Renminbi in the future international monetary system

International Review of Economics and Finance 21 (2012) 106–114

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International Review of Economics and Finance j o u r n a l h o m e p a g e : w w w. e l s ev i e r. c o m / l o c a t e / i r e f

Renminbi in the future international monetary system Kuo-chun Yeh ⁎ Department of Economics, National Chung Cheng University, 168 University Road, Minhsiung Township, Chiayi County 62102, Taiwan

a r t i c l e

i n f o

Article history: Received 27 February 2010 Received in revised form 22 April 2011 Accepted 25 April 2011 Available online 10 May 2011 JEL classification: C70 F33 F42 F47

a b s t r a c t The dollar, euro and yen still dominate the international financial system after the global recession. However, the renminbi is expected to be the next international currency with the continued growth of China. Will a forthcoming multiple reserve currency system be an origin of instability? This study analyzes whether or not a prospective G3 plus renminbi cooperative mechanism can be sustained. A basic assumption is that the four countries can solely use or coordinate their policies without losing their national currencies. We conclude that a multicurrency cooperative mechanism is hardly feasible if the welfare of the individual countries is considered. © 2011 Elsevier Inc. All rights reserved.

Keywords: Renminbi Yen Euro Dollar International monetary system

1. Introduction After the speculative attacks occurred in 1997, East Asian officials rethought their views on international macroeconomic cooperation. 1 The global recession in 2007 has been associated with an unprecedented rise of swap agreements between central banks of larger economies and their counterparts in smaller economies (Aizenman, Jinjarak, & Park, 2011). Contrary to the idea of a durable Bretton Woods II system, Asia then went on to slowly increase flexibility and reduce the role of the US dollar (Patnaik, Shah, Sethy, & Balasubramaniam, 2010). Mundell (2000) argues that the absence of an international currency is one of the two unfinished pieces of the twentieth century. However, a multiple reserve currency system, as predicted by the World Bank (1993), seems to be forthcoming. 2 Currently, the dollar, yen, and the euro, the so-called “G3,” still dominate the current international monetary system. As the Chinese economy continues to grow, the renminbi is expected to be the next international currency. In the area of the G3 plus renminbi, trade and investment are already well-integrated. However, focus should not only be placed on bringing great coherence to trade agreements, but also on deepening policy coordination to require greater monetary and financial stability. Will a forthcoming multiple reserve currency system be an origin of instability, or an engine to improve national macroeconomic policy performance through competition and cooperation? What would be the outcomes if policy coordination were feasible in the G3 plus renminbi? This study extends the previous work (Yeh & Ho, 2010) on a four-country model to analyze

⁎ Tel.: + 886 5 2720411x34118; fax: + 886 5 2720816. E-mail address: [email protected]. 1 2

A famous case is the Chiang Mai Initiative Multilateralisation (CMIM). Since 2010, it has been strengthened, reaching 120 billion U.S. dollars. The World Bank (1993) indicates that the Chinese Economic Area could be the fourth pole of the world.

1059-0560/$ – see front matter © 2011 Elsevier Inc. All rights reserved. doi:10.1016/j.iref.2011.04.003

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whether a prospective G3 plus renminbi monetary cooperative mechanism can be sustained and be helpful to international financial stability. An important assumption is that China, the U.S., Japan, and the European Monetary Union (EMU) can solely use or coordinate their economic policies without losing their independent national currencies. The dynamic game approach is used to simulate possible outcomes of G3 plus renminbi cooperative or non-cooperative mechanisms. A series of publications such as those by Buiter and Marston (1985), Petit (1990) and Plasmans, Engwerda, van Aarle, Di Bartolomeo, and Michalak (2005), provide a comprehensive analysis of the problems that emerge in such dynamic games. From 1999 onwards, the EMU has provided a realistic scenario for the use of this method. Recent works, such as Beetsma and Jensen (2005), Engwerda, van Aarle, and Plasmans (2002) and Yeh (2007), explore the convergence issues of the EMU. This paper is structured as follows. Section 2 presents and explains the modeling, and introduces a multi-country quarterly estimation. Section 3 shows how to trace the different scenarios in a non-cooperative or a cooperative situation. Section 4 combines the theories and empirics presented in Sections 2 and 3 to develop a simulation study from which we can obtain an initial idea about the future of G3 plus renminbi. Section 5 concludes our findings and notes the policy implications of this study. 2. The model and empirics We established a IS-AS model of the four economies, which extends the framework to analyze the monetary union proposed by Wickens (2008). All variables are in logarithm and denote deviations from their long-term equilibrium, which is normalized to zero. Variables with subscripts i = 1, 2, 3, 4, represent China, the EMU, Japan, and the United States, respectively. Eq. (1a) defines the IS curve of each country yi ðt Þ = ∑ δij qij ðt Þ + ∑ ρij yj ðt Þ + ηi fi ðt Þ−γi ri ðt Þ j∈N=i

ð1aÞ

N = 1; 2; 3; 4

j∈N=i

where y(t) qij(t) f(t) r(t)

real output. real exchange rate of country i with respect to country j. real fiscal deficit. real interest rate.

Eq. (1a) expresses the aggregate demand for goods and services of the four economies included in our model. The positive δ, ρ, η and γ imply an improvement in the competitiveness, foreign output growth, and expanding fiscal and monetary policies benefit domestic output. This model helps analyze the roles of the exchange rate, price convergence, and international impact on the domestic economy during the process of economic integration. Eqs. (1b) and (1c) explain the purchasing power parity (PPP) and real interest rate in Eq. (1a) qij ðt Þ = sij ðt Þ−pi ðt Þ + pi ðt Þ; e

ri ðt Þ = ii ðt Þ−p˙ i ðt Þ;

ð1bÞ

subscript i≠j;

ð1cÞ

subscript i = 1; 2; 3; 4;

where sij(t) i(t) p(t) p˙ e ðt Þ

nominal exchange rate of country i with respect to country j. nominal interest rate. price level. expected inflation.

Eq. (1b) explains the competitiveness of country i on the right side of (1a), while ∑ δij qij takes into account the most important j∈N = i

trading partners and the long-term PPP. The nominal exchange rates sij among the four countries also appear in Eq. (1b). The expected real interest rate of each country is defined in (1c). Henceforth, perfect foresight is assumed in this study, so that, in our deterministic context, p˙ ei ðt Þ = p˙ i ðt Þ. 3 The aggregate supply in an open economy is constructed by extending Razin and Yuen (2002) p˙ i ðt Þ = λi Θi ðt Þ + ∑ ςij p˙ j ðt Þ + ξi yi ðt Þ;

ð2aÞ

j∈N=i

3 Note that the perfect foresight assumption may not be appropriate to analyze cases with imperfect information. The empirical results could of course be changed without the assumption of strong rational expectation. However, it is a good benchmark to think of G4 policy coordination. An efficient information sharing and surveillance system should be necessary. For instance, if there is no benefit to carrying out policy coordination under perfect foresight, it could be more difficult to do so under different assumptions.

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K. Yeh / International Review of Economics and Finance 21 (2012) 106–114

where Θi(t) = risk premium. Eq. (2a) describes that CPI inflation is caused by capital inflows, foreign inflation and domestic output. In theory the parameters (λ, ς and ξ) should be positive. Note that capital flows caused by risk premium are defined in Eq. (2b) e

Θi ðt Þ : = ii ðt Þ−ij ðt Þ− s˙ ij ðt Þ;

ð2bÞ

subscript i = 1; 2; 3; subscript j = 4;

e

where s˙ ij ðt Þ = s˙ ij ðt Þ. Capital flows depend on the interest rate parity (IRP). In this study, the nominal interest rate of the U.S. is assumed to be close to the level of the world interest rate. Therefore, the U.S. risk premium is zero (Θ4(t) = 0). We can do a quarterly estimation (from 1998.IV to 2006.II) according to Eqs. (1a) and (2a). The Data Appendix shows the variable definitions and data sources. The purpose of doing so is to determine the values of the parameters for the simulations of the next section. The reason for using quarterly data and choosing 1998.IV as the starting point is that annual data are still limited

Table 1 Aggregate demand (Eq. (1a)) estimated by an error correction mechanism. Variables and countries

China

EMU

Japan

U.S.

Constant

− 99.13 (14.77) 1.141 (0.438) − 1.730 (0.445) 0.854 (2.621)

− 2.251 (0.762) − 0.095 (0.083)

6.679 (0.961)

1.397 (0.820)

Δq12 Δq13 Δq14 Δq23

0.071 (0.189) 0.299 (0.077) − 0.076 (0.015) − 0.086 (0.086)

Δq24 Δq34 q12(− 1) q13(− 1) q14(− 1)

0.076 (0.199) − 0.972 (0.239) − 1.126 (0.339) − 6.372 (1.753)

q24(− 1)

0.392 (0.185) − 0.083 (0.125)

q34(− 1)

r(− 1) Δf f(− 1)

0.077 (0.055) 0.140 (0.048) 0.468 (0.159) 0.858 (0.246)

Δy1 Δy2 Δy3 Δy4 y1(− 1) y2(− 1) y3(− 1) y4(− 1) Adjusted R2

− 23.38 (3.118) 15.01 (2.111) 13.63 (2.938) − 1.816 (0.114) − 14.70 (3.494) 11.70 (1.975) 8.239 (2.006) 0.693

0.158 (0.014) − 0.141 (0.012)

− 0.416 (0.088)

− 0.033 (0.015) − 0.357 (0.089)

q23(− 1)

Δr

0.087 (0.013)

− 0.003 (0.002) 0.001 (0.002) 0.504 (0.086) 0.507 (0.147) − 0.042 (0.005)

0.244 (0.080) 0.234 (0.108) − 0.075 (0.011) − 0.594 (0.160) 0.153 (0.087) 0.328 (0.104) 0.861

0.013 (0.019)

0.364 (0.212) 0.016 (0.024) − 0.039 (0.017) 0.147 (0.094) 0.006 (0.170) 0.036 (0.007) 0.536 (0.204)

− 0.425 (0.211) 0.065 (0.013) − 0.341 (0.217) − 0.747 (0.119) 0.482 (0.221) 0.643

0.030 (0.015) − 0.028 (0.012) 0.004 (0.001) 0.001 (0.001) 0.257 (0.067) 0.288 (0.107) 0.010 (0.008) 0.675 (0.098) 0.050 (0.116)

0.015 (0.014) − 0.209 (0.101) 0.019 (0.116) − 0.219 (0.121) 0.744

Note: The bolded values are significant at a 10% level. The regressions add lag terms should Durbin–Watson statistics suggest a significant autocorrelation.

K. Yeh / International Review of Economics and Finance 21 (2012) 106–114

109

after China's economic reform. In addition, economic exchange among countries was interrupted by the East Asian financial crisis in 1997, but speeded up again after 1998 III. Next, Eqs. (1a) and (2a) can be estimated via an error correction mechanism as Eq. (3) K

K

1

M

Δwt = μ0 + μ1 wt−1 + ∑ ωk xk;t−1 + ∑ ∑ σkl Δxk;t−l + ∑ ϑm Δwt−m + εt ; k=1

k=1 l=0

m=1

ð3Þ

where w represents the left-hand side variable (yi and p˙ i in Eqs. (1a) and (2a)) and x represents all right-hand side variables except the lagged left-hand side term and the differential terms of all relevant lags of w, and the first differential terms of all lags of x. ε is a white noise error term. All variables except for interest rate are seasonally adjusted and expressed in natural logarithms before the seemingly unrelated regressions (SURs) are used to carry out estimation. 4 Tables 1 and 2 present our estimation results. The short run elasticities of ECM (e.g., σkl in Eq. (3)) statistically significant at a 10% level or with the right signs are needed as baseline values for the simulations of the next section. The selected estimation results are as follows: On the aggregate demand side, the demands of Japan and the U.S. still have strong effects on China (ρ13 = 15.01 and ρ14 = 13.63 in Eq. (1a)). Further, fiscal spending (η1 = 0.468 in Eq. (1a)) has an effect on China's growth. In contrast, Japan's fiscal and monetary policies are not effective in boosting its aggregate demand, which indicates that Japan has been in economic recession since the 1990s. Moreover, the demand of the EMU (ρ32 = 0.536 and δ23 = 0.087 in Eq. (1a)) matters for Japan's output. On the aggregate supply side, the price of the U.S. has a positive impact on that of China (ς14 = 1.518 in Eq. (2a)). However, China's inflation now also has a slight impact on the U.S. price (ς41 = 0.114 in Eq. (2a)). Furthermore, according to Eq. (2a), the relationship between inflation and output should be weak in an open economy with a flexible labor market. The empirics suggest that China, Japan and the U.S. fit the above conditions because of the small and insignificant values of ξ (ξ1 and ξ4 insignificant; ξ2 = 0.357; ξ3 = 0.030) in Eq. (2a). 5 Note that the coefficients calibrated from estimation are significant at the 10% level or with the right signs, which still reflect the roles of the variables on explaining the relationships among the four economies. 3. Policy designs of the different scenarios The coordination problem is analyzed as the outcome of a two-stage game in the same manner as has been done in recent studies about endogenous coalition formation. 6 At the first stage, policy makers negotiate policy regimes and in the second, they set the controls according to the agreement signed in the first stage. Following a standard approach, we assume, on the one hand, that each country tries to minimize its loss function which includes variables representing the country's economic growth and inflation. This loss function is subjected to the real exchange rate which functions as an indicator of competitiveness. Economic instruments such as interest rate and fiscal policy are also available for each player to use to improve its objective. Assume that authorities will control their policy instruments. For example, they will minimize the following quadratic loss functions o 1 ∞n 2 2 −θðt−t0 Þ Min Ji = Min ∫t0 αi ð p˙ i ðt ÞÞ + βi ðyi ðt ÞÞ e dt; fi;ii fi;ii 2

i = 1; 2; 3; 4

ð4Þ

in which θ denotes the rate of time preference and α and β represent preference weights that are attached to the stabilization of inflation and output, respectively. Eq. (4) is a conventional form featuring domestic inflation and output. For each of the four countries, Eqs. (1a) and (2a) can be reduced to the output formula when its economy is in equilibrium T

yi ðt Þ = Di xðt Þ;

ð5Þ

  where DiT is the vector of the parameters in the reduced-form model, xT = qT f T iT s˙ T , and qT = ð q1 q2 q3 q4 Þ, f T = ð f1 f2 f3 f4 Þ, iT = ð i1 i2 i3 i4 Þ, s˙ T = ð s˙ 12 s˙ 13 s˙ 14 s˙ 23 s˙ 24 s˙ 34 Þ. In Eq. (5), q, f, i, and s˙ of a country appear in the outputs of other countries at the same time (though some parameters may not be significantly different from zero). This implies that close economic links have been formed among the economies. The derivatives of the real exchange rates with respect to time can now be calculated. q˙ i ðt Þ = ∑ δij q˙ ij ðt Þ

N : = 1; 2; 3; 4;

ð6Þ

j∈N = i

4 SURs propose that the error terms are assumed to be correlated across the equations. The model can be estimated equation-by-equation using standard ordinary least squares (OLS). Such estimates are consistent. However, they are generally not as efficient as the SURs. 5 Liu and Zhang (2010) estimate China's aggregate supply and find ξ1 = 008. The value is small and consistent with our result. But their hybrid monetary policy rule is different from the settings in our study. 6 For instance, Engwerda et al. (2002).

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K. Yeh / International Review of Economics and Finance 21 (2012) 106–114

Table 2 Aggregate supply (Eq. (2a)) estimated by an error correction mechanism. Variables and countries

China

EMU

Japan

U.S.

Constant

0.125 (0.143) − 0.001 (0.006) 0.001 (0.002)

− 0.568 (0.675) 0.012 (0.005) 0.006 (0.002) 0.205 (0.114)

0.073 (0.873) − 0.005 (0.003) − 0.003 (0.001) − 0.290 (0.072) 0.407 (0.114)

− 0.497 (0.217)

ΔΘ Θ(− 1) Δ(Δp1-Δp1(− 1)) Δ(Δp2-Δp2(− 1))

0.174 (0.277) − 1.255 (0.322) 1.518 (0.609) − 0.659 (0.220) 0.213 (0.322) − 1.641 (0.460) 1.864 (0.903) − 0.017 (0.024) − 0.024 (0.019) 0.301

Δ(Δp3-Δp3(− 1)) Δ(Δp4-Δp4(− 1)) Δp1(− 1) Δp2(− 1) Δp3(− 1) Δp4(− 1) Δy y(− 1) Adjusted R2

0.655 (0.206) 0.229 (0.390) 0.152 (0.154) − 1.711 (0.155) 1.103 (0.300) 1.081 (0.639) 0.357 (0.363) 0.081 (0.092) 0.582

− 0.476 (0.291) − 0.032 (0.106) 0.803 (0.190) − 1.773 (0.183) − 0.728 (0.443) 0.030 (0.220) − 0.008 (0.067) 0.784

0.114 (0.052) − 0.099 (0.074) 0.029 (0.105)

0.212 (0.060) − 0.103 (0.090) 0.155 (0.148) − 1.069 (0.165) − 0.148 (0.177) 0.057 (0.024) 0.445

Note: The bolded values are significant at a 10% level. The regressions add lag terms should Durbin–Watson statistics suggest a significant autocorrelation.

By substituting Eqs. (2a) and (5) into formula (6), it can be rewritten as q˙ ðt Þ = ϕT xðt Þ

ϕ∈R18×4

qð0Þ = q0

ð7Þ

;

where ϕ T is the vector of the parameters. The dynamics of the model in Eq. (7) are then represented by four first-order simultaneous differential equations with national fiscal deficits and nominal interest rates as controlled variables, four real exchange rates as state variables, and six nominal cross exchange rate changes as uncontrolled variables. When Eqs. (2a) and (5) are substituted into (4) and t0 = 0, the loss function is simplified to

Ji =

o 1 ∞n T −θt ∫0 x ðt ÞMi xðt Þ e dt 2

ð8Þ

i = 1; 2; 3; 4;

where Mi is a 18 × 18 matrix. Table 3 Baseline values of policy preference weights and bargaining powers.

α β θ τ (G3 + CN FC) τ (CN + EMU) τ (CN + JP) τ (CN + US) τ (EMU + JP) τ (EMU + US) τ (JP + US) τ (EMU + JP + US)

China

EMU

Japan

U.S.

2 5 0.15 1/4 1/2 1/2 1/2 – – – –

2 5 0.15 1/4 1/2 – – 1/2 1/2 – 1/3

2 5 0.15 1/4 – 1/2 – 1/2 – 1/2 1/3

2 5 0.15 1/4 – – 1/2 – 1/2 1/2 1/3

Note: Values of the weights on the loss functions are all based on previous studies (e.g., Engwerda et al. 2002). The values are symmetric once the countries decide to fairly coordinate their economic policies.

K. Yeh / International Review of Economics and Finance 21 (2012) 106–114

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Table 4 Values of the loss functions under Shock 1.

Games Countries

NC

G3 + CN FC

CN + EMU

CN + JP

CN + US

EMU + JP

EMU + US

JP + US

EMU + JP + US

China EMU Japan U.S.

2.5354 0.2989 0.1416 1.8488

2.6947 3.0225 0.1311 1.8863

4.4087 2.8732 6.0e + 05 3.6e + 04

2.5581 5.6e + 04 0.2825 3.5e + 04

-----

2.2e + 08 7.5152 4.7902 2.8e + 06

1.8e + 06 162.33 6.0e + 03 3.7e + 07

3.7501 76.382 0.1163 4.8959

-----

Note: Columns identify policy regimes; rows indicate the policy-makers' optimal losses (divided by 102). All values are computed by using the baseline parameters of Tables 1, 2 and 3. Values marked with gray color are consistent with the profitability property if we choose non-cooperation (NC) as our benchmark.

In non-cooperation, each player minimizes its loss function (8) independently with respect to the dynamic laws of motion (7) of the system. Min

Ji

i = 1; 2; 3; 4

s:t:

q˙ i ðt Þ = Aqi ðt Þ + Bu1 ðt Þ + Cu2 ðt Þ;

qi ð0Þ =

q0i

ð9Þ

where qiT, u1T, u2T are 1 × 4, 1 × 8, and 1 × 6 vectors of state variables, instruments variables (fi and ii), and non-controlled variables ( s˙ ij ), respectively. A, B, and C are 4 × 4, 4 × 8, and 4 × 6 matrices of coefficients. Next, we use the axiomatic approach (Nash, 1950) in which no bargaining process is considered. This approach is therefore static in nature and describes a solution rather than a bargaining process. A two-stage game can be established as follows: first, China, the EMU, Japan and the U.S. decide whether to organize a full cooperative mechanism or a partial coalition. Next, assuming full cooperation or a partial coalition, the four economies adjust their policy tools to deal with the various economic stresses. For instance, we can illustrate the two-stage full cooperation game by solving the open-loop Nash equilibrium in (10) 1;2:3;4

1;2:3;4

i=1

i=1

JFC = ∑ τi Ji

∑ τi = 1;

ð10Þ

where τi measures the bargaining powers between players. In full cooperation, the joint loss function (11) is minimized, subject to (7) JFC =

o 1 ∞n T −θt ∫ x ðt ÞMFC xðt Þ e dt; 2 0

ð11Þ

where MFC = ∑ τi Mi . The partial coalitions can be solved in a similar manner. i=1 Table 3 shows the baseline values of bargaining powers, policy preference weights and the time preference rate of the loss functions taken from a previous study (e.g., Engwerda et al., 2002). First, the policy preferences (α and β) in Eq. (4) and bargaining powers (τ) in Eq. (10) should be symmetric once the countries decide to fairly coordinate their economic policies. Thus, in the cases of full and partial cooperation, the economies have the same policy objectives and bargaining power (e.g., α = 2, β = 5, θ = 0.15 and τ1 = τ2 = τ3 = τ4 = 1/4 in full cooperation). For the same reason, τi can be 1/2 in a two-player partial coalition. Second, β should equal to zero if a country is a strict inflation targeter (Wickens, 2008). In this study, we assume that the four countries still pay attention to their output stabilization. 4. Simulation The result of China's deflation and exchange rate policy on the rest of the world has been the main international economic issue for the past two years. On the one hand, some economists (for example, Blanchard, 2007; Blanchard & Giavazzi, 2006) stress the

Table 5 Values of the loss functions under Shock 2.

Games

NC

G3 + CN FC

CN + EMU

CN + JP

CN + US

EMU + JP

EMU + US

JP + US

EMU + JP + US

3.1463 0.3767 0.0847 0.0213

5.2816 3.4646 0.0690 0.0841

3.3957 3.6608 6.0e + 05 3.7e + 04

6.8220 5.6e + 04 0.0285 3.6e + 04

-----

2.2e + 08 0.7981 7.4628 2.8e + 06

1.8e + 06 86.839 6.1e + 03 3.7e + 07

4.0267 67.231 0.0787 0.0632

-----

Countries China EMU Japan U.S.

Note: The settings are the same as those in Table 4.

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K. Yeh / International Review of Economics and Finance 21 (2012) 106–114

Table 6 Full cooperation under Shock 1 and asymmetric bargaining powers (τi).

Games

NC

Countries China EMU Japan U.S.

2.5354 0.2989 0.1416 1.8488

G3 + CN

G3 + CN

G3 + CN

G3 + CN

(FC1)

(FC2)

(FC3)

(FC4)

2.6947 3.0225 0.1311 1.8863

2.6949 3.0223 0.1312 1.8839

2.6956 3.0220 0.1313 1.8816

2.7064 3.0192 0.1335 1.8796

Note: In FC1, τ1 = τ2 = τ3 = τ4 = 1/4; In FC2, τ1 = τ2 = τ3 = 2/9 and τ4 = 1/3; In FC3, τ1 = τ2 = τ3 = 1/6 and τ4 = 1/2; In FC4, τ1 = τ2 = τ3 = 1/30 and τ4 = 9/10. The rest of the settings are the same as those in Table 4.

necessity of renminbi appreciation to solve global current account imbalances. Chinese authorities did appreciate renminbi, but this still did not satisfy the U.S. and other industrialized countries. It is expected there will be further appreciation of renminbi due to U.S. pressure, which in turns puts pressure on all the other East Asian currencies. In this simulation study, two possible origins of economic stress are assumed, all other things being equal: Shock 1. The price level of China decreases by 10%, while renminbi appreciates with respect to other currencies by 15% (p1 = −10; s12 = s13 = s14 = − 15). Shock 2. The price level of the U.S. increases by 5% (p4 = 5). Shock 1 simulates China's deflation and assumes that exchange rate alignment is occurring through mutual negotiation. Shock 2 simulates inflation of the U.S. Thus, a comparison among different scenarios can be made under the aforementioned stresses, thereby demonstrating whether a cooperative mechanism can benefit the four economies. There are at least fourteen possible scenarios of economic coalitions among the four countries under the assumption of independent policy decisions. Here, we exclude six cases and only discuss nine possibilities closely related to G3 plus renminbi: First, the non-cooperation scenario (NC) is closely related to the current situation, which can be treated as a benchmark of comparison. Second, three types of two-country coalitions including China (CN + EMU, CN + JP and CN + US) and four-country full cooperation (G3 + CN FC) simulate the interaction among China and the G3 countries. Since the 2004 G7 Summit in Atlanta, China has been invited to communicate with the central bankers and financial ministers of the G7. The China–US economic strategic dialog also has been set up since September 20, 2006. These arrangements can be a beginning of further policy coordination for G3 plus renminbi. Third, four coalitions excluding China (EMU + JP, EMU + US, JP + US and EMU + JP + US) predict the results if China is isolated from international monetary coordination. On this account, the international financial situation could worsen without China. There are various definitions of the optimal size of a monetary union (e.g., Demopoulos & Yannacopoulos, 2001; Karras & Stokes, 2001; Kato & Uctum, 2008; Tori, 1997). Based on Demopoulos and Yannacopoulos (2001), a currency area of a given size is an OCA if all its members are better off with a monetary union than without it. Here we assume that in a one-shot game the four economies simultaneously decide according to a simple profitability property. That is, the losses in the coalition must be lower than or equal to the non-cooperative losses for all economy members of the coalition. Matlab was used to write a simulation program to compute the loss function and macroeconomic adjustment of each economy. The results of the loss function computation using the baseline values of Tables 1, 2 and 3 are reported in Tables 4 and 5. 7 Values marked by gray tone are consistent with the profitability condition. Compared with the situation in NC, no coalitional mechanism can be feasible. This result suggests that policy coordination among G3 plus renminbi is difficult to achieve at present. In addition, G3 plus renminbi and other coalitions are not feasible under the two simulated shocks, but some of them signal potential benefits for Japan. In reality, the U.S. economy is about 6 times larger than that of China under the definition of purchasing power parity. However, this does not mean the same gap exists in multilateral bargaining powers. In Table 6, we check full cooperation of G3 plus renminbi by changing the bargaining power of the U.S. from the baseline value (τ4 = 1/4) to 0.9. 8 That is, FC1 is the baseline case (τ1 = τ2 = τ3 = τ4 = 1/4), and τ4 becomes larger and larger from FC2 (τ1 = τ2 = τ3 = 2/9 and τ4 = 1/3), FC3 (τ1 = τ2 = τ3 = 1/6 and τ4 = 1/2) to FC4 (τ1 = τ2 = τ3 = 1/30 and τ4 = 9/10). The results shown in Table 6 are the same as those in the baseline simulation. All simulated mechanisms benefit Japan but may not be accepted by the EMU. G3 plus renminbi is not attractive to China and the U.S., but it does not worsen their welfare, either. The four graphs in Fig. 1 also indicate that τ4 does not have a strong impact on adjustment of the loss functions. In sum, independent policy decisions are still preferred by three of the four countries at the current stage.

7 If matrix M shown in Eq. (8) has more than four positive eigenvalues, multiple equilibria arise, whereas if this matrix has less than four positives eigenvalues no equilibrium exists (for more details see Engwerda 1998). Here we only report a representative case if there exist multiple equilibria. 8 Note that in reality τ may not be continuous, since not every τ can cause sufficient eigenvalues of matrix MFC in Eq. (11).

K. Yeh / International Review of Economics and Finance 21 (2012) 106–114

China

EMU

Japan

U.S.

113

Fig. 1. Adjustment of the loss functions when τ4 changes: The case of G3 + CN FC under Shock 1. Note: Axis x, y, and z represent time (t), the U.S. bargaining power (τ4), and values of the loss functions (LFi), respectively.

5. Conclusion A dynamic game approach was adopted to explore whether a G3 plus renminbi mechanism would be feasible under various scenarios and economic shocks. The simulation results do not provide an optimistic view of the reform of the international monetary system. That is, independent policy decisions by each country are still the best strategy at present. As Miller and Salmon (1985) pointed out, the welfare of each country may decrease even if policy coordination is possible. Why is this? First, according to conventional theory, the high degrees of trade integration and economic symmetry must be satisfied before an OCA can be established. Our estimation results in Section 2 imply that the G3 plus renminbi is not qualified for an OCA. The stability of a monetary cooperative mechanism may also be unsustainable when asymmetric shocks are taking place (Wyplosz, 2004). Second, even if G3 plus renminbi is ready for cooperation on economic grounds, the political preconditions and concrete plans for institutional initiatives have not yet been given. As Mundell (2003) suggested, a monetary system without national central banks should be the most efficient system for the world economy. In other words, a supra-national policy institution is necessary according to the theory of endogenous OCA.

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In sum, we cannot ignore that our results are drawn from the assumption of multi-country coordination without a common policy institution. What would be the effects if there was a G3 plus renminbi common policy institution according to the theory of endogenous OCA? Future research may also need to deal with the above problem, following the framework of this study. Acknowledgments The authors are grateful to an anonymous referee for suggestions and to Taiwan's National Science Council for financial support (NSC97-2415-H-194-011). Data appendix Quarterly data are used in the estimations. All variables are seasonally adjusted in this empirical test. The time period is from 1998 IV to 2006 II:

Variables

Definition

Data sources

Price index (p) Nominal and real exchange rates (s, q) Real GDP (y) Nominal interest rate (i)

p = log(CPIsa). The base year of all economies is 2000. s = log(e); q = (e + CPIsaus/CPIsa). The negative value of changes in real exchange rate means real appreciation. y = log(GDPsa 100 / CPIsa). We mainly use the federal fund rate and money market rate (IFS line 60b) here. However, we use the deposit rate (IFS 60 l) of China since the Chinese discount rate is not available. r = i-Δp Real interest rate is equal to the nominal interest rate minus consumer price inflation, which is consistent with our theoretical model. f = log(GCsa 100 / CPIsa). The quarterly deficits are not available, so we use government consumption (GC) and claims on the central government of China (net) as replacement.

IFS line 64 IFS lines rf, 64

Real interest rate (r) Fiscal policy (f)

IFS lines 99b, 64 IFS lines 60b, 60 l IFS lines 60b, 60 l, 64 IFS lines 91f, 64, 32an

Sources: IFS CD-ROM.

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