Executive Summary of Research Papers and Suggestions KOBE RESEARCH PROJECT. Institute for International Monetary Affairs

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1 Executive Summary of Research Papers and Suggestions of KOBE RESEARCH PROJECT June 2002 Institute for International Monetary Affairs

2 Foreword The Kobe Research Project was endorsed by the ASEM Finance Ministers Meeting held in Kobe in January This is an executive summary of the six studies conducted under the Project and suggestions based on them. Individual research titles and their authors are listed at the end of this report. This report will be presented to the Fourth ASEM Finance Ministers Meeting, to be held in Copenhagen in July The Kobe Research Project is designed to facilitate inter-regional research cooperation on issues of mutual interest to ASEM member countries. First, through enhanced knowledge collaboration among ASEM partners, the Project attempts to collect useful information on the experiences and lessons learned in regional cooperation in Asia and Europe, analyze such experiences, draw lessons to be learned, and disseminate research results among ASEM partners. Second, it attempts to develop a network among Asian and European policymakers and think tanks in the macroeconomic and financial field. Third, it attempts to provide useful input for policymaking and policy dialogues among the partners. In these contexts, it is important for the European and Asian partners to share their respective experiences in fostering regional monetary and financial cooperation with each other, while recognizing the major changes occurring in the international monetary system as a result of the introduction of the euro. We sincerely hope that this Project report will be utilized in policy formulations on regional cooperation in each member country, as well as more widely within the region. Academics and researchers are also expected to make use of the data and analyses of this Project including the full reports of the six studies. We believe that a strong initiative such as this will be needed to further accelerate research activities and studies on regional cooperation under the Asia-Europe framework and to continue to provide useful suggestions for the ASEM Finance Ministers. It is our hope, therefore, that this project will develop further in the coming years, and that there will be further discussions on the related issues.

3 Japan and France have taken the initiatives to coordinate the implementation of this Project. We are very honored that we have had the chance to participate. The Institute for International Monetary Affairs (IIMA) was commissioned by the Ministry of Finance, Japan, to manage and coordinate the concluding part of the Project, under the direction of Professors Junichi Goto, Takatoshi Ito, and Eiji Ogawa. Junichi Goto, Kobe University Takatoshi Ito, University of Tokyo Eiji Ogawa, Hitotsubashi University Institute for International Monetary Affairs June 2002

4 TABLE OF CONTENTS Exchange Rate Regimes for Emerging East Asian and EU Accession Countries...1 Requirements for Successful Currency Regimes: Lessons for East Asia... 8 Regional Financial Cooperation and Surveillance Regional Economic Integration in East Asia and Europe 17 Banking Sector Reform and Capital Market Development Suggestions List of Authors.30

5 1. Exchange Rate Regimes for Emerging East Asian and EU Accession Countries This chapter explores desirable exchange rate regimes for emerging economies in East Asia from several angles, including international trade, foreign direct investment (FDI), and macroeconomic conditions. It also sheds light on reasons for the high diversity of exchange rate regimes in the EU accession countries by reviewing the changing process of the regimes since the early 1990s. In addition, it discusses the role of exchange rates in inflation targeting regimes. One important issue is the pass-through of exchange rates to import prices. In emerging East Asian economies, fluctuations of the U.S. dollar/japanese yen exchange rate affected these economies and their import prices (except for those in Singapore). This reflects the fact that imports from the U.S. and Japan tended to be priced in the producer s currency (non-pricing to market, non-ptm). This suggests that if the exchange rate is volatile, fixing the home currency to a currency basket of the U.S. dollar and the Japanese yen would be better than adopting a floating exchange rate. In light of the importance of FDI for promoting economic development, the study examines the impact of exchange rate volatility on FDI inflows to a host country. Analysis confirms that the depreciation of the host-country currency attracted FDI inflows, while high volatility of the exchange rate discouraged FDI inflows. Openness, low wages, and past FDI in the host country attracted new FDI. These findings indicate that foreign firms seek an open and free environment with low-wage labor for their FDI destinations. The positive impact of past FDI on new FDI confirms the importance of the agglomeration effect, which can be realized by the presence of many foreign firms. The agglomeration effect may give rise to a virtuous cycle, under which FDI flows into a country that has attracted FDI, thus leading to more FDI. On the effectiveness of monetary policy, the study analyzes the effects of various combinations of exchange rate regimes and capital controls, using a simple macroeconometric model. An exchange rate regime is considered optimal if the government can minimize its loss functions under the regime. Under a floating exchange rate regime with free capital mobility, exchange rate volatility can have a negative impact on net exports and GDP. The effects of monetary policy under a fixed exchange rate regime with capital controls are greater than under a floating exchange 1

6 rate regime with free capital mobility. The introduction of capital controls and a fixed exchange rate could be an optimal regime when the policy objectives are the stabilization of GDP and exchange rates, and when exchange rate volatility has a negative impact on aggregate demand. The analysis above leads to the conclusion that for emerging East Asian economies that have a high dependence on trade and FDI and compete in the global market, some degree of intra-regional exchange rate stability is desirable for outwardoriented economic growth. It is desirable for these economies to jointly shift to a currency basket system, where each economy s currency is stabilized to a basket of major currencies, i.e., the U.S. dollar, the Japanese yen, and the euro, and fluctuates within a certain band. The weights of the major currencies in the basket would reflect each economy s trade, FDI, and other economic relationships with the United States, Europe, and Japan. The study shows that emerging East Asian currencies, which reduced their correlations with the U.S. dollar and increased their correlations with the Japanese yen after the crisis, have exhibited a tendency to revert to a de facto peg against the U.S. dollar since the end of the 1990s. Both the Singapore dollar and the Thai baht have increased their correlations with the U.S. dollar drastically and have begun reverting to de facto pegs against the U.S. dollar since Malaysia adopted a fixed exchange rate regime. Although some of these changes are attributed to the structural change in yen/dollar exchange rate movements, most of them are well explained by the strong trade linkages among ASEAN countries. The study explores why some of the emerging East Asian countries have increased the degree of stabilization of their currencies to the U.S. dollar in recent years. Using a two-country model, the study points out the possibility that coordination failure in choosing an exchange rate regime has impeded the monetary authorities from adopting an optimal currency basket system. Based on numerical analyses to investigate whether the monetary authorities in the ASEAN 5 countries, China, and the Republic of Korea have failed to coordinate in choosing an optimal exchange rate regime, the study presents the view that the ASEAN countries and China have been led to adopt a U.S. dollar peg system due to the unstable nature of equilibrium or the coordination failure in choosing an exchange regime. 2

7 The study suggests two ways of calculating a basket currency for emerging East Asian countries, one with and the other without coordination. The results are mixed. Although the coordinated solution theoretically yields better outcomes, it does not produce the expected results of exchange rate overvaluation before the Asian currency crisis. However, in the post-crisis period, the coordinated solution would have led to less currency depreciations and fluctuations than the actual rate, while the uncoordinated solution would have produced large depreciations even in countries other than Indonesia, which did experience a very large depreciation. The coordinated solution would have produced more stable exchange rates in the post-crisis period. This analysis emphasizes the desirability of international coordination of exchange rate policies among East Asian countries. However, there are several difficulties in implementing coordinated regional exchange rate mechanisms both at the conceptual and practical levels. With financial sector problems still unresolved in East Asia, intra-regional exchange rate stabilization is not an easy task. In addition, there is no political consensus as to the future shape of the regional monetary system at this stage. Given these constraints, implementing transitional exchange rate arrangements, such as a regional currency unit à la EMS style, or common basket pegging, would require considerable work as well as regional consensus building. Once the foundation for financial market stability is in place, however, it would be easier for East Asian countries to agree on regional arrangements for exchange rate stability. A Case Study : China Changes in the exchange rate strategy of China would have an impact on the volume and distribution of trade and foreign direct investment in China and in other emerging East Asian countries. An overview of the exports of China and other East Asian countries reveals that a large part of Chinese exports are directed to the United States and, to a lesser extent, to the EU and Japan. China is less involved in regional trade. This feature contrasts with East Asian partners for whom intra-regional trade represents a large share of exports. The possible impact of a regime change is simulated through a model based on exchange-rate variables (real exchange rates and nominal exchange rate volatility) and gravitational variables, such as GDP, population, geographic distance, trade barriers, common language, and openness. The model shows that a domino-style devaluation is a zero-sum game for exports to third markets. The results of the simulation demonstrate that China would have an interest in having close competitors refrain from allowing 3

8 their currencies to depreciate against major developed currencies. A move away from a U.S. dollar peg towards a common East Asian currency independently would reduce China s competitiveness due to the renminbi s increased volatility against key currencies. China would, however, more easily accept a regional arrangement in the form of a common peg to a basket of key currencies, because the simulation results present a gain. A major part of FDI to China comes from Japan, followed by the United States and the EMU countries which invest at a similar level; other countries play a minor role. According to the model, a move away from a U.S. dollar peg towards a peg to a major-currency basket (the U.S. dollar, the yen, and the euro) would have three main consequences for FDI to China. First, it would change the distribution of investors in favor of Japan and EMU countries and moderately raise the aggregate volume of FDI. Second, it would stabilize the total volume of FDI when the U.S. dollar moves against the euro or the yen. Third, changing to another currency anchor may yield different results depending on the anchors used by other countries in the region. Several conclusions can be drawn from empirical results through numerical simulations. First, China could have a greater incentive to adopt a currency basket peg than floating the renminbi. This is because all three key currency blocs the U.S., Japan, Europe still play major roles as export markets and as investors, and because exchange rate volatility is an impediment to both trade flows and FDI. Second, China and other East Asian countries have a smaller incentive to cooperate, because trade flows are more limited between these two blocs. The incentive to cooperate could come from competition in third markets, which would support a common basket agreement rather than a regional monetary arrangement proposal such as an Asian monetary system. Third, intra-regional monetary stability is crucial for East Asian countries other than China, because trade among themselves generally represents a larger share of their total trade. This part of the study concludes with four suggestions on exchange rate regimes and regional monetary and financial cooperation. (1) Stability of exchange rates contributes to growth of international trade and FDI and, in turn, economic growth. It is recommended that the emerging East Asian economies that are open in trade and FDI should maintain stable exchange rates in order to continue to promote trade and FDI liberalization and to pursue outward-oriented economic growth. 4

9 (2) Stabilizing vis-à-vis a currency basket is desirable for emerging East Asian economies. The emerging East Asian economies trade with a variety of countries and receive direct investments from major developed countries including the United States, Europe, and Japan. Therefore, the monetary authorities should focus not on the U.S. dollar alone but on a currency basket for exchange rate stability. It is the stabilization of the local currency vis-à-vis a basket of currencies, consisting of the U.S. dollar, the euro, and the Japanese yen, that the monetary authorities should aim for in their exchange rate policy. (3) Regional cooperation is necessary for achieving an optimal exchange rate regime in emerging East Asia. The monetary authorities, acting independently, may be choosing a de facto dollar peg even though they know that the desirable exchange rate system is not be a de facto U.S. dollar peg but stabilization vis-à-vis a currency basket because of a lack of coordination. The policymakers of emerging East Asian economies must explore the question of the optimal exchange rate system while taking into account regional economic interdependence and the potential benefits of regional coordination in choosing exchange rate arrangements. (4) As a next step, more coordination could be achieved by introducing an Asian currency unit. Coordination of exchange rate policies among the emerging East Asian economies is desirable to produce an exchange rate system that avoids competitive devaluation and ensures stable real effective exchange rates. Each economy should try to stabilize its currency to a basket of major international currencies, that fluctuates within a certain band. Under certain conditions, major currency weights in the basket could be made common across economies. Regional financial cooperation should be directed to support a common currency basket to be adopted in East Asia. Further coordination could be enhanced by the introduction of an Asian currency unit (ACU), a currency basket of East Asian currencies, including the Japanese yen. This would be the next step in search of the best exchange rate arrangement for the region. EU Accession Countries The study identifies main reasons why the EU accession countries decided to adopt a variety of regimes and how macroeconomic achievements differed among the 5

10 countries due to the diverse regimes. Different regime choices can be explained by country characteristics, such as the need for macroeconomic stabilization, the degree of openness, the level of foreign reserves, capital flows, and institutional factors. The main findings are: (i) In the initial years of transition, most accession countries adopted an external anchor to stabilize the economy, while only those countries with limited foreign reserves opted for flexible regimes. (ii) Due to large capital inflows, some countries gradually moved towards more flexible regimes, while institutional factors (ERM II requirements) have been the main driving force for the more recent regime shifts. These shifts were, with a few exceptions, not related to currency crises but were the result of proactive policy management, which was also facilitated by the institutional framework of EU integration. (iii) Large, although declining, discrepancies between de jure and de facto exchange rate regimes also indicate that the exchange rate policy in accession countries was rather carefully managed, by first adjusting the de facto regime and only thereafter the de jure regime. At the same time, the role of the euro as a reference currency has increased sharply since the end of the 1990s, mainly reflecting the increased trade and financial orientation of accession countries to the EU. (iv) Exchange rate regimes have had no discernible impact on progress in real and nominal convergence. Nonetheless progress in disinflation seems to be stronger in countries with fixed regimes, while the capacity to cope with large and volatile capital flows and to maintain the country s external competitiveness tends to be facilitated by a more flexible regime. Similar progress in real and nominal convergence should lead to the conclusion that these achievements have been facilitated rather than hindered by the pursuit of a variety of exchange rate strategies and proactive policy management in accession countries. This part of the study on exchange rate regimes concludes with the following suggestion. During the preparatory phase to EU accession, and after EU accession, the driving force for regime change will increasingly be the prospect of joining the EMU. Accession countries will have to join the ERM II mechanism for a minimum of the two years and thereby bring their monetary exchange strategies in line with ERM II requirements. Increasingly, economic policies and economic structures will be oriented towards the euro area. Meanwhile, ERM II, which allows for a large fluctuation band of +/-15% and the possibility of realignments, is compatible with a variety of monetary and exchange rate policy regimes, and it provides enough flexibility to accommodate needs arising from the catch-up process. 6

11 The Role of Exchange Rates in Inflation Targeting Regimes For countries with a flexible exchange rate regime, inflation targeting is often recommended by the IMF. There are two broad issues that arise for countries adopting inflation targeting: (i) the choice among different approaches for implementing inflation targeting and (ii) the question of how monetary authorities should take into account and/or manage the exchange rate. On the first issue, keeping inflation on target at all times is not feasible or desirable. Efforts to eliminate deviations from the inflation target too quickly can have wrenching effects on economic activity because of lags in the response of the economy to interest rate adjustments. Sophisticated macroeconomic models are certainly not required to implement inflation targeting and a very simple model is enough for policy judgments. Two keys to success are: (i) developing approaches that do not lead to persistent biases or persistently large errors in achieving the inflation forecast, and (ii) making it transparent to the public that the authorities are committed to achieving the inflation target (for example, through timely publication of the minutes of policy discussions). In addressing the impact of exchange rates on inflation targeting in emerging market economies, there is a need to construct a model that would capture not only pass-through effects on domestic prices and expenditure-switching effects on aggregate demand, but also balance sheet effects on risk premiums (or country-specific interest-rate premiums) and access to international capital markets. On the second issue, under an inflation-forecast-based rule, monetary policy reacts to the exchange rate indirectly through its direct response to the effects of exchange rates on the inflation forecast, which normally also takes into account the projected effects of the exchange rate on economic activity. The case for reacting directly to the exchange rate is likely to depend on how well the authorities can estimate its equilibrium or appropriate level. Reacting to the deviation of the exchange rate from an imprecise estimate of its appropriate level can inject confusion into the forecasting and policy analysis process and may well be counterproductive. In light of widespread fear of floating, it is important to ask whether simple inflation-forecast-based rules could be improved by including a direct reaction to the exchange rate to further dampen currency fluctuations on a regular basis. The study suggests that it is important to analyze the issue in models that include persistent shocks to the risk premium in other words, in models consistent with widespread impressions that exchange rates in reality sometimes deviate persistently from levels consistent with macroeconomic fundamentals. 7

12 2. Requirements for Successful Currency Regimes: Lessons for East Asia This chapter identifies requirements for successful currency regimes (in particular, requirements for exchange rate stability) based on the experiences of the Netherlands and Thailand regarding exchange rate policy, capital controls, and developments in the banking sector. It also provides some general lessons from the European experience with respect to regional economic and monetary integration. There are six requirements for exchange rate stability according to the Dutch and Thai experiences. First, in order to achieve exchange rate stability, monetary authorities must have a credible aspiration for domestic price stability. Other partic ipants in the policy arena should be convinced that the monetary authorities will direct their policy instrument, the interest rate, solely at maintaining exchange rate stability. The Dutch case shows that when the monetary authorities commitment to price stability is credible, it can work as a disciplining device that forces the government and social partners to follow stability-oriented policies. Second, it is necessary to have stability-oriented domestic policies, such as fiscal consolidation, moderate wage developments, sound financial and corporate sectors, and measures to improve the functioning of the labor market, because the interest rate is used to maintain exchange rate stability. The Thai case demonstrates that, if domestic financial stability comes under pressure, exchange rate stability can be jeopardized. Prior to the currency crisis of 1997, the interest rate differential between Thailand and the United States widened, and capital inflows surged. This influx of capital combined with the weak domestic fundamentals of the Thai economy, such as a weak banking sector and the high debt-to-equity ratios of Thai companies, constituted a considerable asymmetric shock, rendering the Thai exchange rate peg to the U.S. dollar unsustainable. Third, flexible labor and product markets are instrumental for maintaining exchange rate stability because they make a country well equipped for absorbing asymmetric shocks and reduce the need for significant exchange rate changes. Fourth, the Thai experience illustrates that a strong and competitive financial sector is pivotal for cushioning external shocks properly, without endangering exchange rate stability. Strengthening the quality of the regulatory/supervisory framework will be instrumental in this respect. Fifth, the 1997 financial crisis in Thailand illustrates the importance of 8

13 managing the process of capital account liberalization. This process should be introduced step-by-step, based on the development of fundamentals. The rapid liberalization of financial markets and of the capital account without supporting domestic policies aimed at strengthening the economic structure was one of the factors that led to the currency crisis in Finally, information regarding economic data and policy preferences should be amply and readily available to the general public in order to prevent financial markets from overreacting. For example, financial markets were taken by surprise when the Dutch guilder depreciated vis-à-vis the German mark in 1983, and they started to doubt the credibility of the guilder-mark currency peg. Dutch authorities were subsequently punished for their lack of transparency by having to raise the Dutch interest rate well above the German interest rate until the early 1990s in order to maintain the peg. The East Asian currency crisis was another case in point, where financial markets were not able to discriminate properly between good and bad countries in the region, and the Thai currency crisis provoked speculative attacks on a number of East Asian currencies, which could only in part be attributed to unsound economic fundamentals. This analysis also stresses that Europe and East Asia differ in many respects and one should thus be very cautious in drawing definitive general conclusions. An important difference between Europe and East Asia is that in Europe the currency of a country within the region served as a nominal anchor for monetary policy, inspiring further monetary cooperation. In contrast, many East Asian countries peg(ged) their currencies to the U.S. dollar, the currency of a country outside the region. Notwithstanding this and numerous other differences between Europe and East Asia, the study points to the following lessons regarding monetary cooperation in East Asia. First, the Dutch experience indicates that the path towards increased regional monetary cooperation is a long one and that a monetary union must be considered the crowning step of a process of economic integration. Second, enhancing the institutional underpinnings of regional cooperation and economic integration are mutually reinforcing processes. Empirical evidence indicates that the degree of economic integration between the Netherlands and Germany has actually increased since the start of the European Monetary System (EMS). On the other hand, the EMS was established, among other things, because of strong trade linkages among European countries and the conviction that exchange rate uncertainty would be detrimental in this respect. 9

14 Third, exchange rate flexibility may be instrumental in coping with Balassa-Samuelson-type catching-up effects. Especially when prospective member countries for monetary cooperation have different levels of economic development, changes in the real and/or nominal exchange rate will be inevitable in the process of economic integration. Furthermore, exchange rate flexibility may be needed when policy preferences between countries have not converged sufficiently. For example, when Dutch policymakers in the 1970s gave greater priority to domestic goals and did not strictly adhere to the anti-inflation policy of Germany, the guilder underwent a gradual depreciation vis-à-vis the mark. Finally, regional economic integration entails freedom of movement of both products and product factors, that is labor and capital. This means that at some point in time, capital controls have to be removed. This does not deny the fact that as has been shown by the Dutch experiences capital controls may be effective in shielding an economy from certain types of external shocks for a limited period of time. This span of time, however, should be used wisely; that is, it should be used to increase the ability of the domestic economy to cope with the vigor of the global economy, including its financial markets. Flexibility of labor and product markets should be enhanced to improve the competitive position of the economy. The reinstatement of a number of capital restrictions in Thailand, following the Asian crisis, is a case in point. The controls were combined with measures aimed at a restructuring and strengthening of the domestic banking sector. Such restrictions therefore were not considered to be an end in themselves. A study was also done to provide an overview and assessment of East Asia as a potential candidate for regional monetary and exchange rate cooperation. Its main conclusion is that at least some economies in East Asia may have a strong interest in pursuing regional exchange rate stability by coordinating their monetary and exchange rate policies within a more structured regional framework. East Asian economies have, for the most part, relatively open economies that benefit from a stable exchange rate environment. Such an interest also seems evident in light of current policies which, while being adopted unilaterally, have provided for a high degree of de facto exchange rate stability. At the same time, however, East Asia falls well short of meeting many of the economic, political, and institutional requirements which ultimately proved necessary for the successful pursuit of monetary and exchange rate cooperation in Europe. In light of lessons from the European experience, it is useful to consider how 10

15 East Asian economies might go about meeting these policy requirements. Four aspects of the European experience can be pointed out in creating the conditions for successful monetary and exchange rate cooperation, namely, (i) the creation of sound political, institutional, and legal underpinnings; (ii) the pursuit of a high degree of trade/economic integration through the creation of a single market; (iii) the development of a regional approach to financial market regulation and supervision; and (iv) the pursuit of macroeconomic convergence through economic policy coordination and mutual surveillance. The study emphasizes that European monetary and exchange rate cooperation was pursued, not in isolation, but rather as part of a much broader process of regional integration, built on strong political, institutional, and legal underpinnings. These underpinnings, in addition to sound microeconomic foundations, proved to be an essential prerequisite for creating the necessary conditions for successful monetary and exchange rate cooperation. The study also emphasizes that the European experience after the 1992/1993 ERM crises could offer the most useful and interesting lesson for any future institutionalized monetary and exchange rate cooperation in East Asia, given the present environment of large international capital flows. Under the approach taken by the European Union, economic policy coordination has consisted primarily of the pursuit of commonly agreed nominal targets, not only for the exchange rate but also for other key macroeconomic variables such as inflation, long-term interest rates, budget deficits, and public sector debt to GDP ratios. Moreover, the achievement of these common macroeconomic objectives has been supported by the development of an overarching framework of mutual surveillance. 11

16 3. Regional Financial Cooperation and Surveillance This chapter deals with the issue of how to further enhance regional cooperation, especially in the area of surveillance and monitoring, and a framework to support it. In view of the economic rationale for financial cooperation, the study explores whether East Asia is a suitable grouping for monetary cooperation and integration. Examination of the real data on economic interdependence in East Asia in terms of trade and labor shows that regional interdependence is very strong and the international mobility of goods and labor has increased markedly since the 1990s. Real disturbances in the six East Asian countries are highly synchronized, and their synchronization with those in Japan increased in the 1990s. Synchronization within Europe shows a similar trend as with that within East Asia, though to a lesser degree. On the other hand, synchronization with the U.S. economy was negative, both in the 1980s and 1990s. These findings suggest that there is indeed a case for financial cooperation in East Asia, and exchange rate stabilization to a basket of major currencies (or even to the yen) would be better than pegging to the U.S. dollar alone. In addition, trade and investment, particularly FDI inflows and outflows, are also deepening interdependency among the regional economies. The main cost of financial cooperation is the loss of a country s monetary policy independence or autonomy. Macroeconomic indices, however, do not differ greatly among East Asian economies compared with the range of variance seen among the EU members, and the cost of cooperation is small. In light of the successful introduction of the euro, a review of the history of EU integration reveals two crucial points. The first is the importance of the framework for economic surveillance and policy coordination, and the second is the importance of the statistical infrastructure. Surveillance and policy coordination has played a crucial role in macroeconomic management in the euro area. This is because of the double-decker structure of the EMU in policy formulation and implementation, i.e., unification of monetary and exchange rate policies at the center, while management of economic policies, in particular budgetary and structural policies, remaining under the national control of member states. Statistics that are reliable, impartial, and comparable among members are indispensable in surveillance and economic policy coordination. In the EU, Eurostat and 12

17 the ECB are producing statistics at the central level, and national statistical offices and national central banks are doing so at the national level. In order to meet the statistical requirements of the EMU, European System Accounts (ESA95, an update of ESA79) were put into operation in The most important precondition for successful regional financial cooperation is the institutionalization of a monitoring and surveillance mechanism. In East Asia, there are several obstacles that need to be overcome before meeting this precondition. They include the diversity and heterogeneity of the countries economic characteristics, the lack of potential commitment to economic integration, and the low level of institutional and legal framework development. Some also believe that there is a membership issue. The right grouping depends on the area of economic and financial integration as well as political affinity. Currently in East Asia, shallow forms of financial cooperation are being forged within the ASEAN+3 framework. Under this framework, progress has been made in the form of the Chiang Mai Initiative (CMI). Bilateral swap arrangements under the CMI need to be extended, more structured, and institutionalized. The ASEAN+3 framework has begun its surveillance process. To enhance the regional surveillance process, an independent regional surveillance unit should represent both an independent warehouse of information on the state of regional economies, as well as an independent source of analysis of regional economic developments, supplementing those of international financial institutions. The unit would submit its own report to the ASEAN+3 group, and make policy recommendations to member countries. Approval of financial assistance requires monitoring of the macroeconomic and structural conditions of potential borrower countries and of capital flows, and high frequency of monitoring is key to its effectiveness. In particular, policy dialogue, along with a regular monitoring and surveillance process, forms an essential pillar for financial cooperation. To strengthen the regional surveillance mechanism within the ASEAN+3 framework, the Asian Development Bank (ADB) is providing technical assistance for the development of a regional early warning system (EWS) prototype that would help detect emerging macroeconomic, financial, and corporate sector vulnerabilities and prevent financial crises in the future. The regional EWS prototype comprises four components: (i) a set of macro prudential indicators (MPIs), broadly defined as indicators of the health and stability of financial systems. These indicators can be classified into two categories, the so-called CAMELS [capital adequacy, asset quality, management soundness, earnings, liquidity, 13

18 and sensitivity to market risk] and indicators of macroeconomic developments and external shocks [i.e., growth performance, balance of payments positions, monetary and fiscal conditions, interest rates, exchange rates, and asset prices]; (ii) a nonparametric EWS model designed to assess the probability of currency crisis within a 24-month time horizon based on the signaling approach; (iii) a parametric EWS model designed to assess the probability of currency crisis within a 24-month time horizon based on the probit regression analysis; and (iv) a set of economic leading indicators of business cycles. The ADB s work on the regional EWS prototype is still ongoing. Further work should include: (i) identifying a set of core MPIs; (ii) improving the parametric and nonparametric EWS model; (iii) integrating the parametric EWS model with the nonparametric EWS models; and (iv) extending the analysis of leading indicators of business cycles to more countries where high frequency data is available. The ADB has organized a number of workshops to develop and finalize the EWS prototype. The first workshop was organized in December 2001 jointly with the Bank of Thailand, the Ministry of Finance in Thailand, and the ASEAN Secretariat. The next workshop will be held jointly with the People s Bank of China and the ASEAN Secretariat in October of this year. Once the prototype is finalized, it is expected that individual countries will use it as a model to set up their own early warning systems, taking into account their own circumstances. The ADB has been requested to process another technical assistance to support the modification and implementation of the EWS prototype by individual countries. As a part of the study, a concrete proposal was made on how to further integrate the monetary sphere of the region, although there is room for other approaches on the subject. According to this proposal, Phase I of the integration process is the initial stage of discussion and program design to create a single Asian currency, to be completed by Phase II is the transitional and preparatory period for a single Asian currency, to be completed by Phase III is the final period that begins in 2030, including the launching of an Asian single currency and the establishment of an Asian economic and monetary union. An Asian Central Bank will be responsible for stipulating and implementing the monetary policy for the single currency area. Mechanisms for enhancing regional resource pooling beyond the CMI are suggested. One option would be a common decentralized reserve pooling mechanism, in which each member country contributes a specified share of its total reserves to a 14

19 common pool. Each country would then be eligible to draw on the pool for an amount that is up to a predetermined multiple of the amount deposited. Drawing would be made under certain circumstances and in accordance with certain conditions stipulated by the surveillance unit. Another option would be to model the reserve pooling scheme on a more centralized version, such as the European Monetary Cooperation Fund (EMCF), that was in existence in Europe during the run up to monetary integration, or the Latin American Reserve Fund, that is currently being used by the Andean countries. This chapter concludes with four suggestions. (1) Recognize the importance of surveillance. Surveillance is important from three viewpoints, and leaders in the region must have a common understanding of these three points. First, surveillance contributes to crisis prevention by enabling participating countries to conduct candid exchanges of views with their peers, detect early signs of economic vulnerabilities, and adjust policies to reduce the likelihood of a crisis. Second, surveillance makes it easier for countries to prescribe appropriate remedies for crises, once they occur. It is impossible to prevent all crises in today s complex world. However, when surveillance is carried out adequately and regularly, then crisis-affected countries can react to crises without a long delay and with correct policies. Third, surveillance strengthens institutional capabilities in the region. Surveillance accelerates the process for gathering statistics and analyzing them in the region. (2) Start with ASEAN+3 as a basis for regional financial cooperation in East Asia. The time is ripe for regional cooperation in East Asia and, furthermore, East Asia is an appropriate area for regional cooperation. ASEAN+3 is a good platform for such financial cooperation. ASEAN+3 is building an institutional framework for cooperation in the form of the Chiang Mai Initiative, a financial facility with bilateral swap agreements among member countries. For this facility to function effectively and to prevent crises, surveillance and peer pressure should be in place. In turn, the existence of such a financial facility gives member economies good incentives to participate in regional surveillance. (3) Set up an ASEAN+3 Surveillance Secretariat. 15

20 The surveillance process should focus on the following three issues: the monitoring of the macroeconomic and structural policies of member countries and of capital movements which affect foreign exchange markets of the member currencies; improvement of statistics in terms of coverage, frequency, and accuracy; and the strengthening of financial and capital markets in the region. An independent secretariat should be established for regional surveillance activity. It is important that professional economists support the surveillance process. Competent economists from within and outside the region should be recruited at the secretariat and they should analyze the regional economies, capital flows, and other developments affecting the region, independently of the political interventions of member countries. The long history of EU surveillance shows that an effective surveillance process cannot be achieved overnight but needs many years of effort. It is important, therefore, to start the process now and to accumulate experience and knowledge over the coming years. It is essential that the Surveillance Secretariat maintain constant dialogue and good working relationships with international financial institutions (IFIs) as well as the private sector. (4) Political leaders in the region should develop a long-term vision. A long-term vision for regional cooperation which would serve to guide and motivate current and future generations must be developed. For this purpose, a policy forum may be established in the region. This forum should be a working group to prepare a long-term vision, consisting of specialists from the official and private sectors including academics, policymakers, and business leaders in East Asia. Deeper integration depends on true reconciliation among members. It would also be essential for Japan-China cooperation to lead the process of economic and financial cooperation, as France and Germany played a central role in the integration and cooperation process in Europe. Though reaching a consensus in East Asia may not be easy at this early stage, many possible targets and possible paths must be explored. With a persuasive vision, it would be easier to gain public support for effective cooperation. 16

21 Regional Economic Integration in East Asia and Europe In terms of regional integration, Europe made three key economic achievements. First, it created a single market in which capital, goods, services, and people can move almost freely without the hindrance of cumbersome barriers at the border and other non-border barriers. Progress in deepening integration has been remarkable over recent years, as market liberalization and the adoption of a common regulatory framework have progressed broadly hand-in-hand. This has allowed firms and investors to develop Europe-wide strategies and led to an intense development of trade and financial flows, resulting in economies of scale and higher efficiency. Second, an economic and monetary union was created, and a single currency was adopted. The single currency has accelerated and consolidated the single market, and it has also acted in its own right as a powerful catalyst for further structural reform in the EU. The euro has rapidly become an attractive alternative to the U.S. dollar for international bond issuance, especially in the corporate sector. Equity markets are also evolving rapidly. The last two years have seen a significant increase in the capitalization of euro area stock markets and in the number of enterprises listed in the market. Finally, an efficient system for policy coordination has been developed. In the run-up to the adoption of the euro, there was a remarkable convergence of views on the need to follow prudent macroeconomic policies and to implement structural reforms in the markets for goods, labor, and financial products. The procedures for policy coordination have varied substantially between policy areas. At one extreme, monetary policy has been completely pooled and a new central bank created. Public finances, especially deficits, are subject to strict rules and, in extreme cases, sanctioning mechanisms. However, in other areas, such as employment policy and structural reform, coordination has largely been based on consensus and best practices, while enforcement relies on peer pressure. Some important similarities between East Asia and Europe are identified. First, both regions have a strong common interest in an open international economic and financial system. Second, they share the same ambition to better control the forces of economic and financial globalization, which brought them serious economic, currency, and banking crises in the 1990s, and to create a stability-oriented economic financial system that promotes high and sustainable growth and improves welfare. Finally, they are seeking to preserve the positive features of complex economic and social models. Some large differences between the two regions are also identified. First, 17

22 economic diversity is more pronounced in East Asia, ranging from countries with highly modern economies to others that still have poor and traditional, mostly rural, economic structures. In contrast, the European Union has become a much more homogeneous economic grouping. Second, a more fundamental difference is in the degree and timing of efforts that have been made toward deeper regional integration. European efforts stem directly from the sheer extent of material devastation and moral exhaustion brought by the two World Wars. This has led Europeans to accept a significant pooling of sovereignty over a whole range of political as well as economic issues. How can East Asia take better advantage of globalization while avoiding the recurrence of a crisis similar to that of ? One solution is to deepen regional integration, notably in the areas of trade, macroeconomic surveillance, balance of payments support, and strengthening of financial sectors. Such moves towards regional integration must be fully compatible with international and multilateral agreements. Therefore, one of the European Union s top policy priorities is to continue to press for an ambitious agenda for stronger international rules in the trade, monetary, and financial fields. Recent research by the EC on regional trading arrangements has identified two conditions to maximize gains from trade. One is proximity between partners. This does not mean only geographical proximity but also economic, regulatory, and cultural proximity. The other is willingness to tackle areas beyond the elimination of tariff barriers. This includes measures to be taken in inter alia, non-tariff barriers, regulatory cooperation, capital movements, and provision of services. In addition, as the EU experience shows, improving macroeconomic stability and accelerating structural reform through stable exchange rates, regional macroeconomic surveillance and coordination mechanisms dramatically increase gains from trade. In this context, ASEAN s efforts to move beyond tariff measures and tackle such issues as the harmonization of tariff nomenclatures, the streamlining of Customs procedures, and mutual recognition arrangements are very welcome. Macroeconomic and financial issues are increasingly debated in Asia, including how to prevent crises and how to stabilize exchange rates. Much of what has been done and discussed in Asia, including the ASEAN surveillance process, financial support arrangements, and regulatory cooperation in the banking system, formed part of the European experience in the lead-up to full economic and monetary union in Europe. In Europe, various arrangements for closer monetary cooperation were put in place in the early 1970s, long before the goal of a single currency was adopted. However, as was 18

23 demonstrated during the ERM crises, the monetary arrangements were not as effective as they should have been, essentially because they were not sufficiently backed by coordinated macroeconomic policy and sufficient structural reforms. The drive to adopt a single currency, with its ensuing focus on improving both nominal and real convergence of the European economies, provided the real impetus for strong policy coordination and ensured lasting macro-financial stability in the EU. An ASEAN economic surveillance process, backed by regular dialogue among Finance Ministers on the basis of assessments provided by the ASEAN Secretariat, could be an important instrument. Peer group pressure based on a commonly agreed analysis has certainly been a very useful tool in the EU. Cooperation in Europe has been most effective when it is backed by strong, independent, and respected institutions, and when conclusions and recommendations made by Member States to one another are made public, thereby reinforcing peer pressure. The design and development of an autonomous ASEAN financial support mechanism, based on bilateral swap arrangements and repurchase agreements, must be done carefully, for at least three reasons: (i) This exercise should complement the surveillance by international institutions, most significantly by the IMF; (ii) there is a danger that regional support could inadvertently defend the wrong exchange rate pegs and/or weak financial systems, caution is required when considering pegging East Asian currencies to an external anchor; and (iii) transparency about the purpose and conditions of the use of such financial arrangements is important, and a decision to create such an instrument should be accompanied by a strong commitment by all the countries concerned in order to include policy actions over a broad range of areas. There should also be procedures to help ensure the adoption of policy measures in these areas, especially to accompany any use of the regional financing facility. In the EU, the single market program, which consisted of far-reaching structural reforms in almost all sectors of the economy and was coupled with a positive impetus from world trade liberalization, provided key support for the eventual success of full economic and monetary union and the introduction of a single currency. This was possible while pursuing both nominal and real convergence. Common action plans should be developed in addition to the trade liberalization agenda, in particular in the financial sector and capital movements. Much will be achieved in the reduction of financial vulnerability by broadening the existing cooperation on strengthening prudential regulations and increasing competition in the 19