There has been much talk about whether the Asian economies is decoupling from the US. Will Asia be able to withstand a sharp downturn in the US economy? As of now the answer must surely be “No”. The region remains dependent heavily on the US as the final destination of its exports. There are also many other intricate monetary and financial linkages between the US and Asia, including the heavy dependence on the region on US dollar denominated assets. However, as Asia continues on its path of intensified economic monetary and financial regionalism (MFR), it is plausible that the region can become relatively more independent from the US.

It is in this context that one needs to understand recent ongoings in Asian MFR. There are many gradations of MFR, ranging from the weak form involving regional policy dialogue and surveillance, on the one hand, to exchange rate and monetary coordination, on the other. East Asian economies have made notable strides in promoting policy dialogue. For instance, the Economic Review and Policy Dialogue (ERPD) was established in 2000 to exchange information, conduct regional surveillance, and use of peer pressure for enhancing national and regional policies. The regional economies and have also undertaken a number of steps to enhance “medium” forms of MFR, broadly defined as the development of regional liquidity arrangements and regional financial markets.

In the monetary realm, the most notable medium form of MFR in Asia has been the Chiang-Mai Initiative or CMI. In the financial area, the two main initiatives underway are the Asian Bond Fund (ABF) established by the eleven members of the Executives' Meeting of East Asia-Pacific Central Bank (EMEAP), and the Asian Bond Market Initiative (ABMI) by Asian Plus Three (APT) economies.

While much needs to be done to further the weak and medium forms of MFR, there has, in parallel, been active discussion of the possibility of stronger / deeper forms of MFR. Clearly, effective deepening of regional monetary integration will not happen until there is a considerable strengthening of the regional surveillance mechanism with well worked out surveillance and policy conditionality. While most observers concur that the time is not ripe for Asia to consider a common currency in the near future, there has been some discussion about the possible creation of an Asian Currency Unit (ACU) as a means of deepening monetary integration.

The Asian Currency Unit (ACU) is a weighted average of regional currencies a la the European Currency Unit (ECU) which was created in 1979 under the European Monetary System (EMS) established and remained in operation until the launch of the Euro in 1999. There are in fact at least three rationale for an ACU.

Firstly, as a unit of account; At the micro-level the rationale for an ACU is to afford the opportunity for regional economic agents to invoice regional financial and trade transactions in the ACU, hence reducing the region’s dependence on the US dollar and other external currencies.

The ACU can also be used to devise new instruments that can be easily traded across the border without the underlying exchange rate risk. Importers and exporters can denominate intra-Asia trade in ACU. Asian governments or corporates may wish to issue sovereign or corporate bonds in ACU. The various central banks can hold part of their reserves in ACU and even commercial banks could take deposits and give loans denominated in ACU.

If successful, intra-regional intermediation of savings may be promoted, in the process possibly reducing the region’s exposure to external shocks. However, in reality, it is unlikely that the ACU will be used on a widespread basis for some time to come. The experience of Europe is instructive in this regard. The initial creation of the ECU did not lead to a widespread use of the unit. Even in the 1990s, until the actual creation of the Euro, the vast majority of intra-European financial and trade transactions were not in ECUs but in US dollars primarily and other sovereign national European currencies.

So it is not just the creation that is important; there has to be a coordinated agreement by regional bodies to start transacting in the new unit, failing which no one will want to take the first step. This inertial effect of existing currencies (i.e. advantage of incumbency) is based on the concept of “network externalities” or “lock in” effects, whereby there are limited incentives for economic agents to unilaterally take on a new currency (particularly for invoicing transactions).

A second rationale for an ACU could be to serve as a divergence indicator. The ADB has suggested that in the initial stages the ACU should serve mainly as a means of benchmarking the extent of currency movements and deviations. As the ADB president, Haruhiko Kuroda, noted, “The ACU…could be used to monitor the stability of participating currencies and would tangibly demonstrate the need for greater exchange rate coordination. What Asia needs here is basically an exchange rate that is flexible toward the rest of the world but relatively stable within the region.”

Effectively, as a regional benchmark, the ACU can act as a tool for monitoring foreign exchange market conditions; it could help understand the degree of divergence of each participating countries’ currencies, which might improve the understanding of the idiosyncratic problems in a particular currency’s market, and in pursuing appropriate macroeconomic policies. A final purpose for the ACU would be as an instrument to stabilise exchange rates.

It has also been suggested that the ACU could be used as a means of enhancing internal exchange rate stability if the regional central banks begin to stabilize their respective currencies to the regional unit (i.e. helping reduce the possibility of regional competitive devaluations). The notion of stabilisation vis-à-vis an internal basket a la Europe’s Exchange Rate Mechanism (ERM) is distinct from stabilisation vis-à-vis an external unit which would require that the ACU in turn be pegged in some way to external currencies such as the US dollar or Euro, or some weighted average thereof. Focusing on the notion of stabilisation vis-à-vis an internal basket (i.e. regional currencies benchmarking movements to the ACU), while the potential microeconomic benefits noted above do not require internal stabilisation, the latter could promote the more widespread use of the ACU. This is so as the regional central banks will automatically begin to use the ACU more extensively as a reserve and possibly even intervention currency, thus providing an additional inducement for private agents to intensify use of the unit in invoicing and transactions.

Nonetheless, given the divergences in economic and institutional structures in the region, absent macroeconomic policy coordination and mechanisms for automatic intraregional fiscal transfers, any attempt at formal exchange rate coordination -- including internal stabilisation vis-à-vis the ACU - is far too risky and premature and will likely be a failure, setting back prospects for other forms of economic integration. One feasible way forward for Asia might be for the region to establish an ACU as a parallel currency, with regional economies free to choose among themselves if and to what extent they want to manage their respective currencies against the ACU as well as external currencies such as the US and the Euro.

It is important to keep in mind that management does not involve pegging. One could, for instance, think of a band-basket-crawl (BBC) arrangement where each country chooses different weights in the basket, size of band and extent of crawl. Over time, if there is a convergence in trade and investment structures in the region, consideration could be given to the creation of a common BBC arrangement which involves the management of the exchange rate against a common basket of currencies which includes the ACU, the US dollar and the Euro.

The eventual aim would be to manage individual nominal exchange rates to maintain fluctuation of the common basket index within a band so as to ensure relative stability of their effective exchange rates. Clearly it would be premature to consider harmonisation of Asian exchange rate and monetary policies to a common currency basket at this stage (let alone a currency union based on the ACU) when neither the economic nor the political preconditions exist to do so. Attempting rigid policy coordination before the necessary preconditions are met would be like putting the cart before the horse; it is doomed to fail.

While the ACU cannot be viewed as an attractive nominal anchor for Asian currencies in the near-term, it could potentially have a role to play in Asian monetary and financial cooperation in the future. This in turn should help the region gain a greater degree of economic resiliency and reduce its heavy dependence on the US dollar and the US economy.