period. More recently, Mishra and Sharma (2010) also find some favourable evidence for formation of an OCA in East Asia. Their findings suggest that still the degree of economic integration among the countries needs to be enhanced further for formation of a currency union in the region. 3. Data To examine the long-run co-movements of real output of the sample countries, we use real GDP series as a proxy for real outputs. The data on all variables are of quarterly frequency, expressed in natural logarithms and seasonally adjusted using the Census X-12 method. Nine countries, namely the South Korea, Singapore, Malaysia, Indonesia, Thailand, the Philippines, China, Japan, and India, are included in this study for the empirical investigation. Output series of the USA is also used for the analysis purpose. The sample period spans from 1999Q1 to 2008Q4 for all economies. To avoid the turbulent Asian crisis period (1997 1998) and the sub-prime crisis of 2008 2009 in the US economy and subsequent European Union debt crisis (2010 2011), we did not consider the period before 1999 and after 2008 for the analysis. Further, to test the G-PPP, we utilize monthly data of nominal exchange rate (defined as market rate per US dollar) and price level represented by consumer price index (CPI). In this case, the sample period spans from 1999:01 to 2008:12. All series are seasonally unadjusted and expressed in logarithms before any econometric analysis. We consider USA as the base country to calculate the real exchange rate. All data series are collected from the International Financial Statistics (IFS) database provided by the International Monetary Fund. 4. Empirical Results 4.1. Testing Co-movements of Output: Bivariate Cointegration Test To investigate whether there exists a stable linear steady-state relationship between the real output of the sample countries, we conduct the cointegration test. Testing of cointegration is important as it will indicate whether the real output series share synchronous long-run movements. For testing cointegration, it is required to test the stationarity of variables. If all variables in the system are non-stationary at the level and stationary at their first difference, that is I(1), we can apply the Johansen maximum likelihood (ML) method (Johansen & Juselius, 1990; Johansen, 1991) to test whether these variables are cointegrated. We begin our analysis by providing the univariate properties of the variables of interest using the standard Augmented Dickey Fuller (ADF) and the Phillips Perron (PP) unit root tests to establish the order of integration of all variables. Both the ADF and PP tests fail to reject the null hypothesis of a unit root for all variables at the levels. However, the null hypothesis is overwhelmingly rejected for all the series at first-differences. As all the variables are integrated of the same order, this allows us to conduct the Johansen Jesulius cointegration test.7 We next investigate the bivariate relations of real output co-movements between the ESEA economies. For this purpose, we conduct the Johansen cointegration test for 35 pairs of the economies and their results are reported in Table 1. It is clearly

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214 C. Sharma & R. K. Mishra

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Table 1. Co-movements of output: results of cointegration rank Trace test Country pair (country i&j) Deterministic components Chin Sing Chin Thai Chin Indi Chin Indon Chin Korea Chin-Malay Chin Philip Indi Korea Indi Malay Indi Philip Indi Sing Indi Thai Indi-indon Indon Korea Indon Malay Indon Philip Indon Sing Indon Thai Jap-Chin Jap Indi Jap Indon Jap Korea Jap Malay Jap Philip Jap Sing Jap Thai Korea Malay No trend No trend No trend Trend No trend No trend No trend No trend No trend No trend No trend No trend Trend No trend Trend No trend No trend Trend No-trend No trend No trend Trend No trend No trend No trend No trend No trend lmax Trace test H0: r 5 1 0.150958 0.341573 0.057369** 2.616357 0.89912 0.028937 0.012088 3.618835 1.667937 2.206353 1.20908 0.171394 0.038296 4.423444** 1.596977 1.34292 1.580476 0.100557 0.063481 2.514089 2.641933 2.828426* 3.108751 2.154704 2.494838 2.912503 5.569177** lmax Cointegrating Cointegrated vector (( bj) Yes No Yes No No Yes Yes No Yes Yes Yes No No Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes 2.224186** (0.21647) 2.251138 ** (0.10491) 1.584712** (0.04783) 1.521238** (0.05332) 0.710411** (0.02665) 0.695224** (0.03595) 1.270839** (0.12240) 1.751633** (0.28367) 1.636667** (0.06163) 0.695224** (0.03595) 3.054663** (0.65257) 2.103871** (0.08030) 10.86569** (1.15596) 0.135900** (0.03977) 0.104219** (0.00752) 17.15939** (6.30460) 0.457512** (0.13641) 0.139815** (0.02130) 0.234500** (0.01239) 0.140886** (0.03247) 0.108891** (0.24901)

H0: r 00 19.61556** 12.66725 19.39314** 9.900251 12.05739 14.20491** 38.39309** 10.07799 17.49231** 35.26262** 22.39943** 11.42961 14.3445 22.33580** 19.42353** 33.96150** 23.35268** 29.40074** 21.4246** 27.45547** 22.62306** 15.79471** 15.60576** 37.48481** 15.30830* 18.50924** 13.72269**

19.46461** 0.150958 12.32568 0.341573 19.33577** 0.057369** 7.283894 2.616357 11.15827 0.89912 14.17597** 0.028937 38.38100** 0.012088 7.459153 3.618835 15.82437** 1.667937 33.05627** 2.206353 21.19035** 1.20908 11.25822 0.171394 13.3062 0.038296 4.423444** 17.91236** 17.82656** 1.596977 32.61858** 1.34292 21.77221** 1.580476 29.30018** 0.100557 0.392390** 2.492234 24.931221** 2.516939 19.98112** 2.641933 14.26460** 2.828426* 12.49700** 3.108751 35.33011** 2.154704 12.81346* 2.494838 15.59674** 2.912503 11.153508** 5.569177**

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Table 1. (Continued ) Trace test Country pair (country i&j) Deterministic components Korea Philip Korea Sing Korea Thai Malay Sing Malay Thai Philip Malay Philip Sing Philip Thai Thai -Sing No trend Trend Trend No trend No trend Trend No trend No trend No trend lmax Trace test H0: r 5 1 4.634388** 2.397915 0.781615 2.257342 2.150771 1.521797 1.827456 0.019365 3.313827 lmax Cointegrating Cointegrated vector (( bj) Yes No Yes Yes Yes Yes Yes Yes Yes 0.397957** (0.10225) 0.584825** (0.10882) 9.706248** (4.58192) 1.232829 ** (0.03125) 0.978392 ** (0.04229) 1.691184 ** (0.27346) 1.234723** (0.04562) 0.857194** (0.11061)

H0: r 00 40.45201** 7.987452 17.01554** 17.19921** 18.4608** 36.98675** 39.52308** 31.78751** 21.35249**

35.81763** 4.634388** 5.589537 2.397915 16.23392** 0.781615 14.94187** 2.257342 16.31003** 2.150771 35.46495** 1.521797 18.27456** 37.69562 31.76814** 0.019365 23.313827** 3.03866

Currency Area in East and South East Asia 215

Notes: (1) Asterisks (**) denote statistically significant at the 5% level. (2) Critical values are taken from Osterwald-Lenum (1992). (3) The following notations are applied: Jap, Japan; Indi, India; chin, China; Indon, Indonesia; Malay, Malaysia; Philip, Philippines; Thai, Thailand; Sing, Singapore; and Korea, South Korea.

216 C. Sharma & R. K. Mishra observable that the hypothesis of no cointegration is rejected by either the trace or maximum eigenvalue test at 5% level in 28 cases. Only in the case of seven country pairs, no evidence of cointegrating relationship is observed at conventional level of significance. Surprisingly, the output co-movements of China and India with other economies are not found to be very strong, as countries such as Indonesia, South Korea, and Thailand do not share a cointegrating relationship with both the economies. Nevertheless, both of the economies share a common trend with the rest of the sample countries including cointegrating relation between themselves. Furthermore, results also indicate that output of South Korea and Singapore does not share a similar movement. The last column of the table reports the estimated cointegrated coefficients, which suggest that most of the country pairs have significant impact on each other, and affect each other positively. Therefore, on the basis of these findings, we can argue that there is some evidence to conclude that the ESEA economies have long-run co-movements in their output, and therefore formation of an OCA in the region appears to be a possible economic event in the future. 4.2. Analysis of the Symmetry of Response: Evidence from Impulse Response and Variance Decompositions After examining the bilateral cointegration relationship, it is now relevant to compare the response of economies to different types of shocks in terms of the magnitude and speed of adjustment. This can be done by analysing the impulse response functions (IRFs). The larger the size of the shock, more disruptive will be its effects on the economy. Similarly, if the adjustments after the disturbances are slow, larger will be the cost of maintaining a single currency. Therefore, we have applied the IRF to capture the response of different types of shocks for the analysis. In addition, the forecast error variance can be used to show the contribution of each shock to the movements in the output of countries. This is important because difference in the cause of variability in the countries could be an indicator of underlying difference in transmission mechanism and policy strategies of the countries in the region, which would be an obstacle to regional monetary integration. Keeping this issue in mind, we have also applied the variance decomposition (VD) analysis. Following Chow and Kim (2003) and Soo and Choong (2010), we estimate the output growth DyD t function subject to three different types of shocks, namely global uW , regional uR , and domestic uD -specific:
W DyD b3 LuR b4 LuD t b1 b2 Lu

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(1)

where bi L bi0 bi2 L bi3 L2 is a polynomial function of the lag operator, L. Generally, global shocks can potentially influence economies both inside and outside the regional boundary and regional shocks can affect economies within a certain region. For example, a shock in the yen-dollar exchange rate could synchronize and latter this could pass to other countries in the region (Kwan, 1994). On the other hand, country-specific shocks are generated in a country and can affect uniquely to that country only. Origin of these shocks could be from monetary or fiscal policy changes, demand or supply shocks on productivity, or terms of trade (Bayoumi & Eichengreen, 1993).

Currency Area in East and South East Asia 217 In this context, if it is observed that country-specific shocks are dominating in a country, and it is less correlated across the region, then losing the monetary independence for an OCA could be a costly affair for the country. At the same time, the occurrence of regional shocks or correlated local shocks may indicate for a similar monetary policy within the region therefore the OCA could be a feasible option in this scenario. In contrast, if it is detected that global shocks are dominating and play a crucial role in determining the directions of movement of macro-economic factors of various countries in the region, then a more global arrangement might be more appropriate. Nevertheless, as long as shocks influence all economies in the similar pattern, a global rather than regional policy arrangement may be a more appropriate course of action in dealing with such shocks. Therefore, identification of different shocks could be crucial, as this may provide information regarding the interlinkage among the countries. For this purpose, we move further to identify and analyse the nature and role of observed shocks in the countries. Results of our analysis can indicate for three exhaustive and exclusive outcomes. First, if global shocks are dominating in the region, then we can conclude in favour of the formation of a Dollar bloc. Second, if the analysis observes that regional shocks are dominating in the region, then we can recommend forming a Yen bloc. Finally, the outcome of dominance of domestic shocks would compel us to recommend against any monetary arrangement among the countries. On the basis of these explanations, we apply the vector auto-regression (VAR) model to estimate the impact of these shocks. This framework generates the IRFs and VD, which helps in distinguishing the shocks on output (log of real GDP) of the sample countries. Given the size and impact of USA and Japanese economy on the sample countries, we consider the real GDP of the USA and Japan as proxies for the global shocks uW and regional shocks uR , respectively. Further, to test the impact of regional shocks on the Japanese output, the Chinese GDP is used as a proxy, given the fact that China is the next most important country in this region. Figures 1 9 show the response of each of the nine countries real GDP growth over eight periods to innovations (shocks) in global and regional output growth. We use these results in recognizing the origin of shocks, which are observed by real output of the countries. The results can be understood in the VAR framework. Specifically, we are interested to know here that one standard deviation (SD) shock to the innovations in current and future values of endogenous variables (global, regional, and country-specific shocks) leads to what magnitude of change in output of the sample countries. The effect begins in t(quarter) 0 1, and it is observed until

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Figure 1. Response of China to Cholesky, One SD Innovations.

218 C. Sharma & R. K. Mishra

Figure 2. Response of India to Cholesky, One SD Innovations.

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t(quarter) 0 8 in our analysis. Results of the analysis demonstrate that eight of the nine countries, namely China, Indonesia, Japan, South Korea, Malaysia, the Philippines, Singapore, and Thailand, have broadly symmetrical negative response. Among the sample countries, only India shows a positive response to both global and regional shocks. Response of the Chinese output growth is negative throughout the study period to both global as well as regional shocks. Response of the Indonesian output growth is slightly different, as it is sluggish in the initial period, however, intensified in the latter period (after five quarters). Further, it shows positive response to the regional shocks but negative response to global shocks. Response of South Korea is interesting, it is slow-moving in the initial quarters but negative in the medium period and stable in the long period to both types of external shocks. In the case of Malaysia, it has positive response to global shocks in initial periods, but after five quarters, it demonstrates steep negative response to both types of external shocks. The Philippiness output growth appears to be inversely correlated to the global as well as the regional shocks. Response of Singapores output is mixed towards global and regional shocks. Specifically, the response of both types of shock is estimated to be negative in initial quarters; however, it turns out to be positive after the third quarter. Thailands output growth shows a negative response throughout the observation period to the global as well as regional shocks. In the case of India the evidence is different. It has slow response in the initial quarters, however, it picks up in latter periods. Nevertheless, it consistently demonstrates positive response to regional as well as to global shocks. In the case of Japanese, response of global shocks is positive; however, regional shocks, proxied by Chinese shocks, are identified to be negative throughout the considered time horizon. Next, we discuss the results of orthogonalized forecast error VD, which is based on Choleski factorization with particular ordering, namely: global shock, regional

Figure 3. Response of Indonesia to Cholesky, One SD Innovations.

Currency Area in East and South East Asia 219

Figure 4. Response of South Korea to Cholesky, One SD Innovations.

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shock, and country-specific shock. The analysis is done up to eight-quarter horizon. The VDs are presented in Table 2. The results of the VD of global, regional, and country-specific shocks for eight-quarter ahead forecast errors are produced by their innovations. The table shows that, as expected, the variations in countries output in first two quarters are mainly because of country-specific shocks except in the cases of India and South Korea, where it is mainly driven by global and regional shocks, respectively. In the latter quarters the impact of global and regional shocks has generally dominated across the countries. Only the case of Indonesia and Malaysia is identified to be different. In Indonesia the domestic effect is estimated to be above 90% throughout the time horizon, and the impact of both regional and global shocks on the domestic output is found to be negligible. Similarly, in the case of Malaysia, domestic shocks are found to be most crucial as even in the longer period (eighth quarter) it has more than 50% impact. In the case of South Korea (56%), the Philippines (55%), Japan (47%), India (46%), and Singapore (44%), the regional effect is recognized to be most important in the long-term horizon. On the other hand, Thailand (61%), China (59%), Singapore (41%), and India (37%) observe sizable impact from the global shocks in the long period. Overall, on the basis of these results, it can be inferred that the results do not offer a strong support of the proposition that Asian countries are economically integrated enough to form an OCA in the short-run. The main reason behind this inference is that these countries are strongly affected by their own country-specific shocks. The dominance of country-specific shocks may indicate towards the presence of different aggregate demand shock due to either monetary or fiscal policy changes or supply shocks on productivity or terms of trade (Bayoumi & Eichengreen, 1993).

Figure 5. Response of Malaysia to Cholesky, One SD Innovations.

220 C. Sharma & R. K. Mishra

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Figure 6. Response of the Philippines to Cholesky, One SD Innovations.

4.3. Robustness Check In order to test the feasibility of an OCA in the context of the European Union, Bayoumi and Eichengreen (1993, 1997) followed by Kim and Chow (2003) have introduced an index based on the degree of exchange rate variability, as measured by SD of the log of the bilateral exchange rate between a pair of countries. In this model, a high (low) correlation of aggregate supply shocks between two countries suggests that the economies are subject to symmetric (asymmetric) shocks and consequently likely (unlikely) candidates for an OCA. In the present study, we have computed SD of the log of the exchange rate and then constructed an index of their standard deviation (XSD).8 on the basis of XSD, we have constructed an index of rank (XSD Rank) of the sample countries. Further, the role of regional shocks as an important indicator of regional integration by measuring the extent of symmetric shocks, and thus suitability of countries in joining a currency area in the region, is well established in the literature. We consider Japan as the anchor and the prime source of regional shock. With this viewpoint, we first construct an index based on results of VDs of the regional shock (RS Index). On the basis of RS Index, we rank (RS Rank) the sample countries. Table 3 reports computed values of indices for each country and their ranks. We have constructed both indices with India (panel A of the table) and without India (panel B of the table). In terms of exchange rate variability, Singapore is ranked 1, as it has the lowest variability, while Indonesia has the largest variability in both panels. Focusing on the regional shocks in domestic output (RS Index), both panels suggest that South Korea has the largest value, while Indonesia has the lowest value. Next we estimate the Spearman rank correlations among the rank of indices and the values are reported at the bottom of Table 3. Confirming our previous results, the

Figure 7. Response of Singapore to Cholesky, One SD Innovations.

Currency Area in East and South East Asia 221

Figure 8. Response of Thailand to Cholesky, One SD Innovations.

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correlation coefficients appear to be negative, not sizable and statistically insignificant at the conventional level. Therefore, it seems that these economies are not very strong candidates for forming an OCA, at least in the present scenario. It is also noteworthy that inclusion or exclusion of India in the analysis does not alter these results considerably. 4.4. Concept of G-PPP and OCA So far the analysis of output co-movement and their reaction to various shocks has produced mixed results. In this section, therefore, we move further to examine the issue in an alternative way by focusing on the movements of real exchange rates. To this end, we utilize the concept of G-PPP proposed by Enders and Hurn (1994), which is essentially an alternative way of evaluating exchange rate behaviour across countries. According to the G-PPP theory, even though bilateral real exchange rates are generally non-stationary, they might be cointegrated in the long-run, if the longrun fundamental macro-economic variables that determine real exchange rates are highly associated. If this is true in a suitably defined currency area, then the real exchange rates in the area may share common stochastic trends, and at least one linear combination of various bilateral real exchange rates may exist that is stationary (see Enders & Hurn, 1994). Now, in what follows, we discuss the G-PPP theory and the related empirical methodology in brief (see Enders & Hurn, 1994 and Ahn et al., 2006 for further details). Assume that a subset of m'1 countries in an n-country world constitute a currency area. Given that there are only m independent real

Figure 9. Response of Japan to Cholesky, One SD Innovations.

222 C. Sharma & R. K. Mishra

Table 2. Results of forecast error VDs of domestic output
Period SE 2 4 6 8 Country-specific shock China 98.15782 47.20221 24.66158 27.77714 India 0.042825 7.233278 10.43332 12.93339 1.799352 45.56451 64.90510 59.28946 Regional shock Global shock

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2 4 6 8

37.20035 24.93906 18.92287 16.40275 Indonesia

42.50908 44.55575 46.22821 46.51138

20.29057 30.50519 34.84892 37.08587

2 4 6 8

99.83353 99.43193 97.36585 92.40364 South Korea

0.030827 0.364543 2.268160 4.709245

0.135642 0.203525 0.365988 2.887116

2 4 6 8

44.18149 37.75420 36.61644 40.45731 Malaysia

54.92190 61.18313 60.98224 56.83423

0.896609 1.062671 2.401329 2.708456

2 4 6 8

88.15653 75.13501 64.60440 54.73248 The Philippines

10.89798 19.36502 21.80383 21.18617

0.945487 5.499974 13.59178 24.08135

2 4 6 8

96.72099 68.17624 40.27880 27.51751 Singapore

2.423169 29.42664 49.29285 55.92816

0.855844 2.397121 10.42836 16.55433

2 4 6 8

63.55096 32.25324 19.08810 14.79469 Thailand

26.54588 36.84003 42.62098 44.11359

9.903159 30.90674 38.29092 41.09171

2 4 6 8

57.08141 18.07195 8.039384 4.875078 Japan

18.69839 35.62152 33.88931 33.23685

24.22019 46.30654 58.07131 61.88807

2 4 6 8

64.42786 38.92961 31.75629 29.09604

25.32312 38.58159 44.77222 47.68553

10.24901 22.48879 23.47149 23.21844

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Table 3. Results of Bayoumi and Eichengreens Indices XSD XSD Rank RS Index Panel A China India Indonesia Japan South Korea The Philippines Malaysia Singapore Thailand 0.023752 0.025722 0.053678 0.030296 0.035135 0.059998 0.022505 0.016597 0.023858 3 5 8 6 7 9 2 1 4 7.67 44.95 1.94 39.0875 58.477 34.26325 18.3125 37.5275 30.355 8 2 9 3 1 5 7 4 6 0.023752 0.053678 0.030296 0.035135 0.059998 0.022505 0.016597 0.023858 3 7 5 6 8 2 1 4 RS Rank XSD XSD Rank RS Index Panel B 7.67 1.94 39.0875 58.477 34.26325 18.3125 37.5275 30.355 7 RS Rank

Currency Area in East and South East Asia 223

8 2 1 4 6 3 5

XSD Rank RS Rank

Note: P-value in parentheses.

1.000

Spearman coefficients of rank correlation (0.116 (0.765) 1.000

1.000

(0.1428 (0.735) 1.000

224 C. Sharma & R. K. Mishra exchange rates within the subset of m'1 countries, we can write the reduced form solution for the m independent real exchange rates as follows: 2 32 x 3 1t a11 a12 . . . a1m1 x2t 7 6 ... ... ... 76 . . . 6 7 7 (2) Qt AXt 6 . 7 4 am1 am2 . . . amm1 56 4 . . 5 xm1t where Qt is the m )1 vector of real exchange rates, A is m )(m' 1) parameter matrix and Xt is the (m' 1) )1 vector of real fundamental variables such as output levels. As a matter of fact, the real exchange rate will be stationary and the empirical validity of PP will be confirmed, if all the elements of real fundamentals or Xt are stationary. Given the fact that the elements of Xt represent real shocks, each of the element is assumed to be non-stationary. Now, using the common trend representation developed by Stock and Watson (1988), we can express Xt as follows: Xt W/t ; (3)

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where C is the (m' 1) )(m'1) matrix of the parameters and ft is the (m' 1) )1 vectors of the non-stationary stochastic trends. Thus, the behaviour of the real exchange rates Qt is determined using Equations (2) and (3) as follows: Qt AW/t (4)

The behaviour of real macro-economic shocks and therefore that of real exchange rates depend on the rank of the matrix C . As long as the rank (C ) B m, it is always possible to pre-multiply Qt by m )m matrix b to obtain at least one cointegrating vector of the real exchange rates as follows: bAW 0: (5)

Equations (3) and (4) imply bQt 00. If the rank (C ) 0 1, all the elements of Xt share a single common trend and hence there exist m (1 linear combinations of the real exchange rates, which are stationary. Further, bQt 00 can be rewritten as follows: b2 q12 t b3 q13 t b4 q14 t . . . bm1 q1m1t 0: (6)

where qt is the real exchange rate defined as qt et p t pt (where et is the natural logarithms of the national currency price of foreign currency, p t and pt are the natural logarithms of the foreign domestic price levels, respectively). Equation (6) shows the long-run equilibrium relationship between the m bilateral real exchange rates within the group of m'1 countries. In the next step, we apply the multivariate cointegration technique to test and estimate the cointegrating relations. Now we advance our analysis further to test the potential of an OCA in the ESEA region by examining the empirical validity of G-PPP. As a matter of fact, for the GPPP to hold all the bilateral real exchange rates must be non-stationary individually and there should be at least one linear combination of all non-stationary real exchange rate which is stationary, that is I(0). As a prerequisite to cointegration analysis, we first test the order of integration of all nine real exchange rates. For this

Currency Area in East and South East Asia 225 purpose, we conduct the ADF and PP unit root tests and the results are reported in Table 4 which shows that all the real exchange rates are integrated of order one. After establishing that all variables are I(1), in order to assess whether the sample ESEA countries constitute an OCA using the concept of G-PPP, we perform the Johansen multivariate cointegration test. We have examined the cointegration test for all the sample countries with and without India and results are reported in panels A and B of Table 5. At the group level, the results of cointegration test confirm the presence of cointegrating relationship among the real exchange rate of the countries, as the results reveal that the null hypothesis of no cointegration is strongly rejected in favour of significant cointegrating relation among Asian real exchange rates. Trace statistics confirm the presence of 7 and 4 cointegrating vectors for full sample and the sample excluding India, respectively. This is a supportive evidence for the validity of G-PPP and OCA in the region. The presence of cointegration among real exchange rates of the ESEA countries implies that macro-economic fundamentals that drive real exchange rates are sufficiently interrelated, and hence bilateral real exchange rates of these countries share common stochastic trends in the long-run. Table 6 presents the result of normalized coefficients (panel A) and speed of adjustment parameters (panel B). We use Chinese currency (Renminbi) to obtain the normalized equations in the model. It is, however, noteworthy that there is no specific reason for the choice of Renminbi to create the normalized equations of real exchange rates, and any bilateral real exchange rate could have been utilized for the purpose. In our case the normalized vectors provide information on the interrelation among real exchange rates included in the study. These normalized coefficients can be interpreted as long-run elasticities between the real exchange rates. There seems to be some asymmetries in exchange rate adjustment process in response to any disequilibrium in the system. For full sample countries (row 1), while considering the US dollar-based real exchange rates a 1% rise in the Renminbi (real depreciation) leads to a real depreciation of around 4% in the Indian Rupees, 3% in Indonesian Rupiah, 1% in Korean Won, 14% in Singapore dollar, and 1.3% in Thai Bhat. Japanese Yen, Malaysian Ringgit, and the Philippines Peso have opposite movement,
Table 4. Results of unit root test US dollar-based real exchange rates Countries China India Indonesia Japan Malaysia The Philippines Singapore South Korea Thailand ADF (Level) 0.008020 (2.610610 (2.793979 (1.327378 0.325310 (0.750142 (1.200614 (1.450274 (1.594813 PP (Level) 3.833434 (2.366308 (2.730168 (1.327378 (0.360682 (0.881662 (1.061091 (1.474180 (1.624233 ADF (1st Diff.) (3.252968t' (8.207679* (9.307610* (10.03211* (4.650030* (10.01815* (4.512639* (4.194101* (7.333349* PP (1st Diff.) (5.684161t* (8.143852* (13.98435* (10.03031* (7.439881* (10.01150* (10.85103* (8.799987* (10.72266*

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Notes: (1) Asterisks (*) denote rejection of the null hypothesis at 5% significance level. (2) For the ADF and PP the null hypotheses are series contain unit root. (3) The optimal lag of respective model is determined based on modified SBC. (4) t donates inclusion of trend.

226 C. Sharma & R. K. Mishra

Table 5. Test of G-PPP: results of cointegration rank Eigenvalue Rank r 00 r 51 r 52 r 53 r 54 r 55 r 56 r 57 r 58 Trace stat. Eigenvalue Trace stat.

All sample countries (Panel A) 0.495810 0.410439 0.381687 0.273358 0.228662 0.175822 0.139892 0.091288 0.061208 316.4463** 238.3788** 178.1437** 123.3370** 86.93440** 57.33681** 35.29280** 18.11325 7.200388

All sample countries excluding India (Panel B) 0.439109 0.360521 0.287150 0.224714 0.151357 0.117148 0.088564 0.032468 231.7385** 165.8203** 114.8508** 76.26354** 47.24789 28.53864 14.33443 3.762756

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Notes: (1) Asterisks (**) denote statistically significant at the 5% level. (2) Critical values are taken from Osterwald-Lenum (1992).

which implies depreciation (appreciation) in Renminbi lead to appreciation (depreciation) in these currencies. It is noteworthy that results for other exchange rate do not change considerably when we exclude Indian exchange rate from the analysis, which reflects neutrality of India in the framework. Now we shift our attention on the results of speed of adjustment (panel B, Table 6). We utilize this result to explain how quickly a change in the real exchange rates in the system is inclined to correct itself in the VAR framework. For the US-based real exchange rate system, the largest coefficients are found in the case of Korea and the Philippines. The estimated coefficients for Korea ( (0.143) and the Philippines ( (0.093) imply that US dollar-based real exchange rate adjusts at the rate of 14.3% and 9.2% per month towards the long-run equilibrium (see row 3, Table 6). The adjustment coefficients in the case of Indian Rupees, Singapore Dollar, and Thai Bhat are moderate as they vary from 1% to 5%, whereas adjustment movement in Renminbi and Ringgit is estimated to be very small (below 1%). We also report results of speed of adjustment for the sample excluding India. The exclusion has affected the speed of adjustment of most of the currencies, nevertheless, their signs remain unaffected (see row 4, Table 6). On the basis of these results, we can conclude that the speed of adjustment is relatively high. However, some of the adjustment coefficients are small, which indicate that these currencies are weakly exogenous in the system. To some extent our results are in agreement with the results reported by Choudhry (2005) and Wilson and Choy (2007). Now we focus on two major emerging economies in the region China and India, and make an attempt to examine their suitability to become members in the possible OCA in the ESEA. For this purpose, we test the effect of other countries real exchange rate on the movement of Renminbi/US dollar and Rupees/US dollar real exchange rate in the cointegration framework. For this purpose, we utilize the fully modified OLS (FMOLS) estimator of Phillips and Hansen (1990). The technique is appropriate in the present case as it eliminates the problems caused by the long-run correlation between the cointegrating equation and stochastic regressor innovations, which is likely the case here. The FMOLS estimates are asymptotically unbiased and

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Table 6. Test of G-PPP: results of normalized equations and speed of adjustment parameters China Normalized coefficients (A) All sample countries (1) All sample countries excluding India (2) 1 1 Indonesia 2.8394 (0.446) 3.259031 (0.63932) Korea Malaysia The Philippines (8.1868 (0.997) (8.614644 (1.29675) Singapore 14.20126 (2.66796) 14.40280 (3.43588) Thailand Japan India 3.9275 (1.008)

1.0301 (6.3869 (0.518) (1.548) 2.735173 (4.360977 (0.73620) (1.75860)

1.310425 (3.3846 (1.13724) (0.79964) 1.578339 (3.028933 (1.63816) (0.97870)

Currency Area in East and South East Asia 227

Speed of adjustment parameters (B) All sample 0.000564 (0.014747 (0.143135 (0.001630 countries (3) (0.01115) (0.01447) (0.03275) (0.01886) All sample countries (0.008 (0.11731 (0.06444 (0.00044 excluding India (4) (0.00813) (0.02375) (0.01237) (0.00816)
Note: Standard errors are in parentheses.

(0.092515 (0.01643) (0.02407 (0.01171)

0.002310 (0.014552 (0.028050 (0.051624 (0.01104) (0.01654) (0.00951) (0.01380) (0.02325 (0.0411 (0.01623 (0.00697) (0.01003) (0.01342)

228 C. Sharma & R. K. Mishra has fully efficient mixture of normal asymptotics allowing for standard Wald tests using asymptotic x2 statistical inference. Results of the estimation are reported in Table 7. Column 1 reports results regarding India, which suggests that the real exchange rates of China, Indonesia, Japan, and the Philippines have significant impact on the Indian Rupee. However, the impacts of the first three countries exchange rate are observed to be negative, which indicate for their inverse relationship with India. Only the Peso and Ringgit have positive and significant impact on the movement of Indian Rupees. Therefore, the case of India as a member of possible OCA in the ESEA region appears to be somewhat weak on empirical grounds. Column 2 of the table reports results of China, which suggest that except Thailand, all other sample countries real exchange rate have significant impact on Chinas exchange rate movement. However, only Singapore and the Philippines currency have positive impact on the Renminbi. Therefore, we can conclude that results of the FMOLS analysis indicate that both China and India are not very likely candidates for the possible OCA in the region. 5. Conclusion The present article empirically assesses the level of regional integration and suitability of a monetary union in the ESEA region. For this purpose, we performed three alternative analyses to provide empirical evidence for an OCA. Estimation results of the bivariate relations of real output co-movements between the Asian economies suggest that out of 35 pairs of the sample economies the hypothesis of no cointegration is rejected for 28 cases, and only 7 country pairs do not show any cointegration relationship. Furthermore, the estimated cointegration coefficients suggest that most of the pairs have significant impact on each other, and therefore affect each other positively. On the basis of these results, it appears that the real output of these Asian countries move together in the long-run which in turn provides some support for the feasibility of monetary union in the region. Subsequently, to analyse the issue in more detail, we focus on the impact of three different shocks, namely global, regional and country-specific, on real output of the countries. To this end we employ techniques of impulse response and VD in the VAR framework.
Table 7. Determinants of India and Chinas real exchange rate: results of FMOLS regression Variable Constant China India Indonesia Japan Korea Malaysia The Philippines Singapore Thailand India (1) 1.498443** (0.451162) (0.069086** (0.027344) (0.2265** (0.068643) (0.0002** (0.096359) 0.059222 (0.066442) 0.157144 (0.205031) 0.324965** (0.135986) 0.039597 (0.317782) 0.230701* (0.176189) China (2) 13.66282 (1.513921) (1.880656** (0.762671) (1.767560** (0.287743) (1.316032** (0.415085) (1.073086** (0.294884) (2.914759** (0.877313) 3.151909** (0.593309) 3.197531** (1.450594) (0.180981 (0.880054)

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Notes: (1) Standard error is in parenthesis. (2) Asterisks (**) and (*) denote statistically significant at the 5% and 10% level. (3) R2 00.972386.

Currency Area in East and South East Asia 229 Results of the analysis reveal that regional shocks do not have dominant roles in the sample countries, which is an indication of unfavourable condition to form an OCA in the region. These results are further confirmed by the outcome of computation of the modified Bayoumi and Eichengreens Indices. Nevertheless, results based on GPPP are found to be somewhat supportive for the validity of G-PPP and OCA in the region. The existence of cointegration among real exchange rates of ESEA countries implies that macro-economic fundamentals that drive real exchange rates are sufficiently interrelated, and therefore, bilateral real exchange rates of these countries share common stochastic trends in the long-run. Finally, to investigate the candidature of India and China in the proposed OCA, we have tested the effect of other real exchange rates on the movement of both countries real exchange rate using FMOLS estimator. Results of the analysis indicate that there is no strong evidence to support the view that both India and China are likely candidates of the monetary union in the ESEA region. Overall results suggest that the degree of economic integration has increased among the ESEA countries in the post-Asian crisis period. However, considering the mixed results of this study and the recent European experience, it appears that the right time for the OCA has not come yet. And a still higher degree of economic integration is required to achieve to build a sound economic platform for the OCA. Thus, in the presence of a poor level of integration, presently these countries can pursue only a limited monetary cooperation. In addition, for structural convergence, which is extremely critical for the OCA, these countries can initiate further reforms in important areas, such as industry, financial sector development, capital account openness, and institutional and regulation. These measures may bring them a little closer in near future than now. Our results are somewhat not very favourable for China and India in the analysis. Perhaps the de facto exchange rate policy of China is the reason behind this scenario, and it is becoming one of the biggest hurdles in the process of integration in the region. Therefore, for a coordinated process to begin in the region, China needs to increase its exchange rate flexibility, and accepts the market-driven appreciation of its currency and abandon its existing stabilization policy. On the other hand, the policy suggestion for India is straightforward. If it is looking forward to be a possible candidate of the OCA, then it should consider integrating itself more intensely with other economies in the region in the near future. In this concern, the central bank of the country needs to abandon some its excess risk averse strategies and initiate long waiting reforms in capital account convertibility and financial market. Acknowledgements
We thank two anonymous referees of this journal for their useful comments and helpful suggestions on the previous version of this article. Any errors or omission are solely ours.

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Notes
1 2

OCA and monetary union is used interchangeably in this study. It is also argued that with greater regional monetary and exchange rate stability, the region may become more attractive for foreign investment (Benassy-Quere, 1999). However, the formation of OCA would lead to the loss of monetary autonomy. This will restrict countries to follow export-led catch-up strategy, which worked effectively before the 1990s (see Fabella, 2000). Another problem is the great diversity (in

230 C. Sharma & R. K. Mishra

terms of culture and religion, etc.) among countries in the region which could potentially create some serious problems in the formation of the OCA (see Kawai & Takagi, 2000). The historical facts also suggest that the pattern of use of stabilization policies in the region varies signicantly. 3 See, for example, Park and Park (1990), Frankel (1991, 1993), Bayoumi and Eichengreen (1994), Taguchi (1994), Kwan (1998), Chow and Kim (2003) and Shirono (2007), just to name a few in the long list of recent studies. 4 In the last decade ASEAN countries have increased their trade and nancial relationship with China, Japan, and India. Many agreements have been signed between these economies in direction of free trade zone and monetary cooperation, for instance, ASEAN-China free trade zone, Tokyo Declaration, ASEAN-India Trade in Goods Agreement (TIG) and other AIFTA-related Agreements. 5 Further, in a relatively narrow sense some other important conditions for the formation of an OCA are (1) a large market size, (2) high degree of openness in trade, (3) high degree of intra-regional economic interdependence, (4) symmetry between shocks across countries, and (5) less dependence on exchange rate as an instrument for correcting macro-economic imbalances (Kwan, 1998). Further, some authors have also argued for a supra-national government body able to conduct interregional transfers (see De Grauwe, 1997). 6 Although the idea is theoretically appealing, empirical literature on trade and international nance has not reached a consensus as to whether a large degree of trade relationship between countries will result in correlated business cycles (see Hallett & Richter, 2006). In this regard, evidence presented by Kose et al. (2003) reveals that international trade relationship does not necessarily lead to the synchronization of business cycles. 7 To conserve space, we do not report results of unit root test here but would be made available upon request. 8 It is noteworthy that Bayoumi and Eichengreen (1993, 1997) have consider four factors the SD of relative output growths, the dissimilarity of the composition of exports, the extent of bilateral trade, and the average size of the economy for constructing the index of exchange rate variation. We have broadly followed Kim and Chow (2003) and have taken the variation of exchange rates.

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