China in Transition
China should not Seek Stability between the Yuan and the Yen
Chi Hung KWAN Consulting Fellow, RIETI
Many Asian countries have abandoned their traditional exchange rate policy of pegging to the U.S. dollar since the financial crisis of 1997-1998. At the same time, monetary cooperation at the regional level has also gained momentum. In line with these trends, Mr. Dai Xianglong, Governor of the People's Bank of China (the central bank), has revealed a plan to study the introduction of a currency basket composed of major currencies such as the dollar, the yen, and the euro. Given that the economic structures of Japan and China are complementary rather than competing, however, stabilizing the exchange rate between the yuan and the yen would be counterproductive.
Pegging to a currency basket means following a set of rules that determines how the host country's currency moves against other major currencies. Suppose China pegs the yuan to a basket of currencies in which the yen carries a weight of 20%. When the yen appreciates (depreciates) by 1% against the dollar, the yuan will follow the yen up (down) against the dollar by 0.2%. In the extreme case where the weight of the yen is set at 100%, the rate of the yuan against the yen would always remain the same, and the yuan would synchronize perfectly with the yen against the dollar. As long as the yen-dollar rate fluctuates, however, bringing about the stability of the yuan against the yen means that there is a price to pay in terms of higher volatility against the dollar.
What criteria should actually be used to determine the weights of various currencies in the basket? The majority view holds that they should generally reflect the regional composition of the host country's external trade (particularly exports). For example, if Japan accounts for 20% of China's total exports, the weight of the yen should also be set at 20%. In this era of globalization, however, shifts in a country's competitiveness (and therefore production) are more likely to reflect exchange rate fluctuations against the currencies of its competitors' rather than against those of its export destinations. Thus the "optimal" basket that seeks to achieve macroeconomic stability should better be based upon competitors' weights rather than the weights of export destinations. On the basis of this criterion, China should give the yen a low weighting when it introduces its currency basket in order to reflect the fact that its degree of competition with Japan is low.
A monetary union between Japan and China with a single currency would do both countries more harm than good. In a monetary union, member countries have to give up their own monetary policy in favor of complying with a common monetary policy. According to the theory of the optimum currency areas, the cost of giving up an independent monetary policy is lower for a monetary union among countries with a high degree of homogeneity (countries that compete with one another) and higher for one between countries with a low degree of homogeneity (countries that complement one another). Countries with a high degree of homogeneity are able to respond to common shocks with a common monetary policy, whereas countries with a low degree of homogeneity are likely to suffer unnecessarily fluctuations in their economies if they act in the same way. At the present juncture, the degree of homogeneity between the economic structures of Japan and China is low, and it is clear that the two countries have yet to meet the conditions for an optimum currency area.
April 19, 2002
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