An Optimal Currency Basket to Minimize Output and Inflation Volatility: Theory and an Application to Hong Kong

• DOI: http://doi.org/10.1111/1468-0106.12053
• Date: 01 February 2014
• Author: Zihui Ma,Leonard K. Cheng
• Published date: 01 February 2014

AN OPTIMAL CURRENCY BASKET TO MINIMIZE

OUTPUT AND INFLATION VOLATILITY: THEORY AND

AN APPLICATION TO HONG KONG

ZIHUI MAHuarong Securities Company Limited

LEONARD K. CHENG*Hong Kong University of Science and Technology

and Lingnan University

Abstract. In this paper we develop a theoretical model of an optimal currency basket for a small

open economy. A currency basket for the home economy is defined as a chosen weighted average of

a subset of foreign currencies, and an optimal currency basket is taken to be one that minimizes a

given weighted average of the expected output volatility and expected inflation volatility. This

theoretical model is then applied to Hong Kong, which has adopted a currency board system for

close to 30 years. We estimate an optimal currency basket for Hong Kong and compare its perfor-

mance with the existing currency board system as well as with currency baskets whose weights are

given by export and import trade shares.

1. INTRODUCTION

Since the end of World War II, the US dollar has been the de facto world

currency. Even the collapse of the Bretton Woods system did not seriously

impair its dominant position. Many economies, particularly small open econo-

mies, pegged their currencies to the US dollar. The USSR ruble and the Japa-

nese yen were presented as alternatives to the US dollar, but neither was very

successful due to the issuing countries’ economic and political limitations.

A serious competitor of the US dollar appeared in 1999 with the birth of the

euro in that year, but due to uneven practice of fiscal disciplines by members of

the euro zone, the geographical area of the currency union or even the continued

existence of euro has been called into question. As emerging economies such as

BRIC (Brazil, Russia, India and China) are rising in importance, increasingly

more economies are trying to reduce their dependence on the US dollar. The

global financial crisis of 2008 not only weakened the US economy, but also

raised questions about the stability of the US dollar, which has continued its

trend of devaluation despite reversals during brief periods of global financial

scare. Many economies that used to peg their currencies to the US dollar have

switched or are considering switching to other exchange rate regimes.

When an economy gives up its fixed exchange rate that is pegged to the US

dollar, it may choose a freely floating exchange rate (‘free float’), or peg its

currency to another key international currency as an anchor, or peg its currency

to a basket of currencies, or operate a ‘managed float’ exchange rate based on an

unannounced currency basket. To many small open economies, the benefits of a

*Address for Correspondence: President’s Office, Lingnan University, Tuen Mun, NT, Hong Kong.

E-mail: leonard@ln.edu.hk. We are grateful for valuable comments and suggestions by an anony-

mous referee and the Editor David Cook, and to Dr Winnie Peng for research assistance.

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Pacific Economic Review, 19: 1 (2014) pp. 90–111

doi: 10.1111/1468-0106.12053

© 2014 Wiley Publishing Asia Pty Ltd

free float (derived from an independent monetary policy) are less that the costs

(i.e. the higher volatility of their own exchange rates), so a free float is seldom

considered a real option. Thus, a small open economy like Hong Kong may

consider pegging its currency to a major international currency other than the

US dollar (such as the euro or the renminbi (RMB)) or to several currencies (i.e.

in the form of a currency basket). Williamson (1998) argues that, in a world of

generalized floating among major currencies, the most practical option for small

open economies in Asia may be a currency basket arrangement, which has the

desirable property of insulating them from cross-rate variations (i.e. fluctuations

in the exchange rates between major international currencies).

The concept of pegging one’s own currency to a basket of major currencies is

not new. The Special Drawing Rights (SDR) of the IMF and the European

Currency Unit (ECU) are two well known examples.1A number of developing

and emerging economies peg their respective currencies’ exchange rates to cur-

rency baskets, but some (e.g. Singapore and Malaysia) manage their exchange

rates without revealing the composition of their reference currency baskets.

Before the euro was adopted officially in 1999, most members of the European

Economic Community pegged their exchange rates to the ECU. In July 2005,

the Chinese Government announced the replacement of an RMB exchange rate

pegged to the US dollar with a ‘managed float’ regime with reference to a

currency basket. In 2007, as part of its effort to fight high inflation, Kuwait’s

government shifted from its US dollar peg of the Kuwaiti dinar to a currency

basket.

In the literature on exchange rates, there is a moderate amount of research on

currency baskets. Flanders and Helpman (1979) provide a theoretical frame-

work of an optimal currency basket. Turnovsky (1982), Bhandari (1985), Edison

and Vardal (1990) and Han (2000) extend their approach. These authors have

attempted to identify the optimal composition of a currency basket under dif-

ferent assumptions, and perform some numerical simulations. Their policy

targets include stabilizing the trade balance, output and the price level. Slavov

(2005), Teo (2005) and Shioji (2006) analyse the effect of the currency of foreign

debt denomination and foreign trade invoicing in determining the weight of the

optimal currency basket in a general equilibrium framework. Xu (2011) extends

the general equilibrium framework further by introducing vertical trade, and

applies her model to discuss the choice of exchange rate regime for small open

economies. Most related to the focus of our paper is Zhang et al. (2011), which

analyses an optimal currency basket of RMB and considers its impact on the

Chinese economy.

In this paper, we extend the familiar static framework to a two-stage model in

which the composition of a country’s currency basket is decided ex ante in stage

1 before the external shocks are known, assuming that the country’s government

is able to use fiscal policy to minimize ex post the impact of external shocks on

the domestic economy in stage 2 after the shocks are known.

1It should be noted that the SDR is not traded in the foreign exchange markets. Instead, it may be

used for settling international payments among central banks.

AN OPTIMAL CURRENCY BASKET

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© 2014 Wiley Publishing Asia Pty Ltd