Economic Integration of East Asia and the Exchange Rate Arrangement - A Currency Basket System Most Effective

Masahiro KAWAI (Professor, University of Tokyo)

Interdependence of the East Asian economy is advancing and the conditions for an "optimum currency area" are increasingly being fulfilled. It is desirable initially for Asian countries, excluding Japan, to form a currency basket system based on the yen, the U.S. dollar and the euro in order to stabilize exchange rates within East Asia. Once favorable economic and political conditions are met, Japan should take a lead into instituting a cooperative exchange rate stabilization mechanism similar to that of Europe.

Greater synchronization of the Asian economy

East Asia for the past couple of decades has seen significant increases in intra-regional cross-border trade, investment and financial flows, thereby emerging as an independent economic zone. While the U.S. dollar remains the main anchor currency in the region, the environment necessary to form an independent currency zone is maturing.

Economic integration through market-driven activities-trade, investment, and financial transactions-is progressing rapidly in East Asia. Multinational corporations (MNCs) have created a production network in the region by placing various sub-processes of production in different countries according to comparative advantage-relative factor proportions and technological capabilities. As a result, intra-regional, intra-industry trade in manufactured products-parts, components, semi-finished and finished products-has soared. Essentially, trade has been boosted through increases in direct investments. Not only U.S., European, or Japanese MNCs, but Asian companies also are contributing significantly in making direct investments in the region, further strengthening the economic ties in East Asia. China is clearly part of this production network with its importance rising over time.

As many countries have relaxed their regulations on financial services and capital accounts and opened up their financial markets, capital flows in the form of bank loans and portfolio investments have expanded and begun to connect the region's economies financially. This, together with trade and investment linkages, has strengthened macroeconomic interdependence in the region, creating greater synchronization of business cycles. For example, the degree of cross-country correlations of growth rate of real GDP, personal consumption and fixed capital investments has become large among Japan, Korea, Taiwan, Singapore, Malaysia, and Thailand.

As a result of such market-driven, de facto economic integration and macroeconomic interdependence, it has become desirable to achieve stable exchange rates within the region. Indeed, among the countries listed above, the conditions for an "optimum currency area" have been increasingly fulfilled, perhaps beyond those in the European Union (EU), thereby reducing the cost of intra-regional exchange rate stabilization. China is not part of this optimum currency area, but as the country is expanding as a competitive economy vis-à-vis Association of Southeast Asian Nations (ASEAN) countries, it will be useful to establish a stable relationship between the Chinese renminbi (RMB) and ASEAN currencies.

There are two practical means to establish a stable exchange rate relationship among the currencies of the region. One is for each economy to peg the exchange rate to a common key currency, and the other is for the regional economies to adopt collective policy measures based on certain rules, such as the "Snake" and the "Exchange Rate Mechanism" (ERM) in Europe before the introduction of the euro. As the economic convergence among the East Asian countries is not sufficient enough and their political relationships are not mature enough to opt for a tightly coordinated exchange rate arrangement, it is more realistic to select as an exchange rate anchor a major currency, or a basket of such currencies, to which each country would aim its exchange rate to remain stable.

Currency basket based on the yen, the dollar, and the euro

The next question is what currency-the U.S. dollar, the yen, the euro or the RMB-, or what basket of currencies, East Asia should stabilize exchange rates against. So far, the general practice has been to peg currencies to the U.S. dollar and, by so doing, indirectly stabilize the intra-regional values of East Asian currencies. But this "dollar standard system" revealed its flaws during the Asian currency crisis of 1997. For example, for those countries having strong economic ties with Japan, pegging to the dollar meant that they had to face volatile exchange rates against the yen due to large fluctuations of the yen-dollar rate and, hence, were subjected to large risks in managing their economies. Pegging to the yen is less hazardous because Japan is a core part of the East Asian optimum currency area and it has the largest economic weight in East Asia, but the yen has not achieved sufficient internationalization to assume the sole anchor currency role. Pegging to the euro would be more risky than pegging to the dollar or the yen.

Pegging to the RMB is also problematic. China does not satisfy the optimum currency area conditions and restricts the capital account convertibility of the currency. There is a potential, however, for the RMB to become a key currency in the region in the long run because of the rapid pace of economic growth, possibilities for greater macroeconomic interdependence with other East Asian countries and the eventual achievement of the RMB's capital account convertibility. But in order to function as a regional key currency, China needs to gain full confidence in the international community on such factors as fundamental transformation of the domestic banking system, internationalization and deepening of RMB financial markets, democratization of the political system, eradication of poverty, achievement of economic equity and maintenance of social stability. As such, it would take decades, if ever, for the RMB to function as a key currency in East Asia.

This means that a single currency is not appropriate to function as an anchor currency in East Asia and that several currencies must do the task jointly. It is, therefore, desirable for East Asia to seek currency stability by way of adopting a "G3 currency basket system" composed of the yen, the dollar, and the euro-excluding the RMB due to its lack of convertibility. In the meantime, Japan should maintain the current floating system as one of the G3 currencies. If major East Asian countries could stabilize their currencies against the basket, their exchange rates would be less susceptible to fluctuations among the yen, the dollar, and the euro, thus creating a relatively stable currency environment in the whole region. Their exchange rates vis-à-vis the yen would also become more stable. Singapore has already been managing its exchange rate in a way similar to the currency basket system. Korea and Thailand, without any formal commitment, appear to have adopted such a system in recent years.

The G3 basket system would be an effective protection against the sharp depreciation of the U.S. dollar that may occur in the near future. If the U.S. keeps building up the twin deficits in trade and budget and if East Asia keeps accumulating foreign exchange reserves, the upward pressure on East Asian currencies would inevitably intensify. What is desirable for East Asia in the wake of a possible plunge of the U.S. dollar is to establish a system where the regional currencies would collectively appreciate against the dollar. By adopting the G3 currency basket system in a concerted manner, the region can minimize the adverse effects of fluctuations of major currencies.

It would be advisable, then, for the RMB to have greater flexibility so as to effectively participate in the currency basket system and reduce the potentially large negative effects on China itself as well as on East Asia as a whole. Such a concerted move to protect against fluctuations of the U.S. dollar could lead to a natural currency zone in East Asia with intra-regionally stable exchange rates while exhibiting greater flexibility against the U.S. dollar.

Japan should seek a German model

While governments adopt and maintain a "loose coordination of exchange rate policy," a number of systemic steps should be sought.

First, it will be important to create an Asian Currency Unit (ACU). This would be a synthetic currency composed of Asian currencies which would represent an average value of the currencies in the region. Initially, it would be used as a unit of account to express regional trade and investment flows and foreign exchange reserves, or act as a reference to measure the magnitude of deviations of individual currency values from the regional average. When a single Asian currency is to be established in the future, the ACU could provide its initial value, as the European Currency Unit (ECU) did for the euro on January 1, 1999.

Second, it is crucial to strengthen the "Chiang Mai Initiative" (CMI) and regional economic surveillance. The CMI is designed to establish an Asian financial facility through a network of bilateral currency swaps to provide assistance in the form of short-term liquidity to countries whose currencies are under attack. As of the end of 2003 there were 16 bilateral agreements under the CMI, to provide for a total swap facility of 47 billion dollars, and in May this year it was agreed to expand the capacity. Further efforts should be made to enhance the CMI's function by transforming its bilateral agreement nature into a multilateral agreement and establishing a capable secretariat to carry out in-depth regional economic surveillance and formulate the rules and conditions for activating the CMI. When they are in place, a de facto Asian Monetary Fund (AMF) will have been established.

Third, it is necessary to develop Asian bond markets. While vitalizing long-term bond markets in local currencies would make it possible to avoid the "double mismatch" problem in currencies and maturities, it would also strengthen the financial system, so far mostly dominated by banks, by providing additional means for directly intermediating Asian savings for Asian investment. Currently, there are two schemes being pursued. One is the "Asian Bond Fund" (ABF2) supported by the region's central banks, and the other is the "Asian Bond Market Initiative" (ABMI) promoted by finance ministries. While ABF2 focuses on stimulating the demand side of the market through purchases of Asian-currency denominated bonds, the ABMI intends to activate the supply side by creating conducive environments for bond issuance in Asian currencies. More efforts should be made to nurture the growth of Asian bond markets on a regional basis, for example, by encouraging the issuance of ACU denominated bonds as well as building a regional infrastructure such as the regional settlement system, credit enhancement facilities and rating agencies.

Considering that the economic interdependence within the region would increase further in the future, creation of a monetary union in East Asia in the next 20-30 years is not a fantasy. Starting out with the G3 currency basket system and through various types of financial cooperation, economies in the region can initiate closer monetary policy coordination aimed at stabilizing the currency values in the form similar to the Snake and the ERM in Europe, as they achieve greater economic and political convergence and heighten their political commitments.

When that happens, by applying the analogy of the European experience, Japan must decide whether to opt for the U.K. style to stay as a close ally of the U.S., or to model itself after Germany, which has chosen to go along with France and the rest of the countries on the continent. If Japan follows the route of the U.K., it would be China who would eventually become the core leader of economic and monetary union in East Asia. If Japan is to participate actively in the process of East Asian integration, the only viable option is to adopt the approach similar to that chosen by Germany.

(The original Japanese article appeared in the July 15, 2005 issue of Nihon Keizai Shimbun.)