Towards Monetary and Financial Integration in East Asia

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Towards Monetary and Financial Integration in East Asia

Towards Monetary and Financial Integration in East Asia Edited by

Koichi Hamada Tuntex Professor of Economics, Yale University, New Haven, USA

Beate Reszat Economist, Hamburg Ministry of Science and Research, Hamburg, Germany

Ulrich Volz Senior Economist, German Development Institute, Bonn, Germany

Edward Elgar Cheltenham, UK • Northampton, MA, USA

© Koichi Hamada, Beate Reszat and Ulrich Volz 2009 Chapter 11 © The Peterson Institute for International Economics 2009 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical or photocopying, recording, or otherwise without the prior permission of the publisher. Published by Edward Elgar Publishing Limited The Lypiatts 15 Lansdown Road Cheltenham Glos GL50 2JA UK Edward Elgar Publishing, Inc. William Pratt House 9 Dewey Court Northampton Massachusetts 01060 USA

A catalogue record for this book is available from the British Library Library of Congress Control Number: 2009922771

ISBN 978 1 84844 363 1 Printed and bound in Great Britain by MPG Books Group, UK

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Contents List of contributors Foreword by Richard N. Cooper Acknowledgements

vii ix xi

Introduction: prospects for monetary and financial integration in East Asia—dreams and dilemmas Koichi Hamada, Beate Reszat, and Ulrich Volz PART I

THE POLITICAL ECONOMY OF REGIONAL INTEGRATION

1 The ASEAN economic community and the European experience Michael G. Plummer and Reid W. Click 2 The political economy of European economic and monetary union negotiations and implications for East Asia Heungchong Kim 3 International political conflicts and economic integration Koichi Hamada and Inpyo Lee PART II 4

5

6 7

13

41 61

DEVELOPING BOND MARKETS IN EAST ASIA

Learning by doing in market reform: lessons from a regional bond fund Guonan Ma and Eli Remolona Currency denomination in Asian bond markets Eiji Ogawa and Junko Shimizu

PART III

1

87 104

EXCHANGE RATE POLICIES IN EAST ASIA: THE ROLE OF THE DOLLAR

East Asia’s role in the revived Bretton Woods system Michael P. Dooley, David Folkerts-Landau, and Peter Garber Current account surpluses and conflicted virtue in East Asia: China and Japan under the dollar standard Ronald McKinnon and Gunther Schnabl v

141

159

vi

Contents

PART IV

8 9

Three cases for monetary integration in East Asia Ulrich Volz Monetary and exchange rate policy coordination in ASEAN11 William H. Branson and Conor N. Healy

PART V 10

11 12

14

222

267 290 304

THE ROLE OF CHINA

The illusion of precision and the role of the renminbi in regional integration Yin-Wong Cheung, Menzie D. Chinn, and Eiji Fujii Institutional and structural problems of China’s foreign exchange market and the RMB’s role in East Asia Zhang Jikang and Liang Yuanyuan

Index

195

CURRENCY BASKETS FOR EAST ASIA?

Capital markets and exchange rate stabilization in East Asia: diversifying risk based on currency baskets Gunther Schnabl Asian currency baskets John Williamson The role of an Asian currency unit Masahiro Kawai

PART VI 13

TOWARD MONETARY INTEGRATION IN EAST ASIA?

325

357

387

Contributors William H. Branson, John Foster Dulles Professor of International Affairs and Professor of Economics and International Affairs, emeritus, Department of Economics, Princeton University, Princeton, USA. Yin-Wong Cheung, Professor of Economics, Economics Department, University of California, Santa Cruz, USA. Menzie D. Chinn, Professor of Public Affairs and Economics, Robert M. La Follette School of Public Affairs, University of Wisconsin at Madison, USA. Reid W. Click, Associate Professor of International Business, George Washington University School of Business, Washington, DC, USA. Richard N. Cooper, Maurits C. Boas Professor of International Economics, Harvard University, Cambridge, MA, USA. Michael P. Dooley, Professor of Economics, Economics Department, University of California, Santa Cruz, USA. David Folkerts-Landau, Managing Director and Global Head of Research, Deutsche Bank AG, London, UK. Eiji Fujii, Associate Professor of Economics, Graduate School of Systems and Information Engineering, University of Tsukuba, Japan. Peter Garber, Global Strategist, Deutsche Bank AG, London, UK. Koichi Hamada, Tuntex Professor of Economics, Department of Economics and Economic Growth Center, Yale University, New Haven, USA. Conor N. Healy, Woodrow Wilson School, Princeton University, Princeton, USA. Masahiro Kawai, Dean, Asian Development Bank Institute, Tokyo, Japan. Heungchong Kim, Research Fellow and Head of the Europe Team, Korea Institute for International Economic Policy, Seoul, Korea. Inpyo Lee, Professor of Economics, Ewha University, Seoul, Korea; Visiting Fellow, Economic Growth Center, Yale University, New Haven, USA. vii

viii

Contributors

Liang Yuanyuan, Research Associate, Center for International Finance Studies, Fudan University, Shanghai, China. Guonan Ma, Senior Economist, Representative Office for Asia and the Pacific, Bank for International Settlement, Hong Kong. Ronald McKinnon, William D. Eberle Professor of International Economics, Department of Economics, Stanford University, USA. Eiji Ogawa, Professor of Economics, Graduate School of Commerce and Management, Hitotsubashi University; Deputy Director of the EU Institute in Japan, Tokyo, Japan. Michael G. Plummer, Professor of Economics, Paul H. Nitze School of Advanced International Studies, Johns Hopkins University, Bologna Center, Italy. Eli Remolona, Deputy Chief Representative of the Office for Asia and the Pacific, Bank for International Settlements, Hong Kong. Beate Reszat, Economist, Hamburg Ministry of Science and Research, Hamburg, Germany. Gunther Schnabl, Professor of Economics, Faculty of Economics and Business Administration, University of Leipzig, Germany. Junko Shimizu, Associate Professor, Faculty of Economics, Meikai University, Japan. Ulrich Volz, Senior Economist, German Development Institute, Bonn, Germany. John Williamson, Senior Fellow, Peterson Institute for International Economics, Washington, DC, USA. Zhang Jikang, Professor of Economics, Director of the Center for European Studies, and Deputy Director of the Center for International Finance Studies, Fudan University, Shanghai, China.

Foreword Richard N. Cooper There is a vague but palpable dissatisfaction with existing international monetary arrangements. These entail few formal rules with regard to how countries should manage their exchange rates, and little coherent guidance from the economics profession beyond an apparent consensus that floating a country’s currency is better than fixing it—albeit with many reservations about free floating for any but the largest of economies. Against this intellectual background, Europeans defied many academic reservations and in 1999 created a common currency among 11, later 16, members of the European Union. The resulting euro has now had a decade of experience, without obviously disastrous results. There have been some strains, particularly, as was predicted and feared, regarding Italy, but also a respectable record of achievement in terms of continued growth with modest inflation. At the same time, there have been large and disturbing movements in exchange rates among the major currencies. During the past two decades the yen has ranged from 85 yen to the dollar in 1995 to 148 in 2005, a range of 75 percent, while during the decade of its existence the euro has ranged by over 90 percent, between USD 0.83 and USD 1.60 per euro. Throughout the period, inflation was relatively low in all three regions. What justification is there for such wide swings among major currencies? What are the implications for international trade and especially for investment in tradable goods? And what are the implications for decisions regarding exchange rate policy for other countries, especially developing countries with imperfect capital markets? It is against this general background that the countries of East Asia, one by one, have managed their exchange rates. But could they do better by cooperating among themselves in monetary and exchange rate management, even to the point of adopting a common currency, as some Europeans have done? This volume usefully explores these issues. By wide agreement, a common currency is not in prospect anytime soon—if ever. There are too many political and institutional hurdles, and even the economic gains are not clear. It is worth recalling, however, that it took Europe over four decades between the conception of its economic ix

x

Foreword

community as reflected in the Rome Treaty of 1957 and the creation of the euro in 1999. Many forms of economic and financial cooperation are possible short of adoption of a common currency, some of which would facilitate an eventual move toward that end, should it prove possible and desirable. The first steps have been taken toward mutual financial support among East Asian economies in times of stress, and toward the creation of an Asian bond market in normal times. China must develop a functioning foreign exchange market and move to full convertibility of the yuan if it is to play a central role in regional financial cooperation. The most vexing issue is management of exchange rates. Economic interdependence within East Asia is growing rapidly, even while commercial interactions with countries outside the region continue to grow. Countries thus face the challenging task of framing exchange rate policy with one eye on the region—containing both customers and competitors—and one eye on the rest of the world. The chapters of this book cover all of these challenging issues, and more. They offer a worthy exploration of a complex set of increasingly important issues and help deepen our understanding of a new financial architecture that might be emerging in East Asia.

Acknowledgements During parts of the work on this book Beate Reszat was Head of Research on International Financial Markets at the Hamburg Institute of International Economics. Ulrich Volz was a Fox International Fellow and Max Kade Scholar at Yale University and a DekaBank Fellow at the Hamburg Institute of International Economics. Ulrich Volz would like to thank the Fox International Fellowship at Yale University, the Max Kade Foundation in New York, and DekaBank in Frankfurt for financial support during the work on this project. The editors would like to express their gratitude to all of the contributors to this book. We would very much like to thank Andrei Popovici, our research assistant at Yale, for his scrupulous proofreading and valuable help with the editing of the manuscript. We also thank Edward Elgar Publishing for the professional and speedy handling of the manuscript. Special thanks go to Richard Cooper for writing the foreword. Sadly, during the work on this book we lost two dear friends and colleagues, both of whom contributed chapters. Zhang Jikang of Fudan University died very unexpectedly and tragically on February 18, 2006. William Branson of Princeton University passed away on August 15, 2006, after a long illness. It is to the memories of Jikang and Bill that we dedicate this book.

xi

Introduction: prospects for monetary and financial integration in East Asia— dreams and dilemmas Koichi Hamada, Beate Reszat, and Ulrich Volz The Asian financial crisis of 1997–98 fundamentally changed East Asia’s perspective on economic regionalism and sparked great political interest in monetary and financial cooperation and integration in the region. The crisis revealed the fragility of the region’s prevailing exchange rate arrangements and highlighted the need for a strengthening of the regional financial architecture. Since the crisis, there has been a proliferation of proposals for fostering East Asian monetary and financial integration. Regional cooperation in the field of money and finance already takes place through the Association of Southeast Asian Nations (ASEAN) surveillance process, the Chiang Mai Initiative for the creation of bilateral short-term financing facilities by the ASEAN13 countries (ASEAN plus China, Japan, and Korea), and various initiatives to foster the development of regional security markets. There is also a serious debate about establishing a regional exchange rate arrangement or even a common East Asian currency in the longer term. In December 2005, the Asian Development Bank announced its intention to create an Asian currency unit (ACU) comprising a basket of East Asian currencies akin to the European currency unit (ECU), which evolved into the euro. Although this initiative has not come to fruition, a regional currency unit is now being studied by the ASEAN13 countries. Particularly remarkable is the involvement of China, which has demonstrated an increasing willingness to accept responsibility for the economic progress of the region as a whole. The ASEAN countries, as well as Japan and Korea, have also displayed ample interest in fostering regional cooperation. Deeper integration, however, is still a ways away. Countries participating in more ambitious regional monetary and financial initiatives would need to develop a far-reaching consensus about economic policy preferences. Moreover, national authorities would need to be willing to subordinate national policy goals, at least at times, to a common goal of regional 1

2

Towards monetary and financial integration in East Asia

integration and stability. It does not seem that such a policy consensus and integrationist spirit has sufficiently developed in East Asia as yet. Integration efforts remain strained by tensions between major players in East Asia, most notably China and Japan, both of which tend to claim a leadership role in economic cooperation, and each of which is short of having full trust in the other. The aim of this book is to critically analyze these developments, to delineate the conditions for successful integration, and to examine the forms under which regional monetary and financial cooperation may be favorable options for the East Asian countries. It assesses the steps already taken toward financial integration and brings forward different proposals for future exchange rate arrangements in East Asia. In particular, the book evaluates the economic and politico-economic arguments and conditions for monetary and financial integration in East Asia and explores how and to what extent the countries of the region can integrate despite their heterogeneity and their underlying political tensions. Drawing on the European experiences, this book analyzes the economic logic of monetary and financial integration in East Asia and its political feasibility. The book has three unifying themes. First, it highlights the barriers and dilemmas that East Asian countries face in pursuing monetary and financial integration. Despite a common interest in regional cooperation, East Asian countries are confronted with multiple problems that jeopardize a process of closer integration and that could turn their dream into “pie in the sky”. If we limit our attention to the purely economic dimension, in the short run East Asian countries encounter incentive problems, domestic as well as international, that complicate the process of attaining the ideal state of cooperation which would spell increased welfare for all. The dilemma is further intensified in the short run if we consider political elements. The need to satisfy domestic constituencies limits governments’ capability to participate in joint international actions. At the same time, historical disputes, conflicting national strategic interests, and rivalry for economic and political leadership in the region impede cooperation. In the intermediate and in the long run, however, the situation may turn out to be different. East Asian countries may understand that the cost of constraints on monetary policy by engaging in regional monetary integration is somewhat overestimated. If they widen both their time horizon and their criteria for appraising their self-interest, they will understand the long-run merit of being freed from the de facto dollar standard and factor in the geopolitical peace dividends that will accrue from regional cooperation. Second, since the European monetary union is the prime exemplar of a multilateral currency union, it is crucial to analyze its lessons for successful

Introduction

3

monetary cooperation and financial integration in East Asia. European countries experienced many difficulties on their way to monetary unification, with the currency crisis of 1992–93 being the most critical moment. It is important to see how European countries overcame their political and economic differences and how the motivation for peace and prosperity overrode longstanding national antipathies. The common agency approach to the creation of European monetary integration helped to balance the interests of all countries involved. For instance, the creation of the ECU circumvented the political difficulties associated with selecting an existing currency to be Europe’s lead currency (even though the German mark, in practice, fulfilled this role) and can be seen as providing the historical precedent for the launch of the ACU. At the same time, this volume examines economic and political differences between Europe and East Asia and discusses the unique obstacles to a process of East Asian integration. Finally, East Asian integration needs to be seen in the context of the global financial system. The Asian financial crisis, which made the instability of the international financial markets all too manifest to East Asian policymakers, triggered a desire for a greater level of East Asian policy coordination. Regional cooperation, it can be argued, provides a way to insulate East Asia from global shocks and reduces economic dependency on the United States and Europe. In turn, East Asian financial integration may contribute to the stability of the world monetary system itself. Moreover, it would increase East Asia’s presence and influence on the world stage and give it a stronger voice in the reforming of the international financial architecture. The book is divided into six parts. Part I focuses on the political economy of regional integration. While European monetary integration is frequently considered a blueprint for East Asian integration, the relationships between East Asian countries are very different from those between European Union nations. One major distinction lies in East Asian nations’ conflicting strategic interests. In particular, the rivalries between China and Japan pose great questions about the success of efforts at integration. Nevertheless, the global context—including the prevalence of financial shocks, the posture of the IMF, and the policies of the United States—has opened the door to monetary and financial regionalism in East Asia. The first chapter by Michael Plummer and Reid Click provides an overview and assessment of economic cooperation within ASEAN, the only supranational body promoting economic integration in the region. Drawing on lessons from the European integration experience, Plummer and Click elaborate the particular characteristics of the Southeast Asian integration process. The ASEAN countries, which aim to create an ASEAN Economic Community by 2020, have also been eager to cooperate

4


with China, Japan, and Korea under the ASEAN13 framework on monetary and financial matters. It is commonly asserted that this group of countries is extremely heterogeneous, in terms of economic development as well as in terms of economic and political systems. However, the European Union, often presented as a genuinely homogeneous bloc, is also composed of a very diverse set of countries, with conflicting national views and interests being the rule rather than the exception. In Chapter 2, Heungchong Kim analyzes the roles and policy positions of the various actors in the European monetary integration process and draws implications for East Asian countries. East Asian cooperation, he asserts, will require a good dose of pragmatism, a common vision, and a long breath. In Chapter 3, Koichi Hamada and Inpyo Lee draw attention to the relationship between international political conflicts and economic integration and examine the incentive structure needed for East Asian integration to progress. They argue that the benefits of regional monetary and financial integration may not only derive from the standard arguments highlighted in the economics literature. According to Hamada and Lee, purely economic incentives may not be strong enough to convince nations to join a monetary union. Just as they were in the case of the European Union’s decision to create an economic and monetary union, security reasons may turn out to be a critical motive for fostering monetary integration in East Asia. Part II is devoted to the very topical matter of developing bond markets in East Asia, presently the most ambitious venture in the area of finance in the region. Financial market development can be seen both as a precondition for monetary integration and as a desired outcome of monetary integration. Moreover, financial cooperation, which does not demand as much commitment as exchange rate cooperation, can be viewed as a testing of the waters before moves are made toward monetary integration. In Chapter 4, Guonan Ma and Eli Remolona discuss the rationale for developing a regional securities market and how cooperation in this area has developed so far. In particular, they examine one of the most important regional initiatives to promote regional bond market development, the Asian Bond Fund II, which was established by 11 central banks in East Asia and the Pacific in 2005. They show how working together to create a regional index bond fund and eight single-market funds helped the involved central banks to identify and overcome market impediments in local currency bond markets. In Chapter 5, Eiji Ogawa and Junko Shimizu turn to currency denomination in Asian bond markets. They estimate the risks of various currency basket denominated bonds and show that bonds issued in a currency basket comprised of East Asian currencies would, in general, reduce the foreign

Introduction

5

borrowing costs for bond issuers in all East Asian countries. Especially in the case of bond issuers in dollar-pegging countries, the foreign borrowing costs of issuing the currency basket denominated bonds would be lower than those of issuing home currency denominated bonds. The two contributions in Part III investigate the special role of the US dollar in East Asia. Before the Asian crisis, all East Asian countries except Japan pegged their currencies to the US dollar, either formally or informally. These (soft) pegs made them vulnerable to dollar–yen fluctuations, which contributed to the crisis. Despite numerous recommendations to freely float their currencies in order to avoid future misalignments and a recurrence of exchange rate crises, East Asian countries have in part returned to their pre-crisis exchange rate policies. In Chapter 6, Michael Dooley, David Folkerts-Landau, and Peter Garber explain why most East Asian countries continue with their dollar pegs and develop what has become known as the Bretton Woods II view. They argue that the current international monetary system—in which a macroeconomically important periphery, emerging East Asia, fixes an undervalued exchange rate to the US dollar in order to promote an export-driven development policy—is analogous to that of the Bretton Woods period. So far, the US has willingly played the role of center country again, running balance of payments deficits and serving as the global financial intermediary. Dooley, Folkerts-Landau, and Garber claim that the system will continue for years more because of the incentive that East Asian countries, especially China, have to absorb a vast pool of underemployed labor into the industrial system. Ronald McKinnon and Gunther Schnabl have a similar take on the dollar’s role in East Asia. In Chapter 7, they explain why continuing to peg to the dollar is entirely rational from the East Asian perspective and why the “East Asian dollar standard”, as they call it, is likely to continue. Rather than undervaluing their currencies in order to promote exports, as maintained in the preceding chapter, McKinnon and Schnabl argue that East Asian governments, in particular China, are trapped into maintaining soft dollar pegs. Because most East Asian economies have transformed themselves from dollar debtors into dollar creditors, they face what McKinnon and Schnabl call “conflicted virtue”, pressure to appreciate their currencies that could lead to a deflationary spiral and zero interest liquidity trap. In Part IV, the chapters by Ulrich Volz and by William Branson and Conor Healy argue that the region would be better off pursuing a path of monetary integration instead of relying on the external dollar anchor. In Chapter 8, Ulrich Volz puts forward three cases for monetary integration in East Asia. Besides the traditional trade argument that he underscores

6


by estimating the effect of exchange rate stability on trade in East Asia, he also argues that monetary integration could help overcome the region’s problems with “original sin” and “conflicted virtue”. Moreover, he questions the conventional wisdom that monetary integration always goes along with a loss of monetary policy autonomy and argues that regional monetary integration could actually increase monetary policy influence for most smaller economies in the region. Volz reasons that the current situation under the East Asian dollar standard already severely limits policy autonomy in most countries and that moving toward regional exchange rate cooperation would increase the degree of policy freedom enjoyed by the region as a whole. William Branson and Conor Healy also speak out in favor of explicit regional monetary and exchange rate policy coordination in Chapter 9. Branson and Healy show that the trade structure of ASEAN and China, in terms both of the geographic distribution of imports and exports and of the commodity structure of trade, is consistent with the adoption of a common currency basket for region-wide exchange rate stabilization. Since East Asian countries’ trade patterns are quite similar and their policies are already implicitly coordinated through their (soft) pegs to the dollar, their real effective exchange rates tend to move together. This means that ASEAN and China are already moving toward integration in practical effect. Branson and Healy maintain that an explicit move toward exchange rate coordination, which would require macro policy coordination, would also support regional surveillance and the development of regional bond markets. Moreover, it would facilitate reserve-sharing under the Chiang Mai Initiative. This would, in turn, release reserves that could be invested in a new Asian Development Fund that could be used to support growth and poverty reduction. Part V is dedicated to one particular form of exchange rate arrangement that has received considerable attention since the Asian crisis—currency baskets. In Chapter 10, Gunther Schnabl discusses the rationale for currency baskets and presents original evidence of a move toward basket strategies in East Asia. He argues that because of underdeveloped capital markets and a very limited international role of domestic currencies, the East Asian countries (with the exception of Japan) are likely to continue exchange rate stabilization and the accumulation of international reserves. Yet expectations of a further depreciation of the dollar may trigger a broader orientation of exchange rate policies toward basket strategies. While the direction of trade would suggest a substantial weight for the Japanese yen in East Asian countries’ optimal currency baskets, the role of the euro is enhanced by high expectations of its long-term stability. Schnabl’s estimations of the basket structures of East Asian countries suggest growing euro and

Introduction

7

yen weights in the currency baskets of Indonesia, Korea, the Philippines, Singapore, Taiwan, and Thailand, while the dollar remains the dominant anchor currency for China, Hong Kong, and Malaysia. In Chapter 11, John Williamson, the originator of the currency basket proposal for East Asia, demonstrates how pegging to a currency basket consisting of the dollar, the yen, and the euro would contribute to the stability of the nominal effective exchange rates of the East Asian countries. Pegging to a common basket of major international currencies would not only stabilize the effective exchange rate against the shocks that would be imposed on a country’s macroeconomy by fluctuations in the value of these currencies (which can be highly destabilizing, as shown during the run-up to the Asian crisis) but also yield the benefit of increased regional stability. Williamson’s results indicate that, for countries already pegging to the dollar, pegging to a basket could result in significantly less instability than the current policy. In case of a desire to realize those benefits but also to avoid the risk of pegging, Williamson suggests adopting a managed float guided by the use of a common basket as numeraire. Such a numeraire is the topic of Masahiro Kawai’s contribution in Chapter 12. Kawai, however, proposes a currency basket different from the one Williamson has in mind. Rather than a basket of international currencies, Kawai envisages an Asian currency unit (ACU) consisting of East Asian currencies. The first idea behind the ACU is to monitor the collective movement of regional currencies against key external currencies (such as the US dollar and the euro) as well as each component currency’s movement against the ACU benchmark. Second, the ACU could be useful for developing new tradable instruments, such as futures or ACU denominated bonds. Third, Kawai argues that at some point in the future the ACU could play a role similar to that of the European ECU within a regional monetary system. The appeal of the ACU is that it provides a venue for initiating regional exchange rate cooperation without instantly requiring far-reaching commitments and without requiring the politically difficult task of selecting a single regional lead currency. The two final chapters of the book investigate the special role of the Chinese currency in the region. In Chapter 13, Yin-Wong Cheung, Menzie Chinn, and Eiji Fujii take a fresh look at the renminbi debate that has been one of the hottest issues in international economics in the last few years. They show that the evidence of renminbi undervaluation may not be as strong as it appears, demonstrating that, depending on the estimation method used, conclusions may range from slight overvaluation to undervaluation. Even in the case of undervaluation, the results are not significant in the statistical sense. Cheung, Chinn, and Fujii also note that the fact that China is playing an important economic role in East Asia

8


and that it has established a complex production and trade network with the neighboring economies complicates the calculation of the equilibrium exchange rate. Thus, a change of Chinese exchange rate policy in response to pressure from foreign countries and short-run considerations may have undesirable effects not only on the Chinese economy but also on the region as a whole. The final chapter by Zhang Jikang and Liang Yuanyuan examines the institutional and structural problems with China’s foreign exchange market and derives implications for the renminbi’s role in regional monetary integration. While China has made considerable progress in foreign exchange market reform and has thereby met the preconditions for gradually introducing more flexibility to its exchange regime, Zhang and Liang show that the foreign exchange market is still hampered by structural and institutional problems such as low liquidity, high market concentration, limited transaction instruments, distorted market supply and demand, and passive intervention by the People’s Bank of China. Along with the lack of deep and liquid primary and secondary financial markets, these factors will continue to limit the renminbi’s role in East Asia. For the time being, therefore, the renminbi is far from being prepared to take on the role of a regional anchor currency. Certainly, there are many more related topics that deserve our attention, but we believe that this collection of chapters covers some of the most momentous issues. This volume gathers together the cast of authors best qualified, we may be allowed to say, to tackle these questions and to explore the path to monetary and financial integration. Many scholars writing on East Asian integration emphasize that it took Western European countries almost half a century to create a common market and establish a monetary union and that at least the same time horizon might be realistic for East Asia. We are also fully aware of the numerous problems and obstacles—economic and political—that lie ahead on the way to East Asian monetary and financial integration. And, though we may not see an East Asian monetary union within the next decade, isn’t it amazing to observe the momentum gained and the speed with which East Asian countries have been pushing forward toward integration? Who would have seriously believed in a common East Asian bond market or even an ACU just a decade ago? The dynamics of East Asian integration should by no means be underestimated. The economic potential of the region and the shared desire since the Asian crisis to reduce dependency on Western financial markets will make it increasingly unlikely that the countries of emerging East Asia will continue to link their currencies to the US dollar. To draw an analogy to Europe, it is worthwhile to recall that the main impetus for European

Introduction

9

monetary integration was the collapse of the Bretton Woods system. If we have a Bretton Woods II system today, it will be interesting to see how long the dollar will be able to provide stability to East Asia and if and when the region will emancipate itself from the dollar the way Western Europe did some 30 years ago.

PART I

The political economy of regional integration

1.

The ASEAN economic community and the European experience Michael G. Plummer and Reid W. Click1

1.1

INTRODUCTION

In November 2002, it was proposed at the Association of Southeast Asian Nations (ASEAN) Heads of Government meeting in Phnom Penh that the region should consider the possibility of creating an “ASEAN Economic Community” (AEC) by 2020, a timeframe that was later shortened to 2015. The name is evocative, for an “Economic Community” immediately brings to mind the European experience. In fact, when the Asian Pacific Economic Cooperation (APEC) was “re-inventing” itself, it was proposed that the words behind the organization’s acronym be replaced with “Asia-Pacific Economic Community”. This idea was rejected explicitly for fear that it would give the impression that APEC was intending to move in the direction of the EC model, which was thought to be too controversial. That the ASEAN Heads of Government should consider an “Economic Community”, even with the baggage the term brings, is in some sense nothing new. ASEAN has always studied carefully European economic integration and seen it as a sort of “role model”, though certainly to be adapted in the Southeast Asian development context. In this chapter, we consider what lessons the European experience might hold for ASEAN, as well as extend some suggestions—based in part on the EU experience—as to how ASEAN might evolve into an AEC. We begin with a brief contextual consideration of ASEAN intra-regional economic interaction, in particular with respect to trade, with some comparison to the early years of the EU. This is followed in Section 1.3 by a review of the evolution of ASEAN economic integration, culminating in the AEC. Section 1.4 then proceeds to delineate some salient lessons of the EU experience for ASEAN. Finally, we give some suggestions as to how the AEC might proceed in Section 1.5.

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1.2


INTRA-REGIONAL ASEAN CONTEXT

As of 2004, intra-regional trade in ASEAN came to somewhat less than one fourth of total trade (Table 1.1). At the individual country level, intraregional trade as a percentage of total trade was highest for Myanmar (almost one half) and Laos (one third). In terms of the value of intra-regional trade, Singapore is number one (followed by Malaysia), though it should be noted that Singapore’s share is particularly high because of the fact that it engages considerably in intra-regional entrepot trade. The ASEAN trade share was lowest for Cambodia (8 percent) and Vietnam (13 percent). Outside of the region, approximately 14 percent of ASEAN exports were destined for the EU market, less than the 16 percent accounted for by the United States but greater than the 12 percent going to Japan. The EU is the most important single market for four ASEAN countries (Singapore, Laos, Myanmar, and Vietnam), the United States was the largest market for three countries (Malaysia, Thailand, and Cambodia), and Japan was the largest market for another three countries (Indonesia, the Philippines, and Brunei). The “Triad” (the United States, Japan, and the EU) also dominate foreign direct investment (FDI) flows to the region. Hence, regional economic integration in ASEAN has to be appreciated in the context of a regional organization whose most important economic partners lie outside the region. As will be discussed below, this important fact has been a key reason why ASEAN economic integration has been mainly geared toward “open regionalism”; the cost of an inward-looking approach to regionalism, or “Fortress ASEAN”, would be far too high. Regionalism in developing countries that have focused on creating fortresses has generally failed (e.g., the Latin American Free Trade Area). It would be a disaster in ASEAN’s case. Economic integration in Europe, therefore, stands in contrast to the ASEAN integration process. As we argue below, the EU2 in its earlier stages of economic integration had fairly high levels of trade protection. This was reinforced in the 1950s by the European Payments Union, which discriminated in favor of intra-EU imports. These policies implied considerable costs in terms of lost welfare, and certain institutional arrangements that emerged from the EU integration process (e.g., the Common Agricultural Policy, or CAP) continue to be expensive to the EU. However, in its early stages the share of intra-regional EU trade and investment in economic interaction was far higher than is the case within ASEAN today. For example, in 1958, the first year of the implementation of the European customs union, intra-EU trade was about two-fifths of total trade.3 By the time the customs union was complete, it came to over 50 percent.4 Today, it stands at about 60 percent.

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71 550 126 510 39 680 179 674 96 245 4 511 518 170 2 589 540 3 161 25 850 550 310

17.1 24.0 15.5 22.0 18.1 17.2 20.5 3.0 19.4 44.6 11.4 20.2

18.2 25.1 17.2 24.3 22.0 17.2 22.6 7.5 32.8 45.3 13.0 22.2

6.4 6.7 6.7 8.6 7.4 4.5 7.4 1.1 2.1 5.9 13.6 12.2

World ASEAN- ASEAN- CH (%) (USD mil) 6 (%) 10 (%) 22.3 10.1 20.1 6.4 14.0 38.1 12.2 3.5 1.3 5.2 13.6 12.2

JA (%)

ASEAN exports to selected partners: 2004

55.6 51.3 54.8 53.2 50.4 73.9 52.9 12.5 36.5 58.5 39.5 52.1

APT (%) 37.8 44.8 35.0 50.7 38.5 35.8 43.9 9.1 35.3 66.2 26.4 43.0

DA (%) 2.9 3.6 1.3 4.2 2.9 14.1 3.5 0.1 0.1 0.4 7.2 3.6

CER (%) 12.3 18.8 18.2 13.0 16.1 8.6 15.2 55.9 0.6 0.0 20.1 15.5

US (%) 13.3 19.9 19.2 13.7 17.7 8.7 16.3 60.0 1.9 0.6 21.5 16.6

NAFTA (%)

12.2 11.8 16.4 13.7 14.3 2.6 13.3 25.5 27.0 15.5 22.5 13.8

EU (%)

Source:

IMF, Direction of Trade Statistics, CD-Rom (April 2000).

Notes: CH 5 China; JA 5 Japan; APT 5 ASEAN-10 plus China, Korea, Japan, and Hong Kong; DA 5 Developing Asia, i.e. all of Asia except for Japan; CER 5 Australia–New Zealand Closer Economic Relations Trade Agreement; NAFTA 5 North American Free Trade Agreement.

Indonesia Malaysia Philippines Singapore Thailand Brunei ASEAN-6 Cambodia Laos Myanmar Vietnam ASEAN-10

Source

Table 1.1

16


In addition, it is relevant to note that intra-ASEAN trade has been essentially market-driven, rather than being the result of policy-driven discrimination in favor of intra-regional economic interaction. Again, this distinguishes ASEAN from the EU. Nevertheless, while one could argue that the change from 37 percent to 50 percent in the case of the EU was in part a result of discrimination, it is important to consider the relevant historical context: in the 1950s and early 1960s, Europe was still emerging from the devastation of World War II. Although it would be difficult to assess the economic reconstruction effect (complications with devising an “anti-monde” are many), no doubt the growth over this period was the result of a “normalization process”, during which time Europe grew rapidly relative to the rest of the world. Certainly, given the size, wealth, and distance of European economies, a gravity model would predict high levels of intra-regional trade even in the absence of EU discrimination. This is not the case for ASEAN. Even if ASEAN trades much more than one would predict given the “gravity variables” noted above (see, for example, Asian Development Bank 2002 and Frankel 1997), the economic characteristics of ASEAN member countries would suggest that, while by some definitions it is a “natural economic bloc,” its most important trade and investment partners will continue to lie outside the region, at least in the medium (and probably also the long) run. In sum, in terms of real integration ASEAN’s situation is quite different from that of the EU. Intra-regional trade and investment are considerably less in the case of ASEAN. The differences in the levels of economic development in ASEAN, whose member countries include among the poorest and the richest developing economies in the world, are far more significant than was the case in the EU in its early years, when each EU member country was a developed economy, or at least was so by the end of the 1950s. One should keep this in mind when trying to draw any lessons from the EU for ASEAN. Still, we would argue that the EU process has much to teach ASEAN, both in terms of positive and negative lessons. After all, no two development experiences are going to be the same. But this does not suggest that history has nothing to teach us.

1.3

EVOLUTION OF ASEAN ECONOMIC INTEGRATION IN A REGIONAL CONTEXT

There have been many excellent surveys of regional economic integration in Asia (e.g., Kawai 2005, Naya 2002, Asian Development Bank 2002).5 ASEAN tends to stand at the core of Asian integration, at least from an institutional perspective. We provide in this section a brief contextual review of the evolution of ASEAN in a regional context.

The ASEAN economic community and the European experience

17

Briefly, we would first suggest several factors influencing the regionalism trend in East Asia that stem directly from the Asian financial crisis, including: (1) the obvious contagion relationships, which demonstrated the presence of policy externalities across countries in ASEAN and the newly industrializing economies; (2) major disappointment with the US reaction to the Asian crisis, which left the feeling of “being in it alone together”; (3) disappointing progress in APEC in achieving closer trade and financial cooperation, as well as development assistance cooperation (“ECOTECH”); (4) Japan’s offer to create an Asian Monetary Fund during the Asian crisis (opposed by the IMF and the United States), which gave the impression that Japan wanted to be pro-active in the region; (5) arguably, China’s decision not to devalue during this period, which may have also created a sense of solidarity; (6) the “New Miyazawa Plan”, launched in October 1998, which dedicated USD 30 billion to help spur recovery in East Asia (and has been deemed highly successful);6 and (7) the discrediting of policies promulgated by the IMF to solve the crisis, which gave greater credibility to the “Asian approach”. Hence, the Asian crisis itself set the stage for serious and durable East Asian regionalism. There are many other internal and external forces at work that have expedited the process, such as the rise of regionalism globally and its potential negative effects on the East Asian region; the successful examples of the Single Market Program in Europe (discussed at length below) and, eventually, monetary union; general pessimism regarding what can be achieved at the WTO in light of failure to move forward at the Seattle and Cancun WTO ministerials; and the potential to tap the inherent benefits of FTAs. Table 1.2 gives a chronology of arguably the most important Asian initiatives, with a focus on ASEAN and “ASEAN Plus Three” (ASEAN13), that is, ASEAN, Japan, China, and South Korea. As many early agreements in ASEAN’s history were mainly political and token in nature,7 its first major initiative was the Asian Free Trade Area (AFTA) in 1992. With the exception of the Japan–Singapore FTA (“Japan–Singapore Economic Partnership Agreement”, or JSEPA), which began implementation over 10 years later, AFTA is the only example of cooperation in Asia that is similar in concept to the North American Free Trade Agreement (NAFTA). However, in true ASEAN fashion, rather than overly commit to regional integration in sensitive areas, the specifics of AFTA were purposefully left somewhat ambiguous, with the agreement basically committing the ASEAN members to free trade in a 15-year timeframe. Also, the definition of “free trade” was somewhat loose, as it included tariffs in the range of 0–5 percent, rather than the traditional zero percent.8 After the original agreement, ASEAN broadened the scope of goods covered by AFTA, and

18

Table 1.2


Chronology of Asian integration: ASEAN and ASEAN13

Main points: ASEAN

ASEAN Year Summit

1st Bali 1976 ASEAN Concord ● Established ASEAN Secretariat ● Treaty of Amity: Mutual respect for independence, sovereignty, equality, territorial integrity and identity of nations, i.e. noninterference ● Establishment of “Zone of Peace, Freedom, and Neutrality” 2nd 1977 ● ASEAN Industrial Kuala Project ● Preferential Trading Lumpur Agreement (PTA) 3rd 1987 ● PTA accelerated Manila ● ASEAN Industrial Joint Venture (AIJV) accelerated and made more flexible ● ASEAN Free Trade 4th 1992 Area (AFTA) Singapore ● Common Effective Preferential Tariff (CEPT) 5th 1995 Bangkok ● Proposal for 1st 1996 ASEAN Vision informal 2020 Jakarta 1997 2nd ● ASEAN 2020 presented, a broad informal Kuala long-term vision Lumpur for ASEAN in 2020 (with ASEAN Economic Community in mind)

ASEAN13 Main points: ASEAN13 Summits

1st Kuala Lumpur

1st meeting of ASEAN13


Table 1.2

19

(continued)

Main points: ASEAN

ASEAN Year Summit

1998 Hanoi Plan of Action 6th Hanoi adopted to move towards Vision 2020: ● AFTA advanced to 2002, 90% intraregional trade subject to 0–5% tariff ● ASEAN Investment Area (AIA): goal investment liberalization within ASEAN by 2010, outside ASEAN by 2020 ● ASEAN Surveillance Process ● Eminent Persons Group (EPG) proposed to come up with plan for ASEAN Vision 2020 EPG develops plan for 3rd 1999 Vision 2020: informal ● Financial cooperation Manila proposed over concern that ASEAN was not effective in responding to Asian crisis ● AFTA to be sped up ● AIA to be accelerated ● To respond to surge of China, need to become more competitive, attract investment, implement faster integration, and promote IT Adopted Initiative for 4th 2000 ASEAN Integration informal (IAI): Singapore ● Framework for more developed ASEAN

ASEAN13 Main points: ASEAN13 Summits 2nd Hanoi

●

East Asian Vision Group (EAVG) proposed by Kim Dae Jung, President of Korea, to look into East Asian integration

●

East Asian Study Group (EASG) to consider

3rd Manila

4th Singapore

20


Table 1.2

(continued)

Main points: ASEAN

●

ASEAN Year Summit

ASEAN13 Main points: ASEAN13 Summits

members to assist those less developed members in need Focus on factors needed to enhance competitiveness for new economy: education, skills development, and work training

●

●

●

●

●

●

Discussed 7th challenges facing Brunei ASEAN: declining FDI and erosion of competitiveness. Created a roadmap to achieve ASEAN integration by 2020 Proposed going beyond AFTA and AIA by deepening market liberalization for both trade and investment

2001

5th Brunei

●

●

EAFTA and agreement to hold East Asian Summit Two big ideas proposed: (1) Development of institutional link between Southeast Asia and East Asia (2) Study group for merit of an East Asian Free Trade Area (EAFTA) and investment area Financial cooperation begun, e.g., Chiang Mai Initiative (CMI) of May 2000. By March 2006, bilateral swap arrangements under the CMI came to USD 71.5 billion Expert group study on ASEAN–China FTA proposed EAVG recommendation for EAFTA endorsed but overshadowed by China–ASEAN Free Trade Agreement proposal within 10 years, with the adoption of the Early Harvest Provision to speed up FTA Prompted by China–ASEAN FTA proposal, Prime


Table 1.2

(continued)

Main points: ASEAN

●

AEC end goal of Vision 2020

ASEAN Year Summit

8th Phnom Penh

2002

9th Bali 2003

● ●

Vientiane Action Plan Australia attends for the first time

Source:

21

10th 2004 Vientiane

ASEAN13 Main points: ASEAN13 Summits Minister Koizumi proposed Japan– ASEAN Economic Partnership in reaction to China– ASEAN proposal ● Japan–Singapore Agreement for a New Age Partnership signed January 2002 and enforced summer 2002 6th Phnom EASG Penh recommendations of deepening and broadening of East Asian integration adopted. ASEAN13 Asian Bond Markets Initiative (ABMI) endorsed by ASEAN13 Deputies Meeting in December 2002 in Chiang Mai 9th Bali At the ASEAN13 Finance Ministers Meeting on August 7, 2003, support is extended to the ABMI as well as to other means of closer financial cooperation 10th China speeds up FTA Vientiane with ASEAN from 2015 to 2010

Adapted from Naya and Plummer (2005).

22


the period of implementation has been shortened such that AFTA was technically in full effect at the beginning of 2004 for the original ASEAN countries and Brunei, though there are transitional periods for products on the temporary exclusion lists (e.g., sensitive products such as rice and automobiles in some cases) and some country-specific implementation problems in certain areas. The original target for full implementation for the newer ASEAN members was 2006 for Vietnam, 2008 for Laos and Myanmar, and 2010 for Cambodia. Recently, ASEAN decided to speed up the process such that AFTA would be fully completed by 2007. ASEAN has also made important strides in the area of investment cooperation, such as in the form of ASEAN “one-stop investment centers” and the ASEAN Investment Area (AIA).9 These efforts at industrial cooperation have been designed with essentially the same goal in mind as AFTA, namely, to reduce transaction costs associated with intra-regional economic interaction. As was noted above, in November 2002 the ASEAN Heads of Government proposed that the region should consider the possibility of creating an “ASEAN Economic Community” by 2020.10 This explicitly put the European experience front and center in terms of design, though clearly the ASEAN leaders had in mind an economic community with ASEAN characteristics. The ASEAN leaders actually agreed, at the Bali ASEAN Summit in October 2003, to create a region in which goods, services, capital, and skilled labor would flow freely, though the details remain to be worked out. We offer our own recommendations in this regard, colored by the EU experience, in the penultimate section. The reasons behind the decision to create the AEC are many, including: (1) the desire to create a post-AFTA agenda that would be comprehensive; (2) the perceived need to deepen economic integration in ASEAN in light of the new international commercial environment, especially the dominance of FTAs; (3) given (2), the possibility that bilateral FTAs could actually jeopardize ASEAN integration since all member states were free to pursue their own commercial-policy agenda; and (4) the recognition since the Asian crisis that cooperation in the real and financial sectors must be extended concomitantly, and that free flows of skilled labor will be necessary to do this.11 In addition to an ebb in progress related to the APEC “Bogor Vision” of open trade and investment, there have been several events that have shifted the ASEAN focus to its East Asian neighbors. First, even with the successful APEC Summits at Blake Island and Bogor, the East Asian Economic Grouping (EAEG) concept, proposed as an East Asian “trade bloc” by Prime Minister Mahathir in December 1990, never faded away.12 On the contrary, it began to grow in substance. Strangely, the initiative


23

came from ASEAN’s effort to expand economic cooperation with the EU, as the EU’s desire to deal with all of East Asia led ASEAN to ask China, South Korea, and Japan to participate. The first Asia–Europe Meeting (ASEM) was held in Bangkok in March 1996, and officials from ASEAN and the rest of East Asia met with EU representatives—a format that was regularized and has continued twice a year since. Even though the initial impetus for these meetings was economic cooperation with the EU, the significance for East Asian regionalism lies in the fact that these meetings brought officials from ASEAN, China, South Korea, and Japan together to discuss issues of economic cooperation. In 1997, these meetings culminated in an informal summit of the ASEAN13 heads of state in Kuala Lumpur. The original “Miyazawa Plan” was initiated by Japan during the Asian crisis to create an Asian Monetary Fund to supplement the IMF. It was opposed by the IMF and the United States but eventually led to the establishment of currency swap arrangements among East Asian countries (basically bilateral swaps between Japan and individual countries) during the annual meeting of the Asian Development Bank in May 2000, the “Chiang Mai Agreement” (CMI). The CMI is actually a milestone in the financial cooperation of the region in that it constitutes the first step in the process of financial and monetary cooperation initiatives, which have become an increasing priority of the ASEAN13 leaders. Since the CMI, myriad proposals for cooperation have been put on the table, and a few have actually emerged as promising new features of Asian regional cooperation. For example, the ASEAN13 Bond Market Initiative (ABMI), which was endorsed by ASEAN officials at the ASEAN13 deputies meeting in December 2002, endeavors to create more efficient bond markets in Asia and to reduce the risks associated with raising international capital.13 A complementary initiative was started by the Executives’ Meeting of East Asia-Pacific Central Banks (EMEAP), which launched the Asian Bond Funds I and II in June 2003 and June 2006, respectively (see Ma and Remolona, Chapter 4 in this volume). APEC’s lack of influence in the Asian financial crisis has served to solidify East Asia’s move in favor of an ASEAN13 approach. The current spate of agreements, however, have not been extended to the entire ASEAN13, but rather have come more from ASEAN to individual countries. For example, the completion of the China–ASEAN joint FTA study in the summer of 2001 prompted Japan to quickly initiate a study of its own with ASEAN. One month later, at the 2001 ASEAN13 meeting in November, ASEAN and China announced their intention to negotiate a free trade area within 10 years (the agreement was formalized in a framework agreement in December 2004).

24


1.4

LESSONS FROM THE EU

In trying to glean EU lessons for the AEC, we might begin with several caveats regarding the differences between the subjective environments facing the EU (EEC) in the 1950s and those facing ASEAN today: ●

The institutional environment facing ASEAN in the first decade of the 21st century is much different than that facing the EU of the 1950s.

European integration was clearly pushed by both memories of a devastating war and emerging Cold War concerns. The political and social motivations for economic integration were, thus, far different than those driving ASEAN initiatives today, though, it should be added, ASEAN has been instrumental in keeping Southeast Asia a peaceful region, an important contribution that is often underestimated. The “European Good” is interpreted much differently in Europe than the “ASEAN Good” in ASEAN; this puts considerable limitations on institutional development at many levels. Importantly, it reduces the possibility of the relinquishing of power by ASEAN member nations to supranational organizations. Besides, such institutional development is difficult in the ASEAN context anyway, given that: (1) nation-state formation is much younger than was the case in the European context, and in some countries this still requires a strong priority; (2) divergences in socio-political institutions are far greater than they were in the European context, especially as in some European countries these institutions were being created anew after the war; (3) it is not clear that European institution-building has been particularly successful in all areas, though it would receive high marks for economic-related matters (though this, too, is a testable hypothesis); and (4) these European institutions are quite expensive, while ASEAN government budgets are much smaller (though, fortunately, ASEAN would not have to employ an army of translators, as the EU does). That said, it is important to note that the notion of the “ASEAN Good”, though viewed differently in the ASEAN context, has been changing over the past 10 years. For instance, 10 years ago, few in the region (or the rest of the world) knew what ASEAN was; today it is well known. ●

The international economic environment is far different today than it was in the 1950s.

First, the contemporary global marketplace is extremely open relative to the past. This is true because of extensive reductions in trade barriers internationally, as a result of the GATT/WTO rounds as well as unilateral


25

liberalization and huge increases in international capital flows (including FDI), which have increasingly been knitting an integrated global marketplace. Hence, the costs of using regional integration as a form of “fortress”, that is, to maximize trade diversion, are consequently much higher than they were in the past. Second, regionalism has grown by leaps and bounds recently; trade groupings reported to the WTO come to well over 200, with a majority being established after 1995. Some of these groupings include ASEAN’s most important trading partners and could potentially isolate ASEAN, as well as forcing it to pay the costs of trade diversion. These trends further underscore the need for the AEC to be open as well as for the organization to be engaged in the regionalism movement. The more integrated the ASEAN marketplace is, the easier this will be. These considerations were far less important in the European context. ●

ASEAN features far greater diversity in terms of economic development.

We mentioned in section 1.2 that ASEAN is far more diverse in terms of levels of economic development than was the case of the EU in its earliest phases, when all countries were developed. While the expansion of the EU to include 10 Central and Eastern European countries in May 2004 significantly increased diversity within the EU, the region is still dominated by developed countries and is far more symmetric than ASEAN, which features developed countries, “dynamic Asian economies”, middle-income developing countries, and least-developed countries. As of 2004, the coefficient of variation (standard deviation divided by the mean) on per capita income levels across ASEAN member countries came to 1.62, compared to 0.65 for the EU.14 Hence, the divergence within ASEAN is far greater than that of the EU, and the countries are far poorer. This suggests that matters related to the speed of implementation of the AEC, and even the ability of ASEAN to be completely inclusive for all member states, will be complicated and difficult. Phased “10-X” strategies, which is what AFTA in effect embraces, may be not only desirable but necessary. ●

ASEAN countries are far more open than was the case of Europe in the 1950s.

ASEAN countries are (economically) small and very open relative to the EU of the 1950s (and even with respect to most EU countries today), with the exception of a few of the transitional CMLV (Cambodia, Myanmar, Laos, Vietnam) countries. ASEAN countries are closely integrated with international markets through international trade as well as multinational

26


networks. Not only is this a reality, but it is also a policy focus for ASEAN governments. As noted in section 1.2, intra-regional trade and investment in ASEAN is far less important than was the case with the EU and will likely continue to be so in the future. This is another reason why one would expect the AEC to embrace openness much more than the EU might have. In addition, even as an integrated market, ASEAN countries together still could not influence international terms of trade (the AEC would still be relatively “small”), suggesting that the “optimal” Common External Tariff would be zero. This was not the case with the EU. Having noted these caveats, we can delineate at least three major lessons that can be drawn from the real-side integration experience of the EU. First, we might begin with a negative lesson: ASEAN should avoid some of the pitfalls of inward-looking discrimination from which the EU continues to suffer (especially in agriculture) but which would be potentially catastrophic in the context of the ASEAN countries. Intra-ASEAN trade is only about one-fourth its global trade (compared to two-thirds in the case of the EU) and ASEAN member states are highly integrated globally. Hence, any real-side economic cooperation needs to be outward-looking. In fact, this approach is exactly what the ASEAN leaders ostensibly have in mind, that is, using ASEAN as a means of “going global”. Some scholars have noted that AFTA is actually more of an investment agreement than a trade agreement; free trade reduces intra-regional transaction costs and presents to multinational corporations a vertically integrated market. The AEC should never lose this vision, even when, as in the European case, compromises may have to be made. The EU countries are developed, high-income countries that together form a large economic space. They were able to push economic integration behind relatively protected markets, in the context of an international economy that was still fairly closed. Today, the GATT/WTO has opened up markets considerably and most of the world, the EU and ASEAN included, have internationalized extensively. It could be argued that such a protected approach was not necessary to begin with and should have been avoided (the CAP has been, by many measures, a disaster); however, the cost of an inward-looking approach has increased exponentially. It is not a viable option for the AEC. Second, and partly related to the first, the European experience teaches us that trade–investment links matter and that these relationships are shaping in large part the economic structure of the ASEAN economies. While the transitional ASEAN countries are still in early stages of the economic development process, the original ASEAN countries have experienced tremendous changes in their productive structures in general and trade in particular. Primary-based exports (roughly estimated as SITC 0–4) have


27

fallen in all original ASEAN economies.15 Of the original ASEAN countries only Thailand continues to have a large agricultural-export base (it is, for example, the largest exporter of rice in the world), but it, too, is falling in importance. Energy (SITC 3) continues to be important to Indonesia and Malaysia, with the former being at present a marginal oil importer. The big change throughout the region has been the impressive—in some cases, spectacular—increases in the share of SITC 7, that is, electronics and transport equipment (for ASEAN this means mainly electronics). Over the 1990s, the share of SITC 7 increased in all ASEAN countries. Indeed, in most countries it is the largest export sector; it constituted 58 percent, 41 percent, 72 percent, and 68 percent of total exports in Malaysia, Thailand, the Philippines, and Singapore, respectively.16 While economic reform has played an important role in this process of structural adjustment, so has foreign investment. Tamamura (2002) uses input–output analysis to capture the FDI–export link in East Asia, as well as to decompose the effect of external demand (by country) on production, using electric/electronics as a case study. He finds that, for 1995 (his latest year), in every (original) ASEAN country, external demand induced more production than domestic demand except (marginally) Indonesia, where, however, domestic demand fell in relative importance from 87 percent to 52 percent. Most countries followed a similar pattern of internationalization of electronics production. The most extreme case among the ASEAN countries was Malaysia, where domestic demand induced only 6 percent production. Next, it is noteworthy that most of the directives that led to the creation of a tightly integrated market for FDI in Europe came with the Single European Act, which commenced in 1986–87 and essentially created what is mostly a common market by 1994. The European experience teaches us that accomplishing such a feat goes well beyond mere national treatment/ most-favored-nation treatment in the regional marketplace: economic cooperation needs to reduce myriad transaction costs associated with FDI, including those related to the labor market, different product standards, and the like. The AEC will have to focus per force on many of these areas. A third lesson relates to how the EU has been able to gain from intraregional trade liberalization, though, as noted above, this could have been better organized to minimize trade diversion. The customs union played an important role in building a regional market; the Single European Act, by creating a Common External Commercial Policy, was able to do much more by keeping real-side transaction costs within the EU to a minimum and producing a truly regional marketplace, resulting in a more efficient division of labor in most markets. It should be stressed, however, that the AEC should be concerned not merely with increasing intra-regional but rather with increasing global

28


economic interaction more generally, of which the ASEAN market is only one part—in fact, a part that can be used as an international springboard. Trade and investment integration policies in ASEAN should be expected to achieve the same general results as they did in the EU case, but this increased interaction might actually manifest itself in a different way, given the facts that ASEAN countries are so diverse and that most are still developing countries. To reiterate: the AEC should be a means of increasing economic prosperity and the social good rather than focusing on, say, increases in (sometimes, misleading) indicators such as shares of intra-regional trade and investment. A successful integration program could theoretically lead to a decrease in regional integration, as measured by trade and investment shares, for example.17 A final point would regard the European experience with respect to financial and monetary cooperation and integration, though in part this goes beyond the traditional interpretation of the AEC (discussed below). ASEAN member countries have considered the formation of an ASEAN bond market, though problems related to liquidity, potential market depth, and the like have led ASEAN to think more in terms of an Asian bond market. This will be a long process.18 Nevertheless, it is worthwhile to consider the European experience as well, given that empirical studies (e.g., Frankel and Rose 1998) have shown that monetary integration has strong effects on trade and investment flows. In the past, just about every regional economic integration program focused in the beginning almost exclusively on the real side of the economy. Financial integration was always treated as something separate, to be taken up at a later date. In many ways, this is less true for European integration, though the point is debatable. While the European Payments Union was a financial arrangement, it was only ad hoc and was quickly phased out as soon as European currencies became convertible. This was just as the Treaty of Rome actually began implementation. The EC did publish the Werner Report, which mapped out a plan for monetary union at a time of great turbulence in the Bretton Woods System (1968), and after the Bretton Woods System collapsed it tried to create the (short-lived) European Snake and, eventually, the European Monetary System, which expanded the Snake in March 1979. These attempts at exchange-rate cooperation were important because the “customs union plus” needed stable exchange rates in order to run well. Such cooperation was especially necessary for the CAP: the main goal of the CAP was to stabilize farmer incomes, and flexible exchange rates put this at risk, as a country with a depreciating currency had an advantage over an appreciating-currency country, which was incompatible with the acquis communitaire. Hence, the EC had to develop a “green” exchange rate system, called “monetary compensation amounts”


29

(MCAs), which prevented this “adverse” structural change from happening. However, this system was very expensive: Pomfret (1997) suggests that the MCAs constituted over 15 percent of the CAP’s huge budget. Nevertheless, European capital markets tended to be substantially segmented until the implementation of the Single European Act was fairly advanced. There had been early attempts to create a single banking market as far back as 1972, 15 years after the Treaty of Rome, and in 1977 the European Council established the First Banking Directive (which did very little to integrate the markets19), but these and other attempts only marginally integrated the regional markets until the Single European Act initiatives. Today, the European banking system is far more integrated, but some aspects of finance continue to be among the few areas in which the single market is still incomplete. Capital controls were removed as part of the Single European Act program. In sum, even in the case of the EU, financial integration did not keep pace with integration in the real sector. The tendency seems to be to let financial issues wait, but experience shows that this is an unwise policy. The Asian crisis might also be seen in this light. Prior to the Asian crisis, APEC, for example, all but ignored financial and monetary cooperation, and ASEAN itself did little. In creating the AEC, therefore, ASEAN leaders would do well to focus on financial issues in tandem with real-sector integration. Regarding EU lessons in monetary cooperation, we must again underscore that comparisons are difficult, as relative economic-divergence problems continue to be critical. Nevertheless, even the EU is a diverse group, especially if one considers regions rather than countries. Moreover, ASEAN’s needs in economic cooperation are obviously quite different than those of the EU. While ASEAN integration may be popular in the region, it is less popular than in Europe, particularly among government leaders. In addition, various EU states had perennial macroeconomic (especially, fiscal) problems; economic and monetary union allowed these member states to implement necessary austerity measures in the name of European integration. The result, after a very long process, has been convergence in terms of interest rates, inflation, and other monetary variables. Yet, the credibility of most of the original ASEAN countries in terms of monetary and fiscal policies is actually quite high, especially for developing countries: inflation tends to be quite low in the original ASEAN countries, and most countries had either budget surpluses or essentially balanced budgets prior to the Asian crisis. Today, most have large current-account surpluses. Nevertheless, there continue to be widely divergent interest-rate spreads within ASEAN; convergence could have a major impact on development in certain member countries (discussed below).20

30


Hence, neither political nor political-economy dynamics, which were favorable in the case of most Eurozone countries, could be considered as important in the case of ASEAN. Nevertheless, in the aftermath of the Asian crisis, things are changing. It has become clear to ASEAN leaders that there exist “policy externalities”; some sort of restrictions on the conduct of monetary and fiscal policy could not only improve the macroeconomic environment in the ASEAN countries but also promote regional economic stability. Moreover, the possibility of competitive exchange-rate devaluations could be damaging to the implementation of the AEC. Political arguments for wanting to be part of Europe for European countries would be replaced in the ASEAN context by a fear of repeating the economic disaster of the Asian crisis. Such cooperation could be formally arranged inside or outside of the AEC framework, without any pretension to the initiatives leading to monetary union. Based on the EU experience, closer financial and monetary cooperation in ASEAN could have the following benefits: (1) the necessary Maastrichttype agreements (e.g., restrictions on budget deficits, government debt, inflation, even foreign-currency exposure of the banking system), perhaps interpreted more liberally than in the EU context, that would go along with such cooperation would create a more stable macroeconomic environment in the region, thereby producing significant positive policy externalities; (2) as monetary policy would likely be driven by the most credible country/ countries, less credible countries would be able to “import credibility”, much as, for example, Italy was able to import German monetary credibility; (3) interest-rate spreads would converge, making it easier to price risk at the regional level and lower the cost of capital; and (4) the harmonization of rules, accounting standards, and regulatory frameworks that might accompany regional integration as part of the AEC and in associated financial initiatives would render the region more attractive to foreign investors, as well as stimulate intra-regional capital flows.21 It would also make cooperation and even institutional integration of ASEAN equity and fixed-income markets easier, something that has happened partially in the EU (e.g., smaller stock markets have integrated while the larger markets continue to function separately). The process of financial and monetary cooperation is complicated, and effective integration demands a steady pace of progress, rather than abrupt changes, which can actually be counterproductive. The EU process of financial integration and exchange-rate cooperation, leading up to eventual monetary union, is instructive. The European Currency Unit (ECU) was a basket of the currencies of the member countries of the EC, weighted in line with each country’s GDP and foreign trade (and therefore subject to change periodically). It was introduced in 1979 as part of the European


31

Monetary System (EMS), to be used as the benchmark for determining the overvaluation/undervaluation of individual currencies and to serve as a unit of account among the central banks participating in the EMS. No physical ECU notes or coins ever circulated, so the ECU was strictly an artificial denomination. However, certain European banks established a banking product that allowed lenders and borrowers to carry out transactions in ECU. At first, an ECU transaction was just a portfolio of transactions in the separate underlying currencies; a deposit or loan in ECU typically was recorded as separate deposits or loans in the individual currencies. However, banks soon established a clearing mechanism for the ECU, thus enabling the transfer of ECU without necessitating separate transactions in each of the component currencies. This facilitated the growth of the ECU for private commercial transactions; residents could use the ECU as a unit of account for bank deposits, and companies could use it for invoicing sales or maintaining their accounting records. The first ECU-denominated bond was issued in 1981, just two years after the introduction of the currency basket. The ECU subsequently became a significant “currency” denomination in the Eurobond markets, outranked only by the US dollar and the German mark. A substantial amount of ECU-denominated bonds were placed privately as well. The use of the ECU in private transactions developed rapidly because the ECU exchange rate tended to be more stable than those of its component currencies. For European investors and borrowers, a depreciation of an individual home currency against other European currencies was offset by an increase in the home-currency value of the ECU, so there was an incentive to hold ECUs to diversify a portfolio. Similarly, non-European investors and borrowers were drawn to the ECU because it was less risky than the underlying individual currencies. In short, the ECU was an attractive alternative to single foreign currencies because it was less sensitive to the volatility of a single currency. On January 1, 1999, the euro replaced the ECU on a one-for-one basis as part of the first stage of European Monetary Unification (EMU). The fact that the ECU existed for 20 years prior to EMU suggests that the simple introduction of a currency basket serves as a useful precursor to closer monetary cooperation. The success of the ECU was partially because its official status within the EMS bound the central banks of the participating countries together. Its success was also due in part to the fact that the private sector found a pan-European currency denomination quite useful, and because the banking system was able to accommodate the demand. Certainly, the creation of an Asian Currency Unit that would enjoy widespread use, or the eventual creation of a common currency in Asia, can

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only be a long-run goal. However, the economics are ostensibly lining up in favor of such an initiative, and certainly Asian governments have been placing a higher priority on monetary and financial cooperation. Hence, perhaps we will not all be dead when this goal is reached.

1.5

ON BUILDING THE ASEAN ECONOMIC COMMUNITY

Given the tremendous diversity of ASEAN, how will it be able to create its own “customs union plus”, even by 2015? Tariff dispersion rates across ASEAN countries are, indeed, impressive: while ASEAN members tend to have fairly low tariffs and non-tariff barriers relative to other developing countries (except for the transitional ASEAN economies), they still vary considerably across the region. Moreover, Singapore is unique: it essentially has no tariffs. Given the openness of its economy (trade accounts for over 300 percent of GDP), Singapore cannot raise tariff rates to accept an ASEAN Common External Tariff that is not equal to zero. The EEC did not face this problem. Likely options here would include a complete freetrade zone in ASEAN, perhaps with some external tariff harmonization, or a “10-X” customs union, in which the Common External Tariff would be determined through negotiations similar to those of the EEC, but which not all ASEAN countries would join. It is not clear exactly what form the AEC will take. Some scholars have suggested a less ambitious approach to the AEC, including an “FTA-plus” arrangement, which would include certain elements of a common market (e.g., the free flow of capital, the free flow of skilled labor, and zero tariffs on intra-regional trade) but would not have a Common External Tariff. Noting that the European example teaches that without integrated external tariffs markets continue to be segmented and key benefits of integration are stymied, Plummer (2005) recommends that a 0–5 percent Common External Tariff in an AEC at least be explored for the more developed ASEAN countries. ASEAN might accept making exceptions in very few industries that might be integrated later on (this was done in MERCOSUR—the “Southern Common Market” comprising Argentina, Paraguay, Uruguay, and Brazil—with automobiles, yielding mixed results). While perhaps more difficult to implement, this option would have the effect of reducing transaction costs in the region substantially, mitigating any trade diversion potential of regional integration, increasing the ability of ASEAN to negotiate integration accords with other trading partners, and augmenting its clout in international organizations. It could be a critical step in turning ASEAN into a truly open marketplace.


33

This approach is not really foreign to ideas that ASEAN leaders have proposed in the past, such as the Philippine proposal to multilateralize AFTA cuts. Moreover, many ASEAN countries have committed themselves to “open trade and investment” by the year 2020 as part of the Bogor Vision of APEC. True, it is unclear exactly how the Bogor Vision will be achieved, or even what it means: APEC has not completely spelled out the details, and many ambiguities persist. However, tariffs and non-tariff barriers in ASEAN have been falling over time anyway and will continue to do so thanks to Uruguay Round commitments, potential commitments under Doha (if successful), and the liberal posture of the ASEAN leaders. In this sense, the AEC could be recognized as a purely outward-oriented endeavor. Fortress ASEAN was never an option. Why not, then, create an essentially open region? The economic argument for protectionism is extremely weak, as ASEAN leaders have recognized. Some might continue to adhere to the infant-industry argument. But this argument has been more of an excuse for protection than a true means of efficient industrialization in ASEAN and elsewhere. Even the accelerated AEC process has provided plenty of time for any industry to go through its transition. Besides, in order to make the infant-industry argument convincing, one must identify financial bottlenecks that prevent firms from setting up comparative advantage industries. Given the state of financial markets in at least the original six ASEAN countries, this is not a problem. Moreover, this open-market solution does not mean that governments would have to throw away their ability to foster industrialization directly, should they desire to do so. Regardless of the merits of an active industrial policy, it is still possible even in an open customs union. This is something that the European experience clearly shows. Even today, almost a decade after the completion of the Single European Act and four years after monetary union, governments still tend to have active industrial policies, for example through direct subsidies, special financial and tax credits, and even de facto administrative rules. The EU has formal restrictions on these, but they are constantly tested (e.g., the EU market in financial services is far from complete). Tariffs have always been a clumsy way to foster industrialization, and non-tariff barriers tend to be even worse. Of course, the transitional economies pose an important problem here. Cambodia, for example, until recently received about 70 percent of its government income from import-related taxes. However, it is reducing reliance on international-trade-based taxes as part of its reform program, and this has also been the case in the other CMLV countries. Vietnam has made tremendous progress in its transition program and should be ready to join AFTA in 2006. Allowing the logical progression of this reform program to continue to 2015 will not be easy but would be quite desirable

34


from an economic development perspective. Again, 2015 is a long way off, and much can happen between now and then; Vietnam has reinvented itself from a non-market, closed, and state-directed economy into an increasingly outward-looking, market-oriented economy in less time than it will have for the AEC. It may even be possible for ASEAN to allow for a longer-term transition period for Cambodia, Myanmar, and Laos, especially since there remain political uncertainties in these countries. Regarding labor flows, we note that it would be politically difficult to adopt the Single European Act approach of (technically) free labor mobility. Moreover, this would not be necessary in the ASEAN context, at least from the point of view of multinationals and of integrating the region with the global marketplace. Yet, the free flow of skilled labor would be important, as would be the facilitation of visas for non-ASEAN nationals in the context of a regional framework. However, the process will be difficult, as it was in the European case. Mutual recognition of professional qualifications, university and technical education, and the like will require a great deal of work. Yet, this process actually presents a good opportunity for the region, and especially for the CMLV countries, to embrace “best practices”. It may well be that the process will be easier for ASEAN than it was for the EU, as fewer entrenched special interests and less general resistance to reform in this area are present. Many would welcome this approach. The idea of adopting “best practices” also extends to other areas that were important in the Single European Act, such as product testing, technical standards, food/health-related standards, and the like. Mutual recognition will be necessary in these areas and, hence, harmonization of at least minimum acceptable standards will have to be developed. Codes should borrow from internationally accepted standards wherever possible. Attracting FDI is an important priority among ASEAN leaders. The usefulness of a regional approach has been recognized from the beginning, with the (generally, failed) attempts at industrial cooperation in the mid-1970s, the (marginally more successful) initiatives of the late 1980s, and, finally, the ASEAN Investment Area (AIA) in 1998. The AIA is surprisingly comprehensive; once the exclusion lists are incorporated into the mainstream, it will have gone a long way toward creating an integrated ASEAN market, though national policies will have to be increasingly harmonized in order to create a truly regional market. There is no doubt that FDI will be a high priority in the AEC and that this vision of an integrated market for FDI will not be attainable without the transaction-costs-reducing liberalization and facilitation initiatives under other aspects of the AEC. Free flow of services will also be necessary, especially since services are becoming increasingly important in the ASEAN countries, a process that


35

will continue as ASEAN countries develop. The ASEAN Framework Agreement on Services (AFAS), which takes a “GATS-plus” approach, is an important step toward creating an integrated market. Free flow of services in the AEC will merely involve an expansion in existing commitments since the third round of AFAS negotiations, which began in 2001, should at least in theory cover all sectors and “modes” of service provision defined by the OECD, that is: (1) cross-border supply, in which a company exports the service from home, for example by fax or email; (2) consumption abroad, in which the user of the service consumes it outside his/her home country, for example tourism; (3) commercial presence, in which a company directly supplies the service to foreign customers (this involves establishment of an affiliate abroad and constitutes over three-fourths of all trade in services); and (4) the presence of natural persons, in which case the service-exporting country sends personnel abroad to supply services. The AEC will ultimately have to ensure a generally open market in services, including no policy-induced discriminatory restrictions (including trade taxes), national treatment, mutual recognition, and the like. This was a difficult process in the EU, as some of these sectors remain quite sensitive. For example, in the financial services area, the Single European Act stipulated three principles for integration: (1) the observance of specific minimum requirements; (2) the mutual recognition of member states’ legislation; and (3) the prevailing of the “home country principle”, whereby the regulations of the country in which business was taking place would take precedence (rather than those of the host country).22 However, not even the Single European Act has succeeded in fully integrating the financial services sector; retail banking services in particular continue to be segmented and protected on a national basis. Moreover, the “Services Directive”, which would serve to create a more integrated market in EU services (particularly in light of the EU 2004 expansion), was rejected in early 2005. Hence, as the ASEAN Framework Agreement on Services is expanded as part of the AEC process, it will be necessary to integrate services sectors carefully, for the service sector is by its very nature more complicated than the goods sector. Moreover, the AFAS progress to date has been weak, and there is a reason for this: certain services are sensitive politically. Most likely, it will be necessary to exclude certain sectors from complete liberalization, but these should be kept to a minimum. Developing appropriate institutions under which the AEC can evolve will be necessary. While the ASEAN Secretariat has come a long way, it will have to be enhanced drastically in order to facilitate the creation of the AEC. It will need to have a much larger professional staff recruited from throughout the region and with a regional—rather than national—commitment, as is the case in the EU. Many of the directorates of the EU could be emulated

36


in the ASEAN context. But it is our view that the bureaucracy should be kept, to paraphrase Albert Einstein, “to the minimum possible but no less than that”. The first reason for this is that the EU bureaucracy is simply too big and expensive. In the second place, the drain on human capital in the ASEAN context would be detrimental to other domestic policy priorities, an important consideration for the CMLV countries in particular. Third, at least in the first stages of creating the AEC, ASEAN could keep the “social bureaucracies”, which are fairly substantial in the EU, somewhat of a separate project. While these institutions were important in making the EU what it is today, ASEAN, as noted above, is characterized by a very different socio-political context. A fourth and related point relates to the creation of a “mini-state” in ASEAN, as has been done in the case of the EU, such as in developing an integrated executive, legislative, and judicial system. Because the willingness within the EU to develop supranational institutions is more the exception than the rule, in our view ASEAN should try to minimize the supranational character of AEC, taking the idea of “subsidiarity” to the greatest extent possible. The executive component of ASEAN integration would have to be enhanced considerably, but this could arguably be done by adapting and expanding current institutions. On the other hand, the creation of some sort of judicial authority to “enforce” (hitherto a bad word in ASEAN) AEC rules will be necessary. No doubt this will be difficult; the EU continues to have its own problems (e.g., the Alstom case in France is a good example, but there are many more). As in the case of the EU, it would have to be an evolutionary process. The Asian crisis has underscored the need for greater monetary and financial cooperation, given the importance of these areas to future regional economic development and their importance in supporting initiatives in the real sector. This differentiates it to some degree from the EU experience, in which financial/monetary cooperation came later. Moreover, the fact that ASEAN’s trade and investment links are dominated by partners outside the grouping would suggest that the recent widening of cooperation outside of strictly ASEAN-based institutions to include China, Japan, and South Korea gives it a much greater incentive to promote cooperation in the area of financial and monetary integration, no doubt a reason for the popularity of the ASEAN13 initiatives.

1.6

CONCLUDING REMARKS

In this chapter, we have tried to consider what the objectives and substance of the AEC should be, using wherever possible appropriate lessons from the world’s most successful example of regional economic integration,


37

the European Union. We note that while there is much that the EU can teach ASEAN, ASEAN leaders should not underestimate the differences between the regions and the differing historical contexts. The EU integration experience is remarkable. It took a great deal of time before it became a truly integrated market—about 37 years from the Treaty of Rome in 1957 until the implementation of the Single European Act, which was essentially complete in 1994. Once the process was given a big push in the mid-1980s, however, integration initiatives picked up steam, culminating in monetary union only five years after the promulgation of the Single European Act. At times, some leaders and experts gave up on the EU; the process certainly was familiar with “crisis”. In 1976, for example, France (temporarily) slapped import tariffs on Italian wine. In the early 1980s, market segmentation increased with the use of non-tariff barriers outside the purview of the EC, leading some to suggest that the EC was doomed to retreat. After the September 1992 crisis in the EMS, it was very easy to be pessimistic about the future of monetary union. There were skeptics up to the very the end. But the EU was able to persevere because of the commitment of its leaders and critical social elements. This is a very basic lesson: given the fact that the AEC will have to be far more comprehensive and “intrusive” in national markets than has ever been the case before, it will take strong commitment, indeed, in order to move the process forward. No doubt this is why there is much skepticism regarding the AEC. It was no different in the case of AFTA: in the late 1980s, many pundits were speculating that since the region’s political exigencies had changed, ASEAN had no future as a regional organization. Instead, the ASEAN leaders responded by pushing forward impressively on the economic front, and AFTA became the first major initiative in this process. Since then, AFTA has expanded and deepened, cooperation has advanced significantly in the area of investment (AIA), liberalization of services is being actively pursued in the ASEAN Framework Agreement on Services, other “deepening” measures are being spearheaded, and horizontal integration has expanded about as far as it can go, as ASEAN is now composed of all 10 Southeast Asian nations. While the AEC will take a much more extensive commitment, it can certainly be realized if the ASEAN leaders have the political will to see it through.

NOTES 1.

An earlier version of this chapter was presented at the Inaugural Session of the Regional Integration Seminar Series, Office of Regional Economic Integration, Asian Development Bank, on November 28, 2005, in Manila, the Philippines (and was

38

2.

3. 4. 5. 6. 7.

8. 9.

10.

11. 12.

13. 14. 15. 16.

17.

The political economy of regional integration published in 2006 as one of its working papers), at the joint session of the American Economic Association/American Committee on Asian Economic Studies (and is published along with the rest of the session’s papers in Vol. 17 (3) of the Journal of Asian Economics), January 2006, as well as at the December 2006 HWWA/HWWI conference on East Asian Monetary and Financial Integration in Hamburg, Germany. The authors would like to acknowledge interesting inputs offered at these meetings, especially those by Drs Kawai, Rana, and Capannelli. All remaining errors are those of the authors alone. We have a difficult acronym issue in this chapter: the European Union (EU) was the successor to the European Community (EC), which integrated the various economic communities in Western Europe, including the European Economic Community (EEC) and the European Coal and Steel Community (ECSC). We use EU throughout this chapter for simplicity, but we are actually referring here to the EEC. Hiemenz et al. (1994), Table 2, p. 8. Ibid. This brief review of ASEAN integration borrows from Plummer (2006) and Naya and Plummer (2005). Kawai (2005). For example, the Preferential Trading Agreement was a positive-list approach to trade liberalization with small margins of preference and limited product coverage, expanded somewhat during the 1980s but with no real impact on trade. Industrial cooperation, such as the ASEAN Industrial Project system, never really got off the ground. In fact, this range of tariffs probably contradicts the requirements spelled out in Article XXIV of the GATT/WTO, but as was noted earlier ASEAN benefits from the Enabling Clause, which has always freed it from these constraints. A salient component of the AIA is the ASEAN Industrial Cooperation (AICO) Scheme, which offers more in terms of tariff (0–5 percent) and non-tariff incentives than the traditional industrial cooperation programs. Moreover, in September 1996 the ASEAN countries created the ASEAN Agreement for the Promotion and Protection of Investments, which among other things stipulates the simplification of investment procedures and approval processes, as well as enhanced transparency and predictability of FDI laws. At the 11th ASEAN Summit in Kuala Lumpur, December 2005, the ASEAN leaders discussed the possibility of expediting the AEC process to actually complete it by 2015 (with flexibility for new member countries). This was agreed upon at ASEAN’s annual meeting in January 2007. The free flow of all labor, including unskilled labor, was deemed too politically difficult to consider in the AEC. When proposed, the EAEG was highly controversial, as it suggested that Mahathir wanted to create what might have been construed as a discriminatory bloc, which ran contrary to the goals of ASEAN and, of course, APEC. At the 4th ASEAN Summit in Singapore in 1992, it was downgraded to the more innocuous (and vague) East Asian Economic Caucus (EAEC). For more details on this initiative, see the ADB’s “Asian Bond Markets Initiative” homepage, http://aric.adb.org/asianbond/ASEAN-ABMI.htm. Authors’ calculations, using data on GDP per capita from World Development Indicators On-Line. In 2004, average per capita income in the 10 ASEAN countries and the 25 EU countries came to USD 5271 and USD 18,984, respectively. Data for this structural-change analysis come from Plummer (2003). The case of the Philippines is the most dramatic and surprising: the value of SITC 7 exports increased over this period by over 100 percent, with the largest changes in SITC 723 (civil engineering and contractors plant and parts), SITC 728 (machine & specialized equipment), 736 (machine tools), 751 (office machines), and 752 (automatic data processing machines). This is because, for example, a successful AEC that brings in higher FDI flows from abroad—a key aim of the AIA—would not only reduce intra-regional FDI but also


18. 19. 20. 21. 22.

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could reduce intra-regional trade, if multinationals take advantage of the attractive regional division of labor offered by ASEAN. For example, suppose that, as a result of the AIA, a Japanese automobile multinational set up production stages in Indonesia and Singapore, whereby it exports USD 2 billion in car components to Indonesia, adds USD 100 million in labor-intensive value added to production in Indonesia, exports the semi-processed product to Singapore for further USD 1 billion in processing, and then finally exports back to Japan. This means that ASEAN intra-regional trade would have changed at the margin by exports to Singapore from Indonesia (USD 1.1 billion) divided by exports of Japan to Indonesia (USD 1 billion) plus imports of Japan from Singapore (USD 2.1 billion), or 35 percent, whereas extra-regional trade would have increased by 65 percent. The point is that this could be a successful economic activity for all parties involved, but intra-regional trade shares might fall anyway. See, for example, Plummer and Click (2005). Story and Walter (1997) note (p. 14) that of the EU’s 9434 credit institutions at that time, 429 were classified as foreign banks, and only 107 had a parent company based in a member state. Governments were reluctant to grant licenses. See, for example, Plummer and Click (2005). For a more complete discussion of the potential benefits and costs of financial market cooperation and integration in ASEAN, with comparisons to Europe, see Plummer and Click (2005) and Click and Plummer (2005). Story and Walter (1997).

REFERENCES Asian Development Bank (2002). Asian Development Outlook 2002. Manila: Asian Development Bank. Click, Reid W., and Michael G. Plummer (2005). “Stock Market Integration in ASEAN.” Journal of Asian Economics 16: 5–28. Frankel, Jeffrey (1997). Regional Trading Blocs in the World Trading System. Washington, DC: Institute for International Economics. Frankel, Jeffrey, and Andrew K. Rose (1998). “The Endogeneity of the Optimum Currency Area Criteria.” Economic Journal 108: 1009–25. Hiemenz, Ulrich, Erich Gundlach, Rolf J. Langhammer, and Peter Nunnenkamp (1994). Regional Integration in Europe and Its Effects on Developing Countries. Kieler Studien 260. Tübingen: J.C.B. Mohr. Institute of Southeast Asian Studies (2003). “Concept Paper on the ASEAN Economic Community.” Manuscript, Institute of Southeast Asian Studies, Singapore. Kawai, Masahiro (2005). “East Asian Economic Regionalism: Progress and Challenges.” Journal of Asian Economics 16: 29–55. Naya, Seiji F. (2002). The Asian Development Experience. Manila: Asian Development Bank. Naya, Seiji F., and Michael G. Plummer (2005). The Economics of the Enterprise for ASEAN Initiative. Singapore: Institute of Southeast Asian Studies. Plummer, Michael G. (2002). “EU and ASEAN: Real Integration and Lessons in Financial Cooperation.” World Economy 25: 1469–500. Plummer, Michael G. (2003). “Structural Change in a Globalized Asia: Macro Trends and U.S. Policy Challenges.” Journal of Asian Economics 14: 243–81. Plummer, Michael G. (2005). “Creating an ASEAN Economic Community: Lessons from the EU and Reflections on the Roadmap.” In Denis Hew (ed.),

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Roadmap to an ASEAN Economic Community. Singapore: Institute of Southeast Asian Studies, pp. 31–62. Plummer, Michael G. (2006). “Toward Win–Win Regionalism in Asia: Issues and Challenges in Forming Efficient Trade Agreements.” In Working Papers on Regional Economic Integration. Manila: Asian Development Bank. Plummer, Michael G., and Reid W. Click (2005). “Bond Market Development and Integration in ASEAN.” International Journal of Finance and Economics 10: 133–42. Pomfret, Richard (1997). The Economics of Regional Trading Arrangements. Oxford: Oxford University Press. Story, Jonathan, and Ingo Walter (1997). Political Economy of Financial Integration in Europe: The Battle of the Systems. Cambridge, MA: MIT Press. Tamamura, Chiharu (2002). “Structural Changes in International Industrial Linkages and Export Competitiveness in the Asia-Pacific Region.” ASEAN Economic Bulletin 19: 52–82.

2.

The political economy of European economic and monetary union negotiations and implications for East Asia Heungchong Kim1

2.1

INTRODUCTION

The financial crisis of 1997–98 in East Asia provided a valuable—though costly—lesson for the East Asian countries in the importance of regional cooperation. In the course of the developing crisis, East Asian countries observed that neighboring countries were not at all helpful because of the lack of cooperative facilities within the region, and they were shocked by the posture of mere observance adopted by the advanced countries. The East Asian countries realized that the remarkable economic growth they had achieved over the years was based on a house of cards. After the crisis had passed, various kinds of proposals for regional economic cooperation, to strengthen economic stability as much as economic growth, were discussed and developed in East Asia, including the Chiang Mai Initiative, a burgeoning number of regional free trade agreements (FTAs), potential East Asian bond markets, and so on. While trying to develop proper institutions and tools for regional economic cooperation, it is strongly recommended that East Asia take an interest in the European economic integration process, investigate Europe’s past experiences, and creatively adapt them to East Asia’s circumstances and needs. The creation of Economic and Monetary Union (EMU) in Europe with the introduction of the euro is a good example of economic and monetary integration that East Asia could follow. An examination of the competing views among the European Union (EU) member states on the path to monetary integration and how they were subsequently resolved provides important insights for East Asian countries that have just launched the early stages of monetary cooperation. This chapter attempts to prove this kind of examination. It analyzes the process of EMU negotiations, mainly during the crucial 1988 to 41

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1991 period, in order to derive lessons for potential East Asian monetary cooperation and integration. It excogitates major issues from the EMU negotiations, compares the views of major member states on each issue, and clarifies the process of reaching agreements from the different negotiative positions. The chapter is organized as follows: section 2.2 introduces a brief history of European monetary integration, including the European Monetary System; section 2.3 clarifies some points regarding the formation of EMU and evaluates the current developments in monetary integration in East Asia; section 2.4 illuminates the roles played by the major nations in the EMU negotiation process; and section 2.5 applies the roles revealed in that process to the case of East Asia. Section 2.6 concludes the chapter.

2.2

A BRIEF HISTORY OF EUROPEAN MONETARY INTEGRATION

The idea of a united Europe was once merely a dream conceived of by philosophers and visionaries such as Victor Hugo, who imagined a peaceful “United States of Europe” inspired by humanistic ideals. But the dream was unable to come to fruition because of centuries of war that raged on the European continent. However, the terrible experience of the two World Wars increased the determination to end hatred and rivalry in Europe and build lasting peace between former enemies. The architects of modern day Europe, such as Jean Monnet, Robert Schuman, Konrad Adenauer, and Alcide de Gasperi, recognized that a process of European integration could provide such a lasting peace in Europe and that it could only be achieved gradually by starting with concrete economic and political issues that would have spillover effects in the creation of supranational institutions. This was termed the functional approach toward integration. The motivation for establishing EMU was partly political and partly economic in nature. One impetus was to facilitate trade between the EU countries by eliminating currency exchange costs and uncertainties relating to exchange rates. Another motivating factor was the belief that greater integration between the EU countries’ economies would facilitate the pursuit of common objectives such as a strong growth rate and a high level of employment. However, in a Europe recently ravaged by two World Wars, the ultimate objective was to promote closer European integration in order to avoid future conflicts between former enemies.

European EMU negotiations and implications for East Asia

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The Bretton Woods Era and its Aftermath Despite the fact that the idea of a common European currency began to be discussed in the 1960s, it would take more than 30 years before that vision would materialize. After the Second World War, countries with market economies adopted the Bretton Woods system in order to promote currency stability. The Bretton Woods system was based on a system of fixed but adjustable parities with the US dollar, and it worked well before it faced severe problems in the late 1960s when the credibility of the US dollar was repeatedly damaged. In the European currency market, the devaluation of the French franc and the appreciation of the German mark threatened the stability of the other currencies in the system and jeopardized the system of common prices set up by the Common Agricultural Policy in 1968–69. In light of these developments, the Barre report of 1969 called for greater coordination of economic policies and closer monetary cooperation. The report gave new momentum to the integration process. In December 1969, at the Hague Summit, the European heads of state or government reached an agreement to make economic and monetary union an official objective of European integration. Furthermore, a high-level group chaired by Pierre Werner, then prime minister of Luxembourg, was entrusted with the responsibility of drafting a report on how the goal of economic and monetary union could be achieved by 1980. The Werner Report, submitted in October 1970, envisioned the conclusion of a fully integrated economic and monetary union within 10 years through the implementation of a three-stage plan. The end goal was to accomplish full liberalization of capital movements, the irrevocable fixing of parities, and the replacement of national currencies with a single currency. The report put forward the idea of establishing a European Monetary Cooperation Fund in the first stage as a precursor to a community system of European central banks in the final stage. Despite disagreement over some of the key recommendations of the Werner Report, in March 1971 the member countries gave their approval to pursue monetary integration in three stages. The first stage required the narrowing of currency fluctuation margins and was implemented according to the plan.2 Nevertheless, new developments stalled the progress: the decision of the US government to suspend the gold convertibility of the dollar in August 1971 and the subsequent breakdown of the Bretton Woods system had a destabilizing effect on foreign exchange rates world-wide and also raised questions about the parities between the European currencies. Consequently, an attempt was made in March 1972 to provide intra-regional exchange rate stability by forming the “Snake in the Tunnel”,3 but the oil crises, the weakness of the dollar, and differences in economic policies caused members to back out of

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the Snake until membership was reduced to Germany, the Benelux countries,4 and Denmark, with the Benelux currencies and the Danish krone tied to the German mark. The European Monetary System In March 1979, President Valery Giscard d’Estaing of France and Chancellor Helmut Schmidt of Germany proposed the European Monetary System (EMS), an institutional framework that would replace the Snake with a new system of adjustable exchange rates. The EMS was intended to lay the framework for the creation of closer monetary cooperation leading to a zone of monetary stability in Europe. The EMS was built on three pillars: (1) the Exchange Rate Mechanism (ERM), (2) the European Currency Unit (ECU), and (3) the credit mechanisms of financing facilities. All of the member states of the European Community joined the EMS, with the exception of the United Kingdom, which opted out of the Exchange Rate Mechanism. In the period 1979–91, the EMS helped stabilize exchange rate variability, and sustainable currency stability was achieved thanks to the flexibility of the system and the political resolve to attain economic convergence. The ERM was one of the cornerstones of economic and monetary union. The ERM was conceived in an effort to stabilize exchange rates, encourage trade within Europe, and control inflation. It arose as a result of a compromise between France, which wanted the exchange rate band to be defined around the ECU, and Germany, which wanted the exchange rate band to be defined bilaterally. Thus, each participating country’s currency was allowed to fluctuate within a band defined around each of its bilateral central rates and another band defined around its ECU central rate.5 As the EMU process advanced, the ability of each country to keep its currency within its defined margins became one of the convergence criteria that had to be met in order to be eligible to join the single currency. To ensure that each member country had the necessary resources to intervene in defense of the bilateral exchange rate parities, extensive financing mechanisms were created. In April 1973, the member states of the European Community decided to launch the European Monetary Cooperation Fund (EMCF) in order to facilitate the establishment of an economic and monetary union. The idea for setting up a fund was first proposed by the heads of state or government at the Hague Summit in December 1969, and it was later included in the recommendations of the Werner Report. Within the EMS, the EMCF was responsible for facilitating the gradual narrowing of the margins of the community currencies against one another, the administration of the Short-Term Monetary


45

Support Facility established as a result of an agreement between the community’s central banks, and the multilateralization of positions in the Very Short-Term Financing (VSTF) Facility that arose from intervention carried out by the central banks in community currencies. The establishment of the EMCF resulted in the administration by the Fund of all bilateral debts and credits held by community central banks in regards to the VSTF facility of the Snake arrangement. The adoption of the Single European Act (SEA) in the mid-1980s allowed the community to fulfill its objective of removing impediments to the free movement of goods, services, capital, and labor. However, the Single Market Program also highlighted the existing problems of high transaction costs related to currency conversions and uncertainties associated with exchange rate fluctuations, both of which hampered the exploitation of the full potential of the internal market. Thus, for federalists and those adopting a functional approach toward integration, the next step after the SEA would definitely be toward a monetary union. EMU The Hanover European Council set up a committee in June 1988, chaired by Jacques Delors, then president of the European Commission, to draft a proposal for an economic and monetary union. The Delors Report, submitted in April 1989, proposed a three stage plan, with the execution of Stage I bringing about closer monetary and economic cooperation and with the deadline for implementation set for July 1, 1990 at the latest, to coincide with the implementation of the full liberalization of capital flows within the community. It also emphasized the need for greater coordination of economic policies, rules on the size and financing of national budget deficits, and a new, completely independent central bank, which would be responsible for the union’s monetary policy. On the basis of the Delors Report, in June 1989 the European Council agreed to begin Stage I on the proposed date and reaffirmed the commitment to reach an economic and monetary union in subsequent steps.6 In December 1989, the Strasbourg European Council called for an Intergovernmental Conference (IGC) that would help identify the amendments that needed to be made to the Treaty in order to accomplish economic and monetary union. The efforts of the aforementioned IGC together with that of a second IGC on political union7 resulted in the Treaty on European Union, which was formally adopted by the heads of state or government at the Maastricht European Council in December 1991 and signed on February 7, 1992. The Treaty set out a timetable for economic and monetary convergence in three successive stages.

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During the first stage, which began on July 1, 1990, the European Council was responsible for evaluating progress made with regard to economic and monetary convergence, and member states would be asked to adopt certain measures to comply with certain restrictions specified by the Treaty.8 Stage I did not precede exactly according to the plan because of currency tensions during the period from September 1992 to August 1993. Nonetheless, the transition to Stage II occurred according to the timeline set forth by the Treaty. Stage II called for the completion of a “convergence play”9 of a majority of the member states and the establishment of an operational framework for a common central bank with a single monetary policy. Thus, at the beginning of Stage II, the European Monetary Institute (EMI) was established as a precursor to the European Central Bank (ECB). The EMI was responsible for ensuring a smooth transition to Stage III by strengthening the coordination of monetary policies of the member states with the goal of attaining price stability, making necessary preparations for the establishment of the ECB, and overseeing the progress of the ECU, including ensuring the smooth functioning of the ECU clearing system. Stage III started on January 1, 1999, and it saw the establishment of a single monetary policy that was overseen by the ECB, which took over responsibility for monetary policy from the national central banks. At this stage the euro became the common currency of the 11 members of the monetary union (Greece only joined in 2001). Furthermore, the ERM was transformed into ERM2, the exchange rate arrangement linking currencies of EU countries outside the monetary union to the euro. The crowning achievement came on January 1, 2002, when euro notes and coins were introduced in all EMU member countries. For a specified time, the national notes and coins were legal tender alongside the euro. On March 1, 2002, the euro became the sole legal tender in the countries participating in the monetary union.

2.3

REFLECTIONS ON THE FORMATION OF EMU AND EAST ASIAN MONETARY INTEGRATION

As mentioned earlier, the founding fathers of modern Europe recognized that European integration could only be achieved step by step, by starting out with concrete economic and political issues that would have spillover effects leading to the creation of supranational institutions. The integration process was an evolutionary one, which initially began with real economic cooperation between members. As countries began to realize the gains from real economic cooperation, they came to the understanding that


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they would also need to establish monetary cooperation with each other in order to fully enjoy these gains. European monetary integration can be described as a process of trial and error. It is important to realize that monetary and financial integration was not an explicit aim in the first postwar initiatives. After the creation of the Bretton Woods system, European currencies were embedded in the worldwide system of fixed exchange rates, giving little incentive for European countries to create their own active exchange rate policies (Reszat 2003). It was the problems with, and the eventual collapse of, the Bretton Woods system that provided an impetus for the project of monetary union, as formalized by policymakers in the Barre and Werner Reports. After the first initiative of intra-regional exchange rate stabilization, the Snake, failed to provide the desired sustainable currency stability, European leaders had to conceive new ways of stabilizing exchange rates. Eventually, based on the success of the EMS and the refinement of the process set out in the Delors Report, the plan for implementing EMU was drafted, with timelines created for the initiatives. However, as we have seen, the different stages of advancement were not without problems, and compromises and exceptions had to be made before the end goal, a common currency, could be reached. East Asia can learn from the strategies employed in the course of the EMU negotiation process and recognize the importance of sticking to principles while at the same time allowing exceptions. For example, exceptions were made in the case of the United Kingdom and Denmark, allowing them clauses for exemption from the third stage of EMU negotiations. The protocol was necessary in order to secure the United Kingdom’s agreement to the Treaty. During the process of Treaty ratification, speculation caused by the rejection of the first Danish referendum in June 1992 and uncertainty surrounding the French referendum in September 1992 resulted in speculative monetary turbulence and compelled Italy and the United Kingdom to withdraw their currencies from the ERM. In the summer of 1993, the French franc, too, came under strong pressure. The crisis cast doubts on the feasibility of EMU.10 Despite these setbacks, the preparations went ahead and the set timetables were respected. The important lesson to be learnt here is that when countries have a common goal (such as a monetary union) they can work out their differences and overcome impediments that threaten progress. Consider now the case of the East Asian integration process. East Asia has greatly benefited from the globalization of financial markets. From the middle of the 1980s onwards, the dynamic economic growth of the region was fuelled by huge capital inflows. However, the East Asian financial crisis of 1997 triggered huge capital outflows from the region and caused great

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damage to its economies in the form of a sharp depreciation of exchange rates, steep falls in asset prices, collapses in investment and consumer confidence, and a sharp fall in income. The financial crisis acted as a wake-up call to East Asian countries, clearly showing that their capital markets were not adequately equipped to deal with globalized financial flows. In the post-crisis period, there was growing awareness among the East Asian countries of a need to collectively respond to such situations in the future because of their growing regional integration, as evidenced by their mutual susceptibility to contagion (Wang and Andersen 2002). But East Asia faces several obstacles to monetary integration. One major hindrance is the area’s lack of experience with regard to regionalism. The East Asian countries have very little experience of macroeconomic policy coordination and have not developed any institutions to implement it.11 Also, huge gaps in financial expertise, technology, infrastructure, and market size between the East Asian emerging markets and the international financial centers in developed countries have led to the financial services in the region being provided mostly by foreign corporations, often in New York or London. This could in turn act as a barrier against sufficient expertise being developed in the region and also put constraints on the extent to which regional identification develops as a driving force (Wang and Andersen 2002). Moreover, the two largest economies in the region, China and Japan, differ considerably in their strategies. Japan, the most developed country in the region with a strong international currency, is confronted with skepticism by the other East Asian countries and especially China, which is not willing to let Japan play the lead part in regional integration. Also, as a result of Japanese commercial banks having been driven out of the financial services markets because of prolonged financial problems, the yen is declining in importance, thus making the role of Japan as a leader in the creation of an East Asian economic entity seem increasingly unlikely. China, on the other hand, despite its fast growth and expanding trade relations with its neighbors including ASEAN, is presently lacking deep financial markets and an international currency that would enable it to act as the center country of East Asian monetary integration.12 All of these factors will make it increasingly difficult to reach a consensus on economic and financial integration in an increasingly bipolar East Asian region. While an economic upturn in Japan and more intimate Sino-Japanese relations might help in fostering regional cooperation, nonetheless, the greater differences in governments, legal and regulatory environments, levels of economic development, and local histories than was the case with Europe suggest that the integration process will take considerable time.


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Finally, one of the driving forces behind European integration was the desire for a united Europe. This idea of a common citizenship is lacking in East Asia. In order to reap the benefits of a monetary union, countries will have to cooperate in the political arena as well, and East Asian leaders will have to build a common framework in which decisions are reached based on what is best for East Asia. At present, they do not show the same ambitions that European leaders exhibited half a century ago. Furthermore, East Asia needs to develop ways of interacting that promote collaboration rather than competition between countries. In light of all these obstacles, we can easily see that East Asia has a long way to go before regional integration can be accomplished.

2.4

THE MAIN PLAYERS IN EUROPE’S EMU NEGOTIATIONS

East Asia still has a lot of work to do before it can hope to establish an economic and monetary union. As East Asia differs considerably from Europe and cannot simply emulate its experience with monetary union, it will have to chart its own course toward integration. We nevertheless believe that the process of EMU in Europe can provide important lessons and models for different types of possible coordination and cooperation. In order to derive such implications for monetary cooperation in East Asia, we investigate the roles of the major players in European economic and monetary integration—Germany, France, the United Kingdom, Benelux, and the European Commission—in negotiating EMU. Germany The joint initiative of Chancellor Helmut Kohl of Germany and President Francois Mitterrand of France resulted in a great leap toward the establishment of EMU during their years in power in the 1980s and 1990s. They were convinced that Europe could only be united on the basis of Franco-German reconciliation, with both countries acting together as a locomotive driving the process of European integration. This shared belief contributed a lot to the success of EMU negotiations by preserving “key bilateral relations” between Germany and France. During his 16 years in power (1982–98), Kohl presided over Germany’s unification and became the driving force behind European integration. Kohl’s early years in power were marked by Germany’s growing pains from unemployment and a deep national divide over the deployment of nuclear weapons on German territory. In 1989, the collapse of the East

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German regime and the fall of the Berlin Wall allowed Kohl to grab the “mantle of history”. He became the main influence behind German unification. By skillfully balancing pressure and persuasion, he convinced leaders in Eastern and Western Europe as well as the Soviet Union and the US to accept a large and unified Germany, ending half a century of Cold War division. In Kohl’s view, German unity and European unity were two sides of the same coin. Tying Germany into the double framework of EU and NATO, Kohl hoped to avoid a replay of great power rivalries. However, the triumph of national unification was soon dampened by a string of problems, not only because of structural problems with the European economy but also because of the costs and consequences of unification itself. Like a majority of European countries in the 1990s, Germany faced increased global competition, rising welfare costs, and high unemployment, particularly in its traditional industrial sector. No less importantly, it also faced the overwhelming added expenses of unifying East and West Germany. As a result of a legacy of inefficiency, the former East German economy collapsed, hundreds of thousands of East Germans faced unemployment, and East Germany became heavily dependent on federal subsidies. In a sense, Germany’s EMU participation added another burden to the economic challenge of German reunification. Within the ERM regime, the German mark was the only currency that had never been devalued and acquired great credibility and a reputation as a “hard” currency. In order to maintain parity with the mark, other countries had to adopt domestic monetary policies as disciplined as Germany’s. This caused asymmetry within the functioning of the ERM, with the burden of adjustment falling disproportionately on other countries. Thus, the West German people were generally opposed to entering into EMU because they feared the loss of their monetary supremacy. There were also concerns that entering a monetary union with less disciplined countries would result in a European currency potentially weaker as compared with the mark. To soothe these concerns, the German government, as well as the Bundesbank, demanded many concessions from the other European countries in order to ensure a stable European currency. For instance, the German negotiators insisted on the independence of the common central bank and pushed through the Stability and Growth Pact to ensure that monetary stability would not be undermined by the fiscal recklessness of individual member countries. Over the course of EMU negotiations, Germany had allies in the Netherlands, Denmark, and Luxembourg (and sometimes the United Kingdom), all of which supported the “economist” approach. The economist approach to monetary integration stressed that monetary


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union must be the end result of a long process of economic convergence, following the freeing and opening of markets and, not least, the complete liberalization of capital movements (Stoltenberg 1988). These strategic allies greatly helped the German view dominate during the planning stages of EMU. France France, under the leadership of Francois Mitterrand, played a great role in the advancement of EMU. Mitterrand’s strategy on EMU—balancing domestic interests against international and European interests—reflected those of former French presidents Charles de Gaulle, Georges Pompidou, and Valéry Giscard d’Estaing. They all envisaged an EMU that would counter the monetary hegemony of the US with a common European stance on international monetary reform. At the same time, it would deal with German monetary power by Europeanizing it (Dyson and Featherstone 1999). Thus, with the fall of the Berlin Wall in 1989, Mitterrand pushed for the goal of an EMU with a single currency in order to deepen German integration within Europe. Some of the notable influences on Mitterrand’s policy on EMU were a belief in the unique French role in Europe as the birthplace of democratic values, the desire to be disassociated from the fiscal irresponsibility that was linked to the political left, and memories of French humiliation at German hands, this last factor being the single most important one in the decision to forge closer ties with Germany to ensure peace between the two countries. The vested interest that the French had in European integration also manifested itself in the idea that the French had ownership of European integration. The French felt that they could play a special civilizing role in the world. While Germany’s contribution to the EMU would be economic, the French would contribute through their art, language, and culture. In contrast to the economist approach favored by Germany, France took the so-called monetarist approach, as did Italy, Belgium, and the European Commission.13 The monetarists believed that the way to achieve economic convergence was through the establishment of a new monetary institution that would in turn change market behavior. This argument was consistent with the “community method” approach to European integration, which stressed the role of elite socialization in new institutional structures as the most appropriate method for building Europe (Dyson and Featherstone 1999). The theoretical premise of the monetarist argument was that external discipline could be used to promote the twin goals of domestic policy reform and external credibility.14

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The United Kingdom As mentioned earlier, the Franco-German alliance formed the core of the integration process in Europe, as it was the political will of these two countries that motivated further integration. European unification and FrancoGerman reconciliation were judged to be in both France and Germany’s best interests. British negotiators, however, held a different opinion about the relation of European unification to vital national interests. They saw Europe as one of several fora, rather than a central forum, through which British interests could be pursued (Dyson and Featherstone 1999). Unlike the French and the Germans, the British had a different perception of the necessity of European unification for securing strategic interests. The United Kingdom stands on the boundaries of Europe. As victors emerging from the Second World War, the United Kingdom did not see European integration as a necessary foundation for its security. Furthermore, Britain’s special relationship with the United States caused it to place more emphasis on transatlantic relations. Thus, while the British government favored the single market policy, leading to liberalization, deregulation, and the free movement of capital, it rejected the idea of a monetary union with a single currency, a single European central bank, and stated fiscal policy rules. The then prime minister of Britain, Margaret Thatcher, refused to participate in the Stage I negotiations outlined by the Delores Report if there would be any binding commitments requiring participation in the next stage and the eventual adoption of a common currency. British negotiators like Thatcher, Lawson, Major, and Lamont were reluctant to transfer the sovereignty of monetary policy to a European Central Bank and accept EC rules on fiscal policy. Thatcher was deeply suspicious that European integration was progressing in a federalist manner, with institutions such as the Commission and the European Court of Justice increasingly infringing on national sovereignty. The British government proposed a Hard ECU (HECU) that would become the common currency of the Community. It also proposed that the central value of the HECU not be devalued against other currencies and that over time the HECU become the dominant currency of the union. Unsurprisingly, the British proposal had little support, as the Bundesbank did not want to create a European currency without having an independent European central bank oversee it. Like the Germans, the Danish, and the Dutch, the British mostly supported the economist approach to monetary integration. They advocated that a potential monetary union be the end result of a long process of economic convergence among EC countries, beginning with the opening


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of markets and capital liberalization. They also believed that a multi-speed Europe should be a possibility, since different states would converge at different speeds.15 Benelux In the course of European integration and especially the process of EMU, we cannot deny the important role of big member states such as France and Germany. However, it would be misguided to attribute the formation of the EMU exclusively to the Franco-German alliance or to the convergence of the interests of the four largest countries. Rather, the construction of the EMU was a collective, multilateral achievement, in which all member countries, including the smaller ones, played a part (Maes and Verdun 2005). Great achievements such as approval of the Treaty on European Union could not have been realized without support from small and medium-sized member states, as all member countries of the European Union enjoy the same formal rights within the union, irrespective of their population and economic size. In this regard, the Benelux countries occupied a peculiar position in the process of European integration. The three countries had already formed a customs union before the European integration process that started after the Second World War.16 Hence, they were regarded as a model for European integration and, as such, a “testing bed” for Europe-wide integration. The Benelux countries had long realized that smaller countries (or regions) would be better off if they fused their strengths, so it was an easily accepted premise in the Benelux countries that European integration was the best policy for guaranteeing peace and prosperity for themselves as well as for Europe. The Benelux union was a forerunner of economic integration, which made its countries’ voices more credible and persuasive in the negotiation process. The Benelux countries were some of the strongest supporters of monetary integration throughout the whole EMU negotiation process. Benelux contributed to European integration in many areas, developing many new ideas and tactics. The Spaak report, the Werner report, the Tindermans report, and Duisenberg plan, all bear the names of big figures of European integration from Benelux countries that greatly contributed to the acceleration of the integration process when its momentum began to diminish. The idea of a flexible, “multi-speed Europe” was originally proposed by Belgium, which preferred a realistic approach to European integration. Benelux diplomats were famous for being mediators competent at reaching consensus among seemingly conflicting views and contributed greatly to the success of negotiations.

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In the area of monetary integration, however, Belgium on the one side and the Netherlands and Luxembourg on the other side displayed competing views. While Belgium supported the monetarist approach together with France and the European Commission and was very active in creating the institutional background for monetary union in the Community, the Netherlands and Luxembourg went hand in hand with Germany in their support for the economist approach. All in all, Belgium is said to have played a pace-setting role, as it was a consistent demandeur (Maes and Verdun 2005). Belgium’s constant concern was to have EMU on the agenda. In the 1970s and 1980s, the Netherlands and Luxembourg had a more restrictive view of the conditions under which EMU was possible. Together with Germany, they also took a harder line on the criteria for entry and were seen as gate-keepers (Maes and Verdun 2005). The Netherlands and Luxembourg, however, did not merely side with Germany. They, together with Belgium, were keen to promote vivid discussion among member states about monetary integration. The European Commission It is worthwhile to note the central role played by the European Commission in the negotiation process, despite the fact that it is not a nation with sovereignty but an organization. The European Commission was from the start an active participant in negotiations on the proposed monetary union. Within the institutional framework of the European integration process, the original treaties gave the Commission specific duties, chief among which were that it be an advocate of the common interests of the member states, an initiator of common positions, an objective arbiter between national interests, and, lastly, the guardian of the treaties. The Commission generally supported the French positions on the process of candidacy requirements, EMU implementation, such as the introduction of the opt-out clause, the flexibility of convergence criteria, and fiscal federalism, as it explicitly preferred EMU progress under more relaxed requirements to making no progress under stricter conditions. Jacques Delors played a very important role in the relaunching of the project of EMU. As president of the Commission, Delors was extremely invested in the EMU, and after overcoming resistance from Thatcher he went ahead with his goal of putting monetary union back on the EC’s agenda. The Delors Report helped design the EMU and set timelines for subsequent negotiations. He is one of the main actors and contributors of the formulation of EMU in Europe. The European Commission was also important in facilitating the negotiation process, since it was an independent institution. The European


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Commission was actively involved in the negotiation process that resulted in the Hague Summit, which proposed the establishment of a step-by-step plan for the achievement of EMU. It produced a number of documents addressing shortcomings in economic integration and monetary cooperation and thus provided the background for the decisions made at the Hague Summit. The commission created the first plan toward monetary integration in stages, and the Werner Report drew greatly on this plan. The Delors Report became the reference document for the Maastricht Treaty and for the implementation of EMU over the next 10 years, which resulted in the introduction of a single currency in 1999.

2.5

THE ROLES OF THE EAST ASIAN STATES17

Turning to East Asia and its still young attempts to foster regional monetary and financial cooperation and integration, it is still to be seen how the process will advance and who the key players will be. One possible scenario is that China and Japan will come to realize that despite the differences in their political and economic strategies, working together will be in both countries’ interests and crucial to developing a common political will in East Asia. Sakakibara (2003) and Murase (2004) argue that the roles of China and Japan in East Asia’s integration process would be synonymous with those of France and Germany in Europe’s integration process.18 Similarly, the Kobe Research Project report19 states that “[i]t is essential for the Japan–China cooperation, as a core in East Asia, to lead the process of economic and financial integration, as the Franco-German alliance played a central role in the integration and cooperation process in Europe.” Despite this and similar claims, Japan and China are not yet in a position to emulate the Franco-German partnership and promote regional economic and monetary integration. A Sino-Japanese alliance is unlikely for the time being, as the differences between China and Japan—in terms of economic development, political systems, and regional security interests— offset the similarities. In addition, it must be kept in mind that, while Japan is experiencing stagnating economic growth, China is experiencing high levels of growth and could potentially become a superpower in economic, political, and military terms. Thus, in order for any partnership between these two countries to form, many differences would have to be resolved and mutual benefits recognized.20 With the potential leadership roles in a process of East Asian monetary integration assigned to Japan and China, Korea could take on a proactive role in fostering Sino-Japanese collaboration while at the same time acting as a representative of smaller countries in the region. Korea

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could serve as a mediator between China and Japan, helping to cultivate a common political will. Murase (2004) likens Korea’s potential role in a process of East Asian integration to the one the Benelux countries played in Europe. Murase’s argument on the role of Korea is interesting, but a few issues need to be clarified with regard to Korea’s role in the integration process. First, as was mentioned before, it is quite difficult to sort out a common Benelux role, especially in the early stages of the negotiation process. France’s views and strategy for EMU negotiations were more or less duplicated by Belgium, while the Netherlands and Luxembourg firmly stood by Germany during the negotiations. It was only in the last stages of EMU that a common Benelux view developed that was not so different from what France and Germany agreed upon. Second, Korea can take a strategic position between China and Japan. As China is still considered to be an introvert country that lacks policy harmonization with its neighboring countries, while Japan has not yet shown regional leadership, Korea can function as a kind of “honest broker” in dealing with cooperation and integration issues. Third, it is important to note that, unlike China or Japan, Korea maintains a strong will to promote regional cooperation and integration. Korea is one of the countries most concerned with North Korea’s nuclear crisis and would be devastated if a war in the Korean peninsular were to occur. Recalling that one of the strongest impetuses toward economic integration in Europe after the Second World War was an institutionalization of permanent peace in the region, Korea’s position may indeed mirror that of the Benelux countries in that Korea, as a medium-sized country, has strong motives for proposing regional integration and mediating between its two large neighbors. Korea may be a proponent of hard currency if the negotiation process for monetary integration were started, possibly together with Japan, Singapore, Malaysia, and Thailand.21 Korea may also play a gate-keeping role like the Netherlands and Luxembourg did. However, it would be premature to expect Korea to play an active role in the near future, as its role has been rather limited in the past, while ASEAN has had one of the most active roles in ASEAN13.

2.6

CONCLUDING REMARKS

This chapter suggests several implications for East Asian monetary integration and cooperation. First, the European monetary integration process has demonstrated the need for pragmatic compromises in developing frameworks for monetary cooperation. All through the process of EMU, there were competing views among the EU member states on the


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need for and the form of monetary integration. To ensure the continued participation of all parties, compromises were struck and exceptions, such as the opt-out clauses for the UK and Denmark, were made. In East Asia, governments also need to take a pragmatic approach in working toward a common goal. This might involve, at times, countries agreeing to decisions that only indirectly benefit their economies by helping the overall integration process. Second, the European experience has shown that integration can only be achieved step by step, by starting out with concrete economic and political measures that subsequently help develop a larger framework of cooperation that could later be enforced by common supranational institutions. East Asian countries need to be exposed to opportunities of binding negotiations on regional issues and to accumulate experience in resolving conflicting issues. It took many years for the countries who designed Europe’s EMU to acquire negotiation skills and to reach a stage of mutual understanding. Similarly, a gradual process of integration would help East Asian countries to develop the mutual trust and understanding that is so crucial for monetary cooperation. Third, while the European monetary integration process was a process of trial and error, it was helpful to have blueprints in the form of the Barre, the Werner, and the Delors reports. Although the Barre and the Werner reports had not been implemented immediately, they contributed greatly to shaping Europe’s monetary integration by stirring up discussion about the direction of integration. The Delors plan, which became the actual blueprint for the creation of the EMU, provided binding benchmarks and timelines for the monetary integration process. East Asian countries should also develop an advanced blueprint for monetary cooperation and integration. This would help clarify positions and force the participating countries to agree on common principles for potential integration. Fourth, a variety of policies are required in order to encourage the possible losers of monetary integration to continue to participate in the process. Europe’s Common Agricultural Policy (CAP) and Structural Funds played a key role in this, although the original programs were not developed for that purpose. While it is not recommended that East Asian countries implement programs such as the CAP (and the region would also be lacking the resources to do so), certain fiscal transfer mechanisms would help support the common integration policies within those countries experiencing transitional losses. Fifth, it is recommended that some East Asian countries form a kind of core group so as not to lose the momentum toward integration. In Europe, Germany and France maintained key bilateral relations over the course of the whole integration process. In East Asia, Japan and China could play

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such a role, but, if the two countries are not yet ready, Korea is strongly recommended to initiate trilateral relations. Korea, the uniquely divided country in the region, would have a special interest in initiating and leading a process of economic and monetary integration in order to secure regional peace and prosperity. The process of economic and monetary cooperation in East Asia has just started and is still at a rudimentary stage. However, we need to recall that the original six members of the European Economic Community, which today seem to be more or less homogeneous economies, were regarded as genuinely heterogeneous when the Community was founded some 50 years ago. In those days, the differences between the nations’ economic structures caused people to believe that the integration of such heterogeneous economies was absurd. Therefore, without putting too much emphasis on the differences between East Asian countries, it would be important to encourage closer regional cooperation now in order to prepare the way for solid performances in economic and monetary cooperation and integration.

NOTES 1.

2. 3. 4. 5.

6. 7. 8. 9.

I would like to thank Beate Reszat, Ulrich Volz, and participants of the HWWA/HWWI conference on East Asian Monetary and Financial Integration in Hamburg, on December 15–16, 2005 for their helpful comments and suggestions. The first draft of the chapter was presented at the conference on Regional Monetary Cooperation and Coordination: the Experience in Europe and Feasibilities in Asia, hosted by the Institute of World Economy at Fudan University, Shanghai, on October 25–26, 2004. Comments by the participants of the conference are gratefully acknowledged. The remaining errors are mine alone. The first stage was launched on an experimental basis and did not require a binding commitment from its members to complete the process of economic and monetary union. This was a mechanism for the managed floating of the European currencies: the “snake” within narrow margins of fluctuation against the dollar—the “tunnel”. Benelux refers to Belgium, the Netherlands, and Luxembourg. Exchange rates were based on central rates against the ECU, the European unit of account, which was not a numeraire based on a single currency but a weighted average, or basket, of the currencies of the member states. A grid of bilateral rates was calculated on the basis of these central rates, expressed in ECUs, and currency fluctuations had to be restricted to within a margin of 2.25 percent on either side of the bilateral rates (the Italian lira was allowed a wider margin of 6 percent). The commitment to the formation of an economic and monetary union had already been stated in the SEA of 1986. Both IGCs were launched at the Rome European Council in December 1990. These included restrictions on capital movements, constraints on the overdraft facilities available to public authorities and public undertakings, and limitations on giving preferential access to financial institutions for public undertakings. The four convergence criteria that are presented in Article 121(1) of the Maastricht Treaty relate to price stability, government deficits, exchange rates, and long-term interest rates. Each member state must satisfy all four criteria in order to be able to


10. 11. 12. 13. 14.

15. 16.

17. 18. 19. 20.

21.

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participate in the third stage of economic and monetary union. Budgetary rules were set to become binding and member states not complying with them were likely to be penalized. During the negotiations, Denmark and the United Kingdom opted out of the third stage of EMU. For an analysis of the ERM crisis see Volz (2006). ASEAN13 Financial Minister’s Meetings have discussed the possibilities of macroeconomic policy coordination, but this remains in the rudimentary stages. See also the chapter by Zhang and Liang in this volume (Chapter 14). The monetarists had nothing to do with the school of thought of the same name that was developed by Milton Friedman and the “Chicago School”. The existence of the monetarist and economist policy advocacy groups added tension to the Werner Group negotiations in the 1970s, and also to negotiations and debates about the ERM. Both groups offered diverse opinions on the relationship between economic convergence and monetary union. Still today, the British government maintains that potential membership in the EMU would depend on the fulfillment of “five economic tests” that would ensure convergence with the Eurozone. Belgium, the Netherlands, and Luxembourg founded Benelux on September 5, 1944. Before the formation of Benelux, Belgium and Luxembourg established BLEU (the Belgium–Luxembourg Economic Union) in 1921 and have run a fixed exchange rate system ever since. This section is developed from Section 4 in Kim and Wang (2005). Like China and Japan, France and Germany also had a wartime legacy of animosity. It was submitted to the fourth gathering of the finance ministers of the Asia–Europe Meeting (ASEM Finance Ministers’ Meeting) held in Copenhagen in July 2002. Searching for desirable roles of Japan and China, it would be helpful to also take note of other relations such as the Anglo-German relations and the German–Polish reconciliation process. Japan has shown a more or less similar strategic position to the UK in its regional policies. German–Polish reconciliation is also interesting to note, as a wartime legacy between the two countries had not been resolved until the 1990s because of the Cold War. For an application of EMU criteria to East Asian countries, see Kim and Park (2004, pp. 125–9).

REFERENCES Dyson, Kenneth, and Kevin Featherstone (1999). The Road to Maastricht: Negotiating Economic and Monetary Union. Oxford: Oxford University Press. Kim, Heungchong, and Sung-Hoon Park (2004). “The Political Economy of the EMU Negotiation and its Implications to East Asian Monetary Integration.” KIEP Policy Analysis 04–10. Korea Institute for International Economic Policy, Seoul. Kim, Heungchong, and Yunjong Wang (2005). “Financial Integration in East Asia: Which Role for Korea?” Paper presented at a conference on The Rise of China and Korea’s Regional Policy at Ifri, Paris. Maes, Ivo, and Amy Verdun (2005). “The Role of Medium-sized Countries in the Creation of EMU: The Cases of Belgium and the Netherlands.” Journal of Common Market Studies 43: 27–48. Murase, Tetsuji (2004). “The East Asian Monetary Zone and the Roles of Japan, China and Korea.” Manuscript, Keio University, Tokyo.

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Reszat, Beate (2003). “How has the European Monetary Integration Process Contributed to Regional Financial Market Integration?” HWWA Discussion Paper 221, HWWA, Hamburg. Sakakibara, Eisuke (2003). “Asian Cooperation and the End of Pax Americana.” In Jan Joost Teunissen and Mark Teunissen (eds), Financial Stability and Growth in Emerging Economies: The Role of the Financial Sector. The Hague: FONDAD. Stoltenberg, Gerhard (1988). “The Further Development of Monetary Cooperation in Europe.” Memorandum to ECOFIN Council, Bonn: Ministry of Finance. Volz, Ulrich (2006). “On the Feasibility of a Regional Exchange Rate System for East Asia. Lessons of the 92/93 EMS Crisis.” Journal of Asian Economics 17: 1107–27. Wang, Seok-Dong, and Lene Andersen (2002). “Regional Financial Cooperation in East Asia: The Chiang Mai Initiative and Beyond.” www.unescap.org/pdd/ publications/bulletin2002/ch8.pdf.

3.

International political conflicts and economic integration Koichi Hamada and Inpyo Lee If goods don’t cross borders, armies will. (Attributed to Frédéric Bastiat)

3.1

INTRODUCTION

In ancient times, the Far East, notably China, was a center of civilization and a theater for displays of brilliant military strategies. Now, the Chinese economy is emerging as a dominant player in the world thanks to its sheer size alone. The Japanese economy, with its rapid growth, was hailed as a rising sun. South Korea, Taiwan China, Thailand, and others achieved Asian miracles and then were disrupted by the East Asian crisis but recovered quite successfully. Thus, East Asia—people seldom call it the “Far East” now—has become a dramatic, intriguing, and even threatening area. East Asian countries were notably unconcerned about regional economic cooperation until the late 1990s. The Asian financial crisis of 1997, however, clearly showed that the heightened degree of interdependence in the international economy has increased the need for closer global and regional economic cooperation. Kuroda (2003) suggested a step-by-step plan for financial and monetary cooperation in East Asia: (1) formation of a regional financial safety net, (2) promotion of effective regional surveillance, (3) development of regional bond markets, (4) exchange rate stabilization among regional currencies, and (5) establishment of an Asian common currency. Various efforts for the first to third stages have been taken, with some of them materialized, but the later stages have yet to be realized. After the proposal to create an Asian Monetary Fund was shelved, ASEAN plus China, Japan, and Korea (ASEAN13) agreed to strengthen the existing cooperative frameworks in the region through the Chiang Mai Initiative (CMI) in May 2000. Regional cooperation for financial and 61

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monetary arrangements has just started by way of the CMI, but considerable work remains to strengthen cooperation for a safety net, regional surveillance, bond market development, exchange rate stabilization, and a common currency. In particular, building up the Asian bond market has been a focal point of regional financial cooperation.1 The virtual absence of foreign investment in local bonds in East Asia has been highlighted as a great barrier to financial stability. That is, foreign borrowing by the banking sector, which was used to finance domestic fixed investment, was pointed out to have resulted in the so-called “double mismatch” of maturity and currency. If so, the high risk of short-term borrowing and equity investment still leaves East Asian countries vulnerable to shocks in the global financial market. A true Asian bond market could contribute to the stabilization of the regional financial system by reducing the heavy reliance on short-term external financing of Asian companies through the banking sector. In addition, vitalization of the bond market may help reduce the risk of maturity and currency mismatch. More importantly, successful development of the Asian bond market will signify that ultimate economic and monetary integration in East Asia is quite promising and could accelerate the integration process. In this regard, the East Asian economies have just taken the first steps in a process that could eventually result in an economic and monetary union (EMU) in Asia akin to that in Europe, although it certainly will be a long process. On the other hand, we see several unsettling factors in the diplomatic relations between Japan and its neighbors, China in particular. Japan’s Prime Minister’s visit to the Yasukuni Shrine, threats to reduce foreign aid from Japan, and Japan’s textbook description of wartime conducts generate suspicion about the future course of Japan’s diplomatic policy. China’s alleged operation of submarines within Japan’s territorial sea near the Okinawa islands, its opposition to Japan’s permanent membership in the General Council of the United Nations, and its benign treatment of student protests before the Japan Embassy in Beijing all make Japan nervous. The diplomatic relations between China and Japan appear to have been chilled and to involve more uncertainty and even some military risks. The tension between China and Japan casts clouds over the future of Asia’s political economy, about which serious questions have already been raised, such as those regarding North Korea. This chapter develops economic observations on financial and monetary integration in East Asia. Considering the delicate political situation in East Asia at present, however, we could not help but cross the border of disciplines and discuss the international political implications of monetary

International political conflicts and economic integration

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and financial integration. Needless to say, economic cooperation and integration is not an issue that could be understood and discussed from purely economic perspectives. Peace is of enormous importance for all of East Asia and for the world. In section 3.2, we analyze economic rationale behind the efforts to create the Asian bond market and discuss various policy issues. We address, in addition to the question of what the ideal state of bond market integration would be, the question of what kinds of policy measures should be implemented to achieve a desirable financial integration in terms of the bond market. In section 3.3, we turn to monetary integration and discuss the costs and benefits of joining a monetary union. The normative justification for monetary unification or financial integration is not quite decisive from the purely economic point of view. In section 3.4, we explore the relationship between economic integration and political conflicts from an international political perspective. In order to understand the issues related to economic integration, we have to be aware of the incentives for each participating nation. It is one thing to recommend the formation of a free trade area or common currency area based on benefit–cost analysis, but it is just as important to understand under what conditions nations are motivated to join a club. As is understood from the political economy of monetary integration, purely economic incentives may not exist for nations to join a monetary union. As in the case of the European Union and the euro, security reasons may turn out to be a critical motive for realizing a monetary union in the East Asia. In section 3.5, we illustrate the logic of the situation in East Asia by examining a simple model of nested games, that is, a concurrence of an economic game with a security game between two countries. The economic game can be characterized as a type of the “Prisoners’ Dilemma”, while the security game is characterized as a type of “Hawk–Dove” game. If both governments accurately know the probability of military confrontations, their direct and indirect costs, and the link between the economic game and the security game, then the total game can be seen as a simple game with multiple strategies. The total outcome will not substantially distort the interests of voters in participating nations. In addition, we point out the factors that may distort the play of the above nested game and jeopardize the peace and welfare of nations.

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3.2


FINANCIAL INTEGRATION AND THE COMMON BOND MARKET

Economic and Conceptual Issues Before going into various policy issues regarding bond market integration, it is helpful to review the conceptual distinctions between three basic forms of financial intermediation: bank lending, bond financing, and equity financing. It is important to recognize, first, that financial integration is indeed closely related to monetary integration, but there exists a fundamental functional difference between them.2 Bank lending is characterized by the face-to-face direct relationship between a lender and a borrower and can be described as the “negotiable form” of financial intermediation. Conditions of loans are worked out between the related parties. A prospective lender investigates the credit conditions of prospective borrowers and screens safe borrowers from less safe ones. After the loan is made, the lender often monitors, if not supervises, the business of the borrower. Activities related to information gathering and monitoring are conducted on a bilateral basis between the creditor and the debtor. Normally, the creditor is supposed to hold the claim until the end of the term unless the borrower decides to pay back the debt, and only occasionally is the claim transferred to a third party. The negotiable credit contract cannot go with anonymity. This form of transfer can exploit lender-specific and borrower-specific information that is unavailable to the public. This is often considered a positive aspect of “relationship banking”. On the other hand, this type of transfer of funds can be associated with the “crony banking” of the Japanese Zaibatsu (literally “financial cliques”) or South Korean Chaebol (family-controlled business conglomerates) in the sense that one lends to the other not because of the borrower’s financial suitability but because the lender happens to be a relative or a friend of the borrower. It is no coincidence that the main bank system grew out of the Zaibatsu relationship that was originally based on family ties. On the other hand, bond financing and equity financing can be characterized as the “market form” of financial intermediation. Because of the absence of a direct information channel between essential lenders and borrowers, firms are required to reveal their essential financial data. Underwriting is important not only for the treatment of risks related to public offers but also for the dissemination of business information of a debtor firm to the public. Bonds are standardized and most importantly transferable from one holder to another in the open market. Public business information is also published in a standardized form in order to be


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able to be transmitted to anybody in the market. Bonds have more liquidity because they can be instantaneously sold. Anonymity works in the market form of financial intermediation.3 At the least, there are various merits to cultivating a well functioning bond market. First, since lenders wish to minimize risks through portfolio management, the existence of new forms of investment always helps. Therefore, adding new bond instruments to an economy dominated by bank lending implies that the economy obtains a new form of financial instrument. Second, for firms that are able to demonstrate their sound financial prospects in the open market, bond financing creates a new and profitable opportunity. This is the reason that many prominent Japanese and Korean firms are successfully obtaining funds through public bond offers. Third, this may be a good way to get away from “crony finance”. Although a holder of bonds has a pay-off profile quantitatively similar to that of a holder of loans in terms of the contingent pay-off schedule, they are constructed differently in contractual and procedural terms, in particular when delinquency or bankruptcy situations emerge. Also, the mode of and costs related to monitoring the agency relations are different. Therefore, it is always better for an economy to be able to use both of these alternative means of finance. Bond market development can thus be regarded as a positive direction for economic development policy from this point of view.4 As an application, consider what happens to various asset holders in the case of a financial crisis taking place in a borrowing country. Equity holders of non-performing firms will lose wealth almost immediately. Bondholders retain claims to the remaining worth of the firm and can join the bankruptcy procedure, but the value of bonds will depreciate. In informal expression, the claim to the firm under problematic conditions will be handled by the asset market almost immediately and in parts. On the other hand, if a firm is financed mainly by a bank, it takes time for loans to be known to be delinquent. The problem of “oigashi” (roll-over loan)—the phenomenon observed when a bank official additionally extends to a delinquent “zombie” firm in order to avoid the revelation that the firm is near bankruptcy—aggravates the situation. If the majority of investments were financed by the market type instruments rather than by the negotiable type instrument, the cost of financial crises would be smaller. Political Economy Aspects In addition to the question of what the ideal state of financial intermediation is, we must address the question of what kinds of incentives promote financial integration in terms of bond markets. In general, unless there are

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regulations against the mode of finance, and unless there are externalities or increasing returns, the financial market will choose the right mode or the right combination of modes of financial intermediation. There will be no need for government interventions to facilitate a particular mode of financial intermediation. In the East Asian countries, when a government preaches the need for a well-developed bond market, it often means the need for a domestic market on which it can sell its public debt with a lower rate of interest. This is the wrong reason to develop mature bond markets. By no means should the idea of common basket bonds be the main device for solving the large debt situation of Japan, Korea, and other countries. It does not make sense to spend more tax money in order to facilitate the deficit financing of the government. Incidentally, since the essential characteristic of the bond market lies in its universal, non-name-specific nature, in contrast to the bank loan market, it is an oxymoron to define an Asian bond market as a bond market “By Asians, For Asians, and In Asian currencies”.5 Indeed, denomination may matter. Because of the existence of externalities in the denomination of bonds, people are motivated to use the denominations that are already prevalently used. This gives governments some rationale for promoting the denomination of the bond market in local currencies. But it should be of little significance in determining who issues and who buys a particular brand of bonds. Such a market would not grow and flourish unless the bonds traded there became accessible to non-Asians. Before making any attempts to encourage the creation of a regional bond market through financial support, governments must start dismantling unnecessary regulations that they themselves imposed, such as regulations on the issuance of bonds and obstructions against the free movement of capital and the acquisitions of domestic firms. It is almost a self-defeating policy strategy to promote the Asian bond market through cooperative actions by using taxpayers’ money while keeping barriers to free capital movements across Asian countries. Governments should also improve the accounting, legal, and corporate governance systems to make them incentive compatible and transparent. As Takagi (2002) maintains, the building of proper infrastructures is a prerequisite for building sound bond markets. Politically, of course, the goal of creating a sound bond market may facilitate the building of infrastructure. Under normal conditions, our recommendation for the creation of bond markets is of the laissez-faire type: let the market mechanism develop any new market. What can be the exception to this principle? In general terms, government interventions are justified under the following conditions:


1.

2.

3.

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Externalities exist among various financial markets or among local markets, so the promotion of a bond market and cooperation among many national markets may yield some positive returns. International cooperation through the initiation of experimental bond markets may give market participants signals for noticing Asian markets as focal points. The bond issue in the currency basket may well be a helpful device for focusing the attention of market participants and for developing a market with a greater degree of depth compared to bonds in a single currency. Here an analogy to language use applies. Although this subject needs further empirical research, by initially promoting the common bond market using public funds, government may possibly gain some advantage thanks to the depth of the market in order to market their government bond on better terms. As it is difficult to disseminate a language to another location, this process will take a long time. Similarly, international cooperation may be a sound device for making use of the economies of scale involved in initiating new markets, because a single country market may be too small.

These attempts are justified only as an analogue to the “pump priming policy” that is reminiscent of the earlier Keynesian economics. Unless externalities or increasing returns and information asymmetry are important enough and also of the nature that interventions would be the only remedies, we do not endorse using government policy to artificially promote debt markets. In conclusion, increasing the variety of financial instruments is always welcome. Therefore, the creation of bond markets through natural market mechanisms is advised. In the mean time, deregulation and the construction of financial infrastructures are also always necessary. Excessive artificial encouragement of a particular form of bond market at the expense of taxpayers’ money, however, could be costly for the regional economy as well as individual nations’ economies.

3.3

MONETARY INTEGRATION OR CURRENCY UNION6

Economic and Conceptual Aspects In order to discuss the costs as well as benefits of joining a monetary union, we have to identify alternative forms of monetary integration on the basis of the degree of the strength of the binding agreement.7

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1.

2.

3.

4.


Under a floating exchange rate regime, monetary authorities can engage in cooperative actions to keep exchange rates within a certain range, or a zone. Naturally, joint interventions are more effective than unilateral interventions. As shown in Hamada (1985), the fixed exchange rate necessitates, at least partially, exchange rate coordination by the nature of its rule, and, if not necessitated, coordination has a positive benefit under the fixed exchange rate. Under the flexible exchange rate, however, national monetary authorities recover the independence of their monetary policies. The need for, as well as the benefit from, coordination becomes almost negligible. In its weakest form, monetary integration implies the linking of national currencies with fixed parities accompanied by a narrowing or vanishing band of exchange without common reserves or a common central bank. This is what Corden (1972) called the “pseudo-exchange rate union”. The coordination of economic policies, particularly monetary policies, is needed to prevent disequilibria in the balance of payments. There are a few sub-examples of this type of union. Governments can announce the fixity of exchange rates. The degree by which the public believes in the endurance of the fixed exchange rates depends on various economic and political factors. The Bretton Woods regime of adjustable pegs is a typical example. Participants could change the parity if there was a “fundamental disequilibrium”, a phrase that caused academic and practical controversies but was never defined clearly by the IMF. Or, under the gold standard and other commodity standards, a metal or some other commodity is used as an anchor for keeping the fixed exchange parities among currencies. Through the price–specie flow mechanism, monetary policy coordination is supposed to function automatically. In this regime, however, confidence in the endurance of parities is not absolute. Governments have the option of changing the parity rate of currency with gold, for example. The degree of monetary integration is enhanced by the establishment of public confidence in the irrevocable nature of the fixed exchange parities accompanied by full convertibility between currencies for capital and current account transactions. This confidence normally emerges only after a substantial transition period during which de facto fixed exchange parities are successfully maintained or after some kind of political unification. Full monetary integration or unification is only realized when a common currency issued by a single central bank circulates in the area of the monetary union. A unified currency may prevail in an area where multiple governments exist; this has been the situation in the euro zone


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since the circulation of the euro. Each participating nation retains the right to exit the union, and an exit option will be conceptually possible. We can also think of the circulation of a unified currency under a single government, where the common currency circulates in all regions of the country or federation. Under a united government, discrepancy of fiscal policy can be neglected as people believe that this currency area will never be divided again. For example, after the German unification, Germans trusted in the irrevocable “exchange rate” between the D-Mark and the O-Mark again. Historically, however, as in the cases of the Habsburg Empire and the Soviet Union, a single currency under a unified government could dissolve into multiple currencies under multiple states. Now consider the benefits and costs of attempting monetary integration. Aside from the possible strategic benefits, to be discussed later, the benefits from monetary integration are of a microeconomic nature: users of a common currency economize on information costs and transaction costs. Monetary union members enjoy the benefits of increased trade and differentiated products as a result of the reduction or even disappearance of uncertainty about fluctuations in the exchange rates among member currencies. This benefit is partially delivered by a pseudo-exchange union but substantially realized only after the emergence of public confidence in the fixity of exchange rates. Only after full monetary unification is achieved are the transaction costs arising from currency conversion eliminated and the consequent benefits of increased trade and tourism enjoyed. These microeconomic benefits are closely associated with money’s function as a medium of exchange. Money economizes on the information costs required for transactions and allows for the procurement of a stable bundle of goods at a lower cost than under barter.8 The use of a common currency carries intrinsic externalities as a result of its informational properties. These benefits from economizing on transaction costs and from information spillover have the characteristics of a public good: non-rivalry (consumption by one member does not reduce the good’s availability to other members) and non-excludability (certain members cannot be excluded from enjoying the good). These benefits of complete monetary integration are obtained only partly through the adoption of the fixed exchange rate regime. A secondary benefit of monetary integration is macroeconomic. Mundell’s (1968) theory of policy assignment indicates that the effect of regionally specific real shocks may be absorbed by flexible exchange rates. However, recent studies on regime choice show that country-specific monetary shocks can be better managed under fixed exchange rates or

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under highly managed exchange rates (e.g., Fukuda and Hamada 1987, Eichengreen 1998). Thus the primary benefits of joining a monetary union are microeconomic, while the macroeconomic benefits are limited to smoothing monetary disturbance. In contrast, the costs, making each country vulnerable to real country-specific shocks, are mainly macroeconomic. While countries differ in their rates of productivity growth and in their preferences concerning the choice between unemployment and inflation, countries adhering to a fixed exchange rate or participating in a single currency union sacrifice the ability to independently pursue individual monetary policy objectives. This is particularly true when international capital mobility is high and when wages and prices are rigid. The floating exchange rate system gives national economies the opportunity to secure the minimum state of affairs that can be obtained independently, that is, the opportunity to follow a maxi–min strategy in the interplay of monetary policies. By joining a monetary union, a country gives up this maxi–min position and must seek the mutual consensus demanded by policy coordination. In general, the benefits and costs of monetary integration have several characteristics. First, in contrast to the benefits of monetary integration, which are enjoyed collectively and have a public-good nature across nations, the sacrifices made by joining a monetary union are made at the level of the individual nations. This distinction will play a crucial role in our analysis of the incentives of joining a monetary union. Second, the benefits and costs to participating countries vary over time. Initially, the costs of sacrificing domestic economic objectives and an independent monetary policy are large. As capital market integration proceeds, the financing of fiscal deficits becomes easier, and, hence, these adjustment costs become smaller. However, the common benefits of monetary integration are usually enjoyed only at a later stage when the credibility of the fixity of exchange rates is established or when participating nations’ currencies are unified into a single one. For example, the saving on the costs of currency conversion occurs only after exchange rate union has been accomplished, and the benefits arising from the stability of exchange rates can be reaped only after confidence in the fixity of parities has been established. The only way to make the time profile of the benefits lean toward the present is to adopt a single currency. In this respect the euro zone has had apparently considerable success. We say “apparently” because the assessment of the great euro experiment should be made with caution, as will be discussed later. Third, the openness to trade and factor flows of a monetary union member country has an important influence on the magnitude of the


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benefits and costs arising from monetary integration. If an economy is relatively open, with large import and export flows relative to GDP, the costs of adjusting its output or employment level for balance of payments reasons will be small (McKinnon 1963). The savings in currency conversion costs will also be proportionately larger in a more open economy. If the economy is closed, however, these savings will be less significant, while the costs of adjustment will be relatively large. Prior integration of the markets for goods and services and factors of production among member countries may increase the desirability of monetary integration by increasing average levels of openness.9 Empirical Appraisals First, Andrew Rose, Jeffrey Frankel, and others have conducted extensive research on the benefit of monetary union in numerous articles (e.g., Frankel and Rose 2002, Glick and Rose 2002, Rose and Engel 2002). They conclude, mostly by applying the gravity model to cross-country panel data, that having a single currency exerts a substantial influence on the flow of trade and national income. According to their estimates, the use of a single currency triples the amount of trade and increases national income approximately by a half percent. The effect of the use of a single currency is much larger than the effect of the fixity of exchange rates. The institutional arrangement for keeping exchange parity is one thing, while that for having a single currency is completely different. The latter gives rise to much more confidence in the constancy of future exchange rates and eliminates uncertainty about the future. Although Europe’s experiment with the euro is still young and it is too early to evaluate whether the currency union has resulted in substantial changes, the general consensus in the literature is that the euro’s effect on trade within euro zone countries as well as on trade between euro countries and non-euro countries is positive and significant.10 It is worth noting that the level of trade of member countries with those outside of the euro region did not shrink. Thus, the trade diversion from external trade to internal trade seemingly did not take place in the euro zone. Second, Alesina and Barro (2002) and Alesina et al. (2002) show, based on various indicators, that intra-regional trade in Europe is intense and that there is a satellite-like relationship between the US and many of its trading partners. In other words, one might define a European Trade Area and a North American Trade Area. In contrast, they argue, Japan has many trade partners all over the world, so that it would be difficult to conceive of an entity to be called the Japan Trade Area. In their opinion, the EU had, and NAFTA has, preconditions for a currency, but, compared

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with the EU and the NAFTA area, the Asian region has less compelling reasons for an Asian trade zone and, accordingly, has fewer grounds for an Asian Monetary Union. Third, Goto (2002) argues, on the other hand, by using the principal component approach, that the confluence of business cycles among Asian countries is even stronger than that among European countries and that among NAFTA countries. Principal component analysis is useful for measuring the degree of synchronization of multiple variables in contrast with the conventional method of measuring the bilateral output correlation between each pair of countries (Goto and Hamada 1996). Goto (2002) particularly emphasizes the time series observation that integration among Asian economies has progressed in recent years. While most East Asian variables were correlated with US variables in the past, they are now moving together with Japanese variables, as well. Reservations remain, however, about his findings. First, even though macroeconomic and trade variables are moving together in Asia, as detected by principal component analysis, the openness of Asian countries to trade is not as great as in Europe. In Asia trade moves together, but the amount of trade is often small. Therefore, the level test may fail. The use of the trade intensity index, which is a powerful tool for describing the interdependence of trade flows, may not satisfactorily indicate the closeness of trade relationships between countries because the trade intensity index measures comovements in trade but does not factor in the level of trade. Political Economy Aspects In sum, the pros of creating a monetary union between China, Korea, Japan, and neighboring countries can be stated as follows: The microeconomic benefits will include increased trade and differentiated products for member countries. Moreover, trade partners outside the union will benefit from the savings on transaction and information costs. In addition, we can expect the macroeconomic benefits such as better management of monetary shocks.

Meanwhile, the cons of creating a monetary union can be summarized as follows: Monetary union entails each member country’s loss of monetary independence. Furthermore, the European experience has illustrated that in order to enjoy the true benefits of monetary integration, an exchange rate union is not sufficient, and a uniform currency should be an end goal. Are Asian countries prepared to unify their currency systems despite institutional and cultural difference across


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national borders? Are central banks, including the People’s Bank of China, the Bank of Japan, and the Bank of Korea, willing to give up their autonomy and pool their monetary authority?

Even if we admit the findings by Frankel and Rose (2002) of a large and positive effect of currency union on trade, it is not perfectly certain whether this trade-flow effect dominates the cost in terms of the loss of monetary independence effect. The cost of joining a single currency area beyond the present fixed exchange rate regimes to the dollar could be really serious. Inflation is not serious right now, and there is currently a worry of worldwide deflation. We might encourage worldwide deflation by creating an Asian single currency zone. Just as the leader country of the euro zone, Germany, seems to be suffering from recession, might Japan not suffer from deflationary pressure after unification? Though we recognize the long-run benefit of creating a uniform currency in terms of trade creation, in the foreseeable future the cost in terms of loss of monetary control seems to us more serious. Therefore, as far as economic effects are concerned, we are skeptical about the significance of the benefits of Asian monetary unification. There remains the question of incentives. Under what conditions will national governments find incentives to agree on a monetary union with the benefits far into the future? We strongly believe in the merit of and the need for policy coordination among countries in which fixed exchange rates prevail (Hamada 1985). Under flexible rates, the number of monetary instruments is sufficient for each country to be able to conduct monetary policy regarding its price levels and macroeconomic situations as a policy assignment problem (Feldstein 1997, 2000). On the other hand, if 12 countries join a monetary union, then 11 policy instruments will be lost. Of course, this is true only if the participating countries had monetary autonomy before. In Ulrich Volz’s contribution to this volume (Chapter 8), he argues that most (small) East Asian countries do not have full monetary independence now because of external exchange rate targets as well as weak domestic financial markets. In particular, in the problem termed “conflicted virtue” by McKinnon, countries with large international reserves as well as assets denominated in dollars are constrained against the devaluation of their currencies. This argument is rather persuasive, and we agree with it to a certain extent. The loss of monetary autonomy in the case of the adoption of a common currency is, however, definite, and a country cannot easily go back to a floating rate without a substantial transition cost. This cost must be much more significant than the cost of foregoing devaluation because of the large scale of international reserves in dollars.

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Therefore, the answer to the positive (rather than normative) question from an economic standpoint also does not give strong support in favor of a uniform currency.

3.4

ECONOMIC INTEGRATION AND INTERNATIONAL POLITICAL CONFLICTS

We have seen that the justification for monetary unification or financial integration is not decisive from the economic point of view. If we extend the scope of the arguments from the purely economic dimension to the political one and further to the strategic or security point of view, however, the outcome changes significantly. A positive political economy analysis of nations’ incentives for joining a currency union can tell us what may be needed to create a currency area in East Asia. Over the past few decades, there has been abundant literature on the relationship between economic interdependence and political conflicts.11 Political scientists’ attention to the relationship between national security and economic integration has been centered on the relationship between trade and international conflicts. Among numerous papers on this topic, Oneal and Russett (1997) conducted an extensive study on the relationship between economic integration and the existence of national conflicts. They found, in general, significant results demonstrating that the openness of the pair (dyad) of countries will reduce the probability of conflicting situations between them. For example, if the dyadic trade-to-GDP ratio increases by one standard deviation, the likelihood of conflict between these countries will decrease by about 4.7 percent. As Mansfield and Pollins (2001) pointed out, the direction and timing of causality between economic interdependence and political conflicts should be examined. Gartzke et al. (2001) indicate that investment flows are important, as well, and that incentive aspects should be clarified. Given the serious damage potentially inflicted by wars, we consider the gain in peace from openness as reported by Oneal and Russett to be a substantial dividend. The process of economic and monetary union in Europe can also be understood in the light of these strategic considerations. If openness to trade is a significant factor, then openness to capital market and financial integration should also be an important factor for peace, and the benefits of using a common currency should be even greater. Unfortunately, empirical research is scarce concerning the relationship between monetary unification and peace. However, we can expect that the use of a common currency will significantly increase the amount of trade


75

between participating nations, which, in turn, would reduce the probability of war quite substantially. While most of the literature on the relationship between economic interdependence and political conflict considers that the causal arrow goes from economic integration to the possibility of war, the arrow may also go in the other direction. In their highly persuasive paper, Glick and Taylor (2005) focus their attention on the question of how detrimental war is to trade. They show that wars may cause a serious breakdown in trade and a consequent loss of national and global economic welfare and that the indirect damage to trade by wars may be economic losses of a magnitude equivalent to the direct costs of the war, such as lost human capital. Studies such as those listed above reinforce the argument that a case for a monetary union including security grounds may be much stronger than the case for a monetary union on economic merits alone and that we should develop solid relationships among nations. To this end we have to rely on whatever means are available to foster economic ties between countries, such as free trade areas, foreign investment liberalization, and currency unions. To temper our optimism about the peace effects of monetary union, we should mention the intriguing history of the disintegration of monetary unions, such as that of the Austro-Hungarian empire or the Commonwealth of Independent States (CIS).12 In these examples, economic and monetary union did not preclude political division and even conflicts. Without going into the details of these historical experiences, we will discuss the example of the European Union, where the political leadership apparently succeeded in overcoming the economic difficulties of monetary integration.13 The development of the European Monetary System (EMS) since its inception in 1979 has offered a striking contemporary example of the process of monetary integration. The EMS was founded as a “flexible, symmetric version of the Bretton-Woods system” (Kenen 1992), following long-standing plans of economic and monetary union in Europe. The Werner Report of 1970 envisaged the development of a monetary union by 1980 through economic policy harmonization. Harmonization is a process wherein the differences in participating nations’ key economic indicators, such as the inflation rate, interest rates, and the levels of government deficits and accumulated debt, are gradually narrowed. After frequent early adjustments to the Exchange Rate Mechanism (ERM), there were no major realignments from 1987 until September 1992. This period of stability contributed to the sense of inevitability in the progression toward a fixed parity system, but it proved to be the lull before the storm of the suspensions and devaluations of member currencies in September 1992.

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During this period of turmoil the Deutsche Bundesbank increasingly served as the monetary anchor of the EMS by virtue of the size of the German economy and strength of the Deutschmark. This strength was zealously guarded by the Bundesbank, with its strong reputation for inflation aversion. However, the monetary discipline provided by the Bundesbank became punitive as Germany suffered the real fiscal shock of unification. The cost to other countries of enjoying Bundesbank credibility soared, as high German real interest rates were transmitted throughout the ERM. Members with below full employment felt the effects of the squeeze on interest-sensitive sectors like housing and construction. The growing divergence of the costs and benefits of maintaining the fixed parity created uncertainty about the future of currency union as well as of monetary coordination. It opened the door for speculators to bet that the ERM link was too costly for weaker currencies to sustain. Despite regularly reaffirmed commitments to preserve exchange rate parities, and despite defensive purchases of weaker currencies by central banks, the speculative attacks of September 1992 succeeded in forcing several devaluations. Thus, temporarily, confidence in the ERM bands was substantially undermined, and the system tumbled into its most severe crisis in its then 14-year history. Instead of giving up the process of monetary integration, EMS countries (except the UK and Italy) continued their strategy of creating a common currency area without the slow process of converging exchange rates. In January 1999, the euro was introduced as the single currency, and the European Central Bank (ECB) was established to conduct a unified monetary policy. The euro experience lends a new set of insights to the positive theory of monetary integration. Contrary to conventional wisdom, monetary integration could precede political integration. In spite of economists’ criticism (e.g., Feldstein 1992, 1997), and in spite of severe speculative attacks in 1992, the momentum was strong enough to establish the euro zone. The economic benefit of unification is clear: the economy of transaction and information costs. More importantly, the political will, that is, the perception of political benefits by national leaders, must have been the driving force behind monetary unification in Europe. Europe’s perseverant approach to the introduction of the euro, in spite of the speculative attacks in 1992, could hardly be explained without taking political and strategic considerations into account.


Table 3.1

77

Game I: Prisoners’ Dilemma Country B

Country A

3.5

Free Trade Protection

Free Trade

Protection

(4, 4) (6, 1)

(1, 6) (2, 2)

ECONOMIC COMPETITION AND THE ARMS RACE AS A CONNECTED GAME

In this section, we present a simple representation of two kinds of nested games—an economic game and a security game—to illustrate the situation in East Asia. There are some typical patterns in the pay-off structures of economic games. First, the trade game is characterized by the prisoners’ dilemma. Let us consider the simple case with the pattern shown in Table 3.1. It is well known that the Nash equilibrium is the protection–protection combination (2, 2), because protection is the dominant strategy for both players. Cooperation may emerge in this situation so that by a combination of trigger strategies the cooperative equilibrium (4, 4) may be sustained. This is known as the Folk theorem. Liberalization of the process of trade, the creation of a free trade zone, and the deregulation of foreign investment roughly fit into this type of strategic situation (e.g., Myerson 1991). Alternatively, the pay-off of currency unification can be depicted as shown in Table 3.2. In this example with China and Japan, disagreement over the choice of currency for a common currency union results in the prevailing of the status quo. If the two countries agree on a currency, they benefit from the formation of a currency union, but the country whose currency is chosen will benefit more than the other. The Nash solution is either (3, 2) or (2, 3). A mixed strategy may be realized through the selection of a currency basket, but technical problems remain with currency basket use.14 On the other hand, the security or strategic game has the nature of a chicken game or a Hawk–Dove game. If both countries take Dove strategies, both share the dividend of peace. If one country takes Hawk and the other takes Dove, then the Hawk country will gain. If both countries take Hawk, the world is subject to at least the possibility of severe destruction. The pay-off appears as shown in Table 3.3. (1, 6) and (6, 1) are the Nash equilibria. Once a country takes the Hawk position, the other country would not take the Hawk because that would

78

Table 3.2


Game II: Matching Pennies or the Battle of the Sexes Japan

China

Table 3.3

Yuan Yen

Yuan

Yen

(3, 2) (−1, −1)

(0, 0) (2, 3)

Game III: Hawk–Dove game Country B

Country A

Dove Hawk

Dove

Hawk

(4, 4) (6, 1)

(1, 6) (−10, −10)

lead to mutual destruction or at least the possibility of mutual destruction, as represented by (−10, −10). By itself, the repeated game version of this Hawk–Dove game has a sub-game perfect equilibrium that maintains the pay-off close to the cooperative solution (4, 4) provided that the players’ discount rate is sufficiently small. The trouble is that it also has a sub-game perfect equilibrium that maintains the pay-off close to (−10, −10). The evolution of cooperation (Axelrod 1981) is not automatically guaranteed (Myerson 1991, p. 323ff). In the real world, those games are connected. As the reviewed literature has shown, successful completion of currency union is likely to increase the benefits of trade; the successful cooperation in Game II will improve the cooperative pay-off of Game I. The most serious problem is that the strategic game and economic games are nested or connected. The strategic game of Hawk–Dove is played along with the trade game of the Prisoners’ Dilemma and/or the currency unification game of the Battle of the Sexes. And the pay-off matrices are interrelated. If these two games were played by a coherent and rational government, the nested or connected nature would cause few problems. The problem is that it is hard to find such coherent and rational governments. One can explain the connected nature of the games as follows. Cooperative plays in economic games, either trade or currency, will increase the opportunity cost of the war and deter the onset of the war, changing (−10, −10) into a more severe outcome, such as (−15, −15). On the other hand, more peaceful plays of the strategic game (Game III) will create a sense of assurance about future economic relations and enhance the pay-off of the


79

cooperation solution of the Prisoners’ Dilemma as well as the pay-off of the choice of currency game.15 Cooperation in one sphere will reinforce the possibility of cooperation in the other sphere. A win–win situation will be realized as a virtuous circle. Mistrust over military matters will result in difficulty in economic matters, and vice versa. Here, vicious circles may develop. In particular, the recent strategic or security-related mini-confrontations may imply that China and Japan are engaging in a pecking order game in order to assume a leadership role in the choosing of a currency to be at the center of possible monetary integration. It is also understandable that Japan tries to avoid the tug-of-war conflicts of leadership in monetary integration and that it encourages bond market integration that is more consistent with the concept of a multiple currency basket, a kind of mixed strategy solution. Even if these two kinds of games, economic and strategic, are played with full consistency by two rational governments, the possibility of the emergence of an undesirable, or even destructive, equilibrium still cannot be completely ignored. Myerson (1991) shows that a near-destructive state can be sustained as a sub-game perfect equilibrium by trigger strategies in a repeated Hawk–Dove game. The situation becomes more precarious when we consider the following: 1.

2.

3.

4.

Military conflicts often take place not as a result of governments’ deliberate decisions, but because of accidental events, such as minor cross-border conflicts. Accidental factors may change the pay-off matrix, or the perception of it, drastically. This will increase the risk of uncalculated war. Psychologists find that people have the tendency to assign a smaller probability to events that they dislike, a phenomenon called “cognitive dissonance” (Festinger 1957). Governments tend to underestimate the probability of war and the resulting casualties triggered by their hawkish attitudes. Governments and voters may underestimate the cost of war. Even if they ever take into account the war expenditure, destruction of military capital, the grave human and health losses, and the destruction of physical capital resulting from a war, they may not fully take into account the economic loss caused by deteriorated trade relationships after the war. If a nation’s government is a coherent entity or an effective common agent of the voters, then the benefit–cost assessment of war as well the benefit–cost assessment of economic relations will be taken account in a balanced fashion. The reality is that economic bureaus and security

80


bureaus are operated rather independently of each other. The repercussion to one’s pay-off matrix by the other’s is often neglected by the presence of red tape and sectionalism. Historically, East Asia has enjoyed a common cultural heritage. Many nationals can communicate with each other, even though they do not speak foreign languages, by writing Chinese characters. Japan used coins made in China in the 16th century, and the yen itself is allegedly named after the Hong Kong dollar. Confucius’s teaching has long been a guiding principle of government in the East Asian countries. There are many focal elements that would facilitate coordination in the Asian basin. When Myerson (1991) introduces the possibility of good as well as grim equilibrium, he notices the necessity of the cooperative attitude. “Qualitatively, the more cooperative equilibria seem to involve a kind of reciprocal linkage (e.g., ‘expect me tomorrow to do what you do today’), whereas the more belligerent equilibria seem to involve a kind of extrapolative linkage (e.g., ‘expect me tomorrow to do what I do today’)” (Myerson 1991, p. 331). The first cooperative attitude is similar to Confucius’s Golden Rule, expressed in the Analects: “Do not do to others what you would not wish others do to you.” Diplomacy and clever politics must go beyond the difficulty pointed out by game theorists and endeavor to foster mutual trust to prevent the destructive consequences of a war.

3.6

CONCLUSION

On the grounds of economic reasoning alone, the case for financial integration and, in particular, for monetary integration is not decisive. East Asian nations’ calculus of participation does not give strong motivation for the creation of a common bond market, an integrated financial market, or a uniform currency area. Creating a common bond market may seem less painful and involves only a limited degree of commitment, unlike exchange rate coordination, which involves a certain degree of macro coordination and possibly the pooling of reserves. However, the true functioning of a common bond market still requires, we believe, the development of credit market infrastructures in most East Asian countries. Once we introduce strategic or security considerations, however, the situation changes drastically. This chapter is a tentative survey of the ongoing work in the field of economics and political science and an attempt to explore the importance of security considerations in the issue of monetary cooperation. It is meaningful to compare economic costs and benefits. But, at the same time, if we consider the tremendous human and material costs


81

generated by possible internal conflicts in the region, we need to consider seriously the mutual causality between economic integration and international conflicts. As an impetus for European countries to agree to implement first economic union and then monetary union, the repentance over the past military conflicts in Europe must have played an important role. This must be an important reason that Germany, an economic leader country whose central bank played a dominant role, agreed to give up some of its monetary hegemony in Europe.16 It may be the time to push forward economic and monetary integration in East Asia, not just in order to realize economic gains but also to prevent unfortunate military tragedies such as those seen during World War II. The following statement by Wim Duisenberg (2005), the founding President of the European Central Bank, well illustrates the intention for peace in Europe: European economic integration—in all its aspects—reflects the desire to integrate Europe politically, which, at least in my view, implies that European economic and monetary integration is irreversible. This has been true from the outset of the European integration process in 1952, when six countries established the European Coal and Steel Community (ECSC). The aim of the ECSC was explicitly political—to remove control of the two most important raw materials for the production of heavy weaponry from states that had just fought the bloodiest war in history. This drive for peace remained, quietly, the key motivation behind further steps toward Europe’s economic integration, which was regarded as the vehicle for achieving political integration. […] In particular, Germany under Chancellor Helmut Kohl often linked monetary integration with the objective of political union. Kohl once referred to the single currency’s success as a matter of “war and peace”.

NOTES 1.

The Asia Cooperation Dialogue (ACD), in its first meeting held in June 2002, agreed to set up a working group on financial cooperation in order to set guidelines for the development of Asian bond markets. The second ACD meeting of June 2003 adopted the Chiang Mai Declaration on the Asian Bond Market and the Asia Bond Fund Initiative. In June 2003, the Executives’ Meeting of East Asia-Pacific Central Banks (EMEAP) agreed to establish an Asian Bond Fund (ABF) of USD 1 billion, which was invested in US dollar denominated government bonds issued by Asian countries. In June 2006, the EMEAP central banks launched ABF2, which has invested USD 2 billion of EMEAP central bank reserves in local currency denominated sovereign and quasi-sovereign issues (see Ma and Remolona, Chapter 4 in this volume). In March 2003, the financial ministers of ASEAN13 agreed to create working groups to promote the Asian Bond Markets Initiative (ABMI) for the development of regional bond markets. In April 2003, the APEC convened its first meeting for the development of the Asian bond market and emphasized closer cooperation to achieve better supervision and information sharing. For details, see Ryou et al. (2005).

82 2. 3. 4. 5.

6. 7. 8. 9. 10. 11.

12.

13.

14.

15. 16.

The political economy of regional integration For the conceptual issues, see Ryou et al. (2005). See Cargill and Royama (1988) for the notions of negotiable forms and market forms of financial intermediation. For the contingent nature of financial instruments and its implications, see Allen and Gale (2000). Ito (2003) defines Asian bonds as bonds issued by Asian institutions (government, corporations, financial institutions), denominated in an Asian currency, and sold, traded, and settled in an Asian financial center (Tokyo, Singapore, Hong Kong). Investors are expected to be mainly from regional economies (in particular, Japan, Singapore, and Hong Kong), but others are also welcome. Hamada (2004) contains a more detailed account of the conceptual issues as well as the political economy aspects of economic and monetary integration. The term “monetary integration” or “monetary unification” encompasses varying degrees of integration, and it is usually used for the union of a group of countries and not for all countries of the world. For an attempt to analyze the nature of this cost saving, see Ryou (2003). Feldstein (1992) makes the case that monetary integration is not a necessary condition for the benefits of other forms of economic integration to be enjoyed. For details on the relevant literature, see Baldwin (2006). One view, held by the so-called “liberals”, is that increased economic interdependence among countries fosters peaceful political relations by generating economic benefits and increasing the costs of conflict. Critics of this view, the “realists”, argue that economic interdependence generates political discord, rather than fostering political cooperation, by intensifying competition between the states and by increasing dependence on strategic goods. Many others hold the view that economic interdependence has no systematic influence on politics, maintaining that conflicts originate mainly from the political arena. For a comprehensive survey, see Mansfield and Pollins (2001). Another example of a monetary union that disintegrated is the Scandinavian Monetary Union, which was formed between the neighboring Scandinavian countries of Sweden and Denmark in 1873. Norway joined the union in 1875. A common currency unit, the krone, which was based on gold, circulated as legal tender in member countries. The union was extended to cover note circulation when note-issuing banks in Norway and Sweden agreed to accept each other’s notes at par in 1894. Denmark joined this agreement in 1900. From 1905, the conditions of note circulation were amended to allow for a commission to be charged on foreign notes. Despite this added cost, the joint circulation of notes continued. In 1914, with the outbreak of World War I, the redemption of bank notes was suspended, and the monetary union effectively ended (Nielsen 1933). The West African Economic and Monetary Union (UEMOA, from its name in French) is the longest surviving monetary union today. France exercises direct influence over the affairs of the union through appointees to the Board of the Bank. France also exercises considerable indirect influence on individual members through concessive assistance and commercial links. Broughton (1991) suggested that UEMOA does not meet the conventional criteria for an optimal currency union. Its survival should be understood as a result of the parity between UEMOA’s CFA franc and the French franc and of the political leadership by France. If the two countries propose differently, then an agreement will not be reached. In this interpretation, the off-diagonal elements in the pay-off matrix will be (0, 0). If the use of one country’s money is imposed on the other country, then the situation will be a definite deterioration as expressed in the pay-off matrix. Consider the case of foreign direct investment. Investors will worry less about the possibility of hostage effect, or hold-up effect, for example. Some nationals might even have had psychological resistance to giving up the role of being the country that issued the dominant currency in Europe. See Jonas et al. (2005).


83

REFERENCES Alesina, Alberto F., and Robert J. Barro (2002). “Currency Unions.” Quarterly Journal of Economics 117: 409–36. Alesina, Alberto F., Robert J. Barro, and Silvana Tenreyro (2002). “Optimal Currency Areas.” NBER Working Paper no. 9072, National Bureau of Economic Research, Cambridge, MA. Allen, F., and D. Gale (2000). Comparing Financial Systems. Cambridge, MA: MIT Press. Axelrod, Robert (1981). “The Evolution of Cooperation.” Science 211 (4489): 1390–6. Baldwin, Richard E (2006). “The Euro’s Trade Effect.” ECB Working Paper no. 594, European Central Bank, Frankfurt. Broughton, J.M. (1991). “The CFA Franc Zone: Currency Union and Monetary Standard.” IMF Working Paper no. 91/133, International Monetary Fund, Washington, DC. Cargill, Thomas F., and Shoichi Royama (1988). The Transition of Finance in Japan and the United States. Stanford, CA: Hoover Institution Press. Corden, W. Max (1972). “Monetary Integration.” Essays in International Finance no. 93, Princeton University, Princeton, NJ. Duisenberg, Wim (2005). “Europe, An Engine of Peace.” www.project-syndicate. org/commentary/duisenberg2/English. Eichengreen, Barry (1998). “Exchange Rate Stability and Financial Stability.” Open Economies Review 9:S1: 569–607. Feldstein, Martin (1992). “The Case against EMU.” The Economist June 13: 19–22. Feldstein, Martin (1997). “EMU and International Conflict.” Foreign Affairs November–December 76 (6): 60–74. Feldstein, Martin (2000). “The European Central Bank and the Euro: The First Year.” Remarks prepared for presentation at the annual meeting of the American Economic Association, January 8. Festinger, Leon (1957). Theory of Cognitive Dissonance. Stanford, CA: Stanford University Press. Frankel, Jeffrey, and Andrew K. Rose (2002). “An Estimate of the Effect of Common Currencies on Trade and Income.” Quarterly Journal of Economics 117: 437–66. Fukuda, Shin-ichi, and Koichi Hamada (1987). “Towards Implementation of Desirable Rules of International Coordination and Intervention.” In Yoshio Suzuki and Mitsuaki Okabe (eds), Towards a World of Economic Stability. Tokyo: University of Tokyo Press. Gartzke, Eric, Quan Li, and Charles Boehmer (2001). “Investing in the Peace: Economic Interdependence and International Conflict.” International Organization 55: 391–438. Glick, Reuven, and Andrew K. Rose (2002). “Does a Currency Union Affect Trade? The Time-Series Evidence.” European Economic Review 46, 1125–51. Glick, Reuven, and Alan M. Taylor (2005). “Collateral Damage: Trade Disruption and the Economic Impact of War.” Working Paper 2005-11, FRB San Francisco, CA. Goto, Junichi (2002). “Economic Preconditions for Monetary Integration in East Asia.” Manuscript, Kobe University, Kobe, Japan.

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Goto, Junichi, and Koichi Hamada (1996). “Regional Economic Integration and Article XXIV of the GATT.” Economic Growth Center Discussion Paper no. 754, Yale University, New Haven, CT. Hamada, Koichi (1985). The Political Economy of International Monetary Interdependence. Cambridge, MA: MIT Press. Hamada, Koichi (2004). “A Calculus of Participation Approach to Monetary Integration in Asia.” Paper presented at the Seoul Conference of Korea Money and Finance Association. Ito, Takatoshi (2003). “Construction of Infrastructures for the Development of Regional Bond Market.” In Choong-Yong Ahn, Takatoshi Ito, Masahiro Kawai, and Yung-Chul Park (eds), Financial Development and Integration in East Asia. Seoul: Korea Institute for International Economic Policy. Jonas, Eva, Immo Fritsche, and Jeff Greenberg (2005). “Currencies as Cultural Symbols—An Existential Psychological Perspective on Reactions of Germans Toward the Euro.” Journal of Economic Psychology 26: 129–46. Kenen, Peter (1992). EMU After Maastricht, Washington, DC. Group of Thirty. Kuroda, Haruhiko (2003). “Overview of Financial and Monetary Cooperation in East Asia.” In Choong-Yong Ahn, Takatoshi Ito, Masahiro Kawai, and YungChul Park (eds), Financial Development and Integration in East Asia. Seoul: Korea Institute for International Economic Policy. Mansfield, Edward, and Brian Pollins (2001). “The Study of Interdependence and Conflict: Recent Advances, Open Questions, and Directions for Future Research.” Journal of Conflict Resolution 45: 834–59. McKinnon, Ronald (1963). “Optimum Currency Areas.” American Economic Review 53: 712–24. Mundell, Robert A. (1968). International Economics. New York: Macmillan. Myerson, Roger B. (1991). Game Theory: Analysis of Conflict. Cambridge, MA: Harvard University Press. Nielsen, A. (1933). “Monetary Union.” Encyclopedia of Social Science, Vol. 10. New York: Macmillan. Oneal, John R., and Bruce M. Russett (1997). “The Classical Liberals Were Right: Democracy, Interdependence, and Conflict, 1950–1985.” International Studies Quarterly 41: 267–93. Rose, Andrew K., and Charles Engel (2002). “Currency Unions and International Integration.” Journal of Money, Credit, and Banking 34: 1067–89. Ryou, Jai-Won (2003). “Transaction Costs and Welfare Effects of Currency Unions.” Manuscript, Konkuk University, Seoul. Ryou, Jai-Won, Koichi Hamada, and Seung-Cheol Jeon (2005). “The Asian Bond Market: Issues and Tasks for Financial Cooperation in Northeast Asia.” In Bank of Korea (ed.), Northeast Asian Economic Cooperation and the Korean Economy. Seoul: Bank of Korea, pp. 21–63. Takagi, Shinji (2002). “Fostering Capital Markets in a Bank-based Financial System: A Review of Major Conceptual Issues.” Asian Development Review 19: 67–97.

PART II

Developing bond markets in East Asia

4.

Learning by doing in market reform: lessons from a regional bond fund Guonan Ma and Eli Remolona1

4.1

INTRODUCTION

Since the Asian crisis of 1997, local currency bond markets in the region have expanded rapidly; even so, they are still seen as not achieving their potential to intermediate between domestic savers and borrowers. Capital flows since the crisis show that Asians have been investing largely in lowyielding foreign assets and foreigners in higher-yielding Asian assets. While some of these flows are consistent with portfolio diversification, the broad pattern suggests that a sizeable part of financial intermediation is being carried out abroad at significant cost. To bring such intermediation home, Asian policymakers perceive a need for deeper and more liquid local bond markets. This perception has spawned a number of regional cooperative efforts at market reform. In this chapter, we assess one such undertaking—an unusual one in that it involved the creation of an actual bond fund, with financial contributions from the parties concerned. The regional group involved is the Executives’ Meeting of East Asia and Pacific (EMEAP) central banks.2 The fund they have created is called the Asian Bond Fund 2 (ABF2) which was first launched in mid-2005. We argue that because the group set up an actual fund, its reform efforts enjoyed significant advantages from “learning by doing”. In what follows, we first provide an overview of the recent development of local currency bond markets in East Asia and describe the main impediments in those markets. We then explain the structure and features of ABF2 in the context of various regional initiatives for bond market development. Finally, we comment on the role of the ABF2 exercise in the reform of bond market regulation, providing examples of market impediments that have been reduced in the process of creating the fund and describing the mechanism put in place to provide incentives for reducing impediments further. 87

88

4.2


AN OVERVIEW OF LOCAL CURRENCY BOND MARKETS IN EAST ASIA

In the wake of the Asian crisis of 1997, there was concern at first that the lack of well-developed local currency markets was forcing Asians to borrow in foreign currencies, thus making their economies more vulnerable to a speculative currency attack. Since then, however, governments in the region have accumulated such high levels of foreign exchange reserves that the risk of another currency crisis has ceased to be an immediate concern. Of greater interest to policymakers in the region has been the concern that their stockpiles of official reserves may be a sign of inefficient domestic intermediation, since the reserve assets seem to have been earning much less than what Asians pay when borrowing abroad. McCauley (2003) documents that the broad pattern of gross capital flows since the Asian crisis has indeed been one of Asians investing in lowyielding foreign assets and foreigners investing in higher-yielding assets in the domestic markets of the region. Part of the reason for this pattern is the fact that foreign exchange intervention has resulted in a large accumulation of reserves by central banks, and these institutions by their nature have a safety bias (rather than a home bias). In effect, Asian savings are being sent abroad only to return mostly in the form of private sector foreign investment. Thus, financial intermediation is being carried out in the more developed financial markets of Europe and North America, and the cost of intermediation is reflected in the large differences in returns between Asian assets abroad and foreign assets in Asia. In principle, the importance of local information should lead to such intermediation being done at home. If local currency bond markets in Asia functioned as intended, Asian policymakers now seem to be asking, could they not keep such intermediation at home and in the process save their economies some of the borrowing costs? The Asian crisis did have economic consequences that themselves added impetus to the development of local currency bond markets in the region. As economies contracted, governments in the region found themselves faced with budget deficits. Huge levels of funding were needed for largescale bank restructuring. And this time, the governments in the region made an effort to eschew borrowing abroad, instead borrowing locally in local currencies. As a result, the total amount of domestic debt outstanding in East Asia, excluding Japan, has risen nearly threefold since 1998 (Figure 4.1).3 Hence, to the extent that the sheer volume of debt helps contribute to financial market development, the Asian crisis has contributed to the development of local currency bond markets in the region. Other factors, however, seem to continue to hold back these local

Learning by doing in market reform

89 1800

Total Private*

1600 1400 1200 1000 800 600 400 200

1998

1999

2000

2001

2002

2003

2004

2005

2006

0

Note: “Asia” includes the bond markets of the eight EMEAP members: China, Hong Kong, Indonesia, Malaysia, the Philippines, Singapore, Korea and Thailand. *Excluding the Philippines. Source:

Bank for International Settlements.

Figure 4.1

Domestic debt securities outstanding in Asia (in billions of US dollars)

markets. While the strength of issuance has been beneficial to the primary markets, the secondary markets still suffer from a lack of liquidity. A number of market impediments, both cross-border and local, remain. Takeuchi (2004) provides a survey of cross-border impediments in Asia. While most of these cross-border impediments are well known in the literature on capital controls, some local impediments have been relatively less well appreciated and thus have received insufficient attention. Capital controls typically include a ban on investments by foreigners or on repatriation of principal or income on these investments, restrictions on currency conversion, and other prohibitions and regulatory hurdles for both issuers and investors. There is evidence that such controls still bind in Asia. Ma and McCauley (2006), for example, show that there is still not sufficient arbitrage to equalize onshore and offshore yields in various Asian money markets. Specific examples include tight foreign exchange conversion rules associated with China’s “qualified foreign institutional investor” scheme governing foreign portfolio inflows, Indonesian restrictions on domestic banks purchasing local currency instruments from non-resident issuers, Korea’s ceiling on resident investment in overseas securities and properties, restrictions on foreign investors purchasing foreign currency from the local banking system in the Philippines, and Thailand’s limits on domestic banks’ local-currency lending to non-residents.

90


Local market impediments may take the forms of taxes, insufficient market development, and an inadequate clearing and settlement infrastructure. Withholding taxes and taxes on financial transactions remain a major cost to non-resident investors in some of the local markets. Within EMEAP, some jurisdictions exempt only non-resident investors, and some do so only for certain instruments. Insufficient market development, such as the lack of a broad and diversified bond investor base, issuers and products, is not conducive to liquidity. The lack of an independent and competent rating industry and more consistent rating standards is a barrier to more efficient pricing of credits. In many cases, inadequate disclosure requirements, weak accounting standards, and insufficient creditor rights protection add to the impediment list. For deep and liquid markets in Asia, Jiang and McCauley (2004) identify as essential such factors as market size, the diversity of the investor base, and the availability of hedging instruments. Inadequate custody, clearing, and settlement facilities also hamper bond market development. In most Asian bond markets, it is still rather cumbersome and sometimes impossible to clear and settle cross-border bond transactions.

4.3

REGIONAL COOPERATIVE INITIATIVES AND THE ABF PROJECT

East Asia has seen several initiatives in regional cooperation to develop domestic bond markets. One focus of the various regional initiatives has been to open up domestic markets to foreign portfolio investment by removing both local and cross-border impediments. Among these initiatives, only the ABF2 effort involves actually setting up funds to invest in the local currency markets. We argue in this section that this unusual approach leads regulators to encounter impediments in their actual operations of establishing bond funds so as to make it an effective mechanism for regulatory reform. In principle, private investors could have also lobbied for reforms as they set up investment funds. However, market reform is a public good in the sense that the benefits are enjoyed by many investors. Individually, investors would be unwilling to bear the costs of lobbying fully for such reforms, because they would not be able to keep the benefits to themselves. At least three major government-sponsored regional organizations in Asia are pursuing initiatives to promote financial development in the region (Battellino 2004). First, under the banner of the Asia-Pacific Economic Cooperation (APEC) forum,4 the tripartite structure of the PECC (Pacific Economic Cooperation Council) brings together many of


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the initiatives of government, business, and academe. One such initiative is focusing on the development of securitization and credit guarantees. Second, within the Association of South East Asian Nations Plus Three (ASEAN13) framework,5 six working groups have been set up to address a broad range of issues related to local bond markets in Asia. These issues comprise securitized debt instruments, credit guarantee mechanisms, foreign exchange transactions and settlements, local currency issuance by multinational corporations, local and regional credit rating agencies, and coordinated technical assistance. The third organization consists of the EMEAP central banks, which have been behind the setting-up of the Asian bond funds (ABFs). The initiatives of these three regional organizations tend to complement each other. For example, under ASEAN13 the Asian Bond Market Initiative has helped secure approval from four countries to allow multilateral development institutions to issue bonds in their local currencies. The Asian Development Bank (ADB), the International Finance Corporation (IFC), and the World Bank have already taken advantage of this by each issuing bonds denominated in Malaysian ringgit and Chinese renminbi.6 The ADB has also issued in Thai bahts and Philippine pesos.7 Hence, these actions are adding to the supply of paper in the local bond markets, while the ABF2 exercise is adding to the demand for this paper. The ABF exercises are the first initiatives in which a regional organization has contributed financial resources to setting up actual bond funds in Asia. In June 2003, the EMEAP central banks launched the first fund, the Asian Bond Fund 1 (ABF1), pooling USD 1 billion in international reserves from the 11 central banks and investing in US dollar denominated bonds issued by sovereign and quasi-sovereign borrowers in eight of the EMEAP economies.8 By design, ABF1 was set up to be restricted to EMEAP central bank investment only and thus would not be open to other investors. Nonetheless, it was the first regional pooling of international reserves in Asia. In June 2005, the EMEAP central banks launched the second fund, the Asian Bond Fund 2 (ABF2), which has invested USD 2 billion of EMEAP central bank reserves in local currency denominated sovereign and quasi-sovereign issues in the same eight EMEAP markets.9

4.4

CONCERTED “LEARNING BY DOING”: THE ABF2 EXERCISE

As mentioned, the ABF2 initiative differs from the others in that it involves the actual creation of local currency bond funds. The earlier ABF1 had limited itself to dollar-denominated issues that are mostly traded in more

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Developing bond markets in East Asia USD 1 billion USD 1 billion

EMEAP’s Investment in ABF2

Pan-Asian Bond Index Fund (PAIF)

8 single-country funds Local currency bond markets

China fund

Hong Kong fund

China markets

Hong Kong market

Indonesia fund

Jakarta market

Korea fund

Seoul market

Malaysia fund

Kuala Lumpur market

Philippines fund

Manila market

Singapore fund

Singapore market

Thailand fund

Bangkok market

Figure 4.2 ABF2 structure

developed international bond markets. Nonetheless, that first fund was important because it afforded the EMEAP central banks an opportunity to work together to build trust so as to foster cooperation and to further develop financial markets in the region (Leung 2006). ABF2 is actually nine separate funds: a Pan-Asian Bond Index Fund (PAIF) and eight single-market funds (Figure 4.2). The PAIF is a singleindex bond fund investing in sovereign and quasi-sovereign domestic currency denominated bonds issued in the eight EMEAP markets. The PAIF will be quoted in US dollars on an unhedged basis (for more details about the structure of the PAIF, see section 4.5 below). The eight single-market funds will each invest in the respective local currency bond market. Each of the nine funds will replicate a bond index provided by a third party, the International Index Company (IIC), which has been a major participant in developing the highly successful credit default swap (CDS) indices in Europe and North America.10 All eight single markets funds have been registered locally in their own markets. Private sector fund managers have been designated to individually manage the PAIF and the single-market funds. The mandate of each fund manager is then to try to replicate the relevant index and manage the fund passively. ABF2 has been proceeding in two phases. In Phase 1, investments in both the PAIF and the single-market funds are confined to the international reserves of the 11 EMEAP central banks, with a total sum of USD 2 billion. The EMEAP announced the formal launch of Phase 1 of ABF2 in June 2005. In Phase 2, through public offerings, the PAIF and the eight single-market funds will be gradually opened up to other institutional and retail investors, both within and without the EMEAP region.


Table 4.1

93

Cumulative growth of the ABF2 funds open to non-EMEAP investors

Funds PAIF Hong Kong Bond Index Fund Malaysia Bond Index Fund Philippine Bond Index Fund Singapore Bond Index Fund Thailand Bond Index Fund

Fund size (USD million)

Growth since inception (%)

1156 214 125 57 220 121

14 55 26 3 35 20

Note: As of April 30, 2006, fund size is measured as net asset value, while growth is based on the number of fund units. The IPO dates vary across different funds. Source:

Bloomberg.

The pace and timing of the opening of these nine bond funds could vary across jurisdictions. Between the formal launch of ABF2 in June 2005 and the time of writing, six of the nine ABF funds have opened to the public. They are the PAIF, Hong Kong Bond Index Fund, Malaysia Bond Index Fund, Philippine Bond Index Fund, Singapore Bond Index Fund, and Thailand Bond Index Fund. Some of the remaining three single market funds are expected to be offered publicly in the near future. Undertaking the project in phases has allowed the central banks to identify market impediments in stages and deal with them on a realistic schedule. As more ABF2 funds became available to the public, the total size of the ABF2 funds, including both the USD 2 billion EMEAP seed money and new non-EMEAP investments, increased to USD 2.47 billion as of April 2006. Since their respective listings, the growth of individual funds has varied noticeably, ranging from a rise of 3 percent to above 50 percent (Table 4.1). Part of the reason for the differences is the different timing of their initial public listings. For instance, the Hong Kong Bond Index Fund was listed in June 2005, while the listing of the Philippine Bond Index Fund took place only in late April 2006. Still, these developments suggest reasonable market demand for Asian local currency index bond funds, with the size of the Philippine fund in particular more than doubling since inception. The advantage of creating actual funds in the process of trying to reform markets is that an important element of “learning by doing” is introduced. Informal conversations with the key individuals involved suggest that in

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setting up ABF2 the EMEAP central banks encountered myriad market impediments, many of them seemingly small but each one critical to the operation of the funds. Even when these officials had been aware of the impediments before the exercise, they found some of them to be more significant than initially thought. By undertaking the initiative as a group, the EMEAP central banks improved their understanding of specific impediments in their local bond markets and came up with ways to overcome them. Seeing that the authorities in neighboring jurisdictions had already instituted certain market reforms encouraged the relevant authorities to “fast-track” their own initiatives. Often the central bank officials worked with their counterparts at the finance ministry or the securities regulator to deal with the impediments. Recognizing that their job is far from complete, the central banks have also agreed on an incentive mechanism for further reducing market impediments. In particular, the scheme for allocating the portfolio to the various local markets will take market impediments into account: the portfolio weight in ABF2 for an individual market rises as cross-border and local market impediments in that market are removed (see section 4.7 for a more detailed discussion).

4.5

DESIGNING A LIQUID PAN-ASIAN BOND INDEX FUND11

The Pan-Asian Bond Index Fund (PAIF) is designed to allow institutional and retail investors to gain access to Asia’s local bond markets in a simple and transparent manner. The main challenge was to ensure that investors benefit from the lower transaction costs associated with passively tracking a regional index rather than active management of a portfolio. The specific index is the iBoxx Pan Asia Index, which is constructed to be transparent and to comprehensively cover the eight local Asian bond markets. The index will be quoted in US dollars on an unhedged basis. In practice, the fund will replicate the index closely by holding a selected set of issues rather than all the constituents of the index. Such fund management, however, requires an infrastructure of risk management and analysis of risk factors (Cheung 2006). The fund’s regional scope meant that there was no natural domicile for it in any of the EMEAP jurisdictions. Tax, legal, operational, and marketing considerations suggested that a Singapore-based unit trust listed on the Hong Kong Stock Exchange would offer the best option for all investors, and this is how it was established. The fund is open-ended as well as exchange-listed. Hence, investors are


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Investors Buying and selling

Buying and selling

Stock exchange

Participating dealers

Subscription and redemption

Liquidity Arbitrage

PAIF trustee

Market-makers

Primary market

Secondary market

Figure 4.3

Two ways to trade the PAIF

able to trade the PAIF in two ways. First, as shown in Figure 4.3, investors can go to fund trustees through dealers to buy or redeem units at that day’s closing net asset value, thus engaging in a transaction in the “primary market”. Second, they can buy or sell units on the stock exchange, thus trading in the “secondary market”. As has been the case with other funds previously launched in the region, there are some restrictions on trading PAIF units in the primary market so as to concentrate liquidity in the secondary market. Nonetheless, the primary market continues to provide an important means for arbitrage to ensure that secondary market prices stay in line with the fund’s net asset value. In the primary market, the PAIF follows the “participating dealer model”. This model limits daily subscriptions and redemptions only to dealers who have signed an agreement with the fund manager. To help the manager deal with cash inflows and outflows, the participating dealers may only transact a minimum size. For cash transactions, there is a limit on the total daily volumes, and the manager charges a dilution fee. The limit is waived if transactions are in exchange of a basket of bonds. These transactions are known as “in-kind” subscriptions or redemptions. The “in-kind” facility makes the PAIF similar to an exchange-traded fund (ETF), the main difference being that in-kind dealing is more formalized with an ETF. In the secondary market, the fund manager has appointed marketmakers to provide liquidity in the trading of units on the stock exchange. The market-makers are expected to maintain tight bid and offer quotes on

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the exchange and to seize arbitrage opportunities by closely monitoring the fund’s net asset value and comparing it with the prices on the exchange. To help them provide liquidity, the market-makers have priority in the primary market for trades up to a specified limit per day, and they may borrow fund units from institutional investors. The opening of the PAIF to the public took place at the end of June 2005. Before listing the fund on the exchange, a unit trust was set up by the EMEAP central banks with an “in-kind” transfer of the equivalent of around USD 1 billion in local currency bonds, which was purchased during Phase 1 of ABF2. The fund may be further enlarged through private placements by institutional investors, participating dealers, and market-makers. It has been listed to allow all other investors to acquire the units on the secondary market. This strategy is expected to keep costs low and avoid the volatility usually associated with a sale-driven initial public offering. From then on, listings on other EMEAP stock exchanges will be considered, depending on demand from local investors and on whether local regulatory rules permit it. Once listed, the PAIF became the first low-cost, passively managed investment fund invested in the eight EMEAP local bond markets. These features should potentially make the PAIF attractive in the long term to pension funds and retirement accounts seeking opportunities for diversification and favorable long-term returns.

4.6

MARKET IMPEDIMENTS ALREADY REDUCED

For such relatively small sums, the ABF2 initiative has apparently been unusually effective in promoting the reform of local bond markets.12 Because of the other initiatives that are also under way, it is always difficult to attribute regulatory changes to the ABF2 effort alone. Nonetheless, many of the participants feel that the effort has made a significant difference. In this section, we can provide only a few illustrative examples of reductions in impediments. The most apparent area for reform has been in capital controls. Malaysia, for example, has announced measures to liberalize its foreign exchange market, so that it has now essentially restored the regime that was in place before it imposed capital controls during the Asian crisis. The Malaysian authorities have lifted all restrictions on non-resident hedging activities. Companies controlled by non-residents now enjoy full access to onshore ringgit credit facilities. Residents without domestic ringgit borrowing can freely invest abroad. Finally, the Malaysians have permitted multilateral agencies to issue local currency bonds in the domestic


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market and allowed these non-resident issuers to hedge exchange risks with onshore banks. Korea has also recently announced a series of measures to further liberalize foreign exchange regulations. The limit on won borrowing by foreign investors has been lifted from KRW 1 billion previously to KRW 10 billion. Moreover, Korean residents are now allowed to invest in overseas property up to USD 1 million. In China, the investment quota on portfolio inflows by qualified foreign institutional investors has been raised from the initial USD 2 billion in 2003 to nearly USD 7 billion as of May 2006. Measures have been announced to allow Chinese residents to invest in overseas securities, subject to some quota. China’s active participation in ABF2 also bodes well for the country’s willingness to simplify its still extensive regulations on cross-border portfolio investment and to lower hurdles for the still fragmented domestic bond markets regulated by multiple authorities. In fact, the PAIF is the first foreign institutional investor that has been given direct access to the Chinese interbank bond market.13 Withholding taxes and other taxes are another area of reform. Thailand has already granted non-resident investors withholding tax exemption for income from investing in baht-denominated government bonds and, in most cases, government-guaranteed bonds in the domestic market. Malaysia has also announced the exemption of non-resident investors from the withholding tax on the interest income received from investment in ringgit-denominated debt securities onshore. In Korea, the withholding tax on interest incomes that foreign investors earn on local currency bonds has been reduced. So far, five of the eight EMEAP member markets have either implemented or offered exemption from the withholding tax to nonresidents investing in local currency sovereign or quasi-sovereign issues. In the Philippines, the documentary stamp duty on bond trading will be removed with the introduction of the Philippine single-market fund. One unexpected area of reform has been the legal accommodation of national jurisdictions, so that a fund domiciled in one jurisdiction may be sold in another. The PAIF, for example, is to be domiciled in Singapore to take advantage of a host of factors including bilateral tax agreements between Singapore and the other EMEAP members. However, it will be initially listed in Hong Kong, in part to take advantage of the high degree of liquidity and depth in that market. This combination is the first ever in Asia, demanding a significant learning effort on the part of each regulatory authority.14 To make the fund possible, the participating central banks and the regulatory authorities concerned needed to cooperate in reconciling divergent regulatory frameworks. Direct participation in local currency bond markets by the EMEAP central banks has thus helped them to

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further identify, understand the details of, and gauge the importance of market impediments as well as to better appreciate the diversity of each other’s regulatory frameworks. This appreciation should in turn set the stage for further streamlining of market regulation in the region.

4.7

INCENTIVES TO FURTHER REDUCE IMPEDIMENTS

The central banks involved in ABF2 have devised a mechanism to provide incentives to further reduce impediments in their own local bond markets. These incentives are built into the determination of the market weights in the portfolio of the PAIF and the single-market funds. As the assigned weight on a particular market increases, a larger portion of the investments into these index bond funds will be allocated to that market. Determining the Market Weights in ABF The portfolio allocations of the PAIF and the initial EMEAP investment in the eight single-market funds will be determined in large part by market weights that take account of various factors. There are specifically four such factors: the size of the local market, the turnover ratio in that market, the sovereign credit rating,15 and a market openness factor. Starting from an equal allocation for each local market, the allocation will be adjusted to take account of these four factors. The allocation for a given market will be adjusted upwards if the adjustment factors score better than the averages for the eight markets. In the adjustment, market size, turnover ratio, and credit rating will each carry a 20 percent weight. The greatest part of the adjustment will be determined by the market openness factor, which will be assigned a 40 percent weight. The Market Openness Factor IIC, the company generally responsible for the bond market indices to be replicated by the nine ABF2 funds, has constructed a “qualitative factor that gauges the relative openness of the eight markets” (IIC, 2005a). This factor is measured by a so-called “impediments index” (Table 4.2): the fewer the impediments present, the better the openness factor would score. In creating the index, IIC consulted with a “number of international and domestic market participants through its Asian Index Committee and Asian Oversight Committee, as a means to help ensure the credibility and market acceptance of the indices” (EMEAP 2005).


99

Table 4.2

Five sub-factors of the impediments index

Sub-factors

Description

Regulatory environment

Degree of investor protection and freedom of action, such as restrictions on foreign investments, currency and capital controls, etc. Legal restrictions or laws discriminating against specific investor classes, corporate governance Tax treatment and other monetary duties State of development of the local capital market and its influence on asset management Degree of sophistication and competition in back office functionalities such as settlement, custody, etc.

Legal environment Fiscal environment Market infrastructure Clearing and settlement infrastructure

Note: The higher the score of each sub-factor, the fewer the market impediments present. These scores are derived from polls among members of the iBoxx Asian Index Committee. The impediments index is a weighted average of the five sub-factors. Source:

International Index Company (2005a, 2005b).

Any assessment of market openness might be expected to take account of such considerations as the absence of capital controls, the level of withholding taxes, the availability of hedging instruments, the facilities for real-time gross settlement, and the ability to clear local bonds internationally. The higher the market openness factor assigned for a given market, the more the portfolio allocation is adjusted in favor of that market. The country weights, and thus the market openness factor, will be reviewed every September. As impediments are removed, the changes can be expected to be reflected in a rebalancing of the regional portfolio. In constructing the market openness factor, the iBoxx Asian Index Committee will treat the regulatory environment as the most important consideration. This sub-factor, which includes capital controls and provisions for investor protection, will alone account for 25 percent of the openness score. Notably, the two considerations that have been most neglected in the academic literature—market infrastructure and the payment system—will together receive a weight of 37.5 percent. The legal and fiscal environments will account for the remaining 37.5 percent. An Illustration Figure 4.4 shows the effects of such weight adjustments. It compares the weights based on raw market capitalization data and the adjusted weights in the PAIF portfolio at the time of launch. The allocation after

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Developing bond markets in East Asia A. Market weights based on raw capitalization data

B. Market weights based on the iBoxx PAIF index

Thailand Singapore Thailand

Philippines Malaysia

China

China

Singapore

Hong Kong

Philippines

Indonesia

Hong Kong Korea

Note: Source:

Indonesia

Malaysia Korea

Weights add up to 100% in total. International Index Company.

Figure 4.4

Market weights for the Asian Bond Fund

adjustments differs considerably from the weights on the basis of raw market capitalization data. The allocations in the PAIF to China and Korea fall noticeably below their capitalization-based weights, while the remaining six markets gain. In particular, the Hong Kong and Singapore allocations rise more than fourfold. There are at least two ways in which the ABF2 indices will help the development of Asian local currency bond markets. First, they provide a dynamic mechanism to encourage the eight EMEAP members to continue their efforts at market liberalization. As discussed above, market openness is the single most important adjustment factor in the allocation weights, and these will be reviewed annually. As new market liberalization measures are introduced, the market openness factor would score better, thus increasing the weights on the market in question. Second, the improved transparency, replicability, and credibility of these market indices will provide the kinds of benchmarks that have proven useful elsewhere for the development of markets in corporate bonds.

4.8

CONCLUSION

The ABF2 initiative is a regional cooperative effort aimed at fostering local currency bond markets in Asia. It differs from other such efforts in that it


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involved actually setting up bond funds. Hence, it contains an important element of “learning by doing”, which has enabled EMEAP to identify in detail significant market impediments that had not been well appreciated before. The process has already helped ease various market impediments, both cross-border and local. The exercise also provides incentives to further reduce market impediments. An important test for the exercise will be whether it sets the stage for the development of local currency markets in corporate bonds. Already, ABF2 is bringing new instruments to the local markets. As a listed openended index fund, the PAIF is a relatively low-cost, low-denomination, and transparent fund, which would be potentially appealing to a broad spectrum of institutional and retail investors. Thus, the PAIF may help broaden both the investment menu and the investor base. The ABF may help explore the potential role of ETFs. As of April 2006, six of the eight single-market funds have been exchange-listed.16 China is currently working its own single-market fund to be an ETF in the second phase of ABF2. The introduction of these funds along with a set of transparent and replicable benchmark indices for Asian local currency bond markets may facilitate the development of other fixed income and derivative products, including corporate bonds and credit default swaps.

NOTES 1.

2.

3. 4.

5. 6.

We thank Claudio Borio, Norman Chan, Guy Debelle, Már Gudmundsson, Robert McCauley, Frank Packer, Sakkapopp Panyanukul, Ramona Santiago, Atsushi Takeuchi, Philip Wooldridge, and Sunny Yung for helpful discussions. We have also benefited from the comments and suggestions of participants at the HWWA/ HWWI Conference on East Asian Monetary and Financial Integration in Hamburg in December 2005. The views expressed here are those of the authors and do not necessarily reflect those of the Bank for International Settlements. The 11 EMEAP central banks and monetary authorities are the Reserve Bank of Australia, People’s Bank of China, Hong Kong Monetary Authority, Bank Indonesia, Bank of Japan, Bank of Korea, Bank Negara Malaysia, Reserve Bank of New Zealand, Bangko Sentral ng Pilipinas, Monetary Authority of Singapore, and Bank of Thailand. For a review of bond market development since the 1997 crisis, see Committee on the Global Financial System (1999), McCauley and Remolona (2000), Jiang and McCauley (2004), Battellino (2004), and Sheng (2005). APEC has 21 member economies: Australia, Brunei Darussalam, Canada, Chile, China, Hong Kong SAR, Indonesia, Japan, Korea, Malaysia, Mexico, New Zealand, Papua New Guinea, Peru, the Philippines, Russia, Singapore, Taiwan (China), Thailand, the United States, and Vietnam. The members of ASEAN are Brunei Darussalam, Cambodia, Indonesia, Laos, Malaysia, Myanmar, the Philippines, Singapore, Thailand, and Vietnam. The “13” are China, Japan, and Korea. There have been four issues of supranational local currency bonds in Malaysia since late 2004: MYR 400 million by the ADB, MYR 500 million by the IFC, and MYR

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7. 8. 9. 10.

11. 12. 13. 14. 15. 16.

Developing bond markets in East Asia 760 million by the World Bank. The ADB issue in Thailand in 2005 amounted to THB 4 billion. The ADB came back to Malaysia for a second ringgit offering of MYR 500 million in 2006. In China, IFC and ADB issued so-called panda bonds worth RMB 1.13 billion and RMB 1 billion in 2005. ADB issued PHP 2.5 billion and THB 4 billion bonds, respectively, in the Philippines and Thailand in 2005. The three EMEAP countries in which the ABFs will not invest are Australia, Japan, and New Zealand. The Bank for International Settlements (BIS) acts as manager for ABF1 and as administrator for ABF2. CDS indices are now the most actively traded instruments in credit markets. The main CDS index for Europe is DJ iTraxx and for North America DJ CDX. Both are the result of a merger between two competing families, Trac-x and iBoxx. See Amato and Gyntelberg (2005). This section draws heavily from a box written by Pierre Cardon in Ma and Remolona (2005). In this respect, the small sums involved help in that they avoid the problem of a passive investor taking away from the market too much of the available volume of tradable instruments. Previously, qualified foreign institutional investors were allowed to directly invest in bonds and stocks traded on the smaller Shanghai Stock Exchange and Shenzhen Stock Exchange. In the future, the PAIF may be listed in another market in the region, and some of the eight single-market funds could be managed in jurisdictions other than those where they are registered and listed. Local currency long-term debt ratings of the three international rating agencies (Fitch, Moody’s, and Standard & Poor’s) are applied. The PAIF, and the single-market funds of Hong Kong, Singapore, Malaysia, Thailand and the Philippines.

REFERENCES Amato, Jeffrey D., and Jacob Gyntelberg (2005). “CDS Index Tranches and the Pricing of Credit Risk Correlations.” BIS Quarterly Review March: 73–87. Battellino, Ric (2004). “Recent Developments in Asian Bond Markets.” Speech given at the 17th Australian Finance and Banking Conference, December. Cheung, Hon (2006). “The ABF2 Funds: Pushing the Frontiers in Asian Bonds.” Asiamoney May: 36–41. Committee on the Global Financial System (1999). How Should We Design Deep and Liquid Markets? The Case of Government Securities, October. Basel: CGFS. Executives’ Meeting of East Asia and Pacific Central Banks (2005). “The Asian Bond Fund 2 Has Moved Into Implementation Phase.” www.emeap.org/ press//12May05.htm. International Index Company (2005a). “iBoxx ABF Index Family Guide, Version 2.0, April.” www.indexco.com/news/Attach/DM73/iBoxx_ABF_IndexGuide. pdf. International Index Company (2005b). “iBoxx ABF Bond Indices Launched.” www.indexco.com/news/Attach/DM74/iBoxx_ABF2_BondIndices.pdf. Jiang, Guorong, and Robert N. McCauley (2004). “Asian Local Currency Bond Markets.” BIS Quarterly Review June: 67–79.


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Leung, Julia (2006). “Developing Bond Markets in Asia: Experience With ABF2.” BIS Papers No. 26, “Develop Corporate Bond Markets in Asia”, March: 74–9. Ma, Guonan, and Robert N. McCauley (2006). “Are China’s Capital Controls Still Binding.” Paper presented at the Seoul National University/Korea International Economic Policy Institute Conference “China and Emerging Asia: Reorganising the Global Economy”, Seoul, May. Ma, Guonan, and Eli M. Remolona (2005). “Opening Markets Through a Regional Bond Fund: Lessons from ABF2.” BIS Quarterly Review June: 81–92. McCauley, Robert N (2003). “Capital Flows in East Asia Since the 1997 Crisis.” BIS Quarterly Review June: 41–55. McCauley, Robert N., and Eli M. Remolona (2000). “Size and Liquidity of Government Bond Markets.” BIS Quarterly Review November: 52–8. Sheng, Andrew (2005). “Corporate Debt in Asia and Asian Financial Market Development.” Speech given at the conference on Advancing East Asian Integration, March 3–4. Takeuchi, Atsushi (2004). “Study of Impediments to Cross-border Investment and Issuance in Asian Countries.” Interim Report for the ASEAN13 Asian Bond Market Initiative, November.

5.

Currency denomination in Asian bond markets Eiji Ogawa and Junko Shimizu1

5.1

INTRODUCTION

One of the main features of financial crises, especially those that occurred in the 1990s around the world, is that they tend to spill over from one country to neighboring countries. This was the case during the Asian currency crisis of 1997–98, when contagion throughout the regional economies was fuelled by strong trade linkages among the East Asian countries. The Asian currency crisis brought about a strong awareness of the necessity for regional cooperation, and, accordingly, several policy proposals have been developed for the strengthening of regional financial cooperation. Kuroda and Kawai (2003) proposed a more effective surveillance process and considered the option of creating a common pool of foreign exchange reserves in order to allow flexible financial support during times of crisis and contagion, which would also reduce the problem of moral hazard. The monetary authorities in East Asian countries in 2000 established, and recently have augmented, the Chiang Mai Initiative, a swap agreement meant to prevent future currency and financial crises by boosting short-term liquidity.2 One approach to strengthening regional financial markets and avoiding future financial crises in East Asia that we feel deserves more investigation is the call for a more efficient regional bond market. Ever since the Asian currency crisis, East Asian monetary authorities have recognized the underlying problems caused by a double overdependence on the banking sector in their financial systems on the one hand and on the US dollar in their currency systems on the other hand. Even though there is an abundance of both savings and profitable investment opportunities in East Asian emerging market countries, the inefficiency with which savings and investments are matched within East Asia through regional financial markets has proven to be a problem. East Asian debtors (but also creditors) have been facing foreign exchange risks because they are only able to denominate liabilities (or assets, respectively) in foreign currency 104

Currency denomination in Asian bond markets

105

when they borrow (or lend) internationally. The establishment and development of regional bond markets in East Asia has been proposed in order to directly circulate regional savings into regional investments (Ito 2004, Ito and Park 2004). In addition, the possibilities of introducing a common currency basket unit and even a common currency in East Asia have been discussed.3 The monetary authorities of East Asian countries have already started promoting the development of regional bond markets through various initiatives such as the EMEAP’s Asian Bond Fund4 and ASEAN13’s Asian Bond Market Initiative.5 Recent discussions of the Asian Bond Market Initiative have focused on the choice of denomination currency for bond issues and the establishment of a credit guarantee and rating agency. One choice is to denominate regional bond issues in US dollars. This is what the EMEAP central banks did when they first launched the Asian Bond Fund 1 (ABF1) in June 2003 as a basket of US dollar denominated bonds issued by Asian sovereign and quasi-sovereign issuers in EMEAP economies (excluding Australia, Japan, and New Zealand). Ito (2003) proposed another option, namely, an Asian bond designed as a fund of the local currency denominated bonds issued by governments of East Asian countries. The EMEAP has subsequently worked to extend the ABF concept to bonds denominated in local currencies, which were launched as the ABF2 in June 2005.6 In previous research, Ogawa and Shimizu (2002, 2004) assessed the effectiveness of basket currency denominated bonds in East Asian countries from the points of view of bond issuers and of foreign investors. Conducting empirical analyses, we compared between Asian bonds denominated in terms of a G3 currency basket (a currency basket composed of the US dollar, the euro, and the Japanese yen) with those denominated in terms of a single currency (the US dollar, the euro, the Japanese yen, or one of seven East Asian currencies) in terms of both relative risk and liquidity. The results showed that issuing currency basket denominated bonds would reduce foreign exchange risk for bond issuers in the East Asian countries under investigation, with the exception of the dollar-pegging countries of Malaysia, China, and Hong Kong. Shimizu and Ogawa (2005) considered another type of currency basket, the Asian Monetary Unit (AMU), which is composed of the currencies of the ASEAN14 countries (ASEAN13 and Hong Kong). As Kawai et al. (2004) noted, an AMU composed of East Asian currencies would be equivalent to the G3 currency basket if all East Asian countries were to use the G3 currency basket as a reference or target in conducting their exchange rate policies, though this is not currently the case. Ogawa and Shimizu (2005) proposed an AMU as well as AMU Deviation Indicators to assist

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with the coordination of exchange rate policies by East Asian monetary authorities. Shimizu and Ogawa (2005) investigated the risk properties of AMU denominated Asian bonds by comparing them with those of local currency denominated bonds issued in East Asian countries. Building on our previous empirical research into the choice of denomination currency for Asian bonds, in this chapter we focus on the risk properties of AMU denominated bonds as well as the expected liquidity of AMU bond markets. Defining the AMU as a currency unit comprising a basket of East Asian currencies, we simulate a currency basket composed of the currencies of the ASEAN5 countries (Indonesia, Malaysia, the Philippines, Singapore, and Thailand) plus those of Japan, China, Korea, and Hong Kong. Our results indicate that the portfolio effects of holding AMU denominated bonds can reduce foreign exchange risk for both US and Japanese investors. These results, however, depend on the currency systems of the East Asian countries. This chapter is organized as follows: the next section analyzes foreign exchange risk aspects of Asian bonds for bond issuers, and the third section analyzes foreign exchange risk aspects of Asian bonds for foreign investors. The reduction of foreign exchange risk through the portfolio effects of holding AMU denominated bonds is pointed out in the fourth section. In the fifth section, we focus on liquidity aspects of Asian bond markets. Finally, we summarize and conclude this chapter in the last section.

5.2

FOREIGN EXCHANGE RISKS FOR BOND ISSUERS

Methodology and Data We investigate how much foreign exchange risk bond issuers would face when issuing bonds denominated in terms of various currencies, focusing on the volatility of foreign borrowing costs.7 We compare the volatilities of bonds denominated in terms of the currencies of nine East Asian countries (Singapore, Thailand, Malaysia, the Philippines, Indonesia, Taiwan, Korea, Hong Kong, and China) against those of bonds denominated in terms of three major currencies (the US dollar, the euro, and the Japanese yen) and those of several types of bonds denominated in terms of currency baskets composed of the three major currencies. For the currency baskets, we consider several different currency shares based on exchange rate movements and the trade weights of the nine East Asian countries with the United States, Japan, and the euro area countries.


107

We also consider two types of baskets. The first type of basket is a common basket for the East Asian region as a whole. This kind of basket is based on the proposal for a so-called AMU which was developed by Kawai et al. (2004) and Ogawa and Shimizu (2005). Like the European Currency Unit (ECU) under the European Monetary System during the period from 1979 to 1998, the monetary authorities of East Asian countries could consider creating a common regional unit of account that could be used for trade invoicing, bond issues, and as a reference for their exchange rate policies. For this common basket, we calculate two different kinds of trade weights, named trade-weights I and II, based on the calculation methods of Ogawa and Kawasaki (2003). These trade weights reflect the shares of the total amount of trade between ASEAN514 and the United States, Japan, and the euro area countries. They differ in their inclusion or exclusion of the trade between the nine East Asian countries and the rest of the world. Trade-weight I is based on the share of total trade between the nine East Asian countries and the United States, Japan, and the euro area countries only. Trade-weight II also takes into account trade with the rest of the world. In this case, trade with the rest of the world is added to the share of the United States based on the assumption that trade with the rest of the world is invoiced in US dollars. We calculate both trade weights by using annual data and apply the average share of annual results during the period from 1990 to 2002. The resulting currency basket shares based on tradeweights I and II are calculated as the US dollar: the Japanese yen: the euro 5 35.7 percent: 35.1 percent: 29.2 percent and 69.3 percent: 16.7 percent: 14.0 percent, respectively. The second type of basket is country-specific, tailored specifically for each East Asian country. In order to reflect the characteristics of each nation’s trade relationship with the countries of the three major currencies, we calculate the basket shares based on trade intensity, using the method put forward by Petri (1993).8 The index of trade intensity, which can measure the bilateral trade linkages among countries (or regions), is defined as follows: Ij,k 5 (Tj,k/Tj)/(Tk/Tw),

(5.1)

where Ij,k is the index of trade intensity between country j and country k, Tj,k is the volume of trade between country j and country k, Tj is the total volume of trade of country j, Tk is the total volume of trade of country k, and Tw is the total volume of trade in the world. The index of trade intensity measures the closeness of bilateral trade linkages between countries j and k by comparing bilateral trade volumes

108


with the respective countries’ trade volumes with the rest of the world. An index close to unity can be interpreted as a neutral bilateral trade relationship. Indices less than or greater than one mean that the nation’s trade relationship is biased in comparison with the nation’s trade with the rest of the world. Values greater than one mean that the trade relationship between countries j and k is biased toward stronger interdependence than their trade with the rest of the world, while values less than one indicate that the nation’s trade relationship is biased toward weaker interdependence than their trade with the rest of the world. Our index of trade intensity is based on 2000 trade data.9 The index of trade intensity between every East Asian country and Japan is larger than one. The index of trade intensity between Indonesia and Japan is the greatest, while Hong Kong registers the lowest value of trade intensity with Japan among East Asian nations. The indexes of trade intensity between some East Asian countries and the United States are greater than one but always smaller than those between the East Asian countries and Japan. The indexes of trade intensity between the East Asian countries and the euro area countries are all less than one. Thus, we design three types of currency baskets with different weights for each of the East Asian currencies. With the aim of indicating empirically how the currency basket denominated bonds could contribute to reducing foreign exchange risks, we use historical data on exchange rates and interest rates to simulate foreign borrowing costs by applying these basket shares, which are calculated ex post. Applying these different types of currency basket shares, we can investigate not only whether the hypothetical currency basket denominated bonds would more effectively contribute to decreasing the volatilities of foreign borrowing costs but also which type of currency basket would be more effective in decreasing the volatilities for bond issuers in each of the East Asian countries. Three-month money market interest rates and daily close exchange rates are used to calculate the series of foreign borrowing costs for three-month periods (90 days). Then we calculate the means and the standard deviations of these series for whole sample period. The standard deviation is regarded as the volatility of the foreign borrowing costs. The three-month foreign borrowing costs evaluated in terms of the issuer’s home currency are calculated under the uncovered interest rate parity condition. For example, the costs of three-month borrowing from the United States for issuers in country A are calculated as follows: e

{ 1US$ 1 (1 3 r3 month,us) 3 90/360 } 3 (A/US$) t190 days 1US$ 3 (A/US$) t

2 1 f 3 100 (%) (5.2)


109

where (A/US$) t is the exchange rate between the US dollar and currency A at period t. Our empirical analysis covers the period from January 1, 1999 to March 31, 2006. We calculate three-month foreign borrowing costs for each day during the period. As a result, we have 1888 observations for each type of borrowing pattern during the period under analysis.10 First, we investigate three-month foreign borrowing costs for the nine East Asian countries, namely, Singapore, Thailand, Malaysia, the Philippines, Indonesia, Taiwan, Korea, Hong Kong, and China. For each country, over the sample period we calculate eight different types of foreign borrowing costs associated with issuing bonds denominated in terms of four single currencies (the home currency, the US dollar, the euro, the Japanese yen) and in terms of four types of currency baskets. The currency basket denominated bonds are a kind of portfolio of bonds denominated in terms of the US dollar, the euro, and the Japanese yen. Results Table 5.1 shows the means and standard deviations of 3 month foreign borrowing costs that debtors in each of the nine East Asian countries would face when issuing bonds denominated in terms of the home currency, the US dollar, the euro, the Japanese yen, and the eight different types of currency baskets. We regard the foreign borrowing cost in terms of the US dollar to be a benchmark and statistically test the differences between the means and standard deviations of bonds denominated in terms of the US dollar and bonds denominated in terms of currency baskets.11,12 We obtained two important results. First, the standard deviations of foreign borrowing cost incurred by issuing home currency denominated bonds are far lower than those incurred by issuing foreign currency denominated bonds for the nine East Asian countries. This implies that the foreign exchange risk has a heavy weight in the total cost of borrowing by issuing foreign currency denominated bonds. Second, the issuing of currency basket denominated bonds could contribute to decreasing foreign borrowing costs as well as risks. The volatility of foreign borrowing costs faced when issuing currency basket denominated bonds is lower than when US dollar denominated bonds are issued for Singapore, Thailand, Indonesia, Taiwan, and Korea, since the foreign exchange risks of the three major currencies partially offset each other. The costs of issuing the currency basket denominated bonds are lower than those of issuing the US dollar denominated bond for all of the sample countries. The costs of issuing the currency basket denominated bonds are lower than those of issuing the home currency denominated bonds; this is especially true for dollar-pegging

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Table 5.1

Borrowing from

Singapore Max Min Mean Std dev. Thailand Max Min Mean Std dev. Malaysia Max Min Mean Std dev. Philippines Max Min Mean Std dev. Indonesia Max Min Mean Std dev. Taiwan Max Min Mean Std dev. South Korea Max Min Mean Std dev. Hong Kong Max


Three-month borrowing costs in East Asian Countries (%), Jan 1999–Mar 2006 Single currency type Home currency

USD

0.766 0.109 0.392 0.193

6.627 −4.593 0.631 2.267

13.848 18.174 −9.445 −10.129 0.944 −0.053 4.322 3.942

6.797 −3.727 0.541 1.902

5.481 −3.491 0.587 1.516

11.214 −5.557 0.272 2.300

1.938 0.250 0.631 0.369

14.210 16.051 31.819 −8.312 −12.676 −11.779 1.048 1.340 0.379 3.799 4.836 5.409

19.198 −8.958 0.955 3.528

16.602 −8.514 1.003 3.370

25.092 −7.726 0.657 4.183

1.425 0.713 0.811 0.133

1.665 14.741 17.765 −2.886 −10.365 −10.811 0.704 1.090 0.083 0.543 5.366 4.864

9.046 −5.012 0.658 2.782

4.544 −2.767 0.682 1.308

11.698 −6.817 0.346 3.260

4.181 1.075 1.945 0.566

17.204 26.763 26.522 15.081 −7.320 −12.567 −13.115 −10.467 1.868 2.221 1.254 1.813 3.695 5.917 6.324 4.375

8.500 2.295 3.280 1.404 1.450 0.225 0.727 0.429

2.068 0.870 1.325 0.348 1.871

Euro

Basket type Yen

Trade- Trade- Tradeweight Ia weight intensityc IIb

15.129 19.170 −8.822 −10.274 1.841 1.548 3.754 4.792

31.218 31.210 51.154 37.036 34.007 45.950 −24.957 −27.877 −26.575 −25.802 −24.611 −26.089 1.386 1.659 0.670 1.273 1.331 0.879 8.842 9.070 9.179 8.467 8.539 8.788 8.116 16.915 15.738 −5.951 −10.122 −10.780 0.766 1.113 0.084 2.796 5.302 4.290

15.710 28.557 −11.052 −12.209 0.137 0.492 4.216 6.429 1.679

14.750

8.559 −5.968 0.688 2.948

8.013 −4.791 0.729 2.474

10.622 −8.100 0.330 3.247

22.852 −9.857 −0.575 4.681

16.805 −8.196 0.054 4.212

16.176 −8.356 0.097 3.959

15.793 −7.896 −0.253 3.870

17.897

9.043

4.541

11.668


Table 5.1 Borrowing from

Min Mean Std dev. China Max Min Mean Std dev.

111

(continued) Single currency type Home currency

USD

Euro

Basket type Yen

Trade- Trade- Tradeweight Ia weight intensityc IIb

0.002 0.753 0.582

−1.006 −10.351 −10.821 0.768 1.152 0.145 0.514 5.334 4.829

−4.901 0.721 2.741

−2.150 0.745 1.259

−6.825 0.439 3.355

0.697 0.428 0.470 0.067

1.609 14.737 17.763 −1.565 −10.377 −10.813 0.665 1.053 0.047 0.603 5.399 4.914

9.041 −5.755 0.621 2.836

4.539 −3.436 0.644 1.375

10.553 −6.075 0.359 3.034

Notes: All data calculated by authors. Sample period is 1/1/1999–3/31/2006. All exchange rate and interest rate data are from Datastream. a The basket share of trade-weight I is USD : yen : euro 5 35.7 : 35.1 : 29.2. b The basket share of trade-weight II is USD : yen : euro 5 69.3 : 16.7 : 14.0. c The basket share of trade-intensity is USD : yen : euro 5 31.5 : 57.5 : 11.0 in Singapore, USD : yen : euro 5 25.5 : 65.9 : 8.6 in Thailand, USD : yen : euro 5 29.0 : 62.9 : 8.2 in Malaysia, USD : yen : euro 5 35.3 : 56.7 : 8.0.

countries. Accordingly, issuing currency basket denominated bonds could make both foreign borrowing costs and their volatilities much lower than those of issuing the US dollar denominated bonds in many cases. Obviously, the foreign exchange risk is the smallest for bond issuers in all of the nine East Asian countries when bonds are denominated in the home currency. The currency basket denominated bonds have the second lowest foreign exchange risks for bond issuers in all countries except for the Philippines and the three dollar-pegging countries, Malaysia, Hong Kong, and China. Thus, currency basket denominated bonds would reduce the foreign borrowing costs for bond issuers in most East Asian countries. The foreign borrowing costs of the currency basket denominated bonds with country-specific shares based on trade intensity are the lowest for the bond issuers in all nine countries. The volatilities of the currency basket denominated bonds with the regionally used common shares based on trade-weight II are the lowest for bond issuers in all East Asian countries except Malaysia and Indonesia.13 The currency basket share based on trade-weight II would most effectively contribute to decreasing the volatility for bond issuers in Singapore, Thailand, and Taiwan. The currency basket share based on trade-weight I would most effectively contribute to decreasing the volatility for bond issuers in Indonesia. The currency

112


basket share based on trade intensity would most effectively contribute to decreasing the volatility for Korea. These results suggest that optimal basket shares should be based on the trade relations between each of the East Asian countries and its trading partner countries, although it might be difficult to fix common basket shares across the East Asian countries in order to establish an Asian bond market.

5.3

FOREIGN EXCHANGE RISKS FOR FOREIGN INVESTORS14

We also calculate the returns of local currency denominated bonds for foreign investors and evaluate their risk properties using yield data for benchmark local bonds issued in the nine East Asian countries, namely, the ASEAN5 nations, Japan, China, Korea, and Hong Kong. A partial equilibrium approach is applied to analyzing an investor model under the assumption that interest rates and exchange rates are taken as given (and, therefore, returns and risks are taken as given). This means that investor behavior affects bond returns and risks. We treat bonds as an asset class in isolation from all other assets in order to consider AMU denominated bonds, US dollar denominated bonds, and local currency denominated bonds as objects of investment for foreign investors. In addition to the standard deviation of bond returns, we also use the Sharpe ratio as an indicator of risk, since we focus exclusively on bond portfolios from the standpoint of sub-optimal principal–agency problems. Also, it is useful to measure risk-adjusted performance among the various kinds of bonds. The Sharpe ratio is basically a measure of portfolio returns, and AMU denominated bonds themselves are considered to be a type of portfolio fund.15 In order to make the source of returns clear, we divide bond returns into interest returns and foreign exchange returns. We compare the returns of the AMU denominated bonds with the returns of each of the local currency denominated bonds in terms of interest rate and foreign exchange risks. Risk Properties of Single Local Currency Denominated Bonds in East Asia First, we calculate returns for international investors who evaluate their returns in terms of the major currencies. We suppose that there are two types of international investors: US investors, who evaluate their returns in terms of US dollars, and Japanese investors, who evaluate their returns in terms of Japanese yen. We show the average return, the standard deviation of returns, and the ratio of returns to risk (the Sharpe ratio) for each of the bonds.


113

For an investor who evaluates returns in terms of US dollars, returns on investing in bonds are calculated as follows: the investor exchanges an initial fund of US dollars for a local currency at the relevant exchange rate, purchases local currency denominated bonds at a price in terms of the local currency, holds them for one month, sells them at their price in terms of the local currency one month later, and exchanges the revenue in terms of the local currency into US dollars.16, 17 The returns are then divided into interest rate (bonds yield) returns and foreign exchange returns. A similar calculation is conducted for investors who evaluate their returns in terms of Japanese yen. Our formula for calculating the value of a local currency denominated bond in terms of US dollars for a one-month investment is represented as follows: BondValuet (USdollarEquivalent) 5 5 100 1 a

100 3 Et 3 (1 1 Yt) Et11

100 3 Et 3 Yt 100 3 Et 2 100b b1a Et11 Et11

(5.3)

(5 principal 1 interest return 1 foreign exchange return) where Et is the closing rate of the local currency against the US dollar at month t, and Yt is the closing rate of bond yields on a monthly basis at month t. The interest returns for each of the bonds are calculated from the yield data for local bonds, and the foreign exchange returns are calculated from actual ex post returns that are uncovered by forward transactions at the beginning of the month and realized when the bond values are converted back into US dollars at the end of the month. Values for one-month investments in local currency denominated bonds in terms of Japanese yen are calculated in the same way. Table 5.2 shows bond values and returns for local currency denominated bonds for one-month investments evaluated in terms of US dollars over the period beginning January 1, 1999 and ending March 31, 2006. The data for the sample period clearly show that the standard deviations of the value of the local currency denominated bonds issued by dollarpegging countries (Malaysia, China, and Hong Kong) are far lower than those of bonds issued by the other countries. Their fluctuations are mainly attributed to fluctuations in interest returns for bonds issued in terms of the dollar-pegged currencies. The standard deviation of Hong Kong dollar denominated bonds is the highest among the three dollar-pegging countries.

114

106.58 94.21 100.39 0.39 1.94 0.20 0.695 0.240 0.438 0.097 4.52 6.023 −6.280 −0.044 1.941 −0.02

103.78 96.90 100.35 0.35

1.24 0.28

0.394 0.154 0.293 0.057 5.11

3.468 −3.384 0.057 1.230 0.05

5.533 −6.417 0.241 2.234 0.11

0.808 0.316 0.507 0.135 3.77

2.24 0.33

106.12 94.18 100.75 0.75

Singapore Thailand South Korea

5.000 −9.677 −0.313 1.866 −0.17

1.278 0.422 0.767 0.170 4.51

1.89 0.24

105.96 91.16 100.45 0.45

Philippines

4.374 −4.253 −0.005 2.026 0.00

1.271 0.578 0.801 0.197 4.07

2.12 0.38

105.29 96.37 100.80 0.80

0.888 −0.399 0.031 0.166 0.18

0.459 0.145 0.239 0.046 5.25

0.17 1.58

101.16 99.84 100.27 0.27

0.717 −0.282 −0.002 0.102 −0.02

0.588 0.201 0.396 0.115 3.45

0.14 2.80

101.00 99.97 100.39 0.39

Indonesia Malaysia Hong Kong

One-month bond value of Asian local bonds in terms of US dollar, Jan 1999–Mar 2006

Bond value Max Min Average (m) Return (%), (m − 100/100) Std dev. (s) Return/s Interest return Max Min Average (m) Std dev. (s) m/s Foreign exchange return Max Min Average (m) Std dev. (s) m/s

Table 5.2

1.471 −0.014 0.035 0.176 0.20

0.554 0.000 0.336 0.235 1.43

0.22 2.54

101.98 100.45 100.55 0.55

China

7.108 −6.404 0.023 2.577 0.01

0.167 0.043 0.117 0.027 4.42

2.58 0.05

107.27 93.70 100.14 0.14

Japan

115

Notes: All values are calculated by authors. Sample period is 1/1/1999–3/31/2006. All exchange rate and interest rate data are from Datastream. Bond value for 1 month starts from 100 at the beginning of the month. Then it is invested into every Asian local bond for 1 month and converted in terms of US dollars by using every foreign exchange rate against the US dollar at the end of month. All series without Indonesia and China are from 2/1999 to 12/2003, and the number of the sample is 59. Indonesia and China start from 8/2002 and 6/2001, and the number of the samples is 17 and 31, respectively. Interest returns are calculated by every bond yield. Foreign exchange returns are the actual ex post foreign exchange related returns that are uncovered by forward transaction at the beginning of the period and realized when the bond values are converted in terms of US dollars at the end of the period.

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The standard deviations of bond value for the non-dollar-pegging country bonds are relatively high in comparison with those for the bonds of dollar-pegging countries, and this volatility is mainly attributed to fluctuations in foreign exchange returns, which are far larger than those of interest returns. Among the non-dollar-pegging countries, Singaporean bonds have the lowest standard deviation of bond value (1.24 percent), Japanese bonds have the highest (2.58 percent), and Korean bonds have the second highest value (2.24 percent).18 Indonesian bonds have the highest average bond value (100.80), while Japanese bonds have the lowest (100.14). The Sharpe ratios of the dollar-pegged currency denominated bonds are much larger than those of the non-dollar-pegged currency denominated bonds. Among the non-dollar-pegged currency denominated bonds, the Japanese bonds have the lowest Sharpe ratio (0.05), and the Indonesian and Korean bonds have the highest (0.38 and 0.33, respectively). Table 5.3 shows bond values and returns for single local currency denominated bonds for investments evaluated in terms of Japanese yen over the sample period. In contrast to investments evaluated in terms of US dollars, the standard deviations of bond values evaluated in terms of yen are not so different between the dollar-pegging countries and the others, but their average returns are much higher than those evaluated in terms of US dollars. Excluding Japanese bonds, the Singaporean bonds have the lowest standard deviation (2.13 percent), while Philippine bonds have the highest (3.07 percent) among the local bonds. The fluctuations are mainly attributed to fluctuations in foreign exchange returns. Korean bonds have the highest average bond value (100.77), while Malaysian bonds have the lowest (100.31). As for the Sharpe ratio, Korean bonds and Indonesian bonds have the highest value (0.30), and Malaysian bonds have the lowest (0.12), though the difference between them is small. Risk Properties of AMU Denominated Bonds When we simulate returns for AMU denominated bonds, which are composed of the nine East Asian countries’ government bonds, in order to investigate their risk properties, we need to choose the allocation of weights given to each country’s government bond. An AMU denominated bond composed of an equal share of each of the East Asian countries’ government bonds was used as a benchmark. This is an abstraction from the case of real-world international bond funds, which investors often use as an index for international portfolio investments, in which fund composition weights are practically based on market capitalization or on the outstanding amount of bonds.19 The total value of currently outstanding Japanese government bonds is much larger than that of the

117

106.11 91.49 100.42 0.42 2.63 0.16 0.709 0.236 0.438 0.098 4.48

5.631 −8.994 −0.018 2.616 −0.01

105.92 94.41 100.37 0.37

2.13 0.18

0.394 0.154 0.293 0.057 5.16

5.567 −5.916 0.082 2.131 0.04

Singapore Thailand

5.448 −8.808 0.259 2.547 0.10

0.845 0.314 0.507 0.134 3.78

2.55 0.30

106.29 91.77 100.77 0.77

South Korea

7.171 −8.733 −0.275 2.997 −0.09

1.318 0.408 0.769 0.178 4.33

3.07 0.16

108.18 92.11 100.49 0.49

Philippines

4.676 −6.319 −0.044 2.404 −0.02

1.258 0.580 0.801 0.197 4.07

2.49 0.30

105.60 94.29 100.76 0.76

6.814 −6.638 0.073 2.579 0.03

0.468 0.143 0.240 0.047 5.13

2.59 0.12

107.07 93.59 100.31 0.31

Indonesia Malaysia

6.850 −6.680 0.041 2.567 0.02

0.589 0.202 0.396 0.115 3.44

2.58 0.17

107.31 93.86 100.44 0.44

Hong Kong

6.849 −6.637 0.077 2.587 0.03

0.581 0.000 0.336 0.235 1.43

2.27 0.24

107.01 95.81 100.55 0.55

China

One-month bond value of Asian local bonds in terms of Japanese yen, Jan 1999–Mar 2006

Bond value Max Min Average (m) Return (%), (m − 100/100) Std dev. (s) Return/s Return on interest rate Max Min Average (m) Std dev. (s) m/s Foreign exchange return Max Min Average (m) Std dev. (s) m/s

Table 5.3

0.000 0.000 0.000 0.000 0.000

0.167 0.044 0.117 0.026 4.47

0.03 4.47

100.17 100.04 100.12 0.12

Japan

118

(continued)

Notes: All values are calculated by authors. Sample period is 1/1/1999–3/31/2006. All exchange rate and interest rate data are from Datastream. Bond value for 1 month starts from 100 at the beginning of the month. Then it is invested into every Asian local bond for 1 month and converted in terms of US dollars by using every foreign exchange rate against the US dollar at the end of month. All series without Indonesia and China are from 2/1999 to 12/2003, and the number of the sample is 59. Indonesia and China start from 8/2002 and 6/2001, and the number of the samples is 17 and 31, respectively. Interest returns are calculated by every bond yield. Foreign exchange returns are the actual ex post foreign exchange related returns that are uncovered by forward transaction at the beginning of the period and realized when the bond values are converted in terms of US dollars at the end of the period.

Table 5.3


119

other East Asian countries, meaning that Japanese bonds would occupy an extremely large part of the AMU denominated bonds if their composition were decided on the basis of currently outstanding government bonds in the market. In addition to the equally weighted AMU, we calculate two more kinds of AMUs, each with different country weights. For these, we use two kinds of quarterly data on external debts classified by country and obtained from the Quarterly Review of the Bank for International Settlements (BIS). The first is International Debt Securities by Nationality of Issuer (Table 12A in the Quarterly Review), which we call BIS1, and the other is International Bonds and Notes by Country of Residence (Table 14B in the Quarterly Review), which we call BIS2. We next use these three types of AMU denominated bonds to simulate their returns for US and Japanese investors in the same way that was done for single local currency denominated bonds. Our formula for calculating the value of AMU denominated bonds in terms of US dollars for a onemonth investment is represented as follows:20 9 100 3 Et,i 3 (1 1 Yt,i) BondValuet (USdollarEquivalent) 5 a wi # a b (5.4) E i51

t11,i

9 9 100 3 Et,i 3 Yt,i 100 3 Et,i 5 100 1 a wi # a 2 100b b 1 a wi # a E E i51

t11,i

i51

t11,i

(5 principal 1 interest return 1 foreign exchange return) where Et,i is the closing rate of the exchange rate of the currency of country i against the US dollar at month t and Yt,i is the closing bond yield of country i on a monthly basis at month t. Values of the AMU denominated bonds in terms of Japanese yen for one-month investments are calculated in the same way as values in terms of US dollars. First, we compare the AMU denominated bonds with single local currency denominated bonds in terms of risk and Sharpe ratio. Table 5.4 shows bond values, returns, and risks evaluated in terms of US dollars during the sample period January 1, 1999 to March 31, 2006. The standard deviation of the equally weighted AMU denominated bonds is lower than those of the individual government bonds in the six non-dollar-pegging East Asian countries. There are two reasons why the equally weighted AMU bond’s risk is lower. First, the equal weighting of the government bonds of all nine countries causes a large reduction in foreign exchange risk through a portfolio effect. Second, the inclusion of the Japanese, Malaysian, and Singaporean

120

Table 5.4


One-month AMU denominated Asian bond value in terms of US dollar, Jan 1999–Mar 2006 AMU denominated AMU denominated AMU denominated Asian bond Asian bond Asian bond (equally weighted) (BIS1) (BIS2)


102.79 97.21 100.41 0.41

105.58 94.89 100.29 0.29

104.27 95.54 100.35 0.35

0.99 0.42

1.85 0.16

1.51 0.23

0.539 0.342 0.431 0.048 9.00

0.301 0.176 0.250 0.028 8.81

0.412 0.220 0.312 0.046 6.79

2.333 −3.194 −0.018 0.987 −0.02

5.277 −5.331 0.037 1.850 0.02

3.858 −4.745 0.037 1.507 0.02

Notes: All values are calculated by authors. Sample period is 1/1/1999–3/31/2006. All exchange rate and interest rate data are from Datastream. There are three types of currency basket ratio. The equally weighted AMU denominated Asian bond is composed with all countries’ bonds at the same ratio. The AMU denominated Asian bond BIS1 is composed with all countries’ bonds by using the basket weights based on the amounts of International Debt Securities by Nationality of Issuer (BIS Table 12A). The AMU denominated Asian bond BIS2 is composed with all countries’ bonds by using the basket weights based on the amounts of International Bonds and Notes by Country of Residence (BIS Table 14B).

government bonds reduces interest risk because their interest rates are quite stable. The AMU bond’s Sharpe ratio (0.42) substantially exceeds that of any of the government bonds of non-dollar-pegging countries. The results suggest that for investors who evaluate their returns in terms of US dollars, both foreign exchange risk and interest risk are reduced by investing in AMU denominated bonds rather than in individual local currency denominated bonds. There exist differences in the standard deviations of bond returns among


121

the three types of AMU denominated bonds, with the standard deviation of the BIS1 type of AMU denominated bonds having the highest value (1.85 percent). This is because the weight accorded to Japanese government bonds is 50 percent to 70 percent, which is much higher than the weight of the others. With the exception of Singapore (1.24 percent), the standard deviation of the BIS2 type of AMU denominated bonds (1.51 percent) is lower than the returns on investment in the single currency denominated bonds of the non-dollar-pegging countries. The share of Japanese government bonds in the BIS2 type of AMU denominated bonds is 30 percent to 50 percent, which is still higher than the Japanese share in the equally weighted AMU denominated bonds. The results suggest that a smaller share of the Japanese government bonds is better for investors who evaluate their returns in terms of US dollars, because the returns of Japanese government bonds are low with high fluctuations.21 Table 5.5 shows that the standard deviation of AMU denominated bonds for investors who evaluate their returns in terms of Japanese yen is lower than those of the single local currency denominated bonds, except for Japanese bonds. Also, with the exception of Japanese and Korean bonds, the Sharpe ratios of AMU denominated bonds are higher than the single local currency denominated bonds, indicating that investors who evaluate their returns in terms of Japanese yen can improve their return per unit risk by investing in AMU denominated bonds. Among the three types of AMU denominated bonds, the BIS1 type of AMU denominated bonds has the lowest standard deviation (0.83 percent) and the highest Sharpe ratio (0.34). This is because the BIS1 type of AMU denominated bonds has the highest share of Japanese government bonds. The results suggest that, for investors who evaluate their returns in terms of the Japanese yen, a higher share of Japanese government bonds has a risk-reducing effect. These investors could obtain less risky and more profitable outcomes by investing in AMU denominated bonds, because they consist of both East Asian government bonds, whose returns and risks are high, and Japanese government bonds, whose returns and risks are quite low.

5.4

THE FOREIGN EXCHANGE RISK REDUCTION EFFECT OF THE AMU DENOMINATED BONDS

In the previous section, we conducted a simulation analysis to show that investors would be able to reduce overall risk by investing in AMU denominated bonds. In this section, we focus specifically on foreign exchange risk and give a theoretical explanation of how investing in AMU denominated bonds can contribute to reducing foreign exchange risk.

122

Table 5.5


One-month AMU denominated Asian bond value in terms of Japanese yen, Jan 1999–Mar 2006 AMU denominated AMU denominated AMU denominated Asian bond Asian bond Asian bond (equally weighted) (BIS1) (BIS2)


105.56 95.25 100.43 0.43

102.23 98.24 100.28 0.28

103.43 97.10 100.35 0.35

2.04 0.21

0.83 0.34

1.26 0.28

0.575 0.328 0.426 0.057 7.44

0.303 0.177 0.250 0.028 8.79

0.419 0.221 0.312 0.046 6.73

5.109 −5.221 0.005 2.021 0.00

1.974 −2.031 0.034 0.829 0.04

3.096 −3.228 0.043 1.256 0.03

Notes: All values are calculated by authors. Sample period is 1/1/1999–3/31/2006. All exchange rate and interest rate data are from Datastream. There are three types of currency basket ratio. The equally weighted AMU denominated Asian bond is composed with all countries’ bonds at the same ratio. The AMU denominated Asian bond BIS1 is composed with all countries’ bonds by using the basket weights based on the amounts of International Debt Securities by Nationality of Issuer (BIS Table 12A). The AMU denominated Asian bond BIS2 is composed with all countries’ bonds by using the basket weights based on the amounts of International Bonds and Notes by Country of Residence (BIS Table 14B).

International portfolio diversification is widely practiced by investors who seek to reduce their investment risks. Recently, international investors have been turning to foreign markets to obtain greater scope for diversification than can be offered in domestic markets. However, when investing in foreign currency denominated bonds it is important to consider not only the portfolio effects on interest returns and risks but also foreign exchange returns and risks.


123

To expand on this, we first use basic portfolio theory to explain the reduction of investment risk by the portfolio effect. The return (Rp) on a portfolio investment in bonds of country i (with return Ri) with a portfolio | at time t is represented by share w n

|#R Rp,t 5 a w i,t

(5.5)

i51

| 5 (w ,w ,...,w ) . where w 1 2 n This portfolio has the following expected returns and variance: mp 5 n a wimi

(5.6)

i51

s2p 5 a a sij i,j

5 (w1,...,wn) °

s11,s12,...,s1n w1 ¢ ° ( ( ( ( ¢ sn1,sn2,...,snn wn

|TWw | 5w where mi is the expected value of Ri,s2i is the variance of Ri,sij is the covariance with Ri and Rj,rij is the correlation coefficient with Ri and Rj, and W is the variance–covariance matrix of sij. Then we separate the variance (V 2p) of the portfolio return into a sum of variances and a sum of covariances as follows: n

V 2p 5 a w2i s2i 1 2 a a wiwj sij i51

(5.7)

i,j

The portfolio effect means that the variance of portfolio returns should be smaller when investors increase bond diversity, because individual fluctuations in bond returns partly cancel out with each other. The variance of returns on the equally weighted AMU denominated bonds is represented as follows: 1 1 n 2 s2p 5 a a s2i b 1 2 a a sij n n i51 n i,j

(5.8)

1 n (n 2 1) (average of sij) 5 (average of s2i ) 1 n n2 In the above equation, the first term is the average foreign exchange risk for each of the local government bonds. The AMU denominated bonds are composed of the non-dollar-pegging as well as the dollar-pegging

124


countries’ government bonds. The former have a high foreign exchange risk against the US dollar, while the latter have a near-zero exchange risk. Accordingly, the foreign exchange risk of investing in AMU denominated bonds is substantially lower than that of investing in individual local government bonds in non-dollar-pegging countries. The second term is almost equal to the average covariance of exchange rate returns among the local government bonds. The covariance (sij) is calculated as sij 5 rij # si # sj

(5.9)

If the correlation coefficient rij is negative and, in turn, sij also is negative, portfolio investments reduce foreign exchange risk more. The AMU denominated bonds consist of the dollar-pegged currency denominated bonds and the non-dollar-pegged currency denominated bonds. Even the currencies of the non-dollar-pegging countries in East Asia are highly correlated to movements in the US dollar. Correlation coefficients between East Asian currencies, especially the dollar-pegged currencies and the Japanese yen, tend to be negative in terms of foreign exchange returns. Table 5.6 shows correlation coefficient matrices for one-month investments in government bonds in terms of US dollars. It shows that most of the correlation coefficients between the dollar-pegging countries and the non-dollar-pegging countries are negative. Accordingly, for investors who evaluate their returns in terms of US dollars, the AMU denominated bonds should be effective in reducing foreign exchange risk. For investors who evaluate their returns in terms of Japanese yen, the average foreign exchange risk in the first term of equation (5.8) could be reduced by including Japanese government bonds in the AMU denominated bonds. The higher the share of Japanese government bonds, the lower the foreign exchange risk of the AMU denominated bonds. Accordingly, AMU denominated bonds are likely to have the portfolio effect of reducing foreign exchange risk regardless of whether the investor evaluates returns in terms of US dollars or Japanese yen.

5.5

LIQUIDITY IN ASIAN BOND MARKETS22

We compare the liquidities of bonds denominated in terms of the three major currencies and the East Asian currencies. Because of constraints on bid–ask spread data for bond markets across the sample countries, we use the bid–ask spreads in foreign exchange markets as a measure of liquidity.23 We regard the foreign exchange bid–ask spreads as a measure of liquidity in the Asian bond markets because bond issuers must conduct spot and

125

Source:

Note:

1.0000 0.7176 −0.0986 −0.1090 0.3942 0.4969 0.2604 0.1348 0.6403

Singapore

0.7176 1.0000 −0.2196 0.1076 0.4022 0.5395 0.1306 −0.1742 0.6928

Thailand −0.0986 −0.2196 1.0000 −0.3084 0.1445 −0.3756 −0.0268 −0.1109 −0.0444

Malaysia −0.1090 0.1076 −0.3084 1.0000 0.0363 0.1661 0.0488 0.1536 0.0187

Philippines 0.3942 0.4022 0.1445 0.0363 1.0000 0.1477 0.0815 −0.1226 0.2754

Indonesia 0.4969 0.5395 −0.3756 0.1661 0.1477 1.0000 0.2567 0.0565 0.3680

Korea 0.2604 0.1306 −0.0268 0.0488 0.0815 0.2567 1.0000 0.3148 0.3302

Hong Kong

0.1348 −0.1742 −0.1109 0.1536 −0.1226 0.0565 0.3148 1.0000 0.0509

China

0.6403 0.6928 −0.0444 0.0187 0.2754 0.3680 0.3302 0.0509 1.0000

Japan

Correlation matrix for one-month Asian government bond returns in terms of US dollar, Jan 1999–June 2005

Author’s calculations.

We make the sample period up to June 2005 because Chinese bond returns in terms of the US dollar changed dramatically as a result of their change of currency system.

Singapore Thailand Malaysia Philippines Indonesia Korea Hong Kong China Japan

Table 5.6

126


forward transactions on the foreign exchange market in order to convert their foreign borrowings into their home currencies and because their choice of bond denomination currency is affected by the bid–ask spreads in the foreign exchange market.24 Bid–ask spreads are caused by three factors: (1) order processing costs, (2) inventory holding costs, and (3) information costs for market making (Hartmann 1998). These costs are lowered by a higher volume of trade. Order processing costs are subject to economies of scale because the costs of purchasing the electronic market information needed for processing orders are fixed. The average costs of holding inventory diminish according to the law of large numbers, as statistically independent orders increase. Economies of scale are also present because of substantial fixed information costs for market making. Thus, the average bid–ask spread is reduced by a large volume of trading in liquid markets. Basically, bid–ask spreads for trades between the major currencies and the US dollar and for those between frequently quoted major cross currencies, such as the euro and the Japanese yen, the UK pound and the Japanese yen, the Swiss franc and the Japanese yen, and the UK pound and the euro, are very narrow. On the other hand, direct exchanges between so-called exotic currencies such as the other East Asian currencies may cause some inconvenience and incur higher transaction costs, especially in forward outright trading. It is usually the case that the East Asian currencies are quoted against the US dollar in foreign exchange markets and not against the euro or the Japanese yen. Therefore, we calculate the cross rates of the East Asian currencies vis-à-vis the Japanese yen by using exchange rates of the US dollar vis-à-vis the Japanese yen and the US dollar vis-à-vis East Asian currencies. We use the same procedure to calculate cross rates of East Asian currencies vis-à-vis the euro, using the exchange rates of the US dollar vis-à-vis the euro and of the US dollar vis-à-vis East Asian currencies. In the case of quoting the forward outright rate, we use the same procedure to calculate cross swap rates. Accordingly, the bid–ask spreads for the forward outright rates of the East Asian currencies vis-à-vis the euro or the Japanese yen are wider in comparison with the other major currencies. This seems to be a major reason why borrowers in the East Asian countries did not use swap transactions to cover their foreign borrowings in terms of foreign currencies before the Asian currency crisis in 1997. We compare the bid–ask spreads for the forward swap rates of the seven East Asian currencies vis-à-vis the three major currencies, as well as those of the euro and the Japanese yen vis-à-vis the US dollar. In order to compare the bid–ask spreads, we express them in terms of percentage of transaction-based cost. Transaction-based cost refers to the bid–ask spread


127

one must pay to deal one forward outright transaction. We calculate the bid–ask spreads for eight East Asian currencies for forward transactions with terms of one month, three months, and six months vis-à-vis the US dollar, the euro and the Japanese yen. In order to compare these with the bid–ask spreads for major traded currencies, we calculate spreads for the euro and the Japanese yen vis-à-vis the US dollar as well as those for the Japanese yen vis-à-vis the euro. We use the spot and forward rates from the Bloomberg Currency Composite pages and the broker’s page of Prebon Yamane Asia Region on Bloomberg dated September 13, 2002, February 6, 2003, and May 18, 2006. Table 5.7 shows the transaction-based bid–ask spreads. The bid–ask spreads for all of the East Asian currencies vis-à-vis the US dollar are lowest for all periods, while the bid–ask spreads for all of the East Asian currencies vis-à-vis the euro are highest for the one-month and threemonth forward swap contracts. In addition, the bid–ask spreads for all of the East Asian currencies vis-à-vis the US dollar are far higher than those for the euro and the Japanese yen vis-à-vis the US dollar. The bid–ask spreads for the euro and the Japanese yen vis-à-vis the US dollar are 3 to 4 basis points (bp)25 for one transaction, while those of the East Asian currencies vis-à-vis the US dollar range from 5 bp for the Taiwan dollar to almost 50 bp for the Philippine peso and the Indonesian rupiah vis-à-vis the US dollar. The bid–ask spreads for all of the East Asian currencies visà-vis the euro and the Japanese yen are almost 3 to 4 bp higher than those vis-à-vis the US dollar, and they are higher than those of the Japanese yen vis-à-vis the euro, too. As for the differences resulting from terms, there is not much difference between the bid–ask spreads for contracts with terms of one month, three months, or six months for the Hong Kong dollar, the Singapore dollar, the Thai baht, and the Korean won and the spreads for contracts with those terms for the euro and the Japanese yen. On the other hand, the bid–ask spreads for the rest of the East Asian currencies become higher as the terms become longer. Among the eight East Asian currencies, the Hong Kong dollar and the Taiwan dollar have the lowest bid–ask spreads. The currencies with the next lowest bid–ask spreads include the Singapore dollar, the Thai baht, and the Korean won. The currencies with the highest bid–ask spreads include the Malaysian ringgit, the Philippine peso, and the Indonesian rupiah. It is interesting that the Malaysian ringgit had the highest onemonth forward contract bid–ask spread among the nine East Asian countries as of September 13, 2002. It seems that there is not much demand for forward swaps in the Malaysian ringgit because the monetary authorities of Malaysia have been adopting the dollar-peg system by pegging the spot rate of the Malaysian ringgit to the US dollar.

128

6m

1m

3m

6m

(sample day: May 18, 2006)

Spreads (%)

1m

3m

(average)

Spreads (%)

6m

0.2982 0.3103 0.3354 0.1675 0.2969 0.5384 0.1988 0.2822 0.3672 0.2215 0.2965 0.4136

0.3168 0.3287 0.3499 0.1795 0.3207 0.5710 0.2017 0.2863 0.3736 0.2327 0.3119 0.4315 0.3016 0.3129 0.3404 0.1809 0.2963 0.5073 0.2019 0.2851 0.3701 0.2281 0.2981 0.4059

0.1415 0.1620 0.1384 0.0500 0.0710 0.0509 0.1108 0.1374 0.1388 0.1008 0.1234 0.1094 0.2763 0.2895 0.3158 0.1421 0.2737 0.5368 0.1927 0.2753 0.3579 0.2037 0.2795 0.4035

0.1601 0.1803 0.1526 0.0604 0.0872 0.0586 0.1137 0.1413 0.1443 0.1114 0.1362 0.1185 0.1450 0.1652 0.1455 0.0662 0.0848 0.0708 0.1138 0.1399 0.1409 0.1084 0.1300 0.1191

0.1129 0.1239 0.1240 0.0611 0.0646 0.0621 0.0359 0.0448 0.0528 0.0700 0.0778 0.0796 0.1194 0.1405 0.1171 0.0234 0.0409 0.0234 0.1049 0.1311 0.1311 0.0826 0.1042 0.0905

0.1313 0.1417 0.1373 0.0714 0.0806 0.0693 0.0384 0.0476 0.0565 0.0804 0.0900 0.0877 0.1168 0.1281 0.1327 0.0774 0.0787 0.0825 0.0394 0.0487 0.0576 0.0778 0.0852 0.0909

0.0907 0.1020 0.1020 0.0344 0.0344 0.0344 0.0298 0.0380 0.0444 0.0516 0.0581 0.0603

3m

1m

1m

6m

(sample day: Feb 6, 2003)

(sample day: Sept 13, 2002) 3m

Spreads (%)

Spreads (%)

Forward swap bid–ask spreads (% in transaction basis) in seven East Asian currencies against three major currencies

Singaporian agst US dollar dollar agst euro agst JP yen average Thailand agst US baht dollar agst euro agst JP yen average Malaysian agst US ringgit dollar agst euro agst JP yen average

Currency

Table 5.7

129

agst US dollar agst euro agst JP yen average Indonesian agst US rupiah dollar agst euro agst JP yen average New Taiwan agst US dollar dollar agst euro agst JP yen average South agst US Korean won dollar agst euro agst JP yen average

Philippine peso

0.1135 0.1129 0.1452 0.1029 0.1061 0.1030 0.1110 0.1637 0.1630 0.1091 0.1275 0.1371

0.1322 0.1315 0.1604 0.1135 0.1229 0.1117 0.1145 0.1688 0.1719 0.1200 0.1410 0.1480 0.1169 0.1158 0.1505 0.1188 0.1189 0.1210 0.1129 0.1638 0.1587 0.1162 0.1328 0.1434

0.0804 0.1092 0.1672 0.0727 0.1049 0.1310 0.1000 0.1634 0.1634 0.0844 0.1258 0.1539 0.0914 0.0914 0.1246 0.0764 0.0764 0.0764 0.1056 0.1584 0.1584 0.0911 0.1087 0.1198

0.0988 0.1270 0.1804 0.0830 0.1207 0.1379 0.1030 0.1672 0.1703 0.0949 0.1383 0.1629 0.0843 0.1134 0.1759 0.0890 0.1190 0.1516 0.1029 0.1660 0.1630 0.0921 0.1328 0.1635

0.2437 0.4041 0.5037 0.1836 0.3067 0.4618 0.7627 0.8128 0.8105 0.3967 0.5079 0.5920 0.0581 0.0872 0.1453 0.0460 0.0748 0.1035 0.0942 0.1570 0.1570 0.0661 0.1063 0.1353

0.2639 0.4302 0.5365 0.1952 0.3287 0.4855 0.8000 0.8607 0.8679 0.4197 0.5399 0.6300 0.2443 0.3918 0.4729 0.1975 0.3094 0.4486 0.6989 0.7320 0.7180 0.3802 0.4778 0.5465

0.2130 0.2114 0.3962 0.2104 0.3924 0.5607 0.1950 0.1949 0.1955 0.2061 0.2662 0.3841 0.2230 0.3903 0.5018 0.1580 0.2821 0.4514 0.7892 0.8455 0.8455 0.3901 0.5060 0.5996

0.2321 0.2314 0.4172 0.2226 0.4170 0.5894 0.1993 0.2008 0.2043 0.2180 0.2831 0.4036 0.2157 0.2115 0.3885 0.2233 0.3896 0.5368 0.1955 0.1935 0.1921 0.2115 0.2649 0.3725

0.1914 0.1914 0.3827 0.1853 0.3706 0.5559 0.1902 0.1902 0.1902 0.1889 0.2507 0.3763

130

(continued)

6m

1m

3m

6m


Spreads (%)

1m

3m

(average)

Spreads (%)

6m

0.0668 0.0661 0.0664 0.0799 0.0902 0.0826 0.0173 0.0184 0.0225 0.0547 0.0582 0.0572

0.0261 0.0262 0.0308 0.0429 0.0442 0.0479 0.0096 0.0108 0.0135 0.0262 0.0271 0.0307

0.0505 0.0503 0.0542 0.0949 0.0726 0.0955 0.0228 0.0261 0.0277 0.0561 0.0496 0.0592 0.0408 0.0402 0.0362 0.0371 0.0463 0.0352 0.0086 0.0094 0.0117 0.0288 0.0320 0.0277

0.0690 0.0683 0.0680 0.1053 0.0888 0.1032 0.0254 0.0288 0.0313 0.0666 0.0620 0.0675 0.0543 0.0543 0.0625 0.1110 0.0864 0.1151 0.0264 0.0300 0.0325 0.0639 0.0569 0.0701

0.0282 0.0282 0.0321 0.0683 0.0425 0.0683 0.0168 0.0193 0.0193 0.0378 0.0300 0.0399

3m

1m

1m

6m


(sample day: Sept 13, 2002) 3m

Spreads (%)

Spreads (%)

Sources: Calculated by authors. All spot rates and forward rates are collected from Bloomberg currency composite pages and Prebon Yamane Asia Region pages on sample days. Forward swap spreads are calculated by bid and ask spreads on both spot and forward rates.

Hong Kong agst US dollar dollar agst euro agst JP yen average Euro agst US dollar Japanese agst US yen dollar Japanese agst euro yen

Currency

Table 5.7


131

As explained earlier, an investment in the currency basket denominated bonds means a portfolio investment in the bonds denominated in terms of the US dollar, the euro, and the Japanese yen. It is possible to use weighted averages of the bid–ask spreads for the three currencies as a proxy for the liquidity of the currency basket denominated bonds. Except for the Indonesian rupiah and the Malaysian ringgit, the differences in the bid–ask spreads between the US dollar and the currency basket are around 0.03bp to 0.08 bp for one-month swap transactions, 0.02 bp to 0.03 bp for three-month swap transactions, and 0 bp to 0.01 bp for six-month swap transactions. Thus, we use data on the bid–ask spreads of swap transactions to compare the liquidities of the three major currencies and the currency basket. Our findings show that the US dollar has the highest degree of liquidity for all of the nine East Asian currencies. However, the differences between the US dollar and the currency basket are not very large. This is especially true for three- and six-month swap transactions, though the differences are larger for one-month swap transactions. Next, we choose two East Asian currencies, the Singapore dollar and the Thai baht, both of which are relatively actively traded in East Asian markets. We calculate forward bid–ask spreads vis-à-vis the US dollar, the euro, and the Japanese yen from 2000 to 2006 for the two currencies. Table 5.8 shows the change in transaction-based forward bid–ask spreads from 2000 to 2006. Comparing the same calculations for the bid–ask spreads for the euro and the Japanese yen vis-à-vis the US dollar and the Japanese yen vis-àvis the euro over this time period, it is clear that the bid–ask spreads for the two East Asian currencies become lower. For example, the six-month contract bid–ask spread for the Singapore dollar vis-à-vis the Japanese yen was 16 bp in June 30, 2000, and it was 6 bp in May 18, 2006. Similarly, the six-month contract bid–ask spread for the Thai baht vis-à-vis the Japanese yen was 31 bp on June 30, 2000, and it was 14 bp on May 18, 2006. It means that the conditions of foreign exchange markets in East Asian countries are improving, and that the forward outright contracts for major East Asian currencies are gradually becoming less expensive to trade.

5.6

CONCLUSION

This chapter has explained the advantages and disadvantages of choosing a common currency basket such as the AMU over an international currency as a denomination currency for bond issuers and foreign investors in terms of both foreign exchange risks and liquidity. Performance of the currency

132

US dollar euro JP yen average US dollar euro JP yen average US dollar US dollar euro

Singapore dollar

0.0608 0.1139 0.0992 0.0913 0.1532 0.2064 0.1912 0.1836 0.0530 0.0386 0.0914

0.0926 0.1658 0.1453 0.1346 0.2042 0.2787 0.2539 0.2456 0.0735 0.0518 0.1244

0.0984 0.1817 0.1569 0.1457 0.2553 0.3416 0.3062 0.3010 0.0840 0.0565 0.1384

0.0329 0.0901 0.0684 0.0638 0.2869 0.3443 0.3195 0.3169 0.0572 0.0354 0.0925

0.0604 0.1461 0.0998 0.1021 0.3311 0.4176 0.3596 0.3694 0.0861 0.0395 0.1247

3m 0.0659 0.1371 0.1224 0.1084 0.4414 0.5138 0.4706 0.4753 0.0720 0.0564 0.1268

6m

1m

1m

6m

(sample day: July 1, 2001)

(sample day: June 30, 2000)

3m

Spreads (%)

Spreads (%)

0.0240 0.0847 0.0591 0.0559 0.1445 0.2051 0.1793 0.1763 0.0608 0.0350 0.0957

1m 0.0282 0.0837 0.0701 0.0607 0.1686 0.2237 0.2092 0.2005 0.0557 0.0417 0.0970

3m 0.0395 0.0997 0.0899 0.0764 0.1927 0.2520 0.2402 0.2283 0.0608 0.0501 0.1099

6m

(sample day: July 2, 2002)

Spreads (%)

0.0344 0.0714 0.0774 0.0611 0.0234 0.0604 0.0662 0.0500 0.0371 0.0429 0.0799

1m 0.0344 0.0806 0.0787 0.0646 0.0409 0.0872 0.0848 0.0710 0.0463 0.0442 0.0902

3m 0.0344 0.0693 0.0825 0.0621 0.0234 0.0586 0.0708 0.0509 0.0352 0.0479 0.0826

6m


Spreads (%)

0.0298 0.0384 0.0394 0.0359 0.1049 0.1137 0.1138 0.1108 0.0086 0.0096 0.0173

1m

0.0380 0.0476 0.0487 0.0448 0.1311 0.1413 0.1399 0.1374 0.0094 0.0108 0.0184

3m

0.0444 0.0565 0.0576 0.0528 0.1311 0.1443 0.1409 0.1388 0.0117 0.0135 0.0225

6m


Spreads (%)

2 bid price ) 3 100 3 1/181 6 month bid2ask spread cost (daily based, %) 5 (ask price spot rate



Sources: Calculated by authors. All spot rates and forward rates are collected from Bloomberg Currency Composite pages. Forward swap bid– ask spreads calculated by bid and ask quotations on both spot and forward rates.

Euro JP yen JP yen

Thai baht

Against

The change of forward swap bid–ask spreads (% in transaction basis) in two East Asian currencies against three major currencies

Currency

Table 5.8


133

basket denominated bonds was compared with that of bonds denominated in terms of the US dollar, the euro, and the Japanese yen. Currency basket denominated bonds would have the second lowest foreign exchange risks of foreign borrowing costs in Thailand, the Philippines, Indonesia, and Korea. The foreign exchange risk would be smaller than that of issuing the US dollar denominated bonds. Moreover, currency basket denominated bonds would, in general, reduce the foreign borrowing costs for bond issuers in all of the East Asian countries. Especially for bond issuers in the dollar-pegging countries, the foreign borrowing costs of issuing the currency basket denominated bonds would be lower than those of issuing home currency denominated bonds. Thus, issuing the currency basket denominated bonds would contribute to decreasing foreign borrowing costs and foreign exchange risks for bond issuers in East Asian countries. For the currency basket shares, we investigated two types of basket shares based on trade weights. One was a common basket share for all bond issuers across East Asian countries, while the other was a countryspecific basket share for bond issuers in each of the East Asian countries. The volatilities of the currency basket denominated bonds with the common basket share are the lowest for bond issuers in most of the East Asian countries except for Indonesia and Korea. On the other hand, the means of foreign borrowing costs are the lowest when currency basket denominated bonds are issued with the basket shares based on countryspecific trade intensities. Thus, issuing the currency basket denominated bonds would contribute to decreasing foreign borrowing costs and their foreign exchange risks in many cases. However, US dollar denominated bonds are still the best choice for bond issuers in the dollar-pegging countries. These results suggest that it might be difficult to fix common currency basket shares across the nine East Asian countries. For both investors who evaluate their returns in terms of the US dollar and investors who evaluate their returns in terms of the Japanese yen, the risk of investing in AMU denominated bonds is likely to be lower than that of investing in local currency denominated bonds in all but the dollar-pegging East Asian countries. Especially for investors who evaluate their returns in terms of US dollars, investing in equally weighted AMU denominated bonds is effective both in reducing risk and in improving the Sharpe ratio in comparison with investing in each of the East Asian countries’ government bonds, with the exception of the bonds of the dollar-pegging countries. The reduction of total risk is a result of the reduction of foreign exchange risk from the portfolio effect. It is important to note, however, that these results depend on the currency system in place in the East Asian countries. On the other hand, the composition weight of the Japanese yen denominated bonds in the AMU denominated bonds is critical for investors who

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evaluate their returns in terms of Japanese yen. Because of the higher composition weight of Japanese government bonds in the BIS1 type of AMU denominated bonds, these bonds should have the lowest risk and the highest Sharpe ratio for investors who evaluate their returns in terms of Japanese yen, in contrast to investors who evaluate their returns in terms of US dollars. In addition, for both investors who evaluate their returns in terms of US dollars and those who evaluate them in terms of Japanese yen, the effect on the interest return from including high yield bonds in AMU denominated bonds is larger for longer investment periods. When investors evaluate their returns on investments in single currency denominated government bonds, their risks derive from foreign exchange risk rather than interest risk. Therefore, the introduction of AMU denominated bonds could prevent contagion selling of local currency denominated bonds caused by a sudden depreciation of one local currency. As far as liquidity is concerned, data on the bid–ask spreads of swap transactions show that the US dollar has the highest degree of liquidity for bond issuers in all of the nine East Asian currencies. However, the differences between the US dollar and the currency basket are not very large for three- and six-month swap transactions, though the differences are larger for one-month swap transactions. Accordingly, it is true that bond issuers in East Asia face a trade-off between foreign exchange risk and higher liquidity when they issue the currency basket denominated bonds. Although the currency basket denominated bonds would contribute to decreasing foreign exchange risk, bond issuers might prefer the US dollar denominated bonds to the currency basket denominated bonds as long as they care about liquidity more than foreign exchange risks. When we used forward swap bid–ask spreads as a measure of liquidity, we found that the forward outright contracts for major East Asian currencies have recently become less expensive to trade. Our analyses show that US dollar denomination of bond issues provides the highest degree of liquidity as a result of the US dollar’s dominance in the world financial markets and that the US dollar denominated bonds are still the best choice, especially for bond issuers in the dollar-pegging countries in East Asia. However, we also find that the currency basket denominated bonds would contribute to reducing foreign borrowing costs and their foreign exchange risks in many cases. In order to activate regional bond markets and establish a more solid base for intra-regional capital flows in East Asia, markets for regional bonds denominated in terms of a common currency basket should be developed. Our results were obtained after making some simplifying assumptions in our analysis. However, these assumptions will be reconsidered in future research. First, we assumed a partial equilibrium, and therefore we did


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not consider the possibility of bond returns and risks being affected by investors’ behavior. Examining the effects of the widespread adoption of AMU bonds in East Asian countries on bond returns and risks is therefore a topic for future discussion. Second, we focused only on the risk reduction effects of AMU denominated bonds. However, other important factors, such as transaction costs, market liquidity, and credit rating, all influence investors’ decisions, so they should also be investigated in future analyses of AMU denominated bonds.26 Finally, our results indicate that the risk-reduction effect of AMU denominated bonds largely depends on the country share, meaning that, while taking into account returns from AMU denominated bonds, further discussion on optimal share levels for risk reduction will be called for in the near future.

NOTES 1. 2. 3. 4.

5.

6. 7.

8.

The authors are grateful to Beate Reszat, Koichi Hamada, and Ulrich Volz for their valuable comments and suggestions. The Chiang Mai Initiative, initiated in May 2000, created bilateral swap agreements worth almost USD 40 billion. In 2005, the value of the agreements grew to over USD 70 billion. Research on the common currency basket system has been conducted by Ito et al. (1998); Bénassy-Quéré (1999); Williamson (2000); Ogawa and Ito (2002); and Ogawa et al. (2004). EMEAP (Executives’ Meeting of East-Asia and Pacific Central Banks) is a cooperative organization of central banks and monetary authorities in the East Asia and Pacific region. The 11 EMEAP central banks and monetary authorities are the Reserve Bank of Australia, People’s Bank of China, Hong Kong Monetary Authority, Bank Indonesia, Bank of Japan, Bank of Korea, Bank Negara Malaysia, Reserve Bank of New Zealand, Bangko Sentral ng Pilipinas, Monetary Authority of Singapore, and Bank of Thailand. The ASEAN member countries are Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, the Philippines, Singapore, Thailand, and Vietnam. ASEAN13 refers to the ASEAN member nations plus China, Japan, and Korea. The Asian Bond Market Initiative established six working groups, which include new securitized debt instruments, credit guarantee mechanisms, foreign exchange transactions and settlement issues, issuance of bonds denominated in local currency, local and regional rating agencies, and technical assistance coordination. One of the working groups focuses on currency denomination in Asian bond markets. The Joint Ministerial Statement of the ASEAN13 Finance Ministers’ Meeting on May 4, 2005 in Istanbul stated that “the possible issuance of Asian currency-basket bonds could be explored under the auspices of the roadmap”. See the previous chapter by Ma and Remolona for an extended discussion of the ABF2. Usually ex ante borrowing costs in the real world should be calculated from the prevailing benchmark interest rate, risk premium, and foreign exchange rate fluctuations. However, since our aim is to compare the borrowing costs in different currencies or currency baskets for one country, we assume the risk premium to be common for one country and concentrate on the foreign exchange risk only here. Kawai and Takagi (2000) calculated the trade intensity within East Asia and Western Europe and found that intensity is extremely high for many trading pairs in East Asia, frequently exceeding the corresponding figures for European pairs.

136 9. 10.

11.

12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24. 25. 26.

Developing bond markets in East Asia All trade data except those for Taiwan are from the Direction of Trade Statistics (IMF). The Taiwan data are from the National Statistics of Taiwan. All data are obtained from Datastream. Exchange rates are daily closing rates, and interest rates are the middle rate of three months money market rate. The details of the data are as follows: US TB 3 months, Japan CD 3 months (new issue), euro Interbank 3 months, Singapore Interbank 3 months (MAS), Thailand Deposit 3 months, Malaysia Interbank 3 months, Indonesia Deposit 3 months, Philippine Treasury Bill 91 days, Taiwan Money Market 90 days, Korea Commercial Paper 91 days, Hong Kong Interbank 3 months, China Time Deposit Rate 3 months. The standard deviations might be undervalued because we calculate them by using overlapping data. However, we just compare these values relatively rather than evaluate their absolute value. We conducted test differences among the standard deviations of foreign borrowing costs by issuing different type of bonds. Accordingly, we regard our tests as having no problem even though we used the overlapping data. We use Student’s t and Tukey-Kramer HSD statistics for the test that the means are equal, and the O’Brien test, the Brown-Forsythe test and the Levene test for testing if the variances are equal. We calculate and compare the volatilities of the daily borrowing costs instead of threemonth borrowing costs with the same data and the same sample periods. See Shimizu and Ogawa (2005). Actually, the fund of funds, which invests in a portfolio of several funds (or investment trusts), has recently become more common and increasingly popular for private investors in Japan. We suppose the case in which investors do not use forward swap transactions for covering foreign exchange risk. We suppose each local bond to be a zero coupon bond. In addition, the yield data give rates on an annual basis, so we convert them to a monthly basis for calculation. Because of the limited sample number, we do not compare the standard deviations of Chinese and Indonesian bonds. For example, the Asian Dollar Bond Index (ADBI) of HSBC is calculated on the basis of shares of the total market capital in each of East Asian countries. We suppose the AMU denominated Asian bond is a portfolio investment in the nine East Asian countries’ government bonds in this chapter. In this chapter we focus on the risks and returns of bonds. However, a higher share for Japanese bonds should be desirable if we take into account other factors, such as transaction costs, grade and liquidity in the market. See Ogawa and Shimizu (2004). A commentator indicates that the bid–ask spreads in foreign exchange forward swap markets account for the hedging costs. We consider bid–ask spreads and foreign borrowing costs separately, since bid–ask spreads should not be included in the measure of foreign borrowing costs, as they are one of the transaction costs. 1 basis point (bp) 51/100 percent. For example, concerning the influence of transaction costs, when a transaction cost is required for holding overseas assets, the efficient frontier shifts to the lower part equal to the transaction cost amount and the investor’s utility is seemed to decrease.

REFERENCES Bénassy-Quéré, Agnes (1999). “Optimal Pegs for East Asian Currencies.” Journal of the Japanese and International Economies 13: 44–60. Hartmann, Philipp (1998). Currency Competition and Foreign Exchange


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Markets: The Dollar, the Yen and the Euro. Cambridge: Cambridge University Press. Ito, Takatoshi (2003). “Construction of Infrastructures for the Development of Regional Bonds Market.” In Choong-Yong Ahn, Takatoshi Ito, Masahiro Kawai, and Yung-Chul Park (eds), Financial Development and Integration in East Asia. Seoul: Korea Institute for International Economic Policy, pp. 206–21. Ito, Takatoshi (2004). “Promoting Asian Basket Currency Bonds.” In Takatoshi Ito and Yung Chul Park (eds), Developing Asian Bond Markets. Canberra: Asian Pacific Press at the Australian National University, pp. 67–89. Ito, Takatoshi, Eiji Ogawa, and N. Yuri Sasaki (1998). “How Did the Dollar Peg Fail in Asia?” Journal of the Japanese and International Economies 12: 256–304. Ito, Takatoshi, and Yung Chul Park (2004). “Overview: Challenges and Strategies.” In Takatoshi Ito and Yung Chul Park (eds), Developing Asian Bond Markets. Canberra: Asian Pacific Press at the Australian National University, pp. 1–15. Kawai, Masahiro, Eiji Ogawa, and Takatoshi Ito (2004). “Developing New Regional Financial Architecture: A Proposal.” Mimeograph. Kawai, Masahiro, and Shinji Takagi (2000). “Proposed Strategy for a Regional Exchange Rate Arrangements in Emerging East Asia.” Policy Research Working Paper no. 2502, World Bank, Washington, DC. Kuroda, Haruhiko, and Masahiro Kawai (2003). “Strengthening Regional Financial Cooperation in East Asia.” PRI Discussion Paper Series no. 03A-10, Policy Research Institute, Japanese Ministry of Finance, Tokyo. Ogawa, Eiji, and Takatoshi Ito (2002). “On the Desirability of a Regional Basket Currency Arrangement.” Journal of the Japanese and International Economies 16: 317–34. Ogawa, Eiji, Takatoshi Ito, and N. Yuri Sasaki (2004). “Costs, Benefits, and Constraints of the Currency Basket Regime for East Asia.” In Asian Development Bank (ed.), Monetary and Financial Integration in East Asia. The Way Ahead, Volume 2. New York: Palgrave, pp. 209–39. Ogawa, Eiji, and Kentaro Kawasaki (2003). “What Should be Weights on the Three Major Currencies for a Common Currency Basket in East Asia?” Paper presented at the Regimes and Surveillance in East Asia Conference in Kuala Lumpur, March. Ogawa, Eiji, and Junko Shimizu (2002). “Roles of Regional Currency in Bonds Markets in East Asia.” Faculty of Commerce Working Paper no. 81, Hitotsubashi University, Tokyo. Ogawa, Eiji, and Junko Shimizu (2004). “Bonds Issuers’ Trade-off for Common Currency Basket Denominated Bonds in East Asia.” Journal of Asian Economics 15: 719–38. Ogawa, Eiji, and Junko Shimizu (2005). “A Deviation Measurement for Coordinated Exchange Rate Policies in East Asia.” RIETI Discussion Paper no. 05-E-017, Research Institute Economy, Trade and Industry, Tokyo. Petri, Peter A. (1993). “The East Asian Trading Bloc: An Analytical History.” In Jeffrey Frankel and Miles Kohler (eds), Regionalism and Rivalry: Japan and the United State in Pacific Asia. Chicago: University of Chicago Press, pp. 21–52. Shimizu, Junko, and Eiji Ogawa (2005). “Risk Properties of AMU Denominated Asian Bonds.” Journal of Asian Economics 16: 590–611. Williamson, John (2000). Exchange Rate Regimes of Emerging Markets: Reviving the Intermediate Option. Washington, DC: Institute for International Economics.

PART III

Exchange rate policies in East Asia: the role of the dollar

6.

East Asia’s role in the revived Bretton Woods system Michael P. Dooley, David Folkerts-Landau, and Peter Garber

6.1

INTRODUCTION AND SUMMARY OF RESULTS

In this chapter, we set out in greater detail how we think about the emergence of China and Asia as major players in world capital and foreign exchange markets. Our approach, which has come to be known as the Bretton Woods II view, provides a coherent explanation for the current structure of interest rates, exchange rates, and current account balances and also provides a contingent playbook for future interest and exchange rate movements. We argued in 2003 and 2004 that the de facto global system was analogous to that during the Bretton Woods period because of the existence of a macroeconomically important periphery that fixed an undervalued exchange rate to the dollar to promote an export-driven development policy. The US willingly played the role of center country again, running balance of payments deficits and serving as the global financial intermediary. Further, contrary to most forecasts at the time, we claimed that the system would last for a long time because of the incentives, especially those of China, to absorb a vast pool of underemployed labor into the industrial system.1 Conventional analyses are based on the assertion that the Bretton Woods II system cannot hold together for much longer. This may or may not turn out to be correct, but it does not offer any guidance for further analysis if the system does survive for an extended time period, as we believe it will. For simplicity, our framework divides the world into three regions, emerging Asia, the US, and Euroland.2 Euroland includes all countries outside the US with open capital markets and market-determined exchange rates. We use the euro to stand for the currencies of these countries since it is the dominant currency among them and the renminbi to stand for the currencies of emerging Asia. 141

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Exchange rate policies in East Asia

The analysis leans on four assumptions. We believe these assumptions are realistic, and they dramatically simplify the dynamics of a three region analysis. First, emerging Asian financial markets are assumed to be poorly integrated with those of the other two regions because of capital controls and because Asian assets are imperfect substitutes for US and Euroland assets. This allows Asia to manage the dollar-renminbi exchange rate so that the renminbi appreciates in real terms slowly over an adjustment period of many years. Second, the US and Euroland financial markets, in contrast, are assumed to be very well integrated and their respective assets close substitutes, an assumption consistent with a great deal of empirical work. The US and Euroland do not manage the euro–dollar exchange rate. Third, the dominant changes in the economic environment that are driving the main features of the world economy are the rapid growth of savings rates and the level of savings in emerging Asia and their exportation to the rest of the world. Fourth, the US and Euroland differ in their capacities to utilize Asian savings, with the US having a much greater absorptive capacity. Our analysis departs significantly from the conventional approach that still dominates the official and academic discourse, which includes the following assumptions contrary to ours. First, conventional analysis considers Asian financial markets sufficiently integrated with international markets so that Asian governments will not be able to manage real exchange rates at reasonable costs. Moreover, they will not want to distort real exchange rates to encourage export-led growth for much longer. Second, conventional analysis assumes that US and Euroland financial markets are not well integrated. For this reason, diversification of Asian reserves is thought to have an important effect on the dollar–euro rate. This assumption seems to us inconsistent with substantial evidence that intervention and reserve management by US and Euroland authorities have not had a large or lasting effect on industrial country exchange rates. Third, conventional analysis usually identifies a fall in the US household savings rate or a rise in the government fiscal deficit rate as the driving force behind the US current account deficit and the global imbalances. Fourth, conventional analysis predicts a rise in US interest rates, which in reality has been contradicted by falling interest rates. To circumvent this contradiction, it is conventionally asserted that interest rates and asset prices are driven by incorrect expectations, a misunderstanding of the dangerous nature of the system, or bubbles.

East Asia’s role in the revived Bretton Woods system

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The interesting results of our analysis following a sudden, long-term rise in exports of Asian savings provide a contingent playbook for future real interest and real exchange rate movements. First, at the start of the system, once it becomes generally understood, there is a substantial immediate appreciation of the euro against the dollar. Second, real interest rates in the US and Euroland will remain low relative to historical experience but converge slowly toward world rates as Asian markets become integrated with international markets. Third, the dollar and the euro will gradually depreciate relative to the renminbi but, after the initial euro appreciation against the dollar, remain constant relative to each other. Fourth, more rapid expected growth in Europe would depreciate the euro relative to the dollar and renminbi and raise interest rates in the US and Europe. Fifth, more rapid expected growth in the US, or more investment demand following exogenous shocks such as Hurricane Katrina in 2005, would tend to depreciate the dollar relative to the euro and renminbi. Because the dollar–renminbi rate is managed, the dollar would not fall immediately but would begin to depreciate more rapidly. The euro would appreciate immediately against the dollar and then match the dollar’s more rapid rate of depreciation against the renminbi. Sixth, shifts in the currency composition of Asian reserves from dollars to euros would have little or no lasting effect on the dollar–euro exchange rate. Seventh, effective protection in the US and Euroland or a fall in the savings rate in Asia would generate a stronger dollar in the long run. The immediate effect would be less rapid dollar depreciation against the renminbi. The euro could go either way against the dollar. Eighth, high oil prices and high consumption by oil exporters would generate a slower rate of dollar depreciation against the renminbi and higher interest rates in the US and Euroland. The dollar–euro rate could go either way. Ninth, a decision by Asian governments to manage their exchange rates relative to a dollar/euro basket would reduce the volatility of the dollar–euro exchange rate but not its current or long-term level. Finally, in real terms, the dollar will eventually have to depreciate relative to the renminbi. But most of the adjustment in the US trade account will come as US absorption responds to increases in real interest rates. Slow adjustment in the composition of US output toward traded goods over an extended time period will not require unprecedented dollar depreciation.

6.2

THE CONVENTIONAL APPROACH

Current account deficits and surpluses (i.e. exports and imports of savings) have clearly moved far outside of historical norms and have therefore

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attracted a great deal of attention. Let S stand for national savings and I for investment. A current account deficit must be associated with S < I (United States), a current account surplus with S > I (Asia), and a current account balance with S 5I (approximately, Euroland).3 It follows that if we could explain why net savings are imported by the US, exported by Asia, and not traded much by Euroland, we would understand the current state of the international monetary system. Moreover, if we could explain how trade in savings will evolve over time we could make meaningful asset price forecasts. The conventional approach starts with the assumption that the fundamental cause of the US current account deficit has been an exogenous fall in national savings in the US. Two explanations for the change in US behavior are offered. First, the jump in the US fiscal deficit reduces government savings. Second, bubbles in asset values, for example housing, reduce household savings. (Both are sometimes linked to an even more fundamental moral decline.) The US is able to “live beyond its means” (an emotional way to say S < I) by pulling in goods from abroad. The US current account deficit is identically equal to the increase in book value of US net foreign debt, so the deficit pushes US debt into foreign portfolios. This “profligacy”, it is argued, is bound to lead to crisis and ever-rising ultimate disaster the longer it lasts. A more complete explanation for the US current account deficit would also describe the transmission of the fall in US savings to other regions. In short, why did Asia supply savings and goods to the US? That is, why is S > I in Asia, and why did Asia buy US securities? Moreover, why did Euroland do neither? The standard analysis of the effects of a decline in US savings is straightforward. First, the market reaction to the decline in US savings is a fall in the value of the dollar relative to other currencies. The depreciation of the dollar tends to reduce the US current account deficit below what it would otherwise be, and the cheaper dollar in the medium term will generate a net improvement in trade to help pay the interest on increased US debt. This basic story has been recently augmented by the idea that foreigners really do not want to lend to the US and will do so only if the dollar is expected to rise in value relative to other currencies. This is sometimes called a “home bias” in investment preferences, a bias that is quite clear in portfolios in the US and the rest of the world. Home bias implies that the dollar has to go down even more now so that investors can reasonably expect it to rise in the future. The expected appreciation of the dollar increases the expected yield on dollar assets relative to assets denominated in other currencies and overcomes the reluctance to lend abroad. The dollar has declined against the euro and other floating currencies,


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as the conventional approach predicts, but not against Asian currencies, because governments in Asia intervene in markets to support the dollar and invest the proceeds in US assets. Most experts believe that this artificial tampering with markets cannot last long and will end with a costly speculative attack on the fixed exchange rate arrangements. The US will then suddenly have to “live within its means” and repay debt. This sudden adjustment will be very costly in terms of both unemployment and large declines in the real value of the dollar as resources are shifted from domestic to traded goods industries. This is certainly a good description of what has happened to other fixed rate systems in recent years. If the US were just like Argentina, the formal story would be finished. Economists warn their neighbors, are perplexed by an indifferent financial industry, and wait for the unhappy end. If the model is right, market expectations must be wrong. If it does not end this year, we are even more certain it will end next year, and with a bigger bang. These warnings have been forthcoming for almost six years, even as the global system soldiers on.

6.3

BRETTON WOODS II

But there are problems with this story, and we have emphasized two. First, if a fall in the US savings rate is driving the system, we should expect US real interest rates to rise. In fact, US rates have fallen and remain so low that they constitute as large a mystery as the very large current account deficit. Second, if the current situation is artificial and cannot last long, this expectation should be apparent in longer term interest rates. But again, the yield curve reflects the expectation that US rates will rise very slowly over the next 10 years. For, example implied forward rates on one-year Treasury inflation-protected securities (TIPS) as of September 17, 2005 rise gradually from 1.07 percent to 2.35 percent over 10 years. Strongly contradicting the expectations underlying these price data, the adherents of the conventional model assume that investors do not understand the world and will be surprised when the end comes. In our framework, the fundamental shock to the system is a change in the supply of savings from developing Asia and a suspension of the usual home bias in allocating these savings across world markets. It may not seem all that important to decide whether it was the fall in US savings or the increase in Asian savings that has driven the pattern of current accounts we now see. But it is in fact crucial for understanding the system and the direction it will take. The first obvious departure from the conventional analysis is the observation that Asian real exchange rates are not market-determined prices

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but are heavily and successfully managed by Asian governments. As noted above, the conventional analysis assumes this troublesome fact will soon go away. We argue that this policy behavior will eventually go away but is a central feature of Asian development policies and will not dissipate for a long time.4 It follows that if the rest of the world is to adjust now to a savings shock emanating from Asia, the primary adjustment mechanism will not be changes in Asian real exchange rates. To manage real exchange rates, Asian governments must intervene in foreign exchange markets. That part of the intervention that is sterilized is in fact intervention in credit markets. Asian finance ministries or central banks sell domestic securities, reducing the supply of loanable funds to domestic borrowers, and buy foreign securities, thereby increasing the supply of loanable funds in the US and Euroland. The resulting shift in interest differential is possible because of effective capital controls. That is, Asian governments can manage exchange rates and interest rates because their domestic assets are made imperfect substitutes for foreign assets in private portfolios by policy, if not by private preference. Because Asian exchange rates are managed, adjustment must proceed through current account balances and real interest rates. Recall that to understand current accounts we have to understand savings and investment. The question then is: how are savings and investment changed in the US, Euroland, and elsewhere as Asian savings are offered to the rest of the world? In particular, can we understand why real interest rates might fall in both the US and Euroland while current account balances adjust by very different amounts? In our view, this is a very easy case to understand. We can illustrate our approach first with a set of figures focusing on interest rates and current accounts for Asia, the US, and the Euroland and then with another set focusing on net foreign debt positions and exchange rates. Figure 6.1 shows real interest rates for the US, Euroland, and Asia on the vertical axes. The horizontal axes are the current accounts for these US r

S

S9

r0

Euroland S r

r1 0

Figure 6.1

CA Deficit

S9 S

I

I Surplus

Asia r r1 r0

r0

r1

S9

I 0 Surplus

CA Deficit

Current account and interest rates

0 Surplus

CA Deficit


147

three regions. The upward sloping curves labeled S are national savings. The curves labeled S9 are national savings augmented by imports or exports of savings. The downward sloping curves labeled I are investment. For convenience, we start with balanced current accounts at a common interest rate, but any starting point for the separate economies will do as long as real rates are the same in the US and Euroland. A policy to divert Asian savings to the US and Euroland reduces the supply of savings available in Asia and shifts the Asian domestic supply curve to the left. A current account surplus is generated and interest rates in Asia rise. In the US and Euroland, savings supply curves shift to the right as Asian savings push in. The real interest rate in the US and Euroland falls as we move down the investment demand curves. The demand curves are downward sloping because investment increases relative to domestic savings as interest rates fall. Moreover, consumption rises with a fall in interest rates so domestic savings fall as well. The rise in consumption and investment is matched by an inflow of foreign savings, and the current account deficit increases. The increase in Asia’s current account surplus is matched by the sum of the increases in the current account deficits of the US and Euroland. In the US, the increase in savings demanded is large because investment and savings are quite sensitive to the rate of interest.5 Euroland sees the same qualitative changes, but investment and the current account deficit increase only slightly because there are few profitable investment opportunities and consumption is not very responsive. The fundamental factor driving the different responses of the US and Euroland current account deficits is the difference in opportunities for efficiently utilizing foreign savings as the interest rate falls in both regions. An important aspect of the adjustment process is the equalization of real rates of return on capital invested in the US and Euroland through private arbitrage. When we turn to exchange rate determination below, we use the assumption that real interest rates are equalized by flows of savings. It is clear, however, that expected rates of return on capital in the US and Euroland could be equalized by expected real exchange rate changes in addition to real interest rates. This apparent indeterminacy between real interest rates and expected changes in real exchange rates during the adjustment period is resolved at the end of the period. When the new equilibrium is established there is no reason to predict that the real exchange rate between the euro and the dollar would continue to change over time. Since the capital stocks must have the same expected rate of return looking forward at the end of the adjustment period, it follows that real interest rates must be the same at that time. Arbitrage across time will ensure that any capital

148


put in place in the US and Euroland during the adjustment period that will remain in place in a new steady state must have the same rate of return. The optimal policy over time for Asian governments is to allow gradual real exchange rate appreciation. This reduces over time their intervention in credit markets and their exports of savings. By the end of the adjustment period real interest rates will have equalized across the three regions. We now turn to the foreign exchange markets. There are three keys to understanding the three cross exchange rates. First, for some years Asian governments can and will manage the real dollar value of their currencies. They can do so because capital controls make Asian domestic assets imperfect substitutes for US and Euroland assets in private portfolios. Their ability to manage their real exchange rate will erode over time as capital controls become less effective and their domestic asset markets are integrated with international capital markets. Their desire to maintain the system will also erode as their surplus labor is absorbed. But they will manage rates as long as they can because undervaluation is an important part of their development strategy. Second, in the long run, say 10 years more or less, the real value of the three currencies will have to adjust to changes in the international investment positions of the three regions generated during the adjustment period. Asia’s net asset position will improve, while the US and Euroland positions will deteriorate by relatively large and small amounts, respectively. The relationship between the long run exchange rate and the net foreign debt position of each region is not controversial. As net foreign debt increases, larger trade balance surpluses are needed to service net debt (balance the current account). So a fall in net foreign assets is associated with a depreciation of the real exchange rate. The implication is that the dollar and the euro must depreciate against the renminbi, but the dollar must depreciate by more. Therefore, the dollar must depreciate against the euro.6 Third, exchange rates today would normally reflect these long run expectations to some degree. But intervention by Asian governments is sufficient to manage strictly the dollar–renminbi exchange rate. Intervention will not keep the renminbi undervalued forever, but it can extend the adjustment period. As we have argued elsewhere, the optimal path (from China’s perspective) for Asian real exchange rates is a gradual appreciation toward their new long run values. In contrast, the euro cross-rates both today and along the adjustment path are determined by private investors. The relevant context for these portfolio choices is that dollar and euro assets are close substitutes. The key implication is that once the system comes to be understood the euro and the dollar must depreciate at the same rate over time relative to the renminbi. Recall that real interest rates on capital invested in the US and


149

RMB/ USD A

B

T

0 RMB/ EUR E C

D

0

Figure 6.2

T

Exchange rates

Euroland are equalized by net savings flows. It follows that investors must expect the euro–dollar exchange rate to remain unchanged. Put another way, both currencies must depreciate, and be expected to depreciate, at the same rate against the renminbi. The result of a shift in Asian savings exports is then an immediate euro appreciation against the dollar and the renminbi followed by a constant dollar–euro rate. This means that there will be immediate, maximal political pressure for relief in a Euroland unable to absorb the shock easily, and continuous, though declining, pressure thereafter. These results are illustrated in Figure 6.2. Starting from an initial value A for the renminbi–dollar rate in the top panel and C for the renminbi–euro rate in the bottom panel, we can follow the effects of an increase in Asian savings together with intervention. The increase in savings combined with intervention raises interest rates in Asia and lowers interest rates in the US and Euroland. Asia generates a current account surplus matched by deficits in the US and Euroland. This continues until Asian savings and intervention return to normal levels. In Figure 6.2, this interval is from 0 to T. The eventual fall in the dollar against the renminbi from A to B is required in order to generate the trade surplus needed to service the higher level of US debt at time T and after.

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Without intervention, we would expect an immediate depreciation of the dollar; but this can and will be delayed by intervention.7 Along the adjustment path AB, the dollar is supported by a flow of intervention. Private investors know the dollar will depreciate but nevertheless are willing to hold the stock of dollars, reduced by Asian purchases of US assets.8 US debt to foreigners is growing more rapidly than it would have if the fall in interest rates had been partially offset by a market-determined depreciation of the dollar. The renminbi–euro rate starts at C and must eventually move to D, a much smaller depreciation. Like the US, Euroland will accumulate debt (or reduce net assets below their previous path) during the adjustment period. But in this case Asian governments are not intervening to manage the exchange rate either at point C or along the adjustment path. The question is then: where will the market set euro exchange rates? We can make our analysis more realistic and much more transparent by assuming that US and Euroland assets are close substitutes in private portfolios. This is a very important departure from the usual portfolio balance model because it implies that the currency composition of Asian intervention is of secondary importance. If euro and dollar assets are close substitutes in private portfolios, Asian governments could intervene in either dollars or euros to stabilize the dollar value of their currencies. Moreover, diversification of Asian reserves would have little or no lasting effect on the dollar–euro exchange rates, contrary to a key conclusion of the conventional view. This view is consistent with a very large body of empirical evidence that sterilized intervention has no lasting effect on exchange rates among industrial countries.9 The practical importance of this assumption is that the two adjustment paths in Figure 6.2 must have about the same slope. If they did not, more rapid dollar depreciation against the renminbi, relative to euro depreciation against the renminbi, would imply expected depreciation of the dollar against the euro. Since interest rates in the US and Euroland are the same, arbitrage would be profitable. Private investors would immediately bid for euros against dollars and would do so until the euro jumps to E. From this initial appreciation the euro would then depreciate against the renminbi at the same rate as the dollar. Note that along this adjustment path the euro would remain “overvalued” relative to the dollar and the renminbi throughout the adjustment interval, although the degree of overvaluation would shrink over time. We can now iterate through the current account analysis. If the euro has appreciated against the renminbi and the dollar, Euroland’s current account deficit, already increased by the fall in interest rates, would tend to widen. The dollar would remain unchanged against the renminbi and


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would have depreciated against the euro, so the already increased US current account deficit would be reduced. The Asian surplus would be increased by the euro’s appreciation. These second round effects on the current account positions of the three regions would not alter our basic story assuming the reactions of absorption to interest rates are very different in the US and Euroland.

6.4

WHERE ARE WE NOW COMPARED TO THESE PICTURES?

The discussion above suggests that the dollar should have depreciated against the euro when market participants realized that US imports of savings from Asia would generate a substantial increase in US net investment income payments. But there has been no obvious correspondence between the US current account deficit or the increase in net US international debt and the value of the dollar. The current account deteriorated sharply in 1996, and net debt began to grow at a historically unprecedented rate, but the dollar was strong until 2002. One explanation is found in Figure 6.3, which shows US net investment income payments. As of mid-2004 the US still earned more on its stock of gross financial assets than it paid on its larger stock of gross international Million USD 25 000 20 000 15 000 10 000 5 000

Note: Net investment income 5 Income receipts on US owned assets abroad − Income payments on foreign-owned assets in the United States. Source:

Deutsche Bank.

Figure 6.3

US net investment income

2005 – Q1

2004 – Q1

2003 – Q1

2002 – Q1

2001 – Q1

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1998 – Q1

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debt. Indeed, in the eight most recent quarters (Q2/2003–Q1/2005), US net earnings totaled USD 86 billion, compared to USD 47 billion in the previous eight quarters. The lesson is clear: it is not enough to forecast changes in the US net debt position. We also need to know the stocks of gross international assets and liabilities and the rates of return on these stocks. Our framework suggests that over time the growth in net US debt will generate net investment payments in part because we expect net debt to grow and US interest rates to rise over the adjustment period. But we also expect very substantial capital gains on US-owned foreign direct investment, and this tends to limit the growth in the market value of US net debt and reduces net investment income payments. Forming correct expectations about the long run value of net investment income payments requires a difficult evaluation of the evolution of net and gross investment positions and rates of return.10 Moreover, it would not be surprising if market participants were uncertain about the longevity of US current account deficits. The conventional story still insists that a speculative attack on Asian currencies that will force a revaluation is long past due. If it had occurred, the path of US debt would have already started to reverse. Moreover, the first analysis that we know of that predicted large and sustained US current account deficits as part of a rational global system was not published until mid-2003.11 Perhaps the best way to link the analysis with the experience of the past 10 years is to assume that, as the US deficit has moved to a historically high level and stayed there for an extended period, market participants have placed increased weight on the probability that the very gradual appreciation of Asian currencies requires the substantial near term rise of the euro against the dollar described above. It would not be surprising if this learning process has some way to go. If so, there will be periodic upward pressure on the euro. As the learning curve flattens, the euro should stabilize against the dollar.

6.5

THE BW II PLAYBOOK: HOW WILL BUMP SCENARIOS MOVE INTEREST AND EXCHANGE RATES?

Of course, many changes in conditions could shift the dollar–euro exchange rates along the adjustment path set out in the previous section. The framework developed above is useful for evaluating changes in the economic environment during the adjustment process, and the peculiar nature of the global system produces some remarkable and unanticipated results.


153

RMB/ USD A F

G B

t1

0

T

RMB/ EUR E H

C

D I J

0

t1

T

Figure 6.4 Exchange rates Bump 1: A Stronger Euroland Outlook Suppose, for example, that at time t1 an improved outlook for profits in Euroland were to generate a positive shift in the demand for investment in Euroland. Figure 6.1 suggests that Asian savings would be shifted from the US to Euroland for the balance of the adjustment period and that interest rates in both regions would rise. The effects on exchange rates are illustrated in Figure 6.4. With more Asian savings going to Euroland and less to the US, at the end of the adjustment period (at T) the euro would be weaker and the dollar stronger than would have otherwise been the case. If Asian intervention at t1 were to keep the dollar at F in Figure 6.4, the euro would depreciate sharply at t1 for two reasons. First, it would then need to reach level J at T. And second, it would then depreciate more slowly to match the dollar’s reduced rate of depreciation. Bump 2: A Weaker Euroland Outlook A weaker outlook for Euroland investment would have symmetric effects. In this case there would be a deterioration in the final expected debt position

154


of the US and an improvement in the final debt position of Euroland. This would require a more rapid rate of dollar depreciation against the renminbi and another lurch up for the euro. Interest rates in both regions would fall. Bump 3: A Stronger US Outlook Changes in US growth and investment would have similar effects. As US growth increases, so would the expected stock of US debt. The greater long run depreciation would not affect the current dollar–renminbi rate but would require a more rapid appreciation of the renminbi against the dollar for the balance of the adjustment period. The euro would appreciate against the renminbi and the dollar for two reasons. First, its long run level would jump up. Second, it would have to appreciate immediately in order to match the dollar’s higher expected depreciation rate against the renminbi. This is illustrated in Figure 6.5. The expected RMB/USD at T would shift down from B to G, and the expected RMB/EUR would move up from D to K. The euro would immediately jump from H to I as again the change in the euro would be amplified by arbitrage between dollar and euro assets. Interest rates in both regions would rise. RMB/ USD A F

B G t1

0

RMB/ EUR E

T

I H

C

K D

0

Figure 6.5

Exchange rates

t1

T


155

Bump 4: Exogenous Shocks to the US Economy A shock to the US economy such as Hurricane Katrina in 2005 would be a one-off and would increase US demand for foreign savings, which would lead to an increased US indebtedness at T. Therefore, Bump 3 analysis applies. The euro would appreciate against the dollar. Bump 5: Protectionism Surges; Oil Exporters Start Consuming Asia’s Surplus Savings Bump 5a For example, effective protection against Asian exports in both the US and Euroland would reduce net savings transfers to the US and Euroland from Asia by forcing a reduction in Asia’s net trade surplus. Bump 5b Similarly, a decline in net Asian savings exported to the US and Euroland would occur if a larger share of US, Euroland, and Asian income were transferred to oil exporters via terms of trade shifts. As the oil exporters would start to consume a high fraction of this transfer, fewer excess savings would be available to fund US and Euroland debt accumulation. Each of these developments can be analyzed as illustrated in Figure 6.6. It turns out that both would have the same impacts on interest and exchange rates. In these events expected US debt at T would be reduced, which would increase the terminal exchange rate from B to G. Euroland debt would also fall, which would raise the terminal RMB/EUR from D to K. We assume that the new path for the RMB/USD would not jump up at t1 but that the rate of dollar depreciation would be reduced so that the new path for the RMB/USD would be FG. The RMB/EUR rate must reach K at T, and the path from t1 must have the same slope as FG; that is, the RMB/EUR must have the same expected rate of depreciation as the RMB/ USD. The conclusion is that the euro could either depreciate or appreciate immediately against the dollar, depending on the relative change in debt stocks in response to the new environment. There is no necessary direction of effect for this key exchange rate. Interest rates would rise both in the US and Euroland because of the reduction in available savings. A useful rule of thumb is that events that change expected US and Euroland debt stocks and real exchange rates in opposite directions generate large and immediate changes in the dollar–euro rate. The market rate changes in the same direction as the change in the expected future rates. Events that move both expected debt stocks in the same direction have ambiguous effects on the exchange rate at the point where expectations change.

156

Exchange rate policies in East Asia RMB/ USD A F

G B

t1

0

T

RMB/ EUR E C

I

H K D

0

t1

T

Figure 6.6 Exchange rates Bump 6: A Serious Basket Peg The results discussed above would be altered if Asian authorities ever really did adjust the dollar–renminbi rate in reaction to changes in the dollar– euro rate via the adoption of a basket peg. In the absence of new shocks to the equilibrium path, a basket peg would have no effect because the dollar– euro exchange rate is constant during the adjustment period. However, in the face of the other shocks discussed above, a basket peg would tend to reduce the volatility of the dollar–euro exchange rate and would either increase or decrease the average real value of the renminbi, depending on the nature of shocks. There is no implication that a move from a straight dollar peg to a basket peg would weaken the dollar.

6.7

CONCLUDING REMARKS

It is generally accepted that adjustment must occur to ultimately remove the imbalances from the international monetary system. The dispute has been between a view that the system will end abruptly and soon and a view that it will last for years more with a smooth adjustment in interest


157

rates and exchange rates. Here, we presume that the basic system that has dominated at least the last five years will continue for years more, while converging to a sustainable equilibrium. With this system as a background, we examine the behavior of interest rates and exchange rates following a variety of shocks to the international monetary system. Our analysis suggests that real interest rates in the US and Europe will remain low relative to historical cyclical experience for an extended period but converge slowly toward normal levels. During this adjustment interval, the US will continue to absorb a disproportionate share of world savings. Moreover, after a substantial initial appreciation, the floating currencies will remain constant relative to the dollar in the undisturbed background system. An improvement in the investment climate in Europe during the adjustment period would generate an immediate depreciation of the euro relative to the dollar. In real terms, the dollar and the floating currencies will eventually have to depreciate relative to the managed currencies. But most of the adjustment in the US trade account will come as US absorption responds to increases in real interest rates.

NOTES 1. 2. 3. 4.

5. 6.

7.

For a detailed presentation of this system, see Dooley et al. (2003a, 2003b, and 2004b). This current note is a shorter version of Dooley et al. (2005). Because there is no necessity for geographic contiguity, we have referred to these regions in other essays from the functional viewpoint as the trade account region, the center country, and the capital account region. Of course, Euroland, as we have defined it, includes some countries with large surpluses, such as Canada, or deficits, such as the UK. We consider the impact of the new oil exporter surpluses as a separate issue. Our critics sometimes claim that we predict that Asian governments will fix real exchange rates and finance a US current account deficit forever. This, of course, would make no sense. The tactic of the development strategy is a controlled rise in dollar wages to world levels at the end of a long adjustment period. We have argued that Bretton Woods II might be replaced by a Bretton Woods III as a new set of periphery countries replace Asian graduates. This means that there are lots of viable projects or confident consumers ready to go with a small improvement in financing costs relative to Euroland. In our view, the amount of the eventual dollar depreciation is often overestimated. Recall that the primary factor driving the increase in the US trade and current account deficits is the relatively strong response of US investment and consumption to a decline in interest rates. Over the adjustment period interest rates will rise, thereby causing an equally strong reverse effect; this will help reduce the US deficit. The exchange rate adjustment therefore must be consistent with a slow shift in US output toward traded goods. We could replace time with net debt on the horizontal axis and have a diagram similar to that presented in Blanchard et al. (2005). The case we present here is similar to their discussion of intervention following a shift in preferences away from US goods. The interested reader is encouraged to work through their analysis of an imperfect substitutes model. Their analysis assumes that interest rates are unchanged, and changes in absorption are assumed to be related to fiscal policies.

158 8.

9.

10. 11.

Exchange rate policies in East Asia The portfolio balance equilibrium is based on the idea that residents of all countries prefer home assets but can be moved away from their preferred portfolio by differences in expected yields—that is, by interest differentials adjusted for expected changes in exchange rates. We have also explored the effects of diversification under the assumption of imperfect substitution between dollar and euro assets. Our conclusion was that it is not in the interests of Asian governments to diversify. See Dooley et al. (2004a). The argument presented here suggests that Asian governments can diversify if they choose to do so but that this would have little effect on dollar exchange rates. See Gourinchas and Rey (2005) for a detailed breakdown of the denomination of US gross foreign assets and liabilities. See Dooley et al. (2003a).

REFERENCES Blanchard, Olivier, Francesco Giavazzi, and Filipa Sa (2005). “The U.S. Current Account Deficit and the Dollar.” NBER Working Paper no. 11137, National Bureau of Economic Research, Cambridge, MA. Dooley, Michael, David Folkerts-Landau, and Peter Garber (2003a). “Dollars and Deficits. Where Do We Go from Here?” Deutsche Bank, June 17. Dooley, Michael, David Folkerts-Landau, and Peter Garber (2003b). “An Essay on the Revived Bretton Woods System.” NBER Working Paper no. 9971, National Bureau of Economic Research, Cambridge, MA. Dooley, Michael, David Folkerts-Landau, and Peter Garber (2004a). “The Revived Bretton Woods System: The Effects of Periphery Intervention and Reserve Management on Interest Rates and Exchange Rates in Center Countries.” NBER Working Paper no. 10332, National Bureau of Economic Research, Cambridge, MA. Dooley, Michael, David Folkerts-Landau, and Peter Garber (2004b). “Direct Investment, Rising Real Wages, and the Absorption of Excess Labor in the Periphery.” NBER Working Paper no. 10626, National Bureau of Economic Research, Cambridge, MA. Dooley, Michael, David Folkerts-Landau, and Peter Garber (2005). “Interest Rates, Exchange Rates, and International Adjustment.” NBER Working Paper no. 11771, National Bureau of Economic Research, Cambridge, MA. Gourinchas, Pierre Olivier, and Helene Rey (2005). “From World Banker to World Venture Capitalist: US External Adjustment and the Exorbitant Privilege.” NBER Working Paper no. 11563, National Bureau of Economic Research, Cambridge, MA.

7.

Current account surpluses and conflicted virtue in East Asia: China and Japan under the dollar standard Ronald McKinnon and Gunther Schnabl1

7.1

INTRODUCTION

The 1997–98 Asian crisis triggered a still ongoing debate about what the proper exchange rate policy should be in East Asia. Before 1997, all the East Asian countries—with the important exception of Japan—informally pegged to the dollar at both high and low frequencies of observation. But opinions diverge as to whether this soft dollar pegging aggravated the crisis. The International Monetary Fund’s (IMF) position is that these soft dollar pegs accentuated moral hazard in poorly regulated domestic banks (Fischer 2001). In the absence of immediate foreign exchange risk, they over-borrowed by accepting foreign currency deposits at lower interest rates in order to make higher-yield loans in their domestic currencies. However, floating the exchange rate may not be the correct policy response for curbing moral hazard in banks. McKinnon and Pill (1999) suggest that the differential between domestic and foreign interest rates might actually widen under a volatile float, thus aggravating the temptation to over-borrow. While the academic discussion about the pros and cons of more exchange rate flexibility continues, the focus of the political discussion about the proper exchange rate regimes in East Asia has shifted toward the pros and cons of allowing appreciations of the East Asian currencies against the dollar. Some authors have argued—in particular with respect to China—that countries in the economic catch-up process that are running high saving surpluses should allow their exchange rates to appreciate to curtail “excessive” surpluses in their current accounts (Cline 2005, Frankel 2006). As we show, the East Asian countries are conflicted in making the decision to allow an appreciation of their currencies, as appreciation need not reduce the trade surpluses but could cause serious deflation. Therefore, 159

160


to maintain macroeconomic stability, the East Asian countries are well advised to maintain their dollar pegs, as they have mainly done since 1998.

7.2

THE POST-CRISIS RETURN TO HIGH-FREQUENCY PEGGING

The evidence in favor of the East Asian return to exchange rate stabilization against the dollar in the new millennium has two facets. The first has to do with the weight that the smaller East Asian economies assign to the dollar compared to the weights assigned to other major currencies such as the yen or euro in their “currency baskets”, that is, the weights directing their foreign exchange interventions. The second has to do with the volatility of East Asian dollar exchange rates now as compared to that before the 1997–98 crisis. Let us discuss each in turn. The Composition of Currency Baskets Before the 1997–98 crisis, the East Asian currencies had de jure pegs to baskets of major currencies, but typically the weights assigned to various currencies in the official basket were not announced. Instead, they had de facto or “soft” pegs to the dollar, as Figure 7.1 shows. Although many East Asian countries such as Korea, Thailand, and the Philippines officially shifted toward more flexible exchange rates after the crisis, most East Asian countries seem to have returned to having high dollar weights in their exchange rate strategies. Using an econometric technique proposed by Frankel and Wei (1994), McKinnon and Schnabl (2004) use an “outside” currency—the Swiss franc—as a numéraire for measuring the exchange rate volatility of the East Asian countries (except Japan) in order to detect the composition of their currency baskets.2 For example, if changes in the Korean won to Swiss franc exchange rate are largely explained by the changes in the US dollar to Swiss franc rate, the US dollar will have a weight close to one (100 percent) in the Korean currency basket. In other words, the Korean won can be assumed to be virtually pegged to the US dollar. Alternatively, if movements in the won against the Swiss franc are largely explained by movements in the yen against the Swiss franc, then the yen will have a weight close to one in Korea’s currency basket; and similarly with the euro.3 Figure 7.2 plots 130-day rolling regressions for each East Asian country’s exchange rate against the Swiss franc on the dollar’s exchange rate

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East Asian exchange rate pegs against the dollar, 1990:01–2006:02 (monthly)

IMF: IFS, central bank of China.

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Figure 7.1

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Figure 7.2 Dollar’s weight in East Asian currency baskets, 130-trading-day rolling regressions, 1990:01–2005:12 (daily)

Source:

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Current account surpluses and conflicted virtue in East Asia

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against the Swiss franc using daily exchange rate observations over the period January 1990 to December 2005. The regression coefficients for all East Asian countries’ dollar exchange rates are close to one for the observed period before the crisis. While the pegged exchange rate regimes fell apart during the 1997–98 crisis, following the crisis the coefficients have again remained high for all East Asian countries. The weights of the dollar in the currency baskets have remained close to one for China, Hong Kong, Malaysia, the Philippines, Taiwan, and (although the coefficient is rather erratic) Indonesia. For Korea, Singapore, and Thailand the weight seems to decline to some extent but remains well above 50 percent. Thus, in the new millennium, the dollar retains its predominant weight in all East Asian currency baskets—with the currencies of China, Hong Kong, and Malaysia remaining tightly fixed to the dollar despite the recent shift of China and Malaysia toward slightly more flexible exchange rates (McKinnon 2005). This is not to deny that the yen and, more recently, the euro (Schnabl, Chapter 10, this volume) are accorded some small weights in these currency baskets, which have become larger (although much less than the dollar’s weight) post-crisis, in particular in the cases of Korea, Singapore, and Thailand.4 Exchange Rate Volatility against the Dollar However, knowing the currency basket weights used in the East Asian exchange rate strategies is not the whole story on exchange rate volatility. In complementary tests, we measure volatility as the percentage daily change of the national currency against the dollar (log first differences) from January 1990 through December 2005. We have two standards for assessing this volatility. First, we compare the volatilities of the dollar exchange rates of the smaller East Asian economies with those of the Japanese yen,5 the euro (German mark), and the Swiss franc.6 Figure 7.3 shows that in the noncrisis periods the daily volatilities of the dollar exchange rates of these more developed industrial economies are an order of magnitude higher than those of the smaller East Asian countries. Not only are the daily exchange rate volatilities of these industrial countries very high, but they do not change significantly over time. In contrast, the volatilities of the East Asian currencies are generally much lower—but with greater variability over time, with the crisis periods showing up very starkly in the graph. Second, we compare pre-crisis and post-crisis exchange volatilities. Table 7.1 reports the standard deviations of daily exchange rate fluctuations against the dollar. In the pre-crisis period (before June 1, 1997), the standard deviations of the day-to-day exchange rate volatilities against the dollar of

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4% 3% 2% 1% 0% –1% –2% –3% –4%

96 99 02 05 1. 1. 1. 1. .0 .0 .0 .0 01 01 01 01 Singapore dollar

96 99 02 05 1. 1. 1. 1. .0 .0 .0 .0 01 01 01 01 Indonesian rupiah

96 99 02 05 1. 1. 1. 1. .0 .0 .0 .0 01 01 01 01 Euro (Deutsche mark)

93

1.

.0

01

93

1.

.0

01

93

1.

.0

01

90 1. .0 01

4% 3% 2% 1% 0% –1% –2% –3% –4%

90

1.

.0

01

4% 3% 2% 1% 0% –1% –2% –3% –4%

90

1.

.0

01

4% 3% 2% 1% 0% –1% –2% –3% –4%

93 1. .0 01

99 02 05 1. 1. 1. .0 .0 .0 01 01 01 Korean won

96

1.

.0

01

02 05 99 1. 1. 1. .0 .0 .0 01 01 01 Swiss franc 96

1.

.0 01

05 96 99 02 1. 1. 1. 1. .0 .0 .0 .0 01 01 01 01 New Taiwan dollar 93 1. .0 01

93

1.

.0

01

Exchange rate volatility against the US dollar of selected crisis and non-crisis currencies, 1990:01–2005:12 (daily)

Bloomberg.

Volatility is daily percentage changes against the dollar.

Figure 7.3

Source:

Note:

01

.0

4% 3% 2% 1% 0% –1% –2% –3% –4%

01

90

1.

.0

4% 3% 2% 1% 0% –1% –2% –3% –4%

01

.0

4% 3% 2% 1% 0% –1% –2% –3% –4%


Table 7.1

165

Standard deviations of daily exchange rate fluctuations against the dollar

Chinese yuan Hong Kong dollar Indonesian rupiah Korean won Malaysian ringgit Philippine peso Singapore dollar New Taiwan dollar Thai baht Japanese yen Euro (Deutsche mark) Swiss franc

Pre-crisis

Crisis

Post-crisis

2004/2005

0.03 0.02 0.17 0.22 0.25 0.37 0.20 0.19 0.21 0.67 0.60 0.69

0.01 0.03 4.43 2.35 1.53 1.31 0.75 0.50 1.55 1.00 0.58 0.66

0.05 0.03 1.03 0.46 0.03 0.47 0.29 0.24 0.36 0.64 0.65 0.68

0.09 0.03 0.51 0.42 0.05 0.23 0.29 0.28 0.28 0.59 0.61 0.69

Note: Percent changes. Pre-crisis 5 February 1, 1994–May 30, 1997, crisis 5 June 1, 1997–December 31, 1998, post-crisis 5 January 1, 1999–May 17, 2004, 2004/2005 5 January 1, 2004–December 8, 2005. Source:

Bloomberg.

all East Asian currencies are much smaller than the standard deviations of the so-called free floaters (Japan, Euroland, and Switzerland). The standard deviations of the hard pegs (China and Hong Kong) are close to zero during and after the crisis. For Indonesia, Korea, Malaysia, the Philippines, and Thailand, the standard deviations in Table 7.1 increase massively during the crisis period (June 1, 1997 to December 31, 1998), while those of the noncrisis economies Singapore and Taiwan increase somewhat less. From the end of the crisis to December 2005, the standard deviations of all affected countries decline again (Table 7.1). Except in the case of Malaysia, which fixed firmly to the dollar at the end of 1998, the dollar exchange rate volatilities of the crisis economies for the whole post-crisis period (1999–2005) are slightly larger than before the crisis. In 2004–05 (the right hand column in Table 7.1), with the exception of Malaysia and the Philippines, exchange rate volatilities in East Asia remain somewhat above the pre-crisis levels, but they are significantly lower than those of the freely floating benchmark economies. China has allowed for slightly more exchange rate volatility since July 2005, but has kept its currency tightly fixed to the dollar. With the benefit of hindsight, the post-crisis return to high-frequency dollar pegging is hardly surprising. But how is this exchange rate stabilization at high frequencies linked to the exchange rate fluctuations at lower

166


Table 7.2

Standard deviations of monthly exchange rate fluctuations against the dollar

Chinese yuan Hong Kong dollar Indonesian rupiah Korean won Malaysian ringgit Philippine peso Singapore dollar New Taiwan dollar Thai baht Japanese yen Euro (Deutsche mark) Swiss franc

Pre-crisis

Crisis

Post-crisis

0.25 0.08 0.26 1.01 1.06 1.19 0.76 1.01 0.43 3.66 2.20 2.62

0.03 0.07 26.54 11.53 6.69 5.25 2.88 2.63 8.88 3.64 2.33 2.60

0.18 0.09 4.57 1.90 0.14 1.57 1.09 1.13 1.60 2.32 2.43 2.40

Note: Percent changes. Pre-crisis 5 February 1994–May 1997, crisis 5 June 1997–December 1998, post-crisis 5 January 1999–February 2006. Source:

IMF: IFS.

frequencies? Learning from their past vulnerability to yen/dollar depreciation (McKinnon and Schnabl 2003), many East Asian countries seem to be allowing more dollar exchange rate variability at lower frequencies in the post-crisis period, as shown by Hernández and Montiel (2002). Indeed, Figure 7.1 shows more dollar exchange rate drift after than before the crisis on a month-to-month basis. For Indonesia, Korea, the Philippines, Singapore, Taiwan, and Thailand monthly exchange fluctuations are greater than before—although those for China, Hong Kong, and Malaysia remain close to zero, even after China and Malaysia’s shift to (slightly) more exchange rate flexibility in July 2005. Table 7.2 compares the standard deviations of monthly percentage exchange rate fluctuations against the dollar in the pre-crisis and post-crisis periods. We observe that for all East Asian countries except China, Hong Kong and Malaysia the monthly exchange rate variability against the dollar is still somewhat higher post-crisis than in the pre-crisis period. In part, this could be due to the fact that all appreciated together against the dollar after their “over-shooting” depreciations in early 1998, but attempts to reduce exchange rate fluctuations against the Japanese yen and more recently the euro (Schnabl, Chapter 10, this volume) may also play a role. There is an alternative way to measure exchange rate smoothing at low frequencies in the post-crisis era. Suppose we use fluctuations in the more

Current account surpluses and conflicted virtue in East Asia 0

5

10

15

20

25

30

167 35

Chinese yuan Hong Kong dollar Indonesian rupiah Korean won Malaysian ringgit Philippine peso Singapore dollar New Taiwan dollar Thailand baht Japanese yen Euro Swiss franc Note: Source:

Positive values correspond to depreciation. Bloomberg.

Figure 7.4

Exchange rate changes against the US dollar, 1999:01– 2001:12 (percent)

freely floating euro–dollar exchange rate as the benchmark for measuring general market pressure against the dollar. We assume that the European Central Bank, which only conducts inflation policy, leaves the euro–dollar rate to market forces. We partition the data into the following two subperiods: 1999–2001 (Figure 7.4), when the dollar appreciated generally against the euro, and 2002 to December 2005 (Figure 7.5), when the dollar mostly depreciated against the euro (though tending to appreciate during 2005; Figure 7.6). Figure 7.4 plots the cumulative depreciation of the euro and all East Asian currencies over the period of dollar appreciation. All East Asian currencies, except the Philippine peso but including the Japanese yen, depreciated less than the euro against the dollar. From the beginning of 2002, when the dollar started depreciating, the picture reverses. Figure 7.5 shows that all East Asian currencies except the Korean won appreciated considerably less against the dollar than did the euro. In order to resist this exchange market pressure for local currency appreciation, each East Asian central bank intervened by buying dollars—as reflected in the rise of official foreign reserves shown in Figure 7.6. Official foreign reserves in East Asian countries have increased surprisingly quickly in all East Asian countries.7

168 –30

Exchange rate policies in East Asia –25

–20

–15

–10

–5

0

5 Chinese yuan Hong Kong dollar Indonesian rupiah Korean won Malaysian ringgit Philippine peso Singapore dollar New Taiwan dollar Thailand baht Japanese yen Euro Swiss franc

Note: Source:

Negative values correspond to appreciation. Bloomberg.

Figure 7.5

Exchange rate changes against the US dollar, 2002:01– 2005:12 (percent)

This accumulation of foreign reserves flattened in 2005 as US interest rates considerably increased (Figure 7.6). Nevertheless, the long-term trend of reserve accumulation in East Asia persists. In contrast, the official foreign exchange reserves of the benchmark free floaters, Germany (Euroland, after 1999) and the United States itself, hardly changed over that time period. Far beyond simply rebuilding their pre-crisis levels of exchange reserves, East Asian governments have evidently been intervening on a massive scale to prevent their exchange rates from appreciating.

7.3

THE RATIONALE FOR DOLLAR PEGGING— ORIGINAL SIN AND CONFLICTED VIRTUE

The rationale for dollar pegging, as observed in section 7.2, is not primarily based on strong trade ties between East Asia and the United States. As outlined by McKinnon and Schnabl (2003), the US accounts for only about one fifth to one quarter of the overall exports of the smaller East Asian economies—and for much less of their imports. More important is the widespread use of the dollar as the invoice currency for most of East Asian trade, even though Japanese trade in the region is as large as that of the United States (McKinnon and Schnabl 2004).

169

n

Ja

0

10

20

30

40

50

90

90

90

n Ja

n

n

Ja

Ja

94

94

94

n

98

98

98

Thailand

n

Ja

02

02

02

n

Ja

n

n

Ja

Ja

Malaysia

n

Ja

China

Ja

n

n Ja

06

06

06

n Ja

Ja

n

n

Ja

800 700 600 500 400 300 200 100 0

Ja

18 16 14 12 10 8 6 4 2 0

n Ja

140 120 100 80 60 40 20 0

90

90

90

n Ja

n

Ja

n

Ja

n

Ja

98 n

Ja

n

Ja

98 n

Ja

94

98

Japan

n

Ja

n Ja

Philippines

94

02

02

02

Hong Kong

94

06

06

06

n Ja

n

Ja

n

Ja

n

Ja

120 100 80 60 40 20 0

n

n

Ja

120 100 80 60 40 20 0

Ja

40 35 30 25 20 15 10 5 0

90

90

90

n Ja

n

Ja

n Ja

94

94

94 98

98 n Ja

98

n Ja

Germany

n

Ja

Singapore

n

Ja

02

02

02

n Ja

Indonesia

n Ja

n Ja

n Ja

06

06

06

n

Ja

n

n Ja

60 50 40 30 20 10 0

Ja

280 240 200 160 120 80 40 0

n Ja

200 160 120 80 40 0

90

90

90

n Ja

n

Ja

n

Ja

94

94

94 98

98

98 US

n Ja

n Ja

02

02

02

n Ja

n

Ja

Taiwan

n Ja

Korea

n Ja

n Ja

06

06

06

n Ja

n Ja

Official foreign exchange reserves of crisis and non-crisis countries in billions of dollars, 1990:01–2006:02 (monthly)

IMF: IFS.

Billion dollars. Note different scales on the y-axis.

Figure 7.6

Source:

Note:

n

n Ja

80 70 60 50 40 30 20 10 0

Ja

800 700 600 500 400 300 200 100 0

170


This currency asymmetry extends to the financial markets. The dollar is the dominant inter-bank currency for clearing international payments and denominating short-term capital flows, and it is the principal official intervention and reserve currency for governments (McKinnon 2004). And using a common international money, sometimes called a key currency, in international markets for goods and finance greatly facilitates commerce, particularly within the increasingly integrated East Asian economy. If, in addition, the key currency is itself stable in terms of its purchasing power over tradable goods and services—as the US dollar was in the 1950s and 1960s, and as it has become once more from the mid-1990s into the new millennium—then governments in the peripheral countries are induced to peg their currencies to the key currency in order to better anchor their own price levels. Ideally, the center country should have no exchange rate objectives of its own, allowing it to follow an independent monetary policy more purely focused on stabilizing its own price level. In East Asia, the fact that most of the increasingly integrated economies of the region more or less peg to the dollar greatly widens the effective dollar area—thus enhancing the anchoring effect of any one of them pegging to the dollar. In summary, the benign face of the East Asian dollar standard arises out of the dollar’s microeconomic role in facilitating international commerce on the one hand and out of its macroeconomic role as nominal anchor for national price levels on the other. Both increase incentives for Asian governments to peg to the dollar (McKinnon 2005). However, this dollar dominance also has a more malign aspect that, paradoxically, also induces governments in peripheral countries to peg to the dollar. Domestic financial markets, particularly bond markets, may remain underdeveloped in part because financial instruments denominated in domestic currencies are not used in international transactions. Dollar dominance creates unhedgeable foreign exchange risks in countries whose private sector is a significant net debtor or a significant net creditor internationally. Before 1997–98, Indonesia, Korea, Malaysia, the Philippines, and Malaysia all ran substantial current account deficits (see Table 7.3) that had accumulated into large, mainly dollar-denominated, net debts at the time of the great crisis. Post-crisis, these five “crisis” economies were forced to run current-account surpluses, and four of them, Korea, Malaysia, the Philippines, and Malaysia, are rapidly transforming themselves into creditors—particularly in their net liquid dollar asset positions. In parallel, Table 7.3 also shows the chronic international creditors, Japan, Singapore, Taiwan, and China (a special case discussed more fully below), running current account surpluses from 1990 to 2005. So all the East Asian countries are now, or are close to being, net international creditors in dollars.

171

1990

1991

Source:

Note:

3.02 7.24 3.14 −1.33 0.23 −4.46 −5.55 −5.09 −1.94

1993 2.72 16.17 2.66 −1.58 −0.95 −6.06 −4.60 −5.60 1.28

1994 2.10 17.56 2.07 −3.18 −1.68 −9.71 −2.67 −8.07 0.23

1995 1.40 15.03 3.91 −3.37 −4.16 −4.43 −4.77 −8.07 0.88

1996

1999

2000

3.02 2.57 2.52 22.22 17.85 12.84 1.29 2.78 2.86 4.29 4.13 4.84 11.69 5.51 2.39 13.19 15.92 9.40 2.37 9.48 8.24 12.73 10.13 7.59 3.30 2.11 1.90 1.50 6.28 4.14

1998

2002

2003

2004

2005

2.11 2.83 3.17 3.68 3.59 16.78 17.77 29.03 25.95 28.75 6.36 9.09 9.98 5.74 4.73 4.20 3.91 3.53 1.23 1.07 1.67 0.99 1.96 4.06 2.09 8.28 7.55 12.87 12.57 15.56 1.86 5.71 1.76 2.42 3.01 5.36 5.53 5.56 4.10 −2.16 1.46 2.72 3.12 3.99 7.13 5.88 7.58 10.40 9.48 10.69

2001

−50.1 −84.8 −121.6 −113.7 −124.9 −140.9 −214.0 −300.1 −416.0−389.5 −475.2 −519.7 −668.1 −804.9

117.09 117.63 132.70 93.56 43.83 129.16 244.22 231.28 212.26 176.99 233.44 297.88 357.16 430.48

East Asia does not include Hong Kong from 1990 to 1997.

IMF: IFS, WEO.

2.25 15.58 2.43 −2.27 −1.62 −5.92 −5.28 −2.00 4.09

1997

−0.79 −1.27 −1.72 −1.54 −1.60 −1.70 −2.45 −3.24 −4.24 −3.85 −4.54 −4.74 −5.69 −6.45

2.97 11.87 4.14 −2.00 −1.30 −3.67 −1.89 −5.66 1.36

1992

East Asian and US current accounts in comparison, 1990–2005

Percent of GDP Japan 1.45 1.96 Singapore 8.45 11.32 Taiwan 6.96 7.11 Indonesia −2.61 −3.32 Korea −0.80 −2.85 Malaysia −1.97 −8.51 Philippines −6.08 −2.28 Thailand −8.53 −7.71 China 3.13 3.32 Hong Kong United −1.36 0.05 States Billions of US dollars Total East 54.28 73.35 Asia Total US −78.9 2.8

Table 7.3

172


For countries on the dollar’s periphery, we consider the problems facing debtors and creditors in turn. Debtor Countries with Original Sin In their original formulation, Eichengreen and Hausmann (1999) call “original sin” a situation in which the domestic currency cannot be used to borrow abroad (international original sin) or to borrow long term, even domestically (domestic original sin). Because of incomplete and fragile financial markets, domestic investors face a maturity mismatch (long-term projects are financed by short-term loans) or a currency mismatch (projects that generate domestic currency are financed with dollars). According to Eichengreen and Hausmann, these mismatches are not primarily because banks and enterprises are not prudent enough to hedge their foreign exchange risk exposures. Instead, less developed countries whose liabilities are denominated in foreign currency are unable to hedge because a typical foreign investor won’t accept claims denominated in their domestic currencies. Original sin renders monetary authorities less willing to let the exchange rate move both at low and at high frequencies. At low frequencies, Eichengreen and Hausmann argue that dollar liabilities increase macroeconomic instability by increasing the credit risk for national balance sheets. When debt is denominated in foreign currency, exchange rate fluctuations strongly affect the servicing cost of this debt in terms of the domestic currency. Sharp depreciations can force indebted enterprises and financial institutions into default, with considerable risk for the viability of the whole domestic financial system. In addition, McKinnon and Schnabl (2004) argue that original sin affects exchange rate stabilization in emerging markets at high frequencies. As domestic capital markets are shallow and incomplete, an active forward market in foreign exchange against the dollar—or any other currency— is absent in most developing countries and emerging markets. Forward transactions by risk-averse traders wanting to hedge their open positions in foreign currency are difficult, even when the private sector may not be a net debtor. Potential market makers such as banks cannot easily cover transactions involving selling the domestic currency forward for, say, dollars, because a convenient array of interest-bearing domestic bonds liquid at different terms to maturity is unavailable for foreigners to hold.8 But the problem becomes more acute if the economy is a net debtor. Because economies with uncovered net short-term dollar debts typically have high risk premia in their domestic currency interest rates—as was the case with Indonesia,


173

Korea, Malaysia, the Philippines, and Thailand before the 1997–98 crisis (McKinnon and Pill 1999)—individual owners of dollar liabilities see the cost of forward cover (i.e. the premium on buying dollars forward with the domestic currency) to be too high. Thus, they typically don’t hedge. This induces the government to provide an informal hedge by keeping the exchange rate stable to offset the non-existent private market in forward exchange. If short-term exchange rate fluctuations are low, private banks and enterprises can then repay their short-term foreign currency debts, which are largely denominated in dollars, with minimal exchange rate risk. Thus, if a country’s financial markets are condemned by original sin, its monetary authorities are induced to undertake high-frequency exchange rate pegging in order to mitigate payments risk—and are induced to hold official exchange reserves that offset at least part of the private sector’s net international indebtedness. Creditor Countries with Conflicted Virtue The original sin argument is adequate for explaining the pervasive “fear of floating” in the less developed East Asian debtor countries before the 1997–98 crisis, as well as in developing countries more generally (Calvo and Reinhart 2002). But post-crisis, when all East Asian countries ran current-account surpluses and joined the creditor club (Table 7.3), why has exchange rate stabilization against the dollar persisted? Even highly industrialized Japan, which has had a sustained current account surplus since the early 1980s and has built up an immense international investment position in US dollars, increased its efforts to stabilize the yen against the dollar in the new millennium (Hillebrand and Schnabl 2006). What is the motivation for exchange rate stabilization in the East Asian creditor countries? In Euroland, most private claims on foreigners are denominated in euros. In contrast, East Asian countries hold dollars as the financial counterpart to their cumulative current account surpluses and net inflows of foreign direct investment. Because of underdeveloped financial markets or residual capital controls, private or public investors in most East Asian economies find it more attractive to invest in dollar assets than in claims on foreigners denominated in their home currencies. Even Japan, which has a more highly developed capital market, has built up the lion’s share of its international portfolio assets in US dollars. To put it the other way around, foreigners (among whom Americans are dominant) are disinclined to build up debts denominated in “minor” Asian currencies (including the Chinese yuan) as the counterpart of the huge and still rising US current account deficit (Table 7.3). (Some US firms are more willing to issue bonds in euros in the now highly developed euro

174


bond markets. But Euroland is not as big a net creditor relative to its GDP as are the Asian countries collectively.) There is two-way causation between private portfolio preferences for dollars and government exchange rate policies. Once an Asian government sees its private sector accumulating dollar assets (dollar debts in the case of debtor economies), it becomes more anxious to stabilize its exchange rate against the dollar. And when neighboring countries that are close trading partners are also stabilizing their dollar exchange rates, this enhances the attractiveness of holding dollar assets within any one country. So dollar dominance helps finance the large US current account deficit. The upshot is that the main foreign exchange risk associated with this enormous transfer of capital is shifted to the largely Asian creditor countries.9 Any international creditor country that cannot lend in its own currency accumulates a currency mismatch that we call the syndrome of “conflicted virtue”, the mirror image of the concept of original sin in debtor economies. Countries that are “virtuous” by having a high saving rate (most unlike the United States!) tend to run surpluses in the current account of their international balance of payments, that is, lend to foreigners. With the passage of time, two things happen. First, as the stock of dollar claims accumulates,10 domestic holders of dollar assets worry more about a self-sustaining run on the domestic currency forcing an appreciation. Second, foreign governments start complaining that the country’s ongoing flow of trade surpluses is unfair and the result of having an undervalued currency. Of course, both interact. The greater the foreign mercantilist pressure for appreciation of the domestic currency, the greater the concern of the domestic private holders of dollar assets. This induces them to convert dollars into domestic currency. As runs on the domestic currency and out of dollars begin, the government is “conflicted” because an appreciation would dampen exports and, if repeated, could set in train serious deflation ending with a zero interest liquidity trap. But foreign governments may threaten trade sanctions if the creditor country in question does not allow its currency to appreciate. Hence, the “syndrome of conflicted virtue”. Notice that conflicted virtue would not arise in international creditor countries whose money is internationally accepted. Britain was the world’s dominant creditor country in the 19th century, with huge net capital outflows. But sterling was used to denominate most British claims on foreigners, sometimes with gold clauses. Similarly, for two and half decades after World War II, the US had large trade surpluses and was the world’s biggest creditor, with its claims on foreigners denominated mainly in dollars. However, the East Asian economies are historically unusual in being significant international creditor economies whose currencies are


175

relatively little used. In Japan, current account surpluses have persisted since the early 1980s. Taiwan and Singapore have exhibited current account surpluses since the late 1980s. China’s export surpluses, although not as large relative to its GDP, have persisted since 1994. Since 1998, all East Asian countries have run current account surpluses (reflecting their “virtuously” high saving rates) resulting in high net capital exports (Table 7.3). With the longest modern history of current account surpluses, the build-up of international assets (which are largely dollar-denominated) continues in Japan (Figure 7.7). Japan’s net international investment position, as reported by the Japanese Ministry of Finance, has increased since the early 1980s—reaching a new record high of 1.8 trillion dollars at the end of 2004. Although China’s build-up of liquid dollar claims has a much shorter history than Japan’s, it was and continues to be accelerated by large inflows of foreign direct investment (FDI)—a relatively illiquid longterm liability. McKinnon and Schnabl (2006a) estimate China’s liquid dollar-denominated assets at roughly USD 1000 billion by the end of 2005. Including all the smaller economies as well, the cumulative joint current account surplus of all East Asian countries since 1990 (Table 7.3) amounts to nearly USD 3 trillion. Potential balance sheet losses from the fluctuation of the dollar against the domestic currency increase as these dollar claims accumulate. Should the domestic currency appreciate, unhedged individual or institutional holders of such large dollar assets would be increasingly at risk. Although all East Asian holders of dollar assets like their higher yields compared to those on yen assets, they would suffer capital losses if their domestic currency appreciated. Thus, as the economy’s overall dollar assets accumulate, dollar asset holders become more fearful of a flight from dollars into the domestic currency, followed by appreciation. Like in most other East Asian countries, in China the natural currency habitat of domestic nationals is their home currency. Household consumption expenditures, wages, and claims on financial intermediaries such as banks (deposits) and insurance companies (annuities) are mainly in yuan. Chinese firms and households will hold dollar assets only if there is a substantial business convenience in doing so or if the interest rate on dollar assets is higher. The primary downside risk is for the yuan to appreciate against the dollar and thus reduce the yuan value of dollar assets. Depending on how sensitive domestic holders of dollar assets are to this risk, periodic flights from dollars into yuan could occur just on rumors of appreciation (McKinnon and Schnabl 2006a). Should the domestic currency actually appreciate when the world price level measured in dollars is itself quite stable, each East Asian government

176

Exchange rate policies in East Asia 2000 1800

total public private

Billions of dollars

1600 1400 1200 1000 800 600 400 200 0 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

Source:

Japanese Ministry of Finance.

Figure 7.7

Net international investment position of Japan, 1980–2004 (billions of dollars)

worries about the sudden loss of competitiveness of its exporters followed by a domestic deflationary spiral—as experienced by Japan from the mid1980s through the 1990s as a result of the erratically appreciating yen (McKinnon and Ohno 1997). Implications for Interest Rates: The Negative Risk Premium Governments in creditor economies with conflicted virtue may cut domestic short-term interest rates to forestall or slow the conversion of privately held dollar assets into domestic currency assets. Insofar as people believe that low short-term rates would persist, domestic long-term interest rates would also be bid down. Can a new portfolio equilibrium be found in which, at any given exchange rate, private agents would be willing to finance the ongoing current account surplus by building up liquid dollar claims on foreigners rather than the government having to accumulate official exchange reserves? Japan has the longest experience with current account surpluses, and the associated build up of dollar claims, from the early 1980s into the new millennium. The upper panel of Figure 7.8 shows that interest rates on long-term (10-year) Japanese government bonds (JGBs) are on average about 3 to 4 percentage points less than those on long-term US treasuries; and the lower panel shows more volatile short-term money market rates,


177

16 Japan US

14

Percent per annum

12 10 8 6 4 2 0 Jan 80

Jan 84

Jan 88 Jan 92 Jan 96 Jan 00 Long-term: 10-year US treasuries and JGBs

Jan 04

20 Japan (call money rate) US (federal funds rate)

18 16 Percent per annum

14 12 10 8 6 4 2 0 Jan 80

Figure 7.8

Jan 85

Jan 90 Jan 95 Short-term: money market rates

Jan 00

Jan 05

Interest rates in the US and Japan, 1980:01–2006:02 (percent per annum)

with Japanese rates, on average, also being substantially lower than US interest rates. To account for the sustained interest differential between yen and dollar assets, we postulate the augmented interest parity relationship:

178


i 5 i* 1 Δse 1 f,

(7.1)

where i is the (endogenously determined) Japanese long-term nominal interest rate, i* is the (exogenously given) US long-term nominal interest rate, s is the yen price of one dollar, Δse is the expected depreciation of the yen, and f is the risk premium on yen assets. From the 1970s to the mid-1990s the interest differential, i 2 i*, had been driven primarily by the negative Δse term, when the erratically appreciating yen peaked out in April 1995 (McKinnon and Ohno 1997). Since the mid-1990s, Δse < 0, and the interest differential has been driven primarily by the f term, which is also negative (Goyal and McKinnon 2003). The coefficient f is the excess yield on dollar assets that a Japanese investor demands for bearing foreign exchange risk. For a private Japanese financial institution holding net dollar assets, fluctuations in the yen–dollar exchange rate result in fluctuations in the yen value of the net dollar assets, and hence in the yen value of the net worth of the financial institution. From this perspective, the dollar asset is a risky one because its liabilities are denominated in yen. So f captures the excess yield, over and above expectations of ongoing yen appreciation, on the dollar asset necessary to induce the domestic financial institution to hold it. It follows that f is negative for a creditor country such as Japan with private-sector assets denominated in foreign currency. Conversely, f is positive for a debtor country whose private sector debts are denominated in foreign currency. The size of f depends on the country’s net foreign currency position and on the expected variance in its exchange rate against the dominant foreign money. With a credibly fixed exchange rate, f approaches zero. However, if fluctuations in the yen–dollar exchange rate are “normal” and if interest rates on yen assets are sufficiently below those on dollar assets, the Japanese private sector—banks, insurance companies, trust funds, and so on—can still be persuaded to fund Japan’s ongoing current account surpluses by building up their stocks of higher-yield dollar assets. But there are limits on how negative this risk premium on yen assets, and on how wide the associated interest differential, can become. When American interest rates fell to abnormally low levels, with short rates at just 1 to 1.5 percent, in 2003 and 2004 and Japanese interest rates were bounded from below by zero11 (lower panel of Figure 7.8), the spread simply was not big enough. Then the Japanese private sector refused to keep acquiring enough dollar assets, which they saw to be riskier, to cover Japan’s ongoing current account surplus. Indeed, private agents in Japan started unloading previously accumulated dollar assets in order to acquire near zero-yield yen assets! In 2003, the Bank of Japan intervened massively in the foreign exchange markets, so that official reserves rose by 201.33


179

billion dollars while Japan’s current-account surplus was just 136.4 billion dollars (Table 7.4). In effect, the Japanese government “over-funded” Japan’s current account surplus in 2003 and almost in 2004—although not in earlier years.12 The problem of governments over-funding their current account surpluses—conflicted virtue in an extreme form—has been common in East Asia in recent years. Table 7.4 shows the same phenomenon in Taiwan (2002, 2003, and 2004), Korea (2002, 2003, and 2004), Malaysia (in 2004 and almost in 2003), Thailand (in 2004), and China (2001 to 2005).13 For East Asia as a whole, official reserve accumulation in 2003 and 2004 was 434 and 472 billion dollars, respectively, while the current account surpluses were “just” 255 and 362 billion dollars, respectively. But apart from the extreme case of over-funding in 2003 and 2004, East Asian governments have been trapped into unduly heavy reserve accumulation for several years because of the reluctance of their private sectors to accumulate nearly enough dollar assets, as well as their inability to lend in their domestic currencies to foreigners in order to fully cover their current account surpluses. Recently, even more than in Japan, the over-funding problem has become obvious in China. In the face of increasing current account surpluses and inflows of foreign direct investment, Chinese private firms and individuals have become less willing to accumulate dollar assets because of the threat that the yuan might be appreciated. In contrast to Japan’s, the Chinese exchange rate had remained tightly pegged to the dollar up to July 2005, and it has only appreciated slightly since then. But the threat is there, this is, Δse < 0. Chinese wealth holders see dollar assets to be riskier than yuan assets. In addition, even if there is no unidirectional expectation that the yuan will appreciate, f becomes more negative the more volatile the exchange rate and the greater the private holdings of dollar assets—and Chinese interest rates are driven down further. If the renminbi were to remain credibly pegged to the dollar, as is almost the case in Hong Kong, then both Δse and f would equal zero and shortterm money market interest rates (as in Hong Kong) would converge toward the US federal funds rate. In contrast, suppose the exchange rate were to remain fixed but investors face the risk that the renminbi might appreciate. For portfolio equilibrium, the interest rate on renminbi assets must be less that on dollar assets by Δse 1 f, which reflects the size of any expected discrete appreciation, the probability that it will occur, how distant the event is, and what the subsequent turmoil in exchange market fluctuations would be. Given an increasing uncertainty about exchange rate appreciation, the Chinese interest rate would fall below the US interest rate—as has been the case since early 2005 (Figure 7.9).

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China

Thailand

Philippines

Malaysia

Korea

Indonesia

Taiwan

Singapore

Japan

Table 7.4

CA RC CA RC CA RC CA RC CA RC CA RC CA RC CA RC CA RC

44.1 −8.5 3.1 7.4 10.9 −0.8 −3.0 2.0 −2.0 −0.5 −0.9 1.9 −2.7 −0.5 −7.3 3.8 12.0 11.6

68.2 112.6 131.6 130.3 111.0 65.8 96.8 118.8 114.6 119.7 −7.7 0.1 26.8 26.4 57.3 34.9 0.5 −4.7 74.5 69.5 4.9 5.9 4.2 11.4 14.7 13.9 14.9 18.3 14.8 11.9 6.4 5.7 8.4 9.8 10.5 8.1 −5.6 3.5 1.9 3.4 12.5 8.6 7.0 6.5 5.5 10.9 7.1 3.4 8.0 8.9 10.0 −0.1 1.3 8.9 −2.1 −2.3 −4.5 6.8 15.9 0.5 −4.3 −2.8 −2.1 −2.8 −6.4 −7.7 −4.9 4.1 5.8 8.0 1.8 1.0 0.8 0.8 1.5 4.5 −1.7 6.3 3.8 2.0 −8.4 −4.1 0.8 −4.0 −8.7 −23.2 −8.4 40.4 24.5 12.3 −1.2 3.3 3.1 5.3 6.9 1.3 −13.5 32.3 21.7 22.2 −4.2 −2.2 −3.0 −4.5 −8.6 −4.5 −5.9 9.5 12.6 8.5 1.1 6.4 10.0 −1.9 −1.9 3.2 −6.1 4.7 4.9 −1.1 −1.0 −1.0 −3.0 −3.0 −2.0 −4.0 −4.4 1.6 7.2 6.3 2.3 1.1 0.3 1.3 0.4 3.7 −2.8 2.0 4.0 −0.2 −7.6 −6.3 −6.4 −8.1 −13.6 −14.7 −3.0 14.2 12.4 9.3 4.0 2.7 4.1 4.8 6.6 1.7 −11.5 2.7 5.4 −1.9 13.3 6.4 −11.6 6.9 1.6 7.2 37.0 31.5 21.1 20.5 14.1 −23.2 1.8 30.4 22.0 31.5 34.9 5.1 9.7 10.9

87.8 112.5 136.2 172.1 163.9 40.5 63.7 201.3 171.5 4.6 14.4 15.7 27.0 27.9 33.6 −4.8 6.5 13.6 16.5 3.9 17.9 25.6 29.3 18.5 16.4 15.5 39.5 45.0 35.1 11.6 6.9 7.8 8.4 3.1 3.0 −1.2 3.7 4.0 −0.0 −2.0 8.0 5.4 12.0 27.6 16.6 6.6 18.3 33.7 43.7 11.8 7.3 7.2 13.4 14.9 20.4 1.0 3.7 10.2 21.9 4.3 1.3 4.4 11.4 2.1 2.9 0.4 −0.3 0.3 −0.5 2.8 6.2 7.0 7.9 6.6 −3.8 0.4 5.7 2.9 7.5 2.0 17.4 35.4 45.9 68.7 158.6 46.6 74.2 116.8 206.7 208.9

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

East Asian current accounts (CA) and changes in official foreign reserves (RC), 1990–2005 (billions of dollars)

181

Source:

Note:

CA RC CA 54.3 RC 16.4

4.2 6.4 7.8 6.3 6.2 73.4 117.1 117.6 132.7 93.6 35.0 3.5 64.3 92.2 107.1

2.5 10.3 7.0 9.8 12.4 16.5 15.7 19.0 8.4 29.0 −3.2 6.6 11.3 3.6 0.7 6.5 5.2 0.7 43.8 129.2 244.2 231.3 212.3 177.0 233.4 297.9 357.2 430.5 95.1 18.6 55.6 148.5 116.7 108.5 215.8 434.3 472.5 237.0

IMF: IFS, central bank of China.

East Asia does not include Hong Kong from 1990 to 1997. Shaded areas indicate that reserve accumulation is larger than the current account balances.

Hong Kong East Asia

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13 US (federal funds rate) China (interbank rate)

12 11

Percent per annum

10 9 8 7 6 5 4 3 2 1 0 Jan 90 Source:

Jan 92

Jan 94

Jan 96

Jan 98

Jan 00

Jan 02

Jan 04

IMF: IFS, Bloomberg.

Figure 7.9

Short-term interest rates in the US and China (1990–2005)

All in all, in 2005 and 2006 the appreciation pressure on the East Asian currencies was somewhat released as sharply rising interest rates in the US provided private investors with a greater incentive to invest in the US. In Japan, foreign exchange intervention abated, and the Bank of Japan started to shorten the supply of liquidity to the Japanese economy. In 2006, it was believed that the Bank of Japan might even terminate its zero interest rate policy, and the Japanese money market interest rate may follow the US interest rate path. Figure 7.10 shows how short-term interest rates in nine East Asian countries (not including Japan) have also fallen sharply in the new millennium relative to those of the 1990s. (Unlike that of Japan, their long-term bond markets are too underdeveloped to get meaningful interest-rate quotations.) By the standards of less developed countries, their central banks have allowed short rates to fall to unusually low levels in an attempt to stem upward pressure on their currencies and excess accumulation of official reserves. Ultra-low American interest rates in 2002–04 made it difficult to establish a negative risk premium as in Japan, but domestic interest rates in Hong Kong and Singapore approached zero, and those in Taiwan and Thailand were near the low American level. China, Korea, and Malaysia were just a percentage point or two above American rates. The Philippines

183

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Philippines

Ja

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96

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96

Monthly money market interest rates, 1990:01–2006:01 (percent per annum)

n

Ja

02

Singapore United States

n Ja

Korea

n Ja

Singapore

96

96

Korea United States

96 99 02 05 n n n n Ja Ja Ja Ja China (Bank Rate)

IMF: IFS. (Note different scales).

Figure 7.10

Source:

n Ja

10 9 8 7 6 5 4 3 2 1 0

n Ja

0

5

10

15

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n Ja

12 10 8 6 4 2 0

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and Indonesia were outliers, with an apparently significant positive risk premium. The sharp US interest rate increase since 2004 has triggered respective adjustments. Interest rates in Hong Kong, Singapore, and Thailand have followed the path of the Federal Funds Rate closely while remaining below the US level. In China, Korea, Malaysia, and Taiwan short-term interest rates are now below the US level, reflecting those countries’ growing roles as creditors. The Philippines and Indonesia remain outliers, as their interest rates remain significantly above the US level. The recent increase in US interest rates has—temporarily?—relieved the threat in China and East Asia, that, like in Japan, interest rates might be compressed toward zero, that is, forcing the East Asian countries into the liquidity trap. In the long term, however, this threat will persist as long as the East Asian countries accumulate dollar-denominated assets, the liquidity trap potentially rearing up whenever US interest rates start to decline again. The imperfect solution for ameliorating this risk is for each East Asian government to keep its dollar exchange rate as stable as it can. This then reduces the risk faced by unhedged dollar creditors within the economy in question. Hence monetary authorities resorting to the “soft” or informal dollar pegging we observe in non-crisis periods—and which was documented above. To be sure, some governments would like to give full assurance that the domestic exchange rate is never going to change. But not even China dares to commit itself to an absolutely fixed dollar exchange rate when its neighbors, who are close trading partners, have not done so. The spillover effects from other countries changing their exchange rates are just too great for any country to risk becoming completely inflexible in responding to either an appreciation or a depreciation by a neighboring country.14 So, short of the adoption of a full-fledged system of regional dollar parities (a difficult exercise in collective action although a potentially great public good for East Asia), soft pegging is the result.

7.4

THE SUSTAINABILITY OF THE DOLLAR STANDARD

The large collective trade surplus of the East Asian countries with the United States, matched by the huge East Asian net capital exports to the US, has become a stylized fact. But noting this fact alone does not tell us anything about causality or sustainability. Do the East Asian governments acquire dollar bonds in a conscious effort to keep their exchange rates undervalued in order to promote exports and development? Or is the huge current account deficit of the United States, reflecting low American saving


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and an unlimited line of credit with the rest of the world, forcing more and more countries—but particularly those in East Asia—to run with current account surpluses that lead to conflicted virtue? The DFG Approach Dooley, Folkerts-Landau, and Garber (DFG; 2003, 2004, Chapter 6, this volume) argue that the causality runs from East Asian nations’ trade surpluses—and their governments’ mercantilist policies—to the US trade deficit. Their argument has deeper historical roots. Under the world dollar standard since 1945, DFG see the world divided into a center (the United States) and its periphery. For the 1950s and 1960s, when exchange rates were more or less fixed under the Bretton Woods agreement, they argue that the important periphery was Western Europe and Japan. In order to recover more quickly from the ravages of the war, these countries cooperated (implicitly) to keep their currencies undervalued in order to promote both high export growth in manufactures and investment in higher tech industrial export activities. (In the 1950s and 1960s, less developed countries were then mainly producers and exporters of primary products or embarking on import-substituting industrialization. As such they were not a mercantile threat to the center country.) The “cost” to the European countries was the rapid build-up of low-yield, if highly liquid, dollar assets. But this cost, if any, may have been small or nonexistent. Despres et al. (1966) put forward what they called the “minority view” that the United States, with its more highly developed long-term capital market, was simply providing financial intermediation services to the Europeans by lending long in illiquid forms, including foreign direct investment, while borrowing back short in more liquid forms as Europeans built up dollar bank accounts and official foreign exchange reserves.15 In the 1950s and 1960s, the US had a current account surplus. This intermediation argument still holds in a more limited way today for countries with less developed domestic financial markets, such as China. The United States is an important source of foreign direct investment into China, financed in large measure by China’s huge build-up of more liquid dollar claims on the United States. The difference now, of course, is that the United States, with its large current-account deficit, is no longer a net lender to developing countries In the new millennium, DFG suggest that European countries have matured from being “peripheral” into having their own fully developed financial markets—particularly with the advent of the euro. In our terminology, European countries are now redeemed from original sin (for those that are debtors) and from conflicted virtue (for those that are creditors).

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Therefore, they are quite willing to allow their currencies (principally the euro) to float relatively freely against the dollar without any inordinate build-up of dollar exchange reserves. DFG label these relatively free floaters, including Canada and Australia, “capital-account” countries. However, DFG identify a new periphery of the United States composed of what they call “trade-account” countries: mainly our high-growth East Asian economies. DFG claim that these trade-account countries intervene heavily in the foreign exchanges to keep their currencies undervalued in order to stimulate export expansion into the American market, with a consequent stimulus to investment in these export activities. (As befits the center country in the world dollar standard, the United States has no independent exchange rate objective.) The East Asian countries are willing to bear the opportunity cost, in the form of a huge build-up of low-yield dollar reserves, of their trade surpluses for this “development” objective. At the same time, the American government’s own borrowing constraints on financing wars, cutting taxes, and so on, has been greatly softened because of the large (incidental) foreign capital inflow embodied in the large US current account deficits. Because both sides see themselves as benefiting from this arrangement despite mercantilist conflicts in particular industries, DFG see the East Asian countries’ large trade surpluses and “undervalued” exchange rates to be sustainable for a sustained period of time. The MCS Approach In contrast to DFG, McKinnon and Schnabl (MCS) hypothesize that the relatively high-saving East Asian countries are collectively being forced into running current account surpluses with the relatively low-saving United States. Because of the asymmetrical nature of the world dollar standard, the US alone has a virtually unlimited dollar line of credit with the rest of the world (McKinnon 2004). With low American household saving and the large deficits of the US federal government, the United States is drawing on this dollar line of credit with a vengeance: America’s current account deficit was about 6.5 percent of GDP in 2005 and was set to approach 7 percent in 2006. But this American savings–investment imbalance is not a result of “mercantilist” governments in East Asia undervaluing their exchange rates. The East Asian countries are covering a considerable part (about half), but by no means all, of the US current account deficit. An increasing share of the US current account deficit is covered by oil-exporting countries such as Russia and the Middle East. Why, then, are East Asian governments intervening so heavily (Figure 7.6) to keep their currencies from appreciating if it is not to generate a trade


187

surplus? MCS argue that they are trapped by conflicted virtue. A sharp appreciation by any one East Asian country would: first, impose capital losses on domestic holders of dollar assets and make them even more reluctant to finance future current account surpluses; second, cause an immediate loss of mercantile competitiveness to East Asian neighbors with whom they are all closely integrated in trade and with whom they compete in third markets; and third, risk a macroeconomic slowdown followed by deflation, the more so if the appreciation is repeated. However, undergirding the willingness of East Asian countries to maintain their dollar pegs is the presumption that the purchasing power of the dollar will remain fairly stable through time. Although American fiscal policy seems to be out of control, these countries presume that Federal Reserve Chairman Ben Bernanke will continue using America’s monetary policy to stabilize the US price level, as in the 1990s, into the new millennium. So MCS see exchange rate policy as an important adjunct of the domestic monetary policy of a peripheral country. On the dollar’s periphery, an appreciating currency is a recipe for ongoing deflation with a potential liquidity trap for interest rates—as Japan experienced with its forced appreciations from the mid-1980s to the mid-1990s (Goyal and McKinnon 2003, McKinnon and Schnabl 2006a). But monetary cum exchange rate policy cannot predictably influence a country’s net trade balance, which comes down to saving and investment propensities at home relative to those abroad (McKinnon and Schnabl 2006b). Thus, we part company with DFG’s claim that the currencies of the East Asian countries are now “undervalued” in the new millennium, and we also disagree with their claim that the currencies of the Western European countries and Japan were undervalued in the 1950s and 1960s. Putting aside Balassa-Samuelson effects associated with rapidly growing economies, price inflation in Europe and Japan in the 1950s and 1960s was about the same as that in the United States. By this criterion, the Bretton Woods exchange rates were more or less right as long as the American price level remained stable—which it was until the very end of the 1960s. Similarly, price inflation in most East Asian countries today is about the same as it is in the United States: their “soft” dollar pegs are not obviously misaligned. But with conflicted virtue, the amount their currencies would appreciate if floated has no well-defined upper bound. When DFG link “undervalued” currencies to trade surpluses, they (like most economists) probably have something like the textbook elasticities model of the balance of trade in their minds. This intuitively appealing model predicts that an appreciation will slow a country’s exports while stimulating its imports, resulting in the reduction of its trade surplus. However, the elasticities model only applies to an economy that is insular:

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its foreign trade is a fringe activity, it is closed to international investment flows, and setting the exchange rate is separable from monetary policy. On the other hand, for a fully open economy, McKinnon and Ohno (1997, Chs 6 and 7) show that an appreciation could cause a sufficient slump in domestic investment for imports to fall more than exports, so that the net trade balance would improve. They conclude that the effect of an exchange rate change on the net trade balance is ambiguous.16 However, MCS agree with DFG that the present dollar-based regime with large East Asian trade surpluses and huge trade US deficits is sustainable, or at least is not on the verge of an imminent breakdown. After all, something like this regime has been around since early 1980s when Japan was the dominant external creditor of the United States. But DFG believe it to be a product of export mercantilism in peripheral countries, whereas MCS see them as being trapped by improvident US saving behavior.

7.5

CONCLUSION

The collective macroeconomic consequences of each East Asian government opting individually to peg to the dollar, if only softly, enlarges the effective zone of stable dollar prices far beyond each country’s direct trade with the United States (McKinnon 2005). Thus each national central bank can lean more heavily on its own stable dollar exchange rate to anchor its domestic price level—which in turn helps its neighbors, with whom it is closely connected in trade, to stabilize their own. A virtuous circle for a change! From the 1980s up to the Asian crisis of 1997–98, most East Asian countries could pin down their wholesale price levels by anchoring their currencies to the dollar (McKinnon and Schnabl 2004). Only the wholesale price indices of Indonesia and the Philippines—which allowed their currencies to depreciate continually, but in a controlled fashion—rose significantly. This common dollar anchor was more robust because all East Asian countries except Japan participated in it. International commodity arbitrage within the whole of East Asia, and not just with the United States, helped pin down the price level of each participating country. In the 1990s and earlier, the need for a nominal anchor in East Asia reflected the concern of the smaller countries with the ever-present threat of inflation. (Japan, of course, had been mired in a deflationary spiral for more than a decade and only began to show signs of recovery in 2005.) In the new millennium, however, the increasing need is for a common monetary anchor against the threat of deflation. As the East Asian economies build up their liquid dollar balances in the process of transforming


189

themselves from being dollar debtors into dollar creditors (providing the counterpart to huge American trade deficits), the threat of forced appreciation followed by deflation, that is, the problem of conflicted virtue, has become more acute. Here, again, collective dollar exchange rate stability in East Asia is a public good. As long as all the now more highly integrated East Asian economies stand firm against foreign pressure to appreciate, it will be easier for any one country to avoid appreciating. However, if a major country loses control and allows its currency to appreciate, this could set in train a new East Asian currency crisis with a round of contagious appreciations as private holders of dollar assets in other East Asian countries become more nervous and dump them.

NOTES 1. 2. 3. 4. 5. 6. 7. 8.

9. 10. 11.

12. 13. 14. 15.

We thank Wolfgang Bretschneider and Adrian Höhl for excellent research assistance. An earlier version of this chapter was published in International Finance 7 (2004): 169–201. Any other outside currency, such as the pound sterling, could serve equally well as numéraire. German mark before January 1999. For a more detailed econometric analysis of the evolution of these basket weights before and after the 1997–98 crisis, see Schnabl (Chapter 10, this volume). Hillebrand and Schnabl (2006) show that the exchange rate volatility of the yen against the dollar has declined since 1999. The euro and the Swiss franc are widely regarded as floating freely against the dollar. Singapore “hides” parts of its overseas assets in its Government Investment Corporation. In contrast, forward exchange transactions between any two industrial countries can thrive because each country has a well-developed domestic bond market denominated in its domestic currency. Long-term forward markets, with a well-defined forward premium equal to the interest differential between the two national bond markets at each term to maturity, can thrive at much lower cost. During 2005 and 2006 the importance of the oil-exporting countries as counterparts of the US current account deficit increased significantly. For empirical estimates of the stocks of these liquid dollar claims see Goyal and McKinnon (2003), for the case of Japan, and McKinnon and Schnabl (2006a) for the case of China. The astute reader will note that the story of how foreign exchange risk associated with conflicted virtue creates a negative risk premium on yen assets is also an explanation of why Japan has fallen into a zero interest liquidity trap—the macroeconomic implications of which are spelled out in Goyal and McKinnon (2003) and McKinnon (2005). Hillebrand and Schnabl (2006) analyze the impact of Japanese foreign exchange intervention on the yen-dollar exchange rate. In China, conflicted virtue has been rendered more acute by heavy inflows of foreign direct investment (McKinnon and Schnabl 2006a). Think of what happened to Argentina in the late 1990s when Brazil and Chile allowed large depreciations of their currencies. For a more up-to-date assessment of Despres et al. (1966) see Bisignano (2004).

190 16.

Exchange rate policies in East Asia See also our critique of William Cline’s (2005) advocacy (based on the elasticities model) of massive dollar devaluation to reduce America’s trade deficit (McKinnon and Schnabl 2006b).

REFERENCES Bisignano, Joseph (2004). “Machlup Was Right: Despres, Kindleberger and Salant Briefly Revisited.” Manuscript, Bank for International Settlements, Basel. Calvo, Guillermo, and Carmen Reinhart (2002). “Fear of Floating.” Quarterly Journal of Economics 117: 379–408. Cline, William (2005). The United States as a Debtor Nation. Washington, DC: Institute for International Economics. Despres, Emile, Charles Kindleberger, and Walter Salant (1966). “The Dollar and World Liquidity: A Minority View.” The Economist, February 5. Dooley, Michael, David Folkerts-Landau, and Peter Garber (2003). “An Essay on the Revived Bretton Woods System.” NBER Working Paper no. 9971, National Bureau of Economic Research, Cambridge, MA. Dooley, Michael, David Folkerts-Landau, and Peter Garber (2004). “The Revived Bretton Woods System: The Effects of Periphery Intervention and Reserve Management on Interest Rates and Exchange Rates in Center Countries.” NBER Working Paper no. 10332, National Bureau of Economic Research, Cambridge, MA. Eichengreen, Barry, and Ricardo Hausmann (1999). “Exchange Rates and Financial Fragility.” NBER Working Paper no. 7418, National Bureau of Economic Research, Cambridge, MA. Fischer, Stanley (2001). “Exchange Rate Regimes: Is the Bipolar View Correct?” Journal of Economic Perspectives 15: 3–24. Frankel, Jeffrey (2006). “On the Yuan. The Choice between Adjustment under a Fixed Exchange Rate and a Flexible Exchange Rate.” CESifo Studies 52: 246–75. Frankel, Jeffrey, and Shang-Jin Wei (1994). “Yen Bloc or Dollar Bloc? Exchange Rate Policies in East Asian Economies.” In Takatoshi Ito and Anne Krueger (eds), Macroeconomic Linkages: Savings, Exchange Rates, and Capital Flows. Chicago: University of Chicago Press, pp. 295–329. Goyal, Rishi, and Ronald McKinnon (2003). “Japan’s Negative Risk Premium in Interest Rates: The Liquidity Trap and Fall in Bank Lending.” The World Economy 26: 339–63. Hernández, Leonardo, and Peter Montiel (2002). “Post-crisis Exchange Rate Policy in Five Asian Countries: Filling in the ‘Hollow Middle’?” Journal of the Japanese and International Economies 17: 336–69. Hillebrand, Eric, and Gunther Schnabl (2006). “A Structural Break in the Effects of Japanese Foreign Exchange Intervention on Yen/Dollar Exchange Rate Volatility.” ECB Working Paper no. 650, European Central Bank, Frankfurt. McKinnon, Ronald (2004). “The World Dollar Standard and Globalization: New Rules for the Game?” In Leo Michaelis and Mark Lovewell (eds), Exchange Rates, Economic Integration, and the International Economy. Toronto: APF Press, pp. 3–28. McKinnon, Ronald (2005). Exchange Rates under the East Asian Dollar Standard: Living with Conflicted Virtue. Cambridge, MA: MIT Press.


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McKinnon, Ronald, and Kenichi Ohno (1997). Dollar and Yen: Resolving Economic Conflict between the United States and Japan. Cambridge, MA: MIT Press. McKinnon, Ronald, and Huw Pill (1999). “Exchange Rate Regimes for Emerging Markets: Moral Hazard and International Overborrowing.” Oxford Review of Economic Policy 15: 423–64. McKinnon, Ronald, and Gunther Schnabl (2003). “Synchronized Business Cycles in East Asia and Fluctuations in the Yen–Dollar Exchange Rate.” The World Economy 26: 1067–89. McKinnon, Ronald, and Gunther Schnabl (2004). “The East Asian Dollar Standard, Fear of Floating, and Original Sin.” Review of Development Economics 8: 331–60. McKinnon, Ronald, and Gunther Schnabl (2006a). “China’s Exchange Rate and International Adjustment in Wages, Prices, and Interest Rates: Japan Déjà Vu?” CESifo Studies 52: 276–303. McKinnon, Ronald, and Gunther Schnabl (2006b). “Devaluing the Dollar: A Critical Analysis of William Cline’s Case for a New Plaza Agreement.” Journal of Policy Modeling 28: 683–94.

PART IV

Toward monetary integration in East Asia?

8.

Three cases for monetary integration in East Asia Ulrich Volz1

8.1

INTRODUCTION

Since the Asian financial crisis, monetary and financial integration has become a much-discussed topic in East Asia.2 The past years have seen a proliferation of proposals for fostering East Asian integration, ranging from currency baskets and regional exchange rate systems to monetary union. But unlike in Europe, which saw long-standing discussions on the costs and benefits of monetary unification, a proper debate is not yet underway in East Asia. Instead, the “classical” European arguments for and against monetary integration are implicitly being adopted, despite the very different histories of economic development of East Asian countries as compared to those of European countries. The implications of monetary integration for East Asia have barely been explored. The discussion centers very much on whether East Asia qualifies as an optimum currency area (OCA), even though OCA theory has been rightfully criticized for its static point of view (Frankel and Rose 1998, Schelkle 2001a, 2001b). It is basically concerned with an ex ante analysis of the costs and benefits of monetary integration and does not take into account changes in economic activity that are induced through a policy of integration. Moreover, OCA theory is limited to an analysis of the allocative effects of monetary integration but fails to address potential accumulative effects. The development context of monetary integration has largely been ignored. But monetary integration must not be analyzed solely in terms of whether it is advantageous given the present conditions. It is also important to ask whether and in what ways monetary integration can contribute to overcoming structures that present obstacles to economic development (Roy and Betz 2000). In this context, this chapter investigates three cases for pursuing monetary integration in East Asia in the long run. First, the chapter discusses the potential trade-creating effects of monetary integration. This argument is grounded on the improvement of allocative efficiency within a region and was intensively discussed for Europe in 195

196

Toward monetary integration in East Asia

the 1990s. For East Asia—a region for which intra-regional trade accounts for almost 50 percent of overall trade—exchange rate spillover effects from one country to another are also of great importance. This is even more the case as East Asian countries also compete against each other in third markets. Because of neighborhood effects, nations’ decisions to fix or float should not be made independently of each other. Using a simple gravity model, the chapter shows that the similarity of currency regimes has a significant and large positive effect on trade in the region. Second, the chapter draws attention to the potential role of regional monetary integration in overcoming the problems of “original sin” and “conflicted virtue”, an issue that has rarely been analyzed so far. While original sin refers to a country’s inability to borrow in its own currency, whether internationally or domestically, conflicted virtue describes a country’s inability to lend in its own currency. Both original sin and conflicted virtue force weak currency countries to accumulate a currency mismatch. Estimations of the causes of original sin and conflicted virtue, as well as the existing literature on the determinants of key currency status, suggest that the relative size of an economy is an important explanation for these phenomena. Forming a larger entity through economic integration might therefore be a way for economically small countries to remedy the two problems. Third, the chapter highlights regional monetary integration as a way of (re)gaining some degree of monetary independence in the region. In the European discourse, opponents of monetary union argued that giving up one’s own currency would mean the loss of a forceful policy instrument. By analyzing the policy decisions of national central banks, the chapter shows that member countries of the European Monetary System (except Germany) had already abandoned monetary and exchange rate autonomy long before entering the European Monetary Union (EMU) and that Germany has, in fact, been the only country that has actually lost monetary autonomy through EMU. Virtually all other euro countries have regained a voice in monetary policy decisions through EMU membership. Likewise, the chapter argues that the current (informal) “East Asian dollar standard” (i.e. the common practice of (soft) pegging to the US dollar) has created a situation in which East Asian countries (except Japan) have largely abandoned monetary policy autonomy. Through the creation of a common currency, which could float freely against the dollar, East Asian countries could potentially (re)gain some degrees of shared monetary independence. The rest of the chapter develops these arguments. None of these three cases, however, is sufficiently strong to support monetary union in East Asia on its own. The final decision to move toward monetary unification—or the refusal to do so—will eventually be based on political considerations.

Three cases for monetary integration in East Asia

8.2

197

MONETARY INTEGRATION AND TRADE The greatest thing you ever can do now Is trade a smile with someone who’s blue now It’s very easy just... (Led Zeppelin in “Friends”, from the album Led Zeppelin III, 1970)

Over the past few decades, the share of intra-regional trade in total trade has reached high levels in East Asia (Table 8.1), and the region is set to increase these trading links even more. With the exception of Cambodia, trade with neighboring countries is of great importance for all East Asian nations, with the share of regional exports in total exports ranging from around 40 percent (Laos, China, Japan, Korea, Vietnam) to over 50 percent (Indonesia, Malaysia, Myanmar, the Philippines, Singapore, Thailand, Brunei). In recent years, East Asian countries have been busy signing trade agreements with each other to further encourage trade. In the largest of these, the ASEAN countries have agreed with China to create the world’s largest free trade area by 2012, with more than 1.7 billion people. Moreover, further ASEAN negotiations are under way with Japan and Korea.3 In addition to trade linkages, intra-regional interdependence in foreign direct investment (FDI) has also increased dramatically (Kawai and Urata 2004). Extensive regional production networks have developed in East Asia. In particular, multinational corporations have formed regional supply chains and production networks, taking advantage of intraregional divisions of labor and promoting the specialization of production by breaking the production process down into different sub-processes within the same industry. For a region as economically intertwined as East Asia, exchange rate spillover effects from one country to another are of great importance. There are numerous problems faced by countries that are close trading partners but follow different exchange rate regimes.4 First, exchange rate disagreements could lead to reduced exports from the country that loses competitiveness to its partners. This could evoke increased protectionism and even a scaling back or elimination of trade agreements. The country that loses competitiveness as a result of a real exchange rate appreciation vis-à-vis its trading partners may employ anti-dumping or other administrative measures (if tariffs are precluded through trade agreements) to protect domestic firms. This, in turn, could trigger a trade war as well as a round of beggar-thy-neighbor devaluations. Second, regional trade agreements may spark fierce competition for the location of investment, and swings in the bilateral exchange rates may have important consequences for the location of new investments and might even shift the location of

198

Source:

Note:

2.59 25.87 18.08 13.99 12.63 15.78 14.94 28.55 12.57 15.80 17.18 14.46 14.87 23.59 16.49

EU

55.60 40.04 44.78 36.56 51.34 58.39 54.77 53.24 50.41 39.64 47.12

73.94 12.55 41.31

73.89 12.26 24.31 57.67 53.66 33.78 37.63 36.56 45.38 57.23 46.84 43.41 45.30 38.05 43.28

ASEAN14 ASEAN13

8.55 1.35 10.10 5.17 20.12 6.44 13.98 13.60 12.38

38.11 3.50 12.39 5.32 22.31

Japan

0.24 3.50 0.01 2.80 4.11 1.93 2.37 3.89

13.96 0.24 4.69 2.18 6.75 7.82

Korea

8.37 19.32 26.76 2.11 12.65 7.09 14.61 18.39 12.49 10.59 11.52

4.55 1.34

China & HK

1.94 6.26 7.14 0.00 5.97 1.16 7.93 9.82 5.12 1.59 4.94

0.05 0.29 17.00

HK

IMF/DTS.

ASEAN13 includes ASEAN countries plus China, Japan, and Korea. ASEAN14 also includes Hong Kong.

8.64 55.89 21.09 16.95 12.28 22.73 16.96 0.62 18.77 0.00 18.17 12.96 16.10 20.19 17.24

USA

Export as a percentage of total exports in 2004

Brunei Cambodia China Hong Kong Indonesia Japan Korea Laos Malaysia Myanmar Philippines Singapore Thailand Vietnam Unweighted average

Table 8.1

44.01 6.44 13.06 19.61 2.10 6.69 5.93 6.69 8.57 7.38 9.01 10.39

4.50 1.05

China

17.32 7.47 7.23 6.15 18.17 12.90 9.47 32.86 25.09 45.27 17.23 24.30 22.01 13.07 18.47

ASEAN


199

existing investments. Third, and finally, a change of the exchange regime in one of the partner countries may cause an exchange rate crisis in the other. Exchange rate depreciation in one country may reduce the credibility of the partner’s commitment to a fixed parity and can generate speculative attacks on its currency. A country may thus be forced to abandon its preferred exchange rate policy because of the exchange rate disagreement. This, in turn, could have repercussions for the country that sparked the crisis.5 Hence, the deeper trade relations become and the more comprehensive trade and investment agreements are, the more important the question of macroeconomic policy coordination becomes. Increasing intra-regional trade turns formerly second-order effects into issues that have to be addressed with first-order preference. In highly integrated areas, policy coordination to achieve real exchange rate consistency is therefore essential. Exchange rate cooperation becomes even more important if countries also compete against one another in third markets, as is the case in East Asia. Hence, McKinnon (2005) describes mutual exchange rate stability in East Asia as the “quintessential public good”. Because of neighborhood effects, he reasons, a nation’s decision to fix or float should not be made independently of other nations’ decisions. While these arguments favor exchange rate cooperation over flexible exchange rates, there is no implicit logic for currency integration. Eichengreen (1998) points out that the need for monetary integration depends on the degree of trade integration that is to be achieved. A customs union can be sustained despite the existence of separate national currencies that fluctuate against one another.6 But deeper integration, including the free movement of goods, services, capital, and people, implies an even greater degree of openness of domestic markets and more intense crossborder competition, making exchange rate changes more disruptive. The European Union (EU) has always given great importance to this issue. Indeed, the EU’s reasoning for monetary union can be described as “one market, one money” (Emerson et al. 1992). If East Asian leaders want to foster deeper integration akin to Europe’s single market, they will need to contemplate monetary integration like in Europe. More recently, the potential trade-creating effect of a common currency union has gained wide attention in the literature, reinforcing the trade argument for monetary integration. Rose (2000) turned the EU’s logic upside down and established the case for “one money, one market”. While there has been a lot of controversy about the actual magnitude of the tradecreating effect of monetary union, a broad agreement has emerged that a currency union has a significant positive effect on trade.7

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While it is impossible to accurately predict the trade creating-effect of a potential monetary union in East Asia, we can estimate the effect that the similarity of currency regimes has on bilateral trade in the region. To do this, we apply the following gravity model to the trade data from 13 East Asian countries over the period 1980–2003:8 Tijt 5 b0 1 b1 Fijt 1 b2 Dijt 1 b3 I1ijt 1 eijt, where Tijt is an indicator for the level of bilateral trade integration between countries i and j at time t, Fijt is an indicator for the intensity of bilateral FDI, and Dijt is an indicator for the similarity of currency regimes of the two countries in question. I1ijt is a vector comprising the standard variables of the gravity model, and eijt is a well-behaved error term. The gravity model has become standard in the international trade literature, and hence one can draw on a rich body that employs it. We include the standard variables of the gravity model—that is, the product of the natural logarithms of the populations of the two countries under investigation, a variable describing their combined GDP computed as the product of the natural logarithms of each country’s GDP, the natural logarithm of the distance between the two countries, and a dummy variable indicating whether the countries share a common land border.9 As in Frankel and Rose (1998), bilateral trade integration is measured by computing Tijt 5 (xijt 1 mijt) / (Xit 1 Mit 1 Xjt 1 Mjt), where xijt are the exports from country i to j during period t, mijt are the imports to country i from j, and Xit, Mit, Xjt, Mjt are the total exports/ imports of country i/j respectively. A higher value of Tijt thus represents a greater trade intensity between countries i and j. As is common in the literature, we take the natural logarithm of the ratio. The data are from the IMF’s Direction of Trade Statistics. Data for Taiwan are from the Taiwan Statistical Data Book 2004. Similarly, FDI intensity is measured as Fijt 5 (fdiijt 1 fdijit) / (GDPi 1 GDPj), where fdiijt denotes FDI to country i from country j and fdijit denotes FDI to country j from i. The bilateral FDI flows are divided by the joint GDP of the two countries. As with the trade measure, Fijt takes a higher value the more integrated the countries are. The bilateral FDI data are taken from the UNCTAD Foreign Direct Investment Statistics and CEIC Asia


201

Database. The GDP data are from the IMF’s International Financial Statistics and the Taiwan Statistical Data Book 2004. To measure the similarity of the currency regimes of the two countries in question, hypothetical currency baskets are estimated in order to compute the following indicator (see Volz 2005): Dij 5 1 − |wit − wjt|, where wit is the weight of the US dollar in a hypothetical currency basket of country i. To estimate the weights of the currencies included in the hypothetical currency baskets against which East Asian countries manage their currencies, we follow Frankel and Wei (1994) and regress each East Asian currency e on a constant c, the US dollar, the euro, and the Japanese yen: Δ ln (e/CHF) t 5 c 1 b1 Δ ln (USD/CHF)t 1 b2 Δ ln (EUR/CHF)t 1 b3 Δ ln (JPY/CHF)t 1 et. The Swiss franc, which can be assumed to be uncorrelated with the three basket currencies as well as with the East Asian currencies, is used as numéraire in order to minimize multicolinearity problems. The b coefficients are the weights of the basket. Δ stands for the first-difference operator and t for time. All variables are in natural logarithms. b1 is used to compute the above indicator (Dij); that is, b1 5 wit. If both countries give the same weight to the dollar in their (hypothetical) currency basket, Dij is one; if one of the countries chooses a hard fix to the dollar (b1 5 1) while the other one chooses a zero dollar weight in its currency basket (b1 5 0), Dij is zero.10 The results presented in Table 8.2 show a strong trade-creating effect of similar currency regimes in East Asia. The coefficients for the similarity of the currency regime are large and significant. The trade-creating effect gets smaller if China is excluded from the regression, which can be explained by a “Japan effect”: Japan is a driving force in intra-regional trade but is the only country in the region that does not adhere to the informal East Asian dollar standard. If Japan is omitted from the regression, the currency effect becomes even larger and highly significant. That is, exchange rate stability is beneficial for trade within East Asia, and, given the previous findings in the literature that monetary union has an even larger effect on trade than a hard peg, it is also sensible to expect a significant trade-creating effect of monetary unification in East Asia. The coefficients of the other variables are in line with theoretical expectations. Strong FDI links, a shared land border, and larger GDP all increase bilateral trade whereas distance has the inverse effect. Population

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Table 8.2

Determinants of trade in East Asia

FDI Similarity of currency regime Distance Common border GDP Population Constant Number of observations R-squared

Full sample

Without China

Without Japan

Without China and Japan

0.1012*** (0.0369) 1.1036***

0.0921*** (0.0367) 0.8280*

0.0610 (0.0432) 2.0410***

0.0356 (0.0405) 1.5680**

(0.4633) 20.5866*** (0.1701) 0.7391***

(0.4633) 20.3055* (0.1813) 1.1925***

(0.6743) 20.6808*** (0.2023) 0.7495***

(0.6854) 20.2130 (0.2097) 1.3917***

(0.2808) 0.0210*** (0.0017) 20.0062** (0.0028) 212.2067*** (1.4469) 128

(0.3283) 0.0199*** (0.0018) 20.0048 (0.0037) 213.9071*** (1.5486) 104

(0.2853) 0.0239*** (0.0025) 20.0073** (0.0032) 214.0290*** (1.6989) 100

(0.3255) 0.0229*** (0.0024) 20.0054 (0.0039) 217.3330*** (1.8779) 79

0.5921

0.5951

0.5957

0.6135

Note: *** denotes statistical significance at the 1 percent level, ** at the 5 percent level, and * at the 10 percent level. Standard errors are in parentheses.

apparently is not a major factor for trade, indicating that the overall size of the economy rather than the size of the population matters for trade—a notion that is intuitive given that many of the less populous East Asian economies are among the region’s most successful traders.11

8.3

MONETARY INTEGRATION, INVESTMENT CONDITIONS, AND THE DEVELOPMENT OF REGIONAL CAPITAL MARKETS The best things in life are free But you can keep ’em for the birds and bees. (The Beatles in “Money (That’s What I Want)”, from the album With The Beatles, 1963)12

In the classic as well as neo-classic traditions, money is regarded as a veil over the real economy.13 According to this school of thought, money is


203

merely a means of payment on spot markets and a store of value. The neutrality of money implies that the central bank cannot affect the real economy, and money, therefore, also has no impact on the development of a country’s economy. But if money is regarded as a means of deferred payment in an uncertain world with enterprises that finance investment through capital markets, the denomination of debt becomes crucial for production, employment, and growth (Nitsch 2006). Acknowledging the central role of money in economic development, an analysis of monetary integration between emerging market and developing nations, such as those in East Asia, has to address different questions than does an analysis of monetary integration between developed countries, such as those in the euro area. The former has to take into account the specific problems developing countries face.14 Two of the features that characterize any less developed country are a weak currency status (Schelkle 2000) and a lack of financial maturity (Bordo and Flandreau 2003). As will be argued below, developing countries’ lack of an international currency puts a number of constraints on their development prospects and increases financial fragility. This section of the chapter therefore investigates whether and to what extent monetary integration could be used as a strategy to overcome these impediments in order to create favorable macroeconomic conditions, that is, to promote accumulation and to reduce the risk associated with asset and liability dollarization. The international monetary system is characterized by currency competition and a hierarchy of currencies. Cohen (1998, p. 114) likens currency competition to a “vast, three-dimensional pyramid: narrow at the top, where a few popular currencies dominate; increasingly broad below, reflecting varying degrees of competitive inferiority.” Different currencies exhibit different qualities in their function as storage of wealth. In an open economy, the central bank has to defend the national currency against competition with other currencies in the portfolios of economic agents. Because of devaluation expectations, an agent holding a weaker currency will demand a higher premium, that is, a higher real interest rate. The international hierarchy of currencies thus sets off a cumulative process by which investments in hard currency countries can be financed most cheaply of all, while market forces cause higher interest rates to be demanded in weaker currency countries, making credits dearer and thus retarding growth and development (Nitsch 1999). High real interest rates are a problem for some East Asian countries, but not all. While least developed countries such as Cambodia (11.6 percent), Laos (17.5 percent), and Indonesia (6.6 percent) suffer from relatively high real interest rates, others such as China (−0.7 percent), Malaysia (0.0 percent), the Philippines (3.7 percent), and Thailand (0.9 percent) have managed to

204


establish relatively low levels of real interest despite their weak currency status.15 Low productive power domestically corresponds to low monetary power internationally. This is demonstrated by the fact that developing countries’ currencies are not capable of entering into international contracts (Riese 2004). Weak currency countries are confronted with what Eichengreen and Hausmann (1999) have termed “original sin”.16 They describe original sin as a situation in which the domestic currency cannot be used to borrow long term, even domestically. As a result, financial fragility is unavoidable because all domestic investment will have either a currency mismatch (projects that generate domestic currency will be financed with an international currency) or a maturity mismatch (long-term projects will be financed with short-term loans). Both currency and maturity mismatches increase the danger of financial crises. Indeed, original sin is widely regarded as one of the causes of the Asian crisis. Moreover, in a phenomenon McKinnon (2005) has named “conflicted virtue”, weak currency countries are unable to lend in their own currencies, forcing creditor countries with weak currencies to cumulate currency mismatches. As most East Asian countries have turned into creditor countries after the Asian crisis, the excess build-up of foreign exchange assets has created a conflicted virtue problem for them. While Japan, Singapore, and Taiwan have had current account surpluses for more than two decades and China has had more modest current account surpluses since 1995, even the five former crisis economies (Indonesia, Korea, Malaysia, the Philippines, and Thailand), which had large current account deficits before 1997, have now accumulated large stocks of liquid dollar assets in both private and public portfolios. With mounting dollar claims, non-US holders of dollar assets have to worry more about domestic currency runs, which would cause a domestic currency appreciation and hence a decline of their net wealth. Countries are therefore inclined to avoid large-scale appreciation of their currencies, which might invoke protests from deficit countries about unfair competition through an undervalued currency. A weak currency status therefore brings with it multiple problems, from retarding financial and real development and increasing the risk of financial crisis to triggering potential trade conflict. A hardening of the currency, or a “pyramid-climbing”, is therefore a crucial precondition for creating favorable investment conditions and enabling sustainable economic development and for overcoming the problems of original sin and conflicted virtue. To analyze if and how monetary integration could contribute to a hardening of currencies, it is important to understand what makes a currency an international currency.


205

As Hyman Minsky observed, anyone can create money by issuing IOUs,17 but the difficult part is to get them to be generally accepted (see Kregel 2006). The easiest way to have one’s IOUs accepted is to generate liabilities that can only be extinguished through possession of these IOUs. A government can domestically enforce the acceptance of its currency through the fiscal system. It can create a tax liability on its citizens that can only be redeemed by rendering the government’s IOU in the form of money issued by the government. But this does not work internationally, as a government can only tax its own citizens who are subject to government regulations but cannot force non-residents to hold claims. The only way to make the currency internationally accepted is by building an expectation that these liabilities will act as perfect substitutes for other governments’ liabilities. A number of conditions can be identified that contribute to building such expectations. First, the confidence in a currency’s future value is dependent on the political stability of the country of origin (Cohen 2000). This is the quintessential precondition for establishing a track record of relatively low inflation and low inflation variability. Second, countries need to develop sound and credible fiscal institutions.18 In conjunction with non-inflationary income policies, an austere fiscal framework lays the groundwork for a non-inflationary monetary environment with low nominal as well as real interest rates. Third, countries need to establish credible monetary regimes. Unpredictable monetary policy makes agents unsure about the future real value of their assets issued in domestic currency and may lead them to denominate them in international currency (Jeanne 2005). Establishing a strong (de facto) independent central bank with strong inflation aversion and a clear monetary policy objective is an important way to keep down inflationary expectations and to reduce this uncertainty. Fourth, not running into international debt but instead striving for a surplus in the trade and current account favors national autonomy and employment and helps to create expectations of an appreciation of the national currency. From a long-term development perspective, it is not the short-term stabilization of the exchange rate that is of central importance but rather the durable enhancement of a currency’s quality (Fritz 2002). The quality of a nation’s currency is undermined when a currency regime is chosen that achieves price and exchange rate stabilization at the cost of an increase in the country’s foreign debt. Instead, countries need to develop the ability to generate foreign reserves by generating export surpluses. Such a strategy requires a tendency toward an undervaluation of the currency (Riese 2004). Keeping domestic money scarce represents the necessary condition for securing the undervaluation of the currency because—as a

206


result of its deflationary effects internally—it allows a country to achieve a price advantage over foreign countries, providing the precondition for the stimulation of exports. Successful examples of this development strategy are Western Germany in the 1950s and Japan in the 1970s. The East Asian tiger economies have very successfully followed this strategy more recently. But developing sound fiscal and monetary institutions and generating export surpluses might not be enough. The literature on the determinants of key currency status points to another factor, namely, the size of the economy. Matsuyama et al. (1993) explain the international use of currencies and, succinctly, the determinants of key currency status as a function of relative country size and the degree of international economic integration. Because of network externalities and transaction costs, the global portfolio is concentrated in very few currencies. In some ways money is comparable to language, whose usefulness is also dependent on the number of people with whom one can communicate; similarly, a currency’s utility rises with the number of other market participants using the same currency (Dowd and Greenaway 1993). A currency’s attractiveness increases with its transactional liquidity, which in turn is dependent on the existence of well-developed and broad financial markets that offer a wide range of short- and long-term investment opportunities as well as fully operating secondary markets (Cohen 2000). Eichengreen et al. (2005) point out that larger countries offer significant diversification possibilities, while smaller countries add fewer diversification benefits relative to the additional costs they imply. As a result, the global portfolio is concentrated in a small number of currencies (those at the top of the international currency pyramid) for reasons partly beyond the control of even the countries that follow sound domestic policies. Developing key currency status is hence a very difficult and maybe even impossible endeavor for small economies.19 There is also empirical support for this view. Eichengreen et al. (2005) show that larger economies have less of a problem with original sin than smaller ones. Using three different measures of size (log of total GDP, log of total domestic credit, and log of total trade), their estimates suggest that all measures of size are robustly correlated to original sin. In the face of these constraints, regional monetary integration could be employed by developing nations as a strategy for overcoming their weak currency status and their inability to enter into international contracts with domestic currency. While a hardening of the national currency could in principle also be achieved by each country alone through austere monetary and fiscal policies and through the generation of export surpluses, it might not suffice to develop an international currency. Monetary integration,


207

however, could address both issues at the same time. One the one hand, it would place an external constraint on countries participating in the monetary integration process, facilitating the domestic policy adjustment necessary for a hardening of the currency. In the European context, Giavazzi and Pagano (1988) have termed this the “advantage of tying one’s hands”. Monetary integration could be used as a disciplinary device for inflationprone countries by forcing policy-makers to pursue more restrictive fiscal and monetary policies than they would otherwise. In return, countries would enjoy potential credibility gains. This strategy worked reasonably well in Europe in the run-up to monetary union.20 At the same time, monetary integration would address the problems of original sin and conflicted virtue by creating a larger economic entity with vast investment opportunities which would be hard for international asset managers to ignore and which, if backed by austere monetary and fiscal policies, would increase the chances of entering the club of international currencies. The underlying logic is that the whole would be equal to more than the sum of its parts. To be sure, size alone is not enough: Russia, Argentina, and Brazil are examples of large emerging economies that, despite their size, face problems of original sin. But, as explained before, good domestic policies are necessary as well, and these three countries have not been prime examples for prudent economic policy-making. Bordo et al. (2005), in an analysis of how five former British colonies (the US, Canada, Australia, New Zealand, and South Africa) overcame original sin, point to another interesting factor: the role of shocks such as wars and massive economic disruptions. For instance, the onset of World War I essentially closed the London capital market and led Canada, Australia, New Zealand, and South Africa to suspend the gold convertibility of their domestic currencies and raise funds domestically; that is, the disruption of the war basically forced these countries to create domestic bond markets.21 An interesting parallel can be drawn with East Asia, where the financial crisis had been such a major shock. As one reaction to the crisis, the region has begun trying to develop regional bond markets. The Asian Bond Funds I and II are first attempts to bundle bond issues by East Asian countries in order to make it more attractive for international investors to include them in their portfolios.22 This might be a step in the right direction for East Asia, and pursuing a similar cooperative path in monetary policy could help overcome the problems of original sin and conflicted virtue that are associated with a weak currency status. Individually, most East Asian nations will have little prospect of escaping this trap. For instance, it is hard to imagine how a small developing economy like Vietnam will be ever able to develop its national currency, the dong, into an internationally accepted currency.

208


Yet, united, the region is far too important to be ignored by currency traders. As a possible first move in this direction, in December 2005 the Asian Development Bank announced the launch of a currency unit comprised of a basket of regional currencies akin to the European Currency Unit. This virtual basket currency may give observers a taste of the kind of standing a regional East Asian currency could achieve in international financial markets.23

8.4

MONETARY INTEGRATION AND THE RECOVERY OF MONETARY POLICY INFLUENCE When you got nothing, you got nothing to lose. (Bob Dylan in “Like a Rolling Stone”, from the album Highway 61 Revisited, 1965)

In this last section, the potential for regional monetary integration to be a way for East Asian nations to (re)gain some degrees of monetary influence in the region is highlighted. Monetary cooperation and integration are not necessarily equivalent to a loss of autonomy, as a country can only lose what it has. In the discourse preceding the creation of EMU, opponents of monetary unification argued that giving up one’s own currency would mean losing a forceful policy instrument. However, the discussion in Europe had been somewhat unreal. As Charles Goodhard (1995, p. 458) pointed out, through their membership in the European Monetary System (EMS) EMS countries (except Germany) had already abandoned discretionary monetary policy long before monetary union was finalized, meaning that there would be “virtually no economic cost in doing so formally and completely by moving to a full monetary union”.24 For a formal test of this hypothesis, the following simple Taylor rule is estimated: rct 5 b1 1 b2 IPct-2 1 b3 πct-2 1 b4 rBt-2 1 e, where rct is the central bank interest rate of country c at time t, IPct-2 is country c’s lagged industrial production, and πct-2 is the lagged inflation rate. rBt-2 is the lagged Bundesbank discount rate.25 The results for the period ranging from August 1971 to December 1998, that is, from the breakdown of the Bretton Woods system to the launch of the euro, are presented in Table 8.3. The estimates show that the monetary policy decisions of all European countries analyzed here, with the exceptions of Greece and Norway (both of which were not members of the EMS26), were driven to a large extent by


Table 8.3

Determinants of monetary policy decisions, August 1971 – December 1998 Bundesbank discount rate

Austria

209

CPI

0.6916*** 0.0597 (0.0463) (0.0385) 0.9371*** 0.1575*** Belgiuma (0.1248) (0.0497) Denmark 0.7214*** 0.1933*** (0.0483) (0.0379) Finland 0.3226*** 0.1439*** (0.0464) (0.0226) France 0.7435*** 0.4341*** (0.0785) (0.0420) Greece 0.2366 0.1978*** (0.1561) (0.0565) Italy 0.4584*** 0.3403*** (0.1462) (0.0582) Luxembourga 0.9789*** 0.0449 (0.1181) (0.0737) Netherlands 0.9881*** 20.0457 (0.0594) (0.0295) Norway 0.1592 0.3018*** (0.1365) (0.0949) Portugal 0.7889*** 0.5391*** (0.2442) (0.0626) Spain 0.4329* 0.2147** (0.2354) (0.1045) Sweden 0.4431*** 0.3301*** (0.0968) (0.0437) Switzerland 0.5760*** 0.1695*** (0.0674) (0.0347) UK 0.4792*** 0.2338*** (0.1348) (0.0526) US 20.03 0.5844*** (0.1124) (0.0692)

Industrial production

Observations

R-squared

20.0117* (0.0064) 20.0285* (0.0150) 20.0391*** (0.0069) 20.0407*** (0.0066) 0.0372*** (0.0116) 0.2839*** (0.0261) 0.0548*** (0.0177) 20.0842*** (0.0151) 20.0199** (0.0080) 0.0619*** (0.0160) 0.1824*** (0.0206) 0.0614** (0.0295) 0.0155* (0.0084) n.a.

327

0.7776

327

0.431

298

0.787

327

0.6986

327

0.678

327

0.5864

327

0.3219

327

0.5

327

0.7033

327

0.1089

327

0.4552

327

0.0725

327

0.4673

327

0.6292

20.0039 (0.0260) 0.0016 (0.0121)

327

0.318

327

0.5202

Notes: Data are from IFS and Global Financial Data. Newey West standard errors in parentheses. *** denotes statistical significance at the 1 percent level, ** at the 5 percent level, and * at the 10 percent level. a Luxembourg and Belgium have had a monetary union, the Belgium–Luxembourg Economic Union, since 1922.

210


the interest rate policy of the Bundesbank.27 While domestic inflation and industrial production also seem to have played a role in the conduct of many of these countries’ monetary policies, the Bundesbank discount rate had a far greater impact for all countries. US interest rate policy, in contrast, and as one would expect, was not influenced by the Bundesbank. One can push Goodhard’s argument further and argue that the European countries (except Germany) that entered monetary union not only did not lose monetary autonomy but actually (re)gained some degrees of monetary policy influence through EMU membership. Indeed, it is arguable that Germany was the only country that actually lost monetary autonomy. Virtually all other EMU member countries have obtained a voice in monetary policy decisions. Instead of following the Bundesbank’s policy stance, all EMU member countries are now represented through their national central bank governors in the European Central Bank’s (ECB) Governing Council, the ECB’s monetary policy-making body. Under current rules, the central bank governors of each euro area member, along with the six members of the ECB’s Executive Board, have the right to vote at each council meeting, providing smaller countries such as Austria and Luxembourg with the same de jure influence on monetary policy as the larger members France, Germany, Italy, and Spain.28 Among the central banks of the old EU member countries that did not join EMU, the monetary authorities of Denmark and Sweden have basically been forced to shadow ECB policy, without exerting any influence themselves on the policy they have to follow.29 A different but also Dylanesque situation applies for most East Asian countries when it comes to the conduct of their monetary policy. The region’s exchange rate policy can be described by the “East Asian dollar standard” (see McKinnon 2005), a situation in which all East Asian countries with the exception of Japan operate more or less tight pegs to the US dollar. The pegs were temporarily lifted during and after the Asian crisis (except in the cases of China, Hong Kong, and Singapore), but over the last few years there has been a resurrection of the dollar standard (McKinnon 2001, Schnabl, Chapter 10, this volume), even though most of the countries officially declare their exchange rate regimes as (managed) floats. Table 8.4 gives an overview of East Asian countries’ official and de facto exchange rate regimes. The estimated weights of the US dollar in the hypothetical currency baskets of East Asian countries presented in column three show that China, Hong Kong, Malaysia, and Vietnam maintain fixed exchange rates vis-à-vis the dollar. Cambodia, Laos, Myanmar, and the Philippines also manage tight pegs to the dollar, with the weights of the dollar in their hypothetical currency baskets all about 90 percent. Indonesia, Korea, Singapore (and hence also Brunei, which maintains a currency board vis-à-vis the Singapore dollar), and Thailand


Table 8.4

211

De jure and de facto exchange rate regimes in East Asia IMF classification

Brunei dollar

Currency board arrangement (vis-àvis the Singapore dollar) Cambodian Managed floating with no preriel announced path for the exchange rate Chinese Conventional pegged arrangement renminbi (vis-à-vis the US dollar) Hong Kong Currency board arrangement (vis-àdollar vis the US dollar) Indonesian Managed floating with no prerupiah announced path for the exchange rate Japanese yen Independently floating Korean won Independently floating Lao kip Managed floating with no preannounced path for the exchange rate Malaysian Conventional pegged arrangement ringgit (vis-à-vis the US dollar) Myanmar kyat Managed floating with no preannounced path for the exchange rate Philippine peso Independently floating Singapore Managed floating with no predollar announced path for the exchange rate Thai baht Managed floating with no preannounced path for the exchange rate Vietnamese Managed floating with no predong announced path for the exchange rate

Estimated weight of the USD in hypothetical basket (percent) 65.28 92.56

99.42 99.37 81.47

42.74 74.03 89.15

98.12 93.94

91.04 65.28 69.23

100.40

Notes: The estimates in column three were calculated using Frankel and Wei (1994) as presented in section 8.2 of this chapter with daily exchange rates from 7/21/2005– 4/24/2006.* All dollar weight estimates are significant at the 1 percent level. The yen was regressed only on the dollar and the euro. Data are from Datastream (Reuters and Tenfore). Classifications are from IMF (2005).

* On July 21, 2005 the Chinese central bank officially announced that it had abandoned the 11-year-old peg to the dollar and instead linked the yuan to an undisclosed basket of currencies. Changing the sample period does not alter the results.

212


allow considerably more flexibility toward the dollar than the previously mentioned countries but nevertheless display a strong dollar orientation in their exchange rate regimes, with dollar weights ranging from 65 percent to 80 percent. The only exception to this pattern is Japan, with a dollar weight of only 43 percent. Although most East Asian countries maintain some form of capital controls that, in principle, should allow for monetary policy autonomy in the face of an exchange rate target, historical evidence suggests quite strongly that capital controls are porous and are easily circumvented (Edwards 1999). Furthermore, there is a growing amount of empirical literature that puts into doubt even the traditional argument that countries with flexible exchange rates are able to isolate their domestic interest rates from changes in international interest rates. Frankel et al. (2004), for instance, find that while floating regimes afford greater monetary independence than fixed regimes, they offer only temporary monetary independence.30 That is, while the speed of adjustment of domestic rates toward the long run, one-for-one relation with international interest rates is generally lower under floating than under fixed regimes, even floating regimes cannot exert autonomous monetary policy. Their findings suggest that besides the US, Germany (now the euro zone) and Japan appear to be the only countries that can independently choose their own interest rates in the long run. Fratzscher (2002) also observes that even under flexible exchange rate arrangements it becomes ever more difficult to pursue independent monetary policy.31 Moreover, the underdevelopment of domestic financial markets hampers the conduct of monetary policy, creating a situation wherein the vast majority of East Asian countries have not been able to effectively pursue independent monetary policy.32 The People’s Bank of China (PBC), for instance, did not change interest rates for more than a decade until October 2004, and even this change was very modest and more symbolic than of practical import.33 The most extreme case of a loss of monetary autonomy in East Asia is Hong Kong. To maintain its currency board vis-à-vis the US dollar, the Hong Kong Monetary Authority has to move in tandem with the Federal Reserve, even though local inflation development has been very different from US inflation over recent years. If this argument is correct and the status quo level of East Asian monetary independence is limited, then the costs of monetary integration in East Asia, at least for the economically small and developing countries, are much lower than commonly assumed.34 A common agency approach to monetary unification, as pursued in Europe, could pave the way for greater monetary policy flexibility in East Asia. Through the creation of a common currency, which could float freely against the dollar and the


213

euro, East Asian countries could potentially gain some degrees of shared monetary independence. While they would still face an external constraint on domestic economic policies, the great difference between multilateral monetary union in East Asia and a continued (informal) dollar pegging under the East Asian dollar standard (or even full dollarization) is that the former would give members of the currency union a say in the common policy. Through a pooling of sovereignty, each member of the currency union would have a share in the central bank’s policy-making. In contrast, continued dollar pegging (or dollarization), while basically requiring the same sacrifices in domestic policy autonomy as monetary union, would mean that all monetary policy influence is abandoned (permanently).35 One potentially delicate political problem would be the institutional design of a common central bank and the apportionment of power in an East Asian monetary union. A representational structure akin to that of the EMU, with equal rights between all members, would be unrealistic if either China or Japan were involved, making such an arrangement less attractive for the smaller Southeast Asian countries because of the potential dominance of the bigger member countries. Conversely, neither Japan nor China (nor Korea) would be likely to accept the disproportional representation of the economically smaller Southeast Asian member countries the way Germany did in Europe.36 Even though they are also highly heterogeneous, a solution would probably be easier to reach among ASEAN member nations.37 Because the exit costs associated with a common monetary union are very high, a quick rush into monetary unification is not advisable if the potential partner countries have not had the chance to develop mutual trust as well as an understanding of each other’s policy preferences.38 Therefore, a gradual approach to monetary unification would be preferable, as it would allow East Asian countries to get to know their potential partners more closely. A gradual move toward monetary union in East Asia could first involve a coordinated regional adoption of currency baskets,39 flanked by a strengthening of financing facilities under the Chiang Mai Initiative and a further enhancement of regional surveillance mechanisms. A further option would be the introduction of a parallel basket currency for all participating countries, which could be used as an invoicing currency for trade and bond issues (see Eichengreen 2006). With time, the composition of the baskets could be harmonized among East Asian countries, and exchange rate bands could be introduced, developing a more formal regional exchange rate system. If countries were still committed to regional monetary unification after having experienced what close monetary and exchange rate cooperation really means, they could eventually form an East Asian monetary union.

214

8.5


CONCLUDING REMARKS

The three cases for monetary integration in East Asia presented in this chapter are in principle also valid for developing and emerging countries in other regions contemplating monetary integration, such as Latin America or the Middle East. However, this essay should not be mistaken for a straightforward and unambiguous recommendation for each and every region, including East Asia, to enter into monetary union. Important preconditions need to be in place before embarking on such a big endeavor. Above all, the countries involved need to have a far-reaching consensus on policy preferences as well as a firm agreement about the conduct of macroeconomic and, in particular, monetary policy (Volz 2006b). A very strong commitment is required from all parties willing to engage in regional monetary integration. The willingness and ability to subordinate internal economic objectives to the objective of successful monetary integration is essential. Moreover, the arguments put forward in this chapter have different value for different East Asian countries. The economic size argument certainly does not apply to Japan and China, and applies only to a limited extent to Korea. Also, Japan already has a strong international currency and enjoys monetary policy autonomy. Anyhow, China, Japan, and Korea are very particular cases, and their potential involvement has to be seen in the context of competition for regional leadership. The case for monetary integration is, in general, much stronger for the ASEAN countries, all of which are relatively small in economic terms and dependent on regional as well as global developments. Finally, one needs to recognize that the rationale for (and indeed against) regional monetary integration goes beyond purely economic considerations. In Europe, for instance, economic integration was meant to a large extent to be a means to overcoming centuries of war. From the beginnings of European integration, with the formation of the European Coal and Steel Community in 1951 and the European Economic Community in 1957, economic integration was regarded as much more than a scheme for promoting economic prosperity within Western Europe—it was regarded as a way of building a lasting peace. This has certainly been the greatest and most important achievement of the European Union and cannot be measured in economic terms.

NOTES 1.

Earlier versions of this chapter were presented at a workshop on “Currency Conflicts and Currency Cooperation in the Global Economy” held at the University of British


2.

3. 4. 5. 6. 7. 8.

9.

10.

11. 12. 13. 14. 15.

16. 17. 18. 19.

215

Columbia, Vancouver, February 9–10, 2006 and at the 9th Annual Harvard East Asia Society Conference in Cambridge, MA, February 17–18, 2006. I would like to thank Joshua Aizenman, Yin-Wong Cheung, Jerry Cohen, Manfred Nitsch, Federico Ravenna, and participants at the UBC and Harvard conferences and at seminars at UC Santa Cruz and Yale for valuable comments and suggestions. All errors are my own. Financial support by the Fox International Fellowship at Yale and the Max Kade Foundation is gratefully acknowledged. In this chapter, East Asia refers to the 10 member countries of the Association of the Southeast Asian Nations (ASEAN) as well as China, Hong Kong, Japan, and Korea. The members of ASEAN are Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, the Philippines, Singapore, Thailand, and Vietnam. On the patterns and structure of trade in East Asia see Kawai and Urata (2004). See Fernández-Arias et al. (2004). These problems are nicely illustrated for Brazil and Argentina in the 1990s by Eichengreen (1998). Glick and Rose (1998) have shown that countries that are closely linked through international trade, both as trading partners and competitors, are especially prone to contagious effects. The North American Free Trade Agreement (NAFTA) is a case in point. See Rose (2002, 2004), Frankel and Rose (2002), Nitsch (2002, 2004), Berger and Nitsch (2005), and Baldwin (2006). The countries are Cambodia, China, Hong Kong, Indonesia, Japan, Korea, Laos, Malaysia, the Philippines, Singapore, Taiwan, Thailand, and Vietnam. The sample is divided into three sub-sample periods, 1980–89, 1990–96, and 1999–2003, to capture the change over those years, with the crisis years 1997–98 excluded. GDP and population data are from WDI. Taiwan data are from the Taiwan Statistical Data Book 2004. Distance was calculated using the distance calculator of the US Department of Agriculture/Agricultural Research Service Phoenix, Arizona (www.wcrl. ars.usda.gov/cec/java/capitals.htm). As an alternative measure for the similarity of currency regimes, we compute bilateral exchange rate volatility, that is, the standard deviation of the first differences of the natural logarithms of the nominal exchange rate between the two countries in question. The estimates for the gravity model using this measure, which are not reported here, are almost identical to those in Table 8.2, confirming the robustness of the results. For both indicators, we use monthly exchange rates from the IMF/IFS and the Central Bank of China for Taiwan. Singapore’s share of intra-regional trade, for instance, is particularly high because of the fact that it engages considerably in intra-regional entrepôt trade. “Money” was actually written by Berry Gordy and Janie Bradford and was a 1959 hit single by Barrett Strong for the Tamla label (soon to be renamed Motown). This view dates back to the 18th century, when David Hume (1752) initiated the famous “oil-in-the-machine” illustration of the neutrality of money. Fritz and Metzger (2006) hence distinguish “south–south” cooperation from “north– north” cooperation, where “north” refers to a country’s ability to accumulate debt in its own currency and “south” refers to its inability to do so. All data are for 2004 and are taken from the World Bank’s World Development Indicators. For an explanation how the “threat of currency appreciation” has pushed the interest rates of China and several other East Asian countries below the US interest rate level see McKinnon and Schnabl, Chapter 7, this volume. The term “original sin” has been criticized by Goldstein and Turner (2004) and Nitsch (2006) because it suggests that it cannot be overcome. An IOU is a promise of money, goods, services, or other items of value, which may be either written or verbal. The name derives from the phonetic pronunciations of the respective letters, which sound like the phrase “I owe you”. See, for instance, Corsetti and Maćkowiak (2005). Eichengreen et al. (2005, pp. 250–1) argue that Switzerland and the UK can be regarded as special cases that achieved key currency status due to their unique historical roles.

216 20. 21. 22. 23. 24.

25.

26. 27. 28.

29.

30. 31. 32. 33.

34.

Toward monetary integration in East Asia After entering monetary union, however, the governments of several EMU member countries have manifestly shrugged off fiscal discipline and effectuated a weakening of the Stability and Growth Pact. The case of the USA is quite different from that of the other four former colonies. See Bordo et al. (2005). On the Asian Bond Fund see Ma and Remolona, Chapter 4, this volume. On the Asian Currency Unit see Kawai, Chapter 12, this volume. Goodhard (1995) does mention the costs of losing seignorage, but he argues that the value of seignorage to a stable country with low inflation is small and that the arrangements made under the Maastricht Treaty for returning seignorage to the constituent national central banks suggests that the net loss or gain to most European countries is of secondary importance. One should also highlight the loss of the national central bank’s ability to act as a lender of last resort, but in the EMU this function is still fulfilled by the European System of Central Banks with the European Central Bank at the center. Data are monthly and are taken from the International Financial Statistics and Global Financial Data. As is usual for backward-looking Taylor rules, the estimates are obtained using ordinary least squares with heteroskedasticity- and autocorrelation-consistent standard errors. See, for instance, Orphanides (2001) and Carare and Tchaidze (2005). Changing the lags does not significantly alter the results. The Greek drachma joined the EMS only in March 1998. This result is confirmed by Frankel et al. (2004) and Chinn et al. (1993), who find that interest rates in European countries had become completely insensitive to US interest rates but fully sensitive to German interest rates. The current voting rules are soon to be replaced by a rotating system to ensure efficient decision-making in the face of an increase of the Council’s current size of 18 members to 30 or more in the process of euro area expansion. The new voting scheme will give more weight to the larger euro area economies. But, irrespective of the distribution of voting rights, the ECB statutes stipulate that national central bank governors sit on the Governing Council in a personal and independent capacity, not as representatives of their own countries. The situation is different for the UK, where the Bank of England has managed to continue its independent monetary policy tailored to the national economy’s needs. This can be attributed to the size of the UK’s economy as well as its financial sector, which give it a greater pull compared with smaller economies like Denmark and Sweden. This is not inconsistent with Kim and Lee’s (2004) finding that the sensitivity of local interest rates to US rates has declined for Korea and Thailand since they moved toward less rigid exchange rate regimes after the Asian crisis. See also Calvo and Reinhart (2001 and 2002). This does not apply to Japan, Korea, and Singapore. One must note, however, that China has managed to sterilize the large increase of foreign reserve holdings very well and has thus been able to control inflation. The PBC has also made use of other monetary policy instruments, such as reserve requirements for domestic banks and credit ceilings. In October 2004, when announcing the raising of benchmark rates on one-year yuan loans to 5.58 percent from 5.31 percent and the rate on one-year deposits to 2.25 percent from 1.98 percent, the PBC said in a statement that “[t]his interest rate rise [. . .] is to make bigger use of economic measures in resource allocation and macro-adjustment” (Xu 2004), indicating the country’s intention to increasingly deploy its macroeconomic policy instruments. In April 2006, the PBC raised the interest rate on one-year yuan loans by another 0.27 percentage points to 5.85 percent. This does not imply, however, that there are no costs involved with abandoning the national currency. First, monetary union brings about the loss of the exchange rate as an instrument for coping with idiosyncratic shocks to the national economy. Second, there would still be the political cost of giving up formal monetary independence, that is, the loss of monetary policy autonomy illusion. Furthermore, giving up de jure independence could involve diplomatic costs in the form of political dependency on foreign nations.


35. 36. 37. 38. 39.

217

Third, the cost of exiting a monetary union can be assumed to be much higher than that of exiting a conventional exchange rate peg. On the advantages of multilateral monetary union over dollarization see Alexander and von Furstenberg (2000). On the power structure within the EMU see Berger and De Haan (2002). Volz (2006a) discusses the factors that push ASEAN countries toward greater integration. As Friedrich Schiller versified in The Song of the Bell, “Whoe’er would form eternal bonds should weigh if heart to heart responds.” Schnabl (Chapter 10, this volume) analyzes the use of currency baskets as a way to diversify exchange risk in East Asia and finds hints of a move by several East Asian countries toward a basket strategy. For proposals for currency baskets in East Asia see Williamson (1999 and Chapter 11, this volume) and Ogawa and Ito (2002).

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Williamson, John (1999). “The Case for a Common Basket Peg for East Asian Currencies.” In Stefan Collignon, Jean Pisani-Ferry, and Yung Chul Park (eds), Exchange Rate Policies in Emerging East Asian Countries. London: Routledge, pp. 327–43. Xu, Binlan (2004). “Bank Rates Raised for First Time in a Decade.” China Daily. October 29.

9.

Monetary and exchange rate policy coordination in ASEAN11 William H. Branson and Conor N. Healy

9.1

INTRODUCTION

This chapter develops an argument in favor of monetary and exchange rate coordination in East Asia as part of a package of monetary integration that would be aimed at supporting growth and poverty reduction. This could be achieved directly through coordinated exchange rate stabilization and indirectly through the implications coordination would have for reserve pooling and investment in a new Asian Development Fund and through the development of an Asian bond market. By monetary and exchange rate coordination, we are here referring to flexible joint management of exchange rate movements against a common basket, with the aim of maintaining real effective exchange rates (REERs) near their equilibrium values as underlying real economic conditions evolve. The chapter focuses on establishing the conditions for such coordination. In the next section, we examine the policy of monetary coordination within ASEAN. We address the costs incurred when monetary stabilization is not accompanied by the coordination of sustainable underlying policies. We emphasize a distinction between monetary stabilization with and without such policies. The section uses an analytical narrative of the key macro developments in ASEAN since the early 1990s as its vehicle. Macro and exchange-rate policy coordination could have at least cushioned the effects of the 1997–99 crisis and prevented at least partially the growth slowdown that followed. We use this as a starting point for identifying the direct gains from stabilization with sustainable macro policies, inquiring how the gains from cooperative stabilization would have ruled out the unintended competitive devaluations and cascading of speculation from market to market that was seen in the crisis. Explicit movement toward coordination could also help the development of regional bond markets, support surveillance and reserve-sharing under the Chiang Mai Initiative, and, thus, free up reserves for additional investment through an Asian Development Fund. 222

Monetary and exchange rate policy coordination in ASEAN11

223

In section 9.3 the trade structure of ASEAN and China is laid out in terms of both geographic sources of imports and markets for exports, and of the commodity structure of trade. The structure of trade by commodity and sources and markets is also summarized for major commodity groups. The similarities of the geographic trade structures across the region are consistent with adoption of a common currency basket for stabilization. The similarities of commodity structure in trade across the region are consistent with an argument for monetary integration across the region along the lines of Mundell (1961) on optimum currency areas. The even distributions of trade across sources and markets for the major commodities show that stabilization against a common basket would not create strong differential sectoral strains across the region. Section 9.4 draws on the geographic data of section 9.3 to construct currency baskets and real effective exchange rates for the countries in the region. Since their trade patterns are quite similar and their policies are already implicitly coordinated, their REERs tend to move together. This means that ASEAN and China are already moving toward integration in practical effect, providing support for the implementation of a common (externally based) currency basket. Section 9.4 also draws attention to the effective coordination of monetary policy by studying correlations among monthly movements in nominal exchange rates and changes in reserve money, representing monetary policy. The correlations are positive and quite strong. This is consistent with common reactions to common shocks or with attempts to maintain exchange rates within a stable zone within the region. In this case, monetary policy coordination is already implicit. Making the coordination explicit, or even formal, could yield the benefits of ruling out competitive devaluations and forestalling cascading speculation. Section 9.5 ends with some tentative conclusions about the desirability of monetary cooperation in East Asia.

9.2

MACRO POLICY COORDINATION

This section looks at the policy of coordinated stabilization of real exchange rates, relating it to the Asian crisis as well as to the pre-crisis and postcrisis periods. It is important to make clear that when we consider exchange rate stabilization we are not referring to the unilateral stabilizations that occurred before—and contributed to—the crisis. We argue that while there are substantial benefits to be gained from stabilization, policies of stabilization will be more successful (and less prone to risk) if accompanied by regional cooperation. They are also likely to be successful if accompanied by underlying policies that are more sustainable than those that existed before.

224


Thus, before discussing the explicit benefits of cooperative stabilization, we highlight the costs of maintaining exchange rate stability without the necessary underlying policies and without regional cooperation. We discuss losses from failed stabilization in terms of the events leading to the crisis, the loss of output during the crisis, and the depressed investment and slower growth that have followed the crisis. These are losses that could have been prevented or at least minimized by sustainable underlying macro policies and coordinated exchange-rate policies. We then go on to discuss potential gains from cooperative stabilization, namely, the end of competitive depreciations and the removal of individual country targets for speculative pressure. We also use this discussion as the starting point for our broader discussion of the benefits of reserve sharing and regional bond issues. Exchange Rate Stabilization Without Sustainable Underlying Policies A necessary condition for successful stabilization is a sustainable fiscal position that frees monetary policy to target inflation with exchange rate stability. A focus on exchange rate stabilization thus requires macro policy sustainability, a lesson learned (and being re-learned) in Europe. The data for the ASEAN countries since the early 1990s provide an illustration of the problem of exchange rate stabilization without underlying macro sustainability and the resulting losses from failure of stabilization. Figures 9.1 and 9.2 show monthly USD exchange rates for the core ASEAN countries, indexed to the beginning of 1990. These are defined as units of home currency per dollar, so an upward movement is a depreciation of the home currency. As the extreme movement of the Indonesian rupiah in 1997 distorts the picture in Figure 9.1, Figure 9.2 eliminates Indonesia. Both graphs show the stable and roughly parallel movement of nominal dollar exchange rates before and after the crisis, interrupted by the crisis explosion in 1997–99. Before the crisis, USD exchange rates were stable in nominal terms. But the economies were experiencing investment booms not accompanied by fiscal adjustment, as shown in the tables in the next section. They were overheating, with inflation causing real appreciation of their currencies, although they were stable in nominal terms against the USD. They had large and growing current account deficits and growing external debts denominated in foreign exchange. Thus, the growth in the current account deficits was accompanied by appreciating real effective exchange rates, an unsustainable scenario that can be interpreted as a “bubble” in the foreign exchange market.1 Exchange rate stability was restored in the period after the crisis. However, this period has seen a major depression in investment, with the formation of current account surpluses. This is consistent with real appreciation but

Monetary and exchange rate policy coordination in ASEAN11 800

Indonesia Thailand Philippines

700

225

Singapore Malaysia

600 Indonesia

500 400 300

Philippines

200

Thailand Malaysia Singapore

100

04

03

D ec

02

ec D

01

D ec

00

ec D

99

D ec

98

D ec

97

ec D

D

ec

96

95

ec D

D

ec

94

93

ec D

92

ec D

90

D ec

91

Source:

D ec

ec D

D

ec

89

0

Global Financial Data.

Figure 9.1

Monthly exchange rates for core ASEAN, December 31, 1989–December 31, 2004

300 Thailand Singapore

Malaysia Philippines

Philippines

250

200 Thailand 150 Malaysia 100 Singapore

D

ec

89

D ec 90 D ec 91 D ec 92 D ec 93 D ec 94 D ec 95 D ec 96 D ec 97 D ec 98 D ec 99 D ec 00 D ec 01 D ec 02 D ec 03 D ec 04

50

Source:

Global Financial Data.

Figure 9.2

Monthly exchange rates for core ASEAN, excluding Indonesia, December 31, 1989–December 31, 2004

226


240 Malaysia Philippines Indonesia

220

Singapore Thailand

200 180 160 140 120 100 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Source:

World Bank, World Development Indicators.

Figure 9.3

GDP (constant, 2000 LCU)

slower real growth. The effects of the lack of sustainable policies and the breakdown of exchange rate stability in the crisis are shown in Figure 9.3. The paths of real GDP are interrupted by the crisis, with serious recessions in all the ASEAN countries. More importantly, none of the countries has recovered back to its original growth path, and in all cases the underlying growth rate has been reduced. The unsustainable earlier policies and the crisis have depressed investment, lowered and slowed the real GDP growth path, and substantially reduced the potential for poverty reduction. Investment, saving, the current account, and REERs since 1990 The current account, investment-saving balance, and external debt data for the core ASEAN countries since 1990 are summarized in Table 9.1 and Figures 9.4–9.7. The table shows in the first three lines the evolution of the current account balance (CAB), investment (I), and saving (S), all as percent of GDP. From the GDP accounts, these are connected by the equation CAB 5 I − S. The current deficit is the excess of investment over saving. The current deficit must be financed by borrowing abroad, expanding the external debt. The last line of each table shows the path of the debt/ GDP ratio for each country. The paths of the effective real exchange rates of the core ASEAN countries are shown in Figure 9.8. These are the total trade-weighted indexes from Section 9.4 below. We now analyze in turn the data for the pre-crisis period 1990–1996, the crisis period 1997–99, and the post-crisis period 1999–2004.

227

Ext. balance, goods & services (% GDP) Gross capital formation (% GDP) Gross domestic savings (% GDP)

Ext. balance, goods & services (% GDP) Gross capital formation (% GDP) Gross domestic savings (% GDP) External debt, total (DOD, current US$) GDP (current US$) Ext. debt, % GDP Malaysia

Indonesia

Table 9.1

34.1

62.1

61.1

34.5

128 168

114 427

37.8

79 548

69 872

32.4

33.2

32.3

23.7

31.6

30.7

2.1

1.7

1991

1.6

1990

36.7

35.4

1.4

63.3

139 116

88 002

33.4

30.5

2.9

1992

39.1

39.2

20.1

56.4

158 007

89 172

32.5

29.5

3.0

1993

39.6

41.2

21.6

61.0

176 892

107 824

32.2

31.1

1.1

1994

39.7

43.6

23.9

61.5

202 132

124 398

30.6

31.9

21.3

1995

External balance, investment, savings and debt

42.9

41.5

1.4

56.7

227 370

128 937

30.1

30.7

20.6

1996

48.7

26.7

43.0

43.9

22.0

158.5

95 446

151 236

26.5

16.8

9.8

1998

0.9

63.1

215 749

136 161

31.5

31.8

20.3

1997

47.4

22.4

25.1

108.0

140 001

151 201

19.5

11.4

8.1

1999

47.3

27.3

20.0

96.1

150 196

144 407

25.6

16.1

9.5

2000

42.3

23.9

18.4

93.7

143 034

134 045

24.9

17.4

7.4

2001

42.1

23.8

18.3

76.2

172 971

131 755

22.2

15.7

6.6

2002

42.3

21.4

21.0

64.5

208 312

134 389

21.5

16.0

5.5

2003

228

Ext. balance, goods & services (% GDP)

Ext. balance, goods & services (% GDP) Gross capital formation (% GDP) Gross domestic savings (% GDP) External debt, total (DOD, current US$) GDP (current US$) Ext. debt, % GDP Singapore

External debt, total (DOD, current US$) GDP (current US$) Ext. debt, % GDP Philippines

Table 9.1

34.8

34.8

32 494

45 417

71.5

30 580

44 331

69.0

10.6

17.2

18.4

6.9

20.2

24.2

23.0

49 134

44 024

25.8

17 080

1991

15 328

1990

(continued)

9.7

62.7

52 977

33 220

16.4

21.3

24.9

33.8

59 151

20 018

1992

7.8

66.5

54 368

36 143

15.5

24.0

28.4

39.1

66 894

26 149

1993

14.9

62.8

64 085

40 257

17.8

24.1

26.3

40.7

74 481

30 336

1994

16.1

53.1

74 120

39 391

14.6

22.5

27.8

38.7

88 832

34 343

1995

14.4

53.1

82 847

44 031

15.2

24.0

28.8

39.3

100 852

39 673

1996

12.2

61.6

82 343

50 746

14.4

24.8

210.3

47.1

100 169

47 228

1997

21.0

82.1

65 172

53 529

13.7

20.3

26.6

58.8

72 175

42 409

1998

17.8

76.2

76 157

58 063

18.6

18.4

0.2

52.9

79 148

41 903

1999

16.1

80.2

75 913

60 850

23.1

21.2

1.9

46.4

90 320

41 941

2000

19.4

81.2

72 043

58 499

17.5

20.6

23.1

50.7

88 001

44 612

2001

22.8

77.1

77 954

60 090

18.8

19.3

20.5

51.3

95 164

48 833

2002

33.3

77.8

80 574

62 663

16.2

18.7

22.5

47.3

103 737

49 074

2003

229

Sources:

4 369

43 191

10.1

3 772

36 901

10.2

42.8

36.3

37 703

98 234

38.4

41.4

33.8

28 095

85 345

32.9

26.5

45.1

43.3

27.5

34.5

36.4

37.5

111 453 42.1

125 009

52 638

35.8

36.0

41 784

40.0

24.2

9.5

58 355

5 524

45.2

37.4

40.0

24.0

9.2

49 863

4 582

45.5

35.8

45.3

144 527

65 533

35.4

40.3

24.8

10.8

70 610

59.6

167 896

100 039

35.4

42.1

26.7

10.0

83 933

8 368

50.2

48.0

7 594

34.1

33.1

62.1

181 689

112 838

35.5

41.8

26.3

10.6

92 221

9 802

50.3

35.9

72.7

150 892

109 699

35.1

33.7

1.4

12.4

95 395

11 803

51.4

39.2

93.8

111 860

104 917

36.3

20.4

15.9

14.8

81 911

12 093

53.3

32.3

79.1

122 338

96 770

33.1

20.5

12.6

16.8

81 381

13 701

50.3

32.4

64.9

122 725

79 710

31.4

22.8

8.6

17.1

91 476

15 623

48.5

32.4

All World Bank, World Development Indicators, except Singapore external debt from Economist EIU data.

Ext. balance, goods & services (% GDP) Gross capital formation (% GDP) Gross domestic savings (% GDP) External debt, total (DOD, current US$) GDP (current US$) Ext. debt, % GDP

Gross capital formation (% GDP) Gross domestic savings (% GDP) External debt, (current US$m) GDP (current US$) Ext. debt, % GDP Thailand

58.1

115 536

67 181

30.6

24.1

6.5

21.6

84 871

18 361

44.6

25.2

46.9

126 770

59 459

31.1

23.9

7.2

23.4

88 275

20 657

43.9

21.2

36.2

142 953

51 793

32.0

25.2

6.7

24.3

91 342

22 218

46.7

13.4

230


Pre-crisis, 1990–96 With the exception of Singapore and Indonesia in the early 1990s, the data show substantial and growing current deficits in the period before the crisis. These were generated by investment booms, with investment exceeding domestic saving, where investment and saving both include private and public. The excess of investment over saving could have been remedied by an increase in public saving, that is, fiscal tightening. In the absence of fiscal adjustment, the current deficits persisted and grew, maintaining or increasing the debt/GDP ratios. Thailand provides a good illustration of the stabilization problem before the crisis. From 1990 to 1996 investment was 41–42 percent of GDP, while saving was around 35 percent. Thus, the current deficit stayed near 5 percent of GDP, increasing to over 6 percent over 1995–96, before the crisis. The ratio of external debt to GDP increased from 32 percent in 1990 to 62 percent in 1996 and to 73 percent in 1997. The market could see that this path was unsustainable, and speculative pressure against the Thai baht began the crisis in July 1997. The depreciation of the baht led to contagion across the region and to the cascade of devaluations shown in Figures 9.1 and 9.2 above. Thus, the crisis was the combined effect of unsustainable underlying macroeconomic policies and the lack of cooperative macro policy management. The pattern is basically the same for all the core ASEAN countries except Singapore. The investment ratios in Figure 9.4 are high and rising over the period 1990–97. The picture for saving, illustrated in Figure 9.5, is less clear. Thailand, Indonesia, and, especially, the Philippines have saving ratios that are flat or falling. The saving ratios of Malaysia and Singapore increase all the way until 1998, but Malaysia’s saving is lower than its rising investment through 1995 while Singapore’s saving exceeds investment over the entire period. The external consequences of the investment boom underfinanced by domestic saving are shown in Figures 9.6 and 9.7. Figure 9.6 shows the decreasing current account balances for all the core ASEAN countries except Singapore. The deficits of Thailand and the Philippines are the largest. Those of Malaysia and Indonesia are closer to zero, with Malaysia’s deficit diminishing after 1995. These current account balance patterns are reflected in the debt/GDP ratios of Figure 9.7. With rapid GDP growth, the debt ratios of all but Thailand are stable until 1996–97. Thailand’s debt ratio rises throughout the period 1990–98, with an increase in its growth rate in 1994. This rapidly rising debt ratio signaled the potential unsustainability which led to the onset of the crisis in 1997. The depreciation of the Thai baht in July 1997 put competitive pressure on the other ASEAN countries. This pressure was perceived by the


231

45 40 35 30 25 20 Indonesia Malaysia Philippines

15

Singapore Thailand

10 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Source:


Figure 9.4

Gross capital formation (% GDP)

55 50 45 40 35 30 Indonesia Malaysia Philippines

25 20

Singapore Thailand

15 10 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Source:


Figure 9.5

Gross domestic savings (% GDP)

markets, leading to cascading speculation and devaluations. The source of the competitive pressure was the similarity of ASEAN nations’ trade patterns, which we discuss below. The contagion of this pressure is one argument for cooperative exchange rate management. Movements in the REERs of the core ASEAN countries since 1990

232

Toward monetary integration in East Asia 35 Indonesia Malaysia Philippines

30 25

Singapore Thailand

20 15 10 5 0 –5 –10 –15 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Source:


Figure 9.6

External balance on goods and services (% GDP)

160% Indonesia Malaysia Philippines

140%

Thailand Singapore

120% 100% 80% 60% 40% 20% 0% 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Source:

Economist, EIU data.

Figure 9.7

External debt (% GDP)

are shown in Figure 9.8.2 The REER paths generally show a downward concavity from 1990 to 1996. There is an initial period of depreciation from 1990 to 1992, a more or less flat period from 1992 to 1994, and then an appreciation in 1995–96. Again, the main exception is Singapore, with


233

Core ASEAN real effective exchange rate, total trade basis (markets outside ASEAN + China/HK)

160

Indonesia Malaysia Philippines

150 140

Thailand Singapore

130 120 110 100 90 80 70 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Sources: Global Financial Data; IMF Direction of Trade Statistics; World Bank, World Development Indicators.

Figure 9.8

Real effective exchange rate

a real appreciation from 1989 to 1996, consistent with its rapid growth shown in Figure 9.1 earlier. Combined with the growing current account deficits, the REER paths are consistent with the unsustainable position that developed into a bubble in the ASEAN foreign exchange markets, as shown analytically in Branson (2005). The initial real depreciations over 1990–93 were broadly consistent with stable adjustment. Further depreciation would have contributed to the correction of the current deficits. But the flattening out of the REER paths and the turn to real appreciation were a signal that the economies were moving away from equilibrium. The real appreciations would contribute to further growth in the current account deficits, rather than correcting them. As the markets saw this growing contradiction, speculation on depreciation developed, with the initial pressure on Thailand, the country with the rapidly growing debt ratio. The unsustainability of the underlying macro policies combined with the lack of coordination of exchange rate policy set the stage for the crisis. Crisis, 1997–99 The crisis is clearly visible in Tables 9.1–9.2 and Figures 9.4–9.8. The collapse of the REERs of all the core ASEAN countries except Singapore is evident in

234


Table 9.2

Regional aggregates for percentage of poor at USD 1 and USD 2 per day in East Asia 5*

USD 1 per day USD 2 per day

1990

1996

1999

2000

2001

2002

15.6 53.3

6.9 38.5

9.0 46.2

8.0 44.7

7.0 42.8

6.2 41.1

* East Asia 5 comprises Indonesia, Malaysia, the Philippines, Korea, and Thailand. Source:

World Bank, East Asia Update, September 2000.

Figure 9.8. The real depreciations range from 20 percent for the Philippines to 40 percent for Indonesia. With external debt denominated in foreign currency and domestic assets in home currency, this collapse led to financial institution failures and a breakdown in credit. This phenomenon, in which currency crisis spreads to the financial sector, is well known in the economic literature as a “twin crisis”. As the currencies collapsed, so did the local financial institutions, whose large dollar exposures were no longer matched by equivalent local currency assets. The financial collapse was precipitous. In Thailand, for example, 56 out of 91 finance companies were eventually liquidated. Similarly dramatic levels of collapse were seen elsewhere, especially in Korea and Indonesia (see, for example, Radelet and Sachs 1998). All of this combined with a major increase in uncertainty, leading to the investment collapses shown in Figure 9.4. Investment fell by more than 50 percent in Indonesia, Malaysia, and Thailand and 25 percent in the Philippines. It fell even more steeply from 1997 to 2003 in Singapore. This investment collapse generated the recessions in GDP shown earlier in Figure 9.3. The effects of the crisis on poverty are well documented (e.g., World Bank 2000). The crisis generated recessions, financial failures, and rising import prices, all leading to sharp increases in poverty across the region. Moreover, its effects on poverty have often been understated, as, in the absence of the crisis, poverty rates would have declined further below precrisis levels. Table 9.2 shows the substantial progress in reducing poverty made across the region between 1990 and 1996, with the percentage of people living on less than USD 1 and USD 2 per day falling markedly over this period. The crisis reversed this trend between 1996 and 1999, leaving the percentage living on less than USD 2 a day in 2002 still well above the 1996 level. The effects on the external balances can be seen in Figure 9.6. With saving ratios fairly stable and investment collapsing, the current balances all moved sharply into surplus. This is essentially a macro result, resulting from the real currency depreciations experienced by all of the core


235

ASEAN nations during the crisis. Figure 9.7 shows the crisis results for external debt ratios. With debt mainly denominated in foreign exchange, the depreciations directly increased the debt ratios. The recessions in real GDP added to the increases, most markedly in Indonesia. Thus, the investment collapse in the crisis led to the severe recessions and the shift to current account surpluses, while the depreciations increased the debt ratios. The combination of real recession, financial failures, and rising import prices contributed to significant increases in poverty, reversing the trend of a decade. Post-crisis, 1999–2004 Since the crisis, the ASEAN economies have stabilized, with lower and slower paths of real growth (Figure 9.3), much lower investment ratios (Figure 9.4), current account surpluses in all but the Philippines (Figure 9.6), and currencies depreciated in real terms (Figure 9.8). The lower investment paths are a serious source of concern, as capital formation was a driving force behind the “Asian miracle”.3 The domestic saving ratios remain high, as shown in Figure 9.5. Thus, excess saving in the region now generates current account surpluses and growth in reserves, while the central banks hold currencies stable. The relationship between the paths of current account balances in Figure 9.6 and REERs in Figure 9.8, the main source of instability before the crisis, is mixed. The only country that stands out is Singapore, with a rising surplus and a depreciating currency, an unstable combination. Indonesia and Malaysia have substantial but decreasing surpluses with currencies appreciating in real terms, a stable combination. Thailand has a falling surplus with a slowly depreciating currency, and the Philippines has a small deficit with real depreciation. In summary, the region has settled on a lower and slower, but stable growth path. Macro coordination centered on exchange rate management might have averted the crisis by leading to sustainable macro policies and reduced vulnerability to speculation. Gains from Cooperative Stabilization The direct gains from stabilizing real exchange rates come from the stability provided by the underlying macro policies and the resulting minimization of exchange risk to investors.4 Cooperative exchange rate stabilization against the USD can yield two immediate potential benefits.5 First, it rules out competitive depreciations. Figures 9.1 and 9.2 illustrate the problem. Once the pressure from speculation forced the devaluation in Thailand in July 1997, the other ASEAN countries had to follow. The

236


market understood this, so the pressure moved to Indonesia and Malaysia. These depreciations were not competitive in the sense that they were led by policymakers seeking a competitive edge; they were forced by the market. But they had the same result. Once one goes, the others have to follow. This led to overshooting, as is evident in the graphs. A coordinated policy could have attained an orderly group devaluation, if needed, without the disorganization that at least partially contributed to financial failures and the depth of the recessions. The competitive nature of the depreciations is based on the similarity in the trade structures of the ASEAN economies in terms of both commodity composition and markets (which are discussed in the next section). The second benefit is the removal of convenient individual country targets from potential speculative pressure. In Asia in 1997, as in Europe in 1992, speculators targeted the weakest country in the group and then moved sequentially from country to country. Coordinated stabilization with reserve sharing could remove this targeting convenience. If the coordination were based on an explicit agreement, the market would understand that it is facing a cooperative based on shared reserves. In this case, the group would come to a considered decision on how to deal with speculative pressures.6 Cooperative stabilization would be facilitated by the development of a common currency basket for exchange rate management. The feasibility of an agreement on such a basket is supported by the similarity of the compositions of trade of the core ASEAN countries and China in terms of markets and commodities, as shown in the next section. Thus, a common currency basket weighted according to export destination or import source could be developed as the basis for exchange rate coordination, as well as for regional bond issues. These baskets are discussed in section 9.4. Explicit exchange rate coordination would also support the reserve sharing of the Chiang Mai Initiative (CMI) and help the development of an Asian Bond Market (ABM), two initiatives that have received substantial attention to date.7 The CMI was developed by the ASEAN finance ministers together with their counterparts from China, Japan, and Korea (known as the ASEAN13 grouping) in May 2000 in Chiang Mai, Thailand. It comprises a system of bilateral short-term financing facilities in the form of swap arrangements in the event of a financial crisis within the group. To date, 16 bilateral swap agreements between ASEAN13 countries have been successfully concluded, for a combined total size of USD 75 billion. The political cooperation involved in the CMI and the rhetorical ambition of recent ASEAN13 statements have been taken by many to suggest a new era in region-wide monetary coordination. In practical terms, though, actual progress has been more limited. The CMI swap agreements have not been activated, and the ABM is still mostly denominated in Singapore or


237

Macro policy and exchange rate coordination

Stability, growth and poverty reduction

Sustainable macro policies and surveillance

Exchange rate stability Common basket

Reserve sharing (Chiang Mai) Leveraged ADF

ABM

Derivatives and futures Issuance in common basket

Figure 9.9 The relationship of policy coordination, reserve sharing, and the ABM

US dollars. Regional macro policy and exchange rate coordination would strengthen surveillance under the CMI and can thus be regarded as a necessary condition for further development of such reserve pooling. Furthermore, exchange rate stabilization against a common basket of currencies could reduce risk in bond markets and facilitate development of derivatives and futures.8 Just as was the case with European monetary coordination and the use of the European Currency Unit (ECU), the common basket could act as a focal point for monetary coordination. Moreover, it could also act as a spur for the ABM, particularly through the creation of a broadly accepted local currency for bond issues. These are necessary conditions for the development of an active ABM denominated in the currencies of the region. The relationship of exchange rate and macro policy coordination with reserve sharing and the ABM is summarized in Figure 9.9. Macro policy coordination can contribute directly to stabilization and growth through crisis prevention and the reduction of uncertainty. It could provide the basis for surveillance, activating reserve sharing. Concerted reservesharing would reduce the demand for reserves at the individual country level. This could permit the release of reserves for investment as paid-in capital into a newly created Asian Development Fund (ADF), leveraging it in international markets to become a real influence in regional development. Exchange rate stabilization and the additional flow of investment resources could stimulate development of the ABM, increasing the efficiency of investment in growth and poverty reduction. Thus, macro policy

238


coordination could be viewed as a necessary condition for further development both of reserve pooling via the CMI and of the ABM.

9.3

TRADE STRUCTURE: ASEAN AND CHINA

This section presents and analyzes the trade structures of the ASEAN countries and China (ASEAN11) with two objectives in mind. The first objective is to develop a basis for assigning weights for ASEAN currency baskets in terms of ASEAN’s trade flow. The weights would be based on the currency composition of external trade determined by the geographic distribution of trade. For individual countries, these weights would be used for calculating effective exchange rates, both nominal and real. For ASEAN as a group, the weights would define a common basket for coordinated management of exchange rate policy. This common basket could also be used as the currency of issue in the Asian Bond Market. The second objective is to evaluate the case for some form of monetary integration of ASEAN11 based on the commodity composition of trade. Here we reflect Mundell’s (1961) original view that countries with similar structures of trade by commodity are good candidates for integration into a currency area. The last step is to present a summary of the structure of trade by market and commodity. This summarizes the similarities and differences in trade structure across the region. It can also yield an idea of the effects of stabilizing exchange rates against a geographic basket. Geographic Structure of Trade The geographic structure of trade in 2003 for the core ASEAN economies and China is summarized in Tables 9.3 for exports and 9.4 for imports. Trade structure does not change very quickly over time, so the particular choice of year is not crucial. Each table shows the total trade of the ASEAN11 countries in billions of USD and its percentage distribution across import and export markets. We focus on the large ASEAN countries, because inclusion of the small, newer members does not change the numbers at all significantly. Table 9.3 shows the structure of exports by market for ASEAN11. The first column gives total exports, and the rest give the percentage distribution across major markets. Taiwan and Australia are included among the major markets because of their regional importance; their shares of ASEAN11 exports are similar to Korea’s. In moving to weights for REERs, we concentrate on the six markets that are external to ASEAN11, treating trade

239

Source:

22.3 10.7 15.9 14.2 6.7 13.6 14.6

Japan (%)

IMF DOTS 2004 Yearbook.

60.995 104.966 36.225 80.521 144.121 438.25 490.358 426.828

Total ($bn) 7.1 2.9 3.6 2.0 4.2 4.6 5.0

Korea (%) 12.1 19.6 20.1 17.0 14.3 21.1 27.4

US (%) 13.1 12.1 16.3 14.7 13.4 16.5 20.8

EU (%)

Export distribution by market, ASEAN11, 2003 data

Indonesia Malaysia Philippines Thailand Singapore China China 1 HK Core ASEAN

Table 9.3

3.7 3.6 6.9 3.2 4.8 2.1 2.9

Taiwan (%) 2.9 2.5 0.9 2.7 3.2 1.4 1.8

Australia (%) 17.6 24.8 18.2 20.6 27.9 7.1 9.1

ASEAN (%)

6.2 6.5 5.9 7.1 7.0

China (%)

15.0 17.3 12.3 18.5 18.4 33.7 18.3

Other (%)

240

Source:

13.0 17.3 20.4 24.1 12.5 18.0 19.1

Japan (%)

IMF DOTS 2004 Yearbook.

32.544 82.726 37.5 75.809 127.996 412.836 533.002 356.575

Total ($bn) 4.7 5.5 6.4 3.9 3.7 10.4 10.2

Korea (%) 8.3 15.5 19.8 9.5 14.1 8.2 8.8

US (%) 10.9 11.8 8.0 10.0 12.5 12.9 13.6

EU (%)

Import distribution by market, ASEAN11, 2003 data

Indonesia Malaysia Philippines Thailand Singapore China China 1 HK Core ASEAN

Table 9.4

2.7 5.0 5.0 4.3 5.1 12.0 12.3

Taiwan (%) 5.1 1.5 1.3 2.1 1.7 1.8 1.7

Australia (%) 23.8 24.4 17.1 16.6 28.6 11.5 14.0

ASEAN (%)

9.1 8.8 4.8 8.0 8.7

China (%)

22.5 10.1 17.3 21.6 13.3 25.3 20.4

Other (%)


241

in the region as internal. Here we begin with the broader picture. We note for future reference and research that the total value of Singapore’s trade is exaggerated by its extensive engagement in entrepôt trade. It is not clear what, if any, effect this has on its trade distribution. One thing to notice in Table 9.3 is that the distribution of China’s exports across markets is very similar to ASEAN’s. The shares of the main six markets in the last row of the table fit right into the ASEAN pattern. This also holds for import sources in Table 9.4. This similarity between the geographic distribution of trade of ASEAN and that of China is a first indicator that the two may be good candidates for monetary coordination. We also note that the total value of ASEAN exports (USD 427 billion) is about the same as China’s (USD 438 billion). Turning to some of the notable details of the table, we note that the share of ASEAN internal exports ranges from 17 to 28 percent. The share of China’s exports to ASEAN is smaller, as is ASEAN’s to China, around 6–7 percent. Thus, as of 2003, ASEAN was a denser trade area than ASEAN–China. The total share of the three largest markets (Japan, US, Europe) for all seven countries ranges between 42 percent (for Malaysia) and 52 percent (for the Philippines). Again, China fits into the ASEAN distribution here. If we look at China separately, we see that China’s share of ASEAN exports falls between that of the largest three markets (Japan, US, Europe), and that of the smaller three (Korea, Taiwan, Australia). The export market data would support the adoption of a common currency basket by both ASEAN and China, composed of the currencies either of the three largest export markets (Japan, US, Europe) or of all six (the top three plus Taiwan, Korea, and Australia). Table 9.4 shows the structure of imports by source for ASEAN11. As in Table 9.3, the geographic structure of China’s imports is quite similar to ASEAN’s. China’s shares of imports from Korea and Taiwan are larger than ASEAN’s, while the shares of the US and Australia are smaller. But the overall impression is that China’s import pattern for the major markets fits into the ASEAN pattern, potentially supporting an argument for coordination. The total value of ASEAN’s imports (USD 356 billion) is about the same as China’s (USD 413 billion). Thus, in terms of trade volumes, aggregate ASEAN and China are about the same size. The core ASEAN member nations’ shares of imports from other ASEAN countries range from 17 to 29 percent, and the range is the same in the case of intra-ASEAN exports. ASEAN’s share of Chinese imports is smaller, as is China’s share of ASEAN imports. Thus, on the import side, intra-ASEAN trade is also denser than that between ASEAN and China. The total share of the ASEAN11 nations’ imports from their three largest trade partners (Japan, the EU, and the US) ranges from 39 percent (for

242


China) to 48 percent (for the Philippines). The total import shares for the largest sources are smaller than their shares of exports, especially in the case of China, for whom trade with Japan, the EU, and the US accounts for 51 percent of its exports and 39 percent of its imports. The US’s shares of imports in Table 9.4 are all smaller than its export shares in Table 9.3. The imbalance between the export share and the import share for the three largest trading partners is a reflection of the US trade deficit. As in the case of exports, China’s share of ASEAN imports falls between that of the three largest sources (Japan, US, Europe) and the three smaller ones (Korea, Taiwan, Australia). The import source data of Table 9.4 would also support the adoption of a common currency basket by both ASEAN and China. Commodity or Sector Structure of Trade The commodity structure of trade at the one-digit SIC level of the ASEAN countries and China in 2002 is summarized in Table 9.5 for exports and Table 9.6 for imports. The tables separate the founding “core” ASEAN countries from the later entrants plus Brunei. The latter are much smaller individually as well as in aggregate and have very different trade structures. China and China including Hong Kong are also presented separately, mainly because of the entrepôt nature of Hong Kong’s trade.9 The inclusion of Hong Kong with China does not affect the data or conclusions significantly at this level of aggregation. Table 9.5 for exports shows clearly the results of the “Asian miracle”. SIC 7 is the dominant export sector for all of core ASEAN but Indonesia.10 The largest share of Indonesia’s exports is in SIC 3, which includes oil. But even if SIC 2 and 3 for Indonesia are excluded, the 16.8 percent in SIC 7 becomes 25 percent, still much less than the other core ASEAN countries. China’s share of exports in SIC 7 is about the same as the shares of the Philippines and Thailand. If SIC 7 and 8 are aggregated, the commodity structure of China’s exports fits into the ASEAN pattern, as it did with market distribution earlier. China and the recent ASEAN entrants also have large shares in SIC 8, which includes apparel. This is a major difference between those countries and the core ASEAN countries. Table 9.6 for imports shows a pattern that is dominated by manufactures (SIC 6–8), as is normal for industrializing countries. The core ASEAN countries (except Indonesia) and China show particularly high shares in SIC 7. This is also the case for Laos and Brunei. Indonesia’s import structure more closely resembles that of Vietnam. However, no particular pattern stands out in Table 9.6. Again, the structure of China’s trade resembles that of the ASEAN countries.

243

Source:

7.00

60.30

8.60

1.20

19.20

16.80

14.50

0.60

42.30

7.00

39.70

2.90

1.00

1.00

38.176 3.90 0.20 0.90 1.10

10.60

15.60

39.90

10.20

5.20

0.10

75.043 12.30 0.20 3.90 2.10

4.20

8.90

64.50

3.70

8.70

0.20

127.894 1.50 0.80 0.60 6.90

Sing.

Other ASEAN

7.60

39.70

7.10

5.30

1.10

0.00

16.847 17.40 0.10 2.40 19.20

32.60

27.90

1.10

2.60

0.10

0.10

2.639 21.50 0.50 12.60 1.10

1.60

93.60

0.20

2.30

0.00

0.00

1.909 0.80 0.10 1.40 0.00

Vietnam Myanmar Cambodia

World Trade Analyzer, Statistics Canada. International Trade Division.

4.60

5.00

4.60

5.20

101.797 2.10 0.30 2.30 8.50

61.264 6.30 0.50 8.00 24.40

Indonesia Malaysia Philippines Thailand

Core ASEAN countries

49.50

40.40

0.10

0.70

0.00

0.00

0.33 4.70 0.00 4.60 0.00

Laos

0.20

6.10

4.40

1.10

0.00

0.00

4.074 0.00 0.00 0.00 88.20

Brunei

Commodity exports to the world, % of total exports for each sector by country, 2002

Total, $ bn 0-Food 1-Beverages 2-Crude materials 3-Fuels, lubricants & related materials 4-Animal & vegetable oils, fats & waxes 5-Chemicals & related products, n.e.s. 6-Manufactured goods classified chiefly by material 7-Machinery & transport equipment 8-Miscellaneous manufactured articles 9-Commodities & trans. not classified elsewhere

SIC code

Table 9.5

0.20

31.60

38.60

16.40

4.60

0.00

358.565 4.40 0.30 1.40 2.60

China

0.50

32.80

40.20

15.40

4.60

0.00

564.977 3.20 0.30 1.20 1.70

China1HK

China

244

0.40

6.30

9.60

63.30

6.10

3.90

8.60

12.80

0.20

14.60

16.70

29.80

3.60

1.80

2-Crude materials

3-Fuels, lubricants & related materials 4-Animal & vegetable oils, fats & waxes 5-Chemicals & related products, n.e.s. 6-Manufactured goods classified chiefly by material 7-Machinery & transport equipment 8-Miscellaneous manufactured articles 9-Commodities & trans. not classified elsewhere

Source:

4.10

0.80

1-Beverages

6.50

5.20

48.00

11.90

8.30

0.20

7.60

2.50

2.00

7.80

30.682

4.00

6.60

49.90

16.40

10.80

0.10

4.70

3.50

0.50

3.50

53.332

5.00

8.90

57.90

7.70

5.50

0.30

10.70

0.60

0.70

2.60

114.596

Sing.

1.50

6.00

33.40

26.70

13.60

0.50

8.70

2.20

2.30

5.10

15.443

2.60

5.50

30.50

24.60

9.30

2.50

16.10

0.80

2.70

5.40

2.245

1.80

8.90

17.80

44.80

5.00

0.40

8.80

2.10

8.90

1.50

1.546

Cambodia

Other ASEAN Vietnam Myanmar


1.90

0.50

4.00

11.10

84.884

28.143

0-Food

Indonesia Malaysia Philippines Thailand


8.20

5.50

40.90

14.70

3.60

0.00

6.70

0.30

16.70

3.30

0.186

Laos

3.70

10.70

46.90

20.50

4.40

0.30

1.40

0.50

2.50

9.20

1.884

Brunei

Commodity imports from the world, % of total imports for each sector by country, 2002

Total, $ bn

SIC code

Table 9.6

1.60

7.60

46.70

17.80

12.30

0.60

5.10

6.60

0.10

1.70

328.045

China

1.90

11.10

46.80

18.10

10.20

0.40

4.10

4.70

0.30

2.30

510.141

China1HK

China


245

Disaggregated SIC categories 6–8 at the 2-digit level are shown for exports and imports in Table 9.7. Several patterns stand out. On the export side, the importance of SIC 75–77 for the core ASEAN countries and China is clear. Here again, China’s trade fits in with ASEAN’s. The importance of SIC 84–85 for the other ASEAN countries and to a smaller degree for China is also clear. These countries are the apparel exporters of the region. On the import side, SIC 77 stands out in Table 9.7 for the core ASEAN countries and to a lesser extent for China, reflecting intraindustry trade in electrical machinery. SIC 65 stands out for the other ASEAN countries. Their apparel industry imports textiles, to some extent from China (see China’s 5 percent in imports in SIC 65 in Table 9.7), and exports the finished product. These disaggregated data reinforce the similarity of China’s trade to ASEAN’s, an important condition for monetary coordination. Trade by Sector and Market We now analyze the pattern of trade in SIC 6–8 of the core ASEAN countries and China by sector, export destination, and import source in order to understand the potential differential effects on sectors of coordinating exchange rate policies through a common basket. The same movement of the exchange rate would have differing effects on the aggregate economy of each country depending on the sectors with the largest differences in trade shares across markets and sources. Similar distributions of trade by sectors and markets or sources will minimize differential impacts within the economies; dissimilar distributions will increase these differences, making coordination more costly. Tables 9.8–9.10 show the distributions of manufactured exports by markets for the core ASEAN countries and China in SIC 6–8. The entries in each line show first the fraction of total exports in the SIC category and then the share of total exports in that category separately to each market. The total shares for SIC 7 in Table 9.9 are the largest for the core ASEAN countries except Indonesia, and for China. More than half of total exports are SIC 7 for Malaysia and Singapore. With some exceptions, exports in Tables 9.8–9.10 are evenly distributed across markets. Notable exceptions are the small share of the US in Malaysia’s exports in SIC 6 and the large share in SIC 7 as well as the small share of the US in the Philippines’ exports of SIC 7. These sectors could be differentially affected by movements of the US dollar within a common basket. Tables 9.11–9.13 show the same import source distributions. The import distributions are even more similar than those for exports, with the exception of the low US shares of SIC 6 exports to Malaysia and the Philippines

246

11.40

25.90

8.60 2.10 0.10

5.90

4.10

14.50

7.10

2.00

60.30

16.80

19.10

1.10

5.10

3.80

7.00

19.20

Indonesia Malaysia

0.10

3.90

7.00

16.40

3.00

17.10

39.70

0.70

2.90

Philipp.

1.20

5.40

15.60

11.70

6.70

12.30

39.90

2.10

10.20

Thai.


0.10

1.40

8.90

29.80

6.40

21.00

64.50

0.60

3.70

Sing.

16.90

14.60

39.70

3.60

0.70

0.50

7.10

1.80

5.30

0.80

26.10

27.90

0.30

0.10

0.00

1.10

0.40

2.60

Vietnam Myanmar

7.50

85.60

93.60

0.10

0.00

0.00

0.20

1.30

2.30

Camb.

Other ASEAN

Breakdown of key sectors for commodity exports and imports, %, 2002

6-Manufactured goods classified chiefly by material 65X-Textile yarn, fabrics, made-up art., related products 7-Machinery and transport equipment 75X-Office mach. & automatic data processing equip. 76X-Telecommunic. & sound recording apparatus 77X-Elec. machinery, apparatus & appliances n.e.s. 8-Miscellaneous manufactured articles 84X-Articles of apparel and clothing accessories 851-Footwear Imports

Exports

SIC code

Table 9.7

1.30

38.90

40.40

0.00

0.00

0.00

0.10

0.10

0.70

Laos

0.00

5.90

6.10

0.10

0.10

0.00

4.40

0.60

1.10

Brunei

2.40

9.80

27.90

15.10

9.20

12.20

44.00

6.10

15.40

China

4.40

8.10

29.40

15.50

9.60

11.70

43.80

6.10

15.00

China1HK

China

247

Source:

63.30

37.40

3.20

1.40

5.00

29.80

9.60

16.70

22.90

48.00

3.60

11.90

17.60

49.90

2.30

16.40

24.50

57.90

0.90

7.70

5.90

33.40

9.30

26.70


6-Manufactured goods classified chiefly by material 65X-Textile yarn, fabrics, made-up art., related products 7-Machinery and transport equipment 77X-Elec. machinery, apparatus & appliances n.e.s. 3.40

30.50

12.10

24.60

1.10

17.80

36.70

44.80

5.10

40.90

8.80

14.70

4.60

46.90

8.30

20.50

18.20

45.50

5.00

16.50

18.40

45.90

5.40

17.00

248

15.2 9.7 6.8 14.5 3.1 22.9 18.8

Korea 13.3 2.6 2.3 11.3 0.6 13.2 11.1

US 18.3 6.0 1.5 11.7 1.9 13.8 11.3

Europe 19.2 7.9 1.5 13.1 3.4 17.2 12.2

Taiwan 19.0 10.0 5.9 13.1 4.1 19.1 16.4

Australia

25.0 8.3 3.7 8.8 5.4 20.4 20.2

Other

11.6 42.9 53.2 39.4 59.5 32.4 33.7

Japan 6.2 48.1 26.7 43.7 71.9 30.6 37.4

Korea 19.2 80.6 33.5 39.4 75.7 39.4 35.5

US


16.8 60.3 39.7 39.9 64.5 38.6 40.2

Total

18.3 62.9 54.9 45.8 71.4 40.0 38.3

Europe

7.4 64.7 33.1 55.3 75.2 50.3 55.9

Taiwan

10.4 38.3 58.3 44.2 47.2 32.2 32.1

Australia

22.6 56.0 31.3 36.4 59.1 40.7 44.9

Other

SIC 7, Machinery and transport equipment export shares to markets outside core ASEAN11 countries (percent)

Indonesia Malaysia Philippines Thailand Singapore China China1Hong Kong

Source:

16.3 9.1 3.4 8.7 1.9 12.2 11.1

Japan


Table 9.9

Source:

19.2 7.0 2.9 10.2 3.7 16.4 15.4

Total

SIC 6, Manufactured good export shares to markets outside core ASEAN11 countries (percent)


Table 9.8

249

1.9 2.4 0.9 5.8 9.1 16.5 17.6

Korea 43.6 12.0 18.1 31.9 11.0 41.2 49.0

US 29.0 14.0 6.1 26.5 7.9 35.7 42.2

Europe 2.1 3.6 0.6 3.4 5.2 12.9 16.8

Taiwan 7.0 12.6 8.3 11.3 12.3 38.1 42.6

Australia

19.5 15.0 11.2 18.7 9.0 18.5 16.4

Japan 36.3 13.7 17.0 21.5 9.2 24.8 24.3

Korea 7.0 3.0 3.0 7.6 3.8 6.0 7.6

US


16.7 9.6 11.9 16.4 7.7 17.8 18.1

Total

12.0 9.0 11.4 16.6 9.9 12.7 16.3

Europe

36.6 13.1 18.8 28.0 6.9 24.6 22.8

Taiwan

15.5 26.7 13.3 26.1 5.4 17.8 18.4

Australia

SIC 6, Manufactured good import shares by source, outside core ASEAN11 countries (percent)


Source:

5.6 7.5 3.7 14.8 19.1 35.6 38.3

Japan


Table 9.11

Source:

14.5 8.6 7.0 15.6 8.9 31.6 32.8

Total

14.2 8.8 13.1 14.1 7.9 18.0 18.8

Other

7.2 6.6 2.2 4.6 7.5 24.5 20.8

Other

SIC 8, Miscellaneous manufactured article export shares to markets outside core ASEAN11 countries (percent)


Table.9.10

250

56.6 64.6 66.2 60.9 64.2 54.2 55.4

24.0 75.1 59.9 57.9 71.6 43.5 46.4

Korea 35.7 79.4 66.1 51.2 66.4 54.3 52.2

US


29.8 63.3 48.0 49.9 57.9 46.7 46.8

Japan 44.5 65.1 49.5 46.3 55.7 60.6 52.8

Europe 29.5 72.0 27.2 46.3 80.2 47.5 51.6

Taiwan 13.6 13.0 6.9 5.8 13.0 5.2 6.6

Australia

15.9 56.8 36.0 45.6 53.1 40.4 41.9

Other

Source:

3.6 6.1 5.2 6.6 8.9 7.6 11.1

3.7 7.3 4.4 6.5 8.2 8.7 10.2

Japan 5.4 2.0 2.6 2.9 3.1 4.7 4.6

Korea 2.7 6.4 4.3 8.7 11.2 9.0 10.6

US



Total

3.5 6.6 6.2 10.3 12.3 7.7 12.4

Europe

4.1 4.3 3.4 7.6 5.0 8.7 7.9

Taiwan

1.3 3.6 3.9 2.7 5.4 2.6 4.8

Australia

3.8 6.1 6.4 5.3 8.5 7.3 13.1

Other

Table 9.13 SIC 8, Miscellaneous manufactured article import shares by source, outside core ASEAN11 countries (percent)

Source:


Total

Table 9.12 SIC 7, Machinery and transport equipment import shares by source, outside core ASEAN11 countries (percent)


251

(Table 9.11). To summarize, our analysis of trade patterns by geography and sector does not show serious imbalances in the distributions of trade by sectors. Thus, coordinated exchange-rate stabilization against a common basket based on these sources and markets should not create substantial differential sectoral pressures within ASEAN or China.

9.4

CURRENCY BASKETS AND REAL EFFECTIVE EXCHANGE RATES

This section discusses the construction of currency baskets and REER indexes for the core ASEAN countries and China. These are based on trade of ASEAN11 outside this region, since the focus of the study is first on intra-ASEAN coordination and then on coordination between ASEAN and China. Similar baskets and REERs can be calculated for the ASEAN members’ largest trading partners, regardless of region, or for ASEAN11 or ASEAN13 against major trading partners outside the region. We begin by presenting the alternative weights for exports, imports, and total trade, based on the data from the previous section. Next, the alternative REER measures are shown and discussed. The REERs combine the movements of nominal exchange rates and domestic price levels, both of which are at least partially under the control of the domestic monetary authority, with those of trading partners’ price levels, which are independent of domestic policy. Therefore, the similarity in REER movements across countries implies some form of policy management of movements of domestic inflation and nominal exchange rates. This is presumably aimed at maintaining competitiveness in the region without competitive devaluations. To analyze this policy management, we show the decomposition of movements of the import-weighted REERs at the end of the section. Weights for Currency Baskets The currency basket weights based on exports, imports, and total trade of ASEAN plus China are shown in Tables 9.14–9.16. Tables 9.14 and 9.15 are taken directly from Tables 9.3 and 9.4, scaled to 100. Table 9.16 is based on the total shares from Tables 9.3 and 9.4. The trade shares are quite similar across countries in each table as well as across tables. Exceptions are Indonesia, with a high weight for Japan and a low weight for the US on the export side, and Thailand, with a high weight for Japan on the import side. The weights for China are well within the ASEAN distribution in all three tables.

252

19.8 38.1 31.6 31.6 30.6 35.7 37.8

US 21.4 23.6 25.5 27.3 28.7 27.8 28.6

Europe

10.5 9.7 10.5 7.2 7.4 16.5 15.5

Korea 18.6 27.4 32.5 17.6 28.5 13.0 13.4

US


29.1 30.5 33.5 44.8 25.2 28.4 29.1

Japan

24.5 20.9 13.2 18.6 25.2 20.3 20.7

Europe

Import shares for weighting real effective exchange rates (percent)


Source:

11.6 5.6 5.7 3.7 9.0 7.7 6.9

Korea


Table 9.15

Source:

36.5 20.8 25.0 26.4 14.4 22.9 20.1

Japan

Export shares for weighting real effective exchange rates (percent)


Table 9.14

6.0 8.8 8.2 7.9 10.2 18.9 18.7

Taiwan

6.0 7.0 10.8 6.0 10.3 3.5 4.1

Taiwan

11.3 2.7 2.2 3.9 3.5 2.8 2.5

Australia

4.8 4.8 1.4 5.0 7.0 2.4 2.5

Australia

100.0 100.0 100.0 100.0 100.0 100.0 100.0

100.0 100.0 100.0 100.0 100.0 100.0 100.0

253

Source:

11.3 7.5 8.1 5.4 8.2 7.7 11.2

Korea 19.5 33.1 32.0 24.8 29.6 35.7 25.7

US 22.2 22.3 19.4 23.1 27.0 27.8 24.7

Europe


34.4 25.3 29.2 35.3 19.6 22.9 24.5

Japan

Trade shares for weighting real effective exchange rates (percent)


Table 9.16

6.0 7.8 9.5 6.9 10.2 3.5 11.3

Taiwan

6.6 3.8 1.8 4.5 5.3 2.4 2.5

Australia 100.0 100.0 100.0 100.0 100.0 100.0 100.0

254


The similarities between the ASEAN countries’ weights suggest that a common currency basket could fit ASEAN. Clearly, common weights would have to be the subject of eventual discussion and negotiation within ASEAN. The similarity of ASEAN’s weights to those of China suggests that eventual coordination of ASEAN exchange-rate policy using a basket similar to that of China could be feasible. A common basket would fit both fairly well. REER Indexes Figures 9.10–9.12 show the movements of the REER indexes using the alternative weights from Tables 9.14–9.16. The export-weighted and total trade indexes use GDP price indexes, which include exports but not imports. The import-weighted indexes use CPIs, which include imports but not exports. The ASEAN indexes for total trade from Figure 9.12 are the ones used earlier in Figure 9.8. All three graphs show the stable pattern of REERs before and after the crisis of 1997–98. The REERs of the core ASEAN countries except Singapore show sharp depreciations during the crisis period. Singapore had a milder depreciation of about 15–20 percent from 1996 to 1999 on the bases of export and total trade but only 5 percent on an import basis. China’s REER moved differently, with 180 Malaysia Philippines Thailand

170 160

Singapore Indonesia China + HK

150 140 130 120 110 100 90 80 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Sources: Global Financial Data; IMF Direction of Trade Statistics; World Bank, World Development Indicators.

Figure 9.10

Real effective exchange rate, export basis (markets outside ASEAN1China/HK)


255

180 Indonesia Malaysia Philippines

170 160

Thailand Singapore China + HK

150 140 130 120 110 100 90 80 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Sources: Global Financial Data; IMF Direction of Trade Statistics; World Bank, World Development Indicators.

Figure 9.11

Real effective exchange rate, import basis (markets outside ASEAN1China/HK)

180 Malaysia Philippines Thailand

160

Singapore Indonesia China + HK

140

120

100

80 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Sources: Global Financial Data; IMF Direction of Trade Statistics; World Bank, World Development Indicators.

Figure 9.12

Real effective exchange rate, total trade basis (markets outside ASEAN1China/HK)

256


an early appreciation in 1995–97, followed by a small depreciation. Thus, Singapore and China escaped the contagion of the crisis. The graphs show the highly similar movements of the country indexes across sets of weights. This is expected from Tables 9.14–9.16, where country weights are similar across baskets. They also show similar movements across the ASEAN countries, with China moving somewhat independently. Before and after the crisis, though, the REER indexes, including China’s, show no trend or tendency to diverge. They tend to stay within a fairly well-defined range. After 2000, they seem to converge. This suggests that policies are at work in the background that tend to stabilize REERs in the region and even make them tend to converge. Such policies would be consistent with an implicit coordination of nominal exchange rate movements aimed at maintaining REER stability with a view to maintaining competitive positions. This policy stance can be seen when the REER movements are decomposed into their nominal components. The broad synchronicity of the REER movements across the ASEAN11 countries tells us that it would be possible to construct a common basket and opt for explicit exchange rate stabilization in East Asia with relative ease. The relative export and total trade weightings behind these graphs support this case. The trade structure of these countries is broadly similar, with each country having roughly the same proportions of trade with their major trading partners. It would, therefore, be possible to construct a basket currency based on external or total trade without fundamentally changing each country’s current policies. The regional governments could use this common basket currency as a benchmark against which to coordinate their exchange rate policies. In a similar way, the countries of the European Monetary System used the basket ECU to coordinate their exchange rate policies (though with the distinction that the ECU was an internally based basket currency). Such a basket currency could be used to manage regional stabilization and to address such specific regional concerns as export competitiveness and the response to externally driven shocks. It would also be a natural unit of denomination for ABM issues. Nominal Components of REERs The REER is the nominal exchange rate adjusted for relative price levels. Specifically, here it is constructed as the product of a nominal exchange rate index times the ratio of a trading partner’s price index to the domestic price index. In symbols, the REER index e is defined as e 5 EP*/P, where E is the nominal effective exchange rate (NEER) index and P* is the trading partner’s price index, both defined by the same set of weights, and


257

P is the domestic price index. The trading partner’s price index P* is not substantially affected by domestic policies, but the NEER and P are. Thus, any policy to stabilize a REER must work on the co-movement of E and P to be consistent with that of P*. For example, with a stable P*, domestic inflation in P must be matched by depreciation of E. This is illustrated in Figures 9.13–9.15, which show the components of the REERs weighted by import shares. These are chosen because they use CPIs as the price indexes. Inflation perceptions and policies tend to focus more on CPIs than on GDP deflators. Figure 9.13 depicts the movement of the weighted CPIs for trading partners (the P* indexes). They move closely together, since they differ only in their weights across countries (which, as we have seen, are quite similar). The graph shows a general inflationary trend of about 2 percent per year for trading partners. Figure 9.14 shows highly divergent movements of domestic price indexes (the Ps). These range from nearly flat for Singapore to an average of about 11.5 percent a year for Indonesia, with a jump during the crisis. Figure 9.15 shows the movement of the nominal exchange rate indexes E. These are similar to the movements of the price 140 135 130 125 120 115 110 Indonesia Malaysia Philippines

105


100 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Sources: Global Financial Data; IMF Direction of Trade Statistics; World Bank, World Development Indicators.

Figure 9.13

Weighted CPI indices for trading partners, core ASEAN and China 1 Hong Kong

258



450


400 350 300 250 200 150 100 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Sources: Global Financial Data; IMF Direction of Trade Statistics; World Bank, World Development Indicators.

Figure 9.14

CPI indices for core ASEAN and China 1 Hong Kong

indexes in the previous graph. Thus, policy pressures on domestic price levels and nominal exchange rates tend to produce parallel movements that result in the stability of REERs shown earlier. Coordination of macro policies in ASEAN would work on both nominal variables P and E. Coordination of sustainable macro policies domestically can work to stabilize price levels P across countries around an acceptable rate of inflation. This is the objective of surveillance. Coordination of exchange-rate policies can work to stabilize E. The combination would maintain stable and competitive REERs with an acceptable inflation trend in the region. In the absence of sustainable domestic macro policies that stabilize P around the acceptable trend, price levels will diverge, as in Figure 9.14, and require changes in nominal exchange rates to maintain stability in REERs. A combination of surveillance of sustainable domestic macro policies and coordinated exchange rate policies would be a macropolicy coordination package promoting growth and poverty reduction.


259


470


420 370 320 270 220 170 120 70 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 Sources: Global Financial Data; IMF Direction of Trade Statistics; World Bank, World Development Indicators.

Figure 9.15

Nominal effective exchange rate, import basis (markets outside ASEAN1HK/China)

Implicit Exchange Rate and Monetary Policy Coordination There is already a surprising degree of implicit coordination of exchange rate policies among the ASEAN countries and, even further, among the ASEAN13. Table 9.17 shows the correlations of monthly changes of USD exchange rates for the ASEAN13 countries for the post-crisis period. All the correlations are positive. The correlations for China and Malaysia are small, since these countries essentially fixed their currencies against the USD during this period. The others show generally strong positive correlations, indicating common co-movements against the dollar. Similar results are shown in Table 9.18 for monthly changes in reserve money. These are all positive and quite large for core ASEAN and ASEAN11, indicating monetary policy movements consistent with effective exchange rate coordination. These results show that a movement to explicit coordination would not require a large change in actual policy positions. The ASEAN countries and China already conduct monetary policy in such a way as to maintain stability in exchange rates and REERs,

260

Source:

1 0.15 0.39 0.45 0.54 −0.07 0.12 0.05 −0.10 0.54 −0.18 0.27 0.11 0.25

1 0.09 0.23 0.32 −0.15 0.19 0.00 −0.02 0.34 −0.11 0.29 0.07 0.20

1 0.57 0.33 0.31 0.16 −0.01 −0.15 0.33 −0.27 0.24 0.36 0.19 1 0.65 0.05 0.41 0.08 0.00 0.65 −0.07 0.53 0.62 0.47 1 0.03 0.34 −0.06 −0.22 0.98 −0.15 0.64 0.33 0.47 1 0.00 −0.17 −0.05 0.02 −0.17 0.06 0.37 0.13 1 0.21 −0.03 0.33 0.07 0.35 0.28 0.21 1 0.65 −0.04 −0.03 −0.06 −0.10 −0.05

1 −0.19 0.08 −0.19 0.01 −0.08

1 −0.15 0.58 0.33 0.46

1 −0.06 −0.11 −0.01

1 0.36 0.57

1 0.60

1

Indonesia Malaysia Philippines Thailand Singapore Vietnam Myanmar Cambodia Laos Brunei China Japan Taiwan Korea

Correlation matrix of monthly changes in dollar exchange rates, January 2000–June 2005

Global Financial Data; Datastream.

Indonesia Malaysia Philippines Thailand Singapore Vietnam Myanmar Cambodia Laos Brunei China Japan Taiwan Korea

Table 9.17

261

1 0.07 0.35 0.33 0.37 −0.22 0 −0.08 0.19 0.37 0.5 −0.07 0.35

1 0.1 0.34 0.73 0.55 −0.15 −0.2 −0.22 0.5 0.34 0.46 0.08

1 0.21 0.29 −0.15 0.06 −0.03 0.11 0.27 0.4 0.07 0.15 1 0.51 −0.07 0.1 −0.11 −0.18 0.47 0.65 0.15 0.42 1 0.45 0.02 −0.22 −0.2 0.64 0.61 0.37 0.29 1 −0.13 0.05 −0.1 0.45 −0.26 0.39 −0.07 1 0.06 −0.13 −0.14 0.27 −0.1 −0.01 1 0.04 −0.13 −0.13 −0.04 −0.07

1 −0.03 −0.11 −0.17 −0.12

Indonesia Malaysia Philippines Thailand Singapore Vietnam Myanmar Cambodia Laos

1 0.51 0.33 0.28

China

1 0.04 0.41

1 0.18

IMF IFS; Taiwan CBC.

1

Japan Taiwan Korea

Correlation matrix of monthly changes in reserves, denominated in LCU (starting Jan 1992)

China starting July 99, Vietnam missing July–Dec 99; Laos missing Mar 05; not including Brunei (pegged to Singapore dollar).

Sources:

Note:

Indonesia Malaysia Philippines Thailand Singapore Vietnam Myanmar Cambodia Laos China Japan Taiwan Korea

Table 9.18

262


as discussed above. The policies are implicitly coordinated, as seen in the correlations here. A movement to explicit coordination would present a common posture to the markets and diffuse speculative pressure when it arises.

9.5

CONCLUSIONS

This chapter has examined the prospects for macro policy and exchange rate coordination in Asia (in particular in the ASEAN and in the ASEAN plus China area) and looked at the potential implications of such coordination for reserve sharing and financial developments such as the ADF and the ABM. We argue that better coordination of the underlying macro policies could have prevented the Asian crisis or minimized its costs, in particular through beneficial consequences for pre-crisis policy, the control of exposure to speculative contagion, and swifter post-crisis investment recovery. We argue that the existing geographic and commodity structure of the region’s trade means that REERs already move together, ensuring a minimum autonomy loss from policy coordination. We looked at the geographic structure of trade, using this to develop weights for baskets of ASEAN currencies in terms of major trade partners outside ASEAN and China. Such weights are broadly similar for the main ASEAN countries. The movements of real effective exchange rates are also broadly synchronous. This highlights an existing implicit coordination among the ASEAN11 countries and suggests that the use of a common basket for exchange rate coordination would not mark a radical departure from existing policies or from domestic autonomy. We additionally looked at the commodity composition of trade for the ASEAN11 countries. Once again, this composition is broadly similar for the larger ASEAN11 countries (SIC 7 being the dominant export sector, while the manufactures of SIC 6–8 dominate imports). Such a similar commodity structure implies greater benefits from coordination, as argued by Mundell’s optimal currency area theory. Overall, the trade data by both sector and geography show no serious imbalances across major sources and markets. A coordinated exchange rate stabilization against a common basket based on these sources and markets shouldn’t create substantial differential pressures within ASEAN or China. We construct real and nominal effective exchange rate measures for the countries under examination. These rates demonstrate that moves toward integration are already in practical effect in the region and underline the ease of any potential transition toward greater coordination. In particular, they highlight how an externally based currency basket might


263

easily be constructed, offering a focal point for greater regional integration. Potentially playing a role similar to that of the ECU within the European Monetary System, such a basket currency could permit greater coordination of regional policies, addressing particular regional concerns regarding competitiveness and the response to externally driven shocks or cascading speculation. It would yield direct benefits for growth and poverty reduction, as well as setting the foundation for further cooperation in the areas of reserve sharing and ABM development. The regional currency unit would also provide a natural basis for the denomination of ABM issues.

NOTES 1. 2. 3. 4. 5. 6.

7. 8. 9. 10.

See, for instance, Branson (2005). These are the REERs based on total trade weights for the six major markets outside ASEAN11, indexed to 1989 5 100. The methodology is explained in detail in section 9.4. For clarity, we focus here on the total trade-weighted REERs. See Young (1995) for a fundamental discussion of investment and growth in Asia. For a discussion of the rationale for nominal exchange rate stabilization see also Gunther Schnabl’s chapter in this volume (Chapter 10). These are analyzed in some detail in Branson (2001). The European Monetary System, which actually involved extensive credit facilities in order to secure the stability of intra-regional exchange rates, was in a state of political disarray that made markets doubt the future of European monetary integration when it was hit by the crisis. It was the lack of a cooperative response to speculative pressure that forced its weak members to exit the system. See Volz (2006). See, for example, Kuroda and Kawai (2003) and Nasution (2005). See Ogawa and Shimizu, Chapter 5 in this volume. This problem is more striking and difficult in the case of Singapore. The 42.3 percent in SIC 9 for Philippines is probably unclassified SIC 6–8. See also Myanmar.

REFERENCES Branson, William H. (2001). “Intermediate Exchange-rate Regimes for Groups of Developing Countries.” In Jorge Braga de Macedo, Daniel Cohen, and Helmut Reisen (eds), Don’t Fix, Don’t Float. Paris: OECD. Branson, William H. (2005). “The Asian Crisis as a Bubble in Foreign Exchange Markets.” Manuscript, Princeton University, Princeton, NJ. Kuroda, Haruhilo, and Masahiro Kawai (2003). “Strengthening Regional Financial Cooperation in East Asia.” PRI Discussion Paper 03A-10, Policy Research Institute, Ministry of Finance, Tokyo. Mundell, Robert (1961). “A Theory of Optimal Currency Areas.” American Economic Review 51: 657–65. Nasution, Anwar (2005). “Monetary Cooperation in East Asia.” Journal of Asian Economics 16: 422–42.

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Radelet, Steven, and Jeffrey Sachs (1998). “The Onset of the East Asian Financial Crisis.” NBER Working Paper no. 6680, National Bureau of Economic Research, Cambridge, MA. Volz, Ulrich (2006). “On the Feasibility of a Regional Exchange Rate System for East Asia: Lessons of the 1992/93 EMS Crisis.” Journal of Asian Economics 17: 1107–27. World Bank (2000). “East Asia Update, Special Focus: Poverty During Crisis and Recovery.” East Asia and Pacific Publications, September 18, pp. 1–6. Young, Alwyn (1995). “The Tyranny of Numbers: Confronting the Statistical Realities of the East Asian Growth Experience.” Quarterly Journal of Economics 110: 641–80.

PART V

Currency baskets for East Asia?

10.

Capital markets and exchange rate stabilization in East Asia: diversifying risk based on currency baskets Gunther Schnabl

10.1

INTRODUCTION: MORE EXCHANGE RATE FLEXIBILITY IN EAST ASIA?

Before the Asian crisis of 1997–98, China, Hong Kong, Indonesia, Korea, Malaysia, the Philippines, Singapore, Taiwan, and Thailand pursued a common exchange rate peg to the US dollar. This (informal) East Asian dollar standard (McKinnon and Schnabl 2004a) was beneficial for growth in the region for several reasons. First, it ensured macroeconomic stability by bringing their domestic inflation to US levels. Second, the joint peg to the dollar provided low transaction costs not only for trade with the US but also for intra-regional trade flows, which make up about 50 percent of overall East Asian trade. Third, exchange rate stability provided low transaction costs for short-term and long-term international and intraregional capital flows. After the onset of the East Asian crisis, the East Asian dollar standard fell apart. While China, Hong Kong, Singapore, and Taiwan kept their exchange rates rather stable against the dollar during the crisis, the currencies of the crisis countries—Indonesia, Korea, Malaysia, the Philippines and Thailand—depreciated sharply against the dollar, and the depreciation of their currencies was accompanied by cumbersome recessions. The post-crisis policy recommendations for the exchange regimes in East Asia have been of diverse natures. Associating exchange rate stability against the dollar with overly low risk premia on volatile capital inflows, the IMF recommended more exchange rate flexibility (Fischer 2001). In contrast, McKinnon and Schnabl (2004a, 2004b) argued that exchange rate stabilization against the dollar is fully rational, even post-crisis, because of the high degree of dollarization of international and intraregional trade and capital flows. A third strand of literature has proposed 267

268


maintaining the exchange rate pegs in the region, while at the same time pegging to more than one anchor currency. According to Williamson (2000 and 2005), currency basket arrangements would be beneficial as they stabilize the nominal effective exchange rates. To maintain intra-regional exchange rate stability, Ogawa and Ito (2002) have proposed coordinating the currency baskets in the region. While exchange rate volatility against the dollar—in particular at high frequencies—declined (close) to pre-crisis levels over the period from after the East Asian crisis up to late 2004, over the year 2005 exchange rate volatility against the dollar increased substantially. As will be argued in this chapter, the rising exchange rate flexibility against the dollar may be a result of higher exchange rate stability against the Japanese yen and the euro reflecting the importance of Japan as a trading partner in the region as well as the growing role of the euro as a (stable) international currency.

10.2

THE RATIONALE FOR EXCHANGE RATE STABILIZATION IN EAST ASIA

Despite policy recommendations to pursue more exchange rate flexibility, fully flexible exchange rates such as the dollar–euro rate are unlikely for the East Asian currencies (except the Japanese yen) for several interdependent reasons: transaction costs for international trade, macroeconomic stabilization, and the dollarization of international capital flows. The idea of a positive effect of exchange rate stability on international trade via lower transaction costs has found new support in a branch of literature building on Frankel and Rose (2002). For East Asia, the common dollar peg has been beneficial not only for trade with the US but also (and particularly) for intra-regional trade, which is mostly invoiced in US dollars.1 By jointly pegging to the dollar, the East Asian countries also avoided “beggar-thy-neighbor” depreciation, thereby enhancing macroeconomic stability in the region. Macroeconomic stabilization is another important motivation for exchange rate stabilization. By pegging the exchange rate to the dollar or the euro, a small open economy can sustain a stable price level for two reasons. First, undisciplined monetary policy that aims to finance public expenditure via inflation tax is contained (Crockett and Goldstein 1976). Second, even if public expenditure is sound, in a small open economy nominal exchange rate fluctuations are likely to translate into fluctuations of the domestic price level. Exchange rate stabilization is equivalent to the stabilization of the domestic price level (McKinnon 1963).

Capital markets and exchange rate stabilization in East Asia

269

Besides international trade and macroeconomic stabilization, international capital flows have gained increasing importance as an explanatory variable for exchange rate stabilization in countries that have underdeveloped capital markets in domestic currencies (like most emerging East Asian economies). The incentive for exchange rate stabilization arises from the fact that private and public agents in developing countries and emerging markets find themselves unable to borrow or to lend in their domestic currencies. Liability Dollarization As put forward by Eichengreen and Hausmann (1999), because of a long history of inflation and currency depreciation, banks and enterprises in emerging markets and developing countries cannot use their currencies to borrow abroad or to borrow long term, even domestically, a phenomenon they have called original sin. International creditors lend in dollars or euros and thereby shift the exchange rate risk of open positions in foreign debt to the debtor countries. The consequence is a currency mismatch as projects that are financed with foreign currency generate domestic currency. If private banks are able to shift the foreign exchange risk of international borrowing to (private) domestic debtors by foreign currency lending, the currency risk is transformed into default risk, as households and small private enterprises tend to remain unhedged. The upshot is that liability dollarization creates an incentive for exchange rate stabilization at both high frequencies (i.e. daily exchange rate fluctuations) and low frequencies (fluctuations of the exchange rate level over months, quarters, and years). Short-term exchange rate stabilization With domestic foreign exchange markets being small and illiquid, most international short-term payment transactions in emerging markets and developing countries are denominated in US dollars or euros. Domestic currencies are generally not accepted as international means of payment. In East Asia, the dollar has been used not only for goods and capital transactions with the US but also for invoicing intra-regional trade and capital flows. In these underdeveloped capital markets, an active forward market in foreign exchange against the dollar (or euro) is for the most part nonexistent. If hedging instruments are available, the cost of hedging dollar liabilities (i.e. the premium on buying dollars forward with the domestic currency) is high. The result is that the foreign exchange risk of short-term capital transactions typically remains unhedged. Monetary authorities can provide an informal hedge for private shortterm capital transactions by minimizing daily exchange rate fluctuations. This provides compensation for the underdeveloped private market in

270


forward exchange. In practice, the monetary authorities establish formal or informal limits to daily exchange rate fluctuations defined in terms of percent exchange rate changes (Chmelarova and Schnabl 2006), allowing private banks and enterprises to repay their short-term foreign currency liabilities with minimal exchange rate risk. As shown in Figure 10.1, except for crisis periods, exchange rate volatility against the dollar of the East Asian currencies has tended to be smaller than for freely floating currencies such as the Japanese yen and the euro (before 1999, the German mark). In contrast, the monetary authorities of large countries with highly developed capital markets (mainly the US, the euro area, and Japan) can leave day-to-day exchange rate fluctuations to market forces for two reasons. First, private transactions with emerging markets and developing countries are mainly invoiced in domestic currencies. Second, for transactions between these large countries, well-developed domestic capital markets provide a broad variety of instruments to hedge the foreign exchange exposures at low costs. Long-term exchange rate fluctuations At low frequencies, the rationale for exchange rate stabilization in debtor countries originates in long-term liability dollarization. If net debt is denominated in foreign currency, increasing long-term exchange rate stability is equivalent to reducing default risk on balance sheets (Eichengreen and Hausmann 1999). In particular, a sharp domestic currency depreciation puts balance sheets at risk, possibly forcing indebted enterprises and financial institutions into default. In the case of an appreciation, the competitiveness and profit margins of the export industry are at risk. Even low-frequency exchange rate fluctuations around a constant level may pose a risk for the domestic economy, as larger uncertainty is reflected in higher risk premiums on domestic interest rates. To shield domestic enterprises and financial institutions against this uncertainty, the authorities may control low-frequency exchange rate fluctuations to enhance the stability of the domestic financial system. In practice, monetary authorities in emerging markets and developing countries use daily exchange rate changes as an “intermediate target”, smoothing daily fluctuations in order to control long-term fluctuations of the exchange rate level (Chmelarova and Schnabl 2006). As shown in Figure 10.2, most East Asian currencies have fluctuated significantly less against the dollar since the Asian crisis than the freely floating euro–dollar exchange rate. In contrast, large countries with highly developed capital markets can allow for more long-term exchange rate flexibility for two reasons. First, with international debt denominated in domestic currency, balance sheets are not exposed to exchange rate fluctuations. Second, given the lower degree of openness, export industries are less important for economic growth.

271

99 02 05 1. 1. 1. .0 .0 .0 01 01 01 Thai baht

96

1.

.0

01

93

1.

.0

01

90

1.

Malaysian ringgit

05

1.

.0

01

02

1.

.0

01

99

1.

.0

01

96

1.

.0

01

93

1.

.0

01

90

1.

Chinese yuan

05

1.

.0

01

02

1.

.0

01

99

1.

.0

01

96

1.

.0

01

93

1.

.0

01

90

1.

Philippine peso

05

1.

.0

01

02

1.

.0

01

99

1.

.0

01

96

1.

96 99 02 05 1. 1. 1. 1. .0 .0 .0 .0 01 01 01 01 Japanese yen

93

1.

.0

01

90

1.

.0

01

4% 3% 2% 1% 0% –1% –2% –3% –4%

01

.0

Hong Kong dollar

93

1.

.0

01

90

1.

.0

01

4% 3% 2% 1% 0% –1% –2% –3% –4%

05

1.

.0

01

02

1.

.0

01

99

1.

.0

01

96

1.

.0

01

93

1.

.0

01

90

1.

.0

01

4% 3% 2% 1% 0% –1% –2% –3% –4%

96 99 02 05 1. 1. 1. 1. .0 .0 .0 .0 01 01 01 01 Euro (Deutsche mark )

Singapore dollar

93

1.

.0 01

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1.

.0

01

4% 3% 2% 1% 0% –1% –2% –3% –4%

05

1.

.0

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4% 3% 2% 1% 0% –1% –2% –3% –4%

Indonesian rupiah

05

1.

.0

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02

1.

.0

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99

1.

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4% 3% 2% 1% 0% –1% –2% –3% –4%

96 99 02 05 1. 1. 1. 1. .0 .0 .0 .0 01 01 01 01 Swiss franc

93

New Taiwan dollar

1. .0 01

90 1. .0 01

4% 3% 2% 1% 0% –1% –2% –3% –4%

05 1. .0 01

02 1. .0 01

99 1. .0 01

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90 1.

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4% 3% 2% 1% 0% –1% –2% –3% –4%

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1.

.0

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02

1.

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96

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1.

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01

90

1.

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01

4% 3% 2% 1% 0% –1% –2% –3% –4%

Exchange rate volatility against the US dollar of selected crisis and non-crisis currencies, 1990:01–2005:12 (daily)

Bloomberg. Volatility is measured in daily percentage changes against the dollar.

Figure 10.1

Source:

01

.0

4% 3% 2% 1% 0% –1% –2% –3% –4%

01

.0

4% 3% 2% 1% 0% –1% –2% –3% –4%

01

.0

4% 3% 2% 1% 0% –1% –2% –3% –4%

272 98 J

an

00 J

an

02 J

an

04

90

n Ja

92

n Ja

94

96 n Ja

98 n Ja

00

Taiwan dollar

n Ja

n Ja

n Ja

00

n Ja

02

n Ja

04

90

90

90

n Ja

80

East Asian exchange rates against the dollar, 1990:1–2005:12

Thai baht

98

90

100

110

120

80

n Ja

n

Ja

80

80 n Ja

04

90

96

J

an

90

n Ja

02

100

J

an

100

94

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n Ja

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110

92

98

130

n Ja

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an

Philippine peso

96

90

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120

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n

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80

90

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90

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94

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00

130

02

92

n

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98

Hong Kong dollar

n

Ja

96

140

n Ja

J

an

n

Ja

94

140

90

n

Ja

92

140

J

an

n

90

IMF: IFS, central bank of China. Index 1999.01 5 100.

Figure 10.2

Source:

J

an

Malaysian ringgit

96

80

80

n Ja

90

90

n Ja

100

100

Ja

110

94

n

Ja

110

n Ja

n

Ja

120

92

n

Ja

130

n Ja

n

120

90

Ja

Chinese yuan

n Ja

130

n

Ja

140

n Ja

140

n Ja

04

80 02

80 00

90

90 98

100

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96

110

110

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n

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n Ja

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n

n

n

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Ja

Ja

94

94

94 Ja

n

98 Ja

n

96

n Ja

98

Ja

n

00

00

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96

n Ja

96

n

98

Euro

Ja

Ja

n

00

Singapore dollar

n

n

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n

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02

02

02

n

n

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04

04

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04


273

Asset Dollarization While liability dollarization provides an important rationale for exchange rate stabilization for internationally indebted countries, creditor countries such as China and Russia are also at risk. Supported by the continuous rise in the US current account deficit, an increasing number of countries in East Asia, Latin America, the Middle East, and the Commonwealth of Independent States (CIS) are running sustained current account surpluses. In East Asia, while China, Japan, Singapore, and Taiwan exhibited current account surpluses for most of 1990s, the crisis countries—Indonesia, Korea, Malaysia, the Philippines, and Thailand—reversed their current account positions during or after the Asian crisis and have remained net exporters since then. East Asia has become the most important creditor in the international capital markets. McKinnon and Schnabl (2004b) explain the rationale for exchange rate stabilization in creditor countries that are not able to lend internationally in their domestic currencies. Because of underdeveloped financial markets, capital controls, or even simply the fact that the dollar seems to be a more reliable store of value than the domestic currencies, private investors find dollar assets more attractive than international claims denominated in domestic currency. Conversely, the United States, as the largest debtor country, is disinclined to incur debts denominated in foreign currencies; the position of the US dollar as the world’s prominent international currency allows US private and public agents to borrow internationally in domestic currency. The exchange rate risk of international lending is shifted to the creditors. By fixing exchange rates at high frequencies, the authorities can hedge the risk for private, short-term international lending. If capital markets are underdeveloped, forward transactions by risk-averse East Asian traders wanting to hedge their open positions in foreign exchange are difficult, even for net international creditors. The authorities can provide an overall hedge by minimizing exchange rate fluctuations on a daily basis. In contrast, day-to-day exchange rate fluctuations in Japan, the US and the euro area are left to market forces. At low frequencies, the motivation for exchange rate stabilization by international creditor countries can be linked to the perception of risk by private and public holders of net foreign currency assets. Based on sustained current account surpluses, Japan, China, Korea, and Taiwan (among other East Asian countries) have accumulated substantial amounts of international assets. Because of the asymmetric nature of the world currency system, the greater part of these international assets can be assumed to be denominated in US dollars (for instance, held in US government bonds). When East Asian

274


investors accumulate assets in US dollars, they become anxious about an appreciation of the domestic currency against the dollar, as their savings would lose value in terms of the domestic currency. This “fear of appreciation” may be compensated by higher interest rates in the debtor country as suggested by the open interest rate parity. But, with varying interest rates in the anchor country, the perception of risk may change. If the depreciation pressure on the anchor currency is sustained, individual or institutional holders of large dollar assets will increasingly be at risk. This sets the stage for official foreign exchange intervention. Once private investors decide to repatriate their international assets—or decide to convert domestic dollar assets into domestic currency assets in highly dollarized countries, such as Russia—the appreciation of the domestic currency will reduce the value of dollar assets on domestic balance sheets. For example, for Japanese insurance companies, whose liabilities to annuity holders are in yen but with a substantial share of their assets in dollars, the reduction in the yen value of their dollar assets could wipe out their net worth. In China, firms and households will hold dollar assets only if there is a substantial business convenience in doing so or if the interest rate on dollar assets is higher. The primary downside risk is that the yuan (yen) could appreciate against the dollar and thus reduce the yuan (yen) value of their dollar assets. Depending on how sensitive domestic holders of dollar assets are to this risk, periodic runs from dollars into yuan and yen could occur simply based on rumors of appreciation. The reaction of monetary authorities will depend on the exchange rate regime. In Japan, where the exchange rate is principally flexible, foreign exchange intervention is restricted to periods when the exchange rate level is perceived to be too high and detrimental to growth (Hillebrand and Schnabl 2006). Despite its status as independently floating, Japan has accumulated the largest stock of international assets to date. China, which has been committed to a tight peg to the dollar, has absorbed private capital inflows on a more regular basis. Note that any rise in appreciation expectations will further add to the speed of reserve accumulation.

10.3

CURRENCY DIVERSIFICATION IN INTERNATIONAL RESERVES AND CURRENCY BASKETS

Given this rationale for exchange rate stabilization, it seems unlikely that East Asian countries will pursue fully flexible exchange rate strategies in the short and medium term. Instead, they will tend to stabilize exchange

Capital markets and exchange rate stabilization in East Asia 1.90

275

East Asia (against the dollar) Emerging Europe (against the euro)

1.70

Percent

1.50 1.30 1.10 0.90 0.70 0.50 Jan 00

Jan 01

Jan 02

Jan 03

Jan 04

Jan 05

Source: IMF. Regional exchange rate volatility defined as arithmetic averages of 12 month rolling standard deviations.

Figure 10.3

Exchange rate volatility in East Asia and emerging Europe

rates in the form of tight or soft pegs based on smoothing daily exchange rate fluctuations. McKinnon and Schnabl (2004a) have shown that, postcrisis, the East Asian emerging market countries have returned to their pre-crisis exchange rate stability against the dollar, at least at high frequencies (i.e. day-to-day or week-to-week exchange rate fluctuations). Indeed, measured as an arithmetic average of month-to-month percent exchange rate changes of all East Asian countries, post-crisis exchange rate volatility against the dollar has declined gradually through the year 2004. The Risk of One-Sided Dollar Pegs Although the dollar remains the most important anchor currency in the region, Figure 10.3 also suggests that East Asian exchange rate volatility against the dollar was on the rise in 2005. Chinn and Frankel (2005) argue that the role of the dollar as an international currency may be challenged by the euro, depending on the long-term inflation expectations for the US economy. In East Asia, the degree of macroeconomic stabilization, which is achieved via exchange rate pegs, hinges not only on domestic efforts to keep the exchange rate stable against the anchor currency but also on the monetary policy in the anchor country.

276


While low and stable inflation has been a crucial prerequisite for the role of the dollar as the dominant international currency, the degree of price stability has fluctuated over time. Since the late 1960s, the US dollar has experienced several phases of rising inflation and sustained depreciation pressure. During these periods a relatively loose US monetary policy has been transmitted via reserve accumulation into rising inflationary pressure in countries stabilizing their currencies against the US dollar. Back in the late 1960s and early 1970s, an expansionary fiscal and monetary stance in the US contributed to a world-wide increase in inflation, which finally triggered the breakdown of the Bretton Woods system. While the European currencies were de-linked from the dollar in the early 1970s (thereafter stabilizing their exchange rates against the German mark), most countries outside of Europe, for instance those in East Asia, continued to peg their currencies more or less tightly to the dollar. The international role of the dollar was enhanced by its dominant role as an invoicing currency for international trade, the deepness of US capital markets, and the lack of alternative international currencies. This has led Dooley et al. (2004) to argue that the United States is at the center of what they have called a revived (informal) Bretton Woods system of fixed exchange rates. Recently, however, an exceptionally loose fiscal and monetary stance under the Bush administration has triggered a discussion about the impact of fast reserve accumulation on the countries stabilizing their exchange rates against the dollar. When the Federal Reserve kept the interest rate at historically low levels from 2001 to 2004, the dollar came under strong depreciation pressure. As many countries continued to stabilize exchange rates against the dollar they accumulated large amounts of dollar reserves. Figure 10.4 shows the substantial speed of reserve accumulation in East Asia, which has accelerated in many countries since 2001, most dramatically in China, Korea, Malaysia, and Japan. The fast reserve accumulation has two main downsides. First, as under fixed exchange rates the scope for sterilization of foreign exchange intervention is limited, many countries in East Asia, Latin America, and the Middle East experienced fast monetary expansion. Although inflation has been contained in most countries so far, the fast growth of monetary aggregates has contributed to surging stock and real estate prices. An eventual burst of such “bubbles” may result in cumbersome crises like those experienced after the Asian crisis and painful post-bubble recessions like those experienced in Japan since the early 1990s. Second, for countries with sustained current account surpluses, rising world inflation has a negative impact on the real value of export revenues and international assets. If, as in the case of many commodity exporting countries, export revenues are earned in dollars and spent on imported

277

Malaysia

Thailand

90 92 94 96 98 00 02 04 n n n n n n n n Ja Ja Ja Ja Ja Ja Ja Ja

0

10

20

30

40

50

Hong Kong

90 92 94 96 98 00 02 04 n n n n n n n Ja Ja Ja Ja Ja Ja Ja

Philippines

Japan

90 92 94 96 98 00 02 04 n- an- an- an- an- an- an- anJ J J J J J J

Ja

900 800 700 600 500 400 300 200 100 0


18 16 14 12 10 8 6 4 2 0

n

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20

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60

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100

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Singapore

Germany

90 92 94 96 98 00 02 04 n- an- an- an- an- an- an- anJ J J J J J J

Ja

140 120 100 80 60 40 20 0

90 92 94 96 98 00 02 04 n an an an an an an an J J J J J J J

Indonesia


Ja

120 110 100 90 80 70 60 50 40 30 20 10 0

Ja

40 36 32 28 24 20 16 12 8 4 0

Taiwan

90 92 94 96 98 00 02 04 n- n- n- n- n- n- n- nJ a J a Ja Ja Ja Ja Ja J a US

0

10

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40

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60

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90 92 94 96 98 00 02 04 n an an an an an an an J J J J J J J

n

Ja

280 240 200 160 120 80 40 0

Ja

220 200 180 160 140 120 100 80 60 40 20 0

Official foreign exchange reserves of East Asian and G3 countries in billions of dollars, 1980:01–2005:6 (monthly)

IMF: IFS. Billions of dollars. Note different scales on the y-axis.

Figure 10.4

Source:

China


80 70 60 50 40 30 20 10 0


800 700 600 500 400 300 200 100 0

278


goods from the euro area, dollar depreciation against the euro erodes the real purchasing power of dollar denominated earnings. For international creditor countries, such as Japan, China, Russia, and Saudi Arabia, which have accumulated large stocks of dollar denominated international assets, the appreciation of domestic currencies reduces the value of these assets in terms of domestic currencies (section 10.2). The upshot is that, between 2001 and 2004, private and public investors reacted differently to the sustained dollar depreciation. As the sharply rising US current account deficit went along with rising current account surpluses in countries stabilizing their exchange rates against the dollar, private investors tended to convert dollar positions into domestic currencies, bringing their domestic currencies under appreciation pressure. In contrast, the monetary authorities in many emerging markets in East Asia, the Middle East, Latin America, and the CIS tended to resist this appreciation pressure via foreign exchange intervention. From the perspective of the monetary authorities, this “leaning against the wind” in the build-up of international assets is fully rational because it shields export industries against appreciation and maintains the nominal value of the large stocks of international dollar assets. Both factors contribute to macroeconomic stability. In the longer term, however, the monetary authorities of East Asian countries may change their exchange rate targets. If they expect the depreciation of the dollar to continue, they may consider reducing dependency on the dollar as an anchor and reserve currency (Chinn and Frankel 2005). The current expectations about the future value of the US dollar hinge on the expected macroeconomic policies in the US. During 2004 and 2005, the interest rate increases of the Federal Reserve helped to sustain the value of the dollar, which appreciated against most currencies during 2005. Yet if the US fiscal deficit and the low private savings rate are expected to continue, and if a burst of the current “real estate bubble” seems likely, the future federal funds rate may be expected to be lower. The implication would be a higher level of US inflation and further depreciation pressure on the dollar. Diversification of Risk If central banks around the world that have in the past used the dollar as the predominant anchor and reserve currency see a significant probability of a sustained dollar decline, they will consider reducing their dependency on the US currency. In contrast to former periods of dollar depreciation such as in the 1970s, today the euro has become a viable competitor as a pegging and reserve currency (Chinn and Frankel 2005, ECB 2005).


279

Although the integration of the European financial markets is still lagging behind the US, deep and liquid euro capital markets provide a broad variety of investment opportunities. In addition, the European Central Bank may be perceived as more inflation-averse than the Federal Reserve, strengthening the attractiveness of the euro as an international currency.2 Instead of solely pegging to the dollar, the East Asian countries may peg to a basket of currencies for several reasons. Williamson (2000 and 2005) has proposed that a currency basket for the East Asian countries should reflect the direction of trade (rather than the currency denomination of trade). The benefits would be nominal effective exchange rate stability3 and lower fluctuations of overall trade (Gudmundsson 2005). The weights of such a currency basket would closely reflect the trade structure of the respective countries, giving substantial weights to the dollar, the yen, and the euro as well as to smaller currencies such as the Korean won, the Malaysian ringgit, and the Chinese yuan.4 In particular, Japan is one of the most important trading partners of the smaller East Asian countries. The strong depreciation of the Japanese yen against the dollar after 1995 (when the smaller East Asian countries kept their exchange rates tightly pegged to the dollar) contributed to the Asian crisis (McKinnon and Schnabl 2003). For this reason, Kawai (2002) has proposed that the yen should be given prominent weighting in the East Asian currency baskets in order to maintain intra-East Asian exchange rate stability. Ogawa and Ito (2002), reflecting the argument of McKinnon and Schnabl (2004a) that the common peg of the East Asian currencies to the dollar contributed to the stabilization of intra-regional exchange rates and thereby fostered intra-regional trade, have proposed a coordination of the weights of all East Asian currency baskets. This could be achieved by Williamson’s (2005) proposition that the dollar, yen, and euro should be treated equally in the East Asian exchange rate strategies. In addition to this purely trade-oriented approach, there is also a case for pegging to a basket of currencies from the point of view of macroeconomic stabilization. As shown above, since 2001 the tight pegs to the dollar in East Asia have contributed to a fast accumulation of foreign reserves. With underdeveloped capital markets and partially free capital flows, the scope for sterilization is limited. The respective expansion of the money supply may be regarded as a threat to price and macroeconomic stability. Given the need for exchange rate stabilization as outlined in section 10.2, the domestic price level can be regarded as a function of the price level of the anchor country. In the case of a currency basket, the domestic price level would be a function of the price levels of all anchor countries. For this reason, countries would be inclined to give a higher weight to currencies that are regarded as particularly stable. From this point of view, the

280


Japanese yen may not qualify as an anchor currency as long as the zero interest rate policy and deflation continue. Furthermore, the expectations about the longer-term stability of specific anchor currencies will also have an impact on the choice of the currency composition of foreign reserves. In the past, the foreign reserves of the East Asian countries were widely considered to be denominated in US dollars, as East Asia was widely dollarized and exchange rates were stabilized against the dollar. However, if the East Asian central banks expect a further depreciation of the dollar, they may wish to diversify their portfolio of international currencies, giving a higher weight to the euro (or the yen). This can be achieved with the help of two strategies. First, while pegging against the US dollar continues (causing foreign reserves to be accumulated in US dollars), dollar assets can be converted into euro assets. Although the peg against one anchor currency would be compatible with a diversification of reserves, the downside of this strategy is that dollar sales would put further depreciation pressure on the dollar and therefore would require additional foreign exchange intervention. This effect could be avoided if the restructuring of the currency structure of official foreign reserve holdings were to take place in times of dollar appreciation, as was the case in 2005. Although there is no need to give different currencies similar proportions as anchor and reserve currencies, countries may strive to “harmonize” the currency structure of the foreign assets with the weights of the currencies in their intervention baskets. Gudmundsson (2005) argues that many central banks use a minimum variance analysis to determine their reserve compositions. This implies that reserve structures mirror intervention basket structures in order to reduce nominal fluctuations of the value of the international reserves. For instance, Russia had given the dollar a weight of 60 percent in foreign reserves and 65 percent in the currency basket in mid-2005, giving the euro weights of 33 percent and 35 percent, respectively (Schnabl 2006). To this end, the desire to diversify the currency denomination of international reserves may enhance the role of the euro in possible basket strategies. This implies a causal relation between policy goals concerning the reserve composition and the desired exchange rate target. Further note that exchange rate stabilization based on basket strategies also would allow full hedging of the foreign exchange risk of international payments flows, as uncertainty only originates in the exchange rate fluctuations between the dollar, the euro, and the yen. For these exchange rate fluctuations, the highly developed capital markets in Japan, the US, and the euro area provide sufficient tools for hedging the foreign exchange risk.


10.4

281

ESTIMATION OF BASKET STRUCTURES

Frankel and Wei (1994) have proposed an OLS estimation that allows for the tracking of the structures of undisclosed currency baskets. The empirical analysis of the currency basket structures in East Asia proceeds in two stages. First, we test for the basket structures before the Asian crisis, which are expected to reveal a strong US dollar weight. Second, based on a rolling window approach, possible changes in basket structures are identified, with a special focus on the year 2005. Following Frankel and Wei (1994), we use an “outside” currency—the Swiss franc—as a numéraire for measuring exchange rate volatility in the East Asian currencies (except the yen). This volatility could then be partitioned into movements in major currencies against the Swiss franc. For example, if changes in the Korean won against the Swiss franc are largely explained by changes in the US dollar against the Swiss franc, the US dollar has very high weight in the Korean currency basket. We regress the exchange rates of each of the nine East Asian currencies on the US dollar, the Japanese yen, and the euro5 with the Swiss franc as numéraire: eEastAsiancurrencySwissfranct 5 a1 1 a2eDollarSwissfranct 1 a3eYenSwissfranct 1 a4eEuroSwissfranct 1 ut

(10.1)

The multivariate OLS regression6 is based on first differences of logarithms in the exchange rate e. The residuals are controlled for heteroscedasticity. The daily data are compiled from Bloomberg. The a coefficients represent the weights of the respective currencies in the currency basket. If the East Asian currency is closely fixed to one of the major currencies appearing on the right hand side of equation (10.1), the corresponding a coefficient will be close to unity. If a coefficient is close to zero, there is no exchange rate stabilization against that particular currency. The Pre-Crisis Currency Baskets First, we estimate the composition of East Asian countries’ currency baskets for the pre-Asian crisis period, which starts in February 1994 when China unified its foreign exchange market and ends in May 1997 before the first major turbulence (869 observations). Table 10.1 reports the results, showing the high weights of the dollar in the East Asian currency baskets. The estimates for a2 are all close to unity, ranging from 0.82 for the Singapore dollar up to 1.00 for the Chinese yuan, the Hong Kong dollar, and the Indonesian rupiah. The correlation coefficients (R2) being close to

282


Table 10.1

Pre-Asian crisis East Asian currency basket structures (02/01/94–05/30/97) Constant a1

Chinese yuan Hong Kong dollar Indonesian rupiah Korean won Malaysian ringgit Philippine peso Singapore dollar New Taiwan dollar Thai baht

−0.00 (−1.15) 0.00 (0.30) 0.00 (3.19) 0.00 (1.42) −0.00 (−1.48) −0.00 (−0.34) −0.00 (−1.32) 0.00 (0.84) −0.00 (−0.61)

Yen a3

DM a4

R2

1.01*** −0.01 (−1.48) (158.63) 0.00 1.00*** (0.25) (454.79) 1.00*** −0.01 (−0.92) (144.93) 0.06*** 0.97*** (3.31) (66.27) 0.09*** 0.88*** (5.30) (54.80) 0.02 0.97*** (0.74) (43.34) 0.14*** 0.82*** (4.83) (34.37) 0.03** 0.98*** (1.38) (57.30)

−0.02 (−1.70) −0.01 (−1.36) 0.01 (0.85) 0.01 (0.29) 0.01 (0.45) −0.01 (−0.45) 0.08*** (2.97) −0.01 (−0.54)

0.97

−0.01 (−0.35)

0.95

Dollar a2

0.92*** (81.25)

0.08*** (5.17)

1.00 0.97 0.93 0.90 0.86 0.86 0.93

Notes: t-statistics in parentheses; ** significant at the 5% level; *** significant at the 1% level; 869 observations. White heteroskedasticity-consistent standard errors and covariance. Source:

Datastream. Daily data.

unity indicate that fluctuations of the East Asian currencies’ exchange rates against the Swiss franc can almost fully be explained by fluctuations of the dollar against the Swiss franc. The results show that high dollar weights also can be achieved under a downward crawling peg arrangement, as in Indonesia. Before the Asian crisis, Indonesia let its currency crawl smoothly downward at 4 to 5 percent per year but kept the rupiah virtually fixed to the dollar on a day-to-day basis. The a2 coefficients of the Korean won, the Philippine peso, and the Taiwan dollar are very close to unity with lower, but still large, t-statistics. For the Thai baht and the Malaysian ringgit, the a2-coefficients are still close to 0.9, with some small weight for the yen as measured by a3. Singapore shows the lowest weight for the dollar (82 percent) and smaller (but highly statistically significant) weights for the yen (14 percent) and the


283

German mark (8 percent). There is some evidence of small weights for the yen in the pre-crisis East Asian currency baskets of Korea (6 percent), Malaysia (9 percent), Singapore (14 percent), Taiwan (3 percent), and Thailand (8 percent). However, except for Singapore there is no evidence of exchange rate stabilization against the German mark. All in all, before the Asian crisis East Asia can be characterized as adhering to an informal dollar standard (McKinnon 2005). Changing Currency Structures As outlined in section 10.3, after the Asian crisis there were policy recommendations to increase the weights of the Japanese yen in the East Asian currency baskets to minimize macroeconomic turbulence caused by bilateral exchange rate fluctuations against the Japanese yen. Since 2001 there has also been a rationale for putting the euro into the currency basket, not only because of trade linkages but also because of the high degree of monetary stability of the euro and the wish to diversify international reserves. The year 2005 would have been an optimal time for a change of currency basket structures favoring more euros over dollars as the dollar appreciated against the euro because of rising US interest rates. Using rolling regressions, the country panels in Figure 10.5 summarize the dollar’s weight in each East Asian currency basket since the early 1990s. Based on daily data, the rolling 130-day a2 coefficients are plotted for each of the East Asian countries (except Japan). A window of 130 days corresponds to an observation period of six months (5 observations per week). The first window starts on January 1, 1990 and ends on June 29, 1990. The a2 coefficients are calculated for the first period. Then the window is shifted by one day and the coefficients are calculated again, up to December 2005. A value of unity stands for a 100 percent weight of the respective currency in the respective currency basket. If the coefficient rises above 1, the estimation process is unstable. Figure 10.5 shows the time path of the dollar weights in the East Asian currency baskets. China and Hong Kong have a very stable dollar weight of unity for the whole observation period. Officially shifting toward a currency basket regime in July 2005, China seems to have decreased the weight of the dollar in its basket slightly since then. In Malaysia, which has allowed for more exchange rate flexibility since July 2005, the weight of the dollar remains close to unity. For the other countries in the pre-crisis period, the dollar weights are slightly more volatile but close to unity. During the Asian crisis, the exchange rate stabilization against the dollar broke down in Indonesia, Korea, Malaysia, the Philippines, and Thailand, as is reflected in the sharp declines of the a2 coefficients.

284

Thai baht

Dollar’s weight in East Asian currency baskets: 130-trading-day rolling regressions for a2, 1990:01– 2005:12 (daily)

Bloomberg; 1 corresponds to 100%.

Philippine peso

01.01.90 01.01.93 01.01.96 01.01.99 01.01.02 01.01.05

1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0

01.01.90 01.01.93 01.01.96 01.01.99 01.01.02 01.01.05

1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0

Indonesian rupiah

01.01.90 01.01.93 01.01.96 01.01.99 01.01.02 01.01.05

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

An a2-coefficient close to unity shows 100% weight for the dollar in the currency basket.

Figure 10.5

Source:

Note:

Taiwan dollar

01.01.90 01.01.93 01.01.96 01.01.99 01.01.02 01.01.05

01.01.90 01.01.93 01.01.96 01.01.99 01.01.02 01.01.05

Singapore dollar

1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0

Malaysian ringgit

01.01.90 01.01.93 01.01.96 01.01.99 01.01.02 01.01.05

1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0

Hong Kong dollar

01.01.90 01.01.93 01.01.96 01.01.99 01.01.02 01.01.05

1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0

1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0

Korean won

01.01.90 01.01.93 01.01.96 01.01.99 01.01.02 01.01.05

1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0

Chinese yuan

01.01.90 01.01.93 01.01.96 01.01.99 01.01.02 01.01.05

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6


0.4

0.3

0.3

0.3

0.2

0.2

0.2

0.1

0.1

0.1

0.0

0.0

0.0

Taiwan dollar

.2 0

05 03

05 20 0.

20 4. .0 03

20 1. .0 03

.1

0.

20

05 20 03

.0

7.

4. .0 03

03

20

05 20 1. .0 03

.1

0.

20

05 20 7. .0

03

20 03

03

.0

4.

20 1. .0 03

Singapore dollar

.1

0.0 05

0.0

20

0.1

0.0

03

0.1

7.

0.2

0.1

05

0.2

05

0.3

0.2

05

0.3

05

0.4

0.3

05

0.5

0.4

05

0.5

0.4

05

Philippine peso

0.5

Source:

.2 0 .0 4 03

03

03

.0 1

.2 0

05 .1 0

.2 0

.2 0

05

.0 7 03

03

03

.0 4

.2 0

.2 0 .0 1

.2 0 .1 0

.2 0 .0 7

.2 0 03

03

.0 4

.2 0 .0 1 03

03

Malaysian ringgit

Korean won

.1 0

0.0 .2 0

0.0

03

0.1

0.0

05

0.1

.0 7

0.2

0.1

05

0.2

05

0.3

0.2

05

0.3

05

0.4

0.3

05

0.5

0.4

05

0.5

0.4

05

0.5

05

Indonesian rupiah

Hong Kong dollar

.0

03 .0 1. 20 05 03 .0 4. 20 05 03 .0 7. 20 05 03 .1 0. 20 05

Chinese yuan

03 .0 1. 20 05 03 .0 4. 20 05 03 .0 7. 20 05 03 .1 0. 20 05

0.5

0.4

03 .0 1. 20 05 03 .0 4. 20 05 03 .0 7. 20 05 03 .1 0. 20 05

0.5

0.4

03

0.5

285

Thai baht

Bloomberg. 1 corresponds to 100%.

Figure 10.6

Euro’s weight in East Asian currency baskets: 130-tradingday rolling regressions for a4, 2005:01–2005:12 (daily)

Post-crisis, Figure 10.5 suggests a declining trend for the weight of the dollar in the currency baskets of Indonesia, Korea, the Philippines, Singapore, Taiwan, and Thailand. Based on the Frankel and Wei (1994) estimation, by 2005 the suggested weights of the dollar range from 45 percent in Korea up to 83 percent in the Philippines, while the weights of the dollar remain high for China, Hong Kong, and Malaysia. This may suggest an ongoing trend away from the dollar to the yen and the euro. As the appreciation of the dollar in 2005 provided a particularly good occasion to shift the structure of the currency baskets away from the dollar toward the yen and the euro, the rolling weights of both currencies in the East Asian currency baskets are estimated for this time period. Figure 10.6 shows the weights of the euro in 2005. While the German mark did not have a significant weight in the East Asian currency baskets (except

0.2

0.2

0.1

0.1

0.1

0.0

0.0

0.0

Hong Kong dollar

0.3

0.2

0.2

0.2

0.1

0.1

0.1

0.0

0.0

0.0

Malaysian ringgit

Source:

Taiwan dollar

05 20

20 4. .0 03

20 1. .0 03

20 0. 03

.1

20 .0

7.

20 4. .0 03

03

20 1. .0 03

Singapore dollar

0.

0.0

.1

0.0

03

0.1

0.0

05

0.1

05

0.2

0.1

03 /0 7/ 05 03 /1 0/ 05

0.2

03 /0 4/ 05

0.3

0.2

03 /0 1/ 05

0.4

0.3

05

0.4

0.3

05

0.4

05

0.5

05

0.5

05

Philippine peso

0.5

20

Korean won

03 .0 1. 20 05 03 .0 4. 20 05

0.4

0.3

03 .1 0. 20 05

0.4

0.3

03 .0 1. 20 05 03 .0 4. 20 05 03 .0 7. 20 05

0.4

03 .1 0. 20 05

0.5

03 .0 1. 20 05 03 .0 4. 20 05 03 .0 7. 20 05

0.5

03 .0 7. 20 05 03 .1 0. 20 05

Indonesian rupiah

0.5

7.

Chinese yuan

03 .0 1. 20 05 03 .0 4. 20 05 03 .0 7. 20 05

0.3

0.2

03 .1 0. 20 05

0.3

03 .0 1. 20 05 03 .0 4. 20 05 03 .0 7. 20 05

0.4

0.3

03 .0 7. 20 05 03 .1 0. 20 05

0.5

0.4

03 .0 1. 20 05 03 .0 4. 20 05

0.5

0.4

.0

0.5

03 .1 0. 20 05


03

286

Thai baht

Bloomberg. 1 corresponds to 100%.

Figure 10.7

Yen’s weight in East Asian currency baskets, 130-trading-day rolling regressions for a3, 2005:01–2005:12 (daily)

for Singapore) before the Asian crisis, in 2005 the a4 coefficients increased significantly for all countries except for China, Hong Kong, and Malaysia. Although the coefficients are rather volatile—which may be an indicator for unstable estimations—this may provide first evidence for a growing role of the euro in East Asian exchange rate policies. A similar trend is found for the Japanese yen (a3 coefficient). Except for China, Hong Kong, and Malaysia, there are already significant weights for the yen at the beginning of 2005; they seem to further increase during 2005 for most countries. The weights are highest for Korea and Taiwan, which are important trading partners of Japan and which compete with Japan in third markets because of a similar export structure. We also observe discretionary jumps of the weights around July 21, 2005, when China announced its currency basket (although the Chinese exchange rate policy remains dominated by the US dollar).7 (See Figure 10.7.)


287

100

80

Percent

60 July 21, 2005 40

20

euro yen dollar

0 03.01.2005

Source:

03.03.2005

03.05.2005

03.07.2005

03.09.2005

03.11.2005

Bloomberg. Arithmetic averages of the a-coefficients.

Figure 10.8

The changing East Asian currency structure in 2005

Finally, to obtain a comprehensive picture of the structure of currency baskets in East Asia, we calculate arithmetic averages of the weights of the dollar, the yen, and the euro in the currency baskets of the nine East Asian countries (except Japan) during 2005. The result, shown in Figure 10.8, implies a rising weight for both the euro and the yen. The yen seems to have received a higher weight on average than the euro. The official announcement of the Chinese currency basket on July 21, 2005 seems to have triggered an adjustment of the basket structures in other Asian countries, although the weights of the yen and the euro in the Chinese currency basket still appear to be very small.

10.5

CONCLUSION

Before the 1997/98 East Asian crisis, the East Asian countries (with the exception of Japan) pegged their currencies tightly to the dollar, forming an informal dollar standard. As the motivations for pegging to the dollar— that is, macroeconomic stabilization, dollar denomination of international and intra-regional trade, and capital flows—remained unchanged after the crisis, the East Asian countries (except Japan) have maintained or returned to their dollar pegs. However, the sustained depreciation pressure on the US dollar, which can be linked to the rising US twin deficits, has led to

288


rising reserve accumulation in US dollars, which constitutes a risk for macroeconomic stability. While the successive US interest rate increases since 2004 may put a hold on this trend, expectations of a further decline of the dollar may create an incentive to further diversify the risk of one-sided dollar pegs based on basket strategies. In East Asia, the yen and the euro may enter the currency baskets for (partially) different reasons. As Japan is a more important trading partner than the euro area and an important competitor in third markets, the yen may enter the currency basket to equilibrate intra-Asian competitiveness. Macroeconomic stabilization will matter less in the case of Japan because of the still ongoing zero interest rate policy and deflation. In contrast, both trade and competition in third markets with the euro area are less important, but the role of the euro as a macroeconomic anchor and international store of value is growing. In the long term this may further enhance the role of the euro in East Asia, both for exchange rate stabilization and as a store of value for international reserves.

NOTES 1. For instance, Volz (Chapter 8, this volume) finds a strong trade-creating effect of similar currency regimes in East Asia. 2. Schnabl (2006) shows how the Central Bank of Russia has promoted the role of the euro as anchor, intervention, and reserve currency during 2005. 3. In contrast, for small countries that have one major trading partner, it makes sense to peg to one currency instead of a basket. 4. In July 2005 China announced a currency basket reported to contain the dollar, the yen and the euro, together with a substantial number of smaller currencies, such as the Korean won, the Thai baht, the Malaysian ringgit, the Russian rouble, and the Canadian dollar, among others. 5. Before January 1, 1999 the euro is represented by the German mark as the most important currency of the European Monetary System. 6. Previous tests did not yield any evidence for any co-integrating vector between the four exchange rates. 7. To control for distortions caused by the discretionary jump in the yuan/dollar exchange rate on July 21 2005, this observation is removed from the sample.

REFERENCES Chinn, Menzie, and Jeffrey Frankel (2005). “Will the Euro Eventually Surpass the Dollar as Leading International Reserve Currency?” NBER Working Paper no. 11510, National Bureau of Economic Research, Cambridge, MA. Chmelarova, Viera, and Gunther Schnabl (2006). “Exchange Rate Management in Developed and Underdeveloped Capital Markets.” ECB Working Paper no. 636, European Central Bank, Frankfurt.


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Crockett, Andrew, and Morris Goldstein (1976). “Inflation under Fixed and Flexible Exchange Rates.” IMF Staff Papers 23: 509–44. Dooley, Michael, David Folkerts-Landau, and Peter Garber (2004). “The Revived Bretton Woods System: The Effects of Periphery Intervention and Reserve Management on Interest Rates and Exchange Rates in Center Countries.” NBER Working Paper no. 10332, National Bureau of Economic Research, Cambridge, MA. ECB (2005). Review of the International Role of the Euro. European Central Bank: Frankfurt. Eichengreen, Barry, and Ricardo Hausmann (1999). “Exchange Rates and Financial Fragility.” NBER Working Paper no. 7418, National Bureau of Economic Research, Cambridge, MA. Fischer, Stanley (2001). “Exchange Rate Regimes: Is the Bipolar View Correct?” Journal of Economic Perspectives 15: 3–24. Frankel, Jeffrey, and Andrew Rose (2002). “An Estimate of the Effect of Common Currencies on Trade and Income.” Quarterly Journal of Economics 117: 437–66. Frankel, Jeffrey, and Shang-Jin Wei (1994). “Yen Bloc or Dollar Bloc? Exchange Rate Policies in East Asian Economies.” In Takatoshi Ito and Anne Krueger (eds), Macroeconomic Linkages: Savings, Exchange Rates, and Capital Flows. Chicago: University of Chicago Press, pp. 295–29. Gudmundsson, Már (2005). “The Role of the Effective Exchange Rate in Monetary Frameworks: The International Experience.” Mimeograph. Hillebrand, Eric, and Gunther Schnabl (2006). “A Structural Break in the Effects of Foreign Exchange Intervention.” Mimeograph. Kawai, Masahiro (2002). “Exchange Rate Arrangements in East Asia: Lessons from the 1997/98 Currency Crisis.” Monetary and Economic Studies 20: 167–204. McKinnon, Ronald (1963). “Optimum Currency Areas.” American Economic Review 53: 717–25. McKinnon, Ronald (2005). Exchange Rates under the East Asian Dollar Standard: Living with Conflicted Virtue. Cambridge, MA: MIT Press. McKinnon, Ronald, and Gunther Schnabl (2003). “Synchronized Business Cycles in East Asia and Fluctuations in the Yen/Dollar Exchange Rate.” The World Economy 26: 1067–88. McKinnon, Ronald, and Gunther Schnabl (2004a). “The East Asian Dollar Standard, Fear of Floating, and Original Sin.” Review of Development Economics 8: 331–60. McKinnon, Ronald, and Gunther Schnabl (2004b). “A Return to Exchange Rate Stability in East Asia? Mitigating Conflicted Virtue.” International Finance 7: 169–201. Ogawa, Eiji, and Takatoshi Ito (2002). “On the Desirability of a Regional Basket Currency Arrangement.” Journal of the Japanese and International Economies 16: 317–34. Schnabl, Gunther (2006). “The Russian Currency Basket. The Rising Role of the Euro for Russia’s Exchange Rate Policies.” Intereconomics 41: 135–41. Williamson, John (2000). Exchange Rate Regimes for Emerging Markets: Reviving the Intermediate Option. Washington, DC: Institute for International Economics. Williamson, John (2005). “A Currency Basket for East Asia, Not Just for China.” Policy Briefs in International Economics no. PB05-1, Institute for International Economics, Washington, DC.

11.

Asian currency baskets John Williamson

11.1

INTRODUCTION

Two different types of currency basket have figured in recent discussions on East Asian monetary arrangements. One idea, now being actively promoted by the Asian Development Bank, involves a basket consisting of East Asian currencies. Such a basket could be a fore-runner of an East Asian currency, just as the basket ECU consisting of European currencies was a fore-runner of the euro. It is also in principle possible that a basket of this type could be used as a mechanism for organizing a joint float of the East Asian currencies, just as in pre-euro days the EMU countries could have held their currencies together with interventions motivated by a currency’s deviation from the basket ECU. However, it is a historical fact that this is not how the European currencies maintained the margins of the EMS. In practice, they defended bilateral margins against other members of the EMS, without paying attention to the ECU basket. A separate type of basket would be one to which all the members of a regional bloc decided to peg their currencies. (In practice some members of the bloc may float their currencies and merely use the basket as a numeraire in terms of which to assess whether their exchange rate is getting too strong or too weak rather than pegging to it.) Such a basket need not contain any regional currencies at all; indeed, I will argue subsequently that there would be advantages to excluding all regional currencies (no matter how important they are in regional trade). It is the design of this type of basket that I propose to discuss in this chapter. This is not because I wish to dismiss the importance or potential usefulness of a basket intended to lead on to a regional currency, but simply because of a belief in the division of labor. There are two distinct sets of questions raised by the two different proposals, and we need to keep them strictly separate. The purpose of pegging to a basket of major international currencies is to stabilize the effective exchange rate against the shocks that would

© Peterson Institute for International Economics: All rights reserved.

290

Asian currency baskets

291

be imposed on a country’s macroeconomy by fluctuations in the value of these currencies. Such fluctuations are completely exogenous to the policies of most of the countries of East Asia but in practice have proven highly destabilizing (such as in the run-up to the Asian crisis of 1997, to take the most notorious example). Pegging to a common basket could also yield the benefit of intra-regional stability, something that has been claimed as one of the principal virtues of having all the regional currencies peg to the US dollar (for example, by Ronald McKinnon 2002). The first question taken up in this chapter is whether a basket should reflect just trade or also some (or all) capital movements. The more strategic issues are pursued in subsequent sections. One is which currency areas should use a basket, assuming that a common basket is indeed chosen. The other is whether it would be better to use a common basket or a series of baskets tailored to each country’s individual situation.

11.2

THE WEIGHTING SYSTEM

The argument for using just trade is that this is what determines a country’s effective exchange rate,1 and analysis of the optimal peg concluded that it is the real effective exchange rate that is the most important influence on a country’s macroeconomic situation (both unemployment and inflation).2 Differences between nominal and real effective exchange rates can be accommodated by changes in central rates, so that the contribution of the basket peg should be maintaining the nominal effective exchange rate (NEER) constant in the face of shocks to exchange rates between the basket currencies. Kawai and Takagi (2005) established that stability of the real effective exchange rate is empirically important in achieving macroeconomic stability in the East Asian countries. Against this argument, it is sometimes pointed out that many other transactions, notably capital account transactions, go through the foreign exchange market. China has indicated that the weights in the currency basket it now uses to assess its exchange rate are influenced by the origins of FDI flows as well as of trade flows. Other economists have argued that in many countries capital transactions are many times larger than the value of trade. Personally I see little significance in what are undoubtedly correct facts. On the contrary, I recall that when Chile moved from a peg to the dollar to a peg to a basket of currencies it said that one motivation for the change was to introduce more noise into the dollar–peso relationship so as to discourage short-term capital inflows (which came overwhelmingly out of dollar holdings). Similarly, I do not see any point in having the composition of the basket be influenced by the currencies in

292


which invoices are written. A Japanese exporter to an East Asian country may well invoice in dollars, but if he changes the dollar price he quotes in the light of changes in the dollar–yen relationship, then stabilizing the real effective exchange rate requires weighting the yen by Japanese trade rather than by the number of invoices written in yen. Certainly I would want to interpret “trade” to include all current account transactions rather than just visible exports and imports, but beyond that I see no case for taking other factors into account in determining the composition of the basket. There are at least two subsidiary questions concerning the weights in the basket, both of which I raised in Williamson (1982). The first question is whether weights should be based on imports, exports, or total trade. I concluded that the arguments favored using total trade weights rather than giving either exports or imports special and differential treatment. A second question is whether to use trade weights or elasticity weights. I judged that the arguments favored using elasticity weights if these are available, but of course they usually aren’t; however, trade weights should be a reasonable proxy in most instances. I therefore assume that if a currency basket is used to provide a currency peg or numeraire, it should be weighted by trade shares and not influenced by the direction of capital flows or the currencies in which trade is denominated.

11.3 THE CURRENCY AREAS THAT MIGHT ADOPT A COMMON BASKET The next topic that needs to be addressed is which currency areas might be candidates for pegging to a common basket (or for using it as a numeraire) if it were created. Table 11.1 shows the direction of trade for the five longstanding members of ASEAN (Indonesia, Malaysia, the Philippines, Singapore, Thailand), the three big countries of North East Asia (China, Japan, and Korea), the two smaller currency areas in the Greater China region (Hong Kong and Taiwan), and one other large Asian country that is sometimes now included in such analyses (India). While the trade patterns of these currency areas are obviously different, in most cases they are not dramatically different. All the currency areas except Hong Kong and India show intra-regional trade within 10 percent of the regional average (excluding Japan and India) of 55.5 percent. All except Indonesia and India (and, trivially, Japan) trade with each of the main currency blocs within a range of 10 percent of the regional average (after excluding intra-regional trade). These considerations suggest at least seven currency areas to be good candidates for using a common


Table 11.1

Direction of trade of East Asian economies in 2004 (percentage) Direction United of trade States

China

293

Exports Imports Total Hong Kong Exports Imports Total Indonesia Exports Imports Total South Exports Korea Imports Total Malaysia Exports Imports Total Philippines Exports Imports Total Singapore Exports Imports Total Taiwana Exports Imports Total Thailand Exports Imports Total Weighted Exports averageb Imports Total Japan Exports Imports Total India Exports Imports Total

22.8 7.7 15.2 17.0 5.3 11.1 13.5 5.7 9.6 17.8 12.7 15.3 18.8 14.6 16.7 17.5 16.0 16.7 13.0 12.7 12.9 18.0 13.2 15.6 15.9 7.6 11.8 18.3 9.5 13.9 22.7 14.0 18.4 18.4 7.0 12.7

Japan

EU

12.4 16.1 14.3 5.3 12.1 8.7 21.8 19.3 20.5 8.3 21.6 14.9 10.1 16.1 13.1 15.8 20.6 18.2 6.4 11.7 9.1 8.3 25.6 17.0 13.9 23.6 18.7 11.3 15.9 13.6 NA NA NA 3.5 3.5 3.5

18.1 12.4 15.3 14.0 8.0 11.0 14.3 12.1 13.2 13.8 10.8 12.3 12.6 12.1 12.3 15.5 8.8 12.1 14.5 13.5 14.0 11.3 9.9 10.6 14.7 9.9 12.3 14.9 10.6 12.7 15.8 12.7 14.3 22.6 23.1 22.9

Non-US Western hemisphere 4.6 4.8 4.7 2.7 2.0 2.3 2.1 2.5 2.3 6.3 3.4 4.8 1.8 1.6 1.7 1.9 1.8 1.8 2.1 1.4 1.7 NA NA NA 2.6 2.3 2.5 4.1 3.5 3.8 5.4 4.6 5.0 3.4 5.2 4.3

Rest of NonJapan East Asiac 30.1 39.4 34.8 55.3 67.6 61.5 35.6 43.3 39.4 41.4 28.8 35.1 44.6 47.4 46.0 46.6 42.1 44.3 51.9 45.2 48.5 48.2 30.1 39.2 38.8 34.4 36.6 40.3 43.5 41.9 47.6 44.6 46.1 22.9 24.2 23.5

Rest of worldd

12.1 19.5 15.8 5.8 4.9 5.3 12.7 17.1 14.9 12.5 22.7 17.6 12.2 8.1 10.2 2.8 10.8 6.8 12.1 15.5 13.8 NA NA NA 14.1 22.2 18.2 11.1 16.9 14.0 8.5 24.1 16.3 29.3 37.0 33.1

294


Table 11.1

(continued)

Notes: a Data for Taiwan are from the 2004 Statistical Year Book of the Republic of China, tables 122 and 123. Due to incomplete country detail the Non-US Western hemisphere cannot be calculated; the Rest of the world is left out as a result. Incomplete country detail further means that for Taiwan imports the EU consists of only Belgium, France, Germany, Italy, Netherlands, Sweden, Switzerland (included as it has an FTA with the EU), and Britain. For Taiwan exports the EU consists of Belgium, France, Germany, Ireland, Italy, Netherlands, Spain, Sweden, and Britain. All data for 2003. b For the weighted average Taiwan has been excluded due to incomplete data. Due to inconsistent reporting by countries weights do not add up to exactly 100 percent, but they have been deflated by the actual sum to yield a total of 100 percent. c Non-Japan East Asia is the aggregate in the IMF DOTS database for “Developing Asia” (all Asia, excluding only Japan); subtracted where applicable are Afghanistan, Bangladesh, Bhutan, Sri Lanka, India, Maldives, Nepal, Pakistan, Palau, and Timor. As the aggregated data do not equal the sum of individual countries, Taiwan is assumed to be included in the aggregate; in addition it contains where applicable Brunei, Myanmar, Cambodia, China, Hong Kong, Indonesia, South Korea, Laos, Macau, Malaysia, Philippines, Singapore, Thailand, Vietnam, and Asia Not Elsewhere Reported (NES). d The residual is calculated as 1 minus the other five categories. Source:

IMF Directions of Trade Statistics May 2005.

basket: China, Malaysia, Philippines, Singapore, South Korea, Taiwan, and Thailand.3 To these I would certainly want to add Hong Kong, since adoption of a common basket peg would tend to stabilize relative exchange rates within East Asia, meaning that the crucial variable is the distribution of extra-regional trade, and this is fairly typical in the case of Hong Kong. A more marginal case is Indonesia, whose trade with Japan is more than 10 percent above the regional average, but I shall assume in what follows that Indonesia would adopt a common basket as well. On the other hand, the Indian trade pattern is distinctly different from that of the East Asian countries, so that if India were to adopt a basket of currencies to guide its intervention policy it seems probable that it should adopt its own tailormade basket rather than a common East Asian one. One remaining question is what should happen to the new members of ASEAN, namely, Cambodia, Laos, Myanmar, and Vietnam. I have not analyzed this issue, which at present is of a secondary order of importance. By far the most important issue is whether Japan should adopt a common basket as the numeraire to guide its intervention policy (assuming that it adopts a basket for that purpose at all). The reason for posing this as an issue is not that the Japanese trade pattern is dramatically different from that of other East Asian countries: once one has allowed for the fact that Japan does not trade with itself, its trade pattern is in fact quite similar


295

to that of its neighbors. The reason is rather the fundamental fact that a country cannot peg its currency to itself. If Japan were to peg to a common basket (or use a common basket as numeraire), then the common basket could not include the yen. All the other regional currencies would similarly be excluded from the common basket, which would consist exclusively of extra-regional currencies. If one limits the basket to currency areas with which the region does at least 5 percent of its total trade (on the ground that a string of small currencies complicates the system without much affecting its overall behavior), then a common basket would consist exclusively of dollar and euro. If the yen remained as volatile in terms of those currencies as it has been in the past, this would tend to destabilize the effective exchange rates of all of the other countries that peg to the common basket and thus reduce the value of the system to them. How important would this additional volatility be? That is a question that one can attempt to answer on the basis of a simulation using data from past exchange-rate movements. Such a comparison is made in the next section of this chapter. In parallel, an empirical examination is made of whether a common basket peg would have been advantageous.

11.4

INDIVIDUAL-COUNTRY BASKETS VERSUS COMMON BASKETS

The purpose of this section is to offer a comparison of the behavior of the nominal effective exchange rate of the nine currency areas identified in the last section (China, Hong Kong, Indonesia, Malaysia, Philippines, Singapore, South Korea, Taiwan, and Thailand) under four different hypothetical exchange-rate policies: 1.

2.

The first one considered is the actual policy that was followed, which resulted in the variations in the nominal effective exchange rates in most cases reported by the IMF in International Financial Statistics. Table 11.3 presents, where available, the standard deviation of each currency area’s monthly NEER over the period 2000–04 as reported by IFS. Data for Indonesia, South Korea, Taiwan, and Thailand were not available from that source, but a substitute source or concept as reported in note a to Table 11.3 was used. The second policy supposition is that each currency area pegged its currency to a tailor-made basket representing its own individual trade composition. Each basket was composed of those currencies with which the currency area conducted at least 5 percent of its total trade. The weight of the dollar was supplemented by trade with the rest of the Western

296

3.

4.


hemisphere, the rest of non-Japan East Asia, and two-thirds of the rest of the world, to reflect the fact that the former two regions and a large number of rest of the world countries have traditionally pegged to, or measured their exchange rates in terms of, the US dollar. Similarly, the weight of the euro was supplemented by one-third of the trade with the rest of the world, reflecting the fact that a number of other currencies peg to the euro or else that their exchange rates tend to be influenced by the euro. In the cases of Japan and other East Asian currencies, the weights in the basket were simply set equal to the percentage of trade with the respective currency areas. The resulting baskets are shown in column 2 of Table 11.2. Table 11.3 then presents estimates of what the standard deviations of variations in the NEERs would have been had the currencies in question been pegged to those baskets. The third supposition is that each currency area pegged its currency to a common basket consisting of the three major international currencies, namely, the dollar, the euro, and the yen. The dollar’s weight is again supplemented by the trade of the nine-currency group with the rest of the Western hemisphere and two-thirds of that with the rest of the world (but not, of course, with the rest of non-Japan East Asia, since those countries are assumed to be pegging to the basket). Similarly, the euro’s weight is supplemented by one-third of trade with the rest of the world. The weight of the yen in this basket is given by the percentage of trade conducted in 1999 by the whole of the group of nine currency areas with Japan. These weights add up to less than 100 percent, since they exclude intra-East Asian trade. The weights are therefore blown up to make the weights sum to 100 percent. The composition of the resulting basket is shown in column 3 of Table 11.2. Estimates of the standard deviations of variations in the monthly NEERs had the currencies been pegged to such a basket are presented in Table 11.3. The final supposition is that each currency area pegged its currency to a common basket consisting of the dollar and the euro only. The relative weights of the dollar and the euro are exactly as in the previous basket; they are calculated by blowing up the weights of column 3 for these two currencies so as to make them sum to 100 percent when the yen is no longer in the basket. The composition of the resulting basket is shown in column 4 of Table 11.2. Estimates of the standard deviations of variations in the monthly NEERs had the currencies been pegged to such a basket are presented in Table 11.3.

It can be seen that in the majority of cases (five out of nine) the shift from countries’ actual policies to a peg to a tailor-made basket would have reduced the variability of the effective exchange rate. The rather surprising


Table 11.2

297

Currency weights (percentage)

Country

Currency area/ country

Individual country weights

Weights for 3-currency basket


China

Euro-zone Japan United States Hong Kong South Korea Euro-zone Japan United States China Euro-zone Japan United States China Malaysia Singapore South Korea Euro-zone Japan United States China Hong Kong Singapore Euro-zone Japan United States China Hong Kong Malaysia Singapore Euro-zone Japan United States China Malaysia Euro-zone Japan United States China Euro-zone Japan

18.6 14.5 47.2 12.2 7.4 10.2 9.1 35.6 45.1 16.4 21.0 35.0 9.0 5.6 8.2 4.9 13.6 13.1 46.6 8.4 4.6 13.7 12.7 18.5 39.0 9.6 6.9 5.0 8.2 16.0 9.3 49.5 9.5 15.8 16.4 15.0 50.6 17.9 15.3 16.7

30.0 23.4 46.6

39.1

30.0 23.4 46.6

39.1

30.0 23.4 46.6

39.1

30.0 23.4 46.6

39.1

30.0 23.4 46.6

39.1

30.0 23.4 46.6

39.1

30.0 23.4 46.6

39.1

30.0 23.4

39.1

Hong Kong

Indonesia

Malaysia

Philippines

Singapore

South Korea

Taiwana

60.9

60.9

60.9

60.9

60.9

60.9

60.9

298


Table 11.2 Country

(continued) Currency area/ Individual country country weights

Thailand



United States China Hong Kong Euro-zone

44.5 12.2 11.3 16.0

46.6

60.9

30.0

39.1

Japan

19.2

23.4

United States

44.9

46.6

China

8.2

Malaysia

5.8

Singapore

6.0

60.9

Note: a Taiwan data for 2003 are from the Statistical Yearbook of the Republic of China 2004. The euro zone includes only Belgium, France, Germany, Ireland, Italy, Netherlands, and Spain. Two-thirds of the total of the Non-US Western hemisphere and rest of the world is allocated to the US and one-third is allocated to the euro zone. Source:

IMF DOTS Database May 2005.

fact is that this should not have been true in the other four cases. It is conceivable that this is an artifact that arises from the measurement of the effective exchange rate in column 2 purely on the basis of the major trading partners rather than the more comprehensive base used by the IMF. However, an economic explanation might also lie behind this paradoxical finding: perhaps the dollar peg (in some cases) or near-peg (in others) reduced intra-regional exchange rate instability and this effect outweighed the expected effect of the basket in reducing instability against outside currencies. Indeed, Ronald McKinnon (2002) has argued that an important virtue of a common dollar peg for the region is exactly that it would in this way reduce intra-regional exchange rate instability. Column 3 shows that in every single case a shift to a common basket peg would have reduced effective exchange rate instability as compared both to actual historical experience and to a peg to a tailor-made individualcountry basket. This again has to be a reflection of the McKinnon effect: a common peg—and a common basket peg is as good as a common dollar peg in this respect—eliminates intra-regional exchange-rate instability. Of course it is true that the benefit of a common basket peg is exaggerated in


Table 11.3

Country

China Hong Kong Indonesiaa Malaysia Philippines Singapore South Koreaa Taiwana,d Thailanda

299

Standard deviations of East Asian NEERs under different baskets 2000–04 Actual historical experiencea

Individual country pegb

$–euro–yen basket pegc

$–euro basket pegd

5.21 4.18 6.35 5.29 9.55 2.54 3.32 4.74 2.92

3.49 1.73 5.61 2.77 12.68 1.62 4.42 4.92 3.87

1.58 1.56 3.85 1.58 5.41 1.25 2.01 2.51 1.90

2.11 2.08 5.51 2.11 7.65 1.51 2.17 3.34 2.54

Notes: a Standard deviations of period-end monthly nominal effective exchange rate are from IMF IFS May 2005. Data for Indonesia and Taiwan are end-month from Thomson Datastream Series JPMIDNB (Indonesia) and NTDTWER Taiwan. Data for South Korea and Thailand end-month real effective exchange rates are from the Citibank CTERI Database. Jan 2000 5 100. b Individual country pegs are calculated as the standard deviation of the weighted average (weights from Table 11.2, column 3) of individual country trade weights times the bilateral trading partner currency/LCU. All bilateral exchange rates are set at Jan 2000 5 100. c The common basket peg is calculated using 1999 as the base year (USD 1 5 EUR 0.9363 and USD 1 5 JPY 113.91), with the weights in Table 11.2, column 4, yielding the USD, EUR, JPY composition of USD 0.402, EUR 0.296, and JPY 32.1, respectively. From these the LCU/USD, EUR, JPY rates implied by the basket composition are calculated, and these are subsequently weighted by the implied (deflated to equal 100 percent) individual country total trade weights for the US, the EU, and Japan to yield the variability under a common basket peg. All bilateral exchange rates are set at Jan 2000 5 100. d The common basket peg is calculated using 1999 as the base year (USD 1 5 EUR 0.9363), with the weights in Table 11.2, column 5, yielding the USD, EUR compositions of USD 0.560 and EUR 0.412, respectively. From these the LCU/USD, EUR rates implied by the basket composition are calculated, and these are subsequently weighted by the implied (deflated to equal 100 percent) individual country total trade weights for the US and the EU to yield the variability under a common basket peg. All bilateral exchange rates are set at Jan 2000 5 100. NA 5 not applicable. Source:

Author’s calculations

this simulation, which assumes that intra-regional instability is reduced to zero, something that would be true only if all the regional currencies were to peg rigidly to the common basket. To the extent that countries operate with bands, or even more if they float and merely use the common basket as numeraire, there will still be some intra-regional instability even with a common basket. But I see no reason to expect that a change in third

300


currency exchange rates will have a systematic effect in altering the position of a currency relative to its central rate, so this seems as neutral an assumption as it is possible to make. Column 4 goes on to ask what would have been the effect of substituting a common dollar–euro basket for the dollar–euro–yen basket of column 3. It is assumed that the yen would have continued to float in the same way that it actually did, whereas it might conceivably be that if Japan had adopted the common basket as numeraire this would have influenced the yen’s value and made it less volatile. Neglecting that possibility, it can be seen that omitting the yen from the basket to which the other East Asian countries peg would in every case have led to increased instability. The mean and median increases are around a third. We already noted that Indonesia has a rather different trade pattern than most of the other East Asian countries, so that the greater variability under a common basket peg is not surprising. The other outlier is the Philippines. Since Filipino trade is not so different from the average, this may seem surprising. However, it is also notable that the Filipino effective exchange rate was actually very unstable on the chosen measure, and this would have been even more true with a peg to a tailor-made basket. The explanation is that the Philippine peso was the only currency in East Asia with a trend depreciation over the period in question. The measure of the variability of the effective exchange rate used was the standard deviation of: a wi (ci 2 ĉi) where wi is the (trade) weight of the ith currency area, ci is the exchange rate between the local currency and the ith currency, and ĉi is the average exchange rate between the local currency and the ith currency over the period 2000–04. Where there is a trend change in the value of the local currency in terms of all other currencies, this formula tends to give large measures of the effective exchange rate deviation at the beginning and end of the period. One may in principle eliminate these by deflating all exchange rates by a measure of the trend depreciation of the exchange rate. The first measure used was the IMF’s NEER trend over the period 2000–04. The result of this deflation is shown in the second row of Table 11.4 (whose first row reproduces the result from Table 11.3). It can be seen that this deflation does indeed reduce the standard deviation of the NEER to a level in line with that in other countries, but that variability would still have increased somewhat with a shift to a basket peg. It would have increased further with a shift to a common basket peg, and a part of this increase would have been reversed if the yen were excluded from the


Table 11.4

301

Standard deviation of the Philippine NEER, 2000–04

Basis

Actual historical experiencea

Reported in Table 11.3 Deflating by IMF NEER trend for 2000–04 Deflating by basket trend for period 2000–04

Individual $–euro–yen $–euro basket country pegb basket pegc pegd

9.55

12.68

5.41

7.65

3.05

3.88

5.97

4.40

NA

NA

1.20

1.80

Notes: a Standard deviations of period-end monthly nominal effective exchange are rate from IMF IFS May 2005. b Individual country pegs are calculated as the standard deviation of the weighted average (weights from Table 11.2, column 3) of individual country trade weights times the bilateral trading partner currency/LCU. All bilateral exchange rates are set at Jan 2000 5 100. c The common basket peg is calculated using 1999 as the base year (USD 1 5 EUR 0.9363 and USD 1 5 JPY 113.9), with the weights in Table 11.2, column 4, yielding the USD, EUR, JPY composition of USD 0.402, EUR 0.296, and JPY 32.1, respectively. From these the LCU/USD, EUR, JPY rates implied by the basket composition are calculated, and these are subsequently weighted by the implied (deflated to equal 100 percent) individual country total trade weights for the US, the EU, and Japan to yield the variability under a common basket peg. All bilateral exchange rates are set at Jan 2000 5 100. d The common basket peg is calculated using 1999 as the base year (USD 1 5 EUR 0.9363), with the weights in Table 11.2, column 5, yielding the USD, EUR composition of USD 0.560 and EUR 0.412, respectively. From these the LCU/USD, EUR rates implied by the basket composition are calculated, and these are subsequently weighted by the implied (deflated to equal 100 percent) individual country total trade weights for the US and the EU to yield the variability under a common basket peg. All bilateral exchange rates are set at Jan 2000 5 100. NA 5 not applicable. Source:

Author’s calculations.

basket. Both of these results are contrary to what might be expected as well as to the results of all of the other East Asian currencies. The explanation of these paradoxical findings appears to be that there was a significant divergence between the IMF’s measure of the NEER and the value of the Philippine peso in terms of the basket currencies in the later years of the period, so that deflating the latter by the former gave rise to the same sort of problem as that encountered without deflation. An alternative is to deflate the exchange rates against the basket currencies by the trend depreciation of the Philippine peso in terms of the average basket currency. Some of the results of this exercise are reported in the third row of Table 11.4, although it hardly makes sense to deflate by

302


the basket currencies for the non-basket hypotheses. The measured variability of the basket solutions does indeed decline when that is done, but one worries that this is approaching a tautology.

11.5

CONCLUDING REMARKS

The proposal for a number of East Asian countries to peg their currencies to a common basket comes out relatively well in this comparison. Obviously the proposal can do nothing to lay to rest the concerns that any system of pegging is vulnerable to provoking speculative runs: one has to decide whether that is a risk worth taking in order to gain the benefits of avoiding the instability and the danger that the market may generate misalignments, inherent in floating. What the results suggest is that if a country decides to peg its currency, then pegging to a basket can result in significantly less instability than actual policy. Moreover, pegging to a common basket to which other countries in the region also peg can further reduce instability. If there is a desire to realize those benefits but also to avoid the risk of pegging, then an appropriate policy may be to adopt a managed float guided by the use of a common basket as numeraire. Unfortunately it seems impossible to make any convincing estimate of the impact of this policy in the absence of a theory of floating rates, another of how intervention is determined, and a third of how the rate responds to intervention—none of which we presently have or are likely to have any time in the foreseeable future. Hence the suggestion of what an appropriate policy might be must remain speculative. But that is no excuse for ignoring the results on the advantage of a common basket peg, which are quite strong and, I would conjecture, robust. They point to a need for collective action, such as the region seems increasingly interested in developing.

NOTES 1. A country’s effective exchange rate is defined as its average (trade-weighted) exchange rate. 2. See Williamson (1982) for a survey of this literature and the basis for this statement. 3. I acknowledge that there might be political problems in having both Mainland China and Taiwan use the same basket, although I would note one advantage of any cooperation taking this form: it could in practice be economically effective without imposing the need for direct political dealings.


303

REFERENCES Kawai, Masahiro, and Shinji Takagi (2005). “Strategy for a Regional Exchange Rate Arrangement in East Asia: Analysis, Review, and Proposal.” Global Economic Review 34: 21–64. McKinnon, Ronald (2002). “After the Crisis, The East Asian Dollar Standard Resurrected.” In A.H.H. Tan (ed.), Monetary and Financial Management in the 21st Century. Singapore: World Scientific Publishing Co. Williamson, John (1982). “A Survey of the Literature on the Optimal Peg.” Journal of Development Economics 11: 39–61.

12.

The role of an Asian currency unit Masahiro Kawai1

12.1

INTRODUCTION

ASEAN13 finance ministers have been pursuing regional financial cooperation since the Asian financial crisis of 1997–98.2 Reflecting lessons learned from the crisis, the aim has been to strengthen national financial markets and to establish regional self-help mechanisms for crisis prevention and management. Their efforts have focused on regional economic surveillance (i.e. the Economic Review and Policy Dialogue, ERPD), regional short-term liquidity arrangements (i.e. the Chiang Mai Initiative, CMI), and local-currency bond market development (i.e. the Asian Bond Markets Initiative, ABMI). Asian central bank governors, participating in the Executives Meeting of East Asia-Pacific Central Banks (EMEAP),3 have also made efforts to improve their policy dialogue and promote Asian bond market development, for example through Asian Bond Funds (ABF). While there has been substantial progress in all these areas, little progress has been made in monetary and exchange rate policy coordination. Given the high and ever-rising degree of economic interdependence through market-driven trade, investment, and financial flows, East Asian economies have found it increasingly important to maintain relatively stable intraregional exchange rates while allowing sufficient flexibility against the US dollar. A first, modest step in this direction could be the creation of an Asian currency unit (ACU), which is an appropriately weighted index of East Asian currencies designed to monitor the collective movement of regional currencies against key external currencies—such as the US dollar and the euro—and each component currency’s movement relative to the ACU regional benchmark. Such an index can also be used by markets for varied purposes and, once certain conditions are met in the future, the ACU could be used by the region’s authorities for the purpose of monetary transactions and exchange rate policy coordination. This possibility was highlighted in recent statements at the East Asian Finance Ministers’ meetings in Hyderabad, India, held on the sidelines of the Asian Development Bank (ADB) Annual Meeting.4 304

The role of an Asian currency unit

305

This chapter attempts to explain the objectives of creating such a regional currency unit, clarify some technical issues to be resolved in constructing it, provide the economic logic of the unit, and explore its potential role for future exchange rate and monetary policy coordination in East Asia.

12.2

OBJECTIVES OF CREATING AN ASIAN CURRENCY UNIT

The creation of an ACU was first proposed by Kuroda and Kawai (2002).5 An ACU can be useful in three ways: ● ● ●

as a statistical indicator summarizing the collective movement of Asian currencies; as a currency basket used by the market; and as an official unit of account for monetary and exchange rate policy coordination.

First, the immediate objective of creating an ACU is to use it as one of the tools for monitoring foreign exchange market conditions. It represents the collective movement of regional currencies against key external currencies, such as the US dollar, the euro, and the British pound. Also, as a regional benchmark, an ACU can help gauge the degree of divergence of each component currency. A detailed analysis of divergence indicators offers valuable information for identifying idiosyncratic problems in a particular currency’s market and in helping pursue appropriate macroeconomic policies to eliminate vulnerabilities that adversely affect the exchange rate.6 In this sense, the ACU is nothing more than a statistical indicator that is useful for regional policy dialogue and national policymaking, but without requiring automatic policy changes or market interventions. Thus, it may be more appropriate to call the currency unit an ACU index. Second, the ACU index, if constructed in a market-friendly way, can be useful for financial markets in developing new, tradable instruments. Asia’s futures exchanges may be interested in listing ACU futures as a financial commodity, which can provide hedging instruments for traders— even in the absence of active onshore derivatives markets for some highly regulated currencies. Capital markets may develop ACU-denominated bonds; Asian governments, or any other creditworthy government in the world, could issue sovereign or quasi-sovereign bonds in ACU; private corporations of any nationality could issue corporate bonds in ACU; and pension, provident and mutual funds and other institutional investors could invest in ACU-denominated bonds.7 Both Asian and non-Asian

306


central banks could hold part of their foreign exchange reserves in ACU. Even commercial banks could accept ACU deposits and make ACU loans. Looking beyond the financial markets, exporters and importers may wish to denominate cross-border trade in ACU. Third, in the future, and at a more advanced stage of its development, an ACU could play a significantly important official role, similar to that played by the European currency unit (ECU) within the European Monetary System (EMS) during the 1980s and 1990s.8 Following the European path, East Asian authorities may decide in the years to come to stabilize their exchange rates against the ACU basket—as initially intended under the Exchange Rate Mechanism (ERM). Official ACUs may be created by a regional reserve pooling institution similar to the European Monetary Cooperation Fund, and Asian central banks may be authorized to use official ACUs to settle balances with other central banks. Alternatively an ACU could be allowed to function as a regional “parallel currency”, as part of a market-driven approach to East Asian monetary unification (Eichengreen 2006). The ACU as a parallel currency would compete against other national currencies in the region for use as a unit of account, medium of exchange and store of value. Against the backdrop of the evolution of monetary cooperation in Europe and the creation of the euro, it is crucial to emphasize the significant difference between the ECU and the ACU index. The ECU was an official unit of account from the mid-1970s, while the proposed ACU index is merely a statistical indicator—at least until authorities decide otherwise. Initially, the ACU index movement, and each component currency’s divergence from it, requires neither an automatic policy response nor any obligation for exchange market intervention. In this sense, the ACU index is merely an indicator that offers additional information in helping monitor currency market developments. Once Asian monetary authorities decide to pursue monetary and exchange rate policy coordination, however (whether along the line of the European experience or by using a different approach), the ACU may gain official—or even legal tender—status. But it will take years or even decades before such a decision is made (if at all) given the various impediments to the evolution of Asian monetary integration.9

12.3

CONSTRUCTING AN ACU INDEX

Technical Issues In constructing a weighted index of Asian currencies, or ACU, several technical issues need to be addressed:10

The role of an Asian currency unit ● ● ● ●

307

choice of fixed shares vs. fixed units of component currencies in the basket; choice of economic variables and indicators used to calculate currency weights/units; coverage of currencies included in the basket; and frequency of periodical revisions of currency shares/units.

First, a decision must be made whether to use fixed currency shares or fixed currency units in constructing an ACU. Given the ECU experience, constructing the ACU as fixed units of component currencies is more desirable. The fixed-units formula, as opposed to the fixed-shares formula, can produce a smooth change in the ACU index when revising currency units, adding a new currency to the basket, or eliminating an incumbent currency from the basket. Under the fixed-units formula, effective weights of individual currencies in the basket will fluctuate as their exchange rates change. Second, a decision has to be made as to what economic variables and indicators should be used in calculating the appropriate numbers of currency units in a basket. How to choose these economic variables depends on the ultimate objective for constructing the currency basket. In general, economic size matters in any currency basket as it represents the relative importance of a country in the global and regional economy. If the objective is to measure relative international price competitiveness of Asian economies against the rest of the world or among Asian economies, then a measure of trade activity will be the most important indicator. If the objective is to measure the relative importance of individual national financial markets, particularly for cross-border financial transactions and capital flows, then financial market-related indicators—size and liquidity of financial markets—as well as some measures of overall capital account convertibility, are important factors to consider. As the objective is a combination of these two, I suggest three types of size variables for consideration: (1) the size of the economy; (2) the size of export and import trade activity; and (3) the size of financial market activity, particularly for cross-border purposes. Nominal US dollarbased gross domestic product (GDP) converted at market exchange rates—rather than PPP-based GDP—is the best proxy for economic size of an economy, as it captures the current monetary value of overall national economic activity—rather than measuring a country’s standard of living. Total trade value—exports plus imports—is an appropriate measure of trade activity, though a decision has to be made on the choice between total trade with the rest of the world and total trade with regional partners.11 Total size of national financial markets adjusted for

308


the degrees of exchange and capital controls and/or cross-border capital account transactions—such as the value of international debt securities issued by residents—are a good proxy for cross-border financial market activity.12 These three economic variables can be used in combination in constructing an ACU index. Third, the question of which currencies to include in an ACU index must be addressed. Currency baskets of various regional groups within Asia—such as East Asia, South Asia, Central Asia, and Oceania—may be considered separately. Including all Asian currencies in a single basket would be too complex and diverse to be aggregated. The most promising group thus far is a subset of East Asia—ASEAN13—as its members have actively worked on monetary and financial cooperation since the Asian financial crisis.13 Following the recent East Asia Summit, launched in Kuala Lumpur in December 2005, an ACU index including India, Australia, and New Zealand (in addition to ASEAN13) might also be considered. There can be various combinations of currency coverage, and new currencies may be added to any initial currency basket if deemed appropriate. The formula should thus maintain an open-ended currency composition system. Fourth, a decision must be made on the frequency of periodical revisions of assigned currency units in the basket. This decision is important not only for authorities of component currencies, but especially for markets, as changes in weighting will affect interest rates calculated on the different currency components of the basket. This will impact the value of the various financial instruments denominated in ACU. It is therefore important to set transparent rules for periodic revisions of units to allow financial market analysts to easily calculate basket interest rates. Given the dynamic pace of transformation of many East Asian economies, the numbers of individual currency units could be revised as often as every two to three years. Existing Currency Baskets Let us examine currently existing currency basket indexes in light of the ACU index to be constructed from the perspective of the above considerations. We review currency weights used by the US Federal Reserve (FRB), the European Central Bank (ECB), and the Bank of England (BOE) in defining their nominal effective exchange rates (NEERs) as well as those used by market participants in defining various baskets of bonds. Table 12.1 presents a summary of several currency basket weights that are adjusted so the sum of individual ASEAN13 currency weights equals 100 percent. It also includes several other emerging Asian economies (Hong Kong, Macau, Taipei, China, and India), and Australia and New Zealand for comparison.

309

China, People’s Rep Japan Korea, Rep. of Brunei Darussalam Cambodia Indonesia Laos PDR Malaysia Myanmar Philippines Singapore Thailand Vietnam ASEAN13 Hong Kong SAR Macau SAR

Economies

Table 12.1

– 3.2 – 5.0 – 2.4 7.0 4.5 – 100.0 8.3

–

–

38.7 12.4 –

28.9 11.7 –

– 2.5 – 6.1 – 2.4 5.9 4.1 – 100.0 5.9

26.9

ECB

38.5

FRB

38.8 10.3 –

27.6

BOE

–

– – – 6.0 – – 11.2 6.0 – 100.0 14.7

Central Bank NEER

–

– 5.0 – 8.9 – 3.8 14.8 8.7 – 100.0 15.8

– 25.1 –

33.8

BLBG-JPM ADXY

–

0.2 5.1 0.1 5.3 0.4 2.9 6.4 5.1 1.8 100.0 –

27.8 9.8 0.4

34.8

RIETI AMU

Currency index

Summary of various currency basket weights

–

– 1.9 – 19.4 – 13.0 2.8 2.8 – 100.0 17.0

– 45.2 –

15.0

HSBC ADBI

0.4

– 7.2 – 15.3 – 20.5 13.8 12.1 0.8 100.0 25.4

– 30.7 –

9.6

JACI

–

– 10.4 – – – 9.6 50.1 10.3 – 100.0 47.6

– 10.2 –

9.4

ELMI1

JPMorgan

Bond market index

–

– 7.3 – 13.1 – 6.1 22.3 12.1 – 100.0 22.4

– 25.3 –

13.8

ABF iBoxx

310

3.3 3.5 –

7.9

FRB

5.8 3.2 0.5

10.4

ECB

Central Bank NEER

(continued)

11.2 11.2 –

7.8

BOE

7.2 – –

15.4

BLBG-JPM ADXY

– – –

–

RIETI AMU

Currency index

– – –

–

HSBC ADBI

3.3 – –

1.2

JACI

9.4 – –

9.6

ELMI1

JPMorgan

Bond market index

– – –

–

ABF iBoxx

Note: FRB 5 US Federal Reserve Board’s NEER (nominal effective exchange rate); ECB 5 European Central Bank’s NEER; BOE 5 Bank of England’s NEER; BLBG-JPM ADXY 5 Bloomberg-JPMorgan Asia Currency Index (currency basket); RIETI AMU 5 Research Institute of Economy, Trade and Industry’s Asian Monetary Unit (currency basket); HSBC ADBI 5 HSBC’s Asian USD Bond Index (USD-denominated fixed-rate straight bonds); JACI 5 JPMorgan Asia Credit Index (USD-denominated bonds); ELMI1 5 JPMorgan Emerging Local Markets Index Plus (local currency-denominated money market instruments); ABF iBoxx 5 Asian Bond Fund iBoxx Pan-Asia Index (local currencydenominated bonds).

Taipei, China India Australia New Zealand

Economies

Table 12.1


311

The central banks construct NEERs using bilateral trade (export and import) relationships as weights. In the case of the FRB, ASEAN13 accounts for 32.7 percent of the global USD NEER, while in the case of the ECB and the BOE it accounts for only 22.0 percent and 11.6 percent of their global NEERs, respectively. In these indexes, Japan and the People’s Republic of China (PRC) naturally account for the largest weights at 27–39 percent; followed by Republic of Korea (Korea); Hong Kong; Taipei, China; and Singapore. JPMorgan also calculates the BloombergJPMorgan Asia Currency Index (ADXY) as a measure of aggregate emerging Asian currency movements (i.e. excluding the Japanese yen), using extra-East Asian (including India) trade weights. In ADXY, the pattern of important country weights is basically the same as those for central bank NEERs. The Asian Monetary Unit (AMU) constructed by Japan’s Research Institute of Economy, Trade and Industry uses trade volume and PPP-based GDP to determine currency weights. As a result, the weight assigned to China is the largest, followed by Japan, Korea, and Singapore.14 Several regional bond indexes have been constructed by the private sector. These include: (1) the Asian USD Bond Index (ADBI) calculated by HSBC; (2) the Asia Credit Index (JACI) provided by JPMorgan; (3) Emerging Local Markets Index Plus (ELMI1) calculated by JPMorgan; and (4) the iBoxx Pan-Asia Index, developed by the International Index Company Limited for the Asian Bond Fund (ABF) under the EMEAP initiative.15 In these measures, country weights vary across indexes, but large weights tend to be assigned to economies like Korea, Hong Kong, and Singapore, while smaller weights are assigned to countries like China despite the large economic size. The reason is that in bond market indexes, factors like market size, liquidity, and openness are taken into account, which make weights of economies with developed bond markets higher and those with less developed markets lower. These existing currency basket indexes suggest that depending on the objective of creating such indexes the currency weights can vary considerably. For the construction of the ACU in the current East Asian context, it is crucial to capture the importance of individual participating countries (and hence currencies) for the region’s cross-border activities in the real and financial sectors. From this perspective, an ACU index should be constructed by selecting the most appropriate economic variables and indicators—such as GDP at market exchange rates, trade volume, and financial market size and openness. Once the ACU is constructed, effective currency weights can easily be altered, a new currency can be added, and any component currency can be eliminated without causing discontinuous shifts in the basket value.

312

12.4


ECONOMIC LOGIC OF INTRODUCING AN ACU

If one of the ultimate objectives of Asian monetary and financial cooperation is the promotion of regional monetary integration and the eventual creation of a monetary union, why is an Asian currency basket useful? An ACU is a useful step towards monetary union because it facilitates creating stable exchange rates among the region’s currencies. There are two ways to establish a stable intraregional exchange rate relationship. One is for each economy to peg the exchange rate to a common key currency. The other is for regional economies to adopt collective policy measures based on certain rules—such as the “Snake” and the ERM adopted by Europe in the 1970s and 1980s. As economic, particularly structural, convergence is not sufficiently developed among East Asian economies and their political relationships are not mature enough for a tightly coordinated exchange rate arrangement, it is more realistic to select a major currency—like the US dollar, the euro, the yen, or the yuan—or a basket of global or regional currencies as exchange rate anchor for each country’s exchange rate stabilization. Here we argue that there is a strong case for selecting a basket of Asian currencies, rather than a single currency, as an anchor for exchange rate stabilization in East Asia. Dollar, Yen, or Yuan for East Asia? Until the Asian currency crisis of 1997, the general practice had been to peg currencies to the US dollar and, by so doing, indirectly stabilize intraregional values of East Asian currencies. But this “dollar standard system” revealed its flaws during the crisis. For example, for countries with strong economic ties to Japan—those beginning to satisfy optimum currency area (OCA) conditions—pegging to the US dollar meant volatile yen exchange rates because of large yen–dollar rate fluctuations. This created large financial risks in managing their economies. In addition, many East Asian economies do not satisfy OCA conditions with the US because of structural differences and dissimilar supply shocks affecting the East Asian and US economies.16 Pegging to the yen is therefore more reasonable, particularly given Japan’s economic weight in East Asia and its multinationals’ networking capacity throughout the region. Continuing economic recovery from Japan’s decade-long economic stagnation may also make the yen a strong candidate to become an East Asian anchor. But the problem is that Tokyo has not grown into a world-class financial center comparable to New York or London, and the yen has not achieved full internationalization to


313

assume the sole anchor role in the region. The US dollar remains prominent enough in the region’s finances to warrant shared status with the yen as currency anchor. Current economic trends suggest that China will surpass Japan in economic size by 2020 and the EU and the US by 2050, barring growth disruptions arising from (1) possible economic and financial crises, (2) resource, energy, and environmental constraints, or (3) political and social instability. The issue, then, is whether the yuan will become a currency that matches or even exceeds the US dollar, euro, or yen. Thus, there is strong potential for the yuan to become a key anchor currency in the region in the long run because of China’s rapid pace of economic growth and the possibility for it having greater macroeconomic influences on other East Asian economies. However, the yuan is unlikely to dominate at least for several decades. First, for the yuan to become an international currency, China must transform into a fully open economy with regard to trade, investment, and finance. The country must allow international use and holdings of its currency by liberalizing cross-border capital flows and exchange controls. Full liberalization of the capital account requires complete transition to a market economy and the establishment of a sound and resilient financial sector—which could take another 10–20 years, perhaps longer. Second, even though, in a best case scenario, China’s per capita income may rise to one-third to one-fifth of that in Japan, Europe, or the US by 2050, it is doubtful whether China can sufficiently reduce poverty, build income equality, or ensure smooth political transitions—necessary caveats for credible international currencies. Third, even if the yuan—or for that matter the yen—becomes an international currency, the question remains whether it will grow into a leading international currency that can match the US dollar. This would depend on how the US economy performs in the future. Unless serious difficulties confront the American economy— breaking the US dollar’s “law of inertia” as the incumbent international currency—it is difficult to imagine the yuan challenging the status quo.17 A Case for a Currency Basket In principle, a relatively small country’s currency—the Korean won, Thai baht, or any other East Asian currency—could also be chosen as an anchor currency, but this would be unlikely because of the economy’s small size. Thus, no single currency—be it the dollar, euro, yen, or yuan—is a good candidate as sole anchor currency for East Asia in the future. Rather, it makes sense for regional and non-regional currencies together to fulfill the requirements for an anchor. A currency basket composed of the US dollar, euro, yen, yuan and, possibly, other regional currencies would

314


Table 12.2

Choice of an anchor currency in a game between Japan and China China

Japan

Note:

US dollar yen yuan Thai baht

US dollar

yen

yuan

Thai baht

2, 2 0, 0 0, 0 0, 0

0, 0 3, 2 0, 0 0, 0

0, 0 0, 0 2, 3 0, 0

0, 0 0, 0 0, 0 1, 1

Payoffs are indicated in each cell in the order of Japan and China.

be desirable for East Asia. Although the yuan is not yet an international currency, excluding it from the basket is inappropriate given China’s growing economic stature in East Asia—particularly from a trade or competitiveness perspective. If East Asian economies stabilized their currencies against similarly defined baskets, they could achieve both relatively stable effective exchange rates and relatively stable intraregional exchange rates. Essentially the currency basket arrangement can create a stable exchange rate environment for the entire region. This point can be illustrated by a theoretical game played by Japan and China over the choice of an anchor currency (Table 12.2).18 In this game, if Japan and China propose different currencies as regional anchor for exchange rate stabilization—say Japan chooses the yen and China the yuan—there is no regionally consistent exchange rate arrangement, so each country’s pay-off is zero. If they choose the same currency as the region’s common anchor, they both benefit from exchange rate stabilization, but the country whose currency is chosen may gain more than the other (though this assumption is not crucial). If both countries choose the US dollar, the pay-offs are 2 each; if both countries choose the Thai baht, the pay-offs are 1 each; if they choose the yen, the pay-offs are 3 for Japan and 2 for China; and if they choose the yuan, the pay-offs are 2 for Japan and 3 for China. The pure-strategy Nash equilibrium is the simultaneous choice of either the US dollar, the baht, the yen, or the yuan. Within the context of ASEAN13—composed of 13 authorities as the game’s players—at least 13 Nash equilibria will be obtained (or 14 or 15 depending on whether the US dollar and/or the euro are included in the game). A mixed strategy of these multiple equilibria may be realized by choosing a basket of all these currencies, though some technical issues need to be resolved to find appropriate weights attached to the currencies.


315

The resulting currency basket includes both regional and non-regional currencies. The collection of regional currencies can be called the ACU. If non-regional currencies are excluded from the game’s considerations as candidates for East Asia’s anchor currency, then the authorities will choose a basket comprising only regional currencies, that is, the ACU. Essentially an ACU is useful because no single Asian currency is dominant as a key currency in the region.

12.5

POTENTIAL ROLE OF AN ACU FOR MONETARY AND EXCHANGE RATE POLICY COORDINATION

Once a constructed ACU index fulfills the initial objectives—serving as a statistical indicator for the purpose of currency market monitoring, and as a market index for private (and some public) sector use—the next stage could be for authorities to use the ACU for monetary and exchange rate policy coordination. At this stage, authorities may (but do not have to) give official status—such as legal tender—to the currency basket. Currently no consensus exists, even within ASEAN13, on a regional exchange rate arrangement or on the potential role of an ACU. I offer here a possible scenario on the development of such an arrangement and the potential role of an ACU.19 In this scenario, monetary and exchange rate policy coordination deepens in three stages, starting from loose policy coordination to tight policy coordination, and then to complete policy coordination. East Asian economies are already in the first stage of loose policy coordination, including the strengthening of ongoing financial cooperation initiatives—the ERPD, CMI, ABMI, and ABF under the aegis of the ASEAN13 finance ministers and central bank governors.20 Authorities have started to study ways to further strengthen the reserve pooling arrangement, going beyond the current CMI—toward multilateralization together with enhanced regional economic surveillance.21 They have made significant progress in developing local currency-denominated bond markets—including conducting studies on Asian multi-currency bond issuance and an Asian settlement system.22 At this stage, it would be best for East Asian economies to adopt policies that stabilize exchange rates against a common basket of both regional and external currencies (the US dollar, the euro, and the ACU) to ensure relative stability of their effective exchange rates and intraregional exchange rates.23 An ACU index can serve as a useful tool in measuring the degree of joint movement of East Asian currencies—for example in the context of the eventual unwinding of global payments imbalances. Once China

316


moves to a more flexible exchange rate regime, ACU index movements and divergences of component currencies from the basket can provide more meaningful information. The regional surveillance process can also focus more intensively on exchange rate issues by using an ACU index and divergence indicators. The second stage may take one of two approaches—or an appropriate combination of the two. One is the “parallel currency approach” advocated by Eichengreen (2006), which allows the ACU to freely circulate as legal tender alongside component national currencies.24 As the ACU is increasingly used by the market as a unit of account, store of value, and medium of exchange in East Asia, the role of national currencies may diminish, and there will be greater willingness to shift the role of national currencies over to the ACU, with conditions for monetary unification naturally created. This option emphasizes the role of market forces, rather than political commitment, in dictating transition to a monetary union, which is the goal of the third stage. Another is the launch of intraregional exchange-rate policy coordination along the line of European monetary integration. As East Asian economies become more integrated, achieve greater economic convergence, and hence are better positioned to commit to meaningful policy coordination, a common framework for intraregional exchange rate stabilization can be developed. This can be done by establishing an Asian “Snake” or an Asian “Exchange Rate Mechanism”. One way to do this, after a period of gathering experience and building confidence, is for all participating economies—Japan together with emerging East Asia—to shift from stabilization of their exchange rates against a common basket of external and East Asian currencies (comprising the US dollar, euro, and ACU) to a formal exchange rate stabilization against a common basket of East Asian currencies alone, that is, the ACU. Such an ACU-based exchange rate stabilization scheme requires: (1) well-defined rules for currency market interventions and monetary policy coordination, so as to establish a credible monetary anchor within East Asia; (2) a fully elaborated short-term liquidity support arrangement capable of allowing central banks’ frequent interventions in foreign exchange markets; and (3) fiscal policy rules designed to lend credibility to the exchange-rate stabilization scheme.25 Whichever approach is taken, the second stage requires both market acceptance of the ACU and significant policy initiatives. In this sense, an appropriate combination of the two approaches is realistic and desirable. This transitional stage requires greater institution building—including a regional currency and bond settlement system and a full-fledged reservepooling fund to issue or manage official ACU. The final stage, feasible only in the very long run—if ever—is to adopt


317

a single regional currency, a common monetary policy, and the delegation of monetary policy-making authority to a supranational central bank. This requires a significantly higher level of political commitment and a more heightened sense of shared community among citizens and states of the East Asian economies than currently exists.

12.6

THE WAY FORWARD

To support the ongoing process of market-driven integration, more systematic, coordinated institution building is clearly needed. While several ACU indexes can be constructed for different groups of Asian economies, ASEAN13 is a natural starting point because of its current, increasingly active financial cooperation efforts. Once introduced and operative, the ACU can become an important tool in regional economic surveillance, help develop Asian financial markets—particularly for local currencydenominated bonds—and contribute to further monetary and financial cooperation. It is clearly important for relevant finance ministers and central bank governors to coordinate fully on these initiatives. Nonetheless, its creation does not automatically guarantee the emergence of ACU-denominated bonds or the beginning of close monetary and exchange rate policy coordination. East Asia has yet to achieve significant economic and structural convergence, resilient and open financial markets—particularly bond markets—and adequate regional institutional arrangements to support policy coordination. Authorities have yet to assess the pros and cons of enhanced exchange rate policy coordination—the benefits of stable intraregional exchange rates versus the costs resulting from a potential loss of sovereignty over national monetary policymaking. The impetus toward regional exchange rate policy coordination may come sooner rather than later—when the US dollar depreciates sharply against East Asian (and other major) currencies in the unwinding process of global payments imbalances. If East Asian economies must accept currency appreciation against the dollar, they had better do so collectively—thereby ending the so-called “Bretton Woods System II”—while maintaining intraregional rate stability, so that the costs of adjustment can be spread among them and, hence, reduced for each of them. This type of informal policy coordination—which requires China’s shift toward greater exchange rate flexibility and a faster pace of yuan appreciation—has the potential to create an East Asian monetary zone, of the type observed in Europe after the collapse of Bretton Woods System I in the early 1970s. In this context, an ACU can play a useful role in boosting policy coordination across East Asia.

318


NOTES 1.

2. 3. 4.

5. 6.

7. 8.

9.

The author is grateful to Koichi Hamada and Ulrich Volz for their comments on an earlier version of the chapter, to Giovanni Capannelli for providing data, and to Guy Sacerdoti and Steve Green for their editorial assistance. The findings, interpretations, and conclusions expressed in the chapter are entirely those of the author alone and do not necessarily represent the views of the ADB, its executive directors, or the countries they represent. ASEAN13 includes the 10 ASEAN member countries (Brunei, Cambodia, Indonesia, Lao PDR, Malaysia, Myanmar, the Philippines, Singapore, Thailand and Vietnam) plus China, Japan, and Korea. EMEAP includes Australia, China, Hong Kong, Indonesia, Japan, Korea, Malaysia, New Zealand, the Philippines, Singapore, and Thailand. In Hyderabad the finance ministers of China, Japan, and Korea stated: “We noted the importance of sharing a long-term vision for financial integration in the region; we agreed on further study of related issues, including the usefulness of regional currency units, through the ASEAN13 Finance Ministers’ Process” (Joint Message, the 6th Trilateral [China, Japan, and Korea] Finance Ministers’ Meeting, May 4, 2006). The ASEAN13 finance ministers also agreed on a research project, to be led by a Japanese research institute, on “exploring steps to create regional monetary units” (Joint Ministerial Statement of the 9th ASEAN13 Finance Ministers’ Meeting, May 4, 2006). See also the earlier version of Kawai and Takagi (2005) as well as Mori et al. (2002). For example, the depreciation of the Indonesian rupiah in August 2005 relative to other East Asian currencies—called the “mini-currency crisis”—signaled that the economy required monetary tightening to contain inflation and strong fiscal measures to reduce the budget deficit. The authorities eventually took these actions and stabilized the financial market. Another example is the recent appreciation of the Korean won and, to a lesser extent, the Thai baht against the ACU, which indicate that the two economies’ international price competitiveness has declined relative to other East Asian economies. See Ito and Park (2004), Dammers and McCauley (2006), and Ogawa and Shimizu (Chapter 5, this volume) for the case for developing basket currency bonds. The ECU was defined in 1974 by the members of the European Community (EC) as a basket of participating currencies for EC accounting purposes. In 1975, the ECU became a unit of account for the European Development Fund and, later, for the European Investment Bank and for the EC budget. In 1979, European countries launched the EMS to establish a formal, more systematic mechanism for achieving intraregional exchange rate stability. To do this, they introduced (1) the Exchange Rate Mechanism (ERM) that specified rules for currency market intervention and monetary policy adjustment; (2) the very short-term financing facility that enabled central banks to intervene in currency markets without disruptions; and (3) the ECU for purposes of intraregional exchange rate stabilization. European central banks attempted to stabilize intraregional exchange rates within a narrow fluctuation band using the ECU as central parity. While European currencies remained free to fluctuate against the US dollar, whenever the value of participating currencies in the ERM reached the upper or lower limit of the fluctuation band, central banks were obliged to intervene in the currency market to keep the value within band limits. However, in practice, the German mark became a de facto anchor currency for exchange market interventions for non-German central banks and the German Bundesbank was able to maintain relatively autonomous monetary policy. Hence, the symmetrically designed ERM actually operated asymmetrically with the German mark functioning as a de facto key currency in Europe. The ECU became the newly introduced European single currency, the euro, at the start of the European Monetary Union in 1999. For two or more countries to adopt and successfully maintain a common monetary and exchange rate policy, it is necessary to achieve: (1) sufficient economic integration—for goods, services, capital and labor markets; (2) economic and structural convergence


10. 11. 12.

13. 14. 15.

319

across economies in terms of per capita incomes, market infrastructure and institutions, financial market development and openness, and monetary policy practices; and (3) political commitment to monetary integration. Though East Asia has already achieved significant economic integration through trade and foreign direct investment, the region is still weak in the other aspects. Anderson (2006) points out the importance of economic convergence in the ratios of purchasing power parity (PPP) to market exchange rates and argues that currently Asian economies have a significantly larger variation in these ratios than do the 12 countries of the euro area. See Girardin and Steinherr (2006a) for such technical discussions. Other current account transactions such as remittances and investment income flows may also be considered. Capital account openness is an important factor in encouraging capital market participants to develop ACU-denominated bonds. One of the working groups under the Asian Bond Markets Initiative (ABMI) is focusing on the possibilities of multi-currency bond issuance. Hong Kong may be added to this group as it is also an active participant of ASEAN13 finance and central bank deputies’ processes and a key member of the EMEAP. See Ogawa and Shimizu (2005) and RIETI (2006) for AMU indexes. The ABF initiative has been undertaken by 11 East Asian central banks under EMEAP as a measure to strengthen the demand side of bond markets. ABF1was launched in June 2003 to pool USD 1 billion of the region’s foreign exchange reserves to invest in US dollar-denominated sovereign and quasi-sovereign bonds issued by eight members— excluding Japan, Australia, and New Zealand. ABF2 was launched in December 2004 to invest USD 2 billion of foreign exchange reserves in eight country sub-funds, in local currencies, and the Pan-Asian Bond Index Fund (PAIF), a listed open-ended bond fund with investments across the region. See also Ma and Remolona, Chapter 4 in this volume. The ABF iBoxx Pan-Asia Index calculates the value of a bond fund investing in local currency government and quasi-government bonds in eight emerging East Asian markets. As the fund covers a variety of bond markets, a simple weighting by market capitalization would distort the index in favor of large markets such as the PRC and Korea and reduce the weight for smaller, but more developed, more liquid, and accessible markets such as Hong Kong and Singapore. Therefore, the weight of each economy starts from an equal weighting baseline and is then adjusted by factors such as (a) local bond market size (20 percent), (b) turnover ratio (20 percent), (c) sovereign local debt rating (20 percent), and (d) market openness (40 percent). The ABF iBoxx Pan-Asia Index uses the following methodology: 1. Local bond market size (S) is based on data from the Bank for International Settlements (BIS) where available, or on a consolidated average poll of the iBoxx Asian Index Committee. 2. Turnover ratio (T), considered a proxy for liquidity, is derived by comparing total transaction size to market capitalization. Transaction size is obtained through the consolidated annualized average polled from the iBoxx Asian Index Committee. 3. Sovereign local debt rating (R) is the best (highest) local currency long-term rating from Fitch, Moody’s, or S&P by converting the rating into a numerical equivalent. 4. Market openness (O) is a qualitative measurement of relative market openness, assessed on the basis of the legal and regulatory environment, the fiscal situation, market infrastructure, and back-office infrastructure—currently countries are grouped into the following categories: (a) Hong Kong and Singapore—highly open; (b) Indonesia, Korea, Malaysia, Philippines, Thailand—generally open; (c) China— relatively less open. Given the relative weights of each factor, the following adjustment factor (AF) is calculated for each economy: AF 5 0.2 S 1 0.2 T 1 0.2 R 1 0.4 O. Each country’s weight

320

16. 17.

18.

19.

20.

21.

22.

23. 24.

25.

Currency baskets for East Asia? is then calculated as the sum of the baseline weight (1/8) plus the adjustment factor: Wi 5 (1/8) 1 AFi. A technical committee and an oversight committee review the market allocations annually. The ABF iBoxx index is rebalanced monthly. Pegging to the euro would be more hazardous than pegging to the US dollar or yen because of the lesser economic linkages between East Asia and Europe. These arguments do not preclude the possibility that the yuan begins to function as an important international currency for smaller neighboring countries—such as Lao PDR, Myanmar, and Mongolia. It is said that the yuan tends to be used and held in the northern part of Lao PDR and Myanmar and in the southern part of Mongolia. This could grow as China continues its economic growth. Still, it would take a long time before the yuan becomes a credible international currency from either a worldwide or regional perspective. This is an application of the “battle of the sexes” game-theoretic model, which is a two-player coordination game. An example is the situation where a couple—Kelly and Chris—need to decide whether they want to go to the football game (Kelly’s preference) or the opera (Chris’s preference), both hoping to go to the same place rather than different ones. See Hamada (2006) for the original application of such a game. See Kawai (2006). Although there may be other scenarios, the one proposed here is general enough to capture the substance of necessary elements of any other scenario. However, views may differ across experts and policymakers with regard to the potential role of an ACU. See also Girardin and Steinherr (2006b). Though central bank governors are not formally involved in the ASEAN13 finance ministers’ process, their deputies participate in the important working groups under the finance ministers. See Kuroda and Kawai (2002), Bird and Rajan (2002), Montiel (2004), Rajan and Siregar (2004), Girardin (2004) and Kawai (2006) for a review of recent initiatives undertaken by ASEAN13 finance ministers. Through the ASEAN13 ERPD process, finance ministers meet regularly to review financial and economic issues affecting member countries. Eight members have set up “national surveillance units” or their equivalents for economic and financial monitoring and are developing their own early warning systems. In May 2005, finance ministers agreed to substantially strengthen the CMI by increasing bilateral currency swap size, linking them to regional economic surveillance, raising the level of disbursement permitted without an International Monetary Fund (IMF) program from 10 to 20 percent, and incorporating a collective decision-making mechanism for swap activation (a step toward multilateralization). Total swap size reached USD 75 billion as of May 2006. In May 2006, finance ministers tasked their deputies to further study various options toward an advanced framework of the regional liquidity support arrangement (CMI multilateralization or post-CMI). The ABMI is marshalling technical expertise and building capacity for regional bond market development. Current discussions are focusing on the creation of multi-currency bonds, establishment of a regional credit guarantee mechanism, exploration of an Asian settlement system, strengthening Asian credit rating agencies in conjunction with Basel II implementation, and development of Asian Bond Standards. See Williamson (2005 and Chapter 11, this volume) and Kawai (2006). Eichengreen (2006) considers not only the “parallel currency approach” but also many other potentially important issues on ACU by comparing them with the European ECU experience. According to his findings, Europe should have developed the “parallel currency approach” but did not; instead adopting the ERM. A practical policy in this approach would be to adopt a multi-track, multi-speed process where economies ready for deeper policy coordination start the process, while others begin readying themselves to join. A group of economies largely fulfilling optimum currency area (OCA) conditions in East Asia—like Japan and Korea; China, Hong Kong, and Macau SAR; and Singapore, Malaysia, and Brunei Darussalam—and with sufficient political commitment, may wish to initiate sub-regional currency stabilization schemes. This group would intensify monetary and exchange rate policy coordination while expecting others to join later.


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REFERENCES Anderson, Jonathan (2006). “Still Not a Great Idea.” UBS Asian Focus, May 12. Bird, Graham, and Ramkishen S. Rajan (2002). “The Evolving Asian Financia Architecture.” Princeton Essays in International Economics 226, Princeton University, Princeton, NJ. Dammers, Clifford, and Robert McCauley (2006). “Basket Weaving: The Euro Market Experience with Basket Currency Bonds.” BIS Quarterly Review March: 79–92. Eichengreen, Barry (2006). “The Parallel Currency Approach to Asian Monetary Integration.” AEA Papers and Proceedings 96: 432–6. Girardin, Eric (2004). “Information Exchange, Surveillance Systems and Regional Institutions in East Asia.” In Asian Development Bank (ed.), Monetary and Financial Integration in East Asia. The Way Ahead, Volume 1. Houndmills and New York: Palgrave Macmillan, pp. 53–95. Girardin, Eric, and Alfred Steinherr (2006a). “Lessons in the European Experience for the Creation of an Asian Currency Unit (ACU).” Mimeograph. Asian Development Bank, Manila. Girardin, Eric, and Alfred Steinherr (2006b). “Properties, Requirements, and Benefits of an Asian Currency Unit (ACU).” Mimeograph. Asian Development Bank, Manila. Hamada, Koichi (2006). “A Remark on the Political Economy of East Asia.” Mimeograph. A paper presented to the Young Leaders Forum 2006 “East Asian Integration”, organized by Japanese-German Center Berlin (JDZB), Reichenow. Ito, Takatoshi, and Yung Chul Park (2004). Developing Asian Bond Markets. Canberra: Asia Pacific Press. Kawai, Masahiro (2006). “Toward a Regional Exchange-rate Regime in East Asia.” A revised version (June) of the paper presented to the Bellagio Conference on “New Monetary and Exchange-rate Arrangements for East Asia” held in Bellagio on May 23–26, 2006. Kawai, Masahiro, and Shinji Takagi (2005). “Towards Regional Monetary Cooperation in East Asia: Lessons from Other Parts of the World.” International Journal of Finance and Economics 10: 97–116. Kuroda, Haruhiko, and Masahiro Kawai (2002). “Strengthening Regional Financial Cooperation in East Asia.” Pacific Economic Papers no. PEP-332, Australian National University, Canberra. Montiel, Peter J. (2004). “An Overview of Monetary and Financial Integration in East Asia.” In Asian Development Bank (ed.), Monetary and Financial Integration in East Asia: The Way Ahead, Volume 1. Houndmills and New York: Palgrave Macmillan, pp. 1–52. Mori, Junichi, Naoyoshi Kinukawa, Hideki Nukaya, and Masashi Hashimoto (2002). “Integration of East Asian Economies and a Step by Step Approach towards a Currency Basket Regime.” IIMA Research Report no. 2, Institute for International Monetary Affairs, Tokyo. Ogawa, Eiji, and Junko Shimizu (2005). “A Deviation Measurement for Coordinated Exchange Rate Policies in East Asia.” RIETI Discussion Paper Series 05-E-017, Research Institute of Economy, Trade and Industry, Tokyo. Rajan, Ramkishen, and Reza Siregar (2004). “Centralized Reserve Pooling for the ASEAN13 Countries.” In Asian Development Bank (ed.), Monetary and

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Financial Integration in East Asia. The Way Ahead, Volume 2. Houndmills and New York: Palgrave Macmillan, pp. 285–329. RIETI (2006). “AMU and AMU Deviation Indicators.” Research Institute of Economy, Trade and Industry, Tokyo. Williamson, John (2005). “A Currency Basket for East Asia, Not Just China.” Policy Briefs in International Economics no. PB05-1, Institute for International Economics, Washington, DC.

PART VI

The role of China

13.

The illusion of precision and the role of the renminbi in regional integration Yin-Wong Cheung, Menzie D. Chinn, and Eiji Fujii1

13.1

INTRODUCTION

On July 21, 2005, China announced a long-anticipated revision to its exchange rate regime.2 Against a backdrop of rising protectionist sentiment in the United States and increasingly acrimonious mutual recriminations over the benefits and costs of an open international financial system, the move was warmly, albeit cautiously, welcomed. The wariness arises from the uncertainty surrounding the exact nature of the new exchange rate regime and how rapidly the Chinese authorities are willing to allow the currency, the renminbi (RMB), to appreciate. So far, the increase in the RMB’s value against the dollar has been quite modest—in the order of a few percentage points. The intensity of the debate regarding the degree of RMB misalignment reflects the increasing role of China in the international arena and its rapid pace of export growth and penetration into global markets. Much of the pressure for RMB revaluation is driven by China’s rapidly growing trade surplus with the US (and more recently with the rest of the world) and its accumulation of foreign reserves. On the other hand, China’s domestic problems and its role in the regional production process have received limited attention in the debate. While the theme of the current study is not to evaluate arguments advanced for RMB revaluation, it should be noted that China’s external balances have not—until quite recently—constituted a prima facie case for RMB undervaluation. Economic theory, for instance, suggests that the RMB value should be linked to the magnitude of the overall trade balance instead of to the size of a given bilateral trade balance. Yet in 2004, China’s trade surplus relative to GDP was not particularly large compared with, say, those recorded by, say, Japan and Germany. With respect to 325

326

The role of China

reserve accumulation, however, the recent Chinese experience has been quite phenomenal. Nonetheless, official reserve holdings might be deemed insufficient as concerns over China’s contingent liabilities come to the fore. For instance, one recent study estimates that, in 2005, China’s total nonperforming loan liability, a key component of China’s contingent liability, stood at USD 900 billion, a figure higher than its reserve holdings.3 The extant discussion routinely emphasizes the impact of RMB valuation on global trade relationships and global trade imbalances. We, however, would like to emphasize the role of modern China in East Asia and, thus, the implications of China’s foreign exchange policy for the region. In this regard, two observations are worth mentioning. First, the Asian economies have tended to link their currencies to the US dollar via either a de facto or de jure peg, even after the 1997 financial crisis. As has been observed on a number of occasions, the policymakers in these economies tend to favor a stable foreign exchange environment, often perceived to be conducive to capital inflows and economic growth.4 To the extent that these currencies were stabilized at low values, the East Asian exchange rate regimes are often viewed as part of a mercantilist approach to economic development (e.g., Dooley et al. 2003 and Chapter 6, this volume). Second, the evolution of China’s position in international and regional markets is closely related to the trend toward the globalization of production. Specifically, declining transportation costs and decreasing trade barriers have precipitated the internationalization of the production process, a phenomenon variously termed production fragmentation or vertical specialization (Arndt 1997, Yi 2003). Given these circumstances, China, with its incentive structure and its abundant labor, has grown into a key production/manufacturing hub for East Asia, mainly serving as the last segment in the international production chain. A by-product of the manufacturing relocation process is an upsurge in intra-regional trade between China and its neighboring economies. The integration of China into the world economy has brought about substantial adjustment in production and trade in developing economies, especially those in East Asia. These economies, which beside their extensive production and trade linkages with China possess both real and financial sectors that are less sophisticated than those in developed countries, are very susceptible to the (adverse) effects of RMB exchange rate volatility. Thus, China’s exchange rate policy has implications for both its domestic economy and that of the wider Asian region. In this chapter, we step back from the debate about the merits of one exchange rate regime versus another5 and, indeed, do not take a stand on how large a revaluation—or devaluation—is necessary (although our conclusions will inform the debate over what the appropriate actions might be). Rather, we re-orient the discussion of currency misalignment back

Precision and the role of the renminbi in regional integration

327

toward theory and empirics; in particular, we want to focus on the difficulty in defining and calculating the “equilibrium (real) exchange rate” in theory and on quantifying the uncertainty surrounding the measurement of the level of the equilibrium. Why is such a reassessment necessary? We think it is necessary to review the evidence and conclusions in the context of the various underlying premises. That is, like the story lines in the 1950 Japanese crime drama movie Rashomon, each analyst seems to have a different interpretation of what constitutes misalignment.6 At the heart of the differences are contrasting ideas about what constitutes an equilibrium condition, to what time frame the equilibrium pertains, and, consequently, what econometric method to implement. Even when there is agreement on the fundamental model, questions typically remain about the right variables to use. The flux of exchange rate economics offers a hint of our main argument. Since Meese and Rogoff published their seminal piece on the difficulties inherent to empirical exchange rate modeling in 1983, a voluminous collection of studies echoing their conclusion has accumulated.7 Given the lack of a commonly agreed theoretical model, assertions about the equilibrium (and disequilibrium) level of an exchange rate should be guided by numerous caveats. A hasty decision on RMB policy based on not well-founded evidence can do more harm than benefit to China and to its trading partners, especially the developing economies in the region.

13.2

THE EXTANT LITERATURE

A couple of surveys of the RMB misalignment literature have compared the estimates of the degree to which the RMB is misaligned. The Government Accountability Office (GAO 2005) provides a comparison of the academic and policy literature, while Cairns (2005b) briefly surveys recent point estimates obtained by different analysts. Here, we review the literature to focus on primarily theoretical papers and their economic and econometric distinctions. Most of these papers fall into familiar categories, either relying on some form of relative purchasing power parity (PPP) or cost competitiveness calculation, the modeling of deviations from absolute PPP, a composite model incorporating several channels of effects (sometimes called behavioral equilibrium exchange rate models), or flow equilibrium models. Table 13.1 provides a typology of these approaches, further disaggregated by the data dimension (cross section, time series, or both).8 The relative PPP comparisons are the easiest to make, in terms of calculations. Bilateral real exchange rates are easy to calculate, and there are

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The role of China

Table 13.1

Time series

Studies of the equilibrium exchange rate of the renminbi

BEER Relative PPP, Absolute Balassacompetitiveness PPP–income Samuelson relationship (with productivity)

Macroeconomic balance/external balance

Wang (2004) Cheung et al.(2005a)

Bosworth (2004) Goldstein (2004) Wang (2004)

Bosworth (2004)

Cross section

Coudert and Couharde (2005) Frankel (2005)

Panel

Cairns (2005b) Cheung et al. (2005a)

Cheung et al. (2005a)

Zhang (2001) Wang (2004) Funke and Rahn (2005)

Cheung Coudert and Couharde et al. (2005a) (2005)

Notes: Relative PPP indicates that the real exchange rate is calculated using price or cost indices and that no determinants are accounted for. Absolute PPP indicates the use of comparable price deflators to calculate the real exchange rate. Balassa-Samuelson (with productivity) indicates that the real exchange rate (calculated using price indices) is modeled as a function of sectoral productivity levels. BEER indicates composite models using net foreign assets, relative tradable to nontradable price ratios, trade openness, or other variables. Macroeconomic balance indicates cases where the equilibrium real exchange rate is implicit in a “normal” current account (or combination of current account and persistent capital inflows, for the external balance approach).

now a number of trade-weighted series that incorporate China. On the other hand, relative PPP in levels requires the cointegration of the price indices with the nominal exchange rate (or, equivalently, the stationarity of the real exchange rate),9 but these conditions do not necessarily hold, regardless of the deflator adopted in empirical analyses. Wang (2004) reports interesting IMF estimates of unit labor cost deflated RMB. This series has appreciated in real terms since 1997; of course, this comparison, like all other comparisons based on indices, depends on selecting a year that is deemed to represent equilibrium. Selecting a year before 1992 would imply that the RMB has depreciated over time.


329

Bosworth (2004), Frankel (2005), Coudert and Couharde (2005), and Cairns (2005b) estimate the relationship between the deviation from absolute PPP and relative per capita income. All obtain similar results regarding the relationship between the two variables, although Coudert and Couharde fail to detect this link for the RMB. Zhang (2001), Wang (2004), and Funke and Rahn (2005) implement what could broadly be described as behavioral equilibrium exchange rate (BEER) specifications.10 These models incorporate a variety of channels through which the real exchange rate is affected. Since each author selects different variables to include, the implied misalignments will necessarily vary. Other approaches center on flow equilibria, considering savings and investment behavior and the resulting implied current account. The equilibrium exchange rate is derived from the implied medium term current account using import and export elasticities. In the IMF’s “macroeconomic approach”, the “norms” are estimated, in the spirit of Chinn and Prasad (2003). Wang (2004) discusses the difficulties in using this approach for China but does not present estimates of misalignment based on this framework. Coudert and Couharde (2005) implement a similar approach. Finally, the external balances approach relies on assessments of the persistent components of the balance of payments condition (Goldstein 2004, Bosworth 2004). This last set of approaches is perhaps most useful for conducting short-term analyses. But the wide dispersion in implied misalignments reflects the difficulties in making judgments about what constitutes persistent capital flows. For instance, Prasad and Wei (2005), examining the composition of capital inflows into and out of China, argue that much of the reserve accumulation that has occurred in recent years is a result of speculative inflow; hence, the degree of misalignment is small. Moreover, such judgments based on flow criteria must condition their conclusions on the existence of effective capital controls. This is an obvious—and widely acknowledged—point (e.g., Holtz-Eakin 2005), but one that bears repeating and, indeed, is a point that we return to at the end of this chapter. Two observations are of interest. First, as noted by Cairns (2005a), there is an interesting relationship between the particular approach adopted by a study and the degree of misalignment found.11 Analyses implementing relative PPP and related approaches indicate the least misalignment. Those adopting approaches focusing on the external accounts (either the current account or the current account plus some persistent component of capital flows) yield estimates that are in the intermediate range. Finally, studies implementing an absolute PPP methodology result in the greatest degree of estimated undervaluation.

330

The role of China

Second, while all these papers make reference to the difficulty of applying such approaches in the context of an economy ridden with capital controls, state-owned banks,12 and large contingent liabilities, few have attempted a closer examination of these issues. The current chapter, and its working paper version (denoted as Cheung et al. 2005a, in Table 13.1), contributes to this literature using the BalassaSamuelson approach (in which productivity differentials are used) and implementing panel analyses of the PPP–income relationship, augmented by variables motivated from the BEER and macroeconomic balance literature.

13.3

A SIMPLE TIME SERIES APPROACH

Before turning to the more elaborate frameworks for evaluating the value of the RMB, let us consider an approach often used in the aftermath of the East Asian crisis of the mid-1990s, namely, indicators of exchange rate overvaluation that are measured as deviations from a trend. Adopting this approach in the case of China would not lead to a very satisfactory result. Consider first what a simple examination of the bilateral real exchange rate between the US and the RMB using this measurement would imply. Figure 13.1 depicts the official exchange rate series from 1986:1 to 2005:2, deflated –1.1

Official real exchange rate ($/RMB)

–1.2 –1.3 –1.4

Trend

–1.5 –1.6 Trend for “adjusted” rate

–1.7 –1.8

“Adjusted” real exchange rate

–1.9 88

Figure 13.1

90

92

94

96

98

00

02

04

Real USD/RMB exchange rate, in logs (official and “adjusted”) and trends


331

6.0

Trade weighted value of RMB

5.6

5.2 27.5% Overvaluation 4.8

4.4

4.0 80

Figure 13.2

82

84

86

88

90

92

94

96

98

00

02

04

Real trade-weighted value of RMB, in logs, and trend

by the CPIs of the US and China (higher values constitute a stronger Chinese currency vis-à-vis the dollar). In line with expectations, in the years since the East Asian crises, the RMB has experienced a downward decline in value. Indeed, over the entire sample period, the RMB has experienced a downward trend. However, as is often the case with economies experiencing transitions from controlled to partially decontrolled capital accounts and from dual to unified exchange rate regimes, there is some dispute over what exchange rate measure to use. In the Chinese case, it could be argued that, with a portion of transactions taking place at swap rates, the 1994 “mega-devaluation” would actually be better described as a unification of different rates of exchange.13 The import of this difference can be gleaned from the fact that the imputed time trends then exhibit quite different behaviors and imply different results. Using the “adjusted” rate, one finds a modest undervaluation of 4.8 percent in the second quarter of 2005. Using the official rate would imply a slight, almost imperceptible, overvaluation of 1.4 percent. A natural reaction would be to argue that simple bilateral comparisons are faulty. We would agree. However, appealing to trade-weighted exchange rates would not necessarily clarify matters. Figure 13.2 depicts the IMF’s trade-weighted effective exchange rate index and a linear trend estimated over the available sample period 1980–2005. One finds that a simple trend (as used in the “early warning” literature) indicates that the RMB is 25 percent overvalued.

332

The role of China 6.0 Trade weighted RMB (CPI-deflated)

5.6

5.2 2.1% Undervaluation

4.8

Trade weighted RMB (PPI-deflated)

4.4

4.0 80 Sources:

82

84

86

88

90

92

94

96

98

00

02

04

IMF, Deutsche Bank, and author’s calculations.

Figure 13.3

Real trade-weighted indices of RMB, in logs, and segmented trend

A cursory glance at the data indicates that a simple trend will not do. A test on residuals from recursive regression procedure applied to the constant plus trend suggests a break with maximal probability in the third quarter of 1986. Fitting a broken trend—admittedly an ad hoc procedure—provides a fairly good fit, as illustrated in Figure 13.3. In the second portion of the sample, the estimated trend is essentially zero, a result that is consistent with purchasing power parity. Obviously, a more formal test for stationarity is necessary. Following the methodology outlined in Chinn (2000a), we test for cointegration of the nominal (trade-weighted) exchange rate and the relative price level.14 We find that there is evidence for cointegration of these two variables, with the posited coefficients.15 This means that we can use this trend line as a statistically valid indication of the mean value to which the real exchange rate series reverts. Interestingly, even here, the procedure indicates a very modest 2.1 percent undervaluation. These conclusions are not sensitive to the index. Using Deutsche Bank’s PPI-deflated index, similar movements in the RMB are detected. Before we move on to the next section, we should point out that the data in Figures 13.1 and 13.2 are indexes and do not give the exact exchange


333

value of the underlying currencies. To be sure, the conclusion regarding overvaluation or undervaluation depends on how the trend line is drawn, which in turn depends on the starting point of the sample.

13.4

THE PRODUCTIVITY APPROACH

The role of productivity is central to thinking about the evolution of the Chinese currency. The standard point of reference in thinking about the impact of productivity is the Balassa-Samuelson theory, which focuses on the differential between traded and nontraded sectors (Balassa 1964, Samuelson 1964). Interestingly, to our knowledge, nobody has attempted to estimate the link between sectoral productivity estimates and the real exchange rate for China, with the exception of Chinn (2000b).16 Nontradables, Productivity, and the Real Exchange Rate in Theory Most investigations of the link between the relative price of nontradables and the real exchange rate rely on the following construction. Let the log aggregate price index p be given as a weighted average of log price indices of traded (T) and nontraded (N) goods given by the relationship: pt 5 (1 2 a) pTt 1 apN t ,

(13.1)

where a is the share of nontraded goods in the price index. Suppose further that the foreign country’s aggregate price index is similarly expressed by: T* N* p* t 5 (1 2 a*) p t 1 a*pt .

(13.2)

Then, the real exchange rate is given by: qt ; (st 1 p*t 2 pt) 1 k,

(13.3)

where s is the log of the domestic currency price of foreign currency and k is a constant accounting for the fact that the price levels are indices. In other words, even though productivity is being accounted for, the very fact that we only have price and productivity indices means that we can only evaluate deviations from a relative PPP modified for productivity differentials. For a 5 a*, the following holds: T N* T* qt 5 (st 1 pTt 2 pTt *) 2 a [ ( pN t 2 pt ) 2 ( p t 2 p t ) ] 1 k. (13.4)

334

The role of China

Although there are many alternative decompositions that can be undertaken, equation (13.4) is the most relevant, since most economic models make reference to the second term as the determinant of the real exchange rate, while the first is assumed to be zero by the application of purchasing power parity to traded goods. In order to move away from accounting identities, one requires a model, such as the Balassa-Samuelson framework. The relative prices of nontradables and tradables will be determined solely by productivity differentials, under the stringent conditions that capital is perfectly mobile internationally and that factors of production are free to move between sectors. Substituting out for relative prices yields: | N * T* T* /q ) a t 2 aNt *] 1 k , qt 5 (st 1 pTt 2 pTt *) 2a [ (qN /qT ) aTt 2 aN t ] 1a [ (q (13.5) where ai is total factor productivity in sector i (i 5 N, T ) and the q’s are parameters in the production functions.17 Most researchers have proceeded under the assumption that the first term is I(0). This implies cointegrating relationships of the forms: T N* T* qt 5 2 a ( pN t 2 pt ) 1 a ( p t 2 p t )

(13.6)

T* N* qt 5 2 a [ aTt 2 aN t ] 1 a [at 2 a t ]

(13.7)

N* qt 5 2 a [ aTt 2 aTt *] 1 a [ aN t 2 a t ],

(13.79)

and

respectively (where the production functions in the tradable and nontradable sectors are assumed to be the same, so that the q’s cancel out in equation (13.7) and the constants are suppressed). Equation (13.6) underpins the analysis by Funke and Rahn (2005). Equation (13.79) provides the basis for the empirical work in this section.18 Econometric Specification, Data, and Results The cointegrating relationship is identified using dynamic OLS (DOLS; Stock and Watson 1993). One lead and one lag of the right hand side variables are included. In a simple two-variable cointegrating relationship, the estimated regression equation is: 11

q 5 b0 1 b1x 1 a giDxt1i 1 ut. i5 21

(13.8)


335

Although this approach presupposes that there is only one long-run relationship, this requirement is not problematic, as in these extended samples at most one cointegrating vector is usually detected.19 A deterministic trend is also allowed in equation (13.8). We take the two countries to be the US and China. In principle, it would be preferable to consider China vs. the rest of the world. However, data considerations, plus the fact that the misalignment debate revolves around the US–China nexus, motivate us to adopt this perspective. The data issues present the largest challenges. The straightforward calculations involve the exchange rate and the US variables, although, even in the former instance, there are some calculations. For reasons discussed in section 13.1, we do not rely on the official exchange rate in the years directly leading up to 1994. Rather, the real RMB/USD rate is measured using the nominal exchange rate, which is then “adjusted”, following Fernald et al. (1999), as described above, and then deflated by the respective CPIs. US data are derived from the Bureau of Labor Statistics and the Groningen Growth and Development Center. Once one has to determine the appropriate Chinese productivity numbers, one enters a data quagmire. As is well known, even deciding on the appropriate estimate of Chinese GDP can be a contentious matter (see Rossi 2005). As demonstrated in Young’s (2003) dissection of Chinese data, small changes in assumptions regarding the validity of the output numbers and the deflators can radically alter the implied output per worker and total factor productivity series substantially. Hence, all the estimates provided in this section should be viewed as heroic in nature. Forging ahead, we follow the method adopted in Chinn (2000b). Average labor productivity, obtained by dividing real output in sector i by labor employment in the same sector, is used as the proxy for sectoral total factor productivity.20 The tradables sector is proxied by the manufacturing sector, while the nontradables is proxied by the “other” sector. This latter sector is defined as those sectors besides mining, manufacturing, and agriculture. Two limitations of the data should be emphasized. First, since these labor employment statistics are not adjusted for part-time workers, the constructed sectoral productivity data are cross-checked using the manufacturing productivity reported by the World Bank’s World Development Indicators for several countries. The productivity figures from these two sources match quite well. Further, these series also match quite well for both manufacturing versus tradables and “other” versus nontradables. These outcomes serve to improve one’s confidence that the proxies used are not implausible. Second, the proxy variable is labor productivity, rather than total factor productivity (TFP) as suggested by the model. Canzoneri et al. (1996)

336

The role of China 2.0

1.6 Real manufacturing output divided by manufacturing employment

1.2

0.8

Szirmai et al. manufacturing productivity

0.4

0.0 86

Figure 13.4

88

90

92

94

96

98

00

02

04

Measures of Chinese manufacturing productivity (in logs, normalized to 1986 5 0)

have argued that use of labor productivity is to be preferred because it is less likely to be tainted by misestimates of the capital stock. In any event, there is little possibility of circumventing this problem. To our knowledge, almost all calculations of East Asian TFP over long spans of time have been conducted on an economy-wide basis, with a few exceptions, including Young (1995, 2003). In addition to the productivity series calculated in the described manner, we also relied on a productivity series obtained via a careful analysis of the state-owned enterprise (SOE) and township and village enterprise (TVE) output and employment figures reported by Szirmai et al. (2005). The two Chinese manufacturing productivity series, in logs, normalized to 198650, are shown in Figure 13.4. The productivity growth rates are 9.5 percent and 7.1 percent, respectively, over the 1987–2003 period. These are more rapid than the US manufacturing growth rate of 4.6 percent over the same period. Figure 13.5 depicts the Chinese “other” productivity series, which grows at a rate of 5.0 percent (compared to 2.0 percent for the US). The DOLS results for estimations over the 1988–2002 period are reported in Table 13.2.21 The estimates based on productivity numbers calculated using output and employment figures are reported in columns [1]–[4], while those based on the manufacturing estimates from Szirmai et al. (2005) are reported in columns [5]–[8].


337

1.0

0.8

Real “other” output divided by “other” employment

0.6

0.4

0.2

0.0

–0.2 86

Figure 13.5

88

90

92

94

96

98

00

02

04

The measure of “other” productivity (in logs, normalized to 1986 5 0)

In column [1], estimates from the most basic specification, corresponding to equation (79), indicate that each 1 percent increase in Chinese manufacturing productivity over US productivity results in a half percentage point appreciation in the RMB against the dollar, in real terms. Increases in nontraded sector productivity depreciate the RMB, in line with the theoretical prediction. However, the point estimate is somewhat large; in general, when the productivity coefficients in the tradable and nontradable sectors are similar, the coefficient should be about equal to the share of nontradables in the aggregate price index. On the other hand, the standard error is so large that the 61 standard error bands encompass plausible values of a. In column [2], the specification is augmented by a time trend. The point estimate for the coefficient on traded sector productivity is now larger in absolute value; however, neither the nontradables term nor the time trend itself is statistically significant, casting doubt on the relevance of this specification. Constraining the coefficients on tradables and nontradables productivity to be the same yields a deterioration in the fit (the adjusted R2 declines, while the standard error of regression increases). Augmenting the constrained specification with a time trend produces estimates that are correctly signed and ascribes a large portion of the secular movement in the RMB—3.5 percent per year—to the time trend. This is certainly an undesirable result for prediction purposes, since the time trend is a proxy for our ignorance.

338

(1)

Other prod.

15 0.049

15 0.049

[0.527] 0.028 [0.022]

[0.516]

0.76

[2] −0.921 [0.231] 1.087

[1] −0.556 [0.184] 1.122

0.77

Official deflator

Official deflator

15 0.054

0.71

[0.088]

[3] −0.275 [0.088] 0.275

Official deflatora

15 0.046

0.8

[0.224] 0.035 [0.009]

[4] −0.987 [0.224] 0.987

Official deflatora

15 0.047

0.79

[0.748]

[5] −1.322 [0.550] 1.788

Szirmai Mfg.

15 0.050

0.76

[0.724] −0.007 [0.014]

[6] −1.204 [0.616] 1.882

Szirmai Mfg.

15 0.053

0.73

[0.242]

[7] −0.512 [0.242] 0.512

Szirmai Mfg.a

15 0.052

0.73

[0.735] 0.010 [0.008]

[8] −1.145 [0.735] 1.145

Szirmai Mfg.a

Notes: “Official deflator” refers to estimates obtained using productivity figures calculated using official deflator as reported by Holz (2005); “Szirmai” refers to estimates obtained using manufacturing productivity numbers reported in Szirmai et al. (2005). All estimates use estimated effective exchange rate as described in Fernald et al. (1999). Estimates obtained using dynamic OLS (DOLS) with one lead and lag of the right hand side variables. “Mfg.” (“Other”) productivity is the differential labor productivity in the manufacturing (other) sectors. “Pred.” is the predicted sign according to the Balassa-Samuelson hypothesis. SER is the standard error of regression. N is the number of observations. a Manufacturing and Other productivity are constrained to have equal and opposite signs.

Adjusted R2 N SER

Trend

(−)

Pred.

Balassa-Samuelson model of real exchange rate of renminbi, 1988–03

Mfg. prod.

Table 13.2


339

Using the Szirmai et al. (2005) manufacturing numbers produces interesting results. In column [5], the coefficients are correctly signed, albeit somewhat large in absolute value. Interestingly, the point estimates are not sensitive to the inclusion of a time trend (column [6]). Constraining the coefficients on tradable and nontradable productivity to be equal yields plausible estimates of a. Including a time trend, as in column [8], produces more imprecisely estimated coefficients, while leaving the time trend insignificant. For reasons already alluded to, one may be dubious about these results. An additional reason for skepticism is that the sample covers quite a short period; using the DOLS approach results in a sample of only 15 observations. An obvious question is why we do not extend the sample backward. Two reasons guide our sample choice. First, the data are available on a more or less consistent basis over this time period. Second, and perhaps of even greater importance, it is not clear whether extending the data back in time would be appropriate. The end of the second phase of economic liberalization, which severed the link between firm management and the government’s economic plan objectives, roughly coincides with the beginning of the sample. The data can be extended backward in time. Splicing data utilized in Chinn (2000b) to the series discussed above, the DOLS regressions can be re-estimated over the 1980–2004 period. This produces a sample of 22 observations (or 25, if simple OLS is implemented). The results are surprisingly similar to those reported in the first two columns of Table 13.2. The elasticity of the real exchange rate with respect to the intercountry traded sector productivity differential for the extended data set is 20.50, versus −0.56 for the truncated data used in Table 13.2, while the nontraded differential has an implausibly large impact of 2.2, versus the truncated data set’s 1.1. The pattern of estimates persists even with the inclusion of a time trend.22 To sum up, it appears that, regardless of the measure of manufacturing productivity used, the coefficient estimates point in the directions predicted by the Balassa-Samuelson hypothesis. Implied RMB Misalignment In order to assess whether the RMB is misaligned, we take the long-run coefficients from columns [1] and [5] of Table 13.2 and generate long-run predicted values. One difficulty in conducting the assessment for the recent period is that the sectoral output and employment data are available only up to 2003. Indeed, the estimated manufacturing labor productivity data

340

The role of China 1.9 Real bilateral exchange rate (RMB/USD)

1.8

1.7

1.6

1.5

1.4

Estimated productivity

Szirmai mfg. productivity 1.3 88

Figure 13.6

90

92

94

96

98

00

02

04

Real bilateral (“adjusted”) exchange rate and predicted long run rate, in logs, based on estimated productivity and Szirmai et al. (2005) manufacturing productivity

from Szirmai et al. (2005) extend only up to 2002. We assume that, for the latter, the productivity growth rates in 2003 and 2004 are the same as the 2002 rate of 9.1 percent, while, for the former, the 2004 rate equals the 2003 rate of 4.8 percent. Figure 13.6 depicts the results (higher values of the exchange rate imply weaker values of the RMB against the USD). Using the estimated productivity data, the RMB is only about 6.1 percent undervalued in 2004. Interestingly, the greatest degree of undervaluation is in 1993 (about 30 percent), and it drops in 1994 (to 16 percent), despite that year’s “devaluation”. Using the Szirmai et al. (2005) data, the 2004 undervaluation is negligible, at about 1.4 percent. These counter-intuitive results suggest that something may be missing from this approach. This framework assumes that the relative prices of tradable and nontradable goods are determined solely by the relative production prices. This assumption, in turn, relies on the assumption of homothetic preferences across different per capita income levels. But this is unlikely to be the case; hence, relative prices might be changing for reasons apart from differing productivity trends. In fact, the argument that much of the spectacular growth in Chinese income is a result of labor reallocation rather than rapid sectoral productivity growth is consistent with this view.23


341

Another difficulty with this approach is that it relies on the relationship holding over the sample period. If the entire sample period were one in which the Chinese economy were adjusting toward a condition under which the Balassa-Samuelson hypothesis would hold—without actually achieving that condition—then this approach would be inappropriate. This is not a difficulty specific to the current approach. It also occurs in cases in which one is empirically validating purchasing power parity in levels but using price indices. The limitation of such approaches, based on indices, motivates the use of measurements with which price levels can directly be compared.

13.5

REAL EXCHANGE RATE AND INCOME REGRESSION

In this section, we appeal to cross-country time-series evidence on the determinants of the real exchange rate, where the real exchange rate is measured in such a way that one can identify deviations from absolute purchasing power parity. We conduct the analysis in the following manner. First, we appeal to the well-known cross-sectional relationship between the relative price level and relative per capita income levels to determine whether the Chinese currency is undervalued. Obviously, this approach is not novel; it has been implemented recently by Coudert and Couharde (2005) and Frankel (2005). However, we expand this approach along several directions. First, we augment the approach by incorporating the time series dimension.24 Second, we explicitly characterize the uncertainty surrounding our determinations of currency misalignment. Frankel (2005) exploits the well-known relationship, noted in Summers and Heston (1991), between the real exchange rate and per capita income, as recorded in the Penn World Tables. When the real exchange value of a currency is expressed as the price in common currency terms (“International dollars”) relative to the US price level, there is a positive, monotonic relationship to the relative per capita income. We amass a large data set encompassing up to 158 countries, over the 1975–2003 period. (Because some data are missing, the panel is unbalanced.) Most of the data are drawn from the World Bank’s World Development Indicators (WDI) and the Penn World Tables (PWT; Summers and Heston 1991). Since the PWT data end with 2000, we update the sample using the WDI data up to 2003. Greater detail on the data used in this subsection and elsewhere is reported in Appendix 13.1. We estimate the relationship using a pooled time-series cross-section regression, where all variables are expressed in terms relative to the US.

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The role of China

The results are reported in Table 13.3, for cases in which we measure relative per capita income in terms of either market rates or PPP based exchange rates. Furthermore, to examine the robustness of the results with respect to different specifications, we report not only the pooled time-series cross-section estimates (our preferred specification) but also fixed effects and random effects models. 25 In all cases, the elasticity of the price level with respect to relative per capita income is always around 0.22–0.33, which compares favorably with Frankel’s (2005) 1990 and 2000 year cross-section estimates of 0.38 and 0.32, respectively.26 Interestingly, the elasticity estimate does not appear to be sensitive to measurements of per capita income. In Tables 13.4 and 13.5, the actual and resulting predicted and standard error bands are reported. We make two observations about these misalignment estimates. First, the RMB has been persistently undervalued by this criterion since the mid1980s, even in 1997 and 1998, when China was lauded for its refusal to devalue its currency despite the threat to its competitive position. Second, and perhaps most importantly, in 2003 the RMB was more than one standard error—but less than two standard errors—away from the predicted value, which in the present context is interpreted as the “equilibrium” value. In other words, by the standard statistical criterion that applied economists commonly appeal to, the RMB is not undervalued (as of 2003) in a statistically significant sense. Note that this result relies on an agreement that we have identified the correct model; whether we estimate the true specification adds another layer of uncertainty. Figures 13.7 and 13.8 provide a graphical depiction of the actual versus predicted values (for USD and PPP based per capita incomes), the prediction intervals, and how the RMB fits into the more general relationship. The wide dispersion of observations in the scatter plots should give pause to those who would make strong statements regarding the exact degree of misalignment. It is interesting to consider the path that the RMB has traced out in these graphs. It starts out in the samples as overvalued, and over the next three decades it moves toward the predicted equilibrium value and then overshoots, so that, by 2003, it is substantially undervalued—by between 47 percent and 54 percent in level terms (greater in log terms) by these point estimates. Notice that the deviations from the conditional mean are persistent; this has an important implication for interpreting the degree of uncertainty surrounding these measures of misalignment. This suggests that deviations from the PPP–relative income relationship identified by the regression are persistent, or exhibit serial correlation. Frankel (2005) makes a similar observation, noting that half of the deviation of the RMB from

343

3880

0.245*** (0.003) −0.023** (0.009) 0.483

Pooled OLS

0.252*** (0.016) −0.041 (0.052) 0.601

Between

0.752 27.871***

0.330*** (0.032) –

Fixed effects (within)

USD-based GDP per capita

3.277*

0.276*** (0.012) 0.026 (0.043) 0.483

Random effects

3880

0.294*** (0.006) −0.140*** (0.012) 0.338

Pooled OLS 0.297*** (0.028) −0.183*** (0.064) 0.399

Between

0.745 40.466***

0.217*** (0.032) –

Fixed effects (within)

PPP-based GDP per capita

Panel estimation results of the absolute PPP plus (ln(price) 5 c 1 b1*ln(GDPpc) 1 u)

1.410

0.250*** (0.017) −0.272*** (0.044) 0.338

Random effects

Notes: Unbalanced panel of 174 countries × 29 years (1975–2003). ***, **, and * indicate 1 percent, 5 percent, and 10 percent levels of significance, respectively. Heteroskedasticity-robust standard errors are in parentheses. N is the number of observations.

Adjusted R2 F-test for homo. c Hausman Chi-sq(1) N

Constant

GDP p.c.

Table 13.3

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The role of China

Table 13.4

Actual and predicted price levels for China by panel (pooled OLS): USD-based GDP per capita

Year

Actual

1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

−0.245 −0.344 −0.354 −0.308 −0.272 −0.287 −0.486 −0.661 −0.716 −0.872 −1.041 −1.174 −1.233 −1.161 −1.114 −1.331 −1.406 −1.385 −1.313 −1.555 −1.443 −1.399 −1.405 −1.453 −1.490 −1.510 −1.522 −1.530 −1.517

Notes:

Predicted 12 std. err.11 std. err. −1 std. err. −2 std. err. −1.249 −1.267 −1.261 −1.248 −1.239 −1.220 −1.215 −1.190 −1.176 −1.160 −1.140 −1.129 −1.111 −1.097 −1.097 −1.093 −1.071 −1.046 −1.021 −1.002 −0.983 −0.969 −0.959 −0.950 −0.944 −0.933 −0.915 −0.900 −0.885

−0.452 −0.470 −0.464 −0.451 −0.442 −0.423 −0.418 −0.393 −0.380 −0.363 −0.343 −0.332 −0.315 −0.300 −0.300 −0.296 −0.274 −0.249 −0.224 −0.205 −0.186 −0.173 −0.162 −0.153 −0.147 −0.136 −0.119 −0.103 −0.088

−0.851 −0.869 −0.863 −0.850 −0.840 −0.822 −0.816 −0.791 −0.778 −0.761 −0.741 −0.730 −0.713 −0.698 −0.699 −0.695 −0.673 −0.648 −0.623 −0.603 −0.585 −0.571 −0.561 −0.552 −0.545 −0.534 −0.517 −0.502 −0.487

−1.647 −1.666 −1.660 −1.647 −1.637 −1.619 −1.613 −1.588 −1.575 −1.558 −1.538 −1.527 −1.510 −1.495 −1.495 −1.491 −1.469 −1.445 −1.420 −1.400 −1.381 −1.367 −1.357 −1.348 −1.342 −1.331 −1.313 −1.298 −1.283

−2.046 −2.064 −2.058 −2.045 −2.035 −2.017 −2.011 −1.986 −1.973 −1.957 −1.936 −1.925 −1.908 −1.894 −1.894 −1.890 −1.868 −1.843 −1.818 −1.798 −1.780 −1.766 −1.756 −1.747 −1.740 −1.729 −1.712 −1.697 −1.682

Values in log terms. Based on Table 13.3, USD pooled estimates.

the 1990 conditional mean exists in 2000. We estimate the autoregressive coefficient in our sample at approximately 0.74 to 0.84 (based on USD and PPP based per capita income figures, respectively) on an annual basis. A simple, ad hoc adjustment based on the latter estimate suggests that the standard error of the regression should be adjusted upward by a factor equal to [ 1/ (1 2 r^ 2) ] 0.5 < 2. Figure 13.9 depicts the same data as presented in Figure 13.8, but with the standard errors adjusted to account for the serial correlation. In this case, the actual value of the RMB is always


345

Table 13.5

Actual and predicted price levels for China by panel (pooled OLS): PPP-adjusted GDP per capita

Year

Actual

1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

−0.245 −0.344 −0.354 −0.308 −0.272 −0.287 −0.486 −0.661 −0.716 −0.872 −1.041 −1.174 −1.233 −1.161 −1.114 −1.331 −1.406 −1.385 −1.313 −1.555 −1.443 −1.399 −1.405 −1.453 −1.490 −1.510 −1.522 −1.530 −1.517

Notes:

Predicted +2 std. err. +1 std. err. −1 std. err. −2 std. err. −1.176 −1.199 −1.190 −1.175 −1.164 −1.141 −1.134 −1.101 −1.090 −1.068 −1.044 −1.033 −1.010 −0.990 −0.994 −0.991 −0.964 −0.935 −0.906 −0.883 −0.854 −0.837 −0.825 −0.810 −0.802 −0.786 −0.765 −0.750 −0.735

−0.274 −0.297 −0.289 −0.274 −0.263 −0.240 −0.232 −0.200 −0.188 −0.167 −0.143 −0.131 −0.109 −0.089 −0.092 −0.089 −0.063 −0.034 −0.005 0.019 0.048 0.064 0.076 0.091 0.099 0.115 0.136 0.151 0.166

−0.725 −0.748 −0.740 −0.724 −0.713 −0.691 −0.683 −0.650 −0.639 −0.617 −0.593 −0.582 −0.560 −0.539 −0.543 −0.540 −0.514 −0.485 −0.455 −0.432 −0.403 −0.386 −0.374 −0.359 −0.351 −0.336 −0.315 −0.299 −0.285

−1.627 −1.649 −1.641 −1.626 −1.615 −1.592 −1.584 −1.552 −1.541 −1.519 −1.495 −1.483 −1.461 −1.441 −1.444 −1.441 −1.415 −1.386 −1.357 −1.333 −1.304 −1.288 −1.275 −1.261 −1.253 −1.237 −1.216 −1.201 −1.186

−2.078 −2.100 −2.092 −2.077 −2.066 −2.043 −2.035 −2.003 −1.991 −1.969 −1.946 −1.934 −1.912 −1.891 −1.895 −1.892 −1.866 −1.837 −1.807 −1.784 −1.755 −1.738 −1.726 −1.711 −1.703 −1.688 −1.667 −1.651 −1.636

Values in log terms. Based on Table 13.3, PPP pooled estimates.

within one standard error prediction interval surrounding the equilibrium value.

13.6

IMPLICATIONS FOR FOREIGN EXCHANGE POLICY

The key rationale for undertaking this study was our strongly held conviction that many strong policy recommendations were being made on the

346

The role of China Relative price level

1.5 1 0.5

China 1975

0 –0.5 –1 –1.5 –2 China 2003

–2.5 –3

–7

–6

–5

–4

regression line

–3.5 –3 –2 –1 0 1 2 Relative per capita income in USD terms 1 standard error

2 standard error

Figure 13.7 Scatter plot of relative price level against relative per capita income (in USD), conditional mean, and prediction intervals

Relative price level

1.5 1 0.5

China 1975

0 –0.5 –1 –1.5 –2 China 2003 –2.5 –3 –5

–4

–3

–2

–1

–3.5 0

1

2

Relative per capita income in PPP terms regression line

Figure 13.8

1 standard error

2 standard error

Scatter plot of relative price level against relative per capita income (in PPP terms), conditional mean, and prediction intervals

Precision and the role of the renminbi in regional integration Relative price level

347

3 2

China 1975

1 0 –1 –2 China 2003 –3

–5

–4

–3

–2

–1

–4 0

1

2

Relative per capita income in PPP terms regression line

Figure 13.9

1 standard error

2 standard error

Scatter plot of relative price level against relative per capita income (in PPP terms), conditional mean, and serial correlation adjusted prediction intervals

basis of weak empirical evidence or vague theoretical underpinnings. In particular, we think that there needs to be some humility in recognizing the limitations of our knowledge regarding the appropriate model and the true nature of the relevant data. In this study, contrary to the standard approach, we have documented the extent of our ignorance. The results should give one pause for thought. It may be that the Chinese currency is 20 to 40 percent undervalued, as suggested by the macroeconomic balance approach. But that degree of misalignment pertains to a view of what constitutes equilibrium that obtains when the current account balance offsets the normal level of capital inflows as judged by some usually arbitrary criterion. The normal level, in turn, pertains to specific macroeconomic conditions that might—or might not—persist. The biggest uncertainty pertains to shocks that are difficult to model but could nonetheless induce large changes to the equilibrium value of the exchange rate—namely, the shocks that could spring from contingent liabilities and loopholes of capital controls. The mere act of quickly revaluing—or of moving to a relatively free float—might in itself change the equilibrium exchange rate if it triggers corporate defaults or causes changes in the balance sheets of unhedged firms. The end of capital

348

The role of China

controls, either by fiat or by slow erosion, might also alter the equilibrium exchange rate. It is also important to note that the regime of currency stability has up to this point served China well. The refusal of China to accede to competitive devaluation in the wake of the 1997 financial crisis helped facilitate the recovery of the other East Asian economies. During the same period, the intensity of integration between China and its neighboring economies, as measured by intra-regional trade and financial transactions, was probably encouraged by the stable value of the RMB. Thus, one natural concern is whether the Chinese economy, given its fragile financial systems and hidden domestic economic problems, is capable of handling a floating RMB exchange rate without incurring a substantial domestic economic backlash that would cause substantial repercussions for the regional and even the global economies. Even though some people perceive China to be a market economy, the reality is that China is still intrinsically a transitional economy with a relatively primitive and inefficient banking and financial sector. It is still in the early stage of devising and developing a prudential legal and regulatory framework that promotes governance and financial stability. It is highly questionable whether the current Chinese economy can withstand the potential financial instability induced by full foreign exchange flexibility. A volatile RMB exchange rate would most likely impede China’s economic progress. We also believe that China’s Asian trading partners would suffer more from its economic slowdown than they would benefit from a stronger RMB. A volatile RMB is likely to impose extra costs on the integration between China and its neighboring economies and hinder the cooperation between these economies. With a growing role in an uncertain world, China’s foreign exchange policy can have unexpected (instead of expected) effects on the world in general and on other regional economies in particular. Thus, in designing her exchange rate policy, China should not only consider the policy’s short-term and long-term impacts on the Chinese economy but also take into account the policy’s implications for the region. That being said, we do believe that China should pursue a policy of gradually allowing the RMB to appreciate. Both the macroeconomic balance and real exchange rate–income models suggest some undervaluation. One can think of these two models as bracketing the short run and the long run. The productivity based model is perhaps relevant to the idea of competitiveness over time, and even here there is some doubt. So the implied direction of change is dependent on the horizon. Nonetheless, in order to get to the medium run and the long run, one has to get through the short run. The rapid accumulation of foreign exchange reserves in 2005—in contrast to that in the earlier years—can be attributed


349

to a burgeoning current account surplus that has placed strains on the Chinese economy. With the fragile banking system having difficulties with assimilating this reserve accumulation, it makes sense for Chinese policymakers, in their own interests, to slow the pace of acquisition of dollar assets. The actual value of the RMB-USD exchange rate is not itself so crucial in this respect.

NOTES 1.

2. 3. 4. 5. 6.

7. 8. 9. 10. 11. 12. 13. 14.

We thank Hoyt Bleakley, Henning Bohn, Robert Dekle, Mick Devereux, Michael Frömmel, Reuven Glick, Linda Goldberg, Koichi Hamada, Randall Henning, Owen Humpage, Gary Jefferson, Michael Klein, Inpyo Lee, Jaewoo Lee, Ron McKinnon, Eiji Ogawa, Eswar Prasad, Andy Rose, Margot Schüller, Ulrich Volz, Tom Willett, and participants of the Federal Reserve Bank of San Francisco conference on “External Imbalances and Adjustment in the Pacific Basin”, the HWWA/HWWI Conference on “East Asian Monetary and Financial Integration”, and the 2006 ACEAS panel at the ASSA Meetings for helpful comments. Dickson Tam and Jian Wang provided excellent assistance in collecting data, while Hiro Ito and Michael Spencer provided us with data. An earlier version of the chapter was circulated under the title “Why the Renminbi Might Be Overvalued (But Probably Isn’t)”. Cheung, Chinn, and Fujii gratefully acknowledge the financial support of faculty research funds from the University of California at Santa Cruz and the University of Wisconsin and of the Japan Center for Economic Research grant, respectively. The views expressed are solely those of the authors and do not necessarily represent the views and opinions of institutions with which the authors are, or have been, associated. We use the term “China” to refer to the People’s Republic of China, exclusive of Hong Kong, SAR, Macao, SAR, and Taiwan, ROC, sometimes referred to as Chinese Taipei or Taipei, China. Ernst & Young (2006). The subsequent retraction of this report by the company does not negate the fact that there are substantial amounts of nonperforming loans, the estimation of which is surrounded by considerable uncertainty. See Calvo and Reinhart (2000) for an explication of the “fear of floating” phenomenon. See among others, Eichengreen (2005), Goldstein (2004), Prasad et al. (2005), and Williamson (2005). For a review of the concepts of misalignment and the distinction between short run and long run disequilibria, see articles in Hinkle and Montiel (1999). As Frankel (2005) observes, there is a question about whether there is such a thing as an “equilibrium” exchange rate when there are two or more targets (e.g., internal and external equilibrium). Meese and Rogoff (1983). Cheung et al. (2005c, 2005d) present some recent evidence on this issue. Note that several authors rely on multiple approaches. For a technical discussion, see Chinn (2000a). Also known as BEERs, a composite of exchange rate models. All the studies reviewed by Cairns imply undervaluation or no misalignment. See Cheung et al. (2005b) for a description of how financial links between the rest of the world and China are mediated by capital controls and the banking system. See Fernald et al. (1999) for a discussion in the context of whether the 1994 “devaluation” caused the 1997–98 currency crises. See Cheung and Lai (1993a) for a motivation for using the cointegration technique to investigate the stationarity of real exchange rates.

350 15. 16. 17. 18.

19.

20.

21. 22.

23. 24. 25.

26.

The role of China See Appendix 13.2 for detailed results. Ceglowski and Golub (2005) do calculate relative unit labor costs. If one thought that unit labor costs should be equalized, this would provide a basis for a calculation of equilibrium exchange rates, based solely on the tradables (manufacturing) sector. Note that if the production functions have the same form in the two sectors, then the qs drop out. Both equations have been exploited extensively. Equation (13.6) has been examined by Kakkar and Ogaki (1999) for several exchange rates. Equation (13.7) has been estimated by Hsieh (1982), Marston (1990), and most recently Choudhri and Khan (2004) and Tang and Lee (2003). Application of the Johansen maximum likelihood procedure indicates evidence of cointegration at the 5 percent marginal significance level, using asymptotic critical values. The procedure is implemented by including two lags of the first differences (i.e., a VAR(3) in levels). The cointegration result holds irrespective of whether a deterministic trend is allowed for in the cointegrating vector or not. Unfortunately, we could not obtain long enough series of sector-specific deflators, so we used the aggregate GDP deflator reported in Holz (2005) to deflate the sectoral output reported in the ADB’s Indicators of Developing Asian and Pacific Countries. The employment figures are also drawn from this source. Since the DOLS procedure here uses one lead and lag of the right hand side variables, the sample is truncated to 2002 even when 2003 data are available. The levels observations for 2003 and 2004 are not used in the estimation procedure. However, the results are not similar if the coefficients on the traded and nontraded sectors are constrained to be equal and opposite. The impact of productivity differentials disappears in this longer sample, unless a time trend is included. The sensitivity of the results to the inclusion of time trends is another reason to focus on the shorter sample. This argument is most closely associated with Young (2003), as well as Brandt et al. (2005). Coudert and Couharde (2005) implement the absolute PPP regression on a crosssection, while their panel estimation relies on estimating the relationship between the relative price level to relative tradables to nontradables price indices. Since the price levels being used are comparable across countries, in principle there is no need to incorporate currency-specific constants as in fixed effects or random effects regressions. In addition, fixed effects estimates are biased in the presence of serial correlation, which is obviously present in the data. In addition to the obvious difference in the sample, our estimates differ from Frankel’s in that we measure each country’s (logged) real GDP per capita in terms relative to the US rather than in absolute terms. Hence, the resulting coefficient estimates are not necessarily directly comparable.

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APPENDIX 13.1

The role of China

DATA AND SOURCES

For Section 13.1 The nominal Renminbi exchange rate is the bilateral period average, expressed against the USD (in USD/fcu; i.e. dollars per foreign currency unit), obtained from the IMF’s International Financial Statistics, and from Hali Edison, for the “adjusted” exchange rates (Fernald et al. 1999). The Consumer Price Indexes (CPIs) are drawn from the CEIC database, extrapolated for 2004 and 2005 by using the CPI growth rates reported in IFS. The CPI-deflated trade-weighted exchange rate is drawn from IFS, while the Producer Price Index (PPI) deflated series was provided by Michael Spencer at Deutsche Bank. For Section 13.3 The nominal renminbi exchange rate source is described in section 13.1. Tradables and nontradables are proxied by manufacturing and by “other” (which includes mostly services, construction, and transportation), respectively. For the United States, labor productivity in manufacturing: BLS (Foreign Labor Statistics website) “International Comparisons of Manufacturing Productivity and Unit Labor Cost Trends, Supplementary Tables, 1950– 2003”, www.bls.gov/fls/prodsupptabletoc.htm. US productivity in 2004 calculated from output and hours from BLS website, accessed August 21. Labor productivity in “other” for 1979–2002 from 60-Industry Database (latest update February 2005), www.ggdc.net/dseries/60-industry.shtml from Groningen Growth and Development Center. The 1995 chained value added data and employment numbers for all industries above SIC 3. Productivity growth rate for 2003–04 set at the 2002 rate. For China, the basic productivity data are calculated as the ratio of nominal sectoral output to sectoral employment, as reported in the Asian Development Bank’s Key Indicators of Developing Asian and Pacific Countries. The Chinese real output series are obtained by deflating using the GDP price deflator (base year 2000), as reported in Holz (2005). The alternative manufacturing productivity index is drawn from Szirmai et al. (2005). The 2003 data assume 2002 productivity growth continues; 2004 figures for all Chinese data are extrapolated from 2003 growth rates. Some additional results are also reported using a 1980–2004 sample. These results are based on spliced series, where 1980–85 data on Chinese productivity are drawn from the database used in Chinn (2000b). Manufacturing productivity is that reported by the World Bank’s World


355

Development Indicators, while “Other” productivity is generated in the method described using data from the ADB and the ILO. The effective exchange rate is assumed to equal the official over the 1980–86 period. For Section 13.4 The data for macroeconomic aggregates are mostly drawn from the World Bank’s World Development Indicators. These include demographic variables, per capita income and government deficits. Relative price levels and per capita income are drawn from the Penn World Tables (Summers and Heston, 1991), as drawn from pwt.econ.upenn.edu/. Financial development indicators, including lending, stock and bond market capitalization, are drawn from the Beck et al. (2000). The capital controls index is from Chinn and Ito (2006). The (inverse) corruption index is drawn from the International Country Risk Guide. Data for Taiwan are drawn from the central bank of China, ICSEAD, and ADB, Key Indicators of Developing Asian and Pacific Countries.

356

The role of China

APPENDIX 13.2

RELATIVE PURCHASING POWER PARITY TESTS

Bilateral

Trade weighted

Panel A: Johansen cointegration tests k #,#[#,#] Spec. b1 b2

3 1,1[1,1] w/o 1 1.503*** (0.125)

3 2,2[2,2] w/trend 1 1.455*** (0.118)

2 1,0[0,0] w/o 1 0.765* (0.168)

2 2,0[2,0] w/trend 1 0.828 (0.162)

Panel B: Horvath-Watson cointegration tests Wald Smpl N

12.556 11.427 1987:4–2005:2 1987:4–2005:2 1987:1–2005:1 1987:1–2005:1 71 71 73 73

Notes: Panel A: k is lag in VAR specification. #,#[#,#] is the number of cointegrating vectors according to a likelihood ratio test on the trace, maximal eigenvalue statistic, using asymptotic [finite sample] critical values. Spec. indicates whether a deterministic trend is assumed to be in the data (“w/trend”), or not (“w/o”). Finite sample critical values are from Cheung and Lai (1993b). b1 are cointegrating vector coefficients. *(**)[***] denotes significance at the 10 percent (5 percent)[1 percent] MSL for the null hypothesis of b2 5 1. Panel B: Wald is the Wald test statistic for the joint null that the reversion coefficients in the VECM representation are zero. Critical values are 9.72 (11.62)[15.41], from Horvath and Watson (1995). Smpl is sample, N is the number of observations.

14.

Institutional and structural problems of China’s foreign exchange market and the RMB’s role in East Asia Zhang Jikang and Liang Yuanyuan1

14.1

INTRODUCTION

One big question mark with respect to East Asian monetary integration is the Chinese currency’s potential role in this process. In the 1980s and 1990s, the Japanese government tried to promote the yen as the key regional currency. But the “yen bloc”, as it was often referred to, never came into being, despite the yen’s status as one of the leading international currencies as well as the existence of highly developed and liquid financial markets in Japan.2 Today, after years of deflation and economic weakness in Japan, the prospects of a yen bloc have diminished even further. The failure to establish the yen as the regional anchor currency in East Asia is also a result of noneconomic factors—that is, the other East Asian countries are not willing to accept a Japanese leadership role in East Asia for political and historical reasons. This puts the spotlight on the Chinese renminbi (RMB). Several authors have predicted a growing orientation of East Asian countries’ exchange rate policies toward that of China (see, for example, Ho et al. 2005; and Hefeker and Nabor 2005). But there are many uncertainties surrounding the RMB’s prospects of becoming the leading currency in the region, such as whether China will be able to sustain her economic growth path and maintain political stability, and whether China will be able to develop deep and liquid primary and secondary financial markets. In this chapter, we focus on another aspect that is crucial for developing key currency status, that is, the development of a fully functioning foreign exchange (FX) market. In particular, we investigate the institutional and structural impediments facing the Chinese FX market, taking into account the most recent reforms that accompanied the official change of the Chinese exchange rate regime to a currency basket in July 2005. 357

358

The role of China

Our analysis shows that, while China has made considerable progress in reforming its FX market, for the time being the RMB is far from being prepared to take over the lead role in regional monetary integration and to act as a regional anchor currency. The FX market is hampered by low liquidity, high market concentration, limited transaction instruments, distorted market supply and demand, and passive intervention by the People’s Bank of China (PBOC). This chapter is structured as follows: the following section gives a brief historical overview of the development of China’s foreign exchange market, followed by an explanation of its current institutional structure in section 14.3. Section 14.4 discusses structural features of the FX market, and section 14.5 analyzes its problems. Section 14.6 discusses the recent reform measures in detail. Section 14.7 summarizes and gives recommendations for further FX market reforms.

14.2

THE DEVELOPMENT OF CHINA’S FOREIGN EXCHANGE MARKET

Pre-1979: Strict Central Control Before 1979, China had a highly centralized regime governing the supply, demand, and allocation of foreign exchange. All FX earnings (mainly export proceeds) had to be surrendered to the state-owned banks and the PBOC. All FX expenditures (i.e. for imports or non-trade purposes) had to be approved under the confines of the national FX plan, which leaned toward the state sector.3 There was no market element in the formation of the exchange rate, which was fixed to the British pound from 1952 and then to a basket of international currencies from 1973. 1979–93: FX Retention and Swap Liberalization of FX use began in 1979 with an earnings retention scheme designed to encourage exports. Under this scheme, exporters were entitled to retain a share of their FX earnings, initially with respect to exports above some quota but from 1998 according to the full measure of exports. From 1981 to 1984, exchange rates were set differentially for trade and non-trade activities.4 The first sign of an actual FX market in China appeared in October 1980 when retained FX claims became transferable, first through the swap service launched by the PBOC, then in provincial swap centers, and finally in an integrated nationwide swap market.5 The late 1980s saw the

China’s foreign exchange market and the RMB’s role in East Asia

359

expansion of FX swap activity, with the number of market participants increasing and swap exchange rates becoming more flexible. By the end of 1993, there were 108 local swap centers and 18 markets joined to the nationwide system. A mechanism for forming a market exchange rate had thereby been established in coexistence with an official pegged rate. The development of the swap market with its diversity of swap rates had its own problems, including discrimination, rent-seeking, and unauthorized actions. Nevertheless, it acted as a transitional device, laying a foundation for the emergence of a true FX market in China. The 1979–94 period also saw frequent adjustments of the official exchange rate, with a trend devaluation of the RMB against US dollar.6 After the gradual devaluations of the official rate, the central bank was well prepared to unify the exchange rates and reform the exchange rate regime. 1994 and Post-1994: Compulsory Settlement on a Centralized Platform The year 1994 was a turning point in China’s FX reform. In that year, the system of FX retention and submission that had existed for 15 years was replaced with a compulsory settlement system under which foreign exchange earners were obligated to sell their FX to state banks, while foreign exchange users could buy it subject to certain conditions. On April 1, 1994, the “single managed floating exchange rate regime based on market supply and demand” was adopted. On April 4, 1994, the China Foreign Exchange Trading System (CFETS) began operation, thus launching China’s first unified national inter-bank FX market. The government’s FX management method was also adjusted to rely more on systematic economic and legal measures, in contrast with the former command approach. New rules governing the purchase of FX by individuals for overseas visits, study, or other personal needs took effect on April 1. These rules have been relaxed gradually over time, with the upper limit on individual purchases raised to USD 8000 as of August 2005 from an initial USD 600 per person per visit in 1994. The success of the 1994 reform enabled conditional convertibility of the RMB under the current account and brought a real FX market into existence. Reform continued under the basic framework of the FX purchase and sale system after 1994. In 1995, China added yen trading and ended the circulation of foreign exchange certificates. In July 1996, the FX transactions of Foreign Invested Enterprises (FIEs) were integrated into the FX purchase and sale system, allowing FIEs to buy foreign currency freely on the inter-bank market. On November 27, 1996, China formally notified the International Monetary Fund of the RMB’s convertibility on the current account. In 1997, qualified Chinese companies were allowed to open FX settlement accounts to retain a portion of FX earnings from current account

360

The role of China

transactions. The PBOC’s forward FX purchase and sale experiment was launched in 1997. The 1997–98 Asian financial crisis interrupted China’s aggressive reform timetable. A series of regulations were enacted and clarified by the PBOC to strengthen the responsibilities of the State Administration of Foreign Exchange (SAFE) with respect to falsely obtaining FX, failing to surrender FX, illegal arbitrage, and so on. The swap centers were closed on December 1, 1998, with all FX transactions thereafter integrated into the FX purchase and sale system. In 2001, trading in dollar-denominated B shares on China’s stock market was opened to Chinese nationals (having formerly been limited to foreign passport holders) with necessary currency exchange supported by the CFETS. Trading in euros was introduced in April 2002. Then, in October 2002, all enterprises that qualified for conducting international business or had regular FX incomes from current account transactions were allowed to open foreign currency accounts for holding up to 20 percent of their previous year’s FX income. Two-way trading was permitted from October 2003, with trading hours extended from half to full day. Another landmark in the development of China’s FX market was 2005. Eight foreign currency pairs started trading in the inter-bank market in May 2005. On July 21, the RMB was revalued with a 2 percent appreciation against the US dollar, and the peg to the US dollar was replaced with a reference to a basket of currencies. The July reform was followed by successive reform measures in August7 to enlarge the scope of forward FX purchase and sale and swap between the RMB and foreign currencies to the retail market between banks and their customers, to invite non-financial enterprises and non-bank financial institutions to participate in the inter-bank market, to add a quote-driven dealer market trading mechanism into the current auction market, and to introduce inter-bank FX forward and swap trading. In addition, a long expected market maker system for USD–RMB trade was finally announced in November 2005 based on the CFETS platform.8

14.3

THE CURRENT ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

China’s FX market is composed of two parts, the inter-bank or wholesale market and the retail market (see Figure 14.1). The major parties involved in the FX market are as follows: (1) the CFETS, which functions as the trading platform for the inter-bank market and is responsible for clearing the market and for providing the supervisory authorities with market information; (2) the PBOC and SAFE, which function as regulatory


361

Regulatory Authority PBOC Authorize Open Market Operations

SAFE

Retail Market

Wholesale (Inter-Bank) Market

Non-Financial Enterprises*

CFETS Trading Platform

Designated FX Bank

Individuals

Non-bank Financial Institutions

Enterprises

Note: * The new rules in August 2005 gave permission for non-financial enterprises to trade directly in the inter-bank market, but the first actual market entry license did not emerge until March 2006.

Figure 14.1

Organization of China’s foreign exchange market

authorities (the PBOC authorized SAFE to regulate the inter-bank spot and forward markets and regulates the retail market through SAFE); (3) designated FX banks and other non-bank financial institutions9 authorized by SAFE to engage in foreign exchange business; (4) enterprises that earn and spend FX, whose activities were restricted within the scope of the retail market until the FX market reforms in August 2005, which granted them the right to trade directly in the wholesale market; and (5) individuals who have FX trading needs. The nature of the inter-bank FX market is for designated FX banks to square their FX positions derived from retail FX business after maintaining an allowable FX working position.10 Before the August 2005 reform, the inter-bank market had been a centralized, order-driven auction market making use of organized exchange trading and an electronic broking system, while retail transactions had been carried out in an over-the-counter

362

The role of China

(OTC) market. In May 2005, a new trading system was introduced on the CFETS platform for the trading of eight foreign currency pairs, pioneering the use of market making and request for quote trading arrangements before these were further applied to the inter-bank forward market and the inter-bank spot market in later reforms. Currently, China’s FX market is a quasi-centralized hybrid market with a quote-driven dealer market system facilitated by market makers going hand in hand with the original orderdriven auction market utilizing an electronic broking system.11 As an administrative unit of the PBOC, the CFETS is not only a trading platform but also serves as an information and supervision platform. The CFETS trading services mainly cover the foreign exchange market, the bond market, and the bill market. In the foreign exchange market, the core of the CFETS platform is a membership-based exchange with a nationwide real-time electronic trading system. With an “auction market” trading mechanism similar to that of an electronic broker, members make back-toback (anonymous) quotes on the trading platform through either on-site or distant trading terminals.12 The electronic trading platform automatically enables real-time matching of orders. The clearing function is integrated into the CFETS platform, providing members with centralized, two-way netting/clearing. Since the introduction of eight foreign currency pairs and the August 2005 market reform, the CFETS trading platform has been updated to incorporate new features, such as a market making system and request for quote trading arrangements. We discuss the recent FX market reforms in greater detail in section 14.6. This market infrastructure was originally put in place to serve the needs of the compulsory FX settlement system and facilitate the PBOC’s absolute control of the market. But now it seems that CFETS must undergo major transformation with respect to market-orientation, services offered, technology, efficiency, and risk management. The possible direction of reform will lean toward establishing parallel sub-trading systems targeting different market segments. In the meantime, the CFETS should become more independent of the central bank.13

14.4

STRUCTURAL FEATURES OF THE FX MARKET

Market Size China’s inter-bank FX market is still small and shallow, even though market size has seen a large increase in recent years. The average daily


Table 14.1

363

Foreign exchange market daily average turnover in selected markets, 1995–2004 (USD billion/day)

China Hong Kong Japan Singapore United Kingdom United States

1995

1998

2001

2004

0.26 90 161 105 464 244

0.21 79 136 139 637 351

0.30 67 147 101 504 254

0.83 102 199 125 753 461

Note: For markets other than China’s, daily averages are for the month of April and cover spot, forward, and swap transactions. For China, volume is based on the entire year and pertains only to inter-bank spot transactions. Source:

CFETS, BIS (2004).

turnover in China’s inter-bank FX market is very low compared to that on the world’s major markets (see Table 14.1). But China’s market is growing quickly, with daily turnover in 2004 up by 177 percent relative to 2001 and in 2001 by nearly half relative to 1998. By contrast, all major markets except Japan experienced a decline in turnover between 1998 and 2001, with recovery then following in 2004.14 The small scale of China’s FX market is attributable in part to institutional factors. Restrictions on FX holdings for financial institutions and non-financial enterprises, as well as for individuals, figure significantly in stunting the development of the market. So, too, do capital control measures that discourage cross-capital flows. Other structural features also have a hand in limiting the market size. China’s FX market has been experiencing a high concentration of FX trading among a few large banks that balance trades internally, turning to the inter-bank market just once a day to readjust their reserves to the allowable level (see the discussion later in this section, on market participants and concentration). Market entry requirements that restrict the pool of market participants, prohibition of two-way trading (both buying and selling) during the same trading session until October 2003, and the limited scope of products have all played a part in keeping the market both small and shallow. The recent dramatic growth in China’s inter-bank market follows a sluggish start in the 1990s (see Figure 14.2). The years 1997 to 1999 actually showed a downturn, from which the market did not recover until 2001. This downturn is attributable in part to the adverse impact of the Asian

364

The role of China USD bil/day 1.0

USD bil/yr 250 Daily average turnover

Annual turnover 200

0.8

150

0.6

100

0.4

50

0.2 0.0

0 94 Source:

95

96

97

98

99

00

01

02

03

04

China Money, various issues.

Figure 14.2

Annual and daily average turnover in China’s inter-bank FX market, 1994–2004

financial crisis but also to a broad-based inspection campaign carried out by SAFE to ferret out the purchase of FX under false pretences, and other illegal market activity. With the recovery of economic growth domestically, China’s admission to WTO, and improvement in the foreign trade and investment balance, the market picked up momentum, entering a period of fast growth from 2001 to 2004, with an average growth rate of 50.32 percent. Market turnover reached a new height of USD 209 billion in 2004, with a daily average of USD 830 million. The rising turnover on China’s inter-bank market coincided with rapid growth in balance of payments flows (see Figure 14.3). Under the compulsory FX purchase and sale system, the inter-bank market functions solely for banks to net out FX positions derived from retail trade. This retail trade is in turn driven by bank customer activity captured in the current and capital accounts. In recent years, short-term capital inflows have played a major role in feeding the increase in supply on the FX market. Besides economic fundamentals, this sharp increase in market turnover was driven also by short-term factors on the supply side, including faster settlement of export revenues as a result of the 3 percent reduction in the export tax rebate in 2004, speculation on RMB appreciation, the reductions by banks of their FX working positions to relieve the RMB demand pressure, the repatriation of capital raised in stock listings by overseas listed companies, and the conversion of foreign funds for investment in China’s stock market by qualified foreign institutional investors.


365

1400 1200 1000 800 600 400 200 0

Note: Source:

94

95

96

97

98

99

00

01

02

03

Current account 2-way flow

Capital account 2-way flow

Inter-bank FX market turnover

PBOC net FX purchase

04

PBOC net purchase of FX is measured by the change in official reserves assets. CFETS, PBOC Quarterly Statistical Bulletin.

Figure 14.3

FX market activity and balance of payment flows, 1994–2004 (USD billion)

From 1994 to 2004, spot trading in four currency pairs (RMB against US dollar, RMB against HK dollar, RMB against Japanese yen, and RMB against euro) constituted the whole inter-bank market turnover. But since market segments were enriched after several market reforms in August 2005, the total market size now also covers trading in eight additional foreign currency pairs (for a total of 12) as well as inter-bank forwards. Figures 14.4 and 14.5 give an overview of the market activity in the eight foreign currency pairs currently trading. It can be seen that, though monthly volumes vary a lot, trading in these currency pairs is already an important addition to the total turnover in China’s FX market. The inter-bank forwards started trading in August 2005, but, judging by the number of transactions (see Table 14.2), the market turnover is still lingering at a low level and can make little contribution to the total market volume. With more diversified trading products, China’s inter-bank FX market will be able to attract more trading interest in the long term. Market size will also benefit from increasing volume brought by newly launched market segments, such as foreign currency pairs and inter-bank forwards, but so far this market still lacks depth and breath, and a substantial growth in market size has yet to come.

366

The role of China

14.00

0.60

12.00

0.50

10.00

0.40

8.00 0.30 6.00 0.20

4.00

0.10

2.00 0.00

0.00 May 05

Jun 05

Jul 05

Aug 05

Total Turnover

Sep 05

Oct 05

Nov 05

Dec 05

Daily Turnover

Source: China Money, various issues.

Figure 14.4 Monthly and daily turnover in foreign currency pairs (USD billion) The July 2005 revaluation heralded reforms in the RMB exchange rate regime. With more flexibility in the exchange rate formation mechanism being introduced in the future, China will be expecting larger variations in its FX market. A small and shallow market is certainly no boon to smoothing exchange rate variations. This may add to authorities’ concern about allowing further flexibility in the exchange rate regime and cause delay in the reform timetable; on the other hand, without a more flexible rate, a truly deep market will be hard to achieve. Market Segments China’s FX market is limited in product scope mainly to spot trading in US dollars. For a long time since its establishment, the inter-bank market only offered spot transactions between the RMB and the US dollar, the HK dollar, the Japanese yen, and the euro, respectively. It was not until May 2005 that FX trading was expanded (from the original four) to include eight new foreign currency pairs and not until August 2005 that inter-bank forwards were introduced.15 In the retail market, trading is also dominated by spot transactions, with a small forward market and a nascent swap market. The Bank of China (BOC, not to be confused with the PBOC) was the first financial institution allowed to offer forwards, beginning in 1997,


Turnover in the foreign currency pairs from May 2005 to December 2005

367

52.13

Turnover in the original spot market in the first half of 2005

146.15

0

20

40

60

80

100

120

140

160

Note: As China’s central bank stopped the practice of disclosing inter-bank turnover figures in the spot trading market involving the RMB in the second half of 2005, a comparison between these two segments across the same time range cannot be made. Source: China Money, various issues.

Figure 14.5

Table 14.2

Turnover in Foreign Currency Pairs and the Original Spot Market (USD billion) Monthly number of transactions in the inter-bank forward market

August 2005 September 2005 October 2005 November 2005 December 2005 Source:

8 23 38 94 114


with the other banks following suit after 2002.16 This market segment was opened up to all financial institutions during the August 2005 reform, when retail market FX swaps also started trading. With the inception of forward transactions in 1997, the BOC’s trading volume rose to a peak of USD 11.5 billion in 2000 (see Figure 14.6). This growth reflected a need for businesses to hedge against currency risk during a period when the RMB was under pressure to depreciate in the wake of the

368

The role of China 2004 2003 2002 2001 2000 1999 1998 1997

0.00

5.00

10.00

15.00

20.00

Forward trading

Source: Data for the years 1997–2002 are from Bank of China Annual Reports, while data for the years 2003–04 are estimations made by Zhang (2005).

Figure 14.6

Retail market forward FX trading (USD billion)

RMB/USD 100 875.00 870.00 865.00 860.00 855.00 850.00 845.00 840.00 835.00 830.00 825.00 820.00 815.00 810.00 805.00 800.00

Band narrowed after the Asian Financial Crisis

Ja n Ju 94 Ja l 94 n Ju 95 Ja l 95 n Ju 96 Ja l 96 n Ju 97 Ja l 97 n Ju 98 Ja l 98 n Ju 99 Ja l 99 n Ju 00 Ja l 00 n Ju 01 Ja l 01 n Ju 02 Ja l 02 n Ju 03 Ja l 03 n Ju 04 Ja l 04 n Ju 05 Ja l 05 n 06

July 2005 revaluation

Source:

Year

PBOC.

Figure 14.7

RMB–USD exchange rate, January 1994–June 2006

Asian financial crisis. Rather than devalue, though, the PBOC responded to the crisis by tightening the floating band. This led to a highly stable relationship between the RMB and the US dollar (see Figure 14.7). Under such conditions, the need to hedge risk diminished, and the forward market contracted. In 2002, the BOC’s forward trading volume declined by about


369

Spot 35% Spot Forward

Swap 53%

Swap Forward 12%

Source:

BIS (2004).

Figure 14.8

Shares of FX trading by transaction type in global FX markets, 2004

two-thirds from its peak, but the market has rebounded since 2003, when more players entered the market. Compared with the global FX market (see Figure 14.8), the lack of product range in the Chinese market restricts overall growth in market turnover and limits the functions of the market, especially the risk-hedging function. China’s FX market is also limited by its trading concentration in the US dollar. When the inter-bank market was established in 1994, only the US dollar and the Hong Kong dollar were traded. The yen was added in 1995 and the euro in 2002. The US dollar, however, remains the overwhelmingly dominant currency, accounting for 97.8 percent of total turnover in the first half 2005.17 The dominance of the US dollar actually strengthened during the late 1990s and was little influenced by the introduction of the euro in 2002 (see Figure 14.9). The high concentration in US dollar trading is not inconsistent with the important role the dollar plays in global trade and investment as a vehicle currency (see Figure 14.10). Further, given the highly stable RMB–USD exchange rate, conducting their affairs in dollars allows those engaged in international business to minimize exchange risk. Having come to take the stability of the exchange rate for granted, market participants do not net out their open positions immediately but rather minimize transaction costs by netting out positions internally. Therefore, US dollar domination in the FX market is also a factor in the low level of overall market activity. Great expectations had been attached to the introduction of new currency pairs, especially the EUR–RMB pair. In fact, however, the euro has not come to play an important role in China’s FX market either in terms of increasing market turnover or in terms of influencing the formation

370

The role of China %

USD bil

100

250

98

200

96 150

94

100

92 90

50

88

0

86 95

96

97

98

99

00

Turnover Source:

01

02

03

04

05 1H

Share


Figure 14.9

Turnover and share of the US dollar in the inter-bank market, 1995–first half 2005 Australian dollar 5.5%

Others 25.3%

Swiss franc 6.1% Pound sterling 16.9%

US dollar 88.7%

Japanese yen 20.3% Euro 37.2%

Note: Source:

Total: 200%

Since each currency pair involves two currencies, the total sums up to 200 percent. BIS (2004).

Figure 14.10

Currency composition in the global FX market, 2004

mechanism of the RMB–USD rate. The reason is that the RMB–EUR rate is determined indirectly by the EUR–USD rate vis-à-vis the stable RMB–USD rate. Since banks in China can obtain a better EUR–USD rate in the international market if they have open EUR–RMB positions, they first convert euros to dollars in the international market and then trade the RMB–USD position in the domestic inter-bank market instead of directly trading EUR–RMB positions.


Table 14.3

CFETS members by institutional type

Wholly state-owned banks Joint stock commercial banks Policy banks Urban commercial banks Branch of commercial banks Foreign banks Trust and investment companies Rural credit cooperatives Non-financial enterprises Total Source:

371

January 2003

March 2006

4 10 3 22 108 164 2

4 11 3 44 109 189 2

9 0 322

26 1 389


The US dollar domination in China’s FX market reflects market participants’ dependence on the central bank to clear the market under the rigid exchange rate regime. Lack of motivation to hedge two-way exchange risks has also prevented participants from building up professional skills in FX risk management and retarded the development of FX derivatives. This may turn out to be one of the most important fragilities when an exit from the current peg brings in more variations in the rates. To sum up, China’s inter-bank FX market is currently mainly a spot market. Forward and swap trading have just recently emerged, with volume trivial so far. Even with the introduction of eight foreign currency pairs in 2005, the domination of RMB–USD trading is likely to continue into the near future. The lack of diversity with respect to transaction types restrains market turnover and limits liquidity. Market Participants and Concentration Though membership in CFETS reached 389 by March 2006 (see Table 14.3), market activity remained highly concentrated among a small number of banks. This contrasts with the diverse body of market participants in the global FX market, which includes dealers and non-financial entities as well as banks and non-bank financial institutions. The global FX market has seen trading between banks and other financial institutions seize an increasing share of turnover (33 percent in 2004) (BIS 2004). China’s FX market is characterized by approaching monopoly, especially on the buy side. Although nearly half of CFETS’s members are

372

The role of China

Table 14.4

Market concentration (in percent, as of December 2004)

C1 C2 C3 C4 C5

50.57 64.70 71.71 76.14 79.86

Note:

C1 indicates the market share of the market participant with largest trading volume and C5 indicates the market share of the largest five participants.

Source:

Calculations based on trading volume figures in China Money.

% 100

USD bil 250 200

80

150

60

100

40

50

20 0

0 '95

'96

'97

'98

'99

'00

'01

'02

'03

'04

PBOC net purchase Inter-bank market turnover PBOC net purchase/market turnover Sources:

Shu (2001) and Preeg (2003).

Figure 14.11

PBOC net purchase of FX and inter-bank market turnover, 1995–2004

foreign banks, their trading volume amounts to only a small portion of the total. In 2004, the top five market participants,18 all of them domestic banks, took away nearly 80 percent of market trading (see Table 14.4). These large banks are usually net sellers in the market, with the rest of the market’s participants net buyers. The BOC itself is estimated to account for more than half of net FX selling in 2002 (Xin 2003). On the buy side, the PBOC’s net purchase of FX accounted for an average of 68 percent of the total inter-bank market turnover in the period from 1995 to 2004 (Figure 14.11). In recent years, the PBOC has been obliged to undertake massive buying in the face of heavy supply pressure brought on by speculation on RMB appreciation and a relatively high interest rate paid on RMB deposits. The result has been an increase in


373

official reserve assets to USD 610 billion at the end of 2004, up USD 324 billion in just two years.

14.5

PROBLEMS IN CHINA’S FOREIGN EXCHANGE MARKET

Distorted Market Supply and Demand Foreign exchange market institutions and the choice of exchange rate regime bear integrally on one another. A more flexible exchange rate regime for China, capable of generating an exchange rate consistent with balance of payments fundamentals, cannot be achieved without a foreign exchange market in which supply and demand represent the true preferences of market actors. On the other hand, China’s trouble-ridden exchange rate regime is itself to blame for many structural problems in the FX market. Thus, beginning to fix the cracks in market supply and demand not only would help tackle many structural deficiencies in the FX market but also would be a crucial step toward disentangling the Gordian knot of the RMB exchange rate regime and, in the medium run, developing the RMB into a regional lead currency. Three main problems exist with the market supply and demand for foreign exchange in China. First, supply and demand do not express the will of market participants but rather follow from their compliance with distorting regulations. Under the FX purchase and sale system, exporters and foreign investors must surrender at least 75 percent of their FX earnings to the designated FX banks, and these banks, in turn, must sell their foreign currency receipts on the inter-bank FX market, subject to an allowable working position. On the supply side, then, neither the ultimate suppliers (i.e. exporters and investors) nor the designated banks that enter the inter-bank market have the freedom to choose their preferred levels of FX holdings. On the demand side, capital controls impede Chinese investment overseas and restrict FX use by businesses and individuals. Second, in recent years a pronounced excess dollar supply has emerged on China’s FX market. This excess supply follows from mounting surpluses in the current account and strong inflows of foreign direct investment coupled with an explosive growth in short-term capital flows. A growing part of the excess supply of foreign currency must be absorbed by the PBOC. The imbalance in China’s FX market is aggravated by the compulsory supply and impeded demand that is the product of the regulatory system. With trends of a rising trade surplus, stable FDI inflows, and strengthening shortterm capital inflows powered in part by speculation on RMB appreciation

374

The role of China

4 3 2 1 0 –1 –2 –3 –4 1998

Source:

1999

2000

2001

2002

2003

2004

2005

2006

Federal Reserve Bank of St Louis and IFS.

Figure 14.12

Difference between RMB bank deposit rate and US federal funds rate, 1998–June 2006 (percentage points)

and in part by higher interest rates on RMB deposits (see Figure 14.12), the gap between supply and demand is being driven ever wider. Third, the supply and demand for FX are not fully reflected in the interbank market on the CFETS platform. This is because the large Chinese banks transfer a part of their position-squaring operations to Hong Kong or to the black market. Therefore, the excess supply of foreign exchange on the inter-bank market is not reflective of overall market conditions. All in all, the distorted market supply and demand compromise the market’s ability to yield a meaningful value for the exchange rate. Passive Intervention of the PBOC Surging excess supply of USD in the FX market has put pressure on the RMB to appreciate. In order to maintain the pegged RMB–USD rate, the PBOC has had to intervene by purchasing large quantities of US dollars and then sterilizing these purchases through the issuance of central bank bills in order to control the money supply. The PBOC was forced to play the super market maker role in the FX market. So far, the PBOC has been quite successful in keeping a tight rein on money supply growth through its sterilization operations and in draining liquidity from the banking system (see Figure 14.13); however, the PBOC’s passive intervention could lead to problems. First, supply and demand imbalances under a compulsory FX settlement system leave no leeway for the PBOC, which must absorb the appreciation


375

15% 10% 5% 0% –5% –10% 1999

2000

2001

2002

Bank reserves Source:

2003

2004

2005

Official reserve assets

SAFE and IFS.

Figure 14.13

Growth in China’s bank reserves and official reserve assets, September 1999–June 2006 (monthly rate of change)

pressure. Second, the commitment to maintain stability in the RMB–USD rate results in high US dollar concentration in the FX market. Third, constant intervention in the FX market imposes high monitoring and administrative costs. Finally, PBOC sterilization operations could lead to a vicious cycle, pushing interest rates higher only to attract greater speculative inflows that must be purchased by the PBOC and in turn sterilized. As Figure 14.12 shows, the interest rate on RMB deposits has already been pushed above the US Federal Funds rate. The downside of this kind of passive intervention is that the PBOC loses independence in conducting monetary policy. One way to go about relaxing the constraints on the PBOC would be to delegate the role of market maker to one of the state-owned commercial banks. Any one of the Big Four could be considered for the role. This step could help provide liquidity in the market and ease the pressure on the PBOC. China has been aided in maintaining its currency peg in the face of sizeable current account surpluses by its use of capital controls. These controls have helped protect against the kind of large-scale capital movements that forced many Asian countries off their pegs during the Asian financial crisis. With the gradual easing of capital controls in China, not only does the currency face greater danger of “one way bet” speculative attacks but independent monetary policy becomes more difficult to pursue.19 In the past few years, expansionary fiscal policy has been the preferred approach

376

The role of China

to averting economic slowdown, but, with the Chinese economy’s continued robust growth cycle and a looming threat of inflation, monetary policy could be vital to achieving a soft landing.

14.6

NEW REFORM MEASURES IN FX MARKET

Shortly before and after the July 21 RMB revaluation, several new reforms (see section 14.2) were introduced in the FX market, mainly focusing on three aspects: (1) broadening market access, (2) enriching market segments, and (3) transforming trading arrangements. Theoretically, these new reform measures can improve on the market structures by increasing liquidity and enhancing market functions. But doubts should be cast as to whether these measures can fully deliver their intended effects and whether this “parallel” and “top-down” reform methodology can work well in the FX market. Broadening of Market Access As a result of the market reforms, there were 389 CFETS members as of March 2006, an increase of 23 over June 2005. Among the new participants, Sinochem Corporation became the first non-financial enterprise ever to enter the inter-bank market. Meanwhile, foreign banks continue to show a strong interest in China’s FX market. Foreign banks’ participation: strategic thinking The active participation of foreign banks in China’s FX market is a result of more long-term strategic concerns than of short-term profit concerns. Even though foreign banks make up the largest share of banks in the market, their share of trading volume is lackluster. The foreign banks have, in fact, entered the market mainly to gain a foothold, with the potentially growing international role of the RMB and the Chinese market in mind. First of all, the RMB is still inconvertible, but a gradual loosening of capital controls has already begun, allowing a certain limited volume of cross-broader capital flows in both directions. China’s strong foreign trade sector and economic growth will ensure the RMB an increasingly central role in East Asia and the international arena. The RMB will be one of the most frequently traded currencies in the international FX market, and these banks are counting on their early-on experience and familiarity with RMB trading in China’s FX market to give them a competitive edge in the future. Second, foreign banks will receive full access to China’s banking sector by the end of 2006 as part of China’s WTO commitment. There will exist


377

huge opportunities for the provision of new financial products and services soon, many of them involving FX trading. Besides, gestures of goodwill through helping develop China’s financial market can also help foreign banks maintain an amicable relationship with the Chinese authorities, which is very important now that reforms in China’s financial market are making headway and bringing with them new potential sources of revenue. No matter what their motives are, foreign banks’ presence in China’s FX market will have great demonstration and spillover effects for domestic institutions, and, with their rich experience of FX trading, sophisticated FX risk management skills, and deep understanding of the market, they will become a main pillar in new products trading. Non-financial enterprises: latent needs of hedging against FX risks With combined exports and imports standing at USD 1422.12 billion in 2005,20 non-financial enterprises, especially companies engaged in foreign trade, have every reason to become big players in the FX market. However, the long-time stability of the exchange rate has caused inertia among Chinese enterprises when it comes to hedging against FX risks. The lack of FX risk management awareness and skills may prevent these enterprises from being deeply involved in the inter-bank market. Transaction cost is another concern considering the fact that 54.7 percent of exports in 2005 were in the form of processing trade, which tends to have a relatively low degree of risk exposure and small profit margins. Last but not least, alternative ways of hedging against FX risks can also woo the enterprises away from the domestic FX market. According to a survey conducted after the July 21 reform (PBOC 2006), foreign trade companies in China have responded to the exchange rate adjustment by providing a variety of tools for hedging against greater exchange rate volatilities, with trade finance (used by 31 percent of respondents) as their foremost choice. The use of financial derivatives such as forwards and swaps is still less prevalent. In 2005, the value of forward FX sales was only 2 percent of total FX sales in the spot market, while forward FX purchase was only 4 percent of total FX purchases. The less-regulated offshore market for non-deliverable forwards (NDF), in which some large enterprises have already been participating, is another source of competition for the Chinese onshore FX market. Overall, broadening market access to a wider range of institutions would theoretically increase market liquidity and boost trading volume. According to the market microstructure theory, the heterogeneity of market participants in terms of their motives, analytical methods, and possession of private information and the resulting differences in expectations

378

The role of China EUR–JPY 1% USD–HKD 26% EUR–USD 41%

USD–CHF 1% USD–CAD 1% USD–JPY 23%

Source:

GBP–USD AUD–USD 3% 4%


Figure 14.14

Currency composition in foreign currency pair trading in China’s FX market (in percent), May 2005–December 2005

is responsible for most of the trading volume and exchange rate volatility in the FX market.21 But, in reality, it may take a while for these new participants to familiarize themselves with the rules and skills required for using the FX market to hedge against emerging exchange rate risks. How to encourage new players to enter the market and existing participants to trade in the market goes well beyond simply approving new memberships. Enrichment of Market Segments Measures to enrich FX market segments mainly include adding the eight foreign currency pairs in the spot market and establishing an inter-bank forward market.22 This will enrich the original inter-bank market segments, which previously featured only spot transactions in four RMB related currency pairs, enhance the market functions, and provide market participants a new scope for investing their FX holdings as well as hedging against FX risks. Trading in foreign currency pairs is dominated by the three currency pairs formed by the USD against the EUR, the HKD, and the JPY, respectively, while the EUR–USD pair enjoys the deepest trading, with a market share of 41 percent (Figure 14.14). Bid–ask spreads in trading among the foreign currency pairs are tight, indicating strong competition among market makers and quite high liquidity.


379

Foreign currency pair trading: an experiment ground The most significant feature of the initiation of foreign currency pairs trading is that it was launched in a market parallel to the original spot market. The eight foreign currency pairs were not simply added to the original inter-bank market but formed a new market of their own, making use of a separate trading system on the CFETS platform. The addition makes China’s FX market more complete, incorporating both RMB against foreign currency transactions and foreign currency against foreign currency transactions. At the same time, the introduction of the foreign currency pair trading through a parallel market has allowed Chinese authorities to experiment with new FX market reforms without implementing them fully in the original RMB pairs market. Instead of being restricted by the old market structures, this parallel market experiments with brand new trading arrangements, such as market making, and adopts international practice by introducing foreign banks as market makers and setting up electronic trading systems with flexible trading options. New structural reforms were thus experimented without any changes being made to the FX market institutional frameworks, such as the compulsory FX settlement and rigid exchange rate regime. As an instant structural reform of trading arrangements in the original spot market can be costly and risky insofar as the original market trades RMB related currency pairs and thus cannot avoid the sensitive issue of the RMB exchange rate, conducting experiments in a parallel market circumvents these hurdles and reduces the reform costs. Besides, market activity in the parallel market can provide decision makers with key information needed to carry on further reforms. Inter-bank forward market Establishing the inter-bank forward market was seen as the key to making China’s FX market a truly functional market that could satisfy market participants’ risk hedging needs. Yet, so far, the onshore forward market has not lived up to expectations and has suffered from a low level of market activity, one-way quotes, and a lack of independent pricing. Market activity By the end of 2005, 64 banks had gained authorization to trade in the inter-bank forwards market.23 Inter-bank forwards in four currency pairs were offered by the CFETS in the new market’s debut on August 15, 2005, but by the end of 2005 only RMB–USD and RMB–JPY had been traded in the market and, not surprisingly, trading had been dominated by the USD. Among the 277 market transactions in 2005, 263 involved RMB–USD forwards trading, while the other 14 involved RMB–JPY trading. Term structures are quite diversified, with seven

380

The role of China

different terms for USD forwards and four for JPY forwards. The most liquid contracts are one-month and 12-month USD forwards. Lack of liquidity and limited scale are common for a nascent market, and the onshore market also has to face competition from the RMB NDF market (see below), a market offering products with similar functions and with longer history; however, one-way quotes and a lack of independent pricing are the two largest impediments to greater market activity. One-way quotes One-way quotes result from ubiquitous expectations of RMB appreciation and the imbalance in the retail forward market. As already noted, “agents transact because they differ” (Lyons 2001). Homogeneous expectations, on the other hand, lead to one-way quotes and difficulty in striking a deal. In the current market environment, it is hard not to bet on the appreciation of the Chinese currency. The only heterogeneity comes from different expectations concerning the degree and speed of appreciation, resulting in sporadic trades. The other reason for one-way quotes originates in the retail market, where expectations of RMB appreciation induced a sharp rise in FX forwards sales at the same time that expectations of a US interest rate rise caused a discount in US dollar forwards, which in turn led to a decline in FX forwards purchases. The imbalance in the retail market was carried over to the inter-bank market by banks, which, more often than not, inherit a long forward position in the US dollar from their retail businesses. Lack of independent pricing Since its establishment, quotes in the onshore market have followed those in the RMB NDF market closely. Information flows and the transmission of prices and volatility between two financial markets trading similar products are normal. In the absence of capital controls, arbitrage between two markets will also lead to convergence in prices. But in the case of the RMB onshore forward market two things have stood in the way of price convergence. First, there are capital controls in place.24 Second, the onshore market and the NDF market target different market participants and therefore have different pricing mechanisms. Major participants in the NDF market are multinationals and hedge funds. Expectations, based on interest rate spreads or often purely on speculation, dominate the NDF pricing. On the other hand, the onshore market primarily caters to banks’ and enterprises’ risk hedging needs. Pricing in the onshore market should thus be based on covered interest parity and be more rational than that in the NDF market. So the current similarity between the two markets points to the onshore market’s lack of independent pricing. Actually, market participants in the onshore market largely base their quotes on the prices in the NDF market instead of on interest parity.


381

The NDF market is greatly exposed to speculation and large volatility. Thus, without independent and more rational pricing in the onshore market, its risk-hedging functions will be limited, and it will be at a disadvantage in its competition with the NDF market. As mentioned above, the RMB NDF market has 10 more years of history and a higher liquidity than the onshore market. Considering the self-fulfilling quality of liquidity, the onshore market is already lagging behind. Lack of independent, let alone competitive, pricing can be deadly to the nascent market in its race to draw liquidity. The underdeveloped money market in China may be the first to blame for the lack of independent pricing in the forward market. So far, China’s money market remains inefficient, stifling it from becoming a market where highly liquid products with a whole spectrum of maturities are traded. The determination of interest rates is still regulated by the central bank. As a result, no representative market interest rates for different maturities are quoted, and the onshore forward market, in turn, does not have the interest rate needed in order to apply the interest rate parity based pricing rules.25 Transformation of Trading Arrangements After the market making system and the quote-driven dealer market system were introduced on January 4, 2006, China’s FX market became a quasi-centralized hybrid market featuring the coexistence of a quote-driven dealer market and an order-driven auction market utilizing an electronic broking system. These two transformations in trading arrangements are milestones in China’s FX market reform and will have far-reaching influences on the market structure and exchange rate formation mechanism as well as the central bank’s monetary policy. Diversified market liquidity provision mechanism Providing liquidity is the primary role of a market maker. Market makers regularly quote both bid and ask prices and stand ready to buy and sell at the quoted price. Market makers can absorb excess market supply or demand by holding inventory and make a profit through bid–ask spreads. The role of market makers is thus crucial to achieving market clearing and providing liquidity. A market making system is especially important to nascent markets, which often—as is the case in China—suffer from low liquidity or a one-sided market. With a mixed quote-driven dealer market and order-driven auction market structure, liquidity can be provided through multiple mechanisms, and market participants are given more flexibility in choosing trading arrangements depending on the purposes of the transaction, the type of counterparty, the level of transparency,

382

The role of China

the information they have, and the size of the order (Harris 2002). The biggest problem in China’s FX market structure is a lack of liquidity, and the transformation of the trading arrangement, which brings a diversified market liquidity provision mechanism and increases the probability of deal-making, is the most important move among all the reform measures from the point of view of boosting market liquidity. Price discovery and the exchange rate formation mechanism Another important role of the market maker is price discovery. The other reform measures can indirectly have an impact on the exchange rate formation mechanism by changing FX market structures, but the introduction of market makers and quote-driven dealer markets in the spot market where the RMB is traded against foreign currency pairs has a more direct and central role in the determination of the RMB exchange rate. After the new trading arrangement was put in place, the RMB central rate went from being determined by the previous day’s closing rate formed in the inter-bank spot market to being determined by the weighted average of the prices quoted by 15 market makers consisting of both local banks and foreign banks. However, it should be duly observed that the price discovery function of market makers in China’s FX market is still rather limited. There still exists a narrow floating band prescribed by the central bank, and regulators also regulate market makers’ net open FX position (both gross aggregated position and single currency position) to limit their scope of price discovery.26 The central bank’s control of the FX market As mentioned earlier, before the market making system came into being, the central bank was the largest de facto “market maker” in China’s FX market. Facing strong RMB appreciation pressure, the central bank had—and still has—to frequently and passively absorb excess US dollar supply in order to both clear the market and at the same time maintain the US dollar peg. This leads to a variety of problems, including a lack of independence and flexibility in administering monetary policy. Assigning market making responsibilities to commercial banks gives the central bank a way out of this vicious circle and allows the central bank more freedom to tackle problems at home and to experiment with new open market operations such as currency swaps. The growth rate of FX reserves is also expected to fall with an easing of the pressure on RMB appreciation, so that the central bank would no longer need to absorb huge US dollar sell orders. The central bank’s adjustment to its FX market control mechanism comes with the transformation in trading arrangements. Market makers will inevitably take over at least part of the information processing and


383

price discovery functions. The Chinese authorities have clearly stated their policy of not yielding to foreign political pressures by making any one-off exchange rate adjustments.27 Thus, continuing to breathe more latitude and more market forces into the exchange rate determination mechanism and as a result allowing a certain amount of room for the gradual appreciation of the RMB is an expedient way of coping with the RMB appreciation pressure.

14.7

SUMMARY AND IMPLICATIONS FOR THE RMB’S ROLE IN EAST ASIA

To sum up, China’s FX market is characterized by low turnover; heavy concentration in spot trading, with the retail market in forwards just recently opened up; nascent inter-bank forwards and retail market swap transactions; dominance by US dollar trading, with all other foreign currencies accounting for only a tiny part of the market; a membership-based exchange trading platform evolving toward a mixed trading mode incorporating some features from the dealer market, with banks as the most prevalent type of participants; a high degree of market concentration on both the sellers’ side by the BOC and the buyers’ side by the PBOC; and its simple function as the place for designated FX banks to net out open positions, with only a limited capacity to serve investment or risk-hedging needs of FX users. Among them, the most central problem is the lack of liquidity. Without a deep market, all reform measures will only remain technical adjustments with no profound impact on market functions. The recent policy initiatives addressed some of the structural problems in the FX market and are expected to increase market liquidity, enhance market functions, and influence exchange rate formation mechanisms. But the new reforms and the newly established market have some of their own problems in need of redress, which may reduce their effects with respect to correcting existing structural failures. The new reforms in the FX market are carried out in a “top-down” and “parallel” way. With a “top-down” reform, the market has to undergo a transitional stage in which market participants are given some time to adapt to the new trading rules, to invest in human resources and technology, and to acquire the right market sense. In turn, it may take a while before the market earns recognition and builds momentum in accumulating liquidity. The new FX market reforms were also instituted in a “parallel” way without completely changing the old system, which means that the two institutional factors that most seriously constrain the development of China’s FX market haven’t been completely removed and may continue to take their toll. Nascent market segments such as the inter-bank

384

The role of China

forward market need to have more independent pricing in order to fully realize their risk-hedging potential. In conclusion, certain structural problems in China’s FX market such as low liquidity will linger and continue to afflict the market, but, with the new reforms coming into effect after overcoming their own problems and with the institutional restrictions to be phased out in the future, market structures can expect great improvement in the future. The fact that these institutional constraints and the structures in the FX market are inter-related presents a dilemma for moving forward, as liberalizing on one front is difficult as long as the status quo is maintained on the other. Specifically, the rigidity of the exchange rate regime imposes limits on the growth and diversification of the FX market. But at the same time, allowing more flexibility in the exchange rate requires a broader, more diversified, competitive, and efficient market platform on which real forces of supply and demand can determine the RMB value of foreign currency. A profound change in one institutional pillar or the other is required to break loose from the status quo. Both the rigid exchange rate and the underdevelopment of the Chinese FX market considerably limit the RMB’s prospects for becoming a regional lead currency anytime soon. Despite the enormous size of the Chinese economy and its growing role in world and regional trade, the RMB will not be able to act as key or anchor currency for an East Asian “RMB bloc” unless China develops deep and liquid financial markets and unless the RMB becomes fully convertible. For the latter to happen, continued FX market reform is crucial. In our view, key elements of FX market development must include: (1) further stimulating market demand by lowering market entry requirements, removing the “real trade background” rule in FX trading, and allowing a certain amount of speculation; (2) encouraging enterprises and banks to build up their skills and resources in FX risk management and to speed up reforms in the banking sector; (3) improving the financial environment by speeding up development in the money market, in the market determination of interest rates, and in the credit rating system; (4) phasing out the central bank’s control in the FX market and prudentially and gradually opening capital accounts; and, finally, (5) introducing more flexibility in the exchange rate regime.

NOTES 1.

An earlier version of this chapter was presented at the HWWA/HWWI conference on East Asian Monetary and Financial Integration in Hamburg, Germany, December 15–16, 2005 as well as at the Hamburg Institute’s International Finance Seminar on


2. 3. 4. 5. 6.

7. 8. 9. 10. 11. 12. 13. 14.

15. 16. 17. 18. 19. 20. 21. 22. 23. 24. 25. 26. 27.

385

December 13, 2005. We would like to thank participants at these meetings, especially our discussant Alvaro Santos Rivera, for very useful comments and suggestions. All remaining errors are those of the authors alone. Some parts of this chapter draw from Zhang and Liang (2006). On the yen bloc see Kwan (2001). The FX plan was formulated by the State Planning Commission in consultation with the Ministries of Trade and Finance and the PBOC. See Zhang (2003). The exchange rate for trade activities was set at 2.8 RMB/USD, while the official rate still stood at 1.5 RMB/USD. This practice was abolished on January 1, 1985. Despite the name, the swap market provided spot transactions only. These adjustments were frequent, small, and slow, with mixed appreciation and depreciations, but on the whole the RMB had been devalued against the US dollar from the early 1979 level of 1.50 RMB/USD to 5.72 RMB/USD at the end of 1993. Six large official devaluations took place in 1981, 1984, 1985, 1986, 1989, and 1990. Details of these policies can be seen in the “Notice of the People’s Bank of China on Accelerating the Development of the Foreign Exchange Market” which came out on August 8, 2005 on the central bank’s website: www.pbc.gov.cn. Details can be found on the State Administration of Foreign Exchange’s website: www. safe.gov.cn. Non-financial enterprises were not allowed access until the August 2005 reform. This allowable FX working position has to be verified and approved by SAFE. The market structure part of this chapter focuses primarily on the inter-bank market. Distance connections can be realized through Digital Divide Network, frame-relay, or dial-up. For a discussion on the need for reform of the CFETS see Zhang and Liang (2006). According to the Bank for International Settlements (BIS), the main factors driving the fall in turnover were the introduction of the euro, the growing share of electronic broking in the spot inter-bank market, consolidation in the banking industry, and global concentration in the corporate sector. The eight foreign currency pairs include EUR–USD, AUD–USD, GBP–USD, USD– CHF, USD–HKD, USD–CAD, USD–JPY and EUR–JPY. Presently, forward contracts exist for eight currencies (US dollar, Hong Kong dollar, euro, yen, pound, Swiss franc, Australian dollar, and Canadian dollar) and 14 different terms (from seven days to 12 months). The PBOC stopped the disclosure of FX market turnover data in the second half of 2005. They are the BOC, the Agriculture Bank of China, the Industrial & Commercial Bank of China, the China Construction Bank, and the China International Trust & Investment Corporation (CITIC). The first four are commonly referred to as the “Big Four”. The “impossible trinity” holds that, with free capital mobility, a fixed exchange rate and independent monetary policy cannot be realized simultaneously. Data from the Ministry of Commerce of the People’s Republic of China website: http:// zhs.mofcom.gov.cn/tongji.shtml. See Sarno and Taylor (2001). Other measures, such as opening the retail market forward FX settlement business to all foreign exchange designated banks and introducing swap transactions, will not be discussed here. Among them, 48 are foreign banks, while 16 are domestic banks. Ma et al. (2004) note that there is a large difference between the onshore interest rate and NDF market implied interest rate, reflecting the existence of strict capital controls. The only “market” interest rate in China is the seven-day repo rate. Market makers cannot hold short positions in the US dollar. This was clearly stated when Premier Wen addressed the press after the fourth session of the 10th National People’s Congress. See Wen (2006).

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REFERENCES BIS (2004). Triennial Central Bank Survey of FX and Derivatives Market Activity in 2004. Basel: Bank for International Settlements. China Money (various issues): www.chinamoney.com.cn. Harris, Lawrence (2002). Trading and Exchanges: Market Microstructure for Practitioners. Oxford: Oxford University Press. Hefeker, Carsten, and Andreas Nabor (2005). “China’s Role in East Asian Monetary Integration.” International Journal of Finance and Economics 10: 157–66. Ho, Corinne, Guonan Ma, and Robert N. McCauley (2005). “Trading Asian Currencies.” BIS Quarterly Review March: 49–58. Kwan, Chi Hung (2001). Yen Block. Toward Economic Integration in Asia. Washington, DC: Brookings Institution Press. Lyons, Richard K. (2001). The Microstructure Approach to Exchange Rates. Cambridge, MA: MIT Press. Ma, Guonan, Corrinni Ho, and Robert N. McCauley (2004). “The Market for Non-deliverable Forwards in Asian Currencies.” BIS Quarterly Review June: 81–94. PBOC (2006). “Survey of Enterprises’ Use of FX Risk Hedging Tools.” www.pbc. gov.cn/. Preeg, Ernest H. (2003). “Chinese Currency Manipulation and the U.S. Trade Deficit.” Statement before the US–China Economic and Security Review Commission, September 25. Sarno, Lucio, and Mark P. Taylor (2001). “The Microstructure of the Foreign Exchange Market: A Selective Survey of the Literature.” Princeton Studies in International Economics no. 89, Princeton University, Princeton, NJ. Shu Youdong (2001). “The Appreciation Pressure on RMB and the Releasing Measures.” Zhong Guo Huo Bi Shi Chang (China Money) November: 34–6. Wen Jiabao (2006). “Speech at the Press Conference of the 4th Session of the 10th National People’s Congress”, March 14. http://news.xinhuanet.com/misc/200603/14/content_4301180.htm. Xin Wang (2003). “Problems in China’s FX Market.” International Economic Review 11–12: 1–6. Zhang Guang Ping (2005). “RMB Derivatives, a Market that Shouldn’t be Missed.” China Business News, http://gp.stock.163.com. Zhang Jikang, and Liang Yuanyuan (2006). “Institutional and Structural Problems of China’s Foreign Exchange Market.” China: An International Journal 4: 60–85. Zhang Zhichao (2003). “Harmonious Development of Foreign Exchange Market and Liberalisation of Capital Controls in China.” Paper presented at the International Seminar on Developing China’s Foreign Exchange Market, Shanghai, December.

Index ABMI see Asian Bond Markets Initiative (ABMI) absorptive capacity 142 ACU see Asian Currency Unit (ACU) ADBI see Asian USD Bond Index (ADBI) Adenauer, Konrad 42 ADXY see Bloomberg-JPMorgan Asia Currency Index (ADXY) AFAS see ASEAN Framework Agreement on Services (AFAS) AFTA see Asian Free Trade Area (AFTA) AIA see ASEAN Investment Area (AIA) AICO see ASEAN Industrial Cooperation (AICO) Scheme Alesina, Alberto F. 71 Alexander, Volbert 217 Allen, Franklin 82 allocative efficiency 195−6 Amato, Jeffrey D. 102 AMU see Asian Monetary Unit (AMU) AMU Deviation Indicators 105−6 Andersen, Lene 48 Anderson, Jonathan 319 APEC see Asian Pacific Economic Cooperation (APEC) arbitrage 89, 147−8, 150, 154, 188, 380 Argentina 207, 215 Arndt, Sven 326 ASEAN Agreement for the Promotion and Protection of Investments 38 ASEAN Economic Community attracting FDI to 34, 37 ‘best practices’ adopted in 34 developing institutions in 35−6 end goal of Vision 2020 13, 21, 22 free flow of services in 34−5, 37 labor mobility in 22, 34 lessons from EU 3−4, 24−32, 36−7

rationale for 22 tariff harmonization in 32−4 ASEAN Framework Agreement on Services (AFAS) 35, 37 ASEAN Industrial Cooperation (AICO) Scheme 38 ASEAN Investment Area (AIA) 19, 22, 34, 37 ASEAN region building the ASEAN Economic Community 32−6 diversity in economic development in 25 evolution in a regional context 16−23 exchange rate policy coordination with China 223, 241, 242, 245, 251 implicit coordination of exchange rate policies 259, 260 monetary policy consistent with 223, 256−62 REER indexes 254−6 weights for currency baskets 236, 238, 251−4 exchange rate stabilization with cooperation 235−8 exchange rate stabilization without sustainable underlying policies 224−35 investment, saving, current account and REERs since 1990 226−35 FDI flows to 14, 26, 27, 34, 37 institutional environment facing 24, 35−6 international economic environment facing 24−5 lessons from EU 3−4, 24−32, 36−7 member countries 101, 135, 215 openness of countries in 25−6, 32−4 power structure within 213

387

388

Index

surveillance process 1 trade patterns 6, 14−16, 25−7, 197, 198, 223, 236, 238−42 currency baskets and REER indexes based on 251−6 by sector 242−5, 246−7 by sector and market 245−51 ASEAN Vision 2020 18−19, 21, 22, 33 Asia Credit Index (JACI) 309−10, 311 Asian Bond Fund I 23, 81, 91, 105, 207, 319 Asian Bond Fund II 4, 23, 81, 87, 90, 91−4, 96, 97, 105, 207, 319 further developments arising from 101 incentives to reduce impediments in 94, 98−100 ‘learning by doing’ element in 87, 93−4, 100−101 Asian Bond Market Initiative (ABMI) 21, 23, 28, 81, 91, 105, 304, 315 Asian bond markets see regional bond markets, Asian Asian bonds, definition of 82 Asian Central Bank, creation of 317 Asian Cooperation Dialogue (ACD) 81 Asian crisis (1997−98) capital outflows during 47−8 and China’s foreign exchange market 360, 363−4, 367−8 currency basket structures before and after 281−7 current account balances before and after 29, 170−71, 204, 273−4 debate on exchange rate policy triggered by 159 and development of local currency bond markets 87, 88, 207 dollar pegs temporarily lifted during and after 210, 267 domestic currency interest rates prior to 172−3 exchange rate volatility before, during and after 163−8, 224−6, 267−8, 270−72 inflation rates prior to 188 investment, saving, current account and REERs before, during and after 226−35 ‘Miyazawa Plan’ initiated during 23

original sin as one of causes of 204 and poverty 234, 235 real GDP before, during and after 226 regionalist trend triggered by 1, 3, 17, 22, 30, 36, 41, 61, 104, 195 swap transactions not used prior to 126 Asian Currency Unit (ACU) 1, 3, 7, 31−2, 208, 213, 304−17 constructing ACU index 306−11 currencies to be included 308, 313−15 economic variables and indicators for calculating currency weights 307−8 existing currency baskets 308−11 fixed currency shares vs. fixed currency units 307 frequency of periodical revisions of currency shares/units 308 definition 304 economic logic of introducing 312−15 case for a currency basket 313−15 reasons for not pegging to a common key currency 312−13 objectives 305−6 potential role for monetary and exchange rate policy coordination 315−17 the way forward 317 see also Asian Monetary Unit (AMU) Asian Development Bank (ADB) 1, 16, 23, 91, 208, 290, 304, 354, 355 Asian Development Fund 6, 222, 237, 262 Asian Free Trade Area (AFTA) 17−22, 25, 26, 33, 37 Asian miracle 235, 242 Asian Monetary Fund (AMF) 17, 23, 61 Asian Monetary Unit (AMU) 107 bonds denominated in previous research on 105−6 risks for bond issuers 4−5, 131−3 risks for foreign investors 106, 116−24, 133

Index currency weights in 309−10, 311 as a portfolio fund 112 see also Asian Currency Unit (ACU) Asian Pacific Economic Cooperation (APEC) 13, 17, 22, 23, 29, 81, 90 members 101 Asian USD Bond Index (ADBI) 309−10, 311 asset dollarization 273−4 Association of Southeast Nations (ASEAN) see ASEAN region Australia, East Asian trade with 239, 240, 241, 248, 249, 250, 252, 253 Australian dollar share in global foreign exchange market 370 weight in currency baskets 252, 253, 310 Austria, monetary policy decisions in 209, 210 Austro-Hungarian empire 75 automobiles, trade in 22, 32 Axelrod, Robert 78 Balassa, Bela 333 Balassa-Samuelson approach 187, 328, 330, 333−41 Baldwin, Richard E. 82, 215 Bank for International Settlements (BIS) 89, 102, 119, 363, 369, 370, 371 bank lending, characteristics of 64, 65 Bank of China (BOC) 366−9, 372 Bank of England 216, 308−11 Bank of Japan 73, 178, 182 Bank of Korea 73 bankruptcy 65, 234 Barre Report 43, 47, 57 barriers to monetary and financial integration 2 Barro, Robert J. 71 Battellino, Ric 90, 101 Battle of the Sexes 78, 320 Beck, Thorsten 355 BEER models see behavioral equilibrium exchange rate (BEER) models behavioral equilibrium exchange rate (BEER) models 327, 328, 329, 330 Beijing 62

389

Belgium, monetary policy decisions in 209 Belgium−Luxembourg Economic Union 209 Bénassy-Quéré, Agnes 135 Benelux, role in EMU negotiations 53−4, 56 Berger, Helge 215, 217 Bernanke, Ben 187 ‘best practices’, adoption of 34 Betz, Karl 195 bid−ask spreads 124−31, 132, 134, 378, 381 bilateral trade integration 200−202 Bird, Graham 320 BIS see Bank for International Settlements (BIS) Bisignano, Joseph 189 Blanchard, Olivier 157 Bloomberg 93, 127, 130, 132, 162, 164, 165, 167, 168, 182, 271, 281, 284, 285, 286, 287 Bloomberg-JPMorgan Asia Currency Index (ADXY) 309−10, 311 BOC see Bank of China (BOC) bond financing, characteristics of 64−5 bond markets see currency basket denominated bonds; regional bond markets, Asian; regional bond markets, European Bordo, Michael D. 203, 207, 216 Bosworth, Barry 328, 329 Brandt, Loren 350 Branson, William H. 233, 263 Brazil 207, 215 Bretton Woods System 5, 28, 43, 47, 68, 75, 185, 187, 208, 276, 317 Bretton Woods II view 5, 9, 141, 145−56, 276, 317 British pound Chinese exchange rate fixed to 358 currency basket of 308−11 share in global foreign exchange market 370 Broughton, J.M. 82 Brunei AFTA membership 22 trade patterns 14, 15, 197, 198 by sector 242, 243, 244, 246−7 see also Brunei dollar

390

Index

Brunei dollar currency basket of 210−12 exchange rate volatility against US dollar 260 weight in currency baskets 309 bubbles 142, 144, 224, 233, 276, 278 Bundesbank 50, 52, 76 discount rate 208−10 business cycles 72 Cairns, John 327, 328, 329 Calvo, Guillermo A. 173, 216, 349 Cambodia AFTA membership 22 interest rates 203 monthly changes in reserves 261 openness of 25, 33 trade patterns 14, 15, 197, 198 by sector 243, 244, 246−7 transition period for 34 see also Cambodian riel Cambodian riel currency basket of 210, 211, 294 exchange rate volatility against US dollar 260 pegged to US dollar 210 weight in currency baskets 309 Canzoneri, Matthew 335−6 capital-account countries 186 capital controls 89, 142, 146, 148, 273 by China 89, 97, 313, 329, 330, 347−8, 363, 373, 375, 376, 380 effectiveness of 212, 329 removal of 96−7, 99, 148, 313, 347−8, 375, 376 Carare, Alina 216 Cardon, Pierre 102 Cargill, Thomas F. 82 CDS indices see credit default swap (CDS) indices CEIC Asia Database 200−201 Ceglowski, Janet 350 central bank of China 161, 181, 272, 355 see also People’s Bank of China (PBOC) centre−periphery model 185 CFETS see China Foreign Exchange Trading System (CFETS) Chaebols 64 Cheung, Hon 94

Cheung, Yin-Wong 328, 330, 349, 356 Chiang Mai Initiative (CMI) 1, 6, 20, 23, 41, 61−2, 81, 104, 213, 222, 236−7, 238, 304, 315 China admission to WTO 364, 376 balance of payment flows 364−5 capital controls imposed by 89, 97, 313, 329, 330, 347−8, 363, 373, 375, 376, 380 CPI index for 258 current account balance 170, 171, 175, 179, 180, 204, 273, 325, 348−9, 364, 365, 373 emergence of Chinese economy 61 FDI flows to 175, 179, 185, 291, 373 foreign exchange reserves of 169, 179, 180, 204, 273, 274, 276, 277, 278, 325−6, 329, 348−9, 372−4, 375, 382 foreign exchange risk facing 111 implicit coordination of exchange rate policy with ASEAN 259, 260 interest rates 179, 182, 183, 184, 203−4, 212, 372, 374, 375, 380, 381 labor productivity in 335−41 liquid dollar-denominated assets of 175 monetary policy consistent with exchange rate coordination with ASEAN 223, 256−62 monthly changes in reserves 261 nominal effective exchange rates 259, 299 REER indexes 254−6 relations with Japan 2, 3, 48, 55, 62, 79, 80 role in fostering regional cooperation 1, 4, 7−8, 17, 48, 55, 57−8, 61−2, 326, 376, 383−4 total non-performing loan liability 326 trade patterns 6, 15, 197, 198, 223, 236, 238−42, 326, 377 currency basket and REER indexes based on 251−6, 293, 294, 297, 299

Index by sector 242−5, 246−7 by sector and market 245−51 weighted CPI index for trading partners 257 see also Chinese foreign exchange market; Chinese renminbi, People’s Bank of China China−ASEAN Free Trade Agreement 20−21, 23 China Foreign Exchange Trading System (CFETS) 359, 360, 362, 363, 365, 379 members 371−2, 376 China Money 366, 367, 370, 371, 372, 378 China’s foreign exchange market 357−84 current organization of 360−62 development of 358−60 pre-1979: strict central control 358 1979−93: FX retention and swap 358−9 1994 and post-1994: compulsory settlement on a centralized platform 359−60 new reform measures in 376−83 broadening of market access 376 central bank’s control of FX market 382−3 diversified market liquidity provision mechanism 381−2 enrichment of market segments 378−81 foreign banks’ participation 376−7 non-financial enterprises 377−8 price discovery and the exchange rate formation mechanism 382 transformation of trading arrangements 381 problems in 373−6 distorted market supply and demand 373−4 passive intervention of PBOC 374−6, 382−3 structural features of 362−73 market participants and concentration 371−3 market segments 366−71 market size 362−6

391

summary and implications for RMB’s role in East Asia 383−4 Chinese Bond Index Fund 101 Chinese renminbi (RMB) bonds denominated in 91, 113, 114, 117, 125 currency basket of 7, 162, 163, 210, 211, 223, 236, 238, 241, 242, 251−4, 256, 281−7 passim, 291, 293, 294, 297, 299, 357, 358, 360 ‘equilibrium’ exchange rate of 325−49 extant literature on 327−30 implications for foreign exchange policy 345−9 productivity approach 333−41 real exchange rate and income regression 341−5, 346, 347, 356 simple time series approach 330−33 euro−RMB exchange rate 143, 148−9, 150, 154, 155, 370 nominal effective exchange rates 259, 299 pegged to US dollar 5, 111, 113, 141, 161, 165, 179, 210, 211, 259, 267, 274, 374−5, 382 as proxy for currencies of emerging Asia 141 REER indexes 254−6 role in East Asia 7−8, 376, 383−4 as regional anchor currency 313, 314, 357−8, 384 ‘single managed floating exchange rate’ regime (1994) 359 USD forward trading against 379−80 USD−RMB exchange rate 5, 141−5 passim, 148−50, 154, 155, 156, 161, 164−8 passim, 175, 179, 210, 211, 259, 260, 267, 271, 272, 274, 359, 360, 367−70 passim, 374−5 determination mechanism 382−3 ‘equilibrium’ value of 325−49 weight in currency baskets 279, 297, 298, 309, 311 yen forward trading against 379−80

392

Index

see also China’s foreign exchange market Chinese stock market 360 Chinese yuan see Chinese renminbi Chinn, Menzie D. 216, 275, 278, 329, 332, 333, 335, 339, 349, 354, 355 Chmelarova, Viera 270 Choudhri, Ehsan 350 CIS see Commonwealth of Independent States (CIS) Click, Reid W. 39 Cline, William 159, 190 cognitive dissonance 79 Cohen, Benjamin J. 203, 205, 206 cointegration tests 332, 356 Cold War 24, 50 Committee on the Global Financial System 101 Common Agricultural Policy (CAP) 14, 26, 28−9, 43, 57 common citizenship, desire for 49 Common External Tariff 26, 32 common land border 200, 210, 202 Commonwealth of Independent States (CIS) 75 ‘community method’ approach 51 conflicted virtue 5, 6, 73, 173−6, 179, 183, 185, 187, 189, 196, 204, 207 Confucius 80 contagion 48, 104, 134, 189, 215, 230−31, 235−6, 256, 262 Corden, W. Max 68 corporate bonds 101, 305 Corsetti, Giancarlo 215 Coudert, Virginie 328, 329, 341 Couharde, Cécile 328, 329, 341 CPI index CPI indices for core ASEAN and China + Hong Kong 257, 258 weighted CPI indices for trading partners, core ASEAN and China + Hong Kong 257 crawling peg arrangement 282 credit default swap (CDS) indices 92 credit guarantees 91, 105 credit rating agencies 91, 105 Crockett, Andrew 268 currency basket denominated bonds 67 East Asian currencies previous research on 105−6

regional bond market indexes 94, 99, 309−10, 311 risks for bond issuers 4−5, 131−3 risks for foreign investors 106, 116−24, 133 international currencies (euro/dollar/ yen) liquidity of 130−31, 134 risks for bond issuers 105, 106−8, 109−12 currency baskets bonds issued in see currency basket denominated bonds composition of 6−7, 160−63, 201, 210−12, 279−80, 288, 290, 306−11, 313−15 estimation of undisclosed basket structures 281−7 weighted by financial market activity 307, 311 weighted by GDP size 307, 311 weighted by trade composition 236, 238, 251−6, 279, 291−302, 307−8, 311 currency areas that might adopt a common basket 223, 236, 238, 241, 242, 254, 256, 292−5 ECU as 30−31, 107, 208, 237, 256, 290, 306 effect on USD−euro exchange rate 156 effect on USD−RMB exchange rate 156 individual-country vs common baskets 295−302 reasons for pegging to 279−80, 288, 290−91, 302, 313−15 and stability of nominal effective exchange rates 7, 268, 279, 295−302 see also Asian Currency Unit (ACU); Asian Monetary Unit (AMU) currency competition 203 currency mismatch 62, 172, 174, 196, 204, 269 Dammers, Clifford 318 de Gasperi, Alcide 42 De Haan, Jacob 217 default risk on balance sheets 270

Index deflation, threat of 188−9 delinquent loans 65 Delors, Jacques 45, 54 Delors Report 45, 47, 52, 54, 55, 57 Denmark exemption from third stage EMU negotiations 47, 57 monetary policy decisions in 209, 210 Despres, Emile 185 Deutsche Bank 151, 332, 354 developing nations, financial problems faced by 203−4 disintegration of monetary unions 75 distance, effect of, on trade 200, 201, 202 division of labor 290 dollar, US see US dollar dollar-denominated B shares 360 domestic debt securities outstanding in Asia 88, 89 Dooley, Michael 157, 158, 185, 276, 326 Dowd, Kevin 206 Duisenberg, Wim 81 Duisenberg plan 53 Dylan, Bob 208, 210 dynamic OLS (DOLS) 334, 336, 338, 339 Dyson, Kenneth 51, 52 EAEG see East Asian Economic Grouping (EAEG) EAFTA see East Asian Free Trade Area (EAFTA) earnings retention scheme for exports 358 EASG see East Asian Study Group (EASG) East Asia Summit (Kuala Lumpur, 2005) 308 East Asian bond markets see regional bond markets, Asian ‘East Asian dollar standard’ 5, 169, 201, 210, 213, 267, 274, 283, 287, 312 East Asian Economic Grouping (EAEG) 22 East Asian Free Trade Area (EAFTA) 20

393

East Asian Study Group (EASG) 19−20, 21 East Asian Vision Group (EAVG) 19, 20 economic development, diversity in 25 economic game 63, 77 connected with security game 78−9 Economic Review and Policy Dialogue (ERPD) 304, 315 economies of scale 67, 126 ECOTECH 17 ECU see European Currency Unit (ECU) Edwards, Sebastian 212 Eichengreen, Barry 70, 172, 199, 204, 206, 213, 215, 269, 270, 306, 316, 349 Einstein, Albert 36 elasticities model of the balance of trade 187−8 elasticity weights for currency baskets 292 electronic broking system 361, 362, 379, 381 electronics and transport equipment, trade in 27 ELMI+ see Emerging Local Markets Index Plus (ELMI+) EMEAP see Executives’ Meeting of East Asia-Pacific Central Banks (EMEAP) Emerging Local Markets Index Plus (ELMI+) 309−10, 311 Emerson, Michael 199 energy, trade in 27 Engel, Charles 71 entrepôt trade 241, 242 equity financing, characteristics of 64−5 Ernst & Young 349 ERPD see Economic Review and Policy Dialogue (ERPD) euro bid−ask spreads for trades between East Asian currencies and 126, 127, 128−30, 131, 132 bid−ask spreads for trades between major currencies and 126−7, 130, 131, 132

394

Index

bonds denominated in 110, 173−4 currency basket of 308−11 increasing importance of 278−9, 280, 288 introduction of (1999) 31, 41, 46, 55, 76, 185, 208 as proxy for currencies of non-US market economies 141 RMB−euro exchange rate 143, 148−9, 150, 154, 155, 370 RMB spot trading against 365 share in China’s foreign exchange market 369−70 share in global foreign exchange market 370 USD−euro exchange rate 142−5, 147−57, 163−7 passim, 168, 186, 268, 270, 271, 272, 370 USD spot trading against 378 weight in currency baskets 6−7, 160, 163, 201, 252, 253, 279, 280, 281, 283, 285−6, 287, 288, 296, 297, 298, 299 yen spot trading against 378 euro zone 68−9, 70, 71, 73, 76 trade intensity index between East Asian countries and 108 Eurobond markets 31, 173−4 ‘Euroland’ Asian savings absorbed by 147, 149, 151, 153, 155 assumptions concerning 142 current account balance 146−7, 149, 150 definition 141 expected rate of return on capital in 147−8 improved outlook for growth in 143, 153 interest rates in 143, 146−51 passim, 153, 154, 155, 157 weaker outlook for growth in 153−4 European Central Bank (ECB) 46, 50, 52, 76, 81, 167, 278, 279 currency basket weights used by 308−11 Executive Board 210 Governing Council 210 European Coal and Steel Community (ECSC) 81

European Commission 45, 51, 52, 54−5 European Community 38, 44, 318 European Council 29, 45−6 European Court of Justice 52 European Currency Unit (ECU) 1, 3, 7, 30−31, 44, 46, 107, 208, 237, 256, 290, 306 European Monetary Cooperation Fund 43, 44−5, 306 European Monetary Institute (EMI) 46 European Monetary System (EMS) 28, 30−31, 37, 44−5, 47, 75−6, 107, 196, 208, 256, 288, 290, 306 European Payments Union 14, 28 European Snake 28, 43−4, 45, 47, 312 European Union 4 capital markets in 279 Common Agricultural Policy (CAP) 14, 26, 28−9, 43, 57 determination of monetary policy decisions in 208−10 economic cooperation with ASEAN 23 euro introduced (1999) 31, 41, 46, 55, 76, 185, 208 exchange rate cooperation in 28−9, 30−31, 43−5, 47, 75−6, 237, 256, 306, 312 FDI in ASEAN region 14 financial services integration in 35 industrial policies in 33 lessons for East Asian countries 2−4, 24−32, 36−7, 46−9, 55−8 monetary integration in 2−3, 4, 28−31, 37, 41−58, 68−9, 71−2, 75−6, 196, 199, 207, 208−10, 306 political integration in 81 Single European Act 27, 29, 33, 34, 35, 37, 45 Single Market Program 17, 45 Stability and Growth Pact 50, 216 Structural Funds 57 trade patterns 14, 15, 16, 71−2, 198, 239, 240, 248, 249, 250, 252, 253, 293, 294, 311 exchange rate cooperation see regional exchange rate cooperation

Index Exchange Rate Mechanism (ERM) 44, 47, 50, 75−6, 306, 312 exchange rate spillover effects 196, 197−9 exchange-traded funds (ETF) 95, 101 Executives’ Meeting of East AsiaPacific Central Banks (EMEAP) 23, 81, 87, 90, 91, 92, 94, 96, 97, 98, 100, 105, 304, 311 expected rate of return on capital 147−8 export-driven development policy 5, 141, 142, 185, 186, 188, 205−6 external balances approach 328, 329, 330, 347 externalities 67, 69 FDI see foreign direct investment (FDI) flows FDI intensity 200 Featherstone, Kevin 51, 52 Feldstein, Martin 73, 76, 82 Fernald, John 335, 349, 354 Fernández-Arias, Eduardo 215 Festinger, Leon 79 financial institution failures 234 financial intermediation carried out abroad 87, 88, 185 negotiable and market forms of 64−5 financial maturity, lack of 203 financial services sector, integration in 35 Finland, monetary policy decisions in 209 First Banking Directive 29 First World War 207 fiscal institutions, development of 205 Fischer, Stanley 159, 267 fixed exchange rate regime 68, 69−70, 71, 73 see also Bretton Woods System Flandreau, Marc 203 floating exchange rate regime 68, 70, 73 flow equilibrium models 327, 328, 329 Folk theorem 77 Folkerts-Landau, David 185 foreign direct investment (FDI) flows to ASEAN region 14, 26, 27, 34, 37 to China 175, 179, 185, 291, 373 intra-regional in East Asia 197, 200−201, 202

395

weights in currency baskets influenced by 291−2 foreign exchange market in China see China’s foreign exchange market foreign exchange reserves accumulation of 167−8, 169, 178−9, 180−81, 186, 188−9, 204, 273−4, 276−8, 287−8, 325−6, 329, 348−9, 372−4, 375, 382 in ACU 305−6 conversion of dollar assets into euro assets 280 Foreign Invested Enterprises (FIEs), foreign exchange transactions of 359 France monetary policy decisions in 209, 210 role in EMU negotiations 51−3 see also French franc Frankel, Jeffrey A. 16, 28, 71, 73, 159, 160, 195, 200, 201, 211, 212, 215, 216, 268, 275, 278, 281, 285, 328, 329, 341, 342, 349 Fratzscher, Marcel 212 ‘free trade’, definition of 17 French franc 43, 47, 82 Fritz, Barbara 205, 215 ‘FTA-plus’ arrangement 32 Fukuda, Shin-ichi 70 functional approach toward integration 42 Funke, Michael 328, 329, 334 G3 currency basket 105 Gale, Douglas 82 GAO see Government Accountability Office (GAO) Garber, Peter 185 Gartzke, Eric 74 GATT/WTO 24, 26, 33 see also World Trade Organisation (WTO) German Mark appreciation of 43 Benelux currencies and Danish krone tied to 44 credibility and reputation of 50, 76 exchange rate between D-Mark and O-Mark 69

396

Index

exchange rate volatility against US dollar 163, 164, 165, 166, 270 weight in currency baskets 282−3, 285−6 Germany Bundesbank discount rate 208−10 foreign exchange reserves 169, 277 monetary policy decisions in 196, 208, 210, 212 reunification of 49−50, 69, 76 role in EMU negotiations 49−51, 81 see also German Mark Giavazzi, Francesco 207 Giradin, Eric 319, 320 Glick, Reuven 71, 75, 215 Global Financial Data 209, 225, 254, 255, 257, 258, 259, 260 global financial system 3, 47−8, 62 globalization of production 326 gold standard 68, 207 Goldstein, Morris 215, 268, 328, 329, 349 Golub, Stephen 350 Goodhard, Charles 208 Goto, Junichi 72 Gourinchas, Pierre Olivier 158 Government Accountability Office (GAO) 327 government interventions in bond markets, justification for 66−7 Goyal, Rishi 178, 187, 189 gravity model 71, 200 Greece, monetary policy decisions in 208, 209 Greenaway, David 206 Groningen Growth and Development Center 335, 354 gross capital formation, ASEAN, by country, since 1990 227, 228, 229, 230, 231, 234, 235 gross domestic product (GDP) ASEAN, by country, since 1990 226, 227, 228, 229, 235 size of effect on currency status 206, 207 effect on trade 200, 201, 202 weights in currency baskets related to 307, 311 Gudmundsson, Már 279, 280 Gyntelberg, Jacob 102

Habsburg Empire 69 Hague Summit (1969) 43, 44, 55 Hamada, Koichi 68, 70, 72, 73, 82, 320 Hard ECU (HECU) 52 harmonization, definition of 75 Harris, Lawrence 382 Hartmann, Philipp 126 Hausmann, Ricardo 172, 204, 269, 270 Hawk Dove game 63, 77−9 Hefeker, Carsten 357 Hernández, Leonardo 166 Heston, Alan 341, 355 Hiemenz, Ulrich 38 hierarchy of currencies 203−4 Hillebrand, Eric 173, 189, 274 Hinkle, Lawrence E. 349 Ho, Corinne 357 Holtz-Eakin, Douglas 329 Holz, Carsten 350, 354 home bias in investment preferences 144, 145 home country principle 35 Hong Kong current account balance 171, 181 foreign exchange reserves 169, 181, 277 foreign exchange risk facing 110−11 interest rates 182, 183, 184, 212 nominal effective exchange rates 299 trade patterns 198, 242 currency baskets based on 292, 293, 294, 297, 299 see also Hong Kong dollar Hong Kong Bond Index Fund 93 Hong Kong dollar bid−ask spreads for trades between major currencies and 127, 130 bonds denominated in 113, 114, 117, 125 currency basket of 7, 162, 163, 210, 211, 281, 282, 283, 284, 285, 286, 292, 293, 294, 297, 299 exchange rate volatility against US dollar 164, 165, 166, 167, 168, 267, 271, 272 nominal effective exchange rates 299 pegged to US dollar 111, 113, 161, 165, 210, 211, 212, 267 RMB spot trading against 365

Index USD spot trading against 378 weight in currency baskets 297, 298, 309, 311 Hong Kong Stock Exchange 94, 97 Horvath, Michael 356 Hsieh, David 350 Hugo, Victor 42 Hume, David 215 Hurricane Katrina 143, 155 Hyderabad, East Asian Finance Ministers’ meetings in 304 iBoxx Pan Asia Index 94, 99, 309−10, 311 IIC see International Index Company (IIC) ILO see International Labor Organization (ILO) impediments index 98−9 ‘in-kind’ transactions 95, 96 India, trade patterns of 292, 293, 294 Indian rupee 310 Indonesia capital controls imposed by 89 CPI index for 257, 258 current account balance 170, 171, 180, 204, 227, 230, 232, 235, 273 external debt 227, 232 FDI in 27 financial institution collapses in 234 foreign exchange reserves 169, 180, 204, 277 foreign exchange risk facing 109, 110, 111, 132, 133 GDP 226, 227 gross capital formation 227, 231, 234 interest rates 172−3, 183, 184, 203 monthly changes in reserves 261 nominal effective exchange rates 259, 299 REER movements since 1990 233, 234, 235 savings 227, 230, 231 trade patterns 14, 15, 27, 197, 198, 239, 240 currency baskets and REER indexes based on 251, 252, 253, 254, 255, 292, 293, 294, 297, 299, 300 by sector 242, 243, 244, 246−7

397

by sector and market 245, 248, 249, 250 weighted CPI index for trading partners 257 see also Indonesian rupiah Indonesian rupiah bid−ask spreads for trade between major currencies and 127, 129, 131 bonds denominated in 114, 116, 117, 125 currency basket of 6−7, 162, 163, 210−12, 251, 252, 253, 281−6 passim, 293, 294, 297, 299, 300 exchange rate volatility against US dollar 164−8 passim, 224, 225, 260, 267, 271 nominal effective exchange rates 259, 299 pegged to US dollar 161, 267 REER indexes 254, 255 weight in currency baskets 309 infant industry argument 33 inflation rates in ASEAN countries 29, 30 dollar pegs and 188, 267, 268, 275−8 in Europe 187 harmonization of 75 in Japan 187 and monetary policies 210 and nominal exchange rates 256−8, 268, 328 political stability and 205 restrictions on 30 in United States 187, 275−8 information costs 69, 72, 76, 126 institutional environment 24, 35−6, 48, 66, 205 inter-bank foreign exchange market, Chinese 359, 360−62 market participants and concentration 371−3 market segments 366−71 enrichment of 378−81 non-financial members entering 376 size of 362−6 supply and demand for FX not fully reflected in 374

398

Index

inter-bank forward markets 361, 362, 365, 366−9, 371, 378 problems in 379−81 inter-bank spot markets 361, 362, 365, 366, 367, 369, 371, 378, 379, 382 interest rate parity pricing rules 380−81 interest rates Bundesbank discount rate 208−10 Cambodia 203 changes in currency basket weights affecting 308 China 179, 182, 183, 184, 203−4, 212, 372, 374, 375, 380, 381 currency competition and 203−4 divergence within East Asian countries 29, 30, 204−5 ‘Euroland’ 143, 146−51 passim, 153, 154, 155, 157 interest rate policy under floating exchange rates 212 harmonization within EU 75, 76 Hong Kong 182, 183, 184, 212 Indonesia 172−3, 183, 184, 203 Japan 119−20, 176−8, 182, 184, 187, 212, 280, 288 Korea 172−3, 182, 183, 184 Laos 203 Malaysia 172−3, 182, 183, 184, 203−4 Philippines 172−3, 182−4, 203−4 risk premia on 172−3, 176−84, 270, 274 Singapore 182, 183, 184 Taiwan 182, 183, 184 Thailand 172−3, 182, 183, 184, 203−4 United States 142, 143, 145−52 passim, 154, 155, 157, 168, 176−8, 179, 182−4, 212, 276, 278, 283, 288 Intergovernmental Conferences (IGCs) 45 international capital flows, as incentive for exchange rate stabilization 269−74, 287 international currency, requirements for acceptance as 204−6, 312−13, 357, 384 International Finance Corporation 91

International Index Company (IIC) 92, 98, 99, 100 International Labor Organization (ILO) 355 International Monetary Fund (IMF) 3, 17, 23, 68, 159, 267, 300−301, 320, 328, 329, 331, 332, 359 Annual Report on Exchange Arrangements and Exchange Restrictions 211 Direction of Trade Statistics (DOTS) 15, 136, 198, 200, 233, 239, 240, 254, 255, 257, 258, 259, 294, 298 International Financial Statistics (IFS) 161, 169, 171, 181, 182, 183, 201, 261, 272, 277, 295, 354 World Economic Outlook (WEO) 171 intra-regional FDI 197, 200−201, 202 intra-regional trade East Asia 14−16, 241, 267, 292 trade creating effects of monetary integration 197−202, 268, 279 European Union 14, 71 inventory holding costs 126 Italy monetary policy decisions in 209, 210 withdrawal from ERM 47 Ito, Hiro 355 Ito, Takatoshi 82, 105, 135, 217, 279, 318 JACI see Asia Credit Index (JACI) Japan current account balance 170, 171, 173, 175, 176, 178, 179, 180, 204, 273 FDI in ASEAN region 14 foreign exchange reserves 169, 178−9, 180, 204, 273, 274, 276, 277, 278 interest rates 119−20, 176−8, 182, 184, 187, 212, 280, 288 monthly changes in reserves 261 net international investment position 175, 176 recovery from East Asian crisis 61 relations with China 2, 3, 48, 55, 62, 79, 80

Index role in fostering regional cooperation 1, 4, 17, 48, 55, 57−8, 61−2 trade patterns 14, 15, 71, 108, 168, 197, 198, 239, 240, 248, 249, 250 currency baskets based on 251, 252, 253, 292, 293, 294−5, 296 see also Japanese yen Japan−ASEAN Economic Partnership 21, 23 Japan−Singapore Economic Partnership Agreement (JSEPA) 17, 21 Japanese Ministry of Finance 175, 176 Japanese yen bid−ask spreads for trades between East Asian currencies and 126, 127, 128−30, 131, 132 bid−ask spreads for trades between major currencies and 126−7, 130, 131, 132 bonds denominated in risks for bond issuers 110 risks for foreign investors 114, 116, 117, 119−20, 121, 124, 125 weight in AMU 116−19, 121, 124, 133−4 currency basket of 211, 212, 293, 294−5, 296 declining in importance 48 euro spot trading against 378 origin of 80 as regional anchor currency 312−13, 314, 357 returns to AMU denominated bonds evaluated in terms of 119, 121, 122, 124, 133−4 returns to local currency denominated bonds evaluated in terms of 112, 116, 117−18, 133 RMB forward trading against 379−80 RMB spot trading against 365 share in global foreign exchange market 370 USD spot trading against 378 USD−yen exchange rate 163−8 passim, 173, 176, 178, 260, 270, 271, 274, 279, 312

399

weight in currency baskets 6−7, 160, 163, 201, 251, 252, 253, 279−83, 286, 287, 288, 295−301 passim, 309, 311 Jeanne, Olivier 205 Jiang, Guorong 90, 101 Jonas, Eva 82 judicial system 36 Kakkar, Vikas 350 Kawai, Masahiro 16, 38, 104, 105, 107, 135, 197, 215, 263, 279, 291, 305, 318, 320 Kenen, Peter 75 key currency status, requirements for 204−6, 312−13, 357, 384 Khan, Mohsin 350 Kim, Chung-Jin 216 Kim, Heungchong 59 Kobe Research Project 55 Kohl, Helmut 49−50, 81 Korea capital controls imposed by 89, 97 current account balance 170, 171, 179, 180, 204, 273 financial institution collapses 234 foreign exchange reserves 169, 179, 180, 204, 273, 276, 277 foreign exchange risk facing 109, 110, 112, 132, 133 interest rates 172−3, 182, 183, 184 monthly changes in reserves 261 nominal effective exchange rates 299 role in fostering regional cooperation 1, 4, 55−6, 57−8, 61−2 tax reforms in 97 trade patterns 197, 198, 239, 240, 241, 248, 249, 250 currency baskets based on 252, 253, 293, 294, 297, 299 see also Korean won Korean won bid−ask spreads for trade between major currencies and 127, 129 bonds denominated in 114, 116, 117, 121, 125 currency basket of 6−7, 160, 162, 163, 210−12, 282−6 passim, 293, 294, 297, 299

400

Index

exchange rate volatility against US dollar 164−8 passim, 260, 267, 271, 272 nominal effective exchange rates 299 pegged to US dollar 161, 267 weight in currency baskets 252, 253, 279, 297, 309, 311 Kregel, Jan 205 Kuroda, Haruhiko 61, 104, 263, 305, 320 Kwan, Chi Hung 385 labor mobility 22, 34, 45 Lai, Kon S. 349, 356 Lao kip currency basket of 210, 211, 294 exchange rate volatility against US dollar 260 pegged to US dollar 210 weight in currency baskets 309 Laos AFTA membership 22 interest rates 203 monthly changes in reserves 261 openness of 25 trade patterns 14, 15, 197, 198 by sector 242, 243, 244, 246−7 transition period for 34 see also Lao kip Latin American Free Trade Area 14 learning by doing 87, 93−4, 100−101 Lee, Jaewoo 350 Lee, Jong-Wha 216 Leung, Julia 92 liability dollarization 269−72 Liang Yuanyuan 385 liquidity in Asian bond markets 124−31, 132, 134 in China’s foreign exchange market 381−2 liquidity trap 174, 184, 187 local currency issuance by multinational corporations 91 long-term exchange rate fluctuations 270, 272 Luxembourg, monetary policy decisions in 209, 210 Lyons, Richard K. 380

Ma, Guonan 89, 102, 385 Maastricht Treaty (1992) 45−6, 47, 55 convergence criteria 46 Macau pataca, weight in currency baskets 309 Maćkowiak, Bartosz 215 macroeconomic stability, policies to maintain 267, 268, 275, 278, 279−80, 287−8, 291 Maes, Ivo 53, 54 Mahathir bin Mohamad 22 Malaysia capital controls imposed by 96−7 CPI index for 258 current account balance 170, 171, 179, 180, 204, 227, 230, 232, 235, 273 external debt 228, 232 FDI flows to 27 foreign exchange reserves 169, 179, 180, 204, 276, 277 foreign exchange risk facing 110, 111 GDP 226, 228 gross capital formation 227, 231, 234 interest rates 172−3, 182, 183, 184, 203−4 monthly changes in reserves 261 nominal effective exchange rates 259, 299 REER movements since 1990 233, 235 savings 227, 230, 231 tax reforms in 97 trade patterns 14, 15, 27, 197, 198, 239, 240, 241 currency baskets and REER indexes based on 252, 253, 254, 255, 293, 294, 297, 299 by sector 243, 244, 246−7 by sector and market 245, 248, 249, 250 weighted CPI index for trading partners 257 see also Malaysian ringgit Malaysia Bond Index Fund 93 Malaysian ringgit bid−ask spreads for trade between major currencies and 127, 128, 131

Index bonds denominated in 91, 113, 114, 116, 117, 119−20, 125 currency basket of 7, 162, 163, 210, 211, 252, 253, 282−6 passim, 293, 294, 297, 299 exchange rate volatility against US dollar 164−8 passim, 225, 259, 260, 267, 271, 272 nominal effective exchange rates 259, 299 pegged to US dollar 111, 113, 161, 165, 210, 211, 259, 267 REER indexes 254, 255 weight in currency baskets 279, 297, 298, 309 managed float 290, 302 Mansfield, Edward 74, 82 market impediments 89−91 removal of 94, 96−100 market making 95−6, 360, 362, 374, 375, 379, 381−3 market microstructure theory 377−8 market openness factor 98−9, 100 market size China’s foreign exchange market 362−6 portfolio allocation determined by 98 market weights, determination of 94, 98−100 Marston, Richard 350 Matsuyama, Kiminori 206 maturity mismatch 62, 172, 204 McCauley, Robert N. 88, 89, 90, 101, 318 McKinnon, Ronald 71, 73, 159, 160, 163, 166, 168, 170, 172, 173, 175, 176, 178, 186, 187, 188, 189, 190, 199, 204, 210, 267, 268, 273, 275, 279, 283, 291, 298 Meese, Richard A. 327 MERCOSUR 32 minimum variance analysis 280 Minsky, Hyman 205 Mitterand, François 49, 51 Miyazawa Plan 23 monetary compensation amounts (MCAs) 28−9 monetary integration ACU’s role in 306, 316−17

401

benefits and costs of 67−74 economic and conceptual aspects 67−71 empirical appraisals 71−2 political economy aspects 72−4 case for, in East Asia 5−6, 30, 195−214, 222−63 degrees of 67−9 and development of regional capital markets 202−8, 305−6 ‘economist’ approach to 50−51, 52−3, 54 in EU 2−3, 4, 28−31, 37, 41−58, 68−9, 71−2, 75−6, 196, 199, 207, 208−10, 306 international political conflicts and 74−6, 80−81 game theory applied to 77−80 ‘monetarist’ approach to 51, 54 and recovery of monetary policy influence 208−13 roles of East Asian states in 55−6, 57−8 trade creating effects of 197−202, 268, 279 monetary policy ACU’s role in coordinating 306, 316−17 effective coordination in ASEAN and China 223, 256−62 loose in United States 275−6 monetary integration and recovery of influence over 208−13 monetary regimes, credibility of 205 money, functions of 202−3 Monnet, Jean 42 Montiel, Peter J. 166, 320, 349 moral hazard 104, 159 Mori, Junichi 318 multinational corporations 91, 197, 380 Mundell, Robert A. 69, 223, 238, 262 Murase, Tetsuji 55, 56 Myanmar AFTA membership 22 monthly changes in reserves 261 openness of 25 trade patterns 14, 15, 197, 198 by sector 243, 244, 246−7 transition period for 34 see also Myanmar kyat

402 Myanmar kyat currency basket of 210, 211, 294 exchange rate volatility against US dollar 260 pegged to US dollar 210 weight in currency baskets 309 Myerson, Roger B. 77, 78, 79, 80 Nabor, Andreas 357 NAFTA see North American Free Trade Agreement (NAFTA) Nash equilibrium 77, 314 national jurisdictions, legal accommodation of 97 NATO see North Atlantic Treaty Organization (NATO) Naya, Seiji F. 16, 21, 38 negative risk premium 176−84 nested games 63, 77, 78 net investment income payments, US 151−2 Netherlands, monetary policy decisions in 209 network externalities 206 New Miyazawa Plan 17 New Zealand dollar 310 Nielsen, A. 82 Nitsch, Manfred 203, 215 nominal effective exchange rates correlations in monthly movements in 223, 256−9 currency baskets and stability of 7, 268, 279, 295−302 currency weights used by central banks in defining 308−11 inflation rates and 256−8, 268, 328 non-deliverable forwards (NDF) market 377, 380−81 non-tariff barriers 37 North American Free Trade Agreement (NAFTA) 15, 17, 71−2, 215 North Atlantic Treaty Organization (NATO) 50 Norway, monetary policy decisions in 208, 209 OCA see optimum currency area (OCA)

Index OECD see Organization for Economic Cooperation and Development (OECD) Ogaki, Masao 350 Ogawa, Eiji 105−6, 107, 135, 136, 217, 279, 319 Ohno, Kenichi 176, 178, 188 oigashi (roll-over loan) 65 oil exporters, Asian savings consumed by 143, 155−6 Okinawa islands 62 one-way quotes 380 Oneal, John R. 74 optimum currency area (OCA) 195, 223, 262, 312, 320 order-driven auction market 361, 362, 381 order processing costs 125, 126 Organization for Economic Cooperation and Development (OECD) 35 original sin 6, 172−3, 185, 196, 204, 206, 207, 269 Orphanides, Athanasios 216 Pacific Economic Cooperation Council (PECC) 90−91 Pagano, Marco 207 PAIF see Pan-Asian Bond Index Fund (PAIF) Pan-Asian Bond Index Fund (PAIF) 92, 93, 94−6, 97, 319 further developments arising from 101 incentives to reduce impediments in 98−100 parallel currency approach 213, 306, 316 Park, Sung-Hoon 59 Park, Yung Chul 105, 318 participating dealer model 95 PBOC see People’s Bank of China (PBOC) PECC see Pacific Economic Cooperation Council (PECC) Penn World Tables 341, 355 People’s Bank of China (PBOC) 8, 73, 212, 358, 360−61, 362, 365, 368, 372, 377 passive intervention of 374−6, 382−3

Index Petri, Peter A. 107 Philippine Bond Index Fund 93 Philippine peso bid−ask spreads for trade between major currencies and 127, 129 bonds denominated in 91, 114, 116, 117, 125 currency basket of 6−7, 160, 162, 163, 210, 211, 252, 253, 282−6 passim, 293, 294, 297, 299, 300−301 exchange rate volatility against US dollar 164−8 passim, 225, 260, 267, 271, 272 nominal effective exchange rates 259, 299 pegged to US dollar 161, 210, 267 REER indexes 254, 255 weight in currency baskets 309 Philippines capital controls imposed by 89 CPI index for 258 current account balance 170, 171, 180, 204, 228, 230, 232, 235, 273 external debt 228, 232 foreign exchange reserves 169, 180, 204, 277 foreign exchange risk facing 110, 111, 132 GDP 226, 228 gross capital formation 228, 231, 234 interest rates 172−3, 182−4, 203−4 monthly changes in reserves 261 nominal effective exchange rates 259, 299 REER movements since 1990 233, 234, 235 savings 228, 230, 231 tariffs in 33 tax reforms in 97 trade patterns 14, 15, 27, 197, 198, 239, 240, 241, 242 currency baskets and REER indexes based on 252, 253, 254, 255, 293, 294, 297, 299, 300−301 by sector 242, 243, 244, 246−7 by sector and market 245, 248, 259, 250

403

weighted CPI index for trading partners 257 see also Philippine peso Pill, Huw 159, 173 Plummer, Michael G. 21, 32, 38, 39 policy assignment, theory of 69 policy externalities 30 political conflicts, relationship between economic interdependence and 74−6, 80−81 game theory applied to 63, 77−80 political stability, requirement for 205 Pollins, Brian 74, 82 Pomfret, Richard 29 population, effect on trade 201−2 portfolio balance model 150 portfolio effect of holding AMU bonds 106, 119, 122−4, 133 portfolio management 65, 87, 122 Portugal, monetary policy decisions in 209 poverty rates 234, 235 Prasad, Eswar 329, 349 Preeg, Ernest H. 372 price discovery 382 price−specie flow mechanism 68 primary-based exports 26−7 primary market, transactions in 95 principal component analysis 72 prisoners’ dilemma 63, 77, 78, 79 product testing 34 production fragmentation 326 productivity approach 328, 330, 333−41 pseudo-exchange rate union 68, 69 public goods 69, 90, 189, 199 purchasing power parity (PPP) absolute PPP−income relationship 327, 328, 329, 330, 341−5, 346, 347 relative comparisons of 327−8, 329 pyramid-climbing 204 quote-driven dealer market 362, 381, 382 Radelet, Steven 234 Rahn, Jörg 328, 329, 334 Rajan, Ramkishen 320 Rashomon 327

404

Index

real effective exchange rates (REERs) gains from stabilizing 235−8, 291 movements in core ASEAN countries since 1990 231−4 relationship between current account balances and 235 nominal components of see nominal effective exchange rates weights for currency baskets of ASEAN and China 236, 238, 251−4 movements for REER indexes using 254−6 regional bond market indexes, private sector 94, 99 currency weights used in 309−10, 311 regional bond markets, Asian 1, 4, 61, 62, 87−101 Asian Bond Fund I 23, 81, 91, 105, 207, 319 Asian Bond Fund II 4, 23, 81, 87, 90, 91−4, 96, 97, 105, 207, 319 further developments arising from 101 incentives to reduce impediments in 94, 98−100 ‘learning by doing’ element in 87, 93−4, 100−101 Asian Bond Market Initiative (ABMI) 21, 23, 28, 81, 91, 105, 304, 315 currency denomination in 104−35, 236−7, 305 economic and conceptual issues 64−5 incentives to further reduce impediments 98−100 indexes for 94, 99, 309−10, 311 liquidity in 124−31, 132, 134 market impediments already reduced 96−8 overview of local currency bond markets 88−90, 104−5 Pan-Asian Bond Index Fund (PAIF) 92, 93, 94−6, 97, 319 further developments arising from 101 incentives to reduce impediments in 98−100

policy coordinating, reserve sharing and 236−8 political economy aspects 65−7 regional cooperative initiatives and the ABF project 90−91 shocks and development of 207 regional bond markets, European 31, 173−4 regional capital markets, development of 202−8, 305−6 regional exchange rate cooperation 1 case for, in East Asia 6, 197−9, 222−63 in EU 28−9, 30−31, 43−5, 47, 75−6, 237, 256, 306, 312 role of Chinese currency in 7−8, 376, 383−4 types of 68 see also Asian Currency Unit (ACU); Asian Monetary Unit (AMU); currency baskets Reinhart, Carmen M. 173, 216, 349 Remolona, Eli M. 101, 102 renminbi see Chinese renminbi request for quote trading arrangements 362 Research Institute of Economy, Trade and Industry (RIETI) 309−10, 311 reserve money, correlations in monthly changes in 223, 259, 261 reserve sharing 236−8, 262, 306, 315, 316 see also Chiang Mai Initiative (CMI) Reszat, Beate 47 retail foreign exchange market, Chinese 360−62 imbalance in 380 market segments 366, 367 Rey, Helene 158 rice, trade in 22, 27 Riese, Hajo 204, 205 RIETI see Research Institute of Economy, Trade and Industry (RIETI) Rogoff, Kenneth 327 Rose, Andrew K. 28, 71, 73, 195, 199, 200, 215, 268 Rossi, Vanessa 335 Roy, Tobias 195

Index Royama, Shoichi 82 Russett, Bruce M. 74 Russia 207, 273, 274, 278, 280 Ryou, Jai-Won 81, 82 Sachs, Jeffrey 234 SAFE see State Administration of Foreign Exchange (SAFE) Sakakibara, Eisuke 55 Samuelson, Paul 333 Sarno, Lucio 385 Saudi Arabia 278 savings ASEAN, by country, since 1990 227, 228, 229, 230, 231 Asian 142, 143, 145−6 absorbed by ‘Euroland’ 147, 149, 151, 153, 155 absorbed by US 142, 144, 147, 149, 151, 153, 155, 157 consumed by oil exporters 143, 155−6 ‘virtuously’ high 174, 175 US rate of 142, 144, 145, 184−5, 186, 188, 278 Scandinavian Monetary Union 82 Schelkle, Waltraud 195, 203 Schnabel, Gunther 160, 166, 168, 172, 173, 186, 188, 189, 190, 210, 267, 270, 273, 274, 275, 279, 280, 288 Schuman, Robert 42 Second World War 16, 43, 52, 53, 56, 81 secondary market, transactions in 95−6 securitized debt instruments 91 security game 63, 77−8 connected with economic game 78−9 services, free movement of 34, 37, 45 Sharpe ratio 112, 116, 119, 120, 121, 133, 134 Sheng, Andrew 101 Shimizu, Junko 105, 106, 107, 136, 319 shocks 143, 155, 207, 223, 290−91, 312, 347 short-term exchange rate stabilization 269−70, 271 Short-Term Monetary Support Facility 44−5

405

Shu Youdong 372 Singapore CPI index for 257, 258 current account balance 170, 171, 175, 180, 204, 228, 232, 235, 273 external debt 229, 232 foreign exchange reserves 169, 180, 204, 277 foreign exchange risk facing 109, 110, 111 GDP 226, 228 gross capital formation 229, 231, 234 interest rates 182, 183, 184 monthly changes in reserves 261 nominal effective exchange rates 259, 299 PAIF domiciled in 97 REER movements since 1990 232−3, 235 savings 229, 230, 231 tariffs in 32 trade patterns 14, 15, 27, 197, 198, 239, 240, 241 currency baskets and REER indexes based on 252, 253, 254, 255, 256, 293, 294, 297, 299 by sector 243, 244, 246−7 by sector and market 245, 248, 249, 250 weighted CPI index for trading partners 257 see also Singapore dollar Singapore Bond Index Fund 93 Singapore dollar bid−ask spreads for trade between major currencies and 127, 128, 131, 132 bonds denominated in 114, 116, 117, 119−20, 121, 125 currency basket of 6−7, 162, 163, 210−12, 252, 253, 281−6 passim, 293, 294, 297, 299 exchange rate volatility against US dollar 164−8 passim, 225, 260, 267, 271, 272 nominal effective exchange rates 259, 299 pegged to US dollar 161, 267 REER indexes 254, 255, 256

406

Index

weight in currency baskets 297, 298, 309, 311 Single European Act 27, 29, 33, 34, 35, 37, 45 single local currencies, bonds denominated in 105 risks for bond issuers 109−11 risks for foreign investors 112−16, 117−18, 124, 125, 133, 134 Single Market Program 17, 45 Sinochem Corporation 376 Siregar, Reza 320 size of economy effect on currency status 206, 207 effect on trade 200, 201, 202 weights in currency baskets related to 307, 311 Snake, European 28, 43−4, 45, 47, 312 sovereign credit rating, portfolio allocation determined by 98 Soviet Union 69 Spaak Report 53 Spain, monetary policy decisions in 209, 210 speculative pressures, exchange rate coordination to combat 236 Stability and Growth Pact 50, 216 standards, harmonization of 34 State Administration of Foreign Exchange (SAFE) 360−61, 364 state-owned banks 358 state-owned enterprises (SOEs) 336 Steinherr, Alfred 319, 320 Stock, James H. 334 stock markets 30, 360 Stoltenberg, Gerhard 51 Story, Jonathan 39 subsidiarity principle 36 substitutability of assets 142, 146, 148, 150, 205 Summers, Robert 341, 355 swap markets 358−9, 360, 366, 367, 369, 371 Sweden, monetary policy decisions in 209, 210 Swiss franc exchange rate volatility against US dollar 163, 164, 165, 166, 167, 168, 271, 282

share in global foreign exchange market 370 used as numéraire 160−63, 201, 281 Switzerland monetary policy decisions in 209 see also Swiss franc Szirmai, Adam 336, 338, 339, 340, 354 Taipei, China see Taiwan Taiwan current account balance 171, 175, 179, 180, 204, 273 foreign exchange reserves 169, 179, 180, 204, 273, 277 foreign exchange risk facing 109, 110, 111 interest rates 182, 183, 184 monthly changes in reserves 261 nominal effective exchange rates 299 trade patterns 239, 240, 241, 248, 249, 250 currency baskets based on 252, 253, 293, 294, 297−8, 299 see also Taiwan dollar Taiwan dollar bid−ask spread for trade between US dollar and 127, 127 currency basket of 6−7, 162, 163, 282−6 passim, 293, 294, 297−8, 299 exchange rate volatility against US dollar 164−8 passim, 260, 267, 271, 272 nominal effective exchange rates 299 pegged to US dollar 161, 267 weight in currency baskets 252, 253, 310, 311 Takagi, Shinji 66, 135, 291, 318 Takeuchi, Atsushi 89 Tamamura, Chiharu 27 Tang, Man-Keung 350 tariff harmonization 32−4 taxes 90, 97, 99, 205 Taylor, Alan M. 75 Taylor, Mark P. 385 Taylor rule 208 Tchaidze, Robert 216 technical assistance 91

Index Thai baht bid−ask spreads for trade between major currencies and 127, 128, 131, 132 bonds denominated in 91, 114, 117, 125 contagion caused by depreciation of 230−31, 235−6 currency basket of 6−7, 160, 162, 163, 210−12, 253, 254, 282−6 passim, 293, 294, 298, 299 exchange rate volatility against US dollar 164−8 passim, 225, 260, 267, 271, 272 nominal effective exchange rates 259, 299 pegged to US dollar 161, 267 REER indexes 254, 255 weight in currency baskets 309 Thailand capital controls imposed by 89 CPI index for 258 current account balance 171, 179, 180, 204, 229, 230, 232, 235, 273 external debt 229, 230, 232 financial institution collapses in 234 foreign exchange reserves 169, 179, 180, 204, 277 foreign exchange risk facing 109, 110, 111, 132 GDP 226, 229 gross capital formation 229, 230, 231, 234 interest rates 172−3, 182, 183, 184, 203−4 monthly changes in reserves 261 nominal effective exchange rates 259, 299 REER movements since 1990 233, 235 savings 229, 230, 231 tax reforms in 97 trade patterns 14, 15, 27, 197, 198, 239, 240 currency baskets and REER indexes based on 251, 252, 253, 254, 255, 293, 294, 298, 299 by sector 242, 243, 244, 246 by sector and market 248, 249, 250

407

weighted CPI index for trading partners 257 see also Thai baht Thailand Bond Index Fund 93 Thatcher, Margaret 52, 54 Tindermans Report 53 TIPS see Treasury inflation-protected securities (TIPS) township and village enterprises (TVEs) 336 trade-account countries 186 trade-creating effects of monetary integration 197−202, 268, 279 trade diversion 25, 27, 32, 71 trade intensity index of 72, 107−8 currency baskets based on 110, 111−12, 133 measurement in gravity model 200 trade liberalization 24−5, 27 trade weights, currency baskets based on 106−7, 110, 111, 133 transaction-based cost 126–7 transaction costs in China’s FX market 369, 377 from currency conversions 45, 69, 126, 206, 267 economic cooperation to reduce 22, 27, 34, 69, 72, 76, 267 for international trade 268, 377 investors’ decisions influenced by 135 regional bond index to reduce 94 transportation costs 326 Treasury inflation-protected securities (TIPS) 145 Treaty of Rome 28, 29, 37 Turner, Philip 215 turnover ratio, portfolio allocation determined by 98 twin crisis 234 UEMOA see West African Economic and Monetary Union (UEMOA) UNCTAD Foreign Direct Investment Statistics 200 underwriting 64 United Kingdom exemption from third stage EMU negotiations 47, 57

408

Index

monetary policy decisions in 209, 216 opt-out from ERM 44, 47 role in EMU negotiations 52−3 trade patterns 311 see also British pound United States Asian savings absorbed by 142, 144, 147, 149, 151, 153, 155, 157 current account balance 141, 142, 144, 145, 146−7, 149, 150−51, 152, 171, 173, 174, 184−5, 186, 188, 189, 273, 278, 287 exogenous shocks to economy 143, 155 expected rate of return on capital 147−8 FDI in ASEAN region 14 FDI in China 185 foreign exchange reserves 169, 277 improved outlook for growth in 143, 154 inflation rate 187, 275−8 interest rates 142, 143, 145−52 passim, 154, 155, 157, 168, 176−8, 179, 182−4, 212, 276, 278, 283, 288 labor productivity in 336 monetary policy decisions in 209, 210, 212 net investment income payments 151−2 savings rate 142, 144, 145, 184−5, 186, 188, 278 trade patterns 14, 71, 108, 168, 198, 239, 240, 241, 242, 245−53, 293, 311 see also US dollar Urata, Shujiro 197, 215 Uruguay Round 33 US Bureau of Labor Statistics 335 US dollar bid−ask spreads for trades between East Asian currencies and 126, 127, 128−30, 131, 132 bid−ask spreads for trades between major currencies and 126−7, 130, 131, 132 bonds denominated in ABFI limited to 91−2, 105

liquidity of 131, 134 risks for bond issuers 109−11, 133 correlations of monthly changes of USD exchange rates for ASEAN + 3 countries 259, 260 currency basket of 308−11 East Asian currencies pegged to emancipation from 8−9, 156, 278−9 monetary independence lost through 196, 210−13, 375, 382 reasons for continuance of 5, 141−57, 159−89, 267, 268−74, 287, 291, 326 risks associated with 109−11, 113, 116, 123, 124, 133, 275−8, 287−8, 312 see also Bretton Woods II view; ‘East Asian dollar standard’ euro spot trading against 378 euro−USD exchange rate 142−5, 147−57, 163−7 passim, 186, 268, 270, 271, 272, 370 exchange rate volatility against 163−8, 224−6, 259, 260, 267−8, 270−72, 275, 282 HKD spot trading against 378 as key currency 168−70, 269, 273, 276 monthly USD exchange rates for core ASEAN countries 224, 225 returns to AMU denominated bonds evaluated in terms of 119−21, 124, 133, 134 returns to local currency denominated bonds evaluated in terms of 112−16, 124, 125, 133 RMB forward trading against 379−80 RMB spot trading against 365 RMB−USD exchange rate 5, 141−5 passim, 148−50, 154, 155, 156, 161, 164−8 passim, 175, 179, 210, 211, 259, 260, 267, 271, 272, 274, 359, 360, 367−70 passim, 374−5 determination mechanism 382−3 ‘equilibrium’ value of 325−49

Index share in China’s foreign exchange market 369−71, 375 share in global foreign exchange market 370 weight in currency baskets 6−7, 160−63, 201, 210−12, 251, 252, 253, 279−85, 287, 295−6, 297, 298, 299 yen spot trading against 378 yen−USD exchange rate 163−8 passim, 173, 176, 178, 260, 270, 271, 274, 279, 312 US Federal Reserve, currency basket weights used by 308−11 Verdun, Amy 53, 54 vertical specialization 326 Very Short-Term Financing (VSTF) Facility 45 Vietnam AFTA membership 22 monthly changes in reserves 261 openness of 25, 33−4 trade patterns 14, 15, 197, 198 by sector 242, 243, 244, 246−7 see also Vietnamese dong Vietnamese dong currency basket of 210, 211, 294 exchange rate volatility against US dollar 260 international acceptance of 207 pegged to US dollar 210, 211 weight in currency baskets 309 Vision 2020 18−19, 21, 22, 33 Volz, Ulrich 59, 73, 201, 214, 217, 263, 288 von Furstenberg, George M. 217 Wald test statistic 356 Walter, Ingo 39 Wang, Seok-Dong 48

409

Wang, Tao 328, 329 Wang, Yunjong 59 wars, effects of 207 Watson, Mark W. 334, 352 weak currency status 203 Wei, Shang-Jin 160, 201, 211, 281, 285, 329 Wen Jiabao 385 Werner Report 28, 43, 44, 47, 53, 55, 57, 75 West African Economic and Monetary Union (UEMOA) 82 Williamson, John 135, 217, 268, 279, 292, 302, 320, 349 withholding taxes 90, 97, 99 World Bank ‘East Asia Update’ 234, 254 local currency bonds issued by 91 World Development Indicators 226, 229, 231, 232, 233, 255, 257, 258, 259, 335, 341, 354−5 World Trade Organization (WTO) 17, 24−5, 26, 33, 364, 376 World War I 207 World War II 16, 43, 52, 53, 56, 81 WTO see World Trade Organization (WTO) Xin Wang 372 Yasukuni Shrine 62 yen see Japanese yen Yi, Kei-Mu 326 Young, Alwyn 263, 335, 336, 350 yuan see Chinese renminbi Zaibatsu 64 Zhang Guang Ping 368 Zhang Jikang 385 Zhang Zhichao 328, 329, 385

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