TCS Daily

Towards a More Perfect Asian Union?

By Christopher Lingle - June 15, 2005 12:00 AM

Following the experiences in the euro-zone region of Europe, a common currency area for Asia has been widely discussed. Among the presumed benefits of regional coordination of exchange-rate policies is the reduction of currency volatility that could encourage greater investment.

It turns out that an Asian monetary union is a fantasy that ignores both economic and political realities. Yet this has not stopped respectable economists from opining on the matter.


For example, Professor Robert Mundell, a Nobel laureate in economics, has made statements in support of the creation of an Asian monetary union.


Citing exchange rate volatility between the Japanese yen and the US dollar as being a problem for Asian economies, he suggested introducing a common currency area patterned on the euro-zone.


And a private study group of the International Bureau of the Japanese Finance Ministry promoted the idea of a unified currency for Asia and greater use of the yen in transactions in the region. The final report of the Study Group for the Promotion of the Internationalization of the Yen indicated that a unified currency would increase financial and economic cooperation among ASEAN countries, Japan, China and South Korea.


These proposals have not gone unheeded. ASEAN countries, along with Japan, China, and South Korea set up a system of swap agreements in May 2000 to reduce volatility in exchange rate fluctuations and to protect their currencies from speculative attacks.


In fact, there are more reasons that Asian countries should hesitate before making radical moves towards increased cooperation of their monetary authorities. In the first instance, coordinated monetary policy leads to a reduction in sovereignty. When an economy has free trade but fixed exchange rates, the domestic price level will fluctuate in order to absorb changes in international trade and financial flows. As in the case of Hong Kong, it also brought a long cycle of deflation.


A more important case is that Asia does not constitute what economists refer to an optimum currency area whereby a single currency would generate net economic benefits. Supporters of an Asian currency union make a heroic assumption that East Asia might constitute such an area.  However, this assertion reflects a political judgment that had little to do with the inter-connectedness of Asian economies.


While there is more convergence in economic and political conditions in Europe, it is not clear that it is so well-suited to be a common currency area. One key element in the theoretic models is the high mobility of labor. Language and cultural differences along with distrust of outsiders renders much of Europes labor relatively immobile.


Needless to say, such differences in Asia are much wider than they are in Europe. Never mind migration barriers and diverse political regimes in Asia, there are widely uneven economic development patterns both within and between countries.  While many rural areas depend upon agricultural output while urbanized regions depend upon manufacturing and energy production, the more advanced urban areas and city-states depend more heavily upon services.


Consequently, external shocks will have asymmetrical impacts on different economic sectors of each country. And these shocks will impact upon the different geographical regions across countries and within each country.  A single currency would eliminate the shock absorbing capacity offered by national currencies.  Without the safety valve effect of a fluctuating local currency, unequal development between and within countries will become amplified and rigidified.


One of the strongest arguments behind having a single currency is that it would reduce both the costs of exchanging currencies by tourists, businesses, and governments.  Added to the saving from avoiding these transactions costs, there would be a reduction in the risk associated with holding foreign currencies of other EU members.


However, the reduction of money-changing costs did not require unifying the European currencies. Technology helped reduce the costs to tourists of having national currencies that are supposed to be eliminated by EMU. Something as simple as credit cards allowed people to minimize the costs of using multiple currencies.


Costs to tourists of transacting many different foreign currencies are trivial in value and volume to those that might confront companies with multinational dealings.  And so it is that the development of new currency instruments allowed hedging strategies that are relatively low cost for businesses.  Innovations in the financial derivatives markets allow enterprises to avoid or minimize most of the risks of fluctuations in foreign currencies.


There is a case where a common currency can emerge spontaneously to benefit trading partners. As it is, the US dollar is already a commonly accepted currency used primarily for international trade. Local settlements could be carried out in the US currency that would circulate alongside national currencies.


Following Gresham's Law, the less reliable currency would drive the good one out of circulation as a medium for transactions. The sounder money will become the basis of savings. If a local currency begins to weaken, savings can be converted into the dollar while the local currency would be used in daily transactions.


The good news is that implementing such a proposal does not require armies of researchers and international bureaucrats to hold conferences in Five-Star resorts. Of course, the bad news is that the people who benefit from such largesse would rather not give up the perks and importance.


Given the interventionist inclinations of politicians and international agencies, the construction of a single Asian currency is likely to be a complicated and evolutionary process. The first steps would involve closer coordination of monetary policies and some fixing of exchange rates.


Indeed, this is what happened in Europe with the so-called exchange rate mechanism (ERM) that created massive short-run instability. In the early 1990s, the Fed became concerned about holding down inflation and raised interest rates. As rate in the US rose, it caused pressures to de-link European currencies. Eventually, the ERM broke down as massive currency realignments took place.


Attempts to rig foreign exchange markets have reinforced macroeconomic instability within much of Asia. Instead of spending time and money concocting pipe dreams that enrich researchers, it would be far better to initiate policies that promote investment by allowing private entrepreneurs keep more of the fruits of their efforts.


Only politicians and social engineers can believe that economic developments follow political constructions. In the real world, economic forces set limits and provide the momentum for the success of political arrangements.


When these forces clash, politics will ultimately be the loser. Unfortunately, the adjustment period involves real economic pain due to dislocations, misallocations, and inefficiencies arising from political decisions that conflict with economic forces. 


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