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Towards an Asian economic and currency area

Towards an Asian economic and currency area

Alternatives to dollar and the euro start to stir
Asians heed Europe’s shortcomings

by David Marsh

Tue 2 Oct 2012

Asian central banks are in a nervous mood about both the euro and the dollar. An indication came last week in a Chinese-South Korean central banking symposium in Beijing. Behind the scenes, much more pressure is building up.

The Asians are determined not to introduce their own single currency. But the contours of a more integrated Asian economic and currency area are becoming ever more apparent.

When the euro was established 14 years ago, many Asian central banks – not just the Chinese – saw the new arrival as economic and monetary salvation. No longer would international reserve holders and other institutional asset managers have to rely solely on the dollar, with all its shortcomings.

Yet events have shown it was an illusion to believe that the euro would emerge as a stabilising dollar counterweight, with positive consequences for the global economic balance. So Asia is now attempting to develop long-term policy alternatives to reduce dependence on the world’s two major reserve currencies.

Last week in Beijing Chinese and South Korean central bank officials criticised the US Federal Reserve latest QE3 initiative and called for fresh moves to reduce Asia's international monetary dependence. ‘The rise in global liquidity could lead to rapid capital inflows into emerging markets,’ according to Bank of Korea Governor Kim Choongsoo. ‘Therefore, Korea and China need to make concerted efforts to minimise the negative spillover effect.’ Chen Yulu, an adviser to the People's Bank of China, said Asia needs a ‘regional core currency’ to reduce its dependence on the dollar.

For years, the Asians have been trying to increase common ground in areas such as financial market integration, banking supervision and mutual credit mechanisms and swap lines. These trends have been accelerated by the problematic state of economic and monetary union (EMU).

For many years since the 1950s, Asia saw Europe as an integration model. Now they are not so sure. As a senior Asian central bank official puts it: ‘We always thought the Europeans had better systems and better people. Now we doubt whether this is so.’

Prasarn Trairatvorakul, Governor of the Bank of Thailand, politely summed this up at an OMFIF lecture in London on 12 September. The Southeast Asian countries recovered relatively quickly after the 1997-98 Asian financial crisis, regaining competitiveness through rapid depreciation and general economic flexibility. ‘However this flexibility is not practical for Europe given its single currency setting and attendant political complexities.’

All these considerations become concrete when we look at real and potential losses on the currency reserves of many Asian central banks, which after their post-1998 recovery have become by far the world’s largest reserve holders. Asian central banks usually invest in low-interest government securities denominated in the dollar and the euro, which themselves have been depreciating against Asian currencies. The central banks’ liabilities, on the other hand, are primarily denominated in the state’s own currency, where interest rates are much higher.

This is a glaring currency and interest rate mismatch. And it’s exposing some leading Asian central banks to the politically sensitive requirement of seeking substantial government injections to help plug balance sheets losses.

Long-term, there are only really two ways out of this dilemma. Either a sharp reduction in these countries’ foreign exchange reserves, which can come only in the wake of better world economic balance and will probably take years to achieve. Or the development of alternative assets, primarily through purchases of Asian foreign currencies. Central banks in countries such as China, Indonesia, Malaysia, South Korea and Thailand are already practising mutual reserve holdings of their respective currencies.

Although these markets are small and relatively illiquid, this trend is bound to continue. It will take five to 10 years to come to fruition. But, in Asia, real alternatives to the dollar and the euro are starting to work their way to the surface.

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