«Do Currency Regimes Matter in the 21st Century? An Overview Hiroshi Fujiki and Akira Otani This paper selectively reviews the recent literature on ...»
64 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002 Do Currency Regimes Matter in the 21st Century? An Overview Japanese government officials have expressed views in support of the yen’s internationalization, as well as of basket pegs for Asian economies as a first step.38 In our view, academic opinion regarding a future Asian regional currency is mixed.
However, many Japanese economists are sympathetic to arguments in favor of the internationalization of the yen. We will examine several opinions below.
Kawai and Akiyama (2000) observe that the role of the dollar as the dominant anchor currency in East Asia was reduced during the crisis period, but that its prominence has been restored. They suggest that Asian economies are likely to maintain more flexible exchange rate arrangements, at least officially, but would prefer exchange rate stability without fixed-rate commitments. They expect to choose a balanced currency basket system in which the yen and the euro play a more important role. Moreover, given the strong degree of intra-regional trade and investment interdependence, East Asian economies have incentives to avoid harmful, large exchange rate fluctuations within this region, hence it would be useful for those economies to choose similar currency baskets.
McKinnon (2001) objects to the proposal of Kawai and Akiyama (2000) and suggests that the simplest conceptual framework is to fix the yen to the dollar, rather than worrying about the empirical difficulty inherent in the measurement of a currency basket.39 Glick (2001) also points out that the virtues of simplicity, transparency, and observability are lost if the weights used in the basket are not public information and need to be adjusted over time in a timely manner. He argues that for most emerging market economies in East Asia, floating is a plausible choice, although it might accompany discretionary use of intervention.
Ogawa (2001) reports that the exchange rate of some East Asian economies against the dollar has stabilized, while the exchange rate against the yen has fluctuated since the crisis. His evidence suggests that some East Asian economies have returned to a de facto dollar peg.40 Why is the basket peg not a widespread exchange rate regime in East Asian economies so far? Bénassy-Quéré (1999) points out that the mismatch between the country distribution of trade (high weight of the dollar) and the currency distribution of their external debt (high weight of the yen) could be the reason that Asian economies prefer a low weight for the yen.
38. See for example, the Council on Foreign Exchange and Other Transactions at the Japanese Ministry of Finance (1999), which pointed out the need for internationalization of the yen for the 21st century on April 20, 1999.
(Official statements on this matter by the Japanese Ministry of Finance can be downloaded from http://www.
mof.go.jp.) Japanese Vice Minister of Finance for International Affairs Haruhiko Kuroda stated, “It would be difficult for the yen on its own to play a role similar to that of the euro and the dollar; however, the region could start with a basket composed of the yen, the euro, and the dollar before imagining a common currency for Asia” (Kuroda ).
39. Note that a high level of economic integration is possible without a common currency or currency pegs (for example, Canada, the United States, Switzerland, and Germany). If this is the case, then floating currencies with some leaning against the wind would be of considerable appeal for ASEAN economies as an intermediate transition stage. For example, Williamson (2000) regards East Asian economies as “reluctant floaters,” and recommends that they introduce publicly announced monitoring bands as a viable intermediate regime. The authorities would not be asked to defend a particular rate, and they would announce the rate consistent with long-term fundamentals to enhance the transparency and credibility of the exchange rate regime.
40. Consistent with his finding, the Study Group for the Promotion of the Internationalization of the Yen (2001) concluded that the internationalization of the yen was not so advanced, and thus it should be an item on the long-term agenda for Japan.
65 In our view, the lessons from the EMS suggest that arrangements promoting a stable exchange rate in Asia should accompany a blueprint for the regional safety net of financial stability and a guideline on mutual surveillance on the fiscal and structural policies for all member economies including Japan, together with peer pressure created by such an initiative.41 In this context, the Chiang Mai Initiative, which consists of bilateral swap agreements among the ASEAN economies, Japan, Korea, and China, could be an important first step, and there is no prior reason why regional integration in Asia should take more or less time compared with the European experience.42 Similarly, the initiatives toward a regional free trade area among these economies are also important conditions for deepening regional integration. In particular, the rapid growth in trade with China,43 if continued, would increase the benefit of using a common currency in Asia, although one cannot be sure as to which currency will play a pivotal role.44 One may interpret the current Asian arrangement as a commitment to multilateral integration with the minimum set of regional agreements reflecting the Asian political environment. For example, Mundell (2000) points out that an Asian common currency without the involvement of Japan and China is unrealistic. However, given the differences in the political regimes of the two economies, he expects that it is unrealistic to consider a common central bank that issues a single Asian currency.
Based on such reasoning, he suggests that the Japanese government should not create an Asian currency zone based on the yen for the sake of achieving exchange rate stability in Asia, and that a better alternative is for Japan to stabilize the yen-dollar exchange rate and the yen-euro exchange rate.
If one believes that the stability of the current account is the major and most pressing concern for the Asian economies, a currency basket proposal without a deep commitment would be a good starting point.45 However, as Wyplosz (2001b) states, even if such a practical but piecemeal approach achieved exchange rate stability, it might be subject to a currency attack without a well-designed commitment device to make the peg sufficiently credible.
41. For example, such a guideline could require changes in the current Japanese financial regulatory policies.
42. As of March 28, 2002, Japan has swap agreements with China, Korea, Thailand, Malaysia, and the Philippines.
43. For an impressive example, according to Japanese balance of payments statistics, Japanese imports from China exceeded those from the United States in August 2001. However, Young (2000) estimates that China’s per capita output growth rate from 1978 to 1998 was 6.1 percent, rather than the officially reported 7.8 percent, because of underestimation of the official deflator. He estimates total factor productivity growth in the non-agricultural sector as only 1.4 percent rather than 3.0 percent, using official data.
44. However, regarding the possible future role of China, Cohen (2000) suggests that even though the yuan’s transactional network may eventually become large, the currency’s prospects suffer from the backwardness of China’s financial markets and lingering uncertainty over domestic political stability—to say nothing of the fact that use of the yuan continues to be inhibited by cumbersome exchange and capital controls.
45. Ogawa and Ito (2000) propose an optimal exchange rate regime that minimizes the fluctuation of trade balances in emerging market economies using a two-country model. Without coordination, a Nash equilibrium with higher dollar weight would be chosen. They suggest that a common currency unit in Asia will resolve such coordination failure, because two economies would be better off moving to the basket peg.
VI. Tentative Conclusion and Challenges for Central Banks A. Tentative Conclusions The main observations in this paper are summarized as follows.
First, regarding the bipolar view, the logic behind it is clear. It is true that many currency and banking crises in the 1990s were related to massive capital inflows and outflows. However, in particular in East Asia, many economies do not allow a free float even after the Asian crisis. A clean float without capital controls might be too costly for these economies, perhaps reflecting the lack of deep and liquid financial markets, which makes the economies vulnerable to speculative attacks. Moreover, so far only a few large economies have successfully committed themselves to hard pegs except for the euro-area economies.46 Second, the experience of the EMS and the recent history of the currency board in Argentina show that even a strong fixed exchange rate regime may be subject to pressure from financial markets. Such pressure may stem from rapid capital inflows and outflows that induce dynamic inconsistency on the part of policymakers in defending the peg in the case of the EMS, or to political and institutional factors that do not support an exchange rate peg. The experience of Argentina suggests that even a currency board cannot work if the economy does not follow a prudent fiscal policy.
In addition, policymakers should address structural issues, such as inflexible labor markets, which make adjustment under hard pegs too costly, or dependence on dollar borrowing, which might make policymakers reluctant to revise apparently overvalued parity. These risks could undermine the achievement of price stability either through a political or currency crisis.
Third, the currency crises in the 1990s suggest that economists should prepare analytical tools that go beyond the Mundell-Fleming model, in terms of analysis of financial market imperfections, and general treatment of asset prices. A currency crisis model may in the future be part of an asset pricing model. Indeed, Figure 2 does not look like the traditional model of a currency crisis that focuses on the balance of payments. Krugman (2001) argues, “A fourth-generation crisis model may not be a currency crisis model at all; it may be a more general financial crisis model in which other asset prices play the starring role.” Fourth, the criticism made by Frankel and Rose (1998) and the European experience suggest that the static version of optimum currency area criteria should be evaluated carefully to make inferences regarding the pros and cons of a common currency.
46. One may argue that the relevant question for these economies is “how to float.” In this context, temporary capital controls to discourage excessive short-term capital inflows while posing little barrier to capital outflows, which were employed in Latin American economies such as Chile, Brazil, and Colombia in the 1990s, may be worth mentioning. However, Ariyoshi et al. (2000) conclude that capital controls cannot substitute for sound macroeconomic policies. Edwards (2001b) concludes that Chile’s experience was successful in changing the maturity profile of capital inflow, and of the country’s debt. However, the effect would be short term and not very important quantitatively. Reinhart and Smith (2001) calibrate the potential effectiveness and welfare implication of temporary capital inflow controls. They find that reducing foreign debt by 5 percent of GDP requires 88.9 percent of an inflow tax under their reasonable parametric setup. They also find that the economic benefit of taxing capital inflows is quite small.
67 Fifth, the prospects for regional currencies are very unclear. In particular, currently it is very difficult to predict the development of an Asian currency area.
In sum, we argue that, given the global interdependence among economies that exists today, currency regimes should be always evaluated in terms of their relationship to monetary policy, fiscal policy, structural policies, and the working of financial markets. Thus, a currency regime does matter, and is a relevant concern for policymakers. However, it should be noted that the currency regime is only one element of national economic policymaking, and thus a broader perspective is always needed.
B. Challenges for Central Banks This paper has not been able to discuss many important issues because of space limitations. Let us touch on some of these issues for the sake of further discussions.
First, we did not discuss the debate regarding the appropriate policy response to be made by emerging market economies and international organs. Although economists disagree about the role of the IMF and the appropriate response to be made by emerging market economies, the bottom line of the debate seems to be clear. Policymakers need detailed knowledge about the structures of their economies to analyze currency crises and the resolution of such crises, and central banks are no exception. The knowledge required is broad indeed. For example, Mishkin (2001) lists 12 issues for crisis prevention. These include prudential supervision, accounting and disclosure requirements, legal and judicial systems, market-based disciplines, the entry of foreign banks, capital controls, reduction of the role of state-owned financial institutions, restrictions on foreign currency-denominated debt, elimination of “too-big-to-fail” in the corporate sector, the sequencing of financial liberalization, monetary policy and price stability, and exchange rate regimes and foreign exchange reserves. Thus, the exchange rate regime is just one factor among many.
Second, this paper did not make explicit any consideration of the relationship between exchange rate stability and domestic price stability among the three major currencies. Standard macroeconomic econometric models (such as Taylor ) suggest that the international spillover effect of domestic monetary policy is small.