china's role in east-asian monetary integration

INTERNATIONAL JOURNAL OF FINANCE AND ECONOMICS

Int. J. Fin. Econ. 10: 157–166 (2005)

Published online in Wiley InterScience (www.interscience.wiley.com). DOI: 10.1002/ijfe.265

CHINA’S ROLE IN EAST-ASIAN MONETARY INTEGRATIONCARSTEN HEFEKERa,*,y and ANDREAS NABORb

aUniversity of Siegen and HWWA-Hamburg, Germanyb Isle of Man International Business School, Isle of Man

ABSTRACT

Most proposals for East-Asian monetary cooperation assign a special role to the Japanese yen as anchor currency. Wefocus on the potential role of the Chinese renminbi. Since China will assume the role of the dominant economy in theregion and become a more important destination for Asian products than Japan eventually, this development assigns aspecial role to the Chinese currency. It is rather unlikely that the renminbi will assume a dominant role immediately, buta comparison with the European monetary integration process suggests designing a system where the relative weight ofthe renminbi increases gradually. Copyright # 2005 John Wiley & Sons, Ltd.

JEL CODE: F3; F4

KEY WORDS: China; East Asia; monetary integration; exchange rate regimes

NON-TECHNICAL SUMMARY

In the aftermath of the Asian currency crisis of 1997, a discussion has started about possibilities ofmonetary cooperation in East Asia as an alternative to pegging solely to the US dollar. Although the detailsof the numerous proposals differ, a special role is often assigned to the Japanese yen or to a basket of theyen, the US dollar and the euro. In this paper, we instead focus on the potential role of the Chineseeconomy in the process of regional integration and of the Chinese renminbi (RMB) in a regional basketarrangement. According to many observers, China is set to become the most important economy of theregion in the future and now takes serious steps of integrating into the world economy. Both aspects implya special role for the Chinese currency in any future exchange rate arrangement for East Asia. Chinaassumes an increasingly important role as a trading partner for the region and also as a source of directinvestments. This implies that stable exchange rates with respect to the RMB become more important.Instead, the USA, Europe and Japan are likely to lose relative importance for countries in the region, whileover the longer run the RMB will become the most important currency in the region. We argue that a fixedexchange rate system based around the RMB would make sense in the middle to longer run.

There are at present many obstacles which make it rather unlikely that the RMB will assume such a rolein the near future. The European process of monetary integration, however, suggests that it is possible todesign a flexible system in which the relative weights of currencies shift over time, allowing the RMB’s roleto grow over time. The evolution of the Exchange Rate Mechanism (ERM) of the European MonetarySystem (EMS) is an example that could provide guidance. Starting out as a nominally symmetric system,one of the regional currencies, the German mark, gradually became the anchor currency. Similarly, weargue that the RMB could become increasingly important over time as an anchor currency.

We focus on experiences with the ERM because we do not think that a full monetary union in Asia isdesirable or politically possible. Instead, any monetary system in East Asia would need a considerable

Copyright # 2005 John Wiley & Sons, Ltd.

*Correspondence to: Carsten Hefeker, Department of Economics, University of Siegen, Hoderlinstrasse 3, 57068 Siegen, Germany.yE-mail: [email protected]

degree of flexibility for the foreseeable future, to which experiences with the ERM could be a useful guide.Therefore, a full monetary union for East Asia is not a viable option, but a system like the ERM could be auseful alternative.

1. INTRODUCTION

In the aftermath of the Asian currency crisis of 1997, a discussion has started about possibilities ofmonetary cooperation in East Asia as an alternative to pegging solely to the US dollar. Although the detailsof the numerous proposals differ, a special role is often assigned to the Japanese yen or to a basket of theyen, the US dollar and the euro. In this paper, we instead focus on the potential role of the Chineseeconomy in the process of regional integration and of the Chinese renminbi (RMB) in a regional basketarrangement. According to many observers, China is set to become the most important economy of theregion in the future and now takes serious steps of integrating into the world economy. Both aspects implya special role for the Chinese currency in any future exchange rate arrangement for East Asia.

There are at present many obstacles which make it rather unlikely that the RMB will assume such a rolein the near future. The European process of monetary integration, however, suggests that it is possible todesign a flexible system in which the relative weights of currencies shift over time, allowing the RMB’s roleto grow over time. The evolution of the Exchange Rate Mechanism (ERM) of the European MonetarySystem (EMS) is an example that could provide guidance. We focus on experiences with the ERM becausewe do not think that a full monetary union in Asia is desirable or politically possible. Instead, any monetarysystem in Asia would need a considerable degree of flexibility for the foreseeable future. Discussion onwhether Asia should move towards a monetary union is premature, and so are comparisons drawn withcontemporary Europe.

Section 2 discusses the degree of economic integration among East-Asian countries, with a special focuson China, where we draw on trade and capital flows and the correlation of shocks as the main indicators ofthe theory of optimum currency areas (OCA). Since full monetary integration is not a serious option for thenear future, we discuss in Section 3 arrangements that would offer the necessary flexibility for existingdifferences among the economies, and that would allow for the Chinese RMB to assume gradually a moreimportant role. Section 4 summarizes our main argument.

2. EAST-ASIAN INTEGRATION AND CHINA’S ROLE

To assess China’s importance for the process of regional monetary integration, this section analyses fourmain parameters of benefits and costs of monetary cooperation: regional trade, capital flows, thecorrelation of shocks in the East-Asian region, and inflation differentials.1

2.1. Trade pattern

Fixed exchange rates and monetary cooperation create benefits such as a reduction in the transactionscosts associated with bilateral trade and investment. Countries with close trade links should thereforebenefit from fixed exchange rates and monetary integration. It is therefore remarkable that several studiesargue that East Asia is at least as well integrated as Europe in terms of intra-regional trade.2 Recent tradedata show that intra-regional trade among East-Asian countries as a share of GDP is already similar to thatof the EMU, and higher than that of other regions such as NAFTA or Mercosur. Moreover, the growthrate 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 tradegrowth in the region. In 2003, it was already among the most important export markets for South Korea,Taiwan, Malaysia, the Philippines, Singapore and Japan, and trade integration is expected to grow further

C. HEFEKER AND A. NABOR158

Copyright # 2005 John Wiley & Sons, Ltd. Int. J. Fin. Econ. 10: 157–166 (2005)

through the proposed free trade area of China and the 10 member countries of ASEAN.3 A strongerregionally based trade would thus benefit from a process of monetary integration comprising China as well.

Besides increasingly trading with each other, ASEAN countries and China compete with their labour-intensive products in major markets in the USA, EU and Japan. Trade patterns of China and theEast-Asian NIEs are currently rather complementary, but International Monetary Fund (2004) predictsmore competition as China’s exports move up the value-added chain. In this context, monetary cooperationof ASEANþ 3 could help to stabilize the relative trade competitiveness and avoid conflicts among themember countries, which can be observed in other regions of the world.

2.2. Capital flows and investment

Parallel to trade, Asia shows a high degree of intra-regional concentration of capital flows. Moon andRhee (1999) show that the ratio of intra-regional foreign direct investment (FDI) to the regional GDP ishigher in Asia than in the EU, while Baek and Song (2002) find that the capital mobility of 10 East-Asiancountries during the mid-1990s is only moderately lower than it was in Europe during the late 1980s. Giventhe demonstrated trend towards more intra-Asian direct investment, one can expect that financial relationswould stand to benefit from fixed exchange rates as well.

China is among the largest net recipients of FDI world-wide, accounting for almost one-third (32.5%) ofall FDI flows to developing countries in 2002, but International Monetary Fund (2004) reports that FDIinflows to China come increasingly from within the region, with Japan and the NIEs accounting for about60% of all FDI inflows in the period 2000–2002. FDI from the USA and Europe accounted for about 20%during the same period, underlining China’s increasing importance for the region in terms of capital flowsas well.

Considering the developmental stage of China, the flow of FDI is still a one-way direction into China.Chinese investments to ASEAN, Japan and Korea amount to not more than 170 million US dollars a year.This picture might change, however, with the development of the Chinese economy and if a closer economicrelationship between China and the region could be established, especially because intra-industry tradeinduces trade-related investments. Moreover, China has begun an outward investment campaign and the

Table 1. Regional trade patterns, 1980–2002 (selected years) (percentage of total regional GDP)

1980 1985 1990 1995 2000 2002

Export Import Export Import Export Import Export Import Export Import Export Import

ASEANa

Within ASEAN 6.5 5.0 6.1 5.2 8.2 7.4 12.4 10.3 17.3 14.6 15.3 13.5With Japan 9.9 7.7 8.2 6.1 8.2 11.3 7.2 13.4 10.1 12.4 8.5 9.7With China, PR 0.4 1.0 0.4 1.5 0.8 1.4 1.4 1.7 2.9 3.3 3.6 4.5With South Korea 0.6 0.6 0.9 0.6 1.4 1.5 1.6 2.5 2.8 3.1 2.7 3.0With USA 6.3 5.4 6.3 4.5 8.4 7.1 9.3 7.8 14.3 9.1 12.0 7.7With Euro Area 4.2 3.3 2.8 3.0 5.1 5.5 5.4 6.3 8.3 5.4 7.4 5.0With Total World 37.0 35.1 32.4 29.2 43.3 48.9 50.5 56.3 75.2 65.1 67.4 59.1

East Asiab

Within East Asia 4.7 5.2 5.5 5.5 5.7 5.8 7.5 7.3 9.4 9.3 10.4 10.2With Total World 15.3 16.2 16.6 14.7 15.8 14.8 16.8 15.9 22.0 19.1 23.2 20.7

Euro Areac

Within Euro Area 11.0 10.8 12.1 11.9 12.2 12.0 11.9 11.0 15.6 14.6 15.1 14.0With Total World 21.4 24.4 25.1 25.5 22.1 22.4 23.1 21.6 30.8 30.3 30.5 28.3

aASEAN: Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, Philippines, Singapore, Thailand, Vietnam.bEast Asia: ASEAN plus China, Hong Kong, Japan, Korea.cEuro Area: Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain.

Source: IMF Direction of Trade Statistics, World Development Indicators 2004.

CHINA’S ROLE IN EAST-ASIAN MONETARY INTEGRATION 159


government has encouraged Chinese companies to invest in major engineering and construction projects inthe region.

2.3. Correlation of shocks and inflation differentials

According to theory, the costs of monetary cooperation can best be analysed by looking at thecorrelation of economic shocks. It is less costly to abandon national monetary autonomy for a group ofcountries with similar degrees of shocks or low disturbances than for countries with high or divergentdisturbances, as they would need different monetary policy reactions to these disturbances. Most of theliterature addressing the question of monetary integration in Asia has looked at this issue, withoutproducing clear evidence, however. Most authors use structural VAR to form groups of plausible partnersfor monetary cooperation based on the similarity of supply and demand shocks and the speed ofadjustment, but find different optimal groupings, as demonstrated in Table 2.

Baek and Song (2002) covered the largest group with a sample of 14 East-Asian countries over the period1970–1999. They identified a group of six countries (Hong Kong, Indonesia, Japan, Korea, Malaysia andThailand) experiencing symmetric supply disturbances. Singapore and Taiwan share similar demanddisturbances with this group, while China’s economic disturbances are small in size and quickly absorbed.Thus, they claim that these nine countries are viable candidates for a currency union (EA9). Compared withresults by Bayoumi and Eichengreen (1994) on disturbances within the EMU prior to 1990, the EA9economies show larger disturbances but faster adjustment speeds than the EMU. With small disturbancesand rapid adjustments, China is close to the European anchor country, Germany.

Another source of costs of abandoning monetary policy autonomy could be large inflation differentials,implying cross-country differentials in real interest rates and making a common monetary policy difficult toimplement. In fact, large and only slowly converging inflation differentials had been a main problem of theearly ERM (Gros and Thygesen, 1998). Germany (closely followed by Belgium and the Netherlands) had

Table 2. Major VAR analyses on correlation of and adjustment to economic disturbances

Sample, period Aggregate supply shocks Aggregate demand shocks

Averagesize

Average speedof adjustment

Averagesize

Average speedof adjustment

Group(s) of Asian countrieswith high correlation of shocks

Bayoumi and Eichengreen (1994)

9 EA, 1969–89a 0.036 0.831 0.012 0.871 Japan, Korea, Taiwan15 EU, 1963–90a 0.032 0.534 0.023 0.404 HK, Indonesia, Malaysia,

Singapore

Bayoumi and Mauro (1999)

11 EA, 1968–98b 0.080 0.671 0.061 0.829 HK, Indonesia, Malaysia,15 EU, 1969–89b 0.031 0.685 0.022 0.418 Singapore

Baek and Song (2002)

14 EA, 1970–99c 0.069 0.894 0.175 0.839 China, HK, Indonesia, Japan,Korea, Malaysia, Singapore,Taiwan, Thailand

aEast Asia: HK, Indonesia, Japan, Korea, Malaysia, Philippines, Singapore, Taiwan, Thailand.Europe: Austria, Belgium, Denmark, Finland, France, Germany, Ireland, Italy, Netherlands, Norway, Portugal, Spain, Sweden,Switzerland, UK.bEast Asia: HK, Indonesia, Japan, Korea, Malaysia, Philippines, Singapore, Taiwan, Thailand, Australia, New Zealand.Europe: Austria, Belgium, Denmark, Finland, France, Germany, Ireland, Italy, Netherlands, Norway, Portugal, Spain, Sweden,Switzerland, UK.cEast Asia: Brunei, Indonesia, Laos, Malaysia, Myanmar, Philippines, Singapore, Thailand, Vietnam, HK, Korea, Taiwan, China,Japan.



relatively low rates while other members had initially considerably higher rates, so that the ERM became anominal anchor for some member states. Realignments were therefore necessary from time to time toaccount for real overvaluations and to restore relative competitiveness. A comparison between the earlyyears of ERM and the current situation in Asia, however, suggests that East Asia is likely to experience lessproblems than ERM members during the first years since average inflation and the variance of inflationrates are considerable lower than in the early ERM (see Table 3).

3. MONETARY INTEGRATION IN EAST ASIA

In the above discussion on benefits and costs of monetary cooperation in East Asia, we demonstrated thatthe region can expect benefits from monetary cooperation as it increasingly integrates. We showed furtherthat China plays an increasingly important role in the region, which is likely to expand even more in theforeseeable future.

Given the situation of increasing regional integration and receding dominance of the US dollar,especially in trade flows, several observers suggest a peg to a currency basket including the dollar, the yenand the euro to reflect trade orientation better (Ogawa and Ito, 2000; Williamson, 1999, 2000).4 Such abasket would indeed make more sense than an exclusive peg to the dollar, but it still neglects the growingimportance of intra-regional trade in East Asia. One additional problem with such a peg would be that the

Table 3. Inflation rates in Asia and the Euro Area in selected years (in percent)

ASEAN5a ASEAN5þ 3b Euro Areac

Year Average Standarddeviation



1970 2.58 5.801985 2.00 1.78 1985 2.08 1.46 1975 13.28 4.271986 1.76 2.62 1986 1.66 2.20 1976 11.79 4.351987 3.29 3.54 1987 3.43 3.28 1977 12.17 7.551988 3.86 2.59 1988 6.00 5.82 1978 9.30 6.601989 4.23 1.70 1989 6.25 5.37 1979 10.19 6.711990 4.95 2.04 1990 4.93 2.29 1980 12.26 6.431991 5.73 2.28 1991 5.59 2.54 1981 12.68 6.041992 4.69 1.91 1992 4.71 2.01 1982 11.91 5.831993 4.71 2.91 1993 5.64 4.42 1983 10.52 6.771994 5.12 2.10 1994 7.38 7.23 1984 9.80 7.401995 5.08 2.88 1995 5.97 5.35 1985 7.76 5.971996 4.90 2.27 1996 4.74 2.74 1986 5.37 6.701997 3.93 1.66 1997 3.58 1.55 1987 4.11 4.771998 15.67 21.34 1998 10.71 18.18 1990 6.54 5.281999 6.27 9.03 1999 3.80 7.84 1995 3.18 2.272000 1.30 1.74 2000 1.05 1.60 2000 2.89 1.002001 3.03 4.28 2001 2.36 3.71 2001 3.13 1.002002 3.56 4.42 2002 2.36 3.96 2002 2.60 1.002003 2.70 2.32 2003 2.24 2.15 2003 2.27 0.90

Average Average Average1990–97 4.89 2.26 1990–97 5.32 3.52 1979–86 10.06 6.48

aASEAN5: Indonesia, Malaysia, Philippines, Singapore, Thailand.bASEAN5þChina, Korea, Japan.cEuro Area: Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain.

Source: IMF International Financial Statistics.



central banks of the anchor currencies could not realistically be expected to intervene to defend bilateralexchange rates. This would be different in a system based on member currencies only.

Kwan (2001) instead suggests a peg to a regional currency basket with an increasing weight of the yen,growing to an anchor currency over time. This is based on the presumption that Japan’s trade share in theregion will increase, but neglects the fact that the trade share of China is growing even more.

More flexibility as an alternative to fixed rates, advocated more recently by some observers (Eichengreen,2002), is obviously not the preferred choice of East-Asian countries. Even countries that claim to haveflexible rates show a ‘fear of floating’ and intervene to stabilize their exchange rates. As Baig (2001) andFabella (2002) observe, East-Asian currencies show some flexibility but continue to smooth their exchangerates against the dollar.5 In what follows, we therefore propose a sufficiently flexible exchange ratemechanism for the region in which the weight of the Chinese currency can grow continually to reflect itsincreasing importance.

3.1. Lessons from Europe

Any discussion about a fixed rate system or even more far-reaching attempts at monetary integration inEast Asia is likely to draw comparisons with the European integration process (see e.g. Bayoumi andMauro, 1999; Kwan, 2001; Wyplosz, 2001). Although the European example is informative, manydifferences between Europe and Asia remain. An important difference is that Asia lacks the politicalintegration process that is unique to Europe. However, while politics certainly has an important role to playin the European integration process, it is not a prerequisite for monetary integration.

Even disregarding political integration, however, one has to note that Asia and Europe are still worldsapart in many other aspects as well: GDP per capita differences are considerably higher in Asia than inEurope, the structure of markets range from very concentrated in South Korea to atomistic in Taiwan, andthe amount of regulation in the economic and financial system varies from laissez-faire to bureaucracy-led.Also, the share of openness differs widely, from more than 100% for the city-states to a mere tenth of this inJapan (Eichengreen, 2002).

All this suggests that there will remain considerable need for real exchange rate variability among theEast-Asian countries. It does not rule out a fixed but adjustable arrangement, however. While a fullmonetary union is not advisable in East Asia, the process of monetary integration in Europe can still be amodel for the region. We would hence suggest that the Asian economies adopt a mechanism similar to theERM with a multilateral grid of exchange rate pegs. The ERM had been designed in such a way that eachindividual currency was assigned a certain weight in a basket currency, the ecu, whose value was thusdetermined by the sum of the individual currencies. Countries defined a target with a band against thisbasket that should be kept, and if individual currencies hit the bands all affected countries had to interveneto defend the peg.

The attractive feature of the ERM most relevant to the East-Asian case is that the relative weights of thecurrencies could change over time, as was the case with the German mark, and that the system admittednew members over time. The system was sufficiently flexible to account for these changes and differences.For the East-Asian case this would ideally imply that the Chinese RMB could play a larger role over timeby increasing its relative weight in the basket, like the German mark in Europe. This would obviously implythat other currencies lose influence. Given that the relative economic power within East Asia is shifting, itwould probably be the yen that would lose weight. But any weight increase for the RMB will be gradual,and will come only after economic growth corresponding with increased reliability of monetary andfinancial policy, so that currently dominating political fears against a larger role of the Chinese currency(and its central bank) by the partners should decrease gradually as well. In the first place, however,depending on the date of introduction, the yen would still have a greater or similar weight than the RMB,making it easier for the Japanese government to participate in such a system.

To allow for relative changes, it would be important that the corridors in an East-Asian ERM would notbe too narrow initially and that it would possibly allow countries to have different margins of fluctuation.Our idea would be a corridor of � 5–10% that could be tightened over time. Unlike Williamson (2000),



however, we would prefer broader bands with strict intervention obligation rather than narrow bandswhilst allowing countries to move outside the declared bands. This would signal that countries take thebands seriously and also help to focus expectations and reduce uncertainty. Ideally, the currency, like theecu, would acquire enough credibility over time to become an invoicing currency and debt could be issuedin this currency. This would further reduce the role of the dollar and remove the problem that countries arestill forced to issue debt in dollars.

The major objection against such a system is that it might be vulnerable to occasional crises. Eichengreen(2002) argues that the ERM only gained credibility when it became clear that it was a stepping stone to fullmonetary union. While it is certainly true that a system is strengthened if there is a clear political will toreach a more ambitious goal, like monetary union, this argument tends to overlook that the ERM hadexisted more than 10 years without a fixed timetable for EMU. The collapse of the ERM in 1992 was to alarge extent due to German unification and the lack of will to account for this large asymmetric shockthrough realignments. The ERM crisis thus rather demonstrates that a delay of policy action can furtherundermine the credibility of any arrangement and prompt speculative attacks. This only confirms our pointthat such a system should be adjustable and that flexibility should be used when needed.6

In this respect, Braga de Macedo et al. (2001) stress the positive influence of the mutual surveillanceframework in the ERM that ensured that policies pursued were compatible with the stability of exchangerates. In fact, some coordination mechanism might help greatly to increase the credibility of this system.Such a mechanism could build upon former ASEAN experiences with joint committees and regionalforums, such as the Manila group, although they would have to become more binding. It would clearly helpif such a system would also provide some financial support.

3.2. Chiang Mai and the ERM

A first step in the direction of financial support and a coordination mechanism was taken with theChiang Mai initiative of May 2000, a network of bilateral swap arrangements established amongASEANþ 3 countries for the case of speculative attacks against their currencies. However, a potentiallyserious problem is that the amount of intervention is currently restricted to a rather small sum (Moon andRhee, 1999). In addition, the decision to activate the sum is at the discretion of the lender, which couldfurther erode trust in this mechanism.

Nevertheless, Chiang Mai can be seen as only a first step and more funds might be mobilized in case ofcrisis. Moreover, it should not be forgotten that the ERM also began with rather limited swap provisionsthat were only extended in the course of the Basel–Nyborg agreement as late as 1987. Actually, the ChiangMai initiative is already moving forward since the ADB annual meeting in 2004 with the discussion ofpooling these bilateral agreements into a single fund. This would be a further important step to give upnational autonomy in favour of a multilateral agreement.

If an exchange rate mechanism is adopted, Asian countries should consider introducing an unlimitedintervention requirement for all countries to support currencies that threatened to leave their bands, as alsoprovisioned by the ERM. There, intervention was not only demanded of the ‘weak’ currencies but alsofrom the ‘strong’. Although this did not hinder the German Bundesbank from intervening less than itwould be obliged to under a really symmetric system, this formal requirement (and its announcement) maybe understood as a partial protection against speculative attacks against the weakest currencies of thesystem. At the moment, such an unlimited intervention requirement is rather unlikely to be politicallyacceptable in Asia, in particular for potential main supporters of the system, such as Japan, which fear thatthey will end up in a situation where they have to carry the main burden of intervention. But the steps takenin the wake of the Chiang Mai initiative show that more cooperation seems possible in the future.

3.3. Caveats

The discussion so far hinges on the assumption that China will sooner or later be able to provide thestability that is required from an anchor currency. Currently there are, however, some open questions withrespect to China and its role in the East-Asian integration process.



Given China’s considerable current account surplus and its huge build-up of currency reserves, there ispolitical pressure (not least from the US government) that China revalue the RMB against the USdollar (Goldstein, 2004). Others, however, fear that this could lead China into deflation (McKinnonand Schnabel, 2003). Nevertheless, most observers expect a revaluation of the RMB in the near future.Should China thus join an Asian ERM before this revaluation, the system would be under pressure fromthe beginning. So entry into a system would be a good opportunity for a realignment of East-Asiancurrencies.

Another challenge is rising unemployment, which might trigger not only shrinking private demand, buteven social unrest with predictable negative budgetary and monetary implications. The governmenthas to shift the high amount of surplus labour from inefficient sectors (mainly in the countryside) togrowth industries (mainly in cities). This is not a trivial problem; OECD (2002) estimates suggest thatnearly 70 million workers will exit agriculture between 2000 and 2010. In urban areas, about half of thework force is employed in state companies, which are highly inefficient and in need of restructuring. Thismight put some pressure on Chinese monetary policy, especially since the Chinese central bank is notindependent.

The most striking argument against integrating China into a common monetary system in Asia is thevulnerability of the Chinese banking system to crisis. Almost all banks are still state-owned and lending isstate-controlled. Due to government pressure, most funds of banks flow to state-owned enterprises thatlack strong governance and efficient structures. It is estimated that more than two-thirds of the funds ofbanks go to the state sector (Fernald and Babson, 1999). This could imply even more nonperforming loansin the banking sector. Therefore, banks should be privatized, for which the books of the banks would haveto be cleaned up, and a competitive financial market should be developed. The People’s Bank of Chinaneeds to improve its proficiency in handling and supervising an open financial market. Otherwise, bankingcrises might result, impacting the exchange rate system.

Part of the banking sector’s problems are also due to the fact that China maintains significant capitalcontrols so that its capital markets are not integrated with the rest of the world (Cheung et al., 2005).7 Thismakes foreign investments more difficult, restricting foreign access to firms. Especially in the bankingsector, foreign investment could help to solve the banking industry’s problems. In course of the WTOnegotiations, however, China has agreed to allow the presence of foreign banks in the future and to allowfor jointly managed fund management firms and joint venture security firms where foreigners may holdbetween 49% and 33%, respectively. This will, at least, initially imply a strong advantage for the foreignbanks as they cannot be forced to handle nonperforming loans. This distortion of competition anddisadvantage for the domestic banks will presumably eventually bring the government to sort out thedomestic bad banks problem.

While more generally the different degrees of liberalization of capital flows among the East-Asiancountries might pose a problem, one should also remember that European ERM members also operateddifferent capital control measures without undermining the ERM. Nothing thus prevents the East-Asiancountries from moving towards an Asian ERM with capital controls still present in China. China mightcontinue to follow its own timetable of liberalizing its capital flows while other countries are furtheradvanced in liberalization. Still, such a differentiated approach obviously implies that bilateral exchangerates must be treated differently, leading to more pressure on some rates than on others, depending on thedegree of capital market liberalization.

Finally, weakening macroeconomic performance, rising unemployment and a vulnerable banking systemall pose a challenge to the government budget. The OECD (2002) reports a still manageable governmentdebt–GDP ratio of 32% for 2000, but cautions against future commitments, mainly a bailout of thebanking sector and pension obligations. Rising government debts could result in higher inflation thanacceptable for fixed exchange rates. This would make it difficult to have China as a member or even ananchor in a regional monetary system. But provided that these problems can be solved without negativeimplications for monetary policy, it need not imply that China cannot become part of an East-Asianmonetary system once these problems are being addressed, and if the system allows for adequaterealignments.



4. CONCLUSION

We see no prospects for an immediate full monetary integration among the East-Asian currencies at themoment. However, flexible rates are obviously not the choice of most of the Asian countries. But whereasthe Asian currencies have been pegged to the dollar in the past, this is no longer a solution for the future.The dollar is losing ground because trade shifts from the USA 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 islikely to lose relative weight against the Chinese economy. Although China is not yet the regional dominanteconomic power, it is very likely to grow into that role. This prospect must be taken into considerationwhen planning monetary cooperation.

At present, the appropriate solution seems to be a symmetric monetary system, such as proposed in acommon basket peg with sufficiently wide margins of fluctuation. We consider an East-Asian monetarysystem as a workable solution that would build on the experiences with the EMS. The comparison withEurope should not be taken too far, however. The main difference is that in Asia nothing like a fullmonetary union is seriously debated, nor should it be. We agree with most observers that a full monetaryunion is neither advisable nor politically possible for the foreseeable future. This is a clear difference withthe European case.

Still, the European case shows that the process of monetary integration is in any case a long one, takinghalf a century in Europe. But along the way the system had already provided a significant and substantialdegree of integration and, overall, stability among the European economies and currencies. Such a regionalintegration seems to be more adequate for the East-Asian economies than any suggestions that focus onoutside currencies (such as the dollar) or one particular currency of the region (the yen). A common pegwould be more adequate economically and easier to implement politically.

We leave it open whether such a peg should from the beginning include all ASEANþ 3 currencies. It isonly important that the relative weight of the currencies should be open to adjustment to account forchanges in the relative weight of the economy concerned and for admitting additional members to thesystem. This would allow China to assume a gradually increasing importance, reflecting its growing role ininternational and Asian trade and investment. It would also imply a decreasing weight of the Japanese yenin this basket. It is open to speculation whether that would be an agreeable option for Japan or whetherJapan would prefer to stand apart from such an arrangement. In any case, it seems clear that Japan couldnot be the anchor of such a system, nor could the RMB take this role immediately. The Chinese currencycan only grow into this role through an evolutionary process. In that perspective, an East-Asian ERMcould become a more symmetric system than the European ERM.

ACKNOWLEDGEMENTS

For helpful comments we thank Menzie Chinn, Eric Girardin, David Rusnok and one referee.

NOTES

1. Usually the question of plausible candidates for currency integration is addressed in the theory of optimum currency areas (OCA),partly overlapping with the factors analysed here. However, Frankel and Rose (1998) maintain that OCA criteria are likely to beendogenous. As monetary integration fosters trade, more intra-industry trade makes economic structures more similar andcountries consequently converge.

2. Wyplosz (2001) uses a gravity approach to determine a ‘normal level’ of bilateral trade among Asian and European economies, andcompares that with the actual levels. It appears that Asia is more and Europe less integrated than one would expect on the basis ofthe gravity approach. Gilbert et al. (2001) establish a natural free trade area in Asia that comprises China as well, and propose a freetrade area of ASEANþ 3 (China, Japan and South Korea).

3. For a detailed analysis of China’s expanding role in international trade, see International Monetary Fund (2004).4. Ogawa and Ito (2000) calculate the optimal weights for each of the currencies for every country that depends on the relative weight

that trading partners assign to these currencies.



5. Baig (2001) distinguishes between the observed countries. While Indonesia shows most volatile exchange and interest rates, hisregression results for South Korea indicate a return to a level of pre-crisis weight to the dollar. The Philippines and Thai rates aremore flexible than in the pre-crisis period. Malaysia chose to peg in the aftermath of the crisis. Kang et al. (2005) report that thewon–dollar exchange rate has moved tightly with the yen–dollar rate since the crisis.

6. The possibility of exchange rate adjustments would also raise the incentives for agents to apply appropriate measures against foreignexchange risk and decrease the moral hazard to rely excessively on the peg. Simultaneously, this might reduce the inflow of short-term speculative capital inflows (World Bank, 1999).

7. International Monetary Fund (2002) discusses the Chinese timetable for gradually reducing capital controls.

REFERENCES

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Princeton Studies in International Finance No. 76. Princeton University International Economics Section: Princeton.Bayoumi T, Mauro P. 1999. The suitability of ASEAN for a regional currency arrangement. IMF Working Paper 99/162.Braga de Macedo J, Cohen D, Reisen H. 2001. Monetary integration for sustained integration: earning rather than importing

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Economics 10(2): 117–132.Eichengreen B. 2002. What to do with the Chiang Mai initiative? Mimeo, University of California at Berkeley.Fabella R. 2002. Monetary cooperation in East Asia: a survey. ADB ERD Working Paper Series No. 13.Fernald J, Babson O. 1999. Why has China survived the Asian crisis so well? What risks remain? Federal Reserve Board, International

Finance Discussion Paper 633.Frankel J, Rose A. 1998. The endogeneity of the optimum currency area criteria. Economic Journal 108: 1009–1025.Gilbert J, Scollay R, Bora B. 2001. Assessing Regional Trading Arrangements in the Asia-Pacific. Policy Issues in International Trade

and Commodities Studies Series 15. UNCTAD: Geneva.Goldstein M. 2004. Adjusting China’s exchange rate policies. Mimeo, Institute for International Economics.Gros D, Thygesen N. 1998. European Monetary Integration. Longman: London.International Monetary Fund. 2002. Annual Report on Exchange Arrangements and Exchange Restrictions. IMF: Washington, DC.International Monetary Fund. 2004. China’s growth and integration into the world economy: prospects and challenges. IMF

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Stanford University.Moon W, Rhee Y. 1999. Asian monetary cooperation: lessons from the European monetary integration. Journal of International and

Area Studies 6: 33–49.OECD. 2002. China in the World Economy: The Domestic Policy Challenges. OECD: Paris.Ogawa E, Ito T. 2000. On the desirability of a regional basket currency arrangement. NBER Working Paper 8002.Williamson J. 1999. The case for a common basket peg for East Asian Currencies. In Exchange Rate Policies in Emerging Asian

Countries, Collignon S, Pisani-Ferry J, Park YC (eds). Routledge: London; 327–343.Williamson J. 2000. Exchange Rate Regimes for Emerging Markets: Reviving the Intermediate Option. Institute for International

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