Evaluating the Feasibility of a Pacific Islands Currency Union

Abstract

This thesis evaluates the feasibility of a Pacific Islands currency union involving six Pacific Island countries (PICs) comprising Fiji, Papua New Guinea (PNG), Samoa, Solomon Islands, Tonga and Vanuatu, and their industrialised neighbours, Australia and New Zealand. PICs are vulnerable to internal and external shocks and how they mitigate the effects of these shocks is one of the biggest challenges facing PICs today. The negative effects of these shocks have contributed to a sluggish and subdued economic growth resulting in declining per-capita incomes and rising poverty levels. Although trade among PICs has improved, past and existing regional strategies (e.g., South Pacific Regional Trade and Economic Cooperation Agreement, among others) have generally failed to bring about sustained regional economic growth and integration. These strategies have been less effective in cushioning the effects of negative external shocks. In considering an encompassing framework to mitigate the effects of asymmetric shocks, the appeal and relevance of a currency union emerged. The literature and experience of existing currency unions shows that benefits (e.g., reduction in the effects of asymmetric shocks and exchange rate volatility) leading to price and output stability could be gained with limited costs if PICs entered into a currency union. The challenge is in determining whether PICs are ready to enter into a formal currency union among themselves, or with Australia and New Zealand. Using newly constructed quarterly macroeconomic time series data from 1980 to 2006 based on the modified Chow-Lin (1971) approach, this study drew from the Optimal Currency Area (OCA) theory and related extensions in the analysis of the behaviour of shocks, extent of business cycle synchronisation and alternate choice of anchor currencies in evaluating the preconditions for entering into a currency union. In the analysis of shocks, the Gonzalo and Ng (2001) methodology was applied in decomposing shocks into permanent and transitory components for key macroeconomic policy variables. In the evaluation of the business cycle synchronisation, three appropriate techniques were used, these being the Baxter-King (1999) filter, the Beveridge-Nelson (1981) decomposition following the state-space approach by Morley et al. (2003), and the common features econometric test by Vahid and Engle (1993). Further evaluation of alternative anchor currencies was undertaken based on analysing the effects of a currency union on exchange rate volatility. This involved newly constructed trade-weighted nominal exchange rate indices in the analysis of both short-term and cyclical volatility under varying weighting schemes and currency baskets. The overall findings showed that it was not feasible for the PICs as a group, to form a currency union. However, further investigation showed that the Melanesian sub-group is ready to enter into a currency union. However, more effort in the form of structural adjustment programs, for instance, is needed to realign and harmonise policies among Melanesian member countries. The results also favoured to some extent, the Australian dollar, as a possible anchor currency for Melanesia. The results for a Melanesian currency union reinforces more than three decades of efforts among the Melanesian countries to foster economic co-operation, trade and cultural relations even prior to the formation of the Melanesian Spearhead Group (MSG) in 1993. The recent setting up of the MSG Secretariat in 2008 to coordinate and administer the common policies of MSG countries only strengthens moves towards a formal Melanesian union. At the regional level, consolidating the current regional strategies and agreements (e.g., PACER and the Pacific Plan) into a unified common policy framework is important for future considerations for a single Pacific Islands currency union. The future challenge lies with the political will of Pacific regional leaders. In all, this study provided new evidence to the current debate and an interesting addition to the current literature.