Before the financial crisis, a number of east Asian economies managed their exchange rates with the aim of stabilising the value of their currency against a basket of key major currencies, but overwhelmingly the US dollar (Frankel and Wei 1994). This suited these economies in the first half of the 1990s as the yen appreciated against the dollar, diverting trade and investment their way and stimulating economic growth. But as the dollar appreciated against the yen from 1995, these countries lost competitiveness relative to Japan and Europe, and their trading positions deteriorated, leaving them vulnerable to changes in investor sentiment. This experience has been taken to show the folly of a country tying its currency to that of only one of its several major trading partners: so long as the major currencies move by large amounts against each other, a country which exports to all the major economies but targets stability only in its exchange rate with one major currency will experience variability in its effective exchange rate and its bilateral exchange rates with the other major currencies. At the same time, trade within east Asia has become steadily more important to countries in the region. To the degree that the weights in an effective exchange rate target differ between countries, intra-regional exchange rates will also vary as the major currencies vary between themselves. These two factors have led commentators, such as Williamson (1999), Dornbusch and Park (1999), Murase (2000) and others, to advocate a common-basket exchange rate peg for the east Asian region, or some subset of it. They argue that countries can expect to stabilise overall trade competitiveness by targeting such a peg. They also argue that countries can eliminate intra-regional exchange rate variability by adopting common weights in the basket peg: regional currencies move together so intra-regional competitiveness is unchanged. This proposal seems to have engaged some interest at official levels in the region, especially in Japan (Council on Foreign Exchange and Other Transactions 1999; Sakakibara 1999; Kuroda 2000). This paper looks at some of the issues related to whether a formal common-basket exchange rate peg would be appropriate for east Asia. It first summarises the current debate about common currency arrangements in the region. It then summarises the conceptual arguments for a common-basket exchange rate peg and assesses them with reference to a range of factors. Two are specific to the proposal. The first examines the degree to which trade patterns vary between countries in the region, to see whether particular countries would be disadvantaged relative to their neighbours under a common-basket peg. The other looks at the similarity of exports of countries within the region with those of their neighbours and the major economies. The argument for pegging to a common basket is less strong if the exports of countries within the region are more similar to those of the major economies than their regional neighbours. A range of other factors is also relevant to assessing the likely robustness of a common-basket peg exchange rate regime. A common-basket peg would entail a change in exchange rate regime, and it is necessary to show that a peg would be superior to the current regime — floating exchange rates — to which decision makers have already adapted. Advocacy of a shift to a common-basket peg presumes that exchange rate volatility adversely affects trade and economic performance, and evidence on this for east Asia is examined. Pegging may also affect the adjustment of the real exchange rate, specifically whether it occurs through the nominal exchange rate or changes in the price level. The robustness of a regional exchange rate system depends not only on whether individual country’s economic structures are similar, but also whether they pursue common policies and are subject to common internal and external shocks. This is assessed by identifying common factors and long-run or cointegrating relationships in regional real effective exchange rates. Robustness of a regime also depends on a range of political factors — whether the regime complements or conflicts with domestic policy objectives, whether countries are prepared to make substantive policy decisions collectively rather than preserve policy independence, and whether such a policy suits their strategic interests in the region. To the extent that outcomes under a common-basket peg conflict with national economic and policy interests, the system will be vulnerable to speculative attack. Accordingly, strong political commitment is essential. The arguments are summarised in the conclusion.
