1. 1 Global Currency in the Future Professor Stefan Collignon Monetary cooperation between Asia and Europe Mizuho Research Institute Ltd. Tokyo 24 November 2004 Stefan Collignon Professor of European Political Economy, LSE www.stefan collignon.de

2. 2 Global Currency in the Future Exchange rate regimes matter for long term economic development 1.Exchange rate levels determine relative price levels between goods and assets across nations –Competitiveness –Profitability of capital invested determine relative attractiveness for foreign direct investment (FDI) investment –Multinational firms look at global investment opportunities –Integration into world economy Professor Stefan Collignon

3. 3 Global Currency in the Future Exchange rate regimes matter for long term economic development 2.Exchange rate volatility creates uncertainty about relative prices and profits Portfolio investors should be indifferent as long as derivative markets allow them to hedge Local exporters and FDI-investors cannot hedge given long term horizon of their production facilities Professor Stefan Collignon

4. 4 Global Currency in the Future Exchange rate volatility creates uncertainty about relative prices and profits Risk averse firms look at the risk-return trade-off of location strategies The trade-off exists (Bénassy-Quéré et alt. 2001) - a 1% appreciation in real exchange rate reduces FDI stock by 0.22% - a 1% increase in exchange rate volatility reduces it by 0.60% Professor Stefan Collignon

5. 5 Global Currency in the Future Institutions matter 1.Bretton Woods created a framework for economic stability –fast development of Europe and Japan after the war –based on the leadership of a benevolent hegemon –Stable undervaluation of Japanese and European currencies Professor Stefan Collignon

6. 6 Global Currency in the Future 2.After Bretton Woods (1971) came the market-led international monetary system Rise of financial markets Large transborder financial flows Undervaluation turned into overvaluation High exchange rate volatility Professor Stefan Collignon

7. 7 Global Currency in the Future Professor Stefan Collignon Undervaluation turned into overvaluation

8. 8 Global Currency in the Future Professor Stefan Collignon High exchange rate volatility Forecasting future exchange rates (and relative price levels) becomes highly uncertain 1. Example: DM/euro-dollar

9. 9 Global Currency in the Future Professor Stefan Collignon 2. Example: Japan

10. 10 Global Currency in the Future The economic consequences of monetary instability Lower investment –Uncertainty  “option value of waiting” Professor Stefan Collignon

11. 11 Global Currency in the Future The economic consequences of monetary instability Inflation persistence –Devaluations import price increases –Revaluations dampen growth Professor Stefan Collignon

12. 12 Global Currency in the Future Professor Stefan Collignon The economic consequences of monetary instability Economic stagnation – – obviously other factor matter as well

13. 13 Global Currency in the Future The political reactions to monetary instability 1.In Europe European Monetary System in 1979 –Creating a “zone of monetary instability –Pegging to DM as inflation anchor Supply-side reforms –Single European Act 1986 European Monetary Union in 1999 Professor Stefan Collignon

14. 14 Global Currency in the Future Professor Stefan Collignon 2. 2. Worldwide The emergence of currency blocs – – Deutschmark bloc increasing in 1980 and 90s   But euro is not currency bloc, but new currency – – Asian countries peg to dollar – – No yen bloc emerging The political reactions to monetary instability

15. 15 Global Currency in the Future Professor Stefan Collignon Bloc floating

16. 16 Global Currency in the Future The economic consequences of currency blocs Pegging to dollar allowed emerging Asia the integration into world economy - The most dramatic change of trade pattern has taken place in the share of manufacturing exports from developing countries (from 18.5% to 66.1%) and especially in Asia (from 22.4% to 73.4%) Professor Stefan Collignon

17. 17 Global Currency in the Future The economic consequences of currency blocs But in Europe it created a deflationary bias and led to the break-up in 1992/3 –the bloc was no longer undervalued with respect to the dollar –The Deutschmark was too small as an anchor currency –Solution: euro Transformed the EU-economy Created large trade gains (10-100 percent) Professor Stefan Collignon

18. 18 Global Currency in the Future The economic consequences of currency blocs An unexpected result: –Exchange rate volatility between currency blocs increases as the blocs get bigger –The fundamental (equilibrium) exchange rate must move more to help the adjustment of the anchor currency –Uncertainty increases as markets can no longer perceive the right equilibrium Professor Stefan Collignon

19. 19 Global Currency in the Future Example: USA The high current account deficit requires an adjustment by depreciating the exchange rate But only the trade with the non-dollar zone would be affected Hence, the adjustment of the flexible exchange rate is much larger than it would otherwise be. Consequence: euro and yen become more easily overvalued Professor Stefan Collignon

20. 20 Global Currency in the Future Professor Stefan Collignon US trade deficit is € 500 bn Financed by Euro-surplus of €200 bn And Japanese surplus of €100 bn Rest comes mainly from Asia

21. 21 Global Currency in the Future The problem with today’s world economy (1) Emerging Asia is pegged unilaterally to dollar It achieves high growth because of undervaluation (especially China) USA can only act on yen and euro-exchange rates for adjustment This will cause overvaluations of euro and yen Growth of Japan and Euroland will stagnate Professor Stefan Collignon

22. 22 Global Currency in the Future The problem with today’s world economy (2) Emerging Asia will also suffer from high volatility of euro and yen relative to dollar Japan exports twice as much to US (and to Asia) as to EU, but imports are more balanced China exports more to EU than to USA and Asia, but imports from Asia are important India exports slightly more to EU and USA, but imports 3 times as much from EU and very little from rest of Asia ASEAN has a fairly balanced trade portfolio between EU and US, but much more exposure to Asia Professor Stefan Collignon

23. 23 Global Currency in the Future Professor Stefan Collignon

24. 24 Global Currency in the Future The problem with today’s world economy (3) Conclusion: Asia’s trade is as dependent on the US as it is on the EU –Shifts in the dollar-euro exchange rate have detrimental effects on either trade relation Regional trade within Asia has become a key market –At the moment this trade is stabilised by the dollar peg (like European integration under Bretton Woods) –If US impose “more flexibility”, the foundations of emerging Asia’s success will disappear, as they did for Europe and Japan after Bretton Woods Professor Stefan Collignon

25. 25 Global Currency in the Future Possible solutions 1.Stabilise the triade dollar-yen-euro –Requires cooperation with USA: impossible 2.Stabilise euro-yen exchange rate –Requires cooperation Japan-Europe –Not impossible, but difficult with the institutional deficiencies of Euro-governance 3.Stabilise euro-renminbi exchange rate –Possible as alternative peg to USA –Would also stabilise trade for other Asian countries Professor Stefan Collignon

26. 26 Global Currency in the Future Possible solutions 4.Peg to a regional Asian anchor –Which anchor? –Unresolved history –Slow process –But: financial cooperation has started –Next: Asian currency unit? –Monetary cooperation in Asia is necessary because high degree of regional trade integration Professor Stefan Collignon

27. 27 Global Currency in the Future My preferred solution: More monetary cooperation between Asia and Europe in order to protect the world from potential destabilisation from USA –Need to stabilise euro-yen for financial flows –Need to stabilise Asian trade for world demand –Need to stabilise euro to prevent disastrous overvaluation and maintain growth and employment Professor Stefan Collignon

28. 28 Global Currency in the Future Thank you! Professor Stefan Collignon