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A driver currency hypothesis
Economics Letters 118 (2013) 60–62
Contents lists available at SciVerse ScienceDirect
Economics Letters journal homepage: www.elsevier.com/locate/ecolet
A driver currency hypothesis P.J. Wang ∗ Plymouth Business School, University of Plymouth, Plymouth PL4 8AA, United Kingdom
article
info
Article history: Received 22 December 2011 Received in revised form 11 September 2012 Accepted 16 September 2012 Available online 24 September 2012
abstract The paper puts forward a driver currency hypothesis and assesses the driver currency effect empirically. The results are supportive. © 2012 Elsevier B.V. All rights reserved.
JEL classification: F3 Keywords: Exchange rate Driver currency Anchor currency
1. Introduction The custom of anchor currency has long been an anchor to currency conversions, international trade and international settlements. The US dollar played the role of anchor currency formally for the Bretton Woods period. It is still the dominant anchor albeit not an exclusive one. The desire to anchor the currency of an economy to another has always prevailed in small and large economies alike. Many believe in the safeguard provided by anchors on the volatile high seas of foreign exchange for international settlements. This paper investigates whether there exists a driver currency effect, arising from the peg of a large currency to another, or anchoring a large currency to another large currency. In that case, a large currency’s anchoring to another large currency has an observable effect on the exchange rate of other currencies vis-à-vis the currency being anchored. We then assess this driver currency effect empirically to establish how the exchange rates between various pairs of currencies have been driven by the arrangement between the anchor currency and the driver currency. 2. Related literature, old and emerging issues Meissner and Oomes (2008) review and summarize pegs and scrutinize the evolution of anchor currencies and the determinants of anchor currency choice, which the reader can refer to. Currency anchoring is not mooring ships in a dock however; it is more
∗
Tel.: +44 1752585705; fax: +44 1752585633. E-mail address: [email protected].
0165-1765/$ – see front matter © 2012 Elsevier B.V. All rights reserved. doi:10.1016/j.econlet.2012.09.020
about fastening small boats to a large towing vessel. Whatever the metaphor or comparison, the stability provided by anchors is not surely warranted, let alone any safeguard. This is particularly factual in recent decades with accelerated globalization, when the currencies of some previously closed large economies have emerged as influential monetary forces while seeking an anchor. Notwithstanding, anchoring a large economy’s currency to another does not seem to make much sense of anchoring, at least the original sense of anchoring. A new issue has then emerged: the anchor, whether it is an anchor in a harbor or a large vessel, has itself been towed away, because the anchoring ship is simply too large. Consequently, the positions of all other boats have changed to varied degrees. Put straightforwardly, the exchange rates between various pairs of currencies may be affected by such kinds of anchoring. This newly emerged issue complicates further the dilemma in anchor currency choice, which is rather different from that in the first two decades after the signing of the Smithsonian Agreement, examined by earlier studies such as Heller (1978) and Holden et al. (1979). Since many countries apply de facto pegs while claiming to have floated their currencies, and some other countries prefer de facto pegs to de jure pegs, we adopt loosely defined pegs and anchoring here. Reinhart and Rogoff (2004) have examined extensively de facto peg regimes with natural classifications, detailing pegged floats and floating pegs. Dubas et al. (2010) develop a multinomial logit approach to exchange rate policy classification and Ghosh et al. (1997) question whether nominal exchange rates matter. Our defined pegs, or de facto pegs, are similar to those in the above mentioned studies. Nonetheless, instead of the exchange rate staying within a narrow band against
P.J. Wang / Economics Letters 118 (2013) 60–62
61
Table 1 Long-run causality test results. RMB
Euro
RMB
Yen
RMB
Pound
RMB
SFranc
−0.2295e−2
0.0463*** 0.0138 3.3512
0.0156* 0.0092 1.7006
0.2541*** 0.0664 3.8245
−0.3662e−2
−0.1288***
0.0045 −0.8131
0.0347 −3.7144
0.1023e−2 0.0034 0.3024
0.0816*** 0.0224 3.6432
0.0021 −1.0990 *
** ***
Significant at the 10% level. Significant at the 5% level. Significant at the 1% level.
Table 2 VEC Granger causality/block exogeneity Wald test results. RMB 4.5197 0.9552 11
Euro 29.5293 0.0019 11
RMB ***
15.9993 0.9148 25
Yen 54.4495 0.0006 25
RMB ***
4.8795 0.9396 11
Pound 25.9724 0.0066 11
***
RMB
SFranc
9.1213 0.9364 17
31.2786 ** 0.0185 17
See notes to Table 1.
one particular currency, we prefer and define that a peg is when the exchange rate moves consistently within a narrow band of fluctuations against a particular currency. The currency that pegs may appreciate (depreciate) all the way for a considerably long period. While the band remains narrow, the mean of the band changes and it changes consistently in one direction. This way, the study countenances the driver currency effect through its steady appreciation (depreciation) against the anchor currency, which may or may not be desirable. This treatment does away with the claim for a floating exchange rate regime by the monetary authority whose currency de facto pegs. 3. Hypothesis and definitions We hypothesize that there exists a driver currency effect in the contemporary international economic arena, arising from the anchoring of large currencies to a large currency. Let us do with the smallest number of currencies to define driver currencies. There are three currencies A, B and C . One of them is anchor currency, one is driver currency, and the last one neither anchor nor driver currency. There are three pairs of exchange rates between them. Designate these exchange rates as SAB , SAC and SBC . Definition 1. A currency is a driver currency that changes in its exchange rate vis-à-vis the anchor currency cause (drive) changes in other currencies’ values relative to the anchor currency. Let A be the anchor currency, then C is a driver currency if changes in exchange rate SAC drive changes in exchange rate SAB . Definition 2. It is an implicit definition without a designated anchor currency. A currency is a driver currency that changes in its exchange rate vis-à-vis a reference currency drive changes in the exchange rates of that reference currency vis-à-vis other currencies. 4. Is there a driver currency? A driver currency has to be large and adopts a kind of de facto peg in its exchange rate arrangement while its exchange rate is not totally fixed. The RMB of the PRC is probably the right candidate amongst BRICS economies, as other BRICS currencies are more free to float. There exist exchange controls in the PRC. Conversions of capital and financial account items are subject to approval. Current account transactions are freely convertible through authorized banks or financial institutions at the official exchange rate, set by the central bank with virtual pegs to the US dollar. It is this kind of exchange control mechanism – free conversions at the controlled rate – that makes the RMB a likely driver currency.
Four currencies of the euro, yen, pound and Swiss franc are chosen for testing our hypothesis while the US dollar serves as an anchor to the RMB. Weekly exchange rates are used to reduce the noise in the data while maintaining a reasonably high frequency. The time period is between the first week in August 2005 and the last week in November 2008. The central bank of the PRC announced its adoption of managed floating in July 2005, which the IMF classified as crawling peg. Suchlike, its exchange rate visà-vis the US dollar has no longer been totally fixed with zero standard deviation. The exchange rate started to fluctuate, yet the standard deviation of its changes is considerably lower compared with conventional floating, bearing the hallmark of de facto pegs. The ending date is chosen to exclude the US quantitative easing exercise, since the massive increase in US money supply outdid any other factors in influencing exchange rate movement. We fit a vector error correction model for a pair of exchange rates of the RMB vis-à-vis the US dollar and the euro vis-à-vis the US dollar. The model is symmetric, testing the mutual impact and imposing no prior conditions on patterns of influence. It assesses the impact of the former on the latter and, equally, the impact of the latter on the former. Similarly we fit the model for pairs with the yen, pound and Swiss franc. Lag lengths are selected by the sequential modified likelihood ratio test as recommended in a few recent studies. One of the reasons is that AIC or SC produces statistics that are only marginally different from one lag to very long lags, which fails to differentiate and make optimal choice. Table 1 provides the coefficient of the error correction term, i.e., the long-run effect, estimated for the model. The first row is the coefficient, the second row is the standard error and the third row the t-statistic. Table 2 reports block exogeneity Wald test statistics for VEC Granger causality involving the lagged short-term variables as well as the error correction term.1 The first row is the test statistic, the second is the p-value of the test statistic and the third is the degrees of freedom that are also the lag length of the model. It can be observed in Table 1 that the exchange rate of the RMB vis-à-vis the US dollar causes the exchange rate of the euro vis-à-vis the US dollar, but not vice versa. The coefficient is significant at the 1% level in the euro equation and insignificant in the RMB equation. Similarly, the coefficient is all highly significant in the yen, pound and Swiss franc equations at the 1% level, and insignificant in the RMB equation for pairs with the pound and Swiss franc, though it is significant at a modest 10% level for the pair with the yen. Overwhelmingly the RMB drives the other currencies in the
1 This is for a concise report of the results, especially for long lags. Detailed results, including unit root and cointegration tests, are available upon request.
62
P.J. Wang / Economics Letters 118 (2013) 60–62
long-run. This result is reinforced by block exogeneity Wald test results in Table 2. The hypothesis that the exchange rates of the euro, yen, pound and Swiss franc vis-à-vis the US dollar are exogenous to the RMB dollar exchange rate is resolutely rejected, with the p-value being smaller than 0.01 for the cases of the euro, yen and pound, and smaller than 0.05 for the Swiss franc. On the other hand, the p-value for treating the RMB dollar exchange rate as exogenous is greater than 0.9 in all the cases, indicating the RMB dollar exchange rate is exogenous to these exchange rates.2 Our results suggest that there is a driver currency and the RMB is a currency showing the driver currency effect. Exchange controls for RMB conversions and, in particular, the peg of the RMB to the US dollar, are the contributing factors. 5. Summary In response to a changed international economic environment and consequently emerged new issues, a driver currency
2 The highly significant statistics in the euro, yen, pound and franc equations and the outright insignificant statistics, with very large p-values, in the RMB equation imply that the RMB is not meaningfully pegged to a basket of currencies; the RMB is predominantly, if not exclusively, pegged to the US dollar.
hypothesis has been proposed in this paper and the driver currency effect has been empirically examined amongst five currencies. The results indicate a driver currency effect and the presence of driver currencies. References Dubas, J.M., Lee, B.J., Mark, N.C., 2010. A multinomial logit approach to exchange rate policy classification with an application to growth. Journal of International Money and Finance 29 (7), 1438–1462. Ghosh, A.R., Gulde, A.M., Ostry, J., Wolf, H., 1997. Does the nominal exchange rate matter? NBER Working Paper No. 5874. Heller, H.R., 1978. Determinants of exchange rate practices. Journal of Money, Credit and Banking 10 (3), 308–321. Holden, M., Holden, P., Suss, E., 1979. The determinants of exchange rate flexibility: an empirical investigation. Review of Economics and Statistics 61 (3), 327–333. Meissner, C.M., Oomes, N., 2008. Why do countries peg the way they peg? The determinants of anchor currency choice. IMF Working Paper WP/08/132. Reinhart, C., Rogoff, K., 2004. The modern history of exchange rate arrangements: a reinterpretation. Quarterly Journal of Economics 19 (1), 1–48.
Contents lists available at SciVerse ScienceDirect
Economics Letters journal homepage: www.elsevier.com/locate/ecolet
A driver currency hypothesis P.J. Wang ∗ Plymouth Business School, University of Plymouth, Plymouth PL4 8AA, United Kingdom
article
info
Article history: Received 22 December 2011 Received in revised form 11 September 2012 Accepted 16 September 2012 Available online 24 September 2012
abstract The paper puts forward a driver currency hypothesis and assesses the driver currency effect empirically. The results are supportive. © 2012 Elsevier B.V. All rights reserved.
JEL classification: F3 Keywords: Exchange rate Driver currency Anchor currency
1. Introduction The custom of anchor currency has long been an anchor to currency conversions, international trade and international settlements. The US dollar played the role of anchor currency formally for the Bretton Woods period. It is still the dominant anchor albeit not an exclusive one. The desire to anchor the currency of an economy to another has always prevailed in small and large economies alike. Many believe in the safeguard provided by anchors on the volatile high seas of foreign exchange for international settlements. This paper investigates whether there exists a driver currency effect, arising from the peg of a large currency to another, or anchoring a large currency to another large currency. In that case, a large currency’s anchoring to another large currency has an observable effect on the exchange rate of other currencies vis-à-vis the currency being anchored. We then assess this driver currency effect empirically to establish how the exchange rates between various pairs of currencies have been driven by the arrangement between the anchor currency and the driver currency. 2. Related literature, old and emerging issues Meissner and Oomes (2008) review and summarize pegs and scrutinize the evolution of anchor currencies and the determinants of anchor currency choice, which the reader can refer to. Currency anchoring is not mooring ships in a dock however; it is more
∗
Tel.: +44 1752585705; fax: +44 1752585633. E-mail address: [email protected].
0165-1765/$ – see front matter © 2012 Elsevier B.V. All rights reserved. doi:10.1016/j.econlet.2012.09.020
about fastening small boats to a large towing vessel. Whatever the metaphor or comparison, the stability provided by anchors is not surely warranted, let alone any safeguard. This is particularly factual in recent decades with accelerated globalization, when the currencies of some previously closed large economies have emerged as influential monetary forces while seeking an anchor. Notwithstanding, anchoring a large economy’s currency to another does not seem to make much sense of anchoring, at least the original sense of anchoring. A new issue has then emerged: the anchor, whether it is an anchor in a harbor or a large vessel, has itself been towed away, because the anchoring ship is simply too large. Consequently, the positions of all other boats have changed to varied degrees. Put straightforwardly, the exchange rates between various pairs of currencies may be affected by such kinds of anchoring. This newly emerged issue complicates further the dilemma in anchor currency choice, which is rather different from that in the first two decades after the signing of the Smithsonian Agreement, examined by earlier studies such as Heller (1978) and Holden et al. (1979). Since many countries apply de facto pegs while claiming to have floated their currencies, and some other countries prefer de facto pegs to de jure pegs, we adopt loosely defined pegs and anchoring here. Reinhart and Rogoff (2004) have examined extensively de facto peg regimes with natural classifications, detailing pegged floats and floating pegs. Dubas et al. (2010) develop a multinomial logit approach to exchange rate policy classification and Ghosh et al. (1997) question whether nominal exchange rates matter. Our defined pegs, or de facto pegs, are similar to those in the above mentioned studies. Nonetheless, instead of the exchange rate staying within a narrow band against
P.J. Wang / Economics Letters 118 (2013) 60–62
61
Table 1 Long-run causality test results. RMB
Euro
RMB
Yen
RMB
Pound
RMB
SFranc
−0.2295e−2
0.0463*** 0.0138 3.3512
0.0156* 0.0092 1.7006
0.2541*** 0.0664 3.8245
−0.3662e−2
−0.1288***
0.0045 −0.8131
0.0347 −3.7144
0.1023e−2 0.0034 0.3024
0.0816*** 0.0224 3.6432
0.0021 −1.0990 *
** ***
Significant at the 10% level. Significant at the 5% level. Significant at the 1% level.
Table 2 VEC Granger causality/block exogeneity Wald test results. RMB 4.5197 0.9552 11
Euro 29.5293 0.0019 11
RMB ***
15.9993 0.9148 25
Yen 54.4495 0.0006 25
RMB ***
4.8795 0.9396 11
Pound 25.9724 0.0066 11
***
RMB
SFranc
9.1213 0.9364 17
31.2786 ** 0.0185 17
See notes to Table 1.
one particular currency, we prefer and define that a peg is when the exchange rate moves consistently within a narrow band of fluctuations against a particular currency. The currency that pegs may appreciate (depreciate) all the way for a considerably long period. While the band remains narrow, the mean of the band changes and it changes consistently in one direction. This way, the study countenances the driver currency effect through its steady appreciation (depreciation) against the anchor currency, which may or may not be desirable. This treatment does away with the claim for a floating exchange rate regime by the monetary authority whose currency de facto pegs. 3. Hypothesis and definitions We hypothesize that there exists a driver currency effect in the contemporary international economic arena, arising from the anchoring of large currencies to a large currency. Let us do with the smallest number of currencies to define driver currencies. There are three currencies A, B and C . One of them is anchor currency, one is driver currency, and the last one neither anchor nor driver currency. There are three pairs of exchange rates between them. Designate these exchange rates as SAB , SAC and SBC . Definition 1. A currency is a driver currency that changes in its exchange rate vis-à-vis the anchor currency cause (drive) changes in other currencies’ values relative to the anchor currency. Let A be the anchor currency, then C is a driver currency if changes in exchange rate SAC drive changes in exchange rate SAB . Definition 2. It is an implicit definition without a designated anchor currency. A currency is a driver currency that changes in its exchange rate vis-à-vis a reference currency drive changes in the exchange rates of that reference currency vis-à-vis other currencies. 4. Is there a driver currency? A driver currency has to be large and adopts a kind of de facto peg in its exchange rate arrangement while its exchange rate is not totally fixed. The RMB of the PRC is probably the right candidate amongst BRICS economies, as other BRICS currencies are more free to float. There exist exchange controls in the PRC. Conversions of capital and financial account items are subject to approval. Current account transactions are freely convertible through authorized banks or financial institutions at the official exchange rate, set by the central bank with virtual pegs to the US dollar. It is this kind of exchange control mechanism – free conversions at the controlled rate – that makes the RMB a likely driver currency.
Four currencies of the euro, yen, pound and Swiss franc are chosen for testing our hypothesis while the US dollar serves as an anchor to the RMB. Weekly exchange rates are used to reduce the noise in the data while maintaining a reasonably high frequency. The time period is between the first week in August 2005 and the last week in November 2008. The central bank of the PRC announced its adoption of managed floating in July 2005, which the IMF classified as crawling peg. Suchlike, its exchange rate visà-vis the US dollar has no longer been totally fixed with zero standard deviation. The exchange rate started to fluctuate, yet the standard deviation of its changes is considerably lower compared with conventional floating, bearing the hallmark of de facto pegs. The ending date is chosen to exclude the US quantitative easing exercise, since the massive increase in US money supply outdid any other factors in influencing exchange rate movement. We fit a vector error correction model for a pair of exchange rates of the RMB vis-à-vis the US dollar and the euro vis-à-vis the US dollar. The model is symmetric, testing the mutual impact and imposing no prior conditions on patterns of influence. It assesses the impact of the former on the latter and, equally, the impact of the latter on the former. Similarly we fit the model for pairs with the yen, pound and Swiss franc. Lag lengths are selected by the sequential modified likelihood ratio test as recommended in a few recent studies. One of the reasons is that AIC or SC produces statistics that are only marginally different from one lag to very long lags, which fails to differentiate and make optimal choice. Table 1 provides the coefficient of the error correction term, i.e., the long-run effect, estimated for the model. The first row is the coefficient, the second row is the standard error and the third row the t-statistic. Table 2 reports block exogeneity Wald test statistics for VEC Granger causality involving the lagged short-term variables as well as the error correction term.1 The first row is the test statistic, the second is the p-value of the test statistic and the third is the degrees of freedom that are also the lag length of the model. It can be observed in Table 1 that the exchange rate of the RMB vis-à-vis the US dollar causes the exchange rate of the euro vis-à-vis the US dollar, but not vice versa. The coefficient is significant at the 1% level in the euro equation and insignificant in the RMB equation. Similarly, the coefficient is all highly significant in the yen, pound and Swiss franc equations at the 1% level, and insignificant in the RMB equation for pairs with the pound and Swiss franc, though it is significant at a modest 10% level for the pair with the yen. Overwhelmingly the RMB drives the other currencies in the
1 This is for a concise report of the results, especially for long lags. Detailed results, including unit root and cointegration tests, are available upon request.
62
P.J. Wang / Economics Letters 118 (2013) 60–62
long-run. This result is reinforced by block exogeneity Wald test results in Table 2. The hypothesis that the exchange rates of the euro, yen, pound and Swiss franc vis-à-vis the US dollar are exogenous to the RMB dollar exchange rate is resolutely rejected, with the p-value being smaller than 0.01 for the cases of the euro, yen and pound, and smaller than 0.05 for the Swiss franc. On the other hand, the p-value for treating the RMB dollar exchange rate as exogenous is greater than 0.9 in all the cases, indicating the RMB dollar exchange rate is exogenous to these exchange rates.2 Our results suggest that there is a driver currency and the RMB is a currency showing the driver currency effect. Exchange controls for RMB conversions and, in particular, the peg of the RMB to the US dollar, are the contributing factors. 5. Summary In response to a changed international economic environment and consequently emerged new issues, a driver currency
2 The highly significant statistics in the euro, yen, pound and franc equations and the outright insignificant statistics, with very large p-values, in the RMB equation imply that the RMB is not meaningfully pegged to a basket of currencies; the RMB is predominantly, if not exclusively, pegged to the US dollar.
hypothesis has been proposed in this paper and the driver currency effect has been empirically examined amongst five currencies. The results indicate a driver currency effect and the presence of driver currencies. References Dubas, J.M., Lee, B.J., Mark, N.C., 2010. A multinomial logit approach to exchange rate policy classification with an application to growth. Journal of International Money and Finance 29 (7), 1438–1462. Ghosh, A.R., Gulde, A.M., Ostry, J., Wolf, H., 1997. Does the nominal exchange rate matter? NBER Working Paper No. 5874. Heller, H.R., 1978. Determinants of exchange rate practices. Journal of Money, Credit and Banking 10 (3), 308–321. Holden, M., Holden, P., Suss, E., 1979. The determinants of exchange rate flexibility: an empirical investigation. Review of Economics and Statistics 61 (3), 327–333. Meissner, C.M., Oomes, N., 2008. Why do countries peg the way they peg? The determinants of anchor currency choice. IMF Working Paper WP/08/132. Reinhart, C., Rogoff, K., 2004. The modern history of exchange rate arrangements: a reinterpretation. Quarterly Journal of Economics 19 (1), 1–48.