East Asian Currency Area: A Bayesian Dynamic Factor Model Analysis

There has been recently increasing interest in the establishment of a common currency area in East Asia in the aftermath of the East Asian financial crisis. In this paper, we examine the desirability and feasibility of forming a currency area in the region by checking the symmetry of shocks as an important criterion of the Theory of Optimum Currency Area. We employ a Dynamic Factor Model to decompose aggregate output into global, regional and country-specific components and estimate the model using Gibbs sampling simulation. Persistent properties of those components are examined and variance decomposition analysis is performed to investigate the role of each component in output variance. Based on variance analysis, we find that East Asia countries, on average, are less plausible candidates for a currency area than European counterparts. However, a subgroup of countries in East Asia are as qualified as those in Europe. Given the ongoing integration in East Asia, it is not premature to prepare for such a currency area in this region.