Constructing an Asian Currency Unit

In this section, we first set out the various choices in defining the ACU as a basket currency for East Asia. The appropriate decision will depend on the ultimate purpose of the ACU: will it be, at least for the initial phase, mainly an instrument for exchange market monitoring in the region without any monetary function? Or will it also become a currency for the denomination of debt instruments in the financial market? Finally, will it be admitted for domestic security issues? These choices would fall under the domain of the “store of value” function of money. At some time, possibly from the beginning, a regional currency could, if transactions costs were low enough, be used for invoicing and payments of international trade, rather than the United States (US) dollar. For use in domestic transactions, strong political will and decisions would be required. Both the international and domestic uses of the ACU would correspond to the “means of payments” function of money. As in many Asian countries, the US dollar is used for invoicing and payment; such a decision would be farreaching in gradually developing the ACU and partly replacing other international currencies for transactions in the region. International organizations and corporations, perhaps even domestic firms, may be allowed to use the ACU as a “unit of account” for presenting their balance sheets. This would be the last step in accepting the ACU as a “parallel currency.” The latter decision is surely the most difficult one and may only be taken after a long period of experimentation with the ACU and its growing use by market participants. Clearly, the purpose for creating the ACU in the years to come will influence the choice among various technical options.

In Europe, the EMS that started operations in 1979 required a reference or base currency. For that purpose, Europeans could have taken a European national currency such as the deutschmark, or even the US dollar or gold. For a variety of reasons all these options had unacceptable features. Therefore they opted for a basket currency, the ECU. As had been the case with the special drawing rights, the initial monetary role of the ECU was very limited. It was the reference currency or unit of account of the monetary system. It also served as a unit of account among central banks and European institutions. But it was not conceived of as a means of payment or as a unit for financial assets.

Once the ECU was created with the stamp of official approval, it became a standardized and certified unit, with well-defined rules for changing the composition of the basket. Hence, this standardization gave the ECU a superior status to all other baskets. In principle, any investor could design a portfolio of securities in various currencies corresponding to his preferences. The ECU basket did not correspond to such optimal individual preferences. But it was unique through standardization. This brought benefits in terms of recognition and tradability. The financial industry leaped on this standardized basket for the issuance of securities with an interesting feature of risk diversification.

While in the short run it is easy for investors to make choices among different risk-return combinations, it is not so easy for long-term investments. For example, will the yen appreciate or depreciate with respect to the dollar over the next ten years? Nobody knows. Therefore, with a basket currency one is conscious of having not picked the best performing currency but one is also aware of having not chosen the worst performing one either. In this sense there is an attraction in basket currencies for long-term financial investments.

In light of the European experience and of the reticence among decision makers in Asia, we assume in this paper that if a basket currency was promoted in Asia, its official function would, at least for some time, be limited to one of a regional divergence indicator for national currencies. However, we are convinced that such a step would create incentives for the financial industry to issue securities in the regional basket currency.

The first decision that should be considered is whether to opt for a basket with fixed currency units or with fixed weights. We first consider a basket with fixed currency units, as was the case for the ECU. We then examine the possibility of a hard ACU with fixed weights before considering other open issues.

A. The Fixed Currency Unit – ACU

The value of the ACU in any currency “i” can be computed by applying to all component currencies the appropriate bilateral exchange rate with respect to currency “i.” It is to be noted that the weight of each currency in the basket is therefore a function of the exchange rate. A currency that depreciates with respect to all other currencies in the basket sees its weight decline and the weights of all other currencies increase. This may be considered an attractive feature, as the basket “hardens”: weaker currencies lose in importance to the benefit of harder currencies. If over time the same currencies always appreciate then the basket asymptotically converges to a basket of hard currencies. Politically, this may, however, not be acceptable.

1. Resetting the Weights

For that reason, the ECU underwent revisions of the weights, at 5-year intervals or whenever weights changed by more than a pre-defined barrier of 25%. When new currencies were included in the basket, the weights needed to be reviewed. In this sense, there is also a choice of an open versus closed basket to be taken. In an open basket, currencies initially not in the basket may join, or currencies may leave the basket.

If revisions take place, then they are to be carried out in such a way that the value of the ACU is not affected. This is easily done as there are enough degrees of freedom available. Consider the following example:

Example 1

To simplify, assume that the ACU contains only two currencies, A and B. The exchange rate is 1 A for 2 Bs. Initially, the ACU contains 3 As and 4 Bs. The value of the ACU is therefore 5 As or equivalently 10 Bs. The initial weight of currency A is then 0.6 and 0.4 for currency B. Suppose it was desired to have equal weights. The constraints are the exchange rate, weights of 0.5, and the value of the ACU. The solution is 2.5 units of currency A and 5 units of currency B. The value of the ACU in terms of currency A is unchanged at 5 As and in currency B at 10 Bs.

Example 1 illustrates the fact that the composition of the basket and the value of the ACU in terms of any existing currency are independent. This means that once the decision about the weights of component currencies at initial exchange rates is made, then it can be decided what the initial value of the ACU should be in terms of the US dollar, yen, or any other currency. This is illustrated in Example 2:

Example 2

Taking the assumptions of example 1 and an exchange rate of 1 US dollar = 2 As = 4 Bs, assume that it was desired to set the initial value of the ACU equal to 1 US dollar. How can this be done? If we define the ACU as a basket containing 1.2 As and 1.6 Bs then 1.2 As are worth 0.6 dollar, 1.6 Bs are worth 0.4 dollar and the ACU is worth 1 US dollar. The weight of currency A is 0.6 US dollar/1 US dollar or 0.6 and the weight of currency B is 0.4, as required.

Any resetting of the weights is nothing more than a redefinition without any financial implications. However, there is a problem with financial instruments in ACU. In principle (see below for additional concerns), the interest rate on an ACU instrument is the weighted average of interest rates in the component currencies. If interest rates differ, then the reweighing of the basket changes the weighted interest rate. When the market expects a reweighing of unknown proportions this creates uncertainty and leads to the creation of a risk premium.

Therefore, it might be preferable to aim in the long run at unchanged currency units and limit ex ante the time frame during which changes can be carried out. Such an initial period is necessary to gain experience, as the initial weights cannot be decided on the basis of hard facts alone.

With given currency units of a basket, the weight of each currency is a function of the exchange rate. The weight of a currency decreases after devaluation and increases after revaluation. Example 3 illustrates:

Example 3

Consider the basket of example 2 with 1.2 units of currency A and 1.6 units of currency B. As the exchange rate is 1 A for 2 Bs, the weights are 0.6 and 0.4, respectively. The initial value of the ACU in terms of currency A is 1.2 + 1.6(1/2) = 2. If currency B devalues with respect to currency A by 8% then the value of the ACU in currency A becomes 1.2 + 1.6/(2.16) = 1.94. Then the weights become 1.2/1.94 = 0.62 for currency A and 0.38 for currency B.

2. Interest Rates on ACU

As mentioned above, in principle, the interest rate on ACU instruments should be a weighted average of component interest rates. But there is a complication. Using interest rate parity, currencies with high interest rates are expected to depreciate. Hence, their weights are expected to decline. The longer the maturity, the more the changing weights will assume importance and for long-term instruments the interest rate of the ACU, in the absence of corrective re-weightings, should asymptotically converge to the lowest interest rate in the basket. Example 4 provides a numerical illustration.

Example 4

Consider the ACU as described in Example 2, with 1.2 currency units of A and 1.6 currency units for B and weights for currency A of 0.6 and for currency B of 0.4. Assume the existence of two financial instruments in both currencies A and B, overnight deposits and 1-year deposits. Interest rates are 2% for either deposit in currency A and 10% for either deposit in currency B. The yield curves are thus assumed flat. What will be the rates for ACU overnight and 1-year deposits? For overnight deposits the case is clear. The ACU rate is 0.6(2%) + 0.4(10%) = 5.2%.

For one-year deposits there is an additional difficulty. The existing interest rate differential suggests that on an expected basis, and taking interest-rate-parity into account, currency B is expected to depreciate over one year by 8%. Hence, the expected weights of both currencies change. From Example 3, we know that the weights will be 0.62 for currency A and 0.38 for currency B. Hence, the ACU 1-year interest rate is 0.62(2%) + 0.38(10%) = 5.04.

Example 4 shows that the longer the maturity, the more ACU interest rates will deviate from an average computed with initial weights and approach the lowest interest rate in the basket. The fact that interest rates for long-maturity securities can substantially deviate from an average of current weights is not easily understood by market participants, particularly retail investors. Therefore appropriate communication is necessary and the ECU experience may be an advantage.

3. Enforcement of Equality Between the Value of the ACU and of the Basket

In the case of the ECU another issue had created considerable confusion. Market participants assumed that the value of the ECU had to be equal to the weighted average of the basket. However, this is only the case if some mechanism exists that ensures equality. The definition alone will not achieve that. During the early years of the ECU, the ECU Banking Association (EBA) set up a system making payments in ECU possible. Payments could be made either in ECU or with the basket. This ensured that the value differential was constrained by the transaction costs of delivering component currencies. Because it was difficult to get at low cost currencies with capital controls, the system was discontinued and payment had to be made in ECU. With this decision, the link between the ECU and the basket was taken away. In the EMS crisis of 1992, the differential reached a record of close to 10%, whereas transaction costs for basket payments to cover large positions were less than 0.5%. Therefore, it is necessary to decide what ties the value of the ACU to its basket. One way to do it is via the payments system as during the initial years of the EBA. Another is that one or several central banks, or a special purpose fund backed by all central banks in the ACU area, intervene to tie the value of the ACU to the basket.

4. Payments System for the ACU

The decision on equality of values for the ACU and the basket is tied to another one. How are payments in ACU to be processed? For particular reasons European central banks did not wish to assume that responsibility. Therefore private banks, in fact the largest and most reputable banks in Europe, joined forces to create the EBA with the objective to operate an ECU payments system.⁴ With the creation of the euro, the EBA continued as a private system in competition with the official payments system Trans-European Automated Real- Time Gross Settlement Express Transfer System (TARGET). The EBA is able to compete with TARGET given that the EBA's transaction costs are considerably lower. The alternative is to create a payments system through the participating central banks.

B. A Fixed Weight ACU: the “Hard” Currency Option

Instead of a basket with fixed currency units and hence variable weights, it would be possible to opt for a fixed weight basket (and hence, variable units of currencies). This would require that every time a currency appreciates or depreciates, the number of units is adjusted to keep the weight constant. The implication would be that the ACU would never lose value with respect to any of its component currencies. This is one form of the “hard” ACU that was favored by the British Treasury as a strategy toward monetary union ( H.M. Treasury 1989). It would in fact be the hardest currency of all because any component currency may go through phases of weakening. Example 5 illustrates this point:

Example 5

Pursuing example 2, assume that weights rather than currency units are fixed at 0.6 for currency A and at 0.4 for currency B. The initial currency units are 1.2 for currency A and 1.6 for currency B, given that the initial exchange rates are 1 US dollar = 2 As = 4 Bs. Now assume that currency B devalues by 50% with respect to all currencies. To keep the weight of currency B at 0.4 the number of units of currency B in the ACU basket must be increased by 50%, from 1.6 to 2.4 units. The dollar value of the ACU is then 1.2/2 + 2.4/6 = 1. Similarly, the ACU value in currency A is still 2. Due to the devaluation, the ACU value in terms of currency B is now 6. The ACU can only gain, but cannot lose value with respect to component currencies.

The ACU interest rate would be below all component currencies. Girard, Pacheco, and Steinherr (1991) showed that a fixed-weight basket implicitly embodies an option that has a value. Therefore, the ACU interest rate would be below the lowest interest rate in the basket, the difference being associated with the value of the embodied option. It is also important to note that, in fact, weights do not matter for the value of the “hard” ACU.

C. Does a Basket Currency Require a Fixed Exchange Rate Regime?

The ECU was created as a reference currency for the EMS of fixed (but adjustable) exchange rates. This may raise the question whether the success of the ECU was not conditioned by the EMS. The ACU basket would contain currencies some of which have fixed exchange rates, other are floating with various degrees of management. It needs to be recognized that the EMS, although based on the ECU, did not in its functioning or performance depend on the ECU. Nor did the ECU in an essential way depend on the EMS. The ECU benefited from the official definition and recognition but not from the fixed exchange rate system.

Because a basket currency is a standardized diversified portfolio, it has all the advantages (never the worst performance) and disadvantages (never the best performance) of any diversified portfolio. The greater the volatility of the portfolio's components, the larger will be the gains. From this vantage point, flexible exchange rates are not a problem. Quite the contrary: greater volatility provides larger gains for risk-averse holders of ACU assets or liabilities.

D. Change of Regime Over Time

At the beginning and at the end of the ECU experience there were regime changes. Before the ECU was created, European institutions needed a unit of account for keeping their books and for defining their contractual responsibilities. To that end, the EUA was created. It was not a currency but a simple unit of account. Initially (28 June 1974), one EUA was set equal to one special drawing right. At the time of the creation of the EMS in 1979, the ECU took over the defining characteristics of the EUA on a 1:1 basis. However, the name was changed to signal the creation of a currency. Also EUA is unpronounceable as a word. ECU had the advantage of being pronounceable and of recalling a currency that existed in French history.

As Europe refused to let the market decide through a parallel currency approach, the decision to create a single currency was political and happened on a day decided and announced well in advance. On that day, the ECU was converted 1:1 into the euro. In other words, the choice of value for the euro was completely free. It could have been anything: one euro equal to one deutschmark or one Lira or one US dollar. The obvious choice was to define it equal to one ECU. As the ECU had a value in terms of each component currency the value of the euro in terms of all other currencies was fixed automatically. To avoid having countries aim at entering the euro regime with undervalued exchange rates, the Maastricht Treaty required that no exchange rate adjustment was allowed two years prior to the regime change. Although the fluctuation bands around central parities were widened in August 1993 to 15% as a consequence of the EMS crisis, the terminal condition of euro conversion brought about convergence of the exchange rates to their central parities as predicted by theory.

As this experience indicates, the initial launching of a fixed-currency-units ACU, left many options open for later development: ACU membership can evolve, the ACU could be hardened (by stopping at some point basket revisions), or a hard ACU could be adopted. Such a hard ACU could be basket-based or made independent of the basket. Or the basket ACU could be turned into a non-basket Asian currency. Clearly, one big advantage of the basket construction can be seen in its flexibility.

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