Exchange Rate Options for East Asia
Exchange Rate Options for East Asia
Abstract and Keywords
This chapter discusses three possibilities for future exchange rate options for the East Asian economies. The first would be the adoption of freely floating exchange rates throughout the region (or managed floating without cooperation between East Asian countries). The second possibility would be a continuation of the current system, which can be referred to as the East Asian dollar standard or the “Bretton Woods II system.” The third possibility is to engage in coordinated exchange rate stabilization or at some point even monetary unification. This option could be also described as bloc floating: while intraregional exchange rates would be managed or fixed, the East Asian currencies (or currency) could float freely against outside currencies such as the dollar and the euro.
In principle, there are at least three possibilities for future exchange rate policies in East Asia. A first one would be the adoption of freely floating exchange rates throughout the region (or managed floating without cooperation between East Asian countries). This is basically the policy prescribed by the IMF and most North American economists ever since the Asian crisis (e.g., Fischer 2001; Eichengreen 1999). However, given the high degree of economic interdependence within the region, such a unilateral, noncooperative policy would be problematic. As discussed, because East Asia has already reached a very high level of real integration, intraregional exchange rate volatility would have very disruptive effects on the regional economy, and would be aggravated because of poorly developed financial markets and missing hedging opportunities in most of the region. The historical record on floating exchange rates has shown excessive volatility to result and Friedman’s (1953) optimism regarding the stabilizing nature of freely floating rates to be unwarranted (see chapter 2). The fact that the East Asian dollar standard recovered after the Asian crisis and still prevails is evidence of East Asian countries’s (again, excluding Japan) fear of floating, and it is unlikely that this will change anytime soon. Floating exchange rates, or in general, unilateral exchange rate policies that might go into different directions, would have a highly destabilizing potential for the regional economy. Any monetary and exchange rate policy in East Asia should thus be directed at maintaining relative intraregional exchange rate stability. This leaves two other options.
A second possibility would be a continuation of the current system, which can be referred to as the East Asian dollar standard or the “Bretton Woods II system.” In a series of articles McKinnon (2005), McKinnon and Schnabl (2009), as well as Dooley, Folkerts-Landau, and Garber (2003, 2004, 2009a, b) have explained the rationale for East Asian countries to peg their currencies to the US dollar and maintain that this system will continue for years more.1 The East Asian dollar standard could be managed on an informal or formal basis. That is, East Asian countries could continue just like they do now (basically pegging or soft pegging to the dollar in expectation that the others do the same), or they could develop a more formal Bretton Woods type of arrangement (even though it is (p.158) unlikely that the United States would give its consent to an official role of the dollar in such a system).2
As noted before, pegging to the same external anchor brings about intraregional exchange rate stability, so that an East Asian Bretton Woods II arrangement would be in any case preferable to the free float option.3 However, there are three serious reservations against a continued reliance on the US dollar. First, maintaining fixed parities with the dollar automatically brings about problems when there are swings in the dollar–euro and dollar-yen rates. As seen before, most East Asian countries (without, of course, Japan) have roughly equal trade shares with the United States, Europe, and Japan, which makes none of these three currencies a good candidate for a single peg. As Mundell (2003b: 2) observes, “[a] major threat to the [current] system arises from gyrations of the major exchange rates. The instability of exchange rates between the large currencies has been enormous.” An East Asian Bretton Woods II arrangement, however, would become more sustainable if also Japan were to peg its currency to the dollar, as suggested by McKinnon (2005). This would provide a uniform exchange rate policy for the whole region, as well as stability toward the dollar. It would also preclude instability of the dollar–yen rate, the results of which were painfully felt in the Asian crisis. However, a Japanese decision to link the yen to the dollar again is very unlikely.
Second, the risk of maintaining one-sided dollar pegs depends not only on domestic efforts to keep the dollar exchange rate stable4 but also on the monetary policy in the anchor country and the international value of its currency (Schnabl 2009). The problem is illustrated by the depreciation pressure on the dollar from 2002 until summer 2008, which was in part a result of the historically low US interest rate policy from 2001 up to 2004. To maintain the dollar parity in face of appreciation pressure on their own currencies, East Asian countries were forced to intervene heavily in the foreign exchange market and stockpile dollar reserves. As the scope for sterilization is limited, fast monetary expansion was a result in most East Asian countries, which has led to a fast growth of monetary aggregates, contributed to surging stock and real estate prices (which in some parts of the region had led to financial bubbles that have since burst), and rising inflation.
Rising inflation in the United States and a depreciation of the dollar vis-à-vis other key currencies would erode the international real purchasing power of East Asian countries, especially the commodity exporting countries, as export revenues are mostly earned in dollars while imports are often paid for in euros or other currencies (Schnabl 2009). In addition the international creditor countries in the region face the already mentioned problem of “conflicted virtue,” namely balance sheet losses on assets denominated in US dollars as an appreciation of domestic currencies vis-à-vis the dollar reduces the value of these assets in terms of home currencies. The zero interest rate policy and quantitative easing measures that the Fed initiated to end the credit crunch following the collapse of Lehman Brothers in September 2008 has raised serious concerns about the inflationary consequences of this policy. Whether the Fed can withdraw the liquidity quickly enough (p.159) once the situation changes to prevent the liquidity shortage from turning into a hyperinflation and a free fall of the dollar is of paramount importance for the East Asian creditor countries (Yu 2009). The People’s Bank of China, the biggest US creditor, has openly voiced its concerns about the dollar’s lasting stability and its unease with a continued reliance on the dollar (Zhou 2009).
Chinn and Frankel (2007) argue that whether or not the dollar will be able to maintain its supremacy as the world’s leading international currency depends, besides developments in the euro area, on long-term inflation expectations for the US economy, that is, in the confidence (or lack of it) in US macroeconomic policy.5 If there is serious doubt about the dollar’s future domestic as well as international value, East Asian policy makers will not want to bind their currencies (and indeed economies) to it.6 While the dollar continues to be the world currency for the time being, the meltdown on Wall Street in September 2008 and the loose US monetary and fiscal policy responses have certainly increased uncertainties over the future role of the dollar.7
But even if the dollar maintains its strength, the question remains why a region as economically potent as East Asia should continuously bind itself to an external anchor. As noted earlier, the East Asian dollar standard also constitutes a form of implicit exchange rate coordination. While this system has served the majority of East Asian countries very well (with exception, of course, the period preceding the Asian crisis) we argued earlier that a continued pegging to the dollar involves all the costs, but not all the gains of regional monetary integration.8 The current dollar pegging might well be feasible for a considerable amount of time as claimed by Dooley et al. (2009a), but as a long-term strategy it is a dead end.
This leads to the third principle choice for exchange rate policies of East Asian countries: to engage in coordinated exchange rate stabilization or at some point even monetary unification. This option could be also described as bloc floating: while intraregional exchange rates would be managed or fixed, the East Asian currencies (or currency) could float freely against outside currencies such as the dollar and the euro. This is the option that will be explored in the remainder of this study.
There are several strategies for exchange rate cooperation aimed at stabilizing intraregional exchange rates. Exchange rate coordination based on a dollar anchor was already dismissed (as can be pegging to any other single external currency, such as the euro) as a long-term strategy. This leaves at least five possible future paths for exchange rate coordination in East Asia: (1) pegging to a single internal currency such as the yen or yuan, (2) pegging to a currency basket consisting of external currencies, (3) pegging to a currency basket containing regional currencies, (4) creating a regional currency system, and (5) a monetary union with a newly created East Asian currency.
Option 1 is impracticable because East Asia is lacking a regional lead currency that could act as an anchor for regional monetary cooperation in the same way that the German mark fulfilled this function in Europe. Theoretically the yen could perform this function, (p.160) but Japan’s attempts to promote a “yen bloc” throughout the 1980s and 1990s were not successful, and it is unlikely that it would be more successful today. The reasons are only economic in part and also have to do with the fact that the rest of East Asia, and especially China, is not willing to accept a dominant role of Japan and the yen. On the other side, China’s financial market impotence and the deficient international status of the yuan preclude an anchor role for the yuan anytime soon. While the Chinese authorities have been pushing for financial market reform, the Chinese financial markets are still in a very early stage of development and far from being able to absorb huge amounts of portfolio investment. Also an East Asian “yuan bloc” is not in sight unless the yuan becomes fully convertible, which will require continued reform of China’s foreign exchange market.9 No other currency in the region, be it the Korean won, the Hong Kong dollar, or the Singapore dollar, will be able to fulfill a regional anchor function.
This leaves options 2 to 5, which will be discussed in greater detail in the following. Before turning to these options for monetary cooperation, however, the next chapter will briefly consider a policy of inflation targeting with free floating, given that this is a policy prescription frequently given by critics of any form of regional monetary cooperation in East Asia. Succinctly, chapter 10 will examine the possibility of a regional monetary system for East Asia, drawing from the European experiences with the EMS. This is followed by an analysis of currency baskets for East Asia in chapter 11. Along the way, we will develop some thoughts also on the long-term possibility of a monetary union in East Asia.
(1.) Albeit both McKinnon and Dooley et al. argue that the Bretton Woods II system will prevail, they do so with different reasoning. While Dooley et al. direct their attention more to the trade side, McKinnon’s argumentation is grounded in the region’s financial dependency on the dollar. For a discussion of these two different views, see McKinnon and Schnabl (2009).
(2.) McKinnon (2005) recommends the formal adoption of dollar pegs throughout the region. He argues that formal “parity commitments” to peg the Chinese and Japanese currencies to the US dollar would encourage the smaller East Asian countries to follow their example so that the result would be “a zone of greater monetary and exchange rate stability for the increasingly integrated East Asian economy.” (McKinnon 2005: 52)
(5.) Chinn and Frankel (2007, 2008) point out that the dollar’s supremacy is rivaled, for the first time in postwar history, by another currency, the euro. Galati and Wooldridge (2006) maintain that the introduction of the euro greatly improved the functioning of the euro area financial markets, with liquidity and breadth of the euro financial market fast approaching those of dollar markets. This implies that the traditional argument that there is simply no alternative to the dollar as an investment currency loses value.
(8.) The same is true not only for pegging to the dollar but also full dollarization. While dollarization would not entail the risk of pegging (which will be discussed in detail in the chapter 10), it would mean a complete surrender of both monetary autonomy and sovereignty.
(9.) See Zhang and Liang (2009). A modest step toward convertibility of the yuan has been made in December 2008, when the Standing Committee of the State Council of the People’s Republic of China decided to allow the yuan to be used to settle trade payments with some selected trade partners as a part of a pilot project (see Murase 2009).