Strategy for a Regional Exchange Rate Arrangement in East Asia: Analysis, Review and Proposal

Abstract

This paper discusses major conceptual and empirical issues relevant to the exchange rate policies of East Asian economies. Given the high degree of economic integration, intra-regional exchange rate stability remains an important objective in East Asia. But the current uncoordinated practice of each economy managing exchange rates or maintaining a de facto dollar peg is not optimal for this purpose. The paper suggests that the region's governments take a coordinated action to shift the policy of nominal exchange rate policy from the US dollar alone to a common basket of the US dollar, the Japanese yen, and the Euro, which would be more reflective of the average structure of foreign trade and direct investment. At least initially, each economy is free to choose its own formal exchange rate arrangement, be it a fixed exchange rate regime, a crawling peg or a managed float with wide margins, as long as it chooses the common basket as the reference. Such an arrangement is a pragmatic policy option for East Asia until greater political and institutional developments create an environment conducive to a more robust framework of monetary and exchange rate policy coordination.

Keywords:

• Exchange rate arrangement
• East Asian crisis
• economic integration
• intra-regional exchange rate
• stability

Acknowledgments

This is an updated and substantially revised version of an earlier paper circulated as World Bank Policy Research Working Paper No. 2503, December 2000. The authors are thankful to Patrick Honohan, Yusuke Horiguchi, Paolo Mauro, Alexander Swoboda for their comments, to Shigeru Akiyama, Taro Esaka, Kanda Naknoi, Kimiko Sugimoto, Misa Takebe and Jo-Ann Tan for their assistance with data analysis, and to David Bisbee and Steven Green for editorial assistance. The findings, interpretations, and conclusions expressed in this paper are those of the authors and do not necessarily represent the views of any organization with which they have been affiliated.

Notes

Shinji Takagi, Advisor, Independent Evaluation Office, International Monetary Fund, Washington, DC, USA.

See also Mussa et al. (2000) and Kawai and Akiyama (2000) for earlier studies. Here, flexible arrangements are defined broadly, i.e. those in which the exchange rate is adjusted according to a set of indicators, follows a managed float or is independently floating.

There are exceptions to this claim: Eichengreen (1999a) notes that Poland (in the 1990s), Israel (in the 1980s), and Singapore (in the 1970s) introduced greater exchange rate flexibility when capital inflows placed upward exchange rate pressure.

Observing the prevalence of managed arrangements in East Asia, Hernandez and Montiel (2003) offer some rationales for such an intermediate arrangement: (1) reduction of the noise content of rate movements; (2) temporary preservation of undervalued real exchange rates to assist economic recovery from the crisis; and (3) accumulation of foreign exchange reserves to guard against future currency crises.

As experienced in the European Monetary System (EMS), even fixed exchange rates are not immune from incurring large risk premia if credibility is lacking.

Exchange rate volatility that is seemingly unrelated to fundamentals has led Jeanne and Rose (1999) to argue that the “noise” component of exchange rate volatility depends on the structure of the foreign exchange market, which may be characterized by multiple equilibria with either high or low volatility. In their model, the entry of noise traders in a market changes the structure of risks and returns in a way that makes it more attractive for other noise traders to join, resulting in herd-like behavior. In this environment, it is shown that the monetary authorities can reduce exchange rate volatility induced by the arrival of noise traders, for example, by announcing a target zone. In other words, the very act of floating creates additional volatility (see also Flood & Rose, 1999). This argument, applicable to any foreign exchange market, must apply with greater force to the foreign exchange markets of emerging market economies because of their relative thinness. In the context of Korea, Park et al. (1999) explain the unwillingness of the Korean monetary authorities to allow the currency to float freely by the thinness of the foreign exchange market whose daily turnover amounted to only 1.6% of total exports and imports in 1998 (in contrast, daily turnover was over 20% of total exports and imports in the US, Hong Kong and Japan, over 100% in the UK, and over 60% in Singapore).

Hausmann et al. (1999) measure the ability to borrow in one's own currency by the ratio of all foreign securities issued in a particular currency (e.g. won) to foreign securities issues by the country (e.g. Korea). It turns out that, except for South Africa, Poland and possibly a few others, developing countries do not generally issue foreign debt in their own currencies.

On the otherhand to the extent that purchasing power parity is more likely to hold in the long run, uncertainty associated with exchange rate volatility may have a smaller role to play in investment decisions.

If FDI is directed towards domestic sales, greater exchange rate uncertainty may cause local production to replace exports to that market, thus increasing FDI flows. If FDI is directed towards (re)exports, exchange rate uncertainty increases the riskiness of that particular host country as a production base. See Ito et al. (1996) and Benassy-Quere et al. (1999).

Theoretically, investment can rise or fall with greater exchange rate uncertainty. The types of industries more likely to benefit from exchange rate uncertainty are those with few alternative uses and little scrap value or with large entry costs. In contrast, the types of industries whose investment is likely to benefit from greater exchange rate stability are those with high scrap value but a low opportunity cost of waiting. Based on the estimation of aggregate investment equations for France, Germany, Italy, the UK and the US, Darby et al. (1999) found significant, negative coefficients for exchange rate volatility.

In this connection, Nakamuna and Oyama (1998) provide an interesting insight into how the exchange rate sensitivity of FDI flows can be affected by the type of activities supported by FDI. Using the sample of eight East Asian economies (China, Indonesia, Korea, Malaysia, the Philippines, Singapore, Taiwan, and Thailand), the authors note that Japanese FDI into these countries during 1979–1997 was highly sensitive to changes in the real bilateral exchange rates, such that depreciation against the yen significantly increased FDI from Japan. The exchange rate sensitivity, however, was smaller for local market-oriented FDI inflows. Furthermore, no such strong exchange rate sensitivity was observed for US FDI into the region. For some countries, when the local currency depreciated against the US dollar, there was even a fall in FDI from the US, suggesting that much of US FDI was in real estate and other non-manufacturing sectors where it assumed much of the character of portfolio investment. All in all, exchange rate sensitivity was the most distinguishing feature of Japanese FDI into East Asia.

Separate statistics are reported for high and low per capita income countries. Here, we refer to the results for the low per capita income countries (which do not include industrial countries) as characterizing “developing countries.”

Measures to reduce currency mismatches include: periodic announcements of the size of short-term external debt (as a ratio of foreign exchange reserves), development of deeper capital markets, and regulation of sovereign borrowing in foreign currencies.

It should be noted that, theoretically, closer trade ties could result in either tighter or looser correlation of national business cycles. Cycles could become more idiosyncratic, if countries become more specialized. However, if there are more common (supply or demand) shocks or if intra-industry trade accounts for most trade, cycles may become more similar. Concentrating their attention on the relationship between trade links and business cycle correlation, Frankel and Rose (1998) analyzed the panel data of 21 industrial countries over 30 years to obtain a strong positive relationship, i.e. closer international trade links result in more closely correlated business cycles across countries. This result is robust with respect to the choice of a particular measure of bilateral trade intensity (e.g. imports, exports or total of imports and exports) or bilateral real activity correlation (e.g. GDP, industrial production, or employment).

The corresponding figures for ASEAN were 23%, 20% and 21%, respectively. On this basis, East Asia is a far more self-contained area than ASEAN.

The demand shocks can be highly sensitive to the choice of exchange rate arrangement and macroeconomic policy. For example, Eichengreen and Bayoumi (1999) suggested that the high cross-country correlations of demand shocks among Hong Kong, Indonesia, Malaysia, Singapore, and Thailand were the result of these economies’ dollar peg policy.

For the period 1979–1998, the European Currency Unit (ECU), a precursor of the Euro, is used instead of the Euro. The ECU exchange rate is available going back to 1975, prior to which the ECU rate is calculated by assuming the initial ECU composition. A synthetic Euro whose value was calculated by taking the weighted average of the currencies of all EU member countries, with the weights given by nominal GDP shares in 1990, was also tried instead of the ECU without much difference in results.

The Balassa–Samuelson hypothesis suggests a positive relationship between productivity growth and real exchange rate appreciation, but the evidence of such positive relationships has not been clearly established in East Asia. Covering a relatively long time period, Ito et al. (1996) note that the real exchange rates (measured in GDP deflators) of fast-growing East Asia did not necessarily experience appreciation. For instance, the real exchange rates of Hong Kong, Singapore and Thailand remained fairly constant, while Indonesia and Malaysia experienced a moderate real depreciation.

Continuing this line of argument, Collignon (1999) states that the emergence of a European currency bloc has made exchange rates between the three major world currencies more volatile and, thus, contributed to the reduction of cross-border investment worldwide.

For an early statement of this view, see Ohno and Shirono (1997).

It should be noted quickly, however, that they do not advocate a yen bloc on different grounds, namely, that Japan's on-going structural change would involve a significant real depreciation over the medium term.

Nonetheless, some consultation and surveillance processes among the participating countries are desirable. For technical issues related to the operation of a basket peg, see Takagi (1988).

This was particularly the case in East Asia where a large shock caused massive insolvency problems in the corporate sector and serious NPL problems in the financial system, requiring permanently weaker real exchange rates for adjustment.

This reflects the well-known impossibility trilemma theorem—the impossibility of pursuing three simultaneous policy objectives of free capital mobility, exchange rate stability and monetary policy independence.

In this sense, a regional surveillance mechanism requires mutual consultation among the participating countries about their economic performance and policies, including those of developed nations, and hence differs in nature from the IMF's Article IV consultation process. It resembles the EU's multilateral surveillance (ECOFIN and monetary committee) or the OECD's Economic Development Review Committee.

Additional information

Notes on contributors

Masahiro Kawai

Shinji Takagi, Advisor, Independent Evaluation Office, International Monetary Fund, Washington, DC, USA.