Calls for Asian currency union courting a truly Titanic disaster
with Tom Holland
The week the Titanic went down was hardly the best time to propose building a colossal new transatlantic ocean liner. And the day after the Hindenburg crashed and burned wasn't the most opportune moment for engineers to present their plans for a new generation of hydrogen airships.
So in a way you have to admire the sheer cussedness of the policy wonks at Asia's supranational organisations. Last week, with the euro zone's crisis of confidence raging unabated, the Asian Development Bank called on regional governments to move towards a regional exchange rate mechanism. And the ADB wasn't alone in its unseasonable recommendation. Yesterday the Bangkok-based United Nations Economic and Social Commission for Asia and the Pacific, or Unescap, said regional economies should consider managing their exchange rates against a common basket of reserve currencies.
Unescap says Asia needs 'a currency management system which facilitates trade and macroeconomic stability and discourages beggar-thy-neighbour currency competition'.
And the ADB argues that Asia's extended network of cross-border supply chains needs regional currency stability to operate efficiently. What's more, the Manila-based institution believes a regional exchange rate mechanism would assist global economic rebalancing by removing the danger that individual Asian countries will become less competitive compared with their neighbours if they allow their currencies to appreciate.
The ADB suggests several possible exchange rate mechanisms for the region. Governments could opt for a 'soft' form of co-operation along the lines of the Plaza and Louvre accords. For example, they could jointly agree to allow their currencies to rise against the US dollar, without setting specific targets. Alternatively, Asian governments could agree to manage their exchange rates against a basket of reserve currencies like the International Monetary Fund's special drawing right.
As a stronger form of arrangement they could peg their currencies to each other, allowing them to float together against outside currencies. Or they could go all the way and form a regional monetary union, effectively replicating the European path to a single currency.
But there are problems with each suggestion. Soft agreements break down too easily without binding commitments to hold them together. Meanwhile, maintaining a pan-Asian basket or peg mechanism would be difficult if not impossible. With different growth trajectories and inflation rates, regional countries need exchange rate flexibility against each other if they are to react successfully to economic shocks and highly variable capital flows.
And full-on monetary union looks out of the question. As the ADB points out, 'successful exchange rate - and monetary - co-operation must be supported by very high levels of political, fiscal, and financial co-operation, along with supporting institution building'.
And that's where the problem lies. There is zero chance that Asian governments would agree to anything like European levels of centralised institutional oversight, with a regional central bank and a growth and stability pact. And as we have seen over recent months, even European levels of oversight have proved insufficient to maintain European economic stability.
In any case, despite what the ADB and Unescap say, it is far from clear that a formal exchange rate agreement would be better for Asian economies than the existing situation, which has actually worked rather well.
Germany, Greece and Ireland share a single currency. But as the first chart shows, their real effective exchange rates - a key measure of competitiveness factoring both exchange and inflation rates - have fluctuated widely since the introduction of the euro. In contrast, as the second chart shows, in the absence of any formal mechanism the real effective exchange rates of Asian economies as diverse as China, Thailand and Singapore have been relatively stable.
There's a good reason for that. Contrary to common perceptions, most Asian countries don't manage their currencies against the US dollar. Instead, they manage their exchange rates against the currency of their largest trading partner and regional economic whale, China.
Of course, China itself manages its currency against the US dollar. But as the yuan appreciates, so will other Asian currencies.
In other words, China is calling the tune and other regional economies are dancing in time. It may not be the ideal exchange rate mechanism, but it's a lot better at avoiding icebergs than Europe's, or the sort of arrangements the ADB and Unescap are calling for.