For a number of reasons, all ASEAN+3 countries have sterilized the surplus in their balance of payments (both in the current account and the capital account) and therefore have accumulated large international reserves.
The first reason is to control inflation rates and dampen overheating by controlling their monetary base and money supply. In theory, those countries that adopted the IMF Program in 1997-1998 (Thailand, Indonesia, the Philippines and Korea) had shifted to independent floating.
This exchange policy is replaced by inflation targeting as a monetary policy operating strategy and is supported by conservative fiscal policy and a sustainable debt strategy. In theory, the flexible exchange rate requires a smaller war chest of foreign reserves as the system reduces the need for market intervention.
The second reason for building up foreign exchange reserve is to use the reserves as tools for intervention to avoid large exchange rate fluctuations and prevent adverse impacts on their economies.
In reality, the monetary author is still accumulating foreign exchange reserves and intervening in foreign exchange market to stabilize the exchange. In contrast to the fixed exchange system, there is no more exchange target under the current floating exchange rate system.
The third reason is to prepare for a defense against speculative attack and foreign exchange instability due to shortfalls in exports and capital flow reversals. Large portions of securities of ASEAN countries denominated in national currencies are absorbed by volatile short-term capital inflows. This is because institutional investors (such as pension funds and insurance companies) are at early stages of development in this region. Unlike in Japan, there is no Postal Saving Bank in ASEAN countries that can mobilize low cost domestic savings.
The current crises in the peripheries of eurozone indicate that securities denominated in domestic currencies are shielded from currency risk but not from interest rate risks that could cause fiscal crisis. In 1997, Malaysia introduced market based capital control to prevent massive capital outflows.
The fourth reason is to provide a fiscal space when facing economic crisis. Because ASEAN countries were treated badly when they sought help during the Asian financial crisis in 1997, these countries are reluctant to turn to the IMF.
The fifth reason that the less volatile exchange rate minimizes currency risk of foreign borrowing of domestic companies. As mentioned earlier, this is because the dependency of companies, banking system and the public sector in this region on foreign financing.
Sitting on huge foreign exchange reserves, it is natural for ASEAN+3 to strengthen regional cooperation to provide for financial needs, particularly during the crisis. The meeting of ASEAN+3 Finance Ministers (AFMM+3) in Madrid 2008 made strategic decisions to enlarge the size of the currency swap facility under the Chiang Mai Initiative (CMI), increase the portion that is non-linked to IMF Programs and multilateralize it.
Multilateralization of the CMI is a great leap forward towards greater political cohesion in this region as the member countries transfer some national powers to a regional institution. The multilateralization of the CMI will result in the pooled fund becoming self-managed under a single contract thus reducing costly and time consuming bilateral and wasteful duplication of loan contracts.
In theory, the multilateralization of the CMI, along with the existence of bilateral currency swap arrangement between central banks in ASEAN+3 countries and the revisions of the IMF conditionality should reduce the need for self-insurance by holding external reserves.
In terms of assets and branch network, the commercial banking industry is the core of the financial systems in ASEAN member countries. Financial intermediation is primarily in the form of bank lending rather than issue of bonds and equity in capital market. Banks operations are mainly concentrating in traditional deposit taking and lending and less involved in capital and bond markets.
Despite the rapid growth of their assets, the role of the non-bank financial institutions (NBFIs) is still relatively small and only beginning to provide a competitive challenge for the banks. Domestic financial institutions used few financial innovations such as structured products, derivative and securitization. In addition, their consumer and housing indebtedness are still relatively small.
The leading NBFIs are insurance companies, pension and provident funds and mutual funds. In a least developed country such as Indonesia, most of the pension funds are for civil servants and the military and a few large companies.
The roles of state-owned and family owned banks are dominant in many ASEAN countries. The government has started to corporatize the state-owned financial institutions and reduced intervention on their day-to-day operations. In Indonesia, markets for public sector banks are still well protected. By government regulations, the group of state-owned banks has exclusive monopoly on public sector deposits. Regional development banks are cashiers to their owners, namely, the provincial governments, regencies and cities. Stricter enforcement of legal lending limits regulation reduces related lending provided by private banks to their sister companies that are prone to insider trading and principal-agency problems.
To tap the high domestic savings in ASEAN, local and regional institutional investors need to be developed to provide financing of long-term investment for both the private companies and the public sector, such as infrastructure. The deeper local money and financial markets would allow replacement of foreign institutional investors with domestic financial institutions. The more matured local markets also allows diversion of investment from the US government papers that produce low yields to high returns investment in this region.
At present, most of the monetary authorities in this region sell securities with high coupon rates to buy the foreign exchanges. The yields from their investment in foreign assets (mainly in the US government papers) are close to zero because of the monetary easing policy in advanced economy to push down interest rate close to zero.
Central banks of the EMEAP countries, the ASEAN+3 Asian Bond Market Initiative and ASEAN+3 Bond Market Forum have addressed various important technical issues on how to develop local bond markets in this region.
The issues include new debt instruments, settlement processes, standardization of market practices and harmonization of regulations for cross-border transactions.
The progress, however, is very slow because creation of effective and efficient market also requires modernization of legal, judicial and accounting system to help solve asymmetric market information problem. The legal reforms allows better enforcement of business contracts, protection of property and creditor rights, and makes it possible to define, pledge and execute collaterals. –Anwar Nasution, Yogyakarta, Jakarta Post
The writer is professor of Monetary Economics at the University of Indonesia. He is former senior deputy governor of Bank Indonesia, the country’s central bank. This article is based on his presentation at a recent international conference in Yogyakarta hosted by Gadjah Mada University.
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