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Which country should be the monetaryanchor for East Asia: the US, Japan orChina?Chee-Heong Quah a & Patrick M. Crowley ba Faculty of Business and Accountancy , University of Malaya ,Kuala Lumpur, 50603, Malaysiab College of Business , Texas A&M University - Corpus Christi ,6300 Ocean Drive, Corpus Christi, TX, 78412, USAPublished online: 05 Jan 2012.
To cite this article: Chee-Heong Quah & Patrick M. Crowley (2012) Which country should be themonetary anchor for East Asia: the US, Japan or China?, Journal of the Asia Pacific Economy, 17:1,94-112, DOI: 10.1080/13547860.2012.640004
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Journal of the Asia Pacific EconomyVol. 17, No. 1, February 2012, 94–112
Which country should be the monetary anchor for East Asia:the US, Japan or China?
Chee-Heong Quaha∗ and Patrick M. Crowleyb
aFaculty of Business and Accountancy, University of Malaya, Kuala Lumpur 50603, Malaysia;bCollege of Business, Texas A&M University - Corpus Christi, 6300 Ocean Drive, Corpus Christi,
TX 78412, USA
In this paper, we apply the optimum currency area (OCA) criteria to assess the suitabilityof whether the US, Japan or China would best serve as the monetary anchor countryfor East Asian countries. The OCA criteria used are trade openness, business cyclesynchronisation, real exchange rate volatility, inflation convergence and real interestrate cycle synchronisation. The ‘performance’ of these potential anchor countries iscompared before and after the Asian financial crisis. The findings suggest an increase inthe potential for China as a monetary anchor in the future but the US dollar likely stillis the most obvious choice of anchor currency. From an endogenous OCA perspective,the findings also broadly support the existing currency boards in Hong Kong and Macauand the monetary union between Singapore and Brunei.
Keywords: optimum currency area; Asia; monetary union; business cycle; China;money
JEL classifications: E62, F31, F32, F41, F42, O53
1. Introduction
The international monetary system broke down in 1971 and we moved towards a system whereevery country has its own national monetary system with flexible exchange rates . . . I thinkit is a destructive paradigm, because no one seems to have noticed the fact that there were nofinancial crises during the Bretton Woods period . . . (and) under the gold standard, either.(Mundell 2009, p. 494)
The quotation above demonstrates the continuing relevance of fixed exchange rates,particularly in the wake of the recent global financial and economic crisis.
Indeed, on 25 October 2009, at the Southeast Asian Summit, Yukio Hatoyama, PrimeMinister of Japan suggested a common currency for East Asia while Australian PrimeMinister, Kevin Rudd, proposed a pan-Pacific economic community that would include theUS. Their views are consistent with a poll of corporate executives almost a decade agoin 2002, where 43% of respondents favoured an eventual monetary union in the region(Lincoln 2004).
A leap forward in regional collaboration began in May 2007 when the ASEAN1+3(ASEAN plus Japan, Korea and China) countries agreed on the ‘Chiang Mai Initiative’,
∗Corresponding author. Email: [email protected]
ISSN: 1354-7860 print / 1469-9648 onlineC© 2012 Taylor & Francis
http://dx.doi.org/10.1080/13547860.2012.640004http://www.tandfonline.com
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a network of bilateral swap agreements founded in May 2000 which allows the Asiancountries to borrow funds from one another. The issuance of an Asian Currency Unit(ACU) and bonds denominated in ACU was also proposed. On another front, the recentreconciliation in 2008 between China and Taiwan, long-time arch-rivals since a civil warsplit, was accompanied by liberalisation in foreign exchange, immigration and trade, whichalso enhanced prospects for regional integration.
In the midst of the recent global economic downturn, in 2009, the Special ASEAN+3Finance Ministers’ Meeting endorsed an increase in the size of the Chiang Mai Initia-tive Multilateralisation (CMIM) from US$80 billion to US$120 billion, and at the 12thASEAN+3 Finance Ministers’ Meeting, agreement on all main components of the CMIMwas reached.2
One key motivation behind these efforts and the desirability for monetary union isthe continued progression towards interdependencies within the region. In the early 2000s,more than half of East Asian trade was with itself and the share of intra-regional trade withinthe region was comparable to that in EU, but exceeded that of NAFTA (North American FreeTrade Agreement) (Kawai and Motonishi 2005). Moreover, business cycles in the regionhave been increasingly synchronised as a result of: (1) regional proximity and growingdirect trade linkages, (2) intense intra-regional competition in exports to third markets suchas the US and Japan and (3) vulnerability to fluctuations in the yen–dollar rate (McKinnonand Schnabl 2003). Bayoumi and Eichengreen (1994) Kawai and Takagi (2005) and Quah(Forthcoming) even concluded that East Asia came as close as Western Europe to being asingle currency area.3
Nevertheless, the choice of monetary anchor for East Asia has rarely been exploredin the literature. The primary objective of this paper is to evaluate the appropriateness ofthe US, Japan or China as the anchor country according to the criteria suggested by thetheory of optimum currency areas (OCAs). The evaluation is based on five OCA criteriaand these are specified as trade openness, synchronisation in business cycles, volatilityof the real exchange rate, inflation convergence and synchronisation in real interest rates.Comparisons are made between the period before the Asian turmoil of the late 1990s andthe period after.
An ‘extended East Asia’ comprised 16 East Asian economies (Brunei, Cambodia,China, Hong Kong, Indonesia, Japan, Korea, Laos, Macau, Malaysia, Myanmar, the Philip-pines, Singapore, Taiwan, Thailand and Vietnam), plus India, Australia, New Zealand andCanada are included in the analysis.4 Among these economies, Hong Kong and Macau havecurrency board systems anchored to the US dollar since the 1980s (Macau implements itscurrency board anchor with the HK dollar, which in turn is anchored with the US dollar),while Singapore and Brunei have operated a monetary union since the 1960s based on anundisclosed basket of currencies. A subsidiary objective is to evaluate how these economiesmight fare with greater fixity in their exchange rate regimes using the same measures.
Of course, fixed exchange rate regimes come in various forms, and the exchange rateregimes envisaged do not necessitate a ‘hard’ peg akin to the euro area in the 1999–2003period, but might include the choice of a ‘softer’ peg for Asian currencies. Several academiccontributions have already explored the idea of implementing a target zone arrangementin Asia, an arrangement that has already been dubbed as an Asian Monetary System (or‘AMS’) by some authors (e.g. Yamashita 2009, Chey 2010). This might involve (1) usingan existing currency as an anchor for the system or (2) might involve the creation of anew Asian Currency Unit (or ACU) similar to the European Currency Unit (ECU), thecurrency basket that acted as the anchor for the exchange rate mechanism (ERM) of theEuropean Monetary System (EMS) from 1999 onwards. In either case, our work is still
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relevant as if one country’s currency emerges as an obvious anchor, then this would suggestusing an existing single currency as an anchor for an AMS-type arrangement, and if onlythe currencies indigenous to Asia emerged as the obvious anchors, then this would suggestthat, in theory, a newly constructed ‘ACU’-weighted basket arrangement might be mostappropriate.
The remainder of this paper contains three sections. The second section discusses thecurrent literature on potential monetary anchors for East Asia. The third section introducesthe criteria and assesses countries in the region with reference to the US, Japan and Chinain terms of the criteria. Finally, in the fourth section, we conclude.
2. Current literature
Given the fact that some of the world’s largest economies are in Asia, the designation of amonetary anchor country for East Asia is not only of considerable theoretical importance,but also of practical relevance, particularly for ease of transition and enhanced credibilityin the stages towards a possible Asian monetary union. Due to the absence of institutional,political and economic groundwork such as that exists in the EU, a monetary anchor wouldenable East Asia to leap-frog towards a currency area if potential members, including Japan,were willing to entertain the use of a monetary anchor (Mundell 2003).
The need for a pivotal external anchor was also implied by Menon (2008). As he pointedout, the attempt by Laos to de-dollarise in 1997 has proven to be counter-productive asthe depreciation of the Laos currency, the kip, had more than offset any increase in thevolume of usage as a result of policing measures, leaving its value share in currency incirculation lower than it was before. The causes of the depreciation of the kip were believedto have emanated from macroeconomic instability, political uncertainty, an underdevelopedfinancial and monetary system, and weak legal and institutional systems.
Meanwhile, there are serious impediments for adopting a common currency basket ifmajor currencies continue to be highly volatile5 as it would: (1) entail complex hedgingstrategies, (2) suggest that authorities maintain sufficient liquidity in not just one but a fewmajor currencies in order to keep their currencies sufficiently close to the target valuesdefined by the common basket and (3) require picking the appropriate official weights for acommon basket, which could be problematic for a variety of economic and non-economicreasons.
Viewed in this light, at present, the US, Japan and China are the countries that scholarstypically focus on when considering potential monetary anchor countries for the region.
More than a decade ago, Kwan (1998) evaluated the feasibility of a Japan bloc inAsia but the empirical evidence used did not support it. Many Asian countries display lessdependence on Japan, as their relationships have been supplanted by the rise of China asa major trading nation and the emergence of the Asian newly industrialised economies(NIEs).6
According to Kwack (2004), besides Japan, China continues to play a leadership rolein the push for greater regional monetary integration and cooperation. In addition, theinflation rate in Japan has been significantly lower than those of other East Asian countries,partly due to the prolonged downturn in the Japanese economy during the 1990s and 2000s.This could be a deterrent to regional integration efforts. On the potential for China to be aregional monetary anchor, Hefeker and Nabor (2005) argued that even though China wouldeventually become a more important destination for Asian products than Japan, it is ratherunlikely that the yuan will assume a dominant role immediately; the Chinese financial
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markets are still underdeveloped and its foreign capital flows are still heavily controlled bythe state.
In the meantime, Lim (2005) discovered that co-movements of prices could supporta common dollar or yen area for Hong Kong, South Korea, Malaysia, the Philippines,Singapore and Thailand. Lim also found that countries whose exchange rates had divergedsignificantly from the Japanese rate are South Korea, Malaysia and Thailand. Conversely,Kawai and Motonishi (2005) detected that the degree of emerging East Asia’s real economicinterdependence with Japan is greater than that with the US, while the degree of its nominaleconomic interdependence with Japan is as equal to that with the US. At the same time,Bowman (2005) discovered that the US has already declined in importance in the post-crisis East Asia, while Australia and Japan are becoming increasingly important regionalinfluences.
Some scholars continue to stress the supremacy of the dollar in East Asia. For example,Chow et al. (2007) have confirmed Frankel and Wei’s (1994) finding that the dollar stillplays a prominent role in the exchange rate policies of East Asian economies beyond theshort run. Moreover, as McKinnon and Schnabl (2004) point out, the dollar is widely usedas the invoice currency for most East Asian trade even though Japanese trade in the regionis as large as that of the US; only about half of Japan’s overall exports are invoiced in yen,while three quarters of its imports are invoiced in dollars. Also, Rogoff (2005) has shownthat many developing countries in East Asia still have high levels of debt dollarisation inthe post-crisis era. The present authors of this paper, Quah and Crowley (2010), have alsofound a significant rise in the degree of convergence in East Asia against the US after theAsian crisis (see also Quah and Ismail 2009).
Given the above, it is interesting to assess the appropriateness of whether any of thethree largest economies today, the US, Japan or China, might be the most feasible monetaryanchor country for any potential East Asian monetary standard.
3. OCA criteria
The foundations of the OCA theory were laid out by Mundell (1961) and McKinnon (1963),before being refined by, among others, Kenen (1969) and Krugman (1990). The OCA theoryoutlines criteria under which a country can reap large benefits and/or substantially reducethe cost of joining a currency area. As summarised by Boreiko:
The OCA theory concerns certain benefits and costs associated with adopting a single currencywhich depend on the degree of convergence of the economies. The benefits are associated witheconomizing on exchange costs and importing the credibility of the union’s central bank, thusreducing the inflationary expectations and level of inflation. As for the associated costs, theyare essentially the opposite of the benefits of having an independent monetary policy andexchange rate, which are useful as a means of coping with shocks that are asymmetric betweenthe potential monetary union partners. (2003, p. 315)
Following Quah and Crowley (2010), the OCA criteria investigated are trade openness,business cycle synchronisation, real exchange rate volatility, inflation convergence and realinterest rate synchronisation. The same set of criteria was used by Artis and Zhang (2002)and interestingly the efficacy of the criteria was evidenced when Portugal, Italy, Greece andSpain were selected as the group which possesses the least similar OCA features againstGermany. This group of four member states currently represents some of the most distressedeuro area members.
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In this section, the five reference-dependent criteria are assessed for 20 countries againstthe US, Japan and China using data before and after the Asian financial crisis. Constrainedby data availability, the pre-crisis period is set to be 1981–1997 and the post-crisis periodis 1998–2007. The following discussion evaluates the relative importance of the referencecountries – the US, Japan, and China – with respect to the OCA criteria. Table A1 inAppendix 1 contains data definitions and sources.7
3.1. Trade openness
The OCA theory suggests that countries which trade a great deal with each other are goodcandidates for monetary integration as the benefits in terms of transaction cost savingsand exchange rate should be greatly enhanced (McKinnon 1963). Accordingly, Bayoumiand Eichengreen (1997) have detected that European countries which achieved the greatestlevels of bilateral trade also experienced the greatest increase in their readiness for monetaryunification. Indeed, as suggested by Edison and Melvin (1990), in choosing which currencyto peg to, a country should emphasise a bilateral trade criterion.
A bilateral trade intensity measure, as used by Artis and Zhang (2002), Boreiko (2003)and Nguyen (2007), is adopted here to measure a country’s trade openness with the referencecountry. For a candidate country i, trade openness with the reference country is measuredby bilateral trade intensity, (xi,r + mi,r ) / (xi + mi), where xi and mi are the exports andimports of goods of the country and subscript r indicates destination to or source from thereference country. Period averages are used.
Figures 1 and 2 exhibit the scatterplots comparing the bilateral trade intensities with thereference countries – the US, Japan and China – for the pre-crisis and the post-crisis period,respectively. The scales on the axes represent the relative importance of one referencecountry over the other.
The horizontal axis represents the ratios of trade intensity with China over that withthe US, expressed as the square root in which a value greater than 1 (on the right of thevertical line crossing at 1) indicates that China is more important for trade, while a valueless than 1 (on the left of the vertical line crossing at 1) signifies that the US is moreimportant. A right shift between the two periods indicates increased importance of Chinaover the US, whereas a left shift indicates increased importance of the US over China.The same applies to the vertical axis measuring relative importance of Japan and the US.The square root transformation is used to enable visual comparisons without affecting thequalitative results.
Since both axes are measured against the US, the relative importance of Japan andChina can also be compared. Those countries on the left of the diagonal line have relativelymore trade with Japan than with China, and those on the right have relatively more tradewith China than with Japan. A southeast shift indicates increased importance of China overJapan, while a northwest shift indicates increased importance of Japan over China.
Based on the analysis above, for countries located at the lower-left quadrant of the plot,the US is most important in relation to both Japan and China. For those placed at the upper-left quadrant and at the left triangle of the upper-right quadrant, Japan is most importantrelative to both the US and China. Similarly, for those positioned at the lower-right quadrantand at the right triangle of the upper-right quadrant, China is most important vis-a-vis boththe US and Japan.
As shown by the southeast shift of the countries between the two periods, the risingrole of China and the declining role of Japan in the region’s trade are clearly in evidence.Based on the position of the majority of the countries, for the pre-crisis period, China is
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3.002.502.001.501.000.500.00
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Figure 1. Trade openness for pre-crisis period. Note: See Appendix 1 for data description.
least important, while the US and Japan are almost equally important as trading partners.For the post-crisis period, the US is still the most important, while China and Japan areroughly equally important.
Virtually all countries, including Japan and the US, have traded relatively more withChina and based on the distance of the shift, the largest relative increase in trade with Chinais for Korea and the Philippines. Indeed, China has always been the most important tradingpartner for Hong Kong and Myanmar. Idiosyncratically, though, Myanmar has experiencedthe greatest drop in trade with China.
Despite the rise in China’s economic power, the US has always been most importantrelative to other reference countries for Canada, India, Korea, Singapore, Taiwan, and evenJapan. Based on the distance between their positions in the figures for the two periods,Cambodia and Vietnam exhibit the greatest rise in trade with the US, and the Philippinesreports the greatest fall in trade with the US.
Meanwhile, Japan has always been a more important trading partner for Australia,Brunei, Indonesia and Thailand. However, Brunei and Indonesia, together with Laos andMyanmar, also maintain the greatest reduction in trade with Japan relative to the US andChina.
In summary, with respect to trade relations, the US is still the most influential for theregion despite the rising role of China and the declining role of Japan.
In another respect, for Hong Kong and Macau, the two effective dollar areas, there hasbeen somewhat of a rise in relative importance of China over the US and Japan, more so
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Figure 2. Trade openness for post-crisis period. Note: See Appendix 1 for data description.
for Hong Kong, which is consistent with the return to Chinese rule after the Asian crisisand the fixed yuan–dollar rate in 1995–2005. Singapore and Brunei have also moved in thesame direction, showing a decline in the relative importance of Japan and the US as tradingpartners, and more so for Brunei.
3.2. Business cycle synchronisation
It is clearly understood that when business cycles are more synchronised between twocountries, the argument for flexible exchange rates which serve as a shock absorber toresolve asymmetric recessionary or inflationary pressures becomes largely irrelevant. Inthe light of this, the higher the business cycle synchronisation of an East Asian countrywith the reference country (the US or Japan or China), the stronger the argument that thatreference country should be the anchor.
In terms of measurement, it has become popular to implement this OCA criterionaccording to the synchronicity of business cycles by evaluating the cross-correlation of thecyclical component of output at business cycle frequencies.8 In this paper, the method ofGerlach (1988) and Baxter and Stockman (1989) is adopted, where synchronicity in outputis identified by cross-correlation of the cyclical components of annual real GDP seriesdetrended by applying the Hodrick–Prescott (H-P) filter.9 Values close to +1 indicate ahigh degree of business cycle symmetry, while values close to –1 indicate a high degree ofbusiness cycle asymmetry. Following Artis and Zhang (1997), non-positive values are setto zero for easier interpretation without undermining the results.
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1.000.500.00-0.50-1.00
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MACLAO
KOR
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CAN
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Figure 3. Business cycle synchronisation for pre-crisis period. Note: See Appendix 1 for datadescription.
Figures 3 and 4 exhibit the scatterplots depicting the degree of real business cyclesymmetry with the US, Japan and China for the pre-crisis and the post-crisis period,respectively. The horizontal axis represents the difference between the correlations withChina and those with the US, wherein values greater than zero signify a higher degree ofsymmetry with China than with the US, and values less than zero indicate a higher degreeof symmetry with the US than with China. A rightward shift between the periods signifiesincreased symmetry with China over the US, while a leftward shift indicates increasedsymmetry with the US over China. The same interpretations apply to the vertical axisrepresenting the differences between the correlations with Japan and those with the US.Meanwhile, values on the lower right of the diagonal line denote greater symmetry withChina relative to Japan, whereas values on the upper left denote greater symmetry withJapan relative to China.
Judging by the common tilt towards the northwest between the periods, the changesignifies a general shift towards synchronicity with Japan from that with China and the US.Virtually all countries, including the US and China, have greater degrees of business cyclesymmetry with Japan. Specifically, Japan has always been the most influential for Brunei,the Philippines and Malaysia, with waning influence for the first two countries and risingimportance for Malaysia. In fact, based on the distances of the shift, the largest increase inrelative strength of symmetry with Japan is shown by Hong Kong, Canada and Cambodia.
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1.000.500.00-0.50-1.00
CHN-US
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-US VNM
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JPN
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HKG
CHNCAN
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Figure 4. Business cycle synchronisation for post-crisis period. Note: See Appendix 1 for datadescription.
Nevertheless, Vietnam, the Philippines and Brunei have reduced their degree of symmetrywith Japan.
The change in the configuration might be due to China’s dependence on export marketsoutside of the region to drive growth and its exchange rate policies, which depend on a‘soft peg’ to the US dollar, both of which would likely increase synchronicity with the US.At the same time, a regional business cycle might be beginning to emerge in the rest of theregion, which would therefore give overall a stronger symmetry with Japan.
Meanwhile, the US has always been the most dominant for Canada, Taiwan, Australiaand India despite larger influence from Japan for the three former countries. China has notalways been dominant for any country over the periods.
Despite maintaining a dollar currency board and geographical proximity with China,Hong Kong has reduced its level of business cycle symmetry with the US and China butincreased it with Japan. The same is true for Macau. Since Macau pegs its pataca to theHK dollar, its parallel business cycle experience with Hong Kong is in harmony with itsregime. Meanwhile, Singapore, which sets the monetary standards for Brunei, has beenmore similar to the US. The same is true for Brunei.
3.3. Real exchange rate volatility
Real exchange rate volatility is one indicator of synchronicity of economic forces betweencountries. The level of a country’s need for real exchange rate changes is an important
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determining factor for joining a monetary union because real exchange rate changes areclearly measurable and automatically give the appropriate weights to the economic forcesof which they are the result (Vaubel 1978). These economic forces pertain to inflation rates,openness, economy size, prices, wage flexibility, factor mobility, commodity diversification,goods market integration and fiscal integration (Tavlas 1993). Artis and Zhang (1997)suggested that low real exchange rate volatility might indicate the absence of asymmetricshocks and the presence of business cycle conformity, which may strengthen the case fora currency area. In this paper, volatility in the real exchange rate is represented by thestandard deviation of the log difference of monthly real bilateral exchange rates against thereference country, where the deflator is relative consumer prices.
Figures 5 and 6 display the scatterplots depicting the degrees of real exchange ratevolatility with the US, Japan and China for the pre-crisis and the post-crisis period, respec-tively. The way to interpret these plots is exactly the same as in the trade openness case.However, note the much smaller scales used on the axes for the post-crisis period, indicatingconvergence of outlier cases, namely Canada, Taiwan and Macau towards the rest of thecases.
Judging by the general shift between the periods from above the horizontal line onthe right of the diagonal towards the vertical line above the horizontal line, one can infera common shift from relatively high variability with China to relatively high variabilitywith Japan, while levels of variability with the US have been the smallest. This is obviousbecause China has shown significantly lower real exchange rate volatility with the US, dueto its current exchange rate regime.10 It is also of interest to note the significant reductionin volatility shown by Taiwan against both Japan and China and by Canada against Japan.
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Figure 5. Real exchange rate volatility for pre-crisis period. Note: See Appendix 1 for datadescription.
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2.502.001.501.000.500.00
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Figure 6. Real exchange rate volatility for post-crisis period. Note: See Appendix 1 for datadescription.
The findings appear to also be consistent with the actual monetary union arrangementof Singapore and Brunei. Singapore and Brunei are placed tightly together for both periodsand they have common experience of higher real exchange rate stability with China relativeto that with the US and Japan. A similar experience can be seen for Hong Kong and Macau.
3.4. Inflation convergence
The traditional OCA literature originated during the era of ‘fix-price’ economics, so in-troducing inflation convergence as a criterion could be regarded simply as an appropriatenormalisation (Artis and Zhang 2002). Since similar inflation rates result from similaritiesin monetary and fiscal policy stances and economic structure, the cost of joining a currencyarea is presumably low when inflation rates are similar across members (Nguyen 2007).Moreover, convergence of inflation rates is a central theme of the Maastricht Treaty criteriaand a prerequisite prior to accession into the Economic and Monetary Union (EMU).
This criterion is measured by the absolute inflation differential, |xi − xr |, where xi
and xr are the rates of inflation in country i and the reference country, respectively. Theabsolute value is used since the magnitude is of concern here, not the sign.11 Differentialsare averaged over the relevant period – the smaller the differential, the higher the inflationconvergence.
Figures 7 and 8 show the plots comparing the levels of inflation differentials with theUS, Japan and China for the pre-crisis and the post-crisis period, respectively. The generalshift over the periods from the right towards the diagonal line represents a reduction of
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3.002.502.001.501.000.500.00
SQRT(CHN/US)
3.00
2.50
2.00
1.50
1.00
0.50
0.00
SQ
RT
(JP
N/U
S)
VNM
TWN
THA
SGP
PHL NZL
MYSMMR
MAC
LAO
KOR
KHM
JPN
IND
IDN
HKG
CHN
CAN
BRN
AUS
Figure 7. Inflation differential for pre-crisis period. Note: See Appendix 1 for data description.
3.002.502.001.501.000.500.00
SQRT(CHN/US)
3.00
2.50
2.00
1.50
1.00
0.50
0.00
SQ
RT
(JP
N/U
S)
VNM
TWN
THA
SGP
PHL
NZL
MYS
MMR
MAC LAO
KORKHM
JPN
INDIDN
HKG
CHN
CAN
BRN
AUS
Figure 8. Inflation differential for post-crisis period. Note: See Appendix 1 for data description.
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106 C.-H. Quah and P.M. Crowley
high inflation differentials with China towards levels comparable to those with Japan. Onereason for this is greater degree of convergence of Chinese inflation towards the US andJapan levels.
Despite the increased inflation convergence with China, the inflation rates of India,Thailand, Korea, Malaysia, Canada, Australia and New Zealand have always been moreconvergent with the US level. Meantime, only Brunei has always been more convergentwith Japan, and no country has consistently been more convergent with China.
Hong Kong and Macau have shown parallel changes in inflation convergence in whichboth have been a lot more convergent with China after the crisis. The same applies toSingapore and Brunei, wherein Singapore has greater degree of increased convergencewith China than that of Brunei.
3.5. Real interest rate synchronisation
Though not listed as one of the criteria based on the traditional OCA theory (Tavlas 1993),this factor is indicated by a ‘revealed preference’ argument (Artis and Zhang 2002). Ifthe monetary policy of a candidate country historically has differed little from that of thereference country, the cost of relinquishing monetary independence is accordingly low, sosynchronisation in real interest rates may be interpreted as an indicator of coordination inmonetary policy. It is measured by the cross-correlation of the real interest rate cycle of a
1.000.500.00-0.50-1.00
CHN-US
1.00
0.50
0.00
-0.50
-1.00
JPN
-US
VNM
TWN
THA
SGP
PHL
NZL
MYS
MMR
MAC
LAO
KOR
KHM
JPN
IND
IDN
HKG
CHNCAN AUS
Figure 9. Real interest rate synchronisation for pre-crisis period. Note: See Appendix 1 for datadescription.
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country with that of the reference country.12 Detrending is accomplished by applying the H-P filter as in the synchronisation in the business cycle criterion. The more synchronous thereal interest rate cycle to that of the reference country, the more coordinated the monetarypolicy with that country. Non-positive values are set to zero for easier interpretations withoutimpairing the qualitative results.
Figures 9 and 10 show the scatterplots depicting the degree of real interest rate symmetrywith the US, Japan and China for the pre-crisis13 and the post-crisis period, respectively. Ageneral shift towards the right and the southeast quadrant over the periods reflects a rise inthe degree of symmetry with China relative to that with the US and Japan.
Interestingly, for the pre-crisis period, about half of the countries are scattered aroundthe horizontal line, indicating almost equal levels of synchronicity/asynchronicity againstthe US and Japan, whereas for the post-crisis period, about half of the countries are placedon the diagonal, suggesting equal levels of synchronicity/asynchronicity against Japan andChina.
Although the majority of the countries, including Japan, have experienced a rise in thedegree of real interest rate convergence with China, some countries have instead been moredivergent from China. These countries are Australia, Canada, Korea and New Zealand.Regarding Hong Kong and Macau, based on their position over the periods, both havebeen more divergent from the US relative to their levels of synchronicity with Japan and
1.000.500.00-0.50-1.00
CHN-US
1.00
0.50
0.00
-0.50
-1.00
JPN
-US
VNM
TWN
THA
SGP
PHL
NZL
MYS
MMR
MACLAO
KOR
KHM
JPN
IND
IDN HKG
CHN
CAN
BRNAUS
Figure 10. Real interest rate synchronisation for post-crisis period. Note: See Appendix 1 for datadescription.
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China. Although this may not be entirely consistent with a dollar peg, their monetarypolicies however have been fairly similar. Meanwhile, Singapore has a significantly greaterdegree of convergence with China. Nonetheless, since the pre-crisis data for Brunei arenot available, the change in the pattern of real interest rate symmetry for Brunei cannot bedetermined.
4. Conclusion
The preceding sections have evaluated five OCA criteria for 20 economies in the AsiaPacific region with reference to the US, Japan and China in the period before and after theAsian crisis. The following are the key findings.
In terms of bilateral trade linkages, the US is still the most important trading partnerafter the crisis but China is becoming ever more important as a trading nation, whilethe role of Japan is clearly declining. On the other hand, when it comes to real businesscycle synchronicity, the countries have instead become more aligned with Japan and moredivergent with the US and China. With respect to real exchange rate volatility, there hasbeen a shift towards more stability with China and greater variability with Japan whilemaintaining high stability with the US. With regard to inflation convergence, there has beena common higher degree of inflation convergence with China, comparable to those withthe US and Japan. Finally, pertaining to monetary policy symmetry, there has been a shifttowards greater alignment of policies with China and greater divergence of policy from theUS and Japan.
Based on this evidence, although the US dollar would likely still be the obvious choicefor an anchor currency in the current environment, it is clear that the economic dynamicstaking place in the region point to an ‘internal’ anchor currency being a more likely candidatein the future. This would also facilitate a phased move towards a common currency in muchthe same way that the German mark was the anchor currency in the run up to EMU inEurope.14
Notwithstanding the dominance of the US in the region’s trade and the dominance ofJapan in the region’s business cycles, our assessment is that in the future, China couldbe highly fitting as the anchor country for an Asian monetary union in the post-crisisera. In spite of this, as Dobson and Masson (2009) conclude, it will take decades beforethe Chinese yuan assumes the multi-faceted role of an international currency that includeswidespread use in trade invoicing, countries’ foreign exchange reserves and a major vehiclefor foreign exchange transactions.15 And the fact that China is a one-party state with muchof the economy under the control of the Communist Party would cast doubts as to whetherChina’s political regime can ever be viewed as completely market-friendly for the yuan totake on a role commensurate with the importance of China’s economy in world output andtrade.
In summary, to answer the question we pose in the title to this paper, we would arguethat despite the above reservations, the yuan could be as dominant as the US dollar in theregion in 10–20 years’ time, as the Chinese economy grows towards the size of the US’s andits economic influence spreads throughout the region. Moreover, given the recent expansionin yuan-denominated trade between China and its trading partners, the tensions in the euroarea and the recent inflationary capital flows which flooded the East Asian region and otherparts of the world as a consequence of excess dollar liquidity, it is now more likely thatcentral bankers and governments would be more willing to diversify their currency reservesinto the Chinese currency once it becomes fully convertible.
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Meantime, except for the lower levels of business cycle and monetary policy symmetrywith the US relative to that with China and/or Japan after the Asian turmoil, the criteriasuggest that Hong Kong’s existing dollar currency board is endogenously supported. In thisregard, other factors (e.g. foreign reserves, credibility, etc.) not considered here could alsoplay important roles in sustaining the HK currency board through until the present day. Asfor Macau, since it is virtually in parallel with Hong Kong in all the criteria, the findingsdo support its existing fixed peg against the HK dollar. At the same time, the parallelexperiences of Singapore and Brunei in the criteria also broadly endogenously supporttheir prevailing monetary union.
AcknowledgementSpecial thanks to Aaron Mehrotra of Bank of Finland for his useful comments on China and to ananonymous reviewer for constructive comments.
Notes
1. Association of Southeast Asian Nations (ASEAN) was founded in 1967 and had five membersinitially (Indonesia, Malaysia, the Philippines, Singapore and Thailand). Till 2009, it has fivemore members (Brunei, Myanmar, Cambodia, Laos and Vietnam).
2. Visit ASEAN site at http://www.aseansec.org/JPS-ASEAN+3-Cooperation-Financial-Crisis.pdf (Accessed 28 June 2010)
3. Recent events such as the financial crises in the US and Europe and the subsequent monetarypolicies which affect the world but seldom take into account the needs in emerging markets alsojustify the case for pooled monetary and economic mass in East Asia. A monetary union is aneffective way to consolidate policies towards having a much greater voice vis-a-vis the West inthe global arena.
4. Candidate reference countries are the US, Japan and China. India is included to reflect itsgrowing dominance in the region and the world. Australia, New Zealand and Canada arepermanent members of Asia-Pacific Economic Cooperation (APEC). The country codes usedare displayed in Table A1 in Appendix 1.
5. For a good explanation, see McKinnon and Schnabl (2004).6. Due to the downturn in Japanese growth during the last two decades, plus the recent tsunami and
earthquake, it is likely that Japan is much less synchronous with other East Asian economies,and will continue to be so over the next few years.
7. The absolute variable values are available from the author upon request.8. Although this method is the most popular in the economics literature due to its ease of calculation,
there are other methods for assessing synchronicity.9. Artis and Zhang (1997) have assessed the robustness/sensitivity of widely used filters and found
no evidence that conclusions are sensitive to the choice of filter. For the dampening parameter,Ravn and Uhlig (2002) suggest 6.25 for annual data and 129,600 for monthly data. Theseparameters are used in this paper.
10. A shift towards relatively stable real exchange rates with China and the US is in line with the factthat China has large supply networks in the East Asian region, where they import componentsfrom other East Asian countries and then again export the goods (with some value added inChina) to other countries in the region and to the US. In general, countries that form part ofthese supply chains probably share similar interests (vis-a-vis the levels of exchange rates) withChina and the US. See http://www.voxeu.org/index.php?q=node/4868.
11. In Artis and Zhang (2002), the absolute value is not used. In a correspondence with Artis,however, he indicated that the absolute value may be a better option to avoid the problem ofcancellation of values of the opposite sign.
12. To ensure the greatest degree of data consistency over time and countries, including those withheavily regulated capital markets (such as China and countries in Indochina), discount rates areused, even though some authors may prefer to use market rates as a proxy for monetary policy(and interest rates might not have been the main policy tool for China).
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To an extent, discount rates may be better at reflecting the broad stance of monetary authoritiesbecause the rates are directly set by central banks, while money market rates are influenced byboth monetary authorities and the private market. As pointed out by Friedman (1968), monetarypolicy has little potency in fine-tuning the interest rates (and price levels) in midst of thedynamism in the private markets. This consideration is important for the Asian economies asno one really knows how effective are the authorities in adjusting the market rates, if they do.In addition, countries differ in their monetary targets. In a sense, discount rates may be a betterproxy to reflect monetary policies in general for the countries under review.
Moreover, as the analysis looks at correlation of movement rather than a definitive measureof monetary policy stance, the choice of discount rates or market rates should not matter verymuch.
13. For pre-crisis period, Brunei is not included due to unavailability of data.14. Detailed discussions on implementation, institution and transition of a possible Asian monetary
union can be found in Kawai and Takagi (2005) and Kawai and Motonishi (2005).15. Nonetheless, during the current crisis, China implemented many measures to promote the
internationalisation of its currency. For example, some firms in parts of the coastal regions arenow allowed to use yuan in international trade with Hong Kong and ASEAN countries.
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Appendix 1
Table A1. Data definitions and sources.a
GDP, ExchangeGDP rate,d Interest
Country Code Tradeb deflatorc CPIe rate Periodf
China CHN 81Q1-07Q4 81-06 87:1-08:4 Discount rate 92:6-08:3Hong Kong HKG 81Q1-07Q4 81-06 81:1-08:3 Discount rate 92:6-08:3Korea KOR 81Q1-07Q4 81-07 81:1-08:4 Discount rate 92:6-08:2Taiwang TWN 81-88,
89:1-07:1281-07 81:1-08:4 Discount rate 92:6-08:6
Cambodia KHM 81Q1-07Q4 88-07 94:10-07:12 Lending rate 95:10-07:12Indonesia IDN 81Q1-07Q4 81-07 81:1-08:4 Discount rate 92:6-08:3Laos LAO 81Q1-07Q4 82-07 87:12-01:12,
03:5-08:3Discount rate 92:6-08:3
Malaysia MYS 81Q1-07Q4 81-07 81:1-08:3 Interbank rate 92:6-08:4Myanmar MMR 81Q1-07Q4 81-03 81:1-07:12 Discount rate 92:6-07:12Philippines PHL 81Q1-07Q4 81-05 81:1-08:4 Discount rate 92:6-08:4Singapore SGP 81Q1-07Q4 81-06 81:1-08:3 Interbank rate 92:6-08:4Thailand THA 81Q1-07Q4 81-07 81:1-08:4 Discount rate 92:6-08:4Vietnam VNM 81Q1-07Q4 90-07 90:1-08:4 Discount rate 96:1-06:12India IND 81Q1-07Q4 81-07 81:1-08:3 Discount rate 92:6-08:3Macau MAC 81Q1-07Q4 82-07 88:1-08:3 Interbank rate 92:6-08:4Brunei BRN 81Q1-07Q4 81-04 83:1-08:3h Lending rate 98:1-08:3Japan JPN 81Q1-07Q4 81-07 81:1-08:4 Discount rate 92:6-08:3Australia AUS 81Q1-07Q4 81-07 81Q1-08Q1 Money market
rate92:6-08:3
New Zealand NZL 81Q1-07Q4 81-07 81Q1-08Q1 Discount rate 92:6-08:3Canada CAN 81Q1-07Q4 81-07 81:1-08:4 Discount rate 92:6-08:3United States US n.a.i 81-07 81:1-08:4 Discount rate 92:6-08:3
Note: aSeries are from IMF-IFS database except stated otherwise.bTrade series are from IMF-DOTS database.cGDP = gross domestic product. GDP deflator is used to compute real GDP.dOriginal exchange rate series are rates against the US dollar; exchange rates against the yen and the yuan arederived assuming triangular arbitrage. Data range of exchange rate is tied to data range of CPI since CPI is neededto compute real exchange rate.eCPI = consumer prices index. For China, Vietnam and Brunei, series are spliced using data from ILO-LABORSTAdatabase whenever not available on IMF-IFS database.fThe following starting point is selected to achieve the greatest degree of consistency over countries.gTaiwan data are sourced from Bureau of Foreign Trade, Directorate-General of Budget, Accounting, and Statistics(DGBAS) and central bank databases.hCPI series for Brunei after 2005 are sourced from Department of Economic Planning and Development (DEPD)website (retrieved 17 July 2008, from http://www.depd.gov.bn/archive.html). Data should be consistent since datafrom IFS are sourced from DEPD as well.in.a. = not applicable.
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