Japan, East Asia, and the Limits to Financial Regionalism

Using the term "Limits to Financial Regionalism" is not meant to say anything about the quality or even the progress of the efforts to date in terms of regional cooperation. Some of these have been extremely impressive. The quality of thought that has gone into the various writings on the Asian Bond Market Initiative (ABMI) is very impressive, as is the work that went into the Asian Bond Fund (ABF) by the various central banks of the region and some private sector actors.

It should be pointed out, however, that there are certain natural limits that exist to the progress of some of these regional financial efforts. In terms of the assessment of the success of these efforts, quite a few writers have been arguing that the ABMI is the most likely to proceed and is the effort that has progressed most to date; quite a few people have been writing about surveillance and its importance. My opinion is that it is the Chiang Mai Initiative (CMI) that has made the most impressive gains, while the other two are inherently much more difficult to pull off. For example, the ABMI is taking an extraordinarily ambitious goal and starting from a very low base, so failures can be expected along the way. Similarly, with regard to surveillance, the possible importance of anything called "surveillance," from a political science perspective, immediately strikes one as suspicious, particularly when there is no obvious punishment mechanism.

Financial regionalism essentially refers to the Association of Southeast Asian Nations plus China, Japan and the Republic of Korea (ASEAN+3), sometimes also called "ten-plus-three." However, since Brunei, Cambodia, Laos, Myanmar and Vietnam are not really involved, "five-plus-three" would be more appropriate, joined also by the Executives' Meeting of the East Asia-Pacific Central Banks (EMEAP) which includes New Zealand, Australia and Hong Kong. While there have been other efforts through the Asia-Pacific Economic Cooperation (APEC) forum, they are not anywhere near as developed as those of the ASEAN+3.

Another general point about financial regionalism in East Asia is that it is meant to respond very directly to the lessons of the Asian financial crisis, which governments in the region have taken to be that short-term borrowing in foreign currencies and dollar pegs are very dangerous, and that little support can be expected from the International Monetary Fund (IMF).

There are four major streams of East Asian financial regionalism. One is in terms of emergency liquidity provision, namely the Chiang Mai Initiative, through which, in the case of a currency crisis, help is given in addition to the amount that can be organized by the IMF. The second general area is development of regional bond markets - that is, the Asian Bond Market Initiative (through ASEAN+3) and the Asian Bond Fund (through EMEAP). The third area is improved communication, which has been greatly successful in facilitating surveillance, policy dialogue, informal contacts and various "Track II" projects, such as the Kobe research project. The fourth area is issues of currency management, but this is only at the discussion stage.

The Chiang Mai Initiative is meant to prevent the reoccurrence of the Asian financial crisis by being able to address a similar crisis if it arises. For instance, the Thai crisis would not have happened in the first place if Thailand had had enough foreign exchange reserves to defend its currency. In this way, prevention and emergency management are two sides of one coin and the result is a regional self-help system. An additional element is that the main point of surveillance, or economic review or policy dialogue, is to prevent countries from following policies that might invite speculative attacks on the currency. With its bilateral swap arrangements, the CMI is set up so that countries are able to lend out of their own reserves for a period of 180 days to supplement the foreign reserves of a country that is in trouble. For example, with regard to Thailand, Japan is obligated, if the right conditions hold, to provide $3 billion to Thailand if it requests it.

One criticism raised has been that despite a total of $40 billion in funding, the amount allocated to each country is not very high. Another important fact to note is the IMF link, which states that only 10% of the funds can be released without the approval of the IMF. (This does not mean that an IMF agreement must have already been reached - only that the IMF certifies that the crisis country is negotiating a standby agreement in good faith.) That means that instead of the one-month lag involved in preparing and agreeing upon an IMF plan, money can be released much more quickly. There are also "peacetime bilateral swap arrangements" among the "plus-three" countries to provide emergency liquidity in an extremely severe situation that is not a currency crisis, such as an attack by North Korea. There is surveillance, though not highly standardized, and there is a level of discussion about each country's policy, though not done in the highly structured way that the IMF Article IV surveillance occurs.

In May an agreement was reached in Istanbul to make several changes to the CMI, the most important of which is a doubling or "substantial increase in the size of up to 100% of bilateral swap arrangements." Second, the IMF link has been reduced from 90% to 80% of the funds provided. There have also been some moves toward multilateralization of networks by setting up a "coordinating country system" instead of relying purely on bilateral agreements and action. Several major issues remain, such as harmonization. The big issues, however, are how far the IMF link is going to be reduced and what would happen if a country actually asked for activation of the non-linked swaps.

A final point to be made about the CMI is that it involves real money, comparable to the amount of the proposed Asian Monetary Fund (AMF). More importantly, countries facing a speculative attack, even without having an actual plan or negotiating with third parties, will have funds available to them under the CMI in amounts that easily dwarf their IMF quotas.

The basic reason for setting up the Asian Bond Market Initiative also stems from lessons of the Asian financial crisis, namely the dual or double mismatch problem. In other words, countries were lending long in dollars and borrowing short, so there was a maturity mismatch and also a currency mismatch, thus making them vulnerable to movements in the value of the dollar. It has been suggested that if capital markets had been better in the East Asian emerging markets, they would not have had to do that. If there had been more opportunities for long-term financial intermediation in the local currency within domestic markets, it is likely that the crisis would not have been as severe.

The ABMI is meant to help create regional bond markets, broken down into two parts: development of local bond markets and attempts to create regional efforts in the more distant future. It is obvious that in order to have regional markets, there would have to be an extraordinarily high level of harmonization of policies among the economies, better settlement in terms of regional currencies, efficiently operating local bond markets already in existence and, most importantly, full capital liberalization.

Since this is not a short-term project, it would be useful to focus more on the issue of development of local bond markets. It is a simple observation to note that local bond markets are generally not very highly developed, although they have been growing rapidly. For the most part, emerging market bond markets in Asia mean issuance of government bonds of five years or less that are bought and held to maturity by institutional investors and financial institutions. That is not much of a bond market. It does not create opportunities for small and medium-size enterprise (SME) financing, which is one of the major goals of the initiative. It does not even provide opportunities for price formation because liquidities in the market are so low and people require much higher risk premiums in order to buy these bonds. In addition, there are problems of transparency and data.

The problem can be viewed in terms of both liquidity issues, taking into consideration the amount and variety of bonds and trading that goes on, as well as in terms of infrastructural issues. At Japan's Ministry of Finance, they are addressing the infrastructural issues. They have identified a number of important impediments to development of local bond markets, such as approval processes to issue a bond, default rules, lack of hedging instruments, difficulties in issuing asset-backed securities, problems of disclosure, ratings agencies, and others. There are a lot of very well chosen technical assistance and demonstration projects, but it is very difficult and comes with a number of political sensitivities.

An example of the approval process issue is the effort by the Japan Bank for International Cooperation (JBIC), which, in order to the improve liquidity of local bond markets in East Asia, has been looking into issuing straight bonds in Thailand and China to use the proceeds to help fund the baht or renminbi component of local infrastructure projects. It is an idea that makes a lot of sense, but it takes a lot of time and they are still negotiating these one-shot bond issues a year after they started.

In terms of liquidity issues, the governments involved are trying to add liquidity to the markets, for example, by issuing guarantees for private sector bonds and trying to reduce the burden of the high start-up costs for the private sector. It is a very slow process, but government guarantees can provide what is known as credit enhancement. Notably, the Asian Development Bank and the International Finance Corporation have made efforts to issue local currency bonds as well to try to increase the amount of trading in the markets.

Turning to the Asian Bond Fund efforts of EMEAP, just a few weeks ago ABF II was announced. The first ABF involved a small amount of purchases of dollar-denominated sovereign debt in the emerging-market economies of EMEAP. Most people agree that it did not accomplish very much, but it was practice. Thus, ABF II created investment in local-currency denominated bonds of these authorities. And it was set up as privately managed and passively traded, and based on an index that was created with the cooperation of private sector investors.

The part that the central banks have put their $2 billion into is a closed-end fund. However, there is a parallel open-end fund that is open to private investors and that is also managed by State Street for the regional fund, which tracks the same index. Then there are eight single-country funds which are managed by various private sector managers that in theory and over time will all be opened up to private sector investors as well. This is meant to enhance liquidity by increasing the buying of bonds. There is a lot of discussion about whether this will create a benchmark for regional bonds, which are very useful for creating yield curves and allow for better price formation for private sector bond issues.

While it is not entirely unlikely that the country funds will help to create benchmarks within each country's bond markets, it is rather unlikely for the regional fund. There has been a lot of discussion about whether ASEAN+3 should create an Asian currency unit (ACU), a currency-basket bond system, which would then help lead over time to the development of monetary union. One reason it is not going to happen any time in the near future is that within the Pan-Asian Bond Index Fund, which is the regional part of ABF, it is not just each country economic size that is reflected, but rather the quality of bonds and the liquidity of the various markets.

What may be the most useful aspect of ABF is that it put central bank cooperation into practice. It really improved the quality of discussion among the central banks, many of which are the financial regulators in their own countries. It has helped to get their support for improving market efficiency, for example, in China where steps had to be taken to allow foreigners to purchase bonds in the interbank bond market, where 80% of bond trading in China takes place, and then to be able to take their money out of the country up to some as yet unspecified limit.

The question whether the CMI will become an Asian Monetary Fund is an important one, if for no other reason than because many of the people who are most associated with this effort keep saying that it will. Moreover, there is substantially more CMI money than IMF money. For Thailand, it will be almost 10 times as much once the Istanbul agreement is fully incorporated into its bilateral swap agreements, depending on the SDR exchange rate. And the effectiveness of CMI has been significantly increased with the reduction of the IMF link, the size increase, and efforts toward multilateralization.

But the core of what makes the CMI not an AMF is the decision-making process; in other words, primarily the IMF link. For the foreseeable future, I think that problems of surveillance and enforcement make the IMF link highly attractive to Japan and China. If a country requests money because it is in a crisis and other countries refuse or try to attach their own conditions, the whole thing becomes a very unattractive idea. This is why the IMF link exists in the first place and there is no particular reason to believe that the interest of Japan and China in retaining this link is going to change anytime soon.

As for surveillance, while it can be helpful and particularly useful in peacetime, no enforcement mechanism means no effectiveness. There is no enforcement mechanism in ASEAN+3, except for potentially a veto power on the part of Japan or China, and there is no reason for them to want to change the status quo. However, the AMF may be a useful threat on the part of Japan and China to make the IMF behave in a manner that is positive to the Asian economies. The AMF proposal put pressure on the IMF to be forthcoming toward some of the proposals of the Japanese government, including moving quota increases much more rapidly, establishing the Contingent Credit Line, and expanding other credit facilities.

As for an Asian bond market, there are political and economic problems in terms of creating major, liquid, regional markets. The simple fact is that most Asian markets are destined to be small and not very attractive to foreigners. China in the long-run will continue to be big and if they improve the infrastructure, interest in Chinese bond markets will be high. Other countries, for example Malaysia, have very advanced bond markets and settlement systems but it is unlikely that global investors will be interested in them. Without being attractive in terms of the quality of the currency in which it is held, it is hard to imagine high liquidity in these markets. Having regional markets would address that problem, but currency-basket bonds are not popular, especially because they are difficult to handle and price. Most institutional investors had zero interest in investing in ECU bonds, and it is not obvious why ACU bonds would be any different.

Also, capital liberalization is essential for regional markets, but is very costly. There is a good reason why regional economies do not want to pursue capital liberalization. This is indeed one of the lessons of the Asian financial crisis.

Similarly, costs of infrastructure are very high, especially if the goal is to create more efficient financing mechanisms for SMEs. There are ways of playing with this and the working groups of the ABMI have been addressing them through asset-backed securities, collateralized bond obligations, a variety of very clever plans and ways of creating both internal and external credit enhancement. Of course, there are also going to be problems of creating hedging markets, which are going to be even more difficult to develop.

The question of how East Asian financial regionalism fits into the current world order can be broken down into two parts: first is the relationship with the Bretton Woods institutions, basically the IMF. Currently efforts are made clearly subordinate to the rules of the Bank for International Settlements and the rules or judgment of the IMF. It is expected that there will be great hesitance to move away from the Bretton Woods institutions. East Asia's high integration into the world economy makes that even clearer. Despite the long-term vision of regional financial efforts, there could be a clash of interests in the future and there are clear political limits.

The other big question is how it fits into the current world order in terms of Japan, China and the United States. Japan-China relations are a real problem, particularly when the U.S. is brought into it. The U.S. government clearly does not like regional efforts that exclude it and they make that very clear. The challenge for Japan is to keep the U.S. involved in economic cooperation but not in decision-making, which may involve some delicate balancing. It all comes back to the Japan-China issue and which country should be the regional leader. Another aspect is that China's long-run strategic interest outside economics appears to be in weakening U.S. alliances in East Asia.

While there are serious limits to financial regionalism, its importance cannot be disregarded. The CMI self-help regime and improved regional cooperation and communication are promising signs, especially for handling times of crisis. Roadmaps and visions are useful, even if nobody actually believes in them, because they at least keep the game going and create some sort of schedule for discussions.

Commentator: KIMURA Shigeki, Director, Research Division, International Bureau, Ministry of Finance
My first point relates to the question of whether the Chiang Mai Initiative is going to become an Asian Monetary Fund. In my view, the strategy to pursue an AMF which is independent from the IMF did not work very well. Therefore, the approach has now changed to a more pragmatic one, or gradualism, in which people believe that as long as significant development is made toward more efficient financial cooperation to prevent a financial crisis in Asia, it is not relevant whether it is through an AMF or not. Of course, at a certain point, there may be a need for it to be institutionalized, but I do not believe that we have come close to such a point. We are progressing in a very pragmatic and gradual way.

Secondly, although less significant developments appear to have been made in the area of the ABMI, this is with good reason. While the CMI is basically a negotiation between governments or between central banks, the target of the ABMI is the development of fully independent and privately functioning bond markets that are not wholly controlled by governments. In that sense, what is critical is for there to be a demand from the market to establish some kind of bond market in Asian countries. In order to accomplish this, the focus has been on infrastructure issues. Judging from the experience of the bond market development in Japan, the outlook for building a large bond market in Asia in 10 years' time is not so pessimistic.

Thirdly, I agree that the Japan-China issue is very delicate in many respects but it should be pointed out that as far as the finance ministries are concerned, there is a strong desire on both sides to deepen their very close and cooperative relationship in the midst of a very difficult political situation between the two countries.

Mr. Grimes: The Japanese bond market experience is certainly important, although I think that smaller economies are likely to have a harder time than Japan. For China though, once it tries to improve its infrastructure sufficiently, I am sure it will become a major market as well. I would like to reinforce Mr. Kimura's point that by far the best aspect of Japan-China relations is the positive financial relations between the two countries.

Q: From an economist's point of view, considerations are ongoing from the bottom-up level in integrating the bond market/bond fund approach and its mechanisms in economic partnership agreement initiatives at the country level. What is your opinion on this more optimistic view?

A: I am not a country specialist in terms of Southeast Asia and the specific bond markets, so it is impossible for me to address your question directly. Depending on the supply and demand conditions in a given country and the types of institutions that are there, there will be very differential potentials. For example, given the substantial improvements in Malaysia, it makes it a better place to have effective bond markets.

With regard to the CMI, the reason that it has been more successful is that it is easier. The problem is fairly straightforward, which is to provide large amounts of money extremely quickly in case of an emergency. The difficulty lies in trying to decide what the conditions should be. As for the ABMI, it is proceeding exactly as I would recommend - for example, in terms of technical assistance. What I am suggesting is that some of the larger goals are a bit unrealistic and complicated, such as the recent Korean securitization deal for SMEs. What should be done is to look at the infrastructural issues and concentrate on trying to improve financial regulation of the existing key institutions as well, which is banks in most of these countries.

Q: My feeling is that perhaps the Asian Bond Market, rather than being a phenomenon of financial regionalism, is merely in line with a global trend from indirect to direct financing. Global players are changing global financial methods and Asia is now participating in this transformation. To what extent Asia will become an integral part of the global capital market is yet to be seen, but this is a very natural trend. Perhaps governments are simply trying to facilitate these developments.

A: I agree with the premise of your comment that what we are seeing is financial globalization extending into East Asia, and that it is a question of how much of it will be integrated. In that sense, these regional efforts are best seen as a means of creating support for that larger issue of globalization. Whenever the term "financial globalization" is used, however, it compels us to think about some of the political issues in specific countries with regard to the way they see the benefits of globalization. It could be perceived that too many of the benefits are going toward foreigners. I can imagine that in places like China, that create be a powerful political schism and that there are important limits to financial regional efforts, even though it is very hard to give an exact answer about how far things can go.

Mr. Kimura: I fully agree that it is a kind of inevitable trend in the global financial market, for example, to shift the emphasis from indirect to direct financing. I would like to add that even in 1997 when the Asian financial crisis hit, it was widely believed that globalization of the financial market had already reached Asian markets. As for having a local currency bond market, I think that it is somewhat different from being involved in the global market elsewhere.

Q: You mentioned that the recent developments on the CMI in Istanbul meant that the amount delinked from the IMF increased four times. I find that very hard to understand given, as you said, that the worst nightmare is if someone actually wants to use that delinked money. Why increase the pot if you do not want anyone to touch it, and also if it gives political cover to Japan and China via the link to the IMF?

A: Some people do want to use the pot, namely ASEAN, and, since this is an ASEAN+3 initiative, you have to play along. However, it is still very small amounts. For example, for Thailand, it is less than $3 billion that it can get through CMI even once the Istanbul changes are fully reflected in its swap agreements. Also, without IMF permission, there is no obligation on other countries to provide even the non-linked money except within the ASEAN swap network. Japan is not obligated in its bilateral swap arrangement to provide money if it thinks that it should not, so this very small amount serves as a disincentive.

Q: There is wide speculation that the Chinese currency will further appreciate on the one hand, but on the other hand, that there was a bubble-like phenomenon caused by the mass inflow of capital from the outside world. In the process of revaluation, this capital might flow out. How do you see the situation of China in the future?

A: I imagine that if the renminbi is revalued, a fair amount of money will leave the country. This will be good for China because it has got so much upward pressure in terms of inflation. I do not know how bad the effects will be on the bubble.

Mr. Kimura: We have to carefully read the announcements issued by the People's Bank of China. In yesterday's announcement, they clearly state that they have no intention to make any kind of drastic change in the level of the renminbi. Having said that, they have also made it clear that there is a drastic change in their way of thinking toward more flexibility. Chinese policymakers are very confident that an outflow of capital can be avoided because China still maintains very rigid capital account controls.