E-Notes

East Asian Financial Regionalism and U.S. National Interests

April 2006

by William W. Grimes

William W. Grimes is an associate professor of international relations at Boston University. Much of the research on which this article is based was obtained during a four-month period as a visiting scholar at the Japanese Ministry of Finance, with the financial support of a Fulbright-Hays Faculty Research Fellowship. The author wishes to express his thanks to both. This essay is based on a talk he gave in Philadelphia on November 16, 2005, for FPRI’s Asia Study Group.

Since the 1997-98 Asian financial crisis, East Asian governments have been working to deepen regional financial integration and to create institutions to avert future currency crises. East Asian financial regionalism is a matter of great importance to the United States as well as to the region.

East Asia is not only the fastest growing region in the world economy, it is also the world’s foremost supplier of surplus savings, the largest ongoing purchaser of dollar assets, and a major market for U.S. financial institutions. It is vital to take seriously regional efforts to reshape the financial architecture. This is particularly true given that the locus of financial cooperation in East Asia is the ASEAN+3 (Association of Southeast Asian Nations, plus China, Japan, and South Korea), a forum that specifically excludes the U.S.

While East Asia as a region is highly integrated into the global trading system, finance in the region is characterized by small and fragmented markets with problematic access to outsiders and currency regimes much more oriented toward the U.S. dollar than toward stabilizing against regional currencies. The financial vulnerability of many East Asian economies was demonstrated in 1997. East Asian financial regionalism is meant to respond very directly to the lessons regional governments have drawn from the Asian Financial Crisis: that dollar pegs and short-term borrowing in foreign currencies are very dangerous and that little support can be expected from the International Monetary Fund (IMF) and the U.S. in the event of a crisis.

There are four major streams of East Asian financial regionalism:

Currency management. Ideas about regional currency stabilization and even of the eventual development of a regional common currency have gained attention, but remain at the earliest stages of discussion.

Chiang Mai Initiative: Confronting Currency Crisis

The Chiang Mai Initiative was agreed on by ASEAN+3’s finance ministers in May 2000 and was fully in place by the end of 2003. Based primarily on a network of bilateral swap agreements among participants, CMI is set up so that crisis countries are able to borrow predetermined amounts of their counterparts’ reserves for a renewable period of 90 days to supplement their own foreign reserves. When a member country experiences a currency crisis, it can draw on these funds rapidly and without conditions during the period in which it is negotiating an IMF standby agreement. CMI functions purely on a request basis, and mandates no policy conditions for borrowers. In May 2005 in Istanbul, ministers further agreed to double the size of available funds and to strengthen the initiative in several ways.

The CMI involves real money, comparable to the amount of the failed Japanese proposal for an Asian Monetary Fund (AMF) in 1997. By the time the Istanbul agreement is fully implemented, the sum of all the swap arrangements will be above $80 billion. Countries facing a speculative attack will have funds available to them under the CMI in amounts that easily dwarf their IMF quotas, even without having an actual IMF standby agreement in effect or having to negotiate with third parties. Thailand, for example, will have access to $14 billion through CMI once the Istanbul agreement is fully incorporated into its bilateral swap agreements - nearly 10 times as much as its IMF quota of SDR 1.08 billion (approximately $1.6 billion).

An important aspect of CMI is the IMF link, which dictates that only 10 percent (increasing to 20 percent as the Istanbul agreement is reflected in swap agreements) of funds can be released without the approval of the IMF. This does not mean that an IMF agreement must have already been reached - only that the IMF certifies that the crisis country is negotiating a standby agreement in good faith. Thus, instead of the one-month lag typically involved in preparing and agreeing upon an IMF plan, money can be released within days of the onset of a crisis. A rather rudimentary form of surveillance has also been created, but it is not highly standardized.

The CMI is sometimes compared to the 1997 Japanese proposal for an AMF, which was meant to create a pool of approximately $100 billion collected from regional governments and central banks that would operate independently of the IMF by providing large amounts of foreign exchange rapidly and without conditions in the event of a crisis. Much discussion has centered on the question of whether the CMI will be transformed into something close to the original AMF proposal. The sheer size of the overall funds available keeps such speculation alive, as does the continued resentment of 1997 crisis countries toward the IMF. Eliminating the IMF link would be a serious blow to U.S. interests in East Asia; it would also transform the Chiang Mai swap network from a purely positive financial force for East Asian financial stability into a vehicle for economic and political moral hazard.

The fundamental difference between CMI and the proposed AMF is the decision-making process, particularly the IMF link. And for the foreseeable future, problems of surveillance and enforcement make the IMF link highly attractive to likely creditors like Japan and China. For them, CMI’s rudimentary surveillance regime may be useful in monitoring policies during non-crisis periods, but it cannot enforce responsible economic policies by potential crisis countries. Enforcement is possible only if there is a credible threat not to provide emergency funds to governments that create their own crises. Given its small membership and the political costs to member countries of vetoing a bail-out, only third party certification can both provide discipline to potential crisis governments and take creditor governments off the hook for non-provision of funds. In the absence of a viable autonomous regional institution, only the IMF can fulfill that role.

There is no clear reason at the moment for either Japan or China to want to change the status quo. However, the threat of the elimination of the IMF link may be a useful lever on the part of Japan and China to make the IMF behave in a manner that the Asian economies prefer. In 1997, for example, the AMF proposal put pressure on the IMF and its board of directors to be forthcoming toward some of the proposals of the Japanese government.

Japan’s and China’s interests in maintaining the IMF link could be challenged in the future. It is imaginable that the IMF response to a crisis could so anger ASEAN+3 governments that they would decide that the costs of regional inaction exceed those of regional action. As CMI funds continue to increase relative to IMF quotas, organizational momentum might force the issue as well.

Nurturing Bond Markets - Asian Bond Market Initiative and Asian Bond Fund

The second major pillar of East Asian financial regionalism is the promotion of local-currency bond markets. ASEAN+3’s Asian Bond Market Initiative (ABMI) seeks to address a second lesson of the Asian financial crisis, namely the “double mismatch” problem. In the aggregate, savers in East Asian economies have been investing a significant part of their savings in foreign currency- (primarily dollar-) denominated assets. They have then borrowed the money back in short-term dollar-denominated loans and bonds, and applied the funds to longer-term domestic investments whose returns are in the local currency. The result has been both a maturity mismatch and a currency mismatch, thus making countries highly vulnerable to movements in the value of the dollar.

In the 1997 crisis, the freefall of local currencies versus the dollar made repayment of debt impossible, and in turn fed back into further declines in currency values, in a self-reinforcing downward spiral. Better domestic capital markets would have provided more opportunities for domestic savers in local currencies, potentially dampening or even avoiding the crisis. Expanding bond markets is also seen as a way of improving financial intermediation within the mostly bank-based economies of East Asia.

Although ABMI is often posed as a means of creating an integrated regional market, the more realistic goal is development of domestic bond markets. Domestic bond markets in East Asia are generally not very highly developed, although they have been growing rapidly. Size, turnover, legal infrastructure, transparency, and variety of issuers and maturities remain deficient throughout the region.

The problem of developing domestic bond markets can be viewed in terms of both infrastructural issues and liquidity issues. While ABMI seeks to address both aspects, it is much more feasible for government policy makers and regulators to address the infrastructural issues. The ASEAN+3 members have identified a number of important impediments to development of domestic bond markets in East Asia, such as lengthy approval processes, unclear default rules, lack of hedging instruments, and poor disclosure standards, among others. Some governments (notably South Korea and Malaysia) have made impressive strides in creating efficient and attractive bond market infrastructures, although it is difficult to link these improvements to the ABMI per se. Throughout the region, significant obstacles remain, and many of those obstacles will be far more costly or politically sensitive to surmount than those that have already been met.

The ASEAN+3 governments have also sought to improve the liquidity of bond markets in the region by promoting local-currency bond issues by official actors and through various credit enhancement schemes. Public-sector credit enhancement primarily means issuing guarantees for private sector bonds in order to reduce firms’ cost of financing. ABMI also seeks to improve legal infrastructures to allow for more effective private-sector credit enhancement, such as asset-backed securities . However, while there have been some demonstration projects on both the regional and national levels, they remain few in number and minimal in impact.

A separate effort at spurring regional bond markets’ liquidity can be seen in the Asian Bond Fund (ABF) efforts of the executives’ meeting of the East Asia-Pacific Central Banks (EMEAP), which includes New Zealand, Australia and Hong Kong in addition to the eight core ASEAN+3 countries. In July 2005, EMEAP formally established what is known as ABF 2, to invest in local-currency-denominated public-sector bonds of the emerging-market economies of EMEAP (i.e. not including Japan, Australia, or New Zealand). The central banks have invested a total of $2 billion in the form of a closed-end fund. However, there are parallel open-end funds that are open to private investors and managed by major private financial institutions. This effort is meant to enhance liquidity by making it easier and more attractive to purchase East Asian local-currency bonds. At least initially, Japanese financial institutions as well as Asian local institutional investors of all sorts will be the target customers, but the participation of major Western financial institutions in the design and management of the funds is meant to be enticing to U.S. and European investors as well.

Despite these efforts, there remain important economic and political limits to the development of large and liquid regional bond markets. In particular, the small size of most domestic economies and the lack of international usefulness of their currencies mean that their domestic bond markets will be of limited attractiveness to foreigners. China will likely be an exception to this point in the long run because of the sheer size of its economy.

Financial Regionalism and U.S. Interests

While there are serious limits to financial regionalism, its importance cannot be disregarded. The East Asian states as a group are in the midst of a long-term process of political and economic regionalism. This is reflected in a whole range of efforts, including not only financial initiatives, but also in moves toward preferential trading agreements, the East Asian Summit, a host of smaller-scale and bilateral cooperation initiatives involving economic, political, security, and environmental issues, and a burgeoning of Track-Two and NGO-based regional initiatives. Among the various efforts, financial regionalism is likely to be one of the cornerstones of the political and economic architecture of East Asia in the twenty-first century.

We are still in the initial stages of East Asian financial regionalism, but it is not too early to start thinking about its impact on the U.S. The question of how East Asian financial regionalism affects U.S. interests can be broken down into economic-regional stability and conformance with global financial standards and regimes-and political-the rivalry for regional influence among Japan, China, and the U.S.

The main economic interests of the U.S. in East Asia are economic stability, development of financial opportunities, and equal access. Regional efforts so far have been made clearly subordinate to the rules and judgment of the IMF and the guidelines of the Bank for International Settlements. East Asia’s high integration into the world economy will make it highly unattractive to move away from the overall umbrella of these regimes or from global financial standards.

Looking at bond-market development, the ABMI and ABF appear to comport perfectly with the visions of the U.S. and IMF for financial development and liberalization. There are a couple of potential concerns, however. One is that more attractive local bond markets will reduce demand from the savings-rich economies of East Asia for dollar-denominated assets. However, this should not be a major concern. Any such shift would be long and gradual; moreover, U.S. deficits are a source of global economic imbalances that would be best rectified by greater demand outside the country, especially in high net-savings countries such as Japan and China.

From a different angle, a number of Japanese authors have argued that rising interest in Asian currency assets could weaken the position of the dollar as the world’s key international currency. The U.S. has benefited greatly from having the dominant world currency. But the key to maintaining the international position of the dollar is to make the U.S. economy an attractive place to invest and dollar-denominated markets the most efficient in the world. Even if the position of the dollar erodes (and it is far more likely to be pressured by the euro than by any Asian currency or currencies), responsible macroeconomic policies and financial regulation will still be the best formula for U.S. power and prosperity.

Finally, there is the potential issue of equal access. Global standards provide the basis for discussion and policy recommendations in the ASEAN+3, reflecting the interests of key players such as Japan. However, it is possible that financial liberalization and market development will come to favor local or regional financial actors at the expense of U.S. or European investors and financial institutions. Non-discrimination against foreigners (perhaps especially Westerners) is likely to be politically difficult at various times and in various countries in East Asia. It will be important for the U.S. both on its own and through its leadership role in the IMF and BIS to keep an eye on regional financial markets to ensure that bond market development and capital liberalization in the emerging markets of East Asia proceed on the basis of non-discrimination. Fortunately, East Asian countries with relatively advanced financial systems, such as Japan, Singapore, and South Korea, share the U.S. interest in equal access in the region.

Turning to the CMI, the primary interests of the U.S. are that it promote regional economic stability and responsible economic policies. With regard to stability, the key point is that CMI be effective in preventing and stopping currency crises. While it is unpredictable how CMI will work in an actual crisis, the simplicity of the mechanism is encouraging.

The greater concern is the possibility that CMI will create an environment of moral hazard, by shielding countries from the consequences of irresponsible economic policies. This is most likely to occur if the IMF link is substantially reduced or eliminated, since there is no other viable means of enforcement in the midst of a crisis. The IMF link is important not only to the institutional goals of the IMF or power considerations of the U.S., as is sometimes claimed, but to the question of whether CMI will be a stabilizing or a destabilizing force in the regional economy. For economic reasons even more than political ones, the U.S. should continue to insist that CMI remain under the IMF umbrella.

Politically, the big question is how financial regionalism fits into relations among Japan, China and the U.S. In the long run, two trends will be relevant to East Asian financial regionalism: (1) a contest for regional influence between Japan and China, and (2) efforts by China to weaken U.S. alliances in the region. Japan, increasingly sidelined in East Asia by China’s rapid economic rise and deft political maneuvering as well as its own “history problem,” needs to maintain strong political and economic relations with the U.S. as the basic guarantor of its security and as a key economic partner.

The U.S. government has made clear that it does not like regional efforts that exclude it, and ASEAN+3 financial regionalism is potentially a flashpoint. The U.S. has considerable interests in the outcome of East Asian financial regionalism, and therefore desires direct participation in any substantive negotiations to protect its interests. For the time being, U.S. opposition to exclusive regional arrangements may help to keep regional actors sensitive to U.S. interests.

Longer term, the U.S. (and Japan) should be particularly concerned about the future of the CMI. That Initiative involves large amounts of money, which could form the basis of regional reserve pooling and potentially a weakening of U.S. and IMF input into regional macroeconomic management. It is also possible that at some future point Chinese leaders will propose elimination of the IMF link in order to pressure Japan. This would put Japan in the position of either angering its Southeast Asian partners by vetoing elimination or creating a breach with the U.S. and injuring its own economic interests by going along. Of course, China’s economic interests would also be harmed by elimination, but its leaders may well see that as an acceptable price to pay for weakening the U.S. or Japanese politically in East Asia.

The main responsibility for preventing such a development lies with Japan. The Japanese government cannot be expected to act as a representative of U.S. interests in East Asia, but it must take into account legitimate U.S. economic interests in regional openness and economic stability. Fortunately, the U.S. not only has considerable leverage in its dealings with Japan, but in the financial arena also shares many key interests. It is important to the U.S. that Japan help to create an architecture that is open and stable and will generate incentives to members to maintain those ideals. It is up to the U.S. government to support such efforts.

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