1

Asian Financial Integration:Next Steps

Andrew Sheng

10 May 2006

2

Contents of Presentation

Review of Progress to Date

Review of Literature and Views to Date

Assessment of situation

Roadmap to Integration

Risks and Opportunities

3

Regional IntegrationSource: Padao-Schioppa (2005)

Closed or Open Regionalism?Path to Global Integration

Consensual ASEAN way – “muddling through”

Sequencing

Centripetal forces do not clearly outweigh centrifugal forces

Risks

Gains from trade obvious and some studies show East Asia is an Optimum Currency Area

Gains

No clear objective in AsiaMotivation

4

Current Status: Four PillarsKuroda ( ADB, Dec 2005)

Sub-regional Cooperation – connecting through bridges, ports, roads

Money and Finance – Chiangmai Initiative (CMI); ABF1 & 2

Trade and Investment - FTAs

Provision of Regional Public Goods – funding is lacking

5

Regional Features Compared:Japan’s financial assets are twice rest of Asia put together

Japan accounts for 57% of regional GDP and 65% of total financial assets

Germany accounts for 22% of regional GDP and 19% of total financial assets

Concentration

1513 + No. of members

US$7 trnUS$10.1 trnGDP

15 mn sq. km.3 mn sq. kmArea

2 billion420 mnPopulation

East Asia

(ASEAN+3)

EURegional Features

6

Evolution of Economic Integration:Mario Lamberte (ADB, 2005)

7

Degrees of Integration

Political Integration – the EU Route

Trade Integration – NAFTA Route

Financial Integration – Harmonization or

Mutual Recognition?

Monetary IntegrationACU basket of Asian currencies or

Single currency?

8

Financial Integration still early daysde Brouwer and Corbett (ANU, Oct 2005)

Financial Infrastructure improving, but still disparateSavings still bank dominatedThree advantages for financial integration:-

Internal and external pressure for financial reformOpportunities to improve access and reduce transactions costs for households to global instrumentsStronger voice in global forums and policy-making

Need to engage private sector in financial sector development and reform directions

9

Capital Market Integration: next stepsde Brouwer and Allan (Australian Treasury 2005)

Three steps in advancing cross-border activity:

Create transactions platform for cross-border financial tradeAgree on common standards and principlesRemove legal or informal restrictions

Three ConstraintsLack of political willReluctance of private sector to be involvedLimited capacity to analyze, formulate and implement any consensus on direction, sequencing and process

10

Market-Driven Regional IntegrationSakakibara and Yamakawa (Keio Jun 2003)

Integration in Europe and Asia followed different paths. EU was politically drivenRegional integration is being driven by market driven supply chain integration, rather than explicit policyJapan and China have central roles in this production networksAsian crisis demonstrated vulnerability of Asian financial system and lack of global lender of last resortCrisis demonstrated that IFIs + APEC/ASEAN not much help in stopping contagion

11

Need for Regional InstitutionSakakibara and Yamakawa (Keio 2003)

Asian institution will be countervailing force to non-Asian dominance of IFIs and increase global voice and competitionMarket fundamentalism in IFIs lack local knowledgeRegional institution can push necessary structural reforms essential for regional integration [EU institutions are strong example to transform projects into reality]If there is no credible global lender of last resort, and sole reliance on reserves is inadequate, regional cooperative solution can helpAsia needs to integrate to balance strong EU and NAFTA politically and economically

12

Consensus Building ASEAN-way

Consensus decision-making, accommodation of interest of others,

Non-interference in the internal affairs of neighbours

Enhancing political stability and neutrality

13

Benefits of Asian Bond MarketsMasahiro Kawai (ADB Institute Oct 2005)

Deep and liquid Asian bond market can solve “double mismatch problem” – currency and maturity mismatchesLocal East Asia currency bonds rose from US$356 bn in 1997 to US$1.2 trn by 2003, but only 3% of global local currency bond marketABF development initiative of EMEAP, ASEAN+3 Finance Ministers, APEC Finance Ministers and Asia Cooperation DialogueBIS involvement key to technical cooperation

14

ABF1 & 2

ABF1, June 2003 – US$1 bn, invested in sovereign and quasi-sovereign USD bonds issued by 8 members (exc. JP, AU & NZ)ABF2, Dec 2004 – US$2 bn, Pan-Asian Bond Index Fund (PAIF) investing in sovereign and quasi-sovereign local currency bond funds issued by 8 membersFund of Bond Funds with 8 country sub funds, open to investment by public4 ASEAN+3 working groups working on new securitized debt instruments, credit guarantee mechanisms, fx transactions and settlement issues, rating systems.

15

Financial Integration challenges

No mechanism to involve regulators in regional integration issues [securities regulators not involved in ABF1 & 2]Unintentional barriers against each other stronger than against non-Asian financial firms [e.g. Irish bonds and Luxembourg mutual funds can trade anywhere in Asia, but not Asian bonds and Asian registered mutual funds]IOSCO standards exist, but APRC still trying to devise implementation strategy, shortage of fundingASEAN beginning to look at exchange cooperation and market integration issues, with ministerial working groups set up.

16

Asian Bond Corporation (Beyond ABF)Prof. Taka Ito (Euro 50 Group, Jun 2003)

Asian Basket Currency (ABC) initiative - Asian currencies issue local currency bonds. Asian Bond Corporation would buy these bonds, funded by ABC bonds. Japanese investors would like regional basket bonds because of yieldAs ABC moves forward, introduction of ACU would be more feasible.Outside currency share in ACU basket would be reduced and Asian currency share would be increased.

17

Asian Monetary Institute as precursor to AMFK. Fukushima (NRI, Feb 2004)

Functions of AMIProvide intellectual infrastructure for ASEAN+3 cooperation

Study and make proposals for financial cooperation

Educate public and disseminate information

Hub of a network

Eventual creation of Asian Lender of Last Resort (Japan willing to take that role)

18

What Next? 6 Degrees of Separation

Sharing of InformationArrangements to lend moneyImproving local financial infrastructureStabilize Exchange RatesDomestic policies adjusted to meet explicit exchange rate goalsMonetary union – single ACU

Glenn Stevens (RBA, Oct 2005) – we are currently in steps 1-3.

19

Chinese ViewsYu Yongding (KIEP/PRI, Dec 2004)

AMF 1997 was stillborn because of lack of communication

China cannot consider serious regional monetary or financial integration until capital account is liberalized and internal financial fragility resolved

Complete liberalization of capital account should be final step of China’s economic transformation. If liberalization before financial house is put in order, the 5% swing of Chinese household saving deposits would be sufficient to trigger a currency crisis in China (Goldstein 2004)

Main function of East Asian financial architecture should include exchange of information, promoting transparency and providing rescue packages.

20

Chinese MoF/CASS studyYu Yongding (Dec. 2004)

Focus of efforts in promotion of exchange rate coordination in East Asia should shift to construction of fundamentals, while studies of coordination are continued:-

Formal and regular dialogue on exchange rate policy should be introduced ASAPRegional exchange rate stability should be jointly announced. More stable exchange rate between USD and Yen should be achieved through US-Japan bilateral effortsSet of financial integration arrangements and domestic financial reform plans can be introduced e.g. ABFRegional investment bank can be introducedEstablishing ACU would be ultimate goal, but this implies that East Asians are aiming at Asian Economic Union. This is beyond economics.

21

Hong Kong viewsTony Latter (HKIMR, Jun 2005)

Joseph Yam noted possibility of monetary union to strengthen regional financial stability (Oct 2004), but AMU not formally on agenda.

Greater regional role

Help international balance

Larger financial market

Possible costs of defense of AERM

Eliminate competitive devaluation

No capital controlsCollective discipline

Higher risk of contagionStabler prices

Loss of monetary autonomyGreater trade

Case AgainstCase For

22

Korean viewsYung Chul Park (Korea University, Jun 2003)

Liquidity arrangements under CMI cannot be taken seriously as means to fend off future crises. CMI must move towards AMF despite EU/US opposition.Two basic problems in deciding whether Asian Monetary Integration is desirable:-

No tradition of integrationist thinking in AsiaStatus of any Asian monetary integration in world economy (stumbling block or building block in global integration?)

Difficult to see China-Japan military conflict - rivalry between two will be defined by economic interests and politics will be put aside.

23

Thai viewsThirachai (Bank of Thailand, Jun 2003)

Five points:Events not leading towards monetary union from Thai point of view. Economic integration is not as tight - Asians are still more competitors than cooperative membersFinancial integration is already high, even though economic integration is not. CMI insufficient to deal with capital flows, but local bond markets will help.ABF is to get local bond markets to become viable alternative to capital flowsReal benefits of ABF will come from local currency bond issuance.

24

AMU: Next StepsTony Latter (HKIMR Jun 2005)

Should focus only on three issues:Construct operating framework for AMS as first step to AMUMake institutional preparations for Asian monetary institutionsExamine what sort of monetary regime might prevail

Three possible approachesAn “outside” currency basketA “major” currency basketAn “internal” currency basket

25

A Modular Approach to CooperationMario Arturo Ruiz Estrada (June 2005)

26

SWOT Analysis

Threats:

Continued local crises and destruction of retirement savings

Weaknesses: Fragmented markets, NPLs, lack of local skills, protectionist tendencies

Opportunities:

Third global time zone capital market – Asian currency zone

Strengths: High growth and high savings, key global time zone

27

Realistic Next Steps

Discussion cannot outrun the politicsCurrently no political will, no leadership nor widespread support for AMUCommon grounds:-

Fear of another crisisWant more say in global architectureBut in reality, Non-Asian trade still more important than intra-regional trade

Hence, more jaw-jaw and movements at the margin e.g. ABF3 or political agreement to accelerate regulatory “mutual recognition” as basis for financial integration

28

Roadblocks

Japan-China dialogue; US/EU viewsWill the Asian Lender of Last Resort please stand up?Too many internal silos and institutional rivalries [MoF, Central Banks, Financial Regulators, Local Lobbies]Private sector hardly brought into pictureNo pan-Asian NGO to play catalytic role of researching and stimulating debate [Asian Monetary Institute?]

29

Network Perspective

Three layers: Code, Infrastructure and Network BehaviourGlobal Codes are now available: Asians can implement Global Codes [e.g. Basle II, IOSCO Principles etc] through mutual assistance and mutual recognition [not harmonization]Infrastructure: Again, implementation of CPSS/G30, mutual recognition of Asian products (e.g. ETFs and ABFs) to facilitate regional marketNot clear that ACU will prove to be superior standard vs. Euro or USD. Hence, leading components of ACU basket have to be prepared to offer substantial benefits to others for links to ACU to occur.

30

Bottom-Line Assessment

Conditions for AMU are not quite ready, but financial and trade integration already proceedingAsians need to define:-

Real benefits of AMUObjectives and realistic outcomesStrategic assessments of “global fit”

Reform is a process, but for it to succeed, time has arrived to put issues on the table and to map out “process to manage the roadmap, where final destination is still not clear”.

31

Thank you. Q & A