Currency Union for South Asia: A SWOT Analysis J Ravikumar Stephen

Europe had to face two great wars to go through the new renaissance, which made the European nations bury their hatchet for a political and economic cooperation within Europe. The recent result of the referendum in France was just a break speed on the slippery route to an economic/political integration of Europe. Integration of Europe is a mere survival need; hence, sooner or later this is going to be a reality. No way, the need of South Asia is dissimilar to that of Europe, East Asia, Africa and the Pax-Americana. Before doing the SWOT analysis for South Asia, let us try to re-learn what is money and its significance in terms of international trade.

Currency and Exchange Rates
Money can be described as a unit of account in which debts and prices are expressed. In a hypothetical world in which the number of currencies equaled the number of commodities, the usefulness of money in its roles of unit of account and medium of exchange would disappear, and trade might just as well be conducted in terms of pure barter.

Money is a convenience and this restricts the optimum number of currencies and most of the nations consider that a national currency is a means to achieve identity among other nations. Till the late 19th century, people used to fix currencies to gold. In international trading if the prices of foreign goods are expressed in terms of foreign currency, then it must be translated into domestic currency prices as well. In practice, it is realized that more the number of currencies, more the costs of valuation and money changing.

International Monetary System
In the international jungle of independent currency areas, the superpower, dominates. As the demand for international trading increases, the main beneficiary is the United States. The encourages the US to effect a higher optimal rate of inflation, than would otherwise be adopted. Because of the international demand for its currency, and subject to the constraint imposed by the threat of entry, the United States will have a higher optimal rate of inflation than it would in the absence of the international use of its currency.

The Bellagio-Princeton Study Group on International Monetary Reform, organised by Fritz Machlup, Robert Triffin and William Fellner, distinguished four main options for the international monetary system:

• The gold standard;
• Flexible exchange rates
• A new international reserve facility; and
• A world central bank.

It is true that the rest of the world needs an international monetary system much more than the United States. In the absence of an international monetary system, the superpower dominates and bilateral bashing replaces multilateral rules. Although superpower pre-eminence will be apparent even in an international monetary system, there is at least a set of rules that apply equally and a multilateral framework for resolving disputes.

If the superpower abuses its monopoly position, the rest of the world can form a defensive league against it, and take steps to find alternatives. When, in the late 1970s, the United States went on an irresponsible inflation binge, Europe was provoked into the creation of the European Monetary System (EMS). The second-best alternative to an international monetary system is by regional monetary arrangements. Why not a monetary system for each continent?

This regional monetary system is something similar to the Optimum Currency Area concept, proposal by Robert Mundell in 1960. The system encouraged by Robert Mundell, suggests a Fixed Exchange Rate. Before going to in details of the Optimum Currency Area, let us try to understand the nature of Flexible Exchange Rate.

Disadvantage of Flexible Exchange Rate
Mundell's considerations, several decades ago, seem highly relevant today. Due to increasingly higher capital mobility in the world economy, regimes with a temporarily fixed, but adjustable, exchange rate have become more fragile and a movement to generalized flexible exchange rates would be a step backward for the international monetary system.

Flexible Exchange Rate presents the false suggestion that flexibility of the exchange rate provides an extra degree of freedom. A country has a choice to stabilize such possible targets as the price level, the money supply, the exchange rate, the price of gold or the wage rate. In other words, it can have:

• A commodity standard
• A monetary standard
• A foreign currency standard
• A gold standard or a wage standard.

In the international monetary system of the 1960s the price of gold was fixed by the United States and other countries fixed the price of the US dollar. Moving toward flexible exchange rates (and a flexible price of gold for the United States) shifts the burden of stabilization policy onto a monetary standard, or a commodity standard or a wage standard.

Now GDP is expressed in terms Purchasing Power Parity (PPP). The departure of relative prices from purchasing-power-parity norms should be a wake-up call for those who believe flexible exchange rates are efficient. 1. In 1999 the Nobel Prize for economics was awarded to Robert A Mundell for his analysis of monetary and fiscal policies in different foreign currency exchange rate regimes and for his analysis of optimal currency areas.

Flexible Exchange Rate will be effective, only if regions of the same country have separate currencies:
The price level, the money supply, the exchange rate, the price of gold or the wage rate are not same within the regions of a particular country. If the theory of flexible exchange rates endorsed by James Meade and Milton Friedman were valid, it would apply to a particular region in a country rather than to the entire country itself. Canada is a classical example:

The Canadian dollar, uniquely among the G-10 countries, had adopted flexible exchange rate. This had not helped Canada to escape the US business cycle. Though it had addressed the stability of the heartland economy of Ontario and lower Quebec it failed to stabilise the peripheral regions in the west (British Columbia), the north and the Maritimes.

It is true to any country. The wages in the industrialised states are not similar to the less industrialised states in India itself. Should we have different currencies for individual states? No. Labour mobility equalises inflation in one state with the recession in another state. Hence, having separate currency for each state will not only be superfluous, but will also add up to the cost of transaction, in addition to the extra cost involved in printing separate currencies. If this is true, it supports the theory of expanding the currency area to mutual trading partner countries as well.

Benefit from a common currency
In the absence of Common Currency, countries that are in the process of forming a common market would saddle themselves with a new barrier to trade in the form of uncertainty about exchange rates.

Mundell argues there are advantages to regions that use a common currency (fixed exchange rate). The following are the benefits:

• A particular currency union facilitates international trade and a single medium of exchange reduces transactions costs.
• Larger currency areas disturbances are likely to be offsetting, so that exchange rate changes are smaller, with less feedback on domestic prices.
• As Mussa (1997) argues that the European crisis of 1992 could have been prevented if the European countries were using the same currency.
• Drawbacks of Optimum Currency Areas (OCA)
• Difficulty of maintaining employment when changes in demand or other "asymmetric shocks" require a reduction in real wages in a particular region.
• The loss of monetary independence.

Mundell's Solution to the OCA
Mundell emphasised the importance of high labor mobility to offset such disturbances. He characterised an optimum currency area as a set of regions among which the propensity to migrate is high enough to ensure full employment, when one of the regions faces an asymmetric shock. Suppose demand shifts from Nepali to Indian goods. The increase in demand for India output result in inflationary pressures there, while Nepal goes into recession. For this, Mundell's argument would be: if unemployed labour could move freely from Nepal to relieve inflationary pressures in the India, both problems could be resolved simultaneously.

If a common money can be managed so that its general purchasing power remains stable, then the larger the currency area even one encompassing diverse regions or nations subject to “asymmetric shocks”the better. A country suffering an adverse shock can better share the loss with a trading partner because both countries hold claims on each other's output in a common currency. A harvest failure, strike, or war, in one of the countries causes a loss of real income, but the use of a common currency allows the country to run down its currency holdings and cushion the impact of the loss, drawing on the resources of the other country until the cost of the adjustment has been efficiently spread over the future. If, on the other hand, the two trading partners use separate currencies with flexible exchange rates, the whole loss has to be borne alone.

Optimum Currency Area, which has functioned with fixed exchange rate, does not require political integration. We have thriving examples of fixed exchange rate regimes: Austria, Holland and Belgium (and indirectly Luxembourg), were tied to the DM. Argentina's fixed exchange rate system tied to the dollar is an encouraging sign.

These are examples that eloquently refute the idea that fixed exchange rate systems cannot work without political integration. The best path toward monetary union is through irrevocably fixed exchange rates and the gold standard was a way of organizing a fixed exchange rate system without the need for political integration.

Sequencing Trade and Monetary Integration
There are five levels of integration developed in the early 1960s by Bela Balassa (1961). He proposed the following sequence: preferential trading arrangements, free trade area, customs union, common market, economic union.

Currency Union is not a new concept. The Latin Monetary Union began in 1865 when France, Belgium, Italy and Switzerland (later joined by Greece, Romania, and others) adopted common regulations for currency to encourage its free flow across borders. This essentially amounted to a commitment to minting silver and gold coins to uniform specifications, but without other restrictions on monetary policy. The outbreak of the World War-I effectively ended this currency union. Since 1970, Mundell has enthusiastically advocated European monetary unification (EMU), and seems vindicated by the formal advent of the Euro on January 1, 1999. Hence, he deserves the additional sobriquet of “intellectual father of the Euro”.

Optimum Currency Area in South Asia
The world economy has become increasingly integrated in the last decade. In order to gain from this globalization process, the developing economies have undertaken extensive reforms to integrate themselves more intensively with the rest of the world. The world financial markets are getting synchronized with the liberalization of capital flows, the opening up of capital accounts, the entry of Foreign Direct Investors (FDI) in different markets, and the increase in international trade. The idea of Optimal Currency Area (OCA) stems from the seminal work of Mundell (1961) and McKinnon (1963). According to this view, any region that has high intra-regional trade, fiscal transfers, high labor and capital mobility, and that experience the same economic shocks should have a common currency. Let us do a SWOT (Strength, Weakness, Opportunity & Threat) Analysis for the formation of Optimum Currency Area in South Asia.

Strength
The South Asian countries grew at a 5.4 percent per annum on average from 1990 to 2002, and are projected to grow at the rate of 6/7 percent in the next few years. The structure of production is reasonably similar across the South Asia. The share of agriculture varies from 20 to 25 percent for all, except Nepal (40.6 percent) and Bhutan (33.9 percent). The industrial sector constitutes roughly a fourth of GDP in all countries, varying from 21.8 percent (Nepal) to 37.4 percent (Bhutan) in 2002. Except Nepal and Bhutan, the share of service sector for all other member countries comprises around 50 percent of their total GDP in 2002. All the countries, except Sri Lanka, registered a very low rate of inflation and it stands at an average of 3.7 percent per annum for the SAARC countries. Maldives registered a very low rate of inflation (0.9 percent) in 2002. The figures indicate that most of the South Asian countries have similar growth rate and inflation rate. Inflation rate has, however, been rising in 2005.

The South Asia also exhibits a similar demographic structure. The population growth is 2.0% percent per annum on average from 1980 - 2002. The SAARC countries exhibit similar growth rates in money supply. Except Nepal (6.3 percent), the growth in money supply varies between 19.3 percent (Maldives) and 13.1 percent (Bangladesh). Most of the countries have comfortable levels of foreign exchange reserves. All the countries experienced fiscal deficits (combined states and centre) ranging from 3.9 percent (for Nepal) to 10.1 percent (for India) in 2002. Since most of the South Asian countries currently have low inflation, low current account deficits, similar growth, trade and production structure, it prods us to think of the possibility of monetary cooperation in the region, even if not for all the South Asian countries, certainly for some subgroup (s).

Following are the recommendation by Saxena:

Group 1: India, Pakistan, and Sri Lanka
Group 2: India, Nepal and Sri Lanka
Group 3: Bangladesh, Nepal and Sri Lanka
Group 4: India, Maldives and Pakistan.

Even Maskay (2003) finds India and Pakistan suitable candidates for a common currency. While India, Pakistan and Sri Lanka have a managed float, all the other countries have a pegged exchange rate regime, and Bhutan and Nepal have pegged against the Indian rupee. There is one-to-one convertibility of Indian rupee and Bhutanese ngultrum over the last 20 years and there is no adjustment in the exchange rate between India and Nepalese rupees for the last 10 years. The Group of Eminent Persons (GEP) of SAARC has proposed a roadmap for economic integration through the following:

Formation of a South Asia Free Trade Area (SAFTA) and a South Asian Customs Union (SACU) by 2015, and South Asian Economic Union (SAEU) by 2020.

South Asian countries have also initiated cooperation within the framework of SAARC in poverty alleviation and people-to-people contact programs, expansion in the scope of investment and technology cooperation, besides bilateral initiatives such as Indo-Nepal FTA (Free Trade Agreement) and Indo-Sri Lanka FTA.

Some of the more encouraging signs are:

• First, a framework treaty for the South Asian Free Trade Area (SAFTA), which was signed by the SAARC member countries at the Islamabad SAARC Summit, 2004, is coming into operation this year. This will pave the way for the eventual creation of a South Asian Economic Union, as envisioned by the Group of Eminent Persons.
• Second, The member countries also signed the SAARC Social Charter at the Summit. The Charter encompasses a broad range of targets to be achieved across the region in areas of poverty eradication, empowerment of women, youth mobilization, human resources development, promotion of health and nutrition, protection of children etc.

Weakness
While SAARC began with South Asian Preferential Trading Area (SAPTA) in 1995, the progress has been rather slow, especially when viewed against the worldwide trends.

Labour mobility helps the members of a monetary union adjust to asymmetric shocks by allowing labour to move from areas of high unemployment to low unemployment. Given the geo-political situation in the region, through there are illegal immigrants to India in search of jobs from Bangladesh, we can not expect high labor mobility except a between India and Nepal / Bhutan.

Convergence Criteria: The convergence of macroeconomic indicators like inflation rate, interest rate and exchange rate, public debt, fiscal deficits, etc. are pre-requisites for common monetary arrangements in the region. The fiscal deficit for India in 2002 was 10.1 percent. This fiscal condition will not facilitate the effective stabilization of the South Asian currency.

Opportunity
The increasing global integration is expected to enable the developing countries to benefit from the emerging international fixed exchange rate system and an ultimate common currency can eliminate the risk of exchange rate fluctuations, and thus encourage trade and investment. This would enhance the economic integration process in the region. There are compelling economic reasons to suggest that it is in the interest of all the South Asian countries to promote intra-regional trade and economic cooperation. Direct trade in products like steel and aluminum, textile machinery, chemical products, and dry fruits currently being diverted through third countries will benefit both India and Pakistan quite substantially price, quality, and time. The region can expand trade tea and coffee, cotton and textiles, natural rubber, light engineering goods, iron and steel, medical equipment, pharmaceuticals, and agro-chemicals. The energy problems in the region can be solved through cooperation. The water from the Himalayan Rivers flowing through Bangladesh, Bhutan, India, Nepal and Pakistan can be harnessed for flood prevention and inland navigation system. India assisted Bhutan in constructing the Chukha hydroelectric project, which has the potential to benefit Bangladesh and Nepal.

There are significant complementarities in trade among the South Asian countries. 11 / 11

Sri Lanka can gain by diverting its trade in cement and shipbuilding with South Korea to India and Pakistan. Adverse terms of trade, protectionism from the West and political instability from the civil war have led Sri Lanka to build local ties. Hence, since 1992, Sri Lanka has consistently advocated improving intra regional trade through the framework of South Asian Preferential Trade Agreement (SAPTA). Like all the other South Asian countries, Pakistan also has a limited access to the markets in the developed world and hence Pakistan has taken initiatives to form Economic Cooperation Organization (ECO) to promote its exports and improve intra-regional trade with Central Asia. But given the competition from developed countries, it will be difficult for Pakistan to capture these markets. So, Pakistan has to concentrate on South Asian market to promote its exports where it enjoys comparative advantages after India.

There is a great deal of potential in the region for developing trade and economic cooperation. Increasing openness of the economies with the removal of tariff and non-tariff barriers different national currencies, the movements are very smooth and steady towards an economic integration. According to Mehta and Bhattacharya, the complete elimination of tariffs under SAFTA may increase the intra-regional trade by 1.6 times of the existing level.

The following are some of the general reasons a country would prefer to join an OCA: To gain the inflation rate of the OCA;

• To reduce transactions costs in its trade with a major partner;
• To eliminate the cost of printing and maintaining a separate national currency;
• To participate in a purchasing power parity area, which would be fostered by fixed exchange rates and even more by monetary union;
• To keep the exchange rate from being kicked around as a political football by vested interests that want depreciation to increase profits, or to bail out debtors;
• To establish an automatic mechanism that will enforce monetary and fiscal discipline;
• To have a multinational cushion against shocks;
• To participate more fully and on more equal terms in the financial center and capital market of the union;
• To provide a catalyst for political alliance or integration;
• To establish a power bloc as a countervailing influence against domination of neighboring powers;
• To establish a competing international currency as a rival to the US dollar and earn, instead of paying, seigniorage;
• To reinforce or establish an economic power bloc that will have more clout in international economic parleys and have a greater power to improve, by its trade policy, its terms of trade;
• To participate in a restoration of a reformed international monetary system.

Threat

Here are some of the circumstances under which a country might decide against joining a fixed exchange rate zone or a currency union:

• Because the country wants to use the exchange rate as an instrument of employment policy to lower or raise wages;
• Because, as a large country, the country does not want an unfriendly country to benefit from the economies-of-size advantages of the large currency area, or else because it fears that the addition of another currency will make national macroeconomic policy more difficult;
• Because the country wants to use the money-expansion or the inflation tax to finance government spending, and it would be prevented from doing so to the extent desired by the discipline of fixed exchange rates;
• Because the government of the country wants to use seigniorage as a source of hidden or off-budget funding for personal use by members of a corrupt government;
• Because a regime of fixed exchange rates could conflict with the required policies of a central bank that had a constitutional mandate to preserve price stability;
• Because monetary integration with one or more other countries would remove a dimension of national sovereignty that is a vital symbol of national independence;
• Because the country wants to maintain its monetary independence in order to use the money-expansion or inflation tax in the event of an emergency;
• Because there is no domestic political and economic leadership capable of maintaining a fixed exchange rate system in equilibrium;
• Because the partners in the prospective currency area are politically unstable or prone to invasion by aggressor countries;
• Because the country does not want to accept the degree of integration implied by the OCA agreement, such as common standards, immigration, labour or tax legislation.

Conclusion
It took the European Union a long time to achieve the current levels of labour mobility and this can be enhanced in South Asia through integrated labour laws in South Asia once the process of economic integration officially begins.

Promotion of Intra-Regional Trade: The intra-regional trade can be facilitated through a reduction and ultimate elimination of tariff and non-tariff barriers. The attempt to move towards SAFTA appears to be more promising in this direction. The bilateral FTA between the countries in the region can also supplement this.

Reducing Transaction Costs: To reduce the cost of exchanging currencies for intra-regional trade and to improve the transparency in price setting necessary for the promotion of intra-regional trade and investment flows, the Asian Clearing Union (ACU) can be strengthened further to facilitate such transactions. The scope of ACU can be widened to include tourism, service transactions and others. Maldives, the only country of South Asia, which is not the member of ACU, can seek the membership. The other Asian countries may be invited to join ACU.Monetary Policy for Shocks: A common monetary policy will reduce the asymmetric shocks. For this South Asian Fraternity (SAF), in the respective countries need to coordinate with the Chamber of Commerce and Industry of their respective countries and facilitate exchange of business professionals.

Coordination of Fiscal and Monetary Policies in the Region: Fiscal positions need to be strengthened through deficit and debt reduction. There is a need to establish greater harmony in monetary policies in order to reduce currency misalignment and achieve full convertibility within South Asia.

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J Ravikumar Stephen is a management consultant and a peace Activist. He is a member of the national executive committee of the Pakistan-India Peoples' Forum for Peace and Democracy (PIPFPD) in India.

Bibliography

1. Do Currency Regimes Matter in the 21st Century? An Overview by Hiroshi Fujiki and Akira Otani (MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002)
2. Sequencing Trade and Monetary Integration: Issues and Applications to Asia by Richard Pomfret (Working Paper 2004-14, School of Economics, University of Adelaide University, Australia)
3. Monetary Cooperation in South Asia: Potential and Prospects by Sweta Chaman Saxena and Mirza Allim Baig (Discussion Papers- RIS-DP # 71/2004 - intend to disseminate preliminary findings of the research carried out at the Research and Information System [RIS] for the Non-Aligned and Other Developing Countries)
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