Misdirected and ineffective: Regional financial cooperation in Asia

1
Misdirected and ineffective Regional financial
cooperation in Asia

• C.P.Chandrasekhar

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Regulatory lessons from the crisis

• Need for regulation at the national level to
  influence the behaviour of financial firms and
  the monetary authority
• Need for supra-national regulation given
  financial consolidation and integration through
  cross-border flows
• An affliction in one country affects others
  through multiple means of transmission requiring
  an insurance tool-kit and measures of regulation.

3
Lessons learnt early in Asia

• Asia, especially East and Southeast Asia had
  learnt a number of lessons at the time of the
  1997 crisis.
• Deregulation by exposing countries to
  cross-border flows determined by decisions in
  metropolitan financial centres also exposes them
  to boom-bust cycles.
• Liberalisation makes countries prone to
  contagion, even if their own macroeconomic
  variablesfiscal, trade and current account
  balancesare impeccable. When Thailand slipped so
  did South Korea.
• Liberalisation had not just integrated them, but
  also linked them as a combined entity to the rest
  of the world.

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Some features of the crisis period

• The region as whole characterised by savings
  surpluses, though there were individual countries
  that recorded savings deficits. The savings
  surpluses were being invested in dollar
  denominated assets, and deficit countries were
  increasingly dependent on capital flowsfrom
  outside the region.
• The external exposure of these countries prior to
  1997 involved excessive exposure to foreign debt,
  especially short term debt. The three countries
  where such exposure was large in 1997 were
  Thailand, Indonesia and South Korea, in whose
  case short term foreign debt amounted to 110 per
  cent, 167 per cent and 195 per cent of their
  reserves respectively. When creditors, for
  whatever reason, turned wary and choose to hold
  back on debt rollovers or provision of new debt,
  a crisis ensued.

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The surpluses

• In 1997 only three East Asian countries ran
  current account surpluses Japan, China and
  Singapore. Their combined surpluses totalled 135
  billion.
• The combined deficits of the ASEAN 5 (Thailand,
  Indonesia, Malaysia, Philippines and Singapore)
  stood at 3.3 billion and the surpluses of the
  Plus 3 (Korea, China and Japan) at 125.5
  billion, after accounting for Koreas deficit of
  8.3 billion.
• There was a net surplus in the group of 122
  billion.

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Conclusions drawn

• Excess exposure to short term flows relative to
  reserves, makes countries prone to crisis.
• When one country hit by crisis the affliction
  spread to better placed countries in the region,
  largely because of capital exit.
• Given regional surpluses problem could be
  addressed if crisis-hit countries had the option
  of swapping their own currencies for hard
  currencies and neutralizing the effects of
  capital flight.
• The other response that was recognised but
  largely ignored, except for a short period in
  Malaysia, was to insulate economies from
  boom-bust cycles with capital controls.

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The first phase of regional cooperation

• Developing an arrangement under which such swaps
  were possible.
• Defensive action that presumed that the crisis
  could not have been prevented in the first place
  by abjuring or calibrating financial opening and
  liberalization, or by using regional surpluses
  for financing regional development projects
  without relying excessively on extra-regional
  finance.

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A positive externality

• If dependence on extra-regional finance did
  result in crises that necessitated turning to
  organizations like the IMF for balance of
  payments support, it was accompanied by
  conditonalities that countries in the region,
  their economic strengths notwithstanding, had
  little influence on.
• Such conditionalities were not only procyclical,
  but required countries to pursue and intensify
  the same policies of external and internal
  financial liberalization that led, in the first
  instance, to their difficulties.
• This provided a second reason for cooperation
  based on regional surpluses. If you could borrow
  locally, conditionalities would be more sensitive
  to country needs.

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The real need

• Avoiding measures of liberalization that enhanced
  external and internal vulnerability.
• Adopting such a policy of avoidance was also
  difficult for any single country independent of
  the rest
• It resulted in regulatory arbitrage, which
  diverted capital flows to more liberal
  destinations in the region.
• It cut off access of the interventionist regimes
  to the external resources needed to pursue
  development.
• That put the hold-out country at a disadvantage
  vis-à-vis the rest in terms of the relative
  ability to retain and exploit even useful and
  not-so-harmful capital flows. Real need for
  regulatory cooperation that was ignored.

10
A lesson from the past

• Countries in the East Asian region chose to
  largely restrict themselves to the regional
  borrowing option. This was not just the soft
  option but easy to implement because of a
  platform from the past.
• Even before the 1997 crisis, in August 1977
  central banks and monetary authorities from the
  ASEAN-5 came together to establish the ASEAN Swap
  Arrangement (ASA) with a corpus of 100 million,
  which was raised to 200 million in 1978.
• This proved to be grossly inadequate at the time
  of the 1997 financial crisis.

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Stage 2

• Japan made the first move after the 1997 crisis
  when in the IMF meetings in Hong Kong in
  September 1997 it mooted the idea of an Asian
  Monetary Fund (AMF).
• The AMF idea came to a quick end and in Manila in
  November 1997 finance and central bank officials
  from Asia formulated the Manila Framework for
  regional cooperation to promote financial
  stability. Others, including the US, IMF and the
  World Bank had representatives.
• The Manila Framework was endorsed at a meeting of
  finance ministers from ASEAN Australia PRC
  Hong Kong, China Japan Korea and the United
  States, in Kuala Lumpur, Malaysia, on 2 December
  1997

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The Chiang Mai Initiative

• This led in May 2000 to the launch of the CMI,
  described as a regional financing arrangement to
  supplement the existing international
  facilities.
• Its first pillar was an enhanced ASA with funding
  raised from 200 million to 1 billion, with
  members eligible to borrow up to two times their
  contribution for a period of six months
  (extendable for another six).
• The second was a network of bilateral swap
  arrangements (BSAs) under which countries could
  opt for a swap of currencies upto an agreed
  amount. Initially any swap in excess of 10 per
  cent of the agreed amount required IMF
  surveillance. That was raised to 20 per cent
  subsequently.

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Obvious weaknesses

• It was estimated in 2010 that if all the BSAs
  entered into by Thailand was available to it in
  1997, it would have been able to raise 2 billion
  from the CMI swap arrangement. The IMFs bail-out
  package for Thailand at that time amounted to
  17.2 billion.
• If in addition countries had to accept an IMF
  programme or IMF-designed conditionalities, the
  second reason for opting for a regional fund was
  defeated.
• The CMI had been killed at the very start.

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The problem with CMI

• Japans decision to propose an AMF was seen as
  reflective of the exposure of its own banks in
  the region, and the conviction that after the
  1997 crisis the US and the IMF are unlikely to
  work to restructure Asian debt to save the banks,
  as they did in Latin America in the 1980s.
  However, once mooted the proposal was seen as
  reflective of Asian solidarity against the US and
  the IMF.
• In time, two factors worked to undermine the
  proposal.
• Fear of Japanese dominance in the regiona fear
  which the US is seen as having exploited,
  especially via-a-vis China.
• Dependence of many ASEAN countries on US markets
  and US-mediated capital flows resulted in these
  countries softening their stance once the US and
  the IMF expressed their opposition.
• At Hong Kong ASEAN members and South Korea
  supported the AMF proposal, Hong Kong and
  Australia remained neutral, and China was silent.

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Manila framework

• From summary of proceedings
• This framework, which recognizes the central
  role of the IMF in the international monetary
  system, includes the following initiatives (a) a
  mechanism for regional surveillance to complement
  global surveillance by the IMF (b) enhanced
  economic and technical cooperation particularly
  in strengthening domestic financial systems and
  regulatory capacities (c) measures to strengthen
  the IMFs capacity to respond to financial
  crises and (d) a cooperative financing
  arrangement that would supplement IMF resources.

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Inadequate funding

• In end-2008, though South Korea had 202 billion
  of forex reserves, it was exposed to 191 billion
  of short term debt, 111 bn in the form of equity
  investments and 27 billion in terms of foreign
  holdings of bonds. That amounted to a ratio of
  61.3 per cent.
• Korea could have accessed 18.5 billion under CMI
  through its swap agreements with various
  countries. However, only 3.7 billion of this
  (20) could be drawn without having to be part of
  an IMF program.

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The CMI multilateralised

• Not surprisingly, even the CMI proved inadequate
  at the time of the 2008 crisis. Capital exit at
  that time led to South Korea and Singapore
  borrowing from the Federal Reserve and Indonesia
  from the World Bank and other lenders.
• This experience resulted in one more round of
  expansion when the CMI was multilateralized and
  became the CMIM. The members now include Brunei,
  Cambodia, Hong Kong, Indonesia, Japan, Laos,
  Malaysia, Myanmar, the Peoples Republic of
  China, Philippines, Singapore, South Korea,
  Thailand, Vietnam.
• The facility with a corpus of 120 billion was
  established in March 2010, with the ASEAN-5
  contributing 20 per cent and Korea, Japan and
  China providing 16, 32 and 32 per cent
  respectively. The size of the corpus was doubled
  to 240 billion in 2012.

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The CMIM

• When faced with balance of payments difficulties
  a country can swap its currency for US dollars
  through the facility.
• Each country's borrowing quota is based on its
  contribution multiplied by its respective
  borrowing multiplier. The borrowing multiplier
  was set at 5 for Brunei Darussalam, Cambodia, Lao
  PDR, Myanmar, and Viet Nam, at 2.5 for Hong Kong,
  Indonesia, Malaysia, Singapore and Thailand, at 1
  for Korea, and 0.5 for Japan and China it is 0.5.

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One more failure?

• The CIMM has not emerged a major alternative to
  balance of payments financing from the IMF or
  developed country sources. One factor seen as
  responsible for this is the troubled relationship
  between the two major funders, China and Japan.
• They would prefer to be seen as directly
  supporting distressed nations rather than doing
  so through an impersonal organizational form.
• Though the size of the corpus or common liquidity
  pool available under CMIM is defined, it remains
  a reserve pooling arrangement under which the
  commitments made by various countries remained
  with their central banks to be made available in
  the event of a crisis. The fund was made up of
  promises to pay by these central banks.

20
AMRO

• Despite the creation of an ASEAN 3
  Macroeconomic Research Office no centralised
  monitoring.
• Tensions were seen as ensuring that neither of
  the major donors were in a position to ensure
  that the funds accessed by member countries would
  be put to proper use. Any attempt to impose ex
  ante or ex post conditions on use of the
  resources would risk alienating the borrower and
  losing influence.
• The major donors settled for a system in which
  large volume borrowing from the facility required
  an IMF programme (though now a country was
  allowed to borrow up to 30 per cent of its quota
  without submitting to IMF conditionality). This
  meant that, when financing requirements were
  large, countries would choose to approach the IMF
  directly.

21
Meek recognition

• There are now plans to create a CMIM
  Precautionary Line (CMIM-PL), which will operate
  in parallel with the CMIM mechanism (now renamed
  the Stability Facility, or CMIM-SF).
• While CMIM would require IMF clearance, the
  Precautionary Line would reportedly be based on
  ex ante conditionality, or an assessment of the
  quality of a countrys economic polices (without
  being subject to ex post performance targets).
  But whether quality would be defined by the IMF
  and correspond to typical IMF type conditions is
  not too clear.

22
Autonomous integration

• With no effort to reduce dependence on external
  capital flows, autonomous trends led to a greater
  degree of financial integration between Asian
  countries as a group and the world as a whole.
• Three surges of capital inflows into Asia over
  the last twenty five years
• First from the early 1990s till 1997, when
  Southeast Asia was hit by a crisis
• The second from 2002 till the global financial
  crisis of 2008
• The third from 2008 to 2010 which coincided with
  the easing of monetary policy in the US.
• In each of these periods, the ratio of net
  capital inflows to GDP rose steeply, followed by
  a period of capital exit or flight.

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Two trends

• While crises are episodes precipitated by capital
  exit, they dont preclude the possibility of a
  revival soon thereafter. When the exit occurs and
  when it is reversed is a result of decisions
  outside the ambit of policy.
• While in the early 1990s the inflows into Asia
  were focused on the NICs and second-tier
  industrialisers, the phenomenon is more
  generalized now making the region as a whole
  prone to boom bust cycles.

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Intra-regional flows

• Interestingly despite the availability of large
  surpluses in the region intra-regional portfolio
  flows are still small. Countries prefer to invest
  in dollar denominated assets (especially US
  Treasury bonds), rather than in regional assets
  that investors from the developed countries seem
  to covet.
• For example, the share of developing Asia in the
  aggregate portfolio investment by the ASEAN 3
  grouping, while rising, is still only 15 per
  cent. And much of this goes to the ASEAN 3
  itself. Financial liberalization strengthens
  links with developed country, especially
  Anglo-Saxon, markets rather than between markets
  in the region.

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Consequence

• The increase in the presence of foreign capital
  has necessitated changes in the regulatory
  framework governing finance in these countries.
  Governments in the region have adopted more
  liberal rules with regard to the functioning of
  different kinds of markets and institutions,
  provided greater space for new instruments such
  as derivatives, and shown a willingness to shift
  to globally accepted rules for regulation.
• The message seems to be that if countries choose
  to adopt a policy framework that emphasises the
  need to attract large volumes of foreign capital,
  reform of the regulatory structure governing
  finance in a common, globally dictated direction
  seems to be a prerequisite.
• This exposes these countries to new kinds of
  vulnerability.

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Impact on the cooperation effort

• Cooperation to improve and exploit markets.
• Financial liberalisation undermines the ability
  of governments to finance capital intensive, long
  gestation lag projects either directly through
  the budget, as China and South Korea did for
  long, or through government and central bank
  supported funding by development finance
  institutions, as in India.
• This has given rise to a second, parallel effort
  at regional financial cooperation that seeks to
  develop regional bond markets as a means of
  mobilising savings for long term, less liquid
  investments, such as in infrastructure. Bonds and
  securitised instruments are considered to have
  better risk sharing characteristics and as
  facilitating the diversification of risk.

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Asian Bond Market Initiative

• Launched by ASEAN 3 in 2003 with two
  initiatives.
• Credit Guarantee and Investment Facility (CGIF),
  set up as a trust by ASEAN3 and the Asian
  Development Bank (ADB) in 2010, which provides
  guarantees for bonds issued by firms facing
  constraints in securing long-term funding from
  the local bond market.
• Strengthen the mutual fund infrastructure,
  providing smaller savers with the option of
  buying into liquid mutual funds that in turn
  invest in debt securities.

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Has it worked?

• Even where local currency bond markets are
  developed, government securities seem to account
  for a significant share of all securities issued
  in the domestic market.
• Bond market growth largely the result of capital
  inflow, with foreign investor interest in Asian
  bonds rising. According to Deutsche Bank
  Research Corporate bond market capitalisation
  reached 24.2 of the regions GDP by 2012 from
  just 16.7 in 2008. In value terms, the stock of
  outstanding corporate bonds amounted to USD 3.2
  trillion by Q3 2013 almost triple the value
  recorded at the end of 2008.

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A new initiative

• China mooted and successfully managed to get 21
  Asian nations to come together in October 2014 to
  establish the Asian Infrastructure Investment
  Bank (AIIB) with headquarters in Beijing.
• Starting with a capital base of 50 billion
  contributed by China (out of the authorized
  capital of 100 billion), the AIIB appears a poor
  cousin to the Asian Development Bank with around
  160 billion of capital and the World Bank with
  around 220 billion. But this is just the
  beginning and significant for an institution that
  is expected to focus on infrastructure.

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A role for politics

• Clearly an instance of Chinas push for dominance
  in the Asia-Pacific.
• America has lobbied against the creation of the
  AIIB, Japan, which leads the ADB, is out of the
  AIIB, and Australia and South Korea stayed away.
  So did Indonesia initially, only to change tack
  and join the club.
• While it is too early to even speculate on how
  the AIIB would evolve, to the extent it reduces
  Asian dependence on external finance in general
  and the World Bank and IMF in particular, it
  would increase the ability of countries in the
  region to regulate cross-border flows and reduce
  their vulnerability to boom-bust cycles.

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Concluding remarks

• Regional cooperation in regulation would be
  substantive and can make any difference only if
  it involves imposing controls that help avoid
  boom-bust cycles rather than finding ways to
  adjust when confronted with crises.
• Only then can the effort to build a regional
  financial network catering to regional interests
  is possible.
• Discussions also need to focus on how the
  internal financial structure in these countries
  should be shaped, given their levels of
  development, requirements, and the availability
  of large investible surpluses.
• The AIIB is only a small and as yet half-formed
  step in that direction.