A Study On The Feasibility Of Northeast Asian Currency Union—Focused On Optimum Currency Union Criteria Analysis

The global economy that had experienced a severe recession caused by the global financial crisis in 2007-2008 has recently begun to recover, thanks to the improvement in America’s employment rate and housing index along with the efforts of the EU to resolve its deficits. East Asia currently has a GDP of 16 trillion which is almost equivalent to that of the US. The region which includes Korea, China, Japan and the ASEAN 10, has also been recovering quickly from the crisis and is maintaining its steady economy. However, critical issues such as global imbalance, drastic capital movements, devaluation of key currencies, increase in instability of the global financial system are still prevalent. These are all factors that need to be resolved, but cannot be done without a global collaboration on macro and financial policies.One of the solutions that have been suggested is a currency union among the three Northeast Asian (NEA) countries, Korea, China, and Japan. This solution is meaningful not only as a preventive measure, but also in that it stabilizes the exchange rate, increasing regional trade and investment. Moreover, an established economic bloc would represent East Asia’s crucial position in the global economy.The leadership role of NEA has been emphasized in many studies, but a currency collaboration on the three countries has yet to be properly reviewed. Considering that the crisis within the Euro zone was partially caused by an indiscreet inclusion of member countries, an immediate union in East Asia, as suggested by some studies, can entail great costs. Especially when facing the fact that the economic levels differ significantly among the countries within the region. Therefore, an independent financial cooperation must be considered for NEA which comprises over 90% of East Asia’s economy. In addition, this study is meaningful in that it views a currency union as a means to create a positive economic effect while stabilizing the economy within the region.One of the barriers against a currency cooperation within NEA is also due to the political issues involving diplomacy and security among the three countries. The EU shows a good example that an economic approach in the form of an economic integration can also contribute to resolving such political matters. Therefore, this study also aims to expand the economic cooperation into providing momentum for a political cooperation within the region.From this perspective, the current discussions on financial collaborations among Korea, China, and Japan are an indication of a step in the right direction. As a currency union happens to be the final stage of a financial cooperation, it may seem as a somewhat early solution to discuss. However, the main focus of this study is not to forecast the timing of a currency union. Rather, this study aims to review the feasibility of a currency union, considering its relationship with the current financial cooperations, as well as the expected positive effects.In determining the feasibility of NEA forming a currency union, this study first sets its premise on Neoliberal Institutionalism which states that when absolute benefits are expected, financial collaborations are strengthened. Secondly, a currency union in NEA follows the key objectives of monetary regionalism which skips the stage of establishing an official trade cooperation and jumps directly into stabilizing the regional currency and financial markets. Third, the currency union in NEA follows the mediation level of Pseudo Exchange Union. Currency unions are achieved through numerous phases from agreement to actual integration based on the mediation level. Pseudo Exchange Unions include fixed exchange rate, free flow of capital, and agreements on policy adjustments (Padosa-Schippa 1998; Cordon 1972). This is the mediation level that is deemed appropriate and practical for NEA. This is because free flow of capital is required for the currency union not to hinder the current market led integration among Korea, China, and Japan. Moreover, the political conflicts as well as differences in policy are real matters among the three countries. Maintaining a certain level of flexibility in adjusting the policies would be a more practical approach as opposed to diving into a fully integrated policy. Therefore, in order to analyze the feasibility of a currency union in NEA, this study focuses on the implementation of a fixed regional exchange rate system which happens to be the most critical index for a currency union.This study goes on to analyze the feasibility of NEA establishing a currency union based on the Optimum Currency Area (OCA) theory. Mundell (1961) was the first to suggest the OCA theory to set an optimum area where a fixed exchange rate can be maintained. Previous studies on currency unions had also utilized the OCA theory. The OCA theory defines the costs of a currency union as the loss of an independent currency policy while defining the benefits as the economic gains obtained through eliminating uncertainties of exchange rate fluctuations and reducing trade costs. Although the OCA theory encompasses both costs and benefits in selecting optimal member countries of a currency union, most of the previous studies had been focused on the costs or benefits alone. The research method of this study incorporates both the costs and benefits of the OCA theory. This approach is appropriate in analyzing NEA’s feasibility on establishing a currency union, especially with focus on the feasibility of adopting a fixed exchange rate system. This research method is also practical from the viewpoint of deducing reasonable policy related implications.With the aforementioned background and research method, this study first conducts an empirical analysis on the necessity of a currency union in NEA. The OCA benefit theory is set as the basis of this part analysis. Then, the feasibility of a currency union is analyzed based on the OCA cost theory. Finally, the results of both analyses are put into account in suggesting policy strategies in order to establish a currency union within the region.The empirical analysis determines whether the exchange rate stability that a currency union can provide would have a positive effect on the NEA’s economy. Various studies have already suggested that a fixed exchange rate through a currency union have positive economic effects on the real economy, especially on trade. There are many limitations in analyzing the economic benefits of regional capital movement due to the lack of information and limitations in systematic conditions as well as high levels of regulation. Therefore this study had concentrated on the trade effects that could be brought about by fixing the exchange rate. Numerous factors that affect trade could be inquired into, thus, the gravity model was adopted as the empirical study model as it has been proven useful for analyzing the integration of the global economy.According to the results, fixing the exchange rate within the NEA region by establishing a currency union is expected to have a positive effect on trade. This result fulfills the premise on Neoliberal Institutionalism which means expected economic benefits among the three countries would strengthen their financial collaborations. In addition, the results also emphasize the need for a currency union in NEA. Furthermore, in case other East Asian countries can become involved into NEA’s currency union system, this would vitalize trade within the expanded region of East Asia, expediting regional collaborations and enabling its economic growth. This indicates that a currency union among the three NEA countries can ultimately lead to expanding the growth potential of East Asia.As can be seen in the results above, a currency union in NEA can contribute to the regional economy, satisfying the necessity of a currency union. Based on these results, a feasibility analysis for a NEA currency union was conducted. The focus for this study was on the feasibility of establishing a regional fixed exchange rate by implementing the currency union as a means to set a policy strategy in minimizing economic costs. The OCA criteria set the economic standards by which each country’s suitability in joining the union. For the candidate country, whether the gains outweigh the cost of abandoning its independent currency policy can be determined. This analysis has selected and categorized appropriate OCA criteria, and analyzed whether Korea, China, and Japan satisfy both the necessary and sufficient conditions in establishing a currency union. A comparison between the three NEA countries and the Original Six members of the EU shows that NEA meets the necessary OCA conditions of economic openness and macroeconomic policy preferences. On the other hand, NEA failed to meet the sufficient conditions of labor movement, financial market connectivity, and similarity in economic structure. Among these results, the economic structure differences was shown to be the most crucial reason for such disparity, especially due to the system currently employed by China. However, China is beginning to implement various economic efforts and policies for structural change that reduces the currently prevalent differences. Moreover, the three countries are continuing talks to expand regional collaborations. As long as this momentum is maintained, the currently unmet OCA sufficient conditions are expected to improve. Keeping this direction will eventually develop NEA into an optimal currency area that possesses the function to recover regional imbalance when faced with a macroeconomic shock, without having to resort to exchange rate adjustments.These analysis results also show that a strategy to resolve these barriers against a currency union. In order to do so at minimum costs, the following stages are suggested:First, a NEA free trade area is suggested to help reduce structural and systematic differences. This stage is necessary to minimize asymmetric shocks due to structural discrepancies. Second, a cooperation promotion body is suggested as a political prerequisite to alleviate the current conflicts among the participating countries. The joint vision and spirit that Germany and France played in implementing the Euro can be an effective case to learn from.Once the currency integration conditions are improved by overcoming these economic and political barriers, the short-term approach would be to secure liquidity and to form a regional initiating body. The long-term approach would involve a detailed systemization in order to stabilize and systemize the regional exchange rates.The results of this study suggest that the three NEA countries can progress the feasibility of a currency union within the region by improving the sufficient OCA conditions. Therefore, Korea, China, and Japan should utilize their functional market integration which is an economic environment unique to the region, and proceed with the common strategic goal of establishing a currency union. They should maintain the vision that a regional currency union can eventually lead to creating an East Asian economic bloc that is equivalent to the US or the EU, both in terms of volume and influence. Expanding on this study, additional research should be carried out on how to resolve issues that may arise during each phase reaching towards a currency union. Such follow up studies are expected to contribute to NEA taking a step closer to establishing a currency union.