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Research Papers 13-01 Feb. 01, 2013
- Research Topic Capital Markets
- No other publications.
Background
The global financial crisis ignited skepticism about the current international monetary regime that centers on the US dollar, and the recent European fiscal crisis diminished the possibility of the euro replacing the US dollar. As the chaos around the international monetary regime escalated, China took steps to internationalize the yuan to reform the international monetary regime. As part of the efforts, China recently allowed the yuan to be traded with the Japanese yen directly, not through the US dollar.
Meanwhile, Asian emerging markets have improved their economic stance in the global economy because of their relatively sound macroeconomic fundamentals and growth potential. Nevertheless, the role of their currencies is still limited in the international monetary regime. This stems from the fact that most emerging economies have adopted policies that do not internationalize their currencies and strictly regulate their currency transactions with non-residents.
Especially, emerging economies that were hit hard by the Asian financial crisis have taken serious measures to avoid repeating past mistakes. So, they placed strict limitations on trading of their currencies outside the home country and have accumulated huge foreign reserves in US dollars to prepare for emergencies. This behavior by emerging countries allows the US to control the dollar’s value and use the privilege from their currency’s monopoly status in the international monetary regime. If a nation wants to lower its dependency on the US dollar and make its own currency play a bigger role commensurate with its economic position, that country needs to internationalize its currency.
Currency internationalization refers to the process of making a currency one that is freely traded internationally, not only between residents and non-residents, but also between non-residents. Currency internationalization requires many preconditions. For instance, a nation should first meet certain institutional thresholds, i.e., size of economy, trading volume, size and development of capital markets, and financial openness. Above all, the size of the economy is the most important factor for full internationalization as shown in the case of the US dollar or Euro.
However, Australia and New Zealand show that small open economies can also internationalize their currencies. Inspired by this, our research, instead of discussing full internationalization (i.e., US dollar or Euro), focuses on partial internationalization that helps emerging economies discover their roles, commensurate with their economic sizes, and better capitalize on their currencies in international markets.
Major Empirical Results
After categorizing the 26 currencies into full, partial, and non-internationalization, this research analyzes the determinants of currency internationalization and predicts the probability using the ordered logit model. Major findings of this research are as follows: First, we confirm that the most important determinant of full currency internationalization, as shown in the US dollar or euro, is the size of the economy as measured by GDP or trading volume. However, we show that small open economies such as Australia and New-Zealand can internationalize their currencies through capital markets development and higher financial openness. And higher trade dependence and inflation lower the possibility of currency internationalization.
Second, according to our empirical results of the ordered logit model based on the aforementioned currency internationalization factors, the possibility of partial internationalization was 60% for the Korean won, which was lower than the Mexican peso (83%), Indonesian rupiah (66%), Chinese yuan (76%), and Hungarian forint (62%). The reason why the possibility of partial internationalization of Korean won is lower than others is that they have higher issuance ratio of international bonds denominated in the local currency and financial openness.
Third, under the assumption that macroeconomic conditions are not changed, we ran simulations for the possibility of currency internationalization. In the results, the possibility for the Korean won rose from 4% to 32% points if Korea develops its stock market to a level similar to Australia, Hong Kong, or Singapore; that possibility increases from 22% to 32% points if Korea develops an international bonds market denominated in the local currency at a level similar to other countries; and if Korea increases financial openness at a level similar to Australia, then the possibility of partial internationalization of the Korean won rose by 24% points to 84%.
Policy Implication
For currency internationalization, certain conditions are required. The most important determinant of full currency internationalization, just as shown in the US dollar or euro, is the size of the economy, i.e., GDP or trading volume. However, our scenario analysis also finds that small open economies can raise the possibility of currency internationalization through efforts to develop capital markets and increase financial openness.
According to empirical results, Korea already meets the macroeconomic conditions, but has less developed capital markets and low financial openness compared to other countries that have partial international currencies. Considering these points, it is judged that policy makers should support an international bonds market denominated in the Korean won and take steps to dramatically increase financial openness for the sake of Korean won internationalization.