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FABSF

WEEKLY LETTER

Number 94-31, September 16, 1994

Exchange Rate Arrangements
in the Pacific Basin
This article is adapted from the introduction to
Exchange Rate Policy and Interdependence:
Perspectives from the Pacific Basin (Reuven Click
and Michael Hutchison, eds., Cambridge University Press, 1994), a collection of thirteen
essays originally prepared for the conference
"Exchange Rate Policy in Pacific Basin Countries" sponsored by the Center for Pacific Basin
Monetary and Economic Studies at the Federal
Reserve Bank of San Francisco in September

1992.
Over the past 20 years, almost all countries in
the Pacific Basin have substantially liberalized
their financial systems, removing restrictions to
domestic and international capital flows. These
reforms have led to greater international interdependence, and therefore to more efficient allocation of resources from savers to investors. At the
same time, greater international interdependence
has led many countries in the region to allow
greater exchange rate flexi bi Iity in order to insu late
themselves from foreign disturbances. Because of
the diversity of historical backgrounds, stages
of economic development, and financial environments, the Pacific Basin region provides a
useful set of country experiences for a comparative study of exchange rate arrangements and
their implications for the conduct of monetary
.
policy.

find that the region is still far from achieving complete financial integration, particularly among
the lesser developed countries. For countries with
well-developed forward exchange markets, they
attribute most of the remaining barriers to integration to currency factors, such as expectations
of exchange rate changes or exchange rate premia, rather than to country factors, such as capital controls or differential tax treatment. Although
u.S. rates remain the dominant foreign influence
for most countries, and, indeed, have strengthened that role over the period, there is some evidence of a greater Japanese role in the countries
of Southeast Asia.
As local equity markets have grown in the region, the opportunities for international investors
who are seeking higher return or diversification
have expanded. Charles Engel (University of
Washington) and John Rogers (Pennsylvania State
University) explore the extent to which equity
markets in the Pacific Basin have equalized real
returns on investment opportunities using stock
market data over the period 1983-1991. Consistent with the Chinn and Frankel work on interest
rates, they find substantial differences in real return prospects for equity investors across countries. Their evidence implies that there are still
some restrictions to the flow of financial capital
among Pacific Basin countries that prevent the
equalization of returns.

International financial interdependence
Three papers examine the degree of financial integration among Pacific Basin countries and explore possible remaining barriers to integration.
Menzie Chinn (U.c., Santa Cruz) and Jeffrey
Frankel (U.c., Berkeley) examine the interest rate
linkages of financial assets and the relative influence of the u.s. and Japanese markets in the
Pacific Basin over the period 1982-1992. They

PACIFIC BASin nOTES

In light of prevailing implicit or explicit regulatory controls, Michael Dooley (U.c., Santa Cruz)
and Donald Mathieson (International Monetary
Fund) question the usefulness of observed domestic interest rates in measuring the degree of
capital mobility and extent of international financial market linkages. They construct an alternative measure of capital mobility, not based on
observed domestic interest rates, which gives

Pacific Basin Notes appears on an occasional
basis. It is prepared under the auspices of the Center for Pacific Basin Monetary and Economic Studies
within the FRBSF's Economic Research Department.

FRBSF
results that are sometimes counter to the conventional wisdom about which countries are more
integrated with world capital markets.

Choice of exchange rate regimes
Increasing economic interdependence implies
that countries are subject to a broader range of
shocks. Which exchange rate regime works best
under these circumstances?
Stephen Turnovsky (University of Washington)
provides a review of recent theoretical literature
on exchange rate management and its implications for monetary policy. A common message of
these models is that monetary and exchange rate
policies cannot be conducted independently in
the long run. If the monetary authorities choose
to target a particular level or path for the exchange rate, given the foreign inflation rate, this
implies a corresponding long-run domestic inflation rate, and hence a loss of control over monetary policy.
What are the advantages of choosing to peg the
exchange rate as opposed to allowing it to float?
Turnovsky illustrates how the "optimal" choice of
exchange rate arrangements depends on a host
of economic and political factors, including the
degree of capital mobility, structure of the economy, the nature of disturbances, and policymakers' objectives. Practical problems involved in
discerning the source of shocks and identifying
the relevant structural characteristics, however,
make it difficult for policymakers to apply theoretical criteria for adjusting the exchange rate.
Thus ultimately the choice of exchange rate regimes by policymakers is an empirical question
i nvolvi ng "Iearni ng-by-doi ng:'
Four papers analyze individual countries to assess the extent to which greater exchange rate
flexibility has provided insulation from foreign
disturbances.
Ramon Moreno (Federal Reserve Bank of San
Francisco) considers how exchange rate regime
shifts in Taiwan and Korea affected their domestic vulnerability to external shocks. Both countries maintained adjustable pegs to the U.S.
dollar for most of the 1970s. In the case of Taiwan, large current account surpluses together
with liberalization of international transactions
necessitated a change to a managed float policy
against the dollar in 1979 and a free float in 1989.
Korea also allowed its exchange rate to adjust
more flexibly by adopting a basket currency peg

in the 1980s followed by a more explicit managed float against the dollar in 1990. Using a
vector autoregression model, Moreno finds that
domestic prices in Korea and Taiwan appear to
be more insulated from foreign shocks as a result
of the choice of greater exchange rate flexibility.
John Pitchford (Australian National University)
analyzes several episodes of major foreign price
shocks experienced by Australia and argues that
the lack of exchange rate flexibility in response
to external price shocks in the 1970s exacerbated
Australia's macroeconomic adjustment problems
during that period. The flexible exchange rate
regime adopted at the end of 1983, he concludes, better insulated the economy from the
nominal trade price shocks Australia has traditionally experienced.
New Zealand made a dramatic switch from a
fixed exchange rate to a freely floating exchange
rate policy in March 1985, after finding that a
fixed exchange rate and an independent monetary policy could not be maintained in the wake
of the removal of international capital controls in
the early 1980s. Arthur Grimes and Jason Wong
(Reserve Bank of New Zealand) consider the New
Zealand experience and discuss how the exchange rate is currently used as an intermediate
target by monetary policymakers for achieving
the long-run goal of low inflation. Using a vector
error-correction model approach, they find that
the dominant influence on inflation in New Zealand has come from the exchange rate and foreign price disturbances, implying that targeting
the exchange rate path, rather than the path of
money aggregates, indeed represents the preferable operating procedure.
Helen Popper (Santa Clara University) and Julia
Lowell (Rand) focus their analysis on the exchange rate regimes of Australia, New Zealand,
Canada, and the United States and infer the extent of concern by monetary authorities about the
exchange rate by measuring the influence of foreign developments on domestic prices. They find
some evidence of exchange rate targeting in the
case of Canada, but not for Australia and Japan.
There is weak evidence of targeting for the U.S.,
but only vis-a.-vis the yen.

Intervention and sterilization policies
Although most countries in the Pacific Basin have
moved towards greater exchange rate flexibility,
virtually all central banks in the region actively
intervene in the for~ign exchange market. The
extent to which a central bank can pursuean exchange rate intervention policy independent of
monetary policy depends on its ability to sterilize or offset the effects of international reserve
changes on the monetary base.

Three papers examine the intervention policies
of individual countries in the Pacific Basin.
Reuven Glick (Federal Reserve Bank of San Francisco) and Michael Hutchison (U.c., Santa Cruz)
analyze the Bank of Japan's (BOJ) intervention
policy and its impact on the control of money
aggregates over the post-Bretton Woods period.
They show that the BOJ has actively intervened
in the foreign exchange market over most of the
floating-rate period. They find that the degree of
sterilization is high in the short run but much
lower in the long run. They suggest that incomplete sterilization of intervention against the rise
of the yen in the early 1970s and in the late
1980s contributed to the rapid growth of monetary aggregates during those periods. In the early
1970s this resulted in a surge in inflation. Only
an apparent upward shift in money demand
seems to have prevented this money growth from
resulting in a sharp increase in goods market inflation in the late 1980s.
Sung Kwack (Howard University) examines the
extent to which Korea was able to sterilize the effects on its money supply of large current account
surpluses in the late 1980s. He concludes that the
Bank of Korea was able to sterilize almost all of
the effects of foreign reserve changes and to
achieve its monetary policy goals. Part of the
success of this policy is attributable, however, to
remaining restrictions to capital mobility.
Recent models suggest that sterilized as well as
unsterilized intervention may influence exchange
rates by altering expectations in the exchange
market. One way it might do so is by "signalling" market participants about the direction of
future monetary policy. Tsutomu Watanabe (BOJ)
analyzes how intervention operations by the BOJ
during the period 1973-1992 have acted as a signal about the future stance of monetary policy;
Watanabe finds that the purchase (sale) of foreign currencies tends to precede a reduction (increase) in the BOJ discount rate. The finding that
sterilized intervention to weaken the yen followed expansionary monetary policy suggests
that it provides a credible signal about the stance
of monetary policy.

Prospects for a yen bloc
The progress toward regional economic and financial integration in Europe and in North America, such as the EMU and NAFTA, have led many

to wonder whether a sirnilareconomic blpc:
might form in the Pacific Basin,centered inJapan.
There are several definitions of a "yen bloc:'
Some interpret it as an area in whichthe yeni.s
used extensively in international transactions.
Others interpret it more broadlyas.a free trade
zone or tariff union. It has also been interpreted
as referri ng to a monetary arrangement whereby
countries peg their currencies to the yen.
Takatoshi Ito (Harvard University and Hitotsubashi University) reports evidence that countries
in Asia are gradually increasing their use of the
yen as an invoice currency in international transactions, though they still rely predominantly on
the dollar. In addition, Japan uses the yen to invoice its export and import transactions far less
than other developed countries use their own national currencies for invoicing international export and import transactions. This finding cannot
be explained by Japan's close trade relationship
with the
nor by its role as a major importer
of raw materials and oil, which are generally
priced in dollar terms. While trade between
Japan and other Asian countries increased substantially in the late 1980s, there is no apparent
evidence of an intraregional trade bias after accounting for factors like economicgrowth and
proximity.

u.s.

Michael Melvin, Michael Ormiston, and Bettina
Peiers (Arizona State University) evaluate the
portfolio demand for international currencies and
assess the desirability of forming a yen currency
area from the point ofview of investors in the region. Their portfolio analysis indicates that investors generally prefer the distribution of returns
associated with holding assets denominated in
U.S. dollars. Ito also cites econometric evidence
that the c:urrencies of the smaller countries in
Asia are pegged to the dollar de facto and with
few exceptions place relatively little weight on
the yen. This is consistent with the observation
that these countries typically export more to the
U.S. than to Japan. On balance,lto and Melvin,
et aI., concludethere is little evidence of a yen
bloc at present, nor much likelihood of its forming in the near future.

ReuvenGlick

AssistantVice President and
Director, Center for Pacific Basin
Monetary arid Economic Studies

Opinions expressed in this newsletter do not necessarily reflect the views. of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor or to the author.... Free copies oHederal Reserve publications can be
obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O; Box 7702, San Francisco 94120.
Phone (415) 974-2246, Fax (415) 974-3341.

Research Department

Federal Reserve
Bank of
San Francisco
P.O. Box 7702
San Francisco, CA 94120

Printed on recycled paper Q
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W ~

Index to Recent Issues of FRBSF Weekly Letter

DATE NUMBER TITLE
2/25
3/4
3/11
3/18
3/25
4/1
4/8
4/15
4/21
4/29
5/6
5/13
5/20
5/27
6/10

6/24
7/1
7/15
7/22
8/5
8/19
9/2
9/9

94-08
94-09
94-10
94-11
94-12
94-13
94-14
94-15
94-16
94-17
94-18
94-19
94-20
94-21
94-22
94-23
94-24
94-25
94-26
94-27
94-28
94-29
94-30

1994 District Agricultural Outlook
Monetary Policy in the 1990s
The IPO Underpricing Puzzle
New Measures of the Work Force
Industry Effects: Stock Returns of Banks and Nonfinancial Firms
Monetary Policy in a Low Inflation Regime
Measuring the Gains from International Portfolio Diversification
Interstate Banking in the West
California Banks Playing Catch-up
California Recession and Recovery
just-In-Time Inventory Management: Has It Made a Difference?
GATS and Banking in the Pacific Basin
The Persistence of the Prime Rate
A Market-Based Approach to CRA
Manufacturing Bias in Regional Policy
An "!ntermountain Miracle"?
Trade and Growth: Some Recent Evidence
Should the Central Bank Be Responsible for Regional Stabilization?
Interstate Banking and Risk
A Primer on Monetary Policy Part I: Goals and Instruments
A Primer on Monetary Policy Part II: Targets and Indicators
Linkagesof National Interest Rates
Regional Income Divergence in the 1980s

AUTHOR
Dean
Parry
Booth
Motley
Neuberger
Cogley
Kasa
Furlong
Furlong/Soller
Cromwell
Huh
Moreno
Booth
Neuberger/Schm idt
Schmidt
Sherwood~Call/Schmidt

Trehan
Cogley/Schaan
Levonian
Walsh
Walsh
Throop
Sherwood-Call

The FRBSF Weekly Letter appears on an abbreviated schedule in june, july, August, and December.