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China’s new exchange rate regime, optimal basket currency and currency diversification

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  • Zhang, Zhichao
  • Shi, Nan
  • Zhang, Xiaoli

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 nation’s exchange rate regime and allows the home currency’s 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 country’s external account. A currency invariance index is applied to capture the effect of the country’s 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 portfolio’s 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 dollar’s position.

Suggested Citation

  • Zhang, Zhichao & Shi, Nan & Zhang, Xiaoli, 2011. "China’s new exchange rate regime, optimal basket currency and currency diversification," MPRA Paper 32642, University Library of Munich, Germany.
  • Handle: RePEc:pra:mprapa:32642
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    References listed on IDEAS

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    Cited by:

    1. Aihua Wang & Faruk Balli & Xiumin Li, 2015. "Possible Best Currency Basket Selection from the Perspective of Real Effective Exchange Rate," Pacific Economic Review, Wiley Blackwell, vol. 20(4), pages 635-650, October.
    2. Yoshino, Naoyuki & Kaji, Sahoko & Tamon, Asonuma, 2014. "Dynamic Transition of the Exchange Rate Regime in the People’s Republic of China," ADBI Working Papers 476, Asian Development Bank Institute.
    3. Fang, Ying & Huang, Shicheng & Niu, Linlin, 2012. "De facto currency baskets of China and East Asian economies : The rising weights," BOFIT Discussion Papers 2/2012, Bank of Finland, Institute for Economies in Transition.
    4. Zihui Ma & Leonard K. Cheng, 2014. "An Optimal Currency Basket to Minimize Output and Inflation Volatility: Theory and an Application to Hong Kong," Pacific Economic Review, Wiley Blackwell, vol. 19(1), pages 90-111, February.
    5. Zhang, Zhichao & Shi, Nan & Zhang, Xiaoli, 2011. "China s new exchange rate regime, optimal basket currency and currency diversification," BOFIT Discussion Papers 19/2011, Bank of Finland, Institute for Economies in Transition.

    More about this item

    Keywords

    Exchange rate regime; Basket currency; Currency diversification;

    JEL classification:

    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • P45 - Economic Systems - - Other Economic Systems - - - International Linkages
    • F31 - International Economics - - International Finance - - - Foreign Exchange

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