Cooperation Between the Renminbi and the Yen 9789814339087, 9789814339056

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Enrich Series on Chinese Currency Reform Vol. 3 Cooperation between the Renminbi and the Yen With the continuous rise in the status and importance of China in regional and global economies, the influence of the Renminbi grows proportionately. Currency Reform has become a crucial and inevitable policy choice for China. Based on recent theoretical frameworks and quantitative analyses, this book explores the necessity, feasibility and specific pathway of cooperation between the Renminbi and the Yen, the two dominant East Asian currencies. It also provides an in-depth analysis of the significance of the two currencies in shaping the future situation of the East Asian economy. • Shedding lights on the development strategies of the RMB and the Japanese yen • Providing the agenda for the cooperation between the RMB and the Japanese yen • Exploring characteristics and the current situation of the Japanese yen based on real-world experience

Cooperation between the Renminbi and the Yen

The Dialogue between Two Dominant East Asian Currencies

Enrich Series on Chinese Currency Reform Vol. 3

Cooperation between the Renminbi and the Yen

Editors Public Sector Economy Research Center at the Jilin University. He is also the Vice Chairman of the China Society of World Economics. His main research focus is the international and East Asian economic development. Kamikawa Takao is a Professor in International Economics of the Faculty of Economics at the Yokohama National University, and a committee member of the Japan Society of International Economics.

Edited by Li Xiao, Kamikawa Takao

Li Xiao is a Professor and Deputy Dean of the School of Economics, and Researcher of the China

Edited by Li Xiao, Kamikawa Takao

Supported by the MOE Project of Key Research Institute of Humanities and Social Sciences at Universities

Enrich Series on Chinese Currency Reform With the continuous rise in the status and importance of China in regional and global economies, the influence of the Renminbi grows proportionately. Currency reform has become a crucial and inevitable policy choice for China.

Based on recent theoretical frameworks and quantitaive analyses, this series

explores the relationship between China banking system reform, regionalization and internationalization of the Renminbi as well as the possible cooperation between the Renminbi, the Yen and other Asian currencies.

Vol. 1

Internationalization of the Renminbi: History, Theories and

Vol. 2

Regionalization of the Renminbi

Policies

Vol. 3 Cooperation between the Renminbi and the Yen

Published by Enrich Professional Publishing (S) Private Limited 16L, Enterprise Road, Singapore 627660 Website: www.enrichprofessional.com A Member of Enrich Culture Group Limited Hong Kong Head Office: 1/F., Lemmi Center, 50 Hoi Yuen Road, Kwun Tong, Kowloon, Hong Kong, China Beijing Office: Rm 1108A, Culture Plaza, No. 59 Zhongguancun St., Haidian District, Beijing, China English edition © 2012 by Enrich Professional Publishing (S) Private Limited Chinese original edition © 2010 Tsinghua University Press Translated by Wu Siying and Cui Zengbo All rights reserved. This book, or parts thereof, may not be reproduced in any form or by any means, electronic or mechanical, including photocopying, recording or any information storage

and retrieval system now known or to be invented, without prior written permission from the Publisher.

ISBN (Hardback)

978-981-4339-05-6

ISBN (ebook)

978-981-4339-08-7 (pdf)



978-981-4339-91-9 (epub)

This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. Enrich Professional Publishing is an independent globally minded publisher focusing on the economic and financial developments that have revolutionized new China. We aim to serve the needs of advanced degree students, researchers, and business professionals who are looking for authoritative, accurate and engaging information on China.

Contents vii

Preface

xi

Abbreviations

PART I

The International Monetary System and the East Asia

Chapter 1

An Overview of the Global Financial Crisis and the Future of Asia Kamikawa TAKAO (Japan)

Chapter 2

3

The Financial Crisis and Asia: Impact, Connection and Challenge QI Junyan (China)

29

PART II

The Internationalization of the Japanese Yen

Chapter 3

The Internationalization of the Japanese Yen—Its Asian Strategy Eietsu IMAMATSU (Japan) 55

Chapter 4

The Development and Strategic Adjustment of the Internationalization of the Japanese Yen

Li Xiao (China)

93

Part III

The Emerging of the RMB

Chapter 5

The RMB Asianization and Internationalization Strategies Li Jing (China)

139

Chapter 6

The RMB and the East Asian Currency System Ishida KO (Japan)

193

PART IV

The Present and Future of Asian Monetary Cooperation— The Cooperation between China and Japan

Chapter 7

Asian Monetary Cooperation and Sino–Japan Coordination Ding Yibing (China)

Chapter 8 Notes References Index

225

The Asian and the International Monetary and Financial System Koni HIRONORI (Japan) 267 293 315 347

Preface to the Series The book is the fruit of cooperation between Chinese and Japanese scholars. Through dialogues, the book probes the impact of the global financial crisis on the world economy, especially the East Asian economy. Through analyses on the post-crisis economic development in Eastern Asia, the book also offers discussions of the prospect for Eastern Asian monetary and financial cooperation and the necessity and feasibility of cooperation between the Renminbi and the Yen. The outbreak of the global financial crisis in September 2008 had an immense impact on the global economy. Amid the crisis the Asian economy, especially the real economy, has suffered a grave impact. Notably, despite a string of advances in Eastern Asian monetary and financial cooperation since the 1997 Asian financial crisis, such cooperation, which had largely been designed to tackle regional monetary and financial crisis, was insufficient to effectively curb the tremendous negative impact the global financial crisis made on the region. In other words the regional monetary and financial cooperative framework, the result of efforts that lasted more than a decade by Eastern Asian countries and regions, failed to curb the global financial crisis in any significant way. With the advent of crisis or the post-crisis era, Eastern Asian financial and monetary cooperation is at an important turning point. An important aspect in the post-crisis world economic landscape is the future development of the Asian economy. Since the end of the 20th century, the structure of the economic driving force in Eastern Asia has seen a radical change. The growth of China’s economy is making an increasing contribution to and becoming an important engine for the region’s economic growth. Meanwhile, as a developed nation in the region, mutual reliance also rose between Japan and the rest of Eastern Asia in terms of trade, investment etc. Links between the real economies of countries in the region, including China and Japan, are also continuously being strengthened, with the proportion of intra-regional trade climbing to a new height. However, in contrast, the monetary and financial cooperation of the region is still confined in the Chiang Mai Initiative (CMI) framework with no progress in foreign exchange coordination and cooperation. As is known to all, the Japanese Yen has gradually become a main world currency since the 1980s but its internationalization has been a bumpy journey. Since the end of 2008, in order

Preface

to curb the influence of the global financial crisis, the Chinese government for the first time officially designed and implemented a set of strategies to internationalize the RMB, which included, promoting a trial of RMB settlement in frontier trade and cross border trade, actively facilitating Eastern Asian monetary cooperation, calling for reforms of the international monetary system etc. However the strategy to internationalize the RMB was also confronted with difficulties such as the incomplete liberalization of China’s current account. So far the academia and governments of both China and Japan are seeking to exert a greater influence of their respective home currencies on the Eastern Asian region using the two nations’ own advantages and statuses. China tries to make use of its immense market volume and its momentum for future growth, and to promote the RMB as a settlement currency in its trade with its neighboring countries and countries in other regions, whereby it sets out to popularize the use of the RMB in neighboring countries and regionalize the RMB. Japan tries to make use of the current international status of the Yen and the influence and experience of the country’s more developed financial market, and magnify the role and influence of the Yen in the Eastern Asian region in a more direct way by promoting the Asian Currency Unit (ACU). Undoubtedly both countries pivot their strategies to internationalize their domestic currencies on the regionalization of their home currencies in Asia. Such a common ground provides an important foundation for the currency coordination and cooperation between the two countries. In fact, under the current “USD System,” neither Japan nor China can independently take the initiative in regional monetary and financial cooperation. The unification of the European economy, the history of the birth of the Euro and the complicated history and social, economic and cultural traditions of Asia all lead to one conclusion: the monetary cooperation pattern in the Americas, which is characterized by the monopoly of the U.S. dollar, does not fit Asia. Therefore the stances of China and Japan in this cooperation, as well as the pattern of the cooperation, will exert a profound influence on the future financial and monetary cooperation in Eastern Asia and even determine the future trend of this initiative and eventually determine the future of the current international monetary system. It is based on the abovementioned thinking that this book chooses to start with analyses of the impact of the global financial crisis on the development of the East Asian economy. The book will then provide an indepth discussion of the history, current state and policy, and future trend

viii

Preface

of the internationalization of the Japanese Yen and the RMB, which will be followed by analyses and prospects of the monetary and financial cooperation in Eastern Asia in the post-crisis era and its future. Despite the large amount of research in this regard, research on the financial and monetary cooperation of Eastern Asia and especially in-depth research on the cooperation and coordination of the RMB and the Yen jointly conducted by Japanese and Chinese scholars is rare. Although it is impossible for this book to cover every aspect of the topic in question, the direct dialogue and communication between scholars from the two countries, who share a common wish to promote the sustainable and stable development of the East Asian economy, are very meaningful and necessary. Therefore the book follows the order of The International Monetary System and the East Asia— the International Environment Asia Faces , The Internationalization of the Yen and the East Asia , The Internationalization of the RMB and the East Asia and The Current State and the Future of Asian Monetary Cooperation—the Cooperation between China and Japan , in which every topic contains two indepth discussions of the topic respectively contributed by one Chinese and one Japanese scholar. We hope the publication of this book will facilitate the further study of this topic and contribute its share to the cause of promoting the stable development of the Eastern Asian economy and smooth financial and monetary cooperation, as well as constructing a harmonious and prosperous future for the region. Here, we feel obliged to introduce to the readers how this book was produced. Prof. Kamikawa Takao, the professor in the Economic Department of Yokohama National University, was the main advocate of the production of the book. In February 2007, invited by Prof. Kamikawa Takao, Prof. Li Xiao of the Economic Department of Jilin University made a speech on the regionalization of the RMB in Asia at the Japanese International Financial Study Seminar and International Economic Policy Study Seminar, and held indepth discussions with scholars, experts, journalists and students present in the seminar. In February the following year, again invited by Prof. Kamikawa Takao, Prof. Li Xiao gave another speech on Asian monetary and financial cooperation in a seminar held in the Center for Trade Documentation of the Economic Department of Yokohama National University and had talks and dialogue with 150 students there. In September the same year, invited by Prof. Li Xiao, Prof. Kamikawa Takao delivered a speech on The Experience from the Yen—the Yen’s Foreign Exchange Rate, Its Internationalization and the Japanese Economy to over 100 graduate students and doctoral students. It

ix

Preface

was in the course of such academic exchanges that Prof. Kamikawa Takao and Prof. Li Xiao had the idea of making an in-depth study on topics of interest to both sides and publishing the result. They went back and built their respective teams for this book, and contacted the publisher. On 1 June 2009 Prof. Li Xiao went to Chuo University for an international seminar. He dropped by Yokohama and had a thorough discussion on the publication of the book with Prof. Kamikawa Takao, the main translators of the book, and the Spring Breeze Publishing House. Both sides agreed to publish the book simultaneously as a symbol of the wish of both sides for the in-depth exchange of ideas on cooperation between Japan and China. As this book is the result of the cooperation of scholars of the two countries, the terminology of the book thus includes terms such as “Asia,” “the East Asia,” “the Southeastern Asia,” as well as terms such as “world financial crisis,” “global financial crisis” and “international financial crisis” which are often different terms meaning the same thing. There are also expressions that might need explanation and definition. This book does not adjust such content as it wishes to reflect the original thinking of the authors. Readers of this book may distinguish these expressions and refer to other sources when needed. To make it convenient for readers to refer to literature for detailed information, the book keeps the references of Japanese authors in Japanese. Here we would like to extend our heartfelt appreciation to the scholars from both countries who have contributed to the writing and editing of the book, and the Chinese students studying in Japan who tried their every best to translate the book. Li Xiao Kamikawa Takao February 2010

x

Abbreviations ABF ABMI ACIF ACU ADB AMF ASA ASEAN BWII CDO CMI CMIM CP EAC ECU EMEAP EMS IMF MBS QDII QFII REER SDRs

Asian Bond Fund Asian Bond Market Initiative Asian Cooperative Investment Fund Asian Currency Unit Asian Development Bank Asian Monetary Fund ASEAN Swap Arrangement Association of Southeast Asian Nations Revived Bretton Woods System Collateralized Debt Obligation Chiang Mai Initiative CMI Multilateralization Commercial Paper East Asian Community European Currency Unit Executives’ Meeting of Eastern Asia Pacific Central Banks European Monetary System International Monetary Fund Mortgage Backed Securities Qualified Domestic Industrial Investors Qualified Foreign Industrial Investors Real Effective Foreign Exchange Rate Special Drawing Rights

Currency Unit GBP British Pound HKD Hong Kong Dollar JPY Japanese Yen KRW Korean Won RMB Renminbi

Part III

The Emerging of the RMB

5

Chapter

The RMB Asianization and Internationalization Strategies Li Jing

COOPERATION BETWEEN THE RENMINBI AND THE YEN

Introduction The RMB has been attracting much attention since the Asian financial crisis in 1997. People are focusing on issues from the RMB exchange rate and RMB exchange system to the internationalization of the RMB. The circulation of the RMB in neighboring countries has been continuously expanded since 1990s and the RMB has been taken by some of them as the reserve currency. In 2003 Hong Kong banks were granted permission to operate RMB deposit business, which officially started in 2004. In November 2005 the business was extended to the exchange of RMB and RMB card business etc. The world community saw this cross-border circulation of the RMB as the starting point of the rise or internationalization of the RMB. Chinese scholars differ in their attitudes toward the internationalization of the RMB. Wang Xin (2002) pointed out that RMB internationalization would not only bring China seigniorage, but also gain more say for China in international finance affairs and thus promote the outward investment and trade of China; however China may encounter risks at macro and micro level during the internationalization of the RMB. Ba Shusong (2004) stressed that the expansion of the RMB circulation and the development of the RMB’s business scope in Hong Kong may affect the current control of interest rate and foreign exchange. Wang Jian (2002) believed that since the Chinese economy is greatly affected by the world economy, China should not internationalize the RMB as otherwise China could be involved in new financial storms. After the outbreak of subprime crisis in the U.S. in 2007, Chinese scholars started to adopt a supportive attitude toward the internationalization of RMB. With the spread and worsening of the U.S. subprime crisis and the decline of the developed economies represented by the U.S., the international monetary system based on the U.S. dollar has been subject to more and more doubts. The world community has continually condemned the dollar, believing that the U.S. is the root of crisis and the abuse of U.S. dollar is the “arch criminal.” After the decline of dollar a new international currency will be needed to take its place. In view of the strong economy of China before and after the crisis the RMB, the currency of China (international code: the Chinese Yuan, CNY), is supposed to be an ideal candidate currency. This has been taken as the core logic in the discussion about RMB internationalization after the year 2008. At the same time, European countries such as France and the UK are appealing for the reconstruction of the Bretton Woods System so as to ensure the stability of the international monetary system. Moreover the newly industrialized countries

140

The RMB Asianization and Internationalization Strategies

represented by China and India also began to call loudly for the reconstruction of the international monetary system in order to enable developing countries to gain more say in international finance affairs. With the worsening of the crisis, real economy is subject to erosion. In such a case developed and emerging economies have all implemented packages for economical stimulus. With respect to the economic stimulus plan of China, RMB has become the key word. The Several Opinions of the General Office of the State Council on Promoting Financial Support for Economic Development issued by the State Council of China in December 2008 explicitly requires the extended the use of the RMB in the trade between China and its neighboring countries. In the “two conferences” (i.e. the National People’s Congress and the Chinese People’s Political Consultative Conference) held in March 2009, the RMB’s internationalization became a key proposal presented by the representatives of Chinese People’s Political Consultative Conference and has been put forward as a “security” strategy and “bailout” measure, whereafter this “national demand” has been gradually developed into a “national demand.” On 9 April 2009, the Standing Committee of the State Council decided to launch pilot projects for the RMB settlement in Shanghai, Guangzhou, Shenzhen, Zhuhai and Dongguan etc. On 2 July, six ministries including the People's Bank of China jointly issued the Measures for the Administration of Pilot RMB Settlement in Cross-border Trade. Shanghai, Guangzhou, Shenzhen, Zhuhai and Dongguan take the lead in the RMB settlement, and beyond Mainland China pilots have been launched in Hong Kong, Macau and the ASEAN member states. Between December 2008 and April 2009 China signed bilateral currency swap agreements with a total amount of RMB 650 billion with the Republic of Korea, the Hong Kong Special Administrative Region, Malaysia, Indonesia and Argentina in succession. In this way the use of the RMB has begun to be extended to regions outside Asia. All the media at home and abroad rushed to report “RMB internationalization,” “RMB regionalization” and “RMB Asianization.” On 23 March 2009 Zhou Xiaochuan, the Governor of the People's Bank of China, suggested creating a world currency before the G20 Summit in London and this suggestion caused great repercussions in the world community. Many observers believe that the suggestion of China on a “supersovereign currency” is made to enhance the influence of the RMB, that the objective of China is to promote the internationalization of the RMB in a variety of ways, and that the internationalization of the RMB has been brought into China’s national strategy. Nonetheless a handful of people pay more attention to the risk of internationalizing the RMB, believing that the RMB is unlikely to be internationalized and that risk should be the first consideration.

141

COOPERATION BETWEEN THE RENMINBI AND THE YEN

Amid the large number of comments, the essence and details of the issue

have often been neglected. The studies on RMB internationalization before the financial crisis were mainly from the perspective of market; with the

worsening of the crisis after 2008 the starting point of studies on the RMB

internationalization has changed from a single aspect to diversified aspects.

The ways to identify the characteristics of internationalization of a domestic currency, the characteristics of RMB internationalization, the motive force for

the RMB internationalization, the significance of RMB internationalization to China, Asia and the world community, and the strategies and steps for RMB internationalization are of important theoretical and practical significance.

The structure of research in this Chapter 1s as follows: Section I—analysis

of the major facts and characteristics of the rise of the RMB in Asia; Section

II—analysis of the main driving force for the rise of the RMB in Asia; Section III—analysis of the significance of the rise of the RMB to China, Asia and the international community; Section IV—discussion of the strategies for the Asianization and internationalization of the RMB.

Major Facts and Characteristics of the Rise of the RMB in Asia The first fact about the rise of the RMB in Asia is the cross-border use and

circulation of the RMB. Based on the way of cross-border circulation of the RMB, this section analyzes the major routes and the scale of cross-border circulation, the formation of RMB exchange rate in regions outside Mainland China, and the performance of the RMB as a vehicle currency.

Exit channels for the RMB First, import payment for frontier trade.1

One of the important reasons for cross-border circulation of the RMB is

the explosion in China’s frontier trade. With a vast territory and a long inland border, China is bounded by 15 countries which is a geo-economic advantage

for developing frontier trade. With the development of the Chinese economy, China is trading more frequently with neighboring countries and the volume of

frontier trade has been increasing. Frontier trade has become the “main force” that drives the economic growth of some border provinces. The development of

frontier trade facilitates the circulation of the RMB in regions outside Mainland

142

The RMB Asianization and Internationalization Strategies

China. Since 2000 the volume of both import and export of frontier trade of

China has experienced a great increase. From 1996 to 2004 the frontier trade

of China showed an adverse balance. The total amount of the adverse balance

reached USD 9.523 billion. Since 2004 the export volume of frontier trade has been experiencing great growth and there has been a favorable balance (see Fig. 5.1).

Volume of import and export in frontier trade during 1993–2008

250 200 150 100

Import in frontier trade

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

0

1994

50 1993

Unit: USD 100 million

Fig. 5.1.

Year

Export in frontier trade

Source: CEIC, General Administration of Customs of the People’s Republic of China .

Compared with general trade, the settlement of frontier trade has its own

characteristics which are mainly manifested in the choice of the clearing form and the currency of settlement (see Table 5.1). Table 5.1. Provinces

Statistics of settlement of import and export frontier trade in border provinces and autonomous regions2 Settlement

Heilongjiang

January–October, 2004: bank settlement accounts for 72.8%, among which direct remittances account only for 22.7%; cash settlement accounts for 25.7%, in which USD, Ruble and RMB cash account for 53%, 44% and 3% respectively; “counter-remittance”3 accounts for 1%; barter trade accounts for 0.5%.

Jilin

Barter trade accounts for the largest proportion, followed by USD or RMB settlement.

143

COOPERATION BETWEEN THE RENMINBI AND THE YEN

(Cont'd) Provinces

Settlement

Liaoning

Bank settlement accounts for about 60% and third-party transfer is dominant; cash settlement accounts for about 30% mainly in USD, Euro and Japanese Yen; the remainder is barter trade.

Inner Mongolia

For import, bank settlement accounts for more than 90%; export settlement is made in various ways including spot exchange, cash, and barter trade. In 2003 cash settlement by banks accounted for 69% in frontier trade and RMB remittance and bank settlement accounted for 7% and 76% respectively.

Xinjiang

Bank settlement accounts for about 40% and transfer is the dominant method; in the first half of 2004, cash income in USD accounted for 72% of the total income of frontier trade and RMB cash settlement was only used for countries such as Mongolia and Pakistan which are short of foreign exchange, hence the trade was relatively inactive; in addition, there also is “export serves import” or “import serves export”4 settlement methods.

Tibet

Bank settlement accounts for about 10%. RMB and Nepal Currency cash settlement play a dominant role.

Guangxi

In 2003, bank settlement accounted for 71.4% and became the main method of frontier trade settlement; in January–September, 2004 RMB settlement accounted for 82% and USD accounted for 19% in the settlement for bilateral frontier trades.

Yunnan

The proportion of the settlement in freely convertible currencies (such as USD) increases year by year. At present the settlement in freely convertible currency accounts for 78.1% and RMB settlement for 21.9%; however most cash settlement is in RMB.

Source: A Study on Foreign Exchange Control for Frontier Trade prepared by the current account management department under the State Administration of Foreign Exchange in December 2004 and published in the Study on Cross-border Currency Circulation and Foreign Exchange Control for Frontier Trade (China Financial & Economic Publishing House. 1st Edition, January 2005) compiled by the current account management department under the State Administration of Foreign Exchange.

The results of investigation and study conducted by branch administrations

of the State Administration of Foreign Exchange show that the proportion of

convertible currency represented by the USD is greatly different from the RMB

settlement. Furthermore, the RMB settlement for frontier trade in some provinces

has changed significantly since the year 2004. In recent years, thanks to the combined effect of several policies,5 the frontier trade settlement in Yunnan Province

144

The RMB Asianization and Internationalization Strategies

has changed fundamentally: the major frontier trade settlement currency changed from the USD to the RMB; the proportion of the RMB settlement for frontier trade in Yunnan Province has remained at over 90% for three consecutive years since 2005. Details: the RMB settlement for frontier trade in Yunnan Province was RMB 2.7 billion in 2005, an increase of 265%, and the proportion of RMB settlement changed from about 30% (annual average) to 85%; in the years 2006 and 2007 RMB settlement for frontier trade in Yunnan Province maintained a high-speed growth and the volumes were RMB 3.40 billion and RMB 3.87 billion respectively—the proportion was kept at about 91%. Due to the impact of the global financial crisis, RMB settlement for frontier trade was RMB 3.67 billion in 2008, a slight decline; however, the proportion of RMB settlement reached 90.2%. RMB settlement for frontier trade is the result of market forces, and the system established by the government for RMB settlement further promotes the increase in proportion of RMB settlement. Second, the residents of Mainland China go to Southeast Asia for tourism and to visit relatives, and buy goods there. RMB settlement accounts for a relatively large proportion in the payment of customs charges, tourist consumption and tour fees by residents from Mainland China in Southeast Asia. In recent years, with the increase in income, the number of tourists from Mainland China to other countries and their consumption capacity has been increasing continuously. Since the late 1990s the number of tourists from China to other countries have increased rapidly and the tourist destinations are all over the world. Most of the tourists from Mainland China go to Hong Kong, Macau, Japan, the Republic of Korea, Singapore, the Philippines, Malaysia and Thailand. The increase in RMB payments as a result of the increase in tourists from Mainland China is the principal cause of RMB circulation outside Mainland China (see Table 5.2 for details). Up until the present, tourism and relative visiting consumption by residents from Mainland China in other countries is still the principal channel through which RMB flows out of China. The acceptability of RMB in these countries and the agreement by local people on payment and consumption in RMB have promoted the circulation of RMB there. Third, RMB capital flows out through overseas investment and project contracting etc. The economic and trade cooperation between China and neighboring countries is mainly based on trade of goods. However the amount of overseas investment in government projects has been increasing while private enterprises put investment directly into regions outside Mainland China for factory construction. According to the statistics of the Department of Commerce of Yunnan Province, most of the enterprises conducting overseas investment in the border region of Yunnan

145

146

6,106

7,139

7,588

8,175

8,426

9,232

10,473

12,134

16,602

20,222

28,853

31,026

34,524

40,950

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

34,920

28,799

25,140

22,980

14,811

10,074

6,947

5,631

4,266

3,190

2,440

2,414

2,054

1,642

Private tour

–

14,334

–

–

9,310

7,771

5,319

4,142

3,571

–

–

–

–

–

Hong Kong, China

Source: National Tourism Administration.

Total number of outbound tourists

–

9,895

–

–

4,791

2,783

1,800

1,644

1,551

–

–

–

–

–

Macau, China

–

1,280

–

–

805

760

609

596

538

–

–

–

–

–

Japan

–

1,098

–

–

559

551

460

401

310

–

–

–

–

–

The Republic of Korea

–

557

–

–

262

289

281

263

211

–

–

–

–

–

Singapore

–

138

–

–

73

68

51

34

35

–

–

–

–

–

The Philippines

Statistics of tour destinations of tourists from Mainland China during 1994–2007

Year

Table 5.2.

–

435

–

–

244

231

124

87

84

–

–

–

–

–

Malaysia

–

767

–

–

528

689

652

707

814

–

–

–

–

–

Thailand

(unit: 1,000 tourists)

COOPERATION BETWEEN THE RENMINBI AND THE YEN

The RMB Asianization and Internationalization Strategies

Province are engaged in frontier trade and the overseas investment conducted by enterprises and individuals inside the province is mainly in RMB. In addition, Chinese companies also launch direct investment in RMB in Mongolia. But there is no complete statistical data in China about this part of overseas investment in RMB. Fourth, international development agencies issue bonds in RMB in China. Since the year 2002, international development organizations such as the International Finance Corporation and the ADB have started to raise capital by issuing bonds in RMB in China so as to meet their borrowing needs. According to the requirements of the State Council, the People’s Bank of China together with the departments concerned has made a study of the issuance of bonds in RMB by international development organizations. In 2005 the International Finance Corporation and the ADB obtained permission to issue bonds of RMB 2 billion respectively on the inter-bank market in China. Up to now the International Finance Corporation has completed the issue of bonds with a total amount of RMB 2 billion and the ADB has completed 1 billion. Fifth, RMB business in Hong Kong In order to support Hong Kong banks in operating RMB business, the People’s Bank of China issued an announcement on 19 November 2003 declaring that the People’s Bank would provide arrangement for settlement for banks that operate individual deposit business, exchange, bank card and remittance business in RMB in Hong Kong. Table 5.3 shows the development of and change in RMB business in Hong Kong since the year 2003. The startup of offshore RMB business in Hong Kong promoted RMB circulation in Hong Kong and has been considered an important channel for the RMB circulation between Hong Kong and Mainland China. After the startup of the RMB business, the deposit in RMB in Hong Kong has been increasing steadily. Since 2007 the deposit in the RMB has been experiencing a rapid increase. The amount of the RMB deposit was RMB 12.17 billion at the end of 2004, 22.59 billion at the end of 2005, 23.409 billion at the end of 2006, 33.4 billion at the end of 2007, and 47.829 billion at the end of February, 2008. Fig. 5.2 shows the rapid increase of deposit in the RMB in licensed banks in Hong Kong.6 Sixth, RMB card business On 10 January 2005, the China Unionpay (CUP) card business in the RMB was officially started in the Republic of Korea, Thailand and Singapore. Cash withdrawal and consumption by CUP card holders in the above mentioned three countries is in local currency. Upon the completion of cash withdrawal and consumption, CUP would convert the amount in local currency into the RMB according to the market exchange rate on the day of transaction and provide related information to the issuing bank in China, which would deduct the amount

147

COOPERATION BETWEEN THE RENMINBI AND THE YEN

from the account of the card holder in real time so as to protect the client from exchange rate loss in the case of consumption abroad. Since May 2005, CUP card business has been started in Hong Kong and Macau in progression. At present the tourists holding CUP cards are able to withdraw deposits using ATM and make consumption at post-of-sale terminal (POS) in Asia, Europe, North America and Oceania, which is to say that they are able to purchase commodities and enjoy services directly using the RMB. In case of consumption using the CUP card at abroad, the conversion will be made directly according to the RMB exchange rate Table 5.3.

Contents of RMB business in Hong Kong during 2003–20057

Business scope

Contents of RMB business in Hong Kong under the specification of Announcement issued by the People’s Bank of China in 2003

Contents of extended RMB business in Hong Kong under the specification of Announcement No. 26 issued by the Bank of China in 2005

Deposit

Licensed banks (participating banks) in Hong Kong that operate this business can open the RMB deposit accounts (free withdrawal and depositing) for Hong Kong residents and can voluntarily determine deposit term and interest rate.

Permit the opening of the RMB cash deposit account for designated companies and the one-way exchange of the RMB deposit in their accounts into the Hong Kong dollar.

Exchange

Conduct the exchange between the RMB and the Hong Kong dollar for individuals within the stipulated amount and exchange the RMB cash collected by some companies during the provision of shopping, dining and accommodation services to individuals into Hong Kong dollar. Exchange limit: (1) the amount of cash exchange for each individual shall not exceed RMB 6,000 (or equivalent) at a time; (2) the amount of exchange through deposit account shall not exceed RMB 20,000 (or equivalent) per individual per day.

Extend the scope of business RMB cash exchange from designated Hong Kong companies to the companies providing traffic, communication, medical and educational services in Hong Kong; the limit of amount for individual RMB cash exchange is raised to RMB 20,000 (or equivalent) per person at a time.

Remittance

Banks in Hong Kong can remit the RMB of depositor into the bank account with the same name in Mainland China from Hong Kong; however, the amount of remittance per depositor per day is subject to an upper limit. The remittee of the said remittance must be the remitter himself and the upper limit of remittance amount of the RMB per person per day is RMB 50,000. In this case, the banks in Mainland China shall conduct the release of remittance according to relevant regulations. Unutilized RMB inward remittance can be remitted back to Hong Kong after the examination and verification.

The upper limit of the RMB remittance amount per person per day is RMB 80,000.

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The RMB Asianization and Internationalization Strategies

RMB card

RMB cheque service business

Residents from Mainland China can consume goods or services in Hong Kong with the RMB card issued by banks in Mainland China. With the personal RMB card issued by banks in Mainland China, the residents from there can pay for the goods or services or withdraw a small amount of cash in Hong Kong. The credit granted for each RMB card issued in Hong Kong is RMB 100,000.

The credit limit of RMB 100,000 of each RMB card canceled.

None

The personal RMB cheque of Hong Kong citizens can pay for consumption expenditure in Guangdong Province under the upper limit of RMB 80,000 per day per account and is not transferable.

Source: www.safe.gov.cn.

The RMB deposits in licensed banks in Hong Kong (February 2004–March 2008) 60,000 50,000 40,000 30,000 20,000 10,000 February 2008

November 2007

August 2007

May 2007

February 2007

November 2006

August 2006

May 2006

February 2006

November 2005

August 2005

May 2005

February 2005

November 2004

August 2004

May 2004

0 February 2004

Unit: RMB 1 million

Fig. 5.2.

Total amount of the RMB deposits The RMB time deposit The RMB savings and current deposit Note: Total amount of RMB deposits = the RMB savings and current deposits + RMB time deposit Source: CEIC, Hong Kong Monetary Authority.

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COOPERATION BETWEEN THE RENMINBI AND THE YEN

and local currency on the day of consumption. Seventh, money changers, stall banks and underground exchange etc. In quite a few of neighboring countries and regions, the RMB has been taken as local convertible currency. Money changers, stall banks and other informal financial institutions started the RMB exchange business and underground exchange business, buying and selling the RMB as a special commodity, creating the channel for the outflow and return of the RMB. For example, since there are insufficient legal RMB–Kyat exchange agencies for trading settlement at the border of China and Burma and the commercial banks of these two countries have not established normal agency relations, the market demand contributes to the emergence of “stall banks” due to the poor settlement channel. Since there are no equivalent agencies, the “stall banks” promote the development of frontier trade while bringing major financial risks. From the perspective of the intensity of impact on outflow of the RMB, the major channels for outflow of the RMB include frontier trade settlement, cashes carried by inward and outward going personnel and the operating activities of stall banks and illegal private banks. Offshore gambling, smuggling and payment for drugs are also important channels through which the RMB flows out.

Channels for the RMB backflow Since the RMB has no interest-bearing sources and investment purpose in regions outside Mainland China, most of the RMB that flows out will flow back into Mainland China although a small amount is used as cash position for turnover. The major channels of backflow of the RMB include non-resident inbound tourism and travel on home leave. It has been observed that a large number of Hong Kong residents carry the RMB to Mainland China for consumption every weekend. Payment for frontier trade and relevant handling charges in RMB, the payment in RMB as a result of favorable balance of frontier trade of China, direct investment in Mainland China by non-residents, labor expenses, and purchasing of real estates and stock assets are also important methods by which the RMB flows back.8 Besides the above-mentioned methods, some of the RMB that flows out of Mainland China will flow back through the banking system. This covers two cases: first, non-residents deposit the RMB into financial institutions at the ports of China directly, for example, the banks at border regions of Inner Mongolia and Yunnan can conduct the RMB saving business using the border pass issued by the nation of the counterparty and the balance even accounts for more than

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The RMB Asianization and Internationalization Strategies

1/3 of the local balance of savings; second, the foreign banks redeposit their RMB in banks in Mainland China. At the beginning of 2004, RMB business was started in Hong Kong and Macau in succession, creating the mechanism for legal backflow of the RMB from regions outside Mainland China. The People’s Bank of China issued a proclamation on 1 November 2005 declaring that the range of unwinding and settlement for RMB business conducted in Hong Kong banks would be expanded. The issue of bonds in the RMB in the year 2007 also promoted the backflow of the RMB from Hong Kong to Mainland China through banking system. Cross-border flow of the RMB is an inevitable outcome of market demand. In recent years the motive of cross-border circulation of the RMB has become increasingly complicated, developing from simple transaction demand to transaction, speculation and value reserve etc.; at the same time, the flow channels have been diversified, developing from frontier trade settlement and outbound tourism to cross-border capital investment etc.

Scale of cross-border circulation of the RMB First, estimation of the total amount of the RMB accumulation and circulation in neighboring countries The investigation team on cross-border flow of cash in the RMB (Jiang Wanjin et al., 2005) carried out an investigation on the cross-border flow of the RMB cash in Hong Kong, Macau and neighboring countries, including the Democratic People’s Republic of Korea, Vietnam, Burma, Laos, India, Nepal, Sikkim, Bhutan, Kazakhstan, Kirghizstan, Tajikistan, Afghanistan, Uzbekistan, Pakistan, Mongolia and Russia. Investigation and survey findings showed that the retention of RMB cash in neighboring countries, Hong Kong and Macau was about RMB 21.6 billion by the end of the year 2004, the annual cross-border outflow of the RMB cash was 771.3 billion, and the net outflow amount was 9.9 billion. The data for 2007 given in the RMB Cross-border Flow Monitoring Report in Yunnan Province prepared by the central branch of the People’s Bank of China in Kunming showed that the cross-border RMB outflow and inflow to and from neighboring countries of Yunnan Province reached RMB 66.98 billion in 2007, an increase of nearly 50% over the previous year; the amount of inflow was 33.79 billion and the amount of outflow was 33.19 billion, the net inflow amount was RMB 598 million. It is estimated that the RMB stock in Vietnam, Laos and Burma exceeded 15 billion in 2007 and may have reached about 20 billion by now, which is 4 times the amount in the year 2004. According to the

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COOPERATION BETWEEN THE RENMINBI AND THE YEN

investigation by the central bank of the People᾽s Bank of China in Kunming, the stock amount of the RMB in the Vietnam Agricultural and Rural Development Bank Laojie Branch for the first half of 2008 was about RMB 6 million. Thus it can be seen that RMB in regions outside Mainland China is mainly retained by social sectors. In view of the fact that frontier trade and payment in the RMB for crossborder consumption by tourists are the principal channels of cross-border circulation of the RMB at present, Guan Tao, Pan Hongsheng (2004) and Li Jing (2008) carried out a rough estimation of the amount 9 (see Table 5.4). Since the year 1994, the scale of cross-border circulation of the RMB has been expanding. Due to the dramatic increase of inward and outward personnel in 2001 and 2002, the amount of cross-border circulation of the RMB as a result of frontier trade and cross-border tourism in 2002 reached up to RMB 120 billion. It should be noted that this is just the estimation of the minimum amount of cross-border circulation of RMB. If the underground economy, border trade and statistical error are taken into consideration, the actual cross-border circulation amount of the RMB in 2002 may be larger and it is estimated that this amount is about 120–140 billion. The calculation results show that the stock of RMB in regions outside mainland China is about RMB 5 billion, but when RMB transactions through underground channels are taken into account the stock of RMB in regions outside Mainland China would be 5–12 billion. Since 2002 the number of visitors from Mainland China to other regions of Asia and from Hong Kong and Macau to Mainland China has been increasing rapidly and the cross-border circulation scale of RMB has expanded sharply; by the end of 2007 the amount had reached USD 360.32 billion and the net outflow of RMB for the same period of time reached USD 53.57 billion. This estimation of flow and stock of the RMB in regions outside Mainland China is close to the estimate results of the People’s Bank of China. However when compared with the estimation of UBS Warburg,11 the RMB flow is larger and its stock is smaller. Due to the narrow investment channel of the RMB in regions outside Mainland China and the high proportion of cash used, the holding of a large amount of RMB cash is not economical at present. Theoretically the cross-border circulation of the RMB showing the feature of “large outflow and inflow volume” should be more reasonable. The abovementioned difference between estimations of actual cross-border circulation of the RMB shows that it would be complicated and difficult to control and monitor the amount of cross-border RMB circulation since the cross-border circulation of the RMB gives priority to cash circulation. It should be noted that the following two common methods shall be

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The RMB Asianization and Internationalization Strategies

excluded when estimating the cross-border circulation scale of RMB: first, nondelivery forward (NDF) RMB transaction is not included in the cross-border circulation of the RMB since it would be finally completed in USD although the RMB is used as the subject matter during transaction; second, the “both-ends-

abroad” monetary intermediation method of illegal private banks (collecting Table 5.4.

Estimated amount of cross-border circulation and net outflow of the RMB (1994–2007)10 Outflow due to outbound tourism

Circulation amount due to frontier trade

Year

1994

Total Frontier volume trade of frontier balance trade

Current exchange rate

Cross-border circulation scale of RMB due to frontier trade (unit: RMB 100 million)

Unit: USD 100 million (1)

(RMB/ USD) (3)

(4)=(1)×(3)×a

4.29

Unit: USD 100 million (2) 0.32

8.6187

3.70

Net outflow of RMB due to frontier trade (unit: RMB 100 million)

Payment for private Private tour to consumption other regions in other of Asia (unit: regions of 10,000 people) Asia (unit: RMB 100 million)

(5)=(2)×(3)×a

(6)

(7)=(6)×b

0.28

139.6

27.9 52.4

1995

3.4

0.71

8.3507

2.84

0.59

174.6

1996

10.02

–2.37

8.3142

8.33

–1.97

205.2

82.1

1997

18.84

–3.58

8.2898

15.62

–2.97

207.4

103.7

1998

20.13

–4.04

8.2791

16.67

–3.34

271.2

162.7

1999

31.45

–6.91

8.2783

26.04

–5.72

362.6

217.6

2000

45.66

–19.01

8.2784

189.00

–78.69

478.6

287.2

2001

41.25

–24.43

8.2770

170.71

–101.10

590.5

354.3

2002

56.97

–20.41

8.2773

235.78

–84.47

856.3

513.8

2003

77.78

–8.27

8.2773

321.90

–34.23

1,258.9

755.36

2004

94.36

–6.22

8.2773

390.52

–25.74

1,953.3

1,171.98

2005

131.1

16.91

8.1917

536.97

69.26

2,136.9

1,282.14

2006

161.56

37.29

7.9718

643.96

148.63

2,447.9

1,468.75

2007

213.22

61.49

7.6071

810.99

233.88

2,968.2

1,780.92

1994

3,699.7

74.0

105.60

–46.38

–

–

–

1995

3,885.2

77.7

132.94

–25.89

–

–

–

1996

4,249.5

85.0

175.43

–0.93

–

–

–

1997

4,794.3

95.9

215.22

10.77

–

–

–

1998

5,407.5

162.2

341.57

3.84

–

–

–

1999

6,167.1

246.7

490.34

–23.38

–

–

–

2000

7,009.9

350.5

826.70

15.39

–

–

–

2001

7,434.5

452.1

977.11

3.30

–

–

–

2002

8,080.8

486.5

1,236.08

111.77

–

–

–

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COOPERATION BETWEEN THE RENMINBI AND THE YEN

(Cont'd) Outflow due to outbound tourism

Circulation amount due to frontier trade

Year

Total Frontier volume trade of frontier balance trade

Current exchange rate

Cross-border circulation scale of RMB due to frontier trade (unit: RMB 100 million)

Unit: USD 100 million (1)

(RMB/ USD) (3)

(4)=(1)×(3)×a

Unit: USD 100 million (2)

Net outflow of RMB due to frontier trade (unit: RMB 100 million)

Payment for private Private tour to consumption other regions in other of Asia (unit: regions of 10,000 people) Asia (unit: RMB 100 million)

(5)=(2)×(3)×a

(6)

(7)=(6)×b

2003

7,752.7

464.9

1,542.17

324.69

-

-

-

2004

8,842.0

884.2

2,446.70

313.52

-

-

-

2005

9,592.8

959.3

2,778.39

253.60

-

-

-

2006

9,831.8

983.2

3,095.89

336.93

-

-

-

2007

10,113.6

1,011.4

3,603.27

535.68

-

-

-

Notes: (1) The coefficient “a” used for estimation of cross-border circulation of the RMB in frontier trade indicates the proportion of settlement in the RMB for frontier trade; this coefficient takes 10% for the period 1994–1999 and 50% for the period 2000–2007. In fact the proportions of settlement in RMB in different border regions are different. The values “10%” and “50%” are the rough estimate based on the investigation and study by the People᾽s Bank of China and thus not very accurate.

(2) In the year 2002, the number of people who travelled from Mainland China to other regions of Asia accounted for about 85% of total number of outward personnel, hence the number of outward personnel to other regions of Asia for private purposes shall be the product of the number of outward personnel for private purposes and the percentage value 85%. Since the number of people and the payment for consumption is increasing, the per capita consumption payment coefficient “b” for the period 1994–1997 is estimated based on per capita consumption of RMB 2000–5000. Assuming that the per capita consumption was RMB 2000 in 1994, 3,000 in 1995, 4,000 in 1996, 5,000 in 1997 and 6,000 in 1998, this coefficient is deemed relatively rational when taking into account the consumption in regions outside Mainland China by carrying the amount of cash that exceeds the upper limit.

(3) Since most of the cash from the regions outside Mainland China is from Hong Kong and Macau, the incoming amount of RMB shall be estimated according to the number of people that come to Mainland China from Hong Kong and Macau. Inbound cash carrying coefficient “c”: taking into account the fact that people from Hong Kong and Macau took a very small amount of the RMB to Mainland China before the return of Hong Kong, this coefficient for estimation shall take RMB 200 during 1994–1997, 300 in 1998, 400 in 1999, 500 in 2000 and 600 per capita during 2001–2003. Furthermore, this coefficient shall take RMB 1,000 during 2004– 2007. Source: CEIC 2008; the export and import data for frontier trade are from the statistics of General Administration of Customs of the People᾽s Republic of China. Data about inbound tourism of Hong Kong and Macau residents and the outbound tourism of residents of Mainland China is from the National Tourism Administration. The annual data of exchange rate of the RMB against the USD is from the Administration of Exchange Control.

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The RMB Asianization and Internationalization Strategies

RMB in Mainland China but completing the transaction outside China in foreign currencies) is also not included in the cross-border flow of the RMB but in the conversion of foreign currency and the RMB. Due to their undetectable techniques and convenience of transaction completion, illegal private banks are the principal underground transaction mode at present. After 2002, according to the tendency of cross-border circulation of the RMB, the cross-border circulation scale of the RMB would continue to expand to some extent within the next period of time due to the impact of continuous development of frontier trade, the increase in number of outbound tourists from Mainland China and the acceleration of convertibility process of the RMB. However, due to the official startup of the RMB backflow mechanism in Hong Kong, a larger amount of RMB would flow back from the regions outside Mainland China if the conditions for forward spread and appreciation expectation keep unchanged; in this case, the actual amount of RMB that is accumulated in areas outside Mainland China would decline to a great extent. It is difficult to estimate the cross-border circulation amount and overseas stock of the RMB accurately. However due to the close economic links between Hong Kong and Mainland China, Hong Kong is both the major destination of the RMB outflow and the important source for backflow of the RMB. Hence it is feasible to estimate the RMB stock in Hong Kong and this has a greater value for academic discussion and countermeasure researches. Second, estimation of the amount of RMB circulating in Hong Kong Many researchers have carried out research and estimation on the circulation scale of the RMB in Hong Kong. Table 5.5 is the summary of available investigation findings and studies.

Formation of the RMB’s foreign exchange rate Li Jing and Zhang Zhaohui (2008) made studies of the change in the exchange

rate of currencies of Hong Kong, Thailand, Singapore and the Republic of Korea etc. against the RMB and compared these exchange rates with those

in the foreign exchange market of Mainland China. The results showed that

the exchange rate of the RMB in regions outside Mainland China reflects the demand of the local market for the RMB. In the neighboring countries and regions the demand for the RMB is relatively strong; even in case of a short-

term imbalance between supply and demand of the RMB, the supply and

demand of the RMB tends to balance due to the low arbitrage cost. Hence the local exchange rate of the RMB is close to that in Mainland China. However

the exchange rate of the RMB is high in countries and regions without strong

155

COOPERATION BETWEEN THE RENMINBI AND THE YEN

demand for the RMB. On the other hand, the exchange rate in regions outside

Mainland China is the indicator of expectation of the RMB exchange rate on the local market and international market. When RMB depreciation is expected,

the RMB in regions outside Mainland China will become weak. During the Table 5.5.

Estimation from researchers and research institutions on the RMB stock in Hong Kong

Source

The amount of RMB in Hong Kong

Hu Jiana (1997)

The amount of cash carried by tourists from Mainland China to Hong Kong reaches RMB 10 billion. HKD 15 billion (RMB 9.4 billion) in 1993; the amount of RMB that flows into Hong Kong and Macau per month exceeds 2 billion.

Yang Fan (1998)

In 1993 the Chinese government officially permitted that each person can take RMB 6,000 to Hong Kong per visit. At present RMB 10 billion is taken to Hong Kong per year and the amount of RMB in Hong Kong is equivalent to USD 20 billion.

Zhang Lijuan, Sun Chunguang (2002)

It is estimated the circulation amount of RMB cash in Hong Kong was 60 billion in 2001; about 60 billion flows from Hong Kong into Mainland China via conventional channels and 30 billion flows from Mainland China to Hong Kong through conventional channels; the inflow amount via unconventional channels is 30 billion.

Ba Shusong (2002)

During the period 1996–2001, Hong Kong received 18.9 million visitors from Mainland China. Assuming that each tourist has paid RMB 3,000 for consumption, there should be at least 57 billion in the Hong Kong market.

Yi Xianrong (2003)

Around the year 2003, the amount of RMB stock in Hong Kong was about RMB 50–70 billion.

Huang Shaoming (2004)

According to the number of tourists to Hong Kong in 2003 (6.82 million) and the official regulation specifying that each tourist shall not take more than 6,000 of the RMB to Hong Kong, it is estimated that 41 billion flowed into Hong Kong in 2003.

UBS Warburg

Assuming that the tourists from Mainland China increased by 50% in 2002 and the yearly increase rate would be 15% after that year, if the tourists pay 50% of the RMB 6,000 in Hong Kong, the amount of RMB in Hong Kong would be about 157 billion in 2005; if each of the tourists from Mainland China spends RMB 6,000 in Hong Kong, the amount of RMB in Hong Kong would be 313 billion in 2005.

Note: Xu Qiyuan (2006) estimated the stock amount of RMB in Hong Kong through the gap estimation method and the results divided the change in the amount of RMB in Hong Kong into six stages. The change in stock amount of RMB in Hong Kong is closely associated with the exchange rates of the RMB and the HKD, the exchange rate of the RMB against the HKD, and the economic situation of Mainland China. After the central bank approved personal RMB business in Hong Kong in February 2004, the stock amount of RMB in Hong Kong showed a downward trend.

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The RMB Asianization and Internationalization Strategies

Asian financial crisis, a strong expectation of RMB depreciation occurred in regions outside Mainland China and the level of NDF was lower than the spot exchange rate; when there is a strong appreciation expectation in the market, the RMB will be in strong demand due to the influence of interest arbitrage and exchange arbitrage factors, and the local exchange rate of the RMB will accordingly increase and thus deviate greatly from the exchange rate in Mainland China.

The RMB as a vehicle currency Based on the analysis of cross-border circulation of the RMB described above, we can determine the stage of RMB regionalization according to the definitions of currency internationalization from different perspectives in economics literature. First, the RMB regionalization from the perspective of functional expansion of currency According to the meaning of currency internationalization, the function of an international currency is the extension of the domestic function of currency to foreign areas. The specific functions shall include medium of exchange, accounting unit and value storage (see Table 5.6). Table 5.6.

International currency functions of the RMB

Currency function

Private use

Official use

Medium of exchange

(1) Frontier trade (2) Foreign exchange transaction (on a small scale)

None

Accounting unit

Frontier trade

None

Value storage

Deposits and bonds in RMB in Hong Kong

Reserve currency of Cambodia, the Philippines and South Korea

It can be seen from Table 5.6 that the RMB shows the function of an international currency only within the private section at present. From the perspective of area, the international currency function of the RMB is limited to the neighboring regions of China; with respect to currency function, the RMB is mainly used as an accounting tool for frontier trade. The total transaction volume of the RMB has increased sharply on the foreign exchange market but the scale is still very limited, accounting for 0.5% of the total amount of foreign exchange transactions all over

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COOPERATION BETWEEN THE RENMINBI AND THE YEN

the world in 2007; structurally, the transaction is divided into spot transaction and forward transaction and the former plays a dominant role. Compared with other currencies, this structure of the RMB indicates that the activity of the RMB in the foreign exchange market is significantly lower than that of general international currency; this also reflects the fact that the low participation of the RMB in the international financial market results in weak demand for financial transaction. The medium of exchange is a basic function of international currency and only on this basis can the currency demand of other functions come into being. We can also see that the regionalization of the RMB has been involved with the three functions in the private sector of which the application is the basis of official use. Hence although RMB regionalization is reflected only in the local functions within the range of neighboring regions, it shows some features of an international currency. In this sense, this so-called “regionalization” should be interpreted as the localization of the RMB since it plays the role of an international currency only in neighboring countries and economies. Second, progress of the rise of the RMB from the perspective of the international division system China shows two features in the international division system: first, its economic scale is much larger than the average scale of the world; and second, the labor productivity is much lower than that of the countries with an equivalent economic scale (see Fig. 5.3). These two features determine the fact that China has both weak points and strengths in the international labor division system: compared with the U.S., China has a lower labor division position and shows no advantages compared with some certain countries; but compared with the neighboring countries, China is relatively strong. Fig. 5.3 shows that the economic scales of Tajikistan, Kirghizstan, Kazakhstan, Mongolia, Laos, Nepal, Bhutan, Cambodia and Pakistan etc.12 are much smaller than that of China and the labor productivity in those countries is relatively low. According to the pattern of division systems of the world, the U.S. occupies a clearly dominant position. The situation in East Asia and the neighboring regions of China is relatively complicated since Japan occupies the relatively dominant position and both China and South Korea have a comparative advantage in varying degrees. Among neighboring regions, China has an outstanding advantage in the division system. The multi-level feature of international division system determines the fact that RMB internationalization should be “regional internationalization” in neighboring countries; it can also be observed that the internationalization of the RMB in a large scope would be a long-term process during which the improvement of labor productivity (as the fundamental economic factor) would play a decisive role.

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The RMB Asianization and Internationalization Strategies

The above analysis shows that use of the RMB has already begun in Asia,

and this will be an important variable for the growth of the Chinese economy.

Therefore the factors that determine the acceptability of the RMB in regions outside Mainland China and whether or not these factors are temporary or long term will to some extent determine the sustainability of use of the RMB in Asia.

The Major Driving Force for the Rise of the RMB The rise of the RMB in neighboring countries is closely related with the

economic growth and the change in economic and trade relations with foreign countries and the system arrangement after the reform and opening-up of

China. It is necessary to analyze the major driving force of the rise of the RMB

in Asia and the change of economic relationships of China with neighboring countries, especially with the ASEAN and between Mainland China and Hong

Kong from the perspective of real economy and, according to the general characteristics of currency internationalization, to analyze the change of value

stability and availability of the RMB since the 1990s while analyzing the impact

of exchangeability of the RMB and the change in foreign exchange system on RMB internationalization from the system perspective.

The exchange rate stability, the continuous increase in China’s national comprehensive strength and influence Over the past thirty years China has adhered to the reform and opening-up strategy. It should be particularly noted that since the launch of Ninth Five-

year Plan, thanks to the sustained, rapid and stable growth of the national

economy, the actual economic scale and comprehensive national strength of

China is among the best in the world and has promoted the status and influence of China in the global community, especially in regional economic and financial

affairs. Since the unification of exchange rates conducted in the year 1994, and

especially after the Asian financial crisis, the RMB exchange rate has been kept stable and experienced a slight increase, and the RMB has become one of the emerging strong currencies of the world. Based on the serious inflation and

expectation of exchange depreciation, a strong currency will inevitably replace

a weak currency. The continuous appreciation of the RMB against the currencies of neighboring countries provides a broad space for use and holding of the RMB in regions outside Mainland China.

159

160

Log value of per capita GDP

2.5

3.0

3.5

4.0

4.5

5.0

Fig. 5.3.

8.5

Tonga

9.5

Kuwait UAE

Singapore

Malaysia

Log value of GDP

10.5

Nepal

Combodia Ecuador

11.5

Bangladesh

Pakistan

Indonesia

Thailand Mexico Iran

South Korea Poland

Spain

Brazil

Russia

Italy

UK

India

12.5

ECU

The U.S.

Mainland China

Japan

Australia France Netherland Canada Germany Hong Kong

Venezuela Kazakhstan Guatemala

Panama Salvador

Macau

Laos Kirghizstan Tajikistan

Mongolia

Bhutan

Iceland

Luxembourg

The logarithmic values of GDP and per capita GDP of various countries and regions in 2004

13.5

COOPERATION BETWEEN THE RENMINBI AND THE YEN

The RMB Asianization and Internationalization Strategies

Integration of the Chinese economy with peripheral economies The increase in bilateral trade, investment and personnel exchanges between China and its neighboring countries provides the physical carrier for circulation of the RMB in surrounding regions, and the RMB partially plays the role of a vehicle currency. At present the scope of circulation and use of the RMB is no longer limited to neighboring countries and regions; the RMB has been generally allowed to be used for payment and settlement in Vietnam, Burma, Laos, North Korea, Mongolia, Russia, Pakistan and Nepal and has been used in Hong Kong, Macau, Bangladesh, Malaysia, Indonesia, Singapore, the Philippines and South Korea for deposit and other RMB business. Furthermore the RMB is convertible in some developed countries such as the U.S. and the UK, where the rate of exchange against the local currency is calculated on a day-to-day basis.13

Acquiescence of neighboring countries in the use of the RMB In order to promote the development of frontier trade and tourism, the governments of neighboring countries and regions usually acquiesce in the use of the RMB and take the RMB as a general foreign currency while exerting no special control thereon. The governments of Burma and Laos specify that the RMB is not allowed to flow into areas more than 20km away from the border; however it can be freely used or circulated in areas less than 20km away from the border. Since the RMB is not freely convertible and cannot circulate in the banking systems of neighboring countries and regions, it usually flows within the private sector. For the past few years the proportion of settlement in RMB

has shown an upward trend thanks to the continuous expansion of bilateral trade. China has negotiated with some neighboring countries for settlement

and cooperation in RMB, agreeing that both sides can establish exchange

offices and commercial banks to act for national banks to perform settlement

so as to further legalize bilateral exchange between the RMB and the currencies of neighboring countries. China has now signed bilateral settlement and

cooperation agreements with the central banks of Russia, Mongolia, Vietnam, Laos, South Korea, Kirghizstan and Nepal and these agreements have further

legalized the settlement in local currency. The central banks of Malaysia, South Korea and the Philippines have officially taken the RMB as one of their reserve currencies. In 2005 India brought the RMB into the calculation of the currency basket exchange rate.

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Relatively comfortable institutional environment and the improvement of the RMB convertibility The foreign exchange system of China has limited the outflow of RMB and implemented a “non-internationalization” strategy for a long time, fearing that increased circulation of the RMB in foreign countries may have an impact on the domestic financial market and undermine the independence of monetary policy. Before 1993, China’s monetary authorities specified strict foreign exchange restrictions on the outflow and inflow of the RMB. With the continuous deepening of opening-up and the increase in trade and personnel exchange, since 1993 China has carried out the reform of local currency and foreign currency policies designed to facilitate trade circulation and commercial communication, and this reform has improved the availability of RMB and increased the quota continuously. In the neighboring countries and regions of China, the RMB is equivalent to the USD and other hard currencies and is relatively easy to obtain. In order to enhance the function of the RMB in frontier trade settlement, some border provinces have carried out system innovation. For example, Yunnan Province launched the pilot project of settlement of tax reimbursement for export for petty frontier trade in 2004 (Zhang Yanhua, 2009); in addition, Yunnan Province has founded two RMB settlement models for frontier trade according to the characteristics of Yunnan Province, namely the back-to-back home currency account cross-border settlement for Sino– Vietnam frontier trade and the RMB transfer settlement for Sino–Burma frontier trade. This settlement model requires non-residents to open a “special account for frontier trade settlement in RMB” in Chinese banks and to complete the settlement of frontier trade through domestic RMB transfer. It has effectively facilitated the tax reimbursement for export in RMB for frontier trade in Yunnan Province, cracked down on rampant “stall banks” operations in the China– Burma border area, and brought the frontier trade settlement back into the main channel of bank settlement. Compared with other currencies, the exchange rate of the RMB has been kept stable and increased slightly after the financial crisis in 2008, and the RMB has become a hard currency on the market. In some parts of France and Japan, tourists are able to enjoy RMB foreign currency two-way conversion services. In brief, real economy is the major driving force of the rise of the RMB and the institutional support from government and the comfortable policy environment further improves the availability, acceptability and convenience of the currency. Additionally, due to the limitation of legal official channels

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for cross-border trade in RMB and the partial absence of financial regulation in Mainland China, some underground economic activities have promoted the cross-border circulation of the RMB.

The Significance of the Rise of the RMB to China, Asia and the World Many scholars believe that the two financial crises have provided an opportunity for the rise of the RMB in Asia. In fact it is the continuous rise of China’s status in the global economy that enables China to play a more important role in overcoming regional and global crises. The rise of the RMB is of practical significance to the economy of China, Asia and the world. For China, the greatest benefit of RMB internationalization is to protect the real economy. In international trade, the operating risk of import and export enterprises can be reduced if settlement in local currency is riskfree. Moreover if the RMB is internationalized it would assuredly become an officially held reserve currency, and if that is the case the Chinese economy will be provided with stronger self-balancing ability in case of appreciation or depreciation of reserve currencies such as the USD and Euro. Moreover RMB internationalization would make a great contribution to the steady growth of the Asian and global economy.

The significance to Asia’s trade and investment Since 2000, bilateral trade between China and its neighboring countries has developed rapidly and the volume of trade between China and Northeast Asian countries and ASEAN members has increased sharply. The acceleration of market integration in Asia demonstrates that Asia is more like a unified market. From the perspective of economic efficiency, the highest form of market integration is the emergence of a unicurrency. During the process of trade growth in Asia, the steady growth in contribution of China to regional trade and the stability of trade dependence in Asia shows that China has certain comparative advantage with respect to regional division in Asia, especially when compared with some small economies. The use of the RMB as the denomination currency or settlement currency for bilateral trade reflects the trend of market development, meets the market requirements, facilitates the trade transactions, overcomes the disadvantage of international settlement means of counterparty to some extent, and helps to promote and expand the bilateral trade. The expansion of the RMB transaction network in neighboring countries and regions and the increase of import and export

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volume between China and Asian countries manifest China’s competitiveness

in Asia. Transaction network participants can obtain higher network externality and the selection of the currency of a close trading partner with stable growth

prospects as the denomination currency means the reduction of transaction costs and is consistent with the efficiency principle. When taken as the vehicle currency in trade, the RMB would promote economic circulation between

China and its neighboring countries and gradually expand the transactions

so as to achieve the results of scale economy; additionally, this could reduce

the dependence on the USD and to some extent overcome the risk of USD weakness.

The functioning of the RMB as a partial vehicle currency will promote the

mutual investment between China and neighboring countries. China and its neighboring countries and regions maintain a rapid growth in both trade

and mutual investment. For China, direct investment in RMB in neighboring countries could not only save foreign exchange but could also create a channel for the backflow of RMB; in the future, the counterparty can also make

investment in mainland China in RMB so as to reduce exchange rate risk and transaction costs.

The significance to export-oriented enterprises Due to the “non-internationalization” characteristics of the RMB, a large number of foreign economic transactions are denominated in the USD and as

a result, import and export enterprises often have to deal with USD exchange rate fluctuations. The most instinctive reaction of these enterprises is to take measures for payment in advance and deferred payment which may result in fluctuations of the foreign exchange market. There are a large number of large-

scale export-oriented enterprises in China, but since the products produced in

and exported from China are usually at the lower end of the industrial chain with low domestic added value and marginal profit, and further given that the financial market of China is underdeveloped, these enterprises have a weak

ability to respond to exchange rate fluctuation risks. What invariably happens is that the “breeze” in foreign exchange market may make some enterprises shudder or even result in bankruptcy. Thus the enterprises at the lower end of

the international industrial chain have insufficient ability to respond to and resolve the external impact of the exchange rate. RMB internationalization would largely defuse the risks of enterprises in this respect.

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The significance to banking The expansion of range of the use of the RMB in foreign countries requires banks to provide corresponding financial services. Although the bilateral payment agreements signed by China with neighboring countries and regions are agreements between central banks, they must be implemented through commercial banks which can provide customers with financial services such as currency exchange, settlement, deposit, loan, fund trusteeship and information consultation, and are important participants in the outflow and backflow of the RMB. The extension of range and scale of the use of the RMB outside Mainland China and the increase in demand of non-residents for RMB means the emergence of an offshore RMB market of a certain scale in the future. The demand of RMB holders for the maintenance and increase of RMB value would naturally bring about the demand for RMB deposit and loan. Therefore the development of RMB products would be a new field for Chinese-funded banks to expand their business scope. The development of new RMB products is involved with product pricing, promotion and operation. The exchange rate and interest rate of the RMB on the free market will facilitate the pricing of RMB assets. With the increase in rationality of the RMB interest rate and exchange rate, the overseas RMB business innovation capacity of commercial banks would be improved; these commercial banks would provide non-residents with better financial services and promote the reputation of the RMB on the overseas market. To sum up, the progress of regionalization of the RMB would stimulate the development of offshore RMB business and be of great significance to the promotion of the RMB business operation ability of Chinese-funded banks and the adaptation to the trend of financial globalization.

The significance to Asian monetary and financial cooperation After the financial crisis of 1997–1998, Asian countries realized their weaknesses in trading and financial market construction and have made great efforts in the field of trade integration. For example, these countries put forward the suggestion of bilateral free trading areas when multilateral trade liberalization was hindered and took actions to promote trade integration. Asian countries have also made a lot of efforts in financial market integration, for example the construction of the Asian bond market and the multilateral exchanges under the CMI. Within over one decade after the crisis, Asian countries have found more common interests. Due to the U.S.-oriented trade, Asian countries have been

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subjected to severe impact after the economic recession in the U.S. Additionally, due to the lack of a currency anchor in Asia, the development of the Asian

financial market is also affected by USD fluctuation; the large amount of USD financial assets held by Asian countries face problems when the USD is strong

or weak. To establish a more “Asia-oriented” financial market it is necessary to cultivate a vehicle currency inside Asia. The performance of the RMB over

the past decade shows that the RMB could be taken as a “candidate” for the Asian vehicle currency. The growth of the RMB in Asia is conducive to the

construction of the financial market in Asia and would facilitate the integration

of the Asian market. When unexpected shocks occur in Asia, China can largely assume the responsibility to resolve the impact; the supportive actions of China

would create greater confidence in the market and the RMB would take more effect. Therefore the growth of the RMB would protect the real economy of Asia directly or by promoting financial market integration.

The significance to the construction of an Asian regional monetary system and the reform of the global monetary system After the Asian financial crisis of 1997, the most critical issue for newly industrialized countries was to select a suitable exchange rate system under

the fluctuation of the principal currency. With the enhancement of the status of the Chinese economy in Asia and the increase in degree of Asian market

integration, the RMB is able to provide Asian countries with a generally accepted measure of value, circulation means and reserve means, and help

emerging market economies in Asia to solve the problems in selection of exchange rate system. With the support of the Asian market, the RMB is likely

to become the “common language” of Asian countries and would remarkably improve the imbalanced international monetary system.

Over the past 20 years, great changes have taken place in global industrial

division and China and other emerging Asian market economies have

been playing an increasingly important role in the global industrial chain and the world economy. However the RMB and other Asian currencies

are still non-international currencies. The importance of economic status and the unimportance of currency create an asymmetry or “mismatching.”

Regionalization of the RMB can to a certain extent gradually reduce the

excessive dependence of the global economy or at least Asian economies on the

USD, restrict the behavior of the U.S. and prevent it from abusing the USD. This is of great significance to the correction of global economic imbalances.

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RMB Asianization and Internationalization Strategy The above analysis shows that the rise of the RMB in Asia has become a reality (however, this does not mean that RMB has been internationalized in Asia but just shows that the internationalization of RMB has begun). The relative decline of the USD offers an opportunity for growth of the RMB. Before the financial crisis, China basically had no integral RMB internationalization strategy and the internationalization of the RMB was conducted in the private sector spontaneously. After 2004, China allowed and encouraged some frontier provinces to establish RMB settlement pilot projects and cooperate with some neighboring countries in bilateral settlement in local currency. The main purpose of these practices is to facilitate the foreign trade of frontier provinces, help businesses to reduce settlement risk, weaken underground economic strength and avoid the impact of irregular cross-border flow of the RMB on the financial system. The measures taken by the Chinese government follow the market development trend and have to some extent satisfied the demand of cross-border trade and tourism consumption for RMB. Before the outbreak of international financial crisis in 2008, Chinese scholars had fully discussed the approach and strategy of RMB internationalization. After the outbreak of the crisis, the limitations of non-internationalization of the RMB were fully exposed. Promotion of RMB internationalization is not only a provisional measure for China to counteract the crisis, but also a long-term aspiration for sustainable development to be realized through reform and opening-up.

Bringing RMB internationalization into the national competition strategy Before the outbreak of the financial crisis in 2008, some Chinese scholars considered RMB internationalization from the perspective of national competition strategy. Chen Yulu (2005) analyzed the characteristics of the rise of the USD and revealed the relationship between internationalization and national competition strategy, believing that the internationalization of the USD is part of the national competition strategy of the U.S. Yi Gang (2006)14 raised the issue of RMB strategy in China’s long-term economic development plan, pointing out that the type of RMB strategy adopted is a critical link for the steady development of China’s economy and for good interaction with other countries. He emphasized that, if the domestic currency of an economic giant fails to follow its trade growth trend and become a denomination currency for

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the open international financial market and trade, it would be impossible for that currency to become one of the major international reserve currencies. This means that the domestic currency is not taken as an international currency that is corresponding to the economic aggregate and the total volume of trade. Thus an economic giant should not give up its currency sovereignty and currency competition is closely associated with national competition. The key to economic competition between countries is the direct contest of the domestic currency and other currencies in the international monetary system. After the economic giant reaches a certain stage of development, the highest form of its competition with other countries would be monetary competition. Hence he believes that China should promote the regionalization and internationalization of the RMB based on the current pattern of trade. This is a strategy for the realization of “RMB No.#1.” Huang Da (2004)15 pointed out that the achievements of reform and openingup of China enable the RMB to enter the international economic arena in which China will encounter various conflicts. Concession, coordination and cooperation under the condition of conflict would be the long-term challenge for the RMB. In future, the RMB would be subject to increasingly high exchange rate pressure and convertibility pressure. With respect to RMB strategy, China should pay more attention to the spillover effect of macroeconomic policy, positively and safely deal with the relationship with neighboring countries and the world on the “winwin” and “multi-win” principles, and needs to take a more proactive approach to relevant international coordination. Whether or not the RMB is able to deal with all pressures in future depends on the economic growth of China. Through the continuous solution of conflicts and the continuous efforts made to deal with and transfer the pressures, the RMB would inevitably make a positive contribution to the reform and opening-up of China, to international economic cooperation and to the facilitation of exchanges and mutual understanding between countries. The point of view of Huang Da implies that, as an economic giant, China should properly handle the economic interaction between China and the world, and that RMB internationalization would be accompanied by constant friction, cooperation and coordination. Yu Yongding (2009), a member of the academic committee of the Chinese Academy of Social Sciences and a member of the Committee of Experts on International Monetary Reform of the United Nations established in December 2008, pointed out that China is facing three major issues in the field of international finance: first, how to participate in IMF reform positively; second, how to promote the internationalization of the RMB; third, how to actively take part in regional financial cooperation. The promotion of RMB internationalization is an issue for China to improve resource allocation efficiency in the medium

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term. The financial crisis of 2008 created an opportunity for internationalization of the RMB. The crisis created the demand for international economic transactions in the RMB and the internationalization of the RMB would promote the diversification of the international monetary system, restrict the abuse of the USD and facilitate the development of the global economy in a balanced manner. Zhang Ming (2009) pointed out that the more ambitious objective of RMB internationalization is the free circulation and common use of the RMB in the Greater China region comprising Mainland China, Hong Kong, Macau and Taiwan. The achievement of this objective requires the closer integration of the above economies and the political wisdom of leaders on both sides and would thus need more time. At present the government of China is promoting RMB internationalization, regional monetary and financial cooperation and the reconstruction of international monetary system in parallel and has obtained some achievements at each level. Since the international financial strategies at different levels require different degrees of communication, coordination, and cooperation, the Chinese government shows different initiatives at different levels. Yi Gang (2006) argued that China should take a constant progressive strategy, making the RMB the main currency for settlement in neighboring countries and regions that have similar cultures and close economic and trading relations with China and then making the RMB one of the reserve currencies of these countries. In fact China has a large trade deficit with neighboring countries and regions although it maintains a trade surplus with the U.S. and the European Union. China should take advantage of this pattern of trade to realize the

internationalization of the RMB in surrounding countries and regions. Secondly,

we should develop an open international asset market on which the denomination is in RMB and provide more options of RMB financial assets to foreign investors.

Only by passing through such a stage can the RMB be taken as a reserve currency

in the real sense. China would then not have to worry about the holding amount of foreign exchange reserves.

Based on the general characteristics of local currency internationalization,

the studies of Chinese scholars on RMB Asianization and internationalization

have been gradually broken down and they are making studies on the

establishment and improvement of market and institutional conditions for RMB internationalization from the perspectives of real economy, Asian monetary and

financial cooperation, international monetary system reform, the construction of the domestic financial market and the development of a financial center.

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Lifting China᾽s status in the international division of labor On the long term, the internationalization of the domestic currency depends on China’s status in the international division and the rise of the RMB in Asia (RMB Asianization or the use of the RMB in Asia) is dependent on the promotion of China’s status in the Asian division. As stated above, compared with the U.S.,

China has a comparative disadvantage in division status at present; compared with some countries China has no significant advantage; but compared with

neighboring countries, China has a comparative advantage. The economic scales

of Tajikistan, Kyrgyzstan, Kazakhstan, Mongolia, Laos, Nepal, Bhutan, Cambodia and Pakistan16 are much smaller than that of China and their labor productivities

are relatively low. However since the volume of trade between China and these countries is not large and the regionalization of the RMB (the use of RMB for

economic exchange with neighboring countries) has a relatively small-scale

economic effect, the economic prospect of RMB regionalization would depend on the possibility of improvement of labor productivity in China and enhancing

the divisional advantage of China compared to other important trade partners. At the international level, China needs also to improve its status in the global

industrial division. A country’s position in the international division is reflected

by its industrial competitiveness. The ability of China to cultivate enterprises with strong international competitiveness determines to some extent the future

development of RMB internationalization. The use of the RMB as vehicle currency in international trade is dependent on the willingness of both sides involved in the trade and strong enterprises would have greater say over pricing.

Debate on the “regionalization” of the RMB “One market, one currency” is an important objective of regional economic

cooperation. A common market would bring about the demand for a common currency. The growth rate of the RMB in Asia largely depends on the degree of

Asian economic integration. At present the trading integration and financial integration of Asia has only reached a limited level. Despite the stable growth

in trade within Asia in recent years, the gap with the internal market of Europe is still great. Hence China should gradually reduce trade barriers and

expand the free trade zone during the enhancement of its trading relations with neighboring countries and move to a higher level of integration so as to

realize the Asianization of the RMB or the wide use of the RMB in neighboring countries and regions through regionalization.

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However some scholars have pointed out that the internationalization

of the RMB is not necessarily accomplished by means of regionalization.

Zhao Haikuan (2009) believes regionalization is not necessary prior to internationalization in terms of the relationship between currency

regionalization and internationalization. Comparatively speaking, it is easier to be a world currency than a regional currency. Since a world currency is more diversified, the economic and political obstructions to becoming a world

currency are much less; while on the other hand, to develop into a regional currency is much more complicated. If the model of the Euro is used, namely

one currency is used to replace other currencies, the process would be subject to political and economic interference and a large number of problems need to

be resolved, for example the coordination of financial and monetary policies. Yao Zhizhong (2005), and Xu Qiyuan and Li Jing (2008) analyzed the pressure

index of competition of China with Japan, South Korea, Indonesia, Malaysia, the Philippines, Singapore and Thailand in the global market and the U.S. market

by taking the competition pressure index as the indicator. The results showed that, integrally, China exerts relatively high competition pressure on other Asian countries. However Japan still has strong competition pressure against

China and other Asian countries. Therefore the economic cooperation between China and Japan is of the utmost importance to the stability of the exchange

rate in Asia and the coordinated development of the Asian economy and should not be neglected in studies and policy practice. The analysis also shows that

China has lower competition pressure against highly developed economies which have higher competition pressure on China. This indicates that China

has no significant competitive advantage in the international division. Clearly the regionalization of the RMB could not be realized within a short period of time. China still needs to enhance its position in the international division so as

to create the conditions for internationalization of the RMB. This is a long term mission.

Contention on promoting Asian monetary and financial cooperation Chinese scholars have been had many discussions and arguments on the relationship between Asian monetary and financial cooperation and the regionalization and internationalization of the RMB, and have presented various strategy designs. First, to promote the Asianization of the RMB through systematic construction of Asian monetary and financial cooperation.

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Li Xiao and Ding Yibing (2004) and Li Xiao (2006) proposed the argument for “Asianization of the RMB” for the first time in China, pointing out that RMB Asianization is a process of development into a regional key currency through participation in institutional cooperation in the field of regional currency and finance in East Asia and is an essential key step during internationalization of the RMB. They believe the necessity of RMB Asianization arises from two aspects: on the one hand, the USD holds the dominant position in the current international monetary system and any effort made to challenge the dominance of the USD would be opposed and suppressed by the U.S. Additionally, the failure of the internationalization of the Yen indicates that it is difficult to succeed in challenging international monetary hegemony through “direct internationalization” without the support of regional monetary and financial support. On the other hand, China has an increasingly close economic relationship with East Asian economies and has to play an important role in the economic system of East Asia. Direct internationalization of the RMB would not achieve the goals of participation in globalization and the rational allocation of financial resources but would bring China major risks and losses. For the stable development of the East Asian economy and the sustainable growth of the Chinese economy, China has to realize the Asianization of the RMB first so as to create a regional economic basis and build a strategic platform for RMB internationalization. In the report entitled Investigation and Study Project for Asian Financial Cooperation published by the International Department of the Ministry of Finance of China, Yu Yongding, He Fan and Li Jing (2003) pointed out that Asia needs monetary and financial cooperation at a higher level. The Asian financial crisis in 1998 showed that the adherence to the USD-based exchange rate system is not sustainable and there are various incompatible exchange rate systems in Asia. Asian countries have to take collective action to establish an Asian exchange rate coordination mechanism so as to overcome the risks arising from selection of exchange rate system. But these actions need a leader. Yu Yongding (2009) pointed out that China should positively participate in global monetary and financial system reform with the IMF as the major platform and the actions taken by G20 to overcome the global financial crisis while promoting regional financial cooperation without abandoning the attempts to establish a regional monetary union. China needs to appropriately accelerate the internationalization of the RMB. The cooperation of China in the international financial field covers the international monetary system reform, regional financial cooperation and the internationalization of the RMB, which should be promoted in a coordinated manner.

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Second, to realize a loose currency unification through “large-drive-small” monetary cooperation. From the perspective of the currency pattern in Asia in the future, Huang Yiping (2009) analyzed the prospects for and possible cooperation methods of the main currencies in Asia. He believed that, despite being the only international reserve currency of Asia, the Japanese Yen does not have the potential to replace the USD and it is still not clear whether the Japanese Yen is able to maintain its position as an international reserve currency. The representative currency of Asia may be the Japanese Yen, RMB, Indian Rupee or Asian dollar. However it is difficult for the Japanese Yen and Indian Rupee to become the representative currency and it may be more difficult for the Asian dollar. The ADB-advocated ACU based on the idea of the Euro is a good way. However the situation in Asia is different from that of Europe. Monetary integration would be extremely difficult before the historical conflicts in Asia are resolved properly and a certain level of political cooperation is reached. The selection of a reference standard for the ACU basket composition seems to be a technical issue, but the difficulty in solution of the technical problems is the political implications. Despite the difficulty of monetary integration, Asian countries have to promote cooperation in this aspect in the form of “large-drivesmall” rather following the example of negotiations between EU members on an equal footing. When an economic giant becomes a leader of the global economy, the smaller countries move closer to this giant naturally. From the perspective of economic growth in Asia, a loose currency unification may be realized in the future and the Japanese Yen, RMB and Indian Rupee may become the core currencies. However this possibility is dependent on the future development of these economies and the monetary policy framework. Third, China has the natural initiative in an Asian exchange rate coordination mechanism through the active requirements of other Asian currencies for stability of the RMB exchange rate. Yao Zhizhong (2003)17 first described the symmetric competition pressure of China, Japan, South Korea and ASEAN members on the U.S. and global markets using the “asymmetric competition pressure index” from the perspective of trade competition. The study results showed that, in both the U.S. and global markets, the competition pressure of China against Japan and other countries is higher than that of other countries against China. If the Marshall–Lerner condition holds, other Asian countries would have strong requirement for a stable RMB exchange rate and the RMB would naturally play the dominant role in Asian exchange rate coordination mechanism. This is extremely conductive to

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the expansion of use of the RMB and the promotion of the influence of the RMB in Asia. Li Jing and Xu Qiyuan (2008) used new data to calculate the “asymmetric competition pressure index” given in the report of Yao Zhizhong (2003) and obtained similar results, but they also found that this calculation method may have overestimated the competition pressure of China against other countries. For example, the competition pressure of China against Singapore in the U.S. market. China exports various products such as textiles and toys to the U.S. However since Singapore exports no or only a small amount of these products to the U.S., China creates no competition pressure against Singapore even if the export of the said products is in large volume. It can be observed that the types of export products of Singapore should be taken into account when calculating the competition pressure of China against Singapore. In short, the calculation of competition pressure of A against B should take the types of exported products of B as the reference. Although there is some controversy over the computation result of competition pressure, it is undoubtedly important to explore the growth potential of the RMB in Asia from the perspective of trade competition. Fourth, converting the “implicit anchor” of the RMB into the “explicit anchor” in Asia through internationalization of the RMB. According to the Cournot and Stackelberg equilibrium of non-cooperative game and cooperative game equilibrium, Chen Zhi᾽ang (2008) believed that the monetary competition equilibrium in East Asia is changing from “a prisoner’s dilemma” to oligarch competition equilibrium and has, through empirical study, proved that the RMB actually has a stronger influence on developing countries in East Asia than the USD and has a much stronger influence than the Japanese Yen. Considering the maintenance of competitiveness and export market, the countries in East Asia would inevitably keep a stable exchange rate of domestic currency against the RMB. The appreciation of the local currencies of Malaysia and other Southeast Asian countries against the USD after the reform of the exchange rate formation mechanism on 21 July 2005 shows that a spontaneous informal exchange rate formation mechanism has come into being in East Asia and the RMB may become the “implicit anchor” in this region. He believes that the RMB can still become and is becoming the “implicit internal anchor” of the East Asian economy even if there is no inter-governmental cooperation on exchange rate policy. Without the internationalization of the RMB, the currency anchor is implicit and cannot become explicit. At present the most important issue is to change the asymmetric pattern of “strong real economy and weak virtual economy” in China. Thus only by further deepening the monetary system reform, improving financial openness, promoting the

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development of foreign exchange and capital markets, gradually opening up capital projects and increasing the use rate of the RMB in neighboring regions can we further enhance the position of the RMB as “market supplier” in East Asia, enter into economic and political dialogue between governments in the region and promote the establishment of an exchange rate policy cooperation mechanism. Chinese scholars have very different views on the relationship between the Asianization, regionalization and internationalization of the RMB, Asian financial cooperation, and international monetary system reform. Huang Yiping (2009) believes that, with respect to international monetary system reform, it does not seem necessary for China to waste a lot of valuable time to establish a regional currency since this is extremely difficult and does not necessarily have long-term benefits for China. China should focus on the internationalization of the RMB. Gao Haihong (2009) pointed out that global multilateral cooperation is China’s major consideration in external financial policy; however, one of the important objectives in China’s selection of policies is to ensure a stable external financial environment through participation in Asian regional financial cooperation. China faces three major difficulties during the development of its roadmap for regional financial cooperation. First, how to coordinate the regional role and global role: As a financial stabilizer, China plays a dual role, namely the largest developing country in the world and a power that has a stabilizing effect in Asia. From the perspective of monetary integration, the global role and regional role could coexist at a certain stage; but when we reach the stage at which a sovereign state is required to give up monetary sovereignty due to highly regional monetary integration this means a preference relation with internationalization of the currency of the sovereign state. Since 2008 the currency swap agreements signed by China with some countries have been considered to be an opportunity to promote the internationalization of the RMB while the multilateral mechanism of the CMI is an important platform for regionalization of the RMB. For China, how to promote RMB internationalization by expanding the use of the RMB in Asia is a strategic option. Second, the possibility of establishing a unified exchange rate mechanism under the ASEAN 10+3 framework: This is the key to the promotion of Asian monetary cooperation. The establishment of a collective exchange rate system for Asia would largely depend on the coordination of the relationship between China and Japan. In the aspect of exchange rate policy, China has a stronger regional effect. In any new monetary arrangement, China may be placed at the center.

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Third, constraints of current Asian monetary cooperation: Incomplete convertibility of the RMB under capital account is the hard constraint on the participation by China in Asian financial cooperation. The role of China in regional financial stability is dependent on China’s action, Japan’s attitude to cooperation and the response of the U.S. The regionalization and internationalization of the RMB is facing similar difficulties. Zhang Ming (2009) believes that the reconstruction of the international monetary system should be based on consensus on a global scale and collective action should be taken for regional monetary and financial cooperation in East Asia. The Chinese government can directly promote the internationalization of the RMB and just needs to coordinate and cooperate with trade partners. The existence of a trade deficit of China against East Asian countries lays a perfect foundation for internationalization of the RMB, and RMB internationalization has become a focus of the Chinese government in the short term. The above views indicate that the issues related to the internationalization of the RMB are complicated. Most Chinese scholars take the regionalization of the RMB as a process similar to monetary integration in the form of monetary cooperation seen in Europe. The regionalization of the RMB means the emergence of a future regional currency and the demise of currencies of the countries participating in cooperation. This is the result of regionalization. From this perspective, RMB regionalization is the process of pegging the RMB to Asian monetary integration and then to the creation of a unified currency, so Asian monetary and financial cooperation is of special significance to the progressive internationalization of the RMB. A minority of scholars take the wider use of the RMB in neighboring countries and regions and the regionalization of RMB as the spatial expansion of use of the RMB. It should be noted that the market in neighboring countries and regions for exchange of RMB with other currencies and the substitution of RMB for neighboring currencies to some extent is the result of spontaneous promotion of market development. Hence the regionalization of the RMB would take place first in neighboring countries and regions and then replace other currencies gradually. With the progress of regionalization of the RMB it is bound to become the trading asset of the Asian financial market and RMBdenominated capital mobility would be greatly improved. The effective control of risks has become an important factor for ensuring the favorable operation of the capital market. The expansion of use of the RMB in Asia is an inevitable result of increase in the economic scale of China and in the trade and financial exchange of China with Asian economies. Hence to increase the trading

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opportunities of China with neighboring countries and enlarge the scale of trade is of great significance in moving RMB regionalization to a higher stage. It should also be noted that, with the expansion of the trading scale of China in

Asia, the externality of China’s economic policy would increase and it would be increasingly necessary to coordinate the macroeconomic policies of China and other countries.

Accordingly, the strategy for wider use of the RMB in neighboring countries

and regions requires China to integrate the RMB regionalization with Asian monetary and financial cooperation and combine the market forces, macro-

management and the cooperation between governments. In the latest financial crisis, China and its neighboring countries took collective action and the currency swap agreement was deemed a “timely rain” for suppression of the crisis.

Besides responding to the crisis, the currency swap agreements (see Table

5.7) also indicate that the Chinese government has promoted the use of the

RMB in the aspect of system construction so as to enable the RMB to play a role in trade financing and financial market liquidity support. To select possible

cooperation methods within the regional scope to promote the function of the RMB should be a constituent part of the integral RMB strategy.

Table 5.7.

Counterparty

Bilateral currency swap agreements signed by China with some countries (regions) Date

12 December Bank of Korea 2008

Hong Kong Monetary Authority

20 January2009

Period of validity

Purpose

RMB 180 billion/3.8 trillion Wons

Three years’ period extension is available by mutual consent

Provide shortterm liquidity support for financial system, promote the development of bilateral trade and preserve financial security.

RMB 200 billion/HKD 227 billion

Three years’ period extension is available by mutual consent

Provide short-term liquidity for branches of commercial banks of Mainland China and Hong Kong if necessary; preserve financial security.

Amount

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(Cont'd) Counterparty

Bank Negara Malaysia

Indonesia

Belarus

Date

Amount

Period of validity

Purpose

8 February 2009

RMB 80 billion/40 billion Ringgits

Three years’ period extension is available by mutual consent

Facilitate bilateral settlement, reduce USD exchange rate risk and stimulate bilateral trade; preserve financial security.

24 March 2009

RMB 100 billion/175 trillion Indonesian Rupiahs

Three years’ period extension is available by mutual consent

Support bilateral trade and direct investment so as to promote economic growth and provide shortterm liquidity for stabilization of financial market.

11 March 2009

RMB 20 billion/8 trillion Belarusian Rubles

Three years’ period extension is available by mutual consent

Promote bilateral trade and investment and stimulate the economic growth of both sides.

Source: Website of the People’s Bank of China. www.pbc.gov.cn.

International monetary system reform Since the very beginning of the 21st century, China has been a promoter of international monetary system reform. Like other developing countries, China has always been striving for greater right of discourse by obtaining more voting rights in the IMF. After the outbreak of the 2008 global financial crisis, China proposed the objective of establishing a fair, equitable and inclusive international monetary system. Before the G20 London Summit, on 23 March 2009 Zhou Xiaochuan, the Governor of the People’s Bank of China pointed out in his article that the conflict of domestic policy of reserve currency issuers with the properties (e.g. stable value storage) of reserve currency is an inherent defect of the international monetary system. In view of the fact that “the reconstruction of a new reserve currency with stable valuation benchmark accepted by all countries may be a long-term process,” Zhou Xiaochuan particularly pointed out the way to give full play to the role of SDRs. As the first step of reform, he proposed to expand the issue of SDRs. This suggestion had a response from the U.S. and other countries which believed this could be taken into consideration.

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It is generally believed by the international community that this suggestion expresses China᾽s intention to promote the internationalization of the RMB. However it is difficult or even impossible to implement this suggestion at present. Yu Yongding (2009) believes that whether or not China needs to be concerned about the reform of the international monetary system is a matter of practical significance. In the short term, China hopes to escape the USD trap through international monetary reform; in the medium or long term, China hopes to improve the global allocation of resources and promote the internationalization of the RMB; in the long term, China is confronted with a choice, namely to make RMB a part of an Asian currency. In addition China is also thinking about the possibility of the RMB being an international reserve currency together with the USD and Euro. If this becomes the case, China could be exempted from seigniorage. Ba Shusong (2008) pointed out that China should participate in the reform of the global financial system positively and moderately. However the current pattern of the international monetary system is not ready for subversion; what we can do is to eliminate the defects exposed during this crisis in the existing international currency framework. China should actively promote RMB internationalization when participating in the response to the global subprime crisis, allowing international organizations to issue bonds in RMB in China and providing assistance to developing countries through currency swap or state loans. Therefore, different from the reports in some foreign media, the purpose of domestic scholars is not to cause difficulties for the USD but to improve and perfect the original order with a more moderate attitude while paying more attention to the high cost arising from the change of the order. Guan Tao (2009) emphasized that the future international monetary system would show a tendency to diversification, however the diversification of reserve currency does not conflict with the dominance of the USD. He believes that the change of international reserve currency system and the strength and weakness of the USD feature periodicity. No country or region is able to or needs to eliminate this periodicity, but should adapt to the change in the international monetary system in the way they adapt to the economic cycle. “China should participate in international monetary system reform with an affirmative approach” does not mean abolishing or replacing the USD, but maintaining and realizing the maximum national interest through limited feasible reforms. This requires China to make efforts in a great many aspects such as the reform of the RMB exchange rate formation mechanism, the regionalization and internationalization of the RMB, the enhancement of the

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integral influence of Asia in the international monetary system, the suppression of

USD hegemony through regional cooperation, and the further promotion of reserve currency diversification.

Huang Yiping (2009) believes that the global financial crisis is the historical watershed for the USD and the decline of the USD is inevitable although it will take a long time. On 30 June 2009, the economist from the World Bank᾽s representative office in China also pointed out in the conference on Financial Development Report that the decay of the USD is progressive. Huang Yiping believes one of the positive results of this financial crisis is that the decision makers in China have placed the internationalization of the RMB on the agenda. The reform and openingup that has lasted for 30 years provides China with the basic conditions for RMB internationalization, however the internationalization of the RMB requires reforms in several aspects. We need to establish a floating exchange rate system, implement capital account reform and monetary policy decision mechanism reform, and establish the independence of the central bank. Zhang Ming (2009) pointed out that the current international financial crisis has impaired both the USD and all its competitors. The decay of the USD would be a slow process and the growth of the RMB would be a long term process. Shang Nan (2009) believes that it is impossible for the RMB to replace hard currencies such as the USD, Euro, Japanese Yen and GBP for a long period of time. The development of the RMB18 into a global reserve currency can only be realized under the existing international monetary system framework. China needs to cooperate with these currencies. To achieve this goal, China should request for a voting share of 10–20% in the IMF. Once the RMB earns a place on the world stage, China would be able to control the RMB from an extremely high perspective and consider the free conversion thereof. Wang Qing (2009) pointed out that China needs a stable global exchange rate system which for the moment is the exchange rate system dominated by the USD. At present, the RMB is basically pegged to the USD. China is the biggest beneficiary of this system during the globalization, especially over the past ten years. It is very important to extend this process as much as possible. Hence China may have to be subject to such as global exchange rate system for ten to fifteen years in order to buy time. If the USD system crashes, global trade atrophy would occur and the Chinese economy may be subjected to a hard landing. The author believes that the internationalization of the RMB should be taken as the necessary condition for enhancement of influence on international financial affairs. Only by promoting the position of the RMB in international economy and trade can China exert greater influence.

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Foreign exchange system reform Internationalization of the RMB requires it to have value stability, measurability, availability and an extensive transaction network. At the early stage of RMB internationalization, the availability of currency is of great importance. Hence the RMB must have convertibility, and this is the most fundamental condition. In 1996 the RMB became convertible under current items. After 2001, certain progress has been made for the convertibility of the RMB under capital items. Since 2002 China has actively and selectively taken trade promotion and investment facilitation measures even if the RMB is not fully convertible under capital items. After 2003 the Qualified Foreign Industrial Investors (QFII) and the Qualified Domestic Industrial Investors (QDII) systems were established under the institutional framework in which the RMB is not fully convertible under capital items and the government encourages residents to hold foreign currency or make overseas investment. These institutional innovations promoted the process of development of the RMB to fundamental convertibility. The Decision of the CPC Central Committee on Issues About Improvement of the Socialist Market Economy System passed on 14 October 2003 at the CCP’s Sixteenth National Congress and the Third Plenary Session of its Sixteenth Central Committee pointed out that “the restriction on cross-border capital transaction shall be relaxed selectively step by step under the precondition of effective risk prevention so as to realize the convertibility of capital items gradually.” The Eleventh Five-year Plan and the report of the Seventeenth Congress of the CPC re-emphasized the “gradual realization of convertibility of capital items.” After the RMB exchange rate formation mechanism reform started in July 2005, the freedom for residents to use foreign currency and to select currency for investment has been greatly improved and the convenience of conversion of the RMB under current items has also been remarkably improved. 19 See Table 5.8 for measures for basic convertibility reform of the RMB and information about distribution of transactions. Two-way exchange is not available for the RMB although the convertibility of the RMB has been improved. The institutionally incompletely free convertibility of the RMB has limited the cross-border use of RMB, restricted the role of the RMB as a vehicle currency in international trade and the international financial market, and limited the role of the RMB as a government intervention currency and currency anchor. Furthermore the failure to realize institutional and market-oriented convertibility of the RMB may result in more speculation with the increase in use of RMB in foreign countries. In other words, the RMB is extremely vulnerable to attack.

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Table 5.8.

Measures for basic convertibility reform of the RMB and the distribution of transaction subjects

Measures that have been taken

Financial organization

Enterprise

Individual

Nonresident

1.

QFII

2.

QDII

3.

Implementing the “go global” strategy

√

4.

Foreign-invested enterprises raise funds by being public listed on the capital market of China

√

5.

International financial institutions issue bonds in RMB in China

6.

Financial institutions of China issue bonds in RMB in foreign countries

7.

Transnational corporations handle foreign exchange resources in a centralized manner

8.

Foreign currency exchange for individuals going abroad

√

9.

Carrying foreign currency when exiting from the country

√

10.

Outgoing transfer of personal property

√

11.

Personal investment in foreign countries20

√

12.

Studies on migration and outward remittance of non-resident domestic assets

13.

Foreign exchange account under current items of enterprises

√

14.

Accelerate the implementation of the “go global” strategy

√

15.

Temporary idle funds of foreign-funded transnational corporations transferred to foreign countries and China-funded transnational corporations supplement the capital of overseas company.

√

Relaxation of the restriction on migration and outward remittance or conversion of domestic assets inherited by non-residents

√

16.

Total

√ √

√ √

√ √

√

2

4

4

7

Source: Data arranged by Zhou Xiaochuan (2003) according to the annual reports and Data Compilation of the State Administration for Foreign Exchange.

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In the situation that the outflow and smooth backflow of the RMB lacks institutional guarantee, the risk of circulation of the RMB in the foreign market may be amplified. Hence the institutional promotion of improvement of convertibility of the RMB is very necessary for ensuring the financial stability at the early stage of RMB internationalization (wide use in neighboring countries and regions, or regionalization). The monetary authorities of China should follow the market development trend and conduct necessary institutional innovation from the perspective of satisfaction of requirements of real economic transaction. On 8 December 2008, the General Office of the State Council issued the Opinions of the General Office of the State Council on Promotion of Economic Development by Financial Means , proposing to improve foreign exchange management, vigorously promote the facilitation of trading investment, allow more foreign-funded and China-funded enterprises and groups that meet the conditions to conduct centralized management of foreign exchange funds and improve the utilization efficiency of funds, support the development of RMB business in Hong Kong, expand the denomination and settlement scale of the RMB use in trade with neighboring countries and regions, and reduce the exchange rate risk of outbound economic activities. Based on the foreign exchange system reform, the number and type of participants in the foreign exchange market of China would be subjected to great changes. This is conducive to the improvement of RMB exchange rate formation mechanism and promotes the improvement of marketization of the RMB exchange rate and the expansion of fluctuation flexibility. In the near term, China needs to actively carry out reform of the RMB exchange rate formation mechanism and establish an exchange rate system that is suitable for both China and other Asian countries, making institutional preparation for expansion of the RMB’s influence.

Development of the financial market Despite its giant economic scale and the remarkable improvement of material productivity, China’s financial market is underdeveloped and the way for the RMB to become an international currency still needs to be explored. A sound and effective domestic monetary and financial system is the starting point and fundamental condition for internationalization of a currency. When resources are wasted as a result of a low-efficiency monetary and financial system, the benefit from currency internationalization is much smaller; the blind promotion of RMB internationalization without taking into account the deepening of financial reform “is not worth the candle.” When there is no complete domestic

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monetary and financial system, the rushed promotion of internationalization of the RMB will not succeed but will rather increase the risk of financial crisis (Zhu Min, 2008). The main constraint on RMB internationalization comes from the lagging development of the financial market. Although this financial crisis has exerted no remarkable direct impact on China’s financial industry, this does not mean that China’s financial market is perfect but indicates the closed nature of the financial market in China. China has a large amount of government-based assets in foreign countries and regions while private assets only represent a very small proportion. To “go global,” the enterprises entities and financial enterprises of China have to overcome great difficulties. In case of deterioration of the external financial environment, China-funded enterprises would have to withdraw and the desire to create a pattern of “two-way capital flow” would come to nothing. After the financial crisis, if China can deepen domestic financial reform, improve the depth and breadth of the domestic financial market, promote the liberalization of interest rate and exchange rate etc. and improve the financial supervision ability, the internationalization of the RMB would have better prospects.

The pilot for RMB settlement and the transformation of Shanghai into an international financial center The internationalization of the RMB needs the support of a financial center. As early as 1992, the report of the 14th Party Congress proposed to “build Shanghai into an international economic, financial and trade center so as to drive a new leap forward of the Yangtze River Delta and the whole Yangtze River drainage basin.” After the Asian financial crisis in 1997, whether or not to build Shanghai into the international financial center of East Asia became a hotly debated issue in economic circles of China. In 2001 the State Council approved the overall urban planning of Shanghai for the next 20 years, further demonstrating the purpose to build Shanghai into a modern socialist international metropolis and an international economic, financial, trading and shipping center. Over the past decade the financial service industry has been developing prosperously in Shanghai. After the outbreak of the global financial crisis in 2008, the construction of an international financial center in Shanghai was accelerated. On 23 February 2009, the Regulations for Promotion of Construction of an International Financial Center in Shanghai (draft) —China’s first local draft of laws and regulations on the construction of a financial center, was introduced and reviewed by the Standing Committee of the National People’s Congress of Shanghai and has been further modified according to the widely collected

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opinions. The draft specifies that Shanghai would be built into an international financial center “by taking financial market system construction as the core and focusing on reform and innovation, and environment creation.” To relate financial stability with legal system environment construction and cooperation with steady implementation of national strategy from a local level is a bold exploration in construction of an international financial center in Shanghai. At the end of March 2009, the State Council reviewed and approved (in principle) the opinions on “promotion of the development of service industry and advanced manufacturing industry and the construction of an international financial center and shipping center in Shanghai,” proposing to build Shanghai into an international center that is suited to the economic strength of China and the international status of the RMB by the year 2020. On 8 April 2009, the executive meeting of the State Council decided to establish an RMB settlement pilot for cross-border trade in Shanghai, Guangzhou, Shenzhen, Zhuhai and Dongguan. The meeting required that the relevant departments of the State Council formulate relevant management methods so as to unify and standardize trade settlement in RMB and promote the pilot project steadily. The State Council designated Shanghai and Guangdong as the pilots for RMB settlement. This illustrated the response of China to the financial crisis and the consideration of long-term development (Lu Zhengwei, 2009). As the areas where the volume of export trade occupies the front ranks in China, Shanghai and Guangdong have a strong demand for trade facilitation. Secondly, the establishment of pilot in these two areas clearly reflects the support of the central government for the construction of “two centers” in Shanghai and the consolidation of the status of Hong Kong as an “international financial center.” Shanghai and Guangdong have the most sophisticated financial infrastructures and have a large number of financial organizations which enabled the pilot project to be enacted smoothly. Since April 2008, the Shanghai Finance Office together with the Shanghai Municipal Commission of Commerce and the Shanghai headquarters of the People’s Bank of China have made studies and investigations on international settlement in RMB and prepared a final plan. It is reported that, in the plan developed by Shanghai, the pilot objects of international trade settlement in RMB include ASEAN members, Hong Kong, Macau, Taiwan and Russia. Additionally, Shanghai designated 18 enterprises as the first pilot units, including largescale local import and export enterprise groups such as Shanghai Minmetals and Shanghai Silk. The main actor in the settlement center pilot—the Bank of Communications of China, has made relevant preparations and is making studies on how to open RMB accounts, how to remit accounts and the issues

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related to taxation etc. The establishment of RMB settlement pilots has received a positive response from the banking industry. A number of banks are eager to provide cross-border RMB settlement services after the publication of detailed rules. With respect to operating mode, a clearing model would be probably adopted in Guangdong which is near to Hong Kong and Macau; but in Shanghai far away from Hong Kong and Macau, an agency model is likely to be adopted. Since April 2009, both academic circles and industrial circles have been paying close attention to the launch of the cross-border RMB settlement pilot. On 2 July 2009, the People’s Bank of China, the Ministry of Finance, the Ministry of Commerce, the General Administration of Customs, the State Administration of Taxation and the China Banking Regulatory Commission jointly issued Notice (2009) No.10 , introducing the Measures for the Administration for Pilot RMB Settlement in Cross-border Trade which describes the settlement model, regulation model and the method for export tax rebate in detail from the perspective of trade facilitation. The introduction of these detailed rules is of milestone significance and demonstrates the institutional support from China for the promotion of the function of the RMB as a vehicle currency in international trade. The establishment of the pilot and the cooperation with the monetary authorities of Hong Kong and Macau takes into account the convenience of geographical connection and the communication and coordination of policy while considering the scale economy effect of institutional support. However the transition from denomination in the USD to that in the RMB is a progressive process. After years of development, extensive USD transaction networks (including trade and financial transactions) have been established all over the world and the sophistication of the transaction network has further reinforced the position of the USD as an international currency. The selection of denomination currency is equivalent to the selection of efficiency. The support for cross-border trade settlement in RMB means supporting the RMB to replace other currencies such as the USD. The newly introduced Measures specify that enterprises can voluntarily determine whether to use the RMB for settlement or not. Through the pilot, we can get more information from feedback information from enterprises for the improvement of financial services. Since the system has been established, it is required that the RMB should be able to continuously provide value stability; in this way it is possible for the dealer to have a continuous demand for RMB. Moreover with the development of RMB settlement business, the economic variables that influence the demand for RMB will expand to foreign countries and regions and not be limited to Mainland China. The commencement of this business could bring about substantive

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RMB deposit and loan business, clearing and cross-border flow of the RMB in foreign countries and regions; this may result in the increase in scale of circulation and use of the RMB in foreign countries and regions when there is a strong expectation for appreciation of the RMB. Hence the effective control of RMB settlement risk is still a severe test for the Chinese financial regulatory authorities. Besides establishing pilots for RMB settlement domestically to actively promote the function of the RMB in trade settlement, China has actively negotiated with Brazil, Russia, etc. on issues of local currency settlement. How to identify the obstacles to local currency settlement based on the comprehensive theoretical research and investigations are a key step for the promotion of RMB settlement in general trade.

The special role of Hong Kong In consideration of the difficulties in the comprehensive promotion of RMB internationalization when the full liberalization of capital items has not been realized, the operation could be started from the regions that have the closest economic, trading and financial relationship with Mainland China. Naturally, Hong Kong is an ideal choice. Since its return to China in 1997, Hong Kong has been continuously deepening and tightening economic and trading communications and relations with Mainland China. To promote the exchange and cooperation with Hong Kong, Mainland China signed the Mainland and Hong Kong Closer Economic Partnership Arrangement (CEPA) with Hong Kong in June 2003. Up to now, three stages of the CEPA have been put into effect and the fourth stage was started in 2008. Under the joint effect of the market and policy, the economic dependence between Mainland China and Hong Kong has been improved greatly over the past ten years. According to the statistical data for the year 2007 (MOFCOM, 2007), Hong Kong is the largest transshipment port, the fourth largest trade partner and the third largest export market of Mainland China, which has become the largest export, 21 import 22 and transit object of Hong Kong. Hong Kong is also the largest investor in Mainland China and its investment with a total amount of about USD 20 billion accounts for 32% of direct foreign investment in Mainland China. Over 2000 Mainland Chinese enterprises are engaged in trade, tourism and distribution etc. in Hong Kong. Furthermore, the financial connection between Mainland China and Hong Kong is becoming increasingly close. By the end of December 2007, 14 Hong Kong banks had established branches in Mainland China with assets amounting to USD 42.66

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billion, accounting for 26.54% of total assets of foreign banks in Mainland China. In addition, a total of 12 Mainland Chinese banks have established 23 banking facilities in Hong Kong in the form of holding companies, non-banking institutions and subsidiary banks/branches. In recent years, Hong Kong has become the window and platform for internationalization of enterprises from Mainland China. Enterprises applying for overseas listing from Mainland China usually take Hong Kong as the first choice and the QDII business of banking facilities from Mainland China is also conducted first in Hong Kong. Financial intermediaries play an important role in the stable circulation of the RMB at home and abroad. Due to the underdeveloped domestic financial market of China, the relaxation of comprehensive capital controls cannot be completed in short order. In addition, with the rapid growth of the Chinese economy, the difference between capital account opening speed and the speed of demand for the RMB would inevitably bring about the demand for an offshore currency center. Due to the natural economic ties between Hong Kong and Mainland China and thanks to the position of Hong Kong as the financial center of Southeast Asia, China could establish pilots first in Hong Kong and develop Hong Kong into the offshore center of the RMB under the prior condition that the operation of the offshore market is under the supervision and control of the People᾽s Bank of China. Over the past ten years, with the economic development of Hong Kong and Mainland China, their financial cooperation has been further developed. Due to the unique position of Hong Kong᾽s financial market and the requirement of the finance industry of Mainland China for reform and opening-up, the financial relation will become increasingly close: on the one hand, the financial market of Hong Kong will play an active reference role in the development of Mainland China’s financial market while playing a connecting role in the opening-up of the market of Mainland China; on the other hand, the financial market of Hong Kong can also get strong support from Mainland China. In view of this, under the condition that the financial cooperation between Mainland China and Hong Kong is increasingly enhanced, it is believed that the RMB business in Hong Kong including bond business will develop greatly. After the outbreak of subprime crisis in the U.S. the small open economy of Hong Kong suffered a major impact. The expansion of RMB business was deemed an important method for both sides to ride out the crisis and deepen financial cooperation. On 20 January 2009, the People’s Bank of China and the Hong Kong Monetary Authority officially signed a currency swap arrangement in Beijing which provided liquidity support of RMB 200 billion. After the signing ceremony Joseph Yam Chi Kwong, the President of the Hong Kong

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Monetary Authority said, “this agreement stands for the good beginning of RMB business cooperation between Mainland China and Hong Kong and the banks on both sides can obtain more liquid funds to withstand the risks.” 23 Currency swap arrangement is one of the measures taken by the Chinese government to support the financial stability and economic development of Hong Kong. Allowing qualified enterprises to perform trade settlement in RMB in Hong Kong is the new highlight in financial cooperation between Mainland China and Hong Kong. To do the preparation work necessary for business relevant to the RMB settlement pilot for cross-border trade between Hong Kong and Mainland China Zhou Xiaochuan, the President of the People’s Bank of China and Joseph Yam Chi Kwong, the President of the Hong Kong Monetary Authority, signed the supplementary memorandum of cooperation on 29 June 2009. Both sides agreed within the range of their own responsibility to cooperate in the supervision and control of RMB settlement conducted in Hong Kong banks. Both sides agreed to continue to promote the progressive development of RMB settlement business in Hong Kong, to further enhance the mutual aid, complementary and interactive relationship between financial systems of Mainland China and Hong Kong, and to (consolidate) play the role (the status) of Hong Kong as an international financial center. Ba Shusong (2009) made a positive evaluation of the signing of the memorandum. He believes the further cooperation between the People’s Bank of China and the Hong Kong Monetary Authority is the substantive basis for cross-border settlement in RMB and that the denomination in RMB for trade is an important step for the RMB toward becoming an international currency. After the gradual popularization of cross-border settlement in RMB and the diversification of RMB financial products, other countries and regions may need to perform trade settlement in RMB in Hong Kong. With the flow of the RMB from foreign countries and regions into Hong Kong, Hong Kong could be taken as the “reservoir” of RMB outside Mainland China and be developed gradually into the RMB settlement center. On this basis, Hong Kong would be built into the offshore market of RMB gradually, which would bring greater vitality to Hong Kong. During the Asian financial crisis in 2007, Hong Kong’s economy was devastated and the central government promised to provide foreign exchange reserves support for Hong Kong as the occasion requires and promised a stable exchange rate of the RMB against the USD. However the RMB itself was not the support force of the Hong Kong economy then. The RMB–HKD swap arrangement signed ten years after the Asian financial crisis provides important support for the stability of Hong Kong’s banking system and economy. This shows that the economic link between Hong Kong and Mainland China has

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become closer over the ten years and that the RMB has been considered as an important “bridge” for the financial relationship and real economic relationship between the two sides. This also indicates that the start of RMB business in Hong Kong is an important step for the RMB toward regionalization and is an important reference for the start of RMB business in other neighboring countries and regions. The development of RMB business in Hong Kong will be taken as the “test field” for RMB regionalization. It is reported that Hong Kong enterprises may be qualified to issue bonds in RMB in Hong Kong under the framework of financial cooperation between Hong Kong and Mainland China. On that occasion, the issuing subject of bonds in RMB in Hong Kong would include both commercial banks from Mainland China and enterprises in the offshore market. Taking the RMB as an important financing tool of Hong Kong and Mainland China is an important step in the development of the financial markets in both regions and an important breakthrough in the RMB’s role of carrier in the financial market. The close economic ties between Hong Kong and Mainland China will inevitably bear upon the current currency board system, and the Hong Kong Monetary Authority is bound to pay close attention to the factor of the RMB in determination of the Hong Kong dollar exchange rate. The future development of the currency circle will follow the principle of “one market, one currency,” and the integration of the RMB with the Hong Kong dollar is the inevitable outcome of market development. Therefore, for the integration of the RMB with the HKD, we should pay attention to the current credit guarantee of the Hong Kong dollar. With the expansion of RMB business in Hong Kong, if the RMB grows into a reserve currency and the financial link between Mainland China and Hong Kong becomes increasingly close, institutional support for the integration of the Hong Kong dollar and the RMB would have a large market basis. Hence it is extremely important to realize financial cooperation between Mainland China and Hong Kong and to take this opportunity to promote the financial development of both sides, especially in Mainland China. The above paragraphs analyze the research findings of China᾽s academic circle in various relevant aspects of the rise of the RMB. We found that the rise and internationalization of the RMB is related with all aspects of domestic and external economic issues of China. Some scholars have put forward relatively detailed procedures and proposals based on the objective of RMB internationalization. Li Daokui and Liu Linlin (2008) put forward the concept of a “dual-track” system: the first “track” is the oriented, progressive and gradual convertibility progress under capital items in sync with China᾽s financial reform in Mainland China; the second “track” means that Hong Kong is taken as the

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test field for RMB internationalization outside Mainland China. Tang Shuangning (2008) worked out the timetable and roadmap for internationalization of the RMB, suggesting two “three-step marches.” first, the regional “three-step march” i.e. the wide use in neighboring countries and regions, regionalization and internationalization; second, the functional “three-step march” i.e. settlement currency, investment currency and reserve currency. The time period for each step is designed to be 10 years. Under the assumption that there would be no unexpected shocks, Li Jie (2007) designed four stages for RMB regionalization and pointed out the institutional conditions and policy combination required for each stage. In the primary stage frontier trade and tourist consumption drives the circulation of RMB in neighboring countries. The cross-border circulation of the RMB is mainly stimulated by the real economy. China has the ability to gain the advantage as a result of RMB internationalization, facilitate trade with neighboring countries, reduce exchange rate risk, enhance the credibility of the RMB in regions outside Mainland China, and gather managerial experience in cross-border circulation of the RMB. This is the most critical stage of RMB internationalization. In the second stage of RMB regionalization, the RMB would become an offshore loan asset. In this stage the construction of the domestic financial market in China should make greater progress. If the development of the domestic financial market of China at the first stage lags behind and fails to match the market demand of RMB regionalization, the RMB regionalization would slow down and the offshore deposit and loan business should not be rashly operated. Furthermore, the accumulated RMB in foreign countries may have to earn profit through the underground economy and the financial stability of China may be greatly threatened. In the third stage of RMB regionalization, the RMB would become the Asian investment asset. At this stage we should focus on the construction of an international (Asian) financial market taking the RMB as the dominant currency so as to stimulate the willingness of nonresidents to hold the RMB. At the same time, the cross-border flow of the RMB would have an important link with RMB C/A transaction and exchange, and this trend would contribute to the acceleration of opening of C/A in China. The above two stages may be partially overlapped. In the final stage i.e. the advanced stage of RMB regionalization, the RMB would become the main reserve asset of Asian countries and a regionalized currency. After the RMB becomes the measure of value and medium of exchange for trade and financial affairs in Asia, it will not only be taken as the reserve assets of individuals and enterprises but also become the intervention asset of government. This means that the Chinese government would have to take greater responsibility for the financial stability of Asia.

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Conclusion The rise of the RMB in Asia is the result of market forces. The government should provide institutional guarantee for this process so as to reduce the economic risk to China caused by internationalization of the RMB and obtain the potential benefits from RMB internationalization. At present we can make the following judgments: the regionalization of the RMB depends on the economic fundamentals of China—the importance of China to the international industrial division and network externality as a result of the scale-up of China’s open economy. However the growth of the RMB requires a series of institutional construction measures and international opportunities. The Asian financial crisis of 1997 and the international financial crisis of 2008 are important opportunities for growth of the RMB. This opportunity does not lie in the importance of the RMB itself but in the type of financial service that China can provide in a crisis to meet the demand of Asia and the world for mobility and trade stipulations. With the opportunity in front of us, the most critical point is whether or not the monetary policy authorities will implement institutional innovation and meet the requirements of market development from a more open perspective while taking the internationalization of the RMB as a systematic project. Therefore RMB internationalization cannot be simply expressed by a time point and we cannot provide a detailed timetable for RMB internationalization although some scholars expect that internationalization of the RMB will be realized within 20 years, 30 years or a shorter period of time. In the financial history of the world we cannot find any record of the internationalization of the currency of a developing country. The internationalization (regionalization) of the RMB may open a new Chapter 1n the history of international finance. As a part of financial globalization, the internationalization of a local currency may bring to the country an impact that goes far beyond national pride. The more important issue is to control the risks that may occur during internationalization of the domestic currency and enable this process to serve the real economy in a better way. We believe it is extremely difficult to resolve the regionalization of the RMB into specific controllable steps in practice. However we can divide RMB regionalization into a number of steps according to the functioning of RMB internationalization so that we can better serve this process and reduce the risk thereof. RMB regionalization is not the end of RMB growth; internationalization is the ultimate objective. China is assuming a more open attitude toward this objective and is engaged in positive preparation for it.

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6

Chapter

The RMB and the East Asian Currency System Ishida Ko

COOPERATION BETWEEN THE RENMINBI AND THE YEN

Introduction The stability of the RMB exchange rate is the prior condition for China to “maintain steady and rapid economic development.” Internationalization of the RMB is the topic that China must face with the development and sophistication of the Chinese economy and is the international liability of an economic giant. However the stabilization and internationalization of the RMB is extremely difficult to realize. As the currency of a newly industrialized country with high speed economic development, the RMB shows the potential for instability. Stabilization of the RMB requires the control of capital transaction which may hinder the internationalization of the RMB. The stabilization of the RMB includes stabilization relative to major international1 currencies such as the USD, Euro and Japanese Yen and relative to currencies in East Asia. For East Asia, which must transform its economic development pattern from the excessive dependence on the U.S. to dependence on the demand of the region, it is essential to ensure a stable exchange rate within the region. If the real rate of exchange of the RMB against major international currencies is kept stable and can ensure the stability of the exchange rate in East Asia, then East Asian currencies including the RMB will be integrated and realize stable fluctuation against major international currencies. A great many Chinese scholars argue that the internationalization of the RMB must be based on the fact that the RMB has become the key currency of Asia. In view of the large proportion represented by the Chinese economy in the East Asian economy and the economic integration tendency in East Asia, this is a quite natural idea. As a matter of fact, with this financial crisis as an opportunity, China has tested out the system in which the RMB is used for trade settlement. The purpose is to create an East Asian currency circle centered on the RMB. For China, there are two options for RMB internationalization: first, internationalization of the RMB based on the RMB currency circle; second, borrowing the idea from cooperation between Germany and France in Europe and cooperating with Japan under the East Asian framework of monetary cooperation to strive for the stabilization and internationalization of the RMB. According to what China decides, how shall Japan respond? The decisions of China and Japan will determine the future of the East Asian currency system.

Difficulties in China’s Exchange Rate Policy-Making In the fixed exchange rate system, the currency of newly industrialized country

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The RMB and the East Asian Currency System

at the high-speed growth stage is usually under-evaluated and the expansion of export is intensified day by day. When they get rid of the fixed exchange rate system, the government and market usually do not know how to determine an appropriate exchange rate which may be subject to the risk of instability. As the “sequela” of this financial crisis, the fluctuation of the USD, the RMB appreciation pressure from the U.S. and the requirement for increase of exchange elasticity would constitute one of the factors that threaten the stability of the RMB. It will be difficult for China to deal with this threat.

Characteristics of exchange rate issues of China as a emerging industrialized country As shown in Table 6.1, over the ten years to 1971 during which the fixed exchange rate system based on the USD/JPY exchange rate of 1:360, the volume of export of Japan has increased by 4.89 times. Over the ten years from the year in which the RMB was pegged to the USD to the year 2005, in which the controllable fluctuation system was employed, the export volume of China has increased by 4.97 times. The similarity of the export growth pattern between China and Japan merits attention. The accelerated growth of export of both Japan and China is to a great extent the result of interaction of productivity enhancement and the under-evaluation of currency. Table 6.1.

Growth of export volume of Japan and China during the ten years before the currency appreciation Japan (USD 1 million)

China (RMB 100 million)

1962

4,916

(100)

1996

12,576

(100)

1963

5,452

(111)

1997

15,161

(121)

1964

6,673

(136)

1998

15,224

(121)

1965

8,452

(172)

1999

16,160

(128)

1966

9,776

(199)

2000

20,634

(164)

1967

10,442

(212)

2001

22,024

(175)

1968

12,972

(264)

2002

26,948

(214)

1969

15,990

(325)

2003

36,288

(289)

1970

19,318

(393)

2004

49,103

(390)

1971

24,019

(489)

2005

62,648

(498)

Source: Japanese Ministry of Finance, National Bureau of Statistics of China.

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Despite the international voice for currency revaluation, both Japan and China have postponed currency appreciation on the grounds of being in an “immature situation.” The economic growth at a stable exchange rate has made people comfortable, but the basic economic conditions are changing rapidly. During the period in which both Japan and China postponed their currency appreciation, the under-evaluation of currency has continuously deepened. As L. Summers, the chairman of the U.S. National Economic Commission has said, exchange rate stabilization under market intervention is barely more than illusory stabilization (Summers, 2004). When Japan got rid of the fixed exchange rate system in 1973, neither the government or the market was able to decide the level at which the exchange rate at which the Yen should be kept. After the repeated and considerable fluctuations, the exchange rate of 1:360 rose to the level of 1:80 in April 1995. China raised the exchange rate of the RMB against the USD from 8.28 to 8.11 in July 2005, an increase of 2.1%. The transition from fixed an exchange rate system to a controllable floating exchange rate system was realized. By September 2008, accumulated appreciation of the RMB against the USD had exceeded 20%; in the meantime, export has been increasing steadily. According to the experience of the Japanese Yen, the potential unstable state would last until the market makes a certain evaluation of the RMB exchange rate. It is necessary for the People’s Bank of China to ensure the relative stabilization of the RMB through market intervention. The three major principles of the Chinese exchange rate system are “independence” (superior to external pressure), “progressiveness” (basic stabilization) and “controllability” (change in exchange rate is controlled by the People’s Bank of China.)

The U.S. exchange rate policy The trade policy and exchange rate policies of the U.S. under the pressure of economic rehabilitation may threaten the basic stabilization of the RMB. The U.S. exchange rate policy is the result of domestic policy logistics. Under the stress of requirements of various vested interests for economic expansion and increase in employment, successive U.S. governments have increased fiscal expenditure which has led to the widening of the deficit balance. In order to solve the problems of current deficit balance, the U.S. government does not take measures to suppress domestic demand (interest groups would not like to take this measure) but requires its principal trade partners to open the market, expands domestic demand and increases the exchange rate, declaring that the current deficit balance of the U.S. results from the unfair trade, inadequate domestic

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The RMB and the East Asian Currency System

demand and currency under-evaluation of its trade partners. In the view of the U.S., the method adopted to force Japan that is highly dependent on the U.S. to appreciate the Japanese Yen is effective. Hence the U.S. has paid tribute to this achievement and has continuously increased the pressure on appreciation of the Japanese Yen until Japan opened the market and expanded domestic demand. Accordingly, although the U.S. promised to reduce its financial deficit according to Japan’s requirements, it scarcely fulfilled its promise. The promise of reduction in financial deficit of the U.S. government in various periods barely reaches its target. Congress, which makes decisions on the budget, has been continuously increasing fiscal expenditure so as to meet the aspirations of interest groups. The fulfillment of the Obama administration’s promise of financial perfection made to China would depend on the expansion of financial deficit, the influence on the U.S. economy and the political response of the U.S. U.S. economists always provide economic theories according to the political logistics of the U.S. At the special seminar entitled Does Regulation Mechanism Work?—Lesson of International Adjustment 1985–1991 held by the international economy institute directed by F. Bergsten, W. Chine emphasized that the left part of equation “saving – investment = current revenue and expenditure” is not superior to the right part (Cline, 1991). The outcome of the correction of surplus consumption system through reduction in financial deficit is the same with that of improvement of trade balance through USD depreciation. It has been calculated that the price elasticity of the U.S. for improvement of trade balance through USD depreciation is 1.1 for import and 0.8 for export. P. Krugman made the following conclusion at this seminar. After the signing of Plaza Agreement in 1985 it has been confirmed that the trade volume would change in two years after the change in exchange rate and that the imbalance in trade can be modified through exchange rate adjustment (Krugman, 1991). The problem is that Krugman’s conclusion has been inherited by economists of the U.S. and the IMF. IMF Report 2007 stated that the REER of the USD in the late 1980s dropped by 40% and the reduction in the foreign trade deficit of the U.S. reached 3.5% of the GDP. This proves Krugman’s allegation (IMF, 2007). As a result, the appreciation of the Japanese Yen after the signing of the Plaza Accord that has resulted in the structural depression of Japan is referred to as a successful example of changing the international imbalance through exchange rate adjustment. In May 2007, Fred Bergsten put forward the following at a public hearing in the U.S. Senate (Bergsten, 2007). “Thanks to the RMB under-evaluation policy, the competitiveness of the Chinese economy has been further improved; in the meantime, China ‘exports’

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COOPERATION BETWEEN THE RENMINBI AND THE YEN

unemployment to other countries. The exchange rate policy of China is the most important divergence point in the economic relationship between China and the U.S. The U.S. and China must rectify the trade imbalance in an orderly way so as to realize the change from financial deficit to surplus in the U.S. China needs to expand its fiscal expenditure in the fields of medical treatment, pensions and education so as to expand consumption. The RMB should appreciate by at least 20% against other countries and 40% against the USD. The optimal situation is to realize diversified foreign exchange adjustment through the Asian version of the Plaza Accord. In case of failure to achieve this goal, we can only rely on the independent action of the U.S. If we cannot intervene in the buying-in market of the RMB which is short of exchangeability of capital account, we can buy other Asian currencies such as the Yen. The U.S. should efficiently help along the increase in capital inflow of the RMB by declaring the intention of its policy. It would be extremely difficult for the Chinese government to resist the pressure of inflation and RMB appreciation synchronously.” In fact the principle of the above proposal by Bergsten is the same as the solutions proposed by the U.S. in the 1980s and 1990s for relieving the pressure of Japanese Yen appreciation. The Plaza Accord signed in 1985 i.e. the trial of international USD depreciation brought about an uncontrollable sharp decline of the USD. Asia’s own Plaza Accord proposed by Bergsten or the measures taken by U.S for the appreciation of Asian currencies and the RMB may result in the sharp depreciation of the USD. To resist the RMB appreciation pressure from the U.S., China has been forced to buy the USD for market intervention. This results in the continuous flow of capital into the U.S. In order to cover its huge financial deficit, the U.S. requires the inflow of foreign capital, and it is simplistic to believe that the USD would not depreciate sharply in any case. In the controllable floating exchange rate system established after July 2005, China has successfully realized the progressive induction of the RMB. However it is extremely dangerous to believe that China would be certain to succeed in future relying on successful experience in the past.

Strategic countermeasures of China against the U.S. Since 1980 a significant proportion of the production and employment of the U.S. manufacturing industry has been transferred to overseas and the losses caused thereby have been made up by the prosperous tertiary industry including the financial industry. After the financial crisis in 2008, the decrease in the contribution of the financial industry to the GDP and employment of the U.S. bought about the demand for return of a certain proportion of production

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The RMB and the East Asian Currency System

and employment that had been transferred to overseas to the U.S. It can be imagined that the Obama administration will impose various requirements regarding trade and exchange rate on China, an export market in its growth stage compared with the U.S. Before assuming the position of Secretary of the Treasury Department of the U.S., T. Geithner pointed out in a written report submitted to the treasury board of the Senate on 22 January 2009 that President Obama believed China was manipulating the exchange rate of the RMB according to the demonstration of a number of economists. This was what the U.S believed. The words “although the RMB is under-evaluated, the Chinese government has not been manipulating the exchange rate” in the annual report submitted by the Treasury Department to the U.S. Congress in April 2009 are no more than the usual diplomatic-speak presented every year. Quite a few people in China believe that China should require the U.S. to stop the exertion of pressure RMB appreciation by taking the immense amount of U.S. national debt held as the bargaining chip. But the U.S. knows very well that the sharp depreciation (if any) of the USD as a result of selling of U.S. national debt by China would result in an immense amount of loss in foreign exchange of China while bringing about the rapid appreciation of RMB. Hence it is impossible that heavy selling of U.S. national debt can become the trump card that can threaten the U.S. After the financial crisis, the direction of global capital flow has changed and the increase in China᾽s foreign exchange reserve has slowed. This will directly influence the bargaining power of China against the U.S. From China's perspective, the best choice is to adapt the foreign exchange reserve structure of China to the structure of China᾽s foreign trade while supporting the USD. China's currency basket would be gradually centered on three major currencies i.e. the USD, Euro and Yen. If this is the case, the exchange rate cooperation environment in East Asia with this currency basket as the reference would be developed and improved. Japan was regarded as the threat to the U.S. economy in the 1980s and 1990s. The rise of China as an economic giant is now deemed the threat to the U.S. in the aspects of politics and military affairs in future. China adheres to the principle of “never seeking hegemony” and vigorously advocates peaceful development. However when the economic power of China is strong enough to contend with the U.S., hegemony becomes a practical and inevitable issue. In recent years the U.S has continuously promote the marketization and democratization of China and pushed China into the world community for decision making. To promote its economic development, China needs a peaceful international environment. The way for China to acknowledge the U.S.

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and deal with the relationship is a major issue beyond the issues of currency and economy etc. that determines the destiny of China.

Finally, we shall conclude with an overview of the exchange rate strategies

of Japan and China against the U.S.

For the Chinese leaders, exchange rate strategy is one of the most important

issues. In order to achieve the national strategic goal of ensuring high-speed growth of the economy and the continuous provision of job opportunities, the

maintenance of relative stability of the RMB and the resultant promotion of export growth is deemed indispensable. In order to ensure the relative stability of the RMB, the Chinese government has been restricting capital transaction

and intervening in the foreign exchange market through the People᾽s Bank of

China. The U.S., which treats the above-mentioned efforts made by China to

maintain the stability of the RMB as the cause of the huge trade surplus with

the U.S., will continuously exert pressure for RMB appreciation. The RMB

exchange rate issue will continue to be the economic focus between the U.S. and China.

Japan brought in the floating exchange rate system in 1973 when the

Japanese Yen became a convertible currency. Based on the assumption that

the exchange rate basically depends on the market, the Japanese Ministry of Finance has made the monitoring of the exchange rate market its day-to-day

business. In a situation of dramatic change in the exchange rate, the Ministry of Finance requires the Bank of Japan to undertake market intervention. In 1999 Kato Koichi, the director-general of the Liberal Democratic Party who held a

suspicious attitude to the fact that the exchange rate policy was determined

by bureaucrats, said in terms of the responsibility of government in the field of international finance that, “when reaching its peak, the stabilization of

exchange rate of Japanese Yen will become a problem that may influence the Japan–U.S. security system, which should be resolved by politicians”

(Koichi Kato vs. Yukio Hatoyama, 1999). Thus it can be seen that, compared with China, Japan adopts a different exchange rate strategy. In Japan the

fundamental currency strategy has always been designed by fiscal officers. The AMF concept proposed in 1997 is a typical example.

It should be emphasized that despite the significant difference between

the exchange rate strategies of Japan and China, both countries are faced with a similar strategic environment: on the one hand, both countries hold

a tremendous amount of U.S. national debt; on the other hand, both have to stand opposite to the U.S. while ensuring the stability of the exchange rate.

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The RMB and the East Asian Currency System

The Obstacles to an International RMB The development and improvement of the foreign exchange market in a newly industrialized country often falls behind the rapid expansion of productivity and export. Chinese enterprises have to face the risks of change in exchange rate in the market since there are not sufficient measures for prevention of rate risk in the domestic market. The establishment of a competitive foreign exchange market is a prior condition for the sound development of the Chinese economy and the internationalization of the RMB. China, which is moving forward to internationalization of the RMB and the internationalization market in Shanghai, is walking from the stage of vision mapping to the implementation stage in which the technical details will be continuously improved through the combination of theory and practice.

Market problems caused by hot money The People’s Bank of China has succeeded in the guidance of progressive RMB appreciation. However a huge amount of hot money has flown into China during this period and accelerated the increase in foreign exchange reserve. The inflow of the large quantity of hot money can be considered as the sequel of long-term under-evaluation of the RMB. Hot money is not only related to the current macroeconomic problems but has also raised the issue of development and improvement of the foreign exchange market relevant to the business operation environment in terms of the proper method for exchange rate management and the construction of a forward exchange rate market etc. Since hot money is the result of inflow and outflow of speculative capital that should not exist under China’s exchange rate management system, the correct statistics concerning this are not available at present. Zhang Ming and Xu Yisheng take the errors and omissions reflecting the increase in the foreign exchange reserve that cannot be explained from the perspective of trade balance and capital balance as hot money in the practical sense and add the estimated hot money in trade surplus and direct investment to calculate the total amount of hot money inflow (Zhang Ming and Xu Yisheng, 2008), pointing out that the total amount of hot money that flowed into China from 2003 to 2007 was over USD 1.1 trillion. By this method it can be calculated that more than half of the foreign exchange reserves by the end of 2007 was from the inflow of hot money. Table 6.2 shows the amount of hot money calculated by Zhang Ming and Xu Yisheng. Table 6.3 shows the increase in the foreign exchange reserve of China. Some people believe hot money flows into China via the high export

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Table 6.2.

Amount of inflow of hot money

(unit: USD 100 million)

Year

2003

2004

2005

2006

2007

Increase in foreign exchange reserves

1,352

1,812

2,256

1,929

6,316

Minus trade surplus

255

319

1,017

1,776

2,620

Minus direct investment

544

606

603

695

827

Difference: omitted error

553

887

636

-542

2,819

0

0

601

1,215

1,835

Plus hot money in direct investment

403

511

678

716

706

Total: total amount of hot money inflow

956

1,398

1,915

1,389

5,410

Plus hot money in trade surplus

Source: Zhang Ming and Xu Yisheng (2008). Calculation of Current Scale of Hot Money in China in Full Size . International Finance Research Center for Institute of World Economics and Politics, June.

Table 6.3.

Increase in the foreign exchange reserve of China (unit: USD 100 million)

Year

2001

2002

2003

2004

2005

2006

2007

2008

Amount

2,121

2,864

4,032

6,099

8,188

10,663

15,282

19,460

Source: The People’s Bank of China, HP.

quotation channels. The author does not deny that some hot money has flowed into China through the above channels, but believes that Zhang Ming has overestimated the scale. If the scale estimated by Zhang Ming is roughly correct, a large number of Chinese enterprises have to take part in the above operations while their overseas bases must hold large-scale funds or are able to borrow the funds of the same scale. But under China’s current foreign exchange control system it is almost impossible for the overseas bases of Chinese enterprises to recover such an amount of advance funds. For transactions without the possibility of recovery, enterprises would not borrow money from banks and the banks would not lend the money. This is the fundamental law of sound operation.

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The RMB and the East Asian Currency System

Taking the iron and steel industry of China for example, Yao Zhizhong demonstrated that the explosive growth of trade surplus results mainly from the structural change of industry and overseas market of China. According to Table 6.4, the positive fundamental equipment investment of iron and steel industries in China results in the explosive increase in steel production and export and the reduction of dependence on import and thus brings about the change from iron and steel trade deficit to surplus. Similar examples are also observed in other industries such as the consumer durables industry. The opinion of Yao Zhizhong is consistent with the experience of Japan. Table 6.4.

Changes in the iron and steel industry of China

Year

2004

2005

2006

2007

Production of steel products (unit: 100 million tons)

3.20

3.78

4.69

5.69

Export volume of steel products (unit: 10,000 tons)

1,423

2,052

4,304

6,265

83

131

263

441

2,930

2,582

1,852

1,687

Amount of import of steel products (unit: USD 100 million)

208

246

198

206

Trade surplus of steel products (unit: USD 100 million)

–125

–115

64

236

Favorable balance/amount of export (%)

–149

– 88

25

53

Amount of export of steel products (unit: USD 100 million) Import volume of steel products (unit: 10,000 tons)

Source: Yao Zhizhong (2008). “Trade Surplus or Hot Money?” International Economics Review, No.4.

The calculation of amount of hot money inflow is of great significance to policy decisions. As Yao Zhizhong has pointed out, if the main portion of increase in trade surplus is composed of hot money, the real trade surplus of China would not be so great, thus it can be seen that the trade imbalance of China is at an extremely low level. In contrast, if the trade surplus contains only a small amount of hot money, the trade imbalance of China would be deemed at an extremely high level. The support for both estimations would influence the direction of China’s macroeconomic policy decisions (Yao Zhizhong, 2008).

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COOPERATION BETWEEN THE RENMINBI AND THE YEN

The estimation believing that a large amount of hot money has flowed into China through disguised trade would cause China to reinforce its foreign exchange control system. If this estimation is incorrect, the enhancement of the foreign exchange control system would increase enterprises’ labor and cost burden unnecessarily. The author believes the enhancement of foreign exchange control in 2008 was an over-reaction to the over-estimated hot money. The report of the Standard Chartered Bank for the 3rd quarter of 2008 pointed out that the amount of hot money in China is about USD 500 billion and put forward the slogan “don’t panic.” As a matter of fact, the hot money has started flowing out since the 4th quarter of 2008.

The ideal state of the enterprise activities and the foreign exchange administration In China, the customs data for import and export should always be verified according to the inflow and outflow of foreign exchange funds in banks when export and import settlement is made. This is called “cancellation after verification” in China. Since July 2008, the Chinese government has strengthened the foreign exchange administration. In the re-established “online application and verification system for verification of export payment of exchange,” the enterprises must submit verification related documents to the customs online before handling customs clearance formalities. This sum of foreign currency cannot be converted into the RMB until the export proceeds are put into the “account to be verified” in the form of foreign currency and the auditing of actual state by comparing this export contract with the data in computers of the State Administration of Foreign Exchange Control connected to the Ministry of Commerce and the customs is completed. In other words, the enterprises have to bear exchange rate risks until the completion of verification by the State Administration of Foreign Exchange Control since this sum of funds cannot be used. The “foreign exchange verification system” of China is similar to the foreign exchange recognition bank of Japan which is responsible for confirming the consistence of customs data with settlement involving foreign exchange control in Japan. This system itself has no defects. Despite the certain effectiveness of enhancement of foreign exchange control on the suppression of inflow of hot money, the consistency of the said effectiveness with the huge labor force and cost is doubtful. Provided that, as expected by Yao Zhizhong or the author, the sharp increase in export from China is the result of expansion of production capacity and the hot money in trade surplus is on such a large scale, we can

204

The RMB and the East Asian Currency System

say that the enhancement of foreign exchange control exceeds the necessary level from the perspective of the country. To respond to the increase in various procedures, enterprises have to increase the number of required personnel which results in an increase in administration costs. From this point of view, compared with enterprises of other countries, Chinese enterprises fall into an unfavorable situation in international competition. In order to realize sound economic development, foreign exchange control is required. However we should correctly understand the nature of the problem. In the case of failure to properly deal with the relationship between countermeasure, cost and effect, economic development would be hindered. The economic activities of enterprises are the source of the economic vitality of a country. If the competition environment of Chinese enterprises is significantly different from that of foreign enterprises, it would be difficult for the former to survive in international competition. In the international economy, both currency and the market are faced with severe competition. The experience of Japan in development of its foreign exchange control system can provide China with a lot of inspiration. In 1980 the UK cancelled the foreign exchange control that had completed its historical mission, but in Japan foreign exchange control lasted until 1998. In order to avoid the high cost and excessive foreign exchange control on the Tokyo market the enterprises of Japan, the world’s largest capital exporter, issued bonds in overseas markets such as London. Accordingly Japanese institutional investors bought bonds on the overseas market and this was an inevitable choice for enterprises. But from the perspective of the country, Japan lost the historic opportunity to build Tokyo into an international financial center and realize the internationalization of the Yen (Ishida Ko, 1999). The international use of the Japanese Yen has not increased greatly. There is still excessive “report duty” on the Tokyo financial market, which is far from being internationalized, which is not the case in any other developed countries. Japanese enterprises still conduct global cash management (centralized management of funds and foreign exchange of transnational corporation groups) overseas. The Japanese Ministry of Economy, Trade and Industry warned in its report Facing the advancement of international financial strategy issued in August 2005 that the overseas transfer of the functional portion of the financial foundation of enterprises and the financial organizations that provide financial services would result in the hollowing-out of the Japanese financial market. It can be judged from Japan’s experience that the excessive foreign exchange control of China would not only shackle the development of the national economy but would also exert residual impact on economy even if its historical

205

COOPERATION BETWEEN THE RENMINBI AND THE YEN

mission is completed. Thus the foreign exchange controls may hinder the internationalization of the RMB and major financial markets such as Shanghai. After the threat of hot money, the cancellation of excessive foreign exchange control would be beneficial to China. In this sense the simplification of various formalities through acceleration of reform of the import and export verification system stated in the Several Opinions of the General Office of the State Council on Providing Financial Support for Economic Development on 8 December 2008 is a flexible policy adopted by the Chinese authorities and worth high appraisal. Internationalization of currency is not the result of encouragement from government but the result of market selection (Li Jing, 2007).The reason why the currency of a country can be selected as an international currency is that this country has large economic scale and macroeconomic conditions that can ensure stable economic growth. Moreover the country should not exert any excessive control on its foreign exchange market for the purpose of convenient utilization. The development and improvement of the market should be the responsibility of government. Based on his experience in cancellation of foreign exchange control in Japan from the standpoint of the industrial community, the author believes it is necessary for economic officials, economists and entrepreneurs to cooperate within a certain scope to discuss the proper methods for foreign exchange control and the measures for improvement of the financial market and promotion of capital movement.

Internationalization-oriented improvement of the forward exchange market Although advance payment for export and deferred payment for import is seen as the object of registration and control, it is a method for enterprises to avoid exchange rate risks when the forward exchange market fails to function. The author believes that regarding it as hot money would directly result in the occurrence of new foreign exchange controls, which would further hinder the proper exchange rate risk aversion of enterprise. This is severely worrying. The forward exchange market open to general enterprises was established in August 2005 in China. Due to the lack of demand for exchange rate risk management, Chinese enterprises and banks that have been used to a fixed exchange rate system have limited understanding and ability of evasion of exchange rate risk through forward exchange contract (People’s Bank of China, 2006). Furthermore, in the first year after the start of exchange rate system reform in July 2005, the market exchange rate of the RMB against the USD rose by only 1.25%; enterprises did not much need for forward exchange contract. The RMB

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The RMB and the East Asian Currency System

then appreciated by 5.23% in the following year and 10.95% in the year after. With the acceleration of appreciation of the RMB, enterprises began to be more concerned with forward exchange rate contracts. However due to the insufficient mobility of the forward exchange market, the banks are not able to fully satisfy customers’ demand. The basic cause is that the financial market based on the forward exchange market has not been completely developed and improved. In the short term, due to the dominance of appreciation expectation of the RMB, the demand for avoiding appreciation takes dominance on the market and there is insufficient demand for avoidance of depreciation risk. The countermeasures for advance payment and deferred payment should be divided into current countermeasures and medium-term and long-term countermeasures. The current countermeasure should allow advance payment and deferred payment within a rational range of amount and time limit for avoidance of exchange rate risk. It should be expanded within the limits and enterprises should be provided with the opportunity to avoid risks. In December 2008, the State Council declared that the proportion of advance payment and the proportion of deferred payment for import would be increased to 25% of total amount of export settlement for the previous 12 months from the former 10%. The cultivation of the forward exchange market is a medium-and-long term countermeasure for which the precondition is a financial market with liberalized interest rate and free capital movement since arbitrage would last until the change rate of forward exchange rate against spot exchange rate is equal to the interest margin between the two countries. The current RMB foreign exchange market is isolated from the external environment. Due to the limitation on internal and external capital movement of the forward exchange market and the late start of development and improvement of the short-term money market, interest rate option fails to play its original role. To promote the development of the forward exchange market it is necessary to first develop and improve the short-term financial market since the objects of interest rate option include various financial assets such as high-credit short-term government bonds and inter-bank lending and borrowing. What comes next is to realize capital movement liberalization for deals with foreigners. The forward exchange market is of far reaching importance to the RMB internationalization strategy. To some extent, the forward exchange market could be taken as the “sheltering harbor” for Chinese enterprises to avoid foreign exchange risk when import and export settlement is made in foreign currency. If the Chinese government realizes the settlement of cross-border trade in RMB, Chinese enterprises China would excuse themselves from foreign exchange

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control while their trade partners in foreign countries would have to take measures to fence off RMB fluctuation. For this reason their trade partners in other countries would hesitate about settlement in RMB if there is no forward exchange market. If foreign enterprises refuse to make settlement in RMB, the scale of trade of which the settlement is in RMB will not be expanded. In other words, it would be almost impossible for China to realize the internationalization of the RMB through trading if the forward RMB market in which foreign enterprises can participate is not developed and improved. Almost all Chinese economists are agreed on the liberalization of capital transaction as a long-term objective. However many scholars argue that emergency measures should be taken to enhance the control on capital movement at the stage of threat from hot money. In the current international financial crisis, the external conditions for China to promote the liberalization of capital transaction do not exist. Judged by internal conditions, the Chinese economy is not prepared to resist the change in exchange rate accompanying the liberalization of capital transactions.

The market mechanism of capital export China realized convertibility of the RMB under current items in 1996 and planned to realize RMB convertibility under capital items in 2000. Due to the impact of the 1997 Asian financial crisis, the process was interrupted. Thereafter, due to the lack of an environment for complete convertibility of the RMB, China has taken measures to optionally promote capital transaction. For example, in order to promote the “go global” strategy that encourages direct foreign investment by enterprises, China has established the Qualified Foreign Institutional Investors mechanism through which foreign investors can buy valuable securities from China and the QDII mechanism through which Chinese investors can buy valuable securities from foreign countries (Li Jing, 2009). It is believed that after this financial crisis China will continue with foreign exchange control and capital control for a reasonable period of time so as to ensure the stability of the RMB. However, there is not always a trade-off relationship between the stability of the RMB and the liberalization of capital items. In the long run, current account surplus should be used to develop and improve the market mechanism of capital export due to capital liberalization. At present the People’s Bank of China is exporting capital by buying residual U.S. dollars on the market. Once capital is exported based on market principles, the overall situation will become more balanced and the pressure for RMB appreciation from the market will be moderated.

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Yi Gang, the Assistant Governor of the People’s Bank of China also believes that capital export denominated in RMB is an important part of the RMB internationalization strategy. The UK and U.S. exported capital in domestic currency, but Japan in USD. In the issue, Japanese enterprises and banks suffered from huge losses due to Yen appreciation (Yi Gang, 2006). Japan’s External Trade Organization pointed out in the Suggestion on Stabilization of the Japanese Yen given in 1996 that if capital is exported in Yen for Tokyo market reform, the equilibrium of supply and demand of the USD and the Yen in the market would be improved and the appreciation pressure on the Yen would decrease (Japan External Trade Organization, 2007). Yi Gang pointed out that the long-term strategic objective for the RMB is to establish the position of the RMB as the major transaction currency in Asia and then to construct the capital market with the option of valuation of financial assets in RMB. After the development and improvement of the market mechanism of capital export, market intervention by the People᾽s Bank of China would not absorb residual foreign currency in the daily market but balance any sharp fluctuation in the RMB exchange rate. Of course, the development and improvement of the environment for capital export through the market mechanism does not mean that the stability of the RMB will be guaranteed. Since the collapse of the Bretton Woods System at the beginning of the 1970s, turmoil and crisis in the foreign exchange market have occurred repeatedly. China’s basic mission is to guarantee the relative stability of the RMB while promoting the internationalization of the RMB in such an objective situation.

Excessive control will hamper internationalization China gives a higher priority to RMB stabilization than internationalization because the former is an essential condition for economic growth. The essence of RMB internationalization is the wide use of the RMB as a convertible currency in international transactions. For this reason, capital transaction must be liberalized. Despite the control on capital transaction, the inflow and outflow of hot money would threaten the stability of the RMB. To realize stabilization of the RMB it is necessary to control capital transaction. In the meanwhile, the control over capital transactions would hamper the internationalization of the RMB. As a result it is extremely difficult to realize both the stabilization and internationalization of the RMB. Financial crisis demonstrates the risk of dependence on the USD system and the lagging internationalization of the RMB from two aspects.

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First, it increases the risk of depreciation of foreign exchange reserves accumulated by China over a long period of time. The paper about international monetary system reform issued by Zhou Xiaochuan, the Governor of the People’s Bank of China in March 2009 and Chairman Hu Jintao’s speech at the G20 London Summit in April 2009 put forward the international currency strategy such as international monetary system reform, especially the efficient use of SDRs, etc. Subsequently, China decided to buy SDRs denominated bonds to be issued by the IMF. Second, China had to adjust its economic growth strategy based on the foreign exchange policy with the stability of the USD as a precondition. The instability of both the USD and Euro after the financial crisis increases the foreign exchange risk of export enterprises. Therefore, the Chinese government started the settlement of trade in RMB in specific regions with neighboring countries and regions in December 2008 and established a pilot for settlement of cross-border trade in RMB in Shanghai and another four cities in April 2009. The Methods for Administration of Pilot for Settlement of Cross-border trade in RMB was issued on 2 July 2009. It was announced that this was because the negotiation between the People᾽s Bank of China, the Ministry of Finance, the Ministry of Commerce, the General Administration of Customs, the State Administration of Taxation and the China Banking Regulatory Commission (CBRC) had taken a long time. The People᾽s Bank of China pointed out that the guiding ideology of this management method is to strictly verify the trade authenticity, implement overall control and steadily promote the pilot for settlement of cross-border trade in RMB. The pilot enterprises designated by the relevant local and central administrative organs must ensure the authenticity of cross-border trade settled in RMB, establish original accounts for settlement of cross-border trade in RMB, and correctly record the information about import and export declaration and fund receipt and payment in RMB. Banks must verify the authenticity of transaction documents and the consistency of receipts and disbursements in RMB (People’s Bank of China, 2009). These strong measures of control indicate that strategic intent of the Chinese government to rapidly promote the internationalization of the RMB (starting from the use of RMB in trade settlement) on the premise that the stability of the RMB is not impaired. However if these measures are taken over a long period of time the internationalization of the RMB would be threatened. The principal cause of failure of internationalization of the Japanese Yen and the Tokyo market was that the moderation of rules was given up halfway (Ishida, 1997). To realize the internationalization of the RMB and the Shanghai market seriously, China must relax controls and realize the liberalization of capital transactions at some point.

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The RMB and the East Asian Currency System

From Global Financial Crisis to Asian Monetary Cooperation The stabilization of the RMB shows two development directions. On the one hand, the fixed exchange rate system against the USD was progressively converted into the floating management system of a three-country currency basket since the reform of exchange rate system launched in July 2005; on the other hand, exchange rate stability was restored in the unstable East Asia along with the occurrence of the global financial crisis. The ultimate objective of both measures is to integrate the currencies of East Asian countries (including China) against the fluctuation of major international currencies. During monetary integration in East Asia, neither the establishment of an Asian currency circle with the RMB as the center nor the division of the East Asian circle into RMB and Yen circles would benefit Asia economically or geopolitically. Here the author will make a study of the significance and possibility of cooperation of East Asian currencies including the Japanese Yen.

Asian exchange rate policy coordination is a requirement of our times The economic integration of East Asia based on regional division promotes its economic growth. Up to the present, the relative stability of the exchange rate in East Asia has been supporting the development of economic integration. By 2005 the People’s Bank of China had implemented the floating of the RMB against the USD while other Asian countries had roughly realized the stability of the exchange rate of their currencies against the USD. A stable exchange rate circle in which the East Asian currencies are mutually linked has come into being. This can also be regarded as a stable exchange rate circle that is not institutionalized. In the meantime, the Yen which has frequently fluctuated by a large margin against the USD and become the important cause of economic fluctuation in Asia has maintained the tendency to depreciation and stable fluctuation since 2004. At present, in the transition to a regional demand oriented economy and the stronger requirement for stability of the regional exchange rate, the following situations could result in the decline in exchange rate stability. First, the linkage of the RMB with the USD is decreasing. According to the estimation of Ding Yibing, after the transition of the RMB to a managed floating exchange rate system with a currency basket as a reference, the proportion of the USD in the currency basket was approximately 1 in the first year and

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the proportion of other currencies was close to 0; the proportion of USD in the second year dropped to 0.878 and the reduction was supplemented by the Euro and a small amount of Japanese Yen. The currency basket of the RMB transited to the one containing the Euro and Yen and this could be one of the most important factors that impacts on the pattern of East Asian exchange rate stability based on the USD. Table 6.5.

Correlation coefficient of major currencies in East Asia China

South Korea

Thailand

Malaysia

Indonesia

Philippines

21 July 2005—2 July 2006 South Korea

0.857

Thailand

0.899

0.955

Malaysia

0.851

0.889

0.9098

Indonesia

0.797

0.919

0.9130

0.8237

Philippines

0.762

0.819

0.8150

0.6394

0.9015

Singapore

0.829

0.978

0.9425

0.9238

0.8945

0.7433

21 July 2007—16 September 2008 South Korea

–0.871

Thailand

–0.603

0.7335

Malaysia

0.6321

–0.2734

0.0682

Indonesia

0.0961

0.0976

–0.0352

0.2888

Philippines

0.0940

0.2580

0.6035

0.7191

0.0894

Singapore

0.8836

–0.6181

–0.3087

0.8800

0.2378

0.4108

Source: Calculated and provided by Professor Ding Yibing from Jilin University.

Second, with the expansion of the financial crisis, many of the currencies of East Asian countries began to depreciate. According to the linkage correlation coefficient (see Table 6.5) of the RMB against other principal currencies in East Asia from July 2007 to September 2008, no linkage correlation is found except with the Singapore dollar and Malaysia ringgit. Due to the different impacts of the financial crisis on the different countries, the monetary exchange rates fell to different extents. The effect of intervention made by the countries by using foreign exchange reserves to buy domestic currency was limited. The linkage of currencies with a convergent tendency in East Asia turned to deviation. The regional exchange rate stability as a prior condition for economic

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The RMB and the East Asian Currency System

integration in East Asia is moving backward. Under the impact of the global economic crisis and the measures taken by the countries to ease money excessively, it is difficult to expect stability in the global foreign exchange market including the East Asian foreign exchange market. The regional strategy for the consolidation of economic integration accomplished in East Asia and the pursuit of further development of a regional economy of East Asia is in crisis. A positive exchange rate policy coordination in East Asia is the requirement of our times.

A vision of monetary cooperation in East Asia This financial crisis shows the necessity of regional exchange rate stability for economic development. However East Asia provides no political environment for exchange rate stability. At present it is impossible for the East Asian countries to agree on the establishment of a regional exchange rate coordination mechanism including the Japanese Yen and thus to make substantial progress. The realistic approach in East Asia is to restore the linkage between East Asian currencies based on the understanding of above-mentioned situations and construct the institutional foundation for the realization thereof. If this is referred to as the first stage, the establishment of a regional exchange rate coordination mechanism including the Yen would be taken as the second stage. The first stage responds to the requirements of economic development in the measurable future and the second stage to longer-term and more comprehensive economic requirements. The most important issue is to unite these two stages into one structure. The first stage roughly covers the following items: A number of East Asian countries have taken their own currency basket exchange rate policies that are basically alike except for slight differences. The transition from the RMB reference currency basket containing the USD to the basket containing the USD, Euro and Japanese Yen shows that it is possible for East Asian countries to realize linkage with a currency basket containing the three major currencies. The joint research of Zhang Bin and He Fan, both from the International Finance Research Institute of the Chinese Academy of Social Sciences shows that the linkage with the three major currency basket is the most effective way to realize stability of the real effective exchange rate of China; linkage with the ACU i.e. the regional weighted average currency basket is the second choice; linkage with the USD is the final choice (Zhang and He, 2006). Thus it can be seen that the first stage is linkage with the three major currency basket and the second stage is the linkage with the ACU. In the currency basket in which the USD, Euro and Yen account respectively

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for 1/3 each, the exchange rate fluctuations between major currencies will cancel each other out. In this case East Asia countries can avoid the negative impact of substantial changes in the USD–Yen and USD–Euro exchange rates. When taking this kind of currency basket as a reference to realize exchange rate policy coordination, East Asian countries would be able to evade crisis. At the same time, this is within the realizable scope of East Asian countries. The countries that can participate in the coordination should take part in cooperation first and then promote the degree of cooperation from “reference” to “linkage.” With the coordination of an East Asian monetary exchange rate policy comprising the currency basket of three major currencies, the fluctuation of East Asian currencies against the Japanese Yen would be more moderate. This complies with the needs of Japan and other East Asian countries. If the Japanese Yen is the only currency outside the scope of coordination, Japanese enterprises and the enterprises of other East Asian countries would suffer from the negative effect of wide fluctuation in the Yen–USD exchange rate. Theoretically, the linkage with the common currency basket is different from that with the RMB. In linkage with a common currency basket, the RMB as one of the East Asian currencies is on the same terms with other East Asian currencies. However due to the absolute advantage of China in economic strength in the “ASEAN–China Free Trade Zone,” it is highly possible for the linkage with the common currency basket to turn into actual linkage with the RMB. For all practical purposes, China is trying to construct an exchange rate circle with the RMB as the center by taking the financial crisis as a turning point. Premier Wen Jiabao pointed out at the executive meeting of the State Council held on 24 December 2008 that the RMB will be used as settlement currency for the trade between Guangdong and Hong Kong, Macau and Taiwan and the trade between Guangxi, Yunnan and ASEAN members. Settlement in RMB would reduce the exchange rate risks of Chinese enterprises. The export enterprises of ASEAN members prefer the RMB that is appreciating compared with the USD with a tendency of depreciation. The Oriental Morning Post published on 25 December pointed out that “the pilot of settlement in RMB is the inevitable outcome of sophisticated market conditions.” Thereafter the State Council decided on 8 April 2009 to establish pilots for settlement of cross-border trade in RMB in Shanghai, Guangzhou, Shenzhen, Zhuhai and Dongguan. With respect to the finance field, in order to provide liquidity for trade

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The RMB and the East Asian Currency System

and direct investment, China signed currency swap arrangements with a total amount of RMB 650 billion with the Republic of Korea, Malaysia, Indonesian, Byelorussia, Argentina and Hong Kong Special Administrative Region after the G20 Summit held in Washington D.C. in November 2008. Chinese export enterprises can fence off foreign exchange risks when recovering export proceeds in domestic currency. The central banks of importing countries that have accepted the currency agreement would provide financing for import activities of enterprises using the funds obtained through agreement. The above-mentioned series of measures represent an important step towards internationalization of the RMB. According to the report of The Beijing News published on 9 April 2009 Zhang Jun, the Assistant Dean of the School of Economics of Fudan University, pointed out that the internationalization of the RMB would be subject to the following steps, namely the RMB is used for trade settlement and then becomes one of the global reserve currencies after the second stage in which the RMB is used as a denomination currency for financial transactions. Despite the extremely long process, the internationalization of the RMB has been taken as a national strategy and would proceed steadily. The Xinhua Daily published on 8 April 2009 pointed out that “since the outbreak of the international financial crisis, due to the sharp fluctuation of the USD and Euro, China’s enterprises and its trade partners hope to perform calculation and settlement of trade transactions in the relatively stable RMB.” In fact we are not sure about the willingness of the enterprises of China’s trade partners to make settlement in RMB. Both the pilot for trade settlement in RMB and the currency swap agreement would reduce the exchange rate risk of Chinese enterprises thanks to the collection of export proceeds in RMB while shifting the exchange rate risk to the enterprises of China’s trade partners. Some Chinese economists believe that China, as an economic giant, exerts absolutely asymmetric competition pressure on the medium and small countries in East Asia which have to accept settlement in RMB (Yao Zhizhong, 2006). With the stability of the exchange rate in this region as the background, if China succeeds in its pilot for settlement in RMB, the reform would naturally be expanded to ASEAN members. With the establishment of the “ASEAN– China Free Trade Zone” in 2010, China has concluded investment agreements with various Asian countries. It has been observed that the “ASEAN–China Free Trade Zone” is developing towards a currency circle with the RMB as the center. Since the economic crisis is coming to its end, the linkage of East Asian

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currencies could be restored in the above-mentioned form. Subsequently, after the completion of the first stage of institutionalization, it is highly possible for East Asia to divide into an RMB currency circle and a Japanese Yen currency circle with the Yen only. Japan and China would become the two cores of the production and trading system for promotion of the economic integration of Asia. Economically, the independence of the Yen and the maintenance of its linkage with East Asian currencies would be to the detriment of Japan and East Asian countries. Geopolitically, this would also exert great impact. The task of the second stage is to establish the East Asian exchange rate coordination system with Japan included. The ASEAN 10+3 Summit held in Kuala Lumpur in December 2005 re-confirmed the “joint resolution to realize the EAC” and declared the acceleration of completion of the final report of the East Asia study team including the study on the “closer regional exchange rate mechanism coordination.” On this basis the ASEAN 10+3 finance ministers conference held in Hyderabad in May 2006 announced support for the study on “procedures for establishment of a regional currency unit” and commended the study to the International Currency Research Institute of Japan. The regional currency unit refers to the ACU. First, the ACU would be used as a reference index for economic policy and exchange rate policy coordination of participant countries and then become the linkage object of participants’ currencies, and would finally develop into the common currency of Asia. The second stage stated in this chapter means the period until the realization of ACU linkage. The currency basket for the first stage is composed of currencies such as the USD, Euro and Japanese Yen that are outside the region while the ACU comprises regional currencies. With respect to the transition of the three currency basket to the ACU Masahiro Kawai, Director of the research institute under the Asian Development Bank pointed out that after the basket of three major currencies and the G3 currency basket of the ACU (i.e. the currency basket comprising the USD, Euro and ACU) is realized, the proportion of USD and Euro would decrease gradually; when this proportion decreases to zero, the ACU would be realized (Masahiro Kawai, 2008). The transition from the first to the second stage would take a long time and require sustainable cooperation between the countries in the region.

Is it possible for Japan to join hands with China? To promote the establishment of a regional exchange rate coordination mechanism, the long-term disruption between the RMB circle and the Japanese Yen circle is not possible. It is extremely important for ASEAN 10+3 to reach a

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The RMB and the East Asian Currency System

consensus after the fast realization of the first stage so as to start preparation for the second stage. Unfortunately, both Japan and China which are the key countries for monetary cooperation in East Asia tend to be conservative. Japan is apparently confused by the progressive economic development and economic power of China. Japanese people are not pro-China but are only interested in the Japanese economy and politics. At present there are no political conditions in Japan for the promotion of Japan–China monetary cooperation. China made a negative response to the AMF concept proposed by Japan to deal with the Asian financial crisis and the ACU concept proposed by the ADB in 2006 since China cannot benefit much from these proposals. As Bergsten said, China is not psychologically prepared for rapid development as an economic giant (Bergsten, 2008). At the same time, the deep psychological grudge of China against Japan cannot be ignored. Zhang Ming from the International Financial Center of the Chinese Academy of Social Sciences has pointed out that since political and historical issues are the obstacles to Asian monetary cooperation, monetary cooperation in East Asia “has to be promoted by crisis” (Zhang Ming, 2008). In other words, only when economic requirements force East Asian countries to put political and historical issues aside temporarily so as to overcome a major crisis will it be possible for these countries to carry out monetary cooperation in East Asia. In fact the previous Asian financial crisis provided a turning point for the development of financial cooperation such as the CMI. In 2004 Koizumi, former Prime Minister of Japan, put forward the concept of an “EAC based on ASEAN 10+3” at the United Nations General Assembly. China suggested that the scope of the EAC should be ASEAN 10+3, but Japan suggested the scope should be ASEAN 10+6 including India, Australia and New Zealand. Thereafter, due to the deterioration of political relations between Japan and China, the enthusiasm of both countries for the EAC gradually cooled. Li Xiao and Ding Yibing from Jilin University in China pointed out that the limitation of the CMI is that it is established based only on a practicing philosophy for the prevention of crisis. Hence the CMI lacks consciousness of the joint development and prosperity of the Asian Community (Li Xiao and Ding Yibing, 2008). They also pointed out that it is necessary to take the establishment of the EAC as a long-term historical objective which reflects the common will of Asian countries. At present in the important transition period of East Asian financial cooperation, they advocate the necessity for regional powers to fulfill their due responsibilities. Taking this financial crisis as an opportunity, East Asian powers have

217

COOPERATION BETWEEN THE RENMINBI AND THE YEN

recently shown new development trends so as to realize financial cooperation. In 2008 Japan had a trade deficit for the first time since 1960. Despite the radical financial promotion policy, it is expected that negative growth would inevitably occur in 2009. The key to the economic growth of Japan is to make efficient use of the demand expansion in Asia. For China, a satisfactory export environment is essential for a “high rate of economic growth.” It should be particularly noted that in order to reduce the dependence on export to the U.S., it is important for China to realize the stable expansion of regional trade relations in Asia. Hence China and Japan should share a common understanding of the importance of a regional exchange rate stabilization mechanism that can structurally support the economic integration of East Asia. President Hu Jintao pointed out at the financial summit conference held in Washington D.C. in November 2008 that it is necessary to enhance the ability to provide liquidity to each other and strengthen the construction of a regional financial foundation. Premier Wen Jiabao also emphasized the enhancement of financial cooperation under the ASEAN 10+3 framework at the summit meeting between Japan, China and South Korea held in Fukuoka. The joint declaration by the leaders of Japan, China and South Korea also stressed cooperation with ASEAN to expand the CMI and reinforce the framework of regional economy and financial market monitoring. Since the framework of financial cooperation is still within the scope of ASEAN 10+3, it is impossible to bring India, Australia and New Zealand into the monetary cooperation. However India, Australia and New Zealand would call for the establishment of certain cooperative relationship according to the necessity and possibility of cooperation with the ASEAN 10+3. However the resolution on financial cooperation proposed by the leaders of Japan, China and South Korea does not cover the issue of exchange rate policy coordination. Unlike the provision of credit without constraint on national sovereignty, it would be impossible for the establishment of an exchange rate coordination mechanism with constraint on national sovereignty over economic policy to proceed smoothly without a hitch. On this point Yu Yongding, the former Director of the Research Institute of World Economics and Politics of the Chinese Academy of Social Sciences, pointed out that no discussion about regional exchange rate management framework has been held after Asian monetary crisis and “it is extremely dangerous to relax vigilance” (Yu, 2001). With respect to issues of exchange rate stabilization, the governments of East Asian countries should be willing to stabilize the exchange rate even from the perspective of protection of their own interests. Yu Yongding warned that without taking a regional view, the exchange rate system of East Asia would

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The RMB and the East Asian Currency System

fall into disorder again when a new crisis occurs. Now we can see the negative

effect on East Asian countries caused by relaxation of vigilance in the excellent situation of global economic development.

Director Yu Yongding pointed out at the symposium “The Future of Asia”

held in Tokyo in May 2007 that “the problem of Asia is that we have no 50-year objective which should be determined by politics.” We know perfectly well

turmoil in the foreign exchange market would threaten the stable economic

development of East Asia. It is believed that cooperation on exchange rate

policy would become an important issue for Asian financial cooperation, and

on this a consensus would be reached. It is observed that the preparation work for pursuit of a 50-year objective for Asia has been done to some extent and is waiting for political decisions. At present, Asian countries are discussing the

establishment of an ASEAN 10+3 office which is expected to play an important

role in the investigation and supervision of macroeconomic and financial supervision system and the centralized administration of foreign exchange

reserves of the countries and the contingent credit system. In case of emergency, this office would play the role of credit supply etc. It is feasible to commend

the establishment and improvement of the CMI credit supply function and

the blueprint for East Asian monetary cooperation with an exchange rate

stabilization mechanism as the core to the CMI office. The joint declaration of the ASEAN+3 finance ministers’ conference in 2006 shows support for study of “the method for establishing a regional currency unit” and takes it as one of the

most important research topics of the CMI. The concept of East Asia monetary cooperation must take the first and second stages as an overall blueprint.

Once the RMB becomes the central currency of the RMB currency

circle (the first stage), China would have two choices i.e. striving for the internationalization of the RMB or moving towards the second stage of Asian

monetary cooperation based on the ACU. The precedent of the ECU shows that two or more powerful convertible currencies could coexist within the ACU. The

author believes that it is necessary for China to keep an integrated relation with the above-mentioned East Asian currencies during the internationalization of

the RMB. China did not clearly express its support for the AMF but has actively participated in the realization and expansion of the CMI. Even if China has a

negative attitude toward the ACU now, it may change its ground in the case

of financial crisis and take an active part in the study on the ACU. If political change is driven by economic demand, it can be imagined that the situation would be totally different.

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Conclusion How would the East Asian monetary cooperation influence the international financial situation? Since the collapse of the Bretton Woods System at the beginning of 1970s, the world has been continuously suffering from the USD crisis of which the primary cause is the irresponsible economic policy adopted by the U.S. Thanks to its ability to pay its trade deficit in USD, the U.S. does not have to be subject to the economic policy rules that must be observed by other countries. Before the G20 London Summit Zhou Xiaochuan, the Governor of the People’s Bank of China, suggested developing SDRs of the IMF into a global reserve currency. This means China is showing the world that a reserve currency should not be associated with specific national interests and its value must be kept stable. If it is impossible to realize the proposal of Zhou Xiaochuan, the second choice is to relativize the position of the USD. If the Euro as an international currency inspires popular confidence and its importance is continuously promoted, the U.S. will have to comply with more stringent economic policy rules. If the U.S. continues with irresponsible economic operation, capital will “escape from the USD to the Euro.” If the currency of Asia as an economic growth center with an economic scale is almost on a par with the U.S. and Europe is taken into account, the U.S. will have to observe more rigorous economic rules. However the Japanese Yen lacks the confidence of the market due to its sharp fluctuation while it would be extremely difficult for the RMB with no convertibility to become an international currency. The third choice would take a long time but it is feasible. The third choice is to develop the ACU into a common currency through monetary cooperation in East Asia. Its purpose is not to force the U.S. to observe economic rules, but to make the ACU the basis for the economic stability and prosperity of Asia. At present, there is an economic demand but a lack of political support. Since financial cooperation in Asia is “driven by crisis,” political factors may change the consistent positive attitude in the current financial crisis. Nakasone Yasuhiro, the former Prime Minister of Japan, pointed out in his proposal that the common currency of Asia should be established before 2030 (Nakasone Yasuhiro, 2009). He believes it is important for Asia to set its own development objective. The objective put forward by Nakasone Yasuhiro is the objective stressed by director Yu Yongding in his words, “the problem of Asia is the lack of a 50-year objective.”

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The RMB and the East Asian Currency System

In conclusion, let us summarize the far-reaching significance of monetary cooperation. Like the European currency cooperation that determines the integral development direction of Europe, the discussion about the development direction of monetary cooperation in East Asia is a discussion of the future development direction of Asia.

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Part IV

The Present and Future of Asian Monetary Cooperation—The Cooperation between China and Japan

7

Chapter

Asian Monetary Cooperation and Sino– Japan Coordination Ding Yibing

COOPERATION BETWEEN THE RENMINBI AND THE YEN

Introduction The Asian financial crisis in 1997 indicated many problems in the economic development of East Asia. The lack of monetary and financial coordination and cooperation between the countries and regions is one of the most outstanding problems. One the one hand, the huge impact caused by the crisis forced Asian countries and regions to make an in-depth consideration and thus to recognize the urgency and importance of regional monetary cooperation. On the other hand, under the current international monetary system, being faced with the high-speed and large-scale flow of international capital, like most of the countries in the world the countries and regions especially the developing countries in East Asia were in an asymmetrically weak position and got into trouble in their selection of exchange rate system. Any type of exchange rate system would have adverse impact on economic development unless regional monetary cooperation is strengthened. In such circumstances, the economies in East Asia have attached great importance to Asian monetary cooperation since 1997 and have made some practical progress. The global financial crisis that has brought about significant impact on the global economy since 2008 has placed a new task in the forefront of study of Asian monetary and financial cooperation and has stimulated the academic community of China to expand relevant research. First of all, it is found that this international financial crisis actually further revealed the defects and the necessity for reform of the existing international currency and financial system (Huang Zemin, 2009). Due to the difficulty of fundamental reform of the current international currency and financial system within a short period of time, it seems to be very important to promote the diversified development of the international monetary system (Li Yang, 2008; Ge Huayong, 2009). Secondly, this international financial crisis has exerted an impact on East Asia, making it impossible to preserve its own development and pay no attention to others. The relatively backward regional collective cooperation mechanisms have brought a negative effect (He Liping, 2008). The collective cooperation of East Asian economies is apparently better than unilateral action when responding to crisis (Li Xiao and Ding Yibing, 2008). At the same time, the crisis provides a new opportunity for internationalization of the RMB (Wang Yu, 2009). Against this backdrop, Chinese scholars have held relatively comprehensive investigation of and in-depth discussion about the progress, situation and forthcoming development direction and prospects of Asian monetary cooperation.

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Progress of Asian Monetary Cooperation From China’s perspective, Asian monetary cooperation can be divided into three stages of development. The first stage is the period before outbreak of the Asian financial crisis. In this period the trade investment and technical ties between Asian countries were very close and regional cooperation in the fields of trade or investment and the corresponding cooperation mechanisms existed in local regions and over the whole Asia–Pacific region, for example, the ASEAN Swap Arrangement (ASA) established in 1997 and the Commission of Central Bank Officials in the East Asia and Pacific Region (renamed Executives’ Meeting of East Asia Pacific Central Banks after 1996) established in 1991. However East Asia as a whole did not have a substantive cooperation mechanism in the field of currency and finance. The second stage covers the period from the outbreak of the financial crisis to 2000. In this stage, regional powers proposed rescue plans and concepts. For example the Japanese government put forward the proposal to establish the AMF1 and took proactive rescue measures based on the “Miyazawa Initiative”; and the “no depreciation of the RMB” policy of the Chinese government to a great extent alleviated the crisis. However the East Asian economies did not reach a basic consensus on regional monetary cooperation. The third stage is the actual promotion period from the proposal of the CMI in 2000. In this period, East Asian economies reached a consensus on regional monetary cooperation, took a series of aggressive actions, and made progress in fields such as information sharing and co-regulation mechanisms, currency swap and the promotion of construction of the Asian bond market. It should be particularly noted that the outbreak of the global financial crisis caused by the subprime crisis in the U.S. that occurred in 2007 triggered the willingness of Asian economies to further enhance cooperation. In May 2008 the conference of the ASEAN 10+3 finance ministers and central bank presidents held in Madrid reached a consensus on multilateral CMI issues. The special conference for ASEAN 10+3 finance ministers held in Phuket, Thailand on 22 February 2009 published the Action Plan to Restore Asian Economic and Financial Stability , expanded the scale of the common reserve foundation for the CMI Multilateralization (CMIM), and proposed the establishment of independent regional economy monitoring entity. The conference of the ASEAN 10+3 finance ministers held in Bali, Indonesia on 3 May 2009 declared that the preparation work for construction of a regional foreign exchange reserve pool with a total

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amount of USD 120 billion would be completed by the end of the year 2009. The finance ministers of China, Japan and South Korea reached a consensus on the capital share of an independently managed regional foreign exchange reserve pool under construction. According to this consensus, China will provide USD 38.4 billion, Japan USD 38.4 billion and the Republic of Korea USD 19.2 billion , accounting respectively for 32%, 32% and 16% of the total amount of the reserve pool. In case of financial crisis, the reserve pool will provide financial assistance to the members with liquidity difficulties by means of borrowing. From the overall point of view, the consensus reached by East Asian economies on regional monetary and financial cooperation since 2000 and the efforts made under the CMI framework are mainly reflected by the following aspects.

Establishment of the mechanism for information sharing and common monitoring In view of the lesson learnt from the crisis, East Asian countries and regions have jointly recognized that due to the excess liquidity all over the world, hedge funds have been continuously performing conducting nontransparent speculation. To prevent a reoccurrence of the crisis it is necessary to prevent countries formulating separate policies and establish a regional information sharing and monitoring mechanism. This is an important precondition for the smooth implementation of the CMI. This mechanism mainly comprises two parts: first, exchange and sharing of information about the macroeconomic development, economic policy and financial market etc. of members and the monitoring and analysis thereof; second, to monitor the adverse changes that occurs in macroeconomic operation and the financial market and their impact, and to put forward suggestions on policy. As it stands, the East Asian countries and regions have made some progress with respect to information sharing and a common monitoring mechanism based on the Manila Framework Group (MFG) established in November 1997, the ASEAN Surveillance Process (ASP) launched in October 1998, the ASEAN 10+3 monitoring established in May 2000 and the ASEAN 10+3 Early Warning System (EWS) established in May 2001. However these are only preliminary achievements. For various reasons, East Asian countries and regions have always adhered to the principle of “reaching consensus through consultation” and “not obligatory”2 during their cooperation. Furthermore the existing achievements are not complete. Generally speaking, the establishment of regional policy coordination and a dialogue mechanism covers two aspects: first, the establishment of a monitoring mechanism; second, the disciplinary

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mechanism associated with agreement breaching. Up to now East Asian countries and regions have not arrived at an agreement on the second mechanism, which naturally limits the effect of information sharing and the common monitoring mechanism.

Launch of the CMI and the CMIM Since its establishment, the CMI has roughly experienced three stages of development. The first stage is the start of the CMI. In November 1999 the ASEAN 10+3 conference issued the Joint Statement on East Asia Cooperation that clearly designated the ASEAN 10+3 finance ministers conference as the major framework for this cooperation agenda. The purpose of the ASEAN 10+3 finance ministers conference is to enhance the policy dialogue and coordination between East Asian countries and regions and strengthen the cooperation on common finance, currency and fiscal affairs etc. At the 33rd annual conference of the ADB held in Chiang Mai, Thailand in May 2000, the ASEAN 10+3 finance ministers agreed on an initiative, the CMI. The fundamental purpose of the CMI covers three aspects: first, to take full advantage of the organizational framework of the ASEAN 10+3 to enhance the exchange of data and information on capital flows; second, to improve the ASA, 3 extend it to all ASEAN member countries and increase its total amount from USD 200 million to USD 1 billion; third, to establish Bilateral Currency Swap Network and Repurchase Agreements (BSA) within the scope of ASEAN 10+3 and promise to provide member countries with funds of an appropriate scale as occasion requires so as to help these countries to resolve the problems in short-term international balance of payment or liquidity. It is obvious that the CMI is a crisis rescue mechanism of which the principal objective or principle is to prevent financial crisis and provide assistance. In August 2000, the ASEAN 10+3 central bank presidents’ conference officially extended the ASA to all ASEAN members and increased its swap funds from 200 million to USD 1 billion. At the same time a series of bilateral swap agreements were signed between the ASEAN and Japan, China and South Korea, which expanded the scope of currency swap arrangements. For several years thereafter the ASEAN 10+3 finance ministers’ conference further reached consensus on the contents and implementation of the CMI and entrusted the secretariat of ASEAN to improve the fund settlement systems between the countries and regions outside the BSA so as to expand the currency trading between them and continue to explore an appropriate regional self-financing mechanism to improve the collective ability to respond to financial crisis.

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The second stage refers to the advancement of the CMI from bilateral to multilateral. At the ASEAN 10+3 finance ministers’ conference held in Istanbul in May 2005, the Asian countries and regions reached a consensus on further enhancement of the effectiveness of the CMI. At the APT held in Hyderabad in May 2006, the total amount of bilateral swap reached USD 75 billion and the ASEAN 10+3 members further proposed the prospect and direction of CMI development in future. The members reached an agreement on the establishment of a cooperation framework (the “CMI multilateralization” or the “CMIM”) that was more advanced than a regional liquidity assistance framework, signifying the multilateralization of the CMI. At the APT conference held in Kyoto, Japan in 2007, the total amount of currency swap under the CMI framework confirmed by member countries reached USD 80 billion and the member countries unanimously agreed to establish a reserve pool managed by member countries themselves in principle under the major premise of an integral contract. On this basis, the representatives of the finance ministers were designated to discuss CMI multilateralization issues such as regulatory system, the appropriateness of foreign exchange reserve, the scale of fund agreement, borrowing limit, and initiation mechanism. The establishment of a common foreign exchange reserve pool would technically take the CMI multilateralization plan a big step further and had extremely important significance. The third stage is multilateralization of the CMI. The outbreak of the subprime crisis in the U.S. in July 2007 led to a severe global financial crisis in 2008. Although this crisis did not have a significant impact on financial institutions in East Asia, the East Asian countries and regions were faced with a severe test in the aspect of export due to the negative economic growth of all developed countries represented by the U.S. In the case of lack of countermeasures of International Finance Corporation, whether or not East Asia could enhance its ability to resist the risk through regional self-aid mechanism was of crucial importance. Against this background, the ASEAN 10+3 finance ministers attended the conference Madrid on 5 May 2008, deciding to input USD 80 billion to establish the common foreign exchange reserve fund. The ratio of the contribution of ASEAN to the overall contribution by China, Japan and South Korea was 2:8. In 2009, with the continuous deepening of the global financial crisis and its increasingly serious impact on global real economy, in order to mitigate the damaging impact of the crisis on the financial stability of East Asia, as already stated the ASEAN 10+3 special finance ministers’ conference was held in Phuket, Thailand on 22 February 2009. At this conference the Asian countries jointly issued the Action Plan to Restore Economic and Financial Stability of the Asian Region (the Action Plan for short). This plan

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covered four items: first, increase the scale of the common reserve fund of the CMIM from USD 80 billion to USD 120 billion; second, in order to ensure the effective management and use of common reserve fund, it was recommended that an independent regional monitoring entity be established; third, after the above two measures were taken, the ratio of start-up capital of the common reserve fund to the conditional loan of the IMF would decrease further from the current ratio of 80%; fourth, in view of the backflow of sizeable foreign exchange reserves from member countries to the financial market of the U.S. through various channels, Asian countries were allowed to use a specific part of foreign exchange reserves for specific purpose so as to provide an appropriate method for management of foreign exchange reserves. The implementation of the Action plan laid the foundation for institutionalized construction of the CMIM and provided a platform for higher-level regional policy coordination and monetary cooperation on the medium-and-long term. Furthermore, the establishment of an independent regional monitoring entity is of extremely important significance. If practical implementation could be conducted successfully, this would largely indicate the realization of the AMF concept that was shelved in 1997, 4 and hence the dependence on the IMF in terms of crisis intervention would decrease and the independent operating space would be significantly enlarged.

Development of a regional bond market In the current “USD System,” East Asia owns the world’s highest saving ratio and substantive foreign exchange reserves, but a huge amount of funds has flowed into the financial market of developed countries represented by the U.S. As a result, the economic development of East Asia has to rely on the inflow of short-tem funds. This results in a "double mismatches” which has become the primary cause of financial market turmoil or even financial crisis. After the outbreak of the Asian financial crisis, East Asian countries and regions recognized the hazards of non-development of a regional capital market and especially the backward development of the bond market, and took the development of a regional bond market as an important item on the agenda for regional monetary and financial cooperation. In November 2002 the Republic of Korea proposed the relatively official ABMI at the ASEAN 10+3 informal deputy finance ministers and central bank governors conference held in Tokyo. At the conference held in Tokyo on 28 February 2003, ASEAN 10+3 member countries officially proposed the ABMI specifying that the governments and private enterprises of East Asian countries

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may participate in the issue of Asian Basket Currency (ABC) bonds for which the regional institutions in East Asia would implement the transaction,

management, setting of interest rate, guarantee and acknowledgment. On 2

June of the same year, 11 central banks and monetary authorities of the EMEAP issued a proclamation officially launching the ABF1 (ABF Phase I) with an

initial amount of USD 1 billion. This fund is a common fund composed of official reserves of EMEAP economies and would be put into the basket of sovereign and quasi-sovereign USD bonds issued by EMEAP members (except

Japan, Australia and New Zealand) so as to improve the liquidity of this type of bond and push other investors into Asian bond market.

To achieve the purpose of promoting the regional bond market through the

Asian bond market, after the successful launch of ABF1 EMEAP immediately

started a study on the development of investment in member countries᾽ local-

currency bond market (ABF2). EMEAP announced on 16 December 2004 that the ABF2 with a total amount of USD 2 billion jointly established by its members would be started at the beginning of 2005.

ABF2, which includes the Pan-Asian Bond Index Fund (PAIF) and eight

single-market funds, is also known as the “Fund of Bond Fund” (FoBF). As a

single indexed bond fund with a total investment amount of USD 1 billion, the

PAIF covers the markets of eight EMEAP members (except Japan, Australia and New Zealand) and its investment object is sovereign or quasi-sovereign bonds

denominated in member country᾽s legal currency. The price is offered in unhedged USD. Compared with ABF1, ABF2 is a cooperation model for cultivation

of a regional bond market in local currency and will provide greater impetus for the development of the regional bond market in East Asia. ABF2 will not only

help to expand the demand for and promote the opening of the regional bond

market but will also facilitate the establishment and development of regional regulatory cooperation.

At present, the start of ABF3 is on its way. The new fund has a different goal

and launch framework compared with the previous two phases. The primary

objective of ABF3 is to provide credit support for East Asian bonds, especially non-sovereign bonds that have failed to obtain good ratings, and assist the

banks of developing countries in Asian and Pacific regions to securitize a greater portion of their assets so as to provide more options for investors inside and outside the region. Since ABF3 has to a great extent responded to the worry

of the private sector about the credit quality of bond issuers, the bond market of East Asia will be promoted to a new stage (Huang Meibo and Lin Yang, 2008).

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Proposal for regional exchange rate cooperation The Asian financial crisis fully revealed the three drawbacks in the original exchange rate arrangement in East Asia: first, the exogeneity of monetary policy does not comply with the requirements of the economic development cycle in East Asia; second, the conflict with the trade models of East Asian economies and the frequent fluctuation of the exchange rate of the Japanese Yen against the USD results in the dramatic change in current accounts of the economies; third, the unilateral pegging to the USD and the lack of an exchange rate coordination mechanism brings about a crisis contagion and expansion effect. Therefore, upon the completion of discussion about crisis assistance and the establishment and implementation of policy and mechanism, the issue of a regional exchange rate coordination and cooperation was put on the agenda. In the case of failure to establish an effective regional exchange rate cooperation mechanism in East Asia, the foreign exchange fluctuation based on “benefiting at others’ expense” or “actual pegging to the USD System” in some certain form would occur while the implementation of various convenient arrangements for financing and the development of a regional bond market would be arrested. At the ASEAN 10+3 finance ministers’ meeting held in Istanbul in May 2005 the policy authorities of Asian countries and regions pointed out in their joint statement that it is necessary to enhance economic policy (including exchange rate policy), dialogue and coordination. When renewing the ASA, the conference for the central bank presidents of China, Japan and South Korea also pointed out that exchange rate stability and the enhancement of policy coordination is propitious to all the three countries. However it should be noted that no institutionalized exchange rate coordination and cooperation mechanism has been established in Asia up to now.

Major Difficulties in Asian Monetary and Financial Cooperation at the Present Stage and the Root Cause Thereof Deficiencies in Asian monetary cooperation at the present stage Although Asia has made considerable progress in monetary and financial cooperation, generally speaking the development is relatively slow and no substantive breakthrough has been achieved in some key fields. Li Xiao et al. (Li Xiao and Ding Yibing, 2005; Li Xiao, 2009) pointed out that Asian monetary cooperation shows the following drawbacks at the present.

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First, the scale of monetary cooperation is limited. The scale of monetary cooperation in East Asia and the resource input of the countries do not match with the foreign exchange reserves which amount to nearly USD 4 trillion in East Asia at present. The size of the BSA framework is much smaller than that required by East Asian countries and regions to cope with external impact and monetary crisis. For example, the total amount of the bilateral swap arrangement signed by Thailand has reached USD 9 billion, but Thailand applied to the IMF for financial assistance of USD 17.2 billion in the Asian financial crisis of 1997. On the other hand, the scale of the ABF is much more limited and cannot comply with the requirement of regional bond market construction. Despite the start of regional local-currency bond market through ABF2, due to the weak ability of East Asian enterprises to form capital and make investment and the large number of problems in transaction product design, micro-market structure and investor behavior etc., the Asian bond market features a small transaction size and transaction volume and low turnover rate (Li Xiao and Zheng Wenli, 2006) which have greatly hindered the development of the ABF. It is obvious that there is a necessity and condition for expansion of both the BSA and ABF. But as matters stand, little progress has been made in this aspect. Second, totally independent monetary cooperation has not been realized. The original objective of Asian monetary cooperation is, based on the monetary and financial system in which excessive dependence of East Asian economies on the USD and the external financial market occur in the present international monetary system, to establish a mechanism to prevent and resolve external impact and monetary disturbances, reduce the impact of external economic disturbances such as USD exchange rate fluctuation, and solve the “double mismatches” problem in financing of economies so as to maintain regional financial stability and create a satisfactory monetary and financial environment for the sustained economic growth of the region. Based on this situation, on the one hand East Asian financial cooperation should not be operated solely under a global financial stabilization framework such as the IMF but should have a certain independence so as to solve regional financial problems in a more timely and “target-oriented” manner; on the other hand, the influence of external currency in the financial system of East Asia should be properly weakened so as to reduce the negative consequence of asymmetric shock. In addition, the role of regional currencies should be strengthened so as to reduce potential risk of assets dollarization. However the current cooperation framework has to a great extent not achieved this goal. Firstly, as stated above, the start and operation of the BSA was subject to the limit of IMF assistance framework before 2008.

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Although the start of the CMIM in May 2008 broke the limit of requirement on financing under the IMF fund assistance project framework, how to establish rigorous regional supervision system and to properly handle the relationship with the IMF is still an outstanding issue which will inevitably have some adverse effects on the timeliness, flexibility and pertinence of the CMIM; secondly, although ABF2 has broken the limitation specifying that only USD denominated assets can be bought, due to its small scale ABF2 has not actually solved the problem of “financing currency mismatch” in East Asian countries and regions and would be unable to provide effective liquidity support on a larger scale in case of monetary crisis; thirdly, East Asian economies are still maintaining close ties with the USD in terms of de facto exchange rate arrangement. Third, institutionalized multilateral cooperation is not provided with coordinating bodies that have strong binding force. One of the important prior conditions for independent operation of monetary cooperation is the enhancement of relevant disciplinary restrictions and the normative cooperation of a multilateralized system. Since the proposal and implementation of the CMI in 2000, bilateral cooperation and loose cooperation have taken dominance. Take the ASEAN 10+3 framework for example: in fact, China, Japan and South Korea cooperate with each other and with ASEAN and there is no multilateral system arrangement relevant to financial cooperation between China, Japan and South Korea. Furthermore, no formal institutional arrangement has been established for the supervision process and capital movement regulatory mechanism etc. East Asian monetary cooperation was changed from bilateral to multilateral cooperation in the year 2008, and in order to ensure the effective management and use of the common reserve fund, the CMIM suggested the establishment of an independent regional monitoring entity. However the method for establishment and operation of this entity is still under discussion. The CMIM is mainly proposed and implemented to cope with the liquidity difficulty caused by crisis, and in the case of the lack of a strong supervision and policy coordination function, moral risks would inevitably occur in some economies once crisis breaks out. Moral risk means that some countries or regions use currency swap funds or foreign exchange reserves funds which are a regional public product to take action that would be beneficial to themselves but cause damage to regional benefit. As it stands, the proposal and rapid development of the CMI and ABF is associated with the positive willingness and determination of East Asian economies to cope with financial crisis and is also to some extent related to the intention of these economies to escape the rigorous financing conditions of the IMF and thus to “thumb a ride” (Liu Zhenlin, 2006).

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Therefore how to establish an independent mandatory supervision and policy coordinating body has become an urgent issue at the forefront of regional monetary cooperation in East Asia. In view of setbacks in conception of the AMF and the various complicated relations between East Asian countries and regions, a large number of problems in the development of an institutionalized multilateral cooperation mechanism still need to be resolved. Fourth, delay in the start of exchange rate cooperation in East Asia. At present exchange rate cooperation in Asia still remains at the stage of theoretical analysis. Due to the complicated historical, political, economic and social problems in East Asia and the difficulties in sovereignty transfer, regional exchange rate cooperation is always deemed the long-term goal of East Asian monetary cooperation and has not been listed on the substantive cooperation agenda. However it should be noted that, because of the similar industrialization model and economic development model of East Asian economies, regional exchange rate stability is of essential significance to the smooth development of trade and financial transactions within the region and the economic and trade exchanges with countries outside the region, and has been taken as one of the most important objectives of East Asian monetary cooperation. The lesson of the Asian financial crisis shows that the sharp fluctuation of exchange rate of the USD against the Japanese Yen would create the prerequisite for speculation activities and is the important root cause of economic instability in East Asia. Moreover if regional exchange rate stability cannot be maintained effectively, the implementation of various financing facilitation arrangements and the construction of a regional bond market would meet with obstruction.

The root cause of the obstruction to Asian monetary cooperation at present Admittedly, the difference in economic structure, development level, openness etc. between Asian economies and the level of regional economic integration may have hampered the establishment of higher-level monetary and financial cooperation mechanism. However relevant empirical analysis (Eichengreen and Bayoumi, 1996; Bayoumi and Mauro, 1999; Zhang et al., 2003) shows that East Asia already has the conditions to improve the scale and level of monetary cooperation on the current basis, establish a more institutionalized cooperation mechanism, and carry out elementary exchange rate cooperation. The factors listed below are the more important root causes of challenge to monetary cooperation in East Asia (Li Xiao and Ding Yibing, 2005).

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First, the dependence of East Asian economies on the USD system. Since the collapse of the Bretton Woods System in the early 1970s, the development of the international monetary system has been showing a trend towards diversification of reserve currency. However the “decoupling” of USD from gold has by no means impaired the position of the USD. The USD is still predominant and, as a key currency of the world, plays a central role in international monetary system. The Bretton Woods System has changed into the concealed “USD System.” Due to the further relaxation of financial control and the opening of the financial market together with the successful economic transformation in the late 1980s, the U.S. entered a long period of sustainable growth and a huge amount of capital from other regions flooded into the U.S. market. As a result, although the deficit of current items reached a new high in the 1990s, the huge capital inflows not only made up for these deficits but also brought about a large amount of surplus capital which was put into every corner of the world and thus resulted in the credit turnover system or circulation system with the USD as the core all over the world (see Fig. 7.1). Fig. 7.1.

The USD-centered credit turnover system Investment of the U.S. in foreign counties (3)

The U.S.

Trade (1)

Other countries

Deposit to the U.S. (2) Investment to the U.S. (4)

After the establishment of the EMS, and especially after the 1980s, emerging market economies particularly East Asian countries and regions have gradually become the most important supporter of this credit turnover system and USD system. Some of the funds in USD obtained from the surplus of export to the U.S. are used to import capital goods and the rest is put into U.S. national bonds issued by government and stored as foreign exchange reserves in the U.S. Since the 1990s, about 60% of the capital account surplus of the U.S. has

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been from public sector funds of which the expansion has been supported by developing countries especially the emerging market countries in East Asia besides Japan. Accordingly, East Asian countries are dependent on both the commodity market of the U.S. and also the “USD System.” To ensure export to the U.S., East Asian countries have to maintain the pegged rate against the USD. Thus they want to keep as much USD foreign exchange rate reserve as possible. As a result, the U.S. has attracted more and more external funds and solves the problem in financing the current account deficit while having surplus capital that can be exported. Due to the high return on assets in East Asian countries and regions, a large part of the exported capital flows back to these countries and regions and is converted into the foreign exchange reserves of capital importer and then become investment to the U.S. In this way the USD credit circulation system is increasingly expanded all over the world and promotes the large-scale and frequent flow of funds all over the world. The U.S. provides a continuously growing merchandise export market while supplying continuously increasing financial assets so as to maintain the relative supply and demand balance and the stable exchange rate of USD on international market. This has to some extent resolved the “Triffin Dilemma.” On this basis, the dominance of the USD can be maintained through scale economy effect and network effect. In this sense the U.S. should be considered as a typical “financial nation” controlling the financial hegemony in today’s world. Comparatively speaking, East Asian countries such as Japan should be classified as “trading nations.” 5 As a major “market provider” for East Asia, the U.S. makes it difficult for East Asian countries and regions to get rid of the influence of the USD 6 in terms of selection of international settlement currency and the target to which the exchange rate is pegged. The income in USD from the latter is also put into USD assets, which makes it difficult for East Asia to establish a truly independent financial and exchange rate cooperation mechanism. This is why the USD is still used as the denomination currency in bilateral currency swap in East Asia and is also the root cause of lack of support from private sectors for construction of the Asian bond market. In view of the fact that the U.S. still has the world’s most advanced open financial market and the largest demand for foreign products, taking into account the scale effect and network effect of the “USD System,” the credit turnover system based on the USD between Asia and the United States will not change substantially in the short term. At the same time, in consideration of the time-consuming property and arduousness of economic restructuring, no final product market provider that is strong enough to replace the U.S. will emerge

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in East Asia in the short term. At present the proportion of final product market volume provided by Japan and China is much smaller than that of the U.S. Due to the factors such as small domestic market space and an aging society, it is difficult for Japan to play the role of important final product market provider. Although China has the potential to become the largest final product market provider in East Asia, its ability to expand domestic demand and promote economic growth is limited the short term due to the difficulty and complexity of adjustments of industry structure, economic structure and economic growth pattern. In such a case, the USD and “USD System” will remain a factor that restricts the monetary and financial cooperation in Asia for quite a long period of time. Second, there is no currency that can replace the dominance of the USD at regional level in East Asia. One of the important reasons why it is difficult to further develop a regional currency of East Asia is that regional policy coordination lacks an appropriate regional “core anchor.” To promote policy coordination especially monetary policy coordination within a region requires a core monetary policy objective to be taken by the countries as a basic reference i.e. the anchor, when formulating policies. Germany’s monetary policy is used as a “core anchor” in Europe while East Asian economies take the monetary policy of the U.S. as the core anchor based on the exchange rate system pegged to the USD before and after the crisis. Unlike Europe, the U.S. as an economic giant outside the region attaches greater importance to the adjustment of cyclical fluctuations in economy when formulating its monetary policy. Since the economic relations of the U.S. with East Asia has little effect on its monetary policy and the economic cycle of the U.S. is very different from that of East Asia, the anchor based on the monetary policy of the U.S. apparently does not comply with the requirements of East Asian economies. In fact although the U.S. possesses the inherent advantages of a “financial nation,” it would be feasible to establish a relatively independent regional monetary and financial cooperation mechanism to some extent at regional level if some country could play the role that is the same with the role played by U.S. at the global level to provide an open and huge commodity market and financial assets with sufficiently high liquidity and stable values. Germany in Europe has to some extent achieved the above-mentioned goal through regional trade liberalization and the active opening of the domestic financial market. In Asia, Japan that had conditions that are similar to those of Germany took opposite measures for the internationalization of currency. On the one hand, Japan carried out financial liberalization reform on the principle of “isolating internal from external” that resulted in a relatively

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closed domestic financial market; on the other hand, Japan launched the “Yen Internationalization Strategy” as a direct challenge to USD hegemony and ignored the role of the Yen as a regional key currency (Li Xiao, 2005). As a result, the internationalization of the Japanese Yen was thwarted and Japan is no longer able to lead regional financial cooperation. In East Asia only China has the potential to become a regional “market provider.” However China is unable to assume the responsibility of financial asset provider. As a result it is difficult to construct a regional currency denominated asset market and implement exchange rate cooperation based on a regional currency under current conditions. Third, it is difficult for East Asian countries to transfer sovereignty at the present stage. Both the expansion and institutionalization of monetary cooperation and exchange rate cooperation and coordination require participants to transfer part of “economic sovereignty.” Since most of East Asian countries are at the stage of “sovereignty expansion” of their national state, it is difficult for them to accept the transfer of sovereignty. Generally speaking, national states first experience a stage of “sovereignty expansion” along with the formation and consolidation of the nation state and then enter the “sovereignty convergence” period along with the sophistication of national form and the deepening of international integration or even due to the havoc caused by contradictions, conflicts and wars between countries. Western European countries started their monetary cooperation at the “sovereignty convergence” stage. Modern nation states in East Asia came into being in the late period of modern times and are at their stage of “sovereignty expansion.” Besides, due to historical reasons, many contradictions exist between regional giants like China, South Korea and Japan. It would be extremely difficult to carry out economic sovereignty-related cooperation unless a powerful force drives the cooperation or breakthroughs have been made in willingness for cooperation and the relationship between the regional giants. This is an important reason why trade cooperation in the form of bilateral FTA is given higher priority than monetary and financial cooperation. Specifically, the adverse effect of the common strong sense of sovereignty of East Asian countries on monetary cooperation covers the following items. First, the great attention paid by East Asian countries to economic sovereignty makes it difficult to realize the multilateral institutional arrangement of a regional monetary currency, since an effective multilateral financing mechanism should not only act as the regional “lender of last resort” but should also assume the responsibility of coordinating economic policies,

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strengthening discipline, and supervising economic trends and the international payments position. In other words, this mechanism requires member countries to assume more obligations. Second, the difficulty in progress of a regional exchange rate arrangement is partially because the maintenance of economic sovereignty makes the countries hope to maintain complete autonomy in monetary policy, although this autonomy exists only in name in the current international monetary system. Third, domestic financial reforms caused by financial cooperation involve issues of sovereignty to different degrees. For example, the major purpose of construction of the Asian bond market is to enable East Asian economies to escape the financing structure that relies too much on domestic banks and debt through a regional capital market so as to mitigate the resultant “double mismatches” of currency and time limit. To enable an Asian bond market to obtain sufficient fund support and win the confidence of private sector, requirements would inevitably be made on the contents, procedure or momentum of financial reforms of East Asian countries. This is also a sensitive issues relating to economic sovereignty. Fourth, most East Asian economies are in their developing stage and are participating in some kind of competition in growth and financial reform within the existing international trade pattern and international monetary system (they hope to get into the USD-dominated financial market). This is the reason why it is difficult for them to make the necessary compromises in regional financial cooperation. Fifth, the regional financial and monetary cooperation model based on the response to crisis should be re-examined. The monetary and financial cooperation in East Asia up until now proves that crisis can largely promote monetary and financial cooperation. After the outbreak of the Asian financial crisis, the major objective of regional financial cooperation explored or pursued by East Asian economies is to provide crisis assistance and the further realization of crisis prevention. All parties are making great efforts to explore the way to develop the CMI as a crisis management oriented mechanism into a regional crisis prevention oriented system (the CMIM reflects this effort). The monetary cooperation development in East Asia up until now proves that financial crisis outside the region plays an important role in directly promoting this cooperation. Compared with the development of the European economy and monetary integration, this is a prominent feature of regional monetary cooperation in East Asia. The cooperation mechanism established under the guidance of pragmatism at such a high level is an important reason for difficulties in the development. Since crisis is abnormal and the ultimate goal of

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cooperation should be common prosperity and stable development under the conditions of economic globalization, the cooperation mechanism with direct response to crisis as the objective is an important cause of the weak “Asian consensus” or “community identity.” Hence the “Asian consensus” or the “EAC identity” should set longer-term objectives, exploring and resolving the difficulties in development in the new era while seeking common prosperity and development in East Asia. In this regard regional giants, especially China and Japan, should assume their due responsibilities.

The Necessity for and Conditions of Asian Monetary Cooperation at the Present Stage The Necessity to further promote Asian monetary cooperation at the present stage The outbreak of the subprime crisis and the global financial disturbance caused thereby reflects the fact that there are still inherent risks and hazards that cannot be ignored in highly sophisticated financial markets (models) of developed countries and the rapid development of financial globalization, and these risks and hazards may result in large-scale financial impact. Since East Asian economies are in some sense considered as the “peripheral” areas of financial globalization and feature low openness of financial market and institutions and the slow development of derivatives, they are located at the end of the subprime crisis. As a result, the current external financial disturbance has implicative and indirect impact on East Asian economies; it should be particularly noted that the banking system that occupies a leading position among financial sectors in East Asia has not been subject to obvious adverse effects. However this does not mean that the economy of East Asia has been “decoupled” from the markets of developed countries such as the U.S. The changes in the economic and financial situation of the latter still have an impact that cannot be ignored on economies in East Asia. In an unstable external financial environment that may bring about adverse impact on the economy, the East Asian economies are bound to take measures to make response. East Asian economies are faced with two options: first, unilateral action based on self-interest; second, collective action to resist possible external impacts by enhancing regional financial and monetary cooperation based on the current cooperation framework. It should be noted that unilateral action is not entirely unsuitable for East

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Asian economies. First, East Asian economies with different levels of financial market openness can take different measures to respond to risks and impact from the financial markets of developed countries. In view of the indirectness of impact of global monetary disturbance on the financial sector of East Asia, the countries that are less dependent on the external financial market can enhance control of their financial market and capital movement and restrict the opening of financial departments to the outside world so as to isolate external financial risks to some extent, protect domestic financial departments and maintain macroeconomic stability. Second, for East Asian economies with greatly different economic structure characteristics, the measures taken independently to respond to change in the external economic environment may reduce the cost of policy adjustment. Since global monetary disturbance has different specific impacts on East Asian economies, the economies that are highly dependent on foreign loans and have low economic growth rate, small current account surplus and small size of foreign exchange reserves should take correction measures that are different from the measures taken by those economies with risk of economic overheating, current account surplus and a large amount of foreign exchange reserves. Third, the financial and economic disturbances of developed countries such as the U.S. and the European countries may result in the increase in dependence of small powers in East Asia on some East Asian giants. In this case the small powers may actively seek policy coordination with these giants, which would increase their initiative to take unilateral action. Some scholars such as Yao Zhizhong (2004) believe that since other East Asian economies currently have a unilateral demand for exchange rate coordination with China, China can take the initiative in spontaneously formed regional policy coordination without the necessity for regional cooperation. Despite all this, Li Xiao and Ding Yibing (2008) have pointed out that Asian economies are still faced with obvious difficulties or defects when selecting unilateral action. First, due to the rapid development of the global financial market and corresponding technical means at present, the effectiveness of closing and controlling of a market in isolation of external impact is still open to suspicion. Even if the isolation can be realized to some extent, this kind of stability will probably result in the reduction of economic efficiency, market attractiveness and competitive edge to some degree since development competition commonly exists between developing countries.

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Second, unilateral action may place a premium on the development of “beggar-thy-neighbor” policy and its diffusing and feedback effect will finally impair the stable development of the whole region. Third, unilateral action may bring about a “hitchhike” problem. For example, in the case of economic slowdown of the U.S. and the reduction in external demand, the unilateral action taken to stimulate domestic demand and guarantee economic growth may require a country to practice an expansive fiscal policy which may bring about the spread of expansion effect that is beneficial to the countries which have close trade links with the said country. To obtain benefits from “hitchhiking” these countries may wait for others to carry out adjustment measures and finally get into a “prisoner’s dilemma.” To avoid the occurrence of this situation, East Asian economies need to be closely coordinated at policy level. Fourth, on the one hand, due to the close real economic relations between East Asian economies and the continuous improvement of integration at present, external monetary disturbances will force East Asian economies to pay more attention to regional demand so as to ensure the development of and further promote the integration of the real economy in East Asia. As a result, policy adjustment by any country especially the regional giants would be accompanied by a spillover effect that may exert a rebound impact on other economies and bring about feedback effect locally. On the other hand, in the case of global monetary disturbances, the huge liquidity accumulated in East Asia needs a new field of activity and which inevitably enhances the demand for regional financial cooperation. According to the latest development trend of East Asian economies, the above-mentioned two choices coexist. Based on the study of growth of foreign exchange reserves calculated in USD of 11 East Asian economies during 1994–2006, He Liping (2008) found that the foreign exchange reserves of eight economies have increased significantly and continuously since the 1997 Asian financial crisis which indicates the obvious “preference” of monetary authorities of East Asian economies for increase of foreign exchange reserve. This “preference” occurs in cases of both current account surplus and deficit. It should also be noted that both economies with “tendency towards fixed exchange rate system” and the economies which have selected a floating exchange rate show this “preference.” It is obvious that East Asian economies focus on “foreign exchange reserves” when pursuing stability of the exchange rate. Taking “increase in foreign exchange reserve” as a tool for responding to possible foreign exchange market fluctuation reflects the fact that East Asian economies are still making independent preventive response to the challenges and there is some

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substitutional relation between the growth of foreign exchange reserve in East Asia and regional monetary cooperation. It can be seen that this process is almost in synch with the progress of regional monetary cooperation (e.g. CMIM) in East Asia. To sum up, in a situation of global monetary disturbance it is indeed possible for individual East Asian countries to adjust policies according to their own economic characteristics. However in view of the cost of unilateral action and the close economic relationships within East Asia, the further promotion of regional cooperation especially in monetary and financial fields should be the inevitable choice. From a practical perspective both the proposal of the CMIM and the Action Plan proposed at the ASEAN 10+3 special finance ministers meeting held in February 2009 indicate the strong will of East Asian economies to further promote regional monetary cooperation so as to resist global financial crisis. From the point of view of China or the RMB, Asian monetary cooperation is also of positive significance and is necessary. Li Xiao and Ding Yibing (2004, 2006) state that the Asianization of the RMB is a process in which the RMB tries to be a key currency within the region through participation in institutional cooperation on currency and finance in East Asia and is an indispensable and critical step in the internationalization of the RMB. Li Jing (2005) pointed out that the development and phasic achievements of Asian monetary and financial cooperation reflect the common benefits of Asian countries and economies and their confidence in cooperation. However the current cooperation mechanism still has serious limitations in terms of crisis prevention. Asian countries still have the demand for monetary and financial cooperation in the new economic environment. As the principal requester and provider of Asian monetary and financial cooperation, China’s participation in cooperation is conducive to the economic and financial stability and security of China and the promotion of its economic influence in Asia; China promotes cooperation through market expansion, leading economic growth and the stabilization of the RMB. Zhang Yuyan and Zhang Jingchun (2008) believe that China urgently needs to establish the international position of the RMB in the international monetary system so as to safeguard its political and economic interests. At the moment the conditions for direct internationalization of the RMB do no exist and the regional monetary cooperation that accords with the common interests of Asian countries is of greater practical significance.

Conditions for promoting the Asian monetary cooperation The study of the conditions for or feasibility of Asian monetary cooperation has

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long been one of the research focuses of Chinese academics. Relevant research has verified the possibility and feasibility of overall monetary and financial cooperation in East Asia based on the theory of the OCA and reached a similar conclusion. Huang Meibo (2001) analyzed the possibility of Asian monetary cooperation according to the OCA theory and believed that, as far as mutual economic dependence between the countries is concerned, East Asia is holding a candle to the European Union. Bai Dangwei and Chen Ligao (2002) held that East Asia as a whole does not provide the conditions for establishing monetary union; however the situation of Japan and few other countries and regions comply with the standard for establishment of a monetary union. Wan Zhihong (2003) analyzed the economic symmetry, periodic fluctuation factor and the symmetry of supply and demand impact of East Asian economies and pointed out that the countries with high symmetry can cooperate first in a small group. Dai Jinping and Wan Zhihong (2005) have made static and dynamic investigations based on monetary integration theory especially the feasibility of the OCA theoretical standard in construction of an East Asian regional currency system, believing that according to static economic foundation, the integral currency area standard of East Asia does provided some necessary conditions for monetary cooperation although this standard is not sophisticated. The major factor that results in deficiency of currency area standard in East Asia is that the differences in some aspects are relatively significant while the favorable factor is the close relation caused by integration. With respect to the dynamic conditions for monetary cooperation, East Asian countries have positive correlations in terms of trade connection and convergence of regional output and can start the promotion of monetary cooperation now. In other words, the inadequacy of static conditions for the highest form of monetary integration in East Asia at the present stage would not hamper the preliminary efforts of this region to start the construction of a regional currency system. They also adopted the OCA index technique to make a study of East Asia, pointing out that the OCA index difference in this region is relatively great and from the perspective of a unified currency area, the conditions are not ripe (see Table 7.1). For the further promotion of exchange rate cooperation, the economies must make efforts to reduce cooperation costs. Li Xiao and Ding Yibing (2006) performed an empirical analysis of the shocks of supply, demand and currency in East Asia through the 3-variable structural value-at-risk (VAR) method, pointing out that the overall symmetry of actual economic impact in East Asia is less significant than in the Euro zone but more significant than in the Southern Cone countries; while in the East Asia, the actual impact symmetry of some sub-regional groups (Japan–South Korea, the Southeast Asian Group and Greater China to some extent) is equally or more significant

246

0.046

0.095

0.058

0.057

0.054

0.046

0.049

0.058

0.038

Hong Kong

Indonesia

Japan

South Korea

Malaysia

The Philippines

Singapore

Thailand

Taiwan

0.042

0.047

0.059

0.052

0.057

0.052

0.065

0.076

0.045

0.025

0.043

0.025

0.041

0.023

0.032

0.028

0.069

0.086

0.062

0.092

0.073

0.073

0.075

0.100

Indonesia

0.041

0.068

0.035

0.060

0.045

0.056

Japan

0.037

0.040

0.044

0.041

0.030

South Korea

0.030

0.032

0.022

0.045

Malaysia

0.033

0.047

0.045

The Philippines

0.028

0.048

Singapore

0.049

Thailand

Source: Wan Zhihong and Dai Jinping, “Realistic Basis of Monetary Cooperation in East Asia—Interpretation Based on OCA Index”. Guangdong Social Science , No. 3, (2005).

0.050

Mainland China

United States

Hong Kong

United States

2000

.

Mainland China

East Asian OCA index in 2000

Table 7.1.

Asian Monetary Cooperation and Sino–Japan Coordination

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than average symmetry in the Euro zone. Since the speed of adjustment against impact in these sub-regional groups is obviously higher than in other regions, higher-level monetary cooperation can be carried out in the sub-region. However the low impact symmetry between economic giants (Japan and China) and other economies in the East Asia would weaken their enthusiasm for cooperation. From another perspective, the weak correlation of economic giants in the longterm stable stage with other economies means that a giant can act as a regional economy stabilizer so as to play an active role in cooperation. Therefore it is still possible to further promote the institutionalization of policy coordination and regional economic and monetary cooperation on the existing basis although the conditions do not exist for East Asia to carry out high-level institutionalized economic cooperation and monetary integration. Analysis performed by Yu Xulan (2007) using an error correction model indicates that most East Asian economies show consistency in terms of economic fluctuation in the short term and show a common trend of economic development in the long term. Hence certain conditions for higher-level (e.g. exchange rate) cooperation are there. An empirical study made by Gao Haihong (2007) on degrees of monetary cooperation in ASEAN countries, China, Japan and the Republic of Korea using the general PPP model indicates that sample countries have the potential to create an OCA. The extension of this conclusion means that the non-institutional monetary cooperation in this region has under-evaluated the intensity of actual economic connections. The feasibility study on Asian monetary cooperation made by Zhao Xijun (2007) based on the summarization of elementary theories on regional monetary cooperation shows that Asia has essential conditions only in certain aspects for construction of the OCA but is weak in some important aspects. Besides, not all countries have conditions for monetary cooperation. Hence, Asia has not been provided with conditions for establishment of a real monetary cooperation mechanism with institutional support based on exchange rate target zone. Viable option is that small-scale open economies could, according to their own situations, choose the optimal partners and promote regional monetary cooperation in successive steps. To conclude, a series of relevant researches show that East Asia is not provided with the conditions for establishment of an OCA but has the potential to do so. Additionally, some certain sub-regions of Asia have the making of higher-level cooperation (see Table 7.2). As Li Xiao and Ding Yibing (2006) pointed out, the static condition for the highest form of monetary integration in East Asia is not sufficient but this does not hamper the initial efforts of this region to construct a regional currency system. The complicated and special

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situations in East Asia decide that a regional currency system there is different from “Europeanization (Euroization)” and “Dollarization,” so we should explore the way of “Asianization.” Table 7.2.

Candidates for sub-regional monetary cooperation in Asia (conclusions of relevant research)

Researchers

List of candidates for sub-regional cooperation

Bayoumi and Eichengreen (1994)

Hong Kong, Indonesia, Malaysia, Singapore and Thailand Japan, the Republic of Korea and Taiwan Hong Kong, Indonesia, Malaysia and Singapore

Bayoumi and Mauro (1999)

Hong Kong, Singapore, Indonesia, Malaysia

Yuen (2000)

Singapore and Malaysia Japan and the Republic of Korea Taiwan and Hong Kong

Trivisvaet (2001)

Thailand, Singapore, Malaysia and Indonesia Malaysia and Thailand

Baek and Song (2002)

Japan, the Republic of Korea, Hong Kong, Indonesia, Malaysia and the Republic of Korea

Zhang et al. (2003)

Singapore, Malaysia, Indonesia and Thailand Japan, the Republic of Korea, Taiwan and Hong Kong

Gao Hongmei and Tan Donghai et al.

China, Japan, the Republic of Korea and ASEAN China, Japan and the Republic of Korea ASEAN, Japan and the Republic of Korea

Source: Gao Haihong, “ OCA: An Empirical Study on East Asian Countries ” . World

Economy , No. 6, (2007).

Development Trends in and the Approach to Asian Monetary Cooperation According to feasibility studies on the further promotion of monetary cooperation in Asia, it is universally accepted in the academic community that Asian monetary cooperation should be promoted step by step and should not be attempted in a single action. In other words, since Asia as a whole does not possess the conditions for establishment of an OCA in the short term, the communication and coordination between economies should be enhanced in various aspects from the macroscopic perspective so as to further consolidate the achievements that have been made up to now. Its fundamental purpose is to provide crisis assistance and prevention and enhance regional crisis

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management mechanism. On the other hand, local areas with prior conditions for an OCA could intensify cooperation to move monetary and financial cooperation towards a higher level. With respect to space dimensions, monetary and financial cooperation in Asia should be carried out and promoted at both of the above-mentioned levels. With respect to temporal dimensions, Shi Jianhuai (2004) made a study on financial and monetary cooperation in East Asia from the perspective of time and divided this cooperation into short-term, mediumterm and long-term cooperation, believing that for financial and monetary cooperation East Asia should in the short term focus on the establishment and improvement of regional “lender of last resort” and emergency assistance mechanism; in the medium term it should focus on the development of the regional capital market especially the long-term bond market; and East Asian monetary exchange rate cooperation could only be realized in the future. In the main, cooperation in future would focus on reserve cooperation, regional financial market construction and exchange rate coordination.

Advancement of the reserve cooperation The CMI means the significant progress of reserve cooperation in East Asia and creates conditions for the further deepening of Asian reserve cooperation in future. However Chinese academics have not reached a consensus on the way to further promote regional reserve cooperation. Gao Haihong (2008, 2009) pointed out that the CMIM has actually laid the foundation for further construction of an AMF; in future, the current multilateral CMI mechanism will be further institutionalized although its major function is still to provide shortterm financing support. Wu Jianmin (2008) advocates further promoting reserve cooperation through the establishment of some certain regional infrastructure investment fund and using the reserve resources of Asian economies for regional economic construction. Li Xiao and Ding Yibing (2008) pointed out that it appears difficult to establish a reserve cooperation mechanism that is similar to the European monetary cooperation fund and to intervene in and regulate the foreign exchange market since exchange rate cooperation is not institutionalized at the present stage. Hence to establish a reserve cooperation arrangement that is funded by various countries and can provide short-term financing support based on multilateralization of the current CMI framework may well be a realistic choice. However this arrangement with the purpose of providing short-term financing support has relatively limited practical significance. Firstly, as stated, the manifestation of possible financial and economic impacts on East Asia

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Asian Monetary Cooperation and Sino–Japan Coordination

is not limited to short-term liquidity crisis so this arrangement may not be effective against the risks in future. Secondly, this arrangement is not effectively integrated with financial cooperation in other fields such as financial market construction in East Asia. To sum up, the major objectives of the current reserve cooperation include: first, to make more efficient use of large-scale reserve assets of various countries; second, to use reserve assets to reduce external shocks on the region or improve the shock resistance capacity; third, to use reserve assets for the development of the region; fourth, to stabilize the value of reserve assets or reduce asset risks through reserve cooperation. To achieve the above-mentioned goals, Asian economies could jointly manage a reserve fund of a certain amount and combine it with the function of an ABF used for sovereign and semi-sovereign bond investment within the region so as to establish a multinational sovereign investment fund for investment in financial assets within the region. Specifically, the investment can be first made in sovereign and semi-sovereign bonds within the region denominated in international currency (e.g. USD). Compared with the existing multilateral CMI mechanism, the cooperative investment fund could effectively realize the diversification of reserve assets and the allocation of more reserve assets in the region so as to promote economic development. In addition, this fund could also combine the cooperation of East Asian countries in reserve resources with the construction of the above-mentioned regional financial market especially the bond market. For example, putting reserve investment fund into sovereign bonds and corporate bonds denominated in international currency issued in countries within the region can increase the demand for these bonds and stimulate the development of a regional bond market while maintaining the liquidity of reserve assets and moderating risk. In this way the construction of a regional financial market would win more support. Another advantage of putting the multilateral CMI fund into financial assets such as local sovereign or quasi-sovereign bonds is that the member country suffering from payment crisis can directly obtain funds through the transfer of these bonds so as to protect financiers against realization or exchange risks. Compared with other programs using cooperative fund for fiscal investment such as infrastructure investment, financial investment fund is more advantageous. If the reserve fund is used for fiscal investment such as infrastructure investment on the one hand, disputes would easily occur over the specific allocation of funds, and on the other hand, the profit is highly uncertain and it is practically difficult to enable income distribution to ensure the share

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rights of participants. Generally speaking, since investment in infrastructure etc. is a domestic fiscal issue, excessive risks may occur if reserve funds are used in this field. Comparatively speaking, the use of the funds for financial asset investment results in no disputes over and uncertainty of fund allocation and earnings and would not influence pricing on the financial market or the domestic economic policies of the countries. For specific operation of a cooperative fund, cooperative parties could jointly determine the contribution ratio and national status and establish an institution for joint management of the fund and cooperate with each other to make decisions on the basic fund allocation plan and the principle on which cooperation is implemented with regional financial market construction through this institution. Daily operation should be performed by the institution itself. This joint management institution would facilitate the operation of a shortterm financing mechanism since the relevant joint decision making and booting mechanism etc. could be managed by the same institution. But it should be noted that the establishment and investment of this fund may not help alleviate the problem of excess liquidity within the region. In view of the imbalance of liquidity surplus and deficiency between various countries and regions and taking into account the fact that cooperative investment fund may reallocate the funds within the region in a more efficient manner to some degree, this fund is still a worthwhile option.

Establishment of a regional financial market Chinese academics have recognized that, as an integral part of regional financial cooperation and the inevitable requirement of real economic cooperation such as trade and investment in East Asia, the development of the financial market in Asia is conducive to adjustment of financial and industrial structures in East Asia and provides a new way for Asia to realize regional financial stability through orderly financial liberalization and progressive cooperation. As has been stated, one of the important objectives of Asian monetary and financial cooperation is to prevent and cope with external financial shock and crisis. The development of this global financial turmoil shows the varieties of natures and types of external financial shocks that may exert different impacts on East Asia. In such a case, any specific measure taking previous financial shocks as imaginary targets to be prevented would not be effective against a crisis in future. Hence a more essential method for crisis prevention is to construct a relatively independent regional financial market with higher flexibility, large scale and higher liquidity.

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Asian Monetary Cooperation and Sino–Japan Coordination

In some sense, the relatively small impact of this global monetary disturbance on the financial sector of Asia is the result of the relatively closed financial markets of most East Asian economies. With the further development of financial sectors of these economies in future, the degree of integration with financial globalization will be improved accordingly. In this case, the economies will be confronted with two questions. First, will further opening of the financial sector of an individual economy result in the increase of its sensibility to financial market fluctuation of developed countries? Second, is the scale and liquidity of the financial market of an individual economy sufficient for absorption of and response to external financial shocks? These two problems can be solved through mutual opening-up of financial markets in economies within the region and the construction of a regional financial market. Because of its high liquidity and low risk, the bond market should be taken as the first choice for construction of a regional financial market. Most East Asian economies have reached a consensus on development of a regional bond market at present, but the most important issue is the way to advance the development. According to the new ABMI roadmap proposed at the ASEAN 10+3 meeting, the improvement of issue of and demand for currency-denominated bonds within the region would remain the focus of work. But the problem is that on the one hand, since a number of currencies in East Asia cannot be converted freely and local currency denominated bonds have no sufficient international liquidity, it is difficult to perform cross-border transactions and become a regional bond investment tool desired by the ABMI; on the other hand, the low degree of openness of local-currency bond markets is adverse to international flow of funds and makes it difficult to establish a uniform pricing mechanism within the region. At the same time, due to the lack of an institutional exchange rate cooperation mechanism, the transnational investment in local-currency denominated bonds would be exposed to exchange rate risks, so it is extremely difficult to develop a regional currency denominated bond market at the present stage. From another perspective, the high-priority development of a key international currency (e.g. USD) denominated bond market in regional bond market construction at this stage can bring many benefits that are difficult to replace. Firstly, the international currency denominated bond has advantages both in convenience of cross-border trade and attraction for foreign investors, and its international liquidity that is much higher than that of local currency denominated bond is conducive to the expansion of market scale and liquidity and the formation of scale economy effect for bond market development. Secondly, since local currencies cannot be freely converted at present, it is

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difficult to combine the local-currency bond market of various economies. The foreign-currency denominated bond market is not subject to the above limitations and the denomination of issue and transaction of bonds in the same international currency is conducive to the establishment of a uniform denomination mechanism and credit rating system within the region. In this way a real regional market would be established and lay the foundation for the infrastructure of bond market integration. Thirdly, from the perspective of the issuer, both sovereign and quasi-sovereign bonds are available and the issue of corporate bonds denominated in international currency can be accepted more easily by market. Fourth, with respect to market construction and transaction, the foreign currency denominated bond markets of East Asian economies have been developed to certain scale and the market participators have some relevant experience. Fifthly, from the perspective of investor ’s international asset allocation, the exchange rate risk of international currency bonds is relatively small. It should be pointed out that the development of a regional international currency (e.g. the USD) denominated bond market does not mean the enhancement of dependence of the East Asian financial market on the USD or the U.S. market. This is only a transitional measure for cultivation of a regional financial market in the situation where the currencies within the region are not completely convertible. Furthermore the USD-denominated bond market within the region is relatively independent and has its own yield curve and grading system; and with the development of this market, more funds in USD of the economies would be allocated in the local market which would reduce the dependence on U.S. domestic investment tools. During the construction of a regional international currency denominated bond market, the issue and transaction of sovereign and quasi-sovereign bond needs to be developed preferentially. As has been pointed out in relevant research, one of the difficulties in bond market construction in Asia is the shortage of supply of high-quality bonds that can be issued regularly on a large scale, and the large-scale issue of sovereign bonds or government bonds can solve this problem. Excess government bonds may “force out” private loans, but the insufficient issue of government bonds may result in a shortage of benchmark interest rate curves on the market. The existence of risk-free government bonds and the price discovery of large-volume transactions against the bond market is of far reaching importance to the pricing of other risk bonds such as corporate bonds by the market. The experience of developed countries also indicates that the development of a liquid government bond market is the catalyst for development of the overall bond market (IMF, 2002).

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The establishment of a mechanism and channel for issue and circulation of international currency denominated sovereign and quasi-sovereign bonds within the region and the increase in issue scale facilitates the provision of benchmark interest rate, basic credit rating standard and basic price index for the market. Moreover the improvement of liquidity through official investment and transaction can gradually attract investment from the private sector and thus gradually realize the expansion of market scale. In this way the development of a regional local currency denominated bond market would be provided with more sufficient initial conditions when other conditions are available.

Exchange rate coordination Exchange rate coordination is an important part of regional monetary cooperation. In this respect it is universally accepted by Chinese academics that the exchange rate coordination in Asia should employ the progressive approach from “low level to high level” and from “local to overall.” But scholars have different views on the specific exchange rate coordination model and program. Liu Lizhen and Xie Chaoyang (2003) raised the proposal of pegging to a mixed currency basket, pointing out that the RMB together with other East Asian currencies (excluding the Yen temporarily) should implement the exchange rate arrangement of pegging to a basket of currencies including the USD, Yen and Euro or SDRs and then gradually building a ASEAN 10+3 East Asian monetary union based on this. Li Ping and Liu Peizhi (2003) proposed the “double currency anchor” arrangement, namely that other East Asian currencies take the RMB and Yen which should maintain a relatively stable relationship with the USD. They pointed out that due to the lack of history and experience of Asian economies in cooperation and coordination based on regional integral interests, mutual understanding and mutual accommodation decides that only a low-level and loose monetary cooperation mechanism can be established in the region within a certain period of time and must transit to its advanced stage progressively. The East Asian exchange coordination mechanism with the RMB and Japanese Yen as the currency anchor is designed to maintain within a certain period of time the exchange rate fluctuation at a rational level that is conducive to the stable economic development of the economies and the promotion of regional economic integration. Li Fuyou (2004) pointed out that the cooperation principle of “progressiveness, mutual benefit, win-win cooperation, equal partnership,

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openness and tolerance” should be set up for Asian monetary cooperation while the development model based on a combination of sub-region “oriented parallel currency regionalization” with “regional gradient progress of multiple parallel currencies” should be employed for cooperation. In other words, parallel currency or quasi-parallel currency could be issued first in a sub-region with the right conditions and in a small-scope currency area to realize the regionalization of parallel currency; and then parallel currencies issued in the whole region while promoting multiple currency cooperation gradually in other regions and finally realizing the use of a single currency in the whole region. Ding Zhijie (2005) investigated the development prospects for East Asian regional currency union, believing that some sort of loosely-organized monetary union may occur in East Asia in the foreseeable future. This union would have a relatively flexible exchange rate stabilization mechanism and not pursue excessively institutionalized arrangements. It can be seen that people have reached a consensus on the expectation that some sort of currency basket arrangement would be used for Asian exchange rate coordination. Among various currency basket programs, the ACU program proposed by Japan and relevant ADB scholars has attracted the active interest of Chinese academics. For example, Xu Shaoqiang et al. (2004) believe the creation of the ACU as the composite currency in East Asia is the institutional guarantee for realization of exchange rate stabilization and would have a positive effect on regional exchange rate coordination. Zhang Bin and He Fan (2006) made further studies on the AMU program proposed by Eiji Ogawa et al. They believe the AMU would have the following realistic and potential functions: first, the AMU measures the change in exchange rate of East Asian currency as a whole against the currencies of principal trade partners such as the U.S. and Europe, and the association of these changes with the external payments situation of East Asia as a whole is convenient for determining if concerted actions should be taken over the exchange rate of East Asian currencies against the USD and Euro; second, the change in relative values of currencies within the region against the AMU reflects the relative stability between currencies and provides a policy dialogue basis for relative value adjustment between currencies within the region; third, through the issuance of AMU denominated bonds, the private sector would determine the spot and forward prices of the AMU relative to each currency within the region and other major currencies of the world, which lays the foundation for the use of the AMU as denomination unit in regional trade and investment and lays the foundation for the Asian Dollar (or another type of regional exchange cooperation mechanism). If the AMU is supported by

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regional economies and develops successfully, it would play an important role in prevention of “beggar-thy-neighbor” currency devaluation competition, the promotion of regional exchange rate coordination, the maintenance of relative stability of currency value within the region, the reduction of dependence of East Asia on the USD and the large-scale regional foreign exchange reserve, the assistance in mitigation of imbalance of international payment, and the promotion of economic integration in East Asia. For China, an AMU that bears extremely flexible possibility of exchange rate cooperation would promote the RMB exchange rate formation mechanism based on market supply and demand and with reference to a basket of currencies. They also simulated the pegging of the RMB to the USD and AMU respectively and found that the pegging to the AMU is more conductive to the maintenance of stability of the RMB tradeweighted exchange rate. Through pegging to the AMU we can make reasonable price for the RMB by dint of the international financial market and prevent exchange rate risk at low cost. On the premise that the RMB carries a large weight in the AMU and a relatively flexible parity adjustment rule is maintained between the RMB and AMU, the relative stabilization between the RMB and AMU would promote the RMB exchange rate formation mechanism based on market supply and demand and with reference to a basket of currencies. However some Chinese scholars have put forward their opinions on the deficiencies of the proposed ACU or AMU. Ding Yibing (2006) pointed out that although the computing mode of the ACU under the proposal is similar to that of the ECU, they show huge differences in property and function. The ECU has almost all functions such as economic index, exchange rate “nominal anchor,” unit of account, unit of price, reserve assets and payment instrument etc. that can be assumed by a “currency unit” in the form of a currency basket. The ACU only has the function of weighted average exchange rate index for reference and its purpose includes: first, to enable policy authorities of various countries to learn about the change in exchange rate of East Asian currencies as a whole against principal external currencies such as the USD and Euro; second, enable them to learn about the change and deviation of local currency exchange rate relative to regional weighted average exchange rate, which can reflect the relative stability between various currencies within the region and provide a basis for policy dialogue about adjustment of relative price between currencies within the region; third, to make preparations for the issue of ACUdenominated bonds; for the ACU, private sectors determine the spot and forward price of each currency within the region and the principal currencies of the world. Generally speaking, the ACU reflects the efforts at a regional policy cooperation and supervision system. It does not bind the policies of countries

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within the region and cannot be used for accounting, let alone act as reserve assets and payment instrument. In this connection the ACU also falls behind the EUA which was the predecessor of the ECU. The EUA was not only used for denomination of cross-border bonds but also acted as the computing chip for internal settlement of currency authorities in the European Community and for some external official transactions. As matters stand, the ACU has only limited substantive impact on regional exchange rate cooperation However it is undeniable that the ACU has the potential to play a more important role. For example, provided the EMEAP, ADB or even other East Asian economies issue and hold a huge amount of Asian currency unit denominated bonds, the ACU may become the payment instrument for official settlement even though the East Asian bond market is under-developed and the inconvertibility of the ACU may hinder the development of its secondary market. In this way the ACU would be directly used as unit of account and reserve asset. The policy authorities would then be willing to maintain the relative stability of local currency and the ACU, which would enable the ACU to play a key role in exchange rate cooperation. Nevertheless this requires deficit countries within the region to buy a huge amount of ACU-denominated bonds while surplus countries have to issue a large amount of the bonds and accept it in official settlement. In view of the possible liquidity and security of ACU denominated bonds, it would be extremely difficult to achieve the above-mentioned conditions whether or not the transaction can be made in regional non-convertible currency.

An overall design of East Asian monetary and financial cooperation According to the characteristics of Asian economic development and the progress of monetary and financial cooperation at the present stage, based on regional exchange rate coordination and cooperation, we divide the development path of regional monetary and financial cooperation into four stages i.e. crisis assistance and prevention, exchange rate policy coordination and cooperation, establishment of common exchange rate linkage mechanism, and realization of a unicurrency (see Fig. 7.2). Theoretically the ultimate objective of regional monetary and financial cooperation is to establish a unicurrency area and the achievement of this objective depends on the joint efforts of East Asian economies. It is certain that the achievement of this objective will be a long and tortuous process. At the first stage, the major objective is to establish a stable and safe crisis assistance and prevention system, enhance exchange rate policy coordination

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and information sharing in the current exchange rate systems of economies, and maintain the relative stability of bilateral exchange rate within the region. On the whole, the economies could maintain their own exchange rate systems at this stage and should take progressive measures to weaken the Fig. 7.2.

Local level (China plays the key role)

Overall design of the East Asian monetary and financial cooperation system Stage 1

Stage 2

Stage 3

All countries and regions reform exchange rate systems and establish independent currency basket pegging systems.

Establish common currency pegging systems respectively in local areas and perform exchange rate linkage within sub-region.

Realize monetary integration in local areas.

Carry out crisis assistance and prevention, enhance exchange rate policy coordination and establish AMF based on CMI.*

Establish liberal exchange rate target area, take ACU as the objective, reinforce AMF, establish ACIF, improve reserve configuration and stabilize exchange rate.

Construct common currency basket (ACU) and establish regionallevel exchange rate linkage mechanism.

Stage 4

Coordination and cooperation between China and Japan

Regional level (Japan plays the key role)

Establish common central bank, unify monetary policy and reserve management and establish unicurrency area.

Note*: AMF exists from Stage 1 to Stage 3 and plays the role of monitoring economic index, coordinating policy implementation and providing crisis assistance while providing and carrying out disciplinary restriction on monetary cooperation.

actual pegging of local currency to the USD, enlarge the fluctuation margin of local currency against the USD, and realize a certain independence and flexibility of local currency exchange rate relative to the USD. In addition, the policy authorities of economies should exert intervention and guidance in actual practice to coordinate bilateral exchange rate within the region. Furthermore, the institutional financial institution (i.e. the AMF) should be established based on the CMIM and act as regional “quasi-lender of last resort” to provide and manage the regional emergency relief fund, coordinate and manage crisis relief actions, establish early warning indicators to monitor the

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macroeconomic tendency and balance of payments of various countries and regions, coordinate their economic policies, and enhance discipline restriction on policy coordination. From a local perspective, the economies should establish an independent currency basket pegging systems according to the characteristics of their own economic development. In view of the models of foreign economic relations in East Asian economies, sufficient flexibility should be maintained against the monetary exchange rate outside the region. At this stage it is recommended that the hidden currency basket pegging system that does not publish the pivotal rate be established. In other words, the currency authorities calculate the currency basket composition and the corresponding pivotal rate for medium-and-long-term reference and take the calculated pivotal rate against the currency basket as the reference target to guide the medium-and-longterm tendency of the exchange rate. However it is not necessary to stand on the above-mentioned reference rate but to maintain a certain flexibility of exchange rate in the short run. With the change in economic fundamental factors, it is allowed to adjust the pivotal rate gradually. The objective of the second stage is to establish a local common currency basket pegging system based on independent pegging. At the local level, some economies with a similar economic development level have a common requirement for stabilization of bilateral exchange rate and thus have the conditions to adopt the common currency basket pegging system. These economies could select common currency basket targets within local areas according to the composition of the currency basket and the similarity of economic and trade structures, (publicly or non-publicly) determine the pivotal rate, and limit the deviation of currency value from the pivotal rate to some extent and establish an exchange rate linkage mechanism within the sub-region. In view of the relatively limited economic scale and the differences between economies within a sub-region, a relatively wide exchange rate fluctuating band-gap should be specified so as to prevent speculative attack. The so-called basket-band-crawling (BBC) exchange rate system could be employed to provide certain flexibility under the precondition that the stability of exchange rate is basically ensured (Williamson, 1999). From the overall perspective, the exchange rate target area for the whole region against external currency should be established based on sub-regional exchange rate cooperation (the boundary of target area could be set loosely). The ACU could be taken as the principal reference object so as to coordinate the foreign exchange rate policy of the region, ensure the relative stability of the price environment and prevent cutthroat competition between the countries.

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Considering the differences between local areas, the range of target area could be provided with a certain flexibility and elasticity. At the same time, besides the further enhancement of the AMF function at the regional level, in view of the physical circumstances in East Asia, an Asian Cooperative Investment Fund (ACIF) for investment in financial assets within the region should be established to make investment in international currency—denominated sovereign or quasi-sovereign bonds within the region (Li Xiao and Ding Yibing, 2008). Compared with the CMIM and foreign exchange reserve pool plan, an ACIF can effectively realize the diversification of reserve assets and diversify the risks while enabling more reserve assets to be allocated within the region. It should also be particularly noted that an ACIF can combine the cooperation on reserve resources in East Asia with the construction of a regional financial market and especially a bond market. For example, firstly, the investment in international currency denominated sovereign bonds and debenture bonds issued by various countries within the region using the ACIF could stimulate the demand for bonds and facilitate the development of a regional bond market; secondly, this could ensure the liquidity of reserve assets and reduce the risk thereof; another advantage of investment in international currency denominated sovereign bonds and debenture bonds issued by various countries within the region using the ACIF is that a member country that suffers payment crisis can obtain funds directly through the transfer of the above-mentioned bonds so as to protect the financier against realization or exchange risk; finally, an ACIF could also act as the preparation for issue of regional currency or currency basket denominated assets. Through the issue of regional currency or currency basket denominated bonds based on the development of the international currency denominated bond market within the region, the large amount of reserves of East Asian economies could be properly used to promote the further development of the regional financial market in Asia. European experience shows that it would be easier for private sectors to recognize or even issue regional currency—denominated bonds if the government provides guarantee these. An ACIF would be fully capable of playing the role of official issue preparation and guarantee. The main objective of the third stage is to establish a regional common currency basket system in East Asia so as to create a unified exchange rate linkage mechanism. At the local level we should gradually establish the fixed exchange rate systems in local areas and advance monetary integration within the region after the establishment of a common currency basket pegging system there.

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Due to the instability of the currency basket pegging system, only by replacing a common currency basket pegging system with a relatively rigorous fixed exchange rate system (i.e. the realization of regional monetary integration)

can the stability of the exchange rate be maintained and the sustainability of the exchange rate system to be ensured in the long run. According to the

OCA theory, the smaller the range or scale of a currency area is the higher the consistency of economic development would be, the lower the cost of monetary

integration would be, and the higher the possibility to develop into an OCA would be. Hence we could realize local monetary integration based on subregional common currency basket pegging during the establishment of a regional currency system in East Asia.

At the same time, a regional common currency system should be established

in East Asia at the overall regional level so as to create a unified exchange rate linkage mechanism and put the ACU concept into actual operation and

application in order to enable the ACU to be taken by economies as the regional

currency basket to be pegged to and to determine the pivotal rate against this currency basket. However the original pegging targets of various local

areas should be maintained. Within the area of a of sub-region, the countries

and regions should maintain a relatively rigorous fixed rate of exchange and respectively determine the fluctuation margin of the ACU peg based on the

relationship between the original pegging target and the ACU in local areas.

In other words, with the ACU as the target, “snake pits” of different sizes are

constructed (Li Xiao and Hirayama Kenjiro, 2002). On this basis we can make use of the “self-promotion effect” of monetary integration to make “snake pits”

in local areas converge and thus establish a unified exchange rate mechanism

in East Asia (similar to the EMS in the 1980s). Essentially this is a progress of expanding the bilateral “snake pit” system gradually into a regional “snake pit” system.

The objective of the fourth stage is to realize a unicurrency and establish a

unified central bank.

After a period of operation of the ACU and East Asian regional exchange

rate linkage mechanism, along with the improvement of economic integration of economies, it is suggested to use a unicurrency and establish unified monetary

administrative organization and carry out unified monetary policy if the conditions are ripe. But as stated above, this would be an extremely arduous and long historical process.

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Coordination between the RMB and the Yen in Asian Monetary Cooperation At present, many Chinese scholars have taken cognizance of the necessity for

the RMB to take an active part in Asian monetary cooperation. Li Xiao and Ding Yibing (2004) pointed out that with the continuous increase in the economic

strength of China, trade and industrial correlations between China and other East Asian economies have been enhanced and China has the making of the

major market provider in East Asia. The active participation of China in Asian

monetary cooperation not only helps to overcome the difficulties in regional exchange rate cooperation in East Asia, but will also facilitate the gradual

“Asianization” of the RMB through institutional regional monetary exchange

rate cooperation and enable the RMB to get through the difficult exchange rate situation and become a regional dominant currency. The participation

of the RMB in Asian monetary cooperation will inevitably be involved with the relationship between the RMB and the Japanese Yen, the other principal

currency in East Asia. The proper coordination of this relationship will be

of paramount significance to both the smooth progress of Asian monetary cooperation and the successful implementation of the RMB internationalization strategy.

The need for coordination between the RMB and the Yen Should we carry out competition or cooperation in terms of currency issues

between China and Japan, the two largest economies in East Asia, during regional monetary cooperation? This is the first question we have to answer.

Chen Yulu (2003) analyzed the relation between the Yen and the RMB in East Asian monetary cooperation, believing that despite the competitive relation

between them we should make efforts to pursue coordination and cooperation in monetary cooperation so as to realize the mutual promotion and collaborative

development of regional economy and the economy in each country since no currency in East Asia has the upper hand. Shen Guobing (2004) compared the RMB with the Yen in terms of the economic strength, industrial structure and

trade complementarity and the stability and scale of the currency of China and Japan, proving that only through cooperation between the two currencies can

the win-win situation be achieved and monetary cooperation in East Asia be conducted in an orderly manner.

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In fact neither China nor Japan is able to dominate regional monetary and financial cooperation solely in the “U.S Dollar System” at the present stage. On the one hand, although the Japanese Yen is an international currency it is extremely difficult for Japan to become a more important trade partner of East Asian economies and the core of the regional division system once again. The problems in economic growth, industrial and financial institutions, market opening and ageing of population obstruct Japan’s way of becoming a leading market provider in East Asia and thus prevent the Yen from being the sole regional dominant currency. On the other hand, due to the deficiencies of the RMB in free convertibility, financial sector vulnerability and opening of the financial market etc. it is impossible for the RMB to act as the sole regional dominant currency. To sum up, no matter how the relative position of the RMB and Yen changes in East Asia, neither currency can act as the sole regional dominant currency at the present stage. It is observed from the experience of Europe that active and effective cooperation between regional giants is of far-reaching importance to the establishment of a relatively independent regional currency system and is essentially beneficial to the giants themselves. During the economic and financial cooperation in Europe, Germany and France built a consensus based on the rational thinking of their own political and economic benefits. Strained relations that come into being in history can be eliminated through intentional efforts. In the case of consensus on cooperation, the relation between and position of giants participating in cooperation may change with the change of the actual economic situation. These findings have important reference value for China and Japan (which are the giants in East Asia) and the currency regionalization there. In these circumstances, although neither the RMB nor the Japanese Yen is able to act solely as the dominant currency in East Asia, the monetary and financial cooperation between them is propitious to the regionalization of the RMB. Advancement of currency regionalization through regional cooperation will require effective coordination between the RMB and the Yen since neither of them can compete alone with or replace the USD within the region, and competition between the RMB and the Yen is not worth the candle. Some research has pointed out that due to the asymmetric competition pressure between China and other Asian countries, China can achieve the status of dominant currency without the necessity of cooperating with other Asian countries to establish a common currency basket based exchange rate coordination mechanism (Yao Zhizhong, 2004). However, one the one hand, the

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process of “Yen internationalization” indicates that this asymmetric pressure is insufficient to enable the RMB to act as the regional dominant currency but may result in a repetition of the failure of “Yen internationalization”; on the other hand, considering the situation of Japan, lack of coordination between the RMB and the Yen and competition between them would incur losses to both countries. Hence the regionalization of the RMB should be based on coordination with the Yen. Generally speaking, the Yen has played a very important role in East Asia in the past. However with the long-term economic recession since the 1990s, the impact of the Asian financial crisis and the obstruction of promotion of “Yen internationalization,” although the position of the Yen in the exchange rate arrangement of East Asian economies has risen, its influence in other fields has weakened. In contrast, the position and influence of China and the RMB in East Asia has risen with the continuous high-speed economic growth and the rapid development of foreign trade of China. The regionalization of the RMB and the repositioning of the Japanese Yen in Asia are inevitable. In such a trend, in view of its exchange rate system and market scale, Japan is not able to participate in East Asian exchange rate cooperation in the near future. By contrast, China will make great progress in the promotion of the RMB as the currency for trade settlement in local areas and will further promote exchange rate cooperation in local areas and deepen the monetary and financial cooperation in local areas. China and Japan should reach a high-level consensus on this point and carry out close policy coordination and cooperation on this basis.

Actively enhancing the cooperation between China and Japan During the overall coordination and local deepening of East Asian monetary and financial cooperation, China and Japan as regional giants must aim at the stable and sustainable development of the regional economy and enhance their coordination and cooperation in relevant fields (Li Xiao, 2009). Firstly, from the overall perspective of the region, both China and Japan should enhance coordination and cooperation in the following three aspects. First, to jointly promote the institutionalization of the CMIM and the construction and development of the AMF, and enhance regional financial regulation. Second, to strengthen the coordination of exchange rate policy and information and jointly promote the stability of the exchange rates of the RMB and Japanese Yen. Both China and Japan should, based on the practical situation, establish an

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exchange rate stabilization arrangement that does not cover the counterparty. In particularly some sort of local regional exchange rate stabilization circle or even East Asian exchange rate stabilization circle excluding the Yen could be established for the RMB and we could then consider bringing Yen into this exchange rate stabilization system on a case by case basis. During this process it would be necessary for both China and Japan to maintain close communication about exchange rate policy so as to jointly promote the stable and sustainable development of the East Asian economy. Third, to cultivate and improve the regional financial market. Both countries should jointly promote the establishment and development of the ACIF and assist in the issue and transaction of international bonds denominated in the currency of the counterparty or in a currency basket that includes the currencies of both countries. In addition, China and Japan should also jointly promote the establishment and development of a regional bond rating agency. Secondly, from the local perspective, China and Japan should greatly strengthen coordination and cooperation in the following three fields. First, through close operation between China and Japan in regional organizations such as the AMF, Japan could help China enhance the international regulation of RMB circulation outside China and provide helpful technical support for reform and development of China’s domestic financial market. Second, China and Japan should expand the scale of bilateral currency swap especially the proportion of currency in the counterparty’s official reserve and jointly promote the position and role of the RMB and the Yen as regional reserve currencies. Third, Japan could provide helpful institutional suggestions and technical support for construction of an offshore financial center for the RMB and enhance the transactional association with the Tokyo international financial market (bilateral issue of shares and bonds) so as to promote the establishment and development of a network for an East Asian financial transaction center. In conclusion, based on the global financial crisis and its impact on the world economy and the East Asian regional economy, with an eye to stable and sustainable economic development in future, Asian monetary cooperation must and can be further deepened. During this process China and Japan as regional giants should have a strong sense of responsibility and common purpose and jointly promote regional monetary and financial cooperation so as to push Asia into a new era.

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Chapter

The Asian and the International Monetary and Financial System Koni Hironori

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Introduction The financial crisis triggered by the U.S. ten years after the Asian monetary and financial crisis has increasingly expanded and developed into a global financial crisis that rapidly influenced real economies and brought about global economic panic through devaluation of assets such as stocks and the credit shrinkage of general commercial banks. The purpose of this Chapter 1s to discuss the future while making clear the objective of monetary and financial cooperation between China and Japan. However the study of this topic goes beyond the cooperation between the two countries and the regional characteristics of East Asia, and inevitably involves the restructuring and reform of the post-war international currency and financial system including the IMF and the World Bank and also covers the issue of conversion of the basic monetary system. We also should calmly think about the development of financial liberalization and the problems caused thereby. This is of great significance to Japan and China, between which there is an obvious gap in terms of development of financial liberalization. Japan as a developed country and China as a developing country attended the G20 Summit held for the first time during 14–15 November 2008. Even if we do not make an in-depth evaluation of this conference itself, it is certain that both China and Japan play an important role in and have weighty responsibility for the world economy at present. It should be particularly noted that the positive action of China at this conference attracted worldwide attention. Despite all this, it is obvious that the participating countries have not reached a consensus on the current situation and the future trend of the USD based currency system. Whether or not this financial summit would become the epoch-marking point of the BWII as expected by European leaders depends on the way the international currency and financial system is constructed in future. Accordingly, in view of the monetary and financial crisis that was triggered by Asia ten years ago and influenced developing countries, and the spread of the financial crisis triggered by the U.S. as a basic currency issuer to other parts of the world at present, the significance and importance of Sino–Japan monetary and financial cooperation at the present stage goes beyond the scope of East Asia. It should be particularly noted that some people believe that the U.S. will change its method of intervention in Asia after the establishment of the Obama administration. In these new circumstances, this chapter focuses on the blueprint for regional monetary and financial cooperation in Asia beyond the national interests of China and Japan and, as stated above, pays close attention to the close relationship between this topic and the design of the international financial and monetary system as a medium-and-long-term topic.

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The Objective of Asian Monetary and Financial Cooperation It is evident that the core of monetary and financial cooperation in East Asia is the CMI established in 2000 based on the lesson of the monetary and financial crisis in 1997. This is an emergency currency swap agreement to be implemented in case of a sharp decrease in exchange rate in specially designated countries and regions. The ASA had gradually extended to China, Japan and South Korea; at the same time, agreements between countries for institution intensification were concluded in quick succession. This agreement has now been developed into a multilateral and multi-national swap network agreement. Under the extended influence of the financial crisis, ASEAN 10+3 have reached a consensus on a standing macroeconomic and financial policy survey and monitoring mechanism, the “Survey Lance,” as the high-level institution of the CMI. This is a new stage of development and is of vital importance. This institution has been taken as the basis for discussion about multilateral swap agreements. At the ASEAN 10+3 finance ministers meeting held in February 2009, the total amount of capital provided by agreement accession countries was expanded to USD 120 billion. The size of the fund is more than 20 times the amount agreed at the conclusion of the CMI agreement. This can be regarded as the equivalent realization of the AMF proposal put forward by Japan. Furthermore, if the scale of this fund is expanded and a centralized management system is established, one of the CMI objectives would be achieved; this also indicates that it actually has the characteristic of an “Asian version” of the IMF. This global financial crisis has brought extensive damage to the currencies of Asian countries especially the South Korea. The devaluation of the Korean Won resulted in a monetary crisis which provided an opportunity for China, Japan and South Korea to conclude a swap agreement. The amount of swap agreement between Japan and South Korea has reached USD 30 billion. This is a framework with a total amount of USD 90 billion comprising Sino–Japan and Sino–South Korea cooperation. Let us not discuss the scale of the fund for the present; the characteristics of swap between local currencies indicate that currency swap under the CMI framework shows a different significance with the currency swap with the USD. However under the impact of continuous expansion of this global financial crisis, the practical realization of the concept of an Asian regional fund has to be closely associated with the reform and reconstruction of the IMF. In other words, as the cores of Asia and members of the IMF, China and Japan must play

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a leading role in coordination with the ASEAN countries based on the objectives achieved between the IMF-level global international financial system reform and the East Asia regional crisis management concept. With respect to another important lesson of the Asian monetary and financial crisis, the preparation and cultivation of an Asian financial capital market is being conducted at a steady pace. After the Asian monetary and financial crisis, the issue of local currency denominated bonds increased substantially in Asia and the balance amount of bonds issued by Asian enterprises and government institutions excluding Japan reached USD 4 trillion by the end of 2008. 1 The extension of the financial crisis caused by the U.S. in the international financial market resulted in the outflow of short-term foreign funds from Asia and the instability of currency value and foreign exchange markets of Asian countries. In order to further promote the expansion of the bond market at the ASEAN 10+3 level, the independent settlement institution of Asia was established in the summer in 2009. This settlement system assumes the realization of the use of the ACU and its achievements is no longer limited to expanding the bond market. By drawing on the experience of Europe in the use of the ECU and EMS, it will be a breakthrough for the practice of this experience in Asia. For the purpose of expansion of the bond market, the establishment of an institution that can guarantee the grading of bonds issued by private enterprises is of vital importance. Under the frameworks of ASEAN 10+3 together with the ADB (joint contribution of about USD 500–1,000 million) the establishment of a warranty institution for bonds issued is under discussion.

The Cause of the Global Financial Crisis and the Consensus on Its Countermeasures There is no doubt that the immediate cause of financial crisis in the U.S. after the bankruptcy of Lehman Brothers in September 2008 was the troubles in the U.S. housing finance market marked by the subprime crisis. Why were the world financial market and even the financial system involved in the turmoil of specific market in a specific country? Why could this turmoil have a profound impact on the real economies of both developed countries and developing countries? The financial liberalization and globalization led by Europe and the U.S. since the latter half of the 1980s resulted in the fact that all countries including developing countries all over the world removed the restriction on financial transactions including foreign exchange transactions. This promoted

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international capital movement, realized the unification of financial markets of the countries and provided a platform for expansion of the financial crisis. It goes without saying that the securitization of finance has been integrated with globalization. The starting point of the so-called financial securitization is the prevention of credit risks of original asset holders through asset movement and the transfer of these risks to a third party. But the problem lies in the extension of the financial system between credit risks assumed by “borrowers of last resort” and the investors as “lenders of last resort”; and the repeated creation of asset-backed bonds during the transfer of risks bring about new market risk and fails to show the basis for measurement. The background of this crisis is essentially different from the long-term financial crisis caused by the delayed processing of non-performing loans in Japan ten years ago. Serious problems occurred in financial systems (namely the secondary and tertiary markets as the source of these securitized commodities). Therefore, as we can see on the CDO market, it is difficult to carry out transactions and the size of losses and the bottom of financial crisis cannot be determined even in 2009. It must be pointed out that what happened on the securitized commodity market does not only indicate the “failure of the market” but also proves that the so-called market transaction is a fictitious “relative transaction” that is lacking in transparency and openness. Financial liberalization promotes the mitigation and abolition of regulations to the limit. Its precondition is that the market participants and investors who obtain benefits share the risks according to “their own responsibilities.” However the risk-sharing plays the role of risk diversification and expansion through the “conveyer belt” of financial internationalization and globalization. In this way, the credit risk in the limited market of one country may easily be converted into risk on the world financial market. Notwithstanding the fact that the transition from the operating mode of financial institutions in the U.S. to the business mode of investment banks requires the promotion of financial liberalization, a government that recognizes this system institutionally and politically has huge responsibilities. It is inconceivable that the monetary authorities that should be responsible for management and supervision of financial institutions and markets be influenced by financial liberalization and too tired to deal with the market economy and policy intervention. Since the 1980s, the financial system of Japan has been following the U.S. “structure agreement” with Yen–Dollar Committee as the starting point to continue the type of financial model led by Europe and the U.S. i.e. the transformation from commercial banking to investment banking. If the impact of this financial crisis on the Japanese financial system is smaller than that on

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the financial systems of Europe and the U.S., ironically we can say that this is because Japan is still exploring the construction of the investment bank model and financial conglomeration. Twenty years ago Japan advocated the Japanese version financial “Big Bang.” Even if the financial system reform of Japan is for purpose of adaptation to the “structural reform” in the U.S. financial style, we can also say that Japan has lost the self-discipline and independence of its institutional reform. Even if the issue of non-performing loans is shelved, China has to face a number of problems in domestic financial system reform including the reform of state-owned banks. When solving these problems, China must select policies based on the financial crisis caused by the U.S. China would not be able to draw lessons from the crisis if it merely pursues financial liberalization or reproduces the operating model of Europe and the U.S. Adherence to the socialist market economy principle and construction of a financial system with Chinese characteristics is indispensable. In this regard, Chinese international finance investigators believe that the domestic financial liberalization and financial system reform of China is integrated with the excessive financial liberalization, globalization and the market restriction and emphasis on supervision revealed by the global financial crisis to some extent. For example, with respect to finance securitization, even if it has been recognized that it is necessary to modify the structure of asset liquidation, it would be necessary to exert some sort of global-level constraint on the development of securitized commodities and financial commodity derivatives. Both China and Japan should set a goal based on the construction of their own financial systems. It is important to define the permissible limit of financial liberalization and it is necessary to conduct common discussion and make studies thereon. First of all, this chapter shall describe the key work that needs to be done to overcome global financial crisis.

Stabilization of the international financial market With the development of finance globalization, the financial markets of various countries are integrated with the international financial market through different degrees of liberalization and regulatory mitigation. During this process the financial crisis caused by the U.S. developed into a global financial crisis at an extraordinary rate. In view of the global nature of this crisis, the intensification of financial restrictions or the restrictions on market transactions in individual countries is not effective. Since it has been recognized that the primary cause of such a serious financial crisis is excessive financial liberalization and globalization, it is necessary to think back on and re-examine

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its progress. It should be noted that relevant countries should not take action loosely or regionally but formulate truly equal global rules of restriction on and supervision of market transactions in developed and developing countries. Furthermore the international excess funds (excess monetary capital) flow into both the financial market and precious resources and commodity markets and thus bring about an immeasurable disturbance which cannot be disregarded. Therefore to reach international agreement on restriction on hedge funds is an urgent topic. Some tentative programs have been put forward. China and Japan should go beyond the standpoints of developed country and developing country and play a leading rule effectively.

International financial order reform The expansion of this global financial crisis shows that the strategies of supervision and regulation relating to the financial system within a region can no longer fully play the role of a breakwater. Although the topic of this Chapter 1s Asian monetary and financial cooperation, the significance of monetary and financial cooperation between China and Japan goes beyond bilateral issues and even issues of the Asian region as a whole that have been discussed up to now, and indicate several new factors if we widen our vision and re-consider international monetary and financial system reform in the light of this financial crisis. In other words, the actions taken by China and Japan in future will not only influence the Asian international monetary system but will also connect with profound and important topics for construction of the international monetary system including the radical reform of the IMF system. As is well known, the old IMF agreement collapsed institutionally in the early 1970s due to the cease of exchange between USD and gold, as well as the transition to the floating exchange rate system in developed countries. However it has been preserved until now for the purpose of organization and operation of the IMF as an international body. This agreement was clearly in opposition to developing countries in terms of the Asian monetary and financial crisis that happened ten years ago. The necessity of reform of the operating model of the IMF based on the principle that “voting right depends on the investment proportion based on GDP scale” was pointed out by developing countries before this financial crisis. However this argument should be re-discussed. Reform programs which disregard the increasing influence of emerging countries and developing countries are impractical. China suggests that the investment contribution should depend on the foreign exchange reserve ratio, but since the foreign exchange reserve would inevitably change

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with adjustment of balance of payments it does not seem appropriate to decide investment proportion according to this scale. Whether or not to precisely reflect the IMF accession countries’ economic proportions, and the equitable power of voice and representation, China and Japan shall take wise and concerted action. During the expansion of financial crisis caused by the U.S., Chinese media believed that “such a global financial crisis has no impact on the socialist market economy of China and its response to globalization and will enhance the voice of China in its relationship with the U.S.” To prove this, the Chinese authorities gave speeches and took action in international conferences after the financial crisis. China believes that taking shortsighted action based on the belief that the financial crisis is “the opportunity to create creditor’s rights over the U.S.” would not bring about the desired results to either China or the world. At the present stage, the global financial crisis has resulted in a global economic downturn and the developing countries including those in Asia are uneasy about protectionist policies. It should particularly noted that, when China has the influence to contribute to the creation of global demand through its strong fiscal expenditure policy, a surge of nationalism would urge China to fully promote the internationalization of the RMB and the “RMB Circle.” This is really worrying. Let us not discuss the internationalization of the Japanese Yen for the present. It should be borne in mind that the key to internationalization of a currency is not the currency-issuing country itself but depends on the market with non-resident credit. It goes without saying that the international financial system after the WWII was conceived and implemented during the establishment of hegemony by the U.S. The prior condition for the functioning of this system reflects that fact that the global re-production and consumption cycle would not last if the capitalism of the U.S. was rejected. The system based on the IMF and the World Bank is often considered to be the symbol of the “Washington Consensus.” But this global financial crisis in the 21st century has revealed the vulnerability of a world economic structure based on U.S. style authoritarianism and the risks of systems relying on this structure. Even so, the U.S. has not changed its negative attitude towards the proposal of emerging countries and developing countries on the delivery of international finance regulation and supervision rights to the IMF. This shows that the restriction on and supervision of the globalized international financial market transactions by one country cannot come into play. China and Japan should play a leading role in reform of the IMF and the World Bank by persuading developing countries and Europe to take part in the reform. In regard to the adjustment of the international financial order and the

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reform of the international financial system, it is necessary to mention the important significance of the first G20 Summit held in November 2008 and the second London Summit on 2 April 2009. It is observed from relevant evaluation that developed countries represented by the U.S. and the emerging and developing countries represented by China have many differences in understanding. The macroscopic fiscal policy and measures adopted by the U.S. did not put forward a coordination system that contained quantitative objectives. However in terms of the supervision and rules of activities of international financial institutions (compared with the different standpoints of developed countries and developing countries), since the risks of U.S.–style capitalism or the financial model centering on investment banks influences all countries and regions that adopt both the UK/U.S.–style and Germany/ France–style financial models, all countries have reached a consensus on the need to enhance international supervision and regulation. This is an important achievement in this crisis. From the end of March to April before the G20 London Summit, the various advice (including those not discussed or agreed on at the summit) of leaders and public authorities on this conference covered similar issues that cannot be avoided within the medium or long term. Some of those participating in the discussion worry that, according to the current situation of and difficulty in the WTO, the expansion of scope of discussion about international finance issues from the G8 to the G20 may hinder the conclusion of some tentative agreements. But it is impossible to promote the practical reform in the international finance system and the currency system discussed in the following section if emerging countries and developing countries represented by the countries of Brazil, Russia, India and China (BRICs) are prevented from attending the discussion. There is little doubt in that this sense this marks the end of the era of the “Washington Consensus.”

Reconstruction of the International Monetary System and the Internationalization of the RMB Some Japanese scholars also believe that the serious damage to the European and U.S. financial system and the resultant USD and Euro devaluation provides a golden opportunity to promote the internationalization of the Japanese Yen that has been repeatedly frustrated. In this financial crisis, the Federal Reserve was careless about the fact that liquidity supply would corrupt the balance sheet and the U.S. government promptly injected public funds to expand the financial deficit which resulted in the expansion of USD risks. All this mean

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that it is a critical time for the U.S. in maintaining the position of the USD as a base currency that has experienced several crises. Could the economic structure that supports the economy of U.S. and the USD as its base currency in Asian countries represented by Japan and China be continued? In recent years, the internationalization of the RMB has been developing rapidly. Aside from how China, a country that always adheres to the principle of socialist market economy, will promote its internationalization, the internationalization of local currency is inevitable in the process of economic globalization and especially financial globalization. Two issues are discussed here about the prospects of the international monetary system. Firstly, it is extremely important to distinguish “internationalization” from “international monetization” when looking at the prospects of the RMB. It is obvious that internationalization is the precondition for international monetization of the RMB. But it should be noted that the internationalization of the RMB does not naturally mean its international monetization.2 The internationalization of the RMB requires two basic and necessary conditions: first, flexibility of the exchange rate system; and second, participation in the international financial market based on liberalization of capital transaction. Since the former has been discussed, the attempt at liberalization of capital transaction is evaluated and appraised here. Prior to this, let us simply review the internationalization of the Yen. Japan joined the IMF in 1952 but restored currency exchangeability in 1964 when Japan joined the Article VIII of the IMF’s Articles of Agreement. In the 1970s, along with the decline in credit of the USD as a base currency, Euroyen deposit was launched and the issue and purchase of bonds in Yen was started in the London market. This was the first stage of the Yen’s internationalization. In the 1970s the Yen played the role of trade contract currency, investment currency and foreign exchange reserve centered on Asian countries; certain progress was made for internationalization. The second stage of Yen internationalization was launched by the establishment of the Yen–Dollar Committee between Japan and the U.S. in the 1990s. The background to this is highly associated with the fact that Japan had to open its financial market which had been criticized as a “closed market” under the pressure of financial liberalization and internationalization launched first by European countries and the U.S. First, the restriction on issue of Euroyen bonds to residents was removed in 1983; in the next year, the control on issue of Euroyen bonds to non-residents including private companies was relaxed; in the same year, the ban on the issue of Euroyen CD was lifted; and in 1987 the issue of Yen-denominated CP on the European market was permitted. In recent years,

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Japan has relaxed the control on Euroyen loans in terms of fund application and taken a series of measures for rapid promotion of Yen internationalization in terms of fund raising and application. The internationalization of the Japanese Yen obviously bends to the financial liberalization and internationalization tendency of European countries and the U.S. Accompanied by the exchange rate system reform launched in July 2005, the internationalization of the RMB is developing at a steady pace about twenty years after the stagnancy of Yen internationalization. The internationalization of the RMB mainly covers the following aspects. First, how and to which level will the liberalization of capital transaction develop? Second, how and to which level will the flexibility of the foreign exchange system develop? How to promote these two topics integrally is a unique difficulty facing the RMB compared with internationalization of the Yen. The most obvious background difference is that over the past two decades, the speed of financial liberalization and globalization has been much higher than that of economic globalization and the scale and speed of international money capital flow has been advancing rapidly. The expansion of this financial crisis caused by the U.S. into a global financial crisis is directly related to this. During this process, the relevant work on promotion of RMB internationalization would be inevitably affected, and it would be difficult for the monetary authorities of China to make the decisions. In the above paragraphs, the author has discussed the importance of distinguishing between the international monetization and internationalization of the RMB. It goes without saying that from the perspective of globalization, the position of the RMB has not reached the level “to be an issue” in terms of settlement currency function as the basis for functioning as an international currency and reserve currency. In this regard, the monetary authorities and researchers of China have no objection (the ratio of currency used in foreign exchange transactions to the USD is 86.3%, to the RMB it is only 0.5%. BIS statistics, 2007). However, just as the Deutschmark plays the role of regional base currency in the EC, the decisions made by the Chinese monetary authorities deserve special attention within 1–2 years from the perspective of development towards a regional international currency or base currency of East Asia. This trend is consistent with the internationalization-oriented reform of the RMB. For example, since 1 July 2009 the RMB has been used for trade settlement in some regions of East Asia. The RMB was exceptionally used for settlement in small border transactions with Vietnam etc. At present, RMB-denominated trade settlement is conducted between four cities (Guangzhou, Shenzhen, Zhuhai and Dongguan) and the enterprises of Hong Kong, Macau and ASEAN members

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designated by China. Although this reform cannot be directly associated with the international currency of the RMB, China aims to establish a RMB settlement circle in East Asia. For China, the purpose is to break the dominance of USD-denominated settlement, diversify settlement currencies and mitigate the risks of USD exchange rate fluctuations. The reform of the RMB is limited to within East Asia. However the signs indicate that China will “raise” the RMB to be a regional international currency and base currency. If the function of the RMB as a regional settlement currency is expanded, neighboring countries would hold RMB and take it as reserve currency. Nevertheless the immediate association of this reform with the internationalization of RMB is too hasty. It is necessary to interpret this reform as a prudent step towards East Asia oriented internationalization of the RMB. Secondly, until recently since the externalization of the financial crisis caused by the U.S. in 2008, the Chinese government and monetary authorities have developed strategies for RMB internationalization or international monetization based on the assumption that the base currency system of the USD would continue to exist. Before the second G20 Summit can be seen from the report given by Premier Wen Jiabao at the National People᾽s Congress and his speeches thereafter that the Chinese government᾽s understanding of reform of the USD base currency system and the diversification of the international monetary system has changed. This understanding was not directly reflected in the declaration of this summit. However BRICs members such as Russia and Brazil, of which the international status and voice have been increasingly promoted, and more developing countries are gradually building a consensus on this point. In this sense we can reach a conclusion that this step of the RMB towards becoming a regional trade settlement currency is consistent with the reserve currency diversification proposed by the IMF from the global perspective and also consistent with the proposition of developing countries to reduce the risk of the USD as a base currency. The G20 Summit held successively in 2008 and 2009 were the first significant opportunity for restructuring of the international monetary system and the reform of base currency since the launching of the IMF and Bretton Woods System about 60 years ago and are of epoch-marking significance. The previous IMF agreements were controlled by developed countries and “hegemonist powers” such as the UK and U.S. Today the participants of the international monetary system are not limited to developed countries anymore and it is predicted that developing countries are about to appear on the scene. The fact that the financial crisis caused by the U.S. could be easily converted into a “global

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crisis” as brought about the crisis awareness of the world, and countries all over the world believe they should no longer put the world economy onto a specific base currency (the author believes that a specific national currency resulted in base currency risk). Now we cannot rely on the concept that “even if the USD becomes fragile, no currency including the Euro is able to replace it as a base currency.” With respect to this point we need to go beyond the understanding framework of developed countries over developing countries and of Japan over China and should strive for the common good.

Asian Monetary and Financial Cooperation between China and Japan after the Global Financial Crisis From the first G20 Summit held on 15 November 2008 to the London Summit on 2 April 2009, the global financial crisis expanded and provided an opportunity for countries in the world to reach a consensus on the cause and background of the real economy downturn. As its result, the compromise declaration of the second G20 Summit held in London was reached. However no consensus was reached on the cause and measures for prevention of re-occurrence of financial crisis. The important significance of the G20 Summit was that it went beyond the hedge between developed country and developing country and enabled the countries that have a relatively strong influence in the global economy to directly and rapidly get together to resist financial crisis. Firstly, this financial summit broke the previous G7 framework to discuss the direction towards the international financial system of the 21st century and has become the starting point of re-discussion about the functions of existing international financial institutions such as the IMF and the World Bank. Secondly, on the progress of global economic imbalance and the risk of an international monetary system depending on the base currency function of specific countries’ economic structure and currency, the developing countries clearly expressed their core opinions. This is of epoch-marking significance in the history of international finance. For China and Japan, the important issue that must be faced in monetary and financial cooperation in future is that we should learn the risks of excessive economic development and financial liberalization from this U.S. financial crisis and recognize the fact that the supervision of international financial transactions and the construction of a regulatory system should not be solely entrusted to developed countries but should be jointly decided by developed and developing countries. Furthermore, all countries should participate in

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the design of a functional blueprint for international institutions such as the IMF and the World Bank. In this regard Japan, which has taken a step towards financial liberalization and globalization, should assume great responsibility. It is necessary to summarize the future issues based on the abovementioned understandings in order to further promote the monetary and financial cooperation between China and Japan in Asia and continue the policy coordination between them with the development of this global financial crisis.

Establishment of the AMF To provide emergency assistance for accession countries during financial crisis, Japan together with other Asian countries has made efforts to establish the AMF. In order to respond to this financial crisis caused by the U.S., the multilateralization of the CMI (bilateral agreements between 16 countries) framework established during the Asian monetary crisis in 1997 was realized at the ASEAN 10+3 level. By June 2009, relevant Asian countries had reached a consensus on the establishment of a new AMF but had not made specific progress. Asian countries have learned a lesson from their reforms under pressure of developed countries centering on the IMF during monetary and financial crisis and screamed for the benefits of developing countries and emerging countries in discussions about adjustment of the international financial order. During this process, how should Japan play the leading role in the establishment of the AMF that has been frustrated due to the intervention of the U.S.? The author believes that the integral promotion of IMF-level reform and the establishment of the AMF is the key to solution to the problem. To enable developed countries and developing countries to work together for the reform of the IMF, support from China and Japan and their joint studies on the cause of this financial crisis (including the discussion about the positive and negative effects of financial liberalization and internationalization) is essential. The theoretical research on and practical approach to the establishment of the East Asian common currency unit (based on currency basket system) should now be discussed. As is well known, the concept of the EAC of the ASEAN covers the plan for a common Asian currency. However no consensus has been reached on this plan at the level of ASEAN 10+3. The priority should go to make the necessary condition for unification of the regional exchange rate system based on the currency basket system that has been implemented by some East Asian countries including China (to take “pegging to a currency basket” as a simple policy target value or to take it as reference value etc.) so as to promote the establishment of a common currency unit based on a common

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currency. Even if this Asian common currency unit cannot directly promote the establishment of an Asian common currency, it would play an important role in the construction of a regional settlement system and the cultivation of a balanced regional financial market.

Risk in the accumulation of foreign exchange reserves From the perspective of the influence in global economic development, it is time for China and Japan to assume great responsibility. The ratio of the total GDP of China and Japan to the GDP of the world was 11.5% in 1990 and 14.8% in the year 2006. In addition, the size of foreign exchange reserves of both countries increased sharply after the Asian monetary and financial crisis and reached USD 3 trillion in December 2008, accounting for more than 40% of the total amount of the world’s gross foreign exchange reserves. Despite the difference in development stage of real economy and finance between Japan and China, the development process has common characteristics and is faced with similar problems. Firstly, the high increase rate of the national economy is highly overlapped with the increase in export to the U.S. This indicates a typical economic growth dependent on external demand. Secondly, like the importance of U.S. bonds held by non-residents, the application of foreign exchange reserves accumulated as national wealth lays stress on USD-denominated securities investment in the U.S. The latter problem has resulted in the amplification of the potential USD risk through this financial crisis. Conscious awareness of this has been gradually created among the policy authorities of China and Japan (for example, the speech of Premier Wen Jiabao on 13 March 2009). It can be seen from Table 8.1 that in recent years the amount of U.S. bonds held by Japan has been decreasing while the that held by China has been increasing at the same rate. By the end of September 2008, China held U.S. bonds to an amount of USD 585 billion (more than the amount held by Japan) and had become the largest U.S. bonds holder. Over eight years the amount has increased by 10 times. The decrease in the amount of bonds held by Japan has been much less than the increase in amount of bonds held by China since 2005. However China and Japan still hold more than 40% of U.S. bonds and are playing an important role. At the same time, both countries maintain absolute predominance in the proportion of foreign exchange reserves put into U.S. bonds investment. Since the data of January 2009 showed that the rate at which the U.S. bonds held by China increased was negative, some people believed that

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“China has reduced the U.S. bonds that it holds.” Under the influence of the sharp increase in foreign exchange reserves, at the end of May the amount of U.S., bonds held by China increased by USD 38 billion over the previous month and the total amount exceeded USD 801.5 billion. From this we can glimpse the efforts of the Chinese monetary authorities to analyze the investment orientation of U.S. dollars. With respect to the method for application of foreign exchange reserves, China and Japan should implement effective planning at the regional level in East Asia and go beyond simple regional interests so as to carry out frank joint discussions about the method for application at the level of globalization. Holding the largest foreign exchange reserve among developed countries, Japan should play a leading role in adjustment of the application method of foreign exchange reserves (including reserves of developing countries). Table 8.1.

The volumes of U.S. bonds held by China and Japan and the respective proportion of their overseas holdings (Unit: billion USD, %)

Year

2000

2001

2002

2003

2004

2005

2006

2007

2008

Japan

317.7 (31.3)

317.9 (30.5)

378.1 (30.6)

550.8 (36.1)

689.9 (37.3)

670.0 (32.9)

622.9 (29.6)

581.2 (24.7)

578.3 (20.9)

China

60.3 (5.9)

78.6 (13.2)

118.4 (9.5)

159.0 (10.4)

222.9 (12.0)

310.0 (15.2)

396.9 (18.8)

477.6 (20.3)

696.2 (23.5)

Source: U.S., The Department of the Treasury, TIC data, 2009.

Regardless of the motives of various subjects of investment, it is uncontradictable that these investments have made up for the twin deficits of the U.S. and become important channels for the continuance of current account deficits. Will this inclination be maintained in future? Is it beneficial to China and Japan? At the G20 Summit held in the autumn of 2008, China and Japan reached a consensus on support for the current base currency “USD System” and the maintenance of a stable international financial system. This consensus is based on the fact that most of the foreign exchange reserves held were financial assets denominated in USD. Neither China nor Japan expects devaluation of the USD by a large margin, bringing detrimental effect to national interests. However this consensus between China and Japan is just for “the present stage” and makes no prompt for the form of the international monetary system in future or comprehensive discussion about the stability of the Asian regional exchange rate system and the issues about the IMF after the construction of a

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regional international monetary system. This shows the necessity for in-depth dialogue between China and Japan. With respect to the investment of foreign exchange reserves in U.S. bonds, from the perspective of the financial crisis caused by the U.S. in the summer of 2008, for the U.S. the buyers of U.S. bonds may be the “saviors” in this crisis but in the long run, the foreign exchange reserves of the world are concentrated in assets denominated in particular national currency and in the holding of specific financial assets. This is absolutely not what we want. From the perspective of the U.S. bond holder, the purpose of investment in U.S. bonds is not to “help” the U.S. but is based on the motive of investors to delay the rate risk. The author refers to this as the “base currency risk” or the “USD risk.”2 The damage caused by this global financial crisis to the financial institutions and financial systems of China and Japan is much less than that to Europe and the U.S. China and Japan are able to effectively use their foreign exchange reserves which account for more than 40% of that of the world. It is roughly estimated that the IMF fund is about USD 250 billion which is not large enough to cope with the liquidity shortage of the large number of countries and regions represented by developing countries that have been impacted by this global financial crisis. In the short term, it is extremely important for China and Japan to provide the IMF with short-term funds through coordination and cooperation for the stability of the international financial system. Japan determined to implement financing based on USD 100 billion (upper limit) from its foreign exchange reserve. The IMF is looking for funding assistance from China. However this funding support is just a temporary response strategy. When carrying out the specific work of fund support, we cannot fence with the adjustment and reform of the IMF which is a medium-term assignment. Both China and Japan should clearly recognize that how to realize the integration of the construction of the AMF framework (the Asian version of the “IMF”) and the overall reform of the IMF remains a common topic for both countries. As a medium-and-long-term topic, we can go beyond the focus of the investment framework on securities investment in the U.S. or diversification of international risks and carry out more investment for support of economic growth based on the domestic demand of emerging countries and developing countries. From a medium-and-long-term perspective, this global financial crisis shows that a world economy that is dependent on a specific national economy growth structure and development trend is extremely fragile. Hence Japan as a leading developed country and China as a leading emerging country should play a more active role based on the multi-polarized world economic framework. At present the financial crisis caused by the U.S. has brought

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remarkable impact to the real economies of emerging countries and developing countries and resulted in a decrease in the economic growth rate. However from the medium-and-long-term perspective the Asian economy is still the main driving force for the growth of the world economy. Moreover it is predictable that the Chinese economy will play the decisive role. At the same time, Japan needs to consider whether to maintain an export structure that is dependent on the U.S. or to attach importance to the external demand of Asia. In terms of the future of a base currency, the author believes that it is unpractical and irrational to believe that the internationalization of the RMB or the Japanese Yen should be conducted in case the relative weakening of the USD is inevitable. It is predictable that the international monetary system of the “Post-Dollar Era” would develop into a system in which the USD with weak influence coexists with several regional international currencies or regional common currencies. Hence for China and Japan, this issue is different from the current issue of how to escape the financial crisis caused by the U.S. The old IMF system (the “U.S Dollar System”) with a specific national currency as the base currency should be re-addressed.3 For China and Japan, the Asian monetary and financial crisis of 1997 was different from the current global financial crisis in terms of content and properties. This issue is more one of cooperation between China and Japan than cooperation at the regional level of East Asia. This can even be taken as cooperation at the level of globalization with the international monetary system construction oriented leading role relating to the construction of the world economic order. The objective of this sort of cooperation is to determine the new multi-component structure to which the world economic structure centering on the U.S. (or to be precise, relying on the single pole of the U.S.). The crux of the matter is the possibility of China, Japan and South Korea reaching a consensus on this point.

The concept of the EAC and an common Asian currency It goes without saying that the Asian monetary and financial crisis of 1997–1998 provided an opportunity for ASEAN members to establish an EAC. As the “flood protection embankment” that is used to respond to the threat of a developed country dominating economic globalization and financial globalization, ASEAN started cooperation on currency and finance. China, Japan and South Korea participated in this cooperation later. Over the 10 years so far, with the EAC as the starting point of an economic community, ASEAN has developed the action plan of a regional community into cooperation in political, social and cultural

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fields. This plan was recognized by international law after the signing of the ASEAN charter in 2008. Under the impact of the expansion of this financial and economic crisis, the ASEAN Summit held in March 2009 reached a consensus on the roadmap for construction of this community by 2015. This financial and economic crisis at least accelerated the construction of the EAC at ASEAN level to some extent. However we cannot say that the specific working order for creation of an Asian common currency that has been listed in the schedule of EAC has been clarified since the Asian monetary and financial crisis. The driving force for promotion of the Asian common currency has always come from ASEAN. Hence the policy authorities of Japan, China and South Korea publicly declared that they would take this as a “subject for the future” and that it is too early to realize this at the present stage. On the other hand, many Chinese and Japanese researchers have actively described the significance of the Asian common currency that is closely related with the realization of an EAC. It is noteworthy point that in this financial crisis, the current administration of South Korea began to emphasize that it is possible for Japan, South Korea and China to cooperate to realize a common currency. In the 21st century and before the outbreak of financial crisis caused by the U.S., East Asia, Central Asia, the Gulf Cooperation Council (GCC) and South America successively put forward the concept of a common currency. 4 The background to this concept is the labefaction of the USD-based monetary system and the launching of the Euro based on an artificially created common currency. Generally speaking, it is more difficult for developed countries than developing countries to abandon their own currencies and use a regional common currency. The use of a regional common currency in various financial transactions is greatly different from the decision to use a common currency. In East Asia, the regional trade dependence has been increasing in steady steps over the last ten years and has exceeded North America Free Trade Agreement (NAFTA) and kept pace with the EU. This proves the existence of economic dependence as one of the conditions for the OCA. Although the exchange rate system has changed from the system pegging solely to the USD to the system of pegging to a currency basket (although the currency composition and proportion is not always the same) and the application of the floating exchange rate system is roughly at the same pace, a framework that is similar to the EMS which gave birth to the Euro has not been properly prepared. A close economic relationship does not mean that a common currency can be used. During the introduction of the Euro, the EU constructed an EMS regional common exchange rate system based on the long-term use of a regional

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common currency and the expansion of opportunity and took the introduction of a common currency as the ultimate target (Economic and Monetary Union practice by stages). During this process, the strong political will of leaders of the relevant countries and their efforts to achieve national agreement is indispensable. The author believes that mechanical copying and application of the EU᾽s experience with the Euro is not suitable for the concept of a regional common currency in East Asia. With respect to the construction of a regional common exchange rate system and the transition from a regional common currency unit to the establishment of a common currency, the EU composed of developed countries is different from the ASEAN which is composed of developing countries. Hence the leading role of China, Japan and South Korea and the construction of an assistance system is indispensable during the construction of the East Asian regional exchange rate system (common currency basket) and the establishment and use of a regional common currency unit is an important constituent element. Although China and Japan believe that an Asian common currency is a subject for the future and are unable to abandon their own currencies (the Yen and RMB) and use a common currency, the construction of a regional exchange rate system as the Asian version of the EMS and the use and relevant cooperation of an Asian common currency unit as the prior condition is possible. When making efforts to realize the Asian common currency, China and Japan should both contribute to the stabilization of the exchange rate and international monetary system in Asia even if both the countries cannot work together. Even if the financial crisis caused by the U.S. comes to an end, the extremely exceptional monetary and fiscal policy for risk delay implemented during the crisis would be worrying. Regardless of the conception of exchange rate system and financial system in East Asia as a regional community, we should seek a long-term vision that is independent of specific national currency based on the fact that the “base currency function” of the USD is becoming increasingly fragile.

The IMF reform scheme proposed by developing countries and the construction of the international monetary system It is observed that, with the global financial crisis caused by the U.S. as a turning point, relevant discussions have gone beyond the monetary and financial cooperation of East Asia which bodes well for a major transition in the postwar international financial system i.e. the IMF–USD based currency system.

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The background is the increasing voice and position of developing countries including the BRICs represented by China and Russia and the labefaction of developed countries (especially Europe and the U.S.) based IMF–Bretton Woods System. Before this, due to the direct association of investment proportion in the IMF with voting right, many international institutions failed to reflect the voice of developing countries. It should be particularly noted that for the first time since its establishment, the IMF has raised funds by issuing bonds. In the case of repeated attack by global monetary crisis, the IMF as a short-term international liquidity provider suffered a fund shortage. The process of capital increase proves that this decision is an inevitable outcome. It should be emphasized that the issue of IMF bonds is led by developing countries such as China and Russia but not by developed countries.5 It is obvious that the purpose of this action taken by emerging countries and developing countries is to increase their investment proportion in the IMF and expand their voices through the sharp increase in the ratio of their own GDP to total GDP of the world and through the transition from borrower to lender on the international financial market. Another noteworthy point about the issue of bonds by the IMF is that the bonds were denominated in SDRs. To find the cause, it is necessary to analyze the motives of China and Russia taking the lead in buying IMF bonds. On this the author has made an analysis based on the following two points. Firstly, in the 21st century, the foreign exchange reserves of emerging countries represented by China have increased sharply. 6 Investment in IMF bonds is a good method to prevent asset devaluation that may be caused by the denomination of nearly all foreign exchange reserves in USD and avoid the pressure of the requirement of the U.S. for appreciation of local currency. Secondly, as the Governor of People’s Bank of China, Zhou Xiaochuan pointed out in his paper that the expansion of international liquidity in future should be based on SDRs-denominated assets so as to rectify the international monetary system that lays particular stress on the USD. In this regard the U.S. as the issuer of base currency believes that the relevant proposal is premature at the present stage and that “the position of USD as a base currency has not been threatened.” Thus the background to emerging countries taking an active part in the issue and purchase of IMF bonds is that the guarantee of use of short-term foreign exchange reserve which is an issue about currency policy based on national interest can reflect the position of a developing country or emerging country in the world economy through medium-and-long-term IMF reform and the global issue about construction of international monetary system framework that can

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replace USD based currency system. When the SDRs were conceived due to the “USD shortage” (i.e. insufficient international liquidity) there was discussion about transition from the “dollar standard system” to the “SDRs standard system.” However this discussion was always between some of the developed countries. Today, the proposal about active use of SDRs as reserve asset is put forward again and goes beyond the significance of separate expansion of international liquidity. The action of China and Russia trying to buy IMF bonds shows that this is a strategy for China and Russia to effectively use their foreign exchange reserves although this cannot bring about direct increase in investment proportion in the IMF. Since IMF bonds are denominated in SDRs, the purpose is also to mitigate the impact of devaluation of the USD on foreign exchange reserves that lay stress on the USD and to ensure the voice of the developing country in IMF reform within the medium term and long term from the perspective of an IMF creditor. It should be noted that this covers the adjustment of monetary structure in the SDRs basket or the change of currency constituent ratio. It is obvious that this point does not stay at the viewpoint of IMF reform but shows the possibility of weakening the base currency function of the USD through SDRs reform. Thus the association with international monetary system reform cannot be denied. Although China as a developing country and Japan as a developed country have different standpoints, both of them possess abundant foreign exchange reserves in the unbalanced world economy. The monetary and financial cooperation between China and Japan should go beyond the discussion on how to effectively use foreign exchange reserves and both countries should have the consciousness and sense of responsibility to participate in international monetary system reform in the future.

Conclusion The history of international currency from the 19th to the 20th centuries is proportional to the process that has been gradually freed from the institutional constraint of the gold standard system and reflects the historical process from the competition between the GBP and USD to the change of dominant international currency from the former to the latter and then to the establishment of the “USD System.” It cannot be questioned that the position of international currency is dependent on the change of the central country in the world market; hence the change of the base currency domain of an international

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currency reflects the “hegemony” of political economics. The system which used the GBP as its base currency lasted for about half a century before the USD system was established. After about half a century since the establishment of the USD system, another great transition period has occurred. This period may be referred to as the transition period of the base currency system that gets rid of dependence on a specific national currency. At their acme, both the GBP and the USD had no position in the economics category. The concept that the USD is the world currency reflects an incorrect understanding. The GBP or the currencies of some other countries also have the potentials to act as the world currency. In fact we are facing the following issues. How should we evaluate the process in which “the currency of specific country acts as the sole base currency?” How should we explore the future international monetary system in the context of economic globalization? At the end of the 20th century, EU countries abandoned their own currencies and created the Euro which is an “artificial common currency.” Despite the difficulty in erasing its geographic feature, the international position of the Euro which is second only to the USD is actually being promoted. However, like the GBP–USD competition, the coexistence and competition between the USD and the Euro has gone beyond the scope of hegemonic competition between national currencies. Learning from the experience of the Euro, countries all over the world have tried to break the bonds of the “USD Unipolar System” or to keep away from this system. This is shown concretely as in the following: the transition from a particular currency pegging system to a currency basket system in many countries; the adjustment of the currency composition of foreign exchange reserves in emerging and developing countries; and the “regional common currency” plan under conception within several regions. This is a trend that cannot be ignored when examining the international monetary system of the 21st century based on the above topics. Taking this as the goal, considering the impact of this financial crisis, it is necessary for us to focus on the noteworthy points of view and suggestions in speeches and papers of the Chinese government and economists at the second G20 Summit. For example, the U.S. subprime crisis as described by Fan Gang, the Director of National Economic Research Institute under the China Reform Foundation, made clear the defects of the USD-based global currency system. The important topic is to establish a new diversified global currency system. China, Japan and South Korea should cooperate actively to build a stable international monetary system.7 At the same time the argument of Zhou Xiaochuan, the Governor of

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the People’s Bank of China, had a tremendous impact on the world. Zhou Xiaochuan pointed out in his paper on the website of the People’s Bank of China that the USD-based monetary system has reached its limit and it is necessary to make adjustments.8 His argument is similar to part of this chapter. To build a pluralistic and stable international monetary system, China and Japan should go beyond the internationalization of the Japanese Yen and the RMB with a “hegemonic” nature and the perspective of national interests and jointly assume the responsibility to build a common international monetary system in Asia. East Asian countries including China and Japan catching up with developed European countries and the U.S. in the “USD circle” or “USD bloc” is a post-war trend. No one can deny that the maintenance of a fixed exchange rate system against the USD as the supportive device for export-dependent economic growth has played a significant role. However during the internationalization of national currencies including the USD, the trust of neighboring countries and the country whose currency is not internationalized is indispensable. In the financial crisis caused by the U.S. the structure of world economic growth that is dependent on U.S. personal consumption was questioned and the developing countries had to explore a new growth path. We can summarize the financial crisis in this way: on the one hand, the market-oriented USD enhanced the USD system during the expansion and integration of the international financial market; on the other hand, the expansion of the financial industry that broke away from real economy due to financial liberalization and globalization and the expansion of international financial transactions resulted in the worldwide impact on real economy. As stated above, this result demonstrates the risk of dependence on the base currency system based on the USD as a specific national currency. In fact, the most worrying risk of the USD is the low credit caused by rapid expansion of the U.S. fiscal deficit. When taking into account the medium and long term world economic structure after this global financial crisis, multi-polar world economic trends will be the key to the future international monetary system. In other words, when calling for conversion of a production structure based on the unipolar capitalism monopoly of the U.S., the base currency “USD system” in the international monetary system will inevitably be reformed within the medium and long term. Superiority in the financial sector and constituting the driving force of financial globalization is an important but not sufficient condition for an international currency. In this sense, this financial crisis caused by the U.S. declared the start of the slow ending of the USD system. It is not feasible to conceive and operate an international monetary system under the influence of one country’s prestige and hegemony in the 21st century. Without such

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awareness and understanding, it would be impossible to realize the economic stability of the world or even of East Asia. If that is the case, East Asia which simply looks forward to the expansion from production base to consumption base cannot play its role in globalization. The future monetary and financial cooperation between China and Japan should not be governed by narrow national interests. Rapid and practical action should be taken based on the transformation of the global economic structure.

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Enrich Series on Chinese Currency Reform Vol. 3 Cooperation between the Renminbi and the Yen With the continuous rise in the status and importance of China in regional and global economies, the influence of the Renminbi grows proportionately. Currency Reform has become a crucial and inevitable policy choice for China. Based on recent theoretical frameworks and quantitative analyses, this book explores the necessity, feasibility and specific pathway of cooperation between the Renminbi and the Yen, the two dominant East Asian currencies. It also provides an in-depth analysis of the significance of the two currencies in shaping the future situation of the East Asian economy. • Shedding lights on the development strategies of the RMB and the Japanese yen • Providing the agenda for the cooperation between the RMB and the Japanese yen • Exploring characteristics and the current situation of the Japanese yen based on real-world experience

Cooperation between the Renminbi and the Yen

The Dialogue between Two Dominant East Asian Currencies

Enrich Series on Chinese Currency Reform Vol. 3

Cooperation between the Renminbi and the Yen

Editors Public Sector Economy Research Center at the Jilin University. He is also the Vice Chairman of the China Society of World Economics. His main research focus is the international and East Asian economic development. Kamikawa Takao is a Professor in International Economics of the Faculty of Economics at the Yokohama National University, and a committee member of the Japan Society of International Economics.

Edited by Li Xiao, Kamikawa Takao

Li Xiao is a Professor and Deputy Dean of the School of Economics, and Researcher of the China

Edited by Li Xiao, Kamikawa Takao

Supported by the MOE Project of Key Research Institute of Humanities and Social Sciences at Universities