CLOSER TIES: People visit a South Korean display at an exhibition of small and medium-sized enterprises in China and South Korea in Guangzhou on September 22

On December 12, the People's Bank of China and the Bank of Korea jointly announced a bilateral currency swap arrangement worth 180 billion yuan ($27 billion), or 38 trillion Korean won. The three-year deal aims to provide liquidity for the financial systems in the two countries and keep their currencies stable.

Setting up such a currency swap was the core of the Chiang Mai Initiative, established in 2000 to encourage bilateral swap agreements between countries in the ASEAN+3--the 10 members of the Association of Southeast Asian Nations plus China, Japan and South Korea. Under these agreements, countries exchange currencies for a limited period of time and then return the original amount.

China and South Korea first signed a $2 billion currency swap agreement in June 2002, increasing the amount to $4 billion when they extended the agreement in 2005. The new agreement not only further increases the amount to about $26 billion, but also allows for direct exchanges between the yuan and won instead of using the U.S. dollar.

The expanded agreement is a response by leaders in both countries who are concerned with maintaining currency stability in an unstable global economy. It also reflects China's growing economic strength and the close economic ties between the two countries.

China is now the world's fourth largest economy, and South Korea the 11th largest. The two neighbors have close trade and economic relations. China is South Korea's biggest trading partner, while South Korea is China's sixth biggest. Their bilateral trade volume in 2007 was about $160 billion. Therefore, as the financial crisis drags down the world economy, the currency swap between the two countries will help improve short-term liquidity conditions in their financial systems, promote bilateral trade and advance their economic development. The two sides can increase demand for each other's export commodities while easing capital shortages and keeping the exchange rate stable.

South Korea understands the current global financial turmoil, having emerged from the 1997 Asian financial crisis with huge national debt. In fall 2008, the country feared a currency crisis as U.S. bonds depreciated, drawing down South Korea's foreign exchange reserve. The reasons for these economic upheavals lie in South Korea's financial system. The South Korean economy relies highly on foreign trade, which accounts for about half of total gross domestic product. Lower international demand thus directly impacts the country's economy. South Korea's financial market has also been too open to foreign investors. In the 1970s, the country attracted foreign banks with preferential policies. By the early 1990s, South Korea had begun to internationalize its financial market. As a result, foreign financial capital and short-term capital were too prevalent in South Korea's foreign investment. In October 2008, the country's foreign exchange reserve was $242.2 billion, but its short-term debt stood at $260.4 billion. A shrinking market and capital flight caused double landslides in the stock exchange and foreign exchange markets, threatening South Korea's financial stability. It is important for China to appreciate these lessons while joining hands with its neighbor to beat the current crisis.

The Chiang Mai Initiative was designed to strengthen financial cooperation and to promote financial mutual reliance and mutual support in the region. Financial mutual reliance mainly requires member economies to support each other when any of them has liquidity problems. In the past, currency exchange agreements always involved the dollar and considered loans the only channel for unilateral exchange, so they had very limited effect. Under the initiative, countries in need of liquidity support could only get enough immediate short-term capital to meet 10 percent of their needs, with the remaining 90 percent provided by organizations like the International Monetary Fund. But these capital rescues left countries exposed to speculation and other economic risks. To protect financial stability in the region, Asian economies have to look after each other. In May 2008, finance ministers from the ASEAN+3 agreed to establish an $80-billion emergency fund for countries low on foreign-exchange reserves.

The mutual reliance mechanism also enhances regional financial monitoring and encourages financial reform. East Asia's export-oriented economic structure has financial pitfalls, because free trade opens the door to free financial systems with all their inherent opportunities and risks. When the international capital market is unstable, Asian financial systems suffer. Therefore, it is important for Asian countries to reinforce their financial systems.

The author is an associate researcher at the China Institute of International Studies