Sometimes it's wise to put all your pegs in one basket
Instead of fixing its currency against the US dollar, China would achieve better exchange rate stability by pegging the yuan to a basket of currencies - and so would Hong Kong - according to a research paper* published this month.
The exchange rate against the US dollar would vary, but by adopting a basket peg, China could cut the overall volatility of the yuan against all its trading partners' currencies, argues the paper's author, former World Bank chief economist for South Asia John Williamson. That would be highly advantageous for Chinese importers and exporters and would lend extra comfort to both inward and outward investors.
China has defended the yuan's US dollar peg by arguing that it ensures exchange rate stability. But by fixing the peg to the dollar, China has actually ensured it suffers from major exchange rate volatility against the currencies of its other major trading partners.
Most important are Japan and the eurozone, which together account for 27 per cent of all of China's foreign trade. While the yuan has been kept steady against the greenback, in recent years the Chinese currency has fluctuated by more than 30 per cent against the yen, and by more than 60 per cent against the euro (see chart).
Much of that volatility could be eliminated if China were to peg the yuan against a basket of currencies.
One option would be a basket comprising the currencies of countries that account for more than 5 per cent of China's total foreign trade. This would consist of the yen, the euro, the US dollar, the Hong Kong dollar and the South Korean won (see chart).
If China had adopted this strategy between 2000 and 2004, the yuan's overall volatility against its trading partners' currencies could have been cut by nearly half, says Mr Williamson.
Mr Williamson shoots down some common misconceptions about currency baskets. China would need to change neither the way it manages its foreign reserves nor the way it intervenes in the currency markets to ensure exchange rate stability, he contends.
Foreign reserves could still be held mainly in US dollars and China could maintain its currency's equilibrium against a basket by intervening only against the US dollar, although the exchange rate at which the central bank enters the market would vary. 'There is no necessity at all to start intervening in a basket of currencies,' he writes.
But Mr Williamson does acknowledge some problems with the basket concept. Mainland firms would need to be able to hedge the yuan's movements against the dollar, as well as other currencies.
He also recognises that if basket currencies were to fall against the US dollar, China could find itself also pushing the yuan lower to maintain equilibrium, which would sorely rile Washington.
But Mr Williamson goes much further than merely suggesting that China should implement a basket peg. The whole of emerging East Asia would benefit from managing its currencies against a common basket, he insists.
A common basket would consign to history the 'beggar-thy-neighbour' tendency of Asian countries to engage in competitive devaluations. It would encourage intra-Asian trade by eliminating regional exchange rate swings. And it would mitigate volatility against developed world currencies.
Mr Williamson argues that by pegging their currencies against a common basket of foreign currencies - comprising the US dollar at a 40 per cent weight, the euro at 32 per cent and the yen at 28 per cent - East Asian countries from Korea to Indonesia could significantly reduce economically damaging exchange rate volatility.
One major beneficiary of such an exchange rate strategy would be Hong Kong. If the territory were to adopt the basket alongside the rest of the region, the Hong Kong dollar's overall volatility would be cut by nearly two-thirds, argues Mr Williamson.
*A Basket Numeraire for East Asia, Institute for International Economics, July 2005. http://www.iie.com/publications/pb/pb05-1.pdf