Costs and Benefits of a Common Currency for ASEAN

Madhur, Srinivasa Working Paper Costs and Benefits of a Common Currency for ASEAN ERD Working Paper Series, No. 12 Provided in Cooperation with: Asian Development Bank (ADB), Manila Suggested Citation: Madhur, Srinivasa (2002) : Costs and Benefits of a Common Currency for ASEAN, ERD Working Paper Series, No. 12, Asian Development Bank (ADB), Manila, https://hdl.handle.net/11540/1930 This Version is available at: https://hdl.handle.net/10419/109234 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. http://creativecommons.org/licenses/by/3.0/igo ECONOMICS AND RESEARCH DEPARTMENT ERD WORKING PAPER SERIES NO. 12 Srinivasa Madhur May 2002 Asian Development Bank Costs and Benefits of a Common Currency for ASEAN ERD Working Paper No. 12 COSTS AND BENEFITS OF A COMMON CURRENCY FOR ASEAN 12 ERD Working Paper No. 12 COSTS AND BENEFITS OF A COMMON CURRENCY FOR ASEAN Srinivasa Madhur May 2002 Srinivasa Madhur is a Principal Economist with the Regional Economic Monitoring Unit of the Asian Development Bank. The views expressed here are those of the author and not necessarily those of the Asian Development Bank. Earlier versions of this paper were presented in the ASEAN Task Force on ASEAN Currency and Exchange Rate Mechanism meeting at Kuala Lumpur, 6-7 August 2001, and in the International Conference on Monetary Outlook on East Asia in an Integrating World Economy held at Chulalonghorn University, Bangkok, 5-6 September 2001. 13 Asian Development Bank P.O. Box 789 0980 Manila Philippines 2002 by Asian Development Bank May 2002 ISSN 1655-5252 The views expressed in this paper are those of the author(s) and do not necessarily reflect the views or policies of the Asian Development Bank. ERD Working Paper No. 12 COSTS AND BENEFITS OF A COMMON CURRENCY FOR ASEAN 14 Foreword The ERD Working Paper Series is a forum for ongoing and recently completed research and policy studies undertaken in the Asian Development Bank or on its behalf. The Series is a quick-disseminating, informal publication meant to stimulate discussion and elicit feedback. Papers published under this Series could subsequently be revised for publication as articles in professional journals or chapters in books. 15 Contents Abstract vii I. Introduction 1 II. Perspectives on Optimum Currency Area 2 III. The Suitability of ASEAN for a Common Currency 4 IV. Constraints on the Adoption of a Common Currency 5 V. Conclusion 7 References 9 ERD Working Paper No. 12 COSTS AND BENEFITS OF A COMMON CURRENCY FOR ASEAN 16 Abstract Since the 1997 Asian financial crisis, a popular view among academic economists and policymakers is that developing countries with open capital accounts have only two options in their exchange rate regimes: either float the exchange rate freely or fix it hard. Within a fixed exchange rate regime, two variants can be conceived: (i) a currency board arrangement or its equivalent, the domestic usage of the currency of another country; and (ii) adoption of a new common currency by a group of countries, or the formation of a monetary union. This paper assesses the costs and benefits of the second variant for the Association of Southeast Asian Nations (ASEAN). The paper concludes that although the constraints on the adoption of a common currency by ASEAN are formidable, the long-run goal of a common currency for the region may be worth considering seriously, especially because, judged by the criterion of optimum currency area, the region is as suitable for the adoption of a common currency as Europe was prior to the Maastricht Treaty. 1 I. INTRODUCTION The 1997 Asian financial crisis has brought into sharp focus questions about appropriate exchange rate regimes for the economies in the region. In the aftermath of the crisis, with the notable exception of Malaysia, many countries in the region have now shifted toward greater flexibility in their exchange rates, although, for various reasons including the “fear of floating”, official interventions in the foreign exchange market to stabilize rates are not uncommon. While these countries are experimenting with changes in the exchange rate regimes, a lively debate is continuing on the choice of appropriate exchange rate regimes for developing countries. Since the Asian crisis, a popular view among academic economists and policymakers is that developing countries with open capital accounts have a bipolar solution to the exchange rate dilemma they face: a free float or a hard peg. This paper assesses the costs and benefits of a hard peg, specifically the use of a common currency or formation of a monetary union, for the Association of Southeast Asian Nations (ASEAN). Given that the adoption of a common currency, or the formation of a currency union, was the last step in a sequence of policy initiatives toward regional economic integration in Europe that spanned more than four decades, the ASEAN may perhaps be a long way away from adopting a common currency. Yet, a debate on the adoption of a common currency by these countries is slowly emerging especially in the aftermath of the Asian crisis and after the single currency for Europe, the Euro, became a reality beginning 1999. This paper aims to integrate and synthesize key conclusions in the literature and raise certain issues for further debate and research, rather than break new grounds through fresh research. The assessment is largely organized around some of the well-known results, both theoretical and empirical, of works on optimum currency area (OCA). The paper is organized as follows. Section II presents the theoretical and empirical perspectives from the OCA literature. Section III examines the suitability of ASEAN for adoption of a common currency and Section IV assesses the key constraints on such adoption. Section V concludes by placing the issue in a broader global perspective. ERD Working Paper No. 12 COSTS AND BENEFITS OF A COMMON CURRENCY FOR ASEAN 2 II. PERSPECTIVES ON OPTIMUM CURRENCY AREA According to the OCA literature, the key economic cost from formation of a currency union by a group of countries is the loss of national autonomy in monetary policy. Under a currency union, there is no scope for independent monetary policies by the member countries of the union. However, the cost associated with the loss of monetary independence depends upon how well the individual countries were conducting monetary policy prior to joining the currency union. Many developing countries with open capital accounts have several constraints in the effective conduct of an independent monetary policy. This is especially so in developing countries with thin capital markets and weak central banking institutions. In general, the record of developing countries in conducting independent national monetary policies to minimize cyclical fluctuations in economic activity has been somewhat patchy. This suggests that the economic loss from giving up an independent monetary policy may not be very large for such countries. On the contrary, a currency union may, in fact, elicit commitment to greater macroeconomic stability from countries that otherwise have a mixed track record in implementing monetary policy prior to joining the currency union (Barro 2001). It is possible that this benefit will compensate for the loss of monetary policy autonomy. The major benefit of a common currency that has been emphasized is that it facilitates trade (in both goods and services) and investment among the countries of the union (and hence increases income growth within the region) by reducing transaction costs in cross-border business, and removing volatility in exchange rates across the union. A currency is like language (Barro 2001). As a common language facilitates effective communication among people, a common currency could promote trade and investment among countries. In an environment of different currencies, transaction costs, including the costs of obtaining information about prices, would be higher. This would be a disincentive to trade, commerce, and investment. Moreover, under floating exchange rate regimes—the alternative to a fixed exchange rate regime—exchange rates tend to be more volatile than is warranted by the economic fundamentals of an economy (Rose 1994, Williamson 1999, Bergsten and Henning 1996, Collignon 1999). This is especially true of small developing economies with thin capital markets. Developing countries with large unhedged foreign currency liabilities (original sin), therefore, often “fear to float.” Monetary policies in such countries tend to be pro-cyclical rather than counter-cyclical. Belying the expectations of advocates of floating exchange rate regimes, flexible exchange rates have often become a source of shocks rather than shock absorbers. “Market errors” and the consequent misalignments in exchange rates under floating exchange rate regimes have been substantial (Breur 1994). Disproportionate volatility in exchange rates increases uncertainty, discourages trade, diminishes investment, and reduces overall economic growth (Kenen and Rodrik 1986, Huizinga 1994, Corbo and Cox 1995). It is possible to mitigate some of these adverse effects of floating exchange rates by hedging against exchange rate fluctuations. However, hedging involves nonnegligible transaction costs (Adler 1996, Friberg 1996, Rajan 2000). Development of perfect hedging instruments may even be difficult in practice. 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Quibria, November 1993 No. 52 The Role of the State in Economic Development: Theory, the East Asian Experience, and the Malaysian Case —Jason Brown, December 1993 No. 53 The Economic Benefits of Potable Water Supply Projects to Households in Developing Countries —Dale Whittington and Venkateswarlu Swarna, January 1994 No. 54 Growth Triangles: Conceptual Issues and Operational Problems —Min Tang and Myo Thant, February 1994 No. 55 The Emerging Global Trading Environment and Developing Asia —Arvind Panagariya, M.G. Quibria, and Narhari Rao, July 1996 No. 56 Aspects of Urban Water and Sanitation in the Context of Rapid Urbanization in Developing Asia —Ernesto M. Pernia and Stella LF. Alabastro, September 1997 No. 57 Challenges for Asia’s Trade and Environment —Douglas H. Brooks, January 1998 No. 58 Economic Analysis of Health Sector ProjectsA Review of Issues, Methods, and Approaches —Ramesh Adhikari, Paul Gertler, and Anneli Lagman, March 1999 No. 59 The Asian Crisis: An Alternate View —Rajiv Kumar and Bibek Debroy, July 1999 No. 60 Social Consequences of the Financial Crisis in Asia —James C. Knowles, Ernesto M. Pernia, and Mary Racelis, November 1999 16 No. 10 Some Aspects of Land Administration in Indonesia: Implications for Bank Operations —Sutanu Behuria, July 1994 No. 11 Demographic and Socioeconomic Determinants of Contraceptive Use among Urban Women in the Melanesian Countries in the South Pacific: A Case Study of Port Vila Town in Vanuatu —T.K. Jayaraman, February 1995 No. 12 Managing Development through Institution Building — Hilton L. Root, October 1995 No. 13 Growth, Structural Change, and Optimal Poverty Interventions —Shiladitya Chatterjee, November 1995 No. 14 Private Investment and Macroeconomic Environment in the South Pacific Island Countries: A Cross-Country Analysis —T.K. Jayaraman, October 1996 No. 15 The Rural-Urban Transition in Viet Nam: Some Selected Issues —Sudipto Mundle and Brian Van Arkadie, October 1997 No. 16 A New Approach to Setting the Future Transport Agenda —Roger Allport, Geoff Key, and Charles Melhuish June 1998 No. 17 Adjustment and Distribution: The Indian Experience —Sudipto Mundle and V.B. Tulasidhar, June 1998 No. 18 Tax Reforms in Viet Nam: A Selective Analysis —Sudipto Mundle, December 1998 No. 19 Surges and Volatility of Private Capital Flows to Asian Developing Countries: Implications for Multilateral Development Banks —Pradumna B. Rana, December 1998 No. 20 The Millennium Round and the Asian Economies: An Introduction —Dilip K. Das, October 1999 No. 21 Occupational Segregation and the Gender Earnings Gap —Joseph E. Zveglich, Jr. and Yana van der Meulen Rodgers, December 1999 No. 22 Information Technology: Next Locomotive of Growth? —Dilip K. Das, June 2000 No. 1 Estimates of the Total External Debt of the Developing Member Countries of ADB: 1981-1983 —I.P. David, September 1984 No. 2 Multivariate Statistical and Graphical Classification Techniques Applied to the Problem of Grouping Countries —I.P. David and D.S. Maligalig, March 1985 No. 3 Gross National Product (GNP) Measurement Issues in South Pacific Developing Member Countries of ADB —S.G. Tiwari, September 1985 No. 4 Estimates of Comparable Savings in Selected DMCs —Hananto Sigit, December 1985 No. 5 Keeping Sample Survey Design and Analysis Simple —I.P. David, December 1985 No. 6 External Debt Situation in Asian Developing Countries —I.P. David and Jungsoo Lee, March 1986 No. 7 Study of GNP Measurement Issues in the South Pacific Developing Member Countries. Part I: Existing National Accounts of SPDMCs–Analysis of Methodology and Application of SNA Concepts —P. Hodgkinson, October 1986 No. 8 Study of GNP Measurement Issues in the South Pacific Developing Member Countries. Part II: Factors Affecting Intercountry Comparability of Per Capita GNP —P. Hodgkinson, October 1986 No. 9 Survey of the External Debt Situation in Asian Developing Countries, 1985 —Jungsoo Lee and I.P. David, April 1987 No. 10 A Survey of the External Debt Situation in Asian Developing Countries, 1986 —Jungsoo Lee and I.P. David, April 1988 No. 11 Changing Pattern of Financial Flows to Asian and Pacific Developing Countries —Jungsoo Lee and I.P. David, March 1989 No. 12 The State of Agricultural Statistics in Southeast Asia —I.P. 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