Dean & CEO Asian Development Bank Institute

Asian Monetary integration: A Japanese Perspective Masahiro Kawai Dean & CEO Asian Development Bank Institute Asia-Europe Economic Forum Impact of the Eurozone Debt Crisis on East Asia Hosted by ADBI, Bruegel, CEPII, EC, KIF, Korea University, etc Seoul, 9-10 December 2011

Outline 1. Introduction 2. Impact of the Global Financial Crisis on Japan 3. Japan s Exchange Rate Policy 4. Japan s Strategy for Regional Monetary Integration 5. Conclusion

1. Introduction Is there a case for regional exchange rate policy coordination in Asia? The Asian financial crisis (1997-98) highlighted the value of regional monetary & financial cooperation: CMI, ERPD, ABMI, EMEAP Common shocks from the global capital markets (GFC, US QE2 and possible QE3, the eurozone sovereign debt and banking crisis) affect many economies in the region Rising regional economic inter-dependence in Asia suggests a case for monetary integration What are the lessons from the euro crisis for Asian monetary integration? What is Japan s strategy?

2. Impact of the Global Financial Crisis on Japan Real sector impact Impact on the yen Impact of yen appreciation on the Japanese economy

(1) Real Sector Impact The global financial crisis (GFC) adversely affected Japan s exports, imports, industrial production and real GDP - Japan had negative growth in 2008 - Japan s exports were affected both in finished products for the US & EU markets and parts and components for the EEA markets These impacts were largely similar across East Asia The triple disasters due to the 3.11 earthquake, tsunami and nuclear plant failures affected the economy significantly The economy continued to shrink until 2011Q2; there was a rebound in 2011Q3 and recovery expected in 2012Q4 and in 2012.

Japan s exports plunged, then rebounded Export Growth in Japan and emerging East Asia (in %) 60 40 20 0-20 -40-60 Jan- 06 Apr- 06 Jul- 06 Oct- 06 Jan- 07 Apr- 07 Jul- 07 Oct- 07 Jan- 08 Apr- 08 Jul- 08 Oct- 08 Jan- 09 Apr- 09 Jul- 09 Oct- 09 Jan- 10 Apr- 10 PRC Japan NIEs ASEAN 5 Source: CEIC database

Japan exports by sector: Autos hardest hit, but now rebounding 80 60 40 20 0-20 -40-60 Y/y % change, Yen-v alue 80 60 40 20 0-20 -40-60 -80 06 07 08 09 10 11 General machinery Electrical machinery Transport equipment Autos -80 Source: CEIC Database Co.

Japan import growth remained firm, except from Taipei,China 60 Y/y % change, US$ v alue 60 40 40 20 20 0 0-20 -20-40 06 07 08 09 10 11 Total Korea PRC Taipei,China -40 Source: CEIC Database Co.

Japanese economy contracted sharply due to the global financial crisis 15 10 5 0-5 -10-15 Real GDP growth rate (year-over-year) 2005Q1 Q2 Q3 Q4 2006Q1 Q2 Q3 Q4 2007Q1 Q2 Q3 Q4 2008Q1 Q2 Q3 Q4 2009Q1 Q2 Q3 Q4 2010Q1 Q2 Q3 Q4 2011Q1 Q2 USA EU Japan China India Asian NIEs Asean 5 Source: IMF, International Financial Statistics, CD-ROM; Eurostat

6 4 2 0-2 -4-6 -8-10 GDP rebounded in 2011Q3 GDP growth (y-o-y, %) Contrib. to Real GDP, Y/y Pctg. Pts. 06 07 08 09 10 11 Consumption Priv. cap. ex pend. Net Ex ports GDP 6 4 2 0-2 -4-6 -8-10 Source: Cabinet Office

Japan s economic growth forecasts Consensus forecasts for Japan real GDP (% change) 2011 2012 Median -0.4 2.8 Mean -0.5 2.8 Capital Economics -0.2 2.5 Daiwa Institute of Research -0.7 2.5 UBS -0.4 2.9 CITIC Group -0.2 2.4 Nomura Securities -0.3 3.1 JPMorgan Chase 0.0 -- Morgan Stanley -1.2 2.9 BNP Paribas -0.8 2.1 Credit Agricole -0.7 2.9 Itochu Corp -0.3 2.8 Japan Research Institute -0.9 3.3 Mitsubishi Research Institute -0.4 2.4 Mitsubishi UFJ Research and Consulting -0.8 3.4 Reference IMF -0.7 2.9 OECD -0.9 2.2 Source: Bloomberg accessed on 9 September 2011, IMF (2011), OECD (2011)

(2) Impact on the yen The global financial crisis (GFC) caused the yen to appreciate, rather than depreciate, unlike in many other economies - Massive repatriation of the US dollar back to the US markets, driven by cash-short US financial firms - Korea saw rapid capital outflows and a mini won crisis - Japan s yen appreciation partly due to the unwinding of carry trades Following the triple disasters, the yen began to appreciate with the expectation of Japanese insurance firms repatriation back home The nominal value of the yen continued to appreciate, breaking the historical record reached in April 1995 - Monthly average rate: 76.84 yen/$ (Sep. 2011) vs. 83.67 yen/$ (April 1995)

Why yen appreciation? Despite the aging pressure and rising public debt, the yen remains strong One fundamental reason is price deflation in Japan, that sets the long-term trend of nominal yen rates Another reason is persistent current account surpluses The third reason is a safe haven effect; The Japanese economy is not growing, but its growth prospect is better than those of the US and Europe given the latter s problems - Sovereign debt and banking crisis in the eurozone - Rising public debt, high unemployment, uncertain property prices, and potential for QE3

Nominal yen appreciation driven partly by Japan s price deflation 350 325 300 275 250 225 200 175 150 125 100 75 Yen/US$ 1970 1975 1980 1985 1990 1995 2000 2005 2010 Nominal Rate PPI Ratio CPI Ratio Source: International Monetary Fund, International Financial Statistics, CD-ROM

Japan's current account is still in surplus 5 (% of GDP) 4 3 2 1 0-1 -2 1980 1985 1990 1995 2000 2005 2010 Current Account Sevices Trade Balance Goods Trade Balance Income Balance Source: IMF, International Financial Statistics, CD-ROM

(3) Impact of yen appreciation on the Japanese economy The yen s overall real effective exchange rate (BIS REER), based on relative CPIs, is still about 30% lower than in the previous peak in 1995 But the REER for the automobile sector suggests that the level is about the same as the 1995 level - Large negative spillover effects on the auto-related sectors (steel, tires, glass, electronics, etc) Business concern over the hollowing-out of Japanese manufacturing - Sectors which have exited Japan are less affected - Competitive sectors, like automobiles and technology & knowledge intensive sectors, are now severely affected - Some evidence of a shift towards nontradables

Real effective exchange rates of the yen, BIS data and for automobiles 150 140 2005 = 100 130 120 110 100 90 80 70 60 1980 1985 1990 1995 2000 2005 2010 BIS Automobiles (US & Korea) Automobiles (US, Korea & Germany)

Production of nontradable goods relative to tradables goods (nominal & real), 1980=100100 190 180 170 160 150 140 130 120 110 100 90 1980=100 1980 1985 1990 1995 2000 2005 Nontradable Output/Tradable Output (Nominal Values) Nontradable Output/Tradable Output(Real Values) Trend Line for Nominal Values Trend Line for Real Values Note: Tradable goods are those produced in agriculture, mining and manufacturing, and nontradable goods are those produced by other sectors Source: Constructed from data published by Cabinet Office, Government of Japan

3. Japan s Exchange Rate Policy Japanese yen as a freely floating currency Foreign exchange market intervention Support of emerging Asia s exchange rate stability

(1) Japanese yen free floating Japan fully liberalized its capital account in the 1980s, and adopted free floating in order to pursue monetary policy independence This is different from emerging East Asian economies which are either financially underdeveloped so that they have to maintain some capital controls, or they are small and open (Hong Kong, Singapore) so that they attempt to stabilize their exchange rates against outside currencies As a result exchange rate regimes in Asia are diverse, although there has been some convergence towards greater exchange rate flexibility, except in China Degrees of intra-regional exchange rate fluctuation are often large

Japan adopts free floating while exchange rate regimes in East Asia are diverse Hard Peg Dollarization Currency board Intermediate Regime Conventional fixed peg (Soft peg) Crawling peg Managed float Low Flexibility Exchange Rate Low Hong Kong Brunei Monetary Policy Independence Thailand Malaysia China China Indonesia High Korea Philippines Philippines Singapore Thailand Indonesia Singapore Malaysia Pure Float High Korea Japan Pre-1997 2011 Source: Author

Impossible trinity in East Asia Source: Ito, Hiroyuki and Masahiro Kawai (2011)

Yen and emerging East Asian currencies often move in opposite directions 130 Nominal Exchange Rate vs. USD 125 120 115 110 105 100 95 90 85 80 75 2000M01 2001M01 2002M01 2003M01 2004M01 2005M01 2006M01 2007M01 2008M01 2009M01 2010M01 2011M01 ASEAN currencies Japanese Yen Chinese RMB Korean Won Indian Rupee Source: International Monetary Fund, International Financial Statistics, CD-ROM

15 14 13 12 11 10 The yen-won rate is often very volatile 16 Large yen/won volatility 9 8 7 6 5 4 1 9 9 0 M 0 1 1 9 9 1 M 0 1 1 9 9 2 M 0 1 1 9 9 3 M 0 1 1 9 9 4 M 0 1 1 9 9 5 M 0 1 1 9 9 6 M 0 1 1 9 9 7 M 0 1 1 9 9 8 M 0 1 1 9 9 9 M 0 1 2 0 0 0 M 0 1 2 0 0 1 M 0 1 2 0 0 2 M 0 1 2 0 0 3 M 0 1 2 0 0 4 M 0 1 2 0 0 5 M 0 1 2 0 0 6 M 0 1 2 0 0 7 M 0 1 2 0 0 8 M 0 1 2 0 0 9 M 0 1 2 0 1 0 M 0 1 2 0 1 1 M 0 1 Korean Won/Japanese Yen Source: IMF, International Financial Statistics, online The won was strong before the global financial crisis but, following the Lehman collapse, depreciated sharply from 907 won/$ (Oct. 2007) to 1,483 won/$ (Nov. 2008) The won/yen rate moved from below 8 won/yen in mid-2007 to above 15 won/yen at end-08 and early 09 Such a large volatility of exchange rate is counterproductive to trade and investment

(2) Foreign exchange market intervention Japan intervened heavily in the past on some specific occasions, particularly to prevent rapid yen appreciation such as during 2003-04 The most recent intervention in November 2011 was a record high in terms of monthly intervention volume Intervention was often, but not always, sterilized Intervention was sometimes, but not always, coordinated with the US and other authorities Impacts of intervention have been limited in stopping currency appreciation, but, it likely - Lessened the speed of yen appreciation - Avoided a free fall of the US$ vs. the yen

Japan MOF intervention in the foreign exchange markets 10,000 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0-1,000-2,000-3,000 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 MOF Intervention Note: Positive numbers indicate purchases of foreign currency with the yen, and the negative numbers indicate sales. Source: Japan Ministry of Finance, official website

Coordinated intervention Period # Days Episodes February 1987 January - February 1992 3 April - June 1993 May - June 1994 November 1994 March - May 1995 4 July - August 1995 3 November 1997 5 June 1998 1 September 2000 March 2011 1 1 Yen appreciation (Louvre Agreement) Yen depreciaiton together with low performance in the stock market 4 Yen appreciation due to Japan-US trade friction 2 Yen appreciation due to Japan-US trade friction 2 Yen appreciation due to Japan-US trade friction Yen appreciation due to the Mexican currency crisis and Japan-US trade friction Yen appreciation due to the Mexican currency crisis and Japan-US trade friction Rupia depreciation due to spread of the Asian currency crisis Yen depreciation due to Japan's nonperforming loan problem 1 Euro depreciation Yen appreciation in the aftermath of the Great East Japan Earthquake

(3) Support of emerging Asia s exchange rate stability Japan regards emerging Asia s currency and financial stability as vital Japan took initiatives to support crisis affected countries during the Asian financial crisis of 1997-98 - Currency intervention to support the rupiah in 1997 - Thailand, Indonesia, & Korea which went to IMF - Malaysia which did not go to IMF, but went to WB Japan proposed the creation of an Asian monetary fund (AMF) in 1997 Japan took lead in creating ASEAN+3 processes - CMI/M, ERPD, ABMI, AMRO, CGIF During the GFC, Japan expanded currency swaps and supported Indonesia Japan did this while maintaining a free float

Indonesia and Korea were severely affected in 1997-9898 Indonesia Korea 26 24 22 20 18 14000 12000 10000 8000 6000 75 65 55 45 35 1700 1600 1500 1400 1300 1200 1100 16 4000 25 1000 900 14 2000 15 800 1 9 9 7 M 1 1 9 9 7 M 4 1 9 9 7 M 7 1 9 9 7 M 1 0 1 9 9 8 M 1 1 9 9 8 M 4 1 9 9 8 M 7 1 9 9 8 M 1 0 1 9 9 9 M 1 1 9 9 9 M 4 1 9 9 9 M 7 1 9 9 9 M 1 0 1 9 9 7 M 1 1 9 9 7 M 4 1 9 9 7 M 7 1 9 9 7 M 1 0 1 9 9 8 M 1 1 9 9 8 M 4 1 9 9 8 M 7 1 9 9 8 M 1 0 1 9 9 9 M 1 1 9 9 9 M 4 1 9 9 9 M 7 1 9 9 9 M 1 0 Foreign Exchange Reserves (LHS) Rupiah Exchange Rate (RHS) Foreign Exchange Reserves (LHS) Won Exchange Rate (RHS)

A rapid (temporary) loss of reserves and won & rupiah depreciation in 2008-20092009 Korea Indonesia 270 1500 60 12,000 260 250 240 1400 1300 55 11,000 230 1200 50 220 210 200 1100 1000 45 10,000 190 900 2 0 0 7 M 1 2 0 0 7 M 4 2 0 0 7 M 7 2 0 0 7 M 1 0 2 0 0 8 M 1 2 0 0 8 M 4 2 0 0 8 M 7 2 0 0 8 M 1 0 2 0 0 9 M 1 2 0 0 9 M 4 2 0 0 9 M 7 2 0 0 9 M 1 0 40 2 0 0 7 M 1 2 0 0 7 M 4 2 0 0 7 M 7 2 0 0 7 M 1 0 2 0 0 8 M 1 2 0 0 8 M 4 2 0 0 8 M 7 2 0 0 8 M 1 0 2 0 0 9 M 1 2 0 0 9 M 4 2 0 0 9 M 7 2 0 0 9 M 1 0 9,000 Foreign Exchange Reserves (LHS) Won Exchange Rate (RHS) Foreign Exchange Reserves (LHS) Rupiah Exchange Rate (RHS) Source: IMF, International Financial Statistics, online

4. Japan s Strategy for Regional Monetary Integration Why Asian monetary integration for Japan? Prerequisites of monetary integration Step by step approach

(1) Why Asian monetary integration for Japan? Asia (eg, ASEAN+3) will be the largest economic bloc by the second half of the 2010s and will continue to grow, while achieving greater economic and financial interdependence Such a large, integrated region will have its own currency, and if so it would be Japan s interest to influence the process of monetary integration Creation of a stable monetary zone is anyway beneficial to Japanese MNCs It is Japan s interest to promote the Japanese yen as Asia s important international currency, at least in an Asian currency basket Question: Is Japan ready to accept its cost?

East Asia s intra-regional regional trade dependence rising over time 70 65 60 55 50 45 40 35 30 1980 1985 1990 1995 2000 2005 2010 East Asia EU-15 EU-27 NAFTA Source: International Monetary Fund, Direction of Trade Statistics

GDP growth rate correlations are rising between Japan and ASEAN, China, Korea,.. (10-year moving windows) 1.0 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0.0-0.1-0.2-0.3-0.4-0.5-0.6-0.7 1990 1995 2000 2005 2010 ASEAN - China ASEAN - India ASEAN - Japan ASEAN - Korea China - India China-Japan China - Korea India-Japan India-Korea Japan - Korea Source: International Monetary Fund, World Economic Outlook, database

Fear of RMB dominance? Another driving force behind Japan s interest in Asian monetary integration may be a fear of RMB dominance Given that China s economic growth will continue and the authorities promote RMB internationalization, some Japanese fear that ASEAN and even Korea may become part of a RMB bloc in the not-so-distant future Hence, Japan should play a proactive role in creating an Asian monetary zone in a way that is consistent with Japan s commercial and economic interests From this perspective, ACU (a basket of ASEAN+3 currencies plus HK dollar) is an attractive option for Japan as it allows the yen to play a role in the basket Another option is for Japan to become the UK in Europe; this is hard and may not be beneficial

No dominant currency for a while Dollar, yen or yuan as an anchor for East Asia? Relying solely on the US$ is not feasible in the LR The yen (failed internationalization, size relatively declining) or the yuan (inconvertible, weak prudential supervision, non-independent central bank) alone cannot assume a nominal anchor currency role The yen, the yuan and other important currencies can share the nominal anchor role for East Asia Currency basket system SDR-plus currency basket (dollar, euro, pound, yen plus Asian currencies): Singaporean model ACU-based system: complex and hard to establish internal anchor for now, but potentially a useful starting point

(2) Prerequisites of monetary integration High degrees of economic and financial integration (a region-wide FTA, customs union, regulatory harmonization, competition policy, capital account liberalization) Macroeconomic convergence (inflation, fiscal policy, public debt, exchange rates) Structural convergence (per capita income, financial sector development, human capital development,..) Institutional coordination (credible central banking, financial sector regulation, fiscal discipline, ) Lessons of the euro crisis: Avoidance of domestic financial imbalances, coordination of fiscal policy, crisis management system

Asia has a long way to go East Asia has not achieved macroeconomic or structural convergence For many emerging and developing economies, the first priority is to pursue macroeconomic institutional reforms so as to strengthen macroeconomic policymaking to promote sound macroeconomic performance The next priority is to continue to pursue structural reforms so as to strengthen domestic economic and structural fundamentals and help achieve convergence towards developed country levels Achieving a fiscal union or a social union is out of the question at this point in Asia; Asia should aim to achieve a limited monetary union in the long run without a fiscal or social union

(3) Steps for closer exchange rate policy coordination Progress Exchange rate policy Supporting institutions Tradeinvestment Current State Uncoordinated exchange rate arrangements CMIM, AMRO, regional surveillance Fragmented, overlapping FTAs 1. Intensive policy dialogue on exchange rates 2. Informal coordination (exchange rate regime choice) 3. Formal but loose coordination (exchange rate policy) 4. Tight coordination (monetary policy) Intensive policy dialogue on exchange rates; use of an ACU index for surveillance Greater exchange rate flexibility vs. US$; A wider currency basket (SDR plus) as loose reference A wider currency basket system with clear rules for intraregional rate stability ACU-based system: Asian Snake or Asian ERM AMRO as a powerful secretariat for ERPD and CMIM Asian monetary fund Very short-term liquidity facility ACU clearing and settlement system Coordination of rules & provisions among FTAs An East Asia-wide FTA (ASEAN+3 or +6); East Asian Investment Area Asian customs union, Asian single market (goods, services, capital) Asian regulatory policy integration 5. Full coordination Asian monetary union Asian central bank Fully integrated institutions & policy

Step 1: Intensive policy dialogue Cultivate a culture that views exchange rates (including misalignments) as regional matters Introduce an Asian currency unit (ACU) index as one of the tools of regional economic surveillance Expand capacity & resources of AMRO as an independent secretariat for ERPD and CMIM, with participation of both finance ministers & central bank governors Support collective currency appreciation in the event of rapid capital inflows Continue to develop and deepen local-currency bond markets Make further efforts to internationalize regional currencies

Step 2: Informal coordination (regime choice) Greater exchange rate flexibility vis-à-vis the US dollar, based on a wider currency basket (such as SDR plus, or a basket of dollar, euro, pound, and ACU [= yen plus emerging Asian currencies]) Significant macroeconomic and structural convergence not required for informal stabilization of exchange rates against the SDR-plus basket Creation of an Asian monetary (cooperation) fund (AMF) by delinking the CMIM from IMF and strengthening AMRO and ERPD Promotion of ACU as international reserve assets Real side integration desirable through the consolidation of various, overlapping FTAs into a single East Asia-wide FTA (EAFTA, CEPEA)

Step 3: Formal but loose coordination (exchange rate policy) Adoption of an SDR-plus currency basket with welldefined rules for intraregional exchange rate stability - Greater macro and structural convergence required - Possibility of Japan s participation once sufficient convergence is achieved Regional financial integration to be achieved The need for the AMF to provide very short-term liquidity financing for frequent interventions Goods, services and capital market integration and formation of an East Asia-wide customs union Institution building to coordinate policies within the region

Step 4: Tight coordination (monetary policy) Tightly coordinated intraregional exchange rate stability a la Asian Snake or ERM using ACU as a reference supported by close monetary policy coordination and a short-term liquidity facility - Japan as a full member AMF as a clearing house of frequent currency interventions (due to short-term liquidity finance) for settling balances among the central banks, and issue official ACUs Limited fiscal policy coordination, with sovereign debt restructuring mechanisms in place Selection of a regional anchor country/currency through central bank competition for credibility Complete exchange rate and monetary policy coordination feasible, if ever, only in the LR

(4) Next practical steps Regional surveillance (AMRO & ERPD) Provide sufficient resources for AMRO Strengthen policy dialogue on exchange rate policies among the finance ministers and central bank governors in the ERPD (and CMIM) process CMIM (and an eventual AMF) Increase the size of the fund substantially Introduce flexible, precautionary instruments, like IMF s FCL & PLL Reduce its link with IMF over time, ultimately to zero, by strengthening ERPD Practical suggestions Create an ACU, use its index for surveillance, and promote its assets as international reserves Support RMB internationalization and its flexibility

5. Conclusion For Japan, maintaining exchange rate stability in and with emerging Asia is critical Asian monetary integration will be a long process as it requires macroeconomic and structural convergence in Asia as well as significant fiscal policy coordination Japan needs to work hard with other ASEAN+3 members to initiate much deeper policy dialogue to achieve relatively stable intraregional exchange rates against external financial shocks The current global financial conditions should provide impetus toward such initiatives

Thank you For more information: Dr. Masahiro Kawai Dr. Masahiro Kawai Dean & CEO Asian Development Bank Institute mkawai@adbi.org +81 3 3593 5527 www.adbi.org