The debate whether the exchange rate should be fixed or flexible has remained unresolved ever since Milton Friedman began championing the cause for exchange rate flexibility. Advocates of both corner solutions can be found on either end of the economic theory spectrum. A Keynesian economist would argue for instance that a flexible exchange rate could absorb external and internal shocks without affecting domestic price and wage levels, while his support for

For the needs of this paper, I refer to the ten ASEAN countries together with China, Japan and (the Republic of) Korea (known as ASEAN+3) and Hong Kong and Taiwan as East Asia. For instance Fukuda (2006), Ogawa (2002), Ogawa and Kawasaki (2006).

a fixed exchange rate regime would be based on the belief that it provides a necessary protection from speculative attacks (that result from imperfect foreign exchange markets): the later being a defence for his devising and supporting the Bretton Woods. On the other hand, a market economy believer would argue that flexible exchange rates are a necessary condition for retaining independence of domestic monetary policies under free capital movement (that is indispensable for efficient functioning of a market). Yet fixed exchange rates could, in his reasoning, provide a nominal anchor necessary for stabilising flexible domestic prices and wages. The debate is far from being resolved and in practice a wide range of intermediate regimes has been in place. The Asian currency crisis constitutes a milestone in the debate on the optimal exchange rate regimes for East Asia. Most of the region had adopted a de facto dollar peg before the 1997 crisis (despite official claim of managed float or basket peg). Undoubtedly, the fixed exchange rates helped to encourage capital inflows that contributed to the excellent performance of East Asian economies before 1997. Yet even then the vulnerabilities of the system were quite obvious; the high interest rates necessary for stabilising rapidly growing economies were encouraging more portfolio investment that in turn contributed to the overheating in the region (the impossibility to maintain fixed a exchange rate, capital mobility and independent monetary policy at the same time). After 1997, while leaving the debate on two corner solutions still largely unresolved, the focus of the debate here has shifted to costs and benefits of three alternative exchange rate regimes, a return to the dollar peg, a currency basket regime and a monetary union for East Asia. Aside from the return to the de facto dollar peg after the crisis, some analysts have argued in favour of explicit adoption of a dollar peg (Hong Kong chose to do so ahead of the uncharted days post-merger with China).4 For reasons ranging from transaction costs, direction of trade flows to historical conditions at least some countries of East Asia could be considered as a part of a “greater dollar zone” (with Canada, Mexico and parts of Latin America being a “natural dollar zone”). As Fukuda (2006) convincingly shows, for reasons of history and expectation, invoicing in dollars dominated in Thai (85.7 percent in 2001, down from 92.0 percent in 1997) and Korean (87.43 percent in 2001 down from 89.21 percent in 1997) transactions in spite of the fact that their trade with the United States amounted to only 20.3 and 20.9 percent respectively (against 49 percent of East Asia share in Thailand and 44.3 percent share of East Asia in Korea’s trade). History, lower transaction costs, and a nominal anchor for stabilisation policies constitute the main arguments in favour of a dollar peg. On the other hand, the arguments on the loss of independent monetary policy and the possibility of asymmetric shocks still hold (Table 1).

For instance McKinnon (2004) or Barro (2004).

Source: From Loosely based on Wyplosz (2002) and Ito and Park (2004).

Although being the second best solution, the de facto dollar peg has returned in practice as the first choice of an exchange rate regime in East Asia. But much more attention has been paid to a currency basket peg and to a currency union as optimal forms of monetary unification in the region. Many academicians would prefer the former while the policy makers in the regions apparently favour the latter one. One of main arguments in favour of a basket regime is its ability to stabilise real effective exchange rates (as such a basket would contain currencies of major trading partners). Regarding quite high trade weight with Japan and the European Union, the argument that a basket, apart from dollar, containing the euro and Japanese yen could mitigate the 1997 crisis looks fairly plausible. Another argument in favour of a currency basket peg is its moderating influence on capital flows. Comparing to a single currency peg, a basket peg contains a higher exchange rate risk and therefore has a depressing influence on capital flows. A basket peg provides an economy with some stabilising anchor (compared to a flexible exchange rate) and with more flexibility than would happen under a fixed exchange rate regime.5 There are, however, also some difficulties associated with a currency basket peg. First, complicated basket calculations would certainly result in a loss of transparency. Given difficulties in immediate evaluating the actions the monetary authorities undertake, the credibility of the basket peg may be adversely affected. Needless to say, interventions within the currency basket While the idea of the currency basket for East Asia that comprises three major world currencies has been promoted mainly in Japan, it does not seem to have been given a lot of consideration in other countries of the region. Instead, an alternative of a basket that would be composed of regional currencies has been suggested. I am grateful to Woosik Moon of Seoul National University for pointing this issue in an earlier version of the paper.

regime may be technically much more complex than those that take place under a single currency peg. Second, since each country’s optimal basket is different, adopting a currency basket peg may result in difficulties in policy coordination in the region.6 Table 2 summarises the main costs and benefits of a currency basket regime.

The benefits of monetary union outweigh its costs when the union’s partners are trading intensively with each other, when their economies business cycles are correlated and they suffer from symmetric shocks, when there is high degree of policy coordination in place, production factors mobility between member states is high, financial markets well developed and so on. In other words, when the entire region constitutes an optimum currency area (OCA). This section attempts to address briefly this issue. Most empirical evidence seems to suggest that the region does indeed satisfy the OCA conditions, more or less. Trade openness indices for East Asian economies (defined as a share of total trade in a country’s GDP) show that, with the notable exceptions of Myanmar and Japan, the economies of the region are as open as the EU-15 and more open than the EU economies were in 1990 (before the Maastricht Treaty, Table 4).

For instance Hanke and Schuler (1993).

East Asian economies do similarly well on account of the intra-regional trade. For instance Kawai and Motonishi (2005) as well as Yano and Van Anh (2006) show that the intra-regional trade in East Asia has already reached the level comparable to the pre-Maastricht European Union (Fig.1). The caveat is that the ASEAN economies do not trade much between themselves; in 2003 only 24 percent of their trade was reaching other ASEAN countries. The same applies to the Asian New Industrialised Economies (NIEs; Hong Kong, Korea, Singapore and Taiwan); only 16,1 percent of their trade was directed to the region in 2003. But the trade between the ASEAN, the NIEs and China already accounted for 44.1 percent of their total trade in 2003. When the trade with Japan is included the intra-regional trade amounts to 54 percent of the region’s total trade. Figure 1 (based on Kawai and Motonishi, 2005) shows that this is more than the intra-regional trade within NAFTA and it is comparable to the intensity of the intra-regional trade in the European Union in 1990 (before the Maastricht Treaty). Even more support on the OCA criteria comes from the estimated correlations of real sector macroeconomic variables (real GDP, real personal consumption, and real gross fixed capital formation) as well as financial variables (real money supply, real stock price, and real effective exchange rates) and price variables (GDP deflator, consumer price index, and wholesale price index). Kawai and Motonishi (2005) estimations for the period 1983-2000 as well as Yano and Van Anh (2006) results for 1980-2002, show that East Asian economies do on this account no worse than European countries. A similar conclusion emerges from estimations of demand and supply shock correlations for East Asia, EU15 and NAFTA. The results9 show a similar level of correlation for all groups of countries. Given the specific character of the criteria in question (i.e. once a monetary union has been formed, economic integration will deepen and the degree of asymmetry of shocks will decline) the results support the plausibility of an East Asian monetary union. Some problems arise when the labour mobility criterion is tested. Although limited availability of data constitutes a serious difficulty, Yano and Van Anh (2006) conclude that the labour mobility in the region is rather low. For major economies (Japan, Korea, Taiwan, and Thailand), the approximate stock of migrant workers in 2000 did not exceed 1-2 percent of the labour force in spite of enormous income disparities between labour exporting and labour importing countries (PPP adjusted income per capita in Japan, Singapore, and Hong Kong is 8-9 times higher than that in Indonesia or Philippines). Only Hong Kong (5-7 percent), Malaysia (10-15 percent), and Singapore (25-27 percent) have shares of migrant workers higher than average. In the presence of high capital mobility (except for Malaysia and China) one may argue that, similarly to Europe, labour mobility has largely been replaced with trade and capital flows. The quality of institutional framework constitutes another serious difficulty for East Asia as shown in Chan-Lee (2005). In spite of a relatively high level of capital account openness, the quality of the financial sector prevents capital flows Kawai and Motonishi (2005), Kwack (2004), Yano and Van Anh (2006) and Zhang et al. (2004)

from being efficiently utilised. Table 5 (based on data from Chan-Lee, 2005) presents, apart from the capital account openness, the assessment of the quality of financial systems (scale 1 to 10) and the perception of business environment (here the reversed Price Waterhouse and Coopers’ “business opacity” index). While some of the East Asian countries (Hong Kong, Japan, Singapore or Taiwan) managed to establish relatively sound financial systems, much is to be done to match the level of the EU “southern periphery” (Greece, Portugal, Spain) not to mention the United States. The problems are aggravated by phenomena common for most of emerging market economies such as insufficient property rights protection and contract enforcement, poor transparency, low level of corporate governance and widespread corruption.

Except for Hong Kong and Singapore, the perception of the business environment in East Asia is not encouraging. Poor condition of the region’s financial markets damages East Asia’s image as an optimum currency area. To summarise, on most of accounts East Asia (or at least its parts) seems to be satisfying the OCA criteria. Even if not matching the level of the EU monetary union member countries, East Asia is close to the levels the EU member states had reached before they started the process of monetary unification (i.e. before the Maastricht Treaty). However, the disparities between the East Asian countries are much bigger than in Europe and much is to be done in the area of institution building. Nevertheless the answer to the question whether East Asia needs its monetary union seems to be largely positive (at least for parts of the region). 4. A Lack of Political Will? This section attempts to address the issue of whether it is the lack of political will to implement a monetary integration that is responsible for the slow progress in achieving the goal. There may be no straightforward answer to this problem. On the one hand, there is abundance of political initiative towards deepening integration in the region. ASEAN+3 heads of state have met annually since 1997. Even before their first meeting took place, the Manila Framework Group, a regional surveillance body had been established in November, 1997. Other initiatives include a bilateral swap arrangement (Chiang Mai Initiative) in May, 2000, establishing an inter-governmental East Asia Study Group or the non-government East Asia Vision Group (both agreed at the November, 2000 meeting in Singapore), the Asian Bond Initiative of 2003 and so on. A series of bilateral negotiations has produced a handful of bilateral free trade agreements between countries of the region. Despite being often highly publicised, many of those initiatives never develop beyond the stage of a study group or a political statement: see Table 6. Even the most successful one, the Chiang Mai Initiative still does not seem to be fulfilling its entire potential. Verbal support and statements of good will do not change the fact that, in contrast to Europe, East Asian governments seem to be very reluctant to delegate parts of their prerogatives to supranational institutions.

The East Asian path to monetary unification suffers from the adverse effects of its reversed order (capital account liberalisation ahead of monetary integration) Another way of reasoning would be that they had to liberalise their capital accounts precisely because their capital markets were not developed enough to stem capital inflows necessary for high growth rates. It is a good question whether we can really think about a single unified China in economic terms; systemic and income differences between the regions (Hong Kong, Shanghai, Beijing, the island of Hainan, Manchuria, Tibet, Inner Mongolia, western provinces etc) are so big that one can think about the country as a group of economic entities (forcibly) unified in political terms as for instance the British Empire once used to be. It is precisely as the line of argument runs in Nakashima (2006).

that creates a conflict between monetary cooperation (understood by the region’s opinion makers as a capital movement liberalisation) and exchange rate coordination (ranging between a single currency or currency basket peg and currency union altogether). Also the misconception about the sequence of economic integration (i.e. taking the Balassa, 1962 theory prima facie) has taken its toll on the speed of monetary integration in the region (or may take in the near future). Together with the lack of regional leadership (the role Germany has played in European processes), specific political environment that precludes bold political initiatives, and, to put it straightforward, lack of political vision for the region’s future (i.e. political union) probably rules out any monetary union in East Asia in the near future. However that does not mean nothing can be done in order to deepen monetary integration in the region. In my opinion, the following measures could be helpful for establishing the monetary union in East Asia in the mid- and long run. First, political energy should switch from concluding bilateral FTA towards establishing at least a customs union in the region.13 Then, building sound financial markets should follow. The character of the optimum currency area theory allows for almost discretional interpretation of results. But, let aside Mundell’s original criteria, it is the soundness of the financial system that spells the ability to withstand the adverse shocks that are likely to accompany the monetary unification project. At their current condition East Asian financial markets are as weak as they were at the onset of the 1997 currency crisis and probably could not withstand any similar challenge. Third, through strengthening the Chiang Mai Initiative, the joint surveillance of economic policies and coordination of exchange rate policies could ultimately lead to establishing a decision making framework (or institutions) based on the principle of mutual consent. Only from that point can one realistically think about the East Asian monetary unification process. Besides, there is the problem of what to do with China. If the country is going to assume leadership in the region, then a phased opening of its capital markets has to take place at some time. But, analogously to the Russia’s relations with the EU, there is a well-grounded doubt about the wisdom of creating such an unbalanced integration body. The monetary unification in East Asia is not a political illusion. However, it is not an immediate necessity either. As the Economic and Monetary Union in Europe has taken half a century to materialise, also here, after having addressed its specific problems, fifty years from now, East Asia may be well on its way to a monetary (and economic) union. Author statement: I am grateful to Sadayoshi Takaya of Kansai University, Junji Yano of Hiroshima University and other participants of the Japan Society for Monetary Economics International Finance Division meeting held on April 7, 2007 at Kansai University in Osaka, as well as to Thomas Wright of Ryukoku University for their helpful comments. The usual disclaimer applies. Or parts of it if political considerations allow for excluding the weak elements of the system