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The views expressed in this presentation are the views of the author and do not necessarily reflect the views or policies of the Asian Development Bank Institute (ADBI), the Asian Development Bank (ADB), its Board of Directors, or the governments they represent. ADBI does not guarantee the accuracy of the data included in this paper and accepts no responsibility for any consequences of their use. Terminology used may not necessarily be consistent with ADB official terms.

Dynamic Transition of Exchange Rate Regime in PRC and Its Influence on East Asian Countries’ Exchange Rate Policies

Naoyuki Yoshino, Sahoko Kaji and Tamon Asonuma ADBI, Keio University, and IMF SPR

October 2014

* This does not reflect any views of the ADBI or IMF.

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Motivation

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1, De facto dollar-peg regime in PRC and Malaysia until July 2005 - Basket-peg regime in Singapore (with a high weight on the US$) 2, Change in exchange rate policy in PRC in July 2005 - De facto “managed floating” regime - a trend of appreciation against the US$ since July 2005 - a substantial reduction on a basket weight on the US$ (from 1.0 to 0.814) 3, Malaysian ringgit and Singapore dollar followed a trend of appreciation against the US$.

Main Questions

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4, Is PRC better off shifting towards a basket-peg or a floating regime over the medium term? - How? – a gradual shift or a sudden shift 5, Given PRC’s shift in exchange rate regime, are East Asian countries (Malaysia and Singapore) better off shifting towards a basket-peg or a floating regime over the medium term? 5-1 How? - a gradual or a sudden shift 5-2, When? - before, during, or after PRC’s transition period.

Literature Review

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• Desirability of a basket-peg regime in East Asia - Ito et al. (1998), Ito and Ogawa (2002), Kawai (2002), Yoshino et al.

(2004) • Desirability of a floating (managed) regime in East Asia. - Adams and Semblat (2004), • Exchange rate regime in E.A. with PRC’s transition - Shioji (2006), Gochoco-Bautista and Fabella (2006), Volz (2014),

Henning (2012). • Dynamic analysis in shift in exchange rate regime. - Yoshino et al. (2014)

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Chinese Exchange Rate (RMB) Fluctuations

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6.0

6.5

7.0

7.5

8.0

8.5

Renminbi per US dollar

Period 1 -2003M1-2005M6

Period 2 -2005M7-2008M6

Period 3 -2008M7-2010M5

Period 4 -2010M6-2012M5

Sources: IMF IFS.

PRC

PRC

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Quantitative analysis

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• Cumulative losses : T0=0, T1=18, & T2=18

Policy Implications

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1, For a country like PRC, gradually adjusting to a basket peg regime is superior to the other proposed transition policies. - Advantage : it can minimize the negative influence of both

interest rates and exchange rates on output 2,A sudden shift to a basket peg is the second best solution, and is superior to a sudden shift to floating.

- Drawback : a lack of control over the negative influence of

interest rates and exchange rates during the shift.

- Advantage : it can still assign optimal weights to currencies to stabilize output fluctuations once it has adopted a basket peg regime.

1 Chinese Exchange Rate (RMB) Dollar Peg Imbalance in Current Account Stability of Employment Central Bank Private banks ----------------------- -----――――――― US $ RMB Reserves Deposits Euro (Cash) Loans Gov.Bonds (Reserves) 2, Bubble Bank loans to real estate and housing 16

18

0

200

400

600

800

1000

1200

1400

1600

2001年 2002年 2003年 2004年 2005年 2006年 2007年 2008年 2009年 2010年 2011年 2012年

PRC GDP, Bank Loan, and Real estate Loan

GDP指数（2000年）

LOAN指数（2000年）

不動産ローン指数

（2000年）

Real estate Loans

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「Bank Credit to Housing / GDP」Ratio

0.6

0.8

1.0

1.2

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

0.3

0.4

0.5

0.6

0.7

Japan

USA

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Japanese Housing Price/National Income

21

US Housing Price/Income

Micro behavior of bank and aggregated macro effect

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Japan’s Bubble (1986 – 1990) U.S. Bubble (2002 – 2006)

Japan’s post bubble (1991 – 2001) U.S. post bubble (2007 – 2010)

Individual bank loan

Aggregated bank loans

Influences on Exchange Rate Policies in E.A. Countries

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(2) Dynamic Adjustment to the Basket-peg or Floating in East Asian Countries after China’s Transition in Exchange Rate Regime

forthcoming as ADBI Working Paper

Motivation

24 Sources: IMF IFS.

Macroeconomic Model (cont.)

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PRC

Annex: Macroeconomic Model

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• Small open economy model with three exogenous countries

- following Clarida, Gali, and Gertler (2002) - optimization behaviors of consumers/firms - firms serving domestic markets and foreign markets (FCP) use

imported intermediate goods. • Transition of foreign country (PRC) - exogenous - gradual adjustment of basket weight and degree of capital control

(Yoshino, et al. 2014) • Five exogenous shocks in the economy - foreign real interest rate shocks (PRC, Japan and the US). - PRC’s risk premium shock / oil price shock

Annex: Macroeconomic Model (cont.) • IS

• AS

• Labor market clearing

Annex: Macroeconomic Model (cont.) • LM

• Interest Parity Condition (JP & US assets) • Interest Parity Condition (Chinese assets)

• Loss Function

Key Mechanism of Macroeconomic Model • Interest Parity Condition for PRC

- - expected risk premium • Exchange Rate and Basket Equation (1) Dollar peg (2) Basket peg

Transition Policies

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PRC

Transition Policies (cont.)

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Transition Policies (cont.)

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PRC’s

PRC’s

PRC’s

PRC’s

PRC

PRC

Quantitative analysis

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• Data : Malaysia and Singapore 2000Q1-2012Q4 and IMF IFS/DOT • Cumulative Losses • PRC’s optimal transition

policy (Yoshino et al. 2014) - gradual adjustment of weight (to 0.58) - gradual removal of capital control.

PRC

Quantitative analysis (cont.) - Smaller impacts on output gap due to Japan and US real interest rate shocks under a basket peg (advantage of weights not fixed at 1)

PRC

PRC

PRC

PRC

Quantitative analysis (cont.) - Positive impacts (though smaller) on output gap due to both Japan and US real interest rate shocks under a floating regime.

PRC

PRC

Quantitative analysis (cont.)

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(1) Malaysia

(2) Singapore Policy (1) Policy (2) Policy (3) Policy (4) Policy (5) Policy (6)

Stable regime Dollar peg Basket peg Basket peg Basket peg Floating FloatingAdjustment - Gradual Sudden Sudden Sudden SuddenBasket weight 1.00 0.67 0.9 0.85 - -Cumulative loss (%) 45.60 45.56 45.64 45.61 60.51 64.18

Sources: Authors’ calculations

Sources: Authors’ calculations

Policy (1) Policy (2) Policy (3) Policy (4) Policy (5) Policy (6)Stable regime Dollar peg Basket peg Basket peg Basket peg Floating FloatingAdjustment - Gradual Sudden Sudden Sudden SuddenBasket weight 1.00 0.40 0.54 0.45 - -Cumulative loss (%) 17.51 17.35 17.46 17.46 24.31 25.93

Conclusion

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• East Asian countries (Malaysia and Singapore) better off departing from the current dollar peg regime to a basket peg.

• Gradual adjustment towards a basket peg (during PRC’s transition) is

the most desirable for E.A. countries as they could minimize the negative influence of shocks during the transition.

• A sudden shift to a basket peg (before/after PRC’s transition) remains as the second best solution for Malaysia, but not for Singapore.

• A sudden shift to a floating (before/after PRC’s shift) results in higher cumulative losses than maintaining the current dollar peg for both Malaysia and Singapore since volatile exchange rate fluctuations lead to higher output gap/inflation rates.