Road map for the market based development of the store of value ACU

Once the ACU is well established as an indicator for regional exchange markets and as monetary cooperation progresses, there will be a market demand for ACU-denominated securities. This demand will be all the more pronounced if ASEAN countries pursue a longterm vision of monetary cooperation (Park and Park 2005).

ASEAN+3 countries have already identified bond market development as an important goal for regional cooperation. Instead of issuing foreign debt in US dollar, less exchange risk would be assumed by denominating debt in the regional currency. This is what the European experience suggests.

A. ACU Bond Market Development: Why and How?

At least during an initial phase of development of the ACU into a financial instrument, the ACU's major use will be for denomination of debt instruments. This is suggested by the European experience with the ECU and by our assessment that the political willingness to award to the ACU a role as a unit of account and as a means of payment will require time and success in its store of value function.

Success of the ACU in bond markets depends on frequency of issuing activity, market liquidity, participation of regional and out-of-region borrowers, and participation of first-class borrowers. Without participation by regional governments it would certainly take longer to establish a well-functioning market. The ECU experience suggests that it is feasible to rely on private investors and borrowers. However, at the time of launching the ECU, Europe was already more integrated than ASEAN+3 is today, with greater institutional support for integration. Therefore, it would greatly help ACU market development if regional governments provided early support for the ACU. This should also be in their own interests, as we are showing now.

Many governments or public agencies in the region borrow in US dollars and thereby take a major exchange risk. During the last ten years, integration of the East Asian economies has progressed dramatically. Intra-industry trade has been the driving force; for example, the PRC's export surplus in bilateral trade with the United States and Europe is based on trade deficits with respect to countries from the region. Therefore, while many economies in the region can still suffer from asymmetric shocks, a greater source of concern is regional shocks. If demand in the United States or, to a lesser extent, Europe were to falter or if demand for IT equipment and electronic goods were to fall, then the whole region would be affected. This is also supported by the results of Girardin (2005), which showed that the correlation among ASEAN economies' growth cycles has increased and is close to where Europe was at the beginning of its monetary integration.

The financial consequence is that the risks on dollar assets or liabilities are much larger than they would be on ACU assets or liabilities. Therefore, it would be in the interest of regional governments when borrowing in foreign currency, to borrow in ACU rather than in US dollars.

The same is true for investment of exchange reserves, where Asian economies already exhibit a worrisome concentration on US dollar securities. Diversification into euro securities would be problematic as such a shift would cause an appreciation of the euro with respect to the US dollar, while the major imbalances are between Asia and the US. Moreover, the US authorities would not see such a diversification indifferently.

Investment of foreign exchange reserves in ACU securities would have several advantages. The US cannot possibly block investment in ACU securities as Asian governments would invest in their own currencies. Europeans could not object either as Europe would only be affected indirectly. The consequence would be a depreciation of the US dollar with respect to all currencies. In this sense substitution of the dollar through the ACU in Asian central banks' foreign exchange reserves would contribute positively to the reduction of global imbalances, avoid an excessive burden on individual regions of the world, and diminish the losses central banks are currently exposed to in case of a strong depreciation of the US dollar.

For Asian central banks to be able to diversify their foreign exchange holdings into ACU securities, a market for liquid instruments of high issuer quality must first come into existence. As governments are typically in all countries the single issuer with the highest credit standing and, therefore, are used by market participants as benchmarks, the major governments in the region have a potential role to play in building up a market by issuing ACU securities. If they did so early in the emergence of an ACU market, the take-off would occur much more rapidly than if market development was left to private initiatives alone, as was the case in Europe. ECU securities were first launched by private banks, while European institutions and governments used the ECU bond market only when it was already rapidly developing. We propose a different strategy for the ACU to gain time and to reduce uncertainties with respect to the success of a new currency. If, in addition, with an eye to a liquid market segment, governments launched large issues either in one go or through fungible issues, then the instruments would be created of interest for the portfolios of central banks.

It needs to be recognized that securities markets are examples of network economics. Like a credit card whose utility is increasing with the number of acceptance points, ACU securities gain through wide acceptance by investors and borrowers. In this acceptance process not all parties are of identical importance. For this reason governments and highly-rated international organizations play a central role, acting as leaders and the private sector as followers. By accepting such a leading role, governments are not “paying” an infant-industry subsidy but, as argued above, are acting in their own interests and for their own benefits.

As shown in Steinherr (1988) foreign exchange market interventions in basket currencies have some different implications than interventions in the dollar market. In general terms, any interventions by a particular country will be diffused throughout the region.

B. A Road Map for the ACU

A tempting approach for launching the ACU would be to stand in the footsteps of the initial European experience in the 1970s. Already Boiscuvier and Steinherr (2004) argued that instead of following the European sequence of monetary union before financial market integration, Asia should reverse the sequence. The strategy followed in Europe was initially market-based as far as the bond market was concerned. It involved sequentially private banks, international institutions, and national governments. In the light of the lessons from such an experience plus the specificities of the East Asian region, we suggest a different road map, which should not be seen as a rigid sequence, for the ACU.

The main difference with respect to the European experience is twofold. First, integration is politically, economically, and financially much less advanced in Asia than it was in Europe at the time the ECU was established. Second, financial markets are less developed in most, but obviously not in all, Asian countries. Therefore, it is necessary to proceed differently. In view of the very limited capital integration and lack of a political agenda it would be helpful, if not necessary, to develop first a political vision of monetary cooperation—where it starts, how it could evolve, and where it could end—accompanied by an agenda.

First, we see the desirability of a minimal institutional infrastructure to sustain ACU developments. Second, official institutions could become early lead participants in the ACU market. This leadership of public institutions could act as a trigger for the involvement of other participants. This is particularly the case for the private sector, but also for central banks whose involvement requires a functioning ACU government bond market.

Step 1: Institutional Infrastructure Requirements

ACU financial instruments could be developed without a well developed institutional infrastructure. However, the earlier such an infrastructure becomes operational the better it will be for market development.

Governments would have to decide on the legal status of the ACU. It could be treated, as the ECU in Europe, just like any other foreign currency. This would not be very helpful. A special status would grant the ACU not all the privileges of the national currency but more rights than foreign currencies—for example, exemption from foreign exchange controls and acceptance as a means of payments for certain transactions (e.g., for foreign trade transactions).

In many national regulations investments by pension funds and insurance companies are restricted to investments in national currency. In some countries the share of total investments in foreign currency denominations is severely restricted. It would be helpful to exempt ACU-denominated securities from such restrictions and treat them like domestic currency investments.

ACU-denominated bonds would need to be traded, preferably in one well established exchange in the region. In Europe, most bonds were listed in Luxembourg but also on other exchanges. A legal framework could be developed in the country of location of the exchange dealing with ACU securities. This could become the legal reference for ACU issues worldwide.

For operations in the bond market and for ACU payments, a payment system is required. For the ECU, a group of high-quality banks in Europe with the support of the European Commission, the European Investment Bank, and the Bank for International Settlements created the ECU Banking Association whose job was to establish a cost-effective payments system in ECU. The same private response to market developments would surely occur in Asia. But an early initiative under the leadership of a reputed regional official actor (e.g., a central bank or Asian Development Bank [ADB]) would surely accelerate developments and contribute to confidence building.

Step 2: Launch of the ACU by Public Institutions

Both regional multilateral institutions and national official institutions (I.e., governments, national development banks, etc.) might act in coordination to be the leaders in the launching and nurturing ACU securities.

1. Multilateral Institutions

Some regional financial institutions would start by using the ACU as a unit of account in their own accounting. Holding their accounts in ACU rather than in dollars would be a symbolic step. Issuing bonds in that same unit would be a more profound one. Lending to borrowing countries in ACU would be an even more important step, because of its high visibility in ACU member countries.

For example, multilateral institutions such as ADB or the ASEAN secretariat, could establish their internal accounts in ACU. The ADB could start to issue bonds in ACU and to grant loans to member countries in ACU. This would be an important learning step for member country governments.

2. ASEAN+3 Member Governments

The issuance of sovereign bonds in ACU would be a way for small ASEAN countries to initiate and develop active and liquid bond markets, substituting for inexistent or lessdeveloped domestic ones, and for larger countries within ASEAN+3 to fund widening needs of public sector funding. Governments should also attach importance to maintaining liquidity in the secondary market. Institutional investors in such countries would also benefit from being able to diversify their assets internationally while keeping close to home. The presence of such bond markets would serve as the basis for the development of derivative and options markets in ACU.

Infrastructure development with public sector support should simultaneously be implemented to ensure the functioning of the ACU bond market. This could involve a regional credit guarantee agency and a regional clearing and settlement system. In addition, the set up of East Asian bond rating agencies could be stimulated.

On the demand side, the development of the regional bond market will require national pension or provident funds to be allowed to invest a specified share of their assets in ACUdenominated sovereign or quasi-sovereign bonds. For countries with capital controls, special provisions for the ACU bond market would be an important but controlled step towards greater capital mobility. For example, in Europe several countries with extensive capital controls, such as Italy, Spain, or Ireland, exempted the ECU from such controls.⁸

Step 3: ASEAN+3 Member Central Banks

ASEAN+3 member central banks could start holding a share of the rise in their foreign exchange reserves in ACU. For the central banks involved, this would put upward pressure on the external value of their currencies, particularly against the US dollar, and would contribute, at the margin, to reduce global imbalances. Doing it at the margin would prevent too wide movements in the foreign exchange market.

ASEAN+3 member central banks should start shifting part of their outstanding foreign exchange reserves into ACU. This would gradually deepen the trend triggered by the preceding move at the margin. Such a management of reserves in ACU would be training ground for a possible later development of an East Asian exchange rate mechanism.

Step 4: Private Sector

A crucial step would occur when the private sector started to issue bonds in ACU and banks begin to accept deposits and grant loans in that same unit. The private sector's involvement in both bond and banking markets are closely linked in as much as the firms which raise funds through issuance of ACU-denominated bonds can choose to hold part of them in ACU deposits. Similarly, ACU bonds could serve as collateral for ACU-denominated loans.

1. Issuance of Corporate ACU Bonds

The development of corporate bond markets in East Asia is generally considered to be a win-win solution for a region where bank-intermediated finance has been dominant. The issuance of ACU bonds by East Asian firms and the holding of such bonds by East Asian banks is an ideal way to evolve smoothly towards a more balanced type of external financing of firms. East Asian banks themselves should issue bonds as a means of external finance. An East Asian banking association or some East Asian central banks would have to be involved.

2. Private Loans and Deposits in ACU

East Asian banks would start accepting deposits and granting loans in ACU. For countries which retain capital controls, special treatment would be given to ACU business. The latter would not be treated like foreign currency business, but would be granted special privileges, in the form of tax exemptions or regulatory waivers.

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