Yen Bloc: Toward Economic Integration in Asia

Chapter 4: Asia in Search of a New Exchange Rate Regime

In the summer of 1997, amid intense currency attacks by speculators, many developing Asian countries were forced to abandon their traditional dollar peg system and allow their exchange rates to float. After a period of sharp depreciation accompanied by high volatility, in the autumn of 1998 exchange rates in these countries bottomed out against the U.S. dollar , thanks to the yen’s rebound and a return of confidence in the economic prospects of these countries. However (with the notable exception of the Malaysian ringgit), these currencies have not restored their stability against the U.S. dollar seen before the crisis (figure 4-1).With the dust now settling, it is the right time to explore what should be done about the exchange rate system, in order to restore stable economic growth. The latest currency crisis in Asia has raised a number of important questions relating to exchange rate management: Why has the dollar peg system, which seemed to have served Asian countries so well in the past, become so vulnerable? Is the delinking of Asian currencies from the U.S. dollar just an emergency measure, which should be reversed once the crisis is over? Finally, if the dollar peg system should be abandoned sooner rather than later, what are the alternatives? This chapter seeks to answer these questions by applying the tools of economic analysis to the current circumstances of Asian countries. 61 4 Asia in Search of a New Exchange Rate Regime    20 40 60 80 100 New Taiwan dollar Singapore dollar Taiwan + Singapore 20 40 60 80 100 1995 1996 1997 1998 1999 2000 Korean won Philippine peso Malaysian ringgit Thai baht Indonesian rupiah ASEAN + South Korea 20 40 60 80 100 Chinese yuan Hong Kong dollar China + Hong Kong Index, June 1997 = 100 Figure 4-1. Exchange Rates of Asian Currencies against the U.S. Dollar, 1995–2000 Source: Compiled by Nomura Research Institute based on Bloomberg data.       The Vulnerability of the Dollar Peg System The latest crisis in Asia reveals some weaknesses intrinsic to the traditional dollar peg system, adopted widely by Asian countries. First, fluctuations of the yen against the U.S. dollar have led to sharp swings in export performance as well as in net capital inflow. Second, given the weakening synchronization between Asian and U.S. growth rates, leaving interest rates to be determined in the United States (as required to maintain fixed exchange rates against the dollar) has led to macroeconomic instability. Finally, countries committing to fix their exchange rates against the dollar are vulnerable to speculation. These weaknesses, which are to one extent or another common to all fixed exchange rate regimes, have been aggravated by the sharp rise in the scale of capital flows. In addition, the dollar peg system has been further strained by the growing interdependence among Asian countries (including Japan) at the expense of dependence on the United States as well as by a sharp deterioration of the U.S. balance of payments position. Yen-Dollar Rate Fluctuations and Macroeconomic Instability Led by the yen-dollar rate, exchange rates among the major currencies have become highly volatile since the collapse of the Bretton Woods system in the early 1970s. This has happened against a background of the sharply deteriorating U.S. balance of payments position in general and its growing imbalance with Japan in particular. With the yen fluctuating widely against the dollar, the traditional policy of pegging their exchange rates to the dollar has led to macroeconomic instability in Asia’s developing countries (see chapter 3 for details). Since the Plaza Accord in 1985, there has been a clear tendency for economic growth in Asia to accelerate when the yen appreciates and to decelerate when the yen depreciates. The downturn in Asian economic growth in 1996–97 can largely be explained by the sharp depreciation of the yen against the dollar. The weakening yen also led to a marked deterioration in Asia’s export performance and current account balances, paving the way for the currency crisis. As discussed in more detail in chapter 3, a depreciation of the yen against the dollar (and thus against the Asian currencies under the dollar peg system ) affects the Asian economies mainly through the following five channels . First, a weaker yen makes Japanese exports less expensive relative to those of the Asian countries and Asian products become less competitive against Japanese products in international markets as a...