Yen Bloc: Toward Economic Integration in Asia

Chapter 8: A Regional Perspective

The theory of optimum currency areas considers which countries should come together to form a monetary union.When applied to the possibility of monetary integration in Asia centering upon Japan, it provides a regional perspective of a yen bloc.1 The major cost associated with monetary integration arises from the abandonment of an independent monetary policy. Countries with similar economic structures can respond to a common shock with a common monetary policy, and the costs of giving up an independent monetary policy are relatively small.At the same time, the larger the differential in inflation rates among members, the more difficult it is to maintain fixed exchange rates, and countries with similar inflation rates are therefore more likely candidates for a monetary union. Both the economic structure and the level of inflation in the Asian countries are closely related to the level of economic development. A yen bloc centering on Japan should therefore start with the participation of the Asian NIEs, to be followed by Malaysia and Thailand as they reach a higher level of economic development. Countries still at an early stage of economic development, such as China, Indonesia, and the Philippines, fail to meet the conditions for forming an optimum currency area with Japan. 151 8 A Regional Perspective 1. This chapter is based on Kwan (1998b).      The Theory of Optimum Currency Areas The traditional approach to the theory of optimum currency areas tries to single out a crucial economic characteristic that supposedly indicates where the lines between different blocs should be drawn.2 Studies so far have focused on the costs involved in abandoning an independent monetary policy . Here, I also touch upon the benefits in terms of enhancing the usefulness of money. The decision to participate in a monetary union can be broken down conceptually into a two-step process. The first step involves choosing between fixed and flexible exchange rates (that is, whether to join any monetary union at all); the second step consists of determining the members of the union. Accordingly, the criteria for optimum currency areas can be divided into two groups, one involving characteristics of individual countries and the other involving economic relations among the countries concerned.3 To Peg or Not to Peg A monetary union is composed of countries that adopt (genuinely) fixed exchange rates among themselves, while allowing flexible rates with the rest of the world.4 An optimum currency area refers to the combination of countries that enjoy net gains by forming a monetary union.5 2. For a survey of the literature on the theory of optimum currency areas, see De Grauwe (1992). 3. Drawing an analogy between monetary integration and marriage, the former corresponds to the factors determining whether one should marry or not, while the latter corresponds to factors determining whom one should marry. 4.As pointed out by Corden (1972), the distinction between a pseudo exchange rate union and a complete monetary union should be made when considering the costs and benefits of monetary integration. A pseudo exchange rate union is based on fixed but adjustable exchange rates among participating countries, while a complete monetary union has a single currency issued by a single central bank. Both the costs of giving up an independent monetary policy and the benefits of enhancing the usefulness of the money are much smaller for the former than for the latter. In a pseudo exchange rate union, international trade and investment are still subject to the risk of exchange rate changes, and the transaction costs of changing from one currency to another remain. For the sake of simplicity, I concentrate on the complete monetary union. 5. According to this definition, it is likely that a country belongs to several different optimum currency areas at the same time. Conceptually, given the optimality conditions, there should exist a single optimal way (number of monetary unions and their composition by country) of classifying all nations of the world into mutually exclusive optimum currency areas. Unfortunately, studies so far have failed to identify conditions for determining optimum currency areas in this strict sense. Also, for the sake of simplicity, the term coun-     The major benefits of monetary integration (or participation in a monetary union) are enhancement of the usefulness of money, the “import” of stable monetary policy from abroad, reduction in currency speculation, and saving on foreign reserve holdings. Among them, the enhancement of the usefulness of money seems to be...