Exchange Rate Cooperation in East Asia – Why a Basket Approach may be best

In the aftermath of the Asian financial crisis, the issue of the choice of exchange rate regime for East Asian (EA) countries re-emerged. The crisis had demonstrated, amongst other things, that unilateral exchange rate regimes (including de facto dollar pegging) hadnt coped very well in the 1990s faced with massive capital inflows into the region (Kwan et al., 1998), with the possible exceptions of Singapore and Taiwan. The immediate response to the crisis was that a corner solution might be better. Either keep convertibility and fix the currency, preferably backed up with a currency board, but abandon monetary independence; or keep monetary policy and convertibility but abandon currency management and adopt a free float. But a hard peg is perceived to be too rigid for most countries in EA and the potential costs of a clean float are seen to be too great for emerging economies with weak financial infrastructure because of the risks of serious currency misalignment and destabilising speculation. The objective of this paper is to address some of these counterfactuals by looking at the impact of alternative exchange rate regimes on the volatility of the NEER and the bilateral rate against the US$ for nine EA countries after the Asian financial crisis. 9 Our counterfactuals include a UBP, a CBP, and a hard peg against the US$, but in contrast to previous counterfactual exercises, such as Williamson (1998a) and Ohno (1999) which compute the weights for effective exchange rates on the basis of simple bloc aggregates, we apply a more disaggregated methodology using a larger number of trade partners. We also utilize ARCH/GARCH techniques to obtain estimates of heteroskedastic variances to better capture the time-varying characteristics of volatility for the actual and simulated exchange rate regimes.