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East Asia's Role in Resolving the New Global Imbalances

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If the world economy is to be rebalanced, East Asia will therefore have to play an important role in the adjustment process. As evidenced by the first East Asia Summit in Kuala Lumpur last December, countries in the region are committed to embracing further economic integration. This opening summit is an ideal venue to continue policy dialogue on exchange rate coordination, with a view to facilitating the resolution of current global imbalances and promoting further integration in East Asia.

Rising stock prices in the late 1990s and soaring housing prices in the early 2000s increased spending relative to income and reduced private saving as a share of GDP. Until 2001, fiscal policy had nothing to do with the decline in national saving in the US. This contributed to a 17% decline in the real value of the dollar between the first quarter of 2002 and the fourth quarter of 2004.

However, as we saw in the 1970s, inflation can be devastating to financial markets and the macroeconomy. In the case of China, net inflows of foreign direct investment averaged almost $50 billion between 2001 and 2004, almost twice as large as the average current account surplus. Due to large current account surpluses or large basic balance surpluses, the region's foreign exchange reserves are now significant as a result of heavy interventions in the foreign exchange market.

Ceteris paribus, the accumulation of foreign reserves increases base money and thus creates excess liquidity in the banking system.

Resolving the New Global Imbalances

This would be dangerous for countries with fixed exchange rate regimes because it could undermine the autonomy and effectiveness of monetary policy. This point is reinforced by Figure 2, which shows the real effective exchange rate of the dollar. There may therefore be a role for policy coordination in the next exchange rate realignment in East Asia.

Along with an appreciation in the exchange rate level, it is necessary to consider appropriate exchange rate regimes for countries in the region. As Ito and Ogawa (2005) discuss, there are currently a variety of exchange rate regimes in East Asia. This would undermine the effectiveness of monetary policy for countries that have fixed exchange rate regimes.

He argued that focusing on a basket of currencies would help stabilize the real effective exchange rate. He also claimed that the use of an exchange rate band would be appropriate because of the uncertainty about the value of the underlying equilibrium exchange rate, as well as allowing some flexibility in the face of volatile capital movements. They presented a model where countries seek an exchange rate regime that minimizes current account fluctuations.

Thus, coordination can help overcome the inertia in the choice of an exchange rate regime for the region and lead to a superior Nash equilibrium. Using a common currency basket with common weights for each currency would help ensure that intra-regional exchange rates remain constant in the face of extra-regional exchange rate changes. It is also questionable whether the institutional infrastructure of the region's countries is sufficiently strong to withstand the effects of extreme exchange rate volatility, unless broad bands around the yen reference rate exist.

The AMU can provide monetary authorities in the region with a benchmark to refer to when the exchange rate of a particular currency appears to be out of line, thereby inviting coordination in monetary and exchange rate policies. As Ito (2005) and Williamson (2005) discuss, there are still many unanswered questions about how to coordinate necessary changes in exchange rate regimes in East Asia. A realignment of exchange rate levels may later be followed by a composition of exchange rate regimes in the region.

A regional secretariat would also be better suited to developing the necessary monitoring mechanisms in the context of exchange rate coordination policies aimed at stabilizing mutual exchange rates between East Asian economies. The upcoming East Asia Summit in Kuala Lumpur could be an appropriate place to start discussing whether a regional forum should be established to facilitate cooperation and coordination on exchange rate policy.

Concluding Remarks

This coordination could first involve an appreciation of the exchange rate level and perhaps later a harmonization of exchange rate regimes. These include the correct reference rate, the width of the band and the currencies to include in the basket. Coordinating exchange rate policies could help resolve global imbalances, minimize the deflationary impact of exchange rate appreciation in East Asia, and maintain production and distribution networks in the region.

Obstfeld, M., and Rogoff, K., 2005a, “Global Current Account Imbalances and Exchange Rate Adjustments,” Brookings Papers on Economic Activity. Ogawa, E., and Shimizu, J., 2005, A deviation measure for coordinated exchange rate policy in East Asia, RIETI Discussion Paper Series 05-E-07. Capital Account Liberalization and Exchange Rate Flexibility in China, International Monetary Fund Policy Discussion Paper PDP/05/01, (International Monetary Fund,.

The parameters φ2 and φ5 can be used to test whether the exchange rate is weakly exogenous. The hypothesis that the exchange rate is weakly exogenous is equivalent to the hypothesis that the coefficients φ2 and φ5 are equal to zero. He reported that the real exchange rate was weakly exogenous in many of the specifications.

He also found evidence of statistically significant long-run price and income elasticities, as summarized in the text. In economic gravity models, bilateral trade between two countries is directly proportional to the gross domestic product in both countries and inversely proportional to the distance between them. Global distribution of current account surpluses (net capital exports) and current account deficits (net capital imports) by region and country, 2003. As a percentage of world total current account surpluses or deficits).

1: As measured by countries' current account surpluses (assuming errors and omissions are part of the capital and financial accounts). Note: The exchange rate is the Federal Reserve Board's trade-weighted real exchange rate, deflated using PPIs. Current account deficit, net private capital flows, and the real effective exchange rate of the dollar, 1997–2004.

The exchange rate is the real aggregate exchange rate weighted by the Federal Reserve Board, deflated using the PPI. The current account is measured so that a larger positive number represents an increase in the deficit.

Figure 1. Global Distribution of Current Account Surpluses (Net Capital Exports) and  Current Account Deficits (Net Capital Imports) by Region and Country, 2003
Figure 1. Global Distribution of Current Account Surpluses (Net Capital Exports) and Current Account Deficits (Net Capital Imports) by Region and Country, 2003

Figure 1. Global Distribution of Current Account Surpluses (Net Capital Exports) and  Current Account Deficits (Net Capital Imports) by Region and Country, 2003
Figure 2. U.S. Investment, National Saving, Budget Deficit, and Current Account Deficit
Figure 3.  Current Account Deficit, Net Private Capital Flows, and the Real Effective Exchange Rate of the Dollar, 1997-2004
Figure 5. U.S. Current Account Deficit , Net Private
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