Policy coordination among the ASEAN-5: an empirical investigation

Abstract

The ASEAN-5 economies are pursuing the possibility of exchange rate and monetary policy coordination after having experienced significant spillovers during the Asian Financial Crisis (AFC) that were facilitated by their trade and financial linkages. To do so however, would require ceding national interests and could be costly depending on how often this occurs. According to the optimum currency area (OCA) literature this cost will be significantly reduced if the economies experience common and symmetric shocks. The aim of this thesis is to empirically examine whether exchange rate and monetary policy coordination is feasible among the ASEAN-5 economies based on this OCA criterion, accounting for the existing trade and financial linkages among them.

First, the analysis shows that policy coordination may be needed to manage potential shock spillovers through the market linkages that are present among the ASEAN-5 economies. Significant linkages in their capital, goods and to some extent their labour markets as well, were found. While these linkages are not specifically identified as the primary channels, the transmission of the adverse shock in both the average and volatility of returns during the AFC was found to be due to the strength of the existing economic interdependence, which is facilitated by market linkages. These results suggest that policy coordination may be needed to manage the spillovers that occur among these five economies.

Second, the analysis determines if the ASEAN-5 economies experience common and symmetric shocks. Supply and demand shocks are decomposed from domestic output, with the addition of price information to fully identify these shocks; demand shocks are restricted such that they do not have permanent effects on output while supply shocks do. The supply and demand shock correlations across pairs of countries are then examined. Given that only a few country pairs had correlated shocks, the degree of shock symmetry is low. However, the degree of shock symmetry increased in the post-AFC period. The analysis also isolated a common factor among the ASEAN-5's output variables; each of the economies was positively correlated with this common factor. The common factor identified was found to be best explained by four global variables: US interest rates, US output, China's output, and oil prices. Shocks to each of these global variables yielded common shocks for all the ASEAN-5 economies.

Third, the ASEAN-5 economies are modelled to incorporate the existing trade and financial linkages in a global model in order to determine if they experience symmetric responses to each of the four common shocks identified previously. This is done using a Global VAR model. Output responses for the ASEAN-5 economies were found to be symmetric for all four global shocks explored. Market linkages identified previously underpin this result; trade, financial and labour linkages are present in the form of intra-industry trade flows from product fragmentation, portfolio investments and migrant remittances, respectively. The three economic characteristics of a regional production network, oil reliance and domestic consumption helped to explain the responses observed in domestic variables for the ASEAN-5 economies, more generally.

Overall, the results in this thesis point to common and symmetric shocks among the ASEAN-5 economies and therefore, suggest that exchange rate and monetary policy coordination should be feasible for the group.