East Asia Exchange Rate Arrangements: Executive Summary
Kim-Song Tan Singapore Management University April 2004
The question of what exchange rate arrangements East Asian countries should embrace has been widely discussed. Few policy makers would dispute the positive role that exchange rate stability plays in promoting trade and growth in the region. What they cannot agree on is how such stability should be achieved. Among their key concerns are the costs to an individual economy that a particular exchange rate arrangement entails (e.g. the independence they have to forego with respect to the use of other policy instruments) and the sustainability of the arrangement over time. The experience of the 1997 Asian currency crisis highlighted the urgency of understanding and resolving such differences. It also changed the tone of the discourse. Whereas previous discussions centered largely on the relationship between exchange rate stability and regional trade and investment integration in the long run, post-1997, there is a greater emphasis on “crisis-prevention” i.e. how to design a system that is less crisis-prone in the short to medium term.
One of the clearest expressions of the desire for monetary integration in East Asia came from the proposal of an ASEAN common currency at the 1998 ASEAN Summit Meeting. A number of studies have since been conducted to assess the feasibility of such
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a proposal.
Two conclusions emerged.
Firstly, insofar as a common currency is
concerned, ASEAN+3 represents a more appropriate regional grouping than ASEAN. Various studies have found that ASEAN+3 countries satisfy more Optimum Currency Area (OCC) criteria than ASEAN countries. In addition, there are considerably more benefits to be derived from the monetary integration of a larger group of economies, including the possible use of yen or RMB as an anchor currency and the greater financial resources available to defend the common currency should it come under pressure.
Secondly, it is well recognized that a common currency can only be a long term goal. Despite the advantages that ASEAN+3 has over ASEAN as an optimum currency area, it still does not satisfy enough of the preconditions required for a successful common currency. Compared with the European countries 20 years, the situation in East Asia is not unfavorable, but not sufficiently conclusive either. More importantly, at this point in time, there is little evidence of the kind of strong political commitment needed to make a common currency work. Few East Asian countries are ready to give up control over key economic policies like domestic monetary policy and to act as a single entity.
We believe that a realistic approach to monetary integration in East Asia should begin first with an acceleration of trade and investment integration and development of the relevant supporting institutions and infrastructures. When the trade and investment policies and financial institutions are sufficiently harmonized, East Asian countries will naturally find monetary integration attractive, and political will for it will grow. Indeed the trend of globalization in trade and finance suggests that ultimately, East Asia will
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likely find that it necessary to have some form of exchange rate coordination to help reduce transaction costs in the region. The question is whether such coordination should take the form of a common currency and what this implies for exchange rate arrangements in the interim period. We do not deny the endogenous relationship between real sector and monetary integration. That is, any interim measures that result in greater exchange rate stability will help strengthen intra-regional trade and investment linkages, which will in turn make the region more conducive for monetary integration. What is not clear is whether we can find an interim arrangement that is both effective and sustainable.
It has been argued that if a common currency were indeed endorsed as the long term objective for East Asia, then some intermediate common exchange rate regime should be adopted by the whole region, both to help facilitate the move towards the final destination and to provide opportunities for policy makers to learn from and fine-tune policy coordination with each other. Various alternatives have been suggested though most researchers tend to turn to some form of common basket peg.
Like all exchange rate regimes, a common basket peg suffers from various weaknesses, including the difficulty of defending the peg (i.e. the bipolar hypothesis argument). The difficulty is especially significant given the open capital market and large degree of capital mobility in most East Asian countries. But a more practical problem is to find a basket that is acceptable to all East Asian countries, given their diverse economic structures and policy objectives and their varied readiness to participate in monetary integration. For example, the common basket mentioned above is typically
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constructed based on the shared objective of maintaining a stable Real Effective Exchange Rate (REER). But export competitiveness (which REER reflects) is not the only relevant policy objective. Some countries may want to include other objectives such as foreign capital inflows, asset inflation and foreign debt repayment etc in designing the composition of the basket.
A number of economists have argued that the current arrangement in the region where individual countries follow a wide array of floating systems in fact represent an optimal approach. Eichengreen for example, argues that the job of stabilizing exchange rates in East Asia lies in strengthening and developing the financial markets in the region. Free floating backed by inflation targeting is sufficient to do the job of policy coordination. Attempts at specific intermediate exchange rate stabilizing arrangements, in the absence of sound banking and financial system, will prove futile. This is the case whether the attempts are undertaken with or without the region’s commitment to a common currency as a long term objective.1
We have some sympathy for this view, especially on the need for institution building. Indeed, if the prevention of another 1997-like panic and contagion is a major consideration, it would be more important in the near term to focus on developing sound supporting institutions and mechanisms than on exchange rate coordination. In any case, as the experience of Europe has shown, the deployment of intermediate pegging before the launch of the Euro did not help to prevent various episodes of financial and currency
1
See Eichengreen, in ADB 2004
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instability. The commitment to a common currency had only limited benefits in helping to stabilize exchange rates in the interim period.
However, we would not go so far as to advocate a free float exchange rate system for the region. Having a certain common policy framework, even if it is loose and informal (without binding agreement) could still be useful. Moderate solutions and a gradual path towards convergence could work better than drastic changes in this case. In this context, Singapore’s approach may provide a useful starting point. The Singapore dollar (SGD) is managed against a basket of currencies of its major trading partners and competitors (including the three major global currencies as well as some regional currencies), with the objective of supporting growth while maintaining price stability over the medium term. The trade-weighted exchange rate is allowed to fluctuate within a policy band whose parameters are broadly disclosed to the market. The band itself is periodically reviewed to ensure that it remains consistent with the underlying fundamentals of the economy. The Monetary Authority of Singapore (MAS) makes a distinction between short-term currency volatility and longer-term misalignment. It is prepared to broaden the band width and adjust the level of the band (“equilibrium value” of the exchange rate) if it feels that the currency has become misaligned.
The framework offers a number of advantages common to Williamson’s “basket, band and crawl” (BBC) system. Firstly, an economy is able to keep the Real Effective Exchange Rate (REER) stable. Secondly, flexibility on the width of the band can cater to the different needs of countries in different stages of development. Economies can
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choose a narrower or wider band depending on how strong or weak their underlying fundamentals are. Thirdly, there is no need for agreement on the use of a common basket. Fourthly, the system is consistent with inflation targeting which is an increasingly more important policy consideration for many countries.
While Singapore’s success with such an exchange rate model is no doubt helped by certain unique features of the economy, there is nevertheless sufficient flexibility within the model for it to serve as a basic template for other East Asian countries. The latter can modify the model according to the unique characteristics and requirements of their own economies. For example, there can be considerable variations in the exact composition of the basket and the width of the band. As trade, investment and financial integration in the region deepens over time, the gap will naturally narrow. At some point, one of the regional currencies that are managed on similar baskets can serve as the “numeraire” exchange rate for the whole region.
Does such an approach pull the region away from any long term goal of regional monetary integration? Not necessary. As various authors have pointed out, the EMS experience underscored the point that it was the inability of intermediate arrangements to ensure currency stability that forced European countries to move to monetary union. It is therefore not true that some formal intermediate regimes are needed to provide transition to a common currency. This broad approach also provides the possibility for natural clustering of currency areas. That is, economies with strong trade tie, high degree of factor mobility and synchronized business cycles can adopt more similar policy
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framework (i.e in terms of the composition of their exchange rate basket and the band). Various groupings of countries within East Asia have been identified to have the potential for such clustering.2
As we noted earlier, policy makers in East Asia should focus their efforts on building supporting structures. Indeed, no exchange rate arrangement can be sustainable without the right institutional support. The following issues, in particular, should be given more careful consideration (these are issues that would be dealt with in details in the project on regional financial architecture).
Financial Sector Development Unsound banking/financial and corporate structure, leading to gross inefficiency in capital allocation and intermediation process, was a main reason for the 1997-Asia-crisis. Financial sector reforms to establish strong prudential supervision and regulation, to raise the quality of both the equity and the bond markets and to promote greater transparency and disclosure standards are issues that national policy makers have to tackle. The enormous externalities arising from contagion effects point to the need for regional cooperation and coordination in these efforts. A regional outfit performing some of the functions of the Bank for International Settlement within the East Asian context may be useful. Ditto the development of a region-wide Asian currency bond market.
Regional financing facilities Since a key concern among East Asian countries is prevention of the 1997-type crisis and contagion, the availability of facilities for timely
2
See Yuen, 2000.
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liquidity and other financial support (“lender of last resort”) is important. In any case, unless such support is available, it is difficult to expect East Asian countries to give up some of the domestic monetary independence that exchange rate policy coordination entails. The key challenge here is to have a system that minimizes the moral hazard problem. Some existing regional efforts such as the expanded ASEAN swap
arrangements under the Chiangmai Initiative appear to provide an acceptable basic framework. pursued. Ideas on pooling the foreign reserves in the region should be actively
Regional surveillance and risk monitoring
To pre-empt build-up of exchange
rate pressure in the region, and to facilitate exchange rate coordination, close regional surveillance is needed to ensure that the exchange rate in each country is supported by consistent and sustainable macroeconomic and structural policies. A number of such mechanisms have already been initiated but more resources and efforts are needed to increase their effectiveness.
Coordinated views on capital flow restrictions
A lesson from the EMS
experience is that temporary restrictions on capital flows in the initial stages of monetary integration should not be frowned upon. Singapore’s model provides some middleground examples of such restrictions (as opposed to the strict capital controls in some East Asian countries and the relatively relaxed approach in others).
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