A Dollar or Yen Currency Union in East Asia. Lee K. Lim. School of Accounting, Finance and Economics Edith Cowan University

Transcription

1 A Dollar or Yen Currency Union in Eas Asia By Lee K. Lim School of Accouning, Finance and Economics Edih Cowan Universiy School of Accouning, Finance and Economics & FIMARC Working Paper Series Edih Cowan Universiy November 2004 Working Paper 0405 Correspondence auhor: Lee K. Lim School of Accouning, Finance and Economics Faculy of Business and Public Managemen Edih Cowan Universiy 100 Joondalup Drive Joondalup WA 6027 Ausralia Phone: 61+ (8) Fax: 61+ (8)

2 Absrac There are pros and cons for differen counries o join a union and adop a common currency. The European economic and moneary union is viewed o generae fewer coss and deliver greaer benefis o is members. Several sudies evaluae wheher naural currency areas emerge based on hisorical paern of inernaional rade and of co-movemens of prices and oupus, and found a well-defined dollar and euro areas bu no clear yen area. This paper invesigaes he prospec of a dollar or yen currency union in he Eas Asia region. Differen ime series ess of income convergence are used o deermine wheher increased rade and financial inegraion has led o currency convergence. The counries included in his sudy are he highperforming Eas Asian economies, namely Japan, Hong Kong, Souh Korea, and he five founding ASEAN member counries. Key words: Coinegraion; Currency convergence; Exchange raes; Price comovemens Acknowledgemens: The auhor wishes o acknowledge he financial suppor of he Faculy Small Gran, Faculy of Business and Public Managemen a he Edih Cowan Universiy.

3 1. Inroducion The lieraure on opimum currency area sared in he early 1960s wih he seminal conribuions by Mundell [9] and McKinnon [8]. There are pros and cons for differen counries o join a union and adop a common currency of is member counries. The benefis (in erms of increased macroeconomic sabiliy and posiive exernal effecs) and coss (in erms of he loss of conrol of moneary policies) o he union members largely depend on he similariies in heir economic srucures. The economic heory of convergence implies ha relaively similar economies would make beer candidaes for moneary inegraion. If economies diverge in heir developmen levels and macroeconomic condiions, he coss of moneary inegraion and susaining inegraion would be high. This is evidenced from he enry crieria lised in he Maasrich Treay (see [7]). Precondiions for nominal convergence involve numerical arges on he convergence of ineres raes, inflaion, exchange raes, and governmen debs and deficis. The purpose of such convergence requiremens is o reduce he pre-inegraion levels of divergence among paricipaing counries, so as o alleviae he coss of losing he exchange rae insrumen in macroeconomic sabilizaion afer inegraion. Rapid economic growh in several Eas Asian economies 1 prior o he Asian currency crisis in 1997 brough increased rade and financial inegraion o counries in he Eas Asian region, and srenghened is posiion in he world economy. Several Eas Asian counries have gradually swiched from fixed exchange rae arrangemens o allow heir currency values o be deermined in foreign exchange markes afer he fall of he Breon Woods sysem in he 1970s. Counries end o experience relaively higher volailiy in exchange raes under he floaing exchange rae sysem due o desabilising speculaion and money marke disurbances. In he Eas Asian region, he floaing of he Thai bah in 1997 led o he financial meldown in Thailand, and sared a wave of conagion effecs, spreading quickly o is neighbouring counries in he region. This quesions he suiabiliy of floaing exchange raes for hese counries in a financially inegraed world, where funds can be moved insanly beween naional financial markes. An ineresing proposiion is wheher hese economies can be inegraed o form a moneary union. A regional currency agreemen would provide sable inra-regional exchange raes and mainain flexibiliy of he exchange raes agains ha of non-members. Experience in he European economic and moneary union also suppors ha a currency union generaes fewer coss and delivers greaer benefis o is members.

4 2 One of he imporan requiremens for moneary inegraion is convergence in real exchange raes among is member counries. The purchasing power pariy heory based on he law of one price does no perform well in explaining acual exchange raes movemens. Empirical evidence suggess a posiive relaionship beween counries price levels and heir real incomes per capia, when measured in erms of a single currency (see [7]). Possible explanaions for difference in overall price levels beween rich and poor counries are rade barriers and differences in endowmens of capial and labour and produciviy. There is a large lieraure on esing he income convergence hypohesis, arising from he diversiy in average growh raes and income levels across counries, and found several convergence clubs, in which real per capia incomes have converged for seleced groupings of counries and regions. Empirically, similar ime series ess of convergence can be applied o deermine if here are muli-counry currency unions in Eas Asia. This paper focuses on Japan, Hong Kong, Souh Korea and he five founding members of ASEAN, namely Indonesia, Malaysia, he Philippines, Singapore and Thailand (hereafer referred o as ASEAN-5). Convergence of real exchange raes is esed using ime series daa o deermine he suiabiliy of a moneary inegraion in Eas Asia. Sudy by Alesina e al. [2] evaluae wheher naural currency areas emerge across he world based on hisorical paern of inernaional rade and of co-movemens of prices and oupus (from 1960 o 1997), and found a well-defined dollar and euro areas bu no clear yen area. They sugges ha he coss of adoping anoher counry s currency as an anchor will be lower if he counries have high co-movemens of oupus and prices wih poenial anchors. In Alesina and Barro s [1] sudy, counries ha rade more wih each oher are found o benefi more from adoping he same currency under reasonable assumpions abou elasiciies of subsiuion beween goods. Alesina e al. sugges ha increased rade may also be measured from an increase in he co-movemens of oupus and prices. Using he mehod proposed by Alesina e al., his paper also examines he exen of he price co-movemens beween each Eas Asian counry wih he Unied Saes and Japan. The plan of he paper is as follows. Secion 2 oulines he ime series mehods used o deermine he prospec of a dollar or yen currency union in he Eas Asian region. Secion 3 examines he ime series daa and seleced economic indicaors for he eigh counries. Secion 4 presens he es resuls and some concluding remarks are given in Secion 5.

5 3 2. Mehodology In his paper, hree differen ime series mehods are used o es if here are mulicounry currency unions in he Eas Asian region. The firs mehod examines he comovemen of prices, he second mehod applies a simple saisical es for currency rends, while he hird mehod applies uni roo ess and coinegraion analysis o he real exchange rae series. 2.1 Co-movemens of Prices Alesina e al. [2] proposed a measure of co-movemen of prices beween counries i and j using he following second-order auoregression: P ln P i, j, = a 0 P + a1 ln P i, 1 j, 1 + a 2 P ln P i, 2 j, 2 + ε ij,, (1) where P i, measures how many unis of U.S. dollar can be exchanged wih one uni of counry i s currency a ime. By definiion, his exchange rae is always one when counry i is he Unied Saes. The esimaed residual from equaion (1) is used o compue he following roo mean square error: VP ij = 1 T = εˆ 1 T 3 2 ij,. (2) A higher value of VP ij means less co-movemen of prices beween counries i and j. 2.2 Tes for Converging Trend In a ime series framework, a simple saisical es for converging or diverging rends of an exchange rae series, as proposed by Verspagen [11], can be wrien as follows: W = y y, (3) * i, i, where y i, is he logarihm of he real exchange rae for counry i a ime and y * is he * logarihm of average real exchange rae for n counries in he sample ( y = ( y ) n n i = 1 i, assumed ha, for each ime period, W i changes according o he following process: ). I is

6 4 W i, 1 = ΨWi, + ηi, +. (4) If Ψ > 1, he currency in counry i diverges from he sample group; if Ψ < 1, convergence of he currency occurs. This paper also examines if he currency of individual counry in he sample diverges from he Japanese yen. 2.3 Coinegraion Mehod A sochasic definiion of income convergence requires per capia income dispariies across counries o follow a saionary process. This definiion is applied o es for convergence in currencies across counries. Bernard and Durlauf [3] have proposed a ime series es for convergence and common rends. The noion of convergence in mulivariae exchange raes can be defined such ha he long-erm forecass of real exchange raes for all counries, i = 1,, n, are equal a a fixed ime : lim E( y, + k yi, k I ) = 0, 1 + k > i 1, (5) where I is he informaion se a ime. Applying he conceps of uni roos and coinegraion, he convergence es deermines wheher y 1,+k y i,+k in equaion (5) is a zero mean saionary process in a coinegraion framework. Convergence in exchange raes for wo counries, p and q, implies ha he exchange raes are coinegraed, wih coinegraing vecor [1, -1]. Empirically, esing for convergence and common rends in a coinegraion framework requires he individual exchange rae series o be inegraed of order one. The following augmened Dickey-Fuller [4] (ADF) es is used o deermine he order of inegraion for real exchange raes of he nine Eas Asian counries: p y i, = a0i + a1 i + βi yi, 1 + δ j ji y 1 i, j + εi, =, (6) where y i, approximaes he growh rae of real exchange rae, is he deerminisic rend, p is he order of he auoregressive process, and y i,-j is included o accommodae (possible) serial correlaion in he errors. The rank of he coinegraing marix in a mulivariae framework can be esimaed using he following VAR represenaion [5]: Y = Γ( L) Y + ΠY + µ + ε, (7) k

7 5 where Y is a 8 x 1 vecor of he logarihms of real exchange raes for he nine Eas Asian counries, Π represens he long-run relaionships of he coinegraing vecors, Γ(L) is a polynomial of order k 1 o capure he shor-run dynamics of he sysem, and ε are independen Gaussian errors wih zero mean and covariance marix Ω. The reduced rank (0 rank(π) = r < n) of he long-run impac marix is formulaed as follows: Π = αβ, (8) where β is he 8 x r marix of coinegraing vecors and α is he 8 x r marix of adjusmen coefficiens. Applying he Johansen maximum likelihood esimaion mehod, convergence in mulivariae currencies, as defined in equaion (5), would require r = n 1 (or seven) coinegraing vecors for eigh Eas Asian counries of he form [1, -1] (i.e. one common longrun rend for he individual exchange rae series in Y ). The Johansen procedure permis hypohesis esing of he coinegraing relaions and heir adjusmen coefficiens, using he likelihood raio es which follows a chi-squared disribuion. This mehod is necessary o deermine wheher he r coinegraing vecors are of he form [1, -1], which requires a uni resricion imposed on all he coefficiens of he r coinegraing vecors. 3. Daa Tesing for exchange rae convergence among he eigh Eas Asian counries in a ime series framework requires comparaive daa for hese counries over an exended period. As mos counries radiionally pegged heir currencies agains he U.S. dollar, each counry s currency is expressed in U.S. dollars. Monhly nominal exchange raes of US$ per naional currency for each Eas Asian counry are exraced from he Daasream (and he source is from he Inernaional Financial Saisics) over he period 1990(1) o 2001(12). Real exchange raes of US$ per naional currency are derived by muliplying he nominal exchange raes wih he relaive consumer price index 2 of he naional currency o he US$. Due o vas differences in he values of each Eas Asian currency, he real exchange raes used are US$ per 100 yen, 1 HK$, 100 won, 1,000 rupiah, 1 ringgi, 10 peso, 1 S$ and 10 bah, for Japan, Hong Kong, Souh Korea, Indonesia, Malaysia, he Philippines, Singapore and Thailand, respecively.

8 6 Figure 1 depics he logarihm of real exchange raes for he eigh Eas Asian counries over he period 1990(1)-2001(12). I is eviden from Figure 1 ha he exchange raes for all counries are fairly sable, apar from he Asian financial crisis which caused a subsanial weakening in several currencies. Of he eigh Asian economies, Indonesia, Malaysia, he Philippines, Souh Korea and Thailand were badly affeced by he currency crisis which, o a lesser exen, also affeced counries like Japan and Singapore. Among he eigh currencies, he Indonesian rupiah suffered he larges drop in value, paricularly for 1997(12)-1998(10), as a resul of poliical insabiliy. The Malaysian governmen also chose o fix is exchange rae a ringgi 3.80 per US$ in Ocober Indonesia also has he highes value of real exchange rae volailiy (calculaed as he sandard deviaion of log of real exchange rae over he sample period) which is more han doubled he level of he oher sample counries. Apar from he convergence of exchange raes, he feasibiliy of a common currency area for he eigh Eas Asian economies also requires convergence in developmen levels and macroeconomic condiions. Table 1 provides recen economic indicaors for inflaion raes (average period, % per annum), curren accoun balance (% of GDP), money (M2) growh rae (end of period, % per annum), and ineres raes (3-monh ime deposi, end of period, % per annum) for hese counries. Comparing he figures for 1997 and 2001, here has been Log of US$ per naional currency Philippine Jan-90 Jul-90 Jan-91 Hong Kong Singapore Japan Jul-91 Jan-92 Jul-92 Jan-93 Jul-93 Jan-94 Jul-94 Thailand Jan-95 Jul-95 Jan-96 Monh Indonesia Souh Korea Jul-96 Jan-97 Jul-97 Jan-98 Jul-98 Jan-99 Jul-99 Jan-00 Malaysia Jul-00 Jan-01 Jul-01 Figure 1: Logarihm of Real Exchange Raes for Eas Asian Counries, 1990(1)-2001(12)

9 7 subsanial convergence in inflaion raes, ineres raes and money growh among he eigh economies afer he financial crisis, wih he excepion of Indonesia and he Philippines. In erms of curren accoun balance, boh Singapore and Souh Korea have a much higher percenage han he oher counries implying ha heir economies are relaively more sensiive o exchange rae movemens. Table 1: Seleced Eas Asian Economic Indicaors for 1997 and Inflaion Curren A/c Money (M2) Ineres Raes Counry Rae (average Balance Growh (End (3-monh ime period, %) (% of GDP) of period, %) a deposi, % p.a.) b Japan Hong Kong c Souh Korea Indonesia Malaysia Philippines Singapore Thailand d 2.3 Sources: ASEAN [3] and Daasream. Noes: a For Malaysia and Singapore, he figures are growh raes of M3. b Ineres raes for boh Japan and Hong Kong are 3-monh inerbank raes and overnigh call rae for Souh Korea. c For he year d The figure represens an average of 10.0% and 11.5%. 4. Empirical Resuls The paper applies ime series ess o monhly real exchange raes in naural logarihms (LER) for eigh Eas Asian counries for 1990(1)-2001(12). All esimaion and es resuls are derived using he Microfi 4.0 economeric sofware program [10]. Table 2 presens he esimaed VP ij, which measures he price co-movemens beween each Eas Asian counry wih he Unied Saes and Japan. 3 The lower he value of VP ij, he higher he co-movemen of prices beween counry i and he anchor counry. Apar from Indonesia, all counries have high co-movemens of prices wih boh he Unied Saes and Japan. These resuls indicae

10 8 ha boh he U.S. dollar and he Japanese yen can be a suiable common currency for he six Eas Asian counries. Table 2: Co-movemen of Prices wih U.S. and Japan, 1990(3)-2001(12). U.S. Japan Hong Kong Souh Korea Indonesia Malaysia Philippines Singapore Thailand Using he simple saisical es of Verspagen [11] for converging or diverging rends of he LER series (see equaions (3) and (4)), esimaion resuls for eigh Eas Asian counries are repored in Table 3. Among he ASEAN-5 counries, Singapore is he only diverging counry, whereas he remaining four counries converge owards he mean LER level. Japan Table 3: Tes Resuls for Converging Trends, 1990(2)-2001(12). Group Average Japanese Yen Japan * (0.0028) Hong Kong (0.0020) (0.0013) Souh Korea * * (0.0020) (0.0017) Indonesia (0.0231) (0.0074) Malaysia * (0.0176) (0.0032) Philippines (0.0131) (0.0037) Singapore * (0.0020) (0.0063) Thailand * (0.0175) (0.0035) Noes: * indicaes ha he LER of he counry diverge from he sample group or he Japanese exchange rae. Sandard errors are given in parenheses.

11 9 and Souh Korea are anoher wo counries ha diverge from he average LER. On he oher hand, he counries ha diverge from he Japanese exchange raes are Souh Korea, Malaysia and Thailand. As each esimaed Ψ is fairly close o he value of one, which implies a sable currency movemen beween each currency and he Japanese yen over he sudy period. Before esing for convergence based on he mehod of Bernard and Durlauf [4], i is essenial o deermine he order of inegraion for each of he exchange rae series. ADF ess are used o es for he presence of uni roos in he logarihms of real exchange raes for he eigh Eas Asian counries. For monhly daa, an iniial lag lengh of welve is used for he ADF es. If he -saisic for he larges lag is insignifican, he lag lengh is reduced successively unil a significan lag lengh is obained. Alhough deailed resuls are no repored o save space, he ADF -saisics do no rejec he null hypohesis of a uni roo for he eigh LER series, implying ha each is non-saionary. Upon aking firs differences of he series, which indicae saionariy of he ransformed series, he es resuls indicae ha all eigh LER series are inegraed of order one. Thus, he Johansen maximum likelihood mehod can be used o es for he presence of coinegraing vecors or common rends. Based on he definiion in Bernard and Durlauf [4], he eigh LER series are esed for convergence beween each Eas Asian counry. The Akaike Informaion Crierion is used o deermine he order of he VAR model, wih he es saisics and choice crieria indicaing a VAR model of order four. If he LER for wo counries are coinegraed, he resricion [1, -1] is imposed on he coinegraing vecor. Using unresriced inerceps and no rends in he VAR, Table 4 repors he race and maximal eigenvalue saisics of he sochasic marix o deermine he number of coinegraing vecors (r) ha are significan a he 5% and 10% levels. Boh he race and maximal eigenvalue saisics rejec he exisence of a long-run coinegraing relaionship beween Japan and each of he seven Eas Asian counries, wih he possible excepion of Hong Kong. On he oher hand, Hong Kong is found o have a long-run coinegraing relaionship wih all he counries. In he case of Singapore, boh es saisics indicae ha a long-run coinegraing relaionship exiss wih Souh Korea, Indonesia, Malaysia and Thailand. In addiion, he es saisics also rejec he null hypohesis of no coinegraiong relaionship beween Indonesia and Souh Korea, and Indonesia and Thailand. Overall, here are 13 coinegraing vecors for each pair of Eas Asian counries from he possible 28 coinegraing vecors. Of he 13 coinegraing vecors, he likelihood raio es

12 10 rejecs he null hypohesis of a uni resricion for hree coinegraing vecors (namely, for Singapore and he Philippines, Indonesia and Souh Korea, and Indonesia and Thailand) a he 5% significance level. Table 4: Maximal Eigenvalue and Trace Saisics for he VAR(4) Model, 1990(5)-2001(12). Maximal Eigenvalue Trace Counry H 0 : r = 0, H 0 : r = 0, H a : r = 1 H a : r 1 Hong Kong Japan * Souh Korea ** ** Indonesia ** ** Malaysia ** ** Philippines ** ** Singapore ** ** Thailand ** ** Singapore Souh Korea ** ** Malaysia * Philippines ** ** Thailand ** ** Indonesia Souh Korea ** ** Thailand ** ** Noe: * denoes significance a he 10% level. ** denoes significance a he 5% level. For he eigh Eas Asian counries, ess for he presence of a common long-run rend for individual LER series in he group are also underaken. The maximal eigenvalue and race saisics sugges he presence of a leas four coinegraing vecors a he 5% level of significance, which indicae non-convergence of he currencies for all eigh counries. However, boh es saisics sugges he presence of a leas four coinergraing vecors for

13 11 five Eas Asian counries, namely Hong Kong, Souh Korea, he Philippines, Singapore and Thailand, which suppor convergence of he currencies for hese counries. 5. Conclusion This paper examined he prospec of a dollar or yen currency unions in he Eas Asian region. Three ime series mehods were used o es for convergence of currencies for eigh fas-growing Eas Asian counries. The es resuls from co-movemens of prices suppor a common dollar and yen areas for all counries, excep for Indonesia. There was also evidence of currency convergence for five Eas Asian counries, namely Hong Kong, Indonesia, Malaysia, he Philippines and Thailand, o he group average using he saisical es for converging rend. In addiion, he currency of each counry seems o move a a raher consan rae from he Japanese yen over he sample period. Using he coinegraion mehod, convergence in currencies for all Eas Asian counries was no suppored, excep for convergence in en pairs of Eas Asian currencies. Apar from Hong Kong, none of he Eas Asian currencies had a long-run coinegraing relaionship wih he Japanese yen. However, he coinegraion ess found a common long-run rend for five individual exchange rae series, namely Hong Kong, Souh Korea, he Philippines, Singapore and Thailand, which suppor a currency union for hese counries. I is imporan o emphasise ha he ime series mehods used are limied o esing he ime series properies of currency differences, wihou considering he facors ha deermine exchange rae movemens. Thus, furher research would be valuable on exising ime series mehods for esing he suiabiliy of muli-counry currency union and a consideraion of oher relevan variables, such as financial markes, financial flows and convergence in he levels of ineres raes, inflaion raes and oupus ha are imporan for currency adopion.

14 12 Noes 1. World Bank [12] repored ha from 1965 o 1990 he eigh high-performing Eas Asian economies, namely Japan, Hong Kong, Souh Korea, Taiwan, Singapore, Malaysia, Thailand and Indonesia, had grown more han wice as fas as he res of Eas Asia, roughly hree imes as fas as Lain America and Souh Africa, and weny-five imes faser han Sub-Saharan Africa. 2. The consumer price indices for each Eas Asian counries counry and he USA have been convered o a common base year. 3. The values of VP ij compued from higher order auoregressions are similar o he resuls repored in Table 2.

15 13 References [1] A. Alesina and R. Barro, Currency Unions, Quarerly Journal of Economics 117(2) (2002) [2] A. Alesina, R.J. Barro, and S. Tenreyro, Opimal Currency Areas, Harvard Insiue of Economic Research Discussion Paper No. 1958, June [3] ASEAN, Annual Associaion of Souheas Asian Naions Saisical Indicaors, Rerieved on 26 February 2003, from hp:// [4] A.B. Bernard and S.N. Durlauf, Convergence in Inernaional Oupu, Journal of Applied Economerics 10 (1995) [5] D.A. Dickey and W.A. Fuller, Likelihood Raio Tess for Auoregressive Time Series wih a Uni Roo, Economerica 49 (1981) [6] S. Johansen, Esimaion and Hypohesis Tesing of Coinegraion Vecors in Gaussian Vecor Auoregressive Models, Economerica 59 (1991) [7] P.R. Krugman and M. Obsfeld, Inernaional Economics: Theory and Policy (Fifh Ediion, Addison-Wesley, New York, 2000), 750pp. [8] R.I. McKinnon, Opimum Currency Areas, American Economic Review 52 (1963) [9] R. Mundell, A Theory of Opimum Currency Area, American Economic Review 51 (1961) [10] M.H. Pesaran and B. Pesaran, Working wih Microfi 4.0: Ineracive Economeric Analysis (Oxford Universiy Press, Oxford, 1997), 505pp. [11] B. Verspagen, Technology and Growh: The Complex Dynamics of Convergence and Divergence, in G. Silverberg and L. Soee (eds.), The Economics of Growh and Technical Change: Technologies, Naions, Agens (Edward Elgar, England, 1994), pp [12] World Bank, The Eas Asian Miracle: Economic Growh and Public Policy (Oxford Universiy Press, New York, 1993), 389pp.