Reference. 3

NOTES ON THE APPROPRIATE EXCHANGE RATE REGIME
FOR THE ASIAN COUNTRIES

Mario B. Lamberte
Acting President
Philippine Institute for Development Studies

    One of the prominent issues that cropped up in the aftermath of the Asian currency crisis is the appropriate exchange rate regime that must be adopted by countries that will minimize the occurrence or reduce the cost of currency crisis in the future. This brief Notes explores the exchange rate regime for Asian countries and some areas for Asian regional cooperation.

Appropriate Exchange Rate Regime

    In searching for the appropriate exchange rate regime for the Asian countries, it is useful to start with the classic trilemma or impossible trinity; that is, a country can achieve only two of the following goals: (1) exchange rate stability; (2) full financial integration; and (3) monetary independence. Any pair of the three goals suggests a particular exchange rate regime. A country that tries to achieve both exchange rate stability and monetary independence will have to impose strict and broad-ranging capital controls. A country that aims for both full financial integration with the rest of the world and monetary independence is to adopt a freely floating exchange rate regime. A country that aims for both exchange rate stability and full financial integration must resort to fixing the exchange rate through various mechanisms, such as firm-peg, currency board or monetary union.

    A country that tries to simultaneously achieve the three goals will suffer from policy inconsistency, which could lead to a currency crisis. This was what confronted Asian economies in the eve of the Asian financial crisis. While most of the Asian economies were marching at various speeds towards full financial integration, in the process abandoning some of their controls on capital, they also strongly felt the need for preserving monetary independence. However, they also wanted to achieve exchange rate stability. Although Asian countries formally adopted a variety of exchange rate regimes, such as pure float, bands, baskets, etc., nonetheless most of them virtually adopted a dollar peg system.

    Indeed, the crisis has forcefully reminded Asian countries of the impossibility of simultaneously achieving the three goals mentioned above. Interestinly, the options adopted by Asian countries in the wake of the crisis have varied. Malaysia has opted to firmly fix the exchange rate and introduced capital controls to maintain its monetary independence. The crisis has firmed up China's resolve to maintain its capital controls and fixed exchange rate system. Hong Kong hangs on to its currency board system, foregoing monetary policy autonomy. But it has enabled it to maintain a fixed exchange rate system and fully integrated financial system. The rest of the Asian countries abandoned the dollar peg system in favor of flexible exchange rate system and maintaining monetary independence. Thus, in terms of exchange rate regime, Asian countries today seem to have been polarized; that is, they either go for a flexible exchange rate regime or a fixed exchange rate regime. Intermediate regimes seem to have disappeared.

    The forces of globalization are as strong as ever. Asian countries have recognized these and will eventually continue their march towards full financial integration. However, the recent crisis has taught them the lesson that capital account liberalization must be approached with great caution. Thus, most of them are now instituting market reforms and improving the effectiveness of their regulatory and supervision system for financial intermediaries before moving on to full capital account convertibility. They will now be conscious of their capability to manage surges of capital inflows, particularly volatile, short-term capital.

    What this suggests is that for Asian countries the option to achieve both monetary independence and exchange rate stability with broad-ranging capital controls will eventually disappear as they continue to move towards full financial integration. This, therefore, leaves them with two options; that is, either to achieve both exchange rate stability and financial integration sacrificing monetary independence or aim for monetary independence and financial integration.

    Let us consider the first option first. One exchange rate regime that could be adopted under this option is a truly fixed exchange rate regime, which is a non-market-driven exchange rate regime, whereby the central bank is committed to buy and sell foreign exchange to maintain a given exchange rate. In view of the sad experience of many Asian countries with this regime in the most recent past, it can, therefore, be immediately dismissed.

    Another is a market-driven fixed-exchange rate regime in the form of a currency board system. Hong Kong and thirteen other economies (8 of which are tiny economies) have a currency board system that seems to have worked well. However, the recent experience of Hong Kong suggests that only strong economies with sufficiently large reserves and strong financial system and have been following strict fiscal and monetary discipline can withstand an interest rate pain resulting from a speculative attack on their currencies. It seems that in Asia excluding Japan, only Taiwan and Singapore can qualify for that system. Even then, these countries will have to think twice in view of the interest rate volatility that might result from large flow of funds. They also have to carefully assess the exit cost if circumstances force them to abandon the peg. What this suggests is that it will be extremely difficult for other countries in the region to emulate Hong Kong.

    Still another alternative for solving the trilemma is for Asian economies to adopt a single currency and give up exchange rate flexibility entirely. This is what the members of the euro zone have recently done. Indeed, there have already been suggestions from some Asian leaders to seriously consider similar arrangement for Asia. In this case, Asian countries may use a major currency in the region, such as the Japanese Yen, or a third currency similar to the Euro. Although there are encouraging signs that this arrangement can be made possible in Asia, such as increasing trade and investment flows among Asian countries, however, a number of studies have shown that Asian countries are still far from satisfying the criteria for establishing an optimum currency area. Presently, levels of economic development and political systems are much more diverse among Asian countries than those among the euro zone. Economic integration even among ASEAN member countries is still very shallow. Thus, it is not clear yet at present whether Asian countries will realize net benefits from joining the single currency area and foregoing monetary policy independence. Also, there is yet no regional political consensus to move in that direction. Nonetheless, Asian countries should not immediately dismiss the feasibility of establishing such arrangement. After all, it took European countries almost 40 years of economic cooperation and integration before arriving at the single currency system. Although the single currency area for Asia is not a feasible option in the short-run, this issue should be considered as a major item in the long-term agenda for regional cooperation in Asia. If Asian countries can forge an agreement to enter into a currency union in the next 20 years, then the world will eventually gravitate around three major currencies, namely the US dollar, the Euro and the Asian currency.

    As mentioned above, most of the crisis-affected Asian countries have opted to adopt a purely flexible exchange rate regime in the wake of the regional currency crisis. This was a reaction to the dollar peg system they adopted before the regional crisis that contributed to the loss of confidence in their currencies. In theory, a floating exchange rate system can avoid an overvaluation or undervaluation of the currency. It can also discourage speculators because there is no target that needs to be defended by the government. In a nutshell, therefore, floating exchange rate regime promotes market discipline, thereby reducing the probability of the occurrence of a currency crisis. In reality, however, this system exposes small open economies like Asian countries with the exception of Japan to exchange rate volatility. As Figure 1 shows, exchange rates of selected Asian countries have been volatile in the recent period, especially right after they were floated. Much of this volatility came from the difficulty they have been facing in containing speculative capital movements and attack on currency. Large economies with large and healthy financial sector and flexible real sector can deal adequately with exchange rate volatility. For small open economies, however, exchange rate volatility can be disruptive to the growth and development of their economies. It is to be noted that Asian economies grew rapidly during periods of exchange rate stability.

    The problem arising from exchange rate volatility can easily be magnified if banks and non-bank enterprises are less sophisticated in dealing with such volatility. In the Philippines, for instance, only a few of the enterprises that had foreign exchange exposure made extra effort in availing themselves of hedging instruments before and after the Asian financial crisis (see Figure 2). Other countries in the region may not be far from this situation.

    One way of avoiding excessive exchange rate volatility and undervaluation and overvaluation of the currency, while at the same time maintaining monetary independence and promoting financial market integration, is for Asian countries to link their currencies to a basket of foreign currencies. The weights of the foreign currencies in this basket for each country may vary depending on the extent of their trade relations with trading partners. Three major currencies that can compose the basket - the Japanese Yen, the US dollar and the Euro. It is, of course, expected that the US, the European Union and Japan will continue to float their currencies. If the deepening of economic integration in Asia is to be promoted, then the weight of the Yen in the basket for each country may have to be adjusted to a reasonable level. This, of course, begs the issue regarding the need for the internalization of the Yen in the immediate future.

    One issue that immediately emerges once a trade-weighted basket currency peg is chosen is how wide the band should be. This, of course, depends on each country's structural economic characteristics, but the bottom-line is that it should be sufficiently wide to allow for greater exchange rate flexibility. A corollary issue is whether a country should publish the weights for each country and any updates thereof. In this regard, it may do well for emerging countries to be more transparent to the public and to global investors.

    To recapitulate, Asian countries have chosen different exchange rate regimes in the wake of the regional crisis. Some have opted for a fixed exchange rate regime using either non-market means, such as capital controls, or a market-driven approach in the form of a currency board arrangement. Others opted for a freely floating exchange rate regime. As the Asian economies move towards greater financial market integration, non-market approach to fixing the exchange rate will eventually be abandoned. It might be presumptuous to prescribe one exchange rate regime for all Asian countries in the near term. Hong Kong's cost for exiting from the existing currency board arrangement could easily outweigh the benefits, not to mention its spillover effects to the rest of region. Japan, which is a large economy, will do well if it continues to float its currency. Small open Asian economies, which are currently adopting freely floating exchange rate regime, will have to re-assess their capability to deal with exchange rate volatility without undermining the growth of the real sector. Those that lack the necessary capability may do well if they opt for a trade-weighted basket currency peg with a sufficiently wide band to allow for greater exchange rate flexibility.

Restrictions on Capital Flows

    Large capital flows can cause volatility in the financial market and magnify the problems arising from having a weak financial system. Given the varying structural characteristics of Asian economies and the degree of sophistication of their financial sector, we cannot make a generalization regarding the necessity of imposing capital controls. However, if measures were to be imposed to slow down capital flows, then they should be directed towards short-term flows, especially capital inflows, because of their greater volatility and potential to destabilize the economy while permitting unlimited entry of long-term capital, especially FDIs. Also, it should be price-based capital control, rather than quantity-based capital control, to enhance banking regulation and corporate governance.

Asian Regional Cooperation

    Since currency crisis can be contagious, then there is scope for regional cooperation to make Asia less vulnerable to such crisis. Since the dust of the Asian financial crisis has already begun to settle, this may be the opportune time to revive Japan's proposal to establish the Asian Monetary Fund (AMF), whose role is to complement the efforts to strengthen the international financial architecture.* Its main purpose is to avoid the occurrence currency crisis in Asia in the future; or if ever it occurs, its costs can be minimized. It should serve as a forum among high-level officials in the region for discussing emerging issues in the regional and international financial markets. It may take a stand on important global issues that impinge on the stability of the financial markets in the region, such as the need to regulate and monitor activities of hedge funds headquartered in developed economies. Research and regular monitoring of the economies of Asian countries should also be a major function of the AMF. Finally, the AMF should have a liquidity facility for countries that are suddenly experiencing liquidity problem. While access to this facility should be fairly quick to avert any impending currency crisis, however, it should be formulated in a way that it does not invite any moral hazard problem. Japan's proposal to initially raise US$100 billion and contribute half of it while the rest of the participating Asian countries will pick up the balance seems feasible considering that foreign reserves of ten Asian countries stood about US$740 billion as of 1998. For AMF to be able to tap additional resources from the international capital market, it must be formally institutionalized as a regional monetary fund. Its membership may first be limited to ASEAN-6 plus Japan, South Korea, China, Taiwan and Hong Kong.

    Another urgent area for possible Asian regional cooperation is the internationalization of the Japanese yen. Both Japan and developing Asian countries will stand to benefit from it. The latter will eventually reduce their dependence on the US dollar and easily access the Japanese capital market. Central banks can diversify its reserve assets to reduce currency risk while corporate enterprises can avail themselves of more hedging instruments. More importantly, Asian countries that will adopt a basket currency peg can make appropriate adjustment to the Yen in that basket to a reasonable level.

    The third area for possible Asian regional cooperation, which needs to be considered as a long-term agenda for Asian countries, is the creation of the currency union in Asia. The creation of the AMF and the internationalization of the Yen can serve as building blocks towards this goal. In the Euro zone, the German marks provided leadership in the launching of the euro. Once internationalized, the yen can play the same role for Asia. Admittedly, the formation of a currency union in Asia can take a long time. Political consensus on the creation of such currency union must be secured. Nonetheless, discussions on the need for it and the mechanisms that will be used to achieve it must be started as early as this time.

*Recently, IMF has tried to strengthen its capacity to act as lender of last resort to individual member countries by establishing the Supplemental Reserve Facility (SRF) and the Contingent Credit Line (CCL).

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