Summary of Research Papers and Policy Recommendations Shin-ichi Fukuda Takatoshi Ito Eiji Ogawa Yuri Sasaki Shujiro Urata Naoyuki Yoshino This chapter investigates what kind of exchange rate regime is desirable for East Asian countries from several aspects, including international trade, foreign direct investments, and macroeconomic aspects. It is found difficult that each of East Asian countries might be faced with difficulties in choosing the optimal exchange rate regimes in a context of strong economic interdependence among the East Asian countries. It also investigates how the East Asian countries can solve the difficulties by focusing on international policy coordination because they might be related with coordination failure among East Asian countries in the region. This introduction summarizes the research papers of the project and provides policy recommendations.

Ⅰ Summary of Research Papers In the first part, we analyzed what effects exchange rates had on international trade and foreign direct investments. It has been well known that many East Asian countries had adopted de facto dollar peg system before the Asian currency crisis. One of the reasons for their preference for a fixed exchange rate regime is to promote international trade and foreign direct investments. We analyzed effects of exchange rates on international trade and foreign direct investments in order to compare effects of the de facto dollar peg system on them with those in the cases of alternative exchange rate regimes. In “Pass PassPass-Through of Exchange Rates on Import Prices of East Asian Countries,” Countries Sasaki examined pass-through of exchange rates on import prices of East Asian countries. In the empirical analysis using aggregated data, she found that both the

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US dollar and the Japanese yen had effects on the import prices in Asian countries other than the import prices in Singapore. It means that import prices from US and Japan may be set in producers’ currency (non-pricing to market (non-PTM)). In the empirical analysis using data of 11 products of finer classification, it is shown that some of them are affected by the changes in the Japanese yen. These are small samples but these evidences suggest that the degrees of pass-through differ among the type of goods, and in sum, both the US dollar and the Japanese yen had effects on the import price of Asian countries. In “Exchange Exchange Rate, Exchange Rate Volat Volatility ility and Foreign Direct Investment,” Investment Urata examined the impact of the changes in the exchange rate of the currency of the foreign direct investment (FDI) host country and its volatility on FDI flows to that country in the light of the importance of FDI for the promotion of economic development. Using the three groups of data on FDI flows, namely those from OECD countries, Japan, and the United States, Urata found that depreciation of the currency attracts FDI inflows while high volatility of the exchange rate discourages FDI inflows.

These findings are consistent with the prior expectation

and the previous studies. Depreciation of the currency in the host country reduces the cost of production and the prices of assets for foreign investors, who are interested in achieving low cost production and obtaining assets at low prices. High volatility of the exchange rate of the currency in the host country would discourage investment by foreign firms as it increases uncertainty regarding the future economic and business prospects of the host country. Urata also found that openness, low wages, and past FDI in the potential host country attract new FDI.

These findings appear to indicate that foreign firms seek

for an open and free environment with availability of low wage labor for their FDI destinations.

This kind of behavior can be expected form the firms that are

interested in maximizing profits or minimizing costs.

The finding on the positive

impact of past FDI on new FDI confirms the importance of the agglomeration effect, which can be realized by the presence of many foreign firms.

Indeed, the

agglomeration effect may give rise to a virtuous cycle, under which FDI flows into an attractive country continuously as FDI leads to more FDI.

It should be noted

that this finding also indicates the possibility of a vicious cycle for a country, which is not successful in attracting FDI. Next, we analyzed what kind of exchange rate regime is optimal for East Asian countries by taking into account macroeconomic policy objectives of governments.

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We expect that a currency basket system is desirable for East Asian countries that trade with intra-region, Japan, and the European countries as well as the United States. It is necessary to consider interdependences among choices of exchange rate regimes in East Asia. Moreover, we analyze comovements among East Asian currencies after the Asian currency crisis focusing on especially impacts of the Malaysia’s adoption of fixed exchange rate regime. At the same time, it investigates how far internationalization of the Japanese yen has progressed in East Asian countries. In “The The Comparative Analysis of Exchange RateRegimes,” RateRegimes Yoshino analyzed the effects of some combinations of an exchange rate regime and capital controls, especially in terms of the effectiveness of monetary policy. First, he compared theoretically the relationship among capital controls, exchange rate regimes, and monetary policy, using a simple macroeconomic model. Second, he analyzed the optimal regime in which a government could attain its objectives, by introducing governments’ loss functions. He introduced the exchange rate volatility into this model. He obtained a result that the effects of monetary policy on real GDP depend on combinations of an exchange rate regime and capital controls. Under a floating exchange rate regime with free capital mobility, the effects of monetary policy depend on the sensitivities of exchange rate on net export. In such an economy, exchange rate volatility could damage a net export and then GDP fluctuations become higher. There is a possibility that the effects of monetary policy under a fixed exchange rate regime with capital controls would be larger than under the floating exchange rate regime with free capital mobility. In this case, introduction of capital controls under a fixed exchange rate regime could be better policy for an economy than under the floating exchange rate regime with free capital mobility. When the policy objective is the stability of GDP and the exchange rate, the fixed exchange rate regime with capita controls is superior to the floating exchange rate regime. The introduction of capital controls and fixed exchange rate could be an optimal regime when the impact of the exchange rate volatility on aggregate demand exists. In “Post PostPost-crisis Exchange Rate Regimes in East Asia,” Asia Fukuda’s objective was to investigate what affected the values of three ASEAN currencies, the Malaysia ringgit, the Singapore dollar, and the Thai baht after the crisis.

The particular

interest in his analysis was to explore why the East Asian currencies, which

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temporarily reduced correlations with the U.S. dollar after the crisis, had a tendency to revert back to de facto pegs against the U.S. dollar in the late 1990s. In particular, Fukuda examined how and when these three ASEAN currencies changed their correlations with the U.S. dollar and the Japanese yen in the post-crisis period.

Before September 1st 1998, these currencies increased

correlations with the Japanese yen in the post-crisis period.

In particular, the

increased correlations were larger than theoretical correlations based on the trade weights. temporary.

The increase in correlations with the Japanese yen was, however, After Malaysia adopted the fixed exchange rate, both the Singapore

dollar and the Thai baht increased correlations with the U.S. dollar drastically and began reverting back to de facto pegs against the U.S. dollar.

Some of these

changes were attributable to the structural change of the yen-dollar exchange rate. Most of these changes were, however, explained well by the strong linkage among the ASEAN countries. In the last part, we consider difficulties in adopting the optimal exchange rate regimes in a situation of economic interdependence relationships among East Asian countries. The analysis shows that each government of East Asian countries might face coordination failure in choosing its exchange rate regime. Based on the analytical results, we consider necessity of international coordination in choosing exchange rate regimes in East Asian region. We consider a common currency basket to solve the coordination problem of exchange rate regimes. We investigate problems that include possibilities to create a common currency basket, intervention currencies to keep the currency basket band, merits and demerits of the currency basket band. Also, we study a mechanism that supports the common currency basket by taking into account developments of regional financial cooperation in East Asia such as the Asian Monetary Fund. In “Economic Economic interdependence and international coordination in East Asia,” Asia Ogawa considered necessity of international coordination in exchange rate policy in East Asian countries. Although we experienced the Asian currency crisis under the

de facto dollar peg system, linkages of East Asian currencies with the US dollar have returned to the pre-crisis situation in recent years. Ogawa estimated weights on the US dollar in a possible currency basket for some East Asian countries. An analytical result shows that some of the East Asian countries have increased the linkages of their home currencies with the dollar in recent years. It is important to consider what factors increased the linkage of East Asian currencies with the dollar

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again. Ogawa pointed out that coordination failure in choosing exchange rate system under intra-regional trade competition impede the monetary authorities in adopting optimal currency basket system. Ogawa used a two-country model to show that coordination failure in exchange rate policies among the monetary authorities contributed to their keeping the dollar peg system. The monetary authorities tend to adopt the dollar peg system in a case of unstable equilibrium. Moreover, they are faced with coordination failure if they cannot directly shift from the dollar peg system to the optimal exchange rate system, given that the other countries adopt the dollar peg system, even though they have a stable equilibrium. Ogawa conducted an empirical analysis to investigate whether the monetary authorities in fact were faced with coordination failure in choosing an optimal exchange rate system among ASEAN5 countries, China, and Korea. The analytical result implies that the ASEAN countries and China are enforced to adopt the dollar peg system because they have an unstable equilibrium or coordination failure in choosing exchange rate system. In “A A Case for a Coordinated Basket for Asian Countries,” Countries Ito showed two ways to calculate the basket currency values for Asian countries, one without coordination and one with coordination. The results are mixed. Although the coordinated solution theoretically makes sense, it does not produce a usual result of the actual exchange rate having been overvalued before the Asian currency crisis. However, in the post-crisis period, the coordinated solution is better than the uncoordinated one, and actually it would have pointed to more appreciation than the actual rate turned out to be.

This is because the uncoordinated one would have produced large

depreciation in countries other than Indonesia, because Indonesia had a very large depreciation.

The coordinated solution would have preferred a stable exchange

rate. In other words, the coordination would have produced more stable exchange rate dynamics in the post crisis period.

Ⅱ Policy Recommendations We suggest some policy recommendations, based on the following research papers. (1) Stability of exchange rates contributes to growth of international trade and

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foreign direct investments and, in turn, economic grow growth. th. Urata showed that fluctuations of the host-country currency would discourage foreign direct investment as it increases uncertainty regarding the future economic and business prospects of the host country. It indicates the need to maintain stable macroeconomic

environment

in

potential

FDI

host

countries

and

avoid

over-valuation of the exchange rate in order to maintain attractiveness to foreign investors. Moreover, it argues for the establishment of an exchange rate system, under which the stability of the exchange rates are achieved and maintained. We recommend the potential host countries to choose a flexible but stable exchange rate regime as well as to promote trade and FDI liberalization to achieve an FDI friendly environment. It is clear that the monetary authorities should not choose the free-floating exchange rate system but an exchange rate system under which they stabilize fluctuations of exchange rates. (2) Currency basket system is desirable for East Asian countries. It is noteworthy that East Asian countries are trading with a variety of countries and are receiving direct investments from several developed countries including the United States and Japan. Therefore, the monetary authorities should focus on not the US dollar alone but a currency basket. Thus, it is stabilization of currency basket that the monetary authorities should take care in exchange rate policy from viewpoints of FDI and, in turn, economic growth. Sasaki’s paper indicates that fixing a home currency to a currency basket of the US dollar and the Japanese yen is better than floating exchange rates in a situation of volatile exchange rates because both US and Japanese exporters set the price in producers’ currency. If the exchange rate volatility is very low and has no effects on the import price of East Asian countries, adopting floating rates will become better because exchange rate adjustment allows for a lower variance of consumption. If both US and Japanese exporters set the price in consumers’ currency, adopting floating exchange rate system will become better because exchange rate volatility directly has no effects on import prices of East Asian countries. The point of this implication is that the optimal exchange rate system suggested here is not dollar peg but basket peg to US dollar and Japanese yen. (3) Regional cooperation in choosing exchange rate regime is necessary for realizing an optimal exchange rate regime in each of East Asian countries.

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Our results imply the importance of regional cooperation and coordination among the East Asian countries. Without regional cooperation and coordination, the East Asian countries might come to adopt the exchange rate regime that does not necessarily contribute to economic stability in the region. At present, several East Asian economies adopt different types of exchange rate regimes; Hong Kong has kept its currency board arrangement and the Chinese yuan has virtually maintained its peg to the U.S. dollar. After experiencing some transitional regime, Malaysia has pegged its currency to the US dollar since September 1st 1998. In contrast, Thailand, Indonesia, and Korea as well as the Philippines and Taiwan have adopted managed float since the crisis. It is notable that the East Asian currencies are reverting back to a de facto peg against the US dollar. There are possibilities of coordination failure that the monetary authorities of East Asian countries are enforced to choose the de facto dollar peg without any international coordination among them. The monetary authorities acting independently will be choosing the de facto dollar peg even though they know that desirable exchange rate system should be not the de facto dollar peg but a currency basket system. It is now a high time to reconsider what is the desirable exchange rate system in East Asian countries from a view of regional cooperation. We suggest policy makers of East Asian countries to study the desirable exchange rate system while they consider both economic interdependences among themselves and their regional coordination in choosing the exchange rate system. (4) More coordination can be enhanced by an introduction of Asian currency unit. Policy coordination in the exchange rate policies among the Asian countries is desirable to produce stability in their real effective exchange rate system. It would avoid competitive devaluation by calculating the stable real effective exchange rate only from major currencies outside the region. In the sense this is close to what was practiced in Europe before the introduction of Euro—fixing the exchange rate each other but float jointly against the outside. The coordination can be complex if we are to apply the method proposed in Ito’s paper. In order to make it more practical, a common basket, or an Asian currency

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unit, can be introduced. Each country can peg its currency to the Asian currency unit, with some band. If one can show that deviations of their idiosyncratic weights (coordinated solution) on (Yen, Dollar, Euro) from ones in the common basket are small enough to make the rate with common basket within a band of idiosyncratic rate. More coordination can be enhanced by an introduction of Asian currency unit. This will be the next step in search for the best exchange rate arrangement for the Region. One form of international cooperation is to introduce a common currency basket in East Asia. It is recommended that our regional financial cooperation is enhanced to support a common currency basket to be adopted in the future in East Asia. It is important to investigate feasibility of establishing a regional institution such as the Asian Monetary Fund to support a common currency basket and to give mutual surveillance as well as to give financial assistance to crisis counties.

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