Report

NEAT Working Group on East Asian Financial Cooperation

BeijingJune 6, 2005

1Introduction

The NEAT Working Group on East Asian Financial Cooperation
organized a meeting on East Asian Financial Cooperation in Shanghai
from April 1 to 2, 2005. Participants included scholars and experts from10 of the ASEAN +3 countries (Brunei，Cambodia and Malaysia wereabsent). Ambassador Wu Jianmin, NEAT Co-Interim Coordinator andChina’s Country Coordinator，chaired the meeting. The discussion wascandid, fruitful, and down to earth. It focused on the East Asian financialcooperation, the main obstacles, and the ways for strengthening suchcooperation.

The most important consensus reached at the Meeting is that it is hightime that East Asian nations take practical measures in financial
cooperation. As a Track II process, NEAT has the responsibility to buildon this consensus. After establishing common parameters of theprevailing conditions, participants of the Meeting put forth their policy
proposals for promoting financial cooperation in the region.

I. Three Outstanding Issues in the Region’s Economic Development

1. A high level of economic growth and a low level of2risk-management capability. East Asia has witnessed rapid economicgrowth. The growth rate of East Asia’s GDP reached over 7% in 2004,exceeding not only the world’s average, but also that of the two major
economies – NAFTA and EU. East Asia is now the most dynamic region
in the world. The economic dynamic, however, has not been accompaniedby the expected risk-management capability. Some of the importantfactors that caused the 1997 financial crisis have continued to exist.
Underdevelopment of an internal financial market and inappropriate
exchange rate mechanisms are among the factors that keep the region’s
risk-management capability at a low level. The continued depreciation of
the US dollar has made these deficiencies more conspicuous, further
exposing the region’s weakness in risk-management. People expect Asiancurrencies to appreciate with the amount of hot money flowing into theregion. The risks are there.

2. A high level of foreign exchange reserves and a low level of
effective utilization. In the past few years, the foreign exchange reservesof East Asia have soared. By the end of 2004, the figure reached close to
US$2.3 trillion. Within only four years, it has more than doubled,
accounting for 2/3 of the world’s total. It is true that the high level offoreign exchange reserves has made East Asia more competent and laid amore solid foundation for financial cooperation. But at the same time, it
3has not been used effectively. In addition to the low return rate, thecontinual depreciation of the US dollar has caused a huge loss to East
Asian nations; it is likely that the US dollar will continue to slide.
According to a rough estimation, a 10% depreciation of the US dollar
would cause East Asia to lose US$130 billion. This is tantamount to a 2%
loss in East Asia’s GDP. Therefore East Asian nations, while respecting
each other’s sovereignty, would do well to combine their efforts inimproving the utilization of foreign exchange reserves.

3. A high level of intra-regional trade and a low level of financialcooperation. The development of intra-regional trade is one of the mostremarkable events in East Asia: It had reached 54% by 2003, ranking
below the 64% of the EU, but above the 46 % of NAFTA. In recent years,trade cooperation centering on FTA has accelerated. The FTAs between
ASEAN on the one hand and ROK, China, and Japan on the other will becompleted by 2009, 2010, and 2012 respectively. An East Asia FTA(EAFTA) is also under way. The more integrated the regional trade, themore need for regional financial and monetary cooperation. But in East
Asia, the latter has been lagging far behind. In the past few years,
especially since the 1997 crisis, East Asian nations have realized thenecessity for such cooperation and made efforts to promote it. TheChiang Mai Initiative is a telling example. However, the overall level of4

cooperation in this field is still very low. It has increasingly become theweakest link in the process of East Asian economic cooperation.

II. Policy Recommendations
1. Strengthen and Build on the Chiang Mai Initiative
CMI’s Swap Arrangement is the most important mechanism for monetaryand financial cooperation in East Asia. It has laid the foundation forfurther cooperation. Its expansion to include the 10+3 countries has
produced positive results. By the end of 2004, the overall size of the swap,including 16 bilateral arrangements, had reached US$27.5 billion. OnMay 4, 2005, a Joint Communiqué was made at the 8th Meeting of 10+3
Financial Ministers, in which member states agreed to double the overall
size of bilateral swap arrangements and subject the size of specificbilateral swap arrangement to the countries involved. Despite thecommitment of CMI’s Swap Arrangement to financial cooperation, its
inadequacy was revealed along with the rapid development in other areasof economic cooperation.

There are some major deficiencies. Its function cannot satisfy theexpanded need. Its initial design was to provide short-term liquidity
assistance to solve immediate payment problems. Even for this function,
its start-up procedure, which links 90% of capital to the conditionality of5the International Monetary Fund (IMF), is often too complicated to beeffective. An agreement was reached at the recent 10+3 Financial
Ministers Meeting to raise percentage of the capital unlinked with theconditionality of the IMF from 10% to 20%.

In addition, its size is insufficient. The sum of US$27 billion is notenough for short-term liquidity assistance, let alone preventing andsolving other related problems in the region. Based on the experiences
gained from the 1997-1998 financial crisis, even if the size of swap
arrangement doubles according to the recent 10+3 Financial Ministers
Meeting requirement, it still cannot play its role effectively.

In addition, its bilateral arrangements reveal inadequacies. Since 2001, 16
bilateral agreements have been signed. A more effective multilateralframework needs to be set up to coordinate the 16 bilateral agreements.
Such a framework is more likely to meet the need of the region as awhole and strengthen the risk-management capability of East Asiannations.

To strengthen the CMI mechanism, three specific measures may beconsidered.

6

First, explore the possibility of expanding the functions of the CMI suchas enhancing short-term liquidity assistance, stabilizing the exchange rate,
sustaining the development of the financial market and strengthening
surveillance on the financial and economic situation. These complement
the functions of existing international financial arrangement at theregional level.

Second, expand the size of the CMI. The committed financial assistancefrom the international community during the 1997-98 financial crisis was
US$110 billion and the size of the proposed Asian Monetary Fund was
US$100 billion. A reasonable size for performing the functions mentioned
aforesaid is thus between US$100 and US$110 billion.

Third, set up a multilateral framework. Upgrade existing bilateralagreements to a more effective multilateral framework within the 10+3nations for facilitating the coordination and provision of sufficient funds
when necessary. If a member state without adequate short-term liquidity
suffers from a capital attack before the multilateral framework is built,
countries that have bilateral arrangements with it shall make a collective
decision to make relevant swap arrangements or otherwise so as to avoid
multiple negotiations and to improve efficiency.

72. Further Develop the Asian Bond Market
At present, major problems concerning the development of the Asian
Bond Market include institutional barriers and technical hindrances. Tight
exchange control, underdevelopment of the credit grading system,
imperfect settlement mechanisms and lack of attractive investment
projects have impeded the healthy development of the Bond Market. In
2003, the Asian Bond Market Development Initiative (ABMI) was signed
and six working groups were set up, under which some actions had beentaken or are going to be taken to tackle the aforesaid issues.

To further develop the Asian Bond Market, the following possibilities
may be explored.

First, enhance the coordination mechanisms. The terms of reference forthe six working groups need to be expanded to include in-depth researchon infrastructure development, investment opportunities, accounting
systems, and information sharing. Finance ministers and central bankgovernors should put them on their meeting agenda and coordinate thedevelopment of domestic and regional bond markets.

Second, increase the size. Asian Bond Fund II should be completed at theearliest possible time and expanded to 8 billion dollars to enable an8

increased investment in the regional bond, especially the bond issued bygovernments and financial institutions. Measures shall be taken to attract
investors both in and outside the region.

Third, increase the bond supply. The Asian Development Bank mayissue more bonds in denominations of local currencies or basket currency
in East Asia so as to boost the regional bond market and provide
benchmark bond prices for the development of the bond. Well-performing
transnational corporations are encouraged to issue regional bonds toexpand the size of the bond market.

Fourth, enhance information exchange and surveillance. It is necessary
to entrust an independent institution or use existing secretariat
arrangements to gather information and monitor the progress of the Asian
Bond Market.

3. Deepen the Dialogue on Exchange Rate Policy Coordination
Policy coordination, information exchange, and surveillance areimportant. At present, there are 8 policy dialogue processes, involving
finance ministers and central bank governors. They have played an
important role in coordinating policies, but they perform overlapping
functions. Thus the lack of coordination among these coordinating9

processes is itself a big problem. In addition, since exchange rate is amore sensitive issue for sovereign states, the lack of institutional
discipline and self-restraint seems to be a problem faced by East Asianstates now. Thus the dialogue mechanism at the ministerial level andother existing process shall be strengthened for discussion andcoordination of the exchange rate policy.

Conclusion

Financial cooperation is a critical, yet very weak link in the process of
economic integration in East Asia. The Meeting agreed to welcome all
positive contributions to the process on the basis of open regionalism.
The Meeting was also keenly aware that efforts of 10+3 should beconcerted to make financial cooperation a facilitator rather than ahindrance to regional integration.

10