MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002

Exchange Rate Arrangements
in East Asia:
Lessons from the 1997–98
Currency Crisis
Masahiro Kawai
This paper examines the evolution of exchange rate arrangements in East Asia’s
emerging market economies over the last 10 years. It considers both “official” and“observed” exchange rate arrangements in these economies from an international
comparative perspective. By focusing on the roles of the dollar, the yen, and the euro
as anchor currencies for exchange rate stabilization, the paper claims that the dollar
played a dominant role as a de jure or de facto anchor for emerging East Asia until
the 1997–98 currency crisis. During the crisis, the dollar’s dominance naturally
declined in affected East Asia as a result of a general shift to more flexible exchange
rate arrangements. In the post-crisis period, the dollar has regained prominence insome countries (notably in Malaysia), while its dominance has been reduced andexchange rate flexibility has risen in others (notably in Indonesia). Interesting is theobservation that Korea and Thailand appear to have shifted to a de facto currency
basket arrangement with significant weights on the dollar and the yen, similar to
Singapore’s managed floating arrangement. This paper also considers what may be adesirable currency system for the region. Given the high volatility of yen/dollar
exchange rates and partner diversity of trade and foreign direct investment (FDI)
relationships, it claims that the emerging East Asian economies would be better off
stabilizing their currencies to a balanced currency basket in which the dollar, theyen, and the euro play equally important roles. For intra-regional exchange ratestability, greater coordination on the currency basket policy would be desirable, andthis needs to be supported by regional policy dialogue and financing mechanisms.
Key words: East Asian currency crisis; Exchange rate arrangements; Two-corner
solution approach; Fear of floating; Currency basket system
Deputy Vice Minister for International Affairs, Ministry of Finance, Japan (E-mail: masahiro.kawai@mof.go.jp)
This is a revised version of the paper presented at the 10th International Bank of Japan Conference, “Exchange
Rate Regimes in the 21st Century,” organized by the Institute for Monetary and Economic Studies, Bank ofJapan, and held in Tokyo on July 1–2, 2002. The author is thankful to Chow Hwee Kwan, Hiroshi Fujiki, Eiji
Hirano, and many other participants at the conference for helpful comments, to Ronald McKinnon for
constructive communication, to Shigeru Akiyama for earlier research collaboration, and to Toshiyuki Matsuura,
Kiyotaka Satoyoshi, and Junko Shimizu for their able research assistance. The findings, interpretations, andconclusions expressed in the paper are those of the author and do not necessarily represent the views of theJapanese government. All remaining errors are clearly his own.

167

I. Introduction
Reflecting on the East Asian currency crisis in 1997–98, this paper examines how theEast Asian exchange rate arrangements have evolved over the last decade. For thispurpose, it examines exchange rate arrangements of other developing countries
and evaluates the East Asian practice from an international comparative perspective.
It also explores what may be a resilient regional exchange rate arrangement for East
Asia’s financial stability, economic development, and sustained growth.
The East Asian currency crisis forced many economies in the region to shift awayfrom de facto dollar-pegged regimes to more flexible exchange rate regimes. The
dollar had played a dominant role as an international anchor currency until theoutbreak of the crisis in the summer of 1997. During the crisis, the anchor currencyrole of the dollar was substantially reduced, due to a general shift to more flexible rate
arrangements. As the currency crisis subsided in the second half of 1998, however,the East Asian economies generally restored exchange rate stability—with the
exception of Indonesia. This restoration of rate stability was accompanied by agreater role of the dollar in some countries—notably in Malaysia—and a greater roleof the yen in others—notably in Singapore, Korea, and Thailand.
Emerging market economies, including those in East Asia,1 face a trade-off
between the virtue of exchange rate stability to promote trade, investment, andgrowth and the need for flexibility, particularly during a time of crisis, to maintaininternational price-competitiveness and facilitate adjustment. The “two-corner
solution” approach of choosing either a pure float—often accompanied by inflation
targeting—or a hard peg—an institutionally binding fixed rate regime like monetary
union, unilateral “dollarization” or “yenization,” or a currency board—does notappear to be realistic in many emerging East Asian economies. The reason is thatthey appear to have a “fear of floating” or a preference toward exchange rate stability,
though not necessarily rigidity. Given emerging East Asia’s diversified trade and
FDI relationships with the United States, Japan, and the European Union (EU) andgiven the continued high exchange rate volatility among the tripolar currencies, areasonable exchange rate policy for the region would be to stabilize rates to a basketof currencies consisting of the dollar, the yen, and the euro.
The organization of the paper is as follows: Section II examines the nature of“official” and “observed” exchange rate arrangements for developing economies in theworld. This section finds that many authorities in the developing world exhibit a“fear of floating” or a preference for stable exchange rates vis-à-vis an international
currency or a basket of such currencies. Section III analyzes the changing importanceof the dollar, the yen, and the euro as international anchor currencies for theexchange rate behavior of the emerging East Asian economies before, during, andafter the currency crisis. It finds that the dollar played a dominant role as an anchor
currency for exchange rate stabilization in emerging East Asia in the pre-crisis period,
but that its dominant role naturally declined during the crisis. It also finds that,
1. In this paper, emerging East Asian economies include China, Hong Kong, Indonesia, Korea, Malaysia, thePhilippines, Singapore, Taiwan, and Thailand.

168 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002

Exchange Rate Arrangements in East Asia: Lessons from the 1997–98 Currency Crisisin the post-crisis period, some economies have reverted to a pre-crisis type ofdollar-based exchange rate regime, while others have allowed greater exchange rate
flexibility. Several countries have shifted to a de facto currency basket arrangementwith larger weights on the yen. Section IV proposes a region-wide currency basket
system where the dollar, the yen, and the euro would play more balanced roles. How
tightly or loosely the exchange rate should be stabilized is left to each economy’s
specific conditions and preferences, at least initially. It also argues that a currency
basket system needs to be accompanied by closer regional coordination throughfinancing and policy dialogue mechanisms, in a manner commensurate with real
sector integration. Section V summarizes the paper.

II. Trends in Exchange Rate Arrangements in theDeveloping World
A. “Official” Exchange Rate Arrangements
The International Monetary Fund (IMF) regularly publishes exchange rate arrangements formally reported by its member countries according to its own classification
scheme. In 1999, the IMF started to pay greater attention to the de facto exchange
rate arrangement practices of its members rather than using only formally reported
arrangements. Table 1 summarizes such “official” arrangements for developing
countries during 1980–2001.2 In this table, exchange rate arrangements are classified
broadly into three categories; a fixed exchange rate arrangement, limited exchange
rate flexibility, and a more flexible exchange rate arrangement.3
While the number of IMF members in the developing world has increased
over time (from 118 in 1980 to 163 in 2001), the number of countries under
fixed exchange rate arrangements has decreased (from 90 to 76), and the number ofcountries under more flexible exchange rate arrangements has increased (from about
25 to 83). As far as “official” exchange rate arrangements are concerned, many
countries have shifted from fixed to more flexible arrangements over the last 20 years.
Nonetheless, quite a few countries still attempt to stabilize their exchange rates.
Indeed, 80 countries (49 percent of the total) were on “fixed exchange rate arrangements” and “limited exchange rate flexibility” in 2001. In addition, some countries
under “more flexible arrangements” are known to have stabilized their exchange rates
vis-à-vis a certain currency or a basket of currencies.
2. See International Monetary Fund (1997), and Mussa et al. (2000) for discussions of exchange rate arrangements
in developing countries. Table 1 is compiled from the IMF’s International Financial Statistics (various issues) byremoving industrialized countries.
3. Beginning in January 1999, the IMF introduced a new classification of categories that includes (1) exchange
arrangements with no separate legal tender; (2) currency board arrangements; (3) other conventional fixed-peg
arrangements (including de facto peg arrangements under managed floating); (4) pegged exchange rates within
horizontal bands; (5) crawling pegs; (6) exchange rates within crawling bands; (7) managed floating with nopreannounced path for exchange rate; and (8) independently floating. As the new classification is not strictly
comparable to earlier classifications, I have decided to compile Table 1 according to the earlier classification,
assuming that (1), (2), and (3) belong to a “fixed rate arrangement,” (4) is “limited exchange rate flexibility,” (5),(6), and (7) belong to “managed floating,” and (8) is “independently floating.” The last two combined represent a“more flexible rate arrangement.”169

170 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002

Table 1 Summary of Official Exchange Rate Arrangements of IMF-Member Developing Countries, 1980–2001
Number of countries

Fixed exchange rate arrangement
Pegged to the dollar
Pegged to the euro
Pegged to the French franc
Pegged to the deutschemark
Pegged to other EMU currency
Pegged to the U.K. pound sterling
Pegged to the Russian ruble
Pegged to other currency
Pegged to SDR
Pegged to other currency composite
Limited exchange rate flexibility
More flexible exchange rate arrangement
Adjusted according to a set of indicators
Other managed floating
Independently floating
Unclassified

Dec.
1980
90
39
15
14
0
1
1
0
2
15
18
a
3+b+c
3
b
c
0

Dec.
85
89
31
14
14
0
0
1
0
4
11
28
5
32
4
17
11
1

Dec.
90
81
25
15
14
1
0
0
0
5
6
30
4
46
5
21
20
1

Dec.
91
75
24
15
14
1
0
0
0
3
6
27
4
54
5
25
24
1

Dec.
92
82
24
15
14
1
0
0
6
5
5
27
4
58
3
22
33
0

Dec.
93
71
21
16
14
1
1
0
1
5
4
24
4
77
4
28
45
0

Dec.
94
70
23
16
14
1
1
0
1
6
4
20
4
81
3
30
48
0

Dec.
95
65
22
17
14
2
1
0
0
5
3
18
4
88
2
42
44
0

Dec.
96
65
21
17
14
2
1
0
0
6
2
19
4
89
2
43
44
0

Dec.
97
65
20
19
15
3
1
0
0
7
3
16
4
89
—
44
45
0

Sept.
98
63
20
20
15
3
2
0
0
7
4
12
4
92
—
55
37
0

Jan.
99
73
31
21
15
4
2
0
0
7
2
12
9
80
—
41
39
0

Dec.
99
79
38
21
15
4
2
0
0
7
2
11
3
80
—
37
43
0

Dec.
2000
79
37
22
15
5
2
0
0
7
2
11
4
80
—
42
38
0

Dec.
01
76
38
21
—
—
—
0
0
7
1
9
4
83
—
52
31
0

Total

118

127

132

134

144

152

155

157

158

158

159

162

162

163

163

Notes: 1. Though a new classification of exchange rate arrangements was introduced on January 1, 1999, the table summarizes official exchange rate arrangements on the basis of earlier classification methods. To try to maintain consistency with the earlier classification, several assumptions are made: a “fixed exchange rate arrangement” includes “exchange arrangements withno separate legal tender,” “currency board arrangements,” and “other conventional fixed-peg arrangements (including de facto peg arrangements under managed floating)”; “limited
exchange rate flexibility” corresponds to “pegged exchange rates within horizontal bands”; “managed floating” includes “crawling pegs,” “exchange rates within crawling bands,”and “managed floating with no preannounced path for exchange rate”; and “independently floating” in the table corresponds to “independently floating” under the new classification.
Notes: 2. The number of countries under “fixed exchange rate arrangement” jumped upward in January 1999 because nine countries began to be reclassified as “other conventional fixed-peg
arrangements (including de facto peg arrangements under managed floating)” rather than as managed or independently floating, and three economies (Aruba, Hong Kong, and Netherlands
Antilles) were added to the list.
Notes: 3. Given that the euro was introduced in January 1999, the row for “pegged to the euro” is created to indicate the number of developing countries that had pegged their currencies to EMU-12
currencies—mainly the French franc, the deutschemark, the Spanish peseta, and the Portuguese escudo—until the end of 1998.
Notes: 4. Several IMF-member and non-member developing economies are not always included in this table, e.g., Hong Kong (1980–98), Taiwan, and Cambodia (1980 and 1992).
Notes: 5. The sum of a, b, and c in the table in 1980 is 25.
Source: International Monetary Fund, International Financial Statistics (various issues).

Exchange Rate Arrangements in East Asia: Lessons from the 1997–98 Currency Crisis

Focusing on the fixed rate arrangements in the developing world, as of December
2001, the dollar is the most popular target currency (for 42 developing countries
including four countries under “flexibility limited in terms of a single currency”),
followed by the euro (formerly the French franc for 15 countries, the deutschemark
for four countries and the Portuguese escudo and the Italian lira for one country each
after January 1999), non-special drawing right (SDR) currency baskets (for ninecountries), and the SDR (for one country).4 It is noteworthy to observe that no
developing country pegs its exchange rate any longer to the U.K. pound sterling,
particularly since 1986, or to the yen throughout the period.
B. “Observed” Exchange Rate Arrangements: Quantitative Analyses
The “official” exchange rate arrangements provide information about the natureof the arrangements as reported by individual countries and, where appropriate,
reclassified by the IMF when formally reported arrangements differ from the actual
practices. However, these official arrangements still do not accurately describe theactual practice of exchange rate policies, nor do they offer sufficient information as towhich currency or basket of currencies is chosen as a target for de facto exchange ratestabilization. To understand which exchange rate arrangements are actually in place,
one must statistically examine the observed behavior of relevant variables, particularly
exchange rates.5
One way to do this is through a regression analysis technique used by Frankel andWei (1993, 1994, 1995) and to identify which major currency or currency basket
is chosen as an anchor for a particular country’s exchange rate stabilization andhow closely such a relationship can be observed. In this subsection, we estimate thefollowing type of regression equation:6∆e tj = α + β1∆e USDt + β 2∆e DMt + β 3 ∆e J Yt + β 4∆e FFt + β 5 ∆e UKPt + ut ,where ∆e tj is the monthly change in the log exchange rate of currency j in month t ,α is a constant term, βk (k = 1, 2, . . .) is the coefficient on the monthly change in thelog exchange rate of currency k, and ut is the residual term. The superscripts USD,
DM, JY, FF, and UKP refer to the dollar, the deutschemark, the yen, the Frenchfranc, and the U.K. pound sterling, respectively. The estimated standard error of
regression residuals can be interpreted as a measure of exchange rate volatility. A
monthly change in the exchange rate is defined by the first difference of the natural
logarithm of the nominal exchange rate. For some countries, we use as right-handside variables the exchange rates of the SDR, European Currency Unit (ECU), andother relevant minor, regional currencies, reflecting country-specific characteristics.
Following Frankel and Wei (1994), we express all the exchange rates in terms of a
4. Other target currencies for single-currency pegs include the South African rand (for three countries in December2001), the Indian rupee (for two countries), the Australian dollar, and the Singapore dollar (for one country each).
In the past, the U.K. pound sterling, the Spanish peseta, and the Russian ruble were also targets for single-currency pegs.
5. A more detailed study would require analysis of changes in foreign exchange reserves, foreign exchange market
pressure, and interest rates.
6. This exercise is an extension of the studies conducted by the author for an earlier sample period (see Kawai and
Akiyama [1998]).

171

numeraire currency, the Swiss franc.7 In this exercise, we have decided to remove data
observations with values of log first differences greater than 0.1 to minimize theimpacts of discrete devaluations or revaluations.8
This exercise provides useful information on “observed” exchange rate arrangements
for developing countries. The underlying hypothesis is that every country attempts
to stabilize the exchange rate to a basket of multiple currencies. First, it can identify
specific currencies that comprise a basket in each developing country’s exchange ratestabilization policy in terms of the estimated coefficients in the regression equation.
Exchange rate stabilization to a single currency can be interpreted as a special case inwhich only one currency is identified with a significant and large positive coefficient,while other currencies’ coefficients are small and statistically insignificant. Second, it
can identify the degree to which the authorities allow or limit exchange rate flexibility
depending on the size of exchange rate volatility as measured by the estimated standard
error of regression. A large size of the estimated standard error of regression implies thatthe authorities allow relatively large exchange rate flexibility, while a small size indicatesthat they attempt to stabilize their exchange rates.
Based on the regression analysis, developing economies can be classified into threebroad categories according to their “observed” exchange rate arrangements, that is,pegged, intermediate, and flexible, depending on the size of exchange rate volatility.
Specifically, countries are classified to be under the “pegged” arrangement when
volatility is less than 0.0075, “intermediate” when volatility is between 0.0075
and 0.015, and “flexible” when volatility exceeds 0.015.9 Table 2 summarizes thisinformation for the period 1980–99 by dividing the whole sample into five-year
sub-samples.10 Table 3 summarizes observed exchange rate arrangements of emerging
market economies over the same sample periods.11
Table 2 reveals several interesting points. First, the number of developing
countries under the “pegged” rate arrangement has declined as a trend, though there
was some reversal in this trend in the second half of the 1990s. On the other hand, thenumber of countries under the “flexible” rate arrangement has risen as a trend. The
number of countries under the “intermediate” rate arrangement has risen slightly. In
the second half of the 1990s where 157 developing country currencies are examined,
75 countries (48 percent of the total) are under the “pegged” arrangement, 29 countries(18 percent) under the “intermediate” arrangement, and 53 countries (34 percent)under the “flexible” arrangement. Second, regardless of the extent of exchange rate
flexibility, almost all developing countries appear to have their own preferred anchor in
7. In other papers, Frankel and Wei (1993, 1995) use the SDR as a numeraire currency, but we do not follow thisprocedure because our study regards the SDR as a potential candidate for a nominal anchor.
8. We have done so because countries often change their parities or central rates to accommodate persistent differences
in inflation rates or productivities vis-à-vis their nominal anchor-currency country. Without eliminating theeffects of such discrete devaluations or revaluations, it would be difficult to conclude the presence or absence ofa nominal anchor currency for certain countries.
9. The value 0.0100 is approximately a 1 percent change in monthly exchange rates.
10. Table 2 in the working paper version of this paper also provides the size of exchange rate volatility, the number of
excluded observations due to large, discrete exchange rate changes, and other information. The working paper isdownloadable from http://www.imes.boj.or.jp/english/publication/edps/2002/02-E-17.pdf.
11. Emerging market economies include those in East Asia (see Footnote 1) as well as Argentina, Brazil, Chile,
Colombia, the Czech Republic, Hungary, India, Israel, Mexico, Peru, Poland, the Russian Federation, South
Africa, Turkey, and Venezuela.

172 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002

Exchange Rate Arrangements in East Asia: Lessons from the 1997–98 Currency Crisis

Table 2 Summary of Observed Exchange Rate Arrangements of Developing
Countries (Classified by Monthly Data)
Number of countries; number of emerging market economies in parentheses[1] Pegged:
0 ≤ volatility < 0.0075[2] Intermediate:0.0075 ≤ volatility < 0.015[3] Flexible:
volatility ≥ 0.015

SampleperiodJan. 1980–
Dec. 1984
Jan. 1985–
Dec. 1989
Jan. 1990–
Dec. 1994
Jan. 1995–
Dec. 1999
Jan. 1980–
Dec. 1984
Jan. 1985–
Dec. 1989
Jan. 1990–
Dec. 1994
Jan. 1995–
Dec. 1999
Jan. 1980–
Dec. 1984
Jan. 1985–
Dec. 1989
Jan. 1990–
Dec. 1994
Jan. 1995–
Dec. 1999

DollarOther single
currency

Basket ofcurrencies

Total

39 (3)

23 (0)

21 (4)

83 (7)

32 (1)

22 (0)

15 (3)

69 (4)

31 (2)

22 (0)

14 (4)

67 (6)

37 (3)

24 (0)

14 (0)

75 (3)

10 (3)0 (0)

15 (4)

25 (7)

14 (7)1 (0)

14 (2)

29 (9)

10 (5)1 (0)

23 (7)

34 (12)16 (4)

1 (1)

12 (3)

29 (8)

12 (7)1 (0)

10 (2)

24 (9)

24 (6)2 (0)

10 (4)

36 (10)29 (5)

7 (1)

17 (1)

53 (7)

31 (6)6 (3)

15 (5)

53 (14)

Notes: 1. Countries are classified into three categories of exchange rate arrangements (pegged,intermediate, and flexible), depending on the size of exchange rate volatility as measured
by the standard error of regression. Countries are classified as “pegged” when the volatility
is less than 0.0075, “intermediate” when the volatility is between 0.0075 and 0.015, and“flexible” when the volatility is equal to or greater than 0.015. In each category, countries arefurther classified into three groups, depending on what currency or basket of currencies is
assigned a significant weight in the regression equation. The “dollar” group includes thosefor which the dollar appears as the only significant currency in the regression equation. The“other single currency” group includes those for which another single currency appears as
the only significant currency in the regression equation. The “basket of currencies” group
includes those for which multiple currencies appear as significant in the regression equation.
Notes: 2. Emerging market economies include Argentina, Brazil, Chile, China, Colombia, the Czech
Republic, Hong Kong, Hungary, India, Indonesia, Israel, Korea (Republic of), Malaysia,
Mexico, Pakistan, Peru, the Philippines, Poland, the Russian Federation, Singapore, South
Africa, Taiwan, Thailand, Turkey, and Venezuela.
Notes: 3. There is one country each for the periods January 1980–December 1984 (Lebanon) andJanuary 1995–December 1999 (Congo, Democratic Rep.), whose volatility exceeds 0.03
without any identified currency weight.

terms of a single currency or a basket of currencies. The dollar is the most preferredanchor currency (for 84 countries or 54 percent of all developing countries in thesecond half of the 1990s), followed by a basket of currencies (for 41 countries or
26 percent) and other single currencies (for 31 countries or 20 percent). There
were very few countries where anchor currencies could not be identified. Third, as
can be seen in Table 3, until the mid-1990s, a majority of non-East Asian emerging

173

Table 3 Emerging Market Economies under Alternative, Observed Exchange Rate
Arrangements (Classified by Monthly Data)[1] Pegged

SampleDollarperiodJan. 1980– Venezuela, Colombia,
Dec. 1984 Taiwan
Jan. 1985–
Indonesia
Dec. 1989

Other single
currency

Jan. 1990–
Hong Kong, Korea
Dec. 1994
Jan. 1995–
Dec. 1999[2] Intermediate Jan. 1980–
Dec. 1984

Argentina,
Hong Kong, China
Korea, Mexico,
Philippines
Colombia, China,
Jan. 1985– Korea, Singapore,Dec. 1989 Philippines, Taiwan,
Venezuela
India, Colombia,
Jan. 1990–
Mexico, Chile,
Dec. 1994
China[3] Flexible

Jan. 1995– Venezuela, Peru,
Czech Republic
Dec. 1999 Brazil, Turkey
Hungary, Hong Kong,
Jan. 1980–
Brazil, Peru, Chile,
Dec. 1984
Poland, Argentina
Turkey, Hungary,Jan. 1985–
Israel, Poland, Mexico,
Dec. 1989
BrazilPoland, Philippines,
Jan. 1990–
Venezuela, Peru,
BrazilDec. 1994
Russian Federation
Pakistan, Israel,Jan. 1995– South Africa,
Thailand, Malaysia,
Dec. 1999 Russian Federation,
Indonesia
Mexico, Colombia

Basket ofcurrencies
Indonesia, Singapore,
India, Malaysia
Hong Kong, Thailand,
PakistanCzech Republic,
Thailand, Indonesia,
Singapore

Thailand, Pakistan,
China, Israel
India, Malaysia
Taiwan, Pakistan,South Africa,
Malaysia, Israel,
Hungary, Argentina
Hungary, Taiwan,
India
Turkey, South Africa
Chile, Peru, Argentina,
South Africa
TurkeyChile, Singapore,
Poland, Korea,
Philippines

Notes: 1. Emerging East Asian economies include China, Hong Kong, Indonesia, Korea, Malaysia, thePhilippines, Singapore, Taiwan, and Thailand. They are shown in italics.
Notes: 2. Non-East Asian emerging market economies include Argentina, Brazil, Chile, Colombia, theCzech Republic, Hungary, India, Israel, Mexico, Pakistan, Peru, Poland, the RussianFederation, South Africa, Turkey, and Venezuela.

economies were under the “flexible” or “intermediate” arrangements, while mostof the East Asian emerging economies were under the “pegged” or “intermediate”
arrangements. That is, emerging economies in East Asia showed stronger preferences
for exchange rate stability—or a stronger “fear of floating”—than those in non-East
Asia. However, crisis-affected countries and Singapore shifted to the “flexible”
arrangement due to the outbreak of currency crisis in the second half of the 1990s.12
12. Table 3 reports that while Thailand, Malaysia, and Indonesia adopted a “flexible” rate arrangement in the second
half of the 1990s, they used a non-U.S. dollar currency as a target for exchange rate stabilization. This currency

174 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002

Exchange Rate Arrangements in East Asia: Lessons from the 1997–98 Currency Crisis

While an increasing number of developing countries shifted away from fixed
toward more flexible exchange rate arrangements on an “official” basis by the 1990s,
almost all countries attempted to stabilize their exchange rates against a single currency
or a currency basket, though the degree of rate stabilization varied considerably acrosscountries. Many countries regard the dollar as their anchor currency despite theabsence of a formal commitment to a dollar peg. Notable is the fact that quite a few
economies are using currency baskets as their anchor without officially announcing it.
C. Formation of Tripolar Currency Areas
Using the results in the preceding subsection, we can estimate the size of tripolar
currency areas, that is, currency areas formed by the dollar, the new European single
currency (euro), and the yen. The objective here is to gain insight into the current stateand evolution of the international monetary system by quantitatively gauging the size ofmajor currency areas. Particularly interesting is to evaluate the impact of the creation of
the European Economic and Monetary Union (EMU) and introduction of the euro on
the international monetary system. The main question is whether the newly introduced
euro is strong enough to seriously challenge the dollar’s dominance and to convert the
dollar-dominated international monetary system into a regime centered on both thedollar and the euro. Another important question is what role the yen can play.13
1. Defining currency areas
In this subsection, we calculate the economic size of a currency area in terms of GDP
and trade flows (exports plus imports), expressed as current dollar values, using data forthe period 1990–99. By using different economic variables as the basis for measuring
the size of currency areas, we can further our understanding of the importance of the
major currencies as nominal anchors for the rest of the world.
In this calculation, we undertake the following four steps: first, we start by focusing on the currencies of the G-5 countries (i.e., the United States, Germany, France,
the United Kingdom, and Japan) in addition to the SDR and the ECU. Each of theseG-5 currencies is assumed to form a currency area of its own. If any country rigidly pegs
its exchange rate to a particular G-5 currency, its entire economy, measured by GDP
or trade flows, is classified as belonging to the currency area formed by this particularcurrency. If a country stabilizes its exchange rate to a basket of multiple currencies, its
economy is divided into fractions of major currency areas according to the weights
assigned to these major currencies in a basket. The coefficients that were estimatedin the previous section as statistically significant, at least at the 5 percent level, areinterpreted as the weights assigned to the corresponding currencies. If a country
does not stabilize its exchange rate against any single currency or currency basket, its
turns out to be the Singapore dollar despite the fact that these countries did not pursue conscious policies to use
the Singapore dollar as their official target. Since Singapore was under a currency basket system during thisperiod, these three countries are considered to have been under a similar currency basket arrangement. At any
rate, this result appears to reflect statistical relationships observed on the average during the sample period that
includes the currency crisis episode.
13. See Alogoskoufis and Portes (1997) and Bergsten (1997), who argue that the introduction of the euro will
challenge the dollar’s dominance and convert the international monetary system into a bipolar system centeredon both the dollar and the euro. They do not see much potential for the yen to grow into another dominantinternational currency.

175

economy is considered not to belong to any currency area; it adopts flexible exchange
rates vis-à-vis the major currencies. In essence, we divide each individual country into
different fractions of currency areas and then calculate the size of a currency area for theworld as a whole by summing the corresponding fractions over all countries.14
Second, the weights assigned to anchor currencies are obtained from theestimated coefficients of a regression equation that are positive and statisticallysignificant at the 5 percent level or above. If the sum of the estimated coefficients isequal to or less than one, their values are used as weights. If the sum exceeds unity, all
the coefficients are proportionally rescaled downward to make the sum equal to one
and the rescaled coefficients are used as weights.
Third, using procedures similar to the first step, we also calculate the size of thecurrency area formed by the currency of a minor, regional country—such as Australia,
India, New Zealand, Portugal, Singapore, South Africa, and Spain. We next distributethe currency area formed by such a minor, regional currency to the larger currency
areas formed by the G-5 currencies, the SDR, and the ECU, by using the estimatedregression coefficients for each minor, regional currency. We also distribute thecurrency areas formed by the SDR and the ECU to G-5 currency areas, by using theestimated regression coefficients for these composite currencies. In this way, a country
that stabilizes its currency to a minor, regional currency, the SDR, or the ECU can bedivided into fractions of G-5 currency areas.
2. Currency areas formed by the euro, the dollar, and the yen
Finally, we calculate the global size of the euro area, by adding the size of EMU members and the currency areas formed by the French franc (FF) and the deutschemark(DM)—and by the U.K. pound sterling depending on the definition of the euro area—for non-EMU countries.15 A sample of 99 countries is used for such calculations.
We consider two cases with regard to the scope of the euro area, depending on whichcountries form the EMU: the current case of the EU-12 (Austria, Belgium, Finland,
France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, andSpain) forming the EMU, and the prospective case of the EU-15 (the EU-12 plus
Denmark, Sweden, and the United Kingdom) forming a Greater EMU. The latter casedefines the maximum possible size of the EMU in the conceivable future, because it
also assumes that the transition economies in Central and Eastern Europe and the Baltic
states also stabilize their currencies to the euro.16 If EMU membership is expanded toinclude all EU countries, the size of the euro area will be correspondingly larger while
the size of the dollar area will probably become smaller. The size of the yen area willprobably not be affected much by the scale of EMU membership.
14. We use annual data for the period from 1990 through 1999. Most data series are taken from the IMF’s
International Financial Statistics and, if necessary, are supplemented by national sources. Data for GDP andtrade flows are converted into dollars at the annual average exchange rate. We have selected only those countries
where data series for GDP and trade flows are available. Transition countries in Central and Eastern Europe andin the former Soviet bloc are under-represented in our sample due to the lack of data over the entire sample
period. Many African countries are also absent in the sample. In terms of economic size, however, our sample of
99 countries covers a substantial amount of global economic activity and trade flows.
15. For this purpose, similar regressions have also been run for non-EMU developed countries. These countries havebeen divided into fractions of G-5 currency areas.
16. Honohan and Lane (1999) claim that the Central and Eastern European countries and former Soviet Union countries
willing to be EU members are expected to stabilize their currencies vis-à-vis the euro if they have not done so already.

176 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002

Table 4 Estimated Size of the Currency Areas for the Dollar, the Yen, and the Euro (Percentage Averages Based on 1990–99 Data)[1] Measured by Gross Domestic Product (GDP) in Current Dollars
Percent; US$ billions in parentheses

World total

Yen
area
15.8
0.0
0.0

0.2

0.0

1.1

26.5
0.0
3.0
18.2
0.9
7.3
2.8
1.6
5.5
47.9
(12,570)

0.0
15.7
0.1
0.9
0.0
0.8
0.0
0.0
0.1
16.7
(4,376)

0.0
0.0
1.6
2.3
0.4
0.9
0.7
0.0
0.3
28.7
(7,523)

Case of Greater EMU
Yen
Euro
U.K. pound
area
area
area
15.8
31.5
0.0
0.0
29.5
0.0
0.0
23.7
0.0

0.1
0.1
0.0

Dollar
area
29.6
0.0
0.0

4.4

0.1

0.0

0.0

5.8

0.0
0.0
0.4
0.5
0.1
0.3
0.1
0.1
0.0
5.4
(1,413)

0.0
0.0
0.0
1.2
0.1
0.3
0.4
0.1
0.3
1.3
(351)

26.5
0.0
3.0
15.6
0.9
7.3
0.3
1.6
5.5
45.2
(11,859)

0.0
15.7
0.1
0.8
0.0
0.8
0.0
0.0
0.1
16.7
(4,374)

0.0
0.0
2.1
5.4
0.5
1.1
3.4
0.1
0.3
36.9
(9,691)

Other

Other

Regional total

0.0
0.0
0.0

76.9 (20,182)
29.5 (7,727)
23.7 (6,214)

0.0

0.0

5.8

0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
(0)

0.0
0.0
0.0
1.2
0.1
0.3
0.4
0.1
0.3
1.2
(309)

(1,513)26.5 (6,962)
15.7 (4,117)
5.2 (1,377)
23.1 (6,050)
1.5
(405)
9.5 (2,492)
4.0 (1,059)
1.9
(491)
6.1 (1,603)
100.0 (26,233)(26,233)

Notes: 1. The EU-12 includes Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain.
Notes: 2. Three other EU members are Denmark, Sweden, and the United Kingdom.
Notes: 3. Greater EMU includes all 15 EU member countries and assumes that Central and European countries in transition (e.g., Hungary, Poland, and Romania)
and the Baltic states stabilize exchange rates to the euro.
(Continued on next page)

177

Exchange Rate Arrangements in East Asia: Lessons from the 1997–98 Currency Crisis

Industrial countries
European Union-15
EU-12
Three other EU
members
United States
Japan
Other
Developing countries
AfricaAsia
EuropeMiddle East
Western hemisphere

Case of EMU
Euro
U.K. pound
area
area
26.4
4.9
24.8
4.4
23.7
0.0

Dollar
area
29.8
0.2
0.0

178 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002

Table 4 (continued)[2] Measured by Total Trade Flows (Exports Plus Imports) in Current Dollars
Percent; US$ billions in parentheses

Industrial countries
European Union-15
EU-12
Three other EU
members
United States
Japan
Other
Developing countries
AfricaAsia
EuropeMiddle East
Western hemisphere
World totalCase of EMU
Euro
U.K. pound
area
area
35.9
6.1
33.6
4.5
31.9
0.0

Dollar
area
18.5
0.3
0.0

Yen
area
7.3
0.0
0.0

0.3

0.0

1.7

14.0
0.0
4.3
24.2
1.1
12.9
2.9
2.8
4.5
42.8
(3,942)

0.0
7.2
0.1
1.8
0.0
1.6
0.0
0.1
0.0
9.1
(835)

0.0
0.0
2.3
3.9
0.5
1.7
1.5
0.1
0.1
39.8
(3,670)Case of Greater EMU
Yen
Euro
U.K. pound
area
area
area
7.3
42.4
0.0
0.0
39.4
0.0
0.0
31.9
0.0

0.1
0.1
0.0

Dollar
area
18.3
0.0
0.0

4.5

0.1

0.0

0.0

7.5

0.0
0.0
0.7
0.8
0.2
0.4
0.1
0.1
0.0
6.9
(634)

0.0
0.0
0.0
1.3
0.2
0.4
0.4
0.2
0.1
1.5
(135)

14.0
0.0
4.3
21.6
1.1
12.9
0.3
2.8
4.5
39.9
(3,674)

0.0
7.2
0.1
1.7
0.0
1.6
0.0
0.1
0.0
9.1
(835)

0.0
0.0
3.0
7.5
0.7
2.1
4.3
0.2
0.1
49.9
(4,596)

Other

Other

Regional total

0.5
0.0
0.0

68.0 (6,267)
39.4 (3,634)
31.9 (2,939)

0.0

0.0

7.5

0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
(0)

0.0
0.0
0.0
1.2
0.2
0.4
0.3
0.2
0.1
1.2
(112)

(695)

14.0 (1,289)
7.2
(662)
7.4
(681)
32.0 (2,950)
2.0
(185)
17.0 (1,569)
4.9
(454)
3.3
(302)
4.8
(440)
100.0 (9,216)(9,216)

Notes: 1. The EU-12 includes Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain.
Notes: 2. Three other EU members are Denmark, Sweden, and the United Kingdom.
Notes: 3. Greater EMU includes all 15 EU member countries and assumes that Central and European countries in transition (e.g., Hungary, Poland, and Romania)
and the Baltic states stabilize exchange rates to the euro.

Exchange Rate Arrangements in East Asia: Lessons from the 1997–98 Currency Crisis

Table 4 summarizes the results of these calculations. The table reports the relative
economic shares for each of the three major currency areas, based on GDP and total
trade flows, for developing as well as developed countries. It shows that choice ofmeasurement—GDP or trade flows—influences the size of the dollar and euro areas.
Taking the case of Greater EMU, the GDP measure indicates that the dollar area is stilllarger than the euro area. For example, 45 percent of the world economy is coveredby the dollar area, 37 percent by the euro area, and 17 percent by the yen area. The
dollar area is large because many developing countries, particularly those in Asia andLatin America, regard the dollar as the most important nominal anchor. The size of thedollar area outside the United States is about 19 percent of the world’s GDP, of which
the developing world accounts for 16 percent. In contrast, the size of the euro area
outside the EU-15 members is 7.5 percent of the world’s GDP, of which the developing world accounts for 5 percent. The yen area’s share (17 percent) is only slightly
bigger than the weight of the Japanese economy in the world (16 percent).17 The yen
area outside Japan is small and accounts for only 1 percent of the world’s GDP, which
underlines the fact that the yen is not a full-fledged, global nominal anchor currency.
The trade flow measure indicates that the euro area will be larger than the dollar
area. The euro area accounts for 50 percent of the world total trade flows, the dollar
area 40 percent and the yen area a meager 9 percent. Interpretation of trade-based
economic size requires caution because the underlying trade flows do not net out
intra-EU trade flows, and the predominance of the euro area measured by trade activity may be exaggerated. Essentially, the relative economic size of the euro area
depends on which economic activity is considered more important to the world as awhole, real economic activity or trade activity.
D. Preference for Exchange Rate Stability in Emerging Market Economies
The results described above reveal that the “observed” exchange rate arrangements arelargely consistent with the “official” exchange rate policies, with some exceptions.
The results also provide several stylized facts and general conclusions about theindividual developing economies’ exchange rate arrangements.
First, many developing countries—including emerging market economies—haveshifted their “official” exchange rate arrangements from “fixed” to “more flexible”
rate regimes. However, they often exhibit preferences toward stable exchange rates
vis-à-vis a single currency or a currency basket. Countries facing large exchange rate
fluctuations against major international currencies were those in the early stage of
economic transition in Eastern Europe or the former Soviet Union or economies
subject to chronically high inflation.
Second, non-East Asian emerging market economies tend to have a “flexible” or“intermediate” arrangement, while the East Asian emerging economies tend tochoose a “pegged” or “intermediate” arrangement. The East Asian economies appear
to exhibit greater preference for exchange rate stability or a greater fear of floating
than their non-East Asian counterparts.
17. These relative share numbers correspond to the figures estimated by other authors such as Bergsten (1997) and
Masson and Turtleboom (1997).

179

Third, the dollar is the most favored anchor currency for exchange rate stabilizationin the developing world. However, significant diversity exists across regions globallyin exchange rate arrangements. For African countries, their major exchange ratestabilization anchors are the euro (formerly the French franc), the dollar, and theSDR. Asian economies generally attempt to stabilize their exchange rates vis-à-vis
the dollar, the SDR, and a few regional currencies. The yen has not played a majoranchor currency role even in East Asia. The transition economies in Central andEastern Europe and the former Soviet Union have not experienced stable exchange
rates or stable arrangements in general, but many of them are expected to eventuallystabilize their currencies to the euro. The Middle East includes countries that havesuccessfully stabilized exchange rates vis-à-vis the dollar and/or the SDR. The wholeof Latin America is a de facto dollar area, and even countries not officially pegging
exchange rates to the dollar do assign significantly positive, and close to unitary,weights to the dollar.
Fourth, a developing country’s choice of anchor currency for exchange ratestabilization depends largely on which currency areas the country tends to trade
with, as well as on the country’s geographical location and its past colonial ties.18
For example, a country that trades heavily with the dollar area tends to choose thedollar as an exchange rate stabilization anchor. By implication, a country that tradeswith several currency areas with more or less equal shares is expected to choose awell-balanced currency basket as its anchor for exchange rate stabilization.

III. The East Asian Exchange Rate Arrangements
In this section, we attempt to identify the exchange rate arrangements that haveprevailed in East Asia, particularly in former crisis countries and the neighboring
emerging economies, before and after the 1997–98 currency crisis. An important task
is to identify factors behind the choice of exchange rate arrangements in the pre-crisis
as well as post-crisis periods.
A. Changes in the Official Exchange Rate Arrangements in East Asia
To identify the exchange rate arrangements in emerging East Asia in the pre-crisisand post-crisis periods, it is useful first to take a look at the official exchange rate
arrangements as published by the IMF. Table 5 summarizes changes in exchange rate
arrangements in not only the former crisis countries—Indonesia, Korea, Malaysia,
the Philippines, and Thailand—but also Japan, China, Hong Kong, Taiwan, andother ASEAN countries.
Table 5 indicates several facts. First, emerging East Asia has exhibited a variety
of exchange rate arrangements, ranging from a currency board system (Hong Kong)
to independently floating (Philippines). In between these two polar cases, there areconventional fixed pegs to a single currency (China and post-crisis Malaysia) or acurrency basket (Singapore and pre-crisis Thailand) as well as managed floating
18. See Kawai and Akiyama (2000) for such empirical evidence.

180 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002

Exchange Rate Arrangements in East Asia: Lessons from the 1997–98 Currency Crisis

Table 5 Official Exchange Rate Arrangements in the East Asian Economies
Pre-crisis and mid-crisis
Article VIII
Post-crisis exchange rateexchange rate arrangements(date accepted)
arrangement (Dec. 2001)(dates of change)
Independently floating
Japan
Apr. 1, 1964
Independently floating(July 1982–present)
Managed floating (June 1982–
Korea
Nov. 1, 1988 Nov. 1997); independently
Independently floating
floating (Nov. 1997–present)
Managed floating (Oct. 1986–Sep.
Conventional fixed peg to the
China
Dec. 1, 1996 1998); conventional fixed peg todollarthe dollar (Jan. 1999–present)
Currency board arrangement withCurrency board arrangement with
Hong Kong Feb. 15, 1961 a peg to the dollara peg to the dollar(Oct. 1983–present)
Managed floating
Taiwan—Managed floating(Apr. 1989–present)
Managed floating (Dec. 1983–
Managed floating with noIndonesia
May 7, 1988
July 1997); independently floating preannounced path for exchange(Aug. 1997–Sep. 2001)
rate (Sep. 2001–present)
Peg to other currency composite(Sep. 1975–June 1993);
Conventional fixed peg to the
Malaysia
Nov. 11, 1968 managed floating (June 1993–
dollarSep. 1998); peg to the dollar(Sep. 1998–present)
Independently floating
Philippines
Sep. 8, 1995
Independently floating(Nov. 1984–present)
Managed floating with noManaged floating
SingaporeNov. 9, 1968preannounced path for exchange(Dec. 1987–present)rate
Peg to other currency composite
Managed floating with no(Nov. 1984–June 1997);
ThailandMay 4, 1990
preannounced path for exchange
independently floating
rate (Sep. 2001–present)(July 1997–Sep. 2001)
Currency board arrangement withCurrency board arrangement
BruneiOct. 10, 1995 a peg to the Singapore dollar
with a peg to the Singapore dollar
Darussalam(Mar. 1996–present)
Managed floating with noManaged floatingCambodiaJan. 1, 2002preannounced path for exchange(June 1993–present)
rateManaged floating (Mar. 1989–
Managed floating with noSep. 1995); independently floating
preannounced path for exchange
Laos
Article XIV(Sep. 1995–June 1997); managed
rate
floating (June 1997–present)
Managed floating with noPeg to the SDR
Myanmar
Article XIV
preannounced path for exchange(Feb. 1975–Dec. 2001)
rate (Dec. 2001–present)
Pegged exchange rate within
horizontal bands (Jan. 1999–
Peg to the dollar (Mar. 1989–
Dec. 2001); managed floating
Mar. 1990); managed floating
Vietnam
Article XIV
with no preannounced path for(Mar. 1993–Sep. 1998)
exchange rate (Dec. 2001–
present)
Country

Note: Information on Taiwan is based on Fischer (2001).
Sources: International Monetary Fund, International Financial Statistics (various issues); Annual
Report on Exchange Arrangements and Exchange Restrictions 2001.

181

(pre-crisis Korea, Indonesia, and Singapore).19 Second, three (Korea, Indonesia, andThailand) out of the five former crisis countries saw a change in their official
exchange rate arrangements in the direction of greater exchange rate flexibility, while
Malaysia moved in the opposite direction. Hong Kong, Singapore, Taiwan, and thePhilippines have maintained identical exchange rate arrangements in the pre- andpost-crisis periods.
However, “official” exchange rate arrangements may not describe the accurate
state and evolution of the exchange rate policies in emerging East Asia, particularly
those in the former crisis countries. First, countries under managed floating (Korea,
Indonesia, and Malaysia) or independently floating (the Philippines) in the pre-crisis
period may have had a regime more akin to pegged arrangements, because otherwise
they would not have been subjected to currency speculation. Second, one may
wonder whether economies, particularly former crisis countries that adopted independent floating in the post-crisis period, have really been floating their exchange
rates. The “fear of floating” argument hypothesizes that despite the officially declaredarrangement, the actual practice of exchange rate management is close to managed or
pegged arrangements. Indeed McKinnon (2001) and others claim that the former
crisis countries have reverted to pre-crisis, dollar-based exchange rate arrangements.
It is thus important to examine the actual behavior of the exchange rates for
emerging economies in East Asia, particularly for former crisis countries, andempirically identify their pre-crisis arrangements and changes in such arrangementsin the post-crisis period by looking at the data in a more detailed way.
B. The Changing Roles of the Dollar, the Yen, and the Euro in East Asia
The hypothesis here is that the roles of the dollar, the yen, and the euro (or its
predecessor) as anchors for exchange rate stabilization have changed since theoutbreak of the East Asian currency crisis. A Frankel-Wei type of regression of daily
movements in each economy’s exchange rate on the movements of the three majorinternational currencies facilitates a convenient comparison of the roles of the tripolar
currencies across major emerging East Asian economies as well as over time.
Similarly to the previous case, the daily—rather than monthly—change in the log
exchange rate of each East Asian currency is regressed on the daily changes in the log
exchange rates of the dollar, the yen, and the euro—or the ECU before the introduction of the euro on January 1, 1999. All exchange rates are again expressed vis-à-vis
the Swiss franc. More specifically, we estimate the following regression equation:∆e tj = α + β1∆e USDt + β 2∆e JYt + β 3 ∆e EUROt + vt ,where ∆e tj is the daily change in the log exchange rate of currency j on day t, α isa constant term, βk (k = 1, 2, . . .) is the coefficient on the daily change in thelog exchange rate of currency k, and vt is the residual term. The superscripts USD,
JY, and EURO, respectively, refer to the dollar, the yen, and the euro. As in the
19. Though not indicated in the table, it is well known that Singapore has been under a currency basket-based
managed floating arrangement since 1985.

182 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002

Exchange Rate Arrangements in East Asia: Lessons from the 1997–98 Currency Crisis

previous case, the estimated coefficients are interpreted as the weights assigned by theauthorities to the corresponding currencies in their exchange rate policies. Similarly,
the estimated standard error of regression residuals can be interpreted as a measureof exchange rate volatility.
Table 6 summarizes the regression results for each emerging economy in East Asia
over the sample period January 1990 through June 2002. The sample is divided
into 18-month sub-samples. The mid-crisis period (July 1997–December 1998) isindicated by the shaded areas.
1. Pre-crisis period
Table 6 confirms that in the pre-crisis period (January 1990–June 1997), theestimated coefficients of the dollar were statistically significant and close to unity, theadjusted R2 was close to one, and the estimated standard error of regression was
small for almost all economies—particularly Hong Kong, Korea, Indonesia, andThailand (for the first half of the 1990s). In the case of Singapore and Malaysia, thedollar coefficients were somewhat lower, though generally greater than 0.75 andhighly significant, due to their formal or informal currency basket arrangements.
In the case of Taiwan, the Philippines, Thailand (for the 18 months prior to thebaht crisis) and China (the first half of the 1990s), the adjusted R2 was somewhat
lower and the estimated standard error of regression somewhat higher. In Thailand,
speculative activity that had begun in 1996 and mounted in February and May 1997
had already affected the currency movement prior to the outbreak of the baht crisis.
These results support the proposition that many emerging East Asian economies
were on de jure or de facto dollar-stabilization arrangements until the time of thecrisis. Nonetheless, the estimated coefficients of the yen were also significant, forsome sub-sample periods, in Singapore, Thailand, Korea, and Malaysia, though thesize of its coefficients rarely exceeded 0.1. In this sense, the yen played a limited roleas part of a currency basket in the pre-crisis period. The euro—more accurately, itspredecessor, the ECU—also played some role in Singapore, Malaysia, and Thailand
due to the nature of their currency basket arrangements, though it was relatively
insignificant in other countries.20
2. Mid-crisis period
Not surprisingly, many former crisis countries in East Asia experienced noticeable
declines in dollar weights and in the adjusted R2 in the mid-crisis period (July
1997–December 1998). This was particularly pronounced in Indonesia andThailand. In the case of Korea, Malaysia, and the Philippines, the estimatedcoefficients on the dollar did not decline noticeably, but the adjusted R2 declined
sharply and the estimated standard error of regression rose sharply.21 Even economies
20. The observed role of the yen and the euro—or the ECU—in a currency basket for some countries such as Singapore,
however, may reflect the fact that the authorities chose the SDR as a target in their exchange rate management. The
yen and the European currencies—making up a major part of the ECU—were important components of the SDR.
21. The less noticeable decline in the dollar coefficient in Malaysia may be explained by the authorities’ move to fix
the Malaysian ringgit to the dollar on September 2, 1998. If the mid-crisis sample period were shortened to, say,
July 1997–August 1998, the decline in dollar coefficients would be more pronounced. A series of three-monthrolling regressions strongly indicates this tendency (see details in the Appendix Table of the working paper version,
downloadable from http://www.imes.boj.or.jp/english/publication/edps/2002/02-E-17.pdf). The rolling regression
procedure allows us to analyze the mid-crisis period more carefully because of regional contagion, delayed currency
attacks (Indonesia and Korea), and large exchange rate depreciations at times of political uncertainty (Indonesia).

183

Table 6 Regression Results of Exchange Rate Movements for Major Emerging East
Asian Economies: Pre-Crisis, Mid-Crisis, and Post-Crisis Periods (Daily Data)[1] Hong Kong Dollar
PeriodConst.

U.S.
dollarYen

Euro

Adj. R2

D.W.

Std-resNo. obs.

Jan. 1990–June 1991

–0.014

0.993**–0.0010.007

0.99731.566

0.000425

389

July 1991–Dec. 1992

–0.0080.998**–0.011

0.006

0.99562.579

0.000597

394

Jan. 1993–June 1994

–0.004

0.995**

0.000

0.003

0.99752.147

0.000358

390

July 1994–Dec. 1995

0.002

0.997**

0.000

0.002

0.99942.018

0.000204

391

Jan. 1996–June 1997

0.004

0.997**

0.009**–0.0070.99772.598

0.000277

391

July 1997–Dec. 1998

0.000

1.001**

0.006*

0.000

0.99382.773

0.000528

393

Jan. 1999–June 2000

0.016**

0.993**

0.001

0.003

0.99982.116

0.000087

390

July 2000–Dec. 2001

0.000

1.004**

0.000–0.0020.99992.054

0.000061

392

Jan. 2002–June 2002

0.002

0.998**

0.000

0.001

0.99992.124

0.000024

124

Const.

U.S.
dollarYen

Euro

Adj. R2

D.W.

Std-resNo. obs.

[2] Korean Won
PeriodJan. 1990–June 1991

0.172

1.004**–0.013–0.0110.93361.968

0.002149

389

July 1991–Dec. 1992

0.210

1.026**–0.016–0.0060.80982.005

0.004458

394

Jan. 1993–June 1994

0.045

1.014**–0.021*–0.002

0.97202.255

0.001208

390

July 1994–Dec. 1995

–0.1270.983**

0.081**–0.045*0.93292.008

0.002205

391

Jan. 1996–June 1997

0.354**

0.960**

0.065**

0.020

0.85831.804

0.002378

391

July 1997–Dec. 1998

0.758

1.149**

0.039

0.084

0.09211.607

0.024301

393

Jan. 1999–June 2000

–0.172

1.044**

0.063*–0.0360.72201.645

0.004023

390

July 2000–Dec. 2001

0.256

0.982**

0.284**–0.0560.75502.107

0.004476

392

Jan. 2002–June 2002

–0.510*0.654*

0.175**

0.101

0.75042.092

0.002783

124

Const.

U.S.
dollarYen

Euro

Adj. R2

D.W.

Std-resNo. obs.

[3] Singapore Dollar
PeriodJan. 1990–June 1991

–0.2120.739**

0.065**

0.199**

0.91672.309

0.002188

389

July 1991–Dec. 1992

–0.1400.758**

0.077**

0.185**

0.94822.309

0.001857

394

Jan. 1993–June 1994

–0.1600.865**

0.049**

0.098**

0.91992.131

0.001960

390

July 1994–Dec. 1995

–0.1890.789**

0.098**

0.117**

0.93832.052

0.001915

391

Jan. 1996–June 1997

–0.0190.798**

0.096**

0.144**

0.92942.167

0.001503

391

July 1997–Dec. 1998

0.381

0.635**

0.342**

0.190*

0.48512.181

0.006911

393

Jan. 1999–June 2000

0.103

1.219**

0.123** –0.194**0.85051.925

0.002547

390

July 2000–Dec. 2001

0.035

0.948**

0.197** –0.089*

0.89751.942

0.002236

392

Jan. 2002–June 2002

–0.1700.610**

0.223**

0.87312.019

0.000346

124

0.064

Notes: 1. Daily exchange rate data, obtained from Datastream, are used for regression analysis.
2. Double asterisks and a single asterisk indicate that the estimated coefficients are statistically significant at
the 1 percent and 5 percent levels, respectively.

184 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002

Exchange Rate Arrangements in East Asia: Lessons from the 1997–98 Currency Crisis

Table 6 (continued)[4] New Taiwan Dollar
PeriodConst.

U.S.
dollarYen

Euro

Adj. R2

D.W.

Std-resNo. obs.

Jan. 1990–June 1991

0.040

0.840**–0.0170.240**

0.46052.849

0.008475

389

July 1991–Dec. 1992

–0.1540.967**

0.033–0.0030.63362.913

0.006803

394

Jan. 1993–June 1994

0.193

1.012**

0.055–0.0190.66642.875

0.005199

390

July 1994–Dec. 1995

0.023

0.948**

0.060*

0.028

0.89562.022

0.002807

391

Jan. 1996–June 1997

0.024

0.946**

0.036–0.0010.82642.734

0.002573

391

July 1997–Dec. 1998

0.382

0.867**

0.090**

0.068

0.56981.702

0.005472

393

Jan. 1999–June 2000

–0.1310.999**–0.007–0.0120.89202.289

0.002128

390

July 2000–Dec. 2001

0.322**

1.019**

0.000–0.0170.90301.799

0.002248

392

Jan. 2002–June 2002

–0.2000.990**

0.109** –0.053

0.93202.475

0.001307124

Const.

U.S.
dollarYen

Adj. R2

D.W.

Std-resNo. obs.

[5] Indonesian Rupiah
PeriodEuro

Jan. 1990–June 1991

0.227

0.962**

0.029

0.030

0.90942.084

0.002555

389

July 1991–Dec. 1992

0.145**

0.997**–0.0060.016

0.99032.292

0.000900

394

Jan. 1993–June 1994

0.131*

0.995**

0.010–0.002

0.97392.044

0.001161

390

July 1994–Dec. 1995

0.153*

0.994**–0.0150.011

0.97102.004

0.001438

391

Jan. 1996–June 1997

0.156*

1.009**

0.001

0.002

0.93722.165

0.001528

391

July 1997–Dec. 1998

2.982

0.512

0.692*–0.0670.01671.961

0.053151

393

Jan. 1999–June 2000

0.290

2.147*

0.270**–0.6430.18801.689

0.015509

390

July 2000–Dec. 2001

0.354

1.423**

0.140–0.1380.33701.719

0.012363

392

Jan. 2002–June 2002

–1.410*

0.289

0.012

0.300

0.28701.752

0.006755

124

Const.

U.S.
dollarYen

Euro

Adj. R2

D.W.

Std-resNo. obs.

[6] Malaysian Ringgit
PeriodJan. 1990–June 1991

0.072

0.892**

0.027**

0.096**

0.97392.207

0.001279

389

July 1991–Dec. 1992

–0.1380.874**

0.025

0.090**

0.94872.006

0.001944

394

Jan. 1993–June 1994

0.004

0.906**

0.001

0.020

0.81701.507

0.003072

390

July 1994–Dec. 1995

–0.0620.869**

0.059**

0.084**

0.95321.970

0.001738

391

Jan. 1996–June 1997

–0.0490.885**

0.034*

0.086**

July 1997–Dec. 1998

1.032

0.883**

0.300** –0.035

0.92262.018

0.001611

391

0.18621.742

0.014911

393

Jan. 1999–June 2000

0.000

1.043**

0.000–0.019**0.99802.943

0.000265

390

July 2000–Dec. 2001

0.000

1.000**

0.000

0.000

1.00003.040

0.000000

392

Jan. 2002–June 2002

0.000

1.000**

0.000

0.000

1.00002.919

0.000000

124(Continued on next page)

185

Table 6 (continued)[7] Philippines Peso
PeriodConst.

U.S.
dollarYen

Euro

Adj. R2

D.W.

Std-resNo. obs.

Jan. 1990–June 1991

0.571

1.054**

0.043–0.0480.6891

2.011

0.005762

389

July 1991–Dec. 1992

–0.363

1.048**–0.1100.101

0.67001.991

0.006458

394

Jan. 1993–June 1994

0.309

0.973**–0.006–0.026

0.61542.013

0.005375

390

July 1994–Dec. 1995

–0.0450.986**

0.062–0.0590.78052.221

0.004306

391

Jan. 1996–June 1997

0.020

1.004**–0.005–0.002

0.99362.202

0.000469

391

July 1997–Dec. 1998

0.998

0.876**

0.285**–0.0220.19241.716

0.014420

393

Jan. 1999–June 2000

0.268

1.410**

0.085**–0.243*0.71901.968

0.006247

390

July 2000–Dec. 2001

0.406

0.779*

0.116

0.093

0.44602.067

0.008187

392

Jan. 2002–June 2002

–0.1500.628*

0.031

0.150

0.74601.947

0.002744

124

Const.

U.S.
dollarYen

Euro

Adj. R2

D.W.

Std-resNo. obs.

[8] Thai Baht
PeriodJan. 1990–June 1991

0.014

0.961**

0.031*

0.023

0.95432.034

0.001766

389

July 1991–Dec. 1992

–0.0170.957**

0.019

0.043**

0.97822.007

0.001334

394

Jan. 1993–June 1994

–0.0370.972**

0.012

0.006

0.97782.040

0.001049

390

July 1994–Dec. 1995

0.017

0.877**

0.069**

0.049**

0.98822.410

0.000848

391

Jan. 1996–June 1997

–0.0530.823**

0.178**

0.154

0.4746

1.978

0.006179

391

July 1997–Dec. 1998

1.014

0.608**

0.311**

0.099

0.10461.877

0.017221

393

Jan. 1999–June 2000

0.178

1.432**

0.130**–0.297*0.6291

1.933

0.008783

390

July 2000–Dec. 2001

0.189

0.971**

0.197**–0.0690.79021.980

0.003625

392

Jan. 2002–June 2002

–0.310*0.697**

0.176**

0.070

0.90301.861

0.001558

124

Const.

U.S.
dollarYen

Euro

Adj. R2

D.W.

Std-resNo. obs.

[9] Chinese Renminbi
PeriodJan. 1990–June 1991

0.317

1.025**–0.0360.007

0.71452.007

0.005179

389

July 1991–Dec. 1992

0.211

1.037**–0.041–0.0320.88892.042

0.003212

394

Jan. 1993–June 1994

1.037

0.969**

0.082

0.064

0.11592.007

0.019926

390

July 1994–Dec. 1995

–0.113*1.030**–0.001–0.030**0.98292.082

0.001116

391

Jan. 1996–June 1997

0.000

1.018**–0.010–0.0120.93352.832

0.001569

391

July 1997–Dec. 1998

–0.0080.996**

0.001–0.0020.99192.471

0.000597

393

Jan. 1999–June 2000

0.000

1.002**

0.000–0.0010.99992.019

0.000033

390

July 2000–Dec. 2001

0.000

0.998**

0.000

0.001

1.00002.326

0.000043

392

Jan. 2002–June 2002

0.000

1.001**–0.001*0.000

1.00002.121

0.000018

124

Notes: 1. Daily exchange rate data, obtained from Datastream, are used for regression analysis.
2. Double asterisks and a single asterisk indicate that the estimated coefficients are statistically significant at
the 1 percent and 5 percent levels, respectively.

186 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002

Exchange Rate Arrangements in East Asia: Lessons from the 1997–98 Currency Crisis

not directly affected by the crisis, such as Singapore and Taiwan, also saw declines inthe dollar coefficients and in the adjusted R2. In the case of Singapore, the central
rates were changed a few times to weather the currency crisis occurring in theneighboring countries. But these changes were much less pronounced than thosefor the former crisis country currencies. Hong Kong and China were relatively
immune to currency speculation as far as the observed movements of spot exchange
rates are concerned.22
As the dollar weights declined in the mid-crisis period, the weights of the yen rosein a significant way in some countries, particularly in Indonesia, Singapore,
Thailand, and Malaysia. The size of the yen coefficients jumped upward to 0.7 inIndonesia and to 0.3 in other countries. Only in Korea and China were the yen
coefficients statistically insignificant. The euro coefficients were relatively unaffectedby the crisis. Generally speaking, the importance of the yen in the currency baskets ofmany countries rose during the crisis, while the euro’s importance did not.
3. Post-crisis period
The results for the post-crisis period (January 1999–June 2002) indicate a greater
diversity in exchange rate arrangements than in the pre-crisis period. A few countries
have returned to the pre-crisis pattern of dollar-based exchange rate arrangement,
while others have departed from the pre-crisis arrangement. At one extreme,
economies under a stable dollar peg throughout the period, such as China and Hong
Kong, have maintained dollar coefficients at levels close to unity, the adjusted R2
close to one, and an estimated standard error of regression even smaller than in the
pre-crisis period. Malaysia returned to a formal dollar-peg arrangement, and theregression result indeed confirms it. Taiwan has been stabilizing the currency tothe dollar in a way tighter than in the pre-crisis period, as judged from a larger sizeof the adjusted R2 and a smaller size of the estimated standard error of regression.
Indonesia is at the other extreme where, despite large coefficients on the dollar
in some post-crisis sub-sample periods, the adjusted R2 is much lower and theestimated standard error of regression much higher than in the pre-crisis period. In
this sense, Indonesia has been maintaining an exchange rate arrangement that is mostakin to freely floating among the emerging East Asian economies, despite the factthat Bank Indonesia has often intervened in the foreign exchange market tosmooth the rupiah/dollar exchange rate. Essentially, Indonesia has not been able
to restore exchange rate stability despite interventions, because of the country’s
difficult economic—and social and political—problems.
In between these two groups, there are countries that exhibit statistically significant
dollar coefficients but with a lower value (the Philippines) or with a lower adjusted R2
22. Though the spot exchange rate data do not reveal it, the Hong Kong dollar was under serious attack in August
1998. The authorities resorted to unorthodox measures to contain speculative pressures, by intervening in thestock market and purchasing HK$118 billion of domestic equities in a period of about two weeks. They intervened in the stock market because speculators shorted the currency and stock markets simultaneously,
hoping to profit from the lower stock prices that could result from high interest rates needed to support theexchange rate under the pressure of short selling the Hong Kong dollar. This intervention was also accompanied
by a variety of regulatory measures, including increases in the cost of speculation in financial markets—tighter
enforcement of rules on short selling and settlement of trades, and higher margin requirements in the futures
markets. Aided by an improvement in the external environment, the intervention eventually succeeded incalming the markets.

187

(Korea, Singapore, Thailand, and the Philippines). What is interesting for thesecountries is that the yen coefficients take values of 0.2–0.3 and are statisticallysignificant, except for the Philippines, and the dollar coefficients in the most recent
sub-sample periods are lower than in the pre-crisis period. For these economies,
one cannot conclude that they have reverted to pre-crisis dollar-based exchange ratestabilization policies or that they have shifted to freely floating exchange rate arrangements. Their exchange rates are more flexible than in the pre-crisis period, but morestable than those of a typical free-floating industrial country. Korea and Thailand, inparticular, appear to have shifted to de facto managed floating with a currency basket
arrangement with a relatively large weight on the dollar (on the order of 0.6–0.7) anda smaller, but significant, weight on the yen (on the order of 0.2–0.3). The observed
pattern of these countries’ de facto basket arrangements is very similar to that ofSingapore, which is known to have maintained a managed float with a currency basket
system. It remains to be seen whether this shift reflects a permanent change in thesecountries’ exchange rate policies or a temporary adjustment of their exchange rates
to the recent rapid yen/dollar rate movements.23
C. Rationale for and Problems of Dollar-Based Stabilization Policy
Despite post-crisis diversity in exchange rate arrangements, the fact is that the dollar
continues to play a dominant anchor currency role in emerging economies in East
Asia.24 The East Asian currencies with a large weight on the dollar in their currency
baskets in the pre-crisis period became overvalued on a real, effective basis due toboth higher domestic inflation than in the United States and the dollar’s appreciation
since mid-1995 vis-à-vis the major industrialized currencies, particularly the yen andthe deutschemark. The emergence of real, effective overvaluation of the currencies
was an important factor behind the mounting speculative pressure that developed in
the foreign exchange market in 1997.25 Hence, the de facto dollar-peg system was oneof the underlying triggers of the currency crisis. The issue is whether the continued
importance of the dollar, including the post-crisis resurrection of the dollar standard(McKinnon [2001]) in some countries, is a desirable and sustainable arrangement for
East Asia. We must discuss the issues of the “peg” and the “dollar” separately.
1. De facto currency stabilization
The first question is why many emerging East Asian economies have chosen de jureor de facto currency stabilization rather than “pure floating.” First, emerging
economies in East Asia preferred exchange rate stability, reflecting their desire to
23. Kawai and Akiyama (2000) and McKinnon (2000, 2001) have observed a reversion of the post-crisis exchange
rate arrangement of emerging East Asia to an arrangement akin to the pre-crisis de facto dollar-based stabilization
policies. Their analyses were based on data until 1999 or early 2000. But, as shown in the text, with longer timeseries data available, one can observe a variety of exchange rate arrangements in post-crisis East Asia, ranging froma dollar hard peg (Hong Kong) and a soft peg (China and Malaysia) to a managed float with currency basket
arrangements (Singapore, Korea, and Thailand), and to freely floating (Indonesia).
24. The relatively high dollar weights observed in the post-crisis regressions, with the exception of Indonesia, may
indicate that the monetary authorities continue to regard the dollar as the most relevant anchor currency for
their exchange rate policies despite their stated objective of free floating (with the notable exception of Malaysia),or that the market is simply driving each country’s exchange rate in parallel with the dollar. Whatever theinterpretation, the dollar continues to play a dominant, reference currency role in the region.
25. This was compounded with weaknesses of the domestic financial institutions, particularly in Thailand, which
triggered the twin crises in the domestic financial system and the external capital account.

188 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002

Exchange Rate Arrangements in East Asia: Lessons from the 1997–98 Currency Crisis

promote trade and FDI for economic growth. Excessive exchange rate movements
under free floating have been considered inappropriate for outward-oriented
economies, because of the harmful impacts on trade, investment, and economic
growth. Small, open, and highly trade-dependent economies, like those in East Asia,
benefit from exchange rate stability through creating predictable environments
for trade- and FDI-driven economic development and growth, and avoiding
regional beggar-thy-neighbor policies of competitive depreciation. McKinnon (2000)
claims that exchange rate stability was an important factor behind the remarkableeconomic performance during the “East Asian miracle” period of the mid-1960s
through the mid-1990s.
Second, the emerging economies in East Asia needed to establish a nominal anchor
due to the lack of credible monetary policy, to rely on foreign currency for externalfinancing due to the so-called “original-sin” hypothesis (Eichengreen and Hausmann[1999] and Hausmann [2001]), or simply to overcome their “fear of floating” (Calvoand Reinhart [2002]). “Original sin” is a situation where emerging economy residents
cannot borrow abroad in domestic currency nor borrow long term, even domestically.
Hence domestic banks and corporations tend to face a currency mismatch or amaturity mismatch or both, thus creating balance-sheet vulnerabilities to sharp
exchange rate changes. Given that hedging instruments—currency futures andoptions—are not fully available in these markets due to the lack of well-functioning
domestic bond markets (McKinnon and Schnabl [2002]), the government tends tostabilize exchange rates to mitigate the potential foreign exchange risk.26
2. De facto dollar-based stabilization
Rapid economic development and growth in the emerging East Asian economies in the
10 years prior to the outbreak of the crisis had been stimulated by their stabilization to
the dollar. In the face of steep yen rate appreciation that began in the mid-1980s, thede facto dollar-pegged system allowed these economies to receive FDI from Japanand to integrate themselves into the regional and global trading system. As Japan
had already been gradually losing its international price-competitiveness in low- to
mid-tech manufacturing products, yen rate appreciation accelerated this process by
forcing Japanese multinational corporations to move their production facilities
to emerging East Asia. From the latter’s perspectives, their exchange rate depreciation
vis-à-vis the yen helped transform them into attractive production bases and platforms,
for Japanese multinationals, to export products to the U.S. and European markets. This
process promoted international division of labor in the manufacturing sector within theregion and helped these economies industrialize and grow, at least until early 1995,
when the yen rate started to depreciate rapidly.
Thus, there is no doubt that the emerging East Asian economies enjoyed large
benefits, for a long time until the mid-1990s, by choosing the dollar as an anchor
for exchange rate stabilization. But it is hard to argue that these economies adopted ade facto dollar peg, expecting such developmental benefits arising from the yen’s
26. In economies like the United States, Japan, or Western Europe, free floating is less harmful, because the financial
markets are deeper and economic systems are more resilient. But emerging market economies with shallow
financial and currency markets have limited ability to absorb large exchange rate fluctuations. For these reasons,the authorities in the emerging market economies have preferred some degree of exchange rate stability.

189

appreciation. So the next question is why the East Asian economies have chosen
the dollar as an anchor currency for exchange rate stabilization. Several reasons canbe given.
First, the dollar has been chosen because it has been used extensively as an
invoicing currency for international trade and as a vehicle currency for foreignexchange transactions in East Asia and in other parts of the world.27 For each East
Asian economy, stabilizing the value of its trade and transactions in terms of the dollar
was a reasonable policy given that its neighbors and many other countries in the world
willingly used the dollar for trade invoicing and foreign exchange market transactions.
Second, because the bond and forward exchange markets have not been developed
adequately in emerging East Asia, governments have been induced to provide an
informal hedge by stabilizing the exchange rate against the dollar. Considering therisk of exchange rate fluctuations, the reliance on the dollar made sense, because
forward transactions were more active—though still limited—in the dollar markets
than in markets for other currencies.
Third, a dollar-based system was an arrangement that implicitly guaranteed
intra-regional exchange rate stability for the East Asian economies. Several authors havenoted that the de facto dollar-based system has helped promote intra-regional exchange
rate stability, an important policy objective for a highly interdependent region such as
East Asia (Bayoumi et al. [2000] and McKinnon [2000]). The arrangement essentiallyprevented, at least until the 1997–98 crisis, harmful beggar-thy-neighbor exchange ratecompetition, thereby ensuring environments conducive to outward-oriented economic
growth for the region as a whole.
3. Problems of dollar-based stabilization
Even though some degree of exchange rate stability is desirable for the emerging East
Asian economies, there are several problems associated with choosing the dollar as thesole nominal anchor currency in these economies.
First, using the dollar as the sole anchor is problematic given that the emerging
East Asian economies have diverse economic relationships with the United States,
Japan, and the EU through trade (exports and imports), FDI inflows, and otherforms of capital flows. For emerging East Asia, the United States is no longer themost dominant economic partner and the relative importance of Japan and the EU is
as large as, and in some cases much larger than, that of the United States. The UnitedStates accounts for 18 percent, while Japan and the EU respectively account for
17 percent and 14 percent, of emerging East Asia’s trade (Table 7). Japan and theUnited States are comparable partners as an FDI source country (Table 8).
Second, against the benefit of intra-regional exchange rate stability guaranteed by
the informal dollar-based arrangements, there is a cost in terms of excessive movementsin effective exchange rates induced by yen/dollar rate fluctuations. When the yen began
to depreciate vis-à-vis the dollar in the spring of 1995, emerging East Asian economies
saw their international price-competitiveness deteriorate. Growth driven by Japanese
FDI inflows began to lose its momentum. In addition, yen depreciation dampened real
27. Commodities and primary products exported by many developing countries tend to be priced in the dollar in
the global markets.

190 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002

Exchange Rate Arrangements in East Asia: Lessons from the 1997–98 Currency Crisis

Table 7 Regional Breakdown of East Asian Trade, Average for 1990–98(Percentage Share of Total)[1] Exports
Percent
Exporters/
Exports toBrunei Darussalam
Cambodia
Indonesia
Laos
Malaysia
MyanmarPhilippines
Singapore
Thailand
Vietnam
China
Hong Kong
Korea
Taiwan
ASEAN
EA-14
EA-14 and Japan

ASEAN
21.1
56.8
14.2
46.5
28.2
22.2
10.1
26.1
17.3
20.3
6.3
6.6
12.4
11.7
22.1
13.6
13.8

Other
East Asia
16.3
5.5
16.6
5.3
13.6
20.4
11.4
17.2
11.0
18.1
35.4
36.2
16.4
22.6
14.9
23.7
23.2

EA-14

Japan

37.4
62.3
30.8
51.9
41.7
42.6
21.5
43.2
28.3
38.4
41.7
42.8
28.8
34.3
37.0
37.2
37.0

55.6
6.7
29.3
10.7
13.2
7.4
17.0
7.7
16.5
24.4
16.7
5.7
14.0
11.0
15.4
12.9
8.3

EA-14
United European Rest ofand Japan States
Union the world
93.0
2.7
2.2
2.1
69.0
6.0
18.6
6.4
60.1
13.8
14.5
11.5
62.6
2.6
18.0
16.8
54.9
19.2
14.8
11.0
50.0
7.2
8.4
34.4
38.5
36.5
18.2
6.7
50.9
19.6
14.4
15.1
44.8
20.7
18.2
16.3
62.8
2.0
12.2
23.0
58.4
15.1
12.2
14.2
48.5
22.7
16.1
12.7
42.8
21.4
12.8
23.0
45.2
27.0
15.0
12.8
52.4
19.1
15.2
13.3
50.1
20.7
14.5
14.6
45.4
23.7
15.6
15.3

World
total
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0

EA-14
United European Rest ofand Japan States
Union the world

World
total

[2] Imports
Percent
Importers/
Imports from

ASEAN

Other
East Asia

EA-14

Japan

Brunei Darussalam

41.5

6.3

47.8

10.8

58.6

14.0

21.4

6.0

100.0

Cambodia

57.5

13.6

71.2

9.9

81.1

1.6

9.7

7.6

100.0

Indonesia

11.5

15.6

27.2

22.1

49.2

11.8

20.2

18.7

100.0

Laos

61.8

8.8

70.6

9.4

80.0

0.5

3.7

15.8

100.0

Malaysia

19.9

13.7

33.7

24.9

58.5

16.6

14.2

10.6

100.0

Myanmar

41.7

31.6

73.2

9.5

82.7

1.4

9.0

7.0

100.0

Philippines

11.3

17.6

28.9

21.2

50.1

19.5

11.0

19.4

100.0

Singapore

21.2

13.9

35.2

20.0

55.2

16.3

13.4

15.1

100.0

Thailand

13.1

13.0

26.1

28.4

54.6

12.1

15.2

18.2

100.0

Vietnam

28.4

26.4

54.8

9.9

64.7

1.0

10.2

24.0

100.0

China

7.0

29.2

36.1

19.5

55.6

11.7

15.0

17.7

100.0

Hong Kong

9.1

50.7

59.9

15.2

75.1

7.6

10.3

7.0

100.0

Korea

8.0

7.5

15.5

23.0

38.5

22.2

13.1

26.2

100.0

Taiwan

9.9

7.9

17.7

28.5

46.2

21.0

14.9

17.8

100.0

ASEAN

18.0

14.6

32.7

22.6

55.2

14.8

14.5

15.5

100.0

EA-14

12.1

22.5

34.6

21.4

56.0

14.6

13.5

15.8

100.0

EA-14 and Japan

12.7

21.5

34.2

15.3

49.4

17.0

13.8

19.8

100.0

Note: Other East Asia includes China, Hong Kong, Korea, and Taiwan. The EA-14 includes ASEAN and Other East Asia.
Source: Kawai and Takagi (2000). Constructed from International Monetary Fund, Direction of Trade Statistics.
(Continued on next page)

191

Table 7 (continued)[3] Total Trade (Exports Plus Imports)
Percent
Trading economies/
Trade with

ASEAN

Other
East Asia

EA-14

Japan

EA-14
United European Rest ofand Japan States
Union the world

World
total

Brunei Darussalam

30.2

11.8

42.0

36.4

78.4

7.3

10.4

3.9

100.0

Cambodia

58.8

10.6

69.4

9.0

78.4

3.5

11.6

6.5

100.0

Indonesia

12.9

16.2

29.1

26.0

55.1

13.0

17.1

14.8

100.0

Laos

55.3

7.6

62.9

11.1

74.0

1.2

8.5

16.3

100.0

Malaysia

24.0

13.6

37.7

19.0

56.6

17.9

14.6

10.8

100.0

Myanmar

34.8

27.8

62.6

8.7

71.3

3.3

8.7

16.6

100.0

Philippines

10.8

15.1

25.9

19.5

45.4

26.3

13.9

14.3

100.0

Singapore

23.5

15.5

39.1

14.1

53.1

17.9

13.9

15.1

100.0

Thailand

15.1

12.1

27.2

23.0

50.2

16.0

16.6

17.3

100.0

Vietnam

24.8

23.0

47.8

16.3

64.1

1.4

11.0

23.5

100.0

China

6.6

32.4

39.0

18.1

57.1

13.5

13.5

15.9

100.0

Hong Kong

7.9

43.7

51.6

10.6

62.1

15.0

13.1

9.8

100.0

Korea

10.1

11.9

22.0

18.6

40.6

21.7

13.0

24.6

100.0

Taiwan

10.8

15.6

26.5

19.2

45.7

24.2

15.0

15.1

100.0

ASEAN

19.9

14.7

34.7

19.1

53.8

16.9

14.8

14.5

100.0

EA-14

12.8

23.1

35.9

17.2

53.0

17.7

14.1

15.2

100.0

EA-14 and Japan

13.3

22.4

35.6

11.7

47.3

20.5

14.8

17.5

100.0

Note: Other East Asia includes China, Hong Kong, Korea, and Taiwan. The EA-14 includes ASEAN and Other East Asia.
Source: Kawai and Takagi (2000). Constructed from International Monetary Fund, Direction of Trade Statistics.

Table 8 FDI Inflows to East Asia, 1990–98
US$ millions, percentage of total
RecipientsASEAN1
Investors
57,693
Japan(19.2)
35,082
United States(11.7)
40,375
Europe2(13.4)
27,493ASEAN(9.1)
46,731Other East Asia3(15.5)
Total, including
301,074
others(100.0)

China

Korea

TaiwanTotal

29,715(5.5)
42,658(7.9)
27,311(5.1)
33,421(6.2)
336,132(62.4)
538,477(100.0)2,769(10.5)
9,331(35.3)
8,935(33.8)
3,271(12.4)
551(2.1)
26,422(100.0)4,935(22.7)
3,885(17.8)
2,484(11.4)
1,108
(5.1)
1,571
(7.2)
21,778(100.0)95,112(10.7)
90,956(10.3)
79,105(8.9)
65,293(7.4)
384,985(43.4)
887,751(100.0)Notes: 1. 1991–98 for Brunei and Vietnam, 1992–98 for the Philippines, and 1994–98 for Cambodia.
Notes: 2. These figures underestimate the actual volumes, because some countries with small
volumes are not included.
Notes: 3. Hong Kong, Korea, and Taiwan only.
Source: Kawai and Takagi (2000). Constructed from ASEAN Secretariat, ASEAN Investment Report
1999: Trends and Developments in Foreign Direct Investment, Jakarta, 1999; Japan External
Trade Organization.

192 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002

Exchange Rate Arrangements in East Asia: Lessons from the 1997–98 Currency Crisis

economic activity in relatively advanced emerging East Asian economies (such as Korea,
Taiwan, and Malaysia) that competed against Japan in third markets in the UnitedStates and Europe. If the yen had continued to experience the “ever higher yen syndrome” (McKinnon and Ohno [1997]), then exchange rate stabilization vis-à-vis thedollar would have been attractive to emerging East Asia. Once the yen/dollar exchange
rate became volatile, however, dollar-based exchange rate regimes began to produce
wide fluctuations of economic activity, severely limiting its benefits. The reason for theclose association between yen/dollar exchange rate movements and the real economic
activity of some emerging East Asian economies (Kwan [2001]) is that they not only
trade with Japan, but also compete with Japan in third markets in certain products.
The diverse economic linkages of emerging East Asia with the rest of theworld suggest that exchange rate stabilization vis-à-vis the dollar alone is not the bestpolicy. Rate stabilization vis-à-vis a well-balanced currency basket comprising thedollar, the yen, and the euro is a more reasonable option. The reason is that exchange
rate stabilization against a currency of one major trading partner means the lackof exchange rate stability against currencies of other major trading partners aslong as the exchange rates of these major countries fluctuate in a volatile way. A
currency basket arrangement ensures relative stability of a country’s effective exchange
rates vis-à-vis major trading partners.28 This approach offers a better buffer to an
economy’s exposure to yen/dollar and dollar/euro exchange rate volatility.29

IV. Future of East Asian Exchange Rate Arrangements
A. Options for Possible Arrangements
While the popular “two-corner solution” view gives exclusive attention to the objective of crisis prevention, emerging market economies can pursue other legitimate
objectives such as growth, trade, and investment promotion through their use of
exchange rate policy.30 A desirable option for many emerging market economies,
including those in East Asia, would be neither a pure float because of the potential
for excessive volatility and misalignment and the pervasive “fear of floating,” nor ahard peg except in a very small open economy like Hong Kong.
In view of the impossibility of any country achieving a trinity of simultaneous
exchange rate stability, monetary policy autonomy, and free mobility of capital, theauthorities must make a desirable trade-off. Given the open capital account in mostof emerging East Asia (except in China), a desirable trade-off would be to ensure acertain degree of monetary policy autonomy and a certain degree of exchange rate
28. As discussed in Kawai and Akiyama (2000), an economy that has diversified trade and FDI relationships with the
major currency areas has strong potential for choosing a well-balanced currency basket.
29. A basket system would have preserved more stable effective exchange rates at the time when the dollar began toappreciate in the spring of 1995, without resulting in a loss of international price-competitiveness or an
overvaluation of currencies in emerging East Asia.
30. Adoption of the “two-corner solution” approach (Eichengreen [1994], Obstfeld and Rogoff [1995], and Fischer[2001]) would be unrealistic, with a few exceptions for truly small, open economies—e.g., Hong Kong andBrunei in the case of East Asia. As has been claimed by Frankel (1999), no single-currency regime is suitable forall countries at all times.

193

stability. In China, where capital account transactions are still limited, the authorities
can pursue both stable exchange rates and relatively autonomous monetary policy.
Numerous proposals have been made on the choice of exchange rate arrangements
for East Asia, including the dollar standard (McKinnon [2001], McKinnon and
Schnabl [2002], and Mundell [2001]), a G-3 currency basket system (Williamson[1999a, b, 2000, 2001], Kawai and Akiyama [2000], Kawai and Takagi [2000],
Ogawa and Ito [2000], French and Japanese Staff, Ministries of Finance [2001], andIto [2001]), and regional monetary union (Wyplosz [2001]).
A proposal for the dollar standard emphasizes the advantage for the emerging East
Asian economies to use the existing, most dominant international currency in theregion, i.e., the dollar, while minimizing the yen/dollar exchange rate fluctuations.
The dollar standard is a formalization of the long-standing de facto arrangement,
is simple and transparent, and involves no additional cost in ensuring both interregional and intra-regional exchange rate stability. However, the dollar standard
would result in undesirable fluctuations in effective exchange rates as long as yen/dollar exchange rate fluctuations continue.
The G-3 currency basket system proposal claims that linking the central rate of acountry’s national currency to a basket of major G-3 currencies, i.e., the dollar, theyen, and the euro, rather than the dollar alone, is more desirable. The tightness of
the link and the currency weights may initially be left to each country’s choice, withthe possibility for closer coordination as the authorities increasingly realize theimportance of intra-regional exchange rate stability. The virtue of this system is that
it would prevent excessive fluctuations in effective exchange rates in the face ofvolatile yen/dollar or euro/dollar rate movements, while allowing their currency someflexibility to move within a certain range.
Opponents of a G-3 currency basket system claim that it treats the yen asymmetrically relative to other East Asian currencies, thus providing the Bank of Japan
with the ability to pursue an independent monetary policy, without paying formal
attention to the need for a stable value of the yen. To the extent that this special
position of Japan may jeopardize the goal of intra-regional exchange rate stability,
Japan may also be encouraged to stabilize the external value of the yen.
In the spirit of regional cooperation, a more symmetric approach may be taken,e.g., an Asian Monetary System (patterned after the European Monetary System[EMS]) or even East Asia’s own Economic and Monetary Union in the more distantfuture. Advocates of regional monetary union would claim that in the long run, oneof the corner solutions of the “two-corner solution” approach—that is, introducing acommon currency through coordinated regional integration—may be feasible andeven desirable from optimal currency area criteria.31
Such an approach makes sense, but only in the long run. The region may
eventually develop a common currency arrangement, like the euro in Europe.
31. For example, Bayoumi and Eichengreen (1994) found that Northeast Asia (Japan, Korea, and Taiwan) andSoutheast Asia (Hong Kong, Indonesia, Malaysia, Singapore, and perhaps Thailand), in addition to Northern
Europe (but not the entirety of Western Europe), were respectively plausible candidates for monetary union.
Bayoumi et al. (2000) concluded that in terms of preparedness for monetary union, Asia in 1995 was not muchdifferent from Continental Europe in 1987. But the lack of political commitment and institutional capacity
would make such a move difficult in the short to medium term.

194 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002

Exchange Rate Arrangements in East Asia: Lessons from the 1997–98 Currency Crisis

A common currency arrangement, however, cannot be expected to emerge in
the near future, because of the absence of political commitment within the region, of
formal region-wide trade arrangements, and of convergence in macroeconomic
and structural underpinnings. A common currency would require a substantiallycloser coordination of economic policies and a much greater and sufficiently
sustained buildup of institutional infrastructure.
B. A Currency Basket System for Emerging East Asia
Though formation of regional monetary union may be desirable in the long run, amore realistic approach for emerging East Asia would be to shift to a currency basket
system now, thereby absorbing the impact of yen/dollar volatility on their economies,
and then to start institution building, strive for deeper economic interdependence,
and achieve the convergence needed for future monetary integration.
Under a currency basket arrangement, a reasonable choice of anchor for exchange
rate stabilization is a currency basket that includes the dollar, the yen, and the euro ina more balanced way than in the pre-crisis period. Actual currency weights in thebasket will depend on the relative importance of the United States, Japan, and the EU
as trade partners and FDI sources for each East Asian economy, future expectationsof trend movements of the yen/dollar exchange rate, and the success of the newly
introduced euro. The extent of exchange rate stability also depends on each economy’s
specific conditions and preferences.
1. Intra-regional exchange rate stability
The East Asian region has long enjoyed a market-driven integration process throughinternational trade and FDI within the frameworks of the General Agreement on
Tariffs and Trade (GATT)/World Trade Organization (WTO) and the Asia-Pacific
Economic Cooperation (APEC). The rising intra-regional interdependence throughtrade and investment suggests that economies in the region can benefit from avoiding
large fluctuations in intra-regional exchange rates. This is particularly the case for themembers of the Association of Southeast Asian Nations (ASEAN), which began toimplement the ASEAN Free Trade Agreement (AFTA) in January 2002 by lowering
tariffs on manufactured products below 5 percent.
Essentially, large swings in exchange rates among closely interdependent
economies would be counterproductive, because they would alter international
price-competitiveness suddenly and make the prospective free trade agreement
unsustainable. One way to maintain stable currencies within East Asia is to adopt
similar currency baskets consisting of the dollar, the yen, and the euro and to loosely
stabilize their exchange rates to such baskets. This does not require formal agreements on common baskets or frequent, concerted joint actions in the foreignexchange markets. Instead, the members have only to choose similar baskets. As thedegree of intra-regional integration becomes deeper, however, more concerted actionsin the area of exchange rate, monetary, and fiscal policies may be called for. And
the choice of a “common” currency basket on a formal basis, or even adoption of acommon currency unit, may become desirable.32
32. See Williamson (1999a, b, 2000).

1952. Consistency with inflation targeting
Monetary authorities in general cannot pursue simultaneously both nominal
exchange rate and inflation targets, when the capital account is open. However, if
inflation targeting is defined as a policy of achieving a weighted average of inflation
rates of the United States, Japan, and the EU and if nominal exchange rate targetingis defined as a policy of stabilizing the nominal exchange rate vis-à-vis a basket of thedollar, the yen, and the euro, then these two policies are in fact one and the same aslong as the same weights are chosen for inflation and exchange rate targeting, at leastin the long run when purchasing power parity (PPP) tends to hold.33
Nominal exchange rate targeting has one added advantage over inflation targetingcum free floating: by removing the problems associated with a floating rate regime—
short-run volatility and medium-run misalignment of exchange rates—a policy of
nominal exchange rate targeting (with some bands) can better ensure exchange
rate stability in a manner consistent with inflation targeting (with some bands). Thisis particularly the case for East Asia, where the economies are small and relatively
open, so that domestic price inflation tends to reflect international price movements.
In essence, a loose peg to a basket of the tripolar currencies can ensure stabilizationof intra-regional exchange rates, while maintaining a targeted range of inflation rates.
3. A coordinated move to a currency basket system
Even when a currency basket system is desirable, it is not easy for any single emerging
East Asian economy to move away unilaterally from the existing dollar-based
arrangement to a new arrangement in which the relative weight of the dollar issmaller and those of the yen and euro larger.34 The reason is that when neighboring
countries stabilize their exchange rates primarily against the dollar, each economy
may not have sufficient incentive to unilaterally alter its own exchange rate policy.
Essentially, the situation is one of a less desirable equilibrium due to a coordination
failure.35 This demonstrates the potential importance of collective action on the partof emerging East Asia. A coordinated simultaneous move to a currency basket system
will result in a more desirable equilibrium situation (Ogawa and Ito [2000]).
At least initially, exchange rate policy coordination would simply require emerging
economies in the region to adopt a similar currency basket as an anchor. The
operation of the regional currency basket arrangement requires less formality andgreater flexibility than the EMS of 1979–98 did in Europe, because the proposedcurrency basket arrangement including currencies that are external to the region—in
contrast to internal currencies in the case of Europe’s ECU—does not immediately
demand a formal structure of monetary policy and exchange rate coordination. Thisconsideration is important, given the current lack of a commitment to full-fledged
regional financial cooperation in East Asia, the diversity in the level of economic
and financial developments across countries, the dynamic nature of East Asian
33. See Kawai and Takagi (2000).
34. Honohan and Lane (1999) emphasized the existence of strategic interdependence in the choice of exchange rate
regimes for neighboring countries that compete for exports in third markets and for FDI inflows.
35. Williamson (1999a) has characterized this informal dollar-based arrangement as a classic collective action
problem, whereby each country is compelled to stay close to the dollar because of fears that appreciation vis-à-vis
the dollar would weaken its competitiveness against its regional competitors.

196 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002

Exchange Rate Arrangements in East Asia: Lessons from the 1997–98 Currency Crisis

economies with rapid structural changes, and possibly differing inflationary
tendencies. Economies with different rates of inflation and productivity growth can(and are expected to) adjust the central rates with respect to the basket differently
over the medium term. In the absence of sufficient convergence, adjustment for
inflation and productivity growth differentials may be just as important as the choiceof the basket itself.
On a deeper level, as the region becomes more integrated and hence more
prepared, in terms of both economic criteria and political climate, for a morepermanent commitment to economic and monetary union, greater efforts should
be made to build institutions capable of supporting such a commitment. Given
the possible endogeneity of the optimum currency area criteria (Frankel and Rose[1998]), the process can be self-promoting.
C. Regional Financial Cooperation
Given deepening interdependence of the East Asian economies through trade andinvestment, intra-regional exchange rate stability, possibly supported by a regional
currency basket arrangement, calls for a stronger form of financial cooperation
among the authorities in the region. One country’s exchange rate adjustment canhave serious, competitive implications for its neighboring countries—hence a needfor cooperative behavior. Another good reason for regional cooperation is the factthat crisis contagion tends to be concentrated within a region, as evidenced during
the 1997–98 crisis.
Initiatives to strengthen regional financial cooperation in East Asia can be broken
down into two broad categories: financing arrangements and policy dialogue.36
1. Financing arrangements
The experience of the 1997–98 crisis has convinced many economies in East Asia
that the role of the IMF as an international lender of last resort is limited and that a
regional financing facility can play a useful, complementary role for crisis prevention
and management, through timely and adequate provision of international liquidity
in the face of currency attack, contagion, and crisis.
Inspired by the successful financial support package for Thailand in August 1997,
Japan, with support from Korea and the ASEAN countries that participated in theThai package, proposed to establish an Asian Monetary Fund (AMF) to supplement
IMF resources for crisis prevention, management, and resolution. However, theUnited States and the IMF opposed this proposition on the grounds of moral hazard
and duplication. They argued that an East Asian country hit by a currency crisis
might bypass the tough conditionality of the IMF and receive easy money fromthe AMF, thereby creating potential for moral hazard, and that an AMF would be
redundant in the presence of an effective global crisis manager, the IMF.
Although an AMF was not created, the East Asian economies agreed on the Chiang
Mai Initiative (CMI) in May 2001. The CMI has two components: strengthening thelong-standing ASEAN Swap Arrangement by extending its membership to all ASEAN
members and increasing the size of swap arrangements; and creating a new network of
36. See Kuroda and Kawai (2002).

197

bilateral swap and repurchase arrangements for the ASEAN+3 members, including
China, Japan, and Korea. The initiative is currently in progress; several bilateral swap
agreements have been concluded and several negotiations are underway (Table 9).
The basic framework and main principles of bilateral swap arrangements (BSAs)
under the CMI include linkages to the IMF, maturity, and interest. For example,
countries can borrow liquidity collateralized by domestic currencies with government
guarantees, rather than offering U.S. Treasury bonds as collateral. Members requesting liquidity support can immediately obtain short-term financial assistance for the
first 10 percent of the BSA facility without IMF programs, while the remaining
90 percent is provided to the requesting member under an IMF program or an
activated contingent credit line. The linkage to IMF conditionality is designed toaddress the concern that the problems leading to balance of payments difficulties may
be fundamental in nature and that the potential moral hazard problem could be
non-negligible.37 These main principles, including the issue of IMF linkages, will
be reviewed in May 2004.
Table 9 Progress on the Chiang Mai Initiative (As of June 2002)
Bilateral swap arrangement
Japan–Korea
Japan–Thailand
Japan–Philippines
Japan–Malaysia
China–Thailand
Japan–China
China–Korea
Korea–Thailand

Currencies
Dollar/won
Dollar/baht
Dollar/peso
Dollar/ringgit
Dollar/baht
Yen/renminbi
Renminbi/won
Dollar/won or
Dollar/baht

Conclusion dateJuly 4, 2001
July 30, 2001
Aug. 27, 2001
Oct. 5, 2001
Dec. 6, 2001
Mar. 28, 2002
June 24, 2002

Size
US$7 billion†
US$3 billion
US$3 billion
US$3.5 billion†
US$2 billion
US$3 billion equivalent
US$2 billion equivalent

June 25, 2002

US$1 billion

Korea–Malaysia
Korea–Philippines
Japan–Singapore
Japan–Indonesia

Under negotiation
Under negotiation
Under negotiation
Under negotiation

China–Philippines
China–Malaysia

Under negotiation
To be negotiated in the near future

Note: The daggers indicate that the dollar amounts include the amounts committed under the New
Miyazawa Initiative, US$5 billion for Korea, and US$2.5 billion for Malaysia.
Source: Kuroda and Kawai (2002).

2. Policy dialogue processes
Regional policy dialogue processes are instrumental to the effective functioning ofregional financing arrangements. Several forums have been developed for regional policy
dialogue and economic surveillance. Three major initiatives include the ASEAN+3
Framework, the Manila Framework, and the Executive’s Meeting of East Asia-PacificCentral Banks (EMEAP). In addition to these, there are other forums, including thosefor trans-regional policy dialogue under APEC and the Asia-Europe Meeting (ASEM).
37. The swap is for a period of 90 days, renewable up to seven times, at an interest rate equivalent to the London
interbank offered rate (LIBOR) plus 150 basis points for the first drawing and first renewal. Thereafter, thepremium rises by 50 basis points every two renewals, subject to a maximum of 300 basis points.

198 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002

Exchange Rate Arrangements in East Asia: Lessons from the 1997–98 Currency Crisis

The common objective of these processes is to strengthen policymaking capacity
through information exchanges, peer reviews, and recommendations for action at theregional and national levels. For this purpose, each group monitors global economic
conditions, regional economic developments, capital flows, exchange rates, financialsector conditions, and macroeconomic structural and social policies. Monitoring andanalysis of the regional macroeconomic and structural conditions are indispensable
both for crisis prevention, because of the need to implement corrective policies, andfor crisis financing, because of the need to identify causes of a crisis and formulate
appropriate policy responses.
The ASEAN+3 Economic Review and Policy Dialogue (ERPD) process is the mostimportant among these, particularly given the introduction of the CMI. Its purpose is
to strengthen policy dialogue, coordination, and collaboration on the financial andmacroeconomic issues of common interest, focusing initially on issues related tomacroeconomic risk management, monitoring of regional capital flows, strengtheningof the banking and financial systems, better corporate governance, reform of theinternational financial architecture, and enhancing self-help and support mechanisms
in East Asia. Steps have been taken for cooperation in monitoring short-term capital
flows and developing a regional early warning system to assess regional financial
vulnerabilities, with a view to preventing financial crises in the future.
D. Internationalization of the Yen
For the successful functioning of a currency basket system, and more broadly forregional financial stability, the role of the yen must be increased. For greater international use of the yen, sufficient incentives must be provided to the private sector inusing the yen for international trade, investment, finance, and foreign exchangetransactions. A greater role of the yen can in turn induce regional central banks toadopt a currency basket system.
Ideally, the yen would improve its international status and play a regional key
currency role in a tripolar international monetary system. In reality, as has been
discussed in Section II, the international role of the yen has been quite limited.
The dollar continues to play a dominant role as the key global currency, reflecting
not only the robust economic performance of the U.S. economy in the 1990s
but also the dollar’s historical role and inertia. The euro is emerging as the No. 2
international currency.
The dollar accounts for close to 50 percent of international bonds issued, morethan 40 percent of commercial banks’ external assets, almost 90 percent of foreignexchange transactions in the global market, and 66 percent of foreign exchange
reserves held. The euro accounts for about 30 percent of international bonds issued,
27 percent of commercial banks’ external assets, almost 40 percent of foreignexchange transactions, and only 12 percent of foreign exchange reserves. In contrast,
the yen accounts for less than 10 percent of international bonds issued and commercial banks’ external assets, 23 percent of foreign exchange transactions, and 5 percent
of foreign exchange reserves. While the yen’s invoicing share of Japanese trade with
Asia has risen in the second half of the 1990s, the international status of the yen isstill too low to allow a tripolar monetary system to emerge.

199

Several steps can be taken to increase the attractiveness of the yen for internationaluse. The first is to resume strong economic growth in Japan and regain market
confidence in its economy, which has been undermined during the past 10 years of
economic stagnation and price deflation. Priorities should be given to restoring thesoundness of the financial system through acceleration of the disposal of nonperforming loans, enhancing total factor productivity growth through structuralreform—in particular, deregulation—and ensuring sustainability of the nation’s
public finance through fiscal consolidation.
Second, further opening and liberalization of the Japanese economy that
contributes to larger volumes of its trade with the rest of the world would naturally
increase the trade-invoicing role of the yen. Japan’s trade as a share of GDP, which
is currently one of the lowest among the OECD countries, needs to be increased
substantially. In addition, further integration of the Japanese economy with emerging
East Asia would further encourage intra-industry trade and the associated use of
the yen. In manufacturing products, currently 50 percent of Japan’s exports to, and28 percent of its imports from, Asia are invoiced in the yen, and the yen invoicing
ratios are also high for trade with Europe. These shares, though still low comparedwith those of the United States and Germany, are much higher than those for Japan’s
overall trade denominated in the yen. Greater manufacturing trade with Asia andEurope will lead to greater use of the yen as a trade-invoicing currency.
Third, deeper foreign exchange and capital markets can induce the yen to serve as
an attractive investment currency. In the Tokyo foreign exchange market, for instance,
direct yen/euro trade comprises only one-fifth of euro/dollar trades in terms ofvolume. Development of direct transactions between the yen and non-dollar
currencies, particularly the euro and East Asian currencies, can increase the role of theyen in the foreign exchange market. The recent approval of the Korean authority toallow Japanese banks to trade yen/won in Japan is a step in this direction. In addition,liquid and deep capital markets can encourage yen-denominated investment andfinancing, where risks are easily diversified. A number of measures have been taken
in Japan to improve the efficiency of the capital market in recent years, following
the “financial Big Bang.” These attempts include rationalization of stock exchanges,
corporatization and listing of the Tokyo Stock Exchange, introduction of withholding
tax exemption for Japanese government bond (JGB) interest payments on nonresidents, a review of the syndicate underwriting system for JGBs, and an attempt toshorten the JGB settlement period to T+1.
In the foreseeable future, the role of the dollar will continue to be significant,because of the effects of inertia and history. Nonetheless, there still is room for the yen
to play a more important role as an international nominal anchor currency in East
Asia. The yen may come to share the nominal anchor role with the dollar in East Asia,
in the sense of receiving greater weights assigned by the East Asian authorities intheir currency basket policies.38
38. Hence, the yen’s role in East Asia will not be as distinct as the one that was played by the deutschemark in the
EMS. Even in Western Europe, however, the nominal role of the deutschemark appears to have been shared by
the French franc and the ECU during the EMS period (Kawai and Akiyama [1998]).

200 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002

Exchange Rate Arrangements in East Asia: Lessons from the 1997–98 Currency Crisis

V. Concluding Remarks
The recent currency crisis in East Asia created a common trend toward more flexible
exchange rates, at least as an “official” regime in the affected countries (except for
Malaysia). During the crisis, the role of the dollar as an anchor currency clearly
declined in the affected countries. As the crisis subsided, emerging East Asia’s
exchange rate arrangements began to diverge in comparison to the pre-crisis patternof assigning a considerable weight to the dollar. Malaysia has restored a dollar-peg
arrangement after a short period of crisis-driven floating, while Indonesia has allowed
large fluctuations of the currency. In between these two polar cases, most countries
have adopted managed floating. Korea and Thailand particularly appear to haveshifted to a de facto managed-float, currency-basket arrangement with larger weights
on the yen, an arrangement akin to that of Singapore.
The rest of the paper has proposed that emerging economies in East Asia, inthe short to medium term, achieve real effective exchange rate stabilization byloosely tying their central rates to a currency basket, supported by consistent andsustainable macroeconomic policy. It has argued that (1) a system which ensures
intra-regional exchange rate stability will be beneficial for emerging East Asia topromote trade, FDI, and economic growth; (2) given the high degree of intra-regional
trade and the rising similarity of trade composition in East Asia, each economy’s
exchange rate policy should be directed toward maintaining intra-regional exchange
rate stability; and (3) in view of the sub-optimality of the de facto dollar peg policy as
an informal and uncoordinated mechanism of ensuring intra-regional stability, acoordinated action can be profitably employed to shift the target of nominal
exchange rate stability to a similar currency basket, consisting of the dollar, the yen,and the euro, which is broadly representative of the partner composition of theregion’s trade and FDI.
At least initially, regional currency stabilization to the basket does not have to be
rigid. Each economy may choose its own formal exchange rate arrangement,
provided that a currency basket serves as the reference numeraire in the conduct of
exchange rate policy, be it a currency board, a soft peg, or a managed float with wide
margins. After the initial phase, the East Asian economies may agree on a common
basket and adopt policies that ensure tighter exchange rate stability against thebasket. Such an arrangement is likely to contribute to the simultaneous stabilizationof intra-regional exchange rates as well as individual economies’ effective exchange
rates. It is a pragmatic policy option until greater political and institutional developments create an environment conducive to a more robust framework of monetaryand exchange rate policy coordination that is commensurate with trade and investment integration in the region. To that end, the regional economies are advised tostrengthen financial cooperation through various regional forums, such as ASEAN+3,
the Manila Framework Group and EMEAP, and trans-regional forums, suchas APEC and ASEM, with a view to enhanced financing and policy dialoguemechanisms, which will help foster such a framework.

201

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Comment

Comment
CHOW HWEE KWAN39
Monetary Authority of Singapore

I. Introduction
Masahiro Kawai’s paper takes a stylized and practical approach in characterizing theobserved exchange rate arrangements in East Asia. In particular, the paper focuseson the role played by the U.S. dollar as an international anchor currency for theexchange rate behavior of the East Asian economies before, during, and after thecurrency crisis. It concludes that the dollar continues to play a dominant anchor
currency role for many economies in the region. A key proposal in this paper is forthese economies—given their diversified trade patterns—to loosely tie their central
rates to a balanced currency basket, comprising the G-3 currencies, i.e., the euro,
dollar, and yen, to achieve stable real effective exchange rates.
In this discussion, we will first highlight the approaches concerning the choiceof exchange rate regimes facing East Asian economies, and provide some empiricalevidence from a paper by my colleagues at the Monetary Authority of Singapore(MAS) on the move toward somewhat more flexible arrangements after the crisis, as
observed in Kawai’s paper. Singapore’s exchange rate framework might also serve as a
useful case-study of how a small, open economy has tried to implement the currency
basket framework proposed in Kawai’s paper. Finally, as alluded to in the paper,
the choice of the exchange rate per se is not the only consideration in the conductof exchange rate policy. Policymakers need to take a multi-dimensional approach,thinking hard about the macro- and microeconomic polices as well as supporting
institutions of the chosen exchange rate framework.

II. Approaches in Choosing Exchange Rate Regimes
Corden (2001) identifies in essence three approaches in choosing an exchange
rate regime:(1) Exchange rate stability—an implication of this approach is that the floating
rate creates undue instability or misalignment that is adverse for international
trade and capital movements.
(2) Real targets—this approach uses the nominal exchange rate as a policy
instrument to adjust the real exchange rate to attain, together with fiscal
policy, the targets of internal and external balance.
(3) A nominal anchor—in this approach, an anchor to a country’s inflation rate isprovided by fixing the exchange rate or the rate of crawl.

39. I am grateful to Edward Robinson for useful input and discussion.

205

A history of relatively low inflation for most East Asian countries leads us to ruleout the pressing need for a nominal anchor in this region. We also note that in thecontinuum of exchange rate regimes, the corner solution of a fixed system accords
the advantages of exchange rate stability but not that of achieving real targets.
Meanwhile, the reverse is true for the other corner solution of a flexible system.
The open economy trilemma is also a particularly relevant consideration for the
East Asian economies, since most are integrated in the world capital market. Given
the trade-offs involved, it seems unnecessary to go to the extremes of rigid fixity
or free float; instead, adherence to some interior solution appears plausible (seeFrankel [1999]).

III. Flexible Exchange Rates Enhanced Monetary Autonomy
in East Asia
To confirm Kawai’s observation of East Asia’s move toward more flexible exchange
rate arrangements, we draw on the results of a past study on monetary policy in four
East Asian economies—namely, Indonesia, Korea, Thailand, and Malaysia after thecurrency crisis (see MAS [2000]). The empirical evidence suggests that the first three
countries have transited from the pre-crisis quasi-dollar-peg regime to a more flexible
post-crisis exchange rate regime. In particular, the standard deviations of the daily
percentage change in the rupiah, baht, and won (the Indonesian, Thai, and Koreancurrencies, respectively) against the dollar for the post-crisis period from January 2,
1999 to September 22, 2000, are compared against the daily volatility during thepre-crisis period from January 2, 1995 to January 2, 1997 (Table 1). There has been
an increase in the standard deviation of the daily movements of the three currencies
from the pre- to post-crisis sample period, with the largest increase in volatility being
recorded for the rupiah. Indeed, the de jure regime classification after the crisis for all
three economies is a free float, within the inflation targeting framework that employs
interest rates as the key operating instrument. Meanwhile, Malaysia has pegged its
currency, the ringgit, to the dollar.
Table 1 Daily Exchange Rate Volatility

Standard deviation of daily
percentage change

PeriodJan. 2, 1995–Jan. 2, 1997
Jan. 2, 1999–Sep. 22, 2000

Indonesia
0.20611.8791

Korea
0.25280.4016

Thailand
0.22230.5474

Source: MAS (2000).

The new frameworks adopted are presumably aimed at securing greater autonomy
in monetary policy management, while retaining the anchor on price stability. To
evaluate the degree of monetary independence the authorities of these countries
could exercise, the MAS study also examined the relationship between exchange
rate flexibility and interest rate differentials. A short-term interest rate dynamic
model for the differential between the domestic and dollar interbank interest rates
was estimated using pre- and post-crisis observations from the four countries. The

206 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002

Comment

following discrete time approximation to a continuous-time short-term interest rateadjustment model formulated in Chan et al. (1992) was used:
rt – rt –1 = α + βrt –1 + εt ,σ 2t = a 0 + a 1ε 2t –1 + b 1σ 2t –1,

(1)
(2)

where E (εt /Ωt –1) = 0, E(ε 2t /Ωt –1) = σ 2t , Ωt –1 is the information set at time t – 1, andσ 2t is the conditional variance of interest rate change. The parameter of interest is β,which captures the speed of mean reversion toward the long-run mean following agiven shock.
Estimates from the model (Table 2) indicate that the spread between the domestic
and the U.S. interest rates exhibited slower mean-reversion for Indonesia andThailand after the crisis, as evidenced by the large fall in the respective estimates forβ. In the case of Korea, the post-crisis coefficient was not statistically significant. The
results indicate that the domestic interest rate tends to adjust much more slowly
or not at all to movements in the U.S. rate, in which case the money market
equilibrium is restored under the more flexible exchange rate regime through a moresignificant adjustment in the nominal exchange rate. The relatively small estimatedvalue and the non-significance of the estimate for β in the case of Malaysia indicatethat the presence of capital flow restrictions has effectively severed the linkage
between domestic and foreign interest rates, despite the fact that the exchange rate
was fixed against the dollar.
Table 2 Mean Reversion in Interest Rate Differential

Mean reversion
parameter (β )Pre-crisis(Jan. 1995–Jan. 1997)
Post-crisis(Jan. 1999–Sep. 2000)

Indonesia–0.0107(–1.957)–0.0038(–4.022)

Korea–0.0090(–1.945)–0.0206(–1.469)

Malaysia–0.0065(–1.804)–0.00045(–0.039)

Thailand–0.0363(–2.947)–0.0088(–2.474)

Note: Figures in parentheses are the Bollerslev and Wooldridge t -values.
Source: MAS (2000).

IV. Singapore’s Experiences with the Basket Peg
We would like to share how Singapore operationalizes the basket peg framework
proposed in Kawai’s paper.40 Since 1981, monetary policy in Singapore has been
centered on management of the exchange rate.41 The primary objective has been to
promote price stability as a sound basis for sustainable economic growth (seeRobinson [2001]).
40. The experience of Singapore may not apply to other East Asian economies, because of differing circumstances.
41. The choice of the exchange rate as the intermediate target of monetary policy is predicated on the openness of theSingapore economy to trade and capital flows, and implies that MAS cedes control over domestic interest rates.
In the context of free movement of capital, interest rates in Singapore are largely determined by foreign interest
rates and investor expectations of future movements in the Singapore dollar.

207

A key feature of our exchange rate system is the basket peg. The Singapore dollar ismanaged against a basket of currencies of 10–15 major trading partners. The various
currencies are weighted geometrically, with the weights varying with the extent ofSingapore’s trade dependence with that particular country. Reflecting MAS’ targetingof the nominal effective exchange rate (NEER), Singapore’s trade-weighted exchange
rate has remained fairly stable.42 Volatility as measured by the standard deviation of
the NEER was significantly lower for the Singapore dollar compared to that of the
U.S. dollar and of the yen.43 The standard deviation of the Singapore dollar NEER
was 1.46 percent between 1981/I and 2001/I, compared to 3.45 percent for the U.S.
dollar and 4.82 percent for the yen.
The movements of the Singapore dollar against major currencies, especially the
U.S. dollar, have been less volatile than the movements among the major currencies.
Indeed, the Singapore dollar has been less volatile with respect to the other currencies
than if it had been pegged to any of the main currencies. For example, if theSingapore dollar were pegged against the U.S. dollar, the monthly standard deviation
against the yen and deutschemark would have been 3.42 percent and 3.27 percent,respectively, instead of 2.99 percent and 2.92 percent. The “basket” characteristicof the managed float system has therefore also helped to mitigate some volatility ascompared to if the Singapore dollar were on a bilateral peg.

V. Coping with Short-Term Volatility as Well as Currency
Misalignments
While Kawai has recommended a loose peg to the currency basket for East Asian
economies, the Singapore exchange rate framework contains elements of the BBC
system, i.e., basket, band, and crawl regime (see Williamson [2000]). The MAS
operates a managed float for the Singapore dollar, allowing the trade-weighted exchange
rate to fluctuate within an undisclosed policy band. In the short term, managing theSingapore dollar within a band provides the flexibility to prevent volatility in thefinancial markets from adversely affecting the real economy, as evidenced for example
by the Asian crisis. During that period, MAS was able to widen policy bands asvolatility increased in foreign exchange markets and subsequently narrow them whensome degree of calm had returned to the regional markets. The flexibility accordedby the band is pertinent in view of Singapore’s vulnerability to disturbances in theinternational financial system (strong fundamentals notwithstanding), given our small,
open economy as well as our role as a financial center in Asia.
Another key feature of Singapore’s exchange rate system is the crawl. The exchange
rate policy band is periodically reviewed to ensure that it remains consistent with theunderlying fundamentals of the economy. Over the longer term, the managed float
has provided the flexibility for MAS to prevent currency misalignments by allowing
42. In relation to the endogeneity of a currency regime, the stability in the Singapore dollar could very well reflect thestrong fundamentals underlying the Singapore economy.
43. The NEER series for the U.S. dollar and yen are based on the quarterly series published by the International
Monetary Fund.

208 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002

Comment

the equilibrium (real) value of the exchange rate to reflect changes in underlying
fundamentals, such as the trend increase in the savings rate and higher productivity
in the export sector. Notably, the trade-weighted Singapore dollar has been on asecularly appreciating trend since 1981 in both nominal and real terms. This uptrend
has helped to keep inflationary pressures in check. Between 1981 and 1987, domestic
inflation averaged 2.3 percent, markedly less than external inflation (as proxied bya trade-weighted average of foreign composite consumer price index [CPI]), which
averaged 4.6 percent over the same period.
In addition, we have a semiannual exchange rate policy cycle. In January and Julyeach year, we release our Monetary Policy Statement and publish the Macroeconomic
Review. The latter is aimed at providing information on the background economic
analysis and assessment of GDP growth and inflation developments in the Singapore
economy, thereby sharing the basis for policy decisions articulated in the Monetary
Policy Statement.

VI. A Multi-Dimensional Approach to Exchange Rate
Management
It is generally recognized and can be inferred from Kawai’s paper that the challenges
posed by the global financial markets cannot be met by the choice of exchange rate
regime alone. Exchange rate policy management has moved beyond the confines of
the traditional parameters of instruments, targets, transmission mechanisms, andinflation-output trade-off issues, and needs to be supported by a framework ofconsistent macroeconomic and microeconomic policies, and by strong institutions.
The exchange rate system may therefore be viewed as a “monetary overlay” on thereal economy foundations.
We have identified the following five aspects of an exchange rate support structure(see Robinson [2001]):(1) Sound and credible macroeconomic policies are essential to avoid the buildup
of major macro imbalances in the economy. This will reduce the vulnerability
to speculative attacks by preventing misalignments in the value of the currency.
(2) The flexibility of the product and factor markets is essential to cope with andadjust to shocks arising from the volatility of currency markets and swings
in the terms of trade in world product markets. This is particularly true forsmall, open economies, which are dependent on exports of goods and services.
(3) It is crucial to develop and strengthen financial systems to enhance robustness
to shocks. A sound and efficient banking system, together with deep and liquid
capital markets, contributes to the efficient intermediation of financial flows.
This will help prevent the emergence of vulnerabilities in the financial system
by minimizing unsound lending practices that could lead to the buildup ofexcessive leveraging in the corporate sector and exposure to foreign borrowings.
(4) Countries need to build up their regulatory and supervisory capabilities tokeep pace with financial innovations and the growing complexity of financial
institutions’ activities, as well as new products and services.

209

(5) Policymakers should promote greater disclosure and transparency. This will
help to foster market discipline, as well as reduce the likelihood of markets
over-reacting due to lack of information or information asymmetries.

VII. Monetary Integration in East Asia
We conclude with a brief comment on Kawai’s suggestion for a move toward a
common basket peg for East Asia. First, we agree with him that East Asia is not yet
ready for a monetary union. This is especially so given the relatively wide divergencesin economic characteristics such as GDP per capita, business cycle synchronization,and price and wage flexibility in this region. Empirical evidence revealing asymmetricshocks also suggests that this region currently does not meet the necessary prerequisites
for monetary integration (see, e.g., Chow and Kim [2003]).
Asian countries should focus their efforts instead on deepening the integration of
their markets. This would include developing greater intra-regional trade linkages,
integrating financial markets, and establishing regional production networks.
Underpinning this should be an evolution of common codes of conduct andstandards of corporate governance, as well as greater regulatory cooperation andharmonization. Perhaps in the longer term, when Asia has achieved a certain degreeof integration in its factor and capital markets, some form of closer monetary
cooperation and integration can be an effective means of securing the benefits of theeconomic linkages.

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Policy Analyses in International Economics, 60, Washington, D.C.: Institute for International
Economics, 2000.

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Comment

Comment
EIJI HIRANOBank of Japan
Masahiro Kawai’s paper tackles challenging topics, and I really appreciate his devoted
efforts to map this uncharted territory. Before commenting on his paper, I would liketo summarize its principal line of thought.
First, the paper claims that the dollar remains the de facto anchor currency evenin the post-crisis period, in spite of the shortcomings of the dollar-peg regime thatprevailed before the crisis.
Second, such de facto predominance of the dollar does not reflect the underlying
trade patterns and foreign direct investment flows in the region, and is therefore
sub-optimal.
Third, the emerging East Asian economies should adopt the “soft-peg” regime to thecurrency basket, where the dollar, the yen, and the euro play equally important roles.
Fourth, given the above, greater coordination on the currency basket policy, anenhanced surveillance mechanism, and the internationalization of the yen are desirable.
In my comments on the paper, first I would like to pose a question as to theinterpretation of the existing trade patterns, focusing especially on the expansion of
intra-regional trade in East Asia. The interpretation is of essential importance in thepaper. For example, if the intra-regional trade expansion is driven by region-specific orautonomous factors, excessive dependence on the dollar may be irrelevant. Conversely,
if such expansion is mainly driven by the U.S. economy, then predominance of thedollar may be inevitable.
Recently, economists at the Bank of Japan conducted joint research with economists from the European Central Bank on the intra- and inter-regional trade patterns
in East Asia (Isogai et al. [2002]). Their key finding was that intra-regional trade
expansion in East Asia is mainly induced by the U.S. economy. This result is inline with the intuition that East Asia has become an important production center
for IT-related goods. If so, intra-regional trade expansion in East Asia may not be
independent in nature.
This leads to the second question, of sub-optimality of the present regime. The
paper claims that the present system is sub-optimal, because it does not reflect theunderlying trade patterns in the region. However, one may argue that the present
system does in fact broadly reflect the reality of the real trade patterns. Given
this reservation, I wonder how confidently one could argue for an intentional andcollective shift to a currency basket regime.
Third, I would like to call attention to financial factors in the choice of an
exchange rate regime. The role of the dollar is much larger in the context of financialtransactions than in the area of trade. The emerging East Asian economies borrowmoney mainly in dollars for a number of reasons. We may assume this is one of thereasons why they are particularly sensitive to the stability of their currencies vis-à-vis
the dollar. We should not underestimate such financial factors, particularly in thewake of the currency crisis.

211

Fourth, and last, I would like to argue that a peg is a peg. A currency basket
regime cannot be completely immune from the well-known deficiencies of thepeg system. Problems include how to define an optimal basket, how to design theadjustment mechanism of the weights assigned to basket currencies, how to makeit consistent with monetary policy and capital controls, and so on. Starting with amechanism that is not too rigid may be one idea. However, I wonder from a practical
viewpoint if such a soft and somewhat elusive regime is a meaningful departure fromthe present mechanism.
Let us suppose that Japan can create an autonomous and independent businesscycle, and suppose further that Japan’s economic influence on the rest of the region
becomes dominant. In this case, a greater role played by the yen is conceivable.
Should we initiate such a shift of paradigm as public policy, or should we leave thework to market forces in a broad sense? This may be the fundamental question.
In any event, designing an optimal currency regime requires a long process oftrial and error, and continued effort. Here in East Asia, momentum is clearly building in pursuit of a better currency regime and improved monetary cooperation, andpolicymakers should take advantage of such momentum. In this respect, the paper
provides us with a good reference point, as a catalyst for further discussion.

Reference

Isogai, Takashi, Hirofumi Morishita, and Rasmus Rüffer, “Analysis of Intra- and Inter-Regional Tradein East Asia: Comparative Advantage Structures and Dynamic Interdependency in Trade
Flows,” International Department Working Paper Series 02-E-1, Bank of Japan, 2002
(http://www.boj.or.jp/en/down/siryo/data/iwp02e01.pdf).

General Discussion
Responding to the comments of the discussants, Masahiro Kawai, while acknowledging the importance of the removal of trade barriers, emphasized the need to develop
an exchange rate regime that would be conducive to intra-regional exchange ratestability. Responding to the comment that the region is heavily affected by the U.S.
economy as the source of final demand, he asserted that, given the rapid growth of
intra-regional trade, a dollar peg would give rise to problems in the event of large
fluctuations in the yen-dollar rate. While acknowledging the importance of financialtransactions, Kawai argued that, given the very high dependence of Asian countries
on trade and foreign direct investment (FDI), it was important to discuss desirable
exchange rate regimes from the perspective of international trade and investment.
In the general discussion that followed, Asian participants generally expressedviews in support of currency basket arrangements and agreed with Kawai’s analysis.
Jeong-Ho Hahm (The Bank of Korea) and Amara Sriphayak (Bank of Thailand)
acknowledged the usefulness of currency basket arrangements in simultaneously
achieving exchange rate stability and price stability. Han Ming Zhi noted his support
for currency basket arrangements, subject to the appropriate choice of currency

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General Discussion

composition in such baskets. Robert W. Rankin commented that Kawai’s empiricalresults for the first half of 2002 suggest that Korea and Thailand, like Singapore, werealready operating under a currency basket during this period.
Various criticisms of currency basket arrangements were also voiced. Gabriele
Galati, Chow Hwee Kwan, and Ismail Alowi agreed with the statement of Eiji
Hirano that the importance of the dollar in current account and capital transactions
should be taken into consideration. Alowi and Reuven Glick noted that currency
basket arrangements lacked transparency because information regarding the relative
weights of the currencies in a basket and determination of the fluctuation bands often
were not disclosed. Vittorio Corbo noted that during the past two years, there were nocases of successful intermediate exchange rate regimes outside of Asia. He thenargued that to pursue real exchange rate stability from the perspective of international
competitiveness alone would not be consistent with the goal of price stability.
The following comments were made concerning the empirical analysis of thepresentation. Robert H. Rasche (Federal Reserve Bank of St. Louis) noted that the
reduced-form equations used in the estimation were subject to simultaneous bias,
so that due caution needed to be exercised in applying the results based on such
equations to policy recommendations concerning the choice of exchange rate
regimes. Corbo argued that countries with capital-flow controls should be excluded
from the analysis and emerging market economies should be the study’s focus.
Hiroshi Fujiki commented that, given the fact that certain aspects of the “original-sin
hypothesis” are applicable to the Asian countries, it is necessary to include bothexchange rates and foreign reserves in the analysis.
Commenting on Kawai’s assertion that Singapore represented an almost ideal
form of currency basket arrangement, Corbo, Glick, and Alowi stated that
Singapore’s success was based on its favorable fundamentals, and that it was doubtful
whether the arrangement would work in other countries. Chow responded that,
notwithstanding favorable fundamentals, a small and open economy was prone tobe affected by currency crises in other countries. Kawai responded that, although
pre-crisis fundamentals were believed to be strong, there were currency crises,
which suggested the need to adopt an exchange rate regime that is less prone to acrisis. Also, such a regime should be supported by consistent monetary policy, soundfiscal policy, and a resilient financial sector, as in the case of Singapore. The Asian
region experienced a currency crisis and contagion effects. Rankin commented
that, although the impact of the East Asian crisis on Singapore was reduced by
the depreciation of its currency, if all countries of the region were to depreciate
their currencies in the event of another crisis, foreign exchange adjustment would
be impossible in Asia as a whole.
Comments were also made from a more long-term perspective. Allan H. Meltzer
emphasized the importance of the Chinese economy in considering the future of East
Asian exchange rate regimes. Jerry L. Jordan (Federal Reserve Bank of Cleveland)stated that the elimination of the causes of currency crises requires governments toimprove governance. Jordan also commented that Kawai’s paper failed to present atheoretical model to explain how a specific currency comes to be widely accepted as aregional currency. Jorge A. Braga de Macedo pointed out that Kawai’s paper did not213

clearly identify the process by which currency basket systems can be established in
East Asia. He also emphasized that an institutional framework must be developed to
avoid future financial crises and to promote regional cooperation. Kawai responded
that while a recent attempt to create the Chiang Mai Initiative was a significant
step forward, East Asian regional frameworks for exchanges of information, policy
dialogue, and economic surveillance were relatively underdeveloped given the degreeof regional economic integration, and it was important to start a dialogue process on
exchange rate movements and policies.
Given the important bearing of foreign exchange fluctuations on the discussionsof this session, Meltzer asked Hirano to explain why the Bank of Japan undertakessterilization when intervening in the foreign exchange market. Hirano responded that
there was no effective difference between sterilization and non-sterilization because
the Bank of Japan, under the so-called quantitative easing framework, was targetingoutstanding current account balances of banks with the Bank of Japan, which
effectively created the zero interest rate environment.

214 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002