The New RMB Managed Peg

Economics, Premium POM

ASEAN Economic Community (AEC) and ASEAN Currency Unit (ACU)
– By JC Collins

On March 25, 2015, I published the article When Will China End the Dollar Peg.  That article covered a large amount of material on the renminbi internationalization, its managed peg to the USD, and the start date of January 1, 2016, for the ASEAN Economic Community trade arrangement (AEC).  The article was widely read and opened the door on further discussions surrounding timelines and methods.

When we consider the end of the RMB/USD managed exchange rate, and how that could potentially be achieved, the need to explore what will replace it becomes all the more important. China has been patient and meticulous about how it proceeds with the liberalization of yuan capital markets and the implementation of regional trade agreements, such as the AEC.  This same careful approach is also being applied to the future valuations of the RMB.

Once the managed peg to the US dollar has ended there will need to be an alternative pegging mechanism, or exchange rate arrangement, to take its place.  The Chinese would find a free-floating exchange rate as adding too much risk alongside the broader liberalization and internationalization of the renminbi.  A fixed exchange rate would not meet the requirements set forth in the IMF standards on a freely traded currency.  The alternative to free-float and fixed exchange rate structures is a continuation of the managed peg which Chinese monetary authorities have been adjusting for years now.

But this managed peg will not be with the USD, as it would make sense for China to end that peg in order to facilitate the inclusion of the RMB into the basket composition of the Special Drawing Right (SDR) which will also come into effect on January 1, 2016.

Let’s take a short detour and review some of the material from the article When Will China End the Dollar Peg:

But before making any final conclusions, we will need to take a closer look at the Chiang Mai Initiative Multilateralization and how China’s trade partners will react to an end of the RMB/USD peg.

The CMIM is an agreement between ASEAN members to help provide assistance to countries experiencing balance of payments and short term liquidity difficulties.  The agreement came into effect on July 17, 2014, around the same time the CIPS systems was to come online.

Under CMIM, a member country can draw up to 30% of its allocated quota amount under the agreement, without being subject to IMF conditions. The remaining amount, 70%, is required to be connected with an IMF program.  The CMIM acts as a supplemental regional safety net to the IMF.  As such, the CMIM cannot function without the IMF.

The Chiang Mai Initiative is one segment of the ASEAN Economic Community blueprint.  For those who don’t know, AEC is a game changer.  Its mandates are nothing less than:

  • Harmonization in payment and settlement system (CIPS)
  • An Asian monetary union (with countries maintaining their domestic currencies)
  • Single market for financial products
  • Uniform exchange rates between ASEAN members

All phases of integration are scheduled to be completed and operational by Jan 1, 2016, the same date that the new SDR composition, with the RMB, will take effect.

International audit and financial advisory company Deloitte has published a document titled The ABC of AEC – To 2015 and Beyond.  This document attempts to explain and direct the reader through the maze of AEC integration, and why it’s important.  The document opens with this:

“Across Southeast Asia, all the chatter around the ASEAN Economic Community (AEC) is focused on a single date: 31 December 2015. But the reality is that not everyone understands what that date means. What is it and why wait until then to do it? What will the impact be? Will we wake up to a different world on 1 January 2016?”

The obvious connection between the CMIM, and its IMF structure and mechanics, with the AEC, and its operational start date of Jan 1, 2016, along with the new SDR composition, is clear evidence for the reality of the macro multilateral framework which we have researched and presented here on this site.

The phased integration of AEC and the relationship between the IMF and CMIM make the 2010 IMF Quota and Governance Reforms all the more important.  The AEC, and by default the CMIM, cannot function without the fair representation of China and other emerging economies on the Executive Board of the IMF.  Not to mention that the quota amounts from both the IMF and CMIM will have to align at the 30%/70% ratio defined above.

But it doesn’t end there.

With the regional exchange rate coordination, or uniform exchange rate between ASEAN members, we are likely to see most countries peg their domestic currencies to the Chinese yuan, as it will be the regional reserve currency which is in the SDR composition.  This will position the AEC to avoid the inherent challenges in a regional currency like the euro, which it has publicly stated it does not want.

The uniform exchange rate structure will ensure that no opposing, or dual exchange rates are used within the monetary union.  It is highly unlikely this means all currencies will be at parity, but member countries could use the Shanghai Gold Exchange as a means of supporting the uniform structure, with predetermined rates set for each member country, based on similar weights as what will be used in the SDR composition.

The uniform exchange rate structure which was mentioned in that article from March needs some further discussion.

First, considering the reluctance of China to have the RMB become the primary global reserve currency, or to put the currency at needless risk to outside manipulators and financial gamesmanship, it is also not realistic to expect that China would want all the countries in the AEC to peg with the renminbi.

The list of 10 initial ASEAN members include; Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, Philippines, Singapore, Thailand, and Vietnam.

The list of ASEAN +6, which make up the full list of AEC member countries, include the original 10, plus; China, Japan, South Korea, India, Australia, and New Zealand.

The architecture of the AEC arrangement will support a tariff-free “single market” for the region, based on fairness and balance.

The idea that all member countries would peg their domestic consumption units to the RMB does not stand when measured against the realistic framework which is being developed in the region. This framework is meant to overcome many of the challenges which have been holding back both reform, and a broadening of regional trade agreements.

ASEAN has created significant advances on financial and monetary cooperation, which has been exemplified by the success of the Chiang Mai Initiative, the Economic Review and Policy Dialogue, and Asian Bond Market Initiative.

Regional exchange rate coordination has been one of the more challenging areas for reform and integration as countries fear the loss of autonomy on domestic monetary policies.  These concerns have been addressed within the architecture of the AEC.

In May, 2006, in Hyderabad, India, finance ministers from China, Japan, and South Korea, all members of ASEAN+6, announced plans for a regional currency unit, or Regional Monetary Unit (RMU). This RMU has since come to be known as the ACU, or ASEAN Currency Unit, which will be a trade-weighted basket.

The ACU will not be a real currency, but will be a currency basket, much like the European Currency Unit (ECU) acted as a regional currency basket before the implementation of the euro in January, 2002.  It took Europe decades to align exchange rates and alter monetary policies before the actual currency was established. Along with modernization, we can expect that exchange rate alignments and monetary policies in Asia will progress much faster than in Europe. The AEC itself is a testament to the planning and framework which has already been implemented.

As a trade-weighted index of East Asian currencies, the ACU will function as a benchmark for regional domestic currency movements and will in fact run parallel to the domestic currencies themselves.  This methodology will continue until 2020 when we could see the full framework implemented and the ACU becomes a real currency like the euro.  This will also align with the next SDR adjustments after the one which is taking place this year.  This trial run on the ACU up to 2020 will give the AEC additional time to progress on further monetary integration.

Initial currencies in the ACU basket could be; China, Hong Kong, Indonesia, Korea, Malaysia, Philippines, Singapore, Taiwan, and Thailand.  This broad composition will support the ACU as a sort of Deviation Indicator, which can be used to measure volatility in member currencies, and facilitate the calculation of Bollinger Bands, which is a method of responding to that market volatility.  All of which will help in the coordination of exchange rates and alignment adjustments which will lead into the establishment of the actual ACU currency in and around 2020.

To define the geographical and macroeconomic parameters for any RMU, Regional Monetary Unit, which the ACU will in fact be, a method of calculation has been developed.  This method is called Optimum Currency Area (OCA), and is used to develop the framework of a single currency area.

Methodologies which are used under the OCA are meant to improve and align the following:

  • Level of Trade Integration
  • Capital Mobility
  • Financial and Governmental Institutions
  • Income Levels

ASEAN, and by extension the AEC, along with the BRICS Development Bank and Asian Infrastructure Investment Bank (AIIB), have all achieved a deeper and broader realization of the requirements specified in the OCA methodology.

As the Chinese currency is moved into position within the SDR composition, the dollar peg will end and the RMB could very well establish another managed peg with the ACU.  This would allow for the further expansion of RMB market liquidity which is currently being held back by the USD peg, and integrate the exchange rates of the emerging markets of the AEC members in the new multilateral financial architecture.

It is probable that the exchange rate mechanism used within the ACU will be managed, as opposed to free-floating or fixed.

The important question which needs to be considered before implementing the ACU on January 1, 2016, would be what currencies to include.  This has likely been determined and a possible list was defined above.  If Japan becomes a founding member of the AIIB than the yen could also become a member currency in the ACU.

Other considerations would be on what trade-weight to use for the component currencies, and what institutions to use to publicize the ACU valuation, such as the AIIB and BRICS Development Bank.

The complexity of not just the AEC and ACU (with the corresponding institutions, such as the AIIB), but also the multilateral monetary framework which is meant to replace the existing unipolar USD framework, is becoming more understood and visible with each passing week and month.

The task assigned to the global monetary authorities to address a sovereign debt issue which they themselves have been mostly responsible for, is by and far the largest mandate in the last 100 years.  Sovereign debt restructuring will need to be segmented into domestic held sovereign debt and foreign held sovereign debt, with different approaches on restructuring for both.  The emerging economies hold more of their sovereign debt domestically, while developed countries hold more of the sovereign debt internationally. The need for regional currencies such as the ACU, and in fact the euro, will both enhance and encourage monetary discipline and direct the course of the debt restructuring and multilateral transition.

The situation with Greece and the rest of European could potentially lead to the exit of Greece from the European Monetary Union and its inclusion into the Eurasian Monetary Union, including the Regional Currency Unit for that arrangement, which is being led by Russia.  – JC