Monday, May 7, 2007

A Common Currency for Asia?

From time to time, the idea of a common currency for Asia, similar to the Euro, is mentioned in the press (see, for example, here). It has been actively encouraged by Robert Mundell, winner of the 1999 Nobel Prize. Here I will briefly answer two questions: Is a common currency for Asia possible? And is it a good idea?

Starting with the second question first, a common currency should increase economic efficiency, for two reasons. In all international transactions, there are costs involved in exchanging wealth from one currency to another. The presence of these costs may reduce the willingness of firms to trade. But more importantly, there are risks involved in transacting between currencies. If I invest in assets denominated in another currency, that currency may appreciate or depreciate, potentially making the difference between turning a profit or a loss on my investment.

To understand the extent of this, in May 2000, one Euro bought 89 cents US. Today it buys $1.36 US. If an American invested in Euro denominated assets in 2000, the currency appreciation alone has earned them a 6.2% windfall gain PER YEAR, compounding, over and above any returns on their assets. In contrast, a European investing in the United States has been loosing the same amount.

Investors are risk averse, and respond to risk by reducing their exposure- in this case, by limiting trade across currencies. They may also spend real resources in trying to protect themselves from currency fluctuations, by "hedging" away currency risk, again reducing economic efficiency. These costs would be avoided by adopting a common currency.

But there are also costs to adopting a common currency. Most importantly, monetary policy will be identical across all economies using the common currency, even though individual countries will be subject to different economic shocks and business cycles. The cost of this loss of monetary policy depends on how flexible prices and wages are, i.e. the degree to which the economy can rapidly adjust in response to macroeconomic shocks.

So to answer the question of whether a common currency is a good idea, we would need to weigh the relative benefits of increased efficiency against the relative costs of losing monetary policy as an effective tool to steer the economy.

Moving on to the second question, whether a common currency for Asia is possible, the simple answer is "not for a long time." To understand why, we can look to the experience in Europe.

The development of the Euro in Europe was the result of a drawn-out political process start started with the European Common Market in the late 1950's (see here for a history). It took almost 50 years from the start of the political process to the common currency we have today, and each of the countries involved has sacrificed independent monetary policy to be set by a joint central bank, housed in Frankfurt, Germany.

Consider the situation in Asia. Suppose that the major economies of Asia agreed to a joint central bank. Where would such a central bank be situated? The largest economies are Japan and China, so they are the obvious candidates. However, at the current time it is inconceivable that either country would be willing to allow the central bank to be housed in the other country! And that is just a trivial matter next to the more important agreements that would have to be reached on how monetary policy would be set, and what objectives the central bank should seek to achieve! Developing a common currency requires a high degree of political co-operation and integration, neither of which is evident in Asia!

To be clear, I do not expect to see a common currency in Asia within my lifetime.... and I expect to live a long time!

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