Published in the Far Eastern Economic Review on 08 April 2004 and taken from this URL.

ASIAN FINANCIAL UNION: Thinking the Unthinkable

Asian finance ministers will soon consider a proposal to unify existing bilateral agreements for lending foreign reserves and create a single multilateral facility. By accepting common rules for monitoring and assessing their needs, they will be surrendering a portion of their financial sovereignty

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By Michael Vatikiotis and Tom Holland/HONG KONG
Issue cover-dated April 08, 2004
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WHEN DEPUTY finance ministers from 13 countries in the region assemble on May 15 during the Asian Development Bank’s annual meeting in South Korea, they may decide to take what history will judge to be the first step on the long, long road to Asian economic and monetary union.

On the table at the Korean resort island of Cheju will be a proposal to unify existing bilateral agreements for lending foreign reserves and create a single multilateral facility across East Asia. It’s a significant move: If agreed upon, participating governments will have to accept common rules for monitoring each other’s economies and for deciding when countries can draw on the fund. In essence, they will be surrendering a portion of their economic and financial sovereignty to a regional financial institution. In short, they will have given the green light to some kind of an Asian monetary agency.

“The most logical step would be to transform the network into a centralized facility,” says Toyoo Gyohten, president of the Tokyo-based International Institute for Monetary Affairs and a former vice-finance minister. “To call that an Asian Monetary Fund or an Asian Central Bank would be far-fetched, but institutionalizing the facility is the likely path.”

In tandem, and also working towards closer financial cooperation, Asian finance ministers and central bankers are considering ways to develop a regional bond market. An Asian Bond Fund was launched last year, a largely symbolic, $1 billion fund to invest only in United States-dollar-denominated government debt. New proposals aim to go a stage further within the next year or so, and foster local-currency debt markets. The boldest of them envisage bonds denominated in a notional basket of regional currencies that could eventually become a single Asian currency unit.

If there are faint parallels with Europe, that’s no accident. “Asia has a strong economy, yet its nations are fragmented, so the natural response is to try and model after Europe and try and make the economies bigger,” says Takatoshi Ito, a former Japanese deputy vice-minister of finance and now an economics professor at the University of Tokyo. “The opportunity cost of not moving towards greater integration in Asia is increasing,” warns Yoshihiro Iwasaki, a director-general of the ADB and head of its regional economic-monitoring unit. The principal advantage to the region would be a larger and more stable capital market.

Such sentiment has swirled around academic seminars for years. The difference now is that rapidly growing regional trade flows and closer business ties are forcing the hand of policymakers. A plethora of free-trade agreements is under negotiation within Asia as the focus of diplomacy in the region shifts away from political issues to economics and commerce. In the view of one senior Japanese policymaker, Haruhiko Kuroda, a special adviser to the Japanese cabinet, “all this regional free-trade-agreement activity requires regional financial mechanisms.”

Strategic factors are also driving things along. Japan, from where the leading proponents of closer financial cooperation come, seeks to cement a role for itself in Asia before China becomes too powerful, analysts say. Any moves to build a regional financial mechanism like a monetary fund or single currency would at this point need to take into account the primacy of the Japanese yen, reflecting Japan’s position as the region’s largest economy. That may not be the case in a decade or so, assuming China’s economy continues to grow.

Meanwhile, South Korea, another supporter of closer financial cooperation, worries about dealing all alone with a collapsed North Korean state. Seoul therefore favours the creation of regional institutions that would tie bigger economies like Japan and China into regional funding of any future unification of the Korean peninsula. “We are very eager to have some kind of regional-guarantee institution, a kind of regional-finance corporation,” says Park Yung Chul, an economist at Seoul’s Korea University. The whole process is being driven by “a mixture of dreams, bureaucratic politics and strategic imperatives,” says Wendy Dobson, an economist at Toronto University.

The hard part in all this is forging consensus among Asian economies that have traditionally competed for export markets and investment. International financial institutions like the International Monetary Fund are also suspicious; they witnessed the financial meltdown in 1997 and still question Asia’s commitment to structural reform and transparency.

On the other hand, the timing may be ripe for integration. Emerging Asia’s economies are buoyant and should grow an average of 7% in 2004, reserves are healthy and growing, and no one stands to lose. Intra-regional trade between China, South Korea and Japan is well over one-third of their total trade, and the region’s reserves now exceed $2 trillion.

An initial proposal from Japan in 1997 to set up an Asian Monetary Fund was rebuffed by the U.S. Treasury and received lukewarm support in the region. In late 1997 the Association of Southeast Asian Nations combined with Japan, China and South Korea to begin annual consultations at the finance-ministry level. Then in May 2000, on the margins of the annual ADB meeting in the northern Thai city of Chiang Mai, the first product of this kind of cooperation was launched.

The Chiang Mai Initiative established a framework in the form of a network of bilateral agreements between individual countries to support each other when in need by lending from their foreign-exchange reserves. At Cheju next month, participants will propose increasing the earmarked reserves–currently worth almost $40 billion–and pooling them in a single fund, to be managed centrally on behalf of all the contributors.

“If they consider pooling, they will need to strengthen monitoring mechanisms,” says Iwasaki at the ADB. “That augurs well for other integration measures and eventually a common exchange-rate regime. This goes beyond the idea of an initial reaction to [a] crisis. It is part of a broader integration effort.”

It seems unlikely that the single fund will be launched right away. Korean economist Park Yung Chul predicts months of negotiation before all the participating countries can agree on how the fund could be used. In addition, agencies like the IMF will be watching closely to see if existing links to itself under the current bilateral arrangement are severed. “Malaysia insists on an independent surveillance mechanism; Singapore and Japan are opposed to de-linking from the IMF,” says Park. “Whatever the Chiang Mai Initiative mutates into, we’d like a close linkage with the IMF,” says a senior IMF official.

The IMF favours a more market- driven approach to integration and applauds the idea of a regional bond market. Until now, Asian businesses have been overly reliant on short-term bank lending. Better-developed regional capital markets will supply cheaper and more accessible funds on safer terms. “The whole idea of the Asian bond market is the regional desire to make better use of our own domestic savings,” says Gyohten at the IIMA in Tokyo.

Although Asian countries enjoy high savings rates, poor financial infrastructure in the region means much of that money–in the form of Asia’s high foreign reserves–is channelled into low-yielding U.S.-government debt. Meanwhile, foreign companies and institutions earn high returns through their equity investments in Asia. “There are many Asians who feel this is not very effective,” says Gyohten. “Why not try to utilize our own savings in our own markets?”

BASKET OF CURRENCIES
To reduce the exchange-rate risk, some advocates have proposed issuing bonds denominated in a notional currency whose value is equal to a basket of Asian currencies. The money raised could then be lent onward to corporations in their own domestic currencies. “A basket-currency regime could provide a solid foundation for exchange-rate stability in the region,” special adviser Kuroda told a recent conference on regional economic cooperation in Seoul. “Basket-currency-denominated bonds would be a good starting point to progress to a basket currency in Asia.”

This initiative also reflects a desire among Asian governments to move away from reliance on the U.S. dollar. Right now almost all regional trade and the majority of foreign reserves are denominated in the American currency, leaving Asia exposed to swings in U.S. interest rates. “We should not be exposing countries to a currency mismatch if they borrow in U.S. dollars,” says Mari Pangestu, an economist with the Centre for Strategic and International Studies in Jakarta.

Sceptics criticize schemes for some kind of Asian currency unit as “grandiose.” Local markets are too immature, Gyohten says, and without agreement on stringent monitoring and conditions governing disbursement, there would remain a real risk of moral hazard. “There are countries in the region still unable to provide transparent and open disclosure of their financial situations,” he says. “It took 50 years in Europe. It is fair to say it will take longer in Asia.”

Given the obstacles, the more likely course of integration will be a slow and cautious approach led by countries with more developed financial institutions. More realistic in the medium term is the Asian Bond Fund II proposal suggested by a grouping of 10 regional central banks, including those of Australia, New Zealand and Hong Kong. This second fund will invest in the local-currency debt of regional governments, and possibly of highly rated domestic corporations.

Even for this more modest proposal, the going could be slow. In some countries there are regulatory, legal and tax barriers to foreign investment in the local bond markets. But the project’s backers believe they are already making progress. Thailand, for example, has agreed to suspend withholding tax on some 30 billion baht ($761.4 million) worth of baht-denominated bonds available for purchase by foreigners.

  

Posted on April 2nd, 2004 by jl
Filed under: Regional Financial Concerns: Asia