Entering a New Phase of Financial Cooperation in East Asia
Entering a New Phase of Financial Cooperation in East Asia
In East Asia, the governments of ASEAN+3 (China, Japan and Korea) have been promoting regional cooperation in various fields since the Asian financial crisis of 1997-98. Substantial results have been brought about in financial cooperation, together with developments in intra-regional trade and investment. The guiding principle of financial cooperation in East Asia were stated in the declaration by the ASEAN+3 leaders at the summit meeting held in Manila in 1999[i].
At the 9th ASEAN+3 summit meeting held on December 12, 2005, the leaders declared that they would prepare a second declaration at the tenth anniversary of ASEAN+3 in 2007, in order to “consolidate existing cooperation and to set forth the future direction for the cooperation and East Asia community building". If the regional financial cooperation achieved after the Asian crisis based on the 1999 declaration is named phase 1, we will be entering phase 2 under the second declaration of 2007.
Crisis prevention will be an important element of financial cooperation under phase 2, in addition to the regional arrangements for financial crises. Furthermore, it is necessary to establish a system that will stabilize the exchange rates and monetary systems in the region, in order to attain sustainable economic growth. Two things are needed to be able to carry out these tasks across the region. First, monetary authorities in the region should establish closer dialogue, intensify the exchange of information, as well as coordinate exchange rate policy. and monetary policy among themselves. Second, East Asia should promote regional cooperation, in the context of a closer and more cooperative relationship with the United States and global institutions such as the IMF.
This paper discusses the future direction of phase 2 from a medium to long-term perspective, focusing on how to realize exchange rate and monetary stability in the region, consolidating achievements made up to now and referring to lessons learned from the experience of the European Union.
2. Achievement of ASEAN+3 – the First Phase
The first summit meeting of ASEAN+3 was held in Kuala Lumpur in December 1997. At that time, the financial crisis, which had started in Thailand in July of the same year, was spreading to other countries in the region and forcing numerous banks and corporations into bankruptcy. The leaders in the region recognized the importance of cooperating with each other in order to be able to cope with contagion of financial crises that depressed economies, even those economies that were considered sound in their macro-economic management. Since then, the summit meeting of the ASEAN+3 has been held every year without interruption and has become the most important political event to promote regional cooperation in East Asia. More than 40 forums which meet on a regular basis have reportedly been established under the framework of ASEAN+3.
When the ASEAN+3 summit meeting was held in December 2005, the East Asian Summit, consisting of ASEAN+3 as well as Australia, India and New Zealand was held simultaneously for the first time, creating dual layers for regional cooperation. The dual layered mechanism may encourage ASEAN+3 to become more flexible in terms of its members in the future, depending on the target for cooperation.
While the governments in the region have been working to reform the domestic financial and monetary system after the financial crisis, they have also promoted financial cooperation in East Asia. The following is a summary of major achievements together with their potential for future regional cooperation:
(1) Chiang Mai Initiative (CMI)
Based on the agreement reached at the Finance Ministers' meeting held in May 2000 in Chiang Mai, a network of 16 bilateral swap agreements, reaching a total amount of US$ 75 billion, has been completed by May 2006. The CMI is designed to support countries facing short-term liquidity difficulties in the region, supplementing the global function of the IMF. A strengthening of the functions of the CMI has been proposed at the Finance Ministers' meeting in May this year including, for instance, exploration of ways to achieve multilateralisation of its operations[ii]. The CMI has the potential of expanding its functions to help maintain a stable exchange rate system, since it can extend a short-term facility to a country that needs to support its currency.
(2) Economic Review and Policy Dialogue (ERPD)
At the ASEAN+3 Finance Ministers' meeting held in 2000, the ERPD was introduced as a means to conduct economic surveillance in the region. The major focus of the ERPD is on issues related to risk management, monitoring capital flows, strengthening the banking system through policy dialogue, as well as coordination of and collaboration on financial, monetary and fiscal issues. In May 2005, it was decided that the economic surveillance carried out through the ERPD would be integrated into the CMI framework to develop effective surveillance capabilities. The ERPD has not made much progress until now, probably due to differences in political systems, impediments like the so-called non-interference policy and reluctance in disclosing sensitive economic data. If the bilateral CMI arrangement is multilateralised and if CMI is provided with the proper authority to carry out economic surveillance, the ERPD will become more effective. An efficient surveillance mechanism is a prerequisite for economic cooperation.
(3) Asian Bond Market Initiative (ABMI)
Before the financial crisis, East Asian bond markets were generally underdeveloped and were unable to provide industries with long-term funds denominated in the domestic currency. Efforts have been made to develop an efficient bond market which can function as a financial intermediary, in order to mobilize the existing ample savings to the industries. As a result, the size of the local currency bond markets in the region has dramatically increased since 1997 and local currency denominated cross-border bond issues have been launched in several markets in the region.
(4) Asian Bond Fund (ABF)
Two Asian Bond Funds (ABF1 and 2) were created by the Executives' Meeting of East Asia-Pacific Central Banks (EMEAP)[iii]. ABF1 amounting to US$1 billion was created in 2003 to invest in US dollar-denominated sovereign or quasi-sovereign bonds. ABF2 amounting to US$2 billion was created in 2005 to invest in local-currency denominated sovereign or quasi-sovereign bonds of eight emerging market economies, to promote the development of regional bond markets[iv]. ABF2 introduced market practices like disclosing a benchmark index, and is expected to contribute to the development of a local currency-denominated bond market as a non-resident investment fund.
3. Stability of Regional Currencies
Inter-dependence among regional economies has increased in recent years. Intra-regional trade has reached 51 percent of total trade in 2004 from 48.7 percent in 2000 and it is almost comparable with the EU, surpassing that of NAFTA. The region is now considered to be one of the economically most closely linked areas in the world. Furthermore, undergoing FTA negotiations, particularly those between ASEAN and each of China, Japan and Korea, are expected to be completed by the beginning of the 2010s. The eventual formation of a network of FTAs in East Asia will further enhance economic inter-dependence. In view of this prospect, the general consensus will undoubtedly be that it is dispensable for the region to have stable exchange rates, monetary and financial markets in order to maintain stable economic growth. Therefore, the most important challenge facing financial cooperation in phase 2 will be, how to stabilize exchange rates and monetary and financial markets in East Asia.
Linkages between currencies in the region have also steadily been deepening. Many of the currencies in the region were linked to the US dollar before the Asian financial crisis. Although linkage with the US dollar is still strong, the weight of dollar linkage has been reduced after the crisis. For instance, the Korean won is now more closely linked to the Japanese yen. The Chinese renminbi (RMB) and the Malaysian ringgit were de-pegged from the US dollar in July 2005, and moved to a managed float with reference to a currency basket. Today, only the Hong Kong dollar maintains a hard peg (currency board system) to the US dollar. Since the currencies in the region as a whole have softened their linkage to the US dollar, the policy target of the increasingly inter-dependent regional economies is to stabilize the exchange rate among the currencies and monetary systems in the region.
4. Currency Basket System
In recent years, researchers have advocated that a common currency basket system provides a useful means to stabilize exchange rates in a region, illustrating their point with various types of currency baskets and their policy implications. Judging by the EU's experiences, it is considered more suitable and efficient to adopt a currency basket composed of regional currencies in East Asia, where inter-dependence of the region's economies is expected to reach the level of the EU in the future, than a basket composed of outside currencies such as the US dollar and the euro. In order to ensure confidence in the basket, the currencies in East Asia that would compose it need to meet certain conditions, which include sound macro-economic indicators such as inflation, fiscal balance and government debt, maintaining currency convertibility, and an open and liquid money market (such currency will hereafter be called “core currency"). Let us assume that a common currency basket system composed of such core currencies is named the “Asian Monetary Unit" (AMU).
Once the AMU is created as a common currency basket in the region and an Asian Monetary System, a system similar to the European Monetary System (EMS), is in place, coordination of exchange rates and monetary policy will be strengthened. As a result, the exchange rates of regional currencies will become more stable, and currencies in East Asia as a whole will float against the US dollar and the euro.
The AMU so created will function as an indicator of exchange rates, a basis for the deviation indicator and as a currency unit to be used for settlement between governments. Adoption of a common currency will also have the effect of stabilizing prices, trade balances and flows of capital. The path to creating an AMU will be a long and difficult process, but a most challenging one, which will begin by gaining a broad understanding on a common currency basket system and which will ultimately lead to the ratification of an AMU and AMS by all the governments in the region. This long process may have already started. The decision taken by the governments of China and Malaysia in July 2005, to adopt a managed floating system with reference to a currency basket and thereby departing from the dollar peg system, suggests the future direction towards a kind of common currency basket system.
There are currently only three currencies in the region that meet the above mentioned conditions: the Japanese yen, the Singapore dollar and the Hong Kong dollar. If an unstable currency is included in the AMU, the stability of the AMU could be impaired. On the other hand, when the number of core currencies included in the AMU increases, the unit will gain more credibility and thus have a positive impact on the stability of prices, trade balances and capital flows in the region. Therefore, each of the governments in the region should exert efforts to reform currency and financial markets to enable becoming a core currency. Those currencies not included in the basket will be linked to the currencies in the basket.
Three points need to be considered from the region's viewpoint, if the AMU is to be introduced in the future. First, in order to stabilize exchange rates, it is a prerequisite to maintain policy coordination among the governments in the region. The ERPD agreed to in phase 1 needs to be promoted. While the importance of surveillance has been well understood in East Asia, satisfactory results have not been achieved due to some political issues which need to be addressed with strong political leadership. Second, monetary authorities in the region need to adopt proper policies on currencies while reforming monetary and financial markets. This process is a difficult and time-consuming one in light of the diversified development stages of the East Asian economies. Therefore, it should be carried out on a region-wide cooperation basis where peer pressure works and helps the progress. Third, since economic development in the East Asian region is diversified, a regional mechanism to support this process should be created. One possibility is to create a permanent secretariat within the ASEAN+3, while another possibility is to include such a function in the CMI.
In East Asia, there are different political systems and diversified levels of economic development, making it somewhat different from the EU. East Asia lacks a security arrangement, distinguishing it from the EU where a Franco-German agreement on the peace treaty supported a single market concept from the beginning. It might be more realistic to aim at creating a common currency basket system rather than a single currency, allowing countries to preserve a certain degree of sovereignty. Although East Asia is structurally different in many respects from the EU, there are many lessons which can be learnt from its history, in particular, from its experience with units of account and a currency basket system.
5. Capital Account Liberalization and Currency Convertibility: the European case
It is not easy to generalize about sequencing the liberalization process of the external transactions of a country, since measures can differ greatly from one country to another, depending upon the stage of economic development as well as government policies. However, liberalization usually begins with current account transactions, i.e. trade and trade related financial transactions. Liberalization of financial and monetary transactions usually starts with the liberalization of domestic transactions and later moving to external transactions. The process then moves from the current account to the capital account, which usually starts with inward foreign direct investment (FDI) involving transfer of industries and technology. From FDI, the liberalization process will move gradually on to securities and long-term capital transactions while finally arriving at the liberalization of short-term capital.
When a country moves from current account to capital account liberalization, its economy will be more deeply integrated into the global economy. As a result, the economy will be able to reap the benefits, but at the same time it will be exposed to external risks. Therefore, liberalization of the capital account should be carefully carried out, recognizing its objectives and risks. The IMF, before the Asian currency crisis, recommended unconditional capital account liberalization (this is part of the so-called Washington Consensus). After the crisis, however, the IMF became more sympathetic to market-based controls on short-term capital flows. Accession to organizations as the OECD and WTO often comes with a promise to open up financial and capital markets.
Many European countries established convertibility of their currencies by 1958 and accepted article 8 of the IMF charter at the beginning of the 1960s. At that time, convertibility of a currency was permitted for current account transactions. Although convertibility was restricted with regard to capital account transactions, the foreign exchange spot market was directly or indirectly permitted to non-residents. It was due to this fact that the ECU, referred to below, could be broken down by currency component and reconstructed easily by executing exchange transactions for each of the component currencies in the market.
The European Commission completed liberalization of capital account transactions in 1990, more than 30 years after the Treaty of Rome became effective in 1958, incorporating articles obligating members to liberalize capital account transactions. The European Commission carried out liberalization in accordance with the following classification of capital transactions into three categories.
(1) capital operations such as commercial credit, direct investments or various personal capital movements which are directly linked to the freedom of trade in goods and services, the free movement of persons and the freedom of establishment 1960
(2) operations in financial market securities (bonds, shares and other securities) 1986
(3) operations involving financial credits and operations related to money market instruments 1988
(full liberalization of internal capital movement) 1990
It should be noted that safeguard clauses were included in the Treaty of Rome to protect member states against sudden balance of payments difficulties and disturbances in the capital markets caused by capital movements.
The official ECU was created in 1979, twenty years after European countries accepted article 8 of the IMF charter. Initially, the official ECU was composed of 9 convertible currencies, a number which later increased to 12. In Europe, various types of “Unit of Account" consisting of convertible currencies had developed well before the official ECU was created, which were used for capital market transactions such as bond issues. Some types of investors found Unit of Account-denominated instruments attractive since the risk of the Unit was diversified over several convertible currencies.
Once the official ECU was created, transactions denominated in ECU with an identical composition of currencies became popular in the capital market for private transactions (the private ECU), as banks and investors alike were used to undertaking transactions in some kind of unit of account, as for example the European Unit of Account (EUA). The essential factors that played a decisive role in the development of the private ECU market were:
(1) The component currencies of the ECU had to be convertible. This was a fundamental requirement because the private ECU needed to be freely traded in the foreign exchange market.
(2) The private ECU had to be liquid. As the ECU market grew, an ECU clearing and settlement system was established.
(3) Unlike a national currency which is supported by a nation state, the private ECU was not the legal tender of a country. Therefore, the private ECU had to secure market confidence, which was supported by the following:
- An uninterrupted availability of the official ECU. The European Commission announced the ECU exchange rate every day.
- Each currency composing the private ECU maintained a stable exchange rate. When exchange rate stability was seriously damaged due to a loss of confidence as, for instance, during the European currency crisis of 1992-93, the ECU market receded.
- The European Commission and member states supported the development of the private ECU. For instance, the European Commission encouraged EC institutions to use the ECU.
6. Liberalization of the Capital Account in East Asia and Convertibility of Currencies
Except for Japan, it is relatively recent that major East Asian countries accepted article 8 of the IMF charter, establishing current account convertibility. It was not until 1988 that Korea accepted the article, 1990 for Thailand and as recent as 1996 for China. In countries like Korea and Thailand, foreign capital started to flow in even before they decided to liberalize the current accounts. In the early 1990s, a huge amount of short-term capital and FDI flowed into Korea and Thailand. In the case of Indonesia, the liberalization of capital flows was permitted already in the 1980s. Therefore, in East Asia, the sequence of liberalization of capital movements was quite unique, not necessarily following the conventional path.
While China imposed very strict controls on foreign exchange transactions, countries like Malaysia, Thailand and Indonesia liberalized the use of their currencies in the offshore market, which were subsequently vulnerable to currency attacks. The volatile movements of short-term capital, including speculative funds, attacked fragile currencies and financial markets resulting in the financial crisis. Based on these experiences, Malaysia, Thailand and Indonesia adopted a policy of so-called “non-internationalization of currency", which they imposed on commercial banks. This restricted loans in domestic currency as well as their dealings with non-resident clients. Singapore abolished its foreign exchange controls, but maintained restrictions on lending to non-residents in domestic currency. The use of their own currencies for loans and foreign exchange transactions with non-residents are restricted as follows.
Loans Foreign Exchange
China prohibited prohibited
Malaysia prohibited only for hedge purposes
Thailand up to BHT50mn underlying (?) transaction basis
Indonesia prohibited for hedge purposes only
Korea up to Won 1 bn technically difficult
Thailand: The outstanding balance of a settlement account may not exceed BHTs 300 million.
Korea: Effective as of January 2006, restrictions on lending to non-residents have been liberalized, subject to prior notice to the Bank of Korea.
Since the so-called non-internationalization policy is considered to be temporary in nature, it may be relaxed gradually. The key for determining the timing of relaxation will depend on how the countries make progress with the liberalization of the domestic market, in particular, the short-term money market. If these countries recognize the importance of a currency basket system and adopt necessary policy measures to make their currencies a core currency for the basket, the non-internationalization policy may be withdrawn. In this respect it should be noted that the establishment of partial convertibility may be sufficient to become eligible for the core currency status in a currency basket, as the European experience shows.
7. Capital Account Liberalization in China
In 1996, China accepted article 8 of the IMF charter and liberalized current account transactions. In 2001, China joined the WTO and is now expected to complete its liberalization of domestic financial markets by the end of 2006, in accordance with the agreement with the WTO. In the meantime, China's current account surplus has been increasing over the years and foreign exchange reserves have reached US$853.7 billion in February 2006 which makes it the largest amount in the world, even exceeding that of Japan[v]. China ended the US dollar peg in July 2005 and adopted a managed floating system. The central rate of the RMB to the US dollar was revalued by 2 percent to US$1=RMB8.11. Since then, the RMB has appreciated to around US$1=RMB8.
With regard to the capital account liberalization, the Chinese government has been gradually relaxing inward foreign direct investment (FDI) since the end of the 1970s and is now one of the largest FDI recipient countries in the world. Outward FDI has been relaxed gradually in recent years in order to encourage Chinese companies to invest overseas. With regard to inward securities investment, a scheme called Qualified Foreign Institutional Investor (QFII) was introduced in December 2002, permitting qualified foreign institutional investors to invest in equity and bonds in China. Also, three years after QFII was introduced, a scheme called Qualified Domestic Institutional Investors (QDII) was introduced on April 17th of this year, permitting qualified domestic institutional investors to invest in securities in overseas capital markets. From May 2006, Chinese individuals are allowed purchase up to US$20000 annually for overseas travel.
These liberalization measures, though still at an early stage, permit both inward and outward capital flows, thus paving the way towards more full-fledged capital account liberalization in the future. It is important that liberalization of capital accounts will allow Chinese monetary authorities to conduct a freer and more independent monetary policy. Chinese authorities will continue to take cautious but steady steps in the liberalization process of capital accounts, paying due attention to avoid the risk of exposure of the relatively immature domestic financial and monetary markets.
The question is when will the authorities decide to adopt more flexible exchange rates and convertibility of the RMB? Leaving the exchange rate question aside, the timing of currency convertibility is in China's own interest since convertibility of the RMB will allow China's economy to be integrated more easily into the global economy, thus strengthening its financial system. From the viewpoint of a regional currency system, convertibility of the RMB will be an important step towards regional currency integration.
In March this year, India's Prime Minister Manmohan Singh proposed to establish full convertibility of the rupee which has been a long-standing issue in India since 1997. The Reserve Bank of India is expected to submit a recommendation on capital account convertibility by the end of July this year, as requested by the prime minister. If India goes ahead with this proposal, it will only be carried out cautiously and gradually with adequate safeguards in place to avoid vulnerability to capital flight. The decision of India will certainly affect China's policy on the convertibility of the RMB.
The decision on the sequencing and speed of currency convertibility is at the discretion of the authorities in a country. Convertibility of the RMB, if carried out, will at the initial stage only be permitted for specific types of capital transaction, and then gradually expanded to other types of transaction. Partial convertibility may make a currency eligible as core currency for the common currency basket, if the money market is sufficiently liquid as has been seen in the ECU's history. If such measures are taken and the Chinese authorities decide to establish convertibility, it would be a very important step forward to the establishment of a currency and monetary system in East Asia.
Japan carried out capital account liberalization in tandem with the reform of the domestic money market and nearly completed its capital account liberalization by the middle of the 1980s. It took 20 years for Japan after it accepted article 8 of the IMF charter. If Japan's case is simply applied to China, in 2016 it will be 20 years after China has accepted article 8 of the IMF charter. Japan's case may not be applicable to China, but, if China carries out capital account liberalization in tandem with reforms of the banking and monetary system, it may not be so off the mark to believe that China will complete nearly full convertibility of the RMB sometime in the 2010s, considering the substantial progress which has been made for capital account liberalization and its future prospect. Convertibility of the RMB will play a critical role in realizing a currency basket system in the region. It is expected, therefore, that Chinese authorities will soon indicate a long-term perspective on capital account liberalization and convertibility of the RMB.
8. Relations with the global institution and the United States
Relations between ASEAN+3 and global institutions, particularly the IMF, are important. It is essential to have a close working relationship with the IMF concerning surveillance. With regard to the disbursement of funds under the CMI bilateral swap agreements, 20% may be disbursed freely, but the remaining 80% is subject to the IMF package between a debtor government and the IMF. While the CMI plays a supplementary role to the global function of the IMF, detailed arrangements on their roles and how they are to coordinate have not been made yet.
At the spring meeting of the International Monetary Finance Committee, Mr. Rato, Managing Director of the IMF, proposed the IMF should carry out multilateral surveillance of global imbalances, as well as undertake a review of the IMF quota system. For this he would present detailed proposals at the annual meeting in autumn this year. Multilateral surveillance and quota issues are important for many of the East Asian countries. The relationship between regional financial arrangements and global institutions will become an increasingly important focal point in the future.
The United States maintains very close ties with East Asia and it is the most important partner in trade and investment for most East Asian economies. In socio-cultural and security areas, the United States is considered to be almost a part of Asia. It appears that the United States is uncomfortable with East Asia's regionalism that has been proceeding without its participation. Therefore, a proper forum similar to the Asia-Europe Meeting (ASEM) should be established to maintain close dialogue with the United States.
Regional financial cooperation in East Asia will enter into phase 2, on the basis of regional cooperation achieved in phase 1. It is essential to make meaningful progress in economic surveillance and policy coordination, where peer pressure among members will be an important tool. In order to do so, new guiding principles for phase 2 need to be established based upon common values and objectives for regional cooperation among member countries. In order for ASEAN+3 to be successful in integrating its financial systems, it is indispensable to share a common understanding on East Asian regionalism.
The idea of creating a common currency basket to achieve a stable currency system will provide members in the region with an ideal opportunity to coordinate policies among members. It will be time consuming and painstaking, but also a most challenging process to reach a consensus. It is a very important step forward to understand such a proposal and to prepare the policy measures necessary for capital account liberalization and currency convertibility.