Exchange Rate Regimes of ASEAN Countries 9789814377584

Table of contents :
CONTENTS
PREFACE
INTRODUCTION
I: OFFICIAL AND ACTUAL EXCHANGE RATE REGIMES OF ASEAN
II: DEGREE OF EXCHANGE RATE FLEXIBILITY
III: SINGLE VERSUS BASKET PEGGING
IV: CHOICE OF WEIGHTS
V: ADJUSTMENT OF EXCHANGE RATES UNDER FUNDAMENTAL DISEQUILIBRIUM
VI: ASEAN COUNTRIES: A CASE STUDY
VII: CONCLUDING REMARKS
BIBLIOGRAPHY

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I5EA5 The Institute of Southeast Asian Studies

The Institute of Southeast Asian Studies was established as an autonomous organization in May 1968. It is a regional research centre for scholars and other specialists concerned with modern Southeast Asia. The Institute's research interest is focused on the many-faceted problems of development and modernization, and political and social change in Southeast Asia. The Institute is governed by a twenty-four member Board of Trustees on which are represented the National University of Singapore, appointees from the government, as well as representatives from a broad range of professional and civic organizations and groups. A ten-man Executive Committee oversees day-to-day operations; it is chaired by the Director, the Institute's chief academic and administrative officer.

The responsibility for facts and opinions expressed in this publication rests exclusively with the author and his interpretations do not necessarily reflect the views or the policy of the Institute or its supporters.

"Copyright subsists in this publication under the United Kingdom Copyright Act, 1911, and the Singapore Copyright Act (Cap. 187). No person shall reproduce a copy of this publication, or extracts therefrom, without the written permission of the Institute of Southeast Asian Studies, Singapore."

EXCHANGE RATE REGIMES OF ASEAN COUNTRIES A Critical Evaluation

by

Aleth Yenko

Research Notes and Discussions Paper No. 30 Institute of Southeast Asian Studies

1982

CONTENTS Page

PREFACE

Ill

INTRODUCTION

1:

1

OFFICIAL AND ACTUAL EXCHANGE RATE REGIMES OF ASEAN

4

II:

DEGREE OF EXCHANGE RATE FLEXIBILITY

7

III:

SINGLE VERSUS BASKET PEGGING

15

IV:

CHOICE OF WEIGHTS

17

V:

ADJUSTMENT OF EXCHANGE RATES UNDER FUNDAMENTAL DISEQUILIBRIUM

22

VI:

ASEAN COUNTRIES:

23

VII:

CONCLUDING REMARKS

BIBLIOGRAPHY

A CASE STUDY

35 36

PREFACE

The mm of this paper is to present a theoretical framework, based on existing literature, which could serve as a guide for developing countries in choosing an appropriate exchange rate regime in the present system of generalized floating. The exchange rate regimes of the ASEAN countries are then evaluated in terms of the framework. I am grateful to Pradumna Rana for his invaluable comments and suggestions on earlier drafts of this paper. I am also greatly indebted to Heinz Arndt who contributed much to its improvement. Discussions with Njoman Suwidjana have also been particularly useful. Nonetheless, the author is solely responsible for the contents and opinions expressed in this paper.

January 1982

Aleth U. Y enko

EXCHANGE RATE REGIMES OF ASEAN COUNTRIES: A CRITICAL EVALUATION

INTRODUCTION

The collapse of the Bretton Woods system and the adoption of floating exchange rates by major industrial countries in March 1973 have posed two sets of policy problems for developing countries. The first concerns the appropriate exchange rate policies to adopt under the generalized floating system. The second is the stand that less developed countries (LDCs) should take in international monetary negotiations, based on the impact of the new system on their economies. The impact of generalized floating on a broad set of LDCs has been examined by Cline (1976), De Grauwe (1977), and Rana (1979 and 1982), among others. The present paper is a complement to these studies in that it looks at the other set of policy issues, that is, the question of exchange rate policies, taking the Association of Southeast Asian Nations (ASEAN) as the case study. Since the advent of generalized floating, both industrial and developing countries have experienced volatile nominal 1 exchange rates. Exchange rates of the major industrial countries are, in the short run, primarily determined in the asset markets, and even in a relatively stable world asset market prices tend to fluctuate sharply because of expectations. This exchange rate volatility in the industrial world has been transmitted to the LDCs. The latter's practice of pegging their currencies to a major currency now implies floating vis-a-vis currencies of other currency blocs. Therefore, continuous realignment among the currencies of trading partners has caused unwarranted movements in the home country's effective exchange rate (defined as the weighted average of bilateral exchange rates).

1

In this paper, exchange rates refer to nominal rates (unless otherwise stated} and not real rates.

2

Aside from exchange rate shocks, small open LDCs are also faced with other external disturbances such as commodity price shocks, partner country inflation, etc. These random shocks possibly involve economic costs for the developing countries, such as anti-trade bias, instability in the terms of trade, and increased reserve needs. 2 Being now at liberty to choose from a spectrum of exchange rate regimes (formalized by the Second Amendment to the International Monetary Fund's Articles of Agreement in 1976), LDCs are faced with the new problem of choosing an optimal exchange rate regime -- the exchange rate policy which would minimize undesired effects of random external shocks on the domestic economy. The objective of this paper is to survey recent available theoretical and empirical literature along this topic, for example, Branson and Katseli-Papaefstratiou (1978), Lipschitz and Sundararajan (1978), Black (1976), Heller (1978), and Holden, Holden and Suss (1979). Based on such a survey, the paper evaluates existing exchange rate regimes of the ASEAN countries. The literature on optimal foreign exchange rate regimes addresses three sequential problems. The first is the identification of the criteria that should be used to determine the appropriate degree of exchange rate flexibility -from rigid pegging to free floating. The recent literature on this topic (derived mainly from the optimum currency area theory) emphasizes the role of the structural characteristics of an economy. The other two problems relate to the appropriate pegging policy, namely: (a)

the standard against which the currency should be pegged whether a single currency or a basket of currencies; and

(b)

in the case of basket pegging, the weighting scheme to be used

The analysis focuses on stabilization objectives rather than growth objectives.

2

See for example, V. Joshi (1979) and P. Rana (1982).

3

Section I of this paper outlines the responses of the ASEAN countries to major developments in the international monetary system. A distinction is made between officially announced and actual exchange rate regimes because they are usually inconsistent. In the subsequent four sections, the theoretical framework based on existing literature is presented in order to evaluate the exchange rate policies of the ASEAN countries. Section II considers the various structural factors that should influence the choice of the degree of exchange rate flexibility. It suggests that most LDCs (including the ASEAN countries) generally possess the structural characteristics favouring less flexible exchange rates. The succeeding theoretical sections, therefore, focus on questions relating to the choice of the peg. The choice of the appropriate standard -- single currency or basket of currencies -- against which the value of the currency should be fixed is raised in Section III. In Section IV, various weighting schemes for countries which opt for basket pegging are discussed. Section V touches briefly on exchange rate adjustments when shocks are non-random. Section VI gives an evaluation of the existing exchange rate regimes of the ASEAN countries based on the framework presented in the preceeding sections. Finally, Section VII concludes with some remarks.

4

I:

OFFICIAL AND ACTUAL EXCHANGE RATE REGIMES OF ASEAN 3

The official International Monetary Fund (IMF) classification of exchange rate regimes is based on the reported policy of individual countries, but the actual regime being followed is often different. This is because some currencies that are officially floating are often managed in order to stabilize the rate, and conversely, some currencies that are officially pegged are frequently adjusted. Hence, in evaluating exchange rate policies, inconsistencies in official and actual regimes should be taken into account.

Official Exchange Rate Regimes During the Bretton Woods period of fixed but adjustable exchange rates, four of the five ASEAN countries, with the exception of the Philippines, pegged their currencies to a major currency within the prescribed margin of 1%. Indonesia and Thailand pegged their currencies to the U.S. dollar, while Malaysia and Singapore pegged to the pound sterling. Only the Philippines allowed its currency to float during this era of the par value system. The Philippine peso was first floated in November 1965, but was pegged to the U.S. dollar in 1967. Because of severe balance of payments problems, however, the peso was allowed to float again from February 1970 until the present. By August 1971, the par value system showed signs of breaking down when some major currencies were allowed to float. The system was reinstated, however, after the Smithsonian Agreement in December 1971, only to collapse shortly thereafter. During this unsettled period in the international monetary system, the only countries in ASEAN which changed their exchange rate regimes were Malaysia and Singapore. Both decided not to follow the floating of the pound sterling in June 1972, and instead adopted gold pegging, with the U.S. dollar as intervention currency. Attempts to revive the par value system failed and finally in March 1973 maJor currencies started to float again. This time, the floating system seemed likely to be permanent. In response to this, other countries began to seek

3

Based on P. Rana (1982).

5

suitable exchange rate policies. Of the five ASEAN countries, four (excluding the Philippines) have changed their regimes during the present system of generalized floating. Malaysia and Singapore floated their currencies from June 1973, and in September 1975 pegged them to an undisclosed basket of currencies within certain margins. Indonesia 4 and Thailand followed suit in November 1978. The Philippines has expressed its desire to peg the peso to a basket, but this proposal has not been pursued so far.

Actual Exchange Rate Regimes To determine the actual exchange rate regimes adopted by the ASEAN countries, Rana uses the following rule. The regime is classified as managed floating if fluctuations of greater than a margin of 2.25% in the monthly dollar rates are observed with some frequency. Otherwise, the regime is classified as U.S. dollar pegging. Pegging to a basket presents a problem of classification because it is difficult to detect whether exchange rate fluctuations are due to weight adjustments or to changes in the values of currencies composing the basket. Therefore, the rule above is also used to determine the actual exchange regimes of basket peggers. The results of this exercise togethe_r with the official exchange rate policies are shown in Figure 1. Several differences between official and actual regimes can be noted:

4

(1)

Indonesia and Thailand have continued to peg their currencies to the U.S. dollar even after the declared change of policy in November 1978;

(2)

The Philippines has discontinued floating and has agam pegged its currency to the U.S. dollar since July 1975; and

(3)

Malaysia and Singapore have continued their policy of managed floating which was adopted in June 1973 in spite of their official change in policy.

The IMF classifies the current exchange rate regime of Indonesia as managed floating because the basket is only one of the determinants of the middle rate. However, the other basket-pegging countries of ASEAN also use the basket as only one of the determinants, but are classified by the IMF as basket-peggers.

Figure 1:

Officially Announced and Actual Exchange Rate Regimes of the ASEAN Countries

Generalized floating period

Unsettled period

Bretton Woods period

~

pegged to US$

b:;:;:;:}};J I I

pegged to £

-

pegged to gold pegged to basket within margins floating

Actual

~:==~ ~·.j·:2·::j·.j·:·.j·.j·.j·.j·,;·::::;2:.;:.;:.;.·.;.-.;. .;...;. .;.(.:j.·.;.·;.·;. ;. ;.··;··.;:;.·~·;r·;.. ;.';.';.';.';.';.';.';.';.';.'!;.';.';.';.';.';.';.'il).'ijiii)'\~

I

I I I

=

p Official Actual

Official Actual

Official Actual

11&7

Source:

68

&9

70

71

72

73

74

75

76

77

78

79

80

P. Rana (1981). C)

7

Having outlined the exchange rate regimes m the ASEAN countries, the next four sections will present a theoretical framework against which the exchange rate policies of the ASEAN countries can be evaluated.

II:

DEGREE OF EXCHANGE RATE FLEXIBILITY

The Second Amendment to the Articles of Agreement of the IMF has provided countries the liberty to choose from a spectrum of exchange rate regimes -from free floating to rigid pegging. Thus, it becomes necessary, as a first step, to identify the criteria which should influence the choice of the appropriate degree of exchange rate flexibility. The two extremes of the spectrum can be ruled out from the range of practical policies. At one end of the spectrum is a completely free floating system which even the most liberal economies consider undesirable. Most central banks find it beneficial to intervene in the exchange market to smooth out erratic swings in rates or to avoid "disorderly" market conditions. At the other extreme is a rigid pegging system which is impossible to maintain in a world of floating exchange rates and in the face of a fundamental disequilibrium in the external market. All practical policies lie somewhere in between. The problem of choice of regime then becomes a question of the appropriate degree of exchange rate flexibility. The suitability of a certain degree of flexibility is largely influenced by the structural characteristics of the economy pertaining to its capital market and trade. These determinants are presently discussed.

Capital Market Integration A domestic financial market that is well integrated with international markets is characterized by the existence of adequate domestic securities and forward exchange markets, and the freedom of the exchange market from controls. Such characteristics ensure high capital mobility or substitutability between domestic and foreign assets.

8

According to the asset market view of exchange rate determination, " if a country has financial markets which are integrated into international markets, then in the short run its exchange rate is determined by equilibrium conditions in those markets. Short-run stability of the foreign exchange market in this case depends on overall stability of the financial markets; in general, gross substitutability of domestic and foreign assets in private portfolios will suffice for stability" (Branson and Katseli-Papaefstratiou, 1978). High capital mobility enables adjustments to be made through capital movements rather than changes in the exchange rate. For instance, a balance of trade deficit may be financed by capital movements over the short to medium term. Thus, countries with integrated asset markets can expect a floating rate to be stable, at least in the short run. With low capital mobility, as IS the case in most LDCs, shocks in the external market would largely be borne by exchange rate changes (if under a floating regime). Moreover, the weakness of stabilizing capital flows implies that exchange rate movements may be heavily influenced by the trade account. In the LDCs, however, the short-run response of the trade account to exchange rate changes is expected to be small because of low short-run price elasticities of trade and the high degree of openness of their economy.5 Hence, large exchange rate changes and long time periods are required to produce the desired trade account change. Under such economic conditions, therefore, exchange rates may be unstable if allowed to respond to random shocks in the external sector. This calls for a less flexible exchange rate. It is also believed that in economies with integrated financial markets, a flexible exchange rate regime makes domestic monetary policy more effective as it provides a certain degree of monetary independence to the country. In contrast, under a fixed rate system, high capital mobility may frustrate the aims of monetary policy.

5

See pp. 9-11, Other Criteria for Exchange Rate Flexibility.

9

Other Criteria for Exchange Rate Flexibility As discussed above, with well-developed and integrated capital markets, adjustments may be made through capital movements rather than exchange rate changes in the short to medium run. With lower capital mobility and also m the longer run, the trade account plays a greater role in exchange rate determination. Hence, the characteristics of the economy pertaining to its trade should play a significant part in the choice of the suitable degree of exchange rate flexibility.

( 1) Openness In open 6 economies, such as that of most LDCs, the effect of exchange rate changes on the domestic price level tends to be exacerbated. 7 The impact on the price level is greater than in relatively closed economies with fewer traded goods. Moreover, if prices are rigid downwards, exchange rate changes may cause a spiralling of prices. Therefore, the need to avoid the influence of temporary exchange rate fluctuations on price level is an argument against exchange rate flexibility. The degree of openness can also affect the cost of exchange rate adjustments. Changing the exchange rate to adjust to random external disturbances may be more costly for an open economy than it would be for a relatively closed one. Firstly, in an open economy, the sector that would be affected by the change is larger. Secondly, Tower and Willett (1978) have shown that as openness increases, ceteris paribus, the greater must be the exchange rate change to produce a desired trade balance change. Under floating, the usefulness of money is also decreased as openness mcreases. The more open the economy is, the more attractive it is for domestic citizens to hold contracts effectively denominated in foreign currency in order to avoid exchange rate risk, particularly when the domestic currency is relatively weaker.

The demand for home currency then becomes minimal.

6

"Open" means that traded-goods prices are internationally determined. The discussion does not refer to a completely open economy in which all prices are internationally determined.

7

This is, however, not so when the exchange rate change is due to foreign inflation. This is clarified in (4) .

10

(2} Price Elasticz"t£es of Trade Where price elasticities of trade are low, a flexible exchange rate would be less effective in producing the desired trade balance change. In the LDCs, the price elasticity of demand for imports is likely to be low because there is very limited substitutability between domestically produced goods and imported goods. Likewise, the price elasticity of supply of exports is also expected to be low in the short run since the major exports of LDCs are primary products whose production typically involves long gestation periods. Moreover, there is little potential for shifting the supply of these exports from the domestic market. Thus, as has been mentioned previously, large exchange rate changes and long time periods would be required to produce the desired trade balance change. Exchange rate movements may become volatile if the rate is allowed to respond to every trade account shock.

(3) Diversification of the External Sector For a given degree of openness, the greater the diversification of the external sector, the more insulated the economy will be from external shocks because the more disturbances (for example, sudden shifts in traded goods prices) are likely to be offsetting. Floating can therefore be relatively stable. For a country with an undiversified economy, like that of most LDCs, external disturbances can lead to disruptive exchange rate changes under a floating system. In this case, financing and a more rigid rate would be preferred.

(4) Source of Shocks It is frequently argued that in so far as flexible exchange rates insulate an economy against trade shocks of foreign origin (for example, price and terms of trade shocks), an economy highly susceptible to such shocks should allow its exchange rate to float. On the other hand, if the disturbances which most significantly affect the economy are of domestic origin (for example, natural calamities affecting production}, exchange rates should not be used as a corrective measure, and pegged rates should be maintained to permit the shocks to be filtered abroad and to minimize their effects on the domestic

economy.

11

However, from the arguments above, there is a case for some types of economies to keep their exchange rates fixed even when random external shocks occur. A high frequency in the occurrence of domestic shocks only serves to strengthen the case for pegging for these economies. The distinction between external and domestic shocks can clarify the argument regarding inflation differential as a determinant of exchange rate flexibility. It has been argued that countries which have inflation rates that are significantly different from those of their trading partners need to adjust their exchange rates more frequently. However, a distinction should be made with respect to the origin of the differential. If the inflation differential originates from shocks generated by changes in the general level of world prices, domestic stability can best be achieved by allowing the exchange rate to move. This would insulate domestic prices from fluctuations in foreign prices. Adjustments can be made without trade-offs, therefore making a strong case even for the LDCs to change their exchange rate. On the other hand, inflation differential resulting from domestic price changes can be worsened by changing the exchange rate. Adjustment of the rate may result in an explosive movement in prices. For example, domestic inflation could be further fuelled by an exchange rate depreciation which causes import prices to increase. Among the LDCs, high domestic inflation and volatile prices are common characteristics. Therefore, depreciating their exchange rates can cause spiralling of prices (vicious circle hypothesis).

Capital Markets m the LDCs: Implications on Exchange Regime The use of exchange controls is probably the most prevalent exchange policy in the LDCs. Resources are committed to the mechanism of external controls rather than to the development of market institutions. Thus, market for domestic securities is thin, illiquid or even non-existent; forward exchange market is absent. Under such a state of the capital market, a high degree of flexibility is not desirable. However, as a long-term alternative to adopting limited exchange rate flexibility, the LDCs may choose to develop their financial markets and allow more flexibility in their exchange rates.

12

The development of an adequate financial system required for efficient floating entails the abandonment of exchange controls, the establishment of spot and forward exchange markets and of domestic securities markets, the development of a network of brokers and dealers in securities and foreign exchange, and greater stability of domestic policies. Such changes would definitely involve substantial costs, but would have the benefit of making floating feasible, thus enabling the economy to reap the fruits of floating, such as reduced variance of traded goods prices (that is, assuming that with the development of the financial system, the exchange market would, in fact, be stable under a floating system), savings in reserves, and more efficient allocation of resources. Only after a consideration of such costs and benefits can decisions be made regarding the adoption of an appropriate foreign exchange regime. 8 The difficulties and costs of developing an adequate financial system in the LDCs may be great. Firstly, fewer traders and investors would want to hold the currency and securities of a country with a weak and uncertain economy such as that which characterizes the LDCs. Another reason for the low demand for domestic currency and securities is that small developing countries generally have a small trade and investment position. Thus, it may not be economical to develop a wide network of brokers and dealers that larger volumes in industrial centres can support. Hence, an extensive domestic securities market may fail to develop. Secondly, there exists the likelihood of destabilizing speculative capital movements if foreign exchange controls are lifted. Low substitutability between domestic and foreign assets and higher uncertainty in economic developments increase the possibility of destabilizing speculation. The development of a forward market alone (without the development of the entire financial system) would be an alternative. This would make an independent contribution to reducing fluctuations in traded goods prices, thereby decreasing the necessity of intervention. However, it is subject to several limitations. Firstly, the cost of forward cover for domestic currency assets would be relatively higher in the case of countries with a fragmented financial system because of the greater exchange rate instability resulting from low

8

See S.W. Black (1976) for a more detailed discussion of the costs and benefits.

13

capital mobility. Secondly, even in developed countries, forward cover can reduce only short-term variations in prices caused by exchange rate fluctuations, that is, variations occurring within the period of the contract of the forward cover. Price variation m the long run or between contracts would still prevail. A forward market alone may not ensure the stability of a floating rate system in the LDCs, but it would definitely reduce fluctuations in traded goods prices. Even under a less flexible exchange rate system, it would be beneficial to establish a forward market.

Empirical Evidence

Three available empirical studies on the determinants of exchange rate flexibility show that the behaviour of most countries conforms approximately to the above theoretical propositions. Using discriminant analysis to examine the factors affecting actual choices between floating and pegging, Heller ( 19 78) obtained results consistent with those advanced by the proponents of the optimum currency area theory. Floaters were found to have the following characteristics: relatively low degree of openness, high degree of international financial integration, geographically diversified trade, and high differential inflation rate. Peggers tended to be associated with the opposite characteristics. Holden, Holden and Suss (1979) used multiple regression to examme which variables were significant in explaining the variability of an index of exchange rate flexibility adjusted for the amount of intervention. The independent variables which turned out to be significant were diversification of trade (both geographic and commodity), inflation differential, and level of economic development. The last variable was used as a proxy to reflect the alleged low elasticity values of import demand and export supply in developing countries. All the variables had the expected positive signs. The third study by Dreyer (1978) was based on a probit analysis model. He found that the degree of openness and diversification of foreign trade (geographic and commodity) had a negative influence on exchange rate flexibility. The finding on trade diversification is contradictory to the results of other empirical studies. It is more in line with the argument that since a high degree of diversification insulates the economy from external disturbances, it reduces the necessity to adjust the exchange rate frequently.

14

Studies also indicate that developing countries, m general, have characteristics associated with peggers, while developed countries tend to have the characteristics of floaters. Hence, the LDCs are expected to peg and developed countries to float. This conclusion is supported by Heller's discriminant analysis and Branson and Katseli-Papaefstratiou's (1978) tabulation of the income of countries (proxy for level of development) classified according to the respective exchange rate regimes. In conclusion, the degree of flexibility, or frequency of exchange rate adjustment, depends on the structural characteristics of the economy and on its policy targets. There is a case for pegging the rate in the face of random shocks, particularly for those countries which typify LDCs. (However, there exists the problem of identifying which changes are random and temporary). On the other hand, regular assessment of the exchange rate is called for in order to make adjustments when necessary. Changes in the exchange rate are needed in the event of general inflation (temporary or. permanent) among trading partners in order to maintain constant real effective exchange rate. Adjustments are also sometimes beneficial if shocks are persistent and unidirectional. Under these conditions, the benefits of pegging may be offset by the costs. No hard and fast rule can be made here, and decisions can be made only by examining the costs and benefits involved in each particular case, the costs and benefits being dependent on the characteristics of the economy. Fundamental disequilibrium (or permanent change) calls for exchange rate .adjustment except when the cost of being in disequilibrium is less than the cost of adjustment, which is theoretically unlikely. The topic of adjustment is briefly discussed in the last section of the theoretical presentation. In the long run, an alternative to peggmg may be to develop the capital market and allow more flexibility in the exchange rate. This decision would depend on the costs and benefits of allowing the capital market to develop. However, for some economies, difficulties and costs involved may be considerable. This raises another possibility, which is to establish only a forward (or foreign exchange futures) market to help reduce the effects of exchange rate fluctuations on the economy. However, since a forward market alone does not ensure stability under the floating system, a less flexible exchange rate may be adopted in conjunction with the establishment of a forward market.

15

III:

SINGLE VERSUS BASKET PEGGING

Having concluded that the LDCs should, in general, have less flexible exchange rates, the question arises as to what their currencies should be pegged to. The two options are pegging to a single currency or to a basket of currencies. A major determinant in this choice is the diversification of trade. Diversification can be measured in terms of any of the following (or a combination of them): (1) transaction currency, (2) geographic distribution, or (3) currencies in which international prices are fixed. 9 The choice depends on the time horizon considered. Geographic distribution would be more relevant in the longer run when trade shares are sensitive to relative prices. The other two measures could be used in the short run. In addition to trade, diversification of service, transfer, and particularly capital transactions should also be considered. Countries whose external transactions, both trade and capital, are concentrated on one currency (or country) would benefit from pegging to this currency. The main benefit from such an arrangement is a reduction in uncertainty of the country's foreign exchange transactions. Available studies generally support this argument. Heller's study indicates that trade shares 1 0 were a significant determinant of two single-currency pegging arrangements (U.S.-dollar and French-franc pegging). Branson and KatseliPapaefstratiou find that country membership in currency blocs (U.S. dollar, pound sterling, French franc and European Snake) was influenced by the proportion of the country's exports to and imports from the bloc. Countries which have a sufficiently diversified trade can experience substantial instability if their currency is pegged to a single currency. This suggests that they should peg to a basket of currencies.

9

L. Lipschitz (1979).

10

Trade shares were derived from geographic distribution of trade.

16

A peg by country j to a basket of n currencies, f= j), can be defined as: rjk

=

n L:

= t=

w·I

= 1, . . . , n (where

rik

1

j

where rjk

=

units of arbitrarily chosen numeraue currency k per unit of domestic currency j;

rik

=

units of arbitrarily chosen numeraire currency k per unit of currency i;

wi

=

th { 0 < Wi _s_ 1 weight of i- currency such that l: Wi = 1

and

(In the special case where wi = 1, the basket reduces to a single currency); ( · )

proportional change.

Pegging to a basket of currenCies means then that the value of the domestic currency with respect to the numeraire is changed to match the movements in the weighted average of trading partners' currencies with respect to the numeraire, making the effective exchange rate constant. This can be done by the intervention in the market of any of the i currencies. The natural intervention currency is, of course, the numeraire currency. Having defined the concept of a basket peg, the next task is to choose an appropriate basket against which the value of a currency should be fixed.

17

IV:

CHOICE OF WEIGHTS

Policy Target: Basis for Choice of Weights The choice of an appropriate basket is a question of identifying the weighting scheme that would accomplish the objective of minimizing the effects of third-country exchange rate fluctuations on specific policy target variables m the economy. Two approaches to the derivation of a weighting scheme can be followed. The first approach is that of Branson and Katseli-Papaefstratiou where the objective is to stabilize (or peg) the nominal effective exchange rate. The weighting scheme is selected depending on whether the objective of the exchange rate policy is to insulate external terms of trade, domestic traded goods prices, or balance of trade from third-country exchange rate changes. The second approach is that of Lipschitz and Sundararajan who assume that traders and investors do not have exchange rate illusion and react to changes in only the real effective exchange rates. Their objective is " . . . to minimize variations of the real exchange rate around its equilibrium level over some reference period, and to ensure that the mean value of the real exchange rate remains close to its equilibrium level over the same period". The equilibrium is based on the purchasing power parity (PPP) condition. Branson and Katseli-Papaefstratiou start out with a model defining the supply and demand relations for both exports and imports of a country. Based on the comparative statics of the model, equilibrium price and quantity relations for exports and imports (in terms of, among other variables, measures of market power, 11 export and import shares, and exchange rates) are derived. The policy target, for example, terms of trade, traded goods prices, or balance of trade, is then defined in terms of the price and quantity relationships, and finally the weighting scheme that makes the policy target independent from third-country exchange rate changes is identified.

11

Market power is a function of demand and supply elasticities.

18

(1)

External Terms of Trade Weights

The weighting scheme that eliminates the effects of third-country exchange rate changes on the external terms of trade is a function of the export and import shares of the trading partners, and the market power of the home country on the export and import side. Some interesting properties of the external terms of trade weights are: (a) If a country has no market power on both the export and import side (such as in the case of a small open economy), or if it has symmetric market power, the choice of a weighting scheme will not affect external terms of trade. Hence, the question of optimal choice of weights to minimize variations in the terms of trade is relevant only for countries with asymmetric market power. (b)

To the extent that a country has market power on the export (or import) side, the effects on the terms of trade of exchange rate changes among the export (or import) partners are dampened. Hence, if the choice is between export and import weights, the rule for selection is as follows: if market power is greater on the export side, import weights should be chosen because they would eliminate disturbances from the import side where market power is small. If market power is greater on the import side, the opposite holds.

(2) Traded Goods Price Weights The weighting scheme which insulates traded goods prices from third- country exchange rate changes also depend on the export and import shares of the trading partners, the domestic market power, plus the proportion of ex portables and importables in the tradeable output of the home country. Obviously, the larger the proportion of exportables (or importables), the larger the effects of disturbances from the export (or import) side on traded goods prices. Conversely and as in (1) above, large market power on the export (or import) side dampens disturbances that originate from exports (or imports). Therefore the rule governing the choice between export and import weights mentioned above -that export (or import) weights should be used if market power is greater on the

19

import (or export) side -- still holds provided that the proportion of ex portables (or importables) is not large enough to offset the differential market power. In the case of a country without market power, the weights which stabilize traded goods prices reduce to trade-share weights. For example, assume that the Philippines pegs its currency (peso) to a trade-weighted currency basket, and it conducts half of its trade with the United States and the other half with Japan. If the Japanese yen depreciates against the U.S. dollar by 5%, the peso should be depreciated against the dollar by 2.5%. This implies that the peso would appreciate against the yen by 2.5%. Prices of traded goods would be stabilized since those with the United States would increase by 2.5% and those with Japan would decrease by 2.5%, leaving the average constant.

(3} Balance of Trade Weights The balance of trade weights are a function of market power, export and import values, and price elasticities of export supply and import demand in the home country. The balance of trade weights are analogous with the weights derived from the Multilateral Exchange Rate Model (MERM} of Artus and Rhomberg

(1974). The MERM index is a measure which fully reflects the sensitivity of the trade balance to exchange rate changes among all trading partners. It is more comprehensive than other indices since it takes into account the major determinants of the country's trade structure, namely: ( 1) price elasticities of different products, (2} the competitiveness of a country's exports in foreign markets, (3} the pattern of bilateral trade, and ( 4} the price effects generated by exchange rate changes. However, calculation of the MERM index requires data which are not available in the LDCs, and hence, simpler indices must also be considered. For developing countries, the closest available approximation to the MERM index is the import-weighted index. The reason for this is that the imports of the LDCs (such as industrial products) are generally non-homogeneous and therefore no uniform international price prevails. Accordingly, exchange rate changes of trading partners will affect import prices (except for those items such as crude oil and commodities under long-term contracts). On the

20

other hand, this argument does not hold for LDC exports which are generally homogeneous and whose prices are set in the international markets independently of the geographic pattern of trade. Hence, it is the import-weighted index which would reflect effects on domestic prices of exchange rate changes among trading partners.l2 Lipschitz and Sundararajan's approach uses quadratic programming techniques to minimize variations in the real effective exchange rate caused by transitory deviations from the PPP among trading partners. The objective function of the programming problem is the minimization of the variance of the real effective exchange rate index around its equilibrium level over a certain reference period, subject to the constraint that the mean value of the real effective exchange rate is kept near the equilibrium over the same period. The solution generated is a complicated set of weights drawn up in terms of variances and co-variances of prices and exchange rates of trading partners and the home country. Depending on the relative magnitude of the variances and co-variances, an elasticity-weighted basket can be optimal. Two remarks regarding the equilibrium are m order. Firstly, the equilibrium level of the real exchange rate is based on the PPP condition, that is, the equilibrium level for a particular country is the exchange rate at which it is possible for a certain amount of money in that country to buy the same bundle of commodities in othe1 countries, assuming that other countries' exchange rates are in equilibrium. Secondly, the equilibrium in this approach is simply a particular point, not a trend line. It should be noted, too, that the question of an appropriate price variable to use in computing the real exchange rate is not addressed by Lipschitz and Sundararajan. Using different price variables (that is, tradeable goods price, non-tradeable goods price, or a weighted average of both) would lead to varying effects on macro-economic variables such as trade balance. 13

12

A.D. Crockett and S.M. Nsouli (1977).

13

An examination of how different price indices compare when the objective is to maintain equilibrium in trade balance is discussed by Sundararajan (1976). It would be enlightening to study further how choice of different price indices would affect other objectives, particularly those considered by Branson and Katseli-Papaefstratiou.

21

Literature on the topic of optimal basket weights is still very limited. All the studies deal with only the trade account, without any consideration for the capital account. The weights derived are complicated and are very sensitive to the model and the methodology used.

Choice of Policy Targets Since the choice of the policy target is central to the determination of the currency-basket weight, a brief discussion of the criteria should be made, bearing in mind that trade-offs are sometimes inevitable in the pursuit of policy objectives. The choice of a specific policy target depends on what the most pressing problem of the economy is, and its structural characteristics. Regarding the latter, a few examples can be given. First, if a country has a small non-traded goods sector or if prices of these goods are relatively stable, then policy should focus on external terms of trade rather than traded/non-traded goods ratio. Second, if the price of non-traded goods is dependent on that of traded goods so that instability in the latter is transmitted to the former, the target should be the stabilization of the relative prices of traded goods (exports and imports) against non-traded goods. If the export and import markets are not similar, the target should be relative prices of exports or imports against non-traded goods, depending on the degree of openness of the economy on the export versus import side, and on the price elasticities of demand and supply. The market which is more open and elastic should be the policy target. 14 However, trade-offs are involved here. The decision to stabilize terms of trade would mean that there would be fluctuations in relative prices of traded versus non-traded goods, and vice versa.

14

W.H. Branson and L.T. Katseli-Papaefstratiou (1978).

22

V:

ADJUSTMENT OF EXCHANGE RATES UNDER FUNDAMENTAL DISEQUILIBRIUM

An argument has been made for a less flexible exchange rate regime for the LDCs. The exchange rate should not be allowed to move in response to all external shocks, particularly random external shocks (except when they are persistent and unidirectional). However, adjustments are necessary when there IS fundamental disequilibrium in the external sector of the economy. The value of the currency vis-a-vis a single currency or a basket of currencies can be adjusted by a "one-shot" devaluation or by a crawl until the full adjustment has been made. The pros and cons of alternative methods of adjustment are beyond the scope of this paper. It is sometimes desirable to incorporate in the peggmg formula some factor by which the exchange rate should be moved vis-a-vis the peg. In this case, the peg becomes only one of the determinants of exchange rate adjustments in the long run. Such an arrangement is known as formula flexibility. 15 For example, when persistent foreign inflation or any other fundamental disequilibrium moves the equilibrium value of the exchange rate over time, the peg could be allowed to glide, following a rule, such as the following: rjk

+

rk

F':f=O,

F(B)

F(O)=O

for a single-currency peg, or

rjk

n L: w·1 = 1

f

rik

+

F(B)

j

for a basket peg,

15

This arrangement is common among the LDCs.

F':f=O,

F(O)=O

23

where B is the relevant indicator of fundamental change 1 6 (for example, F(B) could be the differential inflation rate) while rk is the numeraire currency and, at the same time, the peg. All other notations are as before. Under basket peggmg, policy-makers are sometimes interested not only m stabilizing the particular variable for which the weighting scheme is derived, but also in maintaining a certain balance m some other macro-economic variable. The equation above can be used for this purpose in which case, B becomes the relevant balance, such as the level of reserves or the balance of payments.

VI:

ASEAN COUNTRIES:

A CASE STUDY

The ASEAN countries have experienced increased variability in effective exchange rates, both nominal and real, since the advent of generalized floating. The variability has had some adverse effects on the trade flows of the ASEAN countries (Rana, 1982). This suggests that an exchange rate regime that would minimize the effects of third-country exchange rate fluctuations and other random external disturbances on the domestic market should be adopted. Based on the previous discussion of the theory of optimal foreign exchange rate policies, the following are guidelines for the choice of exchange rate regimes for the ASEAN countries.

Degree of Exchange Rate Flexibility To determine whether the exchange rates of the five ASEAN countries should tend towards pegging or floating, measures for some of the major criteria for exchange rate flexibility are computed. There is no widely accepted indicator of the degree of international integration. The index used in this paper is the ratio of foreign assets of the commercial banks to money supply. 17 Openness 16

W.H. Branson and L.T. Katseli-Papaefstratiou (1978).

17

An attempt has been (also employed by P. to be inferior. R.H. supply to be superior

made to use the ratio of gross private capital flows to GDP Holden, M. Holden and E.C. Suss, 1979), but it has been found Heller (1978) has also found the ratio of foreign assets to money to alternative measures he explored.

24

measured by the ratio of exports (f.o.b. basis) plus imports (c.i.f. basis) to GDP (gross domestic product ). The index used for diversification of the economy is the indirect measure suggested by Adelman and Morris (196 7), which indicates the degree to which exports are concentrated in a single closely related group of products. 18 Product concentration in this paper is given by the percentage of the total exports accounted for by the largest export item in terms of the three-digit SITC (Standard International Trade Classification) or the categories given in the IMF Internatz'onal Fz'nancz'al Statistics. The other factors (price elasticities of trade and types of shocks which most significantly affect the economy) are difficult to measure. Nevertheless, they are discussed in the text.

IS

The performance of the ASEAN countries in terms of the criteria for flexibility is compared with that of a sample of peggers and floaters 19 in table 1. Figures are based on the average of the 19 78 and 19 79 values (or for a few countries, the latest two years for which data are available). For the group of floaters and peggers, arithmetic means, standard deviations, and geometric means are given. The number of floaters in the sample is limited by the number of countries which can be classified as independent floaters. The sample of peggers include countries pegging to a single currency, the SDR, or other currency composites. It does not include countries in a co-operative arrangement or those which adjust their currencies according to a set of indicators. The table is merely a summary of how various countries with different characteristics have responded (in terms of their exchange rate regimes) to developments in the international monetary system, and as such cannot be a strong basis of policy recommendations for the ASEAN countries. The latter could, however, learn from the experiences of other countries.

18

See P. Holden, M. Holden and E.C. Suss (1979).

19

Based on the IMF's classification of exchange rate arrangements, 30 June 1979.

25

Table 1:

Criteria for Exchange Rate Flexibility, 1978-1979 (in %) International Financial Integration

A SEAN Indonesia Malaysia Philippines Singapore Thailand

Openness

Product Concentration

34.47 17.22 51.03 110.21 21.91

41.61 89.38 36.63 327.95 42.85

59.89 19.57 23.87 28.75 13.60

Floatersa Arithmetic Average Standard Deviation Geometric Average

31.88 32.31 21.84

29.60 14.33 26.98

10.79 6.51 9.01

Peggersb Arithmetic Average Standard Deviation Geometric Average

26.90 46.04 11.88

51.71 22.25 46.68

43.51 c 23.09c 3 7.67c

Sources:

1. 2.

IMF, International Financial Statistics UN, Yearbook of International Trade Statistics

Note

a

Countries included are Canada, Japan, New Zealand, Spain, United States.

b

The sample includes 26 countries, namely: Austria, Bangladesh, Bolivia, Costa Rica, Dominican Republic, Ecuador, El Salvador, Egypt, Finland, Fiji, Guatemala, Iraq, Jamaica, Jordan, Kenya, Korea, Kuwait, Nepal, Norway, Pakistan, Papua New Guinea, Syrian .Arab Republic, Sweden, Tanzania, Uganda, Venezuela.

c

Includes only 24 countries because of data limitations.

26

International Financial Integration The index of international financial integration m the first column indicates that Singapore, which is a financial centre and recently free of foreign exchange controls, the Philippines, and to some extent Indonesia, have better integrated fmancial systems than the average for the sample of floaters. (Note, however, the high standard deviation for floaters.) These results should be interpreted with caution, however, since countries that serve as hosts to international financial institutions may have a large amount of foreign assets but may actually be quite sheltered (Heller, 1978). The Philippines is a case in point. It has a large stock of foreign assets because of the presence of offshore banking units in the country, but may however be insulated as a result of foreign exchange controls. As for Indonesia, its foreign assets can largely be attributed to the high income from oil. Foreign currency activities may be restricted to trade and hence, may not reflect a well-integrated capital market. The indices for Malaysia and Thailand suggest that these countries are even less integrated than the average pegger, based on the arithmetic mean. Extreme values in the sample, however, can bias the arithmetic mean. The extreme values have also resulted in the large standard deviation. An alternative measure which gives less weight to extreme values is the geometric mean. Using the geometric mean brings down the index to 11.88, lower than any of the indices for the ASEAN countries. The proxy used here is crude, and the results obtained suggest that a better measure is probably needed. Given the importance of international financial integration in the choice of a regime, other proxies should also be explored. Therefore, no strong conclusion can be made from the discussion above, except perhaps for Singapore where there is strong evidence of a financially integrated capital market. Indications are that the ASEAN countries have more integrated capital markets than the average pegger. However, Malaysia and Thailand are not as integrated as the average floater. Thus, implications on exchange rate regimes are that Singapore can expect a floating rate to be stable, at least in the short run, while the other ASEAN countries may be able to tolerate relatively more flexibile exchange rates than the average pegger. However, independent floating may still not be feasible for them.

27 Trade Indicators Looking at the characteristics pertaining to trade, the second and third columns of table 1 generally indicate that all five ASEAN countries belong to the category of peggers rather than floaters. Firstly, the ASEAN countries have a higher index of openness than the average floater; indeed, Malaysia and Singapore are even more open than the average pegger. Secondly, the commodity concentration of trade for ASEAN (Thailand to a lesser extent) is also higher than that of the average floater. Indonesia's is even higher than the average for the peggers. Singapore, which is thought to have the most diversified economy among the five countries, has actually a relatively high concentration based on the measure used. This high concentration in the two countries is due to their large petroleum exports. With regard to price elasticities of trade, since consistent findings are not available, the argument that elasticities in the LDCs are generally low can be used to suggest that a floating exchange rate may be unstable, especially for the four ASEAN countries (see p. 10, Price Elasticities of Trade) for which there is no strong evidence that the domestic capital markets are well integrated. However, Indonesia and particularly Malaysia may have some market power (see pp. 30-33, Choice of Weights) and to that extent, their trade balance could be responsive to exchange rate changes, and therefore a floating rate could be relatively stable, at least in the long run. It is not simple to measure the various types of shocks -- another factor that should be considered in the choice of the degree of flexibility. In fact, it is even difficult to distinguish shocks from more permanent changes in the economic environment. However, some observations can be made. Since the ASEAN countries are relatively open and undiversified, they can be susceptible to external shocks. However, there is no reason to believe that their trading partners are more volatile and can transmit their economic instabilities to the ASEAN countries. In fact, Indonesia, the Philippines, and to some extent, Thailand are experiencing higher inflation rates than their trading partners. A high degree of flexibility may, therefore, be unfavourable since higher inflation in these countries would lead to a depreciation of their currencies, thereby further feeding inflation. In 1978 and 1979, Indonesia's inflation rate was, on the average, twice as much as the OECD (Organization for Economic Co-operation and Development) countries (proxy for trading partners),

28

and the Philippines, 1.5 times as much. Thailand's inflation rate was also slightly higher than that of the OECD countries. However, the inflation rate in Malaysia and Singapore was only about half that of the industrialized countries. Floating may, therefore, help them insulate their economies from foreign inflation. As for domestic disturbances, suffice it to say that the agro-based countries are highly susceptible to domestic shocks, particularly bad weather. With the exception of Singapore, all the ASEAN countries are primarily agricultural. For the four countries, this is another argument for less flexible exchange rates. The implications of the various economic characteristics discussed above on exchange rate flexibility are summarized in table 2 below. A positive sign indicates a tendency favouring a more flexible exchange rate system; and a negative sign, a less flexible system. A double positive or negative sign means a stronger tendency towards either system. A blank indicates a doubtful case.

Table 2:

Implications of Economic Characteristics on Flexibility

International Financial Integration

Indonesia Malaysia Philippines Singapore Thailand

Openness

Product Concentration

Elasticities

Sources of Shocks (Domestic vs. Foreign)

+ ++

+

29 Caution should be observed in interpreting table 2 . Since much of the analysis has been based on a comparison of the ASEAN countries with other countries, which themselves cannot be used as the standard, the conclusions as such cannot be a strong basis for policy recommendations. The only definite implication that can be derived from the analysis is whether the ASEAN countries resemble floaters or peggers. Bearing this in mind, the following conclusion can be made. In general, the four ASEAN countries {Indonesia, the Philippines, Thailand and, to a lesser extent, Malaysia) possess the characteristics of peggers. The same, however, cannot be said strongly for Singapore. It has a relatively integrated capital market to ensure short-run stability under the floating system, but the economy is so open that adjustment costs can be very high. The case of Singapore illustrates the possibility of a conflict in the policy implications derived from the determinants. This suggests the need for a methodology for weighting the various determinants, that is, a system which can assess the relative importance of the different structural characteristics in the determination of the suitable degree of exchange rate flexibility. If the ASEAN countries should peg their currencies, the next two sections could give some indications as to what they should peg to.

Single Versus Basket Pegging Since a closer look at the trading pattern of a country is necessary before a decision can be made on the appropriate trade diversification measure to use, a preliminary analysis can be done using geographic diversification of trade. This commonly used measure is relatively simple and data are readily available. It should be noted that the difference between geographic diversification, currency denomination of trade and currencies in which international prices are fixed would be insignificant in the medium to long run when trade shares are sensitive to prices. In the present study, only trade diversification is considered. transfer and capital transactions are not taken into account.

Se!Vice,

Tables 3 and 4 give the percentage shares of countries which acccount for more than 5% of the ASEAN countries' imports and exports. The averages of 1977 and 1978 figures are used.

30

Table 3:

Import Shares, 1977-1978 (in %) Indonesia

~alay-

P~lip-

SJ.a

pmes

u.s.

12.09

13.22

Japan Germany

28.82 7.97

23.26 5.91 7.48 6.27

Singapore

Thailand

20.76 26.16

12.88 18.58

13.02 31.56 5.65

7.06

13.74

7.03

Imports From:

U.K. Australia Saudi Arabia Singapore Malaysia

Source:

Table 4:

6.85

8.46 12.97

IMF, Direction of Trade.

Export Shares, 1977-1978 (in %) lnd.o· nes1a

l\;lalays1a

PJtilippmes

Singapore

Thailand

27.75 40.68

18.40

34.21 23.76 8.15

15.62 9.85

10.36

Exports To:

u.s. Japan Netherlands

21.12 6.07

Hong Kong India Singapore

7.40 7.96

16.06

Malaysia

Source:

20.25 13.37 5.05

IMF, Direction of Trade.

13.63

7.05 5.49

31

In general, no one partner country dominates the trade of any of the ASEAN countries and therefore they should peg to a basket of currencies. The geographic distribution of trade is quite diversified particularly on the import side. For some of the ASEAN countries, trade is relatively concentrated (notably, imports of Thailand from Japan, exports of Indonesia to Japan, and exports of the Philippines to the U.S.), but other trading partners still account for a large proportion of trade, thereby warranting the inclusion of these partners' currencies in the respective baskets.

Choice of Weights The objective of this paper is not to compute precisely the weights that could be used by the ASEAN countries but only to make some general inferences. Following Branson and Katseli-Papaefstratiou's approach, the approximate weights recommended for the ASEAN countries are summarized in table 5. External terms of trade could be a relevant objective only if a country has asymmetric market power. Branson and Katseli-Papaefstratiou {1980) have computed indices for market power on the export and import side using a sample of 101 countries. The proxy used for export (or import) side market power is the country's export (or import) share of a particular commodity in world trade, weighted by the relative importance of that commodity among the country's exports {or imports).20 The indices computed for the ASEAN countries included in the sample (Malaysia, Singapore, the Philippines and Thailand) are presented in table 6. For comparison purposes, means and standard deviations {in parentheses) of market power for the other countries included in the sample are also given.

20

Note that the indices on the export side could over-estimate true market power as they do not reflect the existence of substitute products. This is not a problem on the import side since substitution possibilities are weak or nil and, as it stands, import side market power is already negligible.

32

Table 5:

Approximate Currency Basket Weights

Indonesia

Malaysia

Philippines

Singapore

Thailand

Terms of Trade

Import Weights

- do -

Weighting scheme cannot influence target

- do -

- do -

Prices of Traded Goods

Import Weights*

- do -

Trade Weights

- do -

- do -

Balance of Payments

MERM or Import Weights

- do -

- do -

MERM Weights

MERM or Import Weights

Policy Targets for Stabilization:

*

Import weights may be used only if the proportion of exportables to importables is not too large.

Table 6:

Market Power Indices, 1974 Market Power Indices on

Malaysia Philippines Singapore Thailand Others

Source:

Export Side

Import Side

.1928 .0552 .0761 .0529 .0455 (.0705)

.0023 .0019 .0115 .0018 .0072 (.0156)

W.H. Branson and L.T. Katseli-Papaefstratiou (1980).

33

Based on the figures, Malaysia seems to have substantial market power on the export side. The Philippines, Singapore, and Thailand do not have substantial market power. They do have some asymmetric market power tending towards the export side, but it is not significant. Indonesia, which was not included in the sample, can also be expected to have greater market power on the export side as it is a major exporter of petroleum. Hence, in terms of stabilizing external terms of trade, import weights rather than export weights would perform better for Malaysia and Indonesia. The best method would be of course to use the derived weighting fmmula. The pegging practices of the other three countries cannot influence their external terms of trade. Since the economy of the five ASEAN countries is very open, instability m prices of traded goods can be a problem. If its stability is an objective, for those countries with market power on the export side, import weights would still be a suitable alternative to the "optimal" weights, just as long as the proportion of exportables to importables is not large enough to offset the differential in market power on the export versus import side (see pp. 17-18, Policy Target: Basis for Choice of Weights). For countries without market power, trade weights would be the optimal (not only second best) choice. Balance of trade stability can be achieved by using MERM weights or its approximate, import weights. Import weights, however, may not be a good choice in the case of Singapore. This is because the argument in the theoretical section may not hold for Singapore since its exports are generally non-homogeneous, just as its imports. Hence, export weights should be taken into account together with import weights. Regarding weights which stabilize real effective exchange rates, no a priori statement can be made about the relative magnitudes of the vanances and co-variances, and therefore, it cannot be inferred whether or not elasticity weights would be a good choice.

34

Optimal and Actual Regimes The discussion above points to the conclusion that peggmg to a basket of currencies may be the "optimal" regime for four out of the five ASEAN countries (with the exception of Singapore). Although there is a case for Singapore to peg to a basket of currencies, its well-integrated financial market indicates that floating is another possibility. It is encouraging that the ASEAN countries, at least officially, have moved towards what seems to be the "optimal" foreign exchange regime for them. Indonesia, Malaysia, Singapore and Thailand are now pegging to a basket within margins. The Philippines, although still "floating", has expressed its intention to peg to a basket. (See pp. 4-7, Official and Actual Exchange Rate Regimes of ASEAN.)

From the actual movements in exchange rates, however, Malaysia and Singapore seem to be operating under a managed float while the other three ASEAN countries are pegged to the U.S. dollar. Except for Singapore (since floating can be optimal), this is perhaps one of the main reasons that the foreign component (due to generalized floating) of their effective exchange rates (import-weighted), as calculated by Rana, is still relatively volatile (compared to the pre-floating era) in spite of the claims to stability of the "optimal" foreign exchange regime which four ASEAN countries have declared to have adopted. The ASEAN countries have realized that currency basket peggmg may be the "optimal" exchange rate policy for them, given their structural characteristics. To obtain the benefits associated with this regime, it remains for them to follow their official declarations, and to go a step further, which is to identify appropriate weights based on their policy targets.

35

VII:

CONCLUDING REMARKS

Especially in this era of floating exchange rates, countries are inevitably faced with the crucial decision of which exchange rate regime to adopt. A systematic decision-making process, backed by theoretical underpinnings, is useful, in spite of the possible limitations that the theory could impose on it. It has been the aim of this paper to outline such a process, based on the new literature of optimal exchange rate regimes for LDCs. Furthermore, it has attempted to give preliminary directions which the ASEAN countries could take. Conclusions are not strong in some cases. Firstly, no rigid methodology has been developed to compare the relative importance of the various determinants of floating versus pegging decision. Secondly, "optimal" basket weights have not been computed. Thirdly, no attempt has been made to systematize selection of targets. These three areas could be the subjects of future research.

36

BIBLIOGRAPHY

Adelman, I. and C.T. Morris Sodety, Politics, and Economic Development, A Quantitative Approach. Baltimore: The Johns Hopkins Press, 1967. Artus, J. and R.R. Rhomberg "A Multilateral Exchange Rate Model". 1973): 591-611.

IMF Staff Papers 20 (November

Black, S.W. "The Analysis of Floating Exchange Rates and the Choice between Crawl and Peg". Paper prepared for Conference on the Crawling Peg: Past Performance and Future Prospects, Rio de Janeiro, October 1979. "Exchange Policies for Less Developed Countries in a World of Floating Rates". Essays in International Finance, No. 119. Princeton University, 1976. Branson, W.H. and L.T. Katseli-Papaefstratiou "Exchange Rate Policy for Developing Countries". Working Papers zn Internatt'onal Economics. Princeton University, 1978. "Income Instability, Terms of Trade and the Choice of Exchange Rate Regime". Journal of Development Economics 7 (March 1980): 49-69. Cline, W. International Monetary System and the Developing Countries. D.C.: Brookings Institution, 1976.

Washington

Crockett, A.D. and S.M. Nsouli "Exchange Rate Policies for Developing Countries". Journal of Development Studies 13 (April-July 1977): 125-43. De Grauwe, P. "Floating Exchange Rates: Mimeographed, 19 77.

Current Experiences and Policies of LDCs".

37

Dreyer, J .S. "Determinants of Exchange-Rate Regimes for Currencies of Developing Countries: Some Preliminary Results". World Development 6 (April 1978): 437-45. Heller, R.H. "Determinants of Exchange Rate Practices". and Banking 10 (August 1978): 308-21.

journal of Money, Credit,

Holden, P., M. Holden, and E.C. Suss. "The Determinants of Exchange Rate Flexibility: An Empirical Investigation". Review of Economics and Statistics 61 (August 1979): 327-33. Joshi, V. "Exchange Rates, International Liquidity and Economic Development". The World Economy (May 1979): 243-75. Lipschitz, L. "Exchange Rate Policies for Developing Countries: Some Simple Arguments for Intervention". IMF Staff Papers 25 (December 1978): 650-75. "Exchange Rate Policy for a Small Developing Country, and the Selection of an Appropriate Standard". IMF Staff Papers 26 (September 1979): 423-49. Lipschitz, L. and V. Sundararajan "The Optimal Basket in a World of Generalized Floating". Papers 27 (March 1980): 80-100.

IMF Staff

Rana, P. The Impact of Generalized Floating on Trade Flows and Reserve Needs: Selected Asian Developing Countries. Ph.D. dissertation, Vanderbilt University, 1979.

ASEAN Exchange Rates: Policies and Trade Effects. Institute of Southeast Asian Studies, 1981.

Singapore:

38

V. Sundararajan "Purchasing Power Parity Computations: Some Extensions to Less Developed Countries". IMF DM/76/101, 1976. Tower, E. and T.D. Willett "The Theory of Optimum Currency Areas and Exchange Rate Flexibility". Special Papers in International Economics, No. 11. Princeton University, 1976.

INSTITUTE OF SOUTHEAST ASIAN STUDIES LIST OF PUBLICATIONS IN THE

RESEARCH NOTES AND DISCUSSIONS PAPERS SERIES 1

M. Mainguy, Economic Problems Related to Oil and Gas Exploration, 1976. 39pp. (Out of print)

2

R. William Liddle, Cultural and Class Politics in New Order Indonesia, 1977. 21pp. (Out of print)

3

Raja Segaran Arumugam, State and Oil in Burma, 1977. (Out of print)

4

Hilman Adil, Australia's Policy Towards Indonesia During Confrontation, 1962-66, 1977. 90pp. (Out of print)

5

Albert D. Moscotti, Burma's Constitution and Elections of 1974: A Source Book, 1977. 184pp. (Out of print)

6

Thamsook Numnonda, Thailand and the Japanese Presence, 1941-45, 1977. 142pp. (Out of print)

7

Nguyen The Anh, The Withering Days of the Nguyen Dynasty, 1978. 33pp. S$4.00

8

M. Rajaretnam, Thailand's Kra Canal: (Out of print)

9

R.O. Whyte and Pauline Whyte, Rural Asian Women: Environment, 1978. 34pp. S$4.00

10

Ismail Kassim, The Politics of Accommodation: An Analysis of the 1978 Malaysian General Election, 1978. llOpp. (Out of print)

11

Leo Suryadinata, The "Overseas Chinese" in Southeast Asia and China's Foreign Policy: An Interpretative Essay, 1978. 45pp. (Out of print)

12

Y. Mansoor Marican, Public Personnel Administration zn Malaysia, 1979. 21pp. (Out of print)

13

Norbert Hofmann, A Survey of Tourism in West Malaysia and Some Soda-Economic Implications, 1979. 48pp. (Out of print)

Some Issues, 1978.

36pp.

82pp.

Status and

THE AUTHOR Aleth Y enko is Research Associate at the ASEAN Economic Research Unit (AERU), Institute of Southeast Asian Studies. Her fields of interest are international finance and econometrics. She is presently doing research on monetary and exchange rate policies in the ASEAN countries.