The problem with currency unions

The problem with currency unions is that while they appear deceptively simple in theory, they are awfully difficult to implement and sustain. To start with, the creation of a union is an administrative nightmare.

More importantly, it involves changes in the institutional and political structures of each participating nation that are, for the lack of a better phrase, far reaching.

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Prime Minister Vajpayee's recent proposal to create a currency union in South Asia (tentatively christened 'rupa') is commendable. However, though the economic benefits are obvious, the non-economic implications of staying in a currency union may prove unpalatable for our neighbours even in the long-term.

What are the economic benefits? A common currency, for one, does wonders for intra-regional trade and capital flows. The uncertainties associated with exchange rate variations and the concomitant costs of hedging these uncertainties disappear and transacting within the region becomes easier and less costly.

A common currency area's trade with the rest of the world also increases -- countries wishing to trade with the region face a single currency rather than a plethora of exchange rates. This, as in the intra-regional case, reduces risks and the cost of hedging.

How are currency unions set up? Countries wishing to participate agree on a set of economic norms that need to be satisfied and then through a set of graded steps finally adopt a common currency that replaces their individual currencies as the legal tender.

The more critical criteria relate to fiscal norms -- under the Maastricht rules that bind the European Union, for instance, member countries have to keep their fiscal deficit at less than 3 per cent of GDP and public debt stock at less than 60 per cent. Typically countries start as tariff unions and trade blocs and then graduate to a full-fledged currency union.

If the benefits of union are so obvious and a blueprint for its creation in place, what is the problem then? To get an answer to this question, the important thing to recognise is that a currency is much more than just a medium of transaction.

Currencies and their rates of exchange are an important tool of macroeconomic policy. Governments and central banks target and alter exchange rates to boost demand or suppress it depending on the domestic economic situation.

There is a further twist to this -- exchange rates and interest rates are two sides of the same coin. Any attempt to tinker with exchange rates spills over to interest rates and variations in interest rates find an automatic analogue in exchange rate changes.

To take an example, if the central bank pushes up domestic interest rates, then foreign capital tends to flow in, seeking a higher rate of return. The result is an appreciation of the currency. The bottom-line is that the exchange rate is a critical component of monetary policy, inseparable from interest rate policy.

The implication is that if a country decides to give its individual currency up and join a currency union, it automatically gives up control over monetary policy. Thus, if India and Pakistan were to form a currency union, the RBI and the Pakistan Central Bank would cease to exist.

Instead there would be a common central bank. In reality, it would be the stronger economy that would dominate monetary policy. France and Germany, for instance, quite clearly play 'big brother' in the euro currency union. For a South Asian currency union, it is very likely that the RBI would de facto, be the central bank for the region.

Now the plot gets a little murkier. Think of a situation where, hypothetically, the cotton crop (one of the biggest contributors to the economy) fails in Pakistan. At the same time, the Indian economy is on a roll (buttressed by booming manufacturing and services) and consequently inflationary pressures are building up.

Thus, while the Pakistan government wants the unified central bank to cut interest rates, India wants interest rates upped. This is the classical quandary in a currency union -- one of its members (Pakistan in this case) has faced an 'asymmetric shock' that has to be offset.

However the cost of using a traditional monetary measure (cutting interest rates) is high since it would set off an inflationary spiral in India.

Economists have found a way around this problem by claiming that labour mobility across regions can 'cure' asymmetric shocks. Thus, if Pakistani cotton farmers could temporarily relocate to India and tide over the cotton crisis, all would be hunky dory.

If the cotton economy shows signs of a long-term glut, the relocation of Pakistani farmers could be permanent. To generalise, a currency union in South Asia or anywhere else for that matter would succeed only if there is perfect labour mobility across countries.

While this might be a neat academic solution.

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