The Return to Soft Dollar Pegging in East Asia Mitigating Conflicted Virtue

1. The Return to Soft Dollar Pegging in East AsiaMitigating Conflicted Virtue Ronald McKinnon and Gunther Schnabl Stanford University Tübingen University October 2004

2. The Exchange Rate Debate in the 1990s Before 1997, East Asian countries, except for Japan, “softly” pegged their exchange rates to the U.S. dollar. 1997-98 Crisis: Thailand, Indonesia, Philippines, Korea, and Malaysia are attacked and devalue—with bankruptcies and economic downturns spreading contagiously. The IMF blames the soft pegging for encouraging over borrowing and current account deficits leading unsustainable dollar and yen debts. It warns against any return to dollar pegging. Williamson (2000), Kawai (2002), Ogawa and Ito (2002)—suggest weighting the Japanese yen more heavily in the currency baskets of the smaller East Asian economies in the face of wide fluctuations in the yen/dollar rate.

3. The Debate In the New Millennium By 2004, the East Asian “crisis” and non crisis economies had returned to soft dollar pegging. China and Hong Kong retained hard pegs through the crisis, and Malaysia pegged in Sept 1998 at 3.8 ringgit per dollar. Even the yen/dollar rate is more stable. But now all East Asian countries run large current account surpluses—even with net inflows of FDI (China). Only massive foreign official interventions kept their exchange rates from appreciating in 2003 and early 2004 Influential articles by Dooley, Folkerts-Landau, and Garber (2003)-(2004) argue that East Asian countries on the dollar’s “periphery” are deliberately undervaluing their currencies to stimulate exports to the U.S. at the “center” to promote development. Intensified pressure from the IMF, the G-7, and the U.S. Treasury, for China to appreciate: “There should be more flexible currencies, not only for China but the whole of Asia” Rodrigo de Rato, IMF Managing Director, 29 Sept 2004 at IMF-World Bank Meetings in Washington.

4. This Paper and McKinnon Book (2005) The Case for Asian Dollar Pegs • East Asian economies • Have sufficient fiscal and monetary control to target exchange rates, but have more difficulty targeting domestic inflation independently. • Are becoming highly integrated economically with more than 50% of trade with each other. They need stable cross rates of exchange. • Debtor countries have “original sin” and creditors have “conflicted virtue” making foreign exchange risks more difficult to hedge.

5. The Rise of Intra Regional Trade in East Asia, 1980-2002 (share of total exports) East Asia: China, Hong Kong, Indonesia, Japan, Korea, Malaysia, Philippines, Singapore, Taiwan, and Thailand

6. The Rise of Intra Regional Trade in East Asia, 1980-2002 (share of total imports) East Asia: China, Hong Kong, Indonesia, Japan, Korea, Malaysia, Philippines, Singapore, Taiwan, and Thailand

7. Chinese Yuan Hong Kong Dollar Singapore Dollar Taiwan Dollar Figure 1: East Asian Exchange Rate Pegs against the Dollar, 1980:01-2004:04 (Monthly)

8. Indonesian Rupiah Korean Won Malaysian Ringgit Philippine Peso Thai Baht Figure 1 (Continued) Crisis Economies, 1980:01-2004:04 (Monthly)

9. Frankel and Wei Regression (1994) Problem: For any one East Asian currency other than Japan, how do you measure the weight of each major currency—the dollar, yen, or euro—in its currency “basket”? Answer: Choose an outside currency as numeraire, e.g., the Swiss Franc, to measure all exchange rates in the above regression.

10. Chinese Yuan Hong Kong Dollar Singapore Dollar Taiwan Dollar Figure 2: Dollar’s Weight in East Asian Currency Baskets, 130-Trading-Day Rolling Regressions, 1990:01-2004:05(Daily)

11. Indonesian Rupiah Korean Won Malaysian Ringgit Philippine Peso Thai Baht Figure 2 (Continued), Dollar’s Weight in East Asian Currency Baskets Crisis Economy, 1990:01-2004:05 (Daily)

12. Chinese Yuan Hong Kong Dollar Thai Baht Malaysian Ringgit Philippine Peso Japanese Yen Figure 3: Exchange Rate Volatility against the US Dollar of Selected Crisis and Non-Crisis Currencies, 1990:01-2004:05 (Daily)

13. Indonesian Rupiah Korean Won Euro (German Mark) Singapore Dollar New Taiwan Dollar Swiss Franc Figure 3 (Continued), Exchange Rate Volatility against the US Dollar, 1990:01-2004:05 (Daily)

14. Table 1: Standard Deviations of Daily Exchange Rate Fluctuations against the Dollar Data source: Datastream. Percent changes. Pre-crisis = 02/01/94 – 05/30/97, crisis = 06/01/97 – 12/31/98, post-crisis = 01/01/99 – 05/17/04, 2003/2004 = 01/01/03 – 05/17/04.

15. Table 2: Standard Deviations of Monthly Exchange Rate Fluctuations against the Dollar Data source: IMF: IFS.

16. Figure 4: Exchange Rate Changes against the US dollar 1999:01-2001:12 Data source: IMF: IFS.

17. Figure 5: Exchange Rate Changes against the US dollar 2002:01-2004:04 Data source: IMF: IFS.

18. China Hong Kong Thailand Malaysia Philippines Germany Figure 6: Official Foreign Exchange Reserves of Crisis and Non-Crisis Countries in Millions of Dollars, 1980:01-2004:04 (Monthly)

19. Indonesia Korea Japan Singapore Taiwan US Figure 6 (Continued), Official Foreign Exchange Reserves, 1980:01-2004:04 (Monthly)

20. Dollar dominance in East Asia • Original sin • Underdeveloped domestic bond market or in some cases developed domestic bond market (India) • Debtors cannot borrow in own currency nor can they hedge their net dollar indebtedness. • Currency mismatch and maturity mismatch. [Eichengreen and Hausmann 1999, Hausmann and Panizza 2003] • Conflicted virtue • Creditors cannot lend in their own currencies nor can they hedge their net dollar assets. • Currency mismatch but no necessary maturity mismatch [McKinnon and Schnabl 2004, McKinnon 2005]

21. High-saving countries lend to foreigners in the form of current account surpluses. However, as the stock of dollar claims cumulates: Foreigners start complaining that the country’s ongoing flow of trade surpluses is unfair and the result of having an undervalued currency. Domestic holders of dollar assets worry more about a self-sustaining run into the domestic currency forcing an appreciation. Conflicted virtue

22. Conflicted virtue: To appreciate or not to appreciate • As runs into the domestic currency out of dollars begin, the government is “conflicted” because (repetitive) appreciation could set in train serious deflation ending with a zero interest liquidity trap (Japan) • But failure to appreciate could elicit trade sanctions from foreigners. • A “free” float becomes an indefinite upward spiral

23. The story of Japan (I) • There were repetitive appreciations of yen from 1970s to mid-’90s under mercantile pressure from trade partners―particularly the United States, but trade surpluses continued to cumulate. • Reason: • Exchange rate changes only determine domestic inflation or deflation, not trade balance. The simple-minded elasticities approach is invalid in financially open economies. [McKinnon and Ohno 1997]

24. Do exchange rate changes necessarily bring BoP balance? • Elasticity model • BoP balance through current account changes if Marshall-Lerner condition holds. • McKinnon and Ohno in Dollar and Yen (1997): • Inflationary/deflationary pressure only. • Indeterminate CA effect in the short term because of domestic absorption effect.

25. The story of Japan (II) • Negative risk premium[Goyal and McKinnon 2003] • To maintain portfolio balance, Japanese financial institutions demand a higher return on dollars (which is riskier given the volatility in exchange rate). • The internationally determined dollar asset return thus pushes down the yen interest rate. It finally forced Japan into the the zero interest liquidity trap by the end of 1996.

26. Is China like Japan? • China has a big advantage over Japan: • The RMB exchange rate has been and can be more credibly maintained at the current level without disturbing domestic price level. • And a disadvantage: • China’s net FDI inflows are much larger than Japan’s. FDI can be seen as illiquid liabilities but imposes liquid dollar claims.

27. Table 3: East Asian Current Accounts in Comparison to the U.S., 1990-2003 Data source: IMF: IFS.

28. Figure 7: International Investment Position of Japan (Billions of Dollars) Source: Japan: Ministry of Finance.

29. Figure 8: Interest Rates in the US and Japan, Long-Term: 10-Year US Treasuries and JGBs, 1980-2004

30. Figure 8: Interest Rates in the US and Japan, Short-Term: Money Market Rates , 1980-2004

31. Implications for Interest Rates: The Negative Risk Premium • To sustain the interest differential between yen and dollar assets, consider an augmented interest parity relationship: i = i* + se +  • where i is the (endogenously determined) Japanese long-term nominal interest rate, i* is the (exogenously given) US long-term nominal interest rate, s is the yen price of one dollar, se is expected depreciation of the yen, and  is the risk premium on yen assets. • From the 70s to the mid 90s, the interest differential, i – i*, was driven primarily by the negative se term when the erratically appreciating yen peaked out in April 1995. Since the mid-90s, se  0 and the interest differential has been driven primarily by the term, which is also negative (Goyal and McKinnon 2003).

32. China (Bank Rate) Hong Kong Singapore Taiwan Figure 9: Money Market Interest Rates 1990:01-2004:01 (Monthly)

33. Indonesia Korea Malaysia Philippines Thailand Figure 9 (Continued), Money Market Interest Rates 1990:01-2004:01 (Monthly)

34. Interest Differentials, Portfolio Balance, and the Impossibility Free Floating • As dollar claims accumulate, a sufficiently large interest differential to induce private portfolio holdings of dollars becomes unsustainable—as in Japan when yen interest rates approach zero. • The problem worsens when US interest rates are unusually low, as in 2003-04. • Then, increasing official foreign exchange reserves become the dominant mode of financing Asian current account surpluses. • And the private unwillingness to hold dollars makes a free float impossible.

35. Table 4: East Asian Current Accounts (CA) and Changes in Foreign Reserves (RC)

36. Figure 10: US and cumulative East Asian Current Accounts (Billions of US Dollars) Data source: IMF: IFS.

37. I. The Dollar Standard and East Asia’s Trade Surplus: The DFG Approach • Revived Bretton Woods: EA Exchange Rates are deliberately undervalued to support an export drive into American markets. • Exports are desired to promote “development”, particularly in manufacturing. • Asian governments are willing to pay the cost of investing in very low yield US Treasuries, and to accept American FDI with high profit repatriation. • US gets finance for its fiscal deficits • Despite adjustment costs in US manufacturing, the ongoing current-account deficit is sustainable

38. II. The Dollar Standard and East Asia’s Trade Surplus: The MCS Approach • With the dollar as international money, the efficiency of world trade and payments increases. • If the U.S. price level is stable, peripheral countries will peg to the dollar to anchor their own price levels—not to “undervalue” their currencies, which would be inflationary. • Massive interventions by East Asian central banks to prevent exchange appreciation incidentally extend the US credit line with the rest of the world, softening borrowing constraints on US households and on the Federal Government. • The upshot has been falling US saving and large current account deficits for more than 20 years.

39. Restraining American Deficits? • An attack on the dollar is unlikely because US debts are denominated in its own currency, unlike peripheral countries with “original sin”. The Fed creates the definitive international money. • But heavy US foreign borrowing is transferred in real terms through large American trade deficits, mainly in manufactures. • The American concern with de-industrialization, i.e., unduly rapid job losses in manufacturing, should be linked to federal fiscal deficits and low American personal saving. • Exchange rate changes, foreign trade restraints, or tax breaks for manufacturers, won’t work. • Instead, with deliberate speed, move the federal budget from deficit to surplus.

40. US Current Account and Manufacturing Sector Trade Balance (% of GDP)

41. Projection of Labor Growth in Manufacturing under Balanced Manufacturing Trade

42. Conclusions for East Asia • Collectively pegging to the dollar enlarges the zone of stable dollar prices far beyond trade with the United States: stronger mutual anchoring of national price levels • Anchors against the threat of appreciation and deflation in creditor countries with “conflicted virtue”—while stabilizing mutual cross rates of exchange. Important for Japan and China. • Mutual exchange stability is a public good among integrated economies. • An “Asian euro” is but a distant possibility, so keying on the dollar is now the only feasible intra Asian mechanism for securing exchange stability.