November 2007 Regional Currency Unit (RCU) and Exchange Rate Policy Cooperation in East ∗

Yung Chul Park Graduate School of International Studies, Seoul National University

Comments on the paper "The Influence of the on Exchange Rate Policy in Other Economies" presented by Takatoshi Ito at the Conference on ’s Exchange Rate Policy, Peterson Institute for International Economics, Washington, DC, October 19, 2007.

1. ACU Arithmetic

As part of their efforts at promoting cooperation for financial and monetary integration, policymakers from ASEAN+3(China, , Korea) agreed to explore steps to create regional monetary units (RCU) as a sequel to the two other regional initiatives-

Chiang Mai Initiative and Asian Bond Market Initiative- in 2006. This agreement was preceded by a proposal for the creation of an Asian Currency Unit (ACU) by the Asian

Development Bank and a number of Japanese economists, among them Mori, Kinukawa,

Nukaya and Hashimoto (2002), Ogawa (2006), and Ogawa and Shimizu(2006).

Both the ADB and Ogawa (2006) define the ACU or Asian Monetary Unit (AMU) as a basket of the thirteen currencies of the ASEAN+3 member countries weighted by their relative importance in terms of GDP, trade volume, population, and the degree of capital account liberalization1

∗ This note draws on Park(2007) 1 In Ogawa (2006)’s construction, the 13 ASEAN+3 currencies are weighted by their relative GDPs valued in terms of purchasing power parity (PPP) and total trade volumes (the sum of exports and imports). In order to reflect the most recent trade relationships and economic trends, Ogawa uses the averages of these variables for the most recent three years for which data are available. The value of the AMU is then quoted in terms of a weighted average of the two major international currencies-the US dollar and the . The weights of the two currencies are the shares of the US and the Euro area in total trade of the ASEAN+3 countries and set at 65% and 35%, respectively. The benchmark period of the AMU exchange rate of the dollar-euro , for which the AMU exchange rate is set at unity, is chosen for a period (2000-2001) when the total trade balance of the thirteen countries with the rest of the world and the total trade balance of ASEAN+2(excluding Japan) with Japan are relatively close to zero.

1 If the ACU is an Asian version of the ECU, it is an accounting unit. However, it is suggested that

(i) the unit could assist ASEAN+3 policy authorities in their conduct of

exchange rate policy and serve as a surveillance indicator for regional

coordination of exchange rate policy in East Asia (Kuroda 2006A and B);

(ii) the ACU could be adopted as an internal common currency basket to which the

ASEAN +3 members except Japan could link their currencies (Ogawa and

Shimizu 2006)1

(iii) it could facilitate the creation of a regional market for basket bonds

denominated in the ACU (Kuroda 2006C); and

(iv) it could be an intermediate step toward making the yen as the anchor currency

for the member states of ASEAN + 3(Ogawa and Shimizu 2006).

These additional functions make the ACU more than a simple numeraire, and have

understandably generated a certain amount of confusion on its role. .

2. The ACU as a Regional Accounting Unit

How would the creation of the ACU contribute to exchange rate policy coordination and monetary integration in East Asia? The experience of the EU with the

European Currency Unit (ECU) may provide both lessons as well as answers.

The ECU was a political gesture towards monetary union. The unit of account was symbolic, just as the SDR is a symbol for a future world currency. It was used as an internal accounting unit for all official transactions and accounts of the EU, although the member central banks did not use it in their transactions. As seen from the management of the EMS, the ECU played no particular role in stabilizing the intra-member exchange rates of the

2 constituent currencies, although it was one of the four elements of the EMS in addition to the grid, mutual support, and a commitment to joint decision of realignments (Baldwin and

Wyplosz 2004 chapter 12).

Initially, the ECU was expected to impose a symmetric burden on both weak and strong currencies to intervene. In reality, market interventions were made by the weak currencies well before the limits of the system were reached so that the burden was largely asymmetric. The only real lasting effect of the ECU is that when the euro became the

European Monetary Union’s new unit of account, its conversion rate was €1 = ECU 1, an obscure stipulation of the Maastricht Treaty2

3. The ACU as the Nuneraire for Asian basket bonds

In the past a few attempts at issuing bonds denominated in a basket of currencies in Europe have not been successful. It is true that debt instruments denominated in the ECU were issued in Europe, but Dammers and McCauley (2006) show that these instruments owed their limited success in the 1980s and 1990s to the restrictions on internationalization of the Deutsche Mark and speculative investments. Certainly the EU did not encourage or render any institutional support for developing a market for bonds denominated in the ECU.

Notwithstanding the European experience, the advocates of Asian basket bonds, however denominated, should be able to spell out justification for the involvement of the public sector in creating a market for such an instrument. It is not clear what the advantages of holding basket bonds over bond portfolios consisting of bonds in different currencies.

Market participants may prefer bond portfolios diversified in terms of currency to basket bonds as they give greater flexibility in managing return and risk profiles of their investments. If there is demand for basket bonds, it is reasonable to argue that private

2 The author owes this point to Charles Wyplosz

3 institutions would not leave the market opportunity unexploited. That is, investment banks and securities firms would be prepared to create and market bonds denominated in many different baskets of different currencies they choose as long as there is demand for them.

The absence of a regional accounting unit does not stand in the way of developing markets for basket bonds.

There may be failures of the market, regulatory controls, or the insufficiency of market infrastructure that have prevented development of markets for basket bonds in Asia.

If that is the case, the advocates of Asian basket bonds should identify what these impediments are and how they could be mitigated before proposing the public sector involvement in fostering basket bond markets in Asia.

4. The ACU as a Surveillance Indicator for Exchange rate Policy Coordination

The role of the ECU in monetary unification of the EU makes it clear that the creation of the AMU in and by itself will not strengthen exchange policy coordination in

East Asia. What is needed for the coordination in East Asia is a collective regional exchange rate regime such as the exchange rate mechanism (ERM) adopted by the EC as part of the

EMS or a common basket pegging. This can be seen from recent movements of some of the key East Asian currencies vis-à-vis the US dollar, the Euro, and the AMU.

Figure 1 depicts changes in the AMU exchange rate in terms of the US dollar and euro. It has appreciated slightly against the dollar while depreciating a great deal vis-à-vis the euro since the mid 2002 largely because of the weakening of the yen and inflexibility of the dollar-renminbi exchange rate. Since ASEAN+3 as a group has been running sizable amounts of surplus in their trade with both the US, and EU, which have become the major sources of the global imbalance, it may be in the interest of ASEAN+3 to let the AMU

4 appreciate against the dollar and euro. What could then these countries do collectively to bring about such an adjustment? The yen is a component currency of the AMU. But since it is a free floating currency, Japanese authorities are not likely to intervene in the dollar-yen

Figure 1 AMU in terms of the US$-euro (benchmark year=2000/2001)

1.2 1.15 1.1 1.05 1 0.95 0.9 0.85 0.8 0.75 0.7 Jul-00 Jul-01 Jul-02 Jul-03 Jul-04 Jul-05 Jul-06 Jul-07 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07

U.S.$-euro/AMU U.S.$/AMU euro/AMU

Source : Ogawa (2006) market. This means that other members of ASEAN +3 will have to adjust their exchange rates, although the yen is largely responsible for the weakening of the AMU vis-à-vis the dollar and the euro.

Except for Japan and the other member countries of ASEAN+3 do not have a domestic currency-yen market and their currencies are largely non-convertible. As a result the only way they can engineer an appreciation of the ACU vis-à-vis the dollar or the euro is to intervene in their local currency- dollar markets to induce an appreciation of their currencies against the dollar. If they do, then their currencies will strengthen further against

5 the yen while Japan is running a surplus with them.

As shown in Figure 2 the Korean won appreciated against the dollar by 11.6 percent and the renminbi by 9.3 percent while depreciated by 12 percent between the early 2005 and September 2007. . These changes in the dollar exchange rates of

Figure 2A. Figure 2 Nominal Exchange Rates of the Yen, Renminbi, and Won against US$ (Yen, Renminbi/$) (Won/$) 160 1,800 140 1,600 120 1,400 1,200 100 1,000 80 800 60 600 40 400 20 200 0 0

5 1 1 7 5 1 9 5 3 1 1 0 0 /0 6/0 /1 8/0 0/03 1/1 /0 4/0 6/0 /1 94 9 996 9 999/ 0 0 002 0 005/ 0 006 19 1995/0319 1 1997/0919 1 20 2001/0120 2 2003/0720 2 20 2 2007/09 Yen/$ Renminbi/$ Won/$

Source : Bank of Korea the three currencies have led to widely divergent movements of their ACU exchange rates as shown in Figure 3.

Figure 3 tracks the movements of the yen, renminbi, and the Korean won against the ACU estimated by Ogawa (2006). Compared to the base period, by the end of

September 2007 the Korean won appreciated by almost 20.7 percent vis-à-vis the ACU, while the yen depreciated by more than 6 percent and the renminbi returned to parity after a

6 period of depreciation. The major cause of these large and varying deviations was the depreciation of the yen vis-à-vis both the renminbi and the Korean won.

Figure 3 AMU exchange rates (renminbi, yen, and won) Real AMU Deviation Indicators (benchmark year=2000/2001,basket weight=2000-2004,monthly) (%) 40

30

20

10

0

-10 Jul-00 Jul-01 Jul-02 Jul-03 Jul-04 Jul-05 Jul-06 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 -20

-30 China Japan Korea

Source : Research Institute of Economy, Trade and Industry

Under these circumstances, if China and Korea were to stabilize their AMU exchange rates for the sake of coordinating their exchange rate polices, they would have to intervene jointly in their local currency-dollar markets: China will have to strengthen its currency against the dollar whereas Korea will need to bring about deprecation of the won vis-à-vis the dollar. If China does not let its dollar-renminbi exchange rate to appreciate,

Korea will have to assume a greater burden of adjustment even though it is running surplus in its trade with the US. Therefore, countries like Korea and will be thrown into an

7 impossible situation where they will have to weaken their currencies against the dollar to keep their currencies in line with the AMU, but to let their dollar exchange rates appreciate for an appreciation of the AMU against the dollar.

In so far as the yen remains a free floating currency and China is reluctant to revalue its currency as it has been, the AMU will be of little use as a surveillance indicator for regional exchange policy coordination. Nor will it provide any useful guidelines to individual members of ASEAN+3 in formulating their exchange rate policies. In a highly unlikely case where all three countries-China, Japan, and Korea- intervene to stabilize the

AMU exchange rates in term of the US dollar or euro, they would have to agree beforehand to a set of rules governing intra-group exchange rate adjustments: what they need is a collective regional exchange regime.

5. The ACU as a Common Basket of Internal Currencies for ASEAN+3

The regime shift in both China and to a basket arrangement in 2004 has underscored the need for closer coordination of exchange rate policy in East Asia. As Kawai

(2002) notes, and Thailand have shifted to a de facto currency basket arrangement similar to Singapore’s managed floating since the 1997-98 crisis. The movements of both the nominal and real effective exchange rates of and the

Philippines also indicate that their currencies are linked to a basket of the currencies of their major trading partners. Practically all seven emerging economies in East Asia - the original

ASEAN 5, China, and South Korea – are now explicitly or implicitly on a variety of basket arrangements.

Now that they have all adopted a similar basket arrangement, these economies will probably monitor changes in the nominal and real effective exchange rates of other

8 members to make sure there is no erosion in their relative export competitiveness, If any one of the seven ASEAN+3 members (China, Korea, and ASEAN 5) moves to weaken its currency vis-à-vis the dollar, such an intervention will set off a competitive devaluation throughout the region. Therefore, the seven countries have a common interest in adopting a collective exchange rate regime to prevent such competitive skirmishes3.

According to Williamson (2005), the seven emerging economies will benefit more from adopting a common basket of external currencies including the dollar, the euro and the yen than different baskets 4 Common basket pegging would not only reduce room for competitive devaluation for export promotion but also help adjust their dollar exchange rates simultaneously and improve the chance for cooperation on monetary integration in the long run.

In a recent paper Ogawa and Shimizu (2006) argue that the AMU they propose can serve as a common basket for the ASEAN+3 countries except for Japan. According to their proposal, the ACU will not entirely be an internal basket to ASEAN+3 because the yen will remain outside of the pegging arrangement as a free floating currency. Yet, the yen will play a dominant role, and more so if the weights of the constituent currencies are calculate in terms of the nominal GDP instead of the GDP in PPP. With the yen in the basket, a great deal of variations of the ACU vis-à-vis the dollar and euro would result from changes in the dollar-yen or the euro-yen exchange rates.

Most of the changes in the ACU exchange rates of the twelve countries of

ASEAN+3 will also be caused by changes in their bilateral exchange rates against the yen

3 With a new regime in place and its growing economic influence in the region as leverage, China may be in a position to initiate the discussion on the coordination of exchange rate policies among the seven countries. 4 Several Japanese economists have also advocated similar arrangements for East Asia’s emerging economies. See Kawai and Takagi (2000), Kawai (2002), and Ito and Ogawa (2002). These economists now argue that the ACU is a more appropriate common basket for ASEAN+3.

9 as they have been in recent years. The twelve members may then ask why the yen, which will increase variability of the ACU against the dollar and euro as well as that of their ACU exchange rates, should be included in a common basket to be chosen for exchange rate policy cooperation.

In theory the common pegging to the AMU may serve as a mechanism for internal exchange rate adjustments among the ASEAN+3 members if Japan forgoes its free floating status. But even in this case, it is highly uncertain whether the member countries would be able to agree to a complicated and elaborate mechanism of intra-group exchange rate adjustments the common pegging may entail.

Suppose Japan can not or does not want to give up its free floating status. Does the preceding analysis mean that the ACU without the yen would be a more viable of basket for

ASEAN+2? The answer is no. The ACU that is composed of the currencies of the

ASEAN+2 will be dominated by the renminbi as China is by far the largest economy in this grouping. ASEAN 5 and Korea, not to mention of the latecomers of ASEAN, will be marginalized in such an ACU. This marginalization means that the creation of the ACU consisting of the ASEAN+2 currencies is in reality equivalent to making the renminbi a regional anchor currency and to forming a de facto renminbi bloc. Whatever the economic rationale behind such a currency bloc, the ASEAN plus Korea will find it politically unacceptable to join the renminbi bloc.

The preceding analysis raises serious doubt as to the viability of the ACU either as a common internal basket for or as an indicator monitoring changes in the exchange rate policies of the ASEAN+3 countries. Why is then Japan at the forefront of advocating the creation of the ACU, knowing it cannot be part of the arrangement? Ogawa and Shimizu

(2006) offer an answer: in their view, the ACU can be an intermediate regime leading to the

10 creation of a yen bloc in East Asia. In their proposal, ASEAN+2 tie their currencies to the

AMU first and after a period of experimentation with the common pegging, they choose the yen as the anchor currency. Ogawa and Shimizu do not explain why the yen should be the key regional currency, although it has become less attractive than the British pound as a reserve currency in recent years.

In conclusion, the creation of a regional currency unit as proposed by ASEAN+3 will mostly be a symbolic gesture that the ASEAN+3 member states are committed to monetary cooperation and integration in East Asia as a long run objective. In this regard, the creation will be a welcome development. However, unless it is followed by establishment of a mechanism for exchange rate policy coordination and mutual support among the members as Europe did before, the ACU will end up as a political gesture.

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