~This Issue's Index~

Counterbalence:
The Euro in Asia

By Ramkishen Rajan

The 1990s have been among the more turbulent decades for the international monetary system. The virtual breakdown of the European Exchange Rate Mechanism (ERM) in 1992-93 was followed in 1994-95 by the Mexican peso crisis, and the accompanying spillover affected both Argentina and Brazil. In July 1997, the Thai baht was devalued after repeated speculative attacks. The crisis quickly spread throughout the rest of East Asia. As the crisis-hit economies saw a single year capital reversal of approximately US$105 billion between 1997 and 1998, the socio-political repercussions that the crisis has had on the East Asian countries have yet to be calculated.

Most policy-makers and businessmen in Asia have been understandably preoccupied with the on-going crisis and have not paid much attention to developments in the European Union. This neglect is unfortunate, as on January 1, 1999, selected EU economies introduced a common currency-a momentous and historically unprecedented event in the international monetary system.

About 66% of global foreign reserves (excluding gold) are denominated in dollars, about 50% of world exports are invoiced in dollars, and slightly more than 40% of foreign exchange turnover involves the dollar. The corresponding figures for the EU currencies in aggregate are 25%, 34%, and 31.5% respectively. With the entire EU constituting about one fifth of global output, two fifths of world trade, and half of the global foreign exchange turnover, the euro is expected to overtake the Japanese yen as the world's second most important currency, and possibly challenge the hegemony of the dollar. Neglect of the EMU will be strategically disadvantageous for Asia.

The debates over whether the EMU will prove positive or negative to the participating European economies, and whether the euro will be a strong or weak currency are far from settled. From the perspective of extra-EU actors, however, the relevant issue is the inevitability of the euro. Ill-advised or not, the euro cannot be ignored.

Regional Self-Help
At the most general level, concerns about the smooth introduction and functioning of the euro, participation of the UK and the other "outs," and expansion of the EU will remain highest on the agenda of European policy-makers. This focus on euro-centric issues implies that attention will be diverted from both the Asian economic crisis and reform of the international financial system. It is possible that international agencies and the world financial community will also focus on the euro and related issues, such as euro-dollar and euro-yen exchange rates. In fact, in early 1999, much attention was devoted to how volatility among the dollar, yen, and euro might be reduced.

Asia, therefore, needs to intensify efforts to establish economic self-help mechanisms to deal with the current crisis and avoid future problems. It must also recognize that all the major currency crises of the 1990s have revealed the relevance and pervasiveness of regional contagion or negative spill-over effects. Regardless of the exact transmission mechanisms and definitions of contagion, economic policy slippage in any one country reverberates rapidly to nearby countries, with the result that currency crises tend to be largely regional.

It is therefore particularly important to ensure that there is some sort of peer pressure or club spirit that promotes the pursuit of sustainable and prudent macroeconomic policies across the region. This suggests that Asia should resuscitate Japan's proposal for an Asian Monetary Fund (AMF). The stated aims are to provide a pool of available funds for quick disbursal to alleviate regional currencies under acute selling pressure. It would also provide emergency balance of payments support for crisis-hit economies, similar to the US Treasury's Exchange Stabilization Fund for Mexico.

The East Asian economies enthusiastically welcomed the AMF. While Japan agreed to provide the bulk of financing, China, Hong Kong, Taiwan, and Singapore also pledged to contribute. The fund was estimated at US$100 billion. The US Treasury, however, saw the fund as a threat to its influence in Asia, and effectively killed the proposal. The IMF was also opposed to the AMF, because it was concerned about the compromise of its own authority and the willingness of regional crisis-hit countries to follow through with the necessary austerity measures.

Asian Monetary Union
Today, discussion abounds in Asia about the merits of maintaining different exchange rate regimes, as well as the costs and benefits of restraints on capital flows. In this climate, it may be useful to pay close attention to the European experience with monetary union. Indeed, following the successful introduction of the euro and the economic turbulence of the Asian financial crisis, ASEAN agreed to study the feasibility of a common currency and exchange rate system. There has also been popular discussion about the economic and political feasibility and desirability of forming an Asian Monetary Union (AMU) similar to the EMU.

To be sure, the conceptual framework within which the costs and benefits of the EMU have been discussed would be just as pertinent in analyzing the feasibility of an AMU, or even global monetary union. Some analysts have already concluded that East Asia satisfies the standard optimum currency area criteria for the adoption of a common monetary policy as well as Western Europe does. Its small, open economies would benefit from the reduction in uncertainty that would result from the creation of a durable peg. Most economists would agree, however, that the necessary political solidarity and institutional framework for contemplating such a union does not yet exist in Asia. Other issues, including acute income disparities, are working against the AMU in the foreseeable future.

The AMF-which would ideally play a complementary role to the IMF-may be a useful first step on the road to greater monetary cooperation and possibly integration. In addition to the greater trust and understanding which countries achieve by working together, the institutional arrangements that develop around the AMF may be extended to facilitate the convergence and synchronization of regional economic policy. Conversely, if Asian governments are unable to cooperate at the level of regional surveillance and pooling of funds, AMU would look much less practical.

Away from the Dollar
In discussing the euro's potential as a reserve currency relative to the dollar and yen, few realize that the decisions Asian governments make determining the mix of their reserve holdings will make a major difference. Specifically, Japan and China, which have the two largest foreign exchange reserves in the world, together hold about US$350 billion in foreign currency. The other newly industrialized Asian economies hold about US$300 billion in aggregate. In comparison, the US holds US$65 billion, and the EU about US$400 billion.

The percentage of Asian countries' currency reserves have risen from less than 50% in 1980 to about 60% today. In contrast, the yen's share has stayed constant at about 13-15%, while the European currencies in aggregate constituted 25% in 1995, down from about 35% in 1980. Thus, if the euro proves to be a stable currency, portfolio diversification gains could be attained by shifting some of Asia's foreign reserves to the euro and away from the dollar, which is over-represented in most portfolios. Should Asian governments do so, it would significantly strengthen the euro relative to the dollar. Given this, recent speculation that China will convert a portion of its reserves into euros is significant.

The mix of reserve currencies in Asia will depend partly on the type of exchange rate regime chosen. Assuming the goal is to maintain a pegged exchange rate, consideration should be given to maintaining a basket peg with appropriate weight given to the euro. The disproportionate weight given to the dollar by regional economies has been among the primary causes of the crisis in East Asia. For instance, the dollar constituted some 85-95% of the total Thai baht basket system, while the yen contributed the remaining 5-15%. This was despite the fact that Thailand's trade with the EU and Japan was as high as that with the US and the rest of East Asia. Indeed, the Japanese government has recently advocated the use of a tri-currency basket peg in East Asia, evenly divided between the dollar, yen, and euro.

The establishment of a single euro bond market, with breadth, depth and liquidity comparable to the US, will provide funding opportunities for Asian governments and businesses to diversify their liabilities. The relative size of the euro-bond market in terms of all publicly issued bonds will be about US$6 trillion, two-thirds that of the US and double that of Japan.

Asian investors have already begun to exploit the opportunities offered by the integrated euro capital markets. For instance, Japanese investors have gradually shifted from US Treasury bills to European ones. The Singapore International Monetary Exchange recently offered a euro-yen futures contract. The Hong Kong company Hutchinson Whampoa launched the first non-Japanese euro denominated bond in London. This was followed almost immediately by the 300 million euro sovereign bond offer by the Philippines government, making it the first Asian country to float a euro currency bond.

Thus, as Asian economies shift some of the external debt liabilities to euros, there will concomitantly be even greater incentive to reduce the dollar reserve holdings in favor of euros.

Coming to Terms with the Euro
Asian companies that have or aim for significant market shares in Europe or strategic partnerships with European-based businesses will have to consider dealing with the euro in their transactions. This ought to reduce currency risks, while also ensuring that Asian companies are not at a strategic disadvantage to Eastern and Central European competitors, whose countries are expected to closely peg their currencies to the euro as a possible prelude to full monetary integration.

The EU has not been a major recipient of direct foreign investment from Asia, receiving only some 5% of total flows from developing Asia and 18% of Japan's total flow between 1991 and 1995. Recent data, however, suggest an increased interest in the EU. Since most Asian investments in Europe have been concentrated in the UK, the successful introduction of the euro on one hand and the non-participation of the UK in the EMU on the other, may prompt Asian investors to modify their strategy in the region.

Just as in the case of international trade, Asia will need to recognize the EMU as a single, major player in the global financial markets. Accordingly, attention must be focused equally among the euro and the European monetary authorities: the dollar, the Federal Reserve, and Treasury Department on the one hand, and the yen, Bank of Japan, and Ministry of Finance on the other.

Japanese authorities have somewhat belatedly recognized the possibility of the euro surpassing the yen as the world's number two currency, and the possibility of the dollar and euro monopolizing international monetary and financial transactions. In response, they have recommended the internationalization of the yen and particularly enhancing the yen's role in intra-Asian transactions. The promotion of a tri-currency basket peg in East Asia is consistent with the goal of maintaining the regional and global role of the yen. Similarly, Japan's AMF scheme may also be seen as a way of promoting the use of the yen. Some have even proposed the establishment of a yen reserve fund to be used in emergencies by regional countries faced with liquidity crises and as a means of promoting the internationalization of the yen following the peso crisis.

The ERM crisis in 1992-93 led most observers (particularly among those outside Western Europe) to prematurely conclude that the goal of creating the EMU was unrealistic for the foreseeable future. Paradoxically, however, the crisis seems to have provided the impetus for Western European governments to see the process through to the implementation of monetary union. It is interesting to observe that while the ERM crisis seems to have fortified the links between the European economies, the East Asian crisis may have done just the reverse.

While the East Asian financial and economic crises have obviously monopolized the time and energy of regional policy-makers and businessmen, the potential significance of the euro in the global economy and a financially integrated European market-at least in the medium- and long-terms-dictates that they pay far greater attention to the EMU than has hitherto been the case.