Concluding Panel Discussion:
Growth, Integration, andMonetary Policy in East Asia
Introductory Remarks
Akinari Horii
Bank of Japan
Now it is time for the concluding panel, where we are going to discuss growth,
integration, and monetary policy in East Asia from policy perspectives.
We have discussed already a number of issues, policy issues, in the previous session.
Therefore, this discussion is quite a natural extension from that one. But there are a
few specific questions I would like to raise here, most of which were covered in theprevious session. Let me start with the one not covered.
The first question concerns East Asian economic and financial integration withthe rest of the world. Because of this integration, the degree of competition in
product markets increased in the global marketplace. As a result, the pricing power of
producers in national markets has weakened.
Also, because of an increase in the supply of labor-intensive products made in
Asia, wages in industrial countries have been under downward pressure. This may bemaking the Phillips curve flat in Japan, the United States, and elsewhere. Of course, inthese price dynamics, a low-inflation expectation is a key element of the flat curves.
Integration of East Asia with the rest of the world, or more generally speaking,globalization, is also very rapid in the financial world. Under financial globalization,
capital moves across the financial markets and product lines instantaneously worldwide, which puts a damper on liquidity premia as well as credit premia, making boththe yield curve and credit spread curve flat.
In these circumstances, saving investment behavior of a national economy seems tohave become more sensitive to changes in interest rates and returns on investment,that is, the IS curve is flat. Now that all the curves are flat, the world is simply flat.
This is what globalization is all about, as Thomas Friedman has written in his book.
But Friedman said, “The world is not round but flat.” I would say the world is flat
instead of steep.
East Asia has played a most significant role in this process of making the world
flat. We are obviously living in a world quite different from the one associated with avertical Phillips curve and steep yield curves. The important question is whether
all these flat curves exist for a transitional period of globalization, or under the present
cyclical conditions, or for a longer period. This is not only an issue of academic
interest, but also a very important question for central bankers in both industrial andemerging countries.
MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2007
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The second question comes from the sustainability of global imbalances.
Globalization has in fact been accompanied by such imbalances. There is an argumentthat globalization has made these imbalances more sustainable than in the past. Decline
in home bias among investors, efficiency in international capital allocation, wideningof the market by hedge funds and other private pools of capital, and the yen carry trade
are the issues related to this question.
Global imbalances have both deficit and surplus sides. The sustainability of the imbalances has long been discussed, mainly on the deficit side, in other words, sustainabilityof U.S. deficit financing. In recent months, the surplus side has been looming larger,
where the sustainability of reserve accumulation is more often discussed, in light of
its side effects on a central bank’s balance sheet and the cost of sterilization. Under thesecircumstances, policy options, monetary policy options in particular, are immediateconcerns for many central banks in East Asia, as we discussed in the earlier session.
Finally, integration within Asia poses interesting questions about the mode ofmonetary cooperation in this area. The Executives’ Meeting of East Asia-PacificCentral Banks (EMEAP), a central banking group, has been active in discussing thisissue and actually producing tangible results, such as the Asian Bond Fund. Are we on
the right track? If yes, what can we do next to promote the welfare of our economies?
These are the questions I would like to put forth at the outset of this session.

Panelists’ Remarks
Leonardo Bartolini
Federal Reserve Bank of New YorkI. East Asia’s Monetary Policy and the Carry Trade:
What Do We Know?
A key way in which East Asia’s monetary policy—especially Japan’s—has been viewed
as impacting the United States and the rest of global finance is through the scope it
opens for the so-called “carry trade,” which we broadly define here as a leveraged,
unhedged short position in a low-yield currency financing a long position in a higheryield currency. Many investors are believed to have taken advantage of Japan’s low
interest rates during the past decade to fund carry trade positions. Such positions, andtheir possible sudden unwinding, have been widely cited as a key contributor to global
market turbulence in May 2006, February 2007, and especially October 1998. The carrytrade is also viewed as posing a special challenge for monetary policy because it
increases the sensitivity of capital flows to interest rate changes.
The logic underlying carry trade strategies is simple. If the exchange rate between“low” and “high” rate currencies is expected not to change (much) over the investment horizon, then the return to a carry trade position approximates the interest
rate differential.

234 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2007

Concluding Panel Discussion

This is not a logic that economists would happily share: interest rate differentials,
according to the uncovered interest parity (UIP) condition, should be offset by a loss
in value of the higher-interest currency, thus eliminating—on average—the interest
rate gain. Empirically, however, high-interest currencies have tended to appreciate
relative to the yen, Swiss franc, and other low-interest currencies that have been usedin recent years as funding currencies for the carry trade. In fact, as carry traders havesold funding currencies and bought investment currencies in recent years, they havecontributed to exchange rate changes that have reinforced, rather than offset, interest rate
gains, encouraging other investors to adopt the same strategy and, in turn, amplifying
the impact on exchange rates.
To illustrate how failure of UIP has worked out in practice for carry traders, Figure 1
displays the returns to a strategy involving the sale of yen in February 1999, whenthe Bank of Japan adopted its zero interest rate policy, and the corresponding purchaseof U.S. dollars at the then-current rate of ¥115 to US$1.1 As Figure 1 shows,the cumulative return to such a position by May 2007 would have been in excess of
30 percent, largely resulting from combining an average annual U.S.–Japan interest rate
differential of 3.5 percentage points with an almost-stable (overall) exchange rate.
Calculations for a portfolio involving selling yen short in 1999 and buying and thenholding until May 2007 an equally weighted basket of the seven OECD currencies thatoffered the highest interest rate in 1999 (the Czech koruna, Hungarian forint,
Norwegian krone, Polish zloty, Turkish lira, British pound, and U.S. dollar) deliver
Figure 1 Cumulative Returns to the Yen-to-U.S. Dollar Carry Trade

50

Cumulative returns, in percent

40

Total returns to position
Cumulative interest differential

30
20
10
0
–10
–20
Mar.
1999

Mar.
2000

Mar.
2001

Mar.
2002

Mar.
2003

Mar.
2004

Mar.
2005

Mar.
2006

Mar.
2007

1. For this calculation, I use short-term interest rates, because carry traders tend to invest in short-term instruments;a computation using longer-term instruments—which would presumably minimize investment transaction costs—
would yield similar conclusions.

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similar (in fact, larger) returns (Figure 2). Different portfolios, excluding the volatile
Turkish lira or including the Swiss franc and other low-yield currencies among funding
currencies, produce similar conclusions. Interestingly, much of the gains accruing tocarry trades investing in currencies other than the dollar reflect the fact that high-yieldcurrencies have gained on low-yield currencies in recent years, thus supplementing
interest rate differentials with capital gains on the foreign exchange position.
The apparent success of the carry trade looks familiar to scholars of international
financial markets, because it represents empirically just one more instance of failure of
UIP. Explanations offered in recent years for the apparent success of the carry tradethus have tracked explanations offered in recent decades for the failure of UIP.
For instance, observing that the carry trades—as uncovered foreign exchange
positions—are risky, observers have emphasized that excess returns to the carry trade
may just compensate for the extra risk involved in such positions. A problem with this
explanation is that investors’ risk aversion would need to be implausibly high to justify
the observed excess returns to the carry trade as an equilibrium outcome. Researchers
who have done more careful calculations than those illustrated here, including detailed
accounting for transaction costs incurred when rolling positions over, at the end of eachmonth, quarter, or year, find the carry trade to involve a high Sharpe ratio—that is, ahigh expected return relative to risk taken—higher, for instance, than that involved inan S&P index portfolio.2
An alternative explanation put forth for the apparent success of the carry trade issimilar to “peso”-style explanations offered for violations of interest parity: calculated
profits on carry positions fail to account for rare but dramatic exchange rate changes
that did not occur in the sample observed, but may occur at any time and—when
Figure 2 Cumulative Returns to the Yen-to-High-Yield Currencies Carry Trade

120

Cumulative returns, in percent

100

Total returns to position
Cumulative interest differential

80
60
40
20
0
–20
Mar.
1999

Mar.
2000

Mar.
2001

Mar.
2002

Mar.
2003

Mar.
2004

Mar.
2005

2. See, for instance, Burnside et al. (2006).

236 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2007

Mar.
2006

Mar.
2007

Concluding Panel Discussion

they do occur—are bound to bring returns to the carry trade back in line with returns
on alternative investments. Indeed, for instance, the carry trade on the Thai baht was
profitable until mid-1997, but returns turned negative when the baht depreciated in
the third quarter of 1997.
Yet even this explanation may be not quite convincing, for wiping out the accumulated gains shown in Figures 1 and 2 would require larger depreciations of the U.S. dollar
and of other currencies than many observers might view as plausible. More generally,studies that have attempted to address small-sample “peso” problems by examining
longer and longer samples have failed to reconcile the data with the presumptionof UIP.
Other explanations that have been invoked—including a role for transaction costs,
central bank intervention, political risk, foreign exchange risk, purchasing power risk,interest rate risk, and the effect of news—have met with limited success. Newer
approaches, motivated by the apparent success of the carry trade and focusing on the
micro-mechanics of foreign exchange markets, are promising but have not yet been
subject to close empirical scrutiny.3 Altogether, the widespread failure of UIP—or, why does the carry trade appear to be so profitable?—still puzzles most observers andscholars of international financial markets.

II. Measurement
So, how large are carry trade positions?
Estimates have been offered ranging from US$80 billion and less, to US$500 billion
and more for the Japanese banking sector alone. This variance in estimates reflects
several layers of difficulty. First, how exactly are carry trade positions defined? A narrow
definition would focus on gross leveraged positions in the spot foreign exchange market.
A broader definition would include positions in derivatives, particularly in futures/
forwards. A related aspect concerns the set of investors whose positions we might want
to investigate. While we may be able to estimate a leveraged position at a very high levelof aggregation for a few economic sectors (e.g., the Japanese banking sector), we havelittle information on carry trade positions for a wide range of global investors, andessentially no information on positions in derivatives markets. And beyond the difficultyof assessing the right instrument and investor lies perhaps the greatest hurdle: toidentify “interest-sensitive” positions. This is a key task, if the goal is to assess the likely
impact of changes in interest rates on global investment and avoid including sectors—
such as the Japanese public sector, with its large stock of foreign reserves funded almost
entirely by yen liabilities—as engaging in the carry trade. Public-sector investors
usually hold foreign assets for wholly different reasons than private investors, they arelikely to have much greater tolerance for risk, and they are unlikely to be subject to themargin calls that often trigger private investors’ exit from carry trade positions, making
their interest sensitivity much smaller than that of private investors.
Altogether, the quest for quantification of carry trades has so far been unsuccessful.
3. See, for instance, Burnside et al. (2006) and Plantin and Shin (2006).

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III. Unwinding
Besides the (likely) large size of the carry trade, public concern with this investment
strategy hinges on its potential for rapid unwinding. Because by definition carry trades
are unhedged, they are vulnerable to adverse price movements, such as a depreciationof investment currencies (or appreciation of funding currencies). These movements
cause a decline in the value of the collateral used to open the position, likely triggering
margin calls and requiring investors to sell the high-yielding currency. This sale, in turn,lowers the value of remaining positions, inducing other investors to rush for the exit
and speed up the unwinding.
Looking for common traits across episodes of presumed unwinding of carry trade
positions, the “spider” chart in Figure 3 focuses on three recent episodes: October
1998, spring 2006, and February 2007. (In the figure, the U.S. dollar/yen exchange
rate is centered on the day prior to the event that reportedly triggered an unwindingof carry trade positions.) The trigger event for October 6, 1998, in particular, wasseen as a yen-favorable piece of legislation supporting banking reform that waspresented in Japan. The event for April 19, 2006 was seen as an unexpectedly
inflationary release of consumer price index data in the United States, which triggereda mini-inflation scare. And the event for February 22, 2007 was seen as the sudden
losses recorded in the Shanghai stock index, which triggered a period of rapid risk
reduction in global financial markets.
The figure shows that the three episodes were associated with a sharp appreciationof the yen, especially in October 1998, the most well-known episode of carry trade
unwinding in the past decade. Figures 4–6 also show that, at the same time, therolling 90-day correlations between the yen/U.S. dollar exchange rate and a basket of
Figure 3 U.S. Dollar/Yen Exchange Rate

120

U.S. dollar/yen rate, value on day prior to event = 100
Oct. 6, 1998
Apr. 19, 2006
Feb. 22, 2007

115
110
105
100
95
90
85
–60

–40

–20

0

20

238 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2007

40
60
Days from event

Concluding Panel Discussion

Figure 4 Yen/U.S. Dollar and High-Yield Currencies/U.S. Dollar Daily Correlation:
October 1998

0.5

Yen/U.S. dollar – high-yield currencies/U.S. dollar correlation

0.4
0.3
Oct. 6, 1998
0.2
0.1
0
–0.1
–0.2
–0.3
–0.4
–0.5
June
1998

July

Aug.

Sep.

Oct.

Nov.

Dec.

Jan.
1999

Figure 5 Yen/U.S. Dollar and High-Yield Currencies/U.S. Dollar Daily Correlation:
Spring 2006

0.5

Yen/U.S. dollar – high-yield currencies/U.S. dollar correlation

0.4
Mar. 10, 2006

Apr. 19, 2006

0.3
0.2
0.1
0
–0.1
–0.2
–0.3
–0.4
–0.5
Jan.
2006

Feb.

Mar.

Apr.

May

June

July

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Figure 6 Yen/U.S. Dollar and High-Yield Currencies/U.S. Dollar Daily Correlation:
February 2007

0.5

Yen/U.S. dollar – high-yield currencies/U.S. dollar correlation

0.4
Feb. 26, 2007
0.3
0.2
0.1
0
–0.1
–0.2
–0.3
–0.4
–0.5
Jan.
2007

Feb.

Mar.

Apr.

other key exchange rates against the dollar4 turned rapidly negative, suggesting thatthese currency pairs suddenly became driven less by dollar movements and more bycross-currency movements, with investors seemingly taking off rapidly from investment
currencies to close their yen positions. The correlation turned negative especially
rapidly in October 1998, while in April 2006 the anticipated nature of the end ofquantitative easing in Japan, in advance of the April inflation scare, caused the decline
to be more gradual.
Beyond the few common traits displayed by exchange rate dynamics, however, thetriggers for carry trade unwinding in the three episodes were far from homogenous,
with the first episode likely triggered by a policy event in the relevant funding country,
the second episode likely triggered by a surprising data release, and the last episode, inFebruary 2007, originating in a fairly distant area of the global financial system,
whose global repercussions caught many observers by surprise. To complicate matters,
we should include as examples of our inability to predict triggers for carry trade
unwinding a number of cases in which “the dog did not bark,” including the end-May
2007 drop in the Shanghai stock market of about 7 percent. The latter event caused
observers around the world to brace for a period of turbulence similar to that ofFebruary 2007, but was not associated with a significant global financial response.
Altogether, it is hard to escape the impression that we know little about even thetype of trigger that we might expect for the next unwinding episode. Even directconversations with market participants are rather uninformative. Investors report
4. These are the Australian dollar, the New Zealand dollar, the Hungarian forint, and the Mexican peso, which inrecent years have been reported as active investment currencies for carry trade positions.

240 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2007

Concluding Panel Discussion

monitoring a variety of asset prices and real economy indicators as early indicatorsof carry trade unwinding. Mostly, however, they report monitoring each otherfor signs that it might be time to pare back positions. This reads like a recipe forsudden unwinding.

IV. Summary
The answer to the question asked at the beginning of these remarks, “What do we know
about the carry trade?” has to be “Not much.” It is difficult to reconcile the successof the carry trade with economic theory. We have made little progress in measuring carrytrade positions. And we know that the carry trade has a penchant for unraveling in ahurry, but we have little confidence in forecasting the next type of trigger we might see.
Given the possible role that the carry trade potentially plays in the financing of current
global imbalances, this lack of success only increases the urgency for greater effort tounderstand the nature and dynamics of this critical form of international investment.

References

Burnside, Craig, Martin Eichenbaum, Isaac Kleshchelski, and Sergio Rebelo, “The Returns to Currency
Speculation,” NBER Working Paper No. 12489, National Bureau of Economic Research, 2006.
Plantin, Guillaume, and Hyun Song Shin, “Carry Trades and Speculative Dynamics,” mimeo, Carnegie
Mellon University, 2006.

Hans Genberg
Hong Kong Monetary Authority
It is a pleasure to participate in this closing panel. We have had a day and a half of
lively discussions based on stimulating papers on each of the three conference topics—
growth, financial integration, and monetary policy in East Asia—and in my intervention I would like to pursue the first and third of these topics somewhat further.
My objective is to clear up some misconceptions that have entered into discussions
and policy prescriptions regarding global imbalances and monetary relations in theregion. The misconceptions relate to the consequences of the external orientation of
East Asian economies on the one hand and with monetary policy strategies followed byregional central banks on the other. The main messages I would like to get across canbe summarized in the following three points.
First, the openness and export orientation of Asian economies have served them,and indeed the rest of the world, well and should not be abandoned in favor of some
ill-defined strategy of domestic demand-led growth.
Second, monetary policy strategies in the region are more heterogeneous thancommonly thought. The region as a whole cannot be described as being on a U.S.
dollar standard. Instead, monetary policies are increasingly focused on a domestic
objective broadly defined as price stability.

241

Third, it follows from the previous point that proposals to coordinate exchange rate
policies in the region should be rejected. The experience of Europe shows that imperfectly credible exchange rate commitments by central banks will lead to currency crisesin the context of increasingly integrated financial markets. A better strategy would beto strengthen and clarify the focus on domestic objectives.

I. Openness, Export-Dependence, and Economic Growth5
In popular discussions about global imbalances, it is often asserted that Asian economies
are too export dependent and need to switch to a growth strategy based on domestic
demand. It is sometimes also asserted that the export dependency is related to mercantilistic pursuits of current account surpluses using undervalued currencies. While the
combination of all these arguments does perhaps sound a bit like a caricature, each one
individually has been put forward by otherwise serious economists.
I want to spend a bit of time on each. It is indeed true that Asian economies arevery open to international trade, but this is not surprising as we would expect small
economies to have large international exposure. The degree of openness in Asia is also
not out of line with that of small European economies (Figure 1).
The empirical evidence presented in the paper by Sanghoon Ahn and Jong-Wha
Lee at this conference (Lee and Ahn [2007]) as well as the literature they cite generally
implies that a high degree of openness to imports and concentration in production
on exports is entirely appropriate, because they are associated with higher rates of
economic growth than otherwise would be the case. The reasons for this are explainedin the paper, and I do not need to dwell on them further. I may be stating the obvious,
Figure 1 Degree of Openness to International Trade[1] Share of Exports in GDP in
East Asian Economies, 2005

[2] Share of Exports in GDP in
Small European Economies, 2005

Percent

Percent
Total exports ofgoods and services
Domestic exports
Re-export earnings

ASEAN
NIE-3

SwedenSwitzerland

Mainland China
Netherlands
Hong Kong
Belgium
0

50

100

150

200

250

0

20

40

60

80

Notes: 1. ASEAN comprises Brunei Darussalam, Cambodia, Indonesia, Laos, Malaysia,
Myanmar, the Philippines, Singapore, Thailand, and Vietnam.
2. NIE-3 comprises Korea, Singapore, and Taiwan.
3. For mainland China, data are based on merchandise exports only.

5. The discussion in this section draws on He, Cheung, and Chang (2007).

242 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2007100

Concluding Panel Discussion

but it is of course the degree of openness and not trade surpluses and deficits thatis related to economic growth, and outward orientation by itself implies neither atendency toward current account surpluses or deficits. For example, economies in theregion generally had balance of trade deficits in the years immediately before thefinancial crisis in 1997–98, and they were as “export-dependent” then as they are now.
So where does the argument come from that Asian economies are too dependent onexports for their growth and should rely on domestic demand? I think it is due to themixing of two arguments. One is the incorrect proposition according to which sustained
economic growth can be influenced by aggregate demand, and that growth can therefore be driven by either domestic or external demand. According to modern theories
of economic growth, however, growth is instead determined by the accumulation offactors of production and technical progress, and this view has been backed up by alarge body of empirical analysis. As already noted, according to this view openness islikely to foster technical progress and growth, and it should therefore be encouraged.
The second argument related to East Asian export dependence is the correctstatement that to reduce current account surpluses domestic absorption must increase
relative to income. But this refers only to a cyclical adjustment phase and has no
implication for the medium- to long-term growth rates of those two variables.
Balanced growth requires that output, domestic demand, and external demand allgrow at the same rate. Indeed if domestic absorption systematically grew faster thandomestic output, the economy would be on a path with increasing trade deficits overtime, a clearly unsustainable situation.
In summary, these arguments imply that (1) openness is beneficial for economic
growth, (2) current account surpluses are not the necessary consequence of opennessand “export dependence,” (3) correcting current account imbalances does not require
reducing openness or switching to “domestic demand-led growth,” and (4) reaping
the benefits from trade and openness does not require keeping the exchange rate
“undervalued.”

II. Changing Strategies for Monetary and Exchange Rate
Policies in East Asia6
Turning to the topic of monetary and exchange rate policy in the region, I would liketo make three points:(1) Policy strategies in the region are quite heterogeneous.
(2) Countries are increasingly focusing on domestic objectives.
(3) Exchange rate coordination should be avoided.
As far as exchange rate regimes are concerned, all types of such regimes are represented in the region, with Hong Kong at one end of the spectrum with a fixed exchange
rate arrangement and a currency board, and Japan on the other with a floating exchange
rate. In between there are (1) China, Malaysia, and Vietnam with heavily managed
U.S. dollar exchange rates but moving toward more flexibility, (2) Singapore with
6. The discussion in this and the following section is based on Genberg (2006).

243

a managed exchange rate used as an instrument for inflation control, and finally(3) Indonesia, the Philippines, Korea, Taiwan, and Thailand, which have adopted
more flexibility.
The region is not on a U.S. dollar standard as suggested by some authors.
Regressions in the spirit of Frankel and Wei show that local currency dollar exchange
rates load significantly on the euro, yen, and Korean won exchange rates. Table 1
presents results from the estimation of regressions of the form
Si,t = 0 + j Sj,t + ui,t ,jj ≠ i,(1)

where Sk represents the dollar exchange rate of currency k. This type of regression canbe used to assess whether a particular currency is more or less rigidly pegged toanother. If a coefficient j is equal to unity and if ui,t is “small” for all t, then currency
i is pegged to currency j. If all ’s are zero and the ui’s are small, then the currency ispegged to the dollar. When some ’s are nonzero, then currency i is systematicallyrelated to the currencies corresponding to the nonzero coefficients. Such relationshipcould come about either because the central bank is actively managing the currency orsimply because the behavior of currency traders/investors in the market generates acorrelation between particular currencies. In either case, however, the conclusion
would be that the regional currencies are not on a dollar standard.
In Genberg (2006), I show results from similar regressions estimated over yearlong samples starting in 2000. The conclusions from these are that U.S. dollar
exchange rates of local currencies do fluctuate with the euro, the yen, and the won,but the correlations change over time. I take this to imply that, with the exception ofSingapore, the countries represented in the table do not have overriding exchange rate
objectives conditioning their monetary policies. Instead, central banks are increasingly
focusing on domestic price stability as their monetary policy objective.
Table 1 Regression Results
Weekly data, 2000–06
Indonesian rupiah
Yen
Korean won
Philippine peso
Singapore dollar
Thai baht
Taiwan dollar

Euro
0.090
(0.199)0.389(0.000)–0.003(0.912)0.013(0.702)0.146(0.000)0.113(0.000)0.072(0.000)Yen
0.095(0.250)
n.a.
n.a.
0.263
(0.000)0.058(0.134)0.181(0.000)0.171(0.000)0.087(0.000)

Korean won
0.383(0.002)
n.a.
n.a.
n.a.
n.a.
0.131
(0.021)0.161(0.000)0.248(0.000)0.266(0.000)Note: Parentheses indicate p-values, and “n.a.” denotes not applicable.

244 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2007

Adjusted R2
0.053
0.172
0.170
0.031
0.527
0.293
0.364

Concluding Panel Discussion

Several central banks have adopted inflation targeting: Korea did so in 1998,
Thailand and Indonesia in 2000, and the Philippines in 2002. While the de facto
commitment to inflation targeting varies across countries and time, the fact that thesecentral banks have announced that they are inflation targeters clearly signals theiremphasis on internal objectives as the guiding principle for their monetary policies.
Other central banks have set price stability as a target without calling themselvesinflation targeters (Japan and Singapore), and others still are moving in this direction(Malaysia and Vietnam).
In view of the openness of the economies to trade, an important issue in theregion is the role of the exchange rate in an inflation-targeting strategy. Policymakers
have two concerns. One is how much attention the central bank should pay tothe exchange rate in the case where it uses a short-term interest rate as the policy
instrument, and the other is whether the exchange rate itself should be used as an
instrument for inflation control. When the pass-through of import prices to domestic
inflation is substantial, the exchange rate may have a prominent place in a targeting
rule for a policy interest rate without constituting an objective. The difficulty for thecentral bank may, however, be to convince economic agents that it is not targetingthe exchange rate as opposed to using it as an indicator of inflationary pressure.
The other issue relating to the exchange rate is whether it should be used as thepolicy instrument, as with the Monetary Authority of Singapore (MAS). Bennett T.
McCallum analyzed this issue in his keynote address (McCallum [2007]), and I thinkfurther work on this would be interesting, at least from an academic point of view.
In practice, however, there does not seem to be any intention among other actual orprospective inflation targeters in the region to follow the example of the MAS.

III. Exchange Rate Coordination in East Asia
There have been suggestions that East Asian central banks should coordinate exchange
rate policies to avoid the emergence of intra-regional misalignments in the process ofadjustment of global imbalances, and as a strategy to create deeper monetary integration.
With respect to the former concern, it is argued that exchange rate stability vis-à-vis
the renminbi has become an important policy concern, given the increasing degree ofvertical integration of regional trade and the central role China plays in this process.
Regarding the road to deeper monetary integration, Europe is sometimes used as amodel. The successful introduction of the euro and the success of the European Central
Bank in delivering monetary stability have naturally raised the question of whether East
Asia might be the next candidate for monetary unification. But in discussing monetaryunification, it is essential to keep in mind that a monetary union between a set of
economies implies a single common currency, which in turn requires a single common
central bank. For this reason, the decision to establish a monetary union becomesintensely political. Indeed, European monetary integration was as much, if not more,a political process as an economic one. Without strong support from the politicalleadership in France and Germany, it was unlikely to have come about at all. Whether
the same political support will emerge in East Asia is at present unclear.

245

Be that as it may, the European experience does carry an important lesson for
East Asia with respect to the consequences of exchange rate cooperation in the presenceof increasingly integrated financial markets and policy objectives that focused on
domestic variables. The lesson from Europe is that such exchange rate cooperation
proved to be a recipe for currency crises.
I think the same would be the case in East Asia. At this conference, we have heard that
financial integration is deepening. I have argued that monetary policy is increasingly
focused on domestic objectives. Under these conditions, exchange rate cooperation
would simply not be credible. It would be far better to consolidate the existing trend
toward strategies based on price stability and, to the extent that monetary unification
is a longer-term goal, start to think about the institutional structure which would
support such unification.

References

Ahn, Sanghoon, and Jong-Wha Lee, “Integration and Growth in East Asia,” Monetary and Economic
Studies, 25 (S-1), Institute for Monetary and Economic Studies, Bank of Japan, 2007, pp. 131–154(this issue).
Genberg, Hans, “Exchange-Rate Arrangements and Financial Integration in East Asia: On a Collision
Course?” International Economics and Economic Policy, 3 (3–4), 2006, pp. 359–377.
He, Dong, Lillian Cheung, and Jian Chang, “Sense and Nonsense on Asia’s Export Dependency andthe Decoupling Thesis,” Hong Kong Monetary Authority, Research Memorandum 06/2007,
April, 2007.
McCallum, Bennett T., “Monetary Policy in East Asia: The Case of Singapore,” Monetary and Economic
Studies, 25 (S-1), Institute for Monetary and Economic Studies, Bank of Japan, 2007, pp. 13–28(this issue).

Már Gudmundsson
Bank for International Settlements
My comments will focus on policies for further financial integration in East Asia.
Before I make those, however, I would like to thank the Institute for Monetary andEconomic Studies of the Bank of Japan for the opportunity to attend this very interesting conference and to speak here today. I should probably also say that the views
I express are mine, and not necessarily those of the Bank for International Settlements.
The subject of my comments is “policies for further financial integration in East
Asia.” However, I will also discuss the implications of such further financial integration for monetary and exchange rate policies, both in the near term and far in the
future. My viewpoint will be that of central banks; that is to say, I will discuss areas
where central banks either run the show or are prominent. The focus will for the mostpart be on emerging East Asia.
I think it is important, before going to the policy agenda, to take stock and ask
ourselves where we are. To my mind, there are four key aspects of the current situationthat the policy agenda must take into account.

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Concluding Panel Discussion

First, regional financial integration in East Asia has lagged trade integration, which
is high compared to many other regions. This lagging of financial integration is partly
because capital controls remain in place in important countries, and partly because
domestic capital markets and banking systems are underdeveloped in some economies.
Furthermore, they will have a tendency to remain so as long as a significant part offinancial intermediation in the region goes through the U.S. financial system.
Second, large-scale sterilized foreign exchange intervention might be beginning
to reach its limits in key countries, as witnessed by increasing distortions in financial
systems that are forced, or induced, to buy sterilization bonds; strong money, credit
and asset price increases; and incipient inflationary pressures. We might also bereaching political limits as expressed in ongoing concerns that accumulation of
low-yielding foreign assets is not necessarily the best investment and in the associatedpressures for higher returns on foreign exchange reserves.
Third, policymakers in the region are very much aware of the need to develop andintegrate domestic regional capital markets. Major initiatives have already been taken
or are under way. I could mention the Asian Bond Fund 2 (ABF2), which directly
enhances the depth and liquidity of domestic bond markets. Maybe more importantly,
the process of setting up the ABF2 gave impetus to the harmonization of rules andregulations pertaining to capital markets. I could also mention the focus on thedevelopment of corporate bond markets, which was the topic of a highly successful
seminar organized by the Bank for International Settlements and the People’s Bank of
China in Kunming in 2005 (see Bank for International Settlements [2006]). Moregenerally, I could mention the report of a working party of the Committee on the
Global Financial System (see Committee on the Global Financial System [2007]).
This issue is also on the agenda of the G-8 countries at the moment. Thus, everybody
is jumping on this important bandwagon.
Fourth, there is a perceived need to gradually lift remaining restrictions on capital
account transactions. Thus, it seems to be on the long-term policy agenda of China
to eventually lift these restrictions. The aim seems to be to integrate more fully withthe global capital markets, and give a further boost to the development of domestic
capital markets. In the discussions yesterday, Maurice Obstfeld asked why countries
seemed to be eager to lift capital controls when it had proven so difficult to quantify
the benefits of free capital movements. I am not going to answer that question,
but rather state as a matter of fact that this is the direction we are going in, which
will in turn have implications for the optimal design of exchange rate policies andmonetary frameworks.
Having listed the most relevant aspects of the current situation, let me ask a generalquestion, the answer to which might affect how best to proceed: should everybody go
it alone? Is it the case that if each country puts its own house in order, develops andliberalizes its own markets, makes its exchange rate flexible and adopts an inflation
target, then the outcome for the region or the global community will be the best
available? Or is regional and global central bank cooperation, or more generally
governmental cooperation, important? I tend to think the latter, in other words, thatcooperation has a role to play. It can provide important peer pressure—think of the roleit played in Europe—and there probably are externalities in economic development247

and policy implementation. Being part of a region that is prosperous and is progressing in the same direction as individual countries want to go will make life easierfor these same countries. An additional reason for cooperation is that the optimalmonetary framework is not given for all times by first principles of economic theory.
It changes as economies and their financial systems evolve. Sharing experiences andlearning from others will thus be helpful. Such knowledge transfer is facilitated byregional or global central bank cooperation.
What are the next steps?
First, to promote the integration of capital markets by proceeding with thegradual opening of capital accounts, by progressive harmonization of financial market
regulations, and some harmonization of monetary instruments that affect howmarkets develop. Examples of these are reserve requirements and the method used by
the central banks to inject or withdraw liquidity.
Second, the development of domestic bond markets: there is a case for widening
the investor base, improving the informational underpinnings of these markets, easing
restrictions on nonresidents’ issuance in domestic markets, nurturing the developmentof corporate bond markets, improving liquidity, and developing repo markets.
The third item on the agenda is more exchange rate flexibility. It is both a policy
goal and, up to a point, unavoidable. It is prompted by further capital accountliberalization and financial sector development and integration. It is made morepressing by the risk to economic stability that is in the long run created by large-scaleforeign exchange intervention. More exchange rate flexibility will in turn stimulatemarket development. Referring to our earlier discussions and taking the example of
China: it is sometimes stated that you cannot have exchange rate flexibility until you
have developed your financial markets. That is true—up to a point. But the reverse isalso true, that if you restrict flexibility of market prices too much, including that of
the exchange rate, then you will put an obstacle in the way of the further developmentof financial markets.
This raises the issue of whether the associated exchange rate volatility might beharmful for the regional input-output matrix and the current high level of tradeintegration. There might be something to that, but I think that in general theevidence seems to show that these effects are smaller than people think, partly because
more developed financial markets provide ways to mitigate these effects.
Even if this is the path that we are going to take, I think we need to acknowledge
that there are significant unresolved problems with pure inflation targeting andfloating exchange rates as financial globalization progresses, especially for smaller
countries. We know from theory that if financial globalization goes all the way, in thesense of financial markets becoming fully integrated and the law of one price holding,then there will be no interest rate channel of monetary transmission and everything
will occur through the exchange rate channel. Whether that is a good or a bad thing
depends to a significant degree on how well the exchange rate behaves. Are exchange
rate changes smooth ways to adjust to shocks and disturbances, or are they themselves
a source of disturbances? I think that the current experience of New Zealand might beindicative of the problems that lie ahead in this regard. Thus, extensive carry trades,
which were mentioned earlier, are both a reflection and a cause of a misbehaving

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Concluding Panel Discussion

exchange rate. If exchange rates were well aligned with fundamentals and uncovered
interest rate parity held in the short to medium term, there would be little money to
be made out of carry trades.
The fourth item on the agenda might be to develop and multilateralize the current
regional reserve pooling. That would require multilateral surveillance. However, there
are some question marks over how beneficial this is going to be, given the relatively
strong correlation of shocks in the region.
Let me now, before I start thinking even more long term, make one comment on
global imbalances, as that was a question posed by the chairperson and also raisedyesterday. I do not think it is clear what is most likely to be the first factor to pull theplug on current global imbalances. We have tended to think about this issue from thestandpoint of the deficit countries: are the deficits in the United States sustainable
and, if not, will the medium-term adjustment be prompted by fiscal policy, exchange
rate movements, or a shift in the saving and investment behavior of the private sector?
However, it is quite conceivable that the adjustment will start among the surplus
countries. More developed domestic and regional financial markets might thus shift
regional or domestic financial intermediation away from the U.S. financial system andinto the region, which in turn might reduce the currently high saving rate in key
countries. There is thus potentially a link between the policy agenda of developing
domestic and regional financial markets and that of getting global external balances
on a more sustainable footing. Another possibility is of course that surplus countries
reach some kind of limit in terms of foreign exchange intervention.
Finally, thinking long term: I made references to the problem that foreignexchange markets have a tendency, even if there is no special government intervention, toward excess volatility and sometimes misalignments. One of the solutions tothis for a small country is to enter a monetary union.
In Europe, the thinking was that monetary union was a necessary complement toeconomic and financial integration. The question is: will the same thought gain
ground in this region? I do not think that history will stop with inflation targetingand flexible exchange rates. Furthermore, near-term exchange rate flexibility does notpreclude monetary union, or unions, further down the road. What I do know,
though, is that the European roadmap is not the best one. Given how far off in the
future monetary unions are likely to be in this region and the difficulty of tightexchange rate management when capital movements are free, I draw the conclusionthat exchange rate cooperation, or multilateral limits on exchange rate movements,
are premature.
Thank you.

References

Bank for International Settlements, “Developing Corporate Bond Markets in Asia,” BIS Working Paper
No. 26, Bank for International Settlements, 2006.
Committee for the Global Financial System, “Financial Stability and Local Currency Bond Markets,”
CGFS Publication No. 28, Bank for International Settlements, 2007.

249

Comments
Bennett T. McCallum
Carnegie Mellon University
From the perspective of a discussant, I found these panel papers to be rather disappointing—but that is a good outcome, because what a discussant really wants issomething with which he can strongly disagree! Unlike in some previous years, I did
not find anything of major importance with which I would clearly disagree in the threepanelists’ presentations.
Let me start with Leonardo Bartolini’s discussion of the carry trade and the failureof uncovered interest parity (UIP). I found it really quite interesting and challenging.
The basic puzzle, of course, from the perspective of economic theory, is why asset
holders were willing to hold yen rather than U.S. dollars or other higher-yielding
currencies, when Japanese interest rates were several percentage points lower and theJapanese exchange rate was not appreciating enough to make expected yields the same.
How could it be that UIP was strongly violated over the long spans of time that hementioned? I think this is a very interesting issue, and I will admit that the explanationthat I offered for the standard version of the UIP problem, in McCallum (1994),
was mainly directed at monthly fluctuations. Also, I think that it probably did not
pertain to situations at the zero lower bound for one country’s interest rate. Maybe theresolution of the puzzle has something to do with the zero lower bound; I will try tothink about that—but I have not succeeded in doing so thus far. One thing that I didnote from Bartolini’s discussion is that the inclusion of the Swiss franc as a funding
currency, in addition to the yen, reduced the earnings from the carry trade.
Anyhow, with respect to monetary policymakers, it would appear that the major
issue is whether the failure of UIP implies that the conduct of monetary policy is notgoing to work in the normal manner, that is, whether unsterilized purchases or salesof foreign exchange are going to have their expected stimulative and contractionary
effects. My impression is that no problem of this type logically follows from the UIP
failure described. Thus, in the model that I used for the simulations in my keynote
speech yesterday, a relation implying UIP was included but with a huge random
stochastic component. That is, the UIP equation reflected a huge random departure from
UIP—one that had a standard deviation of the discrepancy of more than 10 percentage
points on an annual basis. Yet that did not, according to the simulation results reported,
keep the policy rules—either of them, the interest rate or the exchange rate rule that
I was discussing—from having their intended stabilizing effects, despite this ongoinglarge random discrepancy from UIP.
More generally, the failure of UIP in the foreign exchange markets is both theoretically and factually similar to the failure of the expectations theory of the term
structure in domestic bond markets. Marvin Goodfriend mentioned to me the otherday that the carry trade is analogous to the practice of what he called “riding the yield
curve” in the U.S. bond markets that took place during the early 1990s. There seemto be puzzles of this sort in many financial markets if you look closely; enough such

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Concluding Panel Discussion

puzzles that I find it a little bit strange that financial economics has such a glowing
reputation. In any case, I do not see that the failure of UIP or the presence of the carrytrade is posing by itself any special problems for monetary policy, and I would thinkthat trying to respond to the many types of financial market issues that arise would
seem likely to lead to more trouble than if the central bank were to keep its attention
focused on its basic macroeconomic goals.
Már Gudmundsson’s remarks pertained mostly to the topic of a possible singlecurrency arrangement for the East Asian area—at least, part of his remarks did. And
I agree with his practical agenda: for the East Asian countries to continue with
development and integration of financial markets, plus greater flexibility of exchange
rates. However, I find it a little hard to imagine a single-currency area that includes
both China and Japan, basically on political grounds. It must be admitted that thecreation of the euro area was a surprise to many people, and somewhat of a surprise
to me. The objectives behind the creation of the euro area seem, however, to havebeen more political than economic. I had the opportunity to read the paper of
Gudmundsson’s (2007) that Hans Genberg mentioned in his remarks in which heexpands on the discussion, and found it very impressive in its thorough and accurateconsideration of issues. His conclusions, after much discussion, seemed correct to me.
But the amount of “back and forth” in argumentation seemed a bit excessive, and I
think it is because the paper’s discussion was focused on the topic of exchange rate
policy. Now, I argued yesterday that exchange rate policy and monetary policy are twosides of the same coin. Nothing in Gudmundsson (2007) is inconsistent with thatview, but I think it is usually more conducive to clear thinking to focus on monetary
policy rather than on exchange rate policy. Of course, in doing so you recognize thatone kind of monetary policy regime is to join a currency union or have a currencyboard arrangement. Those represent one extreme, and the opposite is often said to bea pure float. At the same time, Mundell (2001) has pointed out that the term “purefloat” is not an adequate description of policy. What is your monetary policy to beonce you are floating? Of course, his point is entirely correct, and it is correct because
the term applies to the exchange rate arrangements, not to monetary policy. So, torepeat, I think it is much clearer to start from the point of view of discussing things interms of monetary policy arrangements.
With respect to Hans Genberg’s remarks, I agree very strongly with most ofwhat he said, and think that, for reasons that are obvious by now, exchange rate
coordination should be avoided. I believe that my time is up.
Thank you.

References

Gudmundsson, Már, “Near-Term Exchange Rate Flexibility in East Asia: Precursor to Regional Monetary
Union?” Pacific Economic Review, 2007 (forthcoming).
McCallum, Bennett T., “A Reconsideration of the Uncovered Interest Parity Relationship,” Journal of
Monetary Economics, 33, 1994, pp. 105–132.
Mundell, Robert, “One World, One Money?” (Debate with Milton Friedman) Options Politiques, May,
2001, pp. 10–30.

251

Maurice Obstfeld
University of California at Berkeley
I am discouraged by the comprehensiveness of the previous speakers’ comments,
because they leave little remaining to be said. Nonetheless, I will offer some reflections
on what has been said here today, starting with Leonardo Bartolini’s very interesting
comments on the carry trade.
My initial reaction is to think that the carry trade per se is less interesting than thereasons for the failure of uncovered interest parity (UIP) in the data. The empiricalregularity that high-interest currencies tend to yield positive excess total returns is avery long-standing one. Seventeen years ago, Ken Froot and Richard Thaler publisheda well-known piece in the Journal of Economic Perspectives setting this out (Frootand Thaler [1990]), and it is amazing that this empirical regularity has not actuallychanged over the years.
One way to frame the issue is to think about the standard risk-neutral UIP theory
and the response of asset markets to monetary shocks within a risk-neutral world.
When a country lowers its rate of interest, the mechanism thought to force the UIP
condition to hold reflects borrowing in the low-interest currency and purchasing of thehigh-interest one until the exchange rate moves in such a way as to eliminate expectedexcess returns measured in any single currency. In the specific case of the United States
and Japan, when Japan lowers its interest rate there would be borrowing of yen anda demand for U.S. dollars until the yen has depreciated in an overshooting mannerto eliminate expected excess returns. That story is consistent with accounts of thecarry trade, except that under UIP the exchange rate ends up moving in a very volatilemanner—an overshooting manner, in fact—to fully eliminate any expected excess returns.
In practice, it seems that the adjustment which this overshooting story describes
is incompletely consummated: excess returns in the high-interest currency remain.
The question is: why? An illuminating paper, “The Limits of Arbitrage,” published adecade ago in the Journal of Finance by Shleifer and Vishny (1997), sets out some of
the reasons why it is difficult in practice to arbitrage away all differences in expected
returns. Here the issues of collateral and margins come up, issues that Bartolini also
raised in his discussion. So we get to the key question of why UIP does not hold. Andif margin requirements or collateral requirements are important, that is going to have
implications for monetary policy, because actions that change the values of collaterals
could have market impacts that feed on themselves and that therefore amplify disturbances. Now, this is not a new idea. A decade ago during the Asian crisis period andshortly after, we saw contagion effects that were said to be based on the same sorts ofmechanisms. For example, when Russia went into its crisis, that event initiated margin
calls on positions in other countries, which in turn led to the appearance of contagion.
Obviously policymakers should and do worry about such spillovers.
What might the equilibria in this sort of market look like? These equilibria mightlook like those we see in speculative attack models. Bartolini mentioned the idea oftraders looking toward each other’s opinions to forecast what might happen, so indeed
there might be coordination problems, particularly in a setting where a central bank
may be standing by effectively presenting a put option by being perceived as having an

252 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2007

Concluding Panel Discussioninterest in preventing an excessively sharp currency movement from occurring too
quickly. I think the future modeling of these possibilities could build on the literatureon speculative attacks, even though we are looking at markets of managed exchange
rate flexibility under a float rather than a pegged rate.
Let me move on to Hans Genberg’s remarks. I agree very strongly with just about
everything he has said. I will mention one sense in which I think export-led growthstrategies have proved to be fragile, and that is in the sense of provoking protectionist
pressures in trading partners. To some degree, this has been a very unfair circumstancefor countries like China, because China over the past decade or more has changed its
trade pattern so that it imports a high volume of intermediates and re-exports them to
the United States and other countries. But it is the bilateral balance with the UnitedStates that has attracted so much attention there. These final exports from China thatare causing so much concern in the U.S. Congress would otherwise be reaching theUnited States as final exports from other East Asian countries, so one can argue that
China is taking a lot of the heat for regional export success. Nonetheless, the patternof export-led growth for China, for Korea, and for Japan has historically led to tradetensions with trading partners.
That is not to deny the other good reasons for moving to a more domesticallyoriented pattern of demand growth. Genberg’s presentation hinted at the otherreasons that one might want to, say, increase Chinese consumption on welfare
grounds. Here is a country that is growing rapidly, it is saving massively, and clearly,
to the extent that some of its future consumption gains can be brought forward topresent generations, that would be a good thing. There is also a strong case forincreasing government consumption in certain key areas—health, the environment,
and the like. And of course, were these changes to occur, not only would the external
imbalance diminish, but also there would necessarily have to be a change in relative
prices—a real appreciation of the currency.
A couple of years ago at Berkeley, when Genberg was discussing a paper of mine
and Kenneth Rogoff ’s on the U.S. current account adjustment, he referred to theSalter-Swan dependent economy model. Today I will return the favor. We know inthat model that when a country reduces an external surplus through an increase indemand, some of that demand will fall on non-tradables, bidding up their relative
price in terms of tradables, thereby causing a real currency appreciation, and increasing the supply of non-tradables. For China, of course, an increase in the consumptionof services and other non-tradables is a totally appropriate development. So if one
looks broadly at what would be a sensible strategy, a welfare-enhancing strategy, forrebalancing China’s economy, it would have to include a rise in consumption andsurely a fall in the current level of investment by Chinese firms, much of which isgoing into fairly unproductive uses due to distortions in the economy. Perhaps Yu
Yongding is going to say some words about that later on.
Már Gudmundsson argued in his comments that more exchange rate flexibility isneeded in the region. I completely agree with that, particularly in connection with
China, as I spelled out at length in my keynote speech yesterday. He also brought up
the very important and related issues of external financial account liberalization andinternal financial reform and development. I have little to add to his presentation,253

although what I would say is that in terms of rebalancing an economy such as
China’s, internal financial strengthening is a key element. It will help allocate thecopious savings of the economy in a more rational way; furthermore, I believe thata stronger financial sector, offering better risk diversification and higher returns tosavers, would actually be likely to reduce the savings rate in China, not raise it, andincrease consumption. The effect on savings would, of course, reflect the interplay of
substitution effects and income effects, and for a high-saving economy like China theincome effects would truly be massive and would allow much higher consumption
today without any diminishment of consumption possibilities tomorrow. So for China,
internal financial strengthening is a very important element of an optimal economic
strategy going forward.
There is also evidence that financial development will spur growth. While theevidence in the growth literature is subject to identification problems, I do believe it
points on the whole to a causal influence of financial development on economic
growth. That is a major reason why all the countries in the East Asian region are
pushing for more sophisticated, more effective, better regulated financial systems.
Some, such as Korea, have made huge strides in this direction.
Yesterday I raised the question: why external liberalization? Part of the answer
lies in domestic financial development. In East Asia we have a region with extensive
openness to trade, a region that is also investing in domestic financial development.
It seems to me impossible in practice that such economies can be kept effectively
financially closed except with massive interventions, truly draconian penalties, andmassive distortions. I think these developments are simply not in the cards: capital
controls will not be enforceable in the environment toward which East Asia is moving.
For the same reason that openness to capital movements is inevitable, I think, as
Gudmundsson has proposed, that exchange rate flexibility is also inevitable, as suggestedby the logic of the trilemma, also known as the impossible trinity. To try to peg
exchange rates while also pursuing the desirable goal of domestic inflation targeting
would leave economies open to speculative crises of the sort that we saw in Europe inthe early 1990s, and in Asia in the late 1990s. I doubt very much that monetary union
is in the cards in the East Asian area, at least not in our lifetimes. Genberg (2006)
reaches the same conclusion in a recent paper.
I find it instructive to reflect upon today’s discussion of different levels of financial
cooperation. The suggestion of a variety of Asian credit unions reminded me of the
proposals for an Asian monetary fund that emerged in the late 1990s, in part out ofannoyance at the way the International Monetary Fund (IMF) had handled aspects of
the Asian crisis. The analytical point that a broader credit union is better than anarrower one is clearly right; the IMF does need to be made more effective. If wethink about a regional central bank, we actually come back to the original Keynes
plan for the international monetary system, which was based on a world central bankissuing a world currency that he called “bancor.” In essence, when we talk abouta regional currency union or look at the European Central Bank we are looking at
institutions of which Keynes would have approved, because Keynes’s original
blueprint for what eventually became the IMF would have been an institution capableof conducting countercyclical monetary policy. That did not come to pass in the

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Concluding Panel Discussion

structure of the IMF itself. Nor do I think we can expect this to happen soon in Asia,
given the diverse sovereignties and the lack of an institutional evolution commensuratewith the remarkable developments in Europe since the early postwar period.
I do think that the argument for some sort of inflation targeting at the individualcountry level in East Asia is a sound one. I expect that inflation targeting at similar
low-inflation rates, with credible and transparent policy procedures, will actually go along way toward a de facto stabilization of exchange rates in the region. I do not believethat monetary union is necessary. I think the experiences of Sweden and the United
Kingdom, as part of the European Union but not part of the euro zone, well illustratethat the case for regional monetary union is not terribly compelling. And of course
within East Asia, much of Europe’s evolution in terms of market unification has not
yet taken place. Much deeper economic integration, based on the standard insights of
optimum currency area theory, is a prerequisite for deep monetary unification.

References

Froot, Ken, and Richard Thaler, “Foreign Exchange,” Journal of Economic Perspectives, 4 (3), 1990,
pp. 179–192.
Genberg, Hans, “Exchange-Rate Arrangements and Financial Integration in East Asia: On a Collision
Course?” International Economics and Economic Policy, 3 (3–4), 2006, pp. 359–377.
Shleifer, Andrei, and Robert W. Vishny, “The Limits of Arbitrage,” Journal of Finance, 52 (1), 1997,
pp. 35–55.

Yu Yongding
Chinese Academy of Social Sciences
Thank you, Mr. Chairman. Thank you, everyone. I have learned a lot from thismorning’s discussion. I share most of the opinions expressed by the previous speakers,
even though I have some reservations regarding certain specific comments. Becauseof time constraints, I am not going to comment on my previous speakers’ discussions.
I would just like to use this opportunity to share with you some of my thoughts oncurrent macroeconomic problems in China.
Most foreign economists tend to use the term “impossible trinity” to analyze Chinese
macroeconomic issues. I think this framework is applicable to China in principle,
but the application needs certain modifications because the Chinese situation is reallyquite different from other countries. It is very difficult for outsiders to have a very clear
picture about what is going on in China.
I returned to China in 1994. I have spent more than 10 years trying to understanddevelopments there. I have managed to achieve a little bit of success. Here I should say
a few things to show that China’s situation is complicated. The first concerns China’s
exchange rate regime. The regime by definition is managed floating, and it is heavily
managed. More precisely, it is a regime with reference to a basket of currencies. Be
aware that the regime is not pegged to a basket, but set with reference to a basket ofcurrencies. So the People’s Bank of China (PBOC) has tremendous leeway with thereference, as you can imagine.

255

The second thing I wish to point out is that in China we still have capital controls.
The most important characteristic of these controls is reflected in the fact that therenminbi (RMB) is not convertible. I think this is a very important point. Many
foreign economists tend to forget this in their analyses. They tend to say that China
does not have independence of monetary policy, but this is not true, because capital
controls still exist and work. This is a very important element that we should notforget. Having said that, I must admit that China’s capital controls are extremely leaky.
So on the one hand the RMB is not convertible; on the other hand, capital controls areleaky. It is very important to take these two points into consideration when we analyze
China’s macroeconomic issues within the framework of the “impossible trinity.”
The third thing concerns the independence of monetary policy. China enjoys
such independence, though it is becoming less and less effective. We use many typesof measurements to check whether China retains such independence. For example,
there is quite a significant interest rate spread between the interest rates in China’s
money market and corresponding U.S. financial asset rates in the London interbank
market. Based on interest rate parity, we can say that China still has certain control
over capital movements, and therefore enjoys independence of monetary policy to acertain extent.
It is essential to keep in mind that the Chinese government emphasizes the importance of independence of monetary policy. To maintain such independence is apriority. Mainland China is not Hong Kong. It is all right for the Hong Kong dollar
to peg to the U.S. dollar and relinquish independence of monetary policy, but not
for mainland China. It is impossible for China to give up independence of monetary
policy, because it is a large country, with a population of 1.3 billion. So the problem
now is, under an inflexible exchange rate regime with leaky capital controls, how China
can maintain such independence. At this moment, the answer to the question lies inthe sustainability of the sterilization operation. Many people ask whether China will beable to maintain a stable exchange rate while maintaining independence of monetary
policy. I think this depends on whether sterilization policy is sustainable.
I would like to give you a very brief introduction to that operation. China iscurrently facing a tremendous problem of excess liquidity, caused by its exchange rate
policy as well as its huge twin surpluses—capital account and current account surpluses.
Last year, the twin surpluses were approximately US$200 billion, and this year I thinkthey will be larger. Inflation in China remains a potential threat, and has surpassed
3 percent, China’s implicit inflation target. So the PBOC has to sterilize the excess
liquidity consistently. One of the major instruments of sterilization is to sell central
bank bills to commercial banks. The PBOC does not currently sell government bonds,
because it has sold out all such bonds. At the same time, the PBOC has to raise reserve
requirements frequently. Currently, the reserve requirement is 11.5 percent. So far
this year, we have raised the requirement five times. Finally, the PBOC has to raisebenchmark interest rates. Here, I should emphasize that to raise the benchmark
interest rate in China is not equivalent to raising the federal funds rate or call rate andso on. When we talk about raising benchmark interest rates, we are talking about
raising the floor of the interest rate on loans by commercial banks and the ceiling of
the interest rate on deposits by the commercial banks. In other countries, to decide

256 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2007

Concluding Panel Discussioninterest rates on loans and deposits is not the business of a central bank, but of privatecommercial banks. However, this is a very important policy instrument used by the
PBOC, because in China interest rates are not fully liberalized.
Besides the three instruments that I just mentioned, there is a fourth instrumentthat can and has been used to sterilize excess liquidity. This fourth instrument is
exchange rate policy. In other words, it is to allow the RMB to appreciate a little,
so that the PBOC’s burden of sterilization can be reduced.
Why do I say that sterilization is not sustainable in China in the long run? Because
there are many constraints. One of the very common constraints is that if you tightenmonetary conditions, raising interest rates, there will be more capital inflows andso this will create more problems. This is a typical issue of the “impossible trinity.”
But in China, in my view, the most important constraint is not capital inflows.
It is sterilization’s negative impact on the performance of commercial banks.
In China, commercial banks are holding an increasing number of central bankbills with very low yields. Over the past four years we have sold, I think, more than
RMB3 trillion of central bank bills net; you can check the precise figures, which
are more than the total amount of government bonds sold by the Chinese Ministryof Finance over the past 10 years. At this moment, the ratio of commercial banks’central bank bills to total assets is more than 10 percent. On top of this, we have areserve requirement of 11.5 percent, and the interest rate on this reserve requirement is
1.8 percent. So you can imagine how important the negative impacts of this kind ofaccumulation of low-yield assets on commercial banks’ performance can be. In China,
commercial banks’ most important source of profits is loan rate × total loans − deposit
rate × total deposits, which accounts for more than 90 percent of commercial banks’
total profits. So if you reduce this ability of the commercial banks, then definitely theirprofitability will worsen. Now, most Chinese banks are listed companies; they have toanswer to their shareholders. So the pressure on banks to earn profits is tremendous,
and they must continually consider how to do this. I think there are basically two ways:
to invest in very risky projects with high yields or to increase loans to the public, so as
to increase the denominator in the ratio of low-yield assets to total assets. Both of thesewill lead to a worsening of a bank’s performance. Banks’ books are mostly quite goodat this moment, due to large capital injection and writing off of nonperforming loans.
But if the sterilization continues for a longer time, these hard-earned achievements
could be lost. This is a serious problem indeed.
Currently, I think there is still some room for the PBOC to carry on with thesterilization policy. Taiwan suffered this kind of problem in the late 1980s. There
the reserve ratio was even higher. Now in mainland China the reserve requirement is11.5 percent; it may rise further; who knows? I think China will be able to continue
to maintain sterilization for a certain period of time, maybe one or two more years,
but certainly not forever. Unsustainability of sterilization will force a change in policy,
if the twin surpluses continue and foreign exchange reserves continue to increase.
Due to the constraints on sterilization and also because of the inflation worry
and asset bubble worry, the PBOC has to further tighten monetary policy. To do so
without further damage to the performance of the commercial banks, the PBOC has
to let the exchange rate go a little. We are doing things in combination. We are doing257

everything to a certain extent, and we try to achieve compromises with everyone.
Each policy instrument has different impacts on different economic entities. We do
not want to hurt the real sector (exporters) very much, hence we do not wish to allow
the RMB to revalue in a big way. We do not want to hurt commercial banks very
much, hence we do not wish to sterilize too heavily. We do not wish to hurt the
PBOC very much, hence we do not raise the yields on central bank bills very much.
As a result, we have to “hurt” everyone slightly and thus compromise becomes thecharacteristic of China’s monetary policy.
So far, the PBOC has successfully managed the “impossible trinity.” Interest rates
have risen a bit; low-yield assets have been forced upon the banks a bit; the exchange
rate has appreciated a bit. The real sector, the banking sector, the central bank, andthe exporting sector have shared the burden jointly. But the fundamental problem of
the “impossible trinity” remains.
Thank you.

General Discussion
I. Exchange Rate Coordination and Monetary Cooperationin East Asia
Enrique Alberola Ila (Banco de España) disagreed with the strong position of Hans
Genberg (Hong Kong Monetary Authority) against exchange rate coordination. He
claimed that the case for exchange rate coordination now was higher than before, since
the Chinese exchange rate regime was under some transition and other countries’
regimes were becoming more flexible. In response to Alberola Ila’s argument, Genberg
explained that the problem of exchange rate coordination was who would be responsible for monetary policy in the region. He remarked that exchange rate coordinationin the region would not be credible, since the central banks in the region wereincreasingly focusing on domestic objectives such as price stability. He then insisted
that monetary policy should explicitly commit to domestic objectives and should
completely leave aside exchange rate coordination.
On the possibility of Asian monetary union, Bennett T. McCallum (Carnegie
Mellon University) claimed that a single currency could not be the choice if policymakers in the region wanted to pursue a policy directed toward inflation targeting.
Maurice Obstfeld (University of California at Berkeley) remarked that the idea of
having a single currency for the region was hopeless unless institutional convergence,in the sense of improving central bank independence, goals, strategies, standards, andinstitutions within financial markets, was attained. Már Gudmundsson (Bank forInternational Settlements) acknowledged that if an Asian monetary union was toemerge at all it would most likely be far in the future. He then remarked that a key
factor behind such an emergence might be that the same concern would arise as inEurope, in other words, that exchange rate volatility would be seen to stand in the wayof reaping the full benefits of an economically and financially integrated region.

258 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2007

Concluding Panel Discussion

Regarding monetary cooperation in East Asia, two issues were raised. First, inregard to Gudmundsson’s argument that the highly correlated shocks made themultilateralization of reserve pooling in East Asia less beneficial than otherwise,
Jong-Wha Lee (Asian Development Bank) asked whether there was strong evidenceof a high correlation among shocks among East Asian countries, and whether we
could judge the desirability of reserve pooling solely based on the correlation ofthese shocks. In response to Lee’s question, Gudmundsson clarified that he was
not saying that multilateralization of reserve pooling was undesirable, only that it
was less beneficial than otherwise if shocks are highly correlated. He then remarked
that multilateralization could, in the current Asian context, have other benefits interms of enhanced central bank cooperation and further integration in the region.
Wataru Takahashi (Bank of Japan) later pointed out that one should not pay too
much attention to the issues such as the common currency and the coordinationof monetary policy. He further insisted that it was crucial to promote cross-borderfinancial activities in the region for the sake of integration. In particular, given
the dominance of bank finance in the region, the reform of the banking sector
involving issues such as cross-border banking and the introduction of foreign banks
were important.
Yu Yongding (Chinese Academy of Social Sciences) commented that the generaltendency of the discussion on monetary union and monetary cooperation in thisconference was very different from that in other forums in which he had participated,
especially in Japan.

II. Monetary Policy and the Carry Trade in East Asia
Hiroshi Nakaso (Bank of Japan) explained how he had looked at the yen carry trade.
The current yen carry trades differ in some ways from those observed in 1998:
namely, (1) they are mostly driven by retail investors rather than large hedge funds;(2) the aggregate positions held by hedge funds are still large, but leverage is probably
lower; and (3) the size of the foreign exchange market is substantially larger. These
differences imply that even if some of the hedge funds unwind their positions, theimpact on the foreign exchange market would be smaller when compared with 1998.
Regarding the size of the yen carry trade, Nakaso claimed that a rough estimate waspossible. He remarked that all kinds of carry trades by retail investors could be broadly
regarded as the correction of a traditional home bias.
Marvin Goodfriend (Carnegie Mellon University) compared the short-term
profitability of the “carry trade” in recent years to the profitability of “riding the U.S.
yield curve” in the early 1990s, following up on McCallum’s comment relating yield
curve issues to carry trades. Goodfriend pointed out that people who borrowed at low
short-term rates to take a position in the long-term U.S. bond market in the 1990s
correctly bet that Federal Reserve Board Chairman Alan Greenspan’s credibility for
low inflation ultimately would keep long-term rates low and long-bond prices high.
Goodfriend remarked by analogy that participants in the carry trade are betting thatmonetary policy in Japan will keep the yen/U.S. dollar exchange rate from falling259

much. He wondered whether this “political economy” story in the context of deflation
could help facilitate understanding of the evolution of the carry trade in Japan.
Leonardo Bartolini (Federal Reserve Bank of New York) claimed that central banks
cared about the carry trade mainly because it may enhance the responsiveness ofcapital flows to monetary policy moves. Gudmundsson disagreed with McCallum’s
argument that the failure in uncovered interest parity itself was not posing any serious
problems for monetary policy. This failure is often a reflection of exchange rates
being misaligned with fundamentals during extended periods, followed by sharp
corrections. That poses a significant challenge for the conduct of monetary policy insmall open economies. In this context, he raised the concern that the road to utilizing
the exchange rate channel may be bumpy in the sense that it had a tendency toovershoot or misalign, while the interest rate channel would be blocked due tofinancial globalization. He also claimed that the use of the exchange rate as an
instrument in Singapore, which had been discussed in McCallum’s keynote speech,should be given serious consideration in small and very open economies, although
it might not be applicable to other countries with relatively bigger non-traded goods
sectors. McCallum replied that his argument about the uncovered interest parity
did not have anything to do with the example of Singapore, and would be equallyapplicable to inflation-targeting regimes and Singapore-style regimes.

260 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2007