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Prospects of Regional Exchange Rate Policy Coordination

So far we have argued that there is a strong case for a collective appreciation of East Asian currencies vis-à-vis the US dollar. The next issue is how a mechanism can be introduced to achieve such coordination in the region. There are at least two ways to do this. One is for each economy to stabilize its currency to a common key currency or a common basket of key (and other) currencies. The other way is for these economies to jointly create a regional, cooperative system similar to the Snake or Exchange Rate Mechanism (ERM) in Europe. Given that economic (particularly structural) convergence among the East Asian economies is not sufficiently advanced—and that political relationships are not sufficiently mature to support the creation of a tightly coordinated regional system— the first option appears more realistic. Only with sufficient economic convergence—and with strong political consensus—East Asia may move to the stage of joint exchange rate stabilization.

Currency basket system. Given East Asia’s diverse economic relationship with the major countries and areas in the world, the traditional practice of choosing the US dollar as the region’s sole monetary anchor is no longer the best policy. An obvious alternative is to choose the yen and/or the yuan as a monetary anchor, given the size and importance of Japan and the PRC in East Asia. However, the yen’s power waned in the 1990s due to Japan’s lost decade following the bursting of asset price bubbles, though it still has potential to play a critical role. The yuan’s international role will rise over time, but decades will have to pass before it becomes fully convertible and can assume an international currency status equivalent to that of the US dollar, the euro, or the yen. Some East Asian economies—particularly those with strong trade ties with the PRC—may consider pegging their currencies to the yuan as desirable from trade perspectives, but many other economies with increasingly open capital accounts will have little incentive to do so because of the limited usefulness of the yuan for international settlement, clearance, financing and liquidity holding. Other East Asian economies, however robust their monetary policies, are too small for their currencies to take on a meaningful international role. This clearly makes it desirable—even necessary—to introduce a mechanism for intraregional exchange rate stability based on a currency basket, as no single currency is capable of playing a monetary anchor role at least in the near future.

Three options can be considered for the region’s currency basket: (i) a G3 currency basket comprising the US dollar, the euro, and the yen; (ii) a G3-plus currency basket comprising the US dollar, the euro, the yen, and emerging East Asian currencies; and (iii) an Asian Currency Unit (ACU)—an appropriately weighted basket of East Asian currencies including the yen, yuan, won, baht, ringgit, etc. The first two options would not require a substantial degree of policy coordination because they rely on external nominal anchors. But the third option requires a high degree of monetary policy coordination, as a regional nominal anchor would have to be jointly established—and neither Japan nor the PRC is likely to play the sole leadership role at least for now. The first option is the simplest, and the third option the most complex. One of the advantages of the second option is that it will be easier to move to the third option at a later stage by reducing weights on the dollar and the euro to zero.

So long as Japan continues to maintain its current free float, it would make sense for other economies in East Asia, including the PRC, to adopt a G3 basket system (the first option). By so doing, they could enjoy more stable effective exchange rates, with less susceptibility to dollaryen and dollar-euro fluctuations than a standard US dollar-based system. Korea and Thailand, in recent years and without any formal commitment, appear to have already adopted a regime resembling a G3 basket system. Singapore has already been managing its exchange rate in a manner of a G3-plus basket system (the second option) as its basket apparently includes the US dollar, the euro, the yen and other major and regional currencies. In July 2005, the PRC and Malaysia also started to move in this direction.

By agreeing on the adoption of a G3 or G3-plus currency basket, East Asian economies will have in place a mechanism through which collective exchange rate adjustment can be engineered. First, this system is particularly suited to the PRC as adopting a freely flexible exchange rate regime is ill-advised unless the country is confident of the depth, functioning and maturity of its money markets and the health of its banking sector, and is ready for advanced liberalization of capital accounts. Until then a G3 or G3 basket system would serve the PRC best in striking the difficult balance between maintaining a certain degree of exchange rate stability while allowing sufficient exchange rate flexibility against the US dollar—particularly given the backdrop of US current account deficits and the PRC’s rising surpluses and official reserves. Second, this system can protect East Asia as a whole against the possibility of a sharp fall in the value of the US dollar in the face of mounting global payments imbalances and/or surging capital inflows.

Steps toward East Asian monetary integration. The measures offered here are intended to provide East Asia with a buffer against sharp depreciation of the US dollar and become a stepping stone toward more formal exchange rate policy coordination and the creation of a monetary zone in East Asia. Such a zone may be characterized by exchange rates that are relatively stable regionally while exhibiting greater flexibility against the US dollar. Following the European example, the transition to an integrated monetary zone could be navigated in several steps, starting from informal to formal policy coordination, and then to tighter policy coordination. East Asian economies are already in the early stage of loose, informal policy coordination, which could be further strengthened. They then could introduce formal policy coordination by adopting a G3-plus currency basket system, and move to more rigid policy coordination for intraregional exchange rate stabilization.

The first step is the introduction of informal policies that attempt to stabilize exchange rates against a basket of G3 or G3-plus currencies rather than against the US dollar alone. This can be done by those economies under US dollar-pegs to reduce dollar weights in their exchange rate management and by all emerging East Asian economies to adopt managed floating targeted at a G3 or G3-plus currency basket. The currency weights in the basket could vary across countries, at least initially; they could depend on the relative importance of the G3 or G3- plus countries as trading partners and FDI sources, and on the attractiveness of holding the component currencies as official reserves. How strictly countries stabilize currencies to this basket should depend in each case on country conditions and preferences. National monetary authorities can maintain most of their independent policy-making by combining an appropriately defined inflation targeting policy and basket-based managed floating. At the same time, an ACU index can be introduced as a useful tool in measuring the degree of joint movements of East Asian currencies and the degree of divergence of each currency movement from the regional average set by ACU.9 Once the PRC moves to a more flexible exchange rate regime, ACU index movements and divergences of component currency movements can provide more meaningful information.

This informal currency coordination should be complemented by stronger institutional arrangements for financial cooperation. This includes an enhanced version of the regional reserve pooling arrangement (the Chiang Mai Initiative, or CMI), the regional economic surveillance process (Economic Review and Policy Dialogue, or ERPD), and the initiatives for Asian bond market development (the Asian Bond Markets Initiative, or ABMI; and the Asian Bond Fund, or ABF), under the aegis of ASEAN+3 finance ministers or Executive Meeting of A practical approach is to take a multi-track, multi-speed approach, whereby economies ready for deeper policy coordination begin the process while others prepare to join later. A group of economies that are sufficiently integrated—Japan and Korea; or the PRC and Hong Kong, China; or Singapore, Malaysia, and Brunei Darussalam—and with sufficient political commitment, may wish at this stage to initiate subregional currency stabilization schemes. Each group would intensify monetary and exchange rate policy coordination while allowing the possibility for others to join them subsequently. Over time these groups may start negotiations to integrate into a larger monetary zone.

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