The Institutional Dollarization of Asian Currencies

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Chapter 3
The Institutional Dollarization of Asian Currencies

Hiroyuki Nakai

The Conflict with Domestic Monetary Policies
The Extreme Openness of the Asian Economies


It is commonly said that since the 1997–1998 Asian financial crisis (hereafter, “the crisis”), Asian currencies have regained their linkages to the U.S. dollar. Most studies show that the U.S. dollar has remained the key determinant of Asian currency movements even after the crisis. For example, McKinnon (2000) says that exchange rate targeting to the dollar is somehow inevitable for Asian currencies. Research on currency baskets by Ogawa and Shimizu (2003) seems to support such views.

The reasons researchers give for the revival of the strong link between Asian currencies and the U.S. dollar can be listed under four categories.1 First, it is a medium of exchange—all exchange rates are quoted in terms of the U.S. dollar (Ogawa, 2001); second, it is a settlement currency—most international trades are settled in U.S. dollars; third, it is a financing convenience—the dollar is convenient for borrowing and asset management while local currencies lack a method of long-term financing (McKinnon and Schnabl, 2003); and lastly, it is because of the increasing weight of the United States as a trading partner (McKinnon and Schnabl, 2003).

Although these are persuasive arguments for pegging a currency to the U.S. dollar, there is room for further discussion, especially because of the following three points. First, there is less urgency for Asian economies to rely on external financing. After the crisis, the current account balances of most Asian economies turned positive, and the surpluses were used to repay existing external debt, such as facilities offered by the International

1 Categories one to three can be mentioned collectively as a network externality. See Ogawa (2001).

Monetary Fund (IMF).2 This means that the importance of the third reason has diminished drastically and that Asian economies do not have to secure nominal stability against the dollar in order to obtain capital inflows.

The second reason is more fundamental. Why do Asian monetary authorities continue to prefer strong linkages to the U.S. dollar even after the crisis? The crisis itself clearly showed the risk of pegging to the dollar in the face of strong market forces for depreciation.3 They have made huge efforts to reduce such risks by tightening regulations and by creating a regional assistance network under the Chiang Mai Initiative. Of course, assuming improved balance of payments achieved through current account surpluses and generally steady capital flows in and out of the Asian economies, the risk now lies mainly on the side of appreciation rather than depreciation. However, Japan's experience with the Smithsonian Agreement of 1971 and the Plaza Accord of 1985 shows that keeping the currency artificially low is another risk which Asian monetary authorities should be familiar with.

This leads to the third reason. What makes (or forces) Asian monetary authorities to keep, or at least accept, the practice of pegging their currencies to the U.S. dollar? Most of them buy the U.S. dollar to curb the appreciation of their currencies and to maintain nominal stability against the greenback (U.S. dollar), which could conflict with domestic monetary policy. From the view of traditional monetary theory, too much nominal exchange rate stability is not rational.

This chapter examines the recent revival of pegging (or strong linkages) between the Asian currencies and the U.S. dollar.


The Nominal Effective Exchange Rate (NEER) and Nominal Exchange Rate against the U.S. Dollar

The system of (quasi) pegging their domestic currencies to the U.S. dollar, adopted by many Asian economies, does not necessarily translate into stable trading terms because of the diversity of trading partners. Hence, before discussing the “institutional dollarization” situation, it is necessary to carry out a quantitative analysis of the relationships between the movements in nominal forex rates and changes in the terms of trade for the Asian countries.

In order to look at how their price competitiveness has changed, calculations were made of the nominal effective exchange rates (NEERs) for ten Asian economies (China, Hong Kong, South Korea, Taiwan, Singapore, Malaysia, Thailand, Indonesia, Philippines, and Japan)

2 South Korea and Thailand fully repaid emergency facilities offered by the IMF and other economies while Indonesia also suspended its acceptance of new facilities.

3 Both external institutions, such as the IMF, and domestic institutions in the crisis-hit economies share the same view after the crisis. See Nukul Commission (1998).

based on the share of exports to various trading partners. The calculations cover the period January 1992 to October 2003, made on a monthly basis.4 Sixteen categories of trading partners were used, comprising the ten Asian economies, the United States, Canada, the United Kingdom, the Euro area, Australia, and “others.” Fifty percent of exports to “other” countries are assumed to be dollar-dominated. Export weights are based on 1991 nominal prices.5

Changes in the NEER were then compared with the volatility of the nominal exchange rate for each economy during four subperiods: before the crisis (January 1992 to March 1997), during the crisis (April 1997 to December 1998), the recovery period (January 1999 to December 2001), and the most recent period (January 2002 to October 2003). The results are shown in Figure 3.1, with the monthly annualized change in the NEER on the vertical axis and the standard deviation of the nominal exchange rate against the U.S. dollar on the horizontal. For each country, the figure plots the average for each of the four subperiods.

The observations can be summarized as follows. First, in the period before the crisis, the average NEER for most economies (except China) was flat, neither appreciating nor depreciating, while the average standard deviation of the nominal exchange rate to the U.S. dollar was low, or close to zero. Then, during the crisis (in most of the economies) volatility against the U.S. dollar increased while price competitiveness improved. Neither Hong Kong nor China, however, was much affected. Finally, after the crisis, price competitiveness for those economies with a strong pegging policy (Hong Kong, China, and Malaysia) declined at first because of the stronger dollar but then improved later as the dollar weakened. Other currencies largely returned to their pre-crisis situation, with low volatility against the dollar.

Linkages between the U.S. dollar and Asian currencies have reverted to the level seen before the crisis. During the crisis, the volatility of exchange rates against the U.S. dollar increased while competitiveness improved through NEER depreciation. Some economies also experienced depreciations in the NEER after the crisis. For China, competitiveness was eroded to some extent during the crisis because of the appreciation of the dollar, then recovered when the greenback weakened.

Income and Price Effects

The Asian currencies depreciated drastically, in NEER terms, during the crisis period, and later stabilized. Theoretically, such a big depreciation in the NEER should help export recovery in Asia. Did this really happen?

To see how movements in the NEER affect exports from the Asian countries, two analyses were carried out. First, a study was made of the correlation between each country's export volume and the variables representing income and price changes during the period 1992–2003. Export volumes were measured by real exports based

4 In this analysis, calculations do not use real (volume–) based numbers because of the lack of suitable price indexes. Asian exports are heavily concentrated in electronic goods, whose prices can fall rapidly. Furthermore, the weights in general price indexes and those for exported goods are not consistent.

5 Changing the base year produced almost the same results.

on national income, except for China, Hong Kong, and Singapore. Income effects were represented by a weighted average of the GDP (gross domestic product) growth rates of export destination countries. Price effects were measured by the change in the NEER. Correlation coefficients were then calculated for year-on-year changes, on a quarterly basis.

Table 3.1 shows the results of these correlations for the entire eleven years spanning the pre- and post-crisis periods. The crisis period (1997 Q2 to 1998 Q4) is excluded because the number of observations is insufficient. For the whole period, income effects seem significant for all economies while the price effect is observed only for two economies: China and Indonesia. Looking at the coefficients calculated for the pre-crisis period,

five countries experienced an income effect and the same number experienced a price effect. In the post-crisis period, however, all nine countries experienced income effects while only six experienced price effects.

Then a regression analysis was used to examine more closely the six countries that appeared to experience both income and price effects in the post-crisis period, applying one simple formula for all economies. Table 3.2 (p. 56) shows the results of regressions of the change in export volume on both the income and price variables and a time trend. For all economies except Indonesia, the absolute size of the t-value is much larger for the

Table 3.1 Correlation coefficients for export volumes
1992/1Q~2003/1QBy GDP growth rates of export destinationsBy change of Nominal Effective Exchange Rates (NEER)
  1. Correlations on quarterly observations of year-on-year changes. The table shows the strongest correlation among lead times for income and price variables of up to 3 quarters, marked by *, **, and *** designating 1, 2, and 3 quarter leads.
  2. Export volume: For China, the amount of industrial goods exported was used. For Hong Kong and Singapore, domestic and non-oil domestic exports and relevant export price indexes were used, respectively.
  3. For other economies, GDP exports were used.
  4. GDP growth rates of export destinations are weighted based on average exports.
  5. Nominal E. ective Exchange Rates are calculated from exports.
  6. Blank indicates no correlation (absolute size of correlation is less than 0.33, or sign condition error.)
SOURCE: Nomura Research Institute.
Hong Kong0.72 
1992/1Q~1997/1QBy GDP growth rates of export destinationsBy change of Nominal Effective Exchange Rates (NEER)
China −0.58
Hong Kong0.46* 
Taiwan0.84 *** 
Thailand −0.65
Indonesia −0.44*
1999/1Q~2003/1QBy GDP growth rates of export destinationsBy change of Nominal Effective Exchange Rates (NEER)
Hong Kong0.82 *0.82 ***
Indonesia0.74 **−0.66
Philippines0.87 *−0.28
Table 3.2 Regression formula and results
1999/1Q~2003/1QGDP growth rates of export destinations (a)Change of Nominal Effective Exchange Rates (b)Trend items (c)
  1. Regression formulas are as follows (common for all economies):
    Export volume (YoY,%) 5 a*weighted economic growth rate of export destinations (YoY,%)    
    + b*NEER (YoY,%)
    + c*trend items (steadily increasing)
  2. Regression period is 1999/1Q to 2003/1Q, on a quarterly basis.
  3. Upper numbers are coe. cients, middle ones are t values, and R2s are adjusted.
  4. *, ** and *** mean 1, 2 and 3 quarter leads in export volumes, respectively.
SOURCE: Nomura Research Institute.
 R2 = 0.817
Hong Kong1.671*21.181***−0.125
 R2 = 0.807 
 R2 = 0.461 
 R2 = 0.916 
 R2 = 0.526 
 R2 = 0.916 

Taiwan; ASEAN-4; and Singapore and Japan) to various destinations in 1996 and 2002 (Table 3.3). Generally speaking, the weight of Japan as an export destination for other countries in Asia declined while that of China increased between the two years. The weight of the United States as an export destination remained constant or increased slightly, while other OECD (Organization for Economic Cooperation and Development) economies kept their positions.

Table 3.3 Trade structure changes for Asian economies
1996 weightsAreas of originChina/Hong KongKorea/TaiwanASEAN-4 +Singapore Japan
Destination AreaUnited States27%20%26%27%
China/Hong Kong21%10%11%
US$ and pegged areas27%41%36%39%
ASEAN-4 + Singapore8%14%17%
Other Asia16%14%8%31%
UK, Canada, Australia6%5%8%6%
Euro Land16%10%15%12%
Total (millions,US$)151,260238,991213,743411,209
Table 3.3 Trade structure changes for Asian economies
1996 weightsAreas of originChina/Hong KongKorea/TaiwanASEAN-4 +Singapore Japan
SOURCE: Calculated from official statistics by Nomura Research Institute.
Destination AreaUnited States30%21%24%29%
China/Hong Kong26%13%16%
US$ and pegged areas32%50%37%47%
ASEAN-4 + Singapore5%8%10%
Other Asia14%8%10%23%
UK, Canada, Australia6%5%7%7%
Euro Land14%11%14%12%
Total (millions,US$)305,839282,569251,449416,138

This situation is consistent with the revival of pegging to the U.S. dollar that was discussed earlier and that forex rate changes did not have a large impact on the volume of exports from Asia. These findings seem to void the effectiveness of a “beggar-thy-neighbor” policy and suggest that exporters would prefer stable terms of trade rather than price competitiveness. The increasing weight of exports to the United States and to strictly dollar-pegged economies (China, Hong Kong, and Malaysia) implies that the stronger the linkage to the dollar, the more stable the terms of trade. Hence, those economies officially adopting a floating currency policy (South Korea, Taiwan, ASEAN-4 except Malaysia, and Singapore) should strengthen the linkage of their currencies to the U.S. dollar in order to enhance stability.6 As a result, it is natural that their currency policy becomes a so-called dirty-float, or quasi-pegging system.


Given the findings above, a comparative institutional approach was used to probe more deeply into why the Asian economies would choose to link their currencies more strongly to the U.S. dollar. Following this approach, the currency rate regime is considered as a rule which is enforced by a rule enforcer and binds all actors. In Asia, central banks or monetary authorities are the rule enforcers since they have the strongest power to decide the currency regime while other actors can complain to the enforcer and request changes if they are not satisfied. Thus, the currency regime is the result of consensus among actors. In addition to the monetary authority, a second actor was identified from the public sector—the economic policy authority. This is because, while the target of the monetary authority is typically general price and financial system stability, the policy focus of ministries of industry or trade is generally economic growth. Exporting enterprises are the key actor from the private sector.

Figure 3.2 shows how interactions among these three actors enhance the Asian currencies' linkages to the U.S. dollar. Thus, the recent situation in Asia is referred to as “Institutional Dollarization.” Without external threats, all three actors are happy to accept strong links between their domestic currency and the U.S. dollar.

From the viewpoint of exporting enterprises, a strong linkage to the U.S. dollar is convenient since most of the trade is settled in U.S. dollars. Nominal stability to the U.S. dollar also offers accounting and management conveniences to subsidiaries of multinational enterprises. On the other hand, weak price effects suggest that exporting enterprises do not have a strong preference for depreciation of their domestic currencies. Their interest is in the level of the exchange rate that does not erode their competitiveness. Given the Asian currencies' “bandwagon” linkages to the U.S. dollar, what they want is to maintain nominal stability to the dollar.

6 Assuming a network externality of the U.S. dollar, this would be a kind of “bandwagon” effect.

Economic policy authorities also demand the same, reflecting the stance of exporting enterprises. Given the Asian economies' highly open structure, the top priority of the authorities is to support these exporting industries. In addition, since the U.S. dollar is the key business currency, maintaining nominal stability to the dollar helps the Asian economies to attract inflows of foreign direct investment (FDI).

With lower inflation rates and relatively weak domestic demand in the aftermath of the crisis, the monetary authorities in the Asian economies do not have much difficulty maintaining nominal stability against the U.S. dollar, since this means lower dollar-denominated interest rates. Thus, under the regime of Institutional Dollarization, all three actors in the Asian economies have the motivation to maintain a strong linkage between their domestic currency and the U.S. dollar, at least in the short-term.

Who is Exporting to Whom?

The World Bank (1993) has described how the Asian economies, especially the ASEAN countries, succeeded with export-oriented industrialization by attracting inflows of foreign direct investment (FDI).7 Though such favorable descriptions have rarely been

7 This would not be the case for Korea, Taiwan, and Japan, since these three have not relied on foreign enterprises for industrialization. However, multinational enterprises headquartered in each economy have the same influence since they have many franchises across Asia.

seen since the crisis, the subsidiaries and affiliates of multinational enterprises had already established strong franchises in the Asian economies, and they are playing an important role there. In Malaysia and Thailand, for example, the combined sales of some Japanese enterprise groups reach single-digit percentages of GDP. Moreover, most foreign-related enterprises operating in the Asian economies are export-oriented. According to a survey by Japan's METI (Ministry of Economy, Trade and Industry), exports accounted for an average of 51.2 percent of the aggregate sales of Japan-affiliated companies in Asia for the fiscal year ended March 2001 (Figure 3.3). The percentage of exports is much higher for the ASEAN-4, but the numbers are on a downward trend as a whole. Moreover, according to official statistics for China, more than 50 percent of China's exports are made by foreign-owned or foreign-affiliated firms (Figure 3.4).

The important role of foreign enterprises in the Asian economies has two implications. The first is the pressure from exporting enterprises on forex rates. Assuming that multinational enterprises keep their global books in a currency other than the local Asian currency, they would not gain much from a depreciation of the local currency since that would only reduce their local-currency costs, such as salaries of personnel. At the same time, depreciation could impose forex losses on their assets. Hence, as a whole, the business community in the Asian economies do not welcome “beggar-thy-neighbor” currency depreciation but just stable exchange rates.

The second implication is the possible conflict of interest between nation-states and the multinational enterprises. Susan Strange (1996) has pointed this out with reference to the advanced economies. Conflicts within one nation-state have already been observed among the advanced economies with respect to exports from Asia, resulting in confrontation between the locally operating manufacturers and others. For example, the Japanese government mooted the idea of introducing safeguards against towel imports from China in 2001 to protect Japanese manufacturers. However, it did not implement the safeguards as some Japanese towel makers which had already shifted their facilities to China, strongly opposed this, with support from the Chinese government. Though at first glance this seems to be an intergovernmental dispute between Japan and China, the bottom-line is that it is a domestic Japanese matter. Given the greater presence of multinational enterprises in Asia, it is understandable that such kinds of conflict are becoming more common.

The Race to Attract FDI

To achieve FDI-led industrialization, the Asian governments were generous in giving incentives to foreign enterprises.8 Though their current accounts have moved into surplus after the crisis and their need for financing has fallen, the Asian economies are still

8 The government's stance varies from industry to industry. Generally, the Asian governments have been generous to export-oriented manufacturing industries while liberalization in the service industries has lagged behind.

eager to attract FDI because of its non-financial benefits, such as technology transfer and sophisticated job opportunities.

Currently, the ASEAN economies lag behind China in attracting FDI (Figure 3.5). Hence, they are now pursuing policy measures to improve the business environment for multinational enterprises, as seen in the formation of the ASEAN Free Trade Area (AFTA). In this context, the Asian governments are also motivated to keep their nominal currency rates against the U.S. dollar stable in order to attract FDI for export-oriented industries.

The De-internationalization of Local Currencies

In terms of monetary policy, the current situation in Asia is interesting in that the problem of the “two-corner solution” does not seem to exist. The Asian monetary authorities are achieving three targets—stable forex rates, free capital movements, and independent monetary policy—simultaneously, while in theory, only two of the three can be satisfied at the same time. Moreover, given their current low rates of inflation, they can maintain the nominal stability of exchange rates to the U.S. dollar and accept the lower interest rate in the United States as the global interest rate.

Two factors are important in this situation. First is the current account surplus of the Asian economies, which enables Asian monetary authorities to accumulate huge foreign exchange reserves. Second is the “de-internationalization” of the local currencies. Except for China and Malaysia, the Asian economies have maintained freedom of their capital accounts, but the currency regime has changed as a result of de- internationalization.9 The crisis-hit economies in ASEAN (Thailand, Malaysia, and Indonesia) have “de- internationalized” their currencies to exclude non-residents from holding large sums of local currencies in cash while maintaining the freedom of capital movements (for Thailand, Malaysia, and China, see Table 3.4). South Korea also has strict regulations on won holdings by non-residents.

In terms of recent market movements, this de-internationalization policy seems to be effective in stabilizing the monetary situation. Restrictions on local currency cash holdings by non-residents minimize speculative forex trades and enhance the efficiency of domestic monetary policy. According to the Asian Development Bank Institute (ADBI, 2003), considering the highly open nature of the Asian economies, such regulations should be on the list of policy recommendations.

Although the current nominal stability of the Asian currencies against the U.S. dollar owes much to de-internationalization, at the same time this has the side effect of intensifying exporting enterprises' reliance on foreign currencies. Since trade settlement in local currencies is prohibited, exporters must use hard foreign currencies, and the U.S. dollar is dominant in this area. This eventually motivates export enterprises to seek stable nominal forex rates against the dollar. Strict regulation also impedes efficient cash management practices adopted by multinational enterprises.10 Furthermore, de-internationalization squeezes the liquidity of the futures and options markets in that currency. This means that exporters and investors cannot access hedging tools, and this further strengthens the use of the U.S. dollar as the key currency for nominal stability.

Relating to this point, the Chinese government is taking a different stance while it is also under pressure to let the renminbi appreciate. As shown in Table 3.4, the Chinese authorities are not adopting the de-internationalizing approach and they recently liberalized to a limited extent renminbi operations in Hong Kong. This is due to another policy target, that of opening the domestic financial market to foreign institutions in conjunction with its entry to the World Trade Organization (WTO). It may also be possible that the Chinese authorities want to make the renminbi an international currency in the long term. China is not a small economy, since it was around US$1,287 billion in 2002. In comparison, Malaysia's economy is only worth US$95 billion, Thailand's, only US$126 billion, and Indonesia's, only US$174 billion. Considering the extent of China's influence because of its economic size and rapid pace of growth, de-internationalization of the renminbi cannot be the best option for China.

9 Malaysia introduced capital controls in September 1998, and then lifted them in May 2001.

10 To ease this problem, Malaysia allowed a Japanese business group to set up an in-house non-bank financial institution.


What are the factors that might upset the “Institutional Dollarization” regime in Asia? Figure 3.6 gives an overview. In contrast to the pre-crisis situation, both the current account surpluses of the Asian economies and their stable capital account flows impose pressure for the appreciation of Asian currencies in the forex market, while the U. S. trade deficits with the Asian economies tend to be political issues in the United States, where the public is sensitive to the threat to domestic employment.

To neutralize such pressures for appreciation, the Asian monetary authorities use two types of tools. The first is the policy toward “de-internationalization,” as already discussed, and the other is through dollar-buying and own currency selling interventions. Such interventions seem limitless but, as Japan learned from the Smithsonian Agreement in 1971, they are also subject to constraints from the expansion of domestic liquidity and the effectiveness of controls on fund inflows.

The Problem of the U.S. Current Account Deficit

The United States is the biggest export destination for most of the Asian economies, and its current account deficit has expanded recently and reached the historically high level of about 5 percent of GDP. Moreover, a breakdown of the main components of the current account shows that China is now the main source of the U.S. trade deficit (Figure 3.7). Other Asian economies are also enjoying trade surpluses with the United States, with the trade surpluses of South Korea and Taiwan each amounting to 0.1 to 0.2 percent of its GDP, while the total surplus of the ASEAN economies amounts to 0.3 percent. China has also expanded its share of U.S. imports, which now exceed those of Japan, while other Asian economies are keeping their shares constant (Figure 3.8).

The size of the U.S. current account deficit raises concern about its sustainability. Hence, the Asian currencies are exposed to the risk of global forex rate adjustments, just as with the Smithsonian Agreement and the Plaza Accord. However, the current situation is different. The Smithsonian Agreement involved an appreciation of major currencies

against the U.S. dollar and keeping a fixed-rate regime. At the time of the Plaza Accord, all the major currencies were floating. From the viewpoint of the effectiveness of adjusting U.S. trade imbalances, the current situation is a mixture of a Smithsonian-style fixed rate regime and a Plaza-type floating regime. Among the United States' major trading partners, the Group of 7, or G-7, economies are on a floating system while China is following a fixed-rate system with respect to the U.S. dollar. Other Asian currencies are also quasi-pegged to the dollar.

China is the biggest contributor to the United States' current account deficit, with a surplus amounting to 1.1 percent of the latter's GDP. The European Union (EU) is second with 0.8 percent, while Japan is third with 0.6 percent. As long as the renminbi is pegged to the U.S. dollar, adjustments through price effects cannot work for China, which accounts for one-fifth of the United States' current account deficit. At the time of the Plaza Accord, Japan accounted for one-third of the trade deficit and the yen experienced the biggest appreciation against the U.S. dollar. For now, the renminbi is expected to appreciate only to the extent that the Chinese government allows it.

Since the G-7 currencies and other Asian currencies except the renminbi are floated, they can appreciate against the U.S. dollar through coordinated interventions. However, because the renminbi is pegged to the U.S. dollar, the depreciation of the latter means that Chinese exports become more price competitive in other economies. Considering

that some Asian and G-7 economies are also suffering from trade deficits with China, they cannot support a depreciation of the U.S. dollar as long as the renminbi is pegged to it.

Thus, floating the Chinese renminbi is necessary to ensure that global forex rate adjustments are effective in fixing the United States' current account deficit through the price effect. Statements by the U.S. Treasury and other officials calling for greater flexibility of the renminbi seem to be based on such recognition, and these statements nurture the expectation of a renminbi appreciation. The currencies of other Asian economies that have trade surpluses with the United States and are under a quasi-pegging regime also share the same pressure.

The Conflict with Domestic Monetary Policies

The stance of the U.S. government, combined with expectations in the financial markets, is putting pressure on Asian currencies to appreciate. However, under the “Institutional Dollarization” regime, the Asian monetary authorities cannot let their currencies appreciate in the foreign exchange markets. Since nominal stability is the agreed rule under this regime, exporting enterprises and economic policy authorities will request the monetary authorities to stop such an appreciation and maintain stability against the U.S. dollar.

To achieve stability these economies have two policy options. The first is to deinternationalize their currencies, discussed earlier. Such regulatory measures would be effective only in curbing speculative transactions but they cannot stop the inflow of funds from current account transactions, since most of the Asian economies are now subject to Article 8 of the International Monetary Fund (IMF) accord. In addition, inward investments, both securities and direct investments, constitute a large part of their capital inflow.

Hence, to absorb currency appreciation pressures from incoming funds, they can use a second tool—intervention involving the selling their own currency and buying the U.S. dollar in the forex market. Reflecting the strong inflow of funds, most of the Asian monetary authorities have increased their reserves of foreign exchange, and the ratio of foreign exchange to total assets has increased drastically since 2000 (Figure 3.9). Although this increase tends to be cited as evidence of the amazing recovery of the Asian economies, the expansion of forex reserves also brings some risks from the point of view of domestic monetary policies.

First, there is the balance sheet risk for the Asian monetary authorities. Apart from Hong Kong and Singapore, the monetary authorities in most of the Asian economies adopt a controlled currency system and their debts are predominately in their own currencies. Hence, if their currencies appreciate against the U.S. dollar, they will experience losses in the value of their forex reserves. For example, at the time of the Smithsonian Agreement in 1971, the Bank of Japan had a loss of 450.8 billion yen in its foreign currency assets. Recently, some Asian monetary authorities have started to use accumulated forex reserves for other purposes, but this is just a means to transfer their forex rate risks

to other institutions.11 Given that the central bank is the ultimate supplier of liquidity, such losses would not be a big impediment to day-to-day monetary operations, as in the case of Japan. Ironically, it could even be welcomed since that would ease the pressure for currency appreciation. Generally speaking, however, losses on forex reserves tend to ignite political disputes, which expose the monetary authorities to criticism from the public. Hence, it can be concluded that higher levels of forex reserves would reduce the flexibility of the monetary authority's forex rate policies because of concern about losses.

The second problem is the conflict with domestic policy. Interventions involving own-currency-selling and dollar-buying should have some easing effects on the domestic monetary situation when such interventions are not sterilized or financed by base money,

11 In January 2004, the Chinese government announced that it used US$45 billion (about 10 percent of its forex reserves) for capital injections into two of the four big state-owned banks. It was reported that these two banks issued preferred stocks in exchange for the U.S. dollar assets. Hence, the officials transferred the forex risk on to these two banks or the holding companies that have the preferred stock. Singapore transferred most of its forex reserves to the Government Investment Corporation (GIC).

which usually carries no interest. Such interventions are compatible with domestic monetary policies when inflationary pressures in both the real economy and the asset market are weak.

Currently in Asia, inflationary pressures in the real economy are generally still calm while the property markets in China and some ASEAN countries show signs of overheating. Chinese monetary policy has already shifted toward tightening, and other Asian monetary authorities are expected to follow. In order to be consistent with this monetary policy, they should sterilize the proceeds of foreign exchange intervention. Japan is somehow an exception since it is free from such conflicts under the current zero-interest-rate regime, and the Japanese authorities can continue their de-sterilizing policy.

When some Asian monetary authorities sterilize funds for forex reserves to minimize the monetary easing effects, they issue notes or collect longer term deposits from banking institutions and pay interest to them. In China and South Korea, however, domestic interest rates are higher than interest rates on U.S. dollar assets. This means that intervention imposes a cost on the monetary authorities and their capacity to absorb these losses would limit the amount of funds available for intervention (Figure 3.10).

The foregoing analysis implies that, although central banks have the ability to create domestic liquidity and sell it in the forex market, they cannot do so without limit. For interventions involving the selling of the domestic currency and buying foreign currency, consistency with domestic monetary policy becomes the issue. There is no apparent limit

to creating domestic liquidity. The Japanese experience with the Smithsonian Agreement seems to suggest that this would work to delay adjustments in the currency regime and result in a shock when such adjustment eventually occurs.

The Extreme Openness of the Asian Economies

It is well known that the Asian economies are small and open. Although the Chinese economy is relatively large, it has a similar degree of openness. As Figure 3.11 shows, currency depreciations after the crisis pushed the weight of exports in GDP even higher for most of the Asian economies. For example, from 1996 to 2002 the weight of exports in GDP expanded from 40.4 percent to 46.1 percent on average for the Asian newly industrializing economies (NIEs) and from 44.8 percent to 61.2 percent for the ASEAN-4.12 Though China was not affected by the crisis, its exports increased from 20.9 percent to 28.1 percent of its GDP as a consequence of its amazing economic growth, led by exports.

12 A weighted average based on 1999 nominal GDP.

The high degree of openness of the Asian economies implies that exporting businesses are quite common and access to foreign currencies is easy for most economic entities. These conditions would limit the effectiveness of any regulations adopted by the monetary authorities to curb capital flows. In addition, the inflow of FDI could be an issue. Two cases will be examined here: Malaysia and China.

Malaysia's balance of payments data for 1997 to 1999 are shown in Figure 3.12. Although Malaysia is a nation-state with more than twenty million people, it is quite open, and the amount of exports is almost equivalent to that of GDP. Before the crisis, Malaysia's currency, the ringgit, circulated in Singapore and many non-residents had ringgit notes and bank accounts there. As a result, it was difficult for the central bank, Bank Negara, to control ringgit capital flows. As seen in Figure 3.12, after the crisis Malaysia had a large deficit, not only in short-term capital, but also in errors and omissions, while it ran a surplus on the current account from the first quarter of 1998. That was why Malaysia introduced strong measures in September 1998. The purpose of these capital controls was to stop the ringgit outflow by de-internationalizing the currency. To achieve

this, Malaysia banned all offshore ringgit holdings in any form, whether in bank accounts or notes. This measure was quite effective, and Malaysia recorded a huge balance of payments surplus in the third quarter of 1998, but this was accompanied by some tradeoff. The strong measures eroded investors' confidence, and Malaysia is still suffering from a smaller capital inflow compared with other Asian economies.

The second example relates to China's balance of payments situation, which is displayed in Figure 3.13. Until recently, the errors and omissions item in China's balance of payments was consistently negative because Chinese residents sent funds abroad, but this item has moved into surplus as funds returned to China because of the expectation of a renminbi appreciation. Furthermore, FDI has been the biggest surplus item in China's balance of payments. Given the current economic situation in China, it is impossible to limit FDI inflows. The income gap between the coastal areas and inland is wide, but the government cannot increase expenditures because its fiscal position is becoming weaker. Hence, as a way of narrowing the gap, the government is launching a “Western Development Plan” to try to introduce FDI to inland areas. The coastal areas also need FDI to support their continued development. This suggests that the renminbi

will continue to be under pressure to appreciate as long as China's economy continues to grow at a fast rate.


To summarize, it can be said that there are both advantages and risks to dollarization and that the risks are institutional and structural. The advantages of dollarization are mainly apparent to exporters and investors who seek stable terms of trade and investment. Under pressure from exporters and investors, as well as from economic policy authorities, Asian monetary authorities try to maintain the nominal stability of their currency against the U.S. dollar by using various policy tools, ranging from de-internationalization of their currencies to intervention in the forex markets. Reflecting the present current account surpluses and stable capital flows, their efforts are now directed to stopping appreciation.

However, the side effects of such operations and policies, or the disadvantages of “Institutional Dollarization,” are seen in the current monetary situation. The monetary easing effects that accompany foreign currency (dollar) buying operations conflict with domestic monetary policies, while the over-accumulation of forex reserves poses a potential risk to the soundness of the central banks. In addition, measures by the Asian monetary authorities to de- internationalize their currencies would strengthen the dependence of exporters and investors on the U.S. dollar. The highly open nature of the Asian economies makes it difficult to control expectations of currency appreciation (or depreciation) and to curb the speculative inflow (or outflow) of money. Not only short-term capital but also current transactions could be affected.

Moreover, since the dollar is the currency of the United States, the present structural weakness of the American economy, such as the large current account deficit, also threatens the stability of nominal exchange rates of the Asian currencies against the greenback. Sometimes this could result in sharp adjustments of forex rates, which could impose big shocks on the Asian economies.

Overall, the analysis suggests the difficulty, or impossibility, for the Asian economies to keep their currencies nominally stable against the U.S. dollar.

How can the pressure for “Institutional Dollarization” be eased? It is easy to recommend a flexible forex rate policy or a gradual loosening of the “pegs” of the Asian currencies to the U.S. dollar. This would benefit Asia since it could reduce the risk to their economic policy operations, and the United States, which has a trade deficit with the Asian economies, should welcome it. Moreover, assuming the price effect on exports from the Asian economies is small, a gradual currency appreciation would not do much harm to the real economy.

In order to achieve such flexibility, however, there is the difficult task of easing the pressures of “Institutional Dollarization.” McKinnon and Schnabl (2003) assert that the “original sin” of the emerging economy is the lack of long-term capital markets, but the degree of openness of the Asian economies is the main source of “Institutional Dollarization” pressure. Furthermore, it is well known that Asia achieved economic development through

export-oriented industrialization by attracting FDI for more than twenty years. Hence, various kinds of initiatives or structural adjustments are required to ease such pressure.

On the financial system side, ongoing measures to improve domestic financial systems, such as the Asian Bond Market Initiative, would ease the transition of Asian financial systems out of dollarization. A long-term bond market is a necessary condition for developing a futures and options market for Asian currencies. Such a market would offer good hedging tools for traders and investors although it would increase exchange rate volatility to some extent.

On this point, the relationship between the internationalization of a currency and the development of forex futures is a kind of “chicken and egg” problem. Market liquidity is another necessary condition for developing a forex futures and options market, but de-internationalization of a currency dries up liquidity while helping to keep nominal stability against the U.S. dollar. At the same time, a developed capital market can reduce the reliance on foreign currency funding. The recent turnaround to positive current account balances means that the Asian economies are generally in a situation of over-saving, which should also prompt more efficient domestic financial resource allocation through the bond market.

From the trading side, reducing the dependence on the U.S. dollar is necessary and the first step would be to increase the use of other hard currencies, such as the yen or the euro, for trade settlement. One option for promoting this shift is to change the exchange rate anchor from the U.S. dollar alone to a basket composed of several hard currencies including the yen and the euro. Assuming that the Asian economies' share of trade within the region is increasing, as suggested earlier, targeting to a currency basket composed of the Asian currencies could be a desirable option. But de-internationalization of the currency again becomes an obstacle.

There are many other possible policy initiatives that the rule enforcers for the currency regime, the monetary authorities, could introduce. On this point, the analysis suggests that such measures should be designed to offer the benefits of “de-dollarization” to economic players (exporting enterprises, investors) and to economic policy authorities. Otherwise, these actors would try to find loopholes and continue to prefer a dollarized situation. The extreme openness of the Asian economies allows these actors to take such action.

It is also important to change the attitudes and expectations of economic players other than the monetary authorities. In the case of Japan, although more than thirty years have passed since the Smithsonian Agreement, public opinion is still nervous about a yen appreciation. This attitude justifies the dangerously out-of-line accumulation of forex reserves, which now exceed 79 trillion yen, and the budget limit will be expanded to 140 trillion yen. Although the risks of “Institutional Dollarization” are now becoming apparent on the monetary policy side in Asia, the sense of caution does not seem to be shared equally by all economic players.


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The Institutional Dollarization of Asian Currencies

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