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Costs, Benefits, and Constraints of the Basket Currency Regime

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Costs, Benefits, and Constraints of the Basket Currency Regime Costs, Benefits, and Constraints of the Basket Currency Regime Eiji Ogawaa, Takatoshi Itob, and Yuri Nagataki Sasakic a Professor, Department of Commerce and Management, Hitotsubashi University, e-mail: [email protected]. b Professor, Institute of Economic Research, Hitotsubashi University and Research Center for Advanced Science and Technology, University of Tokyo. c Associate Professor, Department of Economics, Meijigakuin University. A lesson from our experience of the Asian currency crisis in 1997 is that East Asian countries should not have adopted the de facto dollar peg system before the Asian currency crisis. East Asian countries should have taken into account their partners in international trade and financial transactions in choosing their own exchange rate regimes. Some have proposed that it is desirable for East Asian countries to adopt a basket currency regime, in which the monetary authorities should target their home currency to a basket currency, consisting of the US dollar, the Japanese yen, and the euro. This paper gives an overview of the costs and benefits of the basket currency regime. The benefits of this regime include stabilizing trade balances, capital flows, and gross domestic product (GDP) for East Asian countries that trade with diverse countries, which include Japan, European countries, and intraregion countries as well as the United States (US). The benefits come mainly from the stability of the real effective exchange rate. However, some economists point out that intermediate exchange rate regimes are not a crisis-proof system from the viewpoint of “two corner solutions.” Other costs of intermediate exchange rate systems such as basket currency include complexity, nontransparency, and nonverifiability in operating such an exchange rate system. However, we observe that the benefits outweigh the costs. 1 Next, this paper considers factors that prevent countries from adopting a basket currency. We focus on both the inertia of the US dollar as a key currency and coordination failure in choosing an exchange rate regime. These factors make it difficult for the monetary authorities to adopt a desirable basket currency regime rather than the de facto dollar peg system. Then, this paper will extend these results by examining the feasibility and benefits of the adoption of a common basket currency by a group of East Asian countries that heavily trade with each other and invest in each other in terms of foreign direct investment (FDI). We point out that it is necessary to create a common basket so as to solve coordination failure in choosing exchange rate policies among East Asian countries. Lastly, a Generalized Purchasing Power Parity (PPP) model is used to investigate the feasibility of a common currency basket in East Asia from the viewpoint of the optimal currency area theory. Some subset of East Asian countries will be shown to satisfy conditions for a common currency area. In particular, five Association of Southeast Asian Countries (ASEAN) countries and the Republic of Korea (Korea) will be able to form a common currency area with a common currency basket rather than having 2 the US dollar as an anchor currency. This paper consists of five main sections. The first explains the benefits of a currency basket regime in terms of the stabilizing effects on trade, capital flows, and GDP. The second section considers the costs of adopting the currency basket regime for East Asian countries. The currency basket regime may not be crisis-proof. It may suffer from complexity, nontransparency, and nonverifiability. The third section explains not only the political but also the economic constraints in adopting the currency basket regime. The inertia of the US dollar as a key currency and coordination failure on the choice of an exchange rate regime will be identified. The compatibility of the basket currency regime with domestic objectives such as inflation targeting will be pointed out. In the fourth section, we propose a common basket to solve the coordination failure in choosing an optimal exchange rate regime. We also investigate whether East Asia will be an optimal currency area with a currency basket being an anchor currency. In the conclusion, the results are summarized and assessments and recommendation will be made. Benefits of a Basket Currency Regime The controversy over the exchange rate regime, especially the fixed versus flexible exchange rates, has been discussed again and again. The focus in the controversy has 3 recently shifted from “fixed versus flexible” to “two-corner solutions versus intermediate regimes.” In this section, a case will be made for intermediate regimes, especially a basket currency regime. By examining the merits and shortcomings of a basket currency regime, we make a judgment on what type of exchange rate regime East Asian countries had really adopted. Calvo and Reinhart (2000a) analyzed the exchange rates, foreign reserves, monetary base, and interest rates in Asian countries. They concluded that, although some of the Asian counties announced that they were adopting a floating exchange rate regime, their currencies had strong linkages with the US dollar and the exchange rates were not floating so freely. McKinnon (2000) analyzed how daily changes in the exchange rates of nine East Asian currencies have a strong relationship with the US dollar. He showed that the movements of the East Asian currencies had a high correlation with the movements of the dollar prior to 1997. These two papers suggest that most Asian countries were not floaters and some of them adopted a de facto dollar peg regime, which is classified as an intermediate exchange rate regime. Williamson (2000) explains this “revealed preference” of Asian countries as follows: “they see gains in an intermediate regime that they believe outweigh the costs in 4 terms of greater vulnerability to crises and having less simple policy rules to follow.” Williamson (2000) believes that the primary benefit of an intermediate exchange rate regime is that it allows policy to be directed to limiting misalignments of exchange rates. Overvaluation of home currencies would weaken the competitiveness of tradable goods industries while undervaluation would cause overheating and imported inflation. Thus, the benefit of a basket currency system would have been significant for Asian countries that have been following export-oriented strategies for their economic growth. One corner of the two-corner solutions is the floating exchange rate regime. However, clean float is not quite possible or desirable. Not many countries practice clean float (no intervention at all). If one corner means a "lightly managed" float, then it would become difficult to draw a line between "lightly managed" and "managed" floating regimes. Currency board (and dollarization) is the other corner that will automatically increase and decrease the monetary supply according to the change in foreign reserves. However, the fixed exchange rate will put the currency board under the same criticism as that leveled against a fixed exchange rate regime of soft peg, namely, if a country pegs to a country with which it does not share common shocks, then competitiveness will vary as the key currency appreciates and depreciates. That would then translate in the 5 fluctuations in foreign reserves, the interest rate, price levels, and the capital flows. Domestic sectors have to be really flexible to absorb such volatility. We review in three subsections the analyses that explain the benefits of a basket currency regime as one of the intermediate regimes. The first explains that a basket currency regime stabilizes the trade competitiveness of countries. The second reviews the papers that examined capital inflows, and the third reviews the papers that analyzed the stabilizing effects of a basket currency regime on GDP. Enhanced Trade Competitiveness The most apparent benefit of a basket currency regime is its role in keeping trade competitiveness relatively stable. If the export destination is only one country and there is no competitor other than the destination country, it is enough to peg the currency to that of the export destination country as to maintain trade competitiveness. But actually, a country tends to have many export destinations and many competitors all over the world. In addition, the composition of export destination countries has changed over time. Thus it is not easy to decide the weights of the basket. Taking into account this complexity, some papers suggest the ways to get optimal weights for the currency basket. Ito et al. (1998) calculated the optimal weights that 6 stabilize variances of trade balance. In one paper (Ito et al. 1998), we built a theoretical model in which the Asian firm maximizes its profits, competing with the Japanese and the US firms in their markets. We used a duopoly model to determine export prices and volumes in response to fluctuations of the exchange rate vis-à-vis the Japanese yen and the US dollar. We obtained optimal basket weights that would minimize the fluctuation of the growth rate of the trade balance. Ito et al. (1998) stressed the fact that Asian countries’ adoption of de facto dollar peg regimes, although their trade weight with Japan was substantial, was one of the most significant factors that induced the crisis. As the Japanese yen depreciated against the US dollar from April 1995 to the summer of 1997, the real effective exchange rates of Asian countries appreciated, causing the countries to lose export competitiveness. Thus exports from those countries declined. For example, the gross export values of Thailand did not grow in 1996, compared with 20% growth a year earlier. Figure 1 shows the case of Thailand. [[for Typesetter: xx pls position figure after this reference]] The real exchange rate of the Thai baht vis-à-vis the US dollar had been fixed from 1990 to 1997. Thus, the real exchange rate of the Thai baht vis-à-vis the Japanese yen fluctuated as the Japanese yen/US dollar rate fluctuated.
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