EUROPEAN ECONOMY Economic Papers 329| September 2008 Monetary and Financial Integration in East Asia: The Relevance of European Experience Yung Chul Park and Charles Wyplosz EUROPEAN COMMISSION Economic Papers are written by the Staff of the Directorate-General for Economic and Financial Affairs, or by experts working in association with them. The Papers are intended to increase awareness of the technical work being done by staff and to seek comments and suggestions for further analysis. The views expressed are the author’s alone and do not necessarily correspond to those of the European Commission. Comments and enquiries should be addressed to: European Commission Directorate-General for Economic and Financial Affairs Publications B-1049 Brussels Belgium E-mail: [email protected] This paper exists in English only and can be downloaded from the website http://ec.europa.eu/economy_finance/publications A great deal of additional information is available on the Internet. It can be accessed through the Europa server (http://europa.eu ) ISBN 978-92-79-08254-2 doi 10.2765/80564 © European Communities, 2008 Monetary and Financial Integration in East Asia: The Relevance of European Experience Yung Chul Park Charles Wyplosz Korea University The Graduate Institute, Geneva and CEPR September 2008 Report to the European Commission under Contract ECFIN/D/2007/003 – OJEU 2007/S51 – 062495. We are grateful to Simone Meier for research assistance and to Lucas Papademos, Antonio de Lecea, Moreno Bertoldi and Caroline Gaye for very useful comments and suggestions. We alone are responsible for the views expressed in this report. TABLE OF CONTENTS Executive Summary Introduction Chapter 1. East Asia’s Response to the Crisis: Economic Reforms, Growth, and Integration in East Asia Chapter 2. Critical Survey of the Literature on Financial and Monetary Integration in East Asia Chapter 3. Assessment of the Initiatives for Financial Cooperation and Macroeconomic Surveillance Chapter 4. Europe and Cooperation in East Asia Conclusions 2 Executive Summary This report examines the process of economic and financial integration in East Asia in the light of Europe’s experience. Its aim is to evaluate the evolution of the last decade and to offer policy suggestions. Although, prior to the 1997-8 crisis, the East Asian countries had been enormously successful in achieving fast increases in standards of living, they exhibited a number of distortions. To a varying degree, and with important differences from one country to the other, these distortions played a role during the crisis and threatened to prevent the resumption of sustainable rapid growth afterwards. Europe too exhibited numerous, and often strikingly similar, distortions before the oil shocks of the late 1970s, and never recovered its postwar growth performance. Most East Asian countries undertook structural and institutional reforms to deal with these distortions in the aftermath of the crisis, with varied successes. - Banking sector reform has been limited. For similar, largely protectionist, reasons Europe too found it difficult to make fast progress in this area in the 1980s until the adoption of the Single Act in 1986 gave the European Commission the means to speed up the process. - East Asian capital markets have grown rapidly after the crisis. As a result, in most countries, the financial systems are no longer dominated by the banking sector. Yet, with the exception of Hong Kong and Singapore, institutional reform still has a considerable distance to go. Limitations typically concern shareholder protection, creditor rights, capital account liberalization, regulatory capacity, legal infrastructure and the lack of credit rating agencies. - Governance at various levels – government, financial institutions, and corporations – has improved but, relative to the rest of world, they remain far behind. 3 One reason for the slow progress in financial sector reform is that the institutional process is not subject to pressure from external competition. Europe also kept for a long time underperforming banking sector and asset markets. The trigger was London’s Big Bang in 1986, which forced other countries to speed up their hitherto languishing reform processes. Capital account liberalization is not universally complete in the East Asian region. Prudence in this area is partly driven by the perception that exchange rates cannot be allowed to float freely when exports are seen as the driver of growth. Since the crisis, most East Asian countries have accumulated large amounts of foreign exchange reserves. Given the fast growth of cross-border financial liabilities, it is not clear that these reserves are excessive, with a few exceptions. These reserves are seen by policymakers as a guarantee against speculative attacks. The value of this guarantee may be exaggerated. Much of the post-crisis effort has been devoted to developing regional monetary and financial cooperation. This effort has largely been driven by a defensive logic, that of preventing the occurrence of a new crisis. In contrast, monetary cooperation in Europe has been driven by the wider aim of economic integration and financial reforms have been guided by the goal of integration with the global markets. The Chiang Mai Initiative (CMI) was designed in the aftermath of the crisis to pool foreign exchange reserves at a time of scarcity. It first led to a web of Bilateral Swap Arrangements (BSAs) before being multilateralized as the Self-managed Reserve Pooling Arrangement (SRPA). While, over the years, the amounts available through the BSAs have been raised, the accumulation of foreign exchange reserves has reduced the usefulness of the BSAs. The CMI is also facing the need to develop adequate surveillance, where progress has been slow. Europe had a similar aarrangement in the 1970s within the European Monetary Cooperation Fund (EMCF). The arrangement did not succeed in underpinning the loose exchange rate “snake” arrangement. Still, this experience prompted European policymakers to adopt the tighter and more ambitious 4 ERM arrangement, which in turn made the monetary union possible. Without any exchange rate arrangement, the CMI is unlikely to be more successful than the EMCF. It is now expected to evolve toward a cooperation process through the institutionalization of the Economic Review and Policy Dialogue (ERPD). This is a desirable evolution but casting cooperation within the reserve pooling arrangement may not be the most effective approach. We suggest redirecting ERPD without a flexible exchange rate arrangement, which is detailed below. The Asian Bond Market Initiative (ABMI) was also a direct response to the currency mismatches that lie at the root of the 1997-8 crisis. It aims at creating regional markets where assets denominated in regional currencies can be floated. The ABMI has been slow to produce its effects, because of several roadblocks such as limits to capital mobility, heterogeneous regulatory and supervision frameworks, and slow progress in building regional settlement and guarantees. When these roadblocks are removed, it is likely that the East Asian markets will spontaneously be integrated into the global financial system. This is what happened in Europe, which relied on a market-driven approach that allowed all countries to issue debt instruments in their own currencies. The implication is that the ABMI could evolve from an institutions-based to a market-driven approach based on the liberalization of capital flows and on the adoption of world-class regulation and supervision practices. Being very open to trade, East Asian and European countries share an aversion to exchange rate volatility. Indeed, many – but not all – European countries have actively sought to stabilize their bilateral exchange rates. This has led them to adopt the Exchange Rate Mechanism (ERM), an elaborate arrangement of monetary and exchange rate cooperation. The ERM eventually led to the adoption of a common currency. Europe’s experience shows that exchange rate stabilization is not an all-or-nothing objective. Limited arrangements are helpful, if only because they boost confidence and pave the way for further integrative steps. East Asian countries face two possible paths. One of them is to complete the liberalization of their capital accounts – establishing full convertibility in the case of 5 China – which would require allowing their exchange rates to float fairly freely. The other path is to focus on exchange rate stabilization. An attractive solution is for each country to limit flexibility relative to its own basket. Both objectives can jointly be pursued if the range of allowed fluctuation is wide, possibly with fuzzy limits. 6 Introduction Over the years, there has been a continuing stream of research on “lessons for East Asia from Europe”. This topic is of obvious interest to academic researchers. Indeed, both regions share a number of characteristics. Europe in the 1950s and East Asia in the 1980s both embarked on a successful catching-up process. Because of geographic and, to some extent cultural, proximity, trade integration has been a natural component of the growth process, while financial integration lagged. Made up of number of countries of different sizes, both regions inherited a legacy of bitter infighting. At the same time, important differences exist. East Asia is more diverse and its political regimes have long been less democratic and less stable than in Europe. Reconciliation was deep and deemed essential in Europe. Europe caught up in a word considerably less globalized than the one faced by East Asia at the same stage of development. East Asian countries are also more diverse than Europe in a number of economic and political dimensions. This combination of similarities and differences are fascinating for researchers. The similarities have not escaped East Asian policymakers. They too have been asking what, if anything, could be learned from Europe’s experience. Their interest for policy solutions has been heightened by the 1997-8 crisis. Not only did the crisis expose faults in the region’s amazingly rapid catch-up process, it also established the vulnerabilities of their exchange rate systems.