Empirical Results

Figure 10 [ PDF 170.9KB | 2 page ] shows the impulse responses of interest rates, exchange rates, and foreign exchange reserves to US monetary policy shocks over 24 months, with 90% probability bands. The country names are noted at the top of each column while the names of responding variables are noted at the far left of each row. To compare the interest rate changes of each country with those of the US, the interest rate response of the US is also reported at the last column in each figure. In addition, the scale of the graphs in each row is the same, in order to facilitate the comparison across countries.⁴

The US interest rate increases by 0.15% point on impact and increases up to 0.2 % point in approximately 5 months. Then, the US interest rate decreases back to the initial level in about 20 months. Theoretically, such increases in interest rate are likely to depreciate the exchange rate of East Asian currencies against the US dollar when exchange rate flexibility is allowed. However, the exchange rate depreciation is not significant (based on 90% probability bands) in almost all countries, except for Korea in the long horizon and Japan. Even in Korea, the exchange rate appreciation is not significant in the short run and medium run although it is significant in the long run. In Japan, the short-run and medium-run appreciation is different from zero with more than 95% probability.

The exchange rate responses are quite interesting, given that many East Asian countries allowed some exchange rate flexibility during this period. These exchange rate responses are mostly explained by East Asian countries interest rate and foreign exchange policy responses . The interest rates of most East Asian countries strongly respond to the US monetary policy shocks. In the Philippines, Thailand, and Taipei,China, the domestic interest rate tends to increase as much as the US interest rate increases, which can fully nullify the effects of US monetary policy shocks on the exchange rate. Also in Singapore and Korea, the interest rate increases are significant. In other countries, such as Malaysia and the PRC, the interest rate does not respond much, but a significant drop in foreign exchange reserves is observed, which can also contribute to the exchange rate stability in response to the US interest rate increase. These two countries, in fact, adopted the fixed exchange rate regime. In addition, the capital account restrictions of these countries seem to help to fix the exchange rate while keeping the interest rate. On the other hand, the Japanese interest rate does not respond much to the US interest rate changes. Although foreign exchange reserves fall temporarily in the medium run, this does not seem to be enough to fully nullify the exchange rate depreciation. As a result, a significant exchange rate depreciation is found in Japan.⁵

These results suggest that the conventional exchange rate channel is unlikely to play much role in the transmission of the US monetary policy shocks to emerging East Asian countries, excluding Japan. For example, the conventional exchange rate switching effect that can generate the opposite real effects to East Asian economies is not likely to be important. On the other hand, many emerging Asian countries did increase the interest rate in response to the US interest rate increase. This suggests that US monetary policy changes, for example, monetary expansion, are likely to have a positive spill-over effect to Asian real economies, and will help the synchronization of the US and Asian business cycles. However, in countries with capital account restrictions and a fixed exchange rate regime, the PRC neither channels are likely to play any role in the transmission of the US monetary policy shocks. Finally, in a true free floater like Japan, the exchange rate channel is likely to be important.

Some argue that after a financial crisis, East Asian countries tend to adopt more flexible exchange rate arrangements with liberalized capital accounts. Theoretically, even with liberalized capital accounts, monetary autonomy can be obtained under a flexible exchange rate regime. Reflecting these theories, these East Asian countries try to adopt monetary policy framework that may provide stronger monetary autonomy, for example, inflation targeting. However, empirical results show that, at least conditional on US monetary policy shocks, these countries in fact neither allow the exchange rate to move freely nor perform independent interest rate policy. Fear of floating of these countries may prevent these countries from securing monetary autonomy.

On the other hand, the trilemma also suggests that monetary autonomy can be achieved even under a fixed exchange rate regime by restricting capital mobility. Our empirical results show that two East Asian countries with a fixed exchange rate regime and capital account restrictions (the PRC and Malaysia) seem to be at least partly successful in keeping domestic monetary policy independent from US monetary policy.

These results are interesting since past studies, such as Giovanni and Shambaugh (2008) and Frankel, Schmukler, and Serven (2004) suggest that the interest rate responds more strongly in the fixed exchange rate regime, contrary to our empirical results. In our sample, fixed exchange rate regime countries imposed capital account restrictions, which may make the result different. That is, the monetary independence may be achieved under a fixed exchange rate regime with the help of capital account restrictions. On the other hand, at least some of our sample floating exchange rate regime countries were not true floaters, which may explain strong responses to the interest rate in our floater samples.

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