SMU ECONOMICS & STATISTICS WORKING PAPER SERIES Paper No. 02-2007
This paper considers how a regional currency basket and the associated divergence indicators could be used in official surveillance. Recently, proponents of Asian currency baskets have referred to the role the ECU played in constructing exchange rate divergence indicators in Europe as evidence of the intrinsic usefulness of currency baskets for exchange rate monitoring. We show in this paper a number of problems with the use of regional currency-basket based divergence indicators. First, at a technical level, such indicators involve tracking regional exchange rates against a moving currency basket and can obscure underlying movements in bilateral exchange rates. Second, currency baskets generally treat currencies asymmetrically leading to difficulties interpreting the derived measures of divergence. Third, intra-regional exchange rate monitoring can lead to potentially serious N-1 or anchor problems. Some of these difficulties can be addressed by bilateral divergence indicators but means will need to be found to anchor regional exchange rate surveillance vis--vis currencies outside the region.