Is Economic Development Promoting Monetary Integration in East Asia ?

This paper tries to investigate whether there exist international integrated markets among East Asian economies, by employing the Generalized Purchasing Power Parity (G-PPP) model, then, it would help to suggest whether the East Asian region is the Optimum Currency Area (OCA) or not. The empirical results in this paper suggest that holding the G-PPP among nine Asian countries (China, Indonesia, Japan, Korea, Malaysia, the Philippines, Singapore, Thailand and Vietnam) becomes more applicable in 2000–2013 than of that in 1984–1997. In the period of “globalization,” which is characterized by expansion of world trade, increase of international capital flows, and development of information and communications technologies, Asian economic development has been promoting not only economic integrations but also constructing the stable linkages of real exchange rates. Therefore, it would help to adopt regional coordination for monetary policies to assure the feasibility of a possible monetary union.


Introduction
It is well known that each of the East Asian countries considered here experienced rapid economic growth across two separate periods of development.The first period of rapid growth was called "The East Asian miracle."There were eight high-performing Asian economies (HPAEs): three ASEAN countries, four newly-industrializing countries (NIEs), and Japan, whose economy grew faster than almost all other economies from the mid-1960's until the early 1990's.Most of their economic achievements, in particular a rapid increase in GDP per capita, were based on maintaining macroeconomic stability with sound financial markets, providing government-backed supports for key industries, and maintaining sound fiscal and public policies.Although each country promoted to develop "internationalized" industries by expanding exports of manufacturing, the "localized" monetary environment played important roles in supporting the rapid growth of local infant industries.
The second period of growth has been experienced in the twenty-first century.It can be described as a century of "globalization," which is characterized by the expansion of world trade, the increase of international capital flows, and the development of information-communication technologies.These new growth factors led to spillover effects on developing countries in East Asia.Hence, this recent economic growth promoted an economic integration across the East Asian countries.Therefore, the question arises as to whether economic growth also promotes the monetary integration by moving away from monetary "localization" to monetary "regionalization".
This paper investigates this issue by employing the Generalized Purchasing Power Parity (G-PPP) model, which considers that countries that satisfy the criterion for an Optimum Currency Area (OCA) should share a common stochastic trend in their real exchange rates, which can be defined as the function of the national income process.Our empirical results suggest the existence of integrated markets among the region's economies.It allows us to consider whether the region represents an OCA.By adopting the non-linear co-integration method into Enders and Hurn's (1994) [1] original and well-known G-PPP model, our empirical analysis suggests that a consideration of G-PPP among nine Asian countries is more relevant in 2000-2013 than in the previous period of 1984-1997.This means that Asian economic development has been promoting not only economic integration but also monetary integration, where the stability of real exchange rates among regional currencies also enhances the efficiency of market transactions.Therefore, further economic integration potentially contributes to the coordination of regional monetary/financial policies, thus assuring the feasibility of a monetary union.
The rest of this paper is organized as follows.Section 2 provides the brief reviews of earlier studies on the necessity of monetary cooperation and on the OCA in East Asia.Section 3 gives the details of the G-PPP model.Section 4 provides explanations of the empirical strategy and its results.Section 5 is saved for the concluding remarks.

Monetary Cooperation in East Asia
The economic growth in East Asian area stood out as far back as 50 years ago.Since the 1960s, East Asia had been in a period of high growth; this led to Korea, Taiwan, Hong Kong, and Singapore being billed "The Four Tigers".In the 1980s, the Southeast Asian area-including Malaysia, Indonesia, and Thailand-achieved a high growth rate.The excellent performance of the East Asian economy was considered "The East Asian Miracle" by the World Bank.The myth of economic growth there, however, was broken by the unexpected incident that has since come to be known as the Asian currency crisis.
In the aftermath of the 1997 Asian currency crises, some policymakers and academics proposed surveillance over the intra-regional exchange rates of East Asian currencies, to prevent future crises.In accordance with these proposals, the Chiang Mai Initiative (CMI) was established as a safety net for a liquidity crisis by the members of the Association of Southeast Asian Nations (ASEAN), Japan, China, and Korea (ASEAN+3) in 2000.Concurrently, the finance deputy ministers of the ASEAN+3 countries executed the Economic Review and Policy Dialogue (ERPD) to oversee the macroeconomic performance of each member country.
The objective of entering into a currency swap arrangement is to manage crises; therefore, the CMI exerts its effect only in cases of an actual currency crisis.On the other hand, the ERPD is simply a surveillance system that focuses on the performance of each country's macroeconomic variables (e.g., GDP and inflation rate), as well as the soundness of its financial sector.Therefore, it is necessary to incorporate intra-regional exchange rates into the surveillance process in order to enhance foreign exchange surveillance of the ASEAN+3 countries, which may result in lowering the probability of a future crisis.The monetary authorities are expected to establish a surveillance system to monitor fluctuations and misalignments of each ASEAN+3 currency.The exchange rates to monitor include intra-regional exchange rates, as well as the one vis-à-vis the US dollar.
In line with the need to establish a system for monitoring fluctuations in intra-regional exchange rates, Williamson (2000) [2], Ogawa and Ito (2002) [3], Kuroda and Kawai (2003) [4], and Ogawa (2004) [5] have suggested the introduction in the East Asian area of a common basket system.Given that a common currency basket system could inhibit foreign exchange volatility and contribute to stabilizing trade balance within the East Asian area, the monetary authority of East Asian countries are expected to adopt a common currency basket system.Furthermore, some positive results have been achieved in terms of CMI multi-lateralization (CMIM) and the ASEAN+3 Macroeconomic Research Office (AMRO), after the commencement of regional monetary cooperation in East Asia.
Within the context mentioned above, Kawasaki (2012) [6] employed the G-PPP model to conclude that a common currency basket would be a desirable step toward creating a common currency area in East Asia.With respect to the economic integration in East Asia, this paper investigates whether East Asian countries have been more or less integrated in the first decade of the twenty-first century than the period before Asian currency crisis.Furthermore, recognizing the importance of intra-regional foreign exchange stabilization, this paper also extends Kawasaki (2012) [6] to identify which ASEAN member countries are suitable to form a common currency area with Japan, China, and Korea.

The Generalized Purchasing Power Parity Model
The G-PPP model was developed by Enders and Hurn's (1994) [1], which extends from a simple Purchasing Power Parity (PPP) model.Enders and Hurn's (1994) [1] argue that changes in a bilateral exchange rate depend not only on changes in the relative prices between the related two countries but also on those in relative prices among other countries, such as trade partners.As Mundell (1961) [7] pointed out, countries that have close economic relationships with each other can share factor mobility in their national income processes.The real exchange rates can be defined as a function of countries' income process; hence, the real exchange rates among countries which share factor mobility will be also highly correlated.Therefore, Enders and Hurn's (1994) [1] considered that countries that share factor mobility should exhibit a common stochastic trend in their real exchange rates, which can satisfy the criterion for the OCA.Kawasaki (2012) [6] shows the theoretical background of G-PPP model by extending the two-country and two-commodity model proposed in Obsteld and Rogoff (1996) [8].As domestic labor mobility equalizes the productivity growth in tradables with that of non-tradables, international factor mobility between two countries would equalize the productivity growth in both two countries.Therefore, the nominal exchange rate between two countries would be equal to the relative PPP.The real exchange rates are constants over time; hence, the nominal exchange rate can be fixed between two countries.In consequence, the condition for the PPP to hold between the two countries is regarded as a sufficient condition for the OCA 1 .
Here, following the theoretical background of the G-PPP model proposed by Kawasaki (2012) [6], we assume that m countries (1, 2,…, j,…, m) are expected to compose a common currency area.Country j has a trade relationship with n countries, and a strong trade relationship with m − 1 countries that are expected to compose the common currency area.The real effective exchange rate of country j can be expressed as follows: where rej,i is real exchange rate between country i and country j in logarithm.Then, ζj is the trade weight of the group countries that are expected to compose a common currency area, and βj,i is the trade weight of country j with country ∑ β , , = 1, ∑ β , = 1 .
For simplicity, we focus on the group of countries that is expected to adopt a common currency and the country m + 1 that is not expected to share a common currency with the other countries.Then the real effective exchange rate of country j can be rewritten as follows: , j j j j j m j m j m j m ree re re re re where ωj,i is the trade weight of country j with country ∑ , , = 1 .

2
The real exchange rate between country j and country k can also be expressed as follows: , = − , + , . , Therefore, the real effective exchange rate of other countries country one, country two, …, and country m + 1 can be expressed as follows: The real effective exchange rate of m + 1 countries can be expressed in a vector as follows: where Ω is a matrix, which defines the trade weights, and is the real exchange rate of country j vis-à-vis its trading partners (m countries).
As Enders and Hurn (1994) [1] discussed, within a common currency area the fundamental macroeconomic variables share common trends, and a G-PPP based on real macroeconomic variables suggests that certain groupings of real exchange rates share the same stochastic trends.Therefore, the real effective exchange rates within a currency area will share a common stochastic trend because the fundamental variables are sufficiently interrelated.Using the common trends representation developed in Stock and Watson (1988) [13], the real effective exchange rates can be expressed by the sum of a stationary component and a non-stationary component.That is: where represents a stationary component and represents a non-stationary component.Since the stationary component , which represents the logarithm of the real effective exchange rate, can be expected to converge toward zero over the long run, the real effective exchange rate then can be described as the non-stationary component only 3 .As described in Stock and Watson (1988) [13], in terms of the common trends representation, m + 1 non-stationary variables can be described as m + 1 stochastic trends.We can rewrite the real effective exchange rates as follows: where is a + 1 × + 1 matrix, and is a (m + 1) vector of which the vector is characterized by a random walk with non-stationary stochastic trends.
Based on Equations ( 5) and ( 7), we can obtain: Here, we define a nonzero matrix which is given by + 1 × + 1 components, and then by substituting it into Equation (8), we can rewrite Equation (8) as follows: If • • is expected to be equal to zero over the long run, then • should not be a full rank because that was defined as a random walk with non-stationary stochastic trends is a nonzero vector.The rank condition of • will be expected as follows: As long as the rank condition to be held, there exists a nonzero matrix with which we can obtain the following equation: 0 Ψ⋅Φ = (10) Under the circumstance given by • • = , we can rewrite Equation (9) as follows: where is defined as = • .
If we can find a matrix for which the rank condition satisfies rank < m, then we can obtain • = that there exists at least one linear combination of the real exchange rate co-integrating over the long run.

Empirical Methodology
As mentioned above, the G-PPP model assumes that there are common factors among the bilateral real exchange rates of these countries exhibiting strong economic relationships.Therefore, if we can detect an equilibrium relationship among the real exchange rates over the long run, these countries (with real exchange rates that share common trends), might be defined as representing a common currency area.
Ogawa and Kawasaki (2003) [14] employed the methodology of the Johansen test as elaborated by Johansen and Juselius (1990) [15] to identify whether there exist co-integration relationships among the real exchange rates of East Asian currencies over the long run.As is well known, the Johansen approach is designed to identify a co-integration relationship under the assumption of linear composition.In other words, the short-term instability converges to the long-term equilibrium level linearly.Therefore, when we identify whether combinations satisfy the condition of stationarity over the long run, some of them will be rejected due to the assumption of linear convergence.Here, we employ the momentum threshold autoregressive (M-TAR) model developed by Enders and Granger (1998) [16] to investigate the property of real exchange rates.
It is well known that many macroeconomic variables display an asymmetric adjustment process.The TAR model suggested by Enders and Granger (1998) [16] allows for asymmetric adjustment processes and can capture the key aspects of any "sharp" or "deep" movements in a series.The TAR model with high order processes can be expressed as below:

(
) ( ) ( ) , where ρ1 and ρ2 indicate adjustment process respectively, Itρ1 is regarded as the appreciation correcting coefficient, 1 −  is regarded as the depreciation correcting coefficient, and the nonzero value τ is a threshold.
From Equation ( 12) we could detect whether there exists a long-term equilibrium relationship among the real exchange rate as far as the threshold value τ is given.It is also clear that autoregressive decay depends on the level value of .As another alternative adjustment specification, Enders and Granger (1998) [16] indicated that it is useful to allow the autoregressive decay depending on the previous period's change in instead of on the level value.Therefore, the M-TAR model can also be given as follows: ( ) The M-TAR model suggests that there exists little autoregressive decay for positive ∆ , but a significant decay for negative ∆ as far as the prior condition |ρ | < |ρ |, and vice versa.Based on the theoretical model of G-PPP, we can express the co-integration relationship of • = with the m + 1 real exchange rates as follows: , , where , , is the anchor exchange rate, , , for which i is given by = 1, 2, 3, ⋯ , is the individual 1 components of real exchange rate, β for which i is given by = 1, 2, 3, ⋯ , is estimated parameters, and vt is the disturbance term which is considered serially correlated.
As the two-step methodology entails using the Ordinary least-squares (OLS) to estimate a long-term equilibrium relationship, we also focus on the disturbance term to conduct a co-integration test.However, the error correction model to identify the adjustment process is not symmetric, but asymmetric 4 .

Data
The real exchange rate used in our empirical analysis is based on the nominal exchange rate and the consumer price index (CPI) from the International Financial Statistics of the IMF 5 .The sample periods are from January 1984 to June 1997 and from January 2000 to June 2013.The possible candidates for a common currency area include six ASEAN countries (Singapore, Indonesia, Thailand, Malaysia, the Philippines, and Vietnam) and Japan, China, and Korea (ASEAN6+3).However, Vietnam is excluded from the first sample period (January 1984 to June 1997) and the inclusion of China begins in January 1987 due to data constraints.Since the United States and the euro area are important trading partners of ASEAN6+3, we employ the real exchange rate of the euro vis-à-vis the US dollar as an anchor exchange rate in our empirical analysis 6 .The nominal exchange rates of the US dollar and the euro are also based on the International Financial Statistics of the IMF.The CPI of the euro area from January 1984 to June 1997 is calculated based the member of European Currency Unit (ECU), and that of the second sample period (January 2000 to June 2013) is from DataStream.

Analytical Results
For estimating the co-integration relationship over the long run, the estimation results of OLS coefficients for asymmetric co-integration and M-TAR unit root test were summarized in Tables 1-4 7 .Tables 1 and 3 which show the results of the OLS estimation only include the combinations which all independent variables indicate significant at 5% significance level.In Tables 2 and 4, which show the results of the M-TAR unit root test, the color filled columns suggests that two coefficients of adjustment process in the error correction model indicate significant at 2.5% significance level.
In the sample period from January 2000 to June 2013, there exist 502 possible candidates that contain nine, eight, seven, six, five, four, three, or two countries in the common currency area, and that selected from nine Asian currencies.Seventy-eight combinations were found that all coefficients for independent variables are statistically significant (Table 1).Out of the 78 combinations, 27 combinations were found that both coefficients for the M-TAR unit root test indicate statistically significant at 2.5% significance level (Table 2).
On the other hand, in the sample period from January 1984 to June 1997, of the 247 combinations of 8 currencies, 38 combinations were found that all OLS coefficient estimators indicate statistically significant (Table 3).For six of 38 combinations, adjustment coefficients the M-TAR unit root test are statistically significant (Table 4).The empirical results of this paper are summarized in Table 5.         16 combinations contain co-integration relationship among the currencies of the original ASEAN5+3 countries in the period from January 2000 to June 2013 8 .Second, in the case that the common currency union contains more than four countries, the possible currency union should include the Japanese yen as a key currency when the samples from January 1984 to June 1997 were applied.On the other hand, the ASEAN6 countries could form a common currency union with Japan, China, and/or Korea, in the sample period from January 2000 to June 2013.Therefore, not only Japan but also "the plus three" countries might affect significant impacts on the possible common currency union.
Third, our empirical results suggest the combination of Singapore, Indonesia, Philippines, and Vietnam (94117), and the combination of Singapore, Indonesia, Thailand, and Vietnam (94113) could form a currency union without "the plus three" countries.This might reflect the recent economic integration which is deepening with the intra-industrial trade or the horizontal trade; the regional integration might not be only dominated by the large economies such as Japan or China or by the developed economies such as Japan or Korea.This might suggest that the possible currency union might be deepening not as "vertical integration" but as "horizontal integration".

Discussion
The results can be explained by the recent developments of economic integration in ASEAN6+3.Since the beginning of 2000, on the basis of high economic growth in the East Asian area, intra-regional trade and investment has become more vigorous than ever before, and real economic integration within the area is in progress.Foreign direct investment via intra-regional multinational firms has also given rise to a manufacturing network within the East Asian area.The intra-regional trade volumes of ASEAN6+3 have been increasing steadily since the early 2000s and reached approximately one-half of its total trade volume in recent years.Through this manufacturing network, advanced economies, such as Japan and Korea, have tended to export their low-added-value products to developing countries, and process these products while incurring low labor costs.In contrast, most of the developing countries in East Asia-such as China and Thailand-act as the "workshops" of developed economies by taking on low-added-value work and re-exporting the end products to advanced and other developing economies in the East Asian area.The added-profit trade-which includes processing and assembly-has been a typical economic growth model among most developing East Asian countries, and it is obvious that each country's economic growth is deeply involved in the manufacturing network.Through the integration of real economies, multinational firms have been optimizing their supply chains, information technologies, and capital flows.
Another aspect of the difference between the growth periods of 1984-1997 and 2000-2013 is related to exchange rate regimes or policies.Most of the monetary authorities in East Asian countries had adopted the de facto dollar peg system before the Asian Crisis in 1997, and switched to the floating system after the crisis.In some cases, countries adopted a basket beg system to fix their currencies.Although the East Asian countries could promote exports and investments to/from the US under the fixed exchange rates regimes, they had faced with significant fluctuations in exchange rates against the other trade partner's currencies, such as the Japanese yen, the German mark and the sterling pound.Since the dependencies of East Asian economies are not only on the US economy, but also on other developed economies, a more flexible exchange rate regime, such as the floating or the basket peg, would help the East Asian countries develop their economies in "the globalization era", as the countries expand their trade partners across the world.
Based on our empirical analysis and our conclusions on economic integration, East Asia is now closer than ever to exhibiting the conditions for a common currency.However, the integration of the financial markets in this region is still under development.As the Chinese economy has been growing rapidly, the RMB has become more popular as a currency of settlement for export and import in this area.However, the capital investments across the region are still mostly the dollar-denominated investments because the local financial markets are fragile against liquidity risks, systemic risks, and sovereign risks.This means that the agents in this area still have to manage exchange rate risks of the dollar fluctuations when they invest their local money in the regional economy.In order to utilize the available local/regional savings as a growth engine, the fragile local markets need to be interlinked with the regional financial center.Further regional monetary cooperation or political collective actions should play important roles in developing and integrating the regional financial market.This would contribute to forming a common currency union in this region.

Conclusions
Since the 1960s, economic integration within the East Asia area has been implemented through the use of corporate initiatives, in what has been referred to as "functioning integration".East Asian multi-national production networks have been established through the expansion of Japanese enterprises-as well as those of newly industrialized economies-into ASEAN and China.The trade volumes within the East Asian area are one-half its total trade volume worldwide.FTAs among the East Asian countries have been enacted since the 2000s, and internal trade among them will increase as more FTAs are formulated.However, the exchange rate-one of the key factors affecting trade volume-might be a destabilizing factor in intra-regional trade transactions.In line with the need to stabilize the foreign exchange rate within the East Asian area, the monetary authorities of East Asian countries need to cooperate with each other on their foreign exchange policy.As a measurement to stabilize the foreign exchange rate, the monetary authorities of East Asian countries need to create a common currency basket.Some of the previous studies argued that a common currency basket can rectify currency overvaluation or undervaluation, and is more suitable for East Asian countries to create a common currency area.
In this paper, we investigate whether East Asian countries are suitable candidates for forming a common currency area by employing the G-PPP model and by testing for co-integration with asymmetric error correction.Comparing the pre-and post-period of the Asian currency crisis, some East Asian countries tend to converge.In particular, after the crisis the member countries of ASEAN are converging either around themselves or around the three largest economies of Japan, China, and Korea.
The results of our empirical analysis suggest that East Asian countries are more suitable today for creating a common currency area based on the G-PPP model in the first decade of the twenty-first century than before the Asian currency crisis.It implies that East Asian economic development has been promoting trade transactions and monetary regionalization.In the next decade, a stable real exchange rate among East Asian countries is expected to promote the efficiency of market transactions and economic integration.Furthermore, to evaluate which East Asian countries are more applicable for creating a common currency area appropriately, in future research, we need to improve the anchor exchange rate by reference to a currency basket calculated by including all the trading partners of ASEAN6+3.

Table 1 .
Cont.PHP denotes the Philippine peso, JPY denotes the Japanese yen, CNY denotes the Chinese yuan, and KRW denotes the Korean won.Explained variable for all estimations is the euro real exchange rates against the US dollar.D.F. denotes the degree of freedom and D.W. denotes the Durbin Watson statistics.

Table 2 .
M-TAR Unit Root Test for Residuals from Co-integration Estimation (January 2000-June 2013).

Table 4 .
M-TAR Unit Root Test for Residuals from Co-integration Estimation (January 1984-June 1997).

Table 4 .
Cont.SGD denotes the Singapore dollar, IDR denotes the Indonesian rupiah, THB denotes the Thai baht, MYR denotes the Malaysian ringgit, PHP denotes the Philippine peso, JPY denotes the Japanese yen, CNY denotes the Chinese yuan, and KRW denotes the Korean won.D.F. denotes the degree of freedom and D.W. denotes the Durbin Watson statistics.****, ***, **, and * indicate significance at the 1%, 2.5%, 5%, and 10% levels in two-tailed test, respectively.Standard error is in parentheses.