Prof. Dr. M.A.

Sabry
Hochschule Hof
Economic framework & global governance
Case study 3: Exchange rate regime and central bank
intervention in east and southeast Asia: The Chiang
Mai Initiative
Basics and summary
I. Monetary and exchange rate policy: Three targets
challenge every economy
1. Monetary policy authority to ensure price stability
2. free capital movement to encourage foreign investments
3. Less exchange rate volatility to reduce risk of doing business
(stable exchange rate in a flexible system, fixed rate system or
managed floating?).
It is not possible to maintain the three targets simultaneously. Why?
- Free capital movement could cause exchange rate fluctuations
- Monetary accommodation could cause also exchange rate
fluctuations
- Depreciation of a currency is a reason for inflation process
(imported inflation)
- Appreciation of a currency would harm exports of the domestic
economy, cause a downsizing in business cycle and therefore
deflation.
- Stable but overvalued currency could cause capital flight (see
Asian crisis 1997)
- Stable but undervalued currency could cause imbalances and
excessive capital inflow (see China exchange rate policy)
1. Monetary policy and monetary control
The monetary policy framework of every nation comprises the
general rules for monetary policy instruments and procedures. Main
target of monetary policy is to ensure price stability through control
of money supply and policy rate.
The monetary policy framework consists of a set of monetary policy
instruments, e.g. open market operations, standing facilities and
minimum reserves.
2. Types of capital control:
- Restrictions on portfolio flows:
Tax on Foreign investments
Restrictions by asset type or maturity
- Restrictions on banking flows:
Tax on short-term external borrowing
Quantitative limits on banks’ FX exposure
Required reserves on FX liabilities
3. Exchange rate regimes: Basics and impacts
3.1. Basics of exchange rate regimes
- Free floating
- Managed floating (dirty floating)
- Fixed exchange rate and special forms
o Currency board (hard peg, CB intervention)
o Adjustable peg (no automatic adjustment, CB
intervention)
o Conventional peg (hard peg, CB intervention)
o Crawling peg (automatic adjustment, CB intervention)
3.2. Impacts of exchange rate regimes
- Short run and long run determination of the exchange rate
- Definition of the real exchange rate
- Definition of under- and overvaluation of a currency
- Types and motives of exchange rate regimes
- Definition and impacts of interventions in foreign exchange rate
market.
II. IMF`s point of view concerning monetary and exchange rate
stability
IMF is "lender of last resort". Requirements: Reforms of the
economic system.
IMF generally see capital account liberalization as an optimal policy
in
the long run for all countries and see the regulation of capital flows
as inherently distortionary from that optimum.
Flexible exchange rate systems are pivotal to remedy imbalances in
the balance of payments and reduce exchange rate risks for market
participants. Undervaluation could cause excessive unexpected
capital inflow (see China), overvaluation could cause excessive
unexpected capital outflow (see Asian crisis 1997) .
Excessive capital flows generate externalities because individual
investors and borrowers do not anticipate the possible negative
effects of their financial decisions on financial stability in a nation.
A currency is undervalued if:
1. The government of the country “engages in protracted, large-scale
intervention in one or more foreign exchange markets”;
2. The real effective exchange rate34 of the currency is undervalued
by at least 5%;
3. The country has experienced “significant and persistent global
current account surpluses”; and
4. The foreign asset reserves held by the government of the country
exceed
a. The amount necessary to repay the government’s debt obligations
for the next 12 months;
b. 20% of the country’s money supply; and
c. The value of the country’s imports for the previous four months.
Recommendation of IMF:
- A common response to managing capital flows is to tighten
fiscal policy
- A flexible exchange rate can be a shock absorber in the event of
capital in- or outflow surge.
III. The Asian reaction after the Asian Crisis 1997: Chiang
Mai Initiative (CMI)
1. The Asian Crisis
The Asian financial crisis began with asset bubbles. Growth in the
export oriented economies led to high levels of foreign direct
investment, which in turn led to an increase in real estate values,
higher corporate spending, extreme public infrastructure
investments and heavy borrowing from banks. Many Asian
economies were overheated, accompanied by a higher price level
which normally would lead to a depreciation of corresponding
currencies.
Many Asian currency in this time were however pegged to the US $.
Many investors realized that the higher price level of assets and
currencies were unsustainable. Currency traders began attacking the
Thai baht's peg to the U.S. dollar. This attacks were successful. Many
central banks could not cope with this depreciation pressure on their
currencies. Foreign reserves were not enough to intervene in the
foreign exchange market.
The peg system collapsed and the Thai baht was devalued. Other
Asian currencies including the Malaysian ringgit, Indonesian rupiah,
and Singapore dollar had to devaluate as well and their values
dropped sharply among the US$.
These devaluations led to high inflation and the problem spread to
South Korea and Japan.
The Asian financial crisis was solved by the International Monetary
Fund (IMF), which provided the loans necessary to stabilize the Asian
economies. Th IMF provided 110 billion US$ loans to Thailand,
Indonesia, and South Korea to support their financial system and to
help them adjusting their exchange rate systems.
2. Launch of the Chiang Mai Initiative
(ASEAN+ Japan + China+ Korea)
240 Bl. Dollar official reserves agreement including currency swap
agreement to avoid a shortage in foreign currency and financial crisis
in the future.
The CMI is a landmark liquidity support facility in East Asia
introduced
in May 2000, intended to reduce the risk of currency crises and
manage such crises or crisis contagion. It started as a network of
bilateral swap arrangements (BSAs) among China, Japan, the
Republic
of Korea and ASEAN members.
The number of bilateral currency swaps, and their total amount grew
over time and, by April 2009, had reached 16 swap agreements with
$90 billion just before CMI multilateralization.
2. Chiang Mai Initiative Multilateralization (CMIM)
Given the cumbersome nature of the multiplicity of BSAs, the finance
officials decided to finalize the multilateralization of the CMI, by first
adopting a collective decision-making procedure for CMI swap
activation (May 2006) and then adopting a self-managed reserve
pooling arrangement governed by a single contractual agreement as
a form of CMIM (May 2007). Negotiations to finalize the CMIM
were
not straightforward, particularly on country contributions and voting
weights. However, these were mostly concluded by May 2009 with
some final revisions in 2010. The CMIM came into effect, and
replaced the CMI, in March 2010.
3. Amended Chiang Mai Initiative Multilateralization
(ACMIM) Agreement since June 2020
The ACMIM is a regional financing arrangement among the Finance
Ministers and Central Bank Governors of the ASEAN Members
States,
China, Japan and Korea (ASEAN+3) and the Monetary Authority of
Hong Kong. It came into effect on June 23, 2020.
The two key points of the amendment to strengthen the CMIM are:
- Creation of more flexibilities for the financing period of the IMF
Linked Portion of the CMIM to secure consistency with the
IMFsupported
programs and strengthen coordination mechanism
with the IMF
- Introduction of a legal basis to support members in addressing
their risks and vulnerabilities through policy recommendations
as well as financial support.
Two questions for discussion:
1. Is the ACMIM the new “IMF” in Asia?
2. What is the Renminbi Bloc?