An Asian Currency Band After the RMB Revaluation

An Asian Currency Band after the RMB Revaluation

Chen-Jui Huang*

ABSTRACT

This paper applies an original methodology to propose the first evidence on the feasibility for a market-driven Asian currency band after China’s renminbi (RMB) revaluation in July 2005. Based on daily exchange rate volatility decomposition, it examines, under dynamic interaction among broad-defined regional market forces, contemporaneous and lagged bilateral currency cohesion in terms of synchronization in intra-Asian shocks. With China as the benchmark, an implicit currency band for a core group of seven Asian countries appears emerging. But the long-run stability of this system will crucially depend on the tug-of-war between the yuan and the yen, advancement of the ASEAN in the regional economy, and a possible fine-tuning or switch in the exchange rate regime by Hong Kong’s currency board.

JEL Classification: F15; F31; F33 Keywords: Currency band; Exchange rate; Monetary integration; Asia; RMB

______* Department of Finance, Tunghai University, 181, Taichung-kang Rd. Sec. 3, Taichung 407, Taiwan. Tel: +886 4 23590121 Ext. 3541; Fax: +886 4 23506835; E-mail: [email protected]. 1. Introduction

The Chinese renminbi (RMB) revaluation by 2% to an 8.11 rate in July 2005 unquestionably comes as a significant shock on the international monetary system. It not only corroborates the very end of the status quo in which the People’s Bank of China (PBC) has been firmly committed to the RMB peg to the US dollar at the 8.28 rate despite persistent pressure from the US, but also signals the beginning of a new era where new dynamics of currency relations in Asia as well as in the rest of the world are to take place. The raison d’être lies in the exchange rate regime switch accompanying the revaluation.

As announced by the PBC, the RMB is no longer fixed to the dollar. Instead, it is allowed to adjust vis-à-vis a basket of major currencies. The move towards a more resiliently managed floating exchange rate by the PBC on one hand corresponds to an unavoidable action required for China’s gradual openness to the world economy, and on the other hand reveals the ambition to create under global currency competition a first-mover advantage for the RMB. From the regional view, the start of a floating, albeit limited, RMB, necessitates a thorough review of the currency integration issue in Asia. More specifically, there emerges under the new Chinese exchange rate regime greater room for the role that the RMB will play in Asian currency relations besides China’s growing influence on the regional economy.

It is in this spirit that this paper intends to contribute an original analysis that echoes the aforementioned call for further investigation. With a market approach adopted, preliminary evidence is proposed to shed new lights on the feasibility of promoting closer intra-Asian currency cooperation as the RMB starts to float. In particular, this paper discusses the issue that concerns the choice of a transitional process serving to enhance progressively monetary integration in Asia and suggests alternatives such as an implicit Asian currency band in addition to the often advocated dollar standard or peg to the Japanese yen.

Inspired by the launching of the European single currency, numerous studies have emerged in literature and examined whether a monetary union analogous to the euro area could be created in Asia in the years to come. Works devoted to the debate about the creation of the euro ex ante as well as ex post, as identified by Tavlas (1994) and further elucidated by Huang (2003), can be regrouped in two classes, each of which respectively highlights one of the two distinct but complementary approaches to currency integration. On one side, the concept of optimum currency areas (OCAs) as defined by Mundell (1961) and McKinnon (1963) in their seminal contributions constitutes the core for development of the “criterion approach”. The approach is also incorporated into the Maastricht Treaty as the juristic foundation for the present euro area. On the other side, cost-and-benefit analysis (CBA) provides an alternative framework for evaluating the feasibility of forming a currency union. The commonly cited report by the Commission of the European Communities (1990) is as a matter of fact based on this “income-statement approach”. Bothapproaches have their proper methodological pros and cons as regards analysis of a monetary integration process.

1 The OCA theory proposes criteria that guarantee macroeconomic stability within an OCA and hence justify its “optimality”. Each criterion is a kind of vaccination against the illness of regional macroeconomic instability. Since total immunity does not exist, the list of such vaccinations is never complete. Accordingly, the OCA theory is of enumerative nature and difficult to be modeled. Furthermore, as the OCA criteria are mostly derived from a regional and macroeconomic vision, they are often interdependent and rarely concomitant in the economy. Their empirical applicability is consequently limited and subject to the problem of arbitrariness linked with the choice of the weight assigned to each criterion.

The CBA paradigm partially eliminates methodological drawbacks inherent to the previous theory and permits overall analysis of a monetary integration process. One of its advantages resides in its applicability at both country-specific (net benefit for one country to join a currency union) and region-wide (aggregate net benefit for the union) levels. Another relates to the fact that the optimality defined for a currency union by the CBA framework concerns both microeconomics and macroeconomics, while that by the opposing approach is in essence macroeconomic. However, the CBA framework adopted from the regional perspective does not explicitly treat issues on redistribution of costs and benefits among countries. In contrast, they are stressed by the OCA theory with its convergence criteria. Recent works reviewing foundations for analyzing monetary integration include De Grauwe (2005).

The direct application of these two approaches to the Asian case has surged in literature since the late 1990s. One reason is associated with an imperative call for establishing a new and stable regional monetary system after the end of the Asian Crisis in 1998. Another links with the metamorphosed geopolitics in Asia.

In contrast with Europe which essentially relies on an institutional approach to regional integration, Asian economies traditionally develop on the basis of dynamic regional market forces, with the exception of one formal regional organization, i.e. the ASEAN. Created in 1967 by five founding member countries (Indonesia, Malaysia, Philippines, Singapore, and Thailand), the ASEAN has expanded into a regional economic community composed of ten member countries, adding on Brunei, Cambodia, Laos, Myanmar, and Vietnam. Furthermore, it has created, through the Agreement on the Common Effective Preferential Tariff (CEPT) scheme initiated in 1992 and gradually implemented to date, the ASEAN free trade area (AFTA) aiming to move towards a complete regional economic union.

In parallel, Japan, Korea, and China collaborate with the ASEAN under the label of the “ASEAN + 3”for the eventual conclusion of bilateral free trade agreements (FTAs). FTAs consented between individual Asian countries have also been concretized or are in progress, such as the accord ratified by Singapore and Japan in 2002 and negotiations between Taiwan and Japan, Taiwan and Philippines, Korea and Singapore, and Korea and Japan. It is worth remarking that the regionalism represented by the proliferation of Asian FTAs contradicts in reality the ultimate objective of the World Trade Organization (WTO), which attempts to accomplish global free trade on a multilateral foundation. The obvious failure of the 2003

2 “Cancún trade talks”, partially caught up by limited renegotiations in the latest 2005 “Hong Kong trade talks”, and lastly an indefinite suspension of trade talks declared in July 2006, seemingly reconfirms the malfunctioning of the WTO as an effective forum for multilateral discussion since the turn of the new century.

The activism of the ASEAN and other Asian countries in terms of explicit regional coalition undoubtedly marks a new era of regionalization. A recent example illustrates this tendency. The First East Asia Summit held in December 2005 connects the “ASEAN + 3”with three more new allies (India, Australia, and New Zealand) without inviting the US for participation. In other words, Asian governments now act more vigorously to strengthen regional economic cohesion beyond existing economic activities led by the dynamic Asian private sector.

In this context, incorporation of new visions is indispensable for examining the prospect of currency relations in Asia. Table 1 summarizes three striking changes in Asian trade patterns over the past two decades. Firstly, intra-regional trade among the core NIC8 economies has, both for exports and for imports, significantly increased at the expense of extra-regional trade with the US as well as the rest of the world. Secondly, the rising economic role for China is challenging the position of Japan as a traditional leader in the region. As depicted in Table 1, the rise in intra-regional trade involves mainly China and results thus in a relative decline in the weight for Japan. Thirdly, intra-A10 trade approximately averaged, by 2002, one half of total trade activities. Gradual economic integration in Asia on the one side results from the prompt response by the local market in the face of new regional geopolitical relations, and on the other side develops from the increasingly active cooperation among regional governments in trade and other matters. The following analysis hence considers economic regionalization jointly boosted by markets and institutions to continue to prevail in Asia and examines its implications for regional currency integration after the RMB revaluation.

Table 1. Changes in Trade Patterns in Asia, 1980 –2002 EXPORTS TO IMPORTS FROM NIC8 China Japan A10 US ROW NIC8 China Japan A10 US ROW NIC8 1980 18.9 1.5 19.2 39.6 23.1 37.3 15.3 4.7 23.8 43.8 17.1 39.1 1990 22.3 6.4 14.4 43.1 24.9 32.0 19.6 9.4 23.0 52.0 16.1 31.9 2002 29.0 13.8 9.5 52.2 18.9 28.8 27.2 16.2 15.3 58.7 13.5 27.8 A10 1980 32.0 22.6 45.4 31.8 17.4 50.8 1990 39.6 26.2 34.2 42.9 18.1 39.0 2002 46.9 23.7 29.4 56.3 13.5 30.2 Source: Adapted from Tables 2.1 and 2.2 by Direction-of-Trade Statistics of IMF, in McKinnon (2005). Note: NIC8 (8 Newly Industrializing Countries) = Taiwan + Korea + Singapore + Hong Kong + Thailand + Philippines + Indonesia + Malaysia. A10 (Asian 10) = NIC8 + China + Japan. ROW = Rest of the World.

3 Relevant studies that explicitly extend existing research on European monetary integration can be recapitulated according to the two approaches highlighted previously. Under the OCA framework, analysis of aggregate demand and supply shocks is conducted, inter alias, by Bayoumi, Eichengreen, and Mauro (2000), Chow and Kim (2003), Kwack (2004), and Zhang, Sato, and McAleer (2004). The authors apply the methodology developed by Bayoumi and Eichengreen (1993) for assessing the degree of shock symmetry among European economies to the Asian case, and unanimously confirm that it is too premature to consider the whole region as an OCA. Rather, they argue that it is at present more realistic to reflect on the option of establishing, in particular among smaller economies as the ASEAN countries, a transitory regime that aims to achieve a more complete integration process afterward.

The CBA paradigm complements the OCA theory with emphasis on microeconomic benefits for a currency union, where reduced or eliminated exchange rate fluctuations lower ex post cross-currency transaction costs for more efficient regional goods and financial markets. The process of currency integration generates, in turn, additional trade activities, and favors more synchronous business cycles that dynamically lessen shock asymmetry regarded as the major source of macroeconomic costs in monetary integration. Nevertheless, trade patterns, as suggested by McKinnon (1963), constitute per se an OCA criterion ex ante. The ambiguity concerning the role of trade cohesion in determining an OCA is embodied by Frankel and Rose (1998) who initiate the question on the endogeneity of trade openness. Opinions remain far from unanimous. Bayoumi and Eichengreen (1997) study European data and conclude a two-way symbiotic relationship between trade integration and currency integration. Frankel and Wei (1998) and Glick and Rose (2002) find that currency unions exert in principle a positive effect on trade. Rose (2004) adopts “meta-analysis”to examine whether a consensus has been reached among related empirical studies and finds that creation of a currency union approximately doubles trade. But Hughes-Hallett and Piscitelli (2002), with their theoretically derived model, suggest easy violation of the endogenous convergence hypothesis. As to the debate on the Asian case, Pomfret (2005a) is doubtful about the trade effect. Hefeker and Nabor (2005) instead anticipate that monetary cooperation will generate significant benefits for promoting regional trade and capital flows in Asia, and the benefits will exceed the costs linked with shock asymmetry and inflation differentials in the long run.

To sum up, the principal implication from current studies in literature seems to affirm that formation of an immediate OCA in Asia is quixotic. Searching for an appropriate preparatory regional monetary arrangement encouraging closer linkage among Asian currencies may be a more pragmatic option. Hurley and Santos (2001) find that all the ASEAN currencies except the Malaysian ringgit have become less susceptible to instability after the switch to the de facto dollar-peg. Based on a three-country model, Yoshino, Kaji, and Suzuki (2004) suggest, however, that a basket-peg be more advantageous for small open economies as the Asian ones. McKinnon (2005) advocates the desirability of establishing an East Asian dollar standard, which he calls the “conflicted virtue”, a term that contrasts with the “original sin” proposed by Eichengreen and Hausmann (1999) for studying the problem of currency mismatch. The role for the RMB is also considered. Hefeker and Nabor (2005), for instance, are in favor of

4 an Asian exchange rate mechanism (ERM) analogous to that having functioned in the former European Monetary System (EMS). The authors conjecture that this transition regime will become a system relatively more symmetric than its European counterpart, as long as the Chinese yuan assumes through an evolutionary process the role of a co-leader with the Japanese yen. Their speculation is to be deepened by this paper to derive adequate exchange rate policy implications for Asian monetary authorities.

Whichever the solution will be adopted to promote regional currency integration, it seems indispensable to take into account key specifics inherent to the Asian economy, such as the prevalence of a dynamic regional private sector highlighted in Table 1 above. The emphasis on the role played by market forces in the process of currency integration, as demonstrated by Vaubal (1990) and Dowd and Greenaway (1993), is always desirable even for an explicitly institutionalized process of integration such as the case of Europe. This view becomes even more apparent under ongoing globalization and regionalization. This paper takes the same position and conducts analysis to assess the prospect of an ERM in the form of an Asian currency band driven by the dualism between regional markets and regional institutions under a managed floating RMB after its revaluation. Section 2 presents our sample data adopted as well as the methodology suggested for the subsequent analysis. Section 3 discusses the main empirical results. Section 4 concludes with correspondent policy implications for the regional economy and proposes possible application of our methodology to further studies.

2. Data and Methodology

This paper intends to empirically analyze the feasibility of establishing at present a market-led transitional exchange rate regime in Asia, ahead of a more advanced monetary integration process promoted by regional institutions as in Europe in the long run. It consists in assessing whether current regional exchange rate dynamics allow implementation of an Asian currency band that initially functions without direct participation by local institutions. Our rationale lies in the belief that a complete Asian currency union is most likely to be accomplished through an evolutionary process mainly involving dynamic Asian market forces, as heterogeneity across regional economies is considered. The recent shift towards a more flexible RMB also makes the scenario much more attainable. This market-oriented currency system will have the merit of being relatively stable and symmetric compared to an explicit or implicit peg to the dollar, yen, or a basket of currencies, and will serve to accelerate formation of a de jure Asian monetary union in the decades to come.

Our analysis refines the original methodology proposed by Huang (2006), with examination of nominal exchange rate dynamics after the RMB revaluation to obtain evidence in support of a transitory laissez-faire regional currency band that self-fulfills the condition of narrower exchange rate fluctuations. The complete sample comprises ten Asian economies, identical to the A10 denoted in Table 1. Because the availability and consistency of the nominal bilateral exchange rate series against the US dollar for each country vary according to the data source, this paper resorts to the daily interbank exchange rate series compiled by Taiwan’s monetary

5 authority (www.cbc.gov.tw). Monthly exchange rate series (as the RF series) in International Financial Statistics of the International Monetary Fund are indeed often adopted in literature. But they will lead to a very limited number of observations because our analysis only covers a trading period of 14 months that range from August 1, 2005 to September 29, 2006. The constraint lies in the fact that a managed floating RMB started on July 22, 2005, one day after the revaluation announcement on July 21 by the PBC. Daily exchange rates are up to present the best data type for the current research in terms of availability and feasibility.

It is worth noting that Malaysia followed China’s switch to the limited flexible exchange rate at the same time. Moreover, the Hong Kong dollar, of which the exchange rate is officially linked through its currency board system to the US dollar at 7.80, is allowed to fluctuate between 7.75 and 7.85, prefixed exchange rates for strong-side and week-side Convertibility Undertaking respectively. It is therefore proper to consider in this paper all the A10 currencies and examine them with our methodology to be elucidated below.

From the A10 exchange rate series against the dollar, daily log volatility series are derived and their stationarity is examined by ADF and PP tests. The log volatility series based on the exchange rate of the euro against the dollar is derived in the same manner for the subsequent analysis. The resultant eleven volatility series indicated by their respective currency ISO code are graphically presented in Figure 1. The apparently growing exchange rate fluctuations for MYR, and CNY to a lesser extent, confirm progressive functioning of their new exchange rate regime. The scale within which the Chinese yuan swings in Figure 1 also conforms to the narrow fluctuation band of 0.3% effectively set and maintained by China’s central bank since the RMB revaluation. The exchange rate volatility for HKD under the currency board system is virtually negligible but deserves considered for the following empirical investigation.

Figure 1. Exchange Rate Volatility Series

EUR JPY TWD KRW .012 .02 .012 .02

.008 .008 .01 .01 .004 .004 .000 .00 .00 -.004 .000

-.008 -.01 -.01 -.004 -.012 -.02 -.02 -.008 -.016

-.020 -.03 -.012 -.03 05:08 05:10 05:12 06:02 06:04 06:05 06:07 06:09 05:08 05:10 05:12 06:02 06:04 06:05 06:07 06:09 05:08 05:10 05:12 06:02 06:04 06:05 06:07 06:09 05:08 05:10 05:12 06:02 06:04 06:05 06:07 06:09

SGD HKD CNY THB .012 .0016 .003 .03

.0012 .008 .002 .02 .0008 .004 .001 .01 .0004 .000 .0000 .000 .00 -.004 -.0004 -.001 -.01 -.008 -.0008 -.002 -.02 -.012 -.0012

-.016 -.0016 -.003 -.03 05:08 05:10 05:12 06:02 06:04 06:05 06:07 06:09 05:08 05:10 05:12 06:02 06:04 06:05 06:07 06:09 05:08 05:10 05:12 06:02 06:04 06:05 06:07 06:09 05:08 05:10 05:12 06:02 06:04 06:05 06:07 06:09

PHP IDR MYR .012 .04 .012 .03 .008 .02 .008 .004 .01 .004 .00 .000 -.01 .000 -.004 -.02

-.03 -.004 -.008 -.04 -.012 -.05 -.008 05:08 05:10 05:12 06:02 06:04 06:05 06:07 06:09 05:08 05:10 05:12 06:02 06:04 06:05 06:07 06:09 05:08 05:10 05:12 06:02 06:04 06:05 06:07 06:09

6 The null hypothesis of a unit root is rejected for all the eleven volatility series according to both ADF and PP tests conducted by EViews 5.0. Each of the A10 log volatility series is then regressed, respectively, on the log volatility series for the euro that serves as the common explanatory variable. The specification of each of the underlying ten regressions is conducted with verification of the degree of autocorrelation inherent in each volatility series, comparison between competing models in terms of F-statistic, AIC, and SIC, and finally, residual testing of their serial correlation by the Ljung-Box Q-statistics and ARCH effect with the LM test at the 5% level of significance. For most of the A10 currencies, inclusion of certain lags of the dependent variable (Asian currency volatility) and/or the major independent variable (euro volatility) as additional explanatory variables appears necessary because of their strong significance in the regression equation. As regards the ARCH effect that is ubiquitously found in residuals derived from each preliminary regression, ARCH/GARCH modeling is applied to obtain the finalized version for each of our ten regressions. Produced standardized residual series are double checked with ADF and PP tests and their stationarity is all reconfirmed. The Ljung-Box Q-statistics and LM test also suggest the white noise nature for these processes. Our major estimation results from the ten specified regression models for the A10 currencies are summarized in Table 2 below.

Table 2. Summary of Regression Model Specification Explanatory Variables (X) Variance Equation Regression Model Currency (Y) Constant EUR EUR(-1) Y(-1) Y(-2) Constant Re(-1)2 Re(-2)2 CV(-1) Log LLD Adj. R2 p-value 0.000 0.238 0.479 0.000 0.034 0.936 JPY 1143.09 0.220 0.000 0.334 0.000 0.000 0.230 0.103 0.000

0.000 0.097 0.183 0.000 0.183 0.670 TWD 1355.02 0.172 0.000 0.195 0.000 0.000 0.041 0.026 0.000

-0.000 0.121 0.322 -0.079 0.000 0.172 0.705 KRW 1246.17 0.203 0.000 0.194 0.000 0.000 0.154 0.009 0.000 0.000

-0.000 0.216 0.000 0.162 0.795 SGD 1397.66 0.207 0.000 0.124 0.000 0.014 0.000 0.000

-0.000 0.004 -0.207 0.000 0.199 0.643 HKD 2101.14 0.059 0.000 0.853 0.011 0.001 0.000 0.029 0.000

-0.000 0.028 -0.124 0.000 0.629 0.930 CNY 1839.77 0.066 0.000 0.000 0.000 0.001 0.000 0.000 0.000

-0.000 0.144 0.186 0.000 0.151 0.517 THB 1248.40 0.078 0.000 0.268 0.000 0.000 0.000 0.003 0.000

-0.000 0.086 0.000 0.086 0.801 PHP 1303.45 0.015 0.080 0.039 0.005 0.168 0.033 0.000

-0.000 0.170 0.000 0.782 0.275 IDR 1086.98 N/A N/A 0.000 0.000 0.000 0.000 0.009

-0.000 0.059 0.045 0.000 0.423 0.333 MYR 1478.58 0.052 0.001 0.187 0.000 0.002 0.000 0.001 0.003

7 Each of the A10 currencies acting as the dependent variable (Y) is again abbreviated in their ISO code in Table 2. In addition to the constant term, the explanatory variables (X) in each regression model may include the contemporaneous and/or lagged log volatility of the euro, and/or lags of the explained Asian currency. The estimated value of the coefficient for each of the independent variables is, inside each box in Table 2, presented above the p-value for the corresponding z-statistic. For example, the estimated coefficient for Lag 1 of the euro log volatility in the first regression where JPY is the dependent variable equals 0.479 and is highly significant because of the p-value very close to zero. The ARCH/GARCH estimation results are shown in the variance equation, where Re represents the residual series obtained from the mean equation and CV stands for the conditional variance. The GARCH (1, 1) model is, by our specification principles, selected for six out of the ten regressions, while the ARCH (2) model is adopted for the remaining four regressions. The reason lies in the problem where the sum of the coefficients for Re(-1)2 and CV exceeds one when the four ARCH models are estimated in the form of GARCH (1, 1). Table 2 also reports the value of the log likelihood (Log LLD) function, adjusted R2, as well as the p-value for the F-statistic.

Our rationale for conducting the regressions as recapitulated in Table 2 consists in capturing Asian exchange rate dynamics unrelated to European ones and reflected in residuals obtained from these regressions. Firstly, it is incontestable that today’s international monetary system is essentially centered on the US dollar, with which the Fed has adopted for long an essentially noninterventionist approach to the foreign exchange market. Secondly, the US, the EU, and Asia are considered to be the three major actors in the global economy. Such an economic triangle is incomplete, however. The dollar continues to serve as the intermediary for facilitating transactions between Europe and Asia, both in goods markets (trade) and in financial markets (investment by the private sector and reallocation of foreign exchange reserves by central banks). It is hence sensible to presume, according to the two stylized facts above, that the dollar exchange rate dynamics for Asian currencies are essentially affected by two determinants: either extra-regional factors that influence both them and the euro, or intra-regional shocks that merely concern Asian currencies. The former are explained by the dollar exchange rate volatility for the euro as the main independent variable in the previous regressions, while the latter are extracted through their standardized residuals obtained from the ARCH/GARCH estimation.

Table 2 evidently illustrates significant heterogeneity inherent to the exchange rate behavior across the A10 currencies and consistently echoes Figure 1 that clearly shows a constant lack of synchronization in volatility. However, this is an overall view only. Indeed, besides the difference in terms of ARCH effects, the impact that extra-regional shocks captured by the euro volatility (major determinant in our regression) exert on Asian exchange rate dynamics highly varies from the time (contemporaneous versus lagged) dimension. The autoregressive effect such as Y(-1) or Y(-2) also diverges. But the results estimated from our ten regressions can provide indirect information about a market-driven currency integration process in Asia. The key lies in the very standardized residual series, which reflect intra-regional economic activities that are progressively intensified at the expense of inter-regional ones.

8 In the context of deeper Asian regionalization as previously highlighted by Table 1, the resultant standardized residual series can be regarded as the information that reveals under the broad-defined market mechanism enhanced interaction between the dynamic private sector in the region and actively cooperative Asian governments. In particular, measures taken by Asian central banks in the foreign exchange market can also be considered to be their strategies in a sequential game vis-à-vis private traders and treated as one source of intra-Asian shocks on regional exchange rate movements. Hence, the dynamic behavior of standardized exchange rate volatility residuals for each of the A10 currencies estimated from previous regressions provides an indicator effectively gauging the degree of synchronization between intra-Asian shocks contemporaneously driven by regional market forces, prospective for a de facto Asian currency band after the RMB revaluation, and eventually, the plausibility for a market-led Asian currency integration process. Figure 2 depicts the ten exchange rate volatility residual series, again marked with the respective ISO code. It should be recalled that these series all date from August 1, 2005 to September 29, 2006 (294 observations) in order to be studied on an equal basis. Additional six observations between July 22 (the first day of a floating RMB) and July 29, 2005 have been taken for our regressions to conduct certain lag operations.

Figure 2. Specified Volatility Residual Series

RE_JPY RE_TWD RE_KRW RE_SGD 3 4 3 3 3 2 2 2 2 1 1 1 1 0 0 0 0 -1 -1 -1 -1 -2 -2 -2 -2 -3 -3 -3 -3 -4 -4 -4 -5 -5 -4 -5 05:08 05:10 05:12 06:02 06:04 06:05 06:07 06:09 05:08 05:10 05:12 06:02 06:04 06:05 06:07 06:09 05:08 05:10 05:12 06:02 06:04 06:05 06:07 06:09 05:08 05:10 05:12 06:02 06:04 06:05 06:07 06:09

RE_HKD RE_CNY RE_THB RE_PHP 4 5 8 4

4 3 2 6 3 2 0 2 4 1 1 -2 2 0 0 -1 -4 -1 0 -2 -2 -6 -2 -3 -3 -8 -4 -4 -4 05:08 05:10 05:12 06:02 06:04 06:05 06:07 06:09 05:08 05:10 05:12 06:02 06:04 06:05 06:07 06:09 05:08 05:10 05:12 06:02 06:04 06:05 06:07 06:09 05:08 05:10 05:12 06:02 06:04 06:05 06:07 06:09

RE_IDR RE_MYR 6 8

6 4

4 2 2 0 0

-2 -2

-4 -4 05:08 05:10 05:12 06:02 06:04 06:05 06:07 06:09 05:08 05:10 05:12 06:02 06:04 06:05 06:07 06:09

Representing the core as well as the originality of our research, the ten volatility residual series are to be used for the subsequent analysis that involves investigation into whether exchange rate fluctuations in terms of log volatility do appear stably narrower after the RMB revaluation. A positive answer to the question is analogous to implicit evidence in favor of an informal regional currency band operating through dynamic interaction among Asian market participants, i.e. private traders on one hand and local monetary authorities on the other. As long as the interaction characterized in intra-Asian shocks serves as a stabilizing factor that contributes to a steadier movement of Asian cross exchange rates, maintenance of the status quo will be the relevant option concerning the future monetary integration in Asia, vis-à-vis alternatives such as an explicit peg to the dollar, yen, or a basket of key currencies. In other

9 words, this natural currency band formed through an evolutionary process will be likely to become the prelude to a complete market-driven OCA à la Mundell (1961).

In order to decide which Asian countries are qualified for a quasi-membership in the potential OCA via a transitory currency band of market-led nature, it is indispensable to infer the statistical relationship from the ten residual series derived previously. Focus is to be placed on bilateral currency relations before summarizing multilateral ones on a regional scale. The relations are also to be differentiated temporarily. At the first level, a correlation matrix containing the A10 residual series offers a global picture to select promising currencies for the currency band according to their correlation coefficients. The currency pairs with higher positive correlation coefficients imply that the contemporaneous exchange rate behavior to intra-regional shocks is alike, and the nominal exchange rate of one currency to the other in each pair exhibits smaller daily fluctuations. This is the very target of a currency band, but it operates without any formal commitment by monetary authorities. At the second level, lagged bilateral linkage for each pair of the ten currencies is investigated through the Granger causality test and VAR modeling, which complement the previous analysis by addressing the dynamic stability of the underlying system. Principal results are presented as follows.

3. Empirical Results

As clarified above, our empirical investigation resides in, through our log volatility residual series, an evaluation of the bilateral currency relationship that underlies intra-Asian shocks. It also considers two temporal aspects to provide a complete picture of current connection between the A10 currencies under ongoing regionalization. Stronger currency cohesion favors the proposition for a market-led currency band that will catalyze deepened currency integration in the long run, while weaker or absent linkage implies that an institution-based approach may need to be complemented for the regional integration process.

In order to better capture the short-run dynamic behavior of the bilateral currency relationship, our sample that includes 294 observations from August 1, 2005 to September 29, 2006 is split evenly by months into two sub-samples. The first one (144 observations) ends on February 27, 2006, whereas the second one (150 observations) starts on March 1, 2006. The comparison between the two sub-periods serves to perceive more easily whether there exist significant changes in intra-regional dynamics of exchange rates over the whole sample period remarked by the beginning of a floating RMB. As long as the second sub-period exhibits substantial and positive evolution in currency cohesion vis-à-vis the first sub-period, the RMB revaluation can be interpreted to have paved the very first segment of roads leading to an Asian currency integration process driven by regional market forces over time.

Table 3 consolidates contemporaneous and lagged bilateral relationships between each pair of the A10 currencies examined, and compares their trend over the whole sample period studied, i.e. from August 2005 to September 2006. All the figures reported below the diagonal represent contemporaneous correlation coefficients for our volatility residual series. For each

10 currency pair, the three figures from top to bottom respectively correspond to the correlation coefficient for the whole sample period, for the first sub-period from August 2005 to February 2006, and lastly for the second sub-period from March 2006 to September 2006.

Table 3. Contemporaneous versus Lagged Currency Cohesion JPY TWD KRW SGD HKD CNY THB PHP IDR MYR 13/ /1 3/ 1/ JPY 1/ 23/1 2/ /3 /3 0.535927 /1 /2 TWD 0.466392 /1 3/ 0.600583 /1 0.387591 0.608984 /2 KRW 0.279626 0.567306 /12 0.497078 0.650871 12/ 0.564161 0.620484 0.493556 3/3 /1 /1 SGD 0.571383 0.517171 0.362919 3/ 3/13 3/1 0.557872 0.709388 0.616839 3/3 1/ /13 /1 0.181951 0.202789 0.160026 0.220482 HKD 0.203377 0.168588 *0.093875 *0.159984 0.160496 0.230272 0.211035 0.266214 0.295272 0.269110 0.216318 0.253133 *0.062217 /1 1/ CNY 0.313798 0.274809 0.206807 0.228495 -0.035497 2/ /1 3/1 /1 0.293451 0.272771 0.233673 0.274151 *0.124876 0.362229 0.465016 0.337645 0.458393 0.128180 0.231680 THB 0.391194 0.371027 0.213288 0.384770 0.166784 *0.133060 0.331198 0.563662 0.476387 0.534586 *0.086418 0.315526 /3 /2 0.205734 0.414710 0.331767 0.371514 *0.090816 0.167907 0.273603 PHP *0.118771 0.272043 0.213448 *0.134647 *0.051323 *0.061982 *0.125932 0.287746 0.545267 0.444805 0.580775 *0.111660 0.242885 0.429647 /23 0.157125 0.421007 0.340709 0.381001 *0.093829 0.120227 0.346311 0.391706 IDR *0.070420 0.349167 0.261746 0.227253 -0.060993 *0.071801 0.242730 0.253680 0.253504 0.500439 0.430366 0.542998 0.247679 0.164765 0.473100 0.543236 0.225500 0.418719 0.360704 0.415642 0.221579 0.222440 0.359976 0.365536 0.491287 MYR *0.033132 0.174520 *0.154123 *0.047520 *0.105299 *0.131715 0.286020 0.213677 0.331927 0.341119 0.563738 0.502479 0.614645 0.289157 0.255532 0.437403 0.467637 0.640692

A majority of the correlation coefficients shown in Table 3 have a positive sign and underlie, at the 5% level of significance, a fit regression of one of the two currencies in each pair on the other. In contrast, bilateral currency linkage appears insignificant for the two cases showing negative coefficients (HKD/CNY and HKD/IDR for the first sub-period) as well as those followed by an asterisk. Roughly 80% of the total correlation coefficients (37 out of 45 currency pairs) for the second sub-period are marked in bold type, which signals a rise in the degree of bilateral currency cohesion over the whole sample period. In other words, the Asian exchange rate determinants related to intra-Asian shocks, principally generated by regional market forces in a broader sense, are becoming less heterogeneous with the RMB revaluation

11 and its shift to the limited floating mechanism against a basket of currencies. This seems an encouraging piece of preliminary evidence that substantiates the conjecture by this paper about the feasibility of creating in Asia a market-led OCA emerging on the basis of a de facto currency band characterized by symmetric intra-regional shocks.

With a closer look at the 37 growing bilateral currency relationships, it is perceived that the degree of contemporaneous exchange rate synchronization in terms of intra-Asian shocks can be differentiated at three levels with China as the benchmark. By Table 3, the Chinese yuan actually exhibits increasing linkage with six Asian currencies under its latest switch to the floating regime. Then it is clear that a core group of seven currencies clusters at the upper level where the number of strong currency relationships established by each country exceeds six. They are actually, as denoted in Table 1, the NIC8 excluding Hong Kong, i.e. all the four Southeast Asian tigers (Thailand, Philippines, Indonesia, and Malaysia) together with all the four Asian dragons except Hong Kong (Taiwan, Korea, and Singapore). The remaining two “outsiders”at the lower level involve Japan and Hong Kong. Certainly, the linked exchange rate system applied to the Hong Kong dollar by its currency board since 1983 leads to its volatility almost negligible. The opinion on its seemingly less close linkage with other Asian currencies should therefore be mitigated. This is confirmed by Table 3. Most insignificantly positive coefficients marked with an asterisk as well as the two insignificantly negative ones actually concern the Hong Kong dollar. However, the positive correlation coefficients related to HKD and indicated in bold type for the second sub-periods all range between 0.2 and 0.3. This seems to imply that a kind of moderate regionalization in exchange rate dynamics for the Hong Kong dollar is being established at its early stage. As the Hong Kong economy evolves more closely towards China, its currency cohesion with the Chinese yuan, insignificant so far according to Table 3, will advance further under symmetry in intra-regional shocks. Hong Kong’s currency board may be required to fine-tune its exchange rate regime to accommodate gradual changes in regional market forces.

Lastly, Japan’s comparatively loose currency connection with other Asian economies gives the impression that China is currently replacing the Japanese regional leadership in both real and monetary arenas under global competition. But such interpretation necessitates cautious treatment. Certainly, four in the five cases where bilateral currency cohesion “degenerates” across the two sub-periods involve the yen, i.e. there is a fall in the correlation between Japan and the other economy. Yet, Japan’s linkage with all its Asian counterparts except Hong Kong, in particular, Taiwan, Korea, and Singapore, remains strong. As a market-oriented exchange rate regime for the Chinese yuan has functioned for merely more than one year, it seems too early to ascertain the chance for “currency substitution”between the yen and the yuan in terms of their position vis-à-vis other Asian currencies. Nevertheless, it must be recognized that, from our contemporaneous analysis of symmetry in intra-regional exchange rate shocks, there shows a promising path for the RMB that sets off on its adventure in the international foreign exchange market. Except its missing association with Hong Kong and relatively less obvious connection with Indonesia, China’s regional currency cohesion reflected in exchange rate shocks seems surprisingly high (albeit much lower than Japan’s), given a short time span

12 for the adoption of its managed float. The long-run trend for the Chinese yuan will crucially depend on the possibility and size of a tug-of-war effect that eventually determines the pattern of currency dominance for Asia. More specifically, an asymmetrically growing regional economy unilaterally directed by Japan or China, or, in an opposing scenario, a symmetric regionalization among the A10 countries, will result in two distinct types of market-driven currency integration in the long run. The former case may be in the form of an effective “yen bloc”or “yuan bloc”, while the latter may be analogous to a variant of “East Asian dollar standard”as advocated by McKinnon (2005).

The discussion above focuses on the contemporaneous aspect of currency cohesion in Asia. In a similar fashion, the lagged aspect is examined with our two-stage econometric approach. Firstly, Granger causality tests are employed with the number of lags set from one to three. The bilateral currency relationships that imply significant Granger causality at the 5% level are selected. Secondly, bivariate VAR modeling is conducted to derive more estimation details because the sign of the lagged effect of one currency on the other is beyond the extent of the Granger causality test. The main results are summarized by figures that appear above the diagonal in Table 3. For each pair, the three figures from top to bottom again correspond to our three specified sample periods. Blank boxes imply absence of lagged currency connection between the two currencies concerned. The figures inserted before the slash show that the lags of the currency in the first column exert an influence on the currency in the first row, whereas the figures indicated after the slash imply that the lags of the currency in the first row are found to affect the currency in the first column. The figures marked in bold type suggest that the contemporaneous currency variable is positively explained by the other currency variable in its lag term, while those denoted in normal type imply a negative lag effect. For instance, Table 3 states that intra-regional shocks related to JPY in Lag 2, over the first sub-period, negatively affects contemporaneous shocks associated to MYR. In contrast, it is Lag 1 shocks for MYR that positively explain contemporaneous shocks for JPY during the same sample period. The remaining figures are read in the same way. By Table 3, three main observations about lagged currency cohesion come into sight.

Firstly, overall lagged patterns of bilateral currency cohesion in terms of intra-Asian exchange rate shocks seem to be much less obvious and more heterogeneous than contemporaneous ones. One the one side, the number of the relationships where lagged connection is not present equals 22, almost one half of the 45 currency pairs studied. On the other side, the lagged impact is merely unilateral in a majority of the 23 cases where lagged linkage exists, and 10 cases against 13 involve a negative effect, which, according to our methodology, implies desynchronized intra-regional exchange rate volatility and therefore seems to disprove our conjecture about an implicit Asian currency band created by dynamic regional market forces. The five country pairs that consistently exhibit bilateral lagged cohesion include Singapore and Thailand both for the whole sample period and for the second sub-period, and Singapore and Indonesia, Singapore and Malaysia, Japan and Malaysia, and finally China and Indonesia for the mere first sub-period. But the first relation shows opposite signs from the viewpoint of each country, while the remaining four relations are associated from different

13 time lags (Lag 1 versus Lag 3). In contrast with an overall high degree of association between Asian exchange rate shocks from the contemporaneous dimension, our findings established from the lagged dimension hint that a considerable length of time will be required to accomplish a stable Asian monetary system with a pure evolutionary approach emphasizing the role of regional market forces. Further active participation and cooperation by Asian governments to create a favorable environment that serves to speed such a self-fulfilling integration process appear more reasonable.

Secondly, with China as a benchmark, we have identified a core group of seven countries that demonstrate strong contemporaneous currency cohesion. From the lagged view, however, the clustering phenomenon in currency linkage is mainly reduced, by Table 3, to Southeast Asian countries. Growing regional cooperation that has been deepened by the ASEAN in recent years certainly contributes to closer association between their member economies in terms of both economic and financial activities and hence shocks. The “ASEAN + 3”agenda expected to advance over time will leave room for steady amelioration in the current lack of dynamic synchronization among the currencies implicated. This echoes our preceding discussion on a market-led currency integration process with the institutional approach as a complement.

Thirdly, the total absence of lagged currency cohesion for the Hong Kong dollar with other nine Asian currencies confirms, on one hand, the success of the fixed exchange rate against the US dollar that has been adopted by its currency board over more than two decades, and on the other hand, the resilience of its short-run adjustment quickly accommodating daily shocks to maintain exchange rate stability. However, Table 1 demonstrates a long-term crowding out effect in Asia, by which intra-regional economic activities will continue to predominate at the expense of extra-regional ones. Under the CEPA (Closer Economic Partnership Arrangement) coming into effect on January 1, 2004 between Mainland China, Hong Kong, and Macao, a fine-tuning or more drastically a switch in the exchange rate regime may be ultimately an option to be considered by Hong Kong’s currency board.

Our empirical findings derived from both contemporaneous and lagged analysis seem to lead to a mitigated opinion on the possibility of developing a transitory but natural Asian currency band to promote a deeper and smoother long-run currency integration process. However, our research is in essence subject to limits in observations available for econometric investigation, because the RMB revaluation is a relatively recent event. The major contribution made by this paper lies in the first evidence it proposes for portraying a complete picture of current Asian exchange rate dynamics and recommending policy directions for governments which commit themselves to collaboration with regional partners in a continual way.

4. Conclusion

This paper attempts to propose an original analysis of the feasibility of establishing at present a transitional exchange rate regime in the form of a de facto Asian currency band driven by dynamic regional market forces after the RMB revaluation in July 2005. The Asian regional

14 economy has been characterized by increasingly intensified intra-regional economic activities at the expense of extra-regional ones since the Asian Crisis ended in 1998. The rise of the “ASEAN + 3”has also strengthened regional cohesion with an institutional approach in addition to the traditionally prevailing market dynamism. In the sphere of regional currency relations, the latest regime switch of the RMB makes the Asian currency band this paper questions more attainable. This system will have the merit of being relatively stable and symmetric compared to an explicit or implicit peg to the dollar, yen, or a basket of currencies under persistently significant heterogeneity across regional economies. It will also serve to promote a more mature market-led currency integration process and even possible formation of a de jure Asian currency union as the euro area in the coming decades.

Daily exchange rate dynamics for ten Asian economies that include Japan, China, the four dragons (Taiwan, Korea, Singapore, and Hong Kong), and the four Southeast Asian tigers (Thailand, Philippines, Indonesia, and Malaysia) are examined for the period between August 1, 2005 to September 29, 2006. The volatility, determined by exchange rate shocks, is decomposed into the extra-regional component and the intra-regional component. The latter captures continual interaction between broad-defined regional market forces, i.e. the dynamic Asian private sector on one hand and responsive Asian monetary authorities on the other. Both contemporaneous and lagged bilateral currency cohesion is studied with evaluation of the degree of symmetry in intra-regional exchange rate shocks inherent to volatility for each pair of the ten Asian currencies. The whole sample period is also split into two sub-periods to better perceive the short-run dynamic behavior of Asian currency relations. Progressively high synchronization of intra-Asian shocks implies gradual reduction in daily nominal exchange rate fluctuations, which corresponds to the very target of a currency band operating, however, without any formal commitment by Asian central banks. Major empirical findings based on our methodology can be summarized in three points.

Firstly, an overwhelming majority of the ten Asian currencies studied, despite a constant lack of synchronization in exchange rate volatility before our decomposition, exhibits a growing increase in their cohesion with each other after the RMB revaluation. With China as the benchmark, a core group of seven economies including all the four Southeast Asian tigers and all the four Asian dragons except Hong Kong forms a de facto currency band regarding the symmetry of their contemporaneous intra-regional exchange rate shocks. This emerging band functions analogously to an institution-founded band such as the “Snake”in the 1970s and the exchange rate mechanism (ERM) for the European Monetary System (EMS) in the 1980s. It may favor regional coordination in exchange rate policy by Asian governments, which, in turn, will accelerate the evolutionary process towards complete Asian monetary integration. This encouraging piece of preliminary evidence substantiates our conjecture about a market-driven Asian optimum currency area (OCA), but it seems much less significant as lagged currency cohesion is taken into account. Further cooperation by Asian government to create a favorable environment shortening the length of time required for a stably self-fulfilling Asian monetary system based on an evolutionary approach, in this regard, seems indispensable.

15 Secondly, Japan’s relatively loose currency linkage with the other Asian partners, based on the contemporaneous dimension as well as the lagged dimension, gives the impression that China is currently replacing its regional leadership in both real and monetary arenas under global competition. But Japan’s currency connection with all its Asian counterparts except Hong Kong remains strong over the whole sample period. Since a market-oriented exchange rate regime for the Chinese yuan has functioned for merely more than one year, it seems too early to ascertain the chance for “currency substitution”between the yen and the yuan. Yet, it must be recognized that a promising path for the Chinese currency having set off on its adventure in the international foreign exchange market is being paved. The long-run pattern for currency regionalization in Asia will depend on the tug-of-war between China and Japan as well as the advancement of the ASEAN.Two distinct types of OCAs are then possible: an asymmetric “yen bloc”or “yuan bloc”versus a relatively symmetric currency union analogous to a variant of “East Asian dollar standard”as advocated by McKinnon (2005).

Finally, despite the well-functioning of the linked exchange rate system adopted for the Hong Kong dollar by its currency board since 1983 and total absence of lagged currency cohesion of the currency with other nine Asian ones, our empirical analysis demonstrates that moderate synchronization of contemporaneous intra-Asian exchange rate shocks are being established at its early stage between the Hong Kong dollar and its regional counterparts. Under the CEPA (Closer Economic Partnership Arrangement) coming into effect on January 1, 2004 between Mainland China, Hong Kong, and Macao, the alternative of a fine-tuning or more drastically a switch in the exchange rate regime should not be excluded by the Hong Kong Monetary Authority (HKMA) in the future.

Our findings and related policy implications are nevertheless confronted with some problems underlying the methodology we apply. The major shortcoming involves the limited number of observations available for our investigation since the RMB revaluation is a relatively recent event. But our empirical results can be considered to be the first evidence that founds a new direction for further research, extendable with more data or analysis of real exchange rates to examine bilateral currency cohesion in Asia at the purchasing power parity.

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