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The
World Dollar Standard and the East Asian Exchange Rate Dilemma
- Part Two Ronald I. MCKINNON Part Two: The East Asian Exchange Rate Dilemma [1] (Editor's Note: This article is the second part of the two-part article that was originally prepared as a testimony before the British House of Lords. We thank Professor McKinnon for permitting Perspectives to publish it. The first part was published in the March 2002 issue of Perspectives.) The U.S. dollar serves as international money in the world economy in general, and as the dominant currency in East Asia in particular. Because of this dominance, financial regulation to prevent banking and currency crises can be much more difficult in countries on the periphery of the dollar standard than in the center country itself. Although the United States has never imposed the dollar standard on other countries, markets naturally choose one national currency as a facilitator of international exchange and safe haven store of value. Thus international debt contracts are typically denominated in dollars even if the loan proceeds are switched into the domestic currency of the borrowing country. This natural asymmetry among national monies, between a "center" and a "periphery," is key to understanding how financial crises occur and may be dealt with when economies are ever more globalized. The East Asian Exchange Rate Dilemma But why focus on East Asia? The East Asian economies including Japan now trade as much with each other as they do with the rest of the world. Because this economic integration continues, a common monetary standard that stabilizes exchange rates and anchors a common price level is becoming more necessary. Against this view, the now common advocacy of bipolarity-either let exchange rates float freely or undertake a hard fix-focuses on what an individual country should do. Thus, this received wisdom fails to take regional economic integration seriously. Interest rates must be better aligned and exchange rates made more stable than if each central bank in the region pursued its own monetary policy independently. Otherwise, in the face of great interest rate disparities and uncertain exchange rates, "hot" money flows-cycles of overborrowing followed by capital flight and currency crashes-as in Indonesia, Korea, Malaysia, Philippines, and Thailand, in 1997-98-will recur. When exchange rates change, the spillover effects from one country to another can generate waves of regional inflation or deflation. Thus much of the potential economic benefit from the ongoing integration in goods and capital flows in East Asia could be lost-as the countries of the European Union (EU) learned to their discomfort before the advent of the euro in January 1999. On the positive side, East Asian countries collectively have the fiscal potential for securing regional monetary stability. With the possible major exception of Indonesia, each has sufficient taxing capability, or a large enough domestic banking system, to support its government's finances without inflating. True, their governments can fail to properly regulate their banks and control their money supplies. But, unlike most countries in Latin America and Africa, countries in East Asia need not resort to the inflation tax and ongoing currency depreciation out of fiscal necessity. Thus, East Asian governments could collectively decide on regional monetary harmonization with stable domestic monies. "Could" is not the same as "will", of course. But, unless the economic pros and cons are spelled out, the political will always will be lacking. Short of introducing an "Asian euro," as John Williamson advocates (but certainly none is in prospect), what monetary impasse inhibits collective progress towards regional exchange rate stability? This "East Asian dilemma" has three interrelated facets. First, all the East Asian countries except Japan have more or less pegged their currencies to the U.S. dollar-both before and since the 1997-98 crisis. In the absence of major crises, dollar pegging had served before 1997, and does serve now, as a nominal anchor for their domestic price levels while reducing risks in international flows of short-term capital. But the continued use of an "outside" currency as the monetary basis for securing regional economic integration, when direct trade with the outside country itself may not be dominant, seems anomalous and remains controversial. Second, Japan's position with respect to the United States is peculiarly unbalanced. Although Japan is the region's and world's largest creditor country, most of its accumulated claims on foreigners are denominated in a foreign currency, i.e., dollars. When the yen appreciates, Japanese financial institutions suffer balance-sheet losses (measured in yen). Moreover, since 1945, Japan has been vulnerable to American pressure to change this or that domestic policy. Sometimes this pressure is warranted-as when the Americans push for greater liberalization of the Japanese economy. On the negative side, however, episodic American pressure on Japan to appreciate the yen from 1971 into 1995, ostensibly to reduce Japan's trade surpluses, imparted the deflationary momentum to Japan's economy which continues today. Since the late 1970s, this expectation of an ever higher yen and ongoing deflation has helped drive nominal interest rates on yen assets about 4 percentage points below those on dollar assets. Since 1995, however, the yen has not appreciated on net balance-although it continues to fluctuate widely against the dollar. Nevertheless, the interest differential between yen and dollar assets at all terms to maturity remains as wide as ever-three to five percentage points. Part of the differential could be explained by the market's fear that American mercantile pressure on Japan to appreciate the yen might return-particularly if the American economy turns down. A second part of the differential arises from the risk that Japanese financial institutions now see from holding large stocks of dollar assets, which have been accumulated over the past 20 years of Japan's current account surpluses. Because the yen value of these dollar assets fluctuates with the exchange rate, a negative risk premium reduces interest rates on yen compared to those on dollar assets. Otherwise, private Japanese financial institutions would have insufficient incentive to hold the "surplus" dollar assets. These two sources of pressure in the foreign exchanges force Japanese nominal interest rates below American. But, as long as American nominal interest rates were high as in the 1970s and 1980s, having interest rates lower in Japan was relatively harmless. However, when American interest rates themselves fell to lower levels (on average) from the mid-1990s through 2002, short- and long-term nominal interest rates on yen assets became trapped near zero. In this "externally imposed" liquidity trap, the Bank of Japan remains helpless to deal with the country's deflationary slump. Third, the financial interaction between Japan and the East Asian dollar bloc has been a major source of instability caused by unpredictable changes in the untethered yen/dollar exchange rate when the other East Asian countries are tethered to the dollar. These fluctuations in the yen/dollar rate aggravate fluctuations in income and employment. When the yen is overvalued against the dollar, it is also overvalued against all its East Asian trading partners. This induces an inverse business cycle: other things being equal, when the yen is high, the other smaller economies boom while Japan's is depressed-and vice versa. Also, the discrepancy between the very low interest rates in Japan and the normally higher interest rates in the dollar bloc of East Asian trading partners exacerbates "hot" money flows in the region. For both banks and non financial corporations in East Asian emerging markets, the margin of temptation to borrow un-hedged in foreign exchange can be overwhelming when interest rate differentials are large. The so-called yen carry trade is a case in point. Before the 1997-98 crisis, banks in some of the East Asian debtor economies would accept low-interest dollar or even lower interest yen deposits; then they would on lend at the much higher yields available on domestic-currency loans. This risky currency mismatch was not confined to financial institutions in the debtor economies themselves. With a low-cost deposit base in yen, Japanese banks acquired higher yield assets in dollars, baht, won, rupiah and elsewhere. Last but not least were the highly speculative so-called hedge funds that would borrow in Tokyo and on lend in Seoul, Bangkok, Jakarta, and so on. These hedge funds move funds immediately with any whiff of a possible exchange rate change-very hot money indeed! Such hot money flows were the genesis of the 1997-98 crisis. In the debtor economies of Indonesia, Korea, Malaysia, Philippines, and Thailand, corporations and banks had built up huge uncovered dollar and yen liabilities. When their currencies were attacked, these short-term foreign currency liabilities could not be rolled over. This sudden switch from capital inflows to capital outflows left them helpless to prevent their currencies from depreciating. The depreciations made repaying of their foreign-currency debts, from earnings streams denominated in their domestic currencies, impossible. A less well-known consequence of the crisis was severe deflation in the dollar prices of all goods entering East Asian trade. In the countries with deep depreciations, domestic inflation did not match the depreciation. This meant that they had real depreciations, and the dollar prices of their traded goods fell. As the demand for imports by the crisis economies collapsed, and their exports were artificially stimulated by the deep devaluations of their currencies against the dollar, the American nominal anchor could not hold. That is, commodity arbitrage with the center country was insufficient to prevent the dollar prices of goods and services in East Asia from dipping substantially below those prevailing in the United States. Thus, those East Asian economies which were not forced to devalue-China and Hong Kong have maintained their pre-crisis dollar exchange rates to the present day-suffered severe internal deflations, i.e., price declines measured in terms of their domestic currencies. But their exchange rate steadfastness in the face of falling domestic price levels saved East Asian economies from the much greater calamity that would have ensued if China and Hong Kong had depreciated as well. Clearly, the East Asian monetary system remains unbalanced and accident prone. The post-crash "honeymoon" of 1999 until the present-where short-term interest rates in the crisis economies fell to unusually low levels, and financially chastened corporations, banks, and bank regulators, turned ultra cautious-will not persist indefinitely. The unusually low interest rates on baht, won, and ringgit bank deposits reflect overshooting (over-devaluation) of their currencies, leading to some net expectation of mild appreciation. Once equilibrium real exchange rates are restored, interest rates in these peripheral economies will increase, and the interest differential with the US and Japan (the margin of temptation to over-borrow) will widen once more-particularly with Japan stuck in a deflationary slump where short-term interest rates remain close to zero. Reform Objectives To overcome this financial fragility and lessen incentives for hot money flows, what should be the key objectives of a reformed East Asian dollar standard? A reformed regime should aim for 1.
greater long- run exchange rate security among all the East
Asian economies-not only among the current dollar bloc countries
but with Japan itself; One incidental consequence would be a better interest rate alignment-smaller interest differentials between debtor and creditor. Speculative hedge funds would no longer be attracted to the yen carry trade. The need for draconian regulation of banks and other financial institutions to prevent undue foreign exchange exposure and over-borrowing would be lessened. However, for some emerging-market countries, capital controls (as in China) to prevent undue financial risk-taking would still be necessary. A second consequence would be the dampening, or elimination, of the intra-East Asian business cycle generated from exchange rate spillover effects from one country to another. However, even a reformed East Asian dollar standard would remain vulnerable to worldwide disturbances-including those associated with the United States itself. A third consequence would be help in overcoming Japan's prolonged economic slump. The expectation of ongoing deflation in Japan is now so ingrained that a major international program for ending the threat of yen appreciation and ongoing internal deflation must be seriously considered. The East Asian Dollar Standard Fluctuations in the yen/dollar exchange rate have been all the more disruptive in Japan itself because other East Asian nations-ever more important trading partners-have been pegged de facto to the dollar. Thus prominent economists in Japan and elsewhere, prominently John Williamson, advocate weaning Japan's East Asian trading partners away from their fixation with the dollar towards pegging to a trade-weighted currency composite. In such a "basket peg", the yen would have a heavy weight reflecting Japan's role as the largest East Asian trading country. Then, with each of the other East Asian countries pegged to such a basket, changes in their real exchange rates and Japan's would be dampened as the yen/dollar rate fluctuated. Although smoothing regional real exchange rate fluctuations is all well and good, this basket-peg approach misses the main motivation of why the smaller East Asian economies choose to peg-however loosely and unofficially-to the dollar. The world is on a dollar standard where trade flows in East Asia are overwhelmingly dollar invoiced. Concomitantly, international flows of finance-including huge flows of short-term payments-are also largely dollar denominated. Thus, in non-crisis periods, monetary authorities in emerging markets in East Asia have a dual motivation for trying to keep their exchange rates from moving much against the dollar: (1) Each central bank seeks an external nominal anchor as a target or instrument, or both, for securing its national price level when its domestic capital market is underdeveloped. To anchor the domestic price level effectively, a country's dollar exchange rate can't be allowed to move too much on a low frequency basis, i.e., measured monthly or quarterly, although a few East Asian countries have allowed some drift either up or down at these frequencies. (2) Because finance is so short term in emerging markets generally and in East Asia in particular, monetary policy is organized so as to keep dollar exchange rates very stable at high frequency levels, i.e., measured on a weekly or even a daily basis. Foreign payments risk is reduced under high frequency dollar pegging. So if any East Asian emerging market changes its policy and opts to peg-both at low and high frequencies-against a composite currency basket, its dollar exchange rate will necessarily fluctuate more widely. Hence that country's nominal anchor for domestic prices will become less secure and domestic financial risks will increase-possibly leading to a higher risk premium in its domestic interest rates. Why not go to the opposite extreme and have all emerging markets in East Asia peg to the yen? The problem is that the yen is not an international currency. Official yen pegs-certainly at high frequencies-would increase the risks of making high frequency dollar payments. Nor would a peg to the yen on a monthly or quarterly basis be a satisfactory nominal anchor for prices and interest rates in other East Asian countries. For over a decade, Japan has been unable to shake its ongoing price deflation and economic slump. Thus other East Asian countries would not want to import that deflation by pegging to the yen, and still less would they want interest rates near zero as in Japan. In contrast, U.S. monetary policy in the 1990s until today presents a better choice for a common East Asian monetary anchor. But, unlike diamonds, nothing is forever. East Asia still does not have the degree of economic integration of the countries in the European Union. Nor does it have the necessary political cohesion to impose the fiscal conditions on member countries necessary-in the mode of the Maastricht Treaty-for introducing an independent regional currency similar to the euro. Thus, to resolve the exchange rate dilemma, the East Asian dollar standard needs to be rationalized rather than jettisoned. New Rules for the Dollar Standard Game: A Return to Fixed Exchange Rate Parities? One way of creating a zone of greater exchange rate stability around Japan would be to require the other East Asian countries to peg more to the yen. But then the 10 emerging markets in East Asia would collectively, and against what they (correctly) perceive to be their own best interests, have to change their existing exchange rate practices of keying on the dollar. Instead, the political economy of the situation suggests an alternative route. To build an East Asian zone of monetary and exchange rate stability around Japan, Japan itself should join the dollar bloc: "if you can't beat 'em, join 'em." Could fixing the yen to the dollar within a narrower range in the medium term, and with no upward drift in the longer term, ever be done credibly? Only if there is an explicit agreement with the United States. Beginning in 1971, episodes of American pressure to get the yen up in the face of high and rising Japanese trade surpluses set in train, by the 1990s, much of the deflationary pressure and near zero interest rates we see in Japan today. Thus, quashing the expectation of an ever-higher yen and ongoing deflation requires a pact between the U.S. and Japan with two main provisions: a)
a commercial accord, perhaps in the form of a bilateral free-trade
agreement, for mediating trade disputes without resorting
to, or advocating, changes in the yen/dollar exchange rate;
To maintain this new parity, say 120 yen/dollar, the two governments would stand ready in the short run to intervene jointly-but only if the market rate began to diverge sharply from 120. Without committing themselves to a narrow band with hard margins, they would stand ready to keep nudging any errant market rate back toward 120. As long as these interventions were done jointly and in a determined fashion, the signaling effect to the markets would be sufficiently strong that little if any immediate monetary adjustment would be required in either country. However, to maintain the constant rate in the medium and longer terms, monetary adjustment would be necessary. The main responsibility for adjusting would be with the Bank of Japan rather than with the U.S. Federal Reserve Bank. As nominal interest rates on yen assets rose toward those on dollar assets because the yen/dollar exchange rate in now expected to be constant (Japan escapes from the liquidity trap), the Bank of Japan would stand ready to withdraw or inject domestic base money into the system to maintain the exchange rate. In order to eliminate the fear of future deflation, monetary adjustment in Japan itself is key for maintaining the new yen/dollar parity. In contrast, the Federal Reserve would not adjust the American monetary base to fluctuations in the yen/dollar rate-or in any other exchange rate. Instead, as befits the center country, the Fed would focus-as it does now-on managing the U.S. money supply to stabilize the American price level. Under the dollar standard, the American price level becomes the anchor to which other countries adjust. Once the "loose cannon," i.e., the yen/dollar rate, is properly secured over the long term, the other East Asian countries could more easily convert from informal dollar pegging with drift, to fixed dollar parities with no long-term drift. But why should they even bother converting to more formal long-term exchange parities? The answer is threefold. (1) A currency attack on any one country becomes less likely, and less damaging if it does occur. If the long-term parity is credible, then any sudden crisis where the government has to float the currency and let it depreciate sets up the regressive expectation that the domestic currency must eventually appreciate back to its parity level. Regressive exchange rate expectations limit the extent of any immediate crisis-induced devaluation while reducing the increase in short-term interest rates necessary to defend the currency. (2) Contagion through (inadvertent) beggar-thy-neighbor devaluations is better contained. If markets know that an unexpected devaluation by any one country is only temporary, then the mercantile pressure on neighboring East Asian countries to let their currencies depreciate will be less. And to complete the virtuous circle, any one East Asian country would find it much easier to maintain the credibility of its long-term dollar parity if neighboring counties, which are also mercantile competitors, were on the same exchange rate regime. (3) Developing a long-term domestic bond market while reducing risk premia at all terms to maturity becomes easier. Under the world dollar standard, U.S. Treasury bonds are the "risk free" or safe haven asset in the international capital markets. For a smallish and financially open emerging market economy, long-term bond issues in the domestic currency will be unattractive unless the payouts at maturity have the same (rough) purchasing power as U.S. Treasuries with long maturities. So the payoffs from formalizing the East Asian part of the world dollar standard could be substantial. More secure exchange rate commitments by the smaller, crisis-prone debtor economies-and by Japan as the big creditor-would mutually reinforce the common nominal anchor. A fixed yen/dollar exchange rate is a more powerful anchor against ongoing deflation in Japan if the other East Asian economies have secure long-term dollar parities. And the East Asian emerging markets would find that long-term dollar pegging is much more attractive when the yen/dollar rate is finally tethered. Because of China's rapid economic growth and now huge GNP, its ongoing commitment to a longer-term dollar parity is (would be) particularly beneficial for the East Asian economic system as a whole. Indeed, China's maintaining a fixed exchange rate of 8.3 yuan to the dollar during the great crisis of 1997-98 prevented contagious devaluations from being much worse. China now has an additional reason for formalizing its exchange rate commitment at 8.3 yuan per dollar. Because of the recent large influx of Chinese exports into Japan, Japanese businessmen and farmers are lobbying with some success for tariff and quota protection against Chinese goods. And they also want the Chinese government to appreciate the renminbi! But, of course, appreciation of the RMB would force more deflation on China-just as the lobbying by American businesses to get the yen up in the 1970s through 1995 forced deflation on Japan! Better
to secure the East Asian economy by formalizing long-term
parity commitments such that governments cannot be credibly
accused of manipulating their exchange rates for commercial
advantage. The common monetary standard in East Asia should
be neutral, and seen to be impartial, to the ebb and flow
of mercantile competition. |