The European Experience with Monetary and Exchange Rate Co-operation: Potential lessons for Asia?

Preliminary draft Comments welcome The European Experience with Monetary and Exchange Rate Co-operation: Potential lessons for Asia? By Michael Chui, Richard Morris and Georges Pineau 1 April 2002 1 We would like to thank E. Dorrucci, P. van der Haegen, P. Petit, O. Tristani and participants at the Kobe Research Project seminar on Regional economic, finanacial and monetary co-operation: the European and Asian experiences for their helpful comments and suggestions. The views expressed are those of the authors and do not necessarily reflect those of the ECB.

TABLE OF CONTENTS 1. INTRODUCTION...3 2. DESIRABILITY OF CLOSER MONETARY AND EXCHANGE RATE CO-OPERATION...4 2.1 THE PLUSES...4 2.2 THE MINUSES...8 3. MEETING THE POLICY REQUIREMENTS FOR SUCCESSFUL MONETARY AND EXCHANGE RATE CO-OPERATION...12 3.1 POLITICAL, INSTITUTIONAL AND LEGAL UNDERPINNINGS...12 3.1.1 The political, institutional and legal nature of the Community...13 3.1.2 Importance of political, institutional and legal underpinnings for monetary and exchange rate cooperation...14 3.2 TRADE INTEGRATION...15 3.2.1 European trade integration creating a single market...16 3.2.2 Trade integration and exchange rate stability...18 3.3 REGIONAL FINANCIAL STABILITY...20 3.3.1 Harmonisation and mutual recognition of national regulations...21 3.3.2 Decentralised but closely co-ordinated supervision...22 3.4 MACRO-ECONOMIC CONVERGENCE, POLICY CO-ORDINATION AND MUTUAL SURVEILLANCE...23 3.4.1 A brief history of European monetary and economic policy co-ordination...24 3.4.2 European macroeconomic convergence after 1993...26 4. CONCLUSION...30 2

1. Introduction Since the collapse of the Bretton Woods system of pegged but adjustable exchange rates, most countries have pursued autonomous monetary and exchange rate policies. In some countries, monetary policy has, together with other economic policies, been geared directly towards the achievement of domestic policy goals, such as smoothing output and employment growth and price stability while the external value of the currency has been allowed to fluctuate. In other countries, and during certain periods, a fixed or targeted exchange rate has provided either an implicit or explicit external anchor or intermediate target for monetary policy. However, even in this second group, the maintenance of a fixed or targeted exchange rate has normally constituted a unilateral commitment rather than being part of any wider multilateral framework of monetary and exchange rate co-operation. The European experience stands in stark contrast to this generally observed trend. Since the collapse of the Bretton Woods system, an initially small, but subsequently growing number of countries within the European Community have conducted their monetary and exchange rate policies within an institutionalised framework of regional co-operation. On 1 January 1999, 11 of these (now 12) countries eliminated exchange rate fluctuations altogether by adopting a common currency. This successful European experience has provoked a growing interest in the potential for regional monetary and/or exchange rate arrangements in other parts of the world. The adoption of the single European currency, together with the increased globalisation of the world economy, also seems to have given rise to a growing perception that in future, the number of currencies in existence is likely to fall, with some national currencies being replaced by regional ones. In this sense, the era of national monies which are managed autonomously for the pursuit of purely domestic interests may be passing. In its place may emerge a new era more akin to that which existed in the late 19 th century and beginning of the 20 th century when a global trading and financial system was accompanied by a widely accepted common monetary standard, coupled with a limited number of currencies that were used beyond the national boundaries of the issuing countries. For those who advocate the benefits of regional or common currencies, Asia is one region which has been mentioned as a potential candidate for closer monetary and exchange rate co-operation. This owes, presumably, to the perceived characteristics of Asia as a rapidly developing region with open, export-oriented economies and thus a keen interest in monetary and exchange rate stability. Moreover, a number of countries in Asia have already taken some steps towards closer intra-regional economic integration, also in the institutional sense, through the creation of fora such as the Association of South-East Asian Nations (ASEAN), the ASEAN+3 and the Executives Meeting of East Asia-Pacific Central Banks (EMEAP). Within these fora, initiatives are being undertaken to promote closer trade and financial market integration and regional economic surveillance. 3

Proposals for closer monetary and exchange rate co-operation in Asia are also being studied. At a meeting in Hanoi on 15-16 December 1998, ASEAN leaders endorsed a project to study the feasibility of an ASEAN common currency and exchange rate system. To this end, an ASEAN Currency and Exchange Rate Mechanisms Task Force was established in August 2000 with the aim of facilitating discussion and carrying out work in examining the feasibility of an ASEAN single currency. In May 2000, the ASEAN+3 launched the Chiang Mai initiative which, currently being implemented, will augment the ASEAN swap arrangement of 1977 and supplement it with bilateral swap and repurchase arrangements to provide, respectively, balance of payments assistance and very-short-term liquidity. The Chiang Mai initiative is seen by some as the first concrete step towards greater regional exchange rate stability. Given this interest to consider the potential for closer monetary and exchange rate co-operation, we examine whether there might be potential lessons from the European experience which would be relevant for Asia. We begin by assessing the principal similarities and differences between Asia and Europe as regards the economic, political economy and institutional characteristics which are likely to provide the motives and serve as the key policy requirements for successful monetary and exchange rate co-operation. On this basis, we then go on to discuss the European experience in those areas which we consider to be most likely to offer potentially useful lessons to Asia at this stage. 2. Desirability of closer monetary and exchange rate co-operation Bayoumi and Eichengreen (1999) and Bayoumi, Eichengreen and Mauro (2000), drawing on the theory of optimum currency areas (OCAs), assess the economic costs and benefits of closer monetary co-operation in Asia. In comparing the fulfilment of the OCA criteria in Asia and in Europe, they conclude that some Asian countries are not far behind Europe in terms of meeting the standard preconditions for greater monetary integration. However, they identify a lack of institutional integration as a major obstacle. Along similar lines we present our assessment of the desirability of closer monetary and exchange rate co-operation in Asia in terms of the following pluses and minuses. 2.1 The pluses One of the main benefits of monetary and exchange rate co-operation is that the ensuing reduction of exchange rate variability should reduce the risks and hence the costs of engaging in cross border trade (see also section 3). In this respect, the greater the degree of intra-regional trade, the larger is the potential welfare gain. We examine two simple measures of intra-regional trade: as a percentage of total regional trade and total regional GDP. While the former shows the importance of trade linkages within the region, the latter captures also the degree of openness in the region. Table 1 shows that intra-regional trade as a percentage of total regional trade in both the EU and the euro area were over 50 percent in 1995 and 2000, far higher than that in the ASEAN and Mercosur. However, in term of 4

total regional GDP, the figures are similar for the EU and ASEAN, which are in turn much higher than that for Mercosur, reflecting the high degree of openness of the Asian countries. Table 1: Intra-regional trade patterns 1995 2000 Exports Imports Exports Imports Percentage of total regional trade ASEAN 5 a 23.2 17.8 22.4 22.6 ASEAN b 25.3 19.1 23.9 24.3 ASEAN+3 c 35.2 39.8 33.9 42.4 EU 62.4 61.0 62.1 57.9 Euro area 52.1 51.3 50.8 48.1 Mercosur d 22.6 20.3 23.5 23.9 Percentage of total regional GDP ASEAN 5 a 11.7 9.9 17.0 14.6 ASEAN b 12.6 10.5 17.6 15.3 ASEAN+3 c 5.2 5.4 6.5 7.0 EU 14.6 13.6 18.0 16.8 Euro area 12.2 11.2 15.6 14.6 Mercosur d 1.9 1.8 2.3 2.5 Sources IMF, Direction of Trade Statistics, and World Economic Outlook, and the World Bank World Development Indicators, 2001. a ASEAN 5: Indonesia, Malaysia, Philippines, Singapore and Thailand. b ASEAN: ASEAN 5, Brunei, Cambodia, Laos, Myanmar and Vietnam. c ASEAN + 3: ASEAN, China, Japan and Korea. d Mercosur: Argentina, Brazil, Paraguay, Uruguay and associate members Bolivia and Chile. These welfare gains are also likely to be greater for countries which have a relatively high proportion of manufactures in total exports, as the prices of these products are to a larger extent determined by the domestic producers, as opposed to the commodities prices that are set in international markets. Figure 1 shows that for the ASEAN 5 (Indonesia, Malaysia, Philippines, Singapore and Thailand) and for the European Community over 70 percent of total exports are of manufacturing goods, which again is much higher than for Mercosur (around 40 percent). 2 The importance of regional exchange rate stability to many of the non-japan Asian countries is already reflected in their recent bilateral dollar exchange rate movements. Before the 1997/98 crisis, most Asian currencies (except the Hong Kong dollar) were officially pegged to a basket of convertible currencies from industrial currencies. It has been well documented, however, that they actually followed a de facto US dollar peg. 3 One main advantage of these arrangements was to avoid competitive devaluations and their adverse effects on intra-regional trade and on exports to third markets, in particular the US. During the 1997/98 crisis, a number of Asian currencies depreciated sharply, forcing an abandonment of the exchange rate pegs. But starting from late 1998 when most 2 But one might argue that a large proportion of the exports of some Asian countries such as Malaysia, Korea, the Philippines and Singapore are electronic products with prices being set internationally. 5

Figure 1: Maufactures exports as a percentage of total merchandise exports* Percent ASEAN5 ASEAN5 + 3 Euro area EU Mercosur 100 80 60 40 20 0 1995 1996 1997 1998 1999 Source: World Development Indicators, 2001, World Bank. * Manufactures comprises commodities in SITC section 5 (chemicals), 6 (basic manufactures), 7 (machinery and transport equipment), and 8 (miscellaneous manufactured goods), excluding division 68 (non-ferrous metals). Asian economies started to recover, their currencies appear to have reverted to something like a peg to the US dollar, albeit a more flexible one. The trend has been more apparent recently as the yen has depreciated against the dollar (see Figure 2). 4 In this context, closer monetary policy co-ordination could not only help to foster greater exchange rate stability, but also reduce the disruptions caused by large fluctuations in the yen-dollar bilateral exchange rate. Figure 2: Selected Asian exchange rates against the US dollar. Japan Singapore Philippines Korea Taiwan Thailand Jan 01=100 120 115 110 105 100 95 Jan-01 Apr-01 Jul-01 Oct-01 Jan-02 90 Source: Bloomberg. 3 See, for example, Frankel and Wei (1994) and McKinnon (2000). 4 For empirical evidence, see McKinnon (2000) and Ogawa (2001). 6

In this context, it should be mentioned that the importance of extra-regional trade compared to intraregional trade is one feature which clearly distinguishes Asia from Europe. In our view, such a distinction does not however detract from the importance of cross border trade as a motivation for Asian monetary and exchange rate co-operation. Regional exchange rate stability remains important for Asia in order to avoid the distorting impact of exchange rate fluctuations on competition for exports to important third markets. Rather, the implication is that the design of any future regional monetary and exchange rate co-operation in Asia may differ from the European model, reflecting the importance of extra-regional trade by incorporating some form of external anchor (e.g. a peg or reference to a basket of external currencies). Meanwhile, one of the main potential costs of closely co-ordinated monetary policies is the partial surrender of the option of adopting counter-cyclical monetary policy measures in responding to asymmetric shocks. Countries are arguably better off retaining full control of monetary and exchange rate policy if they exhibit very different business cycles. Bayoumi and Eichengreen (1994), use structural vector autoregression techniques (VARs) to examine business cycles in Western Europe, the Americas and Asia. They find that while Northern Europe (Germany, France, the Netherlands, Belgium, Denmark, Austria and possibly Switzerland), Northeast Asia (Japan, Taipei and Korea); and Southeast Asia (Hong Kong, Singapore, Malaysia, Indonesia, and possibly Thailand) face similar underlying disturbances, the North American or Mercosur countries do not appear to satisfy this criterion. Bayoumi, Eichengreen and Mauro (2000) extend their previous studies to derive underlying domestic aggregate supply and demand disturbances for the ASEAN 5 (1968 1996) and the EU countries (1969 1989). Their results suggest that the aggregate supply disturbances affecting Indonesia, Malaysia and Singapore are relatively highly correlated, while the Philippines and Thailand experience more idiosyncratic shocks. The results are similar to the European experience, where shocks appear to be relatively highly correlated between Germany and France, while those affecting Italy and Spain are more idiosyncratic. One might argue that the convergent business cycles in the emerging Asian economies are themselves driven by the business cycles in the industrialised countries, in particular the United States, and/or common external shocks such as movements in US real interest rates. In the latter case, pegging to the US dollar might be deemed an appropriate exchange rate policy and the development of regional monetary and exchange rate arrangements unnecessary. However, recent empirical work suggests for most emerging markets, output shocks are largely domestically driven. Ahmed (1999) finds that for Argentina, Brazil and Mexico, domestic shocks account for around 80 percent of output fluctuations. Similar results for the ASEAN countries are reported in Ahmed and Loungani (1998). Also, Larsen and Aziz (1997) find evidence that there has been an apparent decoupling in the business cycles of the ASEAN countries and those of the industrialised countries. 7

The need for an independent counter-cyclical monetary policy and hence the potential cost of institutionalised monetary and exchange rate co-operation also increases with the rigidity of domestic factor markets. For example, a country with a more flexible labour market should more easily absorb external shocks through wage-price adjustments. While there exists a large literature on measuring labour market flexibility in Europe (see for example Nickell, 1997), similar empirical research on Asian labour markets is constrained by data availability. Any reasonable measure of labour market flexibility needs to take into account a large number of both quantitative and qualitative features of the labour market such as the level and availability of unemployment benefits, restrictions on hiring and firing and trade union power. Notwithstanding these difficulties, Bayoumi, Eichengreen and Mauro (2000) present empirical results showing that the speed of adjustment to shocks in the ASEAN 5 countries is much faster than in European countries, thus suggesting that the former region has more flexible labour markets. Another factor which seems to count in Asia s favour is fiscal sustainability. The stronger a country s fiscal position, the greater the scope for that country to use fiscal policy to respond to shocks, and hence the less need for a fully autonomous monetary policy. Despite the large restructuring costs borne out by Asian governments after the 1997/98 crisis, their fiscal deficits remain small by emerging market standards (Table 2). Table 2: General government fiscal balance Per cent of GDP Forecast 1996 1997 1998 1999 2000 2001 2002 China 1.5 1.8 3.0 4.0 3.6 3.2 3.2 Korea 1.0 0.9 3.8 2.7 2.5 2.0 1.2 ASEAN 5 Indonesia 0.6 2.1 1.5 2.3 3.7 2.5 Malaysia 2.6 1.8 4.1 4.2 5.9 3.5 Philippines 0.6 2.1 1.5 3.4 1.4 Singapore 9.3 9.2 3.6 4.5 7.9 6.3 3.1 Thailand 2.8 3.2 8.4 12.3 4.1 Sources: World Bank and IMF WEO December, 2001. 2.2 The minuses In the previous section, we examined the OCA criteria concerning trade integration and business cycle synchronisation and argued that on the basis of these criteria, some Asian countries could benefit from closer monetary and exchange rate co-operation. In this respect, Frankel and Rose (1998) have argued that the relationship between these criteria is endogenous, and theoretically, increased trade integration may result in either more correlated business cycles through common demand shocks or more asynchronous business cycles from industry-specific shocks. Using thirty years of data for twenty industrialised countries, they find empirical evidence of closer international trade links resulting in more closely correlated business cycles across countries. In other words, trade and economic 8

integration appears to be mutually reinforcing. In addition, interaction between trade/economic integration and institutional integration can work both ways. Either, institutional integration is used to foster trade/economic integration or actual progress made in trade/economic integration would at some stage make further institutional integration desirable or even necessary to preserve the achieved degree of real interdependence. It seems that the first alternative is well illustrated by the European experience (see below), while Asian countries might face the need to bring institutional integration more in line with the actual degree of trade/economic interdependence that they have already achieved. Progress in institutional integration in Asia has, however, been slow until now. This reflects mainly a lack of political momentum as compared with the European countries. In Europe (see below), economic and monetary co-operation was supported by strong institutional underpinnings which allowed to develop appropriate micro-foundations, effective monitoring, and communication channels through which members countries could co-ordinate their economic policies with a view to eliminating imbalances. By contrast, Asia has relatively few region-wide institutions to support such a process. ASEAN was established on 8 August 1967 with the aim to promote economic and political co-operation and stability in the region. However, during the first thirty years of the association s history, the main agenda of co-operation had been concentrated on trade liberalisation. In the institutional sense therefore, economic integration has not been as broad based in Asia as it has in Europe. Moreover, the institutional and legal foundations which have been put in place are not as far reaching as those which have been developed in Europe. At its third summit, ASEAN leaders signed the Manila Declaration of 1987, which aims to speed up intra-asean co-operation, especially in the areas of trade and industrial joint ventures. There has, however, been no serious attempt to set up European-style institutions to oversee this process. Meanwhile, the progress of the ASEAN Free Trade Area (AFTA) agreement, which aims to reduce import tariffs across the 10 member countries in the next few years, remains slow. Perhaps reflecting the differences in their commitments, the last few years have seen a proliferation of bilateral trading pacts between some ASEAN members and other non-member countries. A more recent example was the bilateral free trade agreement signed between Singapore and Japan. Given that each bilateral deal might have different conditions, these individual deals could even undermine progress on regional and global free trade agreements, thus complicating integration at the regional level. Institutionalised co-operation in the financial sphere lags even further behind, exemplified by the fact that the first ASEAN Finance Ministers Meeting was held only in March 1997. Prior to that, the channels of financial co-operation were limited to the South East Asian Central Banks Research and Training Centre (SEACEN), and the Executives Meeting of East Asia-Pacific Central Banks (EMEAP). SEACEN was established in 1982, consisting of a group of 11 central banks and monetary 9

authorities, 5 with the aim of facilitating co-operation in research and training focused on the policy and operational aspects of central banking. The Executives Meeting of East Asia-Pacific Central Banks (EMEAP) was established in 1991 and, consisting of 11 Asian central banks, 6 organises Governors and Deputies meetings and hosts working groups on financial markets, central bank operations, and prudential supervision. Since the mid-1990s, pairs or small groups of central banks of Asian countries have formed networks of bilateral repurchase agreements designed to provide mutual exchange rate support. Notwithstanding this proliferation of arrangements, however, the substance of co-operation appears limited when measured against European standards. At the same time, the 1997/98 financial crisis can be seen as a wake-up call regarding the need to further strengthen financial co-operation in the region. It has been well documented in the contagion literature that trade and financial linkages are the two main channels through which a crisis can spread from one country to another (see Claessens, Dornbusch and Park, 2001 and Forbes and Rigobon, 2001). Given that trade and financial linkages in Asia can be expected to increases in the wake of further integration, the risk of contagion is also likely to increase. Thus it might be seen as important for Asian countries to enhance inter-governmental co-operation in maintaining regional financial and exchange rate stability. Most recently, the ASEAN countries together with China, Japan and Korea, agreed to set up an extended and revamped network of repurchase agreements under the so-called Chiang Mai Initiative, which aims to provide liquidity support to a country facing financial difficulty. To date, there are, altogether, six such bilateral agreements signed, mostly between Japan and other Asian countries with the maximum amount of USD 3 billion. Note that most regional countries have floating currencies and apart from Indonesia, most countries have improved their external balance sheet position, so a repeat of the 1997/98 crisis is seen as unlikely. Thus the main significance of the Chiang Mai Initiative could be seen as a first step towards greater Asian integration. Beyond enhanced co-operation in the area of regional financial assistance, Asian countries would have to consider closer mutual economic and financial surveillance procedures to prevent excessively diverging macroeconomic and financial developments. Given the degree of interdependence of the countries concerned, such developments would generate negative spillover effects within the region. However, given the lack of political momentum, it is unclear whether the authorities would be able in the near future to make progress in ensuring greater consistency between the degree of trade/economic interdependence of their countries and the level of institutional co-operation. In this respect, the desirability of strengthened monetary and exchange rate co-operation could be negatively correlated with the soundness of the economic fundamentals in the participant countries. 5 Those of Indonesia, Korea, Malaysia, Mongolia, Myanmar, Nepal, the Philippines, Singapore, Sri Lanka, Taipei, and Thailand. 10

During the 1970s and 1980s, major economic indicators such as unemployment and inflation varied by a relatively large margin across EU countries, driving the various governments to seek to import sound policies from other member states. However, the Asian countries appear to have less incentive in this respect, particularly in adopting a common monetary objective. This is because inflation has long been relatively subdued in most Asian countries (at least compared to Latin America), so the benefits of developing a credible monetary policy framework also at the regional level may be less apparent. 7 Moreover, whereas in Europe, the successful German model served as a reference for the design of European monetary institutions, it seems that no such reference country exists in the Asian case. This could complicate the design of an institutional and policy framework for monetary and exchange rate co-operation in Asia. Figure 3. GDP per capita, PPP Cambodia 1989 Indonesia 1999 Lao Malaysia Philippines Singapore Thailand Viet nam China Japan Austria Belgium Denmark Finland France Germany Greece Ireland Italy Luxembourg Netherlands Portugal Spain n.a. 1989 1999 Korea Hong Kong 30000 20000 10000 0 10000 20000 30000 GDP per capita, PPP (current international dollar) Sweden UK 40000 20000 0 20000 40000 60000 GDP per capita, PPP (current international dollar) Source: World Development Indicators, 2001, World Bank. Likewise, differences in levels of economic development may be regarded as a negative factor. Figure 3 shows the distribution of GDP per capita (based on purchasing power parity, PPP) in Asia and Europe in 1989 and 1999. Across EU, the distribution is relatively uniform, which is in stark contrast with that in the ASEAN+3. Even within the ASEAN 5, the GDP per capita in Singapore was more than 6 times that of Indonesia. In so far as these differences give rise to differing responses to 6 Reserve Bank of Australia, People s Bank of China, Hong Kong Monetary Authority, Bank Indonesia, Bank of Japan, Bank of Korea, Bank Negara Malaysia, Reserve Bank of New Zealand, Bankgo Sentral Ng Pilipinas, Monetary Authority of Singapore, and Bank of Thailand. 11

external shocks, monetary and exchange rate co-operation may be complicated by the need for some real exchange rate flexibility. 3. Meeting the requirements for successful monetary and exchange rate co-operation Section 1 has provided an overview and assessment of Asia as a potential candidate for regional monetary and exchange rate co-operation. Our main conclusion is that, at least some countries in Asia may have a strong interest to pursue regional exchange rate stability by conducting their monetary and exchange rate policies within a more structured regional framework. At the same time, Asia falls well short of meeting many of the economic, political economy, and institutional requirements which proved necessary for the successful pursuit of monetary and exchange rate co-operation in Europe. In turning to explore potential lessons from the European experience, we therefore focus primarily on how Asian countries might go about meeting these requirements. To this end, we discuss in this section four broad aspects of the European experience and consider their role in creating the conditions for successful monetary and exchange rate co-operation, namely: The creation of sound political, institutional and legal underpinnings; The pursuit of a high degree of trade/economic integration through the creation of a single market; The development of a regional approach to financial market regulation and supervision; and The pursuit of macroeconomic convergence through economic policy co-ordination and mutual surveillance. 3.1 Political, institutional and legal underpinnings In Europe, monetary and exchange rate co-operation has formed an integral part of a much broader process of integration, the motives for which are as much political as economic. Within this overall context, economic integration and monetary and exchange rate co-operation have been viewed not only as ends in themselves, but also as a means to achieve closer political integration. As Paul-Henri Spaak put it, Those who drew up the Rome Treaty did not think of it as essentially economic; they thought of it as a stage on the way to political union. This political dimension has profoundly shaped the European approach to regional economic integration. In particular, it has led to the pursuit of economic and monetary integration through the creation and development of an institutional and legal framework which goes well beyond the kinds of arrangements which typically characterise international or regional organisations. 7 On the other, one could argue that the present low inflation environment could be seen as a good starting point which would facilitate monetary and exchange rate co-operation once the necessary political momentum has been built up for placing the latter on an institutional footing. 12

3.1.1 The political, institutional and legal nature of the Community Nugent (1999) stresses three key points which distinguish the Community from other international organisations. First, the Community has more institutions, more decision-making arrangements and more policy actors than are found in other international organisations. Second, other international organisations do not have so broad a range of policy responsibilities as the Community. And third, whereas other international organisations are essentially intergovernmental in their structures and internal processes, the Community is, in many respects, supranational. This supra-nationalism derives especially from the frequent application of qualified majority voting, which prevents individual Member States from vetoing Community decisions, and the wide-ranging powers conferred on the Community institutions, in particular the European Commission, as the sole initiator of Community actions. One should perhaps add to this the fact that Community institutions have a broad array of legal instruments at their disposal for achieving the Community s objectives. Moreover, once Community legislation has been adopted, it has precedence over national laws and conveys rights and obligations directly on European citizens which must be respected by the Member States governments and upheld by national courts. Thus, unlike in other international or regional organisations where member countries agree to co-operate in well defined areas while maintaining national sovereignty, the Member States of the Community have agreed to transfer (or pool) their sovereignty by creating a new layer of governance at the Community level. The Community method of economic integration is often likened to the construction of a building. 8 The bricks (i.e. Community laws etc) are superimposed on and strengthen one another as a result of the common action of the builders (i.e. the Community institutions). Together the bricks form floors (i.e. stages of integration) and compartments on each floor (i.e. common policies). Moreover, once a brick has been put in place, it cannot easily be removed (i.e. responsibilities, once conferred on the centre, cannot easily be repatriated). In this way, as economic integration has progressed, so the responsibilities undertaken at the new Community level of government have tended to expand and, as a result, the Member States have become more closely bound within a single political entity. This creeping competence of the Community has been documented in the literature. Pollack (2000), for example, examines the progress of European integration by identifying the level at which decisions were taken in different policy areas at different points in time. Updating earlier work of Lindberg and Scheingold (1970) and Schmitter (1996), he presents a table in which he lists 28 issue areas and classifies each area depending on the extent to which decisions are taken at the Community level, the national level or some combination of the two. Prior to the establishment of the Community, all decisions in all areas were taken only at the national level. By 2001, Pollack s assessment is that there 8 See for example Moussis (1997). 13

remained no area of policy-making in which the Community did not have at least some policy responsibility. Table 3: Legislative activity of the European Community No. of legal acts adopted 1971-75 1976-80 1981-85 1986-90 1991-95 1996-2000 1. International trade 864 2573 2208 3416 2783 2041 2. Common market 133 251 184 268 305 529 3. Money and finance 49 69 98 65 100 249 4. Education, research, culture 15 40 73 104 180 136 5. Environment 29 61 98 131 197 255 6. Business relations, sectoral, inc: 1155 3051 5685 7281 7130 5437 6a. Agriculture and fisheries 980 2479 5165 6880 6654 4907 6b. Industry and energy 109 445 408 300 309 370 6c. Transport 66 127 112 101 167 160 7. Business, non sectoral 116 137 256 358 669 1406 8. International relations, foreign aid 155 100 162 768 426 501 9. Citizens and social protection 96 126 263 521 770 860 Total 2612 6408 9027 12912 12560 11414 Source: Alesina et al. (2001). Alesina, Angeloni and Schuknecht (2001) have also sought to measure the involvement of the Community in policy-making across policy domains. They did this by counting the number of legal, judicial, and other non-binding acts emanating from the Community institutions. The data presented by Alesina et al concerning the adoption of binding legal acts across policy areas are replicated in Table 3. These data serve as a useful guide as to the extent of the Community s influence in European policy-making and the way this influence has grown over time. 3.1.2 Importance of political, institutional and legal underpinnings for monetary and exchange rate co-operation In Europe, the creation and development of strong political, institutional and legal underpinnings proved to be an essential pre-requisite for successful monetary and exchange rate co-operation. First, the pursuit of a broad-based economic and political project greatly strengthened the Member States political commitment to and hence the credibility of the Community s monetary and exchange rate arrangements. It is almost inevitable that, for some countries and during certain periods, the pursuit of common monetary and/or exchange rate objectives will imply some cost compared to the conduct of a purely unilateral monetary and exchange rate policy. For regional monetary and exchange rate co-operation to be credible therefore, it is important that, at such points in time, the overall benefits of co-operation are seen to outweigh the specific costs of any loss of monetary policy autonomy. This cost/benefit trade-off is likely to be fundamentally different if monetary and exchange rate co-operation forms part of a broader and more fundamental process of integration rather than being pursued in isolation. In such a case, a failure to co-operate is likely to imply additional costs in terms of the achievement of broader political objectives or a loss of political influence also in other policy areas. 14

Second, in a more practical sense, the nuts and bolts approach to European integration proved to be instrumental for the creation and maintenance of the microeconomic foundations for successful monetary and exchange rate co-operation and for fostering a high degree of real and nominal economic convergence. The way in which it has done so is explored further in the sections below which review the European experience in the areas of trade and financial market integration and macroeconomic convergence. We simply note here that the importance of these political, institutional and legal underpinnings is currently illustrated by the obligation for applicant countries to first adopt the so-called acquis communautaire before joining the EU. 9 Among other things, the adoption of the acquis provides evidence that a country has a well-functioning market economy which is capable of withstanding competitive pressures. It is therefore a pre-requisite for and must precede participation in the Community s present exchange rate system, the ERM II. As was pointed out in section one, Asia currently lacks the regional political and institutional structures which have been developed in Europe over the past 50 years. In fact, notwithstanding a relatively high degree of trade and financial market openness, from a political and institutional perspective Asia is far less integrated, not only than Europe, but also Latin America and North America where Mercosur and NAFTA seem to be sowing the seeds also for a political and institutional approach to regional integration. Would it not be desirable to put the present level of de facto economic integration in Asia on a sounder footing and pursue integration further by developing a stronger political, institutional and legal framework? Judging by the European experience, an important policy question, both for any future monetary and exchange rate co-operation in particular and regional integration more generally is whether Asian countries are willing to embark on the long and demanding path of creating such a framework. In this regard, it would need to be considered whether the necessary political momentum could first be galvanised and then sustained. Such an approach needs to take into account not only economic considerations pertaining to the welfare benefits of closer economic integration but also the political consequences in terms of lost or shared sovereignty. At the same time, one should be aware that, without such underpinnings, there is a much greater risk that any progress made in the areas of trade integration, financial market integration, macroeconomic convergence and monetary and exchange rate co-operation, could be reversed at a later stage. 3.2 Trade integration One of the principal motivations for monetary and exchange rate co-operation in the European Community has always been to support and promote a harmonious development of cross-border trade. The original Community Treaty, the Treaty of Rome, stressed the need to promote co-ordination of 9 Acquis communautaire is the term commonly used to refer to the rights and obligations deriving from Community treaties and laws. 15

the policies of the Member States in the monetary field to the full extent needed for the functioning of the common market. Three decades later, the need for a single market to be completed by the introduction of a single currency was one of the principle arguments forwarded for economic and monetary union. As the European Commission put it, One Market required One Money (Commission of the European Communities, 1990). As was pointed out above, creating an exchange rate environment conducive to a harmonious development of cross-border trade, free from competitive distortions, is also likely to serve as a principal motive for any future development of monetary and exchange co-operation in Asia. Promoting and achieving a high degree of trade integration, both at the international and at the regional level, is thus one way in which Asia can better meet the requirements for successful monetary and exchange rate co-operation. With regard to the latter, the ASEAN countries are already committed to the goal of establishing an ASEAN Free Trade Area by 2008 (and for the more advance economies of ASEAN by 2003). This objective nonetheless falls well short of the advanced degree of trade integration which has been achieved in Europe. Moreover, Europe s experience suggests that the creation of a free trade area alone may not be sufficient to ensure either lasting trade integration or the successful pursuit of monetary and exchange rate co-operation. To illustrate these points we explain below how European trade integration came to require much more than removing customs duties and show how Europe s successes and failures in the area of trade integration were paralleled in terms of monetary and exchange rate co-operation. 3.2.1 European trade/economic integration creating a single market The traditional approach to analysing European economic integration has been to consider it as the step-by-step achievement of successive stages of integration. The stages most commonly referred to are those identified by Balassa (1961), namely, a free trade area, a customs union, a common market, economic policy harmonisation and co-ordination, and, finally, complete economic union with a number of economic policies conducted at the regional level. Trade integration essentially concerns the first three of these stages. In Europe, the first two stages can be said to have been completed with relative speed and ease. By 1 July 1968 (i.e. 10½ years after the founding of the Community), all customs duties and quantitative restrictions on the import and export of goods and services within the Community had been removed and a common external tariff erected. The establishment of a customs union proved however to be far from sufficient to ensure the free movement of goods and services within the Community. While tariff barriers had been dismantled, other more opaque barriers to trade in the form of health and safety and various other technical standards continued to exist. These non-tariff or regulatory barriers could hinder trade even more than customs duties. A customs duty was easily payable whereas for a product which did not comply with a certain country s technical rules, entry into that country s market 16

was completely blocked or required costly investments in order to adapt production to meet differing national standards. The removal of regulatory obstacles to trade is, however, a considerably complex and difficult task. Unlike customs duties, microeconomic regulations cannot simply be dismantled. Such regulations are often both necessary and justified in order to rationalise industrial production, safeguard workers and consumers health or reduce environmental pollution. The removal of technical obstacles to trade therefore requires the harmonisation of a vast array of national regulations. For more than a decade following the successful achievement of the customs union stage, the Community grappled with the problem of trying to remove the remaining technical barriers to trade but with little success. Only from the mid-1980s onwards with the pursuit of the single market programme did the Community finally start to make significant headway. When it did, the key to success arguably rested on the combination of a number of elements of the Community s supranational institutional and legal framework. In this regard, the following are worthy of particular mention. First, by signing the Rome Treaty, the Member States of the Community had legally committed themselves not only to removing customs duties and quantitative restrictions on the import and export of goods and services but also to all measures having equivalent effect. The latter could, and later was, interpreted in broad terms to include regulatory or technical standards. Second, the EC Treaty provided judicial means in order to ensure that the Member States respected their Treaty obligations. It had established a European Court of Justice to which, inter alia, infringement proceedings could be brought not only by the Community institutions and Member States, but also by private companies and individuals if they were adversely affected by a Member State s failure to respect its obligations under Community law. This provided an avenue through which companies, which as a result of unfair technical standards were prevented from selling their products in another Member State, could challenge the legality of that Member State s legislation. Many cases were brought before the Court of Justice and the Court often ruled in the plaintiff s favour and against the Member State(s) concerned. Third, the European Court of Justice played a key role, not only in enforcing Community law, but also in the interpretations it gave to the provisions of the Treaty. One such interpretation, contained in the Court s judgement in the Cassis de Dijon case of 1979, was that any product which was lawfully manufactured and marketed in one Member State of the Community should in principle be admitted to the markets of the other Member States. 10 The Court thus established the 10 Judgement of 20 February 1979, Case 120/78. The French manufacturer of a blackcurrant liqueur Cassis de Dijon had been prevented from selling its product in Germany as a result of a German law which prohibited the sale of imported drinks which did not meet minimum alcoholic content requirements. The German government argued that the law was necessary in order to protect consumer s health. The European Court of Justice however disagreed and ruled against the German government. It considered that the German law could not be justified on 17

principle of mutual recognition of national regulations. This allowed for a new approach to removing technical barriers to trade which circumvented the need for a detailed harmonisation of national laws. Following this ruling, harmonisation increasingly focused only on broad framework rules within which Member States would have to recognise each other s regulations. Fourth, the strong powers granted to the European Commission, in particular as the initiator of proposals for Community legislation, allowed the process of integration to be pushed forward even in areas and at times where there was reluctance to act on the part of the Member States. The Commission typically acted as the driving force for further integration, as was the case for example in 1985 when it presented a white paper on completing the single market by the end of 1992. This white paper identified some 300 measures for removing remaining physical, technical and fiscal obstacles to trade. 11 Finally, the adoption of the necessary substantial body of legislation by the Council of Ministers (which is the Community s main decision making body comprised of representatives of the Member States) was made possible by the application of qualified majority voting. This prevented any single Member State from blocking or vetoing adoption of the Commission s legislative proposals. In this way, the Community method of integration, based on strong institutional and legal underpinnings, enabled trade/economic integration to be pursued beyond the more limited stages of a free trade area and a customs union. In formal terms, a truly common market was established by 31 December 1992, the date of completion of the Commission s single market programme. In retrospect, however, much remained and still remains to be done to create a truly single market in a number of sectors. Completing the single market in areas such as financial services, energy, and telecommunications continues to be a standing feature on the Community s policy-making agenda. 3.2.2 Trade integration and exchange rate stability Figure 4 shows how European trade integration, as measured by the ratio of intra-community trade to total trade, progressed from 1960 (i.e. shortly following the establishment of the Community) until the end of 1992 (i.e. the formal date of completion of the single market). It can be seen that, on the basis of this measure, trade integration progressed quite rapidly as customs duties were removed during the 1960s, subsequently stagnated, and then took off again from the mid-1980s onwards with the final drive toward completion of the single market programme. These ups and downs were generally paralleled by similar periods of failure and success in the area of monetary and exchange rate co-operation. To illustrate this point, Figure 4 also presents the health and safety grounds since information on bottle labels as to the alcohol content was sufficient to protect the consumer. 18

evolution over the same period of the variability of the nominal effective exchange rates (NEER) of the German mark, French franc and Italian lira against other Community currencies. Variability is represented as the average absolute change of the monthly NEER in each year. It can be seen that the successful early period of European integration was accompanied by a relatively stable exchange rate environment. This was of course a period during which exchange rates were fixed within the Bretton Woods system. The failure to progress further in the area of trade integration during the 1970s was then accompanied by a similar failure to maintain exchange rate stability following the collapse of the Bretton Woods system. These were the years of Euro-pessimism or Euro-sclerosis to coin terms which became popular in the press. Finally, following the establishment of the European monetary system in 1979, exchange rates once again became more stable, this more successful period of monetary and exchange rate co-operation broadly coinciding with one of renewed Euro-optimism and trade integration. Figure 4: Intra-Community trade and exchange rate variability, 1960-1992 Intra-EC trade / total trade EC-12 EC-6 percent 60 55 50 45 40 Exchange rate variability Germany France Italy percent 3.5 3.0 2.5 2.0 1.5 1.0 35 0.5 1960 1966 1972 1978 1984 1990 30 1960 1966 1972 1978 1984 1990 0.0 Sources: BIS and European Commission. Co-incidence does not of course prove either the existence or the direction of causality. A vast body of empirical research has been undertaken to examine more precisely the nature and the extent of the effects of exchange rate variability on cross-border trade. For Europe, as for other regions, most recent studies confirm the hypothesis that exchange rate variability does have a negative and statistically significant impact on trade, even if the size of this impact is generally found to be quite small. 12 Moreover, it should be born in mind that most empirical studies focus on the direct and unidirectional impact of exchange rate movements on trade. In the real world, the causality between monetary and 11 Commission of European Communities (1985). 12 See for example Perée and Steinherr (1989), Chowdhury (1993), Frankel and Wei (1993), Sapir, Sekkat and Weber (1994) and Dell Ariccia (1998). These results are not unanimous however. In an overview of previous literature, Sekkat (1997) points out that while studies which examine the effect of longer-term exchange rate misalignments on trade do find a significant relationship, studies which focus on the impact of exchange rate volatility are less conclusive. These differing results are generally considered to reflect factors such as the ability of firms to hedge exchange rate risk over the short-term but not the longer-term. 19