Blog Post

Who would bet on currency unions after EMU crisis?

The European Monetary Union (EMU) was founded with the idea that nominal convergence would bring real convergence, but structural differences between members have proven wide enough to generate lasting asymmetric negative shocks across the euro area.

By: and Date: March 29, 2017 Topic: Global Economics & Governance

The recent years of crisis have made clear that real convergence in the euro area has been insufficient to prevent stress through asymmetric shocks. Following this experience, and building on earlier work, we assess the opportunities for current union in the two most promising integration processes in the emerging world: ASEAN and the Pacific Alliance. We conclude that both blocs are also far from an Optimal Currency Area (OCA) and should pursue other forms of coordination to be successful.

Economic and financial integration still in its early stages

The degree of integration in the ASEAN, and particularly in the Pacific Alliance, is limited compared to EMU standards when measured as financial, trade and migration relations (Chart 1). Given a negative correlation between the size and openness of countries, this result is widely consistent with the dimensions of the different economic areas. However, other factors might be playing a significant role. These include geographical conditions, which ease trade through land connections in the EMU and through maritime routes in the ASEAN, in clear contrast with the harder natural barriers present in the Pacific Alliance. Lower levels of financial development in the ASEAN and Pacific Alliance regions must also be having an impact through limited cross-border flows.

Chart 1. Intraregional economic relations by area

Percentage of total relations, latest available data

*Including construction and utilities

Note: dotted lines correspond to the simple average of all indicators in each area

Source: own estimations from IMF, OECD and United Nations data

chart 1 Alicia smaller

Maastricht-like nominal criteria fairly simple to meet

The so-called convergence criteria for EMU membership, which were all established in nominal terms, aimed to homogenise the conditions in which a single monetary policy would be implemented. If we were now to apply similar standards to the ASEAN and the Pacific Alliance members, we find that both integration blocs display dispersion levels not higher than in EMU at the time of its foundation– despite a certain degree of heterogeneity among their members (Chart 2A).

In addition, further promising conclusions are drawn when using a tentative Taylor rule, estimating interest rates adjusted for cyclical and inflationary conditions. This shows that in the Pacific Alliance deviations between countries are limited, while the ASEAN would not be worse off than the EMU (Chart 2B).

Having said that, and according to the experience of the EMU during the last 15 years, we have seen that nominal convergence criteria do not eliminate by themselves distortions that affect the implementation of a single monetary policy, requiring real divergences to be minimised.

Chart 2. Nominal convergence and estimated Taylor rule

Chart 2B: Deviation from area average (2014)*

*The reference interest rate is fixed according to the Taylor rule following Nechio (2011): 1 + 1.5*Headline Inflation – Unemployment Rate Gap (gap as the difference between the observed unemployment rate and the 11-year moving average); area average weighted by PPP-adjusted GDP

Source: own estimations from OECD and IMF data

chart 2b Alicia smaller

On-going convergence of income per capita

The Pacific Alliance shows today a degree of convergence (or divergence) similar to the existing one in the EMU in terms of GDP per capita (Chart 3A). Average growth since 2000 has been higher among countries with the lowest development levels (Colombia and Peru) relative to the most developed economies in the area (Chile and Mexico). The narrowing of the income gap has been founded on a higher growth of total factor productivity (TFP) in the less developed countries, while factor accumulation per capita has been pretty similar in both member groups (Chart 3B).

In the case of the ASEAN region, despite positive developments in terms of GDP per capita convergence, dispersion is still very high and much greater than in the other two integration areas. The development levels of some ASEAN members is at opposite ends of the global range: Singapore and Brunei average more than 70000 PPP-adjusted dollars per capita, while Cambodia, Laos, Myanmar and Vietnam do not even reach 6000 dollars. Contrary to what happens in the Pacific Alliance, factor accumulation is the converging driver in the case of the ASEAN. Meanwhile TFP, which increases across the board, shows a faster growth in more developed economies. This latter fact warns us about future divergence risks once the accumulation of labour and capital start to fade away in less developed economies as they reach later stages of income transition.

Chart 3. Real convergence: GDP per capita

Chart 3A: Coefficient of variation for GDP per capita*

*Ratio of the standard deviation to the average of PPP-adjusted GDP per capita; we use population shares for the weighted average

Source: own estimations from IMF data

 

chart 3a Alicia

Chart 3B: Contributions to GDP per capita annual change*

*“ASEAN with higher development” includes Singapore and Malaysia; “ASEAN with middle development” Thailand, Indonesia and the Philippines; and “ASEAN with lower development” Vietnam and Cambodia

Source: own elaboration from The Conference Board and United Nations data

chart 3b Alicia smaller

Asymmetric shocks still very significant

Despite progress in GDP per capita convergence, there is still wide dispersion in competitiveness capacities and in productive structure among countries of the ASEAN and the Pacific Alliance. This affecting the nature of domestic shocks and the response to external shocks, and would therefore distort the management of a single monetary policy.

The degree of divergence is large particularly due to the fact that some members are producers and exporters of raw materials, while others present a very different characterisation of their manufacturing industries in terms of technological content. For instance, in the ASEAN, Cambodia is specialised in textiles and Singapore in chemical and electronic products. In the Pacific Alliance, the share of industries linked to raw materials is high in Colombia and Chile, while Mexico is specialised in automobile industries, electronics and electric manufacturing.

In order to test the importance of these real divergences, we estimate a structural vector autoregression for each available country in the ASEAN and the Pacific Alliance, as well the 11 largest countries in the EMU. We run estimations with quarterly data from Q1/2000 to Q2/2015, extracting external and domestic supply and demand shocks under structural restrictions, following the methodology used in García-Herrero (2014).

The results are shown in Charts 4 and 5. In the best case scenario the Pacific Alliance would be close to the correlation of domestic shocks present in the EMU. But divergences are quite substantial within the ASEAN, and would be even greater if we take into account that data for countries with lower development – such as Cambodia, Laos, Myanmar and Vietnam – is not available.

Chart 5. Real convergence: shocks*

Average correlation of shocks with other area members (2000-2015)

External shocks

*Countries ranked by the average of all shocks correlation

Source: own estimations

 

chart 5a Alicia smaller

Domestic shocks

chart 5b Alicia smaller

Don’t give up, avoid short-cuts and follow other paths for further integration

As shown, progress in the degree of real convergence, which plays a critical role on the transition towards an efficient single monetary policy, is very limited so far in both the Pacific Alliance and, particularly, in the ASEAN. Divergences among members in these two areas are considerable when competitiveness conditions and the productive structure are assessed, conditioning quite heterogeneous domestic shocks and sensitivities to external shocks. These divergences are even more acute due to the limited development of risk mutualisation mechanisms. EMU experience shows how dangerous this can be for a currency area: Greece represents a meagre 2% of EMU’s GDP in contrast with the substantial financial turmoil its situation triggered.

Furthermore, moderate financial deepening (Chart 6) and high reliability on foreign currency in certain markets are significant obstacles for the implementation of a single monetary policy in the two emerging integration processes here considered.

These conclusions perfectly coexist with the fact that both the ASEAN and the Pacific Alliance are indeed making progress in other integration dimensions that could end up in significant welfare gains, either through higher growth and employment rates or through greater financial stability. Cooperation areas are diverse and range from increasing labour mobility to technological diffusion, and their development could pave the way for more ambitious integration steps in the future.

Chart 6. Development of financial markets

Percentage of GDP (2011)

Source: own elaboration from World Bank’s Global Financial Development Database (GFDD)

chart 6 Alicia smaller

References

García-Herero, A., 2014: “How close is Asia to an optimal currency in terms of business cycle co-movement?”, IMES Discussion Paper No. 2014-E-12.

 


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

View comments
Read article Download PDF

External Publication

European Parliament

The single monetary policy and its decentralised implementation: An assessment

This paper assesses the decentralised implementation of monetary policy by the Eurosystem in terms of its transparency, efficiency and simplicity. Compared to the Fed, the Eurosystem seems to have higher staff numbers and operational costs for similar tasks.

By: Francesco Papadia and Alexander Roth Topic: European Macroeconomics & Governance, European Parliament, Testimonies Date: October 4, 2017
Read about event More on this topic

Past Event

Past Event

Europe and Japan: Monetary policies in the age of uncertainty

The 5th Bruegel - Graduate School of Economics, Kobe University conference will focus on monetary policy.

Speakers: Kosuke Aoki, Ulrich Bindseil, Grégory Claeys, Zsolt Darvas, Ester Faia, Lex Hoogduin, Martin Hellwig, Miles Kimball, Eric Lonergan, Benoît Mojon, Tamotsu Nakamura, Marianne Nessén, Athanasios Orphanides, Wataru Takahashi, Tokiko Shimizu and Guntram B. Wolff Topic: Global Economics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: October 2, 2017
Read article Download PDF More on this topic

Policy Contribution

A European perspective on overindebtedness

The sequence of crisis and policy responses after mid-2007 was a gradual recognition of the unsustainability of the euro-area policy framework. The bank-sovereign vicious circle was first observed in 2009 and became widely acknowledged in the course of 2011 and early 2012. The most impactful initiative has been the initiation of a banking union in mid-2012, but this remains incomplete and needs strengthening.

By: Nicolas Véron and Jeromin Zettelmeyer Topic: European Macroeconomics & Governance Date: September 28, 2017
Read article Download PDF More by this author

Policy Contribution

Dutch Senate

Europe’s fourfold union: Updating the 2012 vision

The depiction of the euro area/European Union (EU) as a ‘fourfold union’ emerged in the first half of 2012 at the height of the euro-area crisis. In the past half-decade, Europe’s financial union has been significantly strengthened but remains incomplete and is challenged by Brexit. No consensus has been found on fiscal union and economic union has not made material progress, but political union might have advanced further than many observers realize.

By: Nicolas Véron Topic: Dutch Senate, European Macroeconomics & Governance, Finance & Financial Regulation, Testimonies Date: September 21, 2017
Read article More on this topic More by this author

Opinion

Hong Kong should add the euro to its dollar peg

Volatility offers an opportunity for the territory to rethink its strategy. With the economy now more synchronised with China than ever before, the dollar peg may no longer provide an accurate reflection of the real value of the Hong Kong dollar.

By: Alicia García-Herrero Topic: Global Economics & Governance Date: September 12, 2017
Read article More on this topic More by this author

Blog Post

The international effects of ECB’s monetary policy

What’s at stake: the literature on monetary policy spillovers is abundant of studies investigating the impact of the US Federal Reserve’s monetary policy announcements and actions on emerging market economies. More recently, economists have been investigating the effect of the ECB’s credit easing as well.

By: Silvia Merler Topic: European Macroeconomics & Governance Date: July 24, 2017
Read article More on this topic More by this author

Blog Post

The forward guidance paradox

What’s at stake: the term “forward guidance” is used in economic jargon to describe central bank communications about the likely future path of policy rates. Standard monetary models imply that far future forward guidance has huge effects on current outcomes, and recent literature has been trying to reconcile this with reality.

By: Silvia Merler Topic: European Macroeconomics & Governance Date: July 10, 2017
Read article More on this topic More by this author

Blog Post

Cryptoeconomics – the opportunities and challenges of blockchain

While the activities using the peer-to-peer cryptocurrency Bitcoin swing between legal and illegal, the attention has been increasingly shifting to the technology underlying Bitcoin, known as blockchain. The mechanics and economics of Bitcoin have been reviewed in a previous Bruegel blogpost. In this blog review we explain, or at least attempt to, what blockchain is and whether it contains the extraordinary innovation potential that its proponents believe it to have, or perhaps such hype is oversold.

By: Uuriintuya Batsaikhan Topic: Innovation & Competition Policy Date: July 3, 2017
Read article More on this topic More by this author

Blog Post

Eurozone or EU budget? Confronting a complex political question

This week’s European Commission reflection paper is the latest document to ponder a distinction between EU and euro-area budgets. But do we need to split the two, and what would each budget be used for? In this post, I present an analytical framework for assessing this ultimately political question

By: Guntram B. Wolff Topic: European Macroeconomics & Governance Date: June 29, 2017
Read about event More on this topic

Past Event

Past Event

Can EMU survive a multi speed Europe?

On 6 April Bruegel, as in previous years, hosted the presentation of the Euro Yearbook, a collection of experts’ insights on the construction of the European Monetary Union through 2016.

Speakers: Pablo Zalba Bidegain, Maria Demertzis, Fernando Fernandez, Javier Méndez Llera, Karl Pichelmann and Guntram B. Wolff Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: April 6, 2017
Read about event More on this topic

Past Event

Past Event

Central bank communication in a low interest rate environment

At this event, we are pleased to welcome Mr. Benoît Coeuré, Member of the Executive Board of the European Central Bank at Bruegel.

Speakers: Benoît Coeuré and Guntram B. Wolff Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: March 31, 2017
Read article More on this topic More by this author

Blog Post

Why was the last TLTRO take-up unexpectedly high?

The final round of TLTRO financing was an unexpected hit with euro area banks. The aim of the programme is to encourage banks to increase lending to the real economy. However, with many now expecting a hike in deposit rates, banks’ enthusiasm might be driven largely by the chance to make a profit from the cheap loans.

By: Justine Feliu Topic: European Macroeconomics & Governance Date: March 27, 2017
Load more posts