Yen or Yuan? The law of one price and economic integration in Asia

• Date: 01 January 2018
• DOI: http://doi.org/10.1111/twec.12529
• Author: Yu (Alan) Yang,Kenneth S. Chan,Vinh Q. T. Dang
• Published date: 01 January 2018

ORIGINAL ARTICLE

Yen or Yuan? The law of one price and economic

integration in Asia

Vinh Q. T. Dang

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Yu (Alan) Yang

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Kenneth S. Chan

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1

Nanjing University of Finance and Economics, Nanjing, China

2

University of Wisconsin –Madison, Madison, WI, USA

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McMaster University, Hamilton, ON, Canada

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INTRODUCTION

Asia has emerged in the last three decades as the most dynamic economic region and played

increasingly important role on the world stage. The region has shown economic resilience in the

aftermath of the global financial crisis, accounting for at least 60% of the world output growth

since 2009 (ADB, 2015). Although Japan continues to be a major contributor of output, FDI, inte r-

national trade and financial investment, China has taken over the leading role in some of these

activities in the region. Besides the “tiger”economies of Singapore, Hong Kong, South Korea and

Taiwan, there is tremendous potential from other emerging-market economies in the region such as

India and Indonesia. Asia is projected to account for about half of the world output by 2050

(ADB, 2011).

There have been many initiatives to forge greater economic cooperation, development and inte-

gration in Asia, particularly among the Association of Southeast Asian Nations (ASEAN) mem-

bers, China, Japan, South Korea (collectively referred to as ASEAN+3), Hong Kong and Taiwan

(called East Asia in this paper).

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On the finance side, Chiang Mai Initiative (CMI), a network of

bilateral currency swap arrangements among ASEAN+3 established in 2000 as a response to the

Asian financial crisis of 1997–98, grew to US$240-billion multilateral agreement (CMIM) in 2012.

Instituted in support of CMIM is ASEAN+3 Macroeconomic Research Office, a surveillance group

that monitors and analyses regional economies to maintain monetary cooperation and stability in

the region. The Asian Bond Markets Initiative was established in 2003 to utilise large savings and

reduce dependence on volatile external short-term loans for investment financing in the regio n.

Currently, there is China-led effort to establish Asian Infrastructure Investment Bank, which is sup-

posed to facilitate capacity building for economic development and growth in the region. On the

trade side, ASEAN Free Trade Area, signed in 1992 under Common Effective Preferential Tariff

scheme, was the first trade bloc in the region. ASEAN has since actively liberalised trade with

Japan, China, South Korea and India as well. In fact, these countries now account for the vast

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ASEAN consists of Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, Philippines, Singapore, Thailand and Viet-

nam.

DOI: 10.1111/twec.12529

World Econ. 2018;41:171–193. wileyonlinelibrary.com/journal/twec ©2017 John Wiley & Sons Ltd

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majority of bilateral and “plurilateral”trade agreements in the Asia.

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In addition, ASEAN members

have committed to establishing ASEAN economic community (AEC) by the end of 2015.

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The

region, especially East Asia, has evolved into a tightly linked supply network, with final output no

longer primarily being exported to other parts of the world, but consumed within the region.

ASEAN+3 intraregional trade in 2014, as a share of total, reached 45%, a level comparable to that

in the Eurozone (ADB, 2014).

Motivated by these developments, in this paper we examine economic integration in Asia

through the law of one price (LOP). The LOP states that prices of the same product sold in differ-

ent markets, after conversion to the same currency, should be the same due to market participant’s

taking advantage of arbitrage opportunities. Investigation of whether and how the LOP holds is

useful in assessing how integrated markets in Asia currently are. Moreover, the LOP is the build-

ing block for the purchasing power parity (PPP); these two parities feature prominently in open-

economy macroeconomics. Testing the PPP is one of the most active research areas in international

finance (Frenkel, 1978; Froot & Rogoff, 1995; Rogoff, 1996; Taylor & Taylor, 2004). Therefore,

our results also bear important implications for future cooperation and co-ordination of financial

and monetary policies in the Asia, particularly if the member countries aspire to a monetary union.

Our paper has the following distinguishing features. First, although there have been numerous

empirical studies on the PPP, research on the LOP is scant because of the lack of comparable retail

prices across countries. The use of individual prices reveals more insights and therefore is more

suitable in studying market integration than price indices that are not comparable across countries

due to different weights and compositions of the goods and services contained in those indices. In

this paper, we use a data set that contains highly comparable actual retail prices of 146 tightly

defined goods and services in cities across Asia over the period of 1990–2014. The data set used

in our paper is the most comprehensive survey of retail prices in Asia. There are studies investigat-

ing economic integration or interdependence in Asia, but most of them are based on macro data

(e.g., Binner, Chen, Lai, Mullineux, & Swofford, 2011; Kim, Oh, & Jeong, 2005; Lin, 2012;

Nagayasu, 2010).

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Our analysis contributes to the literature by focusing on retail prices of goods

and services. Second, we examine market integration in Asia from two different, but complemen-

tary, perspectives: price dispersion and convergence to the LOP. The results from different analy-

ses within each approach and between these approaches are consistent with each other; they

collectively shape our interpretation. Third, given the emergence of China as the second-largest

economy in the world and the largest trading partner of many countries in Asia, we also consider

relative integration of Asian economies to Japan and China. Fourth, we employ Phillips and Sul

(2007) log tconvergence test, Pesaran (2006) common correlated effects (CCE) estimator, and

Pesaran (2007) panel unit-root test, which are not only suitable to our inquiry but also reflect

recent advances from panel data econometrics research. For example, since incorrect assumptio n of

cross-section independence in the data would lead to severe size distortion in the test statistic and

therefore wrong conclusion about the degree of market integration, we formally test if cross-corre-

lation exists in our data and then employ a panel unit-root test that explicitly accounts for this

important data feature.

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As of July 2014, there were 278 free trade agreements involving at least one Asian economy (ADB, 2014).

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The AEC is envisaged to possess these characteristics: (i) a single market and production base; (ii) a highly competitive

economic region; (iii) region of equitable economic development and (iv) a region fully integrated into the global economy

(ASEAN, 2011).

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An exception is Ando (2006) who uses firm-level data to examine economic integration in East Asia; his analysis, however,

is limited to tradable goods. Our study covers economies beyond East Asia and includes non-tradable goods as well.

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