Currency Cooperation in East Asia

As East Asia is growing together in real economic terms and becoming the center of gravity of the world economy, voices from business and politics of the region are increasingly calling for intraregional currency cooperation in order to mitigate financial and developmental risks. Taking a closer look, this chapter elaborates the specific environmental conditions for currency cooperation and discusses critically the goals, modes and limits of currency cooperation in the region. Given the diversity of the region and the dominance of national economic objectives, the chapter concludes on a skeptical note to overly inflexible exchange rate systems and overambitious regional funds.

Commensurate with its economic strength, China aims for a financial sector and currency of global importance. To assess the likelihood of this ambition in the light of the not fully convertible renminbi and sheltered financial system, this essay reviews past reform efforts and the current state of the Chinese form of capitalism. It finds that after a decade of bold financial reforms under Jiang Zemin and Zhu Rongji, the momentum began to wane from 2005 onwards. The new leadership under Xi Jinping and Li Keqiang needs to complete important reforms before China’s financial sector and currency can rise to international standards and importance. The new leaders seem to be aware of the historic nature of this task and are willing to close the gaps. In particular this includes introducing market pricing of capital and risk, increasing the breadth, deepness and liquidity of financial markets and improving the institutional framework for financial stability. If successful, these reforms are likely to sustain economic growth in the long term, boost currency cooperation in East Asia and speed up the emergence of a regional RMB bloc.

The Bank of Japan is running an unprecedented historic experiment by doubling its already record high monetary base to more than 50 % of GDP over the next 2 years. The aim is to escape from deflation and achieve 2 % inflation. This chapter questions the main assumptions underlying the new monetary policy: (1) There is little evidence that deflation is a major obstacle to Japan’s prosperity. (2) Japan does not seem to be suffering from insufficient demand. (3) It is not clear how the BoJ can control inflation expectations. (4) Even if it succeeds, it will face the challenge of controlling the negative side effects of rising nominal interest rates, an accelerating velocity of money, lower real wages and a devaluation of the yen that may spur a currency war.

This chapter examines the state of RMB internationalisation, its likely progress over the coming years, and discusses its implications for currency cooperation in East Asia. As part of its internationalisation, the RMB is being gradually delinked from the dollar. This will effectively put an end to the East Asian dollar standard that has shaped the region’s financial architecture over the last three decades and has provided a relatively high degree of intra-regional exchange rate stability. Because of the close trade and investment ties that have developed across the region, the East Asian countries, especially the ASEAN countries which are striving to create an ASEAN Economic Community, will continue to manage their exchange rates and stabilise their currencies against one another to facilitate cross-border investment and commerce. But instead of a replacing of the dollar standard with an RMB standard we are likely to see some rather loose and informal exchange rate co-operation in East Asia based on currency baskets. China herself will move towards a managed exchange rate system guided by a currency basket.

The recent experience of the Chiang Mai process of financial cooperation in East Asia is explored. It serves as a case study of how the challenges of institution building can be overcome in East Asia and what challenges still remain. Such issues include the following: How can one cope with the challenge of leadership and hegemonic rivalry? To what extent are mechanisms robust and reliable in the case of potential crises, or are they merely window-dressing? How can deviant behaviour from opportunistic members be overcome? It is argued that despite impressive formal development over the last 15 years, the Chiang Mai process still lacks the compelling means to work as a regional crisis mechanism. Political symbolism and opening communication channels seem more important than solving hard-core international economic policy challenges. With respect to the institutional prerequisites for future currency cooperation, this elicits only guarded expectations.

This chapter surveys international reserve policies of East Asian central banks. It describes the massive accumulation of foreign exchange reserves since the financial crisis of 1997 and compares the behavior of East Asian countries to that of other emerging markets and the rest of the world. Based on a review of empirical panel data analyses, explanations for rising reserve levels are provided. In particular, mercantilist and precautionary motives, reactions to past financial crises and competitive considerations are discussed. The chapter then assesses the consequences of this reserve demand: Reserve hoarding entails costs and might interfere with domestic monetary policy. Finally, we examine how currency cooperation in East Asia might affect reserve policies. Potential forms of cooperation include bilateral swap agreements and reserve pooling. The Chiang Mai initiative, an illustrative example of reserve pooling, is presented and some ideas for potential improvements are pointed out.

The US-Dollar is still the most widely used currency for the settlement of trade transactions in East Asia. Currency swaps between Asian countries are one possibility to reduce this dependency on the US Dollar. This chapter explains the background and various aspects of the Korea-China currency swap-financed facility. First the framework and mechanisms of the facility with the roles of the involved central banks, commercial banks, importers and exporters are presented. Then the performance and desired effects of the swap agreement are explained. This includes the reduction of exchange rate risks, transaction costs and ultimately the increase of trade between Korea and China. Finally methods to enhance and to build on the facility, like increasing the number of involved businesses, simplifying the process and relaxing Korean foreign exchange transaction regulations are explored.

Foreign exchange fluctuations are an external risk for international cooperation and hinder cross-border trade. From an economic perspective this results in lost trade opportunities. Therefore, this chapter assumes stabilization of the real exchange rate as the major target of currency cooperation. Some basics of corporate currency risk and exposure (management) are summarized. The aim is to highlight the determinants of currency risk. These are contrasted with some readily available empirical data on (South-) East Asia that refer to fluctuations of regional real exchange rates, trade structures and corporate foreign exchange risk management procedures. This analysis shows that none of the determinants of corporate foreign exchange risk have any apparent empirical relevance. Accordingly, the results cast doubt on the positive net effects of further regional currency cooperation.

The role of reserve requirements has evolved significantly over time and differs across countries, though there are two broad trends. For central banks that operate in highly developed financial markets the role of reserve requirements as the primary instrument of monetary policy has been decreasing over the past few decades. The role of mandatory reserves is reduced to smoothing fluctuations of short-term interest rates, which helps to communicate the operational target of the central banks more clearly. For central banks operating in emerging market economies, however, tweaking reserve requirements has gained importance. Reserve requirements supplement a policy mix that aims at stabilizing the exchange rate and combating high and volatile capital inflows, especially as the low interest rate environment of advanced economies has accelerated a global search for higher yield. We offer a comparison of the experience at the People’s Bank of China (PBC) during the recent past and that of the Bundesbank from the post-war period until the start of the European monetary union. It presents a case study suitable for explaining the different functions of reserve requirements and how characteristic features and external conditions influence the feasibility of each function. Reserve requirements have been most actively used in China and Germany during shifts in exchange rate regimes that coincided with periods of high and volatile capital inflows. Economic theory, however, can additionally drive visions of what reserve requirements should perform. We conclude that some misconceptions of the role of money, credit and liquidity influence the bias between theory and practice.