The Return to Soft Dollar Pegging in East AsiaMitigating Conflicted

Virtue

Ronald McKinnon and Gunther Schnabl Stanford University Tübingen University

October 2004

The Exchange Rate Debate in the 1990sBefore 1997, East Asian countries, except for Japan, “softly” pegged

their exchange rates to the U.S. dollar.

1997-98 Crisis: Thailand, Indonesia, Philippines, Korea, and Malaysia are attacked and devalue—with bankruptcies and economic downturns spreading contagiously.

The IMF blames the soft pegging for encouraging over borrowing and current account deficits leading unsustainable dollar and yen debts. It warns against any return to dollar pegging.

Williamson (2000), Kawai (2002), Ogawa and Ito (2002)—suggest weighting the Japanese yen more heavily in the currency baskets of the smaller East Asian economies in the face of wide fluctuations in the yen/dollar rate.

The Debate In the New MillenniumBy 2004, the East Asian “crisis” and non crisis economies had returned

to soft dollar pegging. China and Hong Kong retained hard pegs through the crisis, and Malaysia pegged in Sept 1998 at 3.8 ringgit per dollar. Even the yen/dollar rate is more stable.

But now all East Asian countries run large current account surpluses—even with net inflows of FDI (China). Only massive foreign official interventions kept their exchange rates from appreciating in 2003 and early 2004

Influential articles by Dooley, Folkerts-Landau, and Garber (2003)-(2004) argue that East Asian countries on the dollar’s “periphery” are deliberately undervaluing their currencies to stimulate exports to the U.S. at the “center” to promote development.

Intensified pressure from the IMF, the G-7, and the U.S. Treasury, for China to appreciate: “There should be more flexible currencies, not only for China but the whole of Asia” Rodrigo de Rato, IMF Managing Director, 29 Sept 2004 at IMF-World Bank Meetings in Washington.

This Paper and McKinnon Book (2005) The Case for Asian Dollar Pegs

East Asian economies Have sufficient fiscal and monetary control to

target exchange rates, but have more difficulty targeting domestic inflation independently.

Are becoming highly integrated economically with more than 50% of trade with each other. They need stable cross rates of exchange.

Debtor countries have “original sin” and creditors have “conflicted virtue” making foreign exchange risks more difficult to hedge.

The Rise of Intra Regional Trade in East Asia, 1980-2002 (share of total exports)

Exports

0

10

20

30

40

50

Intra East Asia United States Rest of the World

Perc

enta

ge

1980

1990

2002

East Asia: China, Hong Kong, Indonesia, Japan, Korea, Malaysia, Philippines, Singapore, Taiwan, and Thailand

The Rise of Intra Regional Trade in East Asia, 1980-2002 (share of total imports)

Imports

0

10

20

30

40

50

60

Intra East Asia United States Rest of the World

Pe

rce

nta

ge

1980

1990

2002

East Asia: China, Hong Kong, Indonesia, Japan, Korea, Malaysia, Philippines, Singapore, Taiwan, and Thailand

Figure 1: East Asian Exchange Rate Pegs against the Dollar, 1980:01-2004:04 (Monthly)

Taiwan DollarSingapore Dollar

Hong Kong DollarChinese Yuan

0

100

200

300

400

500

600

700

800

1980.011983.011986.011989.011992.011995.011998.012001.012004.01

0

100

200

300

400

500

600

700

800

0

100

200

300

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500

600

700

800

1980.011983.011986.011989.011992.011995.011998.012001.012004.01

0

100

200

300

400

500

600

700

800

1980.011983.011986.011989.011992.011995.011998.012001.012004.01

Figure 1 (Continued) Crisis Economies, 1980:01-2004:04 (Monthly)

Thai BahtPhilippine Peso

Malaysian RinggitKorean WonIndonesian Rupiah

0

500

1000

1500

2000

2500

1980.011983.011986.011989.011992.011995.011998.012001.012004.010

100

200

300

400

500

600

700

800

1980.011983.011986.011989.011992.011995.011998.012001.012004.01

0

100

200

300

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500

600

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1980.011983.011986.011989.011992.011995.011998.012001.012004.01

0

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600

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800

1980.011983.011986.011989.011992.011995.011998.012001.012004.010

100

200

300

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500

600

700

800

1980.011983.011986.011989.011992.011995.011998.012001.012004.01

Frankel and Wei Regression (1994)

Problem: For any one East Asian currency other than Japan, how do you measure the weight of each major currency—the dollar, yen, or euro—in its currency “basket”?

Answer: Choose an outside currency as numeraire, e.g., the Swiss Franc, to measure all exchange rates in the above regression.

trancMarkSwissfancYenSwissfrsfrancDollarSwis

ssfrancurrencySwiEastAsianc

ueee

e

ttt

t

4321

Figure 2: Dollar’s Weight in East Asian Currency Baskets, 130-Trading-Day Rolling Regressions, 1990:01-2004:05 (Daily)

Taiwan DollarSingapore Dollar

Hong Kong DollarChinese Yuan

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

01.01.1990 01.01.1993 01.01.1996 01.01.1999 01.01.2002

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

01.01.1990 01.01.1993 01.01.1996 01.01.1999 01.01.2002

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

01.01.1990 01.01.1993 01.01.1996 01.01.1999 01.01.20020.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

01.01.1990 01.01.1993 01.01.1996 01.01.1999 01.01.2002

Figure 2 (Continued), Dollar’s Weight in East Asian Currency Baskets Crisis Economy, 1990:01-2004:05 (Daily)

 

Thai BahtPhilippine Peso

Malaysian RinggitKorean WonIndonesian Rupiah

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

01.01.1990 01.01.1993 01.01.1996 01.01.1999 01.01.2002

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

01.01.1990 01.01.1993 01.01.1996 01.01.1999 01.01.20020.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

01.01.1990 01.01.1993 01.01.1996 01.01.1999 01.01.2002

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

01.01.1990 01.01.1993 01.01.1996 01.01.1999 01.01.2002

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

01.01.1990 01.01.1993 01.01.1996 01.01.1999 01.01.2002

Figure 3: Exchange Rate Volatility against the US Dollar of Selected Crisis and Non-Crisis Currencies, 1990:01-2004:05 (Daily)

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

01.01.1990 01.01.1993 01.01.1996 01.01.1999 01.01.2002

Japanese YenPhilippine PesoMalaysian Ringgit

Thai BahtHong Kong DollarChinese Yuan

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

01.01.1990 01.01.1993 01.01.1996 01.01.1999 01.01.2002

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

01.01.1990 01.01.1993 01.01.1996 01.01.1999 01.01.2002

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

01.01.1990 01.01.1993 01.01.1996 01.01.1999 01.01.2002-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

01.01.1990 01.01.1993 01.01.1996 01.01.1999 01.01.2002-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

01.01.1990 01.01.1993 01.01.1996 01.01.1999 01.01.2002

Figure 3 (Continued), Exchange Rate Volatility against the US Dollar, 1990:01-2004:05 (Daily)

Swiss FrancNew Taiwan DollarSingapore Dollar

Euro (German Mark)Korean WonIndonesian Rupiah

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

01.01.1990 01.01.1993 01.01.1996 01.01.1999 01.01.2002

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

01.01.1990 01.01.1993 01.01.1996 01.01.1999 01.01.2002

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

01.01.1990 01.01.1993 01.01.1996 01.01.1999 01.01.2002

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

01.01.1990 01.01.1993 01.01.1996 01.01.1999 01.01.2002

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

01.01.1990 01.01.1993 01.01.1996 01.01.1999 01.01.2002-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

01.01.1990 01.01.1993 01.01.1996 01.01.1999 01.01.2002

Table 1: Standard Deviations of Daily Exchange Rate Fluctuations against the Dollar

Pre-crisis Crisis Post-crisis 2003/2004

Chinese Yuan 0.03 0.01 0.00 0.00

Hong Kong Dollar 0.02 0.03 0.03 0.05

Indonesian Rupiah 0.17 4.43 1.11 0.43

Korean Won 0.22 2.35 0.43 0.43

Malaysian Ringgit 0.25 1.53 0.00 0.00

Philippine Peso 0.37 1.31 0.51 0.25

Singapore Dollar 0.20 0.75 0.27 0.29

New Taiwan Dollar 0.19 0.50 0.21 0.20

Thai Baht 0.21 1.55 0.38 0.27

Japanese Yen 0.67 1.00 0.64 0.57

Euro (Deutsche Mark) 0.60 0.58 0.64 0.64

Swiss Franc 0.69 0.66 0.66 0.70

Data source: Datastream. Percent changes. Pre-crisis = 02/01/94 – 05/30/97, crisis = 06/01/97 – 12/31/98, post-crisis = 01/01/99 – 05/17/04, 2003/2004 = 01/01/03 – 05/17/04.

Table 2: Standard Deviations of Monthly Exchange Rate Fluctuations against the Dollar

Data source: IMF: IFS.

Pre-crisis Crisis Post-crisis

Chinese Yuan 0.25 0.03 0.00

Hong Kong Dollar 0.08 0.07 0.11

Indonesian Rupiah 0.26 26.54 5.16

Korean Won 1.01 11.53 1.92

Malaysian Ringgit 1.06 6.69 0.00

Philippine Peso 1.19 5.25 1.67

Singapore Dollar 0.76 2.88 1.18

New Taiwan Dollar 1.01 2.63 1.35

Thai Baht 0.43 8.88 1.60

Japanese Yen 3.66 3.64 2.39

Euro (Deutsche Mark) 2.20 2.33 2.58

Swiss Franc 2.62 2.60 2.54

Figure 4: Exchange Rate Changes against the US dollar 1999:01-2001:12

0.00% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00% 35.00% 40.00%

Chinese Yuan

Hong Kong Dollar

Indonesian Rupiah

Korean Won

Malaysian Ringgit

Philippine Peso

Singapore Dollar

New Taiwan Dollar

Thai Baht

Japanese Yen

Euro

Swiss Franc

depreciation

Data source: IMF: IFS.

Figure 5: Exchange Rate Changes against the US dollar 2002:01-2004:04-30.00% -25.00% -20.00% -15.00% -10.00% -5.00% 0.00% 5.00% 10.00% 15.00%

Chinese Yuan

Hong Kong Dollar

Indonesian Rupiah

Korean Won

Malaysian Ringgit

Philippine Peso

Singapore Dollar

New Taiwan Dollar

Thai Baht

Japanese Yen

Euro

Swiss Franc

appreciation

Data source: IMF: IFS.

Figure 6: Official Foreign Exchange Reserves of Crisis and Non-Crisis Countries in Millions of Dollars,

1980:01-2004:04 (Monthly)

GermanyPhilippinesMalaysia

ThailandHong Kong China

0

40000

80000

120000

160000

200000

240000

280000

1980:01 1984:01 1988:01 1992:01 1996:01 2000:010

20000

40000

60000

80000

100000

120000

1980:01 1984:01 1988:01 1992:01 1996:01 2000:01

0

5000

10000

15000

20000

25000

30000

35000

40000

1980:01 1984:01 1988:01 1992:01 1996:01 2000:01

0

5000

10000

15000

20000

25000

30000

35000

40000

1980:01 1984:01 1988:01 1992:01 1996:01 2000:01

0

2000

4000

6000

8000

10000

12000

14000

16000

1980:01 1984:01 1988:01 1992:01 1996:01 2000:01

0

20000

40000

60000

80000

100000

120000

1980:01 1984:01 1988:01 1992:01 1996:01 2000:01

Figure 6 (Continued), Official Foreign Exchange Reserves, 1980:01-2004:04 (Monthly)

USTaiwan Singapore

JapanKoreaIndonesia

0

4000

8000

12000

16000

20000

24000

28000

32000

1980:01 1984:01 1988:01 1992:01 1996:01 2000:01

0100002000030000400005000060000700008000090000

100000110000120000130000

1980:01 1984:01 1988:01 1992:01 1996:01 2000:01

0

50000

100000

150000

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250000

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350000

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1980:01 1984:01 1988:01 1992:01 1996:01 2000:01

0

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70000

80000

90000

1980:01 1984:01 1988:01 1992:01 1996:01 2000:01

0

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180000

1980:01 1984:01 1988:01 1992:01 1996:01 2000:01

0

10000

20000

30000

40000

50000

60000

1980:01 1984:01 1988:01 1992:01 1996:01 2000:01

Dollar dominance in East Asia

Original sin Underdeveloped domestic bond market or in some cases

developed domestic bond market (India) Debtors cannot borrow in own currency nor can they hedge

their net dollar indebtedness. Currency mismatch and maturity mismatch.

[Eichengreen and Hausmann 1999, Hausmann and Panizza 2003]

Conflicted virtue Creditors cannot lend in their own currencies nor can they

hedge their net dollar assets. Currency mismatch but no necessary maturity mismatch

[McKinnon and Schnabl 2004, McKinnon 2005]

Conflicted virtue

High-saving countries lend to foreigners in the form of current account surpluses. However, as the stock of dollar claims cumulates: Foreigners start complaining that the country’s ongoing

flow of trade surpluses is unfair and the result of having an undervalued currency.

Domestic holders of dollar assets worry more about a self-sustaining run into the domestic currency forcing an appreciation.

Conflicted virtue: To appreciate or not to appreciate

As runs into the domestic currency out of dollars begin, the government is “conflicted” because (repetitive) appreciation could set in train serious deflation ending with a zero interest liquidity trap (Japan)

But failure to appreciate could elicit trade sanctions from foreigners.

A “free” float becomes an indefinite upward spiral

The story of Japan (I)

There were repetitive appreciations of yen from 1970s to mid-’90s under mercantile pressure from trade partners―particularly the United States, but trade surpluses continued to cumulate.

Reason: Exchange rate changes only determine domestic

inflation or deflation, not trade balance. The simple-minded elasticities approach is invalid in financially open economies. [McKinnon and Ohno 1997]

Do exchange rate changes necessarily bring BoP balance?

Elasticity model BoP balance through current

account changes if Marshall-Lerner condition holds.

McKinnon and Ohno in Dollar and Yen (1997): Inflationary/deflationary pressure

only. Indeterminate CA effect in the

short term because of domestic absorption effect.

The story of Japan (II)

Negative risk premium [Goyal and McKinnon 2003]

To maintain portfolio balance, Japanese financial institutions demand a higher return on dollars (which is riskier given the volatility in exchange rate).

The internationally determined dollar asset return thus pushes down the yen interest rate. It finally forced Japan into the the zero interest liquidity trap by the end of 1996.

Is China like Japan? China has a big advantage over Japan:

The RMB exchange rate has been and can be more credibly maintained at the current level without disturbing domestic price level.

And a disadvantage: China’s net FDI inflows are much larger than

Japan’s. FDI can be seen as illiquid liabilities but imposes liquid dollar claims.

Table 3: East Asian Current Accounts in Comparison to the U.S., 1990-2003

  1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Percent of GDP

Japan 1.5 2.0 3.0 3.0 2.7 2.1 1.4 2.3 3.0 2.6 2.5 2.1 2.8 3.2

Singapore 8.5 11.3 11.9 7.2 16.2 17.7 15.2 15.6 22.6 18.6 14.5 19.0 21.5 30.9

Taiwan 7.0 7.1 4.1 3.1 2.7 2.1 3.9 2.4 1.3 2.8 2.9 6.4 9.1 10.0

Indonesia -2.6 -3.3 -2.0 -1.3 -1.6 -3.2 -3.4 -2.3 4.3 4.1 5.3 4.9 4.5 3.9

Korea -0.8 -2.8 -1.3 0.3 -1.0 -1.7 -4.4 -1.7 12.7 6.0 2.7 1.9 1.3 2.0

Malaysia -2.0 -8.5 -3.7 -4.5 -6.1 -9.7 -4.4 -5.9 13.2 15.9 9.4 8.3 7.6 11.1

Philippines -6.1 -2.3 -1.9 -5.6 -4.6 -2.7 -4.8 -5.3 2.4 9.5 8.2 1.8 5.4 2.1

Thailand -8.5 -7.7 -5.7 -5.1 -5.6 -8.1 -8.1 -2.0 12.7 10.1 7.6 5.4 6.1 5.6

China 3.1 3.3 1.4 0.0 1.3 0.2 0.9 4.1 3.3 2.1 1.9 1.5 2.9 2.1

Hong Kong               1.5 6.4 4.3 6.1 8.5 11.0

United States -1.4 0.1 -0.8 -1.2 -1.7 -1.4 -1.5 -1.5 -2.3 -3.1 -4.2 -3.9 -4.6 -4.9

Billions of US Dollars

Total East Asia 54.5 73.8 117.5 117.8 132.9 93.8 44.2 129.4 244.5 231.7 213.7 179.1 238.9 255.2

Total US -79.0 3.7 -48.0 -82.0-

117.7-

105.2-

117.2-

127.7-

204.7-

290.9-

411.5-

393.7-

480.9-

541.8

Data source: IMF: IFS.

Figure 7: International Investment Position of Japan (Billions of Dollars)

-200

0

200

400

600

800

1000

1200

1400

1600

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002

billi

ons

of d

olla

rs

total

public

private

Source: Japan: Ministry of Finance.

Figure 8: Interest Rates in the US and Japan, Long-Term: 10-Year US Treasuries and JGBs, 1980-2004

0

2

4

6

8

10

12

14

16

1980M1 1983M1 1986M1 1989M1 1992M1 1995M1 1998M1 2001M1 2004M1

perc

ent p

er a

nnum

Japan

US

Figure 8: Interest Rates in the US and Japan, Short-Term: Money Market Rates , 1980-2004

0

2

4

6

8

10

12

14

16

18

20

1980M1 1983M1 1986M1 1989M1 1992M1 1995M1 1998M1 2001M1 2004M1

perc

ent p

er a

nnum

Japan (call money rate)

US (federal funds rate)

Implications for Interest Rates: The Negative Risk Premium To sustain the interest differential between yen and dollar

assets, consider an augmented interest parity relationship:

i = i* + se + where i is the (endogenously determined) Japanese long-

term nominal interest rate, i* is the (exogenously given) US long-term nominal interest rate, s is the yen price of one dollar, se is expected depreciation of the yen, and is the risk premium on yen assets.

From the 70s to the mid 90s, the interest differential, i – i*, was driven primarily by the negative se term when the erratically appreciating yen peaked out in April 1995. Since the mid-90s, se 0 and the interest differential has been driven primarily by the term, which is also negative (Goyal and McKinnon 2003).

Figure 9: Money Market Interest Rates 1990:01-2004:01 (Monthly)

TaiwanSingapore

Hong Kong China (Bank Rate)

0

2

4

6

8

10

12

1990M1 1992M1 1994M1 1996M1 1998M1 2000M1 2002M1 2004M1

China

United States

0

2

4

6

8

10

12

14

16

1990M1 1992M1 1994M1 1996M1 1998M1 2000M1 2002M1 2004M1

Hong Kong

United States

0

1

2

3

4

5

6

7

8

9

10

1990M1 1992M1 1994M1 1996M1 1998M1 2000M1 2002M1 2004M1

Singapore

United States

0

2

4

6

8

10

12

14

1990M1 1992M1 1994M1 1996M1 1998M1 2000M1 2002M1 2004M1

Taiwan

United States

Figure 9 (Continued), Money Market Interest Rates 1990:01-2004:01 (Monthly)

 

ThailandPhilippines

MalaysiaKoreaIndonesia

0

10

20

30

40

50

60

70

80

90

1990M1 1992M1 1994M1 1996M1 1998M1 2000M1 2002M1 2004M1

Indonesia

Singapore

0

5

10

15

20

25

1990M1 1992M1 1994M1 1996M1 1998M1 2000M1 2002M1 2004M1

Korea

United States

0

2

4

6

8

10

12

1990M1 1992M1 1994M1 1996M1 1998M1 2000M1 2002M1 2004M1

Malaysia

United States

0

5

10

15

20

25

30

1990M1 1992M1 1994M1 1996M1 1998M1 2000M1 2002M1 2004M1

Philippines

United States

0

5

10

15

20

25

1990M1 1992M1 1994M1 1996M1 1998M1 2000M1 2002M1 2004M1

Thailand

United States

Interest Differentials, Portfolio Balance, and the Impossibility Free Floating As dollar claims accumulate, a sufficiently large

interest differential to induce private portfolio holdings of dollars becomes unsustainable—as in Japan when yen interest rates approach zero.

The problem worsens when US interest rates are unusually low, as in 2003-04.

Then, increasing official foreign exchange reserves become the dominant mode of financing Asian current account surpluses.

And the private unwillingness to hold dollars makes a free float impossible.

Table 4: East Asian Current Accounts (CA) and Changes in Foreign Reserves (RC)  Billions of Dollars  1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Japan CA 44 68 113 132 130 111 66 97 119 115 120 88 112 136

  RC -9 -8 0 27 26 57 35 1 -5 74 70 41 64 201

Singapore CA 3 5 6 4 11 15 14 15 19 15 13 16 19 28

  RC 7 6 6 8 10 10 8 -6 4 2 3 -5 7 14

Taiwan CA 11 12 9 7 7 5 11 7 3 8 9 18 26 29

  RC -1 10 0 1 9 -2 -2 -5 7 16 1 15 39 45

Indonesia CA -3 -4 -3 -2 -3 -6 -8 -5 4 6 8 7 8 8

  RC 2 2 1 1 1 1 5 -2 6 4 2 -1 4 4

Korea CA -2 -8 -4 1 -4 -9 -23 -8 40 24 12 8 6 12

  RC -1 -1 3 3 5 7 1 -14 32 22 22 7 18 34

Malaysia CA -1 -4 -2 -3 -5 -9 -4 -6 10 13 8 7 7 11

  RC 2 1 6 10 -2 -2 3 -6 5 5 -1 1 4 10

Philippines CA -3 -1 -1 -3 -3 -2 -4 -4 2 7 6 1 4 2

  RC -1 2 1 0 1 0 4 -3 2 4 0 0 0 0

Thailand CA -7 -8 -6 -6 -8 -14 -15 -3 14 12 9 6 8 8

  RC 4 4 3 4 5 7 2 -12 3 5 -2 0 6 3

China CA 12 13 6 -12 7 2 7 37 31 21 21 17 35 31

  RC 12 14 -23 2 30 22 31 35 5 10 11 47 74 117

HK SAR CA 3 10 7 10 14 17

  RC   4 6 8 6 6 8 29 -3 7 11 4 1 6

East Asia CA 56 74 116 125 136 93 45 133 241 230 217 182 248 255

  RC 16 35 3 64 92 107 95 19 56 148 117 109 216 434

Figure 10: US and cumulative East Asian Current Accounts (Billions of US Dollars)

-600

-500

-400

-300

-200

-100

0

100

200

300

400

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002

bill

ions

of

doll

ars

US

East Asia

Data source: IMF: IFS.

Revived Bretton Woods: EA Exchange Rates are deliberately undervalued to support an export drive into American markets.

Exports are desired to promote “development”, particularly in manufacturing.

Asian governments are willing to pay the cost of investing in very low yield US Treasuries, and to accept American FDI with high profit repatriation.

US gets finance for its fiscal deficits Despite adjustment costs in US manufacturing,

the ongoing current-account deficit is sustainable

I. The Dollar Standard and East Asia’s Trade Surplus: The DFG Approach

II. The Dollar Standard and East Asia’s Trade Surplus: The MCS Approach With the dollar as international money, the

efficiency of world trade and payments increases. If the U.S. price level is stable, peripheral

countries will peg to the dollar to anchor their own price levels—not to “undervalue” their currencies, which would be inflationary.

Massive interventions by East Asian central banks to prevent exchange appreciation incidentally extend the US credit line with the rest of the world, softening borrowing constraints on US households and on the Federal Government.

The upshot has been falling US saving and large current account deficits for more than 20 years.

Restraining American Deficits? An attack on the dollar is unlikely because US debts are

denominated in its own currency, unlike peripheral countries with “original sin”. The Fed creates the definitive international money.

But heavy US foreign borrowing is transferred in real terms through large American trade deficits, mainly in manufactures.

The American concern with de-industrialization, i.e., unduly rapid job losses in manufacturing, should be linked to federal fiscal deficits and low American personal saving.

Exchange rate changes, foreign trade restraints, or tax breaks for manufacturers, won’t work.

Instead, with deliberate speed, move the federal budget from deficit to surplus.

US Current Account and Manufacturing Sector Trade Balance (% of GDP)

-6

-5

-4

-3

-2

-1

0

1

2

1965

1966

1967

1968

1969

1970

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2Q

CA Balance

Manufacturing Trade Balance

Source: Bureau of Economic Analysis

Projection of Labor Growth in Manufacturing under Balanced Manufacturing Trade

0.00

5.00

10.00

15.00

20.00

25.00

30.00

(%)

Share of ManufacturingEmployment

Projected Share of ManufacturingEmployment under BalancedManufacturing Trade

Conclusions for East Asia Collectively pegging to the dollar enlarges the

zone of stable dollar prices far beyond trade with the United States: stronger mutual anchoring of national price levels

Anchors against the threat of appreciation and deflation in creditor countries with “conflicted virtue”—while stabilizing mutual cross rates of exchange. Important for Japan and China.

Mutual exchange stability is a public good among integrated economies.

An “Asian euro” is but a distant possibility, so keying on the dollar is now the only feasible intra Asian mechanism for securing exchange stability.