Optimum Currency Research Articles

ON BUSINESS CYCLES SYNCHRONIZATION: SOME DIRECTIONS FOR THE EURASIA

The synchronization of business cycles is strictly related with the functioning conditions in the currency areas. Being a general requirement for membership in such an area, the synchronization of business cycles was probed by the view that, in any case, it would result from the very operation of the optimal currency zone. For Eurasia as a broad context, the European perspective seems to be important. For instance, the experience of a formal economic union such as the one that has existed in Europe since 1999 could be harnessed to better understand the challenges that a union of this kind might face in Eurasia, just as the one that has recently been constituted. The article considers this approach, through the analysis of the evolution of the synchronization of business cycles, as a relevant element in the (smooth) functioning of any economic and monetary union. Taking this into account, we consider a reasonably long time period (1990-2016) and a large sample of countries (50), i.e. all those integrated into some kind of formal economic union existing in this relevant geopolitical region, namely the European Union (EU) and the Eurasian Economic Union (EAEU), as well as 17 non-integrated countries, as a control group. In what concerns the results, during the 1990-1998 period, the degree of business cycles synchronization was, in general, fairly low, even for countries already integrated in an economic community. The degree of synchronization of business cycles has, generally, fairly increased in the period 1999- 2007, notably in European countries (not in the EU alone). Finally, in the period 2008-2016, which includes the recent global financial crisis, there was a broad decline in the synchronization of business cycles, which was not so obvious for the countries integrated in a formal economic union. In fact, it seems to be possible to conclude that belonging to a union of this kind is a crucial prerequisite for the inexistence of evidently idiosyncratic business cycles

Money, Sovereignty, and Optimal Currency Areas

We propose a new theory of Optimum Currency Areas (OCAs) based on monetary sovereignty. We consider two economically integrated countries with separate currencies and monetary policies, but with exchange rate underreaction. We show that the two countries are then engaged in a strategic monetization game, which may generate excessive inflation in equilibrium. A monetary union between the two countries can eliminate this excess inflation cost, but also removes a nation's monetary sovereignty. By eliminating the option to monetize debt in times of exigency, a monetary union may give rise to costly debt defaults. Joining a monetary union therefore involves trading excess monetization costs for debt default costs. Allowing for fiscal transfers within the union and for the option of debt monetization in a generalized crisis are optimal features of a monetary union. Our model also provides a coherent analytical framework that helps shed light of the recent history of OCAs.

Persistence and stochastic convergence of euro area unemployment rates*

This paper analyzes unemployment rates in the euro area (EA) countries to test for EA-related benefits and economic integration of the EA in the form of lower unemployment rates and unemployment rates convergence. We employ recently developed unit root tests with structural breaks and non-normal errors to analyze the persistence, test the stochastic convergence and locate structural break(s) in EA unemployment rates from 1995q1 to 2016q2. Our results imply a certain degree of unemployment hysteresis in the EA. Even though the results support the stochastic convergence of the majority of EA countries, we find that EA membership is not a sufficient condition for stochastic convergence. Nevertheless, EA-related breaks are followed by the periods of convergence to the EA11 average. Crisis-related breaks are followed by the periods of divergence. Although providing initial benefits, EA is not functioning as an optimal currency area.

Appraisal of the preparedness of ECOWAS towards a common currency

This study appraised the preparedness of Economic Community of West African States (ECOWAS) towards the adoption of a common currency by analysing the degree of symmetry and sizes of identified shocks across member countries. The analysis was situated within the framework of the Optimum Currency Area (OCA) theory and the structural vector autoregressive (SVAR) model was employed on secondary data from 1975 to 2015. The findings reveal that external supply shocks across ECOWAS countries are symmetric except for Sierra Leone, while demand, supply and monetary shocks among member countries are asymmetric. The absolute relative sizes of the different shocks across member countries are high and different in sizes. This implies that ECOWAS countries are not fully prepared to adopt a common currency and the fixed exchange rate as a stabilization policy for the entire West Africa. Hence ECOWAS governments should further shift the targeted date beyond 2020 to create ample time for member countries to get fully prepared.

Exchange rate dynamics and their effect on macroeconomic volatility in selected CEE countries

To understand the potential for forming an optimum currency area it is important to investigate the origins of macroeconomic volatility. We focus on the contribution of real exchange rate shocks to macroeconomic volatility in selected Central and Eastern European countries. The contribution of real exchange rate shocks relative to other shocks allows us to evaluate whether the real exchange rate is a source of volatility or a buffer against shocks, as the theory suggests. The identification of the contributions is based on variance decomposition in two-country structural VAR models, which are identified by the sign restriction method. For most of the countries in the sample, shocks are predominantly symmetric relative to their effective counterpart, although the role of non-symmetric shocks is non-negligible. In general, for all the countries considered except Bulgaria and Slovenia, the real exchange rate does not generate large volatility over the business cycle and, with the exception of Bulgaria and Romania, is mostly driven by the non-symmetric shocks. These results are consistent with the real exchange rate having a shock-absorbing nature.

Monetary union in Latin America: an assessment in the context of optimum currency area

ABSTRACT The article applies the optimum currency area (OCA) theory to Latin America to assess the potential of a monetary union in Latin America and in its major existing regional trade agreements (RTAs). According to OCA criteria we find that Latin America is far from being an optimum currency area, as its countries’ exposure to asymmetric shocks is high and their capacities to adjust in response to macroeconomic disturbances are limited. Using a panel of 20 Latin American countries from 1990 to 2014, we apply the dynamic OLS estimation techniques to estimate the costs and benefits of a potential monetary union in Latin America and in its various RTAs. to estimate the costs and benefits of a potential monetary union in Latin America and in its various RTAs. We find that the costs are high, because Latin America’s economies are vulnerable to severe macroeconomic disturbances and its RTAs differ significantly in their response to negative demand shocks. Most of the monetary efficiency gains are shown to be the result of a common restrictive monetary policy which would result in higher FDI inflows and, to a more limited extent, increased GDP, both overall and per capita. Although Central American countries are shown to be most suitable for further monetary integration, we conclude that Latin American countries should head first towards greater economic and political integration.

Migration as an adjustment mechanism in the crisis? A comparison of Europe and the United States 2006–2016

The question of whether migration can be an equilibrating force in the labour market is an important criterion for an optimal currency area. It is of particular interest currently in the context of high and rising levels of labour market disparities, in particular within the Eurozone where there is no exchange-rate mechanism available to play this role. We shed some new light on this question by comparing pre- and post-crisis migration movements at the regional level in both Europe and the United States, and their association with asymmetric labour market shocks. We find that recent migration flows have reacted quite significantly to the EU enlargements in 2004 and 2007 and to changes in labour market conditions, particularly in Europe.Indeed, in contrast to the pre-crisis situation and the findings of previous empirical studies, there is tentative evidence that the migration response to the crisis has been considerable in Europe, in contrast to the United States where the crisis and subsequent sluggish recovery were not accompanied by greater interregional labour mobility in reaction to labour market shocks. Our estimates suggest that, if all measured population changes in Europe were due to migration for employment purposes – i.e. an upper-bound estimate – up to about a quarter of the asymmetric labour market shock would be absorbed by migration within a year. However, in the Eurozone the reaction mainly stems from migration of third-country nationals. Even within the group of Eurozone nationals, a significant part of the free mobility stems from immigrants from third countries who have taken on the nationality of their Eurozone host country.

To Be or Not to Be a Euro Country? The Behavioural Political Economics of Currency Unions

The aim of this paper is to use a behavioural political economy approach to revise the standard approach of optimal currency areas, and applying it to the Eurozone case. We discuss the pros and cons of the Euro membership if behavioural biases - prospect theory - influence the citizens and consequently the political actors. The theoretical framework is used to analyse in general under which conditions the Euro irreversibility assumption is likely to hold and specifically the support in favour of the Euro membership in a country case.

Aftershocks of monetary unification: Hysteresis with a financial twist

Abstract In the 1990s it was widely agreed that neither Europe nor the United States satisfied the conditions for constituting an optimum currency area, although the U.S. came closer (Bayoumi and Eichengreen 1993). Moderating this concern about Europe was the fact that it was possible to distinguish a regional core and periphery. Using updated data, we confirm that the United States remains closer to an optimum currency area. More intriguingly, the Euro Area shows striking changes in correlations and responses. We interpret these as reflecting hysteresis with a financial twist, in which the financial system causes aggregate supply and demand shocks to reinforce each other. An implication is that the Euro Area needs vigorous, coordinated regulation of its banking and financial systems by a single supervisor—that monetary union without banking union will not work.

Scotland as an optimal currency area

AbstractThe June 2016 UK referendum on continued EU membership where the people of Scotland voted to remain, while the rest of the United Kingdom voted to leave, once again makes the issue of whether Scotland is an optimal currency area very topical. England voted strongly to leave Europe while Scotland backed remain by 62% to 38%. The Scottish government published its draft bill on a second independence referendum in October 2016. The move does not mean another referendum will definitely be held, but this does raise the possibility that Scotland might choose independence and staying in the EU without the rest of the United Kingdom. If Scotland charts a course of independence from the rest of the United Kingdom, then they would likely either issue their own currency or join or form another currency area.In this paper, we test the microeconomic foundations of a common currency area for Scotland, United Kingdom, and the rest of the United Kingdom without Scotland. We find that the United Kingdom, Scotland, and the United Kingdom without Scotland all meet the microeconomic criteria for a common currency area. In contrast, banking data suggest that lending in Scotland is different from lending in the rest of the United Kingdom, adding some doubt to the issue of whether or not Scotland is a common currency area with the United Kingdom.

A Search for an Optimum Currency Area

Abstract Economic and monetary integration is the result of unifying efforts that have become a major driving force in post-war Europe. Although some of the initial initiatives, the Monetary Union project has many times been on the brink of interest. It can be as the surprise that Europe has managed to implement the common currency so soon and relatively smoothly. Nevertheless, even after its launch, this project has never completely abandoned criticism and discussion of the legitimacy and meaningfulness of its existence. Critical attitudes to the introduction of the common currency in the European Union are based above all on the Optimum Currency Area theories. The theoretical concept of optimal currency areas is currently considered a standard tool for assessing monetary integration efforts in Europe. OCA criteria are used to estimate the readiness of the candidate countries to adopt the euro, while the convergence processes are linked to the decision on the euro adoption timeline. The aim of our research article is, therefore, to closely analyze the issue of monetary policies and optimal currency areas in the context of convergence efforts towards more closely integrated economic and monetary unions.

Risk Management of Dollarization in Banking: Case of Post-Soviet Countries

Dollarization of bank assets and liabilities is a typical phenomenon with multi-faceted effects. Primarily, this phenomenon raises risks of imbalance in assets and liabilities following a sharp local currency devaluation. However, dollarization may deliver additional returns. This calls for development and implementation of strategies for dollarization risk management. This study aims at designing risk management strategies for ensuring optimal currency structure of loan and deposit portfolio under an extremely high level of devaluation risk in six post-Soviet countries. The study is based on risk modeling methods and asset liability management techniques. The value-at-risk methodology is applied to measure and identify main risks banks face under dollarization. Two types of risk are identified: the strategic risk measured as a ratio of deposits in foreign currency; and the tactical risk measured as a ratio of foreign currency deposits transformed into local currency loans.

Target2: The Silent Bailout System that Keeps the Euro Afloat

Target2 is the Eurozone’s cross-border payment system and is mandatory for the settlement of euro transactions involving Eurozone central banks. It is being used to save the Eurozone from imploding. A key underlying problem is that the Eurozone does not satisfy the economic conditions for being an Optimal Currency Area, a geographical area over which a single currency and monetary policy can operate on a sustainable long-term basis. The different business cycles in the Eurozone, combined with poor labour and capital market flexibility, mean that systematic trade surpluses and deficits will build up – because inter-regional exchange rates can no longer be changed. Surplus regions need to recycle the surpluses back to deficit regions via transfers to keep the Eurozone economies in balance. But the largest surplus country – Germany – refuses formally to accept that the European Union is a ‘transfer union’. However, deficit countries including the largest of these – Italy – is using Target2 for this purpose. Further, the size of the deficits being built up is causing citizens in deficit countries to lose confidence in their banking systems and they are transferring funds to banks in surplus countries. Target2 is also being used to facilitate this capital flight. However, these are not viable long-term solutions to systemic Eurozone trade imbalances and weakening national banking systems. There are only two realistic outcomes. The first is full fiscal and political union – which has long been the objective of Europe’s political establishment. The second is that the Eurozone breaks up.

Optimal Payment Areas or Optimal Currency Areas?

We use the Optimal Capital Structure of Nations framework in Bolton and Huang (2018) to develop a new theory of Optimum Currency Areas. Whether two economically integrated nations should form an optimal currency area depends on a trade-off between financial flexibility (the value of monetary sovereignty) and monetary discipline (the commitment not to engage in competitive monetizations). We show that a monetary union works best when combined with a fiscal union and fiscal transfers. We also show that debt monetization is still desirable in a monetary union when both member-countries simultaneously face a negative output shock.

Lessons from historical monetary unions - is the European monetary union making the same mistakes?

This article examines three historical monetary unions: the Latin Monetary Union (LMU), the Scandinavian Monetary Union (SMU), and the Austro-Hungarian Monetary Union (AHMU) in an attempt to derive possible lessons for the European Monetary Union (EMU). The term ‘monetary union’ can be defined either narrowly or broadly depending on how closely it conforms to Mundell’s notion of ‘Optimal Currency Area’. After examining each of the historical monetary unions from this perspective, the article concludes that none of them ever truly conformed to Mundell’s concept, nor does the EMU. Nevertheless, the article argues that some lessons may be learned from these historical experiences. First, it is necessary that there exist robust institutions such as a common central bank and a unified fiscal policy in order to withstand external shocks. The three early unions could not withstand the shock of WWI. Another important lesson is that continuing national rivalries can undermine any monetary union.

Re-Exploring the Enlargement of the Eurozone: Evidence from the New Member-States

ABSTRACTThe debt crisis of the Euro Area in 2010 raised plenty of doubts concerning the sustainability of the monetary union. Eurozone includes economies which have different structural characteristics. This event does not allow the establishment of an optimal currency area. The present research attempts to explore if the join of Cyprus, Malta, Latvia, Slovenia and Slovakia in the Eurozone was in favor of their economies. We used the nominal exchange rates as a financial instrument by combing the Error Correction Model with the Threshold GARCH, ECM-TGARCH. The empirical findings highly support that the EU membership influenced positively the relationship between the euro and the Cypriot Pound, the Latvian Lats and the Slovenian Tolar. On the contrary, we discovered that the join of Malta in the EU had a slightly negative and a long-term impact in the relationship between the euro and the Maltese currency. Finally, the entrance of Slovakia in the EU influenced positively the Slovakian currency. However, the relationship between the euro and the Slovakian Koruna remained negative.

Optimal Currency Area: A twentieth Century Idea for the twenty-first Century?

We take stock of the history of the European Monetary Union and pegged exchange-rate regimes in recent decades. The post-Bretton Woods greater financial integration and under-regulated financial intermediation have increased the cost of sustaining a currency area and other forms of fixed exchange-rate regimes. Financial crises illustrated that fast-moving asymmetric financial shocks interacting with real distortions pose a grave threat to the stability of currency areas and fixed exchange-rate regimes. Members of a currency union with closer financial links may accumulate asymmetric balance-sheet exposure over time, becoming more susceptible to sudden-stop crises. In a phase of deepening financial ties, countries may end up with more correlated business cycles. Down the road, debtor countries that rely on financial inflows to fund structural imbalances may be exposed to devastating sudden-stop crises, subsequently reducing the correlation of business cycles between currency area’s members, possibly ceasing the gains from membership in a currency union. A currency union of developing countries anchored to a leading global currency stabilizes inflation at a cost of inhibiting the use of monetary policy to deal with real and financial shocks. Currency unions with low financial depth and low financial integration of its members may be more stable at a cost of inhibiting the growth of sectors depending on bank funding.

Exchange rate forecasting and the performance of currency portfolios

AbstractWe examine the potential gains of using exchange rate forecast models and forecast combination methods in the management of currency portfolios for three exchange rates: the euro versus the US dollar, the British pound, and the Japanese yen. We use a battery of econometric specifications to evaluate whether optimal currency portfolios implied by trading strategies based on exchange rate forecasts outperform single currencies and the equally weighted portfolio. We assess the differences in profitability of optimal currency portfolios for different types of investor preferences, two trading strategies, mean squared error‐based composite forecasts, and different forecast horizons. Our results indicate that there are clear benefits of integrating exchange rate forecasts from state‐of‐the‐art econometric models in currency portfolios. These benefits vary across investor preferences and prediction horizons but are rather similar across trading strategies.

The trinity of wage setting in EMU: A policy proposal

Diverging labor cost developments are often considered to be one of the most important factors that led to large current account imbalances in the euro area (EA) in the run-up to the global financial crisis. It has also been shown that wage growth differentials have significantly lowered the co-movement of EA countries’ business cycles – the most widely used meta-criterion for optimum currency areas. Against this background, this paper develops a wage-setting benchmark that aims to keep the economy in internal equilibrium and to maintain price stability, while it also exhibits the capacity to correct for external imbalances. The proposed wage benchmark is very simple and may serve as an anchor for the macroeconomic dialogue in Economic and Monetary Union. In order to demonstrate the potentially beneficial effects of such a wage benchmark we present some simulations showing how current account balances and labor costs would have developed across EA countries if the rule had served as a benchmark already in the run up to the crisis.

Income Convergence in the East African Community

The East African Community partner states aim to establish a Monetary Union by 2023. As advanced by the optimum currency area theory, countries seeking to enter into a monetary union should be as similar as possible to reduce their susceptibility to adverse economic shocks. The East African Monetary Union Protocol signed in 2013 stresses the need for convergence of macroeconomic variables as important preconditions before forming the monetary union. The benchmark macroeconomic indicators include a headline inflation rate of eight per cent, a fiscal deficit of three per cent of the country’s gross domestic product on net present value terms, a debt to gross domestic product ratio of 50 per cent and maintenance of a 4.5 months’ reserves of import cover. Article 82 (1) of the East African Community Treaty also compels partner states to work towards harmonizing their macro-economic policies especially those related to interest and exchange rates, fiscal and monetary policies. However, as argued by many scholars, nominal convergence alone cannot indicate how well countries will perform once they are in a monetary union. The criteria also fail to distinguish the countries that constitute an optimal currency area. An autoregressive distributed model was applied in regression analysis. Empirical findings supported the presence of conditional convergence and that per capita gross domestic product growth was positively influenced by physical capital and nominal exchange rate depreciation and negatively affected by human capital and inflation rate. From the foregoing, it can be concluded that reduction of income differences among the partner states can be fostered through increased investments in physical capital, maintenance of a competitive exchange rate regime and a low inflation rate regime. Keywords: Unconditional convergence, conditional convergence, Solow model, optimum currency areas and autoregressive redistributed lag model