Three Essays on Regional Economic Integration and Exchange Rate Regimes

1. Three Essays on Regional Economic Integration and Exchange Rate Regimes June 9th, 2010 Xiaodan Zhao

2. The degree of economic integration • Preferential trading area • Free trade area • Customs union • Common market • Economic and monetary union • Complete economic integration

3. Benefit and Cost of currency area Benefits • Lower transaction costs • Reduce uncertainty about exchange rate variability and relative price changes • Enhance the confidence in the direction of policies Costs • Lose the monetary independence • Lose nominal rate flexibility • Constraint in the fiscal policy

4. Optimum currency area (OCA) • Definition • Principal criteria for a successful currency union: • Symmetry of shocks across countries (Mundell, 1961) • Labor mobility across the region (Mundell, 1961) • Openness of the economies (McKinnon, 1963) • Well-diversified economies (Kenen, 1969) • In addition…

5. Monetary Unions we study here • The CFA franc zone • The Eastern Caribbean Currency Union • The potential Asian Monetary Union

6. Where in the world are they?

7. “CFA” Colonies Francaisesd’Afrique “French Colonies of Africa” Communauté financière d'Afrique ("Financial Community of Africa") Coopération financière en Afrique centrale ("Financial Cooperation in Central Africa") BCEAO Banque Centrale des États de l'Afrique de l'Ouest "Central Bank of the West African States" Dakar (Senegal) BEAC Banque des États de l'Afrique Centrale "Bank of the Central African States" Yaounde (Cameroon) UEMOA Union Économique et Monétaire Ouest Africaine "West African Economic and Monetary Union" CEMAC Communauté Économique et Monétaire de l'Afrique Centrale "Economic and Monetary Community of Central Africa" • Benin • Burkina Faso • Côte d'Ivoire • Guinea-Bissau • Mali • Niger • Senegal • Togo • Cameroon • Central African Republic • Chad • Republic of the Congo • Equatorial Guinea • Gabon

8. 500 francs between BCEAO and BEAC (2002 banknote)

13. Model • Shocks are classified as being global, regional and country-specific (ug, ur and ud). If the country-specific shocks are prevalent and uncorrelated across countries, the cost to sustain a currency area would be prominent. • where is a polynomial function of the lag operator L

14. Vector Autoregression (VAR) model • A 3×3 structural VAR model is used. Consider a three-variable model with global, regional and local outputs: yg, yr and yd. They are related to three structural shocks as follows: whereis a polynomial function with lag operator L in a matrix form Two restrictions • (1) neither regional nor country-specific shocks have long-run effects on global output; • (2) country-specific shocks have no long-run effects on regional output.

15. Data • Valued added industrial production (constant 2000 US$). • 12 countries (excluding Chad and Equatorial Guinea due to inadequate data) in the CFA franc zone • 10 EMU countries (excluding Belgium and Luxembourg due to data insufficient) and UK, US and Japan • Data for CFA franc zone countries are taken from WDI (World Bank Development Indicators2004). • data for EMU and other developed countries are retrieved from IFS (International Financial Statistics) • Data retrieve from both data sets are annual data from 1970 to 2004 • Exports and imports data for CFA franc zone countries are retrieved from DOTs (Direction of Trade Statistics August,2005)

19. Conclusion • That domestic shocks dominate for CFA franc zone countries shows CFA zone countries are structurally different from each other and thus more likely to be subject to asymmetric shocks. • Reasons: • Low trade among members in the CFA franc zone; • Economic growth in the zone heavily depend on external shocks such as wide variations in the terms of trade. • Implications: • CFA franc zone is not consistent with OCA criteria. • The CFA franc zone should have been costly to maintain.

21. Parity

22. East Caribbean dollar versus Canadian dollar

27. Model • Shocks are classified as being regional and country-specific (ur and ud). If the country-specific shocks are prevalent and uncorrelated across countries, the cost to sustain a currency area would be prominent. • where is a polynomial function of the lag operator L

28. Vector Autoregression (VAR) model • A 2×2 structural VAR model is used. Consider a two-variable model with regional and local outputs: yr and yd. They are related to three structural shocks as follows: whereis a polynomial function with lag operator L in a matrix form Two restrictions country-specific shocks have no long-run effects on regional output. where

29. Data • Gross Domestic Production seasonal adjusted (constant 2000 US$) • 8 ECCU countries • 8 non-ECCU CARICOM countries • 13 CFA franc zone countries • 9 EMU countries and 5 non-EMU European countries • Data for CFA franc zone countries are taken from WDI (World Bank Development Indicators2004). • data for ECCU, other Caribbean countries, EMU and other developed countries are retrieved from IFS (International Financial Statistics) • Data retrieve from both data sets are annual data from 1973 to 2005 • Exports and imports data for ECCU and non-ECCU CARICOM countries are retrieved from DOTs (Direction of Trade Statistics August,2007)

34. Conclusion • The ECCU countries are more strongly influenced by regional shocks compared to those of CFA franc zone where country-specific shocks are dominant. • The ECCU countries are structurally similar to each other and thus more likely to be subject to symmetric shocks. • Implications: The monetary and exchange arrangements in ECCU appear to have well served the region and group of countries is more likely to be an optimum currency area.

39. Data • Major Stock Market Price index data are collected and transformed into U.S. dollar terms • 12 countries in East Asia. • 16 European countries • Data is weekly from 1989 to 2007 • Per I: 1989:7:1 - 1991:6:30; Per II: 1991:7:1 - 1993:6:30; Per III: 1993:7:1 - 1995:6:30; Per IV: 1995:7:1 - 1997:6:30; Per V: 1999:1:1 - 2000:12:31; Per VI: 2001:1:1 - 2002:12:31; Per VII: 2003:1:1 - 2004:12:31; Per VIII: 2005:1:1 - 2006:12:31 • The weights are based on the GDP, PPP (in constant 2000 $)

44. Conclusion • Country-specific shocks are still dominant in East Asian stock markets. • External shocks that combine both global and regional shocks appear to take over the dominant position in European countries. • Despite years of efforts toward liberalization and financial integration in the region, countries in East Asia are subject to asymmetric shocks. • Theory of optimum currency area would predict that pegging to the same currency would be more costly in East Asia than in European countries. A flexible exchange rate regime might be more desirable in the foreseeable future.

45. Thank you for your advice!

46. Backup slides:

47. Parity

48. Exchange rate today • Tuesday, July 1st, 2008 • 1 CFA Franc BCEAO = 0.001524Euro 1 Euro (EUR) = 655.957 CFA Franc BCEAO (XOF) • 1 CFA Franc BEAC = 0.001524 Euro 1 Euro (EUR) = 655.957 CFA Franc BEAC (XAF) • 1 USD = 415.096 CFA franc

49. Major Export Items for CFA franc zone countries