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China and monetary integration in East Asia.

Flaws in East Asia's original exchange rate regime were exposed in the aftermath of the Asian Financial Crisis of 1997-98. Without a regional monetary coordination mechanism, the uncoordinated exchange rate policies of the region meant their economies were vulnerable to fluctuations in exchange rates with the world's major currencies. The Asian Financial Crisis gave much impetus to the quickening pace of East Asian cooperation. The Chiang Mai Initiative (CMI) was agreed upon in May 2000 to provide liquidity support and manage currency crises, and the Asian Bond Initiative (ABI) was endorsed in August 2003 to develop the regional and domestic financial market and improve regional financial cooperation.

The Chinese economy is set to become the most important in the region and the government is now taking serious steps to integrate it into the world economy. In this article, we focus on the potential role of the Chinese economy in the process of regional integration. In particular, we attempt to make some proposals for East Asian monetary coordination and pay more attention to the potential role of the Chinese renminbi (RMB) in a regional basket arrangement.

The Progress of East Asian Cooperation

On 15 December 1997, the first "10 + 3" (ten ASEAN countries plus China, Japan and Republic of Korea) leaders' meeting was held in Kuala Lumpur. (1) The main topic was how to overcome the Asian Financial Crisis. In the following few years following this meeting, remarkable progress has been achieved. The most significant achievements are these:

* A joint statement was issued on the direction and areas of the regional cooperation in 1999, and for the first time the East Asia Vision Group presented their long-term vision for the East Asian region: a free trade and investment area for East Asia, with gradual institution building towards a regional community.

* Institutional infrastructure for cooperation has been developed: leaders' annual meeting, ministers' meetings, senior officials' meeting and functional programmes.

* Financial and monetary cooperation represented by the CMI and regional financial surveillance has become a reality, and the "Greater Mekong River Development Project" was put into the framework of East Asian cooperation.

* China and ASEAN announced plans in 2001 to develop a free trade zone within ten years' time.

* Agreements were made at the ASEAN+3 Finance Ministers' Meeting in Istanbul in May 2005 to further develop the Chiang Mai Swap Mechanism. As of early May 2006, the mechanism had increased by 90 per cent in size from USD39.5 billion to USD75 billion. Moreover, the percentage of automatic drawing rose from 10 to 20 per cent. The latest ASEAN+3 Finance Ministers' Meeting clearly stated that the CMI should be multi-lateralised and finance ministers agreed to build up a self-managed reserve pooling arrangement.

China's Role in East Asian Monetary Integration

In recent years, China has become more interested in regional economic cooperation. This reflects the closer economic ties between China and the rest of East Asia. There are also many potential benefits that China and the other East Asian countries can get from China's participation in regional monetary integration.

Trade Patterns

Fixed exchange rates and monetary cooperation create benefits such as a reduction in the transaction costs associated with bilateral trade and investment. Countries with close trade links should therefore benefit from fixed exchange rates and monetary integration. It is therefore remarkable that several studies argue that East Asia is at least as well integrated as Europe in terms of intraregional trade. (2)

Recent trade data show that intra-regional trade among East Asian countries as a share of GDP is already similar to that of the Economic and Monetary Union of the European Union, and higher than that of other regions such as the North American Free Trade Agreement or Mercado Comun del Sur, or common market of the South (Mercosur). Moreover, the growth rate of intra-regional trade is higher in East Asia than in other areas (see Table 1).

In this process of increasing regional integration, China serves as the engine of intra-regional trade growth in the region. This can be investigated using the Trade Intensity Index (TII). (3) Table 2 shows that the TII between China and the East Asian emerging economies has accelerated since the late 1980s, and now the trade level between among them is much higher than their average trade levels.

From the 1970s to 1990s, a "triangle trade" pattern emerged in East Asia, that is, the East Asian emerging economies import capital goods from Japan and export the final products to the United States. Thus they had a trade deficit with Japan and a trade surplus with the US. In this hub-spoke structure, Japan was the hub, the others are the spokes. (4) However, in recent years, as China's output and foreign trade grew, this trade pattern has changed. A "new triangle trade" pattern has emerged, that is, the other East Asian economies export the capital goods, such as intermediate, parts and some materials to China, and the latter export the final products out of the region. (5) This phenomenon can be observed through the trade balances of these economies. From Table 3 it can be seen that after 1997, China's deficit with South Korea, Taiwan and ASEAN and its surplus against the US and the EU increased rapidly. Roland-Holst's research argues that this pattern will be further confirmed by 2020. It is likely that China is substituting the US as the main "market provider" of the other East Asian economies, as the decentralising of the production process in the region were decentralised and the export of capital goods was also decentralised, but the import of capital goods became concentrated on China. At the same time, Japan's trade status in the region gradually decreased. It is likely that in this new hub-spoke structure, China is more like the hub. The change of China's status in the region implies that if there is a regional exchange rate arrangement, China must be included and play an important role: it is necessary for both China and the other countries.

Capital Flows and Investment

Parallel to trade, Asia shows a high degree of intra-regional concentration of capital flows. In 1990 China attracted 54 per cent of its total foreign direct investment (FDI) from adjacent partners--Japan, Hong Kong, Taiwan and Singapore--compared with 58 per cent in 1996 and 61 per cent in 1999. Japan contributed 712 [yen] billion in FDI to Asian countries (27.8 per cent of total Japanese FDI outflow). In 1996 Japan's FDI in Asia increased to 1,305 [yen] billion (52.7 per cent of its total FDI outflow). During the 1990s, South Korean FDI outflow to Asian countries was more than 43 per cent of its total FDI; in contrast, its FDI to North America dropped from 34.6 per cent in the early 1990s to 24.6 per cent in the late 1990s. (6) China's officially approved investment in Southeast Asia increased from USD72 million in 1999 to USD4 billion in 2005, (7) reflecting an annual increase of 60 per cent in recent years. Now China has begun an outward investment campaign and the government has encouraged Chinese companies to invest in major engineering and construction projects in the region. Thus capital flows between China and Asian countries will increase in the future. Increased intra-regional capital flows reflect regional industrial integration and result in increased industrial and technological transfer, another important aspect of regional interdependence. They also make regional economic integration more likely.

Macroeconomic Policy and Inflation Differentials

Generally speaking, the more consistent a political objective, the easier the coordination in monetary cooperation among countries when facing supply and demand shocks. Some important indexes to be measured are consistency of every country's policies and the inflation rate, unemployment rate and ratio of deficit to GDP. Among them, the inflation rate is the most important index.

Large inflation differentials could cause loss of monetary policy autonomy, implying cross-country differentials in real interest rates and making a common monetary policy difficult to implement. From Table 4 we can see that the average inflation rate and the variance of the inflation rate in Asia are considerable lower than in the early European Exchange Rate Mechanism (ERM). The average inflation rate in China was 0.87 from 1997 to 2005 which was lower than that in most other Asian countries. (8) Large and only slowly converging inflation differentials had been a main problem of the early ERM. Germany had relatively low rates while other members had initially considerable higher rates, so that the ERM became a nominal anchor for some member states. A comparison between the early years of ERM and the current situation in Asia suggests that East Asia is likely to experience fewer problems than ERM members during the early years.

Monetary Integration in East Asia

Although there are many explicit and potential benefits that the regional exchange rate coordination can provide, there is no such mechanism now. The exchange rate policies of the East Asian economies are almost totally independent, and their de jure exchange rate regimes are quite different.

The Evolution of Exchange Rate Arrangement in Asia

Recalling the range of exchange-rate arrangements prevailing in Asia before the Asian Financial Crisis, at one extreme, Japan had a floating exchange rate, although it engaged in substantial intervention to influence the path and rate of change of the yen-dollar. Hong Kong and Brunei had even stricter currency-board regimes, based on the US dollar and Singapore dollar, respectively. As for the other ASEAN countries and Korea, most of them described themselves officially as having flexible exchange rates, though numerous studies have shown that most of them pegged their currencies more or less firmly to the US dollar, partaking in what Ronald McKinnon described as the Asian dollar standard. (9)

During and after the Asian crisis, however, most of the ASEAN countries began to do what they had claimed to do before--letting their exchange rates fluctuate more freely. Malaysia was the clear exception, as it switched to a strict dollar peg backed by the imposition of new capital controls. In July 2005, however, Malaysia loosened its tie to the US dollar.

Before China's exchange rate reform in July 2005, the exchange rate regime was similar to what the emerging Asian countries adopted before the Asian Financial Crisis, i.e., a dollar-pegging system. After the exchange rate reform, China's monetary authority announced that a managed floating regime with reference to a currency basket was adopted, and the member currencies of the referenced basket were also indirectly announced.

Yibing Ding used Frankel and Wei's empirical analytical method to analyse the actual arrangement of RMB. (10) The result is that China's current exchange rate arrangement is like the arrangements of the East Asian emerging countries after they abandoned the dollar-pegging system (the Malaysian exchange rate arrangement after July 2005 has the same character). They all did not actually adopt the managed floating or basket arrangements as they announced. Otherwise their de facto exchange rate arrangements would be more like a soft peg to the US dollar.

Proposals for East Asian Monetary Coordination

While we currently see no prospects for an immediate full monetary integration among the East Asian currencies, we think it could be carried out in three stages:

1. Expanding of the Chiang Mai Swap Agreement to Deal with an Emergency Situation

The CMI's main aims are to extend the original ASEAN swap arrangement and to establish a network of bilateral swap and re-purchase agreement facilities. Ever since then, swap arrangements under the CMI have made some progress. During the ASEAN+3 Finance Ministers meeting in May 2007, they unanimously agreed in principle to build up a sell-managed reserve pooling arrangement governed by a single contractual agreement. However, the CMI has additional shortcomings: First, it does not yet have an operational structure, in particular a monitoring and surveillance mechanism. In addition, most of the financing resources are still tied to IMF assistance. Also, the amount of liquidity currently available through CMI is relatively small compared to the size of past financial rescue packages for the East Asian crisis-hit countries.

The CMI is the most substantial mechanism for monetary and financial cooperation in East Asia but much work remains to be done in this regard. We propose the following: First, expand the size of the CMI. The committed financial assistance from the community during the Asian Financial Crisis was USD110 billion. A reasonable size for performing the function mentioned above is thus between USD100 and 110 billion.

Second, set up an independent monitoring and surveillance institution. The swap arrangement is intended to be a preventive measure for providing support for the balance of payments and short-term liquidity. If CMI is to function effectively, providing added value to existing mechanisms, the network of Bilateral Swap Arrangements will need to establish a very good regional surveillance institution. Its monitoring activities in general cover macroeconomic trends, financial market development and structural change. This institution is also required to make reasonably strict criteria for ASEAN+3 member countries in terms of fiscal balance, economic growth, inflation, capital flows, international reserves and the current account balance. This system would contribute to lowering its risk premium in international capital markets. If a crisis still occurred, interim financing could become available immediately without the need to implement normal IMF conditionality, since presumably these countries would have met such conditions beforehand.

Third, gradually transform the standby credit into the East Asian Reserve Cooperation Fund. By the end of 2006, East Asian foreign reserves reached USD3 trillion, accounting for 60 per cent of the world's total. Despite the importance of foreign exchange reserves in maintaining investor confidence and managing exchange market pressure, countries should seek to balance the opportunity costs of holding large amounts of reserves against the perceived benefits. The East Asian Reserve Cooperation Fund is the way to enable ASEAN+3 countries to improve efficiency in the use of financial resources. This is an effective way to integrate regional financial and monetary arrangements. This approach may differ from a real monetary fund. Our proposal is for ASEAN+3 member countries to pool a portion of their reserves to create a reserve cooperation fund for themselves. The credit quotas in each bilateral agreement could be pooled to help member states in an emergency situation.

Adopting a Common Basket Peg

The CMI can contribute to supporting countries facing short term liquidity difficulties in the region, and is a stepping-stone for launching full-fledged Asian monetary cooperation. The monetary authorities of ASEAN+3 have recognised that monetary and financial cooperation is necessary for preventing and managing a future currency crisis, but there is no such mechanism now and it seems that a formal monetary cooperation mechanism can hardly be accepted by the whole region in the near future. One of the measures to solve the coordination failure would be for them to adopt a common exchange rate policy. Recent trade data show that intra-regional trade in East Asia amounts to over 55 per cent of its total trade volume, nearing that in the European Union (64 per cent). (11) Thus, essential for a high degree of intra-regional trade is a common exchange rate policy to promote trade, investment and economic growth.

In choosing among regional exchange rate arrangements, East Asian countries face a number of alternatives for joint action. They could adopt a single currency to float jointly against other currencies. In addition, East Asian countries could commonly agree or independently choose to peg their currencies to a single currency or a basket.

Despite policy recommendations to pursue more exchange rate flexibility, fully flexible exchange rates are unlikely in the initial East Asian monetary integration. This is because it needs very high-level policy integration and intra-regional exchange rate stabilisation which allows them to float commonly against the euro or dollar. Instead, as the second stage to integrate finance they will tend to stabilise exchange rates in the form of tight or soft pegs based on the smoothing of daily, monthly and yearly exchange rate fluctuations. One way for the ASEAN+3 countries to stabilise their currencies is to peg to one of the major currencies. For example, most of the East Asian countries pegged their currencies to the US dollar before the Asian currency crisis. McKinnon argues that an important virtue of a common US dollar peg for the region is that it would reduce intra-regional exchange rate instability.12 However, if a country pegs its currency to the US dollar, there is a possible risk of deviating its effective exchange rate from a desirable level. The Asian currency crisis taught us that the dollar peg was not the most desirable exchange rate regime in the region.

On the other hand, pegging to a common currency basket with trade-based basket weights could stabilise the effective exchange rate. John Williamson indicates that shifting from a single-currency peg to a basket (which he calls a basket numeraire) is beneficial and can be constructed in a manner that is neither complicated nor results in a lack of transparency. (13) He supports a joint basket, because only this approach he argues, guarantees that changes in external exchange rates do not disturb the intra-regional rates. Kawai and Takagi recommend that a G3 currency basket system preserves both flexibility and stability in order to promote international trade, foreign direct investments and economic developments. (14) Williamson also shows that the economies in question would lose little in terms of stabilising their effective exchange rates by all using the same basket rather than adopting different baskets based on their individual trade patterns.

When deciding to adopt a common currency basket, countries have to decide whether the basket should include only an external basket containing the currencies of outsiders, only an internal basket containing the currencies of the participating countries, or a mixture of the two. Adopting an external basket would confer a degree of exchange rate stability between the participating countries and the set of currencies entering the basket. However, the group of countries imports, to some degree, the monetary policies of the countries whose currencies comprise the external basket. By adopting instead an internal basket, the participating countries would contain the bilateral exchange rates of the member countries but let them float collectively vis-a-vis outside currencies, and this regime needs strong policy integration. So we suggest an internal basket including all member countries would be adopted at the third stage towards a monetary union, and a mixed major internal and external currency basket would be used as a transition mechanism toward monetary union of the region.

There is a large literature on the structure of the East Asian currency baskets. (15) The basket composition proposed by Williamson is straight forward: the dollar should have a weighting of 40.2 per cent, the euro of 31.6 per cent, and yen 28.2 per cent. However, the chief drawback of the G3 currency basket is that it ignores the function of RMB in the region. East Asian countries have strong economic relationships with not only the US, Japan and EU, but also China. We suggest the currency basket would consist of four currencies: dollar, euro, yen and RMB. There are some compelling reasons for including the RMB in the basket.

First, the Chinese currency is one of the world's principal currencies. It is not a key currency in the conventional sense, and it cannot become one until it is fully convertible. Even today, however, the RMB-dollar exchange rate may be more important for the proper functioning of the international monetary system than the dollar-euro rate or dollar-yen rate. There is, in other words, a need to replace the present G-7 with a new G-4, to oversee the macroeconomic management of the world economy. It would comprise China, the Euro Area, Japan and the United States. (16)

Second, all sampled East Asian countries have strong trade relationships with China. Shioji Eturo states that China's choice of its exchange rate regime interacts with the rest of what East Asia chooses. (17) Theoretically, for example, China's increase of basket weight for the Japanese yen would increase other East Asian countries' basket weights on the Japanese yen. These results indicate that a common currency basket could be developed from a de facto dollar peg system to a managed floating exchange rate system with reference to a currency basket. Thus China would gradually increase G3 basket weights consistent with the East Asian countries.

Third, an Asian monetary union could not readily include Japan without including China, and could not readily include China without including Japan. The Asian currencies have been pegged to the dollar in the past, and this is no longer a solution for the future. The dollar is losing ground because trade shifts from the US towards more regionally concentrated trade, and the yen is not set to assume the role of the dollar. Apart from political reasons, the Japanese economy is likely to lose relative weight against the Chinese economy. The Chinese currency is becoming a regional major currency. Ogawa indicated that a currency basket should consist of regional major currencies. (18) This prospect must be taken into consideration when planning monetary cooperation.

Finally, the correlation between the RMB and other regional currencies has been increasing. From Table 5 which shows the correlation of exchange rate (versus dollar) movements among Asian economies before 1997, it can be seen that the correlations are either low or negative, reflecting the fact that there is no exchange rate coordination and the exchange rate policies of the East Asian countries are considerably independent. However, after the Asian Financial Crisis we can see that the correlations among the crisis-affected countries increase with an obvious exception of China, though the corresponding movements are not the results of the initial cooperation behaviour, but these passive reactions provide a foundation for initiative exchange rate policy coordination. Table 5 also shows the correlations of the daily exchange rates of Asian currencies against the US dollar after China's reform. It can be seen that the correlations between the RMB and the other regional currencies changed from negative to significantly positive, thus further raising the feasibility and possibility of regional exchange rate policy coordination.

Next, we estimate the common four-currency basket weight. We apply the Ogawa et al formula to calculate weights on the four major currencies for East Asian currencies. (19) Suppose that country A adopts a currency basket system where currency A is pegged to a currency basket composed of the four currencies (the US dollar, Japanese yen, RMB and euro), currency B and currency C. Country B adopts a currency basket system where currency B is pegged to a currency basket composed of the four currencies. Country C adopts a dollar peg system where currency C is pegged to the US dollar. These exchange rate systems are shown in the following equations:

Currency A = [W.sub.A,USD] * USD + [W.sub.A,JPY] * JPY + [W.sub.A,euro] * euro + [W.sub.A,RMB] * RMB + [W.sub.A,B] * CurrencyB + [W.sub.A,C] * CurrencyC

Currency B = [W.sub.A,USD] * USD + [W.sub.B,JPY] * JPY + [W.sub.B,euro] * euro + [W.sub.B,RMB] * RMB

Currency C = [W.sub.C,USD] * USD

where Wi,j: weight on currency j in its currency basket for currency i, currency A, B, C, USD, JPY, euro and RMB are exchange rates of the relevant currencies, respectively. Then, currency A's basket weights are converted only to the weights of four major currencies as follows:

Currency A = ([W.sub.A,USD] + [W.sub.A,B] * [W.sub.A,USD] + [W.sub.A,C] * [W.sub.C,USD]) * USD + ([W.sub.A,JPY] + [W.sub.A,B] * [W.sub.B,JPY]) * JPY +([W.sub.A,euro] + [W.sub.A,B] * [W.sub.B,euro]) * euro+ ([W.sub.A,RMB] + [W.sub.A,B] * [W.sub.B,RMB]) * RMB

Table 6 shows the estimated four-currency basket weights. We apply ASEAN+3 weights from Ogawa et al. to estimate the common four-currency basket weights. Table 7 shows the results, with the weights of 0.35 for the dollar, 0.29 for the euro, 0.22 for the yen and 0.14 for the RMB.

Another major problem of a common basket system would be the choice of bands. The common basket system would make allowances for bands around central parities and possibly for rates of crawl of the parities themselves. George Halm suggested that "wide" might be +/- 6 per cent, but after the 1993 ERM crisis, the Europeans went to +/- 15 per cent, so wide margins might reduce the likelihood of exchange rate crisis and there is ample scope for selecting a figure to suit local tastes. (20)

Establishing the Asian Monetary Unit (AMU)

When the first two stages work successfully, we could move to the third stage: establishment of an AMU currency basket. The main difference between a common basket peg system and the AMU currency basket system is that the former pegs to external currencies or a mixture of external and internal currencies, such as the US dollar, euro, Japanese yen and RMB, while the latter pegs to the regional currencies. The AMU would be defined as a fixed member of units of each constituent currency comprised of all regional currencies, including the ten ASEAN currencies plus the Japanese yen, RMB and South Korean won.

Comparing a regional currency basket with a common currency basket, we find the former has more advantages. The most apparent benefit of a common currency basket is that it keeps trade competitiveness relatively stable. There are at least four other benefits of a regional currency basket. Firstly, it will stabilise intra-regional exchange rates. Secondly, it will bring a more stable nominal effective exchange rate within the region. Ogawa and Shimizu investigated the stabilisation effects of a common AMU currency basket peg system on East Asian currencies and showed that a common AMU peg system would be more effective in reducing fluctuation in the effective exchange rate than the common G3 basket peg system for some East Asian currencies. (21) Thirdly, the AMU will increase the influence of the yen, RMB, or other major currencies within the region. To keep the regional currencies peg, the East Asia economies will tend to hold more regional currencies. The increased use of local currencies can also help the development of regional currency denominated bond markets. Fourthly, the AMU could reduce the possibility of beggar-thy-neighbour devaluation and strengthen East Asia's voice in the international finance arena.

To promote establishment of an AMU, consider the following steps:

(a) member countries should cooperate with each other to reform the domestic financial system as well as to enhance intra-regional financial integration arrangements. At that time the AMU and AMU deviation indicator should be used to conduct surveillance on the exchange rates and exchange rate policies. This step also requires convertibility of participating currencies to the AMU.

(b) member countries would accelerate the deepening of markets for AMU-based instruments. The AMU needs benchmark issuances such as 5, 10 and 30-year treasury notes and bonds. The existence of these benchmarks would make it more attractive for financial and non-financial firms to issue and accept AMU-denominated liabilities and assets, subject to standard prudential regulations. Bond or deposit documentation would specify that when the composition of the official AMU basket changed, the value of private AMU assets and liabilities would change accordingly. The value of the private AMU would be guaranteed by the commitment of the issuer (such as a bank accepting a deposit) to convert the instrument into its underlying components. Arbitrage would in any case prevent significant divergences from opening up between the value of the private AMU and the constituent currencies.

(c) some ASEAN+3 states would introduce a bilateral grid method based on the AMU to conduct a certain amount of intervention in foreign exchange markets of the relevant intra-regional exchange rates. An Asian Exchange Rate Mechanism should be established for coordinated intervention. This is similar to the Exchange Rate Mechanism under the European Exchange Rate Mechanism prior to the introduction of the euro.

(d) the AMU would choose an anchor currency. Robert Mundell maintains that a monetary union would be best for East Asia and he suggests that this requires the choice of an anchor currency. (22) But which currency would be a suitable anchor? The first-best solution would be an internal anchor. For economic and political reasons the choice is limited in Asia: Either the yen or the RMB could in principle be used as anchors.

Japan evidently continues to be the economic heavyweight in the region with a GDP that is several times larger than China's. Japan is the world's largest creditor nation and inflation rates have been very low for several decades. Although the Japanese currency possesses some qualities an anchor currency should have, much remains to be desired. The Japanese economy is by and large still crippled by the 15-year-long recession that started in 1990. The macro economy is still in a mess. Gross government liabilities will reach about 170 per cent of GDP in 2005, far above any other OECD country. The financial sector still suffers from the aftermath of the simultaneous bubbles in the stock and real estate markets in the 1980s. In addition, perhaps the most significant problem is the volatility that the yen has shown vis-a-vis the dollar. No country would choose an anchor that would provide increased external volatility, instead of stability.

From today's point of view, the only option for an internal anchor is the RMB if current trends continue. By 2010, China might have solved the problems of its financial system and demonstrated its ability to provide a relatively stable exchange rate vis-a-vis the rest of the world.

The introduction of an AMU has naturally raised the question: what is the appropriate geographic scope of an AMU? Should the monetary union span ASEAN plus China, South Korea and Japan rather than just ASEAN alone, or should it have a wider scope, such as ASEAN+6 (the East Asia summit group comprising ASEAN+3, Australia, New Zealand and India)?

A smaller regional grouping, such as ASEAN alone, would be inadequate. Before 1997, swap agreements already existed between some ASEAN members, but these were ineffective in containing the 1997 crisis. One diagnosis of this failure was inadequate scale. Hence, the new arrangement encompassing not just ASEAN but also China, Japan and Korea, marshals more than 3 trillion worth of reserves. Some authors compare welfare in an ASEAN+3 and a smaller grouping. Using a computable general equilibrium model, Masahiro Kawai et al. show that a broader membership will bring a larger income than a narrower one. (23) Gilbert et al. use the Global Trade Analysis Project (GTAP) and find that an ASEAN+3 FTA will produce higher welfare gains for members than a narrower ASEAN, indicating that broadening FTAs in East Asia brings more benefits. (24)

A wider scope would not easily achieve deep monetary integration. Expanding without limit, i.e., ASEAN+7, ASEAN+8 etc., would be akin to another APEC in East Asia. Nonetheless, APEC's prominence appears to have declined since the Asian Financial Crisis because of its inability to effectively respond to the crisis. Judging from global experience to date, the member countries at the initial stage of regional cooperation should be kept to the appropriate members because a monetary union with a limited number of countries can relatively easily achieve deep integration, while a monetary union with a large number of countries may have to compromise on depth. The initial EU member countries were only 6 but there are now 27. This is very relevant. We exclude India because its direction of trade is substantially different from that of East Asia, with a much more substantial volume of trade with Europe and markedly less with Japan and the rest of East Asia. India has relatively high import tariffs (15.7 per cent) and longer time is required for imports to take place (41 days) than the averages for ASEAN (9.5 per cent and 32 days, respectively). Further structural reforms in India will therefore be required before it initiates formal ASEAN+6 FTA negotiations.

ASEAN+3 is the logical grouping. It includes the three large Asian countries and can build on an already existing institutional infrastructure. Not only heads of state but also finance, economics and senior officials already meet regularly under its aegis. As discussed earlier, the existing network of swap arrangements among this grouping of countries had already begun to stimulate efforts to establish a unified policy dialog or surveillance group that would meet on a more regular basis than is now the case for finance ministers or deputies. Thus, ASEAN+3 already possesses an infrastructure of regular meetings, a pool of financial resources and a presumption that national policies are a matter of common concern.

Hence we think the appropriate sequencing could be to start with ASEAN+3 and then expand member countries as conditions are created for ensuring sufficient depth of integration within member countries.


This article discusses the progress of East Asian financial cooperation and analyses the role of China in the East Asian monetary system. We find China's role is obvious based on: (i) extensive and growing Chinese and regional trade; (ii) a high concentration of Chinese and regional capital flows; and (iii) a lower inflation rate.

East Asian exchange rate cooperation is also discussed. We see no prospects for an immediate full monetary integration among the East Asian currencies at the moment, thus propose three stages towards monetary union: firstly expansion of the Chiang Mai Swap, and secondly, adoption of a common currency basket. We suggest adopting a four-currency basket, including the US dollar, euro, Japanese yen and RMB. The third stage is to establish the Asian monetary unit. We believe that ASEAN+3 is the logical grouping for initial monetary cooperation.

East Asian cooperation is evolving and will require several generations. It took half century for Europe to fulfil its dream of real integration, it will probably take longer for East Asia.

(1) At that time the grouping was 9 + 3.

(2) Wyplosz uses a gravity approach to determine a "normal level" of bilateral trade among Asian and European economies, and compares that with the actual levels. It appears that Asia is more and Europe less integrated than one would expect on the basis of the gravity approach. See C. Wyplosz, "A Monetary Union in Asia? Some European Lessons", Mimeo, Graduate Institute for International Studies (2001). Gilbert et al. establish a natural free trade area in Asia that includes China as well, and propose a free trade area of ASEAN+3 (China, Japan and South Korea). See J. Gilbert, R. Scollay and B. Bora, "Assessing Regional Trading Arrangements in the Asia-Pacific", Policy Issues in International Trade and Commodities Studies Series 15 (Geneva: UNCTAD, 2001).

(3) The Trade Intensity Index (TII) can be expressed as: TIIij = [Tij/Tw]/[(Ti/Xw)(Tj/Xw)] = (Tij/Xi)/(Tj/Tw) where Tij is the trade value between country i and country j, Ti is the total trade value of country i, Tj is the total trade value of country j, and Tw is the total trade value of the whole world. This index shows the relative level of trade between country i and country j to the trade between country j and the whole world. The higher the TII is, the closer the trade relations between i and j. If TII>1, the trade relations between i and j will be closer than the average level of j's foreign trade relations.

(4) See Li Xiao and Ding Yibing, "East Asian Regional Cooperation: China's Role and Effect", Jilin University Journal of Social Sciences Edition (March 2004): 81-7.

(5) See Yibing Ding, "Chinese Perspective of East Asian Exchange Rate Coordination", Conference Papers, East Asian Monetary Cooperation and China's Perspective, 24 Aug. 2006.

(6) See Chang Soo Lee, "Korea's FDI: Choice of Location and Effect on Trade", Korean Institute for International Economic Policy Working Paper 02-07, 2002.

(7) See Chinese National Bureau of Statistics at <> [Aug. 2008].

(8) See China Statistical Yearbook 2006.

(9) See Ronald I. Mckinnon, "After the Crisis, the East Asian Dollar Standard Resurrected: An Interpretation of High-Frequency Exchange-Rate Pegging" (Stanford: Stanford University Press 2000) and "After the Crisis, the East Asian Dollar Standard 15 Resurrected", in Monetary and Financial Management in the 21th Century, ed. A.H.H. Tan (Singapore: World Scientific, 2002).

(10) Jeffrey A. Frankel and Shang-Jin Wei, "Yen Bloc or Dollar Bloc? Exchange Rate Policies in East Asian Economies", in Macroeconomic Linkages: Savings, Exchange Rates, and Capital Flows (Chicago: University of Chicago Press, 1994), pp. 295-329.

(11) See Northeast Asian Thinktank (NEAT) Working Group in East Asian Financial Cooperation Report 2007. The NEAT Working Group Meeting on East Asian Financial Cooperation was held in Shanghai, 7-8 April 2007.

(12) Ronald I. McKinnon, "After the Crisis, the East Asian Dollar Standard 15 Resurrected", Monetary and Financial Management in the 21th Century (Singapore: World Scientific, 2002).

(13) John Williamson, "A Currency Basket for East Asia, Not Just China", Policy Briefs in International Economics, no. PB05-1, Institute for International Economics, 2005.

(14) Masahiro Kawai and Shinji Takagi, "Proposed Strategy for a Regional Exchange Rate Arrangement in Post-crisis East Asia", World Bank Policy Research Working Paper no. 2503, 2000. The G3 basket weights proposed by John Williamson are: the dollar should have a weighting of 40.2 per cent, the euro of 31.6 per cent and yen 28.2 per cent.

(15) See Ogawa and Shimizu for a survey of the literature, "Progress toward a Common Currency Basket System in East Asia", RIETI Discussion Paper Series 07-E-002, 2006.

(16) See Peter B. Kenen et al., "International Economic and Financial Cooperation: New Issues, New Actors, New Responses", Geneva and London: International Center for Monetary and Banking Studies and Centre for Economic Policy Research, Ch. 4 (2004).

(17) Shioji Eturo, "Chinese Exchange Rate Regimes and the Optimal Basket Weights for the Rest of East Asia", RIETI Discussion Paper, no. 06-E-024, 2006.

(18) See Ogawa and Shimizu for a survey of the literature, "Progress toward a Common Currency Basket System in East Asia", RIETI Discussion Paper Series 07-E-002, 2006.

(19) Ibid.

(20) George N. Halm, "The 'Band' Proposal: The Limits of Permissible Exchange Rate Fluctuations", Princeton Special Papers in International Economics, no. 6 (1965).

(21) Ogawa and Shimizu, "Progress toward a Common Currency Basket System in East Asia", RIETI Discussion Paper Series 07-E-002, 2006.

(22) Robert A. Mundell, "Prospects For an Asian Currency Area", Journal of Asian Economics, no. 14 (2003): 1-10.

(23) Masahiro Kawai and Ganeshan Wignaraja, "ASEAN+3 or ASEAN+6: Which Way Forward", ADB Institute Discussion Paper, no. 77, Sept. 2007.

(24) J. Gilbert, R. Scollay and B. Bora, "New Regional Trading Developments in the Asia-Pacific Region", in Global Change and East Asian Policy Initiatives, ed. Shahid Yusuf, M. Anjum Altaf and Kaoru Nabeshima (Washington, DC: World Bank Press, 2004), pp. 121-90.


Liu Zi ( is an Associate Professor in the Financial College, Nanjing University of Finance and Economics and a Visiting Scholar at the Centre for East Asia Studies, University of Bristol. Her main research interests include international economics, development and the Chinese economy.

Chen Jinxia ( is senior researcher at the Nanjing University of Finance and Economics. Her main research interests include monetary policy, financial markets and the Chinese economy.
Table l. Regional Trade Patterns, 1980-2005 (selected years,
percentage of total regional GDP)

 1980 1985 1990

 X M X M X M


Within ASEAN 6.5 5.0 6.1 5.2 8.2 7.4
With Japan 9.9 7.7 8.2 6.1 8.2 11.3
With China 0.4 1.0 0.4 1.5 0.8 1.4
With South Korea 0.6 0.6 0.9 0.6 1.4 1.5
With USA 6.3 5.4 6.3 4.5 8.4 7.1
With Euro Area 4.2 3.3 2.8 3.0 5.1 5.5
With Total World 37.0 35.1 32.4 29.2 43.3 48.9

East Asia (b)

Within East Asia 4.7 5.2 5.5 5.5 5.7 5.8
With Total World 15.3 16.2 16.6 14.7 15.8 14.8
Euro Area (c)
Within Euro Area 11.0 10.8 12.1 11.9 12.2 12.0
With Total World 21.4 24.4 25.1 25.5 22.1 22.4

 1995 2000 2005

 X M X M X M


Within ASEAN 12.4 10.3 17.3 14.6 16.3 13.8
With Japan 7.2 13.4 10.1 12.4 7.2 8.5
With China 1.4 1.7 2.9 3.3 4.1 4.9
With South Korea 1.6 2.5 2.8 3.1 2.5 3.0
With USA 9.3 7.8 14.3 9.1 11.0 6.9
With Euro Area 5.4 6.3 8.3 5.4 8.1 5.2
With Total World 50.5 56.3 75.2 65.1 68.8 60.1

East Asia (b)

Within East Asia 7.5 7.3 9.4 9.3 10.8 10.4
With Total World 16.8 15.9 22.0 19.1 23.6 21.3
Euro Area (c)
Within Euro Area 11.9 11.0 15.6 14.6 15.5 14.2
With Total World 23.1 21.6 30.8 30.3 30.3 27.9

Notes: X is exports, M is imports.

(a) ASEAN: Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar,
Philippines, Singapore, Thailand and Vietnam.

(b) East Asia: ASEAN plus China, Hong Kong, Japan and Korea.

(c) Euro Area: Austria, Belgium, Finland, France, Germany, Greece,
Ireland, Italy, Luxembourg, Netherlands, Portugal and Spain.

Source: IMFDirection ofTrade Statistics and World Development
Indicators 2006.

Table 2. Trade Intensity Index between China and the Other
East-Asian Economies

 1985 1995 2000 2005

Hong Kong 17.00 25.57 12.26 20.31
South Korea 0.00 5.62 10.39 12.35
Malaysia 0.68 1.96 4.15 5.27
Singapore 0.95 1.79 4.10 5.58
Taiwan, China 2.02 4.75 13.27 15.80
Thailand 2.49 2.22 4.55 5.90

Source: Asian Development Bank, Asian Development
Outlook 2007 Update.

Table 3. Trade Balance between China and the Other
Areas: Current Status and Potential Trends (billions)

 Japan South Korea and Hong Kong ASEAN
 Taiwan, China

1997 3 -19 37 0
2002 -5 -44 48 -8
2003 -58 61 -15
2020 -5 -135 -135 -41

 US EU Rest of the

1997 16 5 -1
2002 43 10 -13
2003 55 18 -22
2020 166 66 71


1. for trade deficit.

2. The data for 2020 are the expected value. See David
Roland-Holst, "An Overview of PRO's Emergence and East
Asian Trade Patterns to 2020", ADB Institute Research
Paper Series, no. 44.

Sources: Yibing Ding, "Chinese Perspective of East Asian
Exchange Rate Coordination", Conference Papers, EastAsian
Monetary Cooperation and China's Perspective, 24 Aug. 2006.

Table 4. Inflation Rates in Asia and the Euro Area in
Selected Years (%)

ASEAN + 3 (a) Euro Area (b)

Year Average Standard Year Average Standard
 deviation deviation

1985 2.08 1.46 1975 13.28 4.27
1986 1.66 2.20 1976 11.79 4.35
1987 3.43 3.28 1977 12.17 7.55
1988 6.00 5.82 1978 9.30 6.60
1989 6.25 5.37 1979 10.19 6.71
1990 4.93 2.29 1980 12.26 6.43
1991 5.59 2.54 1981 12.68 6.04
1992 4.71 2.01 1982 11.91 5.83
1993 5.64 4.42 1983 10.52 6.77
1994 7.38 7.23 1984 9.80 7.40
1995 5.97 5.35 1985 7.76 5.97
1996 4.74 2.74 1986 5.37 6.70
1997 3.58 1.55 1987 4.11 4.77
1998 10.71 18.18 1990 6.54 5.28
1999 3.8 7.84 1995 3.18 2.27
2000 1.05 1.60 2000 2.89 1.00
2001 2.36 3.71 2001 3.13 1.00
2002 2.36 3.96 2002 2.60 1.00
2003 2.24 2.15 2003 2.27 0.90
2004 3.42 3.52 2004 3.68 0.91
2005 4.15 3.61 2005 2.40 0.90


(a) ASEAN+3: Indonesia, Malaysia, Philippines, Singapore,
Thailand, plus China, Korea and Japan.

(b) Euro Area: Austria, Belgium, Finland, France, Germany,
Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal and Spain.

Source: IMF International Financial Statistics.

Table 5. Correlation ofAsian Currency Exchange Rates against the
US Dollar (weekly exchange rates)

 Before the Asian Financial Crisis (1990.1-1997.6)

China South Korea Thailand Malaysia
 0.6159 -0.4453 -0.5676

 After Asian Financial Crisis (1997.7-2003.10)

China South Korea Thailand Malaysia
 -0.4956 -0.6321 -0.7231

 After China Exchange Rate Reform (2005.7.21-2006.12)

China South Korea Thailand Malaysia
 0.8667 0.9012 0.8728

 Before the Asian Financial Crisis (1990.1-1997.6)

China South Korea Indonesia Philippines
 0.6159 0.8810 0.1409

 After Asian Financial Crisis (1997.7-2003.10)

China South Korea Indonesia Philippines
 -0.4956 -0.5325 -0.17006

 After China Exchange Rate Reform (2005.7.21-2006.12)

China South Korea Indonesia Philippines
 0.8667 0.8976 0.8125

 Before the Asian Financial Crisis (1990.1-1997.6)

China South Korea Singapore
 0.6159 -0.8907

 After Asian Financial Crisis (1997.7-2003.10)

China South Korea Singapore
 -0.4956 -0.9997

 After China Exchange Rate Reform (2005.7.21-2006.12)

China South Korea Singapore
 0.8667 0.8386

Source: International Monetary Fund website:
<> [Aug. 2008].

Table 6. Own Basket Weights for Six EastAsian Currencies (%)

 Currency basket

Country US dollar Euro Yen RMB

Indonesia 21.9 40.4 20.3 17.4
Malaysia 20.6 26.8 35.5 17.1
Philippines 18.8 33.4 30.6 17.2
Singapore 25.9 21.4 30.6 22.1
South Korea 17.6 26.6 25.4 30.4
Thailand 19.8 39.0 24.6 16.6

Note: Each weight is adjusted so as to sum 100.

Source: Author's calculation from the International Monetary
Fund, Direction of Trade Statistics, May 2005.

Table 7. The Common Four-Currency Basket Weights (%)

 Currency basket

Country ASEAN+3 US dollar Euro Yen RMB

Brunei 0.41
Cambodia 0.20
Chian 34.79
Indonesia 5.12
Japan 27.80
South Korea 9.79 34.70 28.70 22.20 14.40
Laos 0.08
Malaysia 5.34
Myanmar 0.38
Philippines 2.93
Singapore 6.36
Thailand 5.08
Vietnam 1.74

Source: Author's calculation. ASEAN+3 weights from Eiji Ogawa and
Junko Shimizu, "Progress toward a Common Currency Basket System in
East Asia", RIETI Discussion Paper Series 07-E-002,2006.
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Author:Zi, Liu; Jinxia, Chen
Publication:China: An International Journal
Article Type:Report
Geographic Code:9CHIN
Date:Mar 1, 2009
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