Monetary Policy in East Asia:
Common Concerns
Marvin Goodfriend

The paper identifies and evaluates consequences for monetary policy of fivefeatures of East Asian development: export orientation, integrated regional
trade, bank-dependent finance, the potential for persistent trade surpluses,
and the aggressive accumulation of international reserves. The case for a
flexible exchange rate is made in terms of the New Neoclassical Synthesis(NNS). NNS logic indicates why fluctuations in “export optimism” create
problems for the sustainability of a fixed exchange rate. Cooperative credit
policy in East Asia is discussed by analogy to a credit union. The paper
outlines problems for monetary policy created by bank-dependent financein East Asia. A two-country NNS model indicates that a revaluation of
the renminbi against the U.S. dollar is likely to exert little effect on the
U.S. trade deficit, although it should help control inflation in China. The
paper argues that China can adopt a flexible exchange rate in a few years
with modest reforms of its banking system. Finally, the paper considers
various reasons for the accumulation of international reserves in East Asia.
Keywords: East Asia; Monetary policy; Banking policy; Exchange rates;
Trade balance; International reserves
JEL Classification: F3, F4Carnegie Mellon University (E-mail: marvingd@andrew.cmu.edu)
Conversations with Hans Genberg, Bennett T. McCallum, Allan Meltzer, and Chris Telmer are muchappreciated, as are comments by the discussants Enrique Alberola Ila and Lawrence Schembri.
The paper benefited from a presentation at the workshop on “New Developments in Monetary Policyin Emerging Markets,” Bank of England, July 2007.
MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2007
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I. Introduction
East Asia is home to a diverse collection of economies ranging in size from the largest
countries to the smallest city states. The regional economies are in various stages of
two great transitions—from central planning or extensive regulation to a reliance onmarkets, and from the use of traditional production processes to the application ofmodern industrial techniques.
Yet the countries of East Asia have a number of distinctive characteristics incommon. For the most part, they have been export-oriented and many have succeeded
consistently over time in improving the attractiveness of their exports to the developed
world. Per capita products throughout the region have been converging to those of
the industrialized world. Rapid productivity growth has been achieved by importing
technology from abroad and building on it to produce ever more desirable goods forexport and greater efficiency of labor at home.1 Productivity growth and export successhave moved the real terms of trade higher over time, providing an additional boost to
well-being by steadily increasing the value of East Asian products at world prices.
Highly integrated regional trade is another manifestation of East Asian development. In particular, there is thriving regional trade in intermediate goods. The
proximity of nations with vastly different labor costs and technological capabilities
creates opportunities for savings in the production of high-value goods. The region isfamous for locating the various stages of production of goods where they are mostcheaply executed. Technologically advanced countries produce sophisticated coreelectronic components such as computer chips. Core components are shipped to lessdeveloped countries for assembly where labor costs are lower. The components areassembled, packaged, and shipped to export markets overseas as part of the so-called“processing trade” in countries with relatively cheap labor.
In the financial sphere, the economies of East Asia share a high degree of bankdependence accompanied by relatively thin corporate bond markets. In large part,
this legacy derives from a history of government direction of economic activity. The
relative absence of opportunities for direct borrowing and lending in the capital
markets served to enhance the power of banking institutions to work closely with business allies and political officials to direct credit to favored borrowers. In recent years,
banking crises in East Asian countries resulted in part from poorly run and inadequately
regulated financial intermediaries. The relative lack of alternative nonbank financial
intermediation, in turn, made entire economies more vulnerable to banking problems
than is the case where corporate bond markets are more developed. In China, thebanking system must be strengthened to enable the country to adopt independent
monetary policy with a fully flexible exchange rate.
The economies of East Asia famously share a high savings rate. The high savings rate
is related to the two great transitions and to the underdeveloped financial markets.
Although many East Asian countries have absorbed domestic savings in domestic
investment on average, investment has fallen short of desired saving for extended periods
in many countries, producing large and persistent trade surpluses. For instance, Japan
1. See, for instance, Goodfriend and McDermott (1998).

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Monetary Policy in East Asia: Common Concerns

long has had persistent trade surpluses, and in the last few years China too has run an
overall trade surplus.
The aggressive accumulation of international reserves by many East Asian central
banks has been a prominent feature of East Asian economic development. Lately,an unprecedented acquisition of international reserves by the People’s Bank of China(PBOC) has been claimed as evidence that China manipulates its currency forcompetitive advantage in international trade. As discussed below, East Asian central
banks have had a variety of motives for accumulating international reserves.
This paper identifies and evaluates consequences for monetary policy of the five
above-mentioned features of East Asian development: (1) export orientation; (2) highly
integrated regional trade; (3) bank-dependent finance; (4) the potential for persistent
trade surpluses; and (5) the aggressive accumulation of international reserves.2
We begin in Section II by presenting the case for inflation targeting with a flexible
exchange rate in terms of the New Neoclassical Synthesis (NNS). The case against afixed exchange rate is made with reference to fluctuations in “export optimism” such asappear to have occurred prior to the East Asian currency collapse of 1997. Section III
considers the case for cooperative credit policy in East Asia in light of the potential for
financial contagion that extensive regional trade entails. In Section IV, the paper
describes the problems that bank-dependent finance, political interference in banking,and thin corporate bond markets create for monetary policy in East Asia.
Section V uses a two-country NNS model to argue that a revaluation of theexchange rate of the renminbi (RMB) against the U.S. dollar is likely to exert little
if any direct influence on the U.S. trade deficit, although it should help to control
Chinese inflation. Section V then insists that what China needs is a flexible exchange
rate, not a revaluation or a sequence of managed revaluations, and argues that China
can adopt an inflation target and float its currency in a few years with modest reformsof its banking system. Section VI considers three reasons, in light of monetary andexchange rate policies, why East Asian central banks have aggressively accumulated
international reserves. A brief summary concludes the paper.

II. The Case for Flexible Exchange Rates and the Fragilityof Fixed Rates in East Asia
The case for a flexible exchange rate in the NNS is based on the case for targeting
inflation in a closed economy originated in Goodfriend and King (1997).3 The idea isthat a monetary economy has a monopolistically competitive real business cycle (RBC)
core in which firms have pricing power over the differentiated goods that they produce.
If prices were costless to adjust, then monopolistically competitive firms would sustain
the flexible-price profit-maximizing markup at all times, and the economy would
display aggregate fluctuations due to supply shocks—shocks to productivity, theterms of trade, or the labor force, and so on. Monetary policy would have little role in
2. Bank for International Settlements (2006c) is a good overview of East Asian monetary policy in practice.
3. See also Clarida, Gali, and Gertler (1999) and Woodford (2003).

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stabilization policy, and business cycles would be efficient in the sense that they would
occur in spite of the fact that prices were fully flexible.
However, frictions associated with the use of money—pricing in money units andthe costly adjustment of differentiated product prices—cause the behavior of the
NNS economy to deviate from that of its RBC core. Firms adjust employment toaccommodate fluctuations in demand at sticky money prices. Fluctuating conditionsin the labor market, in turn, influence unit labor costs. For instance, excessive aggregate demand increases employment, raises unit labor costs, compresses markups, andcreates inflationary potential. If the central bank has credibility for low inflation,then firms adjust prices little in response to current shocks and policy actions, andinstead expect interest rate policy to act on labor market conditions to restore theflexible-price profit-maximizing markup at unchanged prices.
Frictions associated with the use of money expose the NNS economy to inefficient
fluctuations associated with temporary deviations of actual from flexible-price markups.
By the same token, sticky prices provide the leverage for monetary policy to influence
employment and output. The NNS perspective with its RBC core recommends thatinterest rate policy act to stabilize actual markups at profit-maximizing markups tomake the NNS economy behave as if prices were fully flexible.
A key idea is that by stabilizing inflation, monetary policy also stabilizes actual
markups at flexible-price profit-maximizing markups. Otherwise, firms would not be
content to raise prices at the targeted rate of inflation. Hence, the NNS framework
implies that inflation targeting is welfare-maximizing monetary policy. Of course,
problems associated with modeling, forecasting, and measurement prevent interest
rate policy from stabilizing inflation perfectly. So frictions associated with the use ofmoney and with monetary policy inevitably superimpose inefficient fluctuations or“bad” business fluctuations cycles on “good” real business cycles.
Some prices, such as those for energy and food, are typically more flexible thanothers. So the question arises, should targeted inflation include flexible as well as
sticky prices, or should a core measure of inflation be targeted? The NNS perspective
suggests that monetary policy should target the measure of inflation that allows the
economy to behave as much like its flexible-price RBC core as possible. Hence, core
sticky-price inflation should be targeted and flexible prices should be allowed to adjust
freely relative to core prices.
NNS reasoning carries over to an open economy that both imports a share of
consumption goods and exports output at foreign-currency prices given in world
markets.4 Monetary policy should target a core index of domestic-currency denominatedprices of goods and services produced for domestic use by monopolistically competitive
firms. Export and import prices should be free to adjust relative to targeted core prices.
Domestic currency prices of exports and imports would fluctuate due to movements
in foreign-currency prices, and partly with respect to fluctuations in the foreignexchange rate. That said, import prices could be included in the targeted index to theextent that the domestic value added due to transportation and marketing, and so on,
is a significant part of the cost.
4. Goodfriend (2007) and references contained therein make this point.

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Monetary Policy in East Asia: Common Concerns

The capacity for national monetary policies to overcome monetary frictions bytargeting inflation depends critically on the nature of international monetary arrangements. For interest rate policy to target domestic inflation, a country must allow its
exchange rate to float on the foreign exchange market. The exchange rate must be
flexible to support fluctuations in the real terms of trade consistent with domestic
real business cycles, since the national NNS economy must behave like its RBC core
to stabilize inflation.
The case for a flexible exchange rate is particularly strong for rapidly developing
export-oriented economies such as those in East Asia, economies that can expect toimprove the attractiveness of their exports to the developed world over time and thereby
steadily improve their terms of trade. The reason is that interest rate policy forced tosupport a fixed or managed exchange rate is no longer available to stabilize domestic
inflation and employment. And fluctuations in “export optimism” subsequently foundto be excessive can readily create a conflict between stabilizing the exchange rateand stabilizing domestic employment and inflation. Specifically, excessive optimism
about the improvement of the terms of trade that is reversed subsequently can create acredibility crisis for a fixed exchange rate regime.5
The argument goes as follows.6 Suppose that export optimism raises the expected
East Asian terms of trade. Since both East Asian and U.S. residents wish to smoothconsumption over time, East Asian residents borrow against the brighter future income
prospects associated with the improved terms of trade and U.S. residents lend against
the expected deterioration of their terms of trade. Hence, capital flows from the UnitedStates to East Asia, and East Asia runs a trade deficit with the United States.
Given the home bias in consumption, the East Asian trade deficit increases
demand in East Asia. Because prices are sticky initially, employment rises, wages rise,and markups are compressed relative to profit-maximizing markups. Firms raise
prices to restore their profit-maximizing markups, and inflation raises East Asian realexchange rates relative to the United States. These outcomes resemble those of theEast Asian “miracle” in the years preceding the 1997 currency crisis.7
The problem is this: a subsequent moderation of excessive export optimism may
narrow or reverse the East Asian trade deficit and contract demand in East Asia. In thiscase, East Asian price levels that have already adjusted upward in response to excessive
export optimism are exposed to deflationary pressure. At this point, the East Asian fixedexchange rate commitment is called into question. A devaluation of the exchange rate
obviates the need for a period of unemployment to cut wages, elevate markups, andinduce East Asian firms to deflate their prices. A credibility crisis invites speculators to
attack the fixed exchange rate regime. East Asian countries are faced with a dilemma:raise interest rates to deter speculation and incur an inefficient recession, or devalue
the currency to relieve speculative pressure and risk more frequent speculative attacks
in the future.
To sum up, the plausibility of rapid improvement in the terms of trade in East
Asia creates circumstances that jeopardize a fixed exchange rate regime any time a period
5. Obstfeld and Rogoff (1995) and Husain, Mody, and Rogoff (2005).
6. The discussion is based on analysis developed in Goodfriend (2007).
7. Glick (1999).

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of export optimism subsequently proves to be excessive. A flexible exchange rate handles
fluctuations in export optimism smoothly by allowing the exchange rate to appreciate
in response to export optimism and to depreciate if that optimism subsequently
proves excessive.

III. East Asian Financial Cooperation
Highly integrated regional trade and processing of intermediate goods for export ties
the economies of East Asia closely to each other and to fluctuations in the West’s
demand for exports. Tight trade linkages, in turn, create the potential for financial
contagion in East Asia. Since the currency crisis in the late 1990s, the countries of
the region have taken steps to cooperate on exchange rate policy. For instance, with
the Chiang Mai Initiative agreed at the ASEAN+3 Finance Ministers’ meeting inMay 2000, East Asian nations moved to establish a network of bilateral foreignexchange swap agreements to provide liquidity support to countries experiencingbalance of payments difficulties.8 Although further cooperation on financial matters
has moved slowly, the nations of the region continue to explore the possibility anddesirability of closer financial and exchange rate cooperation.9
The case for regional financial cooperation can be explored by thinking of a“credit union.” A credit union is a financial intermediary that accepts deposits
from and makes loans to a group of eligible members. The key is that the members
already share some prior association, such as employment in a company. A credit
union economizes on the evaluation of creditworthiness, on the monitoring of loan
covenants, and on enforcement costs of recovering a loan. For instance, the incentive
to repay is strengthened if failure to repay is known to cost a credit union member
his job. A credit union exploits information produced in a prior association to reducethe cost of financial intermediation.
Loans in a credit union rotate among the membership. The credit union keeps ashare of its assets in “reserves,” external securities that can be sold on short notice tofund emergency advances to its members. The credit union can make funds available
to a member on short notice because the member’s circumstances are well known.
By exploiting the mutual knowledge of its membership, a credit union makes funds
available to its members on better terms than an ordinary commercial bank, andmore cheaply than can be provided individually by holding a portfolio of low-yielding
liquid securities for self-insurance.
The case for financial cooperation among the governments of East Asia rests on thestrength of the analogy to a credit union. East Asian nations constitute an association
to the extent that they interact regularly as a result of geographical proximity, common
export orientation, regional integration, and intergovernmental relationships. If thecountries of East Asia can exchange information and implement surveillance processes
cheaply enough on the basis of these common factors, then it may make sense for thecountries of East Asia to engage in international credit cooperation based on bilateral
8. Rana (2002).
9. See Eichengreen (2006), Fujiki and Terada-Hagiwara (2007), and Kose et al. (2006).

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Monetary Policy in East Asia: Common Concerns

foreign exchange swaps or by setting up a regional financing facility such as a regionalmonetary fund. East Asian credit cooperation would allow the countries to economize
on their holdings of international reserves.
That raises the question: what can international credit policy do in addition todomestic interest rate policies? After all, in Section II we saw that if interest rate
policies are employed independently to target domestic inflation and the exchange
rate is allowed to float freely, then inefficient fluctuations due to sticky prices could be
eliminated. There is no need for international cooperation on monetary or exchange
rate policy to achieve efficient fluctuations relative to the international RBC core.
In fact, the countries of East Asia should allow their exchange rates to float freely witheach other to accommodate fluctuations in relative terms of trade that inevitably occur
due to differences in the nature and pace of development.
To pursue this question further, we must distinguish credit policies from interest
rate policies. Whether done collectively or bilaterally, international credit cooperation
is an arrangement by which one country borrows international reserves from anothercountry or group of countries to finance officially a net capital outflow in its balanceof payments. Credit transactions need not affect national interest rates if the central
banks of the countries involved adjust their balance sheets to sterilize the effect ofcredit flows on the monetary base.
Access to borrowed international reserves helps a country to defend its exchange
rate without raising interest rates. A policy of “financing” a balance of payments
outflow with borrowed international reserves as opposed to “adjusting” the interest rateor the exchange rate may be appropriate when a government believes that a capitaloutflow will be reversed soon of its own accord. The essence of international credit
policy is that it allows a government to “buy time” without resorting to potentiallydisruptive interest rate or exchange rate adjustments.
However reasonable the potential benefits seem, there are a number of reasons toquestion the usefulness of regional credit cooperation in practice. First of all, thepremise presupposes that there are instances when a government has information
about the duration of net capital flows that markets do not have, otherwise one
might expect private capital flows to stabilize exchange rates tolerably well. On theother hand, if an underlying shock turns out to require an adjustment of theexchange rate, then credit policy can be counterproductive and expensive by delaying
the necessary adjustment and incurring additional costs to repay borrowed reserves.
The main benefit to East Asia of creating bilateral or multilateral mechanisms forborrowing international reserves is that such mechanisms could deter a speculative
attack on a particular country that otherwise could spread throughout the region.
However, even this benefit of cooperative credit policy would be offset to the extent
that it provides an incentive for investors to move capital into East Asia on a shortterm rather than on a long-term basis with the expectation that a quick reversal could
be financed by borrowed international reserves.
On balance, the scope for mutually beneficial governmental credit cooperation in
East Asia would appear to be relatively limited. The key to efficient exchange rate
behavior in East Asia is for each country to strengthen the institutional credibilityof its own inflation targeting regime and to allow its exchange rate to float freely on

213the foreign exchange market.10 At best, credit cooperation can supplement but not
substitute for strong, independent monetary policies throughout the region.

IV. Bank-Dependent Finance and Corporate Bond Markets
in East Asia
Corporate bond markets are relatively undeveloped in East Asia, making the region
depend heavily on banks for financial intermediation.11 Bank dependence is a legacyof relatively rapid development in East Asia. When economies are in a traditional
state, firms are small, and self-funding and funding by close relatives overcome problems in identifying reliable borrowers and enforcing repayment. Relationship lendingis efficient. As economies develop further, banks direct deposits to larger enterprises
by recreating relationship lending through credit evaluation, loan monitoring, andmanaging firms in default.
In the West, where development progressed relatively slowly over the centuries,
prominent firms in need of large external funding gradually bypassed informationintensive bank lending and accessed lenders directly with corporate bonds. In the
United States, the development of direct finance occurred simultaneously with thedevelopment of legal frameworks to deal efficiently with bankruptcy and investor
protection.12 Corporate governance standards were established over time to minimize
agency costs of debt. Financial authorities promoted self-regulation of debt markets
and encouraged rules for the disclosure of financial information.
Today, even firms large and visible enough to access corporate debt markets directly
continue to employ banks for a variety of services such as lines of credit, borrowing on
the basis of customized securities, and debtor-in-possession borrowing in bankruptcy.
Moreover, firms diversify their sources of credit to insure against shocks to the cost offunds in either banking or bond markets.13
Nonfinancial development in East Asia proceeded too fast for institutions todevelop in support of a corporate bond market, with consequences that became
evident in the last decade. Greenspan (1999) emphasized the “spare tire” role of a deep
market in nonbank bond finance to cushion financial distress. The 1997 East Asiancurrency crisis was exacerbated by the bank-dependent finance, because when banks
collapsed there were few alternative ways for credit to flow to deserving borrowers.
On the other hand, the 1990 collapse of real estate collateral in the United States thathurt bank lending did not interrupt mortgage lending much, because of the deep
market in mortgage-backed securities. The protracted banking crisis in Japan hurt
the economy more than it might have if nonbank capital markets had been widely
developed in that country.
The direct negative consequences for monetary policy of such developments areclear. Real interest rates have to be lower for longer than otherwise to deliver a given
10. Genberg (2006).
11. Bank for International Settlements (2006a, b).
12. La Porta et al. (1998).
13. Sundaresan (2005).

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Monetary Policy in East Asia: Common Concerns

stimulus to aggregate demand in situations where the firms lose access to credit becauseof a weak banking system. This is one reason why short-term interest rates were driven
to the zero bound in Japan in the 1990s. The lack of deep corporate bond markets
affects monetary policy indirectly too, by depriving the banking system of competitionat the margin. Banks must compete to retain borrowers with access to direct finance.
That discipline is likely to cause banks to be better managed, more innovative, and more
efficient than otherwise.14 Bank regulators benefit, too, because banks are healthier,and also because regulators have greater leeway to credibly enforce tough standards onbanks when alternative avenues of finance are available to pick up the slack if need be.
Regulators can exercise more discipline over the banking system if they are not held
hostage to the fact that there is no alternative to bank intermediation. A financiallyrobust banking system, in turn, is more likely to withstand a period of high interest
rates needed from time to time to stabilize inflation. Thus, a deep corporate bondmarket indirectly enhances a central bank’s credibility for low inflation.
Financial authorities throughout East Asia are aware of the vulnerabilities of excessive dependence on the banking system and have been working to broaden domestic
and regional bond markets. The problem is that developing a corporate bond market
means breaking the monopoly of banking on financial intermediation. Banking long
has been home to well-connected wealthy businessmen and powerful political officials
who collude to dominate finance and who will resist the loss of their monopoly.
To succeed in diversifying financial intermediation fully, East Asia must find a way todeal effectively with the political economy of finance and develop the legal, regulatory,
and market infrastructure to allow deep and resilient bond markets to take root.

V. RMB Revaluation, the U.S. Trade Deficit, and Banking
Reform in China
The U.S. trade deficit with China is commonly ascribed to the fact that China
keeps the RMB undervalued against the U.S. dollar.15 The argument suggests that if
China revalues the RMB, then the U.S. trade deficit should shrink. A benchmark
two-country version of the NNS model suggests otherwise—that a revaluation of theexchange rate fixed by country B has little effect on country A’s trade deficit measured
in units of country A’s output, if country A’s monetary policy targets inflationcredibly.16 What China needs is not a one-time revaluation of its exchange rate or asequence of managed revaluations, but a flexible exchange rate to secure stable inflationand employment at home and to anchor the financial stability of East Asia. China
can undertake modest banking reforms in a few years to make its banking systemsufficiently robust to interest rate fluctuations to adopt a credible inflation target andfloat its currency on the foreign exchange market. These points about the Chinese
exchange rate policy, the trade balance, and banking reform are elaborated below.
14. Economist (2007).
15. Yu (2007) provides a useful perspective on related issues.
16. Devereux and Genberg (2007) also stress the ineffectiveness of nominal currency appreciation as a means ofcurrent account adjustment.

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A. Invariance of the Trade Surplus to a Revaluation of a Fixed Exchange Rate
Goodfriend (2007) develops a two-country, two-good, two-period benchmark NNS
model of international adjustment to explore the behavior of the balance of payments,
the terms of trade, and aggregate fluctuations with respect to interest rate and exchange
rate policies followed by two large countries. In the model, countries A and B eachspecialize in the production of a distinct composite of differentiated consumption goods.
Representative households in A and B live for two periods: the present and the future.
Households choose how much of each composite good to consume each period andsupply work effort each period to firms, which produce the consumption goods. Firms
are owned domestically by households, so household income each period is the sum ofdomestic wages and profits. Households have access to a credit market where they canborrow or lend internationally to consume more or less than their current income allows.
Households maximize lifetime utility taking as given the current and future worldterms of trade, current and future real wages in A and B, and real interest rates in thetwo countries. A no-interest-arbitrage condition links the two financial markets. As isstandard in the benchmark NNS model, there is no capital and all output is consumed
each period. Borrowing by country A from country B in period 1 is reflected in a
trade deficit for A and a trade surplus for B. All international borrowing is repaid inperiod 2. There are three household optimality conditions: one for the allocation of
consumption between the two composite goods, a second for the allocation of time
between work and leisure, and a third for the allocation of consumption over time.
The model determines the endogenous variables in terms of exogenous variables in thetwo countries reflecting productivity levels, home good biases in consumption, and
impatience to consume.
Country A (representing the United States) is assumed to target domestic inflation
with interest rate policy, and thereby to stabilize its actual markup at the flexible-pricemarkup. Importantly, monetary policy in country A makes A’s economy behave like its
RBC core, regardless of what country B does. Country B (representing China) isassumed to employ its interest rate policy to stabilize the B-money price of A-money(the RMB/U.S. dollar exchange rate).
Of particular interest for the question at hand is that country A’s trade balancemeasured in A-good units is independent of the terms of trade. The sign of the tradebalance depends on relative current and future home biases in consumption in thetwo countries and on relative impatience to consume. For instance, country A has a
trade deficit (and country B a trade surplus) if A households are more impatient thanB households or if country A is expected to improve the attractiveness of its exports
relative to country B—in other words, if the B-household home bias in consumption
is expected to decline. (Recall the discussion in Section II.)
What happens if country B (China) revalues B-money relative to A-money(appreciates the RMB against the U.S. dollar), still maintaining a fixed exchange
rate? Assume that central bank A continues to stabilize the dollar price of A goods
exactly. If the RMB price of B goods in country B is sticky, then the revaluation of
the RMB versus the dollar makes Chinese goods more expensive relative to U.S.
goods. In other words, the revaluation temporarily improves the competitiveness of U.S.
exports to China and hurts the competitiveness of Chinese exports to the United States.

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Monetary Policy in East Asia: Common Concerns

According to the benchmark model, however, the revaluation of B’s exchange rate
has no effect on country A’s trade balance measured in A-good units. The reason is asfollows. First of all, monetary policy in country A stabilizes inflation and the markup
in A, and thereby stabilizes A-country output and income measured in A-good units.
Second, the exchange-rate-induced deterioration of A’s terms of trade induces A
households to substitute away from B goods and toward A goods in consumption.
However, the deterioration in A’s terms of trade also reduces the value of A-goodincome in terms of B goods. For separable log utility, the substitution effect exactly
offsets the income effect, leaving unchanged the A-household demand for A goods.
Also, the A-good value of A-household expenditure on B goods remains unchanged.
Third, the real interest rate in country A is invariant to the exchange rate revaluation. Hence, current relative to future A-household spending measured in A-good units
is also stabilized. Since A-household aggregate income and aggregate consumption
expenditure (both measured in A-good units) are each invariant to the revaluationinduced change in the terms of trade, country A’s trade balance measured in A-goodunits is invariant also.
This invariance of country A’s trade balance to the revaluation of country B’s
exchange rate is a consequence of features of the benchmark NNS model. Yet thosefeatures are not unreasonable. And the fact that invariance holds in this case suggeststhat one should not expect a revaluation of the RMB against the U.S. dollar to havemuch if any effect on the U.S. trade balance measured in units of U.S. output.
That said, an RMB revaluation against the U.S. dollar could be helpful in anotherrespect—to contain inflation inside China. According to the model, an RMB revaluation would create a deficiency of demand for Chinese output that would weaken labormarkets and elevate markups in China. Such deflationary pressure on prices inside
China could be useful to offset a preexisting inflationary compression of markups.
What could cause preexisting inflationary pressure? The fixed exchange rate regime in
China is subject to the same kind of inflationary pressure described in Section II withrespect to fixed exchange rates in East Asia more generally. Under a fixed exchange
rate regime, one might expect inflation to develop inside China as it improves theattractiveness of its exports to the developed world and thereby improves its terms oftrade. From this perspective, an appreciation of the RMB against the dollar would
allow China to improve its terms of trade while maintaining domestic price stability.17
B. Banking Reform and Exchange Rate Flexibility in China
The debate about Chinese exchange rate policy is reaching a critical point. If the RMB’svalue continues to be tightly managed, the United States might increase protectionist
pressure against China to try to force a revaluation. In light of the discussion
above, such actions would be needlessly confrontational. Goodfriend and Prasad(2007) argue that modest reforms of China’s banking system would enable China tofloat its currency in a few years and put in place an independent interest rate policy
regime that would improve Chinese macroeconomic performance at home and defuse
tensions abroad.
17. Higgins and Humpage (2005) describe the actual behavior of the RMB’s exchange rate.

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Independent interest rate policy requires a flexible exchange rate, not a one-off
revaluation or a sequence of managed revaluations. But then the exchange rate can nolonger serve as the nominal anchor for monetary policy. China must put in place theinstitutional capacity to target low long-run inflation credibly so that an inflation
target can serve as the new nominal anchor.
To prepare China for independent interest rate policy, Chinese banks must be madefinancially robust to fluctuations in short-term interest rates. Financial robustness isnecessary to allow interbank interest rates to fluctuate credibly as needed to manage
independent monetary policy effectively.
The source of the robustness problem in the Chinese banking system is that Chinesebanks have long been a primary means of financing state-owned enterprises (SOEs),
and many Chinese banks are run by local managers politically motivated (or underpressure from regional government officials) to direct credit to well-connectedborrowers. Chinese banks are assured of a large and growing stock of deposits as aresult of the high savings rate, capital controls, and thin debt and equity markets. Under
these conditions, Chinese banks have had a tendency to build up nonperforming loans(NPLs) over time with the tacit approval of the government.
The problem is that banks whose interest earnings are significantly impaired due
to NPLs may have cash flow sufficient only to pay relatively low interest on deposits.
Since banks are tightly connected through the payments system and a network ofinterbank balances, financial distress anywhere threatens the entire system. A fragile
banking system could make the PBOC reluctant to raise interest rates to head off
inflation. Even the perception that the PBOC is reluctant to raise interest rates would
threaten the credibility of the central bank’s commitment to low inflation.
In recent years, many Chinese banks have been recapitalized with funds from thelarge stock of international reserves, so balance sheets are currently in reasonably good
shape. However, going forward the banking authorities must strengthen incentives forbank managers to make prudent loans to viable enterprises. Bank managers cannot be
asked to lend prudently, with the expectation that a loan be repaid and bank capitalpreserved, when managers are rewarded by the political system for directing credit toconnected borrowers or SOEs, and then largely excused for loan losses.
The Chinese authorities could put in place in a few years the necessary reforms toblunt the incentive for banks to accumulate NPLs, in part because the authorities havebeen working hard to strengthen the banking system for some time now. Much is atstake. The NPL problem must be addressed to make the banking system financiallyrobust to interest rate fluctuations to improve monetary policy and exchange rate policy
in China.

VI. International Reserve Accumulation in East Asia
Many central banks of East Asia have accumulated international reserves at unprecedented
rates in recent years both absolutely and as a percentage of GDP.18 Yet aggressive
18. Alberola and Serena (2007) and Higgins and Klitgaard (2004).

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

Monetary Policy in East Asia: Common Concerns

international reserve accumulation has had very different motives. Foreign exchange
accumulation in Japan may have helped to deter deflation when Japanese interest rate
policy was immobilized at the zero bound. Korea and Singapore, among others,
acquired international reserves after the East Asian currency crisis to self-insure against
another external shock. In China, the accelerated pace of international reserve accumulation in recent years reflects the trade surplus and the fact that capital controls toprotect the banking system limit the private movement of capital abroad.19 Thissection reviews the various motives for acquiring international reserves and theirrelationship to monetary policy.
A. International Reserve Accumulation at the Zero Bound
When interest rate policy is immobilized at the zero bound in an effort to deter
deflation, a central bank must continue to expand its balance sheet to stimulate
the economy. However, base money and domestic short-term securities are perfect
substitutes at the zero bound, so stimulus can no longer be provided by conventional
open market purchases of short-term domestic securities. In that case, however, acentral bank can provide stimulus by purchasing such assets as long-term bonds orforeign exchange on an unsterilized basis, that is, with newly created base money.
By choosing to acquire long-term bonds in the 1990s, the Bank of Japan was able
to provide additional monetary stimulus at the zero bound. If the outstanding
stock of long-term bonds or other domestic assets to buy is deemed insufficient toprovide the necessary stimulus, then the acquisition of international reserves can play
an important, even essential, role in the implementation of monetary policy at thezero bound.
B. International Reserve Accumulation for Self-Insurance
When interest rate policy is not immobilized at the zero bound and the exchange
rate is flexible, operations in international reserves are not needed to implementmonetary policy if there is an adequate stock of short-term securities for a central
bank to buy. Nevertheless, central banks of highly open, export-oriented economies
build up a stock of international reserves with which to intervene on an unsterilizedbasis against turbulence in foreign exchange markets. For example, Korea and Singapore
have each accumulated very large stocks of international reserves even though each has aflexible exchange rate.
As discussed in Section III, however, intervention in foreign exchange markets islikely to be of relatively limited value. Moreover, the accumulation of a very large stockof international reserves can be counterproductive if it causes the public to believe thatthe central bank will employ interest rate policy to stabilize the exchange rate at theexpense of domestic price stability. Benefits believed to derive from foreign exchange
operations must be balanced against credibility problems that such operations cancreate for the central bank’s commitment to targeting low inflation.20

19. Green (2007).
20. Broaddus and Goodfriend (1996).

219

C. International Reserve Accumulation with a Managed Exchange Rate andCapital Controls
In China, the accumulation of international reserves is dictated by the managed
exchange rate and capital controls. The PBOC acquired its large stock of international
reserves mainly by accommodating years of net inflows of foreign direct investment
at a fixed exchange rate and by accommodating the overall trade surplus that emergedin the last few years. To curb the inflationary potential of such reserve accumulation,
the PBOC has sterilized its acquisition of international reserves with sales of nonmonetary central bank debt called PBOC bills.
Many observers regard the acquisition of international reserves by the PBOC as
evidence that China undervalues its exchange rate.21 In the absence of capital controls,
however, Chinese residents would likely move capital out of the country privately toearn higher interest at banks abroad and to diversify their growing wealth in mature
corporate bond and equity markets overseas. In light of the discussion in Section V.B,
it seems reasonable to regard the acquisition of international reserves by the PBOC inlarge part as a consequence of controls on the outflow of capital to protect the weak
Chinese banking system. If Chinese banks were made financially robust to higher
interest rates, then interest rates could move higher to stabilize investment. Interest
rate policy could freely and credibly target inflation, the exchange rate could be floated,and capital controls could be lifted.
Unfortunately, higher interest rates could hurt China’s external balance according
to the “current account identity” by encouraging savings and discouraging investment.22
Even if internal stability were secured by a worsening external balance, however,
the external situation would be improved greatly in one critical respect. China’s
trade surplus could no longer be ascribed to its manipulation of the exchange rate. The
PBOC would no longer need to acquire international reserves, and instead flexible
exchange rate adjustments could encourage private capital outflows to accommodate
China’s current account surplus.

VII. Conclusion
The paper addressed a set of common concerns that pertain to monetary policy in East
Asia. Broadly speaking, the concerns are rooted in the fact that the countries of East
Asia have developed relatively quickly from command-oriented, traditional economies
to modern industrialized market economies. The problem is that nonfinancial
development has outrun financial development. The countries of East Asia recognize
the problem. Governments throughout the region are working to improve thefinancial robustness of banks and deepen nonbank financial markets to strengthen
the institutional capacity to target inflation and facilitate exchange rate flexibility tosecure macroeconomic stability in the future.
21. U.S. Treasury Department (2006).
22. Given the current high savings rate in China, the positive income effect of higher interest on spending could
offset much of the substitution effect of higher interest on savings.

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

Monetary Policy in East Asia: Common Concerns

References

Alberola, Enrique, and José Serena, “Global Financial Integration, Monetary Policy and Reserve
Accumulation: Assessing the Limits in Emerging Economies,” Banco de España Working Paper
No. 706, Banco de España, 2007.
Bank for International Settlements, “Developing Corporate Bond Markets in Asia,” BIS Paper No. 26,
2006a (proceedings of a Bank for International Settlements/People’s Bank of China seminar
held in Kunming, China, on November 17–18, 2005).
———, “The Banking System in Emerging Economies: How Much Progress Has Been Made?” BIS
Paper No. 28, 2006b.
———, “Monetary Policy in Asia: Approaches and Implementation,” BIS Paper No. 31, 2006c(proceedings of a Bank for International Settlements/Hong Kong Institute for Monetary Research
conference held in the Hong Kong SAR on November 21–22, 2005).
Broaddus, J. Alfred, Jr., and Marvin Goodfriend, “Foreign Exchange Operations and the Federal
Reserve,” Economic Quarterly, Federal Reserve Bank of Richmond, Winter, 1996, pp. 1–19.
Clarida, Richard, Jordi Gali, and Mark Gertler, “The Science of Monetary Policy: A New Keynesian
Perspective,” Journal of Economic Literature, 37, 1999, pp. 1661–1707.
Devereux, Michael B., and Hans Genberg, “Currency Appreciation and Current Account Adjustment,”
Journal of International Money and Finance, 2007 (forthcoming).
Economist, The, “Rating Asian Banks,” May 12, 2007, p. 82.
Eichengreen, Barry, “Global Imbalances and the Asian Economies: Implications for Regional Cooperation,”
Working Paper on Regional Economic Integration No. 4, Asian Development Bank, 2006.
Fujiki, Hiroshi, and Akiko Terada-Hagiwara, “Financial Integration in East Asia,” Monetary andEconomic Studies, 25 (S-1), Institute for Monetary and Economic Studies, Bank of Japan, 2007,
pp. 57–88 (this issue).
Genberg, Hans, “Exchange-Rate Arrangements and Financial Integration in East Asia: On a Collision
Course?” Springer-Verlag Online Publishing, November, 2006.
Glick, Reuven, “Thoughts on the Origins of the Asian Crisis: Impulses and Propagation Mechanisms,”
in William C. Hunter, George G. Kaufman, and Thomas H. Krueger, eds. The Asian Financial
Crisis: Origins, Implications, and Solutions, Federal Reserve Bank of Chicago and International
Monetary Fund, Boston: Kluwer Academic Publishers, 1999, pp. 33–63.
Goodfriend, Marvin, “International Adjustment in the New Neoclassical Synthesis,” mimeo, Carnegie
Mellon University, 2007.
———, and Robert G. King, “The New Neoclassical Synthesis and the Role of Monetary Policy,” in Ben
S. Bernanke and Julio J. Rotemberg, eds. NBER Macroeconomics Annual 1997, Cambridge,
Massachusetts: The MIT Press, 1997.
———, and John McDermott, “Industrial Development and the Convergence Question,” American
Economic Review, 88 (5), 1998, pp. 1277–1289.
———, and Eswar Prasad, “A Framework for Independent Monetary Policy in China,” CES ifo Economic
Studies, 2007 (also IMF Working Paper No. 06/111, International Monetary Fund, 2006).
Green, Stephen, “Make Sure You’re Sitting Down: Our New 2007 C/A Forecast,” On the Ground—
Asia, Standard Chartered Bank, May 11, 2007.
Greenspan, Alan, “Do Efficient Financial Markets Mitigate Financial Crises?” Financial Markets
Conference of the Federal Reserve Bank of Atlanta, October 19, 1999.
Higgins, Matthew, and Thomas Klitgaard, “Reserve Accumulation: Implications for Global Capital
Flows and Financial Markets,” Current Issues in Economics and Finance, Federal Reserve Bank of
New York, 10 (10), 2004.
Higgins, Patrick, and Owen F. Humpage, “The Chinese Renminbi: What’s Real, and What’s Not,”
Economic Commentary, Federal Reserve Bank of Cleveland, August 15, 2005.
Husain, Aasim M., Ashoka Mody, and Kenneth S. Rogoff, “Exchange Rate Regime Durability and
Performance in Developing versus Advanced Economies,” Carnegie Rochester Conference
Series on Public Policy, in Bennett T. McCallum and Charles I. Plosser, eds. Journal of Monetary
Economics, 52 (1), 2005, pp. 35–64.

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Kose, M. Ayhan, Eswar Prasad, Kenneth Rogoff, and Shang-Jin Wei, “Financial Globalization: A
Reappraisal,” IMF Working Paper No. 06/189, International Monetary Fund, 2006.
La Porta, Rafael, Florencio Lopez de-Silanes, Andrei Shleifer, and Robert Vishny, “Law and Finance,”
Journal of Political Economy, 1002 (6), 1998, pp. 1113–1155.
Obstfeld, Maurice, and Kenneth Rogoff, “The Mirage of Fixed Exchange Rates,” Journal of Economic
Perspectives, 9 (4), 1995, pp. 73–96.
Rana, Pradumna B., “Monetary and Financial Cooperation in East Asia: The Chiang Mai Initiative andBeyond,” ERD Working Paper No. 6, Asian Development Bank, 2002.
Sundaresan, Suresh, “Developing Multiple Layers of Financial Intermediation: The Complementary Rolesof Corporate Bond Markets and Banks,” in Bank for International Settlements, Developing
Corporate Bond Markets in Asia, Proceedings of a BIS/PBC Seminar in Kunming, China, November
2005, pp. 24–30.
U.S. Treasury Department, Report to Congress on International Economic and Exchange Rate Policies,
May, 2006.
Woodford, Michael, Interest and Prices: Foundations of a Theory of Monetary Policy. Princeton: Princeton
University Press, 2003.
Yu, Yongding,“Global Imbalances and China,” Finch Lecture, Melbourne University, October 17, 2007.

Comment
ENRIQUE ALBEROLA ILA
Banco de España

I. Introduction
Today’s paper presents a very broad set of issues in a compact and smart presentation.
I will start by briefly summarizing what in my view are the main points of the paper
and then highlight some issues worth discussing.

II. Five Key Points of the Paper
Let me set out what are, in my view, the five main points of the paper:(1) The case for inflation targeting and flexibility versus fixed exchange rates. Thisconclusion is based on the New Neoclassical Synthesis (NNS) model. The
point of the paper is that the large terms-of-trade shocks and the tendency
to benefit from them have to be accommodated through flexible exchange
rates, and the openness-convergence dynamic is best served through exchange
rate flexibility.
(2) There is not a clear-cut case for Asian financial cooperation, but I think thisis a natural corollary of the previous point to the extent that financial cooperation,compared by the author to a credit union, is seen as an instrument used tosustain pegs.
(3) The financial structure of Asian countries is unbalanced, since it is too biased
toward banks and implies low corporate bond market development. I completely
agree with this and also with the need for this situation to be corrected.

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

Comment(4) On China’s exchange rate policy, the author underscores that the flexibilityof the renminbi is not a panacea for solving the U.S. trade imbalance, and again
he uses his model. I think this is quite honest because, in the first place, thepaper bets on flexibility. There are good reasons for China to avoid this sudden
flexibility of exchange rate, and the paper stresses very smartly the reasons. The
author argues that this has to be done with patience, because previously thereis the need to develop an adequate internal financial infrastructure. This justifies
the exchange rate gradualism currently taken by the Chinese authorities.
(5) On reserve accumulation, the author mentions that this policy was fine for acentral bank facing the zero bound because it allowed the bank to have anadditional effective liquidity instrument. This is fine for East Asia on thebasis of self-insurance, and this is fine for China in the current context,
although he underscores that this may tend to enforce the incentives for higher
accumulation and for keeping the exchange rate control. Again, the assessments
to some extent refute the case for flexibility, since we know that reserve
accumulation has been used in most cases to back exchange rate rigidity.

III. Comments
I find the ideas conveyed in the paper very interesting, and tend to agree with mostof the conclusions; maybe not with all of them, and maybe in some cases for reasonsdifferent from the author’s.
A first comment on the paper is the broadness I mentioned at the beginning. The
large number of ideas in the paper are scattered around, and there are some loose ends.
I think an effort to link these ideas and the different sections would greatly strengthen
the paper. Therefore, my comments in part are intended precisely to tie some ofthese loose ends together and refute or discuss some other points the author makes.
First, on the applicability of the model to emerging market economies, it is possible
to raise some reservations from three perspectives:• First, on the assumptions. The author recognizes in the paper that there are large
financial imperfections in these countries. I presume this matters for the model,
and it is doubtful that the results or the conclusions can be maintained under thesedifferent assumptions.
• Second, on shocks. Shocks in emerging economies differ in terms of magnitude
and impact. Financial shocks are arguably more important and relevant than realshocks in emerging economies, for the time being.
• Third, on the adjustment. The conclusions are based on the steady-state solution,and then the author recognizes that these economies are going through an important process of transformation and transition. The relevant issue is which is the
optimal regime in the transition. Is the flexibility justified within this financialtransition, also?
Furthermore, an important body of literature argues that the case for flexible
regimes is less applicable to emerging market economies. For instance Lahiri, Singh,
and Vegh (2007) argue that with segmented markets the rigidity of pegs has a point.

223

Also, Caballero and Lorenzoni (2007) focus on Dutch disease and the optimality ofkeeping some control over the exchange rate under these conditions. In the end, I think
the author recognizes that in the paper when he tackles China and says that theunderlying financial conditions are for some gradualism in the flexibility of the exchange
rate. This goes back to the transition point. Then the author mentioned regarding Asia
that the rationale for accumulated reserves has been self-insurance, but it is possible
to argue that this accumulation is linked to exchange rate management. So in the end,
this also backs the idea that rigidity is maybe suboptimal under these circumstances.
Let me develop this last point. First, on self-insurance. There are two main indicators of the adequacy of the stock of reserves for self-insurance against crises. The firstis the ratio reserves over months of imports, and the second is the ratio reserves overshort-term external debt, also known as the Greenspan-Guidotti rule. The thresholds
usually admitted are four and one, respectively. The level of reserves in 2005—and evenmore now—is above the thresholds, and Asia and in particular China are far above.
Looking at these numbers, it is difficult to admit that self-insurance is the still thedriver. A recent paper by Jeanne and Ranciere (2006), in which the optimal level ofreserves is computed, confirms this intuition, since they show that the level of reserves
is excessive in Asia under this criterion.
Rather, Figure 1 suggests that reserves in emerging countries are accumulated forexchange rate management. The figure plots the variation in the exchange rate against
the increase in reserves for 27 countries. The countries that are accumulating mostreserves are those that have the exchange rate more pegged, the exception being Brazil,
which by the way is currently accumulating reserves very intensively.
The policy that consciously limits exchange rate appreciation adds one additional
concern to the ones that the author conveys in the title of the paper. Figure 2 plots theincrease in reserves against the increase in money. Here the 45-degree line implies nosterilization at all. You see that emerging economies are sterilizing increasingly their
expanding reserves. Indeed, in 2006 on average they sterilized the entire increase inreserves. Up to this point that has not created unsurmountable problems for monetary
management, but as long as this sterilization proceeds, countries may be forced to
put too much sterilization paper into the economy, and that brings about different
problems. This process may eventually produce a dilemma between sterilizing andenduring the side effects of such actions (fiscal costs, disturbance to the financial
system, future central bank domestic liabilities, etc.). Economic growth, implying
strong money demand and low inflation, has helped to manage this increase in reserves,
but the question is whether these countries are reaching the limits; Alberola and Serena(2007), from where these graphs have been extracted, show that this is not the caseyet. Even so, there are increasing costs in accumulating reserves and the scope forsterilization is shrinking, but at the moment these increasing costs are not impinging
on accumulation. Maybe today’s paper could emphasize more strongly these issues,
which I think are very relevant at this stage due to the evolution of the sterilization.
The other comment I have concerns the corporate debt markets. I completely agreewith the author: the system is too biased toward banking, massive change is necessary,and probably fixed regimes disturb that development. An interesting fact in the last
few years is the deepening development of local debt markets in emerging countries;

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

Comment

Figure 1 Exchange Rate and Reserve Accumulation, 2004–05
Variation in international reserves, percent

50

Depreciation andgrowth of international
reserves

40

Appreciation andgrowth of international
reserves

30

20

10

0
–20

–16

Algeria
CyprusMalaysia
Russia–12

Argentina
Czech Rep.
MexicoSingapore–8–4

BrazilEgypt
MoroccoSouth Africa

0

Chile
Hungary
PakistanThailand

4
8
12
16
20
Variation in exchange rate, percent
China
IcelandPeru
TurkeyColombia
India
Philippines
Venezuela

Croatia
Korea
PolandSource: International Monetary Fund, International Financial Statistics.

Figure 2 Increases in Reserves and Sterilization, 2002–06

250

Change in money

2002
45˚
200
150

2003

100

2005
2004

50

20061

0
–50
0

50

100

150

200
250
Change in reserves

Note: 1. 2006/Q2 relative to 2005/Q4.
Source: International Monetary Fund, International Financial Statistics.

225

it is true that this hardly includes corporate bond markets, it is just government paper.
However, what governments are trying to do, and this was discussed in a working groupat the Bank for International Settlements (2007) recently, is to set the basis to allow
further development also of corporate markets. This is done very specifically in somecountries through the construction of a yield curve through local debt issued in local
currency with different maturities. Furthermore, we have just seen that a lot of sterilization is occurring. Thus, it might be a good idea in this process of transition to use thissterilization instrument as a complement to build up this yield curve in terms of maturity.
To conclude, I sympathize with the model’s main thrust, that flexibility andinflation targeting are a good endpoint for these economies. My view, however, isthat not all the countries are ready currently, but in the end I think the author andI view things in a similar way, since the paper justifies the status quo: both implicitly(because the paper endorses reserve accumulation, which I think this is basicallythe other side of fixed exchange rates) and explicitly (when it talks about China’s
underdevelopment and imbalances of the financial markets). The message in this case is,be careful flexibilizing your exchange rates. The last point, which I mentioned earlier,is that the paper would clearly benefit from a more consistent presentation linking thedifferent loose ends within it.

References

Alberola, Enrique, and José Serena, “Global Financial Integration, Monetary Policy and Reserve
Accumulation: Assessing the Limits in Emerging Economies,” Banco de España Working Paper
No. 706, Banco de España, 2007.
Bank for International Settlements, “Financial Stability and Local Currency Bond Markets,” CGFS
Paper No. 28 (available at http://www.bis.org/publ/cgfs28.htm).
Caballero, Ricardo J., and Guido Lorenzoni, “Persistent Appreciations and Overshooting: A Normative
Analysis,” NBER Working Paper No. 13077, National Bureau of Economic Research, 2007.
Jeanne, Olivier, and Romain Ranciere, “The Optimal Level of International Reserves for Emerging
Market Countries: Formulas and Applications,” IMF Working Paper No. 06/229, International
Monetary Fund, 2006.
Lahiri, Amartya, Rajesh Singh, and Carlos A. Vegh, “Segmented Asset Markets and Optimal Exchange
Rate Regimes” NBER Working Paper No. 13154, National Bureau of Economic Research, 2007.

Comment
LAWRENCE SCHEMBRIBank of Canada

I. Introduction
I would like to begin by thanking the organizers for inviting me to participate in thisexcellent conference at the Bank of Japan. It is a great pleasure for me to have theopportunity to discuss this very interesting and insightful paper by Goodfriend(2007). Please note that the usual central banker’s warning label applies to my

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

Comment

comments: the views expressed are my own and should not be attributed to the Bankof Canada.
The motivation of the paper is neatly summed up by Governor Fukui’s third
question in his opening address: “What kind of monetary and exchange rate regimes
are appropriate for East Asian emerging economies to pursue sustained economic
growth under price stability?” To address this question, the paper considers several
important characteristics of East Asian economies: namely, export orientation, highly
integrated regional trade, bank-dependent finance, the potential for persistent trade
surpluses, and the aggressive accumulation of official foreign reserves.

II. Summary of the Paper
In reviewing monetary and exchange rate policies in the East Asia, the paper uses avariety of analytical approaches, but the principal one is the New Neoclassical
Synthesis (NNS) model developed by Goodfriend and King (1997). Goodfriend(2007) uses the model to analyze the relationship between monetary and exchange
rate policies and he (rightly) places particular emphasis on the importance of policy
credibility. He also examines the interdependence between the banking system andfinancial markets; this issue is also very important in the context of East Asia. Finally,
the focus of the paper is mainly on China, despite the title’s reference to “East Asia.”
The paper comes to three significant conclusions. First, flexible exchange rate regimes
are desirable in East Asia, especially for the larger countries, primarily because they arecredible. In particular, flexible regimes are not subject to the problems that fixedexchange rate regimes often have; that is, they are not susceptible to speculative pressure
or attacks when there are inconsistencies between domestic policy goals and the fixedexchange rate. Moreover, a flexible exchange rate regime allows for an independent
domestic monetary policy. Second, inflation targeting is the best way to implement an
independent monetary policy, because it duplicates the flexible price equilibrium, as
shown with the NNS model. Third, financial sector underdevelopment in the region,
primarily in China, is delaying the implementation of a market-determined flexible
exchange rate and an independent domestic monetary policy based on inflation targeting.
There are two other notable findings in the paper. Despite the fact that trade in
the region is heavily integrated, regional monetary arrangements are unlikely to havea significantly positive welfare benefit. In general, the larger East Asian countries
would be best served by keeping their own houses in order by adopting the first-best
policies: an inflation target and a flexible exchange rate. The other useful result is thata nominal revaluation of the Chinese renminbi would have little impact on the U.S.
trade balance deficit.

III. Commentary: Four Quibbles
Given that I am from the Bank of Canada, a central bank that has been very successful
with a monetary policy based on an inflation target in conjunction with a flexible

227exchange rate, I cannot disagree with the main message of the paper, so I will call mycomments “quibbles.” The four quibbles could be entitled “slow boat to reform,” whichis really about timing of reform; “virtuous circle—where to get on?”; “neighborhood
effects”; and “rules of the game.”
Regarding the first quibble, “slow boat to reform,” the author states, “Modest
reforms (emphasis added) of China’s banking system would enable China to float its
currency in a few years.” Almost exactly four years earlier, on May 19, 2003, China’s
People’s Daily wrote, “Full liberalization of China’s renminbi exchange rate is inevitable,
but not now,” and “China’s foreign exchange market is still quite thin and imperfect.”
After four years, the outlook for reform remains essentially unchanged. The paper
does not provide a complete explanation of what these “modest reforms” are, nor why
they have not yet been achieved. My concern is that given the lack of progress on bankreform after four years, it is not clear that sufficient reforms will be attained after a few
more years along the current policy path.
The past experiences of other countries suggest that the adoption of a more flexible
exchange rate and an independent domestic monetary policy could, in fact, accelerate
financial sector reform in China. Canada and Mexico’s experiences are good examples.
In 1950, Canada floated its exchange rate under pressure to appreciate—a situation
similar to what China is currently experiencing. One year later, Canada was able toremove capital controls (becoming one of the first countries to do so in the postwar
period), and the following year a short-term money market started. In Canada’s case,the adoption of a flexible exchange rate forced commercial banks to adapt to the challenge of coping with financial market forces. Essentially the same lesson can be drawn
from Mexico’s experience after the collapse of the peso in 1994. The banking system
was initially in disarray, but by adopting a flexible exchange rate and an independent(and credible) monetary policy based on inflation targeting, Mexico was able to achievebanking sector reform and significant financial market development in a few years.
It is also worth noting that the increased presence of foreign banks in China could
have also accelerated the reform process. Countries such as Poland, Estonia, andMexico have achieved rapid financial sector development as result of the presence of
foreign banks, which have transferred their knowledge of banking operations fromthe head office to local subsidiaries.
My second quibble is illustrated in Figure 1, which shows a virtuous circle offinancial reform. At one point on the circle are credible monetary and exchange rate
policies. As argued in the paper, these credible policies for the larger East Asian
countries are the combination of a flexible exchange rate and inflation targeting.
Because these credible policies create what Caballero, Cowan, and Kearns (2005) call“currency trust,” they facilitate the growth of financial markets. More developed
financial markets provide prospective borrowers sources of finance that compete withthe commercial banks, which in turn forces the banks to respond by becoming more
efficient intermediaries. Because financial markets are underdeveloped in China, thiscompetitive pressure on domestic banks is missing. To close the virtuous circle, a
viable banking sector implies that the transmission of monetary policy via the interest
rate channel should be relatively effective, which in turn will enhance the credibilityof monetary and exchange rate policies.

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

Comment

Figure 1 Virtuous Financial Circle

Quibble No. 2: “Virtuous Circle: Where to Get On?”

Credible monetaryandexchange rate policies

Developed
financial markets

Viablebanking
sectorGiven this virtuous circle, the key question is where does a country like China geton the circle? Goodfriend (2007) maintains that the banking sector must be viable
before this virtuous circle can begin. In contrast, I would argue that the starting pointshould be credible monetary and exchange rate policies. I do not want to exaggerate thedifferences between our two positions; it is more a question of emphasis. Clearly, there
are weaknesses in the Chinese banking sector that need to be addressed; nonetheless,I maintain that a faster movement toward increased exchange rate flexibility and amore independent monetary policy is possible and would be beneficial for China
and its trading partners.
My third quibble concerns neighborhood effects: that is, the repercussions ofChina’s current monetary and exchange rate policies on neighboring countries in
East Asia. After the 1997 financial crisis, several countries in the region took on board
the liberalizing reforms recommended by the International Monetary Fund (IMF).
In particular, several did exactly what the author proposes; they adopted a flexible
exchange rate and inflation targeting, and reduced capital controls. As a result, thecurrencies of these countries (e.g., Korea) have appreciated dramatically and now there
is serious tension between maintaining competitiveness in third markets, particularly
with China, and staying on the path of reform. While Korea has largely stayedon course, Thailand has slid back. The concern I have is that we may see morebacksliding in East Asia if reform in China does not take place more quickly.
I call my fourth quibble “the rules of the game” because it refers to China’s practiceof preventing real exchange rate adjustment by sterilizing the impact of balance of
payments surpluses on the domestic money supply in the presence of capital controls.23
I agree with the author’s argument that the current debate on China’s exchange rate
policy misses the point because it focuses primarily on the level of the exchange rate.
23. Dodge (2006) provides a more complete argument.

229

Instead, more attention should be paid to the coherence of exchange rate policy to thegoals of domestic monetary policy and to the extent to which the exchange rate regime
facilitates relative price adjustment to preserve external stability. While most observers,
including myself, the author, and the Chinese authorities, recognize that increased
exchange rate flexibility would be desirable for China to obtain an independent
domestic monetary policy,24 there are different views on timing, which were discussed
above, and on what policy path China should follow in the interim. I maintain that
China should follow the “rules of the game” for external adjustment under the current
pegged exchange rate by permitting domestic price and wage adjustment in the face oflarge balance of payments surpluses. Sterilization of the resultant reserve accumulation
with capital controls in place forestalls the adjustment process. Moreover, sterilization
distorts the incentives and behavior of domestic banks because they are required tohold more and more central bank debt (rather than higher-yielding private assets),through the imposition of higher reserve requirements. This implicit tax retards bankreform. If China is reluctant to move sooner to a more flexible exchange rate, it should
refrain from extensive sterilization activities to allow relative prices to adjust to reduce
external imbalances.

IV. Concluding Remark
My concluding remark concerns the role of the IMF in China’s policy reform process.
The paper examines and is skeptical of the proposal of an East Asian “credit union,”
because it would not be needed if the best-practice policies of a flexible exchange rateand inflation targeting were followed. The IMF was also originally designed as a“credit union” to pool risk to foreign reserves, but its mandate has expanded because
best-practice policies were not always followed by systemically important countries.
In particular, the IMF undertakes bilateral and multilateral surveillance to encouragecountries to follow the “rules of the game” by adopting policies that prevent negative
spillovers and preserve stability of the international monetary system.
The IMF is currently undergoing a reform process called the Medium Term
Strategy, which includes a review of the 1977 decision on surveillance of exchange rates
and a review of quota formulas.25 This reform process represents a genuine effort tomodernize the IMF so that it can meet the challenges of maintaining international
financial stability in a rapidly integrating global economy and to increase the legitimacyof the IMF by giving a larger voice to fast-growing East Asian countries. It is, however,important to emphasize that as East Asian countries obtain a greater voice in the IMF,
they must be willing to take on greater responsibility for maintaining the stability of
the international financial system.

24. Several other arguments could be made in favor of China’s adopting a more flexible exchange rate. Not only
would it allow more rapid relative price adjustment to reduce external imbalances, but it would also facilitate aneeded rebalancing of demand toward consumption and away from investment and net exports.
25. An ad hoc quota increase for China, Korea, Mexico, and Turkey was approved by the IMF’s Board of Governors in
September 2006, and a new surveillance decision was approved by the Executive Board of the IMF on June 15, 2007.

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

General Discussion
References

Caballero, Ricardo J., Kevin Cowan, and Jonathan Kearns, “Fear of Sudden Stops: Lessons from Australia
and Chile,” Journal of Policy Reform, 8 (4), 2005, pp. 313–354.
Dodge, David, “The Evolving International Monetary Order and the Need for an Evolving IMF,” remarksby the Governor of the Bank of Canada to the Woodrow Wilson School of Public and International
Affairs, Princeton, New Jersey, March 30, 2006 (available at www.bankofcanada.ca).
Goodfriend, Marvin, “Monetary Policy in East Asia: Common Concerns,”Monetary and Economic Studies, 25(S-1), Institute for Monetary and Economic Studies, Bank of Japan, 2007, pp. 207–222 (this issue).
———, and Robert G. King, “The New Neoclassical Synthesis and the Role of Monetary Policy,” in Ben
S. Bernanke and Julio J. Rotemberg, eds. NBER Macroeconomics Annual 1997, Cambridge,
Massachusetts: The MIT Press, 1997.

General Discussion
Responding to the comments by the discussants, Marvin Goodfriend stressed that reformin China was a delicate issue and that more open discussion was called for on thismatter. He agreed with Enrique Alberola Ila (Banco de España) on the argument thatsterilization created pressure on domestic markets. Goodfriend claimed that sterilization
mainly buys time so that a country can delay exchange rate or interest rate adjustments
which may be required to achieve external balance. He also addressed the point made by
Lawrence Schembri (Bank of Canada) on the “virtuous circle” by agreeing that the threeelements are interrelated. Goodfriend argued that the sequence of reform should be
decided by Chinese policymakers familiar with Chinese markets, but he emphasized that
China should move quickly to make the modest financial reforms needed to float thecurrency and free interest rate policy to stabilize domestic macroeconomic conditions.
In the general discussion, there were several comments regarding the applicabilityof the New Neoclassical Synthesis (NNS) model to the East Asian economy. Michael
Devereux (University of British Columbia) claimed that with incomplete markets
or with partial exchange rate pass-through (which may be important in East Asia),
inflation targeting may not be the optimal policy. Már Gudmundsson (Bank forInternational Settlements) pointed out that several East Asian countries are small
open economies that may have benefited from fixed exchange rates by reducing
exchange rate uncertainty in trades with large trade partners. Jong-Wha Lee (AsianDevelopment Bank) added that the paper’s discussion was mostly relevant for China,
whereas crisis-hit countries such as Korea have already allowed the currency to float
and faced exchange rate appreciation and a rapid rise in asset prices due to the increasein portfolio investment. In response, Goodfriend agreed that in some models absoluteprice stability was not the welfare-maximizing monetary policy, but emphasized that
his own work and prior work with Robert King indicates that optimal departuresfrom price stability are likely to be minor quantitatively. He also agreed that exchange
rate stability may be important in small open economies. However, he pointed outthat there are also countries such as Singapore which are managing exchange rate
flexibility quite well as they stabilize inflation, despite being small countries.
Akinari Horii (Bank of Japan) warned that with the large volume of turnover on
the Shanghai exchange market, the payment system may not be able to withstand the231volume of transactions once China let its exchange rate fluctuate. He also claimed that
China had yet to build a financial system infrastructure which enables loans to beeffectively repaid and, if not, to be liquidated, and thus the transition to the first-best
policy was challenging. Goodfriend claimed that resources and expertise to update
the payments system in China were readily available and all that was needed now wasrecognition of the urgency of policy change.
With respect to the credit union example, Akira Ariyoshi (International MonetaryFund) argued that global financial institutions such as the IMF still had a role to play in
an imperfect capital market, while acknowledging that regional insurance mechanisms
could also serve as a line of defense against liquidity shocks. Anton Braun (University ofTokyo) also claimed that it was premature to dismiss the credit union idea without
discussion of the nature of risks. Mark Spiegel (Federal Reserve Bank of San Francisco)claimed that the crisis in 1997 was an episode proving the high correlation of shocks
within the region. Further, he argued that this may justify the necessary role of the IMF
rather than a regional monetary fund. Goodfriend agreed that the IMF plays a usefulrole, but emphasized that emergency credit assistance provided by the IMF or by an East
Asian credit union might encourage excessive short-term international capital flows.
Regarding the revaluation of the renminbi (RMB), Shaghil Ahmed (Board ofGovernors of the Federal Reserve System) pointed out that even if this had no effecton the U.S. trade balance in terms of U.S. goods units, as in the model laid out by
Goodfriend, it could have an effect on real expenditure components of Chinese GDP
and, therefore, lead to rebalancing of growth and to changes in the Chinese trade balancemeasured in terms of Chinese goods units. Yu Yongding (Chinese Academy of Social
Sciences) claimed that the revaluation of the RMB would affect the Chinese tradebalance because China was competing with other Asian countries, not just the UnitedStates. Goodfriend agreed that a revaluation of RMB would affect the Chinese tradebalance. He further explained that a revaluation of the RMB would lower the demand
for Chinese exports, which, if the Federal Reserve stabilizes dollar prices in the UnitedStates, would lead to a deflation of money export prices in China. Thus, a revaluationof the RMB against the dollar could offset preexisting inflationary pressures inside China.
There were also several comments on sterilization and its distortionary effects on
the Chinese economy. Michael Moskow (Federal Reserve Bank of Chicago) claimed
that sterilization in China is enormous and that one should consider the long-term
effects it builds into the economy while the banks are reforming. Hans Genberg(Hong Kong Monetary Authority) claimed that to consider the second-best policies
under capital control in China, it is important to identify where sterilization makes
distortions. Georges Pineau (European Central Bank) pointed out that China uses
central bank paper for sterilization, unlike India, which uses government paper: thisleads to additional market segmentation and hinders financial market development.
Made Sukada (Bank Indonesia) added that if the central banks fully sterilized theintervention, the negative spread on interest earning would cause a negative impact
on the balance sheet of the central bank, while any adjustment in the interest
rate would undermine the credibility of inflation targeting. Goodfriend agreed that
capital controls make a difference to the impact of sterilization to the extent that
controls block potentially offsetting private-sector financial actions.

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