Views from the World
What Form Should An Asian Economic Union Take?
Wing Thye Woo, Senior Fellow, Brookings Institution
(Keizai Koho, March 2008 issue)

The Economic Basis for Exchange Rate Coordination and a Common Currency

The two possibly most successful free trade areas in existent are the European Union (EU) and the North American Free Trade Area (NAFTA). EU and NAFTA are similar in that they permit free movement of goods and capital within their respective groupings. However, they also differ in many significant aspects. Unlike the EU, NAFTA allows only limited labor mobility across countries (notably restrictions on labor movements from Mexico to the other two countries); has no plans to coordinate exchange rate policies; and does not envisage an eventual political union.

The most commonly proposed forms of the Asian Economic Union (AEU) are closer to NAFTA rather than to EU. The proposals, especially those not associated with ADB sponsorship, generally anticipate exchange rate coordination to be possible only in the far future; foresee no future political union; and have tighter restrictions on labor mobility than NAFTA.

Is there a case for exchange rate coordination (and, maybe, monetary integration) within AEU in the absence of political unification? In our opinion, we cannot compare the relative merits of an EU-type AEU and an NAFTA-type AEU without stating what the world would look like in the future. Table 1 [1] reports the projections of the inflation-adjusted GDP in 2025 and 2050 in the major countries in EU, NAFTA and AEU.

While the United States would become increasingly large vis-a-vis Canada and decreasingly large vis-a-vis Mexico, the fact is that the US is the overwhelmingly dominant country in NAFTA at the present and will continue to be overwhelmingly dominant in the future. In 2050, the US would be twelve times larger than Canada and almost five times larger than Mexico. Given this great disparity in economic size, it will always be true that independent economic shocks in Canada and Mexico would have very limited impact on the US economy, while a sneeze by the US could send powerful tremors to the other two NAFTA members. In such an unequal situation, the survival of individual currencies is natural because the giant US economy sees no advantage in allowing its monetary policy to be influenced by the concerns of the smaller economies, and Canada and Mexico could use the exchange rate as an additional instrument to help offset shocks (especially trade shocks) originating from the US economy.

Part B of Table 1 reports the GDP of the three largest economies in the EU; Germany, United Kingdom, and France. The table reveals that the biggest EU economies are of the same magnitude now and will continue to be so in the future. This means that independent shocks in each country will have sizable spillover effects on the others. This high level of economic interdependence amongst EU members means that the welfare of each member would be increased if national economic policies were coordinated in a manner that reduces negative spillover effects. One instrument for achieving this welfare-enhancing cooperative solution is a common currency.

Furthermore, on the political dimension, the natural compromise solution for a group of equally powerful countries would be a common currency rather than the adoption of any particular national currency. The fact that Europe is anxious to undertake political union in order to minimise the possibility of another war among Germany, UK, and France means that a common currency is a necessary by-product.

Part C of Table 1 projects that the distribution GDP of the three major East Asian economies -- Japan, China, and South Korea -- display drastic changes over time. Unlike the EU, AEU will not be a club of equals at any point in time; and, unlike NAFTA, there is no stable dominant economic giant across time. Japan is the economic giant in 2005; but China will be the economic giant in 2050. If there is a compelling economic argument to form a Yen-bloc today, then the same compelling economic reasoning would dictate that this Yen-bloc transform itself into a Yuan-bloc by about 2035.

Our opinion is that the NAFTA-like disparity in economic power in AEU at the present and in the future means that the only stable configuration is the survival of individual East Asian currencies with limited coordination among them in normal times. It therefore appears to us that the many present efforts to promote closer exchange rate cooperation will not succeed in the long-run.

The Feasible Financial Architecture for an Asian Economic Union

It must be recognized that the present system of (bilateral and multilateral) swap arrangements is not sustainable and would not increase to meaningful sums unless members believe that the borrowed funds would be used only to defend an exchange rate against speculative attacks not justified by fundamentals (i.e. the borrowed funds would not be used to defend an exchange rate that has been rendered overvalued by inflationary domestic policies). In addition, members would not have such faith unless each country has been pre-qualified by an objective party that is competent to recognise good behavior. This means that a regional surveillance mechanism is required if regional swap arrangements (the pooled reserves) are to reach meaningful sums.

In our opinion, an Asian Monetary Fund (AMF) would be such a surveillance mechanism.[2] Just as we have the system of the World Bank and several regional development banks (like the Asian Development Bank, and the African Development Bank), it is also natural and desirable to have regional monetary funds (RMFs) in addition to the IMF. The IMF can play a very helpful role in speeding up the institutional maturity of the RMF, and in keeping up the competition of ideas.

Given the large size of East Asian foreign reserves, the AMF should take on the additional task of designing a pooling scheme where part of the East Asian reserves could be safely used to finance sound infrastructure projects in the poorest Asian countries. This outcome would be superior to the present practice of putting almost all of the East Asian foreign reserves into the assets of G7 economies.

It is important that the AMF does not suffer from the institutional inertia that is characteristic of the present global organizations like the United Nations, the World Bank and the International Monetary Fund. The leadership structure of the AMF should be designed to avoid simply locking in the balance of economic power that existed at the time of its founding; much like the unchanging composition of the permanent members of the UN Security Council, the head of the World Bank always being a US appointee and the head of the IMF always being a European

To summarise, an Asian Economic Union should take the form of a free trade and open investment area that has a regional monetary fund. And it cannot be over-emphasized that there is no economic logic for a regional monetary fund to naturally morph into the regional central bank. Given the great disparity in the present and future distribution of economic power in East Asia, and the greater restrictions on labor mobility within the (commonly proposed) Asian Economic Union, a NAFTA-type of Asian Economic Union would be preferable to an EU-type of Asian Economic Union.

[1] O'Neill, Jim, Dominic Wilson, Roopa, Purushothaman and Anna Stupnytska, "How Solid are the BRICs?" Global Economics Paper No: 134, Goldman Sachs, December 15, 2005.

[2] Yunjong Wang and Wing Thye Woo, "A timely information exchange mechanism, an effective surveillance system, and an improved financial architecture for East Asia," in Asian Development Bank, Monetary and Financial Integration in East Asia: The Way Forward, Volume 2, Palgrave Macmillan, 2004, pp. 425-458.

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