10 the US dollar and the deutsche mark on three OCA criteria (i.e., relative output variability, similarity of export structure, and strength of bilateral trade), and found that the OCA criteria explained the degree of bilateral exchange rate stability reasonably well. In other words, it was generally found that the first coefficient was positive, and the second and third coefficients were negative, suggesting that asymmetric shocks give incentives for exchange rate flexibility while trade integration leads to more stability. It should also be noted that while OCA theory may explain the degree of exchange rate volatility among East Asian economies, it does not explain their pegging behavior vis-A-vis the major international currencies, notably the high degree of nominal stability against the US dollar. It is possible that the "excess" stability of East Asian currencies against the US dollar (beyond what can be explained by OCA theory on the basis of bilateral linkage) is accounted for by the importance of trade linkage with other countries in the US dollar bloc (Kawai and Akiyama 2000).

While, all in all, the economies of East Asia appear to be plausible candidates for internationally harmonized monetary policies on standard OCA grounds, no less than the members of the European Union, attention has recently been directed to the self-evident fact that some of the celebrated OCA criteria are endogenous. In other words, it is likely that the very act of forning monetary union contributes to the fostering of an optimal currency area, thereby strengthening international trade linkages and the correlation of business cycles.'<sup>1</sup> Indeed, the indices measuring the degree of simulated exchange rate volatility (based on OCA theory) of major Western European countries are shown to have declined rapidly from 1987 to 1995 (Bayoumi, Eichengreen and Mauro 2000). What this means in the context of East Asia is that the OCA criteria by themselves do not provide the overriding basis for determining the type of exchange rate arrangement to be chosen, although they may be useful for giving a quantitative sense of the reasonableness of one type of exchange rate regime or another in a particular situation.

# **2. Integration through Trade and FDI**

In terms of trade shares, East Asia is almost equally connected with Japan, the United States and the European Union (Table 3). During 1990-98, for exports, the United States was by far the most important market for principal Asian exporters, such as Malaysia, the Philippines, Singapore, Thailand, Hong Kong, Korea and Taiwan, although Japan was more important for Vietnam, China and the resource exporting countries of Brunei and Indonesia. For imports, Japan was the most important source country, except in Brunei (for which the European Union was the most important). For total trade (exports plus imports), Japan was the largest trading partner for Indonesia (26 percent), Thailand (23 percent), Malaysia (19 percent) and China (18 " It should be noted that, theoretically, closer trade ties could result in either tighter or looser correlation of national business cycles. Cycles could become more idiosyncratic, if countries become more specialized. On the other hand, if demand shocks are dominant, or there are more common (supply and/or demand) shocks, or intra-industry trade accounts for most trade, cycles may become more similar. Concentrating their attention on the relationship between trade links and business cycle correlation, Frankel and Rose (1998) analyzed the panel data of 21 industrial countries over 30 years to obtain a strong positive relationship, i.e., closer international trade links result in more closely correlated business cycles across countries. This result is robust with respect to the choice of a particular measure of bilateral trade intensity (e.g., imports, exports or total of imports and exports) or bilateral real activity correlation (e.g. GDP, industrial production, or employment).