Advancing Regional Monetary Cooperation

The Case of Fragile Financial Markets

L. Mühlich

• Publisher: Palgrave Macmillan
• Year: 2014
• ISBN:
  9781137427212
• Topic: Business
• Subtopic: International Business
• Index: Business

This book examines regional monetary cooperation as a strategy to enhance macroeconomic stability in developing countries and emerging markets. Interdisciplinary case studies on Southern Africa, Southeast Asia and South America provide a cross-regional perspective on the viability of such strategy.

1

Introduction

The eurozone crisis that began in 2010 may be considered the end of the idea of regional integration. Likewise, the eurozone crisis may be regarded as precisely the reason to enhance regional monetary integration in order to shield against volatility in international financial markets and such crises as the global financial crisis of 2008/2009. Broadly speaking, one may ask whether developing countries¹ and emerging markets should refrain from monetary integration initiatives, in particular since their financial market and macroeconomic conditions are comparatively fragile.

This book provides no simple answer to the question of whether the idea of regional monetary integration has come to an end. Rather, the present analysis aims at introducing a differentiated perspective on regional monetary cooperation between developing countries and emerging markets. Thereby, the book inevitably contributes to demystifying the idea of regional integration. At the same time, a differentiated perspective on the various forms of regional monetary cooperation arrangements is equally insightful regarding their respective stabilization potential. The book theoretically systematizes and empirically compares different regional monetary cooperation arrangements with regard to their contribution to macroeconomic stability and to financial market development. Current economic literature largely ignores such a differentiated perspective. Either the specific perspective of developing countries is missing, or this perspective is employed, but with a focus on only one regional arrangement. This book reframes existing theoretical thinking to examine the relative importance of conventional and new theoretical approaches in order to explain potential contributions of regional monetary cooperation to macroeconomic stabilization and financial market development in the developing world. Modern exchange rate theory serves as a starting point here. Further to existing literature that makes use of modern exchange rate theory in the analysis of regional monetary cooperation and integration,² this book examines the contribution of different forms of regional monetary cooperation across different regions in the developing world. Hence, it covers the variety of regional monetary cooperation arrangements as well as the specific regional context of their respective realization from a theoretical and empirical point of view. In addition, the present analysis specifically aims at understanding the role of emerging markets as regional anchor countries in asymmetric regional monetary cooperation.

Despite, or because of, the eurozone crisis, the number of regional monetary cooperation arrangements is on the rise and gaining ever new momentum with the mounting turmoil in international financial markets. The promise of regional monetary cooperation as a safeguard against financial and currency crises is, accordingly, still increasing. The interest of developing countries and emerging markets in regional monetary policy strategies is motivated largely by three factors.

First, under the current conditions of liberalized capital flows and flexible exchange rates, developing countries and emerging markets find it particularly difficult to achieve macroeconomic stability and favorable conditions for economic growth and development. With the breakup of the Bretton Woods system in 1973, the previous international system of fixed exchange rates was abandoned, and capital controls were removed. Since then, volatility of international capital flows and exchange rates between international key currencies has increased the risk and magnitude of economic and monetary shocks, in particular for those countries whose net wealth or net debt is denominated in a foreign currency.

Second, the introduction of the euro in the European Union (EU) in 1999 attracted particular attention in developing countries, among others, for two reasons. The introduction of the euro represents the most advanced form of an on-going and ever-increasing build-up of regional economic and monetary blocs around international key currencies. Most prominently, it can be observed in the build-up of regional preferential trade agreements and customs unions, but also in the formation of regional currencies, of which the EU represents the most sophisticated example. Countries that do not belong to a major economic bloc are faced with additional difficulties for economic development: the larger regional trade blocs become, the greater are the disadvantages for excluded countries through barriers to market entry (Baldwin, 1993). The larger regional monetary blocs become, the more disruptive are interest rate changes, exchange rate volatility, and redirections of financial flows felt at the periphery. Disruptive effects on peripheral developing countries and emerging markets are aggravated by the fact that no international regulatory agreement on exchange rates and financial or trade flows is currently in place (Kotte, 2010). In addition, the integration of Eastern European transition countries into the eurozone represents the realization of a hitherto unknown and unique monetary integration of countries with highly heterogeneous development levels, which is not likely to be an available option for the majority of developing countries and emerging markets. Hence, regional monetary-bloc building appears to be a viable monetary policy strategy for many developing countries and emerging markets, considering the disadvantages related to their peripheral economic and monetary status coupled with the limited possibility of integrating with key currency areas.

Third, emerging market crises, especially during the 1990s, have been shown to have a contagious element. Abrupt changes in capital flows are related to market perceptions of economic similarity, based on geographical proximity but also on similarities in categories of country characteristics. The unfolding of the Asian financial crisis from its origins in Southeast Asia in 1997 to the sharp devaluation of the Brazilian real in 1999 and further currency crises and economic downturn in South America and also South Africa is telling in this regard. Being tied together through regional contagion of economic, financial, and currency crises provoked the formation not only of regional monetary arrangements but also of financial market development initiatives, most prominently in Southeast Asia. At the same time, the repercussions of the Asian crisis for Latin America showed that regional trade integration alone does not provide a buffer against shocks; rather, increased economic links through regional trade integration may require monetary cooperation as well (Fernández-Arias et al., 2004). Furthermore, it provoked a nascent debate about the need for regionally created regulatory interventions to prevent market contagion in the developing world (Akyüz, 2009).

Therefore, in particular developing countries and emerging market economies at the periphery of the international monetary and trade system have been exploring possibilities for regional monetary cooperation. Developing countries and emerging markets are explicitly aiming at reducing their economies’ vulnerability to economic shocks, based on the expectation that “South-South cooperation can [ ... ] help to shield developing countries from the excessive gyrations of international capital markets.”³ However, whether the stabilizing potential of regional monetary cooperation between developing countries and emerging markets is merely a promise or whether it will deliver on expected outcomes remains to be seen. For example, can regional monetary cooperation help to mitigate the financial vulnerability of developing countries and emerging markets and prevent economic and monetary shocks from growing into regional economic, financial, and currency crises? For which countries and under which circumstances can regional monetary cooperation in the developing world be expected to be beneficial? Economic literature suggests that scholars and policy makers alike seem to be interminably interested in further exploring the regional dimensions of monetary policy options and proposals for new regional financial architectures (see, for example, Birdsall and Rojas-Suarez, 2004; Ponsot and Rochon, 2010). However, economic theory offers little guidance in how to explore these options for developing countries and emerging markets today.

In this context, this book reframes existing strands of economic literature that allude to regional monetary cooperation, macroeconomic stabilization, and financial market development for the case of developing countries and emerging markets. Incorporating modern exchange rate theory provides the basis for the new understanding of the contribution of regional monetary cooperation to macroeconomic stability and financial market development that this book develops. Conventional economic thinking on regional monetary integration is dominated by Optimum Currency Area (OCA) theory. However, modern exchange rate theory shows that OCA theory does not provide an adequate theoretical framework for understanding regional monetary cooperation (Schelkle, 2001a). Nor does OCA theory offer systematic analytical tools to evaluate forms of regional monetary cooperation that precede currency unions, such as regional policy dialogue, regional reserve pooling, or regional exchange rate arrangements. This holds in particular for monetary and exchange rate policy considerations of developing countries and emerging markets. Furthermore, to the best of my knowledge, the economic literature does not offer a systematic empirical research framework that permits investigation of regional monetary cooperation arrangements across different regions and adequately accounts for the vulnerability of developing countries and emerging markets. Furthermore, regional dimensions of exchange rate regime choices barely appear in the literature on exchange rate regime choice. Finally, little guidance exists on links between exchange rate volatility and financial vulnerability under different exchange rate regimes, not to mention regional monetary cooperation or integration arrangements. More specifically, while underdeveloped financial markets are identified by many scholars as a major cause of financial vulnerability, the relationship between exchange rate volatility and financial market development appears to be missing in economic literature (cf. Bordo and Flandreau, 2003).

At the same time, fragile financial markets are a key characteristic of most developing countries and many emerging markets. A fragile financial market is typically underdeveloped, in the sense that hedging options to prevent fluctuations in net wealth are absent or limited (see Eichengreen and Hausmann, 1999). In contrast, developed financial markets are more diversified, liquid, and well capitalized. Furthermore, in a financially mature economy, hedging options are available for private and public market participants.

Underdeveloped financial markets increase a country’s vulnerability to exchange rate fluctuations (cf. Aghion et al., 2009). This assertion holds particularly true for countries whose net assets or net liabilities are largely denominated in foreign currency (cf. Hausmann et al., 1999). In the presence of net asset or net liability holdings in foreign currency, net wealth fluctuates with exchange rate movements, and exposure to the risk of wealth loss is aggravated in less developed domestic financial markets. For example, a sudden reversal of capital flows has a relatively larger influence in a less developed market that does not provide a diversified set of insurance mechanisms, such as hedging operations, and thus may contribute to accelerating a financial crisis. Hence, the less developed the financial market, the more deleterious the effects of economic and monetary shocks for the economy. At the same time, in this situation, the country’s monetary policy – implemented through the money market rate, open market operations, or the exchange rate – faces several constraints when aiming at reducing adverse effects of economic shocks (cf. Dullien, 2009). For instance, the interest rate level needs to be strongly oriented at international levels; otherwise, surges in capital inflows or outflows are likely to put the exchange rate under pressure. Second, depending on the currency denomination of net assets or liabilities, the exchange rate needs to be prevented from fluctuating in order to prevent fluctuation of net wealth. Third, the capacity of the central bank to act as a lender of last resort (LLR) in local currency is limited to the extent that holdings of foreign currency-denominated financial instruments are distributed throughout the economy.

In sum, efficient, mature financial markets can be regarded as an important contribution to a stable macroeconomic environment for economic growth and development. Hence, the question emerges of how regional monetary cooperation as a monetary and exchange rate policy strategy may contribute to enhancing macroeconomic stability, not only with regard to exchange rate regime choice,⁴ but also with regard to enhancing financial market maturity. It is precisely this question that the book explores: how can different forms of regional monetary cooperation be expected to contribute to exchange rate stabilization and financial market development in a way that enhances macroeconomic stability?

South–south and north–south regional monetary cooperation and integration

The book labels regional monetary cooperation between developing countries and emerging markets south–south regional monetary cooperation (SSC). SSC, in contrast to north–south regional monetary cooperation (NSC), does not involve a major key currency, such as the US dollar or the euro. Based on the typology developed by Fritz and Metzger (2006a), the assignment of a country to the typological categories of “south” or “north” is determined not geographically but according to its ability to indebt itself in its own currency (north) or predominantly in foreign currency (south), based on the concept of original sin in Eichengreen and Hausmann (2005a) (cf. Fritz and Metzger, 2006b). The typological categories of “southern” and “northern” countries are accordingly applied to the ability of a country to lend in its own currency (north) or in foreign currency (south) according to the concept of conflicted virtue by McKinnon (2005).

The term regional monetary cooperation is used here to cover a broad range of forms of regional policy cooperation directed towards regionally coordinated stabilization of currencies, primarily exchange rate stabilization (cf. Schelkle, 2001a; see also Corden, 2003: 229 ff.). In this sense, regional monetary cooperation ranges from informal or formal monetary policy consultations and information exchange to regional liquidity sharing arrangements and regional exchange rate arrangements. To date, the economic literature lacks a clear definition of regional monetary cooperation (cf. Rajan, 2004). Generally, the definitions used are based on microeconomic game theory. In this vein, Bénassy-Quéré and Coeuré (2005) define cooperation between different countries as a commitment not only to accommodate domestic shocks but also to jointly optimize a common (regional) loss function.⁵ Regional monetary cooperation is understood here in a broad sense, following Schelkle (2001a). The terms coordination and cooperation are used interchangeably here to refer to the same theoretical concept of cooperation in monetary policy decisions in a broad range of forms in order to coordinate prevention of and adjustment to economic and monetary shocks. This rather loose concept underlines a process-oriented view of regional monetary cooperation. Regional monetary cooperation is understood as a non-predetermined non-linear process of developing shallow or deeper forms of joint monetary policy decision making. It does not necessarily comprise only monetary policy aspects, but also radiates into other policy fields.

Introducing non-neutrality of money into regional monetary integration theory

The aforementioned understanding of economic development relates to the broader context of macroeconomic stability. Macroeconomic stability and, in particular, monetary stability are assumed to be essential for achieving economic development in the aforementioned sense. Here, monetary stability does not only refer to nominal price stability. Rather, when taking into account the specifics of monetary policy in developing countries and emerging markets, a stable macroeconomic environment includes, first and foremost, monetary stability based on stable exchange rates and interest rates as conducive to economic growth and development (cf. Ffrench-Davis, 2006a; Stiglitz et al., 2006: 48 ff.).

In this sense, macroeconomic stability, and monetary stability in particular, are examined here with a focus on the intertemporal character of credit and investment decisions. Monetary stability includes stable exchange rates (a stable value of the local currency against other currencies that allows a stable purchasing power of the local currency), price stability (a low and stable inflation rate that enables using the local currency as a means of deferred payment and store of value without incurring the risk of losing nominal and real wealth), and financial stability (financial markets that allow risk diversification and buffering of economic and monetary shocks with a stable institutional set-up) (cf. Stiglitz et al., 2006: 48 ff.; Blanchard et al., 2010).

Exchange rate stability refers to the absence of large exchange rate devaluations (in nominal or real terms)⁶ or, in other words, the absence of large fluctuations in net purchasing power in local currency. Such stability is considered a crucial condition for better resource allocation and smoothing financial flows, thus increasing investment and enhancing economic development (cf. Dullien, 2009).⁷

Concentrating the analysis on identifying means to achieve a stable exchange rate is based on modern ex...

Table of contents

• Cover
• Title
• 1  Introduction
• Part I  Drivers of Regional Monetary Cooperation
• Part II  New Perspectives on Regional Monetary Cooperation and Integration
• Part III  Regional Monetary Cooperation in CMA, ASEAN/ASEAN+3, and MERCOSUR
• Annex
• References
• Index