A common currency for SAARC?

A PIECE OF MY MIND

Earlier this year, at the twelfth SAARC summit held in Islamabad, then Prime Minister Vajpayee mooted the vision of a common currency for SAARC.

Is this a goal worth pursuing seriously? Or is it one of those PMO/MEA "economic initiatives" with low economic rationality and high temporary utility for fleshing out a prime ministerial speech in a regional summit?

(Incidentally, it is noteworthy that last autumn's official enthusiasm for free-trade-area initiatives has subsided somewhat in the face of reality and some serious questioning by a new Prime Minister with full command over the economics of international trade.) Irrespective of pedigree, let's evaluate the proposal on merits.

Those in favour of a common SAARC currency usually advance four main arguments in support. First, they argue that a common currency is a characteristic of strong regional economic integration and therefore a worthy goal.

Second, they point out that currency unification will eliminate exchange risk and uncertainty and thereby promote inter-country trade and investment. Third, these objectives will also be advanced by the reduction of transaction costs arising from currency conversions. Fourth, advocates back a currency union in the belief that it will promote political unity amongst the constituent nations.

Let's consider these arguments in turn. The first argument is really not an argument at all. It simply states that regional economic integration is a good thing and therefore we should pursue it by all available means, including a common currency.

It begs the obvious question of whether such integration is in the national economic interests of the cooperating nations. That question can only be answered by exploring the costs and benefits of economic cooperation through various means. Similarly, the fourth argument is only a statement of faith, not supported by experience.

In the long sweep of history, common currencies have usually followed political unification (often attained through imperial conquest). Political unity has not been catalysed through currency unification. One possible notable exception is the 50-year-old enterprise of European unification, spawned by the trauma of two world wars.

In this case, clearly the advent of the euro has preceded full political unity. But, even in this instance, it is far from clear whether currency unification (covering a subset of the countries of the recently expanded European Union) is promoting or impeding political unification.

Returning to South Asia, it is surely a very wishful pipe dream to think that the fault lines of political conflict and rivalry between India and Pakistan (to take the obvious bilateral pairing) can be effectively bridged through a programme of monetary unification.

On the contrary, the slow progress of the South Asia Free Trade Area (SAFTA) suggests that political antagonisms have and will seriously impede efforts at regional economic cooperation.

The second and third arguments (of eliminated exchange risk and reduced transaction costs) are genuine economic benefits of a common currency. The question is how significant these benefits are for South Asian countries and how they stack up against the very real costs that currency unification imposes on participating nations.

A rough guide to the significance of these purported economic benefits is provided by the importance of intra-SAARC trade in relation to the total trade of SAARC countries.

This ratio has hovered in the range of only 4"�5 per cent over the past decade, despite SAFTA and various bilateral free trade agreements (FTAs) among SAARC countries.

Contrast this low number with 50 per cent plus for the North American Free Trade Agreement (NAFTA) and 20 per cent plus for ASEAN. (Incidentally, there isn't much impetus for a common currency in even these more successful regional trading arrangements.)

Furthermore, intra-SAARC cross-border flows of capital are even less significant in relation to total investment flows into SAARC nations. Therefore, as a first approximation, it is clear that the benefits from a common currency are likely to be modest for SAARC members.

What about the costs? Although regional integration enthusiasts tend to gloss over these, the costs can be quite substantial for member countries. The most obvious costs arise from the loss of sovereign control over monetary and exchange rate policies.

A common currency means that these policies would be conducted by some version of a SAARC central bank which would subsume much of the policy-making prerogatives of today's national central banks of SAARC countries.

To put it bluntly, the RBI (together with the finance ministry) would no longer determine India's monetary and exchange rate policies. Before turning to the economic costs, we should frankly recognise that the political and psychological costs of such loss of monetary independence are likely to be very substantial for all member countries and their governments.

As for economic costs arising from the loss of policy autonomy, the literature on "optimum currency area" indicates that such costs are likely to be higher to the extent that business cycles across member states are not synchronised and to the extent that member nations are subject to different (in time and degree) shocks, to which their economies have to adjust.

The huge economic costs recently suffered by Argentina at the collapse of its unsustainable currency board system (a weaker version of a common currency with the US) should offer some warning to armchair proponents of currency union for SAARC.

Recent econometric studies by Maskay (e.g. in South Asia Economic Journal, 2001) and others have shown that there has been no significant synchronisation of economic cycles (as reflected in trends in GDP growth and inflation) among SAARC countries during 1980"�2000.

What this means is that the monetary authorities in each SAARC country had to contend with rather different business cycle conditions at any given point in time.

Conversely, any uniform monetary and exchange rate policy imposed by a regional SAARC central bank would not have been in the interests of individual member countries. These studies also suggest that the pattern of exogenous political and climatic "shocks" experienced by SAARC countries was quite diverse, despite some emerging trends of convergence in trade and exchange rate liberalisation.

Overall, the empirical studies point to substantial divergence in the pattern of business cycles and shocks across SAARC countries. This, in turn, means that SAARC countries are better off retaining the freedom of policy action available with separate central banks and independent monetary and exchange rate policies.

None of this should come as a surprise, given the very limited degree of economic integration achieved across SAARC countries thus far. Nor is the situation likely to change dramatically in the foreseeable future.

The advocacy of a common SAARC currency at present is really a case of putting the cart before the horse. We need a far freer movement of goods, services, capital, and people across borders within SAARC before the issue of currency unification can be treated as serious. In any case, there is no real political appetite for a common currency.

The largest SAARC country, India, would consider ceding monetary autonomy to a regional SAARC central bank only if India effectively controlled that institution's policies. Under those conditions the smaller SAARC nations are hardly likely to sign on for a common currency.

To sum up, there are compelling economic and political reasons against a common currency for SAARC. It's an idea whose time has not yet come ... and quite possibly, never will.

(The author is member, 12th Finance Commission, and professor, ICRIER. The views expressed are strictly personal)