Trade, Investment and Financial Integration in East Asia · Trade integration increases economic...

Trade, Investment and Financial Integration

in East Asia

Submitted to the ASEAN Secretariat

May 2005

Daiwa Institute of Research

i

Executive Summary

Ⅰ. Facts Found in the Research

Trade and Investment Integration

Trade and investment integration in East Asia have proceeded since the 1980s.

Accumulation of Foreign Direct Investment (FDI) inflows has been a force driving the

intensification of intra-regional trade in East Asia, as well as multiple engines of the economic

growth. Multinational firms, in particular based in Japan, have extended their activities throughout

Asia by means of FDI, and have played an important role in development of intra-regional

production and procurement networks and the vertical economic integration we see today. What we

are experiencing is ongoing market-driven trade and investment integration.

The shares of intra-regional trade in East Asia still remain at a significantly lower level, at

around 40 percent, than those of the EU or NAFTA. As such, there may be scope for further

expansion of intra-regional trade under a number of possible Free Trade Agreements (FTAs). Any

plausible combinations of FTA in East Asia will bring about welfare gains to all the FTA members.

However, the more national participation in FTAs, the greater the gains in total, as well as the gain

accruing to each member.

Financial Market Integration

There exists a general consensus that financial market integration contributes to long-term

economic growth. The degree of financial integration in East Asia has increased recently, but East

Asia has shown greater financial integration with the global economy than with regional economies.

Regionality is weak and there is no strong pulling, or anchor market that could match the U.S.

market. Lack of success in policy coordination among East Asian countries, despite the efforts that

have been made, seems to be a fact relevant to this.

6/20/2005The many controls and restrictions that remain in place at the domestic level in

the East Asian countries have hampered the development of legal, accounting, supervisory, and

regulatory mechanisms essential to regional financial stability. Without fundamental reforms at the

domestic level, the success of any attempt at regional financial integration may be threatened.

The direction and structure of capital movement in East Asia created a highly vulnerable

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and unstable financial environment in East Asia, and as these causal conditions still

persist they raise the likelihood of a future crisis, one that would impede the development of the

capital market of the region.

Monetary Integration and A Basket Currency Regime

A Basket Currency regime has several benefits as one of the intermediate and optimal

options for East Asia; these benefits include stabilizing trade competitiveness, capital flows and GDP.

However, even after the financial crisis, some of the Asian currencies were de facto pegged to the

US dollar, resulting in several competitive devaluations. Because of a coordination failure problem,

monetary authorities in East Asia have failed to introduce a common currency basket system, even

though they may be aware of the merits of such a system. The five ASEAN countries and Korea will

be candidates for a common currency area with a common Currency Basket as an anchor currency. A

common Currency Basket is more appropriate as an anchor currency than the US Dollar for forming

a common currency area in the region.

Sequencing and Policy Prerequisites of Economic Integration

It is reasonable to believe that economic integration begins with elimination of customs

barriers and quotas. Trade integration increases economic interdependence of member countries in

the region, and this interdependence will garner attention and stimulate interest in taking common

action to prevent economic shocks. Regional trade arrangements will in turn stimulate intra-regional

FDI. Trade openness is closely related to the degree of financial integration.

Trade liberalization is a prerequisite of capital account liberalization. If domestic factor

markets and foreign trade are still heavily distorted when the capital account is liberalized, capital

could flow into sectors heavily affected by distortions, further increasing inefficiencies in domestic

production. Trade openness is found to be closely related to the degree of financial integration.

Even after the FTAs are established, economic agents will face currency exchange costs

and exchange rate risks in international transactions. In such a situation, the movements toward

bilateral and regional free trade agreements might gain momentum to form a common currency area

in East Asia.

Ⅱ. Policy Recommendations

Establish Regional FTAs as Immediate Actions

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Trade integration deserves to be a critical part of any broad regional coordination agenda.

As an item for policy agendas, expansion of FTA membership will properly be the basic strategy.

The goal for the region should be an ASEAN+10+3 FTA, and any subsets would be transition stages.

In such an expansion process, the policy-makers should carefully design all FTAs they work on to be

compatible with larger FTAs in the future. And an FTA should cover services as well as goods.

In the EU, economic cooperation supplemented the integration. A remarkable example is

the European Monetary System (EMS). Stability of the EMS became an essential base from which

the EU could move forward, to monetary integration. As such, economic cooperation has been an

instrument with which the EU governments can handle the issue of the diversity of the participating

countries. Regional FTAs will provide the countries in East Asia with the opportunity to formalize

such cooperation actions.

Promote Financial Market Integration

The countries of East Asia should promote financial market integration. Liberalizing and

opening capital markets are basic measures. Important prerequisites are institutional strengthening of

the domestic financial sectors, development of the required financial markets and establishment of

prudential regulations. In light of experience during the currency crisis, a multi-speed approach to

undertake domestic reforms, together with incentive measures such as the Asian Bond Fund, are

recommendable. Regional financial infrastructures, including a regional settlement and clearing

system and regional harmonization of credit rating standards, should be established for fostering

regional cross-boarder bond markets in East Asia.

Policy Cooperation and Coordination as Prerequisites for Monetary Cooperation

Regional economic integration in terms of trade, FDI, and financial transactions would

make private sectors recognize that foreign exchange transaction costs and foreign exchange risks

are significant obstacles to trade, FDI, and financial transactions. The East Asia economy would

move on monetary cooperation and, in turn, monetary integration. However, it is suggested that

policy cooperation and coordination, especially regarding monetary policy, among East Asian

countries are needed as prerequisites for monetary cooperation. Sovereign East Asian monetary

authorities need to fully develop their own domestic monetary policy capability before engaging in

policy cooperation of any sort. As East Asia deepens its economic integration, policymakers should

fully develop weak-form macroeconomic policy cooperation before contemplating formal

monetary coordination. Regional policy cooperation might take a flexible and multi-speed approach

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that is endogenous to underlying fundamentals and institutions.

Implement Regional Exchange Rate Coordination

At the time of the initial step of currency coordination, the monetary authorities should

have a common understanding about the interactions between their currencies. This understanding

can be achieved by conducting policy dialogue and macroeconomic surveillances by and among the

policymakers of the regional countries. Macroeconomic surveillance alone may not be so effective if

it is conducted by policymakers acting as representatives of each of the regional countries. It may be

desirable that a neutral intraregional institution, which is independent of the governments of regional

countries, should prepare for the macroeconomic surveillance by helping the governments deepen

their common understanding. It is also recommended to promote macroeconomic policy cooperation

prior to formal coordination. Especially for coordinated exchange rate policies among East Asian

countries, it is recommended to introduce deviation measurements of each East Asian currency from

a weighted average of East Asian currencies, which we will call as Asian Currency Unit (ACU).

Create Common Currency Basket as a Common Currency Unit

While all the options have pros and cons, a recommendable option to implement stronger

regional coordination is to have all the monetary authorities in the region agree on an arrangement to

create a common currency unit that consists of a currency basket, named here as the Asian Currency

Unit (ACU). The monetary authorities may use the ACU as a convergence criterion according to the

European precedent. In addition, the monetary authorities could use their home currencies’ deviation

from the ACU to measure convergence and consider their findings when discussing their exchange

rate policies. In addition, the regional currency arrangement whereby regional currencies are all

made related to and through the ACU will help avoid a coordination failure in deciding on exchange

rate policies and, in turn, prevent a competitive devaluation in the region because the monetary

authorities would have jointly committed to the arrangement.

The monetary authorities in East Asian countries should first link their own home

currencies to the ACU before they turn attention to achieving regional monetary integration. This

implies that there is a choice for the monetary authorities to realign the exchange rates of the home

currency vis-à-vis the ACU or to stop linking their home currencies to the ACU. The existence of this

choice might induce speculative attacks on weaker currencies. Such a possibility makes it

recommendable for the monetary authorities to make a strong commitment to link their home

currency to the ACU. The strongest commitment is to proceed to monetary integration. Having made

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such a commitment, the monetary authorities of the participating countries would have no option to

abandon it. Such a commitment would contribute to the stability of the exchange rate system because

private economic agents would build up their confidence in the coordinated exchange rate policy in

East Asia.

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Table of Contents

Executive Summary

Tables/Figures/Abbreviations

Introduction: -------------------------------------------------------------------------------------------------- 1

Chapter 1. Global Trends of Regional Integration: --------------------------------------------------- 3

1.1 Patterns, Stages and Sequencings of Economic Integration in the Case of the European Union: 3

(1) FTA and CU

(2) Development of Economic Integration in the EU

(3) Economic Integration and Cooperation

(4) Sequencing of the Stages of Economic Integration

(5) Enlargement and Diversity

(6) Concluding Remarks

1.2 Another Mega-bloc: North America: ------------------------------------------------------------------ 12

(1) Two-track Approach by the United States

(2) Effects of NAFTA and FTAA

Chapter 2. The Patterns of Integration in Trade and Investment in the East Asia: ----------- 16

2.1 The Market-led Integration in the East Asia: --------------------------------------------------------- 16

(1) Increasing Trade Relations in East Asia

(2) Market-led Integration in the East Asia

2.2 Regional Trade Arrangement in the East Asia: ------------------------------------------------------- 26

(1) Why Push Integration Through Institutionalization?

(2) Scope for Gains from an FTA

(3) Policy Agenda

Chapter 3. Financial Integration in the East Asia: --------------------------------------------------- 38

3.1 Introduction: ---------------------------------------------------------------------------------------------- 38

3.2 Literature Review on Financial Integration: --------------------------------------------------------- 39

3.3 Volume-based Approach: ------------------------------------------------------------------------------- 42

(1) Model Specification

(2) Estimation Results

3.4 Asset Price Based Approach: -------------------------------------------------------------------------- 47

(1) Real Interest Parity Test

(2) I-CAPM Test

3.5 International Risk-sharing Approach: ---------------------------------------------------------------- 59

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(1) Theoretical Background

(2) Decomposing the Ccross-sectional Variance of Shocks to GDP


3.6 Conclusion: ---------------------------------------------------------------------------------------------- 67

Chapter 4. Monetary and Currency integration in East Asia: ------------------------------------ 71

4.1 Analysis of the Macroeconomic Integration: -------------------------------------------------------- 71

(1) Synchronization of Business Cycle

4.2 Analysis of the Optimal Exchange Rate Regime; Time Series Analysis and Exchange Rate

Regimes: ------------------------------------------------------------------------------------------------------ 77

(1) A Currency Basket System in East Asia

a. Enhanced Trade Competitiveness

b. Capital Flow Effects

c. GDP Effects

(2) A Common Currency Basket System in East Asia

a. Linkages of East Asian Currencies to the US Dollar

b. Coordination Failure in Selecting Exchange Rate Regimes and a Common

Currency Basket System

(3) Possibility of a Common Currency Basket System

a. Symmetry of Shocks

b. Generalized Purchasing Power Parity

c. From Trade Integration to Monetary Integration

4.3 Challenges of Regional Monetary and Currency Integration: ----------------------------------- 105

(1) Surveillance Process for Coordinated Exchange Rate Policy

(2) Toward Future Monetary Integration

4.4 Asian Currency Unit (ACU) for Monetary Policy Cooperation in East Asia: ----------------- 110

(1) Introduction

(2) ECU in the European Community

(3) Private Use of the ECU

(4) The ECU Divergence Indicator

(5) Asian Currency Unit: ACU (6) Asian Currency Unit at PPP standard: ACU* (7) ACU* as an Instrument for East Asian Macroeconomic Policy Coordination (8) Longer View

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Conclusions and Policy Recommendations: --------------------------------------------------------- 129

Ⅰ. Conclusions: -------------------------------------------------------------------------------------------- 129

Ⅱ. Policy Recommendations: ---------------------------------------------------------------------------- 142

List of Authors: -------------------------------------------------------------------------------------------- 148

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Tables

1-1-1 Development of the European Economic Integration (Deepening)

1-1-2 Common Policies of the EC/EU

1-2-1 History of Trade Agreements in North America

2-1-1 Exports and Imports of the Region (Amount)

2-1-2 Exports and Imports of the Region (Shares in the World)

2-1-3 Trade Share and Intensity Indexes of Intra-regional Trade

2-1-4 Foreign Direct Investment

2-1-5 Intensity Indexes on FDI Outflows of Japan and Korea

2-1-6 Gravity Model of Trade

2-2-1 Welfare Gains from Various Combinations of FTA

3-1 Panel Estimation of Equation (3-2)

3-2 Real Interest differentials: Pre-crisis and Post-crisis Period

3-3 Stock Exchanges

3-4 Correlation of Stock Market Indices: Jan. 1991 ~ Oct. 2004

3-5 Correlation of Stock Market Indices: Jan. 1991 ~ Mar. 1997

3-6 Correlation of Stock Market Indices: Apr. 1997 ~ Dec. 1998

3-7 Correlation of Stock Market Indices: Jan. 1999 ~ Oct. 2004

3-8 Correlations of Real GDP per capita: 1991 ~ 2000

3-9 CAPM Results to Test Financial Market Integration

3-10 Estimated Risk Sharing (Sub-Periods)

3-11 Estimated Risk Sharing (Sub-Groups)

4-1-1 Correlation Coefficients Among GDP Growth Rates

4-2-1 Optimal Weight for a Currency Basket for East Asian Countries

4-2-2 Means and Standard Errors of Estimated and Simulated Values

4-2-3 Estimates of Weights on the US Dollar (Daily data)

4-2-4 Intervention Correlation Between Japan and Other Selected Countries

4-2-5 Symmetry of Aggregate Supply and Demand Shocks

4-2-6 Summary of Empirical Analysis on a Common Currency Area

4-4-1 Calculation of equivalents for 1 December 1978:

4-4-2 Re-composition of the ECU Basket

4-4-3 Weight of the currencies in the basket (1)

4-4-4 Number of Units of Each Currency

4-4-5 Weight of the nine currencies in the basket - PPP standard -

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Figures

3-1 Trends of Foreign Assets and Liabilities/GDP in ASEAN+3

3-2 Trends of Foreign Assets/GDP in ASEAN+3

3-3 Trends of Foreign Liabilities/GDP in ASEAN+3

4-1 Correlation of GDP Growth Rates Between ASEAN Countries

4-2 Correlation of GDP Growth Rates Between ASEAN Countries and China

4-3 Correlation of GDP Growth Rates Between ASEAN Countries and Japan

4-4 Correlation of GDP Growth Rates Between ASEAN Countries and Korea

4-5 Correlation of GDP Growth Rates Between CJKH.

4-6 Movements of ACU, ACU* and East Asian Currencies (1)

4-7 Movements of ACU, ACU* and East Asian Currencies (2)

4-8 Foreign Exchange Rates of East Asian Currencies (Group 1)



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Abbreviations

ACU Asian Currency Unit

AFTA ASEAN Free Trade Agreement/ASEAN Free Trade

Area

AMU Asian Monetary Unit

BF Belgian Franc

CAPM Capital Asset Pricing Model

CET Common External Tariffs

CNY Chinese Yuan

CM Common Market

CPI Consumer Price Index

CU Customs Union

CUSFTA Canada-US Free Trade Agreement

DKR Danish Crown (Krone)

DM German Mark

ECSC The Coal and Steel Community

ecofins Economic and Finance Ministries

ECU European Currency Unit

EEC European Economic Community

EEMU European Economic and Monetary Union

EFTA European Free Trade Association

EMS European Monetary System

EMU Economic and Monetary Union

EPA Economic Partnership Agreement

ERM Exchange Rate Mechanism

EU European Union

EV Equivalent Variation

FD Financial Depth

FD Financial Development

FDI Foreign Direct Investment

FF French Franc

FTA Free Trade Agreement

FTAA Free Trade Area of the Americas

GATT General Agreement on Tariffs and Trade

G-PPP Generalized Purchasing Power Parity

GTAP Global Trade Analysis Project

HK$ Hong Kong Dollar

IFS International Financial Statistics

IMF International Monetary Fund

IP Irish Pound

JSEPA Japan-Singapore Economic Partnership Agreement

JPY Japanese Yen

KRW Korean Won

LIB Liberalization Index

LIT Italian lira

M&A Merge and Acquisition

MCAP Stock Market Capitalization

MLR Malaysian Ringgit

NAFTA North America Free Trade Agreement

NTBs Non-Tariff Barriers

NTD Taiwan Dollar

NTM Non-Tariff Measures

ODA Official development assistance

Open Trade openness

Per GDP Per capita GDP

PLP Philippine Pesos

RIR-J Real Interest Differential to Japan

RIR-US Real Interest Differential to U.S.

SPD Singapore Dollar

SMC Stock Market Capitalization

TIC Treasury Inter-nation Capital System

TLB Thailand Baht

TW$ Taiwanese Dollar

UKL British Pound

WTO World Trade Organization

1

Introduction

This report examines the economic integration of East Asia. Economic integration implies

various shapes of more intensified international economic relations. Typically, the European Union

(EU) has taken more than half a century to deepen, enforce and extend its integration, both

economically and institutionally. North America, after the establishment of North America Free

Trade Agreement (NAFTA), emerged as another mega regional economic bloc. The economies in

East Asia are clearly following a trend of increasingly intensified economic ties among them.

However, the economic integration in East Asia has been mainly economy-driven, rather than

supported by full-fledged institutional arrangements, which is reflected in the concurrent increase in

intra-regional trade and foreign direct investment (FDI). On the other hand, the degree of financial

integration within East Asia has increased or even somewhat surpassed that of trade integration.

The focuses here are placed on the important linkages among trade, financial and monetary

integration in East Asia. At a basic level, higher levels of trade tend to increase the demand for

financial instruments and services related to trade, and thus provide a catalyst to more financial

liberalization. Financial integration in turn facilitates trade and investment flows through easier

access to necessary financing and risk management tools. Monetary integration, either in a loose

form of exchange rate coordination or a monetary union, usually brings about price stability and

lower risk related to intra-regional trade. As pointed out by the World Economic Outlook of the

International Monetary Fund, “trade integration is needed to take full advantage of international

financial integration, as low trade penetration tends to increase an economy’s vulnerability to

external financial crisis”. To the extent that trade integration can enhance welfare gains and

synchronize business cycles, this will also create an incentive for countries to pursue greater

intra-regional financial and monetary cooperation in order to take the whole advantage from

increased trade.

The first chapter of this report consists of historical reviews and literature surveys on the

experiences of two prominent examples of economic integration in the world, i.e. the EU and

NAFTA. It first examines the stages, phases and sequencing of economic integration, experienced by

the EU, as the reference pattern. The experience of the EU is compared to the theoretical proposition

of Balassa’s five stages. An analysis of NAFTA, the world’s largest Free Trade Agreement (FTA),

follows in the same chapter. Diversity characterizes NAFTA, in that it comprises one giant country

with the highest per capita income, and two other smaller members. A focal point here is how

NAFTA has affected the smaller members, particularly Mexico whose economy is still in the

economic convergence process.

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The second chapter covers the real-side integration in East Asia, i.e., trade and investment

integration. Intra-regional FDI, while representing financial transactions, has played an important

role in promoting intra-regional trade through establishing production networks in East Asia. The

analysis also focuses on comparison of the degree of trade and investment integration among East

Asia, EU and NAFTA. Institutionalization to promote trade and FDI, by means of an FTA or an even

wider Economic Partnership Agreement (EPA) will provide scope for further gains. Indeed, the

recent political agenda in East Asia appears to be shifting to a higher plane, from economy-driven

trade relationships to more institutionally-supported integration, as evidenced by the free trade

negotiations between ASEAN andChina and the Framework for Comprehensive Economic

Partnership between ASEAN and Japan.

The third chapter empirically examines the degree of financial integration in East Asia, by

means of three established analytical approaches. Regional financial integration within East Asia is

compared to the region’s financial integration with the global market as represented by the United

States market. The statistical tests also cover the relation between trade openness and the degree of

financial integration. This will provide important suggestions on the process and sequencing of

economic integration, that may be multi-faceted, rather than single-tracked.

The fourth chapter considers monetary and currency integration in East Asia. The first

section analyzes the synchronization of business cycles that closely reflects the regional production

networks in East Asia. Intensified real-side integration may result in macroeconomic integration.

Then, as an optimal exchange rate system, a currency basket system will be reviewed regarding the

benefits of stabilization on three aspects, namely, trade competitiveness, capital inflows, and

aggregated demand.

After these analyses, the conclusion and policy recommendations follow. Emphasis is

placed on the empirical facts of the inter-relations among the three dimensions of the integration, i.e.,

real-side integration, financial integration and monetary (currency) integration. As implied, these

three correlate with each other to a considerable extent. Real-side integration may proceed to others,

while financial and macroeconomic integration may take place simultaneously with the formation of

the production networks. Recommendations also include discussion on the pre-requisites for the

implementation of institutional arrangements.

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Chapter 1: Global Trends of Regional Integration

1.1 Patterns, Stages and Sequencings of Economic Integration in the Case of the European

Union

(1) Free Trade Agreement and Customs Union

Economic Integration is, first of all, the gradual elimination or abolition of economic

barriers which impede free movement of goods, services, capital and persons among a group of

nation states. Today we can distinguish a variety of economic integrations in the world from

viewpoints of “degree”, “size” and “diversity”.

Concerning the “size” of Economic Integration, we can separate regional Economic

Integration from Global Economic Integration like lowering tariffs in the framework of the rounds

under the General Agreement on Tariffs and Trade (GATT) and World Trade Organization (WTO).

There are more than 150 regional economic integrations in the world, in which the EU integration,

the North America Free Trade Agreement (NAFTA) and the emerging East Asian Economic

Integration are the three biggest regional integrations in their economic size.

Concerning the “degree”, Balassa’s definition (Balassa [1961]) is well known. According

to him, there are five stages of degree of integration: (1) FTA, (2) CU (Customs Union), (3) CM

(Common Market), (4) Economic Union, and (5) Total Economic Integration. More specifically:

1) A FTA abolishes intra-regional tariffs and quotas.

2) A Customs Union (CU) not only abolishes intra-regional tariffs and quotas, but also creates

common external tariffs (CET). In a CET, the competence to change tariffs moves to a

supranational institution like the European Economic Community (EEC) or common agreement

of all the member countries. A member country of a CU cannot change tariff rates of the CET.

In case of the EU, the European Commission, a supranational body of the Union, negotiates

tariffs with member countries of the GATT or WTO.

3) A Common Market is, according to Balassa, a “CU which also abolishes restrictions on factor

movements”. Factor movements include free movement of capital and persons. Though Balassa

did not refer to free movement of services, a common market realizes free movement of

services, namely free supply and demand of services across the frontiers inside the common

market and freedom of establishment of firms supplying services. In order to accomplish free

movement of services, they must abolish regulatory barriers; that is, they must harmonize laws

related to services. As a definition, a common market is an economic area in which free

movement of goods, services, capital and persons (the “four freedoms”) is guaranteed.

4) An Economic Union is a CM with “some degree of harmonization of national economic policies

in order to remove discrimination … due to disparities in these policies”.

5) The total Economic Integration means, according to Balassa, “unification of monetary, fiscal,

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social and counter cyclical policies” and “setting up of a supranational authority where

decisions are binding for the Member States”.

Concerning the “diversity”, economic integration between developed countries and

developing countries can be diverse due to differences in development levels or other factors and

participating countries must deal with the diversity by creating common policies or development

funds etc.

In the 1960s, there were two types of economic integration in Europe: EEC and EFTA

(European Free Trade Association). The EFTA was an FTA and the EEC was a CU with Common

Agricultural Policy. The EFTA is still an FTA 45 years after its birth, though the member countries

have changed. But the EEC raised its degree of integration from a CU via a Common Market to an

Economic and Monetary Union (EMU). This example suggests that choice of an FTA or a CU at an

initial stage of Economic Integration is crucial.

Tinbergen [1954] distinguished “positive” from “negative” integration. A negative

integration is related only to elimination or abolition of economic barriers. A positive integration

establishes supranational institutions or systems which are responsible for implementing common

policies. An economic integration in a real CU is “deep” and “positive”. It is deep, because

participating countries transfer their competence to manage their tariffs to a supranational institution,

namely the CU. When a CU is accomplished, the CU has a common external tariff (CET) as

mentioned above. The CET can be managed by the supranational body and the member states cede

their sovereign rights to participate in negotiation on tariffs in the GATT/WTO. Only the CU can

have power to negotiate with other participating countries belonging to GATT/WTO. The integration

is “positive”, because, adding to elimination of economic barriers inside the CU, a supranational

institution was created and common commercial policy was implemented by the CU.

A real or standard CU is rare in the world. For example, MERCOSUR in South America

names itself as a “common market” or a “CU”. But it has no supranational institution. Top

politicians of the participating countries have decided how and when tariffs are eliminated or what

products were exceptions in a tariff elimination program, and so on. MERCOSUR is similar to the

AFTA (ASEAN Free Trade Agreement), rather than the CU in the EEC.

Economic integration in an FTA is “shallow” and “negative”. It was called “negative

integration”, because an FTA does not create a supranational body and only eliminates tariff barriers

and quotas. It is “shallow”, because participating countries do not lose their sovereignty over

external tariffs. An FTA has never developed into a CU in the past. Choosing an FTA or a CU

depends on the political will of participating countries and what they want to realize by the

integration.

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(2) Development of Economic Integration in the EU

The Economic Integration of the European Union did not necessarily follow the Balassa

scheme of the five stages. The Economic Integration began with creation of the Coal and Steel

Community (ECSC) on the basis of Paris Treaty in 1951. The ECSC was a supranational institution,

hence it was a positive integration. But the Community embraced only the coal and steel sectors. In

1958, the ECSC developed into the EEC created by the Rome Treatyn signed in 1957. The EEC

accomplished a CU and Common Agricultural Policy at the end of the 1960’s.

This is the first half of the history of the European Economic Integration, where a member

nation state kept total control over its national macro-economy. With a transition to the era of

globalization, the EU made headway to the latter half history of its Economic Integration. What the

EU wanted to do in the latter half was to create an “EU-wide national economy” which includes

national economies of the member countries. What the EU has realized since 1985 in the common

market and the European Economic and Monetary Union (EEMU) is the “four freedoms” and the

Single Currency, both of which are major characteristics of a national economy.

After the long stagnation of the economic integration process in the 1970’s and the first

half of the 1980’s, the EU began to create a common market in face of the challenges of American

and Japanese industries to the European economy. The new phase of the Economic Integration was

led by the intelligent European president, Jacques Delors, led the EC to complete the internal market

integration by 1992. The Single Market integration began in 1985 to abolish all non-tariff barriers to

realize free movement of goods, services, capital and persons. This epoch-making integration

succeeded and the single market started in 1993.

The EU made further headway by the introduction of the Single Currency, the euro, in the

late 1990s. There are three likely, basic, reasons for the integration to go further: completing a true

single EU market, the German problem, and the threat of globalization. Different currencies

fragmented the Single Market by diversified foreign exchange rates movements inside the Market.

The slogan of the monetary integration, “one market, one money”, shows why the common market

had to go further to the Single Currency regime. In order to integrate the unified Germany in the EU

system, the EU countries wanted Germany to give up its own currency. Germany accepted the

demand in order to create a stable European order around the EU after the demise of the cold war. In

this sense, the monetary integration was political in nature. Countervailing against U.S.-led

globalization is a continuation of the will of Europeans since 1980’s.

The euro was introduced in 1999 in non-cash form and then the cash was introduced in

2002. Europeans call the Single Market plus the Single Currency regime the European Economic

and Monetary Union (EEMU). In the EEMU, the European Central Bank issues the euro and

implements monetary policy for the euro area. The euro became legal tender in March 2002 among

the twelve countries of the EU. With the accomplishment of the monetary integration, the Economic

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Integration of the EU was fundamentally completed.

The monetary integration looked to be too challenging for several countries. Great Britain,

Sweden and Denmark do not participate in the Single Currency regime, preferring to retain control

of their own monetary policy.

Table 1-1-1 shows how the European Economic Integration deepened during the past half

century.

Table 1-1-1. Development of the European Economic Integration (Deepening)

Decade Institution Integration & common policy Remarks

1950s ECSC Coal and Steel Community Paris Treaty of 1951

1958

-1960s

EEC

EC

CU

Agricultural policy (CAP)

Competition policy

Rome Treaty of 1957, CU

accomplished in 1968. EC since 1967.

1970s EC Commercial (Trade) policy Monetary Cooperation

1980s EC From CU to Common (Single)

Market

Single Market formation by Single

European Act of 1986

1990s From EC to

EU

Strengthened common policies in

Single Market.

Monetary integration and Single

Currency, EURO.

Single Market started in 1993.

EU started in 1993 based on

Maastricht Treaty of 1992.

EURO was introduced by 11

countries in 1999.

2000s EU EURO became legal tender in

2002.

Constitution Treaty of 2004

EURO circulated in 12 countries since

2001.

Political integration to the fore

(Source) Various documents

Compared with Balassa’s definition, there are several differences in the case of the EU’s

experience. The EU introduced a supranational institution at the beginning stage of the integration

(accordant to Balassa’s scheme, it is introduced at the end stage of integration). The EU started from

the CU, not an FTA. Balassa’s last stage is based on a vision of a unitary state, but the EU is far from

such a centralist image. The EU did not unify fiscal, social and countercyclical policies, but unified

only monetary policy. Nor has the EU become a federal state. It is a mixture of a confederation and

federation and is very hard to imagine that the EU will be a federal state in the future.

(3) Economic Integration and Cooperation

In the EU, economic cooperation supplemented the integration. In order to promote

7

Economic Integration, the EU needed a treaty and the treaty had to be ratified by all of the member

countries. If unanimous ratification is not likely to be reached, a group of countries, if they want to

advance further, can have recourse to cooperation. A remarkable example is the EMS (European

Monetary System).

The EMS was a successor to the “Currency Snake” of the 1970’s, which failed because of

several conflicts between Germany on the one side, and France, Italy and the UK on the other side,

and it became at last a small “German Mark zone”. The EMS was created under Franco-German

leadership. The US dollar fluctuated violently and thereby introduced economic confusion into the

EC. Germany and France took the lead in creating a fixed exchange rate regime in the EC. The UK

did not participate and there were objections to such an ambitious attempt in the other countries as

well. In December 1978, the EMS could start by a mere resolution of EU governments to make the

EC “a zone of monetary stability”, which meant a zone which could stabilize foreign exchange rates

within the EMS. The central banks of the eight EC countries concluded the Basel Accord and the

EMS started in March 1979.

The Exchange Rate Mechanism (ERM) of the EMS was a block floating regime. Inside the

ERM, the participating currencies pegged their exchange rates to the central rates. The central rates

were decided by all participating countries’ considering the competitiveness of each currency

(so-called “parity grid system”). The fluctuation margin permitted to each of the currencies was plus

or minus 2.25% around the central rates. The central banks intervened in the foreign exchange

market when the two currencies reach the fluctuation margin. They sold the strong currency against

the weak currency

The participants could change their central rates in order to adjust their inflation

differentials. When more than three currencies were included in the realignment, all of the finance

ministers and central bank presidents had to meet to decide how the realignment should be done.

Such a consultation mechanism worked as a de facto surveillance regime and the peer pressure

pushed the countries to take stability-oriented monetary and fiscal policy.

After the French socialist government decided to adopt a stability-oriented monetary

policy of the German type in 1983, the EMS succeeded in bringing about monetary stability in the

EU. From the start of the ERM to 1987 there central rate realignments in the EMS on 11 occasions.

During this period, the French franc, for example, lost about 30% against the German mark. After

February 1987, there was no central rate realignment among the core countries of the EMS. This

shows that the EMS achieved success at the end of the 1980’s.

The EMS was, however, attacked in 1992 and 1993 by hedge funds led by George Soros.

The speculators sold heavily weak currencies vis-à-vis the mark. In September 1992, Italy and the

UK, which participated in 1990, left the ERM. Though the central banks sold the mark, the

speculators could buy the strong currency at the 2.25% margin as much as they wanted. This is the

8

so-called “one-way-bet speculation”. The high-powered money overflowed in the German money

market so much that the authorities could not maintain the narrow fluctuation margin.

In August 1993, the participating countries decided to widen the fluctuation band from

plus or minus 2.25% to plus or minus 15% around the central rates. The wider margin made it

impossible for speculators to get profits from one-way-bet speculations. The EMS recovered

stability and the central banks could again steer their currencies in the narrow band of plus or minus

2.25% around the central rates after 1996. The stability of the EMS after 1996 became an essential

base for the EU to move forward to the monetary integration.

Economic cooperation is an instrument with which the EU governments can handle the

diversity of the participating countries. Cooperation can be done by a group of countries that want to

promote de facto Economic Integration. The experience of the EMS tells us that skillful cooperation

is much better than bad integration. Economic cooperation will surely be able to play a crucial role

in East Asia, because cooperation can proceed in some cases without any formal treaty or agreement.

(4) Sequencing of the Stages of Economic Integration

Balassa’s five stages scheme suggests that economic integration begins with trade

integration (FTA and CU), and then deepens gradually to abolition of Non-Tariff Barriers (NTBs) in

the process of common market building. The integration moves further to common policy building,

and other economic integrations in the macro-economic field. The monetary integration comes at the

end of the process.

It is reasonable to believe that economic integration begins with elimination of customs

barriers and quotas, which enables the share of intra-regional trade in the total trade of each country

to increase. The trade integration increases economic interdependence of member countries in the

region, which will attract their attention and stimulate their interest in common actions towards

economic shocks. In the case of the EU, the share of intra-regional trade increased from about 35%

to about 50% during the EU’s period of establishing its customs union, i.e., from 1958 to 1968.

In the history of the EU, monetary integration is realized at the last stage in accordance

with the Balassa’s definition. However, we should not forget that the EU began monetary

cooperation in the 1970’s, when the EC was faced with the instability of the dollar rate vis-à-vis

West European currencies. In 1970-71, the EC began to cooperate in the area of foreign exchange

policy in order to solve the instability problem. The EC’s six member countries launched the idea of

Economic and Monetary Union based on the Werner Report of 1970, yet they failed in stepping into

an Economic and Monetary Union in 1971. Hence, they began to cooperate in a foreign exchange

rate accord (the so-called “Snake”) which started in April 1972. Then new countries sought to

become members, and were approved to participate in the EC in 1973 (the UK, Denmark and

Ireland).

9

How to successfully defend the regional trade networks and related production networks is

always a top priority for the member states participating in a regional integration regime, once the

intra-regional trade share reaches a crucial level, such as 50% in the example of the EU. Therefore, it

will be reasonable to predict that the regional integration partners in East Asia will be obliged to

promote monetary cooperation in the near future.

Regarding the ASEAN, it is still unlikely to realize an independent monetary cooperation

framework, since the share of intra-regional trade is only about 20%. However, if we take up the

ASEAN+Three, then the share is up to as much as 50%, which is equal to the level of the EC at the

beginning of the 1970s. Since the ongoing FTA establishment in East Asia will increase the share of

intraregional trade among the ASEAN+Three, this area will be further eligible to foreign exchange

rate cooperation.

An FTA or a CU creates an environment where the members promote monetary

cooperation. When trade barriers are eliminated in a FTA or a CU, the foreign exchange rates of this

region will affect the competitiveness of each member country. Hence, the foreign exchange rate

stability inside the region becomes more important than before, and orderly adjustments of the

foreign exchange rates will become essential.

The previous analysis implies that economic interdependence and trade integration are the

necessary conditions for regional monetary cooperation.

(5) Enlargement and Diversity

The number of member countries of the EU increased from 6 to 25 through the five

enlargements that have taken place to date. Ireland became a member in 1973 and Greece in 1981.

Spain and Portugal participated in 1986. The membership of these four developing countries caused

the EU to encounter a diversity problem in the presence of both the core and the peripheral countries.

Besides, there was another diversity problem, that of the highly industrialized countries and

countries with high share of agriculture in terms of employment and the percentage over GDP. The

EU has handled these diversity problems by adopting several measures.

First of all, common policies were oriented towards the diversity problems. Table 2 shows

the common policies of the EU according to three functions of public policy: allocation,

redistribution and stabilization of a national economy. The second column, redistribution, is related

to the diversity problems of the EU. Common Agricultural Policy (CAP) developed to integrate

complicated agricultural regimes of each country into a common regime. One of its main objectives

was to keep a “fair living standard for farmers” in comparison with urban workers.

10

Table 1-1-2. Common Policies of the EC/EU

Allocation Redistribution Stabilization

1960’s Competition policy Agricultural policy

1970’s Commercial policy Regional policy Monetary cooperation

1980’s Above policies strengthened R.P. strengthened EMS

1990’s Industrial policy Cohesion policy EMS to EEMU

(Source) Summarized by Author

Moreover, regional policy or structural policy was oriented so as to directly support the

poor regions of the EU. In the “poor” regions, where per capita income is less than 75% of the EU

average, the EU transfers funds of the EU budget to such poor regions or structural-decline regions.

However, the member states and regional authorities need to develop structural programs to be

eligible to get money from the EU. Cohesion policy is oriented to develop infrastructure and

environmental facilities in the four developing countries: Ireland, Greece, Spain and Portugal.

Therefore, in order to tackle diversity problems in East Asia, common policies or

cooperation for the sake of redistribution should also be designed to include agriculture. The official

development assistance (ODA) from the wealthier countries should be reorganized and distributed

more efficiently for the sake of integration partners.

The second measure to tackle diversity problems is to design integration methods to

concede handicapped positions to peripheral countries. In the EU, in this connection, they refer to

“multi-speed Europe”, “variable geometry” or “flexibility”. In the ASEAN, special treatments are

allowed for the three new members in Indochina. Appropriate methods of economic integration

should be developed.

(6) Concluding remarks

Liberalization or market forces are not enough to tackle diversity problems in an integrated

region. They tend sometimes to worsen the diversity problems. If the benefits of the economic

integration are absorbed by a country or a small group of countries, the economic integration cannot

proceed smoothly because of the resistance of the others. To design an integration regime where

every member country can share the benefits of the economic integration is crucial. The success of

the EU Economic Integration suggests that the benefits are not necessarily distributed evenly to

every member country. Common policies or other appropriate methods of integration must ensure

that every country gets benefits of the integration equally.

Some European experts on Economic Integration commented that it would be better to

implement a FTA well than a CU badly.

There are two comments that need to be made here about the current economic integration

11

in East Asia. Firstly, there are too many FTAs in East Asia. We need to consider how so many FTAs

will be integrated into only one: the ASEAN + Three FTA. Secondly, the members are currently

building not mere FTAs but a FTA+s (FTA pluses). An EPA (Economic Partnership Agreement) is a

kind of FTA+, namely FTA plus the facilitation measures for customs duty, some movement of

persons or the opening of government procurements etc. Moreover, in the near future, we will be

able to include in these monetary cooperation, environmental policy cooperation, common

development of oil resources in East Asian Sea, etc. Besides, people have started to discuss the

construction of high-speed railway networks and making better use of the ODA funds for developing

East Asian countries. How to devise the ways to add such a “plus” to an FTA will be an original

contribution of the Economic Integration and cooperation in East Asia. If we consider seriously

about the East Asian Community during the process of the Economic Integration, a “plus” will be

even more important than a simple FTA in the future.

References

Balassa, Bela (1961), The Theory of Economic Integration, Irwin, Homewood, Illinois.

Pelkmans, Jacques (2001), European Integration. Methods and Economic Analysis, 2nd ed., Pearson

Education.

Tanaka, Soko (1991), The Completing the Internal Market and Reorganization of Europe, Toyo

Keizai Shimposha (in Japanese).

Tanaka, Soko (1996), The European Monetary System, Yuhikaku (in Japanese).

Tinbergen, Jan (1954), International Economic Integration, North-Holland.

Yoshitomi, Masaru (2003), Reality of Asian Economy, Toyo Keizai Shimposha (in Japanese).

12

1.2 Another Mega-bloc: North America

(1) Two-track Approach by the United States

Since the mid-1980s, regional integration agreements took place along with multilateral

trade liberalization.1 Regional integration agreements have proliferated because the United States

shifted her trade agenda toward to a “two-track” approach, resorting to regional integration

agreements as a way to achieve trade liberalization. Against this background, the North American

Free Trade agreement (NAFTA) was made, superseding the Canada-U.S. Free Trade Agreement

(CUSFTA) when Mexican entry was ratified by all three countries.

This chapter provides a simple assessment of the effects of NAFTA, compared to EU, with

special emphasis on trade patterns. The NAFTA came into effect on January 1, 1994. Its passage

through the United States Congress was surprisingly contentious when it was finally brought

forward for ratification in the fall of 1993. In fact, the United States has been the major trading

partner of both Canada and Mexico for many decades and Canada and the United States have had

free trade arrangements since the mid 1960s. The United States and Mexico began building a

cooperative trading relationship in the mid 1980s (Table 1-2-1).

Nonetheless, NAFTA was created from two bilateral relationships that exist between

United States and Canada and between the United States and Mexico, respectively. The bilateral

relationship Canada and Mexico is not as important quantitatively and qualitatively as the other two.

This is primarily due to the fact that the U.S. economy dominates those of Canada and Mexico and

therefore serves as the ‘hub’ in a ‘hub-and-spoke’ relationship based as much on economic realities

as on geography.

1 The analysis in this part benefits from Li and Li (2002).

13

Table 1-2-1: History of Trade Agreements in North America

19th Century

1854 - 56 U.S. - Canada Reciprocity Treaty

1856 Treaty abrogated by U.S.

1869 – 1923 Canada attempts to reinstate Treaty 7 times

1882 U.S. - Mexico Reciprocity Treaty

20th Century

1965 U.S. - Canada Auto Pact

1979 Mexico rejects GATT membership

1982 Mexico signs an agreement with U.S. on subsidies and countervailing duties

1986 Mexico joins GATT

1987 Framework Agreement on Bilateral Trade (U.S. and Mexico)

1989 Implementation of Canada - U.S. Free Trade Agreement (CUSFTA)

1990 Mexican President Salinas proposes a U.S. - Mexico Trade Agreement

1991 NAFTA negotiations begin

1994 Implementation of NAFTA begins

(Source) Various documents

In 1994 the U.S. population was approximately ten times as large as Canada’s and three

times that of Mexico, while the absolute size of the U.S. economy in terms of GDP was also ten

times that of Canada but nearly twenty times that of Mexico. Thus the United States is both the

largest producer/exporter and the largest market/importer in the North American region. This

structure is similar to the ASEAN + Japan in terms of GDP, and ASEAN + China in terms of

population. In the following section, the economic impacts of NAFTA will be examined, particularly

concerning economic convergence, employment and technology transfers in Mexico that still has

lower per capita income.

(2) Effects of NAFTA and FTAA

As proposed, the Canada-Mexico-United States North American Free Trade Area

(NAFTA) raised a large number of questions regarding its impact on trade flows, incomes, consumer

benefits, the pattern of labor adjustment, and aggregate economic benefits by region. While

empirical studies proliferated, the crude data are sufficient to indicate generally that there has been

an expansion of trade, both absolutely and as a percentage of total trade, among the NAFTA

14

countries in the 1990s. Perhaps the most important conclusion to be drawn is that regional

integration agreements seem to have generated welfare gains for the participants including the U.S.

The economic effects of NAFTA on Mexico would be of interest to East Asia in the

context of the combination of membership of an FTA in the region. The ultimate FTA in East Asia

will include ASEAN plus China, Japan and Korea. In the interim process, however, an FTA may take

a form of any subset of the combinations of membership. It would be likely that such subsets include

Japan or China. The diverted mix of developed and developing members, and large and small

members, in the East Asian FTA is comparable to that of NAFTA.

A recent comprehensive study by World Bank (2003) covers the issue. It concluded that

NAFTA has helped Mexico get closer to the levels of development of its NAFTA partners. The

research suggests, for example, that Mexico’s global exports would have been about 25 percent

lower without NAFTA, and foreign direct investment (FDI) would have been about 40 percent less

without NAFTA. Also, the amount of time required for Mexican manufacturers to adopt U.S.

technological innovations was cut in half. Trade can probably take some credit for moderate declines

in poverty, and is likely to have had positive impacts on the number and quality of jobs. However,

NAFTA is not enough to ensure economic convergence among North American countries and

regions. This reflects both limitations inherent in NAFTA’s design and, more importantly, pending

domestic reforms.

A Free Trade Area of the Americas (FTAA) designed along the lines of NAFTA will offer

new opportunities for growth and development in Latin American countries, particularly if

improvement is achieved on some aspects of NAFTA such as the distorting rules of origin and the

anti-dumping and countervailing duties. However, significant policy and institutional reforms will be

necessary in most countries to seize those opportunities.

Under FTAA, the likely benefits for Latin American countries of an FTA with the U.S. and

Canada go beyond the reduction of barriers to their mutual trade. On the one hand, an FTA implies a

firm guarantee of market access, in contrast with preferences granted unilaterally by the U.S., which

are offered on a temporary basis and subject to unilateral revocation at any time. On the other hand,

an FTA can help lock in progress made on unilateral trade liberalization, making it immune to

protectionist pressures that might arise in the future. It may also have a broader positive impact on

credibility by offering investors, domestic and foreign, a more stable and predictable framework in

the rules governing international trade.

As an important component in addition to tariff cuts, NAFTA includes an explicit

provision to liberalize capital movement, particularly in the form of foreign direct investment (FDI).

The anticipation of higher level of FDI inflow is probably one of the main benefits that prospective

members expect from the upcoming FTAA. The experience with NAFTA appears to validate these

expectations: aggregate FDI flows to Mexico did rise significantly in the period following NAFTA,

15

and econometric analysis suggests that the trade agreement played an instrumental role in the rise.

This may be also the case in East Asia.

References

Baldwin, R.E., and Anthony Venables, (1996) “Regional Economic Integration”, in

Handbook of International Economics, Grossman, G. M. and Kenneth Rogoff, eds.

Volume 3.

Baldwin, R. E., and T. Murray, (1977), “MFN Tariff Reductions and LDC Benefits Under

GSP”, The Economic Journal, January, 30-46.

Brown, Drusilla K., Alan V. Deardorff, and Robert M. Stern, (1992), “A North American

Free Trade Agreement: Analytical Issue and a Computational Assessment”,

The World Economy, January, 11-29.

Li, C. and Li, H. (2002), “Survey on Economic Effects of the EU and NAFTA,” presented for

Trilateral Joint Research by China, Japan and Korea.

Francois, J. F. and C. R. Shiells (1994), “AGE models of North American free trade: An

introduction”, in: J. F. Francois and C. R. Shiells, eds., Modelling trade policy:

Applied general equilibrium assessments of North American free trade,

Cambridge University Press, Cambridge, UK.

Verdoorn, Petrus. J. (1960), “The IntraBloc Trade of Benelux”. In Economic

Consequences of The Site of nations, E. A. G. Robinson, ed., Macmillan for the

International Economic Association, London.

Viner, Jacob (1950), The Customs Union Issue, Carnegie Endowment for International

Peace, New York.

World Bank (2003), Lessons from NAFTA for Latin America and the Caribbean Countries,

16

Chapter 2. The Patterns of Integration in Trade and Investment in East Asia

This chapter follows the review of the perspectives of economic integration in EU and

NAFTA in the former chapter, focusing on real-side economic integration in East Asia. Traditionally,

the increase in the amounts and volumes of intra-regional trade characterized the degree of real-side

integration. In East Asia, however, foreign direct investment, which are basically financial

transactions, has played a key role in the increasingly intensified trade relations. After the analysis of

various indicators to measure the real side integration, a standard gravity model analysis provides the

comparison of the degree of intra-trade relations between East Asia and NAFTA. Finally, in the

context of Free Trade Agreements, a computable general equilibrium model simulation will indicate

the economic effects and outcome of the various scenarios of FTA in East Asia.

2.1 Market-led Integration in East Asia

(1) Increasing Trade Relations in East Asia

Increasing Shares of Trade in ASEAN+3 Members

The ASEAN+3 economies have experienced a remarkable expansion in trade for these two

decades. The amount of exports from ASEAN10+3 increased from US$259 million to US$1,788

million from 1980 to 2003. Their share of world exports became nearly double, from 14.2 percent in

1980 to 23.9 percent in 2003. If Japan is excluded, their trade shares recorded even more remarkable

expansion, from 7.0 percent to 17.5 percent (Table 2-1-1 and 2-1-2).

17

Table 2-1-1: Exports and Imports of the Region (Amount) Exports (million US$) Imports (million US$) 1980 1990 1995 2000 2003 1980 1990 1995 2000 2003

World 1,832,500 3,381,700 5,070,800 6,368,700 7,492,400 1,918,700 3,517,300 5,134,300 6,608,700 7,745,300United States 220,781 393,106 583,451 771,991 724,000 256,959 517,020 770,972 1,238,200 1,305,000

EU (EEC) 776,025 1,526,745 2,097,164 2,404,823 2,888,700 871,083 1,568,614 2,012,483 2,439,158 2,786,600ASEAN10+3 259,372 643,516 1,215,909 1,523,754 1,788,113 269,648 523,499 1,158,541 1,338,781 1,600,419

China 18,139 62,760 148,955 249,195 438,250 19,505 53,809 132,163 225,096 412,836Japan 130,435 287,678 443,047 477,333 473,911 141,284 235,307 336,027 377,153 383,025Korea 17,439 67,812 125,588 171,826 192,750 22,063 74,405 135,352 160,479 178,824

ASEAN10 71,663 144,099 322,774 420,998 456,795 64,989 162,905 360,245 360,339 390,442ASEAN5 66,533 139,120 322,822 395,041 426,828 63,176 158,533 344,617 338,945 356,575Indonesia 21,909 25,681 45,428 62,102 60,995 10,834 22,008 40,629 33,511 32,544Malaysia 12,960 29,420 73,724 98,153 104,966 10,821 29,170 77,620 82,195 82,726

Philippines 5,788 8,194 28,282 31,694 36,225 8,295 12,993 28,282 31,694 37,500Thailand 6,501 23,072 57,201 65,160 80,521 9,213 33,408 73,692 56,915 75,809

Singapore 19,375 52,753 118,187 137,932 144,121 24,013 60,954 124,394 134,630 127,996Viet Nam 62 2,364 5,621 12,597 20,371 459 2,726 8,259 15,377 25,611

Other ASEAN 5,130 4,979 10,863 19,444 29,967 1,813 4,543 15,628 21,394 33,867

(Source) IMF, IFS

Table 2-1-2: Exports and Imports of the Region (Shares in the World) Exports (Shares in world (percent)) Imports (Shares in world (percent)) 1980 1990 1995 2000 2003 1980 1990 1995 2000 2003

World 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00United States 12.05 11.62 11.51 12.12 9.66 13.39 14.70 15.02 18.74 16.85EU (EEC) 42.35 45.15 41.36 37.76 38.56 45.40 44.60 39.20 36.91 35.98

ASEAN10+3 14.15 19.03 23.98 23.93 23.87 14.05 14.88 22.56 20.26 20.66China 0.99 1.86 2.94 3.91 5.85 1.02 1.53 2.57 3.41 5.33Japan 7.12 8.51 8.74 7.49 6.33 7.36 6.69 6.54 5.71 4.95Korea 0.95 2.01 2.48 2.70 2.57 1.15 2.12 2.64 2.43 2.31ASEAN10 3.91 4.26 6.37 6.61 6.10 3.39 4.63 7.02 5.37 5.40

ASEAN5 3.63 4.11 6.37 6.20 5.70 3.29 4.51 6.71 5.13 4.60Indonesia 1.20 0.76 0.90 0.98 0.81 0.56 0.63 0.79 0.51 0.42Malaysia 0.71 0.87 1.45 1.54 1.40 0.56 0.83 1.51 1.24 1.07

Philippines 0.32 0.24 0.56 0.50 0.48 0.43 0.37 0.55 0.48 0.48Thailand 0.35 0.68 1.13 1.02 1.07 0.48 0.95 1.44 0.86 0.98

Singapore 1.06 1.56 2.33 2.17 1.92 1.25 1.73 2.42 2.04 1.65Viet Nam 0.003 0.07 0.11 0.20 0.27 0.02 0.08 0.16 0.23 0.33

Other ASEAN 0.28 0.15 0.21 0.31 0.40 0.09 0.13 0.30 0.32 0.44

(Source) IMF, IFS

Intensified Trade Relation among the East Asia Region

The growth in trade of the ASEAN+3 economies proceeded together with advance of

intensified intra-regional dependence in trade. Economists have developed several indicators to

measure the intra-regional dependence (see Petri [1993] and Urata [2004]). An indicator is “relative

measure”, that is, the shares of the bilateral trade over the total trade of the country. Another more

18

elaborated indicator is “double-relative measure”, or the intensity index. The export intensity index

of country i to country j, IEXij, is defined as:

World)fromjofImportsWorldfromWorldof(ImportsWorldfromjofImports

WorldtoifromExportsjtoifromExports

IEX ij

−

=

By the same token, the import intensity index of country j from country i, IIMij, is defined as

World)tojfromExportsWorldtoWorldfrom(ExportsWorldtoiofExports

jtoWorldfromImportsjtoifromImports

IIMij

−

=

The index shows the intensity, or upward bias, of a bilateral trading relationship by taking account of

its share in the world trade. The value of unity for the intensity index means that the bilateral trade

relationship is neutral, while the relationship is more (or less) biased when the index is greater (or

less) than unity.

The intra-regional trade intensity index, compared to a bilateral trade intensity index,

requires some modification in calculation of the index. The denominator of bilateral export intensity

indexes is a share of imports of the exporting country over the world import net of the imports of the

exporting country. This specification has the assumption that the exporting country does not import

from itself. In contrast, this manipulation should not apply to the regional intensity index, as the

economies in a region may normally import from the other economies in the same region.

Accordingly, the intra-regional export and import intensity indexes, IEX and IIM, respectively, are

defined as:

WorldfromWorldofImportsWorldfromregiontheofImports

regiontheofExportsregiontheineconomyothertoExports

IEX =

WorldtoWorldfromExportsWorldtoregiontheofExports

regiontheofImportsregiontheineconomyotherfromImports

IIM =

According to the definition, Table 2-1-3 below summarizes the shares of exports and

imports, and the export and import intensity indexes of various groups and regions. Intra-regional

trade in ASEAN10+3 increased its importance for the total trade over time, as shown in the increase

in their world share of exports and imports from 31.8 and 33.6 percent in 1980 to 37.5 and 49.7

percent in 2003, respectively. One should note, however, that the share of their intra-regional exports

slightly declined from 1995, while their imports share followed an increasing trend until 2003. For

19

most of the developing member economies in ASEAN, intra-regional trade has grown faster than

trade with any other markets. While Japan and China accounted for the bulk of the intra-regional

trade, the regional trade of most of the smaller economies in ASEAN has also grown2.

2 Ng and Yeats (2003) pointed out that the relative importance of China as a destination for regional exports significantly increased since the mid-1980s, and this trend appears to have sharply accelerated since 1995.

20

Table 2-1-3: Trade Share and Intensity Indexes of Intra-regional Trade

Exports Shares (percent) Imports Shares (percent)

1980 1990 1995 2000 2003 1980 1990 1995 2000 2003 ASEAN10+3 31.75 36.66 44.93 42.60 37.52 33.55 32.99 45.69 48.39 49.71

ASEAN10+China 15.78 14.62 18.15 16.99 16.15 13.76 10.47 15.46 18.18 18.47 ASEAN10+ Japan 23.70 20.39 26.61 24.78 23.52 23.42 20.66 28.79 28.86 27.42 ASEAN10+Korea 17.50 17.80 24.00 22.37 21.30 13.69 10.60 18.50 22.95 22.16

ASEAN10 18.64 18.87 24.64 23.00 22.06 14.45 9.27 18.30 23.32 22.57 ASEAN5+China 16.06 15.36 18.50 17.57 16.87 14.00 11.47 15.51 18.17 18.29 ASEAN5+ Japan 21.35 19.65 25.08 23.50 21.89 21.28 19.80 27.52 27.29 25.28 ASEAN5+Korea 14.58 14.84 19.74 18.30 16.86 11.53 7.87 13.96 18.22 17.03

ASEAN5 16.71 18.14 22.39 21.63 20.41 13.25 8.30 16.67 21.73 20.69 NAFTA 33.62 41.39 46.24 55.74 56.09 33.92 33.25 37.67 39.80 36.45

MERCOSUR 15.91 11.83 23.22 23.32 16.42 11.94 18.35 20.79 24.22 24.64 European Union15 59.51 65.99 62.18 62.07 59.92 55.23 64.89 61.03 57.00 57.79

EEC 45.63 44.78 41.04 40.50 38.36 41.51 41.62 37.96 37.96 38.46 Export Intensity Index Import Intensity Index

1980 1990 1995 2000 2003 1980 1990 1995 2000 2003

ASEAN10+3 2.26 2.46 1.99 2.10 1.82 2.37 1.73 1.91 2.02 2.08 ASEAN10+China 2.85 2.35 1.36 1.40 1.20 2.26 1.22 1.21 1.32 1.23 ASEAN10+ Japan 2.20 1.80 1.96 2.22 2.35 2.12 1.62 1.91 2.05 2.21 ASEAN10+Korea 3.85 2.69 2.49 2.84 3.23 2.81 1.71 2.09 2.47 2.85

ASEAN10 5.50 4.10 3.51 4.22 4.38 3.69 2.18 2.87 3.53 3.70 ASEAN5+China 2.96 2.53 1.41 1.49 1.28 2.41 1.36 1.24 1.35 1.26 ASEAN5+ Japan 2.00 1.76 1.89 2.17 2.29 1.98 1.57 1.85 1.98 2.10 ASEAN5+Korea 3.27 2.29 2.11 2.42 2.44 2.51 1.30 1.62 2.02 2.06

ASEAN5 5.08 4.03 3.34 4.22 4.43 3.65 2.02 2.71 3.45 3.63 NAFTA 1.91 2.18 2.36 2.23 2.56 2.04 2.06 2.24 2.09 2.35

MERCOSUR 6.60 10.35 12.07 13.70 12.81 5.59 10.45 11.31 13.72 12.88 European Union15 1.39 1.72 1.86 1.80 1.67 1.34 1.68 1.71 1.63 1.50

EEC 1.59 1.91 2.01 1.83 1.66 1.45 1.80 1.81 1.63 1.46

(Source) IMF, IFS and Direction of Trade Statistics.

(Note) Export and import shares represent the percentages of the intra-regional exports (imports) over the total

exports (imports).

In spite of their increasing trend, the shares of intra-regional trade in East Asia still remain

at a lower level than those of the EU or NAFTA. The shares of intra-regional exports and imports in

2003 are 59.9 and 57.8 percent in the EU15, and 56.1 and 36.5 percent in NAFTA, respectively.

However, NAFTA’s intra-regional imports share declined from 39.8 percent in 2000, reflecting her

rapid increase in imports from China. This underscores the importance of the United States as a

provider of final demand, or “absorber of the final products from East Asia”. As the other side of the

coin, the lower level of the shares of intra-regional exports in East Asia partly reflects the lack of

large absorbers of the final products in the region.

21

The intra-regional trade intensity indexes, which were invariably above one in East Asia,

indicate the strength of the ex-post trade relations among the region. Economists have observed that

the increase of intra-regional procurement in manufacturing sectors may have directly reflected

intensified trade relations. This is vertical, intra-firm, economic integration. Indeed, an international

input-output analysis concludes that a marginal increase in final demand of an economy in East Asia

induced more increase in production of most of the other economies in the region in 1995 than in

1985 (Urata [2003]). ASEAN10, ASEAN5 and ASEAN5(10)+Korea recorded higher index scores.

This means that the members in such combinations trade among themselves rather exclusively.

Among ASEAN countries and Korea, production and procurement networks appear to be established

comparatively densely.

(2) Market-led Integration in East Asia

A number of economic analyses identified the accumulation of Foreign Direct Investment

(FDI) inflows as the driving force of the intensified intra-regional trade in East Asia. Multinational

firms, in particular Japanese firms, have extended their on-the-ground presence throughout Asia by

means of FDI, and have played an important role in developing intra-regional production and

procurement networks and the vertical economic integration since the early 1980s.

Expansion of Foreign Direct Investment and Intensified Investment Relations

The East Asian economies have experienced rapid expansion of FDI inflows since the

1980s (Table 2-1-4). FDI inflow to the ASEAN5 increased more than six times from 1985 to 2003.

During the 1990s, FDI inflow to China increased remarkably, by more than 15 times. In 2003,

ASEAN10+3 became one of the largest recipients of FDI in the world, representing 15 percent of the

world FDI inflow. Japan is a major supplier of FDI in the region, representing 69 percent in the

regional FDI outflow. But Japan had small shares in the FDI inflows until recently. Singapore and

Korea follow Japan as FDI suppliers, while Singapore is a large FDI recipient.

The increase in FDI inflow of ASEAN countries apparently reflected their liberalization

and measures for facilitation of capital transactions. Moreover, their trade liberalization should have

led to their higher returns on capital, reflecting increased efficiency in the allocation of factors. The

higher potential profitability must have attracted FDI to them.

22

Table 2-1-4: Foreign Direct Investment Outflows (million US$) Inflows (million US$) 1980 1990 1995 2000 2003 1980 1990 1995 2000 2003

World 53,683 242,057 358,235 1,186,838 612,201 54,986 208,646 335,734 1,387,953 559,576United States 19,230 30,982 92,074 142,626 151,884 16,918 48,422 58,772 314,007 29,772

EU(EEC) 14,651 87,835 93,613 408,319 201,044 2,963 8,015 43,549 63,532 407,494ASEAN10+3 2,720 52,233 37,462 44,989 41,871 2,767 18,816 67,127 80,988 82,682

China 0 830 2,000 916 1,800 57 3,487 37,521 40,715 53,505Japan 2,385 48,024 22,630 31,558 28,800 278 1,753 41 8,323 6,324Korea 26 1,052 3,552 4,999 3,429 17 759 1,249 8,572 7,523

ASEAN10 309 2,328 9,280 7,516 7,841 2,415 12,817 28,316 23,379 19,100ASEAN5 309 2,328 9,260 7,345 7,751 2,433 12,403 25,396 21,150 15,407Indonesia 6 -11 1,319 150 130 180 1,092 4,346 -4,550 -597Malaysia 201 129 2,488 2,026 1,370 934 2,611 5,815 3,788 2,474

Philippines 1 22 98 -108 158 -106 550 1,574 1,345 319Thailand 3 154 887 -22 557 189 2,575 2,070 3,350 1,802

Singapore 98 2,034 4,467 5,298 5,536 1,236 5,575 11,591 17,217 11,409Viet Nam 0 0 0 0 0 0 180 1,780 1,289 1,450

Other ASEAN 0 0 20 171 90 -18 414 2,920 2229 3694

(Source) UNCTAD, World Investment Report, various issues.

The limitation of bilateral flow data of FDI prevents the researchers from conducting a

detailed study. However, the bulk of the intra-regional FDI in ASEAN10 has taken the form of

unilateral net flows from Japan and Korea to developing economies in the region. As such, Table

2-1-5 below presents the intensity indexes for the FDI outflows from Japan and Korea to ASEAN,

China and the United States, only. But this may well illustrate the intra-regional FDI relation.

Table 2-1-5: Intensity Indexes on FDI Outflows of Japan and Korea Japan Korea

1990 1995 2000 20032003

(FDI stock)1990 1995 2000 2003

2003 (FDI stock)

China 0.37 0.80 0.63 1.11 1.73 1.73 2.30 4.82 4.04 6.18 ASEAN10 1.16 1.28 3.08 2.28 1.86 4.04 5.40 4.92 4.21 3.34 ASEAN5 1.20 3.37 3.36 2.74 2.00 4.18 1.64 3.95 3.78 2.68 Indonesia 3.67 2.41 - - 3.13 16.35 1.59 - - 3.17 Malaysia 1.01 0.65 1.74 3.50 2.17 6.54 4.44 - 0.39 0.25

Philippines 1.73 2.98 9.82 11.50 4.72 4.33 0.12 3.37 8.07 3.29 Singapore 0.55 0.67 0.75 0.53 4.70 - - - 3.30 1.67 Thailand 1.63 3.91 7.89 6.53 0.60 5.62 4.20 3.26 2.41 3.67

United States 1.96 2.52 1.12 6.65 1.88 1.06 1.58 0.99 5.54 1.50

(Source) UNCTAD, World Investment Report, various issues; MOF (Japan), Foreign Direct investment statistics

The calculation of the intensity indexes follows the method of export and import intensity

indexes, replacing bilateral exports/imports with FDI outflows/inflows. The indexes demonstrate the

strong relations of Japan and Korea to ASEAN. The index of Japan demonstrated a remarkable trend

23

of increasing with Malaysia and the Philippines, while that of Korea did so with China. One should

note that the very high intensity index of Japan to the United States in 2003. This reflects the

increase in merger and acquisition activities in the U.S. market. In spite of the modest number of the

intensity index of Japan to China, the Japanese business particularly shows an FDI boom to China

since 2002.

In 2003, the intensity indexes to ASEAN from Japan declined, while that to China rose.

This may imply a challenge from China to ASEAN in terms of direct investment competition. Such

competition emerged among the ASEAN5 countries.

Development of Production Network in East Asia

For the sake of theoretical discussion, FDI may be taken as complementing or substituting

for trade. FDI will have a positive effect on bilateral trade if it leads to (i) “reverse importing” - the

home country importing the affiliate’s output and replacing what has been produced for the home

market with the import, and (ii) affiliates’ imports of intermediate products including parts from the

parent companies in the home country. FDI will have a negative effect on bilateral trade if it leads to

a partial or full displacement of the home country’s export to the host country with local production.

A number of economic analyses concluded that the FDI and trade in East Asia generally went

together as the complements to each other.

In addition to such FDI-trade linkages, a backward linkage created by FDI in the host

country will have a positive effect on regional economic integration. To the extent that the affiliates

purchase locally produced intermediate goods, the local suppliers join in the international production

network that runs across national boundaries and become indirectly linked with the affiliates’ parent

companies. This inclusion in parent companies’ production networks will have as strong an effect on

regional economic integration as bilateral trade, as in ASEAN economies and the coastal areas of

China.

The networks of production and procurement have promoted economic integration in East

Asia. Particularly, Japanese multinational firms have heavily invested in ASEAN economies and

China by means of FDI. Their increasing intra-firm trade has reflected the growth of components

and partly assembled goods in the region (see Urata [2003]). According to Ng and Yeats (2003),

Japan is an important center or “hub” of production-sharing operations in East Asia, originating

about one-third ($38.7 billion) of all regional exports of components for assembly. Over 70 percent

of Indonesia’s regional imports of components originate in Japan, while the corresponding shares for

Korea and the Philippines exceeds 50 percent.

The multinational firms also of the United States have been active in setting up production

networks in East Asia. But compared to the Japanese multinational firms, the U.S. multinational

24

firms tend to procure more open from other nationalities, seeking the most efficient procurements

(Borrus [1998]). It should be noted, however, that the U.S. has played an important role of absorbing

much of the final products.

Limitation of Market-led Integration in Trade and Investment

The development of the production and procurement networks, being responsible for the

intensified trade relations, characterizes the market-led economic integration in East Asia. A factor to

initiate the integration was the body of trade liberalization measures taken since the early 1980s. It is

often stressed, however, other than such trade liberalization measures and market mechanisms an

institutional driving force has been lacking in East Asia (Perti [1993], Urata [2004]). While

somewhat outdated, Frankel (1992) conducted econometric tests, using gravity equations, on the

formation of an economic bloc in East Asia. He concluded that the level of trade in East Asia is

biased intra-regionally, as it was within the European Community and within the Western

Hemisphere, to a greater extent that can be explained naturally by distance. Frankel also suggested

that there was no evidence of a special Japan effect on her concentrating trade with other Asian

economies, nor that the East Asian countries were collectively moving toward a trade bloc in the

way that Western Europe and Western Hemisphere appeared to be.

The gravity equation includes geographic distances between the trading partners,

representing the trading costs, as an explanatory variable. Other than the distance variable, the other

explanatory variable in the gravity model include the product of GDPs of the trading partners

(GDPiGDPj) as a size variable, the product of per capita GDPs of the trading partners

(GDPPiGDPPj) as a living standard variable, and a number of dummy variables. This study here

will test the following specification:

( ) ( ) ijkk

kijjijiij dummyDistGDPPGDPPGDPGDPT εββββα +++++= ∑ 4321 lnln)ln(ln

and

EAECNAFTAEUASEANBorderLanguagedummy ijijijijijk

kk 4645444342414 βββββββ +++++=∑

where T: bilateral trade (ASEAN5, China, Japan, Korea, EU15(1980-1995:EEC, and

2000-2003:EU15), NAFTA)

GDPiGDPj : Product of GDPs of the trading partners

GDPPiGDPPj: Product of per capita GDPs of the trading partners

Dist: Distance between the trading partners

25

Language, Border, ASEAN, EU, NAFTA, EAEC: dummy variables

Language = 1 if both trading partners use the same language), 0 if otherwise.

Border = 1 if both trading partners share the same border, 0 if not.

NAFTA = 1 if both trading partners are NAFTA members, 0 if not.

EAEC =1 if both trading partners are East Asia Countries, 0 if not.

Frankel (1992) found that the distance, size and standard of living variables are all highly

significant statistically for the samples in 1980, 1985 and 1990. The study tried various dummy

variables, including Border, EC, Western Hemisphere, ASEAN, APEC and EAEC. Analytical focus

was placed on the changes in the value of estimated coefficient of the EAEC dummy. The value was

significantly positive, indeed higher than those of EU and Western Hemisphere, but no statistical

evidence was found that the coefficient of the EAEC dummy increased during 1980s.

Table 2-1-6 below updates the empirical study of Frankel (1992), adopting the gravity

model equation shown above. The estimated coefficients are generally comparable to his study. For

example, the coefficients of GDP, GDP per capita and distance were 0.75, 0.29 and -0.56 as of 1980,

while in Table 5, those are 0.76, 0.18 and -0.51, respectively.

Table 2-1-6: Gravity Model of Trade

1980 1990 1995 2000 2003

Constant -32.88 *** -32.551 *** -4.744 *** -7.743 *** -31.67 ***

GDP 0.764 *** 0.751 *** 0.708 *** 0.774 *** 0.778 ***

GDP per capita 0.180 *** 0.229 *** 0.185 *** 0.120 *** 0.067 ***

Distance -0.512 *** -0.534 *** -0.509 *** -0.452 *** -0.439 ***

Language 1.016 *** 0.918 *** 0.976 *** 0.874 *** 0.954 ***

Border 0.328 * 0.442 *** 0.262 0.273 0.472 ***

ASEAN dummy 0.374 0.278 0.388 * 0.705 *** 0.583 ***

EU dummy 0.521 ** 0.302 * 0.539 *** 0.275 0.484 ***

NAFTA dummy 0.374 0.238 1.123 *** 1.269 *** 0.979 ***

EAEC dummy 1.900 *** 1.579 *** 1.529 *** 1.424 *** 1.557 ***

(Source) Estimated by DIR

(Note) *** 1% level, ** 5% level, * 10% level.

The estimate coefficients of the dummy variables generally have positive signs, all

representing some “super-natural” regional upward bias. Among all, it should be emphasized that the

coefficient of the EAEC dummy did not show any increasing trend from 1980 to 2003, while those

of NAFTA and ASEAN dummies apparently followed increasing trends in the same period. As

26

Frankel (1992) and Urata (2004) concluded, East Asia has lacked a driving force to promote trade

integration, and there may be a scope for further expansion of intra-regional trade.

2.2 Regional Trade Arrangement in the East Asia

(1) Why Push Trade Integration through Institutionalization?

At present, a significant proportion of world trade is conducted under the rules of regional

integration agreements, notably EU and NAFTA. As a counterpart to regional groupings in the

developed world, there do exist customs unions and free-trade areas among the developing countries,

such as the Common Market of the Southern Cone and ASEAN Free Trade Area (AFTA). However,

these groupings are too small to be considered serious counterweights to the EU and NAFTA. There

is intense concern in the developing countries regarding trade and investment diversion in Europe

and North America.

During 1997-1999, this concern was exacerbated by the financial crisis that originated in

Southeast Asia and spread to Korea and elsewhere. The crisis has forced policymakers to rethink the

financial, trade, and investment linkages that connect regional economies. At the same time, it has

given new impetus to ideas for regional institutions to help shape common responses. The countries

seriously felt the lack of and need for regional institutions dedicated to matters of common concern

in finance, investment flows, macroeconomic and exchange rate coordination. (see World Bank

[2004])3. The importance of regional cooperation was reinforced by the challenge of China after her

WTO accession.

Trade integration takes an important part in such broad regional coordination agenda.

Although regional trade negotiations have not advanced as far as those governing financial

arrangements, trade integration is the foundation for regional economic cooperation. Success will

ultimately depend on the consistency of approaches among all elements of integration. To achieve

such consistency, the scope of discussion must be broadened.

Today, East Asia has widening opportunities in the regional trade arrangement options

available to the region. Liberalization of trade and investment policies is recognized as a way to spur

gains in efficiency. As such, it fits well with the new policy emphasis in East Asia on innovation in

firms and on economy-wide productivity growth. The expansion of production and procurement

networks brought about intensified trade relations in East Asia. Policies can support these natural

economic forces, and the drive to liberalize is shaping new institutional arrangements. Indeed, such

strategy appears to be spreading. That is evidenced by the fact that the ASEAN-China Framework

Agreement has been launched and the ideas for a new ASEAN-Japan are creating new alliances in

3 On the financial front, the Chiang Mai initiative has created a web of swap agreements between regional central banks to be deployed in case of future liquidity problems. The Asian Bond Fund concept has been endorsed by several countries.

27

favor of liberalization within the region.

(2) Scope for gains from an FTA

Historically, East Asia generally oreferred the approach of multilateral trade liberalization

under GATT/WTO, making regional integration arrangements exceptional. Such exceptions include

the ASEAN Free Trade Area (AFTA), established in 1993. However, the approach changed around

the year 2000, as evidenced by the Framework Agreement on ASEAN China Comprehensive

Economic Cooperation, signed in November 2002; an East Asia–wide free trade agreement; a more

recent proposal by Japan for an ASEAN-plus-Japan free trade agreement; and bilateral agreements

under negotiation, in particular by Japan, Singapore, Korea, and Thailand.

In this section, scope for gains from the regional arrangements is assessed. The analysis

mainly covers the effects of an FTA, putting a focus on the efficiency improvement gained by trade

liberalization. Indeed, the stated motivation of several initiatives, including the ASEAN-China

Framework Agreement, is to take advantage of complementarities and build on existing strengths in

order to make the region collectively more efficient and competitive and thereby attract investment.

The regional agreements under consideration in East Asia are increasingly comprehensive

in scope, going beyond the removal of tariffs and non-tariff barriers on trade in goods to include

trade facilitation measures, such as conformity of standards and procedures across national

boundaries, and trade in services4. These components are qualitatively assessed.

Economic Effects of an FTA - Survey

An FTA will have a wide variety of impacts. The effects encompass those on welfare,

production, exports and imports in both real and nominal terms. For example, a survey by Baldwin

and Venables (1995) organized the impacts on the national welfare into six effects, based on a

decomposition of an indirect utility function with respect to the consumption expenditure. Assuming

all the trade barriers cause rents only to domestic agencies5, one effect can be omitted. Following

Baldwin and Venables (1995) with simplification (see Annex 1 for details), the effects are sketched

out, as follows:

1) Trade Volume Effect: This is defined as the sum of tariff wedges multiplied by changes in the

volume of trade, caused by the reduction of tariffs and other non-tariff measures (NTMs). As

Meade (1955) demonstrated, the welfare of a country improves if the tariff-weighted change in a

country’s trade volume is positive. This effect is related to the famous paper by Viner (1950) in

4 The New-Age Partnership between Singapore and Japan announced in January 2002 is notable in this regard. 5 In contrast, some trade barriers may be real trade costs or a quota under which foreigners capture the quota rents.

28

which he divided the effects of regional trade liberalization into two types: trade creation and

trade diversion effects. The sum of the two effects produces ambiguous results. Trade diversion

effects mean reduced imports from non-FTA nations, while trade creation effects mean increase

in the sum of increased imports from FTA and non-FTA countries.6 Trade diversion is caused by

discriminatory tariff reduction that leads private agents to import from a supplier that is not the

lowest-cost source. Therefore, trade diversion reduces home welfare by raising the nation’s cost

of consuming such goods.

Thus, if bilateral tariffs are reduced only on imports from countries that are already the

lowest-cost suppliers, trade diversion does not occur. FTAs are likely to be beneficial if the FTA

partners initially account for large shares of each other’s imports, as would be the case if they

were low-cost producers. In the cases of FTAs between East Asian countries, the countries

account for large shares of their trade partners’ imports, and trade diversion effects may be small.

2) Terms of Trade Effect: Changes in the trade by not-small countries will induce changes in

world prices with consequent effects on welfare. If imports of the FTA members from the rest of

the world fall, then the terms of trade of the members of the FTA are likely to improve. The

terms of trade effects have ambiguous results, because in general a FTA may or may not bring

expansion of intra-regional trade and contraction of external trade.

The two effects above appear in models with perfect competition. The following three

effects (Output Effects, Scale Effects and Variety Effects) are only relevant in models that allow for

increasing returns to scale and imperfect competition.7 The effects are important for analyzing the

regional trade agreements between countries with similar industrial and trade structures, and where

intra-industry trade is dominant, as between the United States and Canada.

3) Output Effects: This arises if there is a change in output in industries where price differs from

competitive average costs.

4) Scale Effects: This gives the value of changes in average costs induced by changes in firm

scale. This effect is proved to be important in the case of the European Union and NAFTA.

5) Variety Effects: This arises when the number of differentiated consumer products changes.

The Effects of an FTA on Growth: Accumulation Effects

An FTA will affect growth if it changes the return on investment in capital, as well as

6 According to Kowlczyk (1992), there are many other definitions of trade creation and diversion. 7 The main reference on this theoretical application is Helpman and Krugman (1989).

29

human and knowledge capitals. This is accumulation effects through spurring capital formation.

According to Baldwin and Venables (1995), the changes may be transient, as will be the case if

increased accumulation reduces the return to the accumulated stock, or may be permanent if

diminishing returns to accumulation are not encountered.

In the case of NAFTA, many in Mexico hoped NAFTA would attract foreign investment to

the country, and indeed a surge of such investment occurred when NAFTA became a serious

possibility. In the recent example of China, her WTO accession with concomitant massive trade

liberalization was followed by a kind of direct investment boom from Japan and Korea. China’s

recent intent to form an FTA with other Asian economies may rest on attracting foreign investment,

as well as an attempt to ensure access to external markets in order to maintain her high growth.

Regional integration will usually affect factor productivity and, therefore, factor prices,

including the rate of return on capital. When an FTA raises the demand for capital in the member

countries, this will generate an inflow of investment from non-member countries, in the existence of

perfect international capital mobility. These capital flows will raise GDP through higher saving and

investment rates in the FTA members and lower it elsewhere.

According to Baldwin (1989; 1992), regardless of the sources of any increased investment,

if capital faces diminishing returns, the rate of return will eventually return to its normal level.

Nonetheless, the additional capital will generate permanent changes in output and income, over and

above the static model. An output multiplier, with the empirical values of 1.2 – 2.4 in the case of the

EU, can describe the magnitude of these changes8.

An FTA may increase long-term growth rates, as well as transient medium-term growth, as

long as capital is not subject to diminishing returns. While formal analysis is not found in the

literature, there are many expectations voiced in official documents and other observations.

Location Effects of an FTA: Concerns about Regional Disparity

There is a concern that regional integration may be associated with increased inequality

between the regions. In a perfectly competitive environment, regional integration would reduce

intra-FTA factor price differences, as was proved by the “factor price equalization theorem”. As long

as the countries’ endowments lie inside the same cone of diversification, integration will equalize

factor prices in the long run. For instance, developing economies in ASEAN and Japan have much

different endowments, but the virtual integration of the countries will eventually increase the

internationally traded goods and factors, which will increase the size of the cones of diversification.

Actually, wages in the developing economies increased, while those in Japan have declined.

Economic geography, recently drawing the attention of economists, often assumes

8 In the case of APEC trade liberalization, this multiplier was estimated at approximately 3.5 (APEC Economic Committee (1997)).

30

imperfect competition and scale economies, which sometimes imply reverse outcomes. Scale

economies and economies of agglomeration mean that firms will not locate productive capacity in

every country or region. The decision of the firm depends on the balance between production costs

and the trade costs. This balance changes as trade barriers are reduced, and it is possible that industry

will be drawn into high wage locations, increasing inter-regional wage differences.

Simulation Specifications and Scenarios

To assess the various scenarios of FTA, this study conducts a simulation by using a

standard general equilibrium model with a database developed by the Global Trade Analysis Project

(GTAP) of Purdue University. The GTAP is a multi-region, multi-sector international model,

consisting, in this simulation, of 19 regions and 22 industrial sectors (see Annex 2 for the regions,

sectors and their abbreviations). The most recent version of the database, version 6-beta, covers the

national accounts, trade and tax data in 2001. A model simulation is conducted to measure the

impacts of the elimination of bilateral effective tariffs between the FTA members. Technically, the

simulated impacts equal the differences of the values of the endogenous variables in the model,

brought about by the model shocks.

As China obtained accession to the World Trade Organization (WTO), the related

commitments9 made by China in the accession process should reflect the pre-simulation dataset.

Accordingly, the model shock should not include the commitments. By the same token, the model

shock should not include the existing Japan-Singapore Economic Partnership Agreement10 (JSEPA).

The reference scenario of the model is the formation of an FTA of ASEAN10+3.

Alternative scenarios for comparison, all of which appear to be the plausible subsets of the

ASEAN10+3 FTA membership, include (i) ASEAN10 only; (ii) ASEAN5 only; (iii) ASEAN5+Japan

(5+JPN), (iv) ASEAN5+China (5+CHN), (v) ASEAN5+Korea (5+KOR), and (vi) ASEAN5+CJK

(5+CJK). All of the alternative scenarios have the potential of going forward in light of the recent

political context.

The “free capital mobility” option in the model allows for changes in the amount of

international capital flows, filling the gaps in the rates of returns on capital.11 This means that the

tariff cuts may bring about changes in the current / trade account balance. The model closure may

take both static and dynamic specifications. The dynamic specification, adopted in our simulation

here, assumes the existence of the accumulation effects by Baldwin (1992).

9 In addition to the commitments, China will be eligible for the benefits under the Uruguay Round’s Agreement on Textiles and Clothing, free from the quota by the North American Multi-fiber Agreement. 10 JSEPA includes FTA components, but the salient feature of the agreement exists in the comprehensiveness of the agreement (Ogawa (2004)). 11 Another optional model assumption is “fixed capital movement”, which results in fixed amounts of current accounts.

31

Simulation Result

Table 2-2-1 below summarizes the simulation result of the simulation, showing the welfare

gain of each economy in terms of equivalent variation (EV).

32

Table 2-2-1: Welfare Gains from Various Combinations of FTA

Equivalence Variation (million US$)

ASEAN10 ASEAN5 5+JPN 5+CHN 5+KOR 5+CJK ASEAN10+3

CHN -306.2 -111.4 -417.0 2512.9 -347.2 4877.3 4691.51

JPN -259.2 -153.8 3483.5 -1311.6 -618.0 8987.9 8704.72

KOR -218.2 -105.9 -256.1 -962.7 6691.3 16808.8 17057.53

IDN 1238.7 1141.4 2560.4 2816.9 1652.2 3684.1 3620.37

MYS 1612.7 1490.8 3765.0 3121.8 1738.2 4605.5 4666.89

PHL 981.6 931.1 1213.5 1688.6 1094.2 1535.7 1506.04

SGP 2434.0 1546.6 1561.5 3342.4 1581.8 2153.6 2938.7

THA 3495.0 2460.6 9430.7 6318.6 3450.9 10575.9 11069.73

VNM 286.6 -15.8 -34.1 -35.3 -60.4 -317.9 1819.57

XSEA 383.4 44.5 133.3 -2.0 -0.8 90.7 613.03

ANZ -166.4 -75.8 -39.9 -51.2 -157.9 -664.5 -843.28

HNK 76.6 87.7 191.7 189.3 63.0 -194.1 -260.91

TWN -132.0 -47.7 -203.2 -499.9 -148.0 -1425.5 -1687.7

SAS -26.7 60.3 144.5 -138.4 -88.4 -215.2 -535.03

CAN 81.9 94.1 268.1 162.4 103.6 301.4 196.37

USA 485.2 759.5 2993.3 545.3 224.8 933.3 -1064.37

MEX 59.3 132.0 721.7 58.9 93.8 1015.8 638.44

CHL 14.7 17.2 26.1 17.5 7.2 -48.8 -74.23

EU15 542.6 788.2 3372.8 384.1 381.2 2423.8 803.82

XRW 369.5 548.4 1710.7 921.5 67.9 786.3 -347.27

Total 10953.1 9591.9 30626.3 19078.9 15729.1 55914.0 53513.9

(Source) Estimate by DIR staff, using GTAP version 6-beta

(Note) See Annex 2 for abbreviations

As expected, the reference scenario, ASEAN10+3, will yield a large welfare benefits in

total, amounting to US$53.5 billion. But a more realistic scenario, ASEAN5+3, will bring about

even larger gains than ASEAN10+3, amounting to US$55.9 billion, while the difference is small.

Comparing these two scenarios, the entry of the additional five members in ASEAN under

ASEAN10+3 may bring about a trade diversion effect, leading to small welfare loss to the existing

FTA members. The trade diversion effect should disappear in the near future as these economies

develop.

The combinations of ASEAN5 and one of the northeastern three members will provide

beneficial FTA cases to the ASEAN members, but a trade diversion effect will bring about a welfare

33

loss to the excluded northeastern members. This represents the welfare loss that comes from

“not-being-an-FTA-member” effect. This implies that the three northeastern members should

seriously consider an FTA with ASEAN.

While not shown in the table, the GTAP model simulates the impacts on the industrial

sectors in each region. In general, the sectors protected heavily will shrink, and other, more

competitive sectors will expand. The efficiency improvement here will be obtained from the painful

process of industrial adjustment.

Effects not Simulated

The model simulation only estimates the static efficiency gains followed by capital

accumulations. Actual trade liberalization under an FTA will bring about a wider scope of more

dynamic gains, notably more inflow of FDI, more competition, and stimulated research and

development activities, all of which will lead to higher rates of economic growth in the long run.

From the experience of NAFTA, the free trade agreement contributed to the convergence of real

income and wages, although the treaty does not suffice to ensure convergence because of the large

institutional gap (World Bank [2004]).

The developing countries in ASEAN generally expect that an FTA will stimulate FDI

inflows and technological transfer. An FTA may deepen the degree of financial integration -- in

addition to trade integration - of its member countries. In particular, it may prompt a substantial rise

in foreign investment inflows to FTA newcomers. The experience with NAFTA appears to validate

these expectations: aggregate FDI flows to Mexico did rise significantly in the period following

NAFTA, and econometric analysis suggests that the trade agreement played an instrumental role in

the rise.

Moreover, an FTA will result in a stronger macroeconomic synchronization. The analysis

in the first section of Chapter 4 in this report shows that the correlations have been rising between

the countries in East Asia. Business cycles tend to synchronize more as regional production networks

have been built up. An FTA will further intensify this trend in the region, creating more demand for

the currency system to stabilize the economies.

(3) Policy Agenda

As shown in the simulation, any plausible combinations of FTA will bring about some

benefits to the FTA members. However, the expansion of the membership will raise the amounts of

the gains in total, as well as the gain of each member. As a policy agenda, therefore, expansion of the

membership will be the basic strategy. The goal for the region should be an ASEAN10+3 FTA, and

any subsets should be transitional.

34

In such an expansion process, the policy-makers should take into consideration so-called

spaghetti bowl effects. Any FTA will call for implementation of strict rules of origins that will

increase administrative costs. If a zero-tariff structure of a combination of FTAs is totally different

from that of another combination, expansion of the FTAs will actually raise the trade costs and

prevent the production network and division of labor from working fully. To avoid such situation, the

policy-makers should carefully design any FTA proposal so as to be compatible with other FTAs in

the future. A reporting system and peer review on the FTAs of other parties may be established to

address this issue. In this regard, it is worthwhile to consider forming a Customs Union, even for

limited items, in the region to avoid unnecessary red tape.

Another important policy agenda will be to minimize adjustment costs in transit to expand

the FTA memberships. Future studies on an FTA should place more focus on the assessments on the

impacts to industrial sectors. ASEAN5+3 may be a semi-final goal to East Asia12, and any one FTA

will be a transit. If an industry in a country obtains a benefit and expands because of one FTA, but if

the industry is finally destined to decline under the ASEAN5+3 FTA, the industry should not react to

the one-time benefit. Some adjustment policy should take care of such a situation. But if some

sectors decline in the long-run, the policy-makers should provide well designed grace periods and

aids for adjustment.

An FTA brings about industrial adjustment to the member countries. Some sectors may

take benefits while others may be seriously damaged. Moreover, as shown in the model simulation in

this chapter, some countries take larger benefits than others. The diversity of ASEAN10+3 countries

may aggravate the imbalance. If an ASEAN10+3 FTA is a serious political agenda, the members

should consider establishing a coordination system to reallocate and redistribute the benefits and

achieve economic stability. The EU introduced common policies designed to address such purpose.

The future FTAs in East Asia had better include economic cooperation and promotion of

FDI. The JSEPA is a good example, although it does not have serious bilateral tariff elimination. The

economic cooperation may cover monetary cooperation, environmental policy cooperation, common

development of natural resources development, and common infrastructure improvement. Some of

these are being implemented in the EU.

Finally, it would be worthwhile for the leaders to disclose the plans and agenda on trade

liberalization to the private sector. This will facilitate business planning and help the private sector to

utilize the merits accruing from larger production networks and division of labor.

12 Final goal shall be an ASEAN10+3 FTA and the global liberalization.

35

Annex 1: Simplified Framework for Welfare Analysis

The text adopts an analytical framework which much simplified the formulation by

Baldwin and Venables (1995). Suppose that the welfare of the representative consumer in a country

can be represented by an indirect utility function

),( EtpVV += where p is border price vector, t is a vector of import tariff (domestically

captured rent), and E is total expenditure on consumption. Total expenditure is equal to the sum of

factor income, profits and domestically accruing trade rents including tariff revenue, net of

investment. Therefore,

tmrKwLE ++= where m is the net import vector.

Totally differentiating V and dividing through by the marginal utility of expenditure, and

assuming perfect competition in the market for used capital, we find:

mdptdmVdVdE E −=≈ /

The first term is trade volume effect, and the second, terms of trade effect.

In the case of tariff elimination, the trade volumes effect amounts to the following integral:

[ ] 00

0

0

0

0

00

0

0mtmdtmdttmdt

dtdmtdE

t

ttt−=−=≈ ∫∫∫

where t0 is the level of import tariff before the tariff elimination, and m0 is the amount of import

before the tariff elimination. In a partial equilibrium framework, the first term denotes the trapezoid

sodod1s1, and the second term is the rectangular sodoba in the chart below. The two terms add up to

the sum of two triangles soa s1 and dobd1.

Supply

Demand

Domestic Price

Border Price

P

Q

s0 d0

s1 d1

a b

t0

m0

36

Annex 2: Region and Sector Classification for GTAP Simulation

No. Code Region No. Code Sector

1 CHN China 1 GRN Grains

2 JPN Japan 2 AGR Agriculture

3 KOR Korea 3 FRS Forestry

4 IDN Indonesia 4 FSH Fishing

5 MYS Malaysia 5 MIN Coal

6 PHL Philippines 6 PFD Processed food

7 SGP Singapore 7 TEX Textiles & apparel

8 THA Thailand 8 PPP Wood, paper, publishing

9 VNM Vietnam 9 CHM Chemical, rubber, plastic

10 XSEA Rest of Southeast Asia 10 MTL Metals

11 ANZ Oceania 11 TRN Transport equipment

12 HNK Hong Kong 12 ELE Electronic equipment

13 TWN Taiwan 13 OME Machinery and equipment n.e.c.

14 SAS South Asia 14 OMF Manufactures n.e.c.

15 CAN Canada 15 EGW Electricity

16 USA United States. 16 CNS Construction

17 MEX Mexico 17 TRD Trade

18 CHL Chile 18 TRS Transport n.e.c.

19 EU15 Austria 19 CMN Communication

20 XRW Rest of the World 20 FIN Financial services n.e.c.

21 OSP Business services n.e.c.

22 OSG PubAdmin/Defence/Health/Education

37

References

APEC Economic Committee, (1997) “The Impact of Trade Liberalization in APEC”, APEC

Secretariat, Singapore

Baldwin, R.E., (1989) “The Growth Effects of 1992”, Economic Policy: A European Forum, vol. 9,

247-281.

Baldwin, R.E.,(1992) “Measurable dynamic gains from trade”, Journal of Political Economy, vol.

100, 162-174.

Baldwin, R.E., and Venables, A.J., (1995) “Regional Economic Integration”, Handbook of

International Economics, Vol. 3, Chapter 31.

Borrus, M. (1999) “Exploiting Asia to Beat Japan”, D. Encarnation, ed., Japanese Multinationals in

Asia, New York: Oxford University Press.

Frankel, J., (1992) “Is Japan Creating A Yen Bloc in East Asia and the Pacific?”, NBER Working

Paper No. 4050.

Helpman, E. and Krugman, P.R., (1989) “Trade policy and market structure”, MIT Press,

Cambridge, MA and London

Kowalczyk, C., (1992) “Paradoxes in integration theory”, Open Economies Review, vol. 3, 51-59.

Meade, J.E., (1955) “The theory of customs unions”, North-Holland, Amsterdam

Ng, F., and Yeats, A., (2003) “Major Trade Trends in East Asia: What Are Their Implications for

Regional Cooperation and Growth?”, Policy Research Working Paper 3084. World Bank,

Washington, D.C.

Ogawa, E., (2004) “What Kind of Free Trade Agreement? Modality and Contents”, Exploring a

Possible Japan-Korea FTA, Joint Research between Japan and Korea.

Petri, P., (1993) “The East Asian Trading Bloc: An Analytical History”, Jeffrey A.Frankel and Miles

Kahler, eds., Regionalism and Rivalry: Japan and the United States in Pacific Asia,

Chicago: University of Chicago Press.

Urata, S., (2004) “The Shift from ‘Market-led’ to ‘Institution-led’ Regional Economic Integration in

East Asia in the late 1990s”, RIETI Discussion Paper Series 04-E-012.

Viner, J., (1950) “The customs union issues”, Carnegie Endowment for International Peace, New

York

World Bank, (2004) “East Asia Integrates – Trade Policy Agenda for Shared Growth,” Oxford

University Press.

38

Chapter 3: Financial Integration in East Asia 3.1. Introduction


economic growth. Financial market integration increases benefits for portfolio risk diversification

and consumption smoothing across countries and over time through borrow and lending. In other

words, international financial markets allow different countries to pool idiosyncratic risk. By pooling

the risk from production, consumption and the terms of trade and so on, more inputs will shift into

those industries that have a higher return. Therefore, the general welfare of the country will be

improved. Along with presence of the international financial markets, the completeness of the

markets plays an important role in risk sharing. With the complete market in the sense of Arrow-

Debreu, economic agents are able to pool risks perfectly, and the availability of the other assets is

irrelevant to the agents’ decisions of risk allocation. No one wants to hold incomplete assets in

equilibrium. On the other hand, when markets are incomplete, the nature of incompleteness matters

and monetary or nominal factors may have real effects on the economy.

However, existing international financial markets are incomplete, so an economic agent

cannot perfectly pool away the idiosyncratic risk. Nevertheless, the international financial markets at

least allow agents in different countries to reduce the risk from uncertain, future disturbances, so as

to take opportunities for risk sharing and consumption smoothing. At the same time, financial

integration indirectly contributes to the economic welfare of the country. In addition to consumption

smoothing and risk sharing, the positive impact of capital flows on domestic investment and growth,

enhanced macroeconomic discipline, and increased efficiency and stability of the financial system

are the main benefits of financial integration.

On the other hand, it is increasingly recognized that a high degree of financial openness

may produce significant short-term cost. A debate has emerged on the role of financial integration as

a triggering mechanism in emerging market crises during the last decade, including the Asian crisis.

The costs of financial integration include an inadequate domestic allocation of capital inflows, which

may hamper the country’s economic growth and exaggerate prevailed domestic distortions, the loss

of macroeconomic stability, pro-cyclical movements in short-term capital flows, a higher degree of

volatility of capital flows, and risks associated with foreign financial institutions’ penetration.

In a similar vein, the issue of financial integration in East Asia since the Asian crisis is

attracting public attention among economists and policy makers in the region. A debate on the

degree and process of financial integration in East Asia provides significant policy implications for

the regional capital market development and regional financial architecture. Park and Bae (2002)

assert that East Asian countries have developed stronger ties with advanced countries than with one

another in the process of financial opening. This implies that East Asia suffers from a lack of

39

financial integration. Oh et al. (2003) analyze the current capital movements in East Asia and

conclude several negative impacts on the financial integration; first, the strong tendency of East

Asian countries to invest in safe assets of advanced economies and of advanced economies to invest

in risky assets of East Asia all but causes East Asian economies to reduce the earnings from asset

management and to raise the East Asian risk premium; second, such capital flows do not contribute

positively to the development of the East Asian capital market; third, the characteristic of such

capital flows results in raising the possibility of a currency crisis in East Asia. On the other hand,

McCauley et al. (2002) assert that the finances of East Asia appear more integrated than had been

expected, by investigating bonds underwritten and loan syndicated for borrowers in East Asia, and

conclude that East Asia may be less exposed than is often imagined to sudden and large scale capital

reversals. Against this backdrop, both the matter of how much regional financial integration has

increased, as well as which regional financial markets are integrated are important issues to examine,

and the related issues will provide a variety of economic cooperation in East Asia. This chapter

examines a hypothesis of financial market integration in East Asian, especially ASEAN + 3 countries.

The main objectives of this chapter are two fold. First, we investigate the degree of financial

integration in East Asia. Second, we try to examine whether East Asian countries integrate with

global economies or within the region

This chapter is organized as follows. The next section reviews literature related to financial

integration. Section 3 examines the degree of financial integration based on foreign assets and

liabilities in ASEAN+3, and estimates what factors contribute to financial integration in East Asia.

Section 4 also delves into the degree of financial integration in East Asia based on asset-price

approaches such as real interest rate differential tests and I-CAMP tests. Section 5 presents the

international risk sharing approach to examine the degree and direction of financial integration in

East Asia. Section 6 concludes. 3.2. Literature Review on Financial Integration

Ideally, the degree of financial integration should be measured using the bilateral capital

flows between the countries. However, the bilateral capital flow data are not available for most of

the countries. Only the Treasury International Capital System (TIC) provides bilateral capital flows

data for the U.S. and its counterpart countries. Therefore indirect measures for the financial

integration are taken to analyze the degree of financial integration in most cases.

There are in general three different approaches in the literature that may be used to test

international financial integration: the volume-based approach, asset price-based approach, and risk

sharing approach. The volume-based approach examines the degree of financial integration by using

data on countries’ portfolios of external assets and liabilities. One of the reasonable measures in

judging the degree of financial integration in a country is the level of international asset

40

cross-holdings. When a country integrates with the global financial market, the country’s external

assets and liabilities would increase to obtain gains from portfolio diversification (see Lane and

Milesi-Ferretti [2003]).

Another strand of literature looks directly into the asset prices. The main hypothesis is

somewhat similar to purchasing power parity arguments: If the national financial markets are

perfectly integrated, we should observe the convergence of cross-border asset prices. Evidence of

convergence in asset prices is diverse, being primarily dependent on the asset criteria and potentially

on the choice of the region. For Europe, money markets and equity markets (Centeno and Mello

[1999]) are generally more integrated than real capital markets (de Ménil [1999]; Oh [2003]). For

East Asia, Park (2002) uses a co-integration test for six East Asian national stock markets, but did

not find any meaningful evidence of integration.

Real business cycle theory (Backus et al. [1992: 1995]) extends the role of financial

markets to business cycles. It says that consumption co-movements with integrating international

financial markets should be higher than output co-movements. The empirical failure to confirm this

hypothesis is the strand of literature on the lack of consumption risk sharing. Kim et al. (2003) apply

a related method to East Asian countries and show that East Asian countries show less consumption

risk sharing, and less consumption smoothing, than OECD countries and the EU. Risk sharing at the

international level has been explored by studies such as Sørenson and Yosha (1998) and Mélitz and

Zumer (1999). Sørenson and Yosha (1998) found that for OECD countries as well as for EC

countries, a larger fraction of idiosyncratic output shocks go unsmoothed. 60~70 percent of shocks

are not smoothed for OECD and EC countries. According to Mélitz and Zumer (1999), almost 80

percent of idiosyncratic shocks to OECD and EU region are unsmoothed.

Recent studies show that the phenomenon of international capital market integration

before the First World War was quite pronounced to the extent that the degree of international

capital market integration was as high then as today. Sakakibara and Yamakawa (2003) review the

development of trade in the pre-modern era of Asia and document evidence of a relatively high

intra-regional and global trade as well as financial integration in Asia. Lindert and Williamson

(2001) report the trend of globalization over the last two centuries and show that there has been a

revival of the globalization trend since 1950. They estimate that the world capital market as of year

2000 has reached the level of integration before the First World War. They also report the

importance of migration: between 1870 to 1910 migration was the most important pro-convergence

force of real wages across Atlantic Ocean. They stress that countries that have gained the most from

globalization are the poor ones that have changed their policies to take advantage of it. Bordo,

Eichengreen and Irwin (1999) compare world economic integration of today to that of late 19th

century and conclude that integration in trade and financial markets is more pervasive today than a

century ago due to institutional innovations made over the period such as innovations in information

41

technology, creation of supranational institutions like the IMF and WTO and developments in

financial markets including creation of new types of financial assets, to name a few.

Nonetheless we see evidence that the world economy may be more segmented than it is

commonly perceived. Obstfeld and Rogoff (2001) single out six major puzzles in contemporary

international macroeconomics and all of these puzzles clearly demonstrate that the degree of

segmentation of the world goods and capital markets is high13. However signs of integration are

observed as well. For instance the Feldstein and Horioka coefficient has slightly decreased over the

last four decades. In their original regression14, the correlation coefficient of the national savings on

national investments, β, is 0.89 for 16 OECD countries over the sample period of 1960-74. This

result is one that is expected in a rather closed economy, where national savings flow exclusively to

national investments and the current account deficit is zero. β becomes 0.62 for 22 OECD countries

during the sample period of 1982-91 (Obstfeld and Rogoff [1996] p.162,) and 0.60 during the period

of 1990-1997 for 24 OECD countries in Obstfeld and Rogoff (2001). Though this suggests progress

in international capital market integration, the puzzle is not resolved. Current account balances are

still small relative to total savings and investment and net capital flows are small, even though gross

capital flows are large.

Tesar and Werner (1998) show a decline of equity home bias by the mid-1990s, another

sign of progress in international capital market integration, yet the levels are far less than what

standard models of optimal portfolio diversification imply. Integration of international capital

markets means that national capital markets are getting more strongly linked with other national

markets. The perfect state of international capital market integration refers to the state in which

national barriers disappear within the integrated market. The evidence listed above indicates that

international capital markets have been integrating, but there still exist strong signs of segmentation.

13 The puzzles laid out are 1) the home bias in trade puzzle, the phenomenon that within-country trade is far more intense than between-country trade (McCullum 1995), 2) the Feldstein-Horioka puzzle, the phenomenon that domestic savings stay home and national current account balances are relatively small, 3) the home bias in equity portfolios puzzle (French and Poterba 1991), the phenomenon that national investors hold relatively few foreign equities, 4) the international consumption correlation puzzle (Backus, Kehoe and Kydland 1992), the phenomenon that international consumption correlations are lower than one would expect if agents participated fully in international capital markets to diversify their income risks optimally and are relatively lower than output correlations, 5) the Purchasing Power Parity puzzle and 6) the exchange rate disconnect puzzle, the latter two referring to the lack of the link between exchange rate movements and real macroeconomic variables 14 I/Y = α+ βS/Y + ε with I, S and Y being national investment, national savings and national production respectively.

42

3.3 Volume-based Approach

This section analyzes the degree of financial integration and estimates what factors

contribute to the increasing financial integration in East Asia. We use data on countries’ portfolios of

external assets and liabilities. One reasonable measures in gauging the degree of financial integration

in a country is the level of international asset cross-holdings15. When a country integrates with the

global financial market, the country’s external assets and liabilities would increase to obtain gains

from portfolio diversifications.

In terms of cross-border financial transactions, with an imbalance between savings and

investment, in other words a current account imbalance, in a country, resource transfer appears in the

form of net international capital flows. However, cross-border capital movement does not occur

simply because of a current imbalance. Cross-border capital movement takes place when investment

and savings are balanced; this is when economic entities are both lenders and borrowers. In the case

of cross-border capital movement, this can be translated into gross international capital flows. The

increase of cross-border gross capital flows can build up liquidity in financial markets and diversify

risks. This section aims to find out the degree of international financial integration in ASEAN+3,

and to identify what factor determines the degree of international financial integration in the region.

We follow the concept of the volume-based measure of financial integration and basically use the

panel specification in Lane and Milesi-Ferretti (2003).

If we look at the changes in foreign assets and liabilities in East Asia, we can see that the

degree of international financial integration in the region since the 1980s has been increased. Figure

3-1 shows the sum of foreign assets and liabilities divided by GDP in ASEAN+3. The ratio of the

foreign portfolio holdings to GDP has increased significantly in the region except for the crisis

period.

15 See Lane and Milesi-Ferretti (2003) for details in volume-based approach

43

Figure 3-1: Trends of Foreign Assets and Liabilities/GDP in ASEAN+3

0

0.02

0.04

0.06

0.08

0.1

0.12

0.14

0.16

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

(Source) Caluculated by Author

Comparing foreign assets and liabilities to GDP separately, we can find several stylized

facts about the patterns of capital flows in the region (Figures 3-2 and 3-3). First, East Asia showed

limited cross-border capital transactions in the 1970s and 1980s, mainly due to capital controls and

regulation, as well as the rudimentary nature of domestic financial markets.

Second, during the 1970s and 1980s, bank loan and debt financing had been dominant

capital flows in the region.

Third, since the early 1990s, FDI flows into East Asia have increased. Often it has been

argued that capital flows in the form of FDI are desirable, in that they give positive externalities to

the recipient country, such as transfer of technology and management skills. The arguments further

hold that it is costly for FDI to reverse the direction, thus having less volatility; FDI relies on

long-term profits of investor companies, having less sensitivity to international interest rates. For

foreign direct investors, normal rate of return objectives is a factor for consideration, yet investment

factors based on strategic consideration are equal in importance. FDI is attractive as an alternative

solution for market share cap and market regulation issues in emerging market investment.

Throughout the 1990s, East Asian developing countries have gradually liberalized their financial

markets to the advantage of foreign investors, increasing cross-border bank loans and equity

investment in the region.

Lastly, portfolio transactions were almost negligible in most East Asian economies in the

1980s, but in the following decade, portfolio investment inflow such as into bonds and stocks began

to expand its proportion in the total capital inflow to East Asian. Particularly, gradual liberalization

of foreign investment in emerging economies’ capital markets began around the same time,

enhancing the availability and reliability of financial information of domestic companies. Normally

44

it is difficult to expect active cross-border portfolio investment in a country without well-developed

macroeconomic policy instruments, or with a weak financial system. Nevertheless, the fundamental

reason for the extensive spread of portfolio investment across regions is the international

diversification of assets by advanced economies. Cross-border portfolio investment in emerging

market economies is on the rise, as the demand for bonds and stocks of emerging markets by

institutional investors of the United States, Japan, and Europe is increasing. Extremely low interest

rates and the slowdown of economic growth of major advanced economies are other significant

reasons. At the same time, emerging market economies loosened regulatory measures on domestic

portfolio investment through capital liberalization, leading to the expansion of international portfolio

investment. However, portfolio investment flows generally follow the fluctuations of the business

cycle. Therefore, it is hard to forecast whether greater portfolio investment inflows in the emerging

economies will be maintained or not.

Figure 3-2: Trends of Foreign Assets/GDP in ASEAN+3

0. 000

0. 010

0. 020

0. 030

0. 040

0. 050

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

FDI Equity debt bank


45

Figure 3-3: Trends of Foreign Liabilities/GDP in ASEAN+3

0

0. 01

0. 02

0. 03

0. 04

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

FDI Equity debt bank


(1) Model Specification

A volume-based measure of international financial integration is defined as:

( )

it

ititit GDP

FLFAIFI

+= (3-1)

where FA and FL refer to the stocks of aggregate foreign assets and liabilities for each ASEAN +3

country. GDP stands for Gross Domestic Production.

We construct a panel data for 8 ASEAN + 3 countries from 1981 to 2002. The panel

specification is:

( ) ( ) ititititit εZβXγαIFI +∆++=∆ (3-2)

where itX represents a capital liberalization index (LIB), and itZ includes trade openness (Open),

per capita GDP (perGDP), financial depth (FD), stock market capitalization (SMC), and real interest

differential to Japan (RIR-J) and U.S. (RIR-US). The first difference of variables take into account

the nonstationarity of the level variables in the regression. We conduct the panel estimation of (3-2),

incorporating with White covariance estimation in the standard error specification. ita represents a

country specific intercept or the fixed effect, and itX is a liberalization index, which represents

value of an index of capital account liberalization (see Mody and Murshid [2002]).

46


Table 3-1 shows the estimation result of equation (3-2). The liberalization index (LIB) is

negative and statistically significant for most specifications. This implies that reducing capital

account restrictions do not increase the degree of financial integration, which is somewhat

contradictory. Trade openness (open) is an important factor to explain the degree of financial

integration. The coefficient is positive and highly significant for all specifications. It turns out that

higher income (perGDP) also increases the degree of financial integration: the coefficient is positive

and statistically significant. The coefficients for financial development (FD) and stock market

capitalization (MCAP) are also positive and statistically significant. The overall explanatory power

of the specification rises from 0.11 to 0.61 when stock market capitalization is included.

On the other hand, the real interest rate differentials between each country and the U.S.

and/or Japan are not successful in explaining the direction of the financial integration in East Asia.

When only real interest rate differentials to the U.S. are included in the specification, the coefficient

is negative and significant. However, when both real interest rate differentials are included, the

coefficients are mixed signs and statistically insignificant.

In sum, we find that most important factors in explaining the degree of financial

integration in East Asia are the degree of trade openness, higher income and financial development

and the size of stock market capitalization for East Asian countries.

47

Table 3-1: Panel Estimation of Equation (3-2)

(1) (2) (3) (4) (5) (6) (7)

LIB -0.003

(-2.76)

-0.004

(-4.81)

-0.004

(-4.8)

-0.005

(-4.65)

-0.10

(-3.7)

-0.009

(-3.54)

-0.10

(-3.58)

Open 0.13

(16.5)

0.129

(13.4)

0.125

(10.45)

0.166

(17.5)

0.16

(18.0)

0.17

(18.3)

PerGDP -0.0009

(-0.05)

0.002

(0.17)

0.06

(5.94)

0.07

(6.75)

0.08

(6.75)

FD 0.05

(1.06)

0.1

(2.12)

0.10

(2.22)

0.11

(2.40)

MCAP 0.0001

(3.76)

0.0001

(3.36)

0.0001

(3.25)

RIR-US -0.0001

(-2.08)

0.0006

(1.24)

RIR-J -0.0007

(-1.54)

R2 0.06 0.10 0.10 0.11 0.61 0.62 0.63

D.W. 2.60 2.49 2.49 2.48 2.56 2.57 2.56

N. of Obs. 176 176 176 176 88 88 88

3.4. Asset Price Based Approach

(1) Real Interest Parity Test

This test is based upon the idea that real rates of interest on financial assets like bonds will

tend to converge in integrating financial markets. We examine the cross-country real interest rate

differentials for seven Asian markets – China, Japan, Korea, Hong Kong, Singapore, Taiwan and

Malaysia – and the United States. Our focus is (1) whether these markets are relatively integrated

and (2) how the degree of integration evolves over time.

The hypothesis is that the real interest differentials would be small in absolute value in an

integrating market and they will show a decreasing trend over time if the markets are integrating.

The model we estimate is the following as used in Goldberg, Lothian and Okunev (2003) 16.

16 Open Economics Review (14):299-317, 2003.

48

Δrdijt = α1 + α2D2 + ν1rdijt-1 + ν2D2 rdijt-1 (4-1)

where rdijt is the difference between the real interest rates in country i and country j, and D2 is a

dummy variable that takes a value of 1 for the post-crisis period (January 1999 to now). Note that

the ratio (α1/-υ1) is an estimator of the long-run differential between the two countries’ real

interest rates in the pre-crisis period. Analogously the ratio (α1 + α2)/-(υ1 + υ2) is an estimator

for the post-crisis period. What we are interested in is not the spot real interest rate differentials, but

these long-run interest differentials. If the long-run differentials are significantly different from 0, we

interpret it as indicating the lack of financial integration in the two markets concerned. If (α1 + α

2)/-(υ1 + υ2) is smaller than (α1/-υ1) in absolute value, we interpret it as indicating progress of

financial integration for the markets concerned.

(a) Data

The interest rates are end-of month, short-term domestic money market rates from

International Financial Statistics (IFS), except that 3-month commercial paper rates from Bloomberg

are used for Taiwan. Inflation rates are calculated using CPI’s from IFS. We take by country the

longest time horizon that the data allows, generally starting from 1980s. The real interest rate data

used for estimation starts from January 1980 for most countries, exceptions being China whose data

starts from January 1987, Hong Kong from December 1990 and Taiwan from April 200017. We

divide the period into two: the pre-crisis period,or until March 1997, and the post-crisis period, or

from January 1999 to today18. We do not include the crisis period.

(b) Estimation Results

The following summarizes the estimation results of Table 3-2. First, the long-term real

interest rate differentials of six Asian countries19 vis-à-vis the U.S. rates have generally decreased in

the post-crisis period, except for Hong Kong. However, the long-term real interest rate differentials

of Asian countries vis-à-vis the Japanese rates are generally higher than those vis-à-vis the U.S. in

both the pre- and the post-crisis periods. Second, convergence of the rates of these countries with the

Japanese rates over the pre- and the post-crisis periods is weak compared to the convergence with

the U.S. rates. The real interest rates of China show a converging trend with the real rates of other

countries in our sample. Korea shows the most marked convergence in real interest rates with other

17 Therefore the dynamics in the degree of integration cannot be analyzed for Taiwan. 18 The ending year is 2004, but the ending month varies: July for Hong Kong, Singapore and Malaysia, August for China, Japan and Korea, September for the US and November for Taiwan. 19 The long-term real interest differential of Taiwan vis-à-vis the US is lower than the one vis-à-vis Japan.

49

countries.

These results suggest that Asian financial markets in the post-crisis period became more

integrated with a global market whereas evidence of regional level integration is ambiguous.

50

Table 3-2: Real Interest differentials: Pre-crisis and Post-crisis Period

Δrdijt = α1 + α2D2 + ν1rdijt-1 + ν2D2 rdijt-1

1a 2a 1v 2v 2.Radj

1

1

va− )(

)(

)21

21

vvaa+−+

1v− )( 21 vv+−

CHUS 0.910 0.397 -0.261 -0.285 0.190 3.487 2.394 0.261 0.546

(2.757) (0.680) (-3.567) (-2.088)

HKUS 2.350 -0.034 -0.789 0.187 0.343 2.978 3.847 0.789 0.602

(6.043) (-0.061) (-5.770) (1.106)

JPUS -0.195 0.146 -0.074 0.041 0.025 -2.635 -1.485 0.074 0.033

(-2.064) (1.282) (-2.892) (1.137)

KRUS 0.362 -0.164 -0.070 -0.153 0.044 5.171 0.888 0.070 0.223

(2.925) (-0.839) (-2.829) (-1.151)

MLUS -0.083 0.067 -0.070 0.030 0.025 -1.186 -0.400 0.070 0.040

(-0.910) (0.576) (-2.452) (0.763)

SNUS -0.491 0.365 -0.222 0.135 0.095 -2.212 -1.448 0.222 0.087

(-4.680) (2.955) (-5.306) (2.541)

TWUS 0.012 -0.545 0.261 0.022 0.545

(0.114) (-3.038)

CHJP 0.935 5.310 -0.164 -0.975 0.319 5.701 5.483 0.164 1.139

(4.192) (6.399) (-4.235) (-6.634)

HKJP 0.333 0.223 -0.056 -0.032 0.019 5.946 6.318 0.056 0.088

(2.996) (0.817) (-2.511) (-0.722)

KRJP 0.845 1.890 -0.109 -0.556 0.135 7.752 4.113 0.109 0.665

(3.762) (3.733) (-3.945) (-5.284)

MLJP 0.128 1.301 -0.105 -0.449 0.063 1.219 2.579 0.105 0.554

(1.483) (4.697) (-2.757) (-3.875)

SNJP 0.085 0.443 -0.199 -0.194 0.099 0.427 1.344 0.199 0.393

(1.041) (2.634) (-5.185) (-1.645)

TWJP 0.367 -0.181 0.081 2.028 0.181

(2.033) (-2.438)

51

<Table 3-2 con’t>

1a 2a 1v 2v 2.Radj

1

1

va− )(

)(

)21

21

vvaa+−+

1v− )( 21 vv+−

CHHK 1.178 -2.053 -0.617 0.009 0.306 1.909 -1.439 0.617 0.608

(3.443) (-4.749) (-5.022) (0.054)

CHKR -1.104 2.771 -0.340 -0.960 0.326 -3.247 1.282 0.340 1.300

(-3.632) (7.071) (-3.564) (-6.192)

CHML 1.161 2.111 -0.319 -0.830 0.339 3.639 2.848 0.319 1.149

(3.644) (3.681) (-4.375) (-5.033)

CHSN 1.530 2.868 -0.288 -0.794 0.314 5.313 4.065 0.288 1.082

(3.823) (3.526) (-4.180) (-4.638)

CHTW 2.015 -0.709 0.349 2.842 0.709

(3.163) (-4.102)

HKKR -1.367 2.355 -0.247 -0.103 0.147 -5.534 2.823 0.247 0.350

(-3.061) (3.890) (-3.229) (-0.687)

HKML 0.170 0.196 -0.160 0.074 0.051 1.063 4.256 0.160 0.086

(1.353) (1.025) (-3.242) (1.242)

HKSN 1.269 -0.363 -0.294 0.126 0.102 4.316 5.393 0.294 0.168

(4.465) (-0.991) (-4.072) (1.466)

HKTW 3.077 -0.811 0.383 3.794 0.811

(5.343) (-5.282)

KRML 0.792 0.144 -0.120 -0.501 0.086 6.600 1.507 0.120 0.621

(3.173) (0.491) (-3.360) (-4.760)

KRSN 1.073 0.828 -0.147 -0.549 0.109 7.299 2.731 0.147 0.696

(4.581) (3.078) (-4.316) (-10.375)

KRTW 0.591 -0.370 0.171 1.597 0.370

(2.129) (-3.014)

MLSN 0.071 0.160 -0.092 -0.107 0.040 0.772 1.161 0.092 0.199

(0.856) (1.344) (-2.874) (-1.811)

MLTW 0.103 -0.103 0.037 1.000 0.103

(1.659) (-2.094)

SNTW -0.363 -0.347 0.149 -1.046 0.347

(-2.309) (-2.657)

Sources: IFS (CD-ROM) and Bloomberg

Notes: t-values are indicated in parentheses. The interest rates are end-of month, short-term domestic

52

money market rates from IFS, except that 3-month commercial paper rates from Bloomberg are used

for Taiwan. Inflation rates are calculated using CPI’s from IFS. For each country the longest time

horizon permitted by the data, generally starting from 1980s, was used. The real interest rate data

used for estimation starts from January 1980 for most countries, exceptions being China whose data

starts from January 1987, Hong Kong from December 1990 and Taiwan from April 2000. The

ending months are: July 2004 for Hong Kong, Singapore and Malaysia; August, 2004 for China,

Japan and Korea; September 2004 for the U.S.; November 2004 for Taiwan. The period used was

the pre-crisis period (up to March 1997) and the post-crisis period (January 1999 onward). The crisis

period was excluded.

(2) I-CAPM Test

This section uses the asset price method and attempts to see how converging the asset

prices are in East Asia. In a world populated by risk-averse agents, agents demand compensation for

the risk in holding the risky assets. The CAPM (Capital Asset Pricing Model) takes into account the

risk prospect of the underlying asset in determining the equilibrium price of an asset. Its application

to international capital market integration hinges on the idea that asset prices in the same class of

risk should equalize across countries in an integrated market.

The CAPM determines the individual asset returns and their optimal shares held in

equilibrium. The rates of return on the market portfolio are obtained as the optimal holding of each

asset times its respective return.

To test the hypothesis of international financial market integration, we use the following as

the base specification:

E(rit – rft ) = α [βi E(rmt – rft )] + ∑i γ i Di + εit (4-2)

where rit, rft, and rmt are the rates of return of an risky asset, the risk-free asset and the return of the

market portfolio, respectively. i and t indicate country and time. Di and εit are the dummy variable

for country i and the error-term, respectively. α and γ i are the regression coefficients of βiE(rmt – rft )

and country dummies, respectively. We construct βi separately as cov(rit, rmt )/var(rmt ). α is a

measure of market efficiency in the market. The coefficients of the country dummies indicate the

country-specific effects that remain after the market risk of an asset is controlled for. The hypothesis

that (4-2) examines is the following: If the financial markets are efficient and perfectly integrated, α

should be close to 1 and the country dummies are not significantly different from 0.

To test equation (4-2) we use the monthly rates of return of the stock indices of 12 stock

exchanges that belong to 10 countries in Asia. We further include the U.S. for purposes of

comparation. The data are from Bloomberg. The names of the total 15 stock exchanges are indicated

53

in Table 3-3.

Table 3-3 Stock Exchanges

Country Stock Exchange (Index)

Shanghai SE Composite 1 China

Senzen SE Composite

2 Hong Kong Hang Seng

3 Indonesia Jakarta Se Composite

Topix 4 Japan

Nikkei 225 Stock Average

5 Malaysia Kuala Lumpur Composite

6 Philippines Philippine Se Composite

7 Singapore Singapore All Sing Equities

8 Korea Korea Se Composite

9 Taiwan Taiwan SE Weighted

10 Thailand Bangkok SET

Dow Jones Industrials

S&P 500 Composite

11 U.S.

NASDAQ Composite

The rates of return are nominal and expressed in local currency. We assume PPP holds and

transform them into the nominal rates both in USD and JPY. For consistency we use the monthly

yields of the 10-year U.S. Treasury bond and Japanese 10-year government bond rates for the risk

free rates respectively.20 As the coverage of the return data varies in time series across stock

exchanges and there are some missing values in exchange rate series, the period covered for the

CAPM estimation comes down to March 1992 to October 2004. We divide this period into a

pre-crisis (until March 1997), a during-crisis (April 1997 to December 1998) and a post-crisis

(January 1999 to October 2004) period to see the changes in the degree of financial market

integration.

Results

First we examine how closely the stock prices of Asian countries have moved before and

20 Note that this is not just a change of numéraire, for which case results would not be altered. For the interest rate movement by changing the reference currency changes the asset pricing relation.

54

after the crisis. The results are summarized in Table 3-4 to Table 3-7.

Table 3-4: Correlation of Stock Market Indices: Jan. 1991 ~ Oct. 2004

CHN HK INDO JAP KOR MAL PHIL SING TAW THAI US

CHN 1.000 0.062 0.043 -0.063 -0.028 0.104 0.029 0.074 0.124 0.048 0.019

HK 0.062 1.000 0.535 0.317 0.385 0.567 0.553 0.629 0.528 0.546 0.594

INDO 0.043 0.535 1.000 0.230 0.333 0.578 0.595 0.658 0.301 0.388 0.314

JAP -0.063 0.317 0.230 1.000 0.483 0.170 0.262 0.243 0.229 0.451 0.397

KOR -0.028 0.385 0.333 0.483 1.000 0.302 0.356 0.369 0.339 0.861 0.441

MAL 0.104 0.567 0.578 0.170 0.302 1.000 0.586 0.889 0.467 0.457 0.362

PHIL 0.029 0.553 0.595 0.262 0.356 0.586 1.000 0.892 0.410 0.463 0.336

SING 0.074 0.629 0.658 0.243 0.369 0.889 0.892 1.000 0.492 0.516 0.392

TAW 0.124 0.528 0.301 0.229 0.339 0.467 0.410 0.492 1.000 0.770 0.394

THAI 0.048 0.546 0.388 0.451 0.861 0.457 0.463 0.516 0.770 1.000 0.512

US 0.019 0.594 0.314 0.397 0.441 0.362 0.336 0.392 0.394 0.512 1.000

(Source) Bloomberg.

(Note) In the case of Indonesia and Philippines, data are from December 1991. The data of China

are from March 1992.

55

Table 3-5: Correlation of Stock Market Indices: Jan. 1991 ~ Mar. 1997


CHN 1.000 0.151 0.174 -0.144 -0.073 0.136 0.083 0.117 0.085 0.023 -0.005

HK 0.151 1.000 0.728 0.042 0.157 0.675 0.681 0.752 0.444 0.413 0.438

INDO 0.174 0.728 1.000 -0.049 0.070 0.549 0.639 0.664 0.323 0.277 0.514

JAP -0.144 0.042 -0.049 1.000 0.198 0.044 -0.007 0.017 0.132 0.205 0.155

KOR -0.073 0.157 0.070 0.198 1.000 0.149 -0.026 0.055 0.202 0.689 0.066

MAL 0.136 0.675 0.549 0.044 0.149 1.000 0.623 0.872 0.397 0.374 0.293

PHIL 0.083 0.681 0.639 -0.007 -0.026 0.623 1.000 0.926 0.418 0.295 0.208

SING 0.117 0.752 0.664 0.017 0.055 0.872 0.926 1.000 0.453 0.365 0.272

TAW 0.085 0.444 0.323 0.132 0.202 0.397 0.418 0.453 1.000 0.848 0.124

THAI 0.023 0.413 0.277 0.205 0.689 0.374 0.295 0.365 0.848 1.000 0.127

US -0.005 0.438 0.514 0.155 0.066 0.293 0.208 0.272 0.124 0.127 1.000

(Note): Same as the previous table.

Table 3-6: Correlation of Stock Market Indices: Apr. 1997 ~ Dec. 1998


CHN 1.000 -0.329 -0.160 -0.111 -0.158 0.066 0.097 0.086 0.021 -0.124 0.066

HK -0.329 1.000 0.640 0.515 0.295 0.662 0.633 0.698 0.764 0.538 0.647

INDO -0.160 0.640 1.000 0.407 0.318 0.571 0.592 0.624 0.408 0.422 0.439

JAP -0.111 0.515 0.407 1.000 0.730 0.389 0.663 0.553 0.363 0.750 0.545

KOR -0.158 0.295 0.318 0.730 1.000 0.298 0.423 0.382 0.240 0.930 0.381

MAL 0.066 0.662 0.571 0.389 0.298 1.000 0.729 0.941 0.551 0.459 0.635

PHIL 0.097 0.633 0.592 0.663 0.423 0.729 1.000 0.917 0.514 0.550 0.632

SING 0.086 0.698 0.624 0.553 0.382 0.941 0.917 1.000 0.574 0.538 0.681

TAW 0.021 0.764 0.408 0.363 0.240 0.551 0.514 0.574 1.000 0.581 0.615

THAI -0.124 0.538 0.422 0.750 0.930 0.459 0.550 0.538 0.581 1.000 0.553

US 0.066 0.647 0.439 0.545 0.381 0.635 0.632 0.681 0.615 0.553 1.000

(Note) Same as the previous table.

56

Table 3-7: Correlation of Stock Market Indices: Jan. 1999 ~ Oct. 2004


CHN 1.000 0.110 0.065 0.076 0.105 0.160 -0.149 -0.008 0.250 0.181 0.039

HK 0.110 1.000 0.371 0.659 0.482 0.376 0.324 0.430 0.478 0.652 0.737

INDO 0.065 0.371 1.000 0.411 0.298 0.548 0.603 0.714 0.270 0.392 0.308

JAP 0.076 0.659 0.411 1.000 0.576 0.365 0.490 0.534 0.542 0.890 0.673

KOR 0.105 0.482 0.298 0.576 1.000 0.102 0.253 0.227 0.262 0.486 0.519

MAL 0.160 0.376 0.548 0.365 0.102 1.000 0.305 0.773 0.567 0.524 0.334

PHIL -0.149 0.324 0.603 0.490 0.253 0.305 1.000 0.840 0.353 0.483 0.289

SING -0.008 0.430 0.714 0.534 0.227 0.773 0.840 1.000 0.558 0.621 0.383

TAW 0.250 0.478 0.270 0.542 0.262 0.567 0.353 0.558 1.000 0.866 0.473

THAI 0.181 0.652 0.392 0.890 0.486 0.524 0.483 0.621 0.866 1.000 0.658

US 0.039 0.737 0.308 0.673 0.519 0.334 0.289 0.383 0.473 0.658 1.000

(Note) Same as the previous table.

From the tables we see two very prominent trends. First the Asian stock markets move

more tightly with the U.S. markets after the crisis than during the pre-crisis period: eight out of ten

Asian countries show increasing correlations, exceptions being Indonesia and Philippines. Asian

stock markets seem to move more closely with each other as well. Second, the Chinese stock

markets are on average least correlated with other stock exchanges, but their correlations with Japan,

Korea and Taiwan in the post-crisis period have increased markedly. Moreover the Chinese stock

markets are least correlated with the U.S. market, pre-crisis and post-crisis, among all the Asian

stock markets in our sample. This result may be interpreted as reflecting in part the highly closed and

controlled Chinese market, but it is noteworthy that the Chinese real economy is not very closely

linked with the U.S. economy.

57

Table 3-8: Correlations of Real GDP per capita: 1991 ~ 2000


CHN 1.000 0.921 -0.128 -0.491 -0.393 -0.534 -0.913 -0.305 0.814 0.085 -0.421

HK 0.921 1.000 0.030 -0.422 -0.293 -0.577 -0.907 -0.584 0.876 0.117 -0.335

INDO -0.128 0.030 1.000 0.804 0.017 -0.496 -0.161 -0.066 0.119 -0.715 -0.272

JAP -0.491 -0.422 0.804 1.000 0.437 0.057 0.166 0.051 -0.261 -0.497 -0.408

KOR -0.393 -0.293 0.017 0.437 1.000 0.789 0.236 -0.482 -0.041 0.563 -0.451

MAL -0.534 -0.577 -0.496 0.057 0.789 1.000 0.566 -0.082 -0.396 0.701 -0.067

PHIL -0.913 -0.907 -0.161 0.166 0.236 0.566 1.000 0.464 -0.758 0.065 0.616

SING -0.305 -0.584 -0.066 0.051 -0.482 -0.082 0.464 1.000 -0.553 -0.514 0.351

TAW 0.814 0.876 0.119 -0.261 -0.041 -0.396 -0.758 -0.553 1.000 0.222 -0.454

THAI 0.085 0.117 -0.715 -0.497 0.563 0.701 0.065 -0.514 0.222 1.000 -0.071

US -0.421 -0.335 -0.272 -0.408 -0.451 -0.067 0.616 0.351 -0.454 -0.071 1.000

(Source) Penn World Table 6.1

(Note) Correlations are calculated for the natural logarithms of the growth rates of real GDP per

capita’s of two economies. Singapore has missing values from 1997 to 2000 and Taiwan from 1999

to 2000.

We next estimate our CAPM regression as (1). The three regression results for each of the

cases when the different reference currency is used show that the core variable of the CAPM, βi

E(rmt – rft ), is very significant and its coefficient is close to 1. This implies the East Asian markets

are quite efficient, while the degree is stronger when USD is the reference currency. The CAPM

model seems to account well the price movements at the stock exchange level.

58

Table 3-9: CAPM Results to Test Financial Market Integration

Mar. 1992 - Oct. 2004 Mar. 1992 - Mar. 1997 Jan. 1999 - Oct. 2004

USD JPY USD JPY USD JPY

BETA*Excess

Market Return

0.99 (30.3) 0.73 (22.2) 0.991

(14.7)

0.80 (20.8) 0.998

(29.7)

0.72 (12.1)

China -0.031

(-3.4)

-1.80

(-8.4)

0.009 (0.4) -0.45

(-2.6)

-0.032

(-4.6)

-1.09

(-14.7)

Hong Kong -0.003

(-0.7)

-0.94

(-7.5)

0.008 (1.1) -0.56

(-3.3)

-0.009

(-1.9)

-0.63

(-7.8)

Indonesia 0.016 (2.5) -0.06

(-0.5)

-0.012

(-1.6)

-1.49

(-9.6)

0.020 (2.8) -0.10

(-0.9)

Japan -0.032

(-7.0)

-1.64

(-8.4)

-0.047

(-5.3)

-2.78

(-14.9)

-0.023

(-3.8)

-0.84

(-11.0)

Korea 0.003 (0.5) -0.53

(-5.0)

-0.042

(-5.2)

-2.52

(-14.3)

0.021 (3.4) -0.02

(-0.2)

Malaysia 0.001 (0.3) -0.60

(-5.6)

-0.006

(-1.1)

-1.18

(-7.7)

-0.008

(-2.1)

-0.66

(-8.3)

Philippines -0.000

(-0.1)

-0.57

(-5.4)

0.009 (1.3) -0.50

(-3.0)

-0.016

(-2.0)

-0.57

(-6.7)

Singapore 0.058 (7.4) 1.32

(6.9)

0.069 (6.2) 2.25

(6.9)

0.025 (3.7) 0.22

(1.6)

Thailand 0.052 (7.0) 1.10

(6.1)

0.029 (2.3) 1.20

(4.6)

0.078 (6.9) 1.16

(4.6)

Taiwan -0.009

(-1.3)

-0.87

(-7.2)

0.005 (0.5) -0.21

(-1.2)

0.002 (0.4) -0.26

(-2.6)

N. Obs 1520 1520 610 610 700 700

Adj. R-squared 0.54 0.81 0.40 0.84 0.59 0.78

Durbin-Watson 2.01 0.07 1.89 0.16 2.01 0.53

(Note) The second row indicates the reference currency used. The rates of return are nominal

monthly rates of return expressed in either USD or JPY. The benchmark risk free rates are U.S.

10-year Treasury bond yields and Japanese 10-year government bond rates accordingly. t-values are

indicated in parentheses and no constant is included in the regression. Newey-West HAC standard

errors and covariance are used to correct potential heteroskedasticity in the error-term.

However when USD is the reference currency, the number of countries whose country

59

dummy is significantly different from zero increases in the post-crisis period, while it decreases

when JPY is the reference currency. This suggests progress in the degree of regional integration of

East Asian financial markets and a weakened integration of these markets with the global market in

the post-crisis period. The overall results indicate that market ket efficiency is higher, but country

effects are stronger with USD and market efficiency is lower, but country effects are weaker with

JPY. These results imply that East Asian financial markets are more efficient with USD, but

integration progresses with JPY. The results that some countries show significant country effects

indicate that country premia exist and there is much room for further integration.21

This section looks into the market-determined asset prices of 10 Asian economies and tests

a hypothesis of financial market integration within the region. Our results show that in the post-crisis

period stock markets in these countries moved more tightly with the U.S. and to a lesser extent with

each other. This implies the East Asian markets, relatively, have become more globalized. Efficiency

of East Asian stock markets improved with USD in the post-crisis period and not with JPY, but

country specific effects have strengthened with USD, while they weakened with JPY. The latter

suggests a sign of progressed integration at the regional level in East Asia. Policy makers as well as

academic researchers should identify the factors determining the country-specific effects of East

Asian markets and policy need to be directed to maximize the welfare of the individuals within the

integrated zone. Investment flows tend to move, ceteris paribus, from lower return countries to

higher return countries. East Asia is a region where the degree of disparity in financial market

development, capital controls, income, and information diffusion are not small, which can comprise

the country specific effects. It is not very surprising to see East Asian stock markets are not well

integrated, but it is interesting to see that market efficiency is not so low. Furthermore convergence

in macro-economic variables does not guarantee the convergence of micro-economic variables. And

policy objectives should be designed at the micro level. Even in the EMU area, there is an argument

whether firms and investors are adjusting their behavior fully to the changes brought by

macroeconomic arrangements and no exchange rate risks by the EMU.

3.5. International Risk-sharing Approach

Every economy experiences business fluctuations. The bigger the fluctuation, the less the

nation’s utility. This is why it is so important for a government to stabilize the economy with the help

of fiscal and monetary policy. Then, what is the ultimate target to be stabilized by fiscal and

monetary policy? It is consumption, not the output or investment, ultimately to be stabilized simply

because economic agents can enjoy utility from consumption of various goods and services. Even

21 Kim et al (2003) report a decreasing degree of consumption risk sharing in East Asia in 1990s including the crisis period, which also indicates the lack of financial market integration in this region.

60

without the help of fiscal and monetary policy, consumption can be stabilized by market institutions.

Consumers can stabilize consumption by lending and borrowing through the domestic financial

market. Consumers can buy stocks in the domestic capital market, bonds in the domestic credit

market, and various kinds of insurance policies in the domestic insurance market, and so on. The

larger the financial market, the higher the chance of consumption stabilization. Simply speaking,

market institutions provide risk sharing.

If consumers can borrow and lend with foreign consumers, it is obvious that the chance of

risk sharing rises. The larger pool of stocks, bonds and various kinds of financial claims provided by

the huge international financial market undoubtedly generates much higher potential for risk sharing

and a much smoother consumption profile. Therefore, international risk sharing is also a very

important channel through which consumption can be stabilized. However, in order to maximize the

benefits of international risk sharing, the financial markets should be highly integrated across

countries. Otherwise, the capabilities of consumers in stabilizing consumption fluctuations caused by

idiosyncratic shocks will be limited.

In the literature on the optimum currency area, the incidence of idiosyncratic shocks across

countries is considered as a critical determinant of the design of optimum currency areas. When

asymmetric idiosyncratic shocks occur across the member countries of a currency union, monetary

policy cannot be tailored to an individual country’s particular disturbances. This gap between shocks

and policy is one of the critical factors that may hurt the integrity of a currency union, and may make

the union collapse in an extreme case. This is why we need a macroeconomic synchronization to

successfully implement the currency union. However, if countries can share country specific output

shocks and smooth consumption profile through various arrangements in financial markets, which is

known as “consumption risk sharing”, it is more likely that we can successfully launch the currency

union. Therefore, a high degree of consumption risk sharing can be a good substitute for

synchronized business cycles as a pre-condition for a successful currency union. And consumption

risk sharing is further promoted as financial markets become more integrated across countries.

There are various channels of consumption risk sharing. First, countries can share

idiosyncratic shocks via cross-ownership of productive assets facilitated by a developed international

capital market. Second, countries can stabilize their consumption by adjusting their non-contingent

asset holdings through lending and borrowing in international credit market. Third, governments or

international organizations can arrange fiscal transfer systems that can serve as vehicles for further

income and consumption smoothing.

We try to measure the extent to which financial markets are integrated in East Asia. There

are several other ways measuring the degree of financial integration in a specific region; for example,

the method using CAPM, interest rate differentials, and so on. In this part of the paper, we try to

assess the extent to which financial markets are integrated by looking at the degree of risk sharing

61

across East Asian countries. As we mentioned, risk sharing can be an indicator of financial

integration because the financially integrated region will have more opportunities for larger risk

sharing.

Asdrubali et al. (1996) develops a framework for assessing how much regional shocks are

smoothed by the above three channels of risk sharing. They used decomposition of cross-sectional

variance of GDP for the case of the United States. They found that during the period 1963-1990 in

the U.S., taken to be an equivalent of a successful monetary union, 62 percent of shocks to the per

capita gross product of individual states are smoothed on average through transactions on markets,

13 percent smoothed by the federal tax-transfer and grant system, and 25 percent of shocks are not

smoothed. Out of 62 percent smoothed by markets, 39 percent of shocks are smoothed by capital

markets, and 23 percent are smoothed by the credit market. Although perfect insurance is not

achieved, there is considerable risk sharing among U.S. states.

In this paper, we try to assess the extent to which East Asian countries are financially

integrated by using the framework developed by Asdrubaldi et al. (1996). Section (1) briefly goes

over the theoretical background for the relationship between output and consumption regarding risk

sharing. Section (2) describes the empirical framework. Section (3) provides the empirical results for

the degree of financial integration in East Asia and concluding remarks.

(1) Theoretical Background

We think of GDP as a homogeneous tradable good. The period t per capita output of

country i is an exogenous random variable with a commonly known probability distribution. Let

each country have in representative consumer who is a risk-averse expected-utility maximizer. Consumers in each country are assumed to be identical ex-ante as well as ex-post. Asset markets are

assumed to be complete. Country i faces a single budget constraint in period 0, and chooses a

consumption plan by solving the following problem:22

{ } ( )∑∑∞

= t

tti

t

i

t

tc

cuMaxϖ

ϖϖπδϖ

0

(5-1)

s.t. i

tt

it

t

t

t

ttGDPpcp ϖ

ϖϖ

ϖϖϖ ∑∑∑∑

∞

=

∞

=

≤00

where it

GDPϖ and it

cϖ are per capita output and consumption in state of nature tϖ that occurs

22 The model described in Section 2 comes from Sørenson and Yosha (1998)

62

with probability tϖπ and

tpϖ is the price in period 0 of a state tϖ contingent unit of

consumption. δ is the intertemporal subjective discount factor. The first order condition with

respect to it

cϖ is as follows:

( ) 0=−′ttt

pcu iitϖϖϖ λπδ (5-2)

where iλ is a Lagrange multiplier. Market clearing condition for all tϖ is as follows:

i

i

i

i

iitt

GDPncn ϖϖ ∑∑ = (5-3)

We normalize prices as follows:

10

=∑∑∞

=t t

tp

ϖϖ (5-4)

Letting ( ) ( )ccu log= , an equation for t

pϖ is derived as follows.

∑⋅=

i

iit

t

t

t cnp

ϖ

ϖϖ

πδκ (5-5)

where

1

01

−∞

= ⎭⎬⎫

⎩⎨⎧

⎥⎦

⎤⎢⎣

⎡= ∑ ∑∑

t

tti

ii

t

t cnϖ

ϖϖπδκ . Eliminating t

pϖ using (5-2), (5-3), (5-5) and

denoting world consumption by ∑∑=i

i

i

it

iwt nGDPnc , we can obtain the relationship between

individual consumption and world consumption as follows.

wt

ii cct

κϖ = (5-6)

63

where ( ) ( )∑∞

=

−=0

1t

wt

it

ti cGDPEδδκ 23. Equation (5-6) implies that risk is fully shared among

countries if the consumption of a country comoves with world consumption, but does not comove

with country specific shocks.

There are several mechanisms for sharing risk among countries. For instance, if mutual

funds or pension funds in one country invest internationally, the income of the residents in that

country will comove with the output in other countries. If financial intermediaries in one country

lend to firms in other countries, the flow of interest payments smoothes the income of residents in

the lending country. This kind of international risk sharing, namely, income insurance through

cross-border ownership of productive assets, is reflected in the National Accounts data as the

difference between GDP and GNP. The difference between GDP and GNP is the net flow of factor

income.

If risk is fully shared at this level, then GNP will satisfy equation (5-6):

wt

ii cGNPt

κϖ = (5-7)

Namely, the consumers in each country will want to consume their GNP if risk is fully shared. If risk

is not fully shared through factor income, GNP does not satisfy equation (5-7) and there may be

scope for further consumption saving through saving behavior.

(2) Decomposing the cross-sectional variance of shocks to GDP.

The basic idea of Asdrubali et al. (1996) is to break down cross-sectional consumption

smoothing into several levels. Some levels provide consumption smoothing via risk sharing (i.e.,

through cross-country arrangements that automatically insure consumption against idiosyncratic

output shocks, this is a channel through “capital markets”). Others provide consumption smoothing

via intertemporal trade (i.e., by lending and borrowing internationally, this is a channel through

“credit markets”). Sørenson and Yosha (1998) consider there to be an extra consumption smoothing

channel through international transfer such as the EC structural funds. The EC structural funds are an

example of an international tax-transfer system that may contribute to risk sharing. However, we do

not include in this section the consumption smoothing channel through international transfer system,

because East Asian countries have no international organization that significantly redistributes or

23 This definition of

iκ implies that the share of country i ’s consumption in world consumption is the discounted expected share of its future output in world consumption.

64

stabilizes income within the region.

We turn to the cross-sectional variance decomposition of shocks to GDP. Consider the

following identity, holding for any period t ,

( )iiii

i

i

ii GC

GCGNP

GNPGDPGDP +

+= (5-8)

where all the magnitudes are in per capita terms, and i is an index of countries. Time index is

suppressed. By taking logs and differences on both sides of equation (5-8), multiplying by

GDPlog∆ , and using the definition of covariance, we can obtain the following expression for the

variance decomposition.

( ) { }( ){ }

( ){ }iii

iiii

iiii

GDPGCCovGDPGCGNPCov

GDPGNPGDPCovGDPVar

log,loglog,loglog

log,logloglog

∆+∆+

∆+∆−∆+

∆∆−∆=∆

(5-9)

Dividing both sides of equation (9) by ( )iGDPVar log∆ , we obtain the expression for fractions of

shocks to GDP absorbed at each level of consumption smoothing channel.

uck βββ ++=1 (5-10)

where { } ( )iiiik GDPVarGDPGNPGDPCov loglog,loglog ∆∆∆−∆=β ,

( ){ } ( )iiiiic GDPVarGDPGCGNPCov loglog,loglog ∆∆+∆−∆=β , and

( ){ } ( )iiiiu GDPVarGDPGCCov loglog,log ∆∆+∆=β . kβ is the coefficient in the

regression of GNPGDP loglog ∆−∆ on GDPlog∆ and is interpreted as the percentage of

smoothing of a GDP shock carried out by net factor income payments. cβ is the coefficient in the

regression of ( )GCGNP +∆−∆ loglog on GDPlog∆ and is interpreted as the percentage of

smoothing of a GDP shock carried out by changes in national saving. uβ is the coefficient in the

regression of ( )GC +∆ log on GDPlog∆ and is interpreted as the percentage of smoothing of

a GDP shock that remains unsmoothed.

Therefore, in practice, the following panel equation system is estimated:

65

itk

iktk

ii GDPGNPGDP ,, logloglog εβγ +∆+=∆−∆

( ) itc

ictc

iii GDPGCGNP ,, logloglog εβγ +∆+=+∆−∆

( ) itu

iutu

ii GDPGC ,, loglog εβγ +∆+=+∆ (5-11)

where t,•γ are time fixed effects. The inclusion of time fixed effects is crucial, since they capture

year-specific impacts on growth rates, most notably the impact of the growth in aggregate East Asian

output. With time fixed effects the β coefficients are weighted averages of the year by year

cross-sectional regressions. We estimate the equation system (5-11) by pooled OLS because the RHS

variables are all the same across equations while correcting for heterskedasticity. Annual data series

for East Asian countries are collected from IFS.24


We estimate the equation system (5-11) for the whole sample period 1971~2003 and each

sub-period of 1970s, 1980s, and 1990s. We also estimate the whole sample period only up to 1996

by dropping the Asian crisis. The results are reported in Table 3-10.

For the whole sample period, 89.4 percent of cross-sectional GDP variance is unsmoothed,

but only 11.9 percent is smoothed. Regional credit markets play a consumption smoothing role, but

quite limited. Regional capital markets play virtually no role in sharing risks across East Asian

countries. The degree of consumption smoothing achieved in this region is much lower than that

achieved within OECD and EC countries. Sørenson and Yosha (1998) found that 30~40 percent of

cross-sectional GDP variance is smoothed within OECD and EU. However, Sørenson and Yosha

(1998) also found that factor income flows do not smooth output shocks among EC and OECD

countries, either.

We examine the degree of risk sharing among three groupings of East Asian countries. The

groups to be considered are the ASEAN 5 countries (Singapore, Thailand, Malaysia, Indonesia,

Philippines), three Northeast Asian countries (Korea, Japan, China), and the group of relatively more

developed countries (Korea, Japan, Singapore, Hong Kong). Table 3-11 reports the results. In

general, the results are similar to those for all East Asian countries. The level of risk sharing

achieved in more developed Asian countries is 14.8 percent which is a little bit higher than the level

24 Nine East Asian countries are included in the estimation. Those are Korea, Japan, China, Singapore, Thailand, Hong Kong, Malaysia, Indonesia, and Philippines.

66

obtained for the whole sample. Northeast Asian countries seem to have higher potential for risk

sharing within the region than ASEAN 5 countries have within its region.

In conclusion, we can say that the degree of risk sharing in East Asia is far from complete

and very low; only about 12 percent of cross-sectional GDP variance is smoothed. Regional capital

markets play a minimal role while regional credit markets play some positive role in sharing risks

across countries in East Asia. Risk sharing level achieved in East Asia is far lower than the level

achieved within a successful monetary union such as the U.S. It is also much lower than the level

achieved within industrial countries such as OECD and EC countries. Based on these results, we can

conclude that financial markets in East Asia are far from being completely integrated.

Table 3-10: Estimated Risk Sharing (Sub-Periods)

(%) kβ cβ uβ

1971~2003

1.70

(0.56)

10.16

(2.87)

89.38

(2.57)

1971~1996

1.56

(0.59)

13.60

(3.14)

84.64

(3.09)

1971~1980

1.45

(0.72)

15.96

(4.64)

81.39

(4.84)

1981~1990

1.29

(0.72)

17.09

(5.29)

81.45

(5.29)

1990~2003

2.22

(2.08)

6.86

(4.07)

93.50

(3.48)

(Note) The numbers in parentheses are standard errors.

Table 3-11: Estimated Risk Sharing (Sub-Groups)

(%) kβ cβ uβ

Korea-Japan-China 0.73

(0.07)

7.18

(2.28)

92.07

(2.13)

ASEAN 5 3.61

(1.11)

4.71

(4.80)

94.23

(4.47)

Developed 1.00

(1.12)

13.75

(4.40)

84.76

(4.27)

(Note) The numbers in parentheses are standard errors.

67

3.6. Conclusion

Throughout this paper, we find that the degree of financial integration in East Asia has

been recently increased, but East Asia has shown more financial integration with global economies

than with regional economies. Our finding implies that the regional feature is weak and there is no

strong pulling, or anchor, market that would match the U.S. market. Though global integration is not

a force that competes with regional integration, there seems no strong sign that lessons from the

crisis in 1997-1998 have been transformed into a creation of an effective market mechanism in East

Asia. The lack of success in policy coordination among East Asian countries seems a fact despite

efforts made. However, rightfully, the agenda of regional market integration and deepening is alive

and its direction needs to focus on creation of a market mechanism that will endogenously bring

forward real interest rate differentials to be removed at the regional level.

Another important implication from this chapter is the importance of trade openness, that

is closely related to the degree of financial integration. This implies that considering economic

cooperation in East Asia is a multi-facet process rather than single-track process. Financial

development and economic growth in the region is also an important factor that we should consider

in the multilateral frameworks.

Finally, we may conclude that the current status of the direction and structure of capital

movement in East Asia created a highly vulnerable and unstable financial environment in East Asia,

raising the likelihood of a future crisis impeding the development of capital market in the region.

68

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71

Chapter 4. Monetary and Currency Integration in East Asia

4.1 Analysis on the Macroeconomic Integration

(1) Synchronization of business cycle

This section focuses on synchronization of business cycles among East Asian countries in

order to investigate regional macroeconomic integration in East Asia. In East Asia, regional

production networks have been built up in a form wherein firms mutually supply their parts to each

other in the region. East Asian economies tend to synchronize their business cycles as they deepen

their vertical economic integration. We will examine the changes in synchronization of business

cycle among East Asian countries by calculating the correlation coefficients of GDP growth rates

among them.

Table 4-1-1and Figure 4-1-1 to 4-1-5 show the correlation coefficients of GDP growth

rates among East Asian countries. The correlation coefficients have increased from 1961 to 2003 for

the combinations of Indonesia-Malaysia, Indonesia-Philippines, Indonesia-Singapore,

Indonesia-Thailand, Malaysia-Singapore, Malaysia-Thailand, and Singapore-Thailand among the

ASEAN5 countries. Especially, the correlation coefficients for Indonesia-Malaysia,

Indonesia-Thailand, Malaysia-Thailand, Malaysia-Singapore are higher than 0.8. Accordingly,

Indonesia, Malaysia, Thailand, and Singapore have synchronized business cycles since the 1990s.

The correlation coefficients have increased in 1991-2003 for China and each of the four

ASEAN countries (Indonesia, Malaysia, Thailand, and Singapore). Also, Korea has higher

correlation coefficients with each of the four ASEAN countries. In particular, the correlation

coefficients are higher than 0.8 for Korea-Indonesia, Korea-Malaysia, and Korea-Thailand. On one

hand, Japan has relatively higher correlation coefficients with the ASEAN5 countries although the

correlation coefficient for Japan-Thailand has decreased from 0.838 to 0.498 in 1991-2003. China

has lower correlation coefficients of business cycles with Japan and Korea although Japan and Korea

have relatively synchronized business cycles.

72

Table 4-1-1: Correlation Coefficients Among GDP Growth Rates

ASEAN

1961-1970 1971-1980 1981-1990 1991-2003 1961-2003

Indonesia-Malaysia 0.082 0.307 0.528 0.916 0.647

Indonesia-Philippines -0.468 -0.068 0.209 0.358 0.156

Indonesia-Singapore 0.423 0.341 0.485 0.605 0.458

Indonesia-Thailand -0.002 0.406 0.421 0.902 0.602

Malaysia-Philippines 0.308 0.528 0.486 0.378 0.413

Malaysia-Singapore 0.140 0.449 0.939 0.823 0.618

Malaysia-Thailand 0.080 0.382 0.685 0.856 0.654

Philippines-Singapore 0.242 0.143 0.584 0.290 0.383

Philippines-Thailand -0.282 0.605 0.613 0.243 0.301

Singapore-Thailand 0.195 -0.083 0.624 0.544 0.446

ASEAN-China

1961-1970 1971-1980 1981-1990 1991-2003 1961-2003

China-Indonesia -0.115 0.465 -0.453 0.484 -0.014

China-Malaysia -0.172 -0.490 -0.373 0.524 -0.078

China-Philippines -0.357 -0.258 -0.642 -0.199 -0.290

China-Singapore -0.079 0.074 -0.323 0.577 -0.105

China-Thailand 0.479 0.156 -0.395 0.525 0.071

ASEAN-Japan

1961-1970 1971-1980 1981-1990 1991-2003 1961-2003

Japan-Indonesia 0.704 0.207 0.089 0.836 0.143

Japan-Malaysia -0.283 0.333 0.391 0.649 0.166

Japan-Philippines -0.351 0.529 0.191 0.407 0.263

Japan-Singapore 0.220 0.707 0.250 0.331 0.425

Japan-Thailand -0.179 0.310 0.838 0.498 0.405

73

ASEAN-Korea

1961-1970 1971-1980 1981-1990 1991-2003 1961-2003

Korea-Indonesia 0.395 -0.022 0.089 0.836 0.515

Korea-Malaysia 0.046 0.298 0.015 0.853 0.461

Korea-Philippines -0.100 0.532 0.277 0.436 0.206

Korea-Singapore 0.433 -0.105 0.150 0.612 0.394

Korea-Thailand 0.257 0.641 0.155 0.835 0.644

China- Japan- Korea-Hong Kong

1961-1970 1971-1980 1981-1990 1991-2003 1961-2003

China -HongKong -0.017 -0.291 0.276 0.418 -0.114

China- Japan -0.288 0.242 -0.054 0.020 -0.263

China - Korea 0.443 -0.143 0.286 0.169 0.160

HongKong -Japan -0.341 0.550 -0.251 0.609 0.447

HongKong -Korea -0.382 0.236 0.600 0.742 0.332

Korea- Japan 0.467 0.238 -0.022 0.516 0.336

(Source) Estimated by Author

74

Figure 4-1: Correlation of GDP Growth Rates Between ASEAN Countries

-0.6

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1961-1970 1971-1980 1981-1990 1991-2003

Indonesia-Malaysia Indonesia-Philippines Indonesia-Singapore

Indonesia-Thailand Malaysia-Philippines Malaysia-Singapore

Malaysia-Thailand Philippines-Singapore Philippines-Thailand

Singapore-Thailand

Figure 4-2: Correlation of GDP Growth Rates Between ASEAN Countries and China

-0.8

-0.6

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

1961-1970 1971-1980 1981-1990 1991-2003

China-Indonesia China-MalaysiaChina-Philippines China-SingaporeChina-Thailand

75

Figure 4-3: Correlation of GDP Growth Rates Between ASEAN Countries and Japan

-0.6

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

1961-1970 1971-1980 1981-1990 1991-2003

Japan-Indonesia Japan-MalaysiaJapan-Philippines Japan-SingaporeJapan-Thailand

Figure 4-4: Correlation of GDP Growth Rates Between ASEAN Countries and Korea

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

1961-1970 1971-1980 1981-1990 1991-2003

Korea-Indonesia Korea-Malaysia

Korea-Philippines Korea-Singapore

Korea-Thailand

76

Figure 4-5: Correlation of GDP Growth Rates Between CJKH.

-0.6

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

China -HongKong China- Japan

China - Korea HongKong -Japan

HongKong -Korea Korea- Japan

(Source) World Bank’s World Deveopment Indicators

77

4.2 Analysis of the optimal exchange rate regime

(1) Currency Basket System in East Asia

This section, in three subsections, explains the benefits of a Basket Currency regime as one

of the intermediate and optimal options for East Asia, according to Ogawa, Ito, and Sasaki (2004).

The first subsection explains that a Basket Currency regime stabilizes the trade competitiveness of

countries. The second subsection reviews the papers that examined capital inflows; and the third

subsection reviews the papers that analyzed the stabilizing effects of a Basket Currency regime on

GDP.

(a) Enhanced Trade Competitiveness

The most apparent benefit of a Basket Currency regime is its role in keeping trade

competitiveness relatively stable. If the export destination is only one country and there is no

competitor other than the destination country, it is enough to peg the currency to that of the export

destination country so as to maintain trade competitiveness. However, in actuality, a country tends to

have many export destinations and there are many competitors all over the world. In addition, the

composition of export destination countries changes over time. Thus it is not easy to decide on the

weights of the basket.

Taking into account this complexity, some papers suggest the ways to achieve optimal weights

for the currency basket. Ito, Ogawa, and Sasaki (1998) calculated the optimal weights that stabilize

variances of trade balance. They built a theoretical model in which the Asian firm maximizes its

profits, competing with the Japanese and the U.S. firms in their markets. A duopoly model was used

to determine export prices and volumes in response to fluctuations of the exchange rate vis-à-vis the

Japanese Yen and the US Dollar. They obtained optimal basket weights that would minimize the

fluctuation of the growth rate of the trade balance.

Ito, Ogawa, and Sasaki (1998) stressed the fact that Asian countries have adopted a de facto

Dollar Peg regime, although their trade weights with Japan were substantial which was one of the

most significant factors that induced the recent financial crisis in 1997 and 1998. As the Japanese

Yen depreciated against the US Dollar from April 1995 to the summer of 1997, the real effective

exchange rates of Asian countries appreciated, which causing the loss of their export competitiveness.

Thus, exports from those countries declined. For example, the gross export values of Thailand did

not grow in 1996, compared with 20% growth a year earlier.

The optimal weights proposed by Ito, Ogawa, and Sasaki (1998) are shown in Table 4-2-1. The

estimated weights from actual fluctuations of the exchange rates are quoted from Frankel and Wei

(1994). The optimal weights of the Yen are higher than the estimated weights. This suggests that, if

Asian currencies peg to a Currency Basket with the optimal weights, the real effective exchange

78

rates of Asian countries would be more stable and a large shock to trade balance can be avoided.

Table 4-2-1: Optimal Weight for a Currency Basket for East Asian Countries

Currency Actual weight a Optimal weight b

US$ (%) Yen (%) US$ (%) Yen (%)

Thai Baht 91 5 35.3 64.7

Indonesian Rupiah 95 16 77.9 22.1

Korean Won 96 -10 45.7 54.3

Taiwan Dollar 96 5 7.3 92.7

Singaporean Dollar 75 13 51.0 49.0

Philippine Peso 107 -1 72.8 27.2

(Source) Ogawa, Ito, and Sasaki (2004).

(Notes)

a: The estimated weights from actual fluctuations of the exchange rates are quoted

from Frankel and Wei (1994).

b: The optimal weights were estimated by Ito, Ogawa, and Sasaki (1998).

(b) Capital Flow Effects

As Ito, Ogawa, and Sasaki (1998) emphasized the trade aspect, exchange rates are likely to be

influenced by capital flows. Ogawa and Sun (2001) analyzed how the de facto Dollar Peg Regime

before 1997 had influenced capital inflows to Indonesia, Korea, and Thailand—the three countries

that need IMF financial support during the financial crisis. They conducted a simulation analysis of a

counterfactual hypothesis that the monetary authorities had adopted a currency Basket Peg system

instead of the de facto Dollar Peg system. They assumed that the foreign exchange risks of the home

currency against the US Dollar would be doubled while foreign exchange risks of the home currency

against the Yen would be halved under the currency Basket Peg system.

The regression analysis of the actual capital inflows found that the responsiveness of capital

flows to the foreign exchange risk against the US Dollar is much larger than the responsiveness of

capital flows to the foreign exchange risk against the Yen in the case of Korea and Thailand (Table

4-2-2). The simulation analysis by Ogawa and Sun (2001) found that the currency Basket Peg

system would have had a depressing effect on capital inflows to Korea and Thailand.

79

Table 4-2-2: Means and Standard Errors of Estimated and Simulated Values

Thailand Korea Indonesia

Capital flows Other

Investments

Portfolio and

Other

Investments

Other

Investments

Portfolio and

Other

Investments

Other

Investments

estimated 0.0528

(0.0318)

0.0646

(0.0332)

-0.0025

(0.0182)

0.0116

(0.0264)

0.0195

(0.0060)

1986QI

-1997Q

I simulated 0.0178

(0.0558)

0.0237

(0.0633)

-0.0164

(0.0251)

0.0140

(0.0393)

0.0175

(0.0053)

estimated 0.0720

(0.0118)

0.0856

(0.0086)

0.0089

(0.0095)

0.0272

(0.0178)

0.0158

(0.0036)

1990QI

-1997Q

I simulated 0.0544

(0.0113)

0.0653

(0.0109)

-0.0017

(0.0166)

0.0050

(0.0316)

0.0141

(0.0028)

(Source) Ogawa and Sun (2001)

(Note) Values in ( ) are standard errors.

Sasaki (2002) analyzed whether changes in capital inflows to East Asian countries (Korea,

Malaysia, Philippines, Singapore, and Thailand) could be explained by the variance of exchange

rates. The results showed that capital inflows to East Asian countries increased when the variance of

US Dollar rates (i.e., exchange rates risk of the US Dollar) decreased. Thus, the de facto Dollar Peg

induced more capital inflows than did under the Currency Basket or the floating exchange rate

regime.

Both Ogawa and Sun (2001) and Sasaki (2002) concluded that the de facto Dollar Peg Regime

promoted capital inflows to Asian countries and implied that if Asian countries had adopted a Basket

Currency regime (or the Floating Exchange Rate regime), capital inflows might not have been so

huge. These two papers do not examine whether huge capital inflows due to the de facto Dollar Peg

was good or bad for the economies of those countries in the long run. Capital inflow itself promotes

growth and may be good for an emerging country. But huge capital inflows also pose a risk to the

countries in the sense that a sudden reversal in the direction of capital flows is a possibility. In fact,

the outflow of short-term capital experienced by some of the countries in the region before the crisis

was damaging to the firms in Asian countries.

FDI (long-term capital), as opposed to bank liabilities (short-term capital), is not a likely cause

of short-term exchange rate risk. Sasaki (2002) analyzed capital inflows separately by types:

portfolio investments, bank lending, and FDI. The effect of the variance of the US Dollar on capital

inflows was the strongest in bank liabilities, and was not so large in portfolio investments and FDI. It

implies that if Asian countries had adopted a Basket Currency regime, bank liabilities would have

80

decreased, while portfolio investments and foreign direct investments would not have been affected

so much. Thus, moderating capital inflows is regarded as a benefit of a Basket Currency regime.

(c) GDP Effects

So far, the effect of the Currency Basket on trade and its effect on capital flows are considered

separately, but with a general equilibrium macroeconomic model, Yoshino, Kaji, and Suzuki (2004)

proposed the optimal weights for the Currency Basket that would stabilize GDP.

Yoshino, Kaji, and Suzuki (2004) examined which currency regime, among the Basket Peg,

Dollar Peg, and Floating Exchange Rate regimes, could achieve the lowest in the loss functions

corresponding to the different policy objectives. Those policy objectives include stability of GDP,

the current account, and the exchange rate against the Dollar. They also calculated the optimal

weights in a currency basket. They concluded that the optimal choice of an exchange rate regime for

a small open economy depended on its policy objective. The gains from adopting a Basket Peg

regime is larger when the country uses the Yen in trade with Japan, and the Dollar in trade with the

U.S.

(2) A Common Currency Basket System for East Asia

(a) Linkages of East Asian currencies to the US Dollar

Next, we empirically analyze the magnitude of the weights the monetary authorities placed

on the US Dollar when they conducted exchange rate policy. McKinnon (2000) and Kawai and

Akiyama (2000) used a method of Frankel and Wei (1994) to conduct a similar analysis on weights

on the US Dollar. Bother teams obtained a common result, that correlation between their home

currencies and the US Dollar has recently returned to such high levels as the one prior the Asian

currency crisis. Here, we divide the sample period into sub-sample periods of half-years when we

use daily data in estimation, while we divide it into sub-sample periods of one-year when we use

weekly data in order to keep sample numbers in estimation.

We estimate weights that the monetary authorities placed on major foreign currencies (the

US Dollar, the Japanese Yen, the German Mark, and British Pound) in their possible currency

baskets during the period from January of 1997 to September of 2000. Each of the local currencies

(in terms of the Swiss franc) is regressed on the major currency (in terms of the Swiss franc), for

various sub-periods in 1997-2000, with such high frequency data as daily and weekly data. The

source of the data is Datastream.

Regressions are made in terms of log differences because it is usual that levels of exchange

rates are non-stationary in many cases. Log differences of exchange rates of a local currency

vis-à-vis the Swiss franc on log differences are regressed on exchange rates of the major currencies

vis-à-vis the Swiss franc.

81

0 1 2 3 4log log log log loghome SF USD SF JPY SF DM SF BP SFte a a e a e a e a e ε∆ = + ∆ + ∆ + ∆ + ∆ + (1)

Table 4-2-3 presents abstracted results of the weights on the US Dollar. We can interpret

standard errors of the coefficient as showing how precisely the monetary authorities targeted the

relevant exchange rate. The standard errors were very small in all of the countries before the

currency crisis. The small standard errors correspond to a fact that they adopted the de facto Dollar

Peg system. The standard errors have decreased in all of the countries after the currency crisis. The

standard errors were zero in the case of the Malaysian ringgit because the monetary authority of

Malaysia has adopted the Dollar Peg system since September 1998. Moreover, for the Singapore

Dollar and Korean won, the standard errors have recently returned to almost the same level as the

pre-crisis period.

Table 4-2-3: Estimates of Weights on the US Dollar (Daily data)

Country

(currency) Period Coefficient Standard error

Jan - Jun 1997 0.990*** 0.022

Jul - Dec 1997 0.932** 0.344

Jan - Jun 1998 0.471 0.385

Jul - Dec 1998 1.004*** 0.129

Jan - Jun 1999 0.998*** 0.101

Jul - Dec 1999 1.145*** 0.126

Jan - Jun 2000 0.908*** 0.066

Thailand

Jan - Sep 2000 0.896*** 0.063

Jan - Jun 1997 0.999*** 0.026

Jul - Dec 1997 0.843 0.742

Jan - Jun 1998 -0.203 1.711

Jul - Dec 1998 0.841* 0.503

Jan - Jun 1999 1.159*** 0.296

Jul - Dec 1999 0.477 0.345

Jan - Jun 2000 0.942*** 0.194

Indonesia

Jan - Sep 2000 1.012*** 0.192

82

Jan - Jun 1997 0.999*** 0.003

Jul - Dec 1997 1.232*** 0.310

Jan - Jun 1998 0.656** 0.296

Jul - Dec 1998 1.127*** 0.119

Jan - Jun 1999 0.996*** 0.092

Jul - Dec 1999 1.046*** 0.091

Jan - Jun 2000 0.938*** 0.070

Philippines

Jan - Sep 2000 0.872*** 0.068

Jan - Jun 1997 1.030*** 0.042

Jul - Dec 1997 0.650** 0.278

Jan - Jun 1998 0.867* 0.483

Jul - Dec 1998 1.027*** 0.143

Jan - Jun 1999 1.000*** 0.000

Jul - Dec 1999 1.000*** 0.000

Jan - Jun 2000 1.000*** 0.000

Malaysia

Jan - Sep 2000 1.000*** 0.000

Jan - Jun 1997 0.902*** 0.031

Jul - Dec 1997 0.833*** 0.106

Jan - Jun 1998 0.747*** 0.185

Jul - Dec 1998 0.903*** 0.101

Jan - Jun 1999 0.915*** 0.060

Jul - Dec 1999 0.997*** 0.056

Jan - Jun 2000 0.929*** 0.054

Singapore

Jan - Sep 2000 0.948*** 0.045

Jan - Jun 1997 1.009*** 0.040

Jul - Dec 1997 0.590 0.713

Jan - Jun 1998 0.536 0.519

Jul - Dec 1998 1.015*** 0.135

Jan - Jun 1999 1.008*** 0.104

Jul - Dec 1999 0.951*** 0.078

Jan - Jun 2000 1.027*** 0.068

Korea

Jan - Sep 2000 0.975*** 0.044

83

Jan - Jun 1997 0.990*** 0.018

Jul - Dec 1997 1.020*** 0.164

Jan - Jun 1998 0.895*** 0.116

Jul - Dec 1998 0.957*** 0.052

Jan - Jun 1999 0.974*** 0.043

Jul - Dec 1999 1.000*** 0.016

Jan - Jun 2000 0.971*** 0.040

Taiwan

Jan - Sep 2000 0.981*** 0.030

(Source) Ogawa (2002a)

Ogawa (2004) used daily exchange rates data from 1999 to 2003 to conduct the regression

analysis of the East Asian currencies on three major currencies, the US Dollar, the Japanese Yen, and

the Euro, for each quarter of the sample period from 1999 to 2003. The analysis obtained the

following results. The coefficients on the US Dollar for the Thai baht were nearly equal to unity

although they have decreased from unity since the 4th quarter of 2002. The coefficients on the US

Dollar for the Singapore Dollar are about 0.8 from 1999 to 2001 although they are not significantly

equal to unity almost throughout the period. The coefficients on the US Dollar have decreased since

the 2nd quarter of 2002. The coefficients on the US Dollar for the Korean Won are nearly equal to

unity in 1999 and 2000. After that they have decreased and significantly different from unity for

some of the periods. The analytical results show that the Thai baht, the Singapore Dollar, and the

Korean Won have the similar characteristics that the coefficients on the US Dollar have decreased

since 2001 or 2002.

(b) Coordination failure in selecting exchange rate regimes and a common Currency Basket system

The monetary authorities in the East Asian region may be forced to keep a Dollar Peg

system instead of adopting a Currency Basket System - even if they find that they would be better

off by adopting a Currency Basket System rather than a Dollar Peg system - according to lessons

they learned from the Asian currency crisis in 1997. The situation can be described as a kind of

coordination failure. Suppose that all East Asian countries have been adopting the de facto Dollar

Peg system through the present time and that each of them knows that it should adopt an optimal

Currency Basket system, for example, to stabilize fluctuations of its trade balances with an

internationally diversified trading structure.

84

Suppose that one country switches from the Dollar Peg system to a Currency Basket System

while the others keep the Dollar Peg system. The country with a Currency Basket system, say,

country A, might be faced with an increase in fluctuations in trade balances. If the US Dollar

depreciates against the Japanese Yen, the real effective appreciation of country A’s currency against

the other currencies that are pegged to the US Dollar worsens the price competitiveness of exporting

firms of country A. On the other hand, if the US Dollar appreciates against the Japanese Yen, the real

effective depreciation of country A’s currency against the other currencies improves the price

competitiveness of exporting firms of country A. Thus, the country that adopted a Currency Basket

System alone is faced with an increase in the degree of fluctuations of trade balances. Therefore, the

monetary authorities of country A are induced to keep the Dollar Peg system. Similarly, each of the

monetary authorities rationally keeps the Dollar Peg system if they cannot make a coordinated

decision but a sequential unilateral decision.

Ogawa and Ito (2002) used a two-country game model to analyze theoretically coordination

failure in choosing an exchange rate system. In the paper, coordination failures are shown in the

context of comparing losses for two monetary authorities in the following two situations: a situation

where both monetary authorities adopt the Dollar Peg at the same time and a situation where the

monetary authorities of one country adopt an optimal currency Basket Peg while the monetary

authorities of the other country adopt the Dollar Peg.25

Thus, each of the monetary authorities will keep pegging their home currency to the Dollar

if their trade balances fluctuate more widely in the case of unilaterally pegging the currency to an

optimal currency Basket Peg. When this is the case, they are faced with coordination failure in that

they are forced to adopt the Dollar Peg even though the optimal currency Basket Peg, if jointly

adopted, will minimize the fluctuations in trade balances. Only when both monetary authorities have

coordinated with each other to adopt the optimal Currency Basket Peg simultaneously can they peg

their home currencies to the optimal currency basket.

Suppose that risk-averse monetary authorities choose their exchange rate regime under

uncertainty; then the monetary authorities are more likely to be faced with coordination failure.

Risk-averse monetary authorities, who have a usual utility function with diminishing marginal utility,

place a heavier weight on increase in their utility of loss caused by exchange rate fluctuations than

on decrease in their utility of loss even though they expect that the expected losses are the same.

Suppose that the risk-averse monetary authorities of one country shift from the de facto Dollar Peg

system to an optimal Currency Basket regime while the monetary authorities of other countries keep

the de facto Dollar Peg regime. The currency would appreciate against the neighbors’ currencies if

the US Dollar depreciated against the Japanese Yen, while it would depreciate against the neighbors’

currencies if the US Dollar appreciated against the Japanese Yen. Because risk-averse monetary

25 Bénassy-Quéré (1999) and Ohno (1999) analyzed pegging the US dollar as a coordination failure.

85

authorities place a heavier weight on increases in loss caused by shifting their exchange rate regime,

they tend to hesitate to shift to the optimal Currency Basket regime. Therefore, under such

uncertainty, risk-averse monetary authorities tend to take the strategy of wait and see vis-à-vis the

behavior of the other.

Most of the monetary authorities are likely to take the strategy of wait and see if all others

are risk averse. They cannot help but choose to keep the Dollar Peg regime, which is a Nash

Equilibrium, although they should know that there is a cooperative solution that is superior to a Nash

Equilibrium. Coordination among some of the monetary authorities of the East Asian countries is

necessary for shifting from a situation of the Nash equilibrium to a cooperative solution. The

monetary authorities should implement international coordination for exchange rate arrangements or

exchange rate policies.

Ogawa (2002b) empirically analyzed whether the ASEAN5 countries, China, and Korea

have stable equilibrium or unstable equilibrium in choosing an optimal exchange rate system and

whether they have possibilities of meeting with coordination failure. The analysis was to estimate

both export and import equations for each of the ASEAN5 countries and neighboring countries. The

author took into account effects of the Asian currency crisis to set two analytical periods. The

analytical period is from 1980:Q1 to 1997:Q2 and the other is from 1980:Q1 to 2000:Q1.

In the ASEAN5 case where the other ASEAN5 countries are regarded as neighboring

countries for an ASEAN country, an unstable equilibrium, which implies a coordination failure in

choosing exchange rate system, is found in the cases of Indonesia, Thailand, and Malaysia during the

analytical period from 1980:Q1 to 2000:Q1. Moreover, the author investigated whether the monetary

authorities of the ASEAN5 countries directly shift from the Dollar Peg system to an optimal

exchange rate system, which is related to coordination failure in choosing exchange rate system. The

analytical results show that the monetary authorities in Indonesia, Thailand, and Malaysia cannot

shift from the Dollar Peg system to its optimal exchange rate system. There are possibilities that they

will encounter coordination failure in choosing an optimal exchange rate system.

Next, the author added China and Korea to ASEAN5 countries to conduct the same empirical

analysis on both stability of equilibrium and coordination failure in exchange rate policy. The other

countries of ASEAN5+China+Korea are regarded as neighboring countries for one country of them.

The author could estimate export and import equations during the period from 1981:Q1 to 2000:Q1

because of constraints of Chinese trade data. After adding China and Korea to neighboring

countries of the ASEAN5 countries, equilibrium changed from stable to unstable, which implies a

coordination failure in choosing the exchange rate system, in the cases of Singapore and the

Philippines. The author investigated coordination failure in choosing exchange rate system, that is,

whether the monetary authorities of the ASEAN5 countries, China, and Korea directly shift from the

Dollar Peg system to an optimal exchange rate system when the other countries of the

86

ASEAN5+China+Korea are regarded as neighboring countries. The analytical result shows that the

ASEAN countries and China are forced to adopt the Dollar Peg system because they have an

unstable equilibrium or coordination failure in choosing exchange rate system.

Ogawa and Yang (2004) estimated the correlation on the degree of intervention between

Japan and other selected countries to see how much a(n) (intended) competitive devaluation can take

place in the region. The measures of monthly intervention in the foreign exchange market were used

for the analysis. If the interventions by the Japanese authority influence the Yen/Dollar exchange

rates, then the intervention pressures on exchange rates for the periphery counties increase is a

reasonable assumption. Therefore, as the pressures on competitive devaluation increase, the

correlation between center and peripheral countries’ intervention would increase. Table 4-2-4 reports

the correlation between monthly intervention measure of Japan at time t and that of other countries at

time t+1. It shows that the correlation between Japanese intervention and the other East Asian

countries generally has a negative sign from 1995 to 2001 with few exceptions. However, the

correlation comes to have a positive sign in 2002 and 2003, except for China. The result implies that

the current appreciation pressure for floaters in East Asia has been mitigated by the government

authorities. This will increase the stockpiling of international reserves in East Asia since most

intervention by authorities in East Asia has been conducted by direct purchase of US Dollar in the

foreign exchange markets rather than indirect monetary policies.

Table 4-2-4: Intervention Correlation Between Japan and Other Selected Countries

1995 1996 1997 1998 1999 2000 2001 2002 2003

China -0.188 -0.646 -0.078 -0.461 -0.246

HK 0.318 -0.166 -0.311 -0.198 -0.126 -0.296 0.850

IND 0.420 -0.634 -0.013 0.158 -0.007 0.407 0.293 -0.266 0.007

Korea -0.079 -0.705 -0.025 0.042 -0.691 -0.707 -0.205 -0.085 0.440

ML -0.302 0.119 0.119 -0.050 -0.310 0.160 -0.072 0.060 0.207

PH -0.288 -0.187 -0.393 -0.321 0.144 -0.438 -0.194 -0.192 0.723

SN -0.331 -0.259 -0.147 0.368 -0.658 -0.384 -0.069 0.192 0.159

Thailand -0.652 -0.309 0.469 0.089 -0.503 -0.378 -0.307 0.053 0.553

Taiwan -0.414 -0.147 -0.129 -0.243 0.024 0.080 -0.489 0.459 0.830

(Source) Ogawa and Yang (2004)

Given that the monetary authorities agree to the coordination arrangements of an

international monetary system or exchange rate regime, its implementation is the next problem. It is

pointed out that policy makers find it difficult to implement international policy coordination if they

87

have neither common understanding of their own economic situations nor common policy objectives

among them (Frankel and Rockett [1988)). It is necessary that the monetary authorities should have

some common understanding about what effects their home currencies have on neighbor countries’

currencies and what effects their own exchange rate policy have on neighbor countries’ exchange

rate policy, in order to implement regional coordination of an exchange rate policy. Moreover, they

need to have common understanding about what policy objective they should have for their

exchange rate policy.

It is expected that the monetary authorities can build a common understanding by

conducting policy dialogue and macroeconomic surveillances among policy makers of the regional

countries. Macroeconomic surveillances may not be so effective if they are conducted by policy

makers as representatives of each of the regional countries, who have a direct interest in their own

countries. Thus they cannot easily implement international coordination of the exchange rate policy.

It may be desirable that a neutral intraregional institution, which is independent of the governments

of regional countries, should prepare for the macroeconomic surveillance in order to help the

governments deepen their common understanding.

However, policy dialogue and macroeconomic surveillance will not be so robust in keeping

international policy coordination in the long run because the governments do not have any

commitment to regional coordination. They may make a limited contribution to regional

coordination. It is necessary to have a mechanism that will be robust in keeping regional

coordination in the long run by obliging the governments to have a commitment to regional

coordination.

One way to implement regional coordination is by making all the monetary authorities in

the region agree on an arrangement to create a common currency unit that consists of a currency

basket. They might make a commitment to follow the common currency value in conducting their

exchange rate policy. It is necessary to create a common Currency Basket as a common currency

unit that monetary authorities of East Asian countries should refer to when they conduct their

exchange rate policies with regional coordination.

Such regional currency arrangements would help to prevent competitive devaluation among

the related currencies in a region as well as to solve coordination failure. If the monetary authorities

of a country devalue its home currency, the devaluation worsens the price competitiveness of

products made in neighboring countries. For that reason, the monetary authorities of the other

countries would find it attractive to devalue their home currencies, following the first country’s

devaluation. The regional currency arrangements under which the monetary authorities in the region

make a commitment to a coordinated exchange rate policy would prevent a possible competitive

devaluation as well as the inertia problem that causes coordination failure.

88

(3) Possibility of a Common Currency Basket System

(a) Symmetry of shocks

The feasibility of a common currency area can be tested by the criteria for an optimal

currency area. Mundell (1961) regarded mobility of labor as a necessary condition of common

currency areas, while McKinnon (1963) regarded openness of the economy as another necessary

condition. Symmetry of shocks was also pointed out as a factor for an optimal currency area

(Bayoumi and Eichengreen 1993). It is possible to form an optimal currency area because it is

unnecessary to make intraregional adjustments in a region subject to symmetric shocks only.

Symmetry of supply shocks is often emphasized because supply shocks have long-run effects on

GDP while demand shocks have no long-run effects on GDP when the natural unemployment

hypothesis holds. The supply shocks are those that affect a production function, such as productivity

shocks and oil price shocks.

Bayoumi, Eichgengreen, and Mauro (2000) made an empirical analysis of an optimal

currency area in the East Asian region.26 Correlations of supply shocks were relatively higher

among Indonesia, Malaysia, and Singapore. Also, the correlation was higher between Singapore and

Thailand. Therefore, these four ASEAN countries might be able to form an optimal currency area

from the viewpoint of symmetric shocks. Supply shocks in Japan had a positive correlation with

those of Australia; Taipei, China; and Korea. On one hand, they had a lower correlation with ASEAN

countries except Thailand.

We used a similar structural VAR method to investigate symmetry of supply and demand

shocks among East Asian countries, as well as the United States and the European Union, for

sub-sample periods from 1962 to 2002. Table 4-2-5 shows the correlation of aggregate supply and

demand shocks among the countries. The correlation coefficients of aggregate supply shocks for

combinations of Hong Kong-Malaysia, Indonesia-Korea, Indonesia-Malaysia, Indonesia-Thailand,

Korea-Malaysia, Korea-Thailand, Malaysia-Singapore, and Malaysia-Thailand, are larger than 0.5

during the whole sample period from 1962 to 2002. Those of aggregate demand shocks for

combination of Japan-Singapore, Japan-Thailand, Malaysia-Thailand, the Philippines-Singapore,

and Singapore-Thailand are larger than 0.5 during the whole sample period.

The correlation coefficients of the aggregate supply shocks among the East Asian countries

have increased in recent years. The correlation coefficients of aggregate supply shocks for

combinations of Hong Kong-Korea, Hong Kong-Malaysia, Hong Kong-Singapore, Indonesia-Korea,

Indonesia-Malaysia, Indonesia-Thailand, Korea-Malaysia, and Korea-Thailand, Malaysia-Singapore,

are larger than 0.8 during the recent decade period from 1991-2002. However, the correlation

coefficients of the aggregate demand shocks have decreased in recent years. Only for combination of

Hong Kong-Indonesia, Korea-Thailand, and Malaysia-Thailand, the correlation coefficients are

26 Sato et al. (2001) used a similar structural VAR method to investigate an optimum currency area for East Asia.

89

larger than 0.5 from year 1991 to 2003.

90

Tabl

e 4-

2-5:

Sym

met

ry o

f Agg

rega

te S

uppl

y an

d D

eman

d Sh

ocks

Cas

e 1

Ann

ual D

ata

(196

2-20

02)

1.

1：C

orre

latio

ns o

f Agg

rega

te S

uppl

y Sh

ocks

(Sou

rce)

Wor

ld B

ank’

s Wor

ld D

eveo

pmen

t Ind

icat

ors

C

hina

H

ong

Kon

g In

done

sia

Japa

n K

orea

M

alay

sia

Phili

ppin

esSi

ngap

ore

Thai

land

Ta

iwan

U

SA

EU (1

973-

)

Chi

na

1.00

Hon

g K

ong

0.21

1.

00

Indo

nesi

a -0

.10

0.

28

1.00

Japa

n 0.

06

0.22

0.

26

1.00

Kor

ea

0.10

0.

40

0.59

0.

46

1.00

Mal

aysi

a -0

.07

0.

51

0.63

0.

22

0.52

1.

00

Phili

ppin

es

-0.1

9

0.21

0.

15

0.20

0.

13

0.11

1.

00

Sing

apor

e 0.

01

0.30

0.

45

0.27

0.

39

0.59

0.

15

1.00

Thai

land

0.

11

0.47

0.

54

0.43

0.

65

0.63

0.

23

0.40

1.

00

Taiw

an

0.02

0.

11

-0.2

9

0.28

0.

02

-0.1

0

-0.0

1

-0.0

1

0.00

1.

00

USA

0.

03

0.54

0.

49

0.44

0.

48

0.39

0.

26

0.37

0.

54

0.15

1.

00

EU

-0.3

0

0.31

0.

01

0.31

0.

33

0.22

0.

05

-0.0

1

0.23

0.

39

0.23

1.

00

91

1.2：

Cor

rela

tions

of A

ggre

gate

Dem

and

Shoc

ks

(Sou

rce)

Wor

ld B

ank’

s Wor

ld D

eveo

pmen

t Ind

icat

ors

C

hina

H

ong

Kon

g In

done

sia

Japa

n K

orea

M

alay

sia

Phili

ppin

es

Sing

apor

e Th

aila

nd

Taiw

an

USA

EU

(197

3-)

Chi

na

1.00

Hon

g K

ong

0.19

1.

00

Indo

nesi

a -0

.15

-0.3

1 1.

00

Japa

n 0.

10

0.24

0.

11

1.00

Kor

ea

-0.0

1 0.

02

0.16

0.

37

1.00

Mal

aysi

a 0.

02

0.31

-0

.15

0.47

-0

.00

1.00

Phili

ppin

es

0.16

0.

40

0.00

0.

47

0.06

0.

29

1.00

Sing

apor

e 0.

20

0.17

0.

16

0.58

0.

27

0.43

0.

55

1.00

Thai

land

0.

00

0.00

0.

34

0.63

0.

16

0.57

0.

26

0.64

1.

00

Taiw

an

0.09

-0

.04

0.43

0.

13

0.01

0.

19

0.25

0.

05

0.33

1.

00

USA

-0

.16

0.08

-0

.06

-0.0

1 0.

22

0.05

0.

08

-0.0

4 0.

00

0.03

1.

00

EU

-0.2

2 -0

.04

0.03

-0

.32

0.08

-0

.27

0.10

-0

.08

-0.0

9 -0

.13

0.26

1.

00

92

Cas

e 2

Ann

ual D

ata

(196

2-19

70)

2.1：

Cor

rela

tions

of A

ggre

gate

Sup

ply

Shoc

ks

(Sou

rce)

Wor

ld B

ank’

s Wor

ld D

eveo

pmen

t Ind

icat

ors

C

hina

H

ong

Kon

g In

done

sia

Japa

n K

orea

M

alay

sia

Phili

ppin

es

Sing

apor

e Th

aila

nd

Taiw

an

USA

EU

Chi

na

1.00

Hon

g K

ong

0.75

1.

00

Indo

nesi

a -0

.23

-0.4

3 1.

00

Japa

n -0

.19

-0.4

3 0.

44

1.00

Kor

ea

0.21

-0

.12

0.37

0.

74

1.00

Mal

aysi

a 0.

06

0.16

-0

.11

-0.0

9 0.

14

1.00

Phili

ppin

es

-0.0

5 -0

.12

-0.0

9 -0

.16

0.08

0.

16

1.00

Sing

apor

e -0

.01

-0.4

1 0.

33

-0.0

4 0.

35

0.23

0.

39

1.00

Thai

land

0.

18

0.08

-0

.26

-0.0

5 0.

05

0.55

-0

.54

0.14

1.

00

Taiw

an

0.08

-0

.30

-0.4

2 0.

11

0.05

-0

.36

0.44

0.

17

-0.1

8 1.

00

USA

-0

.30

-0.1

8 -0

.05

0.35

0.

05

-0.2

8 0.

55

-0.2

7 -0

.75

0.43

1.

00

EU

93

2.2：

Cor

rela

tions

of A

ggre

gate

Dem

and

Shoc

ks

(Sou

rce)

Wor

ld B

ank’

s Wor

ld D

eveo

pmen

t Ind

icat

ors

C

hina

H

ong

Kon

g In

done

sia

Japa

n K

orea

M

alay

sia

Phili

ppin

es

Sing

apor

e Th

aila

nd

Taiw

an

USA

EU

Chi

na

1.00

Hon

g K

ong

0.39

1.

00

Indo

nesi

a -0

.47

-0.9

4 1.

00

Japa

n -0

.08

0.21

-0

.04

1.00

Kor

ea

0.04

0.

03

0.03

0.

39

1.00

Mal

aysi

a -0

.28

0.32

-0

.48

-0.2

6 -0

.38

1.00

Phili

ppin

es

0.21

0.

26

-0.2

7 0.

00

0.06

-0

.24

1.00

Sing

apor

e 0.

12

-0.2

8 0.

05

-0.0

9 0.

16

-0.0

5 0.

58

1.00

Thai

land

-0

.42

-0.7

8 0.

66

-0.0

3 -0

.18

0.14

-0

.43

0.22

1.

00

Taiw

an

0.01

-0

.83

0.74

-0

.34

-0.1

4 -0

.25

-0.4

3 0.

13

0.77

1.

00

USA

0.

01

0.53

-0

.36

0.53

0.

53

-0.1

5 -0

.09

-0.4

7 -0

.55

-0.6

2 1.

00

EU

94

Cas

e 3

Ann

ual D

ata

(197

1-19

80)

3.1：

Cor

rela

tions

of A

ggre

gate

Sup

ply

Shoc

ks

(Sou

rce)

Wor

ld B

ank’

s Wor

ld D

eveo

pmen

t Ind

icat

ors

C

hina

H

ong

Kon

g In

done

sia

Japa

n K

orea

M

alay

sia

Phili

ppin

es

Sing

apor

e Th

aila

nd

Taiw

an

USA

EU

Chi

na

1.00

Hon

g K

ong

-0.3

4 1.

00

Indo

nesi

a 0.

62

0.01

1.

00

Japa

n 0.

30

0.52

0.

13

1.00

Kor

ea

-0.1

2 0.

13

-0.0

6 0.

08

1.00

Mal

aysi

a -0

.52

0.68

0.

03

0.16

0.

29

1.00

Phili

ppin

es

0.13

0.

40

-0.1

5 0.

75

-0.0

4 -0

.24

1.00

Sing

apor

e -0

.01

0.46

-0

.02

0.67

-0

.13

0.15

0.

47

1.00

Thai

land

0.

22

0.60

0.

51

0.57

0.

45

0.41

0.

39

0.07

1.

00

Taiw

an

-0.3

4 0.

89

-0.0

8 0.

63

0.29

0.

57

0.49

0.

62

0.56

1.

00

USA

0.

38

0.29

0.

33

0.59

0.

17

-0.0

9 0.

51

0.58

0.

51

0.51

1.

00

EU

-0.3

5 0.

73

0.05

0.

34

0.57

0.

91

-0.0

7 0.

37

0.66

0.

72

0.27

1.

00

95

3.2：

Cor

rela

tions

of A

ggre

gate

Dem

and

Shoc

ks

(Sou

rce)

Wor

ld B

ank’

s Wor

ld D

eveo

pmen

t Ind

icat

ors

C

hina

H

ong

Kon

g In

done

sia

Japa

n K

orea

M

alay

sia

Phili

ppin

es

Sing

apor

e Th

aila

nd

Taiw

an

USA

EU

Chi

na

1.00

Hon

g K

ong

-0.0

4 1.

00

Indo

nesi

a 0.

30

0.50

1.

00

Japa

n 0.

09

0.23

0.

78

1.00

Kor

ea

-0.4

3 0.

03

0.33

0.

48

1.00

Mal

aysi

a 0.

37

0.66

0.

70

0.68

0.

05

1.00

Phili

ppin

es

-0.1

5 0.

48

0.41

0.

52

0.15

0.

67

1.00

Sing

apor

e 0.

14

0.33

0.

81

0.77

0.

51

0.60

0.

65

1.00

Thai

land

0.

10

0.38

0.

87

0.87

0.

36

0.65

0.

45

0.80

1.

00

Taiw

an

0.15

0.

36

0.10

-0

.02

-0.5

3 0.

27

-0.0

8 -0

.24

0.22

1.

00

USA

-0

.17

-0.1

0 -0

.13

-0.2

6 -0

.24

-0.2

0 0.

08

-0.1

6 -0

.16

-0.3

4 1.

00

EU

-0.4

7 -0

.26

-0.5

2 -0

.73

-0.1

3 -0

.73

-0.3

5 -0

.55

-0.5

1 -0

.09

0.60

1.

00

96

Cas

e 4

Ann

ual D

ata

(198

1-19

90)

4.1：

Cor

rela

tions

of A

ggre

gate

Sup

ply

Shoc

ks

(Sou

rce)

Wor

ld B

ank’

s Wor

ld D

eveo

pmen

t Ind

icat

ors

C

hina

H

ong

Kon

g In

done

sia

Japa

n K

orea

M

alay

sia

Phili

ppin

es

Sing

apor

e Th

aila

nd

Taiw

an

USA

EU

Chi

na

1.00

Hon

g K

ong

0.12

1.

00

Indo

nesi

a -0

.43

0.36

1.

00

Japa

n 0.

51

-0.2

4 -0

.22

1.00

Kor

ea

0.23

0.

68

0.32

0.

07

1.00

Mal

aysi

a -0

.23

0.05

0.

45

0.33

0.

12

1.00

Phili

ppin

es

-0.5

9 -0

.02

-0.0

4 -0

.36

0.11

-0

.15

1.00

Sing

apor

e -0

.18

0.35

0.

43

0.14

0.

22

0.87

-0

.12

1.00

Thai

land

-0

.13

0.09

0.

26

0.57

0.

42

0.60

0.

27

0.53

1.

00

Taiw

an

0.46

-0

.25

-0.4

8 -0

.22

-0.1

5 -0

.52

-0.2

2 -0

.64

-0.6

7 1.

00

USA

0.

03

0.75

0.

54

-0.3

2 0.

59

-0.0

2 -0

.11

0.17

0.

10

-0.0

6 1.

00

EU

-0.1

0 -0

.19

0.21

0.

25

0.37

0.

16

0.09

-0

.16

0.45

0.

10

0.25

1.

00

97

4.2：

Cor

rela

tions

of A

ggre

gate

Dem

and

Shoc

ks

(Sou

rce)

Wor

ld B

ank’

s Wor

ld D

eveo

pmen

t Ind

icat

ors

C

hina

H

ong

Kon

g In

done

sia

Japa

n K

orea

M

alay

sia

Phili

ppin

es

Sing

apor

e Th

aila

nd

Taiw

an

USA

EU

Chi

na

1.00

Hon

g K

ong

0.06

1.

00

Indo

nesi

a 0.

07

0.14

1.

00

Japa

n 0.

51

0.12

0.

34

1.00

Kor

ea

0.11

-0

.22

0.52

0.

37

1.00

Mal

aysi

a 0.

36

0.43

0.

39

0.09

-0

.23

1.00

Phili

ppin

es

0.00

0.

53

0.17

0.

37

-0.0

1 -0

.10

1.00

Sing

apor

e 0.

25

-0.1

3 0.

31

-0.2

9 0.

22

0.02

0.

09

1.00

Thai

land

0.

28

0.05

0.

27

-0.3

3 0.

18

0.35

-0

.17

0.71

1.

00

Taiw

an

0.36

0.

13

0.64

0.

76

0.42

0.

22

0.41

-0

.08

0.08

1.

00

USA

-0

.56

-0.1

8 0.

44

0.17

0.

48

-0.5

3 0.

32

-0.0

4 -0

.18

0.41

1.

00

EU

-0.4

5 -0

.06

-0.1

3 -0

.61

0.12

-0

.31

0.14

0.

23

0.04

-0

.39

0.17

1.

00

98

Cas

e 5

Ann

ual D

ata

(199

1-20

02)

5.1：

Cor

rela

tions

of A

ggre

gate

Sup

ply

Shoc

ks

(Sou

rce)

Wor

ld B

ank’

s Wor

ld D

eveo

pmen

t Ind

icat

ors

C

hina

H

ong

Kon

g In

done

sia

Japa

n K

orea

M

alay

sia

Phili

ppin

es

Sing

apor

e Th

aila

nd

Taiw

an

USA

EU

Chi

na

1.00

Hon

g K

ong

0.37

1.

00

Indo

nesi

a 0.

33

0.76

1.

00

Japa

n -0

.17

0.67

0.

60

1.00

Kor

ea

0.17

0.

83

0.95

0.

72

1.00

Mal

aysi

a 0.

45

0.86

0.

94

0.65

0.

90

1.00

Phili

ppin

es

-0.1

3 0.

54

0.60

0.

73

0.59

0.

58

1.00

Sing

apor

e 0.

47

0.80

0.

65

0.53

0.

65

0.84

0.

47

1.00

Thai

land

0.

30

0.69

0.

86

0.53

0.

88

0.78

0.

48

0.59

1.

00

Taiw

an

-0.1

5 -0

.36

-0.6

6 -0

.27

-0.5

9 -0

.49

-0.1

1 -0

.07

-0.4

4 1.

00

USA

0.

41

0.87

0.

83

0.67

0.

90

0.89

0.

47

0.78

0.

89

-0.3

4 1.

00

EU

-0.3

0 0.

11

-0.1

7 0.

25

0.05

-0

.14

0.06

-0

.11

-0.1

3 0.

24

0.01

1.

00

99

5.2：

Cor

rela

tions

of A

ggre

gate

Dem

and

Shoc

ks

(Sou

rce)

Wor

ld B

ank’

s Wor

ld D

eveo

pmen

t Ind

icat

ors

C

hina

H

ong

Kon

gIn

done

sia

Japa

n K

orea

Mal

aysi

aPh

ilipp

ines

Sing

apor

eTh

aila

ndTa

iwan

USA

EU

Chi

na

1.00

Hon

g K

ong

0.19

1.

00

Indo

nesi

a 0.

39

0.70

1.

00

Japa

n 0.

15

0.00

0.

39

1.00

Kor

ea

0.13

-0

.15

-0.2

2 -0

.23

1.00

Mal

aysi

a -0

.31

-0.6

0 -0

.67

-0.1

0 0.

45

1.00

Phili

ppin

es

0.29

-0

.01

0.31

0.

70

-0.6

9 -0

.38

1.00

Sing

apor

e 0.

29

0.05

0.

36

0.41

-0

.19

0.11

0.

23

1.00

Thai

land

0.

05

-0.2

7 -0

.11

-0.0

2 0.

65

0.62

-0

.42

0.27

1.

00

Taiw

an

-0.1

1 -0

.22

-0.1

9 0.

22

-0.3

8 0.

24

0.43

-0

.02

0.05

1.

00

USA

-0

.19

0.07

-0

.24

-0.0

6 0.

55

0.66

-0

.48

-0.0

9 0.

59

0.24

1.

00

EU

0.04

0.

06

0.32

-0

.08

-0.0

5 -0

.26

0.14

-0

.19

0.00

0.

19

-0.2

2 1.

00

100

(b) Generalized Purchasing Power Parity

Ogawa and Kawasaki (2002) used a G-PPP model27 to conduct empirical analysis on the

possibility of an optimal currency area in East Asia. The G-PPP model is an extension of a simple

PPP model and takes into account difficulties in holding the PPP because of nominal and real

shocks that have sustained effects on macro fundamentals. Even in the long run, changes in a

bilateral exchange rate depend not only on changes in relative prices between the related two

countries but also those in other countries. Price levels in other countries have effects on its

domestic price level through prices of intermediate goods imported from abroad.

Therefore, it is assumed in the G-PPP model that there are common factors among some

bilateral real exchange rates, especially those between pairs of strongly linked countries. Thus, real

exchange rates have a stable equilibrium in the long run. The G-PPP model explains that a PPP

holds if a linear combination of some bilateral real exchange rate series has equilibrium in the long

run even though each of the bilateral rate series is non-stationary.

Table 4-2-6 summarizes our empirical results of Ogawa and Kawasaki (2002). It shows

one combination in which all countries in the linear combination indicated significant statistics only

when the common Currency Basket is supposed to be an anchor currency. With the US Dollar as an

anchor currency, there were no combinations in which all countries in the linear combination

indicated significant statistics.

With the common Currency Basket as an anchor currency, it is found that at least five

Asian countries can form a common currency area. Moreover, it is found that all six countries can

form a common currency area if it is allowed to include the case where the Philippine peso is

considered to be weakly exogenous in co-integrated relationships. On the other hand, five Asian

countries (four countries with one exogenous country) are found to be able to form a common

currency area with the US Dollar as an anchor currency. If a number of countries that can form a

common currency area are used to judge a more applicable anchor currency, empirical results

suggest that the common Currency Basket is better as an anchor currency rather than the US Dollar.

The analytical results imply that the five ASEAN countries and Korea will be candidates

for a common currency area with a common Currency Basket as an anchor currency. The

conclusion that a common Currency Basket is more appropriate as an anchor currency than the US

Dollar in forming a common currency area in the region.

(c) From trade integration to monetary integration

In promoting progress toward to a common currency area in East Asia, it is the most

27 The G-PPP theory was developed by Enders and Hurn (1994).

101

realistic thing to begin with efforts aimed at international currency cooperation to stabilize bilateral

exchange rates among East Asian countries that share very strong economic relationships with each

other. For this purpose as well, it is important that East Asian countries rapidly strengthen their

economic relationships with the real economic aspects of other East Asian economies through

intra-regional trade transactions and direct investments. The strengthening relationships in the real

economy would give the governments of East Asian countries an incentive to stabilize bilateral

exchange rates among East Asian currencies and to establish a foundation for circulation of a

common currency in international trade and financial transactions among East Asian countries.

ASEAN countries have already concluded that the ASEAN Free Trade Area (AFTA) will

start from 2002. Also, some governments of East Asian countries, which include Japan and Korea,

are studying about effects and feasibility of bilateral free trade agreements with other East Asian

countries. The ASEAN countries, Japan, Korea, and China suggested establishing an East Asia Free

Trade Area in the ASEAN+3 (China, Japan, and Korea). Bilateral and regional free trade

agreements are complementary to a multilateral trade arrangement represented by the WTO. It is

expected that bilateral free trade agreements among East Asian countries would strengthen both

their trade relationships and their capital relationships. Economic agents in East Asian countries

should face in foreign exchange risks of their bilateral exchange rates that impede international

trade transactions and direct investments even after removal of tariff and non-tariff barriers under

free trade agreements. The economic agents will have to cope with the foreign exchange risks and

will enhance their interest in foreign exchange risks.

Urata et al. (2004) undertook a questionnaire survey of business firms in Japan. The

survey questionnaires include, the question, “What will be the remaining obstacles for the

economic entities in Japan and her possible FTA partners to conduct trade and financial transactions,

even after an FTA is made and tariff and non-tariff barriers are removed? How important for them

are the costs for currency exchange and exchange rate risks for the Japanese firms?”.

To this questionnaire about the exchange rate risks and currency exchange costs as

remaining obstacles after an FTA, the results are:

(i) 82.6 percent of all the respondents indicated that such risks and costs are “very important” or

“important” for trade; 77.8 percent of them, for direct investment; and 65.8 percent of them, for

fund procurement. But this order reverses if the percentages are calculated for the banking and

insurance companies only.

(ii) The companies whose main export destinations are Europe or America tend to put more

importance on such risks and costs, while the companies whose main export destinations are Asian

NIEs tend to put comparatively less importance on such factors. The difference may have simply

reflected the gap between their perspectives on such factors, but perhaps, it was because more trade

102

with Asian NIEs are settled in yen, compared to that with Europe or America.

On the matter of the importance of having a common currency in Asia after the Asian

FTA, 54 percent of all the responding companies expressed their recognition of the importance of a

common currency in Asia. However, whether they favor an Asian common currency or not depends

on to what benchmark are used for comparison. The companies perceived the importance of (i) the

internationalization of yen (80 percent), (ii) currency exchange costs and exchange risks (82.6

percent for trade, 77.8 percent for direct investment and 65.8 percent for fund procurement, as

indicated above). The percentage of the Asian common currency, 54 percent, is not a high score,

compared to these figures. However, it should be interesting that more than half of the Japanese

companies perceive the importance of the Asian common currencies even if the possibility is

thought to be slim for the common currency to materialize.

The movements toward bilateral and regional free trade agreements might gain momentum

to form a common currency area in East Asia if East Asian countries undertake international

cooperation to stabilize bilateral exchange rates among the countries in an international monetary

field. For example, if the free trade agreements include a clause providing that the government and

private sectors in East Asia should make efforts to use their own currencies in their trade and

financial transactions, the clause might gain momentum to depart from the situation of using

exclusively the US dollar as a settlement currency. Moreover, East Asian countries have another

possibility for international monetary cooperation in that they can try to create a foreign exchange

market for East Asian currencies.

Thus, governments of East Asian countries should try to have bilateral and regional free

trade agreements with many other countries in East Asia (including an agreement for international

monetary cooperation) that contributes to gaining momentum to form a common currency area in

East Asia. The free trade agreements are expected to contribute to movement toward an Asian

currency union through strengthening trade and financial relationships among East Asian countries

as well as through the processes of direct international monetary cooperation.

103

Table 4-2-6: Summary of Empirical Analysis on a Common Currency Area

Combinations Number of Countries

in the Currency Area Currency Basket US Dollar

6 Korea + Singapore + Indonesia + Malaysia +

(Philippinesa)+ Thailand

5 Korea + Singapore + Indonesia + Philippines +

Thailand

Korea + Singapore + Indonesia + Malaysia +

(Thailanda)

(Koreaa) + Indonesia + Malaysia + Philippines

(Koreaa) + Malaysia + Philippines + Thailand 4 Singapore + Indonesia + (Philippinesa) + Thailand

Indonesia + Malaysia + Philippines + (Thailanda)

3 Indonesia + (Malaysiaa) + Philippines (Indonesia a) + Malaysia + Philippines

Malaysia + Philippines + (Thailanda)

a Series of the countries with parentheses is a weak exogenous series in the co-integrated

relationship.

(Source) Ogawa and Kawasaki (2002)

104

References

Shin, K. and Y. Wang, “Trade integration and business cycle co-movements: the case of Korea with

other Asian countries,” Japan and the World Economy, 16, 213-230, 2004.

Frankel, J.A. and A.K. Rose, “The endogeneity of the Optimum Currency Area Criteria,” Economic

Journal, 108: 449 (1998), 1009-1025.

Eiji Ogawa " Monetary Integration in East Asia," Journal of East Asian Affairs, XV:2, 2001,

344-368

4.3 Challenges of Regional Monetary and Currency Integration

(1) Surveillance Process for Coordinated Exchange Rate Policy

The monetary authorities in East Asian countries may be forced to keep the de facto Dollar

Peg instead of a desirable exchange rate system which includes a Currency Basket system even if

they understand that they would be better-off by adopting a more desirable exchange rate system.

The situation can be described as kind of a “coordination failure” in choosing an exchange rate

system. In order to solve the problem of the coordination failure and achieve a coordinated exchange

rate policy among the East Asian countries, the monetary authorities in the East Asian countries

should conduct policy dialogues and carry out a surveillance process over their exchange rate policy.

The monetary authorities of East Asian countries should discuss the exchange rate issue as

part of the surveillance process because exchange rates of the home currency against its neighboring

countries’ currencies significantly affect price competitiveness among them. Each of the East Asian

countries has strong economic relationships with other countries in the region. Exchange rates

among the intra-regional currencies affect the economic activities of the East Asian countries

through intra-regional trade, investment, and finance. The monetary authorities should conduct a

surveillance process by focusing on deviations of their own currency from most of the other regional

currencies as well as their exchange policy in itself.

The monetary authorities should have some common understanding of what effect their

home currency has on their neighboring countries’ currencies in order to establish a coordinated

exchange rate policy. Moreover, they need to understand the exchange rate policy objective of other

countries. Policy dialogue and macroeconomic surveillances should be necessary for this objective.

The surveillance process in itself might not have contributed much to maintaining a

coordinated exchange rate policy in the long run because the monetary authorities in each of the

countries do not have any commitment to such a coordinated exchange rate policy. Though it may

make a limited contribution to coordinated exchange rate policy, it is necessary that the East Asian

region have a sufficiently workable mechanism to induce the monetary authorities to have a

commitment to conducting a coordinated exchange rate policy.

It is proposed that the monetary authorities in the East Asian region should have a regional

monetary arrangement to create a regional common unit of account that should be composed of a

basket of the East Asian currencies. The monetary authorities could refer to the regional common

unit of account in conducting their coordinated exchange rate policy. It is desirable to create a

regional common unit of account (Asian Currency Unit; ACU) consisting of regional currencies that

monetary authorities of East Asian countries could refer to when they try to coordinate their

exchange rate policy.

If the ACU were created as an instrument of the regional monetary arrangement in East

106

Asia, the monetary authorities could use the ACU as a common unit of account for the

regi6/20/2005onal policy coordination in order to conduct surveillance over movements of exchange

rates among the intra-regional currencies. The ACU could be used to measure the degree of each

currency’s exchange rate deviation from the regional average. East Asian countries could announce

an official exchange rate of their home currency against the ACU and to use the ACU as a reference

when applying their exchange rate policy while there is no policy coordination. The monetary

authorities in East Asia countries would be able to have policy dialogue and policy coordination

about both the exchange rates between their currencies and their exchange rate policies.

The monetary authorities should give attention to the exchange rate between their home

currency and the ACU as they apply policies to stabilize the exchange rates among the intra-regional

currencies. The regional monetary arrangements would help prevent competitive devaluation among

the related currencies as well as to resolve the problem of coordination failure in their adopting

exchange rate policies. The regional monetary arrangements based on the ACU under which the

monetary authorities in the region would make a commitment to a coordinated exchange rate policy

would prevent a possible competitive devaluation as well as the inertia that causes coordination

failure in adopting exchange rate policies.

The ACU could be used not only by the monetary authorities but also by the private sector.

It could use the ACU to denominate economic transactions (trade and capital flows) and asset stocks

(foreign exchange reserves and cross-border bonds) as the ECU had been used as a denomination

currency in the EU under the EMS. We may use the ACU as a denomination currency for the Asian

Bond that has been studied in line with the Asian Bond Market Initiative. The ACU as a common

denomination currency would contribute to the deepening and increasing of the liquidity in the Asian

Bond Market.

(2) Toward Future Monetary Integration

Movements toward future economic and monetary integration have been initiated in East

Asia now. Monetary integration should follow real economic integration which include free trade

agreements and regional trade agreements. On the real side, establishment of a region-wide FTA

should help in evolving to a region-wide customs union and a common market over time. On the

financial side, the East Asian countries should foster and develop capital financial markets in the

region, which have been shown as the Asian Bond Market Initiative and the Asian Bond Fund.

In the process of moving toward monetary integration in the region, the monetary

authorities may use the above-mentioned ACU as a convergence criterion, following the European

precedent. In addition, the monetary authorities could use their home currencies’ deviation from the

ACU to measure convergence and when reviewing their exchange rate policy. In addition, the

regional currency arrangement to target their intra-regional currencies to the ACU will help avoid

107

coordination failure in choosing their exchange rate policies and, in turn, prevent a competitive

devaluation in the region because the monetary authorities would have a commitment to the

arrangement.


currencies to the ACU before they achieve a regional monetary integration. This implies that there is

a choice for the monetary authorities to realign the exchange rates of the home currency vis-à-vis the

ACU or to stop linking their home currencies to the ACU. The existence of this choice might induce

speculators to make attacks on weaker currencies. Such a possibility makes it recommendable for the

monetary authorities to make a strong commitment to link their home currency to the ACU.

The strongest commitment is to proceed to a monetary integration. In the commitment, the

monetary authorities of the participating countries would have no option to leave it. Such a

commitment would contribute to the stability of the exchange rate system because private economic

agents would build up their confidence in the coordinated exchange rate policy in East Asia. The

increase in confidence would decrease the possibility of exchange rate collapse, which would, in turn,

decrease the domestic interest rates of the home currency because of reduction of expected

depreciation and risk premium. Thus, the monetary integration would contribute to a decrease in

domestic interest rates.

Moreover, the recent movements toward a regional free trade agreement contribute to the

elimination of some trade obstacles that includes tariffs and non-tariff barriers. However, economic

agents will regard the exchange rate risks as an important trade obstacle after they conclude free

trade agreements within the region. Even though we use forward contracts to avoid exchange rate

risks, we have to pay some costs to avoid the risks. Economic agents in the private sector would face

increasing needs to eliminate exchange rate risks and the foreign exchange transaction costs, which

enhance their willingness to introduce a single common currency in this region in the future.

108

References

Bayoumi, T., B. Eichengreen, and P. Mauro, (2000), “On regional monetary arrangements for

ASEAN,” Journal of the Japanese and International Economics, 14, 121-148.

Ito, T., E. Ogawa, and Y.N. Sasaki, (1998), “How Did the Dollar Peg Fail in Asia?” Journal of the

Japanese and International Economies, 12, 256-304.

McKinnon, R. I. (2002), “After the crisis, the East Asian Dollar standard resurrected: An

interpretation of high-frequency exchange rate pegging,” August.

Ogawa, E., (2002a), “Should East Asian Countries Return to Dollar Peg Again?” P. Drysdale and K.

Ishigaki eds., East Asian Trade and Financial Integration: New Issues, Canberra: Asia

Pacific Press, 159-184.

Ogawa, E., (2002b), “Economic interdependence and international coordination in East Asia,” in

Exchange Rate Regimes for Asia (KOBE RESEARCH PROJECT), Ministry of Finance.

Ogawa, E., (2004), “Regional Monetary Cooperation in East Asia against Asymmetric Responses to

the US Dollar Depreciation,” Journal of the Korean Economy, 5:2 (Fall) . (forthcoming)

Ogawa, E, T. Ito, and Y.N. Sasaki, (2004), “Cost, benefits, and constraints of the Currency Basket

regime for East Asia,” in Asian Development Bank ed., Monetary and Financial

Integration in East Asia: The Way Ahead, Volume 2, Palgrave, 209-239.

Ogawa, E. and T. Ito, (2002) “On the desirability of a regional basket currency arrangement,”

Journal of the Japanese and International Economies, 16:3, 317-334.

Ogawa, E. and K. Kawasaki, (2003) “Possibility of Creating a Common Currency Basket for East

Asia,” JBICI Discussion Paper No. 5, Japan Bank for International Cooperation.

Ogawa, E. and K. Kawasaki, (2003) “What should be weights on the three major currencies for a

common Currency Basket in East Asia?” Hi-Stat Discussion Paper No. 6, Hitotsubashi

University.

Ogawa, E. and L. Sun, “How were capital inflows stimulated under the Dollar Peg system?” in T. Ito

and A. O. Krueger eds. (2001),”Regional and Global Capital Flows: Macroeconomic

Causes and Consequences”, University of Chicago Press, Chicago.

Ogawa, E. and Doo Yong Yang, (2004), “Exchange Rate Arrangement in East Asia,” a paper

prepared for the project on Exchange Rate and Monetary Arrangement in East Asia,

organized by KIEP, Seoul, on August 26-27.

Sasaki, Y. N. (2002), “Doru Peggu tai Basuketto Peggu [Dollar Peg versus Basket Peg]”. In Kinyu

no Atarashii Nagare, edited by Katsumi Matsuura and Yasuhiro Yonezawa. Tokyo: Nihon

Hyoron Sha (in Japanese).

Shin, K. and Y. Wang, (2004), “Trade integration and business cycle co-movements: the case of

Korea with other Asian countries,” Japan and the World Economy, 16, 213-230,.

109

Yoshino, N., S. Kaji, and A. Suzuki, (2004), “The basket-peg, Dollar-peg, and floating:

A comparative analysis,” Journal of the Japanese and International Economies, 18,

183-217.

110

4.4 The Asian Currency Unit (ACU) for monetary policy cooperation in East Asia

(1) Introduction

First of all, a currency basket is a response to confusion concerning a standard of value in the world

economy or a regional economy.

Under the Bretton Woods system (between 1945 and 1971), the US Dollar as the key currency of the

system was the solid standard value on the world Market. The US Dollar was convertible to gold at

the rate of one Dollar being equal to 1/35 ounce or 0.888671 gram fine gold at the level of the

monetary authorities of the world. The US Dollar was official key currency. The IMF and the GATT

or other international institutions used the US Dollar as the common standard of value. The

European Economic Community used the Unit of Account (UA) as the common standard of value.

But 1 UA was defined as equal to 0.888671 gram fine gold and 1 US Dollar. The UA was de facto

the US Dollar.

When many countries adopted flexible exchange rates in the beginning of 1970s, they lost their solid

standard of value. The IMF decided to use a currency basket called the SDR as the standard of value

with which the IMF published statistics or counted its lending. The problem of standard of value was

particularly serious in the European Community. In 1975, there were 16 standards of value in the

EC: the Agricultural UA (Unit of Account), Budget UA, EUA (European Unit of Account), EMUA

(European Monetary Unit of Account) for Eurostat, statistical office of the EC, etc. The EUA was a

currency basket which was formulated on April 21, 1975 for use as a denominator in the

development finance of the EC towards less-developed countries in the world

When the EC created the European Monetary System in 1979, it created the European Currency Unit

(ECU). The ECU was used as the official standard of value in almost all activities of the EC

excluding agriculture and got rid of and solved the confusion or burden of the standard problems in

the EC in the 1970’s. The ECU inherited the currency basket EUA. The value and the composition of

the ECU were identical with the value of the EUA at the outset of the EMS.

The ECU was evolved into the Euro when it was introduced in 1999. The Euro inherited the ECU at

par value. During the twenty or so years of its life, the ECU was used officially as well as privately

and developed from a currency basket into a basket currency. The private ECU was used for lending

and borrowing, bond issues and ECU credit cards. The ECU was also used extensively for monetary

cooperation.

If we want to develop monetary cooperation and integration in East Asia, we will have to develop a

currency basket adequate to the East Asian community. In the following, I will explain what the

ECU was and how it developed in the European Community (Union). Then, I will compose a similar

currency basket composed of 9 East Asian currencies, which I name the Asian Currency Unit (ACU)

and show how good it will be in playing a role in East Asian monetary cooperation and integration.

111

(2) The ECU in the European Community

The European Monetary System (EMS) was composed of two elements: the Exchange Rate

Mechanism (ERM) and the European Currency Unit (ECU).

The ERM was a foreign exchange rate arrangement among the EC countries excluding the UK.

Inside the ERM, the participating currencies had bilateral central rates around which exchange rates

fluctuation margins of ±2.25% were established (“parity grid mechanism). It meant that the ERM

was a pegging fixed rate system with the maximum of 4.5% fluctuation margins. The ERM

currencies floated vis-à-vis the US Dollar or other non-EC currencies. So, the ERM was called “a

block floating mechanism.” When two currencies diverged from each other by 2.25%, the related

two central banks had to intervene on their home foreign exchange Markets (compulsory

intervention).

The ECU was designed not only to solve the standard of value problems in the EC mentioned above,

but also to play important roles in the EMS.

The ECU was planned to be used in the EMS :

(1) as the denominator (numeraire) for the ERM;

(2) as the basis for a divergence indicator;

(3) as the denominator for operations in both the intervention and the credit mechanism;

(4) as a means of settlement between monetary authorities of the EC.

These were so-called official use of the ECU. The ECU functioned for and among the monetary

institutions in the European Community.

2-1. Composition of the ECU

The ECU was a currency basket composed of the nine currencies of the European Community when

it was introduced in 1979. The ECU basket was composed as follows:

1ECU ＝

0.828DM+0.0885UKL+1.15FF+109LIT+0.286DFL+3.66BF+0.14LF+0.217DKR+0.00759IRL

（where DM: German Mark, UKL: British pound, FF: French Franc, LIT: Italian lira, DFL: Dutch

Guider, BF：Belgian Franc, LF： Luxembourg Franc, DKR: Danish Crown [Krone], IRL：Irish

pound）

The right-hand side is composed of nine items: each item has a number of currency units (0.828 in

the case of the DM) and the name of each currency (DM etc.). Using the US Dollar rate of each

currency, we can calculate each item expressed in the Dollars.

112

An example is adequate to show how the ECU is calculated. On December 1978, 1 US Dollar was

equal to 1.9358 DM on the Frankfurt foreign exchange Market (or 1 DM= 0.51658 USD), as column

(b) of Table 4-4-1 shows. So, 0.828DM was equal to 0.828*0.51658 USD, namely 0.4277301 USD,

which is shown in the column (c) of Table 1. As the FF row in the column (b) shows, 1 USD was

4.4495 FF (or 1 FF = 0.2247USD) on the same day. So, 1.15FF was 1.15*0.2247USD, namely

0.258456USD. In the same way, the every item of the ECU equation could be calculated, as is

shown in column (b). Adding all items, we can get the ECU rate expressed in USD, which was 1

ECU = 1.3001831 USD.

Then, we can calculate the ECU rate of each component currency. In the case of the DM, 1 ECU =

1.3001831*1.9358 = 2.51689 DM, as column (d) of Table 414-1 shows.

Table 4-4-1: Calculation of equivalents for 1 December 1978:

National currency

Amount of the ECU

Definition

1 December 1978

Exchange rate

Against the USD

Equivalent in dollars

of national currency

amount

Equivalent in national

Currency of total US

dollar amount

(a) (b) © (d)

USD total × (b)

0.828 DM

1.15 FF

0.885 UKL

109 LIT

0.286 DFL

3.66 BFR

0.140 LFR

0.217 DKR

0.00759 IRL

1.9358

4.4495

1.9364

853.00

2.1035

30.6675

30.6675

5.3885

1.9364

0.4277301

0.2584560

0.1713714

0.1277842

0.1359638

0.1193445

0.0045650

0.0402709

0.0146972

2.51689

5.78516

0.671443

1109.06

2.73494

39.8734

39.8734

7.00604

0.671443

Total of the dollar amounts 1 ECU = 1.3001831

(Source) Monetary Committee of the EC [1986], p.110.

In the ECU basket, each currency has its weight. The weight is calculated as a foreign exchange rate

of currency i multiplied by a number of units (0.828 in the case of the Mark) of currency i. If we

express the number of units (0.828 in the case of the Mark) of currency i by ei and foreign exchange

spot rate by ri, the weight of currency i is expressed as eiri /Σeiri. The weight of each currency

reflects a relative weight of each national economy in the EC.

As the ECU was a weighted average of the rate movements of the currencies on the foreign

exchange Markets, it was well utilized for the four objectives in its official uses.

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The EC Council of Ministers determined the weights of the currencies by using the following

criteria:

(a) the relative share of the individual Member States in the Gross Domestic Product (GDP) of the

EC;

(b) the contribution of each Member State to the intra-EC trade; and

(c) the quota of each Member State in the short-term credit mechanism of the EMS.

At the start of the EMS, the EC took the GDP in the previous year, namely in 1978, and the foreign

exchange spot rate on the day preceding the start of the EMS. The EC Council of Ministers

apparently also used other non-disclosed, and possibly more political, criteria in its negotiations,

which generally made the outcome of the composition as unknown factor.

(2)-2. Re-composition of the ECU

The composition of the ECU could be revised. According to section 2.3 of the Resolution on the

establishment of the EMS, “the weights of currencies in the ECU will be re-examined and if

necessary revised within six months of the entry into force of the system and thereafter every five

years, or, on request, if the weight of any currency has changed by 25%.”

There was no reexamination within six months of the entry and no drastic change of the weight as

much as 25%. The re-compositions took place “every five years” in 1984 and 1989. In the

Maastricht Treaty of 1993, the re-composition of the ECU was frozen to stabilize the ECU in view of

the introduction of the ECU as a single currency of the EU.

Re-compositions became necessary to compensate for shifts in the relative strength of the individual

EC economies and to include new currencies in the basket. Changes in the individual strength of the

economies were reflected in corresponding changes in the individual exchange rates. To compensate

for such changes, the ECU composition had to be changed.

The EC revised the basket in September 1984. At that time, all currencies except the Luxembourg

Franc were adjusted to represent more accurately the shares of the Member States in the economy of

the EC. For example, the weight of the German Mark was about 33% when the EMS started in

March 1979. The weight of the Mark increased as the foreign exchange rate of the Mark rose

vis-à-vis the other ERM currencies. The weight of the Mark became about 37% just before the first

re-composition. In the first re-composition of 1984, the number of units of the Mark was reduced

from 0.828 to 0.719 and the weight of the Mark in the new ECU basket became about 32% at the

time of the re-composition. The Greek Drachma (GDR) was incorporated into the basket.

114

In the last re-composition on September 21, 1989, all currencies except the British Pound were

adjusted. Then, the Portuguese Escudo (PES), the Spanish Peseta (SPS) were incorporated in the

basket. These two currencies, the Drachma and the British Pound did not participate in the ERM at

that time, although they were part of the basket.

Table 4-4-2: Re-composition of the ECU Basket

Currency 3/13/79 9/17/84 %-Change 9/21/89 %-Change

DM

FF

UKL

LIT

DFL

BFR

LFR

DKR

IRL

GDR

PES

SPS

0.828

1.15

0.0885

109.0

0.286

3.66

0.14

0.217

0.00759

-

-

-

0.719 - 13.2

1.31 + 13.9

0.0878 - 0.8

140.0 + 28.4

0.256 - 10.5

3.71 + 1.4

0.14 no change

0.219 + 0.9

0.00871 + 14.8

added

-

-

0.6242 - 13.18

1.332 + 1.68

0.08784 no change

151.8 + 8.43

0.2198 - 14.14

3.301 - 11.03

0.13 - 7.14

0.1976 - 9.78

0.008552 - 1.70

1.440 + 25.22

1.393 added

6.885 added

(Source) EC Commission.

The re-compositions table (see Table 4-4-2) shows that the strong currencies like the Mark, Guilder

and the Belgian Franc show diminished numbers of units and the weak currencies like the Lira and

the French Franc increased numbers of units.

The re-compositions changed only e percentage weight of each currency. The total basket was

designed to not disturb the external value of the ECU. The numbers of units of each ECU currency

was decided n in such a way as to not change the external spot value of the ECU at the

re-compositions, namely the US Dollar rate of the new ECU on the previous day of the

re-composition had to be equal to the US Dollar value of the old ECU. Thus, the new ECU inherited

the external value of the old ECU and there no discontinuity of the ECU foreign exchange rates was

caused by the re-compositions.

(3) Private use of the ECU

When two currencies of the ERM diverged and arrived at the margin of 2.25%, the two central banks

had to intervene on the foreign exchange Markets. The central bank of the weak currency borrowed

the intervention money from the central bank of the strong currency. The debts and credits of the

115

central banks were converted into the debts and credits to the European Monetary Cooperation Fund

(EMCF) and were expressed in the ECU. The debtor central bank had to pay interest rate of the ECU

to the creditor central bank at the time of the settlement. The ECU interest rate was a weighted

average of the ECU participating currencies.

The ECU came to accept gradually as a denominator for private and commercial financing

instruments on the international Markets. The private Market for the ECU became possible in the

early 1980s with ECU accounts opened by certain Belgian banks for EC institutions. These accounts

facilitated the cash management of the latter and transfers to the European Investment Bank, an EC

institution. The EIB, in turn, deposited the received and unused ECU assets with Italian banks. The

Belgian and Italian banks wanted to use those deposits for which interest accrued. They created an

ECU loan and foreign exchange Market by granting ECU credits to a limited number of private

customers. The customers used the ECU credits and “unbundled” the ECUs received by breaking

them down into their component national currencies. Similarly, private parties “created” their own

ECUs by buying and “bundling” the appropriate amounts of the component currencies. The banks

also accepted these ECUs as deposits. This process of using ECUs in private transactions and the

establishment of the ECU Clearing System in 1986 increased the number of individual participants

as well as the variety of ECU-denominated banking services.

The volume of the private ECU markets was estimated at over ECU 100 billion as early as 1985 and

exceeded ECU 200 billion in 1991. The private use of the ECU was extensive, and its growth was

facilitated by the range of its use: lending and deposits of banks, bond issues, ECU credit cards, ECU

traveler’s checks, ECU/Dollar options and futures and ECU foreign exchange transactions.

Further explanation of the private use of the ECU cannot be done here, because the main theme of

this study is the use of a currency basket for policy coordination in East Asia. It can be said, however,

that development of an Asian Currency Basket should anticipate use not only for policy coordination

but also for private purpose, if banks and other financial institutions in East Asia will be as skillful in

the private use as their European counterparts. Backup actions by the governments will be also

necessary.

(4) The ECU Divergence Indicator

The EC set up a divergence indicator in the EMS. The ECU was utilized as a surveillance indicator

for macroeconomic policy coordination in the ERM.

Each currency participating in the ERM had central rates vis-à-vis the other currencies and could

fluctuate in the ±2.25％ margin around the central rates. The ECU was a weighted average of the

foreign exchange rate fluctuations of all the participating currencies. This means that a currency

116

drew the ECU to its side in proportion to the weight of the currency. If only currency A moved to the

margin and all of the other currencies stayed at the same rates relative to each other, then currency A

diverged by 2.25％ from every other currency. In this situation, the width of the divergence of the

currency A came to a maximum. It is called the maximum spread.

Let us take the German Mark as an example. The weight of the Mark was 33%, it drew the ECU by

33% to its side when it was standing at the opposite pole from all the other currencies at the

compulsory intervention rates. As the other eight currencies diverged from the Mark by 2.25％, the

other eight currencies drew the ECU by 67% to their sides. The maximum spread of the Mark had to

be 1.51% (= 2.25% times 0.67). In the same way, the maximum spread of the Belgian Franc whose

weight was 9.63% at the starting time of the EMS was 2.03% (= 2.25% times 0.9037). In general,

the maximum spread of currency A was calculated as 2.25％ times (1 – the weight of currency A).

Each currency of the ERM had its ECU central rate. The foreign exchange spot rates of the EMS

currencies on the previous day of the start of the EMS were chosen as the bilateral central rates. If

we put these bilateral central rates in the ECU equation, we could get the ECU central rates. The

ECU central rate of the Mark was 1 ECU = 2.51064 DM and that of the Belgian Franc was 39.4582

BF before the first re-composition in the ERM.

Though the British Pound did not participate in the ERM, it had a notional central rate for the sake of

calculation. When the British pound fluctuate more than 2.25％, the calculation was done assuming

that the pound was at the margin of 2.25%.

The divergence indicator (DI) measured how much a currency fluctuated vis-à-vis the maximum

spread. The daily ECU rate of each currency had premium (P) or discount (D) vis-à-vis the ECU

central rate. P or D = (the daily ECU rate of currency A – the ECU central rate of the currency A) /

the ECU central rate of currency A. For example, the ECU rate of the Belgian Franc on March 27,

1979, was 1 ECU = 32.8226 BF. Then, P = (39.8226 – 39.4582) / 39.4582 = 0.0092 or 0.92%. If we

divide the value by the maximum spread, we can get the divergence indicator of the Belgian Franc

on the day. The DI = 0.92/2.03 = 0.45 (-). The minus showed a depreciation of the BF vis-à-vis the

ECU central rate.

The divergence threshold was decided as three-quarters of the maximum spread. In the case of the

Belgian Franc, it was ±1.52 % (= 2.03 times 0.75). The divergence threshold of the DM, the Dutch

Guilder, the Danish Krone, the FF, the Italian LIT and the Irish Pound was respectively ±1.13%,

±1.51%, ±1.64%, ±1.35%, ±4.07% and ±1.67%. As the fluctuation margin of the Lit was

117

exceptionally wide (± 6 %), the divergence threshold was exceptionally big.

Monetary authorities participating in the ERM should move, when its currency reaches ±75% of the

maximum spread or the divergence threshold. If a currency crossed a divergence threshold, the

authorities concerned were expected to correct the situation by adequate measures, namely:

(a) diversified intervention;

(b) measures of domestic monetary policy;

(c) changes in central rates;

(d) other measures of economic policy.

In case such measures were not taken, the reasons for this should be given to the other authorities.

Here it becomes clear why the maximum spread was not 2.25% for every currency, but 2.25％ times

(1 – the weight of currency A). As the power of the Mark drawing the ECU to its side was about

33% and that of the Belgian Franc was about 10%, the latter tended to be more accessible to the limit.

The item (1 – the weight of currency A) had the effect to mitigate the disadvantage of the

currencies whose weights were relatively small.

The ECU divergence indicator worked for surveillance purpose in the ERM. The divergence

indicator was supposed to provide a signal of divergence of any particular currency with respect to

an average EMS performance. It could also trigger consultations to define the nature of the problem

and to elaborate solutions. For temporary divergence, generous financial instruments were made

available. For structural divergence, appropriate policy measures comprising realignments (changes

in bilateral central rates) and domestic adjustment policies had to be elaborated.

In East Asian monetary cooperation, measures using a currency basket like the ECU should be taken

into consideration. Since the cooperation should proceed on an equal footing for each of the

participating country, no specific currency should be chosen for the key currency. A currency basket

will be able to work in East Asia as the ECU did in Europe, if authorities in East Asia are eager for it

to do so.

(5) Asian Currency Unit ACU and ACU*

(5)-1 ACU and Its Rate Development

An Asian Currency Unit (ACU) is defined as composed of nine East Asian currencies: Japanese Yen,

Chinese Yuan, Korean Won, Taiwan Dollar, Hong Kong Dollar, Singapore Dollar, Malaysian Ringgit,

Thai Baht and Philippine Peso. Indonesian Rupiah is excluded because its fluctuation after the East

Asian currency crisis was too big until 2002.

118

As a weight of each currency in the basket, we take the GDP and trade volume of each country

expressed in US Dollars after the fashion of the ECU. For example, the share of the GDP of Japan in

the nine countries multiplied by 1/2 plus the share of the trade volume of Japan in the total trade

volume of the nine countries multiplied by 1/2 becomes the weight of Japanese Yen in the basket.

The weights of each country are calculated as in Table 4-4-3.

Table 4-4-3: Weight of the currencies in the basket (1)

(%)

1990 1995

Japanese Yen 70.77 68.93

Chinese Yuan 8.84 8.77

Korean Won 5.77 5.82

Taiwanese Dollar 3.90 3.67

Hong Kong Dollar 3.71 4.59

Singapore Dollar 2.57 3.05

Thailand Bah t 2.00 2.27

Philippine Pesos 1.00 0.96

Malaysian Ringgit 1.41 1.93

Total 100.0 100.0

(Note) Calculated by author, using the GDP and trade volume of each country.

We designed an ACU basket based on the 1991 standard as follows. We set the ACU foreign

exchange rate as it was for the starting month (January of 1991: because we could not take daily

forex rates) in such a way as 1 ACU = 1 US Dollar. In this case, the number of currency units of the

Yen in the ACU equation can be calculated as follows. In January 1991, the monthly Yen rate was 1

JPY = 0.007469US$. From the Table 4-4-3, the weight of the Yen in the basket is 70.77%. So, the

number of units times 0.007469 equals to 0.7077. From this equation, the number of units of YEN is

94.7528. The number of units of the other currencies can be calculated in the same way and is

expressed in Table 4-4-4.

119

Table 4-4-4: Number of Units of Each Currency

Currency / Year 1990 1995

Japanese Yen 94.7528 84.08721

Chinese Yuan 0.46176 0.85992

Korean Won 41.4686 53.2378

Taiwanese Dollar 1.06127 1.17966

Hong Kong Dollar 0.28947 0.41879

Singapore Dollar 0.04490 0.05087

Thailand Bah t 0.50564 0.67498

Philippine Pesos 0.28028 0.29614

Malaysian Ringgit 0.03838 0.05790

(Note) Same as Table 4-4-3.

From Table 4-4-4, we can get the following ACU equation.

1 ACU91＝94.7528JPY + 0.46176CNY + 41.4686KRW + 1.06127TW$ + 0.28947HK$

+0.0449SP + 0.50564TLB + 0.28028PLP + 0.03838MLR (1)

If we assign the US Dollar rates of the nine currencies for any given time like 1 JPY =

0.007216US$ etc in the equation, we can get the US Dollar value of 1 ACU91 for the time. Using

the US Dollar rate of each currency, we can also get the ACU91 value of each currency for the time.

We change the ACU equation on January 1996 after the fashion of the ECU which changed the

equation every five years. The foreign exchange rate of the ACU91 was worth 1.1788US$ on

January 1, 1996. The weight of each currency was calculated as Table 4-4-3. And the Yen rate on

January 1, 1996 was worthy of 0.009664US$ (daily foreign exchange rates are available from 1996).

Then, the number of currency units in the ACU96 basket of the Yen is 1.1788 times 0.6893 divided

by 0.009664. It is 84.0872. The number of currency units of the other currencies can be calculated in

the same way.

Then, the ACU96 rate of 1 of January 1996 equals 1.1788 US$ and continuity between ACU91 and

ACU96 can be maintained.

In the same way, we can formulate the ACU01 and calculate its value until April 2004.

Figure 4-6 and Figure 4-7 below show that the ACU rate follows the Yen rate and is not related to

the rate development of the other currencies. The reason lies in the weight of Japanese Yen, which is

about 70%. It pulls the ACU to its side by about 70%. In this case, the ACU would lose its

120

significance as a policy coordination indicator in East Asia, since it reflects only the YEN rate. It is

remembered that the weight of the German Mark was said too big if the weight approached to 40%.

121

0.5

1

1.5

2

2 5

91 95 00 03

/USD

NTD/US$ HK$/US$ S$/US$ Pesos/US$ Ringgit/US$ ACU/US$ ACU＊/US$

Figure 4-6: Movements of ACU, ACU* and East Asian Currencies (1)

(Note) Calculated by Author

Figure 4-7: Movements of ACU, ACU* and East Asian Currencies (2)


0.5

1

1.5

2

2.5

91 95 00 03

ＪＰＹ/US$

ＣＮＹ/US$

Baht/US$

KRW/US$

ACU/US$ ACU＊/US$

122

In the definition of the ACU, we cannot simply follow the ECU calculation mutatis mutandi, because

the economic size of each country in East Asia is quite different from Europe.

(5)-2 Asian Currency Unit at PPP standard: ACU*

In order to correct the deficit of the ACU, we take as the weight of each currency the GDP at PPP

standard of the above countries. For the sake of simplicity, we take this time only the GDP as the

basis of the weight of each currency in the basket. In this case, the weight of the Yen in 1990 gets

lowered to about 35% and about 29% in 2000. The weight of the Chinese Yuan is the biggest in the

currency basket every year (see Table 4-4-5).

Table 4-4-5 Weight of the nine currencies in the basket - PPP standard -

(%)

Currency / Year 1990 1995 2000

Japanese Yen 35.09 32.44 29.00

Chinese Yuan 40.65 41.10 45.36

Korean Won 5.86 6.01 6.86

Taiwanese Dollar 3.90 3.67 3.75

Hong Kong Dollar 2.97 4.08 3.75

Singapore Dollar 1.97 2.73 2.46

Thailand Baht 5.02 5.24 3.81

Philippine Pesos 2.62 2.31 2.68

Malaysian Ringgit 1.91 2.42 2.33

Total 100.0 100.0 100.0

In the same way as for the ACU, we can get the ACU* equation based on the PPP. The foreign

exchange rate of the ACU* of the starting month (January 1991) is 1 ACU96 = 1 US Dollar.

1 ACU*91 = 46.97916JPY + 2.12269CNY + 42.09842KRW + 1.06127TW$ + 0.23124HK$

+ 0.0344SP + 1.26731TLB + 0.73443PLP + 0.05189MLR (2)

We change the ACU* equation based on the GDP at PPP in 1995. From equation (2), 1 ACU*91 was

equal to 0.95542 US$ on January 1, 1996. In order to maintain continuity between ACU*91 and

ACU*96, we take the foreign exchange rate of the US$ of the ACU*91 of January 1, 1996 into

consideration. Then, we get ACU*96 based on the forex rates of the nine Asian currencies on

123

January 1, 1996 as follows:

1 ACU*96 = 32.0722 JPY + 3.2685CNY + 44.5512KRW + 0.95609TW$ + 0.30129HK$

+ 0.03692SP$ + 1.26094TLB + 0.57997PLP + 0.05881MLR (3)

For the continuity of the ACU* to take into consideration the exchange rate of 1 ACU*

= 0.95542US$ on January 1, 2001, we can calculate the ACU*01 as follows.

1 ACU*01 = 28.35057JPY + 3.20948CNY + 74.0379KRW + 1.05756TW$ + 0.25032HK$

+ 0.03636SP$ + 1.41295TLB + 1.14368PLP + 0.075661MLR (4)

We can compare the foreign exchange rates development of the East Asian currencies and the ACU,

the ACU* from 1991 to 2004 (Figure 4-6, Figure 4-7). The figures show that the ACU* rate moved

in the mid-range of the East Asian currencies. During the East Asian Currency Crises in 1997 and

1998, the foreign exchange rates of several South East Asian currencies and the Korean Won

deviated from the ACU* remarkably. However, the ACU* rate was relatively stable vis-à-vis the

US$ and the other currencies, since the forex rate of the two most influential currencies, the Yen and

the Yuan, was not so much influenced by the East Asian currency crises. In the case of the Yuan, the

stability was guarantied by its Dollar-peg and Chinese government rejected to devaluate the Yuan.

The ACU* was more stable than the YEN vis-à-vis the US$, since the CNY devalued drastically in

January 1994 when the YEN kept appreciating vis-à-vis the US$.

Let us show the ACU* rates of the East Asian currencies, namely the forex rates of the East Asian

currencies vis-à-vis the ACU* from 1991 to April 2004 (Figure 4-4-1 and Figure 4-4-2). The Yen

rate appreciated more than 30% from 1991 to the middle of 1995 but fluctuated between 0.7 and 0.8

after that. The ACU* rates of the US$-pegged HK Dollar and the currency-basket-pegged Singapore

Dollar fluctuated in the 1990s relatively strongly but have become relatively stable since 1999. The

Taiwan Dollar (NTD) has depreciated slightly since 1997. The ACU* rate of the Yuan depreciated

drastically in 1994, but recovered since the late 1995 and became relatively stable in the late 1990s.

The crises-hit currencies, KRW, Baht and Ringgit, depreciated and fluctuated tremendously during

the crises period, but were relatively stable before and after the crises. Only the Philippine Peso has

depreciated constantly after the crisis (Figure 4-6).

In the 21st century, the inflation rates of the East Asian countries have declined. In the middle of the

1990s, Chinese and Indonesian inflation entered the double-digit range and the rates of the other

countries were relatively high except Japan, Singapore and Malaysia. But, the rates declined to under

124

5% in the 21st century except Indonesia. In China, the inflation rate rose to 5% in the latter half of

2004 because of the overheating of the economy. However, the core inflation rate was not so high.

The differentials of inflation rates of the countries which participate in an agreement for foreign

exchange rate stability was one of the most important problems in the European Community/Union

in the 1970s and 1980s. Owing to expansion of differentials, high inflation countries like Italy, the

UK or France were obliged to leave the fluctuation band of the agreement. The inflation gap of the

East Asian countries converged to so narrow a range as the EMS countries in the middle of 1980s,

when the EMS came into stability. The time looks ripe for the East Asian countries to devise a

foreign exchange rate stability agreement.

(6) ACU* as an Instrument for East Asian Macroeconomic Policy Coordination

The European Community made use of the ECU divergence indicator for several objects. In East

Asia, we can use the ACU* for macroeconomic policy coordination.

We take the first day of 1999, when forex stability of the East Asian countries became clear, as the

starting day of our observation. The ACU* rate on the day is set as the official ACU* rate. It plays as

a standard rate of each currency. We draw margin lines 10% and 5% above and below the official

ACU* rate.

The currencies are categorized into three groups shown in Figure 4-8, Figure 4-9 and Figure 4-10.

The first group consists of the Yen, the Korean won and Singapore Dollar and fluctuate over 5%

band many times, though Singapore Dollar has been relatively stable. The second group consists of

the USD-pegged currencies and Taiwan Dollar, which fluctuated inside the 5% band, though they

went up or down over the 5% margin line. The third group contains the Baht and the Peso, which

went out of the 10% band for long time. Though the Baht went inside the 10% band, the Pesos

deviated almost always from the 10% margin.

125

Figure 4-8: Foreign Exchange Rates of East Asian Currencies (Group 1)


Figure 4-9 Foreign Exchange Rates of East Asian Currencies (Group 2)


0.6

0.7

0.8

0.9

1

1.1

1.2

91 95 00 03

NTD/ACU＊ S$/ACU＊ＪＰＹ/ACU＊ HK$/ACU＊

0.6

0.8

1

1.2

1.4

1.6

1.8

2

91 95 00 03

Baht/ACU＊ Pesos/ACU＊ＣＮＹ/ACU＊ KRW/ACU＊ Ringgit/ACU＊

126

Figure 4-10: Foreign Exchange Rates of East Asian Currencies (Group 3)


As the added weight of the US$-pegged currencies is more than 50% in the ACU* basket, the rate of

the ACU* is pulled by the currency, i.e., the US Dollar, by more than 50%. This tends to make the

ACU* rate movement in relatively stable manner vis-à-vis the US Dollar. The stability of the ACU*

rate of the US$-pegged currencies explains this character of the ACU*.

As the ACU* rate movement of the East Asian currencies has been relatively stable over the last five

years, we can use 5% margin, if the authorities want to coordinate strictly, or a 10% margin, when

thy want to coordinate loosely, above and below the promised ACU* rate. The margin can work as a

kind of divergence indicator or surveillance instrument. Like the ECU divergence indicator, the

monetary authority of the East Asian countries is expected to take the following measures:

intervention on the forex Market, domestic monetary policy, realignment of the currency and other

economic policies.

They may say that there is discrimination among the nine currencies, if we simply set, for example, a

10 % margin. The Chinese Yuan draws the ACU* to its side by about 45%, proportional to its weight

in the basket, and the Japanese Yen by 29%, yet the Thai Baht only by 4%. For the Thai Baht can

reach its margin much more easily than the Chinese Yuan or the Japanese Yen. In order to cancel

such inequality, a correction measure can be introduced, which is similar to the correction measure

0 8

0 9

1

1 1

1 2

99 00 01 02 03

KRW／ACU＊

S$／ACU＊ JPY／ACB＊ B0（10%） B1（10%） L1(5%） L2（5%）

127

in the case of the ECU divergence indicator. Instead of drawing a margin line of 10% above and

below the official ACU* rate, we can set the line as big as 10% times (1 – weight of the currency).

Hence, in the case of the Chinese Yuan, the width of the fluctuation band is 10*(1 – 0.45), namely

5.5%. In the case of the Japanese Yen, the width becomes 7.1%. In the case of the Thai Baht, it is

9.6%.

The Peso authorities should be advised to devalue the Peso ACU* rate and to adopt domestic

monetary policy and other economic policy measures. In relation to the other currencies, the

monetary authorities should intervene on the forex market using the US Dollar reserves.

There are several comments: Firstly, in case of the European Community, the monetary authorities

and the Eofin (economic and finance ministries) Council of the member states cooperated in a timely

manner and the European Commission advised the member governments in the EMS. The

governments and the monetary authorities of the “ASEAN plus Three” should learn from this

process and endeavor to do just as well. Secondly, policy coordination between the two most

influential countries, Japan and China, will be essential, yet there are remarkable differences

between the two: the matured and the young economy, the low and high economic growth rate, the

difference of the population and even political rivalry. However, the monetary coordination will not

proceed well, without the cooperation between the two. It is still to be seen whether monetary and

economic cooperation between such partners will be able to go well. ASEAN countries may play a

role as mediators or dealmakers between the two, as Benelux countries did between France and

Germany.

6. Longer View

The ECU was used as numeraire and other measures for policy coordination as mentioned above.

The private ECU was also developed. At the last stage, the ECU changed into the Euro at the rate of

1 Euro = 1 ECU based on the Market ECU rate of December 31, 1998. The ACU* can be utilized as

a denomination currency for the Asian bonds and other uses, and policy coordination in East Asia, as

Prof. Ogawa referred in his contribution to this study.

If such coordination could succeed in the long run, the ACU* will be able to be changed into a single

currency for East Asia, namely the Asian Monetary Unit (AMU).

128

References

Grauwe Paul De/ Theo Peters (ed.) [1989], The ECU and European Monetary Integration,

Macmillan.

Hellman, Rainer [1979], Das Europaeische Waehrungssytem, Nomos-Verlag.

Korean Statistics Office, http://www.nso.go.kr/kosisdb/ for forex monthly data during 1991 and

2000.

Levich, Richard M. / Andrea Sommariva (ed.) [1987], The ECU Market, Lexington Books.

Mehnert, Ralph J. [1992], User’s Guide to the Ecu, Graham & Trotman.

Monetary Committee of the EC [1986] [1989], Compendium of the Community Monetary Texts.

OANDA.COM site for forex daily data during 1996 and 2004

Ogawa, Eiji and Kentaro Kawasaki [2002], Possibility of Creating a Common Currency Basket for

East Asia (mimeo).

Park, Yung Chul [2002], Prospects for Financial Integration and Exchange Rate Policy Cooperation

in East Asia, ADB Institute Research Paper 48.

Tanaka, Soko/Jin Minghao [2004], East Asian forex cooperation by means of the currency basket

consisting of the US$, Euro and Yen, in: Journal of World Economy, November [in

Japanese language].

Tanaka, Soko [2002], External Aspects of the Euro – An East Asian Perspective - ,in: Paulo de

Pitta e Cuhna e Manuel Porto (Coord.), The Euro and The World, 2002.02, Almedina

(Portugal), pp.323-353.

Tanaka, Soko [1996], The European Monetary System, Yuhikaku, (in Japanese).

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Conclusions and Policy Recommendations:

I. Conclusions

1. Perspectives of Economic Integration in East Asia

Market-driven Trade Integration in East Asia

The ASEAN+3 economies have experienced a remarkable expansion in trade for these past

two decades. The growth in trade of the ASEAN+3 economies proceeded together with the

intensified intra-regional dependence in trade. Intra-regional trade in ASEAN10+3 increased its

importance in total trade over time. For most of the developing member economies in ASEAN,

intra-regional trade has grown faster than trade with any other markets. While Japan and China

accounted for the bulk of the intra-regional trade, the regional trade of most of the smaller

economies in ASEAN has also grown.

The intra-regional trade intensity indexes, which were invariably above one in East Asia,

indicate the strong ex-post trade relations among the region. The increase of intra-regional

procurement in manufacturing sectors directly reflected the intensified trade relations. This is

vertical, intra-firm, economic integration. ASEAN10, ASEAN5 and ASEAN5(10)+Korea recorded

higher index scores. This means that the members in such combinations trade among themselves

rather exclusively.

The accumulation of Foreign Direct Investment (FDI) inflows worked as the driving force

of the intensified intra-regional trade in the East Asia. Multinational firms, in particular Japanese

firms, have extended throughout Asia by means of FDI, and played an important role in developing

the intra-regional production and procurement networks and the vertical economic integration since

the early 1980s. This is a market-driven trade and investment integration.

The East Asian economies have experienced rapid expansion of FDI inflows since the

1980s. FDI inflow to the ASEAN5 increased by more than six times from 1985 to 2003. During

1990s, FDI inflow to China remarkably increased, by more than 15 times. In 2003, ASEAN10+3

became one of the largest recipients of FDI in the world, representing 15 percent of the world FDI

inflow. Japan is a major supplier of FDI in the region, representing 69 percent in the regional FDI

outflow. Singapore and Korea follow Japan as FDI suppliers. The increase in FDI inflow of ASEAN

countries apparently reflected their liberalization and adoption of measures facilitating capital

130

transactions. Moreover, their trade liberalization should have led to their higher returns on capital,

reflecting increased efficiency in the allocation of factors. The higher potential profitability must

have attracted FDI to them. The increased FDI in turn contributed to the intensified trade

relationship in the region.

Need for Institutionalization to Drive Trade and Investment Integration

In spite of their increasing trend, the shares of intra-regional trade in East Asia still remain

at a lower level, around 40 percent, than those of the EU or NAFTA. The shares of intra-regional

exports and imports in 2003 are 60 and 58 percent in the EU15, and 56 and 37 percent in NAFTA,

respectively. Frankel (1992) suggested that there was no evidence of a special Japan effect on her

concentrating trade with other Asian economies, nor that the East Asian countries were collectively

moving toward a trade bloc in the way that Western Europe and the Western Hemisphere appeared to

be. Our empirical study updates his gravity model, confirming that East Asia has lacked a driving

force to promote trade integration. There may be a scope for further expansion of intra-regional

trade.

At present, a significant proportion of world trade is conducted under the rules of regional

integration agreements, notably EU and NAFTA. There is intense concern in the developing

countries regarding trade and investment diversion in Europe and North America. During 1997-1999,

this concern has been exacerbated by the financial crisis. The crisis has forced policymakers to

rethink the financial, trade, and investment linkages that connect regional economies. At the same

time, it has given new impetus to ideas for regional institutions to help shape common responses.

The countries seriously felt the lack of and need for regional institutions dedicated to finance,

investment flows, macroeconomic and exchange rate coordination.28 The importance of regional

cooperation was reinforced by the challenge of China after her WTO accession.

ASEAN countries have already concluded that the ASEAN Free Trade Area (AFTA) will

start from 2002. Also, some governments of East Asian countries, which include Japan and Korea,

are studying the effects and feasibility of bilateral free trade agreements with other East Asian

countries. The ASEAN countries, Japan, Korea, and China suggested establishing an East Asia Free

Trade Area in the ASEAN+3 (China, Japan, and Korea). Bilateral and regional free trade agreements

are complementary to a multilateral trade arrangement represented by the WTO.

28 On the financial front, the Chiang Mai initiative has created a web of swap agreements between regional central banks to be deployed in case of future liquidity problems. The Asian Bond Fund concept has been endorsed by several countries.

131

Scope for gains from a regional Free Trade Agreement

Our analysis here mainly covers the effects of a Free Trade Agreement (FTA), focusing on

the efficiency improvement made possible by trade liberalization. Indeed, the stated motivation of

several initiatives, including the ASEAN-China Framework Agreement, is to take advantage of

complementarities and build on existing strengths in order to make the region collectively more

efficient and competitive and thereby attract investment. However, the regional agreements under

consideration in East Asia are increasingly comprehensive in scope, going beyond the removal of

tariffs and non-tariff barriers on trade in goods to include trade facilitation measures, such as

conformity of standards and procedures across national boundaries, and trade in services.

The efficiency gains from an FTA include a trade volume effect and a terms of trade effect.

These effects are related to the famous literature by Viner (1950) in which he divided the effects of

regional trade liberalization into two types: trade creation and trade diversion effects. The sum of the

two effects produces ambiguous results. In addition, an FTA will bring about other effects, such as a

scale effect, in models that allow for increasing returns to scale and imperfect competition. Moreover,

an FTA may increase long-term growth rates, as well as transient medium-term growth. Integration

will equalize factor prices in the long run. Moreover, developing economies in ASEAN and Japan

have much different endowments, But their wages will converge, such as in the case of the NAFTA.

However, economic geography, recently drawing the attention of economists, often assumes

imperfect competition and scale economies, which sometimes imply reverse outcomes. Scale

economies and economies of agglomeration mean that firms will not locate productive capacity in

every country or region. The decision of the firm depends on the balance between production costs

and trade costs. This balance changes as trade barriers are reduced, and it is possible that industry

will be drawn into high wage locations, widening the inter-regional wage differences. The location

effect is a remaining issue, yet to be studied.

According to our simulation, using a computable general equilibrium model of GTAP, any

plausible combinations of FTA will bring about some benefits to the FTA members. However, the

expansion of the membership will raise the amounts of the gains in total, as well as the gain of each

member.

The welfare gain to each country varies from one to another, and from 2 to 10 percent of

their GDP. The FTA of the combinations of ASEAN5 and one of the three members in northeast Asia

will provide benefit to the ASEAN members, but a trade diversion effect will bring about a welfare

loss to the excluded northeastern members. This represents the welfare loss that comes from the “not

132

– being – an – FTA – member” effect. This implies that the three northeastern members should

seriously consider an FTA with ASEAN. As for the impacts to the industrial sectors, the sectors

protected heavily will generally shrink, and more competitive sectors will expand. The efficiency

improvement here will be obtained from the painful process of industrial adjustment.

Benefits and Costs of Financial Market Integration


economic growth. Financial market integration increases benefits for portfolio risk diversification

and consumption smoothing across countries and over time through borrowing and lending. By

pooling the idiosyncratic risks from production, consumption and the terms of trade and so on, more

inputs will shift into those industries that have a higher return. Therefore, the general welfare of the

country will be improved.

However, existing international financial markets are incomplete, so an economic agent

cannot perfectly pool away the idiosyncratic risk. Nevertheless, the international financial markets at

least allow agents in different countries to reduce the risk from uncertain future disturbances, so as to

take opportunities for risk sharing and consumption smoothing. In addition to consumption

smoothing and risk sharing, the positive impact of capital flows on domestic investment and growth,

enhanced macroeconomic discipline, and increased efficiency and stability of the financial system

are the main benefits of financial integration.

On the other hand, it is increasingly recognized that a high degree of financial openness

may produce significant short-term cost. A debate has grown on the role of financial integration as a

triggering mechanism in emerging market crises for the last decade including Asian crisis. The costs

of financial integration include an inadequate domestic allocation of capital inflows, which may

hamper the country’s economic growth and exaggerate prevailing domestic distortions, the loss of

macroeconomic stability, pro-cyclical movements in short-term capital flows, a higher degree of

volatility of capital flows, and risks associated with foreign financial institutes’ penetration.

Degree of Financial Integration in East Asia

A debate on the degree and process of financial integration in East Asia provides

significant policy implications for the regional capital market development and regional financial

architecture. According to a study, East Asian countries have developed stronger ties with advanced

countries than with one another in the process of financial opening. This implies that East Asia

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suffers from a lack of financial integration.

There are in general three different approaches in the literature that may be used to test

international financial integration: a volume-based approach, an asset price-based approach, and a

risk-sharing approach. The volume-based approach examines the degree of financial integration by

using data on countries’ portfolios of external assets and liabilities. One of the reasonable measures

in judging the degree of financial integration in a country is the level of international asset

cross-holdings. Another strand of literature looks directly into the asset prices. Real business cycle

theory extends the role of financial markets to business cycles. It says that consumption

co-movements with integrating international financial markets should be higher than output

co-movements.

Volume-based Approach: If we look at the changes in foreign assets and liabilities in East

Asia, we can see that the degree of international financial integration in the region since the 1980s

has been increased. Taking this degree as a ratio (the sum of foreign assets and liabilities divided by

GDP in ASEAN+3) we find that it has increased significantly in the region except for the crisis

period. Comparing foreign assets and liabilities to GDP separately, we can find several stylized facts

about the patterns of capital flows in the region. First, East Asia showed limited cross-border capital

transactions in the 1970s and 1980s, mainly due to capital controls and regulation, as well as

rudimentary domestic financial markets. Second, during the 1970s and 1980s, bank loan and debt

financing had been dominant capital flows in the region. Third, since the early 1990s, FDI flows into

East Asia have increased. Lastly, portfolio transactions were almost negligible in most East Asian

economies in the 1980s, but in the following decade, portfolio investment inflow such as by

acquisition of bonds and stocks began to expand its proportion in the total capital inflow to East

Asian. Our empirical analysis in the volume-based approach finds that most important factors in

explaining the degree of financial integration, i.e., the sum of foreign assets and liabilities divided by

GDP in ASEAN+3, in East Asia are the degree of trade openness, higher income and financial

development and the size of stock market capitalization for East Asian countries.

Asset price-based Approach: A real interest parity test is based upon the idea that real

rates of interest on financial assets like bonds will tend to converge in integrating financial markets.

We examine the cross-country real interest rate differentials, and the results suggest that Asian

financial markets in the post-crisis period became more integrated with a global market whereas

evidence of regional level integration is ambiguous. The CAPM (Capital Asset Pricing Model)

hinges on the idea that asset prices in the same class of risk should equalize across countries in an

integrated market. We estimate our CAPM regression, finding that the East Asian markets are quite

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efficient, while the degree is stronger when the US Dollar is the reference currency. The CAPM

model suggested that East Asian financial markets are more efficient with the US Dollar, but

integration progresses with the Yen. The results that some countries show significant country effects

indicate that country premia exist and there is much room for further integration.

International Risk-sharing Approach: We try to assess the extent to which financial

markets are integrated by looking at the degree of risk sharing across East Asian countries. Risk

sharing can be an indicator of financial integration because a financially integrated region will have

more opportunities for larger risk sharing. The degree of risk sharing in East Asia is far from

complete and very low; only about 12 percent of cross-sectional GDP variance is smoothed.

Regional capital markets play a minimal role while regional credit markets play some positive role

in sharing risks across countries in East Asia. Risk sharing level achieved in East Asia is far lower

than the level achieved within a successful monetary union such as the U.S. It is also much lower

than the level achieved within industrial countries such as OECD and EC countries. Based on these

results, we can conclude that financial markets in East Asia are far from being completely integrated.

We find that the degree of financial integration in East Asia has recently increased, but

East Asia has shown more financial integration with global economies than with regional economies.

Our finding implies that the regional feature is weak and there is no strong pulling, or anchor, market

that would match the U.S. market. Though global integration is not a force that competes with

regional integration, there seems no strong sign that lessons from the crisis in 1997-1998 have been

transformed into creation of an effective market mechanism in East Asia. The lack of success in

policy coordination among East Asian countries seems a fact despite efforts made. However,

rightfully, the agenda of regional market integration and deepening is alive and its direction needs to

focus on creation of a market mechanism that will endogenously bring forward real interest rate

differentials to be removed at the regional level. Another important implication from this chapter is

the importance of trade openness that is closely related to the degree of financial integration. This

implies that considering economic cooperation in East Asia is a multi-facet process rather than

single-track process. Financial development and economic growth in the region are also important

factors that we should consider in the multilateral frameworks. Finally, we may conclude that the

current status of the direction and structure of capital movement in East Asia created a highly

vulnerable and unstable financial environment in East Asia, raising the likelihood of a future crisis

impeding the development of capital market in the region.

Regional Production Networks Synchronize Business Cycles in East Asia

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In East Asia, regional production networks have been built up in a form wherein firms

mutually supply their parts to each other in the region. East Asian economies tend to synchronize

their business cycles as they deepen their vertical economic integration. We will examine the

changes in synchronization of business cycle among East Asian countries by calculating the

correlation coefficients of GDP growth rates among them. The correlation coefficients have

increased from 1961 to 2003 for the combinations of Indonesia-Malaysia, Indonesia-Philippines,

Indonesia-Singapore, Indonesia-Thailand, Malaysia-Singapore, Malaysia-Thailand, and

Singapore-Thailand among the ASEAN5 countries. Especially, the correlation coefficients for

Indonesia-Malaysia, Indonesia-Thailand, Malaysia-Thailand, Malaysia-Singapore are higher than

0.8. Accordingly, Indonesia, Malaysia, Thailand, and Singapore have had synchronized business

cycles since 1990s.

The correlation coefficients have increased in 1991-2003 for China and each of the four

ASEAN countries (Indonesia, Malaysia, Thailand, and Singapore). Also, Korea has higher

correlation coefficients with each of the four ASEAN countries. Especially, the correlation

coefficients are higher than 0.8 for Korea-Indonesia, Korea-Malaysia, and Korea-Thailand. On one

hand, Japan has relatively higher correlation coefficients with the ASEAN5 countries although the

correlation coefficient for Japan-Thailand has decreased from 0.838 to 0.498 in 1991-2003. China

has lower correlation coefficients of business cycles with Japan and Korea although Japan and Korea

have relatively synchronized business cycles.

Benefits of Currency Basket System in East Asia

Stabilizing Trade Competitiveness Effect: A Basket Currency regime has several

benefits as one of the intermediate and optimal options for East Asia. The most apparent is its role in

keeping trade competitiveness relatively stable. If the export destination is only one country and

there is no competitor other than the destination country, it is enough to peg the currency to that of

the export destination country, to maintain trade competitiveness. However, actually, a country tends

to have many export destinations and there are many competitors all over the world. In addition, the

composition of export destination countries changes over time. Thus it is not easy to decide on the

weights of the basket. Taking into account this complexity, some papers suggest the ways to achieve

optimal weights for the currency basket. A study calculated the optimal weights that stabilize

variances of trade balance. In it, a theoretical model was built, in which the Asian firm maximizes its

profits, competing with the Japanese and the U.S. firms in their markets. A duopoly model was used

to determine export prices and volumes in response to fluctuations of the exchange rate vis-à-vis the

Japanese Yen and the US Dollar. This enabled derivation of optimal basket weights that would

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minimize the fluctuation of the growth rate of the trade balance. The paper stressed the fact that

Asian countries have adopted a de facto Dollar Peg regime, although their trade weights with Japan

were substantial which was one of the most significant factors that induced the recent financial crisis

in 1997 and 1998. As the Japanese Yen depreciated against the US Dollar from April 1995 to the

summer of 1997, the real effective exchange rates of Asian countries appreciated, which caused the

loss of their export competitiveness. Thus, exports from those countries declined. For example, the

gross export values of Thailand did not grow in 1996, whereas they grew 20 percent a year earlier.

The estimated weights from actual fluctuations of the exchange rates are quoted from Frankel and

Wei (1994). The optimal weights of the Yen are higher than the estimated weights. It suggests that, if

Asian currencies peg to a Currency Basket with the optimal weights, the real effective exchange

rates of Asian countries would be more stable and a large shock to trade balance can be avoided.

Capital Flow Effects: The Currency Basket System may stabilize capital flows.

According to empirical studies, the de facto Dollar Peg Regime promoted capital inflows to Asian

countries and implied that if Asian countries had adopted a Basket Currency regime (or a Floating

Exchange Rate regime), capital inflows might not have been so huge. The studies do not examine

whether huge capital inflows due to de facto Dollar Peg were good or bad for the economies of those

countries in the long run. Capital inflow itself, as well as financial integration, promotes growth and

may be good for an emerging country. But huge capital inflows also pose a risk to the countries in

the sense that a sudden reversal in the direction of capital flows is a possibility. In fact, the outflow

of short-term capital experienced by some of the countries in the region before the crisis was

damaging firms in Asian countries. Foreign Direct Investment (FDI) (long-term capital), as opposed

to bank liabilities (short-term capital), does not likely cause the short-term exchange rate risks. A

study analyzed capital inflows separately by types: portfolio investments, bank lending, and FDI.

The effect of the variance of the US Dollar on capital inflows was the strongest in bank liabilities,

and was not so large in portfolio investments and FDI. It implies that if Asian countries had adopted

a Basket Currency regime, bank liabilities would have decreased, while portfolio investments and

foreign direct investments would not have been affected so much. Thus, moderating capital inflows

is regarded as a benefit of a Basket Currency regime.

GDP Effects: A study proposed the optimal weights for the Currency Basket so as to

stabilize GDP with a general equilibrium macroeconomic model. The study examined which

currency regime, among the Basket Peg, Dollar Peg, and Floating Exchange Rate regimes, could

achieve the lowest in the loss functions corresponding to the different policy objectives. Those

policy objectives include stability of GDP, the current account, and the exchange rate against the

Dollar. They also calculated the optimal weights in a currency basket. They concluded that the

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optimal choice of an exchange rate regime for a small open economy depended on its policy

objective. The gains from adopting a Basket Peg regime are larger when the country uses the Yen in

trade with Japan, and the Dollar in trade with the U.S..

Coordination Failure in A Common Currency Basket System for East Asia

According to our empirical study, the monetary authorities adopted a de facto Dollar Peg

system. In particular, the monetary authority of Malaysia has adopted the Dollar Peg system since

September 1998. Moreover, the Singapore Dollar and Korean Won recently returned to almost the

same level of dollar peg as in the pre-crisis period.

The monetary authorities in the East Asian region may be forced to keep a Dollar Peg

system instead of adopting a Currency Basket System - even if they know that they would be better

off by adopting a Currency Basket System rather than a Dollar Peg system. The situation can be

described as a kind of coordination failure. Suppose that risk-averse monetary authorities choose

their exchange rate regime under uncertainty; then the monetary authorities are more likely to be

faced with coordination failure. Most of the monetary authorities are likely to take the strategy of

wait and see if all others are risk averse. They cannot help but choose to keep the Dollar Peg regime,

which is a Nash Equilibrium, although they should know that there is a cooperative solution that is

superior to a Nash Equilibrium.

Unfortunately, our study suggests that there are possibilities that Indonesia, Thailand, and

Malaysia will encounter coordination failure in choosing an optimal exchange rate system. Adding

China and Korea to the ASEAN5 countries, then an attempt at coordination will fail in choosing

exchange rate system in the cases of Singapore and the Philippines. Under the de facto Dollar Peg

system, the current appreciation pressure for floaters in East Asia has been mitigated by the

government authorities. This will increase the stockpiling of international reserves in East Asia since

most intervention by authorities in East Asia has been conducted by direct purchase of US dollars in

the foreign exchange markets rather than indirect monetary policies. This underscores the need for

chosing an optimal exchange rate system.

Feasibility of a common Currency Basket system

The feasibility of a common currency area can be tested by the criteria for an optimal

currency area. Symmetry of shocks was pointed out as a factor for an optimal currency area. It

would be possible to form an optimal currency area if it is unnecessary to make intraregional

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adjustments in a region subject to symmetric shocks only. Symmetry of supply shocks is often

emphasized because supply shocks have long-run effects on GDP while demand shocks have no

long-run effects on GDP when the natural unemployment hypothesis holds. According to the

structural VAR method used to investigate symmetry of supply and demand shocks among East

Asian countries, the following recorded higher correlation coefficients of aggregate supply shocks:

Hong Kong - Malaysia, Indonesia - Korea, Indonesia - Malaysia, Indonesia - Thailand, Korea -

Malaysia, Korea - Thailand, Malaysia - Singapore, and Malaysia - Thailand.

The G-PPP model assumes that there are common factors among some bilateral real

exchange rates, especially those between two strongly linked countries, because price levels in other

countries have effects on its domestic price level through prices of intermediate goods imported from

abroad. Thus, real exchange rates have a stable equilibrium in the long run. The G-PPP model

explains that a PPP holds if a linear combination of some bilateral real exchange rate series has

equilibrium in the long run even though each of the bilateral rate series is non-stationary. The

analytical results imply that the five ASEAN countries and Korea will be candidates for a common

currency area with a common Currency Basket as an anchor currency. The conclusion is that a

common Currency Basket is more appropriate as an anchor currency than the US Dollar in forming a

common currency area in the region.

2. Sequencing and Policy Prerequisites of Economic Integration

Stages and Patterns of Economic Integration: the European Union as the Reference

The well-known definition of five stages according to Balassa (1961) is: (1) a Free Trade

Agreement (FTA), (2) a Customs Union (CU), (3) a Common Market, (4) an Economic Union, and

(5) total Economic Integration. The economic integration in the European Union (EU) did not

necessarily follow Balassa’s scheme. There are several differences. The EU introduced a

super-national institution at the beginning of the stage of the integration, instead of the last stage in

the Balassa scheme. The EU started from the CU, instead of an FTA. Balassa’s last stage is based on

a vision of a unitary state, but the EU is far from such a centralist image. The EU did not unify fiscal,

social and counter cyclical macroeconomic policies, but unified only monetary policies. Nor did the

EU become a federal state. It is a mixture of a confederation and federation and is very hard to

imagine that the EU will be a federal state in the future.

However, on the sequencing of the stages of economic integration, it is reasonable to

believe that economic integration begins with elimination of customs barriers and quotas, which

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enables the share of intra-regional trade over the total trade of each country to increase. The trade

integration increases economic interdependence of member countries in the region, which will

attract their attention and stimulate their interess in common actions towards prevention of economic

shocks. In the case of the EU, the shares of intra-regional trade increased from about 35 percent to

about 50 percent during its customs union establishment period, or from 1958 to 1968. The monetary

integration in the EU was realized at the last stage in accordance with Balassa’s definition. However,

it should be remembered that the EU initiated monetary cooperation in 1970s when the EC faced

instability of the U.S. dollar.

How successfully to defend the regional trade networks and related production networks is

always a top priority for the member states participating the regional integration, once the

intra-regional trade share becomes critical number, such as a 50% in the example of the EU.

Therefore, it will be reasonable to predict that the regional integration partners in East Asia will be

obliged to promote a monetary cooperation in the near future. Regarding the ASEAN, it is still

unlikely to realize an independent monetary cooperation framework, since the share of intra-regional

trade is only about 20%. However, if we take up the ASEAN+3, then the share is up to as much as

50 percent, which is equal to the level of the EC at the beginning of 1970s. Since the ongoing FTA

establishment in East Asia will further increase the share of intraregional trade among the ASEAN+3,

this area will be more eligible to foreign exchange rate cooperation.

Institutional Arrangements to Foster Trade and Investment Integration in East Asia

In East Asia, liberalization of trade and investment policies is increasingly recognized as a

way to spur gains in efficiency and other economic benefits. The expansion of production and

procurement networks brought about intensified trade relations in East Asia. Policies can support

these natural economic forces, and the drive to liberalize trade is shaping new institutional

arrangements, namely Free Trade Agreements and other regional trade arrangements. Trade

integration, as the fundamental prerequisite of economic integration, should be further fostered under

the institutional arrangements in East Asia.

Regional trade arrangements will in turn stimulate intra-regional FDI, as evidenced by the

case of NAFTA. The anticipation of higher levels of FDI inflow is probably one of the main benefits

that prospective members expect from the upcoming FTAA. The experience with NAFTA appears to

validate these expectations: aggregate FDI flows to Mexico did rise significantly in the period

following NAFTA, and econometric analysis suggests that the trade agreement played an

instrumental role in the rise. This may be also the case in East Asia.

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Moreover, according to our analysis of financial market integration, trade openness is

found to be closely related to the degree of financial integration. This implies that considering

economic cooperation in East Asia is a multi-facet process rather than single-track process. Financial

development and economic growth in the region is also an important factor that we should consider

in the multilateral frameworks.

From Trade Integration to Monetary Integration

Movements toward future economic and monetary integration have been initiated in East

Asia recently. Monetary integration should follow real economic integration which would include

FTAs and regional trade agreements. On the real side, establishment of a region-wide FTA should

help in evolving to a region-wide customs union and a common market over time. On the financial

side, the East Asian countries should foster and develop their capital and financial markets in the

region, which have been shown as the Asian Bond Market Initiative and the Asian Bond Fund.

The regional FTA will contribute to the elimination of some trade obstacles that include

tariffs and non-tariff barriers. However, economic agents will regard the exchange rate risks as an

important trade obstacle after they conclude free trade agreements within the region. Even though

we use forward contracts to avoid exchange rate risks, we have to pay some costs to avoid the risks.

Economic agents in private sectors would face increasing need to eliminate exchange rate risks and

restrain foreign exchange transaction costs, changes which will enhance their willingness to

introduce a single common currency in the region in the future.

The movements toward bilateral and regional FTAs might gain momentum to form a

common currency area in East Asia if East Asian countries undertake international cooperation to

stabilize bilateral exchange rates among the countries in an international monetary field. For

example, if the FTAs include a clause that government and private sectors in East Asia should make

efforts to use their own currencies in their trade and financial transactions, the clause might gain

momentum to depart from the situation of using exclusively the US Dollar as a settlement currency

in their transactions. Moreover, East Asian countries have another opportunity for international

monetary cooperation in that they can try to create a foreign exchange market for East Asian

currencies.

Thus, governments of East Asian countries should try to have bilateral and regional FTAs

with many other countries in East Asia including the international monetary cooperation that

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contributes to gain in momentum to form a common currency area in East Asia. The FTAs are

expected to contribute to movements toward an Asian currency union through strengthening trade

and financial relationships among East Asian countries as well as through direct international

monetary cooperation.

Prerequisite for a Currency Union

In the literature on the optimum currency area, the incidence of idiosyncratic shocks across

countries is considered as a critical determinant of the design of optimum currency areas. When

asymmetric idiosyncratic shocks occur across the member countries of a currency union, monetary

policy cannot be tailored to an individual country’s particular disturbances. This gap between shocks

and policy is one of the critical factors that may hurt the integrity of the currency union, and may

make the union collapse in an extreme case. This is why we need a macroeconomic synchronization

to successfully implement the currency union. However, if countries can share country specific

output shocks and a smooth consumption profile through various arrangements in financial markets,

which is known as “consumption risk sharing”, it is more likely that we can successfully launch the

currency union. Therefore, a high degree of consumption risk sharing can be a good substitute for

synchronized business cycles as a pre-condition for a successful currency union. And consumption

risk sharing is further promoted as financial markets become more integrated across countries.

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II. Policy Recommendations

Take Immediate Actions to Form Regional Free Trade Agreements

Trade integration takes an important part in broad regional coordination agenda. Although

FTA negotiations have not advanced as far as those governing financial cooperation in East Asia,

trade integration is the foundation for regional economic cooperation. An FTA will bring about the

potential for large gains. Therefore, taking immediate action to form an FTA has a strategic

importance.

Any plausible combinations of FTAs will bring about some benefits to the FTA members.

However, the expansion of the membership will raise the amounts of the gains in total, as well as the

gain of each member. As a policy agenda item, therefore, expansion of the membership will be the

basic strategy. The goal for the region should be an ASEAN+10+3 FTA, and any subset should be

considered a transition.

Moreover, it would be worthwhile for the leaders to disclose the plans and agenda on trade

liberalization to the private sector. This will facilitate the business sector’s planning and help them to

utilize the merits from larger production networks and division of labor.

Need for Well-designed FTAs

An important policy requirement will be to minimize adjustment costs in transition to

expand the FTA memberships. ASEAN5+3 may be a semi-final goal for East Asia29, and any one

FTA will be a transit. If an industry in a country obtains a benefit and expands because of one FTA,

but if the industry is finally destined to decline under the ASEAN5+3 FTA, the industry should not

react to the one-time benefit. Some adjustment policy should take care of such situation. But if some

sectors shall finally decline in the long run, the policy-makers should provide well designed grace

periods and aids for adjustment.

In such an expansion process, the policy-makers should avoid so-called spaghetti bowl

effects. Any FTA will call for implementation of strict rules of origins that will increase

administrative costs. If a zero-tariff structure of a combination of FTA is totally different from that of

other combinations, expansion of an FTA will actually raise trade costs and prevent the production

29 Final goal shall be an ASEAN10+3 FTA and the global liberalization under the World Trade Organization.

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network and division of labor from working fully. To avoid such a situation, the policy-makers

should carefully design any FTA proposal to be compatible with larger FTAs in the future. A

reporting system and peer review on the FTAs of other parties may be established to address this

issue. For reference in this regard, the Pan-European System of Cumulation and Origin in the EU

functions well.

An FTA involves industrial adjustment to the member countries. Some sectors may gain

benefits while others may be seriously damaged. Moreover, as shown in the model simulation in this

Chapter, some countries gain larger benefits than others. The diversity of ASEAN10+3 countries

may aggravate the imbalance. If an ASEAN10+3 FTA is a serious political agenda item, the

members should consider establishing a coordination system to reallocate and redistribute the

benefits and achieve economic stability. The EU introduced common policies designed to address

such purpose.

Future FTAs Should Include Broader Scope of Cooperation

The future FTAs in East Asia had better include economic cooperation and promotion of

FDI. From the lessons in the EU, economic cooperation will surely be able to play a critical role in

East Asia, because cooperation can proceed without any formal treaty or agreement. In the EU,

economic cooperation supplemented the integration. A remarkable example is the European

Monetary System (EMS). The stability of the EMS, achieved in the late 1990s, became an essential

base from which the EU was able to move forward to monetary integration. As such, economic

cooperation has been an instrument with which the EU governments can handle the diversity of the

participating countries. Cooperation can be made by a group of countries which want to promote de

facto economic integration. The experience of the EMS tells us that skilful cooperation is much

better than bad integration.

In East Asia, the JSEPA is a good practice, although it does not provide for significant

bilateral tariff elimination. Economic cooperation may cover monetary cooperation, environmental

policy cooperation, common development of natural resources development, and common

infrastructure improvement. Some of them are implemented in the EU.

Currency Cooperation and Coordination in East Asia

In promoting progress toward to a common currency area in East Asia, it is the most

realistic to begin with efforts aimed at international currency cooperation to stabilize bilateral

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exchange rates among East Asian countries that share very strong economic relationships with each

other. Coordination among some of the monetary authorities of the East Asian countries is necessary

for shifting from a situation of the Nash equilibrium to a cooperative solution. The monetary

authorities should implement international coordination for exchange rate arrangements or exchange

rate policies.

The monetary authorities of East Asian countries should discuss the exchange rate issue as

part of the surveillance process because exchange rates of the home currency against its neighbor

countries’ currencies significantly affect price competitiveness among them. Each of the East Asian

countries has strong economic relationships with other countries in the region. Exchange rates

among the intra-regional currencies affect the economic activities of the East Asian countries

through intra-regional trade, investment, and finance. The monetary authorities should conduct a

surveillance process by focusing on deviations of their own currency from most of the other regional

currencies as well as their exchange policy itself.

Conduct Policy Dialogues and Macroeconomic Surveillance

Given that the monetary authorities agree to the coordination arrangements of an

international monetary system or exchange rate regime, its implementation is the next problem. It is

necessary that the monetary authorities should have some common understanding about what effects

their home currencies have on neighbor countries’ currencies and what effects their own exchange

rate policy have on neighbor countries’ exchange rate policy, in order to implement regional

coordination of an exchange rate policy. Moreover, they need to have a common understanding

about what policy objective they should have for their exchange rate policy.

It is expected that the monetary authorities can build up a common understanding by

conducting policy dialogue and macroeconomic surveillances among policy makers of the regional

countries. Macroeconomic surveillances may not be so effective if they are conducted by policy

makers as representatives of each of the regional countries, who have a direct interest in their own

countries. Thus they cannot easily implement international coordination of the exchange rate policy.

It may be desirable that a neutral intraregional institution, which is independent of governments of

regional countries, should prepare for the macroeconomic surveillance in order to help the

governments deepen their common understanding.

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Make Regional Arrangement to Refer to a Common Currency Basket or Asian Currency Unit

However, policy dialogue and macroeconomic surveillance will not be so robust in

maintaining international policy coordination in the long run because the governments do not have

any commitments to regional coordination. It is necessary to have a mechanism that will be robust in

maintaining regional coordination in the long run by obliging the governments to have a

commitment to regional coordination. One way to implement regional coordination is by making all

the monetary authorities in the region agree on an arrangement to create a common currency unit

that consists of a currency basket. They might make a commitment to follow the common currency

value in conducting their exchange rate policy. It is desirable to create a regional common unit of

account (Asian Currency Unit; ACU) consisting of regional currencies that monetary authorities of

East Asian countries could refer to when they try to coordinate their exchange rate policy.

If the Asia Currency Unit (ACU) were created as an instrument of the regional monetary

arrangement in East Asia, the monetary authorities could use the ACU as a common unit of account

for the regional policy coordination in order to conduct surveillance over movements of exchange

rates among the intra-regional currencies. The ACU could be used to measure the degree of each

currency’s exchange rate deviation from the regional average. East Asian countries could announce

an official exchange rate of their home currency against the ACU and could use the ACU as a

baseline when applying their exchange rate policy while there is no policy coordination. The

monetary authorities in East Asia countries would be able to have policy dialogue and policy

coordination concerning both the exchange rates among their currencies and their exchange rate

policies.

The monetary authorities should give consideration to the exchange rate between their

home currency and the ACU as they apply policies to stabilize the exchange rates among the

intra-regional currencies. The regional monetary arrangements would help prevent competitive

devaluation among the related currencies as well as to solve the problem of coordination failure in

adopting their exchange rate policies among them. The regional monetary arrangements based on the

ACU under which the monetary authorities in the region would make a commitment to a coordinated

exchange rate policy would prevent a possible competitive devaluation as well as the inertia that

causes coordination failure in adopting exchange rate policies.

The ACU could be used not only by the monetary authorities but also by the private sector.

It could use the ACU to denominate economic transactions (trade and capital flows) and asset stocks

(foreign exchange reserves and cross-border bonds) as the ECU had been used as a denomination

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currency in the EU under the EMS. We may use the ACU as a denomination currency for the Asian

Bond that has been studied under the Asian Bond Market Initiative. The ACU as a common

denomination currency would contribute to the deepening and increasing of the liquidity in the Asian

Bond Market.

Toward Future Monetary Integration

In a process toward future monetary integration in the region, the monetary authorities

may use the Asian Currency Unit (ACU) as a convergence criterion, using the European case as a

reference. In addition, the monetary authorities could use their home currencies’ deviation from the

ACU to measure convergence and consider their exchange rate policy. In addition, the regional

currency arrangement of targeting their intra-regional currencies to the ACU will help avoid a

coordination failure in choosing their exchange rate policies and, in turn, prevent a competitive

devaluation in the region because the monetary authorities would have a commitment to the

arrangement.


currencies to the ACU before they achieve a regional monetary integration. This implies that there is

a choice for the monetary authorities to realign the exchange rates of the home currency vis-à-vis the

ACU or to stop linking their home currencies to the ACU. The existence of this choice might induce

speculators to make speculative attacks against weaker currencies. Such a possibility makes it

recommendable for the monetary authorities to make a strong commitment to link their home

currency to the ACU.

The strongest commitment is to proceed to a monetary integration. In such a commitment,

the monetary authorities of the participating countries would have no option to leave it. Such a

commitment would contribute to the stability of exchange rate system because private economic

agents would build up their confidence in the coordinated exchange rate policy in East Asia. Increase

in confidence would decrease the possibility of exchange rate collapse, which would, in turn,

decrease the domestic interest rates of the home currency because of reduction of expected

depreciation and risk premium. Thus, the monetary integration would contribute to a decrease in

domestic interest rates.

147

(Appendix) Hypothetical Weight of the nine currencies in the basket of ACU

- PPP standard -

(%)

Currency / Year 1990 1995 2000

Japanese Yen 35.09 32.44 29.00

Chinese Yuan 40.65 41.10 45.36

Korean Won 5.86 6.01 6.86

Taiwanese Dollar 3.90 3.67 3.75

Hong Kong Dollar 2.97 4.08 3.75

Singapore Dollar 1.97 2.73 2.46

Thailand Baht 5.02 5.24 3.81

Philippine Pesos 2.62 2.31 2.68

Malaysian Ringgit 1.91 2.42 2.33

Total 100.0 100.0 100.0

148

List of Authors Koichi Suzuki (Project Co-Leader)

Executive Vice President, Daiwa Institute of Research

Visiting Professor, Graduate School of Business, Nihon University

Kazutomo Abe (Project Co-Leader)

Professor, Tokyo Denki University

Research Advisor, National Institute for Research Advancement

Hiroo Fukui Visiting Professor, Graduate School of Business, Nihon University

Former Vice President World Bank and Executive Director for Japan,

International Monetary Fund

Eiji Ogawa Professor, Graduate School of Commerce and Management, Hitotsubashi

University

Soko Tanaka Professor, Chuo University

Doo Yong Yang Director, Korean Institute for International Economic Policy

Takehiko Kondo President, Hamamatsu Gakuin University

Shohei Kuwayama Director, Daiwa Institute of Research

Misa Okabe Researcher, National Institute for Research Advancement

Kimiko Sugimoto Associate Professor, Osaka Gakuin University

Ke Li Associate Professor, Graduate School of Business, Nihon University

Toru Washio Researcher, Daiwa Institute of Research

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