Common currency in S Asia: a Trojan horse
by MA Taslim
THE finance minister sometimes says things that embarrass the nation. When the Sonali Bank-Hall Mark scam, a massive Tk 3,600-crore case of embezzlement of state-owned bank money, became public, his nonchalant response was that it was ‘not important’. In a repeat performance this year, he said about the Savar disaster: ‘I don’t think it is really serious — it’s an accident … It happens everywhere.’ It is mind boggling that such a comment could be made by a person of such high office about a tragedy of such magnitude as shook the conscience of the entire world and hogged the headlines of the international media for weeks.
The purpose of this write-up is not to engage in a criticism of these remarks of the finance minister (that has been done adequately in the media), but to draw attention to another apparently careless statement he made during his recent visit to India. This has indeed ‘serious’ implications for the nation, but has largely escaped the notice of the media. He has reportedly agreed with the Indians that Bangladesh and India should take lead to introduce a common currency in South Asia.
The optimum domain of a common currency has attracted a great deal of attention in the economic literature following the now-famous paper of Nobel laureate Robert Mundell (1961). Mundell’s paper was perhaps inspired by the then raging controversy regarding the appropriate exchange rate regime for a country, and the formation of economic community in Europe that had the promise to evolve into a full-blown economic and political union. The paper analysed just one aspect of any such unification, viz. a single currency for the entire region. It was followed by two more seminal papers by Ronald McKinnon (1963) and Peter Kenen (1969). All these papers were sceptical about the benefits of a common currency; they suggested that certain conditions must be fulfilled for a common currency to be beneficial to all member countries that form a common currency area. Incidentally, a number of economists did not consider Europe to be a good candidate for a common currency area for reasons that are now apparent.
The economics of common currency area is an abstruse technical subject that is difficult to fully comprehend or agree on. A common currency area may either have a single common currency or the member states may retain their individual currencies but these must be rigidly pegged against one another. More than four decades of theoretical and empirical analyses and ground preparation preceded the formation of the common currency area in Europe at the turn of the millennium; and yet it was done more on political than on economic considerations. The jury is still out whether the monetary union was the right thing to do in Europe.
There has been hardly any research done in Bangladesh regarding the benefits and costs of a currency or monetary union in South Asia or between Bangladesh and India. Even those organisations that go gaga over regional integration in South Asia have not produced any analytical paper on this topic. Neither the cabinet nor the parliament has, to the best of our knowledge, discussed this issue that has far reaching political and economic implications. Hence, it is not clear what the basis of the definitive statement of the finance minister that Bangladesh should pursue a common currency area in South Asia or with India was. Did he dutifully repeat what the Indians had prompted or was it a thoughtless gaffe of Savar magnitude?
The principal reason commonly advanced for a common currency area in South Asia is that it would promote greater trade and economic integration in the region by reducing transaction costs and exchange rate uncertainty. However, having a common currency does not necessarily promote greater economic integration, nor does not having one prevent integration. Some of the most economically integrated countries, such as USA-Canada, Switzerland-EU and Australia-New Zealand have separate currencies. There are several examples in recent history of countries using US dollar as their currency. Some Central American and Pacific Island countries use (or used) US dollar as their official currency; but this did not greatly promote trade or economic integration with the USA or other dollar countries. European countries did not become substantially more integrated post-1999 (when euro was accepted as a common currency) than they were before. In fact, the common currency was arguably more an outcome, rather than a cause, of economic integration.
An immediate implication of the adoption of a common currency in South Asia is that it will render individual monetary policies inoperable: a member country of a currency or monetary union cannot have an independent monetary policy. Nor can it have any exchange rate policy. An obvious corollary is that there will be no necessity for a central bank. The Bangladesh Bank will cease to exist as it is; it may operate only as a sub-office of a South Asian central bank much like a branch office of the Bangladesh Bank in Sylhet or Barisal.
Not having an independent monetary policy or currency may not always be undesirable. All those countries that have adopted a common currency obviously thought so. The desirability of a common currency sometimes arises from the incompetence (actual or suspected) of monetary authorities or excessive pressure on them from politicians for the adoption of harmful monetary policies. The principal attraction of a stable common currency from an academic point of view is that it avoids the credibility problem and thereby helps to anchor inflationary expectations.
This is highlighted by the recent economic crisis in Zimbabwe where inflation ran at a rate of over hundreds of billions per cent per year. As the Zimbabwean dollar became worthless, the government was forced to officially permit the use of foreign currencies (US dollar, Botswana pula and South African rand) in 2009 to stem the runaway hyperinflation. It fell to less than 3 per cent by the end of 2012.
Except for the first three years of its existence, inflation has never been very high in Bangladesh. By no stretch of imagination can it be determined that the Bangladesh Bank has conducted monetary policy so incompetently (or it has been subjected to such undue pressures) as to justify relieving it of the responsibility of formulating monetary policy altogether. More importantly, is it reasonable to assume that a South Asian (or Indian) central bank will function more efficiently?
The economic realities of South Asia are such that a common currency will in effect mean the Indian rupee (and the Reserve Bank of India will be the de facto South Asian central bank). This is suggested by the fact that Bhutan and Nepal already use Indian rupee alongside their own currencies. Currently, Indian GDP is about 80 per cent of South Asian GDP. It is inconceivable that Pakistan will join a monetary union with India in the foreseeable future such that a South Asian monetary union can be established only by excluding Pakistan. In this event Indian share of the proposed union’s GDP will rise above 90 per cent. A currency union will mean the abolition of the currencies and the central banks of all countries and the formation of a South Asian central bank with a common currency. Each member country will perhaps have some representation in the central bank, but their voice will be mute since, unlike SAARC, decisions will be made by the weight of the economy.
This may not necessarily be undesirable provided that the new central bank could be relied upon to perform efficiently and fairly on behalf of all the countries free of any interference from the Indian government. How sensible is it to assume so when the inflation record of India is worse or at least no better than that of Bangladesh (see figure) and it has at best indifferent relation with all the countries of the region?
Nonetheless, suppose all these issues are satisfactorily resolved by a magic wand and South Asia forms a monetary union. Would that improve economic well-being of the region? Here the concerns of Mundell, McKinnon and Kenen loom large.
To visualise the predicaments that may arise in a monetary union,
suppose that the Indian economy is doing well — its exports soaring, FDI flooding in and remittances rising. These would imply a substantial improvement in the balance of payments of the union and hence a strengthening of the common currency. Now further suppose that the Bangladesh economy is not doing as well; its export stagnant, FDI minimal and remittances modest. Hence, the GDP growth of Bangladesh falters and unemployment rises.
The normal policy response in such a situation in Bangladesh would be a monetary expansion to reduce interest rates and a depreciation of the domestic currency. However, none of these is feasible in the monetary union since neither money nor the exchange rate is controlled by Bangladesh. The only option then is to resort to fiscal expansion.
The government could subsidise export or increase government expenditure on goods and services. Both these fiscal actions will work to raise employment. Since revenue earnings slow down with a declining GDP growth, the only way a fiscal expansion is possible is by borrowing either from the central bank or from domestic banks. Whether it can borrow from the central bank will depend on negotiations, but it is unlikely that the central bank that has the responsibility over the entire union will view a request for discount loans sympathetically since the union as a whole is experiencing a business boom.
It would be rather cautious with monetary expansion lest it let the inflation genie out of the bottle. So the government would have to borrow from the market. Whatever is the source of funds, public debt will mount, and with it the future debt servicing liabilities. If the situation persists for a while, national debt will become a serious fiscal burden and subsidisation will become increasingly difficult. The current fiscal difficulties in some European countries should be a pointer.
A fiscal expansion will encourage a rise in imports. With exports stagnant this will aggravate the balance of payments problem. Unless the situation reverses on its own, foreign debt will also mount with the attendant repayment difficulties.
Note that if Bangladesh economy is doing as well as or better than the union economy, these problems will not occur, and the union policies will be supportive of stable growth.
The problem arises because India’s economic well-being requires a conservative monetary policy, whereas Bangladesh’s ailment calls for an expansionary policy; and there is no easy way to resolve this contradiction under a monetary union except under the conditions discussed below.
If workers in Bangladesh are free to move to other parts of the union when unemployment develops or if wages are flexible, the problem would resolve itself. Since wages tend to be sticky downwards, it is unlikely that these would decline sufficiently when unemployment develops. Free flow of capital will not help adjustments since capital is unlikely to flow into a depressed country with sticky wages. Furthermore, with interest rates equalised across the union there would be little incentives for capital to move. Hence, the solution essentially lies in the free movement of labour, which works not by increasing employment but by exporting the unemployed labour force across the border. The economic difficulties could also be alleviated if there is fiscal integration within the union that permits transfer of union resources to the depressed region.
How likely are these in a South Asian monetary union? With India fencing off entire Bangladesh and shooting down anyone trying to cross the border, it taxes imagination to assume that a significant number of people could move across the border. Nor is it likely that India would unilaterally transfer resources to Bangladesh to stimulate its depressed economy.
Free movement of labour within South Asia might be possible if the member countries agree on a real economic union, while fiscal transfers could be possible only if the member countries agree on a political union. Is Bangladesh or South Asia ready for such a radical step?
It should be understood that if South Asian countries form a monetary union, they would have unleashed unpredictable and irresistible forces that would push them toward either an eventual political union or a chaotic dissolution of the monetary union. Hence, any monetary unification measure must be taken consciously, transparently and deliberately; it must not be advanced ignorantly, hurriedly or surreptitiously.
Common currency in S Asia: a Trojan horse
by MA Taslim
THE finance minister sometimes says things that embarrass the nation. When the Sonali Bank-Hall Mark scam, a massive Tk 3,600-crore case of embezzlement of state-owned bank money, became public, his nonchalant response was that it was ‘not important’. In a repeat performance this year, he said about the Savar disaster: ‘I don’t think it is really serious — it’s an accident … It happens everywhere.’ It is mind boggling that such a comment could be made by a person of such high office about a tragedy of such magnitude as shook the conscience of the entire world and hogged the headlines of the international media for weeks.
The purpose of this write-up is not to engage in a criticism of these remarks of the finance minister (that has been done adequately in the media), but to draw attention to another apparently careless statement he made during his recent visit to India. This has indeed ‘serious’ implications for the nation, but has largely escaped the notice of the media. He has reportedly agreed with the Indians that Bangladesh and India should take lead to introduce a common currency in South Asia.
The optimum domain of a common currency has attracted a great deal of attention in the economic literature following the now-famous paper of Nobel laureate Robert Mundell (1961). Mundell’s paper was perhaps inspired by the then raging controversy regarding the appropriate exchange rate regime for a country, and the formation of economic community in Europe that had the promise to evolve into a full-blown economic and political union. The paper analysed just one aspect of any such unification, viz. a single currency for the entire region. It was followed by two more seminal papers by Ronald McKinnon (1963) and Peter Kenen (1969). All these papers were sceptical about the benefits of a common currency; they suggested that certain conditions must be fulfilled for a common currency to be beneficial to all member countries that form a common currency area. Incidentally, a number of economists did not consider Europe to be a good candidate for a common currency area for reasons that are now apparent.
The economics of common currency area is an abstruse technical subject that is difficult to fully comprehend or agree on. A common currency area may either have a single common currency or the member states may retain their individual currencies but these must be rigidly pegged against one another. More than four decades of theoretical and empirical analyses and ground preparation preceded the formation of the common currency area in Europe at the turn of the millennium; and yet it was done more on political than on economic considerations. The jury is still out whether the monetary union was the right thing to do in Europe.
There has been hardly any research done in Bangladesh regarding the benefits and costs of a currency or monetary union in South Asia or between Bangladesh and India. Even those organisations that go gaga over regional integration in South Asia have not produced any analytical paper on this topic. Neither the cabinet nor the parliament has, to the best of our knowledge, discussed this issue that has far reaching political and economic implications. Hence, it is not clear what the basis of the definitive statement of the finance minister that Bangladesh should pursue a common currency area in South Asia or with India was. Did he dutifully repeat what the Indians had prompted or was it a thoughtless gaffe of Savar magnitude?
The principal reason commonly advanced for a common currency area in South Asia is that it would promote greater trade and economic integration in the region by reducing transaction costs and exchange rate uncertainty. However, having a common currency does not necessarily promote greater economic integration, nor does not having one prevent integration. Some of the most economically integrated countries, such as USA-Canada, Switzerland-EU and Australia-New Zealand have separate currencies. There are several examples in recent history of countries using US dollar as their currency. Some Central American and Pacific Island countries use (or used) US dollar as their official currency; but this did not greatly promote trade or economic integration with the USA or other dollar countries. European countries did not become substantially more integrated post-1999 (when euro was accepted as a common currency) than they were before. In fact, the common currency was arguably more an outcome, rather than a cause, of economic integration.
An immediate implication of the adoption of a common currency in South Asia is that it will render individual monetary policies inoperable: a member country of a currency or monetary union cannot have an independent monetary policy. Nor can it have any exchange rate policy. An obvious corollary is that there will be no necessity for a central bank. The Bangladesh Bank will cease to exist as it is; it may operate only as a sub-office of a South Asian central bank much like a branch office of the Bangladesh Bank in Sylhet or Barisal.
Not having an independent monetary policy or currency may not always be undesirable. All those countries that have adopted a common currency obviously thought so. The desirability of a common currency sometimes arises from the incompetence (actual or suspected) of monetary authorities or excessive pressure on them from politicians for the adoption of harmful monetary policies. The principal attraction of a stable common currency from an academic point of view is that it avoids the credibility problem and thereby helps to anchor inflationary expectations.
This is highlighted by the recent economic crisis in Zimbabwe where inflation ran at a rate of over hundreds of billions per cent per year. As the Zimbabwean dollar became worthless, the government was forced to officially permit the use of foreign currencies (US dollar, Botswana pula and South African rand) in 2009 to stem the runaway hyperinflation. It fell to less than 3 per cent by the end of 2012.
Except for the first three years of its existence, inflation has never been very high in Bangladesh. By no stretch of imagination can it be determined that the Bangladesh Bank has conducted monetary policy so incompetently (or it has been subjected to such undue pressures) as to justify relieving it of the responsibility of formulating monetary policy altogether. More importantly, is it reasonable to assume that a South Asian (or Indian) central bank will function more efficiently?
The economic realities of South Asia are such that a common currency will in effect mean the Indian rupee (and the Reserve Bank of India will be the de facto South Asian central bank). This is suggested by the fact that Bhutan and Nepal already use Indian rupee alongside their own currencies. Currently, Indian GDP is about 80 per cent of South Asian GDP. It is inconceivable that Pakistan will join a monetary union with India in the foreseeable future such that a South Asian monetary union can be established only by excluding Pakistan. In this event Indian share of the proposed union’s GDP will rise above 90 per cent. A currency union will mean the abolition of the currencies and the central banks of all countries and the formation of a South Asian central bank with a common currency. Each member country will perhaps have some representation in the central bank, but their voice will be mute since, unlike SAARC, decisions will be made by the weight of the economy.
This may not necessarily be undesirable provided that the new central bank could be relied upon to perform efficiently and fairly on behalf of all the countries free of any interference from the Indian government. How sensible is it to assume so when the inflation record of India is worse or at least no better than that of Bangladesh (see figure) and it has at best indifferent relation with all the countries of the region?
Nonetheless, suppose all these issues are satisfactorily resolved by a magic wand and South Asia forms a monetary union. Would that improve economic well-being of the region? Here the concerns of Mundell, McKinnon and Kenen loom large.
To visualise the predicaments that may arise in a monetary union,
suppose that the Indian economy is doing well — its exports soaring, FDI flooding in and remittances rising. These would imply a substantial improvement in the balance of payments of the union and hence a strengthening of the common currency. Now further suppose that the Bangladesh economy is not doing as well; its export stagnant, FDI minimal and remittances modest. Hence, the GDP growth of Bangladesh falters and unemployment rises.
The normal policy response in such a situation in Bangladesh would be a monetary expansion to reduce interest rates and a depreciation of the domestic currency. However, none of these is feasible in the monetary union since neither money nor the exchange rate is controlled by Bangladesh. The only option then is to resort to fiscal expansion.
The government could subsidise export or increase government expenditure on goods and services. Both these fiscal actions will work to raise employment. Since revenue earnings slow down with a declining GDP growth, the only way a fiscal expansion is possible is by borrowing either from the central bank or from domestic banks. Whether it can borrow from the central bank will depend on negotiations, but it is unlikely that the central bank that has the responsibility over the entire union will view a request for discount loans sympathetically since the union as a whole is experiencing a business boom.
It would be rather cautious with monetary expansion lest it let the inflation genie out of the bottle. So the government would have to borrow from the market. Whatever is the source of funds, public debt will mount, and with it the future debt servicing liabilities. If the situation persists for a while, national debt will become a serious fiscal burden and subsidisation will become increasingly difficult. The current fiscal difficulties in some European countries should be a pointer.
A fiscal expansion will encourage a rise in imports. With exports stagnant this will aggravate the balance of payments problem. Unless the situation reverses on its own, foreign debt will also mount with the attendant repayment difficulties.
Note that if Bangladesh economy is doing as well as or better than the union economy, these problems will not occur, and the union policies will be supportive of stable growth.
The problem arises because India’s economic well-being requires a conservative monetary policy, whereas Bangladesh’s ailment calls for an expansionary policy; and there is no easy way to resolve this contradiction under a monetary union except under the conditions discussed below.
If workers in Bangladesh are free to move to other parts of the union when unemployment develops or if wages are flexible, the problem would resolve itself. Since wages tend to be sticky downwards, it is unlikely that these would decline sufficiently when unemployment develops. Free flow of capital will not help adjustments since capital is unlikely to flow into a depressed country with sticky wages. Furthermore, with interest rates equalised across the union there would be little incentives for capital to move. Hence, the solution essentially lies in the free movement of labour, which works not by increasing employment but by exporting the unemployed labour force across the border. The economic difficulties could also be alleviated if there is fiscal integration within the union that permits transfer of union resources to the depressed region.
How likely are these in a South Asian monetary union? With India fencing off entire Bangladesh and shooting down anyone trying to cross the border, it taxes imagination to assume that a significant number of people could move across the border. Nor is it likely that India would unilaterally transfer resources to Bangladesh to stimulate its depressed economy.
Free movement of labour within South Asia might be possible if the member countries agree on a real economic union, while fiscal transfers could be possible only if the member countries agree on a political union. Is Bangladesh or South Asia ready for such a radical step?
It should be understood that if South Asian countries form a monetary union, they would have unleashed unpredictable and irresistible forces that would push them toward either an eventual political union or a chaotic dissolution of the monetary union. Hence, any monetary unification measure must be taken consciously, transparently and deliberately; it must not be advanced ignorantly, hurriedly or surreptitiously.
Common currency in S Asia: a Trojan horse
