Discussion Paper No. 572

MONETARY INTEGRATION AHEAD OFTRADE INTEGRATION IN EAST ASIA?

Kwanho ShinandYunjong Wang

March 2003

The Institute of Social and Economic Research
Osaka University
6-1 Mihogaoka, Ibaraki, Osaka 567-0047, Japan

Final Draft

Monetary Integration Ahead of Trade Integrationin East Asia?+
Kwanho Shin* and Yunjong Wang**
October 2002
Abstract
Regionalism is taking two forms. It is occurring firstly through free tradearrangements and secondly through monetary arrangements. In this paper,
we highlight the issues related to the reversal of sequence between tradeintegration (free trade agreement) and monetary integration (a monetary
union). While the Euro area pursued trade integration first, from atheoretical point of view, there is no clear reason for introducing tradeintegration ahead of monetary integration. On the contrary we point out
many good reasons for forming a monetary union before a free trade
agreement.

JEL Classification: E32, F36, F41
Key words: monetary union, monetary integration, free trade agreement+ This paper was prepared for presentation at the conference on “Linkages in East Asia: Implications for Currency Regimes andPolicy Dialogue,” as part of the Joint Australia-Japan Research Project on Future Financial Arrangements in East Asia, held on 2324 September 2002, Seoul, Korea. The first author acknowledges financial support by a Korea University Grant in 2002. Part ofthis paper was written while Kwanho Shin was affiliated as a visiting foreign scholar with Institute of Social and Economic
Research, Osaka University.

*

Department of Economics, Korea University, khshin@korea.ac.kr**

Senior Research Fellow, KIEP, yjwang@kiep.go.kr

1. Introduction
While a flexible exchange rate regime is the trend in one direction, there is also amovement toward the other extreme of a credible bilateral or multilateral parity-fixing
regime. As there is renewed emphasis on price stability, the sanctity of “one country,
one money” has come into question (Alesina and Barro, 2002). In particular, theformation of the European monetary union, in which twelve countries have adopted thesame currency, has given rise to an intense debate on monetary union.
The aim of this paper is to examine the extent to which East Asian countries canintroduce a monetary union. More specifically, we will try to answer the question ofwhether East Asia can introduce a monetary union without making an effort to further
trade integration through a formal free trade agreement (FTA). To put monetary unionahead of trade integration is the opposite sequence to the strategy followed by theEuropean Union. In Europe, a trade-integration-first strategy was natural when six
nations in Europe singed the historic Treaty of Rome in March 1957, which set inmotion the economic and political integration of Western Europe. No serious thought
was given to setting up a regional exchange rate coordination mechanism or the
possibility of introducing a common currency, simply because the Bretton Woods
system provided stability for the European countries. Only when the Bretton Woods
system began to unravel, the pressure for exchange rate stability intensified and thus theEuropean countries started to initiate monetary integration.
Unlike Europe, however, trade agreements among East Asian countries are slow tomaterialize and are subject to severe domestic political resistance. Furthermore,conventional integration process may not work because a formal FTA at the regional
level would be disrupted by the exchange rate instability unless an effective exchange
rate coordinating mechanism is put in place. A point of reference can be found in the
Common Market of the South (MERCOSUR), where economic integration processcame to a deadlock due to frequent currency crises. In contrast to conventional
regionalism through trade integration, monetary regionalism can contribute to thestability of currencies and financial markets without having to formalize trade linkages.
Since the financial crisis, East Asian countries have had a strong impetus to search
for a regional cooperative mechanism that could help secure financial stability in theregion. This search is now gathering momentum and opening the door to possibly
significant policy-led integration in East Asia. The Chiang Mai Initiative (CMI) of
ASEAN+3 is one such available option. At present, however, East Asian countries have
not yet specified a common policy goal in the area of a future exchange rate system in-1-the region. Even the CMI has nothing to do with exchange rate coordination, given thediverse exchange rate systems in East Asia.
When the regional group agrees on deepening regional integration throughexchange rate coordination, monetary policy coordination becomes a crucial element in
the broad context of financial and monetary cooperation. Recently, some observers haveanticipated that East Asia will be successful in its attempt to jump into monetary
cooperation ahead of building up the trade agreements, while many others are still
skeptical.
Based on theory and empirical evidence, this paper explores the issues related to
the reversed sequencing between trade and monetary integration. We organize our
discussion as follows. Section 2 briefly reviews the strategy adopted by European
countries towards the European monetary union. Section 3 then points to the different
situation faced by East Asian countries. Section 4 examines whether East Asia satisfies
the optimum currency area (OCA) criteria. Section 5 discusses the issues related to thereversed sequence of introducing monetary integration ahead of trade integration in East
Asia. Finally, Section 6 concludes the paper.

2. Europe’s Experience: Trade Integration ahead of Monetary
Integration
Since World War II, European countries have identified exchange rate stability as a key
policy target. However, no serious thought was given to creating a regional exchange
rate coordination mechanism, simply because the Bretton Woods system could provide
stability for the European currencies.
The great event in Europe in the late 1950s was the formation of the European
Economic Community (EEC). In March 1957, six European countries signed the Treatyof Rome to build a customs union and the Common Agricultural Policy (CAP). As afirst step, the Treaty of Rome committed the six member countries to eliminate tradebarriers within the Community and to establish a Common Commercial Policy (CCP),
thereby creating a customs union. On the other hand, the Six moved forward with the
CAP, which entailed freer trade within Europe but greater insulation of European
agricultural markets from external competition.
The main issue for the Community in the monetary area in the 1960s was thequestion of whether exchange rate adjustments could disrupt the functioning of thecustoms union and the CAP. In Europe, it was of utmost importance to defend regional-2-

parities from the beginning. The IMF has taken over this concern and supported
securing the system of fixed exchange rates and balance of payments. The European
countries did not have much to do in the monetary area.
In the later 1960s, divergences in inflation rates and external balances began toappear among member states of the European Community. A speculative attack against
the French franc in favor of the deutsche mark in May 1968 put a great deal of pressure
on the bilateral parities of Community currencies. At the same time, policy circles
started to discuss the necessity to coordinate economic and monetary policies among themember states and establish monetary facilities for mutual balance of payments
assistance. The Werner Plan was completed in 1970 and endorsed by the Council of
Ministers in 1971. The Plan had recommended the rapid adoption of a common
currency. Three stages were envisioned, including the pooling of foreign exchange
reserves for joint intervention. However, the Plan was immediately abandoned, because
it was deemed wholly unrealistic.
The main practical outcome was a new system (the ‘Snake’) for limiting
fluctuations in exchange rates between EC currencies. But, with the collapse of the
Bretton Woods system, EC member countries merely sought to solve its own problems
without regarding Europe as a single entity. The economic policy of each country was
made at the national level: the British government soon removed the pound from the
Snake, and other EC governments (the French twice) followed this lead, creating anunsustainable climate in which further progress towards a monetary union was
impossible.
The nine EC member countries were divided into two groups with very different
economic performance and exchange rate regimes by 1977.1 One group had achieved
some success in keeping inflation moderate and had maintained the outward appearanceof having the intention of participating in the Snake System. Germany, Benelux
countries and Denmark, with Norway as an associate member belonged to this firstGroup. The other group floated their currencies individually and all experienced highinflation, current account deficits and substantial depreciation. The currencies in thesecond group were the pound sterling, the French franc, the Italian lira and the Irish
punt. It seemed difficult to devise an exchange rate system which comprised bothgroups of countries.
On the trade integration front, internal trade liberalization also slowed during the1

On January 22, 1972, after difficult negotiations, the United Kingdom, along with Ireland, Denmark,and Norway, signed the Treaty of Accession with the European Community. In a subsequent referendum,
the Norwegian electorate rejected membership.

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1970s, as the elimination of tariffs and quotas exposed the protective effect of numerous,
seemingly immutable, behind-the-border barriers. The only important milestone toward
European integration during the 1970s was the creation, in 1979, of the European
Monetary System (EMS), with its companions, the European currency unit (ECU) andthe Exchange Rate Mechanism (ERM). The three existing credit facilities – the very
short-term financing facility (VSTF), the short-term monetary support facility (STMS),
and the medium-term financial assistance facility (MTFA) – were also extended in the
EMS. The EMS was able to bring together European countries to cooperate again in themonetary sphere and became the focus of the monetary cooperation policy. The EMS
enjoyed stability without realignments and additional participants in the second half ofthe 1980s.
As late as 1988, the idea of a monetary union resurfaced. The Hannover European
Council of June 1988 set up a Committee for the Study of Economic and Monetary
Union in the European Community, presided over by the president of the EC
Commission, Jacques Delors. In April 1989, the so-called Delors Committee published
its Report on Economic and Monetary Union in the European Community, proposing athree-stage process to economic and monetary union (EMU). It stressed the need for
greater coordination of economic policies, rules on the size and financing of national
budget deficits, and a new, completely independent institution which would be
responsible for the Union’s monetary policy. However, this proposal was met with thesame skepticism that was encountered by the earlier Werner Plan. It took an exceptional
event, the collapse of the Berlin Wall, to trigger a serious reassessment that no politicalleader could have predicted only a few weeks earlier (Schweickert, 2002; Wyplosz,
2001).
The EMU negotiations were concluded at the European Council in Maastricht on
9-10 December 1991. The Maastricht Treaty provides for economic and monetary union
to be introduced by the end of the century in three successive stages. The negotiations
concerning the transitional phase proved particularly difficult.2 The European Monetary
Institute (EMI), established in January 1994, as a precursor to the European Central
Bank, played an important role in facilitating and reinforcing coordination of nationalmonetary policies during the transition. The Stability and Growth Pact also clarified the2

Immediately after the crisis, fears were widespread that the Maastricht process was doomed(Eichengreen and Frieddon, 2001). This pessimism turned out to be exaggerated. First, even governmentsthat had been forced to devalue reiterated their commitment to the completion of the monetary union andwere able to keep their currencies close to their central rates. Second, economic developments became
more favorable because German unification effects became weaker. Finally, the Growth and Stability
Pact was added for dealing with “excessive deficits” (Schweickert, 2002).

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Maastricht Treaty’s provision for dealing with “excessive deficits” and provided an
institutional framework for its enforcement, in part through strengthened surveillanceand coordination of economic policies.
Europe’s experience suggests that exchange rate stability was, in fact, the lynchpinof efforts to strengthen trade integration. Whenever there was some doubt about
exchange rate stability, trade integration also becomes sluggish. In this sense, a certain
form of monetary integration is a prerequisite for successful trade integration.

3. Is There Any Difference in East Asia?
Unlike in Europe, historically there has been much less active movement towards
regionalism in East Asia. Besides the political diversity in East Asia, most East Asian
countries have been more reliant on the U.S. and EU markets, so there has been lessincentive for them to expand trade integration within the region. In fact, the first major
attempt was made only in 1992 when 6 ASEAN countries agreed to launch a scheme for
ASEAN free trade.3 Thereafter, the ASEAN free trade area has continued to extend sothat it now includes the whole area of Southeast Asia.
Recently, China has become more active in cooperating with the ASEAN
countries towards a free trade agreement. In November 2001, China committed tonegotiating a free trade agreement with ASEAN. Japan also formed a joint study groupwith ASEAN to find the feasibility of Japan-ASEAN FTA. However, a region-wide
East Asian FTA, covering ASEAN+3 countries, would be slow to materialize because
China and Japan are seeking formal trade arrangements bilaterally rather thanmultilaterally. The current pattern of regional trade agreements in East Asia is also
bewildering (Scollay and Gilbert, 2001), essentially consisting of a web of bilateralarrangements, many of which are still on the drawing board. There has apparently been
no formal attempt at building a regional multilateral agreement similar to the Common
Market. Bilateral negotiation is unlikely to foster a collective framework (Wyplosz,
2002).4
Furthermore, for Korea and Japan, the most difficult problem in reaching a free
trade agreement with other Asian countries is the agricultural sector. In fact, any trade
agreement, because of its differential effects on various sectors, faces the possibility of

3

The six countries are Malaysia, Indonesia, Philippines, Singapore, Thailand and Brunei.
On the monetary front, the preference towards regional exchange rate arrangements become less strongin East Asia because of the absence of multilateral trading arrangement at the regional level.
4-5-

severe resistance from domestic vested interest groups. Korea and Japan have beenheavily subsidizing their agricultural sectors, and there are still mounting concerns that
opening this sector, although beneficial for the economy as a whole, will ruin those who
rely on it for their livelihood. Since many people in Korea and Japan have family rootsin the agricultural region, and in many cases maintain close ties with relatives in therural areas, any policy that inflicts heavy losses on the agricultural sector will bepolitically unpopular. Unlike the free trade agreement, financial and monetary
cooperation among East Asian countries may meet with less political resistance due to
its more neutral consequences.
Since the currency crisis, East Asian countries have come to realize that they needsome arrangements for policy coordination and monetary arrangements to stabilize theexchange rates of regional currencies. While Japan’s attempt to establish a so-called
Asian Monetary Fund (AMF) was not successful, the more recent agreement of the
Chiang Mai Initiative (CMI) indicates that ASEAN+3 can concur on substantial
arrangements towards financial integration in the region. In this context, it is no wonderthat the creation of a regional monetary system or monetary union in East Asia similar
to the type adopted in Europe has been recently proposed and discussed in academic
circles and even policy-making groups.
The background of attempts to introduce a monetary union in East Asia seems tohave multifaceted aspects. Firstly, many East Asian developing countries are stillsearching for an optimal exchange rate regime. After the Asian currency crisis, most
East Asian developing countries abandoned their fixed exchange rate regimes andnominally adopted free-floating regimes (in many cases, with a policy focus on inflation
targeting). However, it is no exaggeration to say that there still exists a “fear of floating”
among many monetary authorities (Calvo and Reinhart, 2002). This makes it difficult
for many Asian countries to take advantage of the benefits of the floating exchange rate
system, such as the autonomy of monetary policy. Of course, there is no point returning
to the previous case of the de facto fixed exchange rate regime which might bevulnerable to another currency crisis. Nevertheless, the regional monetary grouping
could be an alternative to both fixed and flexible rate regimes at the national level.
Secondly, a monetary union in East Asia may be necessary to avoid competitive
devaluation of regional currencies. For many East Asian developing countries with
common export markets, the fluctuation of their exchange rates against the yen could
critically affect the competitiveness of their exports. In fact, it was a depreciation of the
yen against the dollar that resulted in the current account deficit for these countries in
the mid-1990s, which might have been closely related to the subsequent currency crisis-6-

in the region. Kwan (2001) points out that the pro-cyclical aspect of capital flows in andout of East Asia is closely related to the instability of the yen-dollar rate. Although thestability of the G-3 currencies (dollar, euro and yen) is highly beneficial to small open
emerging market economies, the political will for a project of G-3 currency stability
through cooperative schemes is hard to spot, particularly in the United States.
Consequently, a regional response seems to be a plausible second best.
Thirdly, the stabilization of exchange rates will help East Asian countries achieve
their full potential for growth and development. Most Asian countries have relied onexports as a key to their rapid growth. Stabilized exchange rates, hence reduce
exchange risks, encourage firms in the export sector and make it easier for Asian banks
and corporations to borrow abroad. By forming a monetary union, East Asian countries
can expect their common currency to remain stable against outside currencies as well as
their own currencies to stay stable against each other.
Given this backdrop, the Asian currency crisis in 1997 and the launch of the euroin 1999 made the possibility and desirability of introducing a more highly sophisticatedform of economic integration such as a regional monetary union in East Asia a point of
debate.5 However, it has often been argued that East Asia is less self-contained than
Europe. Many East Asian countries rely as heavily on the U.S. and Europe for export
markets as they do on other Asian countries, including Japan (Eichengreen, 2002;
Kawai, 2001; Ogawa and Ito, 2000). In Europe, it was of utmost importance to defend
regional parities given the high degree of regional trade interdependence. On the other
hand, despite increasing intra-regional trade dependence in East Asia, a plan to stabilize
exchange rates vis-à-vis a basket of major international currencies rather than intraregional exchange rates has been proposed (Kawai, 2001; Ogawa and Ito, 2000;
Williamson, 1999). In Section 4, we will consider whether East Asian countries areready to adopt a common currency in terms of optimum currency area (OCA) criteria.
Another important issue is to analyze the advantages of introducing monetary
integration ahead of trade integration. While Europe started with trade integration, someobservers note that East Asia is attempting to start monetary cooperation before
successfully completing a regional multilateral trade agreement (Bergsten 2000; Bird
and Rajan 2001; Dieter 2001). Since trade agreements among East Asian countries are
slow to materialize and tangled in a complex web of bilateral agreements, monetary
regionalism might be an alternative route to regional integration in East Asia.

5

There are various forms of abolishing exchange rates all together, including dollarization, currencyboards, and currency union (or regional monetary arrangement). In this paper, only the form of a regional
currency union will be considered.

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4. Does East Asia Satisfy Optimum Currency Area Criteria?
The seminal paper written by Robert Mundell (1961) was the point of departure for thehuge volume of literature on the topic of optimum currency areas. Mundell observedthat an exchange rate adjustment which permitted the pursuit of independent monetary
policies in two countries (say, the USA and Canada) was of little use if the disturbancedepressed one region within both countries (say, western Canada and the western USA)
while simultaneously boosting other regions within both (say, eastern Canada and theeastern USA). In this case, there could be an efficiency argument for forming one
currency area comprised of the two western parts and another currency area made up of
the eastern parts. In response to this disturbance, the western regions can then adopt one
policy, the eastern regions another, and the exchange rate between them can adjust
accordingly, while the advantages of a common currency are preserved in the form of
reduced exchange rate risk and lower transaction costs within the eastern and westernregions. In Mundell’s framework, the incidence of disturbances across regions is a
critical determinant in the design of currency areas (Bayoumi and Eichengreen 1993, p.
195).
Subsequent literature explored the determinants of the incidence of shocks(McKinnon 1963; Kenen 1969). Most of the literature considers four criteria forforming a monetary union – interdependence through trade, symmetry of shocks,
mobility of factors of production, and convergence of macroeconomic policies. First,
countries that are highly integrated in terms of international trade stand to benefit moreby forming an OCA since a common currency will result in greater savings ontransaction costs and reduce the risks associated with using different currencies.
Therefore trade interdependence is a very important condition for forming an OCA.
The second criterion for an OCA points to the possibility that countries withsymmetric business cycles are more likely to be members of an OCA. As shown above
in Mundell’s intuitive explanation, regions with symmetric shocks can take the samemonetary policy against other regions receiving different shocks. Since adopting amonetary union implies the abandonment of autonomous monetary policies, the costs offorming a monetary union with regions of asymmetric shocks will be tremendous.
Kenen (1969) also highlighted the degree of industry or product diversification as adeterminant of the symmetry of shocks. When two regions are highly specialized in the
production of distinct goods, their prices are affected very differently by disturbances.

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By contrast, when the two regions have the same industrial structure and produce thesame goods, disturbances are more likely symmetric.
Third, if mobility of labor and capital is permitted, the local shock could be
resolved without incurring great adjustment costs. Therefore, countries that want to join
the monetary union have to permit factor mobility more freely. However, Mundell(1961) believed that labor mobility was not the most important condition for an OCA.
Even if labor mobility were not perfectly possible, a country could gain various benefits
by participating in an OCA. McKinnon (1963) also insisted that the currency
arrangements themselves would affect factor mobility, so the extent of factor mobility
had to be considered ex post facto.
Finally, when countries within the region have different policy targets, theirinterests are intensely conflicting with respect to the same external shock so that acoordination system for exchange rate stability could easily collapse (Dixit, 2001).6 In
Europe, a high degree of convergence of macroeconomic policies among the member
countries in the EMU was required to push forward the implementation of a single
monetary policy.7 A set of policy parameters was closely watched to ensure that policy
actions were coordinated effectively.
Among the four criteria, the issue of asymmetric responses to external shocks has
been the focal point of the empirical analysis of the OCA criteria. Most analyses havefocused on whether countries participating in a monetary union reacted symmetricallyin terms of shocks. Bayoumi and Eichengreen (1994), based on a breakdown of shocks
between demand and supply shocks a la Blanchard and Quah (1989), find that there islittle difference in the asymmetry of both shocks between Europe and East Asia.
Eichengreen and Bayoumi (1999), using the OCA index developed in Bayoumi and
Eichengreen (1996), find that the economies of East Asia are more or less as plausible
candidates for a monetary union as the members of the EU. Bayoumi and Mauro(1999) also find that, while East Asian countries are less suited for a regional currency
arrangement than Europe, the difference is not large.
More recently, Baek and Song (2002) and Lee, Park and Shin (2002) also confirm
that East Asia is as plausible a candidate for a common currency area as the Euro area.
Especially, Lee, Park and Shin (2002) improve the methodology of assessing the6

Dixit (2001) raised the issue of the robustness and sustainability of the EMU’s institutionalarrangements by constructing various models when member countries have different policy objectives.
Hughes Hallett and Weymark (2002) also stress the potential tensions among union members that might
threaten the stability of the union. The types of policy heterogeneity include differences in national
preferences for price stability, output growth, and income distribution.
7
All EU members were allowed to participate in the transition process to the EMU, but they had to meet
all the convergence criteria stipulated by the Maastricht Treaty.

-9-symmetry of shocks by considering a model in which the output of an economy isinfluenced by three different shocks - global, regional, and country-specific. The
importance of a common regional shock is interpreted to provide a case for a common
regional currency. They find that the size of regional shocks is comparable to that ofEurope, which is interpreted as an indication that East Asia is well suited for a monetary
union.
On the other hand, Wyplosz (2001) and Chow and Kim (2000) have a less positive
view on whether East Asia satisfies the preconditions for implementing a monetary
union. Eichengreen and Bayoumi (1999) also argue that East Asia lacks important
institutions for implementing a monetary union, such as sound financial systems,
political network, and a long integrationist tradition. We will discuss this issue in moredetail in Section 5.

5. Introducing a Monetary Union ahead of FTA
In this section we will discuss issues related to the reversal of sequence between an FTA
and a monetary union. We organize this section into five subsections. The first four
subsections generally discuss the advantages of introducing a monetary union ahead of
forming an FTA. The last subsection does not point to a disadvantage, but explains thedifficulty of introducing a monetary union in general.

Monetary Union and Trade
In the previous section, we find that most studies on this topic agree that the costs of amonetary union in East Asia are not as high as they were for Europe. However, the factthat most East Asian countries are more dependent on the U.S. and EU markets asoutlets for their exports suggests that the potential benefits from a monetary union mightalso not be as large as they are for Europe (larger intra-regional trade implies larger
benefits). Table 1 shows the pattern of the changes in the importance of intra-regional
trade for East Asia and Europe. In the table, intra-regional trade is measured by theshare of an economy’s total trade with the rest of the economies that belong to the same
region in its total trade. While the gap has narrowed in recent decades, intra-regional
trade in Europe (64.4 in 1980 and 66.4 in 2000) is much higher than in East Asia (51.3
in 2000).
If East Asia were to follow the same strategy as Europe, then it would need to-10-

foster further trade integration until the benefits of a monetary union become highenough. In fact, intra-regional trade in East Asia has also increased from 41.9 in 1980 to
51.3 in 2000. If this trend continues, eventually the level of intra-regional trade in East
Asia could reach the same degree of internal trade in Europe at the time of the euro’s
introduction. Since the East Asian market, especially that of China, is rapidly expanding,
East Asia can be as self-contained as Europe in the future. However, considering the
speed of increase in intra-regional trade in the past 20 years, for East Asian countries toreach the current level of Europe, it may take another 20 years. In particular, given thecurrent low level of intra-regional trade in Japan (38.1) and Korea (42.2), far below theaverage (51.3), the region’s two major trading countries need to play a more active rolein promoting intra-regional trade.
However, one advantage of immediately introducing a monetary union is that it
may speed up intra-regional trade integration significantly without any additional efforts
such as forming a free trade agreement. Rose (2000) estimates the degree to which tradeis affected when exchange rate variability is eliminated through a monetary union.
Using data for a large number of countries during the 1970-1990 period, he finds thatbilateral trade is higher for a pair of countries that use the same currency than for two
countries using their own currencies. More precisely, the coefficient on a monetary
union dummy in an empirical model of bilateral trade is found to be positive andsignificant in both economic and statistical terms. The value of the coefficient suggeststhat membership in a currency union, ceteris paribus, more than triples bilateral trade.8
This is true even after controlling for a number of other factors that might affect tradethrough the gravity model, which shows that trade between a pair of countries is
proportional to their combined incomes, and inversely proportional to the distance
between them. More importantly, a free trade agreement is also one of the controlled
factors in his analysis.
Whether Rose’s findings are directly applicable to East Asia or not is aninteresting question. Can a monetary union in East Asia provide the important
advantage of bypassing the difficult political procedures of free trade agreements?
However, there must be some caveats in interpreting Rose’s estimate. His empiricalfindings are based on cross section data and, in most cases, countries in monetary
8

Rose (2000) emphasizes a phenomenon known as “home bias” in international trade – much more
intense trade inside countries than between countries. He points out that sharing a common currency is amuch more serious and durable commitment than a fixed rate among countries. McCallum (1995)
quantifies the size of the intra-regional bias at more than twenty to one, finding that trade between two
Canadian provinces is more than 20 times larger than trade between a comparable Canadianprovince/American state pair. Rose seems to regard this home bias effect as one of the main driving
forces for increasing trade through monetary union.

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unions are small in size. Hence at least two things are not clear; (i) how long it will takefor a country to triple its trade with other member countries if it joins a monetary unionand (ii) whether the estimate is also applicable to a large country in East Asia. Since
increasing trade three-fold is not easy to accomplish, many people have questioned
Rose’s estimate.9
Glick and Rose (2001) respond to the criticism by estimating the effect ofmonetary union on trade using a time series variation. They use a data set covering alarge number of countries for fifty post-war years. During this sample period, a large
number of monetary unions dissolved, providing both time series and cross-sectionalvariations on the incidence of monetary unions. Specifically, over one hundred countrypairs dissolved common currency linkages during the sample period. By comparing thetrade of these countries before and after this regime change, they estimate the effect ofmonetary union membership on trade. Their empirical results also confirm those of
Rose (2000). They find an economically and statistically significant effect of monetary
union on trade using a number of different panel estimation techniques. Their estimate
is that bilateral trade rises/falls by about 100% as a pair of countries forms/dissolves amonetary union, with other conditions unchanged.
While the time series evidence of a monetary union’s effects on trade is smaller
than that of cross section evidence, it is still large at 100%. Frankel and Rose (2002) go
one step further to estimate the effects of monetary union via trade on output using a
two-stage approach. In the first stage, the results show that a monetary union leads to athree-fold increase in trade. Moreover, there is no evidence of trade diversion. In thesecond stage, their estimates suggest that every 1% increase in trade (relative to GDP)
raises per capita income by roughly 1/3 of a percent over 20 years.10 These empiricalresults support the hypothesis that the beneficial effects of a monetary union on
economic performance are garnered through the promotion of trade rather than througha commitment to a non-inflationary monetary policy or other macroeconomic influences.

Monetary Union and Business Cycle Co-movement
9

Rose’s estimate seems to be especially large given that, in the literature, estimates of the effect of
reduced exchange rate volatility on trade are small. See Alesina, Barro and Tenreyro (2002) for atechnical discussion on empirical problems, such as aggregation bias, omitted variable regression, selfselection, sample selection and so on.
10
As the deadweight losses of using different currencies vanish, competitive pressures increase andconsumers gain static ‘Harberger’ triangles. The size of these gains may be large. Frankel and Romer(1999) estimate that increasing the ratio of trade to GDP by one percentage point raises per capita income
by between one-half and two percent.

-12-Generally, when a number of countries adopt a common currency, each of the countries
must yield its independent monetary policy to a supranational authority. When
asymmetric macroeconomic shocks occur across member countries, they are no longer
able to use the monetary policy to respond. This may be considered a potential cost ofmonetary union according to the classical theory of the optimum currency area.
However, the monetary policy itself could be a shock that leads to macroeconomic
instability. A monetary union can prevent asymmetric monetary shocks through a single
monetary policy.
The fact that a monetary union leads to a significant increase in trade among
member countries also suggests another important implication for adopting a common
currency. Countries with highly positively correlated business cycles are more likely tojoin a monetary union, other things equal. However, because business cycle correlation
is closely related to trade intensity among countries, by affecting trade intensity among
member countries, a monetary union can also alter the costs of sacrificing independent
monetary policy ex post facto. This is what Frankel and Rose (1998) emphasized as theendogenous nature of a decision to join a monetary union. In other words, a naïve
examination of historical data may give a misleading picture of a country’s eligibility
for entry into a monetary union since the economic structure is likely to change
dramatically as a result of a monetary union.11
To see whether a monetary union increases or decreases the costs of joining one ex
post facto, the key is to verify how increased trade affects business cycle co-movement.
From a theoretical point of view, the effects of trade integration can lead to businesscycle synchronization in either direction – convergence or divergence. Eichengreen(1992), Kenen (1969) and Krugman (1993) argued that as trade linkages increased,
greater specialization of production would occur, resulting in less synchronization ofbusiness cycles. In particular, this is more so if business cycles are dominated byindustry-specific technological shocks.
Frankel and Rose (1998) countered Krugman’s argument, insisting that when
demand shocks were dominant and intra-industry trade was more persuasive than interindustry trade between the countries adopting the single currency, business cycles
11

Most previous studies focus on the empirical question of whether or not a monetary union leads tostructural changes in economic fundamentals, which favor business cycle synchronization. Recently,
Corsetti and Pesenti (2002) offer a distinct argument for endogenous optimal currency areas, withconceptual roots in the Lucas critique. They show that the adoption of a common monetary policy can be
self-validating, independent of economic integration. Their assertion is rather compelling. With
incomplete exchange rate pass-through, the optimal monetary policy is to respond symmetrically toshocks anywhere in the region.

-13-

would become more positively correlated as trade becomes more integrated. In theliterature, there are at least two additional important linkages between business cycle
co-movements and increased trade. First, if demand shocks drive a boom in one country,
the effects can spill over to trading partners through an increased volume of imports.
Second, increased trade may create a greater need for more coordinated fiscal as well asmonetary policies, which synchronize policy shocks. Both of these linkages imply that
increased trade leads to tighter business cycle co-movements.
In sum, the theoretical implications of more trade integration on business cycle comovements are not clear; to test the validity of the theories, an empirical investigation isin order. Canova and Dellas (1993) investigated this issue and found that there wassome evidence of trade affecting the transmission of disturbances across countries but it
was not robust to the choice of de-trending method. Frankel and Rose (1998) foundmore positive results. Based on 21 industrialized countries, they found that the morecountries trade with each other, the more highly correlated are their business cycles.
That is, there is a strong positive relationship between the degree of bilateral tradeintensity and the cross-country bilateral correlation of outputs.
These results can be interpreted to assure an early introduction of a monetary
union; it will also decrease the costs of adopting a monetary union by lowering
asymmetric shocks through increased trade. Even a country that is not suited ex ante tojoining a monetary union can be justified ex post facto in joining one due to lowered
asymmetrical shocks. However, an important step is missing in Frankel and Rose’s
analysis. Frankel and Rose (1998) conjectured that their results are due to intra-industry
trade, but did not try to identify the channel through which increased trade affects
business cycle co-movements.
Recently, Fidrmuc (2001) has shown that, based on a cross section of OECD
countries between 1990 and 1999, convergence of business cycles relates to intraindustry trade, but there is no direct relation between business cycles and bilateral tradeintensity. Loayza, Lopez and Ubide (2001) analyze the East Asian countries as a region
which shows significant short-run and long-run co-movement of business cycles. Theyfind that this co-movement is based on the countries’ highly similar trade structures.
Shin and Wang (2002) also find that intra-industry trade is the major channel by which
the business cycle of Korea becomes synchronized with that of 11 other Asian
economies, although increased trade itself does not necessarily lead to close businesscycle coherence. These recent empirical analyses suggest that business cycle comovements are strengthened only when the increased trade is accompanied by more
intra-industry trade. While a monetary union may increase trade afterwards, if mainly-14-inter-industry trade occurs, business cycle co-movements can be weakened and themonetary union become undesirable ex post facto.
Table 2 shows the trends in intra-industry trade for East Asian and European
countries. We calculated an index of intra-industry trade intensity à la Grubel and Lloyd(1975). In constructing the measure, an important consideration is to decide how
detailed a classification of industries is used. Rather than a priori determining a properindustry classification, we construct three measures based on two (IIT-2), three (IIT-3)
and four (IIT-4) digit industry classifications following the International Standard
Industrial Classification (ISIC).12 For each country, we report the average intra-industry
index for the trade with other countries in the same regions, using the trade volume asweights.
Most empirical studies widely confirm the hypothesis that measures of intraindustry trade relative to inter-industry trade decline steeply as the distance between the
trading partners increases. 13 In light of this finding, the intra-industry trade among
geographically neighboring East Asian countries should be high. However, the intraindustry trade index in East Asia was much lower than that of Europe in 1980: 31.3 vs.
60.8 for IIT-2, 22.6 vs. 52.0 for IIT-3 and 20.0 vs. 46.6 for IIT-4. This reflects that, in
1980, European countries, compared to East Asian countries, had more homogeneous
industry structures. 14 The index is monotonically increasing in both regions, but the
speed is much faster in East Asia, so that the gap becomes much smaller in 1999: 56.1
vs. 67.9 for IIT-2, 51.1 vs. 58.9 for IIT-3 and 45.0 vs. 52.3 for IIT-4. This is good news
for a monetary union because trade in East Asia not only increases but also occurs more
and more within the same industries. If this tendency continues, then business cycle comovement can be strengthened.
When we examine individual countries, this index is low in China, Indonesia,
Japan, Korea and Thailand – below the average in the region. Furthermore, the index isincreasing in most East Asian countries except for Hong Kong, China and Korea. If thistrend continues for these countries, then they are likely to have more asymmetric shocks
12

Industry-level trade data are available in Nicita and Olarreaga (2001), which reorganize the United
Nations Statistics Department’s Comtrade database through the World Bank’s World Integrated Trade
Solution (WITS) software. The industry disaggregation in the database follows the International Standard
Industrial Classification (ISIC) and is provided at the 2 digit level (9 industries), the 3 digit level (28industries) and at the 4 digit level (81 industries) manufacturing industries only.
13
See for example, Balassa (1986a, 1986b), Balassa and Bauwens (1987, 1988), Bergstrand (1983),
Culem and Lundberg (1986), Hummels and Levinsohn (1995), Loertscher and Wolter (1980), and Stoneand Lee (1995).
14
Rice, Stewart, and Venables (2002), by using the data of 22 OECD countries, find that closer countries
tend to have more similar structures of underlying export supply and import demand, and as aconsequence, intra-industry trade tends to be relatively high between close (and hence similar) countries.

-15-

over the business cycle, which may prevent them from joining a monetary union.
However, it is very difficult to predict how this trend will change in individual countries
without analyzing what factors contribute to fostering inter- or intra-industry trade. This
will be a good subject for future research.

Preventing Currency Crises and Saving Foreign Reserves
In Rose’s sample (2000), the 284 pairs of a monetary union with positive amounts ofbilateral trade are divided into 108 cases of country pairs that are also members of aformal free trade agreement (FTA) and 176 country pairs that are not (Melitz, 2001).
Since monetary unions may exaggerate exceptionally close trade ties through a formal
FTA, it is necessary to control the effect of FTAs on trade to correct the bias. In Rose
(2000), countries that use the same currencies tend to trade disproportionately, evenholding the various factors constant (including FTAs). A monetary union is expected toincrease trade, thereby promoting welfare. But, unlike FTAs, a monetary union goesbeyond anticipated welfare gains from larger trade. In this subsection, we will discuss
additional benefits from a monetary union.
It is clear form the experience of the East Asian crisis that an FTA is not helpful inpreventing or mitigating a financial crisis. While Indonesia, Malaysia, the Philippines
and Thailand are all members of the ASEAN free trade area (AFTA), AFTA did notplay any role in rescuing those countries. A more vivid example can be found in the
Common Market of the South (MERCOSUR) which is composed of Argentina, Brazil,
Paraguay and Uruguay. Since its creation, MERCOSUR has gone from a free trade area
to an imperfect customs union, adopting economic obligations in common. In the areaof macroeconomic coordination, it has established formal targets for fiscal deficits,
foreign public debt and inflation. However, those macroeconomic targets were notachieved because there were no strong incentives to do so in the absence of monetary
integration.
By contrast, a monetary union implies a more durable political commitment on themacroeconomic policy front. During the transition period, sound macroeconomic
preconditions must be fulfilled. Once a common monetary policy is implemented, morecomprehensive monitoring and surveillance activities over member economies are put
in place for maintaining the stability of the system. Concerted and coordinatedmacroeconomic policies are essential. To the extent that a lack of internal disciplines formonetary policy tends to persist, such countries would benefit the most from the-16-introduction of an external discipline from a monetary union (Alesina, Barro andTenreyro, 2002).
In addition, monetary union is a scheme for reducing foreign currency reserves at
the national level. Now East Asian countries are accumulating a huge amount of foreign
reserves to prevent future crises. As shown in table 3, foreign exchange reserves held byEast Asian economies in 2001 total as much as US$1 trillion. Japan's reserve assets
totaled US$388 billion as of the end of December 2001. China, together with Hong
Kong, has reserves of US$333 billion. The current level of foreign reserves in East Asia
is clearly excessive compared to the optimal level. This is clear when we compare thisamount to the foreign reserves held by the monetary union in Europe, which is about
one sixth of those held in East Asia. If the foreign reserves in East Asian countries werepooled through a central bank of a monetary union, each country would greatly benefit
from it.

Capital Market Integration
While a free trade agreement is not a precondition for a monetary union, a monetary
union usually presupposes that capital is freely mobile across member countries. East
Asian countries have been rapidly deregulating and opening up their capital markets
since the 1990s. Hence completely opening capital markets among East Asian countries
with the introduction of a currency union will not be a difficult task to accomplish. As
pointed out in Lee, Park and Shin (2002), however, East Asian capital markets are moreclosely tied to the global financial centers such as the U.S. and the U.K. and there is noclear evidence that the capital markets of the East Asian countries are more regionallyintegrated. This fact hints that large benefits may not result from further financial
integration in the region through a monetary union.
Lee, Park and Shin (2002) explain why financial integration is taking place at the
global level, not at the regional level. First, unlike home bias at the country level, there
are not many reasons for home bias to occur at the regional level. For example, hedging
is not especially easier by holding a regional portfolio. Information superiority at theregional level does not seem to be enormously more advantageous than at the global
level. Second, the institutional and structural characteristics of East Asian economies,
particularly in the financial systems are likely to limit the extent of regional financial
integration in the future. Especially underdevelopment of financial systems that arelargely bank-oriented leave corporations and financial institutions in the region heavily-17-dependent on Western securities firms, investment banks, insurance companies, andother non-bank financial institutions. Further the rapid development in information andcommunication technology enables local branches of western financial institutions to bewell connected to the centers at low costs. Third, the savings and investment profile is
not well matched within the region. Since the outbreak of the crisis in 1997, all of theEast Asian crisis countries have become net lenders and are likely to continue being so.
Hence the East Asian countries must rely on other areas as outlets for their net savings.
However, there is a possibility that introducing a monetary union can accelerate
the financial integration in East Asia. As pointed out in the case of trade, a monetary
union can endogenously change the nature of financial cooperation among member
countries. For example, a monetary union can eliminate the necessity of using a foreign
currency – particularly the U.S. dollar – for both trade in goods and financialtransactions among member countries, leaving fewer opportunities for foreign financial
institutions to step in. The absence of exchange risk among member countries can also
facilitate investment in their financial assets.
Free capital mobility was not allowed until the last stage of currency unification in
Europe. This is because, as explained in Wyplosz (2001), the conflict between exchange
rate stability and the active use of monetary policy was reconciled through internal andexternal financial repression. In particular, external financial repression took the form ofcapital controls so that arbitrage relative to the world interest rate could be prevented.
Therefore, while Europe has been quite fast at deepening its internal trade, it has beennotoriously slow at liberalizing its financial markets, both internally and externally. As
Europe has liberalized its capital accounts, such a formal coordinated (fixed but
adjustable) exchange rate mechanism was greatly endangered by volatile capital
movements. When capital controls were lifted, monetary union was preferred tomaintaining national monetary policies.

Political Aspects of a Monetary Union
One of the most important hindrances to introducing a monetary union in East Asia isrelated not to economic factors but to political factors. According to Eichengreen andBayoumi (1999), the debate over monetary integration in Western Europe has beenclosely related to discussions of political integration and the creation of a supranational
entity empowered to override previously sovereign national governments. While Europe
has a long history of movement towards integration, Eichengreen and Bayoumi (1999)-18-

point out that there has been resistance to the creation of a supranational authority andthe construction of institutional restraints on national policy every step of the way.
In this regard, East Asia has much weaker precedents of movement towards
political integration. For sure, this will act as a major obstacle to the creation of amonetary union. Traditionally, East Asian countries have put much emphasis on theirnational sovereignty. Given that a national currency is an important symbol ofsovereignty, relinquishing it can be interpreted as an act of humiliation to East Asianpeople.
Unlike trade integration, however, the nature of political objection is more or lessemotional and not based on differential economic consequences of a monetary union todifferent sectors of the economy. In this sense, economic conflicts among members of amonetary union can be less severe. This different nature of economic conflicts informing monetary union suggests that political resolution can be rather easier in somesense.

6. Conclusion
Regionalism is taking two forms. It is occurring firstly through free trade arrangements
and secondly through monetary arrangements. These trade and monetary integration
processes imply that geographically proximate countries hang together to foster trade on
the one hand and to manage intra-regional exchange rate stability on the other. These
two processes interactively reinforce each other.
In this paper, we highlight the issues related to the reversal of sequence between
trade integration (free trade agreement) and monetary integration (a monetary union).
While the Euro area pursued trade integration first, from a theoretical point of view,
there is no clear reason for introducing trade integration ahead of monetary integration.
In fact, even in Europe, trade integration slowed down whenever there were concerns
about exchange rate stability among member countries. In this regard, an important precondition for trade integration is a certain form of monetary cooperation.
We believe that there are many good reasons for forming a monetary union before
a free trade agreement. For example, a monetary union can increase trade among
member countries quite significantly by serving as a device to avoid a bottleneck thatcan be encountered during the process of a free trade agreement. Given that thisincreased trade is likely to occur mostly within the similar industries, weakening
asymmetric shocks across member countries will also decrease the costs of maintaining-19-

a monetary union. Further a monetary union can also accelerate financial integration in
the region, which might not be accomplished otherwise. Hence, a monetary union is aself-validating process.
A major hindrance to a monetary union in East Asia, however, is the lack ofhistorical experience in regionalism in the region. Whatever economic benefits amonetary union brings, however, it is unlikely to be realized in the near future if eachcountry is unwilling to cooperate in the political avenue.

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Table 1. Trends of Intra-region Trade in East Asia and Europe
Intra-region Trade(percentage of total trade)
1980
1990

2000

42.4
46.7
62.6
23.8
32.7
49.2
37.4
49.4
34.9
40.1
41.9

58.9
60.4
56.8
28.0
34.2
55.1
40.0
50.7
43.1
47.5
47.5

48.7
64.1
54.4
38.1
42.2
56.1
46.5
57.5
50.9
54.2
51.3

69.8
74.9
74.4
57.4
57.8
63.9
48.2
77.6
56.1
70.5
78.6
58.7
43.2
73.8
69.0
55.8
64.4

75.6
80.4
75.5
66.6
67.1
67.4
70.1
76.1
67.3
77.0
75.2
78.5
68.2
78.9
72.1
62.8
72.4

71.0
72.5
74.8
61.7
66.7
59.1
56.1
61.3
59.1
67.3
73.7
78.6
67.8
68.4
66.9
57.0
66.4

East Asia
China
Hong Kong
Indonesia
Japan
Korea
Malaysia
Philippines
Singapore
TaiwanThailandAverage

EuropeAustria
Belgium
Denmark
FinlandFranceGermany
GreeceIreland
Italy
Netherlands
NorwayPortugal
Spain
SwedenSwitzerland
United Kingdom
Average

Source: International Monetary Fund, Direction of Trade Statistics.
Note: this table is Table 4 in Lee, Park and shin (2202). Intra-region trade is measured by theshare of an economy’s trade with the rest of the economies that belong the same region, in total
trade.

-26-

Table 2. Trends of Intra-Industry Trade in East Asia and Europe (percentage)
IIT-2

1980
IIT-3

IIT-4

IIT-2

1990
IIT-3

IIT-4

IIT-2

1999
IIT-3

IIT-4

17.7
45.1
33.6
29.8
35.8
39.6
23.4
34.2
23.1
30.3
31.3

14.2
42.2
6.7
18.4
30.2
27.3
19.3
25.5
17.8
24.6
22.6

13.5
41.1
5.8
16.4
28.2
23.1
14.9
22.3
12.2
22.0
20.0

60.7
58.4
34.1
37.5
44.4
48.6
41.8
57.9
32.0
41.3
45.7

55.8
57.1
17.2
30.3
40.1
44.1
30.4
47.2
30.0
37.3
38.9

51.7
55.8
13.6
28.2
37.9
40.1
25.8
42.4
26.0
34.3
35.6

45.8
56.8
44.9
56.4
43.4
68.9
59.9
74.1
60.4
49.9
56.1

42.7
56.6
36.1
49.3
36.0
64.9
54.7
68.2
56.4
46.6
51.1

39.0
56.5
26.0
41.0
32.8
56.5
45.2
61.9
48.1
42.7
45.0

60.4
58.7
49.7
78.2
74.9
67.1
42.6
60.4
71.4
70.7
58.4
32.4
65.9
60.8

52.7
50.8
43.4
65.9
66.8
62.7
22.0
55.0
58.4
63.0
50.6
26.4
58.4
52.0

47.1
44.4
40.5
60.0
61.1
59.4
16.5
45.7
52.9
55.9
46.3
21.2
54.7
46.6

70.5
66.9
59.0
79.3
79.1
71.6
39.1
71.6
69.7
73.3
65.1
45.8
71.9
66.4

60.2
56.5
54.0
71.2
72.3
68.0
30.5
62.9
60.6
65.8
52.5
40.3
64.1
58.4

53.5
49.5
48.9
64.3
65.5
64.5
23.2
51.9
53.9
58.9
47.6
32.7
59.3
51.8

71.2
72.0
63.6
79.4
83.2
71.1
32.4
69.5
72.4
70.8
64.5
54.9
77.3
67.9

63.5
63.0
51.1
71.7
74.3
68.2
26.1
58.3
63.9
62.3
48.4
49.0
66.2
58.9

56.9
53.8
45.4
66.1
65.9
64.1
21.0
49.3
56.2
56.7
43.2
40.7
61.1
52.3

East Asia

China
Hong Kong
Indonesia
Japan
Korea
Malaysia
Philippines
Singapore
TaiwanThailandAverage
EuropeAustria
Denmark
FinlandFranceGBR

Germany
GreeceIreland
Italy
Netherlands
NorwayPortugal
SwedenAverage-27-

Table 3. Foreign Reserve of Asian and Other Countries(In millions US dollar)

Country
Japan
China
Korea
Indonesia
Malaysia
Philippines
Singapore
Thailand
Vietnam
Cambodia
Laos
Myanmar
ASEAN+31
Hong Kong
TaiwanSub-Total
Austria
Belgium
FinlandFranceGermany
GreeceIreland
Italy
Luxembourg
Netherlands
PortugalSpain
EMU Total
U.K.
Swiss
CanadaU.S.A.

1996
207,335
105,029
33,237
17,82026,156
9,902
76,49137,192
1,719
252
159
229
515,52163,80888,038667,367
21,861
15,3806,205
23,12075,803
17,337
7,715
44,06429
24,11915,3595,579
256,571
37,12336,77518,02838,294

1997
207,866
139,890
19,71016,08720,013
7,147
70,88325,697
1,973
287
100
250
509,903
92,804
83,502686,20918,605
14,5197,532
27,097
69,853
12,441
6,020
53,431
24
21,881
15,13066,023
312,556
28,87836,89915,12230,8091998
203,215
144,959
51,96322,401
24,7289,101
74,41828,434
2,000
315
106
315
561,955
89,601
90,341
741,897
20,91815,763
8,508
38,75364,133
17,188
8,622
25,447NA
17,536
15,06752,490284,425
27,36338,346
19,911
36,001

1999
277,708
154,675
73,70026,24529,67013,10376,30433,805
3,325
388
101
265
689,289
96,236106,200
891,725
14,0168,377
6,747
33,93352,661
17,726
4,826
18,623
NA
6,499
8,006
31,329202,743
30,077
34,17624,43232,182

2000
347,212
165,574
95,85528,28028,625
12,936
79,68531,933
3,416
502
139
223
794,380
107,542
106,742
1,008,664
13,492
7,988
7,330
32,114
49,667
13,116
4,983
22,423
NA
7,004
8,539
29,516
196,172
39,28130,854
28,841
31,238Source: IMF, International Financial Statistics 2002, Taiwan, Financial Statistics.
1) Data on Brunei are not available, thus not included.

-28-

2001
387,727
212,165
102,487
27,04829,585
13,31847,85132,350
3,660
586
138
400
857,315
111,155
122,211
1,090,681
11,444
8,743
7,192
26,363
43,615
4,787
5,196
20,905
NA
5,930
9,228
27,905
171,308
31,93830,13430,48428,981