Hitotsubashi University

1. Regional Monetary Cooperation in the US Dollar Key Currency System Eiji Ogawa Deputy Director, EU Studies Institute in Tokyo and Professor, Hitotsubashi University March 31, 2010 Hitotsubashi University Keio University Tsuda College International Conference on “Regulation Crossing Borders”

2. Contents • Motivation and objectives • US dollar key currency systems in the past and the present • Euro and Asian currencies during and after the global financial crisis • Regional vs. international monetary cooperation • Conclusion International Conference on “Regulation Crossing Borders”

3. Motivation (1) • The global financial crisis, started from US financial institutions, seemed to erode confidence of the US$ and, in turn, to give depreciating impacts to the US$ against the other currencies. However, the euro and the sterling pound have depreciated against the US$ during and after the crisis while only the Japanese yen has appreciated. • The situation is deeply related with the current international monetary system where the US$ has still have a position of “key currency” in the world economy. Economic agents in the world economy which include even the EU have to use and hold the US$ as a major settlement currency in international economic transactions. International Conference on “Regulation Crossing Borders”

4. Motivation (2) • On March 25, the heads of state and government of the euro area made an agreement that the euro area member states are ready to contribute to coordinated bilateral loans by complementing International Monetary Fund (IMF) regarding financial assistance to Greece. • Both the Asian currency crisis in 1997 and the Greek fiscal crisis in 2010 have stimulated arguments regarding establishing a regional monetary fund for regional monetary cooperation such as Asian Monetary Fund (AMF) and European Monetary Fund (EMF) • It has been discussed whether regional monetary cooperation should be complementary to IMF or substitute for IMF. International Conference on “Regulation Crossing Borders”

5. Objectives • To consider characteristics of the current international monetary system, that is, the US$ key currency system. • To observe impacts of the global financial crisis on the euro, the pound, the yen, and other Asian currencies. • To consider why the euro and the pound depreciated against the US$ even though the global financial crisis started from the US financial institutions. • To compare arguments regarding AMU and EMU comparing with IMF. • To consider desirable relationship of regional monetary cooperation with the current international monetary system International Conference on “Regulation Crossing Borders”

6. Key currency in the Bretton Woods System and current system • Under the Bretton Woods System (BWS), the key currency (US$) means an only nominal anchor for the other currencies. It was a rule of game in the BWS. Under the BWS, the monetary authorities of the other countries had to fix their home currencies to the US$ while the US had to fix the US$ to gold. • In the current system, a key currency means a major settlement currency in international trade, capital, and financial transactions. There is no longer any rule of game that the other currencies should be fixed to the US$. International Conference on “Regulation Crossing Borders”

7. Bretton Woods system gold US＄ ￡ JPY DM International Conference on “Regulation Crossing Borders”

8. Current system JPY US＄ EU27 EU16 € ￡ International Conference on “Regulation Crossing Borders”

9. Global key currency vs. regional key currency • It needs large momentum to shift from the US$ key currency system because of inertia of the US$ as a key currency in the global economy (Ogawa and Sasaki (1998), Ogawa and Kawasaki (2001)). • Under the current system, little global governance against external currency policy of the US because of currency monopoly (Ogawa (2009)). ⇒Given the single key currency system, external currency policy of the US need to be disciplined by the rest of world. ⇒At the same time, the Fed should play a role as international “lender of last resort” for central banks in the world. • It is possible to make a regional major currency a key currency in the region. （The euro has been already regarded as a regional key currency.） International Conference on “Regulation Crossing Borders”

10. Depreciating euro and pound during the global financial crisis • The euro and the pound have faced two-time depreciations during and after the global financial crisis. • Sudden depreciation since the Lehman Shock in 2008 during the global financial crisis. • The Lehman Shock increased counter-party risk in inter-bank markets especially in Europe while some of European countries faced burst of housing bubbles like in the US. • European financial institutions who damaged their balance sheet due to loss of securities backed by the subprime mortgage could not finance US$ liquidity because of the counter-party risk. • US Fed supplied US$ liquidity to ECB and BOE through currency swap arrangements. ECB and BOE supplied unlimited liquidity to financial institutions on collateral. International Conference on “Regulation Crossing Borders”

11. Movements of euro and pound against US$ International Conference on “Regulation Crossing Borders”

12. Credit spread (LIBOR(US$)-US TB, 3 mos) International Conference on “Regulation Crossing Borders”

13. Depreciating euro and pound after the global financial crisis • Second depreciation since November 2009 in a situation of the Greek fiscal crisis after the global financial crisis. • A fiscal crisis is a typical cause of classical balance of payment (BOP) crisis. It is expected that fiscal deficits have to be financed by issuing money. Fiscal deficits are expected to lead to easy monetary policy, inflation and, in turn, depreciation of the currency. • In addition, it is expected that the fiscal crisis in Greece may have contagion to other countries (so-called PIIGS) in the euro area. The contagion effect to the euro area might damage confidence in the euro. [ One measure to stop the contagion effect is consider to be “regulation” of the Credit Default Swap (CDS) in EU.] International Conference on “Regulation Crossing Borders”

14. Reaction of Asian currencies • AMU and AMU Deviation Indicators （see http://www.rieti.go.jp/users/amu/index.html) • AMU（Asian Monetary Unit）: a weighted average of East Asian (ASEAN+3 (China, Japan, and Korea)) • AMU Deviation Indicator: position of each East Asian currency against the AMU based on benchmark period (2000-2001) • AMU has been appreciating against a currency basket of the US$ and the euro since August 2008. • AMU has been appreciating against the US$ since May 2009 after it depreciated against the US$ from April 2008 to April 2009. • AMU has had twice appreciation against the euro during and after the global financial crisis. International Conference on “Regulation Crossing Borders”

15. Movements of AMU against US$ and euro International Conference on “Regulation Crossing Borders”

16. Asymmetric reactions of Asian currencies • AMU Deviation Indicators of East Asian currencies shows their asymmetric reactions caused by the global financial crisis. • The Japanese yen has been overvalued in terms of the AMU since October 2008. • The Chinese yuan has been depreciating against the AMU since March 2009. • The Korean won changed from 20% of overvaluation in October 2007 to 30% of undervaluation in March 2009. It depreciated by 50% points in terms of the AMU. It has been appreciating against the AMU since then. International Conference on “Regulation Crossing Borders”

17. Nominal AMU Deviation Indicators of Asian currencies International Conference on “Regulation Crossing Borders”

18. Nominal AMU-wide Deviation Indicators of Asian currencies International Conference on “Regulation Crossing Borders”

19. Backgrounds of the asymmetric reactions • Backgrounds of the asymmetric reactions of East Asian currencies • Different exchange rate system adopted among East Asian countries: Japan and Korea adopt flexible rate system. China has fixed RMB to the US$ since July 2008 although it made announcements of adopting a managed floating rate system with reference to a currency basket. Some of ASEAN target a currency basket. • Active regional capital flows: US and European financial institutions conducted yen carry trades by borrowing the yen and investing in the Korean won before the global financial crisis. During the crisis they closed the yen carry trade and Korea faced sudden stops and moreover backward flows from Korea. International Conference on “Regulation Crossing Borders”

20. Regional vs. International Monetary Cooperation • IMF is the only institution for international monetary cooperation which was established to manage BOP crisis in 1944. • In Asia, establishing AMF was proposed for a regional monetary cooperation in Asia during the Asian currency crisis in 1997. • It is discussed that an Euro(pean) Monetary Fund (EMF) should be established for crisis in the euro area after the Greek fiscal crisis. International Conference on “Regulation Crossing Borders”

21. Is the IMF a lender of last resort? • IMF is not a central bank that issues any currencies, especially the US$. [SDR is not any currency but unit of account.] However, it is a kind of pooling and lending institution that givesloans to BOP crisis-hit countries. Moreover, it conducts bilateral surveillance over each of countries for preventing BOP crisis. • In the case of regular facilities (stand-by arrangements (SBA)), it takes some time to implement a financial assistance to BOP crisis-hit countries because of time lags in crisis-hit countries’ decision making process, IMF’s their negotiation process with IMF regarding conditionality, and IMF’s decision-making process. • It is said that the conditionality is supposed for a classical BOP crisis that is caused by fiscal deficits and inflationary monetary policy. The conditionality is regarded as an old-fashioned and in some cases inadequate for new types of currency crisis. International Conference on “Regulation Crossing Borders”

22. IMF’s lending policy improvement: • IMF facilities are needed for giving prompt financial assistance to crisis-hit countries that face with liquidity problem caused by sudden stop of capital flows. Contingent Credit Line (CCL) was created in 1999 (however, no countries applied for it.) In 2009, IMF implemented lending policy improvement which include creating Flexible Credit Line (FCL) as well as modernizing conditionality. • Flexible Credit Line (FCL) • FCL is for countries with very strong fundamentals, policies, and track records of policy implementation and is particularly useful for crisis prevention purposes. • FCL arrangements are approved for countries meeting pre-set qualification criteria. • Disbursements under the FCL are not conditioned on implementation of specific policy understandings as is the case under the SBA. There is flexibility to draw on the credit line at the time it is approved, or it may be treated as precautionary. • Arrangement countries: Colombia, Mexico, and Poland International Conference on “Regulation Crossing Borders”

23. Arguments regarding AMF • Establishing AMF was discussed during the Asian Currency Crisis in 1997. • Arguments for AMF (Japan and ASEAN) • Necessity of regional monetary cooperation. • IMF could not provide enough loans to the crisis-hit countries. (A half of loans to Thailand were made by Asian countries.) • IMF’s conditionality are not adequate for the Asian Currency Crisis that was not a classical crisis but the so-called third generation of crisis (combination of currency and financial crises). • Arguments against AMF (US and IMF) • Duplication with IMF. • Moral hazard problem should be caused by less strict conditionality that AMF imposes to a crisis-hit country. • China was neutral! International Conference on “Regulation Crossing Borders”

24. Regional Monetary Cooperation in Asia • Chiang Mai Initiative (CMI) • Currency Swap Arrangement (CSA) for managing currency crisis ASEAN+3: CMI (2000) to CMIM (CMI Multilateralization) (2010) => reserve pooling and multilateral decision making process Japan-India (July 2008, US$ 3 billion) [IMF link (CSA will be implemented only after IMF decide to give financial assistance to a crisis-hit country) impedes implementation of CSA under CMI. Korean case in 2008-9 was a typical one.] (2) Surveillance process for preventing currency crisis macroeconomic variables (GDP and inflation) and soundness of banking sector They should watch intra-regional exchange rates. International Conference on “Regulation Crossing Borders”

25. EMF Proposal • Wolfgang Schäuble, German finance minister, proposed EMF that should be backed by strict conditionality and sanctions to enforce fiscal discipline (Financial Time (March 12, 2010)). • The EMF proposal is to focus on enforcing fiscal discipline and limiting moral hazard problem. For the purposes, the following mechanism is proposed by Gros and Mayer (2010): • Contribution: Only those countries that breach the Maastricht criteria have to contribute. The contribution rate is 1% annually of the stock of ‘excess debt’ over 60% of GDP and 1% of the excessive fiscal deficit over 3% of GDP. (=> reducing moral hazard of borrowers) • Enforcement mechanism: as a first step, new funding would be cut off. Funding under the structural funds could also be cut off. Finally the country could effectively be cut off from the euro area’s money market when its government debt is no longer eligible as collateral for the ECB’s repo operations. (=> reducing moral hazard of borrowers) • Orderly default: EMF could offer holders of debt of the defaulting country an exchange of this debt with a uniform haircut against claims on EMF. (=> reducing moral hazard of lenders) International Conference on “Regulation Crossing Borders”

26. Fiscal deficit/GDP of Greece International Conference on “Regulation Crossing Borders”

27. Conclusion • The global financial crisis depreciated the euro, the pound, and Asian currencies except for the Japanese yen under the current international monetary system with the US$ as only a key currency in the global economy. • Regional monetary cooperation is regarded to complement IMF because IMF has limited fund to give financial assistance and limited information on crisis-hit countries. On the other hand, it is discussed that regional monetary cooperation should be substitute for IMF. • Countries and regions should have regional monetary cooperation from a view point that “self-help” is the way for them to reduce moral hazard and overcome currency crisis. For the purposes, regional monetary fund with any mechanism to reduce moral hazard are effective in preventing and managing currency crisis. International Conference on “Regulation Crossing Borders”

28. References • Council of the European Union, “Statement by the heads of state and government of the euro area,” March 25, 2010. • Gros, Daniel and Thomas Mayer, “How to deal with sovereign default in Europe: Towards a Euro(pean) Monetary Fund,” CEPS Policy Brief, no. 202/February 2010. • International Monetary Fund, “IMF Overhauls Lending Framework,” March 24, 2009. • Ogawa, Eiji, “Effects of the global financial crisis on the euro, the pound, and the yen,” presentation at the international conference of EUSI Joint Research on EU Economy on December 12, 2009. • Ogawa, Eiji and Kentaro Kawasaki, “Effects of introduction of the euro on international monetary system,” Hitotsubashi University, Graduate School of Commerce and Management, Discussion Paper Series, 2001. (in Japanese) • Ogawa, Eiji and Yuri N. Sasaki, “Inertia in the Key Currency,” Japan and the World Economy, vol. 10, no. 4, 421-439, 1998. • Schäuble,Wolfgang, “Why Europe’s monetary union faces its biggest crisis” Financial Times, March 12, 2010. International Conference on “Regulation Crossing Borders”