The linkage between trade agreements and monetary cooperation

Economic integration is high on the policy agenda in East Asia. One way of proceeding would be to focus on intraregional trade and investment and attempt to foster their further expansion through the negotiation of free trade agreements (FTAs) and investment arrangements. Another, conceivably complementary, approach would be to focus on monetary integration and to seek to develop a regional currency arrangement leading ultimately to an East Asian monetary union. It is not obvious which strategy would be most productive. In a previous article we questioned whether trade integration is a necessary precursor to monetary integration.1 We argued that trade agreements among East Asian countries might be slow to materialize and could be stymied by domestic political resistance. This suggests that it might be advisable for countries to attempt to leap directly to closer monetary integration. Among the advantages of this approach is the possibility that exchange rate stabilization leading to deeper monetary integration might lend further stimulus to intraregional trade and that this might in turn render regional free trade agreements more attractive. Our observation finds some support in subsequent developments, in the sense that the prospects for a regionwide FTA encompassing the ASEAN+3 countries (the 10 members of ASEAN plus China, Japan, and South Korea) remain remote. The two largest East Asian economies, China and Japan, continue to exhibit a preference for bilateral arrangements. Geopolitical rivalry between the two countries and their unsettled historical legacy further cloud the picture. All this raises the danger that if trade integration is viewed as a precondition for monetary integration, difficulties in achieving the first objective might prevent Asian countries from achieving the second. In this chapter, we seek to shed further light on the connections between trade and monetary integration. In doing so we are exploring largely uncharted terrain. Neither theory nor evidence has been effectively mobilized to address the question of whether regional trade arrangements (RTAs) do more to encourage monetary and exchange rate cooperation among the participating countries, or vice versa, and which should come first.2 In East Asia, in particular, debate on the feasibility and desirability of FTAs has mostly abstracted from the linkage to monetary integration. The implications of the exchange rate regime for the political economy of an East Asia FTA are taken as subsidiary considerations- To the extent that they are discussed at all. That attention has not yet focused on these issues reflects, in part, the fact that an ASEAN+3 free trade area is still in its formative stages. The current pattern of trade agreements is essentially bilateral; as yet there is no formal ongoing effort to build a regionwide, multilateral agreement like Europe's Common Market. (An exception is the ASEAN Free Trade Area, or AFTA, but as discussed later in this chapter, this has at yet had little discernible positive impact on intraregional trade.) Bilateral agreements of the sort that have dominated East Asian trade negotiations to date are unlikely to foster the kind of cohesive collective policy framework needed to support monetary cooperation at the regional level. Quite apart from the policy framework, monetary cooperation requires a durable political commitment. And, in East Asia, the relevant level of political cohesion simply does not exist. In Europe, adoption of a trade integration-first strategy was natural, given the importance of intraregional trade for European recovery in the aftermath of World War II. In the wake of the war, other European countries depended on Germany for the provision of capital goods, while Germany depended on its neighbors for consumer goods that were not readily produced at home. Moreover, when the Treaty of Rome was negotiated in 1957, the idea of setting up a regional exchange rate coordination mechanism or of introducing a common currency was less pressing because the Bretton Woods system of pegged but adjustable exchange rates provided adequate levels of exchange rate stability both in Europe and worldwide. Only when the Bretton Woods system began to unravel did pressure develop for regional exchange rate stabilization measures and serious discussions of European monetary integration begin. The North American Free Trade Agreement (NAFTA), another precedent that might conceivably be followed in Asia, was created without explicit consideration of the need for exchange rate stability. To be sure, when the peso crashed in December 1994, the United States provided financial assistance to Mexico and encouraged the International Monetary Fund (IMF) to do likewise, but this was an ad hoc reaction and not an institutionalized response. It is now taken for granted that NAFTA focuses on the integration of trade and production, while monetary management should be left to the national authorities. The Canadian dollar continues to float against the U.S. dollar, and the Mexican peso has grown more flexible with the passage of time. This is in contrast to the situation in Europe, where it has been possible to address a wider range of issues, including monetary ones, because of a willingness to at least contemplate a confederate governance structure.3 In the remainder of this chapter we analyze the linkages between trade and monetary integration in more detail. We show that while intra-East Asian trade as a percentage of East Asia total trade has been rising steadily, this rising trend is entirely attributable to China. We conjecture that the two major obstacles to further progress are the exchange rate volatility experienced since the Asian crisis of 1997-98 and the relatively slow materialization of FTAs involving China, Japan, and South Korea. Building on these observations, we investigate how exchange rate variability influences trade liberalization-if at all. Using a gravity model we estimate the impact of free trade agreements on intraregional trade and examine whether exchange rate volatility lessens the positive effect of those FTAs. We find some evidence that high exchange rate volatility reduces trade. But despite this direct negative effect of exchange rate volatility on bilateral trade, we also find that the level of exchange rate volatility does not diminish the positive impact of FTAs on trade among the participating countries, at least in the case of East Asia. Interestingly, the negative effect of exchange rate volatility on trade appears to have been larger in Europe. Moreover, in Europe high levels of bilateral exchange rate volatility appear to have hampered the growth of intraregional trade not just through their direct effects but also by attenuating the positive impact of the Common Market. These findings thus may help to explain why European countries have, historically, attached such importance to regional initiatives designed to limit exchange rate variability. The results for East Asia are less clear-cut. The gravity model fits the data less well, reflecting the high volume of trade between ASEAN members and their more distant East Asian trading partners, Japan and South Korea. The estimated effect of AFTA membership is now negative. In other words, trade among AFTA members has been growing less rapidly than trade among Asian countries generally-even after controlling for country size, distance, and similar factors. This, clearly, is the China effect: China's trade with its neighbors has been expanding enormously, and limiting the sample to Asian countries places this fact in bold relief. But our key result continues to hold even in this subsample: There is little evidence that exchange rate volatility has a negative effect on the growth of trade and on the trade-creating effects of regional agreements in Asia. Our conclusion remains that the slow progress of regional FTAs has limited the pressure for measures to stabilize exchange rates, while those limited measures that have been taken on the exchange rate front in turn have had little impact in terms of magnifying the positive effects of FTAs. The rest of the chapter is organized as follows. The second and third sections highlight the contrasting experiences of Europe and the Americas and draw out some implications of this history for East Asia. The fourth section describes the progress of trade integration in East Asia and highlights the obstacles to further progress. The fifth section then analyzes how exchange rate volatility conditions the anticipated trade promotion effects of FTAs. The sixth section, finally, concludes with some speculations about the future.