Prospects for Financial Integration and Exchange Rate Policy Cooperation in East Asia

A regional financial arrangement for financial cooperation and policy coordination, as can be inferred from the European experience, in general comprises the following three institutional components: a mechanism of short-term liquidity supports for the members experiencing balance of payments deficits; a mechanism of surveillance for monitoring economic and policy developments in the member countries and for imposing policy conditionality on those countries receiving financial support; and a regional collective exchange rate system designed to stabilize bilateral exchange rates of the member countries.

The financing and surveillance mechanisms for a potential East Asian financial arrangement are extensively analyzed in Bergsten and Park (2002). This paper discusses possibilities of and prospects for constructing a regional collective exchange rate system for East Asia with a view to adopting eventually a common currency. For this purpose, sections 2 and 3 analyze the behavior of nominal as well as real exchange rates and also exchange rate policy of a number of East Asia countries. Except for Malaysia and the People's Republic of China (PRC), other East Asian countries including Indonesia, Korea, the Philippines, and Thailand shifted to free floating after the 1997-98 crisis. However, the available evidence indicates that they seem to have been de jure floaters. Section 3 reviews some of the reasons why these countries have been reluctant floaters and the objectives of their foreign exchange market intervention.

Insofar as East Asian policymakers do not appear to have much confidence in the free floating regime, they are likely to turn to various intermediate regimes as a viable alternative system. Assuming the ultimate objective of exchange rate policy coordination in East Asia is to establish a common currency area (CCA), then it would follow that at a certain stage of integration, the East Asian floaters will have to return to a non-floating regime. In order to identify such a system, section 4 discusses advantages and disadvantages of various intermediate regimes. The seeming preference for non- floating systems may give the impression that possibilities of constructing a collective exchange rate system are greater in East Asia than in any other regions. However, this is not the case.

On the assumption that the thirteen East Asian countries participating in the Chiang Mai Initiative (CMI) are committed to monetary integration in the long-run by following in the footsteps of the European Union, section 5 examines whether the East Asian countries qualify as an optimum currency area. Most of the available studies on East Asian monetary integration, which focus on similarities of the economic structure and whether there has been synchronization of business cycles with the expansion of intra-regional trade, conclude that East Asian countries are as well qualified as European countries were some twenty years before for a CCA.

Section 6 and 7 discuss the progress of financial liberalization in East Asia during the past decade to see whether financial market opening has contributed to financial intergration and in so doing developed conditions favorable for constructing a CCA in the region in the long run. These two sections provide several pieces of empirical evidence suggesting that in contrast to trade liberalization, financial liberalization has steered East Asia toward global rather than regional integration. This empirical evidence therefore casts some doubts as to feasibility as well as viability of creating a CCA in the region.

Section 8 argues on the basis of the analysis of the preceding two sections that future prospects for regional cooperation for financial integration are not as promising as they may appear because East Asian ties with global financial markets will deepen and the cost of constructing regional capital markets are likely to outweigh the benefits accruing from such efforts. As the European experience shows, however, monetary integration can be an endogenous process, and by adopting a region-wide common exchange rate system, East Asia could lay the foundation for a common currency area in the long run. In order to examine this possibility, section 9 is devoted to a discussion of whether East Asian countries could agree to a collective exchange rate system. In view of the diversity of exchange rate systems at present and the difficulty of identifying a non-floating regime acceptable to all East Asian countries a collective exchange rate system is not likely to emerge in the near future.

The views expressed in this paper are the views of the authors and do not necessarily reflect the views or policies of the Asian Development Bank Institute (ADBI), the Asian Development Bank (ADB), its Board of Directors, or the governments they represent. ADBI does not guarantee the accuracy of the data included in this paper and accepts no responsibility for any consequences of their use. Terminology used may not necessarily be consistent with ADB official terms..

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