Edited by Koichi Hamada, Beate Reszat and Ulrich Volz
Chapter 10: Capital Markets and Exchange Rate Stabilization in East Asia: Diversifying Risk Based on Currency Baskets
Gunther Schnabl INTRODUCTION: MORE EXCHANGE RATE FLEXIBILITY IN EAST ASIA? 10.1 Before the Asian crisis of 1997–98, China, Hong Kong, Indonesia, Korea, Malaysia, the Philippines, Singapore, Taiwan, and Thailand pursued a common exchange rate peg to the US dollar. This (informal) East Asian dollar standard (McKinnon and Schnabl 2004a) was beneficial for growth in the region for several reasons. First, it ensured macroeconomic stability by bringing their domestic inflation to US levels. Second, the joint peg to the dollar provided low transaction costs not only for trade with the US but also for intra-regional trade flows, which make up about 50 percent of overall East Asian trade. Third, exchange rate stability provided low transaction costs for short-term and long-term international and intraregional capital flows. After the onset of the East Asian crisis, the East Asian dollar standard fell apart. While China, Hong Kong, Singapore, and Taiwan kept their exchange rates rather stable against the dollar during the crisis, the currencies of the crisis countries—Indonesia, Korea, Malaysia, the Philippines and Thailand—depreciated sharply against the dollar, and the depreciation of their currencies was accompanied by cumbersome recessions. The post-crisis policy recommendations for the exchange regimes in East Asia have been of diverse natures. Associating exchange rate stability against the dollar with overly low risk premia on volatile capital inflows, the IMF recommended more exchange rate flexibility (Fischer 2001). In contrast, McKinnon and Schnabl (2004a, 2004b) argued that exchange rate stabilization against the dollar is fully rational, even post-crisis, because...