The Potential Gains from Regional Pooling Arrangements: the Emergence of a CNY Anchored Block?

A frequent concern has been the growing costs of investing reserves in low yielding assets, thereby exposing the countries to possible losses (see Park [2007]). A less benign interpretation of these trends has been that the growing current account surpluses in East Asia, and current account deficits in the US may lead to instability, requiring adjustment down the road. The adjustment took the form of a hard landing, more specifically a global financial and economic crisis rooted in the US subprime crisis. The onset of the crisis led to various unanticipated consequences such as the initial appreciation of dollar due to the apparent flight to quality, and the massive proliferation of swap-lines between the US Fed and other central banks as well as innovative regional swaps and sharing IR arrangements in East Asia.

Some observers view the crisis as a transitory shock that would not bring about the end of the “dollar standard” or the Bretton Woods II system. However, others view the crisis as caused by the failure of the informal “dollar-standard” to deliver the purported benefit of greater global stability.¹² Accordingly, tensions in the global system imply the fragility of the “dollar-standard.” The stability of the dollar standard ultimately rests on the willingness of the US to refrain from abusing its “privileged position.” Attaining this stability requires low inflation in the US, a stable US real exchange rate, as well as stability of financial intermediation in the US. Macroeconomic and regulatory policy in the US over the last ten years has raised serious questions about the ability of the US to deliver these outcomes. In addition, the continued rapid growth of Asian emerging markets has reduced the world GDP share of the US with a matching increase in Asian world GDP share. This has raised questions about the sustainability and desirability of the “dollar standard” over time. The crisis also illustrated that the “superior intermediation services provided by the US” has been overstated. All these factors are reflected in the weakening trend of the dollar against the euro and other “hard currencies” during the last 10 years.

The emergence of deeper economic cooperation within the Asian region, and the solid growth performance of the People's Republic of China (PRC) and India may weaken the precautionary motive for hoarding dollar reserves in Asia. Hoarding dollar reserves may be partially substituted by deeper regional swap-lines, innovative IR pooling arrangements, diversification of the currency composition of precautionary savings away from US dollar to other currencies, and redirection of more hard currency surpluses towards sovereign wealth funds.

While the “dollar-standard” is attractive under ideal circumstances, the inability of the US to adopt domestic policies required to secure attractiveness of the US dollar contributes to the gradual weakening of Bretton Woods II. Specifically, as long as the US tends to overplay its privileged position, the “dollar-standard” creates the risk of more persistent and bigger US current account deficits. In the absence of more profound financial restructuring in the US, the return to a “dollar-standard” upon the onset of global recovery exposes Asia to the hazard of another global crisis down the road. The decline of the relative economic importance of the US has been a gradual process that started with the global recovery after World War II. The takeoff of the PRC and India has intensified the relative decline of the US. Many observers expect these trends to continue, with emerging Asia deepening its regional integration and gradually moving towards greater convertibility. All these factors suggest that attempts to return to the pre crisis “dollar-standard” are suboptimal, and possibly infeasible.

The wish to return to the ‘dollar-standard' reflects a backward looking mindset of the last 60 years rather than a realistic assessment of probable future trends. A plausible scenario is that I would converge to a tri-polar international monetary system based on the euro, the US dollar, and new monetary arrangements in Asia, possibly a region-wide currency. Such a tri-polar configuration may be associated with significant volatility. The challenge facing Asia is to find, during the transition from the dollar standard to a multi-polar system, a path facilitating the gradual financial maturing of the region, and adopt steps to reduce its exposure to future volatility. Deepening regional pooling and swap arrangements may be the logical conclusion of such efforts.¹³

To a degree, the Chiang Mai Initiative (CMI) may be viewed as a first step, which can be extended to support the emerging needs triggered by the current crisis. An issue that deserves further attention is the optimal duration and size of these swap-lines, balancing the interests of the parties involved, subject to possible moral hazard constraints and the structural factors explaining the linkages between various countries. The impact of introduction of swap-lines on the patterns of using and hoarding IR is complex. Several forces may be at work. Swap-lines may act to stabilize market concerns about the risk of losing control due to deleveraging pressures, thereby preventing downward pressure on IR and the exchange rate and substituting the need to hoard reserves. This was possibly the case for Korea, where the introduction of the FED swap-line prevented a replay of the crisis dynamics of 1997. In these circumstances, access to swap-lines would mitigate the need for Korea to hoard reserves to replace the US$60bn of reserves it used during the first phase of the crisis. Yet, uncertainty regarding the duration of these swap-lines, and lingering concerns that in absence of these swap-lines, the initial level of reserves is insufficient to prevent crisis dynamics, may induce Korea to further accumulate reserves in the future. Therefore, perceptions about the duration of swap-lines play a key role in determining the future path of reserves. To the degree that regional arrangements like the CMI offer pooling schemes of indefinite duration, they may mitigate the urge to hoard reserves. Greater use of regional swap-lines may also reduce excessive hoarding precipitated by the wish to signal that a country's reserves are above the average of its neighbors (the “keeping up with the Joneses' IR” motive.)

A related issue that may be explored is the currency composition of swap-lines. There is no reason why swap-lines have to be denominated solely in US dollars. Just as countries typically hold reserves in different currencies, they could agree to help each other by providing a basket of currencies rather than a single currency. The denomination of swap-lines in non-dollar hard currencies will speed up the diversification of reserves away from dollars into other currencies. For example, euro-denominated swap-lines will raise the demand for euro reserves given that swap-lines are ultimately a mutual promise to provide liquidity support in case of emergencies and the promise will not be credible in absence of reserves. For Asian countries, a more realistic scenario is the denomination of swap lines in the currency of a dominant regional economy such as China or even a real or notional Asian currency. Such development would further hasten the shift away from dollar reserves and the emergence of an Asia-specific hard currency, like the Europe-specific euro. There is also an intriguing possibility that the broadening and deepening of the CMI could be transformed into a more permanent and institutionalized form of regional precautionary insurance against financial crisis.

Recent events call for re-evaluating the desirability and feasibility of pegging Asian currencies to the dollar as the keystone for the regional stability and future growth. The alleged gains from pegging to the dollar are debatable, and there is scarcity of studies that tested it carefully against alternative hypotheses. First, the instability of the dollar against the euro and other key currencies implies that pegging to the dollar would increase the domestic currency volatility against the euro, pound and other currencies. This effect may be suboptimal for countries that experience an increase in the share of trade with the euro block over time. One way to deal with this issue is to evaluate what would have been the optimal weight of achieving real exchange rate stability against a basket of currencies that reflects actual trading patterns of the region.

Recent studies dealing with the Trilemma (Aizenman, Chinn, and Ito [2008]) are consistent with the notion that EMs have moved towards the Trilemma middle ground, associated with greater exchange-rate flexibility and limited but growing financial integration, buffered with sizable reserve holdings.¹⁴ This has enabled them to retain a fair degree of monetary autonomy, even as financial integration continued (see Indian and the PRC before the crisis, a time that both countries exhibited fast growth rate, while maintaining controlled financial openness and limited exchange rate flexibility). During that time, the PRC yuan appreciated significantly, without obvious downside effects. The onset of the crisis led to the renewed pegging of the yuan to the US dollar. However, it is not self-evident that returning to the yuan's rigid peg to the US dollar is desirable and sustainable once the world economy recovers. Applying data predating the crisis, Aizenman, Chinn, and Ito (2008) failed to find evidence that countries which pegged their currency to the dollar performed on average better than those that allowed controlled flexibility. During crises, many developing countries found that allowing the real exchange rate and monetary policy to take the initial brunt facilitated adjustment to the crises. Going forward, costs associated with investing IR in US dollar assets at times when the US dollar declines in value against the euro and other hard currencies, are projected to keep increasing.¹⁵ These costs, and the favorable growth prospects of emerging Asia, should provide further impetus to the emergence of new regional schemes.

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