Asian financial architecture today is still standing on the Bretton Woods system established in 1944 to regulate international finance in the aftermath of World War II. Since then, the U.S. dollar has become the preferred currency in cross-border transactions and central bank reserves, and the International Monetary Fund and the World Bank have taken on a central role in ensuring financial stability and promoting economic development in the region.
Asia's share of global gross domestic product has more than doubled since Bretton Woods, but its financial architecture -- network of private and public institutions and their regulatory frameworks -- is not commensurate with its economic development. As the U.S. continues to hold sway over the financial system, there is now a strong impetus for the region to take control over sources and funds for its own development, and to reshape the financial landscape in Asia.
Despite increased trade and financial ties within the region, Asian markets are still much affected by events in the U.S. and in particular, monetary policy decisions taken by the Federal Reserve.
For instance, Indonesia's stock market and exchange rates fell by about 15% over a few months, following comments by Fed chair Janet Yellen on plans to taper off quantitative easing measures introduced in May 2013.
In terms of development funding, the Asian Development Bank, which is co-led by Japan and the U.S., continues to be the primary multinational development bank providing financial assistance to infrastructure projects in Asia.
The China factor
China is the key actor reshaping the financial landscape in Asia today. Despite being the world's largest economy in terms of purchasing power parity, China's voting power in the IMF, the World Bank and the ADB remains low. China only has voting power of 3.81% in the IMF, lower than Japan's 6.23% and France's 4.29%.
While there have been calls to reform the international monetary system since the onset of the global financial crisis, it is only in recent months that we have seen significant challenges to the incumbent financial system in Asia.
The establishment of the Chinese-led Asian Infrastructure Investment Bank in June is a case in point. As the first MDB initiated and led by China, the AIIB seeks to challenge the duopoly of the World Bank and the ADB in financing regional projects.
This is particularly significant as it is the first major MDB with no U.S. involvement. Indeed, many countries such as the U.K. and Germany have joined the AIIB against the wishes of the U.S. With 57 founding members, and China having de facto a veto, it could signal a transition in the leadership of development finance.
There is little doubt that Asia needs development funding. The ADB Institute identified that an annual $750 billion in infrastructure investment is required in Asia from 2010 to 2020. With the establishment of the AIIB and geo-political competition between the U.S. and China, we should expect to see more efficient use of resources in this area of infrastructure funding, which has been a key challenge faced by Asian economies.
In addition, the yuan could emerge as a global reserve currency given it is increasingly used for payments, trade settlements and investments worldwide. Even as the IMF reviews proposals for the yuan's inclusion in its Special Drawing Rights basket, China has come out with more market-oriented initiatives, including plans to liberalize the country's financial system and interest rates. These have been presented to the IMF, which will decide on the new SDR basket at its executive board meeting on Nov. 30.
China also seeks to increase the international use of its currency through other countries such as Singapore. For instance, it was announced in October that Singaporean banks would be allowed to lend to companies in Suzhou and Tianjin, and conversely, that companies in Suzhou and Tianjin would be able to issue yuan-denominated bonds in Singapore. The ASEAN Economic Community -- to be established on Dec. 31 -- would also open the door for China to ASEAN companies.
China's growing influence in the global financial markets is clear. In August, the People's Bank of China surprised many by devaluing its currency in line with market forces. While the move to allow freer trading of the yuan was welcomed by the IMF, the shock devaluation was seen by many as a harbinger of negative economic news.
Stock markets in China fell dramatically, leading to its largest daily loss since the global financial crisis. Furthermore, China's troubles reverberated through stock markets worldwide, making clear that the country is now a bellwether for the global economy. Significantly, the slowdown in China was then cited as one of the reasons for the Fed's decision to hold rates in September.
U.S. influence and the TPP
Notwithstanding China's growing influence, the power of the U.S. to affect regional fortunes cannot be underestimated. The recently concluded Trans-Pacific Partnership agreement could further boost U.S. influence. With 12 countries (Australia, Brunei, Canada, Chile, Japan, Malaysia, Mexico, New Zealand, Peru, Singapore, the U.S. and Vietnam) that account for more than 40% of the world economy, the TPP seeks to address a wide range of issues besides trade matters.
Inevitably, there would be deregulation in capital flows, leading to more cross-border investments among the countries. Consequently, with the TPP's "rule-based system" in place, we would expect the U.S. to continue to exert strong influence in directing investments in the region.
It is indeed an exciting time for Asia as the U.S. and China seek to exert their influence in the region. Given the size of the Chinese economy and its influence on regional trade and investment, the internationalization of the yuan could generate huge efficiency gains by significantly reducing the transaction costs and exchange rate risks incurred through U.S dollar intermediation.
This will promote financial asset holdings within the region, help Asian countries to better integrate with each other, and ultimately lead to the desynchronization of Asia with the rest of the world. Within a rule-based system, a stronger regional leadership of China should be welcomed.
Tomoo Kikuchi is a senior research fellow at the Centre on Asia and Globalisation, Lee Kuan Yew School of Public Policy, and Chua Yeow Hwee is an instructor in the department of economics, National University of Singapore.