Criteria for the choice of weights

A series of options are open when deciding upon the weights to be granted to ACU component currencies. The European experience offers some useful lessons. It is important to reflect on the role of weights before examining the actual variables to be used in setting such weights for the ACU.

A. The Historic Experience of the ECU

When the EMS started to operate on 13 March 1979, the definition of the ECU coincided with the definition of the European unit of account (EUA). The EUA was a “closed” basket of fixed quantities of the nine European Community (EC) currencies. Unlike the EUA, the ECU was defined as an “open” basket. The resolution of the EEC Council of 5 December 1978 stipulated that “the weights of the currencies in the ECU will be re-examined and, if necessary, revised within a period of six months of the entry into force of the system and thereafter every five years or, on request, if the weight of a currency has changed by 25%.” Moreover, Section 2 of the EEC Regulation of 18 December 1978 provides for the possibility that the Council fixes the terms under which the composition of the ECU could be modified: for example, in the event of inclusion of new countries within the system. In the five year period 1979–1984 the composition of the ECU changed as a consequence of the devaluation or revaluation of component currencies (Table 1 [ PDF 68KB | 1 page ]), even if none of the weights changed by more than 25%. Variations of the exchange rates were particularly wide only in the initial period of the EMS during which inflation rates diverged substantially.

European policymakers defined an “official” ECU by re-denominating a share of exchange reserves in ECU. These ECUs could only be used for transactions among central banks. Simultaneously, securities markets saw the advantage of a basket currency and various baskets were initially defined, differing in detail from the official definition. Although the “official” ECU and the “private” ECU have developed autonomously and with different characteristics, since 1981 the market began to use the same definition of “open” basket as formulated in setting up the EMS and the “open” basket formula became the only one adopted by commercial and financial agents. The adoption of this formula has been important because it has allowed the spontaneous establishment in the market of a uniform status of the ECU. It has increased the confidence of economic agents in the new currency by excluding the risk of coexistence of different types of ECUs. As a consequence, at maturity of an ECU-denominated financial instrument, the definition of the basket is different from the one on which it was initially based, if in the meantime an official re-definition has occurred.

The political motivation for ECU re-compositions was the fear that strong currencies could reach a dominant share of the ECU, which would be politically unacceptable to weakcurrency countries. In particular, as Germany had the largest economy and the largest trade share and therefore the highest weight from the beginning and the strongest currency, the perceived risk was an increasingly dominating share for the deutschmark. Although the administrative procedures and general criteria for re-weighting were well-known, the market was faced with uncertainty as to the precise outcome of an essentially political negotiation. The uncertainty concerned ECU interest rates, which jumped on the day of re-composition, but not the exchange rate, as re-composition was undertaken subject to the constraint of unchanged exchange rate.

Every ECU revision needed the unanimous consent of the Council of Ministers. Beginning at the time of the creation of the ECU, three “economic” criteria were used for determining the weights of currencies in the ECU: the share of the individual member state in the EC's gross domestic product (GDP); the contribution of each member country to intra-EC trade; and, the quota of the individual member countries in the short-term support facility of the EMS (Table 1 [ PDF 68KB | 1 page ]).

However, no explicit rule has been disclosed according to which changes in weights may be determined (Table 2 [ PDF 68.4KB | 1 page ]). Nor is it known to what extent the above criteria were retained and how they were weighted. The British pound, which was not part of the EMS exchange rate mechanism, and the Italian lira, which had a 6% intervention margin, received much lower weights than what the three basic criteria would suggest (Table 1 [ PDF 68KB | 1 page ]). The deutschmark, in contrast, had a larger weight.

At the time of the second revision in September 1989, with a new addition of countries, economic criteria were not followed (Table 3 [ PDF 68.4KB | 1 page ]), thus Spain was granted a share of 5.3% as opposed to its economic share of 6.1%. No lower limit seems to have been activated. Indeed, the weight was not revised upwards for Greece, while the initial weight was set under 1% for Portugal. Subsequently, the fall of the Greek share to 0.5% did not trigger any revision.

B. Do Weights Matter?

One consideration for assessing the importance of weights is surely political. On the most general level, it may be a question of national prestige. Furthermore, weak currencies may attach importance to an initially “exaggerated” weight in anticipation of future devaluations.

A counter argument against larger weights for “weak” currencies is that it can be expected that during the initial years of the ACU, as was the case for the ECU, there will be an excess of assets over liabilities that need to be covered. The higher the share of a currency in the ACU, the higher the demand will be for liabilities in that currency to cover ACU assets. This technical argument is, however, likely to be marginal, except for countries with inconvertible currencies (for capital transactions).

Weak currencies tend to offer higher interest rates to compensate for the devaluation risk. On interest rate parity grounds there is no argument either for or against higher weights for weak or strong currencies, at least as long as the main use of the ACU is in securities markets. That is, the covered returns on all currencies in the same risk class are identical. Once the ACU becomes a transaction currency and is, therefore, held in cash (banking deposits), then obviously the “strong” currency argument becomes pertinent. As the scope for becoming a unit of account and a transaction currency depends on the strategic decision of allowing currency competition (“parallel” currency approach) or not, this argument may or may not be of importance.

The arguments discussed so far suggest that there is no strong ground for not admitting weak currencies into a basket. There is, however, a strong argument for having some strong currencies with a high international acceptance in the basket with a substantial weight. A basket of exclusively unstable, internationally non-traded currencies, will never gain acceptance. Strong currencies with international acceptance buy credibility. Moreover, their weight will increase over time and make the basket harder. If weaker currencies try to avoid losing weight, they have to harden and gain in international reputation. However, weaker currencies contribute to the yield so that both play a significant role.

Is it possible to develop arguments for an “optimal” composition? Only if one defines first “optimal for what purpose”? If the role of the ACU is viewed as one limited to foreign trade transactions, then it would make sense to weight component currencies according to intraregional trade shares.

If the ACU is viewed as a parallel currency then a different weighting seems preferable. Consider the share of country j's imports (Mj) in intra-regional trade (M) as

Sj = Mj/M = (Mj/Yj)/(Yj/M)
or
Mj/Yj = Sj/(M/Yj),
where Yj is total expenditure of country j.

The optimum amount of domestic currency in the ACU should be positively correlated with (1 – Mj/Yj); i.e., with the share of domestic goods in domestic expenditures. For given intraregional trade (M) and given expenditure (Yj), there is a positive correlation between Mj/Yj and Sj. Therefore, the larger a country's share in intra-regional trade, the smaller should be the share of its currency in the ACU. This is a counter-argument to correlating ACU weights with trade shares.

On the other hand, for given intra-regional trade and given trade shares, M and Y are inversely correlated. Hence, the larger gross national product, the larger should be country j's weight in the ACU.

For the ECU, the shares in the short-run EMS facility were taken as a proxy for the importance of a currency in international financial transactions. As such, it was very unsatisfactory. An alternative would be to take only convertibility into account. But this would not give a numerical weight. Better would be to take bond market transaction volumes that are a function of convertibility and financial development. Particularly, if the initial function of the ACU was seen in developing a regional ACU securities market this may be the key variable. Moreover, for investors in ACU securities the weighting is of little importance, as interest-rate-parity makes all convertible currencies equally attractive.

Given uncertainty with respect to the functions that the ACU will fulfill, it may seem reasonable to consider a weighted average of the three candidate criteria: GDP, trade, and financial assets.

To sum up, economic criteria for the weights of currencies in the ACU cannot be derived from any reasonable economic optimization approach. Key is to first define the functions of the ACU, as this will have an impact of the weighting decision. Also of importance is to let the market decide. This can be achieved by not resetting the weights following exchange rate changes. Once exchange rate stability in the region is achieved, implying interest rate convergence, the importance of weights will disappear to a large extent.

As big changes in the structure of weights would upset the market, give the currency a smack of political manipulation, and create unnecessary risks, the following approach appears advisable. If there is no long-term vision about the various steps and the ultimate goal of regional monetary integration, then it seems best to have a weighting that reflects the economic power of the participants but avoids very large shares (What is the point of a basket if one currency accounts for more than half?) and very tiny shares (Can there be a sense of ownership with a share of less than 1%?).

C. Economic and Financial Variables to be Used

In light of the above discussion and in line with the European experience with the ECU, three types of indicators are candidates for a basis for the computation of weights in the ACU: GDP, trade, and financial assets.

1. GDP, Trade, and Financial Assets

Using current nominal GDP in US dollars as the basis (Table 4 [ PDF 68.9KB | 1 page ], column 2), the weight of Japan is more than double that of People's Republic of China (PRC), which is itself three times that of Republic of Korea (hereafter Korea). The weight of Korea is itself three times larger than for Indonesia and four times larger than Thailand's. The Philippines' weight is half that of Thailand's, Malaysia's three-fourths, and Singapore's two-thirds. The sum of Cambodia, Lao People's Democratic Republic (Lao PDR), Myanmar, Brunei Darussalam, and Viet Nam's weights is lower than 1%. The use of the average share over the last three years would make little difference.

Using total trade (Table 4 [ PDF 68.9KB | 1 page ], column 3), the combined share of the two largest East Asian economies (the PRC and Japan) is close to 60%. Korea's and Singapore's shares are around half that of Japan; Malaysia and Thailand a quarter of Japan's and Indonesia, the Philippines and Viet Nam together an eighth of Japan's. Cambodia, Lao PDR, Myanmar, and Brunei's joint share is lower than 0.5%.

Basing weights on the international debt securities outstanding by residence of issuers (Table 4 [ PDF 68.9KB | 1 page ], column 4), the joint share of the PRC plus Korea would be two-thirds that of Japan, and this would leave a third of the weights to South-East Asian countries. The sum of Cambodia, Lao PDR, Myanmar, Brunei and Viet Nam's weights is de facto constrained to 0% because of the lack of issues of such securities by these countries.

2. Equal Shares for Different Indicators

In order to obtain a composite indicator for weights close in spirit to the approach that served as a basis for computing weights in the EMS, we gave equal weight to GDP, trade, and financial criteria. As shown in Table 5 [ PDF 68.9KB | 1 page ], the overall weight of Japan is then 40%, PRC's is close to 22%, and Korea's share is close to 15%. Singapore's share is half of Korea's and Malaysia is close behind. The share of Indonesia, Thailand, and the Philippines is between 2% and 3% for each, Viet Nam's less than 1%. Lao PDR, Myanmar, Cambodia, and Brunei, together amount to around 0.3%.⁵

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