Regional Financial Cooperation

The regional economies have embarked on several initiatives to strengthen the regional financial architecture. These initiatives have three pillars: (i) regional economic surveillance; (ii) a liquidity support facility; and (iii) Asian bond market development.

(1) Regional economic surveillance

Currently, the most prominent regional economic surveillance forum is that of the ASEAN+3 finance ministers’ Economic Review and Policy Dialogue (ERPD) process, introduced in May 2000. There are other forums, such as the ASEAN finance ministers’ Surveillance Process, the ASEAN Central Bank Governors’ Meeting, and the EMEAP process as well as forums for trans-regional policy dialogue under APEC and ASEM (see Table 5 [ PDF 62.8KB | 1 pages ]). The purpose of ASEAN+3 ERPD is to contribute to the prevention of financial crises through the early detection of irregularities and vulnerabilities and the swift implementation of remedial policy actions. For this purpose, the process facilitates information sharing, exchanges of views, assessments of economic conditions and policies, and potential for collaboration on financial, monetary, and fiscal issues of common interest.

The ERPD process encompasses: (i) assessing global, regional, and national economic conditions; (ii) monitoring regional capital flows and currency markets; (iii) identifying macroeconomic and financial risks as well as policies to reduce such risks; (iv) strengthening banking and financial system conditions; and (v) providing an Asian voice in the reform of the international financial system. Steps have been taken for cooperation in monitoring short-term capital flows through the exchange of consistent and timely data and information, establishing national surveillance units for economic and financial monitoring, and developing a regional early-warning system to assess regional financial vulnerabilities. Currently the ASEAN+3 ERPD process is in transition from the information sharing stage to peer reviews, and it will have to aim to achieve the next stage of due diligence—a more rigorous scrutiny of a potential debtor economy from a potential creditor’s perspective (Kawai and Houser, 2007). As this evolution takes place, the ERPD is also being more closely linked to the Chiang Mai Initiative (CMI), which I would like to turn to below.

Central bank governors in the region have formed the ASEAN Central Bank Governors’ Meeting and EMEAP, as completely separate forums from the ASEAN and ASEAN+3 finance ministers’ processes. EMEAP was organized in February 1991 with the leadership of the Bank of Japan and the Reserve Bank of Australia. Its major objectives include exchanges of information and views, policy dialogue, and the promotion of financial market development. Its activities include annual meetings of EMEAP central bank governors, semiannual meetings of the deputy governors, and three working groups concerned with bank supervision, financial markets, and payments and settlement systems.¹⁸ Like the ASEAN+3 finance ministers’ process, EMEAP has no secretariat; instead, the responsibility for organizational matters, along with the meetings themselves, is rotated among the participating central banks.

(2) Regional reserve pooling—Chiang Mai Initiative

The hallmark liquidity support facility in East Asia is the CMI (introduced in May 2000), which was designed to address short-term liquidity needs in the event of a crisis or contagion, and to supplement the existing international financial arrangements. The Asian financial crisis highlighted the importance of creating an effective financing facility so that governments in the region can prevent, or respond effectively to, currency crises in an increasingly connected global economy. The CMI consists of two elements: the enlarged ASEAN Swap Arrangement (ASA), presently with US$2 billion; and the network of sixteen bilateral swap arrangements (BSAs) among 8 ASEAN+3 members with US$83 billion as of July 2007 (Table 6 [ PDF 57.2KB | 1 pages ]).¹⁹

One of the important features of CMI BSAs is that members requesting liquidity support can immediately obtain short-term financial assistance for the first 20 percent of the committed amount. The remaining 80 percent is provided to the requesting member under an IMF program. Linking the CMI liquidity facility to an IMF program—and hence IMF conditionality—is designed to address the concern that the liquidity shortage of a requesting country may be due to fundamental problems, rather than mere panic and herd behavior by investors, and that the potential moral hazard problem could be non-negligible in the absence of rigorous IMF conditionality. The general view is that, with the region’s currently limited capacity to produce and enforce effective adjustment programs in times of crisis, linking CMI to IMF programs is prudent, at least for the time being.²⁰

Continuous progress has been made to strengthen CMI since its launch. Some of the major developments over the last few years include:

• Integration and enhancement of ASEAN+3 ERPD into the CMI framework (May 2005);
• Increasing the ceiling for withdrawal without an IMF program in place from 10% to 20% of the total (May 2005);
• Adoption of the collective decision-making procedure for CMI swap activation, as a step toward multilateralizing the CMI (May 2006); and
• Agreement in principle on a self-managed reserve pooling arrangement governed by a single contractual agreement as an appropriate form of CMI multilateralization (May 2007).

Currently, ASEAN+3 finance and central bank deputies are studying some key elements of CMI multilateralization (“self-managed” reserve pooling)—including surveillance, reserve eligibility, commitment size, borrowing quota, and activation mechanism.

(3) Asian bond market development

Since the 1997–98 financial crisis, there has been a strong recognition that East Asia needs to develop local currency bond markets as an alternative source of financing in view of the region’s heavy dependence on banks. In particular, the development and deepening of local currency-denominated bonds is expected to reduce the “double mismatch” problem, which was at the heart of the crisis, and overcome the so-called original sin problem.²¹ The basic idea is to mobilize the region’s vast pool of savings to be intermediated directly to the region’s long-term investment, without going through financial centers outside the region. Regional financial intermediation through bond markets would diversify the modes of financing in the region and reduce the double mismatch.

This effort began first at the country level to strengthen national market infrastructure for the issuance and trading of sovereign and private bonds, and then at the regional level to encourage the development of regional bond markets. The regional efforts include the Asian Bond Fund (ABF) initiative under the aegis of EMEAP and the Asian Bond Markets Initiative (ABMI) under the auspices of the ASEAN+3 finance ministers. The APEC finance ministers’ process and the Asia-Cooperation Dialogue (ACD) process have also been strongly supporting Asian bond market development.

The EMEAP group introduced the ABF initiative in June 2003. The idea was to help expand the bond market through demand-side stimulus from purchases by central banks of sovereign and quasi-sovereign bonds issued by 8 EMEAP emerging members (including PRC; Hong Kong, China; Indonesia; Korea; Malaysia; Philippines; Singapore; and Thailand) using all eleven members’ foreign exchange reserves. The initial attempt was to purchase US$1 billion of US dollar-denominated bonds (ABF-1). Given the recognition that local currency-denominated bonds needed to be promoted in order to address the “double mismatch” problem, the central bankers introduced ABF-2 in December 2004, involving purchases of US$2 billion equivalent of sovereign and quasi-sovereign local currencydenominated bonds. ABF-2 was designed to facilitate investment by public and private sector entities, through the listing of local currency exchange-traded bond funds (ETF)— already listed in Hong Kong, China; Malaysia; and Singapore.

The ASEAN+3 finance ministers’ process launched the ABMI in August 2003. The ABMI aims to focus on facilitating market access to a diverse issuer and investor base and on enhancing a market infrastructure for bond market development, thereby creating robust primary and secondary markets in the region. The ABMI initially created 6 working groups and later reorganized these into 4 working groups and 2 support teams. The four working groups have been focusing on:

• Issuance of new securitized debt instruments;
• Study of several options and modalities to establish a regional credit guarantee agency to help mitigate risks through credit enhancement;
• Exploration of possible establishment of a regional clearance and settlement system to facilitate cross-border bond transactions without facing the Herstatt risk (i.e., the risk of being in a different time zone); and
• Strengthening of regional rating agencies and harmonization of rating standards.

After careful examinations and discussions, the working groups have chosen a particular modality to establish a regional credit guarantee entity with the Asian Development Bank’s support as well as decided to set up a regional clearance and settlement system.

(4) Lack of exchange rate policy coordination

Despite close and rising interdependence of East Asian economies through trade, investment, and finance, no exchange rate policy coordination has been in place in East Asia. Moreover, the region’s exchange rate regimes are in serious disarray. In contrast to the pre-crisis period, where many emerging market economies in East Asia maintained de jure or de facto US dollar pegged regimes, the post-crisis period exhibits a greater diversity in exchange rate regimes. The two giant economies in the region, Japan and the PRC, adopt different exchange rate regimes—Japan a free float and the PRC a heavily managed, crawling peg regime targeted at the US dollar.

Given the persistent global payments imbalance and rapid accumulation of foreign exchange reserves, abrupt changes in international investor tolerance (or expectations) could put downward pressure on the US dollar and upward pressure on many East Asian currencies. A loss of confidence in the US economy due to the worsening subprime loan problem or a possible economic recession could trigger a portfolio shift away from US dollar assets to other currencies. In addition, East Asia also faces the challenge of surges in short-term capital inflows and the consequent upward pressure on currency values. These inflows are often directed to asset markets—for investment in equities and real property—and hence, if not managed properly, can be a source of macroeconomic and financial sector vulnerabilities. Policy to allow currency appreciation is advisable in the presence of domestic inflationary pressure and incipient asset price bubbles, but it can also damage the country’s international price competitiveness vis-à-vis neighboring countries. So these problems may not be resolved through individual national policies alone. One of the most reasonable policy options is to allow “collective” currency appreciation, which does not differentially affect individual countries’ relative price competitiveness.

Collective currency appreciation would spread the adjustment cost across East Asia, thus minimizing individual country costs. Simple calculation would indicate that a 20% collective appreciation of East Asian currencies vis-à-vis the US dollar implies only a 9% effective (or trade-weighted) appreciation against trading partners—given the intra-regional trade share of 55%—even if all other non-East Asian currencies remain stable vis-à-vis the dollar. To the extent that other currencies also appreciate vis-à-vis the dollar, the degree of effective appreciation of the East Asian currencies would be more limited.

Joint currency appreciation requires a convergence of exchange rate regimes in East Asia to ensure intraregional exchange rate stability. For this to happen, the existing policy dialogue processes among the region’s finance ministers (such as ASEAN+3) and central bank governors (such as EMEAP) can play a critical role. Clearly the first step is to adopt a regime that allows greater currency flexibility vis-à-vis the US dollar. The PRC’s yuan revaluation in July 2005 and its shift to a managed crawling peg—followed by Malaysia’s similar shift to a managed float—suggest the beginning of such coordination.

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