Will Eurozone Crisis deter the formation of an Asian Monetary Union?

Andrew Michael Teo

There have been renewed calls for the creation of a common currency in Asia and that Japan is to take the political initiatives to achieve the Asian monetary unification in the 2030s that supplements the current fragile international economic and financial system.

A report by the Institute for International Policy Studies (IIPS) has suggested that Asian leaders must create the third-polar regime in Asia by introducing the common currency in order for the region to keep growing. This currency will not only stand on par with the US dollar and the Euro currency, but also aims to supplement the dollar regime, which will retain its status as the global’s key currency despite the continued erosion in the relative strength of the U.S. economy, along with the euro currency. The creation of an open, multilayered international economic and financial system is also vital to ensure stable, sustainable development of the world economy.

Regional development towards Asian Monetary Union

Several former ranking officials from Japan’s Finance Ministry and the Bank of Japan took part in the newly created IIPS group’s discussions and issued a plan for reconstructing the Bretton-Woods system, the U.S.-led post war international financial and currency setup.

In the short term, international efforts will be focused on the disposal of massive bad debt by the mid-2010s while achieving a full-fledged economic pickup and working out a new international mechanism to oversee financial transactions within the framework of the current international system, the report says. In the medium- and longer terms, Japan should lead in building a new international system via a unified Asian currency as its principal component, it proposes.

According to the plan, which also envisaged the establishment of a conference of central bankers and finance ministers from ASEAN+3, an intra-regional collaboration mechanism in Asia should be operating in the 2010s with Japan and China as Asia’s two largest economies reaching a consensus on the institution of the Asian currency unit (ACU) which will be based on a “basket,” or the weighted average of currencies used in the 10-member Association of Southeast Asia Countries plus Japan, China and South Korea (ASEAN+3).

At the ASEAN+3 finance ministerial meeting in Hanoi in April 2011, China got its way in grabbing the plum appointment at the newly created ASEAN+3 Macroeconomic Research Office (AMRO), a Singapore-based regional financial surveillance body with the former vice-head of China’s State Administration of Foreign Exchange, Mr Wei Benhua as its first director in May 2011.

With China pushing for a greater role in regional affairs, its currency regime moves that are closely followed by its Asian neighbours, and that the yuan is certain to be featured prominently in the common currency, the prospect of leading one of the most aspirational pan-Asian initiatives that was once championed by Japan, seems attractive. As a result, China began asserting its voice on the ASEAN+3 platforms.

In a survey led by Pradumna Bickram Rana from the Nanyang Technological University which included 1,000 government officials, academics and bankers in the ASEAN+3 countries on implementing a regional currency unit, it was revealed that the regional currency unit should comprise a basket of Asian currencies — with the Chinese yuan and Japanese yen having the highest and equal weights.

This effectively not only reflects the growing recognition of China’s economic clout and its currency’s importance, but also reduced Japan’s economic power as the world’s second largest economy which had been presenting itself as the leader in this decade-old idea of a common currency before the global financial crisis of 2008 diverted attention from it.

The weighting was to be based on the proportionate contributions made by ASEAN+3 members to the Chiang Mai Initiative Multilateralization (CMIM), which is a US$120 billion crisis fund established in the region on 24th March 2010, with the core objectives:

• to address balance of payment and short-term liquidity difficulties in the region;
• to supplement the existing international financial arrangements, the CMIM will provide financial support through currency swap transactions among CMIM participants in times of liquidity need.

Each CMIM participant is entitled, in accordance with the procedures and conditions set out in the Agreement, to swap its local currency with US Dollars for an amount up to its contribution multiplied by its purchasing multiplier.

China had led the Asian pack out of the financial slump, and is moving quickly to regionalize its currency in Asia. This has included setting up clearing banks in Hong Kong and Singapore to support trade settlement and investment products denominated in yuan.

However, before we go any further into the issue of an Asian Currency, let us take a look at the present Euro crisis to understand the nature of the crisis caused by a common currency.

The Euro Crisis

The present “euro crisis” is not only seen as a currency crisis, but it is also a sovereign debt and a banking crisis. The complexity of the situation has bred confusions, and has political consequences. Europe’s various member states have formed widely different views and their policies reflect their views rather than their true national interests. The clash of perceptions carries the seeds of serious political conflicts.

Given the differences in economic growth and development, politics, banking system, public debt management, etc, the euro was an incomplete currency to start with. The Maastricht Treaty of 1992 established a monetary union without a political union.

The euro boasted a common central bank without a common treasury so that when it comes to sovereign credit, each member country is on its own. It was exactly this lack of sovereign backing that was missing which led financial market started questioning. This fact was obscured until recent willingness by the European Central Bank (ECB) to accept sovereign debts of all member countries as riskless and on equal terms at its discount window. That is why the euro has become the focal point of the current crisis.

The Introduction of the Euro and the Crisis Connection

When the euro was introduced, instead of creating the expected convergence as prescribed by the Maastricht Treaty, it however, brought divergence. As banks were obliged to hold riskless assets to meet their liquidity requirement, they were induced to load up on the sovereign debt of weaker countries.

As a result, interest rates in the PIIGS were lowered and generated housing bubbles. The PIIGS grew faster and developed trade deficits within the euro zone, while Germany, at the same time, reigned in its labour costs, became more competitive and developed a chronic trade surplus, had to tighten its belt to cope with the costs of reunification.

The result was a divergence in competitiveness, which now endanger the creditworthiness of German banks and the European banking system. For example, European banks hold nearly a trillion euros of Spanish debt of which half is held by German and French banks. To make matters worse, some of these countries, notably Greece, with the help of Investment Bank Goldman Sachs, ran budget deficits that exceeded the limits set by the Maastricht Treaty.

Hence, it can be seen that the euro crisis is intricately interconnected with the situation of the banks.

Lack of a Common Treasury

A Common Treasury is necessary for the issuance and joint guarantee of all sovereign debts issued by member countries. However, the absence of a common treasury surfaced immediately after the bankruptcy of Lehman Brothers. When finance ministers of the European Union had promised that no other financial institution whose failure could endanger the system would be allowed to default, German Chancellor Angela Merkel had opposed to a joint Europe-wide guarantee; each country had to take care of its own banks.

The financial markets were, at first, impressed by the guarantee that they hardly noticed the difference. Capital then fled from countries which were not in a position to offer similar guarantees, though the interest differentials within the euro zone remained minimal. That was when the countries of Eastern Europe, notably Hungary and the Baltic States, got into difficulties and had to be rescued.

However, in 2010 fears started to brew in the financial markets about the accumulation and credibility of the sovereign debt within the euro zone. Greece became the centre of attention when the newly elected government revealed that the previous government had lied and the deficit for 2009 was much larger than indicated.

Despite widening interest rate differentials, European authorities were slow to react as member countries held radically different views. Hence, the Greek crisis festered and spread. However, when the authorities finally got their act together they had to offer a much larger rescue package than would have been necessary if they had acted earlier.

In the meantime, the crisis spread to the other deficit countries. In order to reassure the markets, the authorities felt obliged to put together a €750 billion European Financial Stabilization Fund, which will be raised by selling bonds to the markets, with €500 billion from the member states and €250 billion from the IMF. As the terms of the Fund were dictated by Germany, the markets were not reassured. The Fund is guaranteed not jointly but only severally so that the weaker countries will in fact be guaranteeing a portion of their own debt.

Flaws of the Euro

The euro has its flaws since its conception and its architects knew it at the time of its creation. They, however, expected its defects to be corrected, if and when they became acute, by the same process that brought the European Union into existence. The biggest deficiency in the euro, the absence of a common fiscal policy, is well known.

Another defect that has received less recognition is a false belief in the stability of financial markets. The Financial Crisis of 2008 has demonstrated that financial markets do not necessarily tend towards equilibrium; they are just as likely to produce bubbles.

Greece abused the privilege by cheating, but Spain did not. It followed sound macro-economic policies, maintained its sovereign debt level below the European average, and exercised exemplary supervision over its banking system. Yet it enjoyed a tremendous real estate boom which has turned into a bust resulting in 20% unemployment. Now it has to rescue the savings banks called “cajas” and the municipalities. And the entire European banking system is weighed down by bad debts and needs to be recapitalized. The design of the euro did not take this possibility into account.

Another structural flaw in the euro is that it guards only against the danger of inflation and ignores the possibility of deflation. In this respect the task assigned to the ECB is asymmetric. This is due to Germany’s fear of inflation. When Germany agreed to substitute the euro for Deutschmark, it insisted on strong safeguards to maintain the value of the currency. The Maastricht Treaty contained a clause that expressly prohibited bailouts which has been reaffirmed by the German Constitutional Court. It is this clause that has made the current situation so difficult to deal with.

The gravest defect in the euro’s design is that it expects member states to abide by the Maastricht criteria without establishing an adequate enforcement mechanism. Since several countries are now far away from the Maastricht criteria, there is neither an adjustment mechanism nor an exit mechanism. These countries are now expected to return to the Maastricht criteria even if such a move sets in motion a deflationary spiral which is likely to push Europe into a period of prolonged stagnation or worse, which will, in turn, generate discontent and social unrest.

Problems with the Banking System

Continental European banking system has not been properly cleansed after the Financial Crisis of 2008. Bad assets have not been marked-to-market but are being held to maturity. When markets started to doubt the creditworthiness of sovereign debt, it was really the solvency of the banking system that is being questioned since they were loaded with the bonds of the weaker countries that are now selling below par.

The crisis has now culminated in forcing the authorities to disclose the results of their banks’ stress tests which will go a long way to clear the air. Though no one can judge how serious the situation is, but it is clear, however, that the banks need to be recapitalized on a compulsory basis since they are way over-leveraged

The fact that the Maastricht criteria were so massively violated shows that the euro does have deficiencies that need to be corrected.

The Asian Currency

Coming back to our topic on the common Asian currency, can ASEAN+3 avoid the same crisis that Europe is now facing with the Euro if the dream of a common Asian currency becomes a reality? The euro crisis has revealed the flaws of the common currency and failures of the member countries in handling the crisis.

The lack of a common banking system, common treasury, common fiscal and monetary policies and especially a common government has resulted in mishandling of the crisis as each member countries hold their own political views instead of real national interests.

The suggestion by Malaysian Deputy Finance Minister Lim Siang Chai that China should take the lead in the creating a unified Asian currency immediately calls to mind China’s banking system. China has a banking system that is entirely different from those of ASEAN, Japan and South Korea. To be able to have common Central Bank and Common Treasury, China needs a complete overhaul of its banking system which is not going to be an easy task.

The Chinese government has been known to borrow directly from the banking system via financial vehicles to finance public projects. This is evident during the Financial Crisis of 2008 when the government embarked on massive infrastructure projects to stimulate the economy. On one hand, this has made it difficult to account for the actual amount of debts which the government had borrowed.

Some analysts have put China’s real debt at as high as 90% of GDP basing on opaque and incomplete information. On the other hand, since the loans are taken via financial vehicles, do these loans constitute government debts? Perhaps it is the latter that reasoned why the Chinese government had insisted that their real debt to GDP ratio was only 18%!

In this aspect, one similarity arises between China and Greece is that both countries borrowed excessively in relation to their GDP. While Greece cheated with the help of Goldman Sachs via issuance of bonds, China did it by borrowing from the banking system via financial vehicles which are really state-owned enterprises, thereby covering up their actual level of debts.

Indeed, it would take more than just the Chiang Mai Initiative Multilateralization for the common currency to be successful. Are members of ASEAN, Japan and South Korea comfortable with China Communist Party as the appointed Common Government? Is China Communist Party comfortable with the appointment of a democratic political party as the Common Government? Are members of the Common Government from different schools of politics and economics able to resolve their differences amicably without jeopardizing regional economic growth?

These are just some of the many questions that should be answered even before the Chiang Mai Initiative Multilateralization was initiated.

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Photo courtesy of Kennedy School of Government, Harvard University.