Pegging or Floating? A Regime-Switching Perspective of Asian Exchange Rate Practices

Abstract
We propose a two-state Markov-switching version of the Frankel and Wei (MS-FW) model to assess Asian exchange rate policies during the period from August 2005 to August 2016. We impose coefficient constraints on FW coefficients to detect floating and pegging episodes against the main anchor currencies, such as the U.S. Dollar (USD), Renminbi (RMB), Euro, Japanese Yen and Asian Currency Unit. After estimating episodes where Asian currencies co-move with international currencies, we link the estimated regime probabilities to a set of economic fundamentals of Asian countries to identify the determinants of exchange rate regimes in Asia. We reveal that most Asian countries tend to constantly adjust the weight of their currency basket. When Asian countries loosen their peg against the USD, these currencies tend to increase their correlation with the RMB. However, the soft USD peg regime has a longer duration in most Asian countries, while the regime with a large RMB weight tends to be of shorter duration. Finally, we show that China’s trade dependence is a key factor in pegging Asian currencies to RMB, though export similarity with China does not necessarily facilitate the RMB regime.