Advancing Regional Monetary Cooperation

The eurozone crisis that began in 2010 may be considered the end of the idea of regional integration. Likewise, the eurozone crisis may be regarded as precisely the reason to enhance regional monetary integration in order to shield against volatility in international financial markets and such crises as the global financial crisis of 2008/2009. Broadly speaking, one may ask whether developing countries¹ and emerging markets should refrain from monetary integration initiatives, in particular since their financial market and macroeconomic conditions are comparatively fragile.

Since the end of the Bretton Woods system, the international monetary order has been marked by multipolarity. The Bretton Woods system was set up in 1944 after the Second World War as an international system of fixed yet adjustable exchange rates, including the foundation of the International Monetary Fund (IMF) as its supervisory body.¹ At the core of the Bretton Woods system stood the US dollar, with the Federal Reserve Bank of the United States (US Fed) ensuring full gold convertibility of the US dollar. The remaining currencies were pegged at par to the US dollar. At the beginning of the 1970s, however, the US current account went into deficit, and market expectations of a US dollar devaluation caused huge capital outflows in the USA. Among other effects, the government of the USA decided to abandon gold convertibility. Even a broadening of the exchange rate bands could not rescue the system. By 1973, the remaining European economies had also suspended the US dollar peg.

Exchange rate regime choice makes up a decisive part of the so-called impossible trinity that is based on the Mundell Fleming model (Fleming, 1962; Mundell, 1963). The “impossible trinity” states that it is impossible for monetary policy authorities to reach policy autonomy (flexible exchange rates), financial integration (open capital accounts), and exchange rate stability (fixed exchange rates) simultaneously (cf. Frankel, 1999: 7; Macedo et al., 2001: 14; Stiglitz, 2004; Aizenman et al., 2008). A country may achieve only two of these three objectives (therefore also called the policy “trilemma”). Based on the trilemma hypothesis, unilateral monetary policy options of either fully flexible or fully fixed exchange rates were defended for a long time as the only valuable exchange rate regime choices, since financial integration used to be considered the untouchable corner of the impossible trinity of monetary policy choices (Ghosh and Ostry, 2009). Drawing on the assumption of perfect markets, it was assumed that free capital flows, just like free trade, would render the highest aggregate welfare gains. Free capital flows would allow investment to be allocated according to the comparatively highest expected returns (cf. Prasad et al., 2003). Hence, a country could choose between monetary policy autonomy with flexible exchange rates and monetary stability with fixed exchange rates.

In fact, in the economic literature, a remarkable consensus exists concerning the importance of financial market development in reducing adverse effects of economic and monetary shocks related to exchange rate changes in the presence of net balance sheet effects (cf. Levy-Yeyati, 2006; Aghion et al., 2009). The literature unambiguously highlights the importance of well-developed financial markets, in particular the development of local currency-denominated financial instruments, as highly relevant to mitigate the aforementioned adverse effects on net wealth and monetary policy constraints.

[T]he development and active use of a fixed-rate local currency market for funding government and corporate financing needs is probably the single most important step an LDC [less developed country] can take in reducing its sensitivity to external shocks. (Pettis, 2001: 168)

The economic literature conventionally investigates regional monetary integration based on the optimum currency area (OCA) theory established by Mundell (1961). Numerous contributions have been made to OCA theory. These studies largely concentrate on empirically exploring how appropriate various regions in the world are in their ability to fit the conditions for successful regional monetary integration that have been set up by the first generation of OCA literature (see Mundell, 1961; Kenen, 1969; McKinnon, 1973; see also Corden, 1972). By and large, OCA theory focuses on examining the economic costs associated with giving up monetary sovereignty by giving up exchange rate policy as an autonomous monetary policy tool. A central conclusion of OCA theory is that integrating countries need to show symmetric reactions to external shocks and a high level of economic convergence in order to benefit from creating a common currency area. In line with this argument, first-generation authors identified three main optimality conditions for regional monetary integration.¹

In order to contribute to a systemized analytical framework for examining SSC beyond OCA, the “regime changing character” (Schelkle, 2001a: 327) of regional monetary cooperation needs to be addressed. Therefore, the research perspective needs to be changed by analyzing regional monetary cooperation as a possible policy strategy to mitigate policy constraints and enhance macroeconomic stability in southern economies with fragile financial markets, instead of focusing on allocation effects in turn for removing supposedly autonomous monetary policy tools (cf. Roy and Betz, 2000; see Chapter 5).

As mentioned in Chapter 5, traditional OCA theory focuses on the question of whether the integrating economies react symmetrically or asymmetrically to external shocks.¹ The OCA literature suggests that asymmetric regional monetary integration is a costly undertaking, because regional monetary policy goes along with policy compromises that are likely to be less suitable, with fewer region-wide synchronized business cycles (cf. Mundell, 1961). In view of OCA theory, the most cost-efficient regional monetary integration arrangement would be one in which monetary policy intervention serves similar needs, that is, whenever none of the participating member countries suffers from an inappropriate regional monetary policy strategy. A heterogeneous and perhaps asymmetric group of mostly financially fragile, less diversified economies with inflexible factor markets would not be considered a cost-efficient candidate for pursuing regional monetary cooperation. However, in reality, a number of such regional monetary cooperation arrangements exist. For example, the CMA region in Southern Africa is a prime example of a highly asymmetric regional monetary cooperation arrangement (see Chapters 6 and 10). From an OCA theoretical point of view, such arrangements should be highly inefficient and probably dissolve at a certain point in time.

Previous chapters reviewed the potential benefits of regional monetary cooperation with regard to macroeconomic stabilization, exchange rate stabilization, and financial market development, including in asymmetric SSC around an anchor currency. This chapter outlines potential economic costs involved in regional monetary cooperation and summarizes supporting conditions for realizing macroeconomic stabilization gains in SSC. Within the scope of this book, this chapter merely seeks to shed some light on major cost considerations that come into play when analyzing SSC rather than fully exploring economic costs involved in SSC.

The following case studies take a closer look at economic and monetary characteristics of the respective regions to analyze the specific regional conditions that contribute to or hinder exchange rate stabilization and financial market development. In particular, the case studies address the question of how region-specific constellations of country characteristics, heterogeneity of member countries, and regional conditions affect the exchange rate stabilizing potential of SSC. The comparative case studies are framed by a brief introduction to the historical and economic conditions of regional monetary cooperation in each region; furthermore, the case studies explore regional macroeconomic stability by examining the member countries’ macroeconomic characteristics with regard to monetary policy constraints, exchange rate stability (cf. Chapter 3), and financial market development (cf. Chapter 4). The case studies specifically aim at identifying regional circumstances that hinder or support exchange rate stabilization and financial market development in regional monetary cooperation compared with non-cooperation.

The foundations for Southern Africa’s regional monetary cooperation date back to the beginning of the 20th century. When the South African Reserve Bank (SARB) was established in 1921, the British pound and, with its introduction in 1961, the South African rand became the regional medium of exchange and legal tender in South Africa, Botswana, Lesotho, Namibia, and Swaziland. “There were no internal restrictions on movements of funds within the area and virtually all external transactions were effected through banks in South Africa and subject to South African exchange controls” (Wang et al., 2007: 7).

Today’s ASEAN/ASEAN+3 regional monetary cooperation framework dates back to initial regional cooperation schemes in the Association of Southeast Asia between the Philippines and Thailand in 1961 and the Maphilindo — an acronym formed of the first letters of the Malaysian Federation, the Philippines, and Indonesia — in 1963 (cf. Sandhu et al., 2003: 29 ff.). However, both arrangements were short-lived, largely due to border conflicts and political disputes. Nevertheless, the Association of Southeast Asia’s organizational structures are still represented in ASEAN.

Regional cooperation in Latin America has a long history. Its first formal initiatives date back to 1826, when Venezuelan Simon Bolivar — “Latin America’s Liberator” (cf. Lawrezki, 1981) — initiated the “First Congress of American States” in Panama. At that time, the countries created the world’s first regional confederation (cf. Siegler and Haefs, 1969: 78), only a few years after the last country had gained independence from Spanish colonization. The contract remained a non-binding expression of interest, but still provides the basis for the narrative of regional cooperation on the continent. However, Latin America’s discursive historical legacy of regional cooperation did not stimulate materialization of regional cooperation. Rather — and in particular in the MERCOSUR region — efforts towards closer economic cooperation have been characterized by stagnation and frequent setbacks (Emmes and Mols, 1993: 47).

An interregional perspective allows the identification of potential drivers of the associations between SSC, exchange rate volatility, and financial market development suggested by the case studies of cooperating regions in CMA and ASEAN/ASEAN+3 and a non-cooperating region in MERCOSUR.

This book examined the potential of regional monetary cooperation to contribute to macroeconomic stabilization and financial market development in developing countries and emerging markets. The findings of this book underline that the idea of regional monetary cooperation has not come to an end in the face of the on-going eurozone crisis. Rather, international financial turmoil, as well as the eurozone crisis, justifies scholarly and political examination of the potential benefits and also of the costs related to different forms of regional monetary cooperation in the developing world.