RIETI Report February 2004

Toward Asian Currency Stability <RIETI Featured Fellow> C. H. KWAN

Greetings from RIETI

Facial hair is the bane of many Japanese men's lives, for perhaps nowhere else in the world is the ritual of purging oneself of morning stubble as rigorously obeyed as in Japan, where one will rarely see an unkempt chin on the train during commuter hours. However, facial hair is proving to be a vital cultural currency for the Self-Defense Forces currently stationed in the Iraq town of Samawa, where male Japanese soldiers are being encouraged to grow moustaches so as to fit in with the local people. The results so far have been very successful with Colonel Sato Masahisa, who led the advance party to Iraq, being described as looking like an Iraqi. Female members of the SDF, on the other hand, are using dark green scarves to cover their hair following local custom. On top of all this, consumption of pork and alcohol has been forbidden at the Japanese army base there. Of course, it is precisely this attention to detail that is going to win the SDF friendly relationships with the Iraqi people and the stability needed to enable the task of reconstruction. This month RIETI Report had the pleasure of speaking with RIETI Senior Fellow C.H. Kwan and learning how stability of an economic sort can be achieved amongst Asia's currencies. (DC)


An Economics graduate of the Chinese University of Hong Kong and holding a Ph.D. in Economics from the University of Tokyo, C.H. Kwan was Senior Economist at the Nomura Research Institute from 1987 to 2001. During this time, Dr. Kwan has held a number of positions on Japanese Government Committees, including the Pacific Economic Outlook Committee, the Economic Advisory Council to the Prime Minister, and the Council on Foreign Exchange and Other Transactions (still held today), while outside of Japan, he has been editor of the Journal of the Asia Pacific Economy since 1996. Dr. Kwan joined RIETI as a Senior Fellow in 2001 and has been most conspicuous in his activities, particularly through his column China in Transition, which is published weekly on RIETI's website in Japanese, Chinese and English. Recent publications include, in English: Yen Bloc - Toward Economic Integration in Asia, Brookings Institution Press (2001) and "The Rise of China and Asia's Flying-Geese Pattern of Economic Development: An Empirical Analysis Based on US Import Statistics," RIETI Discussion Papers, 02-E-009, (September 2002); and in Japanese: A Re-introduction to the Chinese Economy, Toyo-keizai Shimposha, (2002).

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Toward Asian Currency Stability

RIETI Report: The question of how to ensure currency stability in Asia was one of the major topics raised in the RIETI-organized Asian Network of Economic Policy Research (ANEPR) symposium in January. What, in your view, is the way to bring stability to the regional economy and currencies?

Kwan: The Chiang Mai Initiative was launched in reflection of the Asian currency crisis. It is based on the recognition that such a crisis spreads very quickly, it cannot be dealt with by a single country, and that seeking help from the International Monetary Fund could make things worse.

Before that, Japan's initial proposal to create a $100 billion Asian Monetary Fund (AMF) was aborted due to opposition from the United States and the IMF. Also, China was said to be reluctant to go with the idea at the time because it feared that the scheme would lead to further expansion of Japan's influence in Asia. The overall sentiment, however, has changed substantially with 1998 as a turning point. After witnessing currency crises in Russia and Central America, the U.S. has come round to thinking that it would be OK to let Japan take care of Asia. China has also realized that the stabilization of the global economy, particularly that of the Asian economy, is crucial to its own economic development, and thus has come to support the idea of creating a region-wide framework for currency stabilization. As a major step in this direction, the Chiang Mai Initiative, a network of bilateral currency swap agreements, was launched in 2000. These bilateral agreements are reciprocal in form but in reality most of them are channels of one-way assistance from Japan to other Asian countries.

The Chiang Mai Initiative is quite meaningful as a confidence-building step. It has introduced a crisis prevention mechanism and sent out a message that Asian countries would join forces in the event of crisis. Such signaling is quite important because it discourages speculative moves by hedge funds and provides some assurance that a crisis would subside at an early stage even if one occurred.

RIETI Report: What would be the next step?

Kwan: Asian countries should pursue some kind of framework to stabilize exchange rates among themselves, probably in three stages. As the first stage, Asian countries could shift from the current de facto dollar peg system to a band, basket and crawling (BBC) regime with each country pegging its currency to a different currency basket. For instance, South Korea, which competes with Japan in exports, should adopt a basket in which the yen carries substantial weight. Here, the trade volume between the two countries is not a factor. The question is whether they compete in the global market, that is, in exports to the U.S. and Europe.

Newly industrialized economies (NIEs) are generally in the same situation. They should peg their currencies more closely to the yen rather than to the dollar so as to avoid negative impacts from the volatility of dollar-yen exchange rates. But the yen could dominate a much smaller portion of the currency basket for China and other countries that are far behind Japan in economic development and do not compete with Japan in exports. They can change the composition of their currency baskets according to changes in their respective trade structures. When countries come to have similar trade structures, the precondition for forming an optimum currency area, they can move into the second stage, which would be to peg their currencies to a single, common currency basket.

RIETI Report: So, you believe that Asian countries, as they stand today, are not yet ready for a monetary union?

Kwan: Forming a monetary union for which the conditions are not yet ready would be counterproductive. Look at what has happened to Hong Kong, which by pegging its currency to the U.S. dollar has in effect joined the dollar bloc. As a result, Hong Kong is subject to monetary policy spelled out by U.S. Federal Reserve Board (FRB) Chairman, Allan Greenspan. Should the Hong Kong economy move up and down in tandem with the U.S. economy, this de facto dollar peg system would work perfectly. But imagine what would happen if economic cycles differ. What if the U.S. economy is booming and the FRB moves to tighten monetary policy at a time when the Hong Kong economy is in the doldrums? This is exactly how things have been over the past 10 years. When the Hong Kong economy was in the midst of a currency crisis in 1997-98, the U.S. was in an information technology bubble. Lowering interest rates was not an option for Hong Kong despite its economy being in a moribund state. And you cannot expect Greenspan to ease monetary policy for the sake of Hong Kong. Should China peg the yuan to the yen now, its monetary policy would be largely decided by the Bank of Japan, and this may not be in China's own interests.

RIETI Report: So, Asian countries, in general, still need to have their respective monetary policy independence?

Kwan: Yes. They are not ready for a region-wide central bank - such as the one in Europe - to single-handedly implement monetary policy, let alone Greenspan. Economic cycles in different countries basically go hand-in-hand when people, goods and money go back and forth freely between the countries, or when the countries resemble each other in terms of stage of economic development and characteristics of economy. For instance, it would be extremely difficult for an oil-producing country and a non-oil-producing country to have a common currency because fluctuations in oil prices bring opposite effects.

RIETI Report: Does it mean that Asia will never be able to have a single currency?

Kwan: It would take decades at minimum. It is not something that can be done in five to 10 years. I don't think it will happen in my lifetime.

But at least, there are many lessons we can learn from the experiences of Europe. Now we know that there are both pros and cons to having a single currency. We also know that having a single currency is not so simple.

In the aforementioned second stage, the one in which Asian countries peg their currencies to a common basket, we would be still talking about so-and-so percentage of the yen or so-and-so percentage of the U.S. dollar in the basket. In the third stage, when countries finally have a single currency, there would be no such talks. Here, the question boils down to who should take charge of monetary policy, and this is a matter of economic and political power. If Asia is to have a single currency now, Japan - which accounts for two-thirds of gross domestic product in Asia - would play a leading role. In 20, 30 or 50 years from now, however, China would be becoming a substantial economic power. So, these two countries would probably take the leadership in monetary policy.

With regard to lessons from Europe, another thing I would like to point out is that the monetary union in Europe stands on the firm determination of European countries - Germany and France in particular - not to have another war in Europe. It is part of a grand vision that includes the possibility of political integration. Put into this perspective, economy is a relatively small matter. And despite some problems arising from the single currency, the European integration can be perceived to be quite successful.

In this context, I wonder why we cannot have the same way of thinking in Asia. The problem of Japan's military past has been cited as a reason why Asia does not have a single currency. But why can't we look at it the other way round and say that we should have a single currency in order to overcome the past, just as European countries are trying to integrate further by even sacrificing the economy to some extent.

RIETI Report: Chinese officials reportedly said that they will introduce a more flexible foreign exchange regime by the end of this year.

Kwan: The Chinese government is denying the timing in that media report, claiming that they didn't say by the end of this year. But China had committed itself to shifting into a more flexible system in the mid- to long-term period in its negotiations with the U.S. So, it is a matter of timing and I bet they will do so either just before or after the U.S. presidential elections (in November 2004) - before if President George Bush is expected to win, as a gift for him, and after if he is likely to lose, as a congratulatory gift for the new Democrat president.

RIETI Report: What is the economic meaning behind the adoption of a more flexible foreign exchange regime?

Kwan: It is quite meaningful. In the study of exchange rate regimes, there is a concept called the impossible trinity. The idea is that independent monetary policy, exchange rate stability (fixed rate), and full capital mobility cannot be simultaneously achieved, that is to say, you have to give up one of them to save the other two. Currently, China has monetary policy independence and exchange rate stability at the sacrifice of capital mobility. However, now that it is becoming more and more difficult to maintain control over capital flows, China needs to give up either independence in monetary policy or exchange rate stability. Between these two options, the former is unacceptable to China because it is tantamount to letting Greenspan take charge of its monetary policy.

So, shifting into a more flexible foreign exchange system is an inevitable step that China needs to take sooner or later for its own sake, not for the sake of someone else. However, because such a move can be flattering to some other countries, China wants to choose the right timing to play this card so as to maximize chances for reward.


3/11-12 RIETI Symposium
"Fiscal Reform of Japan: Redesigning the Frame of the State"
For event program and information, http://www.rieti.go.jp/en/events/04031101/info.html

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All BBLs run 12:15 - 13:45, unless otherwise stated.

3/8 Speaker: Clyde PRESTOWITZ (President, Economic Strategy Institute)
Moderator: NAKABAYASHI Mieko (RIETI Fellow)
"Foreign policy: Will the U.S. change its course?"

3/23 Speaker: Hadi SOESASTRO (Executive Director, Centre for Strategic and International Studies of Jakarta, Indonesia)
Moderator: URATA Shujiro (RIETI Faculty Fellow / Professor of School of Social Sciences, Waseda University)
"Regional Integration in East Asia: ASEAN's View"

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3/4 TSUGAMI Toshiya (Senior Fellow)
"A Study on China's Sub-National Fiscal Mechanism"

3/18 TANIKAWA Hiroya (Senior Fellow)
Title: tbc

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Toward Asian Currency Stability <RIETI Featured Fellow> C. H. KWAN

C. H. KWANConsulting Fellow, RIETI

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