Asian Development Bank July 1999

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Abstract: As international capital flows return to pre-1998 levels, Asian governments will regain the freedom to establish exchange rate policies. Some may move to reinstitute features of their ex ante policies. To identify those pre-crisis policies, we trace out impulse response functions

relating monetary shocks to the real exchange rate for several key Asian countries. Results from that exercise, together with available descriptive information, show that while Asian monetary authorities used monetary policy to pursue a variety of objectives before the crisis, none but Japan maintained a true float. We describe the major exchange rate policy choices available to Asian governments committed to keeping open capital accounts. The paper concludes that, with the exception of governments running large current account surpluses or facing strong inflationary pressures, Asian monetary authorities would do best with floating exchange rates.

My thanks to Alan Oxley, Jo Bosben, Jackie Taylor, the Australian APEC Study Centre, and the participants at the Trade in Financial Services Conference for their valuable suggestions and support.

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New Exchange Rate Policies for Asia after the Crisis W. Christopher Walker

The Asian financial crisis of 1997 forced the rapid depreciation of five major Asian currencies, and subjected several others to severe pressure. Many countries had their exchange rate policies reset by external forces, as monetary authorities were forced to let the markets determine exchange rates once stocks of foreign reserves were depleted1. But as Asia recovers, governments and central banks will regain the freedom to establish their own policies, and the region will face the challenge of setting up post-crisis monetary and exchange rate regimes.

This paper aims to describe, and provide a limited analysis of, the monetary policy choices available to Asian governments. It begins with a brief listing of the major monetary alternatives. Governments committed to maintaining open capital accounts still have several monetary policy choices, but for convenience we group those into just two major categories -- fixed and floating. We will then look at most of the major Asian economies, in an attempt to determine which policies they actually followed prior to the crisis. The paper concludes with a series of recommendations on exchange rate policy setting in post-crisis Asia.

Fixed Exchange Rate Regimes

We briefly describe each of the major fixed exchange regimes, moving from strongest to weakest.

1

An alternative is to restrict trading of domestic currency through the imposition of capital controls. This was the solution adopted by Malaysia in September 1998.

I. Fixed rate with no possibility of money creation. This possibility encompasses either full monetary union, as in the EMU, or complete dollarization, as practiced by Panama. In either case the country in question relinquishes its own currency and surrenders the power to issue domestic credit. This arrangement makes it impossible for traders or arbitrageurs to speculate against the

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domestic currency. But while it enhances economic security, it reduces monetary and political autonomy, exacting a price that most sovereign governments are still unwilling to pay.

II. Fixed exchange rate with no creation of domestic credit. This category includes the currency board, a monetary arrangement once used for backing colonial currencies with those of the mother country and now again in vogue. The best-known present examples of currency boards are Argentina and Hong Kong, both based on the U.S. dollar. The monetary authority in each country is committed to back every dollar's worth of currency with a dollar in reserve. If reserves are equal to the monetary base, that means that a sale of reserves to meet a demand for dollars must result in a proportionate reduction of the base (unsterilized intervention). Thus, as reserves contract so does the monetary base, with the result that domestic interest rates rise, thereby attracting foreign capital and putting an end to the outflow. While it appears waterproof, the system has some important disadvantages. Salient among these is the fact that the monetary authority has no discretionary power over domestic interest rates, implying that a strong capital outflow may provoke a severe recession.

IIa. Sliding Rate. A variation on the single fixed rate strategy is for the monetary authority to announce a schedule of appreciations or depreciations. That was the policy maintained by Brazil for four years until the Brazilian real was floated under heavy selling pressure in January 1999. Countries strongly committed to maintaining a sliding peg usually back the currency with unsterilized intervention.

III. Fixed exchange rate with free creation of domestic credit (sterilized intervention) The monetary authority declares a specific rate and offers to defend it, but makes no commitment about the money supply. When it wants to support the currency the monetary authority sells foreign reserves, and when it needs to keep the currency from appreciating it buys dollars. The impact of these reserve purchases and sales on the domestic money supply is sterilized by a countervailing sale or purchase of domestic bonds, keeping the domestic money supply unchanged and allowing domestic monetary policy to remain independent of foreign exchange policy. Most

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Asian governments responded to the first wave of capital outflows in 1997 with sterilized interventions (Corsetti, p. 9).

In practice central banks are generally unable to maintain a policy of full sterilization, particularly in times of foreign exchange outflows, since that entails reduction of foreign reserves without an increase in domestic rates to stem the outflow2. The practical solution in this case is often to let the currency depreciate, or reduce the monetary base, or both3.

Floating Exchange Rate Regimes

2

See the literature on the irreconcilable trinity (Krugman, Dornbusch, and others).

3

See, for example, Rogoff and Obstfeld, p. 594, on the questionable efficacy of sterilized intervention.

With a floating rate, the central bank lets the market determine the exchange rate for the currency. That allows prices to adjust to market pressures, protects reserves, and eliminates the possibility of speculative attack. Under the broad heading of floating regimes, there are several important variations.

I. Non-Intervention. In theory the central bank can refrain completely from adjusting domestic credit. In practice this is rare, since economies grow, and even believers in perfect markets (no price stickiness) think that money demand increases with output. A more realistic alternative in the same spirit of non-intervention is monetary targeting, under which the central bank increases the money supply according to a fixed rule (e.g. 3 percent per year). One disadvantage of this approach is that, outside the monetary base, it is difficult in practice to control monetary aggregates. Another is that the central bank is constrained from adjusting monetary policy to respond to price pressures.

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a certain level of inflation. That level is announced in advance. The major benefits of this strategy are transparency and predictability. If everyone knows the targeted rate and sets prices

accordingly, it is unlikely that inflation will spin out of control. This policy should result in a steady depreciation or appreciation of the exchange rate, depending on the target set. Countries that do this include, to one degree or another, Australia, New Zealand, Canada, Sweden, the United Kingdom, and Spain (Mishkin, p. 18). While central banks using this strategy do make inflation their main target, in practice most have some latitude to fit monetary policy to the business cycle. That means easing monetary policy when there is a demand shortfall, which implies a nominal devaluation in the case of an export demand shortfall.

III. Real Exchange Rate targeting. For small open economies real exchange rate targeting is a potentially attractive option. The idea is to keep the cost of a typical basket of home country goods, measured in terms of a typical basket of foreign goods, the same over time. So if, for example, prices rise in the home country, the monetary authority may want to depreciate the currency to compensate. That should help keep the home country’s exports competitive -- a key goal for a highly open economy like Hong Kong or Singapore, where total trade is two or three times output.

IV. Active Intervention Targeting Output or Unemployment Levels. This is traditional Keynesian monetary policy, practiced by a number of industrial democracies in the 1960's and '70's. Central banks may set monetary policy with little regard for the exchange rate, but rather to target a certain level of output on the assumption of a positive correlation between interest and unemployment rates (Phillips curve).

V. Other Floating Rate or Mixed Policies. Again, there are many variations. For example, real exchange rate targeting may be combined with output targeting. And targeting of the real

exchange rate in the case where inflation rates are stable may be observationally equivalent to a sliding peg or exchange rate band.

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6

Asian Exchange Rate Regimes Before the Crisis

Rather than simply accepting policymakers' pronouncements about which exchange rate strategies they followed before the financial crisis, we will use a few diagnostic and analytic techniques to assess de facto exchange rate regimes in Asia. First are three charts of nominal exchange rates against the U.S. dollar for the period 1980-1998, measured monthly. The graphs indicate the value of the local currency in terms of U.S. dollars, with the exchange rate for each currency normalized to one in January 1980. A move down the vertical axis therefore represents a local currency depreciation.

The first chart shows the ASEAN-4 -- Thailand, Malaysia, Indonesia, and the Philippines. At one time or another, all four pegged their currencies implicitly or explicitly to the USD. Some claimed to use a basket of currencies, but in every case the dollar was apparently the main

component. From 1990 to 1997 the Malaysian ringgit traded in a range from 2.7 to 2.5 to the dollar. Thailand maintained a rate fluctuating around 26 baht to the dollar for the whole period. The tight trading range of both currencies is evident from the chart, which shows some monthly variation but a strong tendency to revert to the mean. The Philippine peso traded in a broad 10-15 percent band from 1990-95, and was then set tightly at 26 pesos to the dollar. After a large depreciation in 1986, the Indonesian rupiah appears to have followed a sliding peg against the dollar, with a relatively constant rate of depreciation. Both trends are apparent from the chart.

ASEAN - 4 0 0.2 0.4 0.6 0.8 1 1.2 Malaysia Thailand Indonesia Philippines

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Looking at the group of richer economies, sometimes known as the four Asian tigers, we see more variation. Hong Kong’s currency board has been in place since 1984, making the exchange rate with the U.S. dollar essentially stable. Taiwan, for which data were unfortunately unavailable, followed a form of managed float. The relatively steady nominal exchange rate for the won suggests that Korea targeted a broad exchange rate band. Singapore's policy is more difficult to infer from the graph. The Singapore dollar was the only regional currency that appreciated against the U.S. dollar over the past 19 years. As we will see below, low inflation in Singapore worked to keep the real exchange rate, and thus Singapore's export competitiveness, at a steady level. One possible description of Singapore's dominant exchange rate policy during this time, supported to an extent by government statements, is that the country's monetary authority targeted the real exchange rate.

The final nominal exchange rate chart shows U.S. dollar exchange rates for the German mark and Japanese yen. Both currencies were regarded as floating during the 1980's and '90's.

Tigers 0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6

1980 JAN 1981 JAN 1982 JAN 1983 JAN 1984 JAN 1985 JAN 1986 JAN 1987 JAN 1988 JAN 1989 JAN 1990 JAN 1991 JAN 1992 JAN 1993 JAN 1994 JAN 1995 JAN 1996 JAN 1997 JAN 1998 JAN Singapore

Korea

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A key feature of exchange rate policy that is not revealed by these graphs is the relationship between monetary policy and the exchange rate. To show this link explicitly, we trace out impulse response functions for several economies. In this context, the impulse response functions show the effect over time of a change in the domestic money supply on the real

exchange rate. The real exchange rate, mentioned above, is equivalent to the observed (or

nominal) exchange rate multiplied by the ratio of domestic to foreign prices. That is:

In the equation q is the real exchange rate denominated in number of dollars per unit of local currency, e the nominal exchange rate, p is the domestic price level, and p* the foreign price level. When the real exchange rate appreciates, home goods become more expensive relative to foreign goods. That typically leads to a negative shift in the trade balance as both home country residents and foreigners shift to consuming foreign goods. Conversely, a real depreciation improves the trade balance. J a p a n a n d G e r m a n y 0 0.5 1 1.5 2 2.5 3

1980 JAN 1981 JAN 1982 JAN 1983 JAN 1984 JAN 1985 JAN 1986 JAN 1987 JAN 1988 JAN 1989 JAN 1990 JAN 1991 JAN 1992 JAN 1993 JAN 1994 JAN 1995 JAN 1996 JAN 1997 JAN 1998 JAN Japan G e r m a n y *) (p/p e = q$,lc $,lc •

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Under a floating exchange rate system, monetary policy affects the real exchange rate through two channels -- the nominal exchange rate and domestic prices. Suppose there is a domestic monetary expansion. First consider the effect of that change on domestic prices. With more money circulating domestically prices should eventually rise, but unlike stock prices, for example, goods prices take time to adjust to sudden changes. So immediately after the money supply increases the domestic price level will not have changed. But after some time prices will increase in proportion to the money supply expansion (quantity theory of money).

Now what about the impact on the nominal exchange rate? With a true float, the nominal exchange rate is free to fluctuate as the market demands. Over the long run the market will expect, correctly, that the nominal exchange rate will depreciate from its present level so as to leave the real exchange rate unchanged from its ex ante level. That is, the nominal exchange rate should eventually fall to match the rise in domestic prices. But over the short run the nominal exchange rate falls even beyond that eventual level. The reason is that the monetary expansion increases the amount of real money in circulation (money supply divided by the price level), which leads to a reduction in domestic interest rates. As a result foreign currency will flow out of the economy (foreign reserves will be depleted) until the domestic currency depreciates so much that it is expected to appreciate over time. That will equalize the expected return of investing in the home country's currency or in dollars.

Combining these two effects we can now determine the implication of a money supply increase for the real exchange rate. On impact -- immediately after the shock -- the real exchange rate depreciates because the nominal exchange rate depreciates sharply while prices have yet to change. Over the longer run prices increase in proportion to the monetary expansion while the nominal exchange rate slowly appreciates but remains below its level before the monetary

expansion. (See Appendix 1 for a more technical account). The impulse response function should have the following trajectory:

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With a fixed exchange rate the impulse response function will follow a different trajectory. The impact of a monetary expansion on the domestic price level will be the same as with a floating rate, since domestic prices are determined in the long run by the money supply (and by domestic economic activity, but that is abstracted from our simple model), and prices still take time to adjust to money shocks. But with a fixed rate, by definition, a money shock cannot have an impact on the nominal exchange rate. The simplest way to insure that, as described above, is with a commitment to unsterilized intervention. As foreign reserves dwindle the money supply falls, increasing domestic interest rates and eventually attracting reserve inflows. Under this system monetary policy is not independent but is entirely driven by outside shocks. With a fixed rate the impulse response function should have the following trajectory:

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Using the impulse response function we may also be able to recognize a third alternative --real exchange rate targeting. If the monetary authority is able, for a time at least, to neutralize the impact of monetary shocks on the exchange rate and thereby conduct an independent monetary policy, money shocks should have no impact on the real exchange rate. Of course a monetary expansion will eventually cause an increase in the domestic price level, but the impact of that price increase can be canceled out by a countervailing reserves purchase. Under these circumstances the impulse response function should either be flat or fluctuate close to the horizontal axis:

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Unfortunately our impulse response methodology does not allow us to distinguish

between sterilized and unsterilized intervention with a fixed rate. But, as argued above, sterilized intervention with a fixed exchange rate is unlikely to be feasible over the long run. If the

monetary authority insists on conducting monetary policy independent of exchange rate policy, it will likely soon find itself either subordinating money to exchange rate conditions (unsterilized intervention) or manipulating the nominal exchange rate to fend off imbalances (which could be a form of real exchange rate targeting). Thus it seems plausible that a country engaging in sterilized intervention or a hybrid policy may display some combination of the unsterilized intervention and real exchange rate targeting profiles.

We now turn to the observed impulse response functions for individual countries. (See Appendix 2 for details on data and econometrics). The case of Hong Kong is shown below. The impulse response function has the expected trajectory for a fixed exchange rate (also see chart 1), with gradual appreciation following a monetary expansion. The dotted lines indicating standard errors show that over the longer run (5 years) that response is confirmed within an approximately

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95 percent confidence interval. Hong Kong is regarded here as the classic example of a currency board with a fixed exchange rate, but even Hong Kong does not fit the mold precisely. Because it has maintained reserve levels that for several years have far outstripped the monetary base, Hong Kong has been able to lean against the wind at times by expanding its money supply in the

face of capital outflows.

To show the contrast between fixed and floating regimes we now examine two cases of what are normally taken to be floating rates -- Japan and Germany. Both exhibit real

depreciations on impact, followed by slow appreciations back to the ex ante level (that is, they both revert to zero).

-0.02 -0.01 0.00 0.01 0.02 2 4 6 8 10 12 14 16 18 20

Response of Real Exchange Rate to One S.D. M Innovation

Hong Kong

Number of Quarters after Impact

Dotted lines indicate +-2 standard deviations

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While both conform generally to the model for floating exchange rates, there are

anomalies. In Japan's case, the real exchange rate does not revert to zero, although it does return to a level within the normal statistical margin of error of zero. The anomalous aspect of the German results is that the real exchange rate does not depreciate sharply right away as predicted

-0.015 -0.010 -0.005 0.000 0.005 10 20 30 40 50 60 70 80 90

Japan

Number of Months after Impact Dotted lines indicate +-2 standard deviations -0.008 -0.006 -0.004 -0.002 0.000 0.002 0.004 5 10 15 20 25 30 35 40 45 50 55 60

Germany

Number of Months after Impact

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but declines over several months before beginning to revert.

Having observed the polar cases of fixed and floating exchange rates, let us look at impulse response functions for five other Asian currencies. The impulse response function for Indonesia, shown below, does not resemble either the fixed or floating graphs seen so far.

Certainly, there is no initial depreciation suggestive of a float. It corresponds most closely to our model of the impulse response function for the case of real exchange rate targeting. While

Indonesia’s nominal exchange rate did not vary much during the latter part of the sample period, it did depreciate steadily, approximately matching its inflation differential with trading partners, and thereby keeping the real exchange rate within a set range.

The graph for Malaysia, shown below, resembles the impulse response function for Hong Kong, insofar as it shows a steady real appreciation on impact, with no pronounced tendency to revert to the ex ante level. Given that Chart 1 shows some variation in the nominal exchange rate, that suggests an exchange rate band with little attempt to control the real exchange rate.

-0.02 -0.01 0.00 0.01 0.02 0.03 5 10 15 20 25 30 35 40 45 50 55 60

Indonesia

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Thailand's impulse response function resembles Malaysia's, but with an eventual tendency to

revert to the mean. Such a profile is consistent with a policy of initial fixed rate intervention, followed by either a countervailing monetary action or a reserve operation that does not affect the monetary base. Either action would suggest some degree of real exchange rate targeting.

We now turn to Singapore and Korea, the two Asian economies with relatively large

-0.004 -0.002 0.000 0.002 0.004 0.006 0.008 0.010 5 10 15 20 25 30 35 40 45 50 55 60

Response of Real Exchange to One S.D. M Innovation

Malaysia

Dotted lines indicate +-2 standard deviations -0.005 0.000 0.005 0.010 0.015 5 10 15 20 25 30 35 40 45 50 55 60

Thailand

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nominal exchange rate variations. Singapore’s impulse response function nonetheless resembles Thailand's, suggesting that initial fixed rate interventions were followed by monetary or reserve actions that tended to keep the real effective exchange rate stable:

Results for Korea are perhaps the most dramatic, showing very little impact of monetary shocks on the real exchange rate. That result is clearly consistent with the model of real exchange rate targeting. -0.02 -0.01 0.00 0.01 0.02 0.03 0.04 0.05 5 10 15 20 25 30 35 40 45 50 55 60

Response of Real Exchange Rate to One S.D. M Innovation Singapore

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Comparing the seven impulse response functions, the clearest difference is between the two floating currencies, Japan and Germany, and the other Asian countries. The impulse response functions for Asia outside of Japan demonstrate unambiguously that none of the subject countries practiced a genuine float.

With some basis for classifying countries by exchange rate policies, we now apply a simple measure to our sample group as a first step in assessing the variability of real exchange rates under specific regimes. The following table shows coefficients of variation (CV) for the real exchange rates of each of the countries studied, where the CV is defined as the standard deviation of the real exchange rate, measured monthly, divided by its mean. The higher the CV, the more unstable are relative prices, and, it might be argued, the more difficult the regime for traders. Countries are grouped into different regimes based on the preceding discussion.

-0.02 -0.01 0.00 0.01 0.02 5 10 15 20 25 30 35 40 45 50 55 60 Korea

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Real Exchange Rate Variation Across Countries

Regime Country CV in Percent Group Mean CV

Germany 5.01 Japan 11.21 FLOAT United States 10.13 8.78 Indonesia 33.05 Korea 15.70 Singapore 10.34 REER TARGET Taiwan 7.35 16.61 Hong Kong 11.37 Malaysia 17.91 Philippines 9.23 FIXED Thailand 15.52 13.51

The chart does not provide decisive evidence in favor of any one policy, partly because other macroeconomic variables, such as level of income, are likely to be correlated with the choice of exchange rate regime. There is therefore little basis for concluding, for example, that

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real exchange rates are necessarily more stable under a floating regime than with a fix.

Nonetheless, a cursory review of the chart does suggest the difficulty of arguing that a fixed rate helps exporters by increasing real exchange rate stability.

Pitfalls and Recommendations

These considerations some specific conclusions about exchange rate management in Asia after the financial crisis. In approximately descending order of importance they are:

I. A return to the fixed-rate, dollar peg days would be a mistake. The experience of the Asian financial crisis points to the extensive vulnerabilities and limited benefits available from a fixed exchange rate. There are at least three ways that fixed rate currency policy helped precipitate the crisis. First, banks and other borrowers took the exchange rate policy as an implicit guarantee against currency fluctuation to borrow in dollars and lend at higher rates in local currency. When the market turned, those positions represented a vulnerability that encouraged short sellers, particularly in Indonesia and Thailand. Second, dollar inflows under a fixed peg lead to an

increase in the domestic money supply, even without a currency board. That can produce an asset bubble, which in turn creates market panic when it pops. There is some evidence this happened in Hong Kong. Finally, a fixed peg provides a target for speculators -- it is essentially a necessary condition for a currency crisis.

The claimed advantages of a fixed peg are anti-inflationary credibility and facilitation of trade and investment. There is indeed some evidence of anti-inflationary benefit in the academic literature (Gulde, p.16). But inflation has not, historically, been a problem for Asian countries to the extent it has in Latin America. Intuitively, it seems reasonable that a fixed rate would favor

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trade,but there is little statistical confirmation that this actually occurs (Baccheta and Wincoop, p. 1). Certainly, the results of our informal survey on variability of real exchange rates by regime would tend to reject the trade argument. On the investment side, the type of investment most likely to be encouraged by fixed rates is of the portfolio variety. But those are just the type of short-term capital flows seeking high yields that contributed to capital volatility at the outset of the Asian crisis.

II. If a dollar peg is a bad idea, a yen peg might be even worse. The notion is periodically raised that Asia is a natural sphere of influence for the yen and that a de facto yen standard would suit Asia just as the dollar standard appears to have benefited Latin America. As described above, an overdependence on the dollar before the crisis did constitute a major source of vulnerability for Asian countries. But beyond the general problems with a peg raised above, pegging to the yen would raise specific difficulties. Pegs tend to work better the closer the pegging country's trade relations are to the reserve country. But despite lingering perceptions of a zone of Japanese influence, seven of the eight Asian countries covered in this paper export more to the United States than to Japan. Most even export more to the European Union. An additional problem with a yen peg would be the content of foreign exchange reserves. Given their low yields and the uncertain course of the dollar exchange rate, the opportunity cost of holding yen-denominated financial instruments is relatively high. And the relative lack of depth and sophistication in markets for yen instruments and derivatives make it harder to hedge specific risks.

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III. A currency board can be useful in controlling inflation and resisting attacks, but the costs are too high for most countries. One widely covered proposal made during the heat of the crisis was to institute a currency board in Indonesia. Based on the successful experiences of Hong Kong and Argentina in fighting off speculators during periods of capital outflows, this was recommended as a way of saving the plunging rupiah. Under pressure from the IMF, Indonesia ultimately dropped the idea.

As argued in the first section of this paper, a currency board can provide a theoretically impregnable bulwark against an attack, as long as the monetary authority is willing to contract the money supply and raise rates as far as necessary to defend the currency. But what generally makes the currency board politically and economically viable is the credibility of just that commitment. If markets have little faith in the currency board, in times of crisis the board will have to push up interest rates to intolerable levels, particularly if forex reserves are relatively low. And in countries with weak financial sectors such as Thailand and Indonesia the cost becomes even greater as high interest rates cause banks to fail. The currency board is most suited to open economies with flexible factor markets and a history of inflation, along with strong financial institutions. Outside of Hong Kong, most Asian countries do not appear to fit these requirements.

IV. Real exchange rate targeting may be useful for open economies with persistent current account surpluses. Singapore and Taiwan, both with large perennial current account surpluses, have succeeded with policies of targeting the real exchange rate without explicitly describing that as their monetary policy objective. By being coy about the real policy objective, the monetary authority reserves some freedom to adjust the exchange rate when crisis hits, or to provide extra

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stimulus when demand slackens. But it can be difficult to say what the optimal real exchange rate is at any given time. And too strong a commitment to defend any given rate when the market moves against your currency could be self-defeating if the monetary authority is forced to reverse a publically stated policy.

V. A free float with inflation targeting is the best rule of thumb, even for Asia’s small, open economies. That forces local borrowers to recognize currency risk, and removes the possibility of forced devaluation. It saves central banks from squandering reserves, and allows them to create domestic credit, if market demand allows. Most important, it lets them conduct an independent monetary policy. An inflation target in economies without a chronic history of inflation is likely to be credible, mitigating the need for a fixed peg to establish a reference price in the economy. And recent experience shows that the impact on trade of moving from a fixed to a floating system is likely to be small. For economies such as Thailand, Indonesia, Malaysia, Philippines, Korea, and Taiwan, this is likely to be the best approach.

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References

Charemza, Wojciech W and Derek F. Deadman (1997), “ New Directions in Econometric Practice”, Edward Elgar, U.K.

Hamilton, J.D. (1994), “Time Series Analysis”, Princeton University Press, Princeton. Corsetti, Giancarlo, Pesenti, Paolo, and Roubini, Nouriel (1998), “What Caused the Asian Currency and Financial Crisis? Part II: The Policy Debate,” NBER Working Paper 6834.

Ghosh, Atish R., Gulde, Anne-Marie, Ostry, Jonathan D., and Wolf, Holger C. (1997), “Does the Nominal Exchange Rate Regime Matter?,” NBER Working Paper 5874.

Mishkin, Frederic S. (1999) “International Experiences with Different Monetary Policy Regimes,” NBER Working Paper 7044.

Obstfeld, Maurice and Kenneth Rogoff (1996), “Foundations of International Macroeconomics,” MIT Press, Cambridge, Massachusetts.

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Appendix 1 -- Analytic Derivation of Impulse Response Functions

We use a set of standard equations, expressed primarily in logs, to derive the illustrated impulse

response functions. The first is the usual uncovered interest parity condition

where it represents the home country nominal interest rate, i*t is the foreign interest rate, et is the

(log) nominal exchange rate expressed as the number of units of local currency required to

purchase a unit of foreign currency, and ef is the (log) expected future exchange rate. Thus in the

usual case et is the number of units of an Asian currency required to buy one U.S. dollar. A rise

in et therefore represents a nominal depreciation. (UIP) is best regarded as an arbitrage condition

asserting that any excess of the home interest rate over the foreign rate must equal the expected depreciation of the home currency.

Money demand is determined by a simplified version of the Cagan equation. Ignoring the impact

of output on money demand in order to render the simplest possible model:

Dropping the time subscripts, m is (log) nominal money supply, p is the (log) domestic price level, and ç is a fixed parameter. (CAG) asserts simply that money demand is inversely proportional to the nominal interest rate. Given a fixed level for the real money supply (m-p), there is a unique interest rate at which the money market is in equilibrium. We now define the real exchange rate

in terms of the nominal exchange rate and foreign and domestic price levels:

where q is the (log) real exchange rate. The (log) foreign price level is normalized to 0. We now introduce the following bar notation to denote the long run value of a variable after a

shock, assuming no other shocks to the system:

Assuming that a simplified version of the quantity theory of money applies over the long run: Since prices are sticky over the short run, however, there is no immediate impact of a money

) e e ( + i = it *t f t i -= p mt t η t p e = qt t _t ∞ → s x lim = x t+s p = m

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shock on the price level:

FLOATING RATE CASE

To derive the impulse response function in the floating rate case we make the additional

assumption that the initial real exchange rate q0 is equal to a long run real exchange rate _q that is

unaffected by monetary conditions:

It follows from (7) that the long run impact of a monetary shock on the real exchange rate must be zero. Again using a bar to designate the value of a variable in the long run, equation (RER)

entails:

From (7), (8), and (QTM), it follows that:

That is, over the long run, doubling the money supply will double the price level and cause the domestic currency to depreciate by half.

Now taking the derivative of (CAG) with respect to mt:

Thus the immediate impact of a monetary expansion is to reduce the domestic interest rate. Assume that ef is equal to e_, and that the foreign interest rate does not change, take the derivative

of (UIP) with respect to m to get:

But (d-e/dm0) is equal to one from (9). Thus (de0/dm0) must be greater than one. This is

Dornbusch’s overshooting result -- on impact the nominal exchange rate depreciates even further than its eventual level. And since prices do not change immediately on impact from a monetary shock, it follows from (RER) that the real exchange rate must depreciate as much as the nominal

0 = m d p d t t q = q₀ ) p p ( ) e e ( = ) q q ( 0 0 ₀ ) m m ( = ) p p ( = ) e e ( 0 0 0 η η 1 -= m d p d + m d m d 1 -= m d i d 0 0 0 0 0 0     0 < dm de dm e d = dm di 0 0 0 0 0

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exchange rate on impact:

FIXED RATE CASE

To understand the impact of monetary policy in a fixed rate case we make the simplifying

assumption that all intervention is unsterilized. The money supply m is adjusted only in response to outside shocks, so as to keep the nominal exchange rate e fixed. We can write these

relationships as:

where z is a single-valued function of relevant external variables (e.g., prices in foreign asset

markets).Using the implicit function theorem we can rewrite (13) in terms of a monetary shock as: From equation (SP) we know that the immediate impact of a monetary expansion on the price

level is zero. Therefore:

Over the longer run however, (QTM) entails that prices adjust to accommodate the money shock.

Thus: In bar notation: 1 > m d q d 0 0 0 = z e -z m m e = dz de 0 0 0 0 0 0 0 0 ∂ ∂ ∂ ∂ ∂ ∂ 0 = m z z e -m e = dm de 0 0 0 0 0 0 0 0 ∂ ∂ ∂ ∂ ∂ ∂ 0 = dm dp -dm de = dm dq 0 0 0 0 0 0 1 -= 1 0 = dm ) p e ( d s lim = dm dq s lim 0 s + 0 s + 0 0 s + 0 ∞ → ∞ → q=e - p=_e0 - p

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Therefore the impact of a monetary expansion on the real exchange rate under a fixed rate system is transmitted entirely through the price level. The immediate impact is nil, but over time the price level increases to match the money supply expansion, inducing a real exchange rate appreciation. Note that in the fixed rate case the assumption (7) used in the floating rate case is not maintained -- it is inconsistent with (QTM) and the fixed rate assumption.

REAL EXCHANGE RATE TARGETING

We now allow for the possibility of sterilized intervention such that prices are determined over the long run by monetary operations, while the central bank buys and sells foreign reserves to control the nominal exchange1 rate. We assume for the sake of simplicity that the government wishes to maintain the real exchange rate q at a fixed level. As in the fixed rate case, monetary operations are always undertaken in response to an external shock. If the central bank is successful in

maintaining q at a fixed level then:

as in the floating rate case. However, the central bank also endeavors to absorb the immediate

impact of any external shock so that:

By (SP) then:

And since, by (18):

it follows, given (QTM) that over the long run a monetary expansion will cause a nominal

depreciation. The impulse response of the real exchange rate to a monetary expansion, however, will be zero over the short and long term.

q = q ₀ 0 = dm dp -dm de = dm dq 0 0 0 0 0 0 0 = dm de 0 0 0 = dm ) p e ( d s lim = dm dq s lim 0 s + 0 s + 0 0 s + 0 ∞ → ∞ →

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Appendix 2 -- Vector Autoregression and Data Sources

The estimated impulse response function presented in this paper are derived using

standard vector autoregression (VAR) techniques. For a full technical account of VAR methods see, for example, Hamilton (chapters 10 and 11). A less technical but intuitive account can be found in Charemza and Deadman (chapter 6).

Informally, a VAR consists in regressing each variable from a set of variables (e.g., [x1, x2,

x3]') on its own lagged values together with the lagged values of the other variables. Through

matrix manipulation it is possible to project the effect on the system of a shock to one variable out through time, thereby generating the impulse response function. The VAR approach is designed to avoid endogeneity problems -- all of the variables are considered to be endogenous. However, in order to isolate the effect of a “pure” shock to a given variable it is necessary to orthogonalize the error terms, as is done here. Standard errors are derived using a variation of the delta method applied to the original linear regression covariance matrix.

The actual estimated impulse response functions presented here were obtained using the statistical packages GAUSS and EVIEWS. Graphs of the functions are from EVIEWS.

The real exchange rates used in this paper are from J.P. Morgan's real exchange rate indices. Money supply (M1) and nominal exchange rate data are from the IMF's International Financial Statistics.

While all of the impulse response functions presented are estimated using data from the period 1980-1998, a number of the countries experienced definite regime shifts during that period, so that for most countries it was necessary to confine the regression to a subset of the available data. Thus, for example, estimates for Hong Kong are based on the period 1984-97, since Hong Kong adopted the dollar currency board in 1987. The precise periods for each country are as follows: Germany - Jan 80 to Dec 98, Japan - Jan 80 to Oct 98, Hong Kong - 84Q1 to 98Q1, Indonesia - Aug 86 to Aug 97, Korea - Jan 80 to Oct 98, Malaysia - Jan 80 to Aug 97, Singapore Jan 80 to Oct 98, Thailand - Nov 84 to Aug 97.

Finally, all but one of the regressions used monthly data and incorporated a trend term. The sole exception was Hong Kong, where the unavailability of monthly monetary data made it necessary to use quarterly data. Possibly due to the resulting degrees of freedom problem, the regression with a trend term proved ambiguous, so that the results presented here for Hong Kong do not incorporate a trend.

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1.While this assumption may seem to entail that (UIP) does not hold that is not necessarily so. Traders may regard ef as reflecting a non-zero probability of a large depreciation.