FRBSF Economic Letter
1997-10 | April 11, 1997
Pacific Basin Notes. This series 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.
In recent years, policymakers in the Asian Pacific Basin have paid increasing attention to the possibility of the sudden depreciation of their currencies, in sharp contrast to their traditional concern with currency appreciation. This attention is a response to a number of developments, most notably: speculation against the currencies of Hong Kong, the Philippines, and Thailand in the wake of the Mexican peso crash of December 1994; uncertainty on the part of some observers about the maintenance of the peg of the Hong Kong dollar to the U.S. dollar after the July 1997 transfer of sovereignty to China; and concerns voiced in the financial press about the sustainability of relatively large current account deficits in some Southeast Asian economies. The recent weakness of the yen against the U.S. dollar also has been a contributing factor, as it potentially puts pressure on the currencies of Japan’s competitors to depreciate against the dollar.
Speculative attacks are a concern because a sudden large devaluation may be inflationary. In addition, although a sharp devaluation may stimulate the economy over time, in the short run, the sudden departure of investors and losses of purchasing power associated with a speculative attack may depress domestic demand and lead to sharp reductions in output. The problems associated with speculative attacks have been starkly illustrated by Mexico’s experience after the peso collapse in 1994.
Partly in response to these concerns, exchange rate cooperation has been high on the agenda of recent discussions of policymakers in the Asian Pacific Basin, and central banks in the Asian Pacific Basin have committed to support each other’s currencies during periods of speculative pressure. This Economic Letter briefly summarizes some of these recent initiatives, and discusses alternative paths economies in the Asian Pacific Basin may follow in pursuing exchange rate cooperation.
Policymakers in the Asian Pacific Basin have discussed closer exchange rate cooperation in a number of recent international meetings. Such cooperation was one theme of the first governor-level Executive Meeting of East Asia and Pacific Central Banks (EMEAP) in Tokyo in July 1996. Established in 1991 at the initiative of the Bank of Japan, the EMEAP comprises eleven member central banks in the region (Australia, China, Hong Kong, Indonesia, Japan, Korea, Malaysia, New Zealand, the Philippines, Singapore, and Thailand). The high level of participation in the EMEAP and its broad mandate to examine a wide range of issues has prompted speculation that it may play a key role in managing joint responses to speculative pressures in foreign exchange markets in the region, and that it could subsequently evolve into an “Asian BIS.” The BIS, or Bank for International Settlements, is a Basle-based financial institution that has supported the activities of the central banks of industrial countries since before World War II. While it is probably best known for its recent contributions to the assessment of bank risk and capital standards, the BIS also plays a role in the foreign exchange swap arrangements among central banks of industrial countries. To date, no concrete steps in such a direction have been announced by the EMEAP, and speculation may have been dampened by the recent admission into the BIS of a number of East Asian economies (China, Hong Kong, Korea, and Singapore).
In early March 1997, at their first meeting, finance ministers of the Association of Southeast Asian Nations (ASEAN) agreed to study the possibility of setting up a regional mechanism to defend currencies against speculative attack. They also agreed to review a 1977 ASEAN foreign exchange swap arrangement expiring in August of this year. Under a foreign exchange swap, a central bank exchanges domestic currency for foreign currency, while at the same time agreeing to reverse the transaction after a predetermined period. The total amount of the ASEAN swap arrangement is modest, up to $200 million, although it is apparent that the amounts may be adjusted to reflect changes in the global financial environment. By way of comparison, the Federal Reserve’s (reciprocal currency) swap arrangements with other central banks range from $250 million with the Austrian National Bank, up to $5 billion with the Bank of Japan and $6 billion with the Deutsche Bundesbank.
The meetings cited above include only economies in the Asian Pacific Basin, but countries on the other side of the Pacific also are engaged in related discussions. Regional macroeconomic and exchange rate developments were on the agenda of a meeting of senior Finance Ministry and Central Bank officials held in Tokyo in early March 1997, which involved the U.S., Japan, China, Hong Kong, Singapore, and Australia. Similar topics have been discussed by the finance ministers of the Asia Pacific Economic Cooperation Forum (APEC), comprising 18 economies on both sides of the Pacific.
The set of recent initiatives that may have attracted the most attention is the web of bilateral repurchase (repo) agreements undertaken by monetary authorities in the Asian Pacific Basin, under which a country may exchange U.S. dollar Treasury securities it holds for U.S. dollars from its neighbors in order to support its currency. The first agreements were signed by Australia, Hong Kong, Indonesia, Malaysia, and Thailand, and separately by Singapore and Indonesia in November 1995. These were followed by announcements, or signed agreements, by Hong Kong and the Philippines (December 1995), China and Hong Kong (February 1996), Japan, Australia, Hong Kong, Indonesia, Malaysia, Philippines, Singapore, and Thailand (April 1996), Korea with Australia, Japan, Hong Kong, and Singapore (January 1997), the Philippines and Thailand (February 1997), and Hong Kong and New Zealand (March 1997). It is also worth noting that Hong Kong and Singapore now also may intervene on behalf of the Bank of Japan in foreign exchange markets under an agreement signed in February 1996.
The full scope of these agreements has not been publicly disclosed. However, one noteworthy feature is that the U.S. dollar, rather than the currencies of participating members, is to be used to intervene in foreign exchange markets. To illustrate, if an Asian central bank which has signed a repo agreement with Hong Kong wants to intervene to prevent depreciation of its currency, it can acquire U.S. dollars from Hong Kong to support its currency by selling U.S. Treasury securities, with an agreement to reverse the transaction (repurchase the security) at a mutually agreed price and date. These repos enable the central bank to obtain U.S. dollar liquidity at short notice. The mechanics are similar to the way the Federal Reserve injects liquidity through open market operations; in this case, the Asian country facing depreciation pressures would receive the injection in liquidity from Hong Kong. The total size of the repo transactions depends on the ceilings set in the bilateral agreement, or the amount of U.S. dollar Treasury securities the country facing speculation has available to sell, whichever is lower. For example, the announced ceilings for repo agreements with Japan are US$1 billion each, so a country facing speculation would have to have at least US$ 1 billion in U.S. Treasury securities to reach that ceiling. As is well known, economies in the Asian Pacific Basin have foreign exchange reserves that are large in relation to the markets in their currencies.
As the transactions involve exchanges of U.S. dollar assets, these repo arrangements differ from the swap facilities used by industrialized countries, which involve the direct exchange of currencies. For example, if the Fed wants to intervene to influence the dollar-deutschemark exchange rate, it can swap dollars for deutschemarks with the Bundesbank, Germany’s central bank.
Consultations on exchange rate issues are common among the Group of Seven (G-7) industrial countries, and among European countries, but they represent a significant departure for the Asian Pacific Basin, where countries have traditionally adopted monetary and exchange rate policies without consulting their neighbors. One possible explanation for the change is that in the past policymakers in the Asian Pacific Basin were concerned largely with currency appreciation pressures. If necessary, these pressures can be eliminated by allowing the money supply to increase, a course of action entirely within the ability of an individual central bank. In contrast, responding to depreciation pressures may require the use of foreign exchange reserves, which central banks may prefer not to do. Cooperation among central banks in this case may be helpful in reassuring financial markets, which may help avert unwarranted speculative pressures.
In spite of this incentive for cooperation, there appear to be significant differences in how much each monetary authority in the Asian Pacific Basin tolerates currency depreciation, which can make it harder to determine what criteria to use in cooperating. To illustrate these differences, the figure shows the frequency of monthly exchange rate depreciation rates against the U.S. dollar exceeding 40 basis points (5% annualized) in selected East Asian economies, as well as in Australia and New Zealand, from January 1990 to December 1996. (Taiwan is included for completeness, although it is not participating in these initiatives.) In order to focus on temporary fluctuations, the average rate of change of the exchange rate over the entire sample period has been subtracted. These average changes vary considerably, ranging from appreciation of 2% to 4% (annualized) in Japan, New Zealand, and Singapore, to depreciation of 3% to 4% in the Philippines and Indonesia. The average change in the exchange rates of Australia, Hong Kong, and Thailand is zero.
The figure suggests that economies in the Asian Pacific Basin can be classified roughly into three groups. In one group, comprising Japan, Australia, and New Zealand, exchange rates are more flexible and “large” depreciations occur often, 40% to 45% of the time. In another group, comprising China, Hong Kong, and Indonesia, such depreciations occur rarely, between 6% and 12% of the time. The remaining economies are in a middle range where large depreciations occur 30% to 40% of the time, which indicates a relatively high tolerance for (temporary) depreciation. At the root of the differences illustrated in the figure are differences in the approach to monetary and exchange rate policy.
How will central banks in the Asian Pacific Basin cooperate in foreign exchange markets, given apparently large differences in the tolerance for currency depreciation? One possibility is that monetary authorities in the region will opt to follow the approach of the G-7 industrial countries, where intervention in foreign currency markets has been sporadic, designed mainly to respond to “disorderly markets,” whose emergence may be unpredictable. In line with this, the conditions under which G-7 intervention in foreign exchange markets occur are typically not spelled out in advance, at least not publicly. Similarly, Asia-Pacific central banks’ cooperation in foreign exchange markets might focus on episodes of particularly strong speculative pressure.
Alternatively, economies in the Asian Pacific Basin could follow the European model of cooperation, which is more tightly structured. Prior to speculative attacks in 1992-1993, intervention (and the credibility of such intervention) kept European exchange rates within a relatively tight band (2.25% from a central cross parity), although some flexibility was allowed by setting a wider band for some currencies. However, a key difference between Europe and the Asian Pacific Basin is that Europeans have sought to coordinate not just intervention in foreign exchange markets, but their exchange rate targets and their monetary policies as well. It is too early to say if central banks in the Asian Pacific Basin will consider such extensive coordination.
Opinions expressed in FRBSF Economic Letter 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. This publication is edited by Sam Zuckerman and Anita Todd. Permission to reprint must be obtained in writing.
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