Whither Currency Union in Greater China?

Abstract

The paper attempts to evaluate the prospect of creating a currency union in the "Greater China" economic area including Mainland China, Hong Kong and Taiwan. Despite of the political deadlock and military confrontation in the Taiwan Strait, the Greater China area has experienced rapid and spontaneous regional integration in the past decades as a result of increasingly cross-border trade, foreign direct investment (FDI), technology contracts, and other arrangements in accordance with changes in comparative advantage and industrial upgrading in these economies. In this study, we focus on the symmetry in shocks that is perceived as one of the major preconditions of a currency union. In contrast to the previous studies, we investigate the time-varying correlation of supply and demand shocks by using the Kalman filter technique in order to reveal whether the Greater China economies show a convergence trend. We also examine the costs of forming a currency union in the area that are caused by the loss of monetary autonomy in each economy. Our results emphasize an increasing symmetry in demand shocks and, to a lesser extent, in supply shocks, implying that these economies would not suffer too much from abandoning their monetary policy as an instrument of absorbing shocks. Acknowledgements: An earlier version of the paper was presented at the 9th International Convention of the East Asian Economic Association in Hong Kong and the CITS Research Workshop at Yokohama National University, Japan. The authors wish to thank Rasmus Rffer, Masahito Kobayashi, Hiroyasu Uemura, Craig Parsons, Masaru Inaba, and participants in the conference and seminar for their helpful comments and suggestions. The authors wish to acknowledge the financial support of the JSPS through the Grant-in-Aid for Scientific Research (B), 116330059.Optimum currency area, structural shocks, vector autoregression, Kalman filter, output losses, Greater China