Download Costs, Benefits, and Constraints of the Basket Currency Regime

Costs, Benefits, and Constraints of the Basket Currency Regime
Eiji Ogawaa, Takatoshi Itob, and Yuri Nagataki Sasakic
Professor, Department of Commerce and Management, Hitotsubashi University, e-mail:
[email protected].
b Professor, Institute of Economic Research, Hitotsubashi University and Research
Center for Advanced Science and Technology, University of Tokyo.
c Associate Professor, Department of Economics, Meijigakuin University.
a
A lesson from our experience of the Asian currency crisis in 1997 is that East Asian
countries should not have adopted the de facto dollar peg system before the Asian
currency crisis. East Asian countries should have taken into account their partners in
international trade and financial transactions in choosing their own exchange rate
regimes. Some have proposed that it is desirable for East Asian countries to adopt a
basket currency regime, in which the monetary authorities should target their home
currency to a basket currency, consisting of the US dollar, the Japanese yen, and the
euro.
This paper gives an overview of the costs and benefits of the basket currency
regime. The benefits of this regime include stabilizing trade balances, capital flows, and
gross domestic product (GDP) for East Asian countries that trade with diverse countries,
which include Japan, European countries, and intraregion countries as well as the United
States (US). The benefits come mainly from the stability of the real effective exchange
rate. However, some economists point out that intermediate exchange rate regimes are
not a crisis-proof system from the viewpoint of “two corner solutions.” Other costs of
intermediate exchange rate systems such as basket currency include complexity,
nontransparency, and nonverifiability in operating such an exchange rate system.
However, we observe that the benefits outweigh the costs.
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Next, this paper considers factors that prevent countries from adopting a basket
currency. We focus on both the inertia of the US dollar as a key currency and
coordination failure in choosing an exchange rate regime. These factors make it difficult
for the monetary authorities to adopt a desirable basket currency regime rather than the
de facto dollar peg system.
Then, this paper will extend these results by examining the feasibility and benefits
of the adoption of a common basket currency by a group of East Asian countries that
heavily trade with each other and invest in each other in terms of foreign direct
investment (FDI). We point out that it is necessary to create a common basket so as to
solve coordination failure in choosing exchange rate policies among East Asian
countries.
Lastly, a Generalized Purchasing Power Parity (PPP) model is used to
investigate the feasibility of a common currency basket in East Asia from the viewpoint of
the optimal currency area theory. Some subset of East Asian countries will be shown to
satisfy conditions for a common currency area. In particular, five Association of
Southeast Asian Countries (ASEAN) countries and the Republic of Korea (Korea) will be
able to form a common currency area with a common currency basket rather than having
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the US dollar as an anchor currency.
This paper consists of five main sections. The first explains the benefits of a
currency basket regime in terms of the stabilizing effects on trade, capital flows, and GDP.
The second section considers the costs of adopting the currency basket regime for East
Asian countries. The currency basket regime may not be crisis-proof. It may suffer from
complexity, nontransparency, and nonverifiability. The third section explains not only the
political but also the economic constraints in adopting the currency basket regime. The
inertia of the US dollar as a key currency and coordination failure on the choice of an
exchange rate regime will be identified. The compatibility of the basket currency regime
with domestic objectives such as inflation targeting will be pointed out. In the fourth
section, we propose a common basket to solve the coordination failure in choosing an
optimal exchange rate regime. We also investigate whether East Asia will be an optimal
currency area with a currency basket being an anchor currency. In the conclusion, the
results are summarized and assessments and recommendation will be made.
Benefits of a Basket Currency Regime
The controversy over the exchange rate regime, especially the fixed versus flexible
exchange rates, has been discussed again and again. The focus in the controversy has
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recently shifted from “fixed versus flexible” to “two-corner solutions versus intermediate
regimes.” In this section, a case will be made for intermediate regimes, especially a
basket currency regime.
By examining the merits and shortcomings of a basket currency regime, we make
a judgment on what type of exchange rate regime East Asian countries had really
adopted. Calvo and Reinhart (2000a) analyzed the exchange rates, foreign reserves,
monetary base, and interest rates in Asian countries. They concluded that, although
some of the Asian counties announced that they were adopting a floating exchange rate
regime, their currencies had strong linkages with the US dollar and the exchange rates
were not floating so freely.
McKinnon (2000) analyzed how daily changes in the exchange rates of nine East
Asian currencies have a strong relationship with the US dollar. He showed that the
movements of the East Asian currencies had a high correlation with the movements of
the dollar prior to 1997. These two papers suggest that most Asian countries were not
floaters and some of them adopted a de facto dollar peg regime, which is classified as an
intermediate exchange rate regime.
Williamson (2000) explains this “revealed preference” of Asian countries as
follows: “they see gains in an intermediate regime that they believe outweigh the costs in
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terms of greater vulnerability to crises and having less simple policy rules to follow.”
Williamson (2000) believes that the primary benefit of an intermediate exchange rate
regime is that it allows policy to be directed to limiting misalignments of exchange rates.
Overvaluation of home currencies would weaken the competitiveness of tradable goods
industries while undervaluation would cause overheating and imported inflation. Thus,
the benefit of a basket currency system would have been significant for Asian countries
that have been following export-oriented strategies for their economic growth.
One corner of the two-corner solutions is the floating exchange rate regime.
However, clean float is not quite possible or desirable. Not many countries practice clean
float (no intervention at all). If one corner means a "lightly managed" float, then it would
become difficult to draw a line between "lightly managed" and "managed" floating
regimes.
Currency board (and dollarization) is the other corner that will automatically
increase and decrease the monetary supply according to the change in foreign reserves.
However, the fixed exchange rate will put the currency board under the same criticism as
that leveled against a fixed exchange rate regime of soft peg, namely, if a country pegs to
a country with which it does not share common shocks, then competitiveness will vary as
the key currency appreciates and depreciates. That would then translate in the
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fluctuations in foreign reserves, the interest rate, price levels, and the capital flows.
Domestic sectors have to be really flexible to absorb such volatility.
We review in three subsections the analyses that explain the benefits of a basket
currency regime as one of the intermediate regimes. The first explains that a basket
currency regime stabilizes the trade competitiveness of countries. The second reviews
the papers that examined capital inflows, and the third reviews the papers that analyzed
the stabilizing effects of a basket currency regime on GDP.
Enhanced Trade Competitiveness
The most apparent benefit of a basket currency regime is its role in keeping trade
competitiveness relatively stable. If the export destination is only one country and there is
no competitor other than the destination country, it is enough to peg the currency to that
of the export destination country as to maintain trade competitiveness. But actually, a
country tends to have many export destinations and many competitors all over the world.
In addition, the composition of export destination countries has changed over time. Thus
it is not easy to decide the weights of the basket.
Taking into account this complexity, some papers suggest the ways to get optimal
weights for the currency basket. Ito et al. (1998) calculated the optimal weights that
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stabilize variances of trade balance. In one paper (Ito et al. 1998), we built a theoretical
model in which the Asian firm maximizes its profits, competing with the Japanese and the
US firms in their markets. We used a duopoly model to determine export prices and
volumes in response to fluctuations of the exchange rate vis-à-vis the Japanese yen and
the US dollar. We obtained optimal basket weights that would minimize the fluctuation of
the growth rate of the trade balance.
Ito et al. (1998) stressed the fact that Asian countries’ adoption of de facto dollar
peg regimes, although their trade weight with Japan was substantial, was one of the
most significant factors that induced the crisis. As the Japanese yen depreciated against
the US dollar from April 1995 to the summer of 1997, the real effective exchange rates of
Asian countries appreciated, causing the countries to lose export competitiveness. Thus
exports from those countries declined. For example, the gross export values of Thailand
did not grow in 1996, compared with 20% growth a year earlier.
Figure 1 shows the case of Thailand. [[for Typesetter: xx pls position figure
after this reference]] The real exchange rate of the Thai baht vis-à-vis the US dollar
had been fixed from 1990 to 1997. Thus, the real exchange rate of the Thai baht vis-à-vis
the Japanese yen fluctuated as the Japanese yen/US dollar rate fluctuated. From 1990
to 1995, the Japanese yen had been appreciating against the Thai baht, but the
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Japanese yen sharply depreciated from 1995. This depreciation of the yen significantly
reduced the export volume of Thailand.
The optimal weights proposed by Ito et al. (1998) are shown in Table 1. [[for
Typesetter: xx [pls position Table 1 after this text reference]] estimated weights from
actual fluctuations of the exchange rates are quoted from Frankel and Wei (1994). The
optimal weights of the yen are higher than the estimated weights. It suggests that, if
Asian currencies peg to a currency basket with the optimal weights, the real effective
exchange rates of Asian countries would be more stable and a large shock to trade
balance can be avoided.
Capital Flow Effects
While Ito et al. (1998) emphasized the trade aspect, exchange rates are likely to be
influenced by capital flows. Ogawa and Sun (2001) analyzed how the de facto dollar peg
regime before 1997 had influenced capital inflows to Indonesia, Korea, and
Thailand—the three countries that will need International Monetary Fund (IMF) financial
support later. They conducted a simulation analysis of a counterfactual hypothesis that
the monetary authorities had adopted a currency basket peg system instead of the de
facto dollar peg system. They assumed that the foreign exchange risks of the home
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currency against the US dollar would be doubled while foreign exchange risks of the
home currency against the yen would be halved under the currency basket peg system.
The regression analysis of the actual capital inflows found that the
responsiveness of capital flows to the foreign exchange risk against the US dollar is
much larger than the responsiveness of capital flows to the foreign exchange risk against
the yen in the case of Korea and Thailand. The simulation analysis by Ogawa and Sun
(2001) found that the currency basket peg system would have had a depressing effect on
capital inflows to Korea and Thailand.
Sasaki (2002) analyzed whether changes in capital inflows to East Asian
countries (Korea, Malaysia, Philippines, Singapore, and Thailand) could be explained by
the variance of exchange rates. The results showed that capital inflows to East Asian
countries increased when the variance of US dollar rates (i.e., exchange rates risk of the
US dollar) decreased. Thus, the de facto dollar peg induced more capital inflows than did
under the currency basket or the floating exchange rates regime.
Both Ogawa and Sun (2001) and Sasaki (2002) concluded that the de facto dollar
peg regime promoted capital inflows to Asian countries and implied that if Asian
countries had adopted a basket currency regime (or the floating exchange rate regime),
capital inflows might not have been so huge. These two papers do not examine whether
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huge capital inflows due to de facto dollar peg was good or bad for the economies of
those countries in the long run. Capital inflow itself promotes growth and may be good for
an emerging country. But huge capital inflows also pose a risk to the countries in the
sense that a sudden reversal in the direction of capital flows is a possibility. In fact, the
outflow of short-term capital experienced by some of the countries in the region before
the crisis was damaging to the firms in Asian countries.
FDI (long-term capital), as opposed to bank liabilities (short-term capital), are not
likely to be subject to short-term exchange rate risks. Sasaki (2002) analyzed capital
inflows separately by type: portfolio investments, bank lending, and FDI. The effect of the
variance of the US dollar on capital inflows was the strongest in bank liabilities and was
not so large in portfolio investments and FDI. It means that if Asian countries had
adopted a basket currency regime, bank liabilities would have decreased but portfolio
investments and foreign direct investments would not have been affected so much. Thus,
moderating capital inflows is thought to be a benefit of a basket currency regime.
GDP Effects
So far, the effect of the currency basket on trade and its effect on capital flows are
considered separately, but using a general equilibrium macroeconomic model, Yoshino
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et al. (2001) offer the optimal weight for the currency basket so as to stabilize GDP.
Yoshino et al. (2001) examined which currency regime among the basket peg,
dollar peg, and floating exchange rate regimes could achieve the lowest in the loss
functions corresponding to the different policy objectives. Those policy objectives include
stability of GDP, the current account, and the exchange rate against the dollar. They also
calculated the optimal weights in a currency basket. They concluded that the optimal
choice of an exchange rate regime for a small open economy depended on its policy
objective. Gains from adopting a basket peg is larger when the country uses the yen in
trade with Japan and the dollar in trade with the US.
Costs of Adopting the Currency Basket Regime by East Asian Countries
The main message in the preceding section is that the basket currency regime is
superior to the de facto dollar peg (and floating exchange rate regime in some cases) to
stabilize trade balances, capital inflows, and GDP. But, in practice, the basket currency
regime has some shortcomings to overcome. In this section, we review the costs of
adopting the basket currency regime and also the papers that prefer two-corner
solutions.
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The Currency basket is crisis-proof (criticism from floating exchange rate regime
advocate)
It is said that IMF advised Thailand to change its exchange rates regime in 1996 from a
basket currency regime with heavy weights on the dollar to a floating exchange rate
regime because the economic fundamentals of Thailand had been deteriorating since
1995. After the Asian currency crises, Fischer (2001) recalled that,
“Little wonder, then, that policymakers involved in dealing with these crises have
warned strongly against the use of pegged rates for countries open to international
capital flows. That warning has tended to take the form of advice that intermediate policy
regimes between hard pegs and floating are not sustainable. This is the bipolar or
two-corner solution view, …” [[xx need page numbers?? pp.1-2]]
Fischer (2001) emphasized that soft peg (i.e., basket currency regime) is crisis-prone
and not viable over long periods. Not only Fischer but also other IMF economists seem to
have the same view. However, under the floating exchange rate regime, large
misalignments of exchange rates could emerge. When the exchange rate depreciates
very quickly, it could be as damaging as the collapse of a soft peg. To argue that the
floating regime is superior to the soft peg regime, it should be proved either that under
the soft peg exchange rate regime fundamentals tend to deteriorate (too much capital
inflows) more after, or that crisis management is much more difficult once a crisis breaks
out.
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Complexity, nontransparency, nonverifiability
Economists who advocate an intermediate regime are also aware of the shortcomings of
such a regime. Williamson (2000) wrote that there are three points in which the
intermediate regime (managed float) is inferior to two-corner regimes. The first point is
that a basket currency peg regime is not transparent. He explained that transparency is
important. It is difficult for the public to understand that the policy is seeking to limit
misalignments from the equilibrium rate when the same public is not told the parameters
of the exchange rate policy. The second problem is that an intermediate regime generally
precludes some types of policy cooperation and may indeed permit policy conflict. A
clear example is a peg to a common currency basket. For lack of a policy of cooperation
in pegging to a common currency basket, countries under an intermediate regime
sometimes do competitive devaluations. The third disadvantage is that the basket
currency regime has no announcement of the parameters guiding the management and
it is potentially the most serious. Taking into account these points, Williamson (2000)
recommends BBC rule, where BBC stands for basket, band, and crawl.
Another disadvantage of the basket currency regime is its complexity. It is
complicated to derive optimal weights by estimating various parameters. In addition, it is
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said that the monetary authorities should intervene in the foreign exchange markets of all
the currencies included in the basket. But as for the latter complexity, Ogawa (2001)
introduces the case of the monetary authorities of Singapore and explains that the
Monetary Authority of Singapore intervenes only in the US dollar-Singapore dollar
market. Thus, it seems that there is no complexity in carrying out the intervention.
In connection with its nontransparency and its complexity, Frankel et al. (2000)
suggested that a simple peg or simple float may be more verifiable from the market
participants’ view than a more complicated currency basket regime. The key point of their
paper is that the two-corner regimes may be easier to monitor than the intermediate
regimes.
Losing a nominal anchor (criticism from fixed exchange rate regime advocate)
Adopting a hard peg regime, a country can use the exchange rate as a nominal anchor.
Since the late 1980s, many developing countries with chronically high inflation have
undertaken exchange-rate-based stabilization programs and all these programs had
remarkable success (Mussa et al. (2000)). The basket currency regime does not have
this function and this can be its disadvantage, especially for a country with a history of
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high inflation.
But countries that adopted the disinflation programs became dependent on
international capital markets and more vulnerable to sudden reversals in capital flows.
Thus, an exit strategy from hard peg regimes should be formed after inflation has
subsided, but before a currency pressure. IMF’s study of exit strategies showed that “exit
is best undertaken when the currency is strong, something which is quite likely to happen
as the stabilization gains credibility and capital inflows expand” (Fischer (2001)).
However, can a country exit when its currency becomes strong, it gains credibility,
and capital inflows expand? It seems to be almost impossible to exit in such a wonderful
period because people may not imagine they will experience currency crises and refuse
a policy to abandon the hard peg regime and shift to a floating exchange rate regime. If it
is hard to exit, the hard peg regime becomes crises-prone, eventually, and no better than
the basket currency regime in this respect.
Constraints on adopting the currency basket regime
Inertia of the US dollar as a key currency
The inertia of the US dollar as a key currency in the world economy is pointed out to be
one of the constraints that impede the monetary authorities in adopting a desirable
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exchange rate regime. The US dollar has had a long-run trend to depreciate vis-à-vis the
Japanese yen and the Deutsche mark since the international monetary system shifted
from the US dollar standard system to a current general floating system in 1973.
However, both official authorities and private economic agents in the world economy
have still accept and use the US dollar as a key currency under the present international
monetary system. It may be that the US as a superpower in the economic, political, and
military sense helps its currency to circulate globally.
An international currency has three functions: a medium of exchange, a store of
value, and a measure of value in an international economic context, just like a domestic
currency in a domestic economic context.1 The fact that the depreciating US dollar has
kept a position as a key currency implies that a function of money as a medium of
exchange is in general recognized to be more important than its function as a store of
value in the choice of an international currency in international economic transactions.
Thus, the US dollar would not move in its position as a key currency as long as it
has an advantage as a medium of exchange compared with other currencies. It is true
that other currencies such as the Japanese yen might have the ability to compete with
the US dollar as a store of value. However, a relative advantage in their function as a
1
See Krugman (1984).
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store of value is not sufficient for other currencies to compete effectively with the US
dollar. Rather, it is necessary for the other currencies to improve their function as a
medium of exchange, or convenience in using them as a settlement currency and an
invoice currency in international trade transactions. Both a search theoretic model and a
random matching model 2 in the context of international currencies show that an
international currency is overwhelmingly large in settlements volume of international
trade, used as a medium of exchange in international transactions.
Ogawa and Sasaki (1998), Ogawa and Kawasaki (2001), and Ogawa (2002)
empirically analyzed how much inertia the US dollar has in its position as a key currency
by taking into account both the function as a medium of exchange and a store of value in
the context of international currency competition. International investors could enjoy the
benefits of a medium of exchange function by holding real balances of international
currencies while costs of holding depreciating international currencies are tolerated. The
methodology was to use a money-in-the-utility model to estimate a parameter on the
balances of the US dollar in the utility function. Expected inflation rates were regarded as
the costs of holding depreciating international currencies. The parameters were
normalized to place between 0 and 1.
2
Matsuyama et al. (1993) and Trejos and Wright (1996) applied a random matching model to a theoretic
analysis of international currencies.
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Data on liabilities in home and foreign currencies for euro currency markets are
used as proxy for the balances of international currencies. The data were classified by
currencies of cross-border liabilities denominated in home and foreign currencies that
were published in International Banking and Financial Market Development, Bank of
International Settlements (BIS). It is analyzed how the parameter of the US dollar in a
utility function has changed after the introduction of the euro in January 1999. The
parameter was estimated both for a whole sample period (1986Q1–2000Q1) and two
subperiods (1986Q1–1998Q4 and 1999Q1–2000Q1).
Table 2 [[for typesetter: xx pls position Table 2 after this reference]] shows
that the parameter has changed a little between the two sample subperiods in the case
when we used expected inflation and a plausible range of real interest rates. The
parameter was estimated to be 0.62 with standard deviation of 0.06 and its 99%
confidence interval was 0.59-0.64 during the first subperiod. For the later subperiod, the
parameter was estimated to be 0.58 and its 99% confidence interval was 0.55-0.61. Thus,
the parameter decreased after the introduction of the euro though the changes were not
statistically significant because standard deviations were larger than the changes. It
implies that there has been little change in the position of the US dollar in the
international monetary system after the introduction of the euro.
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Coordination Failure
What is coordination failure?
The monetary authorities in the Asian region may be forced to keep a dollar peg system
instead of adopting a currency basket system―even if they find that they would be
better-off by adopting a currency basket system rather than a dollar peg
system―according to lessons they learned from the Asian currency crisis. The situation
can be described as a kind of coordination failure. Suppose that all East Asian countries
have been adopting the de facto dollar peg system at the present time and that each of
them knows that it should adopt an optimal currency basket system, for example, to
stabilize fluctuations of its trade balances with an internationally diversified trading
structure.
Suppose that one country switches from the dollar peg system to a currency
basket system while the others keep the dollar peg system. The country with a currency
basket system, say, country A, might be faced with an increase in fluctuations in trade
balances. If the US dollar depreciates against the Japanese yen, the real effective
appreciation of country A’s currency against the other currencies that are pegged to the
US dollar worsens the price competitiveness of exporting firms of country A. On the other
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hand, if the US dollar appreciates against the Japanese yen, the real effective
depreciation of country A’s currency against the other currencies improves the price
competitiveness of exporting firms of country A. Thus, the country that adopted a
currency basket system alone is faced with an increase in the degree of fluctuations of
trade balances. Therefore, the monetary authorities of country A are induced to keep the
dollar peg system. Similarly, each of the monetary authorities rationally keeps the dollar
peg system if they cannot make a coordinated decision but a sequential unilateral
decision.
Ogawa and Ito (2002) used a game-theoretic two-country model to analyze
theoretically coordination failure in choosing an exchange rate system. In the paper,
coordination failures are shown in the context of comparing losses for two monetary
authorities in the following two situations: a situation where both monetary authorities
adopt the dollar peg at the same time and a situation where the monetary authorities of
one country adopt an optimal currency basket peg while the monetary authorities of the
other country adopt the dollar peg.3
Thus, each of the monetary authorities will keep pegging their home currencies to
the dollar if their trade balances fluctuate more widely in the case of unilaterally pegging
3
Bénassy-Quéré (1999) and Ohno (1999) analyzed pegging the US dollar as a coordination failure.
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its currency to an optimal currency basket peg. When this is the case, they are faced with
coordination failure in that they are forced to adopt the dollar peg even though the
optimal currency basket peg, if jointly adopted, will minimize the fluctuations in trade
balances. Only when both monetary authorities coordinated with each other to adopt the
optimal currency basket peg simultaneously can they peg their home currencies to the
optimal currency basket.
Suppose that risk-averse monetary authorities choose their exchange rate
regime under uncertainty; then the monetary authorities are more likely to be faced with
coordination failure. Risk-averse monetary authorities, who have a usual utility function
with diminishing marginal utility, place a heavier weight on increase in their utility of loss
caused by exchange rate fluctuations than on decrease in their utility of loss even though
they expect that the expected losses are the same. Suppose that the risk-averse
monetary authorities of one country shift from the de facto dollar peg system to an
optimal currency basket regime while the monetary authorities of other countries keep
the de facto dollar peg regime. The currency would appreciate against the neighbors’
currencies if the US dollar depreciated against the Japanese yen, while it would
depreciate against the neighbors’ currencies if the US dollar appreciated against the
Japanese yen. Because risk-averse monetary authorities place a heavier weight on
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increases in loss caused by shifting their exchange rate regime, they tend to hesitate to
shift to the optimal currency basket regime. Therefore, under such uncertainty,
risk-averse monetary authorities tend to take the strategy of wait and see vis-à-vis
behavior of the other.
Most All [[xx all?? not most?? We select “most” rather than “all”.]] monetary
authorities are likely to take the strategy of wait and see if all others are risk averse. They
cannot help but choose to keep the dollar peg regime, which is Nash equilibrium,
although they should know that there is a cooperative solution that is superior to a Nash
equilibrium. Coordination among some of the monetary authorities of the East Asian
countries is necessary for shifting from a situation of the Nash equilibrium to a
cooperative solution. The monetary authorities should implement international
coordination for exchange rate arrangements or exchange rate policies.
Possible ways to establish coordination
Given that the monetary authorities agree to the coordination arrangements of an
international monetary system or exchange rate regime, its implementation is the next
problem. It is pointed out that policy makers are difficult to implement international policy
coordination if they have neither common understanding of their own economic
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situations nor common policy objectives among them (Frankel and Rockett Rockett in
ref. 1988 spelling). It is necessary that the monetary authorities should have some
common understanding about what effects their home currencies have on neighbor
countries’ currencies and what effects their own exchange rate policy have on neighbor
countries’ exchange rate policy, in order to implement regional coordination of an
exchange rate policy. Moreover, they need to have common understanding about what
policy objective they should have for their exchange rate policy.
It is expected that the monetary authorities can build up common understanding
by conducting policy dialogue and macroeconomic surveillances among policy makers
of the regional countries. Macroeconomic surveillances may not be so effective if they
are conducted by policy makers as representatives of each of the regional countries, who
have a direct interest in their own countries. Thus they cannot easily implement
international coordination of the exchange rate policy. It may be desirable that a neutral
intraregional institution, which is independent of governments of regional countries,
should prepare for the macroeconomic surveillance in order to help the governments
deepen their common understanding.
However, policy dialogue and macroeconomic surveillance will not be so robust
in keeping international policy coordination in the long run because the governments do
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not have any commitments to regional coordination. They may make limited contribution
to regional coordination. It is necessary to have a mechanism that will be robust in
keeping regional coordination in the long run by obliging the governments to have a
commitment to regional coordination.
One way to implement regional coordination is by making all the monetary
authorities in the region agree on an arrangement to create a common currency unit that
consists of a currency basket. They might make a commitment to follow the common
currency value in conducting their exchange rate policy. It is necessary to create a
common currency basket as a common currency unit that monetary authorities of East
Asian countries should refer to when they conduct their exchange rate policies with
regional coordination.
Such regional currency arrangements would help to prevent competitive
devaluation among the related currencies in a region as well as to solve coordination
failure. If the monetary authorities of a country devalue its home currency, the
devaluation worsens the price competitiveness of products made in neighboring
countries. For that reason, the monetary authorities of the other countries would find it
attractive to devalue their home currency, following the first country’s devaluation. The
regional currency arrangements under which the monetary authorities in the region make
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a commitment to a coordinated exchange rate policy would prevent a possible
competitive devaluation as well as the inertia problem that causes coordination failure.
Political constraints
There are some political constraints to international policy coordination among several
governments. The first political constraint is that the monetary authorities might worry
that they would be forced to give up a part of their own monetary sovereignty―because
their autonomy in their monetary policy will be lost―in exchange for international policy
coordination. For reasons of domestic political economy, monetary authorities tend to
prefer keeping their own monetary sovereignty.
It is necessary that the monetary authorities share common objectives in their
exchange rate policy in order to implement international policy coordination. There is
some doubt whether the monetary authorities of countries have common objectives in
their exchange rate policy. In the academic literature, opinions are divided on the
desirability of the monetary authorities’ deciding on priorities between the monetary
policy and the exchange rate policy.
One of the objectives of the exchange rate policy is to achieve stability of the real
effective exchange rate (Lipschitz and Sundrarajan 1980). The objective implicitly
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assumes that the trade balance is stable as long as the monetary authorities keep the
real effective exchange rate stable around an equilibrium. Another objective is to keep
explicitly the balance of trade or current account at a particular level, or to stabilize
explicitly the trade or current balances rather than the real effective exchange rate
(Flanders and Helpman 1979, and Flanders and Tishler 1981). Turnovsky (1982)
proposed that the objective was to stabilize domestic income that was a more general
objective of economic policy. For domestic income stabilization, there are policy options
other than the currency basket weights. Bhandari (1985), extending Turnovsky (1982),
considered four criteria or a combination of them at the same time. The four criteria are
domestic price-output stability, stability of domestic prices, reserve stock stability, and
stability of an external competitiveness.
A question remains with respect to objectives that the monetary authorities in fact
have in conducting their exchange rate policy. They might have objectives that are
different from those supposed in the academic literature. The monetary authorities may
have adopted the dollar peg regime with the objective of attracting the US
dollar-denominated foreign capital. They may have been unable to devalue the home
currency against the US dollar because the economy had a large amount of the US
dollar-denominated foreign liabilities. Moreover, governments might prefer fixing their
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home currencies to the US dollar from [[author: can we delete this statement??]] the
political reason that the US is politically the strongest in the world.
A political will may be needed for countries, in particular a “leader,” in the region to
prevent coordination failure in their exchange rate policies. A leader country has to take
the political initiative in starting policy dialogue on their macroeconomic and exchange
rate policies.
Compatibility with domestic objectives such as inflation targeting
Before the Asian currency crisis of 1997–1998, almost all East Asian countries except
Japan had practiced a de facto dollar peg regime. Under the fixed exchange rate with
liberalized capital transactions, the central bank had to assign the monetary policy to
maintain a fixed exchange rate. The interest rate has to be close to the dollar interest rate
to avoid excessive capital inflows or outflows. However, when the East Asian economies
were growing at exceptionally high rates, often at 8% to 12%, western investors became
interested in investing in stocks, real estate, and other assets, as well as investing
directly in plants and factories. Massive capital inflows were causing economic booms,
sometimes asset price bubbles, in some of the countries, including Korea and Thailand.
The central banks could not raise the interest rate to cool down the overheated
27
economies because that would invite more capital inflows prompted by higher interest
rate at the fixed exchange rate. Thus, overheating continued, sometimes creating a
bubble. This led to the vulnerability of the banks’ balance sheets, and eventually became
one of the serious factors of the Asian currency crisis.
East Asian economies—except the People’s Republic of China; Hong Kong,
China; and Malaysia—adopted the floating exchange rate regime after the Asian
currency crisis. Under the floating exchange rate regime, the central bank regained the
power of independent monetary policy. In theory, when the economy is (going to be)
weak, the monetary policy should be relaxed, and when the economy is (moving toward)
overheating, the monetary policy should be tightened, without worrying about the
consequence on the capital flows or the exchange rate. However, this way of thinking
has two problems. First, theoretically speaking, the central bank may lose monetary
discipline under the floating exchange rate. There may be pressures from the
government to keep the interest rate low so that an economic boom may be sustained
even at the risk of higher inflation later. This was typically the case in Latin American
countries. Second, for small, open economies in East Asia, the exchange rate cannot be
ignored completely. Too much appreciation would make exporters lose their
competitiveness and cause current account deficits as well as job losses. Too much
28
depreciation would cause inflationary pressures from price hikes of imports. The central
bank cannot completely ignore the exchange rate movements even though the floating
exchange rate regime is adopted. Indeed, Asian countries have not completely shied
away from occasional foreign exchange interventions.
To prevent the first problem, IMF has recommended that central banks adopt
inflation targeting and that government and legislature give political independence to the
central bank. Several East Asian countries have adopted the inflation targeting regime.
Indonesia, Korea, and Thailand did so during the period when they were under the IMF
financial support program. The Philippines adopted inflation targeting in January 2002.
The desirability of the managed exchange rate regime was explained in the first
section. An interesting question here is whether inflation targeting and a managed
exchange rate regime could be compatible. Most of the time, they will be compatible with
each other. Consider a situation that an economy, which has achieved internal and
external equilibria, is hit by an exogenous shock of currency appreciation and moved
toward the ceiling of the tolerance range (assuming the basket band system). The
appreciation is undesirable since it makes exporters lose their competitiveness and trade
balance becomes deficits. At the same time, currency appreciation will lower the inflation
rate from two channels: damped demand from a slump in tradable sectors, and lower
29
prices from imports. The basket band consideration will call for a lower interest rate to
encourage capital outflows, and inflation targeting will call for a lower interest rate, to
combat deflationary pressure. Therefore, in this case there is no conflict between the
basket band and inflation targeting. Similarly, a depreciation shock can be countered by
tight monetary policy, both from the basket band and inflation targeting considerations.
Another scenario is a domestic inflation shock, caused by an unexpected
increase in aggregate demand. The higher inflation rate will call for tightening of
monetary policy immediately. The higher domestic prices will make exporters lose
competitiveness, and the trade balances will be adversely impacted. The exchange rate
tends to depreciate if not countered by monetary policies. The interest rate hike would be
desirable to invite some capital inflows that will cause the currency to appreciate. The
appreciation will restore a desirable long-term exchange rate level (determined by the
basket) and prevent import inflation.
Suppose there is an adverse supply shock, such as drought or destruction of
productive capacity. Prices will be higher and output will be lower. The exchange rate will
most likely depreciate due to adverse real economy and current account deficits.
Stagflation may be a result. Since the inflation rate is higher, inflation targeting will call for
higher interest rate, pushing the real economy further into recession. The higher interest
30
rate will contribute to dampen price increases by lowering import prices. Again, there is
no conflict between inflation targeting and the basket band regime. In this case, however,
the output fluctuations will become very large. If this is to be avoided, an escape clause in
inflation targeting should be introduced (inflation targeting can be missed without asking
for responsibility of the central bank), and a basket band should be relaxed in case of
supply shocks.
In sum, a goal of inflation targeting and that of the basket band system will not
point to conflicting directions of monetary policy, most of the time. East Asian economies
with inflation targeting can safely adopt the basket band system.
Common Basket in East Asia
Common basket is necessary to solve coordination failure
As we explained in the section on “Constraints on adopting the currency basket
regime,” it is necessary to create a common currency basket to avoid a coordination
failure in choosing exchange rate regimes in the region. In addition, regional currency
arrangements to keep the exchange rate linked to a common currency basket will help
prevent competitive devaluation among the currencies in a region because the monetary
authorities have a commitment to the arrangements.
31
Under a common currency basket regime, the monetary authorities in the region
should peg or target their home currencies to a common basket currency. In a rigid
system where the monetary authorities peg their home currencies to a common basket
currency, the currencies in the region are pegged with each other. In a more flexible
system where they target their home currencies within a band around a central parity rate
vis-à-vis the common basket currency, the currencies are linked to each other within a
band. Thus, if they adopted a common basket currency regime, their currencies would
be linked with each other at a parity rate or within a band around a central parity rate.
It is more tractable for the monetary authorities to link their home currencies to a
common currency unit that is equivalent to the common basket currency. A common
currency unit should be composed of the US dollar, the Japanese yen, and the euro as
well as the currencies of the participating countries for East Asian countries (Ito et al.
1998).
The countries of the European Union adopted the European Monetary System
(EMS) where their home currencies were linked to a common currency unit, the
European Currency Unit (ECU), during the period 1979–1998. The ECU was composed
of only the currencies of the EMS member countries. Their currencies were linked to the
ECU with a band while the ECU was floating against the other currencies that included
32
the US dollar and the Japanese yen.4 The monetary authorities had the obligation to
intervene in the foreign exchange markets to keep the exchange rates of the currency in
the region against the other EMS currencies within a band.
One method to adopt a common basket currency regime is for the monetary
authorities to create a common currency unit, which consists of currencies of the
member countries like the ECU, and link their currencies to the common currency unit.
Moreover, they link the common currency unit to a currency basket consisting of the US
dollar, the Japanese yen, and the euro. This is the two-stage linkage method.
The monetary authorities of the participating countries have the obligation to
intervene in the foreign exchange markets to link their home currencies to the common
currency unit and, in turn, link their home currencies to each other. At the same time, the
monetary authorities of the participating countries might coordinate to intervene in the
foreign exchange markets so as to link the common currency unit to a basket currency
that is composed of the US dollar, the Japanese, and the euro. Such an intervention is
complicated for the monetary authorities. If the participating countries established an
intraregional institution, it could intervene in foreign exchange markets so as to link the
common currency unit to a basket currency on behalf of the monetary authorities of the
4
Kim et al. (2000) suggested that the Asian currency unit was composed of only the East Asian currencies
including the Japanese yen. In this case, the Japanese yen is inside, rather than outside, the basket.
33
participating country.
Another method is for them to create a common currency unit consisting of the
US dollar, the Japanese yen, and the euro as well as their regional home currencies, and
link directly their home currencies to the common currency unit. This is the direct linkage
method. The monetary authorities of the participating countries have an obligation to
intervene directly in foreign exchange markets so as to link their home currencies to the
common currency unit. In this case it is more difficult to calculate a common currency unit
that consists of the US dollar, the Japanese yen, and the euro as well as their regional
home currencies
The two methods may be theoretically equivalent to each other. However, the
method to be used may depend on the ability of the monetary authorities and the
simplicity of the scheme. It would be easier for the monetary authorities of each country
to implement the two-step linkage method if they could establish an intraregional
institution for the participating countries. Then all the monetary authorities of the
participating countries have to do is to target their home currencies to the common
currency unit.
Is a common basket a step toward a common currency in East Asia?
34
The next step is to attempt to form a currency union. Why should the monetary
authorities in East Asia go forward to a currency union? What benefits do we expect in
regional monetary integration?
One of the benefits of regional monetary integration is to save on transaction costs
accompanied by exchanges of different currencies.5 Travelers and trading firms need to
bear transaction costs (commissions and bid-ask spreads) in carrying out trades.
International monetary unification would save this kind of transaction costs. Moreover,
network externalities work in the sense that a currency as a medium of exchange works
better when fewer currencies are used as a medium of exchange. As for the function as a
store of value, if there are fewer currencies in a region, the function of value measure will
be more efficient.
East Asian countries have their own home currencies that the monetary
authorities link to the currency unit before they achieve regional monetary integration.
This is comparable with stage 2 in the European monetary integration. The situation
implies that it is still possible for the monetary authorities of a country to realign its
exchange rates vis-à-vis the common currency unit or to delink its exchange rate from
the common currency unit. The possibility might induce speculators to make speculative
5
De Grauwe (1992) summarized the merits and demerits of international monetary integration.
35
attacks against weaker currencies, just like the exchange rate management crisis of
1992–1993.
One option for the monetary authorities is to make a stronger commitment to link
their home currencies to the common currency unit in the case where they preannounce
their commitment to keep the currency policy. The strongest commitment is to participate
in a currency union where the monetary authorities of the participating countries already
have, not a country-specific central bank but, a regional central bank so that they have
no option to leave it, just like stage 3 of the European currency integration. The strongest
commitment would contribute to a stability of exchange rate regimes because the
monetary authorities enhance their confidence by appealing to the expectations of
private economic agents. The monetary authorities with the strong commitment may
solve the so-called peso problem, that is, the possibility of exchange rate collapse in the
future will be diminished. The higher domestic interest rates due to risk premium will be
avoided. Accordingly, a currency union contributes to a decrease in domestic interest
rates.
Moreover, in recent years, many countries are establishing bilateral and regional
free trade agreements. Movements toward the free trade area contribute to elimination of
many trade obstacles that include tariffs and nontariff barriers. However, economic
36
agents still regard exchange rate risks as an important trade obstacle under the free
trade regime. Even though we use forward contracts to avoid exchange rate risks, we
have to pay some costs for avoiding the exchange rate risks that are sometimes quite
large. This is a kind of transaction costs. Exchange rate risks and the related transaction
costs are an important barrier to trade and investment that must be eliminated. Exchange
rate risks under a common currency union with a strong commitment will become
minimum.
Is East Asia an optimal currency area?
The feasibility of a common currency area can be tested by the criteria for an optimal
currency area. Mundell (1961) regarded mobility of labor as a necessary condition of
common currency areas, while McKinnon (1963) regarded openness of the economy as
another necessary condition. Symmetry of shocks was also pointed out as a factor for an
optimal currency area (Bayoumi and Eichengreen 1993). It is possible to form an optimal
currency area because it is unnecessary to make intraregional adjustments in a region
subject to symmetric shocks only. Symmetry of supply shocks is often emphasized
because supply shocks have long-run effects on GDP while demand shocks have no
long-run effects on GDP when the natural unemployment hypothesis holds. The supply
37
shocks are those that affect a production function, such as productivity shocks and oil
price shocks.
Bayoumi et al. (2000) made an empirical analysis of an optimal currency area in
the East Asian region.6 Correlations of supply shocks were relatively higher among
Indonesia, Malaysia, and Singapore. Also, the correlation was higher between
Singapore and Thailand. Therefore, these four ASEAN countries might be able to form
an optimal currency area from the viewpoint of symmetric shocks. Supply shocks in
Japan had a positive correlation with those of Australia; Taipei,China; and Korea. On one
hand, they had a lower correlation with ASEAN countries except Thailand.
Ogawa and Kawasaki (2002) used a G-PPP model7 to conduct empirical analysis
on the possibility of an optimal currency area in East Asia. The G-PPP model is an
extension of a simple PPP model by taking into account difficulties in holding the PPP
because of nominal and real shocks that have sustained effects on macro fundamentals.
Even in the long run, changes in a bilateral exchange rate depend not only on changes in
relative prices between the related two countries but also those in other countries. Price
levels in other countries have effects on its domestic price level through prices of
intermediate goods imported from abroad.
6
Sato et al. (2001) used a similar structural VAR method to investigate an optimal currency area for East
Asia.
7
The G-PPP theory was developed by Enders and Hurn (1994).
38
Therefore, it is assumed in the G-PPP model that there are common factors
among some bilateral real exchange rates, especially those between the strongly linked
two countries. Thus, real exchange rates have a stable equilibrium in the long run. The
G-PPP model explains that a PPP holds if a linear combination of some bilateral real
exchange rate series has equilibrium in the long run even though each of the bilateral
rate series is non-stationary.
Table 3 summarizes our empirical results of Ogawa and Kawasaki (2002). It
shows one combination in which all countries in the linear combination indicated
significant statistics only when the common currency basket is supposed to be an anchor
currency. With the US dollar as an anchor currency, there were no combinations in which
all countries in the linear combination indicated significant statistics.
With the common currency basket as an anchor currency, it is found that at least
five Asian countries can form a common currency area. Moreover, it is found that all six
countries can form a common currency area if it is allowed to include the case where the
Philippine peso is considered to be weakly exogenous in co-integrated relationship. On
the other hand, five Asian countries (four countries with one exogenous country) are
found to be able to form a common currency area with the US dollar as an anchor
currency. If a number of countries that can form a common currency area are used to
39
judge a more applicable anchor currency, empirical results suggest that the common
currency basket is better as an anchor currency than the US dollar.
The analytical results imply that the five ASEAN countries and Korea will be
candidates for a common currency area with a common currency basket as an anchor
currency. The conclusion that a common currency basket is more applicable appropriate
appropriate ok? as an anchor currency than the US dollar in forming a common currency
area in the region.
Conclusions: An Assessment
This paper considered the costs and benefits of the basket currency regime. Its benefits
are stabilizing trade balances, capital flows, and GDP for East Asian countries. There are
some constraints when a currency basket regime is implemented. Both the inertia of the
US dollar as a key currency and coordination failure in choosing an appropriate
exchange rate system might impede the monetary authorities in adopting the currency
basket regime.
This paper suggests that it is necessary to implement an international
coordination in the exchange rate policy in order to resolve coordination failure. From this
point of view, a common currency basket in East Asia will be most useful in establishing
40
international coordination. In the case of East Asian countries, international trade
relationship is diversified in terms of trading partners: the intraregion neighbors, the US,
and the European Union. Therefore, a possible common currency basket in East Asia
would consist of the US dollar, the Japanese yen, and the euro, and so on. It may be
contrasted with the ECU case where the ECU consisted of intraregional currencies only.
Is a common basket a step toward common currency in East Asia? It might be
questionable to create a currency union in East Asia in the near future. There may be
political difficulties in forming a common currency area. Among others, two factors are
necessary for creating a currency union: international policy cooperation and an optimal
currency area. Needless to say, the monetary authorities have to make international
policy coordination as a premise that when they plan to when ok? create a common
currency area. It is difficult for them to make international policy coordination unless they
have a common policy objective.
As for an optimal currency area, empirical results have been shown that the five
ASEAN countries and Korea could create a common currency area with a currency
basket as an anchor currency according to G-PPP model. Theoretically it is not difficult to
expect that the East Asia region might form a common currency area in the future.
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47
Table 1: Optimal Weight for a Currency Basket for East Asian Countries
Currency
Thai Baht
Indonesian Rupiah
Korean Won
Taiwan Dollar
Singaporean Dollar
Philippine Peso
meaning of *??
Actual weight *
Optimal weight
$(%) Yen (%)
$(%) Yen (%)
91
5
35.3
64.7
95
16
77.9
22.1
96
-10
45.7
54.3
96
5
7.3
92.7
75
13
51.0
49.0
107
-1
72.8
27.2
Sources: Frankel and Wei (1994) and Ito et al. (1998).
Actual weights were estimated from actual movements of the exchange rates.
Asian currencies (in terms of the Swiss franc) were regressed on the U.S. dollar (in
terms of the Swiss franc) and Japanese yen (in terms of the Swiss franc). Optimal
weights were derived to minimize fluctuation of the growth rate of trade balance.
Delete asterisk (*).
[[xx pls indicate what * means in a footnote or in note]]
[[xx For typesetter: pls position this table right after reference in the
text]]
48
Figure 1.
Thailand, Real Exchange Rate & Export Volume(1990-1997)
0.4
1.6
0.35
1.4
0.2
1
0.15
0.8
0.1
1997
1996
1996
1995
1995
1994
1994
1993
1993
1992
-0.05
1992
0.4
1991
0
1991
0.6
1990
0.05
-0.1
0.2
0
-0.15
Export Volume
Real Exch Rate, 1997:2=1
1.2
0.25
1990
Export Volume Growth
0.3
Real Exchange Rate (Japanese Yen)
Real Exchange Rate (US$)
Please spell it out
Real Exchange Rates
Make the difference clear We think that there is a
clear difference.
[[ xx For typesetter: pls position this figure after the reference in the text]]
49
Table 2: Relative Contribution of the US Dollar to Utility
Standard
Deviation
Mean
99% Confidence Interval
Based on Inflation rate of CPI [[see suggestion below pls]]
1986Q1–2000Q1
Real interest rate = 3%
Real interest rate = 5%
Real interest rate = 8%
0.61
0.62
0.63
Real interest rate = 3%
Real interest rate = 5%
Real interest rate = 8%
0.62
0.62
0.62
Real interest rate = 3%
Real interest rate = 5%
Real interest rate = 8%
0.58
0.58
0.58
0.06
0.06
0.06
0.59-0.63
0.60-0.64
0.60-0.64
1986Q1–1998Q4
0.06
0.06
0.06
0.59-0.64
0.60-0.64
0.60-0.64
1999Q1–2000Q1
0.03
0.02
0.01
0.55-0.61
0.56-0.60
0.57-0.60
CPI = consumer price index.
Source: Ogawa and Kawasaki (2001)
[[xxFor column one title, suggest use either “Based on Inflation” OR “Based on
Change in CPI”]] “Based on Change in CPI” is better.
[[xx For typesetter: pls position this table after reference in the text]]
50
Table 3: Summary of Empirical Analysis on a Common Currency Area
Combinations
Number of Countries in
the Currency Area
a
Currency Basket
US dollar
6
Korea + Singapore + Indonesia + Malaysia +
(Philippinesa)+ Thailand
5
Korea + Singapore + Indonesia + Philippines +
Thailand
Korea + Singapore + Indonesia + Malaysia +
(Thailanda)
4
Singapore + Indonesia + (Philippinesa) + Thailand
(Koreaa) + Indonesia + Malaysia + Philippines
(Koreaa) + Malaysia + Philippines + Thailand
Indonesia + Malaysia + Philippines + (Thailanda)
3
Indonesia + (Malaysiaa) + Philippines
(Indonesia a) + Malaysia + Philippines
Malaysia + Philippines + (Thailanda)
Series of the countries with parentheses is a weak exogenous series in the co-integrated relationship.
[[xx Source??]]Ogawa and Kawasaki (2002).
[[xx For typesetter, pls position this table after reference in the text]]
51