Is East Asia an optimum currency area? A test of generalized purchasing power parity in the presence of structural breaks

Abstract

This paper applies the generalized purchasing power parity (G-PPP) theory to assess the potential for an optimum currency area (OCA) for the ASEAN5 plus the big three (ASEAN5+Big3) during a period containing significant structural breaks, using the US, Japan and China as base countries. The relevance of considering breaks is demonstrated by utilizing the Johansen et al. (2000) procedure that allows for up to two predetermined breaks. The results provide support for long-run G-PPP and suggest that the larger group ASEAN5+Big3 could form an OCA in one step. Conversely, for smaller groups, such as the Big3, an OCA is not supported. However, adding one or more countries to the Big3 supports an OCA. The impact of the Asian crisis seems to be limited to when the US is the base country and the results suggest a change in the G-PPP relationship between the pre- and postcrisis periods. Moreover, stability tests suggest that G-PPP has been stable for the period analyzed.