Book Description

A coordinated action by East Asian countries to stabilize their currencies against a common basket of major currencies (broadly representative of their average structure of trade and foreign direct investment) would help stabilize both intra-regional exchange rates and effective exchange rates - in a way consistent with the medium-term objective of promoting trade, investment, and growth in the region. After discussing major conceptual and empirical issues relevant to the exchange rate policies of East Asian countries, Kawai and Takagi propose a regional exchange rate arrangement designed to promote intraregional exchange rate stability and regional economic growth. They argue that:For developing countries, exchange rate volatility tends to significantly hurt trade and investment, making it inadvisable to adopt a system of freely floating exchange rates.Given the high share of intraregional trade and the similarity of trade composition in East Asia, exchange rate policy should be directed toward maintaining intraregional exchange rate stability, to promote trade, investment, and economic growth.The current policy of maintaining exchange rate stability against the U.S. dollar as an informal, uncoordinated mechanism for ensuring intraregional exchange rate stability is suboptimal. A pragmatic policy option - conducive to a more robust framework for cooperation in monetary and exchange rate policy - would be a coordinated action to shift the target of nominal exchange rate stability to a basket of tripolar currencies (the U.S. dollar, the Japanese yen, and the euro). This alternative would better reflect the region's diverse structure of trade and foreign direct investment.The authors envision no rigid peg. Instead, at least initially, each country could choose its own formal exchange rate arrangement - be it a currency board, a crawling peg, or a basket peg with wide margins. At times of crisis, the peg might be temporarily suspended, subject to the rule that the exchange rate would be restored to the original level as soon as practical. Only in extreme circumstances would the level be adjusted to reflect new equilibrium conditions.This paper - a product of the Office of the Chief Economist, East Asia and Pacific Region - is part of a larger effort in the region to study financial market development, capital flows, and exchange rate arrangements in East Asia.