This paper examines the future evolution of the Asian currency arrangements from broader perspectives, including the optimal currency area theory and the experience with the European Currency Unit (ECU).

Most academic literature on this topic concurs that the optimal currency area conditions seem to be met by subsets of Asian countries although the ultimate success of an Asian currency union hinges crucially on such factors as the historical and political backgrounds, robustness of institutional set-ups, degree of regional convergence in developmental stages, and track record of sound macroeconomic policy in constituent countries.

It is also a valid concern whether the transition toward a currency union could be susceptible to speculative currency assault.

The experience with the ECU suggests that a successful Asian currency unit requires preconditions including the firm political commitment, market-wide expectations of the eventual currency unification, and existence of well-functioning financial markets as well as cross-border payment/settlement systems.

We can learn further from the fact that the ECU was handicapped by a lack of cash currency, which led to its limited use in commercial transactions, and inadequacies of settlement arrangements.

The ECU as a divergence indicator was also rarely focused on, despite the fact that the exchange intervention thresholds were defined in relation to the ECU.

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Shingo Watanabe, Masanobu Ogura
Bank of Japan
2-1-1 Nihonbashi Hongoku-cho, Chuo-ku, Tokyo 103-8660

Bank of Japan Working Paper Series
No.06-E-20
November 2006

Introduction:

Discussions on the desirable Asian currency arrangements are gaining momentum. The Asian currency crises in 1997-98 made affected countries in this region realize that they need to re-examine their currency systems to prevent the recurrence of capital account drains. As is widely known, the Asian currency crises were exacerbated by the dollar-peg exchange regimes that were inherently vulnerable. Based on this reflection, experts have argued for the adoption by Asian countries of the managed floating underpinned by the currency basket consisting primarily of the yen, the US dollar and the euro.

The idea of a currency basket has even galvanized a renewed interest in the creation of a currency union as an ultimate goal. This movement is inspired by the deepening of horizontal/vertical division of production processes among Asian economies, but the successful launch of the euro has also provided fresh impetus.

Recently a special attention is paid to creating Asian currency unit as a future common currency. At the beginning of 2006, officials of the Asian Development Bank (ADB) referred to their plan to publish an Asian currency unit (called ACU hereafter).3,4 The ASEAN+3 Finance Ministers endorsed in May 2006 an affiliated research group mandated with “Toward Greater Financial Stability in the Asian Region: Exploring Steps to Create Regional Monetary Units”.

On the academic front, we also have a wealth of research output exploring the feasibility of Asian currency union from various aspects. In this paper, for example, we will review 14 empirical studies based on the optimal currency area theory in addition to a lot of other studies based on other viewpoints.

The objective of this paper is to summarize proposed future evolution of Asian currency arrangements and examine it theoretically and empirically from a broad perspective. We believe that this kind of study will be indispensable for enhancing current discussions.

Methodologically this paper is structured as follows. We first survey past studies intensively, rather than add new evidences, on issues already discussed, intending to gain robust conclusions. Second, we revisit the experience with the European Currency Unit (ECU) as a “natural experiment” for analyzing the practicality of an ACU. This helps us to identify missing but important points in the current ACU-related discussion.

What follows are the main conclusions of this paper:

1) Most of the proposed ideas on Asian currency arrangements are more or less the variant of the following three-stage process supported by an ACU as a facilitator:
i) the adoption by individual country of a managed floating based on the currency basket consisting of the yen, the US dollar and the euro;
ii) the harmonization of the weights attached to the basket currencies (i.e., a common currency basket); and,
iii) the establishment of a currency union based on an ACU (ACU as a common currency).

2) According to the optimal currency area theory, the benefits brought by a currency union (i.e., stable exchange rate and a reduction in trade costs) are larger if member economies are more externally open and intra-regional trade larger. In contrast, if factor movements and fiscal policy flexibility are constrained, or if the macroeconomic shocks tend to be asymmetric among member countries, a currency union would be welfare-reducing as the adjustments through exchange rate channels and country-specific monetary policies are no longer possible. Most empirical studies based on the optimal currency area theory are positive that the conditions for a currency union are met by subsets of Asian countries. They point out that some Asian countries exhibit almost the same level of external openness, intra-regional trade and symmetricity in macroeconomic shocks as their European counterparts did in the pre-euro period.

3) However, there are other factors that affect the successful establishment of an Asian currency union, such as the historical and political backgrounds, institutional set-ups, regional convergence in developmental stages, and track record of sound macroeconomic policy.

4) Furthermore, it should be noted that the managed floating system is not immune to the risk of currency attacks, as was vividly shown during the introduction of the euro. This risk cannot be ignored in Asia where economic integration has begun relatively recently and both political commitment and institutional frameworks needed for regional integration have yet to be entrenched.

5) The experience with the European Currency Unit (ECU) suggests that a successful currency unit requires such preconditions as the firm political commitment, market-wide expectations of the eventual currency unification, and existence of well-functioning financial markets as well as cross-border payment/settlement systems. We can learn further from the fact that the ECU was handicapped by a lack of cash currency, which led to its limited use in commercial transactions, and inadequacies of settlement arrangements. The ECU as a divergence indicator was also rarely focused on, despite the fact that the exchange intervention thresholds were defined in relation to the ECU.

This paper is structured as follows. The next section reviews proposals for future exchange rate arrangements in Asia, including the expected roles of an ACU. Section 3 provides an overview of the previous research that explores the feasibility of a currency union in Asia from the standpoint of optimal currency area theory. Section 4 outlines issues for discussion regarding the feasibility of a currency union in Asia, taking account of political and institutional dimensions. Section 5 discusses possible risks associated with the transition process toward a currency union. Section 6 revisits the experience of the ECU and Section 7 concludes.

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