Issue Brief: The Chiang Mai Initiative – One step closer to an Asian Monetary Fund? - April 2009

When US financial powerhouse Lehman Brothers collapsed last fall, the world saw the start of an unprecedented collapse in global stock markets, bringing with it the loss of billions of dollars of investment around the world and severely shaking the foundations of the international banking system. Gloomy economic forecasts, a loss of investor confidence, and mass capital flight have all contributed to the worsening of the current global financial crisis. A decade ago, a similar situation unfolded in East Asia when market speculation sparked investors to pull out billions of dollars of capital, inflating debt and destabilizing markets in the region. In response, the Chiang Mai Initiative emerged in an effort to protect Asian markets from future crises. But has it stood up to today’s global economic collapse? And is an Asian Monetary Fund on the horizon? This brief explores these, and other, issues.

What is the Chiang Mai Initiative (CMI)?
The Chiang Mai Initiative (CMI) is a regional financial cooperation initiative for East Asia that was agreed upon at the Finance Ministers’ meeting of the Association of the Southeast Asian Nations (ASEAN) plus China, Japan and South Korea (ASEAN+3) in May 2000 in Chiang Mai, Thailand.  Under the CMI, participating countries can draw on one another’s foreign reserves to offset sudden outflows of foreign currency, and thereby avoid an abrupt destabilization of their domestic economy.

What are the origins of the CMI?
The CMI was developed in response to the Asian financial crisis of 1997-1998, when a rapid devaluation in the currencies of several East Asian countries led to widespread and severe economic recession in the region. Pre-1997, the East Asian economies of countries such as Singapore, Malaysia, South Korea and Thailand, had surprised many observers by the rapid rate at which they were growing. These economies began attracting enormous amount of foreign direct investment and short-term foreign capital inflows as International Monetary Fund (IMF) structural adjustment policies deregulated their capital accounts in the early nineties, making capital flows more mobile. By 1996, capital inflows to the region had risen to US$100 billion. But an abundance of available unregulated and unrestricted capital, seeking higher-yielding loans, led to risky lending practices and pushed up the prices of assets beyond their actual values (as occurred with housing prices in the US). Instead of finding their counterpart in the real economy, complementing productive domestic savings and investment, large infusions of foreign capital fed an East Asian addiction to foreign funds and fueled high-speed growth in a speculative economy.  The recipe became unsustainable and the bubble burst. When Thailand devalued its currency, the baht, in July 1997 by 20 percent against the US dollar due to intense pressure in the foreign exchange market, financial speculators quickly lost confidence in Thai and then other East Asian markets. An estimated US$150 billion in capital fled the region, wreaking havoc on their financial systems.

The Asian financial crisis revealed corrupt and mismanaged banking systems, opaque corporate governance systems, the limits of unfettered market capitalism, and the vulnerability of international financial markets to large speculative flows of capital and sudden reversals of market confidence.  In its wake, the East Asian economies began to seriously question an international financial system designed by the Group of Seven industrialized economies, with the IMF at its helm.  Many of the governments that had received IMF assistance to help buffer the impact of the crisis, saw conditions imposed on them as unreasonable and unnecessary, especially since the IMF’s “one size fits all” approach only worsened the crisis. These same governments also felt that they were not being fairly represented in such institutions as the IMF relative to their growing economic power. As a result, ASEAN+3 came together to pursue alternative regional solutions.

What is the structure of the CMI?
Many lessons were learned from the Asian financial crisis. The ASEAN+3 governments recognized that the emergency support from global institutions to crisis-hit economies was insufficient and that regional financial cooperation was necessary. In September 1997, Japan proposed establishing an Asian Monetary Fund (AMF) as a framework for promoting regional cooperation and policy coordination.  But the IMF and United States rejected the idea, arguing that an AMF would only duplicate the existing global system - centered on the IMF - and that extending credit without IMF conditionality would create a moral hazard.

But the IMF’s response to the crisis made many Asian countries wary of IMF advice. So without sacrificing the independence of their domestic economic policymaking, ASEAN+3 called for:

  1. Establishing a regional financing arrangement (involving an expanded ASEAN Swap Arrangement (ASA) to include ASEAN+3) to supplement existing international facilities.
  2. Using the ASEAN+3 framework to promote the exchange of consistent and timely data and information on capital flows.
  3. Establishing a network of research and training institutions to conduct research and training on issues of mutual interests. 

The ASA, bilateral swap arrangements (BSAs) and repurchasing arrangements are all designed to provide liquidity assistance when countries, individually or jointly, encounter short-term and temporary balance of payments difficulties.

What is a “currency swap”?

A currency swap is an agreement to exchange one currency for another and to reverse the transaction at a date in the future. These swaps are used widely in the private sector and among central banks. They involve two simultaneous transactions: (1) a spot transaction, exchanging currencies at the spot rate and (2) a forward transaction, reversing the exchange at a specified rate and time. The exchange rate for the reverse transaction can be the market spot rate, the market forward rate, or another rate specified in the agreement. Interest is paid on balances outstanding under swap arrangements. Most swaps are in US dollars, meaning potential borrowers get dollars in exchange for their local currency through the swap agreements.

Definition from the Institute for International Economics,, and Reuters on-line:

Under the ASA, the US dollar, yen and euro are available for swaps. Each member commits a certain sum to the ASA, and can draw a maximum of twice that amount for a period of up to six months. For BSAs, a country can swap their domestic currency for another country’s US dollars for 90 days. Essentially, both countries in a bilateral agreement are willing to lend each other foreign reserves to prevent speculative attacks on their currencies. As for repurchase agreements, they provide short-term liquidity to a participating member through a current sale and future buyback of eligible securities such as US Treasury notes or bills that will mature in less than five years. To date, none of these CMI credit lines have been tapped but the number of bilateral agreements has grown.

What are the problems with the Initiative? Where does it fall short?
Ongoing links to the IMF
Though the initiative was created as a regional response to intrusive IMF policies, since no parallel regional economic surveillance and monitoring system exists, access to the majority of Chiang Mai funding is still conditional on countries having an IMF-approved program. In other words, if a country needs to borrow more than 20 percent of the available swaps, it still has to submit to IMF guidelines.  Ironically, while the CMI was established in response to the IMF’s failed policies, richer nations like Japan are still reluctant to lend money without strong IMF-style safeguards. Conversely, the IMF connection has made many other nations reluctant to even tap into the resources of the Chiang Mai scheme. Not surprisingly, the IMF-connection has been characterized as “a fatal problem with the CMI”.  

For now, however, the connection remains, with the two core objectives of the CMI reaffirmed at the May 2007 ASEAN+3 Finance Ministers meeting, namely: “(i) to address short-term liquidity difficulties in the region and (ii) to supplement the existing international financial arrangements.”  Proponents of stronger regional financial infrastructure hope to see a shift where the CMI no longer “supplements” international facilities but provides “alternative” financial facilities and reverses the IMF-centered international financial architecture.

Regional economies are not as insulated from global recessions as once thought
There are other fundamental shortcomings with the CMI. Though such a facility can respond to a concerted attack on one country’s currency, it falls short in addressing the type of systemic shocks that characterize today’s wider financial malaise. As the current financial crisis has demonstrated, even huge reserves can’t protect economies from a global crisis originating in the world’s largest economy. China, sitting on nearly US$2 trillion of foreign reserves, is still experiencing a sharp economic downturn. Over 20 million Chinese migrant workers have been laid off due to a sharp slowdown in exports.  But looking below the surface, this should not be surprising. China has used its reserve to accumulate massive quantities of US treasury bills, driving US consumption and its debt-fueled boom of the past decade. The US collapse not surprisingly affects Asia too, since their economies are so strongly interlinked. Perhaps more problematically for the CMI, countries such as South Korea are also turning to the US Federal Reserve to increase their foreign reserves through a swap line since the amount available through the CMI is insufficient. And when the Fed is not confident that it will get repaid, nations are forced to turn to the only lender of last-resort - the IMF.

Regional solutions not ambitious enough
Another major criticism of the CMI has been that that the amount committed is insufficient. Given that Asian central banks collectively hold US$3.3 trillion, or 46 percent of the world’s international reserves, the amount available as CMI funds remains small.  Until the latter half of 2008, only US$80 billion had been committed for swaps. In December 2008, the fund was expanded to US$120 billion, including a newly expanded yen-won swap line between Japan and South Korea.  Realistically, only US$75 billion is available in case of a crisis because the total amount includes agreements that are more symbolic in nature - where poorer countries offer to help richer ones. Even so, this amount is still large in comparison to regional resources available ten years ago or today from the IMF. At the height of the Asian financial crisis, the IMF agreed to loan just over $10 billion to Indonesia over three years with severe constraints that included structural reform, performance targets, and program reviews. 

Opportunity cost of reserve pooling
There is also an opportunity cost of holding and pooling reserves. The CMI and reserve pool may not be the most economically productive use of foreign reserves, especially when developing countries can benefit from repaying debt and/or investing in the domestic economy instead of building up reserves. Tying up billions more in low yielding and safe financial instruments could actually be hurtful to these emerging markets.  The choice lies between storing capital to finance a potential future threat or to invest productively now in the economy to boost employment, business revenues and infrastructure capacity.

As the current financial crisis hits Asian economies with real consequences, regional economic cooperation is needed now more than ever. However, the serious ASEAN+3 financial cooperation is still waning. Does this expose a fundamental lack of political will to overcome institutional, legal and political constraints in East Asia? If so, East Asian governments need to muster enough political will to either refocus their efforts on small, but important steps, to reform the current IFA  or use the current global economic downturn as a catalyst to move the CMI towards the next stage of regional cooperation – an Asian Monetary Fund.

Beyond the CMI to an Asian Monetary Fund
The 1997 financial crisis was a wake-up call to East Asian governments. As a result, East Asian economies are on a much sounder footing today than in 1997. Banks are better capitalized, large companies are less indebted, and foreign reserve levels are much higher. In fact, Asian governments have helped to insulate their economies from future crises by investing billions in trade gains in American treasury bonds and securities.

But in a globalized economy, individual economies have become more intertwined through trade and finance. And a major recession in several of the world’s largest economies has spread to the rest of the world, shooting holes in the theory that some economies might be “decoupled” from the impacts of a major financial slump. Many Asian economies have in fact been hit harder by the current global financial crisis than their Western counterparts. 

With confidence in the current financial system badly shaken, there has been a renewed push for reform of the international financial architecture and increased attention to initiatives such as the CMI. At the Group of 20 meeting in November in Washington, President Susilo Bambang Yudhoyono of the Republic of Indonesia reiterated the need for ASEAN and ASEAN+3 countries to better synchronize their policies, including through the CMI. On the sidelines, China, Japan and South Korea said they were committed to expediting this process – a positive sign for the region. But since the CMI is clearly insufficient to address the scale of today’s financial and economic crisis – and has not even been drawn upon – is the CMI enough? The success of the CMI is clearly linked to the development of a broader set of robust and comprehensive regional financial mechanisms – a bond market, a multilateralization and scaling up of the CMI, greater progress on financial cooperation and regional surveillance, and perhaps most importantly, grounding all future investment in the real economy.

Building up a domestic bond market
In 2003 the Asia Bond Markets Initiative was introduced to help develop efficient and liquid bond markets in Asia.  If Asian governments and corporations are able to issue bonds in their own currencies for long-term projects, this can help reduce dependence on short-term, foreign currency-denominated financing (i.e. borrowing). When you borrow foreign currency, you are taking a risk on how much of your own money it will take to pay back the loan. This is called a “maturity” and “currency” mismatch that leaves countries vulnerable to volatility in short-term capital movements. For example, if a project is financed with foreign capital and the foreign currency appreciates before the project matures, a much larger amount of domestic currency is needed to pay back the original loan.

Multilateral swaps
More significantly for the CMI, ASEAN+3 have agreed to expand bilateral swaps to multilateral ones. In 2007, finance leaders called for a self-managed reserve pooling mechanism governed by a legally binding single contract as a way to transform the existing network of bilateral currency swaps into multilateral ones. Since the fallout of the US credit crisis, the thirteen East Asian countries have agreed to set the size of the multilateral fund under the CMI at $120 billion. Funding will be split 20:80 by ASEAN and the “plus three” countries respectively.

Financial cooperation and better surveillance
ASEAN members have also been strengthening their financial cooperation with one another, including plans to form an ASEAN Economic Community by 2015. Progress has been slow. In December 2008, China, Japan and South Korea – who combined account for 75 percent of East Asia’s GDP, and about 17 percent of global GDP – held their first trilateral summit.  This is a small step, but still significant, since the success of future regional financial initiatives is closely tied to the ability of these three to narrow their differences, and separate historical and territorial issues from developing a broader cooperative economic framework. At the same time, these three are also symbolic of the considerable gaps in economic, social and political systems and cultures that will need to be bridged for an AMF to become a reality.

Finally, ASEAN+3 will need to build on the CMI through effective regional economic surveillance systems and monitoring banking and capital market conditions within Asia. ASEAN+3 have agreed to establish an independent regional surveillance unit to promote objective economic monitoring in the region. But for longer-term regional macroeconomic stability, meetings between Finance Ministers will have to be more frequent, institutional structures - including physical offices, executive directors, staff and much more – will need to be established. And all of this will require significant “political will” to take shape.

While the Asian Financial Crisis ushered in new initiatives to enhance regional financial cooperation, such cooperation will only truly be successful when the impacts of future financial and economic crises on the real economy and social sectors can be minimized. Since populations are most affected by changes in the real economy, East Asian governments must design future initiatives with this goal in mind. How the current financial crisis plays out in Asia, how the responses of the Group of Twenty reflect Asian interests and influence, may be a strong determinant of the rate at which the political will for such initiatives is mustered.