Editorial: The currency stability net

Thu, 05/08/2008 11:03 AM  |  Opinion

The agreement reached Sunday by finance ministers from 13 Asian countries, including Indonesia, to create a pool of at least US$80 billion in foreign exchange reserves was a significant step toward a regional version of the International Monetary Fund (IMF).

The agreement, made in Madrid at the annual meeting of the Asian Development Bank, was in the interest of protecting participating countries' currencies.

The deal will replace the eight-year arrangement of bilateral currency swaps made in 2000 under the Chiang Mai Initiative and transform it into a more powerful self-managed reserve pooling mechanism governed by a single contract.

Under the Chiang Mai Initiative, only bilateral currency swaps were permitted, which meant a country seeking to swap multiple currencies had to obtain permission from each individual partner country, a time-consuming process.

Now the mechanism is multilateral.

The agreement was seemingly prompted by frustration from countries hit by the 1997 economic crisis in dealing with the IMF. Indonesia, South Korea and Thailand were required to implement harsh and unpopular economic policies in return for bailouts.

The pooling of foreign reserves - timely, in view of global financial market uncertainty, credit crunch and weakening world economy- may help prevent a repeat of the region's financial turmoil or a run on a member's currency, like those that took place in 1997-1998.

The purpose of the fund is to heal wounds before they become serious, should liquidity or financing problems arise. It would be like a first-aid measure providing care before the IMF gets in.

One may argue the situation now is much different from that before the 1997 crisis, especially where Indonesia is concerned. Before 1997, massive capital inflow went mainly to a few large corporations and banks which borrowed recklessly in defiance of Bank Indonesia's warning. Now the lows are mostly channeled into financial markets, automatically spreading the risk to thousands of investors.

Hence, any sudden reversal will also spread losses across a broad investor base, resulting in small losses.

A multilateral swap arrangement is still needed, otherwise vulnerable countries will have to succumb to harsh treatment under the IMF bailout scheme.

The risk of such an arrangement is countries could become complacent, knowing they can draw down on the pool of reserves to defend their currency. Hence, the reserves should be used responsibly and a surveillance mechanism should be improved to provide an early warning.

But what most countries in Asia are now facing is strikingly different from the height of the 1997-1998 crisis. The accumulation of reserves due to surging capital inflow and rising trade surpluses have made most central banks surpass the level of reserves deemed sufficient to counter external payment crises.

Many governments in Asia are encountering excess financial market liquidity, not economic liquidity. Hence, what they currently need is not so much a beefed-up defense system, but more real cooperation among their central banks.

Thailand, in late 2006, gave us a glimpse of what could happen. Faced with burgeoning capital inflow and a rising trade surplus, the baht strengthened against the dollar, despite intense intervention from the central bank in the currency market. Unable to absorb the flood of cash pouring into the country, officials eventually pulled the break and imposed capital control. This, in turn, contributed to a severe downturn in investor confidence, from which the country is still recovering. Clearly, the main problem facing Thailand, like Indonesia now, was how to recycle an overwhelming payment surplus balance, not how to further bolster reserves.

Most importantly, Asia requires genuine exchange rate coordination to manage the appreciation of its currencies against the dollar. Only a coordinated solution is possible whereby all central banks agree to let their currencies creep upward.

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