The endogeneity of the Optimum Currency Area criteria in East Asia

Abstract

The Asian financial crisis in mid-1997 has increased interest in policies to achieve greater regional exchange rate stability in East Asia. It has renewed calls for greater monetary and exchange rate cooperation. A country's suitability to join a monetary union depends, inter alia, on the trade intensity and the business cycle synchronization with other potential members of the monetary union. However, these two Optimum Currency Area criteria are endogenous. Theoretically, the effect of increased trade integration (after the elimination of exchange fluctuations among the countries in the region) on the business cycle synchronization is ambiguous. Reduction in trade barriers can potentially increase industrial specialization by country and therefore resulting in more asymmetry business cycles from industry-specific shocks. On the other hand, increased trade integration may result in more highly correlated business cycles due to common demand shocks or intra-industry trade. If the second hypothesis is empirically verified, policy makers have little to worry about the region being unsynchronized in their business cycles as the business cycles will become more synchronized after the monetary union is formed. This paper assesses the dynamic relationships between trade, finance, specialization and business cycle synchronization for East Asian economies using a Generalized Method of Moments (GMM) approach. The dynamic panel approach improves on previous efforts to examine the business cycle correlationstrade link using panel procedures, which control for the potential endogeneity of all explanatory variables. Based on the findings on how trade, finance and sectoral specialization have effects on the size of common shocks among countries, potential policies that can help East Asian countries move closer toward a regional currency arrangement can be suggested. The empirical results of this study suggest that there exists scope for East Asia to form a monetary union.

Have economic growth and institutional quality contributed to poverty and inequality reduction in Asia?

“…Owing to heterogeneity in the characteristics of different countries, it is likely that the error-variance will not be constant across observations. The explanatory variables are also possibly endogenous and, including the lagged dependent variable on the right hand side of Equations 1 and 2, may lead to correlation between this variable and the first-differenced error [52]. In other words, since Pi,t and Ii,t are functions of ηi, Pi,t-1 and Ii,t-1 will also be functions of ηi.…”

“…In other words, since Pi,t and Ii,t are functions of ηi, Pi,t-1 and Ii,t-1 will also be functions of ηi. Hence, the lagged dependent variables will be correlated with the error term, resulting in biased and inconsistent estimators if the OLS estimation method is used [52]. The standard estimation methods using panel data are fixed effects or random effects, but neither of these methods can be used in this study since Equations 1 and 2 contain a lagged endogenous variable (poverty and inequality measure) [50].…”

“…The use of the first-differenced GMM estimator can, therefore, lead to large finite-sample downward biases [54]. The standard orthogonality conditions under the first-differenced GMM estimator do not hold when the levels series contain unit root [52].…”

“…This estimator estimates a set of first-differenced equations that use suitably lagged levels as instruments, as well as levels equations with suitably lagged first-differences as instruments. The system GMM estimator combines the two sets of moment conditions as a linear GMM estimator in a system that contains both first-differenced and level equations [52]. If unit roots are detected in the series, then following Blundell and Bond's [54] framework, this study will use both the levels and the differences of growth, institutional quality, and lagged poverty and income inequality measures as instrumental variables.…”

Business cycles synchronization in East Asia: A Markov-switching approach

“…The authors find an increasing role of region factor although country-specific factor are significant. Finally, some studies have emphasized the role of trade flows in synchronizing economic fluctuations in East Asia (see, e.g., Shin and Sohn , 2006;Rana , 2007;Lee and Azali , 2010).…”