Meet the Asian Monetary Fund

Economics, Premium POM

By JC Collins

The market turmoil of the last few days is reflective of the deflationary pressure which has been building since 2008.  The imbalances in the monetary framework will continue with increasing levels of volatility until the reason for the imbalances begins to be corrected.

Readers of this site already understand the balance of payments challenges which are present in a USD based unipolar monetary system.  The large accumulation of USD in the foreign exchange reserve accounts around the world is the leading cause of these systemic imbalances.  The deflationary pressure which is inherent in such a system led to the Asian Financial Crisis of 1997 – 1998, as well as the crisis of 2008.

All of these events are deflationary in nature and reflect the natural tendency of the system to correct the imbalances created by the large international accumulation of the domestic currency of one country, in this case the USD.

The monetary policies of low interest rates (ZIRP) and quantitative easing (QE) have been responses of the Federal Reserve, along with support from other central banks around the world, to manage and slow the deflation.  The normalization of these monetary policies, being the reversing of QE and the incremental raising of interest rates, will soon commence.

The current monetary framework creates systemic imbalances and instability, but unwinding that system, or shifting to a more balanced and multilateral framework, will also lead to volatility.  Either path forward will take the world through a period of financial volatility.

The normalization of monetary policy which needs to take place will be implemented through two methods   One, as mentioned, is the raising of interest rates.  The mere concept of this alone is what is causing the current volatility to come to the surface, as China, and others, begin to respond to the end of the era of cheap money.

Two, the reversing of QE will begin.  There are a few different ways this could happen.  The QE assets that were sold could be sold back into the market, but this would be unnecessarily disruptive and would likely add to the growing volatility.  The more practical path forward on reversing QE would be achieved by not replacing the QE assets as they mature.  This would be a gradual and progressive unwinding of QE.

This normalization of monetary policy by the Fed has to take place and the resulting volatility will have to be dealt with.  There is no other solution or path forward, and the timing is getting closer as the multilateral framework which is required to replace the unipolar USD framework is being completed in segments and implemented in piecemeal institutional agreements.

Over the last few years China has been building up a support framework to transition its economy through this unwinding.  Bilateral swap agreements have now created Chinese renminbi deposits equalling 3.1 trillion yuan in the central banks of 28 countries.

The International Monetary Fund treats these swaps as reserve assets which can be used to meet the balance of payments needs.  This in effect has made the renminbi a defacto reserve currency, as we reviewed in this post from September 14, 2014, titled Renminbi Is Already A Defacto Reserve Currency.

With China’s recent move to lower the daily trading rate of its currency against the USD, and the forthcoming widening of its trading band on either end of that peg, China will achieve deeper capital account liberalization and the inclusion of the renminbi in the SDR basket is all but assured.

Any mention of this not happening is misleading, or is not understood by those presenting such information.  The delay in implementing the new SDR basket, which will include the RMB, in no way implies that the decision will not be made by the end of this year, and in no way suggests that it will not happen, as some have stated.

The delay and politics around the SDR/RMB decision and relationship, including recent IMF announcements on such, was fully covered in the post Analysis of Recent IMF Announcement on SDR Adjustments.

The rise of the renminbi as a reserve currency alongside the USD and euro will create additional exchange rate volatility and lead to the shifting of trade relations, as can be witnessed in the geopolitical tension which continues to build around the world.

While the full framework around the SDR multilateral asset continues to be constructed, and macroprudential policies are developed within the multilateral institutions, countries and regions of the world, such as East Asia and China, will have to develop methods of preventing capital outflows when the Fed begins to normalize monetary policies.

Along with managing the imbalances which are inherent in the unipolar monetary framework, capital outflows and exchange rate volatility are the greatest threats to the emerging markets.  The Asian Financial Crisis of 1997 – 1998 devastated both the currencies and financial systems of Indonesia, the Republic of Korea, Malaysia, and Thailand.

The social conditions in each country, along with the political systems, were also deeply affected.  The crisis, which had its source in the inherent imbalances within the monetary framework, revealed that financial systems and economic conditions were more interconnected across East Asia, and both directly and indirectly affected by policies elsewhere, than previously realized.

It became apparent during the crisis that reliance on the IMF alone was not enough, and that the region required a self-help mechanism, or institution of their own, in order to effectively manage any future crisis.

The ASEAN+3 economic association was developed for the purpose of establishing new initiatives for regional financial cooperation, including:

  1. Regional Economic Surveillance
  2. Regional Liquidity Support Facility (Chiang Mai Initiative)
  3. Local Currency Bond Market Development

Along with the 1997 – 1998 crisis, the events of 2008 revealed additional weaknesses in the East Asia region.  The QE and interest rates policies which followed brought additional challenges.

In May of 2013 the Fed began to openly talk about tapering QE and this led to more uncertainty and revealed broader fears associated with the normalization of monetary policy.  It became increasingly apparent that the region would need to implement the required new initiatives before the Fed began to normalize the monetary policies and begin to increase interest rates, as this would lead to a massive capital outflow from the region.

The idea of a region specific Asian Monetary Fund (AMF) was first suggested by Japan in September, 2007, and was supported by all members of the ASEAN+3.  The idea was to pool foreign exchange reserves which would meet the demands of the Chiang Mai Initiative, which would later be called the Chiang Mai Initiative Multilateralization (CMIM).

The idea of the AMF was originally opposed by the United States and the IMF based on the assumption that it would be a straight duplication of what was already established within the International Monetary Fund itself, but the need to establish the new initiatives described above, namely:

  1. Regional Economic Surveillance
  2. Regional Liquidity Support Facility (Chiang Mai Initiative)
  3. Local Currency Bond Market Development

…could not be ignored and a sustainable regional approach and implementation of effective initiatives would have to move forward before the monetary framework imbalances could be corrected.

The CMIM was a contentious issue between Japan and China based on the fact that voting powers would be defined and established based on the financial contributions of members.  The negotiations on the Chiang Mai Initiative Multilateralization were protracted but would eventually lead to an agreement where both countries, one a stout American ally, and the other the largest holder of external US debt, would contribute equal amounts of 32% for equal voting powers.

As such, the initial framework and structure of the CMIM, including financial contributions of member countries, and associated voting powers, was defined as represented in the following chart.  This is the basis for the forthcoming Asian Monetary Fund.

CMIM

The CMIM also contains a portion which is linked to the IMF.  This fact is the undeniable reality of the direct connection and multilateral planning which exists between international institutions like the IMF, and the Asian institutions which are being developed.

The IMF delinked portion does need to be expanded and increased so CMIM members can use the emergency lending component without going to the IMF, as that proved challenging and non-effective in the crisis of 1997 – 1998.

Currently the delinked portion is set at 30%, but will be increased to 40% to accommodate the volatility which will come with the Fed rate increase in September.  The chart below defined the quota amounts of each member country along with the IMF delinked portions.

CMIM IMF Delinked

In regards to the surveillance component of the new initiatives, the CMIM and AMF will use a basket of member currencies called the Asian Currency Unit.  The ACU will serve a similar purpose as the European Currency Unit did in the development of the European common market and ultimate evolution to the euro currency.

The ACU will be used as a tool for exchange rate policy surveillance and will provide the systemic framework for monitoring exchange rate movements.  It will be an appropriately weighted currency basket and will summarize the consolidated movements of member currencies.

The ACU will also provide additional support and alternative method of preventing capital outflows from the emerging markets when the Fed normalizes monetary policy.

There are some key fundamental actions which need to take place in order to turn the CMIM into a true Asian Monetary Fund.  They are as follows:

  1. Reduce IMF link to zero through a gradual and slow process of incremental reductions.
  2. Clarify rules and procedures on lending.
  3. Create an independent secretariat to improve regional surveillance.
  4. Expand total size of CMIM to increase available amount of liquidity.
  5. Create additional bilateral swap agreements with economies inside and outside the region.
  6. Members contribute financial resources to set quota amounts. This will facilitate the pooling of foreign exchange reserves.
  7. Expand membership to include Australia, India, and New Zealand.

As we move into the fall months of 2015, and ever increasing volatility, the IMF will endorse and support the activation of the CMIM to counter the inevitable liquidity crisis.  This crisis will be spurred from the normalization of Fed policy.

In response to the market volatility on Monday, August 24, 2015, the rest of the world, including China and other emerging markets, are telling the Fed not to raise rates as a strong dollar is causing massive exchange rate volatility and capital outflows.  This pretext itself is setting the stage for the faster implementation of multilateral initiatives and drastic fundamental changes to the international exchange rate regime.  This will be the lead in to using the SDR as the reserve asset in place of the dollar and the exchange of USD denominated foreign reserves into SDR reserves through the substitutions accounts.

This has been my analysis all along and it continues to be proven factual and realistic at each new turn.  Events are unfolding as expected – problem, reaction, solution.

There is no doubt that the Asian Monetary Fund will serve as a complimentary institution and multilateral building block of the emerging global financial architecture.  The AMF will work closely with the IMF, which is why China is pushing for the 2010 IMF quota and governance reforms which were agreed upon back in 2010, as a response to the financial crisis of 2008.  The IMF has given the US until September 15th to enact supporting legislation to the reforms.  Just like the RMB will be added to the SDR basket, the 2010 reforms will happen.  – JC