A factor-augmented VAR analysis of business cycle synchronization in east Asia and implications for a regional currency union

Debate continues over whether a monetary or currency union will be a viable alternative to the current exchange arrangements in East Asia. This paper adds to the literature by assessing the level of business cycle synchronization among 10 major East Asian countries, which is considered as a key precondition for a regional currency union. Unlike previous studies, this paper employs a factor-augmented VAR model that encompasses a large set of 62 foreign and domestic variables simultaneously. Five common shocks are identified, and we examine how and to what extent these shocks affect each economy in the region. Empirical results indicate that the majority of East Asian countries respond similarly to world and regional shocks. Of particular importance is the finding that individual GDPs are well synchronized in response to the two major determinants of world and regional GDP shocks. Overall, the evidence presents a positive case for consideration of a regional currency arrangement in East Asia. Some suggestions are offered concerning steps to build a foundation towards greater monetary cooperation in East Asia.