Asian Currency Unit (ACU), deviation indicators and exchange rate coordination in East Asia: A panel-based convergence approach

Highlights

• Intra-East Asian exchange rate movements have not converged to form one bloc.

• A separate number of convergent clubs in the region have formed in recent years.

• The number and composition of clubs depend on which deviation indicator and period used.

• There are two opposing convergent poles of relatively depreciating and appreciating currencies.

• Our results have important policy implications on exchange rate coordination in East Asia.

Abstract

Employing the panel convergence method of Phillips and Sul (2007) to the nominal deviation indicators of two recent unofficial constructions of an Asian Currency Unit (ACU) index, this paper examines the existence and extent of convergence in the movements of East Asian currencies against the ACU. Empirical results reveal that intra-East Asian exchange rate movements have not converged to form one, cohesive and unified bloc where currencies share homogenous movements, regardless of whether one examines the data on intra-East Asian exchange rate movements before or after the collapse of Lehman Brothers in September 2008. Instead, a separate number of convergent clubs or blocs in the region have formed in recent years. Finally, and most importantly, we observe at the end of the period of our examination that economies in the region are, generally, converging at different speeds to two opposing poles of convergence, that is, groups of relatively depreciating currencies and, on the other, groups of relatively appreciating currencies.

Introduction

Over the last 25 years and driven mainly by market forces, regional trade and investment integration has deepened in East Asia. The closer trade and financial ties between East Asian countries have made these economies highly and increasingly interdependent among each other. As a consequence, economies in the region are increasingly affected by shocks that originate from neighboring economies as well as being highly sensitive to policies adopted by their neighboring economies. The latter argument, on the other hand, triggers an important observation that East Asian economies also compete among each other in markets within and outside of the region and as such the potential of losing competitiveness against each other is treated with utmost sensitivity among countries in the region. In the extreme, the prospect of a beggar-thy-neighbor competitive depreciation strategy, which can be costly to the region in terms of large and unnecessary reallocation of resources across the region, always looms large (Kawai and Takagi, 2012). Regardless, however, on whether one views the deepening economic relationships in the East Asian region as a story of economic integration or economic competition, the achievement of exchange rate stability among countries in the region is of paramount importance.¹

Given that a case can be made out of the need to promote greater intra-regional exchange rate stability in East Asia, the key challenge to the achievement of this objective is that this would require a certain degree of exchange rate policy coordination. Since there is currently no consensus about the form that exchange rate policy coordination in the region will take, a number of studies have proposed the creation of a basket of appropriately weighted regional currencies. For instance, Ogawa and Shimizu (2005) proposed the construction of an ASEAN + 3 (Association of Southeast Asian Nations, which includes Brunei Darussalam, Cambodia, Indonesia, Lao PDR, Malaysia, Myanmar, Philippines, Singapore, Thailand and Viet Nam, plus China, Japan and South Korea) regional currency basket a la the European Currency Unit (ECU) and calculated the weights of the ASEAN + 3 currencies as an arithmetic average of the country's respective shares of PPP-based GDP and foreign trade. One important rationale for the calculation of this so-called Asian Currency Unit (henceforth ACU) is that it can serve to monitor the movements of regional currencies relative to this ACU as well as the collective movements of regional currencies against key external currencies such as the US dollar and the euro (Kawai, 2009). In other words, the requirement of exchange rate policy coordination can be met in part by the creation of the ACU as a regional currency basket.

In order, however, for the ACU to be made useful in practice as an exchange rate policy coordinating device, policymakers should be guided on how it can conduct the monitoring of the movements of individual currencies in the region relative to this ACU. The main objective of this paper then is to demonstrate that the monitoring of the movements of individual currencies in the region relative to the ACU can be undertaken based on the idea of convergence in Deviation Indicators. Deviation Indicators measure the direction (i.e. appreciation or depreciation) and the magnitude of movements of individual East Asian currencies relative to the ACU. Given that the ACU is a weighted average of the regional currencies, a careful examination of the convergence in Deviation Indicators allows one to determine, for instance, the number and configuration of currencies that appreciate relative to the ACU regional average and those that depreciate with respect to the ACU regional average. In other words, convergence in Deviation Indicators would provide information on specific group of convergent countries whose currencies have either collectively appreciate or depreciate relative to the ACU regional average. It follows, therefore, that those currencies that belong to the same convergent group would have relatively stable bilateral exchange rates between them, regardless of whether a condition of region-wide exchange rate stability takes hold or not. Furthermore, the illustration of possible paths that describe the movements of each individual currencies and each convergent group relative to the panel average is also a major feature of any analysis conducted on the basis of convergence in Deviation Indicators.

Thus, overall, convergence in Deviation Indicators can then provide policymakers a much more vivid and dynamic picture of exchange rate movements in the region that would be extremely valuable for them to carry out useful and effective exchange rate coordination in the region. In the very long-run for the region, information obtained from an analysis of the convergence in Deviation Indicator can, should the region so desire, facilitate in the formation of sub-regional currency blocs in which currencies in the region that have shown relative bilateral exchange rate stabilities due to the achievement of sufficient convergence in deviation indicator can take a multi-track or multi-speed approach to monetary integration. This can then help set the stage later on, again should the region aspire, with the eventual creation of a wider and unified regional monetary zone in East Asia.

After discussing the underlying motivation of our paper, one can argue that it would be much more convenient and straightforward to examine the Deviation Indicators based on the US dollar (USD) rather than based on the ACU. The main advantage of using the latter, however, is that it allows one to observe the movements of individual currencies relative to the regional average. This would, in turn, assist in understanding important issues with a regional dimension, such as the relative competitiveness of exports within the region. In addition, the limitation of the former is that in situations when, for instance, two regional currencies are both depreciating against the USD, but, at the same time, are both appreciating against the ACU, it would not be able to capture the two currencies’ loss of competitiveness in exports relative to other East Asian countries.

In order for us to fully examine the convergence in Deviation Indicators and provide the above mentioned analysis, we apply the recently developed panel convergence method of Phillips and Sul (2007) (henceforth P-S (2007)) to two alternative Deviation Indicators that are calculated using two recent unofficial constructions of an ACU in East Asia. To the best of our knowledge, there has been no previous work that applied this method to the exchange rates of Asian currencies relative to the ACU. The advantages that this convergence test offers in terms of the tasks set out in this paper, and especially on how this test compares with the traditional beta and sigma convergence tests are as follows: First, based on a time varying factor model, the test does not demand assumptions regarding the stationarity of the variables and allows for individual series to be transitionally divergent. Hence this methodology can accommodate long-run equilibria within a heterogeneous panel, outside of the co-integration setup. Second, this methodology can cluster panel currencies into convergent sub-groups when the whole panel convergence is absent. In other words, the test is able to detect whether any specific sub-groups of currencies are converging or diverging. It additionally provides information on the speed of convergence for each group detected. Third, this method provides information on relative transition parameters for each currency, which can be used to portray each currency's and each group's behavior relative to the panel cross-section average over time.

There have been two recent contrasting unofficial constructions of an ACU in East Asia. One, is the initial work of Ogawa and Shimizu (2005) that constructed an ASEAN + 3 regional currency basket a la the European Currency Unit (ECU), which later on under the joint auspices of the Japan's Research Institute of Economy, Trade and Industry (RIETI) and Hitotsubashi University calculated a regional currency basket for the Chiang Mai Initiative Multilateralization (CMIM) member economies (i.e., ASEAN + 3 plus Hong Kong, China). The other is by Pontines (2013) (henceforth VP (2013)) which is based on the seminal idea of a reduced normalized in exchange (RNVAL) of a currency by Hovanov et al. (2004). The above panel convergence methodology of P-S (2007) is then applied to the so-called Deviation Indicators that were calculated from these two ACU constructions in the region in order to detect for convergence (absolute and conditional). In a nutshell, as also earlier defined, the Deviation Indicators measure the relative value for each of the currencies included in the currency basket against all the other currencies comprising the ACU.

Finally, also to the best of our knowledge, attempts to examine the convergence in Deviation Indicators of currencies in East Asia relative to a regional currency basket are almost virtually non-existent. The only previous and related studies that we can find are by Ogawa and Yoshimi (2009) and Ogawa and Wang (2013), both using traditional beta and sigma convergence tests and finding that the deviations of East Asian currencies relative to the ACU benchmark have been widening during 2005–early 2009 and 2005–early 2010, respectively. In view of this dearth of evidence as to the issue of relative exchange rate movements in East Asia, we believe that our paper makes a worthwhile and fresh contribution to the literature on monetary and financial integration in East Asia, in general, and to the issue of relative exchange rate movements in the region, in particular. Our paper is structured as follows. The next section provides more detail regarding the recent constructions of an ACU and the corresponding Deviation Indicators in the East Asian region. The third section discusses the method used to assess convergence in Deviation The fourth section presents our empirical results. The fifth section concludes.