Cooling Off the Hot Money

Continuing turmoil in western financial markets is having one positive effect – it is encouraging East Asian cooperation. The past week has seen moves by two governments, South Korea and Indonesia, to limit currency flows and hence, they hope, volatility.

In the Korean case, the move followed a sharp drop in the value of the won stemming from speculative outflows following tensions over North Korean responsibility for sinking of the South Korean naval gunboat Choenan with the lives of 44 crewmen. In the Indonesian case the measures stemmed from a desire to halt appreciation of the currency due to short term capital inflows. Both had the desired immediate effect.

Both have their origin in the vulnerability of the small to medium sized open Asian economies, either to turmoil elsewhere or to perceptions of risk by market players in the west who may know little about situations other than what appears on Bloomberg headlines. They are also an indirect response to the problems posed by the Yuan/dollar peg.

The measures taken by the two governments are far from draconian and do not fundamentally change their commitment to free currency markets. They fall within the sort of measures suggested by the Asian Development Bank, and more recently even the International Monetary Fund, as ways of limiting the ability of local financial institutions to take speculative foreign currency positions.

Needless to say however, nothing which dampens speculative activity and the mania for derivatives is likely to meet with approval from the Wall Street crowd who raise the specter of “capital controls” at any attempt to limit financial market activity.

In the Korean case, the measures introduced last week simply limit the currency derivative position of its banks. Indonesia's require investors in Bank Indonesia bills to hold them for not less than one month.

Indonesia's currency has risen 12 percent against the dollar and 25 percent against the Euro over the past year. Like Korea it feel inhibited from raising interest rates to offset rising inflationary pressures for fear of yet more upward currency pressure, or fear that a sudden reversal of sentiment will cause alarm among local depositors.

These actions also underline how much pressure the flexible Asian currencies have been facing as a result of China's refusal to end its dollar peg or make its own currency fully convertible. Hong Kong's dollar peg and Taiwan's pariah political status also limit the choices for money in search of new homes. The two most affected have been Indonesia and Korea, but Thailand and Malaysia have both been facing pressure as players already stuffed full of US dollars and exiting a declining Europe have sought refuge in Asia. The Thai baht even rose through the recent Red Shirt troubles.

Malaysia, Taiwan and Thailand have used limited capital control measures in the past but clearly would feel more comfortable if others do the same. Singapore keeps its currency under tight if flexible management.

Prior to the sinking of the Choenan, the won had been appreciating steadily, reflecting its strong trading fundamentals. But its sudden decline, mirroring an even greater one in late 2008, stemmed from perceptions that it faced short-term debt problems. These in fact arose mainly from short term position taking by Korean banks and corporate and did not reflect any underlying creditworthiness. But there is no accounting for the ignorance of dealers in London and New York.

The Greek and related European debt crises have no direct bearing on the Asian situation, where most countries have relatively low debt levels, flexible currencies and strong international reserves. But they have again underlined the twin dangers of sudden changes in market sentiment and contagion can create major money flow problems for middle size countries – problems for their banking sector as a whole, not just currency volatility.

It is significant that Korea has taken the lead in limiting currency exposures. Its own vulnerability is of course one reason. But another is its position both as a member of the G20, which is supposed to be devising improvements in the global financial system and within the Asian arrangements agreed with the framework of the Chiang Mai Initiative linking the countries of ASEAN with China, Japan and Korea.

With China lacking a convertible currency and usually at loggerheads with Japan, Korea is in a particularly strong position. It has half the voting rights of Japan and China and half the combined total of the ASEAN 10. This voting bias reflects Korean determination to punch above its economic weight.

Maybe moves towards an Asian Monetary Fund, now in embryo through the US$120 billion multilateral reserves pooling arrangement agreed last year, will stall because of China's anomalous position. But Korea's moves in the currency market suggest it wants to be seen to be a leader and catalyst in the region.