BOFIT Discussion Papers, Institute for Economies in Transition, Bank of Finland
No 19/2011:
China’s new exchange rate regime, optimal basket currency and currency diversification
Zhichao Zhang ()
, Nan Shi and Xiaoli Zhang
Abstract: We build an optimising framework to analyse a class of
economies that adopt an ECU-type basket currency while in transition to
increased flexibility of the exchange rate regime. Instead of conventional
basket pegging, such an economy uses an ECU-type currency index as a
benchmark for monitoring and assessing exchange rate movements. This
provides an anchoring device for the nations exchange rate regime and
allows the home currencys exchange rate to fluctuate. Under the assumption
that the central bank is chiefly interested in maintaining stability, the
optimal structure of the basket currency is based on its contribution to
minimizing the volatility of the countrys external account. A currency
invariance index is applied to capture the effect of the countrys exit from
exclusive linkage with the US dollar. The approach is illustrated by
Chinese exchange rate policy. We find it advisable and viable for China to
form a basket currency with a diversified portfolio of currencies. While
the portfolios weighting scheme could favour the dollar, euro and Japanese
yen, we show that the composition of the basket is open to a wide range of
possibilities. Moreover, contrary to general fears, there is considerable
potential for China to engage in currency diversification, which will not
necessarily affect the dollars position.
Keywords: basket currency; currency diversification; China; (follow links to similar papers)
JEL-Codes: E58; F31; P45; (follow links to similar papers)
36 pages, August 22, 2011
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