The Case for a Common Basket Peg for East Asian Currencies

This paper examines the case for a simultaneous change in the exchange rate peg used by a group of East Asian currencies. I assume for the time being that 9 economies would be involved: China, Hong Kong, Indonesia, Korea, Malaysia, the Philippines, Singapore, Taiwan, and Thailand. The reason for picking this group is the impression that they are close competitors to each other; in due course the paper examines whether this is in fact sufficiently true to make these countries a natural monetary grouping like the EMS countries are widely agreed to be.

The first section of the paper describes the current exchange rate policies of the 9 countries. This is followed by a discussion of some of the problems created by those policies. Section 3 describes the advantages of a common peg, and goes on to calculate what a common basket peg for the East Asian countries would look like, both before and after dropping potentially marginal members of the group. The final section of the paper argues that use of a common peg imposes rather few constraints on other dimensions of a country's exchange rate policy.

Current Exchange Rate Policies

China still has an inconvertible currency and the mechanism by which its value is determined on the foreign exchange market is opaque, but it certainly does not float freely and its value is certainly not fixed. The remnimbi appears to be devalued with a substantial step from time to time, rather as under the old Bretton Woods system, and in between to vary quite a lot but in no very systematic way (although it has been more stable recently). For example, it was devalued by about 50 percent against the dollar at the beginning of 1994, and then tended to appreciate a bit until mid-1995, since when the rate has been relatively stable in terms of the dollar.

Table 1 shows 3 measures of exchange rate volatility for the 9 East Asian currencies: the standard deviation of changes in the end-month bilateral exchange rate against the US dollar, and the standard deviation of monthly changes in effective and real effective exchange rates. It can be seen that the volatility of the remnimbi is by far the highest of any of the East Asian currencies, measured either against the dollar or in terms of either effective exchange rate index. China is also unusual in that the volatility of the real effective rate is substantially higher than that of the nominal effective rate.²

The Hong Kong dollar has had a fixed link to the US dollar, backed up by an Exchange Fund that acts effectively as a currency board, since 1983. It is an unambiguous case of a fixed exchange rate, and it is fixed to the US dollar. As a result, its volatility against the dollar is minimal. (One can in fact use a value of 0.1 to calibrate other results in the table; any greater value occurs because policy is not directed at stabilizing the rate in question.) But this stability against the US dollar still leaves the Hong Kong dollar with significant volatility in terms of both the nominal and real effective rates.

Indonesia describes its system as one of a managed float, although it seems that in practice it is closer to a crawling peg, with the crawl defined against the dollar. Thus in the first 8 months of 1995 (the period during which the yen went on its great rollercoaster), the rupiah's bilateral exchange rate against the dollar depreciated between 5 and 10 rupiahs each month, an average of 0.4 percent, while its effective exchange rate varied from a depreciation of 5.5 percent in March when the dollar was weak to an appreciation of 6.8 percent in August when the dollar was recovering. Table 1 shows that on a short-term basis the rupiah has been almost as stable against the dollar as the Hong Kong dollar has been³, but both nominal and real effective rates have been somewhat more volatile than in Hong Kong. In the last year the authorities have gradually opened a band around the official rate, which has now reached +/- 4 percent.

Korea describes its current exchange rate system as a "market average rate system". This means that it has a band with margins of +/- 2 1/4 percent on any day, but today's band is centered on yesterday's average rate. Each day the exchange rate can move within the predetermined band based on the average rate for transactions the previous day, but since those transactions are themselves subject to strong official influence this allows for less impact of the market than might be assumed. The band is defined in terms of the US dollar. As Table 1 shows, the rate is in practice quite stable in terms of the US dollar, while both nominal and real effective rates are not that much more volatile than the dollar rate: indeed, they are the most stable in the region.

Malaysia. The IMF's Annual Report on Exchange Arrangements and Exchange Restrictions has since 1991 described the external value of the Malaysian ringgit as "determined by supply and demand in the foreign exchange market. The Central Bank of Malaysia intervenes only to maintain orderly market conditions and to avoid excessive fluctuations in the value of the ringgit in terms of Malaysia's trading partners and the currencies of settlement." Although Table 1 indicates that the ringgit fluctuates much more than the preceding 3 currencies in terms of the dollar, there have been occasional press reports of heavy intervention designed to prevent the ringgit appreciating to a degree that the authorities feared would jeopardize competitiveness, as well as reports of concerns about downward pressure on the ringgit for a brief period in the wake of the Mexican crisis in early 1995. The volatility of the effective rates is only marginally larger than that against the dollar.

Philippines. The IMF Annual Report on Exchange Arrangements and Exchange Restrictions describes the policy of the Philippines as one of floating, but with the authorities intervening "when necessary to maintain orderly conditions in the exchange market and in light of their other policy objectives in the medium term." Table 1 suggests that volatility has been in the same range as other countries with (largely) freely floating rates, but I do not know whether this is because floating has in fact been quite free or because policy has been erratic. Volatility in the effective rates is again marginally larger than that against the dollar.

Singapore. The IMF Annual Report on Exchange Arrangements and Exchange Restrictions states that Singapore "follows a policy under which the Singapore dollar is permitted to float, and the exchange rate of the Singapore dollar...is freely determined in the foreign exchange market. However, the Monetary Authority of Singapore monitors the external value of the Singapore dollar against a trade-weighted basket of currencies with the objective of maintaining a low and stable domestic inflation rate." Since Singapore had a current account surplus of about 14 percent of GDP in 1995, the highest in the world, and much of this was used to acquire reserves (which stood at some $67 billion in September 1995, for less than 3 million people) rather than to finance a capital outflow, it is clear that the float is far from a free one. The statistics in Table 1 show that volatility was relatively low in terms of the dollar and of both concepts of the effective exchange rate, although it is not so low as to suggest that policy approximates pegging to a trade-weighted basket.

Taiwan is another economy with a float that is reputed to be heavily managed, although the statistics in Table 1 suggest that it is freer than the majority of the other East Asian currencies. Apart from the marginal difference in highly erratic China, Taiwan is the only case where the nominal effective rate is more stable than the dollar rate. Taiwan is also unusual in that, again apart from China, it is the only case where the real effective exchange rate is noticeably more unstable than the nominal effective rate.

Thailand. The Thai baht was officially pegged to the US dollar until a devaluation in November 1984, at which time it was announced that its value would be determined on the basis of a weighted basket of the currencies of Thailand's major trading partners. The same formula has been repeated ever since in the IMF's Annual Report on Exchange Arrangements and Exchange Restrictions. It is therefore somewhat surprising that, despite the gyrations in the value of the dollar, the baht has never varied more than about 5 percent from a rate of 26 bahts to the dollar. The explanation seems to be that the unpublished basket to which Thailand ties the baht has a dollar weight of about 88 percent. This results in dollar volatility being fairly low, while volatility in both the effective rates is also relatively low.

This review suggests that the current exchange rate practices of East Asian currencies are quite varied. At one extreme, those of China have, at least until recently, still been erratic. At the other extreme, Hong Kong has an almost perfectly fixed exchange rate against the dollar. Several other East Asian countries are also heavily dollar-focused: Indonesia (even though the rupiah depreciates continuously), Thailand, and Korea, and perhaps (now) China. Singapore also has a fairly stable rate against the dollar, but it is also relatively stable in effective terms, suggesting that the basket has a significant influence. The Philippines seems to float, while the remaining two countries, Malaysia and Taiwan, have intermediate statistics, suggesting heavily managed floats.

Evaluation

The first point that has to be acknowledged is that East Asian countries have for some years managed their exchange rates far better than other groups of developing countries. They have not crucified their economies by misconceived attempts to use the exchange rate as a nominal anchor. They have not allowed their currencies to become so overvalued, either by keeping their exchange rates fixed in the face of differential inflation or by allowing them to float up too much, as to jeopardize export growth. The faults that I discuss below are second-order as compared to those virtues.

Nevertheless, there remains much room for improvement. China's policy has been undesirably erratic, and in recent years it has run a current account surplus that makes absolutely no sense from the standpoint either of accelerating development or of nurturing harmonious relations with its trading partners and potential fellow-members of the WTO. Hong Kong has paid for its fixed exchange rate by an unnecessarily high rate of inflation, and it suffered a brief but severe speculative attack during the Mexican panic in early 1995. Korea's "market average rate system" means that if the market suddenly decided that the equilibrium rate was very different to the actual rate, it could in principle drive the rate to the edge of the band for a number of days in succession and the band and the rate would migrate together at a rate of 2 1/4 percent per day until they had moved to the new equilibrium, and in the meantime speculators could make a killing at the expense of the central bank. Malaysia and Thailand have confronted the problem of trying to repel excessive capital inflows without the aid of a wide band such as Chile and Colombia have found helpful,⁴ and Thailand has faced speculative pressures both during the Mexican crisis and in the summer of 1996, presumably in part because current account deficits have been so large during the 1990s. The Philippines has suffered the high degree of volatility that one expects to go with floating rates. Singapore, like Korea and Taiwan in the post-Plaza period (Balassa and Williamson 1987), has developed an uneconomically large current account surplus.

These are all problems that could be remedied by policy changes on the part of individual countries quite independently of what is done by their neighbors. However, there is another problem that is common to a number of the East Asian countries, which is the instability of the effective exchange rates of the East Asian currencies that has been noted above. 6 of the 8 currencies are more unstable in nominal effective terms than in terms of the dollar, and in most cases the instability of the real effective rate is (somewhat) greater still. One way of curing this problem would be for each of the East Asian countries to peg its currency unilaterally to a trade-weighted basket. But, since the trading patterns of the East Asian countries differ, the currency baskets would differ between countries. This would mean that a change in the dollar/yen rate would lead to changes in intra-East Asia exchange rates, which is a matter of concern inasmuch as countries not only have to worry about exporting to and competing with imports from the developed countries, but also about their markets, their suppliers, and above all their competitors in other East Asian countries. This problem could be addressed through collective action, specifically in the form of the choice of a common peg. The next section of this paper explores what that would involve.

Selecting a Peg

Consider a simple world where there are only three currencies, the dollar, the yen, and an East Asian currency. For the sake of concreteness let us take the Korean won as our example. Suppose that the dollar and the yen are floating against each other. If Korea pegs the won to the dollar, then an appreciation of the yen will lead to an effective depreciation of the won, which will increase Korean competitiveness and thus tend to increase output and strengthen the current account, but will also exert inflationary pressure. If the won had previously been at just the right level to balance the claims of competitiveness against those of inflation control, it will now be too weak. (If, on the contrary, Korea had pegged the won to the yen, then the yen's appreciation would cause the won to be too strong.)

The obvious solution is to replace the dollar by a basket containing both the dollar and the yen, with weights equal to those in the formula for the effective exchange rate. An unchanged peg to that basket will leave the effective exchange rate of the won unchanged whatever may happen to the yen-dollar rate, changes in which will thus have no impact on Korean output, inflation, or the balance of payments. Korea will have succeeded in insulating itself from the effect of exchange-rate fluctuations between the dollar and the yen. Such insulation is, of course, possible only at the macro level: exporters to Japan will still gain, while those who export to the USA will lose, when the yen appreciates.

The real world contains more than 3 countries, which complicates matters. To some extent this can be addressed by simply adding extra currencies to the basket. Consider, for example, the trade patterns of the East Asian countries as shown in Table 2. It is natural to add a representative European currency, which we assume would be the Deutschemark, to a currency basket for an East Asian currency. The more difficult issues arise in dealing with the weights of the other 3 groupings: East Asia other than the country itself, the rest of the Western Hemisphere, and the rest of the world.

Most developing Western Hemisphere countries peg to the dollar, so the trade weights for these countries can perhaps be added to that for the dollar. The Rest of the World, which is a disparate group consisting of countries in the Middle East, the economies in transition, South Asia, Australia and New Zealand, and Africa, is primarily an exporter of primary products. Now the price of primary products is determined by demand in world markets rather than by supply conditions in the exporting countries, so it would make more sense to distribute the trade shares of those products over the industrial importing countries rather than to include the currencies of the countries that export them. I accordingly assume that the share of the Rest of the World should be distributed in proportion to the shares of the Unites States, Japan, Western Europe, and East Asia in gross world product (GWP) in order to get a correct estimate of the effective exchange rate (and, therefore, to generate an optimal basket).

Constructing an appropriate basket raises other technical issues. First, should one use trade shares as displayed in Table 2, or would it not be more appropriate to use as weights the elasticities that measure how trade responds to exchange-rate changes? Answer: elasticity weights are in principle better, but, unless one has some figures that one believes, it is safer to stay with trade weights.⁵ Second, should one include the nominal exchange rate of a country with such rapid inflation that this will provide erroneous data on the real exchange rate? Answer: clearly not, though correcting for inflation properly will delay the availability of data so much as to vitiate the object of the exercise, which is to have an index that can guide intervention policy on a real-time basis. However, since most of the high-inflation countries fall in the residual Rest of the World category that we have just proposed to redistribute to the industrial countries, this is not in practice a major problem.

One group of countries remains to be dealt with: the other East Asian countries. A unilateral way of dealing with them is to add them also to the basket to which each country would peg. For example, Korea would add China, Hong Kong, Indonesia, Malaysia, Philippines, Singapore, Taiwan, and Thailand to the United States, Japan, and Germany. This has one advantage: that it would stabilize the effective exchange rate whatever the other East Asian countries did. But it also has three disadvantages. First, it would make a rather large basket with a long tail of currencies with small weights, and experience has shown that such long tails cause more bother than they are worth given their very limited impact on the behavior of the basket. Second, several of those countries, notably China and Indonesia, have relatively high inflation, so that it is dangerous to ignore the divergence between nominal and real exchange rates. Third, because the trade structures of the East Asian countries differ significantly, the East Asian currencies would still vary arbitrarily against each other as a result of the fluctuations among the industrial-country currencies.

An alternative approach would be for each of the East Asian countries to peg its currency to a common basket. Let us assume for the moment that the relevant group of countries does indeed consist of the 9 economies that have been discussed in this paper. To calculate this common basket peg, one would calculate the weighted average of the extra-regional trade of these 9 countries, as is done in Table 2, and then assign the weights of the Rest of the Western Hemisphere to the United States and divide that of the Rest of the World proportionately to their shares in GWP among the Unites States, Japan, and Western Europe, as discussed above.

Are the East Asian economies sufficiently important competitors to each other to justify a common monetary arrangement? For each of the 9 East Asian economies, Table 3 lists the 8 countries with the most similar commodity structure of exports (at the 4-digit SITC level). At the bottom of each column one can find the number of countries out of the 8 closest competitors that are among the 8 other East Asian economies being considered in this paper. It can be seen that on average almost 5 of each country's closest 8 competitors come from this group. The hypothesis that they are important competitors to one another thus receives ample confirmation.

Table 4 compares the two alternative strategies outlined above with what actually happened over a period that witnessed a major convulsion in the foreign exchange markets, namely the first 4 months of 1995, when the yen appreciated strongly (by 19.1 percent) against the dollar. Most of the East Asian currencies stuck closely to the dollar (column 1), and in consequence experienced large depreciations in their effective exchange rates (column 2). This had implications that were presumptively unfavorable for them, since if their currency were previously at the optimal level (which is by definition that which balances the benefits of greater competitiveness against the cost of more inflationary pressure) then it must have been too weak afterwards: excess inflation pressure must have emerged. Had they pegged unilaterally to a trade-weighted basket, then by definition there would have been no change in their effective exchange rates. However, as can be seen from column 3 in Table 4, this would have involved significantly different moves against the dollar, and hence against each other. In contrast, a common basket peg based on the external trade of the 9 countries, as constructed in Table 3 and whose results are shown in columns 5 and 6 of Table 4, would have resulted in an identical 9.8 percent appreciation against the dollar, but in modestly different changes in the effective exchange rates.

The identical nominal appreciations presuppose that each of the 9 countries would have pegged rigidly to the common peg. Since only Hong Kong has a rigid peg these days, this is an improbable assumption: moreover, most of us presumably would regard such a move as retrograde. Once one allows for substantial bands around parity, actual outcomes would depend on the workings of the foreign exchange market: an appreciation of the parity would not automatically imply an equal appreciation of the market exchange rate. But, if the band were credible, the central expectation would be for the market exchange rate to stay at the same position within the band, and therefore to appreciate by as much as the parity did. The existence of a common peg would still suffice to create a strong tendency for the East Asian currencies to stick together in the face of common shocks emanating from exchange-rate instability in the outside world.

The 9 countries on which attention has so far been focused were selected because of an a priori belief that they were important as competitors to one another. It is now time to examine whether this is a logical group of countries to share a common exchange rate peg. Such a common peg would be attractive if two conditions are satisfied.

The first is that the geographical distribution of trade (excluding intra-trade) of the countries is similar. Table 2 permits such a comparison. The last row sums the absolute values of the deviations in the trade shares of each country from the regional average. It suggests that a common peg would be particularly good for China, Hong Kong and Malaysia; about average for Korea, the Philippines, Taiwan, and Thailand; but distinctly less satisfactory for Indonesia and Singapore.

The second condition is that the countries are close competitors in world markets. Table 3 shows that, with the exception of Indonesia, each of them has at least half its 8 principal competitors as other countries of the region. Similarly, each except Indonesia and the Philippines appears as one of the principal competitors of at least 4 other countries of the region. Other countries that appear as principal competitors more than twice are Italy (5 times), Japan (4 times), and Portugal (3 times). Italy has none of the East Asian countries among its 8 principal competitors, Japan has 1 (Singapore), and Portugal has 3 (China, Hong Kong, and Korea). If one sums the number of times that each of our 8 countries has, and appears as, a principal competitor of the others, one gets the following result:

Thailand 15
Hong Kong 12
Korea 12
Taiwan 11
Malaysia 10
Singapore 10
China 9
Philippines 7
Indonesia 3

Analogous figures for the non-East Asian countries are:

Portugal 6
Italy 5
Japan 5

With the exception of Indonesia, the East Asian countries are unambiguously more similar to each other than to any outside countries.

Taking the two criteria together, the extent to which a common peg would be satisfactory and the similarity in their export patterns, it is clear that Indonesia is a marginal candidate for inclusion in the East Asian group. Singapore is a weak candidate on the first criterion, and the Philippines is somewhat marginal on the second. Hence two additional trade baskets were calculated: one for 8 countries (excluding Indonesia), and another for the 6 core countries (excluding Indonesia, Philippines, and Singapore).

The final columns of Table 4 show the impact on the dollar and effective exchange rates of each of the East Asian currencies of a peg to each of those two baskets over the period of dramatic yen appreciation in early 1995. The interesting feature is how little difference it makes to a country whether its own trade is included in the basket or not. Indeed, Indonesia would have been slightly better off with the 6-country basket than with the 9-country basket that included its own trade pattern. All of them would still have been vastly better off with the basket than with their actual policy.

It is of course possible that some of the East Asian countries were wanting to increase competitiveness, in which case a common peg would have thwarted what came as a boon to them. But there is another possible explanation for why their appreciations (against the dollar) were weak or non-existent, which is that they were faced with a classic collective action problem. Each of them could quite rationally have felt compelled to stay close to the dollar because they feared that appreciation against the dollar would also have meant appreciation against their regional competitors (as it actually would have done). The solution to this collective action problem is precisely the adoption of a common basket peg. This would provide each of the East Asian countries with some assurance that its competitiveness was not going to be undermined vis-à-vis its peers if it allowed its currency to appreciate against the dollar when the dollar is weak.

To get a summary figure of the relative stability (in terms of effective exchange rates) that would have been yielded by different policies, one can calculate the average absolute value of the changes in nominal effective exchange rates under each of the 5 policies. These are as follows:

Actual policy 7.4
Unilateral basket pegs 0.0
9-currency basket 1.1
8-currency basket 1.1
6-currency basket 1.1

It is evident that the choice between the 3 baskets is not an issue of much consequence. In contrast, any of the common baskets would have got on average 85 percent of the benefits of the set of unilateral pegs, even using a measure that attributes zero significance to holding the relative competitiveness of the East Asian countries constant.

The Constraints Imposed by a Common Peg

The one area of the world that appears to have economies even more competitive with one another than East Asia is Western Europe. Table 5 shows export similarity indices for 9 core members of the European Union analogous to those for the East Asian countries in Table 4, which shows that on average the European countries have 5.8 of their top 8 competitors among the other 8 countries considered, as against an average of 4.9 in East Asia (or 5.1 excluding Indonesia).

Those close trade inter-relations long ago led the European countries to adopt a concerted exchange rate policy. The European Monetary System, and specifically its Exchange Rate Mechanism, was created precisely in order to insulate the European countries from the instabilities that would otherwise have been imposed on Europe by fluctuations in the value of the dollar. The ERM provided for a mutual pegging mechanism among the participating currencies, with narrow bands (+/- 2¼ percent), and requiring unanimous agreement to any parity changes. However, the failure to realign after 1987 led to growing disequilibria, which in due course fostered the great ERM crises of 1992-93, as a result of which the ERM bands had to be widened to +/- 15 percent. It is hoped that the ERM will be replaced by a single money for a number of the core EU countries in 1999.

East Asia seems to me to have got to the stage where it too could benefit from some concertation in its exchange rate policies, but I doubt whether it is ready to replicate the ERM. One reason is that the foreign exchange markets of some of the prospective members, especially China, have not yet developed to the point where one would expect effective intervention to defend the cross-rates in other participating countries to be possible (not to mention possible political problems in agreeing on how to defend the margins between the remnimbi and the New Taiwan dollar). Another reason is that the countries still have too wide a range of preferences as regards exchange rate policy, and of inflation rates, to permit adoption of as tight a system as the ERM, with its presumption against frequent parity changes.

The alternative that I have outlined above is adoption of a common basket peg. This would permit Hong Kong to continue to operate a currency board system, if that is what it wishes to do: it would simply start to trade U.S. dollars for Hong Kong dollars at a price that would vary depending on the value of the US dollar in the foreign exchange markets vis-à-vis the other currencies in the basket (plus or minus the margins), instead of at a fixed rate.⁶ Both China and Taiwan could intervene in their own markets quite independently of one another, pretending that the other does not exist. Some countries can operate wide bands if they so wish, while others can defend much narrower margins. Some can have their bands crawl, if that is needed to offset differential inflation or to avoid importing inflation or to facilitate a desired balance of payments adjustment. If the participants want to get together to concert these policies, they can do so, but it is not essential that they do so.

The object of the change would simply be to create an expectation that, even without any such concertation, variations in the exchange rates among the industrial countries would no longer have major impacts on the relative competitive positions of the East Asian countries. That would be a significant first practical step toward the East Asian monetary cooperation that leaders in the region have begun to call for. It would also have yielded significant benefits over the period 1995-96, inasmuch as one of the reasons for the boom of 1995 and the near-recession of 1996 was the impact on trade flows of the region's effective depreciation early last year and the subsequent appreciation. A basket peg that had kept the region's effective exchange rates roughly constant would have avoided those destabilizing impacts.

Table 1: Relative Exchange Rate Volatility, 1992-5

Table 2: Direction of trade of East Asian economies excluding intra-group trade (1994) (%)

Table 3: Export similarity indices for nine East Asian countries (1992)

Table 4: Actual and hypothetical exchange rate changes , end 1994 to end April 1995

Table 5: Export Similarity Indices For Nine EU Countries (1992)

References

Balassa, Bela, and John Williamson (1997), Adjusting to Success: Balance of Payments Policy in the East Asian NICs (Washington: Institute for International Economics).

Williamson, John (1982), "A Survey of the Literature on the Optimal Peg", Journal of Development Economics, 11, reprinted as ch.4 in C. Milner, ed., Political Economy and International Money: Selected Essays of John Williamson (Brighton: Wheatsheaf, 1987).

____ (1996), The Crawling Band as an Exchange Rate Regime: Lessons from Chile, Colombia, and Israel (Washington: Institute for International Economics).

Notes

1. The author is indebted to Molly Mahar for extremely competent research assistance. Copyright Institute for International Economics: all rights reserved.

2. An "effective exchange rate" is the weighted average exchange rate against all other currencies, where the weights are generally chosen to reflect the pattern of trade. (An alternative weighting system, based on trade elasticities, recognizes also the countries that are important competitors, rather than just trade partners.) A "real effective exchange rate" corrects by changes in relative inflation, so that the index does not change if prices increase as much at home as the weighted average of the country's trading partners. The effective exchange rate indexes used in this paper were calculated from rates against a limited number of other currencies, as explained in the note to Table 1.

3. The definition of volatility employed would result in a measure of zero volatility if a currency depreciated by the same percentage amount each month.

4. See Williamson (1996) for an extended analysis of the policies of Chile and Colombia, and their results. One expects a wide band to help, as long as it is (even partially) credible, because (a) arbitrageurs will allow for the expected return of the exchange rate toward its parity, and deduct an appropriate discount from the local currency yield when they compare with foreign yields; and (b) investors in the tradable goods industries will tend to look at the parity rather than the market rate when assessing whether to go ahead with potential investment projects.

5. These questions are discussed in Williamson (1982).

6. It could easily diversify its reserve holdings to match the currency basket, or cover its dollar holdings forward to provide similar insurance, if it wished to avoid any foreign exchange exposure.