Academic journal article The Lahore Journal of Economics

Choice of Anchor Currencies and Dynamic Preferences for Exchange Rate Pegging in Asia

Academic journal article The Lahore Journal of Economics

Choice of Anchor Currencies and Dynamic Preferences for Exchange Rate Pegging in Asia

Article excerpt

Abstract

This paper attempts to answer two important questions in the context of Asian exchange rate regimes with respect to the choice of anchor currencies and dynamic preferences for exchange rate pegging. According to our results, the US dollar is the first choice of a de facto peg for many countries such as China, Hong Kong, the Philippines, and Pakistan. Other countries, apart from Korea and Indonesia, seem to prefer a basket peg comprising two or more anchor currencies with rapidly increasing weight attached to the euro. This shift from the US dollar to the euro reflects changes in the choices, preferences, and policies of these economies as a result of varying macroeconomic and global financial realities.

Keywords: Exchange rate regime, flexibility, pegging, Asia.

JEL classification: E42, E58, F31, F33, F41.

(ProQuest: ... denotes formula omitted.)

1. Introduction

Despite its several demerits, exchange rate pegging has remained the most popular exchange rate regime for many countries, particularly during the 1990s when formulating their external financial policies. Undoubtedly, it has played a significantly constructive role in the development of several economies across the globe. It was common practice for developing countries with less stable currencies to create a currency peg with a more stable currency to achieve a variety of benefits including but not limited to stable inflation, monetary policy discipline, and control over trade deficits.

Pegged exchange rates have different forms, including unilateral pegs, multilateral pegs, currency unions, and currency boards. In a unilateral peg, an individual country decides on the basis of its indigenous and unique circumstances to peg its domestic currency to a single anchor currency. The domestic country sets its own monetary policy, which is similar to that of the anchor currency country, and tries to target different monetary variables such as inflation, credit expansion, and the interest rate in the currency of the anchor country.

A more rigid form of the unilateral peg-in which the country establishing a peg is prepared to lose its monetary independence by sacrificing its ability to decide the size of its monetary base-might be categorized as a currency board. Multilateral pegs and currency unions are arrangements where several countries jointly agree to follow specific sets of exchange rate parities. The responsibility for protecting the parity and intervening if needed is shared by all member countries. Multilateral pegs can be better understood by looking at the monetary system of the European Union before and after the adoption of a unified currency and a single monetary policy (Dueker & Fischer, 2001).

There are various pros and cons of pegged exchange rate regimes. On one hand, such a regime is extremely beneficial because it serves as a tool for keeping inflation under control and provides policymakers with discipline. On the other hand, it has certain disadvantages when it curtails the freedom of an autonomous monetary policy and increases the country's exposure to shocks and speculative attacks transmitted from the anchor country. It also binds policymakers to pursuing any anti-inflationary measures and potentially exposes the country to financial crises by making it financially fragile (Mishkin, 1998).

However, the sole fact of being a pegged exchange rate regime does not make a country vulnerable to financial crisis and fragility. Other macroeconomic factors also play a role in making an economy vulnerable. These factors include the associated monetary structure, inconsistencies in the exchange rate policy itself, supplementary macroeconomic policies, futile policy execution, the failure to practice effective structural and macroeconomic policies that might have fortified the financial system, and the pursuit of hasty disinflation and obstinacy in managing shocks (Bubula & Otker-Robe, 2003). …

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