China's engagement in East Asian financial integration

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China’s engagement in East

Asian financial integration

By Judith Huismans

24-06-2016

Candidate number: 10002265

Department: Graduate School of Social Sciences

Supervisor: Julia Bader

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Abstract

This thesis uses Mattli’s framework to resolve the controversy in the literature whether political or economic factors are decisive for East Asian financial integration. It looks at how China’s engagement in East Asian financial integration causes Mattli’s demand and supply conditions to be fulfilled, successfully establishing East Asian financial integration. The research question therefore is: How did China’s engagement help to shape East Asian financial integration? This thesis answers this question by tracing the process of East Asian financial integration from the Asian crisis in 1997 up until now. It finds that China’s economic embeddedness is of great importance for understanding its demand for financial integration. However, China was not an undisputed leader as it shared the stage with Japan. Their cooperation was of great importance for resisting US opposition to East Asian financial integration.

Key words: financial integration, East Asia, China, financial crises, regional liquidity

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List of abbreviations

AMF - Asian Monetary Fund

AMRO - ASEAN+3 Macroeconomic Research Organization

APEC - Asia-Pacific Economic Cooperation

ASEAN - Association of Southeast Asian Nations

ASEAN+3 - ASEAN plus China, Japan, and South Korea

BSA - Bilateral Swap Arrangement

CMI - Chiang Mai Initiative

CMIM - Chiang Mai Initiative Multilateralization

CMIM-PL - CMIM Precautionary Line

CMIM-SF - CMIM Stability Facility

EAC - East Asian Community

EAS - East Asian Summit

ERPD - Economic Review and Policy Dialogue

FDI - Foreign Direct Investment

IMF - International Monetary Fund

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1. Introduction

In the 21st_{century, China’s rise will have many implications for international relations and the} existing world order, but also for the East Asian region in particular. This makes China’s regional engagement in East Asia an interesting research topic. An important example of China’s regional engagement in East Asia is financial integration. The Asian crisis in 1997 and the global financial crisis that started in 2008 have had great implications for the region and spurred China’s engagement in financial stability in the region. Therefore, China’s engagement in East Asian financial integration is the topic of this thesis.

There is a controversy in the literature whether political or economic factors are decisive for East Asian financial integration. Mattli’s (1999a, b) framework reconciles both of these aspects and will therefore be used. He argues that two sets of conditions must be satisfied in order for integration to succeed, namely, demand side and supply side conditions.

In his article, Mattli (1999a) is quite negative concerning ASEAN’s chances of success. Regarding demand conditions, he states the following: the members of ASEAN export the bulk of their primary commodities and manufactured goods to the same world markets. Most of their economies are not complementary. Also, there were problems on the supply side: according to Mattli, there is a coordination dilemma (Mattli, 1999a: 20). However, this holds true only for ASEAN itself, not for ASEAN+3, which includes China. This thesis will look at how China’s engagement in East Asian financial integration can cause these demand and supply conditions to be fulfilled, successfully establishing East Asian financial integration. Thus, this thesis answers the following research question: How did China’s engagement help to shape East Asian financial integration?

In short, this thesis finds that regarding the demand condition for East Asian financial integration, China’s economic embeddedness is of great importance for understanding its demand for financial integration.

Regarding the supply condition, it has to be concluded that China did not act as an undisputed leader. In fact, there were two leaders: China and Japan. The dynamic between these two countries shaped East Asian financial integration. However, China’s leadership was necessary

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6 as Japan alone was not powerful enough to resist the United States and International Monetary Fund.

The thesis is organized as follows: Section 2 defines financial integration and describes the current state of East Asian financial integration. Section 3 reviews the existing body of literature regarding East Asian financial integration. Section 4 presents the theoretical framework, which will go into Mattli’s framework extensively, but also discusses alternative explanations. Section 5 will go into the methodology used, namely process tracing. Section 6 discusses the findings. Section 7 concludes and gives recommendations for further research.

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2. The current state of East Asian financial integration

How far does financial integration in East Asia actually go? This section will focus on the current scope of financial integration in East Asia by looking at what institutions and organizations are in place.

First of all, it is important to define regional financial integration. Mattli (1999b: 41) defines integration in the following way: “integration is the voluntary linking in the economic domain of two or more formerly independent states to the extent that authority over key areas of domestic regulation and policy is shifted to the supranational level”. Regional integration than is the process of providing common rules, regulations, and policies for a region (Mattli, 1999b: 44). Finally, regional financial integration is defined in the following way: “regional financial integration is the process through which a country's financial markets become more closely integrated with those in other countries in the region” (Krapohl, 2015: 164).

Regional financial integration can take several forms, for example emergency liquidity assistance, development of regional capital markets and currency management. In East Asia, most progress has been made in the first form of financial integration: emergency liquidity assistance (Cohen, 2013). This entails the sharing of liquidity by the region’s countries. Participating countries earmark parts of their reserves for a regional liquidity arrangement. In times of a financial crisis, these countries are not only able to use their own reserves, but the funds of other participating countries as well. These funds can be provided either by swap agreements or as systems of credit lines. With such regional arrangements, governments can increase their leverage in times of crises without giving up as much influence on the conditions of loans as in the case of global financial solutions (Dieter and Higgott, 2003).

In East Asia, this was done via the Chiang Mai Initiative (CMI), which was followed by the Chiang Mai Initiative Multilateralization (CMIM). This initiative comes from ASEAN+3, which includes the ten members of the Association of Southeast Asian Nations (ASEAN) plus China, Japan, and South Korea. ASEAN+3 has become the principal forum for financial regionalism in East Asia (Cohen, 2013: 42).

Launched in May 2000, the CMI established a network of bilateral swap arrangements (BSAs) between China, Japan and South Korea on the one hand and members of ASEAN on the

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8 other hand. The ‘+3’ countries promised to make dollar resources available to selected ASEAN members in times of crisis, in exchange for local currency (Cohen, 2013: 42).

The roots of the CMI go back to Japan's failed proposal for an Asian Monetary Fund (AMF). In 1997-1998, the Asian crisis largely affected countries in the region. As a result, Tokyo proposed a regional liquidity arrangement called the AMF, to help protect local currencies against speculative attacks. Nothing came of this proposal, but the idea of some kind of mutual safety net survived and eventually took shape in the CMI (Cohen, 2013: 43).

Great hopes have been placed in the CMI as the foundation for increasingly close financial relations in the region. However, achievements have been modest. For example, for a BSA network to function effectively, it must be supported by an independent surveillance system. Governments are reluctant to lend to a neighbor in time of crisis unless they can have some degree of confidence that they will be paid back. A surveillance mechanism is important to ensure that borrowers undertake the needed policy adjustments. However, there are little improvements regarding such an independent surveillance mechanism (Cohen, 2013: 43).

Furthermore, there is a link to the IMF which causes problems. Member countries agreed that participants would be authorized to draw funds only up to 10 percent of the contractual amount of a BSA (this percentage later increased). Beyond that limit participants would have to place themselves under IMF rules. In the absence of a regional surveillance mechanism, the link is necessary to protect the credibility of the CMI. However, it had an important chilling effect on the behavior of participants. No participating country has ever actually drawn on a BSA, not even during the global crisis in 2008-2009 (Cohen, 2013: 43-45).

In an attempt to overcome some of these limitations, governments agreed in 2005 to "multilateralize" the CMI, pooling funds together to enhance the amounts that any single country might draw when in need. Four years later, at the time of the global crisis, action took place and the CMI was transformed into the CMIM (Cohen, 2013: 43-45).

Some scholars see the CMIM as a significant step toward realizing Japan's original plan of an AMF. In practice, however, crucial details are unclear, concerning especially issues of borrowing accessibility, lending terms, and how funds will be disbursed (Cohen, 2013: 43-45).

A second form of financial integration, the area or regional capital markets, has shown moderate improvement. The concept of a regional capital market entails a situation in which

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9 there are no obstacles to the movement of capital or the provision of capital market services. Common obstacles are regulatory barriers, such as exchange control and ownership restrictions; information barriers, such as lack of transparency in trading or corporate disclosure; and unequal treatment of nondomestic participants, such as mistreatment of minority shareholders. There may also be structural barriers, such as monopolistic structures, which restrict access for nondomestic participants; or taxation barriers, such as withholding taxes, which apply unequally to nondomestic participants. If these barriers are overcome, it becomes easier to invest, raise capital or provide services throughout the region (Romero-Torres et al., 2013: xiv).

In East Asia, regarding regional capital markets, two projects have been initiated - the Asian Bond Market Initiative (ABMI) and the Asian Bond Fund (ABF) - both intended to correct for private-sector vulnerabilities which contributed to the Asian crisis in 1997-1998. The aim of the ABMI, an initiative by the ASEAN+3 countries, was to promote infrastructural improvements that might foster local financial development, aiming to eventually create one regional capital market for all of East Asia. The purpose of the ABF, initiated by countries in the Asian-Pacific region, was to increase liquidity in Asian capital markets, mainly through purchases of local government bonds by regional central banks. In practice, capital market integration is still a long way off. Although the volume of new debt issues has grown, markets remain thin and dependent on government bonds of relatively short maturity. Furthermore, the amounts of money committed by regional governments is small (Cohen, 2013: 42).

Finally, although there have been several proposals, the least progress has been made in the area of currency management. Currency management addresses every aspect of the interactions between national monetary, fiscal, and exchange-rate policies. In East Asia, proposals include closer coordination of interest rates and spending programs, various forms of mutual exchange rate stabilization and the creation of an Asian currency unit or even a formal monetary union, complete with a joint central bank and a common currency similar to the Euro. In practice, individual monetary regimes remain very diverse, ranging from currency boards at one extreme to free floating at the other (Cohen, 2013: 41-42).

The focus of this thesis will be on regional liquidity arrangements in particular. Despite its downsides, it is still the most important forum for financial integration in East Asia.

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3. Literature review – political and economic explanations to

East Asian financial integration

In the literature, there is a clear controversy whether political or economic factors are decisive for East Asian financial integration.

Krapohl (2015) stresses the importance of economic factors. He argues that although ASEAN itself is a developing region with low levels of economic interdependence, this picture is different for ASEAN+3, as industrialized Japan and economic powerhouse China are included. The rise of the Chinese economy strengthened China’s economic activity in the region. China is embedded in the region through a high volume of trade and production sharing with countries throughout the region. Therefore, China does not accept Japan to dominate the regional financial architecture. According to Krapohl, the Chiang Mai Initiative (CMI) is an instrument of China and Japan to stabilize East Asia, whereas they themselves do not profit directly from the regional liquidity arrangements. Thus, Japan and China bear a disproportional share of the cooperation costs, whereas only the ASEAN member states and South Korea profit directly from the initiative. The reason for this is the economic embeddedness of the two countries within their region: it provides an incentive to invest at least some resources in order to stabilize their neighborhood in financial terms (Krapohl, 2015: 167-168).

Ravenhill (2010) argues that this economic embeddedness is overstated. He argues that not economic factors, but political factors are most important for East Asian financial integration. A detailed examination of economic data finds no support for the argument that intra-regional economic interdependence in East Asia has increased significantly since the financial crises (Ravenhill, 2010: 178).

In line with Ravenhill, Cohen (2013) also argues that political factors are more important than economic ones. First of all, he argues that the countries in the region are not that deeply integrated. On the economic side, there are several impediments to integration. The countries in East Asia are very diverse when it comes to economic structure and level of development. Moreover, financial ties among the economies of the region are weak. At the macroeconomic level there are few signs of convergence. Business cycles across the region are not synchronized, and little correlation exists in inflation or growth rates. For these reasons, Cohen argues that

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11 political arguments are of greater importance than economic arguments, and currently political will is lacking. First, there is a lack of coherent leadership. There are two plausible leaders, Japan and China, which leads to rivalry. Furthermore, there is also a lack of genuine solidarity in East Asia, as there is no common identity (Cohen, 2013). However, there is still hope. Cohen contends that a reverse causation may also be at work, a process by which tentative steps toward financial regionalism could have the effect of moderating political tensions. Crises can raise the appeal of cooperation, thus leading to the institutionalization of initiatives such as the CMI (Cohen, 2013).

Other authors neglect demand factors. Park (2012) focuses on the topics of political will and regional leadership. He argues that the historical lack of regional leaders in East Asia has been one of the most important causes for the underdevelopment of East Asian regionalism. The rise of China and Japan as regional leaders and their cooperative competition in the late 1990s served as the centripetal force for the establishment of ASEAN+3. However, since the early 2000s, Sino–Japanese conflictive competition has made the idea of East Asian regionalism contested (Park, 2012: 312). Thus, regional leadership dynamics in East Asia have shifted from the absence of regional leaders to Sino–Japanese cooperative competition to their conflictive competition (Park, 2012: 290).

Chey (2009) also focuses on the relationship between China and Japan. In the past, Japan’s problems with its historical legacy, as well as its fears of growing Chinese economic and military power were a problem for cooperation (Chey, 2009: 455). China also showed reluctance in the past. It placed great emphasis on its own autonomy, a key reason being its concern that in multilateral settings it could be outvoted and have its bargaining power decreased. Therefore, China maintained a passive approach toward regional cooperation (Chey, 2009: 459). However, political dynamics of East Asian financial cooperation have changed substantially, and that this has led to successful integration. Of critical importance is the cooperation between Japan and China. Since the 1997 crisis, Japan has willingly taken the initiative on regional financial matters, while China has become more willing to support East Asian financial cooperation. China has changed its stance, so that it now puts higher priority on reducing US influence in the region than on limiting Japan’s role. Thus, China has begun to view regional arrangements as effective means of reducing American influence in East Asia. Meanwhile, China has grown increasingly tolerant of seeing Japanese gains in the region, insofar as China can also gain (Chey, 2009: 462-463).

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12 Also focusing on political factors, Grimes (2015) paints a less positive picture. CMIM is threatened by the potential for internal divisions (Grimes, 2015). The leading East Asian states have developed other, non-regional, options for preventing and resolving regional currency crises. Four members of the ASEAN+3 (China, Indonesia, Japan and South Korea) are also members of the G20, which has had considerable influence in modifying the agenda of the IMF, which makes regional solutions less important. Perhaps more important, China and Japan have recently concluded or expanded bilateral swap agreements with Asian neighbors. These swap lines stand outside the CMIM framework. As such, they threaten CMIM’s long-term relevance (Grimes, 2015: 147).

As could be seen from the literature, there is a controversy whether political or economic factors are decisive for East Asian financial integration. I however argue that both aspects are intertwined, and therefore we need a framework that accommodates both perspectives. An analysis of integration that neglects to incorporate institutional elements risks being empty. First of all, integration takes place in a particular institutional setting. It also carries with it institutional implications which, in turn, affect the course of integration. A dynamic account of integration must consider the reciprocal relationship between economic and politico-institutional factors (Mattli, 1999a: 8).By using Mattli’s framework that reconciles both of these aspects, I will try to solve the controversy in the literature. Mattli’s theory has not yet been fully applied to East Asian financial integration. Looking extensively at demand (economic factors) and supply (political factors) in one coherent framework will help to solve the controversy in the literature. As can be seen in the existing body of literature, most articles focus on supply, either taking demand for granted or arguing that demand is not as important as it seems (e.g. Ravenhill, 2010). However, demand comes prior to supply and is relevant for understanding integration. This thesis will look more extensively at these demand factors, for example by also taking into account informal networks (Peng, 2002). Furthermore, none of the articles focus specifically on China’s role in East Asian financial integration. Finally, most articles study a specific event (e.g. a crisis), but do not look at the entire time period to see how financial integration in East Asia has evolved over time. This thesis will look at financial integration in East Asia from 1997 up until now, looking extensively at the AMF proposal, the CMI and the CMIM.

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4. Theoretical framework

This theoretical framework focuses on the conditions for regional financial integration.

4.1 Mattli’s political economy approach

An account that looks at the dynamics of integration must consider the reciprocal relationship between economic and politico-institutional factors (Mattli, 1999a: 8). In other words, two sets of conditions must be satisfied in order for integration to succeed: demand side and supply side conditions.

Demand side

In short, the demand side argument is that regional institution-building may be viewed as an attempt to internalize externalities that cross borders within a group of countries (Mattli, 1999b: 13).

This demand side condition is derived from insights provided by economic institutional theories, such as property rights theory, economic history, and new institutional economics (Mattli, 1999b: 44). Property rights theory holds that the demand for institutional change comes from the bottom, from actors incurring the greatest opportunity cost in the institutional status quo (Libecap, 1996; Davis and North, 1971; Demsetz, 1969). For example, Libecap (1996) studied the evolution of property rights for mineral resources in the United States. He found that the law changed in response to changes in economic value: as the value of a resource increased, claimants of the resource had an incentive to demand more precision in the definition of property rights in order to capture more fully the potential rental stream from the resource (Libecap, 1996).

The economic history school refines the analysis of the impact of new technologies on markets and institutions by introducing the concept of transaction costs. Transaction costs are the costs of specifying, negotiating, monitoring, and enforcing contracts that underlie exchange. North’s (1985) account of the Industrial Revolution is an important example of the economic history school. New technologies eased communications and shortened distances, thus increasing the size of markets. This had two effects. First, it created pressure to replace medieval and crown restrictions circumscribing entrepreneurs with better specified common law. Second,

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14 the growing size of the market caused a shift from vertically integrated production to specialization. This specialization increased the costs of measuring the inputs and outputs, thus catalyzing organizational innovation to reduce these transaction costs. In short, technological change led to increased specialization which induced organizational innovation; this induced technical change, requiring further organizational innovation (North, 1985).

Transaction costs also play a central role in the new institutional economics (NIE) literature (Williamson, 1975; 1985). NIE theory takes as given the political rules of the game and the production technology. It seeks to explain industrial organization, based only on differences in transaction costs. In particular, the higher the asset specificity (the degree to which durable investments are made to support particular transactions), the greater the institutional complexity required to promote efficient exchange (Williamson, 1985).

Mattli (1999a) extrapolates these theories to an account of demand-side conditions for regional integration. The previous theories provide a first building-block for an account of regional integration. The argument is as follows: “as new technologies increase the scope of markets beyond the boundaries of a single state, actors who stand to gain from wider markets will seek to change an existing governance structure in order to realize these gains to the fullest extent” (Mattli, 1999a: 10).

What are the potential gains from wider markets? Theories of international trade and investment have identified several sources of gains. Trade theorists argue that larger markets help firms to achieve economies of scale in production. Another argument is that trade is beneficial because it permits countries to exploit their comparative advantage. A country gains from specializing in the production and export of those goods which it can produce at relatively low cost (i.e. goods in which it is relatively more efficient than other countries). In addition to these gains from trade, there are also investment gains. Investment theorists argue that firms operating in a given country may accumulate special production advantages over their counterparts in other countries such as cheaper sources of finance, special managerial and marketing skills, and patented or non-marketable technologies. These firm-specific intangible assets provide strong incentives for expanding production abroad, particularly if pulled by location-specific advantages in host countries (such as low labor or material costs) (Mattli, 1999a: 10-11).

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15 However, the costs of international trade and investment transactions can be prohibitive. First, there is uncertainty: civil unrest or economic mismanagement may render foreign assets or trade-related domestic investment worthless. Second, a wide range of ex post hazards due to either firm-level or government-level opportunism may reduce the profitability of international exchange. In addition, a host country can revert to nationalization of foreign assets (Mattli, 1999a: 11).

Firms can seek to minimize transaction costs that arise from firm-level opportunism through private contractual arrangements (Yarbrough and Yarbrough, 1992). However, this does not come without costs. Removing transactions from markets and organizing them internally may sacrifice economies of scale and scope. Internal organizations may also experience serious incentive and bureaucratic disabilities (Williamson, 1985). These problems may make external safeguards in the form of an integrated governance structure more appealing. External safeguards can address not only firm-level problems but also government-level opportunism (Mattli, 1999a: 11).

Based on this account, Mattli’s demand side argument is the following: regional institution-building may be viewed as an attempt to internalize externalities that cross borders within a region (Mattli, 1999a: 3). The following definitions of externalities and internalization are given: “Externalities involve an interdependence of utility of production functions. A negative externality lowers the utility or production of an affected party. For example, the upstream pulp mill which discharges effluent in the river thus reducing the scope for fishing downstream is said to impose an externality on the fishermen. Internalization describes the process of taking into account an externality and reducing the output of the offending good to its optimal level, i.e., the level at which the cost of reducing the externality (by a further unit) is equal to the benefit from such a reduction” (Mattli, 1999b: 13). Externalities affecting cross-border trade and investment arise from economic and political uncertainty as well as a wide range of financial risks that market actors face when dealing with foreign firms and governments. The cost of these externalities increases as new technologies raise the potential for gains from market exchange, thus increasing the payoff to regional governance. Market players who stand to gain the most from new exchange have a strong incentive to lobby for institutional arrangements that render the

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16 realization of these gains possible. Therefore, big business’ demand for regional rules, regulations, and policies is a critical driving force of integration (Mattli, 1999a: 3).

Supply side

However, demand is not enough for integration to succeed. Economic institutional theories have overlooked supply conditions: the importance of a regional leader who supplies the collective good ‘regional integration’ (Mattli, 1999a: 3-4).

This importance of regional powers for the integration of their respective world regions is derived from hegemonic stability theory (Gilpin, 1981; Kindleberger, 1973; Krasner, 1982). According to such realist reasoning, international co-operation will only occur if a benevolent hegemon has interests to provide a collective good on behalf of a group of states. This is based on rational choice theory: a leader is needed to resolve collective action problems that arise when no state in interaction with others can choose its policy without knowing what the other states intend to do, but there is no obvious point at which to coordinate (Kindleberger, 1973).

Mattli (1999a) has applied this argument to the regional level and has pointed out that a regional benevolent hegemon is necessary. Such a benevolent hegemon needs to provide leadership and act as a regional paymaster in order to compensate smaller member states for distributive losses due to regional integration (Mattli, 1999a).

Mattli’s argument is the following: supply conditions are the conditions under which political leaders are willing and able to accommodate demands for functional integration. Willingness depends greatly on the payoff of integration to political leaders. If these leaders value political autonomy and power, they are unlikely to seek deep levels of integration as long as their economies are relatively prosperous. In other words, economically successful leaders are unlikely to pursue deeper integration because their expected marginal benefit from integration in terms of retaining political power is minimal and not worth the cost of integration (Mattli, 1999a: 12). This argument is consistent with the insights from the rent-seeking literature which argues that political leaders value relative independence and “bribe-money” from small and effectively organized groups that stand to lose heavily from integration (Magee, Brock and Young, 1989; Krueger, 1974; Becker; 1983).

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17 However, in times of economic difficulties, political leaders will be more concerned with securing their own survival and are thus likely to implement economic policies that enhance the overall efficiency of the economy (Mattli, 1999a: 12). Distributional considerations become of secondary importance, thus eliminating entrenched interest groups’ resistance to integration (Rodrik, 1994). Webber (2001) argues that these economic difficulties must be seen as an additional ‘background condition’ of integration. He argues that this weak pre-condition of integration sits poorly with the fact that in Europe, integration has tended to proceed most smoothly and rapidly in periods of higher economic growth. Even if economic difficulties should have provided a motive for integration, it is hard to argue, that they have a strong influence on the success or failure (as opposed to launching) of attempts at regional integration (Webber, 2001: 345).

Mattli (1999a) goes on to say that willingness brought about by economic difficulties does not guarantee successful integration, as even willing political leaders may be unable to supply regional integration because of collective action problems such as the Prisoner’s Dilemma (PD) and the Coordination Dilemma (Snidal, 1985; Stein, 1983). The PD problem is one of freeriding. “Freeriding” here means defecting from the obligation to contribute to the building of an integrated economy while enjoying the fruits of the joint effort by others. It is mitigated if ‘commitment institutions’ are established, such as centralized monitoring and third-party enforcement. The provision of such institutions is one supply condition for successful integration, but it is a weak one. In its absence, cooperation may still be possible (Mattli, 1999a: 4).

The problem in the Coordination Dilemma is one of agreeing on one of several possible courses of action in a situation in which states have opposing interests. In short, the problem in the coordination game is one of choice between multiple stable and efficient equilibria over which states have opposed interests; whereas in the Prisoners’ Dilemma game the problem is how to get away from a single but inefficient equilibrium (Snidal, 1985). With regard to integration, this may include efforts to adopt common rules of origin, common commercial policies, common investment codes, common health and safety standards, or common macro-economic policies. Coordination also gives rise to distributional issues, as a chosen course of action benefits some states within the group more than others. These observations lead to a key supply condition for successful integration, namely the presence of an undisputed leader among

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18 the group of countries. Such a state serves as focal point in the coordination of rules, regulations, and policies. Furthermore, it may also help to ease distributional tensions by acting as regional ‘paymaster’ (Mattli, 1999a: 4).

This assumption of an undisputed leader sparks some controversy in the literature. By using the EU example, Webber (2001) questions whether it is correct to argue, as Mattli does, that Germany is the ‘undisputed leader’. While it is indeed undisputed that Germany has acted as the EU’s ‘paymaster’, it is more controversial to regard it as the principal ‘focal point’ of policy coordination. He argues that a more plausible interpretation of the EU’s history would be that leadership has been provided by a coalition of France and Germany, whose governments have developed an intensive bilateral relationship (Webber, 2001: 344-345). Park (2012) also goes into the possibility of multiple regional leaders. He argues that there is no consensus on the implications of the existence of multiple regional leaders in a region. Whereas Mattli (1999a, b) assumes that multiple potential leaders in a region would incur a coordination problem which would become an obstacle to regional integration, neo-liberals implied that multiple regional powers could exercise leadership collectively provided that sufficient mutual interests, or at least compatible interests, exist (Park, 2012: 296). Snidal (1985) also argues convincingly that small sub-groups of cooperative states can provide collective goods on behalf of bigger groups (Krapohl, 2015: 165). Furthermore, Tallberg (2006) has stressed that supranational institutions can also fulfil a leading role, providing policy innovation and reducing policy-based disputes among member states. In 2012, Mattli himself has therefore argued that further research designed to specify more fully the different mechanisms for overcoming co-ordination dilemmas is needed (Mattli and Stone Sweet, 2012: 6-7).

It is important to mention that Mattli’s theory is geared toward explaining, in ‘comparative statics’ terms, why some integration schemes succeed and others fail. It does not attempt to explain how any governance within a specific regime will evolve over time (Mattli and Stone Sweet, 2012: 8). Although Mattli’s framework is comparative in nature and not necessarily meant to look at the evolvement of one regime over time, this thesis not just looks at the evolvement of East Asian integration over time, but also looks at different initiatives (AMF, CMI and CMIM), which makes it a useful framework, as these initiatives and the outcomes can be compared.

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4.2 Application to financial integration

According to Webber (2001), Mattli’s focus is clearly on the integration of markets and the policies required to achieve this. However, in some regional integration schemes, there might be stronger emphasis on the integration or coordination of other kinds of policies (Webber, 2001: 344).

Mattli’s theory can also be applied to financial integration. In the case of financial integration, with regard to the demand side, externalities of financial crises are of great importance (Krapohl, 2015).

The risk of financial crises in countries with less developed domestic capital markets results from pro-cyclical international capital flows, from balance sheet mismatches and from the herd-like behavior of international investors (Fischer, 1999). First, countries are in theory thought to borrow money in bad times and to pay back debts in good times. However, on the contrary, countries which rely on international capital are often faced with high capital inflows in good times and declining capital flows in bad times. This aggravates their economic cycles (Krapohl, 2015: 163).

Second, in countries where domestic capital markets are less developed, market participants often show balance sheet mismatches (Perry, 2009). This can be the case either because long-term investments are financed via short-term borrowing (maturity mismatch) or because liabilities are denoted in foreign currencies (currency mismatch) (Krapohl, 2015: 163).

Finally, these problems are reinforced by a collective action problem, which is inherent to imperfectly informed markets. Market participants often do not evaluate borrowing countries based on their specific economic fundamentals, but based on the evaluation of other market participants. As a result of these three mechanisms, liquidity problems may result in insolvency problems if debtors need new credits in order to roll over existing liabilities but creditors are not willing to provide new funds (Krapohl, 2015: 163). This can lead to financial crises.

Financial crises within single countries can negatively affect neighboring countries in the same region. Neighboring countries may be affected by indirect economic consequences (Glick and Rose, 1999). For example, countries which are suffering from financial crises fall away as trade partners, the returns on foreign direct investments (FDI) within the countries are reduced and they may not be able to pay back their debts (Krapohl, 2015: 164). Furthermore, if financial

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20 markets lose confidence in the soundness of countries’ economic policies, they may easily reevaluate the economic policies of neighboring countries as well. This way, financial crises spill over and affect other regional economies (Pericoli and Sbracia, 2003).

From the demand side, regional powers may profit indirectly from financial stability in their neighborhoods. This depends on their economic and institutional embeddedness within these regions. First, economic embeddedness means the flow of trade and capital (in the form of investments and loans) between the states in the region. The more the regional powers trade within the region, the more they invest in neighboring states and the more loans they grant to their neighbors, the more problematic it is if these neighbors suffer from crises. Institutional embeddedness refers to the strength of regional institutions. These institutions indicate commitments of the member states towards common policies (Krapohl, 2015: 165). Thus, regional powers’ interest in regional financial integration should correlate positively with their own economic and institutional embeddedness within the region (Krapohl, 2015: 162).

From the supply side, financial stability is a collective good for the respective regions. When providing that good, the member states of respective regional groups are facing a prisoner’s dilemma. They all profit from financial stability, but each of them prefers not to provide the necessary funds(Krapohl, 2015: 165). Therefore, it is important that there is a regional leader who supplies the collective good ‘regional integration’.

Economic and/or institutional embeddedness of regional powers is a structural precondition for regional powers to bear the costs of regional financial stability,but this becomes visible only in times of crises. Financial crises open policy windows for the creation of regional liquidity arrangements because negative externalities become visible for the regional powers. Whether regional powers seize the opportunity depends on the embeddedness. The more the regional powers are economically and institutionally embedded within their regions, the more they suffer from regional financial crises and the more costs they accept in order to stabilize their neighborhood by establishing regional liquidity arrangements (Krapohl, 2015: 165).

Regional powers themselves cannot be stabilized by their smaller neighbors. Regional powers can provide resources to bail out their smaller neighbors in case of crises, but it is much harder for the smaller economies to bail out the huge economies of regional powers. As a result,

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21 regional powers may insure their neighbors against financial crises, but they can hardly be insured themselves (Krapohl, 2015: 165). Hence, they act as a ‘regional paymaster’.

4.3 Hypotheses – conditions for financial integration in East Asia

This theoretical framework leads to the following hypotheses:

H1: the demand condition for East Asian financial integration is that China is highly embedded in the region, and therefore stands to reap important gains from integration, as it protects China from suffering from externalities of financial crises.

H2: the supply condition for East Asian financial integration is that the group is led by China as an undisputed leader, which serves as an institutional focal point and regional paymaster.

H3: a further (weak) supply condition for East Asian financial integration is the existence of monitoring and third-party enforcement.

4.4 Alternative hypothesis – US engagement

All the above variables relate to the internal dynamics of regions. However, Webber (2001) and Katzenstein (1996) argue that an external actor, namely the United States, has affected regional financial integration in East Asia in important ways. A critical determinant of the relative strength of European, and relative weakness of Asian, regional integration lies in power and norms in the international system. Specifically, it lies in the attitude taken towards integration in the region by the United States. Following the World War II and during the Cold War, the US encouraged the growth of regional integration in Western Europe. This was not the case in Asia, as they preferred bilateral relations. As the US was more powerful vis-à-vis Asian states than in relation to European states, it could block any initiatives to create strong Asian regional institutions, especially those from which the US was to be excluded and which seemed detrimental to US interests (Katzenstein, 1996).

Webber (2001) argues that the attitude of the United States to integration in a given region can only explain cross-regional variations in integration to the extent that the states in the region, especially those whose stance is critical for the ‘success’ of any attempted integration,

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22 are vulnerable to American influence. This could be the case if they depend on the US for the provision of their external security and/or as an export market (Webber, 2001: 347).

Chey (2009) argues that the region is indeed vulnerable to US influence. The US is a key actor in security affairs in the region. The US is also critical as an end market for East Asian economies’ exports, and thus for their vitality, which makes it important that East Asian countries accommodate US interests (Chey, 2009). On the other hand, as the Cold War has ended, states in some regions may now be less dependent on the US for the provision of their security and consequently less susceptible to US influence (Webber, 2001: 347).

Therefore, an alternative hypothesis would be that an important condition of successful financial integration in East Asia is a positive attitude of the US towards regional integration efforts.

This importance of US engagement does not fit into Mattli’s internal logic of integration as described in the theoretical framework. However, Mattli’s (1999b) broader theory as put forward in his book also knows an external logic of integration. This external logic focuses on the effects of community building on outsiders (Mattli, 1999b: 59). A successful regional integration project can create external effects on countries that do not participate in the process (Mattli, 1999b: 59).

What forms do external effects take? An important effect is relative loss of market access. Countries outside an integrated group may face discriminatory trade policies. Another effect is investment diversion. Rapid economic growth in a union may increase the share of international investment directed to union members at the expense of outsiders (Mattli, 1999b: 59-60).

If the impact of these effects is not noticeable – if economic growth remains robust – the leaders in outsider countries have no incentive to consider institutional change (Mattli, 1999b: 61). However, if the external effects are noticeable, elected officials, mindful of their re-election chances, are likely to change course and embrace pro-integration agendas (Mattli, 1999b: 61).

He argues that states that are negatively affected by regional integration schemes to which they do not belong will respond either by seeking to merge with the area generating external effects (first integrative response), or – if that option is deemed impossible or too costly – by creating their own regional group, a counter-union (second integrative response) (Mattli, 1999b: 128).

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23 In short, the external logic explicates the conditions under which integration may trigger integrative responses in outsider countries (Mattli and Stone Sweet, 2012: 6). However, this external logic says nothing about how a counter-union or the engagement of external actors in general affects the prospect of success for the initial integration project. In other words, he focuses on the effects of community building on outsiders, not on the effects of these outsiders on the initial community building. I would argue that in the case of US engagement, there is a reciprocal relationship. The US is affected by East Asian financial integration, but in turn also strongly influences this integration. This reciprocal relationship is missing in Mattli’s framework of regional integration.

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5. Methodology

To answer the research question of how China’s engagement helped to shape East Asian financial integration, this thesis uses a qualitative research design. My aim is to explain the case of East Asian financial integration from 1997 up until now by using Mattli’s framework. This time frame is chosen as the Asian crisis started in 1997 and this spurred integration in East Asia for the first time.

Using a case study has several shortcomings. Most importantly, it is difficult to generalize. For this thesis, as different regions are not compared, it is difficult to say something about the validity of Mattli’s theory in other cases. However, the strength of using a case study for my research is that it’s possible to focus on and inquire a specific phenomenon in depth, in this case East Asian financial integration. This is of importance, as simply looking at the actual signing of a treaty is not enough, but the period before and after also need to be analyzed. This is necessary in order to know for which reasons integration took place, and whether this integration is successful. Mattli (1999a) argues that one must look at defining events that precede interstate bargains and events that follow instances of bargaining, as the majority of integration schemes have failed at the implementation stage (Mattli, 1999a: 6). The decision to adopt an integration treaty is seen as given, as the signing of such a treaty only signifies a promise by the leaders of several states to engage in a particular course of action over a period of time towards the aim of integrating. True integration is achieved through the implementation of this promise, which entails a lengthy process of establishing common rules, regulations, and policies (Mattli, 1999a: 2-3).

My method of analysis is process tracing. I will look at how East Asian financial integration came about. In doing this, I will focus on if and how China engaged with this at specific points in time, and for what reasons. Process tracing allows me to focus on these issues in depth and look at the rationale behind it. A limitation to process tracing is that there is a risk of confirmation bias when using this method (Bennet and Checkel, 2012: 30). To avoid this, I will consider possible alternative explanations as well.

When using process tracing, it is of importance to define critical moments. Cohen (2013) notes that scholars of international relations have long noted the potentially positive role of

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25 crises for cooperation. The classical definition of a crisis is attributed to Hermann (1972), who mentions three critical dimensions: high threat, short decision time and an element of surprise. In such circumstances, actors might be spurred to jump to a new level of cooperation. In other words, crises represent a "critical juncture" (Calder and Ye, 2004) that can create a window of opportunity for experimentation and policy adaptation (Cohen, 2013: 59).

This principle can be applied to financial crises and the following financial integration. Financial crises are to some degree a collective threat because they tend to be contagious and spread from one country to another. Therefore, countries should fight financial crises collectively and try to shield each other from the fluctuations of international financial markets. Thus, financial integration takes place (Krapohl, 2015: 164).

For these reasons my analysis will focus on the critical moments when crises occur. Therefore, the focus will be mainly on the Asian crisis that started in 1997 and the 2008 global financial crisis. For these crises, I will shortly go into the more general implications of these crises for the region. The main focus however will be on how this affected integration. To see if it is really the crisis that spurred integration and whether this integration is not a temporary measure but sustainable, the period before and after the crises will also be analyzed.

Based on secondary literature, I will focus on three initiatives in particular: the AMF, CMI and CMIM. These three initiatives are often analyzed together, because the CMI and CMIM are seen as following from the failed AMF proposal (Chey, 2009; Cohen, 2013; Rosero and Erten, 2009). Furthermore, all three initiatives are genuinely East Asian, as the US is not included. This is in contrast to for example APEC.

Demand and supply conditions

As mentioned in the theoretical framework, this thesis will look at demand and supply conditions for regional integration. To restate, the hypotheses tested are the following:

H1: the demand condition for East Asian financial integration is that China is highly embedded in the region, and therefore stands to reap important gains from integration, as it protects China from suffering from externalities of financial crises.

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26 H2: the supply condition for East Asian financial integration is that the group is led by China as an undisputed leader, which serves as an institutional focal point and regional paymaster.

H3: a further (weak) supply condition for East Asian financial integration is the existence of monitoring and third-party enforcement.

For the conceptualization of demand conditions, externalities are relevant. Mattli’s demand side argument is that regional institution-building may be viewed as an attempt to internalize externalities that cross borders within a group of countries (Mattli, 1999b: 13).

For the application to financial integration, externalities of financial crises are of great importance. According to Krapohl (2015), whether or not regional powers suffer from the negative externalities of financial crises in their regions depends on their economic and institutional embeddedness within these regions. First, economic embeddedness means the flow of trade and capital (in the form of investments and loans) between the regional states. And second, institutional embeddedness refers to the strength of regional institutions, which indicate commitments of the member states towards common policies. The most important of these institutional linkages is the existence of currency unions, which prevents member states from fighting financial crises with monetary policies and which implies that financial crises in one particular member state destabilize the currencies of all member states (Krapohl, 2015: 165).

As mentioned before, very little progress has been made regarding currency management in East Asia: individual monetary regimes remain very diverse, ranging from currency boards at one extreme to free floating at the other (Cohen, 2013: 41-42). Furthermore, Krapohl (2015) argues that institutional embeddedness within the region is weak (Krapohl, 2015: 166). China and Japan are not members of ASEAN, and even ASEAN’s institutions are weak (Nesadurai, 2008). Lipscy (2003) also argues that institutional linkages are weak within East Asia and do not commit the regional powers China and Japan to regional cooperation (Lipscy, 2003). This has changed very little in the period from 1997 up until now. For these reasons, the focus in this thesis will be on economic embeddedness, not on institutional embeddedness.

For the supply side, the presence of an undisputed leader among the group of countries seeking closer ties is of great importance. This leader serves as an institutional focal point and regional paymaster (Mattli, 1999a: 3-4).

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27 ‘Commitment institutions’ are conceptualized as centralized monitoring and third-party enforcement (Mattli, 1999a: 4).

To operationalize this, I will look for proof that China’s demand and supply are necessary conditions for financial integration in East Asia. For the demand side, I will look at the flow of trade and capital (in the form of investments and loans) between China and the ASEAN+3 countries. In doing this, I will extensively focus on informal networks, as the literature suggest that these are highly relevant for understanding integration in East Asia (Peng, 2002). From the supply perspective, it is important to see how China has shown leadership and for what reasons. Did China serve as an institutional focal point and regional paymaster? Furthermore, I will look into the existence of monitoring and third-party enforcement.

Data collection

I will mostly look at secondary sources. My focus will be on academic literature. Second, I will also look at official statements by ASEAN+3. Finally, I will look at speeches made by Chinese officials. These sources will be about the process of financial integration in East Asia, focusing on the demand and supply conditions mentioned above.

One pitfall of this data collection is the language limitation, as all sources are in English and no Asian language sources are included. This undoubtedly leads to a ‘Western’ bias. My aim is to compensate for this by also using articles that are written in English but have an Asian origin.

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6. Findings

The following sections will look at how this financial integration came into being. The focus here will be on if and how China engaged with this at specific points in time, and for what reasons. In line with the theoretical framework and hypotheses, attention will be paid first of all to the demand condition that China is highly embedded in the region, and therefore stands to reap important gains from integration, as it protects China from suffering from externalities of financial crises. Second, the supply condition is that the group is led only by China, which serves as an institutional focal point and regional paymaster. Third, a further (weak) supply condition integration is the existence of monitoring and third-party enforcement.

6.1 Asian crisis

6.1.1 Prior to the Asian crisis

Prior to the Asian crisis of 1997-1998, integration in East Asia was led mainly by private business, while governments in East Asia showed little interest in regional cooperation. Therefore, regional cooperation in East Asia lagged far behind regional cooperation in the rest of the world (Chey, 2009: 450).

Demand and supply side

How can this lack of integration be explained? The economic embeddedness and therefore the demand for integration in East Asia did not become clear until the Asian crisis, as will become clear later on in this thesis.

For the supply side, a lack of leadership is of great importance. When the first worldwide wave of regionalism took place in the 1950s, there were no regional leaders in East Asia. Both China as a newly emerging state and Japan as a war torn nation concentrated on domestic issues, such as political stability and reconstruction (Park, 2012: 300-301). Therefore, they did not play leading roles in shaping the regional order in Asia. The low degree of regional acceptance of China’s and/or Japan’s leading roles was also of relevance. Some of the smaller neighbors did not accept China as a regional leader due to its role as a forefront of communist revolution from 1949

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29 to the mid-1970s. For Japan, the legacy of World War II and its occupation of many Asian countries allowed it to exercise only “leadership from behind” instead of more visible leadership. The absence of regional leaders caused the emergence of the US hegemonic influence in East Asia (Park, 2012: 300-301).

Although regionalism re-emerged around the globe after the Cold War, East Asia still did not have suitable regional leaders. China did not take a leading position in the region, but opted for bilateral relations with neighboring countries (Park, 2012: 301). China was reluctant to engage in multilateral organizations (Breslin, 2010: 718-719). This was the case for regional arrangements as well, because China’s leaders considered them as representing Western, particularly US interests (Park, 2012: 301). ASEAN was seen as a natural ally of the US and therefore as opposing Chinese interests. Furthermore, China had the occasional military stand-off with regional states over competing territorial claims in the South China Sea (Breslin, 2010: 718-719).

It was perhaps not China but Japan which showed potential as a regional leader, as it had some followers among the ASEAN countries (Park, 2012: 301). Japan’s failure to take a leading role can be explained by several factors, such as its unwillingness to take on the leadership burdens and its relationship with the United States. Moreover, Japan was reluctant to resolve historical tensions with its neighbors (Chey, 2009: 453-454). In short, Japan was an uncommitted leader of East Asian regionalism. Instead of focusing on East Asia, it acted as a proponent of the Asia–Pacific region (Park, 2012: 301).

So while the idea for creating a regional organization embodying the idea of East Asia became more pronounced in the early 1990s, regional leaders were lacking. The regional order in Asia was instead shaped by the US (Chey, 2009: 455). In summary, prior to the Asian crisis the economic embeddedness and therefore the demand for integration in East Asia was not yet clear. The lack of demand, combined with the lack of regional leaders and the influence of the US prevented East Asian integration from occurring.

6.1.2 The Asian crisis

The 1997–1998 Asian financial crisis had a huge impact on East Asia. Several explanations for the crisis exist. In the West, many criticized Asia’s interventionist industrial policies and the political

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30 patronage and close personal connections between politicians, bankers, and business-people (Pempel, 1999). The highly praised “East Asian model” was now all of the sudden seen as the source of the crisis (Peng, 2002: 438). However, Krugman (1999) pointed out that the Asian model worked for many years. According to him, it could not be the fundamental source of the crisis. Instead, he argues that the Asian economies became more vulnerable to the financial panic not because of bad policies, but because of “better” policies according to Western standards—they had opened up their financial markets (Krugman, 1999: 109 –111).

Because of this opening up, many East Asian countries had built up high amounts of short-term external debt which increased their vulnerability to a reversal in capital flows. At the end of 1996 and early 1997 such a reversal in capital flows took place (Krapohl, 2015: 166). The suddenness of the reversal of capital flows had impact on domestic asset prices, exchange rates and output. Two important contributors to the severity of the crisis were asset-liability mismatches in currencies and maturities. Assets were denominated in domestic currency and were long-dated, whereas liabilities were in foreign currencies and had short maturities. These factors combined to create liquidity crunches for the affected countries. Investment rates in the affected countries fell, as did growth and output. Even when growth rates recovered after the crisis, there were permanent output losses (Kaur and Singh, 2014: 5). In short, the financial crisis hit several economies of the region and also had consequences for the region’s real economy. The negative externalities of the crisis also hit Japan, which was not strongly affected by the financial crisis itself (Krapohl, 2015: 166). China was able to sustain investment and growth, having followed policies that were further away from the financial liberalization orthodoxy (Kaur and Singh, 2014: 5).

6.1.3 The failed AMF proposal

At the time of the Asian crisis, the IMF and the US saw the Asian crisis as the result of wrong macroeconomic policies, underdeveloped domestic capital markets and weak national financial regulation. The Asian countries on the other hand, saw the crisis as a result of volatile international capital markets and irrational international investors. Therefore, they envisioned different solutions as well. The IMF deemed a reform of the national financial systems a

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31 necessary condition in order to provide the needed liquidity, while the regional countries expected a fast disbursement without lengthy conditionality negotiations (Dieter, 2005). According to the East Asian countries, the solution as envisioned by the IMF would drive the affected countries deeper into recession (Stiglitz, 2003).

Therefore, Japan wanted to take matters into its own hands. In August 1997, immediately after the outbreak of the Thai financial crisis, Japan initiated Asian regional financial cooperation in the shape of an Asian Monetary Fund (AMF) (Krapohl, 2015: 166-167). Details of the proposal have never been released, but the general contours are known: a regional fund of approximately US$100 billion (50 percent would be provided by Japan) that would provide large-scale liquidity rapidly and without conditions to economies suffering from currency crises (Grimes, 2011a: 86). Japan, China, South Korea, Indonesia, Malaysia, Thailand, the Philippines, Hong Kong, Singapore and Australia were supposed to participate. The AMF proposal was significant because its membership excluded the US and it would not necessarily act in harmony with the IMF. In other words, the AMF proposal was an attempt to build an Asian self-help mechanism (Chey, 2009: 456).

However, the proposal did not make it. Instead, in November 1997, Japan, the US, and 12 other Asia-Pacific countries agreed to create the Manila Framework, a forum for regional economic surveillance and crisis management. According to Chey (2009), the AMF proposal mainly failed because the US strongly opposed it and pushed East Asian countries into accepting the Manila Framework instead of the AMF (Chey, 2009: 458). This Manila framework was not as far reaching as the proposed AMF: the size of the cooperative financing mechanism was only US$20 billion. Furthermore, the mechanism had no institutional components but took the form of a stand-by arrangement. The framework also had no regional orientation, as it included the United States and was subordinated to the IMF (Chey, 2009: 457-458).

Demand side

Which demand factors lead to the initiation and failure of the AMF proposal? Chey (2009) argues that the AMF could have benefited Japan through the quick provision of liquidity for the countries affected by the Asian crisis. Japan had strong economic ties with the affected countries through bank loans, foreign direct investment and trade. A full-blown crisis could have seriously hurt

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32 many of its banks and firms (Chey, 2009: 457). For example, Thailand, where the Asian financial crisis originated, did not only have high outstanding debts to Japan, but Japan was also the largest foreign investor in the country. This was the case for other Southeast Asian countries as well, which made Japan vulnerable to negative externalities of crises within the region (Lipscy, 2003).

China had little demand for regional financial integration as it was far less affected by the Asian crisis than Japan. Thus, Japan was more strongly affected by externalities of the Asian crisis than China and therefore the demand for financial integration was high for Japan but not for China.

Supply side

How can supply factors explain the proposal of the AMF and its failure? When Japan proposed the AMF, it wanted to expand its leadership in the region. Furthermore, Japan had an ideological interest in defending the Asian development model against the IMF’s neoliberal bailout programs (Chey, 2009: 456-457). However, Japanese supply was not enough for the AMF to succeed.

This might have been different if it had received strong support from other regional powers, especially China. China did not support the AMF, because it feared an increase in Japanese regional influence. China perceived the AMF proposal as an attempt by Japan to assume regional leadership and to establish hegemony of the yen in the region. At the time, China was more concerned about Japan becoming powerful than about the US retaining its hegemony in the region. China’s traditional reluctance to participate in multilateral institutions is also relevant. China emphasizes autonomy and independence. In a multilateral settings it could be outvoted and have its bargaining power decreased. Therefore, China maintained a passive approach toward regional cooperation. In these circumstances, Japan made a critical mistake by not consulting with China about the AMF proposal, which raised Chinese suspicion. In addition, the US lobbied China to oppose the plan, by emphasizing the threat of Japanese hegemony. Without Chinese support the AMF proposal could not overcome the strong US opposition (Chey, 2009: 459).

It is likely that the proposal would have made it if China supported it. Japan believed that the US would accept the proposal reluctantly in the face of an Asian consensus, more or less as a fait accompli (Lipscy, 2003: 95). The political costs of not accepting it would have been high for

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33 the US. However, there was no real Asian consensus, as China did not support the AMF. Without Chinese support, the AMF proposal was effectively dead (Lipscy, 2003: 96).

6.1.4 The Chiang Mai Initiative

Despite the failure of the AMF proposal, the dissatisfaction among Asian nations with the international financial structure was such that they did not want to give up on establishing regional financial integration (Rosero and Erten, 2010: 223-224). In December 1997, the ASEAN+3 was founded and ASEAN+3 meetings have become annual events since then (Krapohl, 2015: 167). The Chiang Mai Initiative (CMI) was launched when the ASEAN+3 countries met on the 6th_{of May} 2000 in Chiang Mai, Thailand, at an annual meeting of the Asian Development Bank. The aim of the initiative was to avoid a recurrence of the 1997 Asian crisis (Chan, 2012: 202-203). The two core objectives of the CMI were ‘(i) to address balance of payment and short-term liquidity difficulties in the region and (ii) to supplement the existing international financial arrangements’ like the IMF (ASEAN+3, 2010).

Under the CMI, members of the ASEAN+3 established a system of currency swaps, both bilateral (BSAs) and ASEAN-wide, aimed at providing currency support during speculative attacks. The goal was to increase financial stability in East Asia by providing an additional source of financial assistance to individual countries that faced liquidity crises (versus solvency crises) and were unable to meet financial obligations and control their currency. Under the CMI, countries had prearranged agreements with ASEAN and individual countries which allowed them to swap up to twice their contribution in local currency for foreign currency in times of crisis. This would help them to meet their obligations and stabilize their economies. These short-term, pre-determined arrangements signaled to creditors and potential currency speculators that the local economies were less vulnerable to speculative attacks and exogenous instability (Rosero and Erten, 2010: 223-224). Despite the initial emphasis on a region-wide approach, bilateral agreements had become more prevalent. By the fiscal year 2000, BSAs reached US$35 billion, whereas ASEAN-wide arrangements only reached US$1 billion (Rosero and Erten, 2010: 223-224). The initial amounts of the BSAs were small relative to the amounts likely to be needed in case of a new crisis. However, they were larger than most participants’ IMF quotas, and the agreement provided for them to be disbursed quickly and without negotiated conditions.

China's engagement in East Asian financial integration