A Basket Currency for Asia

Takatoshi Ito, Takatoshi Ito

• Publisher: Routledge
• Year: 2007
• ISBN:
  9781134176014
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

The failure of the dollar peg to prevent the Asian currency crisis of 1997 to 1998 has highlighted the importance of the exchange rate regime in Asia and provoked much discussion as to what the alternatives are in terms of exchange rate systems.

Bringing together extensive research on Asian basket currencies in one volume, this new text discusses whether a currency basket system is the answer, striking a balance between the theoretical and empirical. With strong policy implications for East Asia, the impressive team of contributors argue that for countries that have close economic relationships with several currency areas, it is well worth considering a currency basket system. The book also pursues the important idea of coordination failure, whereby if each individual country tries to adopt an optimal exchange rate given other neighbouring countries' policies, they may collectively fail to reach a region's optimal exchange rate regime.

A Basket Currency for Asia is a topical and significant text that will appeal to students and scholars of international finance and Asian economics.

1 Introduction

Takatoshi Ito

The Asian currency crisis of 1997–98 has taught many lessons to both scholars and policy makers around the world. One of these lessons concerns the exchange rate regime. East Asian countries chose to fix their currencies to the US dollar, whether explicitly as in Hong Kong’s case, or implicitly as in Thailand’s. Because East Asian countries have strong trade and investment ties with many other countries, including Japan, European countries, and the United States as well as their own neighboring countries, the de facto dollar peg was clearly inappropriate even before the Asian currency crisis. The dollar peg was inextricably tied to a boom-and-bust cycle, as the dollar was at times undervalued and at times overvalued against the yen and European currencies. The export boom and domestic over-investment of 1994–95 was followed by a bust in 1996–97, and this was one of the reasons Thailand fell into difficulties; capital inflows dried up and there was an attack on the baht. After the currency crisis, many Asian countries realized the problems that plagued the dollar peg and did not return to it. Once the worst of the crisis was over, many East Asian countries adopted a managed floating exchange rate regime, with the notable exceptions of Hong Kong, China, and Malaysia. Hong Kong has kept its dollar peg regime under a currency board system, and China has maintained a de facto dollar peg. Malaysia officially reverted back to the dollar peg system in September 1998, after using a floating exchange rate regime for a little more than a year.

Another currency crisis could occur if East Asian countries do not improve their exchange rate regimes and instruments for monitoring and controlling capital flows. Even though several years have passed since the Asian currency crisis, the matter of the choice of an exchange rate regime should still be a matter of urgency in East Asian countries. This book includes the proposals and a discussion of what the optimal exchange rate regime for East Asian countries might be. We still observe occasional turmoil in the exchange rate regimes of Latin American countries. New members of the European Union may face exchangerate vulnerability until they are included in the euro area. Countries that have close economic relationships with several currency areas should consider a currency basket system. This group includes East Asian countries, Latin American countries such as Argentina, and Central European countries. This book provides suggestions that could be insightful for many emerging market countries that have trade and investment relationships with several currency areas.

Many economists and policy makers agree that fixed exchange rates are not appropriate for East Asian countries. So why not just float the currency rates? Emerging market economies tend to fear free floating for various reasons. Uncertainties about future exchange rates discourage domestic investment and inbound foreign direct investment. Policy makers in East Asian countries also fear speculative activity in their currency. These currency markets are small, and concerted actions by foreign-controlled funds can easily generate a potentially disruptive boom-and-bust pattern.

To avoid excessive fluctuations in currency value and export competitiveness, one natural choice would be a currency basket, which could minimize fluctuations in the real effective exchange rates. The reference rate (central rate) could be defined as the weighted average of the values of currencies of countries with which the country has significant trade and investment relationships. Policy makers would have the freedom to choose the currencies in the basket, the weighting of those currencies, and the target band within which they would try to limit movements.

This book is a collection of closely related papers on the theme of the basket currency regime. The papers investigate the kind of exchange rate regime that would be desirable for East Asian countries from several perspectives, including international trade and macroeconomic factors. Since the Asian currency crisis, academic economists and policy makers in Asia have been very interested in exchange rate regimes. Both in academic literature and in policy circles, the notion of a basket currency has been put forward as a sensible alternative to a de facto dollar peg or a floating exchange rate.

In fact, some East Asian countries, including Hong Kong, Malaysia (since September 1998), and China, have adopted either an official dollar peg system or a de facto dollar peg system even after the Asian currency crisis.¹ The interdependence that exists among East Asian countries may be one reason for the difficulty of choosing the optimal exchange rate regimes. For example, an optimal exchange rate regime for Thailand depends on the exchange rate regime of Singapore, and vice versa. Therefore, it is important to have regional cooperation among East Asian countries. If currency rates are left to the marketplace, East Asian countries may experience a coordination failure.

This book is the first collection of papers ever to focus on the basket currency system. The book is also unique in its balancing of theoretical and empirical work, with strong policy implications for East Asian countries. The book is focused firmly on the situation in Asia, with a number of empirical evidence and original ideas. The papers pursue the important idea of coordination failure—that is, the risk that if each country tries to adopt the exchange rate system best for itself alone, all may collectively fail to reach the exchange rate regime best for the region as a whole. To move from a bad equilibrium (dollar peg) to a good equilibrium (currency basket), regional cooperation is needed.

This book consists of seven chapters. Chapter 2 shows that the de facto dollar peg, which was the choice made by several East Asian countries before the Asian currency crisis, was actually a factor that contributed to the crisis. This chapter considers the type of exchange rate system that would be most desirable for East Asian countries from the viewpoint of international trade. A currency basket system would be best for East Asian countries that trade with Japan, Europe, and the United States as well as within the region. However, some East Asian countries have returned to the de facto dollar peg system since the currency crisis. Chapter 3 focuses on the impact that Malaysia’s official adoption of the dollar peg system in 1998 had on neighboring countries’ choice of exchange rate regime. Chapter 4 is a theoretical analysis of the difficulties each country in East Asia might face in choosing an exchange rate system, given the strong economic interdependence among them. Chapter 5 empirically analyzes the possibilities of coordination failure. The analytical results underscore the importance of international coordination in choosing an exchange rate system in East Asia. Chapter 6 considers a common currency basket to solve the problem of coordinating exchange rate systems, by comparing coordinated exchange rates with uncoordinated exchange rates. Chapter 7 considers the advantages and disadvantages of a common currency basket in Asia’s bond markets, in terms of liquidity and foreign exchange risks. Chapter 8 investigates the possibility of creating a common currency basket in East Asia according to the Optimal Currency Area theory. It is shown that the ASEAN5 countries (Indonesia, Malaysia, the Philippines, Singapore and Thailand), plus South Korea and China might be able to form a common currency area, and that a common currency basket would be more applicable as an anchor currency than the US dollar if these countries choose this route.

Chapter 2 (‘How did the dollar peg fail in Asia?’), which is a seminal work of this literature that first appeared as an article in the Journal of the Japanese and International Economies, shows that the de facto dollar peg was one cause of the Asian currency crisis of 1997. Monetary authorities in Thailand, for example, had announced as early as 1984 that their country would adopt a currency basket system. Swings in the yen/dollar exchange rate caused trade balances to fluctuate under the de facto dollar peg system. The depreciation of the Japanese yen against the US dollar, in particular, harmed the price competitiveness of East Asian nations’ export products and slashed their export growth during 1995–1997. This chapter formalizes a theoretical model with a micro-economic foundation, to estimate the optimal weighting of the yen and the dollar in a currency basket to stabilize trade balances for some East Asian countries.

Chapter 3 (‘Post-crisis exchange rate regimes in East Asia’) considers the factors that affected the values of three ASEAN currencies—the ringgit, the Singapore dollar, and the baht—after the crisis, taking into account the interaction of exchange rate policies among the ASEAN countries. We explore why these East Asian currencies, which exhibited reduced correlation with the US dollar temporarily after the crisis, tended to revert back to de facto pegs against the US dollar in the late 1990s. After Malaysia adopted the dollar peg system in September 1998, both the Singapore dollar and the baht resumed their strong correlation with the US dollar and began to revert back to de facto dollar pegs. Most of these changes are explained well by the strong links among the ASEAN countries.

Chapter 4 (‘On the desirability of a regional basket currency arrangement’) is a theoretical consideration of how monetary authorities in East Asian countries face coordination failure in choosing an exchange rate system, focusing on the interdependence of the exchange rate policy. The theoretical model in Chapter 2 is extended to construct a theoretical model of exchange rate policy interaction between two countries, both of which export products to the United States and Japan as well as to neighboring countries. It shows that a country’s best choice of exchange rate system (or weights in the basket) is dependent on its neighbor’s. The dollar weights in the currency baskets of the two countries are a Nash equilibrium. The two countries may face coordination failure and be stuck with the dollar peg system instead of an optimal currency basket system. The core part of this chapter appeared in the Journal of the Japanese and International Economies, but the chapter in this book is an extended version of that article, explaining the theory in more detail.

Chapter 5 (‘Economic interdependence and international coordination in East Asia’) considers the necessity of coordination in exchange rate policy. The theoretical model developed in Chapter 5 is used to estimate weights for the US dollar in a possible currency basket for some East Asian countries. An empirical analysis is conducted to investigate whether monetary authorities would, in fact, face coordination failure in choosing an exchange rate system for the ASEAN5 countries, China, and Korea. The results of the analysis imply that the ASEAN countries and China are compelled to adopt the dollar peg system because they have an unstable equilibrium or coordination failure.

Chapter 6 (‘A case for a coordinated basket for Asian countries’) attempts to solve the coordination failure problem demonstrated in Chapters 2, 4, and 5 by considering possible forms of regional coordination for a common currency basket. It shows two ways to calculate the basket currency values for Asian countries, one without coordination and one with coordination. In the post-crisis period, a coordinated solution would have been better than an uncoordinated one, and our study indicates that a coordinated solution would have resulted in a greater appreciation of the regional currencies. Uncoordinated solutions resulted in large currency depreciation for other countries besides Indonesia, precipitated by the very large depreciation in Indonesia’s currency. A coordinated solution would have resulted in a more stable exchange rate. In other words, the coordination would have produced more stable exchange-rate dynamics in the post-crisis period.

Chapter 7 (‘A common currency basket in bond markets in East Asia’) is a discussion of Asian bond markets, and considers the possible advantages and disadvantages of using a common currency basket rather than international currencies for issuing Asian bonds, taking into account liquidity and foreign exchange risks. Chapter 7 focuses on foreign exchange risks to investigate what kind of currency is desirable for bond issuers and investors. In addition, it considers liquidity in Asian bond markets. It concludes that currency-basket-denominated bonds could lessen foreign exchange risks, but might face lower liquidity under current conditions.

Chapter 8 (‘Possibilities for the introduction of a currency basket in East Asia, from an OCA standpoint’) uses a Generalized Purchasing Power Parity (G-PPP) model to investigate the possibility of creating a common currency basket in East Asia according to the Optimal Currency Area theory. It investigates which East Asian countries might be able to create a common currency area. Its conclusions are that the ASEAN5 countries, South Korea, and China might be able to form a common currency area, and that a common currency basket may be a better anchor currency than the US dollar if these countries form a common currency area.

Note

¹ Although China and Malaysia declared their intention to abandon the dollar peg on July 21, 2005, their exchange rates have not fluctuated much between July and December 2005.

2 How did the dollar peg fail in Asia?¹

Takatoshi Ito, Eiji Ogawa, and Yuri Nagataki Sasaki ²

1. Introduction

The currency crises in Asia in 1997 highlighted the danger of the fixed exchange rate system. Four ASEAN currencies (the Thai baht, the Malaysian ringgit, the Indonesian rupiah, and the Philippine peso) all depreciated by 30–40 percent in the three months following the baht depreciation of July 2. Thailand asked International Monetary Fund (IMF) for a balance of payment support package in August. The IMF support ($4 billion) was complemented by Japan ($4 billion) and other Asian nations together with the World Bank and Asian Development Bank (ADB). In November, Indonesia asked the IMF, the World Bank, and the ADB to advise them on economic reform together with a support for a potential balance of payment gap. The Indonesian package by IMF, World Bank, and ADB was also complemented by a secondary line of support by Japan, the United States, and the Asian countries. In late November, Korea, after its currency depreciated sharply, asked for the IMF support. Also in November, the sharp decline in the Hong Kong stock market, which was caused by defending the fixed exchange rate based on the currency board, caused a worldwide turmoil. The crisis spread to Korea in November, and the IMF package was hastily put together in the first week of December. The crises in these countries deepened in December 1997 to January 1998, as the value of the Indonesian rupiah depreciated to a level one-sixth of the precrisis level, and other ASEAN currencies and the Korean won depreciated to a level half of the precrisis level.

One of the common factors among these crisis countries was the choice of a de facto dollar peg. Thailand has adopted a basket system, in which the value of the Thai baht is determined as a weighted average of major currencies. However, it was well-known that the US dollar had an overwhelming weight in the basket since 1985. Indonesia had adopted a slide system with a narrow band, where the slide was adjusted for the inflation rate difference between Indonesia and the United States. The Korean won had also maintained a stable value against the US dollar. The Hong Kon...