Exchange-Rate Arrangements and Financial Integration in East Asia: On a Collision Course?

Financial integration in Ease Asia is actively being pursued and will in due course lead to substantial mobility of capital between economies in the region. Plans for monetary cooperation as a prelude to monetary integration and ultimately monetary unification are also proposed. These plans often suggest that central banks should adopt some form of common exchange rate policy in the transition period towards full monetary union. This paper argues that this is a dangerous path in the context of highly integrated financial markets. An alternative approach is proposed where independent central banks coordinate their monetary policies through the adoption of common objectives and by building an appropriate institutional framework. When this coordination process has progressed to the point where interest rate developments are similar across the region, and if in the meantime the required institutional infrastructure has been build, the next step towards monetary unification can be taken among those central banks that so desire. The claim is that this transition path is likely to be robust and will limit the risk of currency crises.Regional and International Currency Arrangements

Foreign versus domestic factors as sources of macroeconomic fluctuations in Hong Kong

This paper uses a semi-structural vector autoregression approach to estimate the relative importance of domestic and foreign shocks as sources of macroeconomic fluctuations in Hong Kong since the adoption of the currency board. We find that external factors are clearly dominant in the medium- to long run. In view of the highly open nature of the Hong Kong economy and the linkages implied by the currency board arrangement, it is perhaps not unexpected. However, that these factors should account for fifty percent or more of unexpected fluctuations in real gdp and the gdp deflator at shorter horizons of one to two years is more surprising, and it is large in comparisons with other highly open small economies. Even if external shocks are dominant sources of macroeconomic fluctuations, there remain significant short-term influences of domestic variables. For example, in the historical decomposition of the evolution of output growth and inflation we discovered a significant role for domestic factors in the recent recession. Their impact resembles very much those that would be generated by a conventional aggregate supply contraction. A challenge for future research is to identify empirically the exact sources of domestic shocks.new keynesian monetary policy, vector autoregression, macroeconomic fluctuations, economic cycles

Currency Substitution in Anticipation of EU Accession

Countries in Eastern and Central Europe that are likely to join the European Union will eventually also join the European Monetary Union. The process of accession will entail a transition period at the end of which it is certain that the domestic currency will be replaced by the Euro. This paper argues that this programmed demise of the domestic currency may bring about significant spontaneous euroization already during the transition period. If the euro is adopted by the private sector in anticipation of the official changeover, the country incurs a resource cost in the form of lost seignorage. Compared to the initial members of the EMU that could print Euros equal to the outstanding monetary base, a country where euroization takes place before the entry into the EMU will use real resources to obtain the Euros. The paper proposes ways to deal with this difference in treatment.International Economics; Exchange Rates; Euro; Seignorage; Currency Union; Monetary Union; Enlargement.

Inflation Targeting - the Holy Grail of Monetary Policy?

Inflation targeting is a statement about the objective of central bank policy and not about operating procedures. Its success depends not only on the actions of the central bank, but requires a broad consensus concerning the proper role of monetary policy in the economy. It also requires the backing of a sound fiscal policy. As countries differ both in economic structure and monetary transmission mechanism, the implementation of inflation targeting must be country specific. Instability over time in the transmission mechanism also implies that inflation targeting strategies must evolve over time to avoid the fate of previous monetary policy targeting practices.International Economics; Monetary Policy; Inflation targeting; Monetary transmission mechanism

The credibility of The Link from the perspective of modern financial theory

Hong Kong’s Linked Exchange Rate System (LERS) has been in operation for twenty-five years during which time many other fixed exchange rate systems have succumbed to shocks and/or speculative attacks. This fact alone suggests that the LERS is a robust system which enjoys a large measure of credibility in financial markets. This paper intends to investigate whether this is indeed the case, and whether it has been the case throughout its 25-year history. In particular we will use the tools of modern finance to extract information from financial asset prices about market expectations that are related to the credibility of the LERS. The main focus is on how market participants ‘judged’ the various changes made to the LERS, such as the ‘seven technical measures’ introduced in September 1998 and the ‘three refinements’ made in May 2005. These changes have been characterizes as making the system less discretionary over time, and we hypothesize that they have also made it more credible as revealed in the prices of exchange rate related asset prices. We also investigate the relationship between interest rates and exchange rates in the current system in light of modern models of target-zone exchange rate systems. We will examine whether the intramarginal intervention in November 2007 changed the dynamic properties of the exchange rate as suggested by such models

Macroeconomic volatility, debt dynamics, and sovereign interest rate spreads.

While the relationship between volatility and risk is central to much of the financial literature it has not been incorporated systematically into assessment of sovereign debt sustainability. This paper attempts to fill this gap by studying how the probability distribution of sovereign debt to GDP ratios depends on the stochastic properties of underlying variables such as the real interest rate, the real growth rate, and the primary budget deficit. Due to the highly non-linear relationship between these variables and the debt ratios, Monte-Carlo simulations have to be used to estimate the probability distribution at different horizons. Using the right-hand tail of the distribution as a measure of the risk, we are able to show how the volatility of the underlying variables as well as potential interactions between them influences country risk. Using estimates of volatility parameters of a sample of developed and emerging markets, we construct risk measures for each of them. We hypothesize that this risk measure should be positively correlated with the spread of sovereign bonds of the countries. Preliminary econometric tests suggest that this is indeed the case. Thus, while conventional analyses of the determinants of sovereign spreads have not focused on volatility dynamics, financial markets seem to have incorporated it in sovereign bond pricing.Macroeconomic volatility, debt dynamics, sovereign spreads

Wage-Price Dynamics and Deflation in Hong Kong

This paper provides empirical evidence on the dynamics of prices and wages in Hong Kong. The results imply that the deflation in Hong Kong since 1997 can be understood using a conventional macroeconomic framework wherein foreign influences constitute the basic underlying shocks, and adjustment processes in domestic wages and prices determine the details of the transmission mechanism. Our results indicate that the decline in local nominal prices owes much to declining prices of imported intermediate goods. The negative output gap and the increase in unemployment experienced during the deflation period also have their origin in foreign shocks, but the domestic wage adjustment process constitutes an important contributing factor.Deflation, wage-price dynamics, Hong Kong data.

Exchange-Rate Regimes: "Does What Countries Say Matter?"

Traditionally the IMF's Annual Report on Exchange Arrangements and Exchange Restrictions has been the main source of information about the exchange-rate policies pursued by member countries. The classification contained therein has been used to document the evolution of exchange rate regimes over time as well as to study the relationship between economic performance and the choice of exchange rate system. Recently a number of authors have challenged the results of these studies on the grounds that countries may not always be following the exchange rate policy that they have announced. For example, many countries appear to have a 'fear of floating' in the sense that the evolution of their exchange rate corresponds to what one would expect to see in a fixed exchange rate country even though they are officially following a floating rate policy. New classifications have been created claiming to represent countries' actual exchange rate policy as opposed to their declared policy. Using the new classification many results relating to the evolution of exchange rate regimes and the economic consequences of exchange-rate regime choices have been overturned. It is sometimes claimed that the new so-called de facto classifications are superior to the older de jure classifications. In this paper we argue that neither the officially declared exchange rate regime nor the de facto regime tells the full story about exchange rate policy. Both contain useful information and need to be taken into account. In addition we argue that countries which claim to be floating but in fact have relatively stable exchange rates are not necessarily breaking any commitment as sometimes has been suggested. Exchange rate stability may be the result of optimally chosen monetary policies. Furthermore, countries that use monetary policy instruments actively to stabilize their exchange rate may rationally not want to announce and commit to a fixed exchange rate because of a fear of being subject to speculative attacks. We present some empirical evidence consistent with this interpretation.International Economics; Exchange Rates; Trade; Whatever Related