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Asian currency zone beckons

by Mamoru Ishida

There is no doubt that the stable renminbi (RMB) exchange rate, pegged at about 8.25 yuan to the U.S. dollar, has helped China’s economic development. It has brought about enormous production capacity in the export industries. Meanwhile, the sharp increase in exports to the United States has prompted America to pressure China to revalue the RMB. Earlier this year, Zhou Xiaochuan, governor of the People’s Bank of China, said China planned to improve the mechanism for determining the RMB exchange rate.

Revaluing the RMB vis-a-vis the dollar could be like opening a Pandora’s box. As the U.S. trade deficit is unlikely to decline significantly, the U.S. could claim that any revaluation was inadequate and demand further revaluations, as it did with Japan. The market would respond, driving the RMB to fluctuate wildly at the sacrifice of China’s economic stability.

Alternatively, China could peg the RMB to a basket comprising the dollar, yen and euro. John Williamson of the Institute for International Economics proposes a respective dollar-yen-euro ratio of 35 to 40 percent, 30 to 35 percent and about 30 percent.

To the extent that fluctuations between the three currencies are offset, fluctuations of the effective exchange rate of the RMB would be reduced.

Some members of the Association of Southeast Asian Nations have already pegged their currencies to their own baskets including the yen and euro. China is reported to be studying a currency basket. If China and ASEAN countries move to a common basket regime, it could lead to a major change in the U.S. economy.

When the twin U.S. deficits kept increasing in the 1980s, Stephen Marris of the Institute for International Economics predicted that investors would one day refuse to lend to the U.S., causing a hard landing for the U.S. economy. That did not happen because the global capital market kept lending to the U.S.

Now, though, Japanese and Chinese monetary authorities have been financing a significant amount of the U.S. current-account deficits by buying dollars in the markets to prevent the yen and RMB from appreciating.

Two events could make further financing of the U.S. current-account deficits difficult: (1) It has already become possible for investors to shift their assets from the U.S. to the euro capital market; and (2) if China and ASEAN countries move to a basket currency regime, a certain portion of their foreign exchange reserves now invested mostly in dollar assets would shift to yen and euro assets.

Depending on the magnitude of such a shift, the supply of capital to finance U.S. current-account deficits would be reduced. That could signal the beginning of the U.S. becoming an ordinary country that cannot enjoy both economic prosperity and military power by piling up foreign liabilities.

Stephen Roach, chief economist at Morgan Stanley, has warned of vulnerability to the world economy, which depends on the U.S. economy, which in turn depends on ever-increasing foreign liabilities. The U.S. current-account deficits must be addressed. A sharp fall in the dollar is inevitable.

Growing Asia would be the only realistic candidate to take over the role of the world’s growth engine. Asia would have to depend less on exports to the U.S. and more on regional economic activities. A currency system to reduce exchange risks in trade and investment within Asia would be indispensable. China and ASEAN countries could mark the first step in forming such a system by adopting a joint currency basket.

China could explain to the U.S. that the basket regime would possess flexibility to reflect changing economic fundamentals as well as stability, and that a stable currency zone in Asia would be in the interests of the world economy. The higher the weight of the dollar in the basket, the easier it would be for the U.S. to accept it.

A good time to implement the reform would be when U.S. pressure and the market’s speculative waves had subsided as a result of China’s economic boom and worsened trade balance. One idea for an interim measure is to allow a wider trading band.

Asia is practically a dollar zone now, as most Asian countries peg their currencies mainly to the dollar. Japanese companies take yen-to-dollar exchange risks even in trade with Asian countries. They would welcome an Asian currency zone that would result in a more mild fluctuation vis-a-vis the yen. In 1998, then-Finance Minister Kiichi Miyazawa recommended a basket currency regime to Asian countries. It is natural for Japan to participate. If an unprepared Japan faces the sharp fall of the dollar predicted by Stephen Roach, it will risk experiencing another lost decade.

Asian political leaders and monetary authorities are speaking frequently of an Asian common currency. Malaysian Prime Minister Ahmad Badawi said in Tokyo that East Asian integration was not a wish but a reality, and that it was not premature to start studying regional currency integration.

Yu Yongding, director of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences, told a finance ministry’s meeting in Tokyo that the three major international currencies in the future would be the dollar, euro and an Asian common currency, and urged China and its neighbors to cooperate to realize it. Officials of The People’s Bank of China surprised visiting Japanese politicians by proposing a joint study of an Asian common currency. Obviously, Japan is not prepared.

Japan has a serious disadvantage. In Europe, the trust between German and French political leaders was crucially important in realizing the euro. Such trust does not exist between Chinese and Japanese leaders, as Japan has yet to come to terms with parts of its history.

Suppose an Asian currency zone with China but without Japan was formed. Its economic size would overwhelm Japan in time. According to the CIA’s Global Trend, Japan’s gross domestic product in 2015, measured by purchasing power parity, will be $4.5 trillion against China’s $12 trillion.

It is time for Japan to decide how to live in the community of Asian nations and how to participate in forming an Asian currency zone.