«Masahiro Kawai Dean and CEO Asian Development Bank Institute mkawai November 2008 This paper is prepared for the 2008 Macro Research ...»
The Role of Asian Currencies
in the International Monetary System
Dean and CEO
Asian Development Bank Institute
This paper is prepared for the 2008 Macro Research Conference, “The Global Monetary
and Financial System and Its Governance,” organized by the Tokyo Club Foundation for
Global Studies, to be held in Tokyo on 11-12 November 2008. The author is thankful to
Shigeru Akiyama and Doo Yong Yang for providing me with data. The findings, interpretations, and conclusions expressed in the paper are entirely those of the author alone and do not necessarily represent the views of the Asian Development Bank, its Institute, its executive directors, or the countries they represent.
The Role of Asian Currencies in the International Monetary System Masahiro Kawai Asian Development Bank Institute
1. Introduction: Key Issues In recent years East Asia has seen rapid advances in market-driven economic integration through cross-border trade, investment and finance. Following the Asian newly industrialized economies (NIEs) and middle-income Association of Southeast Asian Nations (ASEAN) members, China is the most recent participant in this integration process as a result of further opening of its economy to international trade in goods and services and foreign direct investment (FDI). Growing economic integration has strengthened macroeconomic linkages across those East Asian economies that have also opened financial markets and liberalized capital accounts.
The high and rising degree of economic interdependence in East Asia suggests that it is increasingly important for the region’s economies to achieve intraregional exchange rate stability. Some recent key policymakers in East Asia are increasingly vocal about the need to create a monetary union in the region (for example, De Ocampo 2004; Kuroda 2004; and Chino 2004). The reason is that they believe that intraregional exchange rate stability is desirable for East Asia and a monetary union is the ultimate form to ensure it.
In reality, however, the region remains characterized by diverse, uncoordinated exchange rate arrangements. Japan and China, the two dominant countries in East Asia, respectively adopt an exchange rate regime akin to a pure float and a tightly managed US dollar-based regime. Most other economies—except for the small open economies of Hong Kong and Brunei Darussalam—adopt intermediate regimes of managed floating with the US dollar as the most important anchor currency. As it is becoming difficult to maintain intraregional rate stability through the traditional policy of dollar pegs, a regional framework for exchange rate regime coordination needs to be developed in East Asia. In particular, given the lack of dominant regional currency in East Asia, there is a case for using a basket of regional currencies—called the Asian Currency Unit (ACU)—as the region’s common anchor currency.
Reflecting these issues, this paper asks the following questions:
• How important are the US dollar and the euro as international currencies vis-à-vis Asian currencies, particularly the Japanese yen?
• Is East Asia—or a group of countries in the region—ready for a regional single currency, satisfying optimum currency area (OCA) criteria?
• What is the practical first step towards regional monetary and exchange rate policy coordination and a roadmap to a future Asian monetary union? What role can an ACU play in this effort?
• What are the most serious impediments to such steps?
1 Essentially, East Asia faces three major policy challenges in identifying practical modalities for exchange rate coordination. First, to achieve intraregional exchange rate stability, there must be some convergence of exchange rate regimes in East Asia; the most realistic option is the adoption of similar managed floating regimes—rather than a pure float or a rigid peg to an external currency. This requires major Asian economies— including China—to move to a more flexible regime. Second, given the limited degree of the Japanese yen’s internationalization and the lack of the Chinese yuan’s full convertibility, East Asia needs to secure a credible regional monetary anchor through a combination of some form of national inflation targeting and a currency basket system. An important challenge here is to find a suitable currency basket, particularly that of regional currencies. Third, if the creation of an East Asian monetary zone—and possibly a regional single currency in the distant future—is desirable, the region needs to articulate the roadmap, or the required steps, toward closer monetary and exchange rate policy coordination.
The paper is organized as follows. Section 2 reviews the importance of the U.S. dollar and the euro as international currencies in comparison to Asian currencies. Section 3 tackles the question of whether an integrated East Asia requires a common currency. Section 4 examines the current exchange rate arrangements in East Asia and identifies problems of the current lack of coordination. Section 5 explores policy steps to monetary and exchange rate policy coordination that leads to stable intraregional exchange rates as well as the supporting financial cooperation. Section 6 provides concluding remarks and policy implications.
2. International Roles of the U.S. Dollar, Euro and Japanese Yen
This section reviews the extent to which the U.S. dollar, the euro and the Japanese yen are used as international currencies in foreign exchange market trading, foreign exchange reserve holding, and foreign exchange rate policymaking. It briefly summarizes trends in yen internationalization and compares the share of the yen in these categories to those of other major international currencies.
Foreign exchange market trading and foreign exchange reserve holding. Table 1 summarizes currency compositions of foreign exchange trading in the world's major markets in April 2001 through April 2007. The table indicates that the share of foreign exchange trading involving the U.S. dollar has declined over the six year period, though its level is still significant. The share of the U.S. dollar was 90% in April 2001 and declined to 86% in April 2007. The euro share has remained about the same at 37%. In contrast, the share of the Japanese yen declined from 23% in April 2001 to 17% in April 2007.
The very high weight of the U.S. dollar in foreign exchange market trading suggests that the underlying requirement for the U.S. dollar in trade and capital transactions is large and that the dollar plays the role of a vehicle currency, mediating exchanges of various currencies. For example, conversion of the Japanese yen into the Korean won is done typically through the U.S. dollar, first converting the yen into the dollar and then the dollar into the won. This mediating, vehicle-currency role of the U.S. dollar is usually explained 2 by the low transactions costs due to economies of scale and the public goods nature of the dollar; people prefer to use the U.S. dollar because almost everyone else uses it too. There is no sign that the Japanese yen has been functioning as a vehicle currency in the world’s foreign exchange markets.
Table 2 presents the shares of major currencies in the official foreign exchange reserves held by IMF reporting countries. The share of the U.S. dollar held by all IMF reporting countries, which was about 50% in the early 1990s rose to 71% in around 2000 and then declined to 64% in 2007. The share of the euro rose substantially from 18% in 1999 to 27% in 2007, while the share of the yen declined from 8% in 1990 to a mere 3% in 2007. The share of the U.S. dollar is high because industrialized countries—particularly Japan— prefer to hold the dollar. At the same time, a large part of the fluctuation in the yen’s share over the past twenty years may be explained by rapid changes in the value of the Japanese yen vis-à-vis other major currencies.
Normal anchor currency role of the dollar, euro, and yen. I would like to focus on the nominal anchor currency role of the U.S. dollar, the euro, and the Japanese yen and to report the measured size of the respective currency areas.
First of all, we identify what currency or currency basket each country in the world has chosen as a nominal anchor, that is, as a target currency or currency basket for exchange rate stabilization. To do this, we extend work by Frankel and Wei (1993 and 1994) and Kawai and Akiyama (1998) and attempt to find whether each country’s exchange rate is affected by the currencies of major industrialized countries, such as the U.S. dollar, the euro, the U.K. pound sterling, and the Japanese yen. 1 Specifically, we regress the log first difference in a country’s exchange rate (measured in terms of the Swiss franc) on a constant term and the log first differences in the exchange rates of the major international currencies (all measured vis-à-vis the Swiss franc). 2 The coefficients that are estimated to be statistically significant are interpreted as the weights assigned by the authorities to the corresponding currencies in their exchange rate stabilization policies.
Next, GDP and trade (exports plus imports) are used to measure the economic size of the currency areas for the U.S. dollar, the euro, the U.K. pound, and the yen. For example, for a country pegging its exchange rate to a particular international currency, its entire GDP (or trade volume) is classified as belonging to the currency area formed by this particular currency. If a country does not peg the exchange rate to a single currency but instead assigns several different weights to a basket of major or regional currencies, its GDP (or trade volume) is divided according to these weights and distributed to the corresponding currency areas. The result is summarized in Table 3.
1 Since some countries are known to stabilize their exchange rates against currencies other than major industrialized countries’ currencies (i.e., the South African rand in Africa, and the Australian dollar, the Singapore dollar, and the Indian rupee in Asia), we include in the regression equation the exchange rates of such relatively minor or regional currencies for certain groups of countries.
2 In carrying out econometric exercises, we have deleted data observations with values of log first differences greater than 0.1 to eliminate the effects of discrete currency revaluations or devaluations.
3 Table 3 indicates that according to the GDP measure, the world economy covered by the U.S. dollar area has declined from 53% in the early 1970s to about 45% in 2005-2007. In contrast, the share of the euro area has risen from 22% to 36% during the same period. The share of the yen area has not changed much at 11%, although its relative size rose to 17% during 1985-1999. The U.K. pound area also remains about the same in relative size at 7.6%. The dollar area is large because many developing countries regard the dollar as the most important global anchor. The Japanese yen area is slightly larger than the weight of the Japanese economy in the world. The yen area outside Japan is less than 3 percent of the world economy and, hence, the yen cannot be said to be a full-fledged, global nominal anchor currency. If the trade measure is used, the relative size of the dollar area has not shrunken, and the relative size of the euro area has risen from 36% to 46% over the last 37 years. The relative size of the yen area has diminished from 10% to 7%.
Limits to the yen’s international currency role. The weight of the Japanese yen as an international currency has been limited both in comparison to the U.S. dollar and the euro and relative to the size of the Japanese economy. The yen has not been playing a major role as international money or as a nominal anchor to which other countries may peg, or stabilize the value of, their own currencies. Several explanations can be given for the limited use of the yen as an international currency.
First, use of the Japanese yen in invoicing Japan’s trade has been limited due to the country’s specific trade structure (see Table 4). Japan has been dependent on the United States as its major export market and on imports of large quantities of minerals, fuels, raw materials, and basic commodities for its industrial production. Trade with the United States and trade in primary commodities tend to be dollar denominated, further reducing the use of the yen.
Second, Japanese money and capital markets, particularly for treasury bills and other private short-term instruments, have not been as well liquid as markets in New York or London. Institutional limitations, the lack of a market infrastructure with a global standard, and the perceived overregulation in Tokyo money and capital markets have been pointed to as severe impediments to an expanded use of the yen by many authors (see Garber 1996).
As a result of these impediments in the Tokyo markets, foreign monetary authorities and private investors have been reluctant to use yen instruments to carry out international trade and capital transactions. Table 5 reports currency shares used for invoicing Korean and Thai trade. It is clear that the U.S. dollar is the most dominant invoicing currency and the use of the Japanese yen—though the second most important invoicing currency for these economies—is far below that of the U.S. dollar.
The third explanation concerns the historical context of Japan’s postwar economic development. The post-World War II reconstruction and growth of the Japanese economy were made possible by financial aid and trade opportunities provided by the United States.
Japan received U.S. aid during the reconstruction period, depended on the open U.S.