What are the prospects for East Asian monetary integration? A high-level conference on September 5-6 at Chulalongkorn University, Bangkok, provided a venue for two dozen distinguished speakers and discussants to examine the range of policy options. The conference, organized in cooperation with the universities of Paris-Dauphine and Mannheim and commemorating the thirtieth anniversary of Chulalongkorn’s Faculty of Economics, drew approximately one hundred participants from academic, business, and policymaking communities as well as a large number of Chulalongkorn students.
The conference included lively sessions on specific country issues, such as macroeconomic policies in Thailand after the crisis and the future of multiple monetary systems in China in the face of increasing economic integration between Hong Kong SAR and the Chinese mainland, explored in a paper by Shu-ki Tsang of Hong Kong Baptist University. But alternative monetary and exchange rate regimes for East Asia provided the gathering with its central theme. The debate also addressed related issues, such as capital controls and international “last resort” lending.
Notwithstanding the role of quasi-fixed exchange rates in the run-up to the Asian crisis and the apparent smooth functioning of Asian inflation targeting regimes, such as Thailand’s (discussed in a paper by Chayodom Sabhasri, June Charoenseang, and Pornkamol Manakit of Chulalongkorn University), participants were generally skeptical of the long-term desirability of floating exchange rates for East Asia. This skepticism appeared to be chiefly motivated by two considerations: the desirability of limiting exchange rate volatility from the perspective of regional economic integration, and the potentially destabilizing effect of exchange rate swings in emerging economies with short-term debt denominated in foreign currency.
Beyond this theme, however, little consensus emerged on which exchange rate regime might constitute the best alternative for the region. Discussion largely centered on three main proposals:
- Soft peg to a basket of currencies%. A soft peg, argued Takatoshi Ito of Hitotsubashi University, could limit exchange rate volatility while maintaining a degree of flexibility, thus avoiding the types of misalignments that had preceded the Asian crisis (particularly in the case of the Thai baht). Ito noted that a soft peg could be achieved by allowing some flexibility within a band and by choosing basket weights that were approximately in line with trade importance. This would imply a much higher weight for the Japanese yen than in Thailand’s precrisis basket peg, and thus make the peg less vulnerable to swings in the bilateral U.S. dollar-yen exchange rate.
- East Asian dollar standard%. Ronald McKinnon of Stanford University proposed a system of long-term parities that would tie East Asian currencies—including the Japanese yen—to the U.S. dollar. While temporary suspensions would be acceptable at times of intense exchange market pressure, governments would commit to return to original parities after such crisis episodes (although on a flexible timetable). This would fix long-run expectations and thus reduce exchange rate overshooting in the face of speculative pressure, as many East Asian currencies famously experienced in the second half of 1997.
Maintaining long-term parities to the U.S. dollar would require considerable fiscal discipline, he said, but this was something most Asian authorities were quite capable of. The advantages of such a standard, McKinnon emphasized, were a clear nominal anchor—including against expectations of deflation in Japan—and the reduction or elimination of financial instability caused by the combination of flexible exchange rates and foreign currency-denominated liabilities. Moreover, a “good peg” could be expected to lower interest rate differentials and might thereby reduce incentives to borrow short term in U.S. dollars, gradually reducing systemic vulnerability over time.
- East Asian currency union%. Robert Mundell of Columbia University, Srinivasa Madhur of the Asian Development Bank, and Ricardo Hausmann of Harvard University each proposed variations of an East Asian currency union. Mundell and Madhur envisaged a process of monetary integration along European lines, requiring a combination of exchange market intervention agreements and a coordination of macroeconomic policies during an interim period, and eventually leading to a common currency. The principal advantage would be closer regional economic and financial integration.
Hausmann, on the other hand, was primarily concerned with the risks that foreign currency borrowing—the “original sin” of emerging market economies—implied for financial stability. Dollarization or “yenization” would, he indicated, eliminate these risks, lower real interest rates, encourage domestic savings, promote financial deepening, and provide a fully credible monetary anchor. However, a multilateral arrangement—in other words, a currency union with either the yen or the dollar at its core—would be preferable to the unilateral adoption of the dollar or the yen, because it would provide some seigniorage-sharing and a lender of last resort function that would benefit all members of the system.
All three proposals generated lively exchanges. Some participants criticized Ito’s and McKinnon’s proposals on the grounds that these monetary systems remained vulnerable to speculative attacks—a concern that would also apply to an arrangement similar to the European exchange rate mechanism. In McKinnon’s proposal, temporary flexibility, disciplined macro policies, and commitment to a return to long-run fixed parities might give the system some resilience. But if equilibrium exchange rates shifted for reasons other than macroeconomic policies—for example, as a result of the discovery of large implicit liabilities, or major real or external shocks—a return to the original parities might be painful and perhaps not credible.
Finally, currency unions built around the yen or the U.S. dollar and an East Asian dollar standard that excluded Japan could create competitiveness problems for Southeast Asia in the event of large swings in the yen-dollar exchange rate. For this reason, both Mundell and Hausmann stressed that their proposals would work best if exchange rate volatility among the dollar, the yen, and the euro were limited.
One conclusion that can be drawn from the discussion is that defining a “perfect” exchange rate arrangement for East Asia might be difficult because too much is being demanded from it: providing a nominal anchor, promoting regional trade and economic integration, maintaining competitiveness, and safeguarding the financial system. To really address these multiple objectives, it might be necessary to invoke additional policy instruments.
Conference participants dwelled on two such potential instruments: capital controls, the subject of a paper by Masahiro Kawai, Deputy Vice-Minister for International Affairs in Japan’s Ministry of Finance, and Shinji Takagi of Osaka University; and an international lender of last resort, discussed by Jeromin Zettelmeyer of the IMF. According to Kawai, capital controls are rarely successful over an extended period, but might have a useful role to play in specific circumstances—in particular, as a way of imposing a standstill in a financial panic that arises despite fundamentally sound domestic policies. An example, he said, might be the brief imposition of controls on short-term outflows in Malaysia after the Russian crisis. The Malaysian authorities used capital controls to create breathing space for domestic financial and corporate restructuring and other needed reforms while maintaining a sound macroeconomic framework.
Zettelmeyer argued that maintaining actual or even potential exchange rate flexibility—in other words, any exchange rate arrangement short of full dollarization—might require an international lender of last resort to help domestic financial safety nets deal with the risks associated with foreign-denominated debt. However, neither strategy was without problems, as the authors themselves and subsequent discussants pointed out. Imposition of capital controls, even if only in the context of a panic, might be interpreted as a signal of government willingness to restrict investor rights, and thus could have a damaging effect on the country’s credibility and on inflows of foreign direct investment. And the backing of domestic financial safety nets by an international guarantee might increase both country and investor moral hazard, unless the guarantee could be carefully tailored to the quality of the financial safety net and to domestic financial sector policies.