Only a few years ago, the European common-currency arrangements were held up as a possible model for Asia.
With the euro under serious threat, we do not hear much about this now, but the current mess in Europe could well contain a number of lessons for Asia.
Lesson one might be surprising at first sight: membership of a currency block is still seen as valuable. Ireland, Portugal and Greece seem ready to undergo years of wrenching austerity in order to stay in. Greece understands that in leaving the euro, it would be swapping one set of problems for another. And countries such as Turkey are still very ready to join.
Lesson two is more obvious: it is hard to make common currencies work. Currency blocks work smoothly only if the member economies have a lot in common. There was always the promise — or hope — that membership would be the catalyst to make Greece more like Germany. But for Greece, there has been neither economic nor political convergence, and continuing membership may prove to be unworkable.
Lesson three is an old one: financial markets are prone to radical changes of risk assessment and lemming-like herding. The markets initially treated Greek debt as more or less on par with German debt. But when they belatedly perceived the reality, they pulled the plug.
Lesson four is that support mechanisms are needed when markets lose confidence. Even countries like Spain and Ireland — which are trying harder than Greece to be good euro citizens — need external support. The euro arrangements are providing this through loans and the support of the European Central Bank (ECB). There is a further sub-lesson here: when the crunch comes and confidence is lost, the supportive response is always tentative, inadequate and chaotic. It is always too little, too late.
So, what are the implications for East Asia’s emerging economies? Despite strong international advice after the Asian crisis to adopt freely floating exchange rates, these countries are yet to adopt a pure free float. They are managing their exchange rates, not only to smooth out volatility, but also to resist appreciation pressures that would diminish their international competitiveness. And as their production structures are becoming increasingly integrated through supply-chain frameworks, maintaining competitive parities with neighbours is becoming more important.
So far, this maintenance of competitive parity has been an informal affair, and it could be given more regional structure. If each country maintained stability (perhaps within a band) vis-à-vis a common basket of currencies — including a heavy weighting of Asian currencies — this would have some of the characteristics of the early stages of Europe’s move to the euro.
While this sort of structure creates tighter relativities, it sets up potential vulnerabilities. In Europe, the euro’s precursors — the ‘snake’ and the European Exchange Rate Mechanism — both broke down. So support arrangements like those offered by the ECB would be an essential part of any tighter currency arrangements. Emerging East Asian economies might receive help from the IMF, but many still carry bitter memories of the Fund’s failures in 1997. And while the Chiang Mai Initiative is exactly the sort of arrangement that might do the job, it proved unusable when it was needed in 2008, and in its present form provides only trivial support.
Asia might also heed the lesson that currency blocks should choose their participants carefully. One suggestion is that a smaller yuan-based grouping of ASEAN, China, Hong Kong and Taiwan might make more sense than a region-wide linkage.
All this leaves Asian exchange rates in an awkward policy space. The managed rates of the post-1997 period are working well enough, but continued reserve accumulation is not sustainable, and running chronic current account surpluses is not optimal.
Capital should be flowing ‘downhill’ to these emerging countries, not in the reverse direction. Establishing a stable range of relativities among a sub-set of the region might be a start in the right direction.
Author: Stephen Grenville, Lowy Institute
Stephen Grenville is a Visiting Fellow at the Lowy Institute for International Policy and a former Deputy Governor at the Reserve Bank of Australia.
An earlier version of this article was first published here on the Lowy Institute for International Policy website.
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