Flexible BBC Exchange Rate System and Exchange Rate Cooperation in East Asia

Author: 
Yen Kyun Wang
Description: 
KIEP working paper 08-03
Abstract: 
In order to prevent competitive depreciations, excessive inflows of foreign capital and crisis contagion in the region, cooperation in exchange rate and monetary policy is very desirable, considering the fact that countries in East Asia have high trade dependence among them and similar trade patterns with each other. The BBC system proposed will be examined and the new BBC system will be suggested. The BBC system is desirable as a new exchange rate system in Korea. Singapore has been successful with the BBC system since the early 1980s. It would be more desirable that East Asia adopt the flexible BBC (basket, band, crawl) exchange rate system jointly. Participating countries of East Asia including Japan link their exchange rates to their currency basket (ACU) with bands and the ACU is linked to the basket of the dollar and euro by a regional agency. It will stabilize real effective exchange rates of East Asian countries and reduce excessive short term capital flows into developing East Asian countries. In addition to the above flexible BBC exchange rate system the U.S. and Japan can fix the yen/dollar exchange rate within a band in the short- and medium-run and fix the rate in the long-term. It will further reduce excessive capital inflows into developing countries in the region. Without stabilizing the yen/dollar exchange rate, interest rates of Japan will continue to be lower than those of the U.S. and emerging East Asian countries, and yen-carry trade and excessive capital inflows in developing East Asia will appear when the expected exchange rate of the yen is uncertain or weak. And sudden outflow of short-term capital will follow later. The ACU is linked to the basket of the dollar and yen, and participating countries in the region link their exchange rates to the ACU with bands. The yen is included in the outside basket, but not in the regional basket in this alternative scheme. This scheme will stabilize exchange rates of emerging East Asian countries against the yen and dollar more effectively. When they crawl their central rates within bands, real effective exchange rates (REERs) using unit labor cost indices need to be used to keep their export competitiveness constant. Sound and consistent economic policies are essential for success of the BBC system. Singapore experiences with the BBC system provide good lessons. Prudential fiscal policy, flexible prices of goods and productive factors, proper interest policy and effective use of foreign reserves are needed. Joint or independent capital control could be helpful in the face of excessive capital inflows. Other measures for financial cooperation are discussed also.